Inventory Valuation

Valuation of inventory is an accounting practice carried out by firms to determine the value at which inventory is carried in the financial statements until the related revenues are recognized. A good grasp of inventory valuation helps to maximize profits. 

Inventory is an asset that includes raw materials, WIP, and goods held available for sale in the ordinary course of business. 

For example, a stationery store would consider pens, pencils, notebooks, staplers, erasers, etc. as its inventory that is available for sale in the ordinary course of business.

As it is an asset for a business, it needs to be recorded at a value on the balance sheet. Once the value of inventory is determined, the inventory turnover ratio of the business can be calculated. This ratio can help strategize purchase budget plans. 

Inventory management is critical in manufacturing industries, especially. A minor inconvenience or bad decision could lead to a halt in the production of units. The inventory cost is mainly influenced by carrying cost, lead or delivery time, and purchase cost.

Carrying costs generally make the inventory costlier. Usually, such storage and warehousing costs are feasible only for large businesses. Small businesses tend to operate smoothly and make more profits with less inventory on hand. 

The amount of time between when the purchase order is placed and when it is delivered to the site is called lead time. Lead time plays a critical role in inventory management. There must be sufficient inventory on hand so that there is no shortage during lead time. 

Inventory also faces the obstacles of depreciation, devaluation, depletion, and obsolescence. In dynamic business environments such as technology and electronics, inventory tends to become obsolete fast. Natural resources deplete and other inventory items are subject to depreciation.

All of these factors help us understand how crucial it is to value inventory as accurately as possible and manage inventory in the best manner possible to reduce costs and operate a business smoothly.

What are the objectives of inventory valuation?

Calculating profit for a period

The gross profit of a firm is the excess of sales over the cost of goods sold (COGS). To determine COGS, inventory valuation is vital as COGS is ascertained by deducting closing inventory and adding opening inventory to purchases. 

Determination of the financial position of firms

Closing stock or inventory is shown as a current asset on the balance sheet, which determines the overall financial position of the firm. Undervaluing or overvaluing the closing stock can change the actual value of the firm's profit.

If the closing stock is understated, it indicates there is less inventory in hand than the actual stock. It will deflate the current year's profit, inflate the profit of the next financial year, and understate the assets and equity. 

Similarly, if the closing stock is overstated it indicates there is more inventory in hand than the actual stock. It inflates the current year's profit, deflates the profit of the next financial year, and overstates the assets and equity.

Under US GAAP, inventory is valued at cost or net asset value (NAV), whichever is lower, if the FIFO method is used. 

Why is It so important to firms?

1. Statutory Compliance

Certain frameworks require companies to disclose the valuation of each class of their inventory. Hence it becomes legal compliance for companies to ascertain inventory value as per the guidelines.

2. Liquidity analysis

The speed at which businesses sell their inventory is a key measure of performance. Generally, inventory is not expected to be held for a long period of time. 

The inventory turnover ratio tells us the number of times inventory has been sold out in a certain time period. A high inventory turnover ratio indicates that the business has good liquidity.

There are some exceptions, however. Some industries have a low inventory turnover ratio, but it is conventional as per their industry norms. Wineries, agricultural production crops, and petroleum refining are some examples.

3. Ascertaining the financial position

The framework within which a company values its inventory directly affects its profitability and its potential net worth. Hence, it becomes vital to value inventory in the best possible manner to arrive at the true financial position of the company.

Top methods of inventory valuation

1. FIFO (First In, First Out)

Under FIFO the inventory first purchased or requisitioned is used or sold first. Hence the inventory purchased first is recognized first. The total value of inventory decreases under this method as and when inventory is sold.

Advantages of FIFO

• The FIFO method helps to avoid obsolescence in a company as the oldest items are sold first and maintain the newest items in chronological order.

• It is the most widely used method of valuing inventory and the most accurate method for positioning the expected cash flow with the actual cash flow of inventory. 

• In situations of market inflation, the use of FIFO will result in the lowest estimate of the cost of goods sold and the highest profit.

An example of FIFO

Company ABC Ltd reported opening an inventory of 500 units for $10 each on January 1. It also made the following purchases in the same quarter:

ABC Ltd sold 800 units on March 25. The expenses would be as follows:

Hence COGS for the sale of 800 units would be $7,000 and the value of inventory would be $10,500 with an inventory level of 200 units.

2. LIFO (Last In, First Out)

Under LIFO the latest inventory purchased or requisitioned is used or sold first. The cost of the most recent inventory is to be treated as an expense under COGS. This leads to the value of inventory comprising the cost of older inventory.

Why is LIFO not preferred often?

• In situations of high inflationary markets, LIFO tends to report lower profits due to high COGS. Hence most companies do not prefer to use the LIFO method to value their inventory as it reduces the net income and earnings per share.

• In addition, LIFO is not permitted to be followed under the framework of IFRS. However, it is allowed under GAAP.

Using LIFO deflates the profits of a company, but it could be advantageous to file large taxes during inflation.

Example of LIFO

Company XYZ Ltd reported an opening inventory of 300 units for $10 on January 1. It made the following purchases in the same quarter:

XYZ Ltd sold 600 units on March 20. The expenses would be as follows:

The COGS for 600 units sold would be $5,400 and the value of inventory would be $2,000 with an inventory level of 200 units.

3. WAC (Weighted Average Cost)

Under WAC, the weighted average cost is used to determine the value of inventory. This method is opted for by companies when the items of inventory are closely interlinked, and a specific cost can't be allotted to the item.

It is essential to compute the weighted average cost to use this method. The weighted average cost is calculated by dividing the cost of goods sold by the number of units available for sale or further use.

Periodic and perpetual inventory systems

Using the WAC method results in different outcomes under periodic and perpetual inventory systems.

• Under a periodic system, the firm does an ending or an occasional inventory count to measure the level of inventory and assign inventory cost. This system is better suited to businesses with low sales volumes. 

• Car dealerships, art galleries, and start-ups are examples of firms that use a periodic system.

• Under a perpetual system, the firm keeps a continuous track of inventory levels and revises the cost of inventory. This method can be expensive hence it is better suited to businesses with high volumes of sales. 

• Supermarkets, manufacturing companies, and pharmaceutical stores are examples of firms that use the perpetual system.

Example of WAC under perpetual and periodic inventory systems

At the beginning of its financial year, January 1, a company reported the opening inventory of 400 units for $100 per unit. Over the first quarter, the company made the following purchases:

It also made the following sales in the same quarter:

Under a periodic inventory system the COGS for goods available for sale will be determined at the end of a specified period, in this case, the first quarter.

For the sale of 550 units in February and March, $121.75 will be assigned as the cost per unit. The remaining units will form part of the value of inventory.

Hence the value of COGS will be $121.75 x 550 units = $ 66,962.5 and the value of inventory at the end of the quarter will be $121.75 x 450 units = $ 54,787.5

Under the perpetual inventory system, the COGS for goods available for sale is determined every time there is a sale. Before the sale of 300 units on February 25, the average would be:

Therefore, the COGS for 300 units sold on February 25 will be $112.33 x 300 units = $33,700 and the value of inventory will be $112.33 x 450 units = $ 50,550.

Before the sale of 250 units on March 16, the average would be:

Hence the COGS for 250 units sold on March 16 will be $125.78 x 250 units = $31,446 and the value of inventory will be $125.78 x 450 units = $ 56,600..

4. SIM (Specific Identification Method)

The valuation method of SIM is used to identify, mark and track every single item of inventory separately from the time it enters the company till it is used or sold. This method is useful when all the items in inventory have different features and prices.

Each item is labeled with its purchase cost or any other additional costs incurred. The businesses which deal with high-value inventory such as vehicles, jewelry, art galleries, or furniture prefer to use SIM to value their inventory.

One drawback of SIM is it requires the capability to easily identify all items of inventory separately and track the costs incurred to produce them. This makes it an expensive and time-consuming method of valuation. 

Example of SIM

Let's imagine a jewelry shop owner has 2,000 pieces of ornaments. Each ornament is unique, has different features, and is made up of different elements. Each ornament is tracked separately and carries different values.

By using SIM as the method of inventory valuation, the owner has detailed information on every component of inventory as compared to any other method such as FIFO, LIFO, or WAC.

FIFO vs. LIFO

FIFO and LIFO are two of the most used methods of inventory valuation. FIFO is based on the assumption that the inventory items first purchased are sold off first, whereas LIFO works the other way around; the latest inventory items bought are sold first.

The method of valuation affects the profitability of the business directly. Hence, it is extremely important to choose the method most appropriate and fit for the business for longevity and to value inventory accurately. 

Which method is better, FIFO or LIFO?

FIFO is generally used most often and is considered the best way to value inventory. It allows less room for errors in accounting and considers inventory first received as the COGS for goods used or sold.

On the other hand, LIFO considers the latest inventory received to calculate the value of inventory. The costs are usually higher than the costs to procure inventory previously. This increases the COGS and could result in cost more in situations of an inflationary market. 

FIFO is more suitable than LIFO during periods of inflation, which is typically the case in almost every economy. Hence most companies prefer to follow FIFO.

GAAP vs. IFRS

GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) are the prime accounting frameworks used widely in the financial world today.

The standards that govern financial reporting and accounting vary from nation to nation. Most companies in the US adopt GAAP whereas most companies in other nations prefer to use IFRS.

How do GAAP and IFRS differ in inventory valuation?

There are many misunderstandings and differences of opinions during the application of GAAP and IFRS, especially with inventory valuation; even though the two frameworks have made endeavors to reduce the inconsistency. 

While firms in most countries follow IFRS, the companies based in the US follow GAAP in their accounting practices. This creates room for confusion and disparities.

1. LIFO

One such dissimilarity is the method of valuation permitted to follow: LIFO. While GAAP permits companies to follow LIFO, the same is prohibited under IFRS.

LIFO tends to deflate the profits and most often does not reflect the actual inventory cost. Hence guidelines under IFRS result in more accurate book figures. 

2. Fixed asset valuation

GAAP requires fixed assets to be valued at historical cost after deducting the accumulated depreciation whereas under IFRS fixed assets are allowed to be revalued. 

Therefore, values under fixed assets may increase with time when IFRS is followed but the same doesn't happen with GAAP.

3. Development costs

Under GAAP, development costs are treated as an expense incurred. However, under IFRS, development costs are capitalized and then amortized over several financial years.

4. Write down reversals

Both frameworks, GAAP and IFRS, require the value of inventory or fixed assets to be written down to the market value when it decreases. However, if the value of inventory increases, the write-down can be reversed under IFRS but not under GAAP. 

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Researched and authored by Sumedha Vasadi | LinkedIn

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