inventory Valuation is an important part of the financial closing process at the end. The value of closing inventory thus determined is used to calculate the Cost of Goods sold/ Consumed during the period and further this value also becomes the part balance sheet as value of inventory at balance sheet date.
Inventory VALUation and Balance Sheet.
Inventory makes the second largest item of the balance sheet in a manufacturing business after the property, plant and equipment and can be the largest item in retail businesses. In order to present a true and fair view of the business affairs it is very important that inventories are valued appropriately. Over or undervalued inventory may result in misleading decisions by the stakeholder, especially if the decisions are based on the figures presented in the financial Statement of the company.
The valuation of inventory becomes more complicated in times when rates of the goods are fluctuating more frequently. During such times what shall be the rate at which inventory shall be valued?. Shall we value the inventory at the rate the goods were purchased or shall we value this at the rates on which inventory is being issued.
Inventory VALUation & Profit and Loss Statement.
Practically, the value of inventory keeps fluctuating throughout the year. The price of raw material purchased in July may be different from the same material if purchased in December. And it is highly likely that the closing stock at year end will have the items from both lots purchased in July and December. So what shall be the value of closing stock at period end? Shall this be valued at the price of the latest batch to reflect the current prices?
Further each type of Inventory has different characteristics and therefore can be valued differently. For example it is easier to value spare parts at the exact price at which these were bought by writing down the price at its packing, however what about the raw materials which comes in liquid or weighted as such items get mixed and it is impossible to differentiate between old and new stock.
These are a few examples of the challenges faced while valuing the inventory. To address these challenges it is very important that you are aware of all the valuation methods used.
Factors affecting the selection of valuation methods
The selected method for valuing inventory shall reflect the true and fair view of business activities and shall be in accordance to the nature of inventory. Further the selected method shall be applied consistently and if there are very strong reasons to change the method, then this shall be comprehensively disclosed in the notes to Financial Statements along with the effects on profit if this change in method has not occurred.
However, factor which are usually considered while selecting/ changing a particular method of inventory valuation are;
1. Lack of knowledge- Businesses may have been using a particular method of valuing inventory as the staff may not be aware or have knowledge that inventories could have been valued by any other method.
2. Convenience- The method already selected may have been the easiest method to calculate the inventory. For example, the AVCO is considered as the easiest method among all and widely used to value inventory.
3. Custom in Industry- Sometime the method selected is chosen as it is being used across all the industry and has become a custom to use this method in industry.
4. To save the Tax- FIFO method results in higher COGS thus lower profitability & taxation and lower closing stock during the periods when prices are falling. Companies in order to save the tax may change the valuation method.
5. Directors Remuneration- In larger organizations directors are usually rewarded based on profitability of the company. Directors, in self-interest may change the valuation method to manipulate the result and earn higher rewards.
The most common methods of valuing inventory can be divided into two broad categories i.e.
Both categories are explained in detail in the next pages.
