If you own a business, and the process of selling goods is done by your company. So your main accounting objective is that you need to determine the value of your business’s inventory. Because inventories typically account for a large portion of business assets, the way their value can affect a company’s profits, tax liability, and asset value. You can choose any of the many inventory valuation methods for your business, but you have to choose the best approach for your business. Once a company has chosen the inventory valuation method, it can be a bit difficult to change.
# What is Inventory?
Inventory is used for a term that means goods for sale. Inventory includes all products that go into these products, such as raw materials, work-in-progress and finished goods. It is tangible property that is used in the production of goods or services or held for sale in the normal course of business. Inventories are unsold items. These manufactured goods are generally the largest current assets of manufacturing firms, as it represents the most important asset of a business.
# What is Inventory Valuation?
Inventory valuation or stock valuation is an accounting practice that allows companies to identify the true value of inventories at the end of the year. Inventory typically represents a large portion of the assets of any company selling physical goods, so it is important to measure its value in a consistent manner. A clear understanding of inventory valuation can help companies maximize profitability. The main purpose behind the valuation of the inventory is to determine the company’s real income and actual financial position.
# Why is Inventory Valuation Important for Business?
Inventory valuation is important for the following reasons:
- The way the company values its inventory. Because it directly affects the Cost of Goods Sold (COGS), Gross Income, and the monetary value of the inventory at the end of each period.
- In any company when a higher valuation is added to the exhaust inventory, it costs less for the cost of goods sold, and vice versa.
- Inventory valuations have a major impact on a company’s profitability.
- It is also important for companies to choose the inventory valuation method because once they make their decision, they should generally stick to that decision.
- An incorrect inventory valuation done by the company will cause the reported profits to go wrong in two consecutive periods, as the wrong ending balance will be wrong in the first period, and then move to the beginning inventory balance in the next reporting period.
- The IRS (Internal Revenue Service) requires companies to commit to a method during their initial year for filing tax returns, and they must seek permission if they wish to change the method in subsequent years.
# Objectives of Inventory Valuation
Here are 2 Main Objectives of Inventory Valuation:
1. Determination of true income:- Companies require a closing list to determine profits for the accounting period and the matching process to deduct from the cost of goods sold (COGS).
The cost of goods sold is calculated by adjusting the opening and closing stock for the purchase, which is shown as follows:
Cost of goods sold = Opening stock + Purchases – Closing stock.
2.Determination of actual financial position:- Inventory plays an important role in ascertaining the financial position of a business. The inventory is shown as current stock in the balance sheet at the end of the accounting period. This over and undervaluation of the stock will give a misleading picture of the working capital situation and the overall financial condition of the business.
# Inventory Valuation Methods
1. First In First Out (FIFO) Method
The first-in-first-out (FIFO) method is one of the most common methods of inventory valuation, as it is very simple and at the same time very easy to code. It is used to determine the price or cost of goods, finished inventory of goods, and goods sold (COGS). According to this method, previously purchased inventory is sold first. This method applies to salable the goods of the company. According to this method, closing stock consists of inventions that have recently been purchased. During inflation, the FIFO methodology achieves a higher price of end goods, lower cost of goods sold, and a higher gross profit.
2. Last In First Out (LIFO) Method
The purpose of the LIFO method firstly works on the principle beyond the previous one. Under this inventory valuation method, the assumption is that the new inventory is sold first while the old inventory remains in stock. This method is rarely used by businesses because old goods are rarely sold and at the same time they gradually lose their value. This can cause a lot of damage to any business. In this method, the recent cost of goods sold is matched to recent sales revenue, which helps determine actual income, and as a cost-based method, the business receives any inaccurate profit /loss.
3. Weighted Average Cost (WAC) Method
This method is based on the assumption that all goods available for sale are all the same, and the cost of each unit is calculated using the weighted average of the same starting goods to determine the amount sold. The weighted average price method can be effectively used in process industries and can average the effect of price fluctuations.
The formula applied for inventory evaluation by this method is:
Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory
4. Specific Identification
In this method, you can track every item of your company’s inventory from the time it is sold. It is typically used for large items that are easily identifiable and have widely varying characteristics and costs with these features.
# Basic Principle of Inventory Valuation
The main principle of inventory valuation is that if we run according to Accounting Standard-2 then the valuation fact is just a basic principle that is used to value inventory. This simply means that the firm’s inventory value is less net of cost recoverable. It is a theory that arises from some conservative systems regarding accounting. Accordingly, we can consider the net real value or inventory cost on all shares or inventions. The lesser amount is recorded between the two and that too is done according to the conservative accounting approach. This principle is also known as the IFRS (International Financial Reporting Standard) list, known as the valuation process.
# Which Inventory Valuation Method is the Best for Your Business?
It is important for any company to choose the right inventory valuation method as it directly affects the profit margins of the business. Your choice can make a huge difference in the cost of goods sold, net income, and closing inventory. Choosing the right inventory valuation method for your business depends on many factors, such as where your business is based, whether your costs are going up or down, and how much your inventory varies. When it comes to inventory accounting methods, most businesses opt for the FIFO methodology because it gives you the most accurate picture of cost and profitability. But no size in your business is the solution in all situations – so consulting an accounting professional is the best option to find out which method is the best method for your business situation. That is why each method has its advantages and disadvantages. It is best for you that you need to pay attention to changes in your inventory costs by assessing the methods.
Frequently Asked Questions(FAQs)
# How are inventory valuations calculated?
There are several methods for calculating inventory valuation.
- The first method is: First In First Out (FIFO) method- values the list of whether the first inventory purchased is out of date or not.
- The second method is: Last In First Out (LIFO)- method assumes that the most recently received inventory is sold first.
- The third method is: Weighted Average Cost (WAC) -takes the average inventory cost. And last but method is: specific identification -tracks the cost of each inventory item.
# What is included in valuing inventory?
Inventory valuations cover a wide range of costs. These include direct labor and materials, factory overhead, freight-in, handling and import duties, or other taxes paid on a company’s inventory purchases.
# Is the list valued at price or sale price?
Inventory is usually valued on a cost basis. Cost calculations can be complex, depending on the type of business and the inventory valuation method. To determine the total cost of inventory, the company must first determine how much inventory it has at all stages of production. It is necessary to calculate all the materials, labor, and other expenses associated with that list. And for this, a list evaluation method should also be chosen.
# What is the cost of inventory?
The cost of inventory or stock can be defined as the price paid to purchase different materials. Inventory cost can be a big help when it comes to evaluating inventory with the help of average costing methods.
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