Inventory valuation
/How to Value Inventory
Inventory valuation is the cost associated with an entity's inventory at the end of a reporting period. It forms a key part of the cost of goods sold calculation, and can also be used as collateral for loans. This valuation appears as a current asset on the entity's balance sheet. The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported into the proper place for sale. Do not add any administrative or selling costs to the cost of inventory. The costs that can be included in an inventory valuation are direct labor, direct materials, factory overhead, freight in, handling fees, and import duties.
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Why Inventory Valuation is Important
Inventory valuation is important for the reasons noted below.
Impact on the Cost of Goods Sold
When a higher valuation is recorded for ending inventory, this leaves less expense to be charged to the cost of goods sold, and vice versa. Thus, inventory valuation has a major impact on reported profit levels.
Impact on Multiple Periods
An incorrect inventory valuation will cause the reported profits in two consecutive periods to be incorrect, because the incorrect ending balance in the first period will be wrong, and it then carries over into the beginning inventory balance in the next reporting period.
Impact on Loan Ratios
If an entity has been issued a loan by a lender, the agreement may include a restriction on the allowable proportions of current assets to current liabilities. If the entity cannot meet the target ratio, the lender can call the loan. Since inventory is frequently the largest component of this current ratio, the inventory valuation can be critical.
Impact on Income Taxes
The choice of cost-flow method used can alter the amount of income taxes paid. The LIFO method is commonly used in periods of rising prices to reduce income taxes paid.
The Lower of Cost or Market Rule
Under the lower of cost or market rule, you may be required to reduce the inventory valuation to the market value of the inventory, if it is lower than the recorded cost of the inventory. There are also some very limited circumstances where you are allowed under international financial reporting standards to record the cost of inventory at its market value, irrespective of the cost to produce it (generally limited to agricultural produce).
Additional factors to consider when applying the LCM rule are as follows:
Analysis by category. The LCM rule is normally applied to a specific inventory item, but it can be applied to entire inventory categories. In the latter case, an LCM adjustment can be avoided if there is a balance within an inventory category of items having market below cost and in excess of cost.
Hedges. If inventory is being hedged by a fair value hedge, add the effects of the hedge to the cost of the inventory, which frequently eliminates the need for an LCM adjustment.
Last in, first out layer recovery. A write-down to the lower of cost or market can be avoided in an interim period if there is substantial evidence that inventory amounts will be restored by year end, thereby avoiding recognition of an earlier inventory layer.
Raw materials. Do not write down the cost of raw materials if the finished goods in which they are used are expected to sell either at or above their costs.
Recovery. A write-down to the lower of cost or market can be avoided if there is substantial evidence that market prices will increase before the inventory is sold.
Sales incentives. If there are unexpired sales incentives that will result in a loss on the sale of a specific item, this is a strong indicator that there may be an LCM problem with that item.
Inventory Valuation Methods
When assigning costs to inventory, one should adopt and consistently use a cost-flow assumption regarding how inventory flows through the entity. Examples of cost-flow are noted below. Whichever method chosen will affect the inventory valuation recorded at the end of the reporting period.
Specific Identification Method
The specific identification method is used when you want to track the specific cost of individual items of inventory. It is most commonly used when each inventory item is unique, such as in an art gallery.
First In, First Out Method
The first in, first out method is used when the first items to enter the inventory are the first ones to be used. This means that the costs of the oldest items in the inventory records are charged to the cost of goods sold first. In a period of price inflation, this means that the cost of goods sold tends to be somewhat low, resulting in higher reporting profits and more income taxes.
Last In, First Out Method
The last in, first out method is used when the last items to enter the inventory are the first ones to be used. This implies that the oldest items are kept in stock, which is not likely. However, it is frequently used because it charges the most recent costs to the cost of goods sold; in a period of price inflation, this tends to reduce profits and therefore the amount of income taxes to be paid.
Weighted Average Method
The weighted average method applies an average of the costs in inventory to the cost of goods sold. This means that the cost of goods sold will be neither excessively high nor low in a period of price inflation, making this method representative of the actual cost of the items stored in inventory.