Question

Explain why inventory valuation is such a controversial area and how it impacts the financial statements. Describe two ways in which closing inventory values can be manipulated to smooth profitability. Explain which key performance measures / ratios are affected by inventory valuation and why.

Answer 1

There are multiple valuation methods recognized which can be used for the valuation of inventory. The most two commons are LIFO and FIFO. Inventory valuation is controversial because the wrong inventory valuation leads to wrong profit and losses because of wrong calculation of COGS and can affect current assets.

Two ways in which closing inventory values can be manipulated to smooth profitability.:

1. If a business uses FIFO when prices are rising and inventories are also rising, COGS would be low and net income would be higher.

2. LIFO will have higher COGS and would be more representative of the current economic reality. Hence, profitability will be more accurate, making it a better indicator for forecasting.

Key performance measures/ratios affected by inventory valuation are:

1. Inventory Turnover Ratio is calculated by dividing sales by inventory. The wrong valuation of inventory will lead to wrong ratio calculation. In case of lower inventory levels, the ratio would be high and vice versa.

2. Average Days to Sell Inventory

The Average Days to Sell Inventory is a measure of how long it takes a company to buy or create inventory and turn it into a sale. Average Days to Sell Inventory is calculated as (Inventory divided by Cost of Sales) multiplied by the number of days in the year.

The Average Days to Sell Inventory ratio alerts the business owner to how long on average, in days, it takes to sell each item of inventory. Wrong calculation of inventory will lead to wrong calculation.