Question

7. What is inventory valuation? How does inventory valuation impact the business? Explain the different methods of inventory valuation.

500-600 words please.

Answer 1

Inventory valuation refers to valuation of closing stock in hand which is reflected in Balance Sheet under assets.

Inventory valuation is important because under or over statement can lead to difference in profits.

We all know, closing stock is shown under credit side in Profit and Loss account which is then used to calculate the Profit for the year. Overstatement of closing stock will lead to increase in profit. Similarly, understatement of closing stock will lead decrease in profit.

Such adjustments can be done in order to increase or decrease profit as per need of the user. Hence, inventory valuation is important. Also, inventory is shown under assets in Balance Sheet. Balance Sheet is used for various uses including ratio calcualtion.

Inventory being current asset affects lots of ratio. Hence, inventory valuation is important.

Inventory valuation is therefore done by independent third party. Stock actually available and shown should be same and should match. Also, the value at which it is being reflected should also be correct. Hence, stock audits are conducted.

Inventory valuation is also important for calculation of cost of goods sold. Such calculation is then used to calculate the Gross Profit. Financial position of business can only be determined after such calculation.

Inventory valuation is also important for working capital calculation.

Methods of inventory valuation -

1) Specific Identification

Under this method, every item is specifically identified and RFID tags are put. Such inventory when sold is reduced from stock. This helps in identification of which stock is sold and which is not. This method is useful where individual identification is important and goods are not identical. This method is rarely followed by day to day traders. Only followed for high value goods. Eg - Diamonds, etc.

2) FIFO (FIRST IN FIRST OUT)

Under this method it is assumed that goods that are received first will be sold first. This is most common method of valuation. This method gives proper valuation of stock and profit. As inflation increases over a period of time, goods that are received latest have higher value than goods received first. Hence, closing stock has higher valuation under this method. Followed where identical goods in large quantity are kept.

3) LIFO (LAST IN FIRST OUT)

This method is opposite to FIFO. This method follows the rule that goods that received latest will be sold first and inventory will be of earlier goods. Closing stock value is lower under this method as higher value goods are sold. This method is rarely followed and also not allowed by Accounting Principles. This method is used where identical goods are kept. Due to Lowe CV losing stock valuation, Profit is lower under this method.

4) Weighted Average

Under this method, the goods are valued at weighted average. Goods received first and goods received in next lot, together cost is combined and divided by number of units. Such cost is weighted average cost for all goods. Possible for identical goods. Weighted average cost will be different for different goods. This method is also allowed by Accounting Principles. One of the most common methods followed along with FIFO method.