Valuation of Inventories

Valuation of inventories is carried out to determine the value of excess inventory accumulation at the business site during the preparation of financial statements. Inventory requires having financial substance so that it can be documented in the financial reports of the company. The financial value of inventory aids in knowing about the inventory turnover ratio and also supports the management for the sake of planning about buying or purchasing decisions.

Accounting Standards (AS-2) are the guidelines specified by the government that facilitate the identification of the value of stock involving the determination of inventory of cost and any documented form of that to net realizable amount. For example, in order to prepare the financials for a company that sells ready-to-wear clothing, the financial worth of the stock that remains unsold at the end of the year must be determined and reflected in the balance sheet.

Importance of Stock valuation

 Valuation of inventory is crucial. Below are some reasons to know the importance of stock valuation or valuation of inventory:

Assessing the company’s financial situation: In order to find out the exact financial position of the company, inventories are required to be valued accurately because it is part of important financial disclosures, i.e., profit and loss account, balance sheet.

Liquidity ratio: For identifying liquidity ratio and stock turnover ratio, the company’s inventory plays a great role. Both ratios are required to be within the upper range.

Gross Profit Identification: The profit for the time will be inaccurate if the inventory is valued incorrectly. Inaccurate earnings for the subsequent reporting period will result from incorrectly valued closing inventory being carried over as opening inventory.

Legal Adherence: Information such as the accounting criteria used for inventory valuation, the book value of inventories, whether inventory should be recognized as an expense, and the write-down and reversal of write-down of inventories must be disclosed by the company in order to comply with accounting standards for stock valuation.

Stock Valuation Methods

Three commonly used techniques exist for inventory valuation:

First in First Out (FIFO):

It is the most widely utilized, straightforward, and uncomplicated technique of inventory valuation that businesses employ. This approach requires that the first inventory purchased be sold first. The most recent assets acquired are matched with the assets that are still in stock.

The FIFO approach results in a larger gross profit, a cheaper cost of goods sold, and a higher closing inventory value during inflation. Nevertheless, this approach does not provide tax benefits, and it does not accurately represent inventory costs in the event of a sharp price increase.

Last in First Out (LIFO):

The foundation of this approach is the principle that merchandise that is bought last will be sold first. Because older stocks are seldom traded and progressively lose value, causing a large loss for the company, this strategy is rarely employed by businesses.

LIFO should only be used when management anticipates that inventory costs will rise over time and cause price inflation. Businesses can reduce their stated profit levels by shifting expensive inventory to the cost of goods sold. Businesses are able to pay less in taxes as a result.

Weighted Average Cost (WAC):

The average of all inventory costs is used in this procedure. It is mostly applied to related inventory items. Because it eliminates the need to track the cost of individual inventory purchases for determining profit and tax liability, it can simplify the cost of inventory. WAC also has the benefit of minimizing profit swings brought on the purchasing and selling periods. The weighted average cost per unit is determined using the following formula:

           Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory

Questions to Understand your ability

Q1.) Why do businesses bother with inventory valuation?

a) To figure out how much they can make in profit

b) To get a true picture of their financial health

c) To set the selling price of their products

d) To cut down on the cost of goods sold

Q2.) Which method says the first stuff you buy is the first stuff you sell?

a) Last in First Out (LIFO)

b) Weighted Average Cost (WAC)

c) First in First Out (FIFO)

d) Net Realizable Value (NRV)

Q3.) Which method is almost never used because it could lead to big losses?

a) FIFO

b) LIFO

c) WAC

d) None of the above

Q4.) What’s a downside of using FIFO during inflation?

a) You end up with a smaller profit

b) It won’t help with taxes

c) The cost of goods sold goes up

d) The ending inventory value gets messed up

Q5.) How does the Weighted Average Cost method work?

a) It uses the latest purchase prices

b) It takes the average of all inventory costs

c) It uses the first unit price only

d) It ignores the cost of each purchase

Conclusion

In conclusion, inventory valuation is a critical process that helps businesses determine the true financial value of their stock. It plays a key role in financial reporting, assessing company performance, and ensuring legal compliance. With methods like FIFO, LIFO, and WAC, businesses can choose the best approach based on their needs, each offering distinct advantages and limitations. Accurate stock valuation ultimately supports informed decision-making and better financial management.