Inventory valuation

An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.

Inventory and financial statements

When ending inventory is incorrect, the following balances of the balance sheet will also be incorrect as a result: merchandise inventory, total assets, and owner's equity.

When ending inventory is incorrect, the cost of merchandise sold and net income will also be incorrect on the income statement.

The inventory accounting involves two major aspects:

• The cost of the purchased or manufactured inventory has to be determined and
• Such cost is retained in the inventory accounts of the company until the product is sold

The following methods are the most commonly used for inventory valuation by companies:

• First-in First-Out (FIFO): the first goods to be sold (cost of sales) are the first goods that were purchased or consumed (cost of production). The ending inventory is formed by the last goods that were purchased and came in at the end to the inventory.
• Last-in First-out (LIFO): the first goods to be sold (cost of sales) are the last goods that were purchased or consumed (cost of production). The ending inventory is formed by the first goods that were purchased and came in at the beginning to the inventory.
• Average Cost: this method requires to calculate the average unit cost of the goods in the beginning inventory plus the purchases made in the period. Based on this average unit cost the cost of sales (production) and the ending inventory of the period are determined.
• Specific Identification: each article sold and each unit that remains in the inventory are individually identified.

Inventory accounting systems

The two most widely used inventory accounting systems are the periodic and the perpetual.

• Perpetual: The perpetual inventory system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out.
• Periodic: In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods sold. Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year.

Inventory costing methods - periodic

The periodic system records only revenue each time a sale is made. In order to determine the cost of goods sold, a physical inventory must be taken. The most commonly used inventory costing methods under a periodic system are:

1. first-in first-out (FIFO),
2. last-in first-out (LIFO), and
3. average cost or weighted average cost.

These methods produce different results because their flow of costs are based upon different assumptions. The FIFO method bases its cost flow on the chronological order purchases are made, while the LIFO method bases it cost flow in a reverse chronological order. The average cost method produces a cost flow based on a weighted average of unit costs.

Inventory costing methods - perpetual

The perpetual inventory system requires that a separate inventory ledger be maintained for each good. Inventory ledgers provide detailed information on purchases, cost of goods sold, and inventory on hand. Each column gives information on quantity, unit cost, and total cost.

The most commonly used inventory costing methods under a perpetual system are

1. first-in first-out (FIFO),
2. last-in first-out (LIFO), and
3. average cost or weighted average cost.

In the FIFO and LIFO method, each purchase record is kept with its purchase prices. Every piece sold is subtracted from each purchase record until no qty is left and the next purchase record is considered. When the average cost method is used, an average unit cost of each good is calculated each time a purchase is made.

The advantages of the perpetual inventory system is a high degree of control, it aids in the management of proper inventory levels, and physical inventories can be easily compared.

Whenever a shortage (i.e. a missing or stolen good) is discovered, the Inventory Shortages account should be debited.

Periodic versus perpetual systems

There are fundamental differences for accounting and reporting merchandise inventory transactions under the periodic and perpetual inventory systems.

To record purchases, the periodic system debits the Purchases account while the perpetual system debits the Merchandise Inventory account.

To record sales, the perpetual system requires an extra entry to debit the Cost of goods sold and credit Merchandise Inventory.

By recording the cost of goods sold for each sale, the perpetual inventory system alleviated the need for adjusting entries and calculation of the goods sold at the end of a financial period, both of which the periodic inventory system requires.

In Perpetual Inventory System there must be actual facts and figures.

Using non-cost methods to value inventory

Under certain circumstances, valuation of inventory based on cost is impractical. If the market price of a good drops below the purchase price, the lower of cost or market method of valuation is recommended. This method allows declines in inventory value to be offset against income of the period. When goods are damaged or obsolete, and can only be sold for below purchase prices, they should be recorded at net realizable value. The net realizable value is the estimated selling price less any expense incurred to dispose of the good.

Methods used to estimate inventory cost

In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost.

Two very popular methods are 1)- retail inventory method, and 2)- gross profit (or gross margin) method. The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory.

The gross profit method uses the previous years average gross profit margin (i.e. sales minus cost of goods sold divided by sales). Current year gross profit is estimated by multiplying current year sales by that gross profit margin, the current year cost of goods sold is estimated by subtracting the gross profit from sales, and the ending inventory is estimated by adding cost of goods sold to goods available for sale.

External links

• Financial Accounting Course
• Comparison of Different Methods