Valuation of Inventories is done to find out the value of unsold inventory stockpiling at the Company’s premises at the time of preparation of financial statements. Inventory needs to have a financial value so that the same can be recorded in financials of the organization. This value helps in determining the inventory turnover ratio and also helps the management in planning purchasing or procurement decisions. Accounting standards (AS-2) are set by the government which helps in the determination of the value of stock including the ascertainment of cost of inventories and any write-down thereof to net realizable value. For example, for preparation of financials for an organization which deals in ready-to-wear garments, it is necessary to calculate the financial value of the stock left unsold at the end of the year so that the same can be recorded in the balance sheet.
Importance of Stock valuation
Valuation of inventory is important because of the following reasons:
- Determining the financial position of the Company: In order to assess the correct financial position of the Company, inventories should be correctly valued as it forms part of both the profit and loss account and Balance sheet.
- Liquidity ratio: Inventory helps in determining the Liquidity ratio of the Company and the stock turnover ratio of the company should be on higher side.
- Gross Profit determination: Incorrect inventory valuation will result in incorrect profit for the period. As wrong valued closing inventory will be carried over as opening inventory in the next reporting period leading to incorrect profits for that period also.
- Legal Compliance: Accounting standards for stock valuation require the company to disclose information such as the accounting criteria used for the valuation of inventories, the book value of inventories, Inventory to be recognized as an expense, and their write-down and reversal of write-down which in turn requires for the organization to value their inventories.
Stock Valuation Methods
There are three methods widely used for valuing inventories:
1. First in First Out (FIFO):
It is the most common, simple, and easy method of inventory valuation used by companies. Under this method, the inventory bought first must be sold first. Assets remaining in inventory are matched with the most recently purchased assets.
During inflation, the FIFO method produces a higher value of the closing inventory, a lower cost of goods sold, and a higher gross profit. However, this model does not offer tax advantages and they also fail to present an accurate depiction of the costs of the inventory when there is a rapid increase in prices.
2. Last in First Out (LIFO):
This method is based on the rule that inventory purchased last shall be sold first. This method is rarely used by companies because older stocks are rarely sold and gradually lose value which results in significant loss for the Company.
The only reason to use LIFO is when management expects the inventory cost to increase over time and lead to price inflation. By moving high-cost inventories to the cost of goods sold, the reported profit levels of businesses can be lowered. This allows businesses to pay less tax.
3. Weighted Average Cost (WAC):
This method uses an average of all inventory costs. It is mainly used when inventory items are similar. It can simplify the cost of inventory because it avoids having to track the cost of separate inventory purchases when calculating profit and tax liability. The other advantage of WAC is that it reduces profit fluctuations due to buying and selling times. The formula used to calculate the weighted average cost per unit is:
Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory
The management should choose the right valuation method, as it has a direct impact on the profit margin of the organizations. All the methods have their own advantages and disadvantages like LIFO method will give you the lowest profit because the last stock items purchased are expensive while the FIFO will give you the highest profit as the first items in stock are cheapest. Each method should be analyzed deeply by the management before applying it to any business. The Generally Accepted Accounting Principles accept both FIFO and LIFO methods.