Inventory or stock is the resourceful but idle assets lying with the company at the end of the accounting period. It is one of the most significant assets of a company on its balance sheet. So inventory valuation is a very important factor in the accounting of a company. Let us learn more about it.
Significance of Inventory Valuation
When we talk about inventory we usually refer to the stock-in-trade with a company of raw materials, semi-finished goods, finished goods, and spare parts. So at the end of the year inventory has to be counted to get to the closing stock.
However only counting inventory is not enough, it also has to be valued. The process of inventory valuation helps determine the value at which we will record the inventories in the final accounting statements of the company. The correct inventory valuation is essential to have a fair representation of the company’s finances. Let us take a look at the reasons inventory valuation is so important for a company.
1] Helps Determine Income
To calculate the gross profit or loss for the year we match the cost of goods sold to the direct revenue of an accounting period. The formulae for calculating the cost of goods sold is as follows,
COGS = Opening Inventory + Purchases + Direct Expenses – Closing Inventory
Inventory valuation will have a major impact on income determination if valuations are over or understated, this can be explained as:
- When closing inventory is overstated, net income for the accounting period will be overstated.
- When opening inventory is overstated, net income for the accounting period will be understated.
- When closing inventory is understated, net income for the accounting period will be understated.
- When opening inventory is understated, net income for the accounting period will be overstated.
So as you can see inventory valuation (closing inventory) has a direct impact on income determination of a firm. The misstatement or miscalculation of inventory can overstate or understate the profits of the firm.
2] Helps Determine Financial Position
Inventory is not only a part of the Profit and Loss statement but also of the Balance Sheet, Inventories are considered as Current Assets of a firm. So it is very important to have precise and correct inventory valuation. If the calculated value of the inventory is wrong it will represent a wrong financial position on the date of the balance sheet.
3] Liquidity Analysis
Inventory is a current asset because the firm is not expected to hold it for a long period of time. There is a lot of turnovers when it comes to stock. So inventory actually is a significant portion of the working capital of a company. It is important to value it correctly so the current ratio and liquid ratios can be calculated accurately. These ratios are important to check for the liquidity of a company.
4] Statutory Compliance
Inventory valuation is not statutory compliance under the Companies Act 2013. In accordance with the Accounting Standard (AS2), all firms now have to disclose the valuation of each class of inventory. The disclosure must include
- Accounting policies adopted for the inventory valuation
- The total amount of the inventories along with the classifications (raw materials, WIP, finished goods etc.)
Basic Principle of Inventory Valuation
As per the AS 2, there is one basic principle for inventory valuation. Generally, the inventory of a firm should be valued at the lower of cost or net realizable value. This principle comes from the conservative system of accounting.
So the principle basically states that we must value the inventory either at the cost of the inventory or at its net realizable value. We will record it at the lower amount amongst the two in accordance with the conservative cost approach. Now let us understand the terms cost and net realizable value.
- Cost: Cost of the inventory includes the cost of purchase of the materials. To this, we will add the cost of conversion. These will be the direct expenses of the manufacturing process like direct material and direct labor etc. Any other costs to bring the inventory to its current condition will form a part of this cost. Abnormal losses, storage, distribution and selling costs will be avoided.
- Net Realizable Value: This is the estimated price of a finished good after deducting the costs to make the sale. In the case of raw materials, it will be the replacement cost of the raw materials, i.e. their market price. And for WIP it will be the selling price minus the cost of conversion
Solved Question for You
Q: If by mistake the accountant overstates the inventory what effect will it have on the Income Statement?
Ans: The correct valuation of the inventory is very important while preparing the final accounts of the company. The following is the result of overstating the stock
- If we overstate the closing stock the profit will be overstated
- If we overstate the opening stock the profit will be understated