INVENTORY VALUATION

Inventories generally form one of the largest items in current assets of the companies.
Inventory valuation is crucial to income measurement and inventory management is crucial to financial management.

Meaning
Inventories are assets a) held for sale in the ordinary course of business b) in the process of production or manufacture c) in the form of materials and supplies to be consumed in such process of such production or manufacture. Hence inventories refer to : Finished goods inventory Work in process inventory Raw materials , stores and supplies

Inventory valuation and matching principle According to Matching principle, the expenses during an accounting period should match the income earned during the accounting period. Since goods are continuously bought and sold, the amount of inventories that should be carried forward to the next accounting period should be determined so that the current years revenue is matched with the current years cost of goods sold. Cost of Goods sold = Opening stock + Purchases Closing stock Effect of errors in valuation of inventories. If there is an error in valuation of inventory it will affect not only the current years profits but also the next years profit because the closing stock of current year is the opening stock of next year.

Valuation of Inventory
Cost or Net Realisable value whichever is lower :

Though generally the inventories are valued at cost, sometimes it may be prudent to value it below cost. When the inventory has suffered a reduction in value due to

damage , deterioration, reduction in selling prices, obsolescence

then such loss is recognised by valuing inventory at the lower of cost or net realisable value. Such method may be applied to all items of inventory or similar group of items.

NET REALISABLE VALUE

Net realizable value is generally equal to the selling price of the inventory goods less the selling costs (completion and disposal). In formula: Inventory Sales Value - Estimated Cost of Completion and Disposal = Net Realizable Value Companies need to record the cost of their Ending Inventory at the lower of cost and NRV, to ensure that their inventory and income statement are not overstated. For example at a company's year end, if an unfinished good that already cost $25 is expected to sell for $100 to a customer, but it will take an additional $20 to complete and $10 to advertise to the customer, its NRV will be $100-$20-$10=$70

Inventory Cost
All expenditures incurred to bring the item to its existing condition and location. These apart from the cost will also include: Any freight costs incurred by buyer Cost of insurance for inventory in transit Cost of storing inventory before selling Excise and sales taxes

Valuation of inventories As per generally accepted accounting principles, inventories should be valued at cost. Cost refers to cost of acquisition plus cost of conversion.

Raw materials, Stores, spare parts, consumables etc = cost of acquisition i.e purchase costs including duties and taxes, freight and other expenses directly related to such purchases. Similarly any discounts , rebates on such purchases should be reduced.
Finished goods in case of manufacturing concern = cost of raw materials plus cost of conversion of raw materials into finished goods . It consists of direct expenses like labour costs as well as indirect manufacturing costs like power. Water , fuel, factory rent , factory insurance etc directly attributable to production / manufacturing. Indirect expenses like salaries, office expenses etc. are not included since they are period costs.

Work in process = WIP is valued at cost as above depending upon the stage of completion of labour and overheads which is determined by the production department.

Costing methods : Even though inventories are to be valued at cost , the cost also keeps on changing during the year. It may not be always possible or feasible to link the cots of purchase with the closing stock of goods on hand.The commonly used methods for valuation of inventory at cost are :

FIFO ( First In First Out ) : Here it is assumed that the stock received first is consumed/sold first. Hence the stock at hand at the end of the year is from the latest purchase.
In case of rising prices, this may lead to overvaluation of stocks and overstatement of profits and in case of falling prices this method leads to understatement of stock and profits. LIFO ( Last In First Out ) : Here it is assumed that last units purchased are consumed /sold first .Hence the stock at hand at the end of the year is from the earliest purchases.

In case of falling prices, this may lead to overstatement of stock and profit and in case of rising prices this method leads to understatement of stock and profits.

Weighted Average Cost (WAC) : here the average cost is applied i.e after every purchase an average cost is computed from the cost of purchases and the cost of stock. This method tries to even out the effects of price fluctuations. Specific Identification method : This method determines specific costs for each unit in stock. This method is suitable when the stock is not homogenous, less in quantity and high in value.

Principle of consistency and inventory valuation : If the method of inventory valuation is changed from year to year , the results for two periods becomes incomparable. It will affect the true and fair view of the financial statements. However if a change in method is necessary for better presentation of financial results, it can do so. Hence it is very important to understand a companys policy of inventory valuation while interpreting the financial results.

Adjustment of certain stocks

1. Goods in transit = Goods in transit must be included in stock if it legally belongs to the company. 2. Goods sent on approval basis = Goods sent on approval basis must be included in stock if the customer has not yet approved the same. 3. Goods sent on consignment basis = sometimes goods are sent on consignment basis to an agent, who sells the goods for a commission. In such cases even though the goods may be lying with the agent but legally they belong to the company. Hnece they should be included in the stock.