When it comes to running a business or a company, inventory is one of the most important parts of it. So, for the students who need to gain some insight into this chapter on inventory valuation, this is definitely the right place to be.
What Is Inventory?
Stock or more commonly known as inventory can be defined as the resourceful and yet idle assets which are left lying with the business or the company even after an accounting period is over. This type of asset is very significant to the company and is supposed to be marked in the balance sheet for sure. When it comes to valuing inventory, there is no doubt that it is a very crucial factor when there is a need for accounting in the company. Hence, students will have to read this chapter really carefully so that they know what it means and what its significance is.
Significance of Inventory Valuation
In case there is a talk about inventory, there is a mention of the stock-in-trade which is done for the raw materials of the company, finished goods, semi-finished goods, and the other spare parts. So, in order to get the closing stock, there is a need to calculate the inventory for sure. However, just the counting of inventory is not enough, it needs to be valued as well. This is known as the method of valuation of closing stock. This particular process helps in determining the particular value at which the inventories will be recorded in the company accounting statements. There are so many other inventory valuation methods that students can get to know about.
We have no doubts about the significance of inventory valuation. However, in order to clear out the concept to the students, we are going to provide the benefits in detail.
1. It Helps In Determining Income
With the help of the average cost method of inventory valuation, there is no doubt that people will be able to calculate the gross profit or the loss that happened that particular year. This in turn helps in further calculating the income. This can be done with a basic formula
COGS = Opening Inventory + Purchases + Direct Expenses – Closing Inventory
Students can further get to know about the average cost method formula from the different notes that are provided to them.
2. It Helps In Ascertaining The Company’s Financial Position
When companies understand the inventory valuation meaning and how to calculate it, they can use the information to determine whether the company is in a strong financial position or a weak one. This can be done with the help of proper inventory valuation in the best way.
More information on the 10 methods of inventory valuation can be found in the chapter.
3. Liquidity Analysis
In other words, inventory can also be considered as a proper current asset since the company or the firm is not really expected to hold that for a very long time period. In such cases, there are a lot of different turnovers when there is a question of the stock. That is why inventory forms a very important part of the company’s working capital. Hence, it is essential that the inventory valuation happens properly so the liquid ratios and the current ratios can be accurately calculated without any hassle. These ratios play a very important role when it comes to checking the liquidity of any particular company.
The Main Principles of Inventory Valuation
If we go according to the AS 2 inventory valuation facts there is just one basic principle that is used in the valuation of inventory. In a general sense, the inventory of the firm is supposed to be valued at a lower net or cost realizable value. This is a principle that is generated from certain conservative systems regarding accounting. According to this principle, we are supposed to value all the stock or inventory either at the net realizable value or the inventory cost. The lower amount is recorded between the two and that too is done according to the conservative accounting approach. This principle is also known as the IFRS Inventory valuation process.
FAQs on Inventory Valuation: Methods and Applications
1. What exactly is inventory valuation?
Inventory valuation is the process of assigning a monetary value to the goods a company has in stock at the end of an accounting period. This value is crucial for calculating the cost of goods sold and is reported as a current asset on the company's balance sheet. A correct valuation ensures that financial statements are accurate.
2. What are the main methods of inventory valuation covered in the CBSE syllabus?
The CBSE Commerce syllabus primarily focuses on three main methods for valuing inventory. These methods determine how the cost of goods sold is calculated. They are:
- First-In, First-Out (FIFO): Assumes the first items purchased are the first ones sold.
- Last-In, First-Out (LIFO): Assumes the last items purchased are the first ones sold.
- Weighted Average Cost (WAC): Uses the weighted average cost of all goods available for sale during the period.
3. Can you explain the FIFO method with a simple example?
Certainly. Imagine a store buys 10 pens at ₹5 each on Monday, and another 10 pens at ₹7 each on Tuesday. If the store sells 12 pens on Wednesday, the FIFO method assumes the first 10 pens (from Monday) and 2 pens (from Tuesday) were sold. The cost of the sold pens would be (10 x ₹5) + (2 x ₹7) = ₹64. The remaining 8 pens in inventory would be valued at ₹7 each.
4. How is the LIFO method different from FIFO?
The main difference lies in the assumption of which goods are sold first. FIFO assumes the oldest inventory is sold first, which often matches the actual physical flow of goods. LIFO assumes the newest inventory is sold first. This choice significantly impacts the cost of goods sold and reported profit, especially when prices are rising or falling.
5. How does the choice between FIFO and LIFO affect a company's profit during a period of rising prices?
During a period of rising prices (inflation), the choice has a direct impact on profit.
- Using FIFO, the older, cheaper inventory is considered sold, resulting in a lower cost of goods sold and therefore a higher reported profit.
- Using LIFO, the newer, more expensive inventory is considered sold, leading to a higher cost of goods sold and a lower reported profit.
6. What does the accounting principle 'cost or net realisable value, whichever is lower' mean for inventory?
This is a fundamental rule of accounting conservatism. It means you must value your inventory at either its original purchase cost or its Net Realisable Value (NRV), whichever amount is less. NRV is the estimated selling price minus any costs to complete and sell the goods. This principle ensures that assets are not overstated on the balance sheet and potential losses are recognised early.
7. Which inventory valuation method is permitted for use in India?
In India, as per Accounting Standard 2 (AS-2), companies are permitted to use the FIFO and Weighted Average methods for inventory valuation. The LIFO method is not permitted for financial reporting. This is done to ensure better comparability between the financial statements of different companies and to more accurately reflect the typical physical flow of goods.
