Inventory Valuation

 Definition of Inventory
“Inventory generally refers to stock or stock in trade”.
In trading concern
It refers to goods meant for resale or unsold goods.
In manufacturing concern
It includes items such as raw materials, semi-finished goods, and finished goods.

 Definition of Inventory Valuation

“Inventory valuation is an accounting practice that is followed by companies to
find out the value of unsold inventory stock at the time they are preparing their
financial statements”.

 Cause of Valuating Inventory

The inventory valuation is done at the end of each financial year in order to assess
the operating performance (i.e., to find out profit or loss) and the financial
position of the business (along with others of the business through the balance
sheet).

 Inventory Valuation Methods

There are three methods for inventory valuation:
i. FIFO (First In, First Out)
ii. LIFO (Last In, First Out)
iii. WAC (Weighted Average Cost)
  FIFO Method
First-In, First-Out (FIFO) is one of the methods commonly
used to estimate the value of inventory on hand at the end
of an accounting period and the cost of goods sold during
the period. This method assumes that inventory purchased
or manufactured first is sold first and newer inventory
remains unsold. In FIFO, you assume that the first items
purchased are the first to leave the warehouse
“Items bought first will be sold first”

 Advantages of FIFO Methods

The first in first out (FIFO) method of inventory valuation has the following
advantages for business organization:
i. FIFO method saves money and time in calculating the exact cost of the
inventory being sold because the cost will depend upon the most former cash
flows of purchases to be used first.
ii. It is a simple concept which is easy to understand. Even a layman can grab the
idea with little explanation
iii. It is a widely used and accepted approach of valuation which increases its
comparability and consistency.
iv. It makes manipulation of the income reported in financial statements difficult.

 Disadvantages of FIFO Method

The major disadvantages of using a FIFO inventory valuation method are given
below:
i. One of the biggest disadvantage of FIFO approach of valuation for
inventory/stock is that in the times of inflation it results in higher profits which
creates misleading financial statements.
ii. Inflated margins resulting from FIFO accounting can result in substantially
higher income taxes.
 LIFO Method
“An accounting method for inventory and cost of sales in which the last items
produced or purchased are assumed to be sold first; allows business owner to
value inventory at the less expensive cost of the older inventory; typically used
during times of high inflation”
In LIFO, more expensive inventory is expensed before
less expensive inventory effectively lowering profits
and taxable income. This is why most companies
choose to use LIFO vs FIFO for valuing their inventory.

“Items bought last will be sold first”

 Advantages of LIFO Method

The employment of LIFO is very common among
companies worldwide because of the following
benefits:
i. Tax benefits and improvement in cash flows
ii. LIFO minimizes write-downs to market
iii. Physical flow of inventory

 Disadvantages of LIFO Method

The major drawbacks of using LIFO as inventory costing method are given below:
i. The LIFO method reduces reported earnings during the periods of inflation.
ii. Under LIFO method, the balance sheet inventory figure is usually understated
because it is based on the oldest costs. Due to understatement of inventory,
the working capital position may look worse.
iii. A company using last-in, first-out (LIFO) method can easily manipulate its
reported earnings for a period by changing its purchase pattern at the end of
the year.
iv. IFRS does not recommend the use of LIFO method

 WAC Method

In accounting, the Weighted Average Cost

(WAC) method of inventory valuation uses a
weighted average to determine the amount
that goes into COGS (Cost of goods sold) and
inventory. The weighted average cost method
divides the cost of goods available for sale by
the number of units available for sale. The
WAC method is permitted under both GAAP
(Generally accepted accounting principles) and
IFRS (International Financial Reporting
Standards) accounting.

 Benefits of WAC Method

Benefits of weighted average costing method are as under:
i. The weighted average method minimizes the effect of unusual high and-low
material prices.
ii. The weighted average method is practical and suitable for charging cost of
material used to production.
  Disadvantages of WAC Method
i. It does not match recent costs with current revenue, as well as LIFO, does.
ii. It does not produce an ending inventory amount that contains costs as recent
as those included under.

Difference between Periodic and Perpetual Inventory

System

 Definition of Periodic Inventory System

It is defined as
“The periodic inventory system is a method of inventory valuation for financial
reporting purposes in which a physical count of the inventory is performed at
specific intervals”.
Under the periodic inventory system, a company will not know its unit inventory
levels nor COGS until the physical count process is complete.

 Definition of Perpetual Inventory System

It is defined as
“Perpetual inventory is a method of accounting for inventory that records the sale
or purchase of inventory immediately through the use of computerized point-of-
sale systems”.

 Comparison
The following are the major differences between perpetual and periodic inventory
system:
 Basic Perpetual Inventory Periodic Inventory
System System

Meaning The inventory system in Periodic Inventory

which there is real time System tracks the detail
recording of the receipts of inventory movement
and issues of inventory is at periodic intervals.
known as Perpetual
Inventory System.

Basis The Perpetual Inventory Periodic Inventory

System is based on book System, takes physical
records verification as its base

Updations In Perpetual Inventory In Periodic Inventory

System the records are System the records are
updated continuously, updated after a short
i.e. as the stock duration.
transaction takes place.

Information About In Perpetual Inventory The Periodic Inventory

System, real-time System provides
information about information about
Inventory and Cost of Inventory and Cost of
sales is provided goods sold.

Balancing Figure In Perpetual Inventory In Periodic Inventory

System, the loss of goods System the same is
is included in closing included in Cost of Goods
inventory Sold.

 Conclusion
 The Periodic Inventory System is less costly than the Perpetual
Inventory System, but it gives more accurate information because ongoing
recording and timely verification of inventory are done.
The financial statements are also prepared quickly as the inventory records are
maintained properly in the Perpetual Inventory System, which is not possible in
case of Periodic Inventory System.
The Perpetual Inventory System is best suited for big enterprises while small
businesses can go for Periodic Inventory System.