Evaluation of Inventory Valuation
Evaluation of Inventory Valuation
The true Inventory valuation is very important for showing the true and fair picture of financial statements without which the business will give either over or undervaluation of the financial status of an organisation
which will not be acceptable to the owners,
investors, shareholders, financial institutions, tax authorities or any other
concerned with the company. With the result, the goodwill of the company will
collapse and there will be every chance of failure of the business. Therefore,
the utmost care must be taken to ensure that the valuation of stores is done in
a just and reasonable manner by the qualified accountants.
At the
time of processing of inventory valuation, it must be kept in mind that there
are some types of inventories in which the accounting Standards dealing with
inventory valuation do not apply. These are as follows:
- Direct service contract and work in progress in the construction business.
- Service industries work in progress e.g banks, financial institutions, consulting companies.
- Financial instruments like shares, debentures which are put into the trade.
- The inventories always valued at net realization value like livestock, agriculture and forest products, mineral oil etc.
Before
the valuation of inventory, it is quite necessary to understand what is it?
A) The
inventory includes:
- Finished goods meant for sale in the normal course of business.
- Work in the progress which is under the way of production.
- The raw the material used for production or for rendering services.
B) Net
Realisable Value
The
estimated value of goods or services which could be realised instantly or
within a reasonable period minus estimated selling expenses.
Inventories
Valuation
Inventories
should be valued at production cost or market value, whichever is less. For
example, 100 shirts are produced or purchased @ Rs. 500 each and their
estimated selling price is Rs. 700 each, these inventory of 100 shirts will be
valued @ Rs 500 each i.e Rs. 50,000 (100×500) in the books of accounts.
How
to do Inventory valuation
The right
section of inventory valuation is very complicated because of the cost of
production or cost of purchase and net Realisable value vary from time to time
and place to place which directly affects the profit and loss of an
organisation.
Therefore, to cope up with this problem, the accountants created
certain methods of inventory valuation which are applicable to all industries.
The most common inventory valuation methods are as under:
First In
First Out (FIFO) Method
Under the
first in first out (FIFO) method the goods or services are sold on the basis of
their first acquisition or purchase value. For example, if you produced or
purchased 100 shirts @ Rs. 200 per shirt and next 100 shirts @ Rs. 300 per
shirt and sold 150 shirts @ Rs. 400 per shirt then the cost of shirts sold will
be Rs. 35,000 (100x200 + 50x300), the amount received on shirts sold will be
Rs. 60,000 (150x400). In this sale, the profit will be Rs. 25,000 (Rs.
60,000-3500).
Last In
First Out (LIFO) Method
The LIFO
method is just opposite to the FIFO method. Under the LIFO method inventory
produced or purchased in the last will be sold first. Take the example as given
above in the FIFO method, if you produced or purchased 100 shirts @ Rs.
200 per shirt and next 100 shirts @ Rs. 300 per shirt and sold 150 shirts @ Rs.
400 per shirt then the cost of shirts sold will be Rs. 40,000 (100x300 +
50x200), the amount received on shirts sold will be Rs. 60,000 (150x400). In
this sale the profit is Rs. 20,000 (Rs. 60,000-40,000).
So comparing to both inventory valuation methods (FIFO and LIFO) the profit in
the LIFO method is less than the FIFO method and thereby the profit and tax
liability will also be less as compared to the FIFO method.
The LIFO
method of inventory is accepted only in the US, under Generally Accepted
Accounting Principles (GAAP) rules. This method is not accepted in other
countries where the International Financial Reporting Standards (IFRS) are
applied.
The
average valuation method is the method of inventory valuation under which total
cost of items produced or purchased at different times is divided by the total
number of items produced or purchased. This method is accepted by both GAAP and
IFRS.
Take the example of shirts quoted in both FIFO and LIFO methods above.
you produced or purchased 100 shirts @ Rs. 200 per shirt and next 100 shirts @
Rs. 300 per shirt and sold 150 shirts @ Rs. 400 per shirt then the cost of
shirts sold will be Rs. 37,500 (150x250), the amount received on shirts sold
will be Rs. 60,000 (150x400). In this sale the profit is Rs. 22,500 (Rs.
60,000-37,500).
Since the
inventory prices are supposed to fluctuate from time to time therefore,
weighted average cost also fluctuates. So this method is entirely different
from both the above FIFO and LIFO method of inventory valuation.
Inventory
Management System
There are
two most common inventory management systems, traditional periodical inventory
management system and perpetual inventory management system.
These systems are
not useful for small business because of the laborious physical count of each
and every item of stock in the shop and showroom which needs the big manpower
and time but still used by the business houses.
Traditional
Inventory Management System
Under
this system, the stores are physically counting at the end of each month and a year or any other specified period and reconciled with the purchase and sale
records. In the case of any difference, necessary adjustments are made in the
records.
Perpetual
Inventory Management System
This is
also known as a dynamic inventory management system. it is an alternative of
the traditional inventory management system. This system works with an
automated count of stock.
Under this system when you purchase the stock, the
software automatically counts it and when you sell it will deduct it from the
stock and also give the result that how much money you made in each sale.
Inventory Cost
Inventory cost varies from industry to industry. The goods which are not spoiled
within a short period, their cost will be lesser than the goods spoil in short
period.
Likewise, the stock of hazardous in nature needs more protection in the
storage and also mandatory insurance and therefore, are more expensive than the
normal type of stock.
Thus, the valuation of inventory is subject to
fluctuation and has to be taken into accounts wisely in accordance with
applicable accounting rules and regulations and the government laws and orders.
CONCLUSION
To select the most appropriate inventory valuation method is not so simple and
it is also advisable not to apply a particular method to all industries. The
selection of the appropriate method depends on a number of factors like your
business location, cost of stores and volume of inventory fluctuations.
Though
most of the business adopt the FIFO method because it is most appropriate for
most of the business as it gives the best results but it can not be applied to
all industries. Therefore, for the selection of appropriate inventory valuation
method, the qualified and experienced accountant must be consulted.