Inventory valuation, also known as Stock valuation, is the company’s resourceful but idle assets at the end of the accounting period. When we talk about inventory, we typically mean a company’s stock-in-trade of raw materials, semifinished goods, finished goods, and spare parts. Inventory valuation is a critical factor in a company’s accounting. Inventory must be counted at the end of the year to arrive at the closing stock.
Inventory Valuation Fundamentals
According to AS 2, there is one fundamental principle for inventory valuation. A company’s inventory should be valued at the lower of cost or net realizable values. So the principle states that we must value the inventory at either its cost or its net realizable value.
Following the conservative cost approach, we will record the inventory at a value that is lower of the two. This is because this is derived from the conservative accounting system, known as AS 2.
Let us now define the terms:
- Cost: The cost of inventory includes the cost of materials purchased. We will add the cost of conversion to this. These are the direct costs of the manufacturing process, such as direct materials and direct labour. Any other costs incurred to bring the inventory to its current condition will be included in this cost. Unusual losses, storage, distribution, and selling expenses will be avoided.
- Net Realizable Value: The estimated cost of a finished good after deducting the costs of sale. In the case of raw materials, it will be the raw materials’ replacement cost, i.e. their market price. and for WIP, it will be the selling price less the conversion cost.
Why Does A Business Need Inventory Valuation?
1. Income Calculation process
We match the cost of goods sold to the direct revenue of an accounting period to calculate the gross profit or loss for the year. The following are the formulasfor calculating the cost of goods sold:
Opening Inventory + Purchases + Direct Expenses – Closing Inventory = COGS
Inventory valuation will have a significant impact on income determination if valuations are overstated or understated, as explained below:
A. Net income for the accounting period will be overstated if closing inventory is overstated.
B. Net income for the accounting period will be understated if the opening inventory is overstated.
C. Net income for the accounting period will be understated if closinginventory is understated.
D. Net income for the accounting period will be overstated if the openinginventory is understated
A company’s income determination is directly impacted by the Inventoryvaluation (closing inventory). Inventory misstatements or miscalculations can cause profits to be overstated or understated.
2. Determining financial position
Inventory is classified as a current asset because the firm does not expect to keep it for an extended period. When it comes to stock, there is a lot of movement. As a result, inventory constitutes a significant portion of a company’s working capital. It is critical to correctly value it so that the current and liquid ratios can be calculated accurately. These ratios are important for determining a company’s liquidity.
3. Analyzing Liquidity
Inventory is classified as a current asset because the firm does not expect to keep it for an extended period of time. When it comes to stock, there is a lot of movement. As a result, inventory constitutes a significant portion of a company’s working capital. It is critical to correctly value it so that the current and liquid ratios can be calculated accurately. These ratios are important for determining a company’s liquidity.
4. Complying with Statutory law
Inventory valuation is not required by the Companies Act of 2013. Accounting Standard (AS2) requires all firms to disclose the valuation of each class of inventory. The disclosure must contain
- Inventory valuation accounting policies adopted
- The total number of inventories, as well as their classifications (raw
materials, WIP, finished goods etc.)
However, simply counting inventory is insufficient; it must also be valued. The proper inventory valuation process aids in determining the value at which inventories will be recorded in the company’s final accounting statements. The proper inventory valuation is required to have an accurate representation of the company’s finances.
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