Inventory valuation is the cost associated with an entity's inventory at the end of a reporting period. It forms a key part of the cost of goods sold calculation, and can also be used as collateral for loans. This valuation appears as a current asset on the entity's balance sheet. The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported into the proper place for sale. You are not allowed to add any administrative or selling costs to the cost of inventory. The costs that can be included in an inventory valuation are:
- Direct labor
- Direct materials
- Import duties
- Production overhead
It is also possible under the lower of cost or market rule that you may be required to reduce the inventory valuation to the market value of the inventory, if it is lower than the recorded cost of the inventory. There are also some very limited circumstances where you are allowed under international financial reporting standards to record the cost of inventory at its market value, irrespective of the cost to produce it (which is generally limited to agricultural produce).
Inventory Valuation Methods
When assigning costs to inventory, one should adopt and consistently use a cost-flow assumption regarding how inventory flows through the entity. Examples of cost-flow are:
- The specific identification method, where you track the specific cost of individual items of inventory
- The first in, first out method, where you assume that the first items to enter the inventory are the first ones to be used
- The last in, first out method, where you assume that the last items to enter the inventory are the first ones to be used
- The weighted average method, where an average of the costs in the inventory is used in the cost of goods sold
Whichever method you choose will affect the inventory valuation recorded at the end of the accounting period.
Inventory valuation is important for the following reasons:
- Impact on cost of goods sold. If you record a higher valuation in ending inventory, this leaves less expense to be charged to the cost of goods sold, and vice versa. Thus, inventory valuation has a major impact on reported profit levels.
- Loan ratios. If an entity has been issued a loan by a lender, the agreement may include a restriction on the allowable proportions of current assets to current liabilities. If the entity cannot meet the target ratio, the lender can call the loan. Since inventory is frequently the largest component of this current ratio, the inventory valuation can be critical.
- Income taxes. The choice of cost-flow method used can increase or reduce the amount of income taxes paid. The LIFO method is commonly used in periods of rising prices to reduce income taxes paid.