March 6, 2017
What Business Leaders Need to Know About Inventory Valuations
What Are Inventory Valuations?
An inventory valuation dictates the value that inventory carries on the balance sheet. The standard under US GAAP for reporting inventory on the balance sheet is the lower of cost or net realizable (market) value. Initially, inventory is priced at cost; however, over time it may decrease in value if expected demand decreases and current prices are no longer viable. In this case, a valuation report may be needed to estimate value.
The valuation of inventory on a cost basis includes all costs associated in production of the good up to the point of having it ready to be sold. The account on the income statement associated with these costs is called cost of goods sold. Costs associated with selling or with administration are not included as these are defined as operating expenses.
The value of inventory directly affects both the balance sheet and income statement. It is important to have the value stated correctly because an error would cause two asset accounts to be incorrect since the inventory at the end of one period becomes beginning inventory on the next. In addition, net income on the income statement and the resulting retained earnings for a given period is affected by a misstatement of inventory.
Which Method Is Best for My Business?
Inventory is always changing; new inventory is being bought and sold, and prices associated in making these goods (products) are continually fluctuating. US GAAP allows for three different methods to account for these cost based assumptions: first-in, first- out (FIFO); Last-in, Last-out (LIFO); and weighted- average. Once a method has been chosen, a company must follow that assumption.
When picking a method for inventory valuation the most important aspect is consistency, whichever method is chosen, it is best to stick to that decision to avoid needing to restate historical financials. Each method affects the income statement a bit differently based on whether the cost of your inventory is rising or falling over time. When inventory cost remains stagnant, the method you pick will have the same impact on the financial statements regardless of which method is used.
First-in, first-out accounting practices state that the oldest inventory is sold first. This is generally the most common practice in business and is accepted under international accounting principles as well as US GAAP. When inventory costs are rising over time, taking a FIFO approach will generate a lower cost of goods sold and higher inventory balances. This will increase the profitability of your business. Weighted-average accounting practices takes the average price of inventory over a period and uses that as a per unit cost. LIFO accounting practices state that the last piece of inventory you purchased is the first piece you sell.
During times of rising costs of inventory, the LIFO method will result in lower account balances and higher costs of goods sold. This will lower the profitability of your company on the financial statements. Note that during times of falling costs of inventory, the opposite results would occur. After considering whether costs are expected to increase or decrease in a given industry, it may also be helpful to try researching the common practices in your given industry to select the best method.
How Do I Know When My Inventory Is Worth Less than My Purchase Price?
In certain instances, inventory may become obsolete and the market for inventory may decline or completely disappear. An example of this is with a company that produces computer chips. As technology advances, older chips either lose value or become obsolete as they are not incorporated into newer models.
To check if your inventory has become impaired, a valuation firm may be engaged to perform a valuation study. The firm will research how the goods are selling in the market currently and conclude to whether the initial cost measurement needs to be adjusted to reflect a lower net realizable value, as driven by the market.