Every company seeks ways to enhance its profitability and business performance. On the way to achieving business goals like these, there have to be some strategic grounds where the management will make informed decisions. Information about every single asset of your business can help your cause, and that is why companies should not overlook inventory valuation. The process enables the management to assign values to different assets, ultimately helping the business determine profitability. This article will cover what this valuation is and why it is important. Keep reading to learn more!
What is inventory valuation?
Inventory valuation refers to the process where the management assigns some monitory value to a business's inventory at the end of an accounting period. The valuation is based on the cost incurred to acquire that inventory. Businesses should place a considerable emphasis here since it provides exact estimations, which are utilized to make strategic business decisions.
The valuation is also necessary to make sound financial statements. Inventory and stock are considered the most eminent resource of the company and hence should be valued accurately. At the end of an accounting period, the stock that remains unused should be valued accurately by the management.
How is inventory valued?
There are various methods of inventory valuation. Businesses use the one that suit their financial framework and end needs. The technique for valuing inventory relies upon how the business follows the stock over the long run. The decision of which method to use for value is not easy and should be left to accounting experts. Get in touch with highly professional and the best accounting firms in Dubai to streamline your accounting operations. Following are some of the methods that are generally used in the financial and accounting landscape.
i) Specific Identification:
every business acquires different assets with differentiating features and costs. From high-value to low-value, the inventory class is highly diversified. One method that is used to value such a diverse class of inventory is the specific identification method. Each item in the inventory is tracked from the date it was acquired to the date it was sold. The technique is best for large items which are easily identified.
The specific identification method requires businesses to track each item in the inventory room with a tag, stamped receipt, and date. The method is highly accurate and is used for high-value items. The reason is that these items come with distinguishing features where the specific identification method could better be utilized.
ii) First-In, First-Out (FIFO):
As the name suggests, this method is based on the ground that the first inventory acquired is the first inventory to be sold. The rest of the inventory items are matched against those items that are most recently produced or acquired. Being a simple and easy-to-understand process, this method is widely used by many business entities.
FIFO method comes with its pros and cons. The advantages of using this method are:
- It gives a higher value to the ending inventory
- It poses a lower cost of goods sold (COGS)
- It gives a higher gross profit
However, there are some disadvantages to this technique as well. These are mentioned here.
- It fails to depict accurate costs at the time of inflation
- It does not offer any tax benefits to businesses
iii) Last-In, First-Out (LIFO):
The idea behind this method is that the newer inventory should be sold first than the older one. Most businesses tend to avoid this method since it causes a loss of value to the older inventory. The old inventory is rarely sold in this case, hence causing a loss in its value.
The possible motivation to utilize LIFO is when organizations expect the inventory price to increase after some time and lead to value expansion. By moving significant expense inventories to the COGS, companies can lower their financial statements' profit levels. Doing so allows them to pay lower taxes.
Why is inventory valuation important?
There are several reasons based on which businesses should accurately value their inventory items. These reasons could better be considered possible motivations for doing so. Some of these are discussed here:
i) Determine financial position:
Since inventory is an integral part of both the income statement and the balance sheet, its value is greatly important to financial health. The management should hire the best accounting firms to do an accurate valuation.
ii) Aids in understanding the cash flow:
An accurate calculation of inventory and its costs helps the management know the cash flow position. The valuation acts as a safety net for a business, where the inventory is kept at a minimum price.
iii) Tax advantages:
As mentioned in the LIFO, businesses can report a lower income in their financial statements. Ultimately, they end up paying lower tax duties on their inventory stock.
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Published by guest contributor