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Inventory Valuation

What is inventory valuation?

An inventory valuation allows a business entity to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business. The proper measurement of the inventory of a business is necessary to ensure that accurate financial statements are created. If an inventory is not properly measured, the expenses and revenues of the entity cannot be matched. The drawback is that the business entity could make poor business decisions.

Inventory accounting systems.

The two most widely used inventory accounting systems are the following:

  1. Perpetual stock.
    The accounting records must show the amount of inventory that’s on hand, at all times. It has a separate account in the subsidiary ledger for each item in stock. The account is also updated each time a quantity is added or taken out.
  2. Periodic stock.
    Sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods.

Periodic versus perpetual systems.

There are fundamental differences for accounting and reporting merchandise inventory transactions under the periodic and perpetual inventory systems.

To record purchases, the periodic system debits the Purchases account while the perpetual system debits the Merchandise Inventory account. By recording the cost of goods that are sold for each sale, the perpetual inventory system alleviated the need for adjusting entries and calculation of the goods sold at the end of a financial period.

The perpetual inventory system is based on actual figures and facts while the business is trading.

Using non-cost methods to value inventory.

Under certain circumstances, inventory valuation based on cost is impractical. If the market price of an item drops below the purchase price, the lower of cost or market method of valuation is recommended. This allows the decline in inventory value to be offset against income of the period. When goods are damaged or obsolete, it can only be sold below purchase prices. They should then be recorded at net realizable value. The net realizable value is the estimated selling price minus any expense incurred to dispose of the item.

Methods used to calculate the cost of inventory.

In certain business operations, taking a physical inventory is either impractical or impossible. In such a situation, it is still necessary to calculate the cost of inventory.

Two popular inventory valuation methods are:

  1. Retail inventory method.
    This method uses a cost to retail price ratio. The physical inventory is valued at the retail price. It is multiplied by the cost ratio to determine the cost of the ending inventory.
  2. Gross profit method.
    The average gross profit margin of the previous years is used. The current year’s gross profit is calculated by multiplying the sales of the current year by the gross profit margin of the previous year.  Subtracting the gross profit from sales gives you the current year’s cost of goods. By subtracting the cost of goods sold from goods available for sale gives you the ending inventory.,