Inventory valuation is an integral part of a company’s financial statement audit. It provides an understanding of the value of any unsold inventory and an accurate portrayal of your company’s current financial situation. There are several inventory valuation approaches, and each has its benefits. This article will discuss the importance of inventory valuation and methods used when preparing for future private company audits.
What Is Inventory Valuation?
An inventory valuation is the accounting process of determining the value of a company’s unsold inventory to prepare for an audit. Since inventory stock is considered an asset on a company’s balance sheet, it must have a specific value. Accountants use a valuation method to calculate this number. The valuation process assigns a cost to the inventory that then becomes its value on the balance sheet.
An Essential Part of a Financial Statement Audit
An inventory valuation can significantly impact a company’s financial statements during your audit. There are several practical reasons that inventory valuation is necessary:
- Impacts the value of all goods: identifying a company’s unsold stock and determining its value directly affects the cost of sold goods (COGS), gross income, and the monetary value of the remaining inventory at the close of each fiscal period.
- Lenders rely on it: a company’s inventory valuation can affect loan ratios used by lenders to assess creditworthiness and income taxes.
- Tests the inventory management system: the valuation process can test the effectiveness of a company’s inventory management system by identifying any errors or inefficiencies.
These elements are essential in preparing complete and accurate audited financial statements. Financial statements that do not accurately reflect inventory levels and values can lead to incorrect conclusions about a company’s financial well-being.
Inventory Valuation Methods
Now that we understand the importance of inventory valuation let’s take a look at some of the techniques used to calculate the value of unsold inventory.
Four primary methods can be used to value inventory: specific identification, first-in-first-out (FIFO), last-in-first-out (LIFO), and weighted average. Each of these methods has a different calculation methodology and results.
Specific Identification:
With the specific identification method, inventory is valued according to the particular costs incurred to produce each unit of product. This valuation method is most commonly used when the products are unique and can be easily tracked from production to sale.
First-In-First-Out (FIFO):
The first-in-first-out method values inventory according to the order in which it was produced or acquired. In other words, the first units of inventory to be produced or acquired are also the first units that are valued and sold.
Last-In-First-Out (LIFO):
The last-in-first-out method is the opposite of the FIFO method. With LIFO, the last units of inventory to be produced or acquired are the first units that are valued and sold.
Weighted Average:
The weighted average approach values inventory according to the average cost of all units of product. This method is used when it is difficult to track individual unit costs.
Benefits of each Valuation Method
There are no absolute rules when choosing an inventory valuation method. Each of them has its pros and cons. For example, the specific identification method is the most accurate but can be challenging to implement. And while the FIFO and LIFO methods are simpler to implement but may not provide an accurate picture of current inventory levels. Alternatively, for some companies, the weighted average process is a compromise between accuracy and simplicity.
Ultimately, the best inventory valuation method is the one that provides the most accurate portrayal of your company’s current financial situation, and financial statement audits provide an essential check and balance to ensure your organization’s inventory is accurately valued.
Next Steps
Do you have more questions about inventory valuation methods or how they might affect your financial statement audit? Speak with your audit firm to discuss which inventory calculation method your company has adopted.
At Assurance Dimensions, our team of talented professionals understands the accounting rules associated with inventory valuation. Contact us today to prepare for your next audit.
