An inventory valuation allows a company to provide a monetary value for items that make up their

inventory Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying the sha ...

. Inventories are usually the largest current

asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...

of a business, and proper measurement of them is necessary to assure accurate

financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

s. If inventory is not properly measured,

expenses An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuition is a ...

and

revenue In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive rev ...

s cannot be properly matched and a company could make poor business decisions.

Inventory accounting system

The two most widely used inventory accounting systems are the periodic and the perpetual. * ''Perpetual:'' The perpetual inventory system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out. * ''Periodic:'' In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A

physical inventory Physical inventory is a process where a business physically counts its entire inventory. A physical inventory may be mandated by financial accounting rules or the tax regulations to place an accurate value on the inventory, or the business may ...

must be taken at the end of the year to determine the cost of goods Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year.

Inventory methods - perpetual

The perpetual system records revenue each time a sale is made. Determining the cost of goods sold requires taking inventory. The most commonly used inventory valuation methods under a perpetual system are: # first-in first-out (FIFO) #last-in first-out (LIFO) #(highest in, first out) (HIFO) #

average cost In economics, average cost or unit cost is equal to total cost (TC) divided by the number of units of a good produced (the output Q): AC=\frac. Average cost has strong implication to how firms will choose to price their commodities. Firms’ sale ...

or weighted average cost These methods produce different results because their flow of costs are based upon different assumptions. The FIFO method bases its cost flow on the

chronological order Chronology (from Latin ''chronologia'', from Ancient Greek , ''chrónos'', "time"; and , ''-logia'') is the science of arranging events in their order of occurrence in time. Consider, for example, the use of a timeline or sequence of even ...

in which purchases are made, while the LIFO method bases its cost flow on a reverse chronological order. The average cost method produces a cost flow based on a weighted average of goods.

Periodic versus perpetual systems

There are fundamental differences for accounting and reporting

merchandise Merchandising is any practice which contributes to the sale of products to a retail consumer. At a retail in-store level, merchandising refers to displaying products that are for sale in a creative way that entices customers to purchase more ...

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. To record sales, the perpetual system requires an extra entry to debit the

Cost of goods sold Cost of goods sold (COGS) is the carrying value of goods sold during a particular period. Costs are associated with particular goods using one of the several formulas, including specific identification, first-in first-out (FIFO), or average cost. ...

and credit Merchandise Inventory. By recording the cost of goods 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, both of which the periodic inventory system requires. In Perpetual Inventory System there must be actual figures and facts.

Using non-cost methods to value inventory

Under certain circumstances, valuation of inventory based on cost is impractical. If the

market price A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the ...

of a good drops below the purchase price, the

lower of cost or market Lower of cost or market (LCM or LOCOM) is a conservative approach to valuing and reporting inventory. Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventory is greater than ...

method of valuation is recommended. This method allows declines in inventory value to be offset against income of the period. When goods are damaged or obsolete, and can only be sold for below purchase prices, they should be recorded at net realizable value. The

net realizable value Net realizable value (NRV) is a measure of a fixed or current asset's worth when held in inventory, in the field of accounting. NRV is part of the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (I ...

is the estimated selling price less any expense incurred to dispose of the good.

Methods used to estimate inventory cost

In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. Two very popular methods are 1)- retail inventory method, and 2)- gross profit (or

gross margin Gross margin is the difference between revenue and cost of goods sold (COGS), divided by revenue. Gross margin is expressed as a percentage. Generally, it is calculated as the selling price of an item, less the cost of goods sold (e. g. producti ...

) method. The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. The gross profit method uses the previous years average

gross profit margin Gross margin is the difference between revenue and cost of goods sold (COGS), divided by revenue. Gross margin is expressed as a percentage. Generally, it is calculated as the selling price of an item, less the cost of goods sold (e. g. productio ...

(i.e. sales minus cost of goods sold divided by sales). Current year gross profit is estimated by multiplying current year sales by that gross profit margin, the current year cost of goods sold is estimated by subtracting the gross profit from sales, and the ending inventory is estimated by adding cost of goods sold to goods available for sale.

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Financial Accounting Course

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