1. Introduction:
Inventory is commonly seen as the finished goods an enterprise accumulates before selling them to end users. Inventory can also be in form of the raw materials used to produce the finished goods as they go through the production process (often called “work-in-progress” or WIP).
A primary issue in accounting for different types of inventories is the determination of cost using the right cost formulas and its subsequent recognition as an expense, including any write-down to net realizable value. Inventory represents one of the most important assets of a business because the turnover of inventory signifies one of the primary sources of revenue generation and subsequent earnings for the company’s shareholders. Inventory or stock is the resource but idle means lying with the company at the end of the financial year. Hence, closing stock has a huge impact on the business revenue and the assets itself.
Inventory is classified as a current asset on a company’s balance sheet, and it serves as a buffer between manufacturing and order fulfillment. When an inventory item is sold, it’s carrying cost transfers to the cost of goods sold (COGS) on the income statement.
The concept of inventory, stock, or work-in-progress has been stretched from manufacturing systems to service businesses and projects, by generalizing the definition to be “all work within the process of production/ services.”. In the context of production, inventory refers to all work that has occurred—raw materials, partially finished products, and finished products prior to sale and dispatch from the manufacturing system. In the context of services, inventory refers to all work done prior to sale, including partially process information.
Inventory management is a discipline primarily about specifying the shape and placement of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials.
Reasons for keeping stock: There are five basic reasons for keeping an inventory
- Time – Inherent time delays present in the supply chain, from supplier to consumer at every stage, requires that you maintain certain amounts of inventory to use during the lead time.
- Seasonal Demand – demands varies periodically, but creator’s capacity is fixed. This can lead to stock accumulation.
- Economies of scale – Model condition of “one item at a time at a specific place when a user needs it” belief tends to incur lots of costs in terms of overall logistics. So bulk procurement, movement, and storage brings in economies of scale, thus leading to inventory.
- Appreciation in Value – In some situations, some stock gains the required value when it is held for some time to allow it reach the desired normal for consumption, or for production.
- Uncertainty – Inventories are maintained as cushions to meet uncertainties in demand, supply and arrangements of goods.
2. Purpose of Inventory Valuation:
An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. When we talk about inventory we usually refer to the stock-in-trade with a company of raw materials, semi-finished goods, finished goods, and spare parts. So, at the end of the year inventory has to be counted back to get to the closing stock.
However only counting inventory is not enough, it also has to be valued. The process of inventory valuation helps determine the value at which we will record the inventories in the financial statements of the company. The correct inventory valuation is essential to have a fair representation of the company’s finances. The inventory valuation is done at the end of each accounting year in order to assess the operating performance and the financial position of the business.
Having an accurate valuation of inventory is important because the reported amount of inventory will impact a) the cost of goods sold, gross profit, and net income on the income statement, and b) the amount of current assets, working capital, total assets, and stockholders’ or owner’s equity reported on the balance sheet. As inventory is seldom transacted at an interim stage (e.g., work-in-progress) or may not be frequently sold to a third party to conduct the selling effort (e.g., finished goods sold via distributor networks), the valuation techniques and considerations for inventory frequently vary from those of other assets
Apart from balance sheet accounting there are other purpose too for the valuation of inventory. Impairment assessment of inventory is done to check whether the economic
benefits that the inventory represents have dropped drastically. Companies under the insolvency process requires value of their current inventory as on the CIRP (Corporate Insolvency Resolution Process) commencement date in terms of their Fair Value and Liquidation Value. Similar assessment is required when the company goes into liquidation be it a voluntary (winding up) or otherwise.
Before an entity goes for non-moving inventory disposal it requires reserve price of the inventory to be determined so as they need to have them valued. Last but not least inventories of an entity also need to be valued to determine tax lability under Income tax law. However, the Fair Value of inventory typically differs from and is usually higher than, the book value of inventory.
3. Statutory provisions in India for Inventory Valuation
It is always necessary to value stocks as per relevant provisions of law which outline detailed guidelines/standard. These standards signify the approach and method of valuation of inventories and their subsequent treatment as per law. Some of the specific standards applicable to Inventory valuation are depicted in the figure.
Note: Income Computation and Disclosure Standards (ICDS) were issued by the Govemment of India in exercise of powers conferred to it under section 145(2) of The Income Tax Act, 1961. Applicable for computation of income chargeable under the head “Profits and gains of Business or profession” or “Income from other sources” and not for the purpose of maintenance of books of accounts.
4. Who should do Inventory Valuation & why?
There are grey areas pertaining to Inventory valuation and many times this raises doubt on the efficacy of the valuation. Inventories are the physical asset, not to be confused with financial assets, recorded under current asset in the Balance Sheet (BS) of a Company. They are normally classified as Raw material, Work in Progress (WP), Finished Goods, Spares/Consumables etc.
Each class of inventory is as per the set of technical & functional specification. In most of the time their Life, Usage, Storage are guided by technical parameter and so as their ultimate value. There is a marked difference between recognition in books of account & valuation for books of account. Inventories are measured & recognized in BS as per cost or net realizable value (NRV) whichever is less.
Hence, Accountant dealing with these assets may not be a competent person to value them.
More so ever Valuers determine fair value of inventories which is different than NRV or cost. The Companies (Registered Valuers and Valuation) Rules, 2017 under the Companies Act, as of now recognizes three asset dasses with different set of qualification to value assets of a Business Unit. Land & Building asset class valuer specializes in valuing buildings, structures, civil work, land etc. which is a part of fixed asset. Similarly, Plant & Machinery valuer estimates the value of machinery and other moving assets.
There is special class of valuer who specializes on Security or Financial Asset. So, knowing well that valuation is a specialized field, accountant doing the valuation even for Balance Sheet is completely excluded with the advent of new regulation pertaining to registered valuer, published by the Ministry of Corporate Affairs.
Now question arises among the different classes of valuers who are competent to do the valuation of Inventory. Most of the inventories are in technical nature barring a few like livestock, farm produce, minerals, etc. Since technical nature warrants technical knowledge, these assets have to be valued in general by the P&M/L&B asset class valuer depending upon the nature of inventories.
As per the Valuation Standards Board of The Institute of Chartered Accountants India “A Non-financial asset which is classified as an inventory cannot be valued separately by SFA valuer”. Sometimes technical valuers also need the help of an expert to understand the complicacies of items to be valued but atthe same time, it is also expected from the valuer to understand and take liability for the input of an expert.
5. Inventory Valuation Approach & Method
Before going into the details of Inventory Valuation, let’s look for some of the definition brought from Ind AS 2.
Inventories are assets: held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.
Net realizable value (NRV) is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
Net realizable value for inventories may not equal fair value less costs to sell. NRV is an entity-specific measurement; the fair value is a market-based measurement
Cost of Inventory: Cost component generally form part of the inventory is depicted through the diagram is made out of purchase cost, conversion cost and other cost where some of the costs such as by product cost, scrap cost etc. need to be deducted.
Purpose of valuation can be one among the many explained in earlier section of this article. Entities/organisations defined basis of value can be picked up or can be based on the regulation, case law, and other interpretive guidance related to those bases of value a as on the valuation date.
All three approaches to valuation can be applied to Inventory valuation. Valuer shoulda use judgment in making the determination of specific method depending upon the purpose of valuation and those methods can fall under Cost Approach, Market Approach, and Income Approach. IVS 230 Inventory, Exposure Draft document circulated for comments discussed following aspects for valuation which can be used as a guideline document tilla this becomes generally available for use.
The market approach, i.e. reference to market activity involving identical or similara goods, has only narrow direct application for the valuation of inventory. Such applications typically include a) inventory of commoditized products, or b) inventory in which a market exists for the inventory at an interim stage in the production process. While the market approach is not directly applicable in most instances, valuers should consider market-based indications to determine the selling price as an input for other methods.
The valuation of inventory using The Income Approach requires the allocation of profit (value) contributed pre-valuation date versus the profit (value) contributed post-valuation date. Two method discussed are:
The Top-Down Method is a residual method that begins with the estimated selling price and deducts remaining costs and estimated profit. The Top-Down Method attempts to bifurcate the efforts, and related value, that were completed before the measurement date versus those efforts that are to be completed after the measurement date. The Bottom method2 starts with the book value of the subject inventory, then adding different cost like buying and holding, completion cost etc. This method can be used to corroborate the value derived from the Top-Down Method.
The primary method to value inventory under The Cost Approach is the current replacement cost method. Raw materials inventory is typically valued using the Current Replacement Cost Method. The Current Replacement Cost Method (CRCM) may provide a good indication of market value if inventory is readily replaceable in a wholesale or retail business (eg, raw materials inventory or finished goods).
The market value of raw materials and other inventory may be similar to the net book value as on the valuation date but certain adjustments should be considered. The book value may need to be adjusted to FIFO basis. If raw material prices fluctuate and/or the inventory turnover is slow the book value may need to be adjusted for changes in market prices. The book value of raw materials may also be decreased to account for obsolete and defective goods. The book value may also need to be decreased for shrinkage, which is the difference between inventory listed in the accounting records and the actual inventory due to theft, damage, miscounting, incorrect units of measure, evaporation, etc.
Inventory Measurement Techniques:
Some of the frequently used Inventory measurement techniques are the Specific identification Method, First In First Out (FIFO), Last In First Out (LIFO), and Weighted Average Method. These techniques are used depending upon the purpose of measurement or specific purpose of valuation. In India FIFO & Weighted Average methods are generaly used.
a) Specific Identification:
The specific identification method assigns the specific cost of each inventory item to cost of goods sold. Companies with expensive low-volume merchandise use the specific identification method because the physical flow of goods is easier to track. The ending inventory balance is the total cost of each item remaining in inventory at the end of an accounting period
b) First-In, First-Out (FIFO):
Oldest goods sold first is the essence of this method. If prices rise over time, the ending inventory is valued higher at recent costs hence lower COGS. This produces more gross
profit and a higher taxable income. FIFO is widely accepted. Also, recent costs are reported in the ending inventory on the balance sheet.
c) Last-In, First-Out (LIFO):
Newest goods sold first is the motto of this method. When prices are rising, the ending inventory is valued lower, COGS is higher and thus gross profit and taxable income are lower. LIFO will be used in any industry where the value of products increases with time. Antiques and Wine could be good examples (US GAAP)
d) Weighted Average Cost:
The weighted average is used to determine the amount that goes into the cost of goods sold and inventory. Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory. This method is commonly used to determine a cost for units that are indistinguishable from one another and it is difficult to track the individual costs.
6. A scenario of Inventory valuation under a specific statute and inherent challenges:
Inventory Valuation under Insolvency & Bankruptcy law has been taken up to explain basic requirements during the phases of valuation and the challenges to be overcome. Quantification of services effort required for inventory valuation is one initial challenge as data pertaining to Volume of Inventory, Type of Inventory, Complexity of Inventory, etc. are not known. Getting a physical count of inventory under categories like raw material, work in progress, and finished goods along with their cost is another challenge as this falls under the domain of corporate debtor and many times difficult to ascertain.
Once these challenges are overcome, a valuer needs to identify the Method of inventory flow in the entity i.e. LIFO/FIFO/Weighted Average. Specification of Raw Materials, costing sheet of WIP, and their reuse in case of liquidation have to be understood properly to know the net realizable value. Other documents which help in valuation are the Inspection Report of purchased material, the Latest available purchase documents pertaining to bought out items, Inventory aging report, details of recent sales of finished goods, scrap, etc. Post availability of details, the Current Replacement Cost Method (CRCM) can be an appropriate method to arrive at the value of Inventory.
7. Standardization in Inventory Valuation and need
International Valuation Standard has not come out with any standards specific to the valuation of inventory. They feel that there is limited technical guidance specifically relating to the valuation of inventory. These factors, combined with the unique methodologies to value inventory, indicate that standards would be helpful toward improving consistency and quality in the marketplace. They need to publish detailed guidance notes along with valuation methodology in the near future to remove the non-standard approach.
Once the IVS 230 Inventory Exposure Draft post comments/modification gets adopted, this will pave the way for the standardization of Inventory Valuation. Ind AS 2, AS 2, and ICDS II deal with inventory as a measurement/valuation for a specific purpose whereas IVS will fill the gap with the publication of a generic standard.
8. Limitation in Inventory Valuation:
Getting a fair market price in the open market is difficult for work-in-progress goods. If the net realizable value (NRV) of a company’s inventory declines to a value which is less than its cost, the company is usually required to report the inventory at its net realizable value. Ascertaining NRV of finished products and in-stock Raw materials in case of distressed assets are some of the other limitations. Inventory Costing of WIP is another challenge area where domain knowledge of valuer and flow of information from the company will minimize the inaccuracy.a
9. Conclusion:
Inventory valuation is important as it affects the cost of goods sold – a significant amount reported on the company’s income statement. Inventory is also an important component of a company’s current assets, working capital, and current ratio. The misstatement or a miscalculation of inventory can overstate or understate the profits of the firm.
Inventory is a current asset hence the firm is not expected to hold it for a long period of time. There are a lot of turnovers when it comes to stock. So, inventory actually is a significant portion of the working capital of a company. It is important to value it correctly to know the liquidity of a company.
Apart from financial reporting, Inventory Valuation is equally vital for general engagement
such as Insolvency, collateral lending, and tax reporting.
References:
1. Indian Accounting Standard (Ind AS) 2
2. Accounting Standard (AS) 2
3. IVS 230 Inventory Exposure Draft
4. Income Computation and Disclosure Standard II relating to the valuation of inventories
5. Resources from websites
