What is inventory valuation?

Inventory valuation is the cost associated with an entity's inventory on hand at the end of a reporting period. The inventory valuation is recorded as an asset, which appears as a current asset on the entity's balance sheet.

The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported into the proper place for sale. You are not allowed to add any administrative or selling costs to the cost of inventory. The costs that you can include in an inventory valuation are:

• Direct labor
• Direct materials
• Freight
• Handling
• Import duties
• Production overhead

It is also possible under the lower of cost or market rule that you may be required to reduce the inventory valuation to the market value of the inventory, if it is lower than the recorded cost of the inventory. There are also some very limited circumstances where you are allowed under international financial reporting standards to record the cost of inventory at its market value, irrespective of the cost to produce it (which is generally limited to agricultural produce).

When assigning costs to inventory, you are supposed to adopt and consistently use a cost-flow assumption regarding how inventory flows through the entity. Examples of cost-flow are the specific identification method, where you track the specific cost of individual items of inventory, or the first in, first out method, where you assume that the first items to enter the inventory are the first ones to be used. Other methods are the last in, first out method and the weighted average method. Whichever method you choose will affect the inventory valuation that you record at the end of the accounting period.

Inventory valuation is important for the following reasons:

• Impact on cost of goods sold. If you record a higher valuation in ending inventory, this leaves less expense to be charged to the cost of goods sold, and vice versa. Thus, inventory valuation has a major impact on reported profit levels.
• Loan ratios. If an entity has been issued a loan by a lender, the agreement may include a restriction on the allowable proportions of current assets to current liabilities. If the entity cannot meet the target ratio, the lender can call the loan. Since inventory is frequently the largest component of this current ratio, the inventory valuation can be critical.
• Income taxes. The choice of cost-flow method used can increase or reduce the amount of income taxes paid. The LIFO method is commonly used in periods of rising prices to reduce income taxes paid.

Related Topics

Accounting inventory methods
FIFO vs. LIFO accounting
Lower of cost or market
Weighted average method
What is the effect of overstated ending inventory?