Inventory valuation refers to the process of determining the worth of the goods a company possesses at the end of the accounting period. In accounting, finance, and business, it is an essential process. It helps firms in discovering the right value of unsold stock and analysing accurate profits. So, when you are thinking about what is inventory valuation, it is basically valuating the stock for balance sheets and tax purposes. Business use different techniques to value their inventory. Some of the popular inventory valuation methods are FIFO (First in First Out), LIFO (Last in First Out) and the Weighted Average Method. Different methods yield different numbers that may impact profits and taxes. Which is why the feeling of saying that the right method matters a lot. Accounting Standard 2 (AS 2) in India valuation of inventories is governed by AS 2. It provides guidance on the appropriate way to value inventory. This article will cover everything that you need to know about inventory valuation, types of methods, how do they affect financials and how AS 2 governs them. We will also answer questions like, which option lists inventory valuation method in tally and how is the retail method of inventory valuation implemented.
What is Inventory Valuation and Why is it Important?
Inventory valuation is how much your goods that remain unused at the end of a year or quarter worth. As a current asset, this value is entered into the balance sheet. It also assists in calculating cost of goods sold (COGS), which has an impact on your profit, Thus, when inventory is priced correctly, the true profit is reflected in the business. If it’s wrong, profit will appear to be either too high, or too low. This can result in overpaying tax, or getting into trouble with the law.
The Effects of Inventory on Financial Statements
- Balance Sheet: Inventory appears in current assets.
- The Profit and Loss Account: impacting COGS and net profit
- Cash Flow Statement: Indicates whether cash is stuck in stock.
Therefore, it records every transaction properly using a good method of inventory valuation.
Factors that Affect Inventory Valuation
- Market price of inventory
- Nature of products (perishable, durable)
- Mode of industry(e.g.retail, manufacturing)
- Storage costs
- Damage or spoilage
We should realize it is not just the goods lying in a godown. It has real value. So, it definitely needs to be valued correctly.
Types of Inventory Valuation Methods
Companies adopt different inventory valuation methods as per their requirements. Each approach results in different goods sold and profit. That is the reason that AS 2 permits limited types of methods. So, let us analyze them thoroughly.
FIFO Method of Inventory Valuation
FIFO Inventory Valuation Method in which FIFO stands for First In First Out. First in, first out in terms of what is being sold. This method assumes the oldest stock is used first.
Example of FIFO:
Here’s how that might work in a store that buys goods like this:
- January: 100 units at ₹50 = ₹ 5,000
- Feb 100 units @ ₹60 = ₹6,000
If it sells 150 units, FIFO will expends:
- 100 units at ₹50 = ₹5,000
- 50 units at ₹60 = ₹3,000
- Total COGS = ₹8,000
Closing stock = 50 × ₹60 = ₹3,000
When to Use FIFO?
- When prices are rising
- When there are things that expire (food or medicine)
Advantages of FIFO:
- Simple to understand
- Aligns physical flow of goods
- Makes more money when prices rise
- Under AS 2 and income tax laws accepted
Disadvantages:
- Higher profit = Higher tax
- If prices increase quickly, profit can appear too high
Weighted Average Method of Inventory Valuation
Weighted average method of inventory valuation uses average cost per unit for all items in stock. This approach smooths out the price changes over time.
Formula:
Average cost per unit = Total cost / Total quantity
Example:
- Buy 100 units at ₹50 = ₹5,000
- Buy 100 units at ₹70 = ₹7,000
- Total = ₹12,000 for 200 units
- Average = ₹12,000 ÷ 200 = ₹60
If 150 units are sold:
- COGS = 150 x ₹60 = ₹9,000
- Closing stock = 50 x ₹60 = ₹3,000
When to Use Weighted Average?
- In industries with homogenous products (such as grains, cement, liquids)
- When it is not easy to track each item separately.
Advantages:
- Simple and consistent
- Stable profit and tax
- Accepted by AS 2
Disadvantages:
- May not show real-time prices
- Not as useful if prices are volatile
- Best for Retail Chains: Retail Method of Inventory Valuation
Retail Method of Inventory Valuation
Retail method of inventory valuation is generally applied in case when it is difficult to keep track of the actual cost of each item. It uses selling price and markup to calculate the inventory cost.
Formula:
Cost of inventory = Retail value × (1 – Mark-up %)
Example:
- Retail value of the goods: ₹1,00,000
- Markup is 25%
- Cost = ₹1,00,000 × (1 − 0.25) = ₹75,000
When to Use Retail Method?
- Now in the food section of supermarkets, malls, and large stores
- Where merchandise is sold by mixed lots
- When estimation is needed quickly
Advantages:
- Fast and easy
- You will only see this if you have a lot of products in the shop.
- All articles from Financial Statements Interim
Disadvantages:
- Only an estimate, not exact
- May not be right for all businesses
Other Inventory Valuation Methods (Not Allowed Under AS 2)
Global methods such as LIFO (Last In First Out) are not permitted as per AS 2, but are being applied in the USA etc. LIFO is not permitted in India because international practices are more aligned with FIFO.
- It may undervalue inventory
- It reduces profit, which can influence tax
- It does not reflect the real world flow of goods
India adopted AS 2 and permit only:
- First in first out method of inventory valuation
- Weighted average method of inventory valuation
Valuation of Inventories is Governed by AS-2
In India, valuation of inventories is governed by AS 2. AS 2 is provided by ICAI and all companies are required to follow (except a few industries which are excluded). AS 2: It states that value inventory at the lower of cost or net realizable value. This means:
- Use cost if less than the market price.
- Use market price if market price is less than cost.
Cost Includes:
- Purchase price
- Import duties
- Freight inward
- Storage before production
- Direct labor
Cost Does Not Include:
- Abnormal loss
- Wastage
- Storage after production
- Selling costs
The standard which governs inventory valuation is AS 2. When a company does not commit to this, it can lead to penalty or tax problems.
Inventory Valuation in Tally and Software Tools
When you have Tally-like of accounting software, you can easily and speedily value your inventory. It allows businesses to monitor stock, implement valuation methods, and create accurate reports. Tally has various options for selecting the appropriate inventory valuation method for your business requirements. Tally has got full support for it and manages it smoothly and accurately whether FIFO, average cost or retail method of inventory valuation. Software tools like Tally are helpful if those are of necessity level such as small businesses & accounting students. Tally supports Multiple inventory methods.
Which option lists Inventory valuation method in Tally?
In Tally, go to:
Gateway of Tally → Inventory Info → Stock Item → Alter → Valuation Method
Available methods in Tally:
- FIFO
- LIFO
- Average cost
- Standard cost
- Retail
These choices assist enterprises with mechanizing their records and keeping away from mistakes. Students also practice on Tally for exam preparation.
Impact of Inventory Valuation on Business and Tax
Speaking of the balance sheet, inventory valuation is not only for balance sheets, but also financial reports. That impacts both profit and tax. Depending on how inventory is valued, a company can pay more or less tax. It will directly impact on your profit, tax and financial health. The proper method also wants to be used via enterprise owners in corporations to reflect accurate earnings to store them from tax problems.
How It Affects Tax?
Changes in inventory valuation will change the cost of goods sold and so changes the profit. Higher profit translates to higher tax, and lower profit translates to reduced tax. So the way you do it can add to or subtract from the tax bill.
- FIFO yields higher profit → More taxes
- Stable profit with a weighted average → Balanced tax
- LIFO (not allowed under AS 2) gives less profit → Less tax.
Selecting the correct method aids with the following:
- Planning better
- Avoiding audit issues
- Real profits to investors
For Indian students and small business owners, this impact is crucial to know.
Relevance to ACCA Syllabus
You learn about inventory valuation in Financial Accounting (FA), Financial Reporting (FR), and Strategic Business Reporting (SBR) in ACCA. Students learn how to apply AS 2 or IAS 2 and report inventories properly as per IFRS.
Inventory Valuation ACCA Questions
Q1: Which of the following methods is permitted as per IAS 2 for inventory valuation?
A. LIFO
B. FIFO
C. Retail Inventory Method
D. Last Purchase Price
Answer: B. FIFO
Q2: Inventory should be measured at-
A. Cost or fair value, whichever is higher
B. Cost only
C. Cost or net realizable value.
D. Current replacement cost
Answer C, Lower of cost or net realizable value is the correct answer.
Q3: Which of the following costs is not included in the cost of inventory as per IAS 2?
A. Freight charges
B. Direct labour
C. Selling and marketing expenses.
D. Purchase price
Answer: C. Selling and marketing expenses
Q4: FIFO means First In, First Out, so which inventory item gets sold first?
A. Most recently purchased
B. Cheapest inventory
C. Earliest purchased
D. Random selection
Ans: C. Earliest purchase
Q5: What role does Inventory Valuation play to Financial Reporting?
A. It lowers income tax liability.
B. It determines how much inventory can be discarded.
C. Involves the profitability and the part of cash and current assets.
D. It affects the balance sheet only.
Answer: D. It impacts income and current assets.
Relevance to US CMA Syllabus
Inventory valuation is in Part 1: Financial Planning, Performance and Analytics. Inventory costing, profitability analysis, and internal control on inventory are among the knowledge requirements for CMA candidates.
Inventory Valuation US CMA Questions
Q1: In inflationary conditions, which inventory method reports the lowest profit?
A. FIFO
B. LIFO
C. Weighted average
D. Standard cost
Answer: B. LIFO
Q2: Which of the following costs should a manufacturing company include in inventory?
A. Advertising cost
B. Interest on loans
C. Factory overheads
D. Office salaries
Answer: C.Factory overheads
Q3: When prices change frequently, which inventory method is the most advantageous?
A. FIFO
B. LIFO
C. Weighted average
D. Specific identification
Answer: C. Weighted average
Q4: To which inventory valuation method does IFRS not permit but US GAAP does?
A. FIFO
B. Weighted Average
C. LIFO
D. Specific Identification
Answer: C. LIFO
Q5: What is the impact of FIFO on the financial statements when inflation rises?
A. Increases profit and tax
B. Decreases profit
C. Lowers ending inventory
D. Shows highest COGS
Ans: A. Boost Profit & Tax
Relevance to US CPA Syllabus
Under the Financial Accounting and Reporting (FAR) section in US CPA, candidates should also be able to apply inventory valuation methods and determine their effect on taxes, income statements, and disclosures in accordance with US GAAP.
Inventory Valuation US CPA Questions
Q1: Inventory may be valued under US GAAP using which of the following methods?
A. FIFO only
B. Weighted average only
C. LIFO, FIFO, or Average cost
D. only specific identification
Ans: C. LIFO, FIFO, or Average cost
Q2: What is the cash flow assumption that is allowed under GAAP but is not allowed under IFRS?
A. FIFO
B. LIFO
C. Weighted Average
D. Specific identification
Answer: B. LIFO
Q3: What should NOT be included in inventory cost among these?
A. Import duty
B. Purchase discounts
C. Direct labor
D. Delivery to customers
Answer: D. Delivery to customers
Q4: Which of the following is the best description of “net realizable value”?
A. Historical cost less depreciation
B. Market price
C. Selling price estimated – cost of selling
D. Cost to produce one unit
Answer: C. Selling Cost (Estimate Selling Price)
Q5: FIFO used by a company in a period of increasing prices. The following is/are true:
A. Higher COGS
B. Lower inventory
C. Higher taxes
D. Lower ending inventory
Answer: C. Increased taxation
Relevance to CFA Syllabus
The Financial Reporting and Analysis module of CFA Level I and II goes into great depth on inventory valuation. Methods analyzed by the candidates with respect to their effect on financial ratios, earnings quality and comparability across firms.
Inventory Valuation CFA Questions
Q1: Does anyone know if it’s LIFO, FIFO, AVCO, or something else?
A. LIFO
B. FIFO
C. Weighted Average
D. Standard Cost
Answer: B. FIFO
Q2: Which of the following is NOT influenced by inventory valuation method?
A. Gross profit margin
B. Net income
C. Operating cash flow
D. Inventory turnover ratio
Answer: C. Operating cash flow
Q3: Analysts also adjust LIFO-based financials to FIFO do:
A. Understate COGS
B. Overstate net income
C. Improve comparability
D. Reduce inventory balance
Answer: C. Improve comparability
Q4: What is the LIFO reserve?
A. Total inventory on hand
B. FIFO vs LIFO inventory
C. Inventory that is damaged
D. Safety stock for emergency
Ans: FIFO and LIFO Inventory Difference
Q5: When prices are increasing, which financial ratio is overstated under FIFO?
A. Inventory turnover
B. Gross margin
C. Days inventory outstanding
D. Current ratio
Answer: B) Gross margin
