Inventory Valuation – A Level Business CAIE Revision

Inventory valuation refers to the process of assigning a monetary value to the business’s inventory at the end of a financial period.
It affects the gross profit, net profit, cost of goods sold (COGS), and subsequently, the taxes a company pays.
The main methods of inventory valuation are First-In-First-Out (FIFO), Last-In-First-Out (LIFO), and the Average Cost Method.
A correct inventory valuation is essential to provide accurate and fair financial statements that reflect the business’s accurate financial health.

FIFO (First-In-First-Out) method: This approach assumes that the first goods purchased or manufactured are also the first ones sold. As a result, the inventory at the end of the period consists of the goods most recently acquired.
LIFO (Last-In-First-Out) method: Contrary to FIFO, LIFO assumes that the last goods purchased or produced are the first ones sold. Thus, the closing inventory consists of the oldest stock.
Average Cost Method: Also known as the weighted average cost method, it averages out the cost of all the goods available for sale during the period regardless of when they were purchased or produced. The cost of the remaining stock and the sold goods is the same.

Inventory valuation is necessary to accurately reflect the cost of the inventory on the balance sheet and the cost of goods sold on the income statement, significantly impacting a business’s profitability and tax liability.
Choosing the appropriate inventory valuation method helps businesses maintain consistency in financial reporting. It makes comparing the financial statements of different periods, or different companies, more meaningful.
Inventory valuation affects the cash flow of a company. Methods like FIFO and LIFO have different impacts on cash flow, especially during periods of inflation or deflation.
Decision-making processes based on financial information, like pricing of goods and inventory management, rely heavily on the accurate valuation of inventory.