In a business process with a long selling cycle, why are inventory valuation methods important as they relate to business or profit valuations?
Inventory Valuation
Inventory can be the largest asset an organization holds on its financial reports ("Why is the accuracy…”, n.d.). Inventory valuation, therefore, is the method or process in which these numbers can be measured to accurately reflect their monetary value. This plays a critical role in defining the current state situation for the organization, as well as projecting future revenues and implementing the best business decisions. Whichever method of valuation, of which I will discuss next, will ultimately affect the total inventory valuation and the numbers that will go into the financial reports.
Valuation Methods
In external reading, I learned about LIFO and FIFO methods of achieving the goal of estimating an evaluation. Last-in-first-out and First-in-first-out, respectively, are methods of valuation which essentially assume that the first or last time to enter the inventory are the first ones to be used ("Comparing different inventory valuation methods…", n.d.).
Organizations can utilize either method to determine these values, but they must be aware of the variations between the different methods to understand the discrepancies. There is also a weighted average cost method, or WAC, which takes the average of the costs in the inventory in costs of goods sold. Most importantly, consistently must be applied. One method must be used through the valuation. It would be prudent for organizations to at least try to use two of the three methods. (Bragg, 2018)
Research has shown that most businesses use the FIFO method mentioned earlier since it allows the closest representation of costs and profitability ("Comparing different inventory valuation methods…", n.d.). However, there are many situations where LIFO makes sense and businesses must be able to understand what is best for their situation.
Importance of Valuation Methods
As mentioned in the first section, having an accurate valuation is critical in representing the best numbers in the financial reporting ("Why is the accuracy…”, n.d.). Ultimately, these affect the cost of goods sold and net income, and the number of current assets, working capital, total assets, and stockholders equity – all of which provide a picture of the company and are used to evaluate market capitalization (Bragg, 2018). Not only are reporting statements inaccurate with improper inventory valuations, but there are further consequences that affect loan rates, income taxes, and competitive advantage.
Resources
Bragg, S. (2018, February 01). Inventory Valuation. Retrieved June 13, 2019, from https://www.accountingtools.com/articles/what-is-inventory-valuation.html
Comparing different inventory valuation methods: FIFO, LIFO, and WAC. (n.d.). Retrieved June 13, 2019, from https://www.tradegecko.com/inventory-management/inventory-valuation-methods
Why is the accuracy of inventory valuation so important? | AccountingCoach. (n.d.). Retrieved June 13, 2019, from https://www.accountingcoach.com/blog/accurate-valuation-of-inventory
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