Inventory Valuation

FINANCIAL ACCOUNTING

Unit-4
What Is Inventory?
 Inventory is the term for the goods available for sale and raw materials used to produce goods
available for sale.
 Inventory represents one of the most important asset of a business, because the turnover of
inventory represents one of the primary sources of revenue generation and subsequent earnings
for the company's shareholders.

Understanding Inventory 
 Inventory is the array of finished goods or goods used in production held by a company.
 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, its carrying cost transfers to the cost of goods sold (COGS)
category on the income statement
Inventory can be valued in three ways.

 The first-in, first-out (FIFO) method says that the cost of goods sold is based on the cost of
the earliest purchased materials, while the carrying cost of remaining inventory is based
on the cost of the latest purchased materials.

 The last-in, first-out (LIFO) method states that the cost of goods sold is valued using the cost
of the latest purchased materials, while the value of the remaining inventory is based on
the earliest purchased materials.

 The weighted average method requires valuing both inventory and the cost of goods sold
based on the average cost of all materials bought during the period.
The four types of Inventory Valuation or different conventions on Inventory Valuation Methods.
Most commonly used are
1. Raw Materials,
2. Work-In-Progress (WIP)
3. Finished Goods,
4. Maintenance, Repair, and Overhaul (MRO)
When you know the type of inventory you have, you can make better financial decisions for your supply
chain
1. Raw Materials
Materials that are needed to turn your inventory into a finished product are raw materials.
For example, leather to make belts for your company would fall under this category.
Or
if you sell artificial flowers for your interior design business, the cotton used would be considered raw
materials.
2. Work-In-Progress
Inventory that is being worked on is Work-In-Progress (WIP), just like the name sounds.
 From a cost perspective, WIP includes raw materials, labor, and overhead costs.
 Think of the inventory under this category as being a part of the bigger end-product picture.
 If you sell medical equipment, the packaging would be considered as WIP.
 That’s because the medicine cannot be sold to the consumer until it is stored in proper packaging.
 It’s literally a work-in-progress.
3. Finished Goods
 Maybe the most straight-forward of all inventory types is finished goods inventory.
 That inventory listed for sale on website?
 Those are finished goods.
 Any product that is ready to sold to customers falls under this category.

4. Overhaul / MRO
 Also known as Maintenance, Repair, and Operating Supplies, MRO inventory is all about the
small details.
 It is inventory that is required to assemble and sell the finished product but is not built into the
product itself.
For example, gloves to handle the packaging of a product would be considered MRO.
Basic office supplies such as pens, highlighters, and paper would also be in this category.
Depending on the specifics of your business, this inventory might be in storage, at a supplier, or in
transit out for delivery.
 Inventory valuation is the monetary amount associated with the goods at the end of accounting
period.
 The valuation is based on the costs incurred to acquire the inventory and get it ready for sale.
 Inventories are the largest current business assets.

What is Inventory Valuation?

 Inventory valuation is the total cost that associate with current inventory.
 In other words, it is the total amount of money spent on acquiring the inventory and storing it.
 It is imperative value on inventory, because it is the basis for Cost of Goods Sold (COGS)
calculation in income statement. 

How is inventory valuation calculated?

 Add the cost of beginning inventory to the cost of purchases during the period.
 This is the cost of goods available for sale.
 Multiply the gross profit percentage by sales to find the estimated cost of goods sold.
 Subtract the cost of goods available for sold from the cost of goods sold to get end inventory.
Note that technically Inventory Value is not equal to COGS.
Difference 1: Inventory Value is the value of inventory assets.
 COGS is the part of that value that was sold.
Difference 2: Inventory Value impacts on Balance sheets, while COGS impacts on Profit & Loss
Statement.
 So, what attributes will include in inventory valuation?
 Any and all costs that incur to get the product ready for sale can be included.
 However, cost of advertising cannot include selling costs, in this calculation.

Different Inventory Valuation Methods

There are three most common methods that retailers use:
1. First-In-First-Out (FIFO)
2. Last-In-First-Out (LIFO)
3. Weighted Average Cost (WAC)
 Each of these methods has some distinct benefits and powerful pitfalls.
 The method choose for business depends on which method most accurately reflects the current
state of business.
 A well-versed accounting can give advice on which inventory valuation method to use.
First-In-First-Out Method (FIFO)
In this method, you assume that the first products to enter the inventory are also the first ones to be
sold.
 You always sell oldest inventory first.
 The obvious benefit of this method is that it accurately reflects how most retailers do business.
 Continue to calculate the cost of goods in this manner for the given financial year.

Last-In-First-Out Method (LIFO)

 In this method, the end result of calculations is the exact opposite of what it is in FIFO.
 You assume that the last products to enter inventory are the first ones to be sold.
 In LIFO, the net income would be the lowest possible number to report, since the latest, and most
expensive costs are used first.
 LIFO is used because it keeps taxable income to a minimum.
 However, reported profits would also be lower.
 Moreover, as discussed earlier, LIFO is only accepted under US GAAP rules.
 If expand operations is choose for other countries, then accounting with LIFO.
Weighted Average Cost (WAC)
Because both FIFO and LIFO deal with extreme case scenarios, it is important to have a
system that balances out the pitfalls of both.

Enter, Weighted Average Cost or WAC.

This method is useful if your business does not have too much variation in inventory levels.

In general, given how different the results produced by each method are, you should carefully
consider what benefits outweigh which pitfall.
 Preparation of Financial Statements

 The general purpose of the financial statements is to provide information about the

status of operations, financial position, and cash flows of an organization.
 This information is used by the readers of financial statements to make decisions
regarding the allocation of resources.
 At a more refined level, there is a different purpose associated with each of the financial
statements.
 The income statement informs the reader about the ability of a business to generate a
profit.
 In addition, it reveals the volume of sales, and the nature of the various types of
expenses, depending upon how expense information is aggregated.
 When reviewed over multiple time periods, the income statement can also be used to
analyze trends in the results of company operations.
The purpose of the balance sheet is to inform the reader about the current status of the
business as of the date listed on the balance sheet.

This information is used to estimate the liquidity, funding, and debt position of an
entity, and is the basis for a number of liquidity ratios.

Finally, the purpose of the statement of cash flows is to show the nature of cash
receipts and cash disbursements, by a variety of categories.

This information is of considerable use, since cash flows do not always match the sales
and expenses shown in the income statement.
As a group, the entire set of financial statements can also be assigned
several additional purposes, which are:

Credit decisions:- Lenders use the entire set of financial information to

determine whether they should extend credit to a business, or restrict the
amount of credit already extended.

Investment decisions:- Investors use the information to decide whether to

invest, and the price per share at which they want to invest.
 An acquirer uses the information to develop a price at which to offer to
buy a business.

Taxation decisions:- Government entities may tax a business based on its

assets or income, and can derive this information from the financials.

Union bargaining decisions:- A union can base its bargaining positions on

the perceived ability of a business to pay; this information can be gleaned
from the financial statements.
There are Four Types of Main financial statements in order
They are:
(1) Balance sheets;
(2) Income statements;
(3) Cash flow statements;
(4) Statements of shareholders' equity.
Balance sheets show what a company owns and what it owes at a fixed point in time.
By law, companies prepare financial statements at the end of every quarter and fiscal year.
 Financial statements are critical to your business.
 Without them, you wouldn’t be able to do things like plan expenses, secure loans, or sell your
business.
But how do they get created?

 Through the accounting cycle (sometimes called the “bookkeeping cycle”).

 The accounting cycle is a multi-step process designed to convert all of your company’s raw
financial information into financial statements.
 HOW TO PREPARE A BALANCE SHEET: 5 STEPS FOR BEGINNERS
A company’s balance sheet is one of the most important financial statements it will produce—
typically on a quarterly or even monthly basis (depending on the frequency of reporting).

Depicting total assets, liabilities, and net worth, this document offers a quick look into financial
health and can help inform lenders, investors, or key stakeholders about business. 

Have you found yourself in the position of needing to prepare a balance sheet?
Here's what we need to understand how balance sheets work and what makes them a business
fundamental, as well as general steps can take to create a basic balance sheet for an organization.

WHAT IS A BALANCE SHEET?

 A balance sheet is a financial statement that communicates the so-called “book value” of an
organization, as calculated by subtracting all of the company’s liabilities and shareholder equity
from its total assets.

 A balance sheet offers internal and external analysts a snapshot of how a company is currently
performing, how it performed in the past, and how it expects to perform in the immediate future.

 This makes balance sheets an essential tool for individual and institutional investors, as well as
key stakeholders within an organization and any outside regulators.
Most balance sheets are arranged according to this equation:

Assets = Liabilities + Shareholders’ Equity

The equation above includes three broad buckets, or categories, of value which must be
accounted for:
1. Assets

An asset is anything a company owns which holds some amount of quantifiable value, meaning
that it could be liquidated and turned to cash.
They are the goods and resources owned by the company.
Assets can be further broken down into current assets and noncurrent assets.
1. Current assets are typically what a company expects to convert into cash within a year’s
time, such as cash and cash equivalents, prepaid expenses, inventory, marketable
securities, and accounts receivable.

2. Noncurrent assets are long-term investments that a company does not expect to convert
into cash in the short term, such as land, equipment, patents, trademarks, and intellectual
property.
2. Liabilities

A liability is anything a company or organization owes to a debtor.

This may refer to payroll expenses, rent and utility payments, debt payments, money
owed to suppliers, taxes, or bonds payable.

As with assets, liabilities can be classified as either current liabilities or noncurrent

liabilities.

1. Current liabilities are typically those due within one year, which may include
accounts payable and other accrued expenses.

2. Noncurrent liabilities are typically those that a company doesn’t expect to repay
within one year.

 They are usually long-term obligations, such as leases, bonds payable, or loans.
3. Shareholders’ Equity

Shareholders’ equity refers generally to the net worth of a company, and reflects
the amount of money that would be left over if all assets were sold and liabilities
paid.

Shareholders’ equity belongs to the shareholders, whether they be private or public

owners.

Just as assets must equal liabilities plus shareholders’ equity, shareholders’ equity
can be depicted by this equation:

Shareholders’ Equity = Assets - Liabilities

What goes on a balance sheet

All balance sheets are organized into three categories: assets, liabilities, and owner’s equity.
Assets
List your assets in order of liquidity, or how easily they can be turned into cash, sold or consumed.
Anything you expect to convert into cash within a year are called current assets.
Current assets include:
 Money in a checking account
 Money in transit (money being transferred from another account)
 Accounts receivable (money owed to you by customers)
Short-term investments
 Inventory
 Prepaid expenses
 Cash equivalents (currency, stocks, and bonds)
Long-term assets, on the other hand, are things you don’t plan to convert to cash within a year.

Long-term assets include:

 Buildings and land
 Machinery and equipment (less accumulated depreciation)
 Intangible assets like patents, trademarks, and goodwill (list the market value of what fair price a
buyer might purchase)

Long-term investments-Example
Let’s say you own a V catering business called ‘B”.
As of December 31, your company assets are:
 Money in checking account, an unpaid invoice for a wedding you just catered, and cookware,
dishes and utensils worth $900.
Here’s how you’d list assets on your balance sheet:

ASSETS
Bank account $2,050
Accounts receivable $6,100
Equipment $900
Total assets $9,050
 Liabilities
Liabilities—what your business owes to others.
List your liabilities by their due date.
 Just like assets, classify them as current (due within a year) and long-term (due date
is more than a year away).
Current liabilities might include:
Accounts payable (what you owe suppliers for items you bought on credit)
 Wages you owe to employees for hours they’ve already worked
 Loans that you have to pay back within a year
 Taxes owed
Long-term liabilities(non-current) :
 Loans that you don’t have to pay back within a year
 Bonds your company has issued

 Returning to our catering example, let’s say Not yet paid the latest invoice from
food supplier.
 Also have a business loan, which isn’t due for another 18 months.
 Here is ‘B’ liabilities: Here’s a summary of “B” equity:
LIABILITIES OWNER’S EQUITY
Accounts payable $150 Capital $5,000
Long-term debt $2,000 Retained earnings $10,900
Total liabilities $2,150 Drawing -$9,000
Total equity $6,900
Equity
Equity is money currently held by company.
(This category is usually called “owner’s equity” for sole proprietorships and “stockholders’ equity” for
corporations.) It shows what belongs to the business owners.
Owners’ equity includes:
1. Capital (money invested into the business by the owners)
2. Private or public stock
3. Retained earnings (all revenue minus all expenses since launch).
 Equity can also drop when an owner draws money out of the company to pay them self, or when a
corporation issues dividends to shareholders.
 Where’s B, invested $2,500 to launch business in 2016, and another $2,500 a year later.
 Since money taken $9,000 out of the business to pay self and you’ve left some profit in the bank.
A Sample Balance Sheet
 How to Prepare an Income Statement? A Simple 10 Step
To prepare an income statement generate
1. Trial balance report
2. Calculate revenue
3. Cost of goods sold
4. Gross margin,
5. Operating expenses,
6. Income,
7. Income taxes,
8. Net income
9. Finalize income statement
10.Reporting period

11.PICK A REPORTING PERIOD

 The first step in preparing an income statement is to choose the reporting period of report will cover.
 Businesses typically choose to report their income statement on an annual, quarterly or monthly
basis.
 Publicly traded companies are prepare financial statements on a quarterly and annual basis.
 Small businesses aren’t as heavily regulated in reporting.
 Creating monthly income statements help in identifying trends in profits and expenditures over time.
 That information help in making business decisions to make company more efficient and profitable.
2. GENERATE A TRIAL BALANCE REPORT
 To create income statement for business, you need to print standard trial balance report.
 Trial balance reports are internal documents, that list the end balance of each account in the
general ledger for a specific reporting period.
 It will give you all the end balance figures needed to create an income statement.
3. CALCULATE YOUR REVENUE
 Next, you need to calculate your business’s total sales revenue for the reporting period.
 Revenue includes all the money earned for services during the reporting period, even if you haven’t
yet received all the payments.
 Add all the revenue line items from trial balance report and enter the total amount in the revenue
line item of your income statement.
4. DETERMINE COST OF GOODS SOLD
 Cost of goods sold includes the direct labor, materials and overhead expenses incurred to provide
goods or services.
 Add all the cost of goods sold line items on trial balance report and list the total cost of goods sold
on the income statement, directly below the revenue line item.
5. CALCULATE THE GROSS MARGIN
 Subtract the cost of goods sold total from the revenue total on your income statement.
 This calculation will give you the gross margin, or the gross amount earned from the sale of goods
and services.
6. INCLUDE OPERATING EXPENSES
 Add all the operating expenses listed on trial balance report.
 Enter the total amount into the income statement as the selling and administrative expenses line
item.
 It’s located directly below the gross margin line.
7. CALCULATE YOUR INCOME
 Subtract the selling and administrative expenses total from the gross margin.
 This will give you the pre-tax income.
 Enter the amount at the bottom of the income statement.
8. INCLUDE INCOME TAXES
 To calculate income tax, multiply applicable state tax rate by pre-tax income figure.
 Add this to the income statement, below the pre-tax income figure.
9. CALCULATE NET INCOME
 To determine your business’s net income, subtract the income tax from the pre-tax income figure.
 Enter the figure into the final line item of your income statement.
10. FINALIZE THE INCOME STATEMENT
 To finalize income statement, add a header to the report identifying it as an income statement.
 Add business details and the reporting period covered by the income statement.
Difference Between Balance Sheet and Income
Statement?
There are a few key differences including:

Timing: Income statement reports financial activity for

a specific reporting period, usually a month, a quarter
or a year.
 Balance sheet reports financial activity at a specific
point in time, for snapshot view of business’s
finances.
Information reported: The income statement reports
on a business’s revenues and expenses and ultimately
the amount of profit or loss generated.
 Whereas a balance sheet reports on a company’s
assets, liabilities and equity.
Significance: The income statement is used to report
the overall results of business’s financial performance,
or how much earnings it’s generating.
 The balance sheet is used to analyze whether a
company has enough liquid assets to cover financial
obligations.
 Cash flow statements;

 A cash flow statement of a company lays down an organization's total fund inflow in the form
of cash and cash equivalents through operational, investment, and financing activities.
 It is one of the three most crucial financial reports and statements that any organisation
prepares at the end of every financial year.

 It shall be noted that a cash flow statement's fundamentally distinct from a Balance Sheet or
an Income Statement.

 Apart from Balance Sheet and Income Statement, all registered companies are mandated to
prepare a cash flow statement, according to the revised Accounting Standard – III (AS –III).

Cash Flow Statement – Structure

In the standard cash flow statement format, there are three subdivisions under which all
concerned cash inflow and outflow are classified as
1. Operations
2. Investing
3. Financing
 Cash flow from Operations
 The first section in the statement, it summaries all cash inflow and outflow stemming
from an organization's operational activities.

 Therefore, the first entry in this section is the net income computed in an
organization's Income Statement for a corresponding period.

 Since the net income shown in an Income Statement represents cash and non-cash
transactions, adjustments are made to derive net cash flows.

 Thereafter, both the statements are reconciled to exclude and include all the non-cash
and cash items that were incorporated or omitted respectively during the preparation
of the Income Statement.
Example – The net income of Company A is Rs.5 lakh, as shown in Income Statement. Company A has
listed Rs.75000 as depreciation on Plant & Machinery; Rs. 2 lakh as an increase in the value of
current assets; and Rs. 3 lakh as an increase in the value of current liabilities.
The cash flow statement against
the given data is given below.

Particulars Amount (Rs.)

Second section in a cash flow statement is CFI.
Cash flow from operating
activities
Cash flow from investing activities (CFI)
Net income 5,00,000

Additions  This section denotes all cash inflow and

Depreciation and Amortisation
Increase in current liabilities
Deductions
Increase in current assets
Net cash flow from operating
activities
outflow realise from investing activities of
75,000 an organisation in a specific accounting
year.
3,00,000
 These activities include purchasing and
selling of fixed assets and investments and
disinvestments in securities.
2,00,000
 Therefore, all expenditures listed under this
section are classified as capital expenditure
6,75,000
and all revenues as capital revenue.
 CFI Analysis

Cash flow analysis of investing should not be based on the margin of difference
between cash inflow and outflow.

 A low margin of difference or a negative difference between inflow and

outflow might indicate that a company is spending a substantial amount of
money towards enhancing its financial health by purchasing or improving
its fixed assets.

 Ergo, from an analyst’s perspective, a low margin of difference is sometimes

indicative of a company’s sustainability and growth.

 On the other hand, a high margin of difference might indicate that a

company is not spending enough towards developing its assets or selling
them off without adequately replacing them.

 Therefore, from an analyst’s perspective, a high margin of difference

between cash inflow and outflow can be indicative of a company’s inability
to sustain in the long run.
 Cash flow from financing activities (CFF)
It is the third and last section in a cash flow statement.
 It represents all the cash inflow and outflow of a company stemming from its financing activities.
 These activities are directly linked with a company’s capital, both owned and borrowed.
 Therefore, cash inflows under this section include funds raised from the issuance of stocks and
debentures.
 On the other hand, cash outflows include retiring debts, stock repurchases, interest on debentures,
and dividend payments.
CFF Analysis
 Cash flow from financing activities provides analysts and investors insights into a company’s capital
structure, how well it is managed, and how far it can sustain with the showcased capital strength.
 A positive margin of difference, in this case, is most often desired by investors, since it shows that
more cash is coming in to buttress its financial strength.
 However, it might also imply that a company’s earnings are not sufficient, and thus, it has to resort
to the issuance of stocks or debentures for funding purposes.
 Conversely, a negative margin of difference or a low margin might indicate that a company’s
financial strength is enervating.
Or
 It can also imply that the company is spending substantial amounts towards stock repurchases,
retiring debts, and paying dividends.
Example – In 2019 – 20, Walmart Inc. showed a negative cash flow from financing activities
amounting to $14,299 million.

The financing activities’ components are shown in the table below.

Particulars Amount (in millions)

 The bulk of all cash outflows are for retiring debt, both
Proceeds from issuance of short- and long-term, repurchasing stocks, and paying
$5,492
short-term borrowings dividends.
Net change in short-term
borrowings
($4,656)  Therefore, even with negative net cash flow from operating
activities, it bodes well for investors and the market in
Repayments of long-term debt ($1,907) general.
Stock repurchases ($5,717)
A cash flow statement can be prepared by following either of
Dividends paid ($6,048) the two below-mentioned methods –

Dividends paid to non- 1. Direct

($555)
controlling interest
2. Indirect
Other financing activities ($908)

Net cash flow from

($14,299)
financing activities
 Direct Method
Particulars Amount (Rs.)
 Under this approach of preparing a cash flow statement, all
cash-related transactions within an accounting period Decrease in accounts receivable 10,00,000

are added and deducted accordingly to calculate the net Salary and wages (3,50,000)
cash flows. Taxes (50,000)

 These transactions, in turn, are derived from the opening Cash flow from operating
6,00,000
and closing balances of relevant accounts. activities

Sale of land 7,00,000

Cash flow statement example – Company B has realise Rs.
10 lakh from customers; paid Rs. 3.5 lakh towards salary Net proceeds from maturity of
securities
1,50,000
and wages; realise Rs. 7 lakh from sale of land; paid taxes
Purchase of machinery (10,00,000)
Rs. 50000; earned Rs. 1.5 lakh as net proceeds from
maturity of securities; purchased machinery worth Rs. 10 Cash flow from investing
activities 
(1,50,000)
lakh; spent Rs. 3 lakh towards repayment of debenture;
Repayment of debenture (3,00,000)
and realise Rs. 5 lakh as proceeds from the issuance of
shares in FY 2019 – 20. Shares issued 5,00,000

Cash flow from financing

 The cash flow statement for 2019–20 as per the direct activities
2,00,000

method is laid down . Net cash flow 6,50,000

Indirect Method
 In the indirect method, the net cash flow is derived from the net income shown in an organization's
Income Statement.
 As discussed previously, from the net income, all cash and non-cash transactions are added and
deducted accordingly to derive the net cash flow.
 How to use Cash Flow Statement?
A cash flow statement serves as a crucial tool for investors, analysts, and third parties alongside the
organisation itself.
Use of cash flow statement is mentioned below –
 To assess the financial footing of an organisation.
 To determine its capability to tide over short- and long-term liabilities.
 To gauge a company’s profitability.
 Recognising the sources of capital of an organisation.
 Identifying ways in which a company is spending its capital and earnings.
 Therefore, before making any investment decisions, investors can take a look at a company’s cash
flow statement to see whether it suits their profile and investment objectives.
FAQ
How is a cash flow statement from operating activities prepared under the indirect method?
 The cash flow statement from operating activities can be derived from two stages –
1. Calculation of operating profit prior to any change in working capital.
2. Effect of working capital change.
What is the purpose of a cash flow statement?
 A cash flow statement helps to identify the majority of cash flows that occur during the same time as that recorded
in a company’s income statement.
 Cash flow consists of – operating activities, investing activities and financing activities.
What is a non-cash expense?
These are the expenses that are included in a company’s income statement but do not include any actual
transaction of cash. Depreciation is one of the examples of a non-cash expense.
 Statement of Owner's Equity
The "Statement of Owner's Equity", or "Statement of Changes in Owner's Equity", summarizes the
items affecting the capital account of a sole proprietorship business.
A sole proprietorship's capital is affected by four items: owner's contributions, owner's withdrawals,
income, and expenses
 Stockholders Equity (also known as Shareholders
Equity) is an account on a company’s balance sheet
that consists of share capital plus retained earnings.
 It also represents the residual value of assets minus
liabilities.
 By rearranging the original accounting equation, Assets =
Liabilities + Stockholders Equity, it can also be
expressed as Stockholders Equity = Assets – Liabilities.

 Stockholders Equity provides highly useful information when analyzing financial statements.
 In events of liquidation, equity holders are later in line than debt holders to receive any payments.
 This means that bondholders are paid before equity holders.
 Therefore, debt holders are not very interested in the value of equity beyond the general amount of
equity to determine overall solvency.
 Shareholders, however, are concerned with both liabilities and equity accounts because stockholders
equity can only be paid after bondholders have been paid.