Inventory Valuation Cost Accounting Method

Practices and Thoughts on Inventory Valuation

According to various research, valuation of inventory is one of the main issues in the question, According to Wiley (2012), companies may hold inventory in form of raw materials, finished goods, work-in-progress goods, service items and items purchased for resale, and as such, the value of inventory is often high and representative of a very high sum of money; thus, it becomes important to value this inventory consistently and accurately and proper controls are put in place over the physical inventory. According to the University of California (n.d), inventory should be reported on the balance sheet at its cost, but it may also be reported below cost when there is sufficient evidence that the value of the inventory will be lower than its cost upon sale. This deterioration in the value of inventory may be due to obsolescence, or changes in the prices of this said inventory (UIC, n.d). Nonetheless, determination of the actual market value of the inventory may prove to be a daunting task, which results to difficulties in reporting on the values of inventory.

 

Inventory can be valued either at cost, which related to the purchase price and any other costs incurred during the purchase of the products to its present location and state, or through a net realizable value that is essentially an estimate of the selling price of inventory less the estimated costs of getting the product in the condition for sale (Wiley, 2012). According to Wiley 92012), inventory valuation is often made at the lower of these two values- the lower of the cost and realizable value, and this valuation of obtained from the International Accounting Standard. Wiley (2012), identifies various methods of inventory valuation to include FIFO (an acronym that means first in, first out, which assumes that the inventory that is first purchased is also the inventory that is the first to leave the store during sale of units and AVCO (which stands for an acronym for average cost) (UIC, n.d). In the first method defined by Wiley (2012), the oldest inventory is assumed to be the first to be used. In AVCO, however, the weighted average cost of items held during the beginning is calculated by dividing the total cost of goods in the inventory by the number of items in inventory (Wiley, 2012). Below is a description of various methods of valuation of inventory.

Various ways through which inventory can be valued have been adopted. According to the University of California (n.d), the costs for all goods sold must be determined for each accounting period, with the cost of goods being the inventory in the beginning of the accounting period less the inventory at the end of the accounting period. This final inventory can be determined through either periodic or perpetual inventory methods (UIC, n.d). Previously, the amount of goods that constitute the remaining inventory was determined periodically, with periods established, defined and determined once every accounting period normally in the end of it (UIC, n.d). Once this number is determined, it is then substituted as the beginning inventory for the following period (UIC, n.d). The perpetual method on the other hand involves the provision of estimates of the ending inventory perpetually – continuously, such that once items are sold and leave the inventory, they are updated which leaves only the unsold products under inventory (UIC, n.d). Ergo, the perpetual method is ideally a record of change in inventory with very transaction as opposed to physical check on the said inventory, which is characteristic of the periodic method (UIC, n.d).

It is, however, important for a physical inventory check at the end of every accounting period to determine the actual amount or quantity of inventory such as this is so in the periodic method, since the perpetual method provides an estimate of the ending inventory to facilitate completion of financial statements without necessarily taking a physical check (UIC, n.d). Being an estimate means that the quantity or value derived thereof from the perpetual method may not be entirely accurate and representative of the true value and quantity of inventory. However, in both methods, different means of recording the flow of goods into and out of the firm are necessary, whereby in the periodic method, “purchases” are used to record the increase in inventory from purchase and for sale during an accounting period, whereas in the perpetual system, inventory for the period is directly recorded into the inventory account (UIC, n.d).

At the same time, in valuation of the inventory, certain cost flow assumptions have to be made. According to the University of California (n.d), in some situations, the actual cost of inventory can be determined, such as the motor vehicle industry, and as such, the cost of goods sold is a representative of the cost of sales. However, in some instances, the flow of inventory makes identification of the actual costs of sales impossible, hence, firms must rely on the estimated to value their inventory (UIC, n.d). In such instances, cash flow assumptions have to be made to estimate the cost of sales and the value of the inventory that will be reported in the balance sheet (UIC, n.d). These cash flow assumptions may be based on FIFO.

However, the University of California (n.d), argues against FIFO, stating that it rarely represents the actual physical flow of inventory. Therefore, whether prices rise or fall, the balance sheet inventory value reflects the inventory purchased or produced last while the income statement cost of goods sold is representative of those goods that are purchased last or produced last (UIC, n.d). The cash flow assumptions that facilitates the generation of the current cost of goods sold, as well as the outdated costs for inventory is LIFO, an acronym which stands for last, first out. Lastly, the cash flow assumption that generates the average values for the balance sheet inventory costs and the income statement inventory costs numbers is the weighted average, which presents a weigh of the inventory costs against the units purchased or acquired during a particular period (UIC, n.d). The total cost of inventory after weighing is then divided by the sum of all units in the inventory, to generate an average costs, which is then assigned to the units that comprise the cost of goods as well as those that constitute the ending inventory (UIC, n.d).

On the subject, Keith, Herist and Perri (2011), explain that three inventory valuation methods ca be used to determine the value of company inventory at the end of an accounting period. According to Keith, Herist and Perri (2011), these three inventory valuation methods are obtained via accounting information systems flow of transactions in a company. Keith et al. (2011), in support of the views previously expressed by the University of California reiterates that physical flow of inventory will rarely match the assumed flow of accounting data, and further explains that in these inventory valuation methods, assumptions have to be made pertaining to inventory costs. Keith, Herist and Perri (2011), explain that the easiest valuation method is the one that focusses on the actual physical flow of inventory throughout the company. According to Keith, Herist and Perri (2011), this is the FIFO method, which reduces the value of inventory as they leave and adjusts the value of inventory with every new shipment received. The FIFO inventory valuation method results to the purchase of the most recent inventory items. Due to this, it is also refereed as the Last in Still Here method – LISH (Keith, Herist & Perri, 2011).

One of the main merits of the FIFO method is that the ending inventory value is reflective of the most recent purchase costs (Keith, Herist & Perri, 2011). In this valuation method, the cost of goods sold is determined by cost of materials bought earliest during the accounting period and the adjoining cost of inventory is determined by the materials bought latest in the period. As a result of this, inventory is often valued at a higher value and during periods of inflation the use of this methods culminates in the lowest estimate of the cost of goods sold and a resulting higher net income (Keith, Herist & Perri, 2011).

The LIFO method, on the other hand, is the opposite of the FIFO method, as it involves the sale of the first inventory items purchased and, thus, its reference as “the first in” is still included in the method (Keith, Herist & Perri, 2011). Based on the assumption that the last inventory items purchased end up as the first inventory methods to be sold, a better match between the cost of goods sold and the income statements, which results in the value of the current cost of inventory items (Keith, Herist & Perri, 2011). According to Keith, Herist and Perri, (2011), the First in First Out inventory valuation method, the income statements show the earlier acquisition costs and consequently, this may not accurately be reflective of the current inventory replacement costs . A closer match of the current inventory costs and the income statements is very important during periods of inflation and rising costs, which makes the LIFO method preferable in this regard (Keith, Herist & Perri, 2011).

This is because the LOFO method will result to the highest estimates of the cost of goods sold and the lowest estimate of the net income statement when juxtaposed to the FIFO valuation method (Keith et al, 2011). Ultimately, the LIFO method will state the inventory values at a lower price on the balance sheet as compared to the FIFO, and therefore, firms would be interested in using this method in terms of tax benefits in periods of high inflation (Keith, Herist & Perri, 2011).Ffirms which switch from the FIFO method to the KIFO method will show a reduction in net income and a subsequent increase in cash flows resulting from the tax savings, as well as a reverse will apply when firms switch form one method to another (Keith, Herist & Perri, 2011).

The third method of inventory valuation as identified by the University of California and emphasized by Keith, Herist and Perri (2011), is the weighted average cost method. In this valuation method, the weighted average cost per unit is calculated by dividing the costs of goods sold for goods for goods available for sale by the total number of units for that period. The weighted average cost per unit is determined every accounting period and stated in the balance sheet and the income statement as the cost of goods sold (Keith, Herist & Perri, 2011). According to Keith, Herist and Perri, (2011), the weighted average cost method “levels off” the effects of market fluctuations in the prices of inventory, as is the case of the first in first out method and the last in first out method in periods experiencing rises in prices. The Weighted average costs method thus minimizes the effects of price fluctuations on the balance sheet and the income statements (Keith, Herist & Perri, 2011).

Chase (n.d) unites the two opinions described above and establishes a link between all authors by explaining that inventory valuation involves various stages. The first of these is elimination of the effects of inventory errors which is achieved through selection of an inventory system. These include the periodic inventory system, and the perpetual inventory system, as described by the University of California. This stage also involves selection of a cost flow assumption, which includes specific identification, FIFO, LIFO and average cost as described by Keith, Herist and Perri (Chase, n.d). After this has been done, a physical stock take is conducted to determine the physical quantities held and compare them to the accounting records (Chase, n.d). The third state involves the computation of the value of the ending inventory through the multiplication of the physical quantity on hand with the value of the inventory according to the historical cost (Chase, n.d). Lastly, the lower of cost or market rule is applied to make sure that inventory is not “overhauled” by the accounting books (Chase, n.d).

Arguably, the current practice on valuation of inventory as described above seeks to establish the true value of the inventory based on differing criteria. Nonetheless, the end product is attainment of an estimate or figure that is most representative of inventory, which facilitates effective inventory management.

Current Practices and Thoughts on Tangible Fixed Assets and Intangible Fixed Assets

In line with the accounting standard FR 15, tangible fixed assets should be accounted for a consistent manner save for investments properties (Austin Reed, 2013). According to Paterson (2002), managers and accountants alike rethought the management of fixed assets in the turn of the millennium, owing to the high cost of initial purchase and the adjoining high carrying costs of debt. The factors that resulted to the just in time philosophies and lack of defect control influenced managers perspective on asset management. Historically, accountants perceived fixed assets as not requiring ay management attention, and that these assets remained fixed upon purchase. However, managers have felt it necessary to provide additional information relating to property, plant, equipment and created distinct records which are separate from the accounting property record (Paterson, 2002). Such information includes the current market value for insurance and security purposes and pother records such as maintenance and utilization (Paterson, 2002).

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According to Paterson (2002), a single accounting record for tangible assets with accounting controls is superior to multiple records, and because of this, an integrated record with accounting controls has been simplified by the introduction of computers. For instance, recording of maintenance expenses for very large equipment has been simplified, such as the recording of actual maintenance costs of a fleet of cars in the property record of each vehicle, which allows for review of making sure that preventive maintenance can be scheduled. Similarly, an avenue for disposal of older motor vehicles once their economic sense diminishes is established (Paterson, 2002).

In simple terms, asset management has been facilitated by increased computerization of accounting processes and through integrated records and controls sufficient enough to establish sound valuation and recording of asset information, and as such, better asset management. Nancy Faussett (n.d) explains that a firm’s largest capital investment is the firm investment in property, plant and equipment. In order to mitigate the risk of mismanagement of these fixed assets - which may result in missing lucrative opportunities such as tax deductions, fundamental knowledge and understanding of fixed assets management is warranted. In line with this, Faussett (n.d) emphasizes the need to adhere to the generally accepted accounting principles for the reporting of financial statements, as well as to follow the IRS tax codes and regulations for the reporting of income tax.

Ergo, Faussett brings to light the emphasis on the adherence to IRS rules and regulations, as well as to the accounting principles stipulated in the Generally Accepted Accounting Principles. Faussett (n.d), also elaborates on the elements of depreciation and various ways of calculating depreciation. She holds the premise that in order to calculate the true value of an asset, one has to understand the type and nature of asset it is, since a tangible asset is depreciated whereas an intangible asset is amortized Thus, following the adjustment of the cost and value of the fixed asset and the incorporation of depreciation is essential and crucial to financial reporting of fixed assets She further explains that amortization, which applies to intangible assets, with the main difference between amortization and depreciation being the fact that amortization makes use of the straight line method for tax reporting as well as for financial reporting. Intangible assets are amortized over an estimated useful life as long as it does not have a definite life, but intangible assets should nonetheless be reviewed periodically for impairment losses (Faussett, n.d).

According to Foster, Fletcher and Stout (2006), accounting standards established during the last decade created the need for effective valuation of intangible assets for the purpose of financial statement purposes. Fletcher, Foster and Stout (20060) list a series of accounting standards for the accounting of intangible assets such as SFAS 141 and SFAS 142 among others, These accounting standards are specifically in place to address the accounting concerns for intangible assets after they have been acquired. For instance, in SFAS 141, an intangible asset is recognized as an asset besides goodwill which comes into existence through contractual or other legal rights (Foster, Fletcher, and Stout, 2006). According to Ergo, this standard makes it easier to determine the existence of intangible assets. There has been a great deal of debate over the valuation of intangible assets, with it being linked to the reduction in equity per shares of companies such as Microsoft. Consequently, there has been increased pressure of the improvements of the current accounting models in order to incorporate the value of all intangible assets in reporting of financial statements.

Practice and Thoughts on the Allocation of Fixed Asset Cost

Cost allocation refers to the process of allocating costs to various objects and is used in financial reporting to spread costs among various departments (accounting tools, n.d). Various methods of cost allocation are aimed at allocating costs in the fairest way. These include allocating the costs to various departments or divisions (accounting tools, n.d). In doing this the company charges extra expenses to the areas that are considered high tax areas, and as such, the total taxable income for those departments is minimized (Accounting tools, n.d). However, the business must ensure that it is doing so within the confines of the law and government regulations (accounting methods, n.d). Depending on the cause of the cost, it can be allocated in either one area or all areas of the business (Grace, 2014). Cost allocation for fixed assets results in attainment of accurate costs because it becomes simpler to show that the particular item had a role to play in the generation of the said cost (Grace, 2014). Cost allocation also results to better utilization of resources since the ultimate goal is to show that the benefits outweigh the costs (Grace, 2014). However, one of the main practices that many businesses pursue is reduction of taxable income through mitigating the total amount of taxable income.

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