The Problems in Inventory Valuation Faced by Companies

Abstract

Inventory valuation is done to meet the shareholder’s needs for financial information as well as that of other stakeholders. Inventory, for most companies like manufacturing companies, constitutes a large percentage (20 – 60 %) of the current assets. It, therefore, plays a big role in making decisions regarding the short-term liquidity position of the firm. If the inventories are erroneously valued, this will result in wrong decision-making by the firm’s management. Firms usually encounter problems in valuing inventory. The methods used to value inventory by firms are usually problematic and may result in the wrong figures being reported in the financial statements. There is therefore a need to figure out the problems that firms usually face while valuing their inventories. This research paper attempts to explore the problems encountered in inventory valuation. The paper is guided by the following question: why do firms encounter problems in valuing inventories? This question is answered by exploring the challenges and difficulties that firms are likely to face while valuing their inventories. Inventory valuation is done using several methods, the main one being the FIFO (first in first out method), the LIFO (last in first out method), and the weighted average method among others. This research paper addresses only these three methods. The problems associated with the use of these methods are taken as the main problems in inventory valuation.

Introduction

The term inventory valuation refers to a technique that enables the company to attach a monetary value to the items that constitute their inventory. Inventory usually constitutes the largest part of the current assets in any business. These inventories need to be accurately valued to provide the correct figures to be posted in the financial statements. If the inventories are not correctly valued, the firm will encounter difficulties in matching revenues and expenses and this would mislead the company in decision making. Accountants usually use two accounting systems in valuing inventory. These are periodic and perpetual inventory accounting systems. In a perpetual inventory system, the amount of inventory at hand at all times should be reflected in the books of the account. The system maintains separate accounts for all items of inventory and these accounts are updated in case of an increase or decrease in their values. For the periodic inventory accounting system, the inventory is usually not updated but the sales made by the business are put in the records. At the end of each year, the cost of goods sold will be determined by taking physical inventory as at that period. Whichever system the company may use, physical inventory taking is recommended at least once in every financial year of the business. The most common methods that are used in valuing inventory include First-In-First-Out (FIFO) method, the Last-In Last Out, and the Weighted Average method. The firm usually encounters several problems while using these methods. This research paper aims to explore the problems in inventory valuation that are faced by companies.

The purpose of research

The purpose of this research is to explore and explain the difficulties/problems encountered by the companies while valuing their inventories.

Research questions

The achievement of the above purpose will be guided by the following question: why do most companies face problems in their attempt to value inventories? To answer this question, the research will focus on finding out the possible difficulties that firms are likely to encounter or usually encounter while valuing their inventory.

Methodology

Since there is a lot written about problems in inventory valuation, the information contained in this research paper is gathered from secondary sources. Secondary sources like books and articles will be used to gather the desired information. The materials chosen will be those specifically addressing the issue of inventory valuation and the problems associated with the exercise.

Problems of inventory valuation

Valuation of inventory aims at attaching a monetary value on the inventory in the stores or issued for production. This is useful in costing the output and pricing production as well as decision making. The valuation of inventory is usually a complex process and has many problems. According to Devine (163), for firms that have long production periods and which quote orders when orders are taken, there is a possibility of increasing or decreasing the operating net through changes in the prices of the factors of production while the manufacturing process is taking place. This poses a challenge to these firms while valuing their inventories.

Goods used or sold during a particular accounting period rarely rhymes with those goods produced or sold in the same period. This, therefore, result in either increase or decrease in inventory during the specified period. The firm will therefore find difficulties in allocating the cost of sales between the sales and the inventory or stock of goods still held in the store. Mostly, the problems encountered in the valuation of stock depend on the technique used in valuing the stock. Inventory valuation is conducted using the following techniques:

First in First out (FIFO)

This method is based on the assumption that stock purchased first is issued first. Prices of stock purchased first are used to determine the cost or value of the inventory issued. Closing stock is carried at the latest cost. This method has many advantages but still has its disadvantages which make the valuation of inventory problematic. Some of the advantages are that the system is realistic in that the oldest items are usually issued first out, there are no cases of unrealized profits or losses that come up, the method is easier to use if the prices of materials do not fluctuate and the closing stock values reflect the latest costs thus reflecting the current market values among others. However, the method has some disadvantages that make it problematic to value inventory accurately or with certainty. The first disadvantage is that, if the price of the materials keeps on fluctuating, the method becomes tedious and chances of arriving at the wrong figures are high. The second disadvantage is that product costs, based on the oldest material prices, lags behind the current conditions especially in inflationary markets. The effect of inflation on inventory valuation is usually ignored. This will make the value not reflect the real market situations. As a result, the cost of sales arrived at in this case cannot be reported in the income statement because it will result in the wrong figures. The method fails to match current costs against their corresponding revenues that ought to be reported in the financial statements. The company adopting the FIFO method is forced to employ the oldest costs against the current revenues and this has the effect of causing the wrong figures to be reported as gross profit or net profit.

Last in first out (LIFO)

This method is based on the assumption that the stock purchased last is issued first. According to the method, stock valuation should therefore be based on the prices ruling on the acquisition of the last stocks. The inventory items purchased or produced during the current year are treated as the first item sold during the year. Any inventory items sold more than the current-year inventory is treated as coming from the most recent items added to the beginning inventory. The cost of goods sold for the year will reflect the costs of the newest inventory items and the ending inventory for the year will reflect the costs of the oldest inventory item.

According to Norton, Diamond, and Pagach (374), the use of the LIFO inventory method causes older, less current values to be reported as inventory amounts, causing distortions in the financial statements. These distortions often call for reporting adjustments. The method can also be costly to employ since it requires tracking each unit of inventory as it is purchased and sold. Also, the stocks are valued at the oldest pries. Comparison of one job and another may be unfair and difficult. The chances of arriving at the wrong decision-making are very high. Besides, there are chances of reporting lower profits when the rate of inflation is very high in the economy. The balance sheet will also have a distortion because the ending inventory is valued at the oldest cost. This also may mislead the decision-makers because the working capital position of the firm will be reflected as being worse than is the case. This may also send a signal about the company’s liquidation indicators, which is dangerous for the company.

Weighted average method

According to Bragg (118), this method is a perpetual weighted average system where the issue price is calculated after each receipt of stock, taking into account both quantities and money value of the stock received. In this case, stock used or unused is based on the average price per unit where the average price per unit is calculated as follows:

  • The total value of stocks = Average Price Per Unit

No. of units of stock

The method is based on the assumption that each issue of goods consists of a due proportion of the earlier lots and is valued at the weighted average price. The average price is arrived at by dividing the total cost of goods by the total quantity of gods in stock. This is the price used in pricing all the issues until a new lot is received when a new average price would be calculated. The method evens out the effect of widely varying prices of different lots which make up the stock.

The problem with this method is that the changes in the current replacements costs are completely ignored. The average price used conceals these changes and therefore the inventory will be recorded at the wrong value. The other problem with the method is that the closing stock does not correspond to the conventional accounting of the valuation of the stock. The method also puts a lot of burden on clerical staff because a new weighted average price is required to be calculated on the receipt of a new lot. The method also cannot be used in the job order industry where each order must be priced at each stage up to completion.

Conclusion

Firms need to correctly value their inventories to ensure that they record the right figures in the books of account. Inventory usually carries the biggest percentage of the firm’s current assets, especially for manufacturing companies. As a result, inventory is a very significant part of the firm’s working capital. If the company, for instance, undervalues the inventories, the company’s balance sheet will report that the firm’s liquidity soundness is not up to standard. There is therefore a dire need to value the inventory correctly. Valuation of inventory usually employs some techniques such as the FIFO (first in first out method), the LIFO (last in first out method), and the weighted average method among others. These methods are adopted by many companies despite the difficulties they pose to the firm. This research paper takes the difficulties encountered in using these methods as the main problems of inventory valuation. Each method has its problems. The FIFO method, for instance, assumes that the stock that was purchased first would be the first one to be issued. The inventory is valued and issued at the price of the stock purchased first. The historical cost is therefore used. The closing inventory is valued at the recent prices. The method is difficult to use when the prices are fluctuating. It also ignores the inflationary effects on the prices, making the sales have the wrong figure. The profits arrived at will therefore be erroneous. The method fails to match current costs against their corresponding revenues that ought to be reported in the financial statements.

The LIFO method also has problems. The method assumes that the stock purchased last should be the first to be issued. The inventories are therefore valued at the price of the last purchased stock. The method causes older, less current values to be reported as inventory amounts, causing distortions in the financial statements. Also, the chances of reporting lower profits when the rate of inflation is very high in the economy. The balance sheet will therefore have erroneous figures because the ending inventory is valued at the oldest cost. This also may mislead the decision-makers because the working capital position of the firm will be reflected as being worse than it is in reality.

The Weighted average method is also problematic. The average price of a stock in a given period is calculated and used as the price for valuing the inventories. The average price is calculated by dividing the total cost of goods by the total quantity of goods in stock. Though the method takes care of the fluctuation in prices, it ignores the changes in the current replacements costs. The inventory may therefore be recorded at the wrong figure because the average price does not reflect the actual price. The main violation in accounting made by this method is that the closing stock does not correspond to the conventional accounting of valuation of the stock.

From this research paper, it is vivid that, the problems in inventory valuation are the problems that are encountered in using every method of inventory valuation. Every firm is likely to face these difficulties depending on the technique of inventory valuation it chooses. More research needs to be done to point out more difficulties that are likely to come up as time goes by.

Works Cited

Bragg, Steven. Inventory accounting: a comprehensive guide. New York: John Wiley and Sons, 2005

Devine, Thomas. (1980). Inventory valuation and periodic income. North Stratford: Ayer Publishing, 1980.

Norton, Curtis., Diamond, Michael and Pagach, Donald. Intermediate accounting: Financial reporting and analysis. North Way Andover Hampshire: Cengage Learning, 2006.

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