AS 2 valuations of inventory, which gives instructions on how to estimate the value at which inventories are taken out before the related sales are realized in the financial statement, also suggests inventory accounting care. IAS 2 is an international financial reporting standard established and published by the International Accounting Standards Board (IASB) to provide instructions on inventory value and classification.
Inventory refers to both the raw materials used in production and the finished goods that are ready to sell. Inventory is one of a company’s most valuable assets because inventory turnover is one of the primary sources of revenue creation and, as a result, earnings for the company’s shareholders. Raw materials, work-in-progress, and finished goods are the three forms of inventory. On a company’s balance sheet, it’s classified as a current asset.
Example of inventory
Assume a fashion retailer that works on a seasonal basis, such as Zara. Like other fashion shops, Zara is under pressure to sell goods quickly due to the quick fashion trend of fluctuation. Zara’s inventory is an example of an inventory that is approaching the end. Fabric and other production materials, on the other hand, are termed raw material inventory.
The inventory consists of the following items: –
- kept for sale in the regular course of business (finished goods).
- During the item’s production process (raw material and work-in-progress).
- In the form of products or equipment that will be used in the manufacturing or production process.
- Resource transfer (stores, spares, raw material, consumables).
- The machine is never included in inventories.
Valuation of Inventories
The monetary value associated with the goods in inventories at the end of an accounting period is known as inventory valuation. Inventories are the most valuable current assets of an organization. Inventory valuation helps you assess your cost of goods sold (COGS) and, as a result, your profitability.
AS 2 valuation of inventory defines the accounting treatment for inventories and guides calculating the value at which inventories are carried out in the financial statement until related revenues are recognized.
The objective of Valuation of Inventories
The objective of this Standard is to ensure that inventory accounting is properly handled. A major challenge in inventory accounting is the amount of expense to be recorded as an asset and carried forward before the relevant sales are recorded. This Standard addresses the calculation of cost and subsequent identification, along with any write-down to net realizable value. It also includes advice on how to use the cost formulas for inventory cost distribution.
Applicability of Inventories Valuation
This AS 2 Inventory Valuation does not apply to the following situations:
- Work in process under building projects, including directly connected service contracts (It is specifically covered by AS-7 construction Contracts)
- Work in progress by service providers in the ordinary course of business;
- Owned in the form of shares, debentures, and other financial instruments.
- Inventories of animals, agricultural and forest products, mineral oils, ores, and gases held by suppliers, to the extent that they are calculated at the net realizable value in accordance with well-established industry procedures.
Importance of Inventories Valuation
The following are some of the reasons why inventory value is important:
- The effect on the cost of items sold : When the actual product has a greater valuation, there is less expensive to charge to the cost of goods sold and vice versa. As a result, inventory valuation has a significant impact on profit levels.
- Impact over a long length of time : Because the incorrect closing balance in the first period will be incorrect, it will carry over into the opening inventory balance in the next financial quarter, causing the estimated profits in two consecutive periods to be incorrect.
- Loan ratios : A limit on the permitted proportions of current assets to current liabilities may be included in a loan agreement if a business has received a loan from a lender. The lender has the option to call the loan if the entity fails to satisfy the specified ratio. Inventory valuation is important since inventory is often the key element of this current ratio.
- Taxes on income : The amount of income taxes paid can be affected by the cost-flow technique used. The LIFO approach is widely used to lower income taxes payable during periods of rising prices.
Methods of Inventories Valuation
The cost of inventories of items that can be divided for various projects should be allocated using specific cost identification (Specific identification method). The first-in, first-out (FIFO) or weighted average cost (WAC) method should be used to calculate the cost of all other items.
The formula should reflect the most accurate approximation of the cost of transporting inventory items to their current location and condition. When calculating the cost using the previous methods is difficult, Standard cost and Retail cost might be applied if the results are close to the actual cost.
Software to manage Inventories Valuation
Inventory valuation can be difficult to understand, especially when a business grows. A business may purchase hundreds or thousands of different items for resale or ingredients to manufacture its products, and it must calculate expenses to each one in order to compute profit and tax liability appropriately.
Using spreadsheets to handle and track inventory finances can be terribly inefficient, time-consuming, and a mistake. To simplify the recording and calculation of inventory costs, top financial management software includes the most popular inventory valuation techniques. This makes it easier for management to get a clear, accurate, and up-to-date financial picture of their business at any time, and it also makes financial statement preparation easier. Inventory valuation software can improve accuracy and allow employees to focus on important activities.
For any business, deciding on an inventory valuation is important. Inventory accounts for a significant portion of the total asset value of many businesses. The way a firm values its inventory has a direct impact on its COGS, profit, and tax liabilities, and once a system is chosen, it must stay to it for a long time.
Inventory value takes into account a large number of expenses. Labour cost and materials, manufacturing overhead, freight-in, handling, and import duties or other taxes paid on inventory purchases are all included.
Each method of inventory valuation has its own set of benefits. Many companies use the FIFO technique, which matches the real cost of inventory to its sale price as nearly as possible; however, it might result in higher gross income and taxes. Although the LIFO method matches current revenue to recent expenses, it is not allowed in many countries due to accounting regulations. Accounting can be made easier by using a weighted average cost. Although proper analysis might make inventory management more difficult, it is useful for businesses that offer high-value or one-of-a-kind things.