Accounting standards provide guidelines for inventory valuation to ensure that companies report inventory at an appropriate value on their financial statements. Here’s an overview of how inventory valuation is addressed through accounting standards:
Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) both require inventory to be initially recorded at cost. Cost includes all expenditures incurred to bring the inventory to its present location and condition.
Examples of costs that can be included in inventory valuation are the purchase price, transportation costs, direct labor costs, and applicable overhead costs directly attributable to the production or acquisition of the inventory.
Cost-based valuation methods, such as First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average Cost, are commonly used to assign costs to individual units of inventory.
Lower of Cost or Net Realizable Value (LCNRV):
Both GAAP and IFRS require companies to assess their inventory for potential impairment and write it down to its lower of cost or net realizable value if necessary.
Net realizable value is the estimated selling price in the ordinary course of business, less any estimated costs of completion, disposal, and transportation.
If the net realizable value of the inventory is lower than its cost, a write-down is recognized to reduce the carrying amount of the inventory to its LCNRV. This ensures that inventory is not reported at an amount higher than its recoverable value.
Specific industries and inventory valuation:
Certain industries have specific requirements or practices related to inventory valuation. For example, in the retail industry, the retail inventory method may be used, which estimates the cost and retail value of inventory to determine the cost-to-retail ratio for valuation purposes.
Agriculture, commodity trading, and extractive industries often have unique considerations in inventory valuation due to the nature of their products, such as biological assets or commodities subject to market price fluctuations.
Accounting standards emphasize the importance of disclosures related to inventory valuation. Companies are required to provide information about their accounting policies for inventory, including the cost flow assumption method used and any valuation adjustments made.
Additional disclosures may include carrying amounts of different categories of inventory, changes in inventory valuation methods, and any constraints or restrictions on the sale or use of inventory.
It’s important to note that specific accounting standards may vary across jurisdictions and industries. Therefore, companies must adhere to the relevant accounting standards applicable to their reporting framework (e.g., GAAP or IFRS) and consider any industry-specific guidance or requirements when valuing their inventory.