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Inventory valuation determines the value of closing stock and cost of goods sold. Since closing stock is credited in Trading Account and shown as a current asset, its valuation directly affects gross profit and financial position. As per prudence, inventory is generally valued at lower of cost or net realisable value (NRV).
Objectives:
Inventory is valued at lower of cost or NRV to avoid overstatement of assets and profits.
NRV = Estimated selling price − Estimated selling expenses (and completion cost, if any).
Issues are valued at oldest costs; closing stock reflects latest costs.
Issues are valued at latest costs; closing stock reflects older costs.
Average cost per unit = Total cost of goods available / Total units available.
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Inventory valuation determines the value of closing stock and cost of goods sold. Since closing stock is credited in Trading Account and shown as a current asset, its valuation directly affects gross profit and financial position. As per prudence, inventory is generally valued at lower of cost or net realisable value (NRV).
Objectives:
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Inventory valuation is important to determine the correct cost of goods sold and thus correct gross profit for the period. It also helps to show the true financial position because closing stock is a current asset in the balance sheet. Further, it ensures application of prudence and consistency so that profits and assets are not overstated and financial statements remain comparable.
Cost of inventory includes purchase price plus directly attributable costs such as carriage inward and non-refundable taxes, after deducting trade discounts. NRV is the estimated selling price less costs of completion and selling expenses. Inventory is valued at lower of cost or NRV to follow prudence and to avoid showing stock at a value higher than what can be realised from sale.
Inventory valuation methods decide the cost assigned to issues and the value of closing stock, thereby affecting gross profit.
FIFO (First in First out): earliest purchases are issued first; closing stock reflects recent costs. In rising prices, FIFO generally gives lower COGS and higher profit, and closing stock value is higher.
LIFO (Last in First out): latest purchases are issued first; closing stock reflects older costs. In rising prices, LIFO generally gives higher COGS and lower profit, and closing stock value is lower.
Weighted Average: average cost per unit is computed as total cost of goods available divided by total units available. Issues and closing stock are valued at this average rate, giving a moderate effect and reducing the impact of price fluctuations.
Thus, FIFO, LIFO and weighted average differ in issue assumptions and they significantly influence reported profit and closing stock.