How Inventory Valuation Affects the Balance Sheet

Graziano Stefanelli
4 days ago
3 min read

Inventory is one of the most significant assets on the balance sheet for companies engaged in manufacturing, wholesale, or retail operations. Its valuation directly influences both the measurement of assets and the cost of goods sold, which in turn affects profitability. Because of its dual impact on the balance sheet and the income statement, inventory is carefully regulated under both IFRS and US GAAP. The methods applied in valuing inventory can alter financial ratios, tax obligations, and investors’ perception of a company’s performance.

Inventory represents goods held for sale or production.

According to IAS 2: Inventories under IFRS and ASC 330: Inventory under US GAAP, inventory includes assets that are:

Held for sale in the ordinary course of business.
In the process of production for such sale.
In the form of raw materials or supplies to be consumed in the production process.

For a retailer, this may mean finished goods on shelves, while for a manufacturer, inventory includes raw materials, work in progress, and finished goods ready for shipment.

Measurement principles determine the reported value of inventory.

Inventory is measured at the lower of cost and net realizable value (NRV) under IFRS. Under US GAAP, the rule is the lower of cost or market (LCM), where market is generally defined as replacement cost subject to ceiling and floor limits.

The cost of inventory includes purchase costs, conversion costs (direct labor and overhead), and other costs necessary to bring items to their present location and condition. Storage and administrative expenses are generally excluded.

For example, if a company purchases raw materials for 50,000 and incurs 10,000 in conversion costs, the total inventory cost is 60,000. If the selling price of finished goods declines and the NRV falls to 55,000, inventory must be written down to this lower value.

Cost flow assumptions affect both the balance sheet and income statement.

When identical units are acquired at different costs, companies must adopt a cost flow assumption:

FIFO (First-In, First-Out): Assumes oldest costs flow into COGS first, leaving newer costs in ending inventory.
Weighted Average: Uses an average cost for all units available.
Specific Identification: Tracks the actual cost of each unit sold.
LIFO (Last-In, First-Out): Allowed only under US GAAP, assigns the latest costs to COGS, leaving older costs in inventory.

For example, if a company buys 100 units at 10 each and another 100 at 12 each, the cost of inventory at year-end depends on which assumption is applied. FIFO would leave the more expensive units in inventory, while LIFO would leave the cheaper units.

Journal entries demonstrate inventory valuation and write-downs.

When goods are purchased:

Debit: Inventory 20,000
Credit: Accounts Payable 20,000

When inventory is sold:

Debit: Cost of Goods Sold 12,000
Credit: Inventory 12,000

If inventory needs to be written down from 15,000 to 13,000 due to a fall in NRV:

Debit: Loss on Inventory Write-Down 2,000
Credit: Inventory 2,000

This ensures that assets are not overstated on the balance sheet and that losses are recognized promptly.

Presentation on the balance sheet emphasizes liquidity and risk.

Inventory is classified under current assets, usually after cash, receivables, and before prepaid expenses. Companies often disclose the breakdown between raw materials, work in progress, and finished goods. This allows investors and creditors to assess how much capital is tied up in different stages of production.

A company reporting total current assets of 500,000, including inventory of 200,000, signals that a substantial portion of short-term resources are tied up in stock rather than liquid assets such as cash.

Disclosures improve transparency in financial reporting.

Both IFRS and US GAAP require disclosures of:

The accounting policies adopted for inventory valuation.
The total carrying amount and breakdown by classification.
The cost flow assumption used.
The amount of inventory recognized as expense during the period.
Any write-downs or reversals.

These disclosures allow users of financial statements to compare practices across companies and evaluate the reliability of reported values.

Inventory valuation directly influences profitability and ratios.

Because inventory valuation determines COGS, it affects gross profit and net income. Under FIFO in times of rising prices, COGS is lower and profits are higher, while under LIFO profits are reduced but tax liabilities may also be lower. Inventory valuation also impacts financial ratios such as current ratio, quick ratio, and inventory turnover, all of which are closely monitored by investors.

An overstatement of inventory inflates both assets on the balance sheet and net income in the income statement, creating a misleading picture of financial health. Conversely, conservative write-downs may understate profitability but provide a more cautious view of liquidity.

____________

DATA STUDIOS

datastudios.org