Chapter 8
Inventory Valuation
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The relationship (ratio) is between: 1) howmuch inventory is in stock; and 2) the amount of inventory
used for the year (which is the Cost of Goods Sold). Dividing the average inventory by how much
was used and multiplying this number by 365 (number of days in the year) will convert the ratio to
the number of days on hand based on how much was used.
As in the initial way inventory days on hand was calculated, New Tech Mobile keeps inventory for
58.9 days and its competitor keeps inventory for 40.6 days. A lower number for this ratio means
that it takes less time for a company to move its inventory. This is another way of saying that its
inventory turnover is better.
Management should not make decisions regarding inventory based on ratios alone.There could be
many factors that affect such numbers. For example, some industries might require companies to
wait longer periods of time to have goods shipped to them. High turnover in these instances may
lead to empty warehouses and customer demands not being met.
As an example, a grocery store will have higher inventory turnover than an appliance store.
Alternatively, car engines will move out of an auto plant warehouse much slower than light bulbs
in a hardware store.
It is the responsibility of accountants and management to know what inventory levels are best for
business. Ratios can help but they are only one of many tools that can be used.
An Ethical Approach to Inventory Estimation and Valuation
As mentioned earlier, management is able to choose the method used to value inventory. Thus,
inventory may be open to manipulation. A company can purchase, store and sell many items
throughout the course of a business year, and how all these items are valued can have a significant
impact on a company’s bottom line.
For example, inventory can sometimes be used as collateral when taking out a bank loan; or employees
may steal from the company’s inventory.That is why the inventory asset on a company’s balance sheet
should be subject to ethical guidelines. We will examine some of these guidelines and suggest how
organizations should approach estimating and valuing inventory in an ethical manner.
Impact on Financial Statements
The impact of inflating closing inventory is significant. It reduces the cost of goods sold and
increases net income for the year. It also inflates the cost of goods sold and reduces net income for
the following year.Therefore, any manipulation of inventory value has negative consequences that
extend beyond the current fiscal year. The ethical responsibility of management is to ensure this
does not happen by detecting errors and the causes behind them.
