If you’re a small business owner, assessing the value of your inventory might seem fairly straightforward, but there are actually many different ways of conducting an inventory valuation. The way you approach the valuation affects all parts of your business. You’ll see how this happens in the following sections, as we answer the question: Why is the valuation of inventories important in financial reporting?
Many business owners don’t realize that the cost of inventory is a deductible part of your taxable income. You can either file for the cost of inventory, the market value of your inventory, or the retail value. Depending on how you value inventory, these figures can vary greatly.
The amount your business paid for the inventory is called the cost. If your inventory has depreciated over the last year since you paid for it, you can use that price, instead, as the market value price. The option to claim “other” is determined by adjusting your inventory value depending on the average retail markup you apply to the inventory itself.
These three different figures affect your total deductible income. When tax season comes around, this can boost your returns. Meet with your in-house accountant to see which option is best for your business.
Selling or Buying a Business
Be sure that the buyer will compensate you for your on-hand inventory before deciding to sell your business. Also, make sure that every figure associated with your inventory is factored into the final sale price. The buyer should pay you for any inventory expenses, as well as for the cost of any inventory related expenses filed on your taxes. This includes calculating the cost of labor in any warehouses or inventory maintenance. The buyer is also responsible for any materials and supplies that the business needs for maintaining the inventory. This is why it is very important to know The Hows and Whys of Small Business Expense Tracking before trying to buy or sell any business.
Obviously, the situation is reversed when you’re buying a company. The amount you have to pay for their inventory won’t be an issue if both parties agree to the use the cost basis. After that, you simply count all the inventory and verify all the costs paid using the company’s invoices.
Inventory Valuation and Cash Flow
The method you use to value inventory can greatly affect the minimum amount of safety stock you should keep on hand. Here are the different ways this can play out:
- If you want your safety stock to have a specific value, using the cost basis makes for a much easier task.
- If you decide to use the retail basis, you can’t just assume that the retail price reflects a reasonable mark-up value.
- Using the retail basis also requires that you mark up the inventory at a rate that’s commensurate with how much you paid for it.
The rationale behind this runs as follows. At any given time, your inventory costs might be higher than they previously were. If the cost of your inventory is higher than they previously were, but the price you charge remains unchanged, then your mark-up percentage is now inaccurate. As a result, you’ll end up receiving less cash because a larger portion of your revenue is paying for inventory.
Using Inventory as Collateral
You might not know it, but you can use inventory as collateral when trying to obtain a loan. If you decide to go this route, the lending institution will insist upon an accurate valuation of your inventory. The retail value of your inventory cannot be the basis of most loans. This is because lenders operate under the assumption that you’d be forced to sell off your inventory at a discount in the event of an emergency. Whenever you demonstrate the value of your inventory, use the cost basis and assume that you’ll only be able to borrow a certain percentage of its total value.
Why is The Valuation of Inventories Important in Financial Reporting?
The way you do your taxes, the availability of loans for your business, and even your profit margins can be subject to change according to the way you value your inventory. But the impact of inventory valuation doesn’t stop here. In fact, you cannot conduct your business accounting to maximize your benefit without proper inventory valuation. In the end, this is the most complete answer you can give to the question ‘Why is the valuation of inventories important in financial reporting?’
About Ivan Popov
Ivan has been counting for the past eight years for small and medium sized businesses helping owners with tax planning, financial covenants, financing and tax optimization.
Email: [email protected]
License ID: MA-32053