ICAI Notes- Inventories | Principles and Practice of Accounting - CA Foundation PDF Download

 Page 1


 
LEARNING OUTCOMES 
INVENTORIES  
 
 
After studying this chapter, you will be able to: 
? Understand the meaning of term 'Inventory'. 
? Learn the technique of Specific Identification Method, FIFO, Average 
Price, Weighted Average Price and Adjusted Selling Price methods 
of inventory valuation. 
? Understand the methods of inventory record keeping and 
comprehend the intricacies relating to Inventory taking. 
4 
CHAPTER 
   
© The Institute of Chartered Accountants of India
Page 2


 
LEARNING OUTCOMES 
INVENTORIES  
 
 
After studying this chapter, you will be able to: 
? Understand the meaning of term 'Inventory'. 
? Learn the technique of Specific Identification Method, FIFO, Average 
Price, Weighted Average Price and Adjusted Selling Price methods 
of inventory valuation. 
? Understand the methods of inventory record keeping and 
comprehend the intricacies relating to Inventory taking. 
4 
CHAPTER 
   
© The Institute of Chartered Accountants of India
  ACCOUNTING
1.2 
4.2 
 
Formulae for Determining Cost of Inventory 
 
Basis of Inventory Valuation 
 
Types of Inventory
In case of Manufacturing concerns
Raw 
Materials
Work -in-
progress
Finished 
Goods
Stores and 
Spares
Packing 
Material
In case of Trading  concerns
Traded 
Goods
Inventory Valuation Techniques
Historical Cost 
Methods
Inventory, not ordinarily 
Interchangeable
Specific Identificaion 
Method
Inventory, ordinarily 
Interchangeable
FIFO LIFO
Weighted 
Average Price
Non-Historical 
Cost Methods
Adjusted 
Selling Price
Whichever is less
Cost
Net realisation Value
CHAPTEROVERVIEW 
© The Institute of Chartered Accountants of India
Page 3


 
LEARNING OUTCOMES 
INVENTORIES  
 
 
After studying this chapter, you will be able to: 
? Understand the meaning of term 'Inventory'. 
? Learn the technique of Specific Identification Method, FIFO, Average 
Price, Weighted Average Price and Adjusted Selling Price methods 
of inventory valuation. 
? Understand the methods of inventory record keeping and 
comprehend the intricacies relating to Inventory taking. 
4 
CHAPTER 
   
© The Institute of Chartered Accountants of India
  ACCOUNTING
1.2 
4.2 
 
Formulae for Determining Cost of Inventory 
 
Basis of Inventory Valuation 
 
Types of Inventory
In case of Manufacturing concerns
Raw 
Materials
Work -in-
progress
Finished 
Goods
Stores and 
Spares
Packing 
Material
In case of Trading  concerns
Traded 
Goods
Inventory Valuation Techniques
Historical Cost 
Methods
Inventory, not ordinarily 
Interchangeable
Specific Identificaion 
Method
Inventory, ordinarily 
Interchangeable
FIFO LIFO
Weighted 
Average Price
Non-Historical 
Cost Methods
Adjusted 
Selling Price
Whichever is less
Cost
Net realisation Value
CHAPTEROVERVIEW 
© The Institute of Chartered Accountants of India
4.3 
INVENTORIES 
 1.  MEANING 
Inventory can be defined as assets held 
? for sale in the ordinary course of business, or 
? in the process of production for such sale, or 
? for consumption in the production of goods or services for sale, including maintenance 
supplies and consumables other than machinery spares, servicing equipment and 
standby equipment. 
There can be different types of inventory based on nature of business of an enterprise. The 
inventories of a trading concern consist primarily of products purchased for resale in their 
existing form. It may also have an inventory of supplies such as wrapping paper, cartons, and 
stationery. The inventories of manufacturing concern consist of several types of inventories: 
raw material (which will become part of the goods to be produced), work-in-process (partially 
completed products in the factory) and finished products. In manufacturing concerns 
inventories will also include maintenance supplies, consumables, loose tools and spare parts. 
However, inventories do not include spare parts, servicing equipment and standby equipment 
which can be used only in connection with an item of fixed asset and whose use is expected 
to be irregular; such machinery spares are generally accounted for as fixed assets. Similarly, in 
an enterprise engaged in construction business, projects under construction are also 
considered as inventory.  
At the year-end (or any period for which books are closed) every business entity needs to 
ascertain the closing balance of Inventory which comprise of Inventory of raw material, work-
in-progress, finished goods and other consumable items. Value of closing Inventory is put at 
the credit side of the Trading Account and asset side of the Balance Sheet. So, before 
preparation of final accounts, the accountant should know the value of Inventory of the 
business entity. However, we shall restrict our discussion on inventory valuation of a 
manufacturing concern and goods of a trading concern.  
 2. INVENTORY VALUATION 
A primary issue in accounting for inventories is the determination of the value at which 
inventories are carried in the financial statements until the related revenues are recognized. 
Inventory is generally the most significant component of the current assets held by a trading 
or manufacturing enterprise. It is widely recognized that inventory is one of the major assets 
that affects efficiency of operations. Both excess of inventory and its shortage affects the 
production activity, and the profitability of the enterprise whether it is a manufacturing or a 
trading business. Proper valuation of inventory has a very significant bearing on the 
© The Institute of Chartered Accountants of India
Page 4


 
LEARNING OUTCOMES 
INVENTORIES  
 
 
After studying this chapter, you will be able to: 
? Understand the meaning of term 'Inventory'. 
? Learn the technique of Specific Identification Method, FIFO, Average 
Price, Weighted Average Price and Adjusted Selling Price methods 
of inventory valuation. 
? Understand the methods of inventory record keeping and 
comprehend the intricacies relating to Inventory taking. 
4 
CHAPTER 
   
© The Institute of Chartered Accountants of India
  ACCOUNTING
1.2 
4.2 
 
Formulae for Determining Cost of Inventory 
 
Basis of Inventory Valuation 
 
Types of Inventory
In case of Manufacturing concerns
Raw 
Materials
Work -in-
progress
Finished 
Goods
Stores and 
Spares
Packing 
Material
In case of Trading  concerns
Traded 
Goods
Inventory Valuation Techniques
Historical Cost 
Methods
Inventory, not ordinarily 
Interchangeable
Specific Identificaion 
Method
Inventory, ordinarily 
Interchangeable
FIFO LIFO
Weighted 
Average Price
Non-Historical 
Cost Methods
Adjusted 
Selling Price
Whichever is less
Cost
Net realisation Value
CHAPTEROVERVIEW 
© The Institute of Chartered Accountants of India
4.3 
INVENTORIES 
 1.  MEANING 
Inventory can be defined as assets held 
? for sale in the ordinary course of business, or 
? in the process of production for such sale, or 
? for consumption in the production of goods or services for sale, including maintenance 
supplies and consumables other than machinery spares, servicing equipment and 
standby equipment. 
There can be different types of inventory based on nature of business of an enterprise. The 
inventories of a trading concern consist primarily of products purchased for resale in their 
existing form. It may also have an inventory of supplies such as wrapping paper, cartons, and 
stationery. The inventories of manufacturing concern consist of several types of inventories: 
raw material (which will become part of the goods to be produced), work-in-process (partially 
completed products in the factory) and finished products. In manufacturing concerns 
inventories will also include maintenance supplies, consumables, loose tools and spare parts. 
However, inventories do not include spare parts, servicing equipment and standby equipment 
which can be used only in connection with an item of fixed asset and whose use is expected 
to be irregular; such machinery spares are generally accounted for as fixed assets. Similarly, in 
an enterprise engaged in construction business, projects under construction are also 
considered as inventory.  
At the year-end (or any period for which books are closed) every business entity needs to 
ascertain the closing balance of Inventory which comprise of Inventory of raw material, work-
in-progress, finished goods and other consumable items. Value of closing Inventory is put at 
the credit side of the Trading Account and asset side of the Balance Sheet. So, before 
preparation of final accounts, the accountant should know the value of Inventory of the 
business entity. However, we shall restrict our discussion on inventory valuation of a 
manufacturing concern and goods of a trading concern.  
 2. INVENTORY VALUATION 
A primary issue in accounting for inventories is the determination of the value at which 
inventories are carried in the financial statements until the related revenues are recognized. 
Inventory is generally the most significant component of the current assets held by a trading 
or manufacturing enterprise. It is widely recognized that inventory is one of the major assets 
that affects efficiency of operations. Both excess of inventory and its shortage affects the 
production activity, and the profitability of the enterprise whether it is a manufacturing or a 
trading business. Proper valuation of inventory has a very significant bearing on the 
© The Institute of Chartered Accountants of India
  ACCOUNTING
1.4 
4.4 
authenticity of the financial statements. The significance of inventory valuation arises due to 
various reasons as explained in the following points:  
(i)  Determination of Income 
 The valuation of inventory is necessary for determining the true income earned by a 
business entity during a particular period. To determine gross profit, cost of goods 
sold is matched with revenue of the accounting period. Cost of goods sold is calculated 
as follows: 
 Cost of goods sold = Opening inventory + Purchases + Direct expenses - Closing 
inventory. 
 Inventory valuation will have a major impact on the income determination if 
merchandise cost is large fraction of sales price. The effect of any over or under 
statement of inventory may be explained as: 
If the value of…… Then net income will be….. 
Closing inventory overstated  Overstated 
Opening inventory overstated  Understated                           
Closing inventory understated Understated                           
Opening inventory understated  Overstated 
The effect of misstatement of inventory figure on the net income is always through 
cost of goods sold. Thus, proper calculation of cost of goods sold and for that matter, 
proper valuation of inventory is necessary for determination of correct income. 
(ii)  Ascertainment of Financial Position 
 Inventories are classified as current assets. The value of inventory on the date of 
balance sheet is required to determine the financial position of the business. In case 
the inventory is not properly valued, the balance sheet will not disclose the truthful 
financial position of the business. 
 Usually, slow-moving or non-moving inventory is the basic reason for poor financial 
performance as well as financial position of an enterprise. To identify such items, the 
first step is to value the inventory in the appropriate manner. 
(iii)  Liquidity Analysis 
 Inventory is classified as a current asset, it is one of the components of net working 
capital which reveals the liquidity position of the business. Current ratio which studies 
the relationship between current assets and current liabilities is significantly affected 
by the value of inventory. Bankers rely on the current ratio which is denoted as current 
© The Institute of Chartered Accountants of India
Page 5


 
LEARNING OUTCOMES 
INVENTORIES  
 
 
After studying this chapter, you will be able to: 
? Understand the meaning of term 'Inventory'. 
? Learn the technique of Specific Identification Method, FIFO, Average 
Price, Weighted Average Price and Adjusted Selling Price methods 
of inventory valuation. 
? Understand the methods of inventory record keeping and 
comprehend the intricacies relating to Inventory taking. 
4 
CHAPTER 
   
© The Institute of Chartered Accountants of India
  ACCOUNTING
1.2 
4.2 
 
Formulae for Determining Cost of Inventory 
 
Basis of Inventory Valuation 
 
Types of Inventory
In case of Manufacturing concerns
Raw 
Materials
Work -in-
progress
Finished 
Goods
Stores and 
Spares
Packing 
Material
In case of Trading  concerns
Traded 
Goods
Inventory Valuation Techniques
Historical Cost 
Methods
Inventory, not ordinarily 
Interchangeable
Specific Identificaion 
Method
Inventory, ordinarily 
Interchangeable
FIFO LIFO
Weighted 
Average Price
Non-Historical 
Cost Methods
Adjusted 
Selling Price
Whichever is less
Cost
Net realisation Value
CHAPTEROVERVIEW 
© The Institute of Chartered Accountants of India
4.3 
INVENTORIES 
 1.  MEANING 
Inventory can be defined as assets held 
? for sale in the ordinary course of business, or 
? in the process of production for such sale, or 
? for consumption in the production of goods or services for sale, including maintenance 
supplies and consumables other than machinery spares, servicing equipment and 
standby equipment. 
There can be different types of inventory based on nature of business of an enterprise. The 
inventories of a trading concern consist primarily of products purchased for resale in their 
existing form. It may also have an inventory of supplies such as wrapping paper, cartons, and 
stationery. The inventories of manufacturing concern consist of several types of inventories: 
raw material (which will become part of the goods to be produced), work-in-process (partially 
completed products in the factory) and finished products. In manufacturing concerns 
inventories will also include maintenance supplies, consumables, loose tools and spare parts. 
However, inventories do not include spare parts, servicing equipment and standby equipment 
which can be used only in connection with an item of fixed asset and whose use is expected 
to be irregular; such machinery spares are generally accounted for as fixed assets. Similarly, in 
an enterprise engaged in construction business, projects under construction are also 
considered as inventory.  
At the year-end (or any period for which books are closed) every business entity needs to 
ascertain the closing balance of Inventory which comprise of Inventory of raw material, work-
in-progress, finished goods and other consumable items. Value of closing Inventory is put at 
the credit side of the Trading Account and asset side of the Balance Sheet. So, before 
preparation of final accounts, the accountant should know the value of Inventory of the 
business entity. However, we shall restrict our discussion on inventory valuation of a 
manufacturing concern and goods of a trading concern.  
 2. INVENTORY VALUATION 
A primary issue in accounting for inventories is the determination of the value at which 
inventories are carried in the financial statements until the related revenues are recognized. 
Inventory is generally the most significant component of the current assets held by a trading 
or manufacturing enterprise. It is widely recognized that inventory is one of the major assets 
that affects efficiency of operations. Both excess of inventory and its shortage affects the 
production activity, and the profitability of the enterprise whether it is a manufacturing or a 
trading business. Proper valuation of inventory has a very significant bearing on the 
© The Institute of Chartered Accountants of India
  ACCOUNTING
1.4 
4.4 
authenticity of the financial statements. The significance of inventory valuation arises due to 
various reasons as explained in the following points:  
(i)  Determination of Income 
 The valuation of inventory is necessary for determining the true income earned by a 
business entity during a particular period. To determine gross profit, cost of goods 
sold is matched with revenue of the accounting period. Cost of goods sold is calculated 
as follows: 
 Cost of goods sold = Opening inventory + Purchases + Direct expenses - Closing 
inventory. 
 Inventory valuation will have a major impact on the income determination if 
merchandise cost is large fraction of sales price. The effect of any over or under 
statement of inventory may be explained as: 
If the value of…… Then net income will be….. 
Closing inventory overstated  Overstated 
Opening inventory overstated  Understated                           
Closing inventory understated Understated                           
Opening inventory understated  Overstated 
The effect of misstatement of inventory figure on the net income is always through 
cost of goods sold. Thus, proper calculation of cost of goods sold and for that matter, 
proper valuation of inventory is necessary for determination of correct income. 
(ii)  Ascertainment of Financial Position 
 Inventories are classified as current assets. The value of inventory on the date of 
balance sheet is required to determine the financial position of the business. In case 
the inventory is not properly valued, the balance sheet will not disclose the truthful 
financial position of the business. 
 Usually, slow-moving or non-moving inventory is the basic reason for poor financial 
performance as well as financial position of an enterprise. To identify such items, the 
first step is to value the inventory in the appropriate manner. 
(iii)  Liquidity Analysis 
 Inventory is classified as a current asset, it is one of the components of net working 
capital which reveals the liquidity position of the business. Current ratio which studies 
the relationship between current assets and current liabilities is significantly affected 
by the value of inventory. Bankers rely on the current ratio which is denoted as current 
© The Institute of Chartered Accountants of India
4.5 
INVENTORIES 
assets divided by current liabilities. If inventory is a major part of the current assets 
then, naturally, the next set of questions that arise would be:  
a)  Whether the inventory is properly valued based on consistently applied 
principles? 
b)  Are there any items of inventory that are either slow-moving or non-moving ? 
c)  How often an external auditor has verified the inventories to make the valuation 
reliable? 
 Studies have shown that poor management of inventories, is one of the reasons of 
losses of small manufacturing enterprises which eventually leads to shutting down of 
such business units.  
(iv)   Statutory Compliance 
 Schedule III to the Companies Act, 2013 requires valuation of each class of goods 
i.e.  raw material, work-in-progress and finished goods under broad head to be 
disclosed in the financial statements. As per the requirements of the Accounting 
Standards, the financial statements should disclose: 
 (a)  the accounting policies adopted in measuring inventories, including the cost 
formula used, and 
 (b)  the total carrying amount of inventories and its classification appropriate to the 
enterprise.  
 The common classification of inventories are raw materials; work-in-progress; finished 
goods; stores-in-trade (in respect of goods acquired for trading) and spares and loose 
tools. 
 3. BASIS OF INVENTORY VALUATION 
Inventories should be generally valued at the lower of cost or net realizable value. This 
principle is governed by ‘Principle of Conservative Accounting’ under which any expenses or 
losses from transactions entered or event occurred are to be recognized immediately, 
however, any gains or profits are not recognized until it becomes due or are actually realized. 
Under the principle of ‘lower of cost or net realizable value’ any loss due to decrease in sales 
price of the inventory below its cost is recognized immediately as it is anticipated that the 
enterprise will make losses whenever it will sell. 
 
© The Institute of Chartered Accountants of India