After studying this chapter, you will be able to:
Inventory can be defined as assets held
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 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.
There are two principal systems of determining the physical quantities and monetary value of inventories sold and in hand. One system is known as ‘ Periodic Inventory System’ and the other as the ‘Perpetual Inventory System’. The periodic system is less expensive to use than the perpetual method. But the useful information obtained from perpetual system is more than cost incurred on it. These systems are distinguished on the basis of the actual records kept to ascertain the cost of goods sold and the closing inventory valuations.2.
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 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:
(a) When closing inventory is overstated, net income for the accounting period will be overstated.
(b) When opening inventory is overstated, net income for the accounting period will be understated.
(c) When closing inventory is understated, net income for the accounting period will be understated.
(d) When opening inventory is understated, net income for the accounting period will be 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.
(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.
(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-intrade (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 recognized until its 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.
Cost: As per Accounting Standards, Cost of inventories should comprise
1. all cost of purchase,
2. costs of conversion (primarily for finished goods and work - in progress) and
3. other costs incurred in bringing the inventories to their present location and condition.
Cost of purchase consist of purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining costs of purchase. In other words, cost includes any amount paid to the seller reduced by any discounts/rebates given by the seller. Similarly, any duties paid to the supplier will be part of cost of the inventory unless the enterprises can recover these taxes duties from the authorities.
Costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable overheads.
Other Costs may include administrative overheads incurred to bring the inventory into present location and condition or any cost specifically incurred on inventory of a specified customer. Interest and other borrowing costs are generally not included in the cost of inventory. However, in some circumstances where production process is longer and it is required to carry inventory for a long period e.g. wine, rice and timber it may be appropriate to consider interest and other borrowing cost also part of cost of inventory.
Exclusions from cost of inventories: Following expenses are generally not included in the costs of inventories:
(a) abnormal amounts of wasted materials, labour or other production overheads;
(b) storage costs, unless those costs are necessary in the production process prior to further production stage;
(c) administrative overheads that do not contribute to bringing the inventories to their present location and condition; and
(d) selling and distribution costs
Net realizable value: This is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. In case of finished goods and traded goods Net realizable value will generally mean selling price which reduced by selling and distribution expenses. In case of work in progress, expenses and overheads required to be incurred to convert work -In progress into finished goods and making it ready for sale will also be reduced from selling price. In case of raw materials, replacement cost is generally considered as net realizable value. An assessment is made of as at each balance sheet date. Inventories are usually written down to net realizable value on an item-by-item basis. In some circumstances, however, it may be appropriate to group similar or related items e.g. in case of interchangeable items it may not be possible to identify cost and net realizable value of each item separately.
4. INVENTORY RECORD SYSTEMS:- There are two principal systems of determining the physical quantities and monetary value of inventories sold and in hand. One system is known as ‘ Periodic Inventory System’ and the other as the ‘Perpetual Inventory System’. The periodic system is less expensive to use than the perpetual method. But the useful information obtained from perpetual system is more than cost incurred on it. These systems are distinguished on the basis of the actual records kept to ascertain the cost of goods sold and the closing inventory valuations.
4.1 PERIODIC INVENTORY SYSTEM:- Periodic inventory system is a method of ascertaining inventory by taking an actual physical count (or measure or weight) of all the inventory items on hand at a particular date on which inventory is valued. It is because of actual physical count that the system is also called physical inventory system. The cost of goods sold is determined as shown below:
Opening inventory (known) + Purchases (known) - closing inventory (physically counted) = Cost of goods sold.
Periodic inventory system is simple and less expensive than the perpetual system. In this system, inventory account is adjusted at the end of the accounting period to determine cost of goods sold. This system suffers from various limitations:
(i) Physical inventory taking is required more than once a year for preparation of quarterly or half yearly financial statements thereby making this system more expensive.
(ii) Physical count of goods requires closure of normal operations of business.
(iii) As cost of goods sold is taken as residual figure, it is not possible to identify loss of goods due to pilferage, damage or even fraud.
(iv) Inventory control is not possible under this system.
(v) Books of accounts does not reflect inventory in hand and its value therefore, it is difficult to plan operations e.g. how much or when to order/manufacture.
This system is used by small enterprises where is easy to control physical inventory. This system is not considered suitable for medium or larger enterprises which generally use Perpetual Inventory system.
4.2 PERPETUAL INVENTORY SYSTEM :-
Perpetual inventory system is a system of recording inventory balances after each receipt and issue. In order to ensure accuracy of perpetual inventory records, physical inventory should be checked and compared with recorded balances. Under this system, cost of goods issued is directly determined and inventory of goods is taken as residual figure with the help of inventory ledger in which flow of goods is recorded on continuous basis. The basic feature of this system is the maintenance of inventory ledger to have records of goods on continuous basis. Under perpetual inventory system, closing inventory is determined as follows:
Opening inventory (known) + Purchases during the period (known) – Cost of Goods Sold (known) = Closing Inventory (balancing figure)
Perpetual inventory system helps to overcome the limitations of periodic system. As inventory is taken as residual figure, it includes loss of goods. However, the main limiting factor is the cost of using this system.
4.3 DISTINCTION BETWEEN PERIODIC INVENTORY SYSTEM AND PERPETUAL INVENTORY SYSTEM
Both the systems - Periodic Inventory System and Perpetual Inventory System are not mutually exclusive and complementary in nature. Distinction between both the systems can be explained as follows:
5. FORMULAE/METHODS TO DETERMINE COST OF INVENTORY:
5.1 HISTORICAL COST METHODS :- There is no unique formula for determination of historical cost of inventories. The different techniques for valuation of inventory have been discussed below:
(i) Specific Identification Method:- Pricing under this method is based on actual physical flow of goods. It attributes specific costs to identified goods and requires keeping different lots purchased separately to identify the lot out of which units in inventories are left. The historical costs of such specific purpose inventories may be determined on the basis of their specific purchase price or production cost.
This method is generally used to ascertain the cost of inventories of items that are not ordinarily interchangeable and their value is high like expensive medical equipments, otherwise it requires the use of FIFO (First in first out) or weighted average price/average price formula.
(ii) FIFO (First in first out) Method:- This method is based on the assumption that cost should be charged to revenue in the order in which they are incurred, that is, it is assumed that the issue of goods is usually from the earliest lot on hand. The inventory of goods on hand therefore, consists of the latest consignments. Thus, the closing inventory is valued at the price paid for such consignments.
The FIFO formula assumes that the items of inventories which were purchased or produced first are consumed or sold first and consequently items remaining in the inventory at the end of the period are those most recently purchased or produced. This assumption is in line with the good business practice to disposing goods in the order of their acquisition especially in the case of perishable goods and items with frequent technological changes. It must be kept in mind that this assumption of cost flow or goods flow need not be true as a physical fact i.e. not necessary goods are physically also sold or issued in the chronological order of their purchase or production. It relates only to the method of accounting and not to the actual physical movement of goods.
Now, let us take an example to understand the application of FIFO method.
ILLUSTRATION 1:- A manufacturer has the following record of purchases of a condenser, which he uses while manufacturing radio sets:
1,600 units were issued during the month of December till 18th December.
SOLUTION:- The closing inventory is 1,000 units and would consist of:
800 units received on 28th December; and
200 units received on 19th December as per FIFO
(iii) LIFO (Last in first out) Method:- As the name suggests, the LIFO formula assigns to cost of goods sold, the cost of goods that have been purchased last though the actual issues may be made out of the earliest lot on hand to prevent unnecessary deterioration in value. The closing inventory then is assumed to consist of earlier consignments and its value is then calculated according to such consignments. Under this basis, goods issued are valued at the price paid for the latest lot of goods on hand which means inventory of goods in hand is valued at price paid for the earlier lot of goods. In the absence of details of issue, the price paid for the earliest consignments is used for valuing closing inventory. LIFO method is based on the principle of matching current cost with current revenue as cost of recently purchased or produced goods are charged to cost against each sale. The cost of goods sold under this method represents the cost of recent purchases resulting that there is better matching of current costs with current sales.
In the previous example assume that following issues were made during the month of December:
Record of issues
Therefore, cost of closing inventory of 1,000 pcs will be ₹50,600.
LIFO method is based on an irrational assumption that inventories entering last in the stores are issued or consumed first. However, the flow of goods which is generally observed in business entities is contradictory to this assumption. It should be noted that while applying LIFO, there will be difference in cost of goods sold and value of closing inventory, if the entity follows periodic as against perpetual method of inventory valuation. Therefore, LIFO method is no longer adopted for valuing inventories. Accounting Standards also does not permit the usage of LIFO Method. Generally, in practice, FIFO and Weighted Average Price Method are popular among the business entities and both these methods are also permitted by Accounting Standards.
Computation under periodic inventory system
In the above example, if the entity followed periodic inventory valuation, closing inventory of 1,000 pcs. will be valued as follows:
We can see that cost of closing inventory has changed following LIFO method based on perpetual inventory method and periodic inventory method.
(iv) Simple Average Price Method:- Simple Average price for computing value of inventory is a very simple approach. All the different prices are added together and then divided by the number of prices. The closing inventory is then valued according to the price ascertained. This method is generally followed by the entities using periodic inventory method as it does not require efforts of identifying that closing inventory belongs to which consignments or lots.
ILLUSTRATION 3:- In the same example of a manufacturer of radio sets given earlier, let us calculate the value of closing inventory using Average Price Method:
The simple average in this question is:
[(50 + 55 + 55 + 60 + 47)/5] = 267/5 = ₹53.4
1,000 units valued at ₹53.4 would be ₹53,400
Let us try to analyze the impact of FIFO, LIFO and Simple Average Price Method with the help of the following chart:
Thus we see that value of inventories changes based on different cost formula used.
(v) Weighted Average Price Method:-
Simple average price does not consider quantities purchased in various lots. However, it is more logical to compute weighted average price using the quantities purchased in a lot as weights. Under weighted average price method, cost of goods available for sale during the period is aggregated and then divided by number of units available for sale during the period to calculate weighted average price per unit.
Thus Weighted average price per unit =
Closing inventory = No. of units in inventory × Weighted average price per unit
Cost of goods sold = No. of units sold × Weighted average price per unit.