Inventories Chapter Notes | Accounting for CA Foundation PDF Download

Chapter Overview

Meaning of Inventory

 Inventory refers to the assets held by a business for various purposes, including: 

• Sale in the Ordinary Course of Business: Assets that are intended to be sold as part of the regular business operations. 
• Production for Sale: Items that are in the process of being produced for eventual sale. 
• Consumption in Production: Resources that are used in the production of goods or services for sale, such as maintenance supplies and consumables. 

 It is important to note that certain items, like machinery spares, servicing equipment, and standby equipment, are not considered inventory. These items are typically accounted for as fixed assets because their use is expected to be irregular. 

Types of Inventory

Trading Concern: Businesses that primarily resell products in their existing form. Their inventory may also include supplies like wrapping paper, cartons, and stationery. 

Manufacturing Concern: These businesses have several types of inventory: 

• Raw Material: Basic materials that will be used to produce goods. 
• Work-in-Process: Partially finished products that are still being worked on in the factory. 
• Finished Products: Completed goods that are ready for sale. 
• Maintenance Supplies: Items used for maintenance purposes. 
• Consumables: Items that are used up in the production process. 
• Loose Tools and Spare Parts: Tools and spare parts that are not part of a larger machine. 

Construction Business: In this type of business, projects that are under construction are also considered inventory. 

Valuation of Closing Inventory

•  At the end of the financial year (or any period when the accounts are closed), every business needs to determine the closing balance of inventory. This includes: 
•  Raw Materials 
•  Work-in-Progress 
•  Finished Goods 
•  Other Consumable Items 

Financial Reporting

•  The value of closing inventory is recorded on the credit side of the Trading Account and on the asset side of the Balance Sheet. 
•  Before preparing the final accounts, accountants must know the value of inventory for the business entity. 

Focus of Discussion

•  The discussion is limited to the valuation of inventory for manufacturing concerns and trading goods. 

Inventory valuation

•  Inventory valuation is crucial for determining the value of goods held by a business. 
•  It impacts the financial statements and the reported income of the business. 

1. Determination of Income

•  Inventory valuation is essential for calculating the gross profit of a business. 
•  Gross profit is determined by matching the cost of goods sold (COGS) with the revenue of the accounting period. 
•  COGS is calculated using the formula: 
•  COGS = Opening Inventory + Purchases + Direct Expenses - Closing Inventory 

2. Impact on Profitability

•  Accurate inventory valuation directly affects the profitability of a business. 
•  Overstating or understating inventory can lead to incorrect profit figures, impacting decision-making and financial reporting. 

3. Financial Statement Authenticity

•  Proper inventory valuation is crucial for the authenticity of financial statements. 
•  It ensures that the financial position and performance of the business are accurately represented to stakeholders. 

4. Operational Efficiency

•  Inventory is a significant component of current assets for trading and manufacturing enterprises. 
•  Efficient inventory management, reflected in accurate valuation, is vital for smooth operations. 
•  Both excess and shortage of inventory can disrupt production activities and affect profitability. 

5. Stakeholder Confidence

•  Transparent and accurate inventory valuation builds confidence among stakeholders, including investors, creditors, and regulators. 
•  It reflects the management's ability to oversee and report on critical business assets effectively. 

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:

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.

1. Ascertainment of Financial Position 

•  Inventories are categorized as current assets, and their valuation on the balance sheet date is crucial for accurately reflecting the financial position of the business. 
•  Proper inventory valuation is essential; otherwise, the balance sheet may not present a true picture of the company's financial status. 
•  Slow-moving or non-moving inventory is often a key factor contributing to poor financial performance and position. Identifying such items begins with accurate inventory valuation. 

2. Liquidity Analysis 

•  As a current asset, inventory is a component of net working capital, which indicates the liquidity position of the business. 
•  The current ratio, which compares current assets to current liabilities, is significantly influenced by inventory valuation. 

 Bankers rely on the current ratio (current assets divided by current liabilities) to assess financial health. If inventory constitutes a large portion of current assets, it raises important questions: 

• Is the inventory valued correctly based on consistent principles? 
• Are there any slow-moving or non-moving inventory items? 
• How frequently has an external auditor verified the inventory to ensure reliable valuation? 

 Studies indicate that poor inventory management is a leading cause of losses in small manufacturing enterprises, potentially leading to their closure. 

3. Statutory Compliance 

•  Schedule III of the Companies Act, 2013 mandates the valuation of each class of goods (raw material, work-in-progress, and finished goods) to be disclosed in financial statements. 

 Accounting Standards require disclosure of: 

•  Accounting policies for measuring inventories, including the cost formula used. 
•  Total carrying amount of inventories and their appropriate classification. 

 Common inventory classifications include: 

• Raw materials 
• Work-in-progress 
• Finished goods 
• Stores-in-trade (goods acquired for trading) 
• Spares and loose tools 

Basis of Inventory Valuation 

•  Purchase price including duties and taxes (non-recoverable), freight inwards, and direct acquisition costs. 
•  Deduct trade discounts, rebates, and similar items. 
•  Example: If raw materials are bought at ₹100 per unit plus GST, the GST credit affects the cost of purchase. 

(ii) Costs of Conversion:

•  Include direct labour and systematic allocation of fixed and variable overheads. 
•  Example: Direct labour cost for converting raw materials into finished goods contributes to the cost of conversion. 

(iii) Other Costs:

•  Administrative overheads related to bringing inventory to its present condition. 
•  Interest and borrowing costs may be included in certain long-term inventory situations (e.g., wine, rice, timber). 
•  Example: Unloading charges for raw materials can be included as other costs if they are necessary to bring inventory to the present location. 

(b) Exclusions from Cost of Inventories

•  Abnormal waste of materials, labor, or overheads. 
•  Storage costs unless essential to the production process. 
•  Administrative overheads not contributing to bringing inventories to their current state. 
•  Selling and distribution costs. 

(c) Net Realizable Value (NRV)

•  Estimated selling price minus costs of completion and sale. 
•  NRV for finished goods considers selling price reduced by selling and distribution expenses. 
•  Example: In case of work in progress, overheads for converting work in progress into finished goods are deducted from selling price. 

(d) Assessment and Write-Down

•  Assessment of cost and NRV at each balance sheet date. 
•  Inventories usually written down to NRV on an item-by-item basis, but grouping similar items may be appropriate in certain cases. 

Inventory Record Systems

• The periodic system is less expensive to use than the perpetual method. However, the useful information obtained from the perpetual system is greater than the cost incurred on it. 
• These systems are distinguished based on the actual records kept to ascertain the cost of goods sold and the closing inventory valuations. 

Periodic Inventory System

 In a periodic inventory system, a physical count of all inventory items is conducted at a specific date to determine the inventory on hand. This is why it is also called a physical inventory system. The cost of goods sold (COGS) is calculated using the formula: 

Advantages of Periodic Inventory System:

• Simplicity: The periodic inventory system is straightforward and easier to implement compared to the perpetual system. 
• Cost-Effectiveness: It is generally less expensive to maintain since inventory accounts are adjusted at the end of the accounting period. 

Disadvantages of Periodic Inventory System:

• Frequent Physical Counts: This system requires physical inventory counts more than once a year for preparing quarterly or half-yearly financial statements, increasing costs. 
• Disruption of Operations: Conducting a physical count necessitates the temporary closure of normal business operations, which can be disruptive. 
• Difficulty in Identifying Losses: Since COGS is calculated as a residual figure, it is challenging to identify losses due to theft, damage, or fraud. 
• Limited Inventory Control: The periodic system does not allow for effective inventory control, making it harder to manage stock levels. 
• Inaccurate Inventory Records: Books of accounts do not reflect the current inventory levels and their values, making it difficult to plan operations, such as ordering or manufacturing. 

Suitability:

• The periodic inventory system is typically used by small enterprises where physical inventory control is manageable. 
• Medium or larger enterprises usually prefer the perpetual inventory system due to its advantages in real-time inventory tracking and control. 

Perpetual Inventory System

• The perpetual inventory system involves recording inventory balances after each receipt and issue of goods. To ensure the accuracy of these records, physical inventory counts should be conducted and compared with the recorded balances. 
• In this system, the cost of goods issued is determined directly, and the inventory of goods is calculated as a residual figure using an inventory ledger that records the flow of goods on a continuous basis. 
• The key feature of the perpetual inventory system is the maintenance of this inventory ledger, which provides a continuous record of goods. 
• Closing inventory under this system is calculated using the formula: 

• The perpetual inventory system addresses the limitations of the periodic system by including goods lost in inventory calculations. However, its main drawback is the high cost associated with implementing this system. 

Distinction between Periodic Inventory System and Perpetual Inventory System

•  Based on physical verification of inventory. 
•  Provides information about inventory and cost of goods sold at a specific date. 
•  Determines inventory and takes cost of goods sold as a residual figure. 
•  Cost of goods sold includes loss of goods as items not in inventory are assumed to be sold. 
•  Inventory control is not possible under this method. 
•  Simple and less expensive to implement. 
•  Requires closure of business for counting inventory. 

Perpetual Inventory System

•  Based on book records of inventory. 
•  Provides continuous information about inventory and cost of sales. 
•  Directly determines cost of goods sold and computes inventory as a balancing figure. 
•  Closing inventory includes loss of goods as all unsold items are assumed to be in inventory. 
•  Inventory control can be exercised under this system. 
•  Costlier method to implement. 
•  Inventory can be determined without affecting business operations. 

Formulae/methods to Determine Cost of Inventory

(i) Specific Identification Method

• The Specific Identification Method prices inventory based on the actual physical flow of goods.
• It involves attributing specific costs to identified goods and requires keeping different lots purchased separately to identify the lot from which the units in inventory are left.
• The historical costs of such specific purpose inventories may be determined based on their specific purchase price or production cost.
• This method is typically used for items that are not ordinarily interchangeable and have a high value, such as expensive medical equipment.
• If the items are interchangeable, methods like FIFO (First In, First Out) or weighted average price/average price formula are used instead.

ILLUSTRATION 1
Surekha Ltd deals in 3 products P, Q & R, which are neither similar nor interchangeable. At the end of a financial year, the Historical Cost and NRV of items of Closing Stock are given below. Determine the value of Closing Stock.

SOLUTION

Inventories are to be valued at the lower of cost and Net Realisable Value (NRV). Inventories are usually written down to NRV on an item-by-item basis. The Value of Closing Stocks is determined as under:

(ii) FIFO (First In, First Out) Method
FIFO (First In, First Out) is an inventory valuation method that assumes goods are sold or used in the order they were purchased or produced. According to this method, the oldest inventory items are considered sold first, while the remaining inventory consists of the most recently acquired items. 

Key Points:

• Cost Allocation: FIFO charges costs to revenue in the order they are incurred, reflecting the assumption that goods are issued from the earliest lot on hand. 
• Closing Inventory: Under FIFO, closing inventory is valued at the cost of the latest consignments, as these are the items remaining in stock at the end of the period. 
• Consumption Pattern: The FIFO formula aligns with the practice of selling or using goods in the order of their acquisition, which is especially relevant for perishable items and products with rapid technological changes. 
• Accounting Assumption: It is important to note that FIFO reflects an accounting assumption rather than the physical movement of goods. While it is common for businesses to sell items in the order of purchase, this is not always the case in reality. FIFO is a method of accounting for inventory and does not necessarily correspond to the actual order in which goods are sold or used. 

Now, let us take an example to understand the application of FIFO method.

ILLUSTRATION 2
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. Calculate the value of closing inventory.

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

 The LIFO (Last In, First Out) method assigns the cost of goods sold based on the most recent purchases, even though the actual items issued may come from the earliest lot to prevent value deterioration. Under this method: 

• Cost of Goods Sold (COGS): Goods issued are valued at the price paid for the latest lot of goods on hand. 
• Closing Inventory: Valued at the price paid for earlier consignments. If there are no details of issues, the price paid for the earliest consignments is used for valuing closing inventory. 
• Matching Principle: LIFO aligns current costs with current revenues by charging the cost of recently purchased or produced goods against each sale. This method ensures better matching of current costs with current sales, as COGS reflects the cost of recent purchases. 

ILLUSTRATION 3
In the previous example assume that following issues were made during the month of December:
Record of issues

SOLUTION

Computation of closing stock under perpetual inventory system
Using LIFO method, following will be stock ledger:

Therefore, cost of closing inventory of 1,000 pcs will be ₹50,600.
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:
800 pcs. @ ₹ 47 each (purchased on Dec. 28th) = ₹ 37,600
200 pcs. @ ₹ 60 each (purchased on Dec. 19th) = ₹ 12,000
Total 1,000 pcs.= ₹ 49,600
We can see that cost of closing inventory has changed following LIFO method based on perpetual inventory method and periodic inventory method.

"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. (Periodic and Perpetual methods have been explained later in this chapter). 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."

(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 4
In the same example of a manufacturer of radio sets given earlier, let us calculate the value of closing inventory using Average Price Method:

SOLUTION

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 analyse 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
The simple average price does not take into account the quantities purchased in different lots. Instead, it is more logical to calculate the weighted average price, which uses the quantities purchased as weights. Under the weighted average price method, the total cost of goods available for sale during a period is summed and then divided by the total number of units available for sale during that period to find the weighted average price per unit. Therefore:

• Weighted average price per unit = Total cost of goods available for sale during the period / Total number of units available for sale during the period
• Closing inventory = Number of units in inventory × Weighted average price per unit
• Cost of goods sold = Number of units sold × Weighted average price per unit

ILLUSTRATION 5
On the basis of the data given in illustration 2 and 3, calculate the weighted average price and also the value of closing inventory by weighted average price method.

SOLUTION

The computation of weighted average price in the referred example is shown below:
A new average rate would be calculated on receiving a fresh consignment. Answer on that basis would be as under:

Perpetual and Periodic Inventory System and Average Methods of Cost of Inventory
Both the Simple Average Method and the Weighted Average Method are utilized differently depending on whether periodic or perpetual inventory systems are in place. In a periodic inventory system, the total inventory available for sale during the period is assessed collectively, and an average rate is calculated to value the closing inventory. Conversely, in a perpetual inventory system, the average rate of inventory is recalculated with each new purchase, and the next issue is recorded using the updated average rate.
Illustration 5 above is an example of Weighted average method used in perpetual inventory recording system. In case the entity would have been using periodic inventory recording system, closing inventory would have been valued as below:
Details of purchases/receipt during the period

Accordingly, closing stock of 1,000 pcs. would have been valued at 51,190 @ ₹ 51.19 per unit.

Non-Historical Cost Methods

(i) Adjusted Selling Price Method

•  The Adjusted Selling Price method, also known as the retail inventory method, is commonly used in retail businesses or in situations where the individual costs of inventory items are not easily determined. 
•  This method is suitable for measuring inventories of large quantities of rapidly changing items that have similar profit margins and for which other costing methods are impractical. 
•  To determine the cost of inventory using this method, an appropriate percentage of gross margin is subtracted from the sales value of the inventory. 
•  This percentage accounts for inventory items that have been marked down from their original selling price. 
•  Often, an average percentage for each retail department is used. 
•  The estimated gross margin of profit can be calculated for individual items, groups of items, or by departments, depending on the specific circumstances. 

ILLUSTRATION 6
M/s X, Y and Z are in retail business, following information are obtained from their records for the year ended 31st March, 2022:

Find out the non-historical cost of inventories using adjusted selling price method.

SOLUTION

Determination of cost of purchases:

Determination of estimated gross profit margin:

ILLUSTRATION 7
From the following information, calculate the non historical cost of closing inventories using adjusted selling price method:

SOLUTION

Calculation of gross margin of profit:

Rate of gross margin = 50,000 / 2,50,000 × 100 = 20%
Cost of closing inventory = 50,000 less 20% on ` 50,000 = ` 40,000

(ii) Standard Cost Method 

 The standard cost method is applied in situations where there are frequent fluctuations in the price per unit of goods, and these goods are purchased regularly by the business, such as crude oil. 

• A standard cost is determined based on past experiences and the regular changes in prices. 
• This standard cost is then used to value the inventory, reflecting the price per unit set by this standard. 

Taking Inventory

• Physical Inventory Process: Operations are usually paused for one or two days during the financial year to conduct a physical inventory of all items in the godown or store. This process is done periodically. 
• Year-End Inventory Valuation: Physical inventory taking for year-end valuation is typically done in the last week of the financial year or the first week of the next financial year. 
• Adjustments for Timing: If inventory is completed before the accounting year ends (e.g., on March 26), purchases and sales occurring between the completion date and the year-end (e.g., March 31) are separately adjusted. 
• Valuation Principle: Items are valued based on the principle of cost or net realizable value, whichever is lower. This can be applied to the inventory as a whole or on an item-by-item basis. 
• Timing Preferences: While enterprises prefer to conduct inventory taking on the closing day, there are instances when it cannot be done on that day. In such cases, inventory taking may occur a few days earlier or later. 
• Adjusting Actual Value: When inventory taking is done at a different time, the actual value of the inventory must be adjusted to reflect its value at the end of the financial year. This requires considering goods that have come in (purchases and sales returns) and goods that have gone out (sales and purchase returns) during the interval between the year-end and the actual inventory taking date. 

Sale of Goods on Approval or Return Basis

•  Goods are sent to customers with the option to either keep or return them within a specified period. This arrangement allows customers to evaluate the goods before making a final decision. 

Goods Sent on Consignment

•  In a consignment arrangement, one party (the consignor) sends goods to another party (the consignee) with the understanding that the goods will be sold on behalf of the consignor. 
• Roles in Consignment: The consignor retains ownership of the goods while the consignee acts as an agent responsible for selling them. The consignee does not take ownership of the goods; they are simply tasked with selling them. 
• Ownership Transfer: Once the goods are sold by the consignee, ownership transfers to the buyer. 

Further, the adjustment of all goods must be on the basis of cost or NRV whichever is lower. Suppose, a firm that closes its books on 31st December, carried out the inventory taking on the 7th January next year and actual inventory was of the cost of ₹ 7,85,000, during the period January 1 to 7 purchases were ₹ 1,53,000 and sales ₹ 2,50,000, the mark up being 25% on cost. The inventory on 31st December would be ₹ 8,32,000 as shown below:

ILLUSTRATION 8
From the following particulars ascertain the value of Inventories as on 31st March, 2022:

At the time of valuing inventory as on 31st March, 2021, a sum of ₹17,500 was written off on a particular item, which was originally purchased for ₹ 50,000 and was sold during the year for ₹ 45,000. Barring the transaction relating to this item, the gross profit earned during the year was 20 % on sales.

SOLUTION

ILLUSTRATION 9
A trader prepared his accounts on 31st March, each year. Due to some unavoidable reasons, no stock taking could be possible till 15th April, 2022 on which date total cost of goods in his godown came to ₹ 50,000. The following facts were established between 31st March and 15th April, 2022.
(i) Sales ₹ 41,000 (including cash sales ₹ 10,000).
(ii) Purchases ₹ 5,034 (including cash purchases ₹ 1,990).
(iii) Sales return ₹1,000.
(iv) On 15th March, goods of the sale value of ₹10,000 were sent on sale or return basis to a customer, the period of approval being four weeks. He returned 40% of the goods on 10th April, approving the rest; the customer was billed on 16th April.
(v) The trader had also received goods costing ₹ 8,000 in March, for sale on consignment basis. 20% of the goods had been sold by 31st March, and another 50% by the 15th April. These sales are not included in above sales.
Goods are sold by the trader at a profit of 20% on sales.
You are required to ascertain the value of inventory as on 31st March, 2022.
SOLUTION

ILLUSTRATION 10
Inventory taking for the year ended 31st March, 2022 was completed by 10th April 2022, the valuation of which showed a inventory figure of ₹ 16,75,000 at cost as on the completion date. After the end of the accounting year and till the date of completion of inventory taking, sales for the next year were made for ₹ 68,750, profit margin being 33.33 % on cost. Purchases for the next year included in the inventory amounted to ₹ 90,000 at cost less trade discount 10 %. During this period, goods were added to inventory at the mark up price of ₹ 3,000 in respect of sales returns. After inventory taking it was found that there were certain very old slow-moving items costing ₹ 11,250, which should be taken at ₹ 5,250 to ensure disposal to an interested customer. Due to heavy flood, certain goods costing ₹ 15,500 were received from the supplier beyond the delivery date of customer. As a result, the customer refused to take delivery and net realizable value of the goods was estimated to be ₹ 12,500 on 31st March. Compute the value of inventory for inclusion in the final accounts for the year ended 31st March, 2022.

SOLUTION

Note: Profit margin of 33.33 % on cost means 25 % on sales price.

ILLUSTRATION 11
The following are the details of a spare part of Sriram mills:

Find out the value of Inventory as on 31-3-2022 if the company follows First in first out basis.

SOLUTION

First-in-First out basis

Therefore, the value of Inventory as on 31-3-2022: 50 units @ ₹40 = ₹ 2,000

ILLUSTRATION 12
Continuing with the information given in illustration 11, find out the value of Inventory as on 31-3-2022 if the company follows Weighted Average basis.

SOLUTION

Weighted Average basis

Therefore, the value of Inventory as on 31-3-2022 = 50 units @ ₹ 38 = ₹ 1,900