Accounting of Inventories

Inventory is the part of goods purchased or manufactured that remained unconsumed or unsold Term inventory includes the stock of
Raw materials Work-in-progress Finished goods Stores, Spares, and Accessories

For a manufacturing concern, inventory may consist of all the types mentioned above but for a trading concern inventory consists of finished goods only

Valuation of Inventory
Inventory Valuation and income measurement are inter-related For the ascertainment of income it is only the cost of goods sold that should be charged against revenue This is because not all the goods purchased (or produced) during the year are sold

Determining Cost of Goods Sold

Cost of Goods Sold = Beginning Inventory (at the start of the accounting period) + Purchases (during the accounting period) Ending Inventory (at the end of the accounting period) You take what you have in the beginning, add what you have purchased, subtract what you have at the end and the result is what you have sold

Gross Income
Gross Profit = Sales Cost of Goods Sold = Sales (Beginning Inventory + Purchases Ending Inventory) Every year the unsold inventory will be carried forward to the next year and charged against the revenue of next year and hence the accounting equation discussed above can be re-written as: Gross Profit = Sales Cost of Goods Sold = Sales (Ending Inventory of Last Accounting Period + Purchases Ending Inventory of Present Accounting Period)

Gross Profit Equation

It can be also be observed that for a start-up firm the beginning inventory (or last accounting periods ending inventory) will be zero and so the gross profit equation will get simplified to: Gross Profit = Sales Cost of Goods Sold = Sales (Purchases Ending Inventory) In order to avoid situations of improper valuation accountants in such situations adopt the policy of valuing inventory at lower of cost or market price While this principle based on the concept of conservatism requires providing for all anticipated losses it ensures that the gains are not taken into account for computing income

Note that
Market price does not mean actual market prices paid by the buyer of inventory It indicates the net realizable value by selling the inventory to the buyer In other words, all costs which are to be incurred while selling (such as transportation and taxes) are to be deducted to compute the net realizable value

Govind started the business of vending milk in the city

of Indore and he was in his second week of his

business. He followed a weekly accounting period. He has been procuring milk at a steady rate of Rs 10 per liter from the nearby small farmers (they used to come and supply to him). Govind used to sell this milk to the local community at a rate of Rs 20 per liter. At the end of the first week, he had an ending inventory of 10 litres. During second week, he purchased 100 liters of milk and at the end of second week he found the stock of milk to be only 1 liter. Compute the gross profit of Govinds business and present it in as many possible

ways as possible

Computation of Total Sales

Beginning inventory of 2nd week Rs 100 (10 liters @ Rs 10 per liter) was Purchases in 2nd week was Rs 1000 (100 liters @ Rs 10 per liter)

Ending inventory of 2nd week Rs 10 (being 1 liter @ Rs 10 per was liter) Cost of Goods Sold of 2nd week Rs 1090 (being 109 liters @ Rs 10 would be per liter) Sales of 2nd week would be Rs 2180 (being 109 liters @ Rs 20 per liter)

Total of 109 liters of milk sold in 2nd week

Equation
Beginning Inventory Rs 100 + Purchases Rs 1000 = = Closing Inventory Rs 10 + Cost of Goods Sold Rs 1090

Income Statement: Simplest Form

Used by companies like Blue Dart Express and HLL

Sales

Rs 2180

Expenses
Less Cost of Goods Sold Gross Profit Rs 1090 Rs 1090

Contd
Presenting the change in inventory stocks as part of Sales: Sales Add Increase/(Decrease) in Stocks Adjusted Sales Expenses Less Purchases Gross Profit Rs 1000 Rs 1090 Rs 2180 (Rs 90) Rs 2090

Used by some European and Indian firms

Contd
Most Indian companies such as Raymonds and TV18 present the change in inventory position as part of the expenses:
Sales Rs 2180 Rs 1000 Rs 90

Expenses: Less Purchases Less (Increase)/Decrease in Stocks Gross Profit

Rs 1090

Methods of Inventory Valuation

Inventory Valuation Methods

First-in First-out

Weighted Average Cost

Specific Identification

Last-in First-out

Actual Inventory Movement Examples First In First Out Process Pharmaceutical Medical Shop Products Movement in a

Weighted Process

Average Movement of Gold in Jewelers Unit

Specific Identification Movement of Diamond in a Jewelers Shop Process

Last In 1st Out Process

Movement of Sulphur from a Godown

Comments
Accountants rarely use the physical movement of inventory to decide on the inventory methodology due to difficulty in computing and tracking inventory among others They make assumptions about flow of costs rather than flow of units The first three methods are recommended to be followed by the Accounting Standard 2 on Valuation of Inventories. There are a few cases wherein the Accounting Standard 2 is not mandatory and hence in such cases any of the above method can be followed

First-in First-out Method

This method of valuation is based on the actual cost Here, the goods received first are issued or sold first

Therefore, the closing stock consists of goods or materials purchased most recently

Illustration
For the year ending on 31 March 20X4, Taro Ltd purchased the following:

20-4-X6

04-6-X6
02-12-X6

1,000 units at 10/- per unit 1,000 units at 12/- per unit 500 units at 8/- per unit

Sales during the same year were of 1,000 units on 01-02-X7. Calculate the value of inventory for taking to the balance sheet as at 31-03-X7 based upon First-in First-out method.

Solution
Under the first-in first-out (FIFO) method of inventory valuation, the oldest lot received is issued first In other words, the closing stock consists of materials purchased most recently Accordingly in the above case, the sale of 1,000 units is presumed to be made out of the purchases made on 20-04-X3 and so, the stock value on 31-03-04 is Rs. 16,000 [= (1000 units x 12 per unit) + (500 units x 8 per unit)].

Weighted Average Cost

This method follows the batch or block valuation concept Here, the purchase price is merged to get an average price of the product The closing stock does not consist of any specific batch of goods but consists of the average price paid for all the purchases during the period Under this method the average price of the stock changes with every fresh purchase so in an organization where the purchases are very frequent, valuation of inventory becomes a complex process

Illustration Taro Ltd.

For the year ending on 31 March 20X7, Taro Ltd purchased the following:

20-4-X6

04-6-X6
02-12-X3

1,000 units at 10/- per unit 1,000 units at 12/- per unit 500 units at 8/- per unit

Sales during the same year were of 1,000 units on 01-02-X7. Calculate the value of inventory for taking to the balance sheet as at 31-03-X7 based on Weighted Average Cost Method.

Solution
Date
20-04X6 Transacti Pric Units on e Purchase 1,000 Purchase 1,000 Purchase 500

Amt.

Closing Stock Units Price 10 11 10.4 Amt. 10,000 22,000 26,000

10 10,000 1,000 12 12,000 2,000 8 4,000 2,500

04-06X6 02-12X6
01-02X7

Sale

10.4 1,000 10,400 1,500 0

10.4

15,600

Specific Identification Method

Specific costs are applied to identify items of inventory being consumed The total of various costs of the remaining stock identified constitute the value of inventory This method of valuation is helpful in organizations handling a small number of items

Illustration Taro Ltd.

Considering the information in last illustration, if it has been given that the sale of 1,000 units was made out of the purchases on 02-12-X6 and remaining from purchased lot dated 2004-X6 then the value of inventory using the specific identification method would be: 500 units of purchases made on 20-04-X6 (Rs. 10 per unit) 5,000 1,000 units of purchases made on 04-06-X6 (Rs. 12 per unit) 12,000 1,500 units Rs.17,000 Thus the closing stock will be 1,500 units and the total value of inventory will be Rs. 17,000

Last-in First-out (LIFO)

This method also, like FIFO, is based upon the actual cost of material with a difference that the goods purchased most recently are assumed to be sold first In other words, the valuation of stock is based upon the price of the materials purchased earliest

Illustration Taro Ltd.

In the example, using LIFO method the sales will consist of 500 units purchased as 02-12X3 and 500 units purchased as 04-04-X3. The closing stock consists of

1,000 units purchased on 20-04-03 (at Rs. 10/- per units) 10,000 500 units purchased on 04-06-03 (at Rs. 12/- per units) 6,000 1,500 units Total value Rs 16,000

LIFO vs. FIFO

The difference between LIFO and FIFO ending inventory is due to the rising perfume prices Hence, FIFO method shows higher ending inventory and lower cost of goods sold Consequentially, FIFO method would show higher profit than LIFO method. In scenarios of falling prices LIFO and weighted average method would show higher profit than FIFO method

Observations
Accounting policy adopted in relation to inventory valuation can to a large extent influence income determination

Profits can be manipulated by switching from one method of valuation to another Company Law requires that particular method accepted should be consistently tried at least for a period of three years

Methods of Inventory Valuation

Only thing certain with prices normally is that it is not certain The recording of inventory as well as its expiration as cost of goods sold made on the basis of historical cost
Methods of Inventory Valuation

First in First Out (FIFO)

Last in First Out (LIFO)

Weighted Average Cost (WAC)

Inventory Valuation: FIFO, LIFO, and WAC

Take Home
Purchase Cost is the same irrespective of the method of inventory valuation Cost of goods sold and ending inventory at the end of the period are different for the three different methods of inventory valuation In all the cases inventory plus cost of goods sold amount to the same, that is, Rs 47,500, since it is based on actual historical cost only

Financial Accounting: A Managerial Perspective

Second Edition

Inventory Valuation and Income Measurement

Defining inventories
Goods meant for sale or for further processing

Types of inventories
Raw materials Work in progress Finished goods

Matching inventory costs with revenues Effect of inventory errors

Determining the Physical Inventory

Importance of taking physical inventory Procedure for taking inventory Goods in transit
Shipping terms and passing of property

Goods on consignment

Pricing the Inventory

Cost basis
Inventoriable costs or product costs Period costs

Inventory costing methods

Physical flow and cost flow Specific identification First-in, first-out Last-in, first-out Weighted-average cost

Pricing the Inventory continued

Comparison of alternative methods

Managerial motivations in selection

Other inventory cost methods

Standard cost Base stock

Inventory profits The lower-of-cost or market (LCM) rule The conservatism principle and prudence The consistency principle

Estimating Inventory Value

When is inventory value estimated Methods of estimating inventory value Retail inventory method
Retail to cost ratio Assumptions

Gross profit method

Gross profit ratio Assumptions

Perpetual Inventory System

What is the perpetual inventory system? How is it different from the periodic inventory system? Recording accounting entries Maintaining perpetual inventory records Internal control and perpetual inventory system

Accounting for Manufacturing Costs

Chapter 7

Cost of goods manufactured

Raw materials consumed Direct labour Manufacturing overhead

Direct costing and absorption costing Cost of goods sold

Chapter 7

Reporting Inventories under the Companies Act

Companies (Auditors Report) Order 2003 Periodical physical verification of inventory Adequacy of physical verification Maintenance of proper records for inventories Adequacy of internal control procedure

Financial Analysis of Inventories

Chapter 7

Inventory turnover ratio Interpreting the inventory turnover ratio in financial analysis

INVENTORY PRICING AND VALUATION

Chapter-7 Faculty Ms Sheetal Thomas

Trading company vs. Manufacturing company

Trading companies are those which purchase goods from outside sources and sell them at a profitable price. They normally dont enter into converting raw material into finished goods but can
Repack or process the goods further.

While Manufacturing companies are into conversion of raw material into finished consumable goods.

Cont.
Trading company primarily consists of finished goods, but the inventories of manufacturing company would consist of Inventory Raw material, Work in progress and Finished goods. Manufacturing operations have two types of cost
Direct cost and Indirect costs

Meaning
Direct costs :- they are the costs which are directly identifiable with the end product.
Eg: Raw materials, workmen on machinery .

Indirect costs:- they are the costs which are not directly related for the production of the goods.
Eg: labourers who work in carrying RM from one place to another, all supervisory staff.

 To come to the amount of goods sold in a year, we have to first determine the Raw Material Consumed Manufacturing Direct Expenses and Indirect Manufacturing Expenses. On the basis of this we can calculate the cost of Goods Manufactured Cost of material used -----Add: Direct labour -----Add: Overheads ------

Cost of Goods Sold for Manufacturing Companies

Total cost of Manufacturing Add: Goods in Process (OS) Less: Goods in Process (CS)
COGS

----------_______
________

Cost of Good Sold

Cost of Goods sold can be found by Finished Goods (OS) -----Add: Cost of goods manufactured -----Total finished goods available for sale -----Less: Finished goods (CS) -----COST OF GOODS SOLD ---------

Period Expenses
There are certain costs which are treated as cost for a particular period like selling cost.
Exemption to these are cost like advertising , promotional campaign etc.

When benefit is for a longer period of time they are amortized, written off, or capitalized on the basis of benefit.

Matching of Extraordinary Expenditures

There are certain expenses which cannot be matched with revenues of the same accounting period. This is because the amount spent is large and gives benefit for the future period.
Eg: Depreciation, Advertising expense for the launch, R&D, Strategy changes in the organisation etc. Shifting or expansion of the organisation.

Matching of Prior period Expenditures

This may be the case when there are certain expenditure of revenue which has not been received Or is received after a long period of time after the goods or service has been provided. Here if such amounts are shown in the financial statements of the current year it wont give true and fair value of the financial status. Eg: Bonus, Claims to insurance, suppliers etc

Inventory Pricing and Valuation

Inventory is the part of goods purchased or manufactured that remained unconsumed or unsold Term inventory includes the stock of
Raw materials Work-in-progress Finished goods Stores, Spares, and Accessories

Types of Inventory Example

Integrated Steel Manufacturing Firm Steel Trading Firm Raw Material Inventory Iron Ore, Limestone, and Coal Work-In-Progress Inventory Molten Metal and Steel Slabs Finished Good Inventory Cold Rolled Steel in Stockyards Stores and Spares Inventory Stationary, Bearings, and Grease in Stores Finished Inventory Steel and Steel Products kept in Warehouses

Valuation of Inventory
Inventory Valuation and income measurement are inter-related For the ascertainment of income it is only the cost of goods sold that should be charged against revenue This is because not all the goods purchased (or produced) during the year are sold

Gross Income
Gross Profit = Sales Cost of Goods Sold = Sales (Beginning Inventory + Purchases Ending Inventory) Every year the unsold inventory will be carried forward to the next year and charged against the revenue of next year and hence the accounting equation discussed above can be re-written as: Gross Profit = Sales Cost of Goods Sold = Sales (Ending Inventory of Last Accounting Period + Purchases Ending Inventory of Present Accounting Period)

Gross Profit Equation

It can be also be observed that for a start-up firm the beginning inventory (or last accounting periods ending inventory) will be zero and so the gross profit equation will get simplified to: Gross Profit = Sales Cost of Goods Sold = Sales (Purchases Ending Inventory) In order to avoid situations of improper valuation accountants in such situations adopt the policy of valuing inventory at lower of cost or market price While this principle based on the concept of conservatism requires providing for all anticipated losses it ensures that the gains are not taken into account for computing income

Note that
Market price does not mean actual market prices paid by the buyer of inventory It indicates the net realizable value by selling the inventory to the buyer In other words, all costs which are to be incurred while selling (such as transportation and taxes) are to be deducted to compute the net realizable value

Govind started the business of vending milk in the city

of Indore and he was in his second week of his

business. He followed a weekly accounting period. He has been procuring milk at a steady rate of Rs 10 per liter from the nearby small farmers (they used to come and supply to him). Govind used to sell this milk to the local community at a rate of Rs 20 per liter. At the end of the first week, he had an ending inventory of 10 litres. During second week, he purchased 100 liters of milk and at the end of second week he found the stock of milk to be only 1 liter. Compute the gross profit of Govinds business and present it in as many possible

ways as possible

Computation of Total Sales

Beginning inventory of 2nd week Rs 100 (10 liters @ Rs 10 per liter) was Purchases in 2nd week was Rs 1000 (100 liters @ Rs 10 per liter)

Ending inventory of 2nd week Rs 10 (being 1 liter @ Rs 10 per was liter) Cost of Goods Sold of 2nd week Rs 1090 (being 109 liters @ Rs 10 would be per liter) Sales of 2nd week would be Rs 2180 (being 109 liters @ Rs 20 per liter)

Total of 109 liters of milk sold in 2nd week

Equation
Beginning Inventory Rs 100 + Purchases Rs 1000 = = Closing Inventory Rs 10 + Cost of Goods Sold Rs 1090

Income Statement: Simplest Form

Used by companies like Blue Dart Express and HLL

Sales

Rs 2180

Expenses
Less Cost of Goods Sold Gross Profit Rs 1090 Rs 1090

Contd
Presenting the change in inventory stocks as part of Sales: Sales Add Increase/(Decrease) in Stocks Adjusted Sales Expenses Less Purchases Gross Profit Rs 1000 Rs 1090 Rs 2180 (Rs 90) Rs 2090

Used by some European and Indian firms

Contd
Most Indian companies such as Raymonds and TV18 present the change in inventory position as part of the expenses:
Sales Rs 2180 Rs 1000 Rs 90

Expenses: Less Purchases Less (Increase)/Decrease in Stocks Gross Profit

Rs 1090

Methods of Inventory Valuation

Inventory Valuation Methods

First-in First-out

Weighted Average Cost

Specific Identification

Last-in First-out

Actual Inventory Movement Examples First In First Out Process Pharmaceutical Medical Shop Products Movement in a

Weighted Process

Average Movement of Gold in Jewelers Unit

Specific Identification Movement of Diamond in a Jewelers Shop Process

Last In Last Out Process

Movement of Sulphur from a Godown

Comments
Accountants rarely use the physical movement of inventory to decide on the inventory methodology due to difficulty in computing and tracking inventory among others They make assumptions about flow of costs rather than flow of units The first three methods are recommended to be followed by the Accounting Standard 2 on Valuation of Inventories. There are a few cases wherein the Accounting Standard 2 is not mandatory and hence in such cases any of the above method can be followed

First-in First-out Method

This method of valuation is based on the actual cost Here, the goods received first are issued or sold first

Therefore, the closing stock consists of goods or materials purchased most recently

Illustration
For the year ending on 31 March 20X4, Taro Ltd purchased the following:

20-4-X6

04-6-X6
02-12-X6

1,000 units at 10/- per unit 1,000 units at 12/- per unit 500 units at 8/- per unit

Sales during the same year were of 1,000 units on 01-02-X7. Calculate the value of inventory for taking to the balance sheet as at 31-03-X7 based upon First-in First-out method.

Solution
Under the first-in first-out (FIFO) method of inventory valuation, the oldest lot received is issued first In other words, the closing stock consists of materials purchased most recently Accordingly in the above case, the sale of 1,000 units is presumed to be made out of the purchases made on 20-04-X3 and so, the stock value on 31-03-04 is Rs. 16,000 [= (1000 units x 12 per unit) + (500 units x 8 per unit)].

Weighted Average Cost

This method follows the batch or block valuation concept Here, the purchase price is merged to get an average price of the product The closing stock does not consist of any specific batch of goods but consists of the average price paid for all the purchases during the period Under this method the average price of the stock changes with every fresh purchase so in an organization where the purchases are very frequent, valuation of inventory becomes a complex process

Illustration Taro Ltd.

For the year ending on 31 March 20X7, Taro Ltd purchased the following:

20-4-X6

04-6-X6
02-12-X3

1,000 units at 10/- per unit 1,000 units at 12/- per unit 500 units at 8/- per unit

Sales during the same year were of 1,000 units on 01-02-X7. Calculate the value of inventory for taking to the balance sheet as at 31-03-X7 based on Weighted Average Cost Method.

Solution
Date
20-04-X6 Transacti Pric Units on e Purchas e 1,00 0 10

Amt.

Closing Stock Units Price Amt. 10,000 22,000 26,000

10,00 1,000 0

10 11 10.4

Purchas 04-06-X6 e Purchas 02-12-X6 e 01-02-X7 Sale

1,00 0
500

12,00 12 2,000 0
8 4,000 2,500

1,00 10.4 10,40 1,500 0 0 0

10.4

15,600

Specific Identification Method

Specific costs are applied to identify items of inventory being consumed The total of various costs of the remaining stock identified constitute the value of inventory This method of valuation is helpful in organizations handling a small number of items

Illustration Taro Ltd.

Considering the information in last illustration, if it has been given that the sale of 1,000 units was made out of the purchases on 02-12-X6 and remaining from purchased lot dated 2004-X6 then the value of inventory using the specific identification method would be: 500 units of purchases made on 20-04-X6 (Rs. 10 per unit) 5,000 1,000 units of purchases made on 04-06-X6 (Rs. 12 per unit) 12,000 1,500 units Rs.17,000 Thus the closing stock will be 1,500 units and the total value of inventory will be Rs. 17,000

Last-in First-out (LIFO)

This method also, like FIFO, is based upon the actual cost of material with a difference that the goods purchased most recently are assumed to be sold first In other words, the valuation of stock is based upon the price of the materials purchased earliest

Illustration Taro Ltd.

In the example, using LIFO method the sales will consist of 500 units purchased as 02-12X3 and 500 units purchased as 04-04-X3. The closing stock consists of

1,000 units purchased on 20-04-03 (at Rs. 10/- per units) 10,000 500 units purchased on 04-06-03 (at Rs. 12/- per units) 6,000 1,500 units Total value Rs 16,000

LIFO vs. FIFO

The difference between LIFO and FIFO ending inventory is due to the rising perfume prices Hence, FIFO method shows higher ending inventory and lower cost of goods sold Consequentially, FIFO method would show higher profit than LIFO method. In scenarios of falling prices LIFO and weighted average method would show higher profit than FIFO method

Observations
Accounting policy adopted in relation to inventory valuation can to a large extent influence income determination

Profits can be manipulated by switching from one method of valuation to another Company Law requires that particular method accepted should be consistently tried at least for a period of three years

THANK YOU AND HAVE A GOOD DAY