LECTURE 12 ACCOUNTING AND AUDITING

INVENTORY

Inventory can be defined as assets held

(a) for sale in the ordinary course of business, or
(b) in the process of production for such sale, or

(c) 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.

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.

TYPES OF INVENTORY
In case of Manufacturing Concern

1. Raw Material
2. Work in Progress
3. Finished goods
4. Stores and spares
5. Packing Material
6. Loose Tools

In case of Trading Concern

Traded Goods / Finished Goods

NET REALISABLE 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 material, replacement cost is generally considered as Net realizable

value

BENEFITS OF INVENTORY VALUATION

1. 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.

2. 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.
3. 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.

4. Statutory Compliance : Schedule III to the Companies Act, 2013 requires

valuation of each class of goods
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.

BASIS OF INVENTORY VALUATION

Inventories should be generally valued at the lower of cost or net realizable value
(Conservatism or Prudence Concept)
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 (Overheads)

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.

EXCLUSION OF COST

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

FORMULA FOR DETERMINATION OF COST OF INVENTORY / INVENTRY

VALUATION
HISTORICAL COST METHOD
1. 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
equiptment, otherwise it requires the use of FIFO (First in first out) or weighted
average price/average price formula.

2. 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.

3. 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.
 4. 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. Add the text here before "Simple Average Price Method"
5. 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.

Weighted average price per unit = Total Cost of goods available for sale/ Total
No of units available for sale
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.

NON HISTORICAL COST METHOD

1. Adjusted selling price method

This method is also called retail inventory method. It is used widely in retail
business or in business where the inventory comprises of items, the individual costs
of which are not readily ascertainable. The use of this method is appropriate for
measuring inventories of large numbers of rapidly changing items that have similar
margins and for which it is impracticable to use other costing methods. The cost of
the inventory is determined by reducing from the sales value of the inventory an
appropriate percentage of gross margin. The percentage used takes into
consideration inventory which has been marked below its original selling price. An
average percentage for each retail department is often used. The calculation of the
estimated gross margin of profit may be made for individual items or groups of items
or by departments, as may be appropriate to the circumstances.

INVENTORY MAINTAINANCE SYSTEM

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

Opening inventory (known) + Purchases (known) - closing inventory (physically

counted) = Cost of goods sold.