Q.8.

(a) What is Master Budget? How it is different from Cash Budget?

(b) What are the various methods of inventory valuation? Explain the effect of inventory
valuation methods on profit during inflation. What are the provisions of Accounting
Standard 2 (AS-2) with regards to inventory valuation?
ANS.8. The master budget is the aggregation of all lower-level budgets produced by a
company's various functional areas, and also includes budgeted financial statements, a
cash forecast, and a financing plan.
Cash Budget
Cash budget is a financial budget prepared to calculate the budgeted cash inflows and
outflows during a period and the budgeted cash balance at the end of the period. Cash
budget helps the managers to determine any excessive idle cash or cash shortage that is
expected during the period. Such information helps the managers to plan accordingly.
For example if any cash shortage in expected in future, the managers plan to change the
credit policy or to borrow money and if excessive idle cash is expected, they plan to invest
it or to use it for the repayment of loan.
All businesses need to maintain a safe level of cash to enable them to carry on business
activities. The managers of a business need to determine that safe level. The cash budget
is then prepared by taking into consideration, that safe level of cash. Thus, if a cash
shortage is expected during a period, a plan is made to borrow cash.
Cash budget is a component of master budget and it is based on the following
components of master budget:
Schedule of expected cash collections
Schedule of expected cash payments
Selling and administrative expense budget
There are three basis approaches to valuing inventory that are allowed by Generally
accepted accounting principles (GAAP) (a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of
material bought earliest in the period, while the cost of inventory is based upon the cost
of material bought later in the year. This results in inventory being valued close to current
replacement cost. During periods of inflation, the use of FIFO will result in the lowest
estimate of cost of goods sold among the three approaches, and the highest net income.
(b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of
material bought towards the end of the period, resulting in costs that closely approximate
current costs. The inventory, however, is valued on the basis of the cost of materials
bought earlier in the year. During periods of inflation, the use of LIFO will result in the
highest estimate of cost of goods sold among the three approaches, and the lowest net
income.
(c) Weighted Average: Under the weighted average approach, both inventory and the cost
of goods sold are based upon the average cost of all units bought during the period. When
inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.

Without inflation all three inventory valuation methods would produce the same
results. However, prices do tend to rise over the years, and the company's
method costing method affects the valuation ratios.
The FIFO method assumes that the first unit in inventory is the first until sold. FIFO
gives a more accurate value for ending inventory on the balance sheet. On the other
hand, FIFO increases net income and increased net income can increase taxes owed.
The LIFO method assumes the last item entering inventory is the first sold. During
periods of inflation LIFO shows ending inventory on the balance sheet much lower than
what the inventory is truly worth at current prices, this means lower net income due to a
higher cost of goods sold.
The average cost method takes a weighted average of all units available for sale during
the accounting period and then uses that average cost to determine the value
of COGS and ending inventory.

Provisions of Accounting Standard 2 (AS-2) with regards to inventory valuation are as

follows:1. Inventory
As per the definition of inventory or closing stock it includes following things;

1.

Items which are held for sale in the normal course of business that is finished stock of
goods.

2. Work-in-progress (WIP) for such sale. Goods which are not yet finished or ready to sale.
3. Raw material which is not even issued for production while valuation of closing stock or
inventory. It also includes consumable stores item.

4. Applicability
AS-2 is not applicable to following cases.

1.

Work in process in the construction contract business including, directly related to

service contract.

2. Any financial instruments held as stock in trade which includes shares, debentures,
bonds etc.

3. Other inventories like livestock, agricultural product and forest product, natural gases
and mineral oils etc.
4. Work in progress in the business of banking, consulting and service business. That means
it includes incomplete consulting service, merchant banking service and medical service
in process.
5. All of above are not cover under the definition of inventory/ closing stock that's why this
accounting standard if not become applicable to above cases or in the course of business.

6. Cost of inventory
Valuation of inventory is made at cost or market/ net realisable value whichever is lower.
So that for the purpose of valuation cost of inventory is required to obtain. There can be
three types of cost are included in the inventory which are as follow.

Purchase cost

Invoice price at which goods are purchased

Duties and taxes paid
Freight inward
Any other expenditure directly relating to acquiring goods
Above cost should be reduced by following
Duties and taxes received or receivable back from the tax authority
Trade discount
Rebate
Duty drawback
Cost of conversion
After purchasing the raw material or goods during the production time whatever cost is
paid or payable will be considered as conversion cost. It includes direct labour, material
and other direct expense plus allocation of fixed and variable production overhead
incurred for conversion or raw material in to finished goods. Following things should be
considered for conversion cost of the inventory.

Fixed production overhead it includes indirect cost for production which remains
constant without relating to numbers of units produced. For example depreciation and
maintenance of factory building.

Variable overhead indirect cost of production which depends on the number of units
are produced such as packing material and other supporting material to finished product.

Allocation of fixed expense should be made on the bases of normal capacity and
allocation of variable cost will be done on the basis of actual numbers of units are
produced.
Other cost
It includes any other expenditure incurred to bring inventory or stock in the present
location and condition.
All three are the major part of the cost which required to be considered for valuation of
the inventory. But it should not include abnormal wastage relating to material and
labour, storage cost, administrative expenses & selling and distribution expenses.

Methods of valuation of inventory

There are numbers of method for valuation of the inventory in the normal course of
business which includes FIFO, LIFO, weighted average cost, standard cost and retail
method. But practically following two methods only used.

1.

FIFO (first in first out)

2. Weighted average
Net realisable value
Net realisable value means normal selling price of the goods less estimated expenditure
to sale such goods. It is estimated value on the basis of reliable evidence at time of
valuation. Estimation of net realisable value can be done on the following basis.

1.

If the finished goods in which raw material and supply is used is sold at cost or above
the cost, then the estimated realisable value of raw material and supplies is
considered more than cost.

2. It the finished goods in which raw material and supply are used is sold at below cost
then the estimated realisable value of raw material or supply is equal to replacement
price of raw material or supply.
Disclosure in financial statement
Valuation of inventory is made on comparison of cost and net realisable value whichever
is lower. This value should be disclosed in the financial statements. Other things relating
to inventory to be disclosed in accordance with Accounting Standard-1 are accounting

policies adopted in measuring inventory, cost formula and classification of inventory such
as finished goods, raw material & WIP and stores and spares etc.