Principles and

Practice of
Accounting
Chapter 4 : Inventories

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 Type of inventory

In case of
In case of trading
manufacturing
concerns
concerns

Raw Work in Finished Finished Traded goods

materials progress goods goods

Stores and
Spares

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 Inventory Valuation
Techniques

Inventory Valuation Non-historical cost

Techniques methods

Inventory, Inventory
Traded goods
not ordinarily ordinarily
interchangeable interchangeable

Specific
Historical cost
identification
methods
method

Weighted
FIFO LIFO Average
Price
 Inventory : introduction

Cost

Whichever
Or is less Inventory can be defined as assets
• Held for sale in the ordinary course of
business, or
• in the process of production for such
sale, or
• for consumption in the production of
Net realisable goods or services for sale, including
value maintenance supplies and
consumables other than machinery
spares, servicing equipment and
standby equipment.
 Why is inventory valuation important ?
Determination of Income Liquidity Analysis
The valuation of inventory is
necessary for determining the true
01 Inventory is classified as a
current asset, it is one of the
income earned by a business entity components of net working
during a particular period. capital which reveals
COGS= Opening inventory + 03 the liquidity position of the
Purchases + Direct expenses - business. Current ratio which
Closing inventory. studies the relationship between
GP = Sale value – COGS.
current assets and current
i. If CS is overstated , net income
liabilities is significantly affected
will be overstated
by the value of inventory.
ii. If OS is overstated , net income
will be understated
iii. If CS is understated , net income
will be understated Statutory Compliance
iv. If OS is understated, net income Schedule III to the Companies
will be overstated Act, 2013 requires valuation
of each class of goods i.e.
Ascertainment of Financial
raw material, work-in-
New thinking
Position progress and finished goods
Inventories are classified as current 02 04 under broad head to be
assets. In case the inventory is not disclosed in the financial
properly valued, the balance sheet
statements.
will not disclose the truthful financial
position of the business.
 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.

01 Cost of purchase It includes costs directly related to the units of

production, such as direct labour. They also
include a systematic allocation of fixed and
variable overheads.
Costs of
02
conversion Includes 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
03 Other Costs 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.
 Cost : exclusions
Abnormal amounts of wasted materials, labour or
01
other production overheads

storage costs, unless those costs are necessary in

02 the production process prior to further production
stage
administrative overheads that do not contribute to
03 bringing the inventories to their present location
and condition

04 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 is 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.

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 Particulars FIFO Method LIFO Method

Assumption Goods coming in first will go out first Goods coming in later will go out
first.

Closing Stock Closing Stock consists of latest Closing Stock consists of earlier
purchases purchases

Valuation Closing Stock will be valued at the Closing Stock will be valued at the
Current market prices. prices of initial purchases

Inflation - Prices Increase / Value of Closing Stock will be higher Value of Closing Stock will be lower
rising prices Cost of Goods Sold will be lower Cost of Goods Sold will be higher

Deflation - Prices decrease Value of Closing Stock will be lower Cost Value of Closing Stock will be
/falling prices of Goods Sold will be higher higher Cost of Goods Sold will be
lower

Matching of costs Current Costs are NOT matched with the Current Costs are MATCHED with
current revenues the current revenues

Recognition Approved by AS-2 NOT approved by AS-2

Serial number Periodic Inventory System Perpetual Inventory System

1 This system is based on physical verification. It is based on book records.

2 This system provides information about It provides continuous information about

inventory and cost of goods sold at a particular inventory and cost of sales.
date.
3 This system determines inventory and takes It directly determines cost of goods sold and
cost of goods sold as residual figure. computes inventory as balancing figure.

4 Cost of goods sold includes loss of goods as Closing inventory includes loss of goods as
goods not in inventory are assumed to be sold. all unsold goods are assumed to be in
Inventory.
5 Under this method, inventory control is not Inventory control can be exercised under this
possible. system.
6 This system is simple and less expensive. It is costlier method.

7 Periodic system requires closure of business Inventory can be determined without

for counting of inventory. affecting the operations of the business.

Note: Inventory control system is possible only under perpetual inventory system
 Brief discription
1 2 3
Specific
Identification FIFO LIFO
Method

• This method is generally used to ascertain the The FIFO formula assumes
cost of inventories of items that are not ordinarily that the items of
interchangeable and their value is high like inventories which were The cost of goods sold
expensive medical equipments under this method
purchased or produced
• Pricing under this method is based on actual represents the cost of
physical flow of goods. It attributes specific costs first are consumed or sold
first and consequently recent purchases resulting
to identified goods and requires keeping different
items remaining in the that there is better
lots purchased separately to identify the lot out of
which units in inventories are left. The historical inventory at the end of the matching of current costs
costs of such specific purpose inventories may be period are those most with current sales.
determined on the basis of their specific purchase recently purchased or
price or production cost. produced.
 Brief discription
4 5
Simple Weighted
Average Price Average Price
Method 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
eff orts of identifying that closing
inventory belongs to which
consignments or lots.
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.

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 NON-HISTORICAL COST METHODS

Adjusted selling price method Standard cost 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 This method is used when there is
ascertainable. frequent change in the price per unit of
• The use of this method is appropriate for measuring inventories the goods and goods are purchased
of large numbers of rapidly changing items that have similar frequently by the business e.g. crude oil.
margins and for which it is impracticable to use other costing Based on the experience a standard cost
methods. is determined on the basis of frequent
• The cost of the inventory is determined by reducing from the changes in prices and inventory is valued
sales value of the inventory an appropriate percentage of gross on that price per unit.
margin.
• The percentage used takes into consideration inventory which
has been marked below its original selling price.
• 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.