Inventories

Figure 1: Inventory valuation is crucial for determining income and financial position of a business.

Learning Outcomes

• Understand the meaning of term 'Inventory'.
• Learn the technique of Specific Identification Method, FIFO, Average Price, Weighted Average Price and Adjusted Selling Price methods of inventory valuation.
• Understand the methods of inventory record keeping and comprehend the intricacies relating to Inventory taking.

1. Meaning

• 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 goods or services for sale, including maintenance supplies and consumables other than machinery spares, servicing equipment and standby equipment.

KNOWLEDGE NUGGET

• Trading Concern: Products purchased for resale in their existing form
• Manufacturing Concern: Raw material, Work-in-process, Finished goods
• Construction Business: Projects under construction
• Inventory does NOT include spare parts, servicing equipment and standby equipment which are used only in connection with fixed assets

• At the year-end (or any period for which books are closed) 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.

2. Inventory Valuation

• A primary issue in accounting for inventories is the determination of the value at which inventories are carried in the financial statements until the related revenues are recognized.
• Inventory is generally the most significant component of the current assets held by a trading or manufacturing enterprise.

(i) Determination of Income

• Cost of goods sold is calculated as follows:

COST OF GOODS SOLD

Cost of Goods Sold = Opening Inventory + Purchases + Direct Expenses — Closing Inventory

EFFECT OF INVENTORY MISSTATEMENT ON NET INCOME

If the value of…	Then net income will be…
Closing inventory overstated	Overstated
Opening inventory overstated	Understated
Closing inventory understated	Understated
Opening inventory understated	Overstated

(ii) 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.
• Slow-moving or non-moving inventory is the basic reason for poor financial performance as well as financial position of an enterprise.

(iii) Liquidity Analysis

• Inventory is one of the components of net working capital which reveals the liquidity position of the business.
• Current ratio = Current Assets / Current Liabilities — significantly affected by the value of inventory.
• Poor management of inventories is one of the reasons of losses of small manufacturing enterprises.

(iv) Statutory Compliance

• Schedule III to the Companies Act, 2013 requires valuation of each class of goods to be disclosed in the financial statements.
• Accounting Standards require disclosure of:
  • (a) the accounting policies adopted in measuring inventories, including the cost formula used
  • (b) the total carrying amount of inventories and its classification

3. Basis of Inventory Valuation

• Inventories should be generally valued at the lower of cost or net realizable value.
• This principle is governed by 'Principle of Conservative Accounting'.

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.

COST OF PURCHASE

• Includes: Purchase price including duties and taxes (other than those recoverable), freight inwards and other expenditure directly attributable to acquisition
• Excludes: Trade discounts, rebates, duty drawbacks and other similar items
• Note: GST on purchase is not included in cost if it is available as credit

EXAMPLE — COST OF INVENTORY

• Raw material bought at ₹100 per unit plus GST at 18% — 100 units
• Amount paid: ₹10,000 + GST ₹1,800 = ₹11,800
• Since GST on purchase is available as credit, cost of purchase = ₹10,000 only
• Direct labour cost for conversion = ₹3,000
• Unloading charges = ₹200 (part of cost)
• Total cost of inventory for 100 units = ₹13,200

Exclusions from Cost 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
• (d) selling and distribution costs

Net Realizable Value (NRV)

• 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: NRV = Selling price — Selling and distribution expenses
• In case of work in progress: Expenses required to convert into finished goods are also reduced
• In case of raw materials: Replacement cost is generally considered as NRV

4.1 Periodic Inventory System

• Periodic inventory system is a method of ascertaining inventory by taking an actual physical count (or measure or weight) of all the inventory items on hand at a particular date on which inventory is valued.
• It is because of actual physical count that the system is also called physical inventory system.

COST OF GOODS SOLD — PERIODIC SYSTEM

Opening Inventory + Purchases + Direct Expenses — Closing Inventory = Cost of Goods Sold

LIMITATIONS OF PERIODIC INVENTORY SYSTEM

• (i) Physical inventory taking is required more than once a year
• (ii) Physical count requires closure of normal operations
• (iii) Cost of goods sold is taken as residual figure — cannot identify loss due to pilferage, damage or fraud
• (iv) Inventory control is not possible
• (v) Difficult to plan operations

This system is used by small enterprises where it is easy to control physical inventory.

4.2 Perpetual Inventory System

• Perpetual inventory system is a system of recording inventory balances after each receipt and issue.
• In order to ensure accuracy, physical inventory should be checked and compared with recorded balances.
• The basic feature of this system is the maintenance of inventory ledger to have records of goods on continuous basis.

CLOSING INVENTORY — PERPETUAL SYSTEM

Opening Inventory + Purchases — Cost of Goods Sold = Closing Inventory

ADVANTAGE

• Overcomes the limitations of periodic system
• Inventory control is possible
• Continuous information about inventory

Note: The main limiting factor is the high cost of using this system.

4.3 Distinction between Periodic Inventory System and Perpetual Inventory System

S. No.	Periodic Inventory System	Perpetual Inventory System
1.	Based on physical verification	Based on book records
2.	Provides information at a particular date	Provides continuous information
3.	Cost of goods sold = Residual figure	Inventory = Balancing figure
4.	Cost of goods sold includes loss of goods	Closing inventory includes loss of goods
5.	Inventory control not possible	Inventory control possible
6.	Simple and less expensive	Costlier method
7.	Requires closure of business for counting	Inventory can be determined without affecting operations

5. Formulae/Methods to Determine Cost of Inventory

5.1 Historical Cost Methods

(i) Specific Identification Method

• Pricing under this method is based on actual physical flow of goods.
• Requires keeping different lots purchased separately to identify the lot out of which units in inventories are left.
• Generally used for items that are not ordinarily interchangeable and their value is high like expensive medical equipment.

ILLUSTRATION 1 — Specific Identification Method

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.

Items	Historical Cost (₹ Lakhs)	Net Realisable Value (₹ Lakhs)	Valuation = Least of Cost or NRV
P	38	42	38
Q	29	29	29
R	17	14	14
Total			81

(ii) FIFO (First in first out) Method

• Based on the assumption that cost should be charged to revenue in the order in which they are incurred.
• Assumes 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.
• Closing inventory is valued at the price paid for such consignments.

ILLUSTRATION 2 — FIFO Method

A manufacturer has the following record of purchases of a condenser:

Date	Quantity (units)	Price per unit (₹)
Dec. 4	900	50
Dec. 10	400	55
Dec. 11	300	55
Dec. 19	200	60
Dec. 28	800	47
Total		2,600 units

1,600 units were issued during the month of December till 18th December. Closing inventory is 1,000 units.

Value of closing inventory:

• 800 units received on 28th December @ ₹47 = ₹37,600
• 200 units received on 19th December @ ₹60 = ₹12,000
• Total = ₹49,600

(iii) LIFO (Last in first out) Method

• Assigns to cost of goods sold, the cost of goods that have been purchased last.
• Closing inventory is assumed to consist of earlier consignments.
• Note: LIFO method is no longer adopted for valuing inventories. Accounting Standards does not permit the usage of LIFO Method.

(iv) Simple Average Price Method

• All the different prices are added together and then divided by the number of prices.
• Closing inventory is valued according to the price ascertained.
• Generally followed by entities using periodic inventory method.

(v) Weighted Average Price Method

• Computes weighted average price using the quantities purchased in a lot as weights.

FORMULA — WEIGHTED AVERAGE PRICE

Weighted Average Price per unit = Total Cost of Goods Available for Sale ÷ Total Number of Units Available for Sale

Closing Inventory = No. of units in inventory × Weighted Average Price per unit

5.2 Non-Historical Cost Methods

(i) Adjusted Selling Price Method (Retail Inventory Method)

• Used widely in retail business or where inventory comprises of items, the individual costs of which are not readily ascertainable.
• The cost of the inventory is determined by reducing from the sales value of the inventory an appropriate percentage of gross margin.

ILLUSTRATION — Adjusted Selling Price Method

From the following information, calculate the non historical cost of closing inventories:

• Sales during the year: ₹2,00,000
• Cost of purchases: ₹2,00,000
• Opening inventory: Nil
• Closing inventory at selling price: ₹50,000

Calculation:

• Selling price of goods available for sale = ₹2,00,000 + ₹50,000 = ₹2,50,000
• Gross margin = ₹2,50,000 — ₹2,00,000 = ₹50,000
• Rate of gross margin = (50,000 / 2,50,000) × 100 = 20%
• Cost of closing inventory = ₹50,000 — 20% of ₹50,000 = ₹40,000

(ii) Standard Cost Method

• Used when there is frequent change in the price per unit of the goods.
• Based on the experience, a standard cost is determined on the basis of frequent changes in prices.

6. Inventories Taking

• Normally all operations are suspended for one or two days during the financial year and physical inventory is taken.
• For the year-end inventory valuation, physical inventory taking is done during the last week of the financial year or during the first week of next financial year.
• If inventory taking is finished earlier, purchases and sales between that date and year-end are adjusted.

ADJUSTMENT FOR INVENTORY TAKING ON DIFFERENT DATE

• If inventory taking is carried out a few days earlier or later than the year-end, the actual value must be adjusted.
• Add: Cost of goods sold during the intervening period
• Less: Purchases during the intervening period

Summary

• 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 goods or services for sale.
• The inventories of manufacturing concern consist of several types of inventories: raw material, work-in-process, and finished products.
• Proper valuation of inventory has a very significant bearing on the authenticity of the financial statements.
• Cost of Goods Sold = Opening Inventory + Purchases + Direct expenses — Closing Inventory.
• Inventories should be generally valued at the lower of cost or net realizable value.

Inventory Valuation Techniques

• Historical Cost Methods:
  • Specific Identification Method
  • FIFO (First in first out) Method
  • LIFO (Last in first out) Method (not permitted by Accounting Standards)
  • Average Price Method
  • Weighted Average Price Method
• Non-Historical Cost Methods:
  • Adjusted selling price method (Retail Inventory Method)
  • Standard cost method
• There are two principal systems of determining inventory: Periodic Inventory System and Perpetual Inventory System.

QUICK REFERENCE

• FIFO: Earliest goods sold first — Closing inventory at latest prices
• LIFO: Latest goods sold first — Not permitted by Accounting Standards
• Weighted Average: Average cost based on quantities
• Periodic System: Physical count — Simple, less expensive
• Perpetual System: Continuous records — Costly, better control

Test Your Knowledge

True and False

• 1. Inventories are stocks of goods and materials that are maintained for mainly the purpose of revenue generation. True
• 2. A building is considered inventory in a construction business. True
• 3. Inventory is valued as carrying cost less percentage decreases. False
• 4. Management has daily information about the quantity and valuation of closing stock under physical Inventory System. False
• 5. Periodic Inventory System is more suitable for small enterprises. True
• 6. When closing inventory is overstated, net income for the accounting period will be understated. False
• 7. Closing inventory = Opening inventory + Purchases + Direct expenses + Cost of goods sold. False
• 8. Cost of inventories should comprise all cost of purchase. False
• 9. Inventory by-products should be valued at net realisable value where cost of by products can be separately determined. False
• 10. Abnormal amounts of wasted materials, labour or other production overheads expenses are included in the costs of inventories. False
• 11. Perpetual system requires closure of business for counting of inventory. False
• 12. Periodic inventory system is a method of ascertaining inventory by taking an actual physical count. True
• 13. The value of closing inventory under simple average price method is realistic as compare to LIFO. True
• 14. The value of stock is shown on the assets side of the balance-sheet as fixed assets. False
• 15. Under inflationary conditions, FIFO will not show lowest value of cost of goods sold. False
• 16. Under LIFO, valuation of inventory is based on the assumption that costs are charged against revenue in the order in which they occur. False
• 17. Valuation of inventory, at cost or net realisable value, whichever less, is based on the principle of Conservatism. True
• 18. Finished goods are normally valued at cost or market price whichever is higher. False

Multiple Choice Questions

1. The amount of purchase if Cost of goods sold is ₹80,700, Opening Inventory ₹5,800, Closing Inventory ₹6,000	(a) ₹80,500 (b) ₹74,900 (c) ₹80,900
2. Average Inventory = ₹12,000. Closing Inventory is ₹3,000 more than opening Inventory. The value of closing Inventory =	(a) ₹12,000 (b) ₹24,000 (c) ₹13,500
3. While finalizing the current year's profit, the company realized that there was an error in the valuation of closing Inventory of the previous year. In the previous year, closing Inventory was valued more by ₹50,000. As a result	(a) Previous year's profit is overstated and current year's profit is also overstated (b) Previous year's profit is overstated and current year's profit is understated (c) Previous year's profit is understated and current year's profit is also understated
4. Cost of goods available for sale ₹1,00,000, Total sales ₹80,000, Opening inventory ₹20,000, Gross profit margin on sales 25%. Closing inventory of goods for the year 2021-22 as	(a) ₹80,000 (b) ₹60,000 (c) ₹40,000
5. If the profit is 25% of the cost price then it is	(a) 25% of the sales price (b) 33% of the sales price (c) 20% of the sales price
6. Goods purchased ₹1,00,000. Sales ₹90,000. Margin 20% on cost. Closing Inventory =	(a) ₹20,000 (b) ₹10,000 (c) ₹25,000
7. A company is following weighted average cost method. Opening Inventory 50 units value ₹2,200. Purchased 100 units @ ₹47. Issued 50 units. Purchased 200 units @ ₹48. The value of inventory at the end of the week and the unit weighted average costs is	(a) ₹14,200 — ₹47.33 (b) ₹14,300 — ₹47.67 (c) ₹14,000 — ₹46.66
8. The cost of sales is equal to	(a) Opening stock plus purchases (b) Purchases minus Closing stock (c) Opening stock plus purchases minus closing stock
9. Inventory is disclosed in financial statements under:	(a) Fixed Assets (b) Current Assets (c) Current Liabilities
10. Accounting Standards do not permit following method of inventory valuation	(a) FIFO (b) Average cost (c) LIFO
11. Which inventory costing formula calculates value of closing inventory considering that inventory most recently purchased has not been sold?	(a) FIFO (b) LIFO (c) Weighted average cost
12. Valuing inventory at cost or net realisable value is based on which principle	(a) Consistency (b) Conservatism (c) Going concern
13. Under inflationary trend, which of the methods will show highest value of inventory?	(a) FIFO (b) Weighted average (c) LIFO
14. Which of the following methods does not consider historical cost of inventory?	(a) Weighted average (b) FIFO (c) Retail price method

High-Yield Interactive Quiz — Inventories

Q1. Inventories should be generally valued at:

Correct Answer: B. Inventories should be generally valued at the lower of cost or net realizable value, governed by the principle of Conservative Accounting.

Q2. Under FIFO method, closing inventory consists of:

Correct Answer: B. Under FIFO, the inventory of goods on hand consists of the latest consignments, and closing inventory is valued at the price paid for such consignments.

Q3. Which inventory valuation method is NOT permitted by Accounting Standards?

Correct Answer: C. LIFO (Last in first out) method is no longer adopted for valuing inventories. Accounting Standards do not permit the usage of LIFO Method.

Q4. Cost of Goods Sold is calculated as:

Correct Answer: B. Cost of Goods Sold = Opening Inventory + Purchases + Direct Expenses — Closing Inventory.

Q5. Which system requires physical count of inventory at a particular date?

Correct Answer: B. Periodic inventory system is a method of ascertaining inventory by taking an actual physical count of all inventory items on hand at a particular date.

Q6. If closing inventory is overstated, the net income will be:

Correct Answer: B. When closing inventory is overstated, cost of goods sold is understated, and therefore net income will be overstated.

Q7. Which method is also called Retail Inventory Method?

Correct Answer: C. Adjusted Selling Price Method is also called retail inventory method. It is used widely in retail business where individual costs are not readily ascertainable.

Q8. Which of the following is NOT included in the cost of inventories?

Correct Answer: C. Selling and distribution costs are excluded from the cost of inventories. Cost includes cost of purchase, costs of conversion, and other costs to bring inventory to present location and condition.

Q9. Under inflationary conditions, which method shows the highest value of inventory?

Correct Answer: B. Under inflationary conditions, FIFO will show the highest value of inventory because closing inventory is valued at latest (higher) prices.

Q10. Under Periodic Inventory System, cost of goods sold is treated as:

Correct Answer: B. Under Periodic Inventory System, cost of goods sold is taken as residual figure (Opening Inventory + Purchases — Closing Inventory).

Q11. Net Realizable Value (NRV) is:

Correct Answer: B. Net Realizable Value 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.

Q12. Inventory is classified as a:

Correct Answer: B. Inventories are classified as current assets and are one of the components of net working capital.