Accounting and Valuation of

Inventory

Meaning of Inventory
Inventory includes tangible property that is held for sale in the normal course
of the business or will be used in purchasing goods or services for sale.
Inventories are current assets and shown on the liabilities side of the balance
sheet. As current assets they can be used or converted into cash within one
year or within the next operating cycle of the business whichever is longer.

Inventories are kept by manufacturing firms and merchandising (retailing)

firms. For merchandising firms, inventories are often the largest or most
valuable current asset. Types of inventories normally kept by these two
types of enterprises are as follows:

A. Manufacturing Enterprise

1) Finished Goods Inventory -( Goods finished and kept ready for

sale)

2) Work in progress inventory- Goods in the process of production

not yet completed.

3) Raw Material inventory- Items purchased or acquired for using in

making finished goods

B. Merchandising Enterprise

In merchandising or retailing firms inventory consists of goods held for

resale in the normal course of the business. These goods are acquired
in a finished condition and are ready for sale without further
processing.
Need for Inventories

Inventory is one of the major problems that accountants face. It is difficult to

value it in terms of cash. It is almost impossible to assess its value in terms
of future profits. The basic reason for holding inventories is that it is
physically impossible and economically impractical for each inventory item
to arrive exactly when and where it is needed.

Level of Need Reason to maintain inventory

Fundamental (Primary) Physical impossibility of getting the
right amount of stock at the exact
time of need. Impracticality of getting
the right amount of stock at the
exact time of need.
Secondary Favorable return on investment.
Buffer to reduce uncertainty.
Decouple operations. Level or smooth
production. Reduce material handling
costs. Allow production of family of
parts. Price changes ( can be
disadvantageous)
Bulk Purchases and display to
customers.
Inventory is not purchased as an investment or to hold or to realize a gain
from possession but rather to sell and realize a gain from resale. In fact each
purchase of saleable goods in anticipation of the very next sale. Inventory
should be considered as an investment and should compete for funds with
other investments contemplated by the business firm.

Inventory represents a type of business insurance which assures the

company that it will not have to close down due to shortage of saleable
goods. Inventory is a variable cost insurance. That is the cost of insurance
will vary in the same direction as the value of sales. As the sale increases the
company will find it necessary to maintain larger and larger inventory to
meet the expanded sales volumes.
Objectives of Inventory Measurement

The measurement of inventory has significant effect on income

determination and financial position of a business enterprise. The American
Institute of Certified Public Accountants states:

“ A major objective of accounting for inventories is the proper determination

of income through the process of matching appropriate costs against
revenues.”

It is significant to observe that a direct relationship exists between the cost

of goods and closing inventory. Cost of goods sold in determined by
deducting closing inventory from costs of goods available for sale. Because
of this relationship we can say that the higher the cost of closing inventory ,
the lower the cost of goods sold and the higher the resulting net income.

On the contrary, the lower the value of closing inventory, the higher the
costs of goods sold and lower the net income. Items which are not in the
closing inventory are considered as sold and become the part of cost of
goods sold. In this way measurement of closing inventory influences the
income statements (through influencing cost of goods and net income) and
balance sheet because inventory appears as current assets in balance sheet.

Also closing inventory influences net income of not only the current period
but also of the next period because closing inventor of the current period
becomes the opening inventory of the next period.

Since closing inventories determine cost of goods sold the most common
objective of inventory measurement is the attempt to match costs with
related revenues in order to compute net income within the traditional
accounting structure.
Effect of Inventory Value on net Income

Data Amount (Rs in lakhs) Situations

A B C D
Sale 50 50 50 50
Opening Inventory 6 6 6 6
Purchases 40 40 40 40
Goods Available for Sale 46 46 46 46
Closing Inventory 8 10 12 14
Cost of Goods Sold 38 36 34 32
Net income 12 14 16 18

A second objective of inventory measurement is to state the fair value of

inventory which appears as current assets on the balance sheet. This along
with other assets reflects the value of assets to the firm and in turn the
financial position of the business enterprise.

Further the value of inventory will help permit investors and other users to
predict the future cash flows of the firm. This can be accomplished from two
points of view. First, the amount of the business. Second, the amount of
inventory resources available will, under normal circumstances have an
effect on the amount of cash required during the subsequent period to
acquire the merchandise that will be sold during the period.
Inventory Costing Methods

The pricing or costing of inventory is one of the most interesting and most
widely debated problems in accounting. Generally inventories are priced at
their cost in conformity with the cost concept. According to AICPA “ The
primary basis of accounting for inventory is cost, which is the price paid or
consideration given to acquiring an asset. As applied to inventories cost
means in principle, the sum of the applicable expenditures and charges
directly or indirectly incurred in bringing an articles to its existing condition
or location.”

Hence cost includes:

• Invoice price less cash discounts

• Freight or transportation, insurance including insurance in transit

• Applicable taxes and tariffs. Other costs such as those for purchasing,
receiving and storage should theoretically be included in inventory
cost.

Concept of Goods Flow and Cash Flow

The two terms of goods flow and cash flow are useful in considering the
problems in pricing inventories under fluctuating prices. Goods flow refers to
the actual physical movement of goods in the firm’s operations. Cost flow is
the real or assumed association of costs with goods either sold or in
inventory. The assumed cost flow may or may not be the same as the actual
goods flow. Though this statement or practice may appear strange, there is
nothing wrong or illegal about his practice. Generally Accepted Accounting
Principles (GAAP) accept the use of an assumed cost flow that does not
reflect the real physical movement of goods. In fact the assumption about
the cash flow is more important than goods flow as the former helps in
determining net income which is the major objective of inventory valuation.

Generally Accepted Methods Of Inventory Pricing:

1. First In First Out (FIFO)

2. Last In First Out (LIFO)

3. Average Cost Method

4. Specific Identification Method

The inventory costing methods are also known as cost flow assumptions. The
specific identification method allocates costs according to the physical flow
of goods. The other methods assume certain cost flow patterns that may or
may not reflect the physical flow of goods.

First In First Out (FIFO)

The FIFO assumption of cost flow is recognized intuitively as being generally
consistent with the physical flow of products and goods in most
merchandising operations. This method follows the principle that goods
received first are sold first. After the first lot or batch of the goods is
exhausted the next lot is taken up for sale. It does not suggest however that
the same lot will be sold. Sometimes all items are tagged with their arrival
date and sold in that order specially with stocks that deteriorate. The
inventory is priced at latest stock.

Arguments in favor of FIFO

The FIFO method depends on the assumption that it is good inventory

management to sell or use the oldest goods first and maintain a current
inventory representing the most recent purchases. It has the advantage that
management has little or no control lover the selection of units in order to
influence profits. It also has the advantage of not being influenced by the
arbitrary choices of customers. As a result it provides a more consistent and
systematic of inventory and cost of goods sold. It also permits better
comparison among different firms in the same industry and over several
years.

Another benefit of FIFO is that it combines all elements of profit reported at

the time of sale. Under FIFO no separation can be made of gains and losses
arising from price changes and income resulting from managerial decisions
in the course of normal operations.

A third benefit of FIFO is the presentation of the ending inventory for balance
sheet purposes in terms of the most recent costs which can be assumed to
approximate replacement cost. The closeness of approximation to
replacement cost depends on the stock turnover. When the stock turnover is
rapid the inventory valuation will reflect current prices unless prices change
considerably after the recent purchase.
Arguments Against FIFO

With the FIFO method, the inventory is valued at cost that most closely
represents the current cost. However cost of goods sold is matched with
costs that date back in time. If the prices of goods are rising rapidly the cost
of goods sold may be understated. If the sales price is fixed then sale
revenue may not produce enough income to cover the purchase of goods.
The valuation of inventory in terms of current costs depend on the frequency
of price changes and stock turnover. In case stocks turnover rapidly the
inventory valuations will reflect the current prices. But it is argued that the
inventory valuations will hardly be identical with replacement costs under
FIFO except accidentally or under unusual conditions of stable prices from
date of acquisition of ending inventory to the date of the balance sheet.

The objectives of matching the current cost with current revenues is not
achieved under the FIFO method. FIFO costing is improper if many lots of
goods are purchased during the period at different prices. The method
overstates profit especially with high inflation. It does not consider the cost
of replacing used goods, a situation created by high inflation.

The FIFO method is suitable where 1)the size and cost of units are large, 2)
goods are easily identified as belonging to a particular purchased lot, 3) not
more than two or three receipts of goods are on hand at one time.

Last In First Out (LIFO)

Under LIFO latest stocks of goods flow into cost of goods sold and oldest
stocks are included in stocks of inventories. This method is based on the
assumption that cost of goods sold is charged at prices which almost
correspond to the replacement cost of the goods. The main objective in LIFO
is the matching of current costs against current revenues, resulting in an
operating income which excludes gain and loss from the holding of
inventories.

Advantages:

1. It is a cost method that prices goods sold in a realistic and systematic

manner. It provides a better matching of current costs with current
revenues.

2. It results in real income in time to rising prices by maintaining net

income at a lower level than other costing methods.

3. In industries subject to sharp price fluctuations for goods, the method

minimizes unrealized inventory gains and losses and tends to stabilize
reported operating profits. Income is reported only when it is available
for distributions as dividends or other purposes.

4. Probably the most important argument in favor of LIFO is its role in tax
saving. It is generally considered a cheap form of tax avoidance by
business firms. By valuing inventory at beginning of period price and
calculating cost of sales at the prices of the period, the firms creates
secret reserves which are not taxed. As long as prices and inventory
levels do not decline, this benefit remains, and in this case the tax
saving will be eliminated by higher tax rates.

5. LIFO produces an income statement which shows correct profit and

losses and financial position. It correlates current costs and sales and
income statements show the result of operations excluding profits or
losses due to changing price levels.

Disadvantages:
 1. The valuation of inventory for balance sheet purpose is out of date, as
it reflects prices of some past period. Inventory valuations do not
reflect the current prices, hence are useless in the context of current
conditions.

2. The general argument t for LIFO to be matched with current costs with
current revenue, is not sound. The recent purchase costs are matched
with revenue of the current period. However unless both purchase and
sales occur regularly in even quantities, the revenue will not be
matched with the current costs at the time of sale. When purchases
are irregular and unrelated to the timing of sales, the matching is
illogical and unsystematic particularly if prices and costs are changing
rapidly.

3. The profit of the firm can be manipulated with the LIFO method in
operation. By timing purchases a company can cause higher or lower
costs to flow into the income statement, thus increasing or decreasing
reported net income at will.

4. Another limitation which also results from LIFO’s lowering of the

earning figure is the effect it will have on existing bonus and profit
sharing plan. Employees and managers who are interested in the
growth of these plans may have difficulty in understanding a drop in
benefits created wholly or partially by an accounting change.

Average Cost Method

The use of average cost methods permits each purchase price to influence
the inventory valuation and the cost of goods sold. The assumption in that
the buying and selling operations results in the aggregation of costs and the
assignment of these costs of goods sold and goods unsold on the basis of a
single price. The single price is assumed to be the representative unit cost of
all goods handled during a specific period. No specific flow of goods is
assumed, unless it can be said that it represents a random selection of goods
by customers so that any item handled during the period has an equal
chance of appearing in the inventory at the end of the period. Usually
however it is not thought to be in agreement with the physical flow of goods
but in conflict with it.

Average costs do not reflect either the matching of current costs with current
revenues or balance sheet valuation in terms of current costs. In this respect
they are somewhat neutral in regard to income determination and balance
sheet valuation. But the extent to which they are neutral depends in part on
how the average is computed.

Generally simple average or weighted average price can be calculated for

inventory costing under the average cost methods. Simple average price is
an average of prices without having any regard to the qualities involved.

Under weighted average, total quantities and total costs are considered in
computing the average price and not the total of rates divided by the total
number of rates as in simple average. The weighted average is calculated
each time a purchase is made. The quantity bought is added to the stock in
hand and the new revised balance is then divided by the new total value of
the total stock.

Specific Identification Method

This method involves:

1. Keeping track of the purchase of each specific unit.

 2. Knowing which specific units are sold.

3. Pricing the ending inventory in the actual prices of the specific units
not sold.

The objective is to match the unit cost of the specific item sold with sales
revenue. This method is based on the assumption that each unit sold,
purchased or in inventory has its own identity, that it is separate and
distinguishable from other unit. Each unit sold or remaining in inventory is
identified and its specific unit cost is used in calculating cost of goods sold or
ending inventory cost. To take an example assume that an art dealer
purchased two seemingly identical pieces of pottery during a period.

The first piece is purchased for Rs 3000 and the second is purchased several
months later for 3500. Assume that only one of them is sold by the dealer
during the period. The amount assigned to cost of goods sold and ending
inventory will depend on which specific piece of pottery is sold. If the item
sold is the first piece the cost of goods sold is Rs. 3000 and ending inventory
is 3500. If the second piece was sold the numbers would be reversed.

The specific identification method provides a highly objective procedure for

matching costs with sales revenue because the cost flow pattern matches
the physical flow of goods. However this method does not work for large
volumes of identical low cost items. This method is appropriate for
companies handling low volumes of physical units each having large unit
values. Thus specific identification is not appropriate where each unit is the
same in appearance but is differentiated from other units through serial
numbers, such as the same model of washers, refrigerators or televisions.

ICAI’s Guidelines on Inventory Valuation

The Institute of Chartered Accounts of India has revised Accounting standard
(AS)-2: Valuation of inventories in July 1999. The revised standard
supersedes AS-2 issued in 1981 and AS-2 revised comes into effect in
respect of accounting period commencing on or 1st April 1999 and is
mandatory in nature. It has listed the following guidelines:

1. Inventories should be valued at the lower cost and net realizable value.

2. Net realizable value is defined as the estimated selling price in the

ordinary course of business less the estimated cost of completion and
estimated costs necessary to make the sale. An assessment is made of
net realizable value at each balance sheet date.

3. The cost means historical cost comprising, (i) all costs of purchase
(ii) cost of conversion and (iii) other costs incurred to bring the
inventories to their present location and condition.

4. For the function of comparing historical cost with net realizable value
each item in the inventory may be dealt with separately or similar
items may be dealt with as a group.

5. The standards mention the following formulae for determining the

historical cost:

a) Specific identification of cost

b) First In First Out

c) Weighted average cost

6. The cost of inventories of items that are not ordinarily interchangeable

and goods or services produced and segregated for specific projects
should be assigned by specific identification of their individual costs.

7. Standard cost method or the retail method for the improvement of the
cost of inventories, may be used for convenience if the results
approximate the actual cost.

8. The historical cost of manufactured inventories may be arrived at on

the basis of either direct costing or absorption costing has been used,
the allocation of fixed assets of inventories should be based on the
normal capacity of the production facilities.
 9. When the cost of conversion of each product are not separately
identifiable they are allocated between the products on a rational and
consistent basis.

10. Inventory of by products should be valued at lower of cost and

net realizable value where the byproducts, by their nature, are
immaterial they are measured at a net realizable value and this value
is deducted from cost of main product.

11. The financial statement should disclose:

• The accounting policies adopted in measuring inventories

including the cost formulae used and

• The total carrying amount of inventories and its clarification

appropriate to the enterprise.

INVENTORY SYSTEMS

There are two principle ways of accounting for inventories:

Perpetual Inventory System

The perpetual inventory method requires a continuous record of additions to

or reductions on materials, work-in-progress and cost of goods sold on a day
to day basis. Such a record facilitates managerial control and preparation of
interim financial statements. Physical inventory counts are usually taken at
least once year in order to check on the validity of accounting records.

The perpetual inventory system may give some additional information as

goods ordered, expected delivery date and unit costs. Usually these records
are maintained on a quantity basis but values can be included. It is an
essential feature of the perpetual inventory method that items of stock are
checked periodically normally atleast once or twice a year. This ensures that
the stock records tally with the physical stock which is vital if the control
procedure is to function properly.

The perpetual inventory method has the following advantages:

1. The stock taking task which is long and costly is avoided under this
method. On the other hand the inventory of different items of
materials in accordance with the store ledgers can be promptly
prepared for the preparation of the income statement and balance
sheet and interim periods, if required without a physical inventory
being taken.

2. Management may be informed daily of number of units and the value

of each kind of material on hand information which tends to eliminate
delays and stoppage in production.

3. The investment in materials and supplies may be kept at the lowest

point in conformity with operating requirements.

4. A system of internal check is always in operations and the activities of

different departments, such a s purchasing stores and production are
continuously checked against each other. This results into detailed and
reliable checks on the stores also.

5. It is not necessary to stop production so as to carry out complete

physical stocktaking.

6. Perpetual inventory records provides details about material cost for

individual products, jobs, processes, production orders for
departments. This information is helpful for management in exercising
control over costs.

7. Discrepancies and errors are promptly discovered and localized and

remedial action can be taken to avoid their occurrence in future.
 8. This effect has a moral effect on the staff ; makes them disciplined and
careful and acts as a check against dishonest actions.

9. The disadvantages of excessive stock are avoided, such a loss of

interest on capital invested in stock, loss through deterioration, risk of
obsolescence.

Periodic Inventory System

Under the periodic method the entire book inventory is verified at a given
date by an actual count of materials in hand. The physical inventory is
usually taken near the end of the accounting period. Some firms even
suspend plant operations when this is done. This method provides for the
recording of purchases, purchase returns and purchase allowances on a daily
basis but does not provide for a continuous inventory or for a daily
computation of goods sold.

At the end of each accounting period, a physical count is made of the

quantity of goods on hand and the value of inventory is determined by using
an inventory pricing method and attaching costs to units counted. The costs
of goods sold is computed by deducting closing inventory from the sum of
opening inventory and purchases made during the current period. It is
assumed that goods not on hand at the end of accounting period have been
sold. There is no system and accounting for shrinkage losses theft and waste
throughout the accounting period and they can be discovered only after the
end of the period.

Taking a physical inventory at the year end is important task in the periodic
inventory system. It must be insured that all items have been counted
accurately. Counting procedures usually involves teams of people assigned
to specific sections of the factory and to inventory storage areas. Large items
are counted individually while small items may be weight counted. Counted
items are tagged to prevent double counting and information from the tag
concerning each items description and quantity is recorded on the inventory
sheets.