Inventory Valuation

Chapter Outline:
Introduction Valuation of Inventories Meaning and Significance of Inventories

Inventories are assets:

(a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

The following equation expresses how a company's inventory is determined:

Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending Inventory

Research in Financial Reporting

 Net realisable 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.

Measurement of Inventories
Inventories should be valued at the lower of cost and net realisable value

Cost of Inventories
The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Costs of Purchase
The costs of purchase consist of the purchase price including duties and taxes , freight inwards and other expenditure directly attributable to the acquisition. Trade discounts and rebates, and other similar items are deducted in determining the costs of purchase.

Determining the Physical Inventory

The first step in proper inventory valuation is to determine the physical inventory that belongs to the business Goods on Consignment
Goods on consignment are goods shipped by their owner, the consignor, to another person, the consignee, undertakes to sell the goods for a commission

Physical Inventory
Goods in Transit
A business must include goods in transit in ending inventory if it owns them The terms of shipment determine whether the buyer or seller is the legal owner of the goods Free on Board (FOB) shipping point Free on Board (FOB) destination

Pricing the Inventory

Cost Basis
The primary basis of accounting for inventory is cost, which has been defined generally as the price paid or consideration given to acquire 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 article to its existing condition and location

Inventory Costing Methods

Physical flow refers to the actual sequence in which goods are physically used or sold in the operations of the business Cost flow refers to the association of costs with the assumed sequence in which the goods are used or sold Methods First-in, first-out (FIFO) Last-in, first-out (LIFO) Weighted-average cost (WAC)

First-in, First-out (FIFO)

This method assumes that the first units acquired are the first units sold The cost of the units in the ending inventory is that of the most recent purchases Although FIFO is a cost flow assumption, physical flow too often follows the first-in, first-out sequence It leads to an improper matching of costs with revenues since the cost of goods sold is computed on the basis of old prices that are possibly unrealistic

Last-in, First-Out (LIFO)

This method assumes that the last units acquired are the first units sold The cost of the units in the ending inventory is that of the earliest purchases LIFO ensures that the current revenues are matched with the most recent purchase prices, thus resulting in realistic reported profits LIFO ensures that the current revenues are matched with the most recent purchase prices, thus resulting in realistic reported profits

Last-in, First-Out (LIFO)

This method assumes that the last units acquired are the first units sold The cost of the units in the ending inventory is that of the earliest purchases LIFO ensures that the current revenues are matched with the most recent purchase prices, thus resulting in realistic reported profits The LIFO cost of goods sold will be a good approximation of the current cost of the units sold

 LIFO

Weighted-Average Cost (WAC)

This method assumes that the goods available for sale are homogeneous Average cost is computed by dividing the cost of goods available for sale, which consists of the cost of the beginning inventory and all purchases, by the number of units available for sale The weighted average unit cost that results from the computation is applied to the units in the ending inventory

Weighted-Average Cost (WAC)

WAC is appropriate when the inventory units involved are homogeneous or when it is difficult to make a cost flow assumption The cost figure for the ending inventory reported under this method is influenced by all the purchase prices paid during the year and thus evens out the effect of price increases and decreases on ending inventory value

Comparison Of Impact on COGS and Gross Profit

FIFO
1 2 Sales Net Returns 748933

LIFO
748933 988364

WAC
748933 988364

Purchase net 988364 of Returns and other uses Freight Inwards 8000

3 4

8000 996364

8000 996364

Total Purchase 996364 Cost(2+3) Less: Closing Inventory COGS(4-5) 372056 624308

5 6 7

355736 640628 108305

362919 633455 115488

Gross Profit(1- 124625 6)

 Thank You