37 Valuation of Inventories: Need and Methods

Sanjeet Sharma

epgp books

 

 

LEARNING OBJECTIVES:

 

This module will help the students to:

 

·         Understand the Meaning of Inventory and Inventory Valuation

·         Recognise the Importance of Inventory Valuation

·         Assess the Technical Features of Inventory Records System

·         Distinguish between Periodic Inventory System and Perpetual Inventory System

 

INTRODUCTION

 

Preparation of accurate income statement and balance sheet of a concern depends on correct valuation of its inventory. Companies may have inventories held in the form of raw materials, work-in-progress, finished goods, products bought for resale, and service In trading concern inventory means stock of finished goods only. In a manufacturing concern, it may include raw materials, work in process and stores, etc. All enterprises requires inventory for smooth running of its activities. There should be a proper system for determining the quantities and value of inventories sold and in hand.

 

MEANING OF INVENTORY

 

Inventories include goods purchased or manufactured by a concern and remain unconsumed or unsold. Inventory‟ is also known with name of „merchandise‟ or „stock-in-trade. Further, the term Inventories also include those goods which are in process of production i.e. work-in-progress. All enterprises requires inventory for smooth running of its activities.

 

DEFINITION OF INVENTORY

 

The word inventory is defined by different authors differently.

 

The dictionary meaning of inventory is „stock of goods, or a list of goods‟.

 

As a verb the term inventory means to take count of (or list) units of a resource on hand at one point in time.

 

According to the Accounting Standard 2 (Revised) According to this Accounting Standard, inventories are assets.

  • held for sale in the ordinary course of business,
  • in the process of production for such sale, or
  • in the form of materials or supplies to be consumed in the production process or in the rendering of services.

CATEGORIES OF INVENTORY

 

On the basis of nature of the business the inventory can be defined as below

Trading concern

 

The inventories of a trading concern include mainly products purchased for resale in their existing form. It also consists of an inventory of supplies such as cartons, wrapping paper and stationery. Simply, in case of a trading concern, inventory primarily consists of

 

·         finished goods

 

Manufacturing concern

 

In case of a manufacturing concern, inventory consists of

  •    raw materials,
  •   work-in-process,
  •   Finished goods.
  •  Consumables and Spare

These are explained as below

 

· Raw Material Raw material is an important input for the production of finished goods in the organization. They are most important requirement for carrying out production activities uninterruptedly.

 

·  Work in Progress The work-in-progress is the stage of stocks which is between raw materials and finished goods. The raw materials enter the process of manufacture but they have not attained the final shape of finished goods.

 

·  Finished goods These are the goods which are ready for sale to the consumers. The aim of maintaining inventory of finished goods is to ensure proper supply of goods to customers.

 

·   Consumables and Spare: Consumables are needed to carry smoothly the process of production. These materials do not directly enter production but they act as catalysts in production process. Spares also form a part of inventory. The Consumption pattern of raw materials, finished goods, consumables are different from that of spares. The policies of stocking of spares are different in different industries. Some industries like transport will need more spares than the other concerns.

 

INVENTORY VALUATION

 

The main objective of valuation of inventories is the proper determination of income through the process of matching appropriate costs against revenues. Valuation of inventories assigns proper costs to inventory as well as goods sold. Inventories influence both the balance sheet and the statement of financial position. The inventories held by a business invariably have considerable value and a large amount of money is invested in these. Preparation of accurate income statement and balance sheet of a concern largely depends on correct valuation of its inventory. Valuation of inventories needed in order

 

·         To determine cost of goods sold for matching it against the sales for that period and to know gross profit.

 

·         To determine the value of the stock in hand at the end of its financial period as stock is an important current asset in the statement of financial position.

 

OBECTIVES OF INVENTORY VALUATION

 

Inventory has to be properly valued because of the following reasons:

 

(1) Determination of profitability

 

Inventory is an important item for determining the true profitability a business. Gross profit is determined by deducting the cost of goods sold from sales. Excess of sales over cost of goods sold is called gross profit. Cost of goods sold is ascertained by adjusting the opening and closing stocks to purchases, and it is shown as below:

 

Cost of goods sold = Beginning Inventories + Purchases – Inventories at the end.It is clear from the above formula that that the values of inventories have important impact on the cost and the gross profit. Further, it also reveals that the undervaluation or overvaluation of inventories will seriously affect the profitability of the concern.

(ii) Ascertainment of financial position

 

Inventory also plays an important role in the determination of the financial position of an enterprise. Closing stock or inventories at the end of a period are shown as a current asset in the balance sheet. In case the inventory is not properly valued, the balance sheet

 

·         will not disclose the correct financial position of the business

·         will give a misleading picture about the working capital position of the concern

 

SIGNIFICANCE OF INVENTORY VALUATION

 

Inventory is important current assets of a business concern. It is widely affects efficiency of operations of an enterprise. Both, excess and shortage of inventory affect the productivity and the profitability of the concern. Inventory is an important barometer of business activity. The significance, of inventory valuation is explained below:

1. Lifeblood of the concern

 

Inventory may be termed as “lifeblood” of the concern. An inventory enables

 

·         sale,

·         customer satisfaction,

·         Productive work for company employees. Without inventory the business dies.

 

2.  Impact on liquidity Position: Liquidity refers to firm‟s ability to pay its short term liabilities in time. The liquidity is generally measured through

 

·         Net Working Capital: Inventory is important component of net working capital.

 

·         Current Ratio: Current ratio shows the relationship between current assets and current liabilities.

 

Thus, correct valuation of inventories is very much essential for a concern. If the valuation of inventories is not done accurately then this provide misleading information about liquidity position of the business.

 

3. Effect on Income Statements

 

An accurate valuation is important as incorrect inventory valuation effects following in the Income statement

 

·         Cost of goods sold

 

·         Gross Profit

 

·         Net Income

 

·         balance of retained earnings

 

·         If ending inventory overstated= cost of goods sold is understated= resulting in overstated gross profit and net income.

 

·         If ending inventory understated= cost of goods sold is overstated= resulting in understated gross profit and net income.

 

·         If opening inventory is overstated= cost of goods sold is overstated= resulting in understated gross profit and net income.

  • If opening inventory is understated= cost of goods sold is understated= resulting in overstated gross profit and net income.
  1. Effect on balance sheet

Generally, inventory is the largest of the current assets of a business entity. Inventories are disclosed under the heading Current Assets on the balance sheet. An accurate valuation is important as incorrect inventory valuation effects following in the balance sheet

  • Current Asset
  • Working capital
  • Total assets
  • Retained earnings.

The balance sheet will not give a true and fair view of the affairs of the business. It is necessary to properly value ending inventory. Because overstatement of ending inventory causes

  • current assets to be overstated
  • total assets to be overstated
  • Retained earnings to be overstated.
  1. Effect two years statements

     In fact, an incorrect inventory valuation will effect two years income statements, because inventory at the end of one accounting period will automatically become the inventory at the beginning in nest period. When a- company makes mistake in valuation its ending inventory in the current year, the company carries forward that erroneous ending inventory in the next year.

 

INVENTORY RECORD SYSTEMS

 

There are mainly two systems of determining the quantities and value of inventories sold and in hand. One system is termed as the periodic inventory system and the other is known as the perpetual inventory system. These are explained as below in detail:

PERIODIC INVENTORY SYSTEM

 

Periodic inventory system requires a physical verification or count of all the inventory items in hand at specific times. Because in periodic inventory system actual physical verification of stock is done the system is also called physical inventory system. In case of this system the quantity and value of inventory is determined only at the end of the accounting period after the physical verification or count of the units of inventory in hand. The periodic system relies heavily on physical count of the inventory to determine

  • the ending inventory balance
  • the cost of goods sold.

Calculation of cost of materials used

 

The cost of goods sold is determined as shown below

In periodic inventory system the physical counting is done for determination of value of inventor. On the basis of this counting all corrections are made to ensure the accuracy of the inventory figure shown in the accounts.

 

(b) Less expensive

 

Periodic inventory system is less expensive than the continuous inventory system.

 

LIMITATIONS OF PERIODIC INVENTORY SYSTEM The following are the main drawbacks of this method:

 

(i) Based on wrong assumption

 

Periodic inventory method is based on the assumption that all goods which are not recorded or found by physical inventory count have been either sold or used. Due to this assumption losses due to theft, waste, evaporation etc. are taken in the cost of the goods sold. Thus figure of cost of the goods sold may not be accurate.

 

(ii) Adversely affect normal business operations

 

In this method physical counting is done at the end of accounting period due to this normal business operations will be adversely affected for a number of days. The businesses which are using this method have to stop their normal business operations and employ number of employees for the physical count and valuation of the inventory.

 

(iii) Fail when income statements required frequently

 

Periodic inventory method fails when income statements are required more frequently than once a year. In this case this method would become very expensive.

 

(iv) Not providing information continuously

 

Periodic inventory system does not provide the information regarding the quantity and value of materials in hand on a continuous basis.

 

(v) No Recording for losses

 

In periodic inventory system no accounting is done for losses such as shrinkage, theft, and wastage.

 

·         According to the Chartered Institute of Management Accountants London: Perpetual Inventory System is a system of records maintained by the controlling department, which reflects the physical movement of stocks and their current balance.

 

·         According to the Wheldon: It is “a method of recording inventory balances after every receipt and issue to facilitate regular checking and to obviate closing down for stocktaking.”

 

Perpetual Inventory System is also known as an Automatic Inventory System. In this system balance of raw materials, work-in-progress, and finished goods is provided on a continuing basis. The main aim of this system is to provide all times the information in detail about the quantity and value of stock. This maintains usual ledger accounts for each inventory item. The detailed inventory records for each different item (usually in both quantities and value.) must show:

 

·         Receipts (Purchases);

·         Issues (Sales),

·         Balance on hand,

 

When goods-are purchased or sold, the inventories must be adjusted immediately.

 

BENEFITS OF PERPETUAL INVENTORY SYSTEM The benefits of a perpetual inventory system may be noted as:

 

Perpetual Inventory System is also known as an Automatic Inventory System.

 

2. Continuing basis

 

In perpetual inventory system provides balance of raw materials, work-in-progress, and finished goods on a continuing basis.

 

3. Information Available at any times

 

The basic objective of this system is to make available details about the quantity and value of stock of each item at all times.

 

4. Provides a rigid control

 

Perpetual inventory system helps in exercising a rigid control over stock of materials, as physical stock can be verified with the stock records.

 

5.  No Interruption: The normal business operations are not interrupted by perpetual inventory system.

 

6.  No need for stock taking by actual count: Perpetual inventory system obviates the need for stock taking by actual physical count at the end of accounting period.

 

7.   Suitable when volume of inventory items is large: Perpetual inventory system has to be applied when the volume of inventory items is very large and it is impossible to make a complete count.

 

8.  No need of Special staff: In Perpetual inventory system special staff may be employed for stock taking.

 

9.   Controlling losses: Controlling losses is easier under a perpetual system because inventory records prepared under perpetual system continuously indicate the goods that must be on hand.

 

10.  No out of stock situation: Perpetual inventory system continuously provides detail of goods that must be on hand. So, there will be no sudden out of stock situation.

 

LIMITATIONS OF THE SYSTEM:

Perpetual inventory system is costly to maintain in those business firms which deal with numerous items of small value.

 

PERPETUAL INVENTORY SYSTEM

  • The perpetual system keeps continual track record of inventory balances.
  • Perpetual Inventory System is also known as an Automatic Inventory System.
  • In this system balance of raw materials, work-in-progress, and finished goods is provided on a continuing basis

BENEFITS OF PERPETUAL INVENTORY SYSTEM

  • Automatic Inventory System
  • Continuing basis
  • Provide information about stock at all times
  • Provides a rigid control
  • No Interruption in normal business operations
  • No need for stock taking by actual count
  • Suitable when volume of inventory items is large
  • Special staff may not be employed
  • Controlling losses
  • Check on irregularities or changes in procedures by storekeepers
  • No sudden „out of stock situation

LIMITATIONS OF PERPETUAL INVENTORY SYSTEM

  • costly to maintain especially for those business firms which deal with numerous items of small value

DIFFERENCE BETWEEN PERIODIC INVENTORY SYSTEM AND PERPETUAL INVENTORY SYSTEM

 

The following are the major differences between perpetual and periodic inventory system:

 

Difference between Periodic inventory system and perpetual inventory system

 

Conclusion: Following conclusion can be drawn from above

 

·         Periodic Inventory System is less costly.

·         Perpetual Inventory System but it gives more accurate information.

  • The financial statements prepared quickly as the inventory records are maintained properly in the Perpetual Inventory System.
  • The Perpetual Inventory System is best suited for big enterprises.
  • Small enterprises can go for Periodic Inventory System.
  • Firm generally employs periodic inventory method for low unit selling price.

SUMMARY

 

Inventories include goods purchased or manufactured by a concern and remain are unconsumed or unsold goods. Inventories influence both the balance sheet and the income statement. There are mainly two systems of determining the quantities and value of inventories sold and in hand. One is periodic inventory system and the other is known as the perpetual inventory system. The periodic system relies upon physical count of the inventory to determine the ending inventory balance and the cost of goods sold. Perpetual Inventory System is also known as an Automatic Inventory System. In this system balance of raw materials, work-in-progress, and finished goods is provided on a continuing basis. The Periodic Inventory System is less costly than the Perpetual Inventory System but it gives more accurate information.

 

FEW SUGGESTED BOOKS TO LEARN MORE ABOUT INVENTORY VALAUTION

 

  • Tulsian . P.C (2014) “Financial Accounting” Pearson Education India.
  • Lal, Jawahar  and  Seema  Srivastava  (2004)  “Financial  Accounting”  S.Chand(G/L) & Company Ltd.
  • Goyal, V.K. and Ruchi Goyal (2012) “Financial Accounting” PHI.
  • Maheshwari, S.N., Suneel K Maheshwari and Sharad K Maheshwari(2012) “Financial Accounting” Vikas Publishing House Pvt Ltd
  • Raiyani Jagadish R International Financial Reporting Standards (IFRS) & Indian Accounting Practices” New Century Publications.
  • Patel, Chintan N. and Bhupendra Mantri (2015) “Indian Accounting Standards (IND AS)” Taxmann.
  • Monga, J.R. “Avanced Financial Accounting” Mayoor Paperbacks.
  • Bhattacharyya Ashis K., (2012)” Essentials of Financial Accounting” PHI.

 

POINTS TO PONDER

 

  1. MEANING OF INVENTORY
  • In trading concern. it may mean stock of finished goods only.
  • In a manufacturing concern, it may include raw materials, work in process and stores, etc
  • Preparation of accurate income statement and balance sheet of a concern depends on correct valuation of its inventory.
  1. OBECTIVES OF INVENTORY VALUATION
  • Determination of profitability
  • Ascertainment of financial position
  1. SIGNIFICANCE OF INVENTORY VALUATION
  • Lifeblood of the concern
  • Impact on liquidity Position · Effect on Income Statements · Effect on balance sheet
  • Effect two years statements
  1. PERIODIC INVENTORY SYSTEM

 

This system requires a physical verification or count of all the inventory items on hand at specific times. Because of actual physical verification of stock the system is also called physical inventory system.

  1. BENEFITS OF PERIODIC INVENTORY SYSTEM
  • Ensure the accuracy of the accounts · Less expensive
  1. LIMITATIONS OF PERIODIC INVENTORY SYSTEM
  • Based on wrong assumption
  • Adversely affect normal business operations
  • Becomes expensive when income statements are required more frequently · Not provide the information on a continuous basis
  • No accounting is for shrinkage, losses, theft, and wastage

 

  1. BENEFITS OF PERPETUAL INVENTORY SYSTEM
  • Automatic Inventory System
  • Continuing basis
  • Provide information about stock at all times
  • Provides a rigid control
  • No Interruption in normal business operations
  • No need for stock taking by actual count
  • Suitable when volume of inventory items is large
  • Special staff may not be employed
  • Controlling losses
  • Check on irregularities or changes in procedures by storekeepers
  • No sudden „out of stock situation
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