INVENTORY VALUATION
Meaning:
For Inventory valuation, cost may mean historical, current or
standard cost. Historical costs represents the cost actually incurred
at the time of acquisition. Current replacement cost represents the
replacement price on the date of its consumption. Standard cost
represents the predetermined cost that should be incurred at a given
level of efficiency and capacity utilization.
Inventory Systems:
Periodic Inventory System: It is a method of ascertaining
inventory by taking an actual physical count of all inventory items
on hand at a particular date on which information about inventory
is required. The cost of goods sold is calculated as a residual figure
(which includes lost goods also) as follows:
Cost of Goods sold= Opening inventory + Purchases Closing
stock
Perpetual Inventory System:
It is a method of recording inventory balances after each receipt
and issue in order to ensure accuracy of perpetual inventory
records, physical stocks should be checked and compared with
recorded balances. The discrepancies should be investigated and
adjusted properly in accounts.
The closing inventory is calculated as a residual figure (which
includes lost goods also) as follows:
Closing Inventory = Opening Inventory + Purchases cost of
goods sold
Methods of Valuation of inventories:
The various methods for assigning the cost between sold and
unsold goods include the following:
1. First in first Out (FIFO) Method
2.Average cost Method
3.Last In First Out (LIFO) method
4.Base stock method
5.Specific Identification Method
6.Standard cost
7.Adjusted Selling Price
8. Latest Purchase Price
9.Next In First Out Method ( NIFO) Method
10. Highest In first Out (HIFO) Method
As per Revised Accounting standard 2 issued by the ICAI
i) 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 fifth (SIM)method.
ii) The cost of inventories other than those for which specific
identification of individual cost is appropriate should be assigned
by using FIFO or Weighted Average Cost Method. The formula
should reflect the fairest possible approximation to the cost
incurred in bringing the items of inventory to their present location
and condition.
FIFO Method:
FIFO method is based on the assumption that the goods which are
received first are issued first. This assumption is made for the
purpose of assigning cost and not for physical flow of goods. The
goods sold, therefore ,consists of the earliest lots and are valued at
the price paid for such lots. The ending inventory consists of the
latest lots and is valued at the price paid for such lots. The ending
inventory is stated in the Balance Sheet at a value nearer the
current market price.
LIFO Method:
It is based on the assumption that the goods which are received last
are issued first. This assumption is made for the purpose of
ascertaining cost and not for the purpose of physical flow of goods.
Therefore the goods sold consists of the latest lots and are valued
at the price paid for such lots. The ending inventory consists of the
earliest lots and is valued at the price paid for such lots. The ending
inventory is understated in the Balance Sheet at old cost.
Basis of Distinction FIFO
1.Basic Assumption Goods received first
are issued first
LIFO
Goods received last
are issued first
2.Cost of Goods
sold
Cost of goods sold
represents cost of
recent purchases
B/S is distorted
because ending
inventory is
understated at old
cost
Ending Inventory
represents cost of
earlier purchases
Lower income is
reported
3.Distortion in
Balance sheet
Cost of goods sold
represents cost of
earlier purchases
B/S shows the
ending inventory at a
value nearer the
current market price
4.Ending Inventory Ending Inventory
represents cost of
recent purchases
5. In case of Rising Higher income is
Prices
reported
Illustration:
Date
Inventory No. of
units
1 Jan.
Purchase 500
5 Jan.
Purchase 1000
10 Jan.
Purchase 2000
15 Jan.
Purchase 1000
20 Jan.
Purchase 3000
25 Jan.
Purchase 2000
Total
9500
Inventory
11 Jan.
Sales
14 Jan.
Sales
16 Jan.
Sales
21 Jan.
Sales
30 Jan.
Sales
TOTAL
Cost per
unit(Rs.)
3
4
5
6
4
7
Amt(Rs.)
1500
4000
10000
6000
12000
14000
47500
Units
1000
500
1000
2000
1500
6000
Cost of goods sold & Inventory under FIFO
Date
11 Jan.
Quantity
sold
1000
14 Jan.
16 Jan
21 Jan.
500
1000
2000
30 Jan.
1500
Total
6000
Sales
Inventory 3500
Quantity
break up
500
500
500
1000
1000
1000
1500
Rate
Amt
X3
X4
X4
X5
X5
X6
X4
1500
2000
2000
5000
5000
6000
6000
1500
2000
X4
X7
6000
14000
Total
Amt(Rs.)
3500
2000
5000
11000
6000
27500
20000
Total
9500
47500
Thus, cost of goods sold under FIFO=27,500
Inventory under FIFO
=20,000
47500
Cost of goods sold & Inventory under LIFO
Date
Quantity
break up
1000
Rate
Amt
11 Jan.
Quantity
sold
1000
X5
5000
Total
Amt(Rs.)
5000
14 Jan.
16 Jan
21 Jan.
500
1000
2000
500
1000
2000
X5
X6
X4
2500
6000
8000
2500
6000
8000
30 Jan.
1500
Total
6000
Sales
Inventory 3500
1500
X7
10500
10500
32000
500
1000
500
1000
500
X3
X4
X5
X4
x7
1500
4000
2500
4000
3500
Total
9500
Thus, cost of goods sold under LIFO=32,000
Inventory under LIFO
=15,500
47500
15500
47500
Weighted Average Price method:
The Weighted Average Price method is based on the assumption
that each issue of goods consists of a due proportion of the earlier
lots and is valued at the weighted average price. Weighted Average
Price is calculated by dividing the total cost of goods in stock by
the total quantity of goods in stock. This weighted average price is
used for pricing all the issues until a new lot is received then a new
weighted average price is calculated.
Matching Concept
Meaning:
Matching is the entire process of periodic earnings measurement,
often described as a process of matching expenses with revenues.
In a narrow sense, this means deducting from the revenues of a
period the cost of goods sold or other expenses that can be
identified with such revenues of that period on the basis of cause
and effect.
To ascertain the amt of profit or loss made or suffered during a
particular period proper matching of revenue is required to be done
with the expenses.
It will be appropriate here to understand the meaning of following
terms:
Revenue: Income of recurring nature from any source. Source may
be sale of goods, performance of service for a customer, the rental
for a property etc.
Expense: The term expense denotes the cost of services and things
used for generating revenue
Expenditure : The term expenditure means payment or the
incurring of a debt for an asset or an expense. If an asset is
acquired or an expense is incurred or an expenditure is said to have
been made whether or not the cash is paid immediately.
Thus, every expense is an expenditure, while each expenditure
is not necessarily an expense. For Example, Salaries paid to the
employees of a firm are both an expenditure as well as an expense,
but amount spent for acquisition of fixed assets for a business is an
expenditure but not an expense.
So, while calculating the income or the profit of a business, for a
particular period, the revenue earned during the period is to be
matched with expense incurred in earning that revenue.
Period of recognition: an expense will be recognized as an
expense incurred for earning revenue during a particular period in
each of the following cases:
a) If the expense can be directly identified or associated with
the revenue of the period. For example, when sale of goods is
treated as revenue for a particular period, the cost incurred
for manufacturing of such goods such as those of raw
materials ,wages and other direct charges will be recognized
as an expenditure for earning that revenue.
b) If the expense can be indirectly identified or associated with
the revenue of the period. For example, salary of the
manager, rent, insurance etc. incurred during a particular
period can be charged against the revenue earned during that
period. However, if some part of these indirect costs relates
to the future revenue, such portion of the indirect cost will be
deferred and shown in the Balance sheet as an asset. The
remaining portion of these costs will be matched against the
revenue of the current year.
c) Losses which have no potential for producing the revenue
in future will not be deferred but will be recognized as the
expense of the period in which they have occurred. For
example, damage to property on account of earthquake, loss of
plant ,machinery etc. due to fire or any other reason should not
be carried forward. They should rather be met out of revenue of
the year in which they have occurred.
Determination of Amount of Expense:
Two approaches for regarding determination of amount of
expense to be matched with revenue for measurement of
business income
a)Traditional Approach: The Actual cost incurred for the expense
to be matched with revenue for determination of Business Income.
b) Replacement approach: As per this approach, while comparing
expense with the revenue, the replacement cost should be
considered in place of original cost.
For Example, Cost of goods purchased last year Rs.20 per kg
Sold during current year @ Rs.30 per kg.
And the current market price for purchasing the goods is Rs.25
per kg,
Profit as per traditional approach is Rs. 10/-
Replacement Approach:
Sales
Rs.30
Less: Replacement cost of goods sold Rs.25
Rs.5
Add: Profit realized from market
fluctuations and price level changes Rs.5
Total Profit
Rs.10
In both the cases profit is Rs. 10 but, replacement cost approach
gives a better analysis of profit earned by a business.
So, Replacement cost approach is preferred to Traditional
Approach
