Inventory

Inventory Valuation

Raw materials

Work-in-progress

Finished goods

Other items

Matching inventory cost with revenuesMatching principle requires matching expenses with

revenues earned in an accounting period

Matching the resulting cost of goods sold with the revenues for the period

Matching inventory cost with revenuesOpening stock 100 units at Rs.10 each Rs. 1,000

Purchases made during the year

9,400 units at Rs.10 each Rs.94,000

Rs.95,000

Matching inventory cost with revenuesOpening stock 100 units at Rs.10 each Rs. 1,000

Purchases made during the year

9,400 units at Rs.10 each Rs.94,000

Cost of goods available for sale Rs.95,000

9,000 units are sold at Rs.20 each

Units available for sale 9,500

Units sold 9,000

Ending inventory 500

Matching inventory cost with revenuesOpening stock 100 units at Rs.10 each Rs. 1,000Purchases made during the year9,400 units at Rs.10 each Rs.94,000Cost of goods available for sale Rs.95,0009,000 units are sold at Rs.20 eachUnits available for sale 9,500Units sold 9,000Ending inventory 500Cost of goods available for sale Rs.95,000Less: Value of ending inventory 5,000

Rs.90,000

Matching inventory cost with revenuesOpening stock 100 units at Rs.10 each Rs. 1,000Purchases made during the year9,400 units at Rs.10 each Rs.94,000Cost of goods available for sale Rs.95,0009,000 units are sold at Rs.20 eachUnits available for sale 9,500Units sold 9,000Ending inventory 500Cost of goods available for sale Rs.95,000Less: Value of ending inventory 5,000Cost of goods sold Rs.90,000

Matching inventory cost with revenuesRevenue of goods sold (9,000) Rs.1,80,000

Less: Cost of goods sold (9,000) 90,000

Gross Profit Rs. 90,000

Effect of inventory errorIncorrect ending Inventory

An enterprise overstates its 2008 inventory by Rs.1,000

2008 2009Net Sales 10,000 15,000COGS:Beginning InventoryAdd: PurchasesCost of Goods Available for SalesLess: Ending InventoryCost of Goods Sold

2,0008,500

10,5002,5008,000

2,5009,500

12,0001,000

11,000Gross ProfitLess: Operating Expenses

2,000400

4,000500

Net Profit 1,600 3,500

Effect of inventory errorCorrect ending Inventory

2008 2009Net Sales 10,000 15,000COGS:Beginning InventoryAdd: PurchasesCost of Goods Available for SalesLess: Ending InventoryCost of Goods Sold

2,0008,500

10,5001,5009,000

1,5009,500

11,0001,000

10,000Gross ProfitLess: Operating Expenses

1,000400

5,000500

Net Profit 600 4,500

The self-reversing nature of misreporting inventory is a safeguard against managerial opportunism.

A manager who overvalues the ending inventory can report higher profit for that year.

Unfortunately for him, this will reverse in the following year bringing down the firm’s profit, and his reputation. Thus, his game will be up soon.

Managers who have a horizons beyond the current period should stay away from such a practice.

But the temptation is often irresistible, when faced with tough quarterly earnings targets.

A manager may buy time by fiddling with inventory value. The certain reversal of the increase in profit means that the problem will come back soon.

So he will have to play this game again in the next period, and again for ever.

If you do not want to go down a slippery slope, do not take the first step on the slope. If you do, accounting fraud will no longer be a matter of choice; it will become a compulsion. Stay away from it.

Significant unexplained variation from year to year in inventory value relative to the size of the firm’s operations should worry shareholders, tax authorities and others.

Determining physical inventoryPeriodic inventory system

Perpetual inventory system

Determining physical inventoryGoods in transit

FOB shipping point

FOB destination

Bina bought merchandise from Salil, FOB shipping point, on March 27. Salil shipped goods on March 30, but goods reached to Bina on April 2. March 31 is the year-end for both Bina and Salil.

Determining physical inventoryGoods on Consignment

Even though physical possession of the goods is with the consignee, title of the goods remains with the consignor. Goods out on consignment are therefore part of the consignor’s inventory

Goods transferred to a dealer or distributor for resale as an agent for the owner of the goods, are similar to goods on consignment

Materials belonging to a firm issued to an outside agency to carry out manufacturing process

Pricing the inventoryValue placed on ending inventory may have a dramatic

effect on reported net profit

Users of financial statement show keen interest in the method of pricing inventory

Accountant is faced with conflicting objectives for inventory valuation, like proper income determination, minimizing income tax payable

Conservatism principle and LCM ruleLCM rule can be applied to each item of inventory or to

group of similar items.

Cost MV

Group IItem AItem BItem CItem D

Rs.1,4001,9704,6506,380

Rs.1,3401,9903,7207,040

14,400 14,090

Group IIItem WItem XItem YItem Z

Rs.4,9202,5203,1105,790

Rs.5,2302,6102,9306,140

16,340 16,910

Conservatism principle and LCM ruleCost MV Item-by-

item


Rs.1,4001,9704,6506,380

Rs.1,3401,9903,7207,040

Rs.1,3401,9703,7206,380

14,400 14,090 13,410


Rs.4,9202,5203,1105,790

Rs.5,2302,6102,9306,140

Rs.4,9202,5202,9305,790

16,340 16,910 16,160

Rs.29,570

Conservatism principle and LCM ruleCost MV Group of

similar items


Rs.1,4001,9704,6506,380

Rs.1,3401,9903,7207,040

14,400 14,090 Rs.14,090


Rs.4,9202,5203,1105,790

Rs.5,2302,6102,9306,140

16,340 16,910 Rs.16,340

Rs.30,430

Conservatism principle and LCM ruleCost MV Item-by-

itemGroup of similar items


Rs.1,4001,9704,6506,380

Rs.1,3401,9903,7207,040

Rs.1,3401,9703,7206,380

14,400 14,090 13,410 Rs.14,090


Rs.4,9202,5203,1105,790

Rs.5,2302,6102,9306,140

Rs.4,9202,5202,9305,790

16,340 16,910 16,160 Rs.16,340

Rs.29,570 Rs.30,430

Inventory costing methodsFirst-in, First Out (FIFO)

Last-in, First Out (LIFO)

Weighted Average Cost (WAC)

Specific Identification Method

Units Unit Cost (Rs.)

Total Cost (Rs.)

Jan. 1 Beginning InventoryMar. 27 PurchaseJune 12 PurchaseSept. 19 PurchaseNov. 30 Purchase

100100100100100

23456

200300400500600

Available for sale 500 2,000

Sold 350 10

Dec. 31 Ending inventory 150

April 15 SoldAug. 8 SoldDec. 18 Sold

15075

125

Date Purchase Sale Balance

Qty. Rate Value Qty. Rate COGS Qty. Rate Value

Jan 1 100 2 200

Mar 27

100 3 300 100100

23

200300

Apr 15 10050

23

200150

50 3 150

June 12

100 4 400 50100

34

150400

Aug 8 5025

34

150100

75 4 300

Sep 19 100 5 500 75100

45

300500

Nov 30 100 6 600 75100100

456

300500600

Dec 18 7550

45

300250

50100

56

250600

350 1,150



Jan 1 100 2 200

Mar 27 100 3 300 100100

23

200300

Apr 15 10050

32

300100

50 2 100

June 12 100 4 400 50100

24

100400

Aug 8 75 4 300 5025

24

100100

Sep 19 100 5 500 5025

100

245

100100500

Nov 30 100 6 600 5025

100100

2456

100100500600

Dec 18 10025

65

600125

502575

245

100100375

350 1,425



Jan 1 100 2 200

Mar 27

100 3 300 200 2.5 500

Apr 15 150 2.5 375 50 2.5 125

June 12

100 4 400 150 3.5 525

Aug 8 75 3.5 263 75 3.5 262

Sep 19 100 5 500 175 4.35 762

Nov 30 100 6 600 275 4.95 1,362

Dec 18 125 4.95 619 150 4.95 743

350 1,257

Effect of inventory method on profitFIFO WAC LIFO

Sales (selling price Rs.10) Rs.3,500 Rs.3,500 Rs.3,500

Cost of Goods Sold: Beginning Inventory Add: Purchases Cost of Goods Available for Sale Less: Ending Inventory

2001,8002,000

850

2001,8002,000

743

2001,8002,000

575

Cost of Goods Sold 1,150 1,257 1,425

Gross Profit 2,650 2,243 2,075

Effect of inventory method on cost of ending inventory, cost of goods sold and profit

Trends → Rising Prices Constant Decreasing Prices

Ending Inventory FIFO> WAC>LIFO FIFO=LIFO=WAC FIFO<WAC<LIFO

Cost of Goods Sold FIFO<WAC<LIFO FIFO=LIFO=WAC FIFO>WAC>LIFO

Gross Profit FIFO>WAC>LIFO FIFO=LIFO=WAC FIFO<WAC<LIFO



Total Cost (Rs.)


100100100100100

23456

200300400500600


Sold 350 10


Assume that the December 31 inventory consisted of 60 units from March 27 purchase, 70 units from June 12 purchase and 20 units from the September 19 purchase


Value of ending inventory:

60 units * Rs.3 Rs.180

70 units * Rs.4 280

20 units * Rs.5 120

Rs.560


Less: Ending inventory 560

Cost of goods sold Rs.1,440

Periodic Inventory System


Total Cost (Rs.)


100100100100100

23456

200300400500600


Sold 350 10


April 15 SoldAug. 8 SoldDec. 18 Sold

15075

125

Periodic Inventory SystemFIFO


100 units * Rs.6 Rs.600

50 units * Rs.5 250

Rs.850




Periodic Inventory SystemLIFO


100 units * Rs.2 Rs.200

50 units * Rs.3 150

Rs.350




Periodic Inventory SystemWAC


Number of units available for sale 500

Weighted average unit cost Rs.4

Value of ending inventory: 150 units * Rs.4 = Rs.600

Cost of goods sold: 350 units * Rs.4 = Rs.1,400

Consistency principleFinancial statements should disclose inventory method

Consistency principle requires that an enterprise apply the same accounting method from one accounting period to the next

Profits reported in different accounting period would not be comparable

Frequent accounting changes would destroy credibility of the financial statements

In the event of an accounting change, the effect of the change upon reported profit and the reasons for the change should be disclosed in the footnotes

Chemplast manufactures a variety of chemicals and plastics. The following news report about the company illustrates the effect of change in the inventory valuation method:

Chemplast has registered a turnover of Rs.3,680 million for the year 99-00, a decrease of 2.9% over last year’s figure of Rs.3,796 million. Net Profit for 99-00was Rs.302 million up 6.2% over last year’s figure of Rs.284 million The company has changed inventory valuation to comply with AS 2, and this change coupled with some other items has resulted in an extraordinary income of Rs.44.7 million.

Estimating Inventory ValueIn periodic inventory system physical inventory must be

taken to determine ending inventory value

Physical inventory is taken at the end of accounting period

Occasions when physical inventory cannot be taken, such as when inventory has been destroyed by fire

For such cases estimates are needed for insurance claims

Retail inventory method

Gross profit method

Retail Inventory MethodWidely used by large merchandising firms, departmental

stores

Carry a large number of different items that are marked with selling prices

Necessary to maintain records of beginning inventory and purchases made during the period, both, at cost and at retail

At retail means sticker prices of the inventory items

Retail Inventory MethodCompute amount of goods available for sale, both, at cost

and at retail

Obtain ratio of cost to retail

Deduct sales from goods available for sale at retail to determine ending inventory at retail

Multiply ending inventory at retail by ratio of cost to retail to convert into inventory at cost

Retail Inventory Methodat cost (Rs.) at retail (Rs.)

Beginning inventory 2,500 3,000

Net purchases 11,500 14,500

Goods available for sale 14,000 17,500

Cost to Retail (14,000 / 17,500) * 100 = 80%

Goods available for sale at retail 17,500

Less: Net Sales 13,000

Estimated ending inventory at retail 4,500

Estimated ending inventory at cost

4,500 * 80% = Rs.3,600

Retail Inventory MethodRetail inv method assumes that- ending inv consists of same mix of goods as contained in

the goods available for sale- selling prices of merchandise originally established do

not change

Despite these, retail inv method is considered satisfactory

The following information was available from the records of Joseph Company:

At cost At retail

Beginning inventory Rs.700 Rs.900Purchases 3,400 5,300Purchase returns and allowances 100 200Sales 4,700Sales returns and allowances 500Estimate company’s ending inventory at cost using the

retail inventory method. Suppose during the year the physical year-end inventory at retail was Rs.1,620. What is the estimated cost of the inventory lost through shoplifting and other causes?

Gross Profit MethodBased on the assumption that % of gross profit to sales

remains approximately the same from one period to another

Not normally acceptable for annual financial reporting purposes, as it provides only an estimate

May be used for preparing interim reports

Gross Profit MethodCompute cost of goods available for sale

Estimate cost of goods sold by deducting gross profit from sales

Deduct estimated COGS from cost of goods available for sale to arrive at the estimated ending inventory

Gross Profit MethodRs.

Beginning inventory 300

Net purchases 2,100

Cost of goods available for sale 2,400

Less: Estimated cost of goods sold

Nest sales 3,000

less: estimated gross 750

profit, 25% (assumed)

2,250

Estimated cost of ending inventory 150

Mohan Rao’s video store was totally destroyed in a fire on November 4. The following information for the period July 1 to November 3 was available:

Merchandising inventory at cost, July 1 Rs.1,200

Purchases 12,300

Purchases returns and allowances 700

Freight in 1,200

Sales 25,300

Sales returns and allowances 1,300

Estimate the inventory loss assuming that Mohan Rao’s pricing policy was to earn a gross margin of 60% on selling prices.

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