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
Group IItem AItem BItem CItem D
Rs.1,4001,9704,6506,380
Rs.1,3401,9903,7207,040
Rs.1,3401,9703,7206,380
14,400 14,090 13,410
Group IIItem WItem XItem YItem Z
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
Group IItem AItem BItem CItem D
Rs.1,4001,9704,6506,380
Rs.1,3401,9903,7207,040
14,400 14,090 Rs.14,090
Group IIItem WItem XItem YItem Z
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
Group IItem AItem BItem CItem D
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
Group IIItem WItem XItem YItem Z
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
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
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
Date Purchase Sale Balance
Qty. Rate Value Qty. Rate COGS Qty. Rate Value
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
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
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
Specific Identification Method
Value of ending inventory:
60 units * Rs.3 Rs.180
70 units * Rs.4 280
20 units * Rs.5 120
Rs.560
Cost of goods available for sale Rs.2,000
Less: Ending inventory 560
Cost of goods sold Rs.1,440
Periodic Inventory System
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
Periodic Inventory SystemFIFO
Value of ending inventory:
100 units * Rs.6 Rs.600
50 units * Rs.5 250
Rs.850
Cost of goods available for sale Rs.2,000
Less: Ending inventory 850
Cost of goods sold Rs.1,150
Periodic Inventory SystemLIFO
Value of ending inventory:
100 units * Rs.2 Rs.200
50 units * Rs.3 150
Rs.350
Cost of goods available for sale Rs.2,000
Less: Ending inventory 350
Cost of goods sold Rs.1,650
Periodic Inventory SystemWAC
Cost of goods available for sale Rs.2,000
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.