INVENTORY VALUATION Dr.S.Kishore Assistant Professor Dept of MBA AITS-Tirupati

Inventory:- Arises out of: One of the largest assets of a firm, Time lag between purchase and sales, Processing time lag, One of the largest assets of a firm, Constitutes: finished goods, work-in-progress, raw materials; also consumables, loose tools, stores and spares, etc.

The significance of inventory valuation is as follows: Determination of Income, Determination of Financial Position, Analysis of Financial Statement, Compliance with rules and statutes.

These include all cost of purchase , cost of conversion and other cost incurred in bringing the inventories to their present location and condition. But it does not include: i) abnormal amount. ii) storage cost unless necessary in the production. iii) administrative overheads. iv) selling and distribution cost.

Periodic Inventory System Perpetual Inventory System

Periodic inventory is a system of inventory in which updates are made on a periodic basis. In a periodic inventory system no effort is made to keep up-to-date records of either the inventory or the cost of goods sold. Instead, these amounts are determined only periodically - usually at the end of each year. This physical count determines the amount of inventory appearing in the balance sheet. The cost of goods sold for the entire year then is determined by a short computation

The periodic inventory system only updates the ending inventory balance when you conduct a physical inventory count. Since physical inventory counts are time-consuming, few companies do them more than once a quarter or year. In the meantime, the inventory account in the accounting system continues to show the cost of the inventory that was recorded as of the last physical inventory count. Under the periodic inventory system, all purchases made between physical inventory counts are recorded in a purchases account. When a physical inventory count is done, you then shift the balance in the purchases account into the inventory account, which in turn is adjusted to match the cost of the ending inventory. The calculation of the cost of goods sold under the periodic inventory system is: Beginning inventory + Purchases = Cost of goods available for sale Cost of goods available for sale – Ending inventory = Cost of goods sold

The periodic inventory system is most useful for smaller businesses that maintain minimum amounts of inventory. For them, a physical inventory count is easy to complete, and they can estimate cost of goods sold figures for interim periods. However, there are several problems with the system: It does not yield any information about the cost of goods sold or ending inventory balances during interim periods when there has been no physical inventory count. You must estimate the cost of goods sold during interim periods, which will likely result in a significant adjustment to the actual cost of goods whenever you eventually complete a physical inventory count. There is no way to adjust for obsolete inventory or scrap losses during interim periods, so there tends to be a significant (and expensive) adjustment for these issues when a physical inventory count is eventually completed. It is not an adequate system for larger companies with large inventory investments, given its high level of inaccuracy at any given point in time (other than the day when the system is updated with the latest physical inventory count).

(1). When goods are purchased from supplier: Purchases To Accounts payable (2) When expenses are incurred to obtain goods for sale – freight-in, insurance etc: Freight-in Insurance To Cash/Bank When goods are returned to supplier: Accounts payable To Purchases returns When payment is made to supplier: Accounts payable To Cash/Bank

When goods are sold to customers: Accounts receivable To Sales When goods are returned by customers: Sales returns To Accounts receivable At the end of the period: Inventory (ending) Cost of goods sold (B.F) To Purchases To Inventory (beginning)

In perpetual inventory system, merchandise inventory and cost of goods sold are updated continuously on each sale and purchase transaction. Some other transactions may also require an update to inventory account for example, sale/purchase return, purchase discounts etc. Purchases are directly debited to inventory account whereas for each sale two journal entries are made: one to record sale value of inventory and other to record cost of goods sold. Purchases account is not used in perpetual inventory system.

Perpetual inventory system is costly to maintain but it has numerous advantages which are as follows It obviates the need for stock taking by actual counting at the end of financial period. There is no sudden ‘out of stock’ situation. It does not need special staff to be employed for stock taking. Controlling losses is easier under this method as inventory records continuosly indicate the goods that must be in hand.

For Perpetual Inventory System:

For Perpetual Inventory System For Periodic Inventory System BASIS Basis of Closing Inventory is ascertained by Closing Inventory is ascertained from accounting records. On continuous basis after each purchase and sale. Physical count can be compared with perpetual inventory record and thus inventory control is feasible. It will NOT affect the normal operations of the business if no physical count is made. It requires additional record keeping which is not worth in case of small concerns dealing in low cost items. ascertaining Inventory physical count. Availability of Information Generally at the end of the accounting period or at some other regular intervals. Inventory control Not feasible. Actual amount of closing inventory cannot be compared with book records. Effect on normal operations May affect normal operations of the business for sometime due to physical count. Simplicity and cost effectiveness It is simple and less costly.

SPECIFIC IDENTIFICATION OF COSTS FIRST-IN, FIRST-OUT LAST-IN,FIRST-OUT WEIGHTED AVERAGE METHOD

It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year end inventory. When this information is found, the amount of goods are multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost. In theory, this method is the best method, since it relates the ending inventory goods directly to the specific price they were bought for. However, this method allows management to easily manipulate ending inventory cost, since they can choose to report that the cheaper goods were sold first, hence increasing ending inventory cost and lowering cost of goods sold. This will increase the income. Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay. Using this method, it is very hard to relate shipping and storage costs to a specific inventory item. These numbers will need to be estimated, hence reducing the specific identification method's benefit of being extremely specific.

It is one of the methods commonly used to calculate the value of inventory on hand at the end of an accounting period and the cost of goods sold during the period. This method assumes that inventory purchased or manufactured first is sold first and newer inventory remains unsold. Thus cost of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending inventory. First-In, First-Out method can be applied in both the periodic inventory system and the perpetual inventory system.

Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows: January 1 Purchased 5 bikes @ ₹ 5000 each January 5 Sold 2 bikes January 10 Sold 1 bike January 15 Purchased 5 bikes @ ₹ 7000 each January 25 Sold 3 bikes

DATE PURCHASES UNITS - RATE - AMT SALES UNITS - RATE - AMT STOCK IN HAND UNITS - RATE - AMT JAN1 5 – 5000 - 25000 5 - 5000 - 25000 JAN 5 2 - 5000 - 10000 3 - 5000 - 15000 JAN 10 1 - 5000 - 5000 JAN 15 5 - 7000 35000 JAN 25 2 - 5000 - 10000 4 - 7000 - 28000 1 - 7000 - 7000 The value of 4 bikes held as inventory at the end of January may be calculated as follows: The sales made on January 5 and 10 were clearly made from purchases on 1st January. Of the sales made on January 25, it will be assumed that 2 bikes relate to purchases on January 1 whereas the remaining one bike has been issued from the purchases on 15th January.

This method assumes that inventory purchased last is sold first This method assumes that inventory purchased last is sold first. Therefore, inventory cost under LIFO method will be the cost of earliest purchases. Using the LIFO method to evaluate and manage inventory can be tax advantageous, but it may also increase tax liability.

Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows: January 1 Purchased 5 bikes @ ₹ 5000 each January 5 Sold 2 bikes January 10 Sold 1 bike January 15 Purchased 5 bikes @ ₹ 7000 each January 25 Sold 3 bikes

DATE PURCHASES UNITS - RATE - AMT SALES UNITS - RATE - AMT STOCK IN HAND UNITS - RATE - AMT JAN1 5 – 5000 - 25000 5 - 5000 JAN 5 2 - 5000 - 10000 3 - 5000 - 15000 JAN 10 1 - 5000 - 5000 2 - 5000 - 10000 JAN 15 JAN 25 5 - 7000 35000 3 - 7000 - 21000 2 - 5000 - 10000 2 - 7000 - 14000 The value of 4 bikes held as inventory at the end of January may be calculated as follows: The sales made on January 5 and 10 were clearly made from purchases on 1st January. However, all sales made on January 25 will be assumed to have been made from the purchases on January 15.

POINT OF DIFFERENCE FIFO LIFO Stands for: Unsold inventory: First in, first out Last in, first out Unsold inventory: Unsold inventory is comprised of goods acquired most recently. Unsold inventory is comprised of the earliest acquired goods. Restrictions: There are no GAAP or IFRS restrictions for using FIFO. IFRS does not allow using LIFO for accounting. Effect of Inflation: If costs are increasing, the items acquired first If costs are increasing, then were cheaper. This decreases the cost of goods sold (COGS) under FIFO and increases profit. The income tax is larger. Value of unsold inventory is also higher. recently acquired items are more expensive. This increases the cost of goods sold (COGS) under LIFO and decreases the net profit. The income tax is smaller. Value of unsold inventory is lower. Effect of Deflation: Converse to the inflation scenario, accounting Using LIFO for a deflationary period results profit (and therefore tax) is lower using FIFO in a deflationary period. Value of unsold inventory, is lower. in both accounting profit and value of unsold inventory being higher. Record keeping: Since oldest items are sold first, the number of records to be maintained decreases. Since newest items are sold first, the oldest items may remain in the inventory for many years. This increases the number of records to be maintained. Fluctuations: Only the newest items remain in the inventory and the cost is more recent. Hence, there is no unusual increase or decrease in cost of goods sold. Goods from number of years ago may remain in the inventory. Selling them may result in reporting unusual increase or decrease in cost of goods.

It is a method of calculating Ending Inventory cost. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.

Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows: January 1 Purchased 5 bikes @ ₹ 5000 each January 5 Sold 2 bikes January 10 Sold 1 bike January 15 Purchased 5 bikes @ ₹ 7000 each January 25 Sold 3 bikes

---------------------------- DATE PURCHASES UNITS - RATE - AMT SALES UNITS - RATE - AMT STOCK IN HAND UNITS - RATE - AMT JAN1 5 – 5000 - 25000 5 - 5000 - 25000 JAN 5 2 - 5000 - 10000 3 - 5000 - 15000 JAN 10 1 - 5000 - 5000 JAN 15 5 - 7000 35000 5 - 7000 35000 ---------------------------- 7 - 6428.5 - 45000 JAN 25 3 - 6428.5 - 19285.5 4 - 6428.5 - 25714.5