This comprehensive guide on Inventories covers the meaning, types, and importance of proper inventory valuation, emphasizing its impact on income determination, financial position, and statutory compliance. It explains key valuation principles like “lower of cost or net realizable value” and details the components and exclusions from inventory cost. The notes explore inventory record systems — Periodic and Perpetual — and valuation methods including Specific Identification, FIFO, LIFO (not permitted now), Simple Average, Weighted Average, and non-historical cost methods like Adjusted Selling Price and Standard Cost.
It also highlights inventory-taking procedures, special adjustments for goods on approval or consignment, and provides illustrative examples for clarity, making it an ideal, exam-focused revision tool.
INVENTORIES – Revision Notes by AUBSP
1. MEANING OF INVENTORIES
- Inventory = Assets held:
- For sale in the normal course of business
- In production for sale
- For consumption in production
- Types:
- Trading Concern: Goods purchased for resale + supplies (e.g., cartons, stationery)
- Manufacturing Concern:
- Raw Materials
- Work-in-Progress (WIP)
- Finished Goods
- Stores, spares, consumables
- Exclusion: Machinery spares for irregular use = Fixed Assets.
2. INVENTORY VALUATION – Importance
Income Determination:
- COGS=Opening Inventory + Purchases + Direct Expenses − Closing Inventory
- ➔ Misstatement affects net profit.
Financial Position:
- Inventory = Current Asset
- Incorrect valuation misstates financials.
Liquidity Analysis:
- Affects Current Ratio and working capital.
Statutory Compliance:
- Required under Schedule III of Companies Act, 2013.
- AS mandates disclosure of:
- Policies used
- Carrying amounts (Raw Material, WIP, Finished Goods, etc.)
3. BASIS OF INVENTORY VALUATION
Principle: Lower of Cost or Net Realizable Value (NRV) → Conservatism Concept.
Components of Cost:
| Element | Details |
|---|---|
| Purchase Cost | Invoice price + Taxes (except recoverable) + Freight |
| Conversion Cost | Direct labor + Overheads (allocated) |
| Other Costs | Bringing inventory to current location and condition |
Excluded from Cost:
- Abnormal wastages
- Storage (except production-related)
- Admin overheads not contributing to inventory
- Selling and distribution expenses
4. INVENTORY RECORD SYSTEMS
| Aspect | Periodic System | Perpetual System |
|---|---|---|
| Basis | Physical count | Continuous record |
| Inventory Control | No | Yes |
| Suitability | Small businesses | Medium/Large enterprises |
| Cost | Low | High |
| Operational Disruption | Yes (closure needed) | No |
5. METHODS TO DETERMINE COST OF INVENTORY
5.1 Historical Cost Methods:
| Method | Key Points |
|---|---|
| Specific Identification | For high-value, non-interchangeable items (e.g., medical equipment). |
| FIFO (First In, First Out) | Oldest stock issued first; ending inventory = latest purchases. |
| LIFO (Last In, First Out) | Latest stock issued first; ending inventory = oldest purchases. (Not permitted by AS) |
| Simple Average | Average of prices without considering quantities. |
| Weighted Average | Cost weighted by quantity purchased. More logical than simple average. |
5.2 Non-Historical Cost Methods:
| Method | Description |
|---|---|
| Adjusted Selling Price (Retail Method) | Sales value minus gross margin. Used in retail with rapidly changing items. |
| Standard Cost | Fixed cost based on historical data, used when frequent price changes (e.g., crude oil). |
6. INVENTORY TAKING
- Physical stock-taking is usually done:
- On the year-end date or
- Few days before/after year-end (with adjustments).
- Adjustments required for sales, purchases between inventory taking date and year-end.
Special Situations:
| Situation | Treatment |
|---|---|
| Sale on Approval | Goods not yet approved = Remain in inventory |
| Consignment Goods | Goods with consignee = Remain in inventory |
7. KEY FORMULAS
Cost of Goods Sold:
- COGS=Opening Stock + Purchases + Direct Expenses − Closing Stock
Weighted Average Price:
- Weighted Avg. Price= Total Cost of Goods Available for Sale ÷ Total Units Available for Sale
Gross Profit Margin:
- GP Margin = Gross Profit ÷ Sales × 100
8. ILLUSTRATIONS OVERVIEW
- Specific Identification Example: Choose lower of cost/NRV item-wise.
- FIFO Illustration: Closing inventory = latest batch prices.
- LIFO Illustration: Closing inventory = oldest batch prices (No longer acceptable).
- Simple vs Weighted Average: Weighted considers quantity; more accurate.
- Retail Method: Calculate cost from sales using gross margin %.
9. QUICK TIPS FOR EXAM
| Concept | Tip |
|---|---|
| FIFO under Inflation | Closing stock value ↑ and Net Income ↑ |
| LIFO under Inflation | Closing stock value ↓ and Net Income ↓ |
| Periodic vs Perpetual | Perpetual = real-time control; Periodic = physical count |
| Lower of Cost or NRV | Always apply item-by-item unless impractical |
| Sale or Return Basis | If approval pending ➔ Include in inventory |
SUMMARY SHEET
- Inventory = Current Asset.
- Valuation = Lower of Cost or NRV.
- Inventory Methods: Specific Identification, FIFO, LIFO (not allowed), Simple Avg, Weighted Avg, Retail Price.
- Record Systems: Periodic vs Perpetual.
- Exam Focus: Illustrations on inventory adjustments, valuation under different methods, theoretical differences.
FAQs on Inventory
1. What is inventory in accounting?
Inventory refers to assets held for sale, in production for sale, or for consumption during the production process.
2. What are the types of inventory in a manufacturing business?
Raw materials, work-in-progress, finished goods, stores, spares, and packing materials.
3. What types of inventory exist for trading concerns?
Traded goods and supplies such as wrapping paper, cartons, and stationery.
4. Why is proper inventory valuation important?
It affects the determination of income, financial position, liquidity analysis, and statutory compliance.
5. What is the formula for Cost of Goods Sold (COGS)?
COGS = Opening Inventory + Purchases + Direct Expenses – Closing Inventory.
6. What principle governs inventory valuation?
The Principle of Conservatism: inventory is valued at lower of cost or net realizable value (NRV).
7. What costs are included in inventory valuation?
Cost of purchase, cost of conversion, and other costs incurred to bring inventories to their present location and condition.
8. What expenses are excluded from inventory cost?
Abnormal wastages, unrelated storage costs, admin overheads not linked to production, and selling & distribution expenses.
9. What is Net Realizable Value (NRV)?
The estimated selling price in the ordinary course of business minus costs of completion and costs necessary to make the sale.
10. What are the two main inventory record systems?
Periodic Inventory System and Perpetual Inventory System.
11. What is the Periodic Inventory System?
Inventory is counted physically at period-end; no continuous records of inventory flow are maintained.
12. What is the Perpetual Inventory System?
Continuous real-time tracking of inventory after each purchase or issue, maintained through inventory ledgers.
13. Which businesses typically use the periodic system?
Small enterprises with manageable inventories.
14. Which businesses prefer the perpetual system?
Medium to large enterprises where real-time inventory control is crucial.
15. What is Specific Identification Method?
Assigning specific costs to individually identifiable inventory items; used when goods are non-interchangeable and high-value.
16. What is the FIFO method?
First-In, First-Out assumes that goods purchased first are sold first; ending inventory consists of latest purchases.
17. What is the LIFO method?
Last-In, First-Out assumes that goods purchased last are sold first; ending inventory comprises earliest purchases. (Not permitted by AS.)
18. What is the Simple Average Price Method?
Average of all purchase prices without considering quantities, used often in periodic systems.
19. What is the Weighted Average Price Method?
Weighted average is calculated by dividing total cost by total units, giving more accurate valuation.
20. What is the Adjusted Selling Price Method?
Retail method where cost is derived by reducing gross profit margin from sales price.
21. What is the Standard Cost Method?
Inventory is valued using a standard, predetermined cost, typically used in industries with fluctuating raw material prices.
22. How is inventory handled when physical counting isn’t possible on year-end?
Adjustments for purchases, sales, and returns between the counting date and year-end are made to arrive at correct inventory.
23. How are goods sent on approval treated in inventory?
They are included in the inventory until the customer formally approves the goods.
24. How are goods on consignment treated?
Consigned goods are included in the consignor’s inventory until sold by the consignee.
25. How is abnormal loss of goods handled?
Abnormal losses are not included in inventory cost; they are charged separately to the profit and loss account.
26. What happens if closing inventory is overstated?
Net income will also be overstated.
27. What happens if opening inventory is overstated?
Net income will be understated.
28. What is the impact of poor inventory management?
It affects liquidity, profitability, financial position, and may lead to business failure.
29. Is GST included in inventory cost?
No, if input tax credit is available, GST is not included in the inventory cost.
30. Under what conditions can borrowing costs be included in inventory valuation?
When production requires a substantial time, like wine, rice, or timber production.
31. Why is LIFO method not accepted now?
Because it contradicts the usual flow of inventory and accounting standards disallow its use for financial reporting.
32. Under inflation, which method gives the highest closing inventory value?
FIFO gives the highest inventory value under inflationary conditions.
33. What principle supports valuing inventory at cost or NRV, whichever is lower?
The Principle of Conservatism.
34. How are by-products treated in inventory valuation?
They are valued at NRV if their separate cost cannot be determined.
35. How often should physical inventory verification happen under perpetual system?
Regularly through surprise checks to validate book records.
36. How often should physical inventory verification happen under periodic system?
At the end of each accounting period, typically annually.
37. Is closing stock an asset or a liability?
Closing stock is a Current Asset shown on the asset side of the balance sheet.
38. What disclosures are required under Schedule III regarding inventory?
Classification of inventory and the cost formulas used must be disclosed in financial statements.
Leave a Reply
You must be logged in to post a comment.