INVENTORY VALUATION

— INVENTORY VALUATION

    Inventories generally form one of the largest items in current assets of the companies.

    Inventory valuation is crucial to income measurement and inventory management is crucial to financial management.

    Meaning

    Inventories are assets

      a) held for sale in the ordinary course of business

      b) in the process of production or manufacture

      c) in the form of materials and supplies to be consumed in such         process of such production or manufacture.

    Hence inventories refer to :

    Finished goods inventory

    Work in process inventory

    Raw materials , stores and supplies

   

   

    Inventory valuation and matching principle

    According to Matching principle, the expenses during an accounting period should match the income earned during the accounting period.

    Since goods are continuously bought and sold, the amount of inventories that should be carried forward to the next accounting period should be determined so that the current years revenue is matched with the current years cost of goods sold.

    Cost of Goods sold = Opening stock + Purchases – Closing stock

    Effect of errors in valuation of inventories.

    If there is an error in valuation of inventory it will affect not only the current years profits but also the next years profit because the  closing stock of current year is the opening stock of next year.

    Valuation of inventories

    As per generally accepted accounting principles, inventories should be valued at cost. Cost refers to cost of acquisition plus cost of conversion.

    Raw materials, Stores, spare parts, consumables etc

    = cost of acquisition i.e purchase costs including duties and taxes, freight and other expenses directly related to such purchases. Similarly any discounts , rebates on such purchases should be reduced.

    Finished goods in case of manufacturing concern =

    cost of raw materials plus cost of conversion of raw materials into finished goods . It consists of direct expenses like labour costs as well as indirect manufacturing costs like power. Water , fuel, factory rent , factory insurance etc directly attributable to production / manufacturing. Indirect expenses like salaries, office expenses etc. are not included since they are period costs.

    Work in process =

    WIP is valued at cost as above depending upon the stage of completion of labour  and overheads which is determined by the production department.

   

    Costing methods : Even though inventories are to be valued at cost , the cost also keeps on changing during the year. It may not be always possible or feasible to link the cots of purchase with the closing stock of goods on hand.The commonly used methods for valuation of inventory at cost are :

    FIFO ( First In First Out ) : Here it is assumed that the stock received first is consumed/sold first. Hence the stock at hand at the end of the year is from the latest purchase.

    In case of rising prices, this may lead to overvaluation of stocks and overstatement of profits and in case of falling prices this method leads to understatement of stock and profits.

    LIFO ( Last In First Out ) : Here it is assumed that last units purchased are consumed /sold first .Hence the stock at hand at the end of the year is from the earliest purchases.

   

    In case of falling prices, this may lead to overstatement of stock and profit and in case of rising prices this method leads to understatement of stock and profits.

  Weighted Average Cost (WAC)  : here the average cost is applied i.e after every purchase an average cost is computed from the cost of purchases and the cost of stock. This method tries to even out the effects of price fluctuations.

  Specific Identification method : This method determines specific costs for each unit in stock. This method is suitable when the stock is not homogenous, less in quantity and high in value.

 

  Which is the Best method for inventory valuation ???

   Inventory valuation affects the profit and loss account as well as the balance Sheet

  

   FIFO – more realistic inventory value but unrealistic profit

   LIFO -  more realistic profit but outdated inventory value

   WAC -  the average of the two

   Accounting Standard does not allow the use of LIFO. Under Income Tax law any method may be adopted  but it should be followed consistently.

    Cost or Net Realisable value whichever is lower :

    Though generally the inventories are valued at cost, sometimes it may be prudent to value it below cost. When the inventory has suffered a reduction in value due to

ü  damage ,

ü  deterioration,

ü  reduction in selling prices,

ü  obsolescence

then such loss is recognised by valuing inventory at the lower of cost or net realisable value. Such method may be applied to all items of inventory or similar group of items.

   

   

  Principle of consistency and inventory valuation :

  If the method of inventory valuation is changed from year to year , the results for two periods becomes incomparable. It will affect the true and fair view of the financial statements. However if a change in method is necessary for better presentation of financial results, it can do so. Hence it is very important to understand a company’s policy of inventory valuation while interpreting the financial results.

   Physical verification of stocks

  

   Although records are maintained for the movement of stock enabling valuation of stock at the end of the accounting period, it is very much necessary to physically verify the existence of stock at the end of the accounting period.

   For better internal control, PV of stocks is generally done by the staff who are not maintaining inventory. The actual stock is verified with book stock and differences analysed. Shortage in stock may be an indicator to stock pilferage or theft. Auditors also insist on PV of high value stock and random checks of low value stocks every year.

  

   Adjustment of certain stocks

  

   1. Goods in transit = Goods in transit must be included in stock if it legally belongs to the company.

   2. Goods sent on approval basis = Goods sent on approval basis must be included in stock if the customer has not yet approved the same.

   3. Goods sent on consignment basis = sometimes goods are sent on consignment basis to an agent, who sells the goods for a commission. In such cases even though the goods may be lying with the agent but legally they belong to the company. Hnece they should be included in the stock.

   Perpetual Inventory system

  

   Unlike periodic inventory system where inventory is determined at the end of the accounting period, perpetual inventory system refers to continuous valuation of inventories. Here a continuous record of all purchases and sales is maintained . Today since it is relatively easy to record huge number of transactions electronically , most of the companies have perpetual inventory system.

   It is helpful to the company to assess the movement of stock and also to avoid the situation of overstocking or under stocking. It is also a tool for inventory control and management.

   Identification of old , non-moving and obsolete stock

   To ensure that stocks reflect assets having realisable value , old , non-moving and obsolete stocks should be identified and scrapped periodically and such loss must be recognised in the financial statements.

   Inventory control and managemment

   For every company it is a challenge to maintain optimum inventory levels. There should not be shortages since it may distrupt production or the company may not be able to meet the demand. Excessive stocking is also undesirable since investment in inventories blocks up funds. Inventory turnover ratio is a tool to measure the efficiency of inventory control.

   Inventory turnover ratio =  cost of goods sold

                         Average stock

   Inventory holding period( in months ) =  12/inventory turnover ratio

   A low inventory holding period or a high turnover ratio indicates an efficient inventory management since it indicates rapid movement of stocks.

Fundamental objectives of inventory control

Service to customers

Effective use of capital

Reduction of risk of loss

Promotion of manufacturing efficiency

Economy in purchasing

Avoidance of out of stock danger

Costs associated with inventory

Cost of carrying

ü Risk of obsolescence

ü Interest on investment

ü Handling and transfer

ü Cost of space

ü Property taxes

ü Insurance

ü Clerical costs

Costs of not carrying enough

Foregone quantity discount

Margins on lost sales

Loss of customer goodwill

Cost of uneconomic production runs

   Stock reconciliation

   Stock is taken at the end of the accounting period. If due to any reasons, stock is taken either before or after the accounting period, then such stock has to be adjusted with the relevant transactions of purchases and sales to arrive at the stock at the end of the accounting year. Such a computation is referred to as stock reconciliation.