Inventory Valuation On Reporting Income


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Inventory Valuation On Reporting Income

  1. 1. Issues in Income Determination<br />Inventory Valuation on Reporting Income<br />
  2. 2. Introduction<br />Inventories, also known as stocks, are the largest item of current assets in the Balance Sheet of Merchandising and Manufacturing companies.<br />Inventory valuation and income measurement are inter-related.<br />If the inventory is not correctly valued, it will result in a wrong measurement of income and financial position.<br />For the ascertainment of income, it is only the cost of goods sold, that should be charged against revenue.<br />
  3. 3. Definition of Inventories<br />Inventories are “assets (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services”.<br />The Institute of Chartered Accountants of India, Accounting Standard 2 (Revised), Valuation of Inventories.<br />Merchandising Firms: <br /> merchandise<br />Manufacturing Firms:<br /> Raw materials<br />Work-in-process<br /> Finished Goods<br />Stores and Spares<br />
  4. 4. Matching inventory Costs with Revenues<br />The determination of the cost of goods sold is directly affected by the cost assigned to the ending inventory.<br />Gross Income/Profit = Sales – Cost of Goods Sold<br />CGS = Opening Stock + Net Purchases+ Direct Expenses – Closing Stock<br />Thus, if a higher value is assigned to the ending inventory, the CGS will decrease and the GP will increase.<br />Conversely, if a lower value is assigned to the ending inventory, the CGS will increase and the GP will decrease.<br />Clearly, inventory valuation affects the P&L A/c as well as the B/S.<br />
  5. 5. Effects of Inventory Errors<br />An error in the value of the year-end inventory will cause misstatements in CGS, GP, NP, CAs and Owners Equity because, the ending inventory of one year is the beginning inventory of the next.<br />Therefore, the error will carry forward and cause the P&L A/c for the next period to be incorrect.<br />Besides, major errors in the inventory values will substantially undermine the credibility of the financial statements. <br />
  6. 6. Illustration:<br />Assume that the cost of ending inventory of a company is Rs 15,000 but, it is overstated by Rs 10,000 i.e., as Rs 25,000. The effect of this error will be to overstate the net profit for the current period. The error will be counterbalanced in the next year and the net profit will be understated because the beginning inventory will be overstated.<br />
  7. 7. Effects of Inventory Errors<br />Illustration:<br />
  8. 8. Determining the Physical Inventory<br />The first step in proper inventory valuation is to determine the Physical inventory that belongs to the business.<br />Methods:<br />Periodic Inventory System<br />The units on hand must be counted at the end of the accounting period to determine the ending inventory.<br />Perpetual Inventory System<br />Continuous records of inventory transactions are maintained.<br />A physical inventory is also taken to verify the balances shown in the records.<br />
  9. 9. Pricing the Inventory<br />It is one of the most contentious topics in Accounting.<br />Since the value placed on ending inventory may have a dramatic effect on reported net profit, users of financial statements, particularly investors, managers, and tax authorities show keen interest in the methods of pricing inventory.<br />Proper income determination is the guiding principle of inventory valuation for financial reporting.<br />
  10. 10. Inventory Costing Methods<br />Specific Identification Method<br />First-in, First-out (FIFO) Method<br />Last-in, First-out (LIFO) Method<br />Weighted-Average Cost Method<br />
  11. 11. Illustration:<br />To illustrate the four methods, we assume the following data for an accounting period:<br />
  12. 12. Specific Identification Method<br />It assigns specific costs to each unit sold and each unit on hand.<br />It is used if the units in the ending inventory can be identified as coming from specific purchases.<br />It is particularly suited to inventories of high-value, low-volume items such as jewellery.<br />Each unit in inventory must be identified with an identification tag.<br />
  13. 13. Illustration:<br />Assume that the Dec. 31 inventory consisted of 60 units from the Mar. 27 purchase, 70 units from the June 12 purchase, and 20 units from the Sept. 19 purchase. The cost of the ending inventory is computed as follows:<br />
  14. 14. Demerits of SI method<br />It does not involve any assumption about cost flow.<br />It matches the cost to the physical flow of the inventory and eliminates the effect of cost flow assumption on reported income.<br />
  15. 15. FIFO Method<br />It assumes that the first units acquired are the first units sold.<br />The cost of the units in the ending inventory is that of the most recent purchases.<br />Merits:<br />The inventory valuation reflects the conditions prevalent on the Balance Sheet.<br />It will suit when the prices are declining.<br />Demerits:<br />It leads to improper matching of costs with revenues since the cost of goods sold is computed on the basis of old and possibly unrealistic purchase prices.<br />
  16. 16. Illustration:<br />In our illustration, the cost of the 150 units in the ending inventory would be computed as follows:<br />
  17. 17. LIFO Method<br />It assumes that the last units acquired are the first units sold.<br />The cost of the units in the ending inventory is that of the earliest purchases.<br />Merits:<br />It ensures that the current revenues are matched with the most recent purchases, thus resulting in realistic reported profits.<br />It will suit when the prices are rising.<br />Demerits:<br />The Balance Sheet value of inventories may be outdated and unrealistic.<br />
  18. 18. Illustration<br />In our illustration, the cost of 150 units in the ending inventory would be computed as follows:<br />
  19. 19. Weighted-Average Cost Method<br />It assumes that the goods available for sale are homogeneous.<br />Weighted-Average cost<br /> = The Cost of goods available for Sale/the number of <br /> units available for sale<br /> where,<br />the cost of goods available for sale = cost of beginning inventory + all purchases<br />Merits:<br />It is appropriate when the inventory units involved are homogeneous or when it is difficult to make a flow assumption.<br />Demerits:<br />It assigns no more importance to current prices than to past prices paid several months ago.<br />
  20. 20. Illustration<br />In our illustration, the unit cost under this would be computed as follows:<br />
  21. 21. Comparison of Alternative Inventory Methods on profitability<br />EFFECTS OF INVENTORY METHODS ON PROFIT<br />