INVENTORY VALUATION METHODS NOTES

The literary meaning of the word inventory is stock of goods. To the finance manager, inventory connotes the value of raw materials, consumable, spares, work-in-progress, finished goods and scrap in which a company’s funds have been invested. It constitutes the second largest items after fixed assets in the financial statements, particularly of manufacturing organisation. It is why that inventory valuation and inventory control have become very important functions of the accountants and finance managers. The persons interested in the accounting information assume that the financial statements contain accurate information. However, it is often observed that the financial statements don’t provide actual information about some of the items, e.g. inventory and depreciation. This may be because of the variety of inventory valuation methods available with the accountant.

According to the International Accounting Standard-2 (IAS-2), ‘Inventories’ mean tangible property held;

• for sale in the ordinary course of business,
• in the process of production for such sale, or
• for consumption in the production of goods or services for sale.

Hence, the term inventory includes stock of (i) raw material and components, (ii) work-in-progress and finished goods. In case of manufacturing concern, inventory consists of raw materials, components, stores, semi-finished products and finished goods in case of a trading concern inventory primarily consists of finished goods.

6.2    OBJECTIVES OF INVENTORY VALUATION

Following are the objectives of inventory valuation:

1. Determination of Income: A major objective of inventory valuation is the proper determination of income through the process of matching appropriate cost against revenues. Gross profit is found out by deducting cost of goods sold from sales. Cost of goods sold is purchases plus opening stock minus closing stock. Hence, closing stock must be properly valued and brought into accounts. Over valuation of closing stock leads to inflation of the current year profits and deflation of the profits of succeeding years. Similarly, undervaluation leads to deflation of current years profit and inflation of the profit of the succeeding years.
2. Determination of financial position: In the balance sheet, “inventory’ is a very important item. It is to be shown as current asset in the balance sheet at the end of the year. If the inventory is not properly and correctly valued, to that extent the balance sheet does not give true and fair view of the financial position of the business. Keeping in view the above objectives the auditor’s duty in relation to the verification and valuation of inventories becomes more important. Therefore, while verifying he should ensure that stock taking is done by responsible a officer, stock figures match with that of stock registers, and the basis of valuation has been consistently the same from year to year. Moreover, he should carry out test checks to ensure the accuracy of valuation.

6.3   METHODS OF RECORDING INVENTORY

The records of quantity and value of inventory can be made in two ways. These as follows:

• Periodic Inventory System
• Perpetual Inventory System

1. Periodic Inventory System: Under this system the quantity and value of inventory is ascertained by physically counting the stock at the end of the year and as on the accounting date. In case of big business houses, annual stock taking may even take a week at the end of the year in finalising the stock in hand on continuous basis. In case of this system certain items are physically counted, while others are weighed in kilos or tonnes or measured in litters. For stock taking stock sheets are used. The firms evolve such a performa of stock sheet on which all the relevant informations like particulars of inventory, numbers of units, price per unit, total value, etc. can be listed and added so as to get the figure of inventory. This method offers the advantage of simplicity. Also, there is no used to maintain the various records to be maintained under perpetual inventory system. However, the limitation of this method is that discrepancies and losses in inventory will never come to light as it makes no accounting for theft, losses, shrinkage and wastage.
2. Perpetual Inventory System: This system provides as running record of inventories on hand because under this method stock registers are maintained which will give the inventory balance at any time desired. According to the Institute of Cost and Management Accountants, London, it is “a system of records maintained by the controlling department which reflects the physical movement of stocks and their current balance.” The stores ledger will give the balance of raw materials, work-in-progress and finished goods on hand. Because of this it is for the management to provide for continuous stock-taking, so that by comparing the physical balance with book balance, any discrepancies are ascertained immediately.

In this system business need not be suspended for the purpose of stock taking. The main advantage of this method is that it provides details about the quantity and value of stock of each item all times. Thus it provides a basis for control. The main drawback of this system is that it requires elaborate organisation and records and, therefore, it is more expensive.

6.4   METHODS OF VALUATION OF INVENTORIES

The basic methods of valuation of inventories are as follows:

• Historical cost based method
• Sale price based method
• Lower of cost or sale price

Methods based on Historical cost

According to AS-2 historical cost is the aggregate of costs of purchases, costs of conversion and other costs incurred in the normal course of business in bringing the inventories to their present locations and condition. Cost of purchase comprises purchase price, duties and taxes, freight inwards and other expenditure directly attributable to acquisitions. However, selling expenses such as advertisement expenses or storage cost should not be included.

The valuation of inventory at cost price will be in consonance with the realisation concept. According to this concept, revenue is not realised until the sale is complete and the inventory is converted into either cash or accounts receivable. There can thus be no recognition of revenue accretion except at the point of sale.

This is a method with very high objectivity since the inventory valuer has to base it on a transaction which is completely verifiable. The main limitation of this method is its inability to distinguish operational gains from holding gains during period of inflation. (Note: Holding gain refers to profits which arises as a result of holding inventories during inflation). They may be attributed to the fact that this method matches the past inventories against revenues which have current relations. Thus, this system will result in the inclusion of “inventory profits” (i.e. holding gain) in the income statements during periods of rising prices.

Now, we shall describe the various methods for assigning historical costs to inventory and goods sold.

1. First In First Out Method (FIFO): This method is based on the assumption that the materials which are purchased first are issued first. Issues of inventory are priced in order of their purchases. Inventory issues/sales are priced on the same basis until the first lot of material of goods purchased is exhausted. Thus, units issued are priced at the oldest cost price listed on the stock ledger sheets. Under this system it is not necessary that the material which were longest in stock are exhausted first. But the use of FIFO necessarily mean that the oldest costs are first used for accounting purposes. In practice, an endeavour is made by most business houses to sell of oldest merchandise or materials first. Hence when this system is followed the closing stock does not consist of most recently purchased goods.

Advantages. The following are the advantages of this method:

• This method is easy to operate, provided the prices of materials do not fluctuate frequently.
• It gives such a value of closing stock which is vary near to current market prices since closing inventory is made of most recently purchased goods.
• It is a realistic method because it takes into account the normal procedure of issuing goods/inventory, i.e. the materials are issued to production in the order of their receipts.
• As it is based on historical cost, no unrealised profit enters into the financial statements for the period.

Disadvantages: This method suffers from the following limitations:

• Because of violent changes in prices of materials, it involves somewhat complicated calculations and, therefore, it involves somewhat complicated calculations and, therefore, increase the changes of clerical errors.
• The prices of issues of materials may not reflect current market prices and, therefore, during the period of inflation, the charge to production is unreasonably low.
• Comparison between different jobs executed by the firm becomes sometimes difficult. A job commenced a few minutes before another job might have consumes the supply of lower priced stock. This is particularly because of that

the fact the first job might have completely exhausted the supply of materials of a particular lot.

Suitability: FIFO method is considered more suitable during the periods of falling prices. The reason is that the higher price at which the purchase of materials was made earlier stands recovered in cost. This method is suitable when the size of purchases is large but not much frequent. The moderate fluctuations in the prices of materials, and easy comparison between different jobs are also the important conditions for the use of this method.

 

2. Last in First Out Method (LIFO): Under this method, it is assumed that the material/goods purchased in the last are issued first for production and those received first issued/sold last. In case a new delivery is received before the first lot is fully used, price become the ‘last-in’ price and is used for pricing issued until either the lot is exhausted or a new delivery is received.

As stated above, materials are issued to production at cost which may be vary near to current marked price. However, inventories at the end will be valued at old prices which may be out of tune with the current maked price.

Advantages 

• This method takes into account the current market circumstances while valuing materials issued to various jobs or ascertaining the cost of goods sold.
• No unrealised profit or loss is usually made in case this method is followed.

Disadvantages 

• The stock in hand is valued at a price which have become out-of-date when compared with the current inventory prices.
• This method may not be acceptable for taxation purposes since the value of closing inventory may be quite different from the current market value.
• Comparison among similar jobs is very difficult because they may bear different issue prices for materials consumed.

Suitability: This method is most suitable for materials which are of a bulky and non-perishable type.

 

Implications of FIFO and LIFO method in case of rising and falling prices: Both these methods value the products manufactured at true costs because both are based on actual cost. But in period of rising and falling prices both have conflicting result.

In periods of rising prices the cost of production will be lower in case of FIFO method. This is simply because of the lowest material cost. Contrary to this, LIFO method will result in charging products at highest materials cost. Thus in case of rising price the application of FIFO method will result in higher profitability, and higher income tax liability, whereas the application of LIFO method result in lower profitability, which in turn will reduce income tax liability.

In periods of falling market, the cost of product will tend to be low with reference to the overall cost of inventory in case material cost is to be charged according to LIFO method. Hence, this method will be resulting in inflating of profits and increasing the tax liability. The reverse will be the case if FIFO method is followed. Production will be relatively overcharged. This will deflate the profits and reduce the income tax liability.

In periods of falling prices the ending inventory will be valued in FIFO method at a price lower than in case of LIFO method. The reverse will be the case when the prices are rising. Interestingly, on the basis of above discussion, it may be concluded that in periods of falling prices, LIFO method tends to give a more meaningful balance sheet but less realistic income statement, whereas FIFO method gives a more meaningful income statement but a less realistic balance sheet. The reverse will be the situation in periods of rising prices.

Now the question arises about the superiority of the LIFO and FIFO methods. Based on forgoing discussion about implications of these methods in case of both rising and falling markets, it may be concluded that each method has its own merits and demerits depending upon the circumstances prevailing at a particular moment of time. Thus, no generalisation can be made regarding superiority of LIFO over FIFO or vice-versa.

3. Highest-in-First-our (HIFO): According to this method, the highest priced materials are treated as being issued first irrespective of the date of purchase. In fact, the inventory of materials or goods are kept at the lowest possible price. In periods of rising prices the closing inventory is undervalued and thus secret reserves are created. However, the highest cost of materials is recovered first. Consequently, the closing inventory amount remains at the minimum value. Hence, this method is very appropriate when the prices are frequently fluctuating. As this method involves calculation more than that of LIFO and FIFO methods, it has not been adopted widely.
4. Base stock method: The base stock method assume that each business firm whether small or large must held a minimum quantity of materials finished foods at all times in order to carry on business smoothly. These minimum quantity of inventories are valued at the cost at which the base stock was acquired. It is assumed that the base stock is created out of the lot purchased. Inventories over and above the base stock are valued according to some other appropriate method such as FIFO, LIFO, etc.

AS-2 recommends the use of this method in exception circumstances only. This is because of the fact that a large number of companies customarily maintain a minimum stock level at all times irrespective of its requirement. Actually, sometimes base stock method is used without its justification. Therefore, this method requires a clear existence of the circumstances which require that a minimum level of charging out inventory of raw material and finished goods at actual cost along with merits and demerits of the method which is used for valuation other than the base stock method.

5. Specific Identification Method: Under this method, each item of inventory is identified with its cost. The value of inventory will be constituted by the aggregate of various cost so identified. This method is very suitable for job order industries which carry out individual or goods have been purchased for a specific job or customer. In other words, this method can be applied only where materials used can be specifically and big items such as high quality furniture, paintings, metal jewellery, cars, etc.

However, this method is not appropriate in most industries because of practical problems. For instance, in case of manufacturing company having numerous items of inventory, the task of identifying the cost of every individual item of inventory becomes very cumbersome. Also, it promotes the chances of manipulating the cost of goods sold. It can be done by selecting items that have a relatively high cost or a relatively low cost, as he desires.

5. Simple average Price (SAP): This is the average of prices of different lots of purchase. Under this method no consideration is given to the quantity of purchases in various lots. For example the purchases of 500 units of materials at Rs. 10 per unit are made as on 5th January, 1995 and 800 units of materials at Rs. 14 per unit on 10^th If at the end 200 units remains unissued/unsold, these will be valued at Rs. 12 = [(10 + 14)/2]per unit and hence, the closing inventory will be shown at Rs. 2400 (200 × 12 = 2400). Infact, this method operated on the principle that when items of materials are purchased in big lots and are put in godown, their identity is lost and, therefore, issues should be priced at the average price of the lots in godown.
6. Weighted Average Price (WAP): Under this method, the quantity of material purchased in various lots of purchases is considered as weight while pricing the materials. Weighted average price is calculated by dividing the total cost of material in stock by the total quantity of material at the end. When this method is adopted, the question of profit or loss out of varying prices does not arise because it evens out the effect of widely fluctuating prices of different lots of purchases. This method is very popular because it reduces calculations and is based on quantity and value of material purchased.

 

Method Based on Sale Price: The inventories may be valued at marked or sale prices. Important among these prices are current selling prices, and net realisable value. Both of these are discussed as follows:

1. Current Selling Prices: The method is used in case of the product of which market as well as prices are controlled by a Government. Marketing costs being negligible are ignored under this method. This method is followed in the case of sugar industries, metal industries, etc.
2. Net Realisable Value. According to IAS-2, the net realisable value means, “the estimate selling price in the ordinary course of business costs of completion and less costs necessarily to be incurred in order to make the sale.” Estimates of net realisable value should not be guided by temporary fluctuations in market prices. However, these should be arrived at after taking into consideration all expenses which might have to be incurred for making sales. Such cases where it is difficult to estimate the appropriate costs, say agriculture output, inventory are valued consistently at market values. This procedure of valuation is accepted because of the saleability of the output at quoted prices.
3.            The Lower of Cost or Market Price (LCM Rule)

This method is based on the accounting principle of’ conservatism according to which profits should not be anticipated but all losses foreseen should be provided for. For instance, the ending inventory consist of items purchased at cost of Rs.210 per unit. But the market price has fallen to Rs.200 per unit at the time of valuation of inventory. Hence, the items should be valued at Rs.200 per unit. This rule violate the matching concept which requires matching of revenues with the related product costs. This method also leads to inconsistency since in one year the valuation may be based on cost while in another it may be based on market price. However, even the critics of this rule favour the application of this rule for valuing obsolete or damaged inventories.

About inventories valuation AS-2, recommends that the general rule of valuing inventories should be at lower of historical cost and net realisable value subject to certain exceptions. The historical of the inventories should normally be determined by using ‘FIFO’, ‘LIFO’ or Average ‘Cost’ method. Inventory of by-products cannot be separately determined. It should be valued at net realisable value.

LCM rule can be applied in anyone of the following ways:

1. Aggregate/total inventory method: In this method, cost price of the total inventory is ascertained and then compared with total net realisable price to arise at stock valuation.
2. Group Method: Under this method, groups are formed of similar or interchangeable articles of inventory. The cost and the net realisable value of each group so formed are found out. The LCM rule is applied to each group.
3. Item-by-item-method: According to this method, the cost and net realisable prices of each item of inventory are found out and the lower of the figures is taken into account for valuation of inventory. Both IAS-2 and AS-2 have recommended the use of “Group method” and “Item-by-Item” method for valuation of inventory. The first method namely “Aggregate or Total Inventory method” have not been recommended by both the standards. The learner’s will understand the difference between all the three methods from the following illustration.

 

Valuation of inventory for Balance Sheet purpose 

In certain cases, it is not possible for the business to take inventory on the date of balance sheet. It might have been taken on a date earlier or later than the date of balance sheet. In such a case, when student are required to calculate the value of stock on the date of preparation of final accounts, then they should take into consideration information about additional transactions which occur during the period. For example, if value of stock on 28^th March is given, then in order to find the value of stock on 31^st March all purchases between these dates will be added. Likewise, if value of stock on 4^th April is given and value of stock on the proceeding 31^st March is required then purchases during the period will be deducted and issues/sales (at acquisition price) during this period will be added. Both of the above mentioned cases could be understood and elaborated as under:

• When the Position of stock is given on a date prior to the balance sheet date

In this case, the following adjustments will generally be required:

• Add purchases made during the period.
• Deduct purchases returns during the said period.
• Deduct inventory issued/sold between the two dates.
• Add sales returns between the two dates.
• When the position of stock is given on a date after the balance sheet date

SUMMARY

The word ‘inventory’ means stock of goods. To the finance manager, inventory connotes the value of raw materials, consumable, spares, work-in-progress, finished goods and scrap in which a company’s funds have been invested. A major objective of inventory valuation is the proper determination of income through the process of matching appropriate cost against revenues. The records of quantity and value of inventory can be made in two ways: (i) Periodic inventory system; (ii) Perpetual inventory system. The basic methods of valuation of inventories are: (a) Historical cost based method; (b) Sale price based method; (c) Lower of cost or sale price

6.7     KEYWORDS

Market Price: Market price means net realisable value in the ordinary course of business.

Cost: Cost means the total of the amount paid to the supplier and the expenses incurred till the goods reach the firm’s premises but expenses thereafter will not be included.

Periodic Inventory System: In this system, the quantity and the value of inventory is ascertained by physically counting the stock at the end of the year and as on the accounting date.

Net Realisable Value: It is the estimated selling price in the ordinary course of business less the estimated cost of completion and the estimated costs necessary to make the sale.

6.8     SELF ASSESSMENT QUESTIONS

1. What are the various methods of inventory valuation? Discuss the impact of each method on working results.
2. What is the principle behind valuation of inventory at cost or market price whichever is lower?
3. Differentiate the following:
   • LIFO and FIFO method
   • Periodic inventory valuation and Perpetual inventory valuation
   • Item-by-item method and Group method
4. What is the need of valuing inventory properly? Discuss. To what extent this need is fulfilled by various methods of valuing inventories.