INVENTORY VALUATION

Meaning: For Inventory valuation, cost may mean historical, current or standard cost. Historical costs represents the cost actually incurred at the time of acquisition. Current replacement cost represents the replacement price on the date of its consumption. Standard cost represents the predetermined cost that should be incurred at a given level of efficiency and capacity utilization.

Inventory Systems:
Periodic Inventory System: It is a method of ascertaining inventory by taking an actual physical count of all inventory items on hand at a particular date on which information about inventory is required. The cost of goods sold is calculated as a residual figure (which includes lost goods also) as follows: Cost of Goods sold= Opening inventory + Purchases Closing stock Perpetual Inventory System: It is a method of recording inventory balances after each receipt and issue in order to ensure accuracy of perpetual inventory records, physical stocks should be checked and compared with recorded balances. The discrepancies should be investigated and adjusted properly in accounts. The closing inventory is calculated as a residual figure (which includes lost goods also) as follows: Closing Inventory = Opening Inventory + Purchases cost of goods sold

Methods of Valuation of inventories: The various methods for assigning the cost between sold and unsold goods include the following: 1. First in first Out (FIFO) Method 2.Average cost Method 3.Last In First Out (LIFO) method 4.Base stock method 5.Specific Identification Method 6.Standard cost 7.Adjusted Selling Price 8. Latest Purchase Price 9.Next In First Out Method ( NIFO) Method 10. Highest In first Out (HIFO) Method

As per Revised Accounting standard 2 issued by the ICAI i) The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by fifth (SIM)method. ii) The cost of inventories other than those for which specific identification of individual cost is appropriate should be assigned by using FIFO or Weighted Average Cost Method. The formula should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition. FIFO Method: FIFO method is based on the assumption that the goods which are received first are issued first. This assumption is made for the purpose of assigning cost and not for physical flow of goods. The

goods sold, therefore ,consists of the earliest lots and are valued at the price paid for such lots. The ending inventory consists of the latest lots and is valued at the price paid for such lots. The ending inventory is stated in the Balance Sheet at a value nearer the current market price.

LIFO Method: It is based on the assumption that the goods which are received last are issued first. This assumption is made for the purpose of ascertaining cost and not for the purpose of physical flow of goods. Therefore the goods sold consists of the latest lots and are valued at the price paid for such lots. The ending inventory consists of the earliest lots and is valued at the price paid for such lots. The ending inventory is understated in the Balance Sheet at old cost.

Basis of Distinction FIFO 1.Basic Assumption Goods received first are issued first 2.Cost of Goods sold 3.Distortion in Balance sheet Cost of goods sold represents cost of earlier purchases B/S shows the ending inventory at a value nearer the current market price

LIFO Goods received last are issued first Cost of goods sold represents cost of recent purchases B/S is distorted because ending inventory is understated at old cost Ending Inventory represents cost of earlier purchases Lower income is reported

4.Ending Inventory Ending Inventory represents cost of recent purchases 5. In case of Rising Higher income is Prices reported

Illustration: Date Inventory No. of units 1 Jan. Purchase 500 5 Jan. Purchase 1000 10 Jan. Purchase 2000 15 Jan. Purchase 1000 20 Jan. Purchase 3000 25 Jan. Purchase 2000 Total 9500 Inventory 11 Jan. Sales 14 Jan. Sales 16 Jan. Sales 21 Jan. Sales 30 Jan. Sales TOTAL

Cost per unit(Rs.) 3 4 5 6 4 7

Amt(Rs.) 1500 4000 10000 6000 12000 14000 47500 Units 1000 500 1000 2000 1500 6000

Cost of goods sold & Inventory under FIFO Date 11 Jan. 14 Jan. 16 Jan 21 Jan. Quantity sold 1000 500 1000 2000 Quantity break up 500 500 500 1000 1000 1000 1500 Rate X3 X4 X4 X5 X5 X6 X4 Amt 1500 2000 2000 5000 5000 6000 6000 Total Amt(Rs.) 3500 2000 5000 11000 6000 27500

30 Jan. 1500 Total 6000 Sales Inventory 3500

1500 2000

X4 X7

6000 14000

20000

Total

9500

47500

Thus, cost of goods sold under FIFO=27,500 Inventory under FIFO =20,000 47500

Cost of goods sold & Inventory under LIFO Date 11 Jan. 14 Jan. 16 Jan 21 Jan. Quantity sold 1000 500 1000 2000 Quantity break up 1000 500 1000 2000 1500 Rate X5 X5 X6 X4 X7 Amt 5000 2500 6000 8000 10500 Total Amt(Rs.) 5000 2500 6000 8000 10500 32000

30 Jan. 1500 Total 6000 Sales Inventory 3500

500 1000 500 1000 500

X3 X4 X5 X4 x7

1500 4000 2500 4000 3500

Total

9500

15500 47500

Thus, cost of goods sold under LIFO=32,000 Inventory under LIFO =15,500 47500

Weighted Average Price method: The Weighted Average Price method is based on the assumption that each issue of goods consists of a due proportion of the earlier lots and is valued at the weighted average price. Weighted Average Price is calculated by dividing the total cost of goods in stock by the total quantity of goods in stock. This weighted average price is used for pricing all the issues until a new lot is received then a new weighted average price is calculated.

Matching Concept

Meaning: Matching is the entire process of periodic earnings measurement, often described as a process of matching expenses with revenues. In a narrow sense, this means deducting from the revenues of a period the cost of goods sold or other expenses that can be identified with such revenues of that period on the basis of cause and effect. To ascertain the amt of profit or loss made or suffered during a particular period proper matching of revenue is required to be done with the expenses. It will be appropriate here to understand the meaning of following terms: Revenue: Income of recurring nature from any source. Source may be sale of goods, performance of service for a customer, the rental for a property etc. Expense: The term expense denotes the cost of services and things used for generating revenue

Expenditure : The term expenditure means payment or the incurring of a debt for an asset or an expense. If an asset is acquired or an expense is incurred or an expenditure is said to have been made whether or not the cash is paid immediately. Thus, every expense is an expenditure, while each expenditure is not necessarily an expense. For Example, Salaries paid to the employees of a firm are both an expenditure as well as an expense, but amount spent for acquisition of fixed assets for a business is an expenditure but not an expense. So, while calculating the income or the profit of a business, for a particular period, the revenue earned during the period is to be matched with expense incurred in earning that revenue.

Period of recognition: an expense will be recognized as an expense incurred for earning revenue during a particular period in each of the following cases: a) If the expense can be directly identified or associated with the revenue of the period. For example, when sale of goods is treated as revenue for a particular period, the cost incurred for manufacturing of such goods such as those of raw materials ,wages and other direct charges will be recognized as an expenditure for earning that revenue. b) If the expense can be indirectly identified or associated with the revenue of the period. For example, salary of the manager, rent, insurance etc. incurred during a particular period can be charged against the revenue earned during that period. However, if some part of these indirect costs relates to the future revenue, such portion of the indirect cost will be deferred and shown in the Balance sheet as an asset. The

remaining portion of these costs will be matched against the revenue of the current year. c) Losses which have no potential for producing the revenue in future will not be deferred but will be recognized as the expense of the period in which they have occurred. For example, damage to property on account of earthquake, loss of plant ,machinery etc. due to fire or any other reason should not be carried forward. They should rather be met out of revenue of the year in which they have occurred.

Determination of Amount of Expense:

Two approaches for regarding determination of amount of expense to be matched with revenue for measurement of business income a)Traditional Approach: The Actual cost incurred for the expense to be matched with revenue for determination of Business Income. b) Replacement approach: As per this approach, while comparing expense with the revenue, the replacement cost should be considered in place of original cost.

For Example, Cost of goods purchased last year Rs.20 per kg Sold during current year @ Rs.30 per kg. And the current market price for purchasing the goods is Rs.25 per kg, Profit as per traditional approach is Rs. 10/-

Replacement Approach: Sales Rs.30 Less: Replacement cost of goods sold Rs.25 Rs.5 Add: Profit realized from market fluctuations and price level changes Rs.5 Total Profit Rs.10 In both the cases profit is Rs. 10 but, replacement cost approach gives a better analysis of profit earned by a business. So, Replacement cost approach is preferred to Traditional Approach