Financial Accounting Inventory Valuation – tryspring

By | April 19, 2019

Financial Accounting – Inventory Valuation

The Institute of Chartered Accountant of India as per Accounting
Standard-2 (Revised) defines inventory as the assets held

  • For sale in the ordinary course of a business or

  • In the process of production for such a sale or

  • In the form of materials or supplies to be consumed in the
    production process or in rendering of the services.

Thus, the term inventory includes −

  • Raw Material and supplies,
  • Work in progress, and
  • Finished goods.

Importance of Inventory Valuation

Proper valuation of inventory is important because of the
following three reasons −

  • Importance of sufficient Inventory − An inventory
    represents major current asset investment of any trading or
    manufacturing concern. Shortage of inventory may close down
    the business. Realization of profit from resale of an
    inventory makes valuation of inventory. Therefore, the point
    is that every business unit has to follow a proper method of
    inventory valuation.

  • To Determine True Financial Position − Proper
    valuation of an inventory can only give true and fair view of
    the financial position of a business unit, as it constitutes
    a significant portion of the current assets.

  • For Proper Determination of Income − Proper
    determination of income and profit depends on correct
    valuation of the inventories. Over valuation of closing
    inventory may overstate the profit figure and vice-versa.
    Therefore, proper valuation of an inventory is necessary to
    determine the true income and profit by the business concern.

Methods of Taking Inventory

Following are the two important methods of taking inventory −

  • Periodic Inventory Method and
  • Perpetual Inventory Method

Let’s discuss each of them separately −

Periodic Inventory Method

This method of stock valuation is also known as physical stock
taking method or annual stock taking method. Under this system of
taking inventories, stock is determined by physical counting at
the end of the accounting period i.e. the date of preparation of
final accounts. This system is very simple and useful in small
business organizations.

Perpetual Inventory Method

This system of inventory valuation records every movement of
stock on the receipt and issue of material reflecting running
balances of different kind of inventories through preparation of
store ledgers for raw material, work-in- progress, and finished
goods. To insure the accuracy of store records, a periodic
reconciliation of records is done by taking physical inventories.

Valuation of Inventory at Lower Cost or Market Price

An inventory is valued at a cost or market price, whichever is
lower to ensure that the anticipated profit should not be
accounted for and full provision for anticipated losses should be
done.

As per American Institute of Certified Public Accountants

“A departure from the cost basis of pricing the inventory is
required when the utility of the goods is no longer as great as
its cost. Where there is evidence that the utility of goods, in
their disposal in the ordinary course of business, will be less
than cost, whether due to physical deterioration, obsolescence,
changes in price levels, or other causes, the difference should
be recognized as loss of the current period. This is generally
accomplished by stating such goods at a lower level commonly
designated as market.”

Methods of Valuation of Inventory

The following illustration shows the methods of Valuation of
Inventory −

Valuation of Inventory Methods

Let’s discuss each one of the methods in detail.

First in First out (FIFO) Method

FIFO is the most popular method of an inventory valuation, which
is based on assumption that the material first received or
purchased are the first to be sold or issued. It means, closing
stock is out of the last or latest received or manufactured
goods.

It will clear with a small and simple example as given below −

Date No. of Item Rate Value
Opening stock 100 10 1000
Purchased on 01-04-13 500 10 5000
Purchased on 01-07-13 500 12 6000
Purchased on 01-01-14 1000 15 15000
Total Purchases 2100 27000
Item Sold 1700
Closing stock 400 15 6000

In above example, it is assumed that closing stock of 400 items
was out 1000 items purchased on 01-01-2014.

Last in First out (LIFO) Method

As name suggests, closing stock is valued on the basis of oldest
purchased or manufactured items. First time, this method was used
by the U.S.A., at the time of Second World War to get the
advantage of hike in prices. In the above example, closing stock
will be valued at 400 items @ Rs. 10 each = Rs. 4000

Note − Here 100 items from opening stock and 300 items
were out of purchases made on 01-04- 2013

Average Cost Method

Average cost method is used where identification of stock with
rate or value of stock is not possible. It is of two types Viz…

  • Simple Average Price Method
  • Weighted Average Price Method

Simple Average Price Method

Simple average price method may be explained as below −

Suppose, four types of items are in stock as follows −

500 units purchased @ Rs. 10 per unit = Rs. 5000
750 units purchased @ Rs. 12 per unit = Rs. 9000
600 units purchased @ Rs. 14 per unit = Rs. 8400
Total Units 1850 for = Rs. 22400

Simple average method ignored the inventory at cost, therefore
the valuation of stock of 1850 units will be = 12 × 1850 = Rs.
22,200 whereas the actual cost is Rs. 22,400

So, if we want to choose average method then weighted price
method should be followed under which valuation will be done as
hereunder.

Weighted Average Price Method

In the above example, Rs. 22,400 will be divided by 1850 units
and the average price will be Rs. 12.1081.

Highest in First out (HIFO) Method

This method is based on the assumption that the highest value of
material always consumed first and closing stock will be valued
at the lowest cost of purchased or manufactured material. This
method is not a popular method of valuation of inventory and so,
used only by the business units having monopoly products or who
are dealing with the cost + contract.

Base Stock Method

Base stock means — minimum level of stock maintained by a
business unit to run his business without any interruption or
which is according to AS-2 issued by The Institute of
Chartered Accountants of India
as “the base stock formula
proceeds on the assumption that a minimum quantity of inventory
(base stock) must be held at all times in order to carry on
business
.”

Note − This method can be followed only when LIFO method
is used.

Inflated Price Method

This method of valuation covers normal losses, increasing price
of purchases to calculate closing value of an inventory. For
example, if 550 units purchased for Rs. 2000 and due to normal
loss units, remain 500 then the cost per unit will be 2000/500 =
Rs. 4 per unit, and while calculating closing stock value for 100
unit, cost will be Rs. 400 (100 × 4).

Specific Identification Method

Under this method, where identification of items with price is
possible, then closing stock will be valued accordingly.

Market Price Method

Under this method of valuation, stock is valued at current market
price. It is also called replacement price or realizable price
method.

Method of Valuation of Closing Stock when it is not given

In case, where the value of closing stock is not given, we may
calculate it as −

Opening stock xx
Add: Net Purchases xx
Less: Cost of Sales xx
Less: Gross Profit xx
Value of Closing stock xx

Putting value in above formula, we may also calculate the value
of opening stock.

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