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Our learning in the
Previous Class…
We learnt …
What costs to What costs to be included be included
in inventory?in inventory?
General Rule…
The cost of inventories should
comprise all costs of purchasecosts of purchase,
costs of conversioncosts of conversion and other other
costscosts incurred in bringing the
inventories to their present location
and condition.
COSTS OF PURCHASE…COSTS OF PURCHASE…
Cost of purchases includes all those expenses that are
incurred to bring the raw material at the desired location.
COSTS OF CONVERSIONCOSTS OF CONVERSION … It includes all those expenses that are incurred
to convert raw material into work-in-progress and finally, into finished goods. Such a cost is generally called CONVERSION COST.
Conversion Cost includes…
Direct Labour Cost
Indirect Labour Cost (Production)
Other fixed production overheads – Fixed or Variable.
COSTS OF CONVERSIONCOSTS OF CONVERSION …
Costs of Conversion do not include…•Storage Costs, unless those costs are necessary in the production process prior to a further production stage.•Administrative Overheads that do not contribute to bringing the inventories to their present location and condition.•Selling and Distribution Costs.
OTHER COSTSOTHER COSTS …
Other costs are included in the cost of
inventories only to the extent that they
are incurred in bringing the inventories to
their present location and condition.
What are What are inventory inventory systems?systems?
If we record transactions related to inventory INSTANTANEOUSLY, then we are using a System of Inventory which is known as …
PERPETUAL INVENTORY PERPETUAL INVENTORY SYSTEM SYSTEM
And, if we are recording transactions related to inventory periodically then, it is called … PERIODIC INVENTORY SYSTEM.
How to find How to find the the Value of Value of
InventoryInventory??
The issue of Inventory Valuation requires…
…an assumption about the flow of flow of
inventoryinventory so that we can judge the flow of cost of inventory!!!
COST FLOW ASSUMPTIONS …Four assumptions are made with regard to inventory cost flow:
1.Specific Identification,
2.FIFO,
3.LIFO, and
4.Average Cost.
Any question?
Now, let’s proceed further…
Inventory Cost Flow Methods
FIFO• The oldest units
are sold and the newest units remain in inventory.
• The cost of the oldest units purchased is transferred to COGS.
LIFO• The newest
units are sold and the oldest units remain in inventory.
• The cost of the most recent units purchased is transferred to COGS.
Average Cost• An average cost is
computed for all inventory available for sale during the period.
• COGS is computed by multiplying the number of units sold by the average cost per unit.
Compare Inventory Methods: General
LIFO gives a better reflection of COGS in the income statement.
Therefore, LIFO is a better measure of income.
FIFO gives a better measure of inventory on the balance sheet.
Therefore, FIFO is a better measure of inventory value.
Compare Inventory Methods – During Increasing Prices
LIFO provides a proper value of COGS in the income statement and Profits are less.
But, it provides undervaluation of inventory on Balance Sheet.
It undervalues COGS and provides MORE profit.
FIFO provides proper value of inventory in the balance sheet.
Compare Inventory Methods – During Decreasing Prices
LIFO provides lower value of COGS in the income statement and Profits are more.
But, it provides higher value of inventory on Balance Sheet.
It provides higher COGS and provides less profit.
FIFO provides lower value of inventory in the balance sheet.
Interesting Interesting things things
about about LIFOLIFO??
22
LIFO LayersAny year in which the number of units
purchased exceeds the number of units sold, a new LIFO layerLIFO layer is created in ending inventory.
The creation of LIFO layers results in ending inventory at very old prices
23
LIFO Layers Example
Year of Purchase
Number of Units
Unit Cost
Number of Units
Number of Units Unit Cost Total Cost
2004 120 Rs. 5 100 20 Rs. 5 Rs. 100
2005 150 Rs. 10 120 20 Rs. 530 Rs. 10 Rs. 400
2006 160 Rs. 15 120 20 Rs. 530 Rs. 1040 Rs. 15 Rs. 1,000
Purchases Sales Ending Inventory
20 units from 2004 + 30 units from 2005
20 units from 2004 + 30 units from 2005 + 40 units from 2006
24
LIFO Reserve
The difference between the LIFO ending inventory amount and the amount obtained using another method (e.g., FIFO or average cost)
Disclosed to aid in comparing companies that use different inventory cost flow assumptions
25
LIFO Liquidation
Occurs when the number of units purchased does not exceed the number of units sold.
The old LIFO layer costs to flow through cost of goods sold, reducing cost of goods sold and increasing net income
Other Methods Other Methods of of
Inventory Inventory ValuationValuation??
Other Methods of Inventory Valuation…
Retail Method
Gross Profit Method
Standard Cost Method
Retail MethodOccasionally used for interim period reporting.
Needed information includes:
Beginning inventory at cost and retail.
Net purchases at cost and retail.
Net sales.
Retail Inventory MethodRetail Inventory Method
Step 3 Cost to retail ratio
Ending inventory at
retail
Estimated ending
inventory at cost
=×
Step 2Goods
available for sale at retail
Goods available for sale at cost
=÷ Cost to retail ratio
Step 1 Net sales at retail
Goods available for sale at retail
– =Ending
inventory at retail
Retail Inventory MethodRetail Inventory Method
Retail Inventory MethodRetail Inventory Method
Retail Inventory MethodRetail Inventory Method
Gross Profit MethodEstimate ending inventory by applying the gross
profit ratio to net sales at retail.
Useful when inventories have been destroyed, lost or stolen.
Example:Gross Profit Method
Assume the following data:
Beginning inventory, January 1 Rs. 25,000
Purchases, January 1 through January 31 40,000
Sales, January 1 through January 31 50,000
Historical gross profit percentage 40%
Gross Profit Method
Sales (actual) Rs. 50,000 100%
Gross profit (estimate) Rs. 20,000 40%
Cost of goods sold (estimate) Rs. 30,000 60%
Beginning inventory (actual) Rs. 25,000+ Purchases (actual) 40,000= Cost of goods avail for sale (actual) 65,000
= Ending inventory (estimate) 35,000- Cost of goods sold (estimate) 30,000
Standard Cost MethodStandard costs take into account normal levels
of consumption of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions.
Under this method, the cost of goods sold/issued is calculated at the standard cost and at the end, any variance, if any, needs to be adjusted.
What are the What are the impact of impact of
ERRORS in ERRORS in Inventory Inventory
ValuationValuation??
38
Ending Inventory Errors
If ending inventory is ...
Cost of Goods Sold is ...
Profitis ...
Overstated Understated Overstated
Understated Overstated Understated
How to How to REPORT REPORT Value of Value of
InventoryInventory in in Financial Financial
StatementsStatements??
Indian Accounting Standard – AS 2
AS-2Use Specific Identification Method If Specific Identification Method is not applicable
the, then the cost of inventories can be determined through – FIFO Weighted Average Cost
When it is impractical to calculate, the following methods could be used- Standard Cost Method Retail Method
Remember,The value of Closing Inventory in the Balance Sheet is always to be shown at the cost or the Net Realizable Value.
How to How to DISCLOSURE DISCLOSURE
Value of InventoryValue of Inventory in in Financial Financial
StatementsStatements??
Disclosure
The financial statements should disclose:
(a) the accounting policies adopted in measuring
inventories, including the cost formula used; and
(b) the total carrying amount of inventories and
its classification appropriate to the enterprise.
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