Issues in Income Determination

Inventory Valuation on Reporting Income

Introduction• Inventories, also known as stocks, are the largest

item of current assets in the Balance Sheet of Merchandising and Manufacturing companies.

• Inventory valuation and income measurement are inter-related.

• If the inventory is not correctly valued, it will result in a wrong measurement of income and financial position.

• For the ascertainment of income, it is only the cost of goods sold, that should be charged against revenue.

Definition of Inventories

• 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”.

• The Institute of Chartered Accountants of India, Accounting Standard 2 (Revised), Valuation of Inventories.

– Merchandising Firms: • merchandise

– Manufacturing Firms:• Raw materials• Work-in-process• Finished Goods• Stores and Spares

Matching inventory Costs with Revenues

• The determination of the cost of goods sold is directly affected by the cost assigned to the ending inventory.

• Gross Income/Profit = Sales – Cost of Goods Sold• CGS = Opening Stock + Net Purchases+ Direct Expenses –

Closing Stock

– Thus, if a higher value is assigned to the ending inventory, the CGS will decrease and the GP will increase.

– Conversely, if a lower value is assigned to the ending inventory, the CGS will increase and the GP will decrease.

• Clearly, inventory valuation affects the P&L A/c as well as the B/S.

Effects of Inventory Errors

• 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.

• Therefore, the error will carry forward and cause the P&L A/c for the next period to be incorrect.

• Besides, major errors in the inventory values will substantially undermine the credibility of the financial statements.

Illustration:• 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.

Effects of Inventory Errors

Illustration:

2007 2008 2007 2008Net Sales Rs 1,00,000 Rs 1,00,000 Rs 1,00,000 Rs 1,00,000Cost of Goods Sold:Opening Inventory 20,000 25,000 20,000 15,000Purchases 85,000 65,000 85,000 65,000Cost of Goods available for sale 1,05,000 90,000 1,05,000 80,000Less: Closing Inventory 25,000 10,000 15,000 10,000Cost of Goods Sold: 80,000 80,000 90,000 70,000Gross Profit (Sales - CGS) 20,000 20,000 10,000 30,000Operating Expenses 4,000 5,000 4,000 5,000Net Profit 16,000 15,000 6,000 25,000

Incorrect Ending Inventory Correct Ending InventoryParticulars

Effect of Inventory Error on Two Periods

Determining the Physical Inventory

• The first step in proper inventory valuation is to determine the Physical inventory that belongs to the business.

Methods:1. Periodic Inventory System

– The units on hand must be counted at the end of the accounting period to determine the ending inventory.

2. Perpetual Inventory System– Continuous records of inventory transactions are

maintained.– A physical inventory is also taken to verify the balances

shown in the records.

Pricing the Inventory• It is one of the most contentious topics in

Accounting.• 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.

• Proper income determination is the guiding principle of inventory valuation for financial reporting.

Inventory Costing Methods

• Specific Identification Method• First-in, First-out (FIFO) Method• Last-in, First-out (LIFO) Method• Weighted-Average Cost Method

Illustration:• To illustrate the four methods, we assume the

following data for an accounting period:

Date Particulars Units Unit Cost (Rs) Total Cost (Rs)Jan. 1 Beginning Inventory 100 2 200Mar. 27 Purchase 100 3 300June. 12 Purchase 100 4 400Sept. 19 Purchase 100 5 500Nov. 30 Purchase 100 6 600

Available for sale 500 2000Sold 350

Dec. 31 Ending Inventory 150

Specific Identification Method

• It assigns specific costs to each unit sold and each unit on hand.

• It is used if the units in the ending inventory can be identified as coming from specific purchases.

• It is particularly suited to inventories of high-value, low-volume items such as jewellery.

• Each unit in inventory must be identified with an identification tag.

Illustration:• 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:

60 units from the purchase of Mar. 27 @ Rs 3 Rs. 18070 units from the purchase of June. 12@ Rs 4 28020 units from the purchase of Sept. 19 @ Rs 5 100Ending Inventory 560

Under Spec. Identn. Method, the CGS is computed as Follows:Cost of goods availble for sale Rs 2,000Less: Ending Inventory 560Cost of Goods sold 1,440

Demerits of SI method• It does not involve any assumption about cost

flow.

• It matches the cost to the physical flow of the inventory and eliminates the effect of cost flow assumption on reported income.

FIFO Method• It assumes that the first units acquired are the

first units sold.• The cost of the units in the ending inventory is

that of the most recent purchases.• Merits:

– The inventory valuation reflects the conditions prevalent on the Balance Sheet.

– It will suit when the prices are declining.• Demerits:

– 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.

Illustration:• In our illustration, the cost of the 150 units in the

ending inventory would be computed as follows: 50 units from the purchase of Sept. 19 @ Rs 5 Rs. 250

100 units from the purchase of Nov. 30 @ Rs 6 600Ending Inventory 850

Under the FIFO method, the CGS is computed as follows:Cost of goods availble for sale Rs 2,000Less: Ending Inventory 850Cost of Goods sold 1,150

LIFO Method

• It assumes that the last units acquired are the first units sold.

• The cost of the units in the ending inventory is that of the earliest purchases.

• Merits:– It ensures that the current revenues are matched with

the most recent purchases, thus resulting in realistic reported profits.

– It will suit when the prices are rising.• Demerits:

– The Balance Sheet value of inventories may be outdated and unrealistic.

Illustration • In our illustration, the cost of 150 units in the

ending inventory would be computed as follows:

100 units from the inventory on Jan. 1 @ Rs 2 20050 units from the purchase of Mar. 27 @ Rs 3 150Ending inventory 350

Under LIFO method, the CGS is computed as follows:Cost of goods availble for sale Rs 2,000Less: Ending Inventory 350Cost of Goods sold 1,650

Weighted-Average Cost Method

• It assumes that the goods available for sale are homogeneous.

• Weighted-Average cost = The Cost of goods available for Sale/the

number of units available for sale where, the cost of goods available for sale = cost of beginning inventory +

all purchasesMerits:• It is appropriate when the inventory units involved are

homogeneous or when it is difficult to make a flow assumption.Demerits:• It assigns no more importance to current prices than to past prices

paid several months ago.

Illustration • In our illustration, the unit cost under this would

be computed as follows:Cost of goods availble for sale Rs 2,000Number of units availble for sale 500Weighted-Average unit cost Rs 4Ending Inventory: 150 units @ Rs 4 Rs 600

Under WAC Method, the CGS is computed as follows:Cost of goods availble for sale Rs 2,000Less: Ending Inventory 600Cost of Goods sold 1,400

Comparison of Alternative Inventory Methods on

profitability• EFFECTS OF INVENTORY METHODS ON PROFIT

ParticualrsSpec.Idetn

MethodFIFO

methodLIFO

method WAC

methodSales (350 units @ Rs 10) Rs. 3,500 Rs. 3,500 Rs. 3,500 Rs. 3,500CGS:Beginign Inventory 200 200 200 200Purchases 1, 800 1, 800 1, 800 1, 800Cost of goods availble for sale 2,000 2,000 2,000 2,000Less: Ending Inventory 560 850 350 600Cost of Goods Sold 1,440 1,150 1,650 1,400Gross Profit on Sales 2,060 2,350 1,850 2,100