FINANCIAL ACCOUNTING AND AUDITINGINVENTORY VALUATION

Presented by: GROUP 3 (B. Com H)

Kunal Aggarwal (3901)

Kunal Goel (3924) Kunal Jain (3883) Komal Malik (3804) Kshitij Mudgal (3896) Kshitiz Agarwal (3789)

INTRODUCTION

Inventories are defined by AS-2 (Revised) as an asset: Held for sale in the ordinary course of

business, In the process of production for such sale, In the form of materials or supplies to be

consumed in the production process or in the rendering of services.

CHARACTERISTICS

Inventory:- Arises out of:▪ Time lag between purchase and sales,

▪ Processing time lag,

One of the largest assets of a firm, Constitutes:▪ finished goods,

▪ work-in-progress,

▪ raw materials;

▪ also consumables,

▪ loose tools,

▪ stores and spares, etc.

SIGNIFICANCE

The significance of inventory valuation is as follows:

Determination of Income,

Determination of Financial Position,

Analysis of Financial Statement,

Compliance with rules and statutes.

ACCOUNTING STANDARD - 2 DEALS WITH

DETERMINATION OF VALUE AT WHICH

INVENTORES ARE CARRIED IN B/S.

ASCERTAINMENT OF COST (MANNER)

SITUATION IN WHICH CARRYING COST OF

INVENTORIES IS WRITTEN BELOW COST.

INVENTORIES ARE ASSETS

Held for sale in ordinary course of business .

In the process of production for such sales ,or

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

MEASUREMENT :

Inventories should be valued at lower of cost and net realisable value.

NET REALISABLE VALUE = Estimated selling price – estimated cost necessary to make sale.

COST OF INVENTORIES:

These include all cost of purchase , cost of

conversion and other cost incurred in bringing the

inventories to their present location and condition.

But it does not include:

i) abnormal amount.

ii) storage cost unless necessary in the production.

iii) administrative overheads.

iv) selling and distribution cost.

COST OF PURCHASE

It consists of the purchase price including duties and taxes, freight inwards and other expenditure directly attributable to the acquisition.

Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.

X ltd purchased 1200 kg where purchase policy was as follows:-Purchase lots rates (in Rupees)0-10,000 20Above 10,000 to 15,000 1915,000-20,000 18The vendor offers a 10% discount to X ltd for being a regular customer. A VAT of 20% is applicable. Freight was charged @ Rs.20/kg inclusive of loading in boxes for 100 kg and these boxes are charged @ Rs. 5/kg. These boxes can be returned at 50% of cost. 80% of boxes were returned in the end.

CASE STUDY

STATEMENT FOR CALCULATION OF PURCHASE COSTpurchase cost

(-) trade discount

+ VAT+ freight +cost of boxes (-) returned boxes Total purchase cost Quantity purchased

Effective purchase cost per unit

1200x 19

120x 5

96 x 2.5

2,70,600

1200

228,000(22800)2,05,200

41,040 2400 600(240) 270,600 1200

22.55

NORMAL LOSS

Recurring loss Pre estimated Uncontrollable Inherent to nature of commodity

ITEM Qty Price Total

Mango 100 35 3500

(30) (0) (0)

70 3500

Tomato 100 30 3000

(10) (100)

90 2900

In case of Mango 30 Units were not good therefore there was no scrap value, here cost per unit is 3500/70=50

In case of Tomato 10 Units were not good but the they were sold at Rs. 10 per unit therefore scrap value was Rs. 100, here cost per unit is 2900/90= 32.22

Total Cost – Scrap Value • COST / UNIT = Total Units – Normal Loss

Continuation..

ABNORMAL LOSSES:

Are valued at cost per unit.

After this valuation, abnormal losses are transferred to Profit & Loss Account.

CONVERSION COST:

It includes costs directly related to the units of production, such as direct labour. Direct labour is added on accrual basis.

CASE STUDY:- Find the cost of a product where budgeted output was 10,000 units and actual output is 7,000 units. Material is Rs. 25.00 per unit and wages are Rs. 10.00 per unit, variable overhead is Rs. 5.00 per unit and fixe overhead is Rs. 1,00,000/-Finding out cost per unit.Material = 25Wages = 10Variable overhead = 5Fixed overhead = 1,00,00 = 10 10,000Total cost per unit is Rs. 50/-

NET REALISABLE VALUE:

Expected selling price – cost of completion and those for making sales.

CASE STUDY: Find NRV of the stock of tunkle chips Ltd. There is a stock of 20 Kgs of unpacked chips. These packed in wrapper's of 200 gms. Which are sold at Rs. 20.00/- per packet. The wrapper cost is Rs. 1.00 per packet.Grams = 20 x 1000Numbers of packet = 20,000 = 100 packets

200Cost = 100 x 20 =2,000

(-) 100 x 1 = 100Net Realizable Value = Rs. 1900/-

DISCLOSURE

The Accounting policies adopted in measuring inventories, including the cost formula used.

The cost carrying amount of inventories and its classification appropriate to the enterprises.

INVENTORY RECORD SYSTEMS

Periodic Inventory System

Perpetual Inventory System

PERIODIC INVENTORY SYSTEM

Periodic inventory is a system of inventory in which

updates are made on a periodic basis. In a periodic

inventory system no effort is made to keep up-to-date

records of either the inventory or the cost of goods sold.

Instead, these amounts are determined only periodically

- usually at the end of each year. This physical count

determines the amount of inventory appearing in the

balance sheet. The cost of goods sold for the entire year

then is determined by a short computation

PERIODIC INVENTORY SYSTEM The periodic inventory system only updates the ending inventory

balance when you conduct a physical inventory count. Since physical inventory counts are time-consuming, few companies do them more than once a quarter or year. In the meantime, the inventory account in the accounting system continues to show the cost of the inventory that was recorded as of the last physical inventory count.

Under the periodic inventory system, all purchases made between physical inventory counts are recorded in a purchases account. When a physical inventory count is done, you then shift the balance in the purchases account into the inventory account, which in turn is adjusted to match the cost of the ending inventory.

The calculation of the cost of goods sold under the periodic inventory system is:

Beginning inventory + Purchases = Cost of goods available for sale

Cost of goods available for sale – Ending inventory = Cost of goods sold

Advantages and Disadvantages

The periodic inventory system is most useful for smaller businesses that maintain minimum amounts of inventory. For them, a physical inventory count is easy to complete, and they can estimate cost of goods sold figures for interim periods. However, there are several problems with the system:

It does not yield any information about the cost of goods sold or ending inventory balances during interim periods when there has been no physical inventory count.

You must estimate the cost of goods sold during interim periods, which will likely result in a significant adjustment to the actual cost of goods whenever you eventually complete a physical inventory count.

There is no way to adjust for obsolete inventory or scrap losses during interim periods, so there tends to be a significant (and expensive) adjustment for these issues when a physical inventory count is eventually completed.

It is not an adequate system for larger companies with large inventory investments, given its high level of inaccuracy at any given point in time (other than the day when the system is updated with the latest physical inventory count).

Journal entries in a periodic inventory system:(1). When goods are purchased from supplier:Purchases To Accounts payable

(2) When expenses are incurred to obtain goods for sale – freight-in, insurance etc:

Freight-inInsurance To Cash/Bank

(3). When goods are returned to supplier:Accounts payable To Purchases returns

(4). When payment is made to supplier:Accounts payable To Cash/Bank

Journal entries in a periodic inventory system:

(5). When goods are sold to customers:Accounts receivable To Sales

(6). When goods are returned by customers:Sales returns  To Accounts receivable

(7). At the end of the period:Inventory (ending)Cost of goods sold (B.F) To Purchases To Inventory (beginning)

Perpetual Inventory System

In perpetual inventory system, merchandise

inventory and cost of goods sold are updated

continuously on each sale and purchase

transaction. Some other transactions may also

require an update to inventory account for

example, sale/purchase return, purchase

discounts etc. Purchases are directly debited to

inventory account whereas for each sale two

journal entries are made: one to record sale

value of inventory and other to record cost of

goods sold. Purchases account is not used in

perpetual inventory system.

ADVANTAGES AND DISADVANTAGES

Perpetual inventory system is costly to maintain but it has numerous advantages which are as follows

It obviates the need for stock taking by actual counting at the end of financial period.

There is no sudden ‘out of stock’ situation. It does not need special staff to be employed

for stock taking. Controlling losses is easier under this method

as inventory records continuosly indicate the goods that must be in hand.

For Perpetual Inventory System:

BASIS PERIODIC INVENTORY SYSTEM

PERPETUAL INVENTORY SYSTEM

Basis of ascertaining Inventory

Closing Inventory is ascertained by physical count.

Closing Inventory is ascertained from accounting records.

Availability of Information

Generally at the end of the accounting period or at some other regular intervals.

On continuous basis after each purchase and sale.

Inventory control

Not feasible.Actual amount of closing inventory cannot be compared with book records.

Physical count can be compared with perpetual inventory record and thus inventory control is feasible.

Effect on normal operations

May affect normal operations of the business for sometime due to physical count.

It will NOT affect the normal operations of the business if no physical count is made.

Simplicity and cost effectiveness

It is simple and less costly. It requires additional record keeping which is not worth in case of small concerns dealing in low cost items.

Methods Of Evaluation Of Inventory

SPECIFIC IDENTIFICATION OF COSTS

FIRST-IN, FIRST-OUT

LAST-IN,FIRST-OUT

WEIGHTED AVERAGE METHOD

Specific Identification of Costs

It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year end inventory. When this information is found, the amount of goods are multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost.

In theory, this method is the best method, since it relates the ending inventory goods directly to the specific price they were bought for. However, this method allows management to easily manipulate ending inventory cost, since they can choose to report that the cheaper goods were sold first, hence increasing ending inventory cost and lowering cost of goods sold. This will increase the income. Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay.

Using this method, it is very hard to relate shipping and storage costs to a specific inventory item. These numbers will need to be estimated, hence reducing the specific identification method's benefit of being extremely specific.

FIRST-IN, FIRST-OUT (FIFO)

It is one of the methods commonly used to

calculate the value of inventory on hand at the

end of an accounting period and the cost of

goods sold during the period. This method

assumes that inventory purchased or

manufactured first is sold first and newer

inventory remains unsold. Thus cost of older

inventory is assigned to cost of goods sold and

that of newer inventory is assigned to ending

inventory.

First-In, First-Out method can be applied in both

the periodic inventory system and the perpetual

inventory system.

ILLUSTRATION

Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:January 1 Purchased 5 bikes @ ₹5000 eachJanuary 5 Sold 2 bikesJanuary 10 Sold 1 bikeJanuary 15 Purchased 5 bikes @ ₹7000 eachJanuary 25 Sold 3 bikes

SOLUTIONDAT

EPURCHASES

UNITS - RATE - AMT

SALESUNITS - RATE - AMT

STOCK IN HANDUNITS - RATE - AMT

JAN1 5 – 5000 - 25000 5 - 5000 - 25000

JAN 5 2 - 5000 - 10000 3 - 5000 - 15000

JAN 10

1 - 5000 - 5000 2 - 5000 - 10000

JAN 15

5 - 7000 35000 2 - 5000 - 100005 - 7000 35000

JAN 25

2 - 5000 - 100001 - 7000 - 7000

4 - 7000 - 28000

The value of 4 bikes held as inventory at the end of January may be calculated as follows:The sales made on January 5 and 10 were clearly made from purchases on 1st January. Of the sales made on January 25, it will be assumed that 2 bikes relate to purchases on January 1 whereas the remaining one bike has been issued from the purchases on 15th January.

LAST-IN, LAST-OUT (LIFO)

This method assumes that inventory

purchased last is sold first. Therefore,

inventory cost under LIFO method will be

the cost of earliest purchases. Using the

LIFO method to evaluate and manage

inventory can be tax advantageous, but it

may also increase tax liability.

ILLUSTRATION

Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:January 1 Purchased 5 bikes @ ₹5000 eachJanuary 5 Sold 2 bikesJanuary 10 Sold 1 bikeJanuary 15 Purchased 5 bikes @ ₹7000 eachJanuary 25 Sold 3 bikes

SOLUTIONDAT

EPURCHASES

UNITS - RATE - AMT

SALESUNITS - RATE - AMT

STOCK IN HANDUNITS - RATE - AMT

JAN1 5 – 5000 - 25000 5 - 5000 - 25000

JAN 5 2 - 5000 - 10000 3 - 5000 - 15000

JAN 10

1 - 5000 - 5000 2 - 5000 - 10000

JAN 15

5 - 7000 35000 2 - 5000 - 100005 - 7000 35000

JAN 25

3 - 7000 - 21000 2 - 5000 - 100002 - 7000 - 14000

The value of 4 bikes held as inventory at the end of January may be calculated as follows:The sales made on January 5 and 10 were clearly made from purchases on 1st January. However, all sales made on January 25 will be assumed to have been made from the purchases on January 15.

As can be seen from BEFORE, LIFO method allocates cost on the basis of earliest purchases first and only after inventory from earlier purchases are issued completely is cost from subsequent purchases allocated. Therefore value of inventory using LIFO will be based on outdated prices. This is the reason the use of LIFO method is not allowed for under IAS 2.

POINT OF DIFFERENCE

FIFO LIFO

Stands for: First in, first out Last in, first out

Unsold inventory: Unsold inventory is comprised of goods acquired most recently.

Unsold inventory is comprised of the earliest acquired goods.

Restrictions: There are no GAAP or IFRS restrictions for using FIFO.

IFRS does not allow using LIFO for accounting.

Effect of Inflation: If costs are increasing, the items acquired first were cheaper. This decreases the cost of goods sold (COGS) under FIFO and increases profit. The income tax is larger. Value of unsold inventory is also higher.

If costs are increasing, then recently acquired items are more expensive. This increases the cost of goods sold (COGS) under LIFO and decreases the net profit. The income tax is smaller. Value of unsold inventory is lower.

Effect of Deflation: Converse to the inflation scenario, accounting profit (and therefore tax) is lower using FIFO in a deflationary period. Value of unsold inventory, is lower.

Using LIFO for a deflationary period results in both accounting profit and value of unsold inventory being higher.

Record keeping: Since oldest items are sold first, the number of records to be maintained decreases.

Since newest items are sold first, the oldest items may remain in the inventory for many years. This increases the number of records to be maintained.

Fluctuations: Only the newest items remain in the inventory and the cost is more recent. Hence, there is no unusual increase or decrease in cost of goods sold.

Goods from number of years ago may remain in the inventory. Selling them may result in reporting unusual increase or decrease in cost of goods.

DIFFERENCE

WEIGHTED AVERAGE METHOD

It is a method of calculating Ending Inventory cost. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.

ILLUSTRATION

Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:January 1 Purchased 5 bikes @ ₹5000 eachJanuary 5 Sold 2 bikesJanuary 10 Sold 1 bikeJanuary 15 Purchased 5 bikes @ ₹7000 eachJanuary 25 Sold 3 bikes

SOLUTION

DATE

PURCHASESUNITS - RATE -

AMT

SALESUNITS - RATE - AMT

STOCK IN HANDUNITS - RATE - AMT

JAN1 5 – 5000 - 25000 5 - 5000 - 25000

JAN 5 2 - 5000 - 10000 3 - 5000 - 15000

JAN 10

1 - 5000 - 5000 2 - 5000 - 10000

JAN 15

5 - 7000 35000 2 - 5000 - 100005 - 7000 35000

----------------------------7 - 6428.5 - 45000

JAN 25

3 - 6428.5 - 19285.5 4 - 6428.5 - 25714.5

DIFFERENCE