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Financial Accounting for Managers

Inventory Valuation

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What to we learn?
• Inventory
– Components
• Why valuing inventory?
• Valuation system
– Periodic inventory system
– Perpetual Inventory System
• Valuation Methods
– FIFO
– LIFO
– WAC
• Impact of inventory valuation on the financial
statements

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Current Assets
• CAs
– Sell or consume with in one operating cycle
– Held primarily for trading
– Expected to realize the asset within in 12
months
– Cash equivalent
• Inventory
• Cash
• Receivables

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Inventory
• Raw materials
• Semi finished goods
• Finished goods
• Other items
– Stores and spares i.e. factory supplies
– Loose tools
– Packing materials

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Types of organisations & Inventory

• Manufacturing
– RMs, WIP, FGs
– Other Items
• Merchandising
– Buying and selling
– May be with a little bit of repacking

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Matching Inventory costs with

Revenues
• COAGS(-)Closing Inventory=COGS

• Cost of Closing Inventory  COGS value

• Closing Inventory COGS Gross Profit

• Closing Inventory  COGS Gross Profit

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• Matching Principle
– Matching Expense with Revenues in an Accounting
Period
– Matching for Inventories
• Determining the value of closing inventory to be deducted
from COGAS (to carry forward to the next period)
Thus matching the COGS with the revenue for the period

Value of Inventory at a certain

date=sum of costs attributable to the
goods held by a business
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Inventory Valuation
• LCM Principle
– Lower of Cost or Market Principle
• Cost
– Price at which inventory was acquired
• Market
– Net Realisable Value

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Effect of Inventory Error

• Cascading effect on
– COGS
– Gross Profit
– Net Profit
– Tax payment
– Dividends
– Current assets
– Equity

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Physical Check of inventory

• Periodic inventory system
• Actual physical count
• Goods in transit
– Inclusion in inventory of the seller
– FOB Shipping point and FOB Destination
• Goods on consignment
– Part of consignor’s inventory

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Inventory costs
• Products costs
– Inventoriable costs incurred to bring the inventories up to
their present location and condition
– Cost of purchase, conversion and other related costs
– Including duties, taxes, octroi
• Period expenses
– Expensed in the period in which these are incurred
– General administration, storage, selling, distribution, R&D
and interest
– Losses and abnormal expenses
– Fines, penalties, double freight, wastage, idle facility
expenses

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Cost Formulas
• Physical Flow
– The actual sequence in which the goods are
physically used or sold in the business
operations
• Cost Flow
– Association of costs with the assumed
sequence in which the goods are used or sold

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Inventory Systems
• Periodic
– COGS ascertained at the end of accounting
period when physical inventory is taken
• Perpetual
– Real time basis of updating the purchases
and sales and the inventory on hand

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Periodic Inventory System

• The periodic system uses an occasional
physical count to measure the level of
inventory and the cost of goods sold (COGS).
• Merchandise purchases are recorded in the
purchases account.
• The inventory account and the cost of goods
sold account are updated at the end of a set
period - this could be once a month, once a
quarter or once a year.
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Perpetual Inventory System

• The perpetual system keeps track of
inventory balances continuously, with
updates made automatically whenever a
product is received or sold.
• Purchases and returns are immediately
recorded in the inventory account.
• The cost of goods sold account is also
updated continuously as each sale is
made.

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Methods of Inventory Valuation

• 4 Methods based on different cost flow
assumptions:
– Specific Identification
– FIFO
– LIFO
– WAC

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Comparison of different methods

Basis For
Perpetual Inventory System Periodic Inventory System
Comparison

Basis Book Records Physical Verification

At the end of the accounting

Updations Continuously
period.

Possibility of real-
time Inventory Yes No
Control

This method does not Under this system, the business

Affect on business
influence the business operations need to be stopped
operation
operation. during valuation.

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Inventory Systems and Methods

Perpetual Periodic
Inventory System Inventory System
FIFO √ √
LIFO √ √
WAC √ √

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Inventory and Financial

Statements
Recall any Income statement of a merchandise
or manufacturing organisation…….

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Statement of Profit or Loss for the period ended --/--/----

Income Statement Rs. Rs.

Revenues
Revenues from Sales
Cash Sales 11,111
+ Credit Sales 34,568
Total Gross Sales 45,679
- Sales Returns 101
Net Sales 45,578
Other Incomes 2,000
47,578
- Cost of Goods Sold
Opening Stock 102
+ Purchases 30500
- purchase returns and allowances 103
- Purchase discounts 104 207
Net Purchases 30,293
Freight In 105
Net cost of purchases 30,398
Cost of goods available for sale 30,500
- Closig Stock 106

Cost of Goods sold 30,394

Gross for
Financial Accounting profit 17,184
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4. Financial Statements

Effect of Inventory Value on Income

Inventory
COGS Value Gross Profit
Value
More Less More
Less
Less More

• So,
• If Inventory value is MORE COGS value will be
LESS Gross Profit value will be MORE
• If Inventory value is LESS COGS value will be
MORE Gross Profit value will be LESS
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