This chapter will help the readers to:
In the ordinary course of business an enterprise buys various types of raw materials, consumables and components to be used in production or simply for the purpose of resale. To ensure continuous availability of such items, sufficient quantities are maintained in the store. These materials and components are then put to the production line for processing. Once the production process is over they are stored in the finished form before they are finally sold out. Thus ‘inventory’ is made up of material in various forms as discussed above. Based upon the state of completion, inventories may be classified as under:
Ind AS 2, defines the expression ‘inventories’ as assets:
The composition of inventories will vary from business to business. A trading organization engaged in buying and selling will not have raw material or WIP inventory, whereas a manufacturing organization’s inventory will have all the above components. An enterprise with long production cycle will have higher work in progress inventory, whereas an enterprise with seasonal availability of raw material may have higher amount blocked at that stage. A service organization may not have any inventory at all.
Let us recall the matching principle discussed in Chapter 2 earlier. As per the matching principle, revenue earned by an enterprise is matched against the cost incurred to generate that revenue to ascertain profit. How does matching principle affect accounting for inventory? It may be possible that an enterprise purchases or produces goods in one accounting period which ultimately get sold in the next accounting period, or goods from the previous accounting period get sold in the current accounting period. In these situations inventory cost has been incurred in one accounting period but the revenue is generated in another. The proper matching of revenue and cost is essential to correctly ascertain profit and to depict assets in the balance sheet.
Let us consider an example of Superior Electronics Limited—a dealer in television sets. As on 1st April 2017, it had 100 sets costing ₹ 2,800,000 in the showroom which were purchased in the previous year. During the year 2017–18, it purchased 1,500 sets for ₹ 45,000,000 and it was able to sell 1,300 sets for ₹ 45,500,000. As on 31st March 2018, it has 300 sets still unsold costing ₹ 8,700,000. How will these details be shown in the profit and loss statement for the year 2017–18 and balance sheet as at 31st March 2018?
As the company has sold 1,300 sets during the year, and revenue of ₹ 45,500,000 has been recognized, cost of only 1,300 sets should be matched against this revenue to ascertain profit. The company has a total of 1,600 (100 from previous year and 1,500 purchased during the year) sets available for sale costing ₹ 47,800,000 (₹ 2,800,000 + ₹ 45,000,000). Out of these, 300 sets costing ₹ 8,700,000 are still unsold. Accordingly cost of 1,300 sets sold during the year is ₹ 39,100,000 (₹ 47,800,000 − ₹ 8,700,000). The sets unsold will appear as current asset in the balance sheet at ₹ 8,700,000.
The information will be shown in the profit and loss account and balance sheet as follows:
Profit and Loss Statement | (Amount in ₹) | |
Sales | 45,500,000 | |
Less: Cost of goods sold | ||
Opening stock | 2,800,000 | |
Add: Purchases | 45,000,000 | |
Less: Closing stock | 8,700,000 | 39,100,000 |
Gross profit | 6,400,000 | |
Balance Sheet | ||
Current assets | ||
Closing stock of inventory | 8,700,000 |
From the above example, we can generalize a simple relationship for cost of goods sold as given in Equation 8.1.
It is obvious that the apportionment of the cost of goods available for sale over closing stock and cost of goods sold can have significant impact on both the financial statements. In the above example, if the sets unsold at the close are valued at say ₹ 9,000,000 instead of ₹ 8,700,000, the cost of goods sold will come down to ₹ 38,900,000 resulting in a higher reported profit of ₹ 86,700,000. Similarly, if the closing stock is undervalued, it will result in higher reported cost of goods sold and therefore lower reported profit. One of the key challenges in inventory accounting is determining the value of closing stock which in turn impacts the cost of goods sold and reported profits. The relationship between inventory and financial statements in case of a trading organization is depicted in Figure 8.1.
In case of a manufacturing organization inventory will pass through various stages. The inventory flow for such an organization is depicted in Figure 8.2.
As discussed earlier, the cost of goods sold will appear in the profit and loss statement whereas closing stock of raw material, work-in-progress and finished goods will form part of the balance sheet. It may also be noted that cost of raw material inventory is at the purchase price whereas cost of WIP and finished goods include appropriate conversion cost as well.
Figure 8.1 Trading Organization—Inventory and Financial Statements
Figure 8.2 Manufacturing Organization—Inventory Flow
Inventory records may be kept on a periodic basis or perpetual basis. In periodic inventory system, detailed records are kept for the goods purchased. At the end of the accounting period, physical count of the goods unsold is taken and value of goods at hand is ascertained. The value of the closing stock so computed is deducted from the value of inventory available for sale, (i.e., opening stock + purchases during the period) to arrive at the cost of goods sold. No separate record is kept every time goods are sold or consumed.
On the other hand in perpetual inventory system, detailed records of not only goods purchased but also of goods sold or issued to production are kept. At any point of time, the enterprise will be aware of the goods purchased and goods sold to ascertain the goods in hand. At the end of the period, physical count of inventory is compared with the balance as per books. Difference, if any, is analysed and accounted for separately.
Periodic inventory system though simple to operate has its limitations. Firstly, every time the enterprise wants to prepare its financial statements (say monthly or quarterly) physical count of inventory has to be taken, which for a large enterprise is an enormous task. Whereas in perpetual inventory system, financial statements can be prepared on the basis of inventory records without taking a physical count. Secondly, no control over loss of goods due to normal reasons, (e.g., shrinkage, leakage, etc.) or abnormal reasons, (e.g., theft, accidents, etc.) can be exercised in periodic inventory system as the difference between goods available and closing stock is assumed to have been consumed.
One of the main challenges in inventory accounting relates to the valuation of ending inventory or closing stock. Ending inventory so ascertained is deducted from the inventory available for sale to find the cost of goods consumed or goods sold. Following conservatism principle, Ind AS 2, requires inventories to be measured at the lower of cost and net realizable value. Accordingly, following steps are taken for inventory valuation:
The costs of purchase of inventories includes the purchase price, import duties and other taxes, transport, handling and other costs directly attributable to the acquisition. Taxes and duties which are subsequently recoverable from the tax authorities are excluded from the cost. Any trade discount, quantity discount and rebate given by the supplier of the goods are deducted from the cost of purchase.
The cost of conversion of inventories includes both direct cost and overheads. Costs directly related to production, e.g., direct labour and direct production expenses are included. Fixed and variable production overheads that are incurred in converting materials into finished goods are also systematically allocated to arrive at the cost of inventories.
Other costs, incurred in bringing the inventories to their present location and condition, are also included in the cost of inventories. However, costs like abnormal amounts of wasted materials, labour, storage costs, administrative overheads and selling costs are excluded from the cost of inventories as they do not contribute to bringing inventories to their present location and condition.
If an inventory item necessarily takes a substantial period of time to get ready for its sale, borrowing costs that are directly attributable are also included in the cost of inventories. If, however, inventories are purchased on a deferred credit basis, the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of deferred credit.
As discussed in the previous section, inventory available needs to be divided between closing stock and cost of goods sold. There are various methods for such an apportionment. The enterprise may choose any of the permitted method for the valuation of closing inventory. Inventory method once chosen must be followed consistently period after period. Some of the methods used for this purpose are:
Ind AS 2: The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs.
However, where the enterprise deals with a large number of items which are interchangeable, this method may not be feasible. In such cases, other methods involving approximation can be used.
It may be noted that FIFO and LIFO are merely assumptions for the purpose of ending inventory valuation; the actual flow of material may or may not follow the same flow as suggested by the methods’ names.
The above methods can be used both with periodic inventory system as well as perpetual inventory system. In the former, the assumptions of LIFO, FIFO or average will be applied only at the end of the period. However in perpetual inventory system, the assumption (LIFO, FIFO, etc.) will be applied every time goods are sold or consumed. Likewise in average cost method, new average cost will be computed whenever fresh acquisitions are made and the new average cost is applied to all the units sold till further acquisition.
In case of an inflationary economy, FIFO will result is higher ending inventory and therefore lower cost of goods sold and higher profits compared to LIFO. The numbers as per average cost method will be somewhere in between FIFO and LIFO. Ind AS 2 does not permit use of LIFO and accordingly ‘the cost of inventories should be assigned by using the first-in-first-out (FIFO), or weighted average cost formula’.1 An entity shall use the same cost formula for all inventories which have similar nature and use to the entity. However, it is permitted to use different cost formulas for inventories which are of different nature or use to the entity.
Ind AS 2: The cost of inventories should be assigned by using the first-in, first out (FIFO), or weighted average cost formula.
Based upon the following information ascertain the value of ending inventory using FIFO, LIFO and average cost method:
Number of Units | Unit Cost (₹) | Total Cost (₹) | |
Opening stock | 700 | 1,200 | 840,000 |
Purchases during the year | 3,300 | 1,300 | 4,290,000 |
Available for sale | 4,000 | 5,130,000 | |
Sold during the year | 2,900 | ||
Closing stock | 1,100 |
FIFO Method: Assuming that the ending inventory is made up of most recent purchases.
Number of Units | Unit Cost ( ₹) | Total Cost ( ₹) | |
Cost of goods sold | |||
From opening stock | 700 | 1,200 | 840,000 |
From purchases | 2,200 | 1,300 | 2,860,000 |
Total | 2,900 | 3,700,000 | |
Ending inventory | |||
From purchases | 1,100 | 1,300 | 1,430,000 |
LIFO Method: Assuming that the most recent purchases have been sold first.
Number of Units | Unit Cost ( ₹) | Total Cost ( ₹) | |
Cost of goods sold | |||
From purchases | 2,900 | 1,300 | 3,770,000 |
Total | 2,900 | 3,770.000 | |
Ending inventory | |||
From opening stock | 700 | 1,200 | 840,000 |
From purchases | 400 | 1,300 | 520,000 |
Total | 1,100 | 1,360,000 |
Average Cost Method: Average cost per unit is found by diving the total cost of inventory available for sale (opening stock + purchases) by the total number of units. The closing stock and cost of goods sold is ascertained by applying the average cost per unit.
Number of Units | Unit Cost ( ₹) | Total Cost ( ₹) | |
Cost of goods sold | 2,900 | 1,282.50 | 3,719,250 |
Ending inventory | 1,100 | 1,282.50 | 1,410,750 |
Comparison
FIFO ( ₹) | LIFO ( ₹) | Average cost ( ₹) | |
Cost of goods sold | 3,700,000 | 3,770,000 | 3,719,250 |
Ending inventory | 1,430,000 | 1,360,000 | 1,410,750 |
The methods described above help in measuring the cost of ending inventory. Normally inventory is stated in the balance sheet at its cost. However, there may be situations where the realizable value of the ending inventory may be lower than the cost so calculated. For example, an inventory item is damaged or has become obsolete or the market price of finished goods has declined substantially. If there is any evidence to suggest that the realizable value of an inventory item has fallen, e.g., due to damage, obsolescence or a sharp decline in the market price of raw material or finished goods, the carrying amount of the inventory in the balance sheet may have to be written down. The conservatism principle states that inventory should be shown in the balance sheet at the lower of the cost or realizable value of ending inventory.
Ind AS 2: Inventories should be valued at the lower of the cost and net realizable value
According to Ind AS 2, the net realizable value is ascertained on item by item basis rather than as a group. Such an exercise is required to be done at each balance sheet date. To ascertain the net realizable value, we start by looking at the amount that the inventory is expected to be sold in the ordinary course of business. From the estimated selling price, costs estimated to be incurred towards selling expenses and towards completion of the inventory are deducted to arrive at the net realizable value (NRV). Accordingly, the NRV can be expressed as follows:
The NRV so computed is compared with the cost of inventory and the lower of the two is taken as the carrying amount in the balance sheet.
Materials and other supplies to be used in production are not written down below cost if the finished good in which they will be incorporated are expected to be sold at or above cost. However, when there has been a decline in the price of materials and it is estimated that the cost of the finished products will exceed net realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials is taken as their net realizable value.
Based upon the following information for the inventory items, ascertain the value at which ending inventory should be shown:
Item 1: Net realizable value = ₹ 9,000 − ₹ 800 = ₹ 8,200. As NRV is greater than the cost incurred, it will be shown at the cost price.
Item 2: Net realizable value = ₹ 6,000 − ₹ 700 = ₹ 5,300. As NRV is less than the cost incurred, it will be shown at the NRV.
Item 3: Net realizable value = ₹ 10,500 − ₹ 2,000 = ₹ 8,500. As NRV is less than the cost incurred, it will be shown at the NRV.
The inventory accounting policy of some companies is given in Box 8.1
Ultratech Cements Limited
Inventories are valued as follows:
Bajaj Auto Limited
Cost of inventories have been computed to include all costs of purchases (including materials), cost of conversion and other costs incurred, as the case may be, in bringing the inventories to their present location and condition.
The following disclosures are required to be made in financial statements:
The management was surprised to note that though the sales have increased by 9%, the profit before tax has actually declined almost by 35%. While reviewing the numbers it was revealed that the closing stock for the year 2016 was overstated by ₹ 1,000,000. You are required to restate the Profit and loss statement for both the years.
The sales of the company during the quarter amounted to ₹ 2,700,000. The physical verification at the quarter end revealed 1,200 units in hands.
Using LIFO, FIFO and average cost method calculate:
Using LIFO, FIFO and average cost method, calculate:
As on 31st March, the details of inventory is given below:
= ₹ 840,000 + ₹ 2,520,000 = ₹ 3,360,000
FIFO − 1,200 units at ₹ 1,260 = ₹ 1,512,000
LIFO − 700 units at ₹ 1,200 + 500 units at ₹ 1,260 = ₹ 1,470,000
Average cost method − 1,200 units at ₹ 1,244.44 = ₹ 1,493,333
FIFO = ₹ 3,360,000 − ₹ 1,512,000 = ₹ 1,848,000
LIFO = ₹ 3,360,000 − ₹ 1,470,000 = ₹ 1,890,000 Average cost = ₹ 3,360,000 − ₹ 1,493,333 = ₹ 1,866,667
FIFO = ₹ 2,700,000 − ₹ 1,848,000 = ₹ 852,000
LIFO = ₹ 3,360,000 − ₹ 1,890,000 = ₹ 810,000
Average Cost = ₹ 3,360,000 − ₹ 1,866,667 = ₹ 833,333
Goods available for sale: ₹ 3,360,000
Cost of goods sold: ₹ 1,832,000
Closing inventory: ₹ 1,528,000
Gross profit: ₹ 868,000
LIFO method
Goods available for sale: ₹ 3,360,000
Cost of goods sold: ₹ 1,849,000
Closing inventory: ₹ 1,511,000
Gross profit: ₹ 851,000
Average cost method
Goods available for sale: ₹ 3,360,000
Cost of goods sold: ₹ 1,839,187.50
Closing inventory: ₹ 1,520,812.50
Gross profit: ₹ 860,812.50
101 – ₹ 720,000
102 – ₹ 480,000
103 – ₹ 335,000
104 – ₹ 570,000
105 – ₹ 360,000
While reviewing the numbers, it was revealed that the closing stock for the year 2016 was understated by ₹ 2,300,000. You are required to restate the profit and loss statement for both the years incorporating the revised value of closing stock.
The sales of the company during the quarter amounted to ₹ 14,400,000. The physical verification at the quarter end revealed 170 units in hands.
Using LIFO, FIFO and average cost method, calculate:
Case 8.1: Drink Well Beer Limited—Accounting for Empty Bottles
The Drink Well Beer Limited runs a number of outlets for selling beer. Some of the bottles sold at these outlets are carried by the customers and are consumed later. In other cases, the beer is consumed by the customer in the bar operated by the company near the beer outlets. In such cases the empty bottles are left behind by the customers and the company takes the possession of the empty bottles. The company keeps proper records of these bottles and sells them by inviting tenders. While preparing the accounts for the year 2016–17, the company estimated that the stock of empty bottles in hand has a realizable value of about ₹ 12 million. The accounts team is debating about the possible treatment of these empty bottles in the accounts for the year 2016–17. The following options were discussed:
Case 8.2: The Bombay Dyeing and Manufacturing Company Limited—Valuation of Inventories on Lower of Cost or Realizable Value
The Bombay Dyeing and Manufacturing Company Limited was established in the year 1879. It is a leading player offering products like stylish linens, towels, home furnishings, leisure clothing and kids wear, etc. As per the accounting policy of the company, the inventories are valued at lower of cost and net realizable value.
During the month of March 2003, the company entered into a firm purchase contract for import of raw material viz. paraxylene at an aggregate cost of ₹ 27.82 crore. Paraxylene is an important input for manufacturing dimethyl terephthalate (DMT), one of the main products of the company. The company ‘expected that the net realizable value, estimated at ₹ 14.96 crore, will be substantially lower than the cost, compared with reference to the estimated selling price of DMT’2. Accordingly a provision for this loss, estimated at ₹ 12.86 crore was made in the accounts for the year 2002–03.
However, the company decided to reverse this provision during the year 2003–04. Accordingly, the provision for the loss was reversed during the year 2003–04 by adjusting the same from the cost of raw material consumed. The cost of inventory consumed as shown in the schedule to accounts is shown below:
The profit before tax for the company for the year 2002–03 and 2003–04 stood at ₹ 33.53 crore and ₹ 72.56 crore respectively.