Inventory Valuation Methods

Introduction

The literary meaning of the word inventory is stock of goods. To the finance manager, inventory connotes the value of raw materials, consumable, spares, work-in-progress, finished goods and scrap in which a company’s funds have been invested. It constitutes the second largest items after fixed assets in the financial statements, particularly of manufacturing organisation. It is why that inventory valuation and inventory control have become very important functions of the accountants and finance managers. The persons interested in the accounting information assume that the financial statements contain accurate information. However, it is often observed that the financial statements don’t provide actual information about some of the items, e.g. inventory and depreciation. This may be because of the variety of inventory valuation methods available with the accountant.

According to the International Accounting Standard-2 (IAS-2), ‘Inventories’ mean tangible property held;

(a) for sale in the ordinary course of business,

(b) in the process of production for such sale, or

(c) for consumption in the production of goods or services for sale.

Hence, the term inventory includes stock of (i) raw material and components, (ii) work-in-progress and finished goods. In case of manufacturing concern, inventory consists of raw materials, components, stores, semi-finished products and finished goods in case of a trading concern inventory primarily consists of finished goods.

Objectives Of Inventory Valuation

Following are the objectives of inventory valuation:

a) Determination of Income

A major objective of inventory valuation is the proper determination of income through the process of matching appropriate cost against revenues. Gross profit is found out by deducting cost of goods sold from sales. Cost of goods sold is purchases plus opening stock minus closing stock. Hence, closing stock must be properly valued and brought into accounts. Over valuation of closing stock leads to inflation of the current year profits and deflation of the profits of succeeding years. Similarly, undervaluation leads to deflation of current year’s profit and inflation of the profit of the succeeding years.

b) Determination of financial position

In the balance sheet, “inventory’ is a very important item. It is to be shown as current asset in the balance sheet at the end of the year. If the inventory is not properly and correctly valued, to that extent the balance sheet does not give true and fair view of the financial position of the business. Keeping in view the above objectives the auditor’s duty in relation to the verification and valuation of inventories becomes more important. Therefore, while verifying he should ensure that stock taking is done by responsible a officer, stock figures match with that of stock registers, and the basis of valuation has been consistently the same from year to year. Moreover, he should carry out test checks to ensure the accuracy of valuation.

Methods Of Recording Inventory

The records of quantity and value of inventory can be made in two ways. These as follows:

(i) Periodic Inventory System

(ii) Perpetual Inventory System

Periodic Inventory System

Under this system the quantity and value of inventory is ascertained by physically counting the stock at the end of the year and as on the accounting date. In case of big business houses, annual stock taking may even take a week at the end of the year in finalising the stock in hand on continuous basis. In case of this system certain items are physically counted, while others are weighed in kilos or tonnes or measured in litters. For stock taking stock sheets are used. The firms evolve such a performa of stock sheet on which all the relevant information like particulars of inventory, numbers of units, price per unit, total value, etc. can be listed and added so as to get the figure of inventory. This method offers the advantage of simplicity. Also, there is no used to maintain the various records to be maintained under perpetual inventory system. However, the limitation of this method is that discrepancies and losses in inventory will never come to light as it makes no accounting for theft, losses, shrinkage and wastage.

Perpetual Inventory System

This system provides as running record of inventories on hand because under this method stock registers are maintained which will give the inventory balance at any time desired. According to the Institute of Cost and Management Accountants, London, it is “a system of records maintained by the controlling department which reflects the physical movement of stocks and their current balance.” The stores ledger will give the balance of raw materials, work-in-progress and finished goods on hand. Because of this it is for the management to provide for continuous stock-taking, so that by comparing the physical balance with book balance, any discrepancies are ascertained immediately.

In this system business need not be suspended for the purpose of stock taking. The main advantage of this method is that it provides details about the quantity and value of stock of each item all times. Thus it provides a basis for control. The main drawback of this system is that it requires elaborate organisation and records and, therefore, it is more expensive.