Accounting for Inventory

Importance
Importance

Inventory appears in two principal financial statements.

► Income Statement

► Balance Sheet

Importance
Importance


As an expense

► Balance Sheet

As a current asset

Importance
Importance
As an expense
it is the largest item of
expense in income statement
► Balance Sheet
As a current asset
it is the largest item of
current assets in balance sheet

Importance
Importance

Cost of Goods Sold

Cost of Goods Sold
is deducted from revenue
to arrive at Gross Profit.

Importance
Importance

Cost of Goods Sold
is calculated by
Beginning Inventory + Purchases
= Goods Available.
&
Goods Available – Ending Inventory
= Cost of Goods Sold

Inventory Systems
Inventory Systems

Inventory balances are monitored
following two principal types of
inventory systems -
► Periodic System
► Perpetual System

Inventory Systems
Inventory Systems

following two principal types of inventory
systems -

Periodic System –
useful for inexpensive goods where
need for accurately tracking inventory
does not exist.

Inventory systems
Inventory systems

following two principal types of inventory
systems -
Periodic System
Perpetual System -
provides detailed record of inventory
throughout year and hence, used by
most companies.

Methods of Inventory Costing

GAAP provide for a number of
acceptable inventory costing
methods including –

• Specific Identification.
• Average Cost
• FIFO (First-in First-out)


GAAP provide for a number of
acceptable inventory costing
methods including –

• Specific Identification -

The inventory is valued at actual cost of each unit
of inventory identified. Is used in case of high
value inventory where identification is possible


GAAP provide for a number of acceptable
inventory costing methods including –
Specific Identification.
• Average Cost –
Here the value of inventory is taken on
average cost. All costs incurred in respect of
stock in inventory are added up and then
divided by the number of units in stock.

GAAP provide for a number of acceptable
inventory costing methods including –
Specific Identification.
Average Cost
• FIFO (First-in First-out)

under FIFO, the first units acquired are
assumed to be first units sold.


FIFO (First-in First-out)
advantages –

► Reports current cost for
Ending Inventory

► Reports higher Net Income.


FIFO (First-in First-out)
disadvantages –

► Violates the matching Principle
► Results in higher taxes & lower
cash flows.
► Does not adjust Cost of Goods
sold for the effect of inflation.


There is one more method used
called LIFO (Last-in First-
out)
Under the LIFO method last units
acquired are assumed to be the first
units sold.


There is one more method
used called LIFO (Last-in
First-out)
Advantages
► Always matches expense and revenues.
► Results in lower taxes and higher cash
flow.


out)
Disadvantages
► Reports lower net income.
► Reports understated ending inventory.
► Can be used to manipulate income


out)
Disadvantages
► Reports lower net income.
► Reports understated ending inventory.
► Can be used to manipulate income
► Hence frowned upon by GAAP

Closing Stock Valuation
Broad Guidelines –

Interest & other borrowing costs
Abnormal costs of wasted materials or labour
Storage costs, unless required by production process
distribution, selling and administrative costs

are not considered in valuation of inventory.


Closing stocks of finished goods are generally valued at

“ cost of market value, whichever is lower”


Closing stocks of finished goods are generally valued at
“ cost of market value, whichever is lower”

except when a company is in the business
of mining industry ; where companies value
closing stock at net realizable value.

Inventory -- Accounting Principles
Inventory Accounting Principles

Consistency Principle

Disclosure Principle

Materiality Principle

Conservatism Principle


The same accounting methods
and procedures must be used
period-to-period.


The same accounting methods and procedures
must be used period-to-period.

Once the entity opts for a certain method
of inventory costing, it is not to be changed.

The same accounting methods and procedures
must be used period-to-period.
Once the entity opts for a certain method of
inventory costing, it is not to be changed.
Only valid & compelling reasons
can justify such change
“and effect of change on net results
must be disclosed”


Disclosure Principle –

The entity should disclose all important
information that would enable financial statement
users to make informed decisions about the
entity.

Materiality Principle –

An entity must perform strictly proper accounting
only for items and transactions that are significant
to its financial statements.

Conservatism Principle –

an entity should use the least favorable figure
when preparing its financial statements.

Conservatism Principle –
an entity should use the least favorable figure
when preparing its financial statements.
Lower of cost or market rule for ending inventory
valuation is one of the applications of this
principle

“ Accounting for Inventory is critical as
inventory values
◘ appear on two principal financial
statements – income statement &
balance sheet
◘ are generally largest item of expenses
in income statement & largest item of
current assets on balance sheet.
Accounting for inventory is vital for the
business of the company.”

Accounting for Inventory

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Accounting for Inventory