FINANCIAL ACCOUNTING FOR

MANAGEMENT (FAM)

PROF. (DR.) RANJAN DASGUPTA

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 References:
1) Class discussions and handouts.

2) Accounting Text and Cases by

Robert Anthony, David Hawkins and
Kenneth Merchant (AHM), 13th Edition,
McGraw Hill Edu.

3) Financial Accounting: A Managerial

Perspective by Narayanaswamy, R., 6th
Edition, PHI Learning.
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 SESSION 15-

INVENTORY VALUATION

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 Learning Objectives -
➢ Understanding types of companies
and inventory

➢ Know how to account for inventory

and cost of goods sold (COGS)

➢ Know how to measure inventory

➢ Understanding the impact of

inventory valuation on business
income
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Understanding Types of
Companies & Inventory
❑ Merchandising companies (e.g. retail
stores, wholesalers, distributors,
etc.) (10)(4)(11)

❑ Manufacturing companies (e.g.

construction, automobiles, etc.) (24)
COST OF GOODS
SOLD (COGS)

❑ Service companies (e.g. IT, Banking,

etc.)
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 Types of Manufacturing
Inventories -
• Direct Materials – resources in-stock and
available for use

• Work-in-Process (or progress) – products

started but not yet completed. Often
abbreviated as WIP

• Finished Goods – products completed and

ready for sale
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Understanding Inventory
 As per IndAS 2:6 -
Inventories are assets:
(a) held for sale in the ordinary course
of business;
(b) in the process of production for
such sale; or
(c) in the form of materials or supplies
to be consumed in the production
process or in the rendering of services.

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 Merchandise inventory &
flows: (6)

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 Solution of the problem –
ending inventory? (6)(26)
❑ Periodic inventory method
(physical verification at the end-of-
the-period to determine cost)

❑ Perpetual inventory method

(record-keeping for each inflow and
outflow of inventory)

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 Periodic inventory method

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Perpetual inventory method

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 How to Determine Inventory Value
Presented on the Balance Sheet?

Applying either the periodic inventory system

or the perpetual inventory system and select
a cost flow assumption to determine the
value of inventories.

Both inventory systems require a physical

count of inventory at the end of a period to
determine the units which can be included in
the inventory account.

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 Comparing Perpetual and
Periodic Inventory Systems -
Assuming that a Company had the
following transactions during the
current year:
Inventory Units Unit Cost Total
Beginning Inv. 100 Rs.6 Rs.600

Purchases 900 Rs.6 Rs.5,400

Sales 600 Rs.12 Rs.7,200

Ending Inventory 400 Rs.6 Rs.2,400

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Comparative Entries- Perpetual vs.
Periodic -

Rs.6

Rs.600 Rs.600

Rs.6

Rs.12

Rs.6)

Rs.6

Rs.2,400
(Rs.600+5,400−3,600)
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Estimation of Inventory Value under
Periodic Inventory System -

➢ Retail inventory method. &

➢ Standard cost method.

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Retail Inventory Method – An Example:
Particulars At Cost At Retail
(Rs.) (Rs.)
Beginning inventory 2,500 3,000
Net purchases 11,500 14,500
Goods available for sale 14,000 17,500

Ratio of cost to retail:

Rs.14,000/Rs.17,500 = 0.8

Less: Net sales 13,000

Estimated ending inventory at 4,500
retail
Estimated ending inventory at 3,600
cost (Rs.4,500×0.8)
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Gross Profit Method – An Example:
Particulars Rs. Rs.

Beginning inventory 300

Net purchases 2,100
Cost of goods available for 2,400
sale
Less: Estimated cost of goods
sold (COGS)
Net Sales 3,000
Less: Estimated Gross 750
Profit (25%[assumed])
2,250
Estimated cost of ending 150
inventory

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 Quiz 1 -
The type of inventory system in which the
inventory account is updated at the time of
each sale is called:
1. A periodic system.
2. A perpetual system.
3. An accrual system.
4. None of the above.

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 Quiz 2 -
A company’s entire inventory is destroyed in
a fire. Beginning inventory was Rs.25,000.
Net sales and purchases up to the date of
the fire were Rs.70,000 and Rs.40,000
respectively. The company estimates its
gross profit ratio as 20% of net sales. Using
the Gross Profit method, the estimated
inventory lost in the fire is:
1. Rs.9,000.
2. Rs.11,000.
3. Rs.41,000.
4. None of the above.

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Gross Profit Method – Calculation:
Particulars Rs. Rs.

Beginning inventory 25,000

Net purchases 40,000
Cost of goods available for 65,000
sale
Less: Estimated cost of goods
sold (COGS)
Net Sales 70,000
Less: Estimated Gross 14,000
Profit (20%[assumed])
56,000
Estimated cost of ending 9,000
inventory/Estimated
inventory lost
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 Sale of Profit
and
Finished
Loss
Goods A/c.
Opening
Stock Unsold
Issue of Finished
Materials for Goods
Production

Purchases
Work-in- Balance
Progress Sheet

Unused
Raw
Materials
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Manufacturing inventories &
flows: (26)

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 Quiz 3 -
The three forms or states in the development
of inventory for a manufacturer are:
1. Direct materials, direct labour and
finished goods.
2. Direct materials, direct labour and
manufacturing overheads.
3. Direct materials, work-in-progress and
finished goods.
4. None of the above.

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Know How to Account for
Inventory and Cost of
Goods Sold (COGS)
Cost of Inventories (Product cost):
The cost of inventories should comprise all
costs of purchase, costs of conversion and
other costs incurred in bringing the
inventories to their present location and
condition.
Exclusions from the Cost of Inventories
(Period cost):
➢ storage costs, unless those costs are
necessary in the production process prior
to a further production stage;
➢ administrative overheads; and
➢ selling and distribution costs.
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Four methods are commonly used to
assign cost based on a different cost flow
assumption -
1. Specific identification.
2. First-in, First-out (FIFO).
3. Last-in, First-out (LIFO). &
4. Average cost (AC).

Note: Indian GAAP & IFRS doesn’t permit LIFO (refer

Narayanaswamy, 4th Ed., 2011, P 268).
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 An Example – (30)(32)(33)(34)
(36)(37)
Particulars Units Unit Cost Total
Cost
Jan. 1 – Beginning inventory 100 Rs.2 Rs.200
Mar. 27 – Purchase 100 3 300
June 12 – Purchase 100 4 400
Sept. 19 – Purchase 100 5 500
Nov. 30 – Purchase 100 6 600
Available for sale 500 2,000
Sold 350
Dec. 31 – Ending inventory 150

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1. Specific identification – (29)

This method assigns specific costs to each

unit sold and each unit on hand.

For example:
Assume that the Dec. 31 inventory consisted
of 60 units from the Mar. 27 purchase, 70
units from the June 12 purchase and 20
units from the Sep. 19 purchase.

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Thus, the cost of the ending inventory is
computed as follows: (29)

Particulars Cost
60 units from the purchase of Mar. 27 @ Rs.3 Rs.180
70 units from the purchase of June 12 @ Rs.4 280
20 units from the purchase of Sep. 19 @ Rs.5 100

Ending inventory 560

Cost of goods available for sale Rs.2,000

Less: Ending inventory 560

Cost of Goods Sold (COGS) 1,440

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 2. First-in, First-out (FIFO) -
Particulars Cost
50 units from the purchase of Sep. 19 @ Rs.5 Rs.250
100 units from the purchase of Nov. 30 @ Rs.6 600

Ending inventory 850

Cost of goods available for sale Rs.2,000

Less: Ending inventory 850

Cost of Goods Sold (COGS) 1,150

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 3. Last-in, First-out (LIFO) -
Particulars Cost
100 units from the inventory of Jan. 1 @ Rs.2 Rs.200
50 units from the purchase of Mar. 27 @ Rs.3 150

Ending inventory 350

Cost of goods available for sale Rs.2,000

Less: Ending inventory 350

Cost of Goods Sold (COGS) 1,650

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 4. Average cost (AC) –(36)(37)
Particulars Cost
Cost of goods available for sale Rs.2,000
No. of units available for sale 500
Weighted average unit cost Rs.4

Ending inventory (150 units @ Rs.4) 600

Cost of goods available for sale Rs.2,000

Less: Ending inventory 600

Cost of Goods Sold (COGS) 1,400

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 Impact of inventory valuation
methods under different price
situations -

Prices Ending Inventory Cost of Goods Gross Profit

Sold (COGS)
Increasing FIFO>AC>LIFO LIFO>AC>FIFO FIFO>AC>LIFO
Constant FIFO=AC=LIFO FIFO=AC=LIFO FIFO=AC=LIFO
Decreasing LIFO>AC>FIFO FIFO>AC>LIFO LIFO>AC>FIFO

Implication: The inventory valuation method under which ending

inventory value is higher causes highest gross profit.

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 Problem 1:
On March 31st 2018, Titan had no
alarm clocks in hand. During the next
4 months, it first purchased 50 clocks
@Rs.140 each, and then 75 more
@Rs.120 each. During these 4 months,
100 alarm clocks were sold.
You are required to find July 31st
inventory amount and 4 months cost
of goods sold if Titan uses periodic
inventory method and (a) average cost,
(b) FIFO, (c) LIFO?
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 Problem 2:

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 Assignment 1:

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 Quiz 4 -
For which of the following products is a
company most likely to use the specific
identification method?
1. Boxes of soap in a grocery store.
2. Automobiles at a car dealer.
3. Car batteries at an auto parts store.
4. The specific identification can't be used
by any companies.

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Know How to Measure
Inventory
 Lower-of-cost-or-market (LCM)
Principle -

“Inventories shall be measured at the

lower of cost and net realizable value.”
- IndAS2:9

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 Cost is defined as -

The cost of inventories shall comprise

all costs of purchase, costs of
conversion and other costs incurred in
bringing the inventories to their
present location and condition.
- IndAS2:10

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 Net realizable value (NRV) is
defined as -

“the estimated selling price in the

ordinary course of business less the
estimated costs of completion and the
costs necessary to make the sale.”
- IndAS2:6

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 LCM – An Example:
Real view sells TV sets. The following
information relates to one of the models in
inventory, T24, as on March 31st:
Cost per accounting records – Rs.18,010
Estimated selling price – Rs.18,200
Estimated selling expense – Rs.230
Net Realizable Value is Rs.17,970 (i.e.,
Rs.18,200 − 230).
This is lower than the cost of Rs.18,010.
Applying the LCM Principle, we get an
inventory value of Rs.17,970.
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 Quiz 5 -
The use of the lower-of-cost-or-market price
rule to value inventory is justified on the
basis of what principle?
1. Cost.
2. Materiality.
3. Conservatism.
4. Reliability.

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Learning Objective 4 -

Understanding the
Impact of Inventory
Valuation on Business
Income
 EXHIBIT 1
Effect of Inventory Method on Profit
Profit differs systematically depending on the inventory valuation method
Specific First-in, Last-in, First- Weighted
Identification First-out out (LIFO) Average Cost
(FIFO) (WAC)

Sales Rs.3,500 Rs.3,500 Rs.3,500 Rs.3,500

Cost of Goods
Sold (COGS):
Beginning 200 200 200 200
Inventory
Purchases 1,800 1,800 1,800 1,800
Cost of Goods 2,000 2,000 2,000 2,000
Available for
Sale
Less: Ending 560 850 350 600
Inventory
Cost of Goods 1,440 1,150 1,650 1,400
Sold
Gross Profit 2,060 2,350 1,850 2,100
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Effect of Inventory Valuation Errors -

Ending inventory is over(under)stated due

to quantity and/or costing errors, but the
Purchases Account is correct.

Succeeding Year

Income Statement Balance Sheet

Income is No effect.
under(over)stated and
cost of goods sold is
over(under)stated.
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 An Example -
Through a scheduling error, two
different inventory teams were
assigned to count the inventory in the
same warehouse on Dec. 31st, 2013.
The correct amount of ending
inventory is Rs.2,50,000. But, because
two different teams counted the same
inventory in one warehouse, the
amount recorded is Rs.3,00,000.

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 (in Rs.) 2013 2014
Reported Corrected Effect of Reported Corrected Effect
Error of
Error
Sales 10,00,000 10,00,000 15,00,000 15,00,000
Cost of Goods Sold:
OS
Beginning inventory 2,00,000 2,00,000 3,00,000 2,50,000 Rs.50,000
Add: Purchases 7,00,000 7,00,000 11,00,000 11,00,000
Cost of goods 9,00,000 9,00,000 14,00,000 13,50,000 OS
Rs.50,000
available for sale
OS
Less: Ending 3,00,000 2,50,000 Rs.50,000
3,50,000 3,50,000
inventory OS
6,00,000 6,50,000 US 10,50,000 10,00,000 Rs.50,000
Rs.50,000

Gross Profit
4,00,000 3,50,000 OS 4,50,000 5,00,000 US
Rs.50,000 Rs.50,000
1,00,000 1,00,000 1,20,000 1,20,000
Operating expenses
OS
Net income 3,00,000 2,50,000 Rs.50,000 3,30,000 3,80,000 US
Rs.50,000

Effects of Inventory Error on the Income Statement

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 (in Rs.) 2013 2014
Reported Corrected Effect of Reported Corrected Effect
Error of Error
Beginning retained 3,00,000 3,00,000 Correct 6,00,000 5,50,000 OS
Rs.50,000
earnings US
Add: Net income 3,00,000 2,50,000 OS 3,30,000 3,80,000 Rs.50,000
Rs.50,000
6,00,000 5,50,000 OS 9,30,000 9,30,000 Correct
Rs.50,000

Effect of Inventory Error on the Statement of Retained Earnings

(in Rs.) 2013 2014
Reported Corrected Effect of Reported Corrected Effect
Error of Error
OS
Inventory 3,00,000 2,50,000 Rs.50,000
3,50,000 3,50,000
All other assets 17,00,000 17,00,000 20,80,000 20,80,000
Total Assets 20,00,000 19,50,000 24,30,000 24,30,000
Total Liabilities 4,00,000 4,00,000 5,00,000 5,00,000
Capital 10,00,000 10,00,000 10,00,000 10,00,000
Retained Earnings OS 9,30,000 9,30,000
6,00,000 5,50,000 Rs.50,000

20,00,000 19,50,000 24,30,000 24,30,000

Effects of Inventory Error on the Balance Sheet

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 Thank You

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