Financial Accounting and Analysis

Prof. Padmini Srinivasan

Inventory

Let us now discuss in some detail the important current assets in a balance sheet. Inventory is one of
the important items under the current assets and inventory is often the largest and the most
important asset of a merchandising as well as a manufacturing business.

In merchandising business say for example like a supermarket or a jewellery store, inventory would
be of a high proportion to the total assets as compared to let say property, plant, and equipment or
other assets that the company owns.

While in a manufacturing company the inventory would consist of many other items other than just
the finished goods. In a manufacturing company, we will have three major types of inventory. For
example, we will have raw material.

Raw materials forms the basic material that is part and parcel of the final product. For example, in an
automobile, the raw material would be the metal sheets, the glass, and other parts that are
assembled and part of the car.

Work in progress or semi-finished items are goods that are being assembled and are in progress and
continuously some value is being added.

Finished goods are completed goods and are ready for sale. For example, the completed car. Now
that we visited load controls. Let us see, what kind of inventory Load Controls have?

Here are the raw materials stored in a systematic manner. We also observed work in progress, things
that are getting together, and they will move to the next line item where they are assembled and we
have the finished goods. Finished goods are those that are completed and here they are ready to be
shipped to the customers.

This inventory helps us understand the process of what's happening in a typical factory such as in
Load Controls. As a factor in determining the cost of goods sold, inventory has a direct impact on the
profitability of the business. Thus, understanding and managing inventory becomes very important.

Clever: Professor, how do companies track the inventory? For example, if factories buy materials,
how will they track as to what item is consumed and what is left in the inventory?

Professor: Very good question Clever.

Effective inventory control and management is very crucial for the running of a business. A company
needs to track items of inventory purchased and sold as well as raw material so that business
functions efficiently.

The inventory control and recording procedure depends on the nature of company's operations and
the recording mechanism. For example, a good enterprise resource planning system what we call as
ERP provides specialized inventory management module that can track the level of inventory and
other details.

As we discussed inventory is always taken at the cost price. Now, how do we measure this cost of
inventory which is at the end of the period? Let me show you with an example.

Here is an example take a look at it.

© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Financial
Accounting and Analysis" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
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 Financial Accounting and Analysis
Prof. Padmini Srinivasan

We have 5 amounts for purchases over a period starting with December 1st, December 6, December
7th, December 15th, and December 20. Each of these dates, the company has purchased 100 units,
but of course the rates are varying. Say the rates are 2, 3, 4, 5, and 6. Of course with the total
amount.

The company, let's assume has sold 350 units at $10 each on the last day of the month. After all the
transaction, what would be the closing inventory? Can you think about it? Let's pause and think and
calculate how much would be the closing inventory?

Clever: Inventory is of $850.

Trigger: Professor, inventory is $350. No. I think its $600.

Why are we getting different answers? It is the same data, right. But still, we have got the answer?
That is because each one of us have made different assumption. These assumptions are also termed
as cost flow assumptions and may or may not may make the actual physical flow of inventory.

The cost flow of assumption has to be adopted depending on the nature of the goods. Physically
tracking every item that goes into the production process or the item that is being sold is generally
not possible and therefore certain assumptions are made in terms of "What are the nature of goods
that have come-in and the kind of goods that are gone out?

The IFRS permits the use of the following cost flow assumptions.
1. The FIFO method or the First-In-First-Out-Method.
2. We are also allowed to use the Weighted Average Cost Method. And, of course,
3. Specific Identification Method.

Apart from these methods, we have another method of cost flow assumption called the LIFO
method of inventory valuation. LIFO refers to Last-In-First-Out and as the name suggests, whatever
enters the accounting system, first continues to remain in the inventory for a long period of time.
Whereas whatever enters the books of accounts at the latest stage or the last inventory that gets
consumed first. So Last-In-First-Out. This method is permitted as per U.S. GAAP. However, this
method is not permitted as per IFRS.

LIFO method advantages basically as the cost of goods sold is based on the last inventory it may be
high or low rising price situation you will find that the cost have gone up and as at it enters the
income statement the profit comes down and therefore its preferred sometimes because you need
to pay less income tax. Because of this reason LIFO is generally not preferred by many companies
and it is not permitted as per IFRS.

More on this we will review it a little later in the module.

Professor: Trigger, what are you thinking?

Trigger: I was doing some deep calculations as to which cost flow assumption should I use for valuing
inventory.

Professor: That's good.

© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Financial
Accounting and Analysis" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
 Financial Accounting and Analysis
Prof. Padmini Srinivasan

I appreciate your direction of thoughts. The cost flow assumption adopted effects the profitability of
a company.

Clever: Professor, is the inventory taken at cost price like property, plant, and equipment, how do
we value it?

Professor: Like property, plant, and equipment, inventory is valued at cost price when it is
purchased.

However, on the date of the balance sheet the market value of inventory is reviewed and then the
following rule is applied. At cost or net realizable value whichever is lower.

Let us now conclude on what we have learned under inventory.

1. Inventory is an important element in current assets in the balance sheet.

2. Ending inventory valuation has a significant effect on assets as well as the profit of the
business.
3. There are many methods for valuing inventory. We spoke about FIFO, LIFO, weighted
average, and specific identification method. And,
4. Ending inventory is valued at cost or net realizable value whichever is lower.

© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Financial
Accounting and Analysis" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.