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Principles and Practice of accounting
CA FOUNDATION - PAPER 1 - PRINCIPLES AND PRACTICE OF ACCOUNTING
The objective of Paper 1 “Principles and Practice of Accounting” at Foundation level is to develop an understanding of the
basic concepts and Principles of Accounting and apply the same in preparing financial statements. It has always been the
endeavour of Board of Studies to provide quality academic inputs to the students. Considering this objective, it has been
decided to bring forth a crisp and concise capsule on the topic of Inventory Valuation covered in the syllabus of this paper.
The concepts involved in this chapter have been gathered and presented through pictorial presentations in this capsule which
will help the students in grasping the intricate practical aspects for quick revision of this chapter. Under no circumstances,
such revision can substitute the detailed study of the material provided by the Board of Studies. Students are advised to refer
Chapter 4 of the Study Material for comprehensive study.
CHAPTER 4: INVENTORIES
Introduction The significance of inventory valuation arises
The chapter “Inventories” will help you to understand the term
due to various reasons as explained in the
“Inventory” and the techniques of valuing the inventories. It will also following points:
enable you to comprehend the methods of inventory valuation for
record keeping and intricacies related to book-keeping. (i) Determination of Income
The valuation of inventory is necessary for determining the true
Inventory can be defined as income earned by a business entity during a particular period. To
determine gross profit, cost of goods sold is matched with revenue of
the accounting period.
The effect of over or understatement of inventory may be explained as:
assets held for sale in the ordinary course of
business, or When closing When opening
inventory is overstated, inventory is overstated,
net income for the net income for the
in the process of production for such sale, or accounting period will accounting period will
be overstated. be understated.
for consumption in the production of goods or
services for sale, including maintenance supplies When closing When opening
and consumables other than machinery spares, inventory is understated, inventory is understated,
servicing equipment and standby equipment. net income for the net income for the
accounting period will accounting period will
be understated. be overstated.
Types of Inventory (ii) Ascertainment of Financial Position
Inventories are classified as current assets. The value of inventory on
the date of balance sheet is required to determine the financial position
In case of In case of of the business. If inventory is not properly valued, the balance sheet
Manufacturing Trading will not disclose the truthful financial position of the business.
concerns concerns
(iii) Liquidity Analysis
Traded Inventory is classified as a current asset, it is one of the components
goods of net working capital which reveals the liquidity position of the
business. Current ratio which studies the relationship between
current assets and current liabilities is significantly affected by the
value of inventory.
Raw Work-in- Finished Stores and Packing
(iv) Statutory Compliance
Materials progress goods Spares Material Schedule III to the Companies Act, 2013 requires valuation of each
class of goods i.e. raw material, work-in-progress and finished goods
under broad head to be disclosed in the financial statements.
Inventory Valuation As per the requirements of the
Accounting Standards, the financial
statements should disclose:
Inventory is generally the most significant component
of the current assets held by a trading or manufacturing
enterprise. Both excess of inventory and its shortage affects
the production activity, and the profitability of the enterprise (a) the accounting policies (b) the total carrying
whether it is a manufacturing or a trading business. adopted in measuring amount of inventories and
inventories, including the its classification appropriate
cost formula used, and to the enterprise.
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Principles and Practice of accounting
Basis of Inventory Valuation Net Realisable Value
Inventory This is the estimated selling price in the ordinary course of business
Valuation less the estimated costs of completion and the estimated costs
necessary to make the sale.
Net Realisation In case replacement cost is generally considered
Cost Whichever of raw as net realisable value.
is less Value materials
In case of Net realisable value mean expenses and
The above principle is governed by ‘Principle of Conservative work in overheads required to be incurred to
Accounting’ under which any expenses or losses from transactions progress convert work in progress into finished
entered or event occurred are to be recognized immediately, goods and making it ready for sale as
however, any gains or profits are recognized until it becomes reduced from selling price.
due or are actually realized.
In case of Net realisable value means selling price
finished reduced by selling and distribution
Cost goods and expenses.
traded
As per Accounting Standards, Cost of inventories should goods
comprise
Inventory Record System
costs of
conversion There are two principal systems of determining the physical
(primarily for quantities and monetary value of inventories sold and in hand.
all cost of finished goods
purchase One system is known as ‘Periodic Inventory System’ and the
and work in other as the ‘Perpetual Inventory System’. The periodic system is
progress)
less expensive to use than the perpetual method. But the useful
information obtained from perpetual system is more than cost
incurred on it.
other costs incurred
in bringing the inventories
to their present location Periodic Inventory System
and condition
Periodic inventory system is a method of ascertaining inventory
by taking an actual physical count (or measure or weight) of all the
inventory items on hand at a particular date on which inventory is
includes any amount paid to the seller reduced by any valued.
discounts/rebates given by the seller. Similarly, any duties The cost of goods sold is determined as shown below:
paid to the supplier will be part of cost of the inventory
Cost of
unless the enterprises can recover these taxes duties from
purchase closing
the authorities. opening Cost of
Purchases inventory
inventory goods
(known) (physically
(Known) sold.
counted)
inventories include costs directly related to the units of
production, such as direct labour. They also include a
Costs of systematic allocation of fixed and variable overheads.
conversion Physical inventory taking is required more than once a
year for preparation of quarterly or half yearly financial
statements thereby making this system more expensive.
may include administrative overheads incurred to bring
the inventory into present location and condition or
any cost specifically incurred on inventory of a specified Physical count of goods requires closure of
Other
Costs customer. Interest and other borrowing costs are normal operations of business.
generally not included in the cost of inventory.
As cost of goods sold is taken as residual
figure, it is not possible to identify loss of
Exclusions from cost of inventories goods due to pilferage, damage or even fraud.
Inventory control is not possible under this
system.
storage costs,
administrative
abnormal unless those
overheads
amounts costs are Books of accounts does not reflect inventory in hand
that do not
of wasted necessary
contribute to selling and and its value therefore, it is difficult to plan operations
materials, in the
bringing the distribution e.g. how much or when to order/manufacture.
labour production
inventories to costs.
or other process prior
their present
production to further
location and This system is used by small enterprises where it is easy to control
overheads; production
condition; and physical inventory. This system is not considered suitable for
stage;
medium or larger enterprises which generally use Perpetual
Inventory system.
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Principles and Practice of accounting
Perpetual inventory system Historical Cost Methods
Perpetual inventory system is a system of recording inventory The different techniques for valuation of inventory have been
balances after each receipt and issue. In order to ensure accuracy discussed below:
of perpetual inventory records, physical inventory should be checked
and compared with recorded balances. Under this system, cost of
• It attributes specific costs to identified
goods issued is directly determined and inventory of goods is taken goods and requires keeping different lots
as residual figure with the help of inventory ledger in which flow of purchased separately to identify the lot out
goods is recorded on continuous basis. (i) Specific of which units in inventories are left. The
Identification historical costs of such specific purpose
Closing inventory is determined as follows: Method inventories may be determined on the
basis of their specific purchase price or
Closing production cost.
opening Cost of • This method is generally used to ascertain
Purchases Stock
inventory goods sold the cost of inventories of items that are not
(known) (balancing
(Known) (Known) ordinarily interchangeable and their value is
figure)
high like expensive medical equipments.
Sl. Periodic Inventory System Perpetual Inventory
No. System • This method is based on the assumption
that cost should be charged to revenue in
1. This system is based on It is based on book records. the order in which they are incurred, that
physical verification. (ii) FIFO
is, it is assumed that the issue of goods
2. This system provides It provides continuous (First in first is usually from the earliest lot on hand.
information about inventory information about inventory out) Method The FIFO formula assumes that the items
and cost of goods sold at a and cost of sales. of inventories which were purchased or
particular date. produced first are consumed or sold first
3. This system determines It directly determines cost and consequently items remaining in the
inventory and takes cost of of goods sold and computes inventory at the end of the period are those
goods sold as residual figure. inventory as balancing figure. most recently purchased or produced.
• Thus, the closing inventory is valued at the
4. Cost of goods sold includes Closing inventory includes price paid for latest consignments.
loss of goods as goods not in loss of goods as all unsold
inventory are assumed to be goods are assumed to be in
sold. Inventory.
• The LIFO formula assigns to cost of goods
5. Under this method, Inventory control can be sold, the cost of goods that have been
inventory control is not exercised under this system. purchased last though the actual issues may
possible. (iii) LIFO
be made out of the earliest lot on hand to
(Last in first prevent unnecessary deterioration in value.
6. This system is simple and It is costlier method.
less expensive. out) Method Under this basis, goods issued are valued at
the price paid for the latest lot of goods on
7. Periodic system requires Inventory can be determined hand which means inventory of goods in
closure of business for without affecting the hand is valued at price paid for the earlier
counting of inventory. operations of the business. lot of goods.
• The price paid for the earliest consignments
Methods to Determine cost of Inventory is used for valuing closing inventory.
Formulae for Determining Cost of Inventory
• In Simple Average Price method, all the
different prices are added together and then
(iv) Simple divided by the number of prices.
Inventory Valuation Techniques Average Price • The closing inventory is then valued
Method according to the price ascertained.
Historical Non Historical
Cost Methods Cost Methods
• Under Weighted Average Price method,
cost of goods available for sale during the
period is aggregated and then divided by
(v) Weighted number of units available for sale during the
Inventory, Inventory Adjusted Average Price period to calculate weighted average price
not ordinarily ordinarily Selling Price Method per unit. Thus
interchangeable interchangeable • Weighted average price per unit =
Total cost of goods available for
sale during that period
Specific Total number of units available for
Historical sale during that period
identification
cost methods • Closing inventory = No. of units in
method
inventory × Weighted average price per unit
• Cost of goods sold = No. of units sold ×
Weighted average price per unit.
Simple / Weighted
FIFO LIFO
Average Price
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Principles and Practice of accounting
Non Historical Cost Methods
This method is also called retail
inventory method. It is used widely
in retail business or in business
This method is used when
where the inventory comprises
there is frequent change in
of items, the individual costs of
(i) the price per unit of the goods
which are not readily ascertainable. (ii) and goods are purchased
Adjusted The cost of the inventory is
Standard frequently by the business
selling determined by reducing from
e.g. crude oil. Based on the
the sales value of the inventory cost
price experience a standard cost
an appropriate percentage of method is determined on the basis of
method gross margin. The percentage
frequent changes in prices and
used takes into consideration
inventory is valued on that
inventory which has been marked
price per unit.
below its original selling price. An
average percentage for each retail
department is often used.
Inventory Taking
Normally all operations are suspended for one or two days during the financial year and physical inventory is taken for
everything in the godown or the store periodically. For the year-end inventory valuation, physical inventory taking is done
during the last week of the financial year or during the first week of next financial year. If inventory taking is finished on 26th
March, whereas accounting year ends on 31st March purchases and sales between 26th and 31st March are then separately
adjusted. Later, a value is put on each item. The principle of cost or Net realizable value, whichever is lower, is applied either
for the inventory as a whole or item by item.
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