Accounting Inventory |Net realisable value

Accounting for Inventory:

In this session, describing the Basic concept of Stock or Inventory accounting. So, the first thing what is stock or inventory in accounting?

Stock or Inventory means any stock held by a manufacturing business to meet its production requirements. A trading concern holds stock of goods for sale.

A per Indian Accounting Standard 2 [AS. -2] Inventories mean tangible property held:

• for sale in the ordinary course of business, or
• in the process of production for such sale, or
• for consumption in the production of goods or services for sale, including maintenance supplies and consumables other than machinery spares.

Importance of Stock or Inventory valuation:

AS-2 and its implications--

Before going into any discussion regarding any method of Stock or Inventory valuation the epitome of Indian Accounting Standard 2 (AS 2) should be understood. It says that---

• Stock or Inventory should normally be valued at historical cost or net realisable value whichever is lower.
• Historical Cost is the combination of (a) cost of purchase; (b) cost of conversion; and (c) any other cost incurred in the normal course of a business to bring the inventories up to their present location and condition.
• The net realisable value represents the actual or the estimated selling price less cost of completion and sale.
• By-Products should be valued as the lower of cost and net realisable value. Consumable stores and maintenance supplies should generally be valued at cost.

Re-usable wastes should be values at net realisation value if reprocessing is possible.

Goods that are not interchangeable and which are manufacturers for a specific purpose should be valued at specific costs.

Where there is a scope of analyzing the difference between the Standard Cost and Actual Cost( that is, Variance Analysis) direct costing or absorption Costing may be applied.

• Cost of Purchase = Purchase Price + Duties and Taxes (unless recoverable from taxing authorities like CENVAT credit) + Other expenses directly related to the acquisition of goods (-) Trade Discounts, Rebates, etc.
• Cost of conversion includes any cost related to, production including any overhead cost.
• For retail businesses, adjusted selling price (that is, selling price less gross margin of profit) may be applied.
• Production Overheads should be included only to the extent which has brought the Stock or Inventory to the present condition or location. It may be illustrated as -

      (a) Production Overheads may be Fixed or Variable by nature.

      (b) Fixed Overheads should normally be spread over units produced on the basis of normal capacity.

For example, if the normal capacity is 10,000 units, the actual production is 6,000 units, units sold are 5,000 units and Fixed Overhead is Rs. 30,000--

Normal Recovery Rate should be Rs. 30,000 / 10,000 or Rs. 3 per unit. In the case of actual production overhead recovered becomes 6,000 * Rs 3 or 18,000 (at the normal rate). The under-recovery of 

Rs.30,000 - Rs. 18,000 or Rs. 12,000 is trated as an expense of the year. For valuation of Stock (in this case 6,000 - 5,000 = 1,000 units), Fixed Production Cost is 1,000 * Rs.3 = Rs. 3,000.

But if actual production is abnormally high say 20,000 units, the overhead ate applicable for stock valuation should be based on the actual production. It should be Rs. 30,000 / 20,000 or Rs. 10 per unit.

     (c) Variable Overheads should be based on the actual units produced.

Stock or Inventory carried at net realisable value should be separately disclosed:

What are the Stock or Inventory valuation methods?

As per AS-2, the following two methods of Stock or Inventory valuation are recommended:

 1) FIFO method or FIFO inventory method
 2) Weighted Average Cost

Cost Formulae:

Inventory should be valued at cost price or net realisable price whichever is lower.

If inventory valuation is made at cost any one of the following methods may be adopted:--

1) First in First Out (abbreviated as FIFO) method or FIFO inventory method: 

Under this method, the goods which are produced first or acquired first are sold first or used first for production. 

                The sequence of issue of goods for sale or production follows the sequence or order in which they have been received. The goods which remain as unsold stock are valued at the current cost price. 

                According to Littleton and Paton the cost factors move through the business in procession fashion under the FIFO method.

Advantages:

• Stock or Inventory represents goods purchased recently. So the valuation is made at the current purchase price,
• Accounting involves recording transactions in a chronological manner. FIFO confirms to that order.
• It is a simple method approved by Tax and other authorities.
• As issues are priced in the same order in which materials have acquired, the issues are made at actual cost.

Disadvantages:

• Where the price level goes up steadily or it fluctuates, this method is not useful.
• The prices of issues do not reflect the current market prices.
• Matching of current costs with current revenues does not become possible.

2) Last in First out (abbreviated as LIFO) method LIFO inventory method: 

Here the materials received last are assumed to be issued first from the stores. So, the issue price becomes the price of that lot of materials which has entered last into the stores. 

                The current cost of materials is charged against revenue. The unsold stock is valued at an old price which, generally becomes lower than the current cost price.

It is a method used for the pricing of issues. 

               The physical issue of materials may not follow the principle that goods received last are to be issued first. Its emphasis is on the use of the latest or current cost for computing the cost of production. 

               If it is followed, the replacement of the used Stock or Inventory does not involve an additional cost. So, it is also known as the Replacement Cost Method.

Advantages:

• The cost of production is charged at the current price. If the price level shows an increasing trend, a higher amount is charged against the cost of materials used.
• Closing Stock or Inventory is valued at an earlier or old price. So, the valuation will conform to the minimum realizable price and shall not include any profit element.
• During inflation, the application of this method gives more pragmatic results.
• The current cost is matched against revenue. So, the matching cost principle can be used more effectively.

Disadvantages:

• If the price level is decreasing or fluctuating, this method gives inaccurate results.
• The closing Stock or Inventory can never reflect the current market price.
• In India, AS2 does not approve of it. The Income Tax Authorities do allow it. In the USA the Generally Accepted Accounting Principle allow it for use in Tax Return only.

3) Weighted Average Method: 

For finding out the weighted average rate for stock valuation both quantity and price of different lots of materials existing in the stock are considered. 

               The weighted average rate is found by adding the costs of all lots held at the time of issue and then dividing that cost by the total quantity of the materials held. 

               Once a rate is calculated it is applied until a new purchase is made. It does not consider whether the quantities purchased earlier have already been consumed.

Advantages:

• If prices fluctuate considerably and the issue of materials has to be made in several lots, this method becomes very much useful.
• The weighted average rate is mathematically sound as it considers both quantity and price.
• During inflation, the value of Stock or Inventory becomes much more realistic.
• One rate can be consistently applied till a new purchase is made.

Disadvantages:

• The price at which goods are issued does not reflect their actual costs.
• Closing stock cannot show the current market price.
• Where purchases and receipts of materials are frequent, this method results in mathematical complications.
• If arithmetical accuracy is ignored at the time of calculating, the weighted average rate, unrealized profit, or loss may creep into the value of materials.

4) Base Stock Method: 

Under this method, according to Para 10 of AS2, it is assumed that a minimum quantity of Stock or Inventory (or base stock) must be held at all times to carry on business.

               Up to this quantity, the Stock or Inventory is valued at the cost at which it was acquired, Any excess over this ba stock may be valued under FIFO or LIFO method.

               As this method assumes that a minimum level of stock must be maintained at all times, it has a limited application. Where some basic raw materials are required and these are of the same type. 

               This method is suitable. It is applied in processing industries where processing takes considerable time.

Advantages:

• As already said this method is ideal for processing industries like refineries, tanneries, etc.
• Base Stock or Inventory is always valued at its cost of acquisition.
• The additional stock over the basic requirement can be valued under any suitable method.

Disadvantages:

• Base stock is valued at historical cost. it is treated as a fixed asset, but there is no scope of depreciating it.
• The disadvantages of FIFO or LIFO exist regarding the valuation od additional stock.
• This method is somewhat rigid. It requires necessary changes to cope with changes in production capacity and policy matters regarding stock.

5) Specific Identification Method: 

As per Para 11 of AS2 The specific identification formula attributes specific costs to identify goods that have been brought or manufactured and are segregated for a specific purpose. 

               Thus under this method valuation is made at the original or actual cost price for the specific quantity of identified goods. This method has limited applications. The scale of operation should not be large and identification of goods must be possible. 

               There shouldn't be frequent receipts and issues of materials. The inventories should not be interchangeable and these have to b earmarked for specific purposes.

Its greatest advantage is that it renders a correct valuation of stock and at the same time ensures the correct matching of costs with revenues.

               It involves difficulties and clerical errors if The movement of goods is frequent and if there are considerable price fluctuations.

6)Standard Cost Method:

 Under this method, a rate is predetermined and considered as the standard rate for valuing the cost of sales and inventories. It uses some anticipated rates.

                    According to AS -2, such rates should be realistic and should be reviewed regularly. There should be sufficient scope of analyzing and reconciling the variance between actual costs and standard costs. It is usually found in the job and process type of industries.

7) Adjusted Selling Price (also Called Retail Inventory) Method: 

It is used in retail business or in a business where the Stock or Inventory consists of items whose individual costs cannot be readily ascertained. 

                At first, the retail price of the goods is ascertained and from that, the anticipated gross margin may be made for individual items or groups of items or by the individual departments where departmental accounting is possible.

8) Latest Purchase Price Method & Next In First Out (or NIFO) Method: 

Under this method, the stock is not valued at any historical cost already incurred. 

               Rather valuation of inventory is made at a price which is the probable price of the goods to be received next to the issue of the inventory.

               This method is found to exist very rarely. Its only advantage is that Stock or Inventory valuation is made at the up-to-date replacement cost.

There are some more methods where stock valuation is made at cost. There are--

1) Highest in First Out or HIFO Method: 

Under this method, it is assumed that the lot of materials whose price is the maximum is to be issued first. The date of the actual price of such materials need not be considered. Thus the cost of production is charged at the highest rate but inventory is valued at the lowest price.    
       During a period when the price level changes rapidly, those method becomes useful.

2) Moving Average Method: 

This may also be a Simple Moving Average or Weighted Moving Average. A moving period is ascertained from a study of past movements of materials. Then the average is calculated on the basis of such a period.

If Stock or Inventory is Valued at Market Price:

Issues of materials may be priced at the current market price. This may again be:

1. Replacement Price or Purchase Price: It is the price existing at the time of the issue. If materials are consumed in the process of production or sale, the replacement has to be made by new purchases from the market. So the replacement cost is given importance for inventory valuation.
2. Realizable Price Or sale Price Method: It is the price which can be realized if the materials issued to different jobs or work orders are sold out.

If Inventory is valued at a Notional Price:

National Price is not the cost or market price. It is a price ascertained on some notional basis. It may be:--

• Standard Price Method: The standard price is fixed on the basis of the specific nature of the product or service and the factors related to that. All issues during an accounting period is charged at the Standard Price. The Stock or Inventory is valued as the balancing amount of (i) costs of materials purchased or received at different rates and (ii) the value of quantities issued at the standard price.

• Inflated Price Method: Issued are priced at an inflated rate. Such a rate is calculated after considering

           i) addition of proportionate stock holding or carrying costs like costs of inspecting, issuing, etc.

           ii) deduction of natural or normal losses of materials, like leakage, evaporation, etc. 

The cost of materials issued is computed first by applying any method discussed earlier. The adjustments [(i) and (ii) as stated above] are made to find out the inflated price. The inventory is valued by deducting the issues priced at an inflated rate from the total cost of materials purchased during a period.

It is to be noted that :

• Stock or Inventory means any tangible property held for sale, in the process of production for such sale or for consumption in the production of goods or services for sale. Maintenance supplies and consumables shall be included. But machinery spares should be excluded.
• Valuation of Inventories is required at the end of each accounting period for (i) determining profit/loss during that period; and (ii) for representing these as assets in the Balance Sheet.
• The contents of AS 2 mandatory w.e.f. 1.4.1999, should be complied with by all enterprises for the Valuation of Inventories.
• The method of valuation should be consistent but should not be rigid.
• In India, inventories should normally be valued at historical cost or net realisable value whichever is lower.
• Historical cost is the combination of (a) Cost of Purchase; (b) Cost of Conversion and (c) any other cost incurred in the normal course of business for bringing the inventories up to their present location and condition.
• Net realisable value is the Actual or Estimated Selling Price less cost of completion of works and cost to be incurred to complete the sale.
• Inventories are to be classified normally in the financial statements as :

        i) Raw materials and components;

       ii) Work-in-Process;

      iii) Finished goods; and

      iv) Stores and spares

• Where a Stock or Inventory is carried at net realisable value, to should be disclosed in the financial statements separately.
• By-products should be valued at cost or Net Realisable Value, whichever is lower. But if the cost
• of by-products cannot be ascertained separately, their stock should be valued at Net Realisable Value.
• If there is any scope of reprocessing, the inventory of re-usable scrap should be valued at Net Realisable Value.
• Inventory of non-reusable scrap should be valued at Net Realisable Value.
• Perishable goods may be valued even below cost if conditions demand.

Methods of Ascertaining Net Realisable Value (NRV):

For ascertaining the net realisable value of different items of stock any one of the following methods may usually be followed:

• Total Inventory Method: The aggregate of the total cost of all items is found out. It is compared with the total net realisable value of such items. The lower of the two is applied for inventory valuation.
• Group Method: Items of the same nature are grouped. The cost and NRV of each group are separately compared and the lower amount for each group is applied for Stock or Inventory valuation.
• Individual Identification Method: For each item of stock, the corresponding cost and net realisable value are compared and the lower of the two is considered for the valuation of the individual stock.

Valuation of stock or Inventory as on the Balance Sheet Date:

• Stocktaking should be made on the date of the close of a financial period. It should include every item of goods of which the business is the owner. If there are any goods-in-transit or goods with the selling agent or goods sent on approval for which the sale is yet to be confirmed such goods should be included in stock. On the other hand, goods sold but not yet delivered should be excluded.

Goods purchased within the accounting period and recorded in the accounts should be included in stock. Thus physical stock in the godown of the business may not be the actual value of the stock to be included in the final accounts.

• If stock-taking is made on a date a few days before or after the date of the close of the financial period, Purchases, Purchase Returns, Sales and Sales Return between these two dates should be adjusted (to arrive at the value of the stock on the closing date of the accounting period).

The sales and Sales Return should be taken at cost price or market price whichever is lower:

Notes:

• Where any sales have been made at a loss or at a profit not conforming to the normal rate of profit, the cost price of the goods thus sold should be separately ascertained.
• For valuation of Stock or Inventory, the principle of Cost Price or Net Realisable Price whichever is lower should be applied.
• Adjustment for undercasting/ overcasting of stock, goods held for consignment basis, etc., should also be made.