Accounting of Inventories
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Transcript of Accounting of Inventories
Accounting of Inventories
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Accounting of Inventories
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Accounting of Inventories
Meaning of Inventory
Inventory Valuation - Methods
Effect of Incorrect Inventory Valuation
Store (or Material) Record
Preparation of Trading Account
Treatment of Shortage / Surplus of Material
Pricing of Material Returned to store
Pricing of Material Returned to Vendor.
CHAPTER AT A GLANCE
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Accounting of Inventories
MEANING OF INVENTORY
According to Accounting Standard-2 (AS-2) (Revised) issued by the Institute of Chartered Accountants of India (ICAI):
“Inventories are assets:
(a) Held for sale in the ordinary course of business or
(b) Held in the process of production for such sale, or
(c) Held in the form of materials or supplies to be consumed in the production process or in rendering of services.”
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Accounting of Inventories
MEANING OF INVENTORY
Inventory is synonym of stock
That means goods held for the purposes of sale or to be used for production.
Examples
Stock of finished goods, raw materials, work-in-progress and consumables, stores, supplies, etc.
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Accounting of Inventories
MEANING OF INVENTORY
At the end of an accounting period, an enterprise may have unsold goods in hand.
A manufacturing enterprise may have stock of finished goods, stock of raw materials, stores and work-in-progress.
Similarly, a trading enterprise may have stock of finished goods.
The quantities of goods held at the end of the year are known as Closing Inventory or Closing Stock which is carried forward to the next year as Opening Stock.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Closing Inventory or Closing Stock is taken, valued and credited to the Manufacturing Account, in case of manufacturing enterprises or When drawing manufacturing account and
to the Trading Account, in case of other enterprises to arrive at the correct cost of goods sold and thus correct profit earned or loss incurred for the accounting period is ascertained.
Closing Inventory being an asset is shown in the Balance Sheet as a current asset. Thus, correct financial position at the year end is ascertained.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Inventory is always valued at cost or net realisable value, whichever is lower following the method regularly adopted by the enterprise.
Accounting Standard – 2 (Revised) on Inventory Valuation issued by ICAI is a mandatory accounting standard.
AS – 2 (Revised) permits three methods for inventory valuation namely
1) Specific Identification Method, 2) FIFO Method and 3) Weighted Average Cost Method.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Specific Identification Method.
Under this method, units in inventory are specifically identified and each unit cost is identified with a particular invoice.
Thus, the method tracks the actual physical flow of goods available whether for sale or for production. The method gives the advantage that cost charged to jobs is actual not notional.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Inventory valuation method in which the actual cost of the purchased and issued (used or sold) items is identified by purchase date, serial number or particular code.
This method is suitable when cost of items forming part of inventory are not ordinarily interchangeable
and goods or services produced are segregated for specific projects and valued according to this method.
This method is applied when materials are purchased and set aside for a specific job or work order.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
The method is particularly suitable for automobiles, jewellery, antiques and custom made merchandise.
Thus, the method tracks the actual physical flow of goods available whether for sale or for production.
The method gives the advantage that cost charged to jobs is actual not notional.
The method is not suitable when items are many and also interchangeable.
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Accounting of InventoriesIllustration M/s MR Fabricators Ltd. is in the business of
manufacturing and installing windmills.
M/s BR Enterprises entered into contract with M/s MR Fabricators Ltd. for installing a windmill as per the designs supplied by it.
M/s MR Fabricators Ltd. manufactured the parts for the windmill as per the designs received.
The project was not completed at the year end and thus, inventory had to be carried forward.
Which method of inventory valuation should be applied to value the inventory?
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Accounting of Inventories
The parts have been manufactured for the project of M/s BR Enterprises as per the design supplied by it.
It therefore, cannot be used in any other project.
It is a case of inventory being for a specific project.
Thus, M/s MR Fabricators Ltd. should adopt Specific Identification Method to value the closing inventory.
Solution
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
First In First Out Method (FIFO)
Method of inventory valuation based on the assumption that goods are sold or used in the same chronological order in which they are bought.
Hence, the cost of goods purchased first (first-in) is the cost of goods sold first (first-out).
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
It means, items in the Opening Stock are issued first,
then from the first purchase , and so on.
Items in the Closing Stock of materials are from the last purchases and thus, valued at the latest cost of purchases.
Issue of material is priced in the sequence of purchases received and this flow continues until that lot is exhausted.
Thereafter, the next lot is taken.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
The effects of the method are
The issue is priced at the cost of material used because the material used is the oldest stock in hand.
Closing Stock is valued at the latest cost of purchases. Thus, the closing stock or inventory represents the current value.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
FIFO Method is most suitable in times of falling prices because the issues are priced at the earliest prices which are higher. It means, cost of sales is higher and thus profit is lower.
Since the Closing Stock is valued at the latest cost of purchases, which are lower, the Profit and Loss Account shows the correct profit.
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Accounting of Inventories
Prepare a Stores Ledger Account recording the following transactions for January, 2010 under the FIFO Method
Illustration
Date Particulars Quantity Rate
Jan. 1 Opening Stock 200 Pieces Rs. 2.00 each
Jan. 2 Issue 150 Pieces
Jan. 6 Purchases 100 Pieces Rs. 2.20 each
Jan. 7 Issue 100 Pieces
Jan. 10 Purchases 150 Pieces Rs. 2.40 each
Jan. 12 Issue 100 Pieces
Jan. 20 Purchases 180 Pieces Rs. 2.50 each
Jan. 30 Issue 200 Pieces
Solution
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Advantages of the FIFO Method
It is simple to understand and easy to operate.
It is a more logical method because materials received first are issued first.
The materials are charged at costs only. So, the purchase price is recovered in full without showing any profit or loss on issue.
This method is useful where (a) the prices are falling and (b) the consumption rate of material is low.
The value of Closing Stock is realistic as it is valued at the current prices, i.e., the value is close to the market price.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Disadvantages of the FIFO Method The issue price differs from issue to issue. Therefore, cost
comparisons get distorted if fluctuations in the purchase price of materials are high.
During the period of rising prices, FIFO Method results in higher book profits and therefore higher tax liability because the Closing Stock is valued at the last purchase prices which are higher.
If the prices fluctuate too much, clerical errors may be many.
For pricing one requisition more than one price may often have to be taken.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Weighted Average Cost Method
Under the method, total cost of material is divided
by the total quantity of material in stock.
The Weighted Average Cost is determined, either at periodical intervals or each time when fresh materials are received on purchases.
The average cost thus, is the balance value divided by the balance quantity.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
AS – 2 further permits use of either
Standard Cost Method or
Retail Inventory Method,
if it results in estimating cost of inventory that approximates actual cost.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Standard Cost Method
It is the predetermined cost based on attainable efficiency standards for a given volume of output.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Retail Inventory Method.
The method is not based on actual cost but aims at ensuring that the value of inventories being a close approximation to cost.
The method is used by retail stores which has numerous items having small values. It is difficult to keep track of physical flow of goods.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Thus, a simple method is adopted to value the inventory. But, to make the method effective, near accurate information must be available on retail prices and likely margins.
This method involves three steps
Determining value of end inventory at retail price i.e. price at which they are likely to be sold.
Establishing gross margin based on current year’s data.
Applying the gross margin to retail price of each inventory.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
The process of Inventory Valuation is as follows
(a) Listing items of Closing Inventory
(b) Assigning value to the items of Closing Inventory, using either FIFO Method or Weighted Average Method
(c) Determining the value of items (i.e., Quantity ×Value)
(d) The sum total of value is the Closing Inventory.
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Accounting of Inventories
INVENTORY VALUATION --- METHODS
Net Realizable Value (NRV) is the estimated selling pricein the ordinary course of business less the estimated costs of completion and the estimated cost necessary to make the sale.
The circumstances leading the valuation at NRV would be:
Where the cost of inventories may not be recoverable such as damaged or obsolete stock.
Where there is a fall in market prices.
Where estimated cost of completion or estimated cost to make sale has increased.
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Accounting of Inventories
EFFECT OF INCORRECT INVENTORY VALUATION
When Inventory is under valued
Effect on Cost of Goods Sold
Cost of Goods Sold is shown at higher amount
Effect on Gross Profit and Net Profit
Gross profit is shown at lower amount as a result net profit is also shown in lower amount.
Effect on Balance Sheet
True financial position is not stated in the Balance Sheet as inventory is carried at lower amount
Effect on Gross Profit and Net Profit in Next Year
This result in showing Gross Profit and Net Profit at higher price because the Opining Stock is at lower price
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Accounting of Inventories
EFFECT OF INCORRECT INVENTORY VALUATION
When Inventory is Overvalued
Effect on Cost of Goods Sold
Cost of Goods Sold is shown at lower amount
Effect on Gross Profit and Net Profit
Gross profit is shown at higher amount as a result net profit is also shown in higher amount.
Effect on Balance Sheet
True financial position is not stated in the Balance Sheet as inventory is carried at higher amount
Effect on Gross Profit and Net Profit in Next Year
This result in showing Gross Profit and Net Profit at lower price because the Opining Stock is at higher price
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Stores (or Material) Records are the records maintained with a purpose to have effective control on materials besides knowing the quantity of material in hand and its location.
Stores Ledger and Bin Cards are two important stores records maintained for inventory.
Apart from them, goods received note, Store Requisition Note, Materials Returned Note and Materials Transfer Note are also important.
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Stores Ledger
Stores Ledger is a record of individual items maintained by the Stores Department
Here receipts and Issues both are recorded in term of quantity
Specimen of Stores Ledger in next slide
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Bin Card
The term ‘Bin’ refers to the space where the material is stored.
It may be an almirah, rack or an open space.
In addition to the Stores Ledger, a Bin Card is also maintained for each item or material by the Stores Department.
A Bin Card is attached to the bin, where the material is stored.
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
At the time of each receipt or issue an entry is recorded in the Bin Card and the new balance of stock is ascertained.
The entries of receipts and issues of materials are supported by documents such as Goods Received Note, Materials Returned Note, Store Requisition Note, etc.
The Bin Card balance at any time should agree with the physical balance in the bin and also with the balance in Stores Ledger.
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
A Bin Card is a quantitative record of receipts, issues and the balance of materials for individual item of stores;
it also has minimum and maximum quantity levels and the re-ordering quantity.
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Goods Received Note (GRN) or Materials Received Note (MRN)
Goods Received Note or Materials Received Note is prepared by the Receiving Section of the enterprise.
It prepares the Goods Received Note after verifying that the goods received are in accordance with the Purchase Order, i.e.,
quantity and rate; and quality report approving the goods.
Specimen of Goods Received Note in next slide
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Four copies of the Goods Received Note are prepared and distributed as
One copy is retained by the Receiving Department.
Purchase Department for information regarding the delivery of materials.
Accounts Department for passing supplier’s bills.
Store Department for comparing the type and quantity of materials with the note.
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Stores Requisition Note (SRN) Stores Requisition Note is a written requisition for
material by the Production (user) Section to the Storekeeper duly signed by an authorized officer.
The Stores Department issues material to the user section on the basis of Stores Requisition Note.
SRN contains the relevant information such as, the name of the section making the requisition for the material, job for which it is required, Code No. and description of materials required and signature of the authorized officer.
Specimen of Stores or Materials Requisition Note in next slide
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Accounting of InventoriesSpecimen of Stores or Materials Requisition Note
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
MRN is prepared in triplicate.
The Storekeeper signs all copies and distributes them as
(i) One copy is returned to the Requisitioning Department together with the issued material. It is a proof with the Receiving Department for material received.
(ii) One copy is sent to the Accounts Department as a basis for debiting the Requisitioning Department.
(iii) One copy is retained by the Storekeeper. This copy is a supporting evidence and authorization for issue of materials.
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Materials Returned Note
The Production Department may get excess materials due to wrong estimate of requirement or any other reasons
Excess materials are returned to the stores along with the Materials Returned Note.
Materials Returned Note contains particulars similar to that of Materials Requisition Note.
Specimen of Materials Returned Note in next slide
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Accounting of InventoriesSpecimen of Stores or Materials Returned Note
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Three copies of the note are prepared and distributed as:
(i) One copy duly signed is returned by the Storekeeper to the Returning Department;
(ii) One copy is sent to the Accounts Department as a basis for giving credit to the Returning Department.
(iii) The third copy is retained by the Storekeeper for completing store records.
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Materials Transfer Note
Materials if transferred from one department (or job) to another department (or job) are transferred by preparing a Materials Transfer Note.
Such transfers take place normally when urgent orders are executed.
Specimen of Materials Transfer Note in next slide
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Accounting of Inventories
STORES (OR MATERIAL) RECORDS
Materials Transfer Note is prepared in triplicate by the Transferring Department giving complete details of materials transferred. It is distributed as
One copy is retained by the Transferring Department.
A copy is sent along with the goods to the department to which goods are sent;
Third copy is sent to Accounts Department on the basis of which Transferring Department/job is credited and Transferee department/job is debited.
Storekeeper does not record the transfer of materials in the store records.
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Accounting of InventoriesVALUATION OF INVENTORY AND PREPARATION OF TRADING ACCOUNT Accounting for inventory involves valuation of materials
received (Incoming Materials) and materials issued (Outgoing Materials).
Valuation of Materials Received or Purchased (Incoming Materials): The materials received are valued at invoice price plus expenses incurred for bringing the materials to the stores. These expenses include—(a) freight and duty, (b) insurance and storage costs, (c) cost of containers and (d) sales tax, etc.
Valuation of Materials Issued (Outgoing Materials): Materials are issued for different jobs or work orders from the stores. These jobs or work orders are charged with the value of materials issued to them.
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Accounting of InventoriesVALUATION OF INVENTORY AND PREPARATION OF TRADING ACCOUNTPreparation of Trading Account when FIFO Method is followed
Trading Account is an account that determines the gross profit or gross loss. It is debited with Cost of Goods Sold (Opening Stock + Purchases (Net of Returns) + Direct Expenses – Closing Stock) and credited it with the amount of Sales (Net of Returns).
Specimen of Trading Account in next slide
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Accounting of Inventories
TREATMENT OF SHORTAGE/SURPLUS OF MATERIAL
The physical verification of stock may reveal shortage or surplus of stock as compared to the stores recorded.
This may be due to avoidable and unavoidable causes.
The shortage in stock taking is to be entered in the Issues column and valued at the rate as per the method adopted and treating it as one of the issues.
This treatment should be followed when the shortage is not treated as abnormal shortage.
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Accounting of Inventories
TREATMENT OF SHORTAGE/SURPLUS OF MATERIAL
If the shortage is normal, the amount of shortage not recorded in the amount column, only the quantity is recorded.
The cost of normal shortage is absorbed by the remaining units by inflating the cost per unit.
If Physical verification of stock reveals surplus as compared to the stores recorded,
it will appear in the Receipts column of Stores Ledger and purchase price will be adopted for its valuation.
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Accounting of Inventories
PRICING OF MATERIALS RETURNED TO STORE
Sometimes materials are returned by the Production Department to the store for, say, it remaining unused.
The materials returned are recorded at the price at which they were issued and these units are issued at the old price on the next requisition received.
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Accounting of Inventories
PRICING OF MATERIALS RETURNED TO VENDOR
Sometimes materials received do not conform to specifications and they are returned to vendor.
If the material has not yet been issued, it is credited to stores ledger at its purchase price and no other adjustment is necessary.
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