Unit 1

ACCOUNTING STANDARDS ISSUED BY ICAI & INVENTORY VALUATION

1.1 Introduction

Meaning of Accounting Standards

Accounting Standards are written policy documents issued by expert accounting body or by the government or other regulatory body covering the aspects of recognition, measurement, treatment, presentation, and disclosure of accounting transactions in financial statements

Classification of Enterprises

The enterprises are classified and labeled as Level I, Level II and Level III companies. Based on this classification and the category in which they fall the Accounting standards are applicable to the enterprises

Level I Enterprises

Enterprises which fall under any one or more category below mentioned are termed as Level I Companies

• Enterprises whose equity or debt securities are listed whether in India or outside India
• Enterprises which are in the process of listing their equity or debt securities. Board of directors resolution must be available as an evidence
• Banks including co-operative banks
• Financial institutions
• Enterprises carrying on insurance business
• All commercial, industrial and business reporting enterprises, whose turnover not including ‘other income’ for the immediately preceding accounting period on the basis of audited financial statements exceeds Rs. 50 crore
• All commercial, industrial and business reporting enterprises having borrowings, including public deposits, in excess of Rs. 10 crores at any time during the accounting period
• Holding and subsidiary enterprises of any one of the above at any time during the accounting period

Level II Enterprises

Enterprises which fall under any one or more category below mentioned are termed as Level II Companies

• All commercial, industrial and business reporting enterprises, whose turnover (excluding ‘other income’) for the immediately preceding accounting period on the basis of audited financial statements is greater than Rs. 40 lakhs but less than Rs. 50 crore
• All commercial, industrial and business reporting enterprises having borrowings, including public deposits, is greater Rs. 1 crore but less than  Rs. 10 crores at any time during the accounting period
• Holding and subsidiary enterprises of any one of the above at any time during the accounting period

Level III Enterprises:

Enterprises which do not fall under Level I and Level II, are considered as Level III enterprises

Applicability of Accounting Standards

International Financial Reporting Standards

The field of financial reporting in India has seen major changes in the last 5 years. As the trade increasingly moves beyond the national boundaries, the compliance and reporting requirements move too. Presenting the financial statements of an entity in accordance with the reporting requirements of every country it has a presence in, is becoming increasingly difficult.

What is IFRS?

The International Financial Reporting Standards (IFRS) are accounting standards that are issued by the International Accounting Standards Board (IASB) with the objective of providing a common accounting language to increase transparency in the presentation of financial information.

What is IASB?

The International Accounting Standards Board (IASB), is an independent body formed in 2001 with the sole responsibility of establishing the International Financial Reporting Standards (IFRS). It succeeded the International Accounting Standards Committee (IASC), which was earlier given the responsibility of establishing the international accounting standards. IASB is based in London. It has also provided the ‘Conceptual Framework for Financial Reporting’ issued in September 2010 which provides a conceptual understanding and the basis of the accounting practices under IFRS.

Components of Financial Statements under IFRS

A complete set of financial statements prepared in compliance with the IFRS would ideally comprise of the following:

• A statement of financial position as at the end of the period – more commonly known to us as the ‘Balance sheet’
• A statement of profit and loss for the year and the statement of other comprehensive income – Other comprehensive income would include those items of income/expense that are not recognized in the profit and loss account to comply with the other relevant standards.

Both these statements may either be combined or shown separately.

• A statement of changes in equity – This would include a reconciliation between amounts shown at the beginning and the end of the year.
• A statement of cash flows for the period
• Notes to the financial statements – including a summary of significant accounting policies followed and other explanatory information

The financial statements would sometimes also include a statement of the financial position of an earlier period in the following scenarios:

• When an entity applies an accounting policy retrospectively;
• When an entity retrospectively restated an item in its financial statements; or
• When an entity reclassifies an item in its financial statements.

List of International Financial Reporting Standards (IFRS)

As already discussed, the Standards issued by the IASB are called IFRS. The predecessor body, IASC, had however already issued certain International Standards which are called International Accounting Standards (IAS). These IAS were issued by the IASC between 1973 and 2001. Both IAS and the IFRS continue to be in force. The standards are listed below:

1.2 Objectives of Accounting Standards

Accounting is often considered the language of business, as it communicates to others the financial position of the company. And like every language has certain syntax and grammar rules the same is true here. These rules in the case of accounting are the Accounting Standards (AS). They are the framework of rules and regulations for accounting and reporting in a country. Let us see the main objectives of forming these standards.

1. The main aim is to improve the reliability of financial statements. Now because the financial statements have to be made following the standards the users can rely on them. They know that not conforming to these standards can have serious consequences for the companies.
2. Then there is comparability. Following these standards will allow for inter-firm and intra-firm comparisons. This allows us to check the progress of the firm and its position in the market.
3. It also looks to provide one set of accounting policies that include the necessary disclosure requirements and the valuation methods of various financial transactions.

1.3 Benefits & Limitations of Accounting Standards

Benefits of AS

Accounting Standards are the ruling authority in the world of accounting. It makes sure that the information provided to potential investors is not misleading in any way. Let us take a look at the benefits of AS.

1] Attains Uniformity in Accounting

Accounting Standards provides rules for standard treatment and recording of transactions. They even have a standard format for financial statements. These are steps in achieving uniformity in accounting methods.

2] Improves Reliability of Financial Statements

There are many stakeholders of a company and they rely on the financial statements for their information. Many of these stakeholders base their decisions on the data provided by these financial statements. Then there are also potential investors who make their investment decisions based on such financial statements.

So it is essential these statements present a true and fair picture of the financial situation of the company. The Accounting Standards (AS) ensure this. They make sure the statements are reliable and trustworthy.

3] Prevents Frauds and Accounting Manipulations

Accounting Standards (AS) lay down the accounting principles and methodologies that all entities must follow. One outcome of this is that the management of an entity cannot manipulate with financial data. Following these standards is not optional, it is compulsory.

So these standards make it difficult for the management to misrepresent any financial information. It even makes it harder for them to commit any frauds.

4] Assists Auditors

Now the accounting standards lay down all the accounting policies, rules, regulations, etc in a written format. These policies have to be followed. So if an auditor checks that the policies have been correctly followed he can be assured that the financial statements are true and fair.

5] Comparability

This is another major objective of accounting standards. Since all entities of the country follow the same set of standards their financial accounts become comparable to some extent. The users of the financial statements can analyze and compare the financial performances of various companies before taking any decisions.

Also, two statements of the same company from different years can be compared. This will show the growth curve of the company to the users.

6] Determining Managerial Accountability

The accounting standards help measure the performance of the management of an entity. It can help measure the management’s ability to increase profitability, maintain the solvency of the firm, and other such important financial duties of the management.

Management also must wisely choose their accounting policies. Constant changes in the accounting policies lead to confusion for the user of these financial statements. Also, the principle of consistency and comparability are lost.

Limitations of AS

There are a few limitations of Accounting Standards as well. The regulatory bodies keep updating the standards to restrict these limitations.

1] Difficulty between Choosing Alternatives

There are alternatives for certain accounting treatments or valuations. Like for example, stocks can be valued by LIFO, FIFO, weighted average method, etc. So choosing between these alternatives is a tough decision for the management. The AS does not provide guidelines for the appropriate choice.

2] Restricted Scope

Accounting Standards cannot override the laws or the statutes. They have to be framed within the confines of the laws prevailing at the time. That can limit their scope to provide the best policies for the situation

1.4 Procedure for Issue of Accounting Standards

Formation of the Accounting Standards Board:

The Institute of Chartered Accountants of India, recognizing the need to harmonies the diverse accounting policies and practices at present in use in India, constituted an Accounting Standards Board (ASB) on 21st April, 1977.

Scope and Functions of Accounting Standards Board:

The main function of ASB is to formulate accounting standards so that such standards may be established by the Council of the Institute in India. While formulating the accounting standards, ASB will take into consideration the applicable laws, customs, usages and business environment.

The Institute is one of the Members of the International Accounting Standards Committee (IASC) and has agreed to support the objectives of IASC. While formulating the Accounting Standards, ASB will give due consideration to International Accounting Standards, issued by IASC and try to integrate them, to the extent possible, in the light of the conditions and practices prevailing in India.

The Accounting Standards will be issued under the authority of the Council. ASB has also been entrusted with the responsibility of propagating the Accounting Standards and of persuading the concerned parties to adopt them in the preparation and presentation of financial statements.

ASB will issue guidance notes on the Accounting Standards and give clarifications on issues arising there from. ASB will also review the Accounting Standard at periodical intervals.

Procedure for Issuing Accounting Standards:

Broadly, the following procedure will be adopted for formulating Accounting Standards:

ASB shall determine the broad areas in which Accounting Standards need to be formulated and ‘priority in regard to the selection thereof.

In the preparation of Accounting Standards, ASB will be assisted by Study Groups constituted to consider specific subjects. In the formation of Study Groups, provision will be made for wide participation by the members of the institute and others.

ASB will also hold a dialogue with the representatives of the Government, Public Sector Undertakings, Industry and other organisations for ascertaining their views.

On the basis of the work of the Study Groups and the dialogue with the organisation, an exposure draft of the proposed standard will be prepared and issued for comments by members of the Institute and the public at large.

The draft of the proposed standard will include the following basic points:

• A Statement of concepts and fundamental accounting principles relating to the Standard.
• Definitions of the terms used in the Standard.
• The manner in which the accounting principles have been applied for.
• The presentation and disclosure requirements in complying with the Standard.
• Class of enterprises to which the Standard will apply.
• Date from which the Standard will be effective.

After taking into consideration the comments received, the draft of the proposed Standard will be finalized by ASB and submitted to the Council of the Institute.

The Council of the Institute will consider the final draft of the proposed Standard, and it found necessary, modify the same in consultation with ASB. The Accounting Standard on the relevant subject will then be issued under the authority of the Council.

Accounting Standards By I.C.A.I

Following Accounting Statements are to be studied.

a)      AS 01 – Disclosure of Accounting Policies.

b)     AS 02 – Valuation of Inventories.

c)      AS 09 – Revenue Recognition.

1.5 Accounting Standard 1: Disclosure of Accounting Policies

Accounting Standard (1): Disclosure of Accounting Policies: - AS – 1 is now mandatory (compulsory). It must be following by all of types concern i.e. sole proprietor, firm or a company.

Meaning: - Accounting policies refer to specific accounting principles and the method of applying those principles adopted by the enterprises in preparation and presentation of the financial statement (i.e. Final Accounts)

Purpose: - The purpose of disclosing Accounting policies is for proper and better understanding of financial statement. All important accounting policies should be disclosed at one place to help the reader in understanding the financial statements. Statements of accounting policies are part of financial statements.

Areas: - At the time of preparation of final accounts there are many areas where more than one method of accounting treatment can be followed.

E.g.

a)     Method of Depreciation: -

i)                    Fixed Installment Method.

Ii)                 WDV Method.

b)     Valuation of Stock: -

i)                    FIFO.

Ii)                 Weighted Average.

c)     Treatment of Expenditure during Construction: -

i)                       Written Off.

Ii)                     Capitalization.

Iii)                  Deferment.

Iv)                   Conversion of Foreign currency Item.

v)                     Valuation of Investment.

Vi)                   Treatment of Goodwill.

Vii)                Treatment of Retirement Benefits.

Viii)              Treatment of Contingent Liabilities.

Disclosure of Policies: - For proper and better understanding of financial statements it is required that all significant accounting policies followed in preparation of financial statements should be disclosed. Statement showing disclosure of accounting policies are part of financial statement. To help the reader to understand, it is better to disclose all the policies at one place.

Disclosure of Change in Policies: - If there is any change in accounting policies in preparation of financial statement from one period to subsequent period and such changes affects the state of affairs of Balance Sheets & Profit & Loss A/c of current period or of later period, then such change must be disclosed in the financial statement.

The amount by which the financial statement is affected should be disclosed to the extent possible.

Fundamental Accounting Assumptions: - If fundamental accounting assumptions are followed, then specific disclosure is not required.

E.g.

a)     Treatment of Expenditure during Construction: - It means that the concern is going to continue the business in future and has no intention of closing the business.

b)     Consistency: - It means that same accounting policies are followed from one period to another.

c)     Accrual: - It means that financial statements are prepared on mercantile system only. It means revenue and costs are recorded as they are earned or incurred and not as when money is received or paid.

If fundamental accounting assumption is not followed, then the fact should be disclosed.

1.6 Accounting Standard 2: Valuation of Inventories

Purpose: - The purpose of this standard is to formulate the method of computation of cost of stock, determine the value of closing stock to be shown in the Balance Sheet.

Definition: - AS – 2 defines inventories as assets.

a)      held for sale in ordinary course of business (finished goods).

b)     in the process of production of such sale (raw material and work in progress).

c)      in the form of materials or supplies to be consumed with production process or in the rendering of services.

Measurement: - Stock should be valued at lower cost and net realizable value.

Cost: - Cost of inventory includes:

a)      Cost of Purchase.

b)     Cost of Conversion.

c)      Other cost incurred in bringing the inventories to their present location and condition.

Net Realisable Value (NRV): - means estimated selling price in the ordinary course of business less the estimated costs of completion of work in progress and estimated costs of making the sale.

Cost of Purchase: - Cost of purchase includes Purchase Price, Duties and Taxes, Freight Inward and other expenditure directly attributable to the acquisition. Less Duties and Taxes recoverable by enterprises from taxing authorities, Trade Discount, Rebate, Duty drawback.

Disclosure in Financial Statement: - The financial statement should disclose the following:

a)      Accounting policy adopted in measuring inventories.

b)     Cost formula used.

c)      Classification of inventories i.e. finished goods, work in progress, raw materials etc.

1.7 Accounting Standard 9: Revenue Recognition

Meaning: - Revenue means gross inflow of cash, receivable or other consideration arising in the course of ordinary activities of an enterprise such as

a)      Sale of goods.

b)     Rendering of services.

c)      Use of the enterprises resources by other, yielding interest, dividend and royalties.

Timing: - Revenue should be recognized at the time of sale of rendering of services.

Transaction Excluded: - AS 9 is not applicable to the following:

a)      Revenue arising from construction contracts.

b)     Revenue arising from hire, purchase, lease agreements.

c)      Revenue arising from government grants and subsidies.

d)     Revenues of insurance companies arising from insurance contracts.

Sale of Goods: - As per AS 9 revenue from sale of goods is recorded when

a)      Seller has transferred the ownership of goods to the buyer for a price.

b)     All significant risks and rewards of ownership have been transferred to the buyer.

c)      Seller does not retain any effective control of ownership of the transferred goods.

d)     There is no significant uncertainty in collection of amount of consideration.

Rendering of Services: - Revenue from service is recorded as the service is performed. It is measured by 2 methods.

a)     Completer Service Contract Method: - Revenue is recorded on completion of the contract i.e. when rendering of service is complete.

b)     Propionate Completion Method: - Revenue is recorded proportionately i.e. in proportion to the degree of completion of services under a contract.

Effect of Uncertainties: - Revenue is recorded only when there is no significant uncertainty in collection of amount of consideration. Revenue recognition is if the ultimate collection is uncertain.

When uncertainty of collection of revenue arises after the revenue recognition it is better to make provision for the uncertainty in collection.

Disclosure: - If revenue recognition is postponed, then the circumstances necessitating the postponement must be disclosed.

Part B: Inventory Valuation

1.8 Meaning of Inventory

Inventory, often called merchandise, refers to goods and materials that a business holds for sale to customers in the near future.

In other words, these goods and materials serve no other purpose in the business except to be sold to customers for a profit. They are not used in the produce things or promote the business. The sole purpose of these current assets is to sell them to customers for a profit, but just because an asset is for sale doesn’t mean that it’s considered inventory. We need to look at three main characteristics of inventory to determine whether an asset should be accounted for as merchandise.

First, the assets must be part of the company’s primary business. For instance, a sandwich shop’s delivery truck is not considered inventory because it has nothing to do with the primary business of making and selling sandwiches. This is considered a fixed asset for the sandwich shop. To a car dealership, on the other hand, this truck would be considered inventory because they are in the business of selling vehicles.

Second, the assets must be available for sale or will soon be ready to sell. If some business assets could be sold but are never actually made available for sale, they aren’t inventory. These are just assets or investments of the company.

Third, the purpose of owning the assets must be to sell them to customers. Going back to our sandwich shop example, the truck was never meant to be sold to a customer. It was purchased to deliver sandwiches and was sold when it couldn’t perform that job. The car dealership, on the other hand, purchases vehicles for the sole purpose of reselling them. Thus, the truck is considered inventory to them.

Types of Inventories

According to the inventory definition, there are many different types of inventory and each is accounted for slightly differently. Retailers are the easiest to account for because they typically only have one kind of goods called merchandise. They purchase it from wholesalers or manufacturers as finished products to sell to their customers.

Manufacturers, on the other hand, define inventory a little bit differently because they produce their own products to sell to customers. Thus, they need to account for the inventory at every stage of production. The three categories are raw materials, work-in-process, and finished goods. Let’s take a look at each of these categories in the Ford car plant.

Raw materials – Raw materials are the building blocks to make finished goods. Ford purchases sheet metal, steel bars, and tubing to manufacture car frames and other parts. When they put these materials into produce and start cutting the bars and shaping the metal, the raw materials become work in process inventories.

Work in process – Work in process inventory consists of all partially finished products that a manufacturer produces. As the unfinished cars make their way down the assembly line, they are considered a work-in-progress until they are finished.

Finished goods – Finished goods are exactly what they sound like. These are the finished products that can be sold to wholesalers, retailers, or even the end users. In Ford’s case, they are finished cars that are ready to be sent to dealers.

Each of these different categories is important and managing them is key to any business’ survival. Inventory control is one of the most important concepts for any business especially retailers. Since they purchase goods from manufacturers and resell them to consumers at small margins, they have to manage their purchasing and control the amount of cash that is tied up in merchandise.

1.9 Cost for Inventory Valuation

Inventory valuation is the cost associated with an entity's inventory at the end of a reporting period. It forms a key part of the cost of goods sold calculation, and can also be used as collateral for loans. This valuation appears as a current asset on the entity's balance sheet. The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported into the proper place for sale. Do not add any administrative or selling costs to the cost of inventory. The costs that can be included in an inventory valuation are:

• Direct labor
• Direct materials
• Factory overhead
• Freight in
• Handling
• Import duties

Under the lower of cost or market rule, you may be required to reduce the inventory valuation to the market value of the inventory, if it is lower than the recorded cost of the inventory. There are also some very limited circumstances where you are allowed under international financial reporting standards to record the cost of inventory at its market value, irrespective of the cost to produce it (generally limited to agricultural produce).

**Inventory should be valued at Cost or Market Value (Net Realisable Value), whichever is lower

1.10 Inventory Control Systems

Inventory control systems are technology solutions that integrate all aspects of an organization’s inventory tasks, including shipping, purchasing, receiving, warehouse storage, turn-over, tracking, and reordering. While there is some debate about the differences between inventory management and inventory control, the truth is that a good inventory control system does it all by taking a holistic approach to inventory and empowering organizations to utilize lean practices to optimize productivity and efficiency along the supply chain while having the right inventory at the right locations to meet customer expectations.

That being said, there are two different types of inventory control systems available today: perpetual inventory systems and periodic inventory systems. Within those systems, two main types of inventory management systems – barcode systems and radio frequency identification (RFID) systems – used to support the overall inventory control process:

Main Inventory Control System Types:

1. Perpetual Inventory System
2. Periodic Inventory System

Types of Inventory Management Systems within Inventory Control Systems:

1. Barcode System
2. Radio Frequency Identification (RFID) System

Inventory control systems helps to track inventory and provides the data needed to control and manage it. No matter which type of inventory control system is chosen, the company should make sure that it includes a system for identifying inventory items and their information including barcode labels or asset tags; hardware tools for scanning barcode labels or RFID tags; a central database for all inventory in addition to the ability to analyze data, generate reports, and forecast demand; and processes for labeling, documenting, and reporting inventory along with a proven inventory methodology like just-in-time, ABC analysis, first-in, or first out (FIFO), or last-in-first-out (LIFO).

Perpetual Inventory System

Perpetual Inventory System may be defined as ‘a system of records maintained by the controlling department, which reflects the physical movements of stocks and their current balance’. Thus it is a system of ascertaining balance after every receipt and issue of materials through stock records to facilitate regular checking and to avoid closing down the firm for stock taking. To ensure the accuracy of the perpetual inventory records (bin card and Stores ledger), physical verification of stores is made by a programme of continuous stock taking.

The operation of the perpetual inventory system may be as follows :-

1. The stock records are maintained and up to date posting of transactions are made there in so that current balance may be known at any time.
2. Different sections of the stores are taken up by rotation for physical checking. Every day some items are checked so that every item may be checked for a number of times during the year.
3. Stores received but awaiting quality inspection are not mixed up with the regular stores at the time of physical verification, because entries relating to such stores have not yet been made in the stock records.
4. The physical stock available in the store, after counting, weighing, measuring or listing as the case may be, is properly recorded in the bin cards / Inventory tags and stock verification sheets.

Perpetual inventory system should not be confused with continuous stock taking; Continuous stock taking is an essential feature of perpetual inventory system. Perpetual inventory means the system of stock records and continuous stock taking, where as continuous stock taking means only the physical verification of the stock records with actual stocks.

In continuous stock taking, physical verification is spread throughout the year. Everyday 10 to 15 items are taken at random by rotation and checked so that the surprise element in stock verification may be maintained and each item may be checked for a number of times each year. On the other hand the surprise element is missing in case of periodical checking, because checking is usually done at the end of year.

Advantages of perpetual inventory system:

1. The system obviates the need for the physical checking of all items of stock and stores at the end of the year.
2. It avoids the dislocation of the routine activities of the organisation including production and dispatch.
3. A reliable and detailed check on the stores is maintained.
4. Errors, irregularities and loss of stock through other methods are quickly detached and through necessary action recurrence of such things in future is minimised.
5. As the work is carried out systematically and without undue haste the figures are readily available.
6. Actual stock can be compared with the authorised maximum and minimum levels, thus keeping the stocks within the prescribed limits. The disadvantages of excess stocks are avoided and capitalised up in stores materials cannot exceed the budget.
7. The recorder levels of various items of stores are readily available thus facilitating the work of procurement of stores.
8. For monthly or quarterly financial statements like Profit and Loss Account and Balance Sheet   the stock figures are readily available and it is not necessary to have physical verification of the balances.

Periodic Inventory System

Periodic Inventory System do not track inventory on a daily basis; rather, they allow organizations to know the beginning and ending inventory levels during a certain period of time. These types of inventory control systems track inventory using physical inventory counts. When physical inventory is complete, the balance in the purchases account shifts into the inventory account and is adjusted to match the cost of the ending inventory. Organizations may choose whether to calculate the cost of ending inventory using LIFO or FIFO inventory accounting methods or another method; keep in mind that beginning inventory is the previous period’s ending inventory.

There are a few disadvantages of using a periodic inventory system. First, when physical inventory counts are being completed, normal business activities nearly become suspended. As a result, workers may hurry through their physical counts because of time constraints. Periodic inventory systems typically don’t use inventory trackers, so errors and fraud may be more prevalent because there is no continuous control over inventory. It also becomes more difficult to identify where discrepancies in inventory counts occur when using a periodic inventory control system because so much time passes between counts. The amount of labor that is required for periodic inventory control systems make them better suited to smaller businesses.

Barcode Inventory Systems

Inventory management systems using barcode technology are more accurate and efficient than those using manual processes. When used as part of an overall inventory control system, barcode systems update inventory levels automatically when workers scan them with a barcode scanner or mobile device. The benefits of using barcoding in your inventory management processes are numerous and include:

• Accurate records of all inventory transactions
• Eliminating time-consuming data errors that occur frequently with manual or paper systems
• Eliminating manual data entry mistakes
• Ease and speed of scanning
• Updates on-hand inventory automatically
• Record transaction histories and easily determine minimum levels and reorder quantities
• Streamline documentation and reporting
• Rapid return on investment (ROI)
• Facilitate the movement of inventory within warehouses and between multiple locations and from receiving to picking, packing, and shipping

Radio Frequency Identification (RFID) Inventory Systems

Radio frequency identification (RFID) inventory systems use active and passive technology to manage inventory movements. Active RFID technology uses fixed tag readers throughout the warehouse; RFID tags pass the reader, and the movement is recorded in the inventory management software. For this reason, active systems work best for organizations that require real-time inventory tracking or where inventory security has been an issue. Passive RFID technology, on the other hand, requires the use of handheld readers to monitor inventory movement. When a tag is read, the data is recorded by the inventory management software. RFID technology has a reading range of approximately 40 feet with passive technology and 300 feet with active technology.

RFID inventory management systems have some associated challenges. First, RFID tags are far more expensive than barcode labels; thus, they typically are used for higher value goods. RFID tags also have been known to have interference issues, especially when tags are used in environments with a lot of metal or liquids. It also costs a great deal to transition to RFID equipment, and your suppliers, customers, and transportation companies need to have the required equipment as well. Additionally, RFID tags carry more data than barcode labels, which means your system and servers can become bogged down with too much information.

When choosing an inventory control system for the organization, one should first decide whether a perpetual inventory system or periodic inventory system is best suited to the organisation needs. Then, choose a barcode system or RFID system to use in conjunction with the inventory control system for a complete solution that will enable visibility into their inventory for improved accuracy in scanning, tracking, recording, and reporting inventory movement.

1.11 Valuation: Meaning & Importance

The Institute of Chartered Accountants of India (ICAI) defines in Accounting Standard 2 inventories as tangible properties held:

(a) For sale in the ordinary course of business, or

(b) In the process of production for such sale; or

(c) For consumption in the production of goods or services for sale, including maintenance supplies and consumables other than machinery parts

The inventory valuation is done at the end of each financial year in order to assess the operating performance (i.e., to find out profit or loss) and the financial position of the business (along with others of the business through the balance sheet).

Generally inventory is valued at cost or market price, whichever is lower. The basis of stock valuation adopted should be consistent over a period in order to make comparative evaluation meaningful.

Importance of Inventory Valuation

Inventory valuation is important for the following reasons:

• Impact on cost of goods sold: When a higher valuation is recorded for ending inventory, this leaves less expense to be charged to the cost of goods sold, and vice versa. Thus, inventory valuation has a major impact on reported profit levels.
• Loan ratios: If an entity has been issued a loan by a lender, the agreement may include a restriction on the allowable proportions of current assets to current liabilities. If the entity cannot meet the target ratio, the lender can call the loan. Since inventory is frequently the largest component of this current ratio, the inventory valuation can be critical.
• Income taxes: The choice of cost-flow method used can alter the amount of income taxes paid. The LIFO method is commonly used in periods of rising prices to reduce income taxes paid.

Objectives of Inventory Valuation:

(a) Determination of Trading Profit: Inventory is an important item for ascertaining the trading profit or gross profit. Gross profit is the excess of sales over cost of goods sold.

Cost of goods sold is computed by adjusting the opening and closing stocks to purchases, as shown follows:

Cost of goods sold = Opening stock + Purchases – Closing stock.

From the above equation it may be understood that the values of stocks influence the cost and thereby affect the gross profit. For example, over valuation of closing stock will reduce the cost and increase the current profit and reduce profits of subsequent years and vice versa.

(b) Determination of Financial Position: Inventory plays an important role in the ascertainment of the financial position of a business. Closing stock is shown as a current asset in the balance sheet. Over and under valuation of stock will give a misleading picture about the working capital position and the overall financial position of the business.

The method of inventory valuation is very important because it determines the amount of firm’s investment in inventory and it influences the firm’s reported income. In Financial accounting, the inventory is traditionally valued at lower of the cost or market value. On the other hand, in Cost accounting it is valued at cost of production.

Hence, the valuation of socks in two sets of books will be different and there will be difference in profits shown by financial and cost accounting records. This difference will be reconciled through a Reconciliation Statement.

Historical Cost:

The actual cost of raw materials, Work in Progress, and Finished Goods is the most logical method of valuing inventory. Cost Accounting (Records) Rules also provide that the inventory should be valued ‘at cost’. Historical cost of inventories is the expenditure incurred for bringing inventory in a saleable condition.

Accounting Standard 2 of the Institute of Chartered Accountants of India states that historical cost represents an appropriate combination of cost of purchase, cost of conversion, and other costs incurred in the normal course of business bringing the inventory up to the present location and condition.

Lower of the Cost or Market Price (LCM):

Under this method, the inventory is valued at cost or market price whichever is lower. The market price may be lower than the cost when the price levels of declining (during deflation) and the inventory may become obsolete because of technological and other changes, it is a conservative method. It shows a lower income than the income shown under the cost method.

However, when prices fluctuate, this method switches to period by period from cost to market price and vice versa. This reduces the usefulness of cost data for managerial analysis. It expects only losses but not gains.

Net Realizable Value Method:

This method is used for inventories, which are damaged or partly obsolete. Net realizable value means the estimated selling price less cost of completion. Normally the stock is valued at historical cost as the selling price will be less.

The loss incurred by writing down the stock to the net realizable value is adjusted to the profit and loss account. The inventory value, under this method, should not exceed the expected realizable value.

Replacement Cost Method:

Under this method, the inventories are valued at a price, which is equal to the current acquisition cost either by production or at a price that would have to be paid for those items at the inventory date. Or simply the replacement value may be taken as ‘market value’ or ‘reproduction value’. This method is a conservative method since it takes into consideration all possible losses but not expected profits.

Hence, the inventory is valued at the minimum of:

(a) Historical cost;

(b) Replacement value; and

(c) Net realizable value.

This method is not approved by Income Tax Authorities. Similarly the accountants also do not follow this method in practice.

1.12 First In First Out Method of Valuation (FIFO)

Definition and Explanation:

The first in first out (FIFO) method assumes that goods are used in the order in which they are purchased. In other words, it assumes that the first goods purchased are the first used (in manufacturing concerns) or the first goods sold (in the merchandising concerns). The inventory remaining must therefore represent the most recent purchases.

Example: Assume that a company had the following transactions in the first month of operations.

Periodic Inventory System: Assume that the company uses the periodic inventory system (amount of inventory computed only at the end of the month). The cost of the ending inventory is computed by taking the cost of the most recent purchase and working back until all units in the inventory are accounted for. The ending inventory and cost of goods sold are determined as shown below:

Perpetual Inventory System: If a perpetual inventory system in quantities and dollars is used, a cost figure is attached to each withdrawal. Then the cost of the 4,000 units removed on march 19 would be made up of the items purchased on March 2 and March 15. The inventory on a FIFO basis perpetual system for the company is shown below:

The ending inventory in this situation is Rs. 27,100, and the cost of goods sold is Rs. 16,800 [(2,000 @ Rs. 4.00) + (2,000 @ Rs. 4.40)].

Notice that in these two FIFO examples, the cost of goods sold and ending inventory are the same. In all cases where first in first out method (FIFO Method) is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. This is true because the same costs will always be first in and, therefore, first out - whether cost of goods sold is computed as goods are sold throughout the period (the periodic system).

Objectives and Advantages of FIFO Method:

One objective of FIFO is to approximate the physical flow of goods. When the physical flow of goods is actually first-in, first-out, the FIFO method closely approximates specific identification. At the same time, it does not permit manipulation of income because the enterprise is not free to pick a certain cost item to be charged to expense.

Another advantage of the FIFO method is that the ending inventory is close to current cost. Because the fist goods in are the first goods out, the ending inventory amount will be composed of the most recent purchases. This is particularly true where the inventory turnover is rapid. This approach generally provides a reasonable approximation of replacement cost on the balance sheet when price changes have not occurred since the most recent purchases.

Disadvantages of FIFO Method:

The basic disadvantages of first in first out method (FIFO Method) are that costs are not matched against current revenues on the income statement. The oldest costs are charged against the more revenue, which can lead to distortion in gross profit and net income.

1.13 Weighted Average Method of Valuation

As the name implies, the average cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period.

Example: Assume that a company had the following transactions in the first month of operations.

Assume the company used the periodic inventory method, the ending inventory and cost of goods sold would be computed as follows using a weighted average method.

If the company has a beginning inventory, it is included both in the total units available and in the total cost of goods available in computing the average cost per unit.

Another average cost method is moving average method, which is used with perpetual inventory records. The application of the average cost method for perpetual records is shown below:

In this method a new average unit cost is computed each time a purchase is made. On 15 March, after 6,000 units are purchased for Rs. 26,400, 8,000 units costing Rs. 34,400 (Rs. 8,000 plus Rs. 26,400) are on hand. The average unit cost is Rs. 34,400 divided by 8,000, or Rs. 4.30. This unit cost is used in costing withdrawals until another purchase is made, at which time a new average unit cost is computed. Accordingly, the cost of the 4,000 units withdrawn on March 19 is shown at Rs. 4.30, a total cost of goods sold of Rs. 17,200. On March, following the purchase of 2,000 units for Rs. 9,500, a new unit cost of Rs. 4.45 is determined, resulting in an ending inventory of Rs. 26,700.

The use of average cost methods is usually justified on the basis of practical rather than conceptual reasons. These methods are simple to apply, objective and not as subject to income manipulation as some of the other inventory pricing methods. In addition, proponents of the average cost methods argue that it is often impossible to measure a specific physical flow of inventory, and therefore it is better to cost items on an average price basis. This argument is particularly persuasive when the inventory involved is relatively homogeneous in nature.