TERM REPORT: INVENTORY VALUATION

SUBMITTED TO:

SUBMITTED BY:

Acknowledgement:
First and foremost I would like to express my thanks to Allah because of His love and strength
that He has given to me to finish this term report. I do thank for His blessings to my daily life,
good health, healthy mind and good ideas.
Secondly, I would like to thank my Parents and family who supported and motivate me. Writing
a term report is one of the most significant academic challenges I have ever faced. Though this
report has been presented by me but there are many people who remained in veil, who gave their
all support and helped me to complete this project.
Hereby I want to give my special thanks to;
Maam Zartashia Imran" for given me an opportunity to enhance my skills and knowledge
about that particular topic as well.
In Last, I am very thankful to the librarian who provided me several books on this topic which
proved beneficial in completing this project. I acknowledge my friends who gave their valuable
and meticulous advice which was very useful.

Adeel Tayyab
I.D No. SM-14-EX-0054
2nd semester

Summary
Companies may have inventories held in the form of raw materials, work-in-progress, finished
goods, products bought for resale, and service items.
At the end of the financial year, the company must make a physical inventory count and value
its inventory for use in the financial statements in the calculation of profit, and for the balance
sheet.
In order to be able to calculate accurately the price at which inventories of materials are issued
and to ascertain a valuation of inventory, a stores ledger record or inventory card is used.
The overriding principle of inventory valuation set out in IAS 2, Inventories is that inventories
are to be valued at the lower of cost and net realizable value.
IAS 2, Inventories, allows two methods to be used to value inventory:
FIFO (first in, first out)
AVCO (average cost)
Having chosen an inventory valuation method, a company should apply it consistently.
The use of either FIFO or AVCO may result in a different value for closing inventory and,
hence, a different reported profit for a particular time period. However, over the life of a
business, total profit is the same, which ever method is chosen.
IAS 2, Inventories, requires that, in calculating the lower of cost and net realizable value, note
should be taken of
separate items of inventory, or
groups of similar items
An inventory count is carried out regularly to check that the quantity of inventory held is the
same as that recorded in the inventory records. An inventory count is carried out on either a
periodic basis or continuously.
Inventory reconciliation is the process of comparing the inventory count and the inventory
record. Small shortfalls in physical inventory may be authorized for write-off by the companys
managers or auditors; larger discrepancies will need to be investigated to establish their cause.

INDEX
Abstract.5
Introduction..5
Objective And Scope ...5
Defination..6
Types Of Inventories Measurement / Valuation Of Inventories 7
Valuation of Inventory For Balance Sheet Purpose.8
Principle of Consistency And Inventory Valuation....9
Identification Of Old, Absolute And Non-Moving Stock.9
Reasons For Holding Inventories.....9
Methods of Inventory Valuation..10
Recording of Inventory Values- Store Ledger Records12
Categories of Inventory....14
Inventory Counts And Reconciliation.15
Average Cost...16
Base Stock..17
Inflated Price Method...........................18
Determination of Stock Levels....18
Inventory
System22
Effect of Errors In Inventory Valuation23
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Abstract
The basic financial purpose of a firm is to maximize its value. An inventory management system
should also contribute to realization of this basic aim. Many current asset management models
currently found in financial management literature were constructed with the assumption of
book profit maximization as basic aim. However these models could lack what relates to another
aim, i.e., maximization of enterprise value.

Introduction
The basic financial aim of an enterprise is maximization of its value. At the same time, a large
both theoretical and practical meaning has the research for determinants increasing the firm
value. Most financial literature contains information about numerous factors influencing the
value. Among those factors is the net working capital and elements creating it, such as the level
of cash tied in accounts receivable, inventories and operational cash balances. A large majority
of classic financial models proposals, relating to the optimum current assets management, were
constructed with net profit maximization in view. In order to make these models more suitable
for firms, which want to maximize their value, some of them must be reconstructed. In the
sphere of inventory management, the estimation of the influence of changes in a firm's decisions
is a compromise between limiting risk by having greater inventory and limiting the costs of
inventory. It is the essential problem of the corporate financial management.
The basic financial inventory management aim is holding the inventory to a minimally
acceptable level in relation to its costs. Holding inventory means using capital to finance
inventory and links with inventory storage, insurance, transport, obsolescence, wasting and
spoilage costs. However, maintaining a low inventory level can, in turn, lead to other problems
with regard to meeting supply demands.
The word inventory doesn't have the same meaning in the USA and in the UK:
In American English and in a business accounting context, the word inventory is commonly
used to describe the goods and materials that a business holds for the ultimate purpose of resale
(or repair). In American English, the word stock is commonly used to describe the capital
invested in a business, while in British English; the sentence stock shared is used in the same
context.
In the rest of the English speaking world stock is more commonly used, although the word
inventory is recognized as a synonym. In British English, the word inventory is more

commonly thought of as a list compiled for some formal purpose, such as the details of an estate
going to probate, or the contents of a house let furnished.

Objective And Scope

A primary issue in accounting for inventories is the determination of the value at which
inventories are carried in the financial statements until the related revenues are recognized.

Scope:
1. This Standard should be applied in accounting for inventories other than:
(a) work in progress arising under construction contracts, including directly related service
contracts (see Accounting Standard (AS) 7, Construction Contracts);
(b) work in progress arising in the ordinary course of business of service providers;
(c) shares, debentures and other financial instruments held as stock-in-trade; and
(d) producers inventories of livestock, agricultural and forest products, and mineral oils, ores
and gases to the extent that they are measured at net realizable value in accordance with
well established practices in those industries.
2. The inventories referred to in paragraph 1(d) are measured at net realizable value at
certain stages of production. This occurs, for example, when agricultural crops have been
harvested or mineral oils, ores and gases have been extracted and sale is assured under a
forward contract or a government guarantee, or when a homogenous market exists and there is
a negligible risk of failure to sell. These inventories are excluded from the scope of this
Standard.

Defination
The following terms are used in IAS-2 with the meanings specified:
1. Inventories Are Assets
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(a) held for sale in the ordinary course of business;

(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or in the
rendering of services.
2. Net Realization Method
Net realizable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
Inventories encompass goods purchased and held for resale, for example, merchandise
purchased by a retailer and held for resale, computer software held for resale, or land and other
property held for resale. Inventories also encompass finished goods produced, or work in
progress being produced, by the enterprise and include materials, maintenance supplies,
consumables and loose tools awaiting use in the production process. Inventories do not include
machinery spares which can be used only in connection with an item of fixed asset and whose
use is expected to be irregular; such machinery spares are accounted for in accordance with
Accounting Standard (AS) 10, Accounting for Fixed Assets.

Types of Inventories Measurement / Valuation of inventories

Inventories should be valued at the lower of cost and net realizable value.
1. Cost of inventories
The cost of inventories should comprise all costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their present location and condition.
2. Cost of purchase
The costs of purchase consist of the purchase price including duties and taxes (other than those
subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other
expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and
other similar items are deducted in determining the costs of purchase.
3. Cost of conversion
The costs of conversion of inventories include costs directly related to the units of production,
such as direct labor. They also include a systematic allocation of fixed and variable production
7

overheads that are incurred in converting materials into finished goods. Fixed production
overheads are those indirect costs of production that remain relatively constant regardless of the
volume of production, such as depreciation and maintenance of factory buildings and the cost of
factory management and administration. Variable production overheads are those indirect costs
of production that vary directly, or nearly directly, with the volume of production, such as
indirect materials The allocation of fixed production overheads for the purpose of their inclusion
in the costs of conversion is based on the normal capacity of the production facilities. Normal
capacity is the production expected to be achieved on an average over a number of periods or
seasons under normal circumstances, taking into account the loss of capacity resulting from
planned maintenance. The actual level of production may be used if it approximates normal
capacity. The amount of fixed production overheads allocated to each unit of production is not
increased as a consequence of low production or idle plant. Unallocated overheads are
recognized as an expense in the period in which they are incurred. In periods of abnormally high
production, the amount of fixed production overheads allocated to each unit of production is
decreased so that inventories are not measured above cost. Variable production overheads are
assigned to each unit of production on the basis of the actual use of the production facilities.
A production process may result in more than one product being produced simultaneously. This
is the case, for example, when joint products are produced or when there is a main product and a
by-product. When the costs of conversion of each product are not separately identifiable, they
are allocated between the products on a rational and consistent basis. The allocation may be
based, for example, on the relative sales value of each product either at the stage in the
production process when the products become separately identifiable, or at the completion of
production. Most by-products as well as scrap or waste materials, by their nature, are immaterial.
When this is the case, they are often measured at net realizable value and this value is deducted
from the cost of the main product. As a result, the carrying amount of the main product is not
materially different from its cost.
4. Other cost
Other costs are included in the cost of inventories only to the extent that they are incurred in
bringing the inventories to their present location and condition. For example, it may be
appropriate to include overheads other than production overheads or the costs of designing
products for specific customers in the cost of inventories.
Interest and other borrowing costs are usually considered as not relating to bringing the
inventories to their present location and condition and are, therefore, usually not included in the
cost of inventories.
5. Exclusion of cost of inventories
In determining the cost of inventories in accordance with paragraph 6, it is appropriate to
exclude certain costs and recognize them as expenses in the period in which they are incurred.
Examples of such costs are:
(a) abnormal amounts of wasted materials, labor, or other production costs;
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(b) storage costs, unless those costs are necessary in the production process prior to a further
production stage;
(c) administrative overheads that do not contribute to bringing the inventories to their present
location and condition; and
(d) selling and distribution costs.

Valuation of Inventory for balance sheet purpose

The most generally accepted accounting principle for valuation of inventory is that stock should
be valued at cost or market price, whichever is lower. This flows from the Accounting Principle
of Conservatism. As per the principle of conservatism, recognize all possible losses and
anticipate no profit.
Inventory should be valued at cost or market price (net realizable value), whichever is lower.
Recognize all possible losses in respect of transactions and events that have happened. Do not
recognize anticipated profits, however certain they are, till they are realized.
1. Cost: Cost is the expenditure incurred for bringing the inventory to the place and condition
in which the goods concerned are to be sold. So, it is not only the purchase price, but also
cost of conversion and other costs incurred in bringing the inventories to the present location
and condition. Examples to the later category are wages or manufacturing expenses incurred
for converting raw materials into finished goods, transportation costs, duties paid and
insurance, etc. However, selling expenses and storage expenses are to be excluded.
2. Market Price: Market price means net realizable value, in case of finished goods and
replacement price, in case of raw materials and chief stores. The net realizable value is to be
calculated after considering all the expenses, which might have to be incurred for making
sales. For example, if the seller has to pay commission of 10% of sales, the net realizable
value of an article having a selling price of Rs. 100 is to be taken as Rs. 90.
As per International Accounting Standard (IAS) No. 2, cost or market price method is to be
followed for each item or group of homogeneous items of inventory.

Principle Of Consistency And Inventory Valuation

If the method of inventory valuation is changed from year to year, the results for two periods
becomes incomparable. It will affect the true and fair view of the financial statements. However
if a change in method is necessary for better presentation of financial results, it can do so. Hence
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it is very important to understand a companys policy of inventory valuation while interpreting

the financial results.

Identification Of Old, Absolute And Non-Moving Stock

To ensure that stocks reflect assets having realizable value, old, non-moving and obsolete stocks
should be identified and scrapped periodically and such loss must be recognized in the financial
statements.

Reasons For Holding Inventories

There are six basic reasons for keeping an inventory
1. Time - The time lags present in the supply chain, from supplier to user at every stage,
requires that you maintain certain amounts of inventory to use in this lead time. However, in
practice, inventory is to be maintained for consumption during 'variations in lead time'. Lead
time itself can be addressed by ordering that many days in advance.
2. Uncertainty- Inventories are maintained as buffers to meet uncertainties in demand, supply
and movements of goods.
3. Economies of scale - Ideal condition of "one unit at a time at a place where a user needs it,
when he needs it" principle tends to incur lots of costs in terms of logistics. So bulk buying,
movement and storing brings in economies of scale, thus inventory.

4. Appreciation in Value - In some situations, some stock gains the required value when it is
kept for some time to allow it reach the desired standard for consumption, or for production.
For example; beer in the brewing industry.
5. To facilitate the production process - Stock can allow the manufacturing process to flow
smoothly and help the business to respond quickly and effectively to contingencies.
6. Some processes require holding work in progress - Inventory can also include work in
progress. Some products might have longer production cycles than others (like wine or
cheese for instance). It is necessary to hold a high volume of inventory to cater for the
inherent nature of production in some business contexts.

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All these stock reasons can apply to any owner or product

Methods of Inventory Valuation

The difficulty in inventory valuation is in finding out the cost price of inventory this is not easy
when quantities of a particular inventory item are continually being bought in often at different
prices and then sold. Some companies have inventory in a number of different forms, e.g. a
manufacturer may well have raw materials, work-in-progress and finished goods.
IAS 2, Inventories , allows companies to use one of two methods to calculate the cost price of
their inventory:
1. FIFO
First-In, First-Out (FIFO) is one of the methods commonly used to calculate the value
of inventory on hand at the end of an accounting period and the cost of goods sold during the
period. This method assumes that inventory purchased or manufactured first is sold first and
newer inventory remains unsold.
2. AVCO
In this method, the weighted average cost of items held at the beginning of the year is calculated,
using the formula:
weighted average cost = total cost of goods in inventory /number of items in inventory
The weighted average cost is then used to value goods sold. A new weighted average cost must
be calculated each time that further inventories are bought during the year.
3. LIFO
This method operates in just reverse order of FIFO method.
This method is suitable in times of rising prices because material will be issued from the latest
consignment at a price, which is closely related to current price levels, as far possible.

Recording of Inventory Values- Store Ledger Records

In order to be able to calculate accurately the price at which materials are issued and to ascertain
a valuation of inventory, a stores ledger record or inventory card is used. This method of

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recording inventory data is also used in the Worked Example which follows. STORES LEDGER
RECORD
Note the following points:
1. the layout of the stores ledger record or inventory card may vary slightly from one
business to another
2. many businesses use a computer system for their inventory records.
3. a blank stores ledger record, which may be photocopied, is available for free download from
the Resources section of www.osbornebooks.co.uk
4. whilst it is good learning practice to use a stores ledger record, many examination questions
require a calculation of inventory value this can be completed without a stores ledger
record.

Categories of Inventory
IAS 2, Inventories, requires that, in calculating the lower of cost and net realizable value, note
should be taken of:
separate items of inventory, or
groups of similar items
This means that the inventory valuation 'rule' must be applied to each separate item of inventory,
or each group or category of similar inventories. The total cost cannot be compared with the total
net realizable value, as is shown by the Worked Example which follows

Inventory counts and reconciliation

The Inventory Count
A company needs to check regularly that the quantity of inventory held is the same as that
recorded in the inventory records. This is done by means of an inventory count counting the
physical inventory on hand to check against the balance shown by the records, and to identify
any theft or deterioration.
Inventory Reconciliation
The object of the inventory count is to see if the inventory records represent accurately the level
of inventory held. The comparison between the inventory count and the inventory record is
known as inventory reconciliation. This is an important process because
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1. an accurate inventory figure can then be used to value the inventory

2. it will highlight any discrepancies which can then be investigated
Larger discrepancies will need to be investigated, as they could have been caused by:
a. an error on the inventory record
b. theft of inventory
c. damaged inventory being disposed of without any record having been made
Once an accurate figure for closing inventory has been agreed it can then be used in the financial
statements to calculate profit, and for the balance sheet.

Average Cost
In stores, material is always mixed up. The principal on which the average cost method is based
is that all of the materials in store are so mixed up that an issue cannot be made from any
particular lot of purchases. Therefore, it is proper, if the materials are issued at the average cost
of materials in store.
Average may be of two types:
1. Simple Arithmetic Average.
2. Weighted Arithmetic Average.
1. Simple Average Cost
Simple Average Cost Simple average price is calculated by dividing the total of unit purchase
prices of different lots in stock on the date of issue by the number of prices used in the
calculation. Quantity of different lots is ignored.
Simple average price is not a proper method for issuing the prices as this method does not
recover the full costs, which is the primary requirement of a good pricing method.
2. Weighted Average Cost
Weighted Average Cost The weighted average price takes into account the price and quantity of
the materials in store.

Base stock

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Each concern always maintains a minimum quantity of material in stock. This minimum
quantity is known as safety or base stock and this should be used only when an emergency
arises. The base stock is created out of the first lot of the material purchased and therefore, it is
always valued at the cost price of the first lot and is carried forward as a fixed asset. This
method works with some other method and is generally used with FIFO or LIFO method.
Therefore, the advantages and disadvantages of the method, with which the Base stock method
is used, will arise. Any quantity over and above the base stock is issued in accordance with the
other method, which is used in conjunction with this method. The objective of this method is to
issue the material according to the current prices. This objective will be achieved only when the
LIFO method is used together with the Base Stock method. Base Stock Method is always used
in conjunction with FIFO or LIFO method. So, Base Stock Method would have the same
advantages and disadvantages of the combined method FIFO or LIFO method.

Inflated Price method

There are some materials, which are subject to natural wastage.
Examples are:
(1) Coal lost due to loading and unloading
(2) Timber lost due to seasoning.

Determination of Stock Levels

1. Maximum Level Or Maximum Limit
The maximum stock limit is upper level of the inventory and the quantity that must not be
exceeded without specific authority from management.
Formula:
Maximum level or maximum limit can be calculated by the help of following formula:
Maximum limit or level = Re-order level or ordering point Minimum usage Minimum reorder period + Economic order quantity
Example:
Normal usage

100 units per day

Maximum usage

130 units per day

Minimum usage

70 units per day

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Re-order period

25 to 30 days

Economic order quantity

5,000 units

Calculate maximum limit or level.

In order to calculate maximum limit of stock we must calculate re-order point or re-order
level first.
Ordering point or re-order level = Maximum daily or weekly or monthly usage Maximum reorder
= 130 30
= 39,000 units
Calculation:
Maximum limit or level = Re-order level or ordering point Minimum quantity used in re-order
period usage + Economic order quantity
= 3900 (70 25) + 5,000
= 7150 units

2. Minimum Limit Or Minimum Level Of Stock

The minimum level or minimum stock is that level of stock below which stock should not be
allowed to fall. In case of any item falling below this level, there is danger of stopping of
production and, therefore, the management should give top priority to the acquisition of new
supplies.
Formula:
Minimum level or minimum limit can be calculated by the following formula or equation:
Minimum limit or level = Re-order level or ordering point Average or normal usage Normal
re-order period
Or the formula can be written as:
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Minimum limit or level = Re-order level or ordering point Average usage for Normal period
Example:
Normal usage

100 units per day

Maximum usage

130 units per day

Minimum usage

70 units per day

Re-order period

25 to 30 days

Calculate: minimum limit or level

To calculate minimum limit of materials we must calculate re-order point or re-order level first.
Calculation:
Ordering point or re-order level = Maximum daily or weekly or monthly usage Maximum reorder
= 130 30
= 3,900 units
Minimum limit or level = Re-order level or ordering point Average or normal usage Normal
re-order period
= 3900 (100 27.5*)
1150 units
*(25 + 30 ) / 2

Average Inventory Calculation

Average inventory is used to estimate the amount of inventory that a business typically has on
hand over a longer time period than just the last month. Since the inventory balance is calculated
as of the end of the last business day of a month, it may vary considerably from the average
amount over a longer time period, depending upon whether there was a sudden draw-down of
inventory or perhaps a large supplier delivery at the end of the month.
(Beginning inventory + Ending inventory) / 2
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Days of Inventory
A variation on the average inventory concept is to calculate the exact number of days of
inventory on hand, based on the amount of time it has historically taken to sell the inventory.
This calculation is:
365 / (Annualized cost of goods sold / Inventory)
Thus, if a company has annualized cost of goods sold of $1,000,000 and an ending inventory
balance of $200,000, its days of inventory on hand is calculated as:
365 / ($1,000,000 / $200,000) = 73 Days of inventory

Inventory system
Inventory records relating to quantity and value can be maintained according to any of the
following systems:
1. Periodic Inventory System
2. Perpetual Inventory System
-Periodic Inventory System
Periodic Inventory System 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 information about inventory is required.
-Perpetual Inventory System
Perpetual Inventory System Perpetual Inventory System is a method of recording inventory
balances after each receipt and issue. In order to ensure accuracy of perpetual inventory records,
physical stocks should be checked and compared with recorded balances. The discrepancies, if
any, should be investigated and adjusted in the accounts, properly.
Perpetual Inventory is Better than Periodic Inventory
Periodic inventory is done, normally, at the end of the year, closing business operations, at least
for a few days. In perpetual inventory, the experienced and dedicated staff does stock-taking
throughout the year. All the items of stock are covered in a phased manner. The greatest
advantage with perpetual inventory is this process of stock taking does not disturb the business
17

operations as it is done throughout the year, continuously, in a planned manner, throughout the
year.
Method of Pricing issues and system of inventory influence cost of production and valuation of
closing stock. In consequence, profitability of the firm depends upon the method of issues as
well as system of inventory.

Effect of errors in Inventory valuation

An incorrect inventory balance causes an error in the calculation of cost of goods sold and,
therefore, an error in the calculation of gross profit and net income. Left unchanged, the error
has the opposite effect on cost of goods sold, gross profit, and net income in the following
accounting period because the first accounting periods ending inventory is the second period's
beginning inventory. The total cost of goods sold, gross profit, and net income for the two
periods will be correct, but the allocation of these amounts between periods will be incorrect.
Since financial statement users depend upon accurate statements, care must be taken to ensure
that the

inventory balance at the end of each accounting period is correct. The chart below identifies the
effect that an incorrect inventory balance has on the income statement.

Impact of Error on
Error in Inventory

Cost of Goods Sold

Gross Profit

Net Income

Understated

Overstated

Understated

Understated

Overstated

Understated

Overstated

Overstated

Understated

Overstated

Overstated

Ending Inventory

Beginning Inventory
Understated

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Impact of Error on
Error in Inventory
Overstated

Cost of Goods Sold

Gross Profit

Net Income

Overstated

Understated

Understated

Balance sheet effects. An incorrect inventory balance causes the reported value of assets and
owner's equity on the balance sheet to be wrong. This error does not affect the balance sheet in
the following accounting period, assuming the company accurately determines the inventory
balance for that period.

Impact of Error on
Error in Inventory

Assets =

Liabilities +

Owner's Equity

Understated

Understated

No Effect

Understated

Overstated

Overstated

No Effect

Overstated

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