Study Of The Determination Of Quantity Of Inventories

Published Date: 02 Nov 2017

Inventories are assets:

Held for sale in the ordinary course of business: or

In the process of production for such sale; or

In the form of materials or supplies to be consumed

in the production process or in the rendering of services.

Net Realizable Value

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.

MEASUREMENT OF INVENTORIES

Lower of Cost and Net Realizable Value

HKAS 2 stated that inventories should be measured at the lower of cost and net realizable value.

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.

DETERMINATION OF QUANTITY OF INVENTORIES

Periodic Inventory

The totals of purchases and issues (sales) are recorded at the end of each financial period and the balance of the inventories will only be calculated at the end of each period.

Perpetual Inventory

A running balance is maintained to record the movements of the inventories after every purchase and issue (sale) of the inventories.

METHODS OF INVENTORIES VALUATION

Cost Formula

HKAS stated that the cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by using specific identification of their individual costs. (ex. Antiques, paintings, etc.)

HKAS also stated that the cost of inventories, other than above-mentioned should be assigned by using the first-in, first-out (FIFO) or weighted average cost formulas. An entity shall use the same cost formula for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may be justified.

1. Specific Identification

Specific identification of cost means that specific costs are attributed to identified items of inventory. This is the appropriate treatment for items that are segregated for a specific project, regardless of whether they have been bought or produced. However, specific identification of costs is inappropriate when there are large numbers of items of inventory that are ordinarily interchangeable. In such circumstances, the method of selecting those items that remain in inventories could be used to obtain predetermined effects on profit or loss.

Advantages

(a) It is simple to apply as the closing stock is valued at actual historical cost.

(b) The cost flow is the same as the actual physical stock movement.

 (c) Specific unit costs are used in calculating the cost of goods sold and the value of the closing stock. This provides a true matching of costs and revenues.

Disadvantage

(a) Applications are limited to those companies which have small qualities of high-value goods. It does not work for large volumes of identical and low-cost items.

2. First in, First out (FIFO)

The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced.

The calculation of cost of inventories on the basis that the quantities in hand represent the latest purchases or production.

Example

During the year, the following were the purchases and sales of inventory:

Purchases

Jan

Mar

Aug

6 units @ $ 12

6 units @ $ 15

10 units @ $ 16

Sales

Jul

Nov

4 units @ $22

14 units @ $25

Month

Descriptions

Purchased

Sales

Balance

Unit

Unit Cost $

Amount $

Unit

Unit Cost $

Amount $

Unit

Unit Cost $

Amount $

Jan

Purchases – 6 units @ $ 12

6

12

72

6

-

72

Mar

Purchases – 6 units @ $ 15

6

15

90

12

-

162

Jul

Sales – 4 units

4

12

48

8

-

114

Aug

Purchases – 10 units @ $ 16

10

16

160

18

-

274

Nov

Sales – 14 unit

2

6

6

12

15

16

24

90

96

4

-

64

Total

22

-

322

18

-

258

4

-

64

Advantages

 (a) It is simple to apply.

(b) The value of the closing stock on the balance sheet comprises more current costs than if AVCO or LIFO is used.

(c) The cost flow approximates the actual physical stock movement. Therefore, the value of the closing stock reflects the current replacement cost.

Disadvantages

 (a) The cost of goods sold reflects the oldest price. The FIFO method matches the historical cost with current selling price. It does not match recent costs with current revenues as LIFO does.

 (b) During periods of inflation, the reported profits include holding gains and normal operating profits. It yields a higher taxable income than the LIFO and WAVCO methods.

 (c) It does not assist in fixing the selling price because it may result in an unrealistic pricing structure.

3. Last in, First out (LIFO)

The calculation of cost of inventories on the basis that the quantities in hand represent the earliest purchases or production.

Example

During the year, the following were the purchases and sales of inventory:

Purchases

Jan

Mar

Aug

6 units @ $ 12

6 units @ $ 15

10 units @ $ 16

Sales

Jul

Nov

4 units @ $22

14 units @ $25

Month

Descriptions

Purchased

Sales

Balance

Unit

Unit Cost $

Amount $

Unit

Unit Cost $

Amount $

Unit

Unit Cost $

Amount $

Jan

Purchases – 6 units @ $ 12

6

12

72

6

-

72

Mar

Purchases – 6 units @ $ 15

6

15

90

12

-

162

Jul

Sales – 4 units

4

15

60

8

-

102

Aug

Purchases – 10 units @ $ 16

10

16

160

18

-

262

Nov

Sales – 14 unit

10

2

2

16

15

12

160

30

24

4

-

48

Total

22

-

322

16

-

274

4

-

48

Advantages

 (a) It matches current revenue with more recent costs, and gives more accurate normal operating profits.

 (b) During periods of inflation, it yields a lower reported income than FIFO and WAVCO methods.

(c) It provides a more realistic basis for price determination.

Disadvantages

 (a) The inventory represents the earliest acquisition costs. During periods of inflation, the value of the closing stock may be well below the current cost of replacement. Thus, it is an unrealistic measure of current assets on the balance sheet.

(b) It is complicated to be used when a company has many different products.

 (c) The reported profits may fluctuate widely over time. When the stock is exhausted, the earliest costs (usually the lowest costs) are matched with the current revenues. It may result in a periodic peak in profits.

4. Weighted Average Cost (AVCO)

Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity.

The calculation of the cost of inventories on the bases of the application to the unit of inventories on hand of an average price computed be dividing the total cost of units by the total number of such units.

Example

During the year, the following were the purchases and sales of inventory:

Purchases

Jan

Mar

Aug

6 units @ $ 12

6 units @ $ 15

10 units @ $ 16

Sales

Jul

Nov

4 units @ $22

14 units @ $25

Month

Descriptions

Purchased

Sales

Balance

Unit

Unit Cost $

Amount $

Unit

Unit Cost $

Amount $

Unit

Unit Cost $

Amount $

Jan

Purchases – 6 units @ $ 12

6

12

72

6

12

72

Mar

Purchases – 6 units @ $ 15

6

15

90

12

13.5

162

Jul

Sales – 4 units

4

13.5

54

8

13.5

108

Aug

Purchases – 10 units @ $ 16

10

16

160

18

14.9

268

Nov

Sales – 14 unit

14

14.9

208

4

14.9

59.6

Total

22

-

322

16

-

262

4

14.9

59.6

Advantages

 (a) It assigns an equal unit cost to each unit of stock.

 (b) It smoothes the profit and loss fluctuations.

 (c) The value of the closing stock tends to approach the replacement cost.

Disadvantage

 (a) It does not match recent costs with current revenues as well as LIFO does.

 (b) The closing stock does not reflect the current replacement cost as under FIFO.

 (c) It is more complicated to apply than the FIFO and LIFO methods.