Accounting for Inventories
The inventory can be defined as the list compiled for a formal purpose. In business, inventory holds the raw materials, work-in progress goods along with completely finished good which are considered to be a part of business assets that are, or will be ready for sales. Business store an ideal amount of inventory as high inventory storage can lead to obsolescence and excessive spoilage costs and too little inventory can have the risk of losing potential market share and sales.
There are mainly three reasons for keeping a business inventory
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1. Time-the movement of goods in the supply range can cause supply lags. In this ‘lead time’, the certain amounts of goods which are kept on the inventory are useful.
- 2. Removing uncertainties- inventories act as buffers for meeting the uncertainties in supply, demand, and in the movement of goods.
- 3. Economies of scale-the bulk buying, storing and movement of goods brings in economies of scale, highly beneficial in business.
Buy using the inventory valuation methods, a company can provide monetary value to all the items that constitute the inventory. Inventories often form the largest current asset of any business and its proper measurement is useful in accurate measurement of financial statements. Improper measurement of inventory leads to poor matching of expenses and revenue and also leads to poor business decisions.
The inventory accounting systems
The accounting systems which are most widely use are perpetual and periodic.
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1. Perpetual-when using the perpetual inventory system it s required that the accounting records show the amount inventory in hand at all times. A separate account is maintained in the subsidiary ledger for each of the goods which are in stock. The account is also updated every time we add or take out a quantity.
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2. Periodic-in this method, the inventory is not updated but the sales are recorded when he financial year ends. A physical inventory is taken for determining the costs of all the goods which are sold. The most commonly used methods are:-
- 1. first-in-first-out or FIFO method.
- 2. last-in-first-out or LIFO method and
- 3. The weighted average cost method.
Non-cost methods for valuing inventory
Many-a-times, valuing the inventory in terms of cost is not practical. Therefore, the market method or lower of cost method is used when the market price of goods drop below their purchase price. The decline in the inventory value can be offset against a given period’s income. The goods are recorded at net realizable values when they are obsolete and damaged and can be only sold below their purchase prices. Hence, the net selling price is the estimate selling price minus any expense which has been incurred for disposing off the goods.
Methods used for estimating inventory cost
The inventory cost is estimated when taking the physical inventory is impractical or impossible. Two popular methods for it are:-
The retail inventory method which uses the cost to retail price ratio, and values the physical inventory at retail, which is then multiplied by the cost ratio for determining the estimated cost of the ending inventory.
The gross profit method-this method uses the gross profit margin of the previous year for calculating the current year gross profit. The current year sale is multiplied by the gross profit margin. The end year inventory is estimated by summing up the cost of goods sold with the cost of goods available for sale. The cost of goods sold in the current year is estimated by subtracting the gross profit from the sale.
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