Definition: The word ‘inventory’ refers to the collection of unsold goods ready for sale in the normal course of business. In finer terms, it implies the stock held by the business in the process of production to serve as a buffer, which ensures proper supply of materials and maintains the smooth functioning of the business.
The type of inventory depends on the nature of the business concern. As a manufacturing entity may consist of inventories raw material, work-in-process and finished goods. On the other hand, the trading entity includes products bought for the purpose of resale in their existing state. In case of a concern involved in the construction business, projects that are under construction is termed as inventory.
Valuation of Inventory
The determination of the value of inventory plays a crucial role in the preparation of financial statement, as it decides the authenticity of final accounts. The reasons for the valuation of inventory, are discussed in the points given below:
- Ascertainment of Income: Inventory valuation is important for ascertaining the real income that a business entity earns in a financial year. For the determination of the gross profit, cost of goods sold has to be matched with the respective revenue of the financial period.
- Statutory Compliance: As per Companies Act, 2013, valuation is must for each category of stock, i.e. raw materials, work in progress and finished stock, which appears under the head inventory in the financial statements.
- Ascertainment of Financial Position: The value of inventory must be known, at the time of preparation of balance sheet, to determine the financial position of the business. So, the authenticity of balance sheet highly depends on the accuracy of the value of inventory.
- Liquidity Position: Inventory comes under the category of net working capital, which helps in ascertaining the firm’s overall liquidity position.
The valuation of inventory is based on cost or net realisable value whichever is lower. It is regulated by the Principle of Conservative Accounting, according to which any expenses or losses from the transactions are recorded immediately, whereas any gains or profits are recognized when they actually become due for payment.
The term cost includes the cost of purchase, cost of conversion and all the other costs spent to bring the inventories in the present condition and location. On the other hand, the Net Realizable Value (NRV) is the estimated selling price of the inventory excluding the estimated cost of completion and anticipated costs required to make a sale.
Inventory Record System
Inventory Record System, as the name suggests is one that is concerned with keeping a track of physical quantities and the complete monetary valuation inventories sold and in hand. It helps you in recording the goods as and when it reaches the warehouse or godown, and also when it is issued for the purpose of sale. It ensures that the records maintained by the business enterprise are up-to-date.
Basically, there are two systems of maintaining a record of inventory, i.e. Perpetual Inventory System and Periodic Inventory System.
Periodic Inventory System
Otherwise called as a Physical inventory system, it is a method of determining the value of unsold inventory along with its physical quantities. In this method, an actual physical count is undertaken with respect to the measurement and weight of all the inventory units at a specific date. The calculation of the cost of goods sold is given hereunder:
Cost of Goods Sold = Opening inventory + Purchases – Closing Inventory
One of the major limitations of the physical count is that normal business operations are hampered during the process of physical verification of stock. Further, the cost of goods sold is the residual figure. Hence it is not easy to recognize the loss of stock, out of damage, theft or pilferage.
Perpetual Inventory System
A system of ascertaining the value of inventory in which the inventory balances are entered after every receipt and issue of stock. In addition to this, physical inventory is checked and compared with the balances shown in the books to date, to ensure reliability and accuracy. That is why it is called Continuous Stock Verification.
According to this system, the cost of goods issued is determined instantly with the help of ledger account wherein the receipt and issue of goods is entered perpetually and the balance of goods left is considered as the inventory in hand. The calculation of closing inventory is given as under:
Closing Inventory = Opening Inventory + Purchases – Cost of Goods Sold
The primary drawback of a perpetual inventory system is that closing inventory is taken as the balancing figure which encompasses the loss of goods too.
Of the two systems, the perpetual inventory system is regarded as the costlier one. However, it provides better information in comparison to the periodic inventory system.