Module 05: Inventory Accounting and Valuation

Revenue is the first line of the income statement. The very next line is the cost of what was sold, and that cost comes out of inventory. Module 5 is about one deceptively simple question: when identical items are bought at different prices, which price do you attach to the units that went out, and which to the units still sitting in the store? Every rupee you put into closing inventory is a rupee you take out of cost of sales, and therefore a rupee you add to profit. That is why this module is almost entirely numerical, and why auditors spend more time on inventory than on almost any other balance.

5.1 Why inventory valuation drives reported profit

The income statement above makes the mechanism visible. Revenue 70,000 less cost of goods sold 40,000 gives gross profit 30,000; after SGA 10,000, interest 2,000 and tax 3,600 the net profit is 14,400. The only figure the accountant has real discretion over is the 40,000, and that figure is a residual:

For a manufacturer the same identity is written as:

Memory hook: Closing inventory is the swing figure. Overvalue it and profit is overstated; undervalue it and profit is understated. Nothing else in the trading account is as easy to move.

Inventory has three components:

A trading (merchandise) firm buys and sells without adding value, so it has only one component, finished goods. A manufacturing firm has all three. A pure service firm may have none at all.

5.2 Periodic inventory valuation

In periodic valuation you do not record each issue. At the end of the accounting period you physically count the unsold units, assign a value to them, and derive cost of sales as a residual.

Worked example (the television dealer). A firm bought 100 televisions in three lots over six months: 30 units at Rs 10,000, then 40 units at Rs 9,000, then 30 units at Rs 11,000. It sold 80 units at an average price of Rs 14,000. The accountant valued the 20 unsold units at Rs 2,20,000.

Periodic valuation suits a trading firm dealing in a few items whose closing quantity is small enough to count.

5.3 Perpetual inventory valuation

In perpetual valuation an entry is made at every receipt and every issue, and the balance quantity and balance value are updated after each transaction. The ledger carries three blocks of columns, each with units, rate and value:

Worked example (constant price). An automobile company buys a component on the 1st of each month and issues it to production on the 15th, always at Rs 200 per unit.

Answer: purchases 3,80,000 less issues 3,60,000 leaves closing inventory 20,000, which ties to 100 units at Rs 200.

When perpetual is required. A car manufacturer buys around 500 different components. Physical counting of every bin is not feasible, so the record itself must supply the closing value. Perpetual accounting also lets the storekeeper state the inventory value at any moment, which matters when a bank lending against inventory demands a monthly stock statement.

5.4 The six-month dataset: the module's anchor problem

Everything from 5.5 to 5.9 works the same data. Relax the constant-price assumption and add three more months.

Closing quantity is 300 units under every method. The purchase value of Rs 8,40,000 is also identical under every method. Only the split between consumption and closing stock changes.

Common trap: Candidates try to "check" a method by re-adding purchases. Purchases never differ. The only thing you can get wrong is the split.

5.5 Specific identification method

If each unit can be traced to the lot it came from (a barcode carrying the purchase price, for instance), value the closing stock unit by unit and derive consumption as the residual.

Given: of the 300 closing units, 100 were bought in June at Rs 250 and 200 in May at Rs 220.

Answer: closing inventory Rs 69,000, material consumption Rs 7,71,000.

Suitable only when closing units are few and a technology exists to read the acquisition price off the item.

5.6 First-In-First-Out (FIFO)

Assumption: the units purchased earliest are issued first. Physically this is the storekeeper who empties the oldest box before opening the next one. The accountant applies the assumption whatever the storekeeper actually does.

Answer: FIFO consumption Rs 7,65,000, closing inventory Rs 75,000 (8,40,000 − 7,65,000 = 75,000, which ties).

Notice that under FIFO the closing stock always carries the most recent prices (all 300 units at the June rate of 250), so the balance sheet inventory figure is close to current replacement cost.

5.7 Last-In-First-Out (LIFO)

Assumption: the units purchased most recently are issued first. Physically this is a stack where new arrivals go on top. LIFO forces you to keep layers, because whatever the recent lots cannot absorb is drawn from older layers that then survive for years.

Answer: LIFO consumption Rs 7,84,000, closing inventory Rs 56,000.

Memory hook: The June closing stock under LIFO is 100 January units at Rs 200 and 200 April units at Rs 180. Not a single unit of it is priced at a May or June rate. That is the whole point of LIFO layering, and the whole problem with it.

The long-run LIFO problem. After a few years the closing stock carries price points from several past years and becomes meaningless as a balance sheet number. Accountants who use LIFO periodically average the whole inventory value and treat that single figure as the latest purchase value, erasing the historical layers.

Legality. Most countries, India included, disallow LIFO. The United States permits it. You still need to know the mechanics because you may work for a US-reporting company.

5.8 Weighted average method

Assumption: all lots are interchangeable. Recompute the average rate at every receipt, and apply that rate to every issue until the next receipt.

The rate track, receipt by receipt:

The rate falls when the new lot is cheaper than the running average (March 225.71 to 213.14, April to 183.01) and rises when it is dearer (May to 208.90, June to 227.17).

The issue ledger:

Answer: weighted average consumption Rs 7,71,849, closing inventory Rs 68,151.

5.9 The four-method comparison

This table is the central exam artefact of the module.

Read it in three moves:

1. Purchase value is identical. The method never changes what you paid.
2. Prices rose from 200 in January to 250 in June. Under rising prices LIFO charges the newest, highest costs to consumption, so consumption is highest (7,84,000) and closing stock lowest (56,000). FIFO does the reverse.
3. Weighted average always lands between FIFO and LIFO on both lines. That moderating property is why most Indian companies use it.

5.10 Choosing a method: profit, tax and consistency

Accounting regulations let a company choose any one of the four methods, and tax authorities accept any of them. But the consistency concept applies: once chosen, the same method must be followed in later years, and a change must be disclosed.

Common trap: "LIFO saves tax" is only true under inflation. Under falling prices it is FIFO that saves tax. Always check the direction of the price movement before answering.

5.11 Retail method

Retail stores handle several hundred items, so neither formal perpetual accounting nor physical verification is practical. The retail method works backwards from sales using the average gross margin.

Given: opening stock Rs 20 lakh, purchases Rs 300 lakh, sales Rs 280 lakh, average gross margin 5%.

Answer: cost of sales Rs 266 lakh, closing inventory Rs 54 lakh.

The method assumes a uniform gross margin across all items. If margins differ by category, the store must split sales by category and apply each category's margin separately. Where barcode scanning already captures item-level cost, the retail method (which is only an approximation) is unnecessary.

5.12 Inventory accounting in manufacturing companies

Cost flows through three accounts in sequence:

Raw material → Work in progress → Finished goods → Cost of sales

Rules the lecture insists on:

• Freight-in is capitalised. Transport and other charges incurred to bring material to the stores are added into the rate per unit.
• If inward costs cannot be traced to individual items, they are pooled and allocated to the cost of goods manufactured on a basis such as material quantity or material value.
• WIP absorbs material, labour and direct manufacturing expenses. A share of indirect manufacturing expenses (factory rent, supervisor salary, repairs, insurance, quality control, depreciation on plant) is also allocated to finished goods.
• Some companies separate period costs (factory rent, insurance) and charge them directly to finished goods, never to work in progress.

Worked example (garment manufacturer, January 2024).

Given: material worth Rs 3,00,000 received on 1 January. On 5 January the production department drew Rs 2,00,000 of cloth for 1,000 shirts. The shop incurred Rs 1,00,000 of direct expenses on those 1,000 units. 800 units were completed and transferred to the warehouse on 31 January; 200 remain in the shop. 10% of the shop expenses are attributed to the 200 WIP units and 90% to completed units. The shop also spent Rs 60,000 of period cost, charged wholly to completed units. Of the 800 finished units, 600 were sold for Rs 3,00,000.

Raw material account

Work in progress account

Finished goods account

Profit and loss

Reconciliation (always do this). Total spend for the period = 3,00,000 material + 1,00,000 direct expenses + 60,000 period cost = 4,60,000. That splits into cost of sales 2,32,500 and inventory 2,27,500 (raw material 1,00,000 + WIP 50,000 + finished goods 77,500).

Answer: closing inventory Rs 2,27,500 in total, profit Rs 67,500, reconciliation ties at Rs 4,60,000.

Common trap: Period cost is added at the finished goods stage. If you push the 60,000 into WIP you will get closing WIP of 62,000 and the whole reconciliation collapses.

5.13 Inventory accounting in service industries

Service firms have no raw material and no finished goods, but firms that execute jobs for clients do have work in progress.

• A job cost sheet is opened for each client job. Employee costs and other direct project expenses are booked to it as they are incurred.
• The sheet is closed when the job is completed and handed over.
• Therefore:

Pure service firms such as Amazon Retail, Blue Dart, LIC and Air India carry no inventory at all, not even WIP.

5.14 Cost or net realisable value, whichever is lower

Every example so far assumed market value exceeds cost. When it does not, the conservatism concept requires the lower figure to be used. If a market value is not available (which is normal for work in progress), use net realisable value.

Given: WIP recorded at cost Rs 20,000; a further Rs 10,000 is needed to complete the units; the completed units sell for Rs 28,000.

Cost 20,000 exceeds NRV 18,000.

Answer: carry the work in progress at Rs 18,000 and write down Rs 2,000.

5.15 Exercise 1: Ajanta Electricals (periodic, profit comparison)

Given: a Crompton fan dealer holds 3,000 units on 1 January 2023 purchased at Rs 600. During January it buys 15,000 units at Rs 620 and sells 14,000 units at Rs 720. Closing stock is 4,000 units. Find the profit under FIFO, LIFO and weighted average.

Sales are the same under all methods:

FIFO. The 14,000 units sold are the 3,000 opening units plus 11,000 of the January purchase.

LIFO. All 14,000 come out of the 15,000 bought in January.

Answer: FIFO 14,60,000, LIFO 14,00,000, weighted average 14,46,667. Prices rose from 600 to 620, so LIFO shows the lowest profit and weighted average sits between the two.

This exercise is worked periodically: individual transactions are ignored because the selling price is constant throughout.

5.16 Exercise 2: Cutfast Engineering (perpetual, one month)

Cutfast manufactures steel products and buys steel weekly. Prices move both up and down within the month, so the ledger must be perpetual.

Transactions

Closing quantity is 200 units under all three methods.

FIFO issue ledger

LIFO issue ledger

The day-31 issue is the one to study: it needs a three-way split because the 29th purchase of 2,000 has already given up 500 on day 30, the 15th purchase has only 100 left after day 28, and the balance 200 has to be drawn back from the 8th purchase. Closing stock is 100 at 130 plus 100 at 120 = Rs 25,000.

Weighted average. Only the average rate needs tracking: 120.00 → 129.62 (day 8) → 125.84 (day 15) → 120.97 (day 22) → 136.19 (day 29). Total consumption Rs 12,82,761, closing inventory Rs 27,239.

Common trap: Here prices go 120 → 130 → 125 → 120 → 140, not steadily up. The weighted average consumption (12,82,761) is nonetheless between the two extremes, which is the property that always holds. Do not assume FIFO must be the lowest because "prices rose"; check the actual path.

5.17 Exercise 3: Digital World (tax and cash flow effects)

Given: a dealer in HP laptops buys 3,000 units in two lots, 1,200 at Rs 60,000 and 1,800 at Rs 70,000, and sells 2,500 units at Rs 80,000. Tax rate 30%. All purchases and sales are on a cash basis. Work in thousands of rupees.

The weighted average rate is the average of the entire purchase, not of the units sold:

Cash flow. All 3,000 units were paid for in cash.

Memory hook: Pre-tax cash flow is identical under all three methods. The accounting policy cannot touch it, which is exactly why analysts trust operating cash flow more than reported profit. Only post-tax cash flow differs, and it differs solely through the tax cheque.

Answer: PAT 25,900 / 22,400 / 24,500; pre-tax cash flow +2,000 in every case; post-tax cash flow −9,100 / −7,600 / −8,500. LIFO is least negative because prices rose from 60,000 to 70,000.

5.18 Exercise 4: NaturePro (cost flow with opening balances)

Given: opening material 200, WIP 60, finished goods 140. During the period the company purchased material 800 and paid transport 80; production drew material 900; salaries and wages 300; other manufacturing expenses 300; 1,400 of finished chemicals transferred to the warehouse; goods costing 1,200 sold for 1,800; selling and administrative expenses 100; tax rate 30%.

Profit and loss

Answer: closing material 180, WIP 160, finished goods 340, total inventory 680, PAT 350.

Note that the transport charge of 80 is added to material, not expensed, which is the freight-in rule from 5.12. A useful mental map: the material account is the stores department, WIP is the production department, finished goods is the sales department.

5.19 A nuance the lectures demonstrate but never name

Periodic LIFO and perpetual LIFO give different answers. Ajanta Electricals applies LIFO once at period end against total purchases; Cutfast Engineering applies it transaction by transaction, which forces layer tracking and produces splits that a period-end calculation would never generate. FIFO is far less sensitive to this choice; LIFO is highly sensitive to it.

5.20 Summary and the fraud warning

• Cost of goods manufactured equals total manufacturing expenses of the period less closing inventory, so inventory valuation directly sets profit.
• Periodic valuation counts and values; perpetual valuation records every movement and can state the value at any time.
• Four methods: specific identification, FIFO, LIFO, weighted average. Purchase value is common to all; only the consumption / closing split moves.
• Under rising prices: LIFO consumption highest, profit and tax lowest, closing stock stalest. FIFO the reverse. Weighted average in between, which is why it dominates Indian practice.
• LIFO is disallowed in India and most countries; the US allows it.
• The retail method backs cost of sales out of sales using the average gross margin.
• Manufacturers track cost through raw material → WIP → finished goods, capitalise freight-in, and may charge period cost straight to finished goods.
• Service firms carry WIP equal to the sum of open job cost sheets; pure service firms carry none.
• Inventory is carried at cost or net realisable value, whichever is lower.

Common trap: Many accounting frauds are inventory frauds. Inflating closing stock raises profit without any cash ever moving, which is why auditors examine inventory valuation before certifying the statements, and why analysts read profit alongside operating cash flow. Module 7's REI Agro case is exactly this failure.