Inventory is current assets and it comprises of major part of financial statement in business and manufacturing concerns (Rajasekaran V., 2011). An inventory valuation is important process which assists company to provide a monetary value for items that comprise their inventory. Inventory includes the products available for resale to customers. Inventories are usually the largest existing asset of a business, and proper measurement of them is required to assure precise financial statements. If inventory is not correctly measured, expenses and revenues cannot be correctly matched and a company could make poor business decisions. The inventory valuation consists of all of the costs to get the inventory items in place and ready for sale. The inventory valuation eliminates the costs of business and management. Inventory valuation is critical to income measurement and inventory management is crucial to financial management. In management accounting, theorists described Inventories as assets that held for sale in the ordinary course of business, in the process of production or manufacture and in the form of materials and supplies to be consumed in such process of such production or manufacture. Therefore inventories refer to finished goods inventory, Work in process inventory, Raw materials, stores and supplies. The closing stock an accounting period will become the opening stock of next period therefore valuation of inventories has more significance. But inventory valuation is not accurate because of policies of management of firms and accounting principles adopted by accountants (Rajasekaran V., 2011).
Significance of inventories: Inventory is major assets for business enterprises. Simple way to judge the liquidity position of enterprise is to compute accounting ratios. Inventory valuation is of great importance in judging of liquidity of concern. Another importance of inventory valuation is that in order to determine true income, proper valuation is necessary (Rajasekaran V., 2011):
Gross profit = sales - cost of sold goods.
Inventory valuation is significant to estimate correct gross profit, for comparison, to determine the correct financial position, for good decision making by management and to estimate next year's purchase (Sripal Jain, 2015).
Valuation of inventories: According to the generally accepted accounting principles, inventories should be measured at cost. Cost refers to cost of acquisition plus cost of conversion.Raw materials, Stores, spare parts, consumables is equal to cost of acquisition that is purchase costs including duties and taxes, freight and other expenses directly related to such purchases. Similarly any discounts, rebates on such purchases should be reduced.
Finished goods in case of manufacturing concern = cost of raw materials plus cost of conversion of raw materials into finished goods. It consists of direct expenses like labour costs as well as indirect manufacturing costs like power. Water, fuel, factory rent, factory insurance etc directly attributable to production / manufacturing. Indirect expenses like salaries, office expenses etc. are not included since they are period costs.
Work in process = WIP is valued at cost as above depending upon the stage of completion of labour and overheads which is determined by the production department.
Inventory Valuation Methods: Even though inventories are to be valued at cost, the cost continuously changes during the year. It may not be always possible or practicable to link the cost of purchase with the closing stock of goods on hand. Inventory valuation methods are used to compute the cost of goods sold and cost of ending inventory. There are numerous inventory valuation at cost methods:
First-in-First-Out Method (FIFO): This method indicates that items from the inventory are sold in the order in which they are acquired or produced. This indicates that cost of older inventory is charged to cost of goods sold first and the ending inventory consists of those goods which are purchased or produced later. This is the most common method for inventory valuation. This method is nearer to actual physical flow of goods because companies usually sell goods in order in which they are purchased or produced.
Last-in-First-Out Method: It is abbreviated as LIFO. This method of inventory valuation is exactly contrast to first-in-first-out method. In this procedure, it is assumed that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of goods sold in LIFO method is comparatively higher and ending inventory balance is relatively lower. This is because the cost goods sold mostly consists of newer higher priced goods and ending inventory cost consists of older low priced items.
Average Cost Method: It is called (AVCO). In this method, weighted average cost per unit is calculated for the whole inventory on hand which is used to record cost of goods sold. Weighted average cost per unit is computed as follows:
Weighted Average Cost Per Unit = Total Cost of Goods in Inventory
Total Units in Inventory: The weighted average cost as considered above is multiplied by number of units sold to get cost of goods sold and with number of units in ending inventory to obtain cost of ending inventory.Figure: Techniques of inventory evaluation ( Source: Sripal Jain, 2015 )
It is established that inventory is most significant component of current assets held by manufacturing enterprises. Inventory valuation is needed to determine true income earned by business during a particular period.
Depreciation is explained as the expensing of the cost of an asset involved in producing revenues all through its useful life. Depreciation in accounting arena denotes to the allocation of the cost of assets to periods in which the assets are used that means depreciation with the matching of revenues to expenses principle. Depreciation expense impacts the values of businesses and entities because the accumulated depreciation revealed for each asset lessen its book value on the balance sheet. Depreciation expense also affects net income. Usually the cost is allocated as depreciation expense among the periods in which the asset is expected to be used. Such expense is documented by businesses for financial reporting and tax purposes.
Generally, depreciation is the diminution in the value of an asset because of usage, passage of time, wear and tear, technological obsolescence, depletion, insufficiency, decay and other numerous factors. It is a fall in the value of an asset. Every fixed asset is liable to loss its value once it is put to use, sooner or later the asset will become useless. Accounting standard 6 describes depreciation as a measure of wearing out, consumption or other losses of value of a depreciable asset arising from use and obsolescence through technology. Pickle explained depreciation as permanent and continuing diminution in quantity, quality or value of an assets (Singhvi, 2006).
As per accounting principles, depreciation is used to explain any method of attributing the past or purchase cost of an asset across its useful life, approximately corresponding to normal wear and tear. It is mainly used when dealing with assets of a short, fixed service life, and which is an example of applying the matching principle as per generally accepted accounting principles. Depreciation is computed on all depreciable possessions which can be classified as those which have a useful life for more than one accounting period but is restricted and are held by an enterprise for use in the production or supply of goods and services. Many examples of depreciable assets can be sited such as machines, plants, furniture, buildings, computers, trucks, vans, equipment. Moreover, depreciation is the allocation of 'depreciable amount' which is the 'historical cost' or other amount substituted for historical cost less estimated salvage value. Depreciation has noteworthy effect to assess and present the monetary position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable amount. A systematic process for allocating the cost over the periods of its useful life in a logical manner is termed as depreciation accounting.
There are numerous features of depreciation (Singhvi, 2006):
Main causes of depreciation: The causes of depreciation are as follows (Singhvi, 2006):
The following are the purpose of charging depreciation of fixed assets:
Numerous factors must be taken into account when charging the amount of depreciation:
Various methods are adopted for measuring allocation of depreciation cost:
Straight Line Method: This method is also known as Constant Charge Method in which depreciation is charged for every year and it will be the constant amount throughout the life of the asset. Accordingly depreciation is calculated by deducting the scrap value from the original cost of an asset and the balance is divided by the number of years estimated as the life of the asset. The depreciation charge is calculated as (Kolitz, 2009):
The major advantage of this procedure is that it is simple and easy to calculate, original cost of asset reduced up to Scrap Value at the end of estimated life and estimated useful life of the asset can be estimated under this method. At the same time, there are some limitations for this method such as it does not consider intensity of use of assets, it disregards any additions or opportunity cost while calculating depreciations, it ignores effective utilization of fixed assets, it becomes difficult to calculate correct depreciation rate and under the assumption of constant charges of maintenance of assets it is impossible to calculate true depreciation.
It can be demonstrated in accounting literature that Depreciation is methodical allocation of the cost of a fixed asset over its useful life. Depreciation is part of the original purchase price of the fixed asset consumed during its period of use by the firm. Since the revenue generated from the use of fixed asset will be decreased each year, depreciation thus should be treated as an expense, i.e. it reduces net profit. It is a way of matching the cost of a fixed asset with the revenue it generates over its useful life. Without depreciation accounting, the whole cost of a fixed asset will be documented in the year of purchase. This will give a deceptive view of the profitability of the entity.