UNIT 5 CONTROLLING AND VALUING INVENTORY

Contents
5.0 Aims and Objective
5.1. Introduction
5.2. Inventory Costing Method
5.3. Valuation at Cost or Market, Which Ever is Lower
5.3.1 Lower of Cost or Market by Item
5.3.2. Lower of Total Cost or Total Market
5.3.3. Lower of Total Market by Group
5.4. Applying the Rule of Cost or Market, which ever is Lower
5.5. Inventory Management
5.6. Cutoff Date
5.7. Periodic Physical Inventory
5.7.1. Inventory Taking Technique
5.7.2. Adjustment of Inventory
5.8. Reasons for Inventory Shortages and Overages
5.8.1. Pressure of Large Scale Operation
5.8.2. The Nature of the Material
5.9. Summary
5.10. Answers to Check Your Progress Exercises
5.11. Glossary
5.12. Model Examination Questions

5.0 OBJECTIVE

In the last unit you have learned that the material cost to be constant. But in practice price
normally vary from one purchase to the next, and it is often impossible to tell the specific
purchase from which an issue in made. After completing this unit you should know.

 how physical inventories of materials are taken and valued.

 how inventory adjustments are recorded.
 Inventory costing method

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5.1 INTRODUCTION

How would you price the issue of 90 units of materials? How would you value the 15 units on
hand? The valuation system that you have used directly affects the amount of profits or loss
reported for the accounting period. If other factors remain the same, the higher the ending
inventory valuation will result the lower the cost of good sold, and the higher the reported
profit, or the smaller the reported loss. The lower the ending inventory valuation (and
therefore the higher the cost of good sold), the smaller the reported profit, or the larger the
reported loss.

5.2 INVENTORY COSTING METHOD

Most if not all manufacturers keep perpetual inventory records. Unit costs and total costs
should be computed each time materials are received or issued. The major basis of inventory
valuation is cost. The accountant should make an assumption about the flow of costs since
unit prices often vary from one purchase to another. For inventory valuation purposes, it is not
necessary that the flow of costs match the physical flow of goods. It is the responsibility of
the accountant to choose inventory valuation system that beast meets the need of the
company. The method chosen determine what unit price should be used to determine the cost
of material issued and the ending inventory. In this unit it is not discussed the assumption of
FIFO, LIFO, and Moving Average because it is clearly discussed in principles of accounting
part II.

5.3 VALUATION AT COST OR MARKET, WHICH EVER IS LOWER

The inventory valuation method like FIFO, FIFO, and Moving Average are based on cost.
Most accountants agree that firms should be conservator regarding the asset valuation because
it is better to understate than overset its value. If the market value of raw materials has
declined, the company will probably have problem selling its product at usual prices. If the
price decline is especially sever, the manufacturer may even have to sell the product at loss.
Therefore, accountants may prefer to value raw materials inventory according to the rule cost

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or market, which ever is low. Market should be interpreted as the cost of replacing materials
(not selling price).
When the market price (replacement cost) of an item has declined below the original cost, the
accountant values it at market price instead of at cost. This method reflects the lower current
value on the book so that assets are not overstated. Market price for the purpose of applying
the rule of cost or market, which ever is lower – might be described as the price at which the
material could be bought (at inventory date) through the usual channels and in the usual
quantities.

5.3.1 Lower of cost or market buy item

The cost of each item in inventory is determined according to acceptable valuation method.
The replacement cost (current market price) should be determined for each material. Then the
basis of valuation (the lower figure) is identified for each and is multiplied by the quantity on
hand to obtain the value at the lower of cost or market.

Cost per unit Market price Valuation Lower of cost

Description Quantity per unit basis or market
Material W 200 2 2.25 Cost 400
Material Z 300 2.75 2.50 Market 750
Inventory Valuation $ 1150

5.3.2 Lower of total cost or total market

Another method of valuation is to determine the total cost and the total market value of the
entire inventory. The lower of these total figures is then used as the inventory valuation as
indicated below.

Lower of total cost or total market

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 Cost per Market price Total Total
Description Quantity unit per unit Cost Market
Material W 200 $2 $ 2.25 $ 400 $ 450
Material X 300 $ 2.75 $ 2.50 $ 825 $ 750
$ 1225 $ 1200
Inventory Valuation $ 1200

If the prices of some materials have risen and other has declined, this procedure gives a less
conservative valuation then the item-by-item procedure. Generally most accountants prefer
this method justifying; after all it is only the total inventory figure that should be presented
conservatively.

5.3.3 Lower of total cost or total market by group

The difference on the preceding plan is to classify inventory materials by group or department
and to determine the lower of total cost or total market for each classification. The lower
figure (cost or market) for each group is added to the lower figure for each of the other groups
to obtain the total inventory valuation. Assume materials W and X constitute Group I and
material X and Z constitute Group II the computation required for the group is as follow.

Description Quantity Cost per Market price Total Total

Group I unit per unit Cost Market
Material W 200 $2 $ 2.25 $ 400 $ 450
Material X 300 $ 2.75 $ 2.50 $ 825 $ 750
$ 1225 $ 1200*
1200*

Description Quantity Cost per Market price Total Total

Group II unit per unit Cost Market
Material Y 150 $3 $ 4.00 $ 450 $ 600

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 Material Z 180 $ 3.5 $ 3.25 $ 630 $ 585
$ 1080*
1080* $ 1185

The analysis indicates that market ($ 1200) is the lower basis for valuation of the materials in
group I, and cost ($ 1080) is lower in-group II. The value of inventory group I and II
combined would be $ 2280. Valuation by the lower of total cost or total market by group
produces middle of the road figures. It does not reflect individual fluctuation as the lower of
cost or market by item method does. But it does not off set market increases against market
decline as much as the total cost or total market procedure does. The most commonly used
method is the lower of cost or market by item, which produce the most conservative inventory
valuation.

Check your progress

1. What is the assumption of valuation of inventory at cost or market which ever is lower?
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2. What is the difference between “Lower of cost or market by item” and “Lower of total cost
or total market”?
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3. What is the underling assumption of Lower of total cost or total market by group?
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5.4 APPLING THE RULE OF COST OR MARKET, WHICH EVER IS LOWER

If market value is lower than cost, the inventory will be adjusted to show the lower value.
This procedure is applied except when selling price are expected to be not affected by the

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decline in market price. In such a case, a write – down of inventory would amount to a
fictions loss. Because of that cost rather than market would be used. Among accountants there
is an argument when should the loss be recognized. Some accountant argues that the loss
should not be recorded on the book until the transaction takes place. Others prefer that the loss
be recorded so that overstatement of assets on the balance that could be prevented.

When a company adjust inventory to show the lower value one of the following two methods
may be used if perpetual inventory records are kept.
1. To show the new unit values, each material ledger card may be adjusted.
2. A valuation account can be set up to reduce the total value of the inventory to
market. In this case material ledger cards are not adjusted and will continue to
reflect cost.

Under the first procedure each material ledger card is adjusted according to the lower of cost
or market value. To determine the new valuation, the cards are totaled. The loss is recorded by
a general journal entry debiting an account called loss on Reduction of inventory to market
and crediting Raw material.
material. After posting this entry, the total of the materials ledger cards
will agree with the balance of the Raw material account the general ledger.
This method results in an increase to cost of good sold for the difference between the cost and
the market value and does not show the inventory loss as a separate item on the income
statement.

A second procedure, which overcomes this objection and identifies the inventory loss as a
separate item on the income statement, uses a valuation account that serves a purpose similar
to that of allowance for uncollectible accounts. This valuation account is usually called
Allowance for reduction of inventory to market.
market. It is adjusted at the end of each fiscal
period to value the inventory at the lower of cost of market.

Assume the following data for year 2002, 2003, operations.

Dec. 31/2002 Dec. 31/2003

Inventory at cost per material $250,000 $300,000
Ledger cards
Inventory at market value $240,000 $297,000

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On December 31/2002 the adjusting entry, to set up the valuation accounts for $10,000 the
difference between inventory cost and market value.
Loss on reduction of inventory - $10,000
To market
Allowance for reduction of. $ 10,000
Inventory to market
To record loss resulting from decline in market value of inventory.

In practice the loss on reduction of inventory to market account is treated as an adjustment of

cost of goods sold on the income statement, although there is some argument for showing it as
an adjustment of either the cost of raw materials used or manufacturing overhead.

Treating the loss as an adjustment of the cost of goods sold is very simple and eliminates the
necessity for allocating the loss among the raw materials, work in process, and finished goods
inventories. A partial income statement showing the loss as an adjustment of the cost of good
sold is as follows.

ABEBE METAL LTD

Partial Income Statement
Year ended December 31- Year 2002

Revenue
Net sales 1,700,000
Cost of Goods Sold
Finished goods inventory – Jan. 1 0
Add cost of goods manufactured $ 1,470,000
Total Goods available for sale $ 1,470,000
Deduct finished goods inventory 90,000
Dec. 31 at cost 1,380,000
Add loss on reduction of inventory 10,000
To market
Cost of good sold (1,390,000)

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 Gross profit on sale 310,000

The allowance for reduction of inventory to market account is shown on the balance sheet as a
deduction from inventory.

Abebe Metal Ltd.

Partial Balance sheet
December 31-2002

Inventory at cost $250,000

Deduct allowance for reduction of
Inventory to market value 10,000
Inventory at lower of cost or market $ 240,000

At the end of later period, the allowance account will adjusted to reflect inventory value at
that time. The example given at the end of 2003, the allowance account balance of $10,000
should be reduced to $3000, which is the difference between the cost $300,000, and market
value $297,000. To adjust the balance of the allowance account from $10,000 to $3000, you
should debit the allowance account for $7000, and credit an account called recovery form
decrease in allowance for reduction on inventory to market. The journal entry will be.

Allowance for reduction of inventory $ 7,000

To market
Recovery from Decrees in $ 7000
Allowance for reduction on inv.
To market
To record recovery resulting from adjustment
Of allowance account

On the income statement the recovery account will be shown as a reduction in cost of goods
sold as follow.

ABEBWE Metal Ltd.

Partial income statement
Year ended December 31-2003

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Revenue
Sales (Net) 1,950,000
Cost of Goods sold
Finished goods inventory Jan. 1 $ 90,000
Add cost of goods manufactured 1,825,000
Total goods available for sale 1,915,000
Deduct finished goods inventory Dec. 31 (110,000)
At cost 1,805,000
Deduct Recovery from decrease in
Allowance for reduction of inventory to market (7000)
Cost of goods sold (1,798,000)
Cross profit on sales 152,000

The allowance account balance $3000 at the end of 2003 will again be treated as a deduction
from the inventory at cost on the balance sheet. If the cost of inventory should exceed the
market value, the valuation account is no longer needed. An entry would be made to close
Allowance for reduction of inventory to market by debiting that account for its current
balance and crediting recovery from Decrease in Allowance for Reduction of inventory to
market.

Check your progress

1. Explain the importance of maintain allowance for reduction of inventory to market account.
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2. What is the treatment of (recovery from decrease in allowance) on the income statement?
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3. What are the two procedure firms can follow to treat a loss resulted from market decline.
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5.5 INVENTORY MANAGEMENT

The major objective of inventory management is to gain highest profit by keeping the material
inventory at the lowest level consistent with efficient manufacturing operations. Procedures
such as holding larger quantities of materials in storage than are needed for normal operations,
or purchasing required materials earlier than they are needed for manufacturer, tie up working
capital unnecessarily.

5.6 CUTOFF DATE

To prepare reliable financial statement accuracy in calculating cost of ending materials, work
in process, and finished goods inventories is essential. For ending inventories to be valued as
accurate as possible, it is necessary that all costs associated with the items included be
recorded. In order to ensure that these costs have been recorded, business establishes a cutoff
date for including transactions in a specified period.

The cutoff date is usually the last day of the company’s fiscal year or the end of an interim
period such as a calendar quarter or month.

The accountant examines transactions just before and just after the cutoff date to determine if
they are properly classified. All transaction associated with items in the ending inventories are
included in the current period. Transaction affecting events after the cutoff date either are not
recorded or are entered as deferred item.

5.7 PERIODIC PHYSICAL INVENTORY

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Modern inventory control system use perpetual inventory system. Still, despite carefully
planned procedures and control, some differences often occur between the quantity of a
material on hand and the quantity shown on the material ledger card. It is necessary to count
the materials on hand periodically to detect errors and to correct the records. A physical
inventory can be scheduled in one of two ways.

5.7.1 Inventory taking technique

1. At the end of accounting period, all production is stopped all employee count and
record materials on hand until the inventory counting is completed the plant does
not resume operation.
2. Continues or cycle inventory – under this plan, only a few materials are counted
each day. A schedule is developed so that materials will be inventoried at lest once
each year.

5.7.2 Adjustment of inventory:

Adjusting for inventory shortage and overage is done in two steps

1. The individual materials ledger cards must be corrected. A shortage is recorded by

an entry in the issued section of the materials ledger card for the material found to
be short. The cost is computed on the regular costing basis (FIFO, LIFO, or
Moving Average) as though the missing materials were being charged out on a
requisition on the closing date of the period. An overage is entered in the received
section of the materials ledger card. The cost to be used is the cost of the last issue
of that material.
2. A general journal entry is made to adjust the firm’s ledger accounts for the net
shortage or overage. If shortage were reveled by the periodic inventory total
inventory shortage would be journalized as a debit to manufacturing overhead
control and credit to Raw material. The amount of shortage is also entered under
indirect materials column on the department overhead analysis sheet of the
responsible department.

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Check your progress

1. What is cutoff date?

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2. What are the procedures to record inventory shortage?
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5.8 REASON FOR INVENTORY SHORTAGE AND OVERAGE

5.8.1 Pressure of large-scale operation

Due to large – scale of operation it is certain that there may be inventory shortage or overage.
Some of the reasons are as follows.
 Failure to complete required paperwork at each step of the flow of materials.
 Failure to post receipts
 In correct posting receipts and issue
 Computation error in day – to – day posting
 Errors in recognizing the correct cutoff dates.

5.8.2 The nature of the material

 Spoilage as a result of natural processes or from poor storage conditions.

 Shrinkage due to such natural cases as dehydration.
 Computation error arising from different unit of measurement. Ex. Material might be
bought in ton but issued in kilogram

There are also other reasons other than the nature of material and large scale of operation
which requires the management due attention.
 Losses due to theft of materials by employee.
 Losses arising from theft by outsiders owing to inadequate plant protection.

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  Losses due to short weight or short measures often involving collusion between
suppliers and receiving and purchasing personnel.
 Losses due to unnecessary or deliberate scarping of materials that are still useful.

5.9 SUMMARY

The perpetual inventory system provides a complete record of receipts, issues, and balance of
materials on hand, item by item. The quantity computations can be made easily enough, but
the pricing or valuation process is a difficult one. Prices paid for materials fluctuate from
purchase to purchase. In addition, it is difficult to relate an issue or a balance on hand to a
specific purchase.

The cost accountant resolves this problem of pricing by applying a recognized method of
inventory valuation method like, FIFO, LIFO or moving average method.

The accuracy of the perpetual inventory system must be checked from time to time by an
actual physical count. Some firm take inventory periodically other use the continues, or cycle,
method. Once the count has been fully verified, inventory differences are summarized on an
inventory shortage or overage report. In turn, the material ledger cards are corrected and the
general ledger account balance is adjusted.

5.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1.See 5.3- valuation at cost or market, which ever is lower

2.See 5.31 and 5.3.2 “lower of cost or market by item” is more conservative than “lower of
total cost or total market”
3. See 5.3.3.”Lower of total cost or total market by group” classifies inventory by group or
department and to determine the lower of total cost or total market for each classifications

1. It is used as a contra asset account which will reduce the raw material inventory amount by
its balance-
balance- see 5.4 appalling the rule of cost or market, which ever is lower.
2. It will be deducted from cost of good sold
3. a. To show the new unit values, each material ledger care may be adjusted
b. A valuation account be set up to reduce the total value of the inventory t market

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1. The cutoff date is the last day of the company’s fiscal year or the end of an interim period
such as a calendar quarter or month.
2. a. Individual material ledger card must be adjusted
b. A general journal entry should be made to adjust the firm ledger account

Answer to exercise

1. a. 4812.5
b.4992.5 total cost
b. Group I market 1505 + group II 3485= 4990
2. Cost of good sold = 273,430
3. Loss on reduction of inventory--------7015
Allowance for reduction of inventory ----------------- 7015

5.11 GLOSSARY

FIFO – First in first out inventory valuation assumption

LIFO – Las in first out inventory valuation assumption
Moving average – under this method, the units and cost of each new purchase are added to
the balance already on hand and a new average cost per unit is computed.
Cutoff date – The last day of the company’s fiscal year.

5.12 MODEL EXAMINATION QUESTIONS

1. The data given below relate to the raw materials inventory of the Abebe metal Ltd –
Determine the value of the inventory if the lower of cost or market method is applied to the
individual inventory item.
Unit Cost Market
Group I
Material A 500 $ 1.4 1.3
Material B 950 $ .85 $ .90
Group II
Material C 2200 $1.20 $ 1.45
Material D 1300 $ .65 $ .55

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Required
1. Determine inventory value using the following assumption
a) Item by item assumption
b) Total cost or total market assumption
c) Total cost or total market by group assumption
2. From the data presented below, determine the cost of goods sold to be shown on
The income statement of ABC, manufacturing firm.
Finished goods January 1,2002 – 85,750
Finished goods January 31,2002 – 65,875
Cost of goods manufactured 250,000
Loss on reduction of inventory to market 3555
3. A.B.C., manufacturing company has decided to value its raw materials inventory
At the lower of cost or market. The raw material account has an ending balance of $
85,765. The market value of the raw material is 78,750. Record the necessary general
journal entry to value inventory at the lower of cost or market.

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