Inventories (stocks) are the material assets, which the company uses in its operations. Stocks belong to the current assets of the company. The main difference between stocks and fixed assets is that the stocks are spent entirely in one production cycle and fixed assets are used for many production cycles. We will talk about the features of stocks accounting today.
The company buys stocks from vendors, or received them through exchange for other material assets. Accounts payable arise when company buying stocks. Account receivables for advances paid occur if the supplier requires prepayment.
We have described the classification of material costs, which actually corresponds to the classification of basic material stocks, in article about material costs planning.
Inventories are credited to the company’s balance sheet at their initial value (historical cost). Historical cost of inventories includes the cost of purchase, packaging, transportation and other expenses for these stocks.
Stocks must be accounted by their number and value and stored in warehouses or in special storage locations. Special employees of the company should be responsible for the revenues, storage and use of inventories.
All transactions with stocks should be made with special documents (consignment notes, certificates of acceptance and transfer, etc.).
A periodic raw materials inventory should be conducted to verify the actual quantity of stocks and to avoid losses.
Stocks transferred to production units during the production process while their cost is transferred the cost of manufactured products, as we have discussed in the article about the pricing.
There are the following inventory accounting methods:
1. Identified value inventory valuation method.
Each stocks party deducted by its actual value regardless of the time of its arrival at the company’s balance sheet at the option of the financial manager.
2. FIFO inventory method (first in first on).
Stocks parties, which were first credited to the balance sheet, debited at the production costs also first.
3. LIFO inventory method (last in first on).
Stocks party, which were last credited to the balance debited at the cost first by this method.
4. Average cost method.
The average value of all existing stocks parties is calculated by this method. The actual amount of debited stocks is multiplied by the average cost of stock unit after this.
The objective of inventory management is to identify the method of inventory accounting (valuation). The financial manager must choose the optimal method because it affects the profitability of the company.
Let’s consider the situation when the previous stocks parties have lower price than the next parties:
- Manager selects stocks party at his own opinion when using the identified cost method. He must choose the earlier party if market prices are falling because it will reduce the cost of production. It is better to choose the latter party, when prices are rising.
- Cheaper parties will be written off in the first by FIFO method in this situation. Production costs will be lower at first but then they will increase as a result of this.
- More expensive parties will be written off in the LIFO method. Production costs will be higher at first, but then will be reduced in consequence of this.
- The cost of some stocks parties does not affect the change in the cost of production by using the average cost method.
Effect of FIFO and LIFO methods is reversed in situations when the previous stocks parties have higher price than the next.