Valuation of changes in inventories
10.114 The value of inventories recorded in business accounts at the end of each accounting period is known as the book value. Period to period changes in the book value of inventories can be calculated by deducting the book value of inventories at the end of the previous accounting period from the book value at the end of the current accounting period.
10.115 For national accounting purposes, the physical changes in inventories during a period should be valued at the prices prevailing at the time that inventory change occurs. Therefore, the goods transferred out of inventories (i.e. raw materials and stores) are valued at purchasers' prices current at the time of the withdrawal from inventories. Finished goods transferred into inventories are valued as if they were sold at that time and additions to work-in-progress are given the value they have at the time they are added to inventories.
10.116 In practice, many businesses adopt historical cost measurement whereby inventories are valued at the lower of cost or market prices. Beginning-of-period inventories are valued at costs or prices prevailing at the beginning of the accounting period, and end-of-period inventories are valued at costs or prices prevailing at the end of the period. As a result, in periods of rising prices the book value of inventories will frequently include an element of capital gain, even if there has been no change in the physical quantity of inventories held. Conversely, if prices are falling, the book value of inventories will include an element of capital loss even with no change in the quantity of inventories on hand. Therefore, in times of rising prices, the change in the book value measured on a historical cost basis will include both the value of the physical increase or decrease in inventories and an increase in value due to the effect of rising prices on the value of inventories held. The latter effect is an element of holding gain (or holding loss if prices are falling), which should be excluded from changes in inventories and included in revaluations.
10.117 In the ASNA, an inventory valuation adjustment (IVA) is made to remove the effects of such gains or losses from book values of changes in inventories. As initial estimates of gross operating surplus incorporate the effect of the value of inventories derived on a historical cost basis, the IVA is also deducted from those estimates.
10.118 There are several methods used to measure inventories in business accounts. These include:
- First in first out (FIFO) – items held in store for the longest time are assumed to be the first to be drawn from store, so that inventories will consist of the most recently acquired items.
- Last in first out (LIFO) – this system uses the opposite assumption to FIFO. The most recently acquired items are assumed to be the first drawn from store, so that inventories consist of the items first purchased.
- Historical cost – inventories are valued at the actual cost of acquisition, with no allowance for inflation.
- Current cost – inventories are valued at replacement cost, rather than the cost of acquisition. This measure is generally derived by adjusting values obtained under historical cost for the effect of inflation.
- Average cost – running totals are held of the value and volume of inventories. The average price of goods held in inventories is recalculated periodically; for example, when new goods are received. Any subsequent withdrawal from inventories is then made at that price until the average is recalculated.
- Standard cost – under a standard cost system, items held in stock are each given a unit value, which may be based on recent costs, current costs, or expected future costs. Once this standard has been set, the value of a company's inventories is determined by multiplying the quantity of each commodity in stock by its standard cost. The standard is generally maintained for a fixed period (usually a company's financial year), or until changing prices make the standard inappropriate for current conditions.
10.119 The current methodology underlying the derivation of the IVA in the ASNA assumes that businesses generally value their inventories at historical cost and employ the FIFO method of handling inventories.
10.120 In general, the IVA is calculated in three basic steps:
- an estimate is made of the value of inventories at constant prices at the end of each quarter by revaluing end of quarter book values to base year prices using price indexes; the value of changes in inventories at constant prices is then derived as the difference between successive end of quarter levels;
- the estimates of the values of changes in inventories at constant prices are multiplied by price indexes that reflect current quarter average prices; this calculation gives an estimate of the physical change in inventories at average current quarter prices; and
- the IVA is the difference between the value of changes in the book value of inventories obtained from business accounting records and the value of changes in inventories estimated in 2.
10.121 The following table illustrates how the IVA is calculated by way of an example.
|(1) Change in book value|
|Book value of inventories at end of quarter (t)||=||51,000|
|Book value of inventories at end of quarter (t+1)||=||55,056|
|Change in book value||=||4,056|
|Base of price index||=||100|
|Price index at end of quarter (t)||=||120|
|Price index at end of quarter (t+1)||=||124|
|Average price index for quarter (t+1)||=||122|
|(2) Revaluation to constant prices|
|Constant price level||book value ÷ price index x 100|
|End quarter (t)||51,000 ÷ 120 x 100||42,500|
|End quarter (t+1)||55,056 ÷ 124 x 100||44,400|
|Constant price change in inventories||44,400- 42,500||1,900<|
|(3) Revaluation to current quarter prices|
|Change in inventories at current quarter prices||=||change at constant prices x average price index for current quarter ÷ 100|
|=||1,900 x 122 ÷ 100|
|(4) Derivation of the IVA|
|IVA||=||change in book value - physical change at current quarter prices|
|=||4,056 - 2,318|
10.122 Beside the assumption that book values are based on historical cost and FIFO conventions, the method used to estimate the IVA rests on four other assumptions:
- sales prices for finished goods held in inventories can be used to adjust inventory levels valued at cost; that is, the selling price of finished goods is established as a fixed mark-up on the costs incurred in the current quarter;
- each commodity (or group of commodities) held in inventories has a fixed turnover period; that is, the ratios 'inventory level of materials to value of purchases' and 'inventory level of finished goods to value of sales' remain constant for each commodity;
- the commodity composition of inventories held by any particular industry remains fixed; and
- the rate of physical increase (or decrease) in inventories is constant throughout the quarter.