ACCA F3 (INT) Financial Accounting - 2010 - Study text

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Paper F3 (INT)

Financial Accounting

CHAPTER

Inventory

Contents

1 End‐of‐yearadjustmentsforinventory

2 Valuationofinventory

3 FIFOandweightedaveragecostmethods

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End-of-year adjustments for inventory

 The need for end-of-year adjustments

 Opening and closing inventory and the cost of sales

 Recording opening and closing inventory

 Period-end method: accounting procedures

 Continuous inventory method: accounting procedures

 Transactions between the year-end and the inventory count

1 End-of-year adjustments for inventory

1.1 The need for end-of-year adjustments

At the end of a financial period (‘end of year’) a business calculates the profit or loss

it has made for the year, and produces a statement of financial position as at the end

of the year.

 The items of income and expenses are transferred to the income statement to

calculate the profit or loss for the financial period.

 The assets, liabilities and capital are set out in the statement of financial position.

The profit for the year is added to capital, or the loss is subtracted from capital.

However, certain adjustments must be made to income, expenses, assets and

liabilities, in order to apply the accruals basis to accounting, and the prudence

concept to the valuation of receivables. These adjustments are made at the end of

the financial year, because they are not concerned with regular accounting

transactions that arise in the normal course of business operations. They are not

needed until it is time to prepare the financial statements for the year.

Adjustments are needed for:

 opening and closing inventory

 accrued expenses and prepaid expenses

 bad and doubtful debts

 non-current assets and depreciation.

Having made the adjustments, an income statement and statement of financial

position can be prepared. This section explains the end-of-year adjustments for

inventory.

1.2 Opening and closing inventory and the cost of sales

In an income statement, the gross profit for a period = Sales – Cost of sales. The

accruals concept is applied, and sales are matched with the cost of making those

sales in order to calculate gross profit. However costs of purchases during a period

are not the same as the cost of sales, because of changes in inventory levels.

Chapter 5: Inventory

The Cost of sales = Opening inventory + Purchases – Closing inventory.

Sales

Opening inventory A

Purchases B

A + B

Closing inventory (C)

Cost of sales A + B - C

The cost of sales is shown in an income statement, and is used to calculate the gross

profit (or loss) earned during an accounting period.

Example

Here is an illustrative example.

Sales183,000

Openinginventory 15,000 

Purchases 100,000 

 115,000 

Closinginventory (20,000) 

Costofsales(95,000)

Grossprofit88,000

Otherexpenses(80,000)

Netprofit(orloss)fortheperiod8,000

1.3 Recording opening and closing inventory

In order to prepare an income statement, it is therefore necessary to obtain values

for opening inventory and closing inventory, and to record these in the accounting

system. There are two main methods of recording inventory, a continuous inventory

system and a period-end system.

There is a ledger account (in the main ledger) for inventory. However, inventory can

be accounted for in the ledger in either of two ways, depending on which method of

recording inventory is used.

 In a continuous inventory system, all movements of inventory are recorded in

the inventory account. This includes all purchases and all issues of inventory.

This means that all transactions involving the receipt or issue of inventory must

be recorded, and at any time, the balance on the inventory account should be the

value of inventory currently held. This type of inventory system is time-

consuming, and is not normally used by small businesses.

 The second method of accounting for inventory is the period-end method. In

simple accounting systems such as the accounts of sole traders, it is usual to

have a purchases account to record purchases from suppliers. The inventory

account in the main ledger is used only to record the value of inventory at the

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beginning/end of the financial year. In the period-end method, the value of

inventory is established only once in each financial year, at the end of the year.

For your examination, a question on year-end adjustments for inventories will

normally require you to use the period-end system of accounting.

1.4 Period-end method: accounting procedures

In a period-end system, inventory is normally valued just once each year, at the end

of the financial year. The value of inventory at the end of one year (i.e. closing

inventory) becomes the opening inventory at the beginning of the next year.

Until the end of the year, the balance on the inventory account (a debit balance) is

the value of opening inventory at the beginning of the year.

At the end of the financial year, the closing inventory is counted and valued. The

opening inventory value is replaced in the inventory account by the value of closing

inventory, in the way described below.

The appropriate book-keeping entries in the main ledger are as follows:

For the opening inventory

 Credit the inventory account with the value of the opening inventory

 Debit the income statement with the value of the opening inventory.

The income statement (as well as the inventory account) is an account in the main

ledger, and is part of the double entry book-keeping system.

For the closing inventory

 Debit the inventory account with the value of the closing inventory

 Credit the income statement with the value of the closing inventory.

The closing balance on the inventory account is therefore the value of the closing

inventory, which is carried forward as the opening balance at the beginning of the

next period.

The end-of-year adjustments for inventory are shown in the T account below.

Inventory account

Current year $ $

Opening inventory b/f A Income statement A

Income statement B Closing inventory c/f B

A + B A + B

Next year

Opening inventory b/f B

In a period-end system, all purchases from suppliers are recorded in a Purchases

account: Debit Purchases, Credit Trade payables.

Chapter 5: Inventory

Example

In Year 2, Bubbles had opening inventory of $10,000. Sales during the year were

$80,000 and purchases were $30,000. Closing inventory at the end of Year 2 was

$12,000. The entries in the main ledger of Bubbles can be summarised as follows:

Salesaccount

 $ $

Incomestatement 80,000 Receivables 80,000



Purchasesaccount

 $ $

Tradepayables 30,000 Incomestatement 30,000



Inventoryaccount

 $ $

Openingbalanceb/f 10,000 Incomestatement 10,000

Incomestatement 12,000 Closingbalancec/f 12,000

 22,000 22,000



Openingbalanceb/f 12,000 



Incomestatement

 $ $

Openinginventory 10,000 Sales 80,000

Purchases 30,000 Closinginventory 12,000

Grossprofitc/d 52,000 

 92,000 92,000



Grossprofitb/d 52,000

This part of the income statement can be presented as a report, in vertical format, as

follows:



$ $

Sales80,000

Openinginventory 10,000 

Purchases 30,000 

 40,000 

Closinginventory (12,000) 

Costofsales(28,000)

Grossprofit52,000

If you have difficulty remembering the double entry rules for the opening and

closing inventory adjustments, it might be helpful to remember the following

points.

 In a period-end system of accounting for inventory, the double entries are

between the inventory account and the income statement.

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 The cost of opening inventory is included in the cost of sales. It is an expense,

and expenses are a debit entry. So debit the income statement (and credit the

inventory account) with the cost of the opening inventory.

 The cost of closing inventory is included in the statement of financial position as

an asset, so there must be a debit balance for the closing inventory. So debit

Inventory (and credit Income statement) with the cost of the closing inventory.

Exercise 1

The following trial balance has been extracted from the ledger of Prepp at 30 June

Year 3.

 DebitCredit

 $000 $000

Salaries 10,500 

Drawings 3,000 

Lightingandheating 500 

Sales30,000

Tradereceivables 10,000 

Rent 2,000 

Officeexpenses 1,000 

Capitalat1JulyYear227,500

Purchases 14,000 

Inventoryat1JulyYear2 2,000 

Tradepayables4,000

Property,plantandmachinery 17,500 

Cash 1,000 

 61,50061,500

Closing inventory at 30 June Year 3 has been valued at $1,500,000.

Required

Ignoring accrued and prepaid expenses, doubtful debts and non-current asset

depreciation, prepare the income statement for the year to 30 June Year 3 and the

statement of financial position as at that date.

1.5 Continuous inventory method: accounting procedures

When the continuous inventory method is used, a record is kept of all receipts of

items into inventory (at cost) and all issues of inventory to cost of sales. Each issue

of inventory is given a cost, and the cost of the items issued is either the actual cost

of the inventory (if it is practicable to establish the actual cost) or a cost obtained

using a valuation method such as FIFO or AVCO, which are described later.

Each receipt and issue of inventory is recorded in the inventory account. This means

that a purchases account becomes unnecessary, because all purchases are recorded

in the inventory account.

Debit: Inventory

Chapter 5: Inventory

Credit: Trade payables

The balance on the inventory account is an asset, but the account also records

expenses (purchases).

Inventoryaccount(continuousinventorysystem)

 $ $

Openingbalanceb/f 8,000 Costofsales 79,000

Purchases 84,000 Purchasereturns 1,000

Closingbalancec/f 12,000

 92,000 92,000



Openingbalanceb/f 12,000 

1.6 Transactions between the year-end and the inventory count

To establish a ‘correct’ valuation for closing inventory, it might be necessary to have

an end-of-year inventory count. An inventory count is essential when a period-end

inventory accounting system is used. An inventory count is a physical count of the

inventory items held at the end of the financial year.

However, for practical reasons it is usually impossible to conduct the inventory

count on the last day of the financial year. In many cases, the inventory count takes

place on a day soon before the end of the year, and no further transactions are

allowed to occur until the new financial year begins.

Sometimes, the annual inventory count might not take place until a few days after

the end of the financial year. When this happens, there might be some transactions

in the new financial year, between the end of the previous financial year and the

date of the inventory count.

The inventory valuation obtained from the inventory count must therefore be

adjusted to remove the transactions in the new financial year, in order to obtain a

valuation for inventory as at the end of the previous year.

Example

A business entity has a financial year ending 31 December 2009. An inventory count

on 5 January gave a total inventory value of $94,300 as at that date. However

etween 31 December 2009 and 5 January 2010, the following transactions occurred:



$

Purchasesofgoods 8,000

Salesofgoodsfrominventory(proifitmargin=40%onsalesprice) 30,000

Goodsreturnedtosupplier 2,000

Paper F3: Financial accounting (International)

To prepare the financial statements for the year to 31 December we must adjust the

inventory valuation on 5 January to remove the effect of the transactions that

occurred since 31 December. To do this we must:

 add back inventory that has been sold since the end of the year, at cost

 add back inventory that has been returned to suppliers since the end of the year

 deduct the cost of inventory purchased and received into inventory since the

end of the year

In this example, the cost of inventory at 31 December is calculated as follows:



$

Inventoryat5January 94,300

Less:Purchasesofgoodssince31December (8,000)

Addback:

Salesofgoodsfrominventoryatcost(40%×$30,000)since31Dec 12,000

Goodsreturnedtosuppliersince31December 2,000

Inventoryat31December 100,300

Chapter 5: Inventory

Valuation of inventory

 The requirements for valuation of inventory

 Measurement of inventory: lower of cost or net realisable value

 The cost of inventories

 Carriage inwards and carriage outwards

 Cost formulas for inventory

 Disclosures of acconting policies for inventory

 Inventory and drawings by the business owner

2 Valuation of inventory

2.1 The requirements for valuation of inventory

The valuation of inventory can be extremely important for financial reporting,

because the valuations affect both the cost of sales (and profit) and also total asset

values in the statement of financial position.

There are several aspects of inventory valuation to consider:

 Should the inventory be valued at cost, or might a different valuation be more

appropriate?

 Which items of expense can be included in the cost of inventory?

 What valuation method should be used when it is not practicable to identify the

actual cost of inventory?

Rules for dealing with each of these problems are provided by the international

accounting standard IAS 2 Inventories.

2.2 Measurement of inventory: lower of cost or net realisable value

The discussion of inventory so far has assumed that inventory consists of items

purchased from suppliers and then re-sold. The nature of inventories in reality

varies with the type of business. Inventories might include:

 goods purchased and held for resale

 finished goods produced

 work in progress being produced

 raw materials and components.

It is a requirement of IAS 2 Inventories that inventory must be measured in the

financial statements at the lower of:

 cost, or

 net realisable value (NRV).

Paper F3: Financial accounting (International)

This is an example of the accounting concept of prudence.

When the cost of inventory exceeds its net realisable value, it is written down in

value to net realisable value. The amount of the ‘write-off’ (i.e. reduction in

inventory value) is treated as an expense in the period and charged against profit.

Net realisable value

Net realisable value is the amount that can be obtained from disposing of the

inventory in the normal course of business, less any further costs that will be

incurred in getting it ready for sale or disposal.

 Net realisable value is usually higher than cost. Inventory is therefore usually

valued at cost.

 However, when inventory loses value, perhaps because it has been damaged or

is now obsolete, net realisable value will be lower than cost.

The cost and net realisable value should be compared for each separately-

identifiable item of inventory, or group of similar inventories, rather than for

inventory in total.

Note: IAS 2 uses the term ‘measurement’ of inventory. You may prefer to think of

this as a ‘valuation’ of inventory. ‘Measurement’ here means expressing inventory

as a monetary amount.

Example

In Year 2, A business has four items of inventory. A count of the inventory has

established that the amounts of inventory currently held, at cost, are as follows:

Inventory item A1 8,000

Inventory item A2 14,000

Inventory item B1 16,000

Inventory item C1 6,000

Inventory items A1 and C1 are no longer used in normal business operations, due to

a major change in business strategy. The inventory of item A1 could be disposed of

for $7,800 less selling costs of $500. The inventory of item C1 could be disposed of

for $7,000 less selling costs of $200.

Required

What should be the value for inventory in the statement of financial position?

ACCA F3 (INT) Financial Accounting - 2010 - Study text - Emile Woolf Publishing

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