CIMA - C2 Fundamentals of Financial Accounting
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170 11: Cost of goods sold and inventories ⏐ Part B Accounting systems and accounts preparation
1.7 Example: inventories written off and written down
Lucas Wagg, trading as Fairlock Fashions, ends his financial year on 31 March. At 1 April 20X5 he had goods in
inventory valued at $8,800. During the year to 31 March 20X6, he purchased goods costing $48,000. Fashion goods
which cost $2,100, were still held in inventory at 31 March 20X6 that can only be sold at a sale price of $400. The goods
still held in inventory at 31 March 20X6 (including the fashion goods) had an original purchase cost of $7,600. Sales for
the year were $81,400.
Required
Calculate the gross profit of Fairlock Fashions for the year ended 31 March 20X6.
Solution
INVENTORY COUNT
At cost
Realisable value
Value of closing
( if lower than cost)
inventory
$
$
$
Fashion goods
2,100
400
400
Other goods (balancing figure)
5,500
5,500
7,600
5,900
FAIRLOCK FASHIONS
INCOME STATEMENT FOR THE YEAR ENDED 31 MARCH 20X6
$
$
Sales
81,400
Value of opening inventory
8,800
Purchases
48,000
56,800
Less closing inventory
5,900
Cost of goods sold
50,900
Gross profit
30,500
(a) Cost of sales in the income statement is the cost of goods actually sold in the period (not bought), which is
opening inventory add purchases less closing inventory.
(b) Carriage in is part of cost of sales, and this affects gross profit. Carriage out is an expense and affects net profit.
(c) Inventory is valued at the lower of cost and net realisable value.
Assessment
focus points
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Part B Accounting systems and accounts preparation ⏐ 11: Cost of goods sold and inventories 171
Question
Inventory
A business has three items of inventory X, Y and Z.
Cost NRV
$ $
X 15,000 20,000
Y 5,000 2,000
Z 17,000 13,000
What is the closing value of inventory?
A $37,000
B $35,000
C $30,000
D $42,000
Answer
C Each item has to be valued at the lower of cost and NRV ($15,000 + $2,000 + $13,000).
2 Accounting for opening and closing inventories
Businesses must account accurately for inventory. Inventory in hand can be a substantial asset and inventory used
must be known in order to compute cost of sales.
2.1 Ledger accounting for inventories
The value of closing inventories is accounted for in the nominal ledger by debiting a inventory account and crediting the
trading account at the end of an accounting period. At the beginning of the next accounting period the opening inventory
value b/f in the inventory account is transferred to the trading account.
A inventory account must be kept. This inventory account is only ever used at the end of an accounting period, when the
business counts up and values the inventory in hand (an inventory count). To record this inventory value:
DEBIT Inventory account (closing inventory value) $X
CREDIT Trading account $X
The debit balance on inventory account represents an asset, which will be shown as part of current assets, and the credit
in the trading account is closing inventory, in cost of sales.
Closing inventory at the end of one period becomes opening inventory at the start of the next period. The inventory
account remains unchanged until the end of the next period, when the value of opening inventory is taken to the trading
account.
DEBIT Trading account $X
CREDIT Inventory account (value of opening inventory) $X
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172 11: Cost of goods sold and inventories ⏐ Part B Accounting systems and accounts preparation
Question
Final accounts with inventory
A business is established with capital of $2,000 and this amount is paid into a business bank account by the proprietor.
During the first year's trading, the following transactions occurred:
$
Purchases of goods for resale, on credit 4,300
Payments to trade payables 3,600
Sales, all on credit 4,000
Payments from receivables 3,200
Non-current assets purchased for cash 1,500
Other expenses, all paid in cash 900
The bank has provided an overdraft facility of up to $3,000.
All 'other expenses' relate to the current year (ie no accruals or prepayments).
Closing inventories of goods are valued at $1,800. (This is the first year of the business, so there are no opening
inventories.)
Ignore depreciation and drawings.
Required
Prepare the ledger accounts, an income statement for the year and a statement of financial position as at the end of the
year.
Answer
CASH
$ $
Capital
2,000
Trade payable
3,600
Receivables
3,200
Non-current assets
1,500
Balance c/d
800
Other expenses
900
6,000
6,000
Balance b/d
800
CAPITAL
$ $
Balance c/d
2,600
Cash
2,000
I/S a/c
600
2,600
2,600
Balance b/d
2,600
TRADE PAYABLES
$ $
Cash
3,600
Purchases
4,300
Balance c/d
700
4,300
4,300
Balance b/d
700
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Part B Accounting systems and accounts preparation ⏐ 11: Cost of goods sold and inventories 173
PURCHASES ACCOUNT
$ $
Trade payables 4,300 Trading a/c 4,300
NON-CURRENT ASSETS
$ $
Cash
1,500
Balance c/d
1,500
Balance b/d
1,500
SALES
$ $
Trading a/c
4,000
Receivables
4,000
RECEIVABLES
$ $
Sales
4,000
Cash
3,200
Balance c/d
800
4,000
4,000
Balance b/d
800
OTHER EXPENSES
$ $
Cash
900
I/S a/c
900
INCOME STATEMENT
$ $
Purchases account
4,300
Sales
4,000
Gross profit c/d
1,500
Closing inventory (inventory
account)
1,800
5,800
5,800
Other expenses
900
Gross profit b/d
1,500
Net profit (transferred to
capital account)
600
1,500
1,500
INVENTORY ACCOUNT
$
$
Trading account (closing
inventory)
1,800
Balance c/d
1,800
Balance b/d
1,800
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174 11: Cost of goods sold and inventories ⏐ Part B Accounting systems and accounts preparation
STATEMENT OF FINANCIAL POSITION AS AT THE END OF THE PERIOD
$
$
Non-current assets
1,500
Current assets
Inventory
1,800
Receivables
800
2,600
4,100
Capital
At start of period
2,000
Profit for period
600
2,600
Current liabilities
Bank overdraft
800
Trade payables
700
1,500
4,100
Make sure you understand the entries. The balance on the inventory account was $1,800, which appears as a current
asset. The transfer from the inventory account to the trading account is the closing inventory in the calculation of cost of
sales. The $1,800 closing inventory was the only entry in the inventory account – there was no figure for opening
inventory.
If there had been, it would be eliminated by transferring it as a debit balance to the trading account.
DEBIT Trading account (with value of opening inventory)
CREDIT Inventory account (with value of opening inventory)
The debit in the trading account would then have increased the cost of sales, ie opening inventory is added to purchases
in calculating cost of sales. Remember the formula: opening inventory + purchases – closing inventory = cost of sales.
2.2 Example: inventory account
A trader starts a business on 1 January 20X1.
On 31 December 20X1 inventory is $2,000
31 December 20X2 inventory is $2,500
31 December 20X3 inventory is $3,000
Draw up the inventory account for 20X1, 20X2 and 20X3.
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Part B Accounting systems and accounts preparation ⏐ 11: Cost of goods sold and inventories 175
Solution
INVENTORY ACCOUNT
$
$
31.12.X1
Trading a/c
31.12.X1
Balance c/d
2,000
(closing inventory)
2,000
2,000
2,000
1.1.X2
Balance b/d
2,000
31.12.X2
Trading a/c
(opening inventory)
2,000
31.12.X2
Trading a/c
31.12.X2
Balance c/d
2,500
(closing inventory)
2,500
4,500
4,500
1.1X3
Balance b/d
2,500
31.12.X3
Trading a/c
(opening inventory)
2,500
31.12.X3
Trading a/c
31.12.X3
Balance c/d
3,000
(closing inventory)
3,000
5,500
5,500
1.1.X4
Balance b/d
3,000
The main points
(a) Closing inventory is an asset (a debit) in the statement of financial position and a credit in the trading account.
(b) Opening inventory is a debit in the trading account.
(c) At the year end
(i) Debit trading account
Credit inventory account
(ii) Debit inventory account
Credit trading account
(d) The balance on the inventory account is the figure for the statement of financial position.
3 Inventory count
The quantity of inventories held at the year end is established by means of a physical count of inventory in an annual
inventory count exercise, or by a 'continuous' inventory count.
3.1 Carrying out the physical inventory count
The continuous nature of trading activity may cause a problem in that inventory movements may continue during the
physical inventory count. Two possible solutions are as follows.
• Close down the business while the count takes place
• Keep detailed records of inventory movements during the course of the inventory count
Closing down the business for a short period for a inventory count (eg over a weekend or at Christmas) is considerably
easier than trying to keep detailed records of inventory movements during a inventory count. So most businesses prefer
that method unless they happen to keep detailed records of inventory movements anyway (for example, because they
wish to keep strict control on inventory movements).
}
with opening inventory value
}
with closing inventory valuation
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Assessment
focus point
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176 11: Cost of goods sold and inventories ⏐ Part B Accounting systems and accounts preparation
In more complicated cases, an alternative approach to establishing inventory quantities is to maintain continuous
inventory records. This means that a card is kept for every item of inventory, showing receipts and issues from the
stores, and a running total. A few inventory items are counted each day to make sure the record cards are correct. This is
called a
'continuous' inventory count because it is spread out over the year.
4 Valuing inventories
Inventory is valued in accordance with the prudence concept at the lower of cost and net realisable value (NRV). Cost
comprises purchase costs and costs of conversion.
Net realisable value is the selling price less all costs to completion and less selling costs.
4.1 Applying the basic valuation rule
If a business has many inventory items on hand, the comparison of cost and NRV should be carried out for each item
separately. It is not sufficient to compare the total cost of all inventory items with their total NRV.
4.2 Example: closing inventory
A company has four items of inventory and their cost and NRVs are as follows.
Inventory item
Cost
NRV
Lower of cost/NRV
$
$
$
1
27
32
27
2
14
8
8
3
43
55
43
4
29
40
29
113
135
107
What is the value of closing inventory?
Solution
It would be incorrect to compare total costs ($113) with total NRV ($135) and to state inventories at $113 in the
statement of financial position. The company can foresee a loss of $6 on item 2 and this should be recognised. By
performing the cost/NRV comparison for each item separately the prudent valuation of $107 can be derived. This is the
value which should appear in the statement of financial position.
However, for a company with large amounts of inventory this procedure may be impracticable. In this case it is
acceptable to group similar items into categories and perform the comparison of cost and NRV category by category,
rather than item by item.
4.3 Determining the purchase cost
Inventory may be raw materials or components bought from suppliers, finished goods which have been made by the
business but not yet sold, or work in the process of production, but only part-completed (this is called work in progress
or WIP). It will simplify matters, however, if we think about the cost of purchased raw materials and components.
A business may be continually purchasing a particular component. As each consignment is received from suppliers they
are stored in the appropriate 'bin', where they will be mingled with previous consignments. When the storekeeper issues
components to production, he will simply pull out the nearest components to hand, which may have arrived in the latest
consignment or in an earlier consignment or in several different consignments.
There are several techniques to attribute cost to the components.
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Part B Accounting systems and accounts preparation ⏐ 11: Cost of goods sold and inventories 177
The possible methods of valuing inventories include FIFO, LIFO, average cost, standard cost and replacement cost.
Financial accounts will normally require the use of FIFO or average cost.
(a) FIFO (first in, first out). We assume that components are used in the order in which they are received from
suppliers, so that the issue is part of the oldest consignment still unused and is costed accordingly, inventories
are themselves recent receipts.
(b) Average cost. Each component in the bin is assumed to have been purchased at the weighted average price of all
components in the bin at that moment.
(c) LIFO (last in, first out). Components issued to production formed part of the most recent delivery, inventories
are the oldest receipts.
(d) Standard cost. A pre-determined standard cost is applied to all inventory items. If this standard price differs from
prices actually paid during the period, the difference is written off as a 'variance' in the income statement.
(e) Replacement cost. It is assumed that the cost at which a inventory unit was purchased is the amount it would
cost to replace it.
It is worth mentioning here that if you are preparing financial accounts you would normally expect to use FIFO or
average costs for the statement of financial position valuation of inventory. IAS 2 specifically bans the use of LIFO and
replacement costs. (CA 2006 allows any method the directors think appropriate, so long as, under the historical cost
accounting rules, inventory is stated at production cost or purchase price.)
4.4 Example: inventory valuation
To illustrate the two pricing methods, the following transactions will be used in each case.
TRANSACTIONS DURING MAY 20X3
Quantity Unit cost Total cost
Units
$
$
Opening balance 1 May
100
2.00
200
Receipts 3 May
400
2.10
840
Issues 4 May
200
Receipts 9 May
300
2.12
636
Issues 11 May
400
Receipts 18 May
100
2.40
240
Issues 20 May
100
Closing balance 31 May
200
1,916
'Receipts' means goods received into store, and 'issues' means the issue of goods from store.
How would issues and closing inventory be valued using the following bases.
(a) FIFO?
(b) Average cost?
4.5 FIFO (first in, first out)
FIFO assumes that materials are issued out of inventory in the order in which they were delivered into inventory, ie
issues are priced at the cost of the earliest delivery remaining in inventory.
Key terms
Key term
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178 11: Cost of goods sold and inventories ⏐ Part B Accounting systems and accounts preparation
Solution
The cost of issues and closing inventory value in the example, using FIFO would be as follows.
Date of issue Quantity Value issued Cost of issues
Units
$
$
4 May
200
100 at $2
200
100 at $2.10
210
410
11 May
400
300 at $2.10
630
100 at $2.12
212
842
20 May
100
100 at $2.12
212
1,464
Closing inventory value
200
100 at $2.12
212
100 at $2.40
240
452
1,916
Note that the cost of materials issued plus the value of closing inventory equals the cost of purchases plus the value of
opening inventory ($1,916).
4.6 Average cost
The cumulative weighted average pricing method calculates a weighted average price for all units in inventory. Issues
are priced at this average cost, and the balance of inventory remaining would have the same unit valuation.
A new weighted average price is calculated whenever a new delivery of materials into store is received. This is the key
feature of cumulative weighted average pricing.
Solution continued
In our example, issue costs and closing inventory values would be as follows.
Total
inventory
Price of
Date
Received
Issued
Balance
value
Unit cost
issue
Units
Units
Units
$
$
$
Opening
inventory
100
200
2.00
3 May
400
840
2.10
500
1,040
2.08 *
4 May
200
(416
)
2.08 **
416
300
624
2.08
9 May
300
636
2.12
600
1,260
2.10 *
11 May
400
(840
)
2.10 **
840
200
420
2.10
18 May
100
240
2.40
300
660
2.20 *
20 May
100
(220
)
2.20 **
220
1,476
Closing inventory value
200
440
2.20
440
1,916
Key term
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Part B Accounting systems and accounts preparation ⏐ 11: Cost of goods sold and inventories 179
* A new unit cost of inventory is calculated whenever a new receipt of materials occurs.
** Whenever inventories are issued, the unit value of the items issued is the current weighted average cost per unit at
the time of the issue.
For this method too, the cost of materials issued plus the value of closing inventory equals the cost of purchases plus
the value of opening inventory ($1,916).
4.7 Example: inventory valuations and profit
On 1 November 20X2 a company held 300 units of finished goods item No 9639 in inventory. These were valued at $12
each. During November 20X2 three batches of finished goods were received into store from the production department
as follows.
Date Units received Production cost per unit
10 November
400
$12.50
20 November
400
$14
25 November
400
$15
Goods sold out of inventory during November were as follows.
Date Units sold Sale price per unit
14 November
500
$20
21 November
500
$20
28 November
100
$20
What was the profit from selling inventory item 9639 in November 20X2, applying the following principles of inventory
valuation.
(a) FIFO
(b) Cumulative weighted average costing
(c) LIFO
Ignore administration, sales and distribution costs.
Solution
(a) FIFO
Issue cost
Total
Closing
inventory
$
$
Date
Issue costs
14 November
300 units × $12 plus
200 units × $12.50
6,100
21 November
200 units × $12.50 plus
300 units × $14
6,700
28 November
100 units × $14
1,400
Closing inventory
400 units × $15
_____
6,000
14,200
6,000
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