Inventory and IAS 2

1 Introduction

In this chapter we will look at the adjustment for inventory. Although the actual entries are very simple indeed, they may see m a little strange because with modern computerised accounting it is now common to have continuous accounting for inventory. This will be explained within the chapter. We will also consider the methods of valuing inventory and the provisions of IAS 2 Inventories.

2 The accounting entries

You will recall that whenever we buy goods for resale we debit a purchases account, and that whenever we sell goods we credit a sales account. In all of the examples in these notes until now there has been no inventory at the end of the period and therefore the gross profit was simply the difference between the sales and the purchases.

No entries have been made to an inventory account as part of the day to day bookkeeping, and this will remain the case. Any inventory left at the end of the period will be adjusted for by the accountant when preparing the financial statements.

We will explain the necessary entries by way of three very short examples. Firstly with no inventories; secondly with inventory at the end of the period; and thirdly with inventory at both the beginning and end of the period.

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Summary of the accounting entries

At the end of each period, two entries are required:

1.  remove the opening inventory:

  Debit   Statement of Profit or Loss account

  Credit   Inventory account

1.  create the closing inventory

  Debit   Inventory account

  Credit   Statement of Profit or Loss account

Note that the Inventory account does not keep a day-by-day record of inventory and is therefore only correct at the end of each period after the adjusting entries have been made.

3 The valuation of inventory

The figure for the closing inventory in the above examples would have come from physically counting the inventory. (There are often day by day inventory records kept, but because of the importance of the accuracy of the figure a physical count would still be made as a check.)

The basic rule for valuation is:

Inventory should be valued at the lower of cost and net realisable value.

Cost is the cost of getting the goods to the state that they are in.

Net realisable value is the selling price less any extra costs that there will be in order to get the goods in a state to be sold.

Normally the lower of the two will be the cost (otherwise the business would always be making losses). However, there can be occasions (such as damaged, or obsolete items) when the net realisable value is the lower.

This rule is an application of the prudence concept, in that we will only take profit when it is actually realised (the reason for normally valuing at cost), but that we should charge any loss as soon as it is foreseen (the reason for valuing at net realisable value if this is lower than the cost).

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4 The determination of cost

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The rule above, i.e. that we value at the lower of cost and net realisable value, always applies. However, the cost of an item may not be as obvious as might be seemed.

Suppose that we buy and sell lamps. During the year we have bought 10,000 lamps and at the end of the year we have 1,000 left in inventory.

What was the cost of these 1,000 lamps? The cost is obviously what we paid for them! Suppose at the beginning of the year we were having to pay $1 a lamp but there have been large price increases and by the end of the year we were having to pay $5 a lamp (for identical lamps). Are the ones that we have left in inventory old ones (that therefore cost $1 each) or new ones (that therefore cost $5 each)?

Unless the cost is actually marked on each lamp, the only way in which we can establish a cost it to have a policy of valuation.

There are four approaches that you should be aware of:

(a)   unit cost

  This is where we can establish the cost of each individual item (e.g. the cost is marked on each item).

(b)   FIFO: first-in-first-out

  With this approach we value inventory on the basis that every time we sold items during the year we were selling the oldest ones first

(c)   Average cost

  Under this approach we value the inventory remaining after each sale at the average cost of the inventory prior to the sale.

(d)   Selling price less an estimated profit margin

The first and last approaches do not need illustrating. We will explain the other two approaches by means of an example.

5 The provisions of IAS 2: Inventories

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The following are the main provisions of the accounting standard:

1. Inventories should always be valued at the lower of cost and net realisable value

2. The cost of inventories should include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

  Overhead expenses which should be excluded from cost are:

• selling costs

• storage costs

• abnormal wastage

• administrative costs

  (i.e. only the costs of production should be included)

1. For measuring cost, unit cost should be used if costs can be specifically identified. However, if this is not possible, then the benchmark treatments are FIFO and average cost.

2. Disclosure requirements:

• the accounting policy for valuation

• the inventory total, analysed appropriately

• the amount of any inventories valued at net realisable value

6 Continuous inventory recording

In the accounting entries illustrated earlier in this chapter, the only entries for inventory are made at the end of the period. The inventory account does not keep a day to day record of inventory.

However, in practice it is very common to keep day by day records of inventory, and often (due to the use of computers) these are integrated into the accounting. When this happens, then a record is kept of each movement of inventory.

Although this would make the day by day accounting slightly different, the need to physically count the inventory at the end of the period would remain (as a check on the records). Also, the valuation rules will remain – for example, any damaged inventory might need to be valued lower.