Inventory and IAS 2
Goods bought for resale are always debited to Purchases. At the year end the accountant counts and values what is left, and makes two entries: the opening inventory is removed (Dr Statement of profit or loss, Cr Inventory) and the closing inventory is set up (Dr Inventory, Cr Statement of profit or loss). IAS 2 values inventory at the lower of cost and net realisable value, item by item. Where identical items have been bought at different prices, cost is found by FIFO or average cost; you must also be able to calculate LIFO, although IAS 2 does not allow it in financial statements.
1 Introduction
In this chapter we will look at the adjustment for inventory. Although the actual entries are very simple indeed, they may seem 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
The first lecture works Examples 1 to 3. The tutor says “pounds” where the page uses dollars, and loses his place for a moment while working Example 3 — the profit he settles on, $14,000, is the right one.
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.
In year 1 (the first year of trading), a business had purchases of $20,000 and sales of $30,000. There was no inventory at the end of the period.
Show the trading account of the business for year 1, in a form suitable for presentation to the owners, and
Write up the accounts for purchases and sales, and close them off at the end of the year.
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In year 2, the business had purchases of $25,000 and made sales of $34,000. There was inventory at the end of the period of $4,000.
Show the trading account of the business for year 2, in a form suitable for presentation to the owners, and
Write up the accounts for purchases, sales, and inventory, and close them off at the end of the year.
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In year 3, the business had purchases of $38,000 and made sales of $50,000.
There was inventory at the end of the period of $6,000.
Show the trading account of the business for year 3, in a form suitable for presentation to the owners, and
Write up the accounts for purchases, sales, and inventory, and close them off at the end of the year.
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2.1 Summary of the accounting entries
At the end of each period, two entries are required:
Entry | Debit | Credit |
Remove the opening inventory | Statement of Profit or Loss account | Inventory account |
Create the closing inventory | Inventory account | 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.
Because closing inventory is deducted in arriving at cost of sales, any error in it changes profit by the same amount: if closing inventory is overstated, cost of sales is understated and profit is overstated (and the other way round).
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 (and the place) 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 and to sell them — for example repairs, packing, or delivery to the customer.
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).
The rule is applied to each item (or each group of similar items) separately, not to the inventory as a whole. If 99 desks cost $10 and can be sold for $15, and one damaged desk will only fetch $8, the 99 are valued at $10 each and the damaged one at $8. Inventory is written down to net realisable value when that is lower, but never written up above cost.
A company has closing inventory as follows:
Item | Units | Cost p.u. | Estimated | Estimated |
A | 100 | 10 | 3 | 15 |
B | 200 | 12 | 5 | 16 |
C | 150 | 6 | 4 | 11 |
Calculate the total value of inventory at the end of the period.
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4 The determination of cost
The third lecture explains why cost is a problem and works FIFO and average cost on Example 5. LIFO, which the syllabus also asks you to calculate, is not on the recording — work part (c) of Example 5 on the page. The lecture’s final average-cost figure, $7,240, is the one the page uses.
The rule in section 3, 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 it might seem.
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 is to have a policy of valuation.
There are five approaches that you should be aware of:
Unit cost
This is where we can establish the cost of each individual item (e.g. the cost is marked on each item).
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. The inventory left at the end is therefore the most recent purchases.
LIFO: last-in-first-out
With this approach we value inventory on the basis that every time we sold items we were selling the newest ones first. The inventory left at the end is therefore the oldest. You must be able to calculate it, but IAS 2 does not permit LIFO in financial statements (section 5).
Average cost
Under this approach we value the inventory remaining after each sale at the average cost of the inventory prior to the sale. (A simpler version, the periodic weighted average, works out one average for the whole period — total cost of the opening inventory and all purchases ÷ total units — and applies it to the closing units. Use it only when a question asks for it.)
Selling price less an estimated profit margin
For example a store that marks every item with its selling price and makes a profit of 40% on selling price values an item priced at $100 at $60. It is only acceptable where the result is close to cost, and you will not be asked to calculate it.
The first and last approaches do not need illustrating. We will explain the other three approaches by means of an example.
On 1 November 2002 a company held 300 units of finished goods valued at $12 each.
During November the following purchases took place:
Date | Units purchased | Cost per unit |
10 November | 400 | $12.50 |
20 November | 400 | $14 |
25 November | 400 | $15 |
Goods sold during November were as follows:
Date | Units sold | Sales price per unit |
14 November | 500 | $20 |
21 November | 400 | $20 |
28 November | 100 | $20 |
Calculate the value of the closing inventory applying the FIFO, average cost and LIFO bases of valuation.
FIFO
Average cost
LIFO
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Because the choice of method changes the profit, a business must use the same method every year (the consistency concept). It cannot switch each year to whichever method gives the better-looking result.
5 The provisions of IAS 2: Inventories
The following are the main provisions of the accounting standard:
Inventories should always be valued at the lower of cost and net realisable value, item by item.
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.
Costs of purchase: the purchase price, import duties and carriage inwards (the cost of delivery from the supplier).
Costs of conversion (for goods a business makes itself): direct materials and labour, and production overheads such as factory rent and depreciation of factory machines.
Overhead expenses which should be excluded from cost are:
selling costs (including carriage outwards — delivery to customers)
storage costs
abnormal wastage
administrative costs
(i.e. only the costs of production should be included)
For measuring cost, unit cost should be used if costs can be specifically identified. However, if this is not possible, then FIFO or average cost is used. LIFO is not permitted by IAS 2 for the financial statements, although you may be asked to calculate it.
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 in section 2 of 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.
7 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Inventory and IAS 2
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