Accounting for Inventory

1 Introduction

This chapter looks at how inventory is accounted for.

2 What is inventory and why is it important?

Inventory can be any of the following:

Raw materials are purchased and then undergo further processing or are incorporated into products. Raw materials can be basic materials such as chemicals, flour, or lengths of wood. Or raw materials can be items which have been manufactured by the supplier, such as components and parts for use in production.

Work in progress refers to partly made products. They have progressed from the bought in stage (raw materials) but are not yet complete.

Finished goods are complete and are ready for sale.

When producing a set of financial statements, inventory has two effects:

The statement of financial position: closing inventory is an asset and must therefore appear on the statement of financial position. It will be included in current assets.

The statement of profit or loss: an inventory adjustment is needed to match sales revenues with the cost of the goods sold. Not everything purchased in a period is necessarily sold in that period and to achieve proper matching inventory has to be taken into account.

3 The standard inventory adjustment

So, the standard inventory adjustment for the statement of profit or loss is:

Cost of sales = opening inventory + purchases – closing inventory

4 The standard inventory adjustment in ‘T’ accounts

So, now we know the principle of the inventory adjustment, but how is this recorded in the books of account? Here again are the figures and the statement of profit or loss:

Opening inventory = 2,000 units

Closing inventory = 2,300 units

Units purchased = 8,000 units

All units in inventory and those purchased cost $5 each. All are sold at $9 each.

Expenses amount to $3,700

In ‘T’ accounts this would be recorded as follows:

The opening balance on the inventory account is the closing inventory from the last period. During the year, purchases are debited into the purchases account and sales credited into the sales account, as shown. The inventory account is not touched.

At the end of the period, the amount of closing inventory is assessed and the inventory adjustments will be:

Dr     Cost of sales account     10,000

  Cr     Inventory account     10,000

being the transfer of the opening inventory into cost of sales

Dr     Inventory account     11,500

  Cr     Cost of sales       11,500

being the removal of the closing inventory from cost of sales and establishing it as an inventory asset.

Dr     Cost of sales account     40,000

  Cr     Purchases       40,000

being the transfer of purchases to the cost of sales account.

After these adjustments the accounts will be:

Note that the closing inventory adjustment is:

Dr     Inventory account     11,500

  Cr     Cost of sales       11,500

A business could put any figure it wanted to into that adjustment and the financial statements would still balance. Every extra $ of closing inventory increases the inventory asset by $1 and decreases cost of sales (hence increasing profits) by $1. Therefore, inventory valuation is a very critical area in the preparation of financial statements – and for the audit of those statements.

5 Continuous and period-end inventory records

There are two ways a business can know what inventory it holds, and the study guide asks you to explain both.

A period-end inventory record. No running record is kept. Goods bought are debited to Purchases and nothing is written down when goods are sold. At the year end the business shuts the warehouse, counts everything physically, values it, and that count is the closing inventory figure used in the year-end adjustment. This is the system assumed everywhere else in this chapter.

A continuous (perpetual) inventory record. A record is kept for each line of inventory and updated at every movement - every receipt and every issue - so the quantity and value held are known at any moment. The cumulative weighted average table later in this chapter is exactly such a record. Instead of one big count, the business counts a few lines each week or month (continuous counting), checking the physical quantity against the record and investigating differences as they arise.

A continuous record does not remove the need to count. The record is compared with a physical count and, where they differ, it is the count that is right: the record is adjusted to it, and the difference is written off to cost of sales.

6 Different methods used to price materials issued from inventory and to value closing inventory

In the examples above, all inventory, whether opening, purchases or in closing inventory had the same cost. In practice, the cost of purchases can fluctuate and this forces us to consider how to calculate the cost of the units sold and the cost of the units still in inventory.

Consider the following:

12 March 20X4: buy 1000 units at $5 each

21 March 20X4: buy 500 units at $6 each

31 March 20x4: sell 800 units at $12 each.

It is clear that revenue will be 800 x $12 = $9,600, but what is the cost of the units sold? Which have been sold?

What is their value and the value of the inventory left?

You have to know three approaches:

• FIFO
  

• Cumulative weighted average
  

• Periodic weighted average
  

FIFO (First-in, first out)

This method assumes that the goods that arrive first are the first to be used. It is only an assumption: apart from their price all goods of a given type are identical and therefore you don’t know, or care, how they are physically used.

So, in the above case, all 800 units sold would be assumed to be those delivered on 12 March. They would have a cost of 800 x $5 = $4,000 and the value of the inventory remaining would be 200 x $5 + 500 x $6 = $4,000.

Note that receipts and sales are handled on a strict time basis.

Cumulative weighted average

Every time units are added, a new average price is calculated. Any time goods are removed they are removed at the prevailing average.

12 March 20X4: buy 1000 units at $5 each

21 March 20X4: buy 500 units at $6 each

31 March 20x4: sell 800 units at $12 each.

Note:

Sales do not alter the average cost.

Receipts and sales are handled on a strict time basis.

Periodic weighted average

Here, a new inventory value is calculated at the end of a set period. The cost of goods used is given by:

Average cost per unit = (cost of opening inventory + cost of purchases in the period) ÷ (units in opening inventory + units purchased in the period)

So, all units used in the period will have the same cost.

In the above simple example this method would give the same result as the cumulative weighted average approach

7 The effect of the valuation method on profit, assets and capital

Example 2, now that you have done it, is worth going back to, because it gives three different closing inventory figures for the same goods:

The goods are the same, the sales are the same, and the cash is the same. Only the split between what has been charged to cost of sales and what is still sitting in inventory has changed - and because cost of sales = opening inventory + purchases - closing inventory, a higher closing inventory always means a lower cost of sales and therefore a higher profit.

When prices are RISING, as they are in Example 2:

• FIFO charges the oldest, cheapest goods to cost of sales and leaves the newest, dearest ones in inventory. So FIFO gives the highest closing inventory, the lowest cost of sales and the highest profit.

• The weighted average methods mix old and new prices together, so they give a lower closing inventory and a lower profit than FIFO.

• When prices are FALLING, all of this reverses: FIFO then gives the lowest closing inventory and the lowest profit.

The consequences follow automatically:

• Assets. Closing inventory is a current asset, so the method that gives the higher inventory figure gives the higher total assets.

• Capital. Profit is added to capital, so the method that gives the higher profit gives the higher closing capital by exactly the same amount.

• Next year. The difference is only ever a timing difference. This year's closing inventory is next year's opening inventory, so a higher profit this year means a higher cost of sales and a lower profit next year. Over the life of the business the total profit is the same whichever method is used.

This is why the consistency principle matters here: a business cannot switch methods from year to year to flatter its profit.

8 Other inventory valuation issues: cost and net realisable value

The fundamental principle of IAS 2 is that inventories must be stated at the lower of cost and net realisable value. This valuation rule ensures a prudent approach to inventory accounting: profits are not recognised until earned (ie the inventory is sold at above cost), but losses would be taken as soon as foreseen (because inventory is valued at net realisable value if lower than cost).

Cost should include all:

• Costs of purchase (including taxes, transport, and handling) net of trade discounts received.
  

• Costs of conversion (including fixed and variable manufacturing overheads)
  

• Other costs incurred in bringing the inventories to their present location and condition.
  

Net realisable value is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale.

Each line of inventory has to have its cost/NRV comparison carried out separately. The comparison is not performed on total inventory figures.