Show Chapter learning objectives Upon completion of this chapter you will be able to:
1 Valuation of inventory Inventory consists of:
Inventory is included in the statement of financial position at: Cost Cost includes all the expenditure incurred in bringing the product or service to its present location and condition. This includes:
Costs which must be excluded from the cost of inventory are:
Example Gordano is a small furniture manufacturing company. All of itstimber is imported from Scandinavia and there are only three basicproducts - bookcases, dining tables and cupboards. The company has 200completed bookcases in inventory at the end of the year. For finalaccounts purposes, these will be stated at the lower of cost and netrealisable value. How is 'cost' arrived at? Solution 'Cost' will include several elements:
These groups of cost must relate to either:
NRV The comparison between cost and NRV must be made item by item,not on the total inventory value. It may be acceptable to considergroups of items together if all are worth less than cost. Test your understanding 1Cole’s business sells three products X, Y and Z. The following information was available at the year-end: What is the value of the closing inventory? A $8,400 B $6,800 C $7,100 D $7,200 Test your understanding 2In what circumstances might the NRV of inventories be lower than their cost? Test your understanding 3IAS 2 Inventories defines the items that may be included incomputing the value of an inventory of finished goods manufactured by abusiness. Which one of the following lists consists only of items which maybe included in the statement of financial position value of suchinventories according to IAS 2? A Foreman’s wages, carriage inwards, carriage outwards, raw materials B Raw materials, carriage inwards, costs of storage of finished goods, plant depreciation C Plant depreciation, carriage inwards, raw materials, foreman’s wages D Carriage outwards, raw materials, foreman’s wages, plant depreciation Inventory valuationInventory valuation It can be a complicated procedure to arrive at the valuation placed on closing inventory, because:
The matching and prudence concept
In the context of the value of inventory, this means that if goodsare expected to be sold below cost after the statement of financialposition date (for example, because they are damaged or obsolete),account must be taken of the loss in order to prepare the statement offinancial position. The amount at which inventory should be stated in the statement offinancial position is the lower of cost and net realisable value. Inventory recordsKeeping inventory records A business may choose to keep inventory records on a continuousbasis throughout the year or only count inventory at the period end. In preparing the financial statements, the calculation of what isin closing inventory can be a major exercise for a business. Thebusiness may need to count its inventory at the statement of financialposition date. A formal title for the sheets recording the inventorycount is ‘period-end inventory records’. An alternative would be to have records which show the amount ofinventory at any date, i.e. continuous inventory records. These recordsmay take a variety of forms but, in essence, a record of each item ofinventory would be maintained showing all the receipts and issues forthat item. The merits of continuous inventory records are as follows:
The merits of period-end inventory records are as follows:
2 Adjustments for inventory in the financial statements
In order to be able to prepare a set of financial statements, itis first necessary to learn how to account for any items of goods heldat the end of the year, i.e. closing inventory. (In some countriesinventory is referred to as ‘stock’.) Example A trader starts in business and by the end of his first year hehas purchased goods costing $21,000 and has made sales totalling$25,000. Goods which cost him $3,000 have not been sold by the end ofthe year. What profit has he made in the year? Solution The unsold goods are referred to as closing inventory. This inventory is deducted from purchases in the income statement. Gross profit is thus: Closing inventory of $3,000 will appear on the statement of financial position as an asset. Illustration 1 – Adjustments for inventoryPeter buys and sells washing machines. He has been trading formany years. On 1 January 20X7, his opening inventory is 30 washingmachines which cost $9,500. He purchased 65 machines in the yearamounting to $150,000 and on 31 December 20X7 he has 25 washing machinesleft in inventory with a cost of $7,500. Peter has sold 70 machineswith a sales value of $215,000 in the year. Calculate the gross profit for the year ended 31 December 20X7. SolutionSolution
Continuing from previous Illustration, we will now see how the ledger accounts for inventory are prepared. We will look at the ledger accounts at the following times: (a)Immediately before extracting a trial balance at 31 December 20X7. (b)Immediately after the year-end adjustments and closing off of the ledger accounts. (a)Ledger accounts before extracting a trial balance The inventory is an asset and therefore is a debit entry in the inventory account.
(b) Ledger accounts reflecting the closing inventory
Step 1 The income statement forms part of the double entry. At the yearend the accumulated totals from the sales and purchases accounts must betransferred to it using the following journal entries: These transfers are shown in the ledger accounts below. Step 2 The opening inventory figure ($9,500) must also be transferred tothe income statement account in order to arrive at cost of sales. Dr Income statement $9,500 Cr Inventory $9,500 Step 3 The income statement cannot be completed (and hence gross profit calculated) until the closing inventory is included. Dr Inventory $7,500 Cr Income statement $7,500 After summarising and balancing off, the ledger then becomes: Key pointsKey points:
The more common layout of the first part of the income statement is: Test your understanding 4The trading position of a simple cash-based business for its first week of trading was as follows: At the end of the week there were goods which had cost $300 left in inventory. Write up the ledger accounts for the first week, including theincome statement, and then prepare a vertical income statement togetherwith a statement of financial position at the end of the first week. Test your understanding 5The business described in Test your understanding 1 now continues into its second week. Its transactions are as follows: The goods left in inventory at the end of this second week originally cost $500. Write up the ledger accounts for the second week, including theincome statement, and then prepare a vertical income statement togetherwith a statement of financial position at the end of the second week. 4 Drawings of inventory It is not unusual for a sole trader to take inventory from theirbusiness for their own use. This type of transaction is a form ofdrawings. The correct double entry to account for such drawings is: The credit entry ensures that the cost of inventory taken is notincluded as part of the cost of inventory sold in the income statement. 5 Methods of calculating cost of inventory Test your understanding 6Sam started her business on 1 January and provides details of the following transactions: Purchases (1) January 5 units at $4/unit (2) January 5 units at $5/unit (3) January 5 units at $5.50/unit She then sold 7 units for $10/unit on 5 January. (a) Calculate the value of the closing inventory at the end of the first week of trading using the FIFO and the AVCO methods. (b) Prepare the income statement for the first week of trading under both FIFO and AVCO. Test your understanding 7A business commenced on 1 January and purchases are made as follows: In June, 1,420 articles were sold for $7,000. What is the cost of closing inventory and gross profit for the period using the FIFO method: Profit and Statement of financial positionThe impact of valuation methods on profit and the statement of financial position. Different valuation methods will result in different closing inventory values. This will in turn impact both profit and statement of financial position asset value. Similarly any incorrect valuation of inventory will impact the financial statements. If inventory is overvalued then:
If inventory is undervalued then:
6 Disclosure Inventories Inventories are valued at the lower of cost and net realisablevalue. They will be analysed as follows in the notes to the accounts: Chapter summary Test your understanding answers Test your understanding 1The correct answer is B Test your understanding 2NRV may be relevant in special cases, such as where goods areslow-moving, damaged or obsolete. However, most items of inventory willbe stated at cost. Test your understanding 3The correct answer is C The other three answers contain items which cannot be included in inventory according to IAS 2. Test your understanding 4First, the transactions are entered into the ledger accounts, andthe accounts are balanced. Revenue and purchases are then transferredto the income statement ledger account. Next, the closing inventory must be accounted for in the inventoryaccount and the income statement account. There is no opening inventoryas this is the first week of trading for the business. The income statement is prepared in the vertical format by rearranging the income statement ledger account The statement of financial position is prepared by listing the balances brought down from the ledger accounts. Test your understanding 5First, the ledger accounts must be written up. You must rememberthat there are opening balances on the statement of financial positionaccounts (cash and capital) but the income statement accounts have noopening balances as they were transferred to the income statement inWeek 1. The opening inventory must be transferred to the income statement,and the closing inventory entered into the ledger accounts (inventoryand income statement) leaving the balance carried forward which will beincluded in the statement of financial position. Test your understanding 6Units purchased (5 x 3) = 15 (a) FIFO AVCO Average cost per unit: ((5 x $4) + (5 x $5) + (5 x $5.50))/15 = $4.83 Closing inventory = 8 x $4.83 = $38.64 (b) FIFO Test your understanding 7
Calculation of gross profit:
Why are inventories included in the computation of net income?Why are inventories included in the computation of net income? To determine cost of goods sold.
Is inventory included in the statement of financial position?Inventory is an asset and its ending balance is reported in the current asset section of a company's balance sheet. Inventory is not an income statement account. However, the change in inventory is a component in the calculation of the Cost of Goods Sold, which is often presented on a company's income statement.
How does inventory affect net income?Impact of an Inventory Overstatement on Income Taxes
When an ending inventory overstatement occurs, the cost of goods sold is stated too low, which means that net income before taxes is overstated by the amount of the inventory overstatement. However, income taxes must then be paid on the amount of the overstatement.
Why is the valuation of inventories important in financial reporting?A clear understanding of inventory valuation can help maximize profitability. It also ensures the company can accurately represent the value of inventory on its financial statements.
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