Chapter 7: Inventories Flashcards
*Inventories are the goods and a business holds for sale to its customers.
Inventories are a CURRENT asset because the business intends to sell the inventories (goods held for resale) within the next 12 months
Closing inventories are goods that remain unsold at year-end. The value of closing inventories is categorised as a current asset in the Statement of Financial Position.
Exam* - Inventories can be categorised as raw materials, work-in-progress or finished goods, each with different valuation methods.
FA2 only considers FINISHED goods (goods held for resale)
Overview of Accounting for Inventories
The main steps involved in accounting for inventories are:
- Perform Inventory Count
- Quantify the Inventory
- Value the Inventory
- Record the Value of Inventory in the Final Accounts
- Perform Inventory Count
On the last day of the financial year, the business will arrange for a physical count of all the inventory and record it on a list. Inventory counts will need to be done on all the premises owned by the business with the help of employees.
- Quantify the Inventory
At the end of the inventory count, the business will have a list of all the quantities of each inventory held. It then reviews each list and removes any items that cannot be sold (e.g. broken, damaged, or obsolete).
The list of remaining inventories is compiled into a spreadsheet.
3.Value the Inventory
Once the inventory quantity is identified, the business can value the inventory. This valuation exercise will need to be done for each separate inventory line (product).
For each line of inventory, the valuation is calculated by multiplying the number of items by the value per item. There are three types of valuation methods:
- First-in, first-out (FIFO)
- continuous weighted average (CWA)
- periodic weighted average (PWA)
Inventories are valued at the lower of cost or net realisable value (NRV)
- Record the Value of Inventory in the Final Accounts
After the valuation of each inventory is complete, the total valuation is calculated. The total appears as current assets in the business’s Statement of Financial Position as Inventory.
Establishing Inventory Quantity
Two approaches can be adopted to establish the quantity of inventory:
- the continuous approach
- the periodic approach
The Continuous Approach
In this approach, each product sold by a business has its inventory record, either on a manual card or a computer record.
The card records quantities of purchases and sales of that product. It is set up to keep a running total of the amount of inventory as each new transaction (either sales or purchases) takes place. The record identifies how much inventory the business holds at any time.
This system uses the following principle: Opening Inventory + Purchases − Sales = Closing Inventory
The Periodic Approach
In this approach, there are no record cards. Inventory is physically counted at the end of the year (inventory count), and their quantities are recorded in a list.
The inventory count is usually performed on the last day of the accounting period when the business is closed with no inventory movements occurring.
Keeping continuous records can be time-consuming for businesses with multiple lines of products to sell, even if they are computerised. A business would perform an inventory count at year-end even when continuous records are kept. It may also carry out inventory counts on specific items during the year to verify the card records.
Inventory Valuation (IAS 2)
IAS 2 Inventories governs how inventory should be valued.
*Inventory is valued at COST or NET REALISABLE VALUE (NRV), whichever is lower.
Valuation at Cost
The inventory cost is defined as all expenditures incurred in bringing an item of inventory to its present location and condition.
The cost of an inventory item is the purchase cost, less any trade discounts received, plus handling and delivery costs and duties levied. Settlement discounts are not included in the cost of inventory.
The inventory cost is calculated using one of the valuation methods: FIFO, CWA or PWA.
Valuation at Net Realisable Value (NRV)
The net realisable value is the estimated inventory selling price after deducting the estimated completion costs and the costs necessary to make the sale.
Some inventory items might not sell or need to be heavily discounted to sell. These factors should be considered when calculating the NRV.
The prudence principle affects inventory valuation. Prudence means that assets should not be overstated, and gains should not be recognised until they materialise.
~Example
What is the value of the closing inventory per IAS 2?
The Cost: Purchase cost ($6.20 × 500 dresses) − Trade discount 12% + Other costs $127 = $2,855
The Net Realisable Value: the estimated selling price $5,000 − estimated cost of completion $700 − estimated cost of sale $1,350 = $2,950
IAS 2 states that inventories should be valued at cost or net realisable value, whichever is lower. Since the cost of $2,855 is lower than the NRV of $2,950, the value of the 500 dresses is $2,855.
First In First Out (FIFO) Valuation
assumes that inventory is sold in a strict order: items purchased first will be sold first. This is known as inventory rotation, as the oldest items will be constantly brought to the front for sale and the newest items placed at the back.
During year-end, the inventory held by a business will be those purchased last; hence, the latest purchase prices are used to value them.
The steps taken to value inventory using the FIFO method are:
- Obtain the closing inventory quantity at the end of the period.
(closing inventory = opening inventory + purchases − sales) - Create a table with five columns − date, transaction type, quantity, purchase cost per item and total purchase value.
Include all transaction information such as opening inventory, purchases, and sales in date order. - For each sale, work backwards and identify the earliest inventory purchase price. Inventories sold will use the price of the earliest inventory purchased.
- The closing inventory value is the remaining inventory quantity multiplied by the remainder purchased inventory cost price.
Continuous Weighted Average (CWA) Valuation
The CWA method assumes that inventory is mixed together when purchased and sold in no particular order.
An example would be an inventory of a liquid where amounts are poured into a tank, mixing existing and new inventory. The purchase cost used to value inventory is its average value in the accounting period.
Under CWA, the average cost per unit is recalculated each time inventory is purchased.
The steps taken to value inventory using CWA are:
1. Obtain the closing inventory quantity at the end of the period.
2. Create a table with five columns – date, transaction type, quantity, purchase cost per item and total purchase value.
Include all transaction information such as opening inventory, purchases, and sales in date order.
For purchase transactions, include the purchase cost per unit and the total value of the purchase.
- Work out the continuous average purchase cost per unit for every purchase transaction by dividing the total value by the total quantity.
4.The closing inventory value is the total value at the period’s end.
Periodic Weighted Average (PWC) Valuation
This valuation method also assumes that inventories are mixed when purchased and sold in no particular order.
Under PWA, the average cost per unit is recalculated at period end.
The steps taken to value inventory using PWA are:
- Obtain the closing inventory quantity at the end of the period.
- Create a table with four columns − date of purchase, quantity purchased, purchase cost per item, and total purchase value.
Include all purchases for the period in question and sum up the purchase value. - The average purchase cost is calculated as the total purchase value ÷ total quantity purchased.
- The value of closing inventory is calculated as the average purchase cost from step 3, multiplied by the number of units in closing inventory.
