AAT LEVEL 3 LESSON 7. Association of Accounting Technicians (AAT) Example Course Materials

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1 LESSON 7 Account for the Valuation of Inventory On completing this lesson you should be able to: Identify categories of inventory as referred to within the accounting standard IAS 2 (Inventories) Explain the purpose of valuing inventory, identify the accounting concept on which making an adjustment for closing inventory is based, and process an adjustment to account for the valuation of closing inventory Explain the principle by which inventory should be valued in accordance with the requirements of IAS 2, and identify the accounting concept on which the principle is based Explain the terms cost and net realisable value, make valuations at cost and net realisable value and use the valuations in accordance with the requirements of IAS 2 Adjust a valuation of inventory from retail selling price to cost price given mark-up or margin Maintain an inventories account in the ledger and use inventory valuations in the preparation of final accounts Introduction The accounting term inventory is the term used in international accounting to describe what is referred to in the UK as stock. Inventory represents both an expense (cost), and an asset to a business, therefore, the incorrect treatment and valuation of inventory held by a business will have an impact on the preparation of the Statement of Profit and Loss and the Statement of Financial Position. Due to the fact that Inventory valuation is an important area of accounting it is the subject of an accounting standard - IAS 2 (Inventories). IAS 2 categorises inventories as follows: Finished goods purchased or manufactured for resale. Raw materials or components to be used in the process of manufacturing goods. Products and/ or services in various stages of completion (work in progress). Use of accounting concepts Several accounting concepts are applied in valuing and accounting for inventories, the concepts of accruals, prudence and consistency being of particular relevance.

2 Accruals concept The accruals concept requires that in calculating profit or loss for an accounting period (financial year), the costs and expenses incurred in the accounting period should be deducted from the income earned in the same accounting period. Consider the following example: Example Applying the accruals concept During its financial year ended 31 May 201X Direct Tiles purchased goods for resale at a cost of 600,000. Sales to customers during the same period were 800,000. The gross profit was therefore calculated in the Statement of Profit or Loss (trading section) as follows: Direct Tiles Statement of Profit or Loss (extract) for the Year Ended 31 May 201X Sales 800,000 Less Purchases 600,000 Gross Profit 200,000 Let us now assume that Direct Tiles did not, in fact, sell all the goods it purchased during the year to 31 May 201X. At the year end the business had goods, which cost 80,000, remaining as inventory. It would clearly be unfair to charge the cost of all goods purchased in an accounting period against income earned from selling only some of them. In such circumstance the accruals concept must be applied and an adjustment made to account for closing inventory. The adjustment would result in the closing inventory being valued and deducted from this year s expenses in the Statement of Profit or Loss and carried forward as an asset to the next accounting period. The closing inventory adjustment would be supported by an entry in the journal as follows:

3 Journal 201X Details DR CR 31 May Closing inventory Statement of Financial Position (SFP) 80,000 Closing inventory Statement of Profit or Loss( SPL) Closing inventory as at financial year end 31 May 201X 80,000 The closing inventory valuation as at 31 May 201X would be used in the preparation of the financial statements as follows: Direct Tiles Statement of Profit or Loss (extract) for the Year Ended 31 May 201X Sales 800,000 Less Cost of Goods Sold Purchases 600,000 Less Closing inventory 80,000 Cost of Sales 520,000 Gross Profit 280,000 Direct Tiles Statement of Financial Position (extract) as at 31 May 201X Current assets Inventory 80,000 Of course the closing inventory of one period end becomes the opening inventory of the following accounting period. This has further implications when calculating gross profit.

4 When we now calculate gross profit in applying the accruals concept we must take into account both the opening and closing inventory. The Statement of Profit or Loss (trading section) would now be prepared as follows: Direct Tiles Statement of Profit or Loss (extract) for the Year Ended 31 May 201Y Sales 940,000 Less Cost of Goods Sold Opening inventory 80,000 Add Purchases 700, ,000 Less Closing inventory 100,000 Cost of Sales 680,000 Gross Profit 260,000 Assessment tip remember the rule, the accruals concept requires the cost of unsold goods at the end of an accounting period should be carried forward to a future accounting period in the anticipation of future sales revenue. The valuation of inventory at cost price For the purpose of using an inventory valuation in the financial statements, initially a valuation of inventory at its cost price is required. IAS 2 specifies what represents cost in arriving at a valuation of inventory at cost. The standards describe cost as all costs incurred in bringing inventory to its present location and condition. Such costs are likely to include: Cost of purchase, production and conversion. Import duties. Cost of transportation (delivery). Direct labour costs incurred by a business when its own employees are used in an assembly or conversion process.

5 Specifically excluded from cost are abnormal wastage (materials, labour and overheads), the cost of storing finished goods and selling expenses. Cost is assigned to each unit of inventory separately which causes problems in practice as it is often difficult for a business to ascertain the actual cost of items remaining in inventory at the period end. This is due to the fact that most businesses take numerous deliveries of identical goods during an accounting period, often paying a different purchase price for each consignment. At the end of the accounting period it is often impossible to match individual units of a particular line of inventory to their actual purchase price. The accounting standards allow the following methods of valuing inventory at cost. First in First Out (FIFO) this is a method of inventory valuation whereby inventory items received first are costed out first, resulting in the most recent quantities of inventory in hand being valued at the most recent cost of production or purchase price. This method of inventory valuation is widely used as it appears logical, in that most businesses would wish to issue and price out their oldest goods first to safeguard against deterioration or obsolescence. Continuous Weighted Average (AVCO) inventory is valued at its average cost. This involves dividing the total value of inventory in hand by the total quantity of finished units or partly finished units of inventory to arrive at the average cost price, which is then applied to the issue of inventory. A new average price must be calculated every time there is a receipt of goods into inventory at a price which is higher or lower than the prevailing average price. The AVCO method of inventory valuation is commonly used in practice as it is easy to apply and the valuation which results is thought to be a fair representation of the cost of inventory held. Last in First Out (LIFO) - the last in first out (LIFO) method of inventory valuation, where goods received last are priced out first using the most recent cost prices, whilst widely used in cost and management accounting, is not an acceptable method of inventory valuation for the purpose of financial accounting and the preparation of financial statements. Example The use of FIFO and AVCO Inventory valuation methods A company trades in a single product. At I July 201Y the inventory of the company consisted of 20,000 units of the product at a cost of 10 per unit.

6 During the month of July 201Y purchases and sales of the product were: Date Purchases Sales 2 July 12,000 units 4 July 5, each 8 July 7,000 units 10 July 10, each 15 July 6,000 units 18 July 5, each 26 July 10,000 units 31 July 10, each Note: All sales in the month of July 201Y were at 25 per unit. If the company valued their inventory using the FIFO method, closing inventory would be 15,000 units valued at 220,000 calculated as follows: Closing inventory units Units Opening inventory 20,000 Add purchases 30,000 50,000 Less sales 35,000 Closing inventory 15,000 Closing inventory valuation 10, = 150,000 (purchased 31 July 201Y) 5, = 70,000 (purchased 18 July 201Y) 220,000

7 Gross profit on trading in the product for the month ended 31 July 201Y would be: Revenue 875,000 (35, each) Less Cost of Sales Opening inventory 200,000 (20, each) Purchases 430,000 (20, each + 10, each) 630,000 Closing inventory (220,000) (10, each + 5, each) Cost of Sales 410,000 Gross profit 465,000 If an AVCO method of inventory valuation were used (continuous weighted average), then closing inventory would consist of 15,000 units at a value of 189,000, with the valuation calculated as follows: Opening inventory 200,000 + Purchases 430,000 = 630,000 = per unit Opening inventory 20,000 units + Purchases 30,000 units = 50, x 15,000 (closing inventory units) = 189,000 Gross profit on trading in the product for the year ended 31 July 201Y would be: Revenue 875,000 (35, each) Less Cost of Sales Opening inventory 200,000 (20, each) Purchases 430,000 (20, each + 10, each) 630,000 Closing inventory (189,000) (15, each) Cost of Sales 441,000 Gross profit 434,000

8 Consistency concept In practice an inventory valuation method which is fair and suitable should be selected. The management of a business is expected to choose a method of inventory valuation which provides the fairest possible approximation of the expenditure incurred in bringing a product to its present location and condition. Once a particular method of inventory valuation has been selected it then becomes the business s policy in respect of inventory valuation and should be applied consistently from accounting period to accounting period. The consistency concept prevents a change in policy being introduced just to show information in a more favourable light.