CHAPTER 8: Visual Overview

Objective: To explain the period-end accounting entries for inventory.

1.1 Inventory Overview

1.1.1 Inventory Classification
Inventory is the term used to describe the goods, materials and supplies held at the
accounting period end that have been purchased by a business and are either ready for sale
or used in the production of completed products for sale. Common classifications of
inventories include:
 Goods purchased for resale (For example, by a wholesaler or retailer)
 Raw materials and components purchased for manufacturing into goods for sale
 Products and services in intermediate stages of completion (Work-in-progress)
 Finished goods
Activity 1

Inventory is an asset in the Statement of Financial Position.

What is the future economic benefit that the business will derive from selling the goods
held as inventory?
*Please use the notes feature in the toolbar to help formulate your answer.

ANSWER

The future economic benefit will be the sale proceeds.

IAS 2 states that inventory is valued at the lower figure of either cost or net realisable value. In
practice, this means that if the inventory is expected to be sold at a loss (when the selling price
is less than the cost of the goods), the loss is identified immediately.
If the goods are to be sold for more than the cost, the profit is only recognised once the goods
are sold.
Net realisable value is likely to be less than the cost in the following situations:
 physical damage to inventory
 obsolescence (for example, when a new version of an item replaces an older one)
 the selling prices in the market are falling

1.1.2 Accruals Accounting

Accruals accounting requires that business expenses be matched to the related business
income. This means that the statement of profit or loss needs to ensure that the sales income
generated in the year matches the trading costs associated with those sales.
Inventory purchases not sold during the year make up part of the closing inventory at the
financial year-end. Furthermore, sales generated during the year may be for items purchased in
the previous year that are held as opening inventory.
The Statement of Profit or Loss needs to be adjusted to apply accruals accounting. To correctly
account for inventory according to the accruals concept, the Statement of Profit or Loss records
the cost of goods sold instead of items purchased.
8.1.2 Accounting for Inventories
1.2 Accounting for Inventories
Businesses will purchase raw materials and goods for resale throughout an accounting period.
These purchases are recorded in the Purchases account (expense) at the point of the purchase.
At year-end, the total purchases appear in the Statement of Profit or Loss under the heading
Cost of sales (or cost of goods sold). To determine the final Cost of sales figure, the business
must adjust for opening and closing inventory.
The Cost of sales is the cost of the inventory sold during the accounting period.

Key Point

Cost of Sales = Opening inventory + Cost of goods purchased − Closing inventory

Opening inventory = value of inventory held at the start of the accounting period.
Closing inventory = value of inventory held at the accounting period’s end.
Cost of goods purchased = Purchase cost of the goods for resale or all the direct costs such as
materials, supplies and wages needed to make the goods.

Example 1

Amit runs a shop that sells computer ink cartridges to local offices. He is preparing financial statements for his y
end of 30 November 20X9. Amit has recorded the following:
 During this period, he sold 4,100 cartridges.
 On 1 December 20X8, his inventory consisted of 1,600 cartridges valued at $67,500.
 During the year, he purchased 3,500 cartridges for $129,600.
 On 30 November 20X9, he held 1,000 cartridges in inventory, valued at $34,800.
Cost of sales for the year = Opening inventory + Cost of goods purchased − Closing inventory

Units $

Opening inventory 1,600 67,500

Add: Cost of goods (purchases) 3,500 129,600

Less: Closing inventory (1,000) 34,800

Cost of sales 4,100 162,300

The above table shows that 4,100 units of cartridges were sold during the year. The cost of sales of the 4,100 u
is recorded in Amit’s Statement of Profit or Loss for the year ended 30 November 20X9 as $162,300.
1.2.1 Inventory Journals

The record of inventory and cost of goods sold are made at the end of the year using journals.
The objective of the double entries is to:
 Ensure the Inventory account reflects the closing inventory valuation
 Cost of goods sold account is created and reflects the correct amount
To achieve these objectives, there are three double-entry steps to make:
1. Remove the Opening Inventory
Opening inventories are removed and transferred to the Cost of goods sold account. This entry
is necessary because the opening inventories are now used to generate sales in the current
accounting period.

General Ledger Category Explanation

Account

DR Cost of goods sold Expense Opening inventory cost now included as

expenses

CR Inventory Asset Inventory (asset) decreased

The cost of opening inventories is reflected as a current-year expense in the Statement of Profit
or Loss.
2. Close off the Purchases Account
A business makes purchases for inventory for resale. The cost is debited to the Purchases
account and credited to cash/payables at the point of purchase. At year-end, the amount in the
Purchases account is closed off and transferred to the Cost of Goods Sold.

General Ledger Account Category Explanation

DR Cost of goods sold Expense Purchases (expense) is transferred to COGS

CR Purchases Expense Purchases (expense) is closed off

3. Post the Closing Inventory

The balance in the inventory account at year-end should reflect the value of closing inventory.
The closing balance is presented in the statement of financial position as a current asset.
Since closing inventories are items purchased that are not sold in the accounting period, their
cost should not be reflected as an expense in the Cost of goods sold account (SPL). Therefore,
the value of closing inventory is transferred out of expenses and reflected as Closing inventory
in the Statement of Financial Position.
 Individual Account Category Explanation

DR Inventory Asset Inventory (asset) increased

CR Cost of goods sold Expense Costs (expense) decreased

The value of closing inventory will be next year’s opening inventory value.
Activity 2

For each statement below, state if they are True or False.

1. The opening inventory of $45,000 will be in the inventory account as a debit balance.
2. To record the closing inventory balance of $54,000, the journal entry is:
DR Cost of sales $54,00

CR Inventory account $54,00

3. The opening inventory increases the Cost of sales in the Statement of Profit or Loss, and
the closing inventory reduces it.
4. The closing inventory of $54,000 is recognised in the Statement of Financial Position as a
Non-current asset.
*Please use the notes feature in the toolbar to help formulate your answer.

ANSWER

1. True. The opening inventory is brought down as an asset in the general ledger.
2. False. The correct entry is:
DR Inventory account $54,000
CR Cost of sales $54,000
3. The closing inventory is presented on the Statement of Financial Position as a Current
asset. Being an asset, it will have a debit balance. It is credited to the Cost of sales because
it reduces the expense.
4. True. The opening inventory is added to the purchases figure, and the closing inventory is
deducted to derive the Cost of sales amount.
5. False. The inventory value on the Statement of Financial Position is $54,000, but it is shown
as a Current asset instead of non-current.
1.3 Inventory Quantity

Businesses need to know the inventory volume/quantity to attribute a value to the opening and
closing inventory. This allows the business to calculate the cost of sales, which will be included
in their statement of profit or loss.
Inventory management is also crucial for businesses to track their inventory levels at different
time stages. This allows a smooth process of purchasing further inventory to meet sales.
 1.3.1 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
1.3.2 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 typically performs 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 keep a check on the card records.
Where year-end inventory is based on the valuation of balances extracted from continuous
inventory records, the recorded quantities must be shown to be accurate and up to date.
Businesses may require an inventory-management system, which includes:
 A test-counting program designed to cover all product/line items at least once a year.
 The investigation and correction of differences between the ledger and physical quantities.
Key Point

If the stock-checking system is ineffective, a complete physical count may be required for financial reporting.

2.1 IAS 2 Inventories

Under IAS 2 Inventories, inventories are valued at the lower of cost or net realisable value
(NRV).
2.1.1 Cost

The cost of inventory includes the cost of bringing the inventories to their current location and
condition. The below flowchart illustrates the components that make up the cost of inventories.
If the business manufactures the goods, the inventory cost includes raw materials purchases
plus the cost of converting the material into the finished product (for example, wages and
overheads).
IAS 2 stipulates several costs that are excluded in calculating the cost of inventory, as illustrated
in the diagram below:
The cost is determined using applicable pricing valuation methods (FIFO, continuous weighted
average or periodic weighted average).

Activity 3

For each of the costs below, state whether they should be included in the inventory cost.
1. Purchase of fruit
2. Delivery to customers (Carriage outwards)
3. Cost of rotten fruit that was thrown away
4. Labour cost for those working on the production line
5. Cost of labels for the tin
6. Delivery of fruit to the factory (Carriage inwards)
*Please use the notes feature in the toolbar to help formulate your answer.

ANSWER
2.1.2 Net Realisable Value (NRV)

The net realisable value (NRV) of an item of inventory is its selling price after all further costs
to complete and sell the item have been considered.
Selling expenses include expenses in getting the inventories from the business premises to the
customer, including delivery costs that the business will incur.
NRV = Estimated selling price − Estimated future costs of completion − Estimated future selling
expenses (if inventory is still in production)

Activity 4

1. Hiroto has carried out an inventory count and has 10,000 toy cars in his warehouse. He has
established the following information on the potential inventory value of each toy car.
Cost $5.00

Selling price $6.00

Selling expenses $0.75

Trade discount received 0%

2. What is the correct valuation of the inventory per IAS 2?

3. a) $50,000
4. b) $52,500
5. c) $60,000
6. Hiroto has carried out an inventory count and has 20,000 toy cars in his warehouse. He has
established the following information on the potential inventory value of each toy car.
Cost before trade discount $7.00

Selling price $7.00

Selling expenses $0.25

Trade discount received 5%

7. What is the correct valuation of the inventory per IAS 2?
8. a) $133,000
9. b) $135,000
10. b) $140,000
11. Hiroto has carried out an inventory count and has 5,000 toy cars in his warehouse. He has
established the following information on the potential inventory value of each toy car.
Cost $7.00

Selling price $7.00

Selling expenses $0.25

Settlement discount received 5%

12. What is the correct valuation of the inventory per IAS 2?

13. a) $33,250
14. b) $33,750
15. c) $35,000
*Please use the notes feature in the toolbar to help formulate your answer.

ANSWER

1. The correct answer is A, $50,000.

The cost of each toy car is $5, and the total inventory value based on cost would therefore
be $50,000 ($5 × 10,000). The net realisable value of each toy car is $5.25 ($6 − $0.75).
The total inventory value based on NRV is $52,500.
The lower of these is $50,000 and is, therefore, the value of the inventory.
Answer B did not take the lower of either cost or net realisable value.
Answer C did not take the lower figure and did not deduct the selling expenses from the
selling price.
2. The correct answer is A, $133,000.
The cost of each toy car is $7. Trade discounts are included in the calculation of inventory.
Each vehicle costs $6.65 ($7 × 95%), and the total is $133,000 ($6.65 × 20,000). The net
realisable value of each toy car is $6.75 ($7 − $0.25), and the total NRV would be $135,000.
The lower of these is $133,000.
Answer B did not take the lower of cost and net realisable value.
Answer C did not deduct the trade discount from the purchase price and valued the
inventory at $140,000 ($7 × 20,000).
3. The correct answer is B $33,750.
The cost of each toy car is $7. Settlement discounts are not deductible to arrive at inventory
cost. The total inventory value based on cost is $35,000 ($7.00 × 5,000 items). The net
realisable value of each toy car is $6.75 ($7 − $0.25), and the total inventory value based on
NRV would be $33,750.
The lower of these is $33,750.
Answer A incorrectly deducted the settlement discount, although the lower of the two values
was taken.
 Answer C did not deduct the settlement discount from the purchase price and valued the
inventory at $35,000 ($7 × 5,000), which is incorrect because it is not the lower figure.
2.2 Pricing Valuation Methods

The cost price of each item is called the unit cost. If this stays the same throughout the
accounting period, then it is simple to determine the price per item in the inventory. However,
inventory prices may rise or fall over the accounting period. Therefore, the order of sold
inventory needs to be established to determine the value of closing inventory.
There are two methods of calculating the cost of inventory:
 First In-First Out (FIFO)
This method assumes that inventories that are purchased first are sold first.
 Average Cost (AVCO)
The average cost (AVCO) is calculated by determining the average cost for items held in the
opening inventory and purchased during the period. There are two main methods of
calculating average cost.
o The first is where the calculation is done on a periodic (such as monthly) basis,
known as the periodic weighted average.
o The other method is where an average value for inventory is calculated before
every issue from inventory and is known as the cumulative weighted average.
FIFO and AVCO calculate the cost of inventory, which is then compared to the net realisable
value to determine which is lower and should be presented as the inventory value in the
statement of profit or loss.
After obtaining the opening and closing value, the cost of sales is calculated and recorded in the
statement of profit or loss.
Cost of sales = Opening inventory + Cost of goods − Closing inventory
2.2.1 First In-First Out (FIFO)

FIFO assumes that inventory leaves the warehouse in the same order as its receipt. Therefore,
the inventories remaining in the warehouse at the end of the accounting period are the most
recently purchased and should be valued at the most recent purchase price.

Example 2

Tariq's Lighting Supplies Co. had the following inventory transactions during the first week of April 20X5:

Date Quantity in units Unit cost $ Total cost $

1 April Opening inventory 500 5.00 2,500

2 April Purchase 250 5.10 1,275

 Example 2

3 April Purchase 300 5.20 1,560

4 April Issue 400

5 April Purchase 200 5.30 1,060

6 April Issue 500

7 April Closing inventory 350

These logs show that inventory has left the warehouse because of customer sales. Inventory leaving the warehouse is called a
Using the FIFO method of valuation, the missing figures are calculated as follows:
1. 4 April Issue
Using the FIFO principle, it is assumed that the 400 items sold are the first to have been purchased. These are 400 of the 5
at $5.00, so the total value of the 4 April issue is (400 units × $5) = $2,000
2. 6 April Issue
Applying the FIFO principle, it is assumed that the 500 items are the remaining 100 from 1 April, 250 from the 2 April purch
calculated as (100 units × $5) + (250 units × $5.10) + (150 units × $5.20) = $2,555
3. 7 April Closing Inventory
The 350 items of closing inventory will be valued as the last items that have been purchased and are unsold. These would
remaining 150 units from the 3 April purchase. The value of the inventory is (200 × $5.30) + (150 × $5.20) = $1,840
4. The Cost of Sales
Cost of sales = Opening $2,500 + Cost of goods ($1,275 + $1,560 + $
 Example 2

1,06

Activity 5

Aarav is a sole trader who sells office supplies to businesses. The inventory schedule of issues
and purchases of pens for the month of June 20X3 is available. Aarav is confident that the pens
will be sold for more than he paid. This means that the inventory will be measured at cost.
1. Calculate and enter the missing figures in the inventory schedule and the missing
unit costs in the space below, labelled (a), (b), and (c).
Date Quantity in units Unit cost $ Total cost $
 1 June Opening inventory 1,000 0.75

12 June Purchase 500 0.80

13 June Purchase 1,200 0.85

20 June Issue 1,300 (a)

25 June Purchase 200 0.99

29 June Issue 900 (b)

30 June Closing inventory 700 (c)

2. Calculate the cost of sales.

3. Record the double entry of the closing inventory in the general ledger.
*Please use the notes feature in the toolbar to help formulate your answer.

ANSWER

1. The answers for the missing figures are as follows:

Date Quantity in units Unit cost $ Total cost $

1 June Opening inventory 1,000 0.75 750.00

12 June Purchase 500 0.80 400.00

13 June Purchase 1,200 0.85 1,020.00

20 June Issue 1,300 (a) 990.00

25 June Purchase 200 0.99 198.00

29 June Issue 900 (b) 755.00

30 June Closing inventory 700 (c) 623.00

(a) $0.76

(b) $0.84

(c) $0.89
a. 20 June Issue of 1,300 units is made up of:
 1,000 units from 1 June (1,000 × $0.75) = $750
300 units from 12 June (300 × $0.80) = $240
Total cost = $750 + $240 = $990
Unit cost = $990/1,300 units = $0.76
b. 29 June Issue of 900 units is made up of:
200 units from 12 June (200 × $0.80) = $160
700 units from 13 June (700 × $0.85) = $595
Total cost = $160 + $595 = $755
Unit cost = $755/900 units = $0.84
c. 30 June Closing Inventories of 700 units are made up of:
500 units from 13 June (500 × $0.85) = $425
200 units from 25 June (200 × $0.99) = $198
Total cost = $425 + $198 = $623
Unit cost = $623/700 units = $0.89
2. The cost of sales is $1,745.
$

Opening inventory 750

Purchases (400 + 1,020 + 198) 1,618

Closing inventory (623)

1,745
3. The double entry to record the closing inventory is DR Inventory $623, CR Cost of Sales
$623

2.2.2 Periodic Weighted Average

With this inventory valuation method, the business totals the value of purchases of raw
materials at the end of the reporting period. Then it divides the value by the number of units
acquired.
This provides an average cost used to value the cost of goods sold and the inventory at the
period end.

Example 3

Tariq's Lighting Supplies Co. had the following inventory transactions during the first week of April 20X5:

Date Quantity in units Unit cost $ Total cost $

1 April Opening inventory 500 5.00 2,500

2 April Purchase 250 5.10 1,275

 Example 3

3 April Purchase 300 5.20 1,560

4 April Issue 400

5 April Purchase 200 5.30 1,060

6 April Issue 500

7 April Closing inventory 350

Using the periodic weighted average method of valuation, the missing figures are calculated as follows:
1. Closing Inventory
First, sum up the total cost: $2,500 + $1,275 + $1,560 + $1,060 = $6,395
Then, add up all the purchases in units: (500 + 250 + 300 + 200) = 1,250 units
The average cost per unit is: $6,395 ÷ 1,250 units = $5.12 per unit
The closing inventory: 350 units at $5.12 each = $1,792
Date Quantity in units Unit cost $ Total cost $

1 April Opening inventory 500 5.00 2,500

2 April Purchase 250 5.10 1,275

3 April Purchase 300 5.20 1,560

4 April Issue (400)

5 April Purchase 200 5.30 1,060

6 April Issue (500)

Total for the period $6,395

7 April Closing inventory 350

 Example 3

2. Cost of Sales
The cost of the issues is calculated as the number of units sold x the unit cost
Cost of Sales = (400 units + 500 units) × $5.12 = $4,608

2.2.3 Cumulative Weighted Average

With this inventory valuation method, calculate the average unit price of the inventory after each
purchase. The average is therefore adjusted throughout the period.

Example 6

Tariq's Lighting Supplies Co. had the following inventory transactions during the first week of April 20X5:

Date Quantity in units Unit cost $ Total cost $

1 April Opening inventory 500 5.00 2,500

2 April Purchase 250 5.10 1,275

3 April Purchase 300 5.20 1,560

4 April Issue 400

5 April Purchase 200 5.30 1,060

6 April Issue 500

7 April Closing inventory 350

Using the Cumulative Weighted Average method of valuation, the missing figures are calculated as follows:
1. 4 April Issues
Determine the average cost per unit after 3 April ($2,500 + $1,275 + $1,560) ÷ (500 + 250 + 300 units) =
$5,335/1,050 units = $5.08/unit)
The unit cost for the 4 April issues = 400 units × $5.08 = $2,032
Finally, subtract the 4 April issue from the totals already calculated to arrive at the new quantity in units and the
new total cost.
Note that the average cost is used to value the remaining inventory.
Date Quantity in units Unit cost $ Total cost $ Average cost per
 Example 6

unit $

1 April Opening inventory 500 5.00 2,500

2 April Purchase 250 5.10 1,275

3 April Purchase 300 5.20 1,560

Total 1,050 5,335 $5,335 ÷ 1,050 = $5.08

4 April Issue (400) 5.08 (2,032)

650 5.08 3,303

2. 6 April Issues
The revised totals for the quantity in units and the total cost for the 6 April issues should be calculated according
to the previous step.
Date Quantity in units Unit cost $ Total cost $ Average cost per unit $

Total 650 5.08 3,303

5 April Purchase 200 5.30 1,060

Total 850 4,363 $4,363 ÷ 850 = $5.13

6 April Issue (500) 5.13 (2,565)

3. Closing Inventory
The closing inventory is $5.13 × 350 = $1,796
4. Cost of Sales
The cost of sales Opening $2,500 + Purchases ($1,275 + $1,560 + $1,060) − Closing $1,796 = $4,599
Activity 6

Match the statement to the corresponding pricing valuation method below.

 First In-First Out Net realisable value

The valuation of closing inventory when Values closing inventory at the average purchase
it is sold for below cost. price paid for the inventory items.

Average Cumulative Weighted Values closing inventory at the most recent purchase
Average Method prices paid for the inventory items.

ANSWER

2.2.4 Impact of Pricing Methods on Profit and Assets

The different methods of valuing inventory affect the profit and asset amount reported in the
financial statements.
The closing inventory is reported as the inventory asset amount in the statement of financial
position. At the same time, the cost of goods sold is an expense which reduces the profit figure
in the statement of profit or loss.

Example 4

Under different pricing valuation methods, the closing inventory and cost of sales of Tariq's Lighting Supplies Co
 Example 4

are:

Inventory valuation Cost of sales

($) ($)

FIFO 1,840 4,555

AVCO - periodic method 1,792 4,608

AVCO – cumulative weighted average method 1,798 4,597

 FIFO has the lower cost of sales figure. Therefore, it will show a higher profit. This will always be the case if
the purchase costs rise throughout the period. However, if the purchase costs were falling through the
accounting period, using the AVCO periodic method would give a higher profit figure.
Ethical issues must be considered when determining which valuation method a business should use.
Businesses should consistently apply the FIFO or AVCO methods from one year to the next. This prevents
businesses from using valuation methods to report a better profit figure that may not represent their financial
standing fairly.
If a change is made, the previous year's financial statements must be restated so that results are comparable year-
on-year. However, if the method is used consistently and reflects how the inventory is used, it should be fine, as
there is no intention to mislead.

Activity 7

Kavita oversees buying jewellery in small batches for Emeralds and Diamonds Co. She buys
the jewellery from different suppliers to take advantage of the lowest prices available. Kavita
puts the inventory on display in the order of when it was purchased. All the inventory is sold at a
profit; therefore, the NRV is greater than the cost.
1. Should Kavita use the FIFO or AVCO system to calculate the inventory value?
2. Complete the inventory schedule below:
3. What is the cost of sales?
*Please use the notes feature in the toolbar to help formulate your answer.

ANSWER

1. Kavita should use FIFO, as she issues the inventory in order of when it was purchased.
2. Note (a) 400 units are deemed from opening inventory and will cost $50 each. The cost of
sale is $20,000 (400 × $50)
Note (b) of the 500 units, 100 are deemed from the opening inventory and valued at $50
each, 250 come from the 2 June purchase and are valued at $50.10, and the remaining 150
are from the 3 June and are valued at $50.20. The total value of the issue is [(100 × $50) +
(250 × $50.10) + (150 × $50.20)] = $25,055
Note (c) The closing inventory of 350 units comprises 150 units purchased on 3 June and
200 purchased on 5 June. The value is [(150 × $50.20) + (200 × $50.30)] = $17,590

From Kavita's inventory schedule, the value of the closing inventory is $17,590. The NRV
figure is greater than this cost; therefore, the inventory is valued at $17,590.
The cost of sales is calculated as opening inventory + purchases − closing inventory value.
This is $45,055 ($25,000 + $12,525 + $15,060 + $10,060 − $17,590). This is treated as an
expense in the statement of profit or loss and would reduce the profit. Notice that the same
figure would be arrived at by taking the cost of issues: $45,055 (= $20,000 + $25,055)
2.3 Inventory Disclosures
2.3.1 Disclosure Requirements

For businesses that manufacture goods, the disclosure should include the accounting policy for
inventory and a breakdown of inventory into appropriate classifications such as materials, work-
in-progress and finished goods.
The business is also required to disclose the following in the financial statements:
 The valuation method it has used in valuing its inventories
 How the business has applied those methods to calculate the inventory value