ABFA1163 FINANCIAL ACCOUNTING II 1

Lecture 1: Accounting for Inventories 3 How do we value the inventories in the accounting records?

Important Textbook Reading: Inventories valuation rule

• Chapters 9 & 29: Frank Wood & Alan Sangster “Business Accounting 1 ” LCM (lower of cost and market value) rule: Inventories should be
(13th edition) valued at the lower of cost and net realisable value.

Definition:
Learning Objectives • Cost:
After you have studied this chapter, you should be able to: The original (historical cost) purchase price (choose from 2 different
➢ calculate the value of inventories using three different methods methods – see next section).
➢ explain why using the most appropriate method to value inventories is • Net Realisable Value (NRV):
important The expected selling price (market value), less any cost expected to
➢ explain what effect changing prices has on inventories valuation under be incurred in getting the inventories ready for sale.
each of three different methods
➢ explain why net realisable value is sometimes used instead of cost for • Effect of inventories valuation on gross profit
valuation The lower value of NRV for closing inventories reduces gross profit:
➢ adjust inventories valuations, where necessary, by a reduction to net Using Using
realisable value Cost NRV
➢ explain how subjective factors influence the choice of inventories Trading Accounts RM RM
valuation method Sales 50,000 50,000
➢ explain why goods purchased on ‘sale or return’ are not included in
Less: Cost of goods sold
the buyer’s inventories
Opening inventories 0 0
Purchases 46,000 46,000
1 What are Inventories?
Less: Closing inventories (20,000) (18,000)
At any point of time, most trading and manufacturing enterprises will
(26,000) (28,000)
hold several categories of inventories, as follows:
manufactured Gross profit 24,000 22,000
o Goods for resale (goods purchased for resale)
we should use NRV to get lower value of
o Finished goods (manufactured by the enterprise for sale) until halfway gross profit. We should adopt 18,000 as
o Work-in-progress (partly finished goods still being manufactured) • Relevant accounting concept:
our closing inventories
o Raw materials (components purchased for manufacturing process) Prudence concept: Anticipated losses should be fully written off andPrudence
o Consumable stores (e.g. lubricant, cleaning material, spare parts) profit should not be recognised until there is reasonable degree of concept tell
us we cannot
assurance that they have been earned. Where there is a disagreement overstate our
2 Accounting for Inventories over a particular amount, or a subjective judgement was made, the assets&
There are three questions to be asked in the accounting for inventories: amount that gives a lower profit should be taken, otherwise profit mayincome and
o How do we value the inventories in the accounting records? be overstated. Equally, assets in the Statement of Financial Positioncannot
o How do we manage to get an accurate quantity of inventories? (SFP) should not be overstated. understate
our liability
o How do we record inventories in the ledger?
and equity.
ABFA1163 FINANCIAL ACCOUNTING II 2

Example 1 (single item) Methods to Calculate Cost of Inventories

A machine was purchased at cost RM5,000. Selling price is RM7,000. There are two acceptable approaches to determine the cost of
RM250 selling and distribution expenses will be incurred to bring the inventories, each of which employs different assumptions, i.e.:
machine ready for sale. Therefore, NRV = RM6,750. RM 7,000-RM 250
o First in - first out (FIFO): the oldest items in the inventories are
If the demand for the machine drops and expected selling price is only consumed or sold first, so closing inventories represent the latest or
RM4,500. NRV = RM4,500 - RM250 = RM4,250. Therefore, a loss is most recent purchases.
anticipated: RM5,000 – RM4,250 = RM750. o Weighted average cost (WAC): it requires the combination of the
unit cost of inventories by totaling the cost of existing inventories
Prudence concept requires the business to: and the cost of new inventories purchased, then divided by the total
i) Write off the anticipated loss of RM750 – units of inventories held after the new purchase.
In the Statement of Profit or Loss (SPL), use NRV for closing
inventories RM4,250 in “Cost of goods sold”, the gross profit Lecture illustration 1:
amount will be decreased by RM750; and
ii) Show the lower inventories amount in the Statement of A hardware trader purchases paints for resale. During the month of
Financial Position (SFP) – use NRV for closing inventories September, the following transactions took place:
RM4,250 in “Current assets”
September
Example 2 (many inventories items) 1 Opening balance 10 tins @ RM40
4 Purchases 8 tins @ RM44
Inventories item A B C D E Total 6 Sales 9 tins
Cost (RM) 81 42 129 87 61 400 15 Purchases 6 tins @ RM48
NRV (RM) 96 24 165 120 55 460 18 Sales 11 tins
LCM (RM) 81 24 129 87 55 376 23 Purchases 4 tins @ RM52

The losses of RM18 on item B and RM6 on item E should be written off Required:
immediately, i.e. by using NRV for items B and E in closing Calculate the cost of sales (cost of goods sold) for the month of
inventories. September and the value of closing inventories based on FIFO and
WAC valuation methods.
By performing the LCM rule for each item separately, the prudent
valuation of RM376 is derived, and this value should be appear in the
Statement of Financial Position (Current assets – Inventory) and
Statement of Profit or Loss (Cost of goods sold – Closing inventories),
and NOT RM400 at cost or RM460 at NRV.
 ABFA1163 FINANCIAL ACCOUNTING II 3

FIFO - need to rewrite previous inventory

Purchase Sales
FIFO Goods received Goods issued Balance Comparison of inventories valuation methods under FIFO and WAC:
Date Qty @ RM Qty @ RM Qty @ RM FIFO WAC
Sep 1 10 40 400 COS 848 863
4 10 40 400 C/Inv 400 385
8 44 352 8 44 352 Effect on gross profit Higher Lower
6 9 40 360 1 40 352
8 44 352 As can be seen from the above table:
15 1 40 40 i) FIFO method will give the lower cost of sales figure, the higher
8 44 352 follow closing inventories figure and the higher gross profit figure;
6 48 288 6 48 288 recordii) WAC method will give the higher cost of sales figure, the lower
18 1 40 40 closing inventories figure and the lower gross profit figure.
8 44 352
2 48 96 4 48 192 Note: The above illustration reflects an inflation period, i.e. when prices
23 4 48 192 are increasing over time.
4 52 208 4 52 208
848 848 400
Purch COS C/Inv
40和44之间要选一个最低的cost 所以是40
WAC Goods received Goods issued Balance
Date Qty @ RM Qty @ RM Qty @ RM
Sep 1 10 40 400
4 8 44 352 18 41.78 752 between 44& 41.78, choose the lower one
6 9 41.78 376 9 41.78 376
15 6 48 288 15 44.27 664
18 11 44.27 487 不用40的原因是因为40的这个statement已经过了
4 44.25 177
23 4 52 208 8 48.13 385
848 863 385
Purch COS C/Inv

WAC - no need to rewrite the previous inventory

ABFA1163 FINANCIAL ACCOUNTING II 4

Summary Advantages and disadvantages of the different methods

use to explain FIFO
Under the FIFO inventory valuation method, the first inventory FIFO method
purchased is first to be sold. During inflation, the higher priced Advantages
inventory (most recent purchases) will appear in the SFP as closing o It is realistic because it based on the assumption that inventories are
inventory and the lower priced inventory (earlier purchases) will be issued in the order in which the goods are received.
included in the SPL as cost of sales. Therefore, cost of sales will be o Inventory values are easy to calculate and based on actual price
understated and closing inventories reflect the latest market price. paid.
o Closing inventories is based on the most recent purchase price that
Under the WAC method, the goods sold are based on the weighted reflects the current market value.
average of all purchases. During inflation, the most recent purchases o Acceptable by the Inland Revenue Board, Malaysia for tax purpose.
(higher priced inventory) are also included in the weighted average cost, o Acceptable by the international financial reporting standards.
therefore, resulting in a higher cost of sales figure in SPL. The earlier
purchases (lower priced inventory) are still included in the weighted Disadvantages
average closing inventories, resulting in lower closing inventories in the o In a manufacturing business, raw materials used in production are
SFP. taken using the earliest price (outdated price), which is unrealistic
when setting the selling price of the finished goods.
o Identical items of raw materials may be issued to production/job at
different prices simply because they are deemed to be made out of
different batches of purchases.
o During inflation, FIFO values inventories at the latest (higher) price,
which tends to understate cost of sales and hence overstate profit.
This is not in conformity with the prudence concept, as it gives a
lower cost of sales figure compared to other methods of valuation
and thereby overstating the profit.
ABFA1163 FINANCIAL ACCOUNTING II 5

WAC method 4 How do we manage to get an accurate quantity of inventories?

Advantages
o As prices paid for identical items purchased at different times are Business trading is a continuous activity, but financial statements must
averaged, WAC recognises that all such items have equal value. be prepared as at a particular date. The closing inventories quantity must
o Minimise the variations in the value of raw materials issued to be determined as at a particular date in order to calculate an accurate
different production/jobs, even though they are issued from amount to be included in the financial statements.
different batches of purchases.
o Averaging has the effect of ‘smoothing out’ cost of production and The two approaches in determining an accurate quantity of closing
cost of sales, so that the profits of different periods may be more inventories are:
realistically compared.
o The valuation of closing inventories will usually be fairly close to i) Perpetual method of recording the inflows and outflows of
the latest prices paid (market value). inventories throughout the period. Separate records (inventory
o WAC is especially suited to computerised inventories control cards) are opened for each and every type of inventory. By
system. comparing the inflows and outflows, it is possible to calculate the
balance of inventories on hand at any point of time.
Disadvantages
o A new average must be calculated with every purchase of Note: The lecture illustration 1 above is the perpetual method of
inventories. recording inventories.
o The calculated average does not represent any price actually paid
for inventories. Even though the perpetual method is a very accurate method of
record-keeping, most business enterprises conduct physical
How to decide which method to choose? inventory counts (stock-takes) at the end of the financial year in
o The business enterprises will have to choose between FIFO and order to compare and confirm the accuracy of the inventory records.
WAC methods, on the basis which method is the closest to the
nature of the business operations. Under the perpetual method of accounting, the cost of goods sold is
o The overriding consideration is the need to give a ‘true and fair taken directly from the inventories account in order to prepare the
view’ of the profitability of the business enterprise over the SPL. Therefore, the format of SPL is slightly different from that
reporting period and the position of assets, liabilities and equity as using the periodic method of accounting.
at the reporting date. However, what constitutes ‘true and fair view’
is not precisely defined and it rests with the judgement of the Example:
decision-makers. Based on lecture illustration 1 above, all the purchases are recorded
o The choice of method may also be determined by other factors, such directly into the inventories account.
as ease of recording/calculation, compatibility with the
computerised inventories control system, commonly-used method
by other businesses in the same trade/industry, etc.
ABFA1163 FINANCIAL ACCOUNTING II 6

Inventories Account (FIFO method) Example:

debit site bcuz assetsRM RM Based on lecture illustration 1 above, assume that a physical
Sep 1 Bal b/d 400 Sep6 Cost of goods sold 360 inventory count was conducted on the evening of 30 September. 8
4 Trade payables 352 18 “ 488 tins of paint were counted as closing inventories.
15 “ 288 30 Bal c/d 400
23 “ 208 If FIFO method is used:
1,248 1,248 Closing inventories represent the 8 tins most recently purchased:
Oct1 Bal b/d 400
Date Quantity (tins) Cost per tin (RM) Total cost (RM)
Assuming that all the sales were priced at RM70 per tin, the SPL Sep15 4 48 192
(extract) will look as follows: sale price Sep23 4 52 208
400
Statement of Profit or Loss… (extract)
RM RM RM If WAC method is used:
Sales (20 tins x RM70) 1,400 sales The weighted average cost of all inventories purchased and opening
Less: Cost of goods sold inventories will be calculated at the end of the period = RM(400 +
(RM360 + RM488) (848) 352 + 288 + 208) / 28 tins = RM44.57 per tin. Cost of closing
Gross Profit 552 inventories = 8 tins x RM44.57 = RM357

ii) Periodic method of conducting a physical inventory count (stock- Assuming that all the sales were priced at RM70 per tin, the SPL
take) in order to determine the actual quantity of inventories on (extract) will look as follows:
hand at that particular time. No records were kept of the inflows and
outflows of inventory, hence, no records are available pertaining to Statement of Profit or Loss…(extract)
the balance of inventories on hand at any point of time. FIFO method WAC method
RM RM RM RM
All purchases of goods are debited in the purchases account and Sales 1,400 1,400
credited to trade payables or cash/bank account. After determining Less: Cost of goods sold
the quantity of closing inventories, the next step is to calculate the Opening inventories 400 400
cost of these closing inventories, based on either the FIFO or WAC Purchases 848 848
method. Less: Closing inventories (400) (848) (357) (891)
Gross Profit 552 509
The format of SPL is different from that in the perpetual method of
accounting because the cost of goods sold can be found only by Note: The FIFO method produces identical results for both the
adding opening inventories with purchases during the period, then periodic and perpetual methods of accounting. However, WAC
deducting closing inventories. method will produce different results.
ABFA1163 FINANCIAL ACCOUNTING II 7

5 How do we record inventories in the ledger? iv) Posting to general ledger at the end of accounting period:

i) Source documents are collected from the purchase invoices and General Journal
credit notes from suppliers, and sale invoices and credit notes to Debit Credit
customers. These invoices include both cash and credit terms. RM RM
Dr Inventory X¹
ii) Inventory cards (also called “Bin cards” or “Stock cards”) are Cr SPL X¹
recorded based on the following information from the source Closing inventories transferred to SPL for the 1st year ended 31
documents: December
o Date, quantity, unit price and total amount purchased (after
deducting trade discount) General Ledger
o Date, quantity, unit price and total amount of returns outwards
(after deducting trade discount) Inventory Account
o Date, quantity, unit cost and total cost for sales (FIFO or WAC) 1st year RM 1st year RM
o Date, quantity, unit cost and total cost of returns inwards Dec 31 SPL X¹ Dec 31 Balance c/d X¹
o Drawings of goods, taken for office use, taken for promotion/
advertisement are other examples of goods issued
Note: Closing inventories do not appear in the Trial Balance
Note: Cash discounts are excluded from the inventories records because it is posted to the general ledger after completing the Trial
because it is a financial benefit for early settlement, hence, not Balance. The closing balance in the Inventory Account is carried as
affecting the value of inventories. “Current assets” in the SFP.

iii) Determine the total amount of closing inventories by adding up all v) Bring forward the balance in the Inventory Account as “Opening
amounts that represent the lower of costs (closing balances in the Inventories” in the next accounting period:
inventory cards) and their respective net realisable values.
General Ledger
Note: In manufacturing enterprises, there are more than one
category of inventories, such as raw materials, work-in-progress, Inventory Account
finished goods and consumable stores. For now, we calculate nd
2 year
inventories for trading enterprises, where there is only one category Jan 1 Balance b/d X¹
of inventories.
Note: Opening inventories is carried in the Trial Balance as at 31
December in 2nd year because the year-end posting has not yet
been done.
ABFA1163 FINANCIAL ACCOUNTING II 8

vi) Posting to general ledger at the end of next accounting period:

General Journal
Debit Credit
RM RM
Dr SPL X¹
Cr Inventory X¹
Posting of Opening Inventories to the SPL for the 2nd year ended
31 December

Dr Inventory XX²
Cr SPL XX²
Closing Inventories transferred to the SPL for the 2nd year ended
31 December

General Ledger

Inventory Account
2nd year RM 2nd year RM
Jan 1 Balance b/d X¹ Dec 31 SPL X¹
Dec 31 SPL XX² Dec 31 Balance c/d XX²
3rd year
Jan 1 Balance b/d XX²

Relevant accounting concept:

Matching / Accrual concept: Revenue and expense are recognised as
they are earned or incurred, regardless the actual money received or
paid. The revenue and expense are matched with each other to
determine the profit or loss of the business.

Opening inventories are added to purchases to represent all the goods

available for sale during the accounting period, and closing inventories
are deducted to represent the remaining balance of goods not yet sold
during the accounting period. The net amount is the cost of goods sold
that is matched to sales during the accounting period to determine the
gross profit or loss of the business.