8 - Cost of sales and inventories

Question 1

what is inventory

Answer 1

stock consisting of items which are
- held for sale in ordinary course of business or
- in process of production for such sale

Question 2

how does inventory affect an account

Answer 2

1. statement of financial position: a potentially large balance within current assets
2. statement of profit or loss: opening and closing inventory have a direct impact on cost of sales and therefore profit

inventory significant balance - must be recorded completely and accurately in nominal ledger

Question 3

how is inventory recognised in SPL

Answer 3

as an EXPENSE in the period in which the item is sold
in statement of profit or loss under cost of sales heading

Question 4

what is included within inventory

Answer 4

CARRIAGE INWARDS = cost of transporting inventory to business premises
included in cost of sales

CARRIAGE OUTWARDS = cost of transporting inventory to customers
excluded from cost of sales and is in selling expenses sitting below gross profit line

Question 5

what is a journal entry

Answer 5

when businesses have unsold inventory (closing inventory) which is sold in the next accounting period it wont form part of the current year cost of sales expense

inventory is accounted for in a year end adjustment via a journal entry

Question 6

dual effect in inventory

Answer 6

goods held at end of year are included as an ASSET in the statement of financial position and a REDUCTION in cost of sales in statement of profit or loss

therefore = dual effect on nominal ledger

Question 7

what is the accounting entry and appropriate narrative for closing inventory

Answer 7

debit closing inventory (SOFP)
credit closing inventory (SPL)

Question 8

what two elements is inventory made up of

Answer 8

quantity and valuation

Question 9

how is quantity of inventory obtained

Answer 9

• inventory count at end of accounting period = physical check of no of items for each product
• info listed on period and inventory records
  OR
• established from previous inventory records whereby up to date record of no of items held is made
• inventory record shows product name, product code, cost and quantity

Question 10

how is valuation of inventory obtained

Answer 10

key rule of accounting = ‘inventories shall be measured at the lower of cost and net realisable value’

= if inventories are expected to be sold at profit: value at COST, do not ANTICIPATE profit

= if inventories are expected to be sold at a loss: value at net realisable value and do not provide for future loss

Question 11

what does cost of an item of inventory include

Answer 11

• cost of purchase, including delivery
• cost of conversion, including direct labour
• other costs to bring inventory to its present location and condition

costs NOT included in cost of inventory:
- storage costs of finished goods
- selling costs

Question 12

what is net realisable value

Answer 12

NRV = its net selling proceeds after deduction of all further costs to be incurred in order for item to be sold

Question 13

net realisable value equation

Answer 13

estimated selling price (esp) MINUS estimated costs of completion (ecc) MINUS estimated selling and distribution costs (esdc)

NRV = esp - ecc - esdc

Question 14

why are theoretical methods of estimating costs needed

Answer 14

because most businesses acquire various batches of inventory at different time periods and price points so it is hard to determine which items are held at the year end

Question 15

what are the theoretical methods of estimating costs

Answer 15

1. first in, first out (FIFO)
2. average cost
3. last in, first out (LIFO)

Question 16

how does first in first out work (FIFO)

Answer 16

assumed that:
- first goods purchased or produced will be first to be sold
- remaining inventories are therefore most recent purchases or production

sensible approximation method, especially if business sells perishable items

Question 17

how does average cost work (weighted average cost, AVCO)

Answer 17

simple average cost = cost of all purchases of production during the year divided by total number of units purchased to weighted average cost whereby new average calculated every time new items are purchased

good approximation method where inventory items are interchangeable

Question 18

how does last in first out work

Answer 18

• assumes last goods purchased or produced will be first to be sold
• remaining inventories are the oldest or earliest purchases or production

LIFO is prohibited by international accounting standards because it is unlikely to produce a cost figure which is closest to actual costs

Question 19

advantages of FIFO

Answer 19

• gives more realistic value on statement of financial position

Question 20

advantages/disadvantages of LIFO

Answer 20

advantages:
- gives more realistic profit valuation as cost of sales is close to replacement cost

disadvantages:
- statement of financial position are out of date if prices change, this method not allowed by IAS

Question 21

advantages and disadvantages of average cost method

Answer 21

advantages:
- compromise between LIFO and FIFO

disadvantages:
- it can be complex
- weighted average required by IAS

Question 22

how do the estimation methods affect profit

Answer 22

using LIFO, FIFO and AVC can be illustrated in statement of profit/loss

when the prices are rising: FIFO gives higher inventory values and higher profits

Question 23

what happens if a sole trader takes out goods for own use

Answer 23

if sole traders take goods out of the business for personal use, it should be treated as drawings

the credit entry goes to purchases as this cancels out the original entry in the nominal ledger (the debit to purchases when goods bought by business)

it will be a separated deduction in statement of profit/loss from cost of sales