8 - Cost of sales and inventories Flashcards
what is inventory
stock consisting of items which are
- held for sale in ordinary course of business or
- in process of production for such sale
how does inventory affect an account
- statement of financial position: a potentially large balance within current assets
- 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
how is inventory recognised in SPL
as an EXPENSE in the period in which the item is sold
in statement of profit or loss under cost of sales heading
what is included within inventory
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
what is a journal entry
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
dual effect in inventory
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
what is the accounting entry and appropriate narrative for closing inventory
debit closing inventory (SOFP)
credit closing inventory (SPL)
what two elements is inventory made up of
quantity and valuation
how is quantity of inventory obtained
- 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
how is valuation of inventory obtained
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
what does cost of an item of inventory include
- 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
what is net realisable value
NRV = its net selling proceeds after deduction of all further costs to be incurred in order for item to be sold
net realisable value equation
estimated selling price (esp) MINUS estimated costs of completion (ecc) MINUS estimated selling and distribution costs (esdc)
NRV = esp - ecc - esdc
why are theoretical methods of estimating costs needed
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
what are the theoretical methods of estimating costs
- first in, first out (FIFO)
- average cost
- last in, first out (LIFO)
how does first in first out work (FIFO)
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
how does average cost work (weighted average cost, AVCO)
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
how does last in first out work
- 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
advantages of FIFO
- gives more realistic value on statement of financial position
advantages/disadvantages of LIFO
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
advantages and disadvantages of average cost method
advantages:
- compromise between LIFO and FIFO
disadvantages:
- it can be complex
- weighted average required by IAS
how do the estimation methods affect profit
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
what happens if a sole trader takes out goods for own use
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
