Chapter 7 - Cost of sales and inventories

Question 1

What are the different types of inventories? Give examples

Answer 1

Inventories are current assets that are held for sale in the ordinary course of business. They can include:

RETAILERS E.G. TESCO
 Goods purchased and held for resale

MANUFACTURERS E.G. FERRARI
 Finished goods
 Work in progress
 Raw materials

IAS 2 prescribes the accounting treatment for inventories, in particular the valuation at the reporting date.

Question 2

What is IAS 2?

Answer 2

IAS 2 prescribes the accounting treatment for inventories, in particular the valuation at the reporting date.

IAS 2 provides guidance for determining the cost of inventories and the subsequent recognition of the cost as an expense, including any write-down to net realisable value. It also provides guidance on the cost formulas that are used to assign costs to inventories. Inventories are measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

The cost of inventories includes all costs of purchase, costs of conversion (direct labour and production overhead) and other costs incurred in bringing the inventories to their present location and condition. The cost of inventories is assigned by:

specific identification of cost for items of inventory that are not ordinarily interchangeable; and
the first-in, first-out or weighted average cost formula for items that are ordinarily interchangeable (generally large quantities of individually insignificant items).
When inventories are sold, the carrying amount of those inventories is recognised as an expense in the period in which the related revenue is recognised. The amount of any write-down of inventories to net realisable value and all losses of inventories are recognised as an expense in the period the write-down or loss occurs.

Question 3

Cost of Sales Proforma Layout

Formula

Which financial statement does this affect

Answer 3

See FC

Cost of Sales = Opening inventories + Purchases + Carriage Inwards (deliveries) - Closing inventories

So how many did we start with - how many we have left over - how much did it costs us to get everything

We then use this to calculate cost of sales which is in our Statement of Profit or Loss

Page 66 in ICAEW FI WB

Question 4

How can we calculate Revenue?

Answer 4

REVENUE = SALES

Sales = Gross profit + Cost of Sales

Question 5

How can we calculate Sales?

Answer 5

REVENUE = SALES

Sales = Gross profit + Cost of Sales

Question 6

How can we calculate Gross profit?

Answer 6

Gross profit = Sales (Revenue) - Cost of Sales

Question 7

How can we calculate Net profit?

Answer 7

Net profit = Gross profit - Other expenses

Question 8

What accounting principle is applied when calculating the cost of sales?

Answer 8

Process used to follow the accounting principle of accruals/matching.

Fundamental accounting concept of accruals (or matching) as the
revenue for a period is matched to only the cost of the goods sold.

Accrual accounting is an accounting method where revenue or expenses are recorded when a transaction occurs vs. when payment is received or made.
The method follows the matching principle, which says that revenues and expenses should be recognised in the same period.

Question 9

What is carriage inwards?

Answer 9

• Applied to purchases we make (added on to purchase account)
• Delivered In
• Delivery costs to receive goods from suppliers (carriage inwards) is added to the cost of purchases (and therefore cost of sales) in the statement of profit or loss.

Question 10

What is carriage outwards?

Answer 10

• Applied to sales we make
• Delivered out
• Distribution expense (added to distribution exp/costs account)
• Delivery costs to distribute goods to customers (carriage outwards) is treated as an “expense” (usually distribution costs) below the gross profit line.
• AFFECTS SOPL. The cost of delivery outwards is a distribution cost deducted from gross profit in the statement of profit or loss.

Question 11

What is a delivery cost?

Answer 11

Delivery costs refer to all costs of transporting purchased goods from the supplier to the customer. One party has to pay for these delivery costs: sometimes the supplier pays (in which case the customer has no costs to record) and sometimes the customer pays.
When the supplier pays, the cost to the supplier is known as delivery outwards as the goods are going out of the business. When the customer pays, the cost to the customer is known as delivery inwards as the goods are coming into the business.

Question 12

How is a service cost of sale calculated? What does this mean?

Answer 12

Cost of sales for service = Cost of providing service

Many businesses (for example, accountants) sell services to customers, rather than products. Cost of sales for this type of business may include:

• Direct labour costs: the cost of any labour directly related to the service provided.
• Sales commission: where a business pays its employees a commission for securing work
• Materials used: e.g. printing costs (for a design company)

Question 13

When a cost is not categorised as a cost of sale where would we allocate this expense?

Answer 13

Costs which cannot be presented in cost of sales are included in other expense categories in the statement of profit or loss. Administrative expenses are often used.

Question 14

What is the journal entry for purchases

Answer 14

DR Cost of sales
Cr Purchases

Question 15

When a business purchases goods (inventories) during the year what is the double entry?

Answer 15

Dr Purchase expenses
Cr Trade payables / cash

Inventory does not form part of the double entries during day to day business. In fact, there are only ever two journals that you will ever need for inventories as follows:

Account for year end closing inventories as follows
Dr Inventories (current asset) account £ closing inventories (SOFP)
Cr cost of Sales expense £ closing inventories (SOPL)

Reverse out opening inventories as follows
Dr Cost of sales expense £ opening inventories (SOPL)
Cr Inventories (current asset) account £ opening inventories (SOFP)

These two journals will result in the correct calculation for cost of sales as per the proforma

THESE ARE THE ONLY TWO DOUBLE ENTRIES FOR INVENTORIES, ANYTHING ELSE IS INCORRECT

Question 16

At the year end how do we record/journal closing inventories?

ASKED ALOT IN EXAMS

Answer 16

Account for year end closing inventories as follows
Dr Inventories (current asset) account £ closing inventories (SOFP)
Cr cost of Sales expense £ closing inventories (SOPL)

THESE ARE THE ONLY TWO DOUBLE ENTRIES FOR INVENTORIES, ANYTHING ELSE IS INCORRECT

Question 17

At the start of the year how do we record/journal opening inventories?

Answer 17

Reverse out opening inventories as follows
Dr Cost of sales expense £ opening inventories (SOPL)
Cr Inventories (current asset) account £ opening inventories (SOFP)

THESE ARE THE ONLY TWO DOUBLE ENTRIES FOR INVENTORIES, ANYTHING ELSE IS INCORRECT

Question 18

In the initial TB what inventory can you expect to see?

Answer 18

DR in the opening inventory

Question 19

At the year end how do we record/journal closing inventories and purchases?

ASKED ALOT IN EXAMS

Answer 19

Account for year end closing inventories as follows
Dr Inventories (current asset) account £ closing inventories (SOFP)
Cr cost of Sales expense £ closing inventories (SOPL)

For the purchases we need to transfer these and the inventories to the cost of sales expense line in a TB

Dr Cost of Sales
Cr Purchases/Opening inventories from initial trial balance

THESE ARE THE ONLY TWO DOUBLE ENTRIES FOR INVENTORIES, ANYTHING ELSE IS INCORRECT

Question 20

What are the two ways of counting inventories?

Answer 20

1. Inventory Count or Stock Take - on the last day of a reporting period a business closes and ensures no good come in or out on the day and count the entire stock
2. Continuous Inventory Counts - for companies with large inventory levels it might not be possible to do this in a day/week so they implement a continuous inventory record, they kept a receipt and issues of goods, with a running total which shows the current inventory levels. Throughout the year these are checked with actual stock levels to ensure accuracy. Each product line has been checked against actual stock at least once during the year.

Question 21

How do you calculate closing inventory?

Answer 21

Closing inventory = Quantity (No of units/Stock Count) x Valuation (NRV)

NRV is NET REALISABLE VALUE = Sales price - Cost to complete
Net realisable value is the expected selling price, less any further direct costs before sale (cost to complete, modification costs, selling and distribution expenses

Question 22

What is NRV?

Answer 22

• NRV is NET REALISABLE VALUE = Sales price - Cost to complete
• Net realisable value is the expected selling price, less any further direct costs before sale (cost to complete, modification costs, selling and distribution expenses
• Applies accounting principle of prudence

Prudence - The prudence concept is a core accounting principle that means choosing conservative methods to understate assets and overstate liabilities, anticipating potential losses and recognizing them early, and only recognizing gains when certain – without estimations or presumptions.

Question 23

What is Prudence?

Answer 23

The prudence concept is a core accounting principle that means choosing conservative methods to understate assets and overstate liabilities, anticipating potential losses and recognizing them early, and only recognizing gains when certain – without estimations or presumptions.

Question 24

How should inventories be valued? (2)

Answer 24

Inventories must be valued at the lower of cost and net realisable value (NRV).

Cost
Cost is the historic cost of purchasing the goods or the costs to date of manufacturing them. It includes purchase price, delivery, import taxes and duties, and any conversion costs to bring it to its present location and condition.

Net realisable value
Net realisable value is the expected selling price, less any further direct costs before sale (cost to complete, modification costs, selling and distribution expenses).

Question 25

How can you total up the cost of raw materials, what is included?

Answer 25

Cost = purchase price including import duties, transport, handling and non-recoverable VAT.

Question 26

How can you total up the cost of part completed items (WIP) and finished goods, what is included?

Answer 26

Cost = cost of purchase plus conversion costs (eg labour, production overheads) and other costs to bring it to its present location and condition.

Question 27

Under IFRS account standards there are two methods of calculating costings, what are they?

Answer 27

If a company has a large volume of identical items purchased at different prices (eg nuts and bolts) a method needs to be used to assign a cost to the units sold

FIFO: first in first out. Older items are sold first so closing inventories are the newer items

AVCO: average cost. As each delivery is received a new “average” cost is calculated for the total inventories held. The average is used to value items sold and any remaining inventories.

Question 28

Which method of calculating costings is disallowed under the IFRS standards?

Answer 28

LIFO: last in first out. Sales are made from the most recent deliveries, leaving older items remaining in closing inventories. This assumption is disallowed under IFRS Standards.

Question 29

If supplier prices are rising which method of costing returns a higher profit and closing inventory?

Answer 29

Where supplier prices were rising, we can see that FIFO produced a higher closing inventory and lower cost of sales (and therefore higher profit) than AVCO.

Prices rising:
FIFO Profit > AVCO Profit
FIFO Closing inventories > AVCO closing inventories

Question 30

If supplier prices are falling which method of costing returns a lower profit and closing inventory?

Answer 30

Prices falling:
FIFO Profit < AVCO Profit
FIFO Closing inventories < AVCO closing inventories

Question 31

Mark up and costs

Answer 31

MARK UP is calculated on COSTS
if the markup is on costs
Costs = 100%

We then draw out the table for Sales, Cost of Sales and Gross

if the markup was 40%
Sales = 140%
Cost of Sales = 100%
Gross = 40%

we can then work out the £ value from here

Formula: Sales - Cost of Sales = Gross profit

Question 32

Margins and costs

Answer 32

MARGINS is calculated on SALES
if the margins is on sales
Sales = 100%

We then draw out the table for Sales, Cost of Sales and Gross

if the margin was 40%
Sales = 100%
Cost of Sales = 60%
Gross = 40%

we can then work out the £ value from here

Formula: Sales - Cost of Sales = Gross profit

Question 33

Give three reasons why inventory might have to be written off

Answer 33

1. Goods are stole/ lost
   2.Goods are damaged
2. Goods are obsolete e.g. Obsolete goods are products that have been discontinued, have undergone packaging changes, or are out of season. Seasonal items are some of the most common examples

Question 34

In what cases would we write off inventory?

Answer 34

If inventory is correctly valued at the lower of cost and NRV, no further inventory “write-down” journal entries are needed.
In the rare situation where a material amount of inventory has been stolen or destroyed then then the usual treatment of inventories would unfairly distorted view of the entities gross profitability.

Question 35

When do we need to do write down journals?

Answer 35

If inventory is correctly valued at the lower of cost and NRV, no further inventory “write-down” journal entries are needed.
In the rare situation where a material amount of inventory has been stolen or destroyed then then the usual treatment of inventories would unfairly distorted view of the entities gross profitability.

Question 36

What is the journal entry for when something is stolen or destroyed?

Answer 36

To overcome this, the cost of the goods stolen or destroyed is removed from purchases and shown in other expenses below the gross profit line.
Dr Other expenses £x (could be admin)
Cr Purchases £x

Question 37

What is the journal entry for when something is stolen or destroyed but we have claimed from insurance?

Answer 37

Any insurance the entity has against the loss is recorded as:
Dr Cash/Receivables £x
Cr Other income £x

Question 38

If an owner takes something from the business as drawings what is the journal entry?

Answer 38

If an owner takes items of inventory from the business as drawings, we do not need to adjust opening or closing inventory at all. Instead we reduce the purchases figure in cost of sales with the cost of items withdrawn.

Dr Drawings £ cost of items
Cr Purchases £ cost of items (don’t be tempted to credit inventories)

WE DO NOT TOUCH INVENTORIES - Q MIGHT TRY TO TRICK US

Question 39

Inventory that cost Wasa Ltd £64,500 was destroyed in a fire. The inventory was insured for 60% of its cost. Wasa Ltd made a claim on its insurance policy and the insurance company agreed to settle the claim. No amounts were received from the insurance company before the year end.
Prepare a journal entry to account for this in Wasa Ltd’s accounting records.

What is the full journal entry here?

Answer 39

DR Purchase 64500
CR Expenses 64500

DR Trade Rec (64500x60%) = 38700
CR Other Income (64500x60%) = 38700

Question 40

Define Cost of inventories

Answer 40

Cost of inventories: All costs of purchase, of conversion (eg, labour) and of other costs incurred in bringing the items to their present location and condition.

Question 41

Define Cost of purchase

Answer 41

Cost of purchase: The purchase price, import duties and other non-recoverable taxes, transport, handling and other costs directly attributable to the acquisition of finished goods and materials.

Question 42

Define Conversion costs

Answer 42

Conversion costs: Any costs involved in converting raw materials into final product, including labour, expenses directly related to the product and an appropriate share of production overheads (but not sales, administrative or general overheads).

Question 43

What is included in the total cost of an item of inventory?

Answer 43

The total cost of an item of inventory includes all costs incurred in bringing the item to its present location and condition. This consists of:
* the purchase cost of raw materials
* delivery inwards
* import taxes and duties
* conversion costs