Inventories

Objective A & B: Need for Inventory Adjustments and Recording Cost of Sales

At the end of an accounting period, a business must determine the value of its closing inventory — the goods that remain unsold at the year-end. This is necessary because the cost of goods purchased during the year includes items that have been sold (which should be recognised as cost of sales in the statement of profit or loss) and items that remain unsold (which should be recognised as a current asset in the statement of financial position).

The relationship is expressed by the cost of sales formula:

Cost of Sales = Opening Inventory + Purchases − Closing Inventory

For example, if opening inventory is £10,000, purchases during the year are £80,000, and closing inventory is £15,000:

Cost of Sales = £10,000 + £80,000 − £15,000 = £75,000

The journal entry to record closing inventory at year-end is:

• Debit Inventory (SFP — current asset) with the closing inventory value
• Credit Cost of Sales (SPL) with the closing inventory value

This entry effectively removes the unsold goods from cost of sales and recognises them as an asset.

Objective C & D: IAS 2 — Valuing Inventories

IAS 2 Inventories requires inventory to be valued at the lower of cost and net realisable value (NRV).

Cost includes all costs incurred in bringing the inventories to their present location and condition:

• Purchase price (after deducting trade discounts and rebates)
• Import duties and non-refundable taxes
• Transport and handling costs to bring inventory to its current location
• Direct production costs (for manufactured goods — direct materials, direct labour, and production overheads based on normal capacity)

Costs that should NOT be included:

• Abnormal waste
• Storage costs (unless necessary for the production process)
• Administrative overheads not related to production
• Selling costs

Net realisable value (NRV) 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.

If NRV falls below cost (e.g., due to damage, obsolescence, or declining market prices), inventory must be written down to NRV. This ensures that assets are not overstated — an application of the prudence concept.

Objective E & F: FIFO and AVCO

When a business purchases the same type of goods at different prices over time, it must choose a cost flow assumption to determine which costs are assigned to goods sold and which remain in closing inventory. IAS 2 permits two methods:

FIFO (First In, First Out)

FIFO assumes that the oldest inventory items are sold first. Closing inventory therefore consists of the most recently purchased items. In times of rising prices, FIFO produces:

• Higher closing inventory (valued at recent, higher prices)
• Lower cost of sales
• Higher gross profit

AVCO (Weighted Average Cost)

AVCO calculates a weighted average cost per unit and applies this to both cost of sales and closing inventory. There are two versions:

• Periodic AVCO: The average is calculated once at the end of the period using total cost ÷ total units.
• Continuous (perpetual) AVCO: A new average is calculated after each purchase.

In times of rising prices, AVCO produces results between FIFO and LIFO (LIFO is not permitted under IAS 2).