Welcome to the World of Inventories!
Hello there! Today, we are diving into one of the most important chapters in your BA3 – Fundamentals of Financial Accounting journey: Inventories (IAS 2). Think about any business that sells physical products—a supermarket, a clothing store, or even a smartphone manufacturer. Their success depends heavily on how they manage and value the items they intend to sell. That is exactly what inventory accounting is all about!
By the end of these notes, you will understand how to value inventory, which costs to include, and how this affects the financial statements. Don’t worry if accounting for "stock" sounds a bit dry; we’ll use plenty of real-world examples to keep things clear and interesting. Let’s get started!
1. What Exactly is Inventory?
In simple terms, inventory (often called "stock") consists of assets that a business intends to sell. According to IAS 2 Inventories, this includes:
• Finished Goods: Items held for sale in the ordinary course of business (e.g., a completed loaf of bread at a bakery).
• Work-in-Progress (WIP): Items currently in the process of being produced (e.g., dough sitting in the oven).
• Raw Materials: Materials or supplies to be consumed in the production process (e.g., the flour and sugar in the pantry).
Did you know? For a service-based business, like a law firm, "inventory" might include the costs of services for which the business has not yet recognized the related revenue!
2. The Golden Rule: Valuation of Inventory
This is the most critical concept in this chapter. IAS 2 states that inventory must be valued at the lower of Cost and Net Realisable Value (NRV).
Why do we do this? It’s because of the Prudence Concept. We don't want to overstate the value of our assets. If we think we can only sell an item for $8, but it cost us $10 to make, we must write it down to $8 immediately.
\n\nWhat is "Cost"?
\nCost includes all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
\nIncluded in Cost:
\n• Purchase price (less trade discounts).
\n• Import duties and transport costs (carriage inwards).
\n• Direct labor and systematic allocation of fixed and variable production overheads.
Excluded from Cost (Exclusion Zone!):
\n• Abnormal amounts of wasted materials or labor.
\n• Storage costs (unless they are necessary in the production process before a further production stage).
\n• Administrative overheads that don't contribute to bringing inventory to its current location.
\n• Selling costs.
What is "Net Realisable Value" (NRV)?
\nNRV is the estimated selling price minus any costs to complete the item and any costs to make the sale.
\nThe Formula:
\n\( \text{NRV} = \text{Estimated Selling Price} - \text{Estimated Costs to Complete} - \text{Estimated Selling/Distribution Costs} \)
Example: You have a damaged smartphone in stock. It cost you $200. You can sell it for $150 after spending $20 on repairs and $10 on advertising.
\n\( \text{NRV} = \$150 - \$20 - \$10 = \$120 \).
\nSince the NRV ($120) is lower than the Cost ($200), you must value the phone at $120.
Key Takeaway:
Always compare Cost and NRV for each item (or group of similar items) and pick the lowest figure for your accounts.
3. Inventory Cost Formulas (FIFO vs. AVCO)
In the real world, prices change constantly. If you buy 100 cans of beans on Monday for $1.00 and 100 cans on Friday for $1.10, which cost do you use when you sell one? IAS 2 allows two main methods:
1. FIFO (First-In, First-Out)
This method assumes that the oldest inventory items are sold first. Therefore, the items remaining in stock at the end of the period are the ones most recently purchased.
• Analogy: Think of a milk fridge in a grocery store. The shopkeeper puts the newest milk at the back and the oldest at the front so customers buy the older ones first.
2. AVCO (Weighted Average Cost)
This method calculates a weighted average price for all similar items held in stock. Every time a new purchase is made, a new average cost is calculated.
The Formula:
\( \text{Average Cost} = \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Number of Units Available for Sale}} \)
Important Note: CIMA students should remember that LIFO (Last-In, First-Out) is NOT allowed under IAS 2. Don't let it trick you in an exam!
4. Accounting for Inventory in Financial Statements
Inventory affects both the Statement of Profit or Loss (SPL) and the Statement of Financial Position (SFP).
The Statement of Profit or Loss
Inventory is used to calculate the Cost of Goods Sold (COGS). We only want to match the cost of the items actually sold against the revenue they generated.
The COGS Formula:
\( \text{Opening Inventory} + \text{Purchases} - \text{Closing Inventory} = \text{Cost of Goods Sold} \)
The Statement of Financial Position
The Closing Inventory value is recorded as a Current Asset. Remember, this is the value calculated using the "Lower of Cost and NRV" rule.
Double Entry for Inventory
At the end of the year, we perform a "stock take" and record the closing inventory with this journal entry:
Debit: Inventory (SFP - Asset)
Credit: Inventory (SPL - reduces Cost of Sales)
Quick Review:
• Opening Inventory: Increases COGS (reduces profit).
• Closing Inventory: Decreases COGS (increases profit) and creates an asset.
5. Common Pitfalls and Memory Aids
Don't worry if this seems tricky at first! Many students trip up on the same things. Here is how to avoid those mistakes:
• The "Carriage" Confusion: Remember that Carriage Inwards (cost of bringing goods in) is added to the cost of inventory. Carriage Outwards (cost of shipping to customers) is a selling expense and is never included in inventory value.
• Individual vs. Total: The "Lower of Cost and NRV" rule should be applied item-by-item, not to the total value of all stock combined.
• Mnemonic for NRV: Just remember "SPA" — Selling Price minus Production costs to finish minus Administrative selling costs.
6. Summary Checklist
Before you move on, make sure you can answer these:
1. Can I define Raw Materials, WIP, and Finished Goods?
2. Do I know why we use the "Lower of Cost and NRV" rule?
3. Can I calculate NRV if given selling prices and repair costs?
4. Do I understand the difference between FIFO and AVCO?
5. Can I calculate Cost of Goods Sold (COGS)?
Great job! You have just covered the core essentials of Inventories for your BA3 exam. Keep practicing those calculations, and you'll be an expert in no time!