I n t e r a c t I v e t e X t foundations in Accountancy/ acca financial accounting (ffa/FA) bpp learning Media is an acca approved Content Provider

PART D: RECORDING TRANSACTIONS AND EVENTS 

 

114

 

Required 

Prepare the ledger accounts, a profit or loss account for the year and a statement of financial position as 

at the end of the year. 

ANSWER 

CASH 

 

 

$        

 

$      

 

Capital 

 

2,000 

 

Trade payables 

 

3,600 

 

Trade receivables 

 

3,200 

 

Non-current assets 

 

1,500 

 

Balance c/d 

 

   800 

 

Other expenses 

 

   900 

 

 

6,000   

 

6,000 

 

 

 

Balance b/d 

 

800 

CAPITAL 

 

 

$        

 

$      

 

Balance c/d 

 

2,600 

 

Cash 

 

2,000 

 

          

 

P/L a/c 

 

   600 

 

 

2,600   

 

2,600 

 

 

 

Balance b/d 

 

2,600 

TRADE PAYABLES 

 

 

$        

 

$      

 

Cash 

 

3,600 

 

Purchases 

 

4,300 

 

Balance c/d 

 

   700   

 

          

 

 

4,300   

 

4,300 

 

 

 

Balance b/d 

 

700 

PURCHASES ACCOUNT 

 

 

$        

 

$      

 

Trade payables 

 

4,300 

 

P/L a/c 

 

4,300 

NON-CURRENT ASSETS 

 

 

$        

 

$      

 

Cash 

 

1,500 

 

Balance c/d 

 

1,500 

 

Balance b/d 

 

1,500   

 

SALES 

 

 

$        

 

$      

 

P/L a/c 

 

4,000 

 

Trade receivables 

 

4,000 

TRADE RECEIVABLES 

 

 

$        

 

$      

 

Sales 

 

4,000 

 

Cash 

  

3,200 

 

 

             

 

Balance c/d 

  

   800 

 

 

4,000   

  

4,000 

 

Balance b/d 

 

800   

 

OTHER EXPENSES 

 

 

$        

 

$      

 

Cash 

 

900 

 

P/L a/c 

 

900 

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CHAPTER 7  

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  INVENTORY 

 

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PROFIT OR LOSS ACCOUNT 

 

 

$    

 

 

$    

 

Purchases account 

 

4,300 

 

Sales 

 

4,000 

 

Gross profit c/d 

 

1,500 

 

Closing inventory (inventory a/c) 

 

1,800 

 

 

5,800   

 

5,800 

 

Other expenses 

 

900 

 

Gross profit b/d 

 

1,500 

 

Profit for the year (transferred to 

   

 

    

capital account) 

 

   600   

          

 

 

1,500   

 

1,500 

Alternatively, closing inventory could be shown as a minus value on the debit side of the profit or loss 

account, instead of a credit entry, giving purchases $4,300 less closing inventory $1,800 equals cost of 

goods sold $2,500. 

INVENTORY ACCOUNT 

 

 

$  

 

 

$    

a/c (closing inventory) 

 

1,800 

 

Balance c/d 

 

1,800 

Balance b/d (opening inventory) 

 

1,800 

 

 

STATEMENT OF FINANCIAL POSITION AS AT THE END OF THE PERIOD 

 

 

$    

 

$    

Assets 

 

 

Non-current assets 

 

 

1,500 

Current assets  

 

 

 

Goods in inventory 

 

1,800 

 

 

Trade accounts receivable 

 

   800 

 

 

 

 

2,600 

Total assets 

 

 

4,100 

Capital and liabilities 

 

 

Capital 

 

 

At start of period 

 

2,000 

 

Profit for period 

 

   600 

 

At end of period 

 

 

2,600 

Current liabilities 

 

 

 Bank 

overdraft 

 

800 

 

 

 

Trade accounts payable 

 

   700 

 

 

 

 

1,500 

Total capital and liabilities 

 

  

4,100 

Make sure you can see what has happened here. The balance on the inventory account was $1,800, 

which appears in the statement of financial position as a current asset. As it happens, the $1,800 

closing inventory was the only entry in the inventory account – there was no figure for opening inventory. 

If there had been, it would have been eliminated by transferring it as a debit balance to the income and 

expenditure account, ie: 

DEBIT 

P/L account (with value of opening inventory) 

CREDIT 

Inventory account (with value of opening inventory) 

The debit in the profit or loss account would then have increased the cost of sales, ie opening inventory 

is added to purchases in calculating cost of sales. Again, this is illustrated in Section 2.1 above. 

So if we can establish the value of inventories on hand, the above paragraphs and exercise show us how 

to account for that value. That takes care of one of the problems noted at the beginning of this chapter. 

But now another of those problems becomes apparent – how do we establish the value of inventories on 

hand? The first step must be to establish how much inventory is held.  

 

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PART D: RECORDING TRANSACTIONS AND EVENTS 

 

116

 

 

3

   Counting inventories 

The quantity of inventories held at the year end is established by means of a physical count of inventory 

in an annual counting exercise, or by a 'continuous' inventory count. 

Business trading is a continuous activity, but accounting statements must be drawn up at a particular 

date. In preparing a statement of financial position it is necessary to 'freeze' the activity of a business to 

determine its assets and liabilities at a given moment. This includes establishing the quantities of 

inventories on hand, which can create problems. 

In simple cases, usually when a business holds easily counted and relatively small amounts of inventory, 

quantities of inventories on hand at the reporting date can be determined by physically counting them in 

an inventory count at that date.  

In more complicated cases, where a business holds considerable quantities of varied inventory, an 

alternative approach to establishing quantities is to maintain continuous inventory records. This means 

that a card, or a computerised record, is kept for every item of inventory, showing receipts and issues 

from the stores, and a running total. A few inventory items are counted each day to make sure their 

record cards are correct – this is called a 'continuous' count because it is spread out over the year rather 

than completed in one count at a designated time. 

One obstacle is overcome once a business has established how much inventory is on hand. But another 

of the problems noted in the introduction immediately raises its head. What value should the business 

place on those inventories? 

 

4

   Valuing inventories 

The value of inventories is calculated at the lower of cost and net realisable value for each separate item or 

group of items. Cost can be arrived at by using FIFO (first in, first out) or AVCO (weighted average costing). 

4.1 The basic rule 

There are several methods which, in theory, might be used for the valuation of inventory.  

(a) 

Inventories might be valued at their expected selling price. 

(b) 

Inventories might be valued at their expected selling price, less any costs still to be incurred in 

getting them ready for sale and then selling them. This amount is referred to as the net realisable 

value (NRV) of the inventories. 

(c) 

Inventories might be valued at their historical cost (ie the cost at which they were originally 

bought). 

(d) 

Inventories might be valued at the amount it would cost to replace them. This amount is referred 

to as the current replacement cost of inventories. 

Current replacement costs are not used in the type of accounts dealt with in this syllabus.  

The use of selling prices in inventory valuation is ruled out because this would create a profit for the 

business before the inventory has been sold. 

A simple example might help to explain this. A trader buys two items of inventory, each costing $100. 

They can sell them for $140 each but, in the accounting period we shall consider, they have only sold 

one of them. The other is closing inventory in hand. 

Since only one item has been sold, you might think it is common sense that profit ought to be $40. But 

if closing inventory is valued at selling price, profit would be $80, ie profit would be taken on the closing 

inventory as well. 

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CHAPTER 7  

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The same objection usually applies to the use of NRV in inventory valuation. The item purchased for 

$100 requires $5 of further expenditure in getting it ready for sale and then selling it (eg $5 of 

processing costs and distribution costs). If its expected selling price is $140, its NRV is $(140 – 5) = 

$135. To value it at $135 in the statement of financial position would still be to anticipate a $35 profit. 

We are left with historical cost as the normal basis of inventory valuation. The only time when historical cost 

is not used is where it is prudent to use a lower value. 

Staying with the example above, suppose that the market in this kind of product suddenly slumps and 

the item's expected selling price is only $90. The item's NRV is then $(90 – 5) = $85 and the business 

has in effect made a loss of $15 ($100 – $85). Losses should be recognised as soon as they are 

foreseen. This can be achieved by valuing the inventory item in the statement of financial position at its 

NRV of $85. 

The argument developed above suggests that the rule to follow is that inventories should be valued at 

cost or, if lower, NRV. The accounting treatment of inventory is governed by an accounting standard, 

IAS 2 Inventories. IAS 2 states that 'inventory shall be measured at the lower of cost and net realisable 

value' (para. 9), as we will see below. This is an important rule and one which you should learn by 

heart. 

 

4.2 Applying the basic valuation rule 

If a business has many inventory items on hand, the comparison of cost and NRV should theoretically 

be carried out for each item separately. It is not sufficient to compare the total cost of all inventory items 

with their total NRV. An example will show why. 

Suppose a company has four items of inventory on hand at the end of its accounting period. Their cost 

and NRVs are as follows. 

 Inventory item 

 

Cost 

 

NRV 

 

Lower of cost/NRV 

 

 

$ 

 

$ 

 

$ 

 

1 

 

27 

 

32 

 

27 

 

2 

 

14 

 

8 

 

8 

 

3 

 

43 

 

55 

 

43 

 

4 

 

  29 

 

  40 

 

  29 

 

 

113 

 

135 

 

107 

It would be incorrect to compare total costs ($113) with total NRV ($135) and to state inventories at 

$113 in the statement of financial position. The company can foresee a loss of $6 on item 2 and this 

should be recognised. If the four items are taken together in total, the loss on item 2 is masked by the 

anticipated profits on the other items. By performing the cost/NRV comparison for each item separately 

the prudent valuation of $107 can be derived. This is the value which should appear in the statement of 

financial position. 

 

$  

$

Sales 

 

 140 

Opening inventory  

– 

 

Purchases (2 × $100) 

 200 

 

 

 200 

 

Less closing inventory (at selling price) 

 140 

 

Cost of sales 

 

  60 

Profit 

 

  80 

 IMPORTANT 

Inventory should be valued at the lower of cost and net realisable value.

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