Measurement of Inventory

1 Introduction

The measurement of inventory can be extremely important for financial reporting, because the measurements affect both the cost of sales (and profit) and also total asset values in the statement of financial position. There are several aspects of inventory measurement to consider:

• Should the inventory be valued at cost, or might a different measurement be more appropriate?
• Which items of expense can be included in the cost of inventory?
• What measurement method should be used when it is not practicable to identify the actual cost of inventory?

IAS 2: gives guidance on each of these areas.

Inventory

1 Definition of inventory

The nature of inventories varies with the type of business. Inventories are:

• Assets held for sale. For a retailer, these are items that the business sells – its stock-in trade. For a manufacturer, assets held for sale are usually referred to as ‘finished goods’
• Assets in the process of production for sale (‘work-in-progress’ for a manufacturer)
• Assets in the form of materials or supplies to be used in the production process (‘raw materials’ in the case of a manufacturer).

IAS 2: Inventories sets out the requirements to be followed when accounting for inventory.

Correction of Errors

Errors in the double entry accounting system

Errors can occur in a book-keeping system, because individuals make mistakes.

The types of error that will appear in the accounting records can be classified into four broad categories:

•  Errors of transposition
•  Errors of omission
•  Errors of commission
•  Errors of principle

Bank RECONCILIATIONS

The cash book (bank account in the general ledger) and bank statements

The cash book is a book of prime entry used to record all receipts and payments of cash.

There are many different methods by which a business might make payment to suppliers and receive payment from customers.

Methods include

Control accounts and control account Reconciliations

The receivables control account

The receivables control account is an account for recording the value of transactions in total with credit customers. The balance on the receivables control account (debit balance) is the total amount currently owed by all customers.

The receivables control account will contain some or all of the totals to date for all

of the following postings to the account.

 Illustration:

receivables control account

Some other Issues of Inventory

• Valuation of inventory

Basic rule

The valuation of inventory can be extremely important for financial reporting, because the valuations affect both the cost of sales (and profit) and also total asset values in the statement of financial position.
Inventory must be measured in the financial statements at the lower of:

• cost, or

• net realisable value (NRV).

END-OF-YEAR ADJUSTMENTS for INVENTORY

Recording inventory

In order to prepare a statement of comprehensive income it is necessary to be able to calculate gross profit. This is done by comparing the sale proceeds from the sale of items of inventory to the cost of those items. This is an application of the accruals concept (matching principle).

In order to calculate gross profit it is necessary to record opening inventory, purchases and closing inventory.

There are two main methods of recording inventory.

•  Periodic inventory method (period end system)
•  Perpetual inventory system

UNEARNED Income and ACCRUED Income

Introduction

A business may have miscellaneous forms of income, for example, from renting out property.

When a business entity has income from sources where payments are made in advance or in arrears. The accruals basis of accounting applies, and the amount of income to include in profit and loss for a period is the amount of income that relates to that period. It may therefore be necessary to apportion income on a time basis and there may be unearned income or accrued income to account for.

Approaches for calculating Prepayments

Method 1: the two accounts method

This is the easier approach. Also note that it is the method used in computerized accounting systems.

The prepayment is estimated and then transferred from the expense account to a prepayment account:

Illustration: Prepayment using two accounts.

                                                              Debit       Credit

Prepayment account (an asset)                    X

Expense account                                                              X

The prepayment is a credit entry in the expense account therefore reducing the expense recognised in the current period.

The debit balance on the prepayments account is included in the statement of financial position as a current asset.

Example: Year 1

Approachs for accrued expenses

Method 1: the ‘two account’ approach for accrued expenses

This is the easier approach. Also note that it is the method used in computerized accounting systems.

The accrued expense is recorded in an accrued expenses account. The double entry for this adjustment is as follows

Illustration: Accruals using two accounts.

                                           Debit             Credit

Expense account                   X
Accruals account                                           X

This adds the accrued expense to the expenses recognised as the result of having received invoices earlier in the current accounting period.

The credit balance on the accruals account is a liability, and is included in the statement of financial position as a current liability.

Example: Year 1

Payments in the year were:

                         Rs.

30 April           5,000

31 July            7,500

31 October     8,500

The accrual for November and December Year 1 is Rs. 6,000 (Rs. 9,000 × 2/3).

Method 1: two account approach

 

Method 1: two account approach

The expense in the statement of comprehensive income for Year 1 is Rs. 27,000 and the accrued expense of Rs. 6,000 is included in the statement of financial position as a current liability at the end of Year 1.

Reversal of the accrual

There is a complication. At the year end the expense account is cleared to the statement of comprehensive income and there is a credit balance carried down on the accruals account.

Assume that the invoice that arrives in January is Rs. 9,500. The accounting system will record the following double entry:

Example: January invoice received

invoice received

However, an expense of Rs. 6,000 and a liability of Rs. 6,000 has already been recognised in respect of this invoice. If no further adjustment is made the 6,000 is being included twice.

In Year 2, the telephone invoices are as follows:

                                  Rs.

31 January               9,500

30 April                    9,500

31 July                   10,000

31 October            10,000

To calculate the telephone expenses for Year 2, it is necessary to estimate the expense for November and December, and to make an accrual.

The next invoice (at the end of January Year 3) is expected to be Rs. 10,500.

The accrual for November and December Year 1 should be Rs. 7,000 (Rs. 10,500 × 2/3).

Method 2: the ‘one account’ approach for accrued expenses

This approach is trickier to understand. The accrual is recognised in the expense account.

There are two ways of achieving this.

• The total expense can be calculated and transferred to the statement of comprehensive income (Dr Statement of comprehensive income; Cr

Expense account) leaving a balancing figure on the expense account as an accrual; or

• The accrual can be calculated and recognised in the expense account leaving the amount transferred to the statement of comprehensive income

(Dr Statement of comprehensive income; Cr Expense account) as a balancing figure

Example: Year 1

Wasif set up in business on 1 January Year 1. The business has a 31 December year end.

The business acquired a telephone system on 1 February.

Telephone charges are paid every 3 three months in arrears and telephone invoices received in Year 1 are as follows:

                                Rs.

30 April                  5,000

31 July                   7,500

31 October            8,500

To calculate the telephone expenses for Year 1, it is necessary to estimate the expense for November and December, and to make an accrual.

The next invoice (at the end of January Year 2) is expected to be Rs. 9,000.

The accrual for November and December Year 1 should be Rs. 6,000 (Rs. 9,000 × 2/3).

Method 2: one account approach

one account approach

In order to make the above work either:

1.  Calculate the expense transferred to the statement of comprehensive income (27,000) and calculate the accrual taken as a balancing figure; or
2.  Calculate the accrual needed (6,000) and then calculate the expense transferred to the statement of comprehensive income (27,000) as a balancing figure (6,000). This is usually the easiest way.

There is no need to reverse the accrual using the one account method as it is nalready in the expense account at the start of the next year.

Calculating the expense for the statement of comprehensive income

Method 2 requires the calculation of either the closing accrual or the charge to the statement of comprehensive income, the other number being taken as a balancing figure. It is almost always easier to calculate the accrual.

The amount charged to the statement of comprehensive income can be calculated as follows. It is worth spending a little time trying to understand this.

Illustration:

                                                     Rs.

Invoices/payments for the year        X
+ Closing accrued expense             X
                                                      X
– Opening accrued expense           (X)
= Expense for the year                    X

 Read Also: ACCRUALS AND PREPAYMENTS INTRODUCED

ACCRUALS AND PREPAYMENTS INTRODUCED

The accruals concept (matching concept)

Financial statements are prepared using the accruals basis of accounting rather than on a cash basis. This means that:

•  sales are recognised in the same period as the related cost of making the sale;

•  income is recognised in the statement of comprehensive income in the same period as the transaction that gave rise to it (not necessarily when cash is paid); and

•  expenses are recognised in the statement of comprehensive income as they arise (not as they are paid).

DOUBTFUL DEBTS

1.      Basic double entry for doubtful debts

As stated above, a doubtful debt is an amount owed by a customer that the business believes might prove difficult to collect but they still hope to do so.
The accounting treatment has to serve two objectives. 

•  The exercise of prudence requires that the value of the receivable should be adjusted downwards (perhaps to zero) and an expense recognised for the loss in value; but 
•  The receivable must stay in the accounting records so that the business continues to chase payment.This is achieved in the following way.

 Instead of writing off the debt (which would remove it from the records) a business sets up an allowance account.

Illustration: Accounting for doubtful debts – basic double entry

Accounting for doubtful debts – basic double entry

BAD DEBTS AND DOUBTFUL DEBTS

1.         Introduction
   A business might make all its sales for cash but many businesses make some or even all their sales on credit. There is often no alternative to offering credit to customers. If competitors offer credit, then a business will have little alternative but to offer credit as well so as not to lose custom. A major benefit of offering credit is that it usually increases revenue, compared to what revenue would be if all sales were for cash.

DISPOSAL OF FIXED ASSETS

1.        Gain or loss on disposal of a non-current asset
   Property, plant and equipment are eventually disposed of:
   •  by sale, or
   •  if they have no sale value, through disposal as scrap.
   Disposal can occur at any time and need not be at the end of the asset’s expected useful life.
   The effect of a disposal on the statement of financial position (or accounting equation) is that:
   •  the asset (at cost or valuation) is no longer in the statement of financial position, and
   •   the accumulated depreciation on the asset is also no longer in the statement of financial position.
   The carrying amount of the asset is therefore removed from the accounting equation.
   There is a gain or loss on disposal of the asset, as follows:
    

   

   Gain or loss on disposal

METHODS OF CALCULATING DEPRECIATION

1. 1.      Straight-line method
   Definition: Straight line depreciation
   Where the depreciable amount is charged in equal amounts to each reporting period over the expected useful life of the asset.
   Formula: Straight-line depreciation

   

   Straight-line depreciation

   
   

DEPRECIATION AND CARRYING AMOUNT

1.      Definition of depreciation

Depreciation is a method of spreading the cost of a non-current asset over its expected useful life (economic life), so that an appropriate portion of the cost is charged in each accounting period.

Definitions (from IAS 16)
Depreciation: The systematic allocation of the depreciable amount of an asset over its useful life.

NON-CURRENT ASSETS

1.      Introduction
The assets of a business are classified as current assets or non-current assets.
IAS 1 (Presentation of financial statements) defines current assets and then states that all other assets should be classified as non-current assets.
Current assets include, cash, receivables, prepayments (see chapter 7) and inventory. They are all items that will be used or recovered in the short term.
A non-current asset is an asset which is used by the business over a number of years.
Non-current assets may be:

END OF YEAR ADJUSTMENTS

1. 1.      The need for end-of-year adjustments
   
   
   Start of a financial year
   At the start of a financial year the asset, liability and capital accounts in the general ledger contain the balances brought forward at the end of the last year as set out in last year’s statement of financial position.
   The income and expense accounts in the general ledger are empty as they will have been transferred to the income and expense account for the calculation of profit.

ACCOUNTING FOR CASH

1.      The cash book
The cash book is often a book of prime entry. It is used to record receipts and payments of cash into the business bank account.
The cash book has two sides, a side for receipts of money and a side for payments. Both sides have a number of columns so that cash receipts and payments can be analysed to make it easier to construct journals for double entry.

ACCOUNTING FOR PURCHASES

• 1.      Documents in the purchases cycle
  Businesses make purchases from suppliers. Purchases are similar in many respects to sales, except that the business is buying from a supplier rather than selling to a customer.
  The following documents might be used in a system designed to account for purchases.
  
  
  Purchase invoice: A request for payment from the supplier for goods delivered.
  
  
  
  
  2.      Recording purchases
  Purchases day book
  

Accounting For Sales

1.      Documents in the sales cycle
A business tries to make a profit by selling goods or services to customers. This creates revenue or income for the business.
Sales might be for cash or (coin, by debit card, credit card, cheque or by some less common method such as banker’s draft) or on credit.
The following documents might be used in a system designed to account for sales.
Sales invoice: A request for payment from the customer for goods delivered. Invoices normally show a date, details of transaction and payment terms.
Credit note: Issued when a customer returns goods and the business agrees to this. The business issues a credit note to acknowledge that the amount specified is no longer owed to them by the customer.
 

BOOKS OF PRIME ENTRY

The role of books of prime entry

Book-keeping is the process of recording financial transactions in the accounting records (the ‘books’) of an entity. Transactions are recorded in accounts, and there is a separate account for each different type of transaction.

It is often the case that individual transactions are not recorded in the ledger accounts as they occur. Instead, they are recorded initially in records called books of prime entry (also known as books of original entry). Each of these ‘books’ or ‘journals’ is used to record different types of transaction. Periodically the totals of each type of transaction are double entered into the appropriate ledger accounts in the general ledger.

Books of prime entry include the following:

GENERAL LEDGER

Introduction

The general ledger is a document which contains all of the individual accounts which are used to record the double entries of a business. It may have physical form as a book or it may be a software application.

All of the financial transactions of a business are entered into appropriate accounts in the general ledger. The balances on these individual accounts can be extracted as a trial balance as a step in preparing financial statements for the business.

Preparing accounts from a trial balance

Year-end adjustments

The trial balance provides a foundation for preparing a statement of comprehensive income and a statement of financial position at the end of an accounting period.

•  A trial balance is extracted from the general ledger, and various year-end adjustments are then made to the accounts.

•  These adjustments include adjustments for:

· Depreciation expense (to reflect the use of non-current assets);

· Accruals and prepayments;

· Bad and doubtful debts; and

· Inventory.

Trial balance

The balance extracted for any single account is the net of all of the debit and credit entries in that account.

If double entries have been posted correctly then the total of all debit entries made to all of the accounts in the general ledger must equal the total of all credit entries. It follows that if balances are extracted for every account in the general ledger the sum of the debit balances must equal the sum of the credit balances.

Closing off an account and bringing down the balance

The balance on an account can be established at any time as the difference between the total value of debit entries and the total value of credit entries.

•  If total debit entries in an account exceed total credits, there is a debit balance on the account.
•  If total credit entries in an account exceed total debits there is a credit balance on the account.

BASIC RULES OF DOUBLE ENTRY BOOKKEEPING

Debit and credit entries, and T accounts

Financial transactions are recorded in the accounts in accordance with a set of rules or conventions. The following rules apply to the accounts in the main ledger (nominal ledger or general ledger).

•  Every transaction is recorded twice, as a debit entry in one account and as a credit entry in another account.

•  Total debit entries and total credit entries must always be equal. This maintains the accounting equation.

It therefore helps to show accounts in the shape of a T, with a left-hand and a right-hand side. (Not surprisingly this presentation is known as a T account). By convention:

•  debit entries are made on the left-hand side and

•  credit entries are on the right-hand side.