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.

Recording inventory

In order to prepare a statement of comprehensive income it is necessary to be able to calculate gross profit. This requires the calculation of a cost of sales figure.

There are two main methods of recording inventory so as to allow the calculation of cost of sales.

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

Each method uses a ledger account for inventory but these have different roles.

2 Periodic inventory system (period end system) – summary

Opening inventory in the trial balance (a debit balance) and purchases (a debit balance) are both transferred to cost of sales.

This clears both accounts.

Closing inventory is recognised in the inventory account as an asset (a debit balance) and the other side of the entry is a credit to cost of sales. Cost of sales comprises purchase in the period adjusted for movements in inventory level from the start to the end of the period.

Any loss of inventory is automatically dealt with and does not require a special accounting treatment. Lost inventory is simply not included in closing inventory and thus is written off to cost of sales. There might be a need to disclose a loss as a material item of an unusual nature either on the face of the incomes statement or in the notes to the accounts if it arose in unusual circumstances

3 Perpetual inventory method

This is a system where inventory records are continuously updated so that inventory values are always available.

A single account is used to record all inventory movements. The account is used to record purchases in the period and inventory is brought down on the account at each year-end. The account is also used to record all issues out of inventory.

These issues constitute the cost of sales.

When the perpetual inventory method is used, a record is kept of all receipts of items into inventory (at cost) and all issues of inventory to cost of sales.

Each issue of inventory is given a cost, and the cost of the items issued is either the actual cost of the inventory (if it is practicable to establish the actual cost) or a cost obtained using a valuation method.

Each receipt and issue of inventory is recorded in the inventory account. This means that a purchases account becomes unnecessary, because all purchases are recorded in the inventory account.

All transactions involving the receipt or issue of inventory must be recorded, and at any time, the balance on the inventory account should be the value of inventory currently held.

Furthermore, all transactions involving any kind of adjustment to the cost of inventory must be recorded in the inventory account

Inventory cards

The receipts and issues of inventory are normally recorded on an inventory ledger card (bin card). In modern systems the card might be a computer record.

4 Summary of journal entries under each system

Entry Periodic inventory method Perpetual inventory method

[{(Opening inventory Closing inventory as measured and recognised  rought forward from last period Closing balance on the inventory account as at the end of the previous period Purchase of inventory Dr Purchases Cr Payables/cash Dr Inventory Cr Payables/cash Freight paid Dr Carriage inwards Cr Payables/cash Dr Inventory Cr Payables/cash Return of inventory to supplier Dr Payables Cr Purchase returns Dr Payables Cr Inventory Sale of inventory Dr  receivables Cr Sales Dr Receivables Cr Sales and Dr Cost of goods sold Cr Inventory Return of goods by a supplier Dr Sales returns Cr Receivables Dr Sales returns Cr Receivables and Dr Inventory Cr Cost of goods sold Normal loss No double entry Dr Cost of goods sold Cr Inventory Abnormal loss Dr Abnormal loss Cr Purchases Dr Abnormal loss Cr Inventory Closing inventory Counted, valued and recognised by: Dr Inventory (statement of financial position) Cr Cost of sales (cost of goods sold) Balance on the inventory account)}]

5 Inventory counts (stock takes)

A stock take is a physical verification of the amount of inventory that a business has. Each item of inventory is counted and entered onto inventory sheets. The inventory counted can then be valued.

Periodic inventory systems

Inventory counts are vital for the operation of the periodic inventory system as it depends on the closing inventory at the end of each period being recognised in the system of accounts.

Perpetual inventory systems

Inventory counts are also important to the operation of perpetual inventory systems as the identify differences between the balance on the inventory account (the inventory that should be there) and the actual physical quantity of inventory.

The inventory account must be adjusted for any material difference. Any difference should be investigated. Possible causes of difference between the balance on the inventory account and the physical inventory counted include the following.

• Theft of inventory.
• Damage to inventory with failure to record that damage.
• Mis-posting of inventory receipts or issues (for example posting component A as component B).
• Failure to record a receipt.
• Failure to record an issue.

Timing of inventory counts

Ideally the inventory count takes place on the last day of an accounting period (the reporting date). However, this is not always possible due to the day on which the last day of the accounting period falls or perhaps, not having enough employees to count the inventory at all sites at the same time. If the inventory is counted at a date that differs from the reporting date the balance must be adjusted for transactions between the two dates.

6 Disclosure requirements for inventory

IAS 2 requires the following disclosures in notes to the financial statements.

• The accounting policy adopted for measuring inventories, including the cost measurement method used.
• The total carrying amount of inventories, classified appropriately. (For a manufacturer, appropriate classifications will be raw materials, work-inprogress and finished goods.)
• The amount of inventories carried at net realisable value or NRV.
• The amount of inventories written down in value, and so recognised as an expense during the period.
• Details of any circumstances that have led to the write-down of inventories to NRV.
• The amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period.

• The circumstances or events that led to the reversal of a write-down of inventories.

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