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Maintaining Financial Record FA2

Chapter 8
Cost of goods sold and the treatment
of inventories

Textbook Reading:
FA2 Maintaining Financial Records , 2020 Edition, BPP, Chapter 8
Practice:
FA2 Maintaining Financial Records Practice & Revision Kit, 2020 Edition, BPP
Question 9.1 to 9.13

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 Chapter 8: Cost of goods sold and the treatment of
inventories

Learning objectives:
At the end of this chapter, you should be able to:
• Define inventory.
• Explain and apply the IAS 2 requirements for valuing inventories.
• Recognize which costs should be included when valuing
inventories.
• Explain the use of continuous and period end inventory records.
• Calculate the value of closing inventory and cost of goods sold
using FIFO (first in, first out) and AVCO (average cost) - both
periodic weighted average and continuous weighted average.
• Identify the impact of inventory valuation methods on profit,
assets and capital.
• Report inventory in the final accounts.

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 Chapter 8: Cost of goods sold and the treatment of
inventories

Cost of goods sold

• Inventories are assets held for sale in the ordinary course of

business
• In the statement of profit or loss, profit is defined as the
value of sales less the cost of sales and expenses.
• The cost of goods sold:
$
Opening inventory value X
Add cost of purchase (net of returns) X
X
Less closing inventory value (X)
Cost of goods sold X

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 1
James Terry, trading as the Raincoat Store, ends his financial year
on 30 June each year. On 1 July 20X6 he had no goods in
inventory.
During the year to 30 June 20X7 he purchased 6,000 raincoats
costing $36,000 from raincoat wholesalers and suppliers.
He resold the raincoats for $10 each, and sales for the year
amounted to $45,000 (4,500 raincoats).
At 30 June there were 1,500 unsold raincoats left in inventory,
valued at $6 each.
Required
What was James Terry’s gross profit for the year?

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 2
We shall continue the example of the Raincoat Store into its
next accounting year, 1 June 20X7 to 30 June 20X8.
Suppose that during the course of this year, James Terry
purchased 8,000 raincoats at a total cost of $55,500. During
the year he sold 8,500 raincoats for $95,000.
At 30 June 20X8 he had 1,000 raincoats left in inventory,
which had cost $7,000.
Required
What was his gross profit for the year?

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 Chapter 8: Cost of goods sold and the treatment of
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Carriage inwards and carriage outwards

Carriage inwards:
• Cost paid purchasers of having goods transported to his
business
• Added to cost of purchased

Carriage outwards:
• Cost to seller, paid by the seller, of having goods transported
to customer
• Is a selling and distribution expenses

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 Chapter 8: Cost of goods sold and the treatment of
inventories

Illustration 3
Janice Young, trading as Sven Interiors, imports and resells Scandinavian furniture.
She must pay for the costs of delivering the furniture from her supplier in Sweden to her
shop in Wales. She resells the furniture to other traders throughout the country, paying
the costs of carriage for the consignments from her business premises to her
customers.
On 1 July 20X6, she had furniture in inventory valued at $35,000. During the year to 30
June 20X7 she purchased more furniture at a cost of $180,000. Carriage inwards
amounted to $5,000.
Sales for the year were $330,000. Other expenses of the business amounted to
$72,000 excluding carriage outwards which cost $7,200.
The value of the goods in inventory at the year end was $44,200.
Required
Prepare statement of profit or loss of Sven Interiors for the year ended 30 June 20X7.

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 Chapter 8: Cost of goods sold and the treatment of
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Inventory written off or written down

Value of goods in closing

Inventory written down to
inventory
Worthless Nothing
Worth less than their original cost Net Realizable Value

Net realizable value of inventory is the estimated

selling price less any costs still to be incurred in
getting the inventory ready to sell and selling it.

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 4
Sarah Hughes, trading as Serina Fashions, end her financial year on 31
December. At 1 January 20X6 she had goods in inventory valued at $21,500.
During the year to 31 December 20X6, she purchased goods costing $73,000.
Fashion goods which cost $4,300 were still help in inventory at 31 December
20X6, and Sarah Hughes believes that these could only now be sold at a sale
price of $800.
The goods still held in inventory at 31 December 20X6 (including the fashion
goods) had an original purchase cost of $18,700.
Sales for the year were $132,500.
Required
Calculate the gross profit of Serina Fashions for the year ended 31 December
20X6.

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 Chapter 8: Cost of goods sold and the treatment of
inventories

Accounting for opening and closing inventories

Entries during the year
During the year, purchases are recorded by the
following entry The exact reverse entry is made for the closing
inventory (which will be next year’s opening
Dr. Purchases $ amount bought inventory):
Cr. Cash or payables $ amount bought Dr. Inventory $ closing inventory

The inventory account is not touched at all. Cr. Statement of P/L $ closing inventory

Entries at year-end The balance on the inventory account is still the

The fist thing to do is to transfer the purchases opening inventory balance. This must also be
account balance to the statement of profit or transferred to the statement of profit or loss:
loss: Dr. Statement of P/L $ opening inventory
Dr. Statement of P/L $ total purchases
Cr. Inventory $ opening inventory
Cr. Purchases $ total purchases

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 5
A business is established with capital of $4,000 and this amount is paid into a business bank
account by the proprietor. During the first year’s trading, the following transactions occurred.
Purchase of goods for resale, on credit $8,200
Payments to trade suppliers $7,100
Sales, all on credit $8,000
Payments from customers $6,000
Non-current asset purchased for cash $2,900
Other expenses, all paid in cash $1,600
The bank has provided an overdraft facility of up to $6,000. All other expenses relate to
current year.
Closing inventories of goods are valued at $3,500. (Because this is the first year of the
business, there are no opening inventories.)
Required
Prepare the ledger accounts and a statement of profit or loss for the year. Ignore depreciation
and drawings.

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 Chapter 8: Cost of goods sold and the treatment of
inventories

Inventory counting and inventory accruals

Counting inventory
• In order to make the entry for the closing inventory we need to
know what is in the inventory at the year-end.
• We find this out not from the accounting records, but by going
into the warehouse and actually counting the boxes on the
shelves.
Inventory Accruals
• The double entry once inventory accruals are identifies is:
DEBIT Purchase
CREDIT Trade payables
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 Chapter 8: Cost of goods sold and the treatment of
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Valuing inventories

For each items or group of items, the value of inventories

is calculated by taking

the lower of

Net realizable value Cost

selling price less all comprises purchase
estimated costs to costs, cost of
completion and less conversion and other
estimated selling costs incurred to-
costs. date.

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 6
The following figures related to inventory help by Dean at the year end.

A B C
$ $ $
Cost 20 9 12
Selling price 30 12 22
Modification cost to enable sale - 2 8
Marketing costs 7 2 2
Units held 200 150 300

Required
Calculate the value of inventory held.

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 Chapter 8: Cost of goods sold and the treatment of
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Determining the purchase cost

• If we are using, and units have been bought at different prices during
the year, we need to decide which items are left in inventory at the year-
end.
FIFO (first in, first out)
• We assume that components are used in the order in which they are
received from supplier. The components issued are deemed to have
formed part of the oldest consignment still unused and are costed
accordingly.
Weighted average cost
• As purchase prices change with each new consignment, the average
price of components in the bin is constantly changed. Each component
in the bin at any moment is assumed to have been purchased at the
average price of all components in the bin at that moment.

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 7
Transactions during May 20X7:
Market value
per unit on
Total date of
Quantity Unit cost Cost transaction
Units $ $ $
Opening balance 1 May 100 2.00 200
Receipts 3 May 400 2.10 840 2.11
Issues 4 May 200 2.11
Receipts 9 May 300 2.12 636 2.15
Issues 11 May 400 2.20
Receipts 18 May 100 2.40 240 2.35
Issues 20 May 100 2.35
Closing balance 31 May 200 2.38
1,916

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 7 Continued
Receipts means goods are received into stores (goods purchased) and
issues represent the issue of goods from stores.

Required
How would opening inventory, issues and closing inventory be valued for
May 20X7 using each of the following in turn?
a) FIFO
b) Weighted average cost (continuous)

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 Chapter 8: Cost of goods sold and the treatment of
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Inventory valuation and profit

• Different inventory valuations produce different cost of sales

figures and therefore different profits. This is a temporary
difference.
• Remember. The higher the closing inventory value, the
higher the profit.

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 Chapter 8: Cost of goods sold and the treatment of
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Illustration 8

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Illustration 8 Continued

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Practice Questions

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 Chapter 8: Cost of goods sold and the treatment of
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Question 1
Sarah made a mistake when she calculated the value of her closing
inventory. As a result the inventory is undervalued.

How are her net profits for the year and net assets at the end of the year
affected by this error?

Net profit Net assets

A. Overstated Understated
B. Overstated Overstated
C. Understated Understated
D. Understated Overstated

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 Chapter 8: Cost of goods sold and the treatment of
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Question 2
Fernando runs a clothes shop selling replica football kits and valued all his
inventory at 31 March 20X8 at its cost of $15,550.

Inventory includes 50 of last season's football kits which originally cost

$30 and were on sale during the year for $50 each. However, now that
new kits are out for the coming season, Fernando knows he will have to
reduce the old kits to half price in order to sell them.

Calculate the correct value for inventory at 31 March 20X8.

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 Chapter 8: Cost of goods sold and the treatment of
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Question 3
The following records were kept for an inventory item in June.

June 1 100 units in inventory at $10 each

5 50 units bought at $10 each
12 60 units sold
20 20 units bought at $8 each
29 80 units sold

Using the FIFO method, what would be the value of inventory at 30 June?

A. $300
B. $260
C. $340
D. $220

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 Chapter 8: Cost of goods sold and the treatment of
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Question 4
Adam uses the continuous weighted average cost method of valuing
inventories. During May 20X1, he recorded the following inventory details:

Opening balance 50 units valued at $4 each

4 May purchase of 50 units at $4.40 each
11 May issue of 80 units
19 May purchase of 60 units at $4.60 each
24 May issue of 50 units

What is the value of the inventory held at 31 May 20X1?

A. $120.00
B. $126.00
C. $132.00
D. $135.00

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Question 5
Jack has recently commenced trading and is unsure how to value his inventory. He
needs to decide whether to use First In First Out (FIFO), or continuous weighted
average.

One of the raw materials he uses in his business is oil. The price of oil has consistently
risen and is expected to continue to rise.

Which of the following statements is correct?

A. Jack's profit will be the same regardless of the method of inventory valuation
adopted
B. FIFO will lead to Jack reporting a higher profit than if he uses continuous weighted
average
C. Continuous weighted average will lead to a higher reported profit than if he uses
FIFO
D. A more accurate profit will be reported if FIFO is used

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