AAT LEVEL 3
Association of Accounting Technicians (AAT)
Example Course Materials
LESSON 7
Account for the Valuation of Inventory
On completing this lesson you should be able to:
üü Identify categories of inventory as referred to within the accounting standard IAS 2 (Inventories)
üü Explain the purpose of valuing inventory, identify the accounting concept on which making an adjustment for closing
inventory is based, and process an adjustment to account for the valuation of closing inventory
üü Explain the principle by which inventory should be valued in accordance with the requirements of IAS 2, and identify the
accounting concept on which the principle is based
üü Explain the terms ‘cost’ and ‘net realisable value’, make valuations at cost and net realisable value and use the
valuations in accordance with the requirements of IAS 2
üü Adjust a valuation of inventory from retail selling price to cost price given mark-up or margin
üü Maintain an inventories account in the ledger and use inventory valuations in the preparation of final accounts
Introduction
The accounting term ‘inventory’ is the term used in international accounting to describe what is referred to in the UK as
‘stock’. Inventory represents both an expense (cost), and an asset to a business, therefore, the incorrect treatment and
valuation of inventory held by a business will have an impact on the preparation of the Statement of Profit and Loss and the
Statement of Financial Position.
Due to the fact that Inventory valuation is an important area of accounting it is the subject of an accounting standard - IAS 2
(Inventories). IAS 2 categorises inventories as follows:
üü Finished goods purchased or manufactured for resale.
üü Raw materials or components to be used in the process of manufacturing goods.
üü Products and/ or services in various stages of completion (work in progress).
Use of accounting concepts
Several accounting concepts are applied in valuing and accounting for inventories, the concepts of accruals, prudence and
consistency being of particular relevance.
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AAT LEVEL 3
Association of Accounting Technicians (AAT)
Example Course Materials
Accruals concept
The accruals concept requires that in calculating profit or loss for an accounting period (financial year), the costs and
expenses incurred in the accounting period should be deducted from the income earned in the same accounting period.
Consider the following example:
Example – Applying the accruals concept
During its financial year ended 31 May 201X Direct Tiles purchased goods for resale at a cost of £600,000. Sales to
customers during the same period were £800,000. The gross profit was therefore calculated in the Statement of Profit or
Loss (trading section) as follows:
Direct Tiles
Statement of Profit or Loss (extract) for the Year Ended 31 May 201X
£
Sales
800,000
Less Purchases
600,000
Gross Profit
200,000
Let us now assume that Direct Tiles did not, in fact, sell all the goods it purchased during the year to 31 May 201X. At the
year end the business had goods, which cost £80,000, remaining as inventory.
It would clearly be unfair to charge the cost of all goods purchased in an accounting period against income earned from
selling only some of them. In such circumstance the accruals concept must be applied and an adjustment made to account
for closing inventory. The adjustment would result in the closing inventory being valued and deducted from this year’s
expenses in the Statement of Profit or Loss and carried forward as an asset to the next accounting period. The closing
inventory adjustment would be supported by an entry in the journal as follows:
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AAT LEVEL 3
Association of Accounting Technicians (AAT)
Example Course Materials
Journal
201X
Details
DR
£
31 May
Closing inventory – Statement of Financial Position (SFP)
80,000
Closing inventory – Statement of Profit or Loss( SPL)
CR
£
80,000
Closing inventory as at financial year end 31 May 201X
The closing inventory valuation as at 31 May 201X would be used in the preparation of the financial statements as follows:
Direct Tiles
Statement of Profit or Loss (extract) for the Year Ended 31 May 201X
£ £
Sales
800,000
Less Cost of Goods Sold
Purchases
600,000
Less Closing inventory
80,000
Cost of Sales
520,000
Gross Profit
280,000
Direct Tiles
Statement of Financial Position (extract) as at 31 May 201X
£
Current assets
Inventory
80,000
Of course the closing inventory of one period end becomes the opening inventory of the following accounting period. This
has further implications when calculating gross profit.
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AAT LEVEL 3
Association of Accounting Technicians (AAT)
Example Course Materials
When we now calculate gross profit in applying the accruals concept we must take into account both the opening and
closing inventory. The Statement of Profit or Loss (trading section) would now be prepared as follows:
Direct Tiles
Statement of Profit or Loss (extract) for the Year Ended 31 May 201Y
£ £ £
Sales
940,000
Less Cost of Goods Sold
Opening inventory80,000
Add Purchases
700,000
780,000
Less Closing inventory100,000
Cost of Sales
680,000
Gross Profit
260,000
Assessment tip – remember the rule, the accruals concep t requires ‘the cost of unsold goods at the end
of an accounting period should be carried forward to a future accounting period in the anticipation of
future sales revenue’.
The valuation of inventory at cost price
For the purpose of using an inventory valuation in the financial statements, initially a valuation of inventory at its cost price is
required. IAS 2 specifies what represents cost in arriving at a valuation of inventory at cost. The standards describe cost as
‘all costs incurred in bringing inventory to its present location and condition’. Such costs are likely to include:
üü Cost of purchase, production and conversion.
üü Import duties.
üü Cost of transportation (delivery).
üü Direct labour costs incurred by a business when its own employees are used in an assembly or conversion process.
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AAT LEVEL 3
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Specifically excluded from cost are abnormal wastage (materials, labour and overheads), the cost of storing finished goods
and selling expenses.
Cost is assigned to each unit of inventory separately which causes problems in practice as it is often difficult for a business
to ascertain the actual cost of items remaining in inventory at the period end. This is due to the fact that most businesses
take numerous deliveries of identical goods during an accounting period, often paying a different purchase price for each
consignment. At the end of the accounting period it is often impossible to match individual units of a particular line of
inventory to their actual purchase price.
The accounting standards allow the following methods of valuing inventory at cost.
First in First Out (FIFO) – this is a method of inventory valuation whereby inventory items received first are costed out first,
resulting in the most recent quantities of inventory in hand being valued at the most recent cost of production or purchase
price. This method of inventory valuation is widely used as it appears logical, in that most businesses would wish to issue and
price out their oldest goods first to safeguard against deterioration or obsolescence.
Continuous Weighted Average (AVCO) – inventory is valued at its average cost. This involves dividing the total value of inventory
in hand by the total quantity of finished units or partly finished units of inventory to arrive at the average cost price, which is
then applied to the issue of inventory. A new average price must be calculated every time there is a receipt of goods into
inventory at a price which is higher or lower than the prevailing average price. The AVCO method of inventory valuation is
commonly used in practice as it is easy to apply and the valuation which results is thought to be a fair representation of the
cost of inventory held.
Last in First Out (LIFO) - the last in first out (LIFO) method of inventory valuation, where goods received last are priced out first
using the most recent cost prices, whilst widely used in cost and management accounting, is not an acceptable method of
inventory valuation for the purpose of financial accounting and the preparation of financial statements.
Example – The use of FIFO and AVCO Inventory valuation methods
A company trades in a single product. At I July 201Y the inventory of the company consisted of 20,000 units of the product
at a cost of £10 per unit.
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AAT LEVEL 3
Association of Accounting Technicians (AAT)
Example Course Materials
During the month of July 201Y purchases and sales of the product were:
Date
Purchases
Sales
2 July
12,000 units
4 July
5,000 units @ £14 each
8 July
7,000 units
10 July
10,000 units @ £14 each
15 July
6,000 units
18 July
5,000 units @ £14 each
26 July
10,000 units
31 July
10,000 units @ £15 each
Note: All sales in the month of July 201Y were at £25 per unit.
If the company valued their inventory using the FIFO method, closing inventory would be 15,000 units valued at £220,000
calculated as follows:
Closing inventory – units
Units
Opening inventory
Add purchases
20,000
30,000
50,000
Less sales
35,000
Closing inventory 15,000
Closing inventory – valuation
10,000 units @ £15 = £150,000 (purchased 31 July 201Y)
5,000 units @ £14 = £70,000 (purchased 18 July 201Y)
£220,000
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AAT LEVEL 3
Association of Accounting Technicians (AAT)
Example Course Materials
Gross profit on trading in the product for the month ended 31 July 201Y would be:
£
Revenue 875,000 (35,000 units @ £25 each)
200,000 (20,000 units @ £10 each)
430,000 (20,000 units @ £14 each + 10,000 units @ £15 each)
Less Cost of Sales
Opening inventory
Purchases
630,000
Closing inventory (220,000) Cost of Sales
410,000
465,000
Gross profit
(10,000 units @ £15 each + 5,000 units @ £14 each)
If an AVCO method of inventory valuation were used (continuous weighted average), then closing inventory would consist of
15,000 units at a value of £189,000, with the valuation calculated as follows:
Opening inventory £200,000 + Purchases £430,000 = £ 630,000 = £12.60 per unit
Opening inventory 20,000 units + Purchases 30,000 units = 50,000
£12.60 x 15,000 (closing inventory – units) = £189,000
Gross profit on trading in the product for the year ended 31 July 201Y would be:
£
Revenue 875,000 (35,000 units @ £25 each)
200,000
(20,000 units @ £10 each)
430,000 (20,000 units @ £14 each + 10,000 units @ £15 each)
Less Cost of Sales
Opening inventory
Purchases
630,000
Closing inventory
(189,000) Cost of Sales
441,000
Gross profit
434,000
(15,000 units @ £12.60 each)
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AAT LEVEL 3
Association of Accounting Technicians (AAT)
Example Course Materials
Consistency concept
In practice an inventory valuation method which is fair and suitable should be selected. The management of a business is
expected to choose a method of inventory valuation which provides ‘the fairest possible approximation of the expenditure
incurred in bringing a product to its present location and condition’.
Once a particular method of inventory valuation has been selected it then becomes the business’s policy in respect of
inventory valuation and should be applied consistently from accounting period to accounting period. The consistency
concept prevents a change in policy being introduced just to show information in a more favourable light.
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