F1 3.05 Common Adjustments: Inventories

Preparing financial statements

When students are asked to prepare one or more of the financial students, examiners often provide a trial balance for a company together with further information about transactions that have not been taken into account when the trial balance was prepared. Over the next few webpages we will look at the following types of adjustment that are commonly examined.

  • Period-end inventories
  • Revaluations
  • Tax
  • Accruals and prepayments

In this webpage we shall look at how period-end inventories should be included in the Statement of Financial Position, the Statement of Profit or Loss and the Statement of Changes in Equity.

Inventories

Inventories are a type of current asset and, when we are dealing with a manufacturing company, are split into three types:

  1. Raw materials. These are materials and consumables that will be used in the production process or in the delivery of services
  2. Work in progress. These are items of production that are part-completed at the financial period-end
  3. Finished goods. These are items of production that have been completed and are awaiting sale in the ordinary course of business (nb. a wholesale or retail business might only have this type of inventory)

Valuation of inventories

Items of inventory are valued at the lower of their cost and their net realizable value.

  • Cost is the amount incurred in bring the item of inventory to its current location and condition.
  • Net realizable value is the amount the business expects to gain from the item’s sale. It is the expected selling price, less any costs that would be incurred to sell the item and any costs that would be incurred in order to complete the item before it can be sold.

[NB. We will cover this calculation in more depth in section 5 of the course where we look at IAS 2 Inventories]

Question
A company has calculated that its year-end inventory cost £56,482 to buy and make. This amount includes the cost of an item of inventory that has damaged. The item cost £1,325 but due to the damage, the company believes it will be sold for £695. What is the value of the year-end inventory?
Click here to reveal the answer

The value of the year-end inventory is £55,852. This has been calculated by taking the cost of all of the inventory (i.e. £56,482) we will then deduct the cost of the item that will be valued at its net realisable value (i.e. £1,325) and add the net realisable value of this item (i.e. £695).

Treatment of inventories in the financial statements

Inventories at the start of the financial period

The value of opening inventories will be included in the Cost of Sales line in the Statement of Profit or Loss.

Inventories at the end of the financial period

The value of closing inventories will be included in the Cost of Sales line in the Statement of Profit or Loss (it will be deducted from other costs of sales).

The value of closing inventories will also be included in the Current Assets section of the Statement of Financial Position. This will be shown in a single line in the Statement but will then be analyzed in a note to the financial statements between raw materials, work-in-progress and finished goods.

The value of inventories will affect the Statement of Changes in Equity indirectly as they will affect the profit or loss made for the financial period and this will then affect the company’s Retained Earnings.

[The value of inventories will also affect the Statement of Cash Flows if the Indirect Method is used to calculate Net Cash Flows from Operating Income. This will be covered in section 4 of this course]

Journal to record closing inventories at the end of the financial period

Once the value of the closing inventories have been calculated they can be recorded using the following journal:

Dr Inventories (in the Statement of Financial Position) £X,XXX

Cr Inventories (in the Statement of Profit or Loss) £X,XXX

Question
A company has calculated that the cost of the inventories it held at its year-end are as follows; raw materials of £53,553, work-in-progress of £18,175 and finished goods of £25,810. Included in the company’s raw materials are goods that cost £3,292 but their net realizable value is £2,400.
a) Calculate the total value of inventories
b) Prepare a journal to record the total value of the inventories
Click here to reveal the answers

a) The answer is £96,646. This is calculated as the total cost of inventories (i.e. £97,538) less the cost of the goods to be valued at their net realisable value (i.e. £3,292) plus their net realisable value (i.e. £2,400).

b) Journal to record the year-end inventory

Debit Inventory (SOFP) £96,646

Credit Inventory (SOPL) £96,646

Illustration

Alcon Ltd has prepared its financial statements for the year ended 30 November 2019 but has yet to include the value of its inventory at the year end. Shown below is the company’s draft Statement of Profit or Loss together an analysis detailing how Cost of Sales has been calculated.

The company’s Current Assets at the year-end are as below:

The cost of its inventories at the year end was £200,000 but this included an item that cost £30,000 but was damaged and as a result had a net realizable value of £10,000.

Value of the closing inventory

The value of the closing inventory will be calculated as the total cost less the cost of the damaged item plus the net realizable value of the damaged item; that is:

£200,000 – £30,000 + £10,000 = £180,000

The value of inventory would be entered into the company’s books using the following journal

Dr Inventory (statement of financial position) £180,000

Cr Inventory (statement of profit or loss) £180,000

The inventory would then be recorded as a deduction to the Cost of Sales in the Statement of Profit or Loss and as an additional current asset in the Statement of Financial Position.

Updated financial statements

The updated Statement of Profit or Loss and an updated analysis of Cost of Sales are shown below.

The updated Current assets section of the Statement of Financial Position is as follows:

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