Introduction to Accounting

Accounting refers is information system or process that identifies, records and communicates
economic event of an entity to permit informed judgments and decisions by interested users of
the information (internal and external users).

Conceptual Framework

Define- Conceptual Framework consist of a set if concepts to be followed by preparers of

financial statements and standard setters.

Section1 – The objective of general-purpose financial reporting- is to provide financial

information about the reporting entity that is useful to existing and potential equity investors,
lenders and other creditors in making their decisions about providing resources to entity.

Section 2 – Reporting entity in Statement of Accounting concept 1 (SAC 1) as entity in which it

is reasonable to expect the existence of users who depend on general purpose financial reports
for information to enable them to make economic decision.

An entity is more likely to be classified as reporting entity if it is 1. Managed by individuals who

are not owners of the entity, 2) Politically or economically important and 3) Sizable in any of the
following ways -sales, assets, borrowings, customers, or employees.

Section 3- Definition of elements of financial statements.

Internal user of the accounting information are managers who plan, organize, and run a
business. They do not need to rely on general purpose financial reports as they can obtain the
financial information they need internally.

External users have a interest in financial information about the three main types of activities-
financing, investing and operating.

Statement of profit and loss

The purpose of statement of the profit and loss is to report the success or failure of the entity’s
operations for a period of time. Top Line (Revenue). Profit or net earnings (Bottom Line).
Statement of changes in equity

The statement of changes in equity reports the total comprehensive income for the period and
other changes in equity, such as adjustments to retained earnings for changes in accounting
standards, changes in accounting policies and corrections of error.

Statement of Financial Position- The Statement of financial position reports assets and claims to
those assets at a specific point in time. Claims are subdivided in two categories: Claims of
creditors and claim of owners. Claim of creditors are called liabilities. Claims of owners are
called equity (or shareholder equity).

Basic accounting equation= Assets + Liabilities + Equity

Equity comprises of two parts:

1) Share capital or (known as Paid up capital, issued capital and contributed equity)
2) Retained earnings and reserves

The amount of retained earnings reported in the statement of financial position at end of
the period is the amount of retained earnings at the beginning of the period, plus profit
after tax for the period, less any amount distributed as a dividend during the period.

Statement of cash flows

The main purpose of a statement of cash flows is to provide financial information about the
cash receipts and cash payments of a business for a specific period of time. To help
investors, creditors and others in their analysis of an entity’s cash position, the statement
of cash flows reports the cash effects of an entity’s:

1) Operating activities
2) Investing activities
3) Financing activities

Interrelationships between the statements

1) The statement of financial position depends on the results of the statement of profit or
loss and statement of changes in equity. This amount is added to the beginning amount
of retained earnings as part of the process of determining ending retained earnings.
2) The ending amount of cash shown on the statement of cash flows reflected in amounts
reported on the statement of financial position.
 ASSB Framework

A) Assumptions underlying financial reports:

1) Going concern- the entity assumed to continue indefinitely
2) Accrual Basis- the transaction are recorded when they occur rather than when cash
is received or paid

B) Objective of financial Statements

1) To provide information about the reporting entity that is useful to existing investors
and potential investors, lenders and other creditors in making decisions about
providing the resources to entity.

C) Fundamental Qualitative characteristics of useful financial information- These

qualitative characteristics attributes are useful to users.

1) Relevance- information is considered relevant if its capable of making difference in

the decisions made by users. Information that has predictive value/ or confirmatory
value is considered to be relevant. Information is considered to have predictive
value if it can be used to develop expectations for the future.
 Materiality- The relevance of the information is affected by its materiality.
Information is material if its omission or misstatement could affect users’
decisions. Information that is immaterial need not be separately identified.

2) Faithful Representation (Reliability) – Information is a faithful representation of the

economic phenomena it purports to represent if it is complete, neutral and free
from material error.
3) Enhancing Qualitive characteristics-
 Comparability- must be able to compare financial statements over time and
between entities
 Verifiability: different knowledgeable and independent observers can reach
consensus
 Timeliness: is measured by whether the information is available to users
before it ceases to be relevant.
 Understandability: readily understandable by users assumed to have a
reasonable business knowledge

4) Constraint of Financial reporting: Cost constraints limit the information provided by

financial reporting. Providing decision-useful information imposes costs, and the
benefits of providing the information should outweigh the costs.
 D) Elements of Financial Statements – There are five elements of accounting:

1. Assets: a resource controlled by the entity as a result of a past event and from which
future economic benefits are expected to flow to the entity

Definition Criteria of Assets

(1) Future economic benefits (service potential)

• Potential to contribute, directly or indirectly, to the flow of cash to the
entity
• Generate cash flows through the sale of, or use of, the asset
(2) Control by the entity
• Capacity of the entity to benefit from the asset and deny or regulate the
access of others
• Does not necessarily mean ownership (e.g., leases)
• Does the entity control the resource?
(3) Occurrence of past event
• Transaction or other event giving the entity control of the asset must
have occurred
• e.g. Asset purchase or Non-reciprocal transfer (donation/grant)

Recognition Criteria of Assets: Once the definition is satisfied, an asset should

only be recognised (included) in the financial reports if the recognition criteria
are satisfied!

The essential components of the recognition criteria are:

 Probable future economic benefits

i. More likely than not
ii. Greater than 50% chance of occurring

 Reliable measurement
iii. Transaction to verify the cost
iv. Reasonable estimate
E.g., internally generated goodwill, brand names (Coke)?

Important Term for making conclusion

Recognised: Meets definition and recognition criteria and is therefore included in the financial
reports.

Disclosed: Meets the definition criteria but does not meet the recognition criteria and
therefore, included as note to the financial reports.
 2. Liabilities: a present obligation of the entity arising from the past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.

Definition Criteria for Liabilities

1) Future outflow of economic benefits.

 Settlement of the present obligation E.g., bank contract specifies future
outflow
 Giving up resources to settle the obligation

2) Present obligation
 Legally enforceable obligations (consequences)
 Contractual arrangements (e.g., a bank loan)
 Good business practice or equitable obligations (e.g., repair faults outside
warranty period)
 Constructive obligation – based on a pattern of events (e.g., paying out year-end
bonuses regularly)
 Equitable obligation - fairness
 Does not include future commitments (e.g., decision to purchase asset in the
future)

3) Occurrence of past event

 Transaction creating the present obligation must have occurred
 A present obligation cannot be created by a future transaction

Recognition Criteria for Liabilities

The essential components of the recognition criteria are:

(1) Probable future outflow of economic benefits

• More likely than not
• Greater than 50% chance of occurring
• E.g., a pending decision in a lawsuit
(2) Reliable measurement
• Transaction to verify the cost
• Reasonable estimate

3. Owner Equity: the residual interest in the assets of the entity after deduction of its
liabilities. Owner’s Equity = Assets – Liabilities
 4. Income (Revenue): increases in economic benefits during the accounting period in
the form of inflows or enhancements of assets or decreases of liabilities that result
in increases in equity, other than those relating to contributions from equity
participants

Definition Criteria for Income:

(1) Inflows (increases in assets or decreases in liabilities)

• Cash / credit sale (enhances debtors) / or forgiveness of debt (e.g.,
discount received)

(2) Resultant increase in equity

• Increase in net wealth

(3) Other than contributions by equity participants

• Income cannot be capital contributed by owners

Recognition Criteria for Income

The essential components of the recognition criteria are:

(1) Probable future inflows

• More likely than not
• Greater than 50% chance of occurring

(2) Reliable measurement

• Transaction to verify the cost
• Reasonable estimate

5. Expenses: decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants.

Definition Criteria for Expenses

(1) Outflows of future economic benefits (decrease in assets or increase in liabilities)

• Salaries paid or owed
(2) Resultant decrease in equity
• Reduction in net worth
(3) Other than distributions to equity participants
• Not dividends or withdrawals (drawings) by owner
 Recognition Criteria for Expenses

The essential components of the recognition criteria are:

(1) Probable outflow

• More likely than not
• Greater than 50% chance of occurring

(2) Reliable measurement

• Transaction to verify the cost
• Reasonable estimate

Template
Definition
Future Economic Benefits

Control

Past Event

Recognition Criteria

Probable

Reliable Measurement

Conclusion
 Accounting information System- is the system of collecting and processing
transaction data and communicating financial information to interested parties is
known as the accounting information system.

Extended accounting Equation

Assets = Liabilities + Owner’s Equity + Share capital - Dividends + Income – Expenses Debit
(Dr) Credit (Cr)

When the totals of the two sides of the T account are compared, an account will have a
debit balance if the total of the debit amounts exceeds the total of the credits. Conversely,
an account will have a credit balance if the total of the credit amounts exceeds the total of
the debits.

Assets = Liabilities
+ expenses + Income
+ Drawings + Capital

DEBIT CREDIT
Normal balance normal balance

Increase=debit increase=credit
(decrease=credit) (decrease=debit)

Trail Balance: is a list of accounts and their balances at a given time. Customarily, a trial
balance is prepared at end of an accounting period.

Mistakes Made before

 In one transaction three accounts can be affected. For example, earned $39,000 in
tuition fees during the month. Of these, 25% of the fees were collected in cash and 75%
will be paid within 2 Months.

Date Account Name Post reference Debit ($) Credit ($)

June 30 Tuition Fees 9750
cash (A)
Revenue Service 9750
(OE)
Accounts 29250
receivable

 Revenue received in advance would not be written as service revenue in general journal.
Also, Revenue received in advance would not come in service revenue account, rather a
different account must be created in name of revenue received in advance. The same
followed in the BDA (Balance day adjustments).


Revenue recognition criteria

 The conceptual framework defines revenue as increases in economic benefits
arising in the course of ordinary activities of an entity. It includes sales revenue, fees,
interest, dividends, royalties and rent.

The operating cycle is the length of time it take for a business to acquire goods, sell
them to customers and collect the cash from sale.

Recognition criteria

 it is probable that any future economic benefits associated with the revenue
will flow to the entity.
 The revenue can be measured with reliability.

New accounting standard for revenue recognition criteria

 The contract must be approved by parties of the contract and each party’s
rights with regard to the good or service to be transferred must be clearly
identified as well as the terms for payment. The contract must have
commercial substance and it is probable that the consideration will be
collected to which the entity is entitled in exchange for the goods or services.
 Identity the performance obligation in the contract
 Determine the transaction price –
 Allocate the transaction price to the performance obligation in the contract.
 Recognize revenue when (or as) the entity satisfies the performance
obligation.

Adjusting entries:
 Prepaid expenses- payments of amount that will provide economic benefits for more
than the current accounting period are called prepaid expenses or prepayments.

 Prepaid expenses expire as the service is provided with the passage of time (e.g.
rent and insurance) or through use (e.g. supplies).
 Before adjustment, assets are overstated, and expenses are understated.
 Therefore, adjusting entry for prepaid expenses results in an increase (a debit) to
an expense account and a decrease (a credit) to an asset account.
 Alternatively, some entities may record the cost incurred immediately as an
expense (debit) rather than as an asset. Therefore, the adjusting entry will be to
increase (debit) the asset account for the future benefit which is unexpired and
decrease the expense (credit). Hence, the expense has been deferred.

Examples of Prepaid expense are Supplies, Insurance and rent.

Supplies
The difference between the unadjusted balance in the supplies (assets) account and the actual
cost of supplies on hand represents the supplies used (expense) for that period. That is, the
cost of the supplies used (expense) for that period. That is, the cost of the supplies consumed
during this period is an expense. This use of supplied decreases an asset and decreases equity
by increasing expense account.

General Journal

Date Account name Post Debit ($) Credit ($)

(narration) ref.
2019 Adjusting entries 15000
Aug 22 Advertising supplies
expense

Advertising Supplies 15000

(To record supplies used)

Supplies expense = Unadjusted supplies asset - supplies on hand

Insurance

Insurance payments (premiums) made in advance are normally recorded in the asset account
prepaid insurance. At the end of the reporting period it is necessary to increase (debit)
insurance expense and decrease (credit) prepaid insurance for the cost of insurance that has
expired during the period.

Date Account name Post Debit ($) Credit ($)

(narration) ref.
2019 Adjusting entries 50
Aug 22 Insurance expense

Prepaid Insurance
50
(To record insurance
expired)

Depreciation -The process of allocating the cost of an asset to expense over its useful life.
 Date Account name (narration) Post Debit ($) Credit ($)
ref.
2019 Adjusting entries
Aug 22 Depreciation expense 40

Accumulated depreciation- office

equipment 40

(To record monthly depreciation)

Accumulated depreciation- office equipment is a contra asset account.

The difference between the cost of any depreciable asset and its related accumulated
depreciation is referred to as its carrying amount (also referred to as book value)

Prepaid Revenues

Cash received before the revenue recognition criteria have been met is recorded by increasing
(crediting) a liability account called revenues received in advance. An adjusting entry is made to
record the revenue during the period and to show the liability that remains at the end of the
accounting period. Therefore, adjusting entry for revenues received in advance results in
decrease (a debit) to a liability account and an increase (a credit) to a revenue account.

Date Account name (narration) Post Debit ($) Credit ($)

ref.
2019 Adjusting entries
Aug 22 Service revenue received in advance 400

Service Revenue
400
(To record revenue)

Accrued Revenues
  Accrued Revenues are revenues that are recorded as adjusting entries because they
have not been recorded in the daily recording of the transactions.
 Accrued revenues may accumulate over time, as in the case of rent revenue and interest
revenue, or they may result from services that have been performed but neither
invoiced nor collected.
 Before, the adjusting entries both assets and revenues are understated
 An adjusting entry for accrued revenue results in an increase (a debit) to an asset
account and an increase (a credit) to a revenue account.

Date Account name (narration) Post Debit ($) Credit ($)

ref.
2019 Adjusting entries
Aug 22 Commissions receivable 200

Commissions Revenue
200
(To accrue commissions revenue not
recorded or collected )

Accrued expenses

Expenses not yet paid or recorded at end of the reporting period are called accrued
expenses. Before adjustment, both liabilities and expense are understated. Therefore,
an adjusting entry for accrued expense results in an increase (a debit) to an expense
account an increase (a credit) to a liability account.

Accrued interest

The amount of the interest accumulation is determined by three factors: 1) the principal
borrowed 2) the interest rate, which is always expressed as an annual rate, and 3) the
length of time the loan is outstanding.

Date Account name (narration) Post Debit ($) Credit ($)

ref.
2019 Adjusting entries
Aug 22 Interest expense 50

Interest Payable
50
(To accrue interest on bank loan )

Accrued salaries
 Date Account name (narration) Post Debit ($) Credit ($)
ref.
2019 Adjusting entries
Aug 22 Salaries expense 50

Salaries Payable
50
(To record accrued salaries)

This accrual increases a liability, salaries payable, and an expense account, salaries
expense, and cash (asset).

Deprecation: the systematic allocation of the depreciable amount of an asset over its
useful life.

Carrying amount is the recorded cost of an assets, net of any accumulated depreciation
(or accumulated impairment losses).

Depreciation Expense:

 An expense account – normal balance on debit side.

 Shows the cost of assets that has expired or been consumed in the current
period.

Accumulated Depreciation:

 A contra asset account- normal balance on credit side

 Shows depreciation of asset since acquisition until current period.

Depreciable amount is “the cost of an asset, or other amount substituted for cost, less
its residual value”

Residual value of an asset is “the estimated amount that an entity would currently
obtain from disposal of the asset … at the end of its useful life”

Methods for calculating the deprecation:

 Straight Line Method
 Reducing Balance

Straight Line Method

Cost – Residual value = depreciation expense p.a.

Useful life

To find the deprecation for number of months. First deprecation per annuum and then
multiply by (number of months given/12)

Reducing Balance Method

(Cost – Accum. Depreciation) * Rate = Depreciation p.a.

Two Important journal entries:

1. To write-off bad debts (use real amount)

Dr Allowance for Doubtful Debts (Equity)
Cr Accounts Receivable
2. To increase Allowance account (BDA: use estimate)
Dr Doubtful Debt Expense (Asset)
Cr Allowance for doubtful Debts

1) Direct write-off method –

 % of sales – not examinable
 % of receivables - % of total Receivable
Ageing analysis of receivables
 To determine the adjusting entry amount:

1. Find out the current balance of Allowance account, after writing-

off bad debts

current balance= $ 3,000 CR (Example)

2. Determine the desired closing balance of Allowance account

Desired closing balance= $5,000 CR (Example)

3. Calculate the increase required to bring the Allowance account

balance (this is the adjusting entry amount)
Increase required= $2,000 (Example)
Date Details Debit Credit

Doubtful Debts 2,000

Expense
Allowance for Doubtful 2,000
Debts
(Adjusting entry to record
estimated uncollectables)

Example of calculating the amount of Allowance for Doubtful debts that should be reported on
30 June 2019 given aging analysis of accounts receivable.

Accounts Account age Estimated Estimated Uncollectible

receivable uncollectible (Not give in Question)

$310,000 Not yet due 0.5% $1,550

$135,000 1-30 day overdue 2% $2,700

$72,500 31-60 days overdue 7% $5,075

$27,500 61-90 days overdue 25% $6,875

$16,000 91-120 days overdue 50% $8,000

$9,000 Over 120 days overdue 75% $6,750

 $570,000 $30,950

 $30,950 represents the desired closing balance for the allowance for Doubtful Debts
account.
 The amount of Allowance for Doubtful Debts that should be reported on 30 June 2019 is
$30,950.

The Adjusted Trail Balance and financial statements

 After all, adjusting entries have been journalized and posted, another trail balance is
prepared from the ledger accounts. This trail balance is called an adjusted trail balance.
 The purpose of an adjusted trail balance is to prove that the total debit balances equal the
total credit balance in the ledger after all adjustments have been made.

Closing entries

Closing Books
  After all the adjusting entries have been journalized and posted, another trail balance is
prepared from the ledger account. This trail balance is called an adjusted trail Balance.
 The next step is therefore to close the books by using closing entries to close all the
temporary accounts.

Temporary accounts relate to only a given accounting period: i.e, revenues, expenses,
dividends.

These accounts must be ‘closed’ to set the account balance to zero balance at the end of each
accounting period.

Permanent accounts are carried forward to future accounting periods: i.e., assets, liabilities,
equity.

Preparing Closing entries

 “Closing entries are journal entries that effectively ‘close’ all temporary
accounts to the permanent equity account (Capital for sole trader or
Retained Earnings for company) at the end of the accounting period.”

 “A special temporary account, ‘Profit or Loss Summary’ account, is

created to facilitate the closing process.”

 “Income and expense accounts then begin the next accounting period
with a zero balance.”

Closing entries – step 1

Four Steps in closing entries

1. Close all Income accounts (→ zero bal.) to the P & L Summary account:

DR (EACH INDIVIDUAL) INCOME ACCOUNT

CR P & L SUMMARY

Because ‘INCOME’ accounts have a normal CREDIT balance, we must debit

to close – each GL must be zero.

Closing entries- step 2

2. Close all Expense accounts (→ zero bal.) to the P & L Summary account:

DR P & L SUMMARY
CR (EACH INDIVIDUAL) EXPENSE ACCOUNT

Because ‘EXPENSES’ have a normal DEBIT balance, we must credit all

expenses to close – each GL must be zero.

Closing entries- step 3 (sole Trader)

3. Close P & L Summary account to the Capital account

a) If the P & L Summary account has a CR balance (i.e. net profit)

DR P & L SUMMARY
CR CAPITAL

b) If the P & L Summary account has a DR balance (i.e. net loss)

DR CAPITAL
CR P & L SUMMARY

[Note: we INCREASE Capital account if profit is made, decrease for a loss.

P & L Summary account MUST be ZERO after this step].

Closing entries – step 3 (FOR COMPANY)

3. Close P & L Summary account to the Retained earnings account

a) If the P & L Summary account has a CR balance (i.e. net profit)

DR P & L SUMMARY
 CR RETAINED EARNINGS

b) If the P & L Summary account has a DR balance (i.e. net loss)

DR RETAINED EARNINGS
CR P & L SUMMARY

[Note: we INCREASE Retained earnings account if profit is made, decrease for a

loss. P & L Summary account MUST be ZERO after this step].

Closing entries – step 4 (FOR SOLE TRADER)

4. Close Drawings account (→ zero balance) to the Capital account

DR CAPITAL
CR DRAWINGS

Drawings are also temporary – the balance of the drawings account will
equal ZERO after this step.

Closing entries – step 4 (FOR COMPANY)

4. Close Dividends account (→ zero balance) to the Retained earnings account

DR RETAINED EARNINGS
CR DIVIDENDS

Dividends are also temporary – the balance of the dividends account will
equal ZERO after this step.

At the end result

• All income accounts have nil balances

• All expense accounts have nil balances
• The drawings (dividends) account has a nil balance
• The Capital (retained earnings) account has either been increased by the profit,
or decreased by the loss and decreased by the drawings (dividends)

while doing journal entries for closing entries make ledger accounts for cross references. Cross-
references, e.g. ‘Cash’ in the salaries expense account. Cross references indicate the ledger
account to which the opposite side of the entry is posted.
Example for the Closing entries
Preparing a post-closing trail balance

After all closing entries are journalized and posted, another trail balance, called a post-
closing trail balance, is prepared from the ledge. A post-closing trail balance is a list of all
permanent accounts and their balances after closing entries are journalized and posted.
Since all temporary accounts will have nil balances, the post-closing trail balance will
contain only permanent – statement of financial position- accounts.
 General Purpose Financial Reports

The key financial statements are:

• Income Statement (I, E)

Measures financial performance over a period of time

• Balance Sheet (A, L and OE)

Measures financial position at a point in time

• Statement of Changes in Owners’ Equity (OE)

Presents a summary of changes that occurred in the entity’s equity
between two successive reporting dates

• Statement of Cash Flows (the Asset Cash) (NOT EXAMINABLE)

Measures cash receipts and cash payments over a period of time

Income Statement

• Provides information on an entity’s profitability for a period of time

• Measures the difference between
• Revenues (Income) earned during a period and Expenses incurred in
earning the revenues
• The difference is profit if R > E
• The difference is a loss if R < E
 Income Statement Example

S. Monash
Income Statement
For the period ended 30 June 2019
$ $

Income 50,000

Total Income 50,000

Expenses 26,400

Total Expenses 26,400

Profit 23,600

Statement of changes in the owner equity

• This statement shows all changes to owner’s equity that occurred during
the period.

• These changes could comprise: 

• capital
• profit
• drawings (for sole trader)
• dividends (for company)
Statement of changes in owner equity

S. Monash
Statement of changes in the owner’s equity
For the month ended 30 June 2019

$ $

S Monash, Capital, 1 July 10,000

2019
Owner’s Investment during 1,000
the Month
Profit for the Month (I/S) 3,000

Total 14,000

Withdrawals during the 2,000

Month
S Monash capital, 30 June 12,000
2019 (B/S)

Balance Sheet

• The Balance Sheet summarises the financial position of an entity at a

particular date
• Example for the Balance Sheet
 $ $ $
ASSETS
Current Assets
Cash at Bank 8,607
Accounts receivable 18,886
Prepaid Insurance 1,586
Prepaid Rent 3,112
Hair Styling Supplies 1,385
Books and Magazines 182
Total Current Assets 33,758

Non-Current Assets
Motor Vehicle 32,945
Less Accum Depreciation Motor Vehicle 642 32,303
Hair Styling Equipment 15,997
Less Accum Depreciation Hair Styling Equipment 531 15,466
Total Non-Current Assets 47,769
TOTAL ASSETS $81,527

LIABILITIES
Current Liabilities
Accounts Payable 9,416
Total Current Liabilities 9,416

Non-Current Liabilities
Loan 27,032
Total Non-Current Liabilities 27,032
TOTAL LIABILITIES 36,448

OWNERS’ EQUITY
Capital – (Closing Balance) 42,332
(-) Drawings 1,025
(+) Net Profit 3,773
TOTAL LIAB AND OWNERS’ EQUITY $ 81,527

Accounting for Inventories

 What is Inventory?

Inventories are assets

(a) held for sale in the ordinary course of business (finished goods)

(b) in the process of production for such sale (work in progress); or

(c) in the form of materials or supplies to be consumed in the production process or in

the rendering of services (raw materials)

Merchandising business: are the business which that buy and sell merchandise (known as
inventory) rather than perform services as their main source of revenue.

 Business that sell that sell inventories directly to consumers are called retailers.
 Business that sell inventories to retailers are called wholesalers.
 The main source of revenues for merchandising business is the sale of inventory, often
referred to simply as sales revenue or sales.
 Expenses for merchandising business are divided into two categories the cost of sales
and operating expenses.
 The cost of sales (COS) which can also be called cost of goods sold (COGS) is the total
cost of inventory sold during the period.
 Other expenses = expenses incurred in the process of earning sales revenue (i.e.,
operating expenses)

Operating Cycle

The operating cycle of a merchandising business ordinarily is longer than that of a

service business. The purchase of the inventory and its eventual sale lengthen the cycle.

Inventory systems

A merchandising business keeps track of its inventory to determine what is possible for
sale and what has been sold. There are two methods to account for inventory:

 Perpetual Inventory Control Method – initially records as an asset (inventory)

 Periodic (Count) Inventory Method – initially recorded as an expense (purchases)

Perpetual Inventory Method

 • A continuous record of all inventory transactions is maintained
• A ledger account called Inventory (A) records all inflows and outflows of inventory at the
time
• COGS is updated at the time of every sale
• The amount of inventory that should be on hand is known at all times
• This is compared with the amount actually on hand to see if there is a stock loss/gain
• Actual inventory on hand is determined by physical count

Recording Purchase of Inventory

 The inventory can be purchased either by cash or credit.

 When goods are purchased by cash from sellers /vendors/

retailers/wholesalers/manufacturers they are referred to as cash purchases because the
payment is made at time of delivery. Cash purchases are recorded by an increase in
inventory and a decrease in cash.

 Credit purchases are those that are paid for after delivery of the goods i.e. the purchase is
on credit terms. Credit purchases are recorded by an increase in inventory and increase in
accounts payable. The credit terms of the transaction will be given in supplier’s invoice such
as 2/7, n/30; that is, if purchaser pays within 7 days of the invoice date, it may deduct a 2%
discount. Otherwise, the full invoice is due in 30 days.

The entry for recording the purchase of inventory: (example)

May 5 Inventory 3800

Accounts Payable/ Cash 3800
(To record goods purchased on
account from PW Audio Supply Ltd)
A = L + E
+3800 +3800

 while recording for the purchase of the inventory under the perpetual inventory system,
purchases of good for resale are recorded in the inventory account.

 Not all purchases are debited to inventory. Purchase of assets acquired for use by the
company itself, such as stationery, equipment and similar items, are recorded as
increases to specific asset accounts rather than to inventory.
Purchase returns and allowances
 A purchase return is the return of goods by the business because…

• goods do not meet business’ specifications

• goods are damaged or defective
• goods are of inferior quality

 In such cases, the purchaser may return the goods to the seller for credit if the
purchase was made on credit, or for cash refund if the purchase was for cash. This
transaction is known as a purchase return.
 Alternatively, the purchaser may choose to keep the inventory if the seller is willing to
grant an allowance (deduction) from the purchase price. This transaction is known as a
purchase allowance.

Recording entry for the Purchase return:

May 5 Accounts Payable/ Cash 300
Inventory 300
(To record return of goods received
from PW Audio Supply Ltd)
A = L + E
300 -300

Freight costs
  When the buyers pay the transport costs, these costs are considered part of the
cost of purchasing inventory and are called freight in.

 Conceptually, the cost of inventory includes the invoice price plus freight
charges. However, in practice, freight costs are often recorded in a freight-in
account because of the difficulty of allocating freight costs to individual
inventory items when different items are delivered at the same time.

 As a result, the freight-in costs are not directly debited to inventory, they are
included in the cost of inventory.

Entry to record for freight charges on the delivery of goods (Freight-in)

May 5 Freight-in 150

Cash 150
(To record payment of freight on
goods purchased)
A = L + E
-150 -150

In contrast, freight costs incurred by the seller on outgoing inventory are called freight-out and
are an operating expense to the seller.

May 5 Freight-out 150

Cash 150
(To record payment of freight on
goods purchased)
A = L + E
-150 -150

Purchases discounts

Many businesses offer discounts to their customers. Discounts falls into settlement
discount (can also be called cash discounts) and trade discounts.

Settlement discounts

 The credit terms of purchase on account may permit the buyer to claim a
discount for prompt payment. The buyer calls this settlement discount discount
received.
  This incentive offers advantages to both parties- the purchaser saves money and
the seller is able to shorten the operating cycle by converting the accounts
receivable into cash earlier.
 The credit terms specify the amount of the cash discount and time period during
which it is offered. They also indicate the time within which the purchaser is
expected to pay the full invoice price. For example, credit terms are 2/7, n/30,
which is read as ‘two-seven’, net thirty’. This means that a 2% cash discount may
be taken on the invoice price, less (‘net of’) any returns or allowances, is due 30
days from the invoice date. The term net in ‘net 30’ means the remaining
amount due after subtracting any returns or allowances and partial payments.
 Discounts are recorded by the buyer as revenue, as a discount represents a
saving in outflows and a consequential reduction in liabilities and an increase in
equity.

To record entry for the payment of balance due when discount is received:

May Accounts Payable 3500

12
Cash 3430
Discount Received 70
(To record payment within discount
period)
A = L + E
-3500 -3500 +70

If the company failed to take the discount and instead made full payment within invoice
date.

June 3 Accounts Payable -3500

Cash -3500
(To record payment with no discount
taken)
A = L + E
-3500 - 3500

Another method for accounting discount method.

 Another way is to credit inventory by the amount of the discount when an invoice is
paid within discount period. Entities justify this approach by the arguing the inventory is
recorded at cost and, by paying within discount period, the buyer has reduced its cost.
 To recording of a settlement discount as a credit to inventory is illustrated below.

May Accounts Payable 3500

12

Cash 3430
Inventory 70
(To record payment within discount
period)
A = L + E
-3500
-70 -3500

Another way of looking at the discount is to say that it would cost company an
additional $70 to have the use of the money ($3430) for another 23 days. How does $70
(or 2%) interest for 23 days compare with the interest that company would pay for
money its borrowers from the bank? We can convert the 2% of 23 days to an annual
interest rate as follows:

365
×2 %=31.7 % p . a .
23

Thus, unless company pays more than 31.7% interest p.a. for the money that it uses
(such as a bank overdraft), it will save money by taking advantage of the discount.

Trade discounts

 Trade discounts unlike settlement discounts, do not depend on early payment of the
amount due and are not recorded in the records of either buyer or the seller.
 Trade discounts are disclosed on the sales invoice as a percentage reduction in the list
price of the inventories sold.
 For example, assume that seller quotes a list price of $500 per item and allows a trade
discount of 10% for buyers when purchase in large quantities (in this example assume
that 8 times or more are considered a large purchase). If the buyer purchases 10 items
of inventory on 19 May, taking a trade discount of 10%. The invoice price would be
$4500(10 x $500 x 90%).
The purchase would be recorded in the buyer’s records as:

May 19 Inventory 4500

Accounts Payable/cash 4500
(To record purchase of inventory on
account with trade discount of $500)
A = L + E
+4500 + 4500

In the records of the seller, the sale of inventory would be recorded in the amount of $4500.
Hence, the $500 trade discount is not recorded in the records of either the buyer or the seller.

Recording Sales

Two entries are required:

Inflow
1. to record the sale of goods - at Selling Price
This entry makes us better off - revenue
(with associated increase in an asset – Cash or Accounts Receivable)

Outflow

1. to record the cost of sales - at Cost Price

This entry makes us worse off - expense
(with associated decrease in an asset – Inventory)

Under a perpetual inventory system, two entries are made for each sale.

 The first entry records sale: assuming a cash sale/ Accounts receivable, and
cash/Accounts receivable is increased by debit, and sales is increased by credit
at the selling (invoice) price of the goods.
 The second entry records the cost of the inventory sold: cost of sales is
increased by a debit, and inventory is decreased by a credit for the cost of those
goods.

Recording for sales:

 May 5 Cash/Accounts Receivable 2,200
Sales 2,200
(To record daily cash sales)
5 Cost of sales 1,400
Inventory 1,400
(To record cost of inventories sold for
cash)
A = L + E
+2200 +2200
A = L + E
-1400 -1400

 For internal decision-making purposes, business may use more than one sales
account. By using separate sales accounts for major product lines, rather than a
single combined sales account, management can monitor sales trends more
closely and respond in a more appropriate strategic manner to changes in sales
patterns.
 However, on its statement of profit or loss, presented to outside investors, a
retail entity would normally report only total sales revenue as part of an
aggregate revenue figure.

Sales returns and allowances

 We now look at purchase returns and allowances from the supplier’s perspective.
 The customer will receive a refund in the form of either credit or cash depending on
how the goods were initially purchased
 Cash refunds and credit notes are recorded as sales and returns allowances in the
records of the seller.
 When an entity records a credit for returned goods from sales to customer that are not
faulty or damaged involve:
(1) An increase (debit) in sales returns and allowances in the records of the seller (at
selling price) and a decrease in Accounts receivable/cash at selling price.
(2) An increase in inventory at cost price and decrease in cost of sales (at cost
price).

May 8 Sales returns and allowances 300

 Accounts receivable 300
(To record credit granted to Sauk
Stereo for returned goods)
8 Inventory 140
Cost of sales 140
(To record cost of goods returned)

A = L + E
-300 -300
A = L + E
+140 +140

*Note- Returned goods are debited to Inventory only if they are not damaged or faulty.

Recording Sales Returns where goods are damaged and cannot be resold.

 Faulty and damaged goods cannot be returned to inventory for resale.

 When an entity records a credit for faulty goods returned would involve:
1. An increase in sales return and allowances and a decrease in accounts receivable (or
cash if a refund is given) at the selling price.
2. An increase in an expense account called inventory write down at cost price and a
decrease in cost of sales (at cost price).

May 8 Sales returns and allowances 300

Accounts receivable 300
(To record credit granted to Sauk
Stereo for returned goods)
8 Inventory write-down 140
Cost of sales 140
(To record cost of goods returned)

A = L + E
-300 -300
A = L + E
-140
+140

 The inventory write-down account can also be used to record inventory shrinkage (e.g.
evaporation of inventories such as ink or fuel), inventory waste (e.g. offcuts of fabric or
 building materials), inventory obsolescence or inventory that has been lost or stolen.
(Note: Inventory write down expense can also be referred to as inventory write-off
expense, damaged inventory expense or obsolete inventory expense)
 Sales returns and allowances is a contra revenue account sales. A contra account is
used, instead of debiting sales, to separately identify in the accounts and in the
statement of profit or loss the amount of sales returns and allowances.
 This information is important to management as it may impact on decisions made with
regards to inventory. For example, if excessive returns are due to inferior inventory,
then management may decide to source their products or raw materials for making
those products from different suppliers.
 Excessive returns and allowances may not be indicative only of inferior inventories but
could be due also to inefficiencies in filling orders, errors in invoicing customers, or
mistakes in delivery and shipment of goods.
 Moreover, a decrease (debit) recorded directly to sales would obscure the relative
importance of sales returns and allowances as a percentage of sales. It could distort
comparisons between total sales in different accounting periods.

Sales discounts

 Like a purchase discount, a sales discount is based on the invoice price less returns and
allowances, if any.
 Business decide on the amount of discount to offer based on how much cash they are
willing to forgo while ensuring that the discount provides enough incentive for the
customer to pay within the discount period.
 The discount allowed account is increased (debited) for the discounts that are taken by
customers.

May Cash 3430

12
Discount allowed 70
Accounts receivable 3500

(To record collection with in 2/7, n/30

discount period from Sauk Stereo)
A = L + E
+3430 -70
-3500
 Discount allowed is reported as an expense in the statement of profit or
loss and provides information to the management on the amount of
discount taken by customers.
 Sellers offers customers settlement discounts to encourage early payment
of the account and have the cash available for use by the business before
the end of the period.
The Goods and Service Tax

 Business have to deal with a variety of taxes, both direct and indirect taxes.
 The goods and services tax (GST) which is an indirect tax, i.e. a tax on some other
measure of activity rather than directly on income.
 The GST is a value-added tax which means that the tax is levied on the value added by a
business at each stage in the production and distribution chain, i.e. at each stage from
the initial purchase of supplies for production to the final stage where goods and
services are provided to consumers.
 A business is defined broadly in the legislation to include any profession, trade, religious
institution and charitable organization. This makes the GST a broad-based tax, i.e. the
GST is included in the selling price of most goods and services at each stage in the
production and distribution chain. Goods and services which attract a GST are referred
to as taxable supplies.
 In Australia, the rate levied on taxable supplies is 10% and in New Zealand is 15%.
 There are two exceptions where the consumer does not pay GST- GST-free supplies
(zero rated supplies in New Zealand) and input taxed supplies (exempt supplies in New
Zealand).
 GST-free supplies include basic food, education, health services, and exported goods,
which are non-taxable under GST legislation. Input taxed supplies include financial
services and residential rents.
 The difference between GST-free supplies and input taxed supplier can obtain an input
tax credit from the taxation authority for GST-free supplies but cannot obtain a credit
for input taxed supplies.
 It is important to note that, even though GST may be paid on taxable supplies at each
stage in the commercial chain, in most cases it is the final consumer who bears the cost.
That is, the supplier (seller) includes GST in the final selling price, the GST is imposed on
the final private consumption of goods and services, so the supplier does not bear the
cost of the GST but effectively acts as a collector of GST for the taxation authority.
 The Australian Taxation office (ATO) and the New Zealand.
 In relation to taxable supplies, registered supplies receive a credit (called an input tax
credit) for all the GST paid on goods and services purchased in the commercial chain
 At regular intervals (monthly, quarterly or yearly) business must report the amount of
GST paid and collected during a period and discharge any GST liability owing to taxation
authority. The information is provided by filling in a report called a business activity
statement (BAS) (GST return in New Zealand).
 The GST a business pays is received back from the ATO, thus GST paid is an asset (GST
receivable). On the other hand, the GST a business collects is a liability (GST payable)
because the GST is collected on behalf of the ATO.
 GST is generally collected by a business from its customers and clients when goods or
services are supplied (taxable supplies).
 The business also pays GST on goods and services it purchases (creditable acquisitions)
from its suppliers for which it may claim a tax credit.
  The difference between the total amount of GST the business collects on sales and the
total it pays on purchases is remitted to the taxation authority at regular intervals along
with the BAS.
 If the GST paid is greater than the GST collected, the taxation authority refunds the
amount to the business.

Accounting for GST

 To record the GST two separate accounts will be used, one for GST collected and one for
GST paid. However, some businesses prefer to use one GST clearing account rather than
two separate accounts.
 The debits to the GST clearing account represent the GST paid and the credit to the GST
clearing account represents the GST collected.
 The GST clearing account could be an asset or a liability, depending on whether its
balance represents an amount owing to or owing from the taxation authority.

Purchasing Inventory

Note: In a periodic system, the debit is to purchases not to inventory.

 GST paid account represents an asset, a future economic benefit for the firm, as this
amount can be offset against any future GST liability owing to the taxation authority.
 Purchases returns

Selling Inventory

 When the goods are sold an entry is made to record the cost of sales. This does not
involve GST as the inventory is recorded net of any GST.

Sales Returns and allowances

 The sales account is debited only for $500 as the original sales transaction was net of
GST.
 As the goods were returned into inventory, inventory is increased and cost of sales
decreased, again net of any GST as the asset inventory is recorded net of the GST paid.
Settlement discount

Purchase discount

Remitting GST to the taxation authority

 At the end of each taxation reporting period, the business is required to report to the
taxation authority and pay the GST liability.
 If the GST collected is greater than GST paid. The net balance owing to the tax authority
is remitted.
 If the amount of GST paid is greater than the amount of GST collected, a refund will be
paid to the business.

General Journal entry when GST paid is greater than GST collected.

 requires a debit to GST Collected for the total amount of GST collected during the period
(this sets the liability account to nil), a credit to the GST paid account for the total GST
paid for the reporting period; and a debit to cash, which is the refund due from the
taxation authority.

General Journal entry when amount of GST collected exceeds the amount of GST paid
during a period.

 The accumulated amounts of GST collected, and GST paid in each taxation reporting are
cleared by the payment of the GST to the taxation authority. In the next period the GST
collected, and GST paid accounts accumulate amounts for that taxation reporting
period.
 The business could initially record a receivable for the amount owing from the taxation
authority. Then, once the refund is actually received, the business would debit cash and
credit the receivable.
 Some businesses prefer to use one GST clearing account rather than two separate
accounts — one for GST collected and one for GST paid. The GST clearing account could
be an asset or a liability, depending on whether its balance represents an amount owing
to or owing from the taxation authority. Typically, the GST clearing account is a liability
 account because most businesses collect more GST from customers than they pay to
suppliers.

Periodic Inventory Method

 In merchandising business inventory consists of many different items. For example, in a

supermarket, canned goods, dairy products, meats and produce are just a few of the
inventory items on hand.
 These items have two common characteristics: (1) they are owned by the entity, and (2)
they are in a form ready for sale to customers in the ordinary course of business.
 Thus, only one inventory classification, inventory, is needed to describe the many
different items that make up the total inventory for merchandising business.
 In a manufacturing business, some inventory may not yet be ready for sale. As a result,
inventory is usually classified into three categories: finished goods, work in process, and
raw materials.
 Regardless of the classification, most inventories are reported under current assets on
the statement of financial position.
 Finished goods inventory comprises manufactured items that are completed and ready
for sale.
 Work in process (or work in progress) is that portion of manufactured inventory that has
been placed into the production process but is not yet complete.
 Raw materials are the basic materials that will be used in manufacturing but have not
yet been placed into the production process.
 For example, Coca-Cola Amatil classifies beverages, food and equipment ready for sale
as finished goods. Work in progress, spare parts (manufacturing and cold drink
equipment) and fountain stock (post-mix products) are classified as other inventories.
 By observing the levels and changes in the levels of these three inventory types,
financial statement users can gain insight into management’s production plans.
 For example, low levels of raw materials and high levels of finished goods suggest that
management believes it has enough inventory on hand and production will be slowing
down —perhaps in anticipation of a recession. On the other hand, high levels of raw
materials and low levels of finished goods may indicate that management is planning to
increase Production.

What is the Periodic (Physical) Method?

There is no continuous record of inventory transactions

 There is no record of inventory that should be on hand (except for last period’s balance)
 Purchases of inventory is recorded in a temporary ledger account called Purchases
Expense. The acquisition of inventory creates an expense.
 Returning stock to a supplier is recorded in a Purchase Returns account.
 Separate accounts are also created to record discount received and freight costs on
purchases.
 Inventory on hand and COGS are known only after a physical count thus you cannot
determine whether there is an inventory shortage/gain
 We update inventory and calculate COGS at period end

Recording purchases of inventory

 Purchases is a temporary account whose normal balance is a debit. The purchases

account is used to accumulate the cost of all inventory purchased for resale during the
period.

Purchase returns and allowance

 Purchase returns and allowances is a contra purchases account whose normal balance is
a credit.
 The purchase returns and allowances account is credited to record all returns and
allowances rather than directly crediting the purchases account
 This provides management with information on the magnitude of returns and
allowances in one account. It is also important for management to keep track of goods
being returned as it may require management to source goods from different suppliers
if the return of goods is due to inferior quality.
 Freight costs

 Like purchases, Freight-in is a temporary account whose normal balance is debit.

Freight-in is part of cost of goods purchased.
 Freight costs are not subject to a purchase discount. Purchase discounts apply on the
invoice cost of the inventory.

Purchase discounts

Recording the sales of inventory

Given under Periodic, we do not use the Inventory or Cost of Sales accounts DURING the
period, only ONE entry is required:

 To record the sale of of goods - at Selling Price

This entry makes us better off - revenue

(with associated increase in asset - Cash or Accounts Receivable)

Recording Sales and return allowances

Return of goods by a customer.

One entry is required:

1. To record sales return at selling price.

Calculating the Cost of goods sold

Periodic Inventory and Inventory Gain/Loss

 As we do not maintain a continuous record of inventory under the periodic method, we

cannot determine an inventory gain or loss.
 Any actual inventory gain or loss will be assumed to have been sold.
 And, therefore, it is included as part of cost of sales.
Advantages and disadvantages of the perpetual and periodic inventory Methods

Perpetual Inventory Method Periodic Inventory Method

Facilitates the frequency & timeliness Requires a physical stock take to measure
of financial reporting. Cost of sales is profit, stock takes can be costly & disruptive
updated every time a sale is made so
interim financial statements can be
prepared without having to conduct an
inventory count.

Better control & more efficient Not as efficient as it does not maintain
management of inventory. Moreover, records of inventory movements.
Inventory is updated every time a
purchase or sale is made. This means
that entity will be aware of when to
reorder items of inventory.

Can determine stock loss or gains No stock loss or gains recorded; assumes all
stock is sold

Additional clerical work and additional Lower cost & easier recording procedures.
cost to maintain the records, a
computerized system can minimize this
cost. However, some business finds it
either unnecessary or uneconomical to
invest in a computerized perpetual
inventory system. Many small
businesses, in particular, find that a
perpetual inventory system costs more
than its worth. Managers of small
business can control their inventories
and manage day-to-day operations
without detailed inventory records by
simply looking at their shelves

Measurements of Inventories:
  Cost
 Net realizable Value

How inventory is valued?

 According to the accounting standard (AASB 102 par 9) inventory should be

valued at the lower of cost and NRV. This rule is based on the principle of
conservatism. This is done to avoid overstating the asset and profit.
 If NRV< cost, inventory value must be reduced to NRV.

Calculating the cost of Inventory

Cost of inventory includes: (AASB 102 para. 10)

 Cost of purchase
o Purchase price
o Add import duty and other taxes (not GST)
o Less trade discounts

 Cost of conversion
o Labor costs and other overheads

 Other costs incurred to bring the inventories to their present location and condition.
o Freight-in; transit insurance
o Initial testing cost

 AASB 102 para.11 defines cost of purchase as:

(a) the cost of purchase

o purchase price
o PLUS: import duties and other taxes
o inward transport costs (freight-in)
o any other directly attributable costs of acquisition
o LESS: trade discounts, rebates and other similar items

Note*= Only if they are material, we would them as cost of production

(b) the cost of conversion

 (c) other costs ...incurred in the normal course of operation in bringing the inventories to
their present location and condition

Materiality

These incidental costs are often not included as part of product cost because they are
unlikely to be material when compared to the purchase price.

o An item is material if its omission or misstatement is likely to…. Influence

economic decisions (para 29+30-Framework)
o We include them as cost of inventory if the amount is material!!

AASB 1031: Old Standard on materiality

• Has been withdrawn

• Board does not expect withdrawal to change practice
• amount  10% of an appropriate base amount, then material
• amount  5% of an appropriate base amount, then immaterial
• in between: left to professional judgement

Overridden by ‘notion’ that “Omission or misstatement is material if they …. Influence

economic decisions”

NRV (Net Realizable Value)

• NRV is the net amount that an entity expects from the sale of the inventory in the
ordinary course of business (AASB 102 para 7)

Net realizable value is defined in AASB 102 para 6 as “the estimated selling price in the ordinary
course of business less the estimated costs of completion and the estimated costs necessary to
make the sale”.

Examples of these costs include:

o Freight out
o Advertising
o Re-packaging
o Carry bag for customers
o Commission
 Why have the Lower of the cost or Net Realizable Value?

Instances arises when the market price of inventory is less than the cost price

 Obsolescence (perishables past their ‘use by’ date; audio cassette players,
Technological (new/updated models)
 Damage (damaged goods basket at supermarket)
 Demand (‘summer clearance sale’)
 Pressure from competitors to reduce selling price.
 Changing in customer preference.

 AASB 102 para. 9 specifies that inventory should be valued at lower of cost and NRV
 If NRV<cost, inventory value must be reduced to NRV
 This is based on principle of conservatism
 Avoid overstating assets and profits.

In accordance with the principle of conservatism, this decrease in asset value is to be

recognised when it occurs

• This is known as the lower of cost or net realisable value rule!

Implications of using this Rule

• Need to calculate and compare Cost and Net Realisable Value

• This results in the lowest value of inventory being recognised
• Thus, conservative inventory balance carried over to next period

Lecture Illustration 1

Harewood Air Services Co imports and sells small aeroplanes. During the 2018/2019 financial
year, a plane has been ordered and received.

Costs incurred during the period were:

Manufacturer's list price $500,000

Invoice price: $450,000
Import duty $100,000
Freight and insurance $50,000
Advertising $50,000
Rent $150,000

QUESTION?
What is the cost of inventory on 30 June 2019?

Which costs 'attach' to inventory?

Costs
+ Import Duty
+ Freight and Insurance

Are the freight, insurance, and import duties material?

(100,000 + 50,000)/450,000 = 33.33%

Yes – influence economic decisions as more than 10% of invoice price, and can be
directly associated with specific items

Total cost of inventory on hand at 30 June 2019:

Cost. = $450 000
+ $100 000 Import Duty
+ $50 000 Freight
= $600 000
Cost-flow Method

 We have to choose a method to determine cost when prices vary i.e., choose a COST
FLOW METHOD
 AASB 102 (IAS 2) Inventories permits the use of three cost flow methods:
o Specific Identification
o First-in, First out (FIFO), and
o Weighted average

 A fourth approach, last-in, first-out (LIFO) is not permitted in Australia

Choosing between the periodic and perpetual inventory Method

• Perpetual method maintains a continuous record of inventory and COGS

• Periodic method calculates inventory and COGS once a stocktake has occurred at
period end.

Choosing the perpetual or periodic methods will influence COGS and closing inventory
under some cost-flow methods

Specific Identification
  Specific Identified Cost AASB 102 requires that the cost of inventories of items that are
not ordinarily interchangeable, or are produced and segregated for specific projects,
must be assigned a cost by using specific identification. Specific costs are attributed to
specifically identified items of inventory. Such inventory is usually unique for a specific
purpose or contract.
 It must be possible to identify goods in order to use this method
 It is used only when stock is not interchangeable
 Possible when a business sells a limited variety of high-unit-cost items (e.g., houses;
motor vehicles; expensive jewellery) which can be identified clearly from the time of
purchase to the time of sale.
 Not possible or cost-effective for many entities
 A major disadvantage of the specific identification method is that management may be
able to manipulate profit by choosing to supply a good with a low or high unit cost, once
the sale is made to a customer.
 Specific identification tracks each individual items through the inventory flow
o Accurate
o Based on physical flow of goods
o Time-consuming and expensive
 Technology is making identification easier.

Examples for Special Identification

Specific Identification (Periodic Method)

 Specific identification traces the movement of each unit of inventory

 Implies the use of the perpetual inventory method, as continuous records are
maintained
 Specific identification not used in conjunction with the periodic method
 FIFO (first-in, first-out)

 This method applies to interchangeable stock items

 Assumes the first units acquired are first units sold
o Beginning inventory sold first and next earliest purchases thereafter
 FIFO often parallels the actual physical flow of merchandise because it generally is good
business practice to sell the oldest units first, especially with perishable goods.
 Under the FIFO method, therefore, the costs of the earliest goods purchased are the
first to be recognized as cost of sales.
 Ending inventory costed at most recent purchase prices
 That is, under FIFO, the cost of the ending inventory is obtained by taking the unit cost
of the most recent purchase and working backwards until all units of inventory have
been costed.

Note* sequencing of the allocation under the periodic Method:

(1) calculate ending inventory and

(2) determine cost of sales.
 Weighted Average

Ending inventory is valued at a weighted average of all prices paid for inventory during
the period.

1. Periodic Method

Weighted average calculated as:

T otal cost of goods available for sale for a period

Total numbers of units available for sale for a period

2. Perpetual Method

 Moving weighted average, where average price is recalculated after each

purchase
 The average cost is calculated by dividing the cost of goods available for sale by
the units on hand. The average cost is then applied to (1) the units sold, to
determine the cost of sales, and (2) the remaining units on hand, to determine
the ending inventory amount.

LIFO (Last-in, First-out )

  The LIFO method assumes that the last goods purchased are the first to be sold.
 This method applies to interchangeable stock items.
 Not permitted in Australia (AASB 102 Inventories para 25)
 Has been popular in the United States where it is allowed for tax purposes if used for
accounting purposes but is likely to be phased out with the adoption of IFRS in the US -
the actual date for this to happen is still uncertain

 LIFO seldom (not often, rarely) coincides with the actual physical flow of inventory
(exceptions include foods stored in piles, such as coal or hay, where goods are removed
from the top of the pile as sold).
 Under the LIFO method, the costs of the last goods purchased are the first to be
recognized as cost of sales.
 Therefore, ending inventory is based on the costs of the oldest units purchased.

Periodic Method
Perpetual Method under LIFO

 The use of LIFO in a perpetual system will usually produce cost allocations that differ
from using LIFO in a periodic system. In a perpetual system, the latest units purchased
before each sale are allocated to cost of sales.
 In contrast, in a periodic system, the latest units purchased during the period are
allocated to cost of sales

Effects of cost-flow methods on Statement of profit or loss effects

 In periods of changing prices, the cost flow assumption can have a significant impact on
profit and on evaluations based on profit. In most instances, prices are rising (inflation).
 In a period of inflation, FIFO produces a higher profit because the lower unit costs of the
first units purchased are matched against revenues.
 If prices are falling, the results from the use of FIFO and LIFO are reversed where FIFO
will report the lowest profit and LIFO the highest.
 Some argue that use of LIFO in a period inflation enables an entity to avoid reporting
paper profit or phantom profit.
 The use of FIFO results in higher net profit and higher gross profit.
 The use of LIFO results in lower net profit and lower gross profit.
 Weighted average and specific identification results fall between FIFO and LIFO.

Statement of financial position effects

  A major advantage of the FIFO method is that, in a period of inflation, the costs
allocated to ending inventory will approximate their current cost.
 Conversely, a major shortcoming of the LIFO method is that, in a period of inflation, the
costs allocated to ending inventory may be significantly understated in terms of current
cost.
 The understatement becomes greater over prolonged periods of inflation if the
inventory includes goods purchased several years earlier.
 In the United States, a tax rule, often referred to as the LIFO conformity rule, requires
that if LIFO is used for tax purposes it must also be used for financial reporting purposes.
This means that if a company chooses the LIFO method to reduce its tax expense, it will
also have to report lower profit in its financial statements.

Taxation effects

 In the United States, many companies have switched to LIFO.

 The reason is that LIFO results in the lowest income taxes (because of lower profit)
during times of rising prices.

Using inventory cost flow methods consistently

 Whatever cost flow method a business chooses, it should be used consistently from one
accounting period to another.
 Consistent application enhances the comparability of financial statements over
successive periods.
 In contrast, using the FIFO method one year and the average cost method the next year
makes it difficult to compare the profits of the two years.
 Although consistent application is preferred, it does not mean that a business may never
change its method of inventory costing.
 When a business adopts a different method, the change and its effects on profit should
be disclosed in the financial statements.
 For retail business , determining the cost of inventory can be difficult where the
inventory comprises these circumstances IAS 2/AASB 102 permits the use of the retail
inventory method. This method uses the current selling prices of inventory and reduces
selling prices to cost by subtracting average mark-up ratios.

Determining Ending Inventory Value

Use 6 steps with JUSTIFICATIONS

Step 1. Identify cost attached to inventory (discuss materiality).

Cost of inventory consists of:

 Cost of purchase (including import duties, other taxes, transport, and

handling if material) less trade discounts;
 Cost of conversion; and
 Other costs incurred in bringing the inventories to their present location
and condition

 Example of how to write in exam:

 The accounting standard requires that the cost of inventory is purchase price plus
transport in if material. It also requires trade discounts to be deducted if material

Step 2. Select cost of flow method for each product if required

Step 3. Determine cost of ending inventory based on chosen cost flow method.

Example for FIFO:

Example For weighted average cost:

Step 4: Determine Net

Realizable Value (NRV) for each product
Step 5: Compare cost and NRV for each product, and then select the lower value to determine
total value of ending inventory at lower cost and NRV

Step 6: Record inventory write down in general journal (when required) if NRV<cost.