This text is an excerpt from a BPP Learning Media study text for the ACCA F3 Financial Accounting exam. It covers fundamental accounting principles and practices, including double-entry bookkeeping, the preparation of financial statements, and the application of accounting standards like IFRS and IAS. The text uses numerous examples and practice questions to explain core concepts such as assets, liabilities, equity, revenue, and expenses. Specific topics addressed include inventory valuation, non-current asset accounting, accruals and prepayments, irrecoverable debts, and provisions. Finally, the excerpt also introduces basic company accounting and cash flow statements.

ACCA F3 Financial Accounting (INT) Study Guide

Quiz

Instructions: Answer the following questions in 2-3 sentences each.

1. What are the three main types of business entities, and provide examples of each?
2. Explain the difference between a debit note and a credit note.
3. Describe the imprest system for managing petty cash.
4. What is the purpose of a receivables ledger?
5. What is the accounting equation, and how does it relate to double-entry bookkeeping?
6. Explain the concept of “lower of cost and net realizable value” in inventory valuation.
7. What are the two main methods of depreciation outlined in the syllabus?
8. What are the key differences between a provision and a contingent liability?
9. What are the advantages and disadvantages of a rights issue of shares?
10. What is a database and how can it be used in accounting?

Quiz Answer Key

1. The three main business entities are sole traders (e.g., local shopkeeper), partnerships (e.g., accountancy practice), and limited liability companies (e.g., public corporations).
2. A debit note is issued by a buyer to a seller to request a credit note for returned goods or overcharges. A credit note is issued by a seller to a buyer to reduce the amount owed, often due to returned goods or refunds.
3. The imprest system maintains a fixed amount of petty cash. Reimbursements are made to the petty cash fund for the exact amount spent, ensuring the balance always returns to the predetermined imprest amount.
4. A receivables ledger keeps track of individual customer accounts, detailing amounts owed for goods or services purchased on credit. It helps manage outstanding receivables and track customer payments.
5. The accounting equation is Assets = Liabilities + Equity. It highlights the fundamental relationship between a company’s resources (assets), its obligations (liabilities), and the owners’ stake (equity). Double-entry bookkeeping ensures every transaction is recorded twice, maintaining this balance.
6. “Lower of cost and net realizable value” means inventory is valued at either its original cost or its estimated selling price less any selling costs, whichever is lower. This reflects the prudence concept by recognizing potential losses from unsold inventory.
7. The two main methods are the straight-line method, which depreciates the asset by a fixed amount each period, and the reducing balance method, which depreciates the asset by a fixed percentage of its remaining book value each period.
8. A provision is a recognized liability with an uncertain timing or amount, but it is probable and can be reliably estimated. A contingent liability is a possible obligation arising from past events, dependent on uncertain future events.
9. **Rights issues raise cash for the company and allow existing shareholders to maintain their proportionate ownership. However, they can dilute shareholders’ holdings if they do not participate. **
10. A database is a structured collection of data accessible for various applications. In accounting, databases can store transaction details, customer information, and financial data for analysis and reporting.

Essay Questions

1. Discuss the importance of the going concern concept in financial accounting. What are the implications for the preparation of financial statements if the going concern assumption is not applicable?
2. Explain the difference between capital reserves and revenue reserves, providing examples of each. What are the implications of this distinction for dividend payments?
3. Describe the various methods for valuing inventory, outlining the advantages and disadvantages of each method. Discuss the factors a company should consider when choosing an inventory valuation method.
4. Explain the concept of depreciation and the reasons for charging depreciation on non-current assets. Discuss the different methods of calculating depreciation and the impact of each method on the financial statements.
5. Describe the process of preparing a bank reconciliation statement. Explain the reasons for differences between the cash book balance and the bank statement balance. Why is it important to regularly reconcile bank statements?

Glossary of Key Terms

TermDefinitionAccruals conceptRevenues and expenses are recognized when they are earned or incurred, regardless of when cash is received or paid.AmortisationThe systematic allocation of the cost of an intangible asset over its useful life.AssetsResources owned by a business that have future economic benefits.Balance sheetA financial statement that shows the financial position of a company at a particular point in time.Capital reservesReserves that cannot be distributed as dividends, often arising from share premiums or asset revaluations.Contingent liabilityA possible obligation that depends on the outcome of uncertain future events.Credit noteA document issued by a seller to a buyer to reduce the amount owed.Debit noteA document issued by a buyer to a seller to request a credit note.DepreciationThe systematic allocation of the cost of a tangible asset over its useful life.Double-entry bookkeepingA system of recording transactions where every transaction is recorded twice, once as a debit and once as a credit.Going concernThe assumption that a business will continue to operate in the foreseeable future.Historical costThe original cost of an asset.Imprest systemA system of managing petty cash where a fixed amount is maintained.Income statementA financial statement that shows the revenues and expenses of a company for a period of time.Intangible assetAn asset that does not have a physical form, such as a patent or trademark.InventoryGoods held for sale or for use in the production process.LiabilitiesObligations of a business that represent future sacrifices of economic benefits.Lower of cost and net realizable valueA method of valuing inventory where it is valued at the lower of its original cost and its net realizable value.MaterialityInformation is material if its omission or misstatement could influence the decisions of users of the financial statements.Net realizable valueThe estimated selling price of an asset less the estimated costs of completion and sale.ProvisionA liability of uncertain timing or amount.Receivables ledgerA ledger that keeps track of individual customer accounts.Retained earningsThe accumulated profits of a company that have not been distributed as dividends.Revenue reservesReserves that can be distributed as dividends.Rights issueAn issue of shares for cash offered to existing shareholders.Share capitalThe capital of a company raised by issuing shares.Sole traderA person who owns and operates a business alone.Straight-line methodA method of depreciation where the asset is depreciated by a fixed amount each period.Tangible assetAn asset that has a physical form, such as property, plant, and equipment.Trial balanceA list of all the accounts in the ledger with their debit and credit balances.

Briefing Document: Financial Accounting Principles and Practices

This document reviews key themes and important information extracted from excerpts of the “007-ACCA F3 – Financial Accounting (INT) Study Text”. The text covers fundamental accounting principles, procedures, and the application of International Accounting Standards (IAS).

I. Business Entities and Fundamental Concepts:

• Types of Business Entities: The text outlines the three main types: sole traders, partnerships, and limited liability companies, providing examples for each.
• Liabilities: Defined as “something which is owed to somebody else”, the text emphasizes the importance of understanding liabilities as the debts of a business. It also highlights the varying repayment durations of different types of liabilities.
• The Regulatory Framework: The International Accounting Standards Board (IASB) plays a crucial role in setting accounting standards. The text stresses the significance of understanding this framework for future accounting professionals.
• Key Accounting Concepts:Going Concern: The assumption that a business will continue to operate in the foreseeable future.
• Prudence: Exercising caution in financial reporting to avoid overstating assets or income and understating liabilities or expenses.
• “However, if Emma had decided to give up selling T-shirts, then the going concern assumption no longer applies and the value of the two T-shirts in the statement of financial position is break-up valuation not cost.”
• Materiality: Focuses on the significance of information in financial statements. An item is material if its omission or misstatement could influence the decisions of users.
• “In assessing whether or not an item is material, it is not only the value of the item which needs to be considered. The context is also important.”

II. Recording Transactions and Accounting Systems:

• Source Documents: The text details various documents used in accounting, including invoices, credit notes, debit notes, and goods received notes, explaining their purposes and uses.
• Sales and Purchase Day Books: These books provide chronological records of sales and purchase transactions on credit. The importance of analyzing sales and returns is also highlighted.
• Petty Cash: The text explains the imprest system for managing petty cash, where a fixed amount is maintained, and reimbursements equal the expenses incurred.
• Ledger Accounts: The nominal ledger contains accounts for assets, liabilities, income, and expenses. The text lists various examples of nominal ledger accounts.
• Double-Entry Bookkeeping: This system ensures every financial transaction is recorded in two accounts, maintaining the accounting equation (Assets = Liabilities + Equity). The text provides detailed examples of double-entry bookkeeping for various transactions.
• Receivables and Payables Ledgers: These ledgers track individual customer and supplier balances, providing detailed information for credit management.
• Control Accounts: These summary accounts in the general ledger reconcile with the corresponding subsidiary ledgers (receivables and payables ledgers) to ensure accuracy.

III. Inventory and Non-Current Assets:

• Cost of Goods Sold: The text explains the formula for calculating the cost of goods sold, emphasizing the importance of adjusting for opening and closing inventory.
• Inventory Valuation: The text outlines different methods for valuing inventory, including:
• Historical Cost
• Net Realisable Value (NRV)
• Current Replacement Cost
• FIFO, LIFO, and AVCO: Different methods of attributing costs to inventory.
• IAS 2 Inventories: The text emphasizes the need to apply the principles of IAS 2 in valuing and presenting inventory.
• Tangible Non-Current Assets:Definition: Assets with a useful life of more than one year that are held for use in the business.
• Depreciation: The systematic allocation of the cost of a non-current asset over its useful life. The text explains the straight-line and reducing balance methods.
• Revaluation: IAS 16 allows for revaluation of non-current assets, and the text explains its implications on depreciation and financial statements.
• Intangible Assets:Definition: Assets without a physical form but having value for the business, such as patents and copyrights.
• Amortisation: Similar to depreciation, it allocates the cost of an intangible asset over its useful life.

IV. Irrecoverable Debts, Provisions, and Company Accounting:

• Irrecoverable Debts: Debts considered uncollectible. The text explains the process of writing off irrecoverable debts and the impact on financial statements.
• Allowance for Receivables: A provision made for estimated uncollectible debts. The text outlines the accounting treatment for creating and adjusting the allowance.
• Provisions and Contingencies: Provisions are liabilities of uncertain timing or amount. The text explains the recognition criteria for provisions and how to differentiate them from contingent liabilities and assets.
• Company Accounting: The text highlights key aspects of company accounting, including:
• Share Capital: The capital contributed by shareholders, distinguishing between authorized, issued, called-up, and paid-up capital.
• Reserves: Profits retained in the company, differentiating between revenue reserves and capital reserves.
• Loan Stock: Long-term borrowings issued by the company.
• Dividends: Distributions of profits to shareholders.

V. Financial Statements and Analysis:

• Preparation of Financial Statements: The text provides detailed examples of preparing income statements and balance sheets for sole traders and companies, incorporating adjustments for inventory, depreciation, and other relevant factors.
• Statement of Changes in Equity: This statement tracks changes in share capital, reserves, and other equity components.
• Analysis of Financial Statements: Techniques for analyzing financial statements are introduced, including calculating ratios and interpreting trends.

VI. Computerized Accounting Systems:

• Computerized Systems: The text discusses the benefits of using computerized accounting systems, highlighting features such as integrated modules, data storage, and automated report generation.
• Databases: A database is a structured collection of data that can be accessed and used by multiple applications. The text emphasizes the importance of databases in modern accounting systems.

VII. Conclusion:

The excerpts provide a comprehensive overview of key financial accounting principles and practices, emphasizing the application of IAS. The text provides clear explanations, numerous examples, and practical exercises to aid in understanding fundamental accounting concepts, recording transactions, preparing financial statements, and analyzing financial information.

Financial Accounting FAQ

What are the main types of business entities?

There are three main types of business entities: sole traders, partnerships, and limited liability companies.

• Sole traders are individuals who own and operate their own businesses. Examples include local shopkeepers, plumbers, and hairdressers. Sole traders can have employees but are personally liable for all business debts.
• Partnerships are formed when two or more people agree to run a business together. Examples include accountancy, medical, and legal practices. Partners share profits, losses, and liability for business debts.
• Limited liability companies are separate legal entities from their owners, meaning the shareholders are not personally liable for the company’s debts. These companies are subject to more regulations and have a more complex structure than sole traders or partnerships.

What is the difference between an asset and a liability?

An asset is something a business owns that has a monetary value. Examples include:

• Cash
• Accounts receivable (money owed to the business by customers)
• Inventory
• Property, plant, and equipment

A liability is something a business owes to someone else. It’s essentially a debt the business has incurred. Examples include:

• Accounts payable (money owed by the business to suppliers)
• Bank loans
• Salaries payable

The relationship between assets, liabilities, and equity is represented by the accounting equation: Assets = Liabilities + Equity.

What is the concept of materiality in accounting?

Materiality refers to the significance of an item or transaction in financial statements. An item is considered material if its omission or misstatement could influence the decisions of users of those statements.

When assessing materiality, consider both the value of the item and its context. For example:

• A $20,000 error in inventory valuation is more material for a small business with $30,000 in inventory than for a large company with $2 million in inventory.
• Incorrectly presenting a $50,000 bank loan and a $55,000 bank deposit as a net $5,000 cash balance is a material misstatement, even though there’s no monetary error.

What is the imprest system for petty cash?

The imprest system is a method for managing petty cash, a small amount of cash kept on hand for minor expenses. Under this system:

1. Petty cash starts with a fixed amount, called the imprest amount.
2. When petty cash runs low, it’s replenished back to the imprest amount.
3. Each replenishment equals the total of petty cash vouchers documenting the expenditures.

This system simplifies accounting for petty cash and helps maintain control over small expenses.

What are control accounts in accounting?

Control accounts are summary accounts in the general ledger that represent the total balances of a group of related accounts in a subsidiary ledger. They provide a check on the accuracy of the subsidiary ledger and help to identify any discrepancies.

The most common control accounts are:

• Receivables control account: Tracks the total amount owed to the business by customers.
• Payables control account: Tracks the total amount owed by the business to suppliers.

What is a bank reconciliation statement?

A bank reconciliation statement is a document that compares the cash balance per the company’s books (cash book) with the balance per the bank statement. The purpose is to identify and explain any differences between the two balances.

Common reasons for discrepancies include:

• Timing differences: Deposits in transit, outstanding checks, etc.
• Errors: Made by either the company or the bank.

How do irrecoverable debts and allowance for receivables differ?

• Irrecoverable debts are specific customer debts considered uncollectible and written off as an expense.
• Allowance for receivables is an estimated amount of uncollectible accounts from the total receivables. It’s a contra asset account that reduces the value of receivables reported on the statement of financial position.

While both relate to uncollectible accounts, irrecoverable debts are specific write-offs, while the allowance for receivables is a general provision for potential bad debts.

What is the difference between a provision and a contingent liability?

Both provisions and contingent liabilities relate to uncertainties and potential future obligations. However, there are key distinctions:

• Provisions are recognized liabilities where it’s probable that an outflow of resources will be required to settle the obligation and the amount can be reliably estimated. Examples: provision for doubtful debts, warranty provision.
• Contingent liabilities are potential obligations that depend on future events. They are not recognized in the financial statements unless it’s highly probable that the obligation will arise and the amount can be reasonably estimated. Examples: potential legal claims, guarantees.

Financial Accounting Fundamentals

Financial accounting is a way of recording, analyzing, and summarizing financial data. [1] The data relates to transactions carried out by a business such as sales, purchases, and expenses. [1] The transactions are first recorded in books of prime entry. [1] The transactions are then analyzed in the books of prime entry, with totals posted to ledger accounts. [1] Finally, transactions are summarized in financial statements. [1]

One of the most basic skills in financial accounting is double-entry bookkeeping, which is essential for preparing financial statements. [2] The main financial statements are the statement of financial position and the income statement. [3]

Financial statements are prepared with certain fundamental assumptions and conventions in mind. [4, 5] IAS 1 identifies four fundamental assumptions: fair presentation, going concern, accruals, and consistency. [5] IAS 1 also considers prudence, substance over form, and materiality to be important. [5] Items in the financial statements can be valued using different bases including historical cost, replacement cost, net realizable value, and economic value. [6]

IAS 8 deals with accounting policies, changes in accounting estimates, and errors. [6] The Framework for the Preparation and Presentation of Financial Statements underpins all IASs and IFRSs. [5, 7] The Framework lists four principal qualitative characteristics of financial statements: understandability, relevance, reliability, and comparability. [8] The Framework defines an asset as a resource controlled by an entity as a result of past events, from which future economic benefits are expected to flow to the entity. [9] It defines income as increases in economic benefits during the accounting period in the form of inflows or enhancement of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. [10] It defines expenses as 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. [10]

There are several users of financial statements. [11]

• Managers use financial information to help make planning and control decisions. [12]
• Investors use the information to assess the risks and returns associated with their investment. [12]
• Employees use it to assess the employer’s stability and profitability and to determine the likelihood of future remuneration and pension benefits. [12]
• Lenders use it to determine whether loans and interest will be paid when due. [12]
• Suppliers and other trade payables use it to assess whether amounts owed to them will be paid when due. [12]
• Customers use it to assess the continuity of an entity especially when they have a long-term involvement with or are dependent on it. [12]
• Governments and their agencies use it to regulate entities, assess taxation, and provide statistics. [12]
• The public uses it to assess an entity’s contribution to the local economy, its impact on the environment, and the trends and recent developments in its prosperity. [12]

Financial statements are prepared to satisfy the information needs of these different groups. [12] The needs of all users will not be equally satisfied. [12]

The International Accounting Standards Board (IASB) issues accounting standards and attempts to harmonize regulations, accounting standards, and procedures. [13, 14] The IASB prepares International Financial Reporting Standards (IFRSs). [15]

• These reduce or eliminate confusing variations in the methods used to prepare accounts. [16]
• They provide a focal point for debate and discussions about accounting practice. [16]
• They oblige companies to disclose the accounting policies used in the preparation of accounts. [16]
• They are a less rigid alternative to enforcing conformity by means of legislation. [16]

IAS 10 covers events after the reporting period, which are those events, both favorable and unfavorable, that occur between the end of the reporting period and the date when the financial statements are authorized for issue. [17]

Financial statements may be prepared manually or using computer accounting packages. [18] Computerized accounting systems have advantages over manual systems:

• They are quicker and more efficient. [19]
• They reduce or eliminate the drudgery of repetitive tasks. [19]
• Information is stored electronically so it is easier to access, copy, and distribute. [19]
• It is easier to introduce checks and controls. [19]

Double-Entry Bookkeeping

Double-entry bookkeeping is a fundamental skill in financial accounting that you will need throughout all your studies [1]. The basic rule is that every financial transaction gives rise to two accounting entries: a debit and a credit [2]. The total value of debit entries in the nominal ledger is always equal to the total value of credit entries [2].

A debit entry will:

• increase an asset.
• decrease a liability.
• increase an expense [2].

A credit entry will:

• decrease an asset.
• increase a liability.
• increase income [2].

Double-entry bookkeeping is based on the idea that each transaction has an equal but opposite effect [3]. This is known as the dual effect or duality concept [4]. For example, if you purchase a car for $1,000 in cash:

• you own a car worth $1,000 (increase in assets).
• you have $1,000 less cash (decrease in assets) [4].

Ledger accounts, with their debit and credit sides, are designed to record this two-sided nature of every transaction [5]. The process of recording transactions in ledger accounts using double-entry bookkeeping is how weekly/monthly totals are transferred from books of prime entry to the nominal ledger [4].

For income and expenses, remember that:

• profit retained in the business increases capital.
• income increases profit.
• expenses decrease profit [6].

This means that in the income and expense accounts:

• a debit will decrease income and increase expenses.
• a credit will increase income and decrease expenses [6].

For example, a cash sale of $250 would be recorded as:

• a debit entry of $250 in the cash at bank account (because cash is received—an increase in assets).
• a credit entry of $250 in the sales account (an increase in income) [7].

Not all transactions are settled immediately in cash. A business can purchase goods or non-current assets on credit. A business might also grant credit to its customers [8]. These credit transactions are recorded in the sales day book and purchase day book, but no entries are made in the cash book [8].

When a credit transaction is settled, the following entries are made:

• When a customer pays:
• Cash is received (debit entry in the cash at bank account).
• The amount owed by trade receivables is reduced (credit entry in the trade receivables account) [9, 10].
• When the business pays a supplier:
• Cash is paid (credit entry in the cash at bank account).
• The amount owing to trade payables is reduced (debit entry in the trade payables account) [9].

Financial Statement Fundamentals

The main financial statements of a business are the statement of financial position and the income statement [1]. For limited liability companies, other information may be required such as a statement of comprehensive income and a statement of cash flows [2].

A statement of financial position is a list of all the assets owned and all the liabilities owed by a business as at a particular date [1]. It is a snapshot of the business’ financial position at a particular moment [1]. A statement of financial position used to be called a balance sheet [3]. The statement of financial position follows the basic accounting equation: assets are equal to liabilities plus capital (equity) [3].

An income statement is a record of revenue generated and expenditure incurred over a given period [4]. The statement shows whether the business made a profit or loss [4]. The period covered will depend on the purpose for which the statement is produced [4]. For example, an income statement that is part of the published annual financial statements will usually be for one year, while management might want to see quarterly or monthly statements to monitor profitability [4].

The statement of financial position and income statement form the basis of most business’ financial statements [2].

Companies also must provide a statement of changes in equity, which details the movements in its capital and reserves [5]. This statement shows the amounts for the current statement of financial position and takes the equity section of the statement of financial position to show movements during the year [6].

IAS 1 provides guidance on the form and content of published financial statements, looking at the statement of financial position, income statement, and statement of cash flows [7]. IAS 1 states that financial statements should be prepared at least annually [8]. It also states that entities should distinguish financial statements from other information published with them [9].

The objective of financial statements is to provide information about the financial position, performance, and cash flows that is useful to users in making economic decisions [10]. They also show the result of management’s stewardship of resources [10].

You noted in our earlier conversation that financial statements are prepared to satisfy the information needs of different groups, such as managers, investors, and employees. According to the Framework for the Preparation and Presentation of Financial Statements, financial statements that meet the needs of investors will meet most of the needs of other users [11]. Financial statements cannot meet all user needs, and they have limitations: they are based on past events and do not necessarily contain non-financial information [12].

International Financial Reporting Standards

Accounting standards are sets of rules and principles that govern the preparation and presentation of financial statements. Their purpose is to promote consistency, comparability, and transparency in financial reporting across different organizations and jurisdictions. [1] Accounting standards have reduced or eliminated confusing variations in the methods used to prepare accounts and they have obliged companies to disclose more accounting information than they would otherwise have done. [2]

There are accounting standards at both the national and international level. This text is focused on International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs). [3] IFRSs are produced by the International Accounting Standards Board (IASB). [3] The IASB develops IFRSs through a process that involves the worldwide accountancy profession. [3] The goal of the IASB is to achieve uniformity in the accounting principles which are used by businesses and other organizations around the world. [4] This is known as international harmonization. [4]

Arguments for Accounting Standards

• They reduce or eliminate confusing variations in accounting methods. [2]
• They provide a focal point for discussions about accounting practice. [2]
• They oblige companies to disclose accounting policies. [2]
• They are a less rigid alternative to enforcing conformity through legislation. [2]
• They have required companies to disclose more accounting information. [5]

Arguments Against Accounting Standards (and for Choice)

• Rules backing one method of preparing accounts may be inappropriate in some circumstances. [5]
• Standards may be subject to lobbying or government pressure. [6]
• Many national standards are not based on a conceptual framework of accounting. [6]
• They may lead to rigidity and less flexibility in applying the rules. [6]

Prior to 2003, standards were issued as IASs. [3] All new standards are designated as IFRSs, although the abbreviation IFRSs is used to encompass both IFRSs and IASs. [3] The IASB has adopted the existing IASs and issued 8 IFRSs. [7]

The consolidated accounts of listed companies in the UK have been required to be produced in accordance with IFRSs since January 2005. [8] In the EU, listed companies have been required to prepare consolidated accounts in accordance with IFRSs since January 2005. [7]

IASs/IFRSs are not intended to be applied to immaterial items, and they are not retrospective. [9] Each standard lays out its scope at the beginning. [9]

The IASB concentrates on the essentials when producing standards to avoid complexity. [10]

IAS 8, Accounting policies, changes in accounting estimates and errors, is an important standard. [11] IAS 8 lays down criteria for selecting and changing accounting policies, and it specifies the accounting treatment and disclosure of changes in accounting policies, accounting estimates, and errors. [11, 12] Key definitions in the standard include: [13, 14]

• Accounting policies: the specific principles, bases, conventions, rules and practices used in preparing and presenting financial statements.
• Change in accounting estimate: an adjustment to the carrying amount of an asset or liability, or to the amount of the periodic consumption of an asset.
• Material: omissions or misstatements of items that could, individually or collectively, influence users’ economic decisions.

You mentioned in our previous conversations that in some cases, a company’s managers may depart from the provisions of accounting standards if they are inconsistent with the requirement to give a fair presentation. This is known as the “fair presentation override.” [15]

You should keep in mind that the standards you are learning affect the content and format of almost all financial statements. [16]

Inventory Valuation Under IAS 2

Inventory, or stock, is one of a company’s most important assets [1]. It represents the goods a business holds for resale or uses to produce goods for sale. It is important to value inventory appropriately as its valuation affects both the income statement and the statement of financial position [1].

Inventory on the Financial Statements

Inventory impacts the cost of goods sold, an expense on the income statement. The basic formula for cost of goods sold is: [2]

• Opening Inventory + Purchases – Closing Inventory = Cost of Goods Sold

Closing inventory is also reported as a current asset on the statement of financial position [3, 4].

Valuing Inventory

The general rule for valuing inventory is the lower of cost and net realisable value [5, 6]. Net realisable value (NRV) is the estimated selling price in the ordinary course of business, less the estimated costs to complete the goods and sell them [7].

There are a number of reasons why NRV might be lower than cost, including: [8]

• Increase in costs
• Decrease in selling price
• Damage to inventory
• Product obsolescence
• Marketing strategy to sell products at a loss
• Errors in production or purchasing

IAS 2, Inventories provides guidance on measuring inventory. [9, 10]. IAS 2 states that inventory should be valued at the lower of cost and NRV [6].

Determining Cost

The cost of inventory includes all costs necessary to bring the inventory to its present location and condition. [11] This includes:

• Costs of purchase
• Costs of conversion (for manufacturers)
• Other costs

Costs of purchase include: [11]

• Purchase price
• Import duties and other taxes
• Transport, handling, and other costs directly attributable to acquiring the inventory
• Less: trade discounts, rebates, and similar amounts

Costs of conversion include costs directly related to units of production such as: [12]

• Direct labor
• Production overheads (both fixed and variable)

It is important to note that selling costs cannot be included in the cost of inventory. [13]

IAS 2 permits the use of the following cost formulas to determine the cost of inventory: [14]

• First in, first out (FIFO): assumes that inventory is sold in the order in which it was purchased.
• Weighted average cost (AVCO): uses a weighted average cost based on the cost of all units in inventory.

The last-in, first out method (LIFO) is not permitted under IAS 2 [14, 15]. You mentioned that LIFO is not permitted in the U.S. either.

The choice of cost formula can impact a company’s profits, as different formulas will result in different closing inventory valuations. [16, 17] These profit differences will even out over time, however. [18]

Applying IAS 2

IAS 2 requires companies to apply the lower of cost and NRV to each item of inventory, or to groups of similar items. [5] It is not appropriate to value total inventory based on the lower of total cost and total NRV, as doing so could mask losses on individual inventory items. [19]

IAS 2 also provides guidance on specific issues related to inventory valuation, such as how to account for:

• damaged or obsolete inventory
• work in progress
• inventory write-downs and reversals

In summary, inventory valuation is a complex area with significant implications for a company’s financial statements. A solid understanding of the principles of inventory valuation is essential for anyone involved in financial reporting.

By Amjad Izhar
Contact: amjad.izhar@gmail.com
https://amjadizhar.blog

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