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ACCA Applied Knowledge · Financial Accounting

Inventories for ACCA Financial Accounting: Chapter Guide

Inventories are goods held for sale, in production, or as materials. Under IAS 2 you value them at the lower of cost and net realisable value, item by item. To solve questions, work out cost with FIFO or AVCO, compare it with NRV, then post the closing inventory entries.

What this chapter covers

This chapter covers how a business measures and records the goods it holds. Inventory is a current asset in the statement of financial position, and it also drives cost of sales in the statement of profit or loss. The core rule comes from IAS 2 Inventories: measure inventory at the lower of cost and net realisable value (NRV).

You need four skills. First, know what goes into cost and when NRV is lower. Second, apply the costing methods, FIFO (first in, first out) and AVCO (average cost), to find closing inventory and cost of sales. IAS 2 does not allow LIFO (last in, first out), but you should still understand what it assumes. Third, understand how inventory is counted and how records are checked. Fourth, post the entries for opening and closing inventory, and adjust a count taken on a date other than the year end.

This chapter links to much of the paper. Cost of sales feeds the statement of profit or loss and gross profit. Closing inventory appears in the statement of financial position. Errors in inventory change profit, and so change the figures in accounts preparation questions and the trial balance. Inventory also appears in consolidations, where unrealised profit in group inventory must be removed. Both Section A and the longer Section B questions can test it.

Inventory is a small chapter with high reliability for marks. Section A has 35 two-mark objective test questions, and inventory fits naturally into them: a quick FIFO or AVCO calculation, an NRV comparison, or a choice of the correct journal. Each is short and can be done with care in a minute or two. The same ideas also sit inside the larger accounts preparation question, where a wrong closing inventory figure ruins gross profit, profit for the year and total assets. Mastering this chapter early gives you quick, dependable marks and protects your marks in the bigger questions.

Inventories: topics in the order to study them

  1. 1Inventory Valuation under IAS 2Start with the core rule of lower of cost and NRV, because every later calculation feeds into it.
  2. 2Inventory Costing Methods: FIFO, AVCO and LIFOOnce you know what cost means, learn how to calculate it when purchase prices change.
  3. 3Inventory Counting and RecordsNext see how the physical quantity is found and checked, since cost is applied to those quantities.
  4. 4Inventory Adjustments and Accounting EntriesFinish with the journals and year-end adjustments, which pull valuation, costing and counting together.

How to prepare Inventories

Use a short, practice-heavy plan. The theory is brief, so most of your time should go on calculations and entries.

  1. Learn the IAS 2 rule in one sentence: inventory is measured at the lower of cost and NRV. Then learn what cost includes (purchase price, import duties and non-recoverable taxes, conversion costs, other costs to bring it to its location and condition) and what is excluded (abnormal waste, storage costs not needed in production, administrative overheads, selling costs).
  2. Define NRV as estimated selling price less estimated costs to complete and costs necessary to make the sale. Practise comparing cost with NRV for each item separately, not on the total.
  3. Do FIFO and AVCO on the same data set. Write each receipt and issue in a table, and keep running quantities. Check that both methods give the same total units in closing inventory.
  4. Practise the inventory count topics: counts at the year end, counts on another date, and rolling back or forward to the year-end figure. Work out whether receipts and issues between the dates need adding or subtracting.
  5. Drill the entries. For closing inventory, debit inventory in the statement of financial position and credit cost of sales. For opening inventory, debit cost of sales. Then trace the effect on gross profit and profit.
  6. Finish with timed mixed questions. Practise multiple choice, multiple response and number entry in the same session. Read each option and check units, rounding and whether the question asks for cost of sales or closing inventory.

Common mistakes in Inventories

  • Comparing total cost with total NRV instead of item by item

    Fix: Compare cost and NRV for each item or group of similar items, take the lower figure for each, then add them up.

  • Forgetting to deduct selling costs from selling price when finding NRV

    Fix: Always write NRV = selling price − costs to complete − costs of sale, and fill in each part before comparing.

  • Mixing up FIFO and AVCO closing inventory

    Fix: Use a running table. For FIFO, closing inventory comes from the latest purchases. For AVCO, use the average cost at the time and recalculate after each receipt if using a perpetual approach.

  • Including overheads or costs that IAS 2 excludes

    Fix: Include only costs that bring inventory to its present location and condition. Leave out selling costs, general administration and abnormal waste.

  • Putting the closing inventory entry on the wrong side

    Fix: Closing inventory reduces cost of sales, so it is a credit there and a debit to the asset. Then check whether profit moves in the expected direction.

  • Adjusting a count taken on a different date in the wrong direction

    Fix: Start with the counted value and work to the year end. Items sold after the year end were still in inventory at year end, so add them back at cost. Items received after the year end were not, so remove them.

Last-day revision: Inventories

  • IAS 2: measure inventory at the lower of cost and net realisable value.
  • Apply the lower-of rule to each item or group of similar items, not to the grand total of all inventory.
  • Cost includes purchase price, non-recoverable taxes, conversion costs and other costs to bring items to their present location and condition.
  • Exclude abnormal waste, selling costs, administrative overheads and storage that is not part of production.
  • NRV = estimated selling price − estimated costs to complete − estimated costs to make the sale.
  • FIFO assumes the oldest items are sold first, so closing inventory is valued at the most recent prices.
  • AVCO uses a weighted average cost: total cost of units available ÷ total units available.
  • IAS 2 does not permit LIFO.
  • When prices rise, FIFO gives higher closing inventory and higher profit than AVCO.
  • Cost of sales = opening inventory + purchases − closing inventory.
  • A count on a different date must be adjusted for receipts and issues between that date and the year end.
  • Inventory valued too high increases profit; valued too low decreases profit.

Inventories practice questions

Inventories in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Inventories: frequently asked questions

What is the lower of cost and net realisable value?

It is the IAS 2 rule for measuring inventory. You compare the cost of each item with its NRV and use the lower figure. This stops assets being shown above the amount the business expects to recover.

Is LIFO allowed under IAS 2?

No. IAS 2 does not permit LIFO. You may still see it in a question, so understand that it assumes the newest items are sold first. Answer using the method the question tells you to use, and remember it is not accepted under IFRS.

What is the difference between FIFO and AVCO?

FIFO assumes the oldest inventory is used or sold first, so closing inventory is priced at the latest costs. AVCO uses a weighted average cost for all units available. When prices change, the two give different closing inventory and cost of sales figures.

How does inventory affect profit?

Closing inventory is deducted in cost of sales. A higher closing inventory lowers cost of sales and raises gross profit and profit. A lower figure does the opposite. Opening inventory moves in the reverse direction because it is added to cost of sales.

How should I practise inventory for the computer-based exam?

Practise short calculations in all three question types. Do each by hand with a running table, then check units and rounding. In multiple response questions, select exactly the number the question states.