CIMA CO2 Official Learning System - Fundamentals of Financial Accounting
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STUDY MATERIAL C2
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ORGANISING THE BOOKKEEPING SYSTEM
For example, if some items have been bought at a cost of $5 each but, owing to market
conditions, they can be sold for just $6 each and the cost of packaging and delivering them
to customers is $1.50 each, it can be seen that
Cost $5.00
Net realisable value $4.50
In other words, when the items are eventually sold for $6 each there will be a loss of $0.50
per item.
$ $
Selling price 6.00
Less : Purchase cost 5.00
Packaging/delivery cost 1.50
(6.50)
Loss (0.50)
By valuing the inventories at their net realisable value of $4.50 we are recognising the fore-
seeable loss of $0.50 per item.
The fall in value should be recognised as soon as it is known about. Suppose that we
bought 100 of the above items, and sold 60 in the fi rst month, with the remainder being
carried forward to the next month. The calculation of the loss in the fi rst month would be
as follows:
$ $
Sales (60 $6.00) 360
Less : cost of sales
Purchases (100 $5.00) 500
Packaging costs (60 $1.50) 90
590
Less : closing inventory (40 $4.50) (180) (410)
Loss (50)
The whole of the loss is accounted for in the fi rst month, not just the loss on those sold.
In the second month, assuming the remaining items were all sold, the calculation would
be as follows:
$ $
Sales (40 $6.00) 240.00
Less : cost of sales
Opening inventories (as above) 180.00
Packaging costs (40 $1.50) (60.00)
(240.00)
Profi t/(Loss) –
This treatment is an example of applying the convention of ‘ prudence ’ , which is
explained more fully in Chapter 10.
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FUNDAMENTALS OF FINANCIAL ACCOUNTING
ORGANISING THE BOOKKEEPING SYSTEM
8.7.1 The process of inventories measurement
The value of inventories are obtained at a particular point in time – there are two ways to
achieve this: either physically measure the quantity of inventories held at that time and
then value it, or record the movement of inventories on a regular basis and verify such
records randomly over a period of time. These inventories records are then used as the
basis of the measurement.
Physical inventories count
The physical measur
ement of the quantity of inv
entories held at a particular time is known
as a physical inventories count. It is not always possible to count inventories at the time
required and in these circumstances cut-off procedures are applied to adjust the quantity
actually measured to that which would have been measured had the inventories been meas-
ured at the appropriate time.
Example 8.D
On 3 June, a physical inventories count was carried out that revealed that XYZ Ltd held 405 units of inventory.
According to the company’s records they had received a delivery of 250 units on 2 June and had sold 110 units
since 31 May.
Solution
The inventories that existed on 31 May were therefore:
Units
Quantity as per physical inventories count 405
Add : units sold/used before physical inventories count 110
515
Less : units received before the physical inventories count (250)
Theoretical inventorieson 31 May 265
The cost measurement of these items is then obtained by multiplying the quantity by the cost price per unit.
This technique is most common in small organisations. Larger organisations keep records of the movement of
inventories using bin cards or stores ledger cards, but even so they should physically check their inventories from
time to time and compare it with the inventory recorded on the bin or stores ledger card, and make any neces-
sary investigations and/or adjustments.
A bin card is a document, traditionally made of cardboard, on which is manually recorded the movement
of inventory. It is called a bin card because in storekeeping terminology a ‘bin’ is the location of an item in the
stores. This record is usually kept with the items in the stores so that any movement of the inventory is recorded as
it occurs.
The stores ledger card is similar except that in addition to recording quantities, cost values are also recorded
so that the value of inventories can be seen at any time.
Each item of inventory has its own inventory reference code and bin card/stores ledger card.
STUDY MATERIAL C2
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ORGANISING THE BOOKKEEPING SYSTEM
8.7.2 Application of methods of inventory
measurement (also known as cost formulas)
Consider the following information regarding the movements of inventories during
March:
1 Mar. Opening inventories Nil
2 Mar. Bought 10 units @ $3 each
4 Mar. Sold 5 units @ $8 each
7 Mar. Bought 20 units @ $4 each
10 Mar. Sold 15 units @ $8 each
13 Mar. Bought 20 units @ $5 each
17 Mar. Sold 5 units @ $8 each
Using these fi gures we can calculate that the inventories remaining after these transactions
had occurred was 25 units. The diffi culty is in measuring those units. Are the remaining
inventories made up of items bought recently, or is it made up of items bought earlier? Or
is a mixture of the two? How do we know?
Well, in practice, we do not know. It is up to the storekeeper to exercise good man-
agement of inventories, but it is up to the accountant to determine the cost of those
inventories.
Three cost formulas (or methods) are commonly used in fi nancial accounting. Each of
them gives different measurements of the closing inventories. Each of these methods will
now be considered.
First in, fi rst out (FIFO) . This cost formula assumes that the items bought earliest are
those used (or sold) fi rst. This assumption is made only for cost purposes, it does not have
any connection with the physical usage of the inventories.
Stores ledger card FIFO
Date Units
Receipts
$/unit $ Units
Issues
$/unit $ Units
Balance
$/unit $
1 M a r . N i l N i l
2 Mar. 10 3 30 10 3 30
4 Mar. 5 3 15
5 3 15
7 Mar. 20 4 80 20 4 80
10 Mar. 5 3 15
10 4 40 10 4 40
13 Mar. 20 5 100 20 5 100
17 Mar. 5 4 20
5 4 20
20 5 100
Totals
50 210 25 90 25 120
Note that the card is ‘ ruled off ’ each time there is an ‘ issue ’ of inventory.
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FUNDAMENTALS OF FINANCIAL ACCOUNTING
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This cost formula gives a closing inventory cost of $120 and the cost of sales (obtained
by totalling the cost of each issue) amounted to $90. Using this cost formula, the trading
account would be as follows:
$ $
Sales (25 units @ $8) 200
Opening inventories –
Purchases 210
210
Closing inventories (120)
Cost of sales (90)
Gross profi t
110
Last in, fi rst out (LIFO). This cost formula assumes that the items bought most recently
are those used fi rst. Again, this assumption is made only for cost purposes, it does not have
any connection with the physical usage of the inventories.
Stores ledger card – LIFO
Date Units
Receipts
$/unit $ Units
Issues
$/unit $ Units
Balance
$/unit $
1 M a r . N i l N i l
2 Mar. 10 3 30 10 3 30
4 Mar. 5 3 15 5 3 15
7 Mar. 20 4 80 20 4 80
10 Mar. 15 4 60
5 3 15
5 4 2 0
13 Mar. 20 5 100 20 5 100
17 Mar. 5 5 25
5 3 15
5 4 2 0
1 5 5 7 5
Totals 50 210 25 100 25 110
This cost formula gives a closing inventory cost of $110 and the cost of sales (obtained
by totalling the cost of each issue) amounted to $100. Using this cost formula, the trading
account would be as follows:
$ $
Sales (25 units @ $8) 200
Opening inventories Nil
Purchases 210
210
Closing inventories (110)
Cost of sales (100)
Gross profi t
100
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ORGANISING THE BOOKKEEPING SYSTEM
You can see that this results in a higher cost of sales total than with the FIFO cost
formula, and hence a lower gross profi t, in times of infl ation. It also results in a lower clos-
ing inventories fi gure, as the inventories are valued at earlier prices. The cost formula is
not acceptable when preparing fi nancial statements for external reporting although it may
be useful for management accounts. It can be argued that the profi t is more realistic than
with the FIFO cost formula, as it values cost of sales at a value nearer to the current cost of
replacing the inventories sold with new inventories.
Weighted average cost formula (AVCO). This cost formula recalculates a new weighted
average cost each time a new delivery of units is received using the formula:
Previous balance value new reciepts value
P
r
evious units ne
ww units
Issues are then valued at the new weighted average cost.
Stores ledger card – Weighted average
Date Units
Receipts
$/unit $ Units
Issues
$/unit $ Units
Balance
$/unit $
1 M a r . N i l 2 N i l
2 Mar. 10 3 30 10 3 30
4 Mar. 5 3 15 5 3 15
7 Mar. 20 4 80 25 3 95
10 Mar. 15 3.8 57 10 3.8 38
13 Mar. 20 5 100 30 4.6 138
17 Mar. 5 4.6 23 25 4.6 115
Totals
50 210 20 95
This cost formula gives a closing inventories cost of $115 and the cost of sales (obtained
by totalling the cost of each issue) amounted to $95.
Using this cost formula the trading account would be as follows:
$ $
Sales (25 units @ $8) 200
Opening inventories Nil
Purchases 210
Closing inventories (115)
Cost of sales (95)
Gross profi t 105
You can see from this example that, in times of rising prices, the weighted average cost
formula gives a lower closing inventories cost than FIFO and, consequently, a lower profi t,
but a higher closing inventories cost than the LIFO cost formula, and consequently a
higher profi t. It is an acceptable cost formula for reporting in fi nancial statements.
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FUNDAMENTALS OF FINANCIAL ACCOUNTING
ORGANISING THE BOOKKEEPING SYSTEM
It might be useful for you to see the profi t calculation of the three cost formulas
together, to compare them:
FIFO LIFO AVCO
$ $ $
Sales 200 200 200
Less : cost of sales
Opening inventories Nil Nil Nil
Purchases 210 210 210
Less closing inventories (120) (110) (115)
(90) (100) (95)
Gross profi t 110 100 105
8.7.3 Issues and receipts
The three examples above used the words ‘ receipts ’ to mean ‘ purchases ’ and ‘ issues ’ to
mean ‘ sales ’ , but note that ‘ receipts ’ could also include inventories returned by customers,
and ‘ issues ’ could also include inventories returned to suppliers. ‘ Issues ’ could also mean
inventories taken out of the general store and sent to another department, for example, a
production department.
Take care when doing exercises that require you to calculate cost of sales and purchases,
as well as the closing cost of inventories, if your receipts and issues columns contain items
other than sales and purchases. Remember also that the sales column indicates the cost of
sales, not the selling price.
Exercise 8.6
Explain what is meant by inventories cost using FIFO, LIFO and AVCO.
Solution
The FIFO cost formula is based on the assumption that those received fi rst are used fi rst.
This results in those inventories remaining being valued at more recent prices. In times
of rising prices, this cost formula gives lower cost of sales fi gures and hence a higher gross
profi t, and a higher closing inventories cost than might otherwise be the case. The LIFO
cost formula is based on the assumption that those received most recently are used fi rst,
and hence those remaining are valued at earlier prices. The result is a lower profi t fi gure
and a lower inventories cost. The AVCO cost formula incorporates each new purchase
with the existing inventories, weighted according to the quantity purchased. The result is a
profi t fi gure and an inventories cost of somewhere in between the other two cost formulas.
STUDY MATERIAL C2
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ORGANISING THE BOOKKEEPING SYSTEM
Exercise 8.7
M Lord had inventory on 1 January 20 X 1 consisting of 400 articles bought at $4 each.
His purchases during the month of January consisted of 800 at $4.20 each purchased on
8 January, and 2,000 at $3.80 each on 18 January. He sold 2,400 at $5.00 each on 28
January. Forty of those sold were returned in perfect condition on 31 January.
You are required :
(a) to ascertain, by means of an inventory account:
●
the number of articles held in inventory on 31 January 20 X 1;
●
the unit price and total cost of the inventory.
(b) to show the trading account for the month ended 31 January 20 X 1;
(c) to calculate the gross profi t as a percentage of cost of sales.
Note : Lord uses the FIFO cost formula.
Solution
Date Units
Receipts
$/unit $ Units
Issues
$/unit $ Units
Balance
$/unit $
1 Jan. 400 4.00 1,600
8 Jan. 800 4.20 3,360 800 4.20 3,360
18 Jan. 2,000 3.80 7,600 2,000 3.80 7,600
28 Jan. 400 4.00 1,600
800 4.20 3,360
1,200 3.80 4,560 800 3.80 3,040
31 Jan. 40 3.80 152 840 3.80 3,192
(a) Inventory at 31 January – 840 articles.
(b) Unit price $3.80, total cost $3,192.
(A) Trading account for January:
$ $
Sales 12,000
Less : returns (200)
11,800
Opening inventory 1,600
Purchases 10,960
12,560
Less : closing inventory (3,192)
Cost of sales (9,368)
Gross profi t 2,432
Gross profi t percentage 2,432/11,800 20.6%
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FUNDAMENTALS OF FINANCIAL ACCOUNTING
ORGANISING THE BOOKKEEPING SYSTEM
8.8 Summary
This chapter introduced you to a variety of books, records and documents that can assist
in the recording of fi nancial transactions, especially applicable to larger organisations.
These include:
●
daybooks (books of prime entry);
●
the use of the journal;
●
divisions of the ledger;
●
cash books;
●
inventories records.
Much of the chapter is concerned with the physical maintenance of these books and
records, but you should also appreciate how they fi t into the overall system of control of
the bookkeeping system.
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Question 1 Multiple choice
1.1 An organisation’s cash book has an opening balance in the bank column of $485
credit. The following transactions then took place:
●
cash sales $1,450, including sales tax of $150;
●
receipts from customers of $2,400;
●
payments to payables of $1,800 less 5 per cent cash discount;
●
dishonoured cheques from customers amounting to $250.
The resulting balance in the bank column of the cash book should be:
$ … … … …
1.2 An organisation restores its petty cash balance to $500 at the end of each month.
During January, the total column in the petty cash book was recorded as being $420,
and hence the imprest was restored by this amount. The analysis columns, which
had been posted to the nominal ledger, totalled only $400.
This error would result in:
(A) no imbalance in the trial balance.
(B) the trial balance being $20 higher on the debit side.
(C) the trial balance being $20 higher on the credit side.
(D) the petty cash balance being $20 lower than it should be.
1.3 A book of prime entry is one in which:
(A) the rules of double-entry bookkeeping do not apply.
(B) ledger accounts are maintained.
(C) transactions are entered prior to being recorded in the ledger accounts.
(D) subsidiary accounts are kept.
Revision Questions
8