## **Learning Outcomes**

After studying this article, you will be able to explain the difference between perpetual and periodic inventory systems, perform inventory counts and necessary adjustments, understand and apply write-downs for slow-moving or obsolete goods, and accurately value and report inventory as required for the ACCA FA2 exam.

## **ACCA Maintaining Financial Records (FA2) Syllabus**

For ACCA Maintaining Financial Records (FA2), you are required to understand the key principles and procedures related to inventory systems, inventory valuation, and year-end adjustments. This article covers:

- The need for inventory counts and adjustments in financial statements
- Recording opening and closing inventories
- Inventory valuation methods (e.g., FIFO and AVCO) and their application
- Identifying and accounting for inventory write-downs (e.g., to net realisable value)
- Completing adjustments to ensure correct reporting of inventory, profit, and net assets
- The impact of incorrect inventory valuation on the financial statements

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which inventory valuation principle requires inventory to be stated at the lower of cost and net realisable value?
   a) Historical cost
   b) Prudence
   c) Accruals
   d) Going concern

2. Why is a physical inventory count necessary even in a computerised inventory system?
   a) To calculate VAT
   b) To detect losses, errors, or obsolete items
   c) To avoid paying customs duties
   d) To update the bank balance

3. True or false? Under the periodic system, inventory balances are updated continuously.

4. Suppose an item of inventory cost \$1,000, but due to damage will now sell for only \$900, with \$100 delivery costs. What value should be reported in the statement of financial position? Briefly explain.

## **Introduction**

Inventory is often one of the largest current assets on the statement of financial position for many businesses. Accurate inventory records and regular adjustments are required not only by accounting standards but also to ensure reliable profit calculation. This article explains the importance of inventory counts, using different inventory systems, recognising adjustments such as write-downs for losses or obsolescence, and ensuring all records meet ACCA FA2 assessment requirements.

> **Key Term: inventory**
> Inventory consists of goods held by a business for resale in the ordinary course of activities, including finished goods and raw materials.

## **INVENTORY SYSTEMS**

A business can use either a perpetual (continuous) or periodic inventory record system.

### Perpetual (Continuous) Inventory System

This system updates inventory records after each transaction. Purchases, sales, and returns are recorded as they occur. The system provides real-time inventory information.

### Periodic Inventory System

Under the periodic system, purchases are recorded as expenses, and inventory balances are updated only at the end of the accounting period after a physical count.

> **Key Term: periodic inventory system**
> An inventory recording method where balances are updated only at specific intervals, usually at period end, following a physical count.

### The Need for Physical Inventory Counts

Regardless of the recording system, businesses must conduct a physical inventory count at least once a year. This serves to verify inventory quantities, identify losses, and detect obsolete or slow-moving goods.

> **Key Term: inventory count**
> A process of physically counting all inventory items held by a business at a specific time to ensure the accuracy of records.

## **INVENTORY VALUATION AND ADJUSTMENTS**

### Valuing Inventory: Cost and Net Realisable Value (NRV)

Accounting standards require inventory to be valued at the lower of its cost or its net realisable value (NRV). Cost includes all expenses to bring the inventory to its present condition and location. NRV is the estimated selling price minus any costs to complete or sell the item.

> **Key Term: net realisable value (NRV)**
> The estimated selling price of inventory in the normal course of business, less costs of completion and costs to sell.
>
> **Key Term: write-down**
> A reduction in the carrying value of inventory where its NRV falls below cost, recognising a loss in the period.

### Write-downs and Obsolete Inventory

If inventory becomes obsolete, damaged, or slow-moving, it may need to be written down to NRV. This recognises a loss immediately in line with the prudence concept—anticipated losses are recorded as soon as they are likely, but profits are only recognised when realised.

### **Worked Example 1.1**

A retailer has 20 units of a toy, each purchased at \$12. Due to a safety issue, they can only be sold at a discounted price of \$8 each, with \$2 per unit as selling costs.

**Question:** What is the correct inventory value per unit and in total?

> **Answer:**
> NRV per unit: \$8 (sale price) - \$2 (cost to sell) = \$6. Since \$6 < \$12, the inventory is valued at \$6 per unit.
> Total inventory: 20 units × \$6 = \$120.

### Adjusting Opening and Closing Inventory

At period end, closing inventory is subtracted from the cost of goods available for sale to determine the cost of inventory sold (cost of sales) in the profit calculation. Accurate recording requires adjusting for both opening (previous closing) and closing inventory.

> **Key Term: closing inventory**
> The value of inventory held at the end of an accounting period, reported as a current asset in the statement of financial position.

## **RECOGNISING AND RECORDING INVENTORY ADJUSTMENTS**

### Impact on Financial Statements

- **Overstated inventory**: Understates cost of sales, overstates profit and assets.
- **Understated inventory**: Overstates cost of sales, understates profit and assets.

### **Worked Example 1.2**

A business records closing inventory as \$7,000, but a correct count reveals only \$5,500. What is the impact?

> **Answer:**
> Profit is overstated by \$1,500. Reducing inventory to the correct amount increases cost of sales and reduces profit. Net assets reported on the statement of financial position are also reduced.

### **Exam Warning**

> A physical count is still required even if all inventory purchases and sales are recorded in a computer system. Inventory losses, theft, or damage may not be detected by system records alone.

## **WRITE-DOWNS AND YEAR-END ADJUSTMENTS**

Inventory may require adjustments at year end for several reasons:

- Obsolescence or expiration
- Damage or decline in selling price
- Losses detected during counts

Adjustments may include:

- Reducing inventory values to NRV
- Writing off lost or missing goods as an expense
- Recognising cost of obsolete or damaged items immediately

### **Worked Example 1.3**

A clothing retailer finds \$1,000 of shirts (cost) have faded and can only be sold for \$700 after \$50 in cleaning costs. What is the correct year-end adjustment?

> **Answer:**
> NRV = \$700 (sale price) - \$50 (cleaning) = \$650. Since \$650 < \$1,000 (cost), write inventory down by \$350 to \$650. The loss of \$350 is recorded as an expense in the profit or loss statement.

### **Revision Tip**

> Always check if NRV is less than cost for each inventory item. Value inventory at cost unless NRV is lower, in which case use NRV.

## **Summary**

Robust inventory records and periodic counts ensure that businesses report the correct value for inventory. Inventory is reported in the statement of financial position at the lower of cost or NRV. Write-downs for obsolete, damaged, or slow-moving goods are recognised immediately as an expense, following the prudence concept. Mistakes in inventory valuation directly affect reported profit, net assets, and regulatory compliance for the ACCA FA2 exam.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- The difference between perpetual and periodic inventory systems
- The function and timing of inventory counts
- How to value inventory using cost and NRV
- The prudence concept and inventory write-downs
- Recording opening and closing inventory
- Adjusting for losses, obsolescence, and year-end valuations
- The effects of incorrect inventory values on profit and assets

## **Key Terms and Concepts**

- inventory
- periodic inventory system
- inventory count
- net realisable value (NRV)
- write-down
- closing inventory

Inventory systems and valuation - Inventory counts, write-downs, and adjustments