accountant – Accounting Crash Course

Inventories or Stocks – Part 3, Cost Formula

In Example 1 of my previous post, Inventories or Stocks – Part 2, Methods of Recording in General Ledger, the cost of purchasing inventories had been fixed in order to show the effect of two different methods of recording in General Ledger clearly. In reality, cost of inventory purchases fluctuates from time to time. Let’s explore the common ways of calculating the cost of inventories when purchase price fluctuates from time to time – This is called the Cost Formula of inventories. There are three common Cost Formulas for inventories: –

FIFO (First-in-first-out)
Weighted Average
LIFO (Last-in-last-out)

Please take note of the difference between Cost Formulas (FIFO, Weighted Average or LIFO) and the methods of recording inventories in General Ledger (Periodic Method or Perpetual Method). A business entity could choose a combination of the following in recording its inventories: –

	Methods of recording in General Ledger	Cost Formula
Combination 1	Periodic	FIFO
Combination 2	Periodic	Weighted Average
Combination 3	Periodic	LIFO
Combination 4	Perpetual	FIFO
Combination 5	Perpetual	Weighted Average
Combination 6	Perpetual	LIFO

As you can see from the above table, the choice of cost formula to be used is independent of how an entity chooses the method of recording inventories in the General Ledger.

Referring to the transactions ABC Co. Ltd. in Example 1 of my previous post, assume the following information for ABC Co. Ltd for the financial year ended 31 December 2006 (i.e. the financial period is for 12 months from 1 January 2006 to 31 December 2006):-

Inventories or stocks on hand as at 31 December 2005 comprised the following:-

Quantity

Unit Cost

Total

$

$

Stock Type A

100

5

500

Stock Type B

200

7

1,400

Stock Type C

250

20

5,000

6,900

15 January 2006

Sale of 50 units of Type A stock for $8 each, on credit. Total sales were therefore $400.
20 January 2006

Purchase of 100 units of Type B stock at $7 each, on credit. Total purchases were therefore $700
21 March 2006

Sale of all Type B stocks for $10 each, on credit. Total sales were therefore $4,000.
31 July 2006

Purchase of 50 units of Type A stock at $6 each, on credit. Total purchases were $300.
30 September 2006

Sale of 75 units of Type A stock at $9 each, on credit. Total sales were $675.
30 November 2006

Sale of 150 Type C stock for $25 each, on credit. Total sales were $3,750.

The following table shows the movement of inventories or stocks of ABC Co. Ltd. during the financial year ended 31 December 2006: –

Table 1	Stock Type A	Stock Type B	Stock Type C
	Quantity	Quantity	Quantity
Balance as at 1 January 2006	100	200	250
Stock in:
20 January 2006		100
31 March 2006	50
Stock out:
15 January 2006	(50)
21 March 2006		(300)
30 September 2006	(75)
30 November 2006			(150)
Balance as at 31 December 2006	25	–	100

You would notice that all the above transactions are exactly the same as shown in Example 1 of my previous post except for Transaction e. The purchase cost of Stock A was $6 per unit instead of $5. The difference in this purchase cost requires certain cost formula to determine value of the inventories in hand as at 31 December 2006 and also to determine the cost of goods sold or cost of sales of 75 units of Stock A sold on 30 September 2007. Please take note that the cost of goods sold for the 50 units of Stock A sold on 15 January 2006 makes no difference in terms of the difference cost formula used because the cost per unit of Stock A prior to the sale of this 50 units of Stock A was $5 per unit (assuming the 100 units of Stock A in hand prior to this sale is from the same batch of purchase). The cost of sale and the unit cost of Stock A during the financial year ended 31 December are shown calculated under the three different cost formulas are below: –

FIFO (first-in-first-out)

Under the FIFO cost formula, the earliest batch of inventories would be given the priority over the subsequent batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 2	Stock Type A
	Quantity	Cost	Value	Refer
		$	$
Balance as at 1 January 2006	100	5	500
Stock out:
15 January 2006	(50)	(5)	*(250)
Balance as at 15 January 2006 after the sale of 50 units	50	5	250
Stock in:
31 March 2006	50	6	300
Balance as at 31 March 2006 after the purchase of 75 units	50 50	5 6	250 300	Note 1
Stock out:
30 September 2006	(50) (25)	(5) (6)	(250) (150)	Note 2
Balance as at 31 September 2006 after the sale of 75 units and remained unchanged until year end	25	6	150	Note 3

Note 1: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $5 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 2: Under FIFO cost formula, the earliest batch of stock in hand i.e. the 50 units of Stock A @ $5 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand was therefore 25 units of Stock A @ $6.

Note 3: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006.

*: The total of $650 ($250 + $250 + $150) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006.

Weighted Average

Under the Weighted Average cost formula, the weighted average cost of all existing inventories on hand plus the new purchases is calculated and allocated to all inventories on hand (both old and new batch of purchases) with the same weighted average cost calculated. Table 3 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 3	Stock Type A
	Quantity	Cost	Value	Refer
		$	$
Balance as at 1 January 2006	100	5	500
Stock out:
15 January 2006	(50)	(5)	*(250)
Balance as at 15 January 2006 after the sale of 50 units	50	5	250
Stock in:
31 March 2006	50	6	300
Balance as at 31 March 2006 after the purchase of 75 units	100	5.5	550	Note 4
Stock out:
30 September 2006	(75)	(5.5)	*(412.5)	Note 5
Balance as at 31 September 2006 after the sale of 75 units and remained unchanged until year end	25	5.5	137.5	Note 6

Note 4: The weighted average cost of $5.5 was calculated by taking the total of the old batch of Stock A (50 x $5 = $250) plus the total of the new batch of Stock A purchased (50 x $6 = $300), divided by the total quantity of new and old stocks – {$250 + $300}/{50units + 50Units} = $5.5.

Note 5: Once the weighted average cost of $5.5 has been determined, the calculation of the cost of goods sold for this 75 units of Stock A is straight forward – 75 units x $5.5

Note 6: The calculation of closing inventories in hand is also straight forward – 25 units x $5.5

*: The total of $662.5 ($250 + $412.5) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

LIFO (last-in-first-out)

Under the LIFO cost formula, the latest batch of inventories would be given the priority over the earlier batch of purchases whenever there is sale of goods. In the case of Stock A, Table 2 shows the movement of the quantity, cost per unit and the respective cost of sales and inventory value:

Table 4	Stock Type A
	Quantity	Cost	Value	Refer
		$	$
Balance as at 1 January 2006	100	5	500
Stock out:
15 January 2006	(50)	(5)	*(250)
Balance as at 15 January 2006 after the sale of 50 units	50	5	250
Stock in:
31 March 2006	50	6	300
Balance as at 31 March 2006 after the purchase of 75 units	50 50	5 6	250 300	Note 7
Stock out:
30 September 2006	(50) (25)	(6) (5)	(300) (125)	Note 8
Balance as at 31 September 2006 after the sale of 75 units and remained unchanged until year end	25	5	125	Note 9

Note 7: The balance of Stock A as at 31 March 2006 comprises two different batches of stock – 50 units @ $6 per unit (This batch of stock was from the original 100 units brought forward from the previous financial year) and 50 units of new purchase @ $6 each.

Note 8: Under LIFO cost formula, the latest batch of stock in hand i.e. the 50 units of Stock A @ $6 each is given priority in terms of sale (“Stock out”). The next batch of stocks in hand due for stock out was therefore 25 units @ $5 from the earlier batch of Stock A.

Note 9: This is the batch of stock in hand after all sales taken into account during the entire financial year ended 31 December 2006

*: The total of $675 ($250 + $300 + $120) was the cost of goods sold or cost of sales for Stock A during the financial year ended 31 December 2006

The double entries for recording inventories under both the Periodic and Perpetual methods had been shown in my previous post. Of course the figures for Stock A are different from those shown in Example 1 of my previous post, depending on which cost formula is chosen. Figures for Stock B and Stock C remained the same.

Did you notice that the three cost formulas shown above give different cost of goods sold and also different inventory value at the end of the financial year?

Another point to note is that LIFO cost formula is prohibited in some countries.

The Income Statement

Remember in my previous post on the Balance Sheet? The Balance Sheet shows the “position” of an entity at a certain point in time. However, the Income Statement shows a different picture than the Balance Sheet – Income Statement or Profit and Loss Accounts is used to match the income/revenue generated by an entity with all the expenses/costs/losses the entity incurred over a specific period of time, normally this is done yearly to arrive at the final outcome, i.e. the Profit for the year/period. Examples of transactions that have an effect on the Income Statement are as follows:-

3. Purchase from trade creditor

Assume ABC Co. Ltd purchase goods worth $2,500 from its supplier, Top Goods Co. Ltd on credit term of 30 days. The double entry to record this transaction is as follows: –

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Purchases			$2,500
Cr Trade Creditor		$2,500

Assume the Balance Sheet of ABC Co. Ltd. BEFORE this transaction is as per Example 2 of my post, “the Balance Sheet”, the impact of this purchase transaction of $2,500 on the Balance Sheet and the Income Statement is as follows:-

ABC Co. Limited
Balance Sheet as at 31 December 2006
	BEFORE	Impact of this purchase transaction of $2,500		AFTER
		Dr	Cr
	$			$
Assets
Computer desk	500			500
Cash at bank	10,000			10,000
	10,500			10,500
Liabilities
Trade creditor-Top Goods Co. Ltd			2,500	(2,500)
Creditor-Mr X	(500)			(500)
				(3,000)
TOTAL (Assets – Liabilities)	10,000			7,500
Owners’ Equity
Paid-up share capital	10,000			10,000
Accumulated loss		2,500		(2,500)
TOTAL	10,000			7,500



ABC Co. Limited
Income Statement for the year ended 31 December 2006
	BEFORE	Impact of this purchase transaction of $2,500		AFTER
		Dr	Cr
	$			$
Sales	–			–
Cost of Sales:-	–
Purchases	–	2,500		(2,500)

Other income	–			–
Other expenses	–			–
Loss for the year	–			(2,500)

Please take note of the following points:-

As there were no transactions affecting the Income Statement before this purchase transaction, all the items in the Income Statement have nil value.
As there was no other income statement transactions during the year ended 31 December 2006 (the meaning is-the relevant period that we are talking about here is from 1 January 2006 to 31 December 2006) except this $2,500 purchase of goods, the loss for the year is therefore $2,500.
The loss for the year of $2,500 would be reflected as Accumulated Loss in the Balance Sheet
The impact of this $2,500 purchase transaction MUST be recorded in pair i.e. one Debit (to the Accumulated Loss in this example) and one Credit (to the Trade Creditor-Top Goods Co. Ltd. in this example) to the Balance Sheet. This is the RULE of Double Entry system in accounting! It applies to ALL transactions, except for those transactions affecting items within the Income Statement e.g. reclassifying one type of expense/income to another type of expense/income or setting off an expense item with an income item (e.g. cash discounts against sales).
When you compare the Balance Sheet “Before” and “After” this $2,500 transaction, you would notice that Trade Creditor-Top Goods Co. Ltd and Accumulated Loss which both show the same amount of $2,500 are the “Impact” or “Changes”. In other words, the “Impact” or “Changes” in the Accumulated Loss (Retained earnings/profits if the entity is making profits) account in the Balance Sheet is the NET RESULT comparing the Balance Sheet between two different points in time and the complete details of this NET RESULT are shown in the Income Statement!

4. Recognition of Closing Inventories or Stock

Logically speaking, by making a purchase of $2,500 but unable to sell the goods would result in what we call inventories or closing stock in hand. In other worlds, the Balance Sheet and Income Statement shown in Example 3 above are incomplete without recording the recognition of closing inventories!

After ABC Co. Ltd. made a purchase of $2,500 from Top Goods Co. Ltd but unable to sell these batch of goods to its customer, ABC Co. Ltd would need to recognise closing inventories of $2,500 before finished preparing its Balance Sheet and Income Statement by the following double entry:-

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Inventories	$2,500
Cr Cost of sales-Closing Inventories				$2,500

The Balance Sheet and Income Statement of ABC Co. Ltd showing the impact of both the purchase of goods from Top Goods Co Ltd. and recognition of closing inventories are as follows:-

ABC Co. Limited
Balance Sheet as at 31 December 2006
	BEFORE	Impact of $2,500 purchase transaction and recognition of closing inventories		AFTER
		Dr	Cr
	$			$
Assets
Computer desk	500			500
Inventories		2,500		2,500
Cash at bank	10,000			10,000
	10,500			13,000
Liabilities
Trade creditor-Top Goods Co. Ltd			2,500	(2,500)
Creditor-Mr X	(500)			(500)
				(3,000)
TOTAL (Assets – Liabilities)	10,000			10,000
Owners’ Equity
Paid-up share capital	10,000			10,000
Retained profit/(Accumulated loss)		2,500	2,500	–
TOTAL	10,000			10,000

ABC Co. Limited
Income Statement for the year ended 31 December 2006
	BEFORE	Impact of $2,500 purchase transaction and recognition of closing inventories		AFTER
		Dr	Cr
	$			$
Sales	–			–
Cost of Sales:-	–
Opening inventories	–			–
Purchases	–	2,500		(2,500)
Closing inventories			2,500	2,500
				–
Other income	–			–
Other expenses	–			–
Profit/(Loss) for the year	–			–

Can you see the differences by comparing the Balance Sheet and Income Statement of ABC Co. Ltd in Example 3 and Example 4. Omission of recognising the closing inventories after adjusting the purchases at year end is still a common mistake that I noticed in my auditing assignments to date!

More Examples

5. Sale of goods to customer

Assume ABC Co. Ltd sells goods worth $3,000 to a customer subsequent to 31 December 2006, let’s say on 3 of March 2007, Mr Y. The double entry to record this transaction is:-

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Trade debtor-Mr Y	$3,000
Cr Sales				$3,000

Let’s consider transaction in Example 6 below before ABC Co. Ltd closes its books for the year ended 31 December 2007 (meaning is to end its financial period and prepare a complete set of final accounts which includes the Balance Sheet and the Income Statement for the financial year ended 31 December 2007) and show the Balance Sheet and Income Statement after this sale of goods transaction.

6. Collections from debtors

ABC Co. Ltd received a cheque of $3,000 from Mr Y on 21 May 2007 and subsequently deposited the cheque into ABC Co. Ltd’s bank account. The double entry to record this transaction is as follow: –

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Cash at bank	$3,000
Cr Trade debtor-Mr Y		$3,000

Before ABC Co. Ltd. closes its books and prepares the Balance Sheet and Income Statement for the year ended 31 December 2007, the following double entry is required to be made to recognise the opening inventories for the year ended 31 December 2007:

	Balance Sheet		Income Statement
	Dr	Cr	Dr	Cr
Dr Cost of sales-Opening Inventories			$2,500
Cr Inventories		$2,500

The Balance Sheet and Income Statement of ABC Co. Ltd. after taking into account these 3 transactions (Sale of goods, Collection from debtor and Recognition of Opening Inventories) are as follows:-

ABC Co. Limited
Balance Sheet as at 31 December 2007
	BEFORE	Impact of the 3 double entries in Example 5 & 6		AFTER
		Dr	Cr
	$			$
Assets
Computer desk	500			500
Inventories	2,500		2,500	–
Trade debtor-Mr Y	–	3,000	3,000	–
Cash at bank	10,000	3,000		13,000
	13,000			13,500
Liabilities
Trade creditor-Top Goods Co. Ltd	(2,500)			(2,500)
Creditor-Mr X	(500)			(500)
	(3,000)			(3,000)
TOTAL (Assets – Liabilities)	10,000			10,500
Owners’ Equity
Paid-up share capital	10,000			10,000
Retained profit/(Accumulated loss)	–			500
TOTAL	10,000			10,500

ABC Co. Limited
Income Statement for the year ended 31 December 2007
	BEFORE	Impact of $3,000 sale transaction and recognition of opening inventories		AFTER
		Dr	Cr
	$			$
Sales	–		3,000	3,000
Cost of Sales:-	–
Opening inventories	–	2,500		(2,500)
Purchases	–			–
Closing inventories				–
				(2,500)
Other income	–			–
Other expenses	–			–
Profit/(Loss) for the year	–			500

	Quantity	Unit Cost	Total
		$	$
Stock Type A	100	5	500
Stock Type B	200	7	1,400
Stock Type C	250	20	5,000
			6,900