Inventory valuation and FIFO in QCE Accounting Unit 3
“Apply the perpetual inventory system and the first-in first-out (FIFO) cost assignment method, maintain inventory cards, and report inventory at the lower of cost and net realisable value”
Under the perpetual inventory system an inventory card is kept for each product, updated for every movement, so the business always knows quantity and cost on hand. FIFO assumes the oldest stock is sold first, so cost of goods sold is costed at the earliest prices and the closing inventory is costed at the most recent prices. Inventory is recorded at cost (GST excluded, because GST is claimed separately through GST Clearing). Every credit or cash sale needs two entries: one to record the sale and GST, and one to transfer the cost of the goods from Inventory to Cost of Goods Sold. At period end, if net realisable value is below cost, inventory is written down to net realisable value, reducing the asset and increasing expense.
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What this dot point is asking
QCAA wants you to track and value the inventory of a trading GST business under the perpetual system, where a continuous record is kept for each line of stock. You maintain an inventory card that records every purchase in, every sale out, and the running balance on hand, assigning cost using first-in first-out (FIFO). You record the two-part entry that a perpetual system requires on every sale, and at period end you value inventory at the lower of cost and net realisable value. Getting the cost flow right drives both cost of goods sold and the inventory asset reported in the balance sheet.
The perpetual system and inventory cards
In a perpetual system the Inventory account is updated continuously rather than only at stocktake. Each product line has an inventory card with three sections: purchases (in), sales at cost (out), and the running balance on hand. Inventory is recorded at cost excluding GST, because the GST paid on a purchase is claimed back through GST Clearing and is not part of the asset's cost. When stock is sold, the card records the cost of the units going out, not the selling price.
FIFO cost assignment
First-in first-out assumes the earliest units bought are the earliest units sold. When a sale is recorded, you take its cost from the oldest layer of stock on the card first, then the next oldest. So cost of goods sold reflects older prices while closing inventory reflects the most recent purchase prices. In a period of rising costs, FIFO produces a lower cost of goods sold, a higher gross profit and a higher closing inventory value than methods using later costs.
The double entry on a sale
Because the perpetual system tracks cost continuously, every sale needs two journal entries. For a cash sale of goods for $880 including GST that cost $400:
Entry 1 records the revenue and GST:
- Debit Cash at Bank $880
- Credit Sales $800
- Credit GST Clearing $80
Entry 2 transfers the cost of the goods out of the asset:
- Debit Cost of Goods Sold $400
- Credit Inventory $400
The $400 comes straight off the inventory card using FIFO. The asset falls and the expense rises by the cost, never the selling price.
Lower of cost and net realisable value
At period end inventory is reported at the lower of cost and net realisable value (NRV), the estimated selling price less any costs to sell. If stock is damaged, obsolete or simply worth less than it cost, NRV is below cost and the inventory is written down: the asset is reduced to NRV and the difference is recorded as an expense. This applies conservatism, ensuring inventory is never reported above what it can realistically fetch.
The data
Harbourtown Cycles stocks one model of helmet. Opening balance at 1 May: 10 units at $30 each. Transactions: 4 May buy 20 units at $32; 12 May sell 18 units; 20 May buy 15 units at $35; 25 May sell 14 units. All costs are GST exclusive.
The inventory card (FIFO)
| Date | In | Out (at cost) | Balance |
|---|---|---|---|
| 1 May | 10 @ 30 = 300 | ||
| 4 May | 20 @ 32 = 640 | 10 @ 30; 20 @ 32 = 940 | |
| 12 May | 10 @ 30; 8 @ 32 = 556 | 12 @ 32 = 384 | |
| 20 May | 15 @ 35 = 525 | 12 @ 32; 15 @ 35 = 909 | |
| 25 May | 12 @ 32; 2 @ 35 = 454 | 13 @ 35 = 455 |
Reading the card
The 12 May sale of 18 units takes the 10 oldest units at $30 first, then 8 of the $32 units, costing 300 + 256 = 556. The 25 May sale of 14 units takes the remaining 12 units at $32 then 2 at $35, costing 384 + 70 = 454.
Cost of goods sold for May = 556 + 454 = 1,010. Closing inventory = 13 units at $35 = 455, the most recent cost layer.
Net realisable value check
If at 31 May the helmets could only be sold for $33 each less $1 selling cost, NRV per unit is $32, below the $35 cost. Inventory would be written down to 13 x 32 = 416, recording a $39 write-down as an expense and reporting inventory at $416.
- Recording the cost out at selling price
- The second entry on a sale uses the cost of the goods from the card, never the sale price.
- Including GST in the inventory cost
- Inventory is valued at cost excluding GST; the GST paid is claimed through GST Clearing.
- Taking newest stock first under FIFO
- FIFO sells the oldest layer first; taking the newest is last-in first-out, which the perpetual FIFO method does not use.
- Writing inventory up to net realisable value
- The rule is the lower of cost and NRV. Inventory is written down when NRV is below cost, never written up above cost.
Exam-style questions
Questions in the style of QCAA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
Practice2 marksExplain one limitation and one benefit of recording inventories at net realisable value.Show worked answer →
One mark for a benefit, one for a limitation. Each needs an explanation, not just a label.
Benefit. Recording inventories at net realisable value (NRV) when NRV has fallen below cost upholds the qualitative characteristic of relevance and the prudence or conservatism convention. It prevents inventory and therefore net profit from being overstated, so the Statement of Financial Position reports the asset at the amount the business could actually realise from selling it. This gives users a faithful, realistic measure of the resource.
Limitation. NRV requires an estimate of the future selling price and of the costs still to be incurred to make the sale. Because it relies on judgement about uncertain future amounts, it is less verifiable and less objective than original cost, which is supported by a source document. Different estimates could produce different inventory values, reducing comparability and opening the figure to manipulation.
Practice1 markOn 30 June 2023, a business conducted a stocktake that revealed a shortage of $6 600 (including GST) between its actual inventories and the book value of inventories. Completing the required balance day adjustment would result in the business's net profit figure (A) increasing by $6 000. (B) decreasing by $6 000. (C) increasing by $6 600. (D) decreasing by $6 600.Show worked answer →
The correct answer is (B) decreasing by $6 000.
Under the perpetual system the ledger shows a book value for inventories, and a stocktake reveals the actual quantity on hand. A shortage means the physical count is less than the records, so inventories must be written down to the counted amount, which records an inventory loss (an expense).
The 6 000. Only the $6 000 net amount is the inventory loss that reduces profit; the $600 GST is an adjustment to GST Clearing, not an expense. Recording the $6 000 expense decreases net profit by $6 000, which is why C and D (which keep the GST in the expense) and A (wrong direction) are incorrect.