How does a trading GST business record and value its inventory so that cost of goods sold and the asset reported are accurate?
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
A worked QCE Accounting Unit 3 answer on valuing inventory in a trading GST business. Covers the perpetual inventory system, maintaining inventory cards under first-in first-out (FIFO), recording purchases, sales and cost of goods sold, inventory write-downs to net realisable value, and the effect of valuation on profit.
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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 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.
Exam-style practice questions
Practice questions written in the style of QCAA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
2023 QCAA2 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.
2023 QCAA1 marksOn 30 June 2023, a business conducted a stocktake that revealed a shortage of 6 000. (B) decreasing 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 600 GST is an adjustment to GST Clearing, not an expense. Recording the 6 000, which is why C and D (which keep the GST in the expense) and A (wrong direction) are incorrect.