FINANCIAL ACCOUNTING
CHAPTER 4:
Inventory and Trading Entities
Chapter Outcomes
After successfully covering the contents of this chapter you must be able to do the
following:
Recognize and explain the difference between consumable and trading
inventories.
Describe and calculate a gross profit.
Calculate the selling price of goods using a mark-up percentage.
Record journal entries using the periodic inventory system.
Record journal entries using the perpetual inventory system.
Post into ledger accounts and maintain records using both systems.
A statement of profit and loss and other comprehensive income with atrading
section.
Show the inventories of a trading entity correctly in the financial statements.
Prepare financial statements of trading entities.
4.1. Introduction
Up to this point, we have dealt with the economic activities of service entities. Providing
services requires the purchase of items that will be used/consumed in the provision of
those services e.g., stationery, ink and paper for a printing press, shampoo,
conditioners, hair bleaches and colorings for a hair salon, etc. Trading entities are
those that buy goods specifically for the purpose of selling those goods at a profit.
However, trading entities also have a need to use consumable materials such as
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stationery and packing material. Therefore, trading entities have more than one
category of inventory i.e., trading inventory (merchandise) and consumable inventory.
4.2. Mark-up and Gross Profit
Trading entities need to ensure that they sell goods at a price that is higher than the
cost so that they can make sufficient income to cover expenses and make a profit.
The difference between the actual selling price and the cost price is known as the
gross profit which must be able to cover selling, distribution, and administration
expenses to make a profit
When an entity buys an item that it wants to sell at a profit, a mark-up (MU) of say
50% on cost price is added to the cost price (CP) to arrive at the expected selling
can buy a 5G
memory stick for R100 and adds a mark-up of 50% on cost price. The suggested
selling price will be:
SP = CP + MU
= R100 + [50% of R100]
= R100 + R50
= R150
If the memory stick is actually sold for R150, the gross profit (GP) is:
GP = SP (actual) CP = R150 10
= R50 (same as MU)
Gross profit % on cost = [R50 / R100 x 100]
= 50% on cost
The gross profit is affected if the memory stick is sold for a price different from R150.
Assume the actual selling price was R140, the GP will then decrease as follows:
GP = SP (actual) CP = R140 100 = R40 (not the same as MU)
GP% = SP (actual) CP = R40 / R100 x 100 = 40% on CP
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In this case, actual is not the same as planned i.e., we expected a GP of R50 but
earned just R40. The actual GP is sometimes less than the MU, because prices of
goods are reduced in a sale, price reduction for damaged goods or settlement
discounts granted to customers. The GP will be the same as the MU only if the goods
are sold at the planned price.
4.3. Inventory systems
There are two methods of keeping records of trading inventories i.e., the periodic
inventory method and the perpetual inventory method. Let us examine the features of
each one:
Features of the two inventory methods:
Transaction Periodic inventory method Perpetual inventory method
Cost of sales Does not have a cost of sales A cost of sales account is
account. updated after every
Cost of sales is calculated at transaction.
the end of every financial Cost of sales is always
period. available.
Trading inventory Physical stock must be taken, A trade inventory account is
and the value of the actual updated after every
stock has to be brought into transaction.
the accounting system as an Theoretical balance is always
asset at the end of the available in the inventory
financial period. account.
Physical stock take confirms
the theoretical balance.
Inventory System does not reveal Comparison between value of
surplus/ inventory surplus or inventory actual physical stock and the
deficit deficit. theoretical stock in the
account reveals an inventory
surplus or an inventory deficit.
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A comparison of the accounting entries for the two systems (ignore VAT):
Transaction Periodic inventory method Perpetual inventory
method
Purchase of goods Debit: Purchases a/c Debit: Inventory - trading a/c
for cash/credit. Credit: Bank/Trade Credit: Bank/trade
Creditors amount: Cost price Creditors amount: Cost
of goods. price of goods
Purchasing costs Debit: Purchasing cost a/c Debit: Inventory - trading
are incurred to bring Credit: Bank/trade Creditors a/c
goods to the amount: purchasing cost Credit:
premises e.g., Bank/trade
railage inward creditors
expense. Amount: purchasing cost
Sale of goods for Selling price: Selling price:
cash/credit
Debit: Bank/trade Debit: Bank/trade debtors
Credit: Sales Credit: Sales
Amount: Selling price Amount: Selling price
Cost price: Cost price:
System does not record cost price Debit: Cost of sales
of goods sold on a transaction-by- Credit: Inventory - trading
transaction basis. a/c
Amount: Cost price of goods
sold
Recording trading Debit: Inventory - trading a/c Use the value per stock sheets
inventory on hand at Credit: Trading account (final to update the inventory -
year end a/c). tradinga/c.
Amount: Value per stock
sheets. When total value on
Recording deficits stock sheets is less than
and surpluses NB: The periodic inventory the balance in Inventory
method does not specifically trading account
identify stock deficits or stock
surpluses as part Record inventory deficit:
of its recording procedure. Debit: Inventory/stock deficit
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Therefore, no accounting entry is Credit: Inventory - trading
made for trading inventory deficits a/c.
and trading inventory surpluses Amount: difference in amount
in the periodic inventory method.
When total value on
stock sheets is more
thanthe balance in
Inventorytrading
account.
Record inventory
surplus:
Debit: Inventory trading
a/c.Credit: Inventory surplus
Amount: difference in amount
4.3.1. Illustrative example
Eric Ngidi decided to begin his own business, Incredible Deals, buying and selling
laptops. He arranged a loan of R50 000 for which his brother stood as guarantor. He
purchased 20 laptops at R2 000 each and marked them up at 150% on cost price to
sell them at R5 000 each. Incredible Deals was not registered as a vat vendor.
During the first month of business ended 30 April 2021, Eric had sold 15 laptops at the
marked price of R5 000 each for cash and deposited all monies into the business bank
account. On 30 April 2021, Eric counted that he had four laptops in his storeroom. He
immediately knew that something was wrong but was unsure of how to report it to his
brother who demanded that Eric prepare reports at the end of every month. He
ribution and administration expenses for the
month amounted to R6 000. All transactions were for cash only.
Illustrative example: Solution
Let us record the above trading transactions using both inventory methods. Post to
the relevant ledger accounts. Record closing transfer journal entries and post to a
profit and loss account. After recording all the accounting entries, we will take a look
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at how we show the information relating to trading activities in the financial statements.
Record the above transactions using both methods:
Transaction Periodic inventory method Perpetual inventory method
Purchase of goods for Debit: Purchases Debit: Inventory trading a/c
cash - R40 000 Credit: Bank Credit: Bank
(R2 000 x 20) Amount: R40 000 Amount: R40 000
Sale of goods for cash- 1. Selling price: 1. Selling price:
R75 000 (R5 000 x 15) Debit: Bank Debit: Bank
Credit: Sales Credit: Sales
Amount: R75 000 Amount: R75 000
2. Cost price: 2 Cost price:
System does not record Debit: Cost of Sales
cost price of goods sold Credit: Inventory
on a transaction by Amount: R30 000
transaction basis. (R2 000 x 15)
Recording trade inventory Debit: Inventory - trading Inventory - trading a/c has a
on hand at year end. Credit: Trading account Balance of R10 000
Total per stock sheets: Amount: R8 000 Actual (stock sheets) is less
= R8 000 (actual stock). than theoretical balance in a/c:
R8 000 R10 000 = - R2 000
Record inventory deficit:
Recording inventory surplus
Debit: Inventory deficit
or inventory deficit. NB: Periodic inventory
Credit: Inventory trading a/c
In this case there is a method does not have a
Amount: R2 000
Deficit of R2 000 theoretical balance in the
account to which actual
on stock sheets can be
tested/compared.
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Post to relevant ledger accounts (without the adjustment for Inventory deficit):
Periodic inventory method Perpetual inventory method
Dr Purchases (Ex) Cr Dr Inventory trading (A) Cr
Bank 40 000 Bank 40 000 Cost of sales 30 000
Balance c/d 10 000
40 000
40 000
Balance b/d 10 000
Dr Sales (I) Cr Dr Sales (I) Cr
Bank 75 000 Bank 75 000
Dr Inventory trading (A) Cr Dr Cost of sales (Ex) Cr
Trading a/c 8 000 Inventory trading 30
000
Record closing transfer journal entries on 30 April 2021:
We are going to use a rading account (final account) that is created at the end of
every financial period to close of all the trading accounts and thereby calculate the
gross profit.
Gross Profit = Sales less Cost of sales
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Transaction Periodic inventory method Perpetual inventory method
Close income Debit: Sales Debit: Sales
account Credit: Trading a/c Credit: Trading a/c
Amount: R75 000 Amount: R75 000
1. Close all Debit: Trading a/c Debit: Trading a/c
trading expense Credit: Purchases Credit: Cost of sales
accounts Amount: R40 000 Amount: R30 000
2. Account for Debit: Inventory - trading Debit: Inventory deficit (P & L)
physical inventory Credit: Trading a/c Credit: Inventory trading a/c
taken at month end. Amount: R8 000 Amount: R2 000
3. Account for Debit: Trading a/c Debit: Trading a/c
gross profit and Credit: Profit and loss a/c Credit: Profit and loss a/c
close the trading Amount: R43 000 Amount: R45 000
a/c.
Post the closing transfers to accounts (including adjustment for Inventory deficit)
Income and expense accounts: Assume Selling expenses = R6 000
Periodic inventory method Perpetual inventory method
Dr Purchases (Ex) Cr Dr Inventory trading (A) Cr
Bank 40 000 Trading a/c 40 000 Bank 40 000 Cost of sales 30 000
Balance c/d 10 000
40 000
40 000
Balance b/d 10 000 Inventory. deficit 2
000
Dr Sales (I) Cr Dr Sales (I) Cr
Trading a/c 75 000 Bank 75 000 Bank 75 000
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Dr Inventory trading (A) Cr Dr Cost of sales (Ex) Cr
Trading a/c 8 000 Inventory trading 30 000
Dr Inventory deficit Cr Dr Inventory - deficit (Ex) Cr
No deficit nor surplus shown Inventory trading 2 000
in the periodic inventory system
Final accounts: usually prepared at the end of the financial period to determine:
in the Trading account.
Profit and loss account.
Periodic inventory method Perpetual inventory method
Dr Trading account (F) Cr Dr Trading account (F) Cr
Purchases 40 000 Inventory 8 000 Cost of sales 30 000 Sales 75 000
P&L: GP 43 000 Sales 75 000 P&L- GP 45 000
83 000 83 000 75 000 75 000
Dr Profit and loss a/c (F) Cr Dr Profit and loss a/c (F) Cr
Selling exp. 6 000 Trading: GP 43 000 Selling exp. 6 000 Trading: GP 45 000
Capital: profit 37 000 Inv. Deficit 2 000
43 000 43 000 Capital: profit 37 000
45 000 45 000
Note that, using the periodic inventory method, the gross profit (GP) is calculated to
be R43 000 while using the perpetual inventory method the GP is calculated to be R45
000 method. Eric sold 15 laptops at a GP of R3 000 each (R5 000 less R2 000) which
should realize a total GP of R45 000. Therefore, gross profit calculated in the perpetual
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inventory method is more accurate.
i.e., R37 000. The
perpetual inventory method shows an additional expense of R2 000 called an
we arrive at a net profit that is the same as the periodic inventory system. This
additional expense of R2 000 gives Eric reason to investigate the deficit and find
explanations for the missing computer.
4.4. Financial Statements
The statement of profit or loss and other comprehensive income will be extended to
accommodate a trading section whereby a calculation of the gross profit can be
presented. Inventories shown under current assets in the statement of financial
position will now consist of two categories i.e., trading inventory and consumable
inventory.
The following is a template of the statement of profit or loss for a trading entity:
Periodic inventory method Perpetual inventory method
R R
Sale xxxxxx Sale xxxxxx
Cost of sales (xxxxx) Trading Cost of sales (xxx xx)
Opening inventory xxxxx Gross profit xxxxxx
Purchases xxxxx
Purchasing costs xxxxx section
xxxx
Total goods available xxxxxx
Closing inventory (xxxxx)
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Gross profit xxxx
Profit and loss
Other income xxx Other income xxx
section
Distribution, selling & admin (xxx) Distribution, selling & admin (xxx)
Finance costs (xxx) Finance costs (xxx)
Profit for the period xxxx Profit for the period xxxx
Other comp. income xxxx Other comp. Other comp income xxxx
Total comp. income xxxxx .section Total comp. income xxxxx
Eric Ngidi
Statement of profit or loss and other comprehensive income
for the month ended 30 April 2021:
Periodic inventory method R Perpetual inventory method R
Sales 75 000 Sales 75 000
Cost of sales (32 000) Cost of sales (30 000)
Opening inventory nil Gross profit 45 000
Purchases 40 000 Selling expenses (6 000)
Total goods available for sale 40 000 Inventory deficit (2 000)
Profit for the period * 37 000_
Closing inventory (8 000)
Gross profit 43 000
Selling expenses (6 000)
Profit for the period * 37 000
Showing inventory as an asset in the financial statements:
Assume that Eric Ngidi has trading inventory to the value of R8 000 and stationery to
the value of R700 on hand as of 30 April 2021. These are assets from which Eric will
receive benefits in the future and as the benefits are expected to be received within
the next 12 months, they are regarded as current assets. Show how these will be
reflected in the financial statements.
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Eric Ngidi
Statement of financial position as of 30 April 2021
ASSETS R
Current assets 8 700
Inventory Note 8 8 700
Eric Ngidi
Notes for the year ended 30 April 2021
R
Note 8: Inventories 8 700
Merchandise (Trading inventory) 8 000
Consumable inventory 700
4.5. Valuation of Inventory
When an entity purchases inventory items at different prices, any inventory not sold at the
end of the financial period must be valued to show the item as part of the inventory asset.
Inventory must be valued on a method based on the actual costs to acquire the items. The
following methods can be used to value inventory:
Specific identification method: Actual cost of a particular item is used to calculate the value
of that type of inventory. This type of valuation is more easily implemented in an
environment where electronic methods and computerised equipment is used to track
purchases, sales, and inventory through bar codes etc.
Weighted average cost method: The weighted average cost is determined by dividing the
total cost of inventory bought for the period by the total number of units purchased to arrive
at a weighted average unit cost. For example: Let us say that during March 2021, we
purchased 1 200 pens at various cost prices ranging from R1,00 to R1,40 each. 800 Pens
were sold at R4,00 each and 400 pens were on hand. Calculate the value at which 400
pens be shown as of 31 March 2021. Examine the table below that summarises the buying
and selling of pens.
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Inventory Pens No. of Units Unit Price (R) Cost of Sales (R)
Month: March 2021
Date purchased
01/03/2021 200 1,00 200
07/03/2021 600 1,10 660
17/03/2021 400 1,20 480
24/03/2021 600 1,30 780
30/03/2021 200 1,40 280
2000 2400
Weighted average cost (WAC) = Total cost / total no. of units = R2400 / 2000 = R1,20 pens.
No. of units on hand = Purchases less sales in units = 2000 – 1200 = 800 pens
Value of stock on hand as of 31 March 2019 = 800 x R1,20 = R960
First-in first-out (FIFO) method: In this method an assumption is made that the item that
was purchased first will be sold first. Valuation of inventory on hand is based on that
principle
Inventory No. of Unit Price Sales On Hand Cost of Cost units
Pens Units (R) Units Units Sales (R) on hand
Month:
March
2021 Date
01/03/2021 200 1,00 200 --- 200,00 ---
07/03/2021 600 1,10 600 --- 660,00 ---
17/03/2021 400 1,20 400 --- 480,00 ---
24/03/2021 600 1,30 --- 600 --- 780,00
30/03/2021 200 1,40 --- 200 --- 280,00
2000 (1200) 800 1280,00 1060,00
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