Unlocking Financial Accounting Chapter 8

Chapter 8 Current assets: valuation of inventory, bad debts and bank reconciliationsLearning summary

By the end of this chapter you should know:• the three types of inventory• that inventory is valued at the lower of cost and net

realisable value• two inventory costing assumptions: FIFO and AVCO• that definite bad debts must be removed from receivables• provision/allowance must be made for debts that might not

be received• bad debt expense = bad debts written off +

increase/(decrease) in provision for bad/doubtful debts• the purpose and importance of the bank reconciliation

process.

Unlocking Financial Accounting Chapter 8

Inventory

• Three types of inventory:

• raw materials

• work in progress

• finished goods.

• Two possible assumptions in costing inventory:

• FIFO (first in, first out): assumes the units of inventory that the company buys first are sold first.

• AVCO (average cost): values units at an average of recent cost prices.

Unlocking Financial Accounting Chapter 8

Net realisable value

• Inventory should be valued in the accounts at the lower of cost and net realisable value (NRV).

• NRV = the price which the inventory is now expected to fetch, minus all expenses needed to complete the sale.

Unlocking Financial Accounting Chapter 8

Receivables and bad debts

• Receivables: amounts due from customers.

• Bad debts: where it is highly unlikely that an amount will be received then that debt is known as a bad debt.

• Bad debts must be written-off (removed from receivables).

• Doubtful debts: where the eventual payment by the customer is possible, but there is some doubt.

• Doubtful debts remain in receivables but a provision (or allowance) must be made.

Unlocking Financial Accounting Chapter 8

Example of bad and doubtful debts

X has total receivables of £900. A customer who owes £100 has just gone bankrupt. There is doubt over 10% of the remaining debts. There was a provision for doubtful debts of £50 last year.

Solution:

Extract from balance sheet: £

Receivables (£900 – £100 write-off) 800

Less provision for bad/doubtful debts (10% of receivables) (80)

720

Extract from income statement: £

Bad debt expense (£100 w/o + £30 increase in provision) 130

Unlocking Financial Accounting Chapter 8

Bank reconciliation

• Involves checking the information on the bank statements against the information in the accounting records.

• Is a vital control procedure to identify errors and omissions.

• Once all errors have been corrected, a bank reconciliation statement is produced.

Unlocking Financial Accounting Chapter 8

Example of a bank reconciliation statement

£

Balance per bank statement 600

Less cheque payments not yet cleared (300)

Add deposits not yet credited 200

Balance per the accounting records 500