Inventory 2

Let’s have a quick look at…Let’s have a quick look at…

…… what we have done in …… what we have done in

the previous class.the previous class.

We started with …

Accounting for Inventory

Accounting for Inventory

First, we discussed…

What is Inventory?What is Inventory?What is Inventory?What is Inventory?

… are assets :

Held for sale in the ordinary course of business.

Held in the process of such sale.

Being used in the production of goods to be sold.

Held in the form of materials or supplies that will

be consumed in the production process, or in

rendering services.

Packing material for packing goods to be sold.

Spares used in case of fixed assets whose use is

not regular.

Inventory…

To be brief, inventory includes…

Raw Material

Work-in Progress

Finished Goods

Spares

Consumables

Packaging Material

Inventory Inventory

Flow?Flow?

Inventory Inventory

Flow?Flow?

Flows of Inventory …A Retailer or A merchandiser

MerchandiseMerchandisePurchasesPurchases

MerchandiseMerchandisePurchasesPurchases

Cost ofCost ofGoods SoldGoods Sold


MerchandiseMerchandiseInventoryInventory

MerchandiseMerchandiseInventoryInventory

MerchandisMerchandiserer

Flows of Inventory …A Producer or A Manufacturer

DirectDirectLabourLabour

DirectDirectLabourLabour

FactoryFactoryOverheadOverhead

FactoryFactoryOverheadOverhead

Raw MaterialsRaw MaterialsInventoryInventory

Raw MaterialsRaw MaterialsInventoryInventory

Work in ProcessWork in ProcessInventoryInventory

Work in ProcessWork in ProcessInventoryInventory

Finished GoodsFinished GoodsInventoryInventory

Finished GoodsFinished GoodsInventoryInventory



ManufacturManufacturerer

RawRawMaterialsMaterials

RawRawMaterialsMaterials

Where cost flows Where cost flows of Inventory have of Inventory have

impacts?impacts?

Where cost flows Where cost flows of Inventory have of Inventory have

impacts?impacts?

Balance Sheet…

Raw Material

s

Work in Process

FinisheFinished Goodsd Goods

Balance Sheet: Assets Balance Sheet: Assets SideSide

Manufacturing Overhead

Labour

Profit and Loss Account …

Profit and Loss Account: Expenses Profit and Loss Account: Expenses SideSide

Raw Material

s

Work in Process


Opening StockOpening Stock

Purchases and Production and

Conversions Expenses

Raw Material

s

Work in Process


Closing StockClosing Stock

COST O

F GO

ODS SO

LD

Impact of Inventory Flow…Impact of Inventory Flow…

BeginningBeginningInventoryInventory

BeginningBeginningInventoryInventory

PurchasesPurchasesfor the Periodfor the Period

PurchasesPurchasesfor the Periodfor the Period

Ending Inventory(Balance Sheet)

Ending Inventory(Balance Sheet)

Goods AvailableGoods Availablefor Salefor Sale

Goods AvailableGoods Availablefor Salefor Sale

Cost of Goods Sold(Income Statement)

Cost of Goods Sold(Income Statement)

+

+

When to recordWhen to record

Inventory in books Inventory in books

of accounts?of accounts?

When to recordWhen to record

Inventory in books Inventory in books

of accounts?of accounts?

The General Rule is …

… purchases should be recorded by the buyer when the legal title to the goods passes to the buyer.

But, in some cases, it is But, in some cases, it is difficult to determine difficult to determine when the legal title is when the legal title is passed to the buyer?passed to the buyer?

Exception to the General Rule…

Goods in transit

Goods received on approval basis

Consigned goods

Now, let’s proceed further…

Any question?

First, let’s check the understanding of what all we discussed in the previous class…Indicate which of the following items will be typically

reported as inventory in the financial statements.1. Goods out on consignment at another entity’s

store.2. Goods sold on installment basis.3. Goods purchased f.o.b. shipping point that are in

transit on the closing day of the balance sheet.4. Goods held on consignment from another business.5. Temporary investments in bonds that will be sold in

the near future.6. Materials on hand not yet placed into production

process by the closing date of the balance sheet.7. Goods sold f.o.b. destination that are in transit by

the closing date of the balance sheet.8. Office supplies – stationery9. Goods sent to another business firm on approval

basis.

LEAR

NING

BY

TEST

ING

What costs to What costs to

be included be included

in inventory?in inventory?

What costs to What costs to

be included be included

in inventory?in inventory?

General Rule…

The cost of inventories should

comprise all costs of purchasecosts of purchase,

costs of conversioncosts of conversion and other other

costscosts incurred in bringing the

inventories to their present location

and condition.

COSTS OF PURCHASE…COSTS OF PURCHASE… It includes…

Purchase Price Duties and taxes (other than those subsequently

recoverable by the enterprise from the taxing authorities)

Inward freight and Insurance for goods-in-transit Other expenditure directly attributable to the

acquisition.Cost of purchases includes all those expenses that are

incurred to bring the raw material at the desired location.

COSTS OF PURCHASE…COSTS OF PURCHASE…What it does not include…

Trade Discounts and rebates.

Duty Drawbacks, Duties and taxes subsequently

recoverable by a firm from the taxing authorities.

Trade Discount Vs. Cash Discount

COSTS OF CONVERSIONCOSTS OF CONVERSION … It includes all those expenses that are incurred

to convert raw material into work-in-progress and finally, into finished goods. Such a cost is generally called CONVERSION COST.

Conversion Cost includes…

Direct Labour Cost

Indirect Labour Cost (Production)

Other fixed production overheads – Fixed or Variable.

COSTS OF CONVERSIONCOSTS OF CONVERSION …

Costs of Conversion do not include…•Storage Costs, unless those costs are necessary in the production process prior to a further production stage.•Administrative Overheads that do not contribute to bringing the inventories to their present location and condition.•Selling and Distribution Costs.

OTHER COSTSOTHER COSTS …

Other costs are included in the cost of

inventories only to the extent that they

are incurred in bringing the inventories to

their present location and condition.

Testing Understanding…Suggest which of the following will not be considered for the inventory costs…

1. Cost of Insurance of warehouse.

2. Cost of Spares used in production process.

3. Cash Discount.

4. Transportation costs to bring goods to warehouse.

5. Insurance of goods-in-transit.

6. VAT paid on the purchase of raw material.

7. Paid to workers for packing of goods.

8. Expenses related to heating of factory.

9. Salary paid to CEO of the firm.

10. Cost of issuing cheques to the vendors.

What are What are

inventory inventory

systems?systems?

What are What are

inventory inventory

systems?systems?

The issue of Inventory System is …

… should we record transactions related to

inventory INSTANTANEOUSLY or

PERIODICALLY?

… should we record transactions related to

inventory INSTANTANEOUSLY or

PERIODICALLY?

If we record transactions related to inventory INSTANTANEOUSLY, then we are using a System of Inventory which is known as …

PERPETUAL INVENTORY PERPETUAL INVENTORY SYSTEM SYSTEM

If we record transactions related to inventory INSTANTANEOUSLY, then we are using a System of Inventory which is known as …

PERPETUAL INVENTORY PERPETUAL INVENTORY SYSTEM SYSTEM

And, if we are recording transactions related to inventory periodically then, it is called … PERIODIC INVENTORY SYSTEM.

Overview of Perpetual and Periodic Systems

Perpetual system Inventory records are updated whenever a

purchase or a sale is made.

Advances in information technology have

made the cost of using this system practical.

Periodic system Inventory records are not updated when a

sale is made.

Perpetual Inventory System It is a method of recording changes in

inventories on a continuous basis in the Inventory Account.

It provides a continuous record of the balances in both Inventory Account and Cost of Goods Sold Account.

The affordability of the computerized accounting software have made the perpetual system of inventory cost effective for many kind of businesses.

Periodic Inventory System Under this method, some changes in

inventories are record on periodic basis and thus, inventory balances and the cost of goods sold can be determined only on period basis.

It provides a continuous record of the balances in both Inventory Account and Cost of Goods Sold Account.

The affordability of the computerized accounting software have made the perpetual system of inventory cost effective for many kind of businesses.

Taking a Physical Count of InventoryThe actual quantity on hand is determined by

taking a physical count in case of periodic inventory system and a cost is attached to the quantity counted.

With a perpetual system, closing balance of inventory can be taken from the Inventory Account and a physical count can reveal inventory shrinkage or clerical error.

How to find How to find

the the Value of Value of

InventoryInventory??

How to find How to find

the the Value of Value of

InventoryInventory??

The issue of Inventory Valuation requires…

…an assumption about the flow of flow of

inventoryinventory so that we can judge the flow of cost of inventory!!!

Remember…Flow of physical inventory is difficult

to know and hence, there is a need of making an assumption about the physical movement of inventory.

And, according to the physical physical movement assumptionmovement assumption, cost flow is presumed.

In real life, the actual physical flow of inventory and the cost

flow assumption are quite different.

COST FLOW ASSUMPTIONS …

Four assumptions are made with regard to inventory cost flow:

1.Specific Identification,

2.FIFO,

3.LIFO, and

4.Average Cost.

Cost Flow Assumption #1:

Specific Identification

Specific Identification…

In it, identify the movement of each and every item!

When you buy record an item, record it in Inventory Account as a distinct item.

It requires that when an item is sold, charge it against revenue as Cost of Goods Sold (COGS).

Specific Identification…This method requires no assumption about

the flow of inventory units.

This method is used when items:

…are unique.

…can be directly identified with a specific purchase and its invoice.

…are relatively small in number.

…are easily distinguishable.

Where Specific Identification Method can be used?

Examples: Automobiles, custom Examples: Automobiles, custom

furniture, some types of jewelry, art.furniture, some types of jewelry, art.

Examples: Automobiles, custom Examples: Automobiles, custom

furniture, some types of jewelry, art.furniture, some types of jewelry, art.


FIFO – Fast In, First Out.

FIFO… First In, First Out.The assumption about the flow of inventory

made under FIFO is …

•The items are sold/issued in the order they are acquired. It means that an item received FIRST will be sold/issued FIRST.

It means that the oldest units are sold and the newest units remain in inventory.

FIFO… First In, First Out.When a Sale/an issue occurs:When a Sale/an issue occurs:

The The earliest unitsearliest units purchased are purchased are

charged to charged to Cost of Goods SoldCost of Goods Sold..

The cost of the most The cost of the most recent recent

purchasespurchases remain remain in inventoryin inventory..


LIFO – Last In, First Out.

LIFO… Last In, First Out.The assumption about the flow of inventory

made under LIFO is …

•The items are sold/issued in the reverse order they are acquired. It means that an item received LAST will be sold/issued FIRST.

It means that the newest units are sold and the oldest units remain in inventory.

LIFO… Last In, First Out.When a Sale/an issue occurs:When a Sale/an issue occurs:

The The LATEST unitsLATEST units purchased are purchased are

charged to charged to Cost of Goods SoldCost of Goods Sold..

The cost of the The cost of the OLDEST unitsOLDEST units

remain remain in inventoryin inventory..


Average Cost

Average Cost Method…Under this method, no specific assumption is

made about the flow of inventory made.Cost of Goods Sold/Issued is computed by

multiplying the number of units sold/issued by the average cost per unit.

Average Cost is computed for all inventory available for sale during the period.

Average cost per unitAverage cost per unit

Cost of goods available for saleCost of goods available for saleNumber of units available for saleNumber of units available for sale==

Economy & Finance

Inventory 2