FINANCAIL ACCOUNTING COURSE PART 1

1 ACCOUNITNG IN ACTION

2 THE RECORDING PROCESS

3 ADJUSTING THE ACCOUNTS

4 COMPLETING THE ACCOUNTING CYCLE

5 ACCOUNTING FOR MERCHANDISING OPERATIONS

6 INVENTORIES

7 FRAUD, INTERNAL CONTROL, AND CASH

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CHAPTER 06: ADJUSTING THE ACCOUNTS

6.1 Classifying Inventory

6.2 Determining Inventory Quantities

6.3 Inventory Costing

6.4 Inventory Errors

6.5 Analysis through Inventory turnover

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 6.1 Classifying Inventory
How a company classifies its Finished goods inventory is
inventory depends on whether the manufactured items that are
firm is a merchandiser or a completed and ready for sale.
manufacturer.
In a merchandising company need Work in process is that portion of
only one inventory classification, manufactured inventory that has
merchandise inventory, to describe been placed into the production
the many different items that make process but is not yet complete..
up the total inventory.
Raw materials are the basic goods
In a manufacturing company usually
that will be used in production but
classify inventory into three
have not yet been placed into
categories:-
production.
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6.2 Determining Inventory Quantities
All companies need to determine inventory quantities at the end of the
accounting period.
REASON FOR TAKIN A PHYSICAL INVENTORY REASON FOR TAKIN A PHYSICAL INVENTORY
UNDER PERPETUAL UNDER PERIODIC

1. To check the accuracy of their 1. To determine the inventory on

perpetual inventory records. hand at the statement of
2. To determine the amount of financial position date, and
inventory lost due to wasted 2. To determine the cost of goods
raw materials, shoplifting, or sold for the period.
employee theft.

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6.2 Determining Inventory Quantities

Determining inventory quantities involves two steps:

Taking a physical inventory of Determining the ownership of

goods on hand goods.
Companies take a physical To determine ownership of goods,
inventory at the end of the two questions must be answered:
accounting period. Taking a Do all of the goods included in the
physical inventory involves count belong to the company?
actually counting, weighing, or Does the company own any goods
measuring each kind of inventory that were not included in the
on hand. count?.
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 6.2 Determining Inventory Quantities
GOODS IN TRANSIT
A complication in determining ownership is goods in transit (on board a
truck, train, ship, or plane) at the end of the period.
The company may have purchased goods that have not yet been
received, or it may have sold goods that have not yet been delivered.
Goods in transit should be included in the inventory of the company
depend on the terms of the sale

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 6.2 Determining Inventory Quantities
CONSIGNED GOODS
In some lines of business, it is common to hold the goods of other parties
and try to sell the goods for them for a fee, but without taking ownership
of the goods. These are called consigned goods.

For example, you might have a used car that you would like to sell. If
you take the item to a dealer, the dealer might be willing to put the car
on its lot and charge you a commission if it is sold. Under this
agreement, the dealer would not take ownership of the car, which would
still belong to you. Therefore, if an inventory count were taken, the car
would not be included in the dealer’s inventory.

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 6.3 Inventory Costing
Inventory is accounted for at cost. Cost includes all expenditures
necessary to acquire goods and place them in a condition ready for sale.

For example, freight costs incurred to acquire inventory are added to the
cost of inventory, but the cost of shipping goods to a customer are a
selling expense.
After a company has determined the quantity of units of inventory, it
applies unit costs to the quantities to compute the total cost of the
inventory and the cost of goods sold. This process can be complicated if
a company has purchased inventory items at different times and at
different prices.

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 6.3 Inventory Costing
Specific Identification
Assume that the company sales the
Specific identification requires purchase on 3thrd of feb and 22nd of
that companies keep records of the may, what is the cost of good sold
original cost of each individual
inventory item. Historically,
specific identification was possible
only when a company sold a
limited variety
of high-unit-cost items that could The cost of good sold are (700 +800)
be identified clearly from the time 1,500
of purchase through the time of The ending inventory are 750
sale.
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 6.3 Inventory Costing
Cost Flow Assumptions
Because specific identification is often impractical, other cost flow methods
are permitted. These differ from specific identification in that they assume
flows of costs that may be unrelated to the physical flow of goods. There
are two assumed cost flow methods:

First-in, first-out (FIFO) Average-cost

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 6.3 Inventory Costing
Cost Flow Assumptions To illustrate the two inventory cost
To demonstrate the two cost flow flow methods, we will use the data
methods, we will use a periodic for Lin Electronics’ Astro
inventory system. We assume a condensers, shown below:
periodic system for two main
reasons.
First, many small companies use
periodic rather than perpetual
systems. Second, very few
companies use perpetual FIFO or The cost of goods sold formula in a
average-cost to cost their inventory periodic system is:
and related cost of goods sold.
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 6.3 Inventory Costing
FIRST-IN, FIRST-OUT (FIFO)

The first-in, first-out (FIFO)

method assumes that the earliest
goods purchased are the first to be
sold. FIFO often parallels the
actual physical flow of
merchandise. That is, it generally
is good business practice to sell
the oldest units first.

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 6.3 Inventory Costing
AVERAGE-COST
The average-cost method allocates
the cost of goods available for sale
on the basis of the weighted-
average unit cost incurred. The
average-cost method assumes that
goods are similar in nature.

The company then applies the weighted-

average unit cost to the units on hand to
determine the cost of the ending
inventory,
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6.3 Inventory Costing
Financial Statement and Tax Effects of Cost Flow
Methods
The reasons companies adopt different inventory cost flow methods are
varied, but they usually involve one of three factors:
(1) income statement effects,
(2) statement of financial position effects, or
(3) tax effects.

First-in, first-out (FIFO) Average-cost

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6.3 Inventory Costing
INCOME STATEMENT EFFECTS

To understand why
companies, choose either
FIFO or average-cost,
let’s examine the effects
of these two cost flow
assumptions on the
financial statements of
Lin Electronics.

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6.3 Inventory Costing
INCOME STATEMENT EFFECTS
In periods of In a period of inflation, FIFO produces a higher
changing prices, net income because the lower unit costs of the first
the cost flow units purchased are matched against revenues.
assumption can
have a significant In a period of rising prices (as is the case in the Lin
impact on income example), FIFO reports a higher net income
and on evaluations (HK$2,310) than average-cost (HK$2,030).
based on income, If prices are falling, the results from the use of
such as the FIFO and average-cost are reversed. FIFO will
following. report the lower net income and average-cost the
higher.
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6.3 Inventory Costing
STATEMENT OF FINANCIAL POSITION EFFECTS

A major advantage of the FIFO method is that in a period of inflation,

the costs allocated to ending inventory will approximate their current
cost. For example, for Lin Electronics, 40 of the 45 units in the ending
inventory are costed under FIFO at the higher November 27 unit cost of
HK$130.
Conversely, a shortcoming of the average-cost method is that in a period
of inflation, the costs allocated to ending inventory may be understated
in terms of current cost.

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6.3 Inventory Costing
TAX EFFECTS

We have seen that both inventory on the statement of financial position

and net income on the income statement are higher when companies use
FIFO in a period of inflation. Yet, some companies use average-cost.
Why? The reason is that average-cost results in lower income taxes
(because of lower net income) during times of rising prices. For
example, at Lin Electronics, income taxes are HK$870 under average-
cost, compared to HK$990 under FIFO. The tax savings of HK$120
makes more cash available for use in the business.

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6.3 Inventory Costing
Using Inventory Cost Flow Methods Consistently
Whatever cost flow method a company chooses, it should use that
method consistently from one accounting period to another. This
approach is often referred to as the consistency concept, which means
that a company uses the same accounting principles and methods from
year to year.
Consistent application enhances the comparability of financial
statements over successive time periods.
Although consistent application is preferred, it does not mean that a
company may never change its inventory costing method. When a
company adopts a different method, it should disclose in the financial
statements the change and its effects on net income.
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 6.3 Inventory Costing
Lower-of-Cost-or-Net Realizable Value
The value of inventory for companies selling high-technology or fashion
goods can drop very quickly due to continual changes in technology or
styles.
This situation requires a departure from the cost basis of accounting.
When the value of inventory is lower than its cost, companies must
“write down” the inventory to its net realizable value.
Net realizable value is
the estimated selling
price in the normal
course of business, less
estimated costs to
complete and sell.
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 6.4 Inventory Errors
Unfortunately, errors occasionally occur in accounting for inventory.
In some cases,
 Errors are caused by failure to count or
 Price the inventory correctly,
 companies do not properly recognize the transfer of legal title to goods
that are in transit.

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 6.4 Inventory Errors
When errors occur, they affect both the income statement and the
statement of financial position.
INCOME STATEMENT EFFECTS
The ending inventory of one period automatically becomes the
beginning inventory of the next period. Thus, inventory errors affect the
computation of cost of goods sold and net income in two periods.

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 6.4 Inventory Errors
Statement of Financial Position Effects
Companies can determine the effect of ending inventory errors on the
statement of financial position by using the basic accounting equation:
Assets = Liabilities + Equity. Errors in the ending inventory have the
effects shown below:

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 6.5 Analysis
Inventory turnover measures the number of times on average the inventory
is sold during the period. Its purpose is to measure the liquidity of the
inventory.

For example, Esprit Holdings’ inventory turnover of 3.7 times divided into
365 is approximately 99 days. This is the approximate time that it takes a
company to sell the inventory once it arrives at the store.
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 END OF CHAPTER SIX

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