accounting

How is inventory classified in accounting?

Inventory is classified as a current asset.

Why is inventory considered a current asset?

It is a present economic resource controlled by the business, arising from past events, and expected to provide future economic benefits within 12 months.

List three reasons why accounting for inventory is important.

Ensures correct Balance Sheet valuation, determines accurate Cost of Sales, and helps manage stock levels to avoid shortages or overstocking.

What is 'Cost of Sales'?

The cost of the inventory that has been sold during a specific period.

How is Cost of Sales classified in the Income Statement?

It is classified as an expense.

What is the formula for calculating Gross Profit?

Sales minus Cost of Sales.

What is the Perpetual Inventory System?

A system that records individual inventory transactions in inventory cards as they occur, followed by a physical count to verify balances.

What is a major benefit of the Perpetual Inventory System regarding stock control?

It allows for the identification of inventory losses and gains by comparing card balances to physical counts.

What is a limitation of the Perpetual Inventory System?

It is often timely and expensive to employ staff and technology (like scanners) to maintain the system.

How is inventory donated for promotional purposes classified?

It is classified as an advertising expense.

What is the impact on the accounting equation if inventory donated as advertising is not recorded?

Assets (inventory) are overstated and Owner's Equity (net profit) is overstated.

Why does using different cost valuation methods impact financial reporting?

It can reduce comparability between periods or businesses because profit and inventory values may differ.

What is the 'Identified Cost Method'?

A method of valuing inventory by physically marking each item so its individual cost price can be tracked.

What is a primary benefit of the Identified Cost Method?

It is highly accurate and upholds the principle of faithful representation.

What is a primary limitation of the Identified Cost Method?

It can be administratively costly and time-consuming to label and track individual items.

How is an inventory gain recorded in an inventory card?

It is recorded as an increase in the 'Balance' column, typically identified by a physical count.

How is an inventory loss recorded in an inventory card?

It is recorded as a decrease in the 'Balance' column, typically identified by a physical count.

When inventory is returned by a customer, how is the cost price determined?

The cost is calculated using the cost price identified by the supplier's credit note.

What happens to the accounting equation when inventory is written down?

Assets (inventory) decrease and Owner's Equity (net profit) decreases due to the expense.

Why is it important to be consistent with cost valuation methods?

Consistency over time improves the comparability of financial reports.

What must a business do if it changes its cost valuation method?

The change must be disclosed so users can still make valid comparisons.

In the Perpetual Inventory System, what is the purpose of the 'OUT' column?

To record the cost of inventory leaving the business, such as through sales, drawings, or advertising.

What is the effect of inventory drawings on the accounting equation?

Assets (inventory) decrease and Owner's Equity decreases.

How does the 'Identified Cost Method' handle purchase returns?

The cost of the returned item is identified from the original inventory card or business document.

What is the primary purpose of matching expenses with revenue in inventory accounting?

To ensure accurate profit measurement by only recording inventory as an expense when it is sold.

What technology is often used to support a Perpetual Inventory System?

Scanners and inventory management software.

What is the FIFO method of inventory valuation?

A method that assumes the first items purchased are the first ones sold, valuing inventory sold using the earliest cost price on hand.

What is a primary benefit of using the FIFO method?

It can be applied to all types of inventory and is less costly to administer than the identified cost method.

How are inventory gains calculated in the FIFO method?

By using the latest cost price recorded in the IN column of the inventory card, supporting the qualitative characteristic of Faithful Representation.

How are inventory losses calculated in the FIFO method?

By assuming the inventory lost is calculated using the oldest cost price of available inventory on hand.

How is the cost of inventory returned to suppliers (purchase return) calculated?

By using the cost price identified by the supplier's credit note.

How is the cost of a sales return calculated in the FIFO method?

By using the latest cost prices shown in the OUT column of the inventory card, effectively reversing the last out.

When should the Identified Cost method be used instead of FIFO?

When inventory items are unique or distinguishable, such as cars or jewellery, where each item has a specific, different cost.

Why is FIFO suitable for high-volume, low-value goods?

It is simpler, less time-consuming, and more cost-effective than tracking individual item costs.

If cost prices are rising, what is the impact of FIFO on Cost of Sales?

The Cost of Sales will be lower.

If cost prices are rising, what is the impact of FIFO on Gross and Net Profit?

Gross Profit and Net Profit will be higher.

If cost prices are rising, what is the impact of FIFO on Inventory value?

The value of inventory will be higher.

If cost prices are falling, what is the impact of FIFO on Cost of Sales?

The Cost of Sales will be higher.

If cost prices are falling, what is the impact of FIFO on Owner's Equity?

Owner's Equity will be lower.

What is a physical stocktake?

A physical count of the number of units of each line of inventory on hand.

How does a physical stocktake support Faithful Representation?

It verifies the actual quantity of inventory, ensuring records are accurate, complete, and free from error.

What constitutes an inventory loss?

When the number of units counted during a stocktake is less than the quantity shown in the inventory card balance.

List four common reasons for an inventory loss.

Theft, damage/breakages, undersupply from a supplier, or oversupply to a customer.

Why is an inventory loss classified as an expense?

Because it represents inventory that has been used up or is no longer available to generate revenue, reducing economic benefit.

What is segregation of duties in the context of inventory internal control?

Ensuring that different people handle the ordering, recording, and storage of inventory to reduce the risk of errors or theft.

What is the impact on the accounting equation if an inventory loss is not recorded?

Current assets (inventory) are overstated and net profit is overstated.

What is the primary advantage of using barcodes and scanners for inventory?

They reduce recording errors.

How does FIFO often reflect the physical flow of inventory?

It assumes that older stock is sold first, which often aligns with the actual physical movement of goods.

What is the effect of FIFO on Owner's Equity when cost prices are rising?

Owner's Equity will be higher.

What is the effect of FIFO on Expenses when cost prices are falling?

Expenses will be higher.

What is the purpose of documentation like invoices and delivery dockets in internal control?

To ensure that all inventory movements are recorded accurately.

What is the effect of an inventory loss on the accounting equation?

Current assets decrease and owner's equity decreases (due to an increase in expenses).

What does the FIFO inventory method stand for?

First In, First Out.

How is an inventory gain defined?

An inventory gain occurs when the physical count of units is greater than the quantity shown in the inventory card balance.

Why is an inventory gain classified as revenue?

It represents an increase in economic benefits (more inventory than expected), which leads to an increase in profit.

List two common reasons for an inventory gain.

Oversupply from a supplier (delivered but not charged) or undersupply to a customer (charged but not delivered).

What is the purpose of a physical stocktake in internal control?

To detect unexpected excess or missing stock by comparing physical quantities to inventory records.

How does segregation of duties improve inventory control?

It ensures that different people are responsible for recording, receiving, and checking inventory, reducing the risk of error or theft.

What is the impact of an inventory gain on the accounting equation?

Assets (Inventory) increase and Owner's Equity (Net Profit) increases.

What happens to the accounting equation if an inventory gain is not recorded?

Assets (Inventory) are understated and Owner's Equity (Net Profit) is understated.

What is a product cost?

A cost incurred to bring inventory into a condition and location ready for sale, which can be allocated to individual units on a logical basis.

Provide two examples of product costs.

Delivery in (freight in) and modifications to the inventory.

How are product costs recorded in the financial records?

They are recorded as a current asset (Inventory) rather than an immediate expense.

What is the benefit of the matching principle regarding product costs?

It matches costs with revenue by recording expenses only when the inventory is sold, leading to a more accurate profit figure.

Why is it important to determine an accurate cost price for inventory?

It determines the inventory balance on the balance sheet, helps calculate profit (COGS), and assists in setting appropriate selling prices.

What are the potential consequences of an inaccurate inventory cost price?

Selling prices may be too high (leading to lost sales) or too low (insufficient revenue to cover expenses), and management may make incorrect decisions.

What is the primary role of a perpetual inventory system?

To continuously track stock levels in real-time.

How do barcoding and scanning systems assist in inventory management?

They reduce recording errors during the tracking of inventory movements.

What is the purpose of reconciliation in inventory management?

To compare physical stock counts to inventory records regularly to ensure accuracy.

How is an inventory gain recorded in the General Journal?

Debit Inventory (Asset) and Credit Inventory Gain (Revenue).

Why is unsold inventory treated as an asset?

Because it represents future economic benefits; recording it as an asset prevents profit from being understated by counting costs as expenses too early.

What does 'Identified Cost' refer to in inventory valuation?

A method where the specific cost of each individual item is tracked and assigned to that item.

What is the role of source documents like invoices and delivery dockets?

They are used to verify that the stock received matches the business's internal records.

What is the effect of an inventory gain on liabilities?

There is no effect on liabilities.

What does 'Cartage in' represent in the context of inventory?

It is a product cost representing the freight or delivery expenses incurred to bring inventory into the business.

Why should authorization procedures be used for inventory adjustments?

To ensure that any changes made to inventory records are approved and legitimate.

What is a period cost?

A cost incurred to bring inventory to a condition and location ready for sale that cannot be logically allocated to individual units of inventory.

How are period costs recorded in the accounting records?

They are recorded as an expense in the period they are incurred.

Under the accrual basis assumption, when is a period cost expensed?

It is expensed in the period the cost is incurred, regardless of when the associated inventory is sold.

What is the primary difference between product costs and period costs regarding inventory valuation?

Product costs are included in the cost of inventory, whereas period costs are expensed immediately and do not increase the inventory balance.

How does treating a product cost as a period cost affect net profit if inventory remains unsold?

It results in a lower net profit because the cost is expensed immediately rather than being deferred as an asset.

What is the 'Lower of Cost and Net Realisable Value' (NRV) rule?

A rule stating that inventory must be valued at the lower of its original cost or its estimated net realisable value.

Define Net Realisable Value (NRV).

The estimated selling price of an item of inventory, less any costs incurred in its selling, marketing, or distribution.

List four reasons why the NRV of inventory might fall below its cost.

Physical deterioration or damage, purposeful decrease in selling price for marketing, decrease in demand, or obsolescence.

What is an inventory write-down?

The expense incurred when the Net Realisable Value of an item of inventory falls below its original cost.

Where is an inventory write-down reported in the financial statements?

As an expense in the Income Statement, usually under Cost of Goods Sold or Other Expenses.

What are the three required components of a narration for an inventory write-down?

The number of items written down, the reason for the reduction, and the source document.

How does an inventory write-down affect the accounting equation?

It decreases assets (inventory) and decreases owner's equity (via reduced net profit).

What does the Inventory Turnover (ITO) indicator measure?

How quickly a business sells and replaces its inventory over a specific period.

What does a faster Inventory Turnover generally indicate?

Higher sales, improved liquidity, and effective inventory management.

Name two potential limitations of a very fast Inventory Turnover.

Risk of stock shortages (stockouts) and lost sales opportunities due to insufficient inventory.

What does a slower Inventory Turnover suggest about a business?

Inventory is selling slowly, staying in stock longer, and potentially tying up cash.

What are the benefits of a slower Inventory Turnover?

Lower risk of stock shortages and the ability to meet unexpected customer demand.

Define the 'Cash Cycle'.

The process of turning inventory into sales, and then turning those sales into cash.

How does the length of the cash cycle impact liquidity?

A shorter cash cycle improves liquidity, while a longer cash cycle worsens it.

What are three strategies to improve the cash cycle?

Selling inventory faster, collecting receivables faster, and delaying payments to suppliers.

What is the impact of a period cost on the Cost of Goods Sold if inventory is not sold?

It leads to a higher Cost of Goods Sold in the current period because the cost is expensed immediately.

Why is it important to distinguish between product and period costs for decision-making?

Incorrect assignment impacts the inventory balance and Net Profit, leading to misleading financial information.

What is the effect of an inventory write-down on the inventory balance?

It decreases the inventory balance (asset value) to reflect its lower realisable value.

How can a business determine if its Inventory Turnover is satisfactory?

By comparing it to budgeted performance, previous periods, or industry averages.