Inventory Costing, Accounts Receivable, and Long-Lived Assets

6 Inventory Costing Methods

• Specific Identification Method
    - Definition: The cost of every single item of inventory is calculated and the item is tagged with its specific cost.
    - Usage: Used for unique, high-value items that can be easily identified (e.g., cars with VIN numbers, original art, diamonds).
    - Mechanics: When an item is sold, its exact cost is moved from the Inventory account (asset) to Cost of Goods Sold (expense).
    - Drawbacks: Expensive and time-consuming due to detailed record-keeping requirements.

• Average Cost Method
    - Definition: The average cost of inventory is recalculated every time a new purchase is made.
    - Formula: $\text{Average Cost per Unit} = \frac{\text{Total Cost of Items}}{\text{Number of Items}}$
    - Smoothing Effect: This method "smooths out" price fluctuations, resulting in a consistent gross profit ratio for items sold between purchases.
    - Usage: Typically used for homogeneous (identical) items where customers choose products themselves (e.g., hardware stores selling nails).

• First-In, First-Out (FIFO) Method
    - Definition: Assumes that the oldest inventory items (first in) are the first ones sold (first out).
    - Inventory Valuation: The value of ending inventory on the balance sheet reflects the most recent purchase prices.
    - Replacement Cost: FIFO is often closest to replacement cost, providing a faithful estimate of future benefit.
    - Usage: Preferred by businesses where the physical flow of goods matches the cost flow (e.g., grocery stores or flower shops that rotate stock to prevent spoilage).

7 Inventory Control Systems

• Perpetual Inventory System
    - Tracks inventory costs and quantities at all times.
    - Requires updating the accounting equation for every purchase and sale.
    - Must always match the manual inventory control records; if they do not match, an error has occurred.

• Physical Inventory Count
    - Purpose: Conducted at least once a year to check the accuracy of the perpetual system.
    - Shrinkage: Differences between records and counts caused by theft, human error, damage, or obsolescence.
    - Inventory Losses Account: If a count reveals missing units, the difference is written off to an expense account ($\text{Inventory Losses}$) rather than COGS to avoid distorting gross profit.

• Shipping Terms and Ownership
    - FOB Shipping Point: Ownership transfers to the buyer as soon as the goods are shipped. The buyer must include goods in transit in their year-end inventory count.
    - FOB Destination: Ownership transfers when goods reach the buyer. The seller owns the goods while in transit and must include them in their inventory count.

• Lower of Cost and Net Realizable Value (NRV)
    - Assets must be recorded at their future benefit. If the market selling price drops below the historical cost, the inventory must be written down to the NRV.
    - Example: Blackberry Playbook write-downs when selling prices fell below manufacturing costs.
    - Formula for Adjustment: $\text{Adjustment Amount} = \text{Total Cost} - (\text{Units on Hand} \times \text{Current Selling Price})$

8 Accounts Receivable and Uncollectable Accounts

• The Allowance Method
    - Definition: Estimating uncollectable accounts at the end of the period to match the bad debt expense with the revenue generated.
    - Allowance for Doubtful Accounts (AFDA): A contra-asset account (negative balance) that reduces Accounts Receivable to its Net Realizable Value.
    - Net Realizable Value (NRV): The amount the business expects to actually collect in cash. $\text{NRV} = \text{Accounts Receivable} - \text{AFDA}$
    - Bad Debt Expense: The cost of selling on credit, recorded in the same period as the revenue.

• Estimating the Allowance
    - Overall Percentage Method: A flat rate applied to the total ending Accounts Receivable balance.
    - Aging of Accounts Receivable Method: Grouping invoices by how long they are overdue (Current, 1-30 days, etc.) and applying higher uncollectable percentages to older categories. This is considered more accurate.

• Write-Offs and Recoveries
    - Write-Off: When a specific customer is known to be unable to pay (e.g., bankruptcy), their balance is removed from A/R and set against AFDA. This does not affect the income statement.
    - Recovery: If a customer pays after being written off, the write-off is reversed (reinstated) for the amount received, and the cash payment is recorded.

9 Long-Lived Assets

• Tangible vs. Intangible Assets
    - Tangible (Property, Plant, and Equipment): Physical assets like land, buildings, and equipment.
    - Intangible: Non-physical rights like patents, trademarks, copyrights, and technology assets (software/web design).

• Capitalization vs. Expensing
    - Capitalize: Record as an asset if the cost is required to buy and make the asset ready for use (e.g., delivery, installation, legal fees for patents).
    - Expense: Record as an expense if the cost is a recurring maintenance item, or if the amount is immaterial (below 5% of total assets).

• Straight-Line Depreciation
    - Depreciable Amount: $\text{Cost} - \text{Residual Value}$
    - Annual Depreciation: $\frac{\text{Depreciable Amount}}{\text{Estimated Useful Life}}$
    - Book Value: $\text{Cost} - \text{Accumulated Depreciation}$
    - Partial Year: Depreciation must be prorated based on the number of months the asset was available for use.

• Disposal of Assets
    - Before recording a sale, depreciation must be updated to the date of disposal.
    - Gain on Disposal: Selling Price > Book Value.
    - Loss on Disposal: Selling Price < Book Value.

10 Liabilities and Payroll

• Current vs. Long-Term Liabilities
    - Current: Due within 12 months (e.g., Accounts Payable, Interest Payable, Income Tax Payable, Deferred Revenue).
    - Long-Term: Due after one year (e.g., 5-year Bank Loan).

• Notes Payable and Interest
    - Interest Formula: $\text{Interest} = \text{Principal} \times \text{Annual Interest Rate} \times \frac{\text{Months}}{12}$
    - Interest is accrued at month-end as $\text{Interest Payable}$ (liability) and $\text{Interest Expense}$.

• Payroll Accounting
    - Gross Pay: Total amount earned by the employee.
    - Withholdings at Source: CPP, EI, and Employee Income Tax (EIT) deducted from gross pay.
    - Net Pay: The actual cash paid to the employee. $\text{Gross Pay} - \text{Deductions} = \text{Net Pay}$
    - Employer Contributions: Employers must match CPP and pay 1.4 times the employee\'s EI contribution. These are recorded as $\text{Employee Benefits Expense}$.

11 Financial Statement Analysis

• Horizontal Analysis (Trend Analysis)
    - Compares the same item over different years.
    - Formula: $\frac{\text{Current Year Amount} - \text{Prior Year Amount}}{\text{Prior Year Amount}} \times 100\%$

• Vertical Analysis (Common-Size Analysis)
    - Shows the relationship of each item to a base figure on the same statement.
    - Base for Balance Sheet: Total Assets (100%).
    - Base for Income Statement: Net Sales (100%).

• Ratios
    - Liquidity (Current Ratio): $\frac{\text{Current Assets}}{\text{Current Liabilities}}$
    - Solvency (Debt to Equity): $\frac{\text{Total Liabilities}}{\text{Total Equity}}$
    - Efficiency (A/R Turnover): $\frac{\text{Net Sales}}{\text{Average Net Accounts Receivable}}$
    - Profitability (Gross Profit Ratio): $\frac{\text{Gross Profit}}{\text{Net Sales}}$

• Statement of Cash Flows Analysis
    - Operating: The primarily sustainable source of cash ("life-blood"). Should ideally be positive and higher than net income.
    - Investing: Net outflows often indicate growth (buying equipment).
    - Financing: Inflows indicate raising capital; outflows indicate repaying debt or dividends.