AFA100 - Introductory Financial Accounting - Chapter 6

AFA100 Introductory Financial Accounting

Chapter 6: Reporting and Interpreting Cost of Sales and Inventory

  • Institution: Toronto Metropolitan University

Important Dates and Examination Information

  • Quiz 2: Available from February 28 at 12:00 AM to March 1 at 11:59 PM

  • Midterm Exam:

    • Date: March 8th

    • Time: 1 PM - 4 PM

    • Location: TRS3-099/TRS3-109 (See Exam Room Check List)

    • Content: Chapters 1-6

    • Format: 50 Multiple-Choice Questions and 16 Short-Answer Questions

Review of Last Week's Topics (Week 3)

  • Internal Control

  • Bank Reconciliation

  • Errors and Their Management

    • NSF (Non-Sufficient Funds) cheques received

    • Outstanding cheques

    • Deposits in transit

    • Bank charges/interests

Chapter 6 Learning Objectives

  • LO6-1: Apply the cost principle to identify amounts that should be included in inventory and apply the matching process to determine the cost of sales for typical retailers, wholesalers, and manufacturers.

  • LO6-2: Record inventory and cost of sales using three inventory costing methods.

  • LO6-3: Select the inventory costing method that reports the most faithful representation and relevant information to users of financial statements.

  • LO6-4: Report inventory at the lower of cost and net realizable value (LC&NRV).

  • LO6-5: Describe methods for controlling inventory and analyze the effects of inventory reporting errors on financial statements.

  • LO6-6: Evaluate inventory management by using the inventory turnover ratio and analyze the effects of inventory on cash flows.

  • SUPPLEMENTARY MATERIAL:

    • LO6-S1: Report inventory and cost of sales in a periodic inventory system.

    • LO6-S2: Compare and contrast the recording of inventory transactions in periodic and perpetual inventory systems.

Inventory

  • Definition: Inventory is a tangible asset that is either:

    • Held for sale in the ordinary course of business, or

    • Used in the process of production of goods for sale or rendering of services.

  • Financial Statement Position: Reported as a current asset on the statement of financial position, as it is normally used or converted into cash within one year.

  • Business Dependent Variability: Types of inventory held can vary based on the characteristics of the business.

Types of Inventory by Business Type

  • Merchandisers:

    • Hold merchandise inventory, which consists of finished goods held for resale without further processing.

  • Manufacturers:

    • Hold three types of inventory:

    • Raw Materials Inventory: Items acquired for processing into finished goods.

    • Work-in-Process Inventory: Goods in the manufacturing process that are not yet complete.

    • Finished Goods Inventory: Manufactured goods that are complete and ready for sale.

Goals of Inventory Management System

  1. Sufficiency: Provides sufficient quantities of high-quality inventory.

  2. Minimize Costs: Reduces costs associated with carrying inventory, including storage cost and interest from short-term borrowing.

  3. Avoid Stockouts: Having too few units of a high-demand item can result in lost sales.

  4. Avoid Overstocks: Excess of slow-selling items leads to increased storage costs.

Journal Entries for Inventory Purchases

  • Recording Inventory Purchases:

    • Transactions should reflect an increase in inventory (asset account) and the corresponding decrease in cash or increase in accounts payable.

    • Example Journal Entry:

    • Dr Inventory

    • Cr Cash/Accounts Payable

  • Costs Included in Inventory: Includes the total cost incurred to bring merchandise to a usable/saleable condition and location:

    • Purchase costs

    • Direct labor costs

    • Factory overhead costs

    • Freight (if FOB shipping point) and applicable taxes.

    • Subtract purchase returns, allowances, and discounts.

Returns and Allowances

  • Purchase Returns: Buyer returns merchandise for a cash refund or credit.

  • Purchase Allowance: Merchandise can be kept with an agreed deduction on the purchase price.

  • Journal Entries: Results in a decrease in cost of goods purchased:

    • Dr Cash/Accounts Payable

    • Cr Inventory

Purchase Discounts

  • Definition: Discounts offered when payment is made before the due date, particularly for on-account purchases.

  • Example: Terms specified as 2/10, n/30 imply a 2% discount if paid within 10 days.

  • Journal Entry for Discounts:

    • A credit entry to the 'Inventory' account is required.

Cost of Sales Calculation

  • Cost of Sales Formula:

    • Cost of Goods Available for Sale = Beginning Inventory + Purchases - Ending Inventory

    • Where: Cost of Sales (COS) = BI + P - EI.

  • Numerical Example:

    • BI = $40,000

    • Purchases = $55,000

    • Ending Inventory (EI) = $35,000

    • Cost of Goods Available for Sale = $40,000 + $55,000 = $95,000

    • COS = $95,000 - $35,000 = $60,000

  • Reporting Contexts: Both cost of sales and ending inventory affect the statement of earnings and financial position.

Inventory Systems

Perpetual Inventory System

  • Mechanism: Records transactions directly in the inventory account; suitable for seamless sales and inventory management.

  • Continuous Records: Maintains real-time records of inventory quantities and costs.

  • Physical Inventory: Physical counts are conducted to ensure accuracy.

Periodic Inventory System

  • Mechanism: Inventory records are updated periodically; cost of sales is determined at the end of the accounting period based on a physical count.

  • Journal Entries: Costs of purchases are temporarily recorded and later adjusted to reflect the actual counts.

Inventory Costing Methods

  • Three Main Methods:

    1. Specific Identification: Matches each item sold with its specific cost, applicable to distinguishable items.

    2. FIFO (First-In, First-Out): Assumes that the earliest goods sold are the first to leave (while the most recent remain in inventory).

    3. Weighted Average: Employs an average cost of all goods available for sale when a sale occurs.

Effects of Inventory Measurement Errors

  • Result Implications: Errors in assigning quantity or costs can distort financial statements; inaccuracies can lead to overstated or understated net earnings.

  • Reversal of Errors: Errors in current periods can have reverse effects in subsequent periods, impacting retained earnings.

Valuation of Inventory: Lower of Cost and Net Realizable Value (LC&NRV)

  • LC&NRV Rule: Ending inventory should be valued at the lower of its cost or net realizable value; applicable due to various market conditions.

  • Implications of NRV: If NRV drops below cost, inventory must be written down, affecting financial reporting immediately.

Key Ratios in Inventory Management

  • Inventory Turnover Ratio: Reflects efficiency in managing inventory based on sales cycles; calculated as:

    • Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory

  • Average Days to Sell Inventory: Indicates the average duration taken to sell inventory, providing insights into sales efficiency.

Cash Flow Implications

  • Inventory Management Effects: Overproduction leads to excess inventory, which increases holding costs, potentially leading to negative cash flow implications.

  • Net Earnings Adjustments: Fluctuations in inventory levels directly adjust operating cash flows and affect net earnings reporting.

Chapter Summary

  • Overview of inventory concepts and management systems.

  • Understanding financial implications of inventory purchases, management, and reporting.

  • Insight into errors and their ramifications in inventory practices.

  • Strategies for improving inventory management and performance metrics.

Final Note

  • Best of luck in your endeavors and exams! Remember, persistence is key!