AFA100

Chapter 6: Reporting and Interpreting Cost of Sales and Inventory

Exam Information

  • Quiz 2: March 1st

  • Midterm Exam: March 8th, 1pm-4pm in TRS2-099/TRS2-109 (Check exam room checklist)

  • Coverage: Chapters 1-6

  • Format: 50 MCQs and 16 short-answer questions

Last Week’s Topics

  • Internal Control

  • Bank Reconciliation

  • Errors including: NSF cheques, outstanding cheques, deposits in transit, bank charges/interests

Chapter 6 Learning Objectives

  1. LO6-1: Apply the cost principle to identify inventory amounts and apply the matching process to cost of sales for retailers, wholesalers, and manufacturers.

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

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

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

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

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

    • Supplementary Material: LO6-S1, LO6-S2

Inventory Overview

  • Definition: Inventory is a tangible asset:

    • Held for sale in the ordinary course of business.

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

    • Reported as a current asset on the financial position statement, typically turned into cash within one year.

    • Types depend on business characteristics.

Merchandiser vs. Manufacturing Inventory

  • Merchandisers hold merchandise inventory (finished goods ready for sale).

  • Manufacturers retain:

    • Raw Materials: Purchased for use in production.

    • Work-in-Process: Goods in production but not finished.

    • Finished Goods: Completed products for sale.

Inventory Management Goals

  • Ensure sufficient high-quality inventory:

    • Low quality leads to customer dissatisfaction.

    • Stockouts from insufficient hot-selling items lead to lost sales.

    • Minimize carrying inventory costs associated with slow-selling items.

Journal Entries for Inventory Purchases

  • Record inventory in asset accounts at cost.

  • Included costs:

    • Purchase costs (raw materials, labor, overhead).

    • Freight (if applicable).

    • Less returns, allowances, discounts.

Purchase Returns and Allowances

  • Dissatisfied buyers can return goods or receive allowances:

    • Purchase returns decrease goods purchased in the inventory account.

    • Results in debit to Cash/Account Payable and credit to Inventory.

Purchase Discounts

  • Applied for early payment (e.g., terms 2/10, n/30).

  • Discounts reduce the recognized expense in inventory accounts.

Cost of Sales Calculation

  • Calculated using:

    • Beginning Inventory (BI)

    • Plus Purchases (P)

    • Minus Ending Inventory (EI) yields Cost of Sales (COS):

      COS = BI + P - EI

Inventory Systems

  • Perpetual System: Balances continuously updated.

  • Periodic System: Updates take place after counting inventory, calculates via:

    COS = Goods Available for Sale - Ending Inventory

Inventory Costing Methods

  1. Specific Identification: Assigns specific costs to each item.

  2. FIFO (First-In, First-Out): Assumes oldest inventory items are sold first.

  3. Weighted Average: Costs averaged across units.

Valuation of Inventory

  • Lower of Cost and NRV: Ensures assets are reported at the lower value, applies to high-tech and seasonal goods.

Evaluating Inventory Management

  • Inventory Turnover Ratio: Determines management efficiency in inventory management.

  • Average Days to Sell Inventory: Indicates average time to sell inventory.

  • Excess inventory impacts cash flow negatively.

Conclusion

  • Understanding inventory management is critical for financial analysis and performance measurement, impacting both operational and financial decision-making.