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.