RW Lecture Notes - Chapter 7 (2)

Chapter Overview

  • Financial Accounting Chapter 7 focuses on Inventory Management and valuation.

  • Important concepts to be learned include inventory definitions, classifications, systems, cost formulas, and impacts of valuation errors.

Agenda Items

Learning Objectives (LO)

  • LO 7-1: Discuss the importance of inventory.

  • LO 7-2: Distinguish between different inventory classifications and determine which goods should be included in inventory.

  • LO 7-3: Explain the differences between perpetual and periodic inventory systems.

  • LO 7-4: Explain the necessity of cost formulas and calculate COGS and ending inventory using weighted-average and FIFO under a perpetual system.

  • LO 7-5: Discuss the impact of inventory valuation errors on financial statements.

  • LO 7-6: Explain a company’s gross margin.

  • LO 7-7: Describe internal control measures related to inventory.

What is Inventory?

  • Tangible items held for sale or used to produce goods for sale.

  • Includes all costs incurred to bring inventory to its current location and condition such as:

    • Freight (transportation)

    • Insurance

    • Provincial Sales Tax (PST) with GST/HST refunded to businesses

    • Adjustments for returns, allowances, and discounts.

Financial Statements and Inventory

Balance Sheet Reporting

  • Reported under current assets as "Inventory."

Income Statement Reporting

  • Cost of goods sold (COGS) is recorded as an expense when inventory is sold.

  • COGS is always debited.

Inventory Classifications

Types of Inventory

  • Merchandising Companies: Buy and sell finished goods (e.g., WalMart, Staples).

  • Manufacturing Companies: Purchase raw materials and create finished goods. Three inventory categories:

    • Raw Materials Inventory: Unprocessed materials (e.g., flour, engines).

    • Work in Process Inventory: Incomplete goods not yet finalized.

    • Finished Goods Inventory: Goods ready for sale.

Inventory Accounting Systems

Perpetual vs. Periodic Systems

  • Perpetual Inventory System:

    • Keeps real-time tracking of inventory.

    • Inventory counts continuously update.

    • COGS recorded at time of sale.

  • Periodic Inventory System:

    • Updates inventory at set intervals (usually once a year).

    • Easier, cost-effective, but less up-to-date.

    • COGS computed at the end of the period after an inventory count.

Advantages and Disadvantages of Each System

  • Perpetual System:

    • Pros: Continuous insight into inventory levels.

    • Cons: Expensive to maintain.

  • Periodic System:

    • Pros: Simple to manage, less costly.

    • Cons: Harder to detect inventory loss or theft immediately.

COGS Calculations

Cost Formulas

  1. Specific Identification

    • Individual items identified, typically for expensive items.

  2. Weighted Average Cost

    • COGS = Average cost per unit.

  3. FIFO (First-In, First-Out)

    • Oldest items assumed sold first.

Impact of Unit Costs

  • Rising costs yield lower COGS and higher gross profit under FIFO.

  • Declining costs yield higher COGS and lower gross profit under FIFO.

Valuation of Inventory

  • Must be carried at the lower of cost or net realizable value (NRV).

Determining NRV

  • NRV = Expected selling price less any selling costs.

Errors in Inventory Valuation

Consequences of Errors

  • Failure to accurately count inventory can misstate COGS and net income on financial statements.

  • Errors affect the corresponding year and create offsetting discrepancies the following year.

Example Practice Problems

  1. Inventory Corrections: Determine how inventory inconsistencies can change COGS through detailed calculations with FIFO and weighted averages.

  2. Case Studies: Apply learning objectives in real-company scenarios, such as how valuation errors affect financial statements.

Wrap-Up

  • Ensure familiarity with key terms and concepts.

  • Review practice questions to solidify understanding of inventory management and financial impacts.