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.