Chapter 8 - Inventories page 1 -------------------------------------------------------------------------- 1. Inventory overview and issues 2. Accounting for inventory: frequency and unit flow assumptions 3. Other inventory issues -------------------------------------------------------------------------- Inventories are those goods that a company acquires for the purpose of selling to its customers as part of its normal business operations. Merchandisers purchase finished inventory from others for resale and typically report one inventory account on their Balance Sheet. Manufacturers producegoods to sell and typically report three inventory accounts: Raw Materials, Work in Process, and Finished Goods. Raw materials: cost of materials on hand but not placed into production Work in process: cost of production that has been started but not yet completed. Includes raw materials, direct labor, and overhead costs Finished goods: cost of units that have been completed but not sold Accounting for Inventory: Frequency and Unit Flow Assumptions As discussed in P1, when Inventory is sold, we reduce Inventory account and record Cost of Goods Sold. This matches the expense of the sale with revenue generated from the sale, and reduces Inventory. The problem in accounting for Inventory is not with the physical unit flow. We know the number of units in beginning Inventory, units purchased, units sold, and units in ending Inventory by tracking units as they are sold or by counting the inventory as the end of the period. In short, we know the physical unit flow. We also know the cost of the beginning Inventory and of the Inventory purchased during the period. The issue in accounting for Inventory is how to allocate the cost to the units sold and to the units still in (ending) Inventory. Beginning inventory + Net purchases Total Available for Sale / \
/\ Cost of goods soldEnding inventory The cost that goes into the Inventory account is allocated between the units sold (Cost of Goods Sold) and the units still in inventory Chapter 8 - Inventories page 2 -------------------------------------------------------------------------- This cost assignment is critical as Cost of Goods Sold is often a company's largest expense and Inventory one of the most active assets. How the inventory costs are allocated between cost of goods sold and ending inventory depends two things: Frequency of the cost allocation accounting:perpetual or periodic Assumption as to which units have been sold and which are still in (ending) inventory The FREQUENCYof cost allocation is done either continuously (perpetual) or once at the end of the accounting period (periodic). 1. With a perpetual cost allocation, movement of Inventory is tracked continuously. The result is up-to-date balances for both the Inventory and Cost of Goods Sold accounts. Purchases of inventory are recorded in the Inventory account1 (Debit Inventory, Credit Accounts Payable) Purchase returns or allowances are credited to the Inventory account (Debit Accounts Payable, Credit Inventory) Cost of Goods Sold is recorded when Inventory is sold and the Inventory account is reduced (Debit Cost of Goods Sold, Credit Inventory) Even though inventory units are tracked, companies will count the physical units in the ending inventory in order to determine the inventory shrink. 2 This amount is typically added to the Cost of Goods Sold amount. It may also be reported in the Other (revenue or expense) section of the Income Statement.
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