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ACTG 2011 Lecture Notes - Inventory Control, Perpetual Inventory, Inventory Turnover

Course Code
ACTG 2011
Alex Garber

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Inventory is assets held for sale or assets used to produce goods that will be sold
as part of the business.
Different categories of inventory
Raw Materials:inputs into production process
Work-in-progress of WIP inventory:partially completed product to date
Finished goods:inventory that has been completed and ready for sale
Requires inventory to be valued at costs on the balance sheet
Net Realizable Value (NRV) of inventory is less than costs, the inventory must be
written down to its NRV. LOWER OF COST and MARKET RULE.
Costs of inventory includes all costs incurred to ready the inventory for sale or
use: purchase price, import duties, and other taxes, shipping and handling, and any
other costs directly related to the purchase of the inventory
IFRS requires that the cost of inventory include the cost of materials, labor
costs plus an allocation of overhead incurred in the production process.
Overheadis the costs in manufacturing process other than direct labor and
direct material.
However, IFRS does not give specific directions for determining which costs
and how much of them should be included.
Thus, different entities can determine the cost of inventory differently, which
impairs comparability.
Perpetual and Periodic Inventory Control Systems
Perpetual Inventory control system: keeps an ongoing tally of purchases and
sales of inventory.
Journal Entries:
Cr. Accounts Payable/Cash
Dr. Inventory
To record the purchase of inventory
For the purchase of inventory:
Cr. Revenue
Dr. Cash
To record the sale of inventory
For the sale of inventory
Cr. Inventory
Dr. Cost of goods sold
To record the sale of inventory in a perpetual and the
corresponding cost of sales
Chapter 7: Inventory
5:33 PM
MyNotes Page 1

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a transaction affects inventory. Purchases are accumulated in a separate purchases
account. The balance at the end of year is determined by counting the inventory.
Cost of sales = Beginning inventory + Purchases ±Ending Inventory
Journal Entries:
Cr. Cash/ Accounts Payable
Dr. Purchases
For the purchase of inventory:
Cr. Revenue
Dr. Cash
For when inventory is sold
At the end of the period:
Dr. cost of sales
Cr. Expenses
Dr. Inventory (You debit inventory because you convert the
remaining amount into an asset at the end of the year)
Determine cost of sales using the formula above, followed after is an adjusting entry:
Internal Control
Under perpetual inventory, an inventory count is done to determine the amount of
inventory that maybe stolen, lost, damaged or destroyed.
If inventory is not counted at the end of the period, the amount on the b/s can be
overstated and expenses would be understated.
(Stolen inventory is an expense in the period the theft occurs or is discovered)
Information on stolen inventory is rarely, if ever reported in the f/s. It is usually
accounted for in the cost of sales.
place as there are no records to compare to the physical count.
Inventory Valuation Methods
Three cost formulas allowed by IFRS:
First in first out (FIFO)
Average cost
Specific identification
When inventory is homogeneous or interchangeable then average cost or FIFO
cost formulas can be used.
IFRS requires specific identification for inventory items that are no
models, thus each has a vehicle identification number.
FIFO Method
The costs associated with the inventory that was purchased for produced first is
the cost expensed first
With FIFO, the cost of inv reported on the b/s represents the cost of inv most
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With FIFO, the cost of inv reported on the b/s represents the cost of inv most
recently purchased or produced
The oldest costs are the first ones matched to revenues
Cost formulas address the flow of costs, not the physical flow of goods
Average Cost Method
The average cost of the inventory on hand during the period is calculated and
the average is used to determine cost of sales and ending inventory
Average cost simply assumes all inv units have the same cost and the cost of
individual units of inv is lost
Specific Identification
assigns the actual cost of a particular unit of inv to that unit of inventory
The inventory cost reported on the b/s is the actual cost of the specific item
Specific identification provides some opportunity for management to manipulate
F/S, if there are identical items with different costs in inv, managers could
choose sell the most expensive to lower net income and the sell the least
expensive to increase net income.
It provides an opportunity for income management that the other two do not!
Comparison of Different Cost Formulas
When inventory prices are rising, FIFO cost of sales will always be lower than
average cost method of cost of sales and FIFO gross margin and net income
will always be higher.
If cost of inventory remains constant over a period of time all methods will yield
the same results.
When FIFO is used, the inventory costs reported on the B/S are most current as
a result it gives a close approximation of the replacement cost.
Replacement cost is the amount it would cost to replace inventory, or any
asset, at current prices.
Stakeholders who are interested in predicting future cash flows might find a
FIFO valuation useful.
The current ratio will be higher with FIFO when prices are rising
On the I/S the costs associated with the oldest inventory are expensed to cost
of sales first under FIFO. This means COGS is less current
Thus, gross margin and net income are poor indicators and the effects could be
misleading to stakeholders
Average cost provides a b/s measure less current than FIFO but the cost of
sales is more current
FIFO corresponds to physical flow of the goods
Average cost used when prices are rising because it yields a lower net income
figure. (Used by businesses with tax minimization objective)
Lower of Cost and Market Rule
According to IFRS, inventory on hand at the end of period must be evaluated
according to the lower of cost and market (LCM) rule.
It requires inventory to be recorded at its net realizable value, is NRV is less
than cost.
NRV is the amount the entity would receive from the selling of the inventory,
less any additional costs.
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