AFM101 Lecture and Textbook Notes on Chapter 8.docx

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University of Waterloo
Accounting & Financial Management
AFM 101
Donna Psutka

Notes on Chapter 8 Nature of inventory and cost of sales Items Included in Inventory (tangible property held for sale in the normal course of business or used in producing goods or services for sale) - Merchandise Inventory: goods held for resale in the ordinary course of business - Raw Materials Inventory: includes items acquired for the purpose of processing into finished goods - Work-In-Process Inventory: includes goods in the process of being manufactured - Finished goods Inventory: includes manufactured goods that are complete and available for sale Costs included in inventory purchases - Goods in inventory are recorded in conformity with the cost principle - Inventory cost includes the invoice price and indirect expenditures related to the purchase, such as import duties; freight charges if the items are purchased FOB shipping point Flow of Inventory Costs - Flow of inventory costs for merchandisers is simple: o Merchandise purchases -> merchandise inventory -> cost of sales - Flow of inventory costs in a manufacturing environment is more complex o Raw material purchases -> Raw materials inventory -> + direct labour costs + factory overhead costs = work-in-process inventory -> finished goods inventory -> cost of sales - Note: working closely with suppliers in design, production, and delivery to minimize the quantities of inventories is called just-in-time or JIT Nature of Cost of Sales - Sales revenue is the number of units sold x sales price - Cost of sales is same number of units x unit costs (COGS) - Beginning inventory + purchases = cost of goods available for sale - The portion of cost of goods available for sale that are actually sold becomes cost of sales Control of Inventory Internal Control of Inventory After cash, inventory is the asset second-most vulnerable to theft 1. Separation of responsibilities for inventory accounting and physical handling of inventory 2. Storage of inventory in a manner that protects it from theft and damage 3. Limiting access to inventory to authorized employees 4. Maintaining perpetual inventory records 5. Comparing perpetual records to periodic physical counts of inventory Perpetual and Periodic Inventory Systems - In a Perpetual inventory system, a detailed inventory record is maintained, recording each purchase and sale during the accounting period - In a Periodic inventory system, ending inventory and cost of sales are determined at the end of the accounting period based on a physical count o Inventory purchases are debited to a temporary account called purchases o Cost of sales is not recorded until after the inventory count is completed - The decision to use Perpetual inventory system is based primarily on management’s need for timely information for use in operating decisions and on the cost of the perpetual system Errors in Measuring Ending Inventory - If current year profit is overstated by 20% because one division had overstated ending inventory for the year, COS understated, profit before taxes overstated in the current year. Income tax expense, income tax payable, and profit are overstated. In the following year: COS overstated, profit before taxes understated. Income tax expense, income tax payable, profit understated. - Iron law of accruals – if there are no other changes, an overstatement during one time period will reverse to an identical understatement in the next. - Retained earnings would be overstated by 10 000 less income tax exp. This error is offset in the next year. Retained earnings and inventory at end of next year would be correct. Exhibit 8.4 p414 Inventory Costing Methods Specific Identification Method - Identifies the cost of the specific item that was sold - IFRS prohibits use of this method when there are large numbers of inventory items that are interchangeable - Appropriate when dealing with very expensive items - Keep track of purchase cost of each item. Achieved by: 1. Coding the purchase cost on each unit before placing it in stock 2. Keeping a separate record of the unit and identifying it with a serial number First-In, First-Out Method (FIFO) - Allocates the oldest unit costs to cost of sales. And the newest
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