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Chapter 8

MGAC01H3 Chapter Notes - Chapter 8: Perpetual Inventory, Accounts Payable, Subledger

Financial Accounting
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Chapter 8 Inventory Notes
inventories are defined as “assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale;
or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services”
sometimes there is a fine line between what is inventory and what is better classified as property, plant, and equipment
Inventory Categories
the identification, measurement, and disclosure of inventories must be done carefully because the investment in inventories is often
the largest current asset of many companies; and is usually referred to as merchandise inventory
amounts for goods and materials that are on hand but have not yet gone into production are reported as raw materials inventory
the cost of the raw material on which production has started but is not yet complete, plus the direct labour cost applied specifically to
this material and its applicable share of manufactured overhead costs, constitutes the work-in-process inventory
the costs associated with the completed but still unsold units on hand are reported as finished goods inventory
the cost of goods manufactured represents the product costs of goods that are completed and transferred to Finished Goods Inventory
the cost of goods manufactured during the year is similar to the cost of goods purchased in a merchandising company
Inventory under the Lower of Cost and Net Realizable Value Model
the cost of goods available for sale or use is the total of (1) the cost of the goods on hand at the beginning of the period and (2) the
cost of the goods acquired or produced during the period
the cost of goods sold is the difference between those available for sale during the period and those on hand at the end of the period
Recognition and Measurement
Physical Goods Included in Inventory
Goods in Transit
if the goods are shipped f.o.b. shipping point, the risks and rewards of ownership, which usually go with having legal title, pass to
the buyer when the seller delivers the goods to the common carrier (transporter), who then acts as an agent for the buyer
if goods are shipped f.o.b. destination, ownership and its associated risks and rewards do not pass until they reach the destination
goods in transit at the end of a fiscal period that were sent f.o.b. shipping point are recorded by the buyer as purchases of the period
and should be included in ending inventory, else the result is understated inventories and accounts payable in the balance sheet, and
understated purchases and ending inventories when calculating cost of goods sold for the income statement
the accountant normally prepares a purchase cut-off schedule for the end of a period to ensure that goods received from suppliers
around the end of the year are recorded in the appropriate period
because goods that are bought f.o.b. shipping point may still be in transit when a period ends, the cut-off schedule is not completed
until a few days after the period’s end since this gives time for goods in transit at year end to be received
Consigned Goods
in terms of accounting for inventory, it is important to recognize that goods out on consignment remain the consignor’s property and
are included in their inventory at purchase price or production cost plus the cost of handling and shipping the goods to the consignee
when consignee sells the goods, the revenue, less a selling commission and expenses incurred in accomplishing the sale, is remitted
inventory out on consignment is shown as separate item or is reported in notes, but unless amount is large, there is little need for this
the consignee should be extremely careful not to include any consigned goods in its inventory count
Special Sales Agreements
while the transfer of legal title is a general guideline for whether the risks and rewards of ownership have passed from a seller to a
buyer, transfer of legal title and the transfer of the risks and rewards do not always go hand in hand
sometimes enterprise finances its inventory without reporting either liability or the inventory on its balance sheet; this approach—
often referred to as a product financing arrangement—usually involves a “sale” with either a real or implied “buyback” agreement
if the risks and rewards of ownership have not been transferred, the inventory should remain on the seller’s books
Costs Included in Inventory Cost
Purchase Discounts
when suppliers offer cash discounts to purchasers, there are 2 methods to account for the purchases: gross method and net method
under the gross method, both the purchases and payables are recorded at the gross amount of the invoice, and any purchase discounts
that are later taken are credited to a Purchase Discount account, which is later reported as a contra account to Purchases
under the net method, the purchases and accounts payable are recorded initially at an amount net of the cash discounts
if the account payable is paid within the discount period, the cash payment is exactly equal to the amount originally set up
if the account payable is paid after the discount period is over, the discount that is lost is recorded in Purchase Discounts Lost
recording the loss allows the company to assign responsibility for the loss to a specific employee
this treatment is considered more theoretically appropriate because it (1) provides a correct reporting of the asset cost and related
liability, and (2) makes it possible to measure the inefficiency of financial management if the discount is not taken
Vendor Rebates
in general:
oIf it is discretionary by the supplier, no rebate is recognized until it is paid or supplier becomes obligated to make a payment.

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oIf it is probable and the amount can be estimated, the asset recognition criteria are met and the receivable can be recorded. It is
recognized as a reduction in the cost of purchases. The receivable is allocated between remaining inventory, and goods sold.
oThe receivable recognized is based on the proportion of the total rebate that is expected relative to the transactions to date.
Product Costs
product costs are costs that “attach” to inventory and are recorded in the inventory account—that is, they are capitalized
these costs are directly connected with bringing goods to the buyer’s place of business and converting them to a saleable condition
conversion costs include direct labour and allocation of fixed and variable production overhead costs that are incurred in processing
direct materials into finished goods; the allocation of fixed production costs is based on the company’s normal production capacity
“Basket” Purchases and Joint Product Costs
a group of units with different characteristics is purchased at a single lump-sum price; i.e., in what is called a basket purchase
when this situation occurs most reasonable practice is to allocate total cost among various units based on their relative sales value
relative sales value method is rational, can be applied consistently, is used whenever there is a joint cost that needs to be allocated
Inventory Accounting Systems
Perpetual System
a perpetual inventory system continuously tracks changes in the Inventory account—this means that the cost of all purchases and the
cost of the items sold (or issued out of inventory) are recorded directly in the Inventory account as the purchases and sales occur
the accounting features of a perpetual inventory system are as follows:
1) Purchases of merchandise for resale or raw materials for production are debited to Inventory rather than to Purchases.
2) Freight-in is debited and purchase returns and allowances and purchase discounts are credited to Inventory instead of being
accounted for in separate accounts.
3) The cost of the items sold is recognized at the time of each sale by debiting Cost of Goods Sold and crediting Inventory.
4) Inventory is a control account that is supported by a subsidiary ledger of individual inventory records. The subsidiary records
show the quantity and cost of each type of inventory on hand.
Periodic System
in a periodic inventory system, the quantity of inventory on hand is determined, only periodically
each acquisition of inventory during the accounting period is recorded by a debit to the Purchases account
the total in the Purchases account at the end of the accounting period is added to the cost of the inventory on hand at the beginning of
the period to determine the total cost of the goods available for sale during the period
the cost of ending inventory is subtracted from the cost of goods available for sale to calculate the cost of goods sold
under a periodic inventory system, the cost of goods sold is a residual amount that depends on first calculating the ending inventory
Cost Formulas
a cost formula is a method of assigning inventory costs incurred during the accounting period to inventory that is still on hand at the
end of the period (ending inventory) and to inventory that was sold during the period (cost of goods sold)
both IFRS and ASPE recognize 3 acceptable cost formulas—specific identification; first-in, first-out (FIFO), weighted average cost
Specific Identification
when using the specific identification cost formula, each item that is sold and each item in inventory needs to be identified
the costs of the specific items that are sold are included in COGS, and the costs of the specific items on hand are included in EI
the requirement that this method only be used for goods that are not ordinarily interchangeable is an attempt to make sure the benefit
is achieved and to prevent management from manipulating the amount of net income
in many circumstances, it is difficult to directly relate shipping charges, storage costs, discounts, and other blanket charges to an item
Weighted Average Cost
the weighted average cost formula takes into account that the volume of goods acquired at each price is different
the beginning inventory units and cost are both included in calculating the average cost per unit
another weighted-average cost method is the moving-average cost formula
this method is used with perpetual inventory records that are kept in both units and dollars
in this method, a new average unit cost is calculated each time a purchase is made
this is because the cost of goods sold at the updated average cost has to be recognized at the time of the next sale
First-In, First-Out (FIFO)
the FIFO cost formula assigns costs based on the assumption that goods are used in the order in which they are purchased
in other words, it assumes that the first items purchased are the first ones used (manufacturing) or sold (merchandising)
in all cases where FIFO is used, the inventory and COGS are the same at the end of the period whether perpetual or periodic system
Choice of Cost Formula
the overriding objectives that underlie the inventory standards and guide management are as follows:
1) choose an approach that corresponds as closely as possible to the physical flow of goods
2) report an inventory cost on the balance sheet that is representative of the inventory’s recent cost
3) use the same method for all inventory assets that have similar economic characteristics for the entity
Last-In, First-Out (LIFO)
the LIFO cost formula, no longer permitted under private entity GAAP and IFRS, assigns costs based on the assumption that the cost
of the most recent purchase is the first cost to be charged to cost of goods sold
his method is no longer permitted for the following reasons:
1) In almost all situations, LIFO does not represent the actual flow of costs.
2) The balance sheet cost of ending inventory is not a fair representation of the recent cost of inventories on hand.
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