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Chapter 8

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Wilfrid Laurier University
Arthur Read

Chapter 8: Reporting and Interpreting Cost of Sales and Inventory: Nature of Inventory and Cost of Sales Items Included in Inventory:  Inventory is tangible property that is either o Held for sale in the normal course of business o Used to produce goods or services for sale  Reported as current asset because it normally is used or converted into cash within one year or within the next operating cycle, whichever is longer  Companies that do not make products they sell, but simply purchase products and sell them to customers are called merchandisers  Merchandisers (wholesale or retail businesses) hold the following: o Merchandise inventory  Goods held for resale in the normal course of business  Manufacturing business hold the following types of inventory: o Raw materials inventory  Items acquired by purchase, growth, or extraction for processing into finished goods o Work-in-process inventory  Goods in the process of being made but are not complete yet o Finished goods inventory  Manufactured goods that are complete and available for sale Costs Included in Inventory Purchase:  Goods in inventory are recorded in conformity with the cost principle  Inventory costs include, in principle, the sum of applicable expenditures and charges directly or indirectly incurred in bringing an article to a usable or saleable condition and location  Amount included should include the invoice and indirect expenditures related to purchase (import duties, freight charges if the items are purchased FOB shipping point, as well as inspection and preparation costs) Flow of Inventory Costs:  Flow of inventory costs for merchandisers o When merchandise is purchased, the merchandise inventory account is increased o When the goods are sold, the merchandise inventory is decreased and the cost of goods sold is increased  Flow of inventory costs in a manufacturing environment o Raw materials must be purchased, as they are used in production, their cost is removed from the raw materials inventory and added to the cost of the work-in- process inventory  Two there components of manufacturing costs, direct labour and factory overhead, are also added to the work-in-process inventory when incurred in the manufacturing process  Direct labour cost represents the earnings of employees who work directly o the products being manufactured  Factory overhead—comprises manufacturing costs that are not raw material or direct labour costs Nature of Coat of Sales:  COS is directly related to sales revenue  COS is the number of units sold multiplied by their unit costs  COS=BI+P-EI  Cost of Goods Available for Sale—sum of the cost of beginning inventory and the cost f purchases for the period  Ending inventory for one accounting period becomes the beginning inventory for the next Control of Inventory: Internal Control of Inventory:  Inventory is the asset second most vulnerable to theft  The following are the most important control features o Separation of responsibilities for inventory accounting and physical handling of inventory o Storage of inventory in a manner that protects it from theft and damage o Limiting access to inventory to authorized employees o Maintaining perpetual inventory records (described below) o Comparing perpetual records to periodic physical counts of inventory Perpetual and Periodic Inventory Systems:  To compute costs of sales; beginning inventory, purchases of merchandise, and ending inventory must be known  The amounts of cost of sales and ending inventory can be determined by using one of two different inventory systems Perpetual Inventory System:  Detailed record is maintained for each type of merchandise stocked showing o Units and cost of the beginning inventory o Units and cost of each purchase o Units and cost of goods for each sale o Units and cost of the goods on hand at any point in time  Maintained on transaction by transaction basis  Under this system a physical count must be performed from time to time to ensure records are accurate Periodic Inventory System:  Companies do not maintain an ongoing record of inventory during the year  Cost of sales cannot be determined reliably until the end of the period  Revenues recorded at the time of each sale, however the cost of sales is not recorded until after the inventory count is completed  Primary disadvantage of a periodic inventory system is the lack of timely inventory information  Most modern companies could not survive  Perpetual inventory system provides more timely information about inventory quantities and costs Perpetual Inventory Records in Practice:  Decision to use perpetual is based primarily on management’s need for timely information for use in operating decisions and on the cost of the perpetual system  Many inventory ordering and production decisions require accurate information on inventory quantities but not costs Errors in Measuring Ending Inventory:  Direct relationship between cost of ending inventory and cost of sales  Items not measured in the ending inventory are assumed to ave been sold o Thus measurement of ending inventory quantities and costs affect both statement of financial position and income statement  Ending inventory affects profit for that period and the next accounting period Inventory Costing Methods:  Th
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