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Accounting for current assets

Inventories and cost of goods sold


o The nature of inventory
o Inventory valuation methods
o Effect of inventory valuation on cost of goods sold
Cash and cash equivalents
Accounts receivables
Notes receivables
Nature of inventory
Inventory / Stock
Usually - Asset held for resale
Operating assets are for self use not for resale
Wholesalers and retailers cost of inventory is simply the purchase price
May include such costs as taxes and transportation costs.
On the balance sheet they use a single account for inventory titled merchandise
inventory or simply inventory.
They buy the inventory in finished form and offer it for resale without transforming the
product in any way. Because they do not use factory buildings, assembly lines or
production equipment
They have a relatively small investment in operating asset and a large amount in
inventory.
Manufacturers
Scenario is quite different
Three distinct type of costs are incurred by a manufacturer; direct materials, direct labour
and manufacturing overhead.
Direct material raw material ingredients used
Direct labour workers to manufacture the product
Mfg overheads other costs that are related to the manufacturing process but cannot
be directly matched to specific units of output.
The inventory of a manufacturer takes three distinct forms. The three forms of inventory
are raw materials, work in process, and finished goods.
These are also the stages in the development of products.
Direct materials or raw materials enter a production process in which they are
transformed into a finished product by the addition of direct labour and manufacturing
overhead. Those which are yet to be finished or which are under processing are known
as WIP.
Inventory can be presented in separate heads.
At the end of accounting period the manufacturer will definitely have certain amount of
raw materials, some materials under processing WIP and some finished goods.

Inventory Valuation and measurement of income


The amount assigned to ending inventory is deducted from Cost of goods available for
sale to determine CGS. If the inventory valuation is incorrect, CGS will be wrong and
thus the net income will be in error as well.
Errors
Physical count Inventory in Transit may be erroneously omitted from the valuation of inventory a yearend. Though, they belong to the buyer.
Consignment though not present physically consignor have to count, and the
consignee must also be sure not to include any consigned goods in the physical count of
its own merchandise.
Over/under estimation of valuation Overstatement of ending inventory understatement of CGS overstatement of gross
margin overstatement of net income overstatement of income tax overstatement of
beginning inventory of the following period overstatement of CGS understatement of
gross margin understatement of net income
Inventory Costs to be included
Cost the sum of the applicable expenditures and charges directly or indirectly incurred
in bringing an article to its existing condition and location.
Shipping
Insurance
Taxes
Ordering cost + Handling cost
Valuation methods
Specific identification method
Specific identification of all inventory items
Tracking the record of each individual item
Weighted average cost method
It assigns same unit cost to all units available for sale during the period.
cost of goods available for sale
Weighted average cos t
units available for sale
Ending inventory is found by multiplying the weighted average unit cost by the number of
units on hand:
First in first out method
It assumes the first units in, or purchased, are the first units out, or sold.
While selling, we sale the oldest unit first.
So the ending inventory consists of the most recent purchases of the period.
Perishable goods
LISH - Last In Still Here

In periods of rising prices, FIFO leads to higher net income. Oldest cheapest unit is used
in the calculation of cost of goods sold. Higher reported incomes may favorably affect
investor attitudes toward the company. Similarly, higher reported income may lead to
higher salaries, higher bonuses, or higher status for the management of the company.

Last in first out method


Assumes that the last units in, or purchased, are the first units out, or sold
Latest purchases are sold first.
In a period of rising prices and constant or growing inventories, LIFO yields lower net
income. It is even preferred for the income tax purpose.
During a period of higher inflation firms like to change from FIFO to LIFO.
Perpetual and Periodic Inventory systems
Perpetual inventory system keeps a continuous record that tracks inventories and the
cost of goods sold on a day-to-day basis.
Periodic inventory system does not involve day-to-day record of inventories or of cost of
goods sold. Instead the cost of goods sold and an updated inventory balance are
computed only at the end of an accounting period.
Begining invenotry Purchases Ending Inv Cost of goods sold

Selecting an inventory costing method


Best method is that which should reflect the accurate net income.
Cash flow LIFO saves the tax (cash outflow), in period of rising prices, which can be
invested.
LIFO liquidation heavy tax bill
Actual physical flow of identical products is less important to the financial success of
most businesses than is the flow of units costs
Companies may choose any of the valuation methods
Units are same, but costs are different so tracing the flow or assignment of those costs is
more important than is tracing where each unit goes.
No matter what cost flow assumptions we use, the cumulative gross profit over the life of
a company remains the same.
Whatever be chosen, that should be consistent over time. Otherwise meaningful periodic
comparisons cant be made.

Example:
Beginning inventory Jan 1
Purchases
Jan 20
April 8
September 5
December 12
Total purchase

Units Unit cost


500
10
300
400
200
100

Total cost

11
12
13
14

Available for sale


Units sold
900
?
Units in ending inventory
600
?
FIFO
Ending inventory consists of the most recent purchases of the period. In many
businesses, this cost-flow assumption is a fairly accurate reflection of the physical
flow of products. For example, to maintain a fresh stock of products, the physical
flow in a grocery store is first-in first-out.
To calculate ending inventory we start with the most recent inventory acquired
and work backward:
Date
Units
Cost
Total
December 12
100
14
September 5
200
13
April 8
300
12
Ending inventory 600
7600
Cost of goods sold can then be found:
Cost of goods available for sale 17,100
Less: ending inventory
7,600
Cost of goods sold
9,500
Since it assumes that the first units in are the first ones sold cost of goods sold can
be calculated by starting with the beginning inventory and working forward:
Jan 1
500
10
January 20
300
11
April 8
100
12
Units sold
900
Cost of goods
9,500
sold
For LIFO
To calculate ending inventory using LIFO, we start with the beginning
inventory and work forward:
Beginning inv
500
10
January 20
100
11
Ending inventory 600
61,00
Cost of goods sold can then be found:
Cost of goods available for sale 17,100
Less: ending inventory
6,100
Cost of goods sold
11,000

Since it assumes that the last units in are the first ones sold cost of goods sold can
be calculated by starting with the most recent inventory and working forward:
December 12
September 5
April 8
January 20
Units sold
Cost of goods
sold

100
200
400
200
900

14
13
12
11
11,000

Example 4
The B Oil Company, a well known distributor of fuel oil closes its accounts at the
end of each month.
The following information is available for the month of June, 2005
Sales
Rs. 2,50,000
Administrative expenses
5,000
Inventory, June 1
50 tons @ 1,000
Purchases (including carriage inward)
June 10
150 tons @ 800
June 20
150 tons @ 900
Inventory june 30
100 tons
Compute the following data by the FIFO method:

Inventory valuation on June 30

Amount of cost of goods sold for June

Profit or loss for June


Example 5
The following is an extract of the record of receipts and issues of Sulphur of a
chemical factory during February, 2005
Feb 1 Opening balance 500 tons @ Rs 200
3 Issue: 70 tons
4 Issue: 100 tons
8 Issue 80 tons
13 Received from supplier 200 tons @ 190
14 Returned from department 15 tons
16 Issue 180 tons
20 Received from supplier 240 tons @ 190
24 Issue 300 tons
25 Received from supplier 320 tons @ 190
26 Issue 115 tons
5

27 Returned from department 35 tons


28 Received from supplier 100 tons @ 190
Issues are to be priced on the principal of FIFO. The stock verifier of the factory
had found shortage of 10 tons on the 22nd and left a note accordingly.
Prepare store ledger.
Ex 6
The FD Grocery was not maintaining a perpetual inventory system for its stocks
until recently. Only physical inventory was taken at the end of each month. The
physical inventory at the end of December, 1999 showed 200 bags of fine rice at
Rs 212.25 per bag. The following purchases were made in January, 2000.
3rd
400 bags at 218 per bag
th
10
900 bags at 223.5 per bag
th
15
400 bags at 220
28th 700 bags at 213 per bag
30th 300 bags at 224 per bag
On 31st January 2000 the physical stock was 1200 bags. You are required to
calculate the value of the stock on 31st January 2000 according to FIFO, LIFO and
weighed average method
Ex 7

Do example 5 in LIFO

Example 3 in LIFO and weighted average method.

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