Accounting for Inventory PDF

## Accounting for Inventory ### Understanding Inventory - **Nature of Inventory:** Inventory represents finished and unfinished goods which have not yet been sold by a company. Inventories are maintained as buffers to meet uncertainties in demand, supply, and movements of goods. These holdings ar...

## Accounting for Inventory ### Understanding Inventory - **Nature of Inventory:** Inventory represents finished and unfinished goods which have not yet been sold by a company. Inventories are maintained as buffers to meet uncertainties in demand, supply, and movements of goods. These holdings are recorded in an accounting system. ### Basic Inventory Accounting - An organization's inventory counts as a current asset on an organization's balance sheet because the organization can, in principle, turn into cash by selling it. - However, it ties up money that could serve for other purposes and requires additional expense for its protection. - Inventory may also cause significant tax expenses, depending on particular countries' laws regarding depreciation of inventory, as in the case of Thor Power Tool Company v. Commissioner. ### Inventory Systems - There are two principal systems for determining inventory quantities on hand: periodic and perpetual system. #### The Periodic System This system requires a physical count of goods on hand at the end of a period. A cost basis (i.e., FIFO, LIFO) is then applied to derive an inventory value. Because it is simple and requires records and adjustments mostly at the end of a period, it is widely used. It does lack some of the planning and control benefits of the perpetual system. #### The Perpetual System The perpetual system requires continuous recording of receipt and disbursement for every item of inventory. Most large manufacturing and merchandising companies use this system to ensure adequate supplies are on hand for production or sale, and to minimize costly machine shutdowns and customer complaints. ### Inventory Costing - Inventory cost includes all expenditures relating to inventory acquisition, preparation, and readiness for sale, minus purchase discounts. - **Rationale for Keeping Inventory** #### Time - The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amounts of inventory to use in this lead time. - However, in practice, inventory is to be maintained for consumption during `variations` in lead time. Lead time itself can be addressed by ordering that many days in advance. #### Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply, and movements of goods. #### Economies of Scale - Ideal condition of "one unit at a time at a place where a user needs it when he needs it" principle tends to incur lots of costs in terms of logistics. - So bulk buying, movement, and storing brings in economies of scale, thus inventory. ### Stages of Inventory: - **Raw materials:** materials and components scheduled for use in making a product. - **Work in process (WIP):** materials and components that have begun their transformation to finished goods. - **Finished goods:** goods ready for sale to customers. - **Goods for resale:** returned goods that are salable. ### Categories of Goods Included in Inventory: - While the reasons for holding stock were covered earlier, most manufacturing organizations usually divide their "goods for sale" inventory into several categories: #### Raw Materials - A raw material is a basic material from which a product is manufactured or made. For example, the term is used to denote material that came from nature and is in an unprocessed or minimally processed state. Latex, iron ore, logs, crude oil, and saltwater are examples of raw materials. #### Work in Process (WIP) - WIP, or in-process inventory, includes unfinished items for products in a production process. These items are not yet completed and are just being fabricated, waiting in a queue for further processing, or in a buffer storage. The term is used in production and supply chain management. - Optimal production management aims to minimize work in process. Work in process requires storage space, represents bound capital not available for investment, and carries an inherent risk of earlier expiration of the shelf life of the products. - A queue leading to a production step shows that the step is well buffered for shortage in supplies from preceding steps but may also indicate insufficient capacity to process the output from these preceding steps. #### Finished Goods - Goods that are completed (manufactured) but not yet sold or distributed to the end-user. #### Goods for resale - Returned goods that are salable. This is not always included in the "goods for sale" inventory; that depends on the preference of the company. A canned food manufacturer's materials inventory includes the ingredients needed to form the foods to be canned, empty cans and their lids (or coils of steel or aluminum for constructing those components), labels, and anything else (solder, glue, etc.) that will form part of a finished can. The firm's work in process includes those materials from the time of release to the work floor until they become complete and ready for sale to wholesale or retail customers. This may be vats of prepared food, filled cans not yet labeled, or sub-assemblies of food components. It may also include finished cans that are not yet packaged into cartons or pallets. The manufacturer’s finished good inventory consists of all the filled and labeled cans of food in its warehouse that it has manufactured and wishes to sell to food distributors (wholesalers), to grocery stores (retailers), and even perhaps to consumers through arrangements like factory stores and outlet centers. ### Components of Inventory Cost - The cost of goods produced in the business should include all costs of production: parts, labor, and overhead. #### Cost of Goods - The cost of goods produced in the business should include all costs of production. The key components of cost generally include: - Parts, raw materials, and supplies used - Labor, including associated costs such as payroll taxes and benefits, and - Overhead of the business allocable to production. - Most businesses make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Determining how much of each of these components to allocate to particular goods requires either tracking the particular costs or making some allocations of costs. #### Parts and Raw Materials - Parts and raw materials are often racked to particular sets (e.g., batches or production runs) of goods, then allocated to each item. #### Labor - Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in the production. - Costs of payroll taxes and fringe benefits are generally included in labor costs but may be treated as overhead costs. - Labor costs may be allocated to an item or set of items based on timekeeping records. #### Overhead Costs - Determining overhead costs often involves making assumptions about what costs should be associated with production activities and what costs should be associated with other activities. - Traditional cost accounting methods attempt to make these assumptions based on past experience and management judgment as to factual relationships. - Activity-based costing attempts to allocate costs based on those factors that drive the business to incur the costs. - Overhead costs are often allocated to sets of produced goods based on the ratio of labor hours or costs or the ratio of materials used for producing the set of goods. ### Variable Production Overheads - Variable production overheads are allocated to units produced based on the actual use of production facilities. - Fixed production overheads are often allocated based on normal capacities or expected production. - More or fewer goods may be produced than expected when developing cost assumptions (like burden rates). - These differences in production levels often result in too much or too little cost being assigned to the goods produced. This also gives rise to variances. #### Example - Jane owns a business that resells machines. At the start of 2009, she has no machines or parts on hand. She buys machines [Math Processing Error]A and [Math Processing Error]B for $10 each, and later buys machines [Math Processing Error]C and [Math Processing Error]D for $12 each. - All the machines are the same, but they have serial numbers. Jane sells machines [Math Processing Error]A and [Math Processing Error]C for $20 each. Her cost of goods sold depends on her inventory method. - Under specific identification, the cost of goods sold is: - [Math Processing Error]$10 + $12 = $22 - which is the particular costs of machines [Math Processing Error]A and [Math Processing Error]C. If she uses FIFO, her costs are: - [Math Processing Error]$10 + $10 = $20 - If she uses average cost, her costs are: - [Math Processing Error]$10 + $10 + $12 + $12$4·$2 = $22 - If uses LIFO, her costs are: - [Math Processing Error]$12 + $12 = $24 - Thus, her profit for accounting and tax purposes may be $20, $18, or $16, depending on her inventory method. ### Flow of Inventory Costs - Accounting techniques are used to manage inventory and financial matters - now much money a company has tied up within inventory of produced goods, raw materials, parts, components, etc. These techniques manage assumptions of cost flows related to inventory and stock repurchases. - FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold. - LIFO stands for last-in-first-out. The most recently produced items are recorded as sold first. Since the 1970’s, companies shifted towards the use of LIFO, which reduces their income taxes. The International Financial Reporting Standards banned using LIFO, so companies returned to FIFO. ### Controlling Inventory - Internal controls over a company's inventory are meant to ensure that management has an accurate count of what materials and goods it has available for sale and to protect those goods from being spoiled, stolen, or otherwise made unavailable for sale. - In short, inventory internal controls are meant to ensure that a company always has sufficient resources to produce and sell goods to meet its customer's needs without having an oversupply. #### Internal Controls - Inventory internal controls ensure that a company has sufficient resources to meet its customer's needs without having too much goods. - This process is effected by the company's structure, its employees, and its informational systems. - Since a company's inventory is directly tied to the business's ability to generate profit, the internal controls must be comprehensive and require significant thought when being designed. #### Storage - Companies should store inventory in secure, spacious warehouses so that inventory is not stolen or damaged. Goods and resources of the same or similar type should be kept in the same general area of the warehouse to minimize confusion and to ensure accurate counts ### Inventory Management Systems - [An inventory management system is a series of procedures, often aided by computer software, that tracks assets progression through inventory.] - As the material is processed into the goods for resale, the amount of raw material used should be deducted from the "raw material inventory" and the amount of goods that result from the process should be added to the "finished goods inventory." As each finished item is sold, the "finished goods inventory" should be decreased by that amount. - The benefit of a properly used and maintained inventory management system is that it allows management to be able to know how much inventory it has at any given time. #### Physical Inventory Count - Physical inventory counts are a way of ensuring that a company's inventory management system is accurate and as a check to make sure goods are not being lost or stolen. - A detailed physical count of a company's entire inventory is generally taken prior to the issuance of a company's balance sheet, to ensure that the company accurately report its inventory levels. #### Cycle Counts - Companies usually conduct cycle counts periodically throughout an accounting period as a means to ensure that the information in its inventory management system is correct. - To conduct a cycle count, an auditor will select a small subset of inventory, in a specific location, and count it on a specified day. - The auditor will then compare the count to the related information in the inventory management system. If the counts match, no further action is taken. If the numbers differ, the auditor will take additional steps to determine why the counts do not match. - Cycle counts contrast with traditional physical inventory in that a full physical inventory may stop operation at a facility while all items are counted at one time. - Cycle counts are less disruptive to daily operations, provide an ongoing measure of inventory accuracy and procedure execution, and can be tailored to focus on items with higher value, higher movement volume, or that are critical to business processes. - Cycle counting should only be performed in facilities with a high degree of inventory accuracy. ### Perpetual vs. Periodic Counting - Perpetual inventory updates the quantities continuously and periodic inventory updates the amount only at specific items, such as year-end. #### Perpetual Inventory - Perpetual inventory, also called continuous inventory, is when information about the amount and availability of a product is updated continuously. - Generally, this is accomplished by connecting the inventory system either with the order entry system or for a retail establishment the point of sale system. - A company using the perpetual inventory system would have a book inventory that is exactly (within a small margin of error) the same as the physical (real) inventory. #### Periodic Inventory - Periodic inventory is when information about the amount and availability of a product is updated only periodically. - Physical inventories are conducted at set time intervals; both costs of goods sold and the inventory are adjusted at the time of the physical inventory. Most companies who use periodic inventory perform this at year-end. #### Periodic vs. Perpetual - In earlier periods, non-continuous or periodic inventory systems were more prevalent. Many small businesses still only have a periodic system of inventory. - Perpetual inventory systems can still be vulnerable to errors due to overstatements (phantom inventory) or understatements (missing inventory) that occur as a result of theft, breakage, scanning errors, or untracked inventory movements. These errors lead to systematic errors in replenishment. - While the Perpetual Inventory method provides a close picture of the true inventory information, it is a good idea for companies using a perpetual inventory system to do a physical inventory periodically. ### Conducting a Physical Inventory - Physical Inventory is a process where a business physically counts its entire inventory. Companies perform a physical inventory for several reasons including to satisfy financial accounting rules or tax regulations or to compile a list of items for restocking. - Most companies choose to do a physical inventory at year-end. Businesses may use several different tactics to minimize the disruption caused by physical inventory. - For instance, inventory services provide labor and automation to quickly count inventory and minimize shutdown time. #### The Phases of Physical Inventory: - There are three phases of a physical inventory: ##### 1 - Planning and Preparation - In the planning and preparation period, a list of stocks that need to be counted is set up. Teams are then assigned and sent to count the stock. ##### 2 - Execution - The teams count the inventory items and record the results on an inventory-listing sheet. ##### 3 - Analysis of Results - When analyzing the results, a company must compare the inventory counts submitted by each team with the inventory count from the computer system. - If any discrepancies occur between the actual number and the computer system, it may be necessary to recount the disputed inventory items to determine the correct quantity. - After the final amounts are determined, the company must make an adjusting entry to the computer inventory. ### Impact of Measurement Error - Measurement error leads to systematic errors in replenishment and inaccurate financial statements. #### Measurement Error Impacts - Measurement error is the difference between the true value of a quantity, and the value obtained by measurement. The two main types of error are random errors and systematic errors. - In inventory controlling, measurement error is the difference between the actual number of stocks, and the value obtained by measurement. - Inventory systems can be vulnerable to errors due to overstatements (phantom inventory) when the actual inventory is lower than the measurement or understatements (missing inventory) when the actual stocks are higher than the measurement. - Overstatements and understatements can occur as a result of theft, breakage, scanning errors or untracked inventory movements. It is quite easy to overlook goods on hand, count goods twice, or simply make mathematical mistakes. - Based on inaccurate measurement data, the company will make either excessive orders or late orders which then may cause production disruption. In sum, systematic measurement error can lead to errors in replenishment. - Inventory controlling helps revenue and expenses be recognized. As a result, an incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. - A general rule is that overstatements of ending inventory cause overstatements of income, while understatements of ending inventory cause understatements of income. Since financial statement users depend upon accurate statements, care must be taken to ensure that the inventory balance at the end of each accounting period is correct - It is also vital that accountants and business owners fully understand the effects of inventory errors and grasp the need to be careful to get these numbers as correct as possible. ### Lesson Summary #### Nature of Inventory: - Inventories are maintained because time lags in moving goods to customers could put sales at risk. - Inventories are maintained as buffers to meet uncertainties in demand, supply, and movements of goods. - There are four stages of inventory; raw material, work in progress, finished goods, and goods for resale. - **Raw materials:** materials and components scheduled for use in making a product. - **Work in process (WIP):** materials and components that have begun their transformation to finished goods. - **Finished goods:** goods ready for sale to customers. - **Goods for resale:** returned goods that are salable. - When a merchant buys goods from inventory, the value of the inventory account is reduced by the cost of goods sold. For commodity items that one cannot track individually, accountants must choose a method that fits the nature of the sale. - FIFO (first in-first out) regards the first unit that arrived in inventory as the first sold. LIFO (last in-first out) considers the last unit arriving in inventory as the first sold. Using LIFO accounting for inventory a company reports lower net income and book value, resulting in lower taxation. #### Categories of Goods Included in Inventory: - **Raw materials:** Materials and components scheduled for use in making a product. - **Work in process/progess (WIP):** Materials and components that have began their transformation to finished goods. - **Finished goods:** Goods ready for sale to customers. - **Goods for resale:** Returned goods that are salable. - **Distressed inventory:** is inventory for which the potential to be sold at a normal cost has passed or will soon pass. - **Inventory credit:** refers to the use of stock, or inventory, as collateral to raise finance. #### Components of Inventory Cost: - **Labor costs:** include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in the production. - **Overhead costs:** (costs incurred at the plant or organization level) are often allocated to sets of produced goods based on the radio of labor hours or costs or the radio of materials used for producing the set of goods. - **Most businesses:** make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item. #### Flow of Inventory Costs: - **Accounting techniques:** are used to manage inventory and financial matters - how much money a company has tied up within inventory of produced goods, raw materials, parts, components, etc. These techniques manage assumptions of cost flows related to inventory and stock repurchases. - **FIFO:** stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold. - **LIFO:** stands for last-in-first-out. The most recently produced items are recorded as sold first. Since the 1970s, companies shifted towards the use of LIFO, which reduces their income taxes. The International Financial Reporting Standards banned using LIFO, so companies returned to FIFO. #### Internal Controls: - **Companies:** should store inventory in secure spacious warehouses so that inventory is not stolen or damaged. Goods and resources of the same or similar type should be kept in the same general area of the warehouse to minimize confusion and to ensure accurate counts. - **An inventory management system:** is a series of procedures, often aided by computer software, that tracks assets progression through inventory. A properly used and maintained inventory management system allows management to be able to know how much inventory it has at any given time. - **Detailed physical inventory counts:** are a way of ensuring that a company's inventory management system is accurate and as a check to make sure goods are not being lost or stolen. A physical count of a company's entire inventory is generally taken prior to the issuance of a company's balance sheet. - **To conduct a cycle count,** an auditor will select a small subset of inventory, in a specific location, and count it on a specified day. The auditor will then compare the count to the related information in the inventory management system to ensure the information in the system is correct.