Textbook Chapter 9 Inventories PDF

## Chapter 9: Inventories ### In this chapter, you will learn about these three stages of the accounting information system: * **Recording of:** * Purchase of goods; and * Sale of goods. * **Preparing:** * Inventory. ### Stages of the Accounting Information System | Stage | Descriptio...

## Chapter 9: Inventories ### In this chapter, you will learn about these three stages of the accounting information system: * **Recording of:** * Purchase of goods; and * Sale of goods. * **Preparing:** * Inventory. ### Stages of the Accounting Information System | Stage | Description | |---|---| | Issue or receive source documents | Documents that are the source of information for the accounting system. | | Analyze transactions | Analyzing the financial transactions that have occurred. | | Record journal entries | Recording the financial transactions in the journal. | | Post to ledger accounts | Posting the journal entries to the ledger accounts. | | Prepare trial balance | Preparing a trial balance to ensure that the debits and credits are equal. | | Prepare trial balance (adjusted) | Preparing an adjusted trial balance to reflect any adjusting entries. | | Pass and post adjusting entries | Making any necessary adjusting entries to reflect the correct financial position. | | Prepare financial statements (final) | Preparing the final financial statements for the period. | | Prepare financial statements | Preparing the final financial statements for the period. | ### At the end of this chapter, I am able to... * **Evaluate** which inventory to purchase by considering both accounting and non-accounting information. * **Explain** why businesses keep inventories. ### Accounting Theory * **Explain** the valuation of inventory in relation to prudence theory. ### Accounting * **Calculate:** * Cost of inventory purchased * Cost of sales * Impairment loss on inventory * Ending inventory * **Use** perpetual inventory system and the FIFO method to prepare journal entries to record: * Purchase of inventory * Cost of sales * Impairment loss on inventory * **Prepare** the inventory account **without** adjustments for impairment loss on inventory. ### Analysis * **Interpret** the inventory account with adjustments for impairment loss on inventory. * **State** how profit for the period and current assets will be overstated or understated when impairment loss on inventory is not adjusted. * **State** whether profit for the period and current assets will increase or decrease when impairment loss on inventory is adjusted. ### Presentation * **Prepare** an extract of the statement of financial performance, showing the presentation of: * Cost of sales; and * Impairment loss on inventory. * **Prepare** an extract of the statement of financial position, showing the presentation of: * Ending inventory * Insurance claim receivable ## 9.1 Inventories Inventories refer to **goods bought by businesses to sell to their customers**.  Inventories are **different from non-current assets**, though both are classified as assets. Inventories are bought to be sold, while non-current assets are bought to be used within the business to generate income.  ## 9.2 Decision: Which Inventory to Buy When businesses purchase inventories from their suppliers, they have to consider both accounting and non-accounting information.  ### Accounting Information Accounting information refers to information usually generated by a business' accounting information system, such as the information that can be extracted from the journal, ledger accounts and financial statements. Accounting information such as the cost of inventory and storage cost affects the total cost of inventory. **Rate of inventory turnover (times)** informs the business if it has been efficient in managing its inventory. ### Non-accounting Information Non-accounting information refers to the information about a business that cannot be found in the journal, ledger accounts or financial statements. Non-accounting information such as nature of product, types of storage and customers' preference affects how the business assesses if the product will meet customers' needs and can be adequately kept until it is sold. #### Nature of product Nature of product refers to a feature, attribute, or quality of the product. For example, some products can come with variable components to cater to customers' preferences while some products do not have such variable components. #### Types of storage Different goods may require special types of storage. For example, certain food products require refrigeration. #### Customers' preference Customers' preferences are the motivations and behaviours which influence the customers' purchasing decisions. For example, as the demographics of a country change, the demand for certain products changes. ## 9.3 Accounting for Inventories A trading business buys inventory from its suppliers to sell to its customers. ### Cost of Inventory Purchased A trading business buys inventory from its suppliers and can also return inventory to them. The double entries for recording credit purchase and return of inventory are shown below. | Account | Credit Purchase of Inventory | Return of Inventory to Credit Suppliers | |---|---|---| | Inventory | Dr Inventory (+ asset) <br/> Cr Trade payable (+ liability) | Dr Trade payable (- liability) <br/> Cr Inventory (- asset) | If a business buys goods using cash or cheque previously, it will receive a cash refund from the suppliers when it returns goods to them. Since a trading business buys goods continually, different batches of goods purchased at different times could have different costs. The cost of inventory purchased **includes the purchase price of goods and all costs incurred to bring in and get them ready for sale**. * Transport e.g. shipping fees, air freight charges * Custom duties * Insurance for goods in transit * Packing materials * Wages for employees involved in repacking goods ### Example 9.3 Hossin Trading buys canned fruits from Fruity Group, an overseas supplier. The business has the following transactions in August 20X9. | Date | Description of Transaction | |---|---| | Aug 5 | Purchased 5,000 cans costing $6,600 on credit from Fruity Group | | Aug 16 | Received an invoice of $500 from Reliable Logistics for the transportation costs, insurance for goods in transit and custom duties incurred to import the goods | **a) Calculate the cost of inventory purchased in August 20X9.** **b) Prepare journal entries to record the above transactions.** *Narrations are not required.* **Explanation**  **a) Suggested solution** Cost of inventory purchased = $6,600+$500 = **$7,100** **b) Suggested solution** | Date | Particulars | Debit | Credit | |---|---|---|---| | Aug 5 | Inventory | $6,600 | | | | Trade payable - Fruity Group | |$6,600 | | Aug 16 | Inventory | $500 | | | | Trade payable - Reliable Logistics | | $500 | ### Cost of Sales A trading business sells inventory to its customers and the customers can also return inventory to the business. The double entries for recording credit sale and return of inventory are shown below. | Account | Credit Sale of Inventory | Return of Inventory by Credit Customers | |---|---|---| | Inventory | Dr Cost of sales (+ expense) <br/> Cr Inventory (- asset) | Dr Inventory (+ asset) <br/> Cr Cost of sales (- expense) | | Trade Receivables | Dr Trade receivables (+ asset) <br/> Cr Sales revenue (+ income) | Dr Sales returns (- income) <br/> Cr Trade receivables (- asset) | A trading business buys and sells goods at different timing. Cost of sales can be determined using the **First-In-First-Out (FIFO)** method in which goods that are purchased first are assumed to be sold first.  ## 9.4 Accounting for Impairment Loss on Inventory A trading business usually sells goods at a price higher than the cost price so that it can make a profit. However, due to unforeseen circumstances, the selling price may be reduced to a level that is lower than the cost of the inventory. According to **the prudence theory**, inventory is valued at the lower of cost and net realisable value to ensure that inventory is not overstated. When the **net realisable value** falls below the cost of inventory, the business must reduce the value of inventory and record the potential loss as an expense known as **impairment loss on inventory** even though the inventory has not yet been sold. The double entry for recording impairment loss on inventory is shown below. | Account | Net Realisable Value Falls Below Cost | |---|---| | Impairment loss on inventory | Dr Impairment loss on inventory (+ expense) <br/> Cr Inventory (- asset) | To manage the risk of potential loss caused by damaged goods, a business may buy insurance and make an insurance claim to seek compensation. However, the process usually takes some time as the insurance company needs to validate the claim before it can disburse the funds. The double entries for recording insurance claim receivable are shown below. | Account | Insurance Claim on Damaged Goods | Collection of Insurance Claim | |---|---|---| | Insurance claim receivable | Dr Insurance claim receivable (+ asset) <br/> Cr Impairment loss on inventory (- expense) | Dr Cash at bank (+ asset) <br/> Cr Insurance claim receivable (- asset) | ### Example 9.5 On 30 September 20X9, Hossin Trading had an ending inventory valued at $4,650. Due to flash floods, the packaging of the remaining canned fruits was damaged. Hence, the net realisable value of the ending inventory was reduced to $3,000. **a) Prepare journal entries to record the impairment loss on inventory.** **b) Prepare an extract of the statement of financial performance for the year ended 30 September 20X9, showing the presentation of impairment loss on inventory.** **c) Prepare an extract of the statement of financial position as at 30 September 20X9, showing the presentation of inventory.** **Explanation** Since net realisable value falls below cost, impairment loss on inventory amounts to = $4,650 - $3,000 = $1,650. **a) Suggested solution** | Date | Particulars | Debit | Credit | |---|---|---|---| | Sep 30 | Impairment loss on inventory | $1,650 | | | | Inventory | | $1,650 | **b) Suggested solution** **Hossin Trading <br/> Statement of Financial Performance <br/> for the year ended 30 September 20X9 (extract)** **Less: Other expenses** <br/> Impairment loss on inventory | $1,650 | **c) Suggested solution** **Hossin Trading <br/> Statement of Financial Position as at 30 September 20X9 (extract)** **Current assets** <br/> Inventory | $3,000 | ## Effects of Impairment Loss on Inventory Impairment loss on inventory must be deducted together with other expenses at the end of the financial period. In Example 9.5, impairment loss on inventory of $1,650 was correctly adjusted. The following calculations illustrate the effects when impairment loss on inventory is not adjusted. | Account | Not Adjusted | Adjusted | |---|---|---| | Dr Impairment loss on inventory | $1,650 | | | Cr Inventory | $1,650 | | | Other expenses | | | | Less: Other expenses | $0 | $0 | | Impairment loss on inventory | $0 | $1,650 | | Total other expenses | $0 | $1,650 | | **Profit for the year** | | | | Gross Profit | | $80,000 | | Less: Other expenses | $0 | $1,650 | | Profit for the year | $80,000 | $78,350 | | **Current assets** | | | | Current assets | | | | Inventory | $4,650 | $3,000 | ### Table 9.5 Effects of non-adjustment of impairment loss on inventory | Impairment Loss on Inventory | Effect on Other Expenses | Effect on Profit | Effect on Current Asset | |---|---|---|---| | Not adjusted | Understates | Overstates | Overstates | | Adjusted | Increases | Decreases | Decreases | ## 9.5 Interpreting Inventory In Example 9.4, you have learnt how to calculate the cost of sales using the FIFO method, and prepare journal entries and the inventory account. If you are given an inventory account, are you able to provide a description of the business activity that occurred on a particular date? ### Example 9.6 The following inventory account is extracted from the books of United Rice for the year ended 31 December 20X1. | Date | Particulars | Debit | Credit | Balance | |---|---|---|---|---| | Dec 1 | Balance b/d | | | $2,500 Dr | | | Trade payable | | $1,200 | $13,700 Dr | | 5 | Trade payable | $11,200 | | $12,500 Dr | | 10 | Cost of sales | | $8,600 | $3,900 Dr | | 15 | Cash at bank | $7,800 | | $11,700 Dr | | 19 | Cost of sales | | $6,800 | $4,900 Dr | | 22 | Cost of sales | | $800 | $5,700 Dr | | 31 | Impairment loss on inventory | | $700| $5,000 Dr | **a) Interpret the following entries.** **(i) 7 December** This transaction shows a trade payable of $1,200. This implies that United Rice had received goods on credit from a supplier and owed them $1,200. This reduces the balance in the inventory account. **(ii) 22 December** This transaction shows a cost of sales of $800. This implies that United Rice sold inventory for $800. This reduces the balance in the inventory account. **(iii) 31 December** This transaction shows an impairment loss on inventory of $700. The impairment loss on inventory is an expense that is recorded to reduce the carrying value of inventory when its net realisable value is less than its carrying value. This means that the value of the inventory was reduced by $700 because it had become obsolete or damaged. **b) If the net sales revenue was $25,000, prepare an extract of the statement of financial performance for the year ended 31 December 20X1.** **c) State the effect on profit for the year and current assets if impairment loss on inventory was not adjusted for the year ended 31 December 20X1.** **d) If United Rice has bought insurance for its goods and will be able to receive a full claim on 15 January 20X2, prepare the following:** **(i) Journal entry to record this on 31 December 20X1** **(ii) Extract of the statement of financial position as at 31 December 20X1, showing only the current assets section** **b) Suggested solution** **United Rice <br/> Statement of Financial Performance <br/> for the year ended 31 December 20X1 (extract)** Net sales revenue | $25,000 | Less: Cost of sales (8,600 + 6,800 - 800 ) | $14,600 | Gross profit | $10,400 | Less: Other expenses | | Impairment loss on inventory | $700 | **c) Suggested solution** Both profit for the year and current assets will be overstated by $700. **d) Suggested solution** **(i) Journal entry** | Date | Particulars | Debit | Credit | |---|---|---|---| | Dec 31 | Insurance claim receivable | $700 | | | | Impairment loss on inventory | | $700 | **(ii) Statement of Financial Position** **United Rice <br/> Statement of Financial Position as at 31 December 20X1 (extract)** Current assets <br/> Inventory | $5,000 | Insurance claim receivable | $700 | ## Summary **First-In-First-Out (FIFO)** | Date (20X1) | Quantity Purchased (unit) | Cost of Inventory Purchased ($) | Date (20X1) | Quantity Sold (unit) | Cost of Sales ($) | |---|---|---|---|---|---| | Mar 1 | 1,000 | 1,500 | Mar 18 | 3,000 | 1,500 + 3,100 = 4,600 | | Mar 3 | 2,000 | 3,100 | | | | | Mar 9 | 2,000 | 3,500 | Mar 21 | 5,000 | 3,500 + 5,000 = 8,500 | | Mar 12 | 3,000 | 5,000 | | | | | Mar 15 | 5,000 | 8,300 | | | | **Purchase price of goods** Costs incurred to bring in goods and get them ready for sale: * Transport * Custom duties * Insurance for goods in transit * Packing materials * Wages for employees involved in repacking goods  **Business A <br/> Statement of Financial Position <br/> as at [____]** Current assets <br/> Inventory | $5,000 | Insurance claim receivable | $1,100 | **Business A <br/> Statement of Financial Performance <br/> for the period ended [____]** Less: Cost of sales | $13,100 | Less: Other expenses | | Impairment loss on inventory | $2,200 |