ACC1701 'Inventory' Notes

Inventory

Trading Company

→ Merchandise Inventory: Current Asset giving the stock of the goods that
the company trades (buys and sells)

Perpetual Method

Record INCREASE when goods are purchased

Record DECREASE when goods are sold Cost of Goods Sold

Expense)

Periodic Method NOT in ACC1701

Physically count inventory at the end of the period (stock take)

Update inventory accounts only after the periodic stock take

Purchases are tracked in a separate temporary account called

'Purchases'

Cost of goods sold COGS is calculated indirectly

Cost of goods sold - Periodic System NOT in ACC1701

ACC1701 'Inventory' Notes 1

 Sale Transaction Sale side & COGS Side)

Analyze as TWO transactions

First transaction: Sale

Second transaction: COGS

ACC1701 'Inventory' Notes 2

 Classified Income Statement

Effective Tax Ratio

Income Tax Expense / Profit before Tax

Net Sales

Less Sales Discount

ACC1701 'Inventory' Notes 3

 Less Sales returns and allowances

FOB Free on Board)

FOB Shipping Points

ACC1701 'Inventory' Notes 4

 → Goods are part of the buyer's inventory, out of the seller's inventory
when in transit (when you ship the goods)

FOB Destination

→ Goods are part of the buyer's inventory, out of the seller's inventory
when received by buyer

→ Seller does not recognize revenue until the goods are received by buyer

Important Examples Shipping/ Freight)

For FOB Destination:
→ Seller has to pay for shipping → THUS It's a separate expense!

→ Put as Delivery / Freight-out Expense

Slide

For FOB Shipping Point:

→ Buyer has to pay for shipping → THUS Included in Inventory
Mentioned below)

→ Whatever you add to inventory must be the cost required Historical

cost) to acquire it, so must INCLUDE freight/shipping costs → Freight-in is

ACC1701 'Inventory' Notes 5

 part of inventory cost

Slide

Answer = $105

Credit Terms

Number of days is from INVOICE/SHIPPING DATE

ACC1701 'Inventory' Notes 6

 Accounting Wise Purchases)

Purchases → Dr Merchandise Inventory

Any Allowances, Purchase Discounts, Returns → Cr Merchandise

Inventory

Shipping Costs

→ Dr Delivery Expense for SELLER

→ Dr Merchandise Inventory for BUYER

Gross Method Take pics during lecture) - Purchases

Don't assume got discount first

Purchase Discounts

When got discount, Cr to Merchandise Inventory when cash

payment being made → Because the cost of the inventory is
marked down due to discount!

ACC1701 'Inventory' Notes 7

 Net Method Take pics during lecture) - Purchases

Purchase Discounts

Assume got discount first (first step minus away discount

already)

When turns out no discount, then Dr Discount Lost Expense when

cash payment being made

ACC1701 'Inventory' Notes 8

 Purchase Return & Purchase Allowance - Purchases

Purchase Return

→ Merchandise returned by the purchaser to the supplier

Purchase Allowance

→ A reduction in the cost of defective or unacceptable merchandise

received by a purchaser or supplier

ACC1701 'Inventory' Notes 9

 Basically reduce Merchandise Inventory (Cr) and reduce Accounts
Payable Dr) on the day the allowance/ return is made?

NOT Dr Accounts Receivable!

Since payment isn't made yet! → Just a reduction in payment to be

made!

ACC1701 'Inventory' Notes 10

 Contra-revenue Accounts - Sales

* For Sales, there are/ can be 2 steps at the start Sale and COGS
transactions) → Unlike Purchases

Sales discounts, returns and allowances are tracked in TEMPORARY

accounts

Are like EXPENSES

But are shown as negative adjustments to sales (they reduce revenues)

CANNOT assume there will definitely be discount from the start

Sales Discounts

CONTRAREVENUE ACCOUNT

SALES/ REVENUE ACCOUNT WILL BE DEDUCTED

Sales Returns

Unlike Purchase Return & Purchase Allowance, Sales Allowance does

NOT have same accounting method as Sales Return!

For the sale side:

ACC1701 'Inventory' Notes 11

 Dr Sales Returns and Allowances

Cr Accounts Receivable

For the cost side:

Dr Merchandise Inventory Inventory goes back up again since

returned)

Cr COGS Since the goods no longer sold, so COGS goes down)

CONTRAREVENUE ACCOUNT

SALES/REVENUE ACCOUNT WILL BE REDUCED

ACC1701 'Inventory' Notes 12

 Sales Allowances

Unlike Purchase Return & Purchase Allowance, Sales Allowance does

NOT have same accounting method as Sales Return!

No effect on COGS!

Dr Sales Returns and Allowances

Cr Accounts Receivable Since payment not received yet! Customer

owes us less)

CONTRAREVENUE ACCOUNT

SALES/ REVENUE ACCOUNT WILL BE DEDUCTED

ACC1701 'Inventory' Notes 13

 Gross Profit after Sales Discounts/Returns/Allowances

Revenue amount on Income Statement is after deduction of Revenue

with amount in Sales Discounts, Returns, Allowances

Even the COGS/ Revenue → This Revenue amount is after deduction!

37.79% Mock MCQ 2

Impact on Inventory TAccount

1 Sales → COGS meaning decrease in inventory and returns → Increase

back
2 Purchase discounts, returns and allowances - Cr Merchandise Inventory

3 Purchases → Increase Inventory

ACC1701 'Inventory' Notes 14

 Impact on COGS TAccount

Mainly just for 1 Sales and 2 Returns

Calculating COGS

Use COST BASIS of goods sold - Specific Identification

Increasing in use because of bar-coding

ACC1701 'Inventory' Notes 15

 Calculating COGS - Cost Flow Assumptions

We are allowed to make reasonable assumptions about the inventory

flow

So that we do not need to track costs for each item separately

Assumptions:

1 FIFO First in first out): Goods are sold in order of age, oldest first
2 Weighted Average: The unit cost of goods sold is the average unit cost
of the units in stock just before the sale

NOT ALLOWED LIFO Last in first out?

ACC1701 'Inventory' Notes 16

 FIFO

During FIFO,
Let's say got shipping costs and discounts,
you still find the AVERAGE cost of each item per purchase!

500 @ $24.54 = $12,270 for example

From 500 @ $23 - $230 + $1000 = $12,270 (shipping cost)

ACC1701 'Inventory' Notes 17

 But unlike WAC you don't find the AVERAGE cost for ALL items inventory
so far

Important because there may be returns etc, you use $24.54 instead
of $23! Below)

ACC1701 'Inventory' Notes 18

 Specific Identification

Weighted Average Cost

ACC1701 'Inventory' Notes 19

 Lower of Cost or Net Realizable Value IAS 2 Inventories)

Inventory must be reported at NRV when NRV is lower than cost

NRV = Estimated selling price in the ordinary course of business less

the estimated costs of completion and the estimated costs necessary
to make the sale

NRV = Estimated Selling Price - Estimated Cost to Sell

AY1718 Finals Actual) Example

Estimated Selling Price = 55% of original cost of inventory →

Of the excess inventory → $72,000

Estimated Cost to sell = Incremental Cost to sell etc

Since NRV is lower than cost, inventory must be reported

at NRV

Loss is: Original Cost of Inventory $72,000 - NRV

Dr COGS Loss amount)

Cr Inventory Loss amount)

Can be applied in two ways:

ACC1701 'Inventory' Notes 20

 1 Separately to each individual item
2 To major categories of assets

1 NRV for Individual Inventory items + Recording Inventory Impairment

ACC1701 'Inventory' Notes 21

 Impairment and Sales Returns

Returned goods may often be impaired

Recorded at the lower of their cost of NRV (which can be be zero)

Sales Returns must be ^

Variations in Practice

ACC1701 'Inventory' Notes 22

 Impairment can be recorded as a separate expense Impairment
Expense) rather than an adjustment to COGS → often called
"obsolescence"

Inventory can be reported as the net of two separate accounts:

'Inventory at cost' less a separate account "Allowance for
impairment" [or obsolescence]

Shrinkage

An annual stock-take is standard practice even with the perpetual

system

Usually, the value of the ending inventory from the stock-take is less
than the ending balance in the merchandise inventory account →
Shrinkage

Example

ACC1701 'Inventory' Notes 23

ACC1701 'Inventory' Notes 24
 Effect of Inventory Errors
→ Beginning Inventory - Ending Inventory = Purchases - COGS

→ Inventory errors tend to be: Self-correcting = COGS in 2010 too high

but in 2010 it will be too low → Eventually cancel each other out →
Retained Earnings will still be the correct number!

ACC1701 'Inventory' Notes 25

 Self-Study

Problem 52B

1 Payment for freight charges ASK

→ Dr Merchandise Inventory Why not Dr Delivery Expense?

→ Cr Cash

Answer: Not Dr Delivery Expense because this is FOB Shipping Point →

Buyer has to pay for shipping and this adds on the cost of inventory →
Inventory recorded at (historical) cost → Thus increase Merchandise
Inventory→ Dr Merchandise Inventory

→ If it's FOB Destination → Seller incurs the delivery expense → But this
question itself is about purchaser/buyer!

2 Receiving Credit Memorandum Purchases)

→ Means you returned goods etc

→ Lower the Accounts Payable → Dr Accounts Payable

ACC1701 'Inventory' Notes 26

 → Lower the Merchandise Inventory → Cr Merchandise Inventory

3 Issuing Credit Memorandum Sales)

→ Means someone buying from you, returned goods etc

→ Lower the Accounts Receivable → Cr Accounts Receivable

→ However, do NOT increase Merchandise Inventory → Sales is different

from Purchases

→ Instead, Debit 'Sales Returns and Allowances'

4 Remember the values of your A/P or A/R may change after a credit
memorandum → Then use the new value of A/P or A/R when doing
journal entry for payment made/received

5) Descriptions of Journal Entries

1 Money paid/received → To record for → Receivable collected/ Payable

paid within discount period Calculation of discount)

2 Credit Memorandum → To record for issuance/ receival of credit

memorandum due to 'return/allowance etc'

3 Sales → '... on credit/ in cash'

Problem 61B

FIFO

ACC1701 'Inventory' Notes 27

 WAC

After a sale is made, Inventory Balance = The remaining number x

The average COGS (aka the newest average calculated)

Specific Identification

ACC1701 'Inventory' Notes 28

 Gross Profit = Revenue - Total for COGS Column!

Problem 63B

→ If Cost > Lower of Cost and NVR Applied to Items ASK

Dr COGS

because it is like an expense that causes reduction in Net Profit

Cr Merchandise Inventory

ACC1701 'Inventory' Notes 29

 Classified Income Statement

Net sales

Less Sales Discount

Less Sales returns and allowances

Other Income

Service Revenue Adjusted from Unearned Revenue)

Other kinds of revenue other than sales

Effective Tax Ratio

Income Tax Expense / Profit before Tax x 100

→ REMEMBER 'Amounts in $' → Remember to put units for all Financial

Statements!

Tutorial

FOB Shipping Point → Part of Merchandise Inventory during Invoice date

Buyer)

ACC1701 'Inventory' Notes 30

 FOB Destination → Part of Delivery Expense during Arrival Date → Accrual
Basis Seller)

FOB Shipping Point → Record Dr/Cr of Merchandise Inventory on Invoice Date

FOB Destination → Record Dr/Cr of Merchandise Inventory on Arrival Date

Shipping Terms

→ FOB Terms and Ownership of Goods

Credit Terms

→ Discount days → With respect to invoice date

ACC1701 'Inventory' Notes 31

 For last part

→ Unearned Revenue since payment was before Arrival

ACC1701 'Inventory' Notes 32

 Sales Returns

Even though for 22 Feb's return, the cash for sale on 12 Feb has
already been paid, still Credit A/R since this is an on-going relationship
→ Follow the notes, for sales returns:

Sale Side: Dr Sales returns and Allowances, Cr A/R

COGS Side: Dr Merchandise Inventory, Cr COGS

Answers

ACC1701 'Inventory' Notes 33

ACC1701 'Inventory' Notes 34
 Shipping Expense / Freight-out Expense

The extra practice pointer]

Only incurred if goods shipped Invoice/Shipping date) for FOB

Shipping Point

Only incurred if goods arrive/delivered Arrival date) for FOB

Destination

Cannot 'accrue' like Discount Lost Expense! Since this actually

happens due to accrual basis itself

Discount Lost Expense

The extra practice pointer]

Can also be Adjusting Entry!

If incurred before payment, still need to record due to ACCRUAL

BASIS

Dr Discount Lost Expense

Cr Accounts Payable

ACC1701 'Inventory' Notes 35

 Summary

Net method

Assume got discount first

Deduct the amount from the Merchandise Inventory you Dr

Accounts Payable will be affected at this point due to the

change in Inventory cost

If NO DISCOUNT on PAYMENT DATE

Dr Discount Lost Expense

Cash paid will be higher than previous A/P

Dr Accounts Payable Same as previous JE

Cr Cash

Gross method

Don't assume got discount first

If GOT DISCOUNT on PAYMENT DATE

Cr Merchandise Inventory

Important as it affects the Inventory Balance!

Cash paid will be lower than previous A/P

Cash paid will be lower, A/P debited remains the same

Purchase Discount

Covered above % of PURCHASE/COST Price]

Purchase Return

Dr Accounts Payable PURCHASE/COST Price]

Cr Merchandise Inventory

Purchase Allowance

Dr Accounts Payable PURCHASE/COST Price]

Cr Merchandise Inventory

ACC1701 'Inventory' Notes 36

 Sales Discount No net or gross method, that's only for purchase.
Just follow this)

Dr Cash Lowered amount)

Dr Sales Discount % of SELLING PRICE

Cr Accounts Receivable Remains)

Sales Return

For the sale side:

Dr Sales Returns and Allowances This is the SELLING PRICE x

Number of items returned x DISCOUNT]

Cr Accounts Receivable

IMPORTANT

Remember to reduce the amount of Sales Discount for goods

returned

If any. So previously if got any discount applied must

minus away since returned)

If not, when you put Sales Returns and Allowances in

Income Statement there will be overlap, since there is
also Sales Discount

Also applies to Sales Allowance!

For the cost side:

Dr Merchandise Inventory This is the COST PRICE (of Inventory) x

Number of items returned]

Cr COGS

Note the difference between SELLING PRICE and COST PRICE!

Another note

If it's NRV, then for cost side use NRV! Don't use current cost
of each inventory unit

Sales Allowance

Dr Sales Returns and Allowances SELLING PRICE

ACC1701 'Inventory' Notes 37

 Cr Accounts Receivable

No cost side)

The seller usually prepares a credit memorandum to confirm a buyer’s

return or allowance. A seller’s credit memorandum informs a buyer of
the seller’s credit to the buyer’s Account Receivable (on the seller’s
books)

Sales Discounts, Sales Returns and Allowances

TEMPORARY Accounts

Must be closed to Income Summary Account

Which will be closed to Retained Earnings Account

CONTRAREVENUE Accounts

Must present on Income Statement under Revenue

Representation on Income Statement

NET Sales

ACC1701 'Inventory' Notes 38

 NRV

If got NRV

Must report inventory at NVR on Adjusted Trial Balance and

Statement of Financial Position!

Overstatement/Understatement of Inventory
Inventory errors are self-correcting because it always yields an offsetting
error the next year, but that doesn't mean the errors are not severe!

Income Statement

Statement of Financial Position

ACC1701 'Inventory' Notes 39

 Closing Entries for Merchandisers

Sales Discounts / Sales Returns and Allowances are TEMPORARY

ACCOUNTS

Revenue, COGS, Expenses too

All these accounts above must be closed to Income Summary

Then close Income Summary to RE

Then close Dividends to RE

ACC1701 'Inventory' Notes 40

ACC1701 'Inventory' Notes 41