Interpret disclosures of information concerning operating expenses,
including manufacturing and retail inventory costs
Expense recognition can be generally divided into the following three approaches:
Direct association
Immediate recognition
Systematic allocation
Inventory is reported in the balance sheet at its cost, including any cost to acquire,
transport and prepare goods for sale. It is an asset until it is sold. If a company
qualifies for a supplier’s volume discount or rebate, it should immediately recognise
the effective reduction in the cost of inventory and cost of goods sold. Cash discounts
are usually established as part of the credit terms and stated as a percentage of the
purchase price.
Gross profit = sales revenue - cost of goods sold. The manner in which inventory costs
are transferred from the balance sheet to the income statement affects both the level
of inventories reported on the balance sheet and the amount of gross profit (and net
income) reported on the income statement.
A manufacturing firm produces the goods it sells and, hence, incurs two types of
costs:
Product costs: costs directly associated with production
Period expenses: cost not directly associated with production
Manufacturing firms typically report three categories of inventory account:
Raw materials inventory: the cost of parts and materials purchase from
suppliers for use in the production process. When raw materials are used in the
production process, the costs are moved to:
Work-in-process inventory: the costs of the inventory of partially completed
goods. It includes the materials used in the production of the product as well as
labour cost and overhead cost. When the production process is completed, the
cost of goods sold is transferred to:
Finished goods inventory: the cost of the stock of completed product ready for
delivery to customers. When finished goods are sold, cost of goods sold is
debited and finished goods inventory is credited.
Formulas:
Ending RM inventories = beginning RM inventories + RM purchased - RM used
Ending WIP inventories = beginning WIP inventories + (RM used + factor labour
services received + factory overhead incurred) - goods produced
Ending FG inventories = beginning FG inventories + goods produced - cost of
goods sold
,Account for inventory and cost of goods sold using different costing
methods
Understanding the flow of inventory costs is important. If the beginning inventory +
all inventory purchased or manufactured during the period is sold, then COGS is equal
to the cost of the goods available for sale. However, when the inventory remains at
the end of a period, companies must identify the costs of those inventories that have
been sold and the cost of those inventories that remain. Most companies will organise
the physical flow of their inventories to keep the cost of inventory management low,
while minimising the likelihood of spoilage or obsolescence. However, the accounting
for inventory and cost of goods sold does not have to follow the physical flow of the
units of inventory, so companies may report using a cost flow assumption that does
not conform to the actual movement of product through the firm.
The FIFO inventory costing method transfers costs form inventory in the order that
they were initially recorded. FIFO assumes that the first costs recorded in the
inventory are the first costs transferred from inventory to cost of goods sold.
The average cost method computes an average unit cost, which is used to value
inventories and cost of goods sold. The average is the average of the cost to purchase
all of the inventories that were available for sale during a period. When average cost
is applied to the future years, the beginning inventory balance’s average cost is again
averaged with the inventory acquisitions made during the year. This new average is
used to assign costs to that year’s ending inventory and cost of goods sold.
Apply the lower cost of market rule to value inventory
, Companies are required to write down the carrying amount of inventories on the
balance sheet, if the reported cost exceeds the market value. This process is called
reporting inventories at the lower cost or market. Should net realisable value be less
than reported cost, the inventories must be written down from cost to market value,
resulting in the following financial statement effects:
Inventory book value is written down to current market value, reducing total
assets
Inventory write-down is reflected as an expense (part of cost of goods sold) on
the income statement, reducing current period gross profit, income and equity.
Inventory write-downs are included in cost of goods sold. Companies are allowed to
reserve the write-down of the inventory up to the acquisition cost if market values
warrant. The revaluation result in a debit to inventory and a credit to cost of goods
sold.
Discuss the required financial statement disclosure and how outsiders may
use it to analyse a company’s inventory management
IFRS requires note disclosure about inventory to assist users in understanding a
company’s management of inventory. The required disclosures include:
1. The inventory costing methods used
2. The carrying amount of inventories
3. The carrying amount of inventories carried at net realisable value
4. The amount of inventory write-down
5. The amount of reversal of a write-down and the reasons for the reversal
6. The carrying amount of inventories pledged
7. The cost of goods sold
Companies periodically take a physical count of inventory to identify shrink. Shrink
refers to the loss of inventory due to theft, breakage or damage, spoilage or other
losses, as well as inaccurate records. When businesses adjust inventory balances for
shrink, the loss is debited to cost of goods sold. Hence, cost of goods sold expense on
the income statement includes the actual cost of products sold during the period +
the loss due to shrink as well as losses resulting from lower of cost or market
adjustments and discounts lost.
Why do companies disclose such details on inventory, and why is so much attention
paid to inventory in financial statement analysis?
1. The magnitude of a company‘s investment in inventory is often large,
impacting both balance sheet and income statements
2. Risks of inventory losses are often high, as they are tied to technical
obsolescence and consumer tastes
3. It can provide insight into future performance - both good and bad
4. High inventory levels result in substantial costs for the company, such as:
Financing costs to purchase inventories (when not purchased on credit)
Storage costs of inventories (such as warehousing and related facilities)
Handling costs of inventories (including wages)
Insurance costs of inventories
Companies seek to keep inventories at levels that balance these costs against the
cost of insufficient inventory.
Define and interpret gross profit margin and inventory turnover ratios.
Gross profit margin (GPM) is a measure of profitability that focuses on the amount of
revenue in excess of cost of goods sold as a percentage of revenue. Gross profit
margin is defined as gross profit/sales revenue.
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