Inventories: Measurement RECORDING AND MEASURING INVENTORY TYPES OF INVENTORY There are two types of inventories depending on the kind of business operation. • Merchandise Inventory A merchandising concern buys and resells inventory in the ordinary course of business. Merchandise inventory is reported in the balance sheet as a current asset. • Manufacturing Inventory A manufacturing concern purchases raw materials (Raw Materials Inventory), combines it with labor and factory overhead (Work in Process Inventory) and then sells the finished product (Finished Goods Inventory) to its customers. At the end of each accounting period each category of inventory is reported as a current asset in the balance sheet. CONTROL There are two types of inventory systems that are used in maintain accounting records and report inventory in the financial statements. • Perpetual System Under the perpetual inventory system the entity maintains a continuous record of the balance in the Inventory account and the Cost of Goods Sold account through out the accounting period. a) Raw materials or merchandise purchases are charged to Raw Materials or Merchandise Inventory respectively as the purchases are made. b) Freight-in, purchase returns and allowances and purchase discounts are recorded in the inventory account. c) As each sales transaction is recorded the Inventory account is credited for the cost of the item and the Cost of Goods Sold account is debited. d) Inventory is a control account, which is supported by a detailed subsidiary ledger. • Periodic System Under the periodic inventory system the inventory account reflects the beginning balance of inventory. Throughout the accounting period purchases, freight-in, purchase returns and allowances and purchase discounts are recorded in separate expense accounts. At the end of the accounting period a physical inventory is taken and the inventory account is adjusted to reflect the correct ending inventory. Example of the year-end adjusting journal entries: Date Account Debit CreditEnd of yearIncome summary Beginning inventory InventoryBeginning inventoryTo remove beginning inventory from general ledger inventory account. F:\Teaching\3321\web\module4\c8\tnotes\c8a.doc 3/12/2007 1Inventories: Measurement Date Account Debit CreditEnd of yearInventoryEnding inventory Income summaryEnding inventoryTo record ending inventory in general ledger inventory account. Both the debit and credit are entered in the income summary account because we need both amounts in order to prepare a multi-step income statement. The debit and credit balances in the income summary account combined with the temporary expense accounts result in the computation of cost of goods sold as reported in the income statement at year-end. In the income summary account the debit reflects beginning inventory and the credit reflects ending inventory. PHYSICAL QUANTITIES INCLUDED IN INVENTORY • Goods in Transit The “passage of title” is the key to determining whether goods in transit are part of ending inventory. ¾ f.o.b. destination The title to the goods transfers when received by the buyer. Therefore, goods in transit year-end should be reported in the ending inventory of the seller. ¾ f.o.b. shipping point The title to the goods transfers when the seller delivers the goods to a common carrier. Goods in transit at year-end shipped f.o.b. shipping point should be included in the ending inventory of the buyer. • Consigned Goods The consignor is the seller of the merchandise who ships the goods on consignment to the consignee. The consignee is just an agent in the selling process and does not actually own the goods. Therefore, at year-end the consignor (seller) should include the consigned goods in its inventory even though it may still be in the physical possession of the consignee. • Sales Returns and Allowances When returns and allowances are material the company must estimate an allowance to the amounts reflected in the balance sheet and income statement at year end. In preparing the adjusting journal entry for this allowance the amount of anticipated inventory that will be returned after year end is included in the ending inventory in the balance sheet. EXPENDITURES INCLUDED IN INVENTORY Product Costs Product costs are all of the costs required to obtain inventory and are included in the ending inventory and/or the cost of goods sold. They include • Direct cost of the product • Freight-in • Other direct costs of acquisition F:\Teaching\3321\web\module4\c8\tnotes\c8a.doc 3/12/2007 2Inventories: Measurement • Labor and factory overhead applied to raw material to produce finished goods Period Costs Period costs are those costs that are allocated to the accounting period and are not included in inventory. They include • Selling expenses • General and administrative expenses • Interest expense Manufacturing Costs Manufacturing costs include all of the costs directly involved in the production of a product that becomes finished goods. They include • Direct materials • Direct labor • Manufacturing overhead costs ¾ Indirect material ¾ Indirect labor ¾ Depreciation ¾ Taxes ¾ Insurance ¾ Heat ¾ Electricity Freight-In As indicated above freight-in on merchandise purchases are added to the cost of the merchandise inventory. Under the perpetual method the amount is added to inventory along with the cost of the merchandise. Using the periodic method a company would set up a nominal account, “Freight-In” and would book all freight-in charges to this account. At the end of the year this account becomes part of the multi-step income statement analysis that determines cost of goods available for sale, ending inventory, and cost of goods sold. Purchase Returns and Allowances Purchase returns and allowances are the counter part to sales returns and allowances. Under the perpetual method the purchasing company removes the amount returned from inventory and accounts payable. Using the periodic method a company would set up a nominal account, “Purchase Returns and Allowances” and would book all returns to this account. At the end of the year this account becomes part of the multi-step income statement analysis that determines cost of goods available for sale, ending inventory, and cost of goods sold. Purchase Discounts There are two methods of recording purchase discounts (1) Gross