Introduction to Financial Accounting

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
FOFA: Accounting Part
Topic: Inventories

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2023-24 1
Assets Clasification

➢ Current Assets
➢ Non-current (or Long term) Assets

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Defining Inventories
Inventories are goods that are meant for eventual conversion into cash in the normal course of business.
Raw materials: These consist of goods yet to be introduced into the production process.
Steel and paint for Tata Motors.
Crude oil for Indian Oil.
Work in progress: In any production process, some units will be in the process but are yet to be completed.
Partly assembled cars and car parts for Tata Motors.
Crude oil in the pipeline for Indian Oil.
Finished goods Goods: that have been produced completely but remaining unsold comprise the finished goods inventory of a
manufacturer.
Fully finished cars for Tata Motors.
Petrol awaiting dispatch at the refineries for Indian Oil.
Stock-in-trade: These are goods bought for trading. These are the main inventories for a merchandising firm. Some
manufacturing and service organizations may also keep items for trading.
Clothes for Big Bazar (Future Retail).
Used cars for True Value.
Other items: In addition, most manufacturing firms also keep inventories of factory supplies, such as coolants, fasteners,
cleaning materials, packing materials, and machinery spares.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2023-24 3
EFFECT OF INVENTORY ERROR
➢ An error in the value of the year-end inventory will misrepresent the cost of goods sold, gross profit, net profit, current
assets, and equity. Since the ending inventory of a year becomes the beginning inventory for the next year, the error will
also affect the profit for the next period.

➢ Suppose a business overstates its Year 1 ending inventory by `1,000. The effect of this error is to overstate the profit for
Year 1. As a result of the error, the enterprise will overstate Year 2 beginning inventory and understate Year 2 profit, thus
offsetting the error.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2023-24 4
DETERMINING THE PHYSICAL INVENTORY
Goods in Transit
A business must include goods in transit in ending inventory if it owns them. The terms of shipment determine whether the
buyer or the seller is the legal owner of the goods. Recall from Chapter 4:
❖ If the terms are FOB shipping point, title normally passes to the buyer when the goods are delivered to the carrier (i.e.
when the carrier accepts the goods for transport).
❖ If the terms are FOB destination, title normally passes to the buyer when the goods arrive at their destination.
Goods on Consignment
Recall from Chapter 4 that though the consignee has physical possession of the goods, the consignor owns them. Therefore,
goods on consignment are part of the consignor’s inventory and should be excluded from the consignee’s inventory. Goods
transferred to a dealer or distributor for resale, as an agent for the owner of the goods, are similar to goods on consignment.
Frequently, materials belonging to a firm are issued to an outside agency to carry out manufacturing processes such as
machining or painting. The firm must include these goods in its ending inventory.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2023-24 5
COST FORMULAS
The prices of most of the merchandise change during the year.

So, a business buys unit of a specific item of inventory at different prices on different dates.

When this happens, the accountant has to assume the order in which units have been sold so that the cost of goods available
for sale can be allocated between the ending inventory and the cost of goods sold.

It is necessary to distinguish between physical flow and cost flow.

Physical flow refers to the actual sequence in which goods are physically used or sold in the operations of the business.

In contrast, cost flow refers to the association of costs with the assumed sequence in which the goods are used or sold. Four
methods are commonly used to assign inventory costs:

1. Specific identification;
2. First-in, First-out (FIFO);
3. Last-in, First-out (LIFO); and
4. Weighted-average cost (WAC).

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Specific Identification
➢…

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First-in, First-out (FIFO)
➢…

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Last-in, First-out (LIFO)
➢…

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Weighted-average cost (WAC)
➢…

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Comparing Alternative Inventory Costing Methods

From this illustration,

➢ it is clear that LIFO reports the lowest gross profit in a period of rising prices because it charges the highest
costs to the goods sold.
➢ In contrast, FIFO reports the highest gross profit, because it charges the lowest costs to the goods sold. The
results will be reversed in a period of falling prices.
➢ WAC, by avoiding the extremes of FIFO and LIFO, produces a gross profit somewhere between the two.
➢ It is difficult to generalize about specific identification because the results depend on the prices paid for the
lots selected for sale. In a period of constant prices, the four methods will produce identical results.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2023-24 11
PERPETUAL INVENTORY SYSTEM
➢ Under this system, an enterprise maintains a continuous record of all purchases and sales of merchandise,
resulting in constant updating of the amount of inventory on hand.
➢ With this information, it can carry out many tasks such as the following:
1. Promptly answer questions from customers and salespersons about the availability of an item.
2. Record merchandise in real time and thus avoid running out of stock.
3. Calculate the cost of goods sold and the related profit for each sale.

Not long ago, only companies that sold a limited range of products used the perpetual inventory system because the
cost and effort of maintaining the system were too high for most types of businesses. However, with the availability of
computing and data storage services at relatively low costs, many firms are switching to the perpetual inventory
system.

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