DEFINITION OF INVENTORY. 

INVENTORY or stock refers to the goods and materials that a business holds for the ultimate purpose of resale. Inventory is often the largest item in the current assets category, and must be accurately counted and valued at the end of each accounting period to determine a company’s profit or loss.

 

Inventories are assets items for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold. The investment in inventories is frequently the largest current asset of merchandising and manufacturing businesses. Therefore description and measurement of inventory require careful attention.

Inventories encompass goods purchased and held for resale, for example,merchandise purchased by a retailer and held for resale, computer software held for resale, or land and other property held for resale. Inventories also encompass finished goods produced, or work in progress being produced, by the enterprise and include materials, maintenance supplies, consumables and loose tools awaiting use in the production process. Inventories do not include machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular; such machinery spares are accounted for in accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.

CLASSIFICATION OF INVENTORY. 

Merchandising Companies:

Inventories are assets items for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold. The investment in inventories is frequently the largest current asset of merchandising and manufacturing businesses. Therefore description and measurement of inventory require careful attention.A merchandising company ordinarily purchases its merchandise in a form ready for sale. It reports the cost assigned to unsold units left on hand as merchandise inventory. Only one inventory account, merchandise inventory, appears in the financial statements. Example of such a merchandising company is Wal-Mart.

Manufacturing Companies:

Manufacturing companies produce goods which may be sold to merchandising companies as well as directly to customers. Manufacturing companies normally have three inventory accounts. These are:

  • Raw materials

  • Work in process

  • Finished goods

Raw Materials:

The cost assigned to goods and materials on hand but not yet placed into production is reported as raw materials inventory. Examples include the wood to make a base ball bat and the steel to make a car. These materials can be traced directly to the end product.

Work in Process:

Some units are not completely processed at any point in a continuous process. The cost of the raw material on which production has been started but not completed, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, constitute the work in process inventory.

Finished Goods Inventory:

The costs identified with the completed but unsold units on hand at the end of the fiscal period are reported as finished goods inventory .

DIFFERENCES BETWEEN PERPETUAL AND PERIODIC INVENTORY SYSTEM.

Perpetual Inventory System:

Under a perpetual inventory system, a continuous record of changes in inventory is maintained in the inventory accounting. That is, all purchases and sales (issues) of goods are recorded directly in the inventory account as they occur.

The accounting features of a perpetual inventory system are:

  1. Purchases of merchandise for resale or raw materials for production are debited to inventory rather than to purchases.

  2. Freight-in, purchases returns and allowances, and purchase discounts are recorded in inventory rather than in separate accounts.

  3. Cost of goods sold is recognized for each sale by debiting the account cost of goods sold, and crediting inventory.

  4. Inventory is a control account that is supported by a subsidiary ledger of individual inventory records. The subsidiary records show the quantity and cost of each type of inventory on hand.

The perpetual inventory system provides a continuous record of the balances in both the inventory account and the cost of goods sold account.

A method of accounting for inventory that records the sale or purchase of inventory in near real-time, through the use of computerized point-of-sale and enterprise asset management systems. Perpetual inventory provides a highly detailed view of changes in inventory and allows real-time reporting of the amount of inventory in stock, hence, accurately reflecting the level of goods on hand.

Under a computerized recordkeeping system, additions to and issuance from inventory can be recorded nearly instantaneously. The popularity and affordability of computerized accounting software have made the perpetual system cost-effective for many kinds of businesses. Recording sales with optical scanners at the cash register has been incorporated into perpetual inventory systems at many retail stores.

Periodic Inventory System:

Under a periodic inventory system, the quantity of inventory on hand is determined, as its name implies, on the periodically. all acquisitions of inventory during the accounting period are recorded by debits to a purchases account. The total in the purchases account at the end of the accounting period added to the cost of the inventory on hand at the beginning of the period to determine the total cost of the goods available for sale during the period. Ending inventory is subtracted from the cost of goods available for sale to compute the cost of goods sold. Note that under a periodic inventory system, the cost of goods sold is a residual amount that is dependent upon a physical count of the ending inventory.

The physical inventory count required by a periodic system is taken once a year at the end of the year. However, most companies need more current information regarding their inventory levels to protect against stock outs or over purchasing and to aid in the preparation of monthly or quarterly financial data. As a consequence, many companies choose a modified perpetual inventory system in which increases and decreases in quantities only – not dollar amounts – are kept in a detailed inventory record.  It is merely a memorandum device outside the double entry system which helps in determining the level of inventory at any point in time.

Whether a company maintains a perpetual inventory in quantities and dollars, quantities only, or has no perpetual inventory record at all, it probably takes a physical inventory once a year. No matter what type of inventory records are in use or how well organized procedures for recording purchases and requisitions, the danger of loss and error is always present. Waste, breakage, theft, improper entry, failure to prepare or record requisitions, and any number of similar possibilities may cause the inventory records to differ from the actual inventory on hand. This requires periodic verification of the inventory records by actual count, weight, or measurement. These counts are compared with the detailed inventory records. The records are corrected to agree with the quantities actually on hand.

Insofar as possible, the physical inventory should be taken near the end of a company’s fiscal year so that correct inventory quantities are available for use in preparing annual accounting reports and statements. Because this is not always possible, however, physical inventories taken within two or three months of the year’s end are satisfactory, if the detailed inventory records are maintained with a fair degree of accuracy.

Example:

A company had the following transactions during the current year.

Beginning inventory  100 units at $6 = $600
Purchases  900 units at $6 = $5,400
Sales  600 units at $12 = $7,200
Ending inventory  400 units at $6 = $2,400

The entries to record these transactions during the current year are shown below:

Perpetual Inventory System Periodic Inventory System
1. Beginning inventory, 100 units at $6:
The inventory account shows the inventory on hand at $600
2. Purchase 900 units at $6:
Inventory

5,400

     Accounts Payable

5,400

3. Sale of 600 units at $12:
Accounts receivable

7,200

     Sales

7,200

Cost of goods sold

3,600

     Inventory

3,600

4. End of Period Entries for Inventory Accounts:
No entry necessary
1. Beginning inventory, 100 units at $6:
The inventory account shows the inventory on hand at $600
2. Purchase 900 units at $6:
Purchases 5,400
     Accounts Payable 5,400
3. Sale of 600 units at $12:
Accounts receivable 7,200
     Sales

7,200

No Entry

4. End of Period Entries for Inventory Accounts:
Inventory (Ending by count) 2,400
Cost of goods sold 3,600
     Purchases 5,400
     Inventory (beginning) 600

When a perpetual inventory system is used and a difference exists between the perpetual inventory balance and physical count, a separate entry is needed to adjust the perpetual inventory account. Assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000, but a physical count indicated $3,800 was actually on hand. The entry to record the necessary write-down is as follows:

Inventory over and short 200
     Inventory

200

Perpetual inventory overages and shortages generally represent a misstatement of cost of goods sold. The difference is a result of normal and expected shrinkage, breakage, shoplifting, incorrect record keeping, and the like. Inventory over and short would therefore be adjustment of cost of goods sold. In practice, the account inventory over and short is sometimes reported in the “Other revenues and Gains” or “Other Expenses and Losses” section of the income statement, depending on its balance.

In a periodic inventory system, the account inventory over and short does not arise because there are no accounting records available against which to compare the physical count. Thus, inventory overage and shortages are buried in cost of goods sold.

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