Department of Intelligent Systems

• Course Name
• Management and Accounting

• Resource Person
• Shumaila Noreen
• Lahore Business School
• Shumaila.Noreen@uol.lbs.edu.pk
Inventory
Topics: Inventories – Steps, describe, inventory quantity, inventory cash flow,
methods, perpetual methods, financial effects, lower of cost, net realizable
value, basis of accounting, inventory errors
• What is Inventory?
• Inventory refers to all the items, goods, merchandise, and materials
held by a business for selling in the market to earn a profit.
• Example: If a newspaper vendor uses a vehicle to deliver newspapers
to the customers, only the newspaper will be considered inventory.
The vehicle will be treated as an asset.
• The five essential steps of the inventory management process
• Inventory planning and forecasting. ...
• Purchasing and ordering process. ...
• Receiving, storing, and packing. ...
• Inventory tracking and control. ...
• Order fulfillment and shipping/delivery.
Inventory Management System
Inventory quantity and inventory Cash Flow
• Inventory quantity significantly impacts a company's cash flow. When
a company purchases inventory, it's a cash outflow, and when it sells
inventory, it's a cash inflow. Effective inventory management aims to
optimize both the quantity of inventory and the timing of cash flows
related to it.
• Cash Outflow:
• When a business purchases inventory, it uses cash to pay
suppliers. This purchase reduces the company's cash balance.
• Cash Inflow:
• When inventory is sold, the business receives payment from
customers, increasing its cash balance.
• Inventory as a Current Asset:
• Inventory is a current asset, meaning it's expected to be converted into
cash within a year. This is why it's included on both the balance sheet
and the cash flow statement.
Impact on Cash Flow Statement:
• Increase in Inventory:
• An increase in inventory levels will show as a negative amount in the
cash flow statement from operating activities. This is because the
company has used cash to acquire more inventory than it has sold.
• Decrease in Inventory:
• A decrease in inventory levels will show as a positive amount in the
cash flow statement from operating activities. This means the
company has sold more inventory than it has purchased, increasing
cash flow.
• Examples:
• A retail store that overstocks its inventory will have a large amount of
cash tied up in unsold items. This can lead to lower profitability and
potentially negative cash flow.
• A manufacturing company that is consistently out of stock will miss
out on sales and lose customers, negatively impacting its cash flow.
Inventory Methods
• There are several methods for valuing inventory, including FIFO (First-In, First-
Out), LIFO (Last-In, First-Out), and Weighted Average Cost.
1. First-In, First-Out (FIFO):
• Concept: Assumes that the first items purchased are the first ones sold
• Example: If a store sells a batch of shirts, it would assume the oldest shirts were
the first ones sold.
2. Last-In, First-Out (LIFO):
• Concept: Assumes that the most recently purchased items are the first ones
sold.
• Example: If a company buys materials at different prices, it would use the
newest prices to calculate cost of goods sold.
• 3. Weighted Average Cost (WAC)
• Concept:
• Calculates the average cost of all inventory items and uses that average to
determine the cost of goods sold.
• Example:
• A bakery might use WAC to determine the cost of flour, sugar, and other
ingredients.
Accounting for merchandising operations
Merchandising Business
• Wal-Mart, Kmart, and Target are called merchandising companies because they buy and sell
merchandise rather than perform services as their primary source of revenue. Merchandising
companies that purchase and sell directly to consumers are called retailers. Merchandising
companies that sell to retailers are known as wholesalers.
• Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to
the revenue recognized from the sale of goods.
Operating cycle
• The operating cycle of a merchandising company ordinarily is longer
than that of a service company. The purchase of merchandise
inventory and its eventual sale lengthen the cycle. Illustration 5-2
contrasts the operating cycles of service and merchandising
companies. Note that the added asset account for a merchandising
company is the Merchandise Inventory account. Companies report
merchandise inventory as a current asset on the balance sheet.
Operating Cycles
Flow of costs
• The flow of costs for a merchandising company is as follows: Beginning inventory is added to the
cost of goods purchased to arrive at cost of goods available for sale. Cost of goods available for
sale is assigned to the cost of goods sold (goods sold this period) and ending inventory (goods to
be sold in the future).
• PERPETUAL SYSTEM
• In a perpetual inventory system, companies keep detailed records of the cost of each inventory
purchase and sale. These records continuously—perpetually—show the inventory that should be
on hand for every item. For example, a Ford dealership has separate inventory records for each
automobile, truck, and van on its lot and showroom floor.
Perpetual Inventory System

• Real-time tracking:
• Inventory records are updated automatically and continuously,
reflecting each transaction in real-time.
• Detailed record-keeping:
• Every purchase, sale, and return is recorded, providing a detailed
history of inventory movements.
• Accuracy
• Continuous updates minimize the risk of errors and discrepancies
between physical inventory and recorded inventory levels.
• Efficiency Enables better inventory management, including
forecasting, order placement, and minimizing stockouts.
Periodic system
• Physical counts: Inventory levels are determined by physically
counting items at set intervals, such as weekly, monthly, or quarterly.
• Simpler record-keeping: Less complex than perpetual systems,
requiring less time and effect.
• Cost Effective : Lower initial cost compared to perpetual systems.
• Less Accurate : Physical counts may not be as accurate as real-time
tracking.
• Time Consuming: Requires staff to stop their regular tasks to
conduct physical count.
Perpetual and periodic Inventory System
Periodic Inventory System
• In a periodic inventory system, companies do not keep detailed
inventory records of the goods on hand throughout the period. Instead,
they determine the cost of goods sold only at the end of the
accounting period—that is, periodically.At that point, the company
takes a physical inventory count to determine the cost of goods on hand.
• To determine the cost of goods sold under a periodic inventory system,
the following steps are necessary:
• 1. Determine the cost of goods on hand at the beginning of the
accounting period.
• 2. Add to it the cost of goods purchased.
• 3. Subtract the cost of goods on hand at the end of the accounting
period.
• Illustration 5-4 graphically compares the sequence of activities and the
timing of the cost of goods sold computation under the two inventory
systems.
Comparison of perpetual and periodic inventory systems
Entry to record the purchases/merchandise inventory
• Sauk Stereo makes the following journal entry to record its purchase from PW
• Audio Supply. The entry increases (debits) Merchandise Inventory and increases
• (credits) Accounts Payable.
Freight Costs
• The letters FOB mean free on board. Thus, FOB shipping point means that the seller places the
goods free on board the carrier, and the buyer pays the freight costs.
• Conversely, FOB destination means that the seller places the goods free on board to the buyer’s
place of business, and the seller pays the freight.
Recording of Merchandise Inventory

• When the purchaser incurs the freight costs, it debits (increases) the account
Merchandise Inventory for those costs. For example, if upon delivery of the goods on
May 6, Sauk Stereo pays Acme Freight Company $150 for freight charges, the entry on
Sauk Stereo’s books is:
Recording of Freight cost

• In contrast, freight costs incurred by the seller on outgoing

merchandise are an operating expense to the seller. These
costs increase an expense account titled Freight out or Delivery
Expense.
Purchase Returns and Allowances
• A purchaser may be dissatisfied with the merchandise received because the
goods are damaged or defective, of inferior quality, or do not meet the
purchaser’s specifications. In such cases, the purchaser may return the goods
to the seller for credit if the sale was made on credit, or for a cash refund if the
purchase was for cash. This transaction is known as a purchase return.
• Alternatively, the purchaser may choose to keep the merchandise if the seller
is willing to grant an
• allowance (deduction) from the purchase price. This transaction is known as a
purchase allowance.
Purchase Discounts
• The credit terms of a purchase on account may permit the buyer to claim a cash
discount for prompt payment. The buyer calls this cash discount a purchase
discount
• Credit terms specify the amount of the cash discount and time period in which it
is offered. They also indicate the time period in which the purchaser is expected to
pay the full invoice price. In the sales invoice in Illustration 5-5 (page 204) credit
terms are 2/10, n/30, which is read “two-ten, net thirty.” This means that the buyer
may take a 2% cash discount on the invoice price less (“net of”) any returns or
allowances, if payment is made within 10 days of the invoice date (the discount
period). If the buyer does not pay in that time, the invoice price, less any returns
or allowances, is due 30 days from the invoice date.t.
Entry with Example
• When the buyer pays an invoice within the discount period, the
amount of the discount decreases Merchandise Inventory. Why?
Because companies record inventory at cost and, by paying
within the discount period, the merchandiser has reduced that
cost. To illustrate, assume Sauk Stereo pays the balance due of
$3,500 (gross invoice price of $3,800 less purchase returns and
allowances of $300) on May 14, the last day of the discount
period. The cash discount is $70 ($3,500 2%), and Sauk Stereo
pays $3,430 ($3,500 $70).The entry Sauk makes to record its
May 14 payment decreases (debits) Accounts Payable by the
amount of the gross invoice price, reduces (credits) Merchandise
Inventory by the $70 discount, and reduces (credits) Cash by the
net amount owed.
Recording of Entries
Practice question
Solution
Recording of Sales Merchandise
• Sales may be made on credit or for cash. A business document should support
every sales transaction, to provide written evidence of the sale. Cash register
tapes provide evidence of cash sales. A sales invoice is a document issued by a
seller to a buyer detailing the goods or services sold, quantities, prices, and
payment terms, essentially requesting payment.
Sales Returns and Allowances
• Sales returns and allowances are deductions from a company's gross
sales, representing amounts credited or refunded to customers for
returned merchandise or price reductions granted for defective items.
Sales Discount
• As mentioned earlier, the seller may offer the customer a cash
discount—called by the seller a sales discount—for the prompt
payment of the balance due.
Practice question
• Assume information similar to that in the Do It! on page 207. That is: On
September 5, De La Hoya Company buys merchandise on account from Junot
Diaz Company. The selling price of the goods is $1,500, and the cost to Diaz
Company was $800. On September 8, De La Hoya returns defective goods
with a selling price of $200 and a scrap value of $80. Record the transactions
on the books of Junot Diaz Company.