Chapter 6.1 : Nature of Inventory and Cost of Sales

Question 1

What is inventory, and how is it classified on the statement of financial position?

Answer 1

Inventory is a tangible asset held for sale in the ordinary course of business or used in the production of goods for sale or services.

It is classified as a current asset on the statement of financial position because it is normally converted into cash within one year or the next operating cycle, whichever is longer

Question 2

What are the two main categories of companies dealing with inventory, and how do they differ?

Answer 2

Companies can be either merchandisers or manufacturers.

Merchandisers purchase finished goods for resale, while manufacturers produce their inventory, which includes raw materials, work-in-process, and finished goods.

Question 3

What does merchandise inventory include, and how does it differ from manufacturing inventory?

Answer 3

Merchandise inventory consists of finished goods ready for sale, acquired by merchandisers in a finished condition.

Manufacturing inventory includes raw materials (acquired for processing), work-in-process (partially manufactured goods), and finished goods (complete and available for sale).

Question 4

What does raw materials inventory include, and when do these items become part of work-in-process inventory?

Answer 4

Raw materials inventory consists of items like fabric, down, and thread, acquired for processing into finished goods.

These items become part of work-in-process inventory when they are being actively used in the manufacturing process.

Question 5

What does work-in-process inventory include, and what happens to these goods when they are complete?

Answer 5

Work-in-process inventory includes goods in the process of being manufactured but not yet complete.

When these goods are finished, they become part of the finished goods inventory and are ready for sale.

Question 6

Define finished goods inventory and explain its significance for manufacturing companies.

Answer 6

Finished goods inventory consists of manufactured goods that are complete and available for sale.

It signifies the products ready to be sold, representing the final stage in the manufacturing process before items are distributed to customers.

Question 7

According to IFRS, how should sustainability-related information be depicted, and what is its purpose?

Answer 7

Sustainability-related information, according to IFRS, should be depicted as a neutral and faithful representation of the entity’s sustainability-related financial information.

Its purpose is to provide a basis for users to assess the implications of sustainability-related risks and opportunities on the entity’s enterprise value.

Question 8

What is the primary basis of accounting for inventory, and what does it include?

Answer 8

The primary basis of accounting for inventory is cash-equivalent cost, which includes the price paid or consideration given to acquire an asset.

Inventory cost encompasses costs incurred in bringing an article to a usable or saleable condition and location.

Question 9

What costs should be included when recording inventory purchases for Canada Goose?

Answer 9

Inventory purchases for Canada Goose should include the purchase price, freight charges (freight-in), import taxes, duties, inspection, and preparation costs.

Any purchase returns, allowances, or discounts are subtracted.

Question 10

When should the company cease accumulating purchase costs for merchandise inventory, and what costs should be included after the inventory is ready for sale?

Answer 10

The company should cease accumulating purchase costs when the merchandise inventory is ready for shipment or delivery to customers.

Costs incurred after inventory is ready for sale, such as marketing personnel salaries and dealer training sessions, should be included in selling, general, and administrative expenses.

Question 11

How do companies often handle incidental costs like inspection and preparation costs when assigning unit cost to inventory?

Answer 11

Incidental costs like inspection and preparation costs, often not very large relative to other costs, are often not assigned to inventory cost.

Many companies use the invoice price (less returns and discounts) as the unit cost for raw materials or merchandise and record other indirect expenditures as separate costs reported as expenses.

Question 12

What is the basic flow of inventory costs for merchandisers (wholesalers and retailers)?

Answer 12

When merchandise is purchased, the merchandise inventory account is increased.

When goods are sold, merchandise inventory is decreased, and cost of sales is increased.

Question 13

Describe the flow of inventory costs in a manufacturing environment.

Answer 13

In manufacturing, raw materials are purchased and added to raw materials inventory.

When used, the cost of these materials is transferred to work-in-process inventory.

Direct labor and factory overhead costs are also added to work-in-process inventory.

When goods are completed, their costs are transferred to finished goods inventory. Upon sale, cost of sales increases, and finished goods inventory decreases.

Question 14

What are the components of manufacturing costs apart from raw materials?

Answer 14

Apart from raw materials, manufacturing costs include direct labor (employees’ earnings working directly on products) and factory overhead (other manufacturing costs such as supervisor’s salary, heat, light, and power to operate the factory).

Question 15

How many stages are there in the flow of inventory costs for both merchandisers and manufacturers, and what do these stages involve?

Answer 15

There are three stages in the flow of inventory costs for both merchandisers and manufacturers.

The first stage involves purchasing and/or production activities.

The second stage results in additions to inventory accounts on the statement of financial position.

In the third stage, the inventory items are sold, and the amounts become cost of sales on the statement of earnings.

Question 16

Figure: Flow of Inventory Costs

Answer 16

Question 17

What is the relationship between sales revenue, cost of sales, and unit costs?

Answer 17

Sales revenue is calculated by multiplying the number of units sold by the sales price.

Cost of sales (COS) is determined by multiplying the same number of units by their unit costs, including all costs of merchandise or finished goods sold during the period.

Question 18

Explain the relationship between beginning inventory, purchases, ending inventory, and cost of sales using the cost of sales equation.

Answer 18

The cost of sales equation is BI (Beginning Inventory) + P (Purchases) - EI (Ending Inventory) = COS (Cost of Sales).

Beginning inventory plus purchases represent the cost of goods available for sale.

The portion of this cost that remains unsold (ending inventory) subtracted from the cost of goods available for sale gives the cost of sales.

Question 19

How can the cost of sales equation be used to calculate the cost of goods sold during a period?

Answer 19

The cost of sales equation (BI + P - EI = COS) helps calculate the cost of goods sold. Beginning inventory plus purchases represent the total goods available for sale.

Subtracting the ending inventory from this total provides the cost of goods sold during the period.

Question 20

Nature of Cost of Sales for Merchandise Inventory

Answer 20

Question 21

What are the three key amounts needed to compute the cost of sales?

Answer 21

The three key amounts needed to compute the cost of sales are:
(1) beginning inventory,
(2) purchases of merchandise or additions to finished goods during the period, and
(3) ending inventory.

Question 22

What is a perpetual inventory system, and how does it handle purchase and sale transactions?

Answer 22

In a perpetual inventory system, purchase transactions are directly recorded in an inventory account.

Simultaneously, when each sale is recorded, a companion cost of sales entry is made, decreasing inventory and recording cost of sales.

This system provides up-to-date records for each type of merchandise, showing units and cost of beginning inventory, each purchase, and each sale.

Question 23

Why is a detailed record necessary in a perpetual inventory system, and how is this information used in modern companies?

Answer 23

A detailed record in a perpetual inventory system is essential for purchasing, manufacturing, and distribution decisions.

Modern companies rely on this information to make strategic decisions. It is often shared electronically with suppliers and customers.

Consumers also encounter this system when shopping online, where stock availability and order prompts are based on real-time inventory data.

Question 24

What factors have contributed to the widespread adoption of sophisticated perpetual inventory systems in modern businesses?

Answer 24

Cost and quality pressures from increasing competition, along with dramatic declines in the cost of information systems, have made sophisticated perpetual inventory systems a necessity for all but the smallest companies.

Question 25

What factors influence the decision to use a perpetual versus a periodic inventory system?

Answer 25

The decision to use a perpetual versus a periodic inventory system is based on management’s need for timely information for operating decisions and the cost of implementing the perpetual system.

Trade-offs between timely information and cost are considered.

Question 26

Why are accurate inventory quantities important in the management of inventory, particularly in a perpetual system?

Answer 26

Accurate inventory quantities are crucial in the management of inventory because they provide necessary information for efficient inventory management.

Inventory quantities on hand are essential for making decisions related to inventory ordering and production.

Question 27

What are the principal methods used by sellers to motivate customers to buy their products?

Answer 27

The principal methods used by sellers include

(1) allowing customers to make purchases on account and pay later,
(2) offering business customers discounts for early payment, and
(3) allowing returns from all customers under specific circumstances.

Question 28

How are inventory purchases recorded in a perpetual system, and what costs are included in the recorded amount?

Answer 28

In a perpetual system, inventory purchases are recorded at the invoice price plus related expenditures like import duties, transportation charges (freight-in), inspection, and preparation costs.

Any purchase returns and allowances or purchase discounts taken are subtracted.

Question 29

Explain the impact of purchase returns and allowances on inventory purchases.

Answer 29

Purchase returns and allowances result in a reduction in the cost of inventory purchases associated with unsatisfactory goods. If goods are returned, the cost of those items is subtracted from the total inventory purchases.

Question 30

What are purchase discounts, and how are they accounted for in a perpetual system?

Answer 30

Purchase discounts are reductions in the invoice price if payment is made within a specified period.

In a perpetual system, if inventory is purchased with credit terms such as 2/10, n/30 (2% discount allowed if paid within 10 days, net amount due within 30 days), and the payment is made within 10 days, the discount is deducted from the total amount owed, and the net amount becomes the cost of inventory purchases.