Inventory

Inventory is one of the main items in the financial statements, and as such many time questions are appearing related to it in your final exam.

Inventories are of following types:

• Raw materials
• Work in process
• Consumable stores and spares
• Finished goods

It is appearing in balance sheet as current assets and in cost of goods sold (credit side on income statement) in income statement. Increase or decrease in inventories will directly have impact on current ratio and profit or loss of a company.

Inventory is measured at the lower of cost and net realizable value (NRV). Note that inventory includes land held for resale but does not include financial instruments.

NRV is the estimated selling price in the ordinary course of business less: (1) the estimated costs of completion; and (2) the estimated costs necessary to make the sale.

Cost should include all:

• costs of purchase (including taxes, transport, and handling) net of trade discounts received
• costs of conversion (including fixed and variable manufacturing overheads) and
• other costs incurred in bringing the inventories to their present location and condition

Inventory cost should not include:

• abnormal waste
• storage costs
• administrative overheads unrelated to production
• selling costs

LIFO cost flow assumption is not permitted under IFRS.

Definition and explanation:

Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labour and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method.

 VARIABLE, DIRECT OR MARGINAL COSTING:

Definition and explanation:

Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labour and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing. To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred.

Absorption Costing and Variable Costing Compared:

 The only difference between absorption costing and variable costing is the treatment of fixed manufacturing overhead (FMOH). Under absorption costing, FMOH is allocated to units produced, so that there is a little bit of FMOH included in the cost of every unit of inventory. Under variable costing, FMOH is treated as a period expense, appearing on the income statement as a lump-sum in the period incurred.

Comparing income under absorption costing to income under variable costing, the following observations can be made:

–   When there are beginning and ending inventories, absorption costing and variable costing will generally result in different inventory valuations for beginning inventory, different inventory valuations for ending inventory, and different incomes, but it is possible for the inventory balances and income to be the same under the two methods.

–  If beginning and ending inventory levels are zero, absorption costing and variable costing will always result in the same income.

–   If beginning inventory is zero and ending inventory is positive, absorption costing will always result in higher income than variable costing, and a higher valuation for ending inventory.

–  If beginning inventory is positive and ending inventory is zero, absorption costing will always result in lower income than variable costing, and a higher valuation for beginning inventory.

–   When inventory levels are increasing from period-end to period-end, as would be expected when the company is growing, absorption costing will generally result in higher ending inventory valuations than variable costing, and also higher income in each period. The reason is that absorption costing postpones recognizing ever-increasing amounts of fixed manufacturing overhead on the income statement, because increasing amounts of fixed manufacturing overhead are capitalized as ending inventory.

Over the life of the company (or from any point in time at which there is zero inventory to any other point in time at which there is zero inventory), the sum of income over all periods must be equal under the two methods. The difference between absorption costing and variable costing is only a timing difference: the question of when fixed manufacturing overhead is taken to the income statement

BASIS OF ACCOUNTING: HOW TO DECIDE WHETHER TO USE CASH OR ACCRUAL ACCOUNTING

James runs a side business selling paintings. He does not sell on credit often and he buys all the materials for making the paintings from his local store on cash. In keeping financial records for the business, what basis of accounting should James use?

By basis of accounting, we mean the time in which the various financial transactions of a business are recorded. Should they be recorded immediately value is exchanged or should they only be recorded on receipt of cash?

There are two ways businesses track expenses and revenues: cash accounting/basis and accrual accounting/basis. In the hypothetical case above, cash accounting would be the more straight forward way for James to do his accounting. However, big companies are frequently required by law to use accrual accounting. Firms, Households, Individuals and even countries use the different basis in various situations.

In cases where there is no restriction on which method to use, deciding whether to use the cash method or the accrual method is an important decision for every business as there are advantages and disadvantages mostly due to the tax and business implications.

The cash method is a straightforward method. Expenses are only recorded when they are paid and revenues are recorded only when the cash comes in. For example, a farmer selling oranges to a supermarket uses cash accounting. He gives the supermarket oranges on consignment and the supermarket pays him every weekend for sales made during that week. The farmer would only record as sales the amount that was paid to him every week and not the actual value of the oranges he gave to the supermarket.

There are implications to the use of cash accounting. For example, it may not give a true view of the profit made in a particular time period. It measures pure cash flow and thus sometimes gives a false impression of long term profitability. It is not suitable for companies that carry out a lot of business on credit.

Its major advantage lies in its simplicity. The business does not need to hire expert help as in accrual accounting. Under the cash method, any customer payments the business received in say, 2016 for projects completed in the previous year would be counted as revenue for the 2016 tax year. This reduces the taxable income and as a result, it can lower the tax payments for the 2015 tax year.

The accrual method is the more formal method and records expenses and revenues when they are incurred and earned respectively. The business invoices the amount in question and records it even though the payment has not actually been received. Expenses are thus matched with revenues. For example, a laundry business using accrual method receives quarterly utility bill for November, December and January. Under cash accounting, this expense would only be recorded when it is paid. Accrual accounting, on the other hand, would estimate two months’ portion of the expense (November and December) and record it in the previous year’s financial statements.

Expenses and revenues are thus recorded whether or not cash is made. This has the implication of given a true view of the profitability of the business under a particular time period. Accrual basis of accounting often require expert help as it is complicated. In the example above, adjustments might need to be made as the cleaning company would have estimated expenses before the utility presents the bill. Due to the costs, small companies may not implement accrual accounting.

In conclusion, the decision to choose between cash and accrual basis should not be taken lightly. For a small company with low growth, the cash accounting method may be cheaper. However, companies that intend to grow would eventually need to use the accrual basis.

Concepts of Accounting:

Accounting is based on two basic concepts

• Business entity
• Money measurement

Although there are also other concept of accounting but business entity and money measurement concepts are the basic concepts. Each of the concepts of accounting is discussed below briefly:

Money measurement concept:

According to money measurement idea, only that bonds in our accounting data which are measurable in financial terms, are requested.

Business Entity concept:

Business entity concept says that the firm and the owner of firm are two different entities. In simple words we can say that I and my company are separate.

Going concern concept:

Accounting is based on the inference that trade unit is a going concern. We keep all the economic data of a firm by keeping this point of view that a firm or trade is a going concern; not a gone concern. It means we always consider a trade or business in continuity form. In case if not take it as a going project we will be unable to obtain loans form the banker, we will also not get supplies or services from the supplier. In this case work of  employees will also be lessened, and the process of data recording will altogether.

Some cases have exception to this concept. These cases are:

• One of the units is being stated sick.
• When there is conversion and the converter is being appointed for same.
• When there is extreme economic crisis and the business is going to end up.

Cost concept:

Cost concept is one of the important concept of accounting which depends on the going concern concept. As we always order the value of the things or assets on the basis of their cost instead of  their possible value or wholesale value of the assets based on inference that a firm unit is a going concern. No confusion, we decrease the value of assets giving deflation to assets, but we overlook the value of assets in the market.

The cost concept block all kind of manipulation by taking into account that value of assets in the market. Its bad effect is that this concept neglects the effect of expansion in the market. But still,  this concept generally accepted.

Dual aspect concept:

This concept says that there should be double entry for completion of any economic transaction, means debit and credit should be equal . Therefore,  there is dual aspect in all financial transaction:

• You get benefit
• You give benefit

Accounting Period Concept

For calculation of the loss or profit and to determine economic status of any firm balance sheets and profit, loss accounts for that firm are regularly prepared, most commonly at the end of year. This one year cycle is called as the accounting period for that company. In the view of past performances and to decrease the damage due to seasonal changes , we get guide from the accounting period. Accounting period tells us the exact status of the firm at specific intervals.

Matching concept:

This concept of accounting is based on accounting period concept. According to this concept, the expenses of a firm for specific accounting duration are matched with the credit of similar accounting duration to determine exact profit or loss for the similar duration of accounting. This practice is accepted worldwide.

Accrual concept:

As already said in the matching concept before, the credit for the specific accounting period is considered and expenses related to the accounting duration is also considered. On the basis of this concept if our items are sold or we provided some service, then that is our source of revenue irrespective of the fact that we received cash or not. Cash basis of accounting is used by most of the professionals which means that cash received and expenses during that particular accounting duration is the basis of their accounting.

Objective evidence concept:

According to this concept there should be an evidence of objective behind every economic entry. For example there should be purchase bill for any purchase, sale with their bills, cash memos in case of cash expenditure and cash receipts should be presented for payment to creditors. In case of stock there should be personal verification and its value should also be matched with its purchase bills. In case these are not present, there will be no accuracy in accounting, manipulation chances will be increased to great extent and people will not trust on such economic statements.