Basics of Inventories

ACCOUNTING FOR INVENTORIES:

International Accounting Standard (IAS) 2

This standard is established for providing proper guidance for determining the cost of inventories involved in a business. It provides the information for treating inventories basically at two levels.

1. when the inventory is purchased by the business and its treatment and recording when it is entered in the business.
2. when the inventory is recorded and treated as an expense for the business.

Inventories:

The raw material, work in progress goods and finished goods are treated as inventory for a business. As these are ready for sale or will be ready for sale in future and treated as asset of a business.

---> Work in progress which is under construction, biological instruments and shares and bonds are not included in inventory of business entity.

Objectives:

The main objectives of IAS 2 are as follows;

• guidance for cost evaluation.
• accounting treatment for the inventories of business.
• circumstances for written down and net realizable values.
• cost which is to be recognized
• how to carry forward cost till the revenues are generated 

Measurement of Inventories:

There are basically two approaches for inventories:

1. Perpetual inventory system.

2. Periodic inventory system.

-->Both systems were widely used.The use of computerized accounting system has made perpetual inventory system easy and cost-effective.

-->Periodic approach is used primarily by very small businesses with manual accounting systems.

--> When an  inventory is purchased, it is recorded as an asset in the balance sheet. When it is sold to customers, the asset is converted into an expense, that is the cost of goods sold.

PERPETUAL  INVENTORY SYSTEM:

In a perpetual inventory system, transactions involving costs of inventory are recorded immediately as they occur.

--> This system is known as perpetual accounting system because of the fact that the accounting records are kept perpetually up-to-date.

--> Purchases of inventory are recorded as debit in an asset account named inventory.

-->When merchandize is sold, two entries are recorded:

• one to recognize the revenue earned.
• second to recognize the related cost of goods sold.The second entry also reduces the balance of inventory account to show that the sale of some of the inventory.

--> A Perpetual inventory system uses an inventory subsidiary ledger. This ledger provides up-to-date record about every product that the company is  buying and selling, it also ioncludes the per unit cost and the number of units purchased, sold, and on hand.

PERIODIC INVENTORY SYSTEM:

A periodic inventory system is opposite to a perpetual inventory system.

--> In a periodic inventory system, no effort is made to keep up-to-date records of the inventory and the cost of goods sold.

--> These amounts are determined only periodically usually at the end of each year.

Property Plant and Equipment

IAS 16 Property, Plant and Equipment

This Standard is for the accounting treatment for property, plant and equipment. This principal is used in accounting for property, plant and equipment, their recognition, the determination of their cost amounts and the depreciation charges.

·         Tangible items that;

--> Held for use in the production or supply of goods or services, for rental purposes, or for any other business Purposes.

--> Used for more than one period.

·         Cost of an item;

--> Its purchase price, import duties, non-refundable taxes are included, and trade Discounts and rebates are deducted.

--> Costs in bringing the asset to the location and making it Capable of operating in the manner that is required.

--> Costs of removing the item and restoring the site.

·         Measurement after recognition;

these are measured by 2 methods;
 --> cost model.
--> revaluation model.

·         Cost Model:

After recognition, property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses.

·         Revaluation Model:

After recognition, property, plant and equipment can be measured at a revalued amount, its book value at the date of the revaluation less accumulated depreciation and accumulated impairment losses. Revaluations shall be made with regularity to ensure that the cost value does not differ materially which would be determined using book value at the end of period.

·    Increase in Value:

      If an asset’s book value is increased as a result of a revaluation, the increase shall be recorded in income and add in equity under the heading of revaluation surplus. However, the increase shall be recorded in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recorded in profit or loss.

• Decrease in Value:

If an asset’s book value is decreased as a result of a revaluation, the decrease shall be recorded in profit or loss. However, the decrease shall be recorded in income to the extent of any credit balance existing in the revaluation surplus in respect of that asset.

·         Depreciation:

      It  is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value. Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately.  The depreciation charge for each period shall be recorded in profit or loss unless it is included in the book value of another asset.
     
      The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

·        Residual Value:

      It is the value of an asset as the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.

Introduction to Adjusting Entries

Adjusting Entries:

"Adjusting entries are journal entries made at the end of accounting period to allocate revenue and expenses to the period in which they actually applicable."

• Adjusting entries are required because normal journl entries are based on actual transactions and the date on which these transactions occur may not be the date required for the matching principle of accrual based accounting.

Prepayments:

Adjusting entries for prepayments are necessary for cash that received before delivery of goods or services.

--> When this cash is paid, firstly it is recorded in a prepaid expense account on asset side, this amount is to be expired with the time e.g. rent, insurance as it is consumed.

--> A company receiving the cash for goods and services yet to be delivered will have to record the amount in an unearned revenue or liability account. An adjusting entry to record the revenue is used as necessary.

Accruals:

Accrued revenues are revenues that have been recorded, that is services have been performed or goods have been delivered, but their cash payment yet not received.

--> When the revenue is recorded, it is recorded as a receivable. Accrued expenses have not yet paid, so they are recorded in a payable account.

--> Expenses for interest, taxes, rent, and salaries are commonly accrued for reporting purposes.

Cash Flow Statement

Cash Flow Statement:

Cash flow statement does not include amount of future cash dealings that are on credit. Cash is not same as net income in income statement and balance sheet. There are 3 types of business activities regarding cash dealings. operating , investing and financing activities.

Methods of Cash flow statement:

There are 2 basic methods to make cash flow statements;

1. Direct Method.
2. Indirect Method.

Operating Activities:

Cash inflows and outflows by business operations. Operating activities shows how much cash is generated from products or services of the business. Changes in cash, account receivable, depreciation, account payable etc are shown in cash from operating activities.

---> Cash flow is calculated by adjusting net income by adding or subtracting differences in revenues, expenses and credit dealings resulting from transactions from one period to the next.

---> These adjustments are made because of non-cash items in net income and total assets and liabilities.All transactions does not include cash, many items have to be revised when calculating cash flow.

---> Depreciation is added back in net sales. When the asset is sold the income is iincluded in the cash inflow.

---> Changes in accounts receivable in balance sheet from one period to the next is also included in cash flow statement. If accounts receivable decreases, this shows that more cash is entered from credit accounts, the amount by which account receivable has decreased is added to net sales.

--->If accounts receivable increase from one period to the next, the amount of the increase is subtracted from net sales because, the amount in accounts receivable is revenue and are not cash.

---> An increase in inventory, shows that a company has purchased more raw materials inventory. If the inventory purchased with cash, the increase in inventory is subtracted from net sales.

---> A decrease in inventory will be added to net sales. If inventory was purchased on credit, an increase in accounts payable will be shown on the balance sheet and amount of the increase from one period to the other will be added to net sales.

---> Expenses, for example taxes payable, salaries payable and prepaid insurance. If paid, then the difference in the value from one year to the next has to be subtracted from net income.

--->If there is an amount that is still to be paid, then any differences will have to be added to net earnings.

Investing Activities:

Changes in equipment, assets or investments related to cash flow from investing.

--->Cash changes from investing are due to purchase of new equipment, buildings or other assets that are short term such as marketable securities.

--->When a company sale an asset, the cash inflow occurs.

Financing activities:

Changes in debt, loans or dividends are cash flow from financing activities.

---> Changes in cash from financing activities are when the capital is increased, it is cash inflows.

---> When dividends are paid, this is cash outflows.

--->If a company issues a bond to the public, the company receives cash.

--->When interest is paid to public, the company is reducing its cash.

BANK RECONCILIATION STATEMENT

Since there are timing differences between when data is entered in the banks systems and when data is entered in the individual's system, there is sometimes a normal discrepancy between account balances. The goal of reconciliation is to determine if the discrepancy is due to error rather than timing.

DEBIT CREDIT, BASIC ACCOUNTING EQUATION

For this entry, I’ll try to explain the basic accounting equation in relation to debit-credit.

First, I’m going to define the basic definition, which basically state that for a given business entity, the basic accounting equation is:

Assets = Liabilities + Owner’s Equity

And is derived from:

assets = claims on assets

Assets are items that have monetary value and are owned by the business. By definition, Assets are placed on the left side of the Accounting equation. A term has been assigned describing the left side, known as debit.
Claims on Assets define the claims on every item of the Asset. For example, capital is an item that is known to be assigned to the owner, while payables are claims of others against an Asset. By definition, this side is placed at the right side of the Accounting equation known as credit side.

debit = credit

The equation above has the following meanings:

1. The left side is denoted by the term debit.
2. The right side is denoted by the term credit.
3. The two sides of the equation are equal.

assets = debit

In our basic accounting equation, the element known as Asset is assigned to debit. The equation shown above simply means that all assets are placed on the debit side, left side of the basic accounting equation.

claims on assets = credit

On the right side of the basic accounting equation, we find credit. This simply means that all claims on assets are to be placed on the right side of the equation, known as credit side. To illustrate it, we state claims on assets is equal to credit.

Secondly, At this point, the term Claims on Assets will be covered in detail, showing the two parts. The credit side of the equation has two items, namely: Liabilities and Owner’s Equity.
Liabilities are items owed, they are normally items that were borrowed from other businesses that must be covered or paid sometime in the future.

Owner’s Equity are items belonging to the owner of the business. They are items such as money, equipment, etc that are/were added by the owner to the business.
Example:
1) Mark invested money into the business, worth $25,000.

2) Mark added office equipment, by adding his personal laptop computer worth $1,200.

ADUSTING ENTRIES SOLUTION CRITICAL THINKING CASE# 4.1

a.     On September 1,received advance payment from a shopping centre for property managment services to be performed over the three months period begining Septmeber 1. The entire amount received was credited to our revenue account?

ANS.    No adjusting entry is needed, because although the revenue was collected in advance on September 1, it has all been earned prior to year-end. Thus, inclusion of the entire amount in revenue of the period is correct.

b.     On December 1 received advance payment from the same customer described in parts a services to be rendered over the three months period begining December 1. This time, the entire amount recived was credited to unearned revenue account?

ANS.      Three month's revenue was collected in advance on December 1 and was credited to an unearned revenue account. At December 31, an adjusting entry is needed to recognize that one-third of this advance payment that has now been earned as revenue. The effects of this adjusting entry will be to reduce a liability (unearned revenue) and increase revenue recognized as earned in the period. Of course, recognizing revenue also increases owners’ equity. 

c.     Rendered managment seervices for many customers in December. Normal procedure is to record revenue on the date the customer is build, which is early in the month after the services have been rendered?

ANS.      As we know the customers are billed after the services are rendered. So an adjusting entry is required to record the amount of services rendered in December 2009.The effect of this adjusting entry would be an increase in asset,increase in revenue earned during this period and an increase in owner's equity

d.     On December 15, made full payment for a one year insurance policy that goes into effect on January 2, 2010. The cost of the policy was debited to unexpired insurance?

ANS.        No adjusting entry is required because the insurance will go into effect on January 02, 2010.And no benefit has been derived from the asset.So no insurance expense will be recorded on December 2009.

e.     Numerous purchasis of equipment were to debited to asset accounts, rather then to expence account?

ANS.       An adjusting entry is required because the depreciation on equipment is required to be recorded on December 2009.The effect of this would be an increase in expense,decrease in asset and decrease in Owner's equity.                         

                                            

f.     Payroll expence is recorded when employees are payed. Payday for the last two weeks of December fall on January 2, 2010?

ANS.            An adjusting entry is required for the amount of salaries for December 2009, because the salaries of this month are due on Janauary 02,2010.The effect of this adjusting entry would be an increase in expense , increase in liability and decrease in owner's equity.