by Inventory
Inventory is a very significant current asset for retailers, distributors, and manufacturers. Inventory serves as a buffer between:
1) A company’s sales of goods
2) It’s purchases or production of goods.
Companies strive to find the proper amount of inventory so that it can meet the fluctuating demand of its customers, avoid disruptions in production, and minimize holding costs.
Since the costs of the items purchased or produced are likely to change (especially with inflation), companies must elect a cost flow assumption for valuing its inventory and its cost of goods sold. In the U.S. the common cost flow assumptions are FIFO, LIFO, and average.
A company’s cost of inventory is related to the company’s cost of goods sold that is reported on the company’s income statement.
Manufacturers will have three or four categories of inventories:
- Raw materials
- Work-in-process
- Finished goods
- Manufacturing and packaging supplies
Manufacturers are required to report the amounts of each inventory category on its balance sheet or in the notes to the financial statements.
These basic inventory accounting activities are expanded upon in the following bullet points:
- Determine ending unit counts. A company may use either a periodic or perpetual inventory system to maintain its inventory records. A periodic system relies upon a physical count to determine the ending inventory balance, while a perpetual system uses constant updates of the inventory records to arrive at the same goal.
- Improve record accuracy. If a company uses the perpetual inventory system to arrive at ending inventory balances, the accuracy of the transactions is paramount.
- Conduct physical counts. If a company uses the periodic inventory system to create ending inventory balances, the physical count must be conducted correctly. This involves the completion of a specific series of activities to improve the odds of counting all inventory items.
- Estimate ending inventory. There may be situations where it is not possible to conduct a physical count to arrive at the ending inventory balance. If so, the gross profit method or the retail inventory method can be used to derive an approximate ending balance.
- Assign costs to inventory. The main role of the accountant on a monthly basis is assigning costs to ending inventory unit counts. The basic concept of cost layering, which involves tracking tranches of inventory costs, involves the first in, first out (FIFO) layering system and the last in, first out (LIFO) system. A different approach is the assignment of a standard cost to each inventory item, rather than a historical cost.
- Allocate inventory to overhead. The typical production facility has a large amount of overhead costs, which must be allocated to the units produced in a reporting period.
Incomes
Income is the revenue a business earns from selling its goods and services or the money an individual receives in compensation for his or her labor, services, or investments.
Accounting income is the profit a company retains after paying off all relevant expenses from sales revenue earned. It is synonymous with net income, which is most often found at the end of the income statement. The metric differs from gross income in that the latter accounts for only direct expenses, whereas accounting income also takes into consideration all indirect expenses.
One meaning of income refers to revenue or sales. Revenue is the money that a company receives from selling goods or services throughout the course of business. Revenue is an equity account that has a credit balance. Throughout the year sales are recorded in the revenue accounts and posted to trial balance. The revenue is then reported on the first line of the income statement. This is often called gross income, total sales, or top line sales since it includes all the company income and sales before deducting expenses.
Another meaning of income refers to net income. Net income is completely different than gross income. Net income appears at the bottom of the income statement after all of the cost of goods sold and operating expenses have been subtracted out. Net income equals the total company revenues minus total company expenses.
Expenses
An expense is the reduction in value of an asset as it is used to generate revenue. If the underlying asset is to be used over a long period of time, the expense takes the form of depreciation, and is charged ratably over the useful life of the asset. If the expense is for an immediately consumed item, such as a salary, then it is usually charged to expense as incurred.
The accounting for an expense usually involves one of the following transactions:
- Debit to expense, credit to cash. Reflects a cash payment.
- Debit to expense, credit to accounts payable. Reflects a purchase made on credit.
- Debit to expense, credit to asset account. Reflects the charging to expense of an asset, such as depreciation expense on a fixed asset.
- Debit to expense, credit to other liabilities account. Reflects a payment not involving trade payables, such as the interest payment on a loan, or an accrued expense.
An expense is defined in the following ways:
- Office supplies use up the cash (asset)
- Depreciation expense, which is a charge to reduce the book value of capital equipment (e.g., a machine or a building) to reflect its usage over a period.
- A prepaid expense, such as prepaid rent, is an asset that turns into a cash expense as the rent is used up each month
Types of Expenses
Expenses affect all financial accounting statements but exert the most impact on the income statement. They appear on the income statement under five major headings, as listed below:
- Cost of Goods Sold (COGS)
Cost of Goods Sold (COGS) is the cost of acquiring raw materials and turning them into finished products. It does not include selling and administrative costs incurred by the whole company, nor interest expense or losses on extraordinary items.
- For manufacturing firms, COGS include direct labor, direct materials, and manufacturing overhead.
- For a service company, it is called a cost of services rather than COGS.
- For a company that sells both goods and services, it is called cost of sales.
Examples of COGS include direct material, direct costs, and production overhead.
- Operating Expenses: Selling/General and Admin
Operating expenses are related to selling goods and services and include sales salaries, advertising, and shop rent.
General and administrative expenses include expenses incurred while running the core line of the business and include executive salaries, R&D, travel and training, and IT expenses.
- Financial Expenses
They are costs incurred from borrowing from lenders or creditors. They are expenses outside the company’s core business. Examples include loan origination fees and interest on money borrowed.
- Extraordinary Expenses
Extraordinary expenses are costs incurred for large one-time events or transactions outside the firm’s regular business activity. They include laying off employees, selling land, or disposal of a significant asset.
- Non-Operating Expenses
These are costs that cannot be linked back to operating revenues. Interest expense is the most common non-operating expense. Interest is the cost of borrowing money. Loans from banks usually require interest payments, but such payments don’t generate any operating income. Hence, they are classified as non-operating expenses.
Non-Cash Expenses
Under the accrual method of accounting, non-cash expenses are those expenses that are recorded in the income statement but do not involve an actual cash transaction. Depreciation is the most common type of non-cash expense, as it reduces net profit, but is not a result of a cash outflow. The accounting transaction and its impact on the financial statements are outlined below.:
- A debit to a depreciation expense account and a credit to a contra asset account called accumulated depreciation
- On the balance sheet, the book value of the asset is decreased by the accumulated depreciation.
Expenses are income statement accounts that are debited to an account, and the corresponding credit is booked to a contra asset or liability account.
Creditors
A creditor could be a bank, supplier or person that has provided money, goods, or services to a company and expects to be paid at a later date. In other words, the company owes money to its creditors and the amounts should be reported on the company’s balance sheet as either a current liability or a non-current (or long-term) liability.
Some creditors, such as banks and other lenders, have lent money to the company and will require the company to sign a written promissory note for the amount owed. When a promissory note is required, the company borrowing the money will record and report the amount owed as Notes Payable.
If the creditor is a vendor or supplier that did not require the company to sign a promissory note, the amount owed is likely to be reported as Accounts Payable or Accrued Liabilities.
Other creditors include the company’s employees (who are owed wages and bonuses), governments (who are owed taxes), and customers (who made deposits or other prepayments).
Some creditors are referred to as secured creditors because they have a registered lien on some of the company’s assets. A creditor without a lien (or other legal claim) on the company’s assets is an unsecured creditor.
Debtors
A debtor is a person, company, or other entity that owes money. In other words, the debtor has a debt or legal obligation to pay the amount owed.
A debtor is an individual or entity that owes money to a creditor. The concept can apply to individual transactions, so that someone could be a debtor in regard to a specific supplier invoice, while being a creditor in relation to its own billings to customers. Even a very wealthy person or company is a debtor in some respects, since there are always unpaid invoices payable to suppliers. The only entity that is not a debtor is one that pays up-front in cash for all transactions. Thus, an entity could be a debtor in relation to specific payables, while being flush with cash in all other respects.
A debtor is considered to be in default if it does not pay a debt within the payment terms of the debt agreement. Thus, a short payment or late payment could trigger a default.
The liability owed by a debtor can be discharged in bankruptcy, or with the agreement of the counterparty. In either case, if the liability is no longer valid, the entity involved is no longer a debtor in relation to that liability.
