Inventory and Receivables: Accounting Principles

Posted on Feb 8, 2025 in Accounting and Finance

Inventory and Receivables: Essential Concepts

Inventory Types and Systems

  • Merchandise Inventory: Goods held for resale.
  • Manufacturing Inventory: Includes raw materials, work in progress, and finished goods.
  • Perpetual Inventory System: Continuously updates inventory records for each purchase and sale.
  • Periodic Inventory System: Updates inventory records at the end of an accounting period.

Inventory Costing Methods

  • First-In, First-Out (FIFO): Assumes the earliest goods purchased are the first to be sold.
  • Last-In, First-Out (LIFO): Assumes the latest goods purchased are the first to be sold.
  • Weighted Average Cost: Calculates a weighted average of the costs of goods available for sale.

Lower of Cost or Market (LCM)

Inventory is reported at the lower of its cost or market value to recognize a loss when the market value drops below cost.

Key Inventory Ratios

  • Inventory Turnover Ratio: Measures how efficiently inventory is managed.
    • Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory
  • Days in Inventory: Indicates the average number of days inventory is held.
    • Formula: Days in Inventory = 365 / Inventory Turnover Ratio

Key Points on Inventory

  • Impact of Inventory Errors: Inventory errors affect the cost of goods sold, gross profit, and net income in both the current and subsequent periods.
  • Disclosure Requirements: Companies must disclose the inventory costing method used and any significant inventory write-downs.

Reporting and Analyzing Receivables

Key Concepts

  • Types of Receivables:
    • Accounts Receivable: Amounts due from customers for credit sales.
    • Notes Receivable: Written promises for amounts to be received.
  • Recognition of Receivables: Recognized when a company sells goods or services on credit.
  • Valuation of Receivables: Reported at net realizable value, which is the amount expected to be received.
  • Allowance for Doubtful Accounts: A contra-asset account used to estimate uncollectible receivables.
    • Methods:
      • Percentage of Sales Method: Estimates uncollectible accounts based on a percentage of credit sales.
      • Aging of Receivables Method: Estimates uncollectible accounts based on the age of each account receivable.
  • Bad Debt Expense: Recognized as an expense for estimated uncollectible accounts.
    • Journal Entry: Debit Bad Debt Expense, Credit Allowance for Doubtful Accounts.
  • Accounts Receivable Turnover Ratio: Measures how efficiently receivables are collected.
    • Formula: Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
  • Average Collection Period: Indicates the average number of days it takes to collect receivables.
    • Formula: Average Collection Period = 365 / Accounts Receivable Turnover Ratio

Key Points on Receivables

  • Impact of Receivable Management: Efficient management of receivables improves liquidity and reduces the risk of uncollectible accounts.
  • Disclosure Requirements: Companies must disclose their policies for estimating uncollectible accounts and the methods used to value receivables.

Feel free to ask for more detailed explanations or examples!