Lecture 01: Inventory Accounting. [Intermediate Accounting]

Sir Win - Accounting Lectures

4 chapters6 takeaways12 key terms5 questions

Overview

This lecture introduces the concept of inventory in accounting, differentiating between various business types (trading, manufacturing, service) and their respective inventory classifications. It emphasizes that inventory consists of assets held for sale, in production, or as raw materials/supplies. A key focus is on determining when goods should be included in inventory, primarily based on the passing of legal title, regardless of physical location. The lecture also touches upon specific scenarios like goods in transit, consignment, and goods on approval, highlighting the principle that ownership, not just possession, dictates inventory inclusion, with exceptions for collection purposes.

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Chapters

Inventory encompasses assets held for sale, in production, or as materials/supplies for production or services.
Trading businesses primarily deal with 'merchandise inventory' (goods bought for resale).
Manufacturing businesses have four types of inventory: raw materials, goods in process, finished goods, and factory/manufacturing supplies.
Service businesses may have inventory in the form of labor costs and other personnel expenses directly related to service provision.

Understanding the different types of businesses and their corresponding inventory classifications is crucial for accurate financial reporting and cost management.

A table manufacturer's raw materials (wood, screws), goods in process (partially assembled table), finished goods (completed table), and factory supplies (sandpaper, glue).

The primary rule for including goods in inventory is the 'passing of title,' meaning legal ownership has transferred to the business.
Location is secondary to ownership; goods owned by the business are included regardless of their physical location.
Title can pass through various forms of delivery, including actual delivery (physical transfer) and symbolical delivery (e.g., transferring a deed for land).

Accurately determining when title passes prevents overstating or understating inventory, which directly impacts a company's financial statements and profitability.

When you buy groceries and pay at the counter, the title passes to you immediately, making the groceries your inventory (even before you leave the store).

Goods in transit are included in inventory based on shipping terms (FOB shipping point means buyer owns it; FOB destination means seller owns it until arrival).
Goods out on consignment remain the inventory of the consignor (the owner), not the consignee (the store displaying them).
Goods held by customers on approval or trial are still considered inventory of the seller until the customer formally accepts them.

These scenarios test the understanding of ownership, ensuring that inventory is correctly reported even when physical possession is with another party.

A bakery sends cakes to a cafe to sell on consignment; the cakes are still the bakery's inventory until the cafe sells them.

In installment sales, a seller might retain legal title for collection protection, but the goods are often treated as the buyer's inventory due to the substance of the transaction.
The principle of 'substance over form' applies, meaning the economic reality of the transaction (who bears the risks and rewards) dictates accounting treatment.
If title is retained solely for collection purposes on installment sales, the seller may remove the goods from inventory, and the buyer includes them.

Recognizing exceptions to the title rule ensures that inventory is reported by the party who truly bears the economic risks and benefits of ownership.

A car dealership sells a car on installment. Even if they hold the registration title until the final payment, the car is considered the buyer's inventory because they are using it and bearing its risks.

Key takeaways

1Inventory classification varies significantly based on the business type (trading, manufacturing, service).
2The core principle for inventory inclusion is the transfer of legal title, not just physical possession.
3Shipping terms (FOB shipping point vs. FOB destination) are critical for determining ownership of goods in transit.
4Consigned goods remain the inventory of the original owner until sold by the consignee.
5Goods on trial or approval are still the seller's inventory until accepted by the customer.
6The accounting principle of 'substance over form' can override legal title in certain situations, like installment sales for collection purposes.

Key terms

InventoryMerchandise InventoryRaw MaterialsGoods in ProcessFinished GoodsFactory SuppliesPassing of TitleFOB Shipping PointFOB DestinationConsignmentGoods on Approval/TrialInstallment Sales

Test your understanding

1What are the three main categories of inventory based on the definition provided?
2How does the treatment of inventory differ between a trading business and a manufacturing business?
3Explain the concept of 'passing of title' and why it is the primary determinant for inventory inclusion.
4Under what circumstances would goods in transit be considered the buyer's inventory?
5Why are goods out on consignment still considered the inventory of the original owner?