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(Objective 21-1) Give the reasons why inventory is often the most difficult and timeconsuming…

by | Sep 9, 2023 | accounting

(Objective 21-1) Give the reasons why inventory is often the most difficult and timeconsuming part of many audits.

(Objective 21-1)


Inventory takes many different forms, depending on the nature of the business. For retail or wholesale businesses, the largest account in the financial statements is often merchandise inventory available for sale. To study the inventory and warehousing cycle, we will use an example of a manufacturing company, whose inventory may include raw materials, purchased parts and supplies for use in production, goods in the process of being manufactured, and finished goods available for sale. Still, most of the principles discussed apply to other types of businesses as well. Figure 21-1 shows the physical flow of goods and the flow of costs in the inventory and warehousing cycle for a manufacturing company. Examine the debits to the raw materials, direct labor, and manufacturing overhead T accounts to see how the inventory and warehousing cycle ties in to the acquisition and payment cycle and the payroll and personnel cycle. The direct tie-in to the sales and collection cycle occurs at the point where finished goods are relieved (credited) and a charge is made to cost of goods sold. The inventory and warehousing cycle can be thought of as comprising two separate but closely related systems, one involving the physical flow of goods and the

other the related costs. Six functions make up the inventory and warehousing cycle. Each of these is discussed next. The inventory and warehousing cycle begins with the acquisition of raw materials for production. Adequate controls over purchasing must be maintained whether inventory purchases are for raw materials for a manufacturer or finished goods for a retailer. Purchase requisitions are forms used to request the purchasing department to order inventory. These requisitions may be initiated by stockroom personnel as raw materials are needed, by automated computer software when raw materials reach a predeter – mined level, by orders placed for the materials required to produce a customer order, or by orders initiated on the basis of a periodic raw materials count. Receipt of the ordered materials, which is also part of the acquisition and payment cycle, involves the inspection of material received for quantity and quality. The receiving department prepares a receiving report that becomes a part of the documentation before payment is made. After inspection, the material is sent to the storeroom and copies of the receiving documents, or electronic notifications of the receipt of goods, are typically sent to purchasing, the storeroom, and accounts payable. Control and accountability are necessary for all transfers. Once received, materials are normally stored in a stockroom. When another depart – ment needs materials for production, personnel submit a properly approved materials requisition, work order, or similar document or electronic notice that indicates the type and quantity of materials needed. This requisition document is used to update the perpetual inventory master files and record transfers from raw materials to work-inprocess accounts. These updates occur automatically in organizations with integrated inventory management and accounting software systems. Processing inventory varies greatly from company to company. Companies determine the finished goods items and quantities they will produce based on specific orders from customers, sales forecasts, predetermined finished goods inventory levels, and economical production runs. A separate production control department is often responsible for determining the type and quantities to produce. An adequate cost accounting system is an important part of the processing of goods function for all manufacturing companies. The system shows the relative profitability of the products for management planning and control and values inventories for pre – paring financial statements. Two primary types of cost systems exist: job cost systems and process cost systems, but there are many variations and combinations of these systems. In a job cost system, costs are accumulated by individual jobs when material is issued and labor costs incurred. In a process cost system, they are accumulated by processes, with unit costs for each process assigned to the products passing through the process. Cost accounting records consist of master files, spreadsheets, and reports that accumulate material, labor, and overhead costs by job or process as those costs are incurred. When jobs or products are completed, the related costs are transferred from work-in-process to finished goods based on production department reports. When finished goods are completed, they are placed in the stockroom to await ship – ment. In companies with good internal controls, finished goods are kept under physical control in a separate, limited-access area. The control of finished goods is often considered part of the sales and collection cycle. Shipping completed goods is part of the sales and collection cycle. The actual ship ment of goods to customers in exchange for cash or other assets, such as accounts receivable, creates the exchange of assets necessary for meeting revenue recognition criteria. For most sales transactions, the actual shipment becomes the trigger for recognizing the related accounts receivable and sales in the accounting system. Thus, shipments of finished goods must be authorized by a properly approved shipping document. We have not yet discussed one type of record used for inventory: a perpetual inventory master file. Separate perpetual records are normally kept for raw materials and finished goods. Most companies do not use perpetuals for work-in-process. Perpetual inventory master files typically include information about the units of inventory acquired, sold, and on hand. In well-designed computerized systems, they also include information about unit costs. For acquisitions of raw materials, the perpetual inventory master file is updated automatically when acquisitions of inventory are processed as part of recording acqui – si tions. For example, when the number of units and unit cost for each raw material acquisition are entered in the computer system, this information is used to update perpetual inventory master files along with the acquisitions journal and accounts payable master file. Transfers of raw material from the storeroom must be separately entered into the computer to update the perpetual records. Typically, only the units transferred need to be entered because the computer determines the unit costs from the master file. Finished goods perpetual inventory master files include the same type of informa – tion as raw materials perpetuals but are considerably more complex if costs are included along with units. Finished goods costs include raw materials, direct labor, and manufacturing overhead, which often requires allocations and detailed record keeping. When finished goods perpetuals include unit costs, the cost accounting records must be integrated into the computer system. Figure 21-2 summarizes the business functions and the physical flow of inventory from the purchase of raw materials to the shipment of finished goods. It also includes the most common documents and records used to support the functions and physical flows.




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