1.9. Accounting for inventories (1) – cost travel

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Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

7 ratings

Course 3 of 5 in the Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

From the lesson

Financial Accounting – Basic Principles. Transaction Analysis. Income Recognition. Accounting for Current Assets

In Week 1 we discuss the scope of accounting and its two major areas – financial and managerial accounting. In the first part of the Course – Weeks 1 through 3 – we talk about financial accounting (FA). First, the key financial statements – the Balance Sheet (BS), the Income Statement (IS), and the Statement of Cash Flows (SCF) – are introduced, and the accounting equation is analyzed. Then we move on to the basic accounting principles, standards, and approaches – from double-entry bookkeeping to GAAP. Equipped with the general understanding of the financial accounting approach, we apply accounting procedures to transaction analysis. Then we study revenue and expense recognition, and focus on accounts receivable and bad debts. Finally, you will learn how financial accounting deals with inventories.

1.1. Why study accounting?11:17

1.2. What is accounting? Financial vs. managerial accounting11:41

1.3. Key financial statements – BS, IS, SCF17:49

1.4. Accounting principles. GAAP14:10

1.5. Double-entry bookkeeping6:57

1.6. Transaction analysis – an example15:51

1.7. Revenue and expense recognition16:34

1.8. Cash and accounts receivable14:04

1.9. Accounting for inventories (1) – cost travel13:27

1.10. Accounting for inventories (2) – cost of goods sold9:39

1.11. Accounting for inventories (3) – FIFO, LIFO, LCM9:39

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now we go on to the next important item in our current assets, namely the inventories.

We will discuss the accounting for inventories

in the last three episodes of this week starting from this one.

And here, the key story for the inventories,

so that will be accounting for inventories, let's say one.

And I will put that voted "cost travel."

Now here, I pronounce the idea of a cost openly.

And strictly speaking, cost is the issue in managerial accounting.

Oftentimes, managerial accounting is just entitled to cost accounting.

So clearly, in the second part of a week,

we will talk about that in greater detail.

But for now, we talk about the main idea here.

And again, the main idea in cost travel is the following: If we limit

ourselves only with the enterprise that does not produce anything,

when you just buy and resell these goods,

then you can enjoy some markup only if you do some service.

Let's say you deliver,

you accumulate these goods,

then you provide some terms of credit and so on and so forth.

So you basically, your value added is

not in the process of conversion of some materials by your labor,

by your technology, by you management activity to something more valuable.

For a manufacturing firm however,

this is the case.

So there, we have an idea when you start from some of the raw materials.

Then you have a certain inventory.

Then you transfer them into the production process.

And in this process, you do not only use these raw materials but you use your labor,

you use equipment, you use technology, you use many things.

And all that, in the process of manufacturing is being transferred,

the cost goes up but the result is the finished good.

And this finished good,

it goes to the final inventory.

From this final inventory, you can take it and sell it.

So here, you see some phases,

some stages if you will,

and that is what we'll label here cost travel.

So now, let me put them.

So we have various inventories.

We have raw materials.

We have work in progress inventory.

That's when something is being manufactured.

We have finished goods inventory.

And also, we have so-called manufacturing supplies.

So this is something that we also use in the process but that is not in this.

Well, let's say in the process of manufacturing,

we can use some spare parts or the equipment,

or we can use sometimes some other small things that,

strictly speaking, are not all these raw materials if you will.

Now, let's see what happens.

This, this, and this is

transferred to finished goods inventory.

And your finished goods inventory, this one,

it's your asset until sold.

Then when it's sold and when you collect, that becomes cash.

So that's basically the general approach.

Now, in order to make it sort of more realistic and a stable thing,

I will proceed with an example.

The example is not very complex but it takes some time.

So the example would be

the manufacturing process.

So as we did before in our transaction analysis,

we will have some stages and then we will analyze these inventories.

So the first thing will be purchase of raw materials.

So, and again, here I will show the accounts.

So these will be raw materials, 300.

And then here, let's say it's on credit accounts payable, also 300.

The debit part will be here.

Credit part will be there.

Now the next thing,

issuance of these raw materials

into the production process.

Now, we have this work.

This is raw materials inventory account. It's better to put it this way.

Now, work in progress inventory here,

and this is raw materials inventory.

This is 190 and this is 190.

So, 190 of this 300 is moved to WPI.

Then the next thing is factory labor.

So, people just work on that.

And that is, so again,

WPI, and here, salaries payable.

So that's what you have to pay.

110 travels here, 110 is our obligation.

Now the next thing is in the process, you use equipment.

And this equipment is being depreciated as a result of that.

We will talk about depreciation in much greater detail in our second week.

But for now, I would put that this is depreciation,

goes to WPI as 35,

and then the accumulated depreciation,

which is account recount to the equipment.

Account is 35. As you can see,

in all of these transactions,

we have the proper balance.

Now, we're almost all set.

So we have some other costs which are there.

They also arrive at WPI, 90.

And then here, there are expenses, 90.

That maybe electricity or whatever.

Now, here, I would put in red some interim line.

So these are beginning balances for the inventory accounts.

So, raw materials inventory.

The beginning the balance is 75.

WPI, 95, and then,

finished goods inventory is 60.

These are just givens.

And then, to wrap this up,

we need two more things to be taken into account six.

The finished goods inventory,

we counted them as a result of that, is 195.

And then finally, we can say that goods worth 130 are sold for 210.

So that wraps up our example.

Clearly, it's in greater detail depicting our handouts.

Let's take a look at that and see what happens with these accounts.

So the next page of flip chart,

I will put some of these T accounts and see exactly what's going on.

And that is very fruitful in understanding.

So we start with the balances of our accounts.

So this is raw materials inventory.

And you know that the beginning balance is 75.

Now this is work in progress inventory.

I'll put it a little bit bigger.

And we'll put it here,

and the beginning balance is 95.

And then this is finished goods inventory and the beginning balance is 60.

I'll put that with

some red marks because this was not a transaction.

It was just some red marks.

So, let's proceed.

The first thing is the purchase of raw materials.

So here, we have transaction number one, which is 300.

Now the question is,

where does this go?

We open up the new account, accounts payable.

In here, we have 300.

That is the first transaction.

So far so good. What is the second one?

The second one was when we said that 190 of this traveled to WPI.

So here, this is 2,

and this is 190.

Then the third transaction is,

that we said that this is labor cost.

So here, 110.

Where does it come from?

We open up a new account,

and this account is salaries payable.

And here on the credit side, it's 110.

This is number three. Now the next thing is depreciation.

So here, this is 35,

and we open up a new account,

which is accumulated depreciation.

And here, that is 35,

and this is transaction number 4.

The next thing, transaction number five,

which is other expenses.

Again, we open up this new account,

other expenses, and this is 90.

Number five here.

Now, the next thing is of that 195,

transaction number 6, goes to finished goods inventory.

So this is here, 195.

So we have only transaction number seven.

And this transaction number seven, it starts here.

It says that the goods that were worth 130,

so this is 130,

and I put as 7a because this is part of that.

So we open up new account,

which is cost of goods sold.

I will put a star here because in the next episode,

we will be calculating that.

And here, we have this 130 on the side, which is 7a.

So, that's all great.

But the final thing is that we sold that for 210.

So we open up the last two accounts.

So that will be revenue.

So here, it's 210.

This is 7b.

And the final account is here, accounts receivable.

So this is 210 here,

and this is 7b.

So now, we get everything.

And as you can see, here,

we can provide some ending balances for all of these accounts.

For example, if we took raw materials inventory here, 375,

190, so the total amount will be outputted in red here and in a dotted line.

So it will be 185, the ending balance.

And we can do that for all others.

That's very easy to do.

But now, this is one of the few things.

Either we know these, the trouble here,

like maybe we counted them or we have some labels affixed to them,

or we know these ending balances.

And this is more realistic because with the ending balances,

we can count them at the end of a period.

So, in order to arrive at this 130, in reality,

we are better off if we worked with these ending balances.

So in the next episode,

we will discuss cost of goods sold in

greater detail both for a merchandise firm and for the manufacturing firm,

and we will see how using

the beginning and ending balances of the corresponding accounts,

we can arrive, first of all,

at the cost of goods sold,

and keeping in mind that we have a revenue,

we can arrive at a gross margin.

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