NATURE OF ACCOUNTING

Most of the world’s work is done through organizations i.e. groups of people who work together
to accomplish one or more objectives. In doing this work, an organization uses resources e.g.
labour, materials, various services, building and equipment. These resources need to be financed
or paid for. To work effectively, the people on an organization need information about the amounts
of these resources, the means of financing them and the results achieved through using them.
Parties outside the organization need similar information to make judgments about the
organization.

Accounting is a system that provides such information. This accounting is the process of
identifying, measuring and communicating economic information to permit informed judgments
and decisions by users of the information.

The objectives of accounting

Accounting has many objectives including letting people and organizations know;

- If they are making a profit or a loss

- What their business is worthy
- What a transaction was worth to them
- How much cash they have
- How wealthy they are
- How much they are owed
- How much they owe to someone else etc. However, the primary objective of accounting is
to provide information for decision making.

Accounting is a systematic and comprehensive recording of financial transactions pertaining to a

business.

It is the art of recording, summarizing and classifying in significant manner and in terms of money,
transactions and events, which are in part of list of a financial character and interpretation of results
thereof.
Functions of accounting

The main functions of accounting are the following:-

i) Ascertainment of profit and loss

The main purpose of any business is to make a profit. For this purpose, accurate and
complete recording of all business transactions is essential because this information
will be helpful to determine whether there was profit or loss in any trading period. No
business can survive in the long period without making reasonable profits.

ii) To facilitate credit transactions

Most of the business transactions are made on credit basis. If goods are purchased from
a suppliers on credit basis, then this supplier is known as the creditor and if the goods
are sold to a customer on credit basis, then this customer is known as the debtor.
Accounting records facilitate such credit transactions because these records will
determine the amounts due to creditors and debtors.

iii) Assessment of tax.

Taxes are imposed by the government in all countries.
Accounting records must be maintained properly, otherwise a business enterprise may
be required to pay high tax to the government.

iv) Evaluation of assets and liabilities

Every business enterprise has some assets and liabilities. Assets are the possessions of
the business and liabilities are the amounts which are due to other persons.
A statement of assets and liabilities can be prepared on any particular date which is
known as balance sheet. Thus, the balance sheet shows the value of the assets and
liabilities of any given business.
v) A tool for control
A proper and accurate accounting system controls the unnecessary expenses and
misappropriation of funds of an organization.
vi) Acts as a basis for further or future planning.
 Accounting records provides sufficient data relating to sales, profit, etc for making
decision about the future programs
Users of accounting information
Possible users of accounting information include;
i) Managers
These are the day to day decision makers. They need to know how well things are
progressing financially and about financial status of the business.
ii) Owners (s) of the business
They want to able to see whether or not the business is profitable and the same time, to
know the financial resources of the business.
iii) A prospective buyer.
When the owner wants to sell a business, the buyer will want to know whether the
business is making a profit or not before deciding to buy it.
iv) The bank
If the owner wants to borrow money from the financial institutions for users in the
business, then the bank will need such information before deciding to give out money.
v) Tax inspectors
The information is needed for the purpose of tax calculations.
vi) A prospective partner.
If the owner wants to share ownership with someone else, then the partner to be would
want see such information in order to making proper decisions.

vii) Investors
They want to know whether or not to invest their money in the business.

The accounting equation

By adding up what the accounting records say belongs to a business and deducting
what they say the business owes, you can identify7 what a business is worth according
to those records. The whole of financial accounting is based on this very simple idea.
It is known as the accounting equation.
It can explained by saying that if a business is to be set up and start trading, it will need
resources.
Let us assume first that it is the owner of the business who has supplied all of the
resources.
This can be shown as;
Resources supplied by the owner = Resources in the business
The amount of resources supplied by the owner is called capital. The actual resources
that are then in the business are called assets.

This means that when the owner has supplied all of the resources, the accounting
equation can be shown as
Capital = Assets
Usually, however people other than the owner have supplied some of the assets. These
are called liabilities, the name given to the amounts owing to these people of these
assets.
The accounting equation has now changed to
Capital = Assets – Liabilities
i.e. Assets = Capital + Liabilities

The total of both sides will always equal each other. i.e. the capital will always equal
to the assets of the business minus the liabilities.
Assets consists of property of all kinds, such as buildings, machinery, stocks of goods
and motor vehicle. Other assets include debts owned by customers and the amount of
money in the organization’s bank account.

Liabilities in clued amounts owed by the business for goods and services supplied to
the business and for expenses incurred by the business that have not yet been paid for
they also include the funds borrowed by the business.
 Capital is often called the owner’s equality or net worth. It comprises the funds invested
in the business by the owner plus any profits retained for use in the business less any
share of profits paid out of the business to the owner.

Accounting Concepts

Accounting principles are built on a foundation of a few basic concepts. These concepts are so
basic that most accountants do not consciously think of them, they are regarded as self – evident.

In order to understand accounting, one must understand the following concepts;

1) The Money measurement concept

In financial accounting, are and is made only of information that can be expressed in monetary
terms.

The advantage of such a record is that money provides a common denominator by means of
which heterogeneous facts about an entity can be expressed as numbers that can be added and
subtracted.

Although it may be a fact that a business owns £30,000 of cash, £6000 of raw materials, six
trucks, 50,000 square feet building space, and so on.

These cannot be added together to produce a meaningful total of what the business owns.

Expressing these in monetary terms, £30,000 of cash, £6000 of raw materials £150,000 of
trucks and £4000,000 of buildings, makes such an addition possible. Thus despite the old cliché
about not adding apples and oranges, it is easy to add them if both the apples and the oranges
are expressed in terms of their respective monetary values.

Despite its advantage, the money measurement concept imposes a severe limitation on the
scope of accounting report.

Accounting does report the state of the president’s health, that the sales manager is not on
speaking terms with the production manager that a strike is beginning or that a competitor has
placed a better product on the market.
Accounting therefore does not give a complete account of the happenings in an organization
or a full picture of its condition.

It follows, then that the reader of accounting report should not expect to find therein all of the
facts or perhaps even the most important ones about an organization.

Money is expressed in terms of its values at the time an event is recorded in the accounts.

Subsequent changes in the purchasing power of money do not affect this amount thus a
machine purchased in 2006 for £200,000 and land purchased 20 years earlier for £200,000 are
each listed in 2006 accounting records at £200,000, although the purchasing power of the dollar
in 2006 was much less than it was 20 years earlier.

Accountants know fully well that the purchasing power of the money changes. They do not
however attempt to reflect such changes in the accounts.

2) The entity concept

Accounts are kept for entities as distinguished from the persons who are associated with
these entities. An entity is any organization or activity for which accounting reports are
prepared. Examples of entities include business companies, governments, churches,
universities and non-business organizations.

In recording events in accounting, the important question is how do these events affect the
entity. How they affect the persons who own, operate or otherwise are associated with the
entity is irrelevant.

For example, suppose that the owner of a clothing store removes £100 from the store’s
cash register for his or her personal use. The real effect of this event on the owner as a
person may be negligible, although the cash has been taken out of the business’s pocket
and put into the owner’s pocket either pocket the cash belongs to the owner. Nevertheless,
because of the entity concept, the accounting records show that the business has less than
it had previously.
 It is sometimes difficult to define with precision the entity for which a set of accounts is
kept. Consider the case of a married couple who owns and operates an unincorporated retail
store and those of its owners. A creditor of the store can sue and if successful, collect from
the owner’s personal resources of the business.
In accounting by contrast, a set of accounts is kept for the store as a separate business
entity and the events reflected in these accounts must be those of the store. The non
business events that affect the couple must not be included in these accounts.

In accounting, the business owns the resources of the store, even though the resources are
legally owned by the couple and debts owned by the business are kept separate from
personal debts owed by the couple. The expenses of operating the store are kept separate
from the couple’s personal expenses for food, clothing, housing and the like.

3) The going concern concept

Unless there is a good evidence to the contrary, accounting assumes that an entity is a going
concern, i.e. it will continue to operate for an indefinitely long period in the future.

The significance of this assumption can be indicated by contrasting it with a possible

alternative namely, that the entity is about to be liquidated. Under the latter assumption,
accounting would attempt to measure at all times that the entity’s resources are currently
worth to potential buyers. Under the going concern concept, by contrast, there is no need
to constantly measure an entity’s worthless to potential buyers and it is not done.

Instead, it is assumed that the resources currently available to the entity will be used in its
future operations.

4) The cost concept

It states that an asset is ordinary entered initially in the accounting records at the price paid
to acquire it i.e. at its cost.

5) The dual-aspect concept

 The economic resources of an entity are called assets. The claims of various parties against
these assets are called equities.

There are two types of equities;

a) Liabilities which are the claims of creditors (that is, everyone other than the owners of
the business) and
b) Owners’ equity, which is the claims of the owners of the business.

Since all the assets of a business are claimed by someone (either by its owners or by
creditors) and since the total of these claims cannot exceed the amount of assets to be
claimed it follows that;
Assets = Equities
This is the fundamental accounting equation expressed in its general form.
All accounting procedures are derived from this equation.
To reflect the two types of equities, the expanded version of the equation is;
Assets = Liabilities + Owners’ equity.

6) The accounting period concept

Accounting measures activities for a specified interval of time called accounting period.
The accounting period universally accepted is one year although some businesses may do
it quarterly or half yearly or monthly.

7) The conservatism concept

Managers are human beings. Like most humans, they would like to give a favourable report
on how well the entity for which they are responsible has performed. Yet as the financial
accounting standards board says, prudent reporting based on a healthy skepticism builds
confidence in the results that in the long run, best serves all of the divergent interest of
(financial statement users).

This long standing philosophy of prudent reporting leads to the conservatism concept.
 The concept is articulated as a preference for understatement rather than overstatement of
net income and net assets. When dealing with measurement of uncertainties thus, if two
estimates of some future amount are about equally likely, there is a preference for using
the smaller number when measuring assets or revenues and the larger for liabilities or
expenses.

8) The matching concept

The sale of merchandise has two aspects;
i) Revenue aspect reflecting an increase in retained earnings equal to the amount of
revenue realized.
ii) An expense aspect, reflecting the decrease the decrease in retained earnings because
the merchandise (an asset) has left the business.

In order to measure correctly this sale’s net effect on earnings in a period, both of these
aspects must be recognized in the same accounting period. This leads to the matching
concept; when a given event effects both revenues and expenses, the effect on each should
be recognized in the same accounting period.

9) The consistency concept

The concept states that once an entity has decided on one accounting method, it should use
the same method for all subsequent events of the same character unless it has a sound
reason to change the method(s).

If an entity frequently changed the manner of handling a given class of events in accounting
records, for example frequently changing between the straight line method and an
accelerated method for depreciating its building, comparison of its financial statements for
one period with those of another period would be difficult.

10) The materiality concept

In law there is a doctrine called de minimisnincuratlex, which means that the court will not
consider trivial matters. Similarly, the accountant does not attempt to record events so
insignificant that the work of recording them is not justified by the usefulness of the results.
 Unfortunately, there is no agreement on the exact line separating material from immaterial
events. The decision depends on judgment and common sense of the parties involved.

Rule of double entry system.

1. An increase of asset is debited and a decrease of asset is credited
2. An increase of capital is credited and a decrease of capital is debited
3. An increase of liabilities is credited and a decrease is debited.

Current assets

A current asset is cash and any other company asset that will be turning to cash within one year
from the date shown in the heading of the company's balance sheet. (If a company has an
operating cycle that is longer than one year, an asset that will turn to cash within the length of its
operating cycle is considered to be a current asset.)

Current assets are generally listed first on a company's balance sheet and will be presented in the
order of liquidity. That means they will appear in the following order: cash, cash at bank,
accounts receivable, inventory, supplies, and prepaid expenses. (Supplies and prepaid expenses
will not literally be converted to cash. They are included because they will allow the company to
avoid paying cash for these items during the upcoming year.)

It is important that the amount of each current asset not be overstated. For example, accounts
receivable, inventories, and temporary investments should have valuation accounts so that the
amounts reported will not be greater than the amounts that will be received when the assets turn
to cash. This is important because the amount of company's working capital and its current ratio
are computed using the current assets' reported amounts.

Typical current assets include cash, cash equivalents, short-term investments, accounts
receivable, stock inventory and the portion of prepaid liabilities which will be paid within a year.
On a balance sheet, assets will typically be classified into current assets and long-term assets
Noncurrent assets

A noncurrent asset is an asset that takes a long period of time before it is being turned into cash.
A noncurrent asset is also referred to as a long-term asset. Noncurrent assets are reported under
the following balance sheet headings:

 Investments (long-term)
 Property, plant and equipment
 Intangible assets
 Other assets

Examples of noncurrent assets include, land, buildings, construction in progress, furnishings,

vehicles, leasehold improvements, some deferred income taxes, goodwill, trademarks etc.

Classification of assets into current and non-current is important because non-current assets are
illiquid, i.e. they cannot be easily converted to cash or cash equivalents. Information about how
quickly assets can be converted to cash is important for useful liquidity analysis. Secondly, since
non-current assets are expected to generate economic benefits over multiple periods, they must
be depreciated over their useful lives.
Example

MNO, Inc.
Balance Sheet
as at 30 June 2015

ASSETS Note $ in million

Non-current assets
Goodwill a 25
Other intangible assets b 20
Property, plant and equipment c 157
Long-term investments d 10
Long-term advances e 8

Total non-current assets 220

Current assets
Prepayment f 15
Short-term advances g 2
Inventories h 23
Receivables i 15
Short-term investments j 5
Cash and cash equivalents k 17

Total current assets 77

Total assets 297

Revaluation of assets

Revaluation of fixed assets is the process of increasing or decreasing their carrying value in case
of major changes in fair market value of the fixed asset.

Reasons for revaluation

 To show the true rate of return on capital employed

 To conserve adequate funds in the business for replacement of fixed assets at the end of
their useful lives. Provision for depreciationbased on historic costwill show inflated
profits and lead to payment of excessive dividends.
 To show the fair market value of assets which have considerably appreciated since their
purchase such as land and buildings.
 To negotiate fair price for the assets of the company before merger with or acquisitionby
another company.
 To enable proper internal reconstruction, and external reconstruction.
 To issue shares to existing shareholders (rights issueor follow-on offering).
 To get fair market value of assets, in case of sale and leaseback transaction.
 When the company intends to take a loan from banks/financial institutions by mortgaging
its fixed assets. Proper revaluation of assets would enable the company to get a higher
amount of loan.
 Sale of an individual asset or group of assets.
 In financial firms revaluation reserves are required for regulatory reasons. They are
included when calculating a firm's funds to give a fairer view of resources. Only a portion
of the firm's total funds (usually about 20%) can be loaned or in the hands of any one
counterparty at any one time (large exposures restrictions).
Methods of revaluation of fixed assets

The common methods used in revaluing assets are:

Indexation

Under this method, indices are applied to the cost value of the assets to arrive at the current cost
of the assets. The Indices by the country's departments of Statistical Bureau or Economic
Surveys may be used for the revaluation of assets.

Current market price (CMP)

 Land values can be estimated by using recent prices for similar plots of land sold in the
area. However, certain adjustments will have to be made for the plus and minus points of
the land possessed by the company. This may be done with the assistance of brokers and
agencies dealing in land, or by a licensed appraiser.

Appraisal method

Under this method, technical experts are called in to carry out a detailed examination of the
assets with a view to determining their fair market value. Proper appraisal is necessary when the
company is taking out an insurance policy for protection of its fixed assets. It ensures that the
fixed assets are neither over-insured nor under-insured.

Selective revaluation

Selective revaluation can be defined as revaluation of specific assets within a class or all assets
within a specific location.

A manufacturing company may have its manufacturing facilities spread over different locations.
Suppose it decides to undertake a revaluation of its plant & machinery. Selective revaluation will
mean revaluing specific assets (such as boiler, heater, central air-conditioning system) at all
locations, or revaluing all items of Plant & Machinery at a particular location only. Such
revaluation will lead to unrepresentative amounts being shown in the Fixed Assets Register
(FAR). In case of revaluation of specific assets of a class, while some assets will be shown at a
revalued amount others will be shown at historic cost. The same will happen in case of
revaluation of all assets of plant & machinery at a particular location only.

It is not consistent to value and depreciate fixed assets using different bases. Therefore, selective
revaluation is generally not considered best practice.

Preliminary considerations

Revaluation will typically require liaison between the company's Production Department,
Accounts Department, Technical Department and external appraisers.

Upward revaluation

, upward revaluation is mainly done for fixed assets such as land, and real estate whose value
keeps rising from year to year. It seems the concept of upward revaluation of fixed assets such as
real estate has not been widely welcomed by a majority of companies in USA on account of fear
of paying higher property and capital gains taxes.

Downward revaluation

Revaluation does not mean only an upward revision in the book values of the asset. It can also
mean a downward revision (also called impairment) in the book values of the assets. However,
any downward revision in the book values of the assets is immediately written off to the Profit &
Loss account.An asset is considered to be impaired (and is thus written down) if its carrying
amount is greater than its recoverable amount.

Debtors

A debtor is a person or enterprise that owes money to another party. (The party to whom the
money is owed is often a supplier or bank that will be referred to as the creditor)

A creditor is a person, bank, or other enterprise that has lent money or extended credit to another
party. (The party to whom the credit has been granted is often a customer that will now be
referred to as a debtor.)

If Company X borrowed money from its bank, Company X is the debtorand the bank is the
creditor. If Supplier A sold merchandise to Retailer B, then Supplier A is the creditor and
Retailer B is the debtor.

Or a debtor is a company or individual who owes money. If the debt is in the form of a loan from
a financial institution, the debtor is referred to as a borrower. If the debt is in the form of
securities, such as bonds, the debtor is referred to as an issuer.

It is not a crime to fail to pay a debt. Except in certain bankruptcy situations, debtors can choose
to pay debts in any priority they choose. But if you've failed to pay a debt, you have broken a
contract or agreement between you and a creditor. Generally, most oral and written agreements
for the repayment of consumer debt- debts for personal, family or household purposes secured
primarily by a person's residence - are enforceable.

However, for the most part, debts that are business related must be made in writing to be
enforceable by law. If the written agreement requires the debtor to pay a specific amount of
money, then the creditor does not have to accept any lesser amount, and should be paid in full.

Also, if there was no actual agreement but the creditor has proven to have loaned an amount of
money, undertaken services or given the debtor a product, the debtor must then pay the creditor.

Debtors are normally first recorded in the Sales Ledger which contains a personal account for
each customer. In this way a listing of the sales ledger accounts will give you a listing of
outstanding debts or debtors.

If for example, sales are made on credit to Customer A for £200 and Customer B for £400 the
first entry would be to the sales day book to record the sales.

Debtors are recorded in the balance sheet of the business under the heading Current Assets, that
means they are convertible into cash within a year.
Disposal of Assets

Definition

Asset disposal is the act of selling an asset usually a long term asset that has been depreciated
over its useful life like production equipment.

Reasons for Disposal

There are many reasons for the disposal of capital assets by a business. It may be as simple as
replacing an asset that has outlived its’ useful life, a sale of equipment or just plain retirement.
No matter the reason, it is important that the transaction of a disposal is properly recorded for
accurate accounting.

In most situations an asset is completely disposed, while other times a partial disposal is
executed. For a complete disposal there will be a gain or loss based on the asset’s net book value
(original cost minus accumulated depreciation) and any proceeds of sale. A partial disposal is a
little more complicated since only a portion of the asset is disposed. This can occur with larger
equipment made of several components.Assets may be available for disposal because they are:

 a. required to be disposed of under a particular policy eg. motor

vehicles
 b. no longer required due to changed procedures, functions or
usage patterns;
 c. occupying storage space and not being needed in the foreseeable
future;
 d. reaching their optimum selling time to maximise returns;
 e. no longer complying with workplace health and safety
standards;
 f. found to contain hazardous materials
The disposal of assets involves eliminating assets from the accounting records. This is needed to
completely remove all traces of an asset from the balance sheet (known as derecognition). An
asset disposal may require the recording of a gain or loss on the transaction in the reporting
period when the disposal occurs.

If a company disposes of (sells) a long-term asset for an amount different from its recorded
amount in the company's accounting records (its book value), an adjustment must be made to net
income on the cash flow statement.

For example, let's say a company sells one of its delivery trucks for $3,000. That truck is shown
on the company records at its original cost of $20,000 less accumulated depreciation of $18,000.
When these two amounts are combined ("netted together") the net amount is known as the book
value(or the carrying value) of the asset. In the example, the book value of the truck is $2,000
($20,000 - $18,000).

Because the proceeds from the sale of the truck are $3,000 and the book value is $2,000 the
difference of $1,000 is recorded in the account Gain on Sale of Truck—an income statement
account. The transaction has the effect of increasing the company's net income. If the truck had
sold for $1,500 ($500 less than its $2,000 book value), the difference of $500 would be reported
in the account Loss on Sale of Truckand would reduce the company's net income.

The overall concept for the accounting for asset disposals is to reverse both the recorded cost of
the fixed asset and the corresponding amount of accumulated depreciation. Any remaining
difference between the two is recognized as either a gain or a loss. The gain or loss is calculated
as the net disposal proceeds, minus the asset’s carrying value.

Here are the options for accounting for the disposal of assets:

 No proceeds, fully depreciated. Debit all accumulated depreciation and credit the fixed
asset.
 Loss on sale. Debit cash for the amount received, debit all accumulated depreciation,
debit the loss on sale of asset account, and credit the fixed asset.
  Gain on sale. Debit cash for the amount received, debit all accumulated depreciation,
credit the fixed asset, and credit the gain on sale of asset account.

A proper fixed asset disposal is of some importance from the perspective of maintaining a clean
balance sheet, so that the recorded balances of fixed assets and accumulated depreciation
properly reflect the assets actually owned by a business.

Example of Asset Disposal

For example, ABC International buys a machine for $50,000 and recognizes $5,000 of
depreciation per year over the following ten years. At that time, the machine is fully depreciated,
ABC gives it away, and records the following entry.

Debit Credit

Accumulated depreciation 50,000

Machine asset 50,000

ABC International sells a $100,000 machine for $35,000 in cash, after having compiled $70,000
of accumulated depreciation. The entry is:

Debit Credit

Cash 35,000

Accumulated depreciation 70,000

Gain on asset disposal 5,000

 Machine asset 100,000

ABC International sells another machine that had originally cost it $40,000 for $25,000 in cash.
The company had compiled $10,000 of accumulated depreciation on the machine. The entry is:

Debit Credit

Cash 25,000

Accumulated depreciation 10,000

Loss on asset disposal 5,000

Machine asset

There are two scenarios under which you may dispose of a fixed asset. The first situation arises
when you are eliminating a fixed asset without receiving any payment in return. This is a
common situation when a fixed asset is being scrapped or given away because it is obsolete or no
longer in use, and there is no resale market for it. In this case, you reverse any accumulated
depreciation and reverse the original asset cost. If the asset is fully depreciated, then that is the
extent of your entry.

For example, ABC Corporation buys a machine for $100,000 and recognizes $10,000 of
depreciation per year over the following ten years. At that time, the machine is not only fully
depreciated, but also ready for the scrap heap. ABC gives away the machine for free, and records
the following entry.
 Debit Credit

Accumulated depreciation 100,000

Machine asset 100,000

A variation on this first situation is to write off a fixed asset that has not yet been completely
depreciated. In this situation, write off the remaining undepreciated amount of the asset to a loss
account. To use the same example, ABC Corporation gives away the machine after eight years,
when it has not yet depreciated $20,000 of the asset's original $100,000 cost. In this case, ABC
records the following entry:

Debit Credit

Loss on asset disposal 20,000

Accumulated depreciation 80,000

Machine asset 100,000

The second scenario arises when you sell an asset, so that you receive cash (or some other asset)
in exchange for the fixed asset you are selling. Depending upon the price paid and the remaining
amount of depreciation that has not yet been charged to expense, this can result in either a gain
or a loss on sale of the asset.

For example, ABC Corporation still disposes of its $100,000 machine, but does so after seven
years, and sells it for $35,000 in cash. In this case, it has already recorded $70,000 of
depreciation expense. The entry is:
 Debit Credit

Cash 35,000

Accumulated depreciation 70,000

Gain on asset disposal 5,000

Machine asset 100,000

What if ABC Corporation had sold the machine for $25,000 instead of $35,000? Then there
would be a loss of $5,000 on the sale. The entry would be:

Debit Credit

Cash 25,000

Accumulated depreciation 70,000

Loss on asset disposal 5,000

Machine asset 100,000

The proper recordation of a fixed asset disposal is of some importance from the perspective of
presenting a clean balance sheet to users, since the balance sheet should only aggregate
information for those fixed assets that are still held by the business.
Inventory

Definition: Inventory is an asset that is intended to be sold in the ordinary course of

business. Inventory may not be immediately ready for sale. Inventory items can fall into
one of the following three categories:

 Held for sale in the ordinary course of business; or

 That is in the process of being produced for sale; or
 The materials or supplies intended for consumption in the production process.

This asset classification includes items purchased and held for resale. In the case of services,
inventory can be the costs of a service for which related revenue has not yet been recognized.

In accounting, inventory is typically broken down into three categories, which are:

 Raw materials. Includes materials intended to be consumed in the production of finished

goods.
 Work-in-process. Includes items that are in the midst of the production process, and
which are not yet in a state ready for sale to customers.
 Finished goods. Includes goods ready for sale to customers. May be termed merchandise
in a retail environment where items are bought from suppliers in a state ready for sale.

Inventory is typically classified as a short-term asset, since it is usually liquidated within one
year.

Methods of inventory valuation

Inventory includes the raw materials, work-in-process, and finished goods that a company has
on hand for its own production processes or for sale to customers. Inventory is considered an
asset, so the accountant must consistently use a valid method for assigning costs to inventory in
order to record it as an asset.
The valuation of inventory is not a minor issue, because the accounting method used to create a
valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an
accounting period, and therefore on the amount of income earned. The basic formula for
determining the cost of goods sold in an accounting period is:

Beginning inventory + Purchases - Ending inventory = Cost of goods sold

Thus, the cost of goods sold is largely based on the cost assigned to ending inventory, which
brings us back to the accounting method used to do so. The following are the methods used in
valuation of inventory:

 First in, first out method. Under the FIFO method, you are assuming that items bought
first are also used or sold first, which also means that the items still in stock are the
newest ones. This policy closely matches the actual movement of inventory in most
companies, and so is preferable simply from a theoretical perspective. In periods of rising
prices (which is most of the time in most economies), assuming that the earliest units
bought are the first ones used also means that the least expensive units are charged to the
cost of goods sold first. This means that the cost of goods sold tends to be lower, which
therefore leads to a higher amount of operating earnings, and more income taxes paid.
Also, it means that there tend to be fewer inventory layers than under the LIFO method,
since you will continually use up the oldest layers.
 Last in, first out method. Under the LIFO method, you are assuming that items bought
last are sold first, which also means that the items still in stock are the oldest ones. This
policy does not follow the natural flow of inventory in most companies; in fact, the
method is banned under International Financial Reporting Standards. In periods of rising
prices, assuming that the last units bought are the first ones used also means that the cost
of goods sold tends to be higher, which therefore leads to a lower amount of operating
earnings, and fewer income taxes paid. There tend to be more inventory layers than under
the FIFO method, since the oldest layers may not be flushed out for years.
 Weighted average method. Under the weighted average method, there is only one
inventory layer, since the cost of any new inventory purchases are rolled into the cost of
 any existing inventory to derive a new weighted average cost, which in turn is adjusted
again as more inventory is purchased.

Both the FIFO and LIFO methods require the use of inventory layers, under which you have a
separate cost for each cluster of inventory items that were purchased at a specific price. This
requires a considerable amount of tracking in a database, so both methods work best if inventory
is tracked in a computer system.

Accountants usually adopt the FIFO, LIFO, or Weighted-Average cost flow assumption. The
actual physical flow of the inventory may or may not bear a resemblance to the adopted cost
flow assumption. In the following illustration, assume that Gonzales Chemical Company had a
beginning inventory balance that consisted of 4,000 units costing $12 per unit. Purchases and
sales are shown in the schedule. Assume that Gonzales conducted a physical count of inventory
and confirmed that 5,000 units were actually on hand at the end of the year.

Based on the information in the schedule, Gonzales will report sales of $304,000. This amount is
the result of selling 7,000 units at $22 ($154,000) and 6,000 units at $25 ($150,000). The dollar
amount of sales will be reported in the income statement, along with cost of goods sold and gross
profit. How much is cost of goods sold and gross profit? The answer will depend on the cost
flow assumption.

FIFO

If Gonzales uses FIFO, ending inventory, cost of goods sold, and the resulting financial
statements are as follows:
LIFO

If Gonzales uses LIFO, ending inventory, cost of goods sold, and the resulting financial
statements are as follows:
Weighted average

If Gonzales uses the weighted-average method, ending inventory and cost of goods sold
calculations are as follows:

These calculations support the following financial statement components.

COMPARING METHODS

The following table reveals that the amount of gross profit and ending inventory can appear quite
different, depending on the inventory method selected: