They are physical assets which are consumed either in the manufacture of the goods or the conduct of the business. They are called working and trading assets because they are the assets which the organization is working into goods for sale or into expenses attending such operation or because they are assets which are on hand for sale or trading purposes.
The accounts for items in this group are used in practice in three distinct ways. The first is to combine the old inventory and the purchases in one account and determine the consumption by the inventory method of crediting the new inventory and closing out the balance to a consumption account. The second is to combine the old inventory and the purchases in one account and determine the consumption by the direct method, so that crediting the amount consumed to the asset account will show the inventory. The third way is to run separate accounts for inventories and purchases. The inventory is entered in the asset account both at the beginning and at the end of the period and the difference only, whether it be debit or credit carried to the consumption account. The consumption account as used herein is used in a broad sense. The term is intended to mean any nominal account into which working or trading assets may be closed. It would embrace manufacturing cost, cost of goods sold and expense accounts such as stationery and printing expense, postage expense, etc.
In the illustrations of the varieties of practice which follow let these facts with regard to materials and supplies remain constant: inventory December 31, 1910, $20,000; purchases, $15,000; inventory December 31, 1911, $28,000; consumption, $7,000.
In the first case, the account becomes a mixed one. It partakes of the nature of both a real and a nominal account. At the beginning it is a real account. During the period it is a mixed account. In construction it is precisely like the old-fashioned merchandise account. In operation it is also identical. It is opened on the debit side with the inventory at the beginning of the period. It is charged with the purchases. It is credited with the inventory at the end of the period. It is closed by the balance in the account which is carried to the consumption or manufacturing account. Thus, if to the inventory at the beginning of the period of $20,000 we add the purchases of $15,000 there is $35,000 to be accounted for. If at the end of the period $28,000 remains on hand, $7,000 must have been consumed or have disappeared. It will be seen that the amount of material has been determined by the inventory method. The accounts would appear as follows:
In the second case, the account can scarcely be called a mixed one. It might appear without thought to partake of the nature of both a real and a nominal account. It does not, however, since the consumption is determined by the direct method. When the account is used in this way the materials and supplies are usually issued on requisition. The requisition when honored and priced becomes the basis of a charge to the consumption account and a corresponding credit to materials and supplies account. It is true of course that for convenience the requisition will be summarized and the aggregate amount credited to the materials and supplies account only at the end of the month, or end of the accounting period. Theoretically, however, the materials and supplies account is reduced every time a requisition is filled.
In many instances the consumption is determined by keeping a running stock account with each class of material or stock. The determining of consumption does not necessarily depend upon the use of requisitions. The stock account may be kept in a book, either bound, or composed of loose leaves, or upon cards. For convenience cards are sometimes located adjacent to the stock itself. The location of the record has little bearing upon the method so long as there is an account for each class of stock. . Given such accounts, they are debited with the opening inventory. They are subsequently charged with any receipts, whether by purchase or otherwise. They are credited with all issues at the time the issues are made. The balance in the account should show the stock on hand.
In connection with stock records, the question frequently arises, “what shall be done when the balance in the stock accounts does not agree with the physical inventory?” The disposition of such discrepancies must necessarily depend upon the cause. There are various things which cause the difference which may arise. One is failure to enter all receipts on the debit side of the account. Another is an error in footing the debit side. Still another may be failure to record an issue on the credit side. It is also possible that the actual stock issued did not agree with the record which was made of the issue or that the credit side of the account has been incorrectly footed. An attempt should first be made to correct any of the above mentioned causes of the discrepancy. If such measures prove ineffectual the account should be adjusted to agree with the physical inventory.
The question which now presents itself is “which complimentary account shall be affected by the difference?” If the physical inventory is greater than the book inventory the stock account must be charged. Which account is to be credited, consumption or profit and loss? If the physical inventory is less than the book inventory the stock account must be credited. Which account is to be charged, consumption or profit and loss? If the consumption account is charged or credited the cost of the goods manufactured or sold will be affected accordingly. Supposing, for example, that profit and loss has been charged for a shortage which although not clearly shown by the accounts was actually consumed in the manufacture of goods. The cost of manufacture will be incorrect to the extent of the shortage thus charged. On the other hand suppose that the difference was due to theft and instead of being charged to profit and loss the amount was charged to consumption or cost of manufacture. Again the consumption account would be incorrect to the extent of the shortage. To frame a hard and fast rule in this case is a difficult one. The best apparently that can be done is to say that the consumption account should be adjusted in accordance with any necessary adjustments to the stock account, except where it is known definitely that the consumption account has not been affected, when the adjustment should be carried to profit and loss.
The general ledger account, controlling any subsidiary records of stock, would, where the direct method of ascertaining the consumption is in force, appear as follows:
Materials And Supplies
Inventory, beginning. $20,000 Consumption $7,000
Purchases 15,000 Inventory, end 28,000
Inventory, new $28,000
Materials and Supplies $7,000
The third method of arriving at the consumption it will be remembered contemplated both an inventory account and a purchase account. The inventory account would show the inventory at the beginning on the debit side with the inventory at the end on the credit side. At the time of placing the inventory at the end on the credit side it would be carried down on the debit side to constitute the opening inventory for the next period. The balance in the inventory account would be carried to the purchase account. The effect of this procedure would be to increase or decrease the purchases for the period, depending upon whether the inventory at the end were larger or smaller than at the beginning. The purchase account thus adjusted would be closed out to the manufacturing cost account or to the account for cost of goods sold. Using again the same figures as heretofore the accounts would appear as follows:
The latter method just described is illustrated in the statement of income and profit and loss wherein, the section dealing with cost of goods sold, shows first the purchases and second the application of the inventory. This form of presentation is frequently difficult for the student to understand because of the terms used. Unless they be analyzed as to their meaning they strike one off-hand as being somewhat contradictory. The confusion seems to arise when the expressions add decrease of inventory and deduct increase of inventory are used. This point might be cleared up if one would stop to reason as follows: The cost of the materials and supplies consumed for the period is $7,000. This is represented by purchases amounting to $15,000, and an increase in inventory of $8,000, which is deducted from the purchases of $15,000. Why do we deduct the increase in inventory? Because of the fact that there has been consumed not the amount purchased, $15,000, but $15,000 less the $8,000, which remains unconsumed and appears in the inventory at the end of the period, $28,000. Conversely the same thing would be true. If the purchases for the period were the same $15,000, the inventory at the beginning being $28,000, and the inventory at the end $20,000, then the cost of the materials and supplies consumed during the period would be $23,000, represented by purchases of $15,000 plus a decrease in the inventory of $8,000. This may be reasoned out by following the facts which show that while $15,000 worth of materials were purchased during the period, $8,000 worth more have been used and have been deducted from the inventory at the beginning of $28,000, making the inventory at the end $20,000.
It is to be noted that applying the difference in inventory method to the materials and supplies, goods in process, finished parts to complete goods in process and finished goods, taking into consideration any purchases, will give the cost of the goods sold during the period. To illustrate this let the following series of transactions be followed: Inventories at the beginning; materials and supplies, $10,000; goods in process, $40,000; finished parts, $8,000; finished goods, $75,000; purchases of materials and supplies, $20,000. Inventories at the end; materials and supplies, $5,000; goods in process, $12,000; finished parts, $2,000; finished goods, $34,000. The account with the materials and supplies inventory would show an opening balance of $10,000, a closing balance of $5,000, with $5,000 carried to the materials and supplies purchase account. This latter account, amounting now to $25,000, would be closed out to the goods in process account. The goods in process account, opening with a balance of $40,000, would show a debit of $25,000 for materials and supplies, a debit of $6,000 coming from the account for finished parts or total debits amounting to $71,000. The credits in the goods in process account would comprise $12,000, the closing inventory and $59,000 transferred to the finished goods account. The finished goods account would show an opening balance of $75,000, a debit of $59,000, credits of $34,000, covering the new inventory, and $100,000, which would be transferred to the account for cost of goods sold. If instead of tracing the transactions through the above named steps in the respective account the differences in inventories were to be carried direct to the cost of goods sold account, it would show various debits comprising difference in inventory of materials and supplies of $5,000, purchases $20,000, difference in inventory goods in process $28,000, difference in inventory of finished parts $6,000, difference in inventory of finished goods $41,000, or a total of $100,000.
Of the miscellaneous items found in this group of assets, such as stationery and printing, postage, etc., comparatively little need be said apparently. In some concerns stock accounts are kept with those items and the amount chargeable to operations determined by requisitions issued. In other cases the amount chargeable to operations is determined by taking an inventory, placing upon it a value and charging off the difference in the account to operations. The materials and supplies, goods in process, etc., are of course closely related to cost accounting. These accounts serve as controlling accounts for the cost department, and where such department exists are usually supported by subsidiary records showing the details.
Possibly the most interesting phase of the discussion in connection with the inventory is the values at which items like materials and supplies, goods in process, and finished goods shall be carried. Some proprietors insist that they shall be carried at market prices. Some text-books advocate carrying them at cost except where the cost is lower than the market price, when they should be carried at the market price. It would seem that in order to be consistent one basis should be the rule in all cases. There is decided objection to carrying them at market prices or sale prices, when same is higher than cost, because of the fact that such procedure anticipates profits. Materials and supplies if carried at market prices may show either a profit or a loss when the cost of the materials and supplies is compared with the market price. What seems to be a fact is that materials and supplies on hand will be used in the product and not sold as materials and supplies if the market is above cost, or withheld from use and new supplies purchased if the market is below cost. It would appear to be a pretty good rule with regard to materials and supplies to carry them in the inventory at cost. Their value if the market is lower than cost may be shown on the balance sheet by opposing against the cost a reserve for decline in market values. Such procedure accomplishes two things. If the concern is ultraconservative and wishes to be exact, the true market value of the inventory is thus stated in the balance sheet, and at the same time the account for materials and supplies maintains its true relation to the details of which it is composed and continues to be a controlling account in the strict sense of the word. There is no objection and in fact it is considered more nearly correct to include in the pricing of inventory of materials and supplies the inward freight, cartage, etc., applicable to the goods remaining on hand.
With goods in process the question of valuation becomes somewhat more complex. Such goods will include in addition to the materials and supplies the labor and certain portions of the manufacturing overhead. The question presenting itself in this connection is whether or not such goods shall be carried at prime cost, which includes merely materials and supplies and direct labor, or whether they shall be carried at manufacturing cost, which includes in addition to prime cost the manufacturing overhead. The latter basis is undoubtedly the more equitable, but if desired or indicated by ultraconservatism the overhead may be offset by a reserve which will have the effect in the balance sheet of carrying the goods at their prime cost.
Finished goods involve in their cost an item of general overhead which is comprised of the selling, administrative and other expenses. If it is equitable to carry goods in process of manufacture at manufacturing cost, then it would seem equitable also to carry the finished goods at selling cost. The objection to this lies in the fact that in so doing a portion of the general overhead expense is capitalized and such procedure is questionable. Theoretically it is correct to carry finished goods at selling cost. Practically it is objected to because of the fact that it shows as an asset a proportion of expense applicable to the unsold product. It is hard to say why a distinction should be made between deferring charges to operations for such items as insurance for the unexpired proportion thereof, whereas the expenses of a given period are all charged up against the product sold during that period, when a portion of such expenses must in the nature of things apply to product completed in one period and sold in subsequent period, which period will benefit in the matter of profit proportionately. It is probably true that in the case of a business in which the manufacture and sale of the product is uniform that it will not make great difference. Most authorities advocate carrying finished goods at manufacturing cost, but when it is desirable to maintain control over underlying records by carrying them at selling cost, both results may be accomplished by setting up a reserve on the balance sheet for the proportion of general overhead expense which the selling costs contain.
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