Needles Powers Principles of Financial Accounting 12e Inventories 7 C H A P T E R ©human/iStockphoto

NeedlesPowers

Principles of Financial Accounting

12e

Inventories7C H A P T E R

©human/iStockphoto

Concepts Underlying Inventory Accounting

Manufacturing companies have three kinds of inventory:– Raw materials (goods used in making

products)– Work in process (partially completed

products)– Finished goods ready for sale

For a merchandising company, inventory consists of all goods owned and held for sale in the regular course of business.

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Accrual Accounting and Valuation of Inventories

Inventory accounting applies accrual accounting to the determination of the cost of inventory sold.

– Inventory cost includes the following: invoice price less purchases discounts; freight-in, including insurance in transit; applicable taxes and tariffs.

– Inventory valuation depends on the prices of goods, which can vary during the year. Thus, it is necessary to make an assumption about the order in which items have been sold.

Goods flow refers to the actual physical measurement of goods in the operations of a company.

Cost flow refers to the association of costs with their assumed flow.


Merchandise in Transit

Outgoing goods shipped FOB destination are included in the seller’s merchandise inventory, whereas those shipped FOB shipping point are not.

Incoming goods shipped FOB shipping point are included in the buyer’s merchandise inventory, but those shipped FOB destination are not.


Merchandise Not Included in Inventory

Goods to which the company does not hold title should not be included in its physical inventory. These include:– Goods sold but not yet delivered to the

buyer– Goods held on consignment—

merchandise that its owner (the consignor) places on the premises of another company (the consignee) with the understanding that payment is expected only when the merchandise is sold and that unsold items may be returned to the consignor


Conservatism and the Lower-of-Cost-or-Market (LCM) Rule

If the market value of inventory falls below its historical cost because of physical deterioration, obsolescence, or decline in the price level, a loss has occurred. This loss is recognized by writing the inventory down to market, or its current replacement cost.– When the replacement cost of inventory

falls below its historical cost, the lower-of-cost-or-market (LCM) rule requires that the inventory be written down to the lower value and that a loss be recorded.


Inventory Cost Under the Periodic Inventory System

The value assigned to the ending inventory is the result of two measurements: quantity and cost.– Under the periodic inventory system, quantity is

determined by taking a physical inventory.– Cost is determined by using one of the following

methods: specific identification, average-cost, first-in, first-out (FIFO), or last-in, first-out (LIFO).

– The choice of method depends on the nature of the business, the financial effects, and the cost of implementation.


Specific Identification Method

The specific identification method identifies the cost of each item in the ending inventory.– It can be used only when it is possible to identify

the units as coming from specific purchases.– Although this method may appear logical, most

companies do not use it for the following reasons: It is usually impractical, if not impossible, to keep track

of the purchase and sale of individual items. When a company deals in items that are identical but

bought at different prices, deciding which items were sold becomes arbitrary.


Average Cost Method

Under the average-cost method (or weighted average method), inventory is priced at the average cost of the goods available for sale during the period. Average cost is computed as follows:

Average Cost = Total Cost of Goods Available for Sale Total Units Available for Sale

- The average cost method tends to level out the effects of cost increases and decreases because the cost of the ending inventory is influenced by all the prices paid during the year and the cost of the beginning inventory.


First-In, First-Out (FIFO) Method

The first-in, first-out (FIFO) method assumes that the costs of the first items acquired should be assigned to the first items sold. – The costs of the goods on hand at the end of a

period are assumed to be from the most recent purchases, and the costs assigned to goods that have been sold are assumed to be from the earliest purchases.

– Thus, the FIFO method values the ending inventory at the most recent costs and includes earlier costs in the cost of goods sold.


Last-In, First-Out (LIFO) Method

The last-in, first-out (LIFO) method of costing inventories assumes that the costs of the last items purchased should be assigned to the first items sold and that the cost of the ending inventory should reflect the cost of the goods purchased earliest.– The effect of LIFO is to value inventory at the

earliest prices and to include the cost of the most recently purchased goods in the cost of goods sold.


Impact of Inventory Decisions

In a period of rising prices, LIFO, which charges the most recent prices to the cost of goods sold, results in the lowest gross margin.

In a period of rising prices, FIFO, which charges the earliest prices to the cost of goods sold, produces the highest gross margin.

The gross margin under the average-cost method falls between the gross margins produced by LIFO and FIFO.


Effects on Income Taxes

The Internal Revenue Service governs how inventories must be valued for federal income tax purposes. – IRS regulations give companies a wide choice of

inventory costing methods, including specific identification, average-cost, FIFO, and LIFO.

– During a period of rising prices, a company using LIFO will pay higher income taxes if it lets the inventory at year end fall below the level at the beginning of the year. This is called a LIFO liquidation—that is, units sold exceed units purchased for the period.


Inventory Cost Under the Perpetual Inventory System

Under the perpetual inventory system, inventory is updated as purchases and sales take place.

The cost of goods sold is accumulated as sales are made and costs are transferred from the Inventory account to the Cost of Goods Sold account.

The cost of the ending inventory is the balance of the Inventory account.

Goods are valued using one of these methods: specific identification, average-cost, FIFO, or LIFO.


Specific Identification Method

The detailed records of purchases and sales maintained under the perpetual system facilitate the use of the specific identification method.


Average-Cost Method

Under the perpetual system, an average is computed after each purchase or series of purchases.


FIFO Method

When costing inventory with the FIFO or LIFO methods, it is necessary to keep track of the components of inventory because, as sales are made, the costs must be assigned in the proper order.


Valuing Inventory by Estimation

The most commonly used methods for estimating the value of the ending inventory are:– the retail method, which estimates the cost of

the ending inventory by using the ratio of cost to retail price. It can be used to estimate the cost without taking time to determine the cost of each item in the inventory.

– the gross profit method (or gross margin method), which assumes that the ratio of gross margin for a business remains relatively stable from year to year.


Gross Profit Method

The gross profit method is used in place of the retail method when records of the retail prices of the beginning inventory and purchases are not available.

This method is acceptable for estimating the cost of inventory for insurance claims and for interim reports, but it is not acceptable for valuing inventory in the annual financial statements.

The gross profit method involves three steps.


Inventory Turnover

Inventory turnover is the average number of times a company sells an amount equal to its average level of inventory during a period.


Days’ Inventory on Hand

Day’s inventory on hand is the average number of days it takes a company to sell an amount equal to its average inventory.


Inventory Management

To reduce their levels of inventory, many merchandisers and manufacturers use supply-chain management in conjunction with a just-in-time operating environment.– With supply-chain management, a

company uses the Internet to order and track goods that it needs immediately.

– A just-in-time (JIT) operating environment is one in which goods arrive just at the time they are needed.


Inventory Misstatements and Fraud

Inventory is particularly susceptible to fraudulent financial reporting.– It is easy to overstate or understate inventory

by including end-of-the-year purchase and sale transactions in the wrong fiscal year or by simply misstating inventory by mistake.

– A misstatement can also occur because of deliberate manipulation of operating results motivated by a desire to enhance the market’s perception of the company, obtain bank financing, or achieve compensation incentives.


Inventory Misstatements Illustrated

Because the ending inventory in one period becomes the beginning inventory in the following period, a misstatement in inventory valuation affects both periods.


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Needles Powers Principles of Financial Accounting 12e Inventories 7 C H A P T E R ©human/iStockphoto