Inventory

Inventory includes assets that are held for sale

in the normal course of business, work in the
process of being produced for sale, or raw
materials used to produce salable goods.
Items that are not sold in the usual course of
business are not inventory.

Inventory is classified by its use. Retailers often

have only one category, called merchandise,
which includes retail goods that were purchased
ready for sale.
Manufacturers often have three categories: raw
materials, work in process, and finished goods.
Costs of direct materials, labor, overhead, and
storage are traced or allocated to these categories as appropriate. Manufacturers may also need
inventory categories for other materials used internally, such as manufacturing supplies,
indirect materials, parts inventory, or factory supplies.

Inventories are generally classified as current assets in the financial statements. They are
expected to be realized in cash or sold or consumed during the normal operating cycle of the
business. Inventory is not only reported on the balance sheet as an asset, but it is also an
important item used to calculate the cost of goods sold on the income statement.

Inventory Valuation

Inventory valuation is the process of determining what items to include

in inventory, what costs should be included in inventory, and which cost
flow assumption should be used.
There are two systems of accounting for inventory: the perpetual system
and the periodic system. There are four cost flow assumptions from
which a company may choose: specific identification, weighted-average,
FIFO, and LIFO.
The overall cost of goods is allocated between the goods sold and the goods still on hand. The
cost of goods available for sale or use is the cost of goods on hand at the start of the period
plus the cost of goods acquired or produced throughout the period. The cost of goods sold is
the cost of goods available for sale or use minus the cost of goods on hand at the end of the
period, that is, ending inventory.

Which Goods to Include in Inventory

Purchases of inventory generally are recorded when the goods are received by the buyer, even
though ownership legally transfers when the title passes to the buyer. Exceptions to this practice
include:

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 ▪ Consigned goods. Consignment is a way for the
retailer (consignee) to mitigate the risk of
unsalable inventory by allowing the wholesale
seller (consignor) to retain ownership of the
goods until a sale is made. The wholesaler
receives payment for the goods from the retailer,
who takes a commission for holding, marketing,
and selling the goods. The consignor keeps the
goods on its inventory until the sale to a third
party. The consignee never records the goods as
inventory.

▪ Goods in transit are items that have been shipped but have not
yet reached their destination. Ownership of goods in transit is
determined by the shipping terms. Under FOB (free on board)
shipping point, title transfers as soon as the seller delivers the item
to a common carrier serving as an agent of the buyer. Under FOB
destination, title transfers only when the goods arrive at the
buyer’s warehouse. Title is important because damages to the
goods are the owner’s responsibility. Before title transfers, the
goods are the property of the seller; after transfer, they must be
accounted for on the books of the buyer.

▪ Sale agreements may involve a transfer of title at a different point from the transfer of the risks
of ownership. Sales with high rates of return are common in the publishing, sporting goods,
music, and other seasonal industries, where customers are permitted to return unsold inventory
for a full or partial refund. If the number of returns can be reasonably estimated,
the goods should be considered sold and a sales return and allowances account
established. However, when such an estimate is impossible, the seller should not
record a sale until the amount of returns is known.

▪ Sales with buyback agreements are a type of swap in which a firm sells its
inventory and agrees to repurchase the inventory at a specific price and at a specific
time. Such a transaction is called a parking transaction because the seller “parks”
inventory on the buyer’s balance sheet for a short time. Effectively, the seller is
financing its inventory and retaining the risks of ownership, but transfers title to the goods.
When a repurchase-agreement has a set price that covers all the buyer’s costs plus the cost of
the inventory, the inventory and the liability under the repurchase-agreement should remain on
the seller’s balance sheet.

▪ Obsolete Inventory items are items that can no longer be sold and thus should not be included
in the balance on the balance sheet. Items may become obsolete for a number of reasons:
technological advancement that makes the product useless, market loss, new features in newer
products, or the item is used with another product that is no longer available for sale. Any
inventory that becomes obsolete should be written off as a loss in the period in which it is
determined to be obsolete.

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 Note: A physical count is required by U.S. GAAP for annual reporting purposes. Under
GAAP, a physical count of the inventory must be done each year regardless of which inventory
cost flow method is being used. A physical count is not required for interim financial statements,
however.

Example: Goods Out on Consignment- Entity A’s December 31, Year 1, warehouse
inventory physical count results in the amount of inventory of $50,000. The following is
additional information regarding Entity A’s year-end inventory:

• During the year, Entity A consigned goods with a total cost of $60,000 to Entity B (the
consignee). The annual statement that was sent from Entity B to Entity A states that 60%
of the consignment goods were sold for $42,000.

• Merchandise costing $40,000 shipped FOB shipping point from a vendor on December 29,
Year 1, and was received by Entity A on January 4, Year 2.

• Merchandise costing $70,000 shipped FOB destination from a vendor on December 30,
Year 1, and was received by Entity A on January 5, Year 2.

• The goods billed to the customer FOB destination on December 27, Year 1, had a cost of
$25,000. The goods were shipped by Entity A on December 28, Year 1, and were received
by the customer on January 3, Year 2.

In the December 31, Year 1, balance sheet, Entity A reports an inventory amount of $139,000.
This amount consists of

Warehouse physical inventory count $ 50,000

Goods held on consignment ($60,000 × 40%) 24,000
Merchandise shipped FOB shipping point (title and risk of loss passed 40,000
to Entity A on December 29, Year 1, at the time of shipment)
Goods shipped FOB destination to customer (title and the risk of loss 25,000
will pass to the customer only on January 3, Year 2)
December 31, Year 1, inventory balance $ 139,000

What Costs to Include in Inventory

The types of costs to be included or excluded in the determination of inventory value are:

▪ Manufacturing overhead costs. For entities that make their own goods for sale, the cost of
inventory should include all direct and indirect costs incurred in production. Acquisition and
production costs are included. Overhead is allocated to goods manufactured using traditional
or activity-based approach. For example, a line manager’s salary would be part of the fixed
overhead pool attributable to a specific product line.

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▪ Product costs. Product costs include freight-in, labor costs, and all direct and indirect costs of
acquisition, production, and processing.

▪ Cash discounts. cash discounts are discounts for early payment. The gross method records all
purchases at the gross price, and discounts are recorded only if taken. The net method records
all purchases net of discounts. Purchase discounts lost are then charged to an expense account.

▪ Period costs. Items not included as part of inventory, such as selling, general and
administrative expenses, are called period costs and are expensed in the period in which they
are incurred. These costs are generally unrelated to production. Interest costs related to the
preparation of inventory are also treated as period costs. Under GAAP, only interest costs for
internally constructed assets or discrete projects, such as ships or real estate for sale or lease,
can be capitalized. Financing costs for routine manufacture of inventory are not capitalized.

Perpetual and Periodic Inventory Systems

There are two basic approaches to inventory record keeping: perpetual and periodic. The
perpetual system relies on computers and bar code scanners to update inventory records
continuously as purchases and sales are made. The periodic system evolved before computers
were used to track inventory.

Perpetual Inventory System

The perpetual inventory system tracks changes in the inventory account as they occur.
Sophisticated databases record sales, purchases, conversions, and transfers in real time. Retail
systems recognize inventory changes directly at the point of sale, updating both inventory and
COGS. All purchases return and allowances, discounts, and freight-in are also updated. When
a firm uses a perpetual inventory system, a journal entry is made with each sale to reduce
inventory and increase COGS. However, some goods may be stolen, accidentally shipped
without an invoice, or damaged and discarded without being recorded. Therefore, inventory
recorded on the books generally will be higher than the amount on hand, although overages
can also occur. Firms using the perpetual system must periodically compare their physical
inventory count to their records and write off any difference. Since the difference between
actual and recorded inventory can be measured, management can determine the amount of such
losses each year.

The basic formula for the perpetual system is:

Beginning Inventory + Purchases (Net) – COGS = Ending Inventory

Note: The basic formula to calculate Ending Inventory or COGS is helpful when analyzing the
effects of inventory errors. Remember that COGS is an expense and impacts the income
statement and net income, while ending inventory is an asset and impacts the current assets
section on the balance sheet and may also impact the current ratio of a company.

An advantage of the perpetual inventory system is that the amount of inventory on hand and
the cost of goods sold can be determined at any time. A disadvantage of the perpetual
inventory system is that the bookkeeping is more complex and expensive. perpetual system is

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more often used when individual inventory items are of high value because a perpetual system
provides better internal control.

Periodic Inventory System

By contrast, the periodic system does not track cost of goods sold during the period, so COGS
must be computed at the end of the period once the physical inventory count is complete. The
basic formula for the periodic system is:

Beginning Inventory + Purchases (Net) – Ending Inventory = COGS

The periodic inventory system is becoming obsolete as more companies adopt inventory
tracking databases and technologies. This system does not record an increase to cost of goods
sold or a decrease to inventory at the time of sale. Instead, this amount must be computed at
the end of the accounting period:

Purchases
– Purchase discounts
– Purchase returns and allowances
+ Freight in
Cost of goods purchased

Cost of goods purchased

+ Merchandise inventory (beginning balance)
Cost of goods available for sale

Cost of goods available for sale

- Merchandise inventory (ending physical count)
Cost of goods sold

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 Since cost of goods sold is determined only once a year, the information is not timely. To
deal with this problem, companies can use a modified perpetual inventory system that keeps a
detailed record of quantities (but not prices) in a memorandum account off the books. Another
drawback of the periodic system is that it cannot measure losses due to theft or damage.
Instead, these losses are included in COGS.

Cost Flow Assumptions

Cost flow assumptions are methods to account for inventory costs,

but they do not represent the actual physical flow of goods. The four
cost flow assumptions currently in use are:

1. Specific identification,
2. Average cost,
3. FIFO (first in, first out), and
4. LIFO (last in, first out).

▪ Specific identification tracks the cost of each individual item and records the item in cost of
goods sold or inventory depending on whether that item was sold. This method is feasible only
if all items are uniquely tagged, so it works best with small numbers of expensive items, such
as jewelry or automobiles, with special orders, or with products manufactured using a job
costing system.

▪ Average cost is a method that determines an average cost for all similar inventory items and
uses that cost during the period to assign costs to cost of goods sold and ending inventory. In
the perpetual inventory system, this method is called the moving average method, because
a new average cost must be calculated after each purchase, and that average is used until
another purchase is made and a new average cost is calculated. In the periodic system, the
weighted-average method is used. Divide the total cost of the goods available for sale
(beginning inventory + purchases) by the total number of units available to find a weighted-
average cost per unit. Multiply the units in ending inventory by the average cost to determine
the value of ending inventory. To find cost of goods sold, subtract ending inventory from the
cost of goods available for sale or multiply the units sold by the average cost. The average cost
method is objective and simple, so firms may choose to use it for practical reasons.

▪ First in, first out (FIFO) recognizes older inventory costs in cost of
goods sold and more recent inventory costs as ending inventory.
When costs are increasing, FIFO yields a lower cost of goods sold
because it includes the older, lower costs, whereas ending inventory
is relatively high because it includes higher, newer cost. If costs were
going down, the converse would be true. When a quantity sold
exceeds the number of units obtained at the earliest price, the price of
the next most recent purchase is used. Cost of goods sold is always
based on the earliest costs. If the periodic system is used, ending
inventory is calculated using the most recent costs. The cost of goods
available for sale minus the ending inventory equals the cost of goods
sold. FIFO perpetual and FIFO periodic will always yield the same results because the
same costs are always the first in. FIFO approximates the actual flow of inventory. When the

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oldest goods are sold first, FIFO approximates the specific identification method and FIFO
ending inventory values are approximate inventory replacement costs. However, FIFO does
not match current costs with current revenues on the income statement. Since the oldest costs
are matched with revenue, FIFO can distort net income and produce phantom profits.

▪ Last in, first out (LIFO) assigns the cost of the newest goods to cost of
goods sold and the cost of the oldest goods to ending inventory. When
costs are increasing, LIFO produces the highest cost of goods sold and the
lowest ending inventory. In the perpetual inventory system, which
records events in the order they occur, the LIFO cost of goods sold must
be determined after each sale.

Unlike FIFO, the LIFO perpetual inventory system and the LIFO
periodic system will yield different costs of goods sold and ending
inventory figures. This happens because the periodic system measures
LIFO cost as of the end of the accounting period, whereas the perpetual method measures LIFO
cost as of the date of each sale. When using LIFO in the periodic system, the cost of goods
sold is calculated by subtracting the ending inventory from the cost of goods available for sale.

LIFO has the advantage of providing a better measure of current

earnings because it matches recent costs against current revenues. LIFO
also allows income tax deferrals when costs are rising, and inventory
levels remain stable because cost of goods sold will be higher and net
income lower compared to other methods. Lower taxes increase a
company’s cash flows. LIFO can also hedge against price declines
because it rarely requires markdowns to market value because of price
decreases, which might be needed under FIFO. However, the lower
reported earnings that reduce taxes under LIFO are a disadvantage to
firms that wish to report higher income. LIFO also distorts the balance
sheet by understating inventory values and working capital.

Example: Inventory Information for Part 686 for the month of June as follows:
June 1 Beg. Balance 300 Unit @ $10
June 10 Sold 200 Unit @ $24
June 11 Purchased 800 Unit @ $12
June 15 Sold 500 Unit @ $25
June 20 Purchased 500 Unit @ $13
June 27 Sold 300 Unit @ $27

Required:
1. Assuming the perpetual Inventory Method, compute the cost of goods sold and Ending
Inventory under FIFO, LIFO and Average cost

2. Assuming the periodic Inventory Method, Compute the cost of goods sold and ending
inventory under FIFO, LIFO and Average cost.

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 Results Summary
EI COGS Total
FIFO perpetual $7,700 $11,400 $19,100
FIFO periodic 7,700 11,400 19,100
LIFO perpetual 7,200 11,900 19,100
LIFO periodic 6,600 12,500 19,100
MA perpetual 7,472 11,628 19,100
WA periodic 7,163 11,938 19,100

Inventory Estimation

An estimate of inventory may be needed when an exact count is not feasible, e.g., for interim
reporting purposes or when inventory records have been destroyed. The gross profit method
may be used for inventory estimation, even when the inventory may have been stolen or
destroyed by fire.

Gross profit margin (%) = Gross profit ÷ Sales

Example: Inventory Estimation - A retailer needs to estimate ending inventory for quarterly
reporting purposes. The firm’s best estimate of the gross percentage is its historical rate of
25%. The following additional information is available:

Net sales $1,000,000

Purchases 300,000
Beginning inventory 800,000

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 Beginning inventory $ 800,000
Purchases 300,000
Goods available for sale $1,100,000
Sales $1,000,000
Gross profit (Sales × Gross profit margin) (250,000)
Cost of goods sold [Sales × (1 – Gross profit margin)] (750,000)
Ending inventory $ 350,000

Retail Inventory Method

The retail inventory method is a very effective means of estimating inventory value. It
is used for

1. Interim and annual financial reporting in accordance with GAAP,

2. Federal income tax purposes, and
3. Verifying year-end inventory and cost of goods sold data, e.g., as an analytical procedure
by an independent auditor.

A summary of inventory cost flow assumptions.

Valuation Description EI COGS NI Perpetual Periodic LCM LCNRV

method
Tracks cost
of each NA NA NA NA NA
Specific ID unique item
for inventory
& cost
Moving ×
Average cost Inventory & average –
Average of similar COGS results average Weighted
cost item for are between cost Average
inventory & FIFO & LIFO recalculate
cost d with each
purchase
Cost of first Result of same amount ×
FIFO in go to reported for both
COGS inventory & COGS
Cost of last in Layers Layers ×
go to COGS calculated determine
with each d for time
LIFI purchases period
& then
subsequent COGS is
sale calculated
Calculate a ×
Cost to retail
ratio then
apply the NA

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 Retail ratio to EI at NA
Inventory the retail to
method estimate the
cost of EI
EI: Ending Inventory
COGS: Cost of Goods Sold
NI: Net Income
LCM: Lower of Cost or Market
LCNRV: Lower of Cost or Net Realizable Value
Cost-to-Retail Ratio: Cost of goods available for sale divided by retail value of goods available for sale

Question: The advantage of the last-in, first-out inventory method assumes that
a) The most recently incurred costs should be allocated to cost of goods sold.
b) Costs should be charged to revenue in the order in which they are incurred.
c) Costs should be charged to cost of goods sold at average cost.
d) Current costs should be based on representative or normal conditions of efficiency and
volume of operations.

Question: In a period of rising prices, which one of the following inventory methods usually
provides the best matching of expenses against revenues?
a) Weighted average
b) First-in, first-out
c) Last-in, first-out
d) Specific identification

Question: Which one of the following actions would result in a decrease in income?
a) Liquidating last-in, first-out layers of inventory when prices have been increasing.
b) Changing from the first-in, first-out to the last-in, first-out inventory method when prices
are decreasing.
c) Accelerating purchases at the end of the year when using the last-in, first-out inventory
method in times of rising prices.
d) Changing the number of last-in, first-out pools.

Question: In periods of rising costs, which one of the following inventory cost flow
assumptions will result in higher cost of sales?
a) First-in, first-out
b) Last-in, first-out
c) Weighted average
d) Moving average

Question: The inventory method that will yield the same inventory value and cost of goods
sold whether a perpetual or periodic system is used is
a) average cost
b) first-in, first out
c) last-in, first-out
d) either first-in, first-out or last-in, first-out

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Lower of Cost or Market Rule

The amendments in the updated FASB ASC Inventory do not apply to inventory measured
using last-in, first-out (LIFO), or the retail inventory method. This inventory will continue to
be measured at the lower of cost or market (LCM) just as they have been. Market is still defined
as a replacement cost of the inventory based on the current inventory’s utility.
The difference will be recognized as a loss in the current period. Inventory is initially recorded
at historical cost, but if it declines in value due to obsolescence, damage, or price level changes,
then the inventory should be written down to its current value.

The lower of cost or market (LCM) rule now applies when inventory that is valued using the
last-in, first-out (LIFO) or the retail inventory method of cost flow becomes obsolete or
declines in value (e.g., foreign competition brings prices down). In such situations, inventory
is valued at either its cost or its market value, whichever is lower. Market value is generally
considered to be the cost to replace the item by purchasing or reproducing it. Thus, it is the
value in the purchase market, not in the sales market. Inventory is written down in the period
when the value declines, not the period when the item is sold.

Lower of Cost or Market Ceiling and Floor

Two constraints limit replacement cost as a measure of market value:

1. Ceiling. Market value should not be greater than the inventory’s net realizable value.
2. Floor. Market value should not be less than the inventory’s net realizable value less an
allowance for a normal markup or profit margin.

The ceiling (upper limit) is designed to make sure that the inventory is not overstated, and the
loss understated, thus avoiding the need to recognize further losses in future periods. The floor
(lower limit) is designed to make sure that the loss is not overstated, and the inventory is not
understated, preventing the recognition of excessive future profits.

The lower of cost or market rule may be applied to individual items, to categories of items, or
to the total inventory if it’s consistently applied year to year. When applying LCM to categories
or the total inventory, increases in market price for some items tend to offset decreases in the
market price for other items, generally leading to a smaller restatement than if LCM is applied
to individual items. Item level LCM is the most common, and it is generally required for taxes.
Item-level LCM produces the most conservative (lowest) inventory value and largest holding
loss, because for each item the lower of cost or market is chosen.

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Recording Lower of Cost or Market
The difference is recognized as a loss in the current period and reported in the income statement.

Example: Plumbing Wholesale sells several inventory items and values its inventory using
LIFO. Four of the items and the calculation of their lower-of-cost-or-market values are as
follows (the columns containing the two amounts to be compared for each item to determine
its lower of cost or market are marked with arrows):

Cost Normal NRV

Hist. Sell to Normal profit Replacement NRV - Designated LCM
cost price sell profit % amount cost profit market
S 7 10 1 30% 3 7.5 9 6 7.5 7
T 8 10 1 27% 2.7 7.25 9 6.3 7.25 7.25
U 14 19 1 26% 5 19.5 18 13 18 14
V 16 20 1 20% 4 14 19 15 15 15

For each item, the designated market value is the middle value of the replacement cost, the
NRV, and the NRV minus Normal Profit. That designated market value is compared with the
item’s historical cost. The lower of the two amounts is the LCM.

Lower of Cost and Net Realizable Value (NRV) The Updated Standard

The amendments in the update apply to inventory measured using either the first-in, first-out
(FIFO) or average cost method. The entity will apply the new standard “prospectively to the
measurement of inventory after the date of adoption.” During the transition to the updated
standard, the entity will “disclose the nature of and reason for the change in accounting
principle in the first interim and annual period of adoption.”

The definition of NRV is:

Net Realizable Value (NRV) is “the estimated selling prices in the ordinary course of
business, less reasonably predictable costs of completion, disposal, and transportation.”

When the NRV of inventory is lower than its cost, the difference is recognized as a loss in
earnings in the period when it occurs. The purpose is to fairly reflect the income for the period.
The cost and accompanying NRV can be applied directly to each item, components of a major
category, or to the total inventory. This is like the LCM method.

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U.S. GAAP does not specify what account should be debited for the write-down. The loss may
be recorded on the income statement in either of two ways. Both ways are acceptable.

1. The loss method debits a loss account such as loss on inventory

write-down. The loss is identified separately on the income
statement. The loss is an operating loss, so the loss account is in
the administrative expense area of the income statement.

2. The cost-of-goods-sold method debits cost of goods sold for the

inventory write-down. If the loss is simply debited to cost of
goods sold, though, it is not identified separately on the income
statement. It is buried in cost of goods sold. Furthermore, the
income statement lacks representational faithfulness because cost
of goods sold does not represent what it purports to represent.

Example: Inventory write-down - LCM “Recording Loss”

Ending inventory (COST) $ 415,000
Ending inventory (LCM) $ 350,000
Adjustment to LCM $ 65,000

Allowance Method (If the Loss is Significant Separate item in IS)

Loss on inventory 65,000
Allowance on inventory 65,000

Direct Method (If the Loss isn’t Significant)

COGS 65,000
Inventory 65,000

Example: LCNRV “Lower of Cost or NRV” Under IFRS & US GAAP (FIFO & WA)

Dr. Loss from Inventory Write-down

Cr. Inventory

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 Effects of Inventory Errors

Two main types of inventory errors are misstatements in

ending inventory and misstatements in purchases.

▪ Misstated ending inventory. When items are

incorrectly omitted from ending inventory, the balance sheet
understates inventory, which in turn understates retained
earnings, working capital, and possibly the current ratio. In
addition, income is understated because the cost of goods
sold is overstated. If the error is not corrected in the
following period, the opposite effect will result, so the two
periods’ statements viewed together will result in the same
total income as if no error had occurred.

However, the net income for each year will be misstated when viewed individually. When
ending inventory is overstated, the opposite occurs: Net income, inventory, retained earnings,
working capital, and the current ratio is overstated while the cost of goods sold is understated.

For example, table below shows the effects of overstating ending inventory by $10,000 in
Year 1 and the reversal of this error in Year 2. Increases or decreases are represented by up or
down arrows.

Correcting an Inventory Misstatement

Timing Change
Ending inventory misstated Year 1 ↑ $10,000
Cost of sales Year 1 ↓ $10,000
Operating income Year 1 ↑ $10,000
Tax expense (40% tax rate) Year 1 ↑ $4,000
Net income Year 1 ↑ $6,000
Retained earnings Year 1 ↑ $6,000
Beginning inventory Year 2 ↑ $10,000
Cost of sales Year 2 ↑ $10,000
Operating income Year 2 ↓ $10,000
Tax expense (40% tax rate) Year 2 ↓ $4,000
Net income Year 2 ↓ $6,000
Ending inventory Year 2 Correct
Retained earnings Year 2 Correct

▪ Misstated purchases. When a purchase is not recorded or included in ending inventory,

the balance sheet understates inventory and accounts payable. The current ratio will be
overstated or understated depending on what the original current ratio was. On the income
statement, both purchases and ending inventory are understated, so the cost of goods sold
is correct. Therefore, net income is not affected. The current ratio will be overstated if the

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 original current ratio is greater than 1 to 1 because reducing the size of both current assets
and current liabilities yields a higher ratio.

However, if the original current ratio is less than 1 to 1 the current ratio will decrease and be
understated. When both purchases and inventory are overstated, the opposite is true in each of
these situations.

Question: Holly Company’s inventory is overstated at December 31 of this year. The result
will be
a) Understated income this year
b) Understated retained earnings this year
c) Understated retained earnings next year
d) Understated income next year
Question: Which one of the following errors will result in the overstatement of net income?
a) Overstatement of beginning inventory
b) Overstatement of ending inventory
c) Overstatement of goodwill amortization
d) Overstatement of credit loss expense

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