Inventories (asset)
- items held for sale in ordinary course of business, or
- goods to be used in production of goods to be sold
- Merchandiser or Manufacturer
Merchandising co. inventory
Classification
- One inventory account
- Purchase merchandise in a form ready for sale
Manufacturing co. inventory
Three accounts
- Raw Materials
- Work in Process
- Finished Goods
Perpetual inventory system
- Purchases of merchandise are debited to Inventory.
- Freight-in is debited to Inventory.
- Purchase returns and allowances and purchase discounts are credited to Inventory.
- Cost of goods sold is debited and Inventory is credited for each sale.
- Subsidiary records show quantity and cost of each type of inventory on hand.
Periodic inventory system
-Purchases of merchandise are debited to Purchases.
-Ending Inventory determined by physical count.
-Calculation of Cost of Goods Sold:
Beg. inventory
+ Purchases, net
= Goods available for sale
- Ending inventory
= Cost of Goods Sold
Inventory Control
All companies need periodic verification of the inventory records
- By actual count, weight, or measurement
- With counts compared with detailed inventory records
Companies should take the physical inventory
- Near the end of their fiscal year,
- To properly report inventory quantities in their annual accounting reports
Determining Cost of Goods Sold
Companies must allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand.
Beg. inventory, Jan. 1
+ Cost of goods acquired or produced during year
= Total Cost of Goods available for sale
- Ending inventory, Dec. 31
= Cost of goods sold during the year
Goods Included in Inventory
- A company recognizes inventory and accounts payable at the time it controls the asset.
- Passage of title is often used to determine control because the rights and obligations are established legally.
Goods in transit
- Goods in transit at the end of the period, shipped f.o.b. shipping point, should be included in the buyer’s ending inventory.
- If goods are shipped f.o.b. destination, they belong to the seller until actually received by the buyer.
Consigned Goods
- Goods out on consignment remain the property of the consignor
- Consignee makes no entry to the inventory account for goods received
Special Sales Agreements
-Sales with Repurchase Agreement
Often referred to as a repurchase (or product financing) agreement, usually involves a transfer (sale) with either an implicit or explicit repurchase agreement.
These arrangements are often described in practice as “parking transactions.”
Special Sales Agreements
-Sales with High Rates of Return
Seller:
-Record sales revenue at the amount it expects to receive from the transaction.
-Establishes an estimated inventory return account at the date of sale to recognize that some of its inventory will be returned.
Costs Included in Inventory
Costs directly connected with bringing the goods to Product Costs:
-the buyer’s place of business and converting such goods to a salable condition.
Period Costs :
-Generally selling, general, and administrative expenses.
Treatment of Purchase Discounts
Gross method:
-purchase discounts should be reported as a deduction from purchases on the income statement.
Net method:
-purchase discounts lost should be considered a financial expense and reported in the “other expense and loss” section of the income statement.
Cost Flow Assumption
-Specific identification
- Includes in cost of goods sold the costs of specific items sold
- Used when handling a relatively small number of costly, easily distinguishable items
- Matches actual costs against actual revenue
- Cost flow matches physical flow of goods
- May allow a company to manipulate net income
Cost Flow Assumption
-Average-cost method
- Prices items in inventory on basis of average cost of all similar goods available during the period
- Not subject to income manipulation
- Measuring a specific physical flow of inventory is often impossible
First-in, First-out (FIFO)
- Assumes goods are used in order in which they are purchased
- Approximates physical flow of goods
- Ending inventory is close to current cost
- Fails to match current costs against current revenues
Last-in, First-out (LIFO)
- The cost of the total quantity sold or issued during the month comes from the most recent purchases.
- The L I F O method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method.
LIFO Reserve
LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO.
Many companies use:
- LIFO for tax and external financial reporting purposes
- FIFO, average cost, or standard cost system for internal reporting purposes
Reasons:
(1) Pricing decisions, (2) Record keeping easier, (3) Profit-sharing or bonus arrangements, (4) L I F O troublesome for interim periods.
LIFO Liquidation
Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes.
The specific-goods approach to costing LIFO inventories is often unrealistic for two reasons:
- Cost of tracking each inventory item is expensive.
- Erosion of the LIFO inventory can easily occur (LIFO liquidation) which often distorts net income and leads to substantial tax payments.
Dollar-Value LIFO
Increases and decreases in a pool are measured in terms of total dollar value, not physical quantity of goods.
Advantage:
- Broader range of goods in pool
- Permits replacement of goods that are similar
- Helps protect LIFO layers from erosion
Dollar-Value LIFO
-Selecting a Price Index
Many companies use the general price-level index that the federal government publishes each month.
- Most popular is Consumer Price Index for Urban Consumers (CPI-U)
- Companies also use more-specific external price indexes
- Company may compute its own specific internal price index
Comparison of LIFO Approaches
1)Specific-goods L I F O - costing goods on a unit basis is expensive and time consuming
2) Specific-goods pooled LIFO approach
- Reduces record keeping and clerical costs
- More difficult to erode layers
- Using quantities as measurement basis can lead to untimely LIFO liquidations
3)Dollar-value L I F O is used by most companies
Major Advantages of LIFO
- Matching
- Tax Benefits/Improved Cash Flow
- Future Earnings Hedge
