Inventories and Cost of Sales

Introduction

This chapter covers the fundamental principles of accounting for inventories and cost of sales. It explains how to identify inventory items and costs, apply different inventory costing methods, analyze the effects of inventory errors, and assess inventory management using key metrics.

Learning Objectives

• Identify the items and costs of merchandise inventory.

• Analyze the effects of inventory methods for both financial and tax reporting.

• Analyze the effects of inventory errors on current and future financial statements.

• Assess inventory management using both inventory turnover and days' sales in inventory.

• Compute inventory in perpetual and periodic systems using specific identification, FIFO, LIFO, and weighted average methods.

• Compute the lower of cost or market/net realizable value amount of inventory.

• Apply retail inventory and gross profit methods to estimate inventory.

Items and Costs of Merchandise Inventory

Determining Inventory Items

Merchandise inventory includes all goods a company owns and holds for sale, regardless of their location at the time of inventory count. Special attention is required for certain types of goods:

• Goods in Transit: Inventory ownership depends on shipping terms:

  • FOB Shipping Point: Goods belong to the buyer once shipped.

  • FOB Destination: Goods belong to the buyer only after arrival at the destination.

• Goods on Consignment:

  • Consignor: The owner of the goods; reports the goods in inventory.

  • Consignee: Sells goods for the owner; does not report consigned goods in inventory.

• Goods Damaged or Obsolete:

  • Not reported in inventory if unsellable.

  • If sellable, included at net realizable value (NRV):

  • Loss is recorded when damage or obsolescence occurs.

Determining Inventory Costs

Inventory cost includes all expenditures necessary to bring an item to a salable condition and location.

• Inventory cost formula:

• Other costs may include:

  • Shipping

  • Storage

  • Insurance

  • Import duties

Inventory Costing Methods

Overview of Costing Methods

Four main methods are used to assign costs to inventory and cost of goods sold:

• Specific Identification

• First-In, First-Out (FIFO)

• Last-In, First-Out (LIFO)

• Weighted Average

Inventory Costing under a Perpetual System

In a perpetual system, inventory records are updated continuously. The physical flow of goods does not need to match the cost flow method chosen.

• Specific Identification: Tracks the actual cost of each specific item sold.

• FIFO: Assumes oldest inventory costs are assigned to cost of goods sold; recent costs remain in ending inventory.

• LIFO: Assumes most recent inventory costs are assigned to cost of goods sold; oldest costs remain in ending inventory.

• Weighted Average: Assigns average cost to each unit sold and remaining in inventory.

Weighted Average Cost Formula:

Inventory Costing under a Periodic System

In a periodic system, inventory records are updated at the end of the accounting period. The same four costing methods apply, but calculations are performed less frequently.

• Specific Identification

• FIFO

• LIFO

• Weighted Average

Financial and Tax Reporting Effects of Inventory Methods

Financial Statement Effects

The choice of inventory costing method affects both the cost of goods sold and ending inventory values, especially when prices change:

• FIFO: Ending inventory approximates current costs; cost of goods sold reflects older costs.

• LIFO: Cost of goods sold approximates current costs; ending inventory reflects older costs.

• Weighted Average: Smooths out price fluctuations; both cost of goods sold and ending inventory are averages.

Tax Effects

• The LIFO conformity rule requires that if LIFO is used for tax reporting, it must also be used for financial reporting.

Lower of Cost or Market / Net Realizable Value (NRV)

Inventory Valuation Adjustments

Inventory must be reported at the lower of its cost or market value (replacement cost), or at net realizable value (NRV) if using FIFO, weighted average, or specific identification.

• If market value or NRV is lower than cost, inventory is written down.

• If market value or NRV is higher than cost, no adjustment is made.

Net Realizable Value Formula:

Effects of Inventory Errors

Income Statement Effects

Inventory errors affect the cost of goods sold and net income for the current and subsequent periods.

• Understated ending inventory: Overstates cost of goods sold, understates net income.

• Overstated ending inventory: Understates cost of goods sold, overstates net income.

Balance Sheet Effects

• Understated inventory: Understates assets and equity.

• Overstated inventory: Overstates assets and equity.

Inventory Management Metrics

Inventory Turnover

Shows how many times a company sells and replaces its inventory during a period. Indicates management efficiency in controlling inventory.

Inventory Turnover Formula:

Days' Sales in Inventory

Reveals how much inventory is available in terms of the number of days' sales.

Days' Sales in Inventory Formula:

Inventory Estimation Methods

Retail Inventory Method

Used to estimate ending inventory when a physical count is not possible, such as after a casualty loss.

Gross Profit Method

Estimates ending inventory by applying the gross profit rate to net sales.

Summary Table: Inventory Costing Methods

Key Terms

• Merchandise Inventory: Goods held for sale by a company.

• FOB Shipping Point: Ownership transfers to buyer when goods are shipped.

• FOB Destination: Ownership transfers to buyer when goods arrive.

• Consignor: Owner of consigned goods.

• Consignee: Agent selling goods for the consignor.

• Net Realizable Value (NRV): Estimated selling price minus selling costs.

• Inventory Turnover: Ratio showing how often inventory is sold.

• Days' Sales in Inventory: Number of days inventory remains unsold.

Additional info: Academic context and formulas have been expanded for clarity and completeness. Examples and applications are included where relevant.