Financial accounting

Chapter 8

Inventory represents the goods that a business owns and has available to sell to its customers, not for use by the business; it is the products that the business holds for sale as part of its normal operations.

1. Wholesalers and retailers have an inventory of goods available for resale.

2. Manufacturers have inventory of raw materials to be used in production, work in process of partially completed goods, and finished goods ready to sell.

Businesses may have inventories of supplies but they are accounted for as supplies.

Inventory is a current asset usually listed after receivables on the balance sheet. Inventory is probably the business’s largest current asset, as well as the center of merchandising transactions.

Inventory shrinkage is the loss of inventory; it is the difference between actual inventory value and the inventory value recorded in the accounting records. Each loss decreases the inventory value as well as net income. Sources of inventory shrinkage are:

1. Employee theft: employee theft of goods can occur when the store is opened or closed.

2. Customer shoplifting: customer theft of goods can occur during store hours.

3. Administrative error: loss from poor purchasing decisions, poor physical organization, and poor inventory management can result in damage, spoilage, obsolescence, or errors in counting inventory.

4. Vendor fraud: vendors can charge excessive prices for merchandise or accept payment for merchandise that is never received.

To prevent inventory shrinkage, businesses need sound internal controls. The objectives of internal controls for inventory are to ensure inventory is physically safe and secure, reasonably well organized, not obsolete, properly recorded, and properly valued.

Key internal controls procedures for inventory are:

1. Separation of duties – individuals who have access to inventory items should not maintain inventory records, and individuals authorizing transactions should not record them.

2. Physical safeguards – restrict access to inventory items, including keys to store; leave no employee alone in the store; physically count inventory in a regular basis, at least once a year; and use electronic security systems, security mirrors, and video cameras to monitor activity.

3. Independent checks on performance – reconcile physical counts to counts reflected in accounting records by someone who does not handle inventory or inventory records; review and analyze relevant data such as inventory turnover, shrinkage, and sales trends; and inspect garbage for evidence of stolen inventory before garbage is dumped.

4. Proper authorization – individual approving inventory transactions should not have access to inventory.

5. Adequate documents and records – maintain perpetual records of inventory, and document purchase and sale transactions.

A retailer can prevent losses in other ways related to employee management:

1. Obtain reference checks on employees.

2. Educate employees on the costs of inventory shrinkage.

3. Give employees discounts in order to monitor employee purchases.

4. Reward employees who recover goods from shoplifters.

5. Reward employees who identify employees who are stealing.

Most retailers count inventory only once a year at the end of the fiscal year because a physical count of inventory is costly and time consuming; however, more frequent inventory counts could help the retailer detect theft sooner. A physical count usually occurs when the store is closed. Employees use maps of inventory locations, prenumbered count sheets, ink pens, and may count in pairs. The count may also involve prewritten inventory instructions and tags to identify merchandise to be counted, and is typically supervised. An outside inventory-taking firm may be used to take counts instead of employees.

The actual inventory count derived from the physical inventory is used to determine the inventory account balance on the balance sheet as well as the related costs of goods sold on the income statement, adjusting accounting records as necessary for any shrinkage. If the entity has its financial statements audited, a representative of the audit firm will probably be present at the count to take test counts and determine whether inventory instructions are being followed. This allows the auditor to evaluate whether inventory and cost of goods sold are fairly presented in the statement.

Inventory Cost Flows

The Inventory account is a current asset with a normal debit balance. In a perpetual inventory system, purchases of goods for resale increase the balance of the inventory account, while sales of goods to customers decrease the account’s balance. The Inventory account also reflects purchase discounts, purchase returns and allowances, and shipping costs related to the purchase of goods.

The costs of the units on hand in inventory at the beginning of the period are added to the net cots of units purchased for the period to determine the cost of goods available for sale. The objective of tracking the inventory cost is to assign the cost of the goods available for sale to the following categories:

1. Units sold, which, as recorded in costs of Goods Sold, is subtracted from net sales revenue on the income statement to arrive at gross profit

2. Units on hand, or unsold, which, as inventory are current assets on the balance sheet

Different costing methods help assign the cost of goods available for sale to the Cost of Goods Sold account and the inventory account:

1. Specific identification method (specific-unit-cost method) – this method values inventory according to the specific cost of each unit of inventory.

2. First-in, first-out (FIFO) method – The first inventory costs each period are the first costs assigned to cost of goods sold. FIFO assumes that the first inventory items owned are the first inventory items sold. FIFO leaves the in ending inventory the last, the most recent, costs incurred.

3. Last-in, first-out(LIFO) method – The last, most recent costs incurred are the first costs assigned to the cost of goods sold. LIFO assumes that the last inventory items owned are the first inventory items sold. Ending inventory’s cost comes from the oldest, earliest costs of the period. When costs are increasing, LIFO often results in the highest cost of goods sold, and the lowest income tax, the main advantage of LIFO.

4. Average cost method – the business computes a new, weighted average cost per unit after each purchase based on the number of items purchased at each price. Ending inventory and cost of goods sold are then based on the average cost per unit.

Sample problem

Aug 1 beginning inventory 10 units @ $ 91 = $ 910

Aug 3 purchases 15 units @ $106 = $1,590

Aug 17 purchases 20 units @ $115 = $2,300

Aug 28 purchases 10 units @ $119 = $1,190

Total 55 units $5,990

Sales

Aug 14 sales 20 units @ $130 = $2,600

Aug 31 sales 23 units @ $150 = $3,450

Total 43 units $6,050

Specific identification

Each item can be directly identified with a specific purchase and its invoice.

6 of the unsold items are from the august 28 purchase

6 of the unsold items are from the august 17 purchase

First-in, first –out (fifo)

Assumes inventory items are sold in the order acquired. Costs of earliest items are charged to cost of goods sold when sales occur. This leaves the cost of the most recent purchases in inventory.

Last-in, first-out (lifo)

Assumes that the most recent purchases are sold first. Their costs are charged to cost of goods sold, and the costs of the earliest purchases are assigned to inventory.

Average cost (weighted average)

A method of assigning costs by computing the average cost per unit of merchandise inventory at the time of each purchase. The weighted average cost is computed at the time of each purchase by dividing the cost of goods available for sale by the units on hand.

Comparing costing methods:

1. FIFO – Cost of goods sold has older, lower costs. Ending inventory has the newer, higher costs. Most closely matches actual flow of goods in most cases. Maximizes net income. Use method to attract investors or borrow money.

2. LIFO – Cost of goods sold has newer, higher costs. Ending inventory has the older, lower costs. Minimizes net income and income tax and minimizes ending inventory. Use method to reduce income tax and cash needed to pay tax.

3. Average cost – Averages costs in ending inventory and cost of goods sold. A “middle-ground solution” for reporting net income and inventory and paying income tax.

Lower of cost or market

When the cost of replacing items in inventory is lower than the historical cost, the price of the items at the time of purchase, the lower-of-cost-or-market rule (LCM) applies. LCM requires businesses to report inventory in the financial statements at whichever is lower, the historical cost, or the market value of each inventory item. Market value means current replacement cost, that is, the cost to replace the inventory on hand at that point in time.

The lower-of-cost-or-market method is an example of an important accounting principle, conservatism. Conservatism in accounting means reporting items in the financial statements at amounts that lead to the most cautious immediate results.

Examples of conservatism:

1. Anticipate no gains, but provide for all probable losses.

2. If in doubt, record an asset at the lowest reasonable amount and a liability at the highest reasonable amount.

3. When there’s a question, record an expense rather than an asset.

If the replacement cost of inventory is less than its historical cost, we write down the inventory value by decreasing inventory and increasing cost of goods sold. Net income is decreased in the period in which the decrease in market value occurred.

Example of lower of cost or market

Some businesses will use the concept of materiality to decide whether inventory needs to be written down to its current replacement cost. The materiality concept states that a company must perform strictly proper accounting only for items that are significant for the business’s financial statements. Information is material when its presentation in the financial statements would cause someone to change a decision. A material amount is one large enough to make a difference to a user of the financial statements.

The full disclosure principle holds that a company’s financial statements should report enough information for outsiders to make knowledgeable decisions about the company. To provide this information, a set of disclosures or footnotes will accompany the financial statements. The disclosure principle means stating the method being used to value inventory.

The consistency principle states that businesses should use the same accounting methods and procedures from period to period. Consistency helps investors compare a company’s financial statements from one period to the next.

Companies must report any changes in the accounting methods they use and they generally must retrospectively apply the impact of the change as an adjustment to beginning retained earnings, unless it is impractical to do so.

Errors in the inventory count can happen due to:

1. Human error

A. Incorrectly counting inventory

B. Double counting inventory

C. Not counting one section of the storeroom or excluding incoming goods shipped FOB shipping point

2. Failure to recognize obsolete or damaged goods, resulting in failure to write down their value accordingly.

A count that disagrees with the accounting records of inventory will result in making a journal entry to adjust the balance in the Inventory account. Because cost of goods available sale is divided between those goods on hand at the end of the period and those goods sold, this adjustment will also affect the Cost of Goods Sold account.

An error in the ending inventory creates an error in the cost of goods sold. The cost of goods sold is subtracted from net sales revenue to obtain gross profit, so the resulting gross profit and net income will also be wrong.

Example off counting inventory incorrectly

One period’s ending inventory becomes the next period’s beginning inventory. The error in ending inventory carries over into the next period. The error cancels out after two periods.

Ending inventory overstated – cost of goods sold understated, gross profit and net income overstated

Ending inventory understated – cost of goods sold overstated, gross profit and net income understated

Gross profit method to estimate ending inventory

The gross profit method estimates the cost of ending inventory by applying the gross profit ratio to net sales (at retail.)

This method uses the historical relationship between cost of merchandise sold and sales to estimate inventory.

In order to use this method, you must have:

1. Normal gross profit margin

2. Cost of beginning inventory

3. Cost of purchases

4. Transportation-in charges

5. Amount of sales

6. Amount of sales returns

Whatever portion of each dollar of net sales is gross profit, the remaining portion is cost of goods sold.

Example of gross profit method

APPENDIX A

Periodic System of counting Inventory

The only way to determine the ending inventory and cost of goods sold in a periodic system is to count the goods at the end of the accounting period, usually at the end of the year.

The periodic system uses four additional accounts to track certain transactions, rather than including these activities in a single Inventory account.

1. Purchases – This account holds the cost of inventory as it is purchased and carries a debit balance.

2. Purchase discounts – This contra-account carries a credit balance because it offsets the purchase costs with any discounts received for making payments on purchases within the discount period.

3. Purchase returns and allowances – this contra-account carries a credit balance because it offsets the purchase costs with the costs of any returns or allowances on damaged goods.

4. Freight-in – this account carries a debit balance because it reflects the additional costs of shipping goods that are included in inventory.

The end-of-period entries are more extensive because the beginning inventory balance must be removed and replaced with the ending inventory balance.

Cost of goods is computed by using the following formula:

Beginning inventory $ 5,000

Add: Net purchases 20,000

Cost of Goods Available for Sale 25,000

Less: Ending inventory (7,000)

Cost of goods sold $18,000

Net purchases

Purchases $21,000

Less: Purchase discounts (2,000)

Purchase returns and allowances (5,000)

Add: Freight in 6,000

Net purchases $20,000

Sample problem of valuing inventory under the periodic system