CHAPTER 2 ACCOUNTING FOR INVENTORIES

7.1. Definition and Classification of Inventory

Inventories are asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. They are mainly divided into three
major categories.
 Merchandising inventory
 Manufacturing inventory
 Supplies inventory
7.1.1 Merchandising Inventory
Merchandising inventory consists of many different items. For example, in a grocery store,
canned goods, dairy products, meats, and produce are just a few of the inventory items on hand.
These items have two common characteristics: (1) They are owned by the company, and (2) they
are in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers
need only one inventory classification, merchandise inventory, to describe the many different
items that make up the total inventory.
7.1.2. Manufacturing Inventory
Manufacturers normally have three inventory accounts—Raw Materials, Work in Process, and
Finished Goods. A company reports the cost assigned to goods and materials on hand but not yet
placed into production as raw materials inventory. Raw materials include the wood to make a
baseball bat or the steel to make a car. These materials can be traced directly to the end product.
At any point in a continuous production process, some units are only partially processed. The
cost of the raw material for these unfinished units, plus the direct labor cost applied specifically
to this material and a ratable share of manufacturing overhead costs, constitute the work in
process inventory.
Companies report the costs identified with the completed but unsold units on hand at the end of
the fiscal period as finished goods inventory.
7.1.3 Supplies Inventory
A Merchandising and Manufacturing Company, might include a merchandising or
Manufacturing Supplies Inventory account. In it, theses companies would include such items as
stationary materials, cleaning material, and the like—supplies that are used in production but are
not the primary materials being sold or processed.
7.3. Inventory Costing Method under a Perpetual and Periodic Inventory System
Perpetual Inventory System
A perpetual inventory system continuously tracks changes in the Inventory account. That is, a
company records all purchases and sales (issues) of goods directly in the Inventory account as
they occur. The accounting features of a perpetual inventory system are as follows.
1. Purchases of merchandise for resale or raw materials for production are debited to Inventory
rather than to Purchases.
2. Freight-in is debited to Inventory, not Purchases. Purchase returns and allowances and
purchase discounts are credited to Inventory rather than to separate accounts.
3. Cost of goods sold is recorded at the time of each sale by debiting Cost of Goods Sold and
crediting Inventory.
4. A subsidiary ledger of individual inventory records is maintained as a control measure. T he
subsidiary records show the quantity and cost of each type of inventory on hand.
The perpetual inventory system provides a continuous record of the balances in both the
Inventory account and the Cost of Goods Sold account.
Periodic System
Under a periodic inventory system, a company determines the quantity of inventory on hand
only periodically, as the name implies. It records all acquisitions of inventory during the
accounting period by debiting the Purchases account. A company then adds the total in the
Purchases account at the end of the accounting period to the cost of the inventory on hand at the
beginning of the period. This sum determines the total cost of the goods available for sale during
the period.
To compute the cost of goods sold, the company then subtracts the ending inventory from the
cost of goods available for sale. Note that under a periodic inventory system, the cost of goods
sold is a residual amount that depends on a physical count of ending inventory. This process is
referred to as “taking a physical inventory.” Companies that use the periodic system take a
physical inventory at least once a year.
Adjustments for a Perpetual Inventory System
When a company uses a perpetual inventory system and a difference exists between the perpetual
inventory balance and the physical inventory count, it needs a separate entry to adjust the
perpetual inventory account. To illustrate, assume that at the end of the reporting period, the
perpetual inventory account reported an inventory balance of $4,000. However, a physical count
indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down
is as follows.
Images
Inventory Over and Short……………………….. 200
Inventory ……………………………………….200
Inventory overages and shortages generally represent a misstatement of cost of goods sold. The
difference results from normal and expected shrinkage, breakage, shoplifting, incorrect
recordkeeping, and the like. Inventory Over and Short therefore adjusts Cost of Goods Sold. In
practice, companies sometimes report Inventory Over and Short in the “Other income and
expense” section of the income statement.
7.4. Effects of inventory error on financial statements
Effects of inventory errors on current year’s income statement
Cost of
When Inventory Error: Goods Sold Is: Net Income Is:
Understates beginning inventory Understated Overstated
Overstates beginning inventory Overstated Understated
Understates ending inventory Overstated Understated
Overstates ending inventory Understated Overstated

Effects of inventory error on the subsequent year’s Balance Sheet

Ending Merchandise Current Total Owner’s Equity

Inventory Error Inventory Assets Assets (Capital)
Understated Understated Understated Understated Understated
Overstated Overstated Overstated Overstated Overstated

7.4. Determining Inventory Quantities

No matter whether they are using a periodic or perpetual inventory system, all companies need to
determine inventory quantities at the end of the accounting period. If using a perpetual system,
companies take a physical inventory for two reasons:
1. To check the accuracy of their perpetual inventory records.
2. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or
employee theft.
Companies using a periodic inventory system take a physical inventory to determine the
inventory on hand at the balance sheet date, and to determine the cost of goods sold for the
period. Determining inventory quantities involves two steps: (1) taking a physical inventory of
goods on hand and (2) determining the ownership of goods.
Taking Physical Inventory
Companies take a physical inventory at the end of the accounting period. Taking a physical
inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In
many companies, taking an inventory is a formidable task. Retailers such as Target, True Value
Hardware, or Home Depot have thousands of different inventory items. An inventory count is
generally more accurate when goods are not being sold or received during the counting.
Consequently, companies often “take inventory” when the business is closed or when business is
slow. Many retailers close early on a chosen day in January—after the holiday sales and returns,
when inventories are at their lowest level—to count inventory.
Determining Ownership of Goods
One challenge in computing inventory quantities is determining what inventory a company
owns. To determine ownership of goods, two questions must be answered:
Do all of the goods included in the count belong to the company?
Does the company own any goods that were not included in the count?
Goods in Transit
A complication in determining ownership is goods in transit (on board a truck, train, ship, or
plane) at the end of the period. The company may have purchased goods that have not yet been
received, or it may have sold goods that have not yet been delivered. To arrive at an accurate
count, the company must determine ownership of these goods.
Goods in transit should be included in the inventory of the company that has legal title to the
goods. Legal title is determined by the terms of the sale, i.e FOB Shipping and FOB destination
If goods in transit at the statement date are ignored, inventory quantities may be seriously
miscounted. Assume, for example, that Hargrove Company has 20,000 units of inventory on
hand on December 31. It also has the following goods in transit:
1. Sales of 1,500 units shipped December 31 FOB destination.
2. Purchases of 2,500 units shipped FOB shipping point by the seller on December 31. Hargrove
has legal title to both the 1,500 units sold and the 2,500 units purchased. If the company ignores
the units in transit, it would understate inventory quantities by 4,000 units (1,500 1 2,500).
Inaccurate inventory counts affect not only the inventory amount shown on the balance sheet but
also the cost of goods sold calculation on the income statement.
Consigned Goods
In some lines of business, it is common to hold the goods of other parties and try to sell the
goods for them for a fee, but without taking ownership of the goods. These are called consigned
goods.
For example, you might have a used car that you would like to sell. If you take the item to a
dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is
sold. Under this agreement, the dealer would not take ownership of the car, which would still
belong to you. Therefore, if an inventory count were taken, the car would not be included in the
dealer’s inventory.
7.5. Inventory Valuation
7.5.1 Basic issued on Inventory Valuation
Goods sold (or used) during an accounting period seldom correspond exactly to the goods bought
(or produced) during that period. As a result, inventories either increase or decrease during the
period. Companies must then 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. The cost of goods available for
sale or use is the sum of (1) the cost of the goods on hand at the beginning of the period, and (2)
the cost of the goods acquired or produced during the period. The cost of goods sold is the
difference between (1) the cost of goods available for sale during the period, and (2) the cost of
goods on hand at the end of the period.
Valuing inventories can be complex. It requires determining the following.
1. The physical goods to include in inventory (who owns the goods?—goods in transit,
consigned goods, special sales agreements).
NB: refer to the issue under the title taking physical count
2. The costs to include in inventory (product vs. period costs).
3. The cost flow assumption to adopt (specific identification, average- cost, FIFO, etc.).

Product Costs
Product costs are those costs that “attach” to the inventory. As a result, a company records
product costs in the Inventory account. These costs are directly connected with bringing the
goods to the buyer's place of business and converting such goods to a salable condition. Such
charges generally include (1) costs of purchase, (2) costs of conversion, and (3) “other costs”
incurred in bringing the inventories to the point of sale and in salable condition.
Cost of purchase includes all of:
1. The purchase price.
2. Import duties and other taxes.
3. Transportation costs.
4. Handling costs directly related to the acquisition of the goods.
Conversion costs for a manufacturing company include direct materials, direct labor, and
manufacturing overhead costs.
“Other costs” include costs incurred to bring the inventory to its present location and condition
ready to sell.
Period Costs
Period costs are those costs that are indirectly related to the acquisition or production of goods.
Period costs such as selling expenses, Interest Expenses are not part of the inventory cost. Ion
7.5.2. Cost Flow Assumptions
Because specific identification is often impractical, other cost flow methods are permitted. These
differ from specific identification in that they assume flows of costs that may be unrelated to the
physical flow of goods. There are two assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Average-cost
There is no accounting requirement that the cost flow assumption be consistent with the
physical movement of the goods. Company management selects the appropriate cost flow
method.
Specific Identification
Specific identification calls for identifying each item sold and each item in inventory. A
company includes in cost of goods sold the costs of the specific items sold. It includes in
inventory the costs of the specific items on hand. This method may be used only in instances
where it is practical to separate physically the different purchases made. As a result, most
companies only use this method when handling a relatively small number of costly, easily
distinguishable items. In the retail trade, this includes some types of jewelry, fur coats,
automobiles, and some furniture. In manufacturing, it includes special orders and many products
manufactured under a job cost system.
Average Cost
As the name implies the average-cost method, prices items in the inventory on the basis of the
average cost of all similar goods available during the period. In computing the average cost per
unit, companies includes the beginning inventory, if any, both in the total units available and in
the total cost of goods available.
Companies use the moving-average method with perpetual inventory records. Illustration 8-14
shows the application of the average-cost
method for perpetual records For the periodic inventory system uses weighted-average method.
.

Whereas, for perpetual inventory system uses Moving Average method.

Companies often use average-cost methods for practical rather than conceptual reasons. These
methods are simple to apply and objective. They are not as subject to income manipulation as
some of the other inventory pricing methods. In addition, proponents of the average-cost
methods reason that measuring a specific physical flow of inventory is often impossible.
Therefore, it is better to cost items on an average-price basis. This argument is particularly
persuasive when dealing with similar inventory items.
First in First out (FIFO)
The first-in, first-out (FIFO) method assumes that a company uses goods in the order in which it
purchases them. In other words, the FIFO method assumes that the first goods purchased are the
first used (in a manufacturing concern) or the first sold (in a merchandising concern). The
inventory remaining must therefore represent the most recent purchase.
The accounting records of Shumway Ag Implement show the following data.
Beginning inventory 4,000 units at $ 3
Purchases 6,000 units at $ 4
Sales 7,000 units at $12
Determine the cost of goods sold during the period under a periodic inventory system
using (a) the FIFO method, and (b) the average-cost method.
Solution

Cost of goods available for sale = (4,000 * $3) + (6,000 * $4) = $36,000
Ending inventory = 10,000 - 7,000 = 3,000 units
(a) FIFO: $36,000 - (3,000 * $4) = $24,000
(b) Average cost per unit: [(4,000 @ $3) + (6,000 @ $4)] / 10,000 = $3.60
Average-cost: $36,000 - (3,000 * $3.60) = $25,200
One objective of FIFO is to approximate the physical flow of goods. When the physical flow of
goods is actually first-in, first-out, the FIFO method closely approximates specific identification.
At the same time, it prevents manipulation of income. With FIFO, a company cannot pick a
certain cost item to charge to expense.
Another advantage of the FIFO method is that the ending inventory is close to current cost.
Because the first goods in are the first goods out, the ending inventory amount consists of the
most recent purchases. This is particularly true with rapid inventory turnover. This approach
generally approximates replacement cost on the statement of financial position when price
changes have not occurred since the most recent purchases.
However, the FIFO method fails to match current costs against current revenues on the income
statement. A company charges the oldest costs against the more current revenue, possibly
distorting gross profit and net income.
Summery errors on Inventory

7.5.3.Valuation of Inventory Other than Cost

Lower-of-cost or-net realizable value rule.
Inventories are recorded at their cost. However, if inventory declines in value below its original
cost, a major departure from the historical cost principle occurs. Whatever the reason for a
decline—obsolescence, price-level changes, or damaged goods—a company should write down
the inventory to net realizable value to report this loss. A company abandons the historical cost
principle when the future utility (revenue-producing ability ) of the asset drops below its original
cost.
Recall that cost is the acquisition price of inventory computed using one of the historical cost-
based methods—specific identification, average- cost, or FIFO. The term net realizable value
(NRV) refers to the net amount that a company expects to realize from the sale of inventory.
Follow these steps to determine the net realizable value of an inventory item:

1. Determine the market value of the inventory item.

2. Summarize all costs associated with completing and selling the asset, such as final
production, testing, and prep costs.
 3. Subtract the selling costs from the market value to arrive at the net realizable value.

Thus, the formula for net realizable value is:

Inventory market value - Costs to complete and sell goods = Net realizable value

Example of Lower of Cost or Net Realizable Value

ABC International has a green widget in inventory with a cost of $50. The market value of the
widget is $130. The cost to prepare the widget for sale is $20, so the net realizable value is $60
($130 market value - $50 cost - $20 completion cost). Since the cost of $50 is lower than the net
realizable value of $60, you continue to record the inventory item at its $50 cost.

In the following year, the market value of the green widget declines to $115. The cost is still $50,
and the cost to prepare it for sale is $20, so the net realizable value is $45 ($115 market value -
$50 cost - $20 completion cost). Since the net realizable value of $45 is lower than the cost of
$50, you should record a loss of $5 on the inventory item, thereby reducing its recorded cost to
$45.

If the amount of a write-down caused by the lower of cost or market analysis is minor, then
charge the expense to the cost of goods sold. If the loss is material, then you may want to track it
in a separate account (especially if such losses are recurring), such as “Loss on LCM
adjustment.” To use the information in the preceding example, the journal entry would be:

7.5.4 Estimating Inventory Costs

Two circumstances explain why companies sometimes estimate inventories. First, a casualty
such as fire, flood, or earthquake may make it impossible to take a physical inventory. Second,
managers may want monthly or quarterly financial statements, but a physical inventory is taken
only annually. The need for estimating inventories occurs primarily with a periodic inventory
system because of the absence of perpetual inventory records. There are two widely used
methods of estimating inventories: (1) the gross profit method, and (2) the retail inventory
method
Gross Profit Method
The gross profit method uses the estimated gross profit for the period to estimate the inventory
at the end of the period. The gross profit is estimated from the preceding year, adjusted for any
current-period changes in the cost and sales prices. The gross profit method is applied as follows:
Step 1. Determine the merchandise available for sale at cost.
Step 2. Determine the estimated gross profit by multiplying the net sales by the gross profit
percentage.
Step 3. Determine the estimated cost of merchandise sold by deducting the estimated gross profit
from the net sales.
Step 4. Estimate the ending inventory cost by deducting the estimated cost of merchandise sold
from the merchandise available for sale.
Exhibit 1 illustrates the gross profit inventory costing method
A B C
Merchandise inventory, January 1 57,000
Purchases in January (net) 180,000
Merchandise available for sale 237,000
Sales for January (net) 250,000
Less estimated gross profit ($250,000 _ 30%) 75,000
Estimated cost of merchandise sold 175000
Estimated merchandise inventory, January 31 62,000

Retail Method of Inventory Costing

The retail inventory method of estimating inventory cost requires costs and retail prices to be
maintained for the merchandise available for sale. A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate the ending inventory cost. The retail inventory
method is applied as follows:
Step 1. Determine the total merchandise available for sale at cost and retail.
Step 2. Determine the ratio of the cost to retail of the merchandise available for sale.
Step 3. Determine the ending inventory at retail by deducting the net sales from the merchandise
available for sale at retail.
Step 4 . Estimate the ending inventory cost by multiplying the ending inventory at retail by the
cost to retail ratio.
Exhibit 2 illustrates the retail inventory method

Cost Retail
Merchandise inventory, January 1 $19,400 36,000
Purchases in January (net) 42,600 64,000
Merchandise available for sale 62,000 100,000
Ratio of cost to retail price: $62,000/$100,000=62%
Sales for January (net) 70,000
Merchandise inventory, January 31, at retail 30,000
Merchandise inventory, January 31, at estimated cost 18,600
($30,000 _ 62%)

7.6. Control of Inventory

Two primary objectives of control over inventory are as follows:
1. Safeguarding the inventory from damage or theft.
2. Reporting inventory in the financial statements.
Safeguarding Inventory
Controls for safeguarding inventory begin as soon as the inventory is ordered. The following
documents are often used for inventory control:
Purchase order
Receiving report
Vendor’s invoice
The purchase order authorizes the purchase of the inventory from an approved vendor. As soon
as the inventory is received, a receiving report is completed. The receiving report establishes an
initial record of the receipt of the inventory. To make sure the inventory received is what was
ordered, the receiving report is compared with the company’s purchase order. The price,
quantity, and description of the item on the purchase order and receiving report are then
compared to the vendor’s invoice. If the receiving report, purchase order, and vendor’s invoice
agree, the inventory is recorded in the accounting records. If any differences exist, they should be
investigated and reconciled.
Recording inventory using a perpetual inventory system is also an effective means of control.
The amount of inventory is always available in the subsidiary inventory ledger. This helps
keep inventory quantities at proper levels. For example, comparing inventory quantities with
maximum and minimum levels allows for the timely reordering of inventory and prevents
ordering excess inventory.
Finally, controls for safeguarding inventory should include security measures to prevent damage
and customer or employee theft. Some examples of security measures include the following:
1. Storing inventory in areas that are restricted to only authorized employees.
2. Locking high-priced inventory in cabinets.
3. Using two-way mirrors, cameras, security tags, and guards.