Chapter 10

Inventories

Accounting for Inventory

• Merchandise inventory is usually a very large asset for retailers and manufacturers.
• Three types of inventory for manufacturers
• raw materials
• work in process
• finished goods



• Inventory systems and costing methods
• Management may choose either the periodic or perpetual inventory system
• Under the periodic system, the inventory account is only updated at year end
• Under the perpetual system, all purchases and sales are immediately reflected in inventory



• Proper valuation of ending inventory is necessary for proper valuation of COGS and net income. Several types of costing methods are available

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Inventory Costs

• The cost of inventory, like any asset, includes all the costs necessary to get the asset ready for its intended use. These costs generally include
• purchase price less discounts and returns
• freight in
• insurance in transit
• taxes
• tariffs
• goods on consignment with another company



• Goods flow versus cost flow
• Goods flow reflects the actual physical flow of inventory in and out of the company.



• Cost flow is an assumption that management makes about costs for accounting purposes
• Cost flow does not have to mirror goods flow
• Cost flow assumptions include:
• Specific identification
• Average cost
• First-in, First-out (FIFO)
• Last-in, Last-out (LIFO)

Inventory costing methods - Periodic system

• Specific identification
• Ending inventory can be identified as having come from specific purchases - i.e. the goods flow and the cost flow are the same
• Primarily used for high-priced items such as cars, furniture and expensive jewelry



• Average cost method
• Process
• Average cost per unit is computed for the goods available for sale during the period (cost of goods available for sale divided by the units available for sale)
• Average cost per unit is multipled by the number of units in ending inventory to obtain the cost of ending inventory
• Advantages - levels the effects of variations in cost
• Disadvantages - does not use the most recent costs which are most relevant in determining cost of goods sold



• FIFO
• Assumes that the first units purchased are the first units sold
• COGS is costed at the prices of the least recent purchases
• Ending inventory is costed at the prices of the most recent purchases



• During periods of rising prices, FIFO will produce the highest net income of the four costing methods.



• LIFO
• Assumes that the last units purchased are the first units sold
• COGS is costed at the prices for the most recent purchases
• Ending inventory is costed at the prices of the least recent purchases



• LIFO matches current costs (COGS) with current revenues, smoothing out the effects of the business cycle



• Disadvantages of LIFO
• reports the lowest net income of the four methods during inflationary times
• not an accepted method in most other countries
• tax rule - if use LIFO for tax or accounting, must use for both.

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Inventory costing methods - Perpetual system

• Specific identification - no changes from applying this method to a periodic system



• Average cost - moving average cost is computed after each purchase. This amount is applied to inventory sold until the next purchase occurs and a new average is calculated.



• FIFO and LIFO
• each layer of inventory is listed separately, with individual units and costs identified



• FIFO will result in the same ending inventory balance under the perpetual and periodic systems.



• LIFO will produce different figures for ending inventory and cost of goods sold.

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Effects of inventory methods and inventory misstatements

• During periods of rising prices
• FIFO provides a higher net income than LIFO.
• Average cost method produces net income between FIFO and LIFO
• Can't generalize about the specific identification method



• During periods of falling prices - LIFO produces higher net income than FIFO



• General comments
• LIFO best follows the matching rule
• FIFO provides a more up-to-date ending inventory figure for balance sheet purposes



• Beginning and ending inventory misstatements
• When ending inventory is under- or overstated, net income will be under- or overstated, respectively



• When beginning inventory is under- or overstated, net income will be over- or understated.



• Inventory errors are counterbalancing because their effects are reversed within two accounting periods.

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