This chapter covers inventory topics such as FIFO, LIFO, Weighted Average, specific identification, LIFO reverse, LIFO Liquidation and Dollar Value LIFO.
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Careful attention is given to the inventory account by many business organizations because it represents one of the most significant assets held by a company. Inventories are of particular importance to merchandising and manufacturing companies because they represent the primary source of revenue for these organizations. Inventories are also significant because of their impact on both the balance sheet and the income statement. Chapter 8 initiates the discussion of the basic issues involved in recording, costing, and valuing items classified as inventory.
Inventories are asset items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold. Merchandise inventory refers to the goods held for resale by a merchandising concern. The inventory of a manufacturer is composed of three separate accounts representing stages of completion: raw materials, work in process, and finished goods.
Inventory records may be maintained on a perpetual or periodic inventory system basis. A perpetual inventory system provides a means for generating up-to-date records related to inventory quantities. Under this inventory system, data are available at any time relative to the quantity of material or type of merchandise on hand and the related cost. In a perpetual inventory system, purchases and sales of goods are recorded directly in the Inventory account as they occur. A Cost of Goods Sold account is used to accumulate the issuances from inventory. The balance in the Inventory account at the end of the year should represent the ending inventory cost.
When inventory is accounted for on a periodic inventory system, the acquisition of inventory is debited to a Purchases account. Cost of goods sold must be calculated at the end of the period when a periodic inventory system is in use. The computation of cost of goods sold is made by adding beginning inventory to net purchases and then subtracting ending inventory. Ending inventory is determined by a physical count at the end of the period under a periodic inventory system. Even in a perpetual inventory system, an annual physical inventory count is normally taken due to the potential for loss, error, or shrinkage of inventory during the year.
Inventory planning and control is of vital importance to the success of a merchandising or manufacturing concern. If an excessive amount of inventory is accumulated, there is the danger of loss owing to obsolescence. If the supply of inventory is inadequate, the potential for lost sales exists. This dilemma makes inventory an asset to which management must devote a great deal of attention.
Reconciliation between the recorded inventory amount and the actual amount of inventory on hand is normally performed at least once a year. This is called a physical inventory and involves counting all inventory items and comparing the amount counted with the amount shown in the detailed inventory records. Any errors in the records are corrected to agree with the physical count.
The cost of goods sold during any accounting period is defined as all the goods available for sale during the period less any unsold goods on hand at the end of the period (ending inventory). The process of computing cost of goods sold is complicated by the determination of (a) the physical goods to be included in inventory, (b) the costs to be included in inventory, and (c) the cost flow assumption to be used.
Physical Goods to be Included in Inventory
Normally, goods are included in inventory when they are received from the supplier. However, at the end of the period, proper accounting requires that all goods to which the company has legal title be included in ending inventory. 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. Inventory out on consignment belongs to the consignor’s inventory.
In actual practice a few exceptions exist regarding the general rule that inventory is recorded by the company that has legal title to the merchandise. These exceptions are known as special sale agreements. Two of the more common special sales agreements are (a) sales with a repurchase agreement and (b) sales with high rates of return.
Costs Included in Inventory
Inventories are recorded at cost when acquired. Cost in terms of inventory acquisition includes all expenditures necessary in acquiring the goods and converting them to a saleable condition. Product costs are those costs that “attach” to the inventory and are recorded in the inventory account. These costs include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs, such as selling expenses and general and administrative expenses, are not considered inventoriable costs. The reason these costs are not included as a part of the inventory valuation concerns the fact that, in most instances, these costs are unrelated to the immediate production process.
The FASB allows for the capitalization of interest costs related to assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease. In the case of inventories that are routinely manufactured or produced in large quantities on a repetitive basis, interest costs should not be capitalized.
When purchases are recorded net of discounts, failure to pay within the discount period results in the treatment of lost discounts as a financial expense. If the gross method is used, purchase discounts should be reported as a deduction from purchases on the income statement. If the net method is used, purchase discounts lost should be considered a financial expense and reported in the “other expense and loss” section of the income statement.
Cost Flow Assumptions
Determining the specific cost of inventory items that have been sold as well as those remaining in ending inventory is sometimes a difficult process. This is due, in part, to the fact that there is no requirement that the cost flow assumption adopted be consistent with the physical flow of the goods through the inventory account. Thus, it is important when accounting for inventory costs that a company make consistent use of a cost flow assumption. The major objective in selecting a method should be to choose the one which most clearly reflects periodic income.
Inventory cost flow assumptions include (a) specific identification, (b) average-cost, (c) first-in, first-out (FIFO), (d) last-in, first-out (LIFO), and (e) dollar-value LIFO. It should be remembered that these assumptions relate to the flow of costs and not the physical flow of inventory items into and out of the company.
Specific identification calls for identifying each item sold and each item in inventory. The costs of the specific items sold are included in cost of goods sold, and the costs of the specific items on hand are included in inventory. The average-cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period.
Use of the FIFO inventory method assumes that the first goods purchased are the first used or sold. In all cases where FIFO is used, the inventory and cost of goods sold will be the same amount at the end of the month whether a perpetual or periodic system is used.
A major advantage of the FIFO method is that the ending inventory is stated in terms of an approximate current cost figure. However, because FIFO tends to reflect current costs on the balance sheet, a basic disadvantage of this method is that current costs are not matched against current revenues on the income statement.
Use of the LIFO inventory method assumes that the most recent inventory costs are the first costs recognized as goods manufactured or sold. When inventory records are kept on a periodic basis, the ending inventory is priced by using the total units as a basis of computation, disregarding the exact dates of purchases. The calculation of ending inventory and cost of goods sold changes somewhat when the LIFO method is used in connection with perpetual inventory records.
Many companies use LIFO for tax and external reporting purposes, but maintain a FIFO, average cost, or standard cost system for internal reporting purposes. The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO Reserve. The change in the allowance balance from one period to the next is the LIFO effect.
When the LIFO inventory method is used, many companies combine inventory items into natural groups or pools. Each pool is assumed to be one unit for the purpose of costing the inventory. Any increment above beginning inventory is normally identified as a new inventory layer and priced at the average cost of goods purchased during the year. When inventory levels decrease, the most recently added inventory layer is the first layer eliminated (last-in, first-out). The specific-goods pooled LIFO approach reduces record keeping and, accordingly, LIFO liquidations, which causes the cost of utilizing the LIFO inventory method to decline.
Use of the specific-goods pooled approach can result in problems for companies that often change the mix of their products, materials, and production methods. To overcome these problems, the dollar-value LIFO method has been developed. The important feature of the dollar-value LIFO method is that increases and decreases in a pool are determined and measured in terms of total dollar value, not the physical quantity of the goods as is done in the traditional LIFO pool approach.
In computing inventory under the dollar-value LIFO method, the ending inventory is first priced at the most current cost. Current cost is then restated to prices prevailing when LIFO was adopted. This is accomplished by using a price index. A new inventory layer is formed when the ending inventory, stated in base-year costs, exceeds the base-year costs of beginning inventory. Increases are priced at current cost. If the ending inventory, stated at base-year costs, is less than beginning inventory, the decrease is subtracted from the most recently added layer. The dollar-value method is a more practical way of valuing a complex, multiple-item inventory than the traditional LIFO method.
A price index for the current year is computed by using the double-extension method by dividing Ending Inventory for the Period at Current-Year Costs by Ending Inventory for the Period at Base-Year Costs.
Advantages and Disadvantages of LIFO
Proponents of the LIFO method advocate its use on the basis of its (a) proper matching of recent costs with current revenue, (b) tax benefits, (c) improved cash flow, and (d) future earnings hedge. Those opposed to the LIFO method claim that it (a) lowers reported earnings in periods of rising prices, (b) reports outdated costs on the balance sheet, (c) is contrary to normal physical flow, (d) creates involuntary liquidation problems, and (e) invites poor buying habits.
Selection of Inventory Method
LIFO is generally preferable to FIFO when: (a) selling prices and revenues have been increasing faster than costs, and (b) LIFO has been traditional, such as its use by department stores and industries where a fairly constant “base stock” is present. LIFO would not be preferable when: (a) prices tend to lag behind costs, (b) specific identification is traditional, and (c) unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.
Effect of Inventory Errors
Errors in recording inventory can affect the balance sheet, the income statement, or both, because inventory is used in the preparation of both financial statements. For example, the failure to include certain inventory items in a year-end physical inventory count would result in the following items being overstated (O) or understated (U): ending inventory (U); working capital (U); cost of goods sold (O); and net income (U). If merchandise was not recorded as a purchase nor counted in the ending inventory, the result would be an under-statement of inventory and accounts payable in the balance sheet and an understatement of purchases and inventory in the income statement. Net income would be unaffected by this omission as purchases and ending inventory would be misstated by the same amount.