Chapter 8: Inventory Accounting
- 1 Learning Objectives
- 2 Fundamental Theories Used in Inventory Accounting
- 3 Inventory Classifications
- 4 Determining Inventory Quantity on Hand
- 5 Inventory Costing Methods
- 6 Specific Identification
- 7 First-In First-Out (FIFO) (Periodic Inventory System)
- 8 Last-In First-Out (LIFO) (Periodic Inventory System)
- 9 Weighted-Average Cost (Periodic Inventory System)
- 10 Comparison of Cost Flow Assumptions Under the Periodic Inventory System
- 11 FIFO (Perpetual System)
- 12 LIFO (Perpetual System)
- 13 Weighted-Average Cost (Perpetual System)
- 14 Comparison of Cost Flow Assumptions Under the Perpetual Inventory System
- 15 Inventory Costing Method Impact on The Income Statement
- 16 Lower of Cost or Market
- 17 Inventory Errors
Fundamental Theories Used in Inventory Accounting
Overall there are five primary theories that are relevant to inventories: full disclosure, consistency, materiality, and the conservatism principle.
The full disclosure principle states a company should fully disclose the accounting methods they used in their financial statements. This principle is important because different entities can use different methods of measuring and valuing their inventories. If the inventory methods were not disclosed then comparability of the financial statements would be reduced.
The consistency principle states that once an accounting method is applied then that method should be applied to all future periods unless another method is used that would provide more accurate financial statements. The consistency principle helps to aid users in comparing the financial statements from period to period. The consistency principle is important for inventories because the methods used for inventories could affect how much costs are reported and the effect on net income.
The materiality principle states that items should only be reported if their aggregate value will affect the decisions of financial statement users. In terms of inventory, what this ultimately means is that every single item in inventory need not be included in inventory. Small items that would have an insignificant impact on the value of inventory can be excluded. The reason is because the cost to count that inventory would be insignificant to the inventory account.
The conservatism principle states that accountants should use conservative measures when preparing financial statements. This ultimately means following the practices below:
- Never record gains until they are realized.
- Record all loses when they are more than likely to occur.
- Record all expenses when they are more than likely to occur.
- Never record an asset until ownership and control has been obtained.
- Record the lowest estimate of a range.
The overall goal of conservatism is to show the worst possible outcome while delaying the best outcomes until they have occurred. Essentially, we want to tell financial statement users the bad news first and then only tell them the good news when it has happened.
Different type of businesses have different ways of classifying their inventories. For merchandising operations, the merchandiser will only have inventory. That is, their current goods that are available for sale. A manufacturing operation, on the other hand, will have three different types of inventory classifications: raw materials, work-in-process, and finished goods.
Raw Materials: Raw materials are the basic materials used in a manufacturing process to create finished goods. Some examples of raw materials are lumber, cotton, coal and various chemicals.
Work-in-Process: When a manufacturing company begins processing their raw materials those materials become classified as work in process. Work in process is the intermediate stage between raw materials and finished goods. The goods are undergoing processing and are not yet ready for sale to customers.
Finished Goods: These are goods that have finished the manufacturing process. Finished goods will remain in storage or a warehouse until they are shipped to customers.
The study of the manufacturing inventory accounting is usually covered in a managerial or cost accounting course. Financial accounting is focused on studying how inventory costs flow on the income statement and balance sheet.
Determining Inventory Quantity on Hand
A company must determine how much quantity of inventory it has on hand. The first step in this process is to take an inventory count. An inventory count is when an accountant or inventory personnel physically count the inventory they are in possession of to determine how much quantity of each item they have. The inventory count ensures accurate inventory valuation and also makes sure that no unnoticed problems have been occurring, such as, employee theft of inventory.
An inventory count seems simple enough to determine our inventory on hand but what about for inventory that is in transit from a vendor or goods held on consignment? The answer to these questions is that it all depends on who has ownership or title to the product. For goods in transit, the title of the product transfers based on the terms of the shipping contract. To determine when title transfers, we use either FOB: shipping point or FOB: Destination.
FOB:Shipping Point: Ownership of the product transfers to the buyer when the goods are placed in the common carrier (truck, van, rail car, ship etc.)
FOB: Destination: Ownership of the product transfers when the common carrier has delivered the product to the unloading dock of the buyer.
Consignment is the business practice of holding another entity's products while the consignee attempts to sell those goods. This practice is often used in art galleries. The artist (consignor) will place their pieces of art in an art gallery (consignee) for sale. When the art sells, the consignee takes a portion of the revenue and remits the remaining amount to the consignor. The question is who can report the art in their inventory? The answer is the art will be placed in the inventory of the entity that holds ownership of the art. In this case, the artist will report the art in their inventory while the art gallery will not report it even though the art is placed in their gallery. The reason is because in consignment transactions, the consignor simply gives the product to the consignee to sell. When the product is sold, the title of the product directly transfers from the consignor to the buyer while the consignee simply takes a portion of the revenue.
Inventory Costing Methods
Inventory is reported at the cost to acquire the material or manufacture it. For a merchandising operation, this would mean reporting inventory at the cost to acquire the inventory and prepare it for sale. For a manufacturing operation, inventory is reported at the cost to manufacture the inventory. As new inventory is acquired and sold we must calculate two numbers: the value of inventory on the balance sheet and the cost of goods sold on the income statement.
At the end of the accounting period, an inventory count is conducted to calculate what our inventory account should be reported at on the balance sheet. We simply count the number of items in our inventory, figure out the cost per unit and multiply the two numbers. We then add up each inventory line up total cost amount to obtain the valuation of our inventory at the end of the accounting period.
To calculate cost of goods sold, we figure out how many units were sold and at what cost. We then multiply the two numbers to calculate our cost of goods sold for the period.
As we can see, calculating ending inventory and cost of goods sold is quite simple. However, the overall process is not simple when the costs are changing. Just imagine a situation where a retailer is continuously buying new inventory at various prices. For these types of situations, we use a variety of methods to determine our cost of goods sold and ending inventory. For the business, it is important to select the accounting method that provides the most accurate reflection of ending inventory and cost of goods sold.
The managers of the company can decide which inventory costing method they will use and that method does not need to follow the exact flow of inventory. In all of our explanations, we will assume that the company is using a periodic system due to the simplified calculations and allows for a better conceptual understanding of the inventory costing methods. The inventory costing methods we discuss can also be used in a perpetual system. We will review the perpetual calculations after covering the periodic calculations.
Overall, there are four primary inventory costing methods: specific-identification, first-in first out (FIFO), last-in first-out (LIFO) and weighted-average cost. We will cover these accounting methods now.
Specific-Identification: This method is used when you have exact information information on inventory purchase cost per item and which inventory items were not sold. It provides the exact amount of ending inventory and cost of goods sold but can be difficult to apply with many inventory items that are rapidly purchased and sold.
First-In, First-Out (FIFO): Using the FIFO method, cost of goods sold is determined by using the purchase cost of the oldest items in inventory. Thus, the oldest item in the inventory becomes the cost basis for the inventory that is sold. It tracks the physical flow of inventory to determine inventory cost.
Last-in, First-Out (LIFO): Using the LIFO method, cost of goods sold is determined by using the purchase cost of the most recently purchased inventory item. It is essentially the opposite of FIFO. It assumes that the company is selling their newest inventory first.
Weighted-Average Cost: The weighted-average cost method recalculates an average cost per unit based on the most recent purchase. This average cost is then assigned to cost of goods sold based on the amount of goods sold.
The last three methods are called cost flow assumptions because they do not calculate the exact amount of ending inventory or cost of goods sold. Even though these methods do not calculate exact amounts, they are still accepted due to practical business needs. Furthermore, the account standard explicitly recognize the need for cost versus benefit. It would be unrealistic to expect every company to be able to compute COGS and ending inventory using specific-identification.
The specific identification method is used when each inventory item sold can be determined and each item not sold can be determined. Generally, this method of inventory costing is used when a small amount of high-value items is being sold. Some examples might be an art gallery or a car dealership. However, lower value inventory based businesses could also use this method with precise inventory tracking technology, such as radio frequency identification tags (RFID). In a specific identification inventory system, the cost of each item would be recorded and then each item sold or not sold would be listed. Using this information, we can determine what our ending inventory is and what our cost of goods sold is. Depending on the technology being used in the inventory system this method can be applied using periodic or perpetual inventory systems. The following example shows the specific identification method being used:
Alpha corporation prepared the following computer print outs from their inventory tracking system. The company uses specific identification inventory costing.
Using the above data, we can calculate cost of good sold and ending inventory. To calculate cost of goods sold we simply multiply the amount sold by the cost to purchase each inventory item. We do this for each computer type and then add all the totals up. We calculate this step as follows:
Cost of Goods Sold = ($250 x 5) + ($310 X 4) + ($150 X 1) + ($210 X 5)
Cost of Goods Sold = $1,250 + $1,240 + $150 + $1,050
Cost of Goods Sold = $3,690
Therefore, our cost of goods sold for the period is $3,690. Next we will calculate our ending inventory.
To calculate ending inventory we first need to figure out what is left in our inventory and what cost those items were purchased at. In order to calculate how much ending inventory we have left for each item we simply take the beginning quantity (2nd column) and subtract the amount sold. We then take the ending inventory amount for each item and multiply it by the cost to acquire. Our calculation is as follows:
Ending inventory for each item:
Computer A: 20-5 = 15
Computer B: 15-4 = 11
Computer C: 10-1 = 9
Computer D: 20-5 = 15
We then multiply those ending inventory numbers by the cost to acquire, as follows:
Ending Inventory = ($250 X 15) + ($310 X 11) + ($150 X 9) + ($210 X 15)
Ending Inventory = $3,750 + $3,410 + $1,350 + $3,150
Ending Inventory = $11,660
Therefore, our ending inventory is $11,660.
This method is the most ideal method to use because it provides us with the exact amount of cost of goods sold and ending inventory. However, this method is not always practical in the real world. For other situations we will use cost flow assumptions to estimate what our ending inventory and cost of goods sold is. We will cover three cost flow assumptions in this chapter: First-in First-out (FIFO), Last-in First-out (LIFO) and weighted-average cost.
First-In First-Out (FIFO) (Periodic Inventory System)
To fully explain each method and compare them, we need to use the same data for all three methods. For our examples, we will use the following data set:
In our examples, we use the periodic inventory system to make our examples simple. In the above data set, we begin with our beginning inventory of 10 units. We then made three purchases throughout the year totaling 60 units. Adding beginning inventory to our total purchases we calculate our goods available for sale of 70 units. On December 31st, we took a physical inventory count and noted that we had 30 units in our inventory. This means we must have sold the remaining 40 units, as shown above.
As a reminder from our previous chapter, our cost of goods sold formula for a periodic inventory system is as follows:
Cost of goods Sold = (Beginning Inventory + Purchases) - Ending Inventory
Using the above formula and our data set. We can make the following calculations: Our beginning inventory was 10 units and our purchases for the year were 60 units which totals 70 units. We then subtract our ending inventory of 30 to equal 40 units for cost of goods sold. We now need to assign a cost to the cost of goods sold and ending inventory. How we assign this cost depends on our cost flow assumption. We know that our total cost is $410 so this cost must be allocated between ending inventory and cost of goods sold. Depending on which inventory cost flow assumption we use, these two numbers will be different but they will always add up to $410.
As was mentioned previously, the FIFO inventory cost assumption calculates cost of goods sold based on the purchase cost of the oldest items in inventory. What this means is that the first goods purchased are the first goods to be sold which makes sense on how a business might operate. For example, just think about a business that sells televisions. Their inventory will consist of items on the shelf and inventory in the store's storage room. As new shipments are received they first go into the storage room until the older inventory sitting on the shelf is sold. Once that inventory is sold then we will move the televisions from the storage room to the retail shelf.
From an accounting standpoint, this means that the earliest costs will be recognized first as inventory is sold. Remember, an inventory cost assumption does not need to track the exact flow of inventory sold. To best illustrate the FIFO calculations, we should use an example using our above data set. In this example we will calculate COGS and ending inventory.
Our company must first determine how many units were sold and how many units are left in ending inventory. In this case, our provided data shows us that 40 units were sold and 30 units are in ending inventory. We now proceed to assign costs to our cost of goods sold and ending inventory based on those unit amounts using the FIFO cost flow assumption. Our method will be first to assign cost to ending inventory and then cost of goods sold. To calculate our ending inventory cost we will use the cost of our most recent purchases and then assign the remaining cost to cost of goods sold. We had 30 units in ending inventory and our most recent purchase occurred on June 26th at a cost of $7 per unit. Therefor our ending inventory cost is going to be $210. For the cost of goods sold, we sold 40 units which we simply calculate by taking the total cost of $410 and subtracting the $210 ending inventory to get a cost of goods sold value of $200.
Our calculations are illustrated by the image below:
At this point, an interesting question would be what if our ending inventory had more than 30 units in it? In this case, we would use the cost prices from the older purchases. For example, if we had 40 units in ending inventory then we would use the cost price for 30 units at $7 and the remaining 10 units would be costed at $5.
We can also calculate COGS first followed by ending inventory. In this case, to calculate the cost of the 40 units sold we would add the total cost from the beginning inventory and the first two purchases which equals $300 the remaining units would be costed to ending inventory of $210.
Overall, the FIFO method makes sense when you think that the first units in the inventory are the first costs to be assigned to COGS as units are sold.
Last-In First-Out (LIFO) (Periodic Inventory System)
The LIFO inventory costing assumption is essentially the opposite of FIFO. LIFO uses the cost from the most recent inventory purchases to assign costs to COGS. The key to understanding LIFO is to simply visualize the flow of inventory in your mind. With FIFO we were able to visualize inventory going into a store room and then being moved to the sales floor as inventory was sold which would reflect the actual flow of inventory in a real business. With LIFO, we need to visualize the flow of inventory as new inventory being placed on top of old inventory. Think of it like a bin of items. As new inventory is purchased, the new inventory is placed on top of the older inventory. When customers come to purchase merchandise, they will be buying the inventory that was most recently purchased because it was placed at the top. Now that we have a visualization of how LIFO works, let's move on to our calculation example.
Once again, we will use our standard data set for cost of goods available for sale. Just like with the FIFO method, we will first calculate ending inventory and then we will calculate COGS. Our strategy will be to assign costs to ending inventory by using the costs data from the oldest purchases. We will then assign the remaining costs to cost of goods sold, as seen below:
As you can see above, our calculation is slightly confusing at first glance. Our ending inventory is 30 units and our units sold is 40. We must first assign a cost to the 30 units of ending inventory and then assign a cost to the 40 units sold. Since LIFO assigns costs to ending inventory by using the oldest items in inventory we use the beginning inventory cost, the February purchase and half of the March purchase. We use half of the March purchase because after we have assigned all the cost from the beginning inventory and February purchase we only have 10 units left. The March purchase has 20 units so we assign 10 units of cost to ending inventory while the other half gets assigned to cost of goods sold. We then calculate the cost remaining by taking the total cost and subtracting the ending inventory cost. The remaining cost is then assigned to cost of goods sold.
Since we are using a periodic system, all beginning inventory is assumed to able to be assigned to ending inventory. In a perpetual system, the calculation would be slightly different.
Weighted-Average Cost (Periodic Inventory System)
The weighted-average cost method calculates a weighted-average per unit and then uses this cost to assign to ending inventory and cost of goods sold. Compared to the other methods, this method is relatively straight forward. To use this method we first calculate the weighted-average cost per unit and then use that number to assign costs to ending inventory and cost of goods sold. This method is useful if your inventory consists of one item that has similar characteristics.
Our first step is to calculate the weighted-average cost per unit. This step is accomplished by taking the total cost of goods available for sale ($510 from our sample data) and dividing it by the total units available for sale (70 units from our sample data). Our weighted-average cost per unit is calculated below:
Now that we have our weighted-average cost per unit all we need to do is assign this amount to our ending inventory and cost of goods sold. Just like with FIFO and LIFO, we begin by calculating our ending inventory. In this case, we calculate our ending inventory as 30 x $7.29 to get an ending cost of $218.70. The remaining cost is assigned to COGS. In this case our calculation is as follows: $510 - $218.70 = $291.30. We can also verify our COGS calculation by multiplying 40 by $7.29 to get $291.60. Our Calculation is slightly off due to a rounding.
Comparison of Cost Flow Assumptions Under the Periodic Inventory System
Now that we understand the basics of each inventory costing methods we can move on to studying the difference between the various methods. Companies can elect to use any inventory cost assumption that best fits their needs. Going back to the fundamental principles of accounting, the method selected should be a method that accurately reflects the value of the inventory. Overall, the inventory costing methods will have various impacts on the financial statements by affecting the balance sheet and income statement. The various methods also impact net income and will have a impact on the amount of taxes paid by a company. With those factors in mind, selecting the most appropriate inventory costing method should be thoroughly thought out.
FIFO (Perpetual System)
For our explanations of the cost flow assumptions under the perpetual system, we will be using the same data set that we used for our periodic inventory system examples:
The primary difference between the perpetual and periodic systems is that a journal entry is made after each purchase or sale for perpetual systems. The revenue and cost information is calculated at the time of purchase or sale. Inventory on hand accounts are updated continuously after each each purchase or sale. The inventory needs to be inspected periodically to determine that the inventory account is not overstated due to spoilage, damage or theft. Unlike a periodic system, a purchases account is not used in a perpetual system.
LIFO (Perpetual System)
Weighted-Average Cost (Perpetual System)
Comparison of Cost Flow Assumptions Under the Perpetual Inventory System
Inventory Costing Method Impact on The Income Statement
Each inventory costing method will create a different cost of goods sold amount which will ultimately impact net income. To best explain the impact on the income statement, we will discuss an example. In our example we will use the inventory data that we used in the above explanations of FIFO,LIFO and Weighted-Average Cost. We will assume the company has sales revenue of $2,000 and operating costs of $1,000. The rest of the data has been calculated in the above examples. Our comparison of the various methods is as follows:
In terms of our inventory calculations, we can see that the only difference in numbers is between ending inventory and cost of goods sold. This is because of the method we are using to allocate costs between ending inventory and cost of goods sold. In terms of net income, FIFO produced the highest net income followed by weighted-average and LIFO. The reason for the differences has to do with changing prices.
In economics, changing prices can be classified as either inflation or deflation.
Inflation: A general rising of prices.
Deflation: A general decreasing of prices.
If you look at our purchase data, you will see our earliest purchases occurring at $10/unit and then falling to $5/unit with the the most recent purchases at $7/unit. In other words we had a high rate of deflation and then a small inflation at the end but the overall trend is of deflation since our purchases went from $10/unit to $7/unit over the entire period. The fact that we have deflation explains why FIFO produced the highest amount of net income while LIFO produced the lowest amount. During period of inflation, the opposite would be true. FIFO would produce the lowest amount of net income and LIFO would produce the highest.
A company would want to analyze which method to use to determine how much net income they would report as the amount of net income reported is important to external uses. Higher net income is viewed favorable by external users. However, it is important to note that these effects are only temporary as the costs eventually get pushed through the accounting system. If a company is using an inventory method specifically to boost net income to higher than normal levels then these higher than normal net income is referred to as phantom profits since they only exist on the financial statements.
Lower of Cost or Market
Inventories are naturally subject to obsolescence (an item no longer being useful) or an overall decrease in value. When this occurs the inventory account on the balance sheet will be overstated or be valued at a higher amount than the actual value of the inventories. When an asset account is overstated it is called being impaired. Inventories can decrease in value for a variety of reasons. Some of the more common reasons are introduction on new products, spoilage, damage or cost to manufacture the item has decreased. When the inventory account is overstated on the balance sheet the company must write down (reduce) the inventory account to a more accurate value. When the company writes down inventories the company has suffered a holding loss. Inventories are normally reported at historical cost but this principle is not used when using historical cost would create misleading financial statements.
Companies will use the method of lower of cost or market (LCM) to determine if their inventory account is overstated. This method is based on the fundamental principle of conservatism which states that liabilities and expenses should be recognized immediately when uncertainty exists while revenues and assets should be recognized when earned. In the case of LCM, an uncertainty exists in terms of the value of the asset so we must use LCM to recognize a loss on the income statement if the inventory is found to be overstated. Companies should apply LCM to their financial statements before they are issued.
For example, Let's assume that a company is holding inventory that originally cost $5 million. New technology has been introduced over the past few months which makes the existing inventory reduce in value by $2.5 million. The current value value of the inventory is only $2.5 million instead of $5 million. The proper accounting for this event is to mark down the inventory by $2.5 million which would be reported as a loss on the income statement. The loss would be reported in cost of goods sold and the inventory balance sheet account would be reported at $2.5 million. The impairment loss is recorded using the following entry:
The loss could also be recorded to unrealized holding loss to provide additional information for the financial statement users. The unrealized holding cost would be categorized under cost of goods sold and is a contra inventory asset account.
To use the LCM method, we will report the inventory account at replacement cost and net realizable value (NRV) of the inventory. While the calculation sounds confusing, it involves step major steps to properly perform the calculation. We will discuss the calculation of LCM next.
To calculate inventory based on LCM we need to report the inventory account at replacement cost and net realizable value. Replacement cost is the cost to either manufacturer a new unit or the cost to purchase an additional unit from a 3rd party company. Net realizable value is defined as the estimated selling price in the ordinary course of business less the cost of completion, disposal, and transportation. To properly calculate the market value, we must make sure that the value does not fall outside of a ceiling and floor limit. The ceiling is net realizable value and the floor is net realizable value less a normal profit. We will illustrate this calculation, as follows:
To illustrate our example we will use the following data sets:
We begin by gathering the historical cost data (purchase price of the assets) from our accounting system:
By using the LCM method, we must calculate what our market value is going to be. To calculate market value, we must gather data on replacement cost, net realizable value and net realizable value less a normal profit margin. When we have gathered that data, we make a comparison between the three data points and we will select the middle value to be our market price.
We now have the data for our historical cost and market value. We input our calculated market value into the first chart to make our final comparison. For our last comparison we will select the lower of historical cost or market value.
After we have compared the historical cost to the market value we will have our inventory LCM costs. These new costs should be reported on the balance sheet.
Accounting for inventory affects both the balance sheet and the income statement. Due to this nature of inventory accounting, errors inventory tend to have a pervasive effect on the financial statements. An error in one account will likely produce additional overstatements or understatements in related accounts. We will cover errors and how they are reflected in the balance sheet and income statement.
Balance sheet Inventory Errors
Inventory errors on the balance sheet are directly related to overstatement or understatements in the ending inventory account. An overstatement or understatement will have a pervasive effect on related asset and stockholder's equity accounts. The effect is a direct effect on assets and stockholder's equity. If the ending inventory account is overstated then assets and stockholder's equity will also be overstated. The vice versa is true for understatements: if ending inventory is understated then assets and stockholder's equity will also be understated. The relationship is logical when we understand the fundamentals of how an overstated or understated ending inventory account works.
On a fundamental level, ending inventory is an asset account so if ending inventory is overstated or understated then the asset account will have the same error. For stockholder's equity, the relationship has to do with keeping the accounting equation in balance. As you are well aware by now: assets = liabilities + stockholder's equity and the equation must always be in balance. If the asset account is overstated or understated then either liabilities or stockholder's equity must also be overstated or understated. Ending inventory never affects a liability account so the overstatement or understatement will show up in the stockholder's equity account.
Income Statement Inventory Errors
Similar to the balance sheet, the income statement also has accounts that create a pervasive error if the accounts are understated or overstated.