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ACCOUNTING FOR INVENTORY
Key Terms and Concepts to Know
Ownership: Ownership includes all inventory owned by the purchaser, regardless of location or possession. The following items are included in inventory:
- Owned inventory at the company’s location
- Inventory purchased FOB Shipping Point and still in-transit from the seller
- Inventory sold FOB Destination and still in-transit to the seller
- Owned inventory on consignment to others Physical Inventory:
- Inventory is physically counted to determine the actual quantity on hand.
- The units of inventory physical counted are then valued at cost to determine the value of inventory that SHOULD be recorded in the general ledger.
- Any difference between the general ledger balance and the value of the physical inventory is recorded as shrinkage. Inventory Methods
- Perpetual Inventory Method o Perpetual inventory method records all inventory-related transactions in one account, Merchandise Inventory o Perpetual inventory method records cost of goods sold each time a sales transaction occurs. o Merchandise inventory account always shows the current balance of inventory on hand
- Periodic Inventory Method o Periodic inventory method records each type of inventory-related transaction in a separate account. o Periodic inventory method records cost of goods sold only at the end of the accounting period, based on a physical inventory o Merchandise inventory account is always the balance of inventory on hand at the beginning of the current period.
Inventory cost flow assumptions
- Conceptually, each inventory purchase transaction is recorded at cost. The units of inventory and their unit costs are then separated. The cost flow assumption used determines how the unit costs will be assigned to the items in inventory and the items sold
- Four inventory cost flow assumptions are: Specific Identification, Average Cost, FIFO and LIFO
- Both the inventory method used and the cost flow assumption used determine how the dollar amount of cost of goods sold and ending inventory are computed Specific Identification
- Units in inventory and units sold are assigned their original, historic unit costs.
- Used when there are relatively few units of inventory and unit costs are relatively high and unique
- Unaffected by the choice or perpetual or periodic inventory method
- Typically used by a car dealer Average Cost
- Units sold and units in inventory are valued at the weighted average cost per unit at that time
- For perpetual inventory, a new average cost is computed after each purchase based on the number of units and their unit costs
- For periodic inventory, the average cost is computed based on the all of the units and their unit costs available for sale during the period
- Provides a “middle of the road” value for cost of goods sold and inventory that fall between the FIFO and LIFO cost of goods sold and ending inventory amounts First In First Out (FIFO)
- Means that the first unit costs going into inventory are the first unit costs taken out of inventory and added to cost of goods sold, leaving the most recent unit costs assigned to inventory.
- Perpetual and periodic inventory methods result in the same cost of goods sold and ending inventory because both methods start wit the same oldest unit costs.
- When purchase costs of inventory are rising, cost of goods sold will contain the older, lower unit costs and inventory will contain the more recent, higher unit costs.
- When purchase costs are declining, the opposite is true. Last In Last Out (LIFO)
- Means that the most recent unit costs going into inventory are the first unit costs taken out of inventory and added to cost of goods sold, leaving the first unit costs assigned to inventory
Key Topics to Know
Inventory Cost Flow Assumptions:
Specific Identification
- Specific Identification means that each item in inventory retains its purchase cost throughout the inventory and cost of goods sold cycle. This inventory method is appropriate for a low volume, high value inventory, such as a new car dealer or a high-end jewelry store would have. Specific identification is typically used with the perpetual inventory method. This method provides the “truest” value for both ending inventory and cost of goods sold, but is too cumbersome for many applications. Example # G Company had 50 units in inventory at the end of the year. Transactions during the year are as follows: Transaction Type # of Units Unit Cost Beginning Inventory 10 $ Purchase A 40 $ Sold 20 Purchase B 50 $ Sold 20 Sold 30 Purchase C 40 $ Sold 20 During the year, a total of 90 units were sold: Beginning Inventory 5 Purchase A 25 Purchase B 20 Purchase C 40 Required: Determine the cost of goods sold and ending inventory using the specific identification method.
Solution # Units Available Unit Cost Units Sold Cost of Goods Sold Units in Inventory Ending Inventory Beginning Inventory
Purchase A 40 125 25 3,125 15 1, Purchase B 50 130 20 2,600 30 3, Purchase C 40 132 40 5,280 0 0 140 90 $11,605 50 $6,
Inventory Cost Flow Assumptions:
FIFO, LIFO and Average Cost
- Under these three inventory methods, inventory items or units do not retain their unit purchase cost after the purchase has been recorded. Instead, units sold during the accounting period and units remaining in inventory at the end of the accounting period are assigned a cost according to the rules of FIFO, LIFO or Average Cost.
- How costs are assigned the units in ending inventory and units sold is controlled by two factors: o Whether the Periodic or Perpetual inventory method is used. o Whether FIFO, LIFO or Average Cost assumption is used for the flow of costs assigned to inventory and cost of goods sold.
- In summary: o Under FIFO, unit costs are assigned to units sold in the order in which they were incurred, regardless of which units were actually sold. The oldest or first-in unit costs are used to calculate cost of goods sold; remaining unit costs are assigned to the units in ending inventory. o Under LIFO, unit costs are assigned to units sold in the reverse order of which they were incurred, regardless of which units were actually sold. The most recent or last-in unit costs are used to calculate cost of goods sold; remaining unit costs are assigned to the units in ending inventory. o Under Average Cost, an average cost for all units cost for all units in inventory is calculated and used to value the units in both cost of goods sold and ending inventory.
Solution #2- 2 LIFO/Periodic Cost of Goods Sold Ending Inventory Units Cost/unit Total Units Cost/unit Total 50 $130 $6,500 10 $120 $1, 40 $132 5,280 40 $125 5, $11,780 $6, Solution # 2 - 3 Average Cost/Periodic Transaction Type # of Units Unit Cost Value Beginning Inventory 10 $120 $1, Purchased 40 $125 5, Purchased 50 $130 6, Purchased 40 $132 5, Total 140 $128.43 $17, Average Cost: $17,980 / 140 total units = $128.43/unit (rounded). Average cost is calculated at the end of the period. Cost of Goods Sold Ending Inventory Units Cost/unit Total Units Cost/unit Total 90 $128.43 $11,558.50 50 $128.43 $6,421.
Solution # 2 - 4 FIFO/Perpetual Transaction Type Purchases Cost of Goods Sold Balance Beginning Inventory
Purchased 40@$125=$5,000 10@$120=$1, 40@$125=$5, Sold 10@$120=$1, 10@$125=$1,250 30@$125=$3, Purchased 50@$130=$6,500 30@$125=$3, 50@$130=$6, Sold 20@$125=$2,500 10@$125=$1, 50@$130=$6, Sold 10@$125=$1, 20@$130=$2,600 30@$130=$3, Purchased 40@$132=$5,280 30@$130=$3, 40@$132=$5, Sold 20@$130=$2,600 10@$130=$1, 40@$132=$5, Total/Balance $11,400 $6,
Average cost (highlighted in red) is calculated after each purchase and is used to value both cost of goods sold and inventory until the next purchase is made. Summary of Solutions #1 through # Cost of Goods Sold Ending Inventory Units Value Units Value Periodic Example #1 90 $11,400 50 $6, Example #2 90 $11,780 50 $6, Example #3 90 $11,558 50 $6, Perpetual Example #4 90 $11,400 50 $6, Example #5 90 $11,640 50 $6, Example #6 90 $11,471 50 $6, Six different inventory methods, five different costs of goods sold and five different ending inventory vales and all of them are GAAP. Periodic and perpetual FIFO will always produce the same cost of goods sold and ending inventory.
Lower of Cost or Market
- Lower of Cost or Market is an issue regardless of the inventory method or cost flow assumption made.
- At times, the replacement cost of the inventory on hand may fall below the historical acquisition cost. This could occur because of technology improvements in the production process or an increase in availability of raw materials used to make the inventory.
- This decrease or impairment of value must be quantified and accounted for in the accounting period in which it occurs.
- Market means current replacement cost not market (selling) price.
- The lower-of-cost-or-market principle may be applied in one of three ways: o To the entire inventory taken as a whole o By group or class or type of product o To each item individually
- The required journal entry to record the decline in the value of the inventory on hand: Cost of Goods Sold xxx Merchandise Inventory xxx
Example # R Company manufactures four products, two for the US market and two for the international market. As of year-end, June 30, the quantities on hand, historic cost and replacement (market) cost are shown below: Quantity on hand Historic Cost per unit Market Cost per unit US Market Product 38 100 $10 $ Product 44 75 16 14 International Market Product 123 60 14 13 Product 289 40 11.50 20 Required: Determine the value of ending inventory and the required LCM adjustment for a) The entire inventory taken as a whole b) By group or class or type of product c) Each item individually Solution # a) LCM applied to total inventory: Quantity on hand Historic Cost per unit Market Cost per unit Total Cost Total Market US Market Product 38 100 $10 $11 $1,000 $1, Product 44 75 16 14 1,200 1, International Market Product 123 60 14 13 840 780 Product 289 40 11.50 20 460 800 Total $3,500 $3, Inventory Value $3,
Practice Problems
Practice Problem # H Company reported the following inventory transactions for the month. Transaction # of Units Unit Cost Beginning Inventory 20 $2, Purchase 25 $2, Sold 10 Sold 14 Purchase 15 $2, Sold 26 Purchase 20 $2, According to the table above, there are 30 units in the ending inventory. Required: What is the cost of these units under each of the following assumptions? a) FIFO/Periodic b) FIFO/Perpetual c) LIFO/Periodic d) LIFO/Perpetual e) Average Cost/Periodic f) Average Cost/Perpetual Practice Problem #2: Inventory Costs Higher Total Assets Higher Cost of Goods Sold Higher Net Income Rising ___________ ___________ ___________ Falling ___________ ___________ ___________ Required: For each item in the table, indicate whether FIFO or LIFO will generally result in a higher reported amount when inventory costs are rising versus falling.
Practice Problem # During the year, U Company sold 200 units of inventory for $50 each. U Company had the following inventory purchase transactions for the year: Date Transaction Units Unit Cost Total Cost Jan 1 Beginning Inventory 50 $39 $1, May 5 Purchase 100 38 3, Nov 3 Purchase 80 37 2, 230 $8, Actual sales by the company include its entire beginning inventory, 80 units of inventory from the May 5 purchase, and 70 units from the November 3 purchase. Required: a) Calculate cost of goods sold for the year assuming the company uses specific identification. b) Calculate ending inventory for the year assuming the company uses specific identification. Practice Problem # F Company reports inventory using the lower-of-cost-or-market method. Below is information related to its year-end inventory: Inventory Quantity Cost Market Item A 100 $25 $ Item B 50 30 20 Required: a) Calculate ending inventory under lower-of-cost-or-market. b) Prepare any necessary journal entry to adjust inventory.
True / False Questions
- Goods in transit are automatically included in a company's inventory account. a)True False
- Using the weighted-average cost method, the average cost of inventory is the average unit cost of inventory purchased during the year. True False
- When costs are rising, FIFO results in a higher cost of goods sold. True False
- When costs are rising, LIFO results in a higher ending inventory balance. True False
- FIFO is called the balance sheet approach because the amount it reports for ending inventory better approximates the current cost of inventory. True False
- The use of the lower-of-cost-or-market method to report inventory is an example of conservatism in financial reporting. True False
- A company that has average inventory of $500 and cost of goods sold of $2,000 would have an inventory turnover ratio of 0.25. True False
- Using the first-in, first-out method (FIFO), the first units purchased are assumed to be the first ones sold. True False
- For most companies, actual physical flow of their inventory follows LIFO. True False
- One of the primary benefits of using FIFO when inventory costs are rising is that it results in greater tax savings. True False
- Days in Inventory ratio is calculated as Inventory Turnover divided by 365 days. True False
- When the value of inventory falls below its cost, companies have the option of recording the inventory at cost or the lower market value. True False
- The adjustment to write down inventory from cost to its lower market value includes a debit to Cost of Goods Sold and a credit to Inventory. True False
- The inventory turnover ratio equals cost of goods sold divided by average inventory. True False
- During periods of rising costs, LIFO generally results in a higher cost of goods sold. True False
The next 2 questions refer to the following information. A Company just started business in August and they use the periodic inventory system. The following purchases were made during August: August 01 300 units $1,560 total cost August 12 400 units 2,340 total cost August 24 400 units 2,520 total cost
6. A physical count of the inventory on August 31 reveals that there are 500^ units
on hand. Using a LIFO cost flow assumption, the value of the ending inventory on August 31 is: a) $3,24 0 b) $2, c) $5, d) $5,
7. A physical count of the inventory on August 31 reveals that there are 500 units
on hand. Using the average cost method, the cost of goods sold for August is: a) $2, b) $2, c) $3, d) $3,5 04
- D Company sold 700 units of inventory during the month. Cost of goods sold assuming LIFO would be: a) $1,73 0 b) $1, c) $1,72 0 d) $1,71 0
- D Company sold 700 units of inventory during the month. Ending inventory assuming weighted-average cost would be (round unit cost to four decimals): a) $ b) $ c) $ d) $
- During periods when inventory costs are rising, cost of goods sold will most likely be: a) Higher under FIFO than LIFO. b) Higher under FIFO than average cost. c) Lower under average cost than LIFO. d) Lower under LIFO than FIFO.
- N Company has supplied the following information for their products A, B, C, and D: Quantity Historical cost Market value A 15 20 25 B 20 35 30 C 40 25 40 D 25 50 35 Applying lower-of-cost-or-market to each product, the necessary adjustment would be: a) Inventory 675 Cost of Goods Sold 675 b) Cost of Goods Sold 675 Inventory 675 c) Inventory 475 Cost of Goods Sold 475 d) Cost of Goods Sold 475 Inventory 475
- Under the principle of lower-of-cost-or-market, when a company has 10 units of inventory A with market value of $50 and a cost of $60, what is the adjustment? a) Debit Inventory $100; credit Cost of Goods Sold $100. b) Debit Inventory $500; credit Cost of Goods Sold $500. c) Debit Cost of Goods Sold $100; credit Inventory $100. d) Debit Cost of Goods Sold $500; credit Inventory $500.
- At the end of a reporting period, G Company determines that its ending inventory has a cost of $300,000 and a market value of $230,000. What would be the effect(s) of the adjustment to write down inventory to market value? a) Decrease total assets b) Decrease net income c) Increase retained earnings d) Both a) and b)
