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Study Unit 10: A.2. Inventory and Inventory Tracking Methods

1b) Inventory Overview

• Definition: Inventory includes all goods held for sale and is a key asset for companies that sell or produce products.

• Accounting Standards Codification: Guidance is found in lASC 330.

• Balance Sheet Position: Inventory often represents one of the largest items on the balance sheet for a merchandising company.

Importance of Inventory

• Cost of Goods Sold (COGS): Inventory is crucial for calculating COGS, a major expense for merchandising companies.

• Types of Inventory: A manufacturing company has several inventory classifications: raw materials, work-in-process, finished goods. A retailer or wholesaler typically only has finished goods.

Key Inventory Accounting Issues

1. Valuation at Purchase: How inventory is valued upon acquisition.

2. Ending Inventory Determination: Identifying which items are included in inventory at year-end.

3. Permanent Declines: Recognizing when the value of inventory permanently declines.

Valuing Inventory When Purchased

• Costs Included: Inventory should reflect all costs necessary to acquire and prepare it for sale, including:

  • Inventory purchase price.

  • Shipping costs.

  • Insurance during transit.

  • Taxes, tariffs, and duties.

  • These costs are categorized as landing costs.

• Journal Entry Example:

  • Debit: Inventory

  • Credit: Cash

Determining Included Goods

In-Transit Goods

• FOB Shipping Point: Ownership transfers to the buyer as soon as it ships, thus included in buyer’s ending inventory.

• FOB Destination: Ownership remains with the seller until received; excluded from the buyer's inventory while in transit.

Consigned Goods

• Consigned goods remain the property of the consignor; they are recorded in the consignor's inventory until sold.

• Cost of Consigned Goods: Includes the cost paid and shipping to the consignee.

Goods Out on Approval

• These goods are in the possession of potential customers but not purchased; they remain in the seller's inventory until the purchase decision is made.

Obsolete Inventory

• Items that can no longer be sold are written off as losses and excluded from the inventory balance.

Costs Included in Inventory

• Product Costs: Directly associated with inventory production or purchase, including:

  • Product cost

  • Freight on incoming shipments

  • Production costs like materials, labor, and overhead.

• Period Costs vs. Product Costs: Period costs (including administrative expenses) are expensed when incurred, whereas product costs are capitalized until sold.

Inventory Cost Flow Assumptions

• Importance of Cost Flow Assumptions: Determine which inventory costs are matched with sales and reported in the income statement:

  1. First in, First Out (FIFO): Assumes oldest items are sold first.

  2. Last in, First Out (LIFO): Assumes newest items are sold first.

  3. Average Cost Method: An average is calculated for items sold and ending inventory.

  4. Specific Identification: Tracks individual items, used for high-value, low-quantity goods.

FIFO Method

• Effect in Rising Costs: Higher ending inventory and lower COGS leading to higher operating income.

• Practical Example: Like a fruit stand selling the oldest fruit first to prevent spoilage.

LIFO Method

• Effect in Rising Costs: Lower ending inventory and higher COGS leading to lower operating income.

• Layer Liquidation: Selling from older layers can inflate income temporarily if inventory is sold before new stock is purchased.

Average Cost Method

• Application: Balances FIFO and LIFO, resulting in moderate COGS and controlling inventory value. Not permitted for tax returns but can be used for financial reporting.

The Periodic vs. Perpetual Inventory Systems

• Periodic Method: Calculates inventory and COGS at period-end.

• Perpetual Method: Updates inventory and COGS continuously with each transaction.

Summary of Inventory Calculations

• Different methods yield varying COGS and ending inventory balances based on rising or falling prices. Key outcomes include:

  Method	Ending Inventory	COGS	Total Cost
  FIFO Periodic	$7,600	$13,400	$21,000
  LIFO Periodic	$5,600	$15,400	$21,000
  Weighted Average Periodic	$6,600	$14,400	$21,000

Conclusion

• Impact on Financial Statements: LIFO generally results in the lowest net income during rising price periods, whereas FIFO reflects a higher income, affecting tax implications and cash flow. Average cost methods offer results between FIFO and LIFO.