Accounting Principles: Inventory Costing Summary

Learning Objectives

• Describe the steps in determining inventory quantities.
• Calculate cost of goods sold and ending inventory in a perpetual inventory system using the following methods:
  • Specific identification
  • FIFO (First-in, First-out)
  • Weighted average
• Explain the financial statement effects of inventory cost determination methods.
• Determine the financial statement effects of inventory errors.
• Value inventory at the lower of cost and net realizable value (LCNRV).
• Demonstrate the presentation and analysis of inventory.
• Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average methods.
• Estimate ending inventory using the gross profit and retail inventory methods.

Determining Inventory Quantities

• Companies must accurately determine the quantity and value of their inventory for financial statements.
• Steps involve:
  • Conducting a physical inventory count.
  • Determining ownership of goods.

Taking Physical Inventory

• Involves counting, weighing, or measuring inventory on hand.
• Requires strong internal controls:
  • Counts should not be conducted by regular inventory custodians.
  • Presence of an observer to confirm item existence.
  • Second count by another employee.
  • Use pre-numbered tags to avoid missing items.

Determining Ownership of Goods

• Control transfers when:
  • The customer has physical possession of goods.
  • The customer obtains legal title.
• Typically, possession also means legal title.
  • Only include inventory owned by the company.

Goods in Transit

• Determine ownership based on shipping terms (FOB Shipping Point vs. FOB Destination):
  • FOB Shipping Point: Ownership passes to the buyer once the goods are loaded onto the carrier.
  • FOB Destination: Ownership remains with the seller until goods reach the buyer's destination.

Consigned Goods

• Goods sold on behalf of another party (consignor).
• Excluded from the consignee's inventory.

Cost Determination Methods

Specific Identification Method

• Each item of inventory is tracked for actual cost allocation.
• Best for items that are not interchangeable (e.g., cars).

Cost Formulas

• Used when specific identification isn't feasible:
  • FIFO: Assumes oldest inventory items are sold first.
  • Weighted Average: Calculates a new average cost after each purchase.

Perpetual Inventory System

• FIFO:
  • Costs of the oldest goods are recognized first in COGS.
  • Remaining inventory reflects the cost of most recent purchases.
• Weighted Average:
  • New average cost calculated after each purchase and applied when sold.

Financial Statement Effects

Choice of Cost Determination Method

• Consistent use of a cost formula enhances comparability.
• The chosen method should align with actual physical flow of inventory.

Income Statement Effects

• When prices rise:
  • FIFO results in higher profits.
  • COGS for FIFO is lower compared to LIFO.
• When prices fall, the opposite occurs.

Balance Sheet Effects

• FIFO provides a more current valuation of inventory; better reflects replacement cost.

Effects of Inventory Errors

• Errors in inventory can distort both income statements and balance sheets:
  • An ending inventory error impacts the subsequent period’s beginning inventory and, consequently, future profit calculations.
• Error types:
  • Overstatement of ending inventory leads to understated COGS and overstated income.
  • Understatement of ending inventory has the opposite effect.

Valuation of Inventory

Lower of Cost and Net Realizable Value (LCNRV)

• If NRV is lower than cost, inventory is written down.
• NRV is selling price minus any costs necessary to make the goods ready for sale.
• Valuation is assessed on an item-by-item basis and can be reversed if conditions improve.

Presentation and Analysis of Inventory

Inventory Classification

• Differ based on whether the company is a merchandiser or manufacturer:
  • Merchandisers hold finished inventory.
  • Manufacturers classify inventory into raw materials, work in process, and finished goods.
• Inventory is typically a current asset but can be non-current if held for longer than a year.

Analyzing Inventory

• Balancing inventory levels is crucial:
  • Excessive inventory leads to increased carrying costs.
  • Insufficient inventory can lead to lost sales.
• Analyze using:
  • Inventory Turnover Ratio: Equals COGS divided by average inventory.
  • Days Sales in Inventory: Days in a year divided by inventory turnover ratio.

Periodic Inventory System Calculations

1. Calculate Cost of Goods Available for Sale
   • Beginning Inventory + Purchases = Available for Sale.
2. Determine Ending Inventory and Cost of Goods Sold
   • Use FIFO or Weighted Average formulas to calculate as shown in examples.

Estimating Ending Inventory

Gross Profit Method

• Applied gross profit margin to sales to estimate ending inventory.

Retail Inventory Method

• Uses cost-to-retail ratio applied to the ending inventory at retail to calculate estimated cost of inventory.