Inventories: Measurement
RECORDING AND MEASURING INVENTORY
TYPES OF INVENTORY
There are two types of inventories depending on the kind of business operation.
• Merchandise Inventory
A merchandising concern buys and resells inventory in the ordinary course of business.
Merchandise inventory is reported in the balance sheet as a current asset.
• Manufacturing Inventory
A manufacturing concern purchases raw materials (Raw Materials Inventory), combines it
with labor and factory overhead (Work in Process Inventory) and then sells the finished
product (Finished Goods Inventory) to its customers. At the end of each accounting period
each category of inventory is reported as a current asset in the balance sheet.
CONTROL
There are two types of inventory systems that are used in maintain accounting records and report
inventory in the financial statements.
• Perpetual System
Under the perpetual inventory system the entity maintains a continuous record of the balance
in the Inventory account and the Cost of Goods Sold account through out the accounting
period.
a) Raw materials or merchandise purchases are charged to Raw Materials or Merchandise
Inventory respectively as the purchases are made.
b) Freight-in, purchase returns and allowances and purchase discounts are recorded in the
inventory account.
c) As each sales transaction is recorded the Inventory account is credited for the cost of the
item and the Cost of Goods Sold account is debited.
d) Inventory is a control account, which is supported by a detailed subsidiary ledger.
• Periodic System
Under the periodic inventory system the inventory account reflects the beginning balance of
inventory. Throughout the accounting period purchases, freight-in, purchase returns and
allowances and purchase discounts are recorded in separate expense accounts. At the end of
the accounting period a physical inventory is taken and the inventory account is adjusted to
reflect the correct ending inventory.
Example of the year-end adjusting journal entries:
Date
Account
Debit
Beginning
inventory
End of year Income summary
Credit
Beginning
inventory
Inventory
To remove beginning inventory from general ledger inventory account.
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Inventories: Measurement
Date
Account
Debit
Ending
inventory
End of year Inventory
Credit
Ending
inventory
Income summary
To record ending inventory in general ledger inventory account.
Both the debit and credit are entered in the income summary account because we need both
amounts in order to prepare a multi-step income statement. The debit and credit balances in the
income summary account combined with the temporary expense accounts result in the
computation of cost of goods sold as reported in the income statement at year-end. In the income
summary account the debit reflects beginning inventory and the credit reflects ending inventory.
PHYSICAL QUANTITIES INCLUDED IN INVENTORY
• Goods in Transit
The “passage of title” is the key to determining whether goods in transit are part of ending
inventory.
¾ f.o.b. destination
The title to the goods transfers when received by the buyer. Therefore, goods in transit
year-end should be reported in the ending inventory of the seller.
¾ f.o.b. shipping point
The title to the goods transfers when the seller delivers the goods to a common carrier.
Goods in transit at year-end shipped f.o.b. shipping point should be included in the
ending inventory of the buyer.
•
Consigned Goods
The consignor is the seller of the merchandise who ships the goods on consignment to the
consignee. The consignee is just an agent in the selling process and does not actually own
the goods. Therefore, at year-end the consignor (seller) should include the consigned goods
in its inventory even though it may still be in the physical possession of the consignee.
•
Sales Returns and Allowances
When returns and allowances are material the company must estimate an allowance to the
amounts reflected in the balance sheet and income statement at year end. In preparing the
adjusting journal entry for this allowance the amount of anticipated inventory that will be
returned after year end is included in the ending inventory in the balance sheet.
EXPENDITURES INCLUDED IN INVENTORY
Product Costs
Product costs are all of the costs required to obtain inventory and are included in the ending
inventory and/or the cost of goods sold. They include
• Direct cost of the product
• Freight-in
• Other direct costs of acquisition
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•
Labor and factory overhead applied to raw material to produce finished goods
Period Costs
Period costs are those costs that are allocated to the accounting period and are not included in
inventory. They include
• Selling expenses
• General and administrative expenses
• Interest expense
Manufacturing Costs
Manufacturing costs include all of the costs directly involved in the production of a product that
becomes finished goods. They include
• Direct materials
• Direct labor
• Manufacturing overhead costs
¾ Indirect material
¾ Indirect labor
¾ Depreciation
¾ Taxes
¾ Insurance
¾ Heat
¾ Electricity
Freight-In
As indicated above freight-in on merchandise purchases are added to the cost of the merchandise
inventory. Under the perpetual method the amount is added to inventory along with the cost of
the merchandise. Using the periodic method a company would set up a nominal account,
“Freight-In” and would book all freight-in charges to this account. At the end of the year this
account becomes part of the multi-step income statement analysis that determines cost of goods
available for sale, ending inventory, and cost of goods sold.
Purchase Returns and Allowances
Purchase returns and allowances are the counter part to sales returns and allowances. Under the
perpetual method the purchasing company removes the amount returned from inventory and
accounts payable. Using the periodic method a company would set up a nominal account,
“Purchase Returns and Allowances” and would book all returns to this account. At the end of
the year this account becomes part of the multi-step income statement analysis that determines
cost of goods available for sale, ending inventory, and cost of goods sold.
Purchase Discounts
There are two methods of recording purchase discounts
(1) Gross Method
Under the gross method a purchase discounts account is used. The purchase and related
account payable is recorded at the full invoice amount. If the purchaser makes payment by
the discount date, the credit for the discount is recorded in the “purchase discounts”
account.
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Inventories: Measurement
Example: On September 15, 2001, Spencer Company purchases $100,000 of merchandise
with terms of 2/10, n/30. The company pays the invoice on September 23, 2001 (within the
discount) and takes the 2% discount. Using the gross method Spencer Company would
record the purchase and payment as follows:
Date
9/15/01
Date
9/23/01
Account
Debit
$100,000
Inventory
Accounts payable
To record purchase of merchandise inventory, terms 2/10, n/30
Account
Debit
$100,000
Credit
$100,000
Credit
Accounts payable
Purchase discounts
$2,000
98,000
Cash
To record the payment net of the 2% cash discount on merchandise
(2) Net Method
Under the net method a “purchase discounts lost” account is used. The purchase and
related account payable are recorded at net of the discount. It is assumed that the purchaser
will always take advantage of the cash discount. If the purchaser fails to make payment by
the discount date the debit is charged to a “purchase discounts lost” account.
Special Sale Agreements
There are special circumstances where the legal title to the goods might have changed hands
but there is a high degree of uncertainty as to whether the sale has been completed.
•
Sales with Buyback Agreement
¾ Product Financing Agreement
The buyer takes title to the merchandise but has the option to return the merchandise for a
full refund including holding costs. Under these circumstances the seller should report
the inventory and related liability on its books.
¾ Parking Transaction
There are certain industries where it is common for the seller to ship merchandise to the
buyer. The buyer holds the merchandise for a short period of time (through year-end)
and then returns the merchandise. This is sometimes called window dressing with respect
to the preparation of year-end financial statements. No matter what it is called, based on
historical facts or agreements between the parties, the seller should continue to report the
inventory on its year-end financial statements.
•
Sales with High Rates of Return
In some industries the buyer is allowed to return unsold merchandise for a partial or full
refund. If the returns can be estimated then a provision (an allowance account) should be
made and the goods should be treated as sold to the buyer. If it is not possible to determine
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the estimated amount of returned goods, the seller should continue to report the inventory on
its books.
COST FLOW ASSUMPTIONS
The physical flow of movement of goods and the cost flow assumptions used to maintain
accounting records are not always the same.
Specific Identification
This is the only cost flow assumption where the physical flow and the cost flows are identical.
Under this method each item of inventory is accounted for separately and the actual cost of that
item is recorded in the cost of goods sold account when the item is sold. This is only practical
for high-ticket items and relatively low sales volume in terms of the number of units.
Average Cost
Under this method ending inventory and cost of goods sold are priced based on the average cost
of the goods available for sale during the accounting period.
• Periodic inventory system
If the entity is using a periodic inventory system the calculation is based on the weightedaverage of the number of units and their respective costs at the end of the accounting period.
This is called the weighted-average method.
Example: The following inventory transactions took place in September 2000.
Spencer Company
Inventory Transactions
For the Month of September 2000
Periodic Inventory System, Weighted Average
Date
9/1/00
9/10/00
9/25/00
Transaction
Beginning inventory
Purchase of merchandise
Purchase of merchandise
Units
2,000
500
1,000
Price
$10.00
11.00
12.50
Total
$20,000
5,500
12,500
The company sold 2,800 units of merchandise inventory during the month. The following
provides an analysis of the cost of goods sold and the ending inventory using the weightaverage method of assigning costs.
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Spencer Company
Inventory Transactions
For the Month of September 2000
Periodic Inventory System, Weighted Average
Date
9/1/00
9/10/00
9/25/00
9/30/00
9/30/00
•
Transaction
Beginning inventory
Purchase of merchandise
Purchase of merchandise
Goods available for sale
Cost of goods sold:
Merchandise sold in September
Ending Inventory:
Merchandise on hand
Analysis of weighted average:
Goods available for sale:
Total cost
Total units
Weighted average
Units
2,000
500
1,000
3,500
Price
$10.00
11.00
12.50
$10.86
Total
$20,000
5,500
12,500
$38,000
2,800
$10.86
$30,400
700
$10.86
$7,600
$38,000
3,500
$10.86
Perpetual inventory system
If the entity is using the perpetual inventory system the calculation is based on the movingaverage of the number of units and their respective costs after each purchase. This is called
the moving-average method.
Example: Using the same information as above but assuming that Spencer Company uses the
perpetual inventory system the calculation of cost of goods sold and ending inventory is much
different. Each time the company purchases merchandise the new moving weighted average has
to be recalculated. This average cost is then used to calculate the cost of goods sold on any
subsequent sales transactions.
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Pepetual Inventory System, Moving Average
Cost of goods available
Cost of goods sold
Date Transaction Units Price
Total Units Price
Total
Beginning
9/1/00
9/10/00 Purchase
500 $11.00 $5,500
9/15/00 Sold
9/25/00 Purchase
9/30/00 Sold
9/30/00 Ending
Ending inventory
Units Price
Total
2,000 $10.00 $20,000
2,000
$20,000
500
5,500
2,500 $10.20 $25,500
800 $10.20 $8,160 2,500
$25,500
(800)
($8,160)
1,700 $10.20 $17,340
1,000 $12.50 $12,500
1,700
17,340
1,000
12,500
2,700 $11.05 $29,840
2,000 $11.05 $22,104 2,700
29,840
(2,000)
(22,104)
1,500
$18,000 2,800
$30,264
700 $11.05 $7,736
First-In, First-Out (FIFO)
Under FIFO it is assumed that the cost of goods sold are recorded based on the order that the
merchandise was purchased. The best way to think about FIFO is to think about the sale of milk.
The grocery store puts the oldest milk in front so that it will be sold first. The milk that was
purchased most recently will be part of ending inventory whereas the older milk will be part of
the cost of goods sold.
Using the FIFO cost flow assumption the cost of goods sold and ending inventory are identical
under the perpetual and periodic inventory systems. Ending inventory is based on the most
recently purchased merchandise. Cost of goods sold is based on the oldest inventory and ending
inventory is based on the merchandise purchased most recently.
In many cases the FIFO method approximates the physical flow of goods. The balance sheet
reflects an ending inventory that is valued at current costs. The major disadvantage to the FIFO
assumption is that in inflationary times the cost of goods sold can be materially distorted. If the
costs in beginning inventory are substantially lower than current costs, gross profit is overstated
by the amount of inflation that took place during the accounting period.
Example: Assuming the same facts as above the cost of goods sold and ending inventory using
the FIFO cost flow assumption is as follows:
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Spencer Company
Inventory Transactions
For the Month of September 2000
FIFO Cost Flow Assumption
Date
Transaction
9/1/00 Beginning inventory
9/10/00 Purchase of merchandise
9/25/00 Purchase of merchandise
9/30/00 Goods available for sale
Cost of goods sold:
9/1/00 Beginning inventory
9/10/00 Purchase of merchandise
9/25/00 Purchase of merchandise
Cost of goods sold
Ending Inventory:
9/25/00 Purchase of merchandise
Units
2,000
500
1,000
3,500
Price
$10.00
11.00
12.50
Total
$20,000
5,500
12,500
$38,000
2,000
500
300
2,800
$10.00
$11.00
$12.50
$20,000
5,500
3,750
$29,250
700
$12.50
$8,750
Last-In, First-Out (LIFO)
Under LIFO it is assumed that the cost of goods sold reflect the most recently purchased
merchandise. The ending inventory in the balance sheet contains costs that reflect beginning
inventory and possibly merchandise purchased early in the accounting period. The inventory
method has an impact on the calculation of ending inventory and cost of goods sold.
• Periodic inventory system
If the entity is using a periodic inventory system cost of goods sold is calculated based on the
most recently purchased merchandise.
Example: Assuming the same facts as above the cost of goods sold and ending inventory
using the Periodic Inventory and applying the LIFO cost flow assumption is as follows:
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Spencer Company
Inventory Transactions
For the Month of September 2000
Periodic Inventory System - LIFO Cost Flow Assumption
Date
Transaction
9/1/00 Beginning inventory
9/10/00 Purchase of merchandise
9/25/00 Purchase of merchandise
9/30/00 Goods available for sale
Cost of goods sold:
9/25/00 Purchase of merchandise
9/10/00 Purchase of merchandise
9/1/00 Beginning inventory
Cost of goods sold
Ending Inventory:
9/1/00 Beginning inventory
•
Units
2,000
500
1,000
3,500
Price
$10.00
11.00
12.50
Total
$20,000
5,500
12,500
$38,000
1,000
500
1,300
2,800
$12.50
$11.00
$10.00
$12,500
5,500
13,000
$31,000
700
$10.00
$7,000
Perpetual inventory system
If the entity is using the perpetual inventory system cost of goods sold is calculated at point
of each sale based on the most recently purchased merchandise at that date.
Example: Assuming the same facts as above the cost of goods sold and ending inventory
using the Perpetual Inventory and applying the LIFO cost flow assumption is as follows:
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Pepetual Inventory System, LIFO Cost Flow Assumption
Cost of goods available
Cost of goods sold
Date Transaction Units Price
Total Units Price
Total
Beginning
9/1/00
9/10/00 Purchase
500 $11.00 $5,500
9/15/00 Sold
9/25/00 Purchase
500 $11.00
300 10.00
800
1,000 $12.50 $12,500
9/30/00 Sold
9/30/00 Ending
$5,500
3,000
$8,500
1,500
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1,000 $12.50 $12,500
1,000 10.00 10,000
2,000
$22,500
$18,000 5,600
$62,000
3/12/2007
Ending inventory
Units Price
Total
2,000 $10.00 $20,000
2,000 $10.00 $20,000
500 $11.00
5,500
2,500
$25,500
2,500
$25,500
1,700 $10.00 $17,000
1,700 $10.00 $17,000
1,000 $12.50 12,500
2,700
$29,500
700 $10.00
$7,000
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