The Objective of Inventory Accounting
1. To match the cost of goods sold, and expense, with the revenue earned from the sale of those
goods in an accounting period, and
2. To measure the cost of inventory on hand at the end of the period, which is an asset.
Merchandise Companies
A merchandising company has one inventory account.
The problem to be discussed in this section is how to divide the number of goods available for sale
between (1) the ending inventory and (2) the cost of goods sold → can be accomplished by either the
periodic inventory method or the perpetual inventory method.
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ending inventory is obtained by a physical count.
the cost of goods sold is obtained by deduction.
In the latter, both amounts are obtained directly from inventory records.
Periodic Inventory Method
a physical count is made of merchandise in the ending
inventory, and the cost of this inventory is determined.
Perpetual Inventory
Method
a record is maintained of each item carried in the
inventory.
2 approaches:
Manufacturing Companies
A manufacturing company has three inventory accounts: Materials, Work in Process, and Finished Goods.
Periodic Inventory Method
the amount in each account is determined by taking a
physical inventory and then deducing the cost of
materials used, the cost of goods manufactured, and
the cost of goods sold.
Perpetual Inventory
Method
also called a product costing system, these costs are
obtained directly from the accounting records.
2 approaches:
Inventory is ordinarily measured at its cost.
-
in a merchandising company, the cost is essentially the amount expended to acquire the goods.
in a manufacturing company, product costs include, in addition to materials costs, the labor cost
and other production costs incurred in converting the materials into finished goods. Other
operating costs, in either type of company, are called period costs; they are expenses of the
current period.
Inventory Costing Methods
We shall discuss four widely used methods:
1. Specific identification → is common practice with certain big-ticket items such as automobiles and
with unique items such as paintings, expensive jewelry, and custom-made furniture; and bar
codes and scanners are making it feasible with lower-cost items.
2. Average cost → the average cost of the goods available for sale is computed, and the units in both
costs of goods sold and ending inventory are costed at this average cost.
3. First-in, first-out (FIFO) → the FIFO method assumes that the oldest goods are sold first and that
the most recently purchased goods are in the ending inventory.
For the moment, it is sufficient to note that with FIFO:
(1) cost of goods sold is likely to approximate the physical flow of the goods because most
companies sell their oldest merchandise first.
(2) the ending inventory approximates the current cost of the goods since it is costed at the
amounts of most recent purchases.
4. Last-in, first-out (LIFO) → the cost of goods sold is based on the cost of the most recent purchases,
and ending inventory is costed at the cost of the oldest units available.
Note that with LIFO:
(1) cost of goods sold does not reflect the usual physical flow of merchandise.
(2) the ending inventory may be costed at amounts prevailing several years ago, which is an
era of rapid inflation are far below current costs.
Although the LIFO method usually results in lower income taxes, some companies do not use it
because the LIFO conformity rule would result in their reporting lower net income to their
shareholders. IFRS does not permit the use of LIFO. If the market value of an inventory item is
below cost, the item is reported at its market value.
Ratio
Summary two ratios helpful in analyzing inventories are inventory turnover and days’ inventory.