When Inventory grows faster than sales, profits drop. “That is, when companies face slowing sales and growing inventory, then markdowns in prices usually result. These markdowns, in turn, lead to lower sales revenue and income, thereby squeezing profit margins on sales.

 A perpetual inventory system continuously tracks changes in the inventory account. That is, a company records all purchases and sales (issues) of goods directly in the inventory account as they occur. The accounting features of a perpetual inventory system are as follows:

1.       Purchases of merchandise for resale or raw materials for production are debited to inventory rather than to purchases.

2.       Freight-in, purchase returns and allowances, and purchase discounts are debited to inventory rather than in separate accounts.

3.       Cost of goods sold is recorded at the time of each sale by debiting cost of goods sold and crediting inventory.

4.       A subsidiary ledger of individual inventory records is maintained as a control measure. The subsidiary records show the quantity and cost of each type of inventory on hand.

Periodic System: For determining the cost of goods sold under periodic inventory, a company should add the total in purchases account at the end of the accounting period to the cost of the inventory on hand at the beginning of the period; this sum determines the total cost of the goods available for sale during the period, then subtract the cost of the inventory on hand. The cost of goods sold is residual amount that depends on a physically counted ending inventory.

No matter what type of inventory records companies use, they all face the danger of loss and error. Waste, breakage, theft, improper entry failure to prepare or record requisitions, and other similar possibilities may cause the inventory records to differ from the actual inventory on hand. A company corrects the record to agree with the quantities actually on hand.

 

Perpetual Inventory System

Periodic Inventory System

1)      Beginning Inventory

The inventory account shows the inventory on hand

Dr. Inventory, beginning balance.

Cr. Inventory, ending balance.

2)      Purchases

Dr. Inventory

Cr. Accounts Payables

Dr. Purchases

Cr. Accounts Payables

3)      Sales

Dr. Accounts Receivables

Cr. Sales

Dr. Cost of goods Sold

Cr. Inventory

Dr. Accounts Receivables

Cr. Sales

4)      End-of-period entries for inventory accounts

No entry necessary, the account inventory shows the ending balance

Dr. Inventory, ending balance (based on count)

      Cost of goods sold

Cr. Purchases

      Inventory, beginning balance

 In the perpetual inventory overage and shortages generally represent a misstatement of cost of goods sold. The difference results from normal and expected shrinkage, break-age, shoplifting, incorrect recordkeeping, and the like. Inventory over and short therefore adjusts cost of goods sold. In practice, companies sometimes report inventory over and short in “Other revenues and gains” or “Other expenses and losses” section of the income statement, depending on its balance. Note that a company using the periodic inventory system does not report the account inventory over and short. The reason: The periodic method does not have accounting records against which to compare the physical count. Instead, a company buries inventory overages and shortages in cost of goods sold.

Technically a company should record purchases when it obtains legal title to the goods to practice, however, a company records acquisitions when it receives the goods. The below table indicates the guidelines companies use in evaluating whether company reports inventory or nots.

 

Case Description

Reporting as inventory

Presentation

FOB/CIF shipping point

Buying Company should report those goods as “Material/Goods in Transit” when the goods delivered to the carrier at the shipping point

Inventory

DDP buyer’s premise/Ex-work buyer’s store

Buying Company should report those goods as “inventory” when the goods received at the buyer’s warehouse.

Inventory

Consignment Goods

Buying Company should not report it as inventory at all

Selling Company should report it as “consignment inventory”

 

 

Inventory

Sales with buyback

Buying Company should not report it as inventory at all

Selling Company should report it as inventory.

 

 

Inventory

Sales with high rates of return

Buying Company should report it as “Inventory” if it can estimate the returns

Inventory

Sales in installment

Buying Company should report it as “Inventory” if it can estimate the collectability. Means, company should exclude the sold goods from inventory if it can estimate the bad debts

Inventory

  

Effect of purchases misstatements is as follow.

Effect of ending inventory misstatement is as follow.

Effect of purchases and ending inventory misstatements is as follow.

the understatement of accounts payable and ending inventory can lead to a “dressing financial statements” and vice versa.

 Inventory Cost

The inventory costs include all the costs that associated to bring the goods or materials ready to sale or use. Those costs are the purchasing costs of goods/materials, freight cost, insurance of transporting the items, transportations, customs duty and levies. It seems proper also to allocate to inventories a share of any buying costs or expenses of purchasing department, storage costs, and other costs incurred in storing or handling the goods before their sale. However, because of the practical difficulties involved in allocating such costs and expenses, companies usually exclude these items in valuing inventories.

Interest is another period costs that should not capitalized in inventory costs. Companies usually expense interest costs associated with getting inventories ready for sale. Supporters of this approach argue that interest costs are really a cost of financing. Others contend that interest costs incurred to finance activities associated with readying inventories for sale are as much a cost of the asset as materials, labor, and overhead. Therefore, they reason, companies should capitalize interest costs.

The FASB emphasized that these discrete projects should take considerable time, entail substantial expenditures, and be likely to involve significant amounts of interest cost. A company should not capitalize interest costs for inventories that it routinely manufactures or otherwise produces in large quantities on a repetitive basis.

Practically, most companies record the cost of inventory or purchases at gross price but excluding the purchasing/volume discount. Theoretically, few companies that always or most probably pay the invoices within cash discount recorded the cost of inventory or purchases at net method by deducting the cash discount from the price, and if it cannot pay within discount period it record it as purchase discounts lost.

Cost Flow Assumption

There are four methods for calculating the cost flow of inventory and cost of goods sold

 

Cost Formula

Description

Major Advantage

Major Disadvantage

Financial Statement Effects

Specific Identification

It identify each items sold/used and each item in inventory

-It is used for few quantities and category inventories. And It is applied for each item of inventories that can be separated physically.

- It applies match principle.

- It reports actual inventory costs.

- it is difficult be applied for many various and quantities of items

- The ending inventory does not reflect the current prices of items

- Understated Inventory

First-in, First-out (FIFO)

This method assumes that company uses or sells goods in the order in which it purchases them. FIFO assumes that the first goods purchased are the first used or sold.

In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used

-It is used for many quantities and category inventories under inflation economy.

- It is appropriate for each batch of inventories that can be physically separated

- The ending inventory reflects the current prices of items

- It does not apply match principle.

- It is not appropriate for heap of coal, sands, aggregates, cements, and such things or

- Increasing Inventory

- Increasing working capital.

- Increasing current ratio

- Decreasing the cost of sales

- Increasing net income

Last-in, First-out (LIFO)

LIFO assumes that the last goods purchased are the first used or sold.

- It meets match principle.

-It is used for many quantities and category inventories under decreasing prices or recession economy.

- It is more appropriate for heap of coal, sands, aggregates, cements, and such things or for each batch of inventories that can be physically separated

- The ending inventory does not reflect the current prices of items

-Decreasing the inventory.

- Decreasing working capital.

- Decreasing current ratio

- Increasing cost of goods sold

- Decreasing net income

Average Cost

It prices items in the inventory on the basis of the average cost of all similar goods available during the period.

Under perpetual inventory, moving average is used.

-It is used for many quantities and category inventories specially under non-settled economy or fluctuated prices.

- It is more appropriate for batches of inventories that cannot be physically separated or recorded.

 

 

 Issues related to LIFO

The difference between the inventory method used for internal reporting purposes and LIFO is the allowance to reduce inventory to LIFO or the LIFO reserve

Dr. Cost of goods sold

Cr. Allowance  to reduce inventory to LIFO

 

Dollar-value LIFO determines and measures any increase or decrease in terms of total dollar value. To compute the total dollar-value LIFO inventories, the following steps should be applied:

Step 1: Selecting Price Index

Price Index for Current Year =

Current ending Inventory at current cost

Current ending Inventory at Base-Year cost

=

∑(qn,1*pn,1)

∑(qn,0*pn,0)

 

Step 2: Computation end-of-year inventory at Base-Year Prices

Year

Inventory at End-of-Year Prices

÷ Price Index %

= End-of-Year Inventory at Base-Year Prices

 

Step 3: Computation of each year inventory at LIFO cost

End-of-Year Inventory at Base-Year Prices

Layer at Base-Year Prices (Current Year – Prior Year increase – Year base)

*  Price Index %

= Ending Inventory at Lifo cost

 

Companies face an ongoing challenge, they need to keep enough inventory to meet customer demand, but not to accumulate too much inventory. If demand falls short of expectations, the companies may be forced to reduce prices on its existing inventory, thus losing sales revenues.

 Inventory Valuation:

Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline – obsolescence, price-level changes, or damaged goods, Company should write down the inventory to market to report this loss. Accountant should value and report the inventory based on cost or market whichever is lower.

Inventory Valuation for Lower-of-Cost-or-Market is computed as follow

Step 1: Computing Net Realizable Value (Ceiling)

The net realizable value (NRV) is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal (often referred to as net selling price).

Step 2: Computing Net Realizable Value Less a Normal Profit Margin (Floor)

A normal profit margin is subtracted from NRV to arrive at NRV less normal profit margin.

Step 3: Computing Replacement Cost and Market value

Replacement cost is used as “market” price if it falls between eh ceiling and the floor, the ceiling amount is used as “market” price when replacement cost is above the ceiling; and the floor amount is used as “market” when replacement cost is below the floor.

Step 4: Selecting the designated Market Value

Designated market value is always the middle (median) value of three amounts: replacement cost, net realizable value, and net realizable value less a normal profit margin.

Step 5: Valuing the inventory

Final inventory value is the amount that a company compares the designated market value to cost and selecting whichever is the lower for valuing the inventory.

 

Stock Items

Replacement Cost

Net Realizable Value (Ceiling)

Net Realizable Value Less a Normal Profit Margin (Floor)

Designated Market Value

 

 

 

 

 

Total

 

 

 

 

 

Stock Items

Cost

Designated Market Value

Final Inventory Value

 

 

 

 

Total

 

 

 

 Companies usually price inventory on item-by-item basis. And Tax rules require to use an individual-item basis barring practical difficulties. In addition, the individual-item approach gives the most conservative valuation for balance sheet purposes.

There are two methods for recording the declining in inventory values

 

Direct Method

Indirect Method

Dr. Cost of Goods Sold

Cr. Inventory

Dr. Loss Due to Market Declining of Inventory

Cr. Allowance to Reduce Inventory to Market

 Also, the accounting entries for the obsolescence is as follow

 

Direct Method

Indirect Method

Dr. Cost of Goods Sold

Cr. Inventory

Dr. Loss Due to obsolescent Inventory

Cr. Allowance of obsolescent inventory

 Damaged or obsolete goods frequently are valued at net realizable value – estimated selling price less direct costs of completion and disposal. If there is doubt about the existence of any net realizable value, the cost of the damaged or obsolete goods should be reduced to scrap value or zero in the absence of scrap value.

Under limited circumstances, support exists for recording inventory at net realizable value, even if that amount is above cost. GAAP permits this exception to the normal recognition rule under the following conditions:

a)      When there is controlled market with a quoted price applicable to all quantities, and

b)      When no significant costs of disposal are involved.

For example mining companies ordinarily report it inventories of certain minerals (rare metals) at selling prices because there is often a controlled market without significant costs of disposal.

 

Company makes many products from one “unit” of raw material. To allocate the cost of animal “on the hoof” into the cost of, say, ribs, chuck, and shoulders, is a practical impossibility. It is much easier and more useful for the company to determine the market price of the various products and value them in the inventory at selling price less the various costs necessary to get them to market (costs such as shipping and handing). When a company buys a group of varying units in a single lump-sum purchase, also called a basket purchase, and the accurately value each unit is by using the most logical practice is to allocate the total among the various units on the basis of their related sales value.

There are two methods for estimating the inventory.

  1. Gross Profit Method

Auditors widely used this method in situations where they need only an estimate of the company’s inventory (e.g. interim reports). Companies also use this method when fire of other catastrophe destroys either inventory or inventory records. The gross profit method relies on three assumptions:

1)      The beginning inventory plus purchases equal total goods to be accounted for.

2)      Goods not sold must be on hand.

3)      The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.

 

Beginning inventory (at cost)

 

Xxxx

Purchases (at cost)

 

Xxxxx

Goods available (at cost)

 

 

Sales (at selling price)

Xxxxx

 

Less: Gross Profit (30% of sales)

Xxxxx

 

Sales (at cost)

 

Xxxxx

Approximate inventory (at cost)

 

Xxxxx

 Gross profit on selling price is the common method for quoting the profit for several reasons:

1)      Most companies state goods on a retail basis, not a cost basis,

2)      A profit quoted on selling price is lower than one based on cost. This lower rate gives a favorable impression to the consumer.

3)      The gross profit based on selling price can never exceed 100%.

The following formula is used for computation of gross profit percentage

a.       Gross Profit on selling price = (Percentage markup on cost) ÷(100%+Percentage markup on cost)

b.      Gross Profit on cost = (Gross Profit on selling price) ÷(100%+Gross profit on selling price)

As long as selling price exceeds cost, the gross profit on selling price will always be less than the related percentage based on cost.

  1. Retail Inventory Method

Retailer can use formula to convert retail prices to cost. This method is called the retail inventory method. It requires that the retailer keep a record of 1) the total cost and retail value of goods purchased, 2) the total cost and retail value of the goods available for sale, and 3) the sales for the period.

The retail inventory method is particularly useful for any type of interim report because such reports usually need a fairly quick and reliable measure of the inventory. Also, insurance adjusters often use this method to estimate losses from fire, flood, or other type of casualty. In a competitive market retailers often need to use markdowns, which are decreases in the original sales prices. Such cuts in sales prices may be necessary because of a decrease in the general level of prices, special sales, soiled or damaged goods overstocking, and market competition. Markdown cancellations occur when the markdowns are later offset by increases in the prices of goods that retailer had marked down.

 

 

Cost

Retail

Beginning inventory

Xxxx

xxxx

Purchases

Xxxx

xxxx

Freight-in

Xxxx

 

Purchases returns

(xxxx)

(xxxx)

Purchases discount and allowances

(xxxx)

(xxxx)

Merchandise available for sale

Xxxxx

xxxxx

Add: Markups

 

Xxx

Less: Markup cancellations

 

(xxx)

          Net markups

 

Xxx

Abnormal shortage

(xxx)

(xxx)

 

Xxxxx

Xxxxx

(A)                                                          Cost-to-retail ratio

Cost ÷ retail value

Deduct:

 

 

Markdowns

 

Xxxx

Less: Markdown cancellations

 

(xxx)

           Net Markdowns

 

Xxx

 

Xxxxx

Xxxx

(B)                                                          Cost-to-retail ratio

Cost ÷ retail value

Deduct:

 

 

Sales

 

Xxxxxxx

Sales returns

 

(xxxx)

Employee discounts

 

Xxxx

Normal shortage

 

Xxxx

Ending Inventory at retail

Xxxxxxx

Xxxxxxx

            Computation for value of ending inventory

Assumption A: Ending inventory at retail value x Cost-to-retail ratio

Assumption B: Ending inventory at retail value x Cost-to-retail ratio

  

Step 1: Analyzing the physical flow of production units

Step 2: Calculating equivalent units for each manufacturing cost element

Step 3: Determining total costs for each manufacturing cost element

Step 4: Allocating Joint Cost

Joint cost allocation is necessary for inventory valuation, determination of cost of goods sold, deriving selling prices, meeting regulatory agency requirements, and taxation. Joint cost information assists you in looking at the effect of altering the output mix on costs and profitability, establishing a selling price for the product, determining the relative profitability between products and controlling and evaluating the production and distribution processes. Processing efficiency may be appraised by determining the physical yield for each product. An index of production (i.e, weighted-average index) may be computed to evaluate output efficiency.

Some ways to allocate costs among joint products are:

-          Market value at the split-off point.

-          Net realizable value (final sales price less separable costs)

-          Final sales price

-          Physical measure (e.g. units, feet, grams)

-          Unit cost

-          Gross margin

-          Chemical property

-          Energy potential

-          Opportunity cost

-          Arbitrary mathematical techniques

-          Judgmental allocation

Commonly used allocation methods are based on average unit costs ,sales value, market value, and physical measure.

a)      Average unit costs

Total labor hours of all items = labor hours of product1 + labor hours of product2

Average unit cost = Joint Cost ÷ Total labor hours of all items

Joint cost portion of Product1 = labor hours spent for a product x Average unit cost

b)      Net realizable value or market value at split off point

Total units of outputs of all products = Units of outputs of product1 + Units of outputs of product1

Total Net realizable value of all products = ∑ (quantities of output) * (selling unit price – unit cost of completion/separation and delivery)

Fractional part of total NRV = NRV of product 1 ÷ Total Net realizable value of all products

Joint cost portion of product = Fractional part of product x joint cost

c)       Physical output measure

Total outputs of all products = outputs of product1 + outputs of product2

Fractional part of outputs of a product= outputs of a product ÷ Total outputs of all products

Joint cost portion of Product1 = Fractional part of outputs of a product x Average unit cost

The joint costs under multiple split-off points is allocated based on one of the above method applied for all split-off points and start from the first split-off point and cost is cumulated to the last split-off point.

Generally speaking, if product’s value is too small to affect the decision to produce, it is a by-product. By-products are immaterial in nature which is evaluated at net realizable value and it is deducted from cost of main product. The method used for by-product valuation depends on whether:

-          The by-product’s value is uncertain when produced

-          There is an established market for the by-product.

-          The by-product can be used as a substitute for other raw materials

-          The by product can be used as an energy source for the firm

-          The external outlet for by-products cannot be used internally

-          The market is characterized as a long-term rather than temporary short-term situation

By products may be accounted for by the following methods:

a)      Income from by-products may be reported as “other income”

b)      Income from by-products may be reducing cost of sales, the manufacturing cost of the main product or joint cost.

c)       Income from by-products is reflected in the foregoing methods except that the by-product income is reduced by appropriate expenses, such as marketing and administrative costs.

Step 5: Computing cost per equivalent unit

Step 6: Assign total manufacturing costs to units completed and ending WIP

Step 7: Reconciling costs and preparing Production Cost Report (PCR).

 

 For a manufacturing enterprise, a sound cost accounting system is an essential component of financial accounting. Two types of cost systems may be used to accumulate product costs for manufacturing enterprise: the job order cost system and the process cost system.

The job order system is used when an enterprise manufactures several distinct products such as construction for specialty product enterprise. Job order cost sheets are used to accumulate the cost of direct material, direct labor and factory overhead incurred on each job. Costs entered in job order cost sheets make up the goods in process inventory until the jobs are completed. The cost of completed jobs is a part of the finished goods inventory until the goods are sold.

The process cost system is used when large numbers of similar units are produced on an assembly-line operation. The production process typically is divided responsibility. Direct material, direct labor, and factory overhead costs then are accumulated by cost center, and the goods in process inventory is the sum of all costs incurred on the partially finished units in the various cost centers. The finished goods inventory is composed of all costs incurred to produce the completed goods on hand.

When the process cost system is used, the cost to produce a complete unit of product usually is determined from departmental cost of production reports. Such reports show how the total costs incurred were assigned to any by-products (or scrap) and to the main products. By-products usually are priced at net realizable value; if such value is immaterial, no cost is assigned to by-products.

The allocation of joint costs is necessary to determine the unit cost of each product and frequently is made on the basis of the relative sales value of the joint products. Dividing the total costs by the total sales value of the joint product determines the cost percentage, which then is applied to the unit selling prices of each product to determine the estimated unit cost of each product.

Manufacturing company’s costs include direct materials, e.g. raw materials, and direct labor and manufacturing overhead costs. Manufacturing overhead costs include indirect materials.

For financial reporting purposes, it is acceptable to price inventories at standard cost if there is no significant difference between the actual costs and standard costs. If there is a significant difference, companies should adjust the inventory amounts to actual cost.

 It is quite common for a company to make purchase commitments, which are agreements to buy inventory weeks, months, or even years in advances. Generally the seller retains title to the merchandise or materials covered in the purchase commitments.

Usually it is neither necessary nor proper for the buyer to make any entries to reflect commitments for purchases of goods that the seller has not shipped. If a buyer enters into a formal no cancelable purchase contract, even then, the buyer recognizes no asset or liability at the date of inception, because the contract is “executor” in nature: Neither party has fulfilled its part of the contract. However, if material the buyer should disclose such contract details in a note to its financial statements.

If the contract price is more than market price at the balance sheet date and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize losses in the period during which such declines in market prices take place.  Company can record such loss in their books as the following accounting entry.

Dr. Unrealized Holding Gain or Loss from Purchase commitments             xxxx

Cr. Estimated Liability on Purchase Commitments                                             xxxx

If the materials were received and their market price is still less than the contract price, the inventory accounting entry will be as follow:

Dr. Purchases or Inventory                                                          xxxx

      Estimated Liability on Purchase Commitments              xxxx

Cr. Cash                                                                                                xxxx

If the market price increased and become greater than or equal to contract price, the loss should be recovered and reversed the first entry and book the inventory at the contract price.

 Presentation

 The presentation of declined value of inventory is to be as follows

a)      Income Statement

Direct Method

Amount

Revenue from sales

xxxx

Cost of goods sold (after adjustment to market1)

xxxx

Gross Profit on Sales

xxxx

 

Indirect Method

Amount

Revenue from sales

xxxx

Cost of goods sold

xxxx

Gross Profit on Sales

xxxx

Loss due to market decline of inventory

xxxx

 

b)      Balance Sheet

 

Amount

Finished Goods Inventory

xxxx

Work-In-Process Inventory

xxxx

Raw Materials Inventory

xxxx

Reserves to LIFO/Allowance to reduce to market price

Xxxx

Net Inventory

xxxx

 

 Disclosure

 Disclosure of direct method for declining inventory value

Direct Method

Amount

Cost of goods sold (before adjustment to market)

xxxx

Difference between inventory at cost and market

xxxx

Cost of goods sold (after adjustment to market)

xxxx

 Disclosure for significant policies:

“Note 1: Inventories

Inventories are prices at the lower of cost (average; first-in, first-out; and minor amounts at last-in, first-out) or market. In accordance with generally recognized trade practice, the items ________ inventories are classified as current assets. Although part of such inventories due to the duration of the aging process, ordinarily will not be sold within one year.”

Or

“Ore and in-process inventory and materials and supplies are stated at the lower of average cost or net realizable value. ____ item and _______ are stated at market value, less a provision for estimated completion and delivery charges. Expenditures capitalized as ore and in-process inventory include labor, material and other production costs.

                Non current inventories are stated at the lower of average cost or net realizable value and represent ore in stockpiles anticipated to be processed in future years.”

 Disclosure of LIFO reserve

“At Dec 32, 20xx, $xxxx of inventories were valued using the LIFO method. This amount is less than the corresponding replacement value by $xxxxx.”

Additional LIFO reserve disclosure

“Inventories are valued at the lower of cost or market determined principally by the last-in, first-out (LIFO) method. If the first-in, first-out (FIFO) cost method had been used, inventories would have been $xxxx higher in the current year and $xxxx higher in the previous year.”

Disclosure of purchase commitments:

“Contracts for the purchase of ________ in 20xx has been executed in the amount of $_____. The market price of such raw materials on December 31, 20xx-1 is $_______.”

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