Chapter 6: Merchandise Inventory

Classifying Inventory

Inventories can can simply be defined as asset items that a company holds for sale in the ordinary course of business, or items that will be used or consumed in the production of goods to be sold. Inventories are assets;

a. held for sale in the ordinary course of business;
b. use in the process of production for such sale; or
c. in the form of materials or supplies to be consumed in the production process or in the rendering of the services.

Inventories are usually made up of a combination of goods, raw materials and finished products.

A merchandising company usually purchases its merchandise in a form ready for sale and reports only the cost assigned to unsold units left on hand as “Merchandise Inventory” in its financial statements.

A manufacturing company produces goods and usually sells them to merchandising firms. Although the products they produce may differ, manufacturers normally have three inventory accounts in their financial statements: raw materials, work in process, and finished goods.

Raw Materials Inventory reports the cost of goods and materials on hand which will be used in production.

Work in Process Inventory reports the cost of goods, materials and other components of manufacturing process used for the inventory which are still in production process, in other words unfinished at the time financial statements are prepared.

Finished Goods Inventory reports the cost of goods, materials and other components of manufacturing process used for the inventory produced and available for sale.

A service company usually reports goods which are used in their service providing facilities as inventories or stocks.

Inventory-Related Accounting Principles

The guidelines for accounting information are called Generally Accepted Accounting Principles (GAAP). Generally Accepted Accounting Principles (GAAP) rests on a conceptual framework that identifies the objectives, characteristics, elements, and implementation of financial statements and creates the accepted accounting principles. In order to use and prepare financial statements, it’s important that we understand GAAP. To understand accounting and reporting inventories, first, we should understand the principles which are related to them such as consistency, disclosure, materiality, and accounting conservatism.

Consistency Principle

The consistency principle holds that companies should use the same accounting methods and procedures in each accounting period, so that the information provided will help investors and creditors to compare a company’s financial statements from one period to the next.

Disclosure Principle

The disclosure principle holds that a company should report enough information for financial statement users to understand methods and procedures used for each component of the financial statements to make wise decisions about the company by providing additional information. From the point of merchandising inventories, companies should disclose all methods being used to account for merchandise inventories.

Materiality Concept

The materiality concept states that a company must perform strictly proper accounting only for significant items.2 Information is significant (material in accounting terms) when it would cause someone to change a decision. The most important point about this concept is to understand what is significant or material. When you do not report some information in your financial statements, and if it affects the decision of financial statement users, then this information is accepted to be material. From company to company, this information might differ.

Conservatism

A business should report the least favorable figures in the financial statements when two or more possible options are presented according to the conservatism concept requirements

Inventory Costing Methods

Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and make them ready for sale. Businesses must have a way to determine the value of merchandise inventory on hand and also the value sold (cost of goods sold). For this reason, first they have to choose an accounting system and then a cost flow system for their inventories.

Inventory Accounting Systems

There are two basic inventory accounting systems: “Perpetual Inventory System” and “Periodic Inventory System”.

Perpetual Inventory System is a system of tracking and recording inventory and costs of goods sold on a continual basis, so current inventory balance can be calculated on real time basis, and the accounting system can display the current inventory balance at any point in time. Perpetual Inventory System always provides real time balances of Inventory Account and the Cost of Goods Sold Account.

This system achieves better control over the inventory by recording the following information:

• Units purchased and cost amounts
• Units sold and sales and cost amounts
• The quantity of merchandise inventory on hand and its cost.

Periodic Inventory System is an inventory system which relies upon physical count of the inventory to determine the ending inventory balance and cost of goods sold. Periodic Inventory System calculates the Cost of Ending Inventory and Cost of Goods Sold once at the end of an accounting period. The periodic inventory system requires businesses to obtain a physical count of inventory to determine quantities on hand. The system is normally used for relatively inexpensive goods, such as in a small, local store without optical-scanning cash registers that does not keep a running record of every loaf of bread and every key chain that it sells.

Inventory Cost Flow Methods

Inventory Cost Flow Method is a method of approximating the flow of inventory costs in a business that is used to determine the amount of cost of goods sold and ending merchandise inventory.

There are three common cost flow assumptions used in business. Each of thewse assumptions is identified with an inventory costing method, as shown below:

• First-In First-Out (FIFO)
• Last-In First-Out (LIFO)
• Average Cost

Specific Identification Method

Specific Identification Method is an inventory costing method based on the specific cost of particular units of inventory. In the specific identification method, the company knows exactly which item was sold and exactly what the item cost. The specific identification method is impractical unless each unit can be identified accurately. This costing method is best for businesses that sell unique, easily identified inventory items, such as jeweler (a specific diamond earring), an automobile dealer (each automobile has a unique serial number) and real estate (identified by address). This method requires the business maintains detailed records of inventory sales and purchases as well as carefully identifying the inventory sold.

Average Cost Method

Average Cost Method is an inventory costing method based on the weighted average cost per unit of inventory that is calculated after each purchase. Weighted average cost per unit is determined by dividing the cost of goods available for sale by the number of units available.

When the average cost method is used in a perpetual inventory system, the business computes a new weighted average cost per unit after each purchase. This unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed. Ending inventory and cost of goods sold are then based on the same average cost per unit.

First-In, First-Out (FIFO) Method

The First-In, First-Out (FIFO) method assumes that the earliest goods purchased arethe first to besold. Under the first-in, first-out (FIFO) method, the cost of goods sold is based on the oldest purchases – that is, the first units to come in are assumed to be the first units to go out of the warehouse (sold). FIFO costing is consistent with the physical movement of inventory (for most companies). That is, under the FIFO inventory costing method, companies sell their oldest inventory first.

Last-In, First-Out (LIFO) Method

Last-in, First-out (LIFO) is just the opposite of FIFO. Under the last-in, first-out (LIFO) method, ending inventory comes from the oldest costs (beginning inventory and earliest purchases) of the period. The cost of goods sold is based on the most recent purchases (new costs) –that is, the last units in are assumed to be the first units out of the warehouse (sold). This method is forbidden for being misleading especially in hyperinflationary economies.

Valuation of Inventories

In order to prepare reliable financial statements, they should be prepared with up to date and relevant information. That’s the reason why at the end of each accounting period valuation process takes place for each item reported. As we mentioned earlier, cost is the primary basis for valuing inventories. But the value of inventory for companies selling high-technology or fashion goods might drop very quickly due to changes in technology or fashions. In such cases, inventory is valued at market value other than cost. Two such cases arise when (1) the cost of replacing items in inventory is below the recorded cost and (2) the inventory is not salable at normal sales prices.

If the market value is lower than the cost, the lower-ofcost-or-market (LCM) method is used to value the inventory. This method requires inventory to be reported in the financial statements at “historical cost” or “market value” whichever is lower.

For inventories, market value is generally accepted as current replacement cost or net realizable value. When the replacement cost of inventory falls below its historical cost, the Lower of Cost or Market Value Method (LCM) rules require that the inventory should be written down to the lower value and that a loss be recorded. This rule is an example of the application of the conservatism principle because the loss is recognized before an actual transaction takes place. If the market value is greater than cost, then we don’t adjust the inventory account because of the conservatism principle.

Estimated cost of completion is used for the calculation of the market value of work-inprocess inventory in manufacturing companies.

Impact of Inventory Errors on Financial Statements

Having the ability to measure inventory in a timely and accurate manner is critical for having uninterrupted business operations since inventory is often one of the largest current assets on a company’s balance sheet. An error in ending merchandise inventory creates a whole string of errors in other related accounts. So, businesses have to perform a physical count of their merchandise inventory at the end of each accounting period to report their inventories with correct values.

We should also remember that in accounting, ending inventory balance of one period is the beginning inventory balance of the next period. So, if there is an error in ending merchandise inventory, this error directly affects the beginning balance of the next period’s inventory.

Inventory Related Ratios Used in Decision Making

Organizations pay more and more attention to their inventory management systems every single day because effective inventory management is accepted as a fundamental measure of the overall health and success of a business. There are two financial ratios which are used by managers to monitor their inventory levels: Inventory Turnover Ratio and Days’ Sales in Inventory.

Inventory Turnover Ratio

Companies always try to manage their inventory levels in a way to meet their customer demand on a timely basis without making large investments. Inventory turnover ratio is used to determine how frequently merchandise inventory is sold and it is calculated as follows:

Inventory Turnover Ratio = Cost of Goods Sold / Average Merchandise Inventory

Average Merchandise Inventory = (Beginning Merchandise Inventory + Ending Merchandise Inventory) / 2

The answer is measured in terms of “times”. A high turnover ratio indicates that a company sells its inventory easily whereas a low turnover ratio indicates that there is a problem.

Inventory Turnover Ratio measures number of times a company sells average level of merchandise inventory during a period.

Days’ Sales in Inventory

Days’ Sales in Inventory Ratio is the other key ratio used by the management of a company to measure average number of days that merchandise inventory is held by the company. It is calculated as follows:

Days’ Sales in Inventory =365/inventory turnover

Days’ Sales in Inventory ratio measures the number days that inventory is held by a company.

Average number of days simply varies from company to company depending on the industry it operates. However, generally lower days’ sales in inventory is more preferable by companies than higher days.