INVENTORY

Determining Inventory Levels

Merchandising and manufacturing companies keep an inventory of goods held for sale.
Management is responsible for determining and maintaining the proper level of goods in
inventory. If inventory contains too few items, sales may be missed. If inventory
contains too many items, the business pays unnecessary amounts to warehouse,
secure, and insure the items, and the company's cash flow becomes one sided‐cash
flows out to purchase inventory but cash does not flow in from sales.

Companies take physical inventories to count how many (or measure how much) of
each item the company owns. Inventory is easier to count when sales and deliveries are
not occurring, so many companies take inventory when the business is closed.

Taking a physical inventory involves internal control principles. Examples of these

internal control principles include the following:

• Segregation of duties. Specific items should be counted by employees who do

not have custody of the items.
• Proper authorization. Managers are responsible for assigning each employee
to a specific set of inventory tasks. In addition, employees who help take
inventory are responsible for verifying the contents of boxes, barrels, and other
containers.
 • Adequate documents and records. Prenumbered count sheets are provided to
all employees involved in taking inventory. These count sheets provide evidence
to support reported inventory levels and, when signed, show exactly who is
responsible for the information they include.
• Physical controls. Access to inventory should be limited until the physical
inventory is completed. If the company plans to ship inventory items during a
physical inventory, these items should be placed in a separate area. Similarly, if
the company receives inventory items during a physical inventory, these items
should be kept in a designated area and counted separately.
• Independent checks on performance. After the employees finish counting, a
supervisor should verify that all items have been counted and that none have
been counted twice. Some companies use a second counter to check the first
counter's results.

Consigned merchandise. Consigned merchandise is merchandise sold on behalf of

another company or individual, who retains title to it. Although the seller (consignee) of
the merchandise displays the items, only the owner (consignor) includes the items in
inventory. Therefore, companies that sell goods on consignment must be careful to
exclude from inventory those items provided by consignors.

Goods in transit. Goods in transit must be included in either the seller's or the buyer's
inventory. When merchandise is shipped FOB (free on board) shipping point, the
purchaser pays the shipping fees and gains title to the merchandise once it is shipped.
Therefore, the merchandise must be included in the purchaser's inventory even if the
purchaser has not yet received it. When merchandise is shipped FOB (free on board)
destination, the seller pays the shipping fees and maintains title until the merchandise
reaches the purchaser's place of business. Such merchandise must be included in the
seller's inventory until the purchaser receives it. In addition to counting merchandise on
hand, therefore, someone must examine the freight terms and shipping and receiving
documents on purchases and sales just before and just after the count takes place to
establish a more complete and accurate inventory count.

The Cost of Inventory

The cost of inventory includes the cost of purchased merchandise, less discounts that
are taken, plus any duties and transportation costs paid by the purchaser. If the
merchandise must be assembled or otherwise prepared for sale, then the cost of getting
the product ready for sale is considered part of the cost of inventory. Technically,
inventory costs include warehousing and insurance expenses associated with storing
unsold merchandise. However, the cost of tracking this information often outweighs the
benefits of allocating these costs to each unit of inventory, so many companies simply
apply these costs directly to the cost of goods sold as the expenses are incurred.
The Valuation of Merchandise
To ensure the proper matching of expenses and revenues, decreases in the value of
inventory due to usage, damage, deterioration, obsolescence, and other factors must be
recognized in the accounting period during which the decrease occurs rather than the
period during which the merchandise sells. Inventory should never be valued at more
than its net realizable value, which equals its expected sales price minus any
associated selling expenses. For example, if a storm damages a car that cost an
automobile dealer $25,000, and if the car can now be sold for no more than $23,000.
Then the value of the car must be reported at $23,000. This decrease in the value of
inventory is recognized by debiting the loss on inventory write‐down account, which is
an expense account, and by crediting inventory.

Some companies attribute inventory write‐downs directly to the cost of goods sold, and
some companies use other expense accounts for this purpose, so write‐downs are not
usually identified separately on financial statements.

Market value generally equals the replacement cost of inventory. Items sometimes
decrease in value because they become less expensive to purchase. In other words,
the market value drops. The lower‐of‐cost‐or‐market (LCM) rule is used to determine
the value of merchandise inventory.
Suppose a retail computer store purchases one hundred computers for $3,000 each.
After the store sells fifty of them, the manufacturer decreases the computer's price,
enabling the store‐as well as the store's competitors‐to purchase the same type of
computer for $2,500. Applying the lower‐of‐cost‐or‐market rule means the value of the
fifty remaining computers equals $125,000 (50 × $2,500) rather than $150,000 (50 ×
$3,000). This $25,000 write‐down is recorded by debiting the loss on inventory write‐
down account and by crediting inventory.

Again, many companies choose to record write‐downs using a different expense

account than the one shown above.

The LCM rule may be applied to individual inventory items, to groups of similar items, or
if the inventory consists of related items, to the entire inventory. As the chart below
indicates, applying the LCM rule to individual items produces the most conservative
valuation of inventory. As the number of items grouped together increases, the reported
value of inventory tends to increase because increases in the market value of some
items may partially offset decreases in the market value of other items in the same
group.

| | | | LCM Rule applied to

| | Cost | Market | Items | Groups | Entire Inventory
| Computers | | | | |
| Model EX7 | $150,000 | $125,000 | $125,000 | |
| Model NX8 | 30,000 | 32,000 | 30,000 | |
| Model VX9 | 50,000 | 55,000 | 50,000 | |
| Total | 230,000 | 212,000 | | $212,000 |
| Printers | | | | |
| Model PL30 | 30,000 | 34,000 | 30,000 | |
| Model PL60 | 15,000 | 18,000 | 15,000 | |
| Model PL90 | 25,000 | 24,000 | 24,000 | |
| Total | 70,000 | 76,000 | | 70,000 |
| Total inventory | $300,000 | $288,000 | $274,000 | $282,000 | $288,000

After the value of inventory has been written down, an increase in net realizable value
or market value is not recorded. Instead, such increases are recognized as revenue
when sales actually occur. Because companies must estimate net realizable value and
because applying the LCM rule to individual items or groups of items yields different
inventory values, financial statements should disclose the company's basis for
determining the value of inventory.

Inventory Systems: Perpetual or Periodic

Companies may use either the perpetual system or the periodic system to account for
inventory. Under the periodic system, merchandise purchases are recorded in the
purchases account, and the inventory account balance is updated only at the end of
each accounting period. Perpetual inventory systems have traditionally been associated
with companies that sell small numbers of high‐priced items, but the development of
modern scanning and computer technology has enabled almost any type of
merchandiser to consider using this system.

Under the perpetual system, purchases, purchase returns and allowances, purchase
discounts, sales, and sales returns are immediately recognized in the inventory account,
so the inventory account balance should always remain accurate, assuming there is no
theft, spoilage, or other losses. Consider several entries under both systems. The
reference columns are removed from the illustration to simplify what you're seeing.
(Note: Ap stands for accounts payable, and AR stands for accounts receivable.)
As the two sets of circled entries indicate, two things happen when there is a sale or a
sales return. First, the sales transaction's effect on revenue must be recognized by
making an entry to increase accounts receivable and the sales account. Second, the
flow of merchandise between inventory (an asset) and cost of goods sold (an expense)
is recorded in accordance with the matching principle. A sales return has the opposite
effect on the same accounts. Under the periodic system, the inventory and cost of
goods sold accounts are updated only periodically, but under the perpetual system,
entries that recognize a transaction's effect on these accounts occur when the revenue
from the sale is recognized.

For convenience, a sale or sales return can be recorded under the perpetual system
with a compound entry that lists all four accounts.
The general journal provides a simple, consistent format to present new information.
However, most companies would record the sale in a sales journal.

Inventory Subsidiary Ledger Accounts

Companies that use the perpetual system maintain an inventory control account and an
inventory subsidiary ledger with separate accounts for each type of item the business
sells. Whenever a transaction affects inventory, the specific item's subsidiary ledger
account is also updated. Inventory subsidiary ledger accounts usually contain separate
sets of columns for purchases, sales, and the account balance. Each set has three
columns, which are used to record the number of units, the cost of each unit, and the
total cost. The inventory‐tires account from the previous example appears below.

The numbers in the maximum and minimum fields near the upper left corner of the
account are optional control fields designed to prevent the company from having too
many or too few of the items in stock. In this example, the company purchases new tires
whenever the overall number of units in stock drops to seven or less, and the number
purchased should never cause the company's stock to exceed fifteen units.

If you study the journal entries on the subsidiary ledger account immediately previous,
you will notice that the cost of the tires sold on April 22 changes from $100 in the journal
entries to $99 in the inventory account. These examples illustrate two different cost flow
methods, so they are intended to be used for illustration purposes only. A company
must use one cost flow method consistently.

Cost Flow Methods

The cost of items remaining in inventory and the cost of goods sold are easy to
determine if purchase prices and other inventory costs never change, but price
fluctuations may force a company to make certain assumptions about which items have
sold and which items remain in inventory. There are four generally accepted methods
for assigning costs to ending inventory and cost of goods sold: specific cost; average
cost; first‐in, first‐out (FIFO); and last‐in, first‐out (LIFO). Each method is applied to the
information in the following illustrations, summarizing the activity in one inventory
subsidiary ledger account at a company named Zapp Electronics.

| January 1 | Beginning inventory–100 units @ $ 14/unit

| March 20 | Sale of 50 units
| April 10 | Purchase of 150 units @ $16/unit
| July 15 | Sale of 100 units
| September 30 | Sale of 50 units
| October 10 | Purchase of 200 units @ $ 17/unit
| December 15 | Sale of 150 units
| December 31 | Ending Inventory–100 units

The cost of goods available for sale equals the beginning value of inventory plus the
cost of goods purchased. Two purchases occurred during the year, so the cost of goods
available for sale is $ 7,200.

| | Units | | Per Unit Cost | | Total Cost

| Beginning Inventory | 100 | × | $ 14 | = | $ 1,400
| + Purchase–April 10 | 150 | × | $ 16 | = | 2,400
| + Purchase–October 10 | 200 | × | $ 17 | = | 3,400
| = Cost of Goods Available for Sale | 450 | | | | $ 7,200

Specific cost. Companies can use the specific cost method only when the purchase
date and cost of each unit in inventory is identifiable. For the most part, companies that
use this method sell a small number of expensive items, such as automobiles or
appliances.

If specially coded price tags or some other technique enables Zapp Electronics to
determine that 15 units in ending inventory were purchased on April 10 and the
remaining 85 units were purchased on October 10, then the ending value of inventory
and the cost of goods sold can be determined precisely.

| | Units | | Per Unit Cost | | Total Cost

| + Purchase–April 10 | 15 | × | $16 | = | 240
| Purchase–October 10 | 85 | × | $17 | = | 1,445
| Ending Inventory | 100 | $ 1,685 | | | $ 7,200

| Cost of Goods Available for Sale | $ 7,200

| - Ending Inventory | (1,685)
| = Cost of Goods Sold | $ 5,515

Since the specific cost of each unit is known, the resulting values for ending inventory
and cost of goods sold are not affected by whether the company uses a periodic or
perpetual system to account for inventory. The only difference between the systems is
that the value of inventory and the cost of goods sold is determined every time a sale
occurs under the perpetual system, and these amounts are calculated at the end of the
accounting period under the periodic system. Check the value found for cost of goods
sold by multiplying the 350 units that sold by their per unit cost.

| | Units | | Per Unit Cost | | Total Cost

| Beginning Inventory | 100 | × | $ 14 | = | $ 1,400
| Purchase–April 10 | 135 | × | $ 16 | = | 2,160
| Purchase–October 10 | 115 | × | $ 17 | = | 1,955
| Cost of Goods Available for Sale | 350 | | | | $5,515

Companies that sell a large number of inexpensive items generally do not track the
specific cost of each unit in inventory. Instead, they use one of the other three methods
to allocate inventoriable costs. These other methods (average cost, FIFO, and LIFO)
are built upon certain assumptions about how merchandise flows through the company,
so they are often referred to as assumed cost flow methods or cost flow
assumptions. Accounting principles do not require companies to choose a cost flow
method that approximates the actual movement of inventory items.

Average cost. Companies that use the periodic system and want to apply the same
cost to all units in an inventory account use the weighted average cost method. The
weighted average cost per unit equals the cost of goods available for sale divided by the
number of units available for sale.

For Zapp Electronics, the cost of goods available for sale is $ 7,200 and the number of
units available for sale is 450, so the weighted average cost per unit is $ 16.
The weighted average cost per unit multiplied by the number of units remaining in
inventory determines the ending value of inventory. Subtracting this amount from the
cost of goods available for sale equals the cost of goods sold.

| Cost of Goods Available for Sale | $ 7,200

| - Ending Inventory (100 × $ 16) | (1,600)
| = Cost of Goods Sold | $ 5,600

Check the value found for cost of goods sold by multiplying the 350 units that sold by
the weighted average cost per unit.

Companies that use the perpetual system and want to apply the average cost to all
units in an inventory account use the moving average method. Every time a purchase
occurs under this method, a new weighted average cost per unit is calculated and
applied to the items.

As the chart below indicates, the moving average cost per unit changes from $14.00 to
$15.50 after the purchase on April 10 and becomes $16.70 after the purchase on
October 10.

Use the final moving average cost per unit to calculate the ending value of inventory
and the cost of goods sold.

| Cost of Goods Available for Sale | $ 7,200

| - Ending Inventory (100 × $ 16.70) | (1,670)
| = Cost of Goods Sold | $ 5,530

First‐in, first‐out. The first‐in, first‐out (FIFO) method assumes the first units purchased
are the first to be sold. In other words, the last units purchased are always the ones
remaining in inventory. Using this method, Zapp Electronics assumes that all 100 units
in ending inventory were purchased on October 10.
| Cost of Goods Available for Sale | $ 7,200
| - Ending Inventory (100 × $ 17) | (1,700)
| = Cost of Goods Sold | $ 5,500

Check the value found for cost of goods sold by multiplying the 350 units that sold by
their per unit cost.

| | Units | | Per Unit Cost | | Total Cost

| Beginning Inventory | 100 | × | $ 14 | = | $ 1,400
| Purchase–April 10 | 150 | × | $ 16 | = | 2,400
| Purchase–October 10 | 100 | × | $ 17 | = | 1,700
| Cost of Goods Sold | 350 | | | | $ 5,500

The first‐in, first‐out method yields the same result whether the company uses a
periodic or perpetual system. Under the perpetual system, the first‐in, first‐out method is
applied at the time of sale. The earliest purchases on hand at the time of sale are
assumed to be sold.

Last‐in, first‐out. The last‐in, first‐out (LIFO) method assumes the last units purchased
are the first to be sold. Therefore, the first units purchased always remain in inventory.
This method usually produces different results depending on whether the company uses
a periodic or perpetual system.

If Zapp Electronics uses the last‐in, first‐out method with a periodic system, the 100
units remaining at the end of the period are assumed to be the same 100 units in
beginning inventory.

| Cost of Goods Available for Sale | $ 7,200

| - Ending Inventory (100 × $ 14) | (1,400)
| = Cost of Goods Sold | $ 5,800
Check the value found for cost of goods sold by multiplying the 350 units that sold by
their per unit cost.

| | Units | | Per Unit Cost | | Total Cost

| + Purchase–April 10 | 200 | × | $ 17 | = | 3,400
| Purchased April 10 | 150 | × | $ 16 | = | 2,400
| Cost of Goods Sold | 350 | | | | $ 5,800

If Zapp Electronics uses the last‐in, first‐out method with a perpetual system, the cost of
the last units purchased is allocated to cost of goods sold whenever a sale occurs.
Therefore, the assumption would be that the 50 units sold on March 20 came from
beginning inventory, the units sold on July 15 and September 30 were all purchased on
April 10, and the units sold on December 15 were all purchased on October 10.
Therefore ending inventory consists of 50 units from beginning inventory and 50 units
from the October 10 purchase.

| | Units | | Per Unit Cost | | Total Cost

| Beginning Inventory | 50 | × | $ 14 | = | $ 700
| Purchase–April 10 | 150 | × | $ 16 | = | 2,400
| Purchase–October 10 | 150 | × | $ 17 | = | 850
| Ending Enventory | 100 | | | | $ 1,500

| Cost of Goods Available for Sale | $ 7,200

| - Ending Inventory | (1,550)
| = Cost of Goods Sold | $ 5,650

Check the value found for cost of goods sold by multiplying the 350 units that sold by
their per unit cost.

| | Units | | Per Unit Cost | | Total Cost

| Beginning Inventory | 50 | × | $ 14 | = | $ 700
| Purchase–April 10 | 150 | × | $ 16 | = | 2,400
| Purchase–October 10 | 150 | × | $ 17 | = | 2,550
| Cost of Goods Available for Sale | 350 | | | | $5,650

Comparing the assumed cost flow methods. Although the cost of goods available for
sale is the same under each cost flow method, each method allocates costs to ending
inventory and cost of goods sold differently. Compare the values found for ending
inventory and cost of goods sold under the various assumed cost flow methods in the
previous examples.

| | Weighted Average (Periodic) | Moving Average (Perpetual) | FIFO (Periodic

or Perpetual) | LIFO (Periodic) | LIFO (Perpetual)
| Ending Inventory | $ 1,600 | $ 1,670 | $ 1,700 | $ 1,400 | $ 1,550
| Cost of Goods Sold | 5,600 | 5,530 | 5,500 | 5,800 | 5,650
| Cost of Goods Available for Sale | $ 7,200 | $ 7,200 | $ 7,200 | $ 7,200 | $ 7,200

If the cost of goods sold varies, net income varies. Less net income means a smaller tax
bill. In times of rising prices, LIFO (especially LIFO in a periodic system) produces the
lowest ending inventory value, the highest cost of goods sold, and the lowest net
income. Therefore, many companies in the United States use LIFO even if the method
does not accurately reflect the actual flow of merchandise through the company. The
Internal Revenue Service accepts LIFO as long as the same method is used for
financial reporting purposes.

Inventory Errors and Financial Statements

Income statement effects. An incorrect inventory balance causes an error in the
calculation of cost of goods sold and, therefore, an error in the calculation of gross profit
and net income. Left unchanged, the error has the opposite effect on cost of goods sold,
gross profit, and net income in the following accounting period because the first
accounting period's ending inventory is the second period's beginning inventory. The
total cost of goods sold, gross profit, and net income for the two periods will be correct,
but the allocation of these amounts between periods will be incorrect. Since financial
statement users depend upon accurate statements, care must be taken to ensure that
the inventory balance at the end of each accounting period is correct. The chart below
identifies the effect that an incorrect inventory balance has on the income statement.

| | Impact of Error on
| Error in Inventory | Cost of Goods Sold | Gross Profit | Net Income
| Ending Inventory | | |
| Understated | Overstated | Understated | Understated
| Overstated | Understated | Overstated | Overstated
| Beginning Inventory | | |
| Understated | Understated | Overstated | Overstated
| Overstated | Overstated | Understated | Understated

Balance sheet effects. An incorrect inventory balance causes the reported value of
assets and owner's equity on the balance sheet to be wrong. This error does not affect
the balance sheet in the following accounting period, assuming the company accurately
determines the inventory balance for that period.

| | Impact of Error on
| Error in Inventory | Assets = | Liabilities + | Owner's Equity
| Understated | Understated | No Effect | Understated
| Overstated | Overstated | No Effect | Overstated

Estimating Inventories
Companies sometimes need to determine the value of inventory when a physical count
is impossible or impractical. For example, a company may need to know how much
inventory was destroyed in a fire. Companies using the perpetual system simply report
the inventory account balance in such situations, but companies using the periodic
system must estimate the value of inventory. Two ways of estimating inventory levels
are the gross profit method and the retail inventory method.

Gross profit method. The gross profit method estimates the value of inventory by
applying the company's historical gross profit percentage to current‐period information
about net sales and the cost of goods available for sale. Gross profit equals net sales
minus the cost of goods sold. The gross profit margin equals gross profit divided by
net sales. If a company had net sales of $4,000,000 during the previous year and the
cost of goods sold during that year was $2,600,000, then gross profit was $1,400,000
and the gross profit margin was 35%.

| Net Sales | $ 4,000,000

| Less: Cost of Goods Sold | (2,600,000)
| Gross Profit | $ 1,400,000

If gross profit margin is 35%, then cost of goods sold is 65% of net sales.

Suppose that one month into the current fiscal year, the company decides to use the
gross profit margin from the previous year to estimate inventory. Net sales for the month
were $500,000, beginning inventory was $50,000, and purchases during the month
totaled $300,000. First, the company multiplies net sales for the month by the historical
gross profit margin to estimate gross profit.
Next, estimated gross profit is subtracted from net sales to estimate the cost of goods
sold.

| Net Sales | $ 500,000

| Gross Profit | (175,000)
| Cost of Goods Sold | $ 325,000

Alternatively, cost of goods sold may be determined by multiplying net sales by 65%
(100% – gross profit margin of 35%).

Finally, the estimated cost of goods sold is subtracted from the cost of goods available
for sale to estimate the value of inventory.

| Beginning Inventory | $ 50,000

| Purchases | 300,000
| Cost of Goods Available for Sale | 350,000
| Less: Cost of Goods Sold | (325,000)
| Ending Inventory | $ 25,000

The gross profit method produces a reasonably accurate result as long as the historical
gross profit margin still applies to the current period. However, increasing competition,
new market conditions, and other factors may cause the historical gross profit margin to
change over time.

Retail inventory method. Retail businesses track both the cost and retail sales price of
inventory. This information provides another way to estimate ending inventory. Suppose
a retail store wants to estimate the cost of ending inventory using the information shown
below.

| | Cost | Retail
| Beginning Inventory | $ 49,000 | 80,000
| Purchases | 209,000 | 350,000
| Goods Available for Sale | $ 258,000 | 430,000
| Net Sales | | $ 400,000

The first step is to calculate the retail value of ending inventory by subtracting net sales
from the retail value of goods available for sale.
| | Cost | Retail
| Beginning Inventory | $ 49,000 | 80,000
| Purchases | 209,000 | 350,000
| Goods Available for Sale | $ 258,000 | 430,000
| Net Sales | | 400,000
| Ending Inventory (Retail) | | $ 30,000

Next, the cost‐to‐retail ratio is calculated by dividing the cost of goods available for sale
by the retail value of goods available for sale.

| | Cost | Retail
| Beginning Inventory | $ 49,000 | 80,000
| Purchases | 209,000 | 350,000
| Goods Available for Sale | $ 258,000 | 430,000
| Net Sales | | 400,000
| Ending Inventory (Retail) | | $ 30,000
| Cost to Retail Ratio ($ 258,000 + $ 430,000 = 60%) | |

Then, the estimated cost of ending inventory is found by multiplying the retail value of
ending inventory by the cost‐to‐retail ratio.

| | Cost | Retail
| Beginning Inventory | $ 49,000 | 80,000
| Purchases | 209,000 | 350,000
| Goods Available for Sale | $ 258,000 | 430,000
| Net Sales | | 400,000
| Ending Inventory (Retail) | | $ 30,000
| Cost to Retail Ratio ($ 258,000 + $ 430,000 = 60%) | |
| Ending Inventory (Cost) ($ 30,000 × 60%) | | $ 18,000

One limitation of the retail inventory method is that a store's cost‐to‐retail ratio may vary
significantly from one type of item to another, but the calculation simply uses an
average ratio. If the items that actually sold have a cost‐to‐retail ratio that differs
significantly from the ratio used in the calculation, the estimate will be inaccurate.