Accounting for Inventories Inventory
ADMS 2500 Nov.04.2011 Module 9- Accounting for Inventories Inventory - goods held by retail or wholesale business called merchandise inventory - goods held for sale by manufacturing called finished inventory - inventories of manufacturing also include raw materials and work in progress inventory - significant asset - inventory accounting for merchandisers is the firm that buys the finished products to sell to their customers The Need for Inventories - need to decide optimal level of inventory to carry - firm can sell more goods then it purchases or produces only if it has a beginning inventory Inventory Valuation - accounting correctly for inventories is important in determining net income - changing dollar amount for ending inventories changes net income dollar for dollar - dollar amount of inventory dependent on: ~ quantity ~ price quantity x price = goods on hand at specific time - ‘taking’ inventory means: (1) counting the items involved (2) pricing each item (3) summing the amounts
Effect of Inventory Errors - accounting inventories effects income measurement by assigning costs to different accounting periods as expenses - total cost of goods for sale during the period must be allocated between current period’s usage (COGS, an expense) and amounts carried forward (end of period inventory, an asset) - overstating/understating inventory overstates/understates income
Complexities of Inventory Accounting - major problems in inventory accounting arise because the unit acquisition costs of inventory items fluctuate over time - variation in values of inventories result only from the changes of quantities Specific Identification and the Need for a Cost Flow Assumption - individual items sold can sometimes be matched with specific purchases - cost can be marked on the unit or on its customer, or the unit can be traced back to its purchase invoice or receipt - accounting solves issue of tracing cost flow not physical flow of goods - inventory costing problem arises because of two unknowns in the inventory equation:
- question is to compute amounts for the units in ending inventory based on: most recent costs, oldest costs, average costs or some other cost Cost Flow Assumptions - accountant computes acquisition cost applicable to the units remaining in the inventory - three cost flow assumptions: (1) first-in, first-out (FIFO): oldest costs are flowed to cost of goods sold, most recent costs are used to value inventory (2) last-in, first-out (LIFO): most recent costs are flowed to cost of goods sold, oldest costs used to value inventory (3) weighted average: both units sold and units remaining in inventory are priced at the weighted average- dollar value of goods available for sale/unit available for sale
First-in, First-out (FIFO) - assigns cost of earliest units acquired to the withdrawals and the cost of the most recent acquisitions to the ending inventory - the cost flow assumes that the oldest materials and goods are used first - cost flow assumption conforms to good business practice in managing physical flows, especially in the items that deteriorate and become obsolete Ex: TV set 1 is assumed to be old; whereas TV sets 2 and 3 are assumed to remain in inventory Weighted Average - average costs of all goods available for sale during the accounting period including the cost applicable to beginning inventory must be calculated - applied to units sold and those on hand at the total dollar amount at the end of the month Ex: if TV set sold on the last day of the accounting period than 280 [=t/3 x (250 + 290 + 300)] cost of goods sold is $280 and ending inventory is $560 = 2 x 280 - only works in a periodic inventory system - if perpetual system is used, must use moving average, where units are recognized as coming and going and must redo the calculations after every transaction Last-in, First-out (LIFO) - assigns cost of latest units acquired to the withdrawals and the cost of the oldest units to the ending inventory Ex: if TV set sold on last accounting period when all three sets are available, the $300 cost of all three is assumed to leave; whereas the cost of TV set 1 and 2 are assumed to remain in inventory - period of consistently rising prices (inflation) LIFO results in a higher cost of goods sold and lower reported periodic income then FIFO or FIFO weighted average - choosing one method over the other results in different reported income - difference in income reported evens out over time - ‘timing difference’ refers to an accounting policy choice that affects when any particular income sream actually reaches the income statement Comparison of Cost Flow Assumptions - FIFO gives balances that are closest to current cost because latest purchases dominate ending inventory amounts - FIFO leads to highest reported net income when prices are high and smallest when low - LIFO inflationary environment produces balance sheet figures usually much lower than current costs - LIFO’s cost of goods sold closely resembles current costs - LIFO leads to smallest net income when prices rise and largest when falling - weighted average more like FIFO then LIFO
Timing of Cost of Goods Sold Computations - timing of purchases and sales transactions effect computations of ending inventory and COGS - in periodic inventory system records do not have detailed, dated purchase and sales information necessary to determine ‘most recent’ cost, assumes all sales occur on the last day of the accounting period
Choosing Between Periodic and Perpetual Inventory Systems - periodic system reduces bookkeeping costs and fewer accounting transactions, could cost more in the long run - perpetual system helps keep up-to-date information on quantities and: ~ being ‘out-of-stock’ may lead to costly consequences ~ physical stock taking could interfere with sales ~ purchasing systems depend on accurate ‘on hand’ information ~ items are susceptible to theft and shrinkage reports are necessary ~ technical expertise and support is available to manage a sophisticated accounting system - cost of perpetual inventories decline as cost of record keeping with computers decline and users therefore begin to increase Estimating Inventory Values When the Periodic Method is Used - end of periodic period where financial statements are drawn up estimates regarding ending inventory and COGS can be estimated through gross profit and retail method - businesses mark up the cost of similar kinds of merchandise by a relatively constant percentage, method called gross profit method
- cost to retail percentage can be used to find the cost of physical inventory taken at retail prices (units x selling price) Ex: merchandise on hand totaling $940,000 with 60% cost would be $564,000, the accuracy of this depends on the assumption that the ending inventory has the same mix of products did the original merchandise Generally Accepted Accounting Basis for Inventory: Lower of Cost and Market - accounting uses historical cost basis for most assets - ‘market value’ can change because of: ~ price changes for type of inventory ~ physical deterioration of particular item so GAAP prefers to use the lower of cost - period of inflation market value might be higher than acquisition costs, so valuation at cost and the lower of cost and market usually gives the same valuation - recoveries are recorded as gains
Other Basis for Valuing Inventory - manufacturing firms usually use standard cost system for internal performance measurement and control - standard cost is a predetermined estimate of what items of manufactured inventory should costs - studies of past and estimated future cost data provide the basis for standard cost - current cost basis values units in inventory at a current market price - when inventories stated at current market price, gains and losses from changes in prices are recognized during the holding period that elapses between acquisition (or production) and the time of sale - because of measurement uncertainties current costs are used for supplemental reporting, but lower acquisition cost and market is used for financial statement reporting
Effect of Inventory Errors - accounting inventories effects income measurement by assigning costs to different accounting periods as expenses - total cost of goods for sale during the period must be allocated between current period’s usage (COGS, an expense) and amounts carried forward (end of period inventory, an asset) - overstating/understating inventory overstates/understates income
Complexities of Inventory Accounting - major problems in inventory accounting arise because the unit acquisition costs of inventory items fluctuate over time - variation in values of inventories result only from the changes of quantities Specific Identification and the Need for a Cost Flow Assumption - individual items sold can sometimes be matched with specific purchases - cost can be marked on the unit or on its customer, or the unit can be traced back to its purchase invoice or receipt - accounting solves issue of tracing cost flow not physical flow of goods - inventory costing problem arises because of two unknowns in the inventory equation:
- question is to compute amounts for the units in ending inventory based on: most recent costs, oldest costs, average costs or some other cost Cost Flow Assumptions - accountant computes acquisition cost applicable to the units remaining in the inventory - three cost flow assumptions: (1) first-in, first-out (FIFO): oldest costs are flowed to cost of goods sold, most recent costs are used to value inventory (2) last-in, first-out (LIFO): most recent costs are flowed to cost of goods sold, oldest costs used to value inventory (3) weighted average: both units sold and units remaining in inventory are priced at the weighted average- dollar value of goods available for sale/unit available for sale
First-in, First-out (FIFO) - assigns cost of earliest units acquired to the withdrawals and the cost of the most recent acquisitions to the ending inventory - the cost flow assumes that the oldest materials and goods are used first - cost flow assumption conforms to good business practice in managing physical flows, especially in the items that deteriorate and become obsolete Ex: TV set 1 is assumed to be old; whereas TV sets 2 and 3 are assumed to remain in inventory Weighted Average - average costs of all goods available for sale during the accounting period including the cost applicable to beginning inventory must be calculated - applied to units sold and those on hand at the total dollar amount at the end of the month Ex: if TV set sold on the last day of the accounting period than 280 [=t/3 x (250 + 290 + 300)] cost of goods sold is $280 and ending inventory is $560 = 2 x 280 - only works in a periodic inventory system - if perpetual system is used, must use moving average, where units are recognized as coming and going and must redo the calculations after every transaction Last-in, First-out (LIFO) - assigns cost of latest units acquired to the withdrawals and the cost of the oldest units to the ending inventory Ex: if TV set sold on last accounting period when all three sets are available, the $300 cost of all three is assumed to leave; whereas the cost of TV set 1 and 2 are assumed to remain in inventory - period of consistently rising prices (inflation) LIFO results in a higher cost of goods sold and lower reported periodic income then FIFO or FIFO weighted average - choosing one method over the other results in different reported income - difference in income reported evens out over time - ‘timing difference’ refers to an accounting policy choice that affects when any particular income sream actually reaches the income statement Comparison of Cost Flow Assumptions - FIFO gives balances that are closest to current cost because latest purchases dominate ending inventory amounts - FIFO leads to highest reported net income when prices are high and smallest when low - LIFO inflationary environment produces balance sheet figures usually much lower than current costs - LIFO’s cost of goods sold closely resembles current costs - LIFO leads to smallest net income when prices rise and largest when falling - weighted average more like FIFO then LIFO
Timing of Cost of Goods Sold Computations - timing of purchases and sales transactions effect computations of ending inventory and COGS - in periodic inventory system records do not have detailed, dated purchase and sales information necessary to determine ‘most recent’ cost, assumes all sales occur on the last day of the accounting period
Choosing Between Periodic and Perpetual Inventory Systems - periodic system reduces bookkeeping costs and fewer accounting transactions, could cost more in the long run - perpetual system helps keep up-to-date information on quantities and: ~ being ‘out-of-stock’ may lead to costly consequences ~ physical stock taking could interfere with sales ~ purchasing systems depend on accurate ‘on hand’ information ~ items are susceptible to theft and shrinkage reports are necessary ~ technical expertise and support is available to manage a sophisticated accounting system - cost of perpetual inventories decline as cost of record keeping with computers decline and users therefore begin to increase Estimating Inventory Values When the Periodic Method is Used - end of periodic period where financial statements are drawn up estimates regarding ending inventory and COGS can be estimated through gross profit and retail method - businesses mark up the cost of similar kinds of merchandise by a relatively constant percentage, method called gross profit method
- cost to retail percentage can be used to find the cost of physical inventory taken at retail prices (units x selling price) Ex: merchandise on hand totaling $940,000 with 60% cost would be $564,000, the accuracy of this depends on the assumption that the ending inventory has the same mix of products did the original merchandise Generally Accepted Accounting Basis for Inventory: Lower of Cost and Market - accounting uses historical cost basis for most assets - ‘market value’ can change because of: ~ price changes for type of inventory ~ physical deterioration of particular item so GAAP prefers to use the lower of cost - period of inflation market value might be higher than acquisition costs, so valuation at cost and the lower of cost and market usually gives the same valuation - recoveries are recorded as gains
Other Basis for Valuing Inventory - manufacturing firms usually use standard cost system for internal performance measurement and control - standard cost is a predetermined estimate of what items of manufactured inventory should costs - studies of past and estimated future cost data provide the basis for standard cost - current cost basis values units in inventory at a current market price - when inventories stated at current market price, gains and losses from changes in prices are recognized during the holding period that elapses between acquisition (or production) and the time of sale - because of measurement uncertainties current costs are used for supplemental reporting, but lower acquisition cost and market is used for financial statement reporting
