Inventories and the Cost of Goods Sold

Inventories and the Cost of Goods Sold

• Inventory accounting is challenging due to changing prices of items. Records must be kept of items for sale and their purchase and sale prices.
• How inventory and the cost of goods sold are accounted for is reviewed.

Inventory Defined

• Inventory is goods owned and held for sale to customers in a merchandising firm. It becomes cash within the operating cycle.
• Inventory is listed after accounts receivable, because it is closer to becoming cash.

The Flow of Inventory Costs

• Inventory is a nonfinancial asset shown on the balance sheet at cost. Costs are transferred to the cost of goods sold on the income statement when items are sold.
• In a perpetual inventory system entries parallel the flow of costs. Costs are added when merchandise is purchased and removed when sold.
• Inventory and the cost of goods sold valuation is of critical importance to managers/external users.
• Inventory is a company's largest asset, and the cost of goods sold is its most significant expense. These accounts affect financial statement subtotals/ratios.
• Inventory and the cost of goods sold can be priced/measured in a few different ways under generally accepted accounting principles.

Which Unit Was Sold?

• Merchandise purchases are recorded the same way under each inventory valuation method. Methods differ on which costs should be removed from 'Inventory' when merchandise is sold.
• A new cost layer is created whenever identical units of inventory are acquired at a different per-unit cost. As each cost layer sells, the layer is eliminated from inventory.
• When identical inventory units have different unit costs, a question arises as to which cost should be used in measuring the cost of goods sold.

Specific Identification

• Accountants may use specific identification or adopt a cost flow assumption to answer inventory costing questions. An approach, once selected, must be applied consistently.
• Actual merchandise unit costs must be determined from accounting records to use specific identification.
• Using specific identification, the inventory cost is the cost of goods sold.

Cost Flow Assumptions

• It is not necessary to use the specific identification method if the inventory items are homogeneous. The seller can follow a cost flow assumption, also called a "flow assumption."
• "Flow assumption" is particularly common where a company purchased a large number of identical inventory that was purchased at different prices.
• When a cost flow assumption is in use, the seller assumes the order in which units are withdrawn from inventory, regardless of order. There are three cost-flow assumptions in widespread use:

Average Cost

• All merchandise is valued at the average per-unit cost. Units sold and the units remaining in inventory. The units are assumed to be withdrawn randomly.
• When the average-cost method is in use, the average cost of all units in inventory is computed after every purchase. This average cost is computed by dividing the total cost of goods available for sale by the number of units in inventory. Because the average cost may change following each purchase, this method also is called the moving average method when a perpetual inventory system is used.
• All items are assigned the same per-unit cost, and the cost of goods sold always is based on the current average unit cost.

First-In, First-Out (FIFO)

• FIFO assumes that the goods sold are the first units purchased. Thus the remaining inventory includes the most recent purchases.

Last-In, First-Out (LIFO)

• LIFO means the units sold are the most recently acquired. Therefore, any remaining inventory would consist of the earliest purchases.
• The flow assumption that is chosen doesn't have to match the company's merchandise's actual physical movement. When the merchandise units are identical, it doesn't matter which units are delivered.

Cost Flow Assumption

• Using a cost flow assumption eliminates the need to identify each unit sold separately, and then lookup its actual cost.
• Cost flow assumptions provide reliable and useful measurements of the cost of goods sold. The costs are applied consistently to all sales of that particular merchandise type.
• In the balance sheet inventory, inventory is valued at recent purchase costs in FIFO. For LIFO, the remaining goods are valued at the oldest acquisition costs.

Evaluation of the Methods

• Financial statements and income tax returns must make use of each of the three cost flow assumption. It isn't necessary that the merchandise's physical flow coincide with the cost flow assumption. Different flow assumptions may be used for different inventory types.
• The only requirement for using a flow assumption is that the units should be homogenous in nature. Only the specific identification method can match a sale with the cost of goods sold.
• Each inventory valuation method has advantages and shortcomings; in the end, the inventory valuation method selection should be a management decision. All financial statement methods should be disclosed.

Specific Identification method

• The specific identification method is best for inventories with low-volume and high-priced items. It parallels the merchandise's physical flow.
• Specific identification assigns actual purchase pricing to merchandise in inventory and sold. However, it may produce misleading implications in value, and there's potential to manipulate financial data.

Average Cost

• Only under average-cost method does identical items share accounting values.
• A shortcoming of the average-cost method results from how costs are averaged together, and this conceals the variance in the inventory that occurs between older costs and current replacement costs.

First-In, First Out (FIFO)

• A key part of the FIFO method involves the transfer of older purchase costs to the cost of the good sold. At the same time, relatively new costs remain among inventory.
• In an inflationary economy, purchase costs are usually increasing, meaning FIFO assigns lower, older costs to the cost of the goods sold and newer costs to inventory.
• FIFO usually causes an overstatement of a business's profitability. Revenue is based on current markets which means that offsetting this revenue with older costs may result in overstated gross profits consistently.
• The major benefit of FIFO involves how in the balance sheet, inventory can be valued at recent purchase costs, which more closely matches replacement values.

Last-In, First-Out

• In a LIFO system, cost assignments tend to reflect the most current values. This is related to the concept of cost having more importance than items' physical flow.
• By using the LIFO system, current sales revenue is offset with the current costs of the merchandise sold.

Shortcoming of LIFO

• The valuation of any LIFO-based inventory is set in the valuation of the company's oldest acquisition costs. If a company has existed in business for an extensive time, these costs may understate the value of the current inventory. Therefore, companies of this nature should also disclose the current replacement cost of their inventory.
• When inventory replacement costs steadily rise, LIFO has the effect of ensuring the lowest value of inventory. It also helps improve the measurement of net income.
• This can cause LIFO to become the most conservative of inventory pricing methods. Additionally, it can cause FIFO to become the least conservative.
• LIFO helps companies to improve, and even lessen income tax obligations related to their income statements. For a corporation to use the LIFO method in its income tax returns, it must use LIFO in its financial statements.

Do Inventory Methods Really Affect Performance

• An inventory valuation method affects the allocation of costs between the Inventory account and the Cost of Goods Sold account. Outside of income taxes, differences in reported profitability only exist on paper, but the inventory method affects income taxes owned and can increase profitability.

The Principle of Consistency

• Consistency is a basic concept underlying reliable financial statements. It enforces that a company stick with a chosen accounting method. The change has to be explained with the effects disclosed.

Just-in-Time (JIT) Inventory Systems

• In the JIT system raw materials and component parts arrive just in time for use in the manufacturing process, often within a few hours of the time scheduled for use.
• Another just-in-time concept helps to complete manufacturing just in time in order to ship finished goods ASAP.

Taking a Physical Inventory

• The concept of lowering inventories involves working to offer clients a wide array of different options - which translates to a bigger inventory.
• A key part of an accounting system involves providing management with useful information about both the efficacy, as well as the potential inefficacy of a given operation.
• A business needs to make a complete physical tally of all their merchandise on hand at least one time per year.

Recording Shrinkage Losses

• In most cases, the year-end physical count of inventory shows shortages/damaged merchandise. The costs of any damaged/missing units are removed from inventory data.
• A physical inventory should be performed near the end of the year so that any shrinkage loss, is reflected in financial information.

The Lower-of-Cost-or-Market(LCM) Rule;

• It can be said that a resource is only worth up to the amount that it costs to replace that resource in open markets. As such inventory is traditionally calculated in a balance sheet based on the lower of its cost or market value and this accounting method is referred to the lower-of-cost-or-market (LCM) rule.
• The rule should be used with a cost flow assumption and applied on the basis of individual items and major categories. In an inflationary economy the lower of these amounts ends up being cost for companies that operate with LIFO.

The Year-End Cutoff of Transactions

• Making a proper cutoff of transactions amounts to ensuring that all transactions that occur related to year-end, are recorded under the correct accounting period.
• A proper cutoff involves the cost of all merchandise sold through year's end being removed from inventory and being charged to the Cost of Goods Sold, and not listed in year-end physical count.
• Making a proper cutoff can be difficult if sales are occurring under merchandise is being tallied.*

Matching Revenue and the Cost of Goods Sold

• Accountants need to ensure that the revenue from sales, and the cost of goods sold, line up within the accounting records under the same period.

Goods in transit

• Record a sale when the title to the merchandise transfers to the buyer. Sales should be recorded when ownership of the merchandise is transferred. Questions on ownership may arise when goods are in transit.
• Many companies ignore these distinctions, because the amount of merchandise during transit isn't impactful in dollar amount. It's convenient to record all purchases once they arrive, and sales upon shipping.

Periodic Inventory Systems

• With the arrival of technology perpetual inventory systems make this easier for large businesses.
• In a periodic inventory system, cost of stock purchased that year is debited into purchases account and the amount determined debit inventory account or to recognize the cost of goods sold. The inventory at hand and the cost are not figured out until the end of year.
• Determining the costs for year-end inventory entails counting what stock is on deck, and then setting a price for it.

Applying Flow Assumptions in a Periodic System

• Emphasis on the costs transferred from inventory to the cost of goods sold in perpetual inventory systems has been highlighted . There is now a shift to inventory at the end of a period. It is essential to have this be accurate.
• LIFO, FIFO and even what is sold overall, can look different in a periodic inventory system. This has had many implications due to the changes and even fluctuations that often result from LIFO accounting. The costs are more or less equivalent under LIFO and average for period.
• Periodic LIFO restates costs for the year with adjustments to perpetual reports. While both methods end up showing the effect more or less equivalent.
• The LIFO usually ends up higher.*

Receiving Maximum Tax Benefit from the LIFO Method

• Many businesses that operate under perpetual inventory, use LIFO for the year and adjust it to reflect what can be obtained from any yearly operations. This adjustment comes via any debits/credits to inventory and or offsetting entries for the cost of the goods sold.
• When a company determines its values and costs, in a periodic way, it may determine much lower unit costs than it does otherwise

Pricing the Year-End Inventory by Computer

• If computer-based accounts are kept the value of any and all end-loading inventory, can be determined automatically and based on flow assumption.

International financial reporting standards

• There is one important caveat. Global standards are different and may or may not recognize using certain inventory and cost valuation, standards.
• Another involves not permitting some industries, like retailers to account for stock using methods, such as last in first out. If this were to occur both global standards and standards out of the US, could apply.
• LIFO is not considered an acceptable procedure in some countries. Where the cost of inventories differ between the U.S. and international standards one item may be written down with cost recovery.

Importance of an Accurate Valuation of Inventory

• Of the most important liquid assets, inventory continues to be one of the greatest. It affects all balance sheet measurements.

Effects of Errors in Valuing Ending Inventory

• If some items of merchandise from within an entire inventory get overlooked during the year-end count it will become understated, by that number. This further will cause the goods sold amount to become overstated as well.

Effects of Inventory Errors

• Over the course of each of the accounting periods, this action has the effect of not only influencing the statements from within that accounting period - the action will affect the subsequent one.

Techniques for Estimating the Cost of Goods Sold and the Ending Inventory

• A more accurate assessment can be maintained if accounting for the ending inventory, in addition to cost of the goods sold can be estimated for each such period. The main approach involves what is known as the gross profit method.
• By knowing each rate, inventories can be assessed via the gross profit method and the percentages used. An exact level of the gross profit involves determining what can best offset the income.

The Retail Method

• The retail method for estimating cost functions very much like the gross income method. For a good cost level it's important to ascertain each appropriate percentage. The process approximates evaluation by considering the retail sales price.

Inventory Systems

• Companies can use a multitude of methods for inventory data that might involve the inventory valuation to help generate reliable documentation.

Inventory Turnover

• As an asset, inventory is usually the largest of the company's current assets. It is defined via a specific ratio - turnover. This turnover ratio has several uses.
• High turnover rates usually translate to a company's efficient sales rates
• Lower turnover can mean more efficient sales rates.

Accounting Methods Can Affect Financial Ratios

• Accounting methods may also impact income, such as when Alpha Company uses the LIFPO for its income statements.

Concluding remarks

• The range of methods shows cost flows being an indirect pattern to movement of selling items. The options mean that the method can impact a company's financial status with how the method affects taxes.