CHAPTER 1️⃣ : Inventory Management Basics

Classifying Inventory

• Merchandising companies use one inventory classification: inventory.
• Manufacturing companies use three classifications: raw materials, work in process, and finished goods.
• Regardless of classification, companies report all inventories as current assets on the statement of financial position.

Importance of Inventories

• Inventories ensure businesses meet customer demand without delays.
• Effective inventory management minimizes holding costs and reduces waste.
• Having the right products available enhances customer satisfaction and loyalty.
• Inventories provide data for analyzing market trends and consumer behavior, aiding in demand forecasting and strategy adjustment.
• A well-managed inventory system gives businesses a competitive advantage.
• Maintaining inventories buffers against supply chain disruptions.
• Inventories are assets, contributing to financial health and improving liquidity.

Determining Inventory Quantities

• Determining inventory involves taking a physical inventory of goods on hand and determining ownership of goods.
• Physical inventory is taken to check accuracy of records and to determine lost inventory amounts in a perpetual system.
• Physical inventory is taken to determine inventory on hand and cost of goods sold for the period in a periodic system.
• Taking a physical inventory involves counting, weighting, or measuring each kind of inventory on hand.
• Companies often take inventory when the business is closed or slow, or at the end of the accounting period.
• Goods in transit are included in the inventory of the company with legal title, determined by the terms of sale.
• In FOB Shipping Point, the goods' ownership transfers to the buyer when the public carrier accepts them from the seller, and the buyer pays the freight costs.
• In FOB Destination, the ownership the goods remains with the seller until the goods reach the buyer, and the Seller pays freight costs.
• In consignments, the consignor ships goods to the consignee, who acts as the consignor's agent to sell the goods without taking ownership.

Inventory Valuation Methods

• Inventory is accounted for at cost, including all expenditures to acquire goods and prepare them for sale.
• Unit costs are applied to quantities to compute the total cost of inventory and CGS using specific identification, FIFO, or average-cost methods.

Specific Identification

• Specific identification is the method of physically tracking items still on hand to arrive at the total cost of the ending inventory/
• The method is rarely used because it could be used to manipulate net income

Cost Flow Assumptions

• Under IFRS, two assumed cost flow methods are permitted: FIFO (First-In, First-Out) and weighted average.
• Cost flow does not need to be consistent with the physical movement of goods.
• Last-In, First-Out (LIFO) cost flow cannot be used.

First-In, First-Out (FIFO)

• The first costs are recognized in determining cost of goods sold.
• Often parallels the actual physical flow of merchandise.
• Ending inventory is obtained by taking the unit cost of the most recent purchase, working backward until all units of inventory have been costed.
• If prices are rising, CGS is low, and net income and ending inventory are high because inventory is most recent price or the highest price

Periodic Inventory System

• With the Periodic Inventory System using FIFO, Total units available for sale consist of beginning inventory plus each purchase
• The units in ending inventory consists of products purchased most recently.
• Ending inventory - the total costs of the most recent product.
• Cost of goods available for sale less the ending inventory gets cost of goods sold.

Average-Cost Method

• The weighted-average unit cost is weighted-average unit cost incurred.
• The weighted-average unit cost is applied to the units on hand to determine cost of the ending inventory.

Average-Cost Method Calculations for Periodic Inventory System

• Divide the cost of goods available for sale by the total cost, for cost per unit; this applies to both the inventory and cost of goods sold.

LIFO Method

• Last-In/First Out (LIFO) is not a financial reporting method under IFRS.
• Assumes latest units purchased are first to be sold.
• Coincides with actual flow of merchandise only when goods such as coal are stored in piles.
• If using LIFO in rising prices, companies have highest CGS and lowest net income.

Financial Statement and Tax Effects

• Accepted methods are average cost and FIFO.
• adidas (DEU) and Lenovo (CHN) use average-cost, while Syngenta Group (CHE) and Nokia (FIN) use FIFO.
• 60% of IFRS companies use average-cost, 40% use FIFO, and 23% use both.

DO IT! Example

• Determining cost of goods sold under periodic system:
  • Determine the cost of goods sold during the period under a periodic inventory system using (a) the FIFO method and (b) the average-cost method.

Income Statement Effects

• In rising prices situations, FIFO and LIFO inventory methods are used: -FIFO: Inventory and net income are higher. -Average-cost: Lower income taxes because on lower net income.

Consistent Cost Flow Methods

• Cost Flow Methods should be used consistently, to enhance comparability.
• Although consistency is preferred, a company may change its inventory costing method.

Lower-of-Cost-or-Net Realizable Value

• Net realizable value is the amount a company expects to realize (receive from the sale of inventory).
• Companies must "write down" the inventory to its net realizable value when the value of inventory is lower than its cost.

Inventory Errors

• Inventory errors can occur from failure to count or price inventory correctly, or from not properly recognizing the transfer of legal title to goods in transit.
• Errors affect both the income statement and statement of financial position.

Income Statement Effects of Errors

• Inventory errors affect the computation of cost of goods sold and net income in two periods.
• An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.
• The total net income is correct over the two years because the errors offset each other.
• Ending inventory depends entirely on the accuracy of taking and costing the inventory.

Statement of Financial Position Effects of Errors

• Effect of inventory errors on the statement of financial position is determined by using the basic accounting equation: Assets = Liabilities + Equity.

Statement Presentation and Analysis of Financial Position

• Inventory classified as current asset in the statement of financial position and the costs of goods sold are subtracted from total sales.

Disclosure of information

• There should be disclosure of major inventory classifications, basis of accounting (cost or LCNRV), and costing method (specific identification, FIFO, or average-cost).

Inventory Analysis

• Inventory management is a double-edged sword.
• High inventory levels may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage).
• Low inventory levels may lead to stock-outs and lost sales.
• Inventory turnover measures the number of times on average the inventory is sold during the period.
• Days in inventory measures the average number of days inventory is held.

Estimating Inventory

• Two circumstances explain why companies sometimes estimate inventories:
  • A casualty such as fire, flood, or earthquake may make it impossible to take a physical inventory.
  • Managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually. Methods of inventory estimation:
  • the gross profit method
  • the retail inventory.

Gross Profit Method

• Estimating inventories using the gross profit method with the formula net sales X gross profit percentage.

Retail Inventory Method

• Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.

U.S. GAAP

• LIFO is prohibited under IFRS

Specific Identification Methods

• The method must be used under IFRS if the inventory items are not interchangeable.