Understanding Inventory Classification

Classifying Inventory

• Merchandising companies have one inventory classification: Inventory.
• Manufacturing companies have three inventory classifications: Raw Materials, Work in Process, and Finished Goods.
• Regardless of classification, firms report inventories under Current Assets on the statement of financial position.

Importance of Inventories

• Inventories help meet customer demand without delays, streamlining operations.
• Effective inventory management minimizes holding costs and reduces waste, optimizing purchasing strategies.
• Maintaining inventories decreases stockouts, ensuring customers find desired goods.
• Inventories can give crucial data for analyzing market trends and consumer behavior, aiding in demand forecasting.
• A well-managed inventory system can set a business apart, helping companies quickly adapt to market changes.
• Maintaining inventories can act as a buffer against supply chain disruptions and helps to maintain the business continuity.
• Inventories are considered an asset on the balance sheet, which can help improve liquidity and aid investment opportunities.

Determining Inventory Quantities

• Determining the correct inventory quantities involves taking a physical inventory of goods on hand and determining the ownership of goods.
• Physical inventory: Taking physical inventory involves counting, weighing, or measuring each kind of inventory on hand as often as is sensible and practical for the business.
• Companies often "take inventory" when the business is closed or business is slow, and at the end of the accounting period.
• Goods in transit should be included in the inventory of the company that has legal title to the goods as determined by the terms of sale.
• In FOB Shipping Point, the ownership of goods passes to the buyer when the public carrier accepts the goods from the seller and the Buyer pays freight costs.
• In FOB Destination, ownership of the goods remains with the seller untill the goods reach the buyer, and the Seller pays freight costs.
• Goods in transit should be included in the inventory of the buyer when the terms of sale are FOB shipping point.
• Consigned goods are held by one party (consignee) who tries to sell them for another party (consignor) for a fee, without taking ownership.

Inventory Valuation

• Inventory is accounted for at cost, including all expenditures necessary to acquire goods and place them in a condition ready for sale.
• Unit costs are applied to quantities to compute the total cost of the inventory and the cost of goods sold.
• Cost Flow assumed to make inventory valuations include Specific Identification, First-In, First-Out (FIFO) and Average-Cost.

Specific Identification

• Actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory.
• Practice is relatively rare, and most companies make assumptions (cost flow assumptions) about which units were sold

Cost Flow Assumptions and IFRS

• Under IFRS, there are two assumed cost flow methods: First-in, first-out (FIFO) and Average-cost.
• Cost flow doesn't have to be consistent with the physical movement of the goods.
• The 3rd cost flow assumption of Last-in First –out(LIFO) has been omitted by IFRS

FIFO (First-In, First-Out)

• Cost of the earliest goods purchased are the first to be recognized in determining cost of goods sold.
• FIFO often parallels actual physical flow of merchandise.
• Companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.
• In a periodic system: Price is rising, the low CGS translates to a higher Net income, as the ending Inventory has a more recent (ie. higher) price.

Average Cost

• Allocates the cost of goods available for sale based on the weighted-average unit cost incurred.
• Applies weighted-average unit cost to the units on hand to determine the cost of the ending inventory.

LIFO (Last-In, First-Out)

• Not permitted for financial reporting purposes by IFRS, but often used in US GAAP.
• Assumes latest goods purchased are the first to be sold.
• Seldom coincides with actual physical flow of merchandise, except for goods stored in piles, such as coal or hay.
• Has the highest Cost of Goods Sold (CGS) but Lowest Net Income, because the ending Inventory reflects older costs.

Financial Statement and Tax Effects

• Both of the two inventory cost flow assumptions are acceptable for use.
• Adidas (DEU) and Lenovo (CHN) use the average-cost method, whereas Syngenta Group (CHE) and Nokia (FIN) use FIFO.
• Approximately 60% of IFRS companies use the average-cost method, 40% use FIFO, and 23% use both for different parts of their inventory.
• In periods of rising prices, average-cost produces consistently lower net incomes than FIFO.

Statement of Financial Position Effects:

• A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost.
• A major shortcoming of the average-cost method is that in a period of inflation, the costs allocated to ending inventory may be understated in terms of current cost.

Tax Effects:

• Both inventory and net income are higher when companies use FIFO in a period of inflation.
• Average-cost results in lower income taxes (because of lower net income) during times of rising prices.

Consistency in Method Selection

• Inventory valuation method 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

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

Inventory Errors

• Common causes include failure to count or price inventory correctly and/or not properly recognizing the transfer of legal title to goods in transit.
• Inventory errors affect both the income statement and statement of financial position.

Income Statement

• An error in ending inventory of the current period has a reverse effect on net income of the next accounting period.
• Over the two years, the total net income is correct because the errors offset each other.
• Ending inventory depends entirely on the accuracy of taking and costing the inventory. Ending / Beginning Inventory error overstatement / understatement: Net Income is Overstated and Goods sold are Understated Understatement / Overstatement : Net Income is Understated and Goods sold are Overstated

Statement of Financial Position Effects

• Inventory errors effect the basic account equation : Assets = Liabilities + Equity
  • Ending Inventory overstated leads to Assets and Equity Overstated
  • Ending Inventory understated leads to Assets and Equity Understated

Statement Presentation

• Inventory is classified as a current asset on the Statement of Financial Position.
• On the Income Statement - the cost of goods sold is subtracted from sales.
• Disclosures include major inventory classifications, the basis of accounting (cost or LCNRV), and costing methods (specific identification, FIFO, or average-cost).

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: Cost of Goods Sold / Average Inventory
• Days in inventory measures the average number of days inventory is held: Days in Year (365) / Inventory Turnover

Estimating Inventories

• Two circumstances explain why companies sometimes estimate inventories, as a casualty occurs such as damage due to fire damage etc or monthly and quarterly financial statements desired.
• Estimating inventories may be necessary on a periodic inventory system because of the absence of perpetual inventory records.

Gross Profit Method Estimating

• Estimation of the cost of ending inventory by applying a gross profit rate to net sales (net sales X gross profit percentage )
• Net Sales minus Estimated Gross profit is estimated Goods sold (Step 1)
• Cost of Goods available for sale minus Estimated Goods Sold is estimated cost of ending inventory (Step 2)

Retail Inventory Method

• Company applies the cost-to-retail percentage to ending inventory at retail prices to determine inventory at cost.
• Available Goods for Sale at Retail minus Net Sales equals Ending Inventory at Retail. (Step 1)
• Available Goods for Sale at Cost Available Goods for Sale at Retail equals Cost-to-Retail Ratio. (Step 2)
• Ending Inventory at Retail X Cost-to-Retail Ratio equals Estimated Cost of Ending Inventory. (Step 3)