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Accounting: The Language of Business (Part 53)

“Accounting for the most part, remains a legalistic and traditional practice, almost immune to self-criticism by scientific methods.” —Kenneth E. Boulding

Inventories (Part E)

by

Charles Lamson

Comparing Inventory Costing Methods

As was illustrated in part 52, a different cost flow is assumed for each of the three alternative methods of costing inventories. You should note that if the cost of units had remained stable, all three methods would have yielded the same results. Since prices do change, however, the three methods will normally use different amounts for (1) the cost of the merchandise sold for the period, (2) the gross profit (and net income) for the period, and (3) the ending inventory. Using the preceding examples (from part 52) for the periodic inventory system and assuming the net sales were $15,000, the following partial income statements indicate the effects of each method when prices are rising:

As shown above, the fifo method yielded the lowest amount for the cost of merchandise sold and the highest amount for gross profit (and net income). It also yielded the highest amount for the ending inventory. On the other hand, the lifo method yielded the highest amount for the cost of merchandise sold, the lowest amount for gross profit (and net income), and the lowest amount for ending inventory. The average cost method yielded results that were between those of fifo and lifo.

Use of the First-In, First-Out Method

When the fifo method is used during a period of inflation or rising prices, the earlier unit costs are lower then the more recent unit costs, as shown in the preceding fifo example. Thus, fifo will show a larger gross profit. However, the inventory must be replaced at prices higher than indicated by the cost of merchandise sold. In fact, the balance sheet will report the ending merchandise inventory at an amount that is about the same as its current replacement cost. When the rate of inflation reaches double digits, as it did during the 1970s, the larger gross profits that result from the fifo method are often called inventory profits or illusory profits. You should note that in a period of deflation or declining prices, the effect is just the opposite.

Use of the Last-In, First-Out Method

When the lifo method is used during a period of inflation or rising prices, the results are opposite those of the other two methods. As shown in the preceding example, the lifo method will yield a higher amount of cost of merchandise sold, a lower amount of gross profit, and a lower amount of inventory at the end of the period than the other two methods. The reason for these effects is that the cost of the most recently acquired two units is about the same as the cost of their replacements. In a period of inflation, the more recent unit costs are higher than the earlier unit costs. Thus, it can be argued that the lifo method more nearly matches current costs with current revenues.

During periods of rising prices, using lifo offers an income tax savings. The income tax savings results because lifo reports the lowest amount of net income of the three methods. During the double-digit inflationary period of the 1970s, many businesses changed from fifo to lifo for the tax savings. However, the ending inventory on the balance sheet may be quite different from its current replacement cost. In such cases, the financial statements normally include a note that states the estimated difference between the lifo inventory and the inventory if fifo had been used. Again, you should note that in a period of deflation or falling price levels, the effects are just the opposite.

Use of the Average Cost Method

As you might have already reasoned, the average cost method of inventory costing is, in a sense, a compromise between fifo and lifo. The effect of price trends is averaged in determining the cost of merchandise sold and the ending inventory. For a series of purchases, the average cost will be the same, regardless of the direction of price trends. For example, a complete reversal of the sequence of unit costs presented in the preceding illustration would not affect the reported cost of merchandise sold, gross profit, or ending inventory. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 365-367*

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Accounting: The Language of Business (Part 52)

“There is always something for which there is no accounting. Take, for example, the whole world.” —Unknown

Inventories (Part D)

by

Charles Lamson

Inventory Costing Methods Under a Periodic Inventory System

When the periodic inventory system is used, only revenue is recorded each time a sale is made. No entry is made at the time of the sale to record the cost of the merchandise sold. At the end of the accounting period, a physical inventory is taken to determine the cost of the inventory and the cost of the merchandise sold.

Like the perpetual inventory system, all cost flow assumption must be made when identical units are acquired at different unit costs during a period. In such cases, the fifo, lifo, or average cost method is used.

First-In, First-Out Method

To illustrate the use of the fifo method in a periodic inventory system, we assume the following data:

The physical count on December 31 shows that 300 units have not been sold. Using the fifo method, the cost of the 700 units sold is determined as follows:

Deducting the cost of merchandise sold of $7,000 from the $10,400 of merchandise available for sale yields $3,400 as the cost of the inventory at December 31. The $3,400 inventory is made up of the most recent costs incurred for this item. Exhibit 5 shows the relationship of the cost of merchandise sold during the year and the inventory at December 31. 

EXHIBIT 5 First-In, First-Out Flow of Costs

Last-In, First-Out Method

When the lifo method is used, the cost of merchandise sold is made up of the most recent costs. Based on the data in the fifo example, the cost of the 700 units of inventory is determined as follows:

Deducting the cost of merchandise sold of $7,600 from the $10,400 of merchandise available for sale yields $2,800 as the cost of the inventory at December 31. The $2,800 inventory is made up of the earliest costs incurred for this item. Exhibit 6 shows the relationship of the cost of merchandise sold during the year and the inventory at December 31.

EXHIBIT 6

Average Cost Method

The average cost method is sometimes called the weighted average method. When this method is used, costs are matched against revenue according to an average of the unit costs of the goods sold. The same weighted average unit costs are used in determining the cost of the merchandise inventory at the end of the period. For businesses in which merchandise sales may be made up of various purchases of identical units, the average method approximates the physical flow of goods.

The weighted average unit cost is determined by dividing the total cost of the units of each item available for sale during the period by the related number of units of that item. Using the same cost data as in the fifo and lifo examples, the average cost of the 1,000 units, $10.40, and the cost of the 700 units, $7,280, are determined as follows:

Average unit cost: $10,400 / 1000 units = $10.40

Cost of merchandise sold: 700 units at $10.40 = $7,280

Deducting the cost of merchandise sold of $7,280 from the $10,400 of merchandise available for sale yields $3,120 as the cost of the inventory at December 31. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 363-365*

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Accounting: The Language of Business (Part 51)

“And he read Principles of Accounting all morning, but just to make it interesting, he put lots of dragons in it.” —Terry Pratchett

Inventories (Part C)

by

Charles Lamson

Inventory Costing Methods Under a Perpetual Inventory System

In a perpetual inventory system, as we discussed in a previous post, all merchandise increases and decreases are recorded in a manner similar to recording increases and decreases in cash. The merchandise inventory account at the beginning of an accounting period indicates the merchandise in stock on that date. Purchases are recorded by debiting Merchandise Inventory and crediting Cash or Accounts Payable. On the date of each sale, the cost of the merchandise sold is recorded by debiting cost of merchandise sold and crediting merchandise inventory.

As we illustrated in part 50, when identical units of an item are purchased at different unit costs during a period, a cost flow must be assumed. In such cases, the first-in, first-out (fifo), last-in, last-out (lifo), or average cost method is used. We illustrate each of these methods, using the data for item 127B, shown below.

First-In, First-Out Method

Most businesses dispose of goods in the order in which the goods are purchased. This would be especially true of perishables and goods whose styles or models often change. For example, grocery stores shelve their milk products by expiration dates. Likewise, men's and women's clothing stores display clothes by season. At the end of the season, they often have sales to clear their stores of off-season or out-of-style clothing. Thus, the fifo method is often consistent with the physical flow or movement of merchandise. To the extent that this is the case, the fifo method provides results that are about the same as those obtained by identifying the specific costs of each item sold and in inventory. 

When the fifo method of costing inventory is used, costs are included in the cost of merchandise sold in the order in which they were incurred. To illustrate, Exhibit 3 shows the journal entries for purchases and sales and the inventory subsidiary ledger account for Item 127B. The number of units in inventory after each transaction, together with total costs and unit costs, are shown in the account. We assume that the units are sold for $30 each on account.

EXHIBIT 3 Entries and Perpetual Inventory Account (Fifo)

You should note that after the 7 units were sold on January 4, there was an inventory of 3 units at $20 each. The eight units purchased on January 10 were acquired at a unit cost of $21, instead of $20. Therefore, the inventory after the January 10 purchase is reported on two lines, 3 units at $20 each and 8 units at $21 each. Next, note that the $81 cost of the four units sold on January 22 is made up of the remaining three units at $20 each and one unit at $21. At this point, 7 units are in inventory at a cost of $21 per unit. The remainder of the illustration is explained in a similar manner.

Last-In, First-Out Method

When the lifo method is used in a perpetual inventory system, the cost of the units sold is the cost of the most recent purchases. To illustrate, Exhibit 4 shows the journal entries for purchases and sales and the subsidiary ledger account for item 127B, prepared on a lifo basis. 

EXHIBIT 4 Entries and Perpetual Inventory Account (Lifo)

If you compare the ledger accounts for the fifo perpetual system and the lifo perpetual system, you should discover that the accounts are the same through the January 10 purchase using lifo, however, the cost of the four units sold on January 22 is the cost of the units from the January 10 purchase ($21 per unit). The cost of the seven units in inventory after the sale on January 22 is the cost of the three units remaining from the beginning inventory and the cost of the four units remaining from the January 10 purchase. The remainder of the lifo illustration is explained in a similar manner.

When the lifo method is used, the inventory ledger is sometimes maintained in units only. The units are converted to dollars when the financial statements are prepared at the end of the period.

The use of the lifo method was originally limited to rare situations in which the units sold were taken from the most recently acquired goods. For tax reasons, which we will discuss later, its use has greatly increased during the past few decades. Lifo is now often used even when it does not represent the physical flow of goods.

Average Cost Method

When the average cost method is used in a perpetual inventory system, an average unit cost for each type of item is computed each time a purchase is made. This unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed. This averaging technique is called a moving average. Since the average cost method is rarely used in a perpetual inventory system, we do not Illustrate it in this post.

Computerized Perpetual Inventory Systems

The records for a perpetual inventory system may be maintained manually. However, such a system is costly and time-consuming for businesses with a large number of inventory items with many purchase and sales transactions. In most cases, the record-keeping for perpetual inventory systems is computerized.

An example of using computers and maintaining professional inventory records for retail stores follows.

1. The relevant details for each inventory item, such as a description, quantity, and unit size, are stored in an inventory record. The individual inventory records make up the computerized inventory file, the total of which agrees with the balance of the inventory ledger account.

2.  Each time an item is purchased or returned by a customer, the inventory data are entered into the computer's inventory records and files.

3.  Each time an item is sold, a salesclerk scans the item's bar code with an optical scanner. The scanner reads the magnetic code and it rings up the sale on the cash register. The inventory records and files are then updated for the cost of goods sold.

4.  After a physical inventory is taken, the inventory count data are entered into the computer. These data are compared with the current balances, and a listing of the coverages and shortages is printed. The inventory balances are then adjusted to the quantities determined by the physical count.

Such systems can be extended to aid managers in controlling and managing inventory quantities. For example, items that are selling fast can be reordered before the stock is depleted. Past sales patterns can be analyzed to determine when to mark down merchandise for sales and when to restock seasonal merchandise. In addition, such systems can provide managers with data for developing and fine-tuning their marketing strategies. For example, such data can be used to evaluate the effectiveness of advertising campaigns and sales promotions. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 360-363*

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Accounting: The Language of Business (Part 50)

“Only accountants can save the world – through peace, goodwill and reconciliations.” —Unknown

Inventories (Part B)

by

Charles Lamson

Effect of Inventory Errors on Financial Statements

Any errors in the inventory count will affect both the balance sheet and the income statement. For example, an error in the physical inventory will misstate the ending inventory, current assets, and total assets on the balance sheet. This is because the physical inventory is the basis for recording the adjusting entry for inventory shrinkage. Also, an error in taking the physical inventory misstates the cost of goods sold, gross profit, and net income on the income statement. In addition, because net income is closed to the owner's equity at the end of the period, owner's equity will also be misstated on the balance sheet. The misstatement of owner's equity will equal the misstatement of the ending inventory, current assets, and total assets.

To illustrate, assume that in taking the physical inventory on December 31, 2023, Sapra Company incorrectly recorded its physical inventory as $115,000 instead of the correct amount of $125,000. As a result, the merchandise inventory, current assets, and total assets reported on the December 31, 2023 balance sheet would be understated by $10,000 ($125,000 - $115,000). Because the ending physical inventory is understated, the inventory shrinkage in the cost of merchandise sold will be overstated by $10,000. Thus, the gross profit and the net income for the year will be understated by $10,000. Since the net income is closed to owner's equity at the end of the period, the owner's equity on December 31, 2023 balance sheet will also be understated by $10,000. The effects on a company's financial statements are summarized as follows:

Now assume that in the preceding example the physical inventory had been overstated on December 31, 2023, by $10,000. That is, Sapra Company erroneously recorded its inventory as $135,000. In this case, the effect on the balance sheet and income statement would be just the opposite of those indicated above.

Errors in the physical inventory are normally detected in the period after they occur. In such cases, the financial statements of the prior year must be corrected. We will discuss such corrections in a later post.

Inventory Cost Flow Assumptions

A major accounting issue arises when identical units of merchandise are acquired at different unit costs during a period. In such cases, when an item is sold, it is necessary to determine its unit cost so that the proper accounting entry can be recorded. To illustrate, assume that three identical units of item X are purchased during May, as shown below.

Assume that one unit is sold on May 30 for $20. If this unit can be identified with a specific purchase, the specific identification method can be used to determine the cost of the unit sold. For example, if the unit sold was purchased on May 18, the cost assigned to the unit is $13 and the gross profit is $7 ($20 - $13). If, however, the unit sold was purchased on May 10, the cost assigned to the unit is $9 and the gross profit is $11 ($20 - $9).

The specific identification method is not practical unless each unit can be identified accurately. An automobile dealer, for example, may be able to use this method, since each automobile has a unique serial number. For many businesses, however, identical units cannot be separately identified, and a cost flow must be assumed. That is, which units have been sold and which units are still in inventory must be assumed.

There are three common cost flow assumptions used in business. Each of these assumptions is identified with an inventory costing method.

When the first-in, first-out (fifo) method is used, the inventory is made up of the most recent costs. When the last-in, first-out (lifo) method is used, the ending inventory is made up of the earliest costs. When the average cost method is used, the cost of the units in inventory is an average of the purchase costs.

The selection of an inventory costing method can have a significant impact on the financial statements. For this reason, the selection has important implications for managers and others in analyzing and interpreting the financial statements.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 357-360*

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Accounting: The Language of Business (Part 49)

“Accountants are dynamic, interesting, highly intelligent, hard-working individuals.” —Alexa Loo

Inventories (Part A)

by

Charles Lamson

Assume that you purchased a stereo receiver in June. You planned on attaching two pairs of speakers to the system. Initially, however, you could afford only one pair of speakers, which cost $160. In October, you purchased the second pair of speakers at a cost of $180.

Over the holidays, someone broke into your home and stole one pair of speakers. Luckily, your renters/homeowners insurance policy will cover the theft, but the insurance company needs to know the cost of the speakers that were stolen.

All of the speakers are identical. To respond to the insurance company, however, you will need to identify which pair of speakers was stolen. Was it the first pair, which cost $160? Or was it the second pair, which cost $180? Whichever assumption you make may determine the amount that you receive from the insurance company.

Merchandising businesses make similar assumptions when identical merchandise is purchased at different costs. At the end of the period, some of the merchandise will be in inventory and some will have been sold. But which costs relate to the sold merchandise and which costs relate to the merchandise in inventory? The company's assumption can involve large dollar amounts and thus can have a significant impact on the financial statements.

In the next several posts, we will discuss such issues as how to determine the cost of merchandise and inventory and the cost of merchandise sold. However, in this post, we discuss internal controls over merchandise inventory.

Internal Control of Inventory

The cost of inventory is a significant item in many businesses' financial statements. What do we mean by the term inventory? Inventory is used to indicate (1) merchandise held for sale in the normal course of business and (2) materials in the process of production or held for production. In the next several posts, we focus primarily on inventory of merchandise purchased for resale.

What costs should be included in inventory? As we have illustrated in earlier posts, the cost of merchandise is its purchase price, less any purchases discounts. These costs are usually the largest portion of the inventory cost. Merchandise inventory also includes other costs, such as transportation, import duties, and insurance against losses in transit.

Not only must the cost inventory be determined, but good internal control over inventory must also be maintained. Two primary objectives of internal control over inventory are safeguarding the inventory and properly reporting it in the financial statements. These internal controls can be either preventive or detective in nature. A preventive control is designed to prevent errors or misstatements from occurring. A detective control is designed to detect an error or misstatement after it has occurred.

Control over inventory should begin as soon as the inventory is received. Prenumbered receiving reports should be completed by the company receiving department in order to establish the initial accountability for the inventory. To make sure the inventory received is what was ordered, each receiving report should agree with the company's original purchase order for the merchandise. Likewise, the price at which the inventory was ordered, as shown on the purchase order, should be compared to the price at which the vendor billed the company, as shown on the vendor's invoice. After the receiving report, purchase order, and the vendors invoice have been reconciled, the company should record the inventory and related account payable in the accounting records.

Controls for safeguarding inventory include developing and using security measures to prevent inventory damage or employee theft. For example, inventory should be stored in a warehouse or other area to which access is restricted to authorized employees. The removal of merchandise from the warehouse should be controlled by using requisition forms, which should be properly authorized. The storage area should also be climate controlled to prevent damage from heat or cold. Further, when the business is not operating or is not open, the storage area should be locked.

When shopping, you may have noticed how retail stores protect inventory from customer theft. Retail stores often use such devices as two-way mirrors, cameras, and security guards. High price items are often displayed in locked cabinets. Retail clothing stores often place plastic alarm tags on valuable items such as leather coats. Sensors at the exit doors set off alarms if the tags have not been removed by the clerk. These controls are designed to prevent customers from shoplifting.

Using a perpetual inventory system (a program that continuously estimates your inventory based on your electronic records, not a physical inventory) for merchandise also provides an effective means of control over inventory. The amount of each type of merchandise is always readily available in a subsidiary inventory ledger. In addition, the subsidiaries ledger can be an aid in maintaining inventory quantities at proper levels. Frequently comparing balances with predetermined minimum and maximum levels allows for timely reordering and prevents ordering excess inventory.

To ensure the accuracy of the amount of inventory reported in the financial statements, a merchandising business should take a physical inventory (i.e., count the merchandise). In a perpetual inventory system, the physical inventory is compared to the recorded inventory in order to determine the amount of shrinkage or shortage. If the inventory shrinkage is unusually large, management can investigate further and take any necessary corrective action. Knowledge that a physical inventory will be taken also helps prevent employee thefts or misuses of inventory. 

How does a business "take" a physical inventory? The first step in this process is to determine the quantity of each kind of merchandise owned by the business. A common practice is to use teams of two persons. One person determines the quantity, and the other lists the quantity and description on inventory count sheets. Quantities of high-cost items are usually verified by supervisors or a second count team.

What merchandise should be included in inventory? All the merchandise owned by the business on the inventory dates should be included. For merchandise in transit, the party (the seller or the buyer) who has title to the merchandise on the inventory date is the owner. To determine who has title, it may be necessary to examine purchases and sales invoices of the last few days of the current period and the first few days of the following period.

As we discussed in an earlier post, shipping terms determine when the title passes. Free on board (FOB) is a shipment term used to indicate whether the seller or the buyer is liable for goods that are damaged or destroyed during shipping. When goods are purchased or sold FOB shipping point, title passes to the buyer when the goods are shipped. When the terms are FOB destination, title passes to the buyer when the goods are delivered.

To illustrate, assume that Roper Co. orders $25,000 of merchandise on December 28, 2023. The merchandise is shipped FOB shipping point by the seller on December 31 and arrives at Roper Co.'s warehouse on January 4, 2024. As a result, the merchandise is not counted by the inventory crew on December 31, the end of Roper Co.'s fiscal year. However, the $25,000 of merchandise should be included in Roper's inventory because title has passed. Roper Co. should record the merchandise in transit on December 31, debiting merchandise inventory and crediting accounts payable for $25,000. 

Manufacturers sometimes ship merchandise to retailers who act as the manufacturer's agent when selling the merchandise. The manufacturer retains title until the goods are sold. Such merchandise is said to be shipped on consignment to the retailers. The unsold merchandise is a part of the manufacturer's (consigner's) inventory, even though the merchandise is in the hands of the retailers. The consigned merchandise should not be included in the retailer's (consignee's) inventory. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 355-357*

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