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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