Accounting: The Language of Business - Vol. 2 (Intermediate: Part 155)

2 Corinthians 8:18-24; Acts 6:3-6: For accountability, more than one person should perform each function.

Short-Term Operating Assets: Inventory (Part A)

by

Charles Lamson

Introduction

Go into any store and you will see inventory (see Image 1) all around you. Grocery stores are stocked with fresh fruits and vegetables, boxes of cereal, and gallons of milk. Retailers like Abercrombie & Fitch and Old Navy sell all types of clothing such as pants, shirts, and sweaters. Best Buy is stocked with computers, cell phones, and flat screen televisions. Maintaining sufficient inventory levels is critical to operating a successful business.

Image 1: Inventory

Consider Foot Locker, Inc., the world's leading retailer of athletically inspired footwear and apparel. Foot Locker's $1.307 billion inventory represented about 34% of its total assets at the end of 2016. Foot Locker seeks to accurately predict the market for the merchandise and its stores as well as its customers' purchasing habits, which enables it to maintain sufficient inventory levels to increase inventory turnover and merchandise flow. If Foot Locker accumulates excess inventory, it may be forced to mark down or hold promotional sales to dispose of any excess or slow-moving inventory. Both outcomes could have a materially adverse effect on Foot Locker's business, financial condition, and results of operations. By analyzing its market and consumer purchasing habits and maintaining sufficient levels of inventory, Foot Locker increased its gross profit percentage by 0.1% from 33.8% in 2015 to 33.9% in 2016.

In the next several parts, we discuss key issues in accounting for inventory. Inventory is a short-term operating asset consisting of goods held for resale for a merchandising company and inventory of raw materials, work in process, and finished goods for a manufacturing company. As is the case with Foot Locker, inventory is typically a significant portion of a company's total current assets. The evaluation of inventory affects the company's balance sheet and the cost of goods sold on the income statement.

We first cover the periodic and perpetual methods company uses to account for inventory. Then, we address costs to include an inventory and present inventory cost flow assumptions including specific identification, first in, first out (FIFO), last in, first out (LIFO), and moving average. We also consider the issues related to the LIFO cost flow assumption and the tax and cash flow implications of Interational Financial Recording Standards (IFRS) not allowing the LIFO inventory cost flow assumption. Next, we address specific guidelines for reporting inventory with the lower of cost or market rule, including differences between generally accepted accounting principles (GAAP or U.S. GAAP) and IFRS. Then, we discuss the conventional retail inventory method, a technique that Foot Locker uses. Finally, we illustrate estimating ending inventory using the gross profit method and detail required disclosures. We discuss inventory errors in a future part.

Types of Inventory and Inventory Systems

We begin our discussion of inventory measurements with an overview of the inventory classifications and the two types of inventory systems [For most of the relevant authoritative literature for the topic, see FASB ASC 330 - Inventory for U.S. GAAP and IASC, International Accounting Standard 2, “Inventories” (London, UK International Accounting Standards Committee, revised) for IFRS.]

Types of Inventory

Retail, wholesale, and manufacturing firms hold inventory. Retailers and wholesalers typically hold only merchandise inventory, which consists of goods purchased to resell without any additional manufacturing. Manufacturing firms generally report three types of inventory based on the stage of the production process:

1. Raw materials

2. Work-in-process

3. Finished goods

Raw materials inventory is composed of inputs that the firm has not paid placed into production. For example, cloth would be included in the raw materials inventory for a clothing manufacturer. The raw materials inventory is increased by purchases and decreased when these items are transferred into work-in-process inventory.

Work-in-process inventory, the goods that are currently in the manufacturing process, includes three different types of costs: raw materials, cost of labor, and allocated overhead costs. Overhead includes expenditures made for factory-related costs such as supervisory salaries, utilities, and supplies.

Work in process inventory becomes finished goods at the end of the production process. Finished goods inventory includes those goods for which the manufacturing process is complete. A company charges the value of finished goods to the cost of goods sold account when it sells the inventory. Increases in raw materials and work-in-process inventories are often indicators that a company plans to expand production to meet expected future sales increases.

Exhibit 10.1 summarizes the flow of inventory costs on the balance sheet and income statement from raw materials inventory to work-in-process inventory and finish the goods inventory, and finally to cost of goods sold when the inventory is sold.

 EXHIBIT 10.1 Cost Flows In A Manufacturing Firm

Exhibit 10.2 shows Johnson & Johnson's disclosures by types of inventory from its 2016 annual report. Approximately 61% of Johnson & Johnson's inventories are comprised of finished goods, and 39% is made up of raw materials and work in process.

EXHIBIT 10.2 Types of Inventories, Johnson & Johnson, Financial Statements, January 1, 2017

 SOURCE: Johnson & Johnson's 2016 Annual Report. 

*GORDON, RAEDY, SANNELLA, 2019, IINTERMEDIATE ACCOUNTING, 2ND ED., PP. 507-509*

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