INVENTORY

I. SUMMARY
1. Introduction to Inventory:
• Definition and importance of inventory.
− Inventory refers to the tangible assets held by a company for the purpose of sale or
production. It includes raw materials, work-in-progress, and finished goods. Inventory
is essential for the smooth operation of a business as it ensures a continuous supply of
goods for sale or production. It serves as a buffer to meet customer demand and
reduces the risk of stockouts. Proper management and valuation of inventory are
crucial for accurate financial reporting and decision-making, as inventory represents a
significant portion of a company's assets and affects profitability and cash flow.

• Different types and classifications of inventory

− Inventory can be classified into three main types: raw materials, work-in-progress,
and finished goods. Raw materials consist of items that are used in the production
process but have not undergone any significant transformation. Work-in-progress
includes goods that are currently being produced or assembled but are not yet
completed. Finished goods are the final products that are ready for sale to customers.

2. Inventory Valuation Methods:

• Specific Identification Method: Assigning actual costs to specific units of inventory.
− The specific identification method is an inventory valuation method where the actual
cost of each individual unit of inventory is tracked and assigned. It involves matching
the specific cost of each unit sold with the revenue generated from its sale, providing
a precise calculation of cost of goods sold and ending inventory

• First-In, First-Out (FIFO) Method: Assuming the earliest inventory purchased is the
first to be sold.
− The FIFO method of inventory valuation assumes that the earliest inventory items
purchased are the first to be sold, leaving the most recent inventory on hand. This
results in the cost of goods sold being calculated based on the older, lower-cost
inventory, while the ending inventory is valued using the more recent, higher-cost
inventory.
• Last-In, First-Out (LIFO) Method: Assuming the latest inventory purchased is the first
to be sold.
− The LIFO method of inventory valuation assumes that the most recent inventory items
purchased are the first to be sold, leaving the older inventory on hand. This results in
the cost of goods sold being calculated based on the more recent, higher-cost
inventory, while the ending inventory is valued using the older, lower-cost inventory.
• Weighted Average Cost Method: Calculating the average cost of inventory based on
the weighted average of costs.
 − The weighted average cost method is an inventory valuation method that calculates
the average cost of inventory by considering both the quantity and cost of each unit. It
involves dividing the total cost of goods available for sale by the total quantity of
units available to determine a weighted average cost, which is then applied to
determine the cost of goods sold and ending inventory.

3. Lower of Cost or Market (LCM) Rule:

• Explanation of the LCM rule and its application to inventory valuation.
− The Lower of Cost or Market (LCM) rule is an accounting principle that states that
inventory should be reported at the lower of its cost or its net realizable value. It
requires companies to compare the original cost of inventory with its market value,
which is the amount it could be sold for in the current market, and report the lower of
the two values as the inventory's value on the financial statements.
• Determining cost and market values of inventory.
− It involves calculating the actual cost incurred to acquire or produce the inventory,
including direct costs and relevant overheads. Market value, on the other hand,
represents the estimated selling price of the inventory in the current market,
considering factors such as supply and demand, obsolescence, and any restrictions or
limitations that may affect its saleability.
• Implications of LCM on financial statements.
− The application of the Lower of Cost or Market (LCM) rule to inventory valuation
can have significant implications on financial statements. If the market value of
inventory is lower than its cost, the LCM rule requires a write-down of the inventory
value, resulting in a reduction of reported assets and potential decrease in net income,
reflecting a more conservative and realistic representation of the company's financial
position and performance.

4. Inventory Costing Methods:

• Perpetual Inventory System: Continuous tracking of inventory quantities and costs.
− The perpetual inventory system is a method of tracking inventory where inventory
quantities and costs are continuously updated in real-time. It involves the use of
computerized systems and barcode scanners to record inventory movements, such as
sales, purchases, and returns, allowing for accurate and up-to-date information on
inventory levels and costs at any given time.
• Periodic Inventory System: Periodic determination of inventory quantities and costs
through physical counts.
− The periodic inventory system is a method of tracking inventory where inventory
quantities and costs are determined periodically through physical counts. Rather than
continuously updating inventory records, this system relies on occasional physical
counts to determine the ending inventory and cost of goods sold.

5. Presentation and Disclosure of Inventory:

 • Classification of inventory on the balance sheet.
− Inventory is typically classified as a current asset on the balance sheet. It is reported in
a separate line item under the current assets section, along with other short-term assets
that are expected to be converted into cash or consumed within one year or the
operating cycle, whichever is longer. The specific classification of inventory may
vary depending on the nature of the business and the accounting standards followed.
• Presentation of inventory costs, including direct costs and relevant overheads.
− Inventory costs, including direct costs and relevant overheads, are typically presented
in the financial statements by including direct costs as part of the cost of goods sold
and adding relevant overheads to the inventory value. This provides a comprehensive
view of the total inventory cost and its impact on the company's financial
performance.
• Disclosure requirements for additional inventory-related information in financial
statements.
− Disclosure requirements for additional inventory-related information in financial
statements may include the disclosure of significant accounting policies, carrying
amount of inventory, and any impairment or write-downs, as well as information
about inventory reserves, obsolescence, estimation uncertainty, and any other relevant
qualitative or quantitative details necessary for users to understand the nature and
value of the inventory. The specific disclosure requirements may vary based on the
applicable accounting standards and regulatory guidelines

6. Specific Inventory Issues:

• Determining the net realizable value of inventory.
− Determining the net realizable value (NRV) of inventory involves estimating the
amount of revenue that can be generated from the sale of inventory, minus any costs
necessary to make the sale. It is typically calculated by subtracting estimated selling
expenses, such as marketing costs or discounts, from the estimated selling price of the
inventory. The NRV is important for evaluating the recoverable value of inventory
and assessing whether any impairment or write-down adjustments are necessary to
reflect the lower value of the inventory.
• Treatment of obsolete or damaged inventory.
− The treatment of obsolete or damaged inventory involves recognizing the loss in value
and properly adjusting the inventory value on the financial statements. Generally,
when inventory becomes obsolete or damaged, it is written down to its net realizable
value (NRV), which is the estimated selling price less any costs necessary to make the
sale. The write-down is recorded as an expense, such as "Inventory Obsolescence
Expense" or "Inventory Write-Down," and reduces the inventory value on the balance
sheet.
• Inventory reserves and write-downs.
− Inventory reserves and write-downs are accounting adjustments made to reflect a
decrease in the value of inventory. They are established to account for potential losses
due to factors like obsolescence, damage, or declines in market value, reducing the
reported value of inventory on the balance sheet and ensuring more accurate financial
reporting.
II. PROBLEM AND SOLUTION
Ella Company had the following consignment transaction during the current year:
Inventory shipped on consignment to a consignee 600,000
Freight paid by Ella Company 50,000
Inventory received on consignment from a consignor 800,000
Freight prepaid by consignor 50,000

No sales of consigned goods were during the current year.

What amount should be reported as consigned inventory at year-end?
Solution:
Inventory shipped on consignment to consignee 600,000
Freight paid by Ella Company 50,000
Consigned Inventory 650,000

III. CONCLUSION
1. Significance of Inventory: Inventory represents a substantial portion of assets for many
businesses, especially those involved in manufacturing, retail, and distribution.
Understanding how inventory is accounted for and valued is essential for accurately reporting
a company's financial position and performance.
2. Complex Accounting Principles: Inventory accounting involves various complex principles
and methods, such as cost allocation, inventory costing methods (FIFO, LIFO, weighted
average), lower of cost or market (LCM) rule, and inventory valuation adjustments.
Mastering these concepts is crucial for preparing financial statements and ensuring
compliance with accounting standards.

3. Impacts Financial Statements: Inventory valuation directly affects financial statements.

The choice of inventory costing method impacts the cost of goods sold, gross profit, and net
income. The proper disclosure of inventory-related information is crucial for providing
transparent and reliable financial statements to stakeholders.
4. Decision-Making and Financial Analysis: Understanding inventory accounting allows
accountants and CPAs to provide meaningful insights for decision-making and financial
analysis. Assessing inventory turnover, obsolete inventory, and inventory-related ratios helps
evaluate a company's operational efficiency, profitability, liquidity, and risk management.
5. Regulatory Compliance: Accountants and CPAs must comply with accounting standards
and regulations such as Generally Accepted Accounting Principles (GAAP) or International
Financial Reporting Standards (IFRS). Proficiency in inventory accounting ensures accurate
and compliant financial reporting, which is essential for regulatory compliance and building
stakeholders' trust.
The inventory chapter in Intermediate Accounting is crucial for accountancy students and
future CPAs for several reasons. Firstly, inventory represents a significant asset for many
businesses, and understanding its accounting and valuation is essential for accurate financial
reporting. Secondly, the chapter covers various inventory costing methods like FIFO, LIFO,
and weighted average, which impact financial statements and tax calculations. Thirdly,
knowledge of inventory allows accountants to assess a company's liquidity, profitability, and
risk by analyzing inventory turnover and obsolescence. Fourthly, inventory valuation plays a
role in decision-making, such as pricing, production planning, and investment analysis.
Lastly, compliance with accounting standards and regulations, including inventory
disclosures, is critical for maintaining integrity and trust in financial reporting. Overall, a
solid understanding of inventory accounting in Intermediate Accounting is vital for
accountancy students and future CPAs to excel in their roles, contribute to effective financial
management, and meet the demands of the profession.

CONCEPTUAL FRAMEWORK
CASH AND CASH EQUIVALENTS
TRADE AND OTHER RECEIVABLES
INVENTORY
INVESTMENTS
PROPERTY PLANT AND EQUIPMENT
INTANGIBLE ASSET