INVETORIES

1. Nature and Definition of Inventory

Definition: Inventories can be goods held for resale in merchandizing enterprises; materials and parts, factory
supply, goods in process and finished goods in manufacturing enterprises. The major classification of
inventories depends on the operation of the business. A retailing or wholesale entity acquires merchandise for
resale. A manufacturing entity acquires raw materials and component part, manufactures finished goods, and
then sells them. Machinery and equipment, for example, are considered operational assets by the company that
buys them, but before sale they are part of the inventory of the manufacturer who made them. Even a building,
during its construction period, is an inventory item for the builder.
Inventory is used to designate
1. Merchandise held for sale in the normal course of business, which is termed merchandise inventory.
2. Materials in the process of production or held for such use.
Importance of inventories
 It is the principal source of revenue for wholesale and retail businesses.
 Loss of merchandise sold is the largest deduction from sales to determine net income.
 A substantial part of merchandising firm’s resources is invested in inventory
 It is the largest of the current assets on merchandisers businesses.

2. Inclusion and Exclusions

In accounting, inventory refers to goods or materials that a company holds for sale in the ordinary course of
business or uses in producing goods for sale. Proper classification of items as *inclusions* or *exclusions* in
inventory is essential for accurately reporting financial position and calculating cost of goods sold (COGS).

Inventory Inclusions
1.Goods in Transit:
 FOB (Free on Board) Shipping Point: If goods are shipped under FOB shipping point terms,
ownership transfers to the buyer as soon as the goods leave the seller's premises. Thus, the buyer
should include these goods in their inventory. –
 FOB Destination*: Ownership transfers to the buyer when the goods arrive at the buyer’s
location. Therefore, the seller should include these goods in their inventory until they reach the
buyer.
2. Raw Materials - Any materials that will be used in production processes should be included in inventory as
raw materials.
3. Work-in-Process (WIP): - Partially completed products that are still in the production process should be
included in inventory as work-in-process. This also includes associated direct labor and manufacturing overhead
costs.
4. Finished Goods- Completed products that are ready for sale should be included in inventory as finished
goods.
5. Goods on Consignment - Goods that are sent to another party (the consignee) for sale but remain the
property of the consignor should be included in the consignor's inventory.
6. Purchased Goods (Not Yet Paid For) - Goods purchased on credit are included in inventory upon transfer of
ownership, regardless of whether payment has been made.
7. Goods Held for Resale- Items a company holds for resale (i.e., merchandise inventory) should be included in
the inventory balance.
8. Capitalized Cost- Any costs that are directly attributable to bringing the inventory to its present condition
and location (e.g., transportation, handling, duties, etc.) should be included in inventory costs.

Inventory Exclusions:
1. Goods Sold - Goods for which ownership has transferred to the customer should be excluded from the
seller's inventory, regardless of whether the goods are still in transit.
2. Goods on Consignment (Held by Company)- If a company holds goods on consignment for another entity,
those goods should not be included in the company's inventory. The ownership remains with the consignor.
3. Goods Received but Not Yet Owned- If goods are received under FOB shipping point terms but the
ownership has not yet transferred to the company (FOB destination), they should not be included in inventory.
4. Obsolete or Damaged Goods- Goods that are no longer sellable or usable (e.g., damaged, obsolete) should
not be included in the inventory. If they are still on hand, they may be written off or reduced in value through an
inventory write-down.
5. Advances to Suppliers - Any prepayments or deposits made to suppliers for goods that have not yet been
delivered should not be included in the inventory. These are recorded as advances or prepaid expenses.
6. Factory Supplies - Factory supplies or indirect materials (e.g., cleaning supplies, lubricants) that are used in
the production process but do not directly become part of the finished goods are generally excluded from
inventory and recorded as expenses.

3. Inventory Systems
There are two principal inventory systems, periodic and perpetual.

Periodic inventory system

 In this system, only the revenue from sales is recorded each time a sale is made.
 No entry will be made to record the cost of merchandise sold at the time of sale.
 Physical inventory will be taken to find the cost of the ending inventory.
 The system is likely to be used by a business that sells a variety of merchandise with
low unit prices such as drug stores.

Perpetual inventory system

 Uses according to records that continuously disclose the amount of the inventory.
 The cost of merchandise sold will be recorded each time a sale is made.
 A merchandise acquired is added to an inventory account
 When goods are sold, their cost is transferred out of inventory into the cost of goods sold account
 Freight-in, purchase return and allowance, and purchase discounts are recorded in inventory rather than in
separate account

4. Inventory Cost Flows methods

Inventory cost flow methods are accounting techniques used to value inventory and determine the cost of goods
sold (COGS). These methods affect the company's financial statements and tax liabilities, as they influence the
reported profit and ending inventory balances.

Key Inventory Cost Flow Methods

1. First-In, First-Out (FIFO) –
 Concept: The first items purchased (first in) are the first ones sold (first out).
 COGS: COGS is based on the cost of older inventory.
 Ending Inventory: Ending inventory reflects the cost of the most recent purchases.
Impact: In times of rising prices, FIFO results in lower COGS (because older, cheaper items are sold first),
leading to higher net income and higher taxes. - Ending inventory will be higher since it reflects more recent,
higher costs.

2. Last-In, First-Out (LIFO)

 Concept: The most recent items purchased (last in) are the first ones sold (first out). –
 COGS: COGS is based on the cost of the latest purchases.
  Ending Inventory: Ending inventory consists of older, cheaper items (if prices are rising).
Impact: - In times of rising prices, LIFO results in higher COGS (because newer, more expensive inventory is
sold first), leading to lower net income and lower taxes. - Ending inventory will be lower since it reflects older,
lower costs. –
Note: LIFO is allowed under U.S. GAAP but not under IFRS (International Financial Reporting Standards). -

3. Weighted Average Cost (WAC)

 Concept: The cost of inventory is based on the weighted average of all units available for sale during
the period.
 COGS: COGS is calculated using the average cost per unit.
 Ending Inventory: Ending inventory is also valued using the average cost.
Impact: - This method smooths out price fluctuations since COGS and ending inventory reflect the average cost
of all purchases.

4. Specific Identification
 Concept: Each item in inventory is individually tracked and matched to its specific cost.
 COGS: The exact cost of the specific items sold is recorded.
 Ending Inventory: Ending inventory reflects the actual cost of each remaining item.
Impact: - This method is best for businesses that sell unique or high-value items, like cars, jewelry, or real
estate. - It provides the most accurate reflection of COGS and ending inventory but can be impractical for
businesses with large volumes of identical or similar items.

Comparison of Method
FIFO
 Advantages: Results in higher net income in times of inflation; inventory reflects current market values.
 Disadvantages: Higher taxes due to higher reported profits during inflationary periods.
LIFO
 Advantages: Reduces taxable income during inflationary periods, thus saving on taxes.
 Disadvantages: Ending inventory values may be understated; not allowed under IFRS.
Weighted Average Cost
 Advantages: Smooths out price fluctuations, simple to apply, especially for homogeneous products.
 Disadvantages: May not reflect current market values for inventory or COGS. –
Specific Identification
 Advantages: Most precise method for matching costs to revenues.
 Disadvantages: Impractical for businesses with large volumes of identical items.
Impact of Cost Flow Methods on Financials
1. COGS: - LIFO leads to higher COGS and lower net income in periods of rising prices, whereas FIFO leads
to lower COGS and higher net income.
2. Net Income: - FIFO generally results in higher net income in inflationary times compared to LIFO.
3. Taxes: - LIFO reduces taxable income during inflationary periods, leading to tax savings.
4. Inventory Valuation: - FIFO results in higher ending inventory values during inflation, while LIFO shows
lower ending inventory values.
Each method serves different strategic purposes and can have significant effects on financial reporting and tax
liabilities, so companies choose based on their specific financial goals and regulatory requirements.

5. Measurement of Inventories
 Initial measurement of inventories should be at cost.
 Subsequent measurement of inventories should be measured at the lower of cost and net realizable
value (LCNRV).
  Net realizable value Net realizable value or NRV is the estimated selling price in the ordinary course of
business less the estimated cost of completion and the estimated cost of disposal.

6. Accounting for Purchase Commitments

In inventory accounting, purchase commitments refer to agreements or contracts that a company enters into to
buy goods in the future at predetermined prices. These commitments are usually made to lock in prices or
secure supply for a later period. Proper accounting for these commitments is essential to accurately reflect a
company’s financial position.

Accounting Treatment of Purchase Commitments

1. Disclosure - Companies are generally required to disclose significant purchase commitments in the notes to
their financial statements, particularly when they may have a material impact on the financial position or results
of operations.
2. Recognition of Losses - If the market price of the committed inventory falls below the contract price (i.e.,
the company will have to pay more than the market price), a *loss* is recognized in the financial statements.
This is based on the *lower of cost or market (LCM)* principle.
 The loss is recognized in the period the market price falls, even though the goods have not yet been
delivered. This ensures that potential unfavorable outcomes are recognized early.
Journal Entry-
Loss on Purchase Commitments xxx
Estimated Liability for Purchase Commitments xxx

3. Delivery of Goods - When the goods are eventually delivered: - The liability is removed, and the inventory is
recognized at the contracted price. - If a loss was previously recognized, the difference between the market price
and the contract price is adjusted to reflect the actual cost.

4. Fair Value Hedging - If a company enters into a *hedging* arrangement to mitigate the risk of price
fluctuations, hedge accounting rules may apply, allowing the company to recognize both the purchase
commitment and the hedge in its financial statements. ### Example: A company enters into a contract to
purchase 1,000 units of inventory at $50 per unit. However, before the goods are delivered, the market price
drops to $45 per unit. - The company would record a loss of $5,000 (1,000 units × ($50 - $45)) for the period in
which the price drop occurred, even though the inventory has not been received yet.

7. Inventory Estimation Method

Inventory estimation methods are used when a physical count of inventory is not feasible or practical, often
during interim periods or when quick estimates are needed for financial reporting. These methods help estimate
the amount of ending inventory and the cost of goods sold (COGS) without having to perform a full physical
count. Two commonly used inventory estimation methods are:

1. Gross Profit Method

-The gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of
goods sold divided by sales) to calculate the value of the inventory. Keep in mind the gross profit method assumes that
gross profit ratio remains stable during the period.

Basic Formula:
GOODS AVAILABLE FOR SALE xxx
LESS: COST OF GOODS SOLD xx
ENDING INVENTORY xxx

2. Retail Inventory Method

-The retail inventory method is an accounting method used to estimate the value of a store's merchandise. The retail
method provides the ending inventory balance for a store by measuring the cost of inventory relative to the price of
the merchandise. Along with sales and inventory for a period, the retail inventory method uses the cost-to-retail ratio.
Basic Formula:
Goods available for sale at retail or selling price xxx
Less: Net sales (Gross sales minus sales return only) xx
Ending inventory at selling price xxx
Multiply by cost ratio xx
Ending inventory at cost xxx

COST RATIO = GOODS AVAILABLE FOR SALE AT COST

GOODS AVAILABLE FOR SALE AT SELLING PRICE