Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory.
Transportation costs are sometimes included in the cost of Merchandise Inventory. The FOB terms designate when title passes and who pays the transportation costs. FOB stands for “Free On Board.” So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means the buyer will pay all transportation costs. In this case, the transportation costs will be added to the merchandise inventory account. On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means the seller will pay the transportation costs.
Goods on consignment are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownership of them and should include them in our inventory count.
Damaged and obsolete goods are not counted in inventory if they cannot be sold. If these goods can be sold at a reduced price, they are included in inventory at a conservative estimate of their net realizable value. Net realizable value is sales price minus the cost of making the sale.
The cost of inventory includes any cost that is necessary and reasonable to get the inventory to your place of business and to get it in a salable condition. We already know that the invoice price and transportation costs are included in the total cost of inventory. Other costs to include are insurance, storage and import duties. Any purchase discounts or allowances received reduce the cost of the inventory purchased.
Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in our inventory records. In reality, this is not the case. The physical count may not match our records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps us get our records up to date to reflect what we actually have on hand. A company has adequate internal controls over the inventory count if, (1) it uses pre-numbered inventory tags, (2) inventory counters have no responsibility for inventory, (3) the count confirms the existence, amount, and quality of inventory items counted, (4) a second count of the inventory is made, and (5) a count supervisor confirms that all items in inventory have been counted.
We must make assumptions about the inventory cost flow. First-in, first-out assumes costs flow in the order incurred. Last-in, first-out assumes costs flow in the reverse order incurred. Weighted average assumes costs flow at an average of the costs available.
The first-in, first-out method is abbreviated as FIFO, and pronounced as Fifo. When using FIFO, we assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory.
The last-in, first-out method is abbreviated as LIFO, and pronounced as Lifo. When using LIFO, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.
When using weighted average, we assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand.
This slide presents a comparison of the impact on the income statement of using the different inventory costing methods. Everything is the same in each example, except the amount of Cost of Goods Sold, and its flow through effects on Income Before Taxes, Income Tax Expense, and Net Income. Specific identification provides the most accurate cost of goods sold amount. But, this method is very costly to use. In periods of rising prices, of the other three methods, FIFO will provide the lowest Cost of Goods Sold amount. This is because it uses the older costs which tend to be lower to arrive at this amount. LIFO will provide the highest Cost of Goods Sold amount. This is because it uses the most recent costs which tend to be higher to arrive at this amount. Weighted average will provide a Cost of Goods Sold amount that falls between FIFO and LIFO. As you can see, the impact on net income is that FIFO results in the highest net income, LIFO results in the lowest net income, and weighted average results in net income that falls in the middle of these two.
An advantage of weighted average is that it smoothes out peaks and valleys in price changes that may occur during the period. FIFO does a great job of valuing Ending Inventory at an approximate replacement cost. This is because FIFO uses the most recent costs to value Ending Inventory. LIFO does a great job of matching current costs in Cost of Goods Sold with current revenues. This is because LIFO uses the most recent costs to determine Cost of Goods Sold.
Using LIFO for tax reporting purposes makes sense because it provides the lowest net income figure, and, therefore, the lowest tax expense of the three methods. However, the Internal Revenue Service requires that if a company uses LIFO for tax reporting purposes, it must also use LIFO for financial reporting.
When we report inventory on the balance sheet, we report it at the lower of cost or market value. Cost is determined using one of the methods we just discussed: Specific identification, FIFO, LIFO or weighted average. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market value follows the conservatism principle by not overstating the value of assets. We can apply the lower of cost or market concept on an individual item basis, for similar categories of inventory, or for the inventory as a whole.
Take a few minutes and review this chart. It shows the impact of inventory errors on the income statement. For example, if Ending Inventory is understated, that will result in an overstatement of Cost of Goods Sold which will result in an understatement of Net Income.
Take a few minutes and review this chart. It shows the impact of inventory errors on the balance sheet. As we just noted on the previous slide, if Ending Inventory is understated, Cost of Goods Sold will be overstated, which will result in an understatement of net income. An understatement of net income will result in an understatement of equity. Also, if Ending Inventory is understated, then assets on the balance sheet will be understated.
6 - 2DETERMINING INVENTORY ITEMSMerchandise inventory includes all goods that aMerchandise inventory includes all goods that acompany owns and holds for sale, regardless of wherecompany owns and holds for sale, regardless of wherethe goods are located when inventory is counted.the goods are located when inventory is counted.Items requiring special attention include:Items requiring special attention include:Items requiring special attention include:Items requiring special attention include:Goods inTransitGoodsDamaged orObsoleteGoods onConsignmentC1
6 - 3FOB Destination PointPublicCarrierSeller BuyerGOODS IN TRANSITPublicCarrierSeller BuyerFOB Shipping PointOwnership passesto the buyer here.C1
6 - 4GOODS ON CONSIGNMENTMerchandise is included in the inventory of theconsignor, the owner of the inventory.ConsignorConsigneeThanks for selling myinventory in yourstore.C1
6 - 5GOODS DAMAGED OR OBSOLETEDamaged or obsolete goods are not counted ininventory if they cannot be sold.Cost should be reduced to net realizablevalue if they can be sold.C1
6 - 6DETERMINING INVENTORY COSTSInvoiceCostInvoiceCostInclude all expenditures necessary to bring an item toInclude all expenditures necessary to bring an item toa salable condition and location.a salable condition and location.MinusDiscountsandAllowancesMinusDiscountsandAllowancesPlus ImportDutiesPlus ImportDuties PlusFreightPlusFreightPlusStoragePlusStoragePlusInsurancePlusInsuranceC2
6 - 7Most companies take aphysical count ofinventory at least onceeach year.INTERNAL CONTROLS AND TAKING APHYSICAL COUNTWhen the physical countdoes not match theMerchandise Inventoryaccount, an adjustmentmust be made.Good internal controls over count include:1.Pre-numbered inventory tickets.2.Counters have no inventory responsibility.3.Counts confirm existence, amount, andquality of inventory item.4.Second count is taken.5.Manager confirms all items counted.Good internal controls over count include:1.Pre-numbered inventory tickets.2.Counters have no inventory responsibility.3.Counts confirm existence, amount, andquality of inventory item.4.Second count is taken.5.Manager confirms all items counted.C2
6 - 8INVENTORY COST FLOWASSUMPTIONSFirst-In, First-OutFirst-In, First-Out(FIFO)(FIFO)Assumes costs flow in the orderAssumes costs flow in the orderincurred.incurred.Last-In, First-OutLast-In, First-Out(LIFO)(LIFO)Assumes costs flow in theAssumes costs flow in thereverse order incurred.reverse order incurred.WeightedWeightedAverageAverageAssumes costs flow at anAssumes costs flow at anaverage of the costs available.average of the costs available.P1
6 - 13FINANCIAL STATEMENT EFFECTSOF COSTING METHODSAdvantages of MethodsAdvantages of MethodsAdvantages of MethodsAdvantages of MethodsSmoothes outprice changes.Smoothes outprice changes.Better matchescurrent costs in costof goods sold withrevenues.Better matchescurrent costs in costof goods sold withrevenues.Ending inventoryapproximatescurrentreplacement cost.Ending inventoryapproximatescurrentreplacement cost.First-In,First-OutFirst-In,First-OutWeightedAverageWeightedAverageLast-In,First-OutLast-In,First-OutA1
6 - 14TAX EFFECTS OF COSTINGMETHODSThe Internal Revenue Service (IRS) identifies severalThe Internal Revenue Service (IRS) identifies severalacceptable inventory costing methods for reportingacceptable inventory costing methods for reportingtaxable income.taxable income.If LIFO is used for taxIf LIFO is used for taxpurposes, the IRS requirespurposes, the IRS requiresit be used in financialit be used in financialstatements.statements.If LIFO is used for taxIf LIFO is used for taxpurposes, the IRS requirespurposes, the IRS requiresit be used in financialit be used in financialstatements.statements.A1
6 - 15LOWER OF COST OR MARKETInventory must be reported at market valueInventory must be reported at market valuewhenwhen marketmarket isis lowerlower than cost.than cost.Can be applied three ways:(1) separately to eachindividual item.(2) to major categories ofassets.(3) to the whole inventory.Can be applied three ways:(1) separately to eachindividual item.(2) to major categories ofassets.(3) to the whole inventory.P2