Inventory control

1
Inventory control Inventory Tracking.

• November 12-2023

2
Inventory Defined

• Inventory is a critical asset reported both in
  the Balance Sheet and Income Statement.
• Important issues to be familiar with in regard to
  inventory include
• 1) The valuation of the inventory when it is
  purchased and recorded
• 2) The determination of which specific items of
  inventory are included in inventory at year end
• 3) The recognition of permanent declines in the
  value of the inventory
• Valuing the Inventory When It Is Purchased
• costs paid for the inventory and for getting the
  inventory ready and available for sale, these
  include the cost of the inventory, shipping costs
  to receive the inventory, insurance while the
  inventory is in transit, taxes and tariffs,
  duties, and any other costs without which the
  company could not receive the inventory to sell
  to the customer.
• Costs of receiving the inventory are called
  landing costs.

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Inventory Defined

• The journal entry to record the purchase of
  inventory is as follows
• Dr Inventory......................................
  .............. all costs required
• Cr Cash...........................................
  .................. all costs required
• If more than one type of inventory is purchased
  for only one purchase price, the cost needs to be
  allocated among the different inventories
  purchased using a pro rata distribution based on
  the fair values of the different items purchased.
• If a company receives any discounts related to
  the purchase of the inventory, the discounted
  price it pays is the amount that should be
  recorded as the value of the inventory.

4
 Which Goods Are Included in Inventory?

• Transit, consigned, out on approval, or obsolete.
• Product costs are all the costs directly incurred
  to bring the goods in and, for a manufacturer, to
  convert them to a product that can be sold.
• the cost of the product itself,
• freight charges on the incoming shipments,
• other direct costs to acquire the product,
• and, for a manufacturer, production costs
  incurred in production of a salable product
• For a manufacturer, production costs include
• direct materials,
• direct labor,
• and manufacturing overhead.
• Product costs are held in inventory on the
  balance sheet until the items they are attached
  to are sold, and then they are expensed as cost
  of goods sold
• costs of purchasing and storing the inventory
  are not included in product costs because of the
  difficulty of allocating them to specific units.

5
Determining Which Item Is Sold

• Because the inventory on hand that a company
  holds is purchased at different times, the prices
  paid for individual units of the same item are
  different, the company must have a method of
  determining exactly which unit of inventory is
  sold for each and every sale.
• The different methods for determining which units
  have been sold are called cost flow assumptions.
  The four main cost flow assumptions are
• First in First Out (FIFO), in which it is assumed
  that the item sold to the customer is the
  earliest unit purchased by the seller that has
  not yet been sold (that is, the oldest item in
  inventory).
• Last in First Out (LIFO), in which it is assumed
  that the item sold to the customer is the latest
  unit purchased by the seller (that is, the newest
  item in inventory).
• Average Cost, in which the costs paid for all the
  individual units of a given item in inventory are
  summed and divided by the number of units
  purchased to find the average cost for each unit.
• Specific Identification, in which each unit of
  inventory is individually tracked. The specific
  iden- tification method is used for low quantity,
  high value inventory items, such as merchandise
  in a jewelry store or serialized electronic
  merchandise where inventory records are kept by
  serial number.
• IFRS Note Under IFRS, LIFO is prohibited.

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Benefits Challenges of inventory tracking
methods

• Benefits of FIFO
• In a period of rising prices, cost of goods sold
  will be lower with FIFO than with other cost flow
  assumptions because the oldest, lowest-cost
  inventory will be assumed sold for each sale.
  Consequently, reported net income will be higher
  than it would be with other cost flow
  assumptions, which may be of benefit to some
  companies.
• When FIFO is used, inventory on hand will reflect
  more-current market prices than would be the case
  under other cost flow assumptions because the
  inventory on the balance sheet will be reported
  at the cost of the most recently purchased items.
• In the U.S., FIFO is the only inventory cost flow
  assumption that is not restricted in its usage
  for income tax purposes by the IRS.
• Limitations of FIFO
• Although reported net income is higher under FIFO
  than under other cost flow assumptions, net cash
  flow will probably be lower. In a period of
  rising prices, taxable income will be higher, and
  higher taxable income means higher income taxes
  paid, which decreases net cash flow.
• Use of FIFO when prices are rising creates
  short-term, overstated operating income that is
  not sustainable due to lower-cost units purchased
  long ago being the ones expensed as cost of goods
  sold.

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Benefits Challenges of inventory tracking
methods

• Benefits of LIFO
• LIFO is sometimes the best match for the way
  goods physically flow into and out of inventory.
  When new inventory is received and displayed for
  sale, items may be placed in front of the
  existing inventory unless a concerted effort is
  made to position newer items behind older ones.
  If newer items are consistently placed in front
  of older ones, the newest units are always the
  units sold.
• LIFO better matches current costs against current
  revenues and therefore provides a better measure
  of current earnings. When prices are rising, use
  of LIFO leads to better quality earnings.
• The primary advantage of LIFO is that when prices
  are rising the use of LIFO for tax reporting
  results in a higher cost of goods sold and a
  lower taxable income. Lower taxable income leads
  to lower income taxes and higher cash flow.
• Limitations of LIFO
• If a company uses LIFO for its tax reporting to
  gain the advantage of lower taxes, tax law in the
  U.S. requires that the company also use LIFO for
  its financial reporting. Therefore, the companys
  reported earnings will be lower than they would
  be under the other cost flow assumptions,
  assuming rising prices. Tax law does not have a
  similar requirement for other inventory cost flow
  assumptions.
• Since the items reported as inventory on the
  balance sheet will be the earliest items
  purchased, when prices rise inventory will be
  valued too low on the balance sheet.
• If sales exceed purchases of inventory, layers of
  old inventory will be liquidated. The old costs
  will be matched against current revenues and will
  cause an increase in reported income for the
  period in which the liquidation occurs.
• A company using LIFO may be able to manipulate
  its net income by altering its purchasing pattern
  at year end.
• Accounting under LIFO can be complex because of
  the LIFO cost layers.
• Using LIFO for inventory valuation is not
  permitted if a company is using IFRS.

8
Benefits Challenges of inventory tracking
methods
9
Benefits Challenges of inventory tracking
methods

• In general, LIFO is preferable when
• Selling prices and revenues are increasing faster
  than costs and thus distorting net income
• LIFO has traditionally been used, such as in
  department stores and in industries where a
  fairly constant core inventory remains on hand,
  such as refining, chemicals, and glass.
• LIFO is probably less preferable or even
  inappropriate when
• prices tend to lag behind costs
• specific identification is needed, such as with
  automobiles, farm equipment, serialized
  electronic equipment, art, and antique jewelry

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Benefits Challenges of inventory tracking
methods

• unit costs tend to decrease as production
  increases, which would nullify any tax benefit
  that LIFO might provide because the most recently
  produced units would be in inventory at lower
  costs than inventory produced earlier because the
  lower-cost units would be the units sold
• prices tend to decrease, for example in
  electronics where prices are high when a new
  technology is introduced and prices for the same
  item typically decrease as time passes.

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The Frequency of Determining Inventory Balances

• Two systems are used for determining the
  frequency of making inventory entries
• the periodic method and
• the perpetual method
• The difference between the two systems lies in
  how often a company makes the calculation of its
  ending inventory and cost of goods sold.
• FIFO in the Periodic System Ending inventory
  consists of the most recently purchased units or
  those purchased toward the end of the period that
  had not been sold before the end of the period.
  The value of the ending inventory is determined
  only at the end of the period.
• LIFO in the Periodic System Again, the value of
  the ending inventory is determined only at the
  end of the period.
• Average Cost in the Periodic System A The
  calculation of the weighted average cost in the
  periodic system is done only at the end of the
  period.

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The Frequency of Determining Inventory Balances

• 2) Perpetual System Under the perpetual system,
  the calculation of the cost of the unit of
  inventory sold is made after each individual
  sale.
• FIFO in the Perpetual System Under FIFO, the
  periodic and the perpetual methods result in the
  same numbers because according to FIFO the oldest
  unit is sold first
• LIFO in the Perpetual System
• With perpetual LIFO, it is slightly more
  difficult to calculate the ending inventory
  because the LIFO inventory is in LIFO layers.
• Average Cost in the Perpetual System A Moving
  Average When the average cost method is performed
  on a perpetual basis, the method is called the
  moving aver- age method because the average
  applied to ending inventory and COGS is
  constantly changing because of calculating a new
  average cost after each purchase of inventory

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The Frequency of Determining Inventory Balances

• Note In a period of rising prices, LIFO yields
  the highest cost of goods sold and thus the
  lowest net income of all the methods, while FIFO
  results in the lowest cost of goods sold and the
  highest net income.
• If prices are falling, the opposite will be true.
• The resulting cost of goods sold and operating
  income from the average cost method (weighted or
  mov-ing) will always be in between LIFO and FIFO

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 INVENTORY COUNT, ERRORS, AND VALUATION

• Once the company knows how many units are
  physically on hand, it will use its inventory
  method (FIFO or LIFO, for example) to determine
  the cost of those units. The result of the
  calculation is recorded in the financial
  statements because it is the actual inventory
  balance.
• After the inventory count is made, the company
  will need to make an adjusting journal entry so
  that the balance sheet reflects the true
  inventory balance.
• If the actual count of inventory is less than the
  accounting records indicate, the journal entry to
  write down inventory is
• Dr Inventory loss ................................
  ................................... X
• Cr Inventory .....................................
  ....................................... X
• If the physical count of inventory is greater
  than the amount recorded in the accounting
  records, the value of the inventory needs to be
  written up. The journal entry is
• Dr Inventory......................................
  .................................... X
• Cr Inventory gain ................................
  ..................................... X
• Note A physical count is required by U.S. GAAP
  for annual reporting purposes. Under GAAP, a
  physical count of the inventory must be done each
  year regardless of which inventory cost flow
  method is being used. A physical count is not
  required for interim financial statements,
  however.

15
 INVENTORY COUNT, ERRORS, AND VALUATION

• Errors in Inventory
• The two most common questions about errors are
  What was the effect on ending inventory? and
  What was the effect on cost of goods sold? The
  relevant formulas are below.
• Note When COGS (an expense) is overstated,
  operating income is understated. Conversely, when
  COGS is understated, operating income is
  overstated.

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 INVENTORY COUNT, ERRORS, AND VALUATION

• A self-correcting error is one that corrects
  itself in time, even if it is not discovered. The
  miscounting of inventory is a self-correcting
  error. While the error in ending inventory will
  affect two balance sheets and two income
  statements, if inventory is correctly counted at
  the end of the next year, then no further errors
  will be caused by the original miscounting
• Recognizing Permanent Declines in Inventory
  Values
• Inventories are initially recorded at their cost.
  However, the value of inventory may decline over
  time.
• If the inventory becomes obsolete, is damaged, or
  is impacted by market conditions, the benefit the
  company can expect to receive from its sale may
  decline to a level below its cost, leading to
  inventory being over-stated on the balance sheet.
• Because inventory is an asset, it is important
  not to overvalue it on the balance sheet. If the
  inventorys value declines, it should be written
  down.
• Therefore, at the end of each period a company
  must evaluate its inventory to make sure the
  carrying amount is actually less than or equal to
  the amount of benefit the company will receive
  from it in the future.
• The process of valuing inventory is similar to
  the processes of valuing accounts receivable
  through the allowance for credit losses and
  determining impairment of fixedassets and
  intangible assets.

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 INVENTORY COUNT, ERRORS, AND VALUATION

• For inventories measured using any method other
  than LIFO or the Retail Method, the inventory
  should be measured at the lower of cost or net
  realizable value (LCNRV). Net realizable value is
  defined as the estimated selling price in the
  ordinary course of business, minus reasonably
  pre-dictable costs of selling, including costs of
  completion, disposal, and transportation.
• Measurement for inventory measured using LIFO
  or the Retail Method (including all cost flow as-
  sumptions when the Retail Method is used) is at
  the lower of cost or market (LCM).
• LIFO and LCM
• When the LIFO cost flow assumption is used, the
  market value used in the LCM calculation is a
  designated market value.
• The cost of the inventory is its historical cost,
  determined using LIFO.
• The market value used is called the designated
  market value and it is the middle value of the
  following three numbers, as follows
• 1) Ceiling, also called the Net Realizable Value
  or NRV. The net realizable value is the items
  estimated normal selling price minus reasonable
  costs to complete and dispose of the item.
• Net realizable value is the maximum value for the
  designated market value of the inventory.

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 INVENTORY COUNT, ERRORS, AND VALUATION

• 3) Floor, or the minimum value that will be used
  as the designated market value for the inventory.
  The floor is the net realizable value minus a
  normal profit margin.
• Note The LCM Method can be applied to the entire
  inventory as one group, to groups or pools of
  inventory items, or to each item individually.
  Applying it to each item individually will
  provide the lowest amount for ending inventory.
  When each item is calculated separately, any
  decrease in value will be recorded. However, when
  groups, or pools, of inventory are used a decline
  in the value of one item may be offset by an
  increase in the value of another item.
• If the designated market value is lower than the
  cost of the inventory, the difference (the loss)
  must be written off.

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 INVENTORY COUNT, ERRORS, AND VALUATION