INVENTORY
Accounting Theory
Accounting theory for inventory concerns the matching principle and cost principle. There is goods in process
inventory and finished goods inventory.
Goods in process inventory have further manufacturing costs before they become finished goods inventory.
Goods in process inventory affects the cost of goods of manufactured. The goods in process inventory at the
beginning of the year plus the manufacturing costs less the goods in process inventory at the end of the year are
the cost of finished goods inventory that are available for sale from manufacturing.
The finished goods inventory affects the cost of goods sold. The finished goods inventory at the beginning of the
year
plus the finished goods inventory that are available for sale from manufacturing are the total cost of goods
available for sale. The total cost of goods available for sale less the finished goods inventory at the end of the year
are the cost of goods sold.
Valuation matters concern raw material inventory, manufacturing costs, goods in process inventory and finished
goods inventory. Cost for goods in process inventory and finished goods inventory consists of direct materials,
direct labor and applied overhead. Cost of inventory must be matched against the sale of inventory for the
income statement and inventory must be valued for the balance sheet.
Inventory is recorded at cost when manufactured or acquired. Subsequent to when the inventory is acquired in
accordance with the exception principle of conservatism on the balance sheet the inventory valuation is at the
lower of cost or market. Lower of cost or market valuation would apply when the cost to manufacture or replace
the inventory is less than the original cost of the inventory. For basic materials and stock-in-trade market
is purchase cost. For goods in process and finished goods market is reproduction cost. While market means
current replacement cost by purchase or reproduction there are exceptions. Market should not exceed the net
realizable value which is selling price less costs of completion and disposal and Market should not be less than net
realizable value reduced by a normal profit margin.
Each item in inventory is compared by cost and market and the lower of each item is the inventory valuation.
When there are aggregate costs of an item in inventory the aggregate cost is compared to the aggregate
market. An aggregate cost of an item in inventory consists of two or more purchases at different costs. The
market price would apply to the combined purchases in inventory while the cost would be from each separate
purchase.
When actual costs for an item of inventory cannot be determined the inventory should be valued at net realizable
value reduced by a normal profit margin. If the inventory is damaged or has become obsolete it should be valued
at net realized value reduced by a normal profit margin. Damaged and obsolete inventory should be reported on
the balance sheet separately in accordance with the full disclosure principle. Any inventory that has destroyed by
fire, water or extraordinary events should be reported on the income statement as an extraordinary item.
When inventory is valued at the lower of cost or market the question that remains is how should the inventory
reduction from cost be reported. Three methods of reporting are as follows:
Report Loss on Inventory Reduction to Market in the Cost of Goods Sold
One method in practice is to account for the reduction in inventory by reporting the inventory at the lower of cost
or market for both the beginning and ending inventory in the cost of goods sold section of the income statement.
INVENTORY
Report Loss on Ending Inventory Reduction to Market as Extraordinary Item
A second method is to record only the beginning inventory at the lower of cost or market and to report the ending
inventory at cost in the cost of goods sold section of the income statement and to recognize a loss on ending
inventory reduction to market as an extraordinary item on the income statement. An allowance account should
be set up to record the loss on ending inventory reduction to market in the preceding year. In the current year
the balance in the allowance account is reversed so the beginning inventory is reported at the lower of cost or
market. In the current year the allowance account should again be set up to record loss on ending inventory
reduction to market.
Report Loss on Inventory Reduction to Market as Extraordinary Item
A third method is to record the beginning and ending inventory at cost in the cost of goods sold section of the
income statement. An allowance account should be set up to record the loss on ending inventory reduction to
market in the preceding year. The allowance account should be adjusted to the amount of loss on ending
inventory reduction to market in the current year. The adjustment to the allowance account is an extraordinary
item on the income statement.
Purchase Commitments
When product is ordered for future delivery either a near term purchase commitment or a long-term purchase
commitment there is an element of risk of falling prices. Where there is a falling market, the excess of the
commitment price over the market price at date of delivery is a contingent loss.
When management determines that a contingent liability may materialize retained earnings can be appropriated
in the amount of the potential loss. Retained earnings is debited and an appropriation account is credited. A
footnote should provide an explanation for full disclosure. When the contingency is finally made certain the
appropriation is returned to retained earnings. If the loss does materialize the loss would be reported as an
extraordinary item on the income statement as a loss from inventory reduction to market.
When goods are purchased or manufactured there is an inflow of costs. When the goods are sold there is an
outflow of costs. What remains is the goods in inventory. The flow of inventory is twofold as follows:
First is the actual flow of the physical goods. Separate purchases are made during the year at different costs and
sales consist of those purchases with the different costs. The concern is to use an appropriate unit cost for cost of
sales if a perpetual inventory system is used and of costing the units in inventory at the end of the accounting
period.
Second is the flow of inventory (physical goods) costs. Should the flow of costs inventory valuation prefer the
measurement of income (the income statement) or the flow of the physical goods (the balance sheet)? In
accordance with the matching principle the method of determining the flow of inventory costs should be the
method that best matches cost with revenue.
Whatever inventory flow method is decided upon is must be used in a consistent manner. The consistency
principle allows for comparability of financial information in future accounting periods. The various inventory
flow methods regarding cost are in accordance with the cost principle.
The inventory flow methods are Average Cost, First-In First-Out (FIFO) and Last-In First-Out (LIFO).
INVENTORY
Average Cost can be calculated by a weighted average of moving average.
Weighted average consists of a unit purchase price and the number of units purchased. That includes the
beginning inventory and subsequent purchases in the accounting period. It is calculated based in the total cost of
units available for sale divided by the total number of units available for sale. The units in inventory at the end of
the accounting period are priced at the weighted average. Cost of goods sold are costed at the weighted average
at the end of the accounting period when the weighted average is calculated. The units in inventory and the units
sold are costed at the same weighted average.
Moving average also consists of a unit purchase price and the number of units purchased. That includes the
beginning inventory and subsequent purchases in the accounting period. The moving average is calculated at
the time of each purchase and sale. Whatever the moving average becomes after each purchase is the unit cost
for the next sale. The units in inventory always have a current moving average. Cost of goods sold are costed at
the moving average at the time of sale. The moving average will result in an inventory valuation with more
current costs and a cost of goods sold costed at older costs. When using a perpetual inventory system the moving
average is preferable over the weighted average because cost of sales can be recorded immediately since there is
no waiting until the last purchase has been made in the accounting period.
First-In First-Out (FIFO) is an inventory flow of costs whereby the outflow of costs follows the order of the
inflow of costs. The units in inventory are costed at the most recent purchase price. Cost of goods sold are costed
at the oldest unit costs including the beginning inventory and subsequent purchases in that order. The flow of
costs follows the flow of the physical goods. A perpetual inventory system using FIFO will have the same
amounts for cost of goods sold and inventory as that of a physical inventory using FIFO. Since FIFO follows the
physical flow of goods it is focused on the balance sheet. The inventory valuation is costed at more current costs
and the cost of goods sold is costed at older costs.
Last-In Last-Out (LIFO) is an inventory flow of costs whereby the outflow of costs are from the most recent
purchases. The units in inventory are costed at the oldest unit costs including the beginning inventory and layers
of inventory are added based on the subsequent purchases in that order. Cost of goods sold are costed at the
most recent purchase price. For a perpetual inventory system using LIFO the cost of sales can be costed
currently or at the end of the period when the last purchase has occurred. If costed currently there will be a
different inventory valuation then that of the physical inventory using LIFO and if costed at the end of the
period. Since LIFO does not follow the physical flow of goods it is focused on the income statement. The
inventory valuation is costed at the older costs and the cost of goods sold is costed at more recent costs.
Small Business is the Engine that Drives our Economy. The Men and Women who Work to make our Country Great
Should be Recognized for their Achievement and Courage in Very Difficult Economic Times.