Sequence N°: 03

Title: Inventory Accounting

A.Inventory
For any company that makes or sells merchandise, inventory is an
extremely important asset. Managing this asset requires not only protecting
goods from theft or loss, but also ensuring that operations are highly efficient.
Further, proper accounting for inventory is essential because misstatements will
affect net income in at least two years.
Inventory is considered a current asset because a company normally sells
it within a year or within its operating cycle. Inventory consists of all goods
owned and held for sale in the regular course of business. Because
manufacturing companies like Toyota are engaged in making products, they
have three kinds of inventory:
■■ Raw materials (goods used in making products)
■■ Work in process (partially completed products)
■■ Finished goods ready for sale

In a note to its financial statements, Toyota showed the following breakdown of

its inventories (figures are in millions):

Inventories 2015 2016

Raw materials (includes supplies) $ 4,457 $ 3,634
Work in process 2,626 2,142
Finished goods 8,602 9,512
Total inventories $15,685 $15,288

The work in process and the finished goods inventories have three cost
components:
■■ Cost of the raw materials that go into the product
■■ Cost of the labor used to convert the raw materials to finished goods
■■ Overhead costs that support the production process

Overhead costs include the costs of indirect materials (such as packing

materials), indirect labor (such as the salaries of supervisors), factory rent,
depreciation of plant assets, utilities, and insurance.

B. Accrual Accounting and Valuation of Inventories

The primary objective of inventory accounting is to apply accrual

accounting to the determination of cost of inventory sold during the accounting

1
period. Valuation of inventories is usually at cost. Inventory cost includes the
following:

■■ Invoice price less purchases discounts

■■ Freight-in, including insurance in transit
■■ Applicable taxes and tariffs

Other costs—for ordering, receiving, and storing—should, in principle,

be included in inventory cost. In practice, however, it is so difficult to allocate
such costs to specific inventory items that they are usually considered expenses
of the period.
Inventory valuation depends on the prices of goods, which usually vary
during the year. A company may have purchased identical lots of merchandise at
different prices. Also, for identical items, it is often impossible to tell which
have been sold and which are still in inventory. Thus, it is necessary to make an
assumption about the order in which items have been sold. Because the assumed
order of sale may or may not be the same as the actual order of sale, the
assumption is really about the flow of costs rather than the flow of physical
inventory.

C. Goods Flows and Cost Flows

Goods flow refers to the actual physical movement of goods in the

operations of a company. Cost flow refers to the association of costs with their
assumed flow. The assumed cost flow may or may not be the same as the actual
goods flow. A difference arises because several choices of assumed cost flow
are available under generally accepted accounting principles. In fact, it is
sometimes preferable to use an assumed cost flow that bears no relationship to
goods flow because it results in a better estimate of income, which is the main
goal of inventory accounting.

Merchandise in Transit Because merchandise inventory includes all items

that a company owns and holds for sale, the status of any merchandise in transit,
whether the company is selling it or buying it, must be evaluated to see if the
merchandise should be included in the inventory count. Neither the seller nor the
buyer has physical possession of merchandise in transit. As Exhibit 1 shows,
ownership is determined by the terms of the shipping agreement, which indicate
when title passes. Outgoing goods shipped FOB (free on board) destination are
included in the seller’s merchandise inventory, whereas those shipped FOB
shipping point are not. Conversely, incoming goods shipped FOB shipping point
are included in the buyer’s merchandise inventory, but those shipped FOB
destination are not.

2
Merchandise Not Included in Inventory At the time a company takes a physical
inventory, it may have merchandise to which it does not hold title. For example,
it may have sold goods but not yet delivered them to the buyer, but because the
sale has been completed, title has passed to the buyer. Thus, the merchandise
should be included in the buyer’s inventory, not the seller’s. Goods held on
consignment also fall into this category.

A consignment is merchandise that its owner (the consignor) places on the

premises of another company (the consignee) with the understanding that
payment is expected only when the merchandise is sold and that unsold items
may be returned to the consignor. Title to consigned goods remains with the
consignor until the consignee sells the goods. Consigned goods should not be
included in the consignee’s physical inventory.

D.Conservatism and the Lower-of- Cost-or-Market (LCM) Rule

Although cost is usually the most appropriate valuation basis, inventory

may at times be properly shown in the financial statements at less than its
historical, or original, cost. If the market value of inventory falls below its
historical cost because of physical deterioration, obsolescence, or decline in
price level, a loss has occurred. This loss is recognized by writing the inventory
down to market —that is, to its current replacement cost. For a merchandising
company, market is the amount that it would pay at the present time for the same
goods, purchased from the usual suppliers and in the usual quantities.

3
When the replacement cost of inventory falls below its historical cost (as
determined by an inventory costing method), the lower-of-cost-or-market
(LCM) rule requires that the inventory be written down to the lower value and
that a loss be recorded. This rule is an example of the conservatism concept
because the loss is recognized before an actual transaction takes place. It is also
an application of conservatism because, if the replacement cost rises, no gain is
recognized and the inventory remains at cost until it is sold. According to
survey, approximately 80 percent of large companies apply the LCM rule to
their inventories for financial reporting.

F. Gross Profit Method

The gross profit method (or gross margin method) assumes that the ratio
of gross margin for a business remains relatively stable from year to year. The
gross profit method is used in place of the retail method when records of the
retail prices of the beginning inventory and purchases are not available. It is a
useful way of estimating the amount of inventory lost or destroyed by theft, fire,
or other hazards. Insurance companies often use it to verify loss claims. The
gross profit method is acceptable for estimating the cost of inventory for interim
reports, but it is not acceptable for valuing inventory in the annual financial
statements.
As Exhibit 2 shows, the gross profit method involves the following steps:
■■ Step 1. Calculate the cost of goods available for sale in the usual way (add
purchases to beginning inventory).
■■ Step 2. Estimate the cost of goods sold by deducting the estimated gross
margin of 30 percent from sales.
■■ Step 3. Deduct the estimated cost of goods sold from the goods available for
sale to arrive at the estimated cost of the ending inventory.

4
Summary of Inventory Decisions

As you can see in Exhibit 3, in accounting for inventory, management must

choose among different processing systems, costing methods, and valuation
methods. These different systems and methods usually result in different
amounts of reported net income. Thus, management’s choices affect investors’
and creditors’ evaluations of a company, as well as the internal performance
reviews on which bonuses and executive compensation are based.
The consistency concept requires that once a company has decided on the
accounting systems and methods it will use for inventory, it must use them from
one period to the next. When a change is justifiable, the full disclosure
convention requires that the company clearly describes the change and its effects
in the notes to the financial statements.
Because the valuation of inventory affects income, it can have a large impact on
the income taxes a company pays—and the taxes it pays can impact its cash
flows. Federal income tax regulations are specific about the valuation methods a
company may use. As a result, management is sometimes faced with the
dilemma of how to apply GAAP to income determination and still minimize
income taxes.