Measuring and Reporting Inventories

Learning objectives

After studying this chapter, you should be able to:

• Explain and calculate the effects of inventory errors on certain financial statement items.
• Indicate which costs are properly included in inventory.
• Calculate cost of ending inventory and cost of goods sold under the four major inventory costing methods using periodic and perpetual inventory procedures.
• Explain the advantages and disadvantages of the four major inventory costing methods.
• Record merchandise transactions under perpetual inventory procedure.
• Apply net realizable value and the lower-of-cost-or-market method of inventory.
• Estimate cost of ending inventory using the gross margin and retail inventory methods.
• Analyze and use the financial results- inventory turnover ratio.

Source: Textbook Equity, https://learn.saylor.org/pluginfile.php/41219/mod_resource/content/3/AccountingPrinciples.pdf
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Choosing an accounting career

Chapter 7 discusses how companies have a choice in inventory cost methods between specific identification, FIFO, LIFO, and weighted-average. Similarly, one of the greatest benefits of obtaining an accounting degree is the broad range of career choices available. There are over 40 different types of accounting jobs available in public accounting, private industry, and governmental accounting. 

One of the primary reasons many students go into accounting is successful job placement. Accounting majors have been better able to find positions than majors in any of the other business options, with the possible exception of management information systems (MIS). Even the relative demand for MIS majors has diminished recently, while the demand for accounting majors remains strong. We are currently experiencing a shortage of accounting majors across the nation. Another important factor to keep in mind regarding job placement is where you would like to be three to five years from now. Accounting offers an excellent foundation with opportunities for advancement, whereby many accounting graduates make double their entry-level salary in only five years.

Many students pursue an accounting degree because it does not restrict their career opportunities as much as having a different business degree. For example, with an accounting degree, a student can apply for positions in management, marketing, and finance, as well as accounting. In fact, many recruiters in business favor accounting graduates because they recognize an accounting degree as a more difficult business degree to obtain. However, management, marketing, and finance students cannot apply for accounting positions because they lack necessary accounting coursework. In fact, with some additional courses in systems, an accounting major is well equipped to pursue a career in any business field including information systems.

Have you ever taken advantage of a pre-inventory sale at your favorite retail store? Many stores offer bargain prices to reduce the merchandise on hand and to minimize the time and expense of taking the inventory. A smaller inventory also enhances the probability of taking an accurate inventory since the store has less merchandise to count. From Chapter 6 you know that companies use inventory amounts to determine the cost of goods sold; this major expense affects a merchandising company's net income. In this chapter, you learn how important inventories are in preparing an accurate income statement, statement of retained earnings, and balance sheet.

This chapter discusses merchandise inventory carried by merchandising retailers and wholesalers. Merchandise inventory is the quantity of goods held by a merchandising company for resale to customers. Merchandising companies determine the quantity of inventory items by a physical count.

The merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost of the items. This chapter discusses four accepted methods of costing the items: (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted average. Each method has advantages and disadvantages.

This chapter stresses the importance of having accurate inventory figures and the serious consequences of using inaccurate inventory figures. When you finish this chapter, you should understand how taking inventory connects with the cost of goods sold figure on the store's income statement, the retained earnings amount on the statement of retained earnings, and both the inventory figure and the retained earnings amount on the store's balance sheet.

Inventories and cost of goods sold

Inventory is often the largest and most important asset owned by a merchandising business. The inventory of some companies, like car dealerships or jewelry stores, may cost several times more than any other asset the company owns. As an asset, the inventory figure has a direct impact on reporting the solvency of the company in the balance sheet. As a factor in determining cost of goods sold, the inventory figure has a direct impact on the profitability of the company's operations as reported in the income statement. Thus, the importance of the inventory figure should not be underestimated.

Importance of proper inventory valuation

A merchandising company can prepare accurate income statements, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, a company using periodic inventory procedure takes a physical inventory to determine the cost of goods sold. Since the cost of goods sold figure affects the company's net income, it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading "Current Assets", which reports current assets in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet.

Recall that under periodic inventory procedure we determine the cost of goods sold figure by adding the beginning inventory to the net cost of purchases and deducting the ending inventory. In each accounting period, the appropriate expenses must be matched with the revenues of that period to determine the net income. Applied to inventory, matching involves determining (1) how much of the cost of goods available for sale during the period should be deducted from current revenues and (2) how much should be allocated to goods on hand and thus carried forward as an asset (merchandise inventory) in the balance sheet to be matched against future revenues. Because we determine the cost of goods sold by deducting the ending inventory from the cost of goods available for sale, a highly significant relationship exists: Net income for an accounting period depends directly on the valuation of ending inventory. This relationship involves three items:

First, a merchandising company must be sure that it has properly valued its ending inventory. If the ending inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross margin and net income. Also, overstatement of ending inventory causes current assets, total assets, and retained earnings to be overstated. Thus, any change in the calculation of ending inventory is reflected, dollar for dollar (ignoring any income tax effects), in net income, current assets, total assets, and retained earnings.

Second, when a company misstates its ending inventory in the current year, the company carries forward that misstatement into the next year. This misstatement occurs because the ending inventory amount of the current year is the beginning inventory amount for the next year.

Third, an error in one period's ending inventory automatically causes an error in net income in the opposite direction in the next period. After two years, however, the error washes out, and assets and retained earnings are properly stated.

Exhibit 44 and Exhibit 45 prove that net income for an accounting period depends directly on the valuation of the inventory. Allen Company's income statements and the statements of retained earnings for years 2009 and 2010 show this relationship.

ALLEN COMPANY

For Year Ended 2009 December 31

Ending Inventory

Exhibit 44: Effects of an overstated ending inventory

ALLEN COMPANY

For Year Ended 2010 December 31

Exhibit 45: Effects of an overstated beginning inventory

In Exhibit 44 the correctly stated ending inventory for the year 2009 is USD 35,000. As a result, Allen has a gross margin of USD 135,000 and net income of USD 50,000. The statement of retained earnings shows a beginning retained earnings of USD 120,000 and an ending retained earnings of USD 170,000. When the ending inventory is overstated by USD 5,000, as shown on the right in Exhibit 44, the gross margin is USD 140,000, and net income is USD 55,000. The statement of retained earnings then has an ending retained earnings of USD 175,000. The ending inventory overstatement of USD 5,000 causes a USD 5,000 overstatement of net income and a USD 5,000 overstatement of retained earnings. The balance sheet would show both an overstated inventory and an overstated retained earnings. Due to the error in ending inventory, both the stockholders and creditors may overestimate the profitability of the business.

Exhibit 45 is a continuation of Exhibit 44 and contains Allen's operating results for the year ended 2010 December 31. Note that the ending inventory in Exhibit 44 now becomes the beginning inventory of Exhibit 45. However, Allen's inventory at 2010 December 31, is now an accurate inventory of USD 45,000. As a result, the gross margin in the income statement with the beginning inventory correctly stated is USD 145,000, and Allen Company has net income of USD 91,500 and an ending retained earnings of USD 261,500. In the income statement columns at the right, in which the beginning inventory is overstated by USD 5,000, the gross margin is USD 140,000 and net income is USD 86,500, with the ending retained earnings also at USD 261,500.

Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated beginning inventory results in an understatement of net income. If the beginning inventory is overstated, then cost of goods available for sale and cost of goods sold also are overstated. Consequently, gross margin and net income are understated. Note, however, that when net income in the second year is closed to retained earnings, the retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset by the understatement of net income in the second year. For the two years combined the net income is correct. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings. Exhibit 46 summarizes the effects of errors of inventory valuation:

Exhibit 46: Inventory errors

Determining inventory cost

To place the proper valuation on inventory, a business must answer the question: Which costs should be included in inventory cost? Then, when the business purchases identical goods at different costs, it must answer the question: Which cost should be assigned to the items sold? In this section, you learn how accountants answer these questions.

The costs included in inventory depend on two variables: quantity and price. To arrive at a current inventory figure, companies must begin with an accurate physical count of inventory items. They multiply the quantity of inventory by the unit cost to compute the cost of ending inventory. This section discusses the taking of a physical inventory and the methods of costing the physical inventory under both perpetual and periodic inventory procedures. The remainder of the chapter discusses departures from the cost basis of inventory measurement.

As briefly described in Chapter 6, to take a physical inventory, a company must count, weigh, measure, or estimate the physical quantities of the goods on hand. For example, a clothing store may count its suits; a hardware store may weigh bolts, washers, and nails; a gasoline company may measure gasoline in storage tanks; and a lumberyard may estimate quantities of lumber, coal, or other bulky materials. Throughout the taking of a physical inventory, the goal should be accuracy.

Taking a physical inventory may disrupt the normal operations of a business. Thus, the count should be administered as quickly and as efficiently as possible. The actual taking of the inventory is not an accounting function; however, accountants often plan and coordinate the count. Proper forms are required to record accurate counts and determine totals. Identification names or symbols must be chosen, and those persons who count, weigh, or measure the inventory items must know these symbols.

Exhibit 47: Inventory tag

Taking a physical inventory often involves using inventory tags, such as that in Exhibit 47. These tags are consecutively numbered for control purposes. A tag usually consists of a stub and a detachable duplicate section. The duplicate section facilitates checking discrepancies. The format of the tags can vary. However, the tag usually provides space for (1) a detailed description and identification of inventory items by product, class, and model; (2) location of items; (3) quantity of items on hand; and (4) initials of the counters and checkers.

The descriptive information and count may be entered on one copy of the tag by one team of counters. Another team of counters may record its count on the duplicate copy of the tag. Discrepancies between counts of the same items by different teams are reconciled by supervisors, and the correct counts are assembled on intermediate inventory sheets. Only when the inventory counts are completed and checked does management send the final sheets to the accounting department for pricing and extensions (quantity X price). The tabulated result is the dollar amount of the physical inventory. Later in the chapter we explain the different methods accountants use to cost inventory.

Usually, inventory cost includes all the necessary outlays to obtain the goods, get the goods ready to sell, and have the goods in the desired location for sale to customers. Thus, inventory cost includes:

• Seller's invoice price less any purchase discount.
• Cost of the buyer's insurance to cover the goods while in transit.
• Transportation charges when borne by the buyer.
• Handling costs, such as the cost of pressing clothes wrinkled during shipment.

In theory, the cost of each unit of inventory should include its net invoice price plus its share of other costs incurred in shipment. The 1986 Tax Reform Act requires companies to assign these costs to inventory for tax purposes. For accounting purposes, these cost assignments are recommended but not required.

Practical difficulties arise in allocating some of these costs to inventory items. Assume, for example, that the freight bill on a shipment of clothes does not separate out the cost of shipping one shirt. Also, assume that the company wants to include the freight cost as part of the inventory cost of the shirt. Then, the freight cost would have to be allocated to each unit because it cannot be measured directly. In practice, allocations of freight, insurance, and handling costs to the individual units of inventory purchased are often not worth the additional cost. Consequently, in the past many companies have not assigned the costs of freight, insurance, and handling to inventory. Instead, they have expensed these costs as incurred. When companies omit these costs from both beginning and ending inventories, they minimize the effect of expensing these costs on net income. The required allocation for tax purposes has probably resulted in many companies using the same inventory amounts in their financial statements.

Even if a company derives a cost for each unit in inventory, the inventory valuation problem is not solved. Management must consider two other aspects of the problem:

• If goods were purchased at varying unit costs, how should the cost of goods available for sale be allocated between the units sold and those that remain in inventory? For example, assume Hi-Fi Buys, Inc., purchased two identical DVD players for resale. One cost USD 250 and the other, USD 200. If one was sold during the period, should Hi-Fi Buys assign it a cost of USD 250, USD 200, or an average cost of USD 225?
• Does the fact that current replacement costs are less than the costs of some units in inventory have any bearing on the amount at which inventory should be carried? Using the same example, if Hi-Fi Buys can currently buy all DVD players for USD 200, is it reasonable to carry some units in inventory at USD 250 rather than USD 200?

We answer these questions in the next section.

Generally companies should account for inventories at historical cost; that is, the cost at which the items were purchased. However, this rule does not indicate how to assign costs to ending inventory and to cost of goods sold when the goods have been purchased at different unit costs. For example, suppose a retailer has three shirts on hand. One costs USD 20; another, USD 22; and a third, USD 24. If the retailer sells two shirts for USD 30 each, what is the cost of the two shirts sold?

Accountants developed these four inventory costing methods to solve costing problems: (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Before explaining the inventory costing methods, we briefly introduce perpetual inventory procedure and compare periodic and perpetual inventory procedures.

In Chapter 6, the emphasis was on periodic inventory procedure. Under periodic inventory procedure, firms debit the Purchases account when goods are acquired; they use other accounts, such as Purchase Discounts, Purchase Returns and Allowances, and Transportation-In, for purchase-related transactions. Companies determine cost of goods sold only at the end of the period as the difference between cost of goods available for sale and ending inventory. They keep no records of the cost of items as they are sold, and have no information on possible inventory shortages. They assume any goods not in ending inventory have been sold.

Exhibit 48: Perpetual inventory record (FIFO method)

The availability of inventory management software packages is causing more and more businesses to change from periodic to perpetual inventory procedure. Under perpetual inventory procedure, companies have no Purchases and purchase-related accounts. Instead, they make all entries involving merchandise purchased for sale to customers directly in the Merchandise Inventory account. Thus, they debit or credit Merchandise Inventory in place of debiting or crediting Purchases, Purchase Discounts, Purchase Returns and Allowances, and Transportation-In. At the time of each sale, firms make two entries: the first debits Accounts Receivable or Cash and credits Sales at the retail selling price. The second debits Cost of Goods Sold and credits Merchandise Inventory at cost. Therefore, at the end of the period the Merchandise Inventory account shows the cost of the inventory that should be on hand. Comparison of this amount with the cost obtained by taking and pricing a physical inventory may reveal inventory shortages. Thus, perpetual inventory procedure is an important element in providing internal control over goods in inventory.

Perpetual inventory records Even though companies could apply perpetual inventory procedure manually, tracking units and dollars in and out of inventory is much easier using a computer. Both manual and computer processing maintain a record for each item in inventory. Look at Exhibit 48, an inventory record for Entertainment World, a firm that sells many different brands of television sets. This inventory record shows the information on one particular brand and model of television set carried in inventory. Other information on the record includes (1) the maximum and minimum number of units the company wishes to stock at any time, (2) when and how many units were acquired and at what cost, and (3) when and how many units were sold and what cost was assigned to cost of goods sold. The number of units on hand and their cost are readily available also. Entertainment World assumes that the first units acquired are the first units sold. This assumption is the first-in, first-out (FIFO) method of inventory costing; we will discuss it later.

An accounting perspective: Uses of technology

Keeping track of inventories under a perpetual inventory system is much more cost effective with computers. Under a manual system, the cost of an up-to-date inventory for stores with high turnover would outweigh the benefit. Most retail stores use scanning devices to read the inventory numbers of products purchased at the cash register. These bar codes not only provide accurate sales prices but also record the merchandise sold so that the total cost of the store's inventory is up to date.

The following comparison reveals several differences between accounting for inventories under periodic and perpetual procedures. We explain these differences by using data from Exhibit 48 and making additional assumptions. Later, we discuss other journal entries under perpetual inventory procedure.

These entries record the purchase on July 5 under each of the methods:

Assuming the merchandise sold on July 7 was priced at USD 4,800, these entries record the sale:

Several other transactions not included in Exhibit 48 could occur:

• Assume that two of the units purchased on July 5 were returned to the supplier because they were defective. The entries would be:

Assume that the supplier instead granted an allowance of USD 600 to the company because of the defective merchandise. The entries would be:

Assume that the company incurred and paid freight charges of USD 100 on the purchase of July 5. The entries would be:

In these entries, notice that under perpetual inventory procedure the Merchandise Inventory account records purchases, purchase returns and allowances, purchase discounts, and transportationin. Also, when goods are sold, the seller debits (increases) Cost of Goods Sold and credits or reduces Merchandise Inventory.

At the end of the accounting period, under perpetual inventory procedure, the only merchandiserelated expense account to be closed is Cost of Goods Sold. The Purchases, Purchase Returns and Allowances, Purchase Discounts, and Transportation-In accounts do not even exist.

Ending inventory = 20 units, determined By taking a physical inventory.

Exhibit 49: Beginning inventory, purchases, and sales

An accounting perspective: Business insight

When you buy a box of breakfast cereal at the supermarket, the cashier scans the bar code on the box. The name of the item and the price appear on a video display that you can see. The information is also printed on the sales slip so that you can later compare the items paid for with the items received. But this is not the end of the story. The information is also fed to the store's computer to update the inventory records. The information is included with other information and is used to order more merchandise from the warehouse so the items can be replenished in the store. At a certain point, the company also uses the reduced inventory levels to order more merchandise from suppliers, such as wholesalers that supply the region with breakfast cereals and other goods. The paperwork for the purchase and payment are often handled electronically through a process called electronic data interchange (EDI) and electronic funds transfer (EFT).

Using the data for purchases, sales, and beginning inventory in Exhibit 49, next we explain the four inventory costing methods. Except for the specific identification method, we first present all of the methods using periodic inventory procedure and then present all of the methods using perpetual inventory procedure. Total goods available for sale consist of 80 units with a total cost of USD 690. A physical inventory determined that 20 units are on hand at the end of the period. Sales revenue for the 60 units sold was USD 780. The questions to be answered are: What is the cost of the 20 units in inventory? What is the cost of the 60 units sold?

Specific identification The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as autos. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial number or identification tag.

To illustrate, assume that the company in Exhibit 49 can identify the 20 units on hand at year-end as 10 units from the August 12 purchase and 10 units from the December 21 purchase. The company computes the ending inventory as shown in Exhibit 50; it subtracts the USD 181 ending inventory cost from the USD 690 cost of goods available for sale to obtain the USD 509 cost of goods sold. Note that you can also determine the cost of goods sold for the year by recording the cost of each unit sold. The USD 509 cost of goods sold is an expense on the income statement, and the USD 181 ending inventory is a current asset on the balance sheet.

The specific identification costing method attaches cost to an identifiable unit of inventory. The method does not involve any assumptions about the flow of the costs as in the other inventory costing methods. Conceptually, the method matches the cost to the physical flow of the inventory and eliminates the emphasis on the timing of the cost determination. Therefore, periodic and perpetual inventory procedures produce the same results for the specific identification method.

Exhibit 50: Determining ending inventory under specific identification

FIFO (first-in, first-out) under periodic inventory procedure The FIFO (first-in, firstout) method of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods. This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods.

Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the ending inventory consists of the most recent purchases. When using periodic inventory procedure, to determine the cost of the ending inventory at the end of the period under FIFO, you would begin by listing the cost of the most recent purchase. If the ending inventory contains more units than acquired in the most recent purchase, it also includes units from the next-to-the-latest purchase at the unit cost incurred, and so on. You would list these units from the latest purchases until that number agrees with the units in the ending inventory.

In Exhibit 51, you can see how to determine the cost of ending inventory under FIFO using periodic inventory procedure. The company assumes that the 20 units in inventory consist of 10 units purchased December 21 and 10 units purchased October 12. The total cost of ending inventory is USD 179, and the cost of goods sold is USD 511.

We show the relationship between the cost of goods sold and the cost of ending inventory under FIFO using periodic inventory procedure in Exhibit 52. The 80 units in cost of goods available for sale consists of the beginning inventory and all of the purchases during the period. Under FIFO, the ending inventory of 20 units consists of the most recent purchases - 10 units of the December 21 purchase and 10 units of the October 12 purchase - costing USD 179. We assume the beginning inventory and other earlier purchases have been sold during the period, representing the cost of goods sold of USD 511.

Exhibit 51: Determining FIFO cost of ending inventory under periodic inventory procedure

Exhibit 52: FIFO flow of costs

LIFO (last-in, first-out) under periodic inventory procedure The LIFO (last-in, firstout) method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods.

In Exhibit 53, we show the use of LIFO under periodic inventory procedure. Since the company charges the latest costs to cost of goods sold under periodic inventory procedure, the ending inventory always consists of the oldest costs. Therefore, when determining the cost of inventory under periodic inventory procedure, the company lists the oldest units and their costs. The first units listed are those in beginning inventory, then the first purchase, and so on, until the number listed agrees with the units in ending inventory. Thus, ending inventory in Exhibit 53 consists of the 10 units from beginning inventory and the 10 units purchased on March 2. The total cost of these 20 units, USD 165, is the ending inventory cost; the cost of goods sold is USD 525. Exhibit 54 is a graphic representation of the LIFO flow of costs under periodic inventory procedure.

Exhibit 53: Determining LIFO cost of ending inventory under periodic inventory procedure

Exhibit 54: LIFO flow of costs under periodic inventory procedure

Weighted-average under periodic inventory procedure The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them.

Under periodic inventory procedure, a company determines the average cost at the end of the accounting period by dividing the total units purchased plus those in beginning inventory into total cost of goods available for sale. The ending inventory is carried at this per unit cost. To see how a company uses the weighted-average method to determine inventory costs using periodic inventory procedure, look at Exhibit 55. Note that we compute weighted-average cost per unit by dividing the cost of units available for sale, USD 690, by the total number of units available for sale, 80. Thus, the weighted-average cost per unit is USD 8.625, meaning that each unit sold or remaining in inventory is valued at USD 8.625.

Exhibit 55: Determining ending inventory under weighted-average method using periodic inventory procedure

Exhibit 56: Determining FIFO cost of ending inventory under perpetual inventory procedure

FIFO under perpetual inventory procedure Under perpetual inventory procedure, the ending balance in the Merchandise Inventory account reflects the most recent purchases as a result of making the required entries during the period. Also, the firm has already recorded the cost of goods sold in the Cost of Goods Sold account. Exhibit 56 shows how to determine the cost of ending inventory under FIFO using perpetual inventory procedure. This illustration uses the same format as the earlier perpetual inventory record in Exhibit 48. The company keeps a record of the balance in the inventory account as it makes purchases and sells items from inventory.

Exhibit 57: Determining LIFO cost of ending inventory under perpetual inventory procedure

Notice in Exhibit 56 that each time a sale occurs, the company assumes the items sold are the oldest on hand. Thus, after each transaction, it can readily determine the balance in the Merchandise Inventory account from the perpetual inventory record. The balance after the December 21 purchase represents the 20 units from the most recent purchases. The total cost of ending inventory is USD 179, which the company reports as a current asset on the balance sheet. During the accounting period, as sales occurred the firm would have debited a total of USD 511 to Cost of Goods Sold. Adding this USD 511 to the ending inventory of USD 179 accounts for the USD 690 cost of goods available for sale. Under FIFO, using either perpetual or periodic inventory procedures results in the same total amounts for ending inventory and for cost of goods sold.

LIFO under perpetual inventory procedure Look at Exhibit 57 to see the LIFO method using perpetual inventory procedure. Under this procedure, the inventory composition and balance are updated with each purchase and sale. Notice in Exhibit 57 that each time a sale occurs, the items sold are assumed to be the most recent ones acquired. Despite numerous purchases and sales during the year, the ending inventory still includes the 10 units from beginning inventory in our example. The remainder of the ending inventory consists of the last purchase because no sale occurred after the December 21 purchase. The total cost of the 20 units in ending inventory is USD 171; the cost of goods sold is USD 519. Exhibit 58 shows graphically the LIFO flow of costs under perpetual inventory procedure.

Applying LIFO on a perpetual basis during the accounting period, as shown in Exhibit 57, results in different ending inventory and cost of goods sold figures than applying LIFO only at year-end using periodic inventory procedure. (Compare Exhibit 57 and Exhibit 53 to verify that ending inventory and cost of goods sold are different under the two procedures.) For this reason, if LIFO is applied on a perpetual basis during the period, special adjustments are sometimes necessary at year-end to take full advantage of using LIFO for tax purposes. Complicated applications of LIFO perpetual inventory procedures that require such adjustments are beyond the scope of this text.

Exhibit 58: LIFO flow of costs under perpetual inventory procedure

^AA new unit cost is calculated after each purchase. ^BThe unit cost of sales is the most recently calculated cost. ^C Balance of $178.58 would agree with balance already existing in the Merchandise Inventory account.

Exhibit 59: Determining ending inventory under weighted-average method using perpetual inventory procedure

Look at Exhibit 58 and Exhibit 54, the flow of inventory costs under LIFO using both the perpetual and periodic inventory procedures. Note that ending inventory and cost of goods sold are different under the two procedures.

Weighted-average under perpetual inventory procedure Under perpetual inventory procedure, firms compute a new weighted-average unit cost after each purchase by dividing total cost of goods available for sale by total units available for sale. The unit cost is a moving weighted-average because it changes after each purchase. In Exhibit 59, you can see how to compute the moving weighted-average using perpetual inventory procedure. The new weighted-average unit cost computed after each purchase is the unit cost for inventory items sold until a new purchase is made. The unit cost of the 20 units in ending inventory is USD 8.929 for a total inventory cost of USD 178.58. Cost of goods sold under this procedure is USD 690 minus the USD 178.58, or USD 511.42.

Advantages and disadvantages of specific identification Companies that use the specific identification method of inventory costing state their cost of goods sold and ending inventory at the actual cost of specific units sold and on hand. Some accountants argue that this method provides the most precise matching of costs and revenues and is, therefore, the most theoretically sound method. This statement is true for some one-of-a-kind items, such as autos or real estate. For these items, use of any other method would seem illogical.

One disadvantage of the specific identification method is that it permits the manipulation of income. For example, assume that a company bought three identical units of a given product at different prices. One unit cost USD 2,000, the second cost USD 2,100, and the third cost USD 2,200. The company sold one unit for USD 2,800. The units are alike, so the customer does not care which of the identical units the company ships. However, the gross margin on the sale could be either USD 800, USD 700, or USD 600, depending on which unit the company ships.

Advantages and disadvantages of FIFO The FIFO method has four major advantages: (1) it is easy to apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market value. All the advantages of FIFO occur because when a company sells goods, the first costs it removes from inventory are the oldest unit costs. A company cannot manipulate income by choosing which unit to ship because the cost of a unit sold is not determined by a serial number. Instead, the cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income.

The disadvantages of FIFO include (1) the recognition of paper profits and (2) a heavier tax burden if used for tax purposes in periods of inflation. We discuss these disadvantages later as advantages of LIFO.

Advantages and disadvantages of LIFO The advantages of the LIFO method are based on the fact that prices have risen almost constantly for decades. LIFO supporters claim this upward trend in prices leads to inventory, or paper, profits if the FIFO method is used. Inventory, or paper, profits are equal to the current replacement cost of a unit of inventory at the time of sale minus the unit's historical cost.

For example, assume a company has three units of a product on hand, each purchased at a different cost: USD 12, USD 15, and USD 20 (the most recent cost). The sales price of the unit normally rises because the unit's replacement cost is rising. Assume that the company sells one unit for USD 30. FIFO gross margin would be USD 18 (USD 30 – USD 12), while LIFO would show a gross margin of USD 10 (USD 30 – USD 20). LIFO supporters would say that the extra USD 8 gross margin shown under FIFO represents inventory (paper) profit; it is merely the additional amount that the company must spend over cost of goods sold to purchase another unit of inventory (USD 8 + USD 12 = USD 20). Thus, the profit is not real; it exists only on paper. The company cannot distribute the USD 8 to owners, but must retain it to continue handling that particular product. LIFO shows the actual profits that the company can distribute to the owners while still replenishing inventory.

During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income.

Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management's ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.

Supporters of FIFO argue that LIFO (1) matches the cost of goods not sold against revenues, (2) grossly understates inventory, and (3) permits income manipulation.

The first criticism - that LIFO matches the cost of goods not sold against revenues - is an extension of the debate over whether the assumed flow of costs should agree with the physical flow of goods. LIFO supporters contend that it makes more sense to match current costs against current revenues than to worry about matching costs for the physical flow of goods.

The second criticism - that LIFO grossly understates inventory - is valid. A company may report LIFO inventory at a fraction of its current replacement cost, especially if the historical costs are from several decades ago. LIFO supporters contend that the increased usefulness of the income statement more than offsets the negative effect of this undervaluation of inventory on the balance sheet.

The third criticism - that LIFO permits income manipulation - is also valid. Income manipulation is possible under LIFO. For example, assume that management wishes to reduce income. The company could purchase an abnormal amount of goods at current high prices near the end of the current period, with the purpose of selling the goods in the next period. Under LIFO, these higher costs are charged to cost of goods sold in the current period, resulting in a substantial decline in reported net income. To obtain higher income, management could delay making the normal amount of purchases until the next period and thus include some of the older, lower costs in cost of goods sold.

Tax benefit of LIFO The LIFO method results in the lowest taxable income, and thus the lowest income taxes, when prices are rising. The Internal Revenue Service allows companies to use LIFO for tax purposes only if they use LIFO for financial reporting purposes. Companies may also report an alternative inventory amount in the notes to their financial statements for comparison purposes. Because of high inflation during the 1970s, many companies switched from FIFO to LIFO for tax advantages.

Advantages and disadvantages of weighted-average When a company uses the weighted-

average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as badly understated as under LIFO, but it is not as up-to-date as under FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve assumptions about how costs flow through a business. In some instances, assumed cost flows may correspond with the actual physical flow of goods. For example, fresh meats and dairy products must flow in a FIFO manner to avoid spoilage losses. In contrast, firms use coal stacked in a pile in a

LIFO manner because the newest units purchased are unloaded on top of the pile and sold first. Gasoline held in a tank is a good example of an inventory that has an average physical flow. As the tank is refilled, the new gasoline mixes with the old. Thus, any amount used is a blend of the old gas with the new.

Although physical flows are sometimes cited as support for an inventory method, accountants now recognize that an inventory method's assumed cost flows need not necessarily correspond with the actual physical flow of the goods. In fact, good reasons exist for simply ignoring physical flows and choosing an inventory method based on other criteria.

In Exhibit 60 and Exhibit 61, we use data from Exhibit 49 to show the cost of goods sold, inventory cost, and gross margin for each of the four basic costing methods using perpetual and periodic inventory procedures. The differences for the four methods occur because the company paid different prices for goods purchased. No differences would occur if purchase prices were constant. Since a company's purchase prices are seldom constant, inventory costing method affects cost of goods sold, inventory cost, gross margin, and net income. Therefore, companies must disclose on their financial statements which inventory costing methods were used.

Which is the correct method? All four methods of inventory costing are acceptable; no single method is the only correct method. Different methods are attractive under different conditions.

If a company wants to match sales revenue with current cost of goods sold, it would use LIFO. If a company seeks to reduce its income taxes in a period of rising prices, it would also use LIFO. On the other hand, LIFO often charges against revenues the cost of goods not actually sold. Also, LIFO may allow the company to manipulate net income by changing the timing of additional purchases.

The FIFO and specific identification methods result in a more precise matching of historical cost with revenue. However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation. The weighted-average method also allows manipulation of income. Only under FIFO is the manipulation of net income not possible.

An accounting perspective: Business insight

Management decides which inventory costing method or methods (LIFO, FIFO, etc.) to use. Also, management must determine which method is the most meaningful and useful in representing economic results. Then, it must use the selected method consistently.

The principal business of Kellwood Company is the marketing, merchandising, and manufacturing of apparel, primarily for women. Note in the following footnote from Kellwood's financial statements that it, like other companies, uses several costing methods within the same enterprise:

“Summary of significant accounting policies

3. Inventories and revenue recognition

Inventories are stated at the lower of cost or market. The first-in, first-out (FIFO) method is used to determine the value of 46 per cent of the domestic inventories, and the last-in, first-out (LIFO) method is used to value the remaining domestic inventories. Inventories of foreign subsidiaries are valued using the specific identification method. Sales are recognized when goods are shipped”.

Generally, companies use the inventory method that best fits their individual circumstances. However, this freedom of choice does not include changing inventory methods every year or so, especially if the goal is to report higher income. Continuous switching of methods violates the accounting principle of consistency, which requires using the same accounting methods from period to period in preparing financial statements. Consistency of methods in preparing financial statements enables financial statement users to compare statements of a company from period to period and determine trends.

Exhibit 60: Effects of different inventory costing methods using perpetual inventory procedure

Exhibit 61: Effects of different inventory costing methods using periodic inventory procedure

An accounting perspective: Business insight

Sometimes, companies change inventory methods in spite of the principle of consistency. Improved financial reporting is the only justification for a change in inventory method. A company that changes its inventory method must make a full disclosure of the change. Usually, the company makes a full disclosure in a footnote to the financial statements. The footnote consists of a complete description of the change, the reasons why the change was made, and, if possible, the effect of the change on net income.

1. M. Tull Industries, Inc., sells a diverse range of metals (aluminum, brass, copper, steel, stainless steel, and nickel alloys) for severe corrosion conditions and hightemperature applications. For example, when J. M. Tull changed from lower of average cost or market to LIFO, the following footnote appeared in its annual report:

Note B. Change in accounting method for inventory

The company changed its method of determining inventory cost from the lower of average cost or market method to the last-in, first-out (LIFO) method for substantially all inventory. This change was made because management believes LIFO more clearly reflects income by providing a closer matching of current cost against current revenue.

Now we illustrate in more detail the journal entries made when using perpetual inventory procedure. Data from Exhibit 56 serves as the basis for some of the entries.

You would debit the Merchandise Inventory account to record the increases in the asset due to purchase costs and transportation-in costs. You would credit Merchandise Inventory to record the decreases in the asset brought about by purchase returns and allowances, purchase discounts, and cost of goods sold to customers. The balance in the account is the cost of the inventory that should be on hand at any date. This entry records the purchase of 10 units on March 2 in Exhibit 56:

You would also record the 10 units sold on the perpetual inventory record in Exhibit 56. Perpetual inventory procedure requires two journal entries for each sale. One entry is at selling price - a debit to Accounts Receivable (or Cash) and a credit to Sales. The other entry is at cost - a debit to Cost of Goods Sold and a credit to Merchandise Inventory. Assuming that the 10 units sold on March 10 in Exhibit 56 had a retail price of USD 13 each, you would record the following entries:

When a company sells merchandise to customers, it transfers the cost of the merchandise from an asset account (Merchandise Inventory) to an expense account (Cost of Goods Sold). The company makes this transfer because the sale reduces the asset, and the cost of the goods sold is one of the expenses of making the sale. Thus, the Cost of Goods Sold account accumulates the cost of all the merchandise that the company sells during a period.

A sales return also requires two entries, one at selling price and one at cost. Assume that a customer returned merchandise that cost USD 20 and originally sold for USD 32. The entry to reduce the accounts receivable and to record the sales return of USD 32 is:

The entry that increases the Merchandise Inventory account and decreases the Cost of Goods Sold account by USD 20 is as follows:

Sales returns affect both revenues and cost of goods sold because the goods charged to cost of goods sold are actually returned to the seller. In contrast, sales allowances granted to customers affect only revenues because the customers do not have to return goods. Thus, if the company had granted a sales allowance of USD 32 on March 17, only the first entry would be required.

The balance of the Merchandise Inventory account is the cost of the inventory that should be on hand. This fact is a major reason some companies choose to use perpetual inventory procedure. The cost of inventory that should be on hand is readily available. A physical inventory determines the accuracy of the account balance. Management may investigate any major discrepancies between the balance in the account and the cost based on the physical count. It thereby achieves greater control over inventory. When a shortage is discovered, an adjusting entry is required. Assuming a USD 15 shortage (at cost) is discovered, the entry is:

Assume that the Cost of Goods Sold account had a balance of USD 200,000 by year-end when it is closed to Income Summary. There are no other purchase-related accounts to be closed. The entry to close the Cost of Goods Sold account is:

Departures from cost basis of inventory measurement

Analyzing and using financial results - inventory turnover ratio

Understanding the learning objectives