Intermediate Accounting Ch. 8

Goods and Costs Included in Inventory: Goods Included in Inventory

A company recognizes inventory and accounts payable at the time it controls the asset. Control is the key factor in determining when purchases and sales of a product are recognized. The FASB indicates that a company controls the product when it has the ability to direct the use of and obtain substantially all the benefits from these watches. Companies then look to various indicators to determining whether control has passed. One of these indicators, passage of title, is often used to determine control because the rights and obligations are established legally. But sometimes other indicators must be considered because legal title and passage of control do not match.

Last in, first out LIFO

Matches the cost of the last goods purchased against revenue. If a periodic system used, it assumes that the cost of the total quantity sold or issued during the month comes from the most recent purchases. If uses perpetual system, record in quantities and dollars, use of the LIFO method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method. The periodic system matches the total withdrawals for the month with the total purchases for the month in applying the last in, first out method. In perpetual system, matches each withdrawal with the immediately proceeding purchases.

Sales with Repurchase Agreement

Sometimes a company finances its inventory without reporting either a liability or the inventory on its balance sheet. This approach is referred to as a repurchase (or product financing) agreement, usually involves a transfer (sale) with either an implicit or explicit repurchase agreement. This avoids personal property taxes in certain states. Other advantages from this are the removal of the current liabilities from its balance sheet and the ability to manipulate income. These are described as parking transactions.

finished goods inventory

companies report the costs identified with the completed but unsold units on hand at the end of the fiscal period as finished goods inventory. A manufacturing company like Sherwin-Williams also might include a manufacturing or factory supplies inventory account. in it, they would include items such as machine oils, nails, cleaning material, the supplies that are used in the production but are not the primary materials being processed.

inventory cost flow

companies that sell or produce goods report inventory and cost of goods sold at the end of each accounting period. the flow of costs for a company is as follows. beginning inventory plus the cost of goods sold purchased or manufactured is the cost of goods sold available for sale. as goods are sold, they are assigned to cost of goods sold. those goods that are not sold by the end of the accounting period represent ending inventory. companies use one of two types of systems for maintaining accurate inventory records for these costs- perpetual and periodic systems.

Which cost flow assumption to adopt?

During any given fiscal period, companies typically purchase merchandise at several different prices. If a company prices inventories at cost and it made numerous purchases at different unit costs, which cost price should it use? Conceptually, a specific identification of the given items sold and unsold seems optimal. But this measure often proves both expensive and impossible to achieve. Consequently, companies use one of several systematic inventory cost flow assumptions. Indeed, the actual physical flow of goods and the cost flow assumption often greatly differ. There is no requirement that the cost flow assumption adopted be consistent with the physical movement of goods. A company's major objective in selecting a method should be to choose the one that, under the circumstances, most clearly reflects periodic income.

Determining Cost of Goods Sold

Goods sold (or used) during an accounting period seldom correspond exactly to the goods bought (or produced) during that period. As a result, inventories either increase or decrease during the period. Companies must then allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand. The cost of goods available for sale or use is the sum of 1. the cost of the goods on hand at the beginning of the period, and 2. the cost of the goods acquired or produced during the period. The cost of goods sold is the difference between 1. the cost of goods available for sale during the period, and 2. the cost of goods on hand at the end of the period.

Sales with High Rates of Return

In industries such as publishing, music, toys, and sporting goods, formal or informal agreements often exist that permit purchasers to return inventory for a full or partial refund. The key question to determine whether a sale occurs is: Has that company transferred control of these goods to the other company? They are normally recorded as a sale. Normal indicators for transfer of control are passage of legal title, loss of physical control, and transfer of risks and rewards of ownership. When a company recognizes that only partial control has transferred to the other company, it must 1. record sales revenue at the amount it expects to receive from the transaction: this transaction involves variable consideration and therefore the transaction price is adjusted to recognize that a portion of these textbooks will be returned. 2. Establish as estimated inventory return account to recognize that some of its textbooks will be returned: the reason for recording estimated inventory is that control over a significant number of the textbooks has not passed to the other company. Basically, control does pass from seller to buyer for a majority of the textbooks but not all of them. So the other company will record an estimated inventory return amount to recognize that fact. If returns are unpredictable and uncertain, the company should not consider the textbooks sold and should not remove the goods from its inventory.

Treatment of Purchase Discounts

The use of a purchase discounts account in a periodic inventory system indicates that the company is reporting its purchases and account payable at the gross amount. If a company uses this gross method, it reports purchase discounts as a deduction from purchases on the income statement. Another approach is to record the purchases and accounts payable at an amount net of the cash discounts. In this approach, the company records failure to take a purchase discount within the discount period in a Purchase Discounts Lost account. If a company uses this net method, is considers purchase discounts lost as a financial expense and reports it in the "other expenses and losses" section of the income statement. This treatment is considered better for two reasons. 1. it provides a correct reporting of the cost of the asset and related liability 2. it can measure management inefficiency by holding management responsible for discounts not taken. Many believe that the somewhat more complicated net method is not justified by the resulting benefits. This could account for the widespread use of the less logical but simpler gross method. In addition, some contend that management is reluctant to report in the financial statements the amount of purchase discounts lost. Use the gross method to record purchase discounts for homework problems unless specified otherwise.

Special Sales Agreements

Transfer of legal title is the general guideline used to determine whether a company should include an item in inventory. Sometimes however, transfer of legal title and the underlying substance of the transaction sometimes do not match. There are two special sells situations are illustrated here to indicate the types of problems companies encounter in practice: 1. sales with repurchase agreement 2. sales with high rates of return

Goods in Transit

Transit- not yet received-at the end of a fiscal period. The accounting for these shipped goods depends on who controls the merchandise. In these situations, companies generally determine control based on who has legal title to the goods by applying the "passage of title" rule. If a supplier ships goods to Walgreens f.o.b. shipping point, title passes to Walgreens when the supplier delivers the goods to the common carrier, who acts as an agent for Walgreens. If the supplier ships the goods f.o.b., title passes to Walgreens only when it receives the goods from the common carrier "shipping point" and "destination" are often designated by a particular location, for example, f.o.b. Denver.

raw materials inventory

a company reports the cost assigned to goods and materials on hand but not yet placed into production as raw materials inventory. raw materials include the wood to make a baseball bat or the steel to make a car. these materials can be traced directly to the end product

period costs

are those costs that are indirectly related to the acquisition or production of goods. period costs such as selling expenses and, under ordinary circumstances, general and administrative expenses are therefore not included as part of inventory cost. Companies exclude these costs from inventorial items because, companies generally consider selling expenses as more directly related to the cost of goods sold than to the unsold inventory. Also, period costs, especially administrative expenses are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary. Interest is another period cost. Companies usually expense interest costs associated with getting inventories ready for sale. Supporters of this approach argue that interest costs are really a cost of financing. Others contend that interest costs incurred to finance activities associated with readying inventories for sale are as much a cost of the asset as materials, labor, and overhead. So, companies should capitalize interest costs. The FASB ruled that companies should capitalize interest costs related assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease. A company should not capitalized interest costs for inventories that it routinely manufactures or otherwise produces in large quantities on a repetitive basis. In this case, the informational benefit does not justify the cost.

work in process inventory

at any point in a continuous production process, some units are only partially proceed. the cost of the raw material for these unfinished units, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, constitute the work in process inventory.

periodic system

under a periodic system, a company determines the quantity of inventory on hand only periodically, as the name implies. to do so, a company does the following: 1. it records all acquisitions of inventory during the accounting period by debiting the purchases account 2. a company then adds the total in the purchases account at the end of the accounting period to the cost of the inventory on hand at the beginning of the period. 3. to compute the cost of goods sold, the company then subtracts the ending inventory from the cost of goods available for sale. under the periodic system, the cost of goods sold is a residual amount that depends on a physical count of ending inventory. this process is referred to as "taking a physical inventory". companies that use the periodic system take a physical inventory at least once a year.

comparing perpetual and periodic systems

when a company uses a perpetual inventory system and a difference exists between the perpetual inventory balance and the physical inventory count, it needs a separate entry to adjust the perpetual inventory account. perpetual inventory overages and shortages generally represents a misstatement of cost of goods sold. the difference results from normal and expected shrinkage, breakage, shoplifting, incorrect record keeping, and the like. Inventory over and short therefore adjusts cost of goods sold. companies sometimes report inventory over and short in the other revenues and gains or other expenses and losses section of the income statement. note that a company using the periodic inventory system does not report the account inventory over and short. the reason: the periodic method does not have accounting records against which to compare the physical count. as a result, a company buries inventory overages and shortages in cost of goods sold

First In First Out FIFO

Assumes that a company uses goods in the order in which it purchases them. In other words, the FIFO method assumes that the first goods purchased are the first used (in a manufacturing concern) or the first sold (in a merchandising concern). The inventory remaining must therefore represent the most recent purchases. In all cases when FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perceptual or periodic system is used. Because the same costs will always be first in and, therefore, first out. This is true whether a company computes cost of goods sold as it sells goods throughout the accounting period (periodic system). One objective of FIFO is to approximate the physical flow of goods. When the physical flow of goods is actually first in, first out, the FIFO method closely approximates specific identification. At the same time, it prevents manipulation of income. With FIFO, a company cannot pick a certain cost item to charge to expense. Another advantage is that the ending inventory is close to current cost. Because the first goods in are the first goods out, the ending inventory amount consists of the most recent purchases. This is particularly true with rapid inventory turnover. This approach generally approximates replacement cost on the balance sheet when price changes have not occurred since the most recent purchases. However, the FIFO method fails to match current costs against current revenues on the income statement. A company charges the oldest costs against the more current revenue, possibly distorting gross profit and net income.

Consigned Goods

Companies market certain products through as consignment shipment. Under this arrangement, a company like Williams Art Gallery (the consignor) ships various art merchandise to Sotheby's Holdings (the consignee), who acts as Williams' agent in selling the consigned goods. Sotheby's agrees to accept the goods without any liability, except to exercise due care and reasonable protection from loss or damage, until it sells the goods to a third party.When Sotheby's sells the goods, it remits the revenue, less a selling commission and expenses incurred in accomplishing the sale, to Williams. Goods out on consignment remain the property of the consignor (Williams in the example above). Although Sotheby's has physical possession of the goods, it does not have control because legal title and the risks and rewards of ownership remain with Williams. Williams thus includes the goods in its inventory at purchase price or production cost. Occasionally, and only for a significant amount, the consignor shows the inventory out on consignment as a separate item. Sometimes a consignor reports the inventory on consignment in the notes (subsidiary) to the financial statements. The consignee makes no entry to the inventory account for goods received. These goods remain the property of the consignor until sold.

Costs Included in Inventory: Product Costs

One of the most important problems in dealing with inventory concerns the dollar amount at which to carry the inventory in the accounts. Companies generally account for the acquisition of inventories, like other assets, on a cost basis. Product costs are those costs that attach to the inventory. As a result, a company records costs in the inventory account. These costs are directly connected with bringing the goods to the buyer's place of business and converting such goods to a salable condition. Such charges include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. It seems proper also to allocate to inventories a share of any buying costs or expenses of a purchasing department, storage costs, and other costs incurred in storing or handling the goods before their sale. However that is difficult, so companies usually exclude these items in valuing inventories. A manufacturing company's costs include direct materials, direct labor, and manufacturing overhead costs. Manufacturing overhead costs include indirect materials, indirect labor, and various costs, such as depreciation, taxes, insurance, and utilities.

Average Cost

Prices items in the inventory on the basis of the average cost of all similar goods available during the period. In computing average cost per unit, include beginning inventory if any, both in the total units available and in the total cost of goods available. Companies use the moving-average method with perpetual inventory records, and weighted-average method with periodic. For the moving-average method, a company computes a new average unit cost each time it makes a purchase, unit costs total divided by beginning unit cost amount. And they use this unit cost in costing withdrawals until it makes another purchase. Companies often use average-cost methods for practical rather than conceptual reasons. These methods are both simple to apply and objective. They are not as subject to income manipulation as some of the other inventory costing methods. In addition, proponents of the average-cost methods reason that measuring a specific physical flow of inventory is often impossible. Therefore, it is better to cost items on an average-price basis. This argument is particularly persuasive when dealing with similar inventory items.

Specific Identification

Specific identification calls for identifying each item sold and each item in inventory. A company includes in cost of goods sold the specific items on hand. This method may be used only in instances where it is practical to separate physically the different purchases made. As a result, most companies only use this method when handling a relatively small number of costly, easily distinguishable items. In the retail trade, this includes some types of jewelry, fur coats, automobiles, and some furniture. In manufacturing, it includes special orders and many products manufactured under a job cost system. This method appears ideal. Specific identification matches actual costs against actual revenue. Thus, a company reports ending inventory at actual cost. Under specific identification the cost flow matches the physical flow of the goods. But actually, this method has certain deficiencies. Some argue that specific identification allows a company to manipulate net income. For example, assume that a wholesaler purchases identical plywood early in the year at three different prices. When it sells the plywood, the wholesaler can select either the lowest or the highest price to charge to expense. It simply selects the plywood from a specific lot for delivery to the customer. A business manager, therefore, can manipulate net income by delivering to the customer. A business manager, therefore, can manipulate net income by delivering to the customer the higher or lower priced item, depending on whether the company seeks lower or higher reported earnings for the period. Another problem related to the arbitrary allocation of costs that sometimes occurs with specific inventory items. For example, a company often faces difficulty in relating shipping charges, storage costs, and discounts directly to a given inventory item. This results in allocating these costs somewhat arbitrary, leading to a breakdown in the precision of the specific identification method

perpetual system

continuously tracks changes in the inventory account. that is, a company records all purchases and sales (issues) of goods directly in the inventory account as they occur. the accounting features of a perpetual system are as follows. 1. purchases of merchandise for resale or raw materials for production are debited to inventory rather than to purchases 2. freight-in is debited to inventory, not purchases. purchase returns and allowances and purchase discounts are credited to inventory rather than to separate accounts 3. cost of goods sold is recorded at the time of each sale by debiting cost of goods sold and crediting inventory 4. a subsidiary ledger of individual inventory records is maintained as a control measure. the subsidiary records show the quantity and cost of each type of inventory on hand. the perpetual system provides a continuous record of the balances in both the inventory account and the cost of goods sold account

Inventory Issues: Classification

inventories are asset items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold. the description and measurement of inventory require careful attention. the investment in inventories is frequently the largest current asset of merchandising (retail) and manufacturing businesses.

inventory control

management is vitally interested in inventory planning and control. whether a company manufactures or merchandises goods, it needs an accurate accounting system with up to date records. it may lose sales and customers if it does not stock products in the desired style, quality, and quantity. further, companies must monitor inventory levels carefully to limit the financing costs of carrying large amounts of inventory. in a perfect world, companies would like a continuous record of both their inventory levels and their cost of goods sold. the popularity and affordability of accounting software makes the perpetual system cost-effective for many kinds of businesses. But many companies cannot afford a complete perpetual system. but most of these companies need current information regarding their inventory levels, to protect against stock-outs or over purchasing, and to aid in preparation of monthly or quarterly financial data. As a result, these companies use a modified perpetual inventory system. This system provides detailed inventory records of increases and decreases in quantities only-not dollar amounts. It is merely a memorandum device outside the double-entry system, which helps in determining the level of inventory at any point in time. companies will take a physical inventory once a year, and they all face the danger of loss or error. So companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records. A company corrects the records to agree with the quantities actually on hand

manufacturing concern

produce goods to sell to merchandising firms. many of the largest U.S. businesses are manufacturers, such as Boeing, IBM, Exxon, Proctor and Gamble, Ford, and Motorola. although the products they produce may differ, manufacturers normally have 3 inventory accounts- raw materials, work in process, and finished goods

a merchandising concern

such as Walmart Inc, usually purchases its merchandise in a form ready for sale. it reports the cost assigned to unsold units left on hand as merchandise inventory. only one inventory account, inventory, appears in the financials statements