"chapter 5 InventoryCopyright Barbara Chase/Corbis/AP Images Learning Goals •\t Know the basics of recording inventory purchases and sales. •\t Understand the typical categories of inventory and their contents. •\t Understand how an expanded income statement presentation can enhance reporting usefulness. •\t Explain how inventory costs are allocated to inventory and cost of goods sold and the importance of this allocation to income measurement. •\t Know how to apply FIFO, LIFO, and moving average inventory-costing assumptions. •\t Apply specific identification, retail, and lower-of-cost-or-market concepts. waL80144_05_c05_111-134.indd 1 8/29/12 2:44 PMChapter Outline CHAPTER 5 Chapter Outline 5.1 Categories of Inventory Inventory Costs Freight Expanded Income Reporting Consigned Goods Critical Thinking About Inventory Cost 5.2 Cost Assignment 5.3 Perpetual Systems First-In, First-Out Last-In, First-Out The Average Cost Approach 5.4 Comparing Methods Specific Identification The Retail Method Lower-of-Cost-or-Market Adjustments 5.5 The Importance of Accuracy ow hard could it be to account for inventory? The basic concept is very simple. WhenHyou buy inventory, you record the purchase of the asset, like this: 2-10-XX Inventory 10,000.00 Accounts Payable 10,000.00 Purchased $10,000 of inventory on accountThen, when the inventory is resold, two entries are needed—one to record the sales pro- ceeds and another to remove the inventory and charge it to an expense category calledcost of goods sold: 3-15-XX Accounts Receivable 15,000.00 Sales 15,000.00 Sold merchandise on account 112 waL80144_05_c05_111-134.indd 2 8/29/12 2:44 PMSection 5.1 Categories of Inventory CHAPTER 5 3-15-XX Cost of Goods Sold 10,000.00 Inventory 10,000.00 To record the cost of merchandise sold This very basic approach would result in the following income statement results: Sales $15,000 Cost of goods sold10,000 Gross proft $5,000 The gross profit is simply the net difference between the cost of inventory that has beensold and the sales proceeds. It is not the net income because it does not reflect all othercosts of doing business. Of course, if inventory accounting was only this simple, therewould be no need for a separate chapter. So, what issues could possibly arise to compli - cate the accounting for inventory? For starters, there are issues about what goods are appropriately included in inventory.What is the appropriate moment to conclude that a transaction has resulted in a sale?What costs, in addition to the direct purchase price, are to be placed into the inventoryaccounts? How do we attach costs to specific units sold when numerous identical unitshave been purchased at different costs on different dates, and we are not sure which phys - ical units have actually been delivered to a customer? Suddenly, accounting for inventoryappears to present a number of vexing challenges. This chapter helps sort out these issuesand provides you with a sound understanding of the accounting principles you need toknow to answer these types of questions and more. 5.1 Categories of Inventory he very simple journal entry that opened this chapter contemplated a retail businessTmodel. The company bought goods from a supplier and resold those goods to custom - ers at a higher price point. Retailing is a large segment of the economy but not the onlysegment. The goods must have been manufactured. Therefore, manufacturers also carryinventory on their books. A manufacturer’s inventory may consist of goods in various stages of development. Itmay have raw materials consisting of components and parts that will eventually be putinto production. The manufacturer may also havework-in-process inventory consisting ofgoods being manufactured but not yet completed. A third category of inventory isfinishedgoods. These are completed goods awaiting sale. Consider that the manufacturer’s processentails converting raw material into finished goods. During production, raw materials areconverted via the addition of labor and other factors of production (such factory costs arecalled overhead). 113 waL80144_05_c05_111-134.indd 3 8/29/12 2:44 PMSection 5.1 Categories of Inventory CHAPTER 5 The process for correctly accumulating and attaching these costs to work in processrequires substantial skill and is covered in depth in the managerial accounting course. Fornow, be aware that much more is to be learned about how costs attach to products in amanufacturing environment. Let’s focus just on the general inventory-accounting princi - ples that would be applicable to most businesses, using scenarios involving the purchaseand resale of goods. Inventory Costs As a general rule, inventory should include all costs that are ordinary and necessary toput the goods in place and in condition for their resale. Inventory therefore includes theinvoice price, shipping costs incurred when buying the goods, and similar costs. Costslike interest charges on money borrowed to buy inventory, storage costs, and insuranceare not included in inventory accounts because they do not meet the general rule. Thosecosts are called carrying costs and are to be expensed in the period incurred. Freight Few people think deeply about how significant freight cost can be to the overall cost ofbringing a product to market. It can be expressed in very simple terms. If you drive to thestore for a gallon of milk costing $3 and spend $3 on gas to make the trip, how much didthe milk actually cost? If you were trying to categorize your milk in the refrigerator as anasset on an accounting balance sheet, would your report its cost at $3 or $6? Because ofits significance, accountants have been very careful to describe fully a framework for thehandling of freight costs. To develop an understanding of this framework begins withspecific knowledge about freight terms. FOB is a common freight nomenclature. It is an abbreviation for “free on board.” Whatthat really means is the point at which the ownership of goods shifts from the seller to thebuyer. Thus, goods may be sold FOB shipping point. Once goods are shipped, they aredeemed the property of the buyer. Equally important, the buyer must assume responsibil - ity for payment of freight to the destination. ConverselyFOB destination ,means thatthe seller owns the goods until they are delivered and must bear the cost of shipping. Theimplications of freight terms should not be underestimated. There are two highly signifi - cant inventory accounting considerations that are directly affected by the FOB terms. First, goods sold FOB destination do not belong to the purchaser until they arrive at theirfinal destination. Therefore, goods that have been purchased but not yet received wouldnot be carried in the buyer’s balance sheet at the end of the accounting period. Similarly,no liability would be reported for the payment obligation. Conversely, goods purchasedFOB shipping point that have been shipped by the seller should be reflected on the buy - er’s balance sheet, even though they may not be in the buyer’s physical possession. Inthis case, the buyer needs to show both the inventory and related liability on its books.Accountants can face interesting challenges to determine the status of goods in transit atthe end of each accounting period. 114 waL80144_05_c05_111-134.indd 4 8/29/12 2:44 PMSection 5.1 Categories of Inventory CHAPTER 5 The second major issue pertains to the freight cost. When the buyer assumes the freightcost (as with FOB shipping point), it is deemed to be an ordinary and necessary cost toput the goods in place and in condition for resale. As such, accountants will add freight-into the cost of the inventory. Thus, the Inventory account will reflect both the invoice costof the goods, along with any additional amounts for freight. You should be aware thatfreight-out incurred by a seller of goods faces a different accounting rule. Freight-out istreated like a sales expense and does not increase the cost of goods sold amount; instead,the freight out is subtracted from gross profit in calculating income. Expanded Income Reporting The foregoing issues begin to show why a merchant’s income statement can be expanded.Merchants and others frequently present a multiple-step income statement. This for - mat divides business results into separate categories. The first category clearly shows thedifference between the selling price of the product and its cost. This difference is calledgross profit. Following gross profit are the other expenses of doing business. This usu - ally consists of the selling, general, and administrative expenses (SG&A) associated withrunning the business. These primary categories on the multiple-step income statementrelate to the business’s core performance. An investor would closely follow these num - bers, especially noting trends and changes. Investors often compare cost categories tosales on a percentage basis. For instance, cost of goods sold may be 40%, 50%, or 60% ofsales. Monitoring this percentage will reveal pricing power and how the potential impactincreases or decreases sales. However, other business events can give rise to income statement effects. It is commonfor a business to have incidental transactions that contribute to profits and losses. Exam - ples include the sale of corporate assets (not inventory), losses from catastrophes, andsimilar events. If significant, these items are typically presented after the SG&A section.Although potentially meaningful, the sometimes nonrecurring nature makes it easier todiscount their ongoing impacts to the business. Finally, financing costs are frequentlybroken out from other expense components. The reason is that investors may wish toevaluate financial performance separate and apart from the cost of funds that are used tofinance the business. This does not mean interest is not a real expense. Expense is a realcost, but its different character justifies clearly breaking it out within the income state - ment. This provides information needed to fully understand and evaluate the business’sincome generation capacity. Table 5.1 is an example an income statement reflecting thesespecial considerations. 115 waL80144_05_c05_111-134.indd 5 8/29/12 2:44 PMSection 5.1 Categories of Inventory CHAPTER 5 Table 5.1: An example of an income statement that refects special consideratons INCOME STATEMENTExample CompanyFor the Month Ending January 31, 20XX Sales $179,000 Cost of Goods Sold 100,000 Gr oss\tPr oft $79,000 Selling Expenses Adv ertsing $10,000 Freight-out 8,000 Depr ecia ton 6,000 Salaries 3,000 $27,000 General and Administratve Salaries $14,000 Depr ecia ton 5,000 Rent 2,000 Insurance 1,000 22,000 Other Loss on Sale of Stock $4,000 Interest Expense 6,000 10,000 59,000 Income Before Taxes $20,000 Income tax expense 6,500 Net income $13,500 Consigned Goods On occasion, a manufacturer may approach a merchant about stocking a particular prod - uct. The merchant may be reluctant, not wanting to invest in inventory that may not sell.This negotiation may result in a consignment of inventory. A consignment is an agree- ment whereby the inventory’s owner, the consignor, places it with another party in thehope that the goods will be resold to an end consumer. The party holding physical pos- session is the consignee but not the legal owner. It must care for the goods and try to sellthem to an end customer. The consignor surrenders physical custody but maintains legalownership. The consignor would continue to carry the goods in its inventory records. Consigned goods pose a record keeping challenge. Because physical custody does notrepresent ownership, it becomes difficult for both consignees and consignors to main - tain proper accountability over consigned inventory. When the consignee sells consigned116 waL80144_05_c05_111-134.indd 6 8/29/12 2:44 PMSection 5.1 Categories of Inventory CHAPTER 5 goods to an end user, the consignee becomes obligated to remit a portion of the final salesprice to the consignor. Otherwise, it is understood that the consignee reserves the right toreturn the inventory without obligation to make payment. Critical Thinking About Inventory Cost Consider that a business is likely to open a new accounting period with a carryover balanceof inventory from the preceding period. This is probably rather obvious. Just because anaccounting period has ended does not mean that unsold goods must be dumped. Instead,the ending balance of one period becomes the beginning inventory balance of the next.Exhibit 5.1 shows how a period’s beginning inventory, plus additional purchases, can becombined to represent the total goods available for sale. Some of the goods available forsale are sold and become cost of goods sold, and the unsold portion represents the endinginventory (which will carry forward into the next accounting period). Exhibit 5.1: Goods available for sale Beginning inventory + Ending inventory + Goods available for sale Net purchases Cost of goods sold Exhibit 5.1 shows how goods available for sale must be split between ending inventory andcost of goods sold. Though a picture may be worth a thousand words, it is also true thataccountants rarely communicate with pictures. Thus, the drawing is usually converted toa calculation format such as the following (all amounts are assumed for the time being): Beginning inventory $100,000 Plus: Purchases450,000 Goods available for sale $550,000 Less: Ending inventory50,000 Cost of goods sold $500,000 In the drawing, the units appear as physical units, but the natural commingling of homog - enous inventory sometimes makes it difficult or impossible to truly know which units arewhich. Accountants therefore express inventory on the balance sheet in units of moneyrather than physical quantity descriptions. A critical factor in determining income is the allocation of the cost of goods available for salebetween ending inventory and cost of goods sold. Accountants have a significant task toassess what cost attaches to ending inventory and what cost attaches to cost of goods sold,especially in light of the fact that the exact physical flow of goods is probably unknown. 117 waL80144_05_c05_111-134.indd 7 8/29/12 2:44 PMSection 5.3 Perpetual Systems CHAPTER 5 5.2 Cost Assignment t is unlikely that each unit of inventory will have the exact same cost. It can be impracticalIto trace the exact cost of each unit; even when possible, accountants do not require thisassociation. Instead, accountants use inventory cost flow assumptions. These assump- tions do not need to relate to the physical flow of the inventory. Thus, the inventory costallocation approach is just a systematic approach for dealing with the question of whatcost is to be attached to ending inventory and cost of goods sold. To illustrate this point, consider the case of Umps Baseball Supply. Umps maintains a stor - age bin full of balls. As customers purchase balls, Umps randomly selects them from thebin. As Umps restocks, they dump newly purchased balls into the bin. The balls are con- stantly being mixed up such that Umps has no way of knowing the exact purchase dateor price of any particular ball remaining in the bin. During a recent period, the bin hadan opening supply of 500 balls and was restocked two different times. At each restocking,500 balls were added. The balls in beginning inventory cost $2 per ball. The first restock - ing had a unit cost of $2.25. The final restocking was at $2.75. The bin was never allowed toempty completely. At the end of the period, the bin contains 125 balls, probably includingsome from beginning inventory and each restocking event. What is the cost of the ending inventory? The answer to this important question willdirectly impact the calculation of not only ending inventory but also cost of goods sold(and thereforeincome). Umps must adopt an inventory-costing method. There are severalcost flow assumptions to choose from. One is a first-in, first-out (FIFO) approach.Another is the last-in, first-out (LIFO) approach. The third method reflects a more com - plex average cost approach. The complexity arises because the average cost method isnot just the simple average of the per-unit price but instead weights the cost by thenum-ber of units purchased at each price point. Thus, it is also known as a weighted- average cost concept. In the average cost example that follows, the weighted-average costis recalculated each time there is a new purchase, resulting in a further refinement of itsmoniker as the moving-average method. 5.3 Perpetual Systems efore more closely examining the accounting for Umps’s inventory under the FIFO,BLIFO, and average cost approaches, it is first necessary to point out that inventorycosts can be accumulated on either a real-time perpetual inventory system or occasionalupdating via a periodic inventory system. As the name suggests, a perpetual system isone in which inventory records are continuously updated for all inventory changes. Asinventory is purchased, it is added into the Inventory account. As inventory is sold, it issubtracted from the Inventory accounts. A periodic system is one in which the Inventoryaccounts are only updated on designated intervals, such as at the end of each accountingperiod. At one time, accumulating and assigning costs on a perpetual basis was exceed- ingly difficult because of the extraordinarily tedious recordkeeping that ensues. Then,companies necessarily resorted to simplifying techniques that only periodically updatedinventory records. Modern computers have allowed companies to adopt more sophisti- cated real-time, or perpetual, tracking of inventory. These systems greatly improve assetaccountability and business decision making. With a perpetual system, each inventorypurchase or sale transaction triggers an update of the inventory records and corporate118 waL80144_05_c05_111-134.indd 8 8/29/12 2:44 PMSection 5.3 Perpetual Systems CHAPTER 5 general ledger. To begin to see how this operates, closely examine the details about Umps’sinventory purchases in Table 5.2. Table 5.2: Umps’s inventory purchases Date Quantty Purchased Cost per Unit Total CostBeginning balance July 1 500 $2.00 $1,000 Purchase 2 July 15 500 $2.25 $1,125 Purchase 3 July 24 500 $2.75 $1,375 In addition to information about the purchasing activity, we also need detailed informa - tion about Umps’s sales. Table 5.3 provides detailed sales data: Table 5.3: Umps’s sales data Date Quantty Sold Sales Price per Unit Total Sales Sale 1 July 9 400 $4.00 $1,600 Sale 2 July 20 550 $4.50 $2,475 Sale 3 July 28 425 $5.00 $2,125 Overall, you will notice that Umps had 1,500 units available (500 ? 500 ? 500) and sold1,375 units (400 ? 550 ? 425), leaving the remaining ending inventory on hand at theend of July at 125 units. We mustn’t lose sight of our accounting goals: to determine thetotal sales, total cost of goods sold, gross profit, and ending inventory balances to reportin the financial statements. To make this determination will require an inventory costflow assumption. Importantly, the cost flow assumption is used to describe the flow of the cost of goodsthrough the accounting system. It is not necessary that a cost flow assumption actuallycorrespond to a physical flow, but it useful to visual a cost flow assumption by thinkingabout physical flow. If you owned a convenience store, you would probably sell milk ona FIFO basis. To minimize spoilage, you would sell the oldest milk first. This is logical.On the other hand, if you sold crushed rock that was dumped in large stacks as it wasprocessed and delivered via a loader scooping from the pile as it was sold, you can likelyunderstand the LIFO cost flow concept. We will first perform Umps’s inventory calcula - tions using a perpetual FIFO method. First-In, First-Out Table 5.4 shows the level of detail that is necessary to track the inventory correctly. Studythis very carefully. Perhaps you can follow the logic by only tracking amounts in the table;if not, additional explanatory details are provided below the table. Remember, this is aFIFO example. When a sale occurs, the assumption is that the units sold were from thefirst, or earliest, available units: first-in, first-out. 119 waL80144_05_c05_111-134.indd 9 8/29/12 2:44 PMSection 5.3 Perpetual Systems CHAPTER 5 Table 5.4: FIFO inventory tracking Date Purchases Sales Cost of Goods Sold Remaining InventoryBalance July 1 500 , $2.00 5 $1,000.00 July 9 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 100 , $2.00 5 $200.00 July 15 500 , $2.25 5 $1,125.00 100 , $2.00 5 $ 200.00500 , $2.25 5 1,125.00 $1,325.00 July 20 550 , $4.50 5 $2,475.00 100 , $2.00 5 $ 200.00 50 , $2.25 5 $112.50 450 , $2.25 5 1,012.50 $1,212.50 July 24 500 , $2.75 5 $1,375.00 50 , $2.25 5 $112.50500 , $2.75 51,375.00 $1,487.50 July 28 425 , $5.00 5 $2,125.00 50 , $2.25 5 $112.50 125 , $2.75 5 $343.75 375 , $2.75 51,031.25 $1,143.75 Notice that a significant amount of detail is in tracking inventory using a perpetualapproach; without computers, this becomes nearly impossible to do correctly when vastinventories and large volumes of transactions are involved. However, given a properlyprogrammed computer, the task is inconsequential. Many businesses have a sufficientlevel of sophistication that inventory records are being updated as each sale is recorded ata point-of-sale terminal. Be sure to note exactly what is occurring on each date. For example, on July 20, 50 unitsremain after selling 550 units. This is determined by first noting that 600 units were onhand prior to the sale transaction (consisting of 100 units that are assumed to cost $2.00each and 500 units that are assumed to cost $2.25 each). After removing 550 units fromstock (assumed to consist of 100 units costing $2.00 and 450 units costing $2.25), only 50remain at an assumed unit cost of $2.25. This cost analysis and allocation process must berepeated with each transaction that results in increasing or decreasing the inventory bal- ance. With FIFO, keep in mind that the layers of inventory assumed to be sold are basedon the chronological order in which they were purchased. The analysis provided within Table 5.4 provides a basis for actually recording the transac - tions into the general journal. Be sure to trace the amounts in the entries back into Table5.4. Remember, Inventory is debited as purchases occur and credited as sales occur. Fol- lowing are the necessary entries to record July’s activity: 120 waL80144_05_c05_111-134.indd 10 8/29/12 2:44 PM"