© 1991 John Petroff

INVENTORIES AND FINANCIAL STATEMENTS
Inventories are usually the largest current asset of a business, and
proper measurement of them is necessary to assure accurate financial
statements. If inventory is not properly measured, expenses and
revenues cannot be properly matched. When ending inventory is
incorrect, the following balances of the balance sheet will also be
incorrect as a result: merchandise inventory, total assets, and
owner's equity. When ending inventory is incorrect, the cost of
merchandise sold and net income will also be incorrect on the income
statement.

INVENTORY ACCOUNTING SYSTEMS
The two most widely used inventory accounting systems are the
periodic and the perpetual. The perpetual inventory system requires
accounting records to show the amount of inventory on hand at all
times. It maintains a separate account in the subsidiary ledger
for each good in stock, and the account is updated each time a
quantity is added or taken out. In the periodic inventory system,
sales are recorded as they occur but the inventory is not updated. A
physical inventory must be taken at the end of the year to determine
the cost of goods sold. Regardless of what inventory accounting
system is used, it is good practice to perform a physical inventory
at least once a year.

DETERMINING INVENTORY QUANTITIES & COSTS
All goods owned by a business (whether or not physically present on
the business premises), are included in inventory when an inventory
is taken. This requires that all shipping documents be examined, and
all merchandise out on consignment be identified. Determining
the quantity of goods on hand should be performed by at least two
individuals, and a third should verify accuracy of the count
(especially if the goods have a high monetary value). When
determining the cost of goods, all expenses incurred to acquire them
are included in the purchase price.

INVENTORY COSTING METHODS - PERIODIC
The periodic system records only revenue each time a sale is made.
In order to determine the cost of goods sold, a physical inventory
must be taken. The most commonly used inventory costing
methods under a periodic system are
1)- first-in first-out (FIFO),
2)- last-in first-out (LIFO), and
3)- average cost or weighted average cost.
These methods produce different results because their flow of
costs are based upon different assumptions. The FIFO method bases
its cost flow on the chronological order purchases are made, while
the LIFO method bases it cost flow in a reverse chronological
order. The average cost method produces a cost flow based on a
weighted average of unit costs.

COMPARING INVENTORY COSTING METHODS
The choice of inventory costing method affects the balances of
1)- ending inventory,
2)- cost of goods sold, and
3)- gross and net profit.
During periods of rising prices, the FIFO method generally produces
a larger ending inventory, a smaller cost of goods sold and a higher
profit. During periods of rising prices, the LIFO method produces
a smaller ending inventory, a larger cost of goods sold and a
smaller profit. During periods of declining prices the effects of
the two methods are reversed. The average cost method produces
results that are in between the LIFO and FIFO methods.

USING NON-COST METHODS TO VALUE INVENTORY
Under certain circumstances, valuation of inventory based on cost
is impractical. If the market price of a good drops below the
purchase price, the lower of cost or market method of valuation is
recommended. This method allows declines in inventory value to be
offset against income of the period. When goods are damaged or
obsolete, and can only be sold for below purchase prices, they
should be recorded at net realizable value. The net realizable
value is the estimated selling price less any expense incurred to
dispose of the good.

PERIODIC VS. PERPETUAL INVENTORY SYSTEMS
There are fundamental differences for accounting and reporting
merchandise inventory transactions under the periodic and perpetual
inventory systems. To record purchases, the periodic system debits
the Purchases account while the perpetual system debits the
Merchandise Inventory account. To record sales, the perpetual
system requires an extra entry to debit the Cost of goods sold and
credit Merchandise Inventory. By recording the cost of goods sold
for each sale, the perpetual inventory system alleviated the need
for adjusting entries and calculation of the goods sold at the end
of a financial period, both of which the periodic inventory system
requires.

INVENTORY COSTING METHODS - PERPETUAL
The perpetual inventory system requires that a separate inventory
ledger be maintained for each good. Inventory ledgers provide
detailed information on purchases, cost of goods sold, and inventory
on hand. Each column gives information on quantity, unit cost,
and total cost. When the average cost method is used, an average
unit cost of each good is calculated each time a purchase is made.
The advantages of the perpetual inventory system is a high degree
of control, it aids in the management of proper inventory levels,
and physical inventories can be easily compared. Whenever a shortage
(i.e. a missing or stolen good) is discovered, the Inventory
Shortages account should be debited.

METHODS USED TO ESTIMATE INVENTORY COST
In certain business operations, taking a physical inventory is
impossible or impractical. In such a situation, it is necessary to
estimate the inventory cost. Two very popular methods are
1)- retail inventory method, and
2)- gross profit (or gross margin) method.
The retail inventory method uses a cost to retail price ratio. The
physical inventory is valued at retail, and it is multiplied by the
cost ratio (or percentage) to determine the estimated cost of the
ending inventory.
The gross profit method uses the previous years average gross profit
margin (i.e. sales minus cost of goods sold divided by sales).
Current year gross profit is estimated by multiplying current year
sales by that gross profit margin, the current year cost of goods
sold is estimated by subtracting the gross profit from sales, and
the ending inventory is estimated by adding cost of goods sold to
goods available for sale.

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