In the previous article, we looked at recording transactions for a merchandise business that has inventory to track. This seems pretty straight forward... as long as the cost of the goods (the amount paid to get the inventory) stays the same. In the economic world, however, we know that the costs fluctuate.
Let's say we have an item we are going to sell, and it costs us $20 each. We buy 100, and sell 95 over a period of time. While we still have 5 items left in stock, we purchase another 100 to make sure we do not run out of inventory. These, however, cost us $23 each. We now have 5 units of an item that cost $20 each, and 100 units of that item that cost $23 each. When we make our next sell, what do we use as our cost of merchandise sold? Do we use $20? Do we use $23? Do we make a guess of somewhere in between? The amount we use is determined by which of the three Inventory Cost Flow Assumptions is used. The three methods are FIFO (first-in, first out) Method, LIFO (last-in, last-out) Method and Average Cost Method.
FIFO means that the first items purchased for inventory are the first ones that are sold. When this method is used, it will result in the lowest cost of goods, highest gross margin and net income, and highest ending inventory. This method shows on the balance sheet the current costs of the goods.
LIFO means that the last items purchased for inventory are the first ones that are sold. When this method is used, it will result in the highest cost of goods, lowest gross margin and net income, and lowest ending inventory. This method shows on the income statement the most recent costs of goods.
The average method will indicate an amount in each area that is between FIFO and LIFO. It is not used much, and is extremely rare in a perpetual inventory system. Due to that, we are not going to discuss much of it.
FIFO, since it shows a better net income, will make the company appear to be making more money than if it used the LIFO method. However, any inventory on hand is taxed at the end of the year by taxing agencies. For this reason, some companies prefer the LIFO method. Although it shows a lower net income, it also shows a lower inventory. That means when inventory taxes are calculated, they will be calculated off of a lower amount. Although we will be discussing LIFO in this article, there is an important note on this. Under FASB, LIFO is allowed. However, as we've discussed previously, there is a movement to move our accounting standards in line with the international standards. Under the international standards, LIFO is not allowed. Therefore, in the future, LIFO may not be used.
A quick example of the three and how they are different would be as follows: Three units of an item are purchased. The costs of the first item is $9, the second is $13 and the third is $14. The total cost of inventory is 9 + 13 + 14, or $36. One unit is sold for $20.
Under the FIFO method, the cost of merchandise sold is $9. This makes the gross profit (20 - 9) $11, and the merchandise inventory is $27 (36 - 0).
Under the LIFO method, the cost of merchandise is $14. This makes the gross profit (20 - 14) $6, and the merchandise inventory is $22 (36 - 14).
Under the average method, the cost of merchandise is $12 (36 divided by 3). This makes the gross profit (20 - 12) $8, and the merchandise inventory is $24 (36 - 12).
Above, we looked at a quick example. However, most merchandise companies buy more than one unit at a time, sell more than one unit at a time, and have more sells through the accounting period than one. Let's take a look at another example, with more detail, and how it would be calculated using FIFO and the Perpetual Inventory System.
Let's assume that a company is buying and selling units of an item. For the month of March, the following transactions occurred:
The transactions, and how they would be listed on a journal with debits and credits to cash, accounts receivable, cost of merchandise sold and merchandise inventory were discussed in the previous chapter. The transactions can also be illustrated through an Inventory Card. An inventory card shows the transactions of purchasing and selling inventory, and the balance of the inventory for the units based off unit cost.
For the transactions above, we start with a beginning inventory of 100 units at $20 each. We then sell 70 units, leaving us with an inventory of 30. We then buy 100 more units at $21. This gives us an inventory of 30 units at $20, and 100 units at $21. We sell 60 units. Since we're moving out the items that were purchased first, we're going to clear out the units of $20 before we start working on the units of $21. Therefore, we clear out the 30 units at $20, and then take out the remaining 30 units from the ones that cost us $21. This leaves an inventory of 70 units at $21. We then continue the inventory card in the same way, ending with the following inventory card:
That total of the Cost of Merchandise Sold gives us the total cost of merchandise sold. The balance of inventory left (in this case 50 units at $21 and 100 units at $22, for a total of $3250) is the merchandise inventory.
Let's look at the same example using LIFO and the perpetual accounting system. We start off pretty much the same as with FIFO, until we get to the sale on the 22nd. With LIFO, we take the inventory from the latest units sold first. So instead of clearing out the units at $20, we take the entire amount from the units at $21. Now, instead of having one line in the inventory showing the newest items purchased, we have two lines. One shows what is left of the oldest items purchased, and one shows the balance of what's left of the latest items purchased. We then continue the inventory card in the same way, ending with the following card:
Under LIFO, the cost of the inventory sold is higher than with FIFO, but the total of merchandise inventory is lower.
Periodic Accounting System
Under the periodic accounting system, only revenue is recorded each time that a sale is made. No entry is made at the time of purchase to record the cost of the merchandise sold. Because of the fact that the beginning inventory is subtracted out first under FIFO, the same balances will be computed through the perpetual and periodic accounting systems. This is not true, however, for LIFO.
Using the same example as above for FIFO, we get the following:
|Cost of Merchandise available for sale in March||$6300.00|
|Cost of Merchandise Sold:||$3050.00|
LIFO will give a different result. The cost of the 150 units at the end of the accounting cycle are determined as follows:
|Beginning Inventory:||100 units at $20||$2000.00|
|Next earliest cost:||50 units at $21||$1050.00|
|Total Ending Inventory:||150 units||$3050.00|
Although there were 100 units purchased at $21, we're only concerned with the 50 that are left over. With the LIFO method, these are the ones considered to be still on hand.
Using the same example as above for LIFO, however, we get the following:
|Cost of Merchandise available for sale in March||$6300.00|
|Cost of Merchandise Sold:||$3250.00|
The $3050.00 is made up of the earliest costs, showing that the later costs were sold. With a perpetual system, some of the earlier costs will be sold, so you end up with a mixture of older and newer items. That is why the perpetual and periodic accounting systems will give two different amounts under LIFO.
Valuation of Costs
Previously, we've valued costs with the primary basis of cost. In come cases, inventory is valued at amounts other than cost. Two cases where this will happen are when the cost of replacing the items in inventory is below the recorded cost, and when the inventory is not salable at normal sale prices. The second reason is usually due to imperfections, style changes, shop wear, or other such causes.
If the cost of replacing an item is lower than the original purchase cost, then the lower-of-cost-or-market method, or LCM method) is used to value the inventory. Market, in this case, is the cost to replace the merchandise on the inventory date. Market value is based on quantities normally purchased from the usual source of supply. The main advantage of the LCM method is that gross profit and net income is reduced in the period in which the market decline occurred. There are three ways to apply LCM: each item in inventory, major classes or categories of inventory, or the inventory as a whole.
Assume there are four items in inventory. Each has a quantity, unit price that they were acquired at, and a current market price. Let's look at these below:
As you can see, with the first and fourth items, the market price is the lower price. with the second, the cost is the lower price. The third stayed the same. If we look at each item as a separate amount, item 1 is valued at $3,800.00. Item 2 is valued at $4,000.00. Item 3 is valued at $3,500.00. Item 4 is valued at $500.00. This gives a total value of the inventory of $11,800. If we were to look at the inventory as a whole, however, we'd get a different amount. The total of the costs of the inventory is $12,350.00 and the total of the market is $12,200. The lower is the market amount, giving a total inventory of $12,200.00. As you can see, if you go by each individual item, or each individual category, then you will end up with a lower amount for inventory than if you do it as a whole.
Net Realizable Value
Sometimes merchandise looses value due to being out of date, spoiled or damaged, or that can be sold only at prices below cost. Merchandise that falls into these categories should be written down. These should be valued at net realizable value. Net realizable value is the estimated selling price less any direct costs, such as sales commissions. For example: Damaged merchandise costing $100.00 can only be sold at $75.00. Direct selling expenses are estimated at $7.50. This inventory should be valued at $67.50 (75 - 7.50).
Inventory and The Balance Sheet
Inventory is usually listed in the Current Assets section of the balance sheet, following the receivables. Both the method of determining the cost of the inventory (FIFO, LIFO or average) and the method of valuing the inventory (cost or LCM) should be shown.
Estimated Inventory Cost
There may be times where a business does not use the perpetual inventory method and it is impractical to take a physical inventory. However, the business may need to know the amount of inventory. In such cases, the inventory can be estimated by using either the retail inventory method, or the gross profit method.
In the retail inventory method of estimating the inventory, cost is based on the relationship of the cost of merchandise available for sale to it's retail price. To use this method, the retail prices of all merchandise are maintained and totaled. The sales for the period are deducted from the retail price of the goods that were available for sale during the period to arrive at the inventory at retail. The estimated inventory cost is then computed by multiplying the inventory at retail by the ratio of retail price for the merchandise available for sale. See illustration below:
In the gross profit method, the estimated gross profit for the period is used to estimate the inventory at the end of the period. The gross profits are usually estimated from the actual rate for the preceding year, and are adjusted for any changes made in the cost and sales prices during the current accounting period. By using the gross profit rate, the the dollar amount of sales for a period can be divided into its two components. These are the gross profit, and the cost of merchandise sold. The cost of merchandise sold can then be deducted from the cost of merchandise available to arrive at the estimated inventory. See illustration below, assuming that the historical gross profit was 30% of the net sales: