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Inventory Accounting: 7 Things You Need To Know



Inventory accounting is a wide topic. I would need to write a book to cover every bit of it. But through this post I am going to squeeze it into 7 bullet points to cover, just the meat (Cost of Good Sold, cash discount on a purchase of inventory, inventory write-off, error on the inventory record, estimating inventory value for interim reporting purpose, gross profit method, and applying dollar value LIFO.) In short, it is a quick inventory accounting reference you may use for an immediate decision. Enjoy!



1. Cost Of Good Sold (COGS)

Cost of goods sold (COGS) is computed by adding beginning inventory to purchases (including transportation-in and any other normal and necessary costs) and then subtracting ending inventory.

In contrast, transportation out in not an inventory cost but a delivery expense. Both inventory and cost of goods sold can be monitored on an ongoing basis by a perpetual system or only at the end of the year by a periodic system.

Under a periodic system, the costs to be expensed are not determined until the end of the year. Under a perpetual system, the next costs to be expensed are determined every time that a new transaction occurs. Applying costs to units sold and units retained can be done by a FIFO (first-in, first-out) system, LIFO (last-in, first-out), or averaging. Periodic and perpetual systems give different results except when applying FIFO.

For averaging in a periodic system (called weighted averaging), one average is determined at the end of the year; for averaging in a perpetual system (called moving averaging), a new average is computed each time a new purchase is made.


2. Cash Discount On a Purchase of Inventory

A cash discount reduces inventory cost if paid within a specified time. A 2/10, n/30 discount, for example, gives a 2% discount if bill is paid in ten days. Remaining (net) balance must be paid in thirty days.

Theoretically, inventory cost should be reduced even if discount is not taken since it is not a necessary cost of acquiring the inventory. This is called the net method and any discount not taken is recorded as a loss rather than being capitalized. Can also record inventory at gross figure and record separate reduction at the time discount is actually taken.

Trade discount is a percentage reduction in the invoice price given to retailers. It is not recorded, it is just used to establish the price to be charged. If two percentages are given, the second is applied after the first is removed.


3. Writing-off Obsolete Inventory

Because of obsolescence, inventory cost may have to be written down to a lower market value since accounting is conservative. Cost is compared to market value and the lower figure is reported.

Replacement cost is used as market value for comparison with cost of inventory unless replacement cost lies outside of two boundaries. The ceiling boundary is estimated sales price less anticipated selling expenses.

If replacement cost is above the ceiling, ceiling is used as market value. The floor boundary is estimated sales price less anticipated selling expenses and normal profit. If replacement cost is below the floor, the floor figure is used as market value. If goods are damaged, cost should be reduced to net realizable value.


4. Errors In Recording and Counting Inventory

Errors in recording and counting inventory affect reported figures.

Errors can be made in recording the transfer of inventory, either goods being bought or sold. Transfer should be recorded at FOB point. This is point where legal title changes hands. Since ending inventory is determined by count, an error in recording a purchase or sale does not necessarily affect the reporting of ending inventory.

As a second problem, ending inventory can be counted incorrectly so that both ending inventory and COGS are wrong. If ending inventory is overstated, COGS is too low, and net income is too high. If ending inventory is too low, COGS is too high, and net income is too low. Ending inventory error automatically carries over to the next year’s beginning inventory. If beginning inventory is overstated, COGS is too high, and net income is too low. If beginning inventory is too low, COGS is too low, and net income is too high.


5. Estimating Inventory For Interim Reporting Purpose

Inventory may need to be estimated for many reasons: preparation of interim financial statements, a check figure for a physical inventory count, to estimate fire and theft losses, etc.

Retail inventory method can be used to estimate inventory but only if records are kept at both cost and retail. Ending inventory is first estimated at its retail value by taking the beginning inventory and adding purchases and mark ups and subtracting mark downs, losses (theft and breakage, for example) and sales.

Estimated ending inventory at retail is then converted to a cost figure by multiplying it times a cost/retail ratio. Inventory at retail will not vary but there are several ways to determine the cost/retail ratio, including:

1. Average method for calculating cost/retail ratio. All cost figures (beginning inventory and purchases) are used and all retail figures (beginning inventory, purchases, markups, and markdowns) are used.

2. Conventional (or conventional-lower of cost or market) is same as averaging except that mark downs are left out of the retail part of the ratio.

3. FIFO is same as averaging except that beginning inventory is left out of both cost and retail figures.

4. FIFO lower of cost or market is same as averaging except that beginning inventory is left out of both cost and retail figures and markdowns are left out of the retail part of the ratio.

Gross profit method of estimating inventory is used when only cost figures are recorded. Normal gross profit percentage (gross profit/sales) computed from the past is multiplied times current sales to provide an estimate of current gross profit. This figure is subtracted from sales to arrive at an estimate of the cost of inventory that has been sold in the current period. Cost of beginning inventory is added to current purchases to get total goods available. The estimated cost of the inventory that has been sold this period is subtracted to leave the estimated cost of the inventory still on hand.


6. What Is Consignment Inventory

Consignment inventory is merchandise held for sell by one party (a consignee) although the goods are owned by another (a consignor). Cost of consignment inventory is recorded by the owner (at cost) and not by the consignee. The party physically holding the items does not have them recorded. Consignor cannot record receivable until goods are sold.


7. Applying Dollar Value LIFO

LIFO has some technical problems that make it difficult to use. Dollar value LIFO is one practical way to apply LIFO. For one thing, inventory is grouped into similar pools rather than handling items individually.

All LIFO systems start with a base inventory which is usually the quantity when LIFO is first applied times the price on that date;

  • If inventory increases, a new layer is added: it is the additional quantity at the latest prices.
  • If inventory decreases, cost is removed from the most recent layers.

When applying dollar value LIFO, the base inventory of a pool is also recorded. However, for each additional layer of inventory, the increase in quantity is measured in dollars and not units. For each additional layer, the latest price is measured as an index and not in dollars. The base inventory plus all of the added layers gives ending inventory. A layer might be a $10,000 increase in quantity times an index of 1.12 or $11,200.

Increase in quantity for the current period is the difference between the beginning inventory measured at base year prices and the ending inventory measured at base year prices. Since the prices are held constant, any difference is caused by quantity change. The index for the current period is the ending inventory at ending prices divided by the ending inventory at base year prices.

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