Summary Note: Accounting for Inventories - Fundamental Accounting II
Nature of Inventories
Inventories are assets held for sale, in production, or as materials/supplies to be used in
production or services (IAS 2). Classification depends on business type:
Merchandising companies: Merchandise inventory.
Manufacturers: Finished goods, work in process (materials, labor, overhead), and raw
materials.
Importance of Inventories
Inventory is the most active element in merchandising businesses.
Sales of merchandise are the principal revenue source.
Cost of merchandise sold is the largest deduction from sales.
Ending inventories form the largest portion of current assets.
Errors in inventory valuation distort financial statements for current and following
periods.
Internal Control of Inventories
Internal controls help ensure growth and profitability through accurate inventory management:
Documents and records: Receiving reports, inventory ledgers, cost reports, inventory
status, shipping orders.
Functions: Inventory management (authorization and level maintenance), purchasing,
and inventory custody.
Segregation of duties: Purchase, custody, recording, and physical inventory supervision
should be separate to prevent errors and fraud.
Effects of Inventory Errors on Financial Statements
Inventory errors impact both the income statement and statement of financial position.
Understating beginning inventory understates cost of goods sold and overstates net
income for the current period.
Understating ending inventory overstates cost of goods sold and understates net income.
Errors in ending inventory reverse their effect on net income in the next accounting
period.
Ending inventory errors affect assets and equity but not liabilities on the balance sheet.
Inventory Costing Methods
Costs included in inventory consist of purchase costs, conversion costs (direct labor and
overhead), and other costs to bring inventory to usable condition.
Specific Identification: Tracks cost of actual items sold or held; used when items are
easily identifiable.
First-In, First-Out (FIFO): Assumes earliest goods purchased are sold first; ending
inventory consists of the most recent purchases.
Average Cost Methods: Includes weighted average (periodic) and moving average
(perpetual), which allocate costs based on average prices.
FIFO generally yields higher net income in rising prices, while average cost smooths cost
variations.
Inventory Estimation Methods
Lower of Cost or Net Realizable Value (LCNRV): Inventory is valued at cost or net
realizable value (expected selling price less costs to sell/complete), whichever is lower, to
reflect losses in value.
Gross Profit Method: Uses historical gross profit ratios applied to net sales to estimate
ending inventory cost; useful for interim financial analysis or loss estimation.
Retail Inventory Method: Estimates inventory cost by applying a cost-to-retail
percentage to ending inventory at retail prices; practical for retail businesses with many
low-cost