INVENTORY

What is Inventory?

Inventory refers to goods that a business holds for the purpose of resale or for use in the
production of goods to be sold. It represents one of the most important current assets of a
company. For merchandising firms, inventory consists of goods purchased for resale. For
manufacturing firms, inventory includes raw materials, work in process, and finished goods.

CLASSIFYING INVENTORY

How a company classifies its inventory depends on whether the firm is a merchandiser or a
manufacturer.

In a merchandising company, inventory consists of many different items. For example, in a

grocery store, canned goods, dairy products, meats are just a few of the inventory items on
hand. These items have two common characteristics:

(1) They are owned by the company,

(2) They are in a form ready for sale to customers in the ordinary course of business.

In a manufacturing company, some inventory may not be ready yet for sale. As a result,
manufacturers usually classify inventory into three categories:

 finished goods,
 work in process,
 raw materials.

Finished goods inventory is manufactured items that are completed and ready for sale.

Work in process is that portion of manufactured inventory that has been placed into the
production process but is not yet complete.

Raw materials are the basic goods that will be used in production but have not been placed
yet into production.
By observing the levels and changes in the levels of these three inventory types, financial
statement users can gain insight into management’s production plans.

For example,

 low levels of raw materials and high levels of finished goods suggest that management
believes it has enough inventory on hand, and production will be slowing down—
perhaps in anticipation of a recession.
 On the other hand, high levels of raw materials and low levels of finished goods
probably signal that management is planning to step up production.

Regardless of the classification, companies report all inventories under Current Assets on the
statement of financial position.

Inventory Systems
Before discussing how companies determine inventory quantities, let us briefly talk about the
two main inventory systems.
There are two main inventory systems used in accounting:
1. Perpetual Inventory System
In this system, inventory records are updated continuously. Every purchase and sale is
recorded immediately in the relevant inventory and income/expense accounts. So the
company always knows the current inventory balance.
2. Periodic Inventory System
In this system, inventory records are updated at the end of the accounting period. The
company determines the ending inventory by taking a physical count.

 Perpetual → “We update inventory continuously.”

 Periodic → “We update inventory at the end of the period.”

DETERMINING INVENTORY QUANTITIES

All companies need to determine inventory quantities at the end of the accounting period.

 If using a perpetual system, companies take a physical inventory for two reasons:

1. To check the accuracy of their perpetual inventory records.

2. To determine the amount of inventory lost because of wasted raw materials, shoplifting, or
employee theft.

 Companies using a periodic inventory system take a physical inventory

at the statement of financial position date

1. To determine the inventory on hand.

2. To determine the cost of goods sold for the period.

Perpetual inventory system (Sürekli envanter sistemi) şu demek:

👉 Stoklar her işlemde anlık olarak güncellenir. Yani:

 Her satın alma → stok artar

 Her satış → stok azalır
 Ve aynı anda satılan malın maliyeti (COGS) de kaydedilir

🔹 Mantık

Stok = her an sistemde güncel görünür

🔹 Küçük örnek

 100 adet malın var

 10 adet sattın

👉 Sistem anında:

 Stok = 90 olur
 Aynı anda Cost of Goods Sold kaydı yapılır

🔹 Journal entry mantığı

Satışta 2 kayıt vardır:

1️ Gelir kaydı

 Dr Cash / Receivable
 Cr Sales

2️ Maliyet kaydı

 Dr Cost of Goods Sold

 Cr Inventory

🔹 Perpetual vs Periodic farkı (kısa kritik nokta)

Özellik Perpetual Periodic

Stok takibi Anlık Dönem sonunda
COGS Her satışta Dönem sonunda hesaplanır
Doğruluk Yüksek Daha düşük
Kullanım Modern sistemler Eski yöntem

Determining inventory quantities involves two steps:

(1) taking a physical inventory of goods on hand,

(2) determining the ownership of goods.

Taking a Physical Inventory

Companies take a physical inventory at the end of the accounting period.

Taking a physical inventory involves actually

 counting
 weighing
 measuring

each kind of inventory on hand.

In many companies, taking an inventory is a formidable task. Retailers such as PPR (FRA),
Esprit Holdings (HKG), Kingfisher (GBR), or Migros (TR) have thousands of different
inventory items.

An inventory count is generally more accurate when goods are not being sold or received
during the counting. Consequently, companies often “take inventory” when the business is
closed or when business is slow. Many retailers close early on a chosen day in January.

Determining Ownership of Goods

One challenge in computing inventory quantities is determining what inventory a company

owns. To determine ownership of goods, two questions must be answered:

 Do all of the goods included in the count belong to the company?

 Does the company own any goods that were not included in the count?

Goods in Transit

A complication in determining ownership is goods in transit (on board a truck, train, ship, or
plane) at the end of the period.

The company may have purchased goods that haven’t been received yet, or it may have sold
goods that haven’t been delivered yet.

To arrive at an accurate count, the company must determine ownership of these goods.

Consigned Goods

In business life, it is common to hold the goods of other parties and try to sell these goods for
them for a fee, but without taking ownership of the goods. These are called consigned goods.

For example,
you might have a used car that you would like to sell. If you take your car to a dealer, the
dealer might be willing to put the car on its lot and charge you a commission if it is sold.
Under this agreement, the dealer would not take ownership of the car. So the car still
belongs to you until it is sold. Therefore, if an inventory count were taken, the car wouldn’t be
included in the dealer’s inventory.

INVENTORY COSTING

Inventory is accounted for at cost.

Cost includes all expenditures necessary to acquire goods and place them in a condition ready
for sale.

For example,

 freight costs incurred to acquire inventory are added to the cost of inventory,
 but the cost of shipping goods to a customer are a selling expense.

After a company has determined the quantity of units of inventory, it calculates

 total inventory cost,

 cost of goods sold

by multiplying units by their cost.

This process can be complicated if a company has purchased inventory items at different
times and at different prices.

For example, assume that Vestel TV Company purchases three identical 50-inch TVs on
different dates at costs of £700, £750, and £800. During the year, Vestel sold two sets at
£1,200 each. These facts are summarized below.

Cost of goods sold will differ depending on which two TVs the company sold.

For example, it might be

 £1,450 (£700 + £750), or

 £1,500 (£700 + £800), or
 £1,550 (£750 + £800).

Now in this section, we will discuss alternative costing methods available to Vestel.

Specific Identification
If Vestel can identify which particular units it sold and which are still available in ending
inventory, it can use the specific identification method.

For example,

if Vestel sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is
£1,500 (£700 + £800), and its ending inventory is £750.

Using this method, companies can accurately determine ending inventory and cost of goods
sold.

Specific identification requires that companies keep records of the original cost of each
individual inventory item.

Historically, specific identification was possible only when a company sold a limited variety
of high-unit-cost items. These items can be identified clearly from the time of purchase to the
selling time.

Examples of such products are

cars, pianos, expensive antiques etc.

Unfortunately, for most companies, the specific identification method is still not practical.
Instead of tracking the cost of each item sold, most companies make assumptions. These
assumptions about which units were sold are called cost flow assumptions.

Cost Flow Assumptions

Because specific identification is often impractical, other cost flow methods are permitted.
These methods are different from specific identification because they assume a cost flow that
may not match the actual movement of goods. There are two assumed cost flow methods:

1. First-in, first-out (FIFO)

2. Average-cost

There is no accounting requirement that the cost flow assumption be consistent with the
physical movement of the goods.

Company management selects the appropriate cost flow method.

To indicate these methods, we will use the data for Lin Electronics.

The cost of goods sold formula in a periodic system is:

 Lin Electronics had in total 100 units available to sell during the period (beginning
inventory plus purchases).
 The total cost of these 100 units is $12,000, referred to as cost of goods available for
sale.
 A physical inventory taken at December 31 determined that there were 45 units in
ending inventory.
 Therefore, Lin sold 55 units (100 − 45) during the period.
 To determine the cost of the 55 units that were sold (the cost of goods sold),
o we assign a cost to the ending inventory and
o subtract that value from the cost of goods available for sale.
 The value assigned to the ending inventory will depend on which method we use.
 No matter which assumption we use, though, the sum of cost of goods sold plus the
cost of the ending inventory must equal the cost of goods available for sale—in this
case, $12,000.

FIRST-IN, FIRST-OUT (FIFO)

The FIFO method assumes that the earliest goods purchased are the first to be sold.
This doesn’t necessarily mean;
 that the oldest units are sold first,
but means;
 that the costs of the oldest units are recognized first.

Illustration below shows the allocation of the cost of goods available for sale at Lin
Electronics under FIFO.
Under FIFO, since it is assumed that the first goods purchased were the first goods sold,
ending inventory is based on the prices of the most recent units purchased.

That is, under FIFO, companies obtain the cost of the ending inventory by taking the
unit cost of the most recent purchase and working backward until all units of inventory
have been costed.

In this example,

Lin Electronics prices the 45 units of ending inventory using the most recent prices.

The last purchase was 40 units at $130 on November 27.

The remaining 5 units are priced using the unit cost of the second most recent purchase, $120,
on August 24.

Next, Lin Electronics calculates cost of goods sold by subtracting the cost of the units not
sold (ending inventory) from the cost of all goods available for sale.

Illustration below demonstrates that companies also can calculate cost of goods sold by
pricing the 55 units sold using the prices of the first 55 units acquired. Note that of the 30
units purchased on August 24, only 25 units are assumed sold. This agrees with our
calculation of the cost of ending inventory, where 5 of these units were assumed unsold and
thus included in ending inventory.

Proof of cost of goods sold:

AVERAGE-COST

Under the average-cost method, we calculate a weighted-average unit cost and use it to value
both inventory and cost of goods sold. The average-cost method assumes that goods are
similar in nature. Illustration below presents the formula and a sample computation of the
weighted-average unit cost.

Formula for weighted-average unit cost:

The company then applies the weighted-average unit cost to the units on hand to determine
the cost of the ending inventory.

Illustration below shows the allocation of the cost of goods available for sale at Lin
Electronics using average-cost.

Allocation of costs— average-cost method:

We can verify the cost of goods sold under this method by multiplying the units sold times the
weighted-average unit cost (55 × $120 = $6,600).

Note that this method does not use the average of the unit costs. That average is $115 ($100 +
$110 + $120 + $130 = $460; $460 ÷ 4).

The average-cost method instead uses the average weighted by the quantities purchased at
each unit cost.

DO IT !

The accounting records of Shumway Ag Implement show the following data.

 Beginning inventory 4,000 units at £3

 Purchases 6,000 units at £4
 Sales 7,000 units at £12

Determine the cost of goods sold during the period under a periodic inventory system using

(a) the FIFO method,

(b) the average-cost method.

Solution

Cost of goods available for sale = (4,000 × £3) + (6,000 × £4) = £36,000
Ending inventory = 10,000 − 7,000 = 3,000 units

(a) FIFO : £36,000 − (3,000 × £4) = £24,000

(b) Average cost per unit : [(4,000 × £3) + (6,000 × £4)] ÷ 10,000 = £3.60
Average-cost : £36,000 − (3,000 × £3.60) = £25,200

Financial Statement and Tax Effects of Cost Flow Methods

Either of the two cost flow assumptions is acceptable for use.

For example, adidas (DEU) and Lenovo (CHN) use the average-cost method, whereas Nokia
(FIN) use FIFO.

A recent survey of IFRS companies indicated that approximately 60% of these companies use
the average-cost method, with 40% using FIFO. In fact, approximately 23% use both average-
cost and FIFO for different parts of their inventory.

The reasons companies adopt different inventory cost flow methods are varied, but they
usually involve one of three factors:

(1) income statement effects,

(2) statement of financial position effects,

(3) tax effects.

INCOME STATEMENT EFFECTS

To understand why companies choose either FIFO or average-cost, let’s examine the effects
of these two cost flow assumptions on the financial statements of Lin Electronics. The
condensed income statements assume that Lin sold its 55 units for $11,500, had operating
expenses of $2,000, and is subject to an income tax rate of 30%.

Note the cost of goods available for sale ($12,000) is the same under both FIFO and average-
cost. However, the ending inventories and the costs of goods sold are different. This
difference is due to the unit costs that the company allocated to cost of goods sold and to
ending inventory. Each dollar of difference in ending inventory results in a corresponding
dollar difference in income before income taxes. For Lin, a $400 difference exists between
cost of goods sold using FIFO versus average-cost.
In periods of changing prices, the cost flow assumption can have a significant impact on
income and on evaluations based on income.

In most instances, prices are rising (inflation). In a period of inflation, FIFO produces a higher
net income because the lower unit costs of the first units purchased are matched against
revenues. In a period of rising prices (as is the case in the Lin example), FIFO reports a higher
net income ($2,310) than average-cost ($2,030).

If prices are falling, the results from the use of FIFO and average-cost are reversed. FIFO will
report the lower net income and average-cost the higher.

To management, higher net income is an advantage. It causes external users to view the
company more favorably. In addition, management bonuses, if based on net income, will be
higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer
FIFO because it results in higher net income.

STATEMENT OF FINANCIAL POSITION EFFECTS

A major advantage of the FIFO method is that in a period of inflation, the costs allocated to
ending inventory will approximate their current cost. For example, for Lin Electronics, 40 of
the 45 units in the ending inventory are costed under FIFO at the higher November 27 unit
cost of $130.

Conversely, a shortcoming of the average-cost method is that in a period of inflation, the costs
allocated to ending inventory may be understated in terms of current cost. The understatement
becomes greater over prolonged periods of inflation if the inventory includes goods purchased
in one or more prior accounting periods.

TAX EFFECTS

We have seen that both inventory on the statement of financial position and net income on the
income statement are higher when companies use FIFO in a period of inflation. Yet, some
companies use average-cost. Why? The reason is that average-cost results in lower income
taxes (because of lower net income) during times of rising prices. For example, at Lin
Electronics, income taxes are $870 under average-cost, compared to $990 under FIFO. The
tax savings of $120 makes more cash available for use in the business.