Inventory is often the largest asset on a company’s books in terms of total dollars. As a result, therefore, it should come as no surprise that inventory topics are heavily tested on the FAR section of the CPA exam.
The term 'inventory' designates tangible personal property, which is:
- Held for sale in the ordinary course of business,
- In process of production for such sale, or
- To be currently consumed in the production of goods and services to be available for sale.
- Merchandise: items purchased for resale
- Raw Materials: materials on hand not yet placed into production
- Supplies: manufacturing supplies only, others are prepaid expenses
- Work in process: direct material, labor and overhead cost of unfinished units
- Finished goods
The major objective of inventory accounting is proper income measurement through the process of matching costs against revenues. The inventory method used should be consistently applied. The primary basis of accounting for inventories is the cost, which is the price paid plus the direct or indirect cost of bringing the article to its existing condition or location.
METHODS OF INVENTORY MEASUREMENT
Periodic Method: The asset costs are accumulated in inventory and in related purchases accounts. The cost expiration is determined through the use of a cost of goods sold account and is affected by the period change in the asset inventories. A physical inventory is necessary to prepare statements.
Perpetual or Book Inventories: The cost of goods sold can be determined with each sale or issuance of raw material to production. The physical inventory can be taken on a cycle basis with the objective of verifying the inventory records. A perpetual inventory system is costly to install and maintain.
Gross Profit Method: The gross profit method is used to estimate the inventory in situations in which it is not desirable or possible to take a physical inventory. It is used mostly for interim financial statements or in determining inventory in the event of a fire or other casualty. The gross profit method is not appropriate for year-end financial reporting purposes as it does not provide for a "proper determination of the realized income"; an estimate of the cost of goods sold and ending inventory is not adequate. The gross profit method does not provide for the taking or pricing (costing) of physical inventory on hand under any cost flow assumption.
ADJUSTMENTS TO INVENTORY COST
Cash Discounts: These should be treated as a reduction in the cost of purchases. Because of the difficulty of associating a discount with a particular purchase, discounts are frequently treated as other income or as a reduction of purchases in the income statement. Theoretically, discounts are cost reductions since income cannot be generated by purchasing goods.
Discounts are usually handled in one of two ways in the accounts:
Use of "Discounts Lost" Account (Net Price Method) In the use of a "discounts lost" account, it is assumed the discount will be taken, and the amount originally recorded in purchases and accounts payable is net of the discount.
Use of "Discounts" Account. (Gross Price Method) In this method, discounts are deducted from purchases.
Trade Discounts: Trade discounts (also referred to as volume or quantity discounts) are discounts from a catalog or list price, used to establish a pricing policy and, therefore, do not enter into the accounting system. These discounts are usually stated as a percentage of the list price and are deducted from the list or catalog price to determine the recorded invoice price. Each discount applies to the net price computed after deducting the previous discount.
Transportation Costs: These should be added to inventory costs.
Purchasing, Handling, and Storage Costs: These costs should also be added to inventory cost, but because of the difficulty of association, they are usually expensed as period costs.
INVENTORY VALUATION METHODS
Specific Identification: This method recognizes inventory based on the movement of specific items. When items are sold or otherwise disposed of, the actual cost of the specific item is assigned to the transaction and the ending inventory consists of the actual costs of the specific items on hand. It is usually used for high cost items which are individually identifiable (autos, appliances, jewelry, etc.).
Average Cost: The average cost flow assumption assumes that all costs and units are merged (commingled) so that no specific item or cost can be separately identified. Both the cost of goods sold and ending inventory are valued at the average unit cost. The average cost method may be used with either the periodic or perpetual inventory system.
a) Weighted Average - Periodic: The cost of units is calculated at the end of the period based upon the average price paid (including freight, etc.), weighted by the number of units purchased at each price (the cost of goods available for sale divided by the number of units available for sale).
b) Moving Average - Perpetual: The cost of units is calculated in the same manner as was used for weighted average except a new weighted average cost is calculated after each purchase. This average cost is used to determine the cost of each unit sold prior to the next purchase.
• FIFO (First In, First Out): An assumption that goods are sold in the chronological order purchased. The ending inventory will consist of the last purchases made during the accounting period.
• LIFO (Last In, First Out): The last goods purchased are assumed to be sold. The ending inventory consists of the goods first purchased.
The above article is about inventories on the FAR CPA Exam. Hope this helps. If you have any queries, feel free to comment in the section below. Happy Learning!
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