Chapter 8: How Does a Company Gather Information about Its Inventory?

The Reported Inventory Balance

Question: The asset section of the February 26, 2011, balance sheet produced by Best Buy Co. Inc. reports net accounts receivable of $2.348 billion. Based on coverage provided in the previous chapter, savvy decision makers should know that this figure reflects net realizable value—the estimation by officials of the cash amount that will be collected from the receivables owed to the company by its customers. Knowledge of financial accounting allows any individual to understand the information conveyed in a set of financial statements.

As is common, the next account that appears on Best Buy’s balance sheet is “merchandise inventories.” This asset includes all items held as of that date that were acquired for sales purposes—televisions, cameras, computers, and the like. The monetary figure disclosed by the company for this asset is $5.897 billion. Does this balance also indicate net realizable value—the cash expected to be generated from the company’s merchandise—or is different information reflected? On a balance sheet, what does the amount reported for inventory represent?

Answer: The challenge of analyzing the various assets reported by an organization would be reduced substantially if all account balances disclosed the same basic information, such as net realizable value. However, over the decades, virtually every asset has come to have its own individualized method of reporting, one created to address the special peculiarities of that account. Thus, the term “presented fairly” is often reflected in a totally different way for each asset. Reporting accounts receivables, for example, at net realizable value has no impact on the approach that is generally accepted for inventoryA current asset bought or manufactured for the purpose of selling in order to generate revenue..

Accounting for inventory is more complicated because reporting is not as standardized as with accounts receivable. For example, under certain circumstances, the balance sheet amount shown for inventory actually does reflect net realizable value. However, several other meanings for that balance are more likely. The range of accounting alternatives emphasizes the need for a careful reading of financial statement notes rather than fixating on a few reported numbers alone. Without study of the available disclosures, a decision maker simply cannot know what Best Buy means by the $5.897 billion figure reported for its inventory.

For all cases, though, the reporting of inventory begins with its cost. In contrast, cost is never an issue even considered in the reporting of accounts receivable.

Determining the Cost of Inventory

Question: Every item bought for sales purposes has a definite cost. The accounting process for inventory begins with a calculation of that cost. How does an accountant determine the cost of acquired inventory?

Answer: The financial reporting for inventory starts by identifying the cost paid to obtain the item. In acquiring inventory, officials make the considered decision to allocate a certain amount of their scarce resources. The amount of that sacrifice is interesting information. What did the company expend to obtain this merchandise? That is a reasonable question to ask since this information can be valuable to decision makers.

To illustrate, assume that a sporting goods company (Rider Inc.) acquires a new bicycle (Model XY-7) to sell. Rider’s accounting system should be designed to determine the cost of this piece of inventory, the price that the company willingly paid to obtain the asset. Assume that $250 was charged by the manufacturer (Builder Company) for the bicycle, and the purchase was made by Rider on credit. Rider spends $9 in cash to transport the item from the factory to one of its retail stores and another $6 to have the pieces assembled so that the bicycle can be displayed in the salesroom for customers to examine.

In accounting for the acquisition of inventory, cost is said to include all normal and necessary amounts incurred to get the item into condition and position to be sold. All such expenditures provide future value. Hence, as shown in Figure 8.1 “Monitoring the Cost of an Inventory Item—Subsidiary Ledger”, by the time this bicycle has reached Rider’s retail location and been readied for sale, the cost to the sporting goods company is $265.

Figure 8.1 Monitoring the Cost of an Inventory Item—Subsidiary Ledger

Charges for delivering this merchandise and assembling the parts were included in the asset account (the traditional term for adding a cost to an asset account, capitalizationThe process of recording a cost as an asset rather than an expense; for inventory, it includes all normal and necessary costs associated with getting the asset into position and condition to be sold., was introduced previously). Both of these expenditures were properly viewed as normal and necessary to get the bicycle into condition and position to be sold. Interestingly, any amount later expended by the company to transport inventory from the store to a buying customer is recorded as an expense because that cost is incurred after the sale takes place. At that point, no further future value exists since the merchandise has already been sold.

Occasionally, costs arise where the “normal and necessary” standard may be difficult to apply. To illustrate, assume that the president of a store that sells antiques buys a 120-year-old table for resell purposes. When the table arrives at the store, another $300 must be spent to fix a scratch cut across its surface. Should this added cost be capitalized (added to the reported balance for inventory) or expensed? The answer to this question is not readily apparent and depends on ascertaining the relevant facts. Here are two possibilities.

Scenario one: The table was acquired by the president with the knowledge that the scratch already existed and needed to be fixed prior to offering the merchandise for sale. In that case, repair is a normal and necessary activity to bring the table into the condition necessary to be sold. The $300 is capitalized, recorded as an addition to the reported cost of the inventory.

Scenario two: The table was bought without the scratch but was damaged when first moved into the store through an act of employee carelessness. The table must be repaired, but the scratch was neither normal nor necessary. The cost could have been avoided. This $300 is not capitalized but rather reported as a repair expense by the store.

As discussed in an earlier chapter, if the accountant cannot make a reasonable determination as to whether a particular cost qualifies as normal and necessary, the practice of conservatism requires the $300 to be reported as an expense. When in doubt, the alternative that makes reported figures look best is avoided so that decision makers are not encouraged to be overly optimistic about the company’s financial health and future prospects.

Offering Discounts for Quick Payment

Question: When inventory is sold, some sellers are willing to accept a reduced amount to encourage fast payment—an offer that is called a cash discount (or sales discount or purchases discount depending on whether the seller or the buyer is making the entry). Cash becomes available sooner so that the seller can quickly put it back into circulation to make more profits. In addition, the possibility that a receivable will become uncollectible is reduced if the balance due is not allowed to get too old. Tempting buyers to make quick payments to reduce their cost is viewed as a smart business practice by many sellers.

To illustrate, assume the invoice received by the sporting goods company (Rider) for the above bicycle indicates the proper $250 balance but also includes the notation: 2/10, n/45. What message is being conveyed by the seller? How do cash discounts impact the reporting of inventory?

Answer: Sellers—such as Builder Company in this example—can offer a wide variety of discount terms to encourage speedy payment. One such as 2/10, n/45 is generally read “two ten, net 45.” It informs the buyer that a 2 percent discount is available if the invoice is paid by the tenth day. The net amount that remains unpaid (after any merchandise returns or partial cash payments) is due on the forty-fifth day. Rider has the option to pay $245 for the bicycle within ten days of receiving the invoice by taking advantage of the $5 discount ($250 × 0.02). Or the sporting goods company can wait until the forty-fifth day but then is responsible for the entire $250. In practice, a variety of other discount terms are frequently encountered such as 1/10, n/30 or 2/10, n/30.

Many companies automatically take all cash discounts as a matter of policy because of the high rate of interest earned. If Rider does not submit the money after ten days, it must pay an extra $5 in order to hold onto $245 for an additional thirty-five days. This delay equates to a 2.04 percent interest rate over just that short period of time ($5/$245 = 2.04 percent [rounded]). There are over ten thirty-five-day periods in a year. Paying the extra $5 is the equivalent of an annual interest rate in excess of 21 percent.

That substantial rate of interest expense is avoided by making early payment, a decision chosen by most companies unless they are experiencing serious cash flow difficulties.

Assuming that Rider avails itself of the discount offer, the capitalized cost of the inventory is reduced to $260.

Figure 8.2 Cost of Inventory Reduced by Cash Discount—Subsidiary Ledger

Maintaining Inventory Costs in a Perpetual System

Question: In an earlier chapter, differences between a perpetual inventory system and a periodic inventory system were discussed briefly. Because of the availability of modern technology, most companies—but not all—maintain some type of perpetual inventory records. A perpetual system—which frequently relies on bar coding and computer scanning—provides an ongoing record of all items present, both in total and individually. How is the recording of an inventory purchase carried out in a perpetual system?

Answer: When a perpetual inventory systemAccounting system that maintains an ongoing record of all inventory items both in total and individually; records increases and decreases in inventory accounts as they occur as well as the cost of goods sold to date. is in use, all additions and reductions are monitored in the inventory T-account. Thus, theoretically, the balance found in that general ledger account at any point in time is identical to the merchandise physically on hand. In actual practice, recording mistakes as well as losses such as theft and breakage create some (hopefully small) discrepancies. Consequently, even with a perpetual system, inventory records must be reconciled occasionally with the items actually present to reestablish accuracy.

In a perpetual inventory system, the maintenance of a separate subsidiary ledger showing data about the individual items on hand is essential. On February 26, 2011, Best Buy reported inventory totaling $5.897 billion. However, internally the company also needs specific information as to the quantity, type, and location of all televisions, cameras, computers, and the like that make up this sum. That is the significance of a perpetual system; it provides the ability to keep track of the various types of merchandise. The total cost is available in the inventory T-account but detailed data about the composition (the quantity and frequently the cost) of merchandise physically on hand is found in a subsidiary ledger where an individual file can be available for each item as is shown in Figure 8.2 “Cost of Inventory Reduced by Cash Discount—Subsidiary Ledger”.

Assume that Rider Inc. (the sporting goods company) uses a perpetual inventory system. In Figure 8.3 “Rider Inc.—Journal Entries—Perpetual Inventory System”, journal entries are shown for the purchase of a bicycle to sell (Model XY-7). The bicycle is recorded at the $250 invoice amount and then reduced by $5 at the time the discount is taken. This approach is known as the “gross method of reporting discounts.” As an alternative, companies can choose to anticipate taking the discount and simply make the initial entry for the $245 expected payment. This option is referred to as the “net method of reporting discounts.” Under that approach, if the discount is not actually taken, the additional $5 cost is recorded as a loss or an expense rather than as a capitalized cost of the inventory because it is not normal or necessary to pay the extra amount.

Figure 8.3 Rider Inc.—Journal Entries—Perpetual Inventory System

After posting these entries, the inventory T-account in the general ledger reports a net cost of $260 ($250 − $5 + $9 + $6) and the separate subsidiary ledger shown previously indicates that one Model XY-7 bicycle is on hand with a cost of $260.

Recording Inventory Purchases in a Periodic System

Question: In a periodic system, no attempt is made to keep an ongoing record of a company’s inventory. Instead, the quantity and cost of merchandise is only determined periodically as a preliminary step in preparing financial statements. How is the actual recording of an inventory purchase carried out in a periodic system?

Answer: If a company uses a periodic inventory systemAccounting system that does not maintain an ongoing record of all inventory items; instead, ending inventory is determined by a physical count so that a formula (beginning inventory plus purchases less ending inventory) can be used to calculate cost of goods sold., neither the cost nor the quantity of the items on hand is monitored. Inventory amounts are unknown both in total and individually. These figures are not viewed by company officials as worth the cost and effort necessary to gather them. However, purchases are still made, and a record must be maintained of the costs incurred. This information is eventually used for financial reporting but also—more immediately—for control purposes. Regardless of the recording system, companies want to avoid spending unnecessary amounts on inventory as well as tangential expenditures such as transportation and assembly. If the accounting system indicates that a particular cost is growing too rapidly, alternatives can be investigated and implemented before the problem becomes serious. Periodic systems are designed to provide such information through the use of separate general ledger T-accounts for each cost incurred.

Assume that Rider uses a periodic inventory system. Its journal entries for the acquisition of the Model XY-7 bicycle are as shown in Figure 8.4 “Rider Inc.—Journal Entries—Periodic Inventory System”. No separate subsidiary ledger is maintained. The overall cost of this inventory item is not readily available in the accounting records and the quantity (except by visual inspection) is unknown. At any point in time, company officials do have access to the amounts spent for each of the individual costs (such as transportation and assembly) for monitoring purposes.

Because these costs result from the acquisition of an asset that eventually becomes an expense when sold, they follow the same debit and credit rules as those accounts.

Figure 8.4 Rider Inc.—Journal Entries—Periodic Inventory System

In a periodic system, when a sale occurs, the revenue entry is made as always. However, no journal entry is made for cost of goods sold. Because of the lack of information, the dollar amount of the cost is not known at this time so inventory is not reduced and cost of goods sold is not recognized. Instead, when a periodic system is in use, cost of goods sold is only determined and recorded when financial statements are prepared through the use of the following formula:

Note that the choice between using a perpetual and periodic system impacts the following:

• Information available to company officials on a daily basis
• Journal entries to be made
• Cost necessary to operate the accounting system (the technology required by a perpetual system is more expensive)

Regardless of the system in use, Rider holds one piece of inventory with a cost of $260. The decision as to whether to utilize a perpetual or periodic system is based on the added cost of the perpetual system and the difference in the available information generated for use by company officials. The company’s inventory is not physically affected by the method selected.

Actual Use of Periodic Inventory Systems

Question: Given the availability of sophisticated computers at moderate prices, do any companies still use periodic inventory systems? With bar coding and the advanced state of technology, are periodic inventory procedures so antiquated that they are no longer found in actual practice?

Answer: Obviously, in this computer age, perpetual inventory systems have come to dominate because they provide valuable and immediate information to company officials. However, some businesses are unlikely to ever change from the simplicity of a periodic system.

A beauty salon or barber shop, for example, where services are rendered but a small amount of inventory is kept on hand for occasional sales, would certainly not need to absorb the cost of a perpetual system. Visual inspection can alert employees as to the quantity of inventory on hand.

Restaurants, sandwich shops, ice cream stores, and the like might well choose to use a periodic system because customer purchases take place at a small establishment where quantities are easy to observe and manage. In such operations, the information provided by a perpetual system does not necessarily provide additional benefit.

“Dollar stores,” which have become particularly prevalent in recent years, sell huge quantities of low-priced merchandise. Goods tend to be added to a store’s inventory as they become available rather than based on a formal managed inventory strategy. Again, officials must decide whether keeping up with the amount of inventory on hand will improve their decision making. If not, the cost of a perpetual system is unnecessary.

Perhaps, most importantly, some companies use a hybrid system where the units on hand and sold are monitored carefully with a perpetual system. However, to reduce accounting costs, the dollar amounts for inventory and cost of goods sold are determined using a periodic system when financial statements are to be prepared. In that way, the company gains valuable information (the number of units on hand) but still utilizes a cheaper system.

Recording Purchases Based on the FOB Point

Question: Rider Inc. (the sporting goods company) buys a bicycle for sales purposes. The company can record the transaction using either a perpetual system (debit Inventory) or periodic system (debit Purchases of Inventory). When should an inventory purchase be recorded? Assume, for example, that Builder Company (the manufacturer of this bicycle) is located in Wisconsin, whereas the retail store operated by Rider is in Kentucky. Delivery takes several days at a minimum. The precise moment for recording the transaction is probably not critical except near the end of the year when the timing of journal entries will impact balances that are included on the financial statements.

To illustrate, assume this bicycle is ordered by Rider Inc. on December 27 of Year One. It is shipped by Builder Company from Wisconsin on December 29 of Year One and arrives at the retail store on January 4 of Year Two. When Rider produces financial statements for Year One, should the inventory cost and related payable be included even though the bicycle was not physically received until Year Two?

Answer: Documents prepared in connection with inventory shipments are normally marked with an “FOB” point. FOB stands for “Free On Board” (a traditional maritime term that has gained a wider use over the years) and indicates when legal title to property is transferred from seller to buyer. At that moment, ownership of the bicycle is conveyed. The FOB point signifies the appropriate date for recording.

If Builder Company specifies that the sale of this bicycle is made FOB shipping pointTerms of sale stipulating that legal title to shipped goods passes to the buyer at the time of shipment so that the buyer is responsible for transportation costs and any damages or losses in transit. and Rider Inc. agrees to this condition, conveyance occurs on December 29, Year One, when the bicycle leaves the seller. Consequently, both the asset and the liability appear on the December 31, Year One, balance sheet prepared by the buyer. For the same reason, Builder records sales revenue in Year One.

However, if the contract states that the transaction is made FOB destinationTerms of sale stipulating that legal title to shipped goods passes to the buyer when they arrive at the final destination so that the seller is responsible for transportation costs and any damages or losses in transit., the seller maintains ownership until the bicycle arrives at Rider’s store on January 4, Year Two. Neither party records the transaction until that date. The date of recognition is based on the FOB point.

The FOB point can be important for two additional reasons.

• The party that holds legal title to merchandise during its delivery from seller to buyer normally incurs all transportation costs. If no other arrangements are negotiated, “FOB shipping point” means that Rider Inc. as the buyer is responsible for the delivery. “FOB destination” assigns this cost to Builder, as the seller.
• Any losses or damages that occur in route affect the party holding legal title (again, unless other arrangements are agreed upon by the parties). If shipment from Wisconsin to Kentucky was noted as FOB shipping point and the bicycle breaks as the result of an accident in Illinois, it is the buyer’s inventory that was harmed. However, it is the seller’s problem if the shipment is marked as FOB destination. The legal owner bears the cost of any damages that occur during the physical conveyance of property.

Recording Cost Of Goods Sold: Perpetual and Periodic

Question: When a sale of inventory is made, the seller recognizes an expense that has previously been identified as “cost of goods sold” or “cost of sales.” For example, Best Buy reported “cost of goods sold,” for the year ended February 26, 2011, as $37.611 billion. When should cost of goods sold be determined?

To illustrate, assume that Rider Inc. begins the current year holding three Model XY-7 bicycles costing $260 each—$780 in total. During the period, another five units of this same model are acquired, again for $260 apiece or $1,300 in total. At this introductory stage, utilizing a single cost of $260 for all items eliminates a significant theoretical problem, one that will be discussed in detail in the following chapter.

Eventually, a customer buys seven of these bicycles for her family and friends paying cash of $440 each or $3,080 in total. No further sales are made of this model during the current period so that only a single bicycle remains (3 + 5 − 7). One is still in stock while seven have been sold. What is the proper method of recording the company’s cost of goods sold?

Answer: The answer here depends on whether a perpetual or a periodic system is used by the company.

Perpetual inventory system. The acquisition and subsequent sale of inventory when a perpetual system is in use was demonstrated briefly in an earlier chapter. The accounting records maintain current balances so that officials are cognizant of (a) the amount of merchandise on hand and (b) the cost of goods sold for the year to date. These figures are readily available in general ledger T-accounts. In addition, separate subsidiary ledger balances are usually established for the individual items in stock, showing the quantity on hand and the cost. When each sale is made, the applicable cost is reclassified from the inventory account on the balance sheet to cost of goods sold on the income statement. Simultaneously, the corresponding balance in the subsidiary ledger is lowered.

In this example, bicycles were acquired by Rider Inc. Seven of them, costing $260 each (a total of $1,820), are then sold to a customer for $440 apiece or $3,080. When a perpetual system is in use, two journal entries are prepared at the time of each sale: one for the sale and a second to shift the cost of the inventory from asset to expense.

Figure 8.5 Journal Entries for Sale of Seven Model XY-7 Bicycles—Perpetual Inventory System

Removing $1,820 from inventory leaves a balance of $260 ($780 + $1,300 – $1,820) representing the cost of the one remaining unit. The $1,260 difference between revenue and cost of goods sold ($3,080 minus $1,820) is the markup (also known as gross profitDifference between sales and cost of goods sold; also called gross margin or markup. or “gross margin”) earned on the sale.

Periodic inventory system. In contrast, a periodic system monitors the various inventory expenditures but makes no attempt to maintain a record of the merchandise on hand or the cost of goods sold during the year. Although cheap to create and operate, the information available to company officials is extremely limited.

At the time the sale of these seven bicycles takes place, the first journal entry shown in Figure 8.5 “Journal Entries for Sale of Seven Model XY-7 Bicycles—Perpetual Inventory System” is still made to recognize the revenue. Cash is debited for $3,080 and Sales Revenue-Merchandise is credited for $3,080. However, if a periodic system is in use, the second entry is omitted. Cost of goods sold is neither calculated nor recorded when a sale occurs. The available information is not sufficient to determine the amount. The inventory balance remains unadjusted throughout the year. Eventually, whenever financial statements are prepared, the figure to be reported for the asset (inventory) on that date must be determined along with the expense (cost of goods sold) for the entire period.

Because totals are not updated, the only accounts found in the general ledger relating to inventory show balances of $780 (beginning balance) and $1,300 (purchases of inventory).

Based on this information, total inventory available to be sold by Rider Inc. during this period is eight units costing $2,080 ($780 plus $1,300).

When using a periodic system, cost of goods sold is computed as a prerequisite step in preparing financial statements. Inventory on hand is counted (a process known as a physical inventoryA count of inventory on hand; necessary for reporting purposes when using a periodic system but also required for a perpetual system to ensure the accuracy of recorded information.), and all units that are no longer present are assumed to have been sold. The resulting figure is then reported as the company’s cost of goods sold for the period. Because complete inventory records are not available, any units that are lost, stolen, or broken cannot be separately derived. All missing inventory is grouped into one expense—cost of goods sold.

In this example, a physical inventory count will be taken by the employees of Rider Inc. on or near the last day of the year so that financial statements can be produced. Because eight bicycles (Model XY-7) were available during the year but seven have now been sold, one unit—costing $260—remains (if no accident or theft has occurred). This amount is the inventory figure that appears in the asset section of the balance sheet.

Cost of goods sold is then computed by the following formula.

Figure 8.6 Computation of Cost of Goods Sold in a Periodic SystemThe Purchases figure here could have also been shown by displaying the various cost components such as the invoice price, purchases discount, transportation-in, and assembly. That breakdown is important for internal decision making and control but probably of less interest to external parties.

In a periodic system, three costs are used to arrive at the amount reported as cost of goods sold. It is important to understand how each of these figures is derived.

• Beginning inventory was derived by a count taken at the end of the previous year. After determining the number of units on hand (three bicycles), the accountant inserts the cost of these items based on the amount paid during the period ($260 each). The resulting monetary balance was recorded in the inventory T-account at the end of that year and has remained unchanged until the end of the current year. A periodic system only updates general ledger accounts when financial statements are prepared.
• The purchases figure has been maintained throughout the year in the general ledger to provide a record of the amounts expended ($1,300) for all normal and necessary costs (invoice price, discounts, transportation-in, assembly costs, and the like) needed to get the inventory into position and condition to be sold.
• Ending inventory is found by making a new physical count at the end of the current period. The number of units that are still held (one, in this case) is multiplied by the unit cost ($260) to arrive at the proper inventory total reported on the balance sheet.

Periodic Inventory—Year-End Recording Process

Question: In a perpetual inventory system, cost of goods sold is determined at the time of each sale. Figures retained in a subsidiary ledger provide the cost of the specific item being surrendered so that an immediate reclassification from asset to expense is made.

With a periodic system, cost of goods sold is not calculated until financial statements are prepared. The beginning inventory balance (the ending amount from the previous year) is combined with the total acquisition costs for the current period. Merchandise still on hand is counted, and its cost is determined. All missing inventory is assumed to reflect the cost of goods sold. When a periodic inventory system is used, how are ending inventory and cost of goods sold for the year physically entered into the accounting records? These figures have not been recorded on an ongoing basis; the general ledger must now be updated to agree with the reported balances.

Answer: In the bicycle example, opening inventory for the period was three items costing $780. Another five were bought during the year for $1,300. The total cost of these eight units is $2,080. Because the financial impact of lost or broken units cannot be ascertained in a periodic system, the entire $2,080 is assigned to either ending inventory (one unit at a cost of $260) or cost of goods sold ($780 + $1,300 – $260 or $1,820). No other account exists in which to record inventory costs in a periodic system. The goods are assumed to be on hand or to have been sold.

For a periodic inventory system, a year-end adjusting entry is prepared so that these newly computed amounts are reflected as the final account balances. Transportation and assembly costs are included within the purchases figure in this entry for convenience.

Figure 8.7 Adjusting Entry—Recording Inventory and Cost of Goods Sold as Determined in Periodic Inventory SystemAs mentioned previously, if separate T-account balances are established for cost components such as transportation-in, assembly costs, and the like, they must be included in this entry rather than just a single Purchases figure.

In this entry, the cost of the beginning inventory and the purchases for the period are basically switched to cost of goods sold and ending inventory.

Note that the reported costs on the financial statements ($260 for ending inventory and $1,820 for cost of goods sold) are identical under both perpetual and periodic systems. As will be demonstrated in another chapter, this agreement does not always exist when inventory items are acquired during the year at differing costs.

Inventory—The Reporting of Cost or Market Value

Question: In the example of Rider Inc., Model XY-7 bicycles have been bought and sold, and one unit remains in stock at year’s end. The cost of this model has held steady at $260. However, its market value is likely to differ from that figure.

Assume that, because of the sales made during the period, company officials believe that a buyer will soon be found to pay $440 for this last bicycle. Is inventory always reported on a balance sheet at historical cost or is market (or fair) value ever taken into consideration? Should this bicycle be shown as an asset at $260, $440, or some other pertinent figure?

Answer: Under normal conditions, market value is rarely relevant in the reporting of inventory. For Rider Inc. this bicycle will likely appear as an asset at its cost of $260 until sold. Value is such a subjective figure that it is usually ignored in reporting inventory. The company has no reliable proof that the bicycle will bring in $440 until a sale actually occurs. The conservative nature of accounting resists the temptation to inflate reported inventory figures based purely on the anticipation of a profitable transaction at some future point in time.

An exception to this rule becomes relevant if the value of inventory falls below cost. Once again, the conservatism inherent in financial accounting is easily seen. If market value remains greater than cost, no change is made in the reported balance until a sale occurs. In contrast, if the value drops so that inventory is worth less than cost, a loss is recognized immediately. Accountants often say that losses are anticipated but gains are not.

As a note to the May 31, 2011, financial statements for Nike Inc. states, “inventories are stated at lower of cost or market.” Whenever inventory appears to have lost value for any reason, the accountant compares the cost of the item to its market value and the lower figure then appears on the balance sheet.

Arriving at a Figure for Market Value

Question: As mentioned, market value is a subjective figure. When applying the lower-of-cost-or-market approach to inventory, how does the owner of the merchandise ascertain market value?

Answer: The practical problem in applying the lower-of-cost-or-market approach arises from the difficulty in ascertaining an appropriate market value. There are several plausible ways to view the worth of any asset. For inventory, there is both a “purchase value” (replacement cost—the amount needed to acquire the same item again at the present time) and a “sales value” (net realizable value—the amount of cash expected from an eventual sale). When preparing financial statements, if either of these amounts is impaired, recognition of a loss is likely. Thus, the accountant must watch both values and be alert for potential problems.

Purchase Value. In some cases, often because of bad timing, a company finds that it has paid an excessive amount for inventory. Usually as the result of an increase in supply or a decrease in demand, replacement cost might drop after an item is acquired.

To illustrate, assume that Builder Company—the manufacturer of bicycle Model XY-7—has trouble selling the expected quantity of this particular style to retail stores because the design is not viewed as attractive. Near the end of the current year, Builder reduces the wholesale price offered for this model by $50 in hopes of stimulating sales. Rider Inc. bought a number of these bicycles earlier at a total cost of $260 each but now, before the last unit is sold, could obtain the same model for only $210. The bicycle held in Rider’s inventory is literally worth less than what the company paid for it. The purchase value, as demonstrated by replacement cost, has fallen to a figure lower than its historical cost.

When replacement cost for inventory drops below the amount paid, the lower (more conservative) figure is reported on the balance sheet, and the related loss is recognized on the income statement. In applying lower of cost or marketConservative approach to the reporting of inventory used when either the purchase value or the sales value has decreased; a reduction in the asset is recorded along with a loss to reflect the decline in market value if it falls below cost., the remaining bicycle is now reported by Rider Inc. at its purchase value. A loss of $50 is created by the reduction in the inventory account from $260 to $210.

Sales value. Inventory also has a sales value that is, frequently, independent of replacement cost. The sales value of an item can fall for any number of reasons. For example, technological innovation will almost automatically reduce the amount that can be charged for earlier models. This phenomenon is typically seen whenever a new computer, camera, or phone is introduced to the market. Older items still in stock must be discounted significantly to attract buyers.

Similarly, changes in fashions and fads will hurt the sales value of certain types of inventory. Swim suits usually are offered at reduced prices in August and September as the summer season draws to a close. Damage can also impact an owner’s ability to recoup the cost of inventory. Advertised sales tempt buyers by offering scratched and dented products, such as microwaves and refrigerators, at especially low prices.

For accounting purposes, the sales value of inventory is normally defined as estimated net realizable value. As discussed in the previous chapter, this figure is the amount of cash expected to be derived from an asset. For inventory, net realizable value is the anticipated sales price less any cost required to generate the sale. For example, the net realizable value of an older model digital camera might be the expected amount a customer will pay after money is spent to advertise the product. The net realizable value for a scratched refrigerator is likely to be the anticipated price of the item less the cost of any repairs that must be made prior to sale.

As with purchase value, if the sales value of an inventory item falls below its historical cost, the lower figure is reported along with a loss to mirror the impact of the asset reduction.

Applying Lower of Cost or Market

Question: Inventory records are maintained at the historical cost of each item. For reporting purposes, this figure is utilized unless market value is lower. A reduction in value can result because of a drop in replacement cost (a purchase value) or in net realizable value (a sales value). How is the comparison of cost and market value actually made when inventory is reported?

Assume that Rider Inc. is currently preparing financial statements and holds two bicycles in ending inventory. Model XY-7 cost the company $260 while Model AB-9 cost $380. As mentioned, Model XY-7 now has a replacement cost of only $210. Because of market conditions, the exact sales value is uncertain. The other unit, Model AB-9, has been damaged and can only be sold for $400 after $50 is spent for necessary repairs. This inventory has a cost of $640 ($260 + $380). What should Rider report for its asset inventory?

Answer: As a preliminary step in preparing financial statements, a comparison of the cost and market value of the inventory is made. Although other alternatives exist, assume that Rider compares the cost to the market value for each separate item.In applying the lower-of-cost-or-market approach to inventory, the comparison can be made on an item-by-item basis. For example, XY-7 can be valued based on the lower of cost and market for that one item and then, separately, a similar determination can be made for AB-9. A company can also group its inventory (all bicycles, for example, might comprise a group that is separate from all motorcycles) and report the lower amount determined for each group. A third possibility is to sum the cost of all inventory items and make a single comparison of that figure to the total of all market values. U.S. GAAP does not specify a mechanical approach to use in applying lower of cost or market. Market value used for the first item (XY-7) is its purchase value (replacement cost of $210) whereas the market value for the second item (AB-9) is the sales value of $350 (net realizable value of $400 minus $50). A problem with either value can lead to a reduction in the reported asset balance, which causes the recognition of a loss.

Figure 8.8 Recognition of a Loss on Impaired Inventory Value

Rider Inc. reports its inventory at the conservative $560 amount on its balance sheet with an $80 loss ($640 – $560) appearing in the income statement for this period. Such losses can be quite significant. Mitsui & Co. (U.S.A.) recognized a $25.3 million loss for the year ending March 31, 2011, that was attributed to applying the lower-of-cost-or-market approach to its inventory.

Counting Inventory in a Perpetual System

Question: In a periodic inventory system, a physical count is always taken at or near the end of the fiscal year. This procedure is essential in determining the final inventory figure and, hence, cost of goods sold for the period. When a company uses a perpetual system, is a count of the goods on hand still needed since both the inventory balance and cost of goods sold are maintained and available in the accounting records?

Answer: A physical inventory is necessary even if a company has invested the effort and cost to install a perpetual system. Merchandise can be lost, broken, or stolen. Errors can occur in the record keeping. Thus, a count is taken on a regular basis simply to ensure that subsidiary and general ledger balances are kept in alignment with the actual items held. Unless differences become material, this physical inventory can take place at a convenient time rather than at the end of the year. For example, assume that a company sells snow ski apparel. If an efficient perpetual system is in use, the merchandise could be inspected and counted by employees in May when quantities are low and damaged goods easier to spot.

An adjustment is necessary when the count does not agree with perpetual inventory figures. To illustrate, assume that company records indicate that 65 ski jackets are currently in stock costing $70 apiece. The physical inventory finds that only 63 items are actually on hand. The inventory account is reduced (credited) by $140 to mirror the shortfall (two missing units at $70 each).

The other half of the adjusting entry depends on the perceived cause of the shortage. For example, officials might have reason to believe that errors took place in the accounting process during the period. When merchandise is bought and sold, recording miscues do occur. Possibly two ski jackets were sold on a busy afternoon. The clerk got distracted and the cost of this merchandise was never reclassified to expense. This type of mistake means that the cost of goods sold figure is too low. The balance reported for these two jackets is moved to the expense account to rectify the mistake.

Figure 8.9 Adjusting Entry—To Bring Perpetual Inventory Records in Line with Physical Count, a Recording Error Is Assumed

Conversely, if differences between actual and recorded inventory amounts occur because of damage, loss, or theft, the reported balance for cost of goods sold should not bear the cost of these items. The two jackets were not sold. Instead, a loss occurred.

If the assumption is made that the missing jackets were lost or stolen, rather than sold, the following alternative adjustment is appropriate.

Figure 8.10 Adjusting Entry—To Bring Perpetual Inventory Records in Line with Physical Count, Theft or Loss Is Assumed

In practice, when an inventory count is made and the results differ from the amount of recorded merchandise, the exact cause is often impossible to identify. Whether a loss is reported or a change is made in reporting cost of goods sold, the impact on net income is the same. In such cases, construction of the adjustment is at the discretion of company officials. Normally, consistent application from year to year is the major objective.

Estimating the Amount of Inventory on Hand

Question: A periodic system is cheap and easy to operate. However, the lack of available information does present some practical problems. Assume that a company experiences a fire, flood, or other disaster and is attempting to gather evidence—for insurance or tax purposes—as to the amount of merchandise that was destroyed. If a periodic system has been used, how can the company support its claim? Or assume a company wants to produce interim financial statements for a single month or quarter (rather than a full year) without going to the cost and trouble of taking a complete physical inventory count. If the information is needed, how can a reasonable approximation of inventory on hand be derived when a periodic system is in use?

Answer: One entire branch of accounting—known as forensic accountingA branch of accounting specializing in investigating and reporting on situations where important information is limited or unavailable.—specializes in investigations where information is limited or not available (or has even been purposely altered to be misleading). For example, assume that a hurricane floods a retail clothing store in Charleston, South Carolina. Only a portion of the merchandise costing $80,000 is salvaged.For a full description of forensic accounting, see Frank J. Grippo and J. W. (Ted) Ibex, “Introduction to Forensic Accounting,” The National Public Accountant, June 2003. In trying to determine the resulting loss, the amount of inventory in the building prior to the storm needs to be calculated. A forensic accountant might be hired, by either the owner of the store or the insurance company, to produce a reasonable estimate of the merchandise on hand at the time of the flood. Obviously, if the company had used a perpetual rather than a periodic system, the need to hire the services of an accounting expert would be less likely unless fraud was suspected.

In some cases, arriving at a probable inventory balance is not extremely complicated even if periodic inventory procedures are utilized. When historical trends can be determined with assurance, a valid estimation of the goods on hand is possible at any point in time without the benefit of perpetual records. To illustrate, assume that the general ledger for the Charleston store is located after the disaster. A periodic system was in use and the T-account balances provide the following information.

Figure 8.11 Estimating Inventory—General Ledger Balances

If no sales had taken place prior to the flood, the inventory on hand would have cost $571,000 as shown by these ledger accounts. However, sales had occurred, and a significant amount of merchandise was removed by customers as a result of those transactions. The $480,000 balance shown in the sales T-account does not reflect the cost of inventory items that were surrendered. It is a retail amount, the summation of the price charged for all sales during the year to date.

To determine the cost of inventory held at the time of the catastrophe, cost of goods sold for the current year has to be approximated and then removed from the $571,000 total. Many companies use a fairly standard markup percentage to set retail prices. By looking at previously reported balances, the forensic accountant is often able to make a reasonable determination of that markup. For example, assume that in the preceding year, this company reported sales revenue of $500,000 along with cost of goods sold of $300,000 and, hence, gross profit of $200,000. In this earlier period, cost of goods sold was 60 percent of sales revenue ($300,000/$500,000) while gross profit was 40 percent ($200,000/$500,000).

If available evidence does not indicate any significant changes this year in the method used to set retail prices, the accountant can assume that cost of goods sold during the period prior to the storm was about $288,000 ($480,000 sales revenue × 60 percent). Because the cost of all inventory was $571,000, approximately $283,000 of those goods were still in stock at the store when the hurricane hit Charleston ($571,000 total cost less $288,000 estimated cost of goods sold). This residual figure then serves as the basis for the insurance or tax claim. Only goods costing $80,000 were saved. Thus, the estimated loss was $203,000 ($283,000 inventory in stock less $80,000 inventory saved).

An identical set of procedures could also be used if the company was preparing financial statements for a period of time of less than a year (for example, a month or a quarter). For such interim reporting, companies often determine inventory and cost of goods sold based on estimations to avoid the cost of frequent physical counts.

The biggest obstacle in this type calculation is the validity of the cost and markup percentages. Many companies offer an eclectic variety of products, each with its own typical gross margin. Other companies change their markups frequently based on market conditions. In these cases, determining a reliable percentage can be difficult and the accuracy of the resulting estimation is much more questionable.