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Inventories

 

Inventory Measurement

 

The cost assigned to ending inventory depends on two measurements: quantity and price. At least once each year, a business must take an actual physical count of all items of merchandise held for sale. Although companies may take inventory at anytime of the year, most companies take inventories only at the end of their fiscal year. Taking inventory consists of: (1) counting, weighing, or measuring the items on hand, (2) pricing each item, and (3) extending (multiplying) to determine the total cost.

 

Merchandise in Transit

 

Merchandise inventory includes all items owned by the company and held for sale, the status of any merchandise in transit, either being sold or purchase by the inventory company, must be examined to determine if it should be included in the inventory count. Outgoing goods shipped FOB destination, well as incoming goods shipped FOB shipping point should be consider part of the inventory count. Outgoing goods shipped FOB shipping point and incoming goods shipped FOB destination will not be part of the inventory count.

 

Merchandise on Hand Not Included in Inventory

 

At the time the physical inventory is taken, there may be merchandise on hand which the company does not hold title. These may include merchandise sold and awaiting delivery to the buyer and goods held on consignment.

 

Methods of Pricing Inventory at Cost

 

The cost of inventory includes

  1. invoice price less purchase discounts,
  2. freight or transportation in, including insurance in transit, and
  3. applicable taxes and tariffs.

The prices of most kinds of merchandise vary during the year. Identical lots of merchandise may have been purchased at different prices. When identical items are brought and sold, it could be impossible to tell which have been sold and which are still in inventory. For this reason, it is necessary to make an assumption about the order in which items have been sold. The assumed order of sale may or may not be the same as the actual order of sale, the assumption is really an assumption about the flow of costs rather than the flow of physical inventory.

 

The term goods flow refers to the actual physical movement of goods in the operations of the company, and the term cost flow refers to the association of cost with their assumed flow in the operations of the company. The assumed cost flow may or may not be the same as the actual goods flow. There are several assumed cost flows are available under generally accepted accounting principles. It is sometimes preferable to use an assumed cost flow that bears no relationship to goods flow because it gives a better estimate of income, which is the major goal of inventory valuation.

 

Accountants usually price inventory by using one of the following generally accepted methods, each based on a different assumption of cost flow:

  1. Specific Identification method
  2. Average-Cost method
  3. First-In, First-Out (FIFO) method
  4. Last-In, First-Out (LIFO) method

The method chosen will depend on the nature of the business, the financial effects on the methods, and the costs of implementing them.

 

Valuing Inventory by Estimation

 

It is sometimes necessary or desirable to estimate the value of ending inventory. The two most commonly used methods for this purpose are the:

  1. Retail method
  2. Gross Profit method

How errors in inventory measurement affects income

 

The objective of accounting for inventories is the proper determination of income. If the value of ending inventory is understated or overstated, a corresponding error -dollar for dollar- will be made in net income. Furthermore, because the ending inventory of one period is the beginning inventory of the next, because the ending inventory of one period is the beginning inventory of the next, the misstatement affects two accounting periods, although the effects are opposite.

 

Effects of inventory measurement on income determination and income taxes in periods of changing prices

 

During periods of rising prices, the LIFO method will show the lowest net income; FIFO, the highest; and average cost, in between. The opposite effects occur in periods of falling prices. No generalization can be made regarding the specific identification method. The Internal Revenue Service requires that if LIFO is used for tax purposes, it must be used for book purposes, and that the lower the lower-of-cost-or-market rule cannot be applied to the LIFO method.