Unit 5: Inventory Methods – Principles, Controls, and Financial Statement Effects

Study Guide - Smart Notes

Tailored notes based on your materials, expanded with key definitions, examples, and context.

Accounting Principles and Controls Related to Merchandise Inventory

Overview of Accounting Principles

Accounting principles guide the classification and reporting of merchandise inventory on financial statements. These principles ensure consistency, transparency, and reliability in financial reporting.

Consistency Principle: Requires the use of the same accounting methods and procedures from period to period. Changes in methods must be disclosed in the notes to financial statements.
Disclosure Principle: Financial statements should provide sufficient information for external users to make informed decisions. Information must be relevant and faithfully represented.
Materiality Concept: Only items significant to the business’s financial situation require strict accounting. Materiality depends on the size and context of the business.
Conservatism: When faced with options, report the least favorable figures. Anticipate no gains, provide for probable losses, record assets at the lowest reasonable amount, and liabilities at the highest.

Inventory Controls

Effective inventory controls ensure that purchases and sales are properly authorized and recorded. Controls include:

Authorization of inventory purchases
Tracking and documenting inventory receipts
Proper recording of damaged inventory
Annual physical counts
Recording and removing inventory when sold

Determining Merchandise Inventory Costs Under a Perpetual Inventory System

Basic Calculations

In a perpetual inventory system, inventory records are updated continuously. Key calculations include:

Ending Merchandise Inventory:
Cost of Goods Sold (COGS):

At period end, count units in inventory and assign dollar amounts to both ending inventory and COGS.

Inventory Costing Methods

When inventory costs vary, selecting the appropriate costing method is essential. Four methods are permitted by GAAP:

Specific Identification: Assigns actual cost to each specific unit. Used for unique, high-value items (e.g., automobiles, jewels, real estate).
First-In, First-Out (FIFO): Assumes earliest units purchased are sold first. COGS is based on oldest costs; ending inventory reflects recent costs.
Last-In, First-Out (LIFO): Assumes latest units purchased are sold first. COGS is based on newest costs; ending inventory reflects oldest costs.
Weighted-Average: Computes a new average cost per unit after each purchase. Both COGS and ending inventory use this average cost.

Example: Perpetual Inventory Records

Date	Quantity Purchased	Quantity Sold	Cost per Unit	Quantity on Hand
Aug 1	2		$350	2
Aug 5	4		$360	6
Aug 15		4	$350/$360	2
Aug 26	6		$380	8
Aug 31		4	$350/$380	4

Additional info: Table structure inferred from provided examples.

Inventory Costing Methods Explained

Specific Identification Method

This method tracks the actual cost of each specific item sold and remaining in inventory. It is suitable for businesses with unique, high-value items.

Example: On August 15, 1 tablet sold at $350 and 3 at $360; on August 31, 1 at $350 and 9 at $380 remain.

First-In, First-Out (FIFO) Method

FIFO assumes the earliest goods purchased are the first to be sold. This method is widely used and often reflects the physical flow of inventory.

COGS: Based on oldest purchases.
Ending Inventory: Based on most recent purchases.
Example: If 14 units are sold, COGS uses the cost of the first 14 units purchased.

Last-In, First-Out (LIFO) Method

LIFO assumes the most recently purchased goods are sold first. This method can reduce taxable income during periods of rising prices.

COGS: Based on newest purchases.
Ending Inventory: Based on oldest purchases.

Weighted-Average Method

This method calculates a new average cost per unit after each purchase. Both COGS and ending inventory are valued at this average cost.

Weighted-Average Cost per Unit:
Example: After purchases, the average cost is recalculated and applied to all units sold and remaining.

Effects of Inventory Costing Methods on Financial Statements

Income Statement

COGS is higher under LIFO than FIFO when costs are rising.
Net income is lower under LIFO than FIFO when costs are rising.

Balance Sheet

When costs increase, FIFO inventory is highest, LIFO is lowest.

Method	Net Sales Revenue	COGS	Gross Profit
Specific Identification	$7,000	$5,200	$1,800
FIFO	$7,000	$5,180	$1,820
LIFO	$7,000	$5,240	$1,760
Weighted-Average	$7,000	$5,193	$1,807

Additional info: Table inferred from provided slides.

Lower-of-Cost-or-Market (LCM) Rule

Inventory Valuation

The LCM rule requires inventory to be reported at the lower of its historical cost or market value. Market value typically means current replacement cost.

Under IFRS, market value is the net realizable value (estimated selling price minus costs of completion and sale).
If market value drops below cost, inventory is written down and a loss is recognized.

Adjusting Journal Entry Example

Date	Accounts and Explanation	Debit	Credit
Dec 31	Cost of Goods Sold Merchandise Inventory ($3,000 - $2,200)	800	800

Additional info: Entry records inventory write-down to market value.

Effects of Merchandise Inventory Errors on Financial Statements

Impact of Errors

Inventory errors affect related accounts and computations, including COGS, gross profit, and net income. Errors in ending inventory propagate to other financial statement items.

Overstated ending inventory leads to understated COGS and overstated net income.
Understated ending inventory leads to overstated COGS and understated net income.
Errors typically self-correct after two periods.

Period	COGS	Gross Profit	Net Income
1 (Overstated Inventory)	Understated	Overstated	Overstated
2 (Counterbalancing)	Overstated	Understated	Understated

Additional info: Table inferred from inventory error examples.