Accounting for inventory Why is accounting for inventory so important For many merchandising companies inventory is the largest asset on the balance sheet and cost of goods sold is the largest expense on the income statement Amounts reported for inventory and cost of goods sold generally have a material impact on a company s financial statements What is an inventory cost flow assumption A company may purchase identical units of inventory at different unit costs When this happens the company must determine a consistent method for assigning these costs to both the units sold during the period and to the units left on hand at the end of the period This is an inventory cost flow assumption As an example assume a company sells tennis rackets At the beginning of the period the company had one racket which cost 30 on hand During the period the company purchased another identical tennis racket this racket cost the company 38 At the end of the period the company determined that one racket was left on hand and therefore one racket had been sold A cost flow assumption is needed to determine which cost 30 or 38 will be assigned to the racket sold and which will be assigned to the racket left on hand What is the FIFO inventory cost flow assumption FIFO stands for First in first out This cost flow method assumes that units are sold in the same order as they are purchased it assigns the cost of the first or oldest items purchased to the expense category It follows that the most recent costs are then assigned to ending inventory Using the tennis racket example described earlier UnitsUnit cost Beginning inventory Purchases 1 1 38 Goods available for sale 30 2 unit sold unit left on hand 68 Cost of goods sold 1 unit 30 30 Ending inventory 1 unit 38 38 What is the LIFO inventory cost flow assumption LIFO stands for Last in first out This cost flow method assumes that units are sold in reverse of the order purchased it assigns the cost of the last or most recent items purchased to the expense category It follows that the oldest costs are then assigned to ending inventory Using the tennis racket example described earlier UnitsUnit cost Beginning inventory Purchases 1 1 38 Goods available for sale 30 2 unit sold 68 Cost of goods sold 1 unit 38 38 Ending inventory 1 unit 30 30 unit left on hand What is the weighted average inventory cost flow assumption The weighted average method assumes that all units available for sale during the period had the same average unit cost Using the tennis racket example described earlier Units Unit cost Beginning inventory Purchases 1 1 38 30 unit left on hand unit sold Goods available for sale 2 68 Weighted average cost per unit total cost of goods available for sale total number of units available for sale Cost of goods sold 1 34 34 Ending inventory 1 34 34 68 2 34 per unit How do errors in counting ending inventory affect the financial statements Using a periodic inventory system an error in counting ending inventory affect both the income statement and the balance sheet in the year the error is made The income statement for the subsequent year is also affected Cost of goods sold is calculated based on the physical count of inventory at year end If this count is incorrect both the ending inventory reported on the balance sheet and the cost of goods sold reported on the income statement will be incorrect Additionally since the ending inventory of one year becomes beginning inventory for the next year the cost of goods sold calculations for the year after the error will also be affected Effect of inventory error assume the ending inventory for year 1 is overstated Year 1 Year 2 Cost of goods sold Beginning inventory overstated Net purchases and freight in Goods available for sale overstated Ending inventory overstated Cost of goods sold understated OK overstated What methods are available to estimate the goods left in ending inventory Companies should take a physical count of inventory at least once each year In a periodic system the number of units left on hand is needed to determine the number of units sold In a perpetual system the count is needed for control purposes to ensure that the actual units on hand agree with the company s inventory records and to account for any lost or stolen units But what if the company wants to estimate the number of units on hand without taking a physical count perhaps for interim statements Or what is some disaster flood fire or theft destroys the inventory so that a physical count is impossible Companies can estimate the ending that should be on hand using two different methods One is based on the company s historical gross profit as a percentage of sales one is based on the relationship between inventory cost and its selling price Using inventory information Companies need to keep enough inventory on hand to meet demand However excess inventory ties up funds that could be used elsewhere and increases storage and security costs One measure that helps determine efficiency and effectiveness of inventory management is Inventory turnover Inventory turnover cost of goods sold average inventory