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Inventory Accounting Methods Explained

This document discusses accounting for inventories for merchandising and manufacturing firms. For merchandising firms, inventories are valued at cost using methods like FIFO, LIFO, and weighted average. The lower of cost or market principle requires writing down inventories if the fair market value falls below cost. Manufacturing firms use raw materials, work-in-process, and finished goods inventory accounts and apply absorption costing to capitalize production costs into inventory values.

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142 views2 pages

Inventory Accounting Methods Explained

This document discusses accounting for inventories for merchandising and manufacturing firms. For merchandising firms, inventories are valued at cost using methods like FIFO, LIFO, and weighted average. The lower of cost or market principle requires writing down inventories if the fair market value falls below cost. Manufacturing firms use raw materials, work-in-process, and finished goods inventory accounts and apply absorption costing to capitalize production costs into inventory values.

Uploaded by

onsongoalexmunavi
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© © All Rights Reserved
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ACCOUNTING FOR INVENTORIES

For Merchandising Firms


Inventories are valued at cost, net of discounts, and including transportation and other costs (ie: import
duties) to prepare the goods for sale.

Buying Inventory:
 DR Merchandise Inventory, CR Cash/Accounts Payable
Selling Inventory:
 DR A/R or Cash, CR Revenues
 DR Cost of Goods Sold Expense, CR Merchandise Inventory

Lower of Cost or Market (LOCOM):


Inventories can sometimes decrease in value while stored due to market conditions, obsolescence or
damage.
Accounting standards require firms to subject their inventories to an impairment test at fiscal year-end
and, where the FMV < Purchase Price, write down the value of their inventory
FMV in IRFS = “net realizable value”; in US GAAP = “replacement cost”

For example, if you purchased 200 ropes at $40 but they are only worth $30 at year end:
DR Impairment expense $2000, CR Accumulated Inventory Impairment $2,000
The reason we don’t subtract impairment directly from merchandise inventory is because the
loss is still unrealized and there is a possibility of recovery in the future.
For example, say market conditions improved and now ropes were valued at $50
DR Accumulated Inventory Impairment $2,000, CR Impairment Expense $2,000
Here it does not matter how much greater the value is, we do not account for increases in value

Methods of Inventory Valuation


FIFO (First In, First Out) – units purchased first are the ones to be sold first. Assigns most recent costs to
inventory and older costs to COGS. This is the normal course of business – older units are always shipped
first.

LIFO (Last In, First Out) – units purchased last are the ones to be sold first. Assigns most recent costs to
COGS, and older costs to Inventory.

WAC (Weighted Average Cost) – take the average cost of all units and assign this cost to COGS and
Inventory
When prices are rising – LIFO produces lower profits and lower taxes due to higher COGS
LIFO Reserve – difference between valuing inventories with FIFO and LIFO
WAC’s outcome – always something between FIFO and LIFO

Method to Track Inventory


The Periodic Method – valuing inventory and COGS at the end of the accounting period.
Allows firms to affect the value of ending inventories and COGS
A large purchase at the end of the year can drive up COGS and decrease inventory
FIFO is unaffected by last-minute purchases
For Manufacturing Firms
Manufacturing Firms use three different inventory accounts to reflect stages of production:
Raw Materials Inventory Work-In-Process Inventory Finished Goods Inventory
Materials and supplies for Partially completed Completed but unsold
manufacturing products manufactured products manufactured products
  Absorption costing:  

Capitalization of costs related


to production such as labor
and manufacturing overhead.
These manufacturing costs
add value to products in the
inventory. Costs unrelated to
production such as selling,
general and admin costs
  are expensed as normal.  

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