Lecture 4 - Accounting for Inventory (cont.)

Midterm Exam is next week

Income Statement - Retained Earnings - Balance Sheet
Calculators will be provided
ACE questions will be useful review
Midterm questions come from the book test bank

Misstatements of Inventory

Fundamental formula for accounting of inventory is:

COGS = Beginning Inventory + Purchases - Ending Inventory

The consequences to income of misstatements of inventory fall into the following four scenarios:

Overstatement of ending inventory decreases COGS which increases net income. Then, next beginning inventory next year will also be overstated as well. This will increase next year's COGS and decrease next year's net income. Overstating ending inventory takes next year's income and brings it into this year.

Overstatement of beginning inventory increases COGS which decreases net income. This overstatement will not effect next year's income.

Understatement of ending income increases COGS which decreases net income. Next year's beginning income is therefore too low and net income will be too high.

Understatement of beginning inventory decreases COGS which increases net income. Net year's net income is not effected.

Terminology: "Cost of goods available for sale" = Beginning Inventory + Purchases

Lower of Cost or Market

Some companies can use the Lower of Cost or Market technique. (If you use LIFO, you can't use it.) The concept is not to overvalue inventory. Use the lower of cost or market. If cost is lower, use that as usual. If market is lower, mark down the cost to market cost.

When we say "market cost", we refer to the current replacement cost.

In summary, the Lower of Cost or Market rule requires that when the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value.

It can be applied item by item or as an aggregate on major categories of items. Item by item will always be equal to or lower than the aggregate method. For tax accounting, you must use the item by item method.

Retail Method

When taking physical inventory, it's often easier to record the retail price and derive the cost from that. We also sometimes want to estimate the ending inventory without making a physical count. To accomplish these goals, we use the Retail Method.

Calculate the ratio of the cost vs. retail of all goods available for sale (=beginning inventory + purchases) and apply that ratio to the ending inventory which you value at retail price to get the cost of ending inventory. However, doing this is very difficult in practice.

Modify the inventory equation to read:
Ending Inventory = Beginning Inventory + Purchases - COGS

Goods Available for sale - Sales = Estimate of Ending Inventory at retail
Then apply the ratio to get the Estimate of Ending Inventory at cost

Gross Profit Method

The Gross Profit Method usually deals with estimating loss due to damaged inventory. Often used for insurance purposes. This method uses the modified inventory equation that we saw above: Ending Inventory = Beginning Inventory + Purchases - COGS. It uses this equation to determine the inventory that was on hand when it was damaged (e.g. by fire, tornado, etc).

Usually, you have records of beginning inventory and purchases from accounting records. You can derive COGS from Sales x Historic Gross Margin, where Gross Margin = Historic (Sales-COGS/Sales).

David H. Brooks

See the case of David Brooks who overstated inventory to hide his theft from the company.

Inventory Quiz