Mastering Inventory is mastering its accounting. Inventories are assets, and COGS are the related expenses. Manufacturing (different from Merchandising) requires Raw Materials (Direct Labor, Manufacturing Overhead), WIP, and Finished Goods. Perpetual and Period Systems account for Sales/COGS continually or at the end of the period, respectively. COGS are calculated by Beginning Inventory + Purchases + Freight – Returns – Discounts – Ending Inventory. Important Journal Entries to note are:
Specific ID, Average Cost, FIFO, and LIFO are the methods to help evaluate inventory balances. Periodic systems will evaluate at the end of the period, while for perpetual system, we need to remember to carry over the COGS balances after purchases. For Average Cost, we need too re-weight the Inventory valuation (FIFO ensure oldest units out, and LIFO the opposite applies). Factors influencing method choices are physical flow, net income, and taxes. If LIFO is chosen, it is important to remember the “Conformity Rule”, which means both tax and external reporting is LIFO. Therefore, LIFO reserves (a contra account) are created to maintain FIFO records (lower record keeping costs, used for certain bonus calculations, and if needed for pricing strategies).
Then, this leads us to LIFO liquidations, Inventory Pools, and Dollar Value LIFO. LIFO Liquidations occurs when units sold will be greater than items purchased, and results in previous years’ layers of inventory recorded as sold, and old costs being matched with current selling prices. If cost has been increasing, LIFO liquidations will result in higher net income, with lower COGS. Moreover, LIFO Inventory Pools and Dollar Value LIFO Method help simplify LIFO via keeping low record keeping costs when unit costs often change and a company has numerous individual units.
Inventory Pools will group inventory units, keep purchases made during the same period at the same cost, convert units to an average cost, and Ending Inventory will equal Beginning Inventory + Layer added during the period of the pool. Dollar Value LIFO comprises of layers from different years, made up of items that face same cost changes, viewed as a quantity of value (rather than physical quantity), and allowed to combine large variety of goods to one pool to help simplify record keeping procedures. This minimizes the probability of LIFO liquidations, and new acquisitions are viewed as dollar replacements.
It is important to discuss subsequent measurements of inventory, where if you were to purchase inventory, what will the actualized measure be for damage, deterioration, obsolescence, and changes in price levels? And remember, GAAP requires companies to evaluate unsold inventory after every reporting period.
So, we have the Lower of Cost or Net Realizable Value (LCNRV) used for FIFO and Average Cost (essentially non- LIFO or Retail Inventory Method), and Lower of Cost or Market (used for LIFO or Retail Inventory Method). This is used to evaluate inventory write downs, that implicate inventory and net income downward. With LCNRV, NRV = Estimated Selling Price and Cost of Completion, Disposal, or Transportation.
Essentially, the amount that will be realized. So, if NRV is lower than cost, it will require an adjusting write-down entry. If NRV is greater than cost, no adjusting entry is required. And this can be done by individual items, which calculates item by item the NRV or Cost, and then sums the individual components. You can do it by Category, and then sum the components. Or it can be done by total inventory.
So, you potentially can have an adjusting entry if you were to do it by item, but not necessarily, if you were to do it by the total. For instance, if you have Unit A with NRV of 60 and Cost of 70, and Unit B with NRV 20 and Cost of 10, you will notice that both have an inventory value of 80. So, at total no adjusted entry is required. However, if you were to take the lower NRV value of 60 and lower cost value of 10, you have a 70 value vs. the 80 totals.
That requires an adjusting entry of Dr. COGS by 10, Cr. Inventory by 10 (if this is usual and common); however, if it is unusual and substantial, you will Dr. Loss on Write Down Inventory Expense, and Cr. Inventory. In terms of Lower of Cost or Market (LCM), cost vs. market will always be below the ceiling (Market should not exceed NRV) or above the floor (Market should not be less than NRV by profit margin allowance).
Therefore, the first step is calculating individual item ceilings being (Selling Price – Estimated Selling Costs) and items floors being (Ceiling – (Selling Price * Profit Margin). Then step two is comparing “Cost” to the middle of a Replacement Cost, Ceiling, or Floor. Then you will sum the lowest of Cost to the middle of those three (replacement cost, ceiling, or floor), by summing down individual items. There, you can determine if an adjusting entry is required.