Avoiding Management Letter Comments – Inventory

Blog
August 6, 2014

Common issues related to accounting for inventory include: incorrect valuation, too small or no allowances for slow moving inventory, not disposing of obsolete inventory and not having a regular count of inventory on hand.

Inventory should be valued at the lower of cost or market. The value of all items should be compared to market at least annually to ensure that market prices have not fallen below cost. If the market price has declined to less than the cost of the item in inventory an adjustment should be booked to reduce the recorded value. A key indicator would be if your organization has placed an item on sale for lower than the purchase price.

Determining original cost can be difficult if the items were produced in house and not purchased.  If the inventory is produced in house, the original costs is based on direct materials, direct labor, and a proportionate share of indirect costs. All costs used to determine the price of the inventory need to have supporting documentation.

The value recorded for inventory should also be adjusted depending on what method the organization is using to record sales; first in first out (FIFO), last in first out (LIFO), or weighted average.  LIFO and FIFO are the easiest to compute.  See below for how each method would affect the value of inventory and cost of goods sold (COGS).

FIFO is based on recording inventory so that the first widgets sold were the first ones purchased.  This would be used by grocery

stores or other businesses that have perishable goods. A schedule calculating inventory using the FIFO method is as follows:

Action Date Quantity Cost per unit Addition to inventory COGS Ending Value price per unit
Purchase 1/1/2001 100 1.00 100.00 0 100.00 1.00
Sale 4/1/2001 (60) 0 0 (60.00) 40.00 1.00
Purchase 7/1/2001 50 1.20 60.00 100.00 1.11
Sale 10/1/2001 (60) 0 0 (64.00) 36.00 1.20
Ending 12/31/2001 30 0 0 0 36.00 1.20
Purchase 2/1/2002 50 1.40 70.00 0 106.00 1.33
Sale 6/1/2002 (60) 0 0 (78.00) 28.00 1.40
Ending 6/30/2002 20 0 0 0 28.00 1.40

 

As you can see with FIFO the value at the end inventory is based on the most recent purchase as all older inventories has been sold. The COGS for the sale on 10/1/01 is based on 40 of the items purchased on 1/1/01 and 10 purchased on 7/1/01.  The COGS for the 6/1/02 sale is based on a similar calculation.
LIFO is based on the ending value of the inventory consisting of the oldest items in inventory.  This would be used in an industry where costs are rising and the business wants to match costs to rising revenues. A schedule calculating inventory using the LIFO method is as follows:

Action Date Quantity Cost per unit Addition to inventory COGS Ending Value price per unit
Purchase 1/1/2001 100 1.00 100.00 0 100.00 1.00
Sale 4/1/2001 (60) 0 0 (60.00) 40.00 1.00
Purchase 7/1/2001 50 1.20 60.00 0 100.00 1.11
Sale 10/1/2001 (60) 0 0 (70.00) 30.00 1.00
Ending 12/31/2001 30 0 0 0 30.00 1.00
Purchase 2/1/2002 50 1.40 70.00 0 100.00 1.25
Sale 6/1/2002 (60) 0 0 (80.00) 20.00 1.00
Ending 6/30/2002 20 0 0 0 20.00 1.00

 

LIFO looks remarkably similar to FIFO except the ending value is based on the oldest items. The COGS for the 10/1/01 sale is based on 50 from the 7/1/01 purchase and 10 from the 1/1 purchase.  The 6/1/02 sale is calculated similarly.

Weighted average is more complicated as it is based on the average price for the items remaining in inventory. This helps smooth the costs of rising prices over the period. Using the same data for purchases and sales as shown above in the FIFO and LIFO examples see how weighted average affects the ending balances. Weighted average is typically used by companies that produce mass amounts of the same item such as manufacturers, farmers, and fuel companies. A schedule using the weighted average method is as follows:

Action Date Quantity Cost per unit Addition to inventory COGS Ending Value price per unit
Purchase 1/1/2001 100 1.00 100.00 0 100.00 1.00
Sale 4/1/2001 (60) 0 0 (60.00) 40.00 1.00
Purchase 7/1/2001 50 1.20 60.00 0 100.00 1.11
Sale 10/1/2001 (60) 0 0 (66.67) 33.33 1.11
Ending 12/31/2001 30 0 0 0 33.33 1.11
Purchase 2/1/2002 50 1.40 70.00 0 103.33 1.29
Sale 6/1/2002 (60) 0 0 (77.50) 25.83 1.29
Ending 6/30/2002 20 0 0 0 25.83 1.29

 

In this example the COGS for the 10/1/01 sale is based on the average cost of the remaining 40 items at $1/unit and the additional 50 purchased at $1.20/unit for an average price per unit of $1.11. The 6/1/02 sale is similar, with it based on the average price of the remaining 30 units at end of the prior year plus the purchased items of 50 at $1.40/unit.

If the inventory become slow moving, selling only a few to none a year then an allowance should be booked for those items.  The allowance should be set up be debiting COGS and crediting an allowance account.  The longer the item is considered slow moving the larger the allowance should be until the item is considered obsolete.

When inventory is no longer selling due to it becoming obsolete (i.e. VHS, laser disc, etc) the items need to be written off.  To do this you would make an entry to inventory and COGS unless a previous allowance had been created then you would remove the allowance before writing off any additional remaining inventory to COGS. Carrying obsolete inventory on your books incorrectly overstates the value of the inventory.

Other inventory issues arise due to an organization not performing annual counts.  Inventory should be counted at least annually to insure that the quantity per the books agrees to the actual quantity on hand.  This discourages theft of items.  If they are never counted, items could slowly disappear from where they are kept. Annual counting also helps to spot items that maybe damaged or have become obsolete.

If you have any questions on how to value the inventory or how to determine an allowance feel free to contact us.