April 17, 2016

Inventories and Cost of Goods Sold - Review Notes

Determining Cost (Accounting Value) of Inventory

Specific unit cost
 Mandated by AASB when inventory items differ (e.g. motor vehicles, jewellery)
 Average cost
 First-In, First-Out (FIFO)
 Oldest units sold first
 Last-In, First-Out (LIFO):

Calculate periodic inventory amounts under
FIFO, LIFO and average cost.

Journal Entry for Purchase of Inventory
Purchases (not inventory) 400
Accounts Payable (Cash) 400


Beginning Inventory (1 @ 40)  = $40
Purchases (6 @ 45 + 7 @ 50)  = 620
Cost of goods available for sale (14 numbers)   =  660
Less: Ending Inventory (2 @ 50)   =   (100)
Cost of Sales  =  $560

Beginning Inventory (1 @ 40)  =  $40
Purchases (6 @ 45 + 7 @ 50)   =  620
Cost of goods available for sale (14)  =  660

Cost of goods available for sale (14) =  660
Less: Ending Inventory  (1 @ 40 + 1 @ 45)  =  (85)
Cost of Sales  =   $575

Weighted Average
Beginning Inventory (1 @ 40)   =  $40
Purchases (6 @ 45 + 7 @ 50)  = 620
Cost of goods available for sale (14 @ 47 14) =  660 (14 @ 47.14)
Less: Ending Inventory (2 @ 47.14)  =  (94)
Cost of Sales  =   $566

Accounting Principles and Inventories

Several accounting principles affect inventories. Among them are consistency, disclosure, materiality, and accounting conservatism.

Consistency Principle

The consistency principle states that businesses should use the same accounting
methods from period to period. Consistency helps investors compare a company’s
financial statements from one period to the next.

Disclosure Principle

The disclosure principle holds that a company should report enough information
for outsiders to make wise decisions about the company. In short, the company
should report relevant, reliable, and comparable information about itself. This
includes disclosing the method being used to account for inventories. All major
accounting decisions are described in the footnotes to the financial statements.

Materiality Concept

The materiality concept states that a company must perform strictly proper accounting
only for significant items. Information is significant—or, in accounting terms, material—
when it would cause someone to change a decision. The materiality concept frees
accountants from having to report every last item in strict accordance with GAAP. For
example, $1,000 is material to a small business with annual sales of $100,000.
However, $1,000 isn’t material to a large company like Apple.

Accounting Conservatism

Conservatism in accounting means exercising caution in reporting items in the financial statements. Conservatism says,

● “Anticipate no gains, but provide for all probable losses.”
● “If in doubt, record an asset at the lowest reasonable amount and a liability at the highest reasonable amount.”
● “When there’s a question, record an expense rather than an asset.”
● “When you are faced with a decision between two options, you must choose the option that undervalues, rather than overvalues, your business.”

The goal of conservatism is to report realistic figures.

Lower-of-Cost-or-Market Rule
In addition to the FIFO, LIFO, and average costing methods, accounts must use the  the lower-of-cost-or-market rule (abbreviated as LCM).

LCM shows accounting conservatism in action and requires that inventory be reported in the financial statements at whichever is lower—
● the historical cost of the inventory, or
● the market value of the inventory.

For inventories, market value generally means the current replacement cost (that is, the cost to replace the inventory on hand). If the replacement cost of inventory is less than its historical cost, the business must adjust the inventory value. By adjusting the inventory down (crediting Inventory), the balance sheet value of the asset, Inventory, is at its correct value (market) rather than its overstated accounting value (cost).

Review Notes
Inventory Accounting

Presentation slides


Updated 17 Apr 2016
8 Dec 2011

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