Inventory Accounting

Inventory represents goods held for sale in the ordinary course of business or materials used in production. Proper inventory accounting directly affects both the balance sheet and income statement.

Inventory Cost Flow Assumptions

Since inventory units are often purchased at different costs, companies must adopt a cost flow assumption to determine which costs go to cost of goods sold (COGS) and which remain in ending inventory.

Exam Tip: LIFO is permitted under U.S. GAAP but prohibited under IFRS. If a company uses LIFO for tax purposes, it must also use LIFO for financial reporting (LIFO conformity rule).

FIFO Example:

A company has the following inventory activity:

• Beginning inventory: 100 units @ $10 = $1,000
• Purchase 1: 200 units @ $12 = $2,400
• Purchase 2: 150 units @ $15 = $2,250
• Units sold: 300 units

Under FIFO:

• COGS = (100 x $10) + (200 x $12) = $1,000 + $2,400 = $3,400
• Ending inventory = 150 x $15 = $2,250

LIFO Example (same data):

Under LIFO:

• COGS = (150 x $15) + (150 x $12) = $2,250 + $1,800 = $4,050
• Ending inventory = (100 x $10) + (50 x $12) = $1,000 + $600 = $1,600

LIFO Reserve and LIFO Liquidation

LIFO Reserve = FIFO Inventory - LIFO Inventory

The LIFO reserve represents the cumulative difference between inventory valued at FIFO versus LIFO. Companies using LIFO must disclose the LIFO reserve.

LIFO Liquidation occurs when a LIFO company sells more units than it purchases during a period, dipping into older, lower-cost inventory layers. This results in:

• Artificially lower COGS
• Higher gross profit
• Higher taxable income (unfavorable tax consequence)

Lower of Cost or Net Realizable Value

Under ASC 330, inventory is measured at the lower of cost or net realizable value (NRV).

Net Realizable Value = Estimated Selling Price - Estimated Costs to Complete - Estimated Costs to Sell

If NRV is below cost, write down inventory and recognize a loss:

Dr. Loss on Inventory Write-Down (or COGS)
    Cr. Inventory

Exam Tip: Under IFRS, inventory is measured at lower of cost or NRV, and write-downs can be reversed if NRV recovers. Under U.S. GAAP, write-downs of inventory cannot be reversed.

Inventory Errors

Inventory errors affect both the balance sheet and income statement over two periods:

The effects reverse in the following year, so retained earnings at the end of Year 2 will be correct (assuming no new errors).

Fixed Asset Accounting

Capitalization of Fixed Assets

Fixed assets (property, plant, and equipment) are initially recorded at cost, which includes all expenditures necessary to acquire the asset and prepare it for its intended use:

Costs Expensed:

• Repairs and maintenance (ordinary)
• Training costs
• Administrative and general overhead (unless directly attributable)
• Costs incurred after asset is in place and ready for use

Depreciation Methods

Depreciation systematically allocates the depreciable base (cost minus residual value) over the asset's useful life.

1. Straight-Line Method:

Annual Depreciation = (Cost - Residual Value) / Useful Life

Example: Asset cost $50,000, residual value $5,000, useful life 5 years Annual depreciation = ($50,000 - $5,000) / 5 = $9,000 per year

2. Declining Balance Methods:

Annual Depreciation = Book Value at Beginning of Year x Depreciation Rate

• Double-declining balance (DDB): Rate = 2 / Useful Life
• Book value is not reduced below residual value

Example (DDB): Asset cost $50,000, residual $5,000, useful life 5 years

• Rate = 2/5 = 40%
• Year 1: $50,000 x 40% = $20,000
• Year 2: $30,000 x 40% = $12,000
• Year 3: $18,000 x 40% = $7,200
• Year 4: $10,800 x 40% = $4,320 (but limited to $10,800 - $5,000 = $5,800)
• Year 5: Remaining to reach residual value

3. Sum-of-the-Years'-Digits (SYD):

Annual Depreciation = (Remaining Life / SYD) x Depreciable Base

SYD for 5 years = 5 + 4 + 3 + 2 + 1 = 15

Example: Depreciable base = $45,000, 5-year life

• Year 1: (5/15) x $45,000 = $15,000
• Year 2: (4/15) x $45,000 = $12,000
• Year 3: (3/15) x $45,000 = $9,000

4. Units-of-Production Method:

Depreciation per Unit = Depreciable Base / Total Estimated Units

Annual Depreciation = Depreciation per Unit x Units Produced

Changes in Depreciation

A change in useful life or residual value is a change in accounting estimate:

• Apply prospectively (no restatement of prior periods)
• Adjust depreciation for current and future periods using new estimates

A change in depreciation method is typically treated as a change in estimate effected by a change in principle:

• Apply prospectively

Impairment of Long-Lived Assets

Under ASC 360, long-lived assets held for use are tested for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable.

Two-Step Impairment Test:

Step 1: Recoverability Test

• Compare carrying amount to undiscounted future cash flows
• If carrying amount > undiscounted cash flows, impairment exists

Step 2: Measure Impairment Loss

• Impairment loss = Carrying amount - Fair value

Example:

• Carrying amount: $500,000
• Undiscounted future cash flows: $450,000 (impairment exists)
• Fair value: $400,000
• Impairment loss = $500,000 - $400,000 = $100,000

Exam Tip: Under U.S. GAAP, impairment losses on long-lived assets held for use cannot be reversed. Under IFRS, reversals are permitted.

Assets Held for Sale

When management commits to a plan to sell an asset:

• Reclassify to "held for sale"
• Cease depreciation
• Measure at lower of carrying amount or fair value less costs to sell
• Present separately on balance sheet