9.1 Inventory Valuation and Cost Flows
Key Takeaways
- Under US GAAP, inventory must be initially recorded at cost, which includes all costs necessary to bring the inventory to its present location and condition, such as freight-in, import duties, and insurance during transit.
- FIFO (First-In, First-Out) assumes the oldest inventory is sold first, producing the same cost of goods sold (COGS) and ending inventory under both periodic and perpetual inventory systems.
- LIFO (Last-In, First-Out) assumes the newest inventory is sold first, matching current costs with current revenues, but requires different calculations under periodic and perpetual systems and is prohibited under IFRS.
- Weighted Average cost is calculated at the end of the period in a periodic system, whereas the Moving Average method updates the unit cost after every purchase under a perpetual system.
- The LIFO Conformity Rule dictates that if LIFO is used for tax purposes, it must also be used for financial reporting under US GAAP, leading to the creation of a LIFO Reserve account to adjust to FIFO for internal reporting.
Inventory Valuation and Cost Flows
Inventory represents assets held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or rendering of services. For many companies, inventory is the most significant current asset on the balance sheet, and its valuation directly impacts both the balance sheet and the income statement.
1. Ownership and Goods in Transit
Determining which items are included in physical inventory is a critical accounting concern. Ownership depends on legal title, which is governed by the shipping terms:
- FOB Shipping Point (Free on Board Shipping Point): Title and risk of loss pass to the buyer when the seller delivers the goods to the common carrier. The buyer must include these goods in its inventory while they are in transit, even if the goods have not physically arrived.
- FOB Destination: Title and risk of loss pass to the buyer only when the goods reach the buyer's location. The seller includes these goods in its inventory while in transit.
- Consigned Goods: Under a consignment arrangement, the consignee (who sells the goods) does not take ownership. The goods remain in the inventory of the consignor (the owner) until sold to a third party. The consignee does not record the goods on its balance sheet but may record a liability for any sales proceeds owed to the consignor.
2. Capitalizable Costs vs. Period Costs
US GAAP (ASC 330) requires that inventory is initially measured at cost.
- Product (Capitalizable) Costs: These costs "attach" to the inventory and are capitalized. They include purchase price (less trade discounts and rebates), import duties, freight-in (transportation costs paid by the buyer), handling, and insurance during transit. For manufactured goods, product costs include direct materials, direct labor, and manufacturing overhead.
- Period Costs: These expenses do not relate to bringing inventory to its present location and condition. They are expensed in the period incurred and include selling expenses (marketing, freight-out/delivery to customers), general and administrative overhead, and abnormal waste or storage costs.
3. Periodic vs. Perpetual Systems
The timing and accounts used to record inventory depend on the inventory system:
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Periodic System: The inventory account is not adjusted during the period. Purchases are recorded in temporary accounts (Purchases, Purchase Discounts, Freight-In). At the end of the period, a physical count is conducted to determine ending inventory, and Cost of Goods Sold (COGS) is calculated using the following formula:
COGS = Beginning Inventory + Net Purchases + Freight-In - Ending Inventory
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Perpetual System: This system continuously updates inventory and COGS accounts as transactions occur. Every purchase is debited directly to Inventory, and every sale requires two journal entries: one to record sales revenue and one to record the cost of the sale (debiting COGS and crediting Inventory).
| Transaction | Periodic Inventory System | Perpetual Inventory System |
|---|---|---|
| Purchase of inventory on account | Debit Purchases, Credit Accounts Payable | Debit Inventory, Credit Accounts Payable |
| Payment of freight-in | Debit Freight-In, Credit Cash | Debit Inventory, Credit Cash |
| Sale of inventory on account | Debit Accounts Receivable, Credit Sales Revenue | Debit Accounts Receivable, Credit Sales Revenue AND Debit Cost of Goods Sold, Credit Inventory |
| Year-end closing adjustment | Debit Inventory (Ending), Debit COGS; Credit Inventory (Beginning), Credit Purchases, Credit Freight-In | No adjustment required (unless physical count reveals shrinkage; Debit Loss from Inventory Shrinkage, Credit Inventory) |
4. Cost Flow Assumptions
When identical units of inventory are purchased at different costs, companies must select a cost flow assumption to allocate costs between ending inventory and COGS.
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First-In, First-Out (FIFO): Assumes that the earliest goods purchased are the first sold. Therefore, ending inventory consists of the most recent purchases. FIFO yields the same ending inventory and COGS under both periodic and perpetual systems. In an inflationary environment, FIFO matches old, lower costs against current higher revenues, producing the highest net income and highest ending inventory.
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Last-In, First-Out (LIFO): Assumes that the latest goods purchased are the first sold. Ending inventory consists of the oldest costs. LIFO results differ between periodic and perpetual systems because the timing of sales under perpetual limits which purchases are available to be "last-in." In inflation, LIFO matches current higher costs against current revenues, resulting in the highest COGS, lowest ending inventory, and lowest net income (and lowest tax liability). Under the LIFO Conformity Rule, if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting under US GAAP.
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LIFO Reserve: Many companies use FIFO for internal management but LIFO for external reporting. The LIFO Reserve is a contra-asset account representing the difference between inventory valued under FIFO and LIFO:
Inventory (FIFO basis) - LIFO Reserve = Inventory (LIFO basis)
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Weighted Average (Periodic): Calculates a single average cost per unit at the end of the period:
Weighted Average Cost per Unit = Total Cost of Goods Available / Total Units Available
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Moving Average (Perpetual): Computes a new average unit cost after every purchase. This new cost is used to value subsequent sales until the next purchase occurs.
5. Comprehensive Cost Flow Example
Consider the following inventory transaction log for Apex Corporation:
- Beginning Inventory (Jan 1): 100 units @ $10.00 each ($1,000)
- Purchase 1 (Feb 15): 150 units @ $12.00 each ($1,800)
- Sale 1 (Mar 10): 120 units
- Purchase 2 (May 20): 200 units @ $15.00 each ($3,000)
- Sale 2 (Jun 15): 180 units
Total units available = 450 units. Total cost available = $5,800. Total units sold = 300 units. Ending units = 150 units.
Calculations under Periodic System:
- FIFO: Ending inventory (150 units) comes from May 20 purchase: 150 units * $15 = $2,250. COGS = $5,800 - $2,250 = $3,550.
- LIFO: Ending inventory (150 units) comes from oldest layers: 100 units from Beginning Inventory ($1,000) and 50 units from Feb 15 purchase (50 * $12 = $600). Ending Inventory = $1,600. COGS = $5,800 - $1,600 = $4,200.
- Weighted Average: Cost per unit = $5,800 / 450 = $12.89. Ending Inventory = 150 * $12.89 = $1,933.50. COGS = 300 * $12.89 = $3,867.00.
Calculations under Perpetual System:
- LIFO (Perpetual):
- Sale 1 (Mar 10 - 120 units): Sold from Feb 15 purchase (120 units @ $12 = $1,440). Inventory left: 100 units @ $10, 30 units @ $12.
- Purchase 2 (May 20): Adds 200 units @ $15.
- Sale 2 (Jun 15 - 180 units): Sold from newest layer (180 units @ $15 = $2,700).
- Ending Inventory: (100 * $10) + (30 * $12) + (20 * $15) = $1,660. COGS = $1,440 + $2,700 = $4,140.
- Moving Average (Perpetual):
- Before Sale 1 (Mar 10): Pool is 100 units @ $10 and 150 units @ $12. Total = 250 units at $2,800. Average cost = $2,800 / 250 = $11.20.
- Sale 1: 120 units costed at $11.20 = $1,344. Remaining inventory = 130 units @ $11.20 = $1,456.
- Before Sale 2 (Jun 15): Add purchase of 200 units @ $15 ($3,000). Pool is 130 + 200 = 330 units at cost of $1,456 + 3,000 = $4,456. New average cost = $4,456 / 330 = $13.50.
- Sale 2: 180 units costed at $13.50 = $2,430.
- Ending Inventory: 150 units @ $13.50 = $2,026. COGS = $1,344 + $2,430 = $3,774.
Which of the following inventory cost flow assumptions produces the exact same ending inventory and cost of goods sold values under both periodic and perpetual inventory systems?
In a period of inflation (rising prices), which inventory cost flow assumption will result in the lowest net income, highest cost of goods sold, and lowest ending inventory?
Apex Corporation purchased inventory under terms FOB shipping point on December 28, Year 1. The goods were shipped on December 30, Year 1, and received by Apex on January 3, Year 2. How should this transaction be recorded in Apex's financial statements for the year ended December 31, Year 1?
Which of the following costs should be expensed as a period cost rather than capitalized as inventory?