Mastering Accounting For Inventory Part VI

Mastering Inventory is mastering its accounting. Inventories are assets, and COGS are the related expenses. Manufacturing inventory (which is separate from Merchandising) requires splitting Raw Materials, WIP, and Finished Goods. Perpetual Inventory Systems continually adjusts inventory balances and COGS, where Periodic systems does it at the end of the period, understanding that the COGS formula is Beginning Inventory + Purchases + Freight – Returns – Discounts – Ending Inventory. Accounting for transactions with Inventory (via account purchases) includes:
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1. Dr. Inventory, Cr. AP; before COGS
2. Dr. Freight Expense, Cr. Cash;
3. Dr. AP, Cr. Sales Discounts (using the gross method) and Cash;
4. For Sales, Dr. AR, Cr. Sales Revenue;
5. When it is time to recognize COGS if periodic, it will include Dr. COGS, Dr. Ending Inventory, Dr. Sales Discounts, Dr. Returns, Cr. Beginning Inventory, Cr. Purchases, and Cr. Freight.

In terms of calculating costs and inventory, you have the Specific ID, Average Cost, FIFO, and LIFO methods. Weighted Average takes the average of the mix of inventory, FIFO assumes first inventory in, first out (LIFO the opposite), therefore, in terms of rising prices, FIFO will have lower COGS and higher inventory balances. For perpetual systems, when calculating either Average Costs, FIFO, or LIFO, it is important to carry over the COGS balance.

Only Average Cost, requires a re-weighting of the inventory balance. Periodic systems, it is done at the end to calculate COGS. This then lead to factors influencing method choices, which is inclusive of Physical Flow (attempts to sell oldest inventory first, it is not mandatory to choose a method that approximates physical flow, and FIFO best suits physical flow), Income Taxes, and Net Income (sometimes, companies choose LIFO to reduce income taxes in times of rising costs).

This then leads to the “Conformity Rule”, which states that if LIFO is being used for tax reporting purposes, then it must effectively be used for external reporting. Which then lends to the next topic of LIFO Reserves, being a “contra account” to adjust the balance of inventory from the internal method of LIFO to external reporting.

​Reasons to keep internal records other than LIFO are high record keeping costs, contractual agreements that requires other methods than LIFO, or using FIFO to make strategic pricing decisions. So, LIFO reserves are essentially the difference between LIFO and FIFO inventory, and if the reserve needed to be higher, that will be done by Dr. COGS, and Cr. LIFO Reserve (reducing inventory by increasing the contra asset).