Mastering Accounting For Inventory Part VII

Mastering Inventory is mastering its accounting. Inentories are assets, and COGS are the related expenses. Manufacturing (different from Merchandising) requires Raw Materials (Direct Labor, Manufacturing Overhead), WIP, and Finished Goods. Perpetual and Period Systems account for Sales/COGS continually or at the end of the period, respectively. COGS are calculated by Beginning Inventory + Purchases + Freight – Returns – Discounts – Ending Inventory. Important Journal Entries to note are:
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1. Dr. Inventory, Cr. AP;
2. Dr. AR, Cr. Sales Revenue;
3. Dr. Freight Expense, Cr. Cash;
4. Dr. AP, Cr. Discounts (using gross method) and Cash;
5. Dr. AP, Cr. Sales Returns, and during the end of the period for COGS if periodic;
6. Dr. COGS, Ending Inventory, Returns, Discounts, Cr. Beginning Inventory, Purchases, and Freight.

Specific ID, Average Cost, FIFO, and LIFO are the methods to help evaluate inventory balances. Periodic systems will evaluate at the end of the period, while perpetual system, we need to remember to carry over the COGS balances after purchases, and for Average Cost, to re-weight the Inventory valuation (FIFO ensure oldest units out, and LIFO the opposite applies). Factors influencing method choices are physical flow, net income, and taxes. If LIFO is chosen, it is important to remember the “Conformity Rule”, which means both tax and external reporting is LIFO. Therefore, LIFO reserves (a contra account) are created to maintain FIFO records (lower record keeping costs, used for certain bonus calculations, and if needed for pricing strategies).

Then, this leads us to LIFO liquidations, Inventory Pools, and Dollar Value LIFO. LIFO Liquidations occurs when units sold will be greater than items purchased, and results in previous years’ layers of inventory recorded as sold, and old costs being matched with current selling prices. If cost has been increasing, LIFO liquidations will result in higher net income, with lower COGS. Moreover, LIFO Inventory Pools and Dollar Value LIFO Method help simplify LIFO via keeping low record keeping costs when unit costs often change and a company has numerous individual units.

Inventory Pools will group inventory units, keep purchases made during the same period at the same cost, convert units to an average cost, and Ending Inventory will equal Beginning Inventory + Layer added during the period of the pool. For instance, unit A, B, C, with costs 1, 2, 4, with units 100, 50, 50 equate to a total cost of 600 which equates to average cost of pool of $3. And any remaining purchases will have a different weight, and be added to the ending inventory cost.

So, if the next round of purchase, units A, B, C have the same 200 units, with an average cost of $3.50, and 10 remain, then Beginning inventory of $600 + $35 (remaining units * purchase round weighted average) renders an inventory balance of $635. Lastly, Dollar Value LIFO comprises of layers from different years, is made up of items that face same cost changes, is viewed as a quantity of value (rather than physical quantity), and allows to combine large variety of goods to one pool (to help simplify record keeping procedures).

​This minimizes the probability of LIFO liquidations, and new acquisitions are viewed as dollar replacements. Therefore, to do this, it requires converting ending inventory to base year costs, identify ending inventory balances for the year, and then restate the layer using a cost index. So, if cost in base year is 110, and cost in layer year is 100, then cost index is 110%.