Examining the different types of inventory measurement

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Inventory is defined as items of tangible personal property which are (1) held for sale in the ordinary course of business (2) in process of production for such sale or (3) to be currently consumed in the production off goods or services to be available for sale. (Statement of Financial Accounting Standards No. 4, Accounting Standards Council)

Passing of title is an important thing to consider for items to be included in inventory. It is a legal word that means the time at which ownership changes.

The following are items that must be included in inventory:

good items that are on hand

items sold F.O.B. Destination but still in transit

items purchased in transit, F.O.B. Shipping Point

items out on consignment

items in the care of salesman or agents and

items on customers for trial or approval

Inventories are used in trading (buying and selling items same shape as purchased) and manufacturing (buying items which are being transformed into another form before they will be used for selling). Trading uses Merchandise Inventory as their inventory account while manufacturing uses different kinds of inventories: (1) direct or raw materials, (2) work in process (3) finished goods and (4) indirect materials. Direct or Raw Materials are items to be used for production. These are the items that will make up work-in process or finished goods. Work-in Process inventories are those items which are partially but not totally complete. These still need to undergo additional process before they can be available for sale. Finished Goods are those items which are totally complete and are already available for sale. Indirect materials are items which are not directly identified with the goods being manufactured or produced.

Ownership on the Basis of F.O.B. (Freight on Board)

F.O.B. destination vs. F.O.B. Shipping Point:

on F.O.B. Destination term, the title or ownership still remains with the seller not until the items are received by the buyer. The inventory items will be included on the seller’s Balance Sheet (if still in-transit).

on F.O.B. Shipping Point term, the title or ownership is transferred already to the buyer upon shipping of the items. The inventory items will be included on the buyer’s Balance Sheet upon shipping.

Items Out on Consignment

Consignment is a form of selling items or goods in which the consignor places the items on the care of a consignee to sell them on their behalf. The title of the items is with the consignor. Certain charges such as freight and handling charges are included on the Cost of Goods Sold by the consignor.

MEASUREMENT, PRESENTATION AND DISCLOSURE DETAILS

Measurement

There are different types of inventory measurement: (1) FIFO (First-in, First-out), (2) LIFO (Last-in, First-out), (3) Average Cost, and (4) Specific Identification.

FIFO and LIFO are almost self-explanatory. On FIFO measurement, inventories are being cost based on the first items purchased, while LIFO cost inventories based on the last items purchased.

Average Cost has three types: (1) Simple Average, (2) Weighted-Average and (3) Moving Average.

Simple average divides the sum of the total cost over the total units on hand.

Weighted Average Cost divides the sum of Beginning Inventory and Purchases over Cost of Goods Available for Sale.

Moving-Average Cost has this formula: The balance of cost after every purchase is divided by the balance of units. In every purchase, a new unit cost is being calculated. This kind of inventory is used in perpetual inventory system.

Specific Identification is calculated by multiplying the actual units on hand by their actual unit cost. Whatever the original cost of the units sold will be the same cost to be used to compute the Cost of Goods Sold.

Presentation

Inventories are part of the Current Asset portion in the Balance Sheet.

They are two systems used in accounting inventories: (1) Periodic System and (2) Perpetual System.

Periodic system needs the counting of items to determine inventory on hand every end of an accounting period. The actual on hand are then multiplied with the related unit cost to come up with the value of inventory which will be used on balance sheet. This kind is system is more concerned on the actual inventories on hand and represents small peso investment.

Perpetual system uses stock cards the shows the running balance of an inventory. The movement of the inventories is also reflected on stock cards. This kind is system is more concerned on controlling and represents large peso investment.

Disclosure Details

Disclosures are important part in a Financial Statement in order to understand silent issues or matters related to the accounts used.

For inventories, the disclosures must include: (1) breakdown of the total amount, stating the types or kinds of inventories, whether on hand or not but remains with company’s ownership (2) valuation type or the type of cost used and (3) change from one inventory valuation to another.

COMPARISON WITH U.S. GAAP

GAAP (Generally Accepted Accounting Principles) requires the valuation on inventory based on COST OR MARKET VALUE, whichever is lower. If cost is higher than the market value, an adjusting entry must be made to correct the inventory account stated on the balance sheet. This usually happens because of rapid change in the marketability of a product. In this case, it is important to note that GAAP can change its set of principle from time to time depending on the need of every existing operation.

DISCUSSIONS

Inventories play important part on determining income of a profit-oriented company. Proper costing of inventories must be clearly presented and matters that need explanation regarding the account must be disclosed on the Financial Statements.

Management on this account must be given attention. Since this item determines profitability of the company, next to cash, they are prone to theft. Careful implementations of control procedures for this type of account must be strict.

Having inventory is not enough. The company must assess the timeliness of the item deliveries against their on-going sales demand. Some companies are using buffer stock in case high demand. There are different kinds of inventories: Raw Materials, Work-in Process, Finished Goods and Goods for resale. With these inventories, method of costing must be identified for Financial Statement presentation.

Aside from the types of inventory valuation, estimation is also allowed on the following situations: (1) fire has destroyed the inventories, theft or catastrophic incident happened (2) to prove the correctness of a physical count (3) inventory valuation is needed on Interim Reports where gathering physical inventory may take time to do.

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