Accounting Principles I – Inventory - Quick Guides

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Study GuideAccounting Principles I–Inventory1. Determining Inventory LevelsWhat is inventory, and why does it matter?Merchandising and manufacturing companies keepinventory, which means the goods they havestored and ready to sell.Management has the job of decidinghow much inventorythe company should keep on hand. Thisis important because inventory levels affect bothsalesandcosts.•Too little inventory:The company may run out of products andmiss sales.•Too much inventory:The company spends extra money tostore, protect, and insurethegoods. It can also hurtcash flow, because money goes out to buy inventory, but moneydoesn’t come back in until the goods are sold.So the goal is to keepthe right amount—not too much and not too little.1.1 Physical Inventory CountsTo figure out exactly how much inventory the company owns, companies take aphysical inventory.This means theycountitems (or sometimesmeasurethem, depending on the type of inventory).Since counting is easier when the business is not busy, many companies do physical inventorycounts when:•the store isclosed, or•sales and deliveries arenot happeningThis helps reduce mistakes and makes the count more accurate.1.2 Internal Controls During Inventory CountsTaking a physical inventory is not just about counting—it also involvesinternal control principles,which help prevent errors, fraud, and confusion.

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Study GuideHere are the key internal control practices companies follow:1. Segregation of DutiesInventory should be counted by employees whodo not have custodyof the items.In simple terms:The person whohandles or storesinventory should not be the same person whocounts and reportsit.This reduces the chance of dishonest reporting or accidental mistakes.2. Proper AuthorizationManagers must assign each employee specific inventory tasks.Also, employees helping with inventory mustverifywhat’s inside containers like:•boxes•barrels•other packagingThis makes sure items are not guessed or assumed—they are actually confirmed.3. Adequate Documents and RecordsCompanies useprenumbered count sheetsduring physical inventory.These count sheets are important because they:•provideproof of what was counted•support the inventory amount that gets reported•show responsibility when employeessignthemThe prenumbered system also helps make sure no count sheets are missing.

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Study Guide4. Physical ControlsAccess to inventory should belimiteduntil the count is done.This prevents items from being moved around during counting, which could cause errors.If shipping or receiving must still happen during the inventory count:•Items being shippedshould be placed in aseparate area•Items being receivedshould go into adesignated areaand be counted separatelyThis keeps the count clean and organized.5. Independent Checks on PerformanceAfter counting is finished, a supervisor should check to make sure:•every item was counted•no item was counted twiceSome companies even use asecond counterto double-check the first person’s results. This helpscatch mistakes early.1.3 Special Inventory SituationsSome inventory situations can easily causeconfusion, so companies must pay close attention tothem.1.4 Consigned MerchandiseConsigned merchandisemeans goods that are being soldfor someone else.Here’s the key idea:•The company selling the items is theconsignee•The actual owner is theconsignor, and the consignor keepslegal title(ownership)

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Study GuideEven though the consignee displays and sells the items,only the consignor includes them ininventory.So, companies that sell consignment goods must be careful toexclude those itemsfrom their owninventory records.1.5 Goods in TransitGoods in transitare items that have been shipped but are not yet received by the buyer.These goods must be counted ineither:•the seller’s inventoryor•the buyer’s inventoryWhich one depends on theshipping terms.FOB Shipping PointWhen goods are shippedFOB shipping point:•thebuyer paysshipping costs•the buyer gains ownershipas soon as the goods are shippedSo even if the buyer hasn’t received the goods yet, they must still be included in thebuyer’sinventory.FOB DestinationWhen goods are shippedFOB destination:•theseller paysshipping costs•the seller keeps ownership until the goodsreach the buyer’s businessSo the goods stay in theseller’s inventoryuntil the buyer actually receives them.

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Study Guide2. The Cost of InventoryWhat counts as the “cost” of inventory?When a company buys inventory to sell later, thecost of inventoryis more than just the price on theinvoice. It includesall the costsneeded to get the goods ready to sell.Think of it like this:Inventory cost =what it takes to buy it + what it takes to bring it in + what it takes to prepare it1. Cost of Purchased MerchandiseThe starting point is thepurchase priceof the merchandise.But there’s an important detail:If the company receives a discount and actually takes it, the inventory cost is recordedaftersubtracting the discount.So the inventory cost includes:•purchase price•minus discounts taken2. Extra Costs Added to InventoryCompanies often pay additional costs to get merchandise into the business. These costs are alsoincluded in inventory cost, such as:•Duties(taxes on imported goods)•Transportation costs paid by the purchaser(like freight charges)These costs are included because they are necessary to bring the merchandise into the company’spossession.

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Study Guide3. Costs to Prepare Inventory for SaleSometimes products can’t be sold immediately when they arrive. They might need to be:•assembled•packaged•labeled•prepared in some other wayIf that work is required to make the product ready for customers, then the cost of doing it isconsideredpart of inventory cost.4. What About Warehousing and Insurance?Technically, inventory costs can include expenses like:•warehouse storage•insurance for unsold goodsThese are real costs of having inventory, so it makes sense that they relate to inventory.However, tracking these costs foreach individual unitof inventory can be expensive and time-consuming. Many companies decide it’s not worth the effort.So instead, they often record these costs as part of:cost of goods sold (COGS)as the expenses happen, rather than attaching them to inventory units.3.The Valuation of Merchandise1) Why inventory value mattersIn accounting, we try tomatch expenses with the revenues they help produce.That means if inventory loses valuethis year, we must record that lossthis year—even if the goodswill be sold later.

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Study GuideInventory can lose value because of things like:•Damage(broken, spoiled, storm damage)•Deterioration(wear and tear over time)•Obsolescence(old models replaced by new ones)•Other declines in usefulness or selling price2) Inventory should not be overstatedA key rule is:Inventory should never be reported at more than its Net Realizable Value (NRV).Net Realizable Value (NRV)means:Expected selling price − selling expensesSo NRV is basically:“How much money will we actually end up with after selling it?”3) Example: inventory damaged by a stormImagine a car dealer has a car that originally cost$25,000.A storm damages the car, and now it can only be sold for$23,000.That means the inventory value must be reduced to$23,000, and the$2,000 lossmust be recordedright away.To record the write-down:•Debit: Loss on Inventory Write-Down(expense)•Credit: Inventory(asset decreases)This shows that the company suffered a loss because inventory became less valuable.

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Study Guide4) Write-downs may appear under different accountsNot every company uses the exact same expense account name.Some businesses record inventory write-downs directly in:•Cost of Goods Sold (COGS)or they may use another expense account.So, write-downs are oftennot shown separatelyon the financial statements.5) Understanding “Market Value” in inventoryIn inventory topics,market value usually means replacement cost.That means:Market value = the cost to buy the same item again todaySometimes products become cheaper over time, so theirmarket value drops.6) The Lower-of-Cost-or-Market (LCM) ruleTo avoid overstating inventory, accountants use the:

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Study GuideLower-of-Cost-or-Market (LCM) RuleThis rule says:Inventory should be reported at the lower of its original cost OR its current market value.7) Example: computers drop in priceA computer store buys100 computers, each costing$3,000.8) LCM can be applied in different waysThe LCM rule can be applied to:1.Individual inventory items2.Groups of similar items3.The entire inventory (if items are related)Important idea:Applying LCM toindividual itemsgives themost conservative (lowest)inventory value.Why?

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