Chapter 7
Inventory

Learning objective

  • Identify accounting principles and reporting practices applicable to inventory.

Overview

FASB Accounting Standards Codification® (ASC) 330, Inventory, addresses accounting principles and reporting practices applicable to inventory. A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

FASB ASC 330 applies to all entities with inventory, but does not necessarily apply to the following entity types:

  • Not-for-profit entities (NFPs)
  • Regulated utilities

Initial measurement

The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset, including the applicable expenditures and charges directly or indirectly incurred in bringing the inventory to its existing condition and location. Therefore, determining the initial cost of inventory, which includes both its acquisition and production cost, involves several considerations, such as the allocation of costs and changes to inventory items that are at various stages of completion (known as work in process), or in a state of finished goods. For example:

  • Variable production overheads (budgeted) are allocated to each unit of production on the basis of the actual use of the production facilities. These costs change with the production of unit of output, for example, indirect material or indirect labor because they cannot be directly allocated to a specific product.
  • The allocation of fixed production overheads (budgeted) to the costs of conversion is based on the normal capacity of the production facilities. Examples of fixed production costs might include rent that will remain fixed per unit of output within a relevant range.

The term normal capacity refers to a range of production levels expected to be achieved over a number of periods or seasons, under normal circumstances, and takes into account the loss of capacity resulting from planned maintenance; some variation in production levels from period to period is expected and establishes the range of normal capacity. The range of normal capacity varies, based on business- and industry-specific factors, so judgment is required to determine when a production level is outside the range of expected variation in production (abnormally low). Examples of factors that might be anticipated to cause an abnormally low production level might include:

  • Significantly reduced demand
  • Labor and material shortages
  • Unplanned facility or equipment downtime

The actual level of production may be used if it approximates normal capacity. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production should be decreased so that inventories are not measured above cost, but the amount of fixed overhead allocated to each unit of production should not be increased as a consequence of abnormally low production or idle plant.

Unallocated overheads should be recognized as an expense in the period in which they are incurred. Other items such as abnormal freight, handling costs, and amounts of wasted materials (spoilage) require treatment as current period charges rather than as a portion of the inventory cost.

Under most circumstances, general and administrative expenses are expensed as incurred, except for the portion of an expense that may be clearly related to production and therefore is capitalized into inventory costs (product charges). Selling expenses constitute no part of inventory costs.

Exclusion of all overheads from inventory costs does not constitute GAAP. Judgment needs to be exercised in each individual situation and involves the consideration of the adequacy of the procedures of the cost accounting system in use, the soundness of the principles applied, and their consistent application.

General and administrative expenses

Entities that have not adopted FASB ASC 606, Revenue from Contracts with Customers, and FASB ASC 340-40, Other Assets and Deferred Costs — Contracts with Customers

General and administrative expenses are ordinarily charged to expense as incurred but may be accounted for as contract costs under the completed-contract method of accounting or, in some circumstances, as indirect contract costs by government contractors.

Entities that have adopted FASB ASC 606 and FASB ASC 340

Upon adoption of FASB ASC 606, entities that did not expense general and administrative expenses as incurred will no longer be able to account for such costs as contract costs under the completed-contract method of accounting or, in some circumstances, as indirect contract costs by government contractors.

Inventory methods

The costs for inventory may be determined under any one of several assumptions as to the flow of cost factors. The major objective in selecting a method should be to choose the one that, under the circumstances, most clearly reflects periodic income. Such methods include the following:

  • First-in first-out (FIFO)
  • Average cost (or weighted-average)
  • Last-in first-out (LIFO)

In some lines of business specific lots are clearly identified from the time of purchase through the time of sale and are costed on this basis (commonly referred to as specific identification). Ordinarily, the costs to be matched against revenues from a sale may not be the identified cost of the specific item which is sold, especially in cases in which similar goods are purchased at different times and at different prices.

Therefore, if identical and interchangeable materials were purchased in various lots, the use of identified cost of the various lots may not produce the most useful financial statements. Because of this, there is general acceptance of several assumptions with respect to the flow of cost factors such as FIFO, weighted-average, and LIFO to provide practical bases for the measurement of periodic income.

Standard costs (which are predetermined costs generally expressed on a per-unit basis) are acceptable if adjusted at reasonable intervals to reflect current conditions so that at the balance-sheet date standard costs reasonably approximate costs computed under one of the recognized bases. In such cases, descriptive language is used to express their relationship, for instance, “approximate costs determined on the first-in first-out basis,” or, if it is desired to mention standard costs, “at standard costs, approximating average costs.”

In some situations, a reversed mark-up procedure of inventory pricing, known as the retail inventory method, may be both practical and appropriate. This method is a quick way to determine an approximate ending inventory balance but is merely only an estimate generally works only with inventory that has a consistent mark-up.

An inventory method should be selected based on the individual circumstances, but financial statements are generally more useful to their users if uniform methods of inventory pricing are adopted by all entities within a given industry.

Consistent application

Although, the basis of stating inventories using one of the various acceptable inventory methods does not affect the overall gain or loss on the ultimate disposition of inventory items, any inconsistency in the application of a method may improperly affect the periodic amounts of income or loss. Therefore, the adoption and treatment of inventory items should be consistently applied to allocate results fairly between years (periods).

Subsequent measurement

The subsequent measurement of inventory depends on the cost method and is different for the following:

  • Inventory measured using any method other than last-in, first-out (LIFO) or the retail inventory method (such as first-in, first-out [FIFO] or average cost)
  • Inventory measured using LIFO or the retail inventory method

Inventory measured using FIFO or the average cost inventory method

Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out [FIFO] or average cost) should be measured at the lower of cost and net realizable value (NRV).

NRV is defined in the master glossary of the FASB ASC as: Estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.

When evidence exists that the NRV of inventory is lower than its cost, the difference should be recognized as a loss in earnings in the period in which it occurs. That loss may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes.

Inventory measured using LIFO or the retail inventory method

A departure from the cost basis of pricing inventory measured using LIFO or the retail inventory method is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to damage, physical deterioration, obsolescence, changes in price levels, or other causes, the difference should be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.

The cost basis of recording inventory ordinarily achieves the objective of a proper matching of costs and revenues. However, under certain circumstances cost may not be the amount properly chargeable against the revenues of future periods. A departure from cost is required in these circumstances because cost is satisfactory only if the utility of the goods has not diminished since their acquisition; a loss of utility should be reflected as a charge against the revenues of the period in which it occurs. Thus, in accounting for inventories, a loss should be recognized whenever the utility of goods is impaired by damage, deterioration, obsolescence, changes in price levels, or other causes. The measurement of such losses for inventory measured using LIFO or the retail inventory method should be accomplished by applying the rule of pricing inventories at the lower of cost or market. This provides a practical means of measuring utility and thereby determining the amount of the loss to be recognized and accounted for in the current period.

The rule of lower of cost or market is intended to provide a means of measuring the residual usefulness of an inventory expenditure. The term market is therefore to be interpreted as indicating utility on the inventory date and may be thought of in terms of the equivalent expenditure, which would have to be made in the ordinary course at that date to procure corresponding utility.

As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. In applying the rule, however, judgment must always be exercised and no loss should be recognized unless the evidence indicates clearly that a loss has been sustained. There are therefore exceptions to such a standard. Replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility.

Furthermore, when the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss should be recognized even though replacement or reproduction costs are lower. This might be true, for example, in the case of production under firm sales contracts at fixed prices, or when a reasonable volume of future orders is assured at stable selling prices.

Because of the many variations of circumstances encountered in inventory pricing, the definition of market is intended as a guide rather than a literal rule. It should be applied realistically in light of the objectives expressed in this subtopic and with due regard to the form, content, and composition of the inventory. For example, the retail inventory method, if adequate markdowns are currently taken, accomplishes the objectives described herein. It is also recognized that, if a business is expected to lose money for a sustained period, the inventory should not be written down to offset a loss inherent in the subsequent operations.

Subsequent measurement information applicable to all inventory methods

If inventory has been the hedged item in a fair value hedge, the inventory’s cost basis for purposes of subsequent measurement should reflect the effect of the adjustments of its carrying amount made pursuant to the guidance in FASB ASC 815, Derivatives and Hedging.

Depending on the character and composition of the inventory, applicable subsequent measurement guidance may properly be applied either directly to each item or to the total of the inventory (or, in some cases, to the total of the components of each major category). The method should be that which most clearly reflects periodic income.

The purpose of reducing the carrying amount of inventory is to reflect fairly the income of the period. The most common practice is to apply the applicable subsequent measurement guidance separately to each item of the inventory. However, if there is only one end-product category, the application of the applicable subsequent measurement guidance to inventory in its entirety may have the greatest significance for accounting purposes. Accordingly, the remeasurement of individual items may not always lead to the most useful result if the market value (for inventory measured using LIFO or the retail inventory method) or NRV (for all other inventory) of the total inventory is not below its cost. This might be the case, for example, if selling prices are not affected by temporary or small fluctuations in current costs of purchase or manufacture.

Similarly, where more than one major product or operational category exists, the application of the applicable subsequent measurement guidance to the total of the items included in such major categories may result in the most useful determination of income. When no loss of income is expected to take place as a result of a reduction of cost prices of certain goods because others forming components of the same general categories of finished products have a market value (for inventory measured using LIFO or the retail inventory method) or NRV (for all other inventory) equally in excess of cost, such components need not be adjusted to the extent that they are in balanced quantities. Thus, in such cases, the guidance on subsequent measurement may be applied directly to the totals of the entire inventory, rather than to the individual inventory items, if they enter into the same category of finished product and if they are in balanced quantities, provided the procedure is applied consistently from year to year.

To the extent, however, that the stocks of particular materials or components are excessive in relation to others, the more widely recognized procedure of applying the guidance on subsequent measurement to the individual items constituting the excess should be followed. This would also apply in cases in which the items enter into the production of unrelated products or products having a material variation in the rate of turnover. Unless an effective method of classifying categories is practicable, the rule should be applied to each item in the inventory.

Other subsequent measurement information

Loss of sales incentive — A sales incentive that will result in a loss on the sale of a product may indicate an impairment of existing inventory.

Inventories stated above cost — An inventory cost that has been written down below cost at the close of a fiscal year is considered to be the cost for subsequent accounting purposes. Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by the inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability. Where such inventories are stated at sales prices, they should be reduced by expenditures to be incurred in disposal.

Purchase commitments — Net losses on firm purchase commitments for inventory are measured in the same way as are inventory losses, and therefore the loss is recognized in the current period.

Disclosure

FASB ASC 330 provides the following inventory disclosures:

  • The inventory method used for stating inventories should be consistently applied and disclosed in the financial statements. Whenever there is a significant change is made, the nature of the change and, if material, the effect on income should be disclosed.
  • When substantial and unusual losses result from the subsequent measurement of inventory, that fact should be disclosed.
  • When inventory is stated above cost that fact should be fully disclosed.
  • For inventories stated at sales prices should be fully disclosed in the financial statements.
  • The amounts of net losses on firm purchase commitments accrued should be disclosed separately in the income statement.

Knowledge check

  1. Which would not be a factor anticipated to cause an abnormally low production level?
    1. Significantly reduced demand.
    2. Labor and materials shortages.
    3. Significant increase in demand.
    4. Unplanned facility or equipment downtime.
  2. Fill in the blanks with the applicable options:

    The basis of stating inventories using one of the various acceptable inventory methods ________________ the overall gain or loss on the ultimate disposition of inventory items; inconsistency in the application of a method ________________ the periodic amounts of income or loss.

    1. Does not affect; affects.
    2. Affects; affects.
    3. Affects; does not affect.
    4. Does not affect; does not affect.
  3. Which is accurate relating to the subsequent measurement of inventory?
    1. A sales incentive that will result in a loss on the sale of a product may indicate an impairment of future inventory.
    2. An inventory cost that has been written down below cost at the close of a fiscal year can be recovered in subsequent accounting periods.
    3. Only in exceptional cases may inventories properly be stated above cost.
    4. Net losses on firm purchase commitments for inventory are measured in the same way as inventory losses, and therefore, the loss is recognized in the period the inventory is sold.

Practice question

  1. Describe the various acceptable inventory costing methods.

     

     

Note

  1. 1   The full text of the financial statement that includes the following excerpt can be found on the SEC’s website at www.sec.gov/Archives/edgar/data/789019/000156459018019062/msft-10k_20180630.htm.
..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.144.1.156