Page 279 - Accounting Principles (A Business Perspective)

7. Measuring and reporting inventories

Have you ever taken advantage of a pre-inventory sale at your favorite retail store? Many stores offer bargain
prices to reduce the merchandise on hand and to minimize the time and expense of taking the inventory. A smaller
inventory also enhances the probability of taking an accurate inventory since the store has less merchandise to

count. From Chapter 6 you know that companies use inventory amounts to determine the cost of goods sold; this
major expense affects a merchandising company's net income. In this chapter, you learn how important inventories
are in preparing an accurate income statement, statement of retained earnings, and balance sheet.
This chapter discusses merchandise inventory carried by merchandising retailers and wholesalers.
Merchandise inventory is the quantity of goods held by a merchandising company for resale to customers.
Merchandising companies determine the quantity of inventory items by a physical count.
The merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost

of the items. This chapter discusses four accepted methods of costing the items: (1) specific identification; (2) first-
in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Each method has advantages and
disadvantages.
This chapter stresses the importance of having accurate inventory figures and the serious consequences of using
inaccurate inventory figures. When you finish this chapter, you should understand how taking inventory connects
with the cost of goods sold figure on the store's income statement, the retained earnings amount on the statement
of retained earnings, and both the inventory figure and the retained earnings amount on the store's balance sheet.

Inventories and cost of goods sold
Inventory is often the largest and most important asset owned by a merchandising business. The inventory of
some companies, like car dealerships or jewelry stores, may cost several times more than any other asset the

company owns. As an asset, the inventory figure has a direct impact on reporting the solvency of the company in
the balance sheet. As a factor in determining cost of goods sold, the inventory figure has a direct impact on the
profitability of the company's operations as reported in the income statement. Thus, the importance of the
inventory figure should not be underestimated.
Importance of proper inventory valuation

A merchandising company can prepare accurate income statements, statements of retained earnings, and
balance sheets only if its inventory is correctly valued. On the income statement, a company using periodic
inventory procedure takes a physical inventory to determine the cost of goods sold. Since the cost of goods sold
figure affects the company's net income, it also affects the balance of retained earnings on the statement of retained
earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained
earnings. Inventories appear on the balance sheet under the heading "Current Assets", which reports current assets

in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one
operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet.
Recall that under periodic inventory procedure we determine the cost of goods sold figure by adding the
beginning inventory to the net cost of purchases and deducting the ending inventory. In each accounting period, the
appropriate expenses must be matched with the revenues of that period to determine the net income. Applied to
inventory, matching involves determining (1) how much of the cost of goods available for sale during the period
should be deducted from current revenues and (2) how much should be allocated to goods on hand and thus carried
forward as an asset (merchandise inventory) in the balance sheet to be matched against future revenues. Because

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