Inventory

Why this topic matters

Inventory (Accounting Standards Codification (ASC) 330) is tested in Financial Accounting and Reporting (FAR) Area II. You need to know what belongs in inventory, how cost flows to cost of goods sold (COGS), how to apply the lower-of-cost rules, and how to estimate inventory. Calculation questions are common, and errors in inventory carry through two years of income.

What goes into inventory

Ownership of goods

Situation	Whose inventory?
Free on board (FOB) shipping point, in transit	Buyer's — title passes when shipped
FOB destination, in transit	Seller's — title passes on delivery
Goods on consignment	Consignor's (owner), not the consignee's
Sales with a high rate of return and no reasonable estimate	Seller's until returns can be estimated or the period ends
Bill-and-hold where control has passed	Buyer's

Costs to capitalize

• Include: purchase price, freight-in, import duties, handling, and costs to bring goods to a saleable condition and location; for manufacturers, direct materials, direct labor, and allocated manufacturing overhead.
• Exclude (expense): selling costs, freight-out, general and administrative costs, abnormal waste, and storage costs (unless storage is part of production, such as aging wine). Fixed overhead is allocated using normal capacity; unallocated overhead from abnormally low production is expensed.
• Purchase discounts reduce cost. Under the net method, discounts lost are a financial expense.

Cost-flow assumptions

Method	Cost of goods sold	Ending inventory	Rising prices effect
Specific identification	Actual cost of items sold	Actual cost of items on hand	—
First-in, first-out (FIFO)	Oldest costs	Newest costs	Highest income and inventory
Last-in, first-out (LIFO)	Newest costs	Oldest costs	Lowest income and taxes; highest COGS
Weighted average (periodic)	Average cost of goods available	Same average	In between
Moving average (perpetual)	New average after every purchase	Latest average	In between

FIFO gives the same result under periodic and perpetual systems. LIFO and average cost usually do not.

LIFO rules to know

• LIFO conformity rule: if LIFO is used for tax, it must be used for financial reporting.
• LIFO liquidation: selling old, low-cost layers inflates income in periods of rising prices; disclose material effects.
• LIFO reserve = FIFO inventory − LIFO inventory; disclosed so users can compare with FIFO companies.
• LIFO is prohibited under International Financial Reporting Standards (IFRS).

Dollar-value LIFO

1. Deflate ending inventory at current-year cost to base-year prices: ending ÷ current price index.
2. Compare to the prior year at base-year prices to find a new layer (or a decrement).
3. Price each new layer at the index of the year it was added.

Subsequent measurement — the lower-of rules

Cost method	Rule
FIFO, average cost, and all others	Lower of cost and net realizable value (NRV); NRV = estimated selling price − costs of completion, disposal, and transportation
LIFO and the retail inventory method	Lower of cost or market (LCM); market = replacement cost, but not above the ceiling (NRV) or below the floor (NRV − normal profit margin)

Write-downs are recognized in income (usually in COGS). Under US Generally Accepted Accounting Principles (GAAP), reversals are prohibited for annual periods; IFRS allows reversal up to original cost. An interim-period decline expected to reverse by year-end need not be recognized.

Estimating inventory

Gross profit method

Used for interim reporting and casualty losses — not acceptable for annual GAAP statements.

Estimated COGS = Sales × (1 − gross profit %). Ending inventory = Goods available − estimated COGS. If the markup is stated on cost, convert: gross profit % on sales = markup ÷ (1 + markup).

Retail inventory method

• Cost-to-retail ratio = goods available at cost ÷ goods available at retail.
• Conventional (lower of cost or market) method: include net markups but exclude net markdowns from the ratio's denominator — produces a lower ratio and a conservative inventory.
• Average cost method: include both markups and markdowns.
• Beginning inventory is excluded from the ratio under the retail LIFO method.
• Ending retail = goods available at retail − net sales − normal shrinkage and employee discounts.

Inventory errors

Error	Year 1 net income	Year 2 net income	Retained earnings end of Year 2
Ending inventory overstated in Year 1	Overstated	Understated	Correct (self-correcting)
Ending inventory understated in Year 1	Understated	Overstated	Correct

Purchase commitments

A loss on a non-cancelable purchase commitment is recognized when the market price falls below the contract price, and it is disclosed if material.

How it is tested

• Compute COGS and ending inventory under FIFO, LIFO, and average cost.
• Apply the lower of cost and NRV, or LCM with ceiling and floor.
• Estimate inventory using the gross profit or retail method.
• Determine which goods belong in inventory (FOB terms, consignment).