Auxiliary Standard Operating Procedures


SUBJECT:

Inventory Accounting Methods

SOURCE:

Auxiliary Accounting, Financial Management Services

DATE ISSUED:

October 2003

DATE OF LAST REVISION:

March 2008 

ASOP NO:

10.0 

RATIONALE:

To explain the accruing and adjusting methodologies as they pertain to recording inventory balances into the KFS, and the methods of inventory valuation used by Indiana University auxiliary units in order to ensure compliance with Generally Accepted Accounting Principles (GAAP). (See ASOP 3.0, which discusses accruing and adjusting entries.)

ASOP:

Overview

Accrual Method

Adjustment Method

Recording Estimated Inventory Shrinkage

Appendix A – Methods of Inventory Valuation

 

Overview


There are two methods used to account for inventory. The accrual method is recommended for organizations that know their ending inventory balances but do not have a systematic method to track cost of goods sold (COGS).

 

The second method, the adjustment method, is recommended for organizations that have a systematic method to track COGS. In the event an organization has a system that can track both amounts (ending inventory and COGS), either method may be used. In the case of organizations that do not have an internal inventory tracking system, a physical count must be done each month.

 

The following formula is used to calculate cost of goods sold regardless of the method used:


  Beginning Inventory
+ Inventory Purchases during period
Returns
= Cost of Goods available for Sale
Ending Inventory
= Cost of Goods Sold

 

Note: Refer to Appendix A for valuation methods. Contact your Auxiliary Consultant before determining or changing your valuation method.


Accrual Method

 

Note: The accrual method is recommended for organizations that have a systematic method to track their inventory balances but do not have such a method to track cost of goods sold (COGS).

  • All inventory purchases (less returns) acquired during the period is recorded by debiting purchases (53xx or 21xx object code). The offsetting entry is to accounts payable (9041 object code). See Step 1 in the following example. This entry fully expenses the entire purchase amount (less returns). This is a significant difference when compared to the adjustment method.
  • At the end of each month, update the KFS balances of inventory based upon the balances maintained in internal records. Use an AVAE document for this entry. Inventory is debited (83xx) for the dollar amount of the ending inventory balance. Cost of goods sold is credited for the dollar amount of the ending inventory balance (53xx or 21xx). This entry reduces COGS by the amount of inventory remaining on the books. See Step 2 in the following example.
  • It is required that a physical inventory count be done at least once per fiscal year. After the inventory on hand is counted, adjust the internal records to match the physical count. Once the internal records are adjusted, update the balances in the KFS. If, based on the physical count, the organization has experienced any shrinkage in the inventory balances, see Step 5 in the following example.
  • If, when reviewing the Monthly Operating Detail, extra purchases are identified that were not posted directly to COGS/AP, they would need to be added via the AP accrual process. (See the Accounts Payable ASOP 8.0.) 
Accrual Entries

STEP 1 - To record the initial purchase of widgets (if you are using KFS PURAP)

 

Beginning of January

Object Code

Debit

Credit

KFS PURAP

(Automated Entry)

Purch. for Resale (80 x $400)

21xx/53xx

$32,000

 

 

Accounts Payable

9041

 

$32,000


This step is for the Accrual Method only. This step fully expenses (COGS) the inventory upon purchase and increases Accounts Payable. For further information regarding Accounts Payable and the treatment of the Accounts Payable object code, please refer to ASOP 8.0.

 

STEP 2 - To record monthly ending inventory valuation (based on internal systems)

 

End of January

Object Code

Debit

Credit

AVAE

Ending Inventory (30 x $400)

83xx

$12,000

 

 

Purchases for Resale (80 x $400)

21xx/53xx

 

$12,000


This step is performed at the end of the month, January in this example, based upon the balances of the internal system. The balance of ending inventory in KFS should always reconcile with the balance of ending inventory in the internal system. Once the reconciliation of the inventory is complete, enter the value of the ending inventory on an AVAE as shown above. This adds inventory to the balance sheet, and reduces the expense amount (equal to the unsold inventory). It is important to enter this amount on an AVAE document, as this will cause the entry to auto-reverse (Step3) at the beginning of the next month (February).

 

STEP 3 - Auto-Reversal of prior month AVAE

 

Beginning of February

Object Code

Debit

Credit

AVAE

Cost of Sales

21xx/53xx

$12,000

 

 

Inventory

83xx

 

$12,000


This step is done automatically, because Step 2 was entered on an AVAE.

 

STEP 4 - To record monthly ending inventory valuation (based on internal systems)


 

End of February

Object Code

Debit

Credit

AVAE

Ending Inventory (20 x $400)

83xx

$8,000

 

 

Purchases for Resale (80 x $400)

21xx/53xx

 

$8,000


This step is the recording of inventory at the end of February (exactly the same process as Step 2). Again, the important factor is that this valuation comes from the internal system. The balance of ending inventory in KFS should always reconcile with the balance of ending inventory in the internal system. Enter the reconciled value on the AVAE document. At the beginning of March, this document will auto-reverse (see Step 3 above).

 

STEP 5 - Shrinkage


Based on your physical inventory count and valuation (to be performed at a minimum of once a year), It is common for your physical count to differ from your balance on the internal systems (theft, data entry error, etc). However, significant differences between your physical count of inventory and your internal system balances should raise a flag that your controls need to be reviewed and reassessed. The KFS balance must be adjusted to reflect your actual physical inventory and internal system balances. The adjustment for inventory shrinkage is as follows:

 

 

Object Code

Debit

Credit

AVAD

Inventory Shrinkage (1 x $400)

5140

$400

 

 

Cost of Sales

21xx

 

$400


When Cost of Sales Entries are Unnecessary


Some organizations do not purchase products or materials for resale; however, they do maintain inventory for their own use in the provision of a service. Two illustrations of this are units such as Campus Bus Services or the Motor Pool. Organizations such as these may maintain an inventory of spare vehicle parts, for example. These parts are used to make repairs to buses or other vehicles utilized by the university community. In cases such as these, expenditures are booked directly to the appropriate expense and inventory object codes. The accrual entry is recorded as follows:

 

To record the initial purchase (if you are using KFS PURAP)

 

Beginning of January

Object Code

Debit

Credit

KFS PURAP

(Automated Entry)

Expenses

4xxx

$32,000

 

 

Accounts Payable

9041

 

$32,000


Example--January Entry (End of Month Inventory Valuation Count)


A

 

Object Code

Debit

Credit

AVAE

Inventory

83xx

$12,000

 

 

Expenses

4xxx

 

$12,000


Reversing Entry--Beginning of February


B

 

Object Code

Debit

Credit

AVAE

Expenses

4xxx

$12,000

 

 

Inventory

83xx

 

$12,000


February Entry (End of Month Inventory Valuation Count)


C

 

Object Code

Debit

Credit

AVAE

Inventory

83xx

$10,000

 

 

Expenses

4xxx

 

$10,000


The example above illustrates that at the end of January, the auxiliary had $12,000 worth of inventory remaining (entry A). Since this entry is an AVAE, it automatically reverses at the beginning of the next month (B). At the end of February (C), the auxiliary had only $10,000 remaining (they used $2,000 worth of their inventory during the month of February).

Adjustment Method

Note: The adjustment method is recommended for organizations that have a systematic method to track their COGS balances.

  • The inventory object code (83xx) is debited when inventory is acquired (Step 1 below). The offsetting entry is to accounts payable (9041 object code). This is a significant difference when compared to the accrual method.
  • Sales of inventory are recorded by debiting cost of goods sold, and crediting inventory for the cost of the merchandise sold. This provides a continuous record of balances in both the inventory object code and cost of goods sold. See Step 2 below.
  • A physical inventory and reconciliation to the general ledger is required at least once a year.
  • If the physical inventory count differs from the official inventory figures recorded in the general ledger, the inventory shortage object code is debited or the overage is credited to appropriately adjust the KFS inventory figures to physical count values. See Step 3 below.

Perpetual Entries


STEP 1 - To record purchase of widgets for sale (if you are using KFS PURAP)


 

 

Object Code

Debit

Credit

KFS PURAP

(Automated Entry)

Inventory

83xx

$32,000

 

 

Accounts Payable

9041

 

$32,000

 

(80 x $400)

 

 

 


Step 1 is to record the initial purchase of inventory.


STEP 2 - Recording the Cost of a Sale


 

 

Object Code

Debit

Credit

AVAD

Cost of Goods sold

21xx/53xx

$29,600

 

 

Inventory (74 x $400)

83xx

 

$29,600


Step 2 is to record the cost of a sale and to remove the inventory from the books. Care should be taken to reconcile the balance of ending inventory and COGS in KFS with the balances in the internal system before using those values for this document.

 

STEP 3 - Physical Inventory Adjustment at Period End (adjusting and closing)


 

 

Object Code

Debit

Credit

AVAD

Inventory Shortage

5140

$400

 

 

Inventory (1 x $400)

83xx

 

$400


Step 3 is performed at period end, after a physical inventory count. This example illustrates accounting for an inventory shortage (shrinkage) based on the results of the physical count.

Reclassifying Entries


If, when reviewing the Monthly Operating Detail, extra purchases are identified that were not posted directly to inventory, they would need to be reclassified to inventory.

 

Period end adjusting and closing


 

 

Object Code

Debit

Credit

AVAD

Reclassification from
Monthly Operating Detail:

 

 

 

 

Inventory

83xx

$32,000

 

 

Purchases (80 x $400)

21xx/53xx

 

$32,000


RECORDING ESTIMATED INVENTORY SHRINKAGE


Organizations that carry inventory generally experience inventory shrinkage. Shrinkage is normally only identified after a physical inventory count. However, the shrinkage probably occurred throughout the period of time since the last physical count. Therefore, if the shrinkage is material to the organization, it should be accrued on a monthly basis. Often the best way to estimate this is to consider the organization's shrinkage history and then accrue this monthly in proportion to the organization's activity. For example, a unit selling dentistry supplies may have an estimated shrinkage of 1% of sales. Therefore, each month they would accrue 1% of the month's sales toward shrinkage.

 

Calculating Shrinkage

 

 

Inventory on the books

$10,000,000

 

Inventory valuation at physical count

$9,800,000

 

Shrinkage

$200,000

 

 

 

 

Annual Sales

$20,000,000

 

Shrinkage as a percentage of sales

1%

$200,000/$20,000,000


The example below will assume sales of $1,500,000 monthly--shrinkage estimate will be $15,000 monthly (1%).


a. Accrual Method


The easiest method of accounting for this in the KFS is: each month, use an AVAE to reverse in the month of the next physical inventory. Then when the actual shrinkage is known the accrual will automatically reverse and an AVAD can be done to enter the actual shrinkage.

 

Monthly entry set to reverse in month of next physical inventory


At June 30th a total of $180,000 was recorded to shrinkage which will reverse.

 

 

 

Object Code

Debit

Credit

AVAE

Shrinkage Expense

5140

$15,000

 

 

Shrinkage Allowance

8955/8918

 

$15,000


Entry to record actual inventory shrinkage based on a physical count


 

 

Object Code

Debit

Credit

AVAD

Shrinkage Expense

5140

$165,000

 

 

Inventory

83xx

 

$165,000


This entry is used to record the actual shrinkage when it is known.

b) Adjustment Method


If the month of the next physical inventory is not known then a perpetual shrinkage can be kept using an AVAD.


Monthly entry to record estimated shrinkage


 

 

Object Code

Debit

Credit

AVAD

Shrinkage Expense

5140

$15,000

 

 

Shrinkage Allowance

8955/8918

 

$15,000


Entry to record actual inventory shrinkage


 

 

Object Code

Debit

Credit

 

Shrinkage Allowance

8955/8918

$180,000

 

AVAD

Inventory

83xx

 

$165,000

 

Shrinkage Expense

5140

 

$15,000


In the example above the shrinkage was over-estimated (by $15,000) so 5140 was subsequently credited. If it had been an under-estimate then 5140 would have been debited for the extra (unexpected) shrinkage.

APPENDIX A – METHODS OF INVENTORY VALUATION


Overview

 

Note: Generally Accepted Accounting Principles require that the lower of cost of market be used no matter which inventory valuation method is used. A valuation method is used to compute the cost of the inventory dollar amounts and then it is compared to the market dollar amount. The lower of the two amounts must be used when recording inventory.


Regardless of which inventory accounting method is used, inventory values must be assigned. Four types of historical-cost-based inventory valuation are covered on the following pages: Specific Identification, Average Cost, FIFO, and LIFO. The retail Method, which uses an estimated inventory cost, is also discussed.

 

The data below is used in all historical-cost-based inventory valuation examples to follow.

 

 

Number of Units

Cost Per Unit

Total
Cost

Beginning Inventory, 7/1

200

$25

$5,000

Purchase, 8/10

100

26

2,600

Purchase, 12/7

600

27

16,200

Purchase, 3/20

300

28

8,400

Goods available for sale

1200

 

$32,200

 

 

 

 

Sale, 9/15

100

 

 

Sale, 12/18

300

 

 

Sale, 2/22

250

 

 

Sale, 5/15

150

 

 

Goods Sold

(800)

 

 

Inventory, 6/30

400

 

 

 

Historical-Cost-Based Inventory Valuation Methods

 

1) Specific Identification


Specific Identification traces actual cost flows. The flow of costs through goods available for sale into cost of goods sold or cost of ending inventory matches the physical flow of inventory units. Each unit of inventory and its cost must be specifically identified.

 

Example: Each of the 100 units sold on 9/15 must be specifically identified as being a $25 unit from the beginning inventory or a $26 unit from the 8/10 purchase. Therefore, the cost of goods sold depends on which units were sold.


This method is used when there is an expensive, distinguishable, and a small number of items in inventory. It is very accurate but is also less practical since it is more costly and allows for manipulation of the cost of ending inventory.

 

2) Average Cost Valuation Method


In this valuation method, the calculation of cost of goods is averaged among the units of inventory. The two methods consist of weighted average, which is used in a perpetual system.

 

Weighted Average--Periodic and/or Perpetual

Total cost of goods available

for sale during period

=

Average cost of goods available

for sale during the period

Total units of goods available

for sale during period


Example:
$32,200 = $26.83
$1,200

Cost of goods sold = 800 x 26.83 = $21,464

Ending inventory = 400 x $26.83 = $10,732

Moving Average--Perpetual


Continuous or moving average assigns a unit value to cost of goods available for sale. In this scenario, the average cost determines cost of goods sold at the time of each sale. This method requires a calculation of average unit cost after each purchase as illustrated below.

 

 

# of Units

Cost per Unit

Total Cost

Moving Avg. Cost

Beginning inventory, 7/1

200

 

$5,000

$25.00

Purchase, 8/10

100

$26.00

2,600

 

     Inv. Balance

300

7,600

 

25.33

Sale, 9/15

(100)

25.33

(2,533)

 

     Inv. Balance

200

 

5,067

 

Purchase, 12/7

600

27.00

16,200

 

     Inv. Balance

800

 

21,267

26.58

Sale, 12/18

(300)

26.58

(7,975)

 

     Inv. Balance

500

 

13,292

 

Sale, 2/22

(250)

26.58

(6,645

 

     Inv. Balance

250

 

6,647

 

Purchase, 3/20

300

28.00

8,400

 

     Inv. Balance

550

 

15,047

27.36

Sale, 5/15

(150)

27.36

(4,104)

 

     Inv. Balance

400

27.36

10,943

 

Ending Inventory

400

10,943

   

Cost of Goods Sold

100

2,533

   
 

300

7,975

   
 

250

6,645

   
 

150

4,104

   
 

800

$21,257

   
 
3) FIFO (First In First Out)

Regardless of the actual physical flow of goods, FIFO is calculated by assuming that goods entering inventory first are sold first, and goods entering inventory last are sold last. In a sense, the earliest inventory costs are considered cost of goods sold and the latest are considered ending inventory. There is a FIFO method for both Periodic and Perpetual.

 

FIFO--Periodic


Ending inventory by physical count is 400 units.

 

# of Units

Date Purchased

Cost Per Unit

Total Cost

300

3/20/04

$28

$ 8,400

100

12/7/03

27

2,700

 

 

 

$11,100

 

Cost of goods sold:

 

 

# of Units

Total Cost

Goods available for sale

1,200

$32,200

Less: Ending inventory

(400)

(11,100)

   Goods sold

800

$21,100

 

FIFO--Perpetual


Cost of goods sold:

 

# of Units

Date Sold

Cost Per Unit

Total Cost

100

9/15/03

$25.00

$2,500

300

12/18/03

25.00/100

 

 

 

26.00/100

 

 

 

27.00/100

7,800

250

2/22/04

27.00

6,750

150

5/15/04

27.00

4,050

800

 

 

$21,100

 

Ending inventory:

 

 

# of Units

Total Cost

Goods available for sale

1,200

$32,200

Less: Goods sold

(800)

(21,100)

Ending inventory

400

$11,100

 

4) LIFO (Last In First Out)


Regardless of the actual physical flow of goods, LIFO is calculated by assuming that goods entering inventory last are sold first, and goods entering inventory first are sold last. In a sense, the latest inventory costs are considered cost of goods sold and the earliest are considered ending inventory. There is a LIFO method for both Periodic and Perpetual.


LIFO--Periodic

 

Ending inventory by physical count is 400 units.

 

# of Units

Date Purchased

Cost Per Unit

Total Cost

200

7/1/03

$25

$5,000

100

8/10/03

26

2,600

100

12/7/03

27

2,700

 

 

 

$10,300

 

Cost of goods sold:

 

 

# of Units

Total Cost

Goods available for sale

1,200

$32,200

Less: Ending inventory

(400)

(10,300)

   Goods sold

800

$21,900


LIFO--Perpetual


Date

Transaction

Cost of
Goods
Purchased

Cost of
Goods Sold

Cumulative
Balance of
Inventory

7/1/03

Beg. Inventory

 

 

200@$25=$5,000

8/10/03

Purchase

100@$26=$2,600

 

100@$26=$2,600

 

   Sub-total

 

 

$7,600

9/15/03

Sale

 

100@$26=$2,600

100@$26=($2,600)

12/7/03

Purchase

600@$27=$16,200

 

600@$27=$16,200

 

   Sub-total

 

 

$21,100

12/18/03

Sale

 

300@$27=$8,100

300@$27=($8,100)

 

   Sub-total

 

 

$13,100

2/22/04

Sale

 

250@$27=$6,750

250@$27=($6,750)

 

   Sub-total

 

 

$6,350

3/20/04

Purchase

300@$28=$8,400

 

300@$28=$8,400

 

   Sub-total

 

 

$14,750

5/15/04

Sale

 

150@$28=$4,200

150@$28=($4,200)

 

   Total

 

$21,650

$10,550

 

Perpetual  Total Cost of Goods sold = $21,650  End Inv. = $10,550

 

5) Retail Method


The retail method estimates the dollar amount of ending inventory, and is acceptable for external reporting if it yields results that reasonably approximate the result that would have been obtained under one of the cost flow methods.

 

The simple form of the Retail Method requires the following:

  1. Cost and retail beginning inventory selling prices.
  2. Cost and retail current period purchases.
  3. Retail sales for period.
 

Data used in the Retail Method example:

Cost

Retail

Beginning inventory

$11,000

$12,000

Purchases

50,000

60,000

Sales

 

70,000

 

 

 

Method:

 

 

Beginning inventory

11,000

12,000

Purchases

50,000

60,000

     Goods available for sale

61,000

72,000

Less: Sales

 

(70,000)

Estimated ending inventory at retail

 

$  2,000

Estimated ending inventory at cost (2,000 x 85%*)

$  1,700

 

*Cost-to-retail percentage: 61,000 / 72,000 = 85%

 

 

 

The following are possible complications that should be considered:

  • Freight in: Added to the cost column as an addition to purchases.
  • Purchase allowances: Subtracted from the cost column from purchases.
  • Purchase returns: Should be deducted from both the cost and retail sides.
  • Purchase discounts: Should be deducted in the cost side if purchases are recorded as gross amounts.
  • Sales returns and allowances: Should be subtracted from sales on the retail side if sales are recorded as gross amounts.
  • Employee discounts: The employee discount should be added to sales on retail side if sales to employees are recorded net of employee discounts.
  • Normal spoilage: Should be subtracted from goods available on retail side after the cost-to-retail percentage is calculated.
  • Abnormal spoilage: Should be subtracted from cost and retail before the cost-to-retail percentage is calculated.

Variations of the Retail Inventory Method


To provide estimates of inventory by using average cost, FIFO, and LIFO. They differ by the calculations included in the cost-to-retail percentage.

 

Average Cost: Percentage includes cost and retail for beginning inventory and net purchases that are adjusted for net markups and markdowns.

 

FIFO: Percentage excludes cost and retail for beginning inventory and includes net markups and markdowns. Goods available for sale include cost and retail for beginning inventory.

 

LIFO: Separate percentage is calculated for beginning inventory and net purchases. The cost-to-retail percentage for net purchases includes net markups and markdowns. LIFO layers are accounted for and identified.

DEFINITIONS:

Cost of Goods Sold (COGS) – COGS is the difference between the cost of goods available for sale during the period and the cost of goods on hand at the end of the period.

 

Inventory – Inventories are asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold.

 

Inventory Shrinkage – Inventory Shrinkage is the difference between the booked inventory as a result of purchase and sales, and the actual inventory on hand. Common sources of shrinkage include theft, inventory counting errors, loss and damage etc.

CROSS

REFERENCE:

ASOP 3.0 - Accruing vs Adjusting Entries

ASOP 8.0 - Accounts Payable

RESPONSIBLE

ORGANIZATION:

 

Auxiliary Accounting, Financial Management Services