Inventories are assets which are held for sale in the course of business, in the process of production for such sale or in the form of materials or supplies to be consumed in the production process or in the rendering of services.
Merchandise Inventory is the key factor in determining cost of sales. Because merchandise inventory represents goods that are available for sale, there must be a method of determining both the quantity and the cost of these goods .There are two systems available to merchandising entities to record events related to merchandise inventory - the perpetual inventory system and periodic inventory system.
Inventories encompass finished goods produced, goods in process and materials and supplies awaiting to be used in the production process.
Three Types of Inventories
- Finished goods - these are completed products which are ready for sale and could be consumed outright by the customer.
- Goods in process or work in process - these are partially completed products which require further process or work before they can be sold.
- Raw materials - these are goods that are to be used in the production process. No work or process has been done on them as yet by the entity inventorying them.
Perpetual and Periodic Inventory System
Under the perpetual inventory system, a continuous record of changes in inventory is maintained in the Inventory account. That is, all purchases and sales (issues) of goods are recorded directly in the Inventory account as they occur.
Under the periodic inventory system, the quantity of inventory on hand is determined only periodically, as its name implies. All acquisitions of inventory during the accounting period are recorded by debits to a Purchases account.
Goods in Transit
Goods in Transit are goods that are being delivered by the seller to buyer. In other words, goods in transit or inventories in transit refer to merchandise and/or inventory items that have been shipped or are being delivered by the seller, but have not yet been received or acknowledged by the buyer.
Depending on the terms of contract (sales contract), the goods in transit may form part of the inventories of either the buyer or seller but not both. There are two terms in shipping agreement, either the FOB Shipping Point or FOB Destination. FOB means “Free on board”.
- FOB shipping point – the buyer shoulders the cost of shipment. Therefore, ownership over the goods is transferred to the buyer upon shipment. Therefore , sales and accounts receivables are recognized upon shipment by the seller and inventory is recorded by the buyer.
- FOB destination – the seller shoulders the cost of shipment. In this agreement, ownership over the goods is transferred only upon receipt of the goods over the buyer. Therefore, sales and accounts receivable are recognize by the seller and inventory is recorded by the buyer only when the buyer receives the goods.
Goods in Transit Sample Problem
KAMIMURA Corp (seller). ships a truckload of merchandise on December 29 to KAMIMAHAL Corp. (buyer), The two corporations are separated by a thousand miles. The truckload of merchandise arrives at the headquarters of KAMIMAHAL Corp. on January 4. Between December 29 and January 4, the truckload of merchandise is goods in transit. The goods in transit requires special attention if the companies issue financial statements as of December 31. The reason is that the merchandise is included in the inventory of one of the two companies, but the merchandise is NOT physically present at either company. One of the two companies must add the cost of the goods in transit to the cost of the inventory that it has in its possession.
The terms of the sale will indicate which company should report the goods in transit as its inventory as of December 31.
If the term is FOB shipping point, the seller (KAMIMURA Corp.) will record a December sale and receivable, and will not include the goods in transit as its inventory. On December 31, Customer KAMIMAHAL is the owner of the goods in transit and will need to report a purchase, a payable, and must add the cost of the goods in transit to the cost of the inventories which are in its possession.
If the terms of the sale are FOB destination, Company KAMIMURA will not have a sale and receivable until January 4. This means KAMIMURA Corp. must report the cost of the goods in transit in its inventory on December 31. (Customer KAMIMAHAL will not have a purchase, payable, or inventory of these goods until January 4.)
Consigned Goods Inventory
A consignment involves a “consignor” transferring goods to a “consignee” who will act as an agent of the consignor in trying to sell the goods.
CONSIGNED GOODS are included in the consignor’s inventory and exluded from the consignor’s inventory. When the goods are delivered to the consignee, the consignor retains ownership over the consigned goods. Thus, consigned goods remain the property of the consignor and hence, includible in his inventories.
Since ownership is not transferred, transfers of consigned goods between the consignor and consignee are normally made through memo entries. Freight and other incidental costs of transferring consigned goods to the consignee forms part of the cost of the consigned goods. Repair costs for damages during shipment and storage and other maintenance costs are charged as expenses.
In a typical consignment, the consignee is entitled to receive commission based on sales made. In other arrangements, the consignee “purchases” the goods simultaneously with the sale of the goods to the final customer. In effect, the consignee’s commission is based on the markup he made on the final selling price.
Commissions earned by the consignee are normally deducted from the amounts to be remitted to the consignor. In cases where commissions are given to the consignee in advance, the consignor should record the advances made as receivables and not cost of inventory.
Valuation of Inventories
PAS 2, PARAGRAPH 9, provides that “inventories shall be measured at the lower cost and net realizable value”. The measurement of inventory at the Lower of cost and Net Realizable Value is also known by the acronym LCNRV.
The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
One of the major objectives of inventory accounting is the determination of costs of inventories recognized as expense when the related revenues are recognized. This is important for the proper determination of periodic income. Proper determination of such costs may be obtained by selecting an appropriate cost formula.
PAS 2, PARAGRAPH 25, expressly provides that the cost of inventories shall be determined by using either:
The standard does not permit anymore the use of last in, first out (LIFO) as an alternative formula in measuring cost of inventories.
A purchase commitment is a firm commitment to acquire goods/ services from a supplier. Purchase commitments are also a contracts to obligate a company to purchase a specified amount of merchandise or raw materials specified prices on specified dates.
Companies enter into agreement to make sure they will be able to obtain important inventory as well as to protect against increases in purchase price. They cannot cancel the contract with any penalty.
When the goods purchased under purchase commitment become impaired, such as when prices decline after the specified date, LOSS ON PURCHASE COMMITMENT is recognized . Then when prices increase after recognized a loss, the recovery is recognized as GAIN on PURCHASE COMMITMENT.
Purchase Commitment Sample Problem
On July 1, 2017, Emz Company signed a three year purchase contract which allows Emz Company to purchase up to 20,000 units of a microchip annually from Ords Company at 27 per unit and guarantees a minimum annual purchase of 5,000 units. At year end, it was found that the goods are obsolete. Emz had 2,500 units of this inventory at Dec. 31,2017, and believes these parts can be sold as scrap for 7 per unit.
The loss on purchase commitment is computed as follows: