Inventory

Inventory questions in FAR usually combine three issues: ownership, cost flow assumptions, and subsequent measurement. The exam often gives a short fact pattern and asks what belongs in ending inventory or which method produces higher income.

What counts as inventory

Inventory includes goods held for sale, goods in production, and materials that will be consumed in production.

Category	Example
Raw materials	Lumber used by Kingfisher Industries
Work in process	Partially completed audio equipment at Illini Entertainment
Finished goods	Completed products ready for sale

Ownership of Goods

The first step in many inventory problems is deciding who owns the goods at year-end.

FOB shipping terms

Shipping term	When title passes	Include in buyer's inventory when...
FOB shipping point	When goods are given to the common carrier	goods are shipped
FOB destination	When goods are received by the buyer	goods are received

Consigned goods

In a consignment arrangement, the consignor keeps title until the consignee sells the goods to a third party. That means the goods remain in the consignor's inventory.

warning

Consigned goods sitting at another party's location are still inventory of the consignor, not the consignee.

Cost Flow Assumptions

U.S. GAAP permits several cost flow methods.

Method	Basic idea
Specific identification	Tracks the actual cost of specific items
FIFO	Oldest costs move to cost of goods sold first
LIFO	Newest costs move to cost of goods sold first
Weighted average	Uses average unit cost
Moving average	Rolling average in a perpetual system

Rising prices: FIFO vs. LIFO

During periods of rising prices:

• FIFO usually produces higher ending inventory and higher net income
• LIFO usually produces lower ending inventory and lower net income

:::tip Memory aid

LIFO = lowest ending inventory and income when prices are rising.

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Periodic vs. Perpetual Systems

System	Main feature
Periodic	Ending inventory is determined by physical count and cost of goods sold is computed at period-end
Perpetual	Inventory records update with each purchase and sale and maintain a running balance

Weighted average is commonly associated with the periodic system, while moving average is commonly associated with the perpetual system.

Lower of Cost and Subsequent Measurement

Lower of cost and net realizable value

For inventory measured under FIFO or average methods, inventory is generally carried at the lower of cost and net realizable value (NRV).

$$\text{NRV} = \text{Estimated selling price} - \text{Completion and disposal costs}$$

Example: Bear Co. has inventory with cost of $42,000 and estimated selling price of $45,000. It expects $2,000 of completion costs and $1,000 of selling costs.

$$\text{NRV} = \$45{,}000 - \$2{,}000 - \$1{,}000 = \$42{,}000$$

No write-down is needed because cost equals NRV.

Lower of cost or market

For older GAAP-style questions using the lower of cost or market model, "market" usually means replacement cost subject to a ceiling and floor.

Limit	Amount
Ceiling	NRV
Floor	NRV minus normal profit margin
Market	Replacement cost, constrained by the ceiling and floor

info

If replacement cost is above the ceiling, use the ceiling. If it is below the floor, use the floor.

Firm Purchase Commitments

If a company is committed to buy inventory in the future and prices decline below the commitment price, the loss is recognized in the period of the decline.

Example: Gies Co. commits to buy materials for $90,000. Before delivery, the market value drops to $74,000.

Debit

Credit

Estimated loss on purchase commitment

$16,000

Estimated liability on purchase commitment

$16,000

Estimating Ending Inventory

When a physical count is not practical (e.g., interim reporting, inventory destroyed by fire), companies use estimation methods based on historical relationships.

Gross Profit Method

The gross profit method estimates ending inventory by working backward from an assumed gross profit percentage.

$$\text{Estimated COGS} = \text{Net Sales} \times (1 - \text{Gross Profit \%})$$ $$\text{Estimated Ending Inventory} = \text{Goods Available for Sale} - \text{Estimated COGS}$$

Example: Bear Inc. has beginning inventory of $50,000 and purchases of $200,000. Net sales for the period are $275,000, and the historical gross profit percentage is 40%.

$$\text{Goods Available for Sale} = \$50{,}000 + \$200{,}000 = \$250{,}000$$ $$\text{Estimated COGS} = \$275{,}000 \times (1 - 0.40) = \$165{,}000$$ $$\text{Estimated Ending Inventory} = \$250{,}000 - \$165{,}000 = \$85{,}000$$

:::tip Exam Tip

The gross profit method is not acceptable for annual financial statements under GAAP. It is used for interim reporting, insurance claims, and reasonableness checks. Be careful with how the gross profit percentage is expressed — "markup on cost" and "gross profit as a percentage of sales" produce different results.

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Retail Inventory Method

The retail inventory method estimates ending inventory by converting the retail value of ending inventory to cost using a cost-to-retail ratio (also called the cost complement).

$$\text{Cost-to-Retail Ratio} = \frac{\text{Goods Available for Sale at Cost}}{\text{Goods Available for Sale at Retail}}$$ $$\text{Estimated Ending Inventory at Cost} = \text{Ending Inventory at Retail} \times \text{Cost-to-Retail Ratio}$$

Example: Gies Co. has the following data:

	At Cost	At Retail
Beginning inventory	$30,000	$50,000
Purchases	$120,000	$190,000
Goods available for sale	$150,000	$240,000
Net sales		$210,000

$$\text{Cost-to-Retail Ratio} = \frac{\$150{,}000}{\$240{,}000} = 62.5\%$$ $$\text{Ending Inventory at Retail} = \$240{,}000 - \$210{,}000 = \$30{,}000$$ $$\text{Ending Inventory at Cost} = \$30{,}000 \times 62.5\% = \$18{,}750$$

info

Under U.S. GAAP, the retail inventory method can approximate lower of cost or market (LCM) when net markdowns are excluded from the cost-to-retail ratio calculation. This produces a lower ratio and a more conservative ending inventory.

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Inventory Costing Illustration

Assume Bear Inc. purchases the following units:

Date	Units	Cost per unit
Jan. 3	100	$10
Mar. 8	100	$12
Oct. 2	100	$14

If Bear Inc. sells 220 units during a period of rising prices:

• FIFO leaves the newest costs in ending inventory
• LIFO leaves the oldest costs in ending inventory
• Weighted average smooths the effect

The exam may not ask you for every journal entry, but it often asks which method gives the highest income or highest ending inventory.

Consignment Example

Kingfisher Industries sends goods costing $18,000 to a retailer on consignment.

Kingfisher continues to report the goods as inventory until the retailer sells them to an outside customer.

Key Inventory Entries

Purchase under a perpetual system

Debit

Credit

Inventory

$25,000

Accounts payable

$25,000

Sale under a perpetual system

Debit

Credit

Accounts receivable

$40,000

Sales revenue

$40,000

Debit

Credit

Cost of goods sold

$24,000

Inventory

$24,000

Write-down to NRV

Debit

Credit

Loss on inventory write-down

$6,500

Inventory

$6,500

Inventory Takeaways for FAR

:::note Checklist

• Determine ownership first: FOB terms and consignment can change the answer.
• Know the difference between periodic and perpetual systems.
• Know the major cost flow assumptions.
• Know the effect of LIFO versus FIFO in rising prices.
• Know NRV and, when tested, the ceiling-and-floor approach for market.
• Recognize losses on firm purchase commitments when prices decline.

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