How Inventory is Valued: From an Accountant’s Perspective
By DM Studler, SDC CPAs LLC
Inventory or stock refers to the goods and materials that a business holds or owns for the ultimate purpose of resale (or repair). Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, serves to balance the need for product availability against the need for minimizing stock holding and handling costs.
Inventory, like any asset, ties up valuable funds an organization might otherwise use to increase profitability, so accountants pay special attention to how companies build, hold and protect stock. As a “current asset,” which a company theoretically could turn into cash at any point, inventory can round out a company’s balance sheet or artificially inflate its perceived profitability. As laws regarding the depreciation of inventory vary among countries and states, accountants also have to anticipate any potential significant tax expenses an organization might incur from the size of its inventory.
For a manufacturer to effectively manage inventory, it must choose how it will track and analyze its inventory costs relative to its costs of goods sold. On either a periodic or perpetual schedule, accounting principles provide three options for cost flow assumptions: first in, first out (FIFO); last in, last out (LILO); and (rga) average. The manufacturer can then monitor its inventory and sales using consistent metrics that will help more accurately predict its inventory needs in the future.
Each of the three cost flow assumptions can be used with periodic or perpetual inventory systems. Under a periodic inventory system, the amount appearing in the inventory account is not updated when purchases of merchandise are made from suppliers. Rather, the inventory account is commonly updated or adjusted only once-at the end of the year. During the year the Inventory account will likely show only the cost of inventory at the end of the previous year. Under the periodic inventory system, purchases of merchandise are recorded in one or more Purchases accounts. At the end of the year the Purchases account(s) are closed and the Inventory account is adjusted to equal the cost of the merchandise actually on hand at the end of the year. Under the periodic system there is no Cost of Goods Sold account to be updated when a sale of merchandise occurs. In short, under the periodic inventory system there is no way to tell from the general ledger accounts the amount of inventory or the cost of goods sold.
Under a perpetual inventory system, the inventory account is continuously updated. The inventory account is increased with the cost of merchandise purchased from suppliers and it is reduced by the cost of merchandise that has been sold to customers or used to manufacture goods. Under the perpetual system there is a Cost of Goods Sold account that is debited at the time of each sale for the cost of the merchandise that was sold or used to manufacture goods. Under the perpetual system a sale of merchandise or use to manufacture goods (rga) will result in two journal entries: one to record the sale and the cash or accounts receivable, and one to reduce inventory and to increase cost of goods sold.
Inventory Consists of Two Variables: Quantity x Unit Value = Total Value / Quantum. Quantum is unit value times quantity. Under the crime policy, inventory valuation (unit value) is often addressed as RCV or ACV (actual cash value). Therefore, the quantity, not quantum, is important to reviewing inventory claims.
Without a historical analysis of how accurate our inventory is, the reliance on assumptions make a calculation inside a calculation, which makes the review of inventory calculations even more complex and susceptible to more variance and errors not related to actual employee misappropriation. Often this concept is considered the normal shortage due to obsolescence, normal breakage and the need to adjust the “calculated” recorded book inventory. Can an insured tell us and prove what is normal shortage using historical proven loss patterns and accuracy?
Reasons For Inventory Shortages/Variances
A variance or shortage is the difference between recorded or expected inventory quantity or inventory quantum. There are numerous reasons for inventory variances in quantities: duplicate payment of inventory purchases, miscounts, under shipments or over shipments, unrecorded returns to vendors or usage of inventory, lack of recording of gifted or donated inventory, miscalculation of inventory usage or manufacturing rates, obsolescence, unrecorded breakage or damage, unrecorded scrap or under recorded scrap rates, shoplifting or vandalisms, unrecorded inventory removal for quality control, incorrect prior or current cycle counts and physical inventory counts, incorrect recording of inventory location or inventory description, or inventory items given wrong codes.
Each Company’s Choice of Inventory is Unique
Inventory computations are multiple calculations within calculations and can be challenging. Focus on quantity, not quantum, as pricing adds another variable, which is difficult to isolate and analyze.Each company will handle their inventory and record their inventory quantities, unit value and total value/quantum. Make no assumptions. Be inquisitive. Be skeptical. And leave your pride at home and be willing to ask questions.
DM Studler is the founding member and managing officer of SDC CPAs LLC, a global investigation and forensic accounting firm. Contact her at 630-820-5770 or firstname.lastname@example.org