The accounting treatment of inventory involves its recognition, measurement, and subsequent valuation. Here are the key aspects of inventory accounting:
- Recognition: Inventory is recognized as an asset on the balance sheet when it meets specific criteria. Generally, inventory is recognized when it is held for sale in the ordinary course of business or in the process of production for such sale.
- Measurement: Inventory is initially measured at its cost, which includes all costs directly related to bringing the inventory to its present location and condition. This includes purchase or production costs, freight, handling, and any other directly attributable costs.
- Cost Flow Assumptions: GAAP allows for different cost flow assumptions to assign costs to inventory items. The most commonly used methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average Cost. The chosen method should reflect the flow of goods and the economic circumstances of the entity.
- Lower of Cost or Net Realizable Value (LCNRV): Inventory is evaluated for potential obsolescence, damage, or decline in value. If the net realizable value (estimated selling price less selling costs) of an inventory item is lower than its cost, the inventory is written down to its LCNRV. This prudence concept ensures that inventory is not carried at an amount higher than its recoverable value.
- Disclosure: GAAP requires disclosure of significant accounting policies related to inventory, including the cost flow assumptions used and any valuation adjustments made. Additionally, information about the carrying amount of inventory, inventory turnover, and any constraints or restrictions on the sale or use of inventory may be disclosed.
Example:
Let’s consider a company called XYZ Corp. that sells electronic devices. On January 1, Year 1, XYZ Corp. purchases 100 smartphones for $20 each. On February 1, Year 1, an additional 150 smartphones are purchased for $25 each. During February, XYZ Corp. sells 120 smartphones.
The inventory and related accounting entries would be as follows:
Initial Purchase on January 1, Year 1:
Inventory: 100 smartphones x $20 = $2,000 (Debit)
Accounts Payable (or Cash): $2,000 (Credit)
Purchase on February 1, Year 1:
Inventory: 150 smartphones x $25 = $3,750 (Debit)
Accounts Payable (or Cash): $3,750 (Credit)
Sale during February, Year 1:
Cost of Goods Sold: 120 smartphones x Cost per unit (FIFO) = $20 x 100 + $25 x 20 = $2,800 (Debit)
Inventory: $2,800 (Credit)
At the end of February, Year 1, the remaining inventory balance and the related accounting entry would be:
Inventory: 30 smartphones x Cost per unit (FIFO) = $25 x 30 = $750 (Debit)
Cost of Goods Sold: $750 (Credit)
This example demonstrates how inventory is recorded initially at its cost and subsequently adjusted based on the cost flow assumption. In this case, FIFO assumes that the first units purchased are the first ones sold, resulting in the cost of goods sold being based on the cost of the oldest inventory.
It’s important to note that this is a simplified example for illustrative purposes, and in practice, companies may have more complex inventory systems, valuation adjustments, and additional considerations for specific industries or circumstances.