Understanding Inventory Valuation and Its Impact on Business Financials, Slides of Accounting

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Learning Objectives

1. Explain the importance of inventory

for asset valuation and income

measurement

Inventories are a significant asset for

many businesses

Learning Objectives

2. Understand the nature of inventory

and what is included in it

Types of inventory

1. Assets held for sale (or resale) in the

ordinary course of business

2. Assets used or consumed in the production

of goods to be sold in the ordinary course of

business

A manufacturer

(Ford, IBM, Exxon)

Has inventories used or consumed in the

production of goods for sale

A manufacturer’s inventories

will usually include

Raw materials inventory

Items used in producing the product

Work in process inventory

Products started but not yet completed

Finished goods inventory

Products completed but not yet sold

If you are in Los Angeles and your supplier is in New York City

You

Them

If you are in Los Angeles and your supplier is in New York City

Somebody has to pay for moving the goods

across the country

You

Them

The F.O.B. designation determines who that “somebody” is

You

Them

If the goods are shipped F.O.B. New York

(or F.O.B. origin)

You will pay the transportation cost and you will own the merchandise once it is turned over to the carrier in NYC

You

Them

The owner of the goods

Is usually the entity that should include

those goods in inventory

This applies to goods in transit

and to consignment situations

But there are exceptions for some

special sales agreements

An interesting situation arises

in purchase commitments

These are noncancellable, long-term contracts to purchase goods at a set price

You might enter into such an agreement to buy a product if you thought its price was about to go up

If the price does go up, everything is cool and you will make lots of money

But if the price goes down, you have an economic problem and an accounting problem

On December 31, 19X1, gas is selling for $.

Since Peck has agreed to pay $1.00 per gallon, accounting conservatism mandates:

December 31, 19X

Est. Loss on Purch. Commit. 6,

Est. Liab. on Contract 6,

This reduces Peck’s income and increases his liabilities

Assume that on the April 1, 19X2, delivery date, gas is selling for $.

Since Peck has agreed to pay $1.00 per gallon, there is an additional loss:

April 1, 19X

Purchases 90,

Est. Liab. on Contract 6,

Loss on Purchase Contract 4,

Cash 100,