Internal Controls and Taking a Physical Count
Fraud: Auditors commonly observe employees as they take a physical inventory. Auditors take their own test counts to monitor the accuracy of a company's count.
Events can cause the Inventory account balance to differ from the actual inventory available. Such events include theft, loss, damage, and errors. Thus, nearly all companies take a physical count of inventory at least once each year—informally called taking an inventory. This often occurs at the end of a fiscal year or when inventory amounts are low. This physical count is used to adjust the Inventory account balance to the actual inventory available.
A company applies internal controls when taking a physical count of inventory that usually include the following procedures to minimize fraud and to increase reliability:
Point: The Inventory account is a controlling account for the inventory subsidiary ledger. This subsidiary ledger contains a separate record (units and costs) for each separate product, and it can be in electronic or paper form. Subsidiary records assist managers in planning and monitoring inventory.
Prenumbered inventory tickets are prepared and distributed to the counters—each ticket must be accounted for.
Counters of inventory are assigned and do not include those responsible for inventory.
Counters confirm the validity of inventory, including its existence, amount, and quality.
A second count is taken by a different counter.
A manager confirms that all inventories are ticketed once, and only once.
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Answers — p. 257
What accounting principle most guides the allocation of cost of goods available for sale between ending inventory and cost of goods sold?
If Skechers sells goods to Famous Footwear with terms FOB shipping point, which company reports these goods in its inventory while they are in transit?
An art gallery purchases a painting for $11,400 on terms FOB shipping point. Additional costs in obtaining and offering the artwork for sale include $130 for transportation-in, $150 for import tariffs, $100 for insurance during shipment, $180 for advertising, $400 for framing, and $800 for office salaries. In computing inventory, what cost is assigned to the painting?
Inventory costing under a perpetual system
Accounting for inventory affects both the balance sheet and the income statement. A major goal in accounting for inventory is to properly match costs with sales. We use the expense recognition (ormatching) principle to decide how much of the cost of the goods available for sale is deducted from sales and how much is carried forward as inventory and matched against future sales.
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Management decisions in accounting for inventory involve the following:
Items included in inventory and their costs.
Costing method (specific identification, FIFO, LIFO, or weighted average).
Inventory system (perpetual or periodic).
Use of market values or other estimates.
The first point was explained on the prior two pages. The second and third points will be addressed now. The fourth point is the focus at the end of this chapter. Decisions on these points affect the reported amounts for inventory, cost of goods sold, gross profit, income, current assets, and other accounts.
One of the most important issues in accounting for inventory is determining the per unit costs assigned to inventory items. When all units are purchased at the same unit cost, this process is simple. When identical items are purchased at different costs, however, a question arises as to which amounts to record in cost of goods sold and which amounts remain in inventory.
Four methods are commonly used to assign costs to inventory and to cost of goods sold: (1) specific identification; (2) first-in, first-out; (3) last-in, first-out; and (4) weighted average. Exhibit 6.1 shows the frequency in the use of these methods.
EXHIBIT 6.1
Frequency in Use of Inventory Methods
Each method assumes a particular pattern for how costs flow through inventory. Each of these four methods is acceptable whether or not the actual physical flow of goods follows the cost flow assumption. Physical flow of goods depends on the type of product and the way it is stored. (Perishable goods such as fresh fruit demand that a business attempt to sell them in a first-in, first-out physical flow. Other products such as crude oil and minerals such as coal, gold, and decorative stone can be sold in a last-in, first-out physical flow.) Physical flow and cost flow need not be the same.