Most small business accountants have some clients who maintain inventory for resale. Inventory creates its own special problems. The client must maintain inventory records on the accrual method including accounts payable using either a periodic or perpetual inventory system.
What is the difference between perpetual and periodic inventory? Perpetual inventory reflects the exact dollar amount for inventory as records are continually maintained. This works well for large items such as automobiles. Many retail stores use a perpetual inventory system as the computer removes the item from inventory at the point of sale.
A periodic inventory system carries the beginning inventory dollar figure on the books until the end of the period when a physical inventory it taken.
When computing inventory, the cost should reflect all expenses associated with the inventory. This could be the purchase price, freight, receiving, storage and any other costs incurred in readying the goods for sale.
All merchandise owned must be included in inventory. If merchandise has been ordered but not received, the amount must be entered into the inventory account if title has passed. The terms of the sale determine when title passes. If the goods are purchased FOB shipping point, title passes at the time the goods are placed on the carrier. At year end, these goods are included in inventory. When terms of sale are FOB destination, title passes when the goods are received by the purchaser. If you are taking year end inventory, the goods are not included unless received.
Another area that creates confusion is goods on consignment. Goods that are held by someone else on consignment but have not been sold are still the property of the client and must be included in inventory. Similarly, if the client is holding items belonging to someone else, those goods are not included in the inventory.
What happens if the client uses a periodic inventory system and loses inventory because of theft, fire or natural disaster? The accountant must then determine the inventory cost by using the gross profit method. This method of estimating inventory assumes a relationship between gross profit and sales. A gross profit percentage is applied to sales to obtain cost of goods sold. This is then subtracted from cost of goods available for sale to find ending inventory. This gross profit percentage is obtained from past experiences.
Example: A client has a fire in his warehouse and all inventory is destroyed. To estimate the amount of inventory destroyed assume that the gross profit percentage for past years was as follows: 1985 - 34% 1986 - 29% 1987 - 35% 1988 - 32% Total 130/4 = 32.5%
The beginning inventory was $10,000, sales for the period were $100,000 and purchases were $72,000.
$100,000 sales x 67.5% (100% - 32.5%) $ 67,500 cost of goods sold.
$10,000 beginning inventory + $72,000 purchases - $67,500 cost of goods sold $14,500 inventory destroyed
Another method used to estimate ending inventory is the retail inventory method. The retail method is used by many retail stores to arrive at reliable estimates of inventory as needed. Stores that use this method maintain two sets of records, one at cost and one at retail. This can be done quite easily with a computer. Cost percentage is computed by dividing the goods available for sale at the cost price by the goods available for sale at the retail price. This percentage is then multiplied to the ending inventory at retail. (See Example 1 on page 7.)
What are the advantages of using the retail method?
1. Inventory for interim statements can be estimated.
2. The physical inventory can be taken at retail and converted to cost without referring to costs and invoices, thus saving time and expense.
3. Shoplifting losses are easier to account for. Physical counts can be monitored against calculations and differences accounted for.
More information on inventory can be found in NSPA's Comprehensive Accounting Course.