Inventory System Using Merchandise Inventory

the Inventory System That Uses The Merchandise Inventory Account As

The inventory system that uses the merchandise inventory account as an active account is called the perpetual inventory system. In a perpetual inventory system, inventory and cost of goods sold are continuously updated with each sale or purchase transaction, providing real-time inventory data (Gibson, 2020). This approach contrasts with the periodic inventory system, where inventory updates occur only at specific intervals.

A method of valuing inventory based on the assumption that the oldest goods will be sold first is called the FIFO (First-In, First-Out) method. FIFO assumes that the earliest purchased or produced items are sold first, which can influence the company's reported income and inventory valuation, especially during inflationary periods (Brigham & Ehrhardt, 2017).

Cost of goods sold (COGS) is shown on the income statement. It represents the direct costs attributable to the production of the goods sold by a company during a specific period (Hilton & Platt, 2019). COGS is deducted from net sales to determine gross profit.

To pay the least income tax possible in periods of rising inventory costs, the company should use the LIFO (Last-In, First-Out) inventory costing method. LIFO assumes that the most recent inventory purchases are sold first, which often results in higher COGS and lower taxable income during inflationary times (Kieso, Weygandt, & Warfield, 2019).

Ignoring a write-off of inventory that will not affect the financial statements to users of the information is an example of material misstatement. Such an omission can lead to inaccurate representation of assets, earnings, and the company's financial health, potentially violating accounting principles and legal standards (Schroeder, Clark, & Cathey, 2019).

A physical count of the inventory is typically taken when using a periodic inventory system. Since inventory updates are not continuously tracked, physical counts are necessary to determine ending inventory and COGS at the period's end (Wild, Subramanyam, & Halsey, 2021).

Assigning the Lowest Cost to the items that make up the inventory of merchandise at the end of the accounting period is an application of the Lower of Cost or Market (LCM) concept. This valuation approach ensures that inventory is not overstated on the balance sheet, aligning with conservative accounting principles (Garrison, Noreen, & Brewer, 2020).

If Period 1 ending inventory is understated, then the cost of goods sold for the following period will be overstated, and net income will be understated. This occurs because ending inventory from one period becomes beginning inventory for the next; understatement affects both periods’ financial statements (Kieso et al., 2019).

Net sales minus estimated gross profit yields the estimated cost of goods sold (COGS). This estimation helps in situations where inventory is not physically counted or for interim financial reporting (Hilton & Platt, 2019).

Given the data: net sales of $8,200, gross profit of $1,100, beginning inventory of $2,000, and ending inventory of $2,500, the company's cost of goods sold is calculated as follows:

Gross profit = Net sales - COGS

$1,100 = $8,200 - COGS

COGS = $8,200 - $1,100 = $7,100

Alternatively, using the inventory data to confirm:

Beginning Inventory + Purchases – Ending Inventory = COGS

Assuming all inventory changes are purchases, then:

If actual purchases are not specified, the calculation based on given gross profit is sufficient. Hence, the COGS is $7,100.

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The inventory management and valuation methods are crucial components of accurate financial reporting and efficient business operations. The perpetual inventory system is distinguished by its continuous update of inventory and cost of goods sold (COGS) after each transaction, providing real-time inventory data, and is favored over the periodic system in modern retail and manufacturing environments (Gibson, 2020). This system enhances inventory control, reduces errors, and improves decision-making processes by offering immediate insights into inventory levels.

The FIFO (First-In, First-Out) method of inventory valuation presumes that the oldest inventory items are sold first, which impacts net income and inventory valuation, especially during periods of rising prices. FIFO often results in higher ending inventory valuation on the balance sheet and higher net income compared to other methods, such as LIFO, during inflationary times (Brigham & Ehrhardt, 2017). In contrast, the LIFO (Last-In, First-Out) method assigns recent purchases to COGS, often resulting in lower taxable income when prices are rising, thus saving taxes and providing a cash flow advantage (Kieso et al., 2019).

Cost of Goods Sold (COGS) appears on the income statement as a direct expense and is subtracted from net sales to compute gross profit. This figure represents the total cost of inventory that was sold during a specific accounting period (Hilton & Platt, 2019). Accurate calculation of COGS is essential for financial statement accuracy and assessing operational profitability.

Generally Accepted Accounting Principles (GAAP) require that inventory be reported at the lower of cost or market (LCM). When applying LCM, businesses assign the lowest possible value—whether cost or current market value—to inventory items to avoid overstating assets and income. This conservative approach safeguards against the overstatement of net income and balancesheet valuations (Garrison et al., 2020).

In the context of inventory management errors, ignoring inventory write-offs that impact the financial statements constitutes material misstatement, which can distort financial health representations, mislead stakeholders, and potentially lead to legal ramifications if misstatements are deemed fraudulent or negligent (Schroeder et al., 2019). Physical counts are integral to the periodic inventory system because it lacks continuous tracking, and accurate physical verification is necessary to determine true ending inventory and COGS at period-end (Wild et al., 2021).

The impact of understated ending inventory in one period extends into subsequent periods: it results in overstated COGS and understated net income, affecting the accuracy of financial statements over time. Precise inventory valuation and consistent application of inventory methods are vital for transparent financial reporting (Kieso et al., 2019).

Estimating COGS by subtracting gross profit from net sales allows businesses to assess profitability even without detailed inventory data at interim periods. This estimation becomes particularly useful for managerial decision-making and external reporting (Hilton & Platt, 2019).

In the specific numerical example, the company's net sales of $8,200, combined with a gross profit of $1,100, leads to a calculated COGS of $7,100. This figure aligns with accounting principles and provides a clear picture of the company's cost structure during the period.

Overall, understanding various inventory systems, valuation methods, and their implications on financial statements is essential for accountants, auditors, and business managers. These practices ensure compliance with accounting standards, optimize tax advantages, and sustain stakeholder trust through transparent financial reporting (Gibson, 2020; Kieso et al., 2019).

References

• Brigham, E. F., & Ehrhardt, M. C. (2017). Financial Management: Theory & Practice. Cengage Learning.
• Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2020). Managerial Accounting. McGraw-Hill Education.
• Gibson, C. H. (2020). Financial Reporting & Analysis. South-Western College Pub.
• Hilton, R. W., & Platt, D. E. (2019). Managerial Accounting: Creating Value in a Dynamic Business Environment. McGraw-Hill Education.
• Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate Accounting. Wiley.
• Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2019). Financial Accounting Theory and Analysis. Wiley.
• Wild, J. J., Subramanyam, K. R., & Halsey, R. F. (2021). Financial Statement Analysis. McGraw-Hill Education.