1. Overview
2. Accrual Method
3. Adjustment Method
4. Recording Estimated Inventory Shrinkage
5. Appendix A – Methods of Inventory Valuation

1. Overview
   

   There are two methods used to account for inventory. The accrual method is recommended for organizations that know their ending inventory balances but do not have a systematic method to track cost of goods sold (COGS). The second method, the adjustment method, is recommended for organizations that have a systematic method to track COGS.

   In the event an organization has a system that can track both amounts (ending inventory and COGS), either method may be used. In the case of organizations that do not have an internal inventory tracking system, a physical count must be done each month.

   The following formula is used to calculate cost of goods sold regardless of the method used:

   Beginning Inventory
   + Inventory purchases during period
   (less returns)
   

   ---

   = Cost of goods available for sale
   - Ending inventory
   

   ---

   = Cost of goods sold

   Note: Refer to Appendix A for valuation methods. Contact your Auxiliary Consultant before determining or changing your valuation method.

2. Accrual Method

   Note: The accrual method is recommended for organizations that have a systematic method to track their inventory balances but do not have such a method to track cost of goods sold (COGS).
   

   • All inventory purchases (less returns) acquired during the period is recorded by debiting purchases (53xx or 21xx object code). The offsetting entry is to accounts payable (9041 object code). See Step 1 in the following example. This entry fully expenses the entire purchase amount (less returns). This is a significant difference when compared to the adjustment method.
   • At the end of each month, update the FIS balances of inventory based upon the balances maintained in internal records. Use an AVAE document for this entry. Inventory is debited (83xx) for the dollar amount of the ending inventory balance. Cost of goods sold is credited for the dollar amount of the ending inventory balance (53xx or 21xx). This entry reduces COGS by the amount of inventory remaining on the books. See Step 2 in the following example.
   • It is required that a physical inventory count be done at least once per fiscal year. After the inventory on hand is counted, adjust the internal records to match the physical count. Once the internal records are adjusted, update the balances in the FIS. If, based on the physical count, the organization has experienced any shrinkage in the inventory balances, see Step 5 in the following example.
   • If, when reviewing the Monthly Operating Detail, extra purchases are identified that were not posted directly to COGS/AP, they would need to be added via the AP accrual process. (See the Accounts Payable ASOP number 8.0.)

   Accrual Entries
   

   STEP 1 - To record the initial purchase of widgets (if you are using EPIC)

   	Beginning of January	Object Code	Debit	Credit
   EPIC (Automated Entry)	Purchase for Resale (80 x $400)	21xx/53xx	$32,000
   	Accounts Payable	9041		$32,000

   This step is for the Accrual Method only. This step fully expenses (COGS) the inventory upon purchase and increases Accounts Payable. For further information regarding Accounts Payable and the treatment of the Accounts Payable object code, please refer to ASOP 8.0.

   STEP 2 - To record monthly ending inventory valuation (based on internal systems)

   	End of January	Object Code	Debit	Credit
   AVAE	Ending Inventory (30 x $400)	83xx	$12,000
   	Purchases for Resale (80 x $400)	21xx/53xx		$12,000

   This step is performed at the end of the month, January in this example, based upon the balances of the internal system. The balance of ending inventory in FIS should always reconcile with the balance of ending inventory in the internal system. Once the reconciliation of the inventory is complete, enter the value of the ending inventory on an AVAE as shown above. This adds inventory to the balance sheet, and reduces the expense amount (equal to the unsold inventory). It is important to enter this amount on an AVAE document, as this will cause the entry to auto-reverse (Step3) at the beginning of the next month (February).

   STEP 3 - Auto-Reversal of prior month AVAE

   	Beginning of February	Object Code	Debit	Credit
   AVAE	Cost of Sales	21xx/53xx	$12,000
   	Inventory	83xx		$12,000

   This step is done automatically, because Step 2 was entered on an AVAE.

   STEP 4 - To record monthly ending inventory valuation (based on internal systems)

   	End of February	Object Code	Debit	Credit
   AVAE	Ending Inventory (20 x $400)	83xx	$8,000
   	Purchases for Resale (80 x $400)	21xx/53xx		$8,000

   This step is the recording of inventory at the end of February (exactly the same process as Step 2). Again, the important factor is that this valuation comes from the internal system. The balance of ending inventory in FIS should always reconcile with the balance of ending inventory in the internal system. Enter the reconciled value on the AVAE document. At the beginning of March, this document will auto-reverse (see Step 3 above).

   STEP 5 - Shrinkage

   Based on your physical inventory count and valuation (to be performed at a minimum of once a year), It is common for your physical count to differ from your balance on the internal systems (theft, data entry error, etc). However, significant differences between your physical count of inventory and your internal system balances should raise a flag that your controls need to be reviewed and reassessed.

   The FIS balance must be adjusted to reflect your actual physical inventory and internal system balances. The adjustment for inventory shrinkage is as follows:

   		Object Code	Debit	Credit
   AVAD	Inventory Shrinkage	5140	$400
   	Cost of Sales	21xx		$400

   When Cost of Sales Entries are Unnecessary

   Some organizations do not purchase products or materials for resale; however, they do maintain inventory for their own use in the provision of a service. Two illustrations of this are units such as Campus Bus Services or the Motor Pool. Organizations such as these may maintain an inventory of spare vehicle parts, for example. These parts are used to make repairs to buses or other vehicles utilized by the university community. In cases such as these, expenditures are booked directly to the appropriate expense and inventory object codes. The accrual entry is recorded as follows:

   To record the initial purchase (if you are using EPIC)

   	Beginning of January	Object Code	Debit	Credit
   EPIC (Automated Entry)	Expenses	4xxx	$32,000
   	Accounts Payable	9041		$32,000

   Example--January Entry (End of Month Inventory Valuation Count)

   A		Object Code	Debit	Credit
   AVAE	Inventory	83xx	$12,000
   	Expenses	4xxx		$12,000

   Reversing Entry--Beginning of February

   B		Object Code	Debit	Credit
   AVAE	Expenses	4xxx	$12,000
   	Inventory	83xx		$12,000

   February Entry (End of Month Inventory Valuation Count)

   C		Object Code	Debit	Credit
   AVAE	Inventory	83xx	$10,000
   	Expenses	4xxx		$10,000

   The example above illustrates that at the end of January, the auxiliary had $12,000 worth of inventory remaining (entry A). Since this entry is an AVAE, it automatically reverses at the beginning of the next month (B). At the end of February (C), the auxiliary had only $10,000 remaining (they used $2.000 worth of their inventory during the month of February).

3. ADJUSTMENT METHOD

   Note: The adjustment method is recommended for organizations that have a systematic method to track their COGS balances.

   • The inventory object code (83xx) is debited when inventory is acquired (Step 1 below). The offsetting entry is to accounts payable (9041 object code). This is a significant difference when compared to the accrual method.
   • Sales of inventory are recorded by debiting cost of goods sold, and crediting inventory for the cost of the merchandise sold. This provides a continuous record of balances in both the inventory object code and cost of goods sold. See Step 2 below.
   • A physical inventory and reconciliation to the general ledger is required at least once a year.
   • If the physical inventory count differs from the official inventory figures recorded in the general ledger, the inventory shortage object code is debited or the overage is credited to appropriately adjust the FIS inventory figures to physical count values. See Step 3 below.

   Perpetual Entries

   STEP 1 - To record purchase of widgets for sale (if you are using EPIC)

   		Object Code	Debit	Credit
   EPIC (Automated Entry)	Inventory	83xx	$32,000
   	Accounts Payables	9041		$32,000
   	(80 x $400)

   Step 1 is to record the initial purchase of inventory.

   STEP 2 - Recording the Cost of a Sale

   		Object Code	Debit	Credit
   AVAD	Cost of Goods sold	21xx/53xx	$29,600
   	Inventory	83xx		$400
   	(1 x $400)

   Step 2 is to record the cost of a sale and to remove the inventory from the books. Care should be taken to reconcile the balance of ending inventory and COGS in FIS with the balances in the internal system before using those values for this document.

   STEP 3 - Physical Inventory Adjustment at Period End (adjusting and closing)

   		Object Code	Debit	Credit
   AVAD	Inventory Shortage	5140	$400
   	Inventory	83xx		$400
   	(1x$400)

   Step 3 is performed at period end, after a physical inventory count. This example illustrates accounting for an inventory shortage (shrinkage) based on the results of the physical count.

   Reclassifying Entries

   If, when reviewing the Monthly Operating Detail, extra purchases are identified that were not posted directly to inventory, they would need to be reclassified to inventory.

   Period end adjusting and closing

   		Object Code	Debit	Credit
   AVAD	Reclassification from Monthly Operating Detail:
   	Inventory	83xx	$32,000
   	Purchases (80 x $400)			$32,000

4. RECORDING ESTIMATED INVENTORY SHRINKAGE

   Organizations that carry inventory generally experience inventory shrinkage. Shrinkage is normally only identified after a physical inventory count. However, the shrinkage probably occurred throughout the period of time since the last physical count. Therefore, if the shrinkage is material to the organization, it should be accrued on a monthly basis. Often the best way to estimate this is to consider the organization's shrinkage history and then accrue this monthly in proportion to the organization's activity. For example, a unit selling dentistry supplies may have an estimated shrinkage of 1% of sales. Therefore, each month they would accrue 1% of the month's sales toward shrinkage.

   Calculating Shrinkage
   Inventory on the books	$10,000,000
   Inventory valuation at physical count	$9,800,000
   Shrinkage	$200,000
   Annual Sales	$20,000
   Shrinkage as a percentage of sales	1%	$200,000/$20,000,000

   The example below will assume sales of $1,500,000 monthly--shrinkage estimate will be $15,000 monthly (1%).

   a. Accrual Method

   The easiest method of accounting for this in the FIS is: each month, use an AVAE to reverse in the month of the next physical inventory. Then when the actual shrinkage is known the accrual will automatically reverse and an AVAD can be done to enter the actual shrinkage.

   Monthly entry set to reverse in month of next physical inventory

   At June 30th a total of $180,000 was recorded to shrinkage which will reverse.

   		Object Code	Debit	Credit
   AVAE	Shrinkage Expense	5140	$15,000
   	Shrinkage Allowance	8955/8918		$15,000

   Entry to record actual inventory shrinkage based on a physical count

   		Object Code	Debit	Credit
   AVAD	Shrinkage Expense	5140	$165,000
   	Inventory	83xx		$165,000

   This entry is used to record the actual shrinkage when it is known.

   b. Adjustment Method

   If the month of the next physical inventory is not known then a perpetual shrinkage can be kept using an AVAD.

   Monthly entry to record estimated shrinkage

   		Object Code	Debit	Credit
   AVAD	Shrinkage Expense	5140	$15,000
   	Shrinkage Allowance	8955/8918		$15,000

   Entry to record actual inventory shrinkage

   		Object Code	Debit	Credit
   	Shrinkage Allowance	8955/8918	$180,000
   AVAD	Shrinkage Expense	5140		$165,000
   	Inventory	83xx		$15,000

   In the example above the shrinkage was over-estimated (by $15,000) so 5140 was subsequently credited. If it had been an under-estimate then 5140 would have been debited for the extra (unexpected) shrinkage.

   APPENDIX A

   METHODS OF INVENTORY VALUATION

   Overview

   Note: Generally Accepted Accounting Principles require that the lower of cost of market be used no matter which inventory valuation method is used. A valuation method is used to compute the cost of the inventory dollar amounts and then it is compared to the market dollar amount. The lower of the two amounts must be used when recording inventory.

   Regardless of which inventory accounting method is used, inventory values must be assigned. Four types of historical-cost-based inventory valuation are covered on the following pages: Specific Identification, Average Cost, FIFO, and LIFO. The retail Method, which uses an estimated inventory cost, is also discussed.

   The data below is used in all historical-cost-based inventory valuation examples to follow.

   	Number of Units	Cost Per Unit	Total Cost
   Beginning Inventory, 7/1	200	$25	$5,000
   Purchase, 8/10	100	26	2,600
   Purchase, 12/7	600	27	16,200
   Purchase, 3/20	300	28	8,400
   Goods available for sale	1200		$32,200
   Sale, 9/15	100
   Sale, 12/18	300
   Sale, 2/22	250
   Sale, 5/15	150
   Goods Sold	(800)
   Inventory, 6/30	400

   Historical-Cost-Based Inventory Valuation Methods

   1. Specific Identification

      Specific Identification traces actual cost flows. The flow of costs through goods available for sale into cost of goods sold or cost of ending inventory matches the physical flow of inventory units. Each unit of inventory and its cost must be specifically identified.

      Example: Each of the 100 units sold on 9/15 must be specifically identified as being a $25 unit from the beginning inventory or a $26 unit from the 8/10 purchase. Therefore, the cost of goods sold depends on which units were sold.

      This method is used when there is an expensive, distinguishable, and a small number of items in inventory. It is very accurate but is also less practical since it is more costly and allows for manipulation of the cost of ending inventory

   2. Average Cost Valuation Method
      

      In this valuation method, the calculation of cost of goods is averaged among the units of inventory. The two methods consist of weighted average, which is used in a perpetual system.
      
      Weighted Average--Periodic and/or Perpetual

      Total cost of goods available
      for sale during period		Average cost of goods available
      Total units of goods available	=	for sale during the period
      for sale during period

      
      
      Example:
      

      $32,200
      1,200	=	$26.83

      
      
      Cost of goods sold = 800 x 26.83 = $21,464
      Ending inventory = 400 x $26.83 = $10,732
      
      Moving Average--Perpetual

      Continuous or moving average assigns a unit value to cost of goods available for sale. In this scenario, the average cost determines cost of goods sold at the time of each sale. This method requires a calculation of average unit cost after each purchase as illustrated below.
      
      

      	# of Units	Cost per Unit	Total Cost	Moving Avg. Cost
      Beginning inventory, 7/1	200		$5,000	$25.00
      Purchase, 8/10	100	$26.00	2,600
      Inv. Balance	300	7,600		25.33
      Sale, 9/15	(100)	25.33	(2,533)
      Inv. Balance	200		5,067
      Purchase, 12/7	600	27.00	16,200
      Inv. Balance	800		21,267	26.58
      Sale, 12/18	(300)	26.58	(7,975)
      Inv. Balance	500		13,292
      Sale, 2/22	(250)	26.58	(6,645
      Inv. Balance	250		6,647
      Purchase, 3/20	300	28.00	8,400
      Inv. Balance	550		15,047	27.36
      Sale, 5/15	(150)	27.36	(4,104)
      Inv. Balance	400	27.36	10,943
      Ending Inventory	400	10,943
      Cost of Goods Sold	100	2,533
      	300	7,975
      	250	6,645
      	150	4,104
      	800	$21,257

      
      
      

   3. FIFO (First In First Out)

      Regardless of the actual physical flow of goods, FIFO is calculated by assuming that goods entering inventory first are sold first, and goods entering inventory last are sold last. In a sense, the earliest inventory costs are considered cost of goods sold and the latest are considered ending inventory. There is a FIFO method for both Periodic and Perpetual.
      
      FIFO--Periodic

      Ending inventory by physical count is 400 units.
      
      

      # of Units	Date Purchased	Cost Per Unit	Total Cost
      200	7/1/03	$25	$5,000
      100	8/10/03	26	2,600
      100	12/7/03	27	2,700
      			$10,300

      
      
      Cost of goods sold:
      

      	# of Units	Total Cost
      Goods available for sale	1,200	$32,200
      Less: Ending inventory	(400)	(10,300)
      Goods sold	800	$21,900

      
      
      FIFO--Perpetual

      Cost of goods sold:
      

      # of Units	Date Sold	Cost Per Unit	Total Cost
      100	9/15/03	$25.00	$2,500
      300	12/18/03	25.00/100
      		26.00/100
      		27.00/100	7,800
      250	2/22/04	27.00	6,750
      150	5/15/04	27.00	4,050
      800			$21,100

      
      
      Ending inventory:
      

      	# of Units	Total Cost
      Goods available for sale	1,200	$32,200
      Less: Goods sold	(800)	(21,100)
      Ending inventory	400	$11,100

      
      
      

   4. LIFO (Last In First Out)

      Regardless of the actual physical flow of goods, LIFO is calculated by assuming that goods entering inventory last are sold first, and goods entering inventory first are sold last. In a sense, the latest inventory costs are considered cost of goods sold and the earliest are considered ending inventory. There is a LIFO method for both Periodic and Perpetual.
      
      LIFO--Periodic

      Ending inventory by physical count is 400 units.
      

      # of Units	Date Purchased	Cost Per Unit	Total Cost
      200	7/1/03	$25	$5,000
      100	8/10/03	26	2,600
      100	12/7/03	27	2,700
      			$10,300

      
      
      Cost of goods sold:
      

      	# of Units	Total Cost
      Goods available for sale	1,200	$32,200
      Less: Ending inventory	(400)	(10,300)
      Goods sold	800	$21,900

      
      
      LIFO--Perpetual

      Date	Transaction	Cost of Goods Purchased	Cost of Goods Sold	Cumulative Balance of Inventory
      7/1/03	Beg. Inventory			200@$25=$5,000
      8/10/03	Purchase	100@$26=$2,600		100@$26=$2,600
      	Sub-total			$7,600
      9/15/03	Sale		100@$26=$2,600	100@$26=($2,600)
      12/7/03	Purchase	600@$27=$16,200		600@$27=$16,200
      	Sub-total			$21,100
      12/18/03	Sale		300@$27=$8,100	300@$27=($8,100)
      	Sub-total			$13,100
      2/22/04	Sale		250@$27=$6,750	250@$27=($6,750)
      	Sub-total			$6,350
      3/20/04	Purchase	300@$28=$8,400		300@$28=$8,400
      	Sub-total			$14,750
      5/15/04	Sale		150@$28=$4,200	150@$28=($4,200)
      	Total		$21,650	$10,550

      Perpetual                    Total Cost of Goods sold = $21,650       End Inv. = $10,550

      
      
      

   5. Retail Method

      The retail method estimates the dollar amount of ending inventory, and is acceptable for external reporting if it yields results that reasonably approximate the result that would have been obtained under one of the cost flow methods.

      The simple form of the Retail Method requires the following:
      

      1. Cost and retail beginning inventory selling prices.
      2. Cost and retail current period purchases.
      3. Retail sales for period.

      Data used in the Retail Method example:	Cost	Retail
      Beginning inventory	$11,000	$12,000
      Purchases	50,000	60,000
      Sales		70,000
      Method:
      Beginning inventory	11,000	12,000
      Purchases	50,000	60,000
      Goods available for sale	61,000	72,000
      Less: Sales		(70,000)
      Estimated ending inventory at retail		$  2,000
      Estimated ending inventory at cost (2,000 x 85%*)	1,700
      *Cost-to-retail percentage: 61,000 / 72,000 = 85%

      
      
      The following are possible complications that should be considered:
      

      • Freight in: Added to the cost column as an addition to purchases.
      • Purchase allowances: Subtracted from the cost column from purchases.
      • Purchase returns: Should be deducted from both the cost and retail sides.
      • Purchase discounts: Should be deducted in the cost side if purchases are recorded as gross amounts.
      • Sales returns and allowances: Should be subtracted from sales on the retail side if sales are recorded as gross amounts.
      • Employee discounts: The employee discount should be added to sales on retail side if sales to employees are recorded net of employee discounts.
      • Normal spoilage: Should be subtracted from goods available on retail side after the cost-to-retail percentage is calculated.
      • Abnormal spoilage: Should be subtracted from cost and retail before the cost-to-retail percentage is calculated.

      Variations of the Retail Inventory Method

      To provide estimates of inventory by using average cost, FIFO and LIFO. They differ by the calculations included in the cost-to-retail percentage.
      
      Average Cost: Percentage includes cost and retail for beginning inventory and net purchases that are adjusted for net markups and markdowns.
      
      FIFO: Percentage excludes cost and retail for beginning inventory and includes net markups and markdowns. Goods available for sale include cost and retail for beginning inventory.
      
      LIFO: Separate percentage is calculated for beginning inventory and net purchases. The cost-to-retail percentage for net purchases includes net markups and markdowns. LIFO layers are accounted for and identified.
      
      

Inventory – Inventories are asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold.

Cost of Goods Sold (COGS) – COGS is the difference between the cost of goods available for sale during the period and the cost of goods on hand at the end of the period.