Inventory Expense Recognition

Mastering Inventory Expense Recognition | CFA Level I FSA

In this lesson, we’ll dive into expense recognition, focusing on inventory expenses. Ready? Let’s jump in!

Inventory Expense Recognition: An Introduction

Expenses are subtracted from revenue to calculate net income. Under accrual accounting, revenue is recorded when earned, regardless of cash payment. But when should we record the expenses for a sale?

Expense recognition is based on the matching principle, where expenses are recognized in the same period as the revenue they generate. Let’s examine this through the lens of inventory.

Inventory: A Practical Example

EXAMPLE

A shoe retailer uses $1000 cash to buy 10 shoes from a manufacturer. Cash decreases by $1000, an inventory increases by $1000. When the 10 shoes are sold for $3000 on credit, sales revenue of $3000 is recorded. Using the matching principle, the expense (cost of goods sold) of $1000 is recognized in the same period. In the balance sheet, inventory is reduced by $1000, and accrued revenue is increased by $3000. The company earns a gross income of $2000.

Methods of Inventory Expense Recognition

Inventory expense recognition can be more complicated. Here are some methods:

  • Specific Identification Method: Used when a firm can track the exact items sold and remaining in inventory.
  • First-In, First-Out (FIFO): Assumes the first item purchased is the first item sold. Appropriate for perishable inventory with limited shelf life.
  • Last-In, First-Out (LIFO): Assumes the last item purchased is the first item sold. Appropriate for inventory that doesn’t deteriorate with age. Note: LIFO is prohibited under IFRS.
  • Weighted Average Cost Method: Makes no assumption about the physical flow of inventory. Easy to use and calculates the cost per unit by dividing the cost of available goods by total units available.

Working Through an Example

EXAMPLE

A furniture retailer’s inventory data requires calculation of cost of goods sold and ending inventory for January to June under FIFO, LIFO, and weighted average cost methods.

To calculate the cost of goods sold and ending inventory, we’ll use the total cost of all goods available, which is $530.

In an inflationary environment, FIFO will have the lowest cost of goods sold, followed by weighted average, with LIFO having the highest. LIFO is popular for its income tax benefits, as it results in lower taxable income and therefore lower income taxes.

Expense Recognition for Sales on Credit and Warranty

For sales on credit or with warranties, the matching principle requires firms to estimate bad debt expense and/or warranty expense. This ensures that the expense is recognized in the period of the sale, rather than at a later date. However, there are some challenges with this approach.

Shortcomings and Manipulation in Expense Recognition

When estimates are required, there’s potential for manipulation. By altering the expense estimates, firms can increase or decrease their net income for the current accounting period. For example:

  • Bad debts expense: An estimate of how much revenue earned on credit sales will not be realized in the future.
  • Warranty expense: An estimate of sales revenue that will be lost in the future to provide warranty services for goods sold.

If a firm lowers these estimates or has estimates that don’t align with industry standards, it may imply more aggressive accounting. Analysts should question the justification behind these estimates.

Wrapping Up Inventory Expense Recognition

That’s it for inventory expense recognition! We’ve covered the matching principle, practical examples, various methods of inventory expense recognition, and potential manipulation in expense recognition. Next up, we’ll explore depreciation and amortization expenses.

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