Question

FASB ASC 8‐3 Inventory

Search the FASB ASC database to determine the accounting objective of accounting for inventory, and cite the paragraph number. Cite the original pronouncement that stated this objective.

Answer 1

3. Objectives of Inventory Measurement:

The measurement of inventory has a significant effect on income determination and financial position of a business enterprise.

The American Institute of Certified Public Accountants (USA) states:

“A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.”

It is significant to observe that a direct relationship exists between cost of goods sold and closing inventory. Costs of goods sold is measured by deducting closing inventory from cost of goods available for sale. Because of these relationships, it may be said that the higher the cost of closing inventory, the lower the cost of goods sold will be and the higher the resulting net income.

On the contrary, the lower the value of closing inventory, the higher the cost of goods sold and the lower the net income. Items which are not in the closing inventory are considered as sold and become the part of cost of goods sold.

In this way, measurement of closing inventory influences the income statements (through influencing cost of goods, and net income) and balance sheet because inventory appears as current assets on the balance sheet.

Also, closing inventory influences net income of not only the current period but it also influences the net income of the next accounting period because closing inventory of the current period becomes the opening inventory for the next period and thus becomes cost of goods sold.

Since closing inventory determines cost of goods sold, the most common objective of inventory measurement is the attempt to match costs with related revenues in order to compute net income within the traditional accounting structure. The relationship of inventories to the process of income measurement is similar to the common characteristics of prepaid expenses and plant and equipment.

The expression matching costs against revenues means determining what portion of the cost of goods available for sale should be as cost of the period and deducted from the revenue of the current period and what portion should be carried (as inventory) to be matched against the revenue of the following period.

Other things remaining the same, i.e., if all other items appearing on an income statement are constant and also income tax rates do not change, any change in the amount of closing inventory will bring similar change in the amount of reported net income. This is illustrated in the following data taken to explain this situation.

In the above example, it can be noticed that in all four situations, (A, B, C, D) sale, opening inventory, purchases are identical. As the value of closing inventory changes among the four situations, net income also changes, to the extent the closing inventory increases or decreases. For instance, closing inventory increases by Rs. 2 lakhs from situation A to B, from B to C, C to D, so net income also goes up by Rs. 2 lakhs.

A second objective of inventory measurement is to state the fair value of inventory which appears as current assets on the balance sheet. This, along with other assets, reflect the value of assets to the firm and in turn, the financial position of a business enterprise.

Further, the value of inventory will help permit inventory and other users to predict the future cash flows of the firm. This can be accomplished from two points of view.

First, the amount of inventory resources available will support the inflow of cash through their sale in the ordinary course of business.

Second, the amount of inventory resources available will, under normal circumstances, have an effect on the amount of cash required during the subsequent period to acquire the merchandise that will be sold during the period.