Chapter Seven

INVENTORIES

Reference to the inventory of the Blank Manufacturing Company, on page 51 of Chapter Four, will show that the inventory is made up as follows: Finished stock, $80,000.00; materials and stock in process, $55,000.00.

1. ACCOUNTING THEORY

Book Inventories. There is a growing tendency on the part of manufacturing and trading concerns to keep a merchandise stock ledger, commonly known as a "running" or "going" inventory. Every business firm keeps a record of cash regardless of what other records are kept. It is difficult to understand why it isn't just as important to keep an accurate record of merchandise as it is of cash. Without a doubt, the loss from thefts and misappropriation of merchandise amounts to more in a year than embezzlements of cash amount to in a decade. It is a well known fact that merchandise, worth millions of dollars, is carried away annually by employees and others because they know it will never be discovered. In the face of these facts, it would seem to be equally important to keep an accurate record of all merchandise, whether the business is a trading or a manufacturing concern.

Without the waste of time, labor and delay incident to stocktaking, the manufacturer and trader should, at all times, know exactly how he stands concerning the amount and value at cost price of all stock on hand, whether it be raw material, goods in process of manufacture, or finished goods.

If a separate merchandise stock ledger is kept, then it will be necessary to maintain a controlling account in the general ledger the same as for any other subsidiary ledger. The accounts in the merchandise stock ledger will usually show on the debit side quantities purchased, cost per unit and amount; on the credit side quantities sold, cost per unit and cost of quantity sold. A balance column is also provided so that there is shown quantities on hand, cost per unit and total amount or value at cost price. Where prices are subject to fluctuations or have fluctuated considerably, the average cost and amount is often used. It is better, however, to use the exact cost per unit and exact amount where it can be ascertained, and it usually can be ascertained.

Physical Inventories. Whether or not a book inventory is maintained, it is important that at least once a year, and oftener in some cases, a physical inventory be taken. For the same reason that cash is counted to verify the cash book balance so an inventory should be taken to verify the result shown by the stock records. In the event that there is a differentiation between the physical and book inventories, it should be of as great concern as a shortage of cash. Isn't it a fact that merchandise represents money's worth? If a cashier is short in his cash, he must pay it out of his pocket or the proprietor must pay it out of his capital. Why should not the liability of either the store-keeper or stock-keeper be regarded in the same light as is the cashier with respect to responsibility?

At the present time most accounting firms agree that the inventory should be taken at cost price or market price, whichever may be the lower, but in no event should it be taken at a price higher than the actual cost price. An exception to this general theory is the following, quoted from Paul Joseph Esquerre*:

"The inventory of a trading concern should be valued at cost. It has been held that it is proper to compute it on the basis of the market value, if such a value is smaller than cost; but it is generally denied that a market value higher than cost can be used. If the lower value is allowed, there is no reason why the higher one should not be. There is, however, a good reason why market values should not be used at all. Accounting is not interested in what would have happened 'if', but in what has actually happened; and since the goods unsold were purchased at a certain price, the profits realized are to be measured by comparing that price with the proceeds. To reduce the inventory to a value lower than cost, is to add to the cost of the goods sold during the period; and to raise the inventory to a value greater than cost, is to reduce the cost of the goods during the period. In either case, the result is contrary to the truth."

A quotation from William R. Basset's "Accounting as an Aid to Business Profits" is to be contrasted with the above:

"The rules for values are arbitrary and, to some extent, unreasonable, but they are accepted everywhere and bankers. look askance at any departure from them. Here they are: 1. "Value at cost.

2. "If the cost is above the market, then value at the market.

3. "If the cost is below the market, do not raise the valueskeep them still at cost.

"It is not logical to bring down cost to the market and at the same time refuse to raise the inventory if the market is above the cost; but the procedure is so established that it should not be departed from. And also it does prevent a mere bookkeeping profit from appearing as an actual profit. An excellent practice is to value according to the above rules and attach a *Author of "Applied Theory of Accounts."

footnote showing the increased values according to market prices. This gives the necessary information without inflation."

The latter seems to be the more general procedure and throughout this course there will be noted the fact that all inventories have been taken at cost or market value, whichever is the lower.

In some cases there would seem to be just cause for taking an inventory at a price exceeding the cost price. For instance, in determining the value of stock on hand at the time of the sale of a business, the inventory may be taken at market price, even though it be above cost price. In any event, if an auditor were asked to certify to a statement in which the inventory had been taken at a price higher than cost price, the fact should be noted either in the Balance Sheet or as a footnote to it. In a manufacturing business the inventory will usually be subdivided into three parts as follows:

The method of taking the inventory will not vary from the standpoint of valuation from that of a trading concern. All stock regardless of what stage it may be in should be priced at cost or market, whichever may be the lower. The cost price of raw materials can always be determined from the purchase records. The price of goods in process will not be so easily determined. During the process of manufacturing the cost increases until at the time the goods are finished they represent to the manufacturing concern the same as merchandise does to the trading concern. In other words, the finished goods of the manufacturer is the stock-in-trade. There are three items of cost to consider in determining the inventory value of goods in pro

cess:

1. Cost price of raw materials consumed.

2.

Direct labor.

3. Factory overhead or manufacturing expenses.

The inventory value of finished goods will be the same as the cost of production. The cost of production here is to the manufacturer what the cost of merchandise purchased is to the merchant.

Turnover. The rate of "turnover" is the number of times a firm "turns" its stock during the year. For instance, when a stock of goods has been purchased and has been sold, it is known as a turnover; if the money is reinvested in another stock of goods and this is disposed of within the year, there is said to have been a second turnover. The process of determining the rate of turnover seems to vary with different authorities. Montgomery says:

"To ascertain the turnover, take the starting inventory, add the purchases or cost of manufactured goods, and deduct the inventory at the end; divide the total by the starting inventory. The calculations are based upon a normal inventory.

The result will be the number of times the capital invested in stock-in-trade has been turned over during the period."

It will, therefore, be seen that according to Mr. Montgomery's idea the turnover would be found by dividing the COST OF SALES by the beginning inventory, provided that inventory is a normal inventory. In order to determine whether it is a normal inventory or not, it would be best to average the inventory for a period of years If the inventories for a period of, say, five years were used in determining the average, and it approximated the same as the inventory for the present year, then it will be seen that it constitutes a normal inventory. This seems to be the more uniform practice. However, it is well to give consideration to what others have to say on the matter. Walton says:

'If we adopt working capital as the basis of the turnover the difficulty disappears, because the amount of working capital is indicated in the Balance Sheet, if we adopt the definition of working capital as that part of the proprietorship not tied up in fixed assets, in other words, the excess of current assets over current liabilities. Except as affected by the slight increase due to accumulating undistributed profits, it remains the same throughout the entire period and therefore affords a stable basis of comparison.

"The use of working capital as the basis of turnover is logical because it was put in the business for the purpose of being turned over as rapidly as possible, because it is virtually constant, and because it represents all the elements concerned in the turnover-not only the stock-in-trade, but also the accounts and notes receivable that are the means by which the turnover is effected."

The difficulty with this theory lies in determining the meaning of the term "working capital." H. R. Hatfield* says:

"Working capital has long had a specific meaning as a collective term for what are often called quick assets, e. g., cash, accounts receivable, perhaps merchandise, etc."

H. C. Bentley says: "Working capital is the excess of quick assets over quick liabilities."

Walton considers Bentley's definition as the correct one. At any rate, he further says: "It is in my opinion the accounting view of what capital is." Therefore, the whole problem is narrowed down to the question as to whether we are to consider the normal inventory as the basis of a turnover, or whether we are to consider the working capital as the basis. It is unfortunate that accountants cannot find some means for arriving at uniformity in practice with reference to the more important accounting principles.

Determining the Value of Merchandise Destroyed by Fire. All business men anticipate the possibility of a fire, but few give thought to how they will collect their insurance. Frequently settlement must be made upon a basis satisfactory only *Author of "Modern Accounting."

†Author of "Science of Accounts."

to the insurance company for the reason that the business man is unable to prove what has been destroyed and the value thereof.

A properly authenticated Balance Sheet certified to by a public accountant is a material aid in the adjustment of claims as has often been demonstrated in practice. Where an inventory is not available at the time of fire, the claim is usually adjusted by using the "gross trading profit" test. The average gross trading profit in prior periods is used as the basis of determining the cost of sales. Deduct the average gross trading profit from sales and the result is the cost of sales. Having determined this, take the last known or recorded inventory, add purchases to date of fire and deduct cost of sales. The result is the inventory at time of fire. If a perpetual inventory has been maintained and the last Balance Sheet prepared by a Certified Public Accountant, no compromise with the insurance company need be made, but allowance for the full amount of the claim may be insisted upon.

2. AUDITING THEORY

Quoting from Federal Reserve Bulletin:

Inventory Must Include Only Goods Owned. "Under this caption must be included only stocks of goods owned and under control of the owner. Stocks are often hypothecated and if this is the case the fact should be stated on the Balance Sheet. Beginning Inventory Must Be Verified. "Inasmuch as the accuracy of the Profit and Loss account is absolutely dependent upon the accuracy of the inventories of merchandise at the beginning and end of the period under review, this part of the verification should receive special attention. When a Balance Sheet audit is being made for the first time, the inventory at the beginning of the period should receive as much attention as that at the end, and the auditor should take every precaution to satisfy himself that both inventories were taken on the same basis.

Audit Program. "An acceptable program of audit for inventories is as follows:

Stock Sheets. "(1) Secure the original stock sheets if they are in existence and carefully test the typewritten copies with them and with tickets, cards, or other memoranda that show the original count.

Inventory Certificate. "(2) See that the sheets are certified to or initialed by the persons who took the stock, made the calculations and footings, and fixed the prices, and satisfy yourself that they are dependable and responsible persons. Obtain a clear and detailed statement in writing as to the method followed in taking stock and pricing it; also a certificate from a responsible head as to the accuracy of the inventory as a whole.

Footings and Extensions. "(3) A thorough test of the accuracy of the footings and extensions should be made, especially of all large items.