In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual inventory

system. In this chapter, we explain the methods used to calculate the cost of inventory on hand at the statement of financial position date and the cost of goods sold.
The content and organization of this chapter are as follows.

Finished goods
Work in process
Raw materials

Regardless of the classification, companies

report all inventories
under Current Assets on
the statement of
financial position.

Taking a physical
inventory
Determining
ownership of
goods

Specific
identification
Cost flow
assumptions
Financial statement
and tax effects
Consistent use
Lower-of-cost-ornet realizable value

Income statement
effects
Statement of
financial position
effects

Presentation
Analysis using
inventory turhover

How a company classifies its inventory depends on whether the firm is a merchandiser
or a manufacturer. In a merchandising company, such as those described in Chapter 5,
inventory consists of many different items. For example, in a grocery store, canned
goods, dairy products, meats, and produce are just a few of the inventory items on
hand. These items have two common characteristics: (1)They are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary course of
business. Thus, merchandisers need only one inventory classification, merchandise
inventory, to describe the many different items that make up the total inventory.
In a manufacturing company, some inventory may not yet be ready for sale. As
a result, manufacturers usually classify inventory into three categories: finished
goods, work in process, and raw materials. Finished goods inventory is manufactured items that are completed and ready for sale. Work in process is that portion
of manufactured inventory that has been placed into the production process but is
not yet complete. Raw materials are the basic goods that will be used in production
but have not yet been placed into production.
For example, Caterpillar (USA) classifies earth-moving tractors completed
and ready for sale as finished goods. It classifies the tractors on the assembly line in
various stages of production as work in process. The steel, glass, tires, and other
components that are on hand waiting to be used in the production of tractors are
identified as raw materials.
By observing the levels and changes in the levels of these three inventory types,
financial statement users can gain insight into management's production plans. For
example, low levels of raw materials and high levels of finished goods suggest that
management believes it has enough inventory on hand, and production will be
slowing down-perhaps in anticipation of a recession. On the other hand, high levels
of raw materials and low levels of finished goods probably indicate that management
is planning to step up production.