Chapter 8
Inventory Valuation
237
Methods of Estimating Inventory
In a perpetual inventory system, a company maintains a continuous record of the changes to
inventory.This means that, at any given point in time, a company can take an instant snapshot of
its inventory value, including the amounts for cost of goods sold and ending inventory. Modern
scanning and computer technology can help a company update its financial situation quickly and
accurately.
Alternatively, a periodic inventory system poses greater challenges in obtaining up-to-date
inventory information, since the value of the inventory cannot be tracked from start to finish.
Taking a physical count of inventory can be very costly, therefore a physical count may be done
only for year-end reports. If inventory values are required at other times for internal reporting, they
will have to be estimated.
We will examine two methods of estimating inventory under a periodic inventory system: the gross
profit method and the retail method.
The Gross Profit Method
The
gross profit method
uses a company’s gross profit figure to estimate the value of inventory.
More specifically, a company analyzes the gross profit numbers of prior years to come up with a
current gross profit number to apply to estimation figures.
Every now and then, you might see the term:
pro forma
financial statements. Simply stated, these are
statements prepared by a company that do not necessarily adhere to ASPE nor IFRS.
There are various reasons why companies prepare such reports. They can be used in an informal way
to temporarily guide managerial decision-making. They can also be used to present financial figures in a
way that at times might be distorted by accounting principles. For example, costs associated with a previous
accounting scandal must be included in formal reports, yet such numbers may inaccurately reflect how the
company is currently performing.
Pro forma
statements can provide the public with a clearer snapshot of current organizational performance.
In fact,
pro forma
financial figures were reported publicly and often during the dot.com boom of the late
1990s. However, regulators began to crack down on such practices, since even
pro forma
statements have
their limitations and are not a substitute for documents that adhere to ASPE or IFRS. For example, critics of
pro forma
statements argue that financial stresses from previous periods happen often and are part of the
capitalist economic system. Leaving them out can itself be a distortion of a company’s status and not fully
reflect its performance.
Nevertheless,
pro forma
financial statements serve as a tool for company management when it wants a
financial snapshot of the company that isn’t as formal, or potentially cumbersome, as accounting principles
require.
INTHE REAL WORLD
Other figures a company needs to complete the gross profit method that can be taken from the
general ledger are: sales, opening inventory and purchases. Once an accountant has these numbers,
then the rest of the numbers needed to estimate inventory can be determined.
