Identify the items making up merchandise inventory. Merchandise inventory refers to goods owned by a company and held for resale. Three special cases merit our attention. Goods in transit are reported in inventory of the company that holds ownership rights. Goods on consignment are reported in the consignor's inventory. Goods damaged or obsolete are reported in inventory at their net realizable value.

Identify the costs of merchandise inventory. Costs of merchandise inventory include expenditures necessary to bring an item to a salable condition and location. This includes its invoice cost minus any discount plus any added or incidental costs necessary to put it in a place and condition for sale.

Analyze the effects of inventory methods for both financial and tax reporting. When purchase costs are rising or falling, the inventory costing methods are likely to assign different costs to inventory. Specific identification exactly matches costs and revenues. Weighted average smooths out cost changes. FIFO assigns an amount to inventory closely approximating current replacement cost. LIFO assigns the most recent costs incurred to cost of goods sold and likely better matches current costs with revenues.

Analyze the effects of inventory errors on current and future financial statements. An error in the amount of ending inventory affects assets (inventory), net income (cost of goods sold), and equity for that period. Since ending inventory is next period's beginning inventory, an error in ending inventory affects next period's cost of goods sold and net income. Inventory errors in one period are offset in the next period.

Assess inventory management using both inventory turnover and days' sales in inventory. We prefer a high inventory turnover, provided that goods are not out of stock and customers are not turned away. We use days' sales in inventory to assess the likelihood of goods being out of stock. We prefer a small number of days' sales in inventory if we can serve customer needs and provide a buffer for uncertainties.

Compute inventory in a perpetual system using the methods of specific identification, FIFO, LIFO, and weighted average. Costs are assigned to the cost of goods sold account each time a sale occurs in a perpetual system. Specific identification assigns a cost to each item sold by referring to its actual cost (for example, its net invoice cost). Weighted average assigns a cost to items sold by dividing the current balance in the inventory account by the total items available for sale to determine cost per unit. We then multiply the number of units sold by this cost per unit to get the cost of each sale. FIFO assigns cost to items sold assuming that the earliest units purchased are the first units sold. LIFO assigns cost to items sold assuming that the most recent units purchased are the first units sold.

Compute the lower of cost or market amount of inventory. Inventory is reported at market cost when market is lower than recorded cost, called the lower of cost or market (LCM) inventory. Market is typically measured as replacement cost. Lower of cost or market can be applied separately to each item, to major categories of items, or to the entire inventory.

Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and weighted average. Periodic inventory systems allocate the cost of goods available for sale between cost of goods sold and ending inventory at the end of a period. Specific identification and FIFO give identical results whether the periodic or perpetual system is used. LIFO assigns costs to cost of goods sold assuming the last units purchased for the period are the first units sold. The weighted average cost per unit is computed by dividing the total cost of beginning inventory and net purchases for the period by the total number of units available. Then, it multiplies cost per unit by the number of units sold to give cost of goods sold.