Financial Accounting: In an Economic Context

ACQUIRING INVENTORY: WHAT COSTS TO CAPITALIZE?

Inventory costs are capitalized because inventories are assets that provide future economic benefits. When inventories are sold, these benefits are realized. According to the matching principle, the capitalized cost should at this time be matched against the revenue recognized from the sale. Determining the amount of capitalized cost involves two steps: The number of items or units that belong in inventory must first be determined, and then costs must be attached to each item.

What Items or Units to Include?

Decisions as to what items or units to include in inventory are governed by a general rule. However, the general rule is not always simple to apply.

GENERAL RULE

Items should be included in a company's inventory if they are being held for sale and the company has complete and unrestricted ownership of them. Such ownership indicates that (1) the company bears the complete loss if the inventory is lost, stolen, or destroyed and (2) the company owns all rights to the benefits produced by the items.

In most cases, ownership is accompanied by possession: Companies that own inventory are usually in possession of it. Under these circumstances, determining the number of units that belong in inventory is straightforward: The number of inventory units on the company's premises can simply be counted. In some cases, however, ownership is not accompanied by possession, and it becomes somewhat more difficult to find and determine the appropriate ...