Chapter 7 Notes

Inventory and Cost of Goods Sold

 Many companies are in the business of selling goods, rather than services
 Manufacturers produce and sell goods, wholesalers purchase and resell completed goods, and
retailers sell those goods directly to the public
 In accounting, these goods are referred to as Inventory and classified as current assets
- Inventory – tangible property that is (1) held for sale in the normal course of business or
(2) used in producing goods or services available for sale
 The nature of the company’s business will dictate the type of inventory they maintain
- Merchandisers (wholesale/retail) hold merchandise inventory, which are goods or
merchandise held for sale in the ordinary course of business that are acquired in a
finished condition and are ready for sale
- Manufacturers hold 3 types of inventory:
1. Raw Materials – items acquired for processing into finished goods; they remain in
Raw Materials Inventory until used and transferred to Work in Process Inventory
2. Work in Process – goods in process of being manufactured, but not yet complete
3. Finished Goods – manufactured goods that are complete and ready for sale
 Once a company sells inventory, the associated expense that must be matched to the related
revenue is called the Cost of Goods Sold (COGS)
 There are 3 stages of the inventory cycle we must consider:
1. Determining initial cost of inventory
2. Allocating costs between goods sold and goods remaining in inventory
3. Evaluating the net realizable value of inventory-on-hand

1. Determining Initial Cost of Inventory

 Goods are initially recorded at the sum of all costs incurred to bring the inventory to a usable
or salable condition and location
 Costs typically include:
- Invoice Price (cost to obtain raw materials or finished goods from third party)
- Plus: Purchase-related expenditures
 Freight-in (cost to ship goods to the business)
 Inspection costs (cost to check purchased goods are complete and in good condition)
 Preparation costs (e.g., costs to unpack and shelve goods)
- Plus: Manufacturing expenditures (for manufacturers only)
 Direct labor (earnings of employees working directly to produce manufactured good)
 Factory overhead (manufacturing costs not directly related to the invoice price or
labor, such as supervisor salaries and factory utility expenditures)
- Less: Purchase returns and allowances (unsatisfactory goods returned/discounted)
- Less: Purchase discounts (reductions to invoice price for early payment)
 These costs are accumulated in the inventory accounts (Dr asset) until they are ready for sale
 All costs after inventory is ready for sale (e.g., freight-out, marketing) are typically included
in the Selling, General, and Administrative Expense (SGA) account
 Allocation to COGS vs. SGA matters for determining Gross Profit (Net Sales – COGS)

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2. Allocating Costs between Goods Sold and Ending Inventory

 When goods are sold, they are removed (credited) from the Inventory account and the cost of
“using up the asset” is recorded (debited) as the Cost of Goods Sold in the period of the sale
 COGS is determined using the COGS equation, which is derived from the T-account
- COGS = Beginning Inventory (BI) + Purchases (P) – Ending Inventory (EI)
- Note: BI + P = Cost of Goods Available for Sale (COGAS)

+ Inventory -
Beginning Inventory (BI)
Purchases (P) Cost of Goods Sold (COGS)
Ending Inventory (EI)

 Determining COGS would be simple if the cost of the goods remained the same over the
period, but they typically fluctuate, so managers must determine how to allocate inventory
costs between the goods that are sold and those remaining in inventory
 Some companies are able to track each specific item in inventory, so they know exactly what
costs go into COGS vs. ending inventory, but most will need to apply an assumption
 Cost flow assumptions are not necessarily based on the actual physical flow of goods, but are
simply an assumption applied to make accounting simpler and more consistent
 There are 4 generally accepted inventory costing methods (2-4 require assumptions)
1. Specific Identification Method
- Cost method that identifies the cost of each specific item sold (no assumptions!)
- Requires keeping track of the purchase cost of each item and knowing when it’s sold
- Impractical when a company sells large quantities of similar items
- May make sense for companies that sell low volumes of unique goods (e.g., jewelry)
- Calculation:
 COGS = cost of specific goods sold
 EI = cost of specific goods left in inventory
2. First-In, First-Out (FIFO)
- Assumes the earliest goods purchased (oldest) are the first goods sold  COGS
- Assumes the most recently purchased goods (newest) are left  EI
- Calculation:
 First determine the number of goods sold and how many are left in inventory
 COGS: Start with the oldest goods purchased and work down toward the newer
goods, accumulating costs (quantity sold x unit price) of each until you reach the
number of goods sold
 EI: Continue accumulating costs from where you left off for COGS through the
newest goods purchased – or – subtract COGS from the total COGAS
3. Last-In, First-Out (LIFO)
- Assumes most recently purchased goods (newest) are the first goods sold  COGS
- Assumes the earliest purchased goods (oldest) are left  EI
- Calculation:
 First determine the number of goods sold and how many are left in inventory

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  COGS: Start with the newest goods purchased and work up toward the older
goods, accumulating costs (quantity sold x unit price) of each until you reach the
number of goods sold
 EI: Continue accumulating costs from where you left off for COGS through the
oldest goods purchased – or – subtract COGS from the total COGAS
4. Average Cost Method
- Uses the weighted average unit cost of the goods available for sale for COGS and EI
- The average is considered weighted because it factors in how many units are
available at each cost rather than just taking an average of all available costs
- Weighted Average Cost = COGAS/# Units Available for Sale
- COGAS = Sum of #Units x Unit Cost for each purchase date
- Calculation:
 Calculate Weighted Average Cost
 Determine the number of goods sold and how many are left in inventory
 COGS: Multiply Weighted Average Cost by the number of goods sold
 EI: Multiply Weighted Average Cost by the number of goods left in inventory
 When calculating COGS and EI for FIFO, LIFO, or Average Cost, it is helpful to set up a
table with the following information:

FIFO Date of Purchase # Units Unit Price Total Cost

Beginning Inventory a $x $a*x
Midyear Purchase b $y $b*y
Last Purchase c $z $c*z
LIFO Goods Available for Sale a+b+c $a*x + $b*y + $c*z
Ending Inventory m ?
Goods Sold a+b+c–m ?
Note: Average Cost = ($a*x + $b*y + $c*z)/(a + b + c)

 Manager’s choice of inventory cost method is less likely to be related to the physical flow
of goods and more likely related to their tax policy
- In times of increasing costs ($z > $y > $x), LIFO will lead to higher COGS and lower EI
because the more recent, higher costs are all assigned to COGS and older, lower costs are
assigned to EI
- In times of decreasing costs ($x > $y > $z), FIFO will lead to higher COGS and lower EI
because the older, higher costs are all assigned to COGS and more recent, lower costs are
assigned to EI
- Higher COGS decreases Net Income because it is an expense
- While managers generally want to increase Net Income, they do not want to do so by
paying higher taxes, which is cash they can no longer use to invest in the company
- Managers typically follow a “least-latest” rule of thumb for taxes, meaning they want to
pay the lowest amount allowed by the law as late as possible
- Therefore, managers will often choose to use LIFO for tax purposes in times of
increasing costs (lower net income  lower cash taxes paid)
- US GAAP requires that companies that use LIFO for tax purposes must also use it for
financial reporting, while IFRS does not allow the use of LIFO at all
- Companies must be consistent in their assumption choice and justify any changes

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 Reporting inventory costing methods in the financial statements
- Companies typically report their chosen costing method in the Notes
- US GAAP requires companies that use LIFO to report the difference between LIFO and
FIFO for beginning and ending inventory balances if the difference is material
- The difference between LIFO and FIFO inventory is called the LIFO Reserve
 LIFO Reserve = FIFO Inventory – LIFO Inventory
- The difference between the beginning and ending LIFO Reserve is equal to the difference
in COGS between the two methods for the period
 COGS Difference = Beginning LIFO Reserve – Ending LIFO Reserve
- Companies also have to consider the tax effect of using LIFO on Net Income (recall that
using LIFO saves the company on taxes if costs are rising)
 Tax Difference = COGS Difference x Tax Rate
- Convert the Income Statement from LIFO to FIFO by adding the COGS Difference
(recall that COGS is lower under FIFO, so Income increases) and subtracting the Tax
Difference (lower COGS  higher pre-tax income  higher taxes  lower net income)
 FIFO Net Income = LIFO Net Income + COGS Difference – Tax Difference
- Convert the Balance Sheet from LIFO to FIFO by substituting the FIFO value of
Inventory for the LIFO value or just adding the LIFO Reserve to the balance
 Accounting system considerations
- Inventory accounting systems help managers by providing:
1. Accurate information to prepare periodic financial statements and tax returns
2. Up-to-date information on quantities and costs for ordering/manufacturing decisions
3. Information needed to protect inventory from theft or misuse
- Based on their needs, managers may choose to use a perpetual or period inventory system
1. Periodic Inventory System
 COGS and EI are determined at the end of the accounting period
 EI is determined from a period-end physical count of what is left
 COGS is calculated using the COGS equation after count is complete
 Primary disadvantage is lack of up-to-date information about inventory levels
2. Perpetual Inventory System
 Inventory is adjusted with each purchase and sale during the period
 COGS is recorded at the time of the sale (Dr COGS / Cr Inventory)
 Maintains a record of inventory-on-hand (quantity and cost) at any point in time
 Perpetual systems are necessary at almost all businesses nowadays
- FIFO inventory balances are identical under a periodic or perpetual inventory system
since the cost is always drawn from the oldest inventory on hand
- LIFO inventory balances (and therefore COGS) are different under periodic and
perpetual systems because a periodic system uses costs from the end of the period while a
perpetual system would use the latest cost at the time of the sale (typically lower)
- Similarly, average cost balances would be different under the two systems because the
average cost changes as purchases are made and goods are sold under a perpetual system
- Many LIFO companies that use a perpetual system will record sales transactions at the
time of the sale using FIFO or average cost and then record an adjusting entry at period-
end to true-up Inventory and COGS balances to the periodic LIFO amount

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3. Evaluating the Net Realizable Value of Inventory-on-Hand

 In line with Historical Cost Principle, inventory is initially recorded at cost (discussed earlier)
 Conservatism constraints force us to depart from this principle at period-end
- Conservatism is special care to avoid overstating assets and income
 Every period, managers must determine if they will be able to sell inventory at or above cost,
otherwise they will not have the probable future economic benefit the inventory asset implies
 This implies that inventory is valued at the lower of cost or market (LCM)
- LCM is a valuation method where a loss is recognized if the net realizable value (NRV)
is less than cost (not in line with the Cost Principle!)
- NRV = Expected sales price – Selling costs
 If NRV of goods in EI < cost recorded in the books, then NRV is assigned as the new cost
and a “holding loss” is immediately recorded (Dr COGS / Cr Inventory)
 Note: US GAAP does not allow recognition of “holding gains”
 If inventory is written down, COGS will be higher in the current period (due to write-off
expense) and lower in the next period (new lower cost basis), effectively transferring COGS
from the period of sale to the write-down period
 LCM valuation is especially important for companies in the technology sector (costs are
often decreasing and inventory quickly becomes obsolete) and those selling seasonal goods
(values drop rapidly after the applicable season)

Inventory Management
 Primary goals of inventory management are to have sufficient quantities of high quality
inventory available to serve customer needs while minimizing costs of carrying inventory
- Inventory management is needed to prevent theft (inventory is 2nd most vulnerable asset)
- Inventory management is crucial to avoid costs of stock-outs and overstock
 Companies need controls to safeguard assets and provide up-to-date information
 Key Controls over Inventory
- Separate responsibility for inventory accounting and physical handling of inventory
- Storage of inventory in a manner that protects it from theft
- Limiting access to inventory to authorized personnel
- Maintaining perpetual inventory records
- Comparing perpetual records to periodic physical counts of inventory
 What happens when there are errors in the physical count of inventory?
- Items not included in EI are assumed to be sold and included in COGS
- If EI is overstated  COGS understated  Net Income and Taxes overstated
- If EI is understated  COGS overstated  Net Income and Taxes understated
- Next period will also be affected because it will start with the incorrect BI balance
- Correct Net Income by +/- COGS difference and -/+ tax difference

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Ratio Analysis

Evaluating Inventory Management using the Inventory Turnover Ratio

 Q: How efficient are inventory management activities?

Cost of Goods Sold

Inventory Turnover Ratio=
Average Inventory

 Interpretation: How many times average inventory was produced and sold during the period
 Higher turnover indicates:
- Quicker movement through the production process to the ultimate customer
- More efficient purchasing and production techniques and/or higher demand
- Less cash is tied up in inventory, so the company can invest/earn interest and borrow less
 Sudden decline may mean a drop in demand or sloppier production management
 Calculate “Average Days to Sell” as # Days in Period (i.e., 365 for a year; 90 for a quarter)
divided by the Inventory Turnover Ratio
 Cautions:
- Industry matters! Some industries tend to sell inventory more quickly than others
- LIFO companies may have a higher ratio compared to FIFO companies because Average
Inventory value would be smaller and COGS would be higher