Reporting and Interpreting Cost of Goods Sold and Inventory

Raw Materials Flow of Inventory Costs - Manufacturer

First, a manufacturer purchases raw materials for use in making inventory. The items (and their costs) are included in raw materials inventory until they are used, at which point they become part of work in process inventory

NRV > Costs

Good can still generate a profit, so the original cost is kept in the statements

NRV < Costs

Good is more expensive than what it sells for currently, NRV value is recorded

Cost of Goods Sold

Goods Available for Sale - Ending inventory an expense account (Income Statement)

What companies is the conservatism constraint important to

High-technology companies Companies that sell seasonal goods

LIFO Conformity Rule

If LIFO is used on the income tax return, it must be used to calculate inventory and cost of goods sold for financial statements

What does the cost principle require

Inventory is initially recorded at cost. Inventory cost includes the costs to bring an article to usable or salable condition and location

Periodic Inventory System

No up-to-date record of inventory is maintained during the year Sales require one entry to record the sale. Cost of goods sold is calculated at the end of each period.

The two inventory systems used to determine the amount of COGS and ending inventory

Perpetual and Periodic

Primary Goals of Inventory Management

Provide sufficient quantities of high quality inventory Minimize the costs of carrying inventory

Perpetual Inventory System

Purchase transactions are recorded directly in an inventory account. Sales require two entries to record: (1) the sale and (2) the cost of goods sold

Flow of Inventory Costs - Manufacturer

Raw Materials Inventory Work in Progress Inventory Finished Goods Inventory

Net Realizable Value (NRV)

Sales price - costs to sell

Weighted Average Advantages

Smoothes out price changes

What is Inventory

Tangible Property Held for Sale Used to Produce Goods and Services

Cost Flow Assumptions

The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves. That is why they are called cost flow assumptions

What happens when the net realizable value of goods in ending inventory falls below cost?

These goods must be assigned a unit cost equal to their net realizable value This rule is known as measuring inventories at the lower of cost or net realizable value (lower of cost or market)

Inventory Turnover Ratio

This ratio reflects how many times average inventory was produced and sold during the period. Higher ratio indicates that inventory moves more quickly thus reducing storage and costs. Average inventory (AMOUNT) = (beginning inventory + ending inventory) / 2

Internal Control of Inventory

Inventory is the Asset that is the second most vulnerable to theft, so internal control is crucial: - Separation of inventory accounting and physical handling of inventory - Storage in a manner that protects from theft and damage - Limiting access to authorised employees - Maintaining perpetual inventory records - Comparing perpetual records to periodic physical counts

Types of Inventory

Merchandise Inventory Raw Materials Inventory Work in Process Inventory Finished Goods Inventory

Average Days to Sell Inventory

365 / Inventory Turnover This ratio reflects the average time in days it takes a company to produce and deliver inventory to its customers

Flow of Inventory Costs - Merchandiser

A merchandiser purchases inventory that is in ready to sell condition. When merchandise inventory is purchased, the merchandise inventory account is increased. When the goods are sold, cost of goods sold is increased and merchandise inventory is decreased.

Work in Progress Inventory Flow of Inventory Costs - Manufacturer

As goods are manufactured, two other costs of manufacturing, direct labor and factory overhead, are also added. • Direct labor refers to earnings of employees who work directly on the products being manufactured. • Factory overhead includes manufacturing costs such as the costs of heat, light, and power to operate the factory

What are ending inventories

Assets

Last in, 1st out (LIFO) Inventory Costing Method

Assumes that the most recently purchased goods are sold first and the oldest units are left in ending inventory

1st in, 1st out (FIFO) Inventory Costing Method

Assumes the earliest goods purchased are the first goods sold, and the last goods purchased are left in ending inventory

Goods Available for Sale

Beginning inventory + Purchases

Last in, First Out Advantages

Better matches current costs in cost of goods sold with revenues

NRV

Companies recognize "holding" a loss in the period in which the NRV of an item drops below original cost, rather than recording the loss in the period the item is sold. If the NRV of the inventory is lower than original cost, the firm would make a "write-down" entry to reduce the inventory balance to NRV. No write-down is necessary if the net realizable value is higher than the original cost. Recognition of holding gains on inventory is not permitted by GAAP

Costs Included in Inventory Purchases

Company should cease accumulating purchase costs when the raw materials are ready for use or when the merchandise inventory is ready for shipment Costs related to selling the inventory (e.g. marketing department salaries, dealer training sessions) should be included in selling, general, and administrative expenses

What happens when the finished goods are sold?

Cost of goods sold is increased and finished goods inventory decreases Inventory goes from being on the balance sheet to the income statement

First in, First out Advantages

Ending inventory approximates current replacement cost

Inventory Costing Method

Estimating how much of the inventory will be cost of goods sold (ratio) 1. Specific Identification 2. First-in, First-out 3. Last-in, First-out 4. Weighted Average

LIFO and International Comparisons

U.S GAPP allows companies to choose from the three reporting methods International Financial Reporting Standards (IFRS) currently prohibits the use of LIFO

Weighted Average Inventory Costing Method

Weighted Average unit cost of the goods available for sale for both cost of goods sold and ending inventory

Average Cost Method

When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold Cost of goods available for sale / Number of units available for sale

Finished Goods Inventory Flow of Inventory Costs - Manufacturer

When the inventory is complete and ready for sale, the related amounts of work in process inventory are transferred to finished goods inventory When the finished goods are sold, cost of goods sold is increased and finished goods inventory decreases

Specific Identification Inventory Costing Method

When the unit is sold, the specific cost of the unit is added to the cost of the goods sold Not efficient since it must track the flow of every single unit in its inventory

What are the Lower of Cost or Net Realizable Value based on?

the conservatism constraint, which requires companies to avoid overstating assets and income