Chapter 6 - Financial Accounting

Inventory

Items a company intends for sale to customers in the ordinary course of business 

• Inventory also includes items that are not yet finished products 

• Typically reported as a current asset in the balance sheet

Manufacturing Companies 

• Produce the inventories they sell (rather than buying the finished form) 

• Buy the inputs for the products they manufacture 

Three Categories of Inventory for Manufacturers

• These separate accounts are added together and reported as total inventories 

Raw Materials Inventory 

• Includes the cost of components that will become part of the finished product but have not yet been used in production 

Work-in-progress(process) Inventory 

• The products that have been started in the production process but aren't yet complete at the end of the period 

• Total costs include raw materials, direct labor, and indirect manufacturing costs (called overhead) 

Finished Goods Inventory 

• The cost of fully assembled inventory that is ready for sale to customers 

Merchandising Companies

• Don't manufacture products or their components 

  • May assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install 

• Serve as intermediaries in process of moving inventory from the manufacturer to the end user 

• Hold inventories in a single category simply called inventory/merchandise inventory 

Wholesalers and Retailers

• Merchandising companies can further be classified as wholesalers or retailers 

Wholesalers:

• resell inventory to retail companies or to professional users 

Retailers:

• purchase inventory from manufacturers or wholesalers and then sell this inventory to end users 

Cost of Goods Sold

Cost of the inventory that was sold during the period 

• Cost of sales, cost of revenues, or cost of products sold 

• Expense in the income statement 

COGS = Beginning Inventory + Purchases + Additional Costs - Ending Inventory

Total Inventory Available

Ending Inventory + Cost of Goods Sold

Multiple-Step Income Statement

An income statement that reports multiple levels of income (or profitability) 

• Most companies use this, as it show the revenues and expenses that arise from different types of activities 

  • Investors and creditors are better able to determine the source of a company's profitability 

  • Shows gross profit, operating income, and income before income taxes 

 

Gross Profit =

net sales - COGS

Operating Income =

gross profit - operating expenses

Income before income taxes =

operating income + nonoperating revenues - nonoperating expenses

Net income =

Income before income taxes - income tax expense

Gross profit

The difference between net sales and cost of goods sold 

• Inventory transactions are usually the most important activities of a merchandising company, so these transactions are at the top section of the statement above 

Revenues/Net Sales 

• Include the sale of products and services to customers 

• Reported after subtracting returns, allowances, and discounts 

Cost of Goods Sold 

• The cost of inventory sold during the year 

• Not only the purchase of the physical merchandise, but costs related to getting it ready for sale, like shipping and distributing 

  • Operating expenses: selling, general, and administrative expenses (SG&A) 

Operating Income

Profitability from normal operations that equals gross profit minus operating expenses 

• Measures profitability from primary operations 

  • Helps predicting the future profit-generating ability of company 

Income before Income Taxes

Operating income plus nonoperating revenues less nonoperating expenses 

• Nonoperating revenues and expenses arise from activities that are not part of the company's primary operations 

Nonoperating expenses 

• Most commonly include interest expense 

  • Could also include losses on the sale of investments 

• Typically do not have long-term implications on the company's profitability (or nonoperating revenues) 

Net Income

Difference between all revenues and all expenses for the period 

• Income before income taxes minus income tax expense 

  • Income tax expense is reported separate as it represents a large expense 

  • By separately reporting income tax expense, the income statement clearly labels the difference in profitability associated with the income taxes of a corporation 

Companies are allowed to report inventory costs by assuming

which units of inventory are sold and not sold, even if this does not match the actual flow 

Specific Identification Method

Inventory costing method that matches or identifies each unit of inventory with its actual cost 

• Works well in cases where inventory items are unique and easy to differentiate (expensive products with low sales volume) 

First-in, First-out Method (FIFO)

Inventory costing method that assumes the first units purchased (the first in) are the first ones sold (the first out) 

• Once cost of goods sold or inventory is calculated the other can be indirectly determines, as the amount add up the cost of goods available for sale 

• Sold in order purchased 

• More closely resembles the actual physical flow of inventory 

• Top down 

• larger ending inventory worth

• smaller COGS, higher profit, higher taxability

Last-in, First-out Method (LIFO)

Inventory costing method that assumes the last units purchased (the last in) are the first ones sold (the first out) 

• This type is unrealistic for most companies 

• Companies that use LIFO for financial reporting purposes calculate cost of goods sold and ending inventory only ONCE per period (at the end) 

• Assume inventory is sold in the opposite order purchased 

• LIFO the party, Bottoms up 

• higher cogs, lower profits, lower taxability

Weighted-Average Cost Method

Inventory costing method that assumes both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale and that each unit has a cost equal to the weighted average unit cost of all inventory items 

• Weighted-average unit cost = cost of goods available for sale / number of units available for sale

Do NOT find the simple average of unit cost

FIFO

If lowest COGS wanted 

But greater taxes 

• when inventory costs are rising, FIFO results in: higher inventory and gross profit

LIFO

Most companies use this

Things more expensive 

Less taxes 

Stock market might not like how that looks 

• when inventory costs are falling, LIFO results in: higher inventory and gross profit

LIFO conformity rule

IRS rule requiring a company that uses LIFO for tax reporting to also use LIFO for financial reporting

Perpetual Inventory System

Inventory system that maintains a continual record of inventory purchased and sold 

• Used by almost all companies 

• Helps to make good decisions related to purchase orders, pricing, product development, and employee management 

When companies purchase inventory

• Increase inventory account 

• Either decrease cash or increase accounts payable 

When companies sell inventory

• Increase an asset account (cash or accts receiv.) and increase sales revenue 

• Increase cost of goods sold and decrease inventory 

LIFO adjustment

An adjustment used to convert a company's own inventory records maintained throughout the year on a FIFO basis to LIFO basis for preparing financial statements at the end of the year 

• If LIFO Inventory balance is greater than FIFO (inventory costs declining), the entry would be reversed 

FROM FIFO TO LIFO 

Periodic Inventory System 

Inventory system that periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand 

• When a sale occurs, we record: only the sale, but not the related cost of goods sold 

Freight Charges

• Significant cost, includes cost of shipments of inventory from suppliers and shipments to customers 

• Freight-on-board (FOB) 

FOB shipping point

• Means title passes when the seller ships the inventory 

• Come and get tvs from docks yourself, if lost at sea ifs your loss (PUT THEM INTO YOUR INVENTORY) 

• "free on board": indicates when ownership goes from seller to buyer 

FOB destination

• Means title passes when the inventory reaches the buyer's destination 

• I don't take ownership until I actually receive it, the shipper bares all the risk 

 

Freight-in

Cost to transport inventory to the company, which is included as part of inventory cost 

• When that inventory is sold, those freight charges become part of the cost of goods sold 

Freight-Out

Cost of freight on shipments to customers, which is included in the income statement either as part of cost of goods sold or as a selling expense 

 

Purchase Discounts

Allow buyers to trim a portion of the cost of the purchase in exchange for payment within a certain period of time 

• Discount offered by seller to buyer for quick payment 

• Subtract from the cost of inventory and therefore reduce the cost of goods sold once those items are sold 

Debit: Account Payable

Credit: Inventory, cash

Purchase Returns 

Done if a company find inventory items to be unsellable, damaged or different from expected 

• Buyer returns unwanted or defective inventory 

Debit: Accounts Payable

Credit: Inventory (units returned x price per unit)

Net Realizable Value

Estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal, and transportation 

• When the value of inventory falls below its original cost, companies are required to report inventory at this value 

• It’s the net amount a company expects to realize in cash from the sale of inventory

Lower of cost and net realizable value 

Method where companies report inventory in the balance sheet at the lower of cost and net realizable value, where net realizable value equals estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal, and transportation 

• use the lower of value

Inventory turnover ratio

= Cost of Goods Sold/ Average inventory 

• Shows the number of times the firm sells its average inventory balance during a reporting period 

Average days in inventory

= 365/inventory turnover ratio 

• Indicates the approximate number of days the average inventory is held 

Gross Profit Ratio

= Gross Profit/Net Sales

• Indicator of the company's successful management of inventory exceeds its cost per dollar of sales