ACCT 2110 - Chapter 6: Cost of Goods Sold and Inventory

What is inventory?

Products held for resale; a current asset on the balance sheet.

What is cost of goods sold (COGS)?

Expense recognized for the cost of inventory sold.

What is gross margin (gross profit)?

Sales revenue minus cost of goods sold.

Formula: gross margin

Net sales minus COGS.

Who are merchandisers?

Businesses that buy finished products and resell them without processing.

Retailer vs. wholesaler

Retailers sell to consumers; wholesalers sell to retailers.

What is merchandise inventory?

Goods held for resale by a merchandiser.

Who are manufacturers?

Businesses that turn raw materials into finished products.

What is raw materials inventory?

Basic ingredients and materials used in production.

What is work-in-process inventory?

Partially completed products, including material, labor, and overhead costs.

What is finished goods inventory?

Completed products ready for sale.

Inventory cost flow: merchandiser

Merchandise inventory → COGS when sold.

Inventory cost flow: manufacturer

Raw materials → work in process → finished goods → COGS.

Formula: cost of goods available for sale

Beginning inventory + purchases.

Formula: cost of goods sold model

Beginning inventory + purchases − ending inventory.

Given beginning inventory $4,000, purchases $9,000, ending $3,000: COGS?

$10,000.

What is a perpetual inventory system?

Updates inventory and COGS continually as purchases and sales occur.

Main advantage of perpetual inventory

Inventory and COGS balances are continuously available.

What is a periodic inventory system?

Uses a physical count and COGS model to determine inventory and COGS at period-end.

Main advantage of periodic inventory

Relatively inexpensive to operate.

Under periodic inventory, when is COGS calculated?

At the end of the accounting period.

Under perpetual inventory, what account records purchases?

Inventory.

Under periodic inventory, what account normally records purchases?

Purchases (a temporary account).

What is inventory shrinkage?

Missing inventory found by comparing book records with physical counts.

Why physically count inventory under a perpetual system?

To detect shortages or errors and verify the book balance.

What costs are included in inventory under historical cost?

Purchase price plus costs to get goods to saleable condition and location.

Examples of additional inventory costs

Freight-in, insurance during transit, and applicable taxes.

What are purchases?

Cost of merchandise acquired for resale during the period.

What is a purchase discount?

Price reduction for paying promptly.

What does 2/10, n/30 mean?

2% discount if paid within 10 days; full balance due in 30 days.

Invoice $2,000, terms 2/10, n/30; cash paid within 10 days?

$1,960.

What is a purchase return?

Merchandise sent back to the supplier.

What is a purchase allowance?

Price reduction when buyer keeps unsatisfactory goods.

Effect of purchase returns and allowances on Inventory

Decrease Inventory.

Effect of purchase discounts on Inventory (perpetual)

Decrease Inventory.

What does FOB shipping point mean?

Buyer owns goods once shipped; buyer usually pays freight.

What does FOB destination mean?

Buyer owns goods upon delivery; seller usually pays freight.

When does seller recognize revenue with FOB shipping point?

At shipment.

When does seller recognize revenue with FOB destination?

At delivery.

What is freight-in?

Transportation cost normally paid by buyer under FOB shipping point.

What is freight-out?

Transportation cost normally paid by seller under FOB destination.

Does buyer-paid freight-in increase inventory cost?

Yes; it is added to Inventory.

Goods shipped FOB shipping point at year-end: whose inventory?

Buyer's inventory, once shipped.

Goods in transit FOB destination at year-end: whose inventory?

Seller's inventory, until delivered.

What is consignment?

One party owns goods while another holds and sells them.

Who owns consigned goods?

Consignor (original owner).

What does a consignee receive?

A fee for selling goods owned by the consignor.

What is channel stuffing?

Pressuring customers to accept excess shipments to accelerate revenue.

Entry: buy inventory on account (perpetual)

Debit Inventory; credit Accounts Payable.

Entry: pay freight-in in cash (perpetual)

Debit Inventory; credit Cash.

Entry: purchase return on account (perpetual)

Debit Accounts Payable; credit Inventory.

Entry: payment within purchase discount period (perpetual)

Debit Accounts Payable; credit Cash and Inventory for discount.

How many journal entries record a sale under perpetual inventory?

Two: one for revenue, one for COGS and inventory.

Entry: sale on account (revenue portion)

Debit Accounts Receivable; credit Sales Revenue.

Entry: sale under perpetual system (cost portion)

Debit COGS; credit Inventory.

Entry: customer returns goods (revenue reversal)

Reverse the related revenue/receivable or cash; record sales return.

Entry: returned saleable goods under perpetual system (cost)

Debit Inventory; credit COGS.

Do periodic systems record COGS with each sale?

No; COGS is determined at period-end.

Name the four inventory costing methods

Specific identification, FIFO, LIFO, and average cost.

What is specific identification?

Tracks the actual cost of each specific unit sold or remaining.

When is specific identification most practical?

Distinct high-value items, such as automobiles.

What is FIFO?

Oldest purchase costs go to COGS; newest costs remain in inventory.

What is LIFO?

Newest purchase costs go to COGS; oldest costs remain in inventory.

What is the average cost method?

Uses a weighted average unit cost to allocate COGS and inventory.

Formula: weighted average cost per unit

Cost of goods available for sale ÷ units available for sale.

Formula: ending inventory using weighted average

Units on hand × weighted average cost per unit.

Formula: COGS using weighted average

Units sold × weighted average cost per unit.

When is moving-average unit cost recalculated (perpetual)?

After each purchase.

Under periodic costing, when are costs allocated?

At period-end, treating all purchases as before sales.

Which costing method gives identical periodic and perpetual results?

FIFO.

Which methods can differ between periodic and perpetual?

LIFO and average cost.

Rising prices: FIFO effects?

Highest ending inventory; lowest COGS; highest income.

Rising prices: LIFO effects?

Lowest ending inventory; highest COGS; lowest income.

Falling prices: FIFO effects?

Lowest ending inventory; highest COGS; lowest income.

Falling prices: LIFO effects?

Highest ending inventory; lowest COGS; highest income.

Rising prices: which method generally minimizes current income taxes?

LIFO, because it reports the lowest current income.

Does LIFO permanently eliminate income taxes?

No; it postpones some tax payments.

If LIFO is used for income taxes, what must be used for financial reporting?

LIFO.

What is the consistency requirement for inventory methods?

Apply an adopted costing method consistently over time.

What is lower of cost or net realizable value (LCNRV)?

Report inventory at the lower of historical cost or net realizable value.

Formula: net realizable value (NRV)

Estimated selling price − costs of disposal.

Cost $90, selling price $100, disposal cost $15: inventory value under LCNRV?

$85 (NRV is $85, which is below cost).

When is an LCNRV inventory write-down required?

When NRV is below historical cost.

What is gross profit margin?

Gross profit ÷ net sales.

What does gross profit margin measure?

Share of each sales dollar available for other expenses and profit.

Gross profit $30,000 and net sales $120,000: gross profit margin?

25%.

Formula: inventory turnover ratio

COGS ÷ average inventory.

Formula: average inventory

(Beginning inventory + ending inventory) ÷ 2.

What does inventory turnover measure?

How quickly inventory is purchased or produced and sold.

Formula: average days to sell inventory

365 ÷ inventory turnover ratio.

Turnover is 5 times: average days to sell?

73 days.

Ending inventory overstated: effect on current-year COGS?

COGS is understated.

Ending inventory overstated: effect on current-year net income?

Net income is overstated.

Ending inventory overstated: effect on year-end assets and equity?

Both are overstated.

Ending inventory understated: effect on current-year COGS and income?

COGS overstated; income understated.

Why can an ending inventory error affect two years?

One year's ending inventory becomes next year's beginning inventory.

Prior-year ending inventory overstated: effect on next-year income?

Next-year income understated, assuming no other error.

Will an isolated inventory error self-correct in the next year?

Yes, assuming no further errors; the income effect reverses.