chapter 5: inventories + cost of sales

net realizable value

expected selling price/ value of an item - the cost of making the sale

• loss is recorded when the damage

Merchandise Inventory

Merchandise Inventory includes costs to bring an item to a salable condition and location

Inventory Costs

includes invoice cost - any discounts + any other costs

expense recognition principle

the expense recognition principle says inv. costs are expensed as cogs when inventory is sold.

Specific Identification

Methods to assign costs to inventory + costs to inv. + cogs

i. specific identification

ii. first-in, first-out: FIFO

iii. last-in, first-out LIFO

iv. weighted average

first-in, first-out FIFO

• FIFO assumes costs flow in order incurred

• earliest units acquired are charged to COGS

• leaves out costs from the most recent purchases in ending inventory.

• cogs and ending are the same for periodic and perpetual

ADVANTAGES:

• inventory on the balance sheet approximated its current costs

• follows the actual flow of goods for most businesses

last-in, first-out LIFO

• assumes costs flow in the reverse order incurred

ADVANTAGES:

• cogs on the income statement approximated its current costs

• matches current costs with revenues

Weighted Average

Weighted Average assumes cost flow at an average of the costs available.

WA = cost of goods available for sale (at each sale)/

number of units available for sale

Specific Identification

method for assigning cost to inventory when the purchase of each item in inventoyr is identified and used to compute the COGS and/ or costs of inventory

Rising Costs

When purchasing costs regularly RISE, the following occurs:

• FIFO

  • reports the lowest cost of goods sold - yielding the HIGHEST gross profit & net income

  • inventory on the balance sheet approximated its current costs

  • follows the actual flow of goods for most businesses

• LIFO

  • reports the highest cost of goods sold - yielding the LOWEST gross profit & net income

• Weighted Average

  • average yields results between FIFO & LIFO

falling costs

When purchasing costs regularly DECLINE, the following occurs:

• FIFO

  • reports the highest cost of goods sold - yielding the LOWEST gross profit & net income

• LIFO

  • reports the lowest cost of goods sold - yielding the HIGHEST gross profit & net income

Lower of Cost/ Market (LCM)

required method to report inventory at market replacement cost when that market cost is lower than recorded costs

…. adjustment required when market value of inventory is lower than its cost

(‘market’ in the term LCM is replacement cost for LIFO, but net realizable value)

LCM Journal Entry:

cost of goods sold #

merchandise inv. #

COST OF GOODS SOLD

beg. inventory + net purchases - ending inventory = COGS

effects of inventory errors

Balance Sheet

inventory turnover

shows how many times a business sells its inventory in a period

Inventory Turnover = COGS/ average inventory

• low ratio shows the company has more inventory than it needs/ struggles to sell inventory

• high ratio shows inventory might be too low

  • preferable

days sales in inventory

day sales in inventory = ending inventory/ cogs (365)

Periodic Inventory System

merchandise inventory account is updated at the end of each period to reflect purchases and sales

Retail Inventory Method

method for estimating ending inventory based on the ratio of the amount of goods for sale at cost to the amount of goods for sale at retail

STEP I:

i. goods available for sale at retail - net sales at retail = ending inv. @ retail

STEP II:

i. goods available for sale at cost - net sales at retail = cost-to-retail ratio

STEP III:

i. ending inv. at retail x cost-to-retail ratio = ESTIMATED ENDING INV AT COST

Gross Profit of Inventory Estimation

STEP I:

i. net sales at retail (x) 1.0 - gross profit ratio = est. cogs

STEP II:

i. goods available for sale at cost (-) estimated cogs = estimated ending inventory at costs

Effects of Overstated/ Understated Inventory for Income Statement

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