Chapter 6: Inventory & Cost of Goods Sold

merchandising companies

buy from suppliers & sell goods to customers

• needs to account for cost of goods sold unlike service companies

goods in transit

inventory items that are shipped by the seller but not yet received by the buyer, ownership depends on shipping terms

shipping terms (aka FOB terms)

describes when ownership of goods in transit is transferred

• which entity/when must record as assets

• which entity has to pay freight cost

FOB = Free on Board

FOB shipping point vs FOB destination

FOB shipping point

legal title passes to buyer at a shipping point, after which the buyer:

• records a purchase (seller records sale)

• owns the goods in transit

• pays for transportation related costs like freight-in & insurance

FOB destination

legal title does not pass to buyer until goods reach destination, so at time of shipping:

• no transaction is recorded (neither sale nor purchase)

• goods in transit belong to seller

• seller pays transportation related costs like freight-out and insurance

consigned goods

goods held & sold by another party on behalf of owner

• consigner: supplier who has legal ownership of goods

• consignee: retailer who physically keeps and sells goods

perpetual vs periodic inventory system

perpetual:

• keeps running record of all goods bought, sold, and on hand

• used for all types of goods

• counts inventory at least once a year to ensure accuracy

periodic:

• keeps running record of goods purchased

• only used for inexpensive goods

• counts inventory once a year to determine inventory on hand

accounting for purchases as a buyer (assuming perpetual)

when something is purchased

• dr. inventory / cr. A/P or cash

for freight-in charges (FOB shipping point)

• dr. inventory / cr. A/P or cash

for purchase returns & allowance

• dr. A/P or cash / cr. inventory

for purchase discount

• dr. A/P or cash / cr. inventory

net purchases

net costs to purchase inventories in the current period

= purchase price + freight-in (if FOB shipping point) - purchase returns/allowances - purchase discounts

net sales

= sales - sales returns & allowances - sales discount

inventory (costing) methods

• specific unit

• average cost

• FIFO

• LIFO

(all permitted by GAAP, LIFO is not permitted by IFRS)

impact of inventory methods on F/S

if costs are DECREASING:

lowest e. inv: FIFO & highest e. inv: LIFO

highest COGS: FIFO & lowest COGS: LIFO

lowest gross profit: FIFO & highest gross profit: LIFO

lowest tax & net income: FIFO & highest tax & net income: LIFO

(directly opposite if costs are INCREASING)

LIFO vs FIFO

LIFO:

• better matching of expense to revenue

  • more recent costs on COGS

• more realistic COGS

• more realistic I/S

LIFO:

• more up-to-date inventory cost

  • more recent costs in inventory

• more realistic ending inventory

• more realistic B/S

issues of LIFO

potential for earnings manipulation b/c latest goods tend to be more expensive, so if large quantities are purchased at year end then COGS increases, decreasing gross profit, decreases tax expense

• this is why large year end purchases under LIFO require disclosure

Principle of consistency

Use the same accting methods from year to year to allow easier financial statement comparison from one period to next

• however companies are permitted to change methods if they disclose effects on N/I

Principle of disclosure

financial statements should disclose sufficient information for users to make decisions

• e.g. accting methods used, substance of material transactions

Principle of conservatism

anticipate no gains, but provide for probable losses in order to protect current and potential investors

• lowers N/I (also lowers SE & tax expense)

• if in doubt, record asset at lowest reasonable amt and liability at highest reasonable amt

  • = lower-of-cost-or-market (LCM)

Lower-of-Cost-or-Market (LCM)

inventory is reported at lower of historical cost or market value, only downward revaluation is allowed

• if market value drops lower than cost:

  • dr. COGS / cr. inventory

• required by GAAP

COGS

= b. inventory + net purchases - e. inventory

gross profit

= net sales - COGS

gross profit percentage (GPP)

= gross profit / net sales

• for each dollar of sale, how much goes to profit

• lower GPP = more sales needed to get same level of gross profit (GP)

average inventory

= (b. inventory + e. inventory) / 2

inventory turnover

= COGS / average inventory

• how quickly company can sell its inventory

• too high = insufficient inventory, but too low = excessive inventory