ACCT*1220 Chapter 5 - Inventory and Cost of Goods Sold

Difference between service company and merchandising company inc statement

merchandise company has sales revenue - cost of goods sold to equal gross profit and then operating expenses.

inventory turnover

shows how fast inventory is sold

Days’ inventory outstanding

indicated how long it takes to sell inventory

Days’ inventory outstanding eqn

365 / inventory turnover

direct relationship between

Ending Inventory and Gross Profit

inverse relationship between

Beginning Inventory and Gross Profit

Inventory cost includes

basic purchase price + freight-in + insurance while in transit + costs paid to get the inventory ready to sell, - returns - allowances - discounts.

lower ending inventory results in

higher cost of goods sold

lower gross profit

lower beginning inventory results in

lower cost of goods sold

higher Gross profit

As inventory gets used up,

shifted into expense account : cost of sales

assets transferred to expense when

seller delivers goods

Sales revenue based on

sale price (price item was sold for)

cost of goods sold based on

cost of purchasing/ making good

Sales Discount

incentive for customers to pay early in order to speed up cash flow

2/ 10, n/ 30 meaning

2% discount if paid by 10 days, other wise due in 30 days.

Income tax expense lower under

Weighted-average cost

Income tax expense higher under

FIFO

gross profit / gross margin

excess of sales revenue over cost of goods sold

Difference between service company and merchandising company balance sheet

Merchandising company has inventory account where service doesn’t

merchandise inventory on the balance sheet

asset: cost of inventory on hand

merchandise inventory on income statement

Expense: cost of inventory that’s been sold

record sales transaction

DR cash CR sales revenue

record changes in inventory

DR cost of goods sold CR Inventory

Inventory cost eqn

quantity x unit cost

Physical Count

method to determine inventory quantity

check accuracy if the perpetual inventory records

determine ending inventory in periodic system

steps to complete a physical count of inventory

determine goods owned (depends on shipping terms)

taking physical inventory count

FOB Shipping Point

Legal title passes to customer when items leave seller’s place of business.

Purchaser owns the good while its in transit (purchaser’s inv. count)

purchaser pays shipping costs

FOB Destination

Legal title passes to purchaser when the items arrive at purchaser’s receiving dock

Seller owns good while in transit (seller’s inv. count)

seller pays transport costs

Inventory

goods held by a business that it intends to sell to earn revenue

Perpetual inventory system

used for all types of goods

keeps running total of all goods bought, sold, and on hand

inventory counted at least once a year

Periodic Inventory System

Used for inexpensive goods

Does not keep running total

purchases recorded in purchases account not inventory account

inventory counted at end of period

two entries needed for each sale

1. revenue and asset received (cash / receivables)

2. record cost of sale and reduction of inventory

Cost of goods sold eqn (periodic inventory)

Beginning inventory + purchases - ending inventory (physical count) = cost of goods sold

to balance cost of goods sold eqn (periodic)

beginning inventory + purchases = cost of goods sold + ending inventory

inventory costing methods

1. specific identification cost

2. weighted-average cost

3. FIFO

Specific Identification Cost

Used for businesses with unique inventory items

Cost of particular inventory unit can be determined

FIFO (Periodic and Perpetual)

Cost of first item purchased is cost of first item sold

oldest items assumed to be sold first at the latest price

Ending inventory consists of most recent purchases (both periodic and perpetual)

Weighted-average cost

cost determined using a moving (weighted) average of the cost of the items purchased

Weighted average (periodic)

weighted average calculated for entire period

Weighted average (perpetual)

weighted average adjusted with every purchase transaction, record sales after required amount of inventory is collected

Weighted average cost (periodic)

use cost of goods sold eqn (num of units sold x average cost per unit)

Average cost per unit eqn

(cost of goods available)/ (num of units available)

Goods available eqn

beginning inventory + purchases

cost of goods sold eqn

number of goods sold x average cost per unit

ending inventory eqn

number of units on hand x average cost per unit

What happens when inventory costs are INCREASING in FIFO?

FIFO cost of goods sold is LOWER (based on oldest costs), gross profit HIGHER

What happens when inventory costs are INCREASING in Weighted-average?

WA cost of goods sold is higher, gross profit lower

Lower-of-Cots-and-Net-Realizable-Value Rule

based on premise that inventory can become damaged or obsolete or selling price can decline.

if inventory has been written down to net realizable value NRV,

it should be reassessed each period

The faster the sales,

HIGHER the company’s income

the slower the sales,

LOWER the company’s income

If net realizable value NRV is lower

inventory is written down

to write inventory down to net realizable value

DR Cost of Goods Sold CR Inventory

Gross profit Percentage eqn

Gross profit / Net sales revenue

Inventory turnover eqn

cost of goods sold / average inventory

average inventory eqn

(beginning inventory + ending inventory)/ 2

Ending inventory overstated in period 1 effects

Period 1: Cost of goods sold Understated, gross profit and net income overstated

Period 2: Cost of goods sold Overstated, gross profit and net income understated

Ending inventory understated in period 1 effects

Period 1: costs of Goods sold overstated, gross profit and net income understated

Period 2: Cost of goods sold Understated, gross profit and net income overstated

Inventory transactions on statement of cash flows

operating activities

purchase of inventory requires

cash payment

sale of inventory requires

cash receipt