MGT Chp 6: Inventory and Cost of Goods Sold

Inventory

includes 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 current asset in the balance sheet

• represents the cost of inventory not yet sold at the end of the period

Cost of Goods Sold

an expense reported in the income statement and represents the cost of inventory sold

What are the 3 essential sections in an Income Statement?

Revenues

• sales revenue

• service revenue

• net revenues (after subtracting returns, allowances, and discounts)

= how much money the company brought in

Expenses : the costs incurred to earn the revenues

• COGS

• operating expenses

• interest expense

• income tax expense

= how much it cost the company to operate

Net Income

= Revenues - Expenses

• revenues > expenses = net gain

• revenues < expenses = net loss

= did the company make a profit?

Gross Profit

= net revenues (or net sales) - cost of goods sold (COGS)

Operating income

= gross profit - operating expenses

Income before income taxes

= operating income + nonoperating revenues - nonoperating expenses

Net Income

= Total revenue - total expenses

a multi-step income statement includes…

• gross profit

• operating income

• income before income taxes

• net income

FIFO method

the first in, first out method.
an inventory costing method where the oldest inventory items purchased are the first ones recorded as sold

Perpetual inventory System

• Maintains a continual record of inventory on hand and inventory purchases and sold

• helps managers make good decisions

• most often used in practice

When companies sell inventory they make 2 entries

1) increase asset account (cash or accounts receivable) and increase sales revenue

2) increase COGS and decrease inventory

Freight chargers (Shipping): FOB shipping point

means title passes when they seller ships the inventory

• Purchase would be recorded the same day

Freight chargers (Shipping): FOB destination

means title passes when the inventory reaches the buyers destination

• purchase would be recorded the day it arrived at their destination

Purchase discounts

discounted offered by the seller to buyer for quick paymentPur

Purchase returns

Buyer returns unwanted or defective inventory

Lower of Cost and Net Realizable Value (NRV)

• Compare cost vs. net realizable value for ending inventory.

• Record inventory at the lower of the two.

• If NRV < cost → Write down inventory and record an expense.

• If cost < NRV → do nothing.

What is NRV (net realizable value)

• estimate the selling price of the item

• subtract any cost required to

  • complete the production

  • market the item

  • ship it

Lower Cost vs Net Realizable Value example

A company plans to sell a jacket:

• Estimated selling price: $100

• Costs to sell (shipping + packaging + sales commission): $15

NRV = $100 − $15 = $85

So, the jacket must be reported at $85, not its original cost, if cost > $85

inventory has to be reported at the lower of the two. This prevents companies from overstating assets. If NRV<Cost → reduce inventory value with the difference as an expense

Inventory Turnover Ratio

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

= cost of goods sold / average inventory

Average Days In Inventory

indicates the approximate number of days the average inventory is held

= 365/Inventory turnover ratio

Gross Profit Ratio

Indicator of the company’s successful management of inventory

• measures the amount by which the sale price of inventory exceeds its cost per dollar of sales

= Gross Profit / Net Sales x 100

• Gross Profit = Net Sales – Cost of Goods Sold (COGS)

• Net Sales = Total Sales – Sales Returns – Discounts

Tangible Assets

Physical Subtance

• land

• land improvements

• buildings

• equipment

• natural resources

Intangible Assets

Lack of Physical substance; Existence often based on legal contracts

• patents

• trademarks

• copyrights

• franchises

• goodwill

A Balance Sheet will always include…

current assets

• accounts receivable

• inventory

• prepaid expenses

noncurrent assets

• property, plants and equipment

• long term investments

• intangible assets

Liabilities

• current liabilities

• noncurrent liabilities

  • long term loans, bonds payable, lease obligations

• Owner’s Equity

Property, Plant and Equipment - recorded as

The original cost of the asset + all expenditures necessary to get the asset ready for use

Land

includes the cost of the land and all expenditures necessary to get the land ready for its intended use

• costs include

  • real estate commission and fees, back property taxes, clearing, filling, and leveling land, cash received from selling salvaged building materials reduces the cost of the land

• Cash received from the sale of salvages materials reduces the total cost of land

Land Improvements

amounts spent to improve the land

• parking lots, sideways, driveways, landscapping etc

• land improvements have limited useful lives and are recorded separately from the land account

Buildings

administrative offices, retail stores, manufacturing facilities, and storage warehouses

• cost of getting a building ready for use include items such as:

  • realtor commissions and legal fees, remodeling costs

Equipment

machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures

• The cost of equipment might include sales tax, shipping, assembly, and any other costs to prepare the asset for use

• Recurring costs such as annual property insurance and annual property taxes on vehicles are expensed as incurred

Basket Purchases

purchase of more than one asset at the same time for one purchase price

• we still need to record each of the assets acquired (land, building and equipment) in separate accounts

• we allocate the total purchase price based on the relative fair values of the individual assets

Allocation of Cost in a Basket Purchase

1. determine each assets fair value

2. compute each asset’s allocation percentage

   1. asset fair value/ total fair value

3. multiply each percentage by the total purchse price

4. record the allocated cost

Key Point: Property, Plant, Equipment

Tangible assets such as land, land improvements, buildings, equipment, and natural resources are recorded at cost plus all costs necessary to get the asset ready for its intended use

After a company buys a long-term asset (like a building, equipment, or vehicle), it will often spend more money on it later. These additional costs must be classified as either:

Capitalize or Expense

Capitalize

add the cost to the asset value on the balance sheet

• You capitalize a cost when:

  • It increases the future economic benefit of the asset.
    This may mean:

  • Extending the asset’s useful life

  • Increasing its productivity or efficiency

  • Improving the asset beyond its original condition

Expense

record the cost immediately as an expense on the income statement

You expense a cost when:

• It benefits only the current period

• It is routine, recurring maintenance

• It does not extend the life or improve the asset

Depreciation

Allocation of a portion of the asset’s cost to an expense over all periods benefited

Journal entry for recording depreciation

Debit: Depreciation Expense
Credit: Accumulated Depreciation

Accumulated Depreciation

the total amount of depreciation that has been recorded for an asset from the time it was acquired up to the present date

• It shows how much of an asset’s cost has been “used up.”

• It reduces the asset’s book value on the balance sheet.

• It does not represent cash or the asset’s market value — it's purely an accounting measure.

Service life (useful life)

the estimated use the company expects to receive from the asset before disposing of it

Residual Value (salvage value)

the amount the company expects to receive from selling the asset at the end of its service life

Depreciation method

the pattern in which the asset’s depreciable cost (original cost - residual value) is allocated over time

Depreciation Methods

Three common methods:

1. Straight-line

2. Declining-balance

3. Activity-based

Straight Line Depreciation

Annual Depreciation = (Cost - Residual value )/ useful life

• Depreciates the asset evenly over its useful life.

• Same expense every year.

Declining-Balance (Accelerated Depreciation)

Concept

Depreciates more in the early years and less in later years.
Reflects assets that lose value faster when new.

Formula

Depreciation = Book Value at Beginning of Year × Rate

Common rates: Double-declining balance (DDB) = 2× straight-line rate.

Activity Based (Units of Production)

• Depreciation rate per Unit = Depreciable cost Value/ total units expected to be produced

  • depreciable cost → cost of asset - residual life value (what it will cost when its old)

• Depreciation expense = depreciation per unit x units used
  

• Depreciation depends on actual usage, not time.

• Best for machines or vehicles where wear relates to activity level.

• Varies each year depending on production or mileage

• Most accurate for usage-driven assets

• More complex because usage must be tracked

Land depreciation

• We record depreciation for land improvements, buildings, and equipment, but we don’t record depreciation for land.

• Unlike other long-term assets, land is not “used up” over time

Double-Declining-Balance Depreciation

an accelerated depreciation method that expenses more of an asset’s cost in the early years and less in later years.

1. calcualte the straight line rate

   1. 1/ useful life

2. double that rate → 2 x (straight line rate)

3. apply this doubled rate to the book value at the beginning of each year, not the original cost

4. stop when the asset reaches its residual (salvage) value
   

Depreciation expense = Beg. Book Value x (2 × 1/useful life)

Asset Disposal methods

• sale → most common method to dispose of a long term asset

• retirement → occurs when a long term asset is no longer useful but cannot be sold

• exchange → occurs when two companies trade long term assets

Gain on a Sale Journal Entry

Debit: Cash, Accumulated Depreciation

Credit: Equipment and Gain

Loss on Sale Journal Entry

Debit: Cash, Accumulated Depreciation, and Loss

Credit: Equipment

Retirement of Long Term Asset Journal Entry

Debit: Accumulated Depreciation, Loss
Credit: equipment

Gain on Exchange Journal Entry

• example: In year 3 out of 5 esimtated service life, you trade your old truck that cost you 40k for new truck that cost 45k but you will trade in your truck and pay 23k for new truck.

• Debit:

  • New Equipment 45k,

  • Accumulated Depreciation of old equipment (3yrs x 7k per year) 21k

• Credit: Cash (paid for new equipment) 22k

  • Equipment old (the cost of the old equipment) 40k

  • Gain 4k

Purchased Intangible Assets

• record at their original cost plus all other costs necessary to get the asset ready for use

Research and Development (R&D)

• costs incurred to conduct research and to develop a new product or process

• not reported as an intangible asset in the balance sheet

• reported as an expense in the income statement rather than as an intangible asset in the balance sheet

  • expensed because of the difficulty in determining the portion of R&D that benefits future periods

• Long term assets

Patents

• Exclusive right to manufacture a product or to use a process • Granted for a period of 20 years

• When purchased:

  • Capitalize the purchase price plus legal and filing fees

• When developed internally:

  • Capitalize legal and filing fees only (Research and Development costs are expensed as incurred)

Purchased Patent

When a company buys a patent from someone else, all costs required to acquire and prepare the patent for use are capitalized (recorded as an asset).

These include:

• Purchase price

• Legal fees

• Filing fees

So the cost of Patent #1 is capitalized as an intangible asset

Internally Developed Patent

Accounting rules do NOT allow companies to capitalize most internally generated R&D costs.
Instead, research and development costs must be expensed as incurred.

What is expensed?

• The development cost → recorded as R&D expense, not part of the patent asset.

Copyrights

• Exclusive right of protection given to the creator of a published work

• Granted for the life of the creator plus 70 years

• Allows holder to pursue legal action against anyone who attempts to infringe the copyright

• Accounting is virtually identical to that of patent

Trademarks

• Word, slogan, or symbol that distinctively identifies a company, product, or service

• Renewable for an indefinite number of 10 year periods

• Capitalize legal, registration, and design fees

Goodwill

• Goodwill is the portion of the purchase price that exceeds the fair value of identifiable net assets

• Recorded only when one company acquires another company

• Net assets = assets acquired less liabilities assumed

• Most companies also create goodwill to some extent through advertising, employee training, and other efforts. However, as it does for other internally generated intangibles, a company must expense costs incurred in the internal generation of goodwill.

Amortization of Intangible Asset

• Allocating the cost of most tangible assets to expense is called depreciation.

• Allocating the cost of intangible assets to expense is called amortization.

• Most intangible assets have a finite useful life that can be estimated.

  • The service life of an intangible asset usually is limited by legal, regulatory, or contractual provisions.

• Most companies use straight-line amortization for intangibles

Return on Assets

• indicates the amount of net income generated for each dollar invested in assets

Return on Assets = net income/ average total assets

• can be separated into profit margin and asset turnover

Profit Margin

indicates the earnings per dollar of sales

= net income/ net sales

Assets turnover

measures the sales per dollar of assets invested

= net sales/ average total assets

deferred revenue

arise when a company receives cash in advance from customers

• these liabilities represent an obligation of the compnay to transfer inventory or services to those customers in the future

Operating cycle

An operating cycle is the length of time from spending cash to provide goods and services to a customer until collection of cash from that customer. If a company has an operating cycle longer than one year (a winery, for example), its current liabilities are defined by the operating cycle rather than by the length of a year

Current Liability

usually payable within one year from the balance sheet date

long term liability

payable in more than one year from the balance sheet date

Notes Payable

notes signed by a firm promising to repay the amount borrowed plus interest

Interest on Notes

Interest = face value x annual interest rate x fraction of the year

Accounts Payable

• Amounts owed to suppliers of merchandise or services

• Sometimes called trade accounts payable

• Most accounts payable are current liabilities, but they could be long-term liabilities, depending on the due date.

Sales tax payable

sales tax collected from customers by the seller, representing current liabilities payable to the government

Current portion of long term debt

debt that will be paid within one year from the balance sheet date

Deferred Revenue or Unearned Revenue

cash received in advance from a customer for products or services to be provided in the future

Current Portion of Long Term Debt

• The current portion of long-term debt is the amount that will be paid within one year from the balance sheet date.

• Management needs to know this amount in order to budget the cash flow necessary to pay the current portion as it comes due.

Installment Notes

• Most car loans and home loans call for payment in monthly installments rather than by a single amount at maturity

• Each installment payment includes both:

  • interest on borrowed amount

  • reduction of outstanding loan balance

• companies often borrow cash using installment notes

Debt Covenants

• A debt covenant is a condition or promise in a loan that requires or restricts a borrower’s actions to protect the lender

• They are used to ensure a borrower can repay the debt by requiring them to maintain certain financial ratios or by restricting them from taking on additional debt

Liquidity

refers to having sufficient cash or other current assets to pay currently maturing debts

• lack of liquidity can result in financial difficulties or even bankruptcy

Three liquidity measures

• working capital

• current ratio

• acid test ratio

Working Capital

= Current assets - current liabilities

• measure of current assets remaining after paying current liabilities

• a large positive working capital is an indicator of liquidity - whether a company will be able to pay its current obligations on time

• not the best measure of liquidity for comparing one company with another

Current Ratio

= current assets. current liabilities

• the amount of current assets available for every $1 of current liabilities

• the higher the current ratio the greater the companys liquidity

• a current ratio of 1.5 indicates that for every dollar of current liabilities, the company has $1.50 of current assets

Acid Test Ratio

• the amount of “quick assets; available for every $1 of current liabilities

• includes only cash, current investments, and accounts receivable

  • exclude other current assets such as inventory and prepaid rent

• many provide a better overall indicator of a company’s liquidity

Acid Test Ratio = (Cash + Current Investments + Accounts receivable) / current liabilities

Debt to Equity Ratio

• a measure of risk

• other things being equal, the higher the debt to equity ratio, the nigher the risk of bankruptcy. When a company assumes more debt, risk increases

Debt to equity ratio = total liabilities / stockholder’s equity

How is the COGS classified in the financial statement

Expense in the income statement

Beginning inventory is $20,000. Purchases of inventory during the year are $100,000. Ending inventory is $50,000. What is the cost of goods sold?

COGS = Beg Inventory + Purchase - End Inventory = 70k

Blog Inc., has net sales of $50,000, cost of goods sold of $30,000, and selling expenses of $5,000. What is Blogs gross profit?

1. Gross Profit = Net Sales - Cost of Goods Sold

2. Net Sales = 50k

3. Cost of goods sold = 30K

4. 50k- 30k=20k

What does FOB stand for

Free on board