Chapter 6: Reporting and Analyzing Inventory and Cost of Goods Sold

The allowance method records bad debt expense in the period of sale to match it against revenues in accordance with the matching concept.
Key Result: Bad debt expense is recognized before the actual default occurs.
An account known as the Allowance for Doubtful Accounts is established to store estimates of potentially uncollectible accounts.
When a specific account is deemed uncollectible:
- Written off by debiting the Allowance account and crediting accounts receivable.
Common methods for estimating bad debt expense include:
1. Percentage of Credit Sales Method
2. Aging Method

This method is simpler and estimates bad debt expense based on the percentage of current credit sales expected to default:
- Formula:
  $( ext{Total Credit Sales}) imes ( ext{Percentage of Credit Sales Estimated to Default}) = ext{Estimated Bad Debt Expense}$

Estimates bad debt expense by assessing the collectability of accounts receivable rather than a percentage of total credit sales.
At the end of each accounting period:
- Individual accounts receivable are categorized by age.
- An estimate is made regarding the amount expected to default in each age category, based on past experience and future expectations.
The aging method aims to estimate the ending balance in the allowance for doubtful accounts.
Existing balances in the allowance account must be considered when calculating the adjusting entry.

Identify and explain types of inventories held by merchandisers and manufacturers, understanding how inventory costs flow through a company.
Record purchases and sales of inventory using a perpetual inventory system.
Apply three inventory costing methods to compute ending inventory and cost of goods sold under a perpetual inventory system.
Apply the lower of cost and net realizable value rule to inventory valuation.

Inventory: Products held for resale; classified as a current asset on the statement of financial position.
Upon sale, the cost of inventory transitions into an expense known as cost of goods sold (COGS).
- COGS reflects outflows of asset resources due to inventory sale, significant for firms selling goods over services.
- Gross Margin (Gross Profit): A key performance metric reflecting sales' potential to cover operating expenses and provide net income.
- Formula:
  $( ext{Revenue}) - ( ext{Cost of Goods Sold}) = ext{Gross Margin}$

Merchandisers: Companies that acquire inventory in finished form for resale.
Retailers: Sell directly to consumers.
Wholesalers: Sell to other retailers.
Merchandise Inventory: Inventory specifically held for resale.
Manufacturers: Companies transforming raw materials into finished products, which are then sold.

Raw Materials: Basic ingredients for production.
Work-in-Process: Raw materials and production costs (like labor and utilities) that are in production.
Finished Goods: Final products ready for sale.

Inventory systems include:
1. Perpetual System: COGS is updated with each sale.
2. Periodic System: COGS recorded only at period end.

The cost of inventory includes the purchase price plus incidental costs (e.g., freight to deliver merchandise, insurance while in transit, taxes).

Sellers often offer discounts to encourage prompt payment:
- E.g., Credit Terms of "2/10, n/30" indicates a 2% discount if paid within 10 days; otherwise due in 30 days.

Purchase Returns: Goods returned to sellers due to dissatisfaction.
Purchase Allowances: Deductions from purchase price instead of returning items.

Transportation (Freight) Costs: Costs incurred to move inventory, dependent on shipping terms:
- F.O.B. Shipping Point: Ownership passes at shipping; buyer pays freight (freight-in).
- F.O.B. Destination: Ownership passes upon delivery; seller pays freight (freight-out).

Requires two journal entries under a perpetual inventory system:
1. Recognizing the sales revenue.
2. Recording the cost of goods sold and reducing the inventory account.

Transaction: On August 1, Brandon Shoes sold 100 pairs of cleats for $12,000, with a cost of $10,000. On August 15, 10 pairs were returned.
Journal Entries Required:
1. Record sale of cleats.
2. Record return of cleats.

Cost of goods sold calculation involves allocating costs of goods available for sale between ending inventory and COGS.
Sometimes prices for goods change; thus, various costing methods exist:
1. Specific Identification Method
2. First-In, First-Out (FIFO)
3. Weighted Average Cost Method

Determines cost based on actual units sold/in inventory.
Requires detailed record-keeping of each purchase/sale, typically used for high-cost, unique items.

Based on the premise that earliest purchased inventory is sold first.
- Advantageous as it often reflects actual physical flow of goods.

Allocates costs between ending inventory and COGS based on weighted average cost per unit, recalculated after each purchase.

Comparison illustrates differing metrics such as Sales, COGS, Gross Margin, and Net Income using FIFO, Specific Identification, and Weighted Average Cost methods.

If net realizable value (NRV) of inventory is lower than cost, the inventory is written down to NRV:
1. Calculate inventory cost using one of the methods (specific identification, FIFO, weighted average).
2. Establish the NRV (expected selling price less selling costs).
3. Compare cost with NRV and use the lower value for financial reporting.