Chapter 7: Reporting & Interpreting Cost of Goods Sold & Inventory

Inventory:

• Inventory is defined as tangible property that is either:

  • Held for sale in the normal course of business

  • Used in producing units or services

• Always classified as “current” on the Balance Sheet

• Inventory is intended to be sold

• Does NOT include Supplies, PP&E, or Intangible Assets

Inventory Types:

• Types of inventory held depend on the nature of the business

• Manufacturers have three types:

  • Raw Materials — Items acquired for processing into finished goods

  • Work in Process —- Goods in the process of being manufactured, not yet complete

  • Finished Goods —- Manufactured goods that are complete & ready for sale

• Merchandisers (Retailer/Wholesalers) hold merchandise inventory

  • Merchandise Inventory: Units/Merchandise acquired in finished condition & held for sale in the ordinary course of business

  • Inventory is initially recorded at the cost

    • The sum of costs incurred in bringing an article to usable or salable condition & location

    • Stop accumulating costs when it's ready for sale

    • Costs after this point (ie marketing) are included in Selling, General, & Administrative expenses

Inventory Costing Methods:

• Specific Identification:

  • Requires keeping track of the purchase cost of each item

    • COGS includes the specific cost of each item sold

    • Ending Inventory includes the specific cost of each unit left in the inventory

    • Not commonly used unless the company sells unique items (ie jewelry)

First-In, First-Out (FIFO):

• Assumes the earliest units purchased are the first units sold & the last units purchased are left in ending inventory

• Oldest Units → COGS

• Newest Units → Ending Inventory

Last-In, First-Out (LIFO):

• Assumes the latest units purchased are the first units sold & the first units purchased are left in the ending inventory

• Oldest Units → Ending Inventory

• Newest Units → COGS

Weighted Average Method:

• Uses the weighted average unit cost of the units available for sale for both COGS & ending Inventory

  • Weighted average cost of all units → COGS & Ending Inventory

Choice of Inventory Costing Methods:

• Financial Statement effects of inventory costing methods

  • Inventory costs are increasing → Newer units cost more → LIFO has higher COGS & lower inventory

• Why does it matter?

  • Higher COGS → Lower Profit (bad) → Lower Taxes (good)

• Managers want higher profits but do not want to get there by paying more taxes

• Under IFRS, LIFO is not permitted

Inventory Valuation:

• Inventory is initially recorded at cost in conformity with the historical cost principle

• However, if the market value < cost, the company will not receive future benefits at the value initially recorded

• Inventory is therefore carried on the balance sheet at the lower of cost or NRV (LCNRV)

• If NRV of goods in ending inventory < purchase cost, write down inventory balance to purchase cost

  Dr. COGS

  Cr. Inventory

US GAAP does not allow for any “holding gains” (Asymmetric treatments concerning gain vs loss)