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

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

Learning Objectives

After studying this chapter, you should be able to:

  • 7-1 Apply the cost principle to identify the amounts that should be included in inventory and cost of goods sold for typical retailers, wholesalers, and manufacturers.

  • 7-2 Report inventory and cost of goods sold using the four inventory costing methods.

  • 7-3 Decide when the use of different inventory costing methods is beneficial to a company.

  • 7-4 Report inventory at the lower of cost or net realizable value.

  • 7-5 Understand methods for controlling inventory and analyze the effects of inventory errors on financial statements.

  • 7-6 Evaluate inventory management using the inventory turnover ratio.

Understanding the Business

  • Primary Goals of Inventory Management:

    • Have sufficient quantities of high-quality inventory available to serve customers’ needs.

    • Minimize the costs of carrying inventory, which includes production, storage, obsolescence, and financing.

Items Included in Inventory

  • Types of Inventory:

    • Raw Materials Inventory

    • Work in Process Inventory

    • Finished Goods Inventory

    • Merchandise Inventory

    • Categories specifically involve: Merchandisers and Manufacturers.

Costs Included in Inventory

  • Inventory Initial Recording:

    • Inventory is initially recorded at cost.

    • Inventory cost includes:

    • Invoice price

    • Freight-In (freight charges to deliver items to the company warehouse)

    • Inspection costs

    • Preparation costs

    • Minus:

      • Purchase returns and allowances

      • Purchase discounts

    • Formula for Total Inventory Cost:
      extTotalInventoryCost=extInvoicePrice+extFreight−In+extInspectionCosts+extPreparationCosts−extPurchaseReturnsandAllowances−extPurchaseDiscountsext{Total Inventory Cost} = ext{Invoice Price} + ext{Freight-In} + ext{Inspection Costs} + ext{Preparation Costs} - ext{Purchase Returns and Allowances} - ext{Purchase Discounts}

    • Important Note: Companies should cease accumulating purchase costs when raw materials are ready for use or merchandise inventory is ready for shipment.

    • Costs related to selling inventory should be included in selling, general, and administrative expenses.

Inventory Cost Flow

  • Flow of Inventory Costs:

    • Stage 1: Purchasing/Production Activities

    • For Merchandiser:

      • Merchandise purchased:

      • Merchandise inventory increases

    • For Manufacturer:

      • Raw Materials purchased:

      • Raw materials inventory increases

      • Work in process inventory reflects manufacturing progress

      • Finished goods inventory ready for sale

    • Stage 2: Additions to Inventory on the Balance Sheet

    • Stage 3: Sale - Cost of Goods Sold on Income Statement

Cost of Goods Sold Calculation

  • Formula for Cost of Goods Sold: extCGS=extBeginningInventory+extPurchases−extEndingInventoryext{CGS} = ext{Beginning Inventory} + ext{Purchases} - ext{Ending Inventory}

    • Example Calculation for Harley-Davidson:

    • Beginning Inventory: $40,000 worth of Motorclothes

    • Purchases during the period: $55,000

    • Ending Inventory: $35,000

    • Combination leads to CGS =
      40,000+55,000−35,000=extCGSof60,00040,000 + 55,000 - 35,000 = ext{CGS of } 60,000

Inventory Costing Methods

  • Four Inventory Costing Methods:

    1. Specific identification

    2. First-in, first-out (FIFO)

    3. Last-in, first-out (LIFO)

    4. Average cost

  • Purpose: These methods assign the total dollar amount of goods available for sale between ending inventory and cost of goods sold.

Cost Flow Assumptions

  • The choice of an inventory costing method does not necessarily reflect the actual physical flow of goods. Hence, they are called cost flow assumptions:

    • FIFO

    • LIFO

    • Average Cost

LIFO & FIFO Examples

  • FIFO Example:

    • Transaction Dates:

    • Jan. 1: Beginning inventory of two units at $70 each.

    • Jan. 12: Purchased four units at $80 each.

    • Jan. 14: Purchased one unit for $100.

    • Jan. 15: Sold four units for $120 each.

  • **Cost Structure:

    • Goods Available for Sale:** $560

    • Ending Inventory: $260

    • Cost of Goods Sold: $300

  • LIFO Example:

    • Similar structure applied: events would affect calculations for ending inventory and cost of goods sold accordingly.

Financial Statement Effects of Inventory Costing Methods

  • Influence on the Income Statement and Balance Sheet varies based on the inventory costing method:

    • FIFO: Higher Earnings, lower taxes in periods of rising prices.

    • LIFO: Low net income but can defer taxes.

    • Average Cost: Balanced approach with steady income projection.

  • The metric to evaluate different methods:

    • Sales

    • Cost of Goods Sold

    • Gross profit

    • Other expenses

    • Net income

Reporting Inventory at Lower of Cost or Net Realizable Value

  • Initial Measurement and Write-Down Requirements:

    • Inventories must be initially measured at purchase cost.

    • If net realizable value (NRV) of goods falls below cost, allocate at NRV.

    • Formula for NRV:
      extNRV=extSalesPrice−extCoststoSellext{NRV} = ext{Sales Price} - ext{Costs to Sell}

  • Write-down mechanics detailed through journal entries to reflect current financial standings.

Internal Control of Inventory

  • Methods and practices to ensure proper inventory management include:

    • Separation of responsibilities for inventory accounting.

    • Protecting inventory from theft/damage.

    • Limiting access only to authorized personnel.

    • Maintaining perpetual inventory records and reconciling periodic counts.

Effect of Inventory Errors on Financial Statements

  • Any error in inventory measurement directly impacts both the current year and subsequent year’s financial results. Overstating inventory results in improved profits in the current period, while affecting costs of goods sold in the next cycle.

Inventory Turnover Ratio Evaluation

  • Definition and Calculation: extInventoryTurnover=racextCostofGoodsSoldextAverageInventoryext{Inventory Turnover} = rac{ ext{Cost of Goods Sold}}{ ext{Average Inventory}} Where: extAverageInventory=racextBeginningInventory+extEndingInventory2ext{Average Inventory} = rac{ ext{Beginning Inventory} + ext{Ending Inventory}}{2}

    • Higher turnover indicates efficient inventory management, reflecting quicker normalization of inventory for sale.

    • Presents implications into carrying costs and inventory obsolescence.

Average Days to Sell Inventory

  • Measurement of Efficiency: extAverageDaystoSellInventory=rac365extInventoryTurnoverext{Average Days to Sell Inventory} = rac{365}{ ext{Inventory Turnover}}

    • Provides insights into the average duration taken by a company to sell its inventory, influencing production and stocking strategies accordingly.