Chapter 7-Financial Accounting

Authors

  • Susan Coomer Galbreath, Ph.D., CPA

  • Charles W Caldwell, D.B.A., CMA

  • Jon A. Booker, Ph.D., CPA, CIA

  • Cynthia J. Rooney, Ph.D., CPA

Chapter Overview

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

  • Source: Financial Accounting, 11e by Libby, Libby & Hodge

  • Publisher: McGraw Hill LLC

Learning Objectives

After studying this chapter, students should be able to:

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

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

  • 7-3: Decide when different inventory costing methods benefit a company.

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

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

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

Understanding the Business

Primary Goals of Inventory Management

  • Ensure sufficient quantities of high-quality inventory to meet customer needs.

  • Minimize costs associated with carrying inventory including production, storage, obsolescence, and financing.

Inventory Components

Items Included in Inventory

  1. Raw Materials Inventory

  2. Work in Process Inventory

  3. Finished Goods Inventory

  4. Merchandise Inventory

    • Merchandisers vs. Manufacturers

Costs Included in Inventory

  • Inventory is initially recorded at cost. The cost includes:

    • Invoice price

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

    • Inspection costs

    • Preparation costs

    • Subtract: Purchase returns and allowances, Purchase discounts

    • Total Inventory Cost = Invoice Price + Freight-In + Inspection Costs + Preparation Costs - Purchase Returns and Allowances - Purchase Discounts

  • Companies cease accumulating purchases costs once:

    • Raw materials are ready for use, or

    • Merchandise is ready for shipment.

  • Costs related to selling inventory are categorized under selling, general, and administrative expenses.

Flow of Inventory Costs

Stages of Inventory Flow

  1. Purchasing/Production Activities:

    • For Merchandisers: Merchandise purchased leads to Merchandise Inventory which when sold becomes Cost of Goods Sold (COGS) on the income statement.

    • For Manufacturers: Raw materials purchased lead to several stages: Raw Materials Inventory, Work in Process Inventory, Finished Goods Inventory, eventually resulting in Cost of Goods Sold.

Cost of Goods Sold Calculation

  1. Basic Equation:

    • extCostofGoodsSold(COGS)=extBeginningInventory+extPurchases−extEndingInventoryext{Cost of Goods Sold (COGS)} = ext{Beginning Inventory} + ext{Purchases} - ext{Ending Inventory}

  2. Example Calculation:

    • Assume Harley-Davidson's initial inventory is $40,000, additional purchases are $55,000, and ending inventory is $35,000, then

    • extCOGS=40,000+55,000−35,000=60,000ext{COGS} = 40,000 + 55,000 - 35,000 = 60,000

Inventory Costing Methods

Learning Objective 7-2

Inventory Costing Methods Overview

  • Four primary inventory costing methods:

    1. Specific identification

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

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

    4. Average cost

  • These methods allocate dollar amounts of goods available for sale between ending inventory and COGS.

Cost Flow Assumptions

  • The choice of an inventory costing method is not necessarily based on the physical flow of goods, resulting in different financial reporting outcomes depending on the chosen method.

  • Key Assumptions:

    • FIFO

    • LIFO

    • Average Cost

Example of Inventory Costing

FIFO Method

  • Flow of Inventory:

    • Merchandise purchases of $420 with beginning inventory of $140 leads to total goods available for sale of $560.

    • Ending inventory is $260, COGS is $300.

  • Transactional Example:

    • Beginning inventory of two units at $70 each, purchases at varying prices ($80 each for four units, and $100 for one).

    • Selling price of $120 each for four sold units.

LIFO Method

  • Flow of Inventory:

    • Similar to FIFO with different ending inventory and COGS calculations (Ending inventory = $220, COGS = $340).

Average Cost Method

  • Cost of goods sold and ending inventory assigned the same weighted average cost of $80.

  • Financial Breakdown:

    • Goods Available for Sale total $560. Ending Inventory = $240, COGS = $320.

Financial Statement Effects of Inventory Costing Methods

Method

Inventory

COGS

Gross Profit

Income Tax Expense

Net Income

FIFO

480

300

180

25% (−50)

75

LIFO

340

140

60

15% (−6)

45

Average

320

160

80

20% (−12)

60

Learning Objective 7-3

Decision-Making in Inventory Costing Methods

  • Net Income Effects:

    • Companies prefer to report higher earnings.

  • Income Tax Effects:

    • Managers aim for minimized tax liabilities, often conflicting with higher profit reporting.

  • LIFO Conformity Rule:

    • If LIFO is required for tax computations, it must also be used for financial statement COGS calculations.

Management's Selection of Inventory Methods

  • Influenced by inventory cost trends.

    • Increasing Costs: Companies use LIFO for lower taxes.

    • Decreasing Costs: FIFO preferred for both returns and financial statements.

Lower of Cost or Net Realizable Value

Learning Objective 7-4

  • Net Realizable Value (NRV) Definition:

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

  • Measurement Rule:

    • Inventories initially measured at purchase cost; must adjust to NRV when it falls below that cost (applying conservatism constraint).

  • Importance for industries like high-tech and seasonal goods.

  • Recognition of holding gains on inventory not permitted by GAAP.

Example of Cost and NRV Comparison

  • HP Example:

    • Inventory of 1,000 Intel chips to be recorded at NRV of $200 (cost $250).

    • Disk drives remain at original cost of $100.

Internal Control of Inventory

Learning Objective 7-5

  • Separation of Responsibilities:

    • Disparate roles for accounting and physical handling of inventory are crucial to avoid mismanagement.

  • Inventory Protection Measures:

    • Secure storage, limited access, perpetual inventory records, and periodic physical counts.

Effects of Inventory Errors

Learning Objective 7-5

  • Impact of Errors:

    • Errors affecting ending inventory lead to misstatements in asset values and income statements.

  • Example of Overstated Inventory Effect:

    • Overstating ending inventory by $10,000 leads to inflated current year profits and reduced profits in subsequent years due to adjusted COGS.

Inventory Management Evaluation

Learning Objective 7-6

Inventory Turnover Ratio Calculation

  • extInventoryTurnover=racextCostofGoodsSoldextAverageInventoryext{Inventory Turnover} = rac{ ext{Cost of Goods Sold}}{ ext{Average Inventory}}

  • Average Inventory Calculation:

    • extAverageInventory=racextBeginningInventory+extEndingInventory2ext{Average Inventory} = rac{ ext{Beginning Inventory} + ext{Ending Inventory}}{2}

  • A higher ratio indicates efficient inventory management and reduced carrying costs.

Average Days to Sell Inventory Calculation

  • extAverageDaystoSellInventory=rac365extInventoryTurnoverext{Average Days to Sell Inventory} = rac{365}{ ext{Inventory Turnover}}

  • This ratio signifies the average time taken to transition inventory through production and to customers.