Financial Accounting - Inventory and Cost of Goods Sold

This part explains the main ideas, kinds, and ways of keeping track of inventory in both companies that make products and companies that sell them. It highlights why it's important to report inventory and the cost of goods sold (COGS) correctly.

LO6–1: Understand how products (inventory) move from makers to sellers and how they are shown as an asset (something the company owns) on the balance sheet.
LO6–2: Know how COGS is presented on a detailed income statement.
LO6–3: Figure out COGS and how much inventory is left at the end of a period using different ways to cost inventory.
LO6–4: Explain how different inventory costing methods affect a company's money (financials) and its taxes.
LO6–5: Record inventory deals using a system that updates inventory continuously (perpetual inventory system).
LO6–6: Use the rule that says inventory should be valued at the lower of its original cost or what it can actually be sold for (net realizable value).
LO6–7: Look at how well a company manages its inventory by checking its inventory turnover and gross profit ratios.
LO6–8: Record inventory deals using a system that updates inventory only at certain times (periodic inventory system).
LO6–9: Figure out what happens to financial statements when there are mistakes in inventory.

Inventory includes:
- Things a company plans to sell as part of its regular business.
- Unsold items that are partly finished or still being made.
Usually shown as a short-term asset (something easily turned into cash) on the balance sheet.

Merchandising Companies

Examples: Stores (retailers) and companies that sell to other businesses (wholesalers).
Their inventory is mostly finished products ready for sale.

Manufacturing Companies

Their inventory includes:
- Raw Materials: Basic parts or ingredients used to make final products.
- Work in Process: Products that are currently being made but are not yet complete.
- Finished Goods: Completed products that are ready to be sold.

Service Companies: Report income when they provide a service.
Merchandising and Manufacturing Companies: Report income when they sell their products.

COGS is:
- Shown as an expense on the income statement.
- The cost of the inventory that was sold during the period.
- Not a short-term asset but is directly linked to the cost of products and sales.

Calculation of COGS

How COGS is figured out can change based on how we assume inventory costs flow:
- FIFO (First-in, First-out): Assumes the oldest items are sold first.
- LIFO (Last-in, First-out): Assumes the newest items are sold first.
- Weighted Average Cost: Uses an average cost for all items.

Balance Sheet: Displays inventory as an asset.
Income Statement: Displays COGS as an expense, which affects how much gross profit and net income a company makes.

Levels of Profitability

Gross Profit:
- Gross Profit = ext{Net Revenue} - ext{COGS} (Net sales minus the cost of what was sold).
Operating Income:
- Operating Income = ext{Gross Profit} - ext{Operating Expenses} (Gross profit minus costs of running the business).
Income Before Taxes:
- Income Before Taxes = ext{Operating Income} + ext{Non-Operating Revenue} - ext{Non-Operating Expenses} (Operating income plus other income and minus other expenses).
Net Income:
- Net Income = ext{Income Before Taxes} - ext{Income Tax Expense} (Income before taxes minus the taxes owed).

Specific Identification

This method matches each item sold with its exact cost. It's mostly used for unique, expensive items that don't sell often.

FIFO Method

This method assumes that the first items bought are the first ones sold. If prices are going up, this means:
- Lower COGS (cost of items sold) and a higher value for ending inventory.

LIFO Method

This method assumes that the last items bought are the first ones sold. If prices are going up, this means:
- Higher COGS (cost of items sold) and a lower value for ending inventory.

Weighted Average Cost

This method assumes all items are mixed together, so it uses an average cost for all available inventory.

FIFO vs. LIFO impact on profits and tax payments:
- FIFO: Shows higher reported profits when prices are rising.
- LIFO: Shows lower reported profits and might lead to lower taxes.

LIFO Conformity Rule

Companies that use LIFO to calculate their taxes must also use LIFO for their financial reports. This makes sure their numbers are consistent.

This tells you how many times a company sells and restocks its inventory during a financial period:
- Formula: Inventory Turnover Ratio = ext{COGS} / ext{Average Inventory}
Average Days in Inventory:
- Average Days in Inventory = 365 / ext{Inventory Turnover Ratio}

Using the inventory at the very end of the period instead of the average inventory for ratio calculations.
Not updating records for returns, shipping costs, and discounts received for buying items.

Inventory should be reported at the lower amount between its original cost and what it's expected to be sold for (net realizable value). If the net realizable value is lower, the inventory balance must be reduced.

Reporting less ending inventory than there actually is will make COGS seem too high and net income seem too low in the current year.
These mistakes fix themselves in the next year, meaning the amounts that were overstated or understated will adjust to the correct values in the following periods.