Study Notes on Inventory and Cost of Goods Sold

Financial Accounting - Inventory and Cost of Goods Sold

Reporting Inventory and Cost of Goods Sold

• Inventory, an asset, flows from manufacturing to merchandising companies and is reported on the balance sheet.

• Cost of Goods Sold (COGS), an expense, is reported on the income statement.

Inventory Definition and Importance

• Inventory consists of items for sale, including raw materials, work in process, and finished goods, reported as a current asset.

Types of Companies Involved with Inventory

• Merchandising Companies buy finished goods for resale.

• Manufacturing Companies transform raw materials into finished goods (Raw Materials, Work in Process, Finished Goods).

Recording Revenue and COGS

• Merchandising and Manufacturing companies record revenue upon selling inventory.

• Cost of Goods Sold (COGS) is the expense of inventory sold, affecting profitability levels on a multiple-step income statement:

  • Gross Profit: Net revenues minus COGS.

  • Operating Income: Gross profit minus operating expenses.

  • Net Income: All income before taxes minus income tax expense.

Cost Methods for Inventory

• Specific Identification: Matches actual unit cost.

• First-In, First-Out (FIFO): Assumes first units purchased are first sold.

• Last-In, First-Out (LIFO): Assumes last units purchased are first sold.

• Weighted-Average Cost: Uses the average cost of all inventory.

Financial Statement Effects of Inventory Cost Methods

• LIFO generally results in lower profits and taxes during rising prices.

• FIFO generally results in higher profits and a lower COGS during rising prices.

Recording Inventory Transactions

• Perpetual Inventory System: Maintains continuous, real-time records.

• Periodic Inventory System: Updates inventory balances at period-end via physical counts.

Special Considerations in Inventory Accounting

• Lower of Cost and Net Realizable Value: Inventory is reported at the lower of its cost or its expected selling price less completion and selling costs.

• Adjustments for freight charges, purchase discounts, and returns are crucial.

Analyzing Inventory Management

• Inventory Turnover Ratio: Measures sales frequency of average inventory (Formula: $rac{ ext{Cost of Goods Sold}}{ ext{Average Inventory}}$ ).

• Gross Profit Ratio: Measures profit from sales relative to cost (Formula: $rac{ ext{Gross Profit}}{ ext{Net Sales}}$).

• Inventory Errors: Impact COGS, gross profit, and retained earnings; an understated ending inventory overstates current COGS and affects future reporting.