Inventory and Cost of Goods Sold: Financial Accounting Chapter 5 Study Notes

Inventory and Cost of Goods Sold

Introduction

This chapter covers the accounting for inventory and cost of goods sold (COGS) in merchandising companies. It explains the differences between service and merchandising companies, the treatment of inventory in financial statements, and the methods used to account for inventory and its cost.

Income Statements and Balance Sheets

Service vs. Merchandising Companies

• Service Companies earn revenue by providing services and do not have inventory or COGS on their income statements.

• Merchandising Companies buy and sell goods. Their income statements include Sales Revenue, Cost of Goods Sold (COGS), and Gross Profit (Sales Revenue minus COGS).

On the balance sheet, only merchandising companies report Inventory as a current asset.

Merchandise Inventory

Definition and Financial Statement Impact

• Inventory is the cost of goods on hand and is reported as an asset on the balance sheet.

• Cost of Goods Sold (COGS) is the cost of inventory that has been sold and is reported as an expense on the income statement.

• Gross Profit (or Gross Margin) is calculated as:

$\text{Gross Profit} = \text{Sales Revenue} - \text{Cost of Goods Sold}$

Example

• Inventory (1 chair @ cost of $300) appears as $300 on the balance sheet.

• COGS (2 chairs @ $300 each) totals $600 on the income statement.

• Gross profit from selling 2 chairs at $500 each: $1,000 - $600 = $400.

Inventory Cost and Units

Determining Inventory Units

• Units are determined from accounting records and verified by physical count at year-end.

• Goods in transit are included in inventory based on shipping terms.

Inventory Cost Components

• Basic purchase price

• Freight-in, insurance while in transit, and costs to get inventory ready to sell

• Less: Returns, allowances, and discounts

Shipping Terms

FOB Shipping Point	FOB Destination
Legal title passes to purchaser when items leave seller's place of business. Purchaser owns goods while in transit. Purchaser pays transportation costs.	Legal title passes to purchaser when items arrive at purchaser's receiving dock. Seller owns goods while in transit. Seller pays transportation costs.

Inventory Accounting Systems

Perpetual Inventory System	Periodic Inventory System
Used for all types of goods. Keeps a running total of all goods bought, sold, and on hand. Inventory counted at least once a year.	Used for inexpensive goods. Does not keep a running total of all goods bought, sold, and on hand. Inventory counted at least once a year.

Perpetual Inventory System

• Bar codes on products provide information for recording sales and updating inventory records.

• Each sale requires two entries:

  • Record revenue and asset received (cash or receivables).

  • Record cost of sale and reduction of inventory.

Recording Inventory Transactions (Example)

Date	Accounts and Explanation	Debit	Credit
	Inventory Accounts Payable Purchased inventory on account	560,000	560,000
	Accounts Receivable Sales Sold inventory on account	900,000	900,000
	Cost of Goods Sold Inventory Recorded cost of goods sold	540,000	540,000

Cost of Net Purchases

Item	Amount
Purchase price of inventory	$600,000
+ Freight-in	4,000
- Purchase returns	(25,000)
- Purchase allowances	(5,000)
- Purchase discounts	(14,000)
= Net purchases of inventory	$560,000

Net Sales

Item	Amount
Sales revenue
- Sales returns and allowances
- Sales discounts
= Net sales

Sales Returns, Allowances, and Discounts (IFRS)

Sales Returns and Allowances

• Customers may return unsatisfactory or damaged merchandise for refund, credit, or exchange, or be granted an allowance.

• Under IFRS, when a right of return exists, companies must:

  1. Recognize an accrued liability (Sales Refund Payable) for the expected returns.

  2. Adjust inventory and COGS for the cost of items expected to be returned using Estimated Inventory Returns.

Example Journal Entries

Date	Accounts and Explanation	Debit	Credit
	Cash, or Accounts Receivable	200,000
	Sales Revenue		198,000
	Sales Refund Payable ($200,000 × 1%)		2,000
	Record the price of product expected to be returned
	Cost of Goods Sold	118,800
	Inventory Returns Estimated ($120,000 × 1%)	1,200
	Inventory		120,000
	Record the cost of product expected to be returned

Sales Discounts

• Sales terms of 2/10, n/30 mean a 2% discount is available if payment is made within 10 days; otherwise, full payment is due in 30 days.

Date	Accounts and Explanation	Debit	Credit
	Accounts Receivable	1,500
	Sales Revenue		1,500
	Cost of Goods Sold	600
	Inventory		600
	To record sale and cost of inventory sold

Inventory Costing Methods

Overview

• Specific Identification Cost: Used for unique items (e.g., cars, jewelry). Each item is tracked at its specific cost.

• Weighted-Average Cost: Inventory cost is based on the average cost of all units available for sale.

• First-In, First-Out (FIFO): Assumes oldest inventory items are sold first; ending inventory consists of most recent purchases.

Example: Weighted Average and FIFO

• Beginning inventory: 10 units @ $11 = $110

• Purchases: 20 units @ $14, 15 units @ $16, 15 units @ $18

• Sold: 40 units; Ending inventory: 20 units

FIFO Calculation

• COGS: 10 units @ $11 + 20 units @ $14 + 10 units @ $16 = $550

• Ending Inventory: 5 units @ $16 + 15 units @ $18 = $350

Weighted-Average Cost Calculation

• Average cost per unit = Total cost of goods available / Total units available

• Example: $900 total cost / 60 units = $15/unit

• COGS: 40 units × $15 = $600

• Ending inventory: 20 units × $15 = $300

Comparison When Inventory Costs Are Increasing

• Weighted-average COGS is higher; gross profit and ending inventory are lower.

• FIFO COGS is lower; gross profit and ending inventory are higher.

Accounting Standards and Inventory

Comparability Principle

• Companies must use the same inventory accounting method from period to period for comparability.

• Changes in method require justification and restatement of prior financial statements.

Lower-of-Cost-and-Net-Realizable-Value (LCNRV) Rule

• Inventory is reported at the lower of cost or net realizable value (NRV), usually replacement cost.

• If NRV is lower than cost, inventory is written down:

$\text{Cost of Goods Sold} = \text{Inventory write-down to NRV}$

Inventory Analysis Ratios

Gross Profit Percentage

$\text{Gross Profit Percentage} = \frac{\text{Gross Profit}}{\text{Net Sales Revenue}}$

Inventory Turnover

$\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

Where $\text{Average Inventory} = \frac{\text{Beginning Inventory} + \text{Ending Inventory}}{2}$

Days' Inventory Outstanding

$\text{Days' Inventory Outstanding} = \frac{365 \text{ days}}{\text{Inventory Turnover}}$

Effects of Inventory Errors

• Errors in inventory affect COGS, gross profit, and net income.

• Overstating ending inventory understates COGS and overstates net income; understating ending inventory has the opposite effect.

Inventory and the Statement of Cash Flows

• Inventory transactions are classified as operating activities.

• Purchases of inventory require cash outflows; sales generate cash inflows.

Ethical Considerations

• Managers may be tempted to manipulate inventory figures to meet profit expectations.

• Common unethical practices include overstating ending inventory or creating fictitious sales.

Appendix: Periodic Inventory System

• Does not keep a running total of inventory; updates inventory and COGS at period end.

• COGS is calculated as:

$\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$

• Inventory costing methods (FIFO, weighted-average) can also be applied under the periodic system.