Inventory and Cost of Goods Sold: Study Notes for Financial Accounting

Inventory and Cost of Goods Sold

Introduction

This chapter covers the accounting principles and practices related to inventory and cost of goods sold (COGS), a fundamental topic in financial accounting. Understanding inventory accounting is essential for accurate financial reporting, management decision-making, and compliance with U.S. GAAP.

Learning Objectives

• Show how to account for inventory

• Apply and compare various inventory cost methods

• Explain and apply underlying U.S. GAAP for inventory

• Compute and evaluate gross profit percentage, inventory turnover, and days’ inventory outstanding (DIO)

• Use the cost-of-goods-sold (COGS) model to make management decisions

• Analyze effects of inventory errors

• Analyze inventory records using the XLOOKUP function in Excel

Accounting for Inventory

Definition and Classification

Inventory refers to goods purchased for resale, distinct from supplies or equipment used internally. Inventory is classified as an asset on the balance sheet because it provides future economic benefit through eventual sale.

• Asset: Inventory is expected to be sold for cash, which can be used in operations.

• Cost of Goods Sold (COGS): When inventory is sold, its cost is transferred from asset to expense on the income statement.

Service vs. Merchandising Companies

Merchandising companies have two accounts not needed by service companies:

• Inventory (Balance Sheet)

• Cost of Goods Sold (Income Statement)

Inventory Equation

The basic inventory accounting equation is:

• Beginning Inventory + Purchases = Inventory Sold + Ending Inventory

This equation ensures all inventory purchased is either sold or remains in inventory.

Sales Price vs. Cost of Inventory

• Sales Revenue: Based on the sale price of inventory sold.

• COGS: Based on the cost of inventory sold.

• Inventory (Balance Sheet): Based on the cost of inventory still on hand.

• Gross Profit: The excess of sales revenue over COGS. $Gross\ Profit = Sales\ Revenue - COGS$

Inventory Counting and Consignment

• Inventory units are determined from accounting records and physical counts.

• Consigned goods are included in the seller’s inventory, not the retailer’s.

Cost per Unit and Inventory Systems

• Unit costs may vary throughout the year, affecting COGS and ending inventory.

• Perpetual Inventory System: Maintains a running record of inventory; used for all types of goods.

• Periodic Inventory System: Used for inexpensive goods; inventory counted at least once a year.

Shipping Terms

• FOB Shipping Point: Buyer owns goods during transit and pays transportation costs.

• FOB Destination: Seller owns goods during transit and pays transportation costs.

Recording Inventory Transactions (Perpetual System)

• Purchases: Debit Inventory, Credit Cash/Accounts Payable

• Sales: Debit Cash/Accounts Receivable, Credit Sales Revenue; Debit COGS, Credit Inventory

• Freight-in, purchase returns, purchase allowances, and purchase discounts affect inventory cost.

• Freight-out is a selling expense, not part of inventory cost.

The cost of inventory includes all costs to bring the asset to its intended use, less any discounts.

Inventory Costing Methods

Overview

The method chosen affects reported profits, income tax, and key ratios. Four main methods are used:

• Specific Identification: Used for unique items; assigns actual cost to each unit.

• Average-Cost (Weighted-Average): Uses average cost of inventory during the period.

• FIFO (First-In, First-Out): First costs in are first assigned to COGS; ending inventory reflects latest costs.

• LIFO (Last-In, First-Out): Last costs in are first assigned to COGS; ending inventory reflects oldest costs.

Example: Average-Cost Method

• Goods Available for Sale: 60 units, $900 total cost

• COGS: 40 units, $600

• Ending Inventory: 20 units, $300

Average cost per unit: $\frac{Total\ Cost}{Total\ Units} = \frac{900}{60} = 15$

FIFO vs. LIFO

• FIFO: Assigns oldest costs to COGS; ending inventory is valued at most recent costs.

• LIFO: Assigns newest costs to COGS; ending inventory is valued at oldest costs.

When inventory costs are rising, LIFO results in lower taxable income and lower taxes, while FIFO provides a more up-to-date inventory cost on the balance sheet.

U.S. GAAP for Inventory

Key Principles

• Disclosure: Financial statements must provide enough information for informed decisions.

• Representational Faithfulness: Inventory methods and material transactions must be properly disclosed.

• Consistency: Use comparable methods from period to period.

Lower-of-Cost-or-Market (LCM) Rule

Inventory must be reported at the lower of historical cost or market value (net realizable value). If inventory value drops below cost, the asset is written down to market value.

• Example: Inventory purchased for $3,000,000, estimated recoverable value $2,000,000. Report inventory at $2,000,000.

Gross Profit, Inventory Turnover, and DIO

Gross Profit Percentage

Gross profit percentage is a key indicator of a company’s ability to sell inventory at a profit.

• $Gross\ Profit = Sales - COGS$

• $Gross\ Profit\ Percentage = \frac{Gross\ Profit}{Sales}$

• Example: Under Armour’s gross profit percentage of 46.9% means each $1 of sales generates $0.469 of gross profit.

Inventory Turnover and Days Inventory Outstanding (DIO)

• $Inventory\ Turnover = \frac{COGS}{Average\ Inventory}$

• $DIO = \frac{365}{Inventory\ Turnover}$

• Higher turnover indicates rapid sales; varies by industry.

Comparative statistics show that companies with similar gross margins may differ in inventory turnover, affecting overall profitability.

Cost-of-Goods-Sold Model and Management Decisions

Periodic Inventory System

When perpetual tracking is unavailable, companies use the periodic system:

• Ending inventory is determined by physical count.

• COGS is calculated as: $COGS = Beginning\ Inventory + Purchases - Ending\ Inventory$

Physical counts are necessary even in perpetual systems to account for theft or damage.

Excel Functions for Inventory Analysis

XLOOKUP Function

Inventory identifiers (SKU, UPC, serial numbers) are used to match transaction data with inventory records. The XLOOKUP function in Excel helps managers retrieve information such as description, warehouse location, and inventory type for analysis.

• Useful for combining sales transaction files with inventory reference files.

Practice Questions and Applications

Gross Profit Calculation

• Gross profit plus COGS equals sales revenue.

• Example: Sales price $100, cost $70, profit $30.

Gross Margin Calculation

• Net sales: $88,500; COGS: $28,500

• Gross profit: $88,500 - $28,500 = $60,000

• Gross margin percentage: $\frac{60,000}{88,500} \approx 68\%$

COGS Calculation (Periodic System)

• Beginning inventory: $10,500; Purchases: $28,000; Freight-in: $2,000; Ending inventory: $12,000

• COGS: $10,500 + 28,000 + 2,000 - 12,000 = 28,500$

Summary Table: Inventory Costing Methods

Method	Application	Effect on COGS	Effect on Ending Inventory
Specific Identification	Unique items (e.g., cars, antiques)	Actual cost of each unit	Actual cost of each unit
Average-Cost	Homogeneous items	Average cost per unit	Average cost per unit
FIFO	Any inventory	Oldest costs	Most recent costs
LIFO	Any inventory	Newest costs	Oldest costs

Conclusion

Inventory accounting is crucial for accurate financial reporting and management decision-making. Understanding the different inventory costing methods, their effects on financial statements, and the application of U.S. GAAP ensures compliance and provides valuable insights for business operations.