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

Inventory and Cost of Goods Sold

Accounting for Inventory

Definition and Classification

Inventory consists of goods purchased for resale, distinct from supplies or equipment used internally. Inventory is classified as an asset because it provides future economic benefit, being convertible to cash through sales.

• Inventory: Asset on the balance sheet

• Cost of Goods Sold (COGS): Expense on the income statement

All inventory purchased is either sold (COGS) or remains in inventory (asset).

Inventory Equation:

$\text{Beginning Inventory} + \text{Purchases} = \text{Inventory Sold} + \text{Ending Inventory}$

Service vs. Merchandising Companies

• Merchandisers have two accounts not needed by service entities: COGS (income statement) and Inventory (balance sheet).

Sales Price vs. Cost of Inventory

• Sales Revenue: Based on sale price of inventory sold

• COGS: Based on cost of inventory sold

• Inventory: Based on cost of inventory still on hand

• Gross Profit: Excess of sales revenue over COGS; also called gross margin

$\text{Gross Profit} = \text{Sales} - \text{COGS}$

Inventory Counting and Ownership

• Number of units determined by accounting records and physical count

• Consigned goods: Inventory on consignment is included in seller’s records

• In transit goods: Ownership depends on shipping terms (FOB Shipping Point vs. FOB Destination)

Inventory Systems

• Perpetual Inventory System: Real-time record of goods bought, sold, and on hand; inventory counted at least annually

• Periodic Inventory System: Used for inexpensive goods; no running record; inventory counted at least annually

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: Transportation cost under FOB shipping point

• Purchase returns/allowances: Reduce inventory cost

• Purchase discounts: Earned by paying quickly

• Freight-out: Selling cost, 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 selected affects profits, taxes, and financial ratios. Four main methods:

• 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 most recent costs

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

Specific Identification Method

• Used for items like automobiles, antiques, real estate

• Assigns actual cost to each unit sold and remaining

Average-Cost Method

• Calculates average cost per unit

• COGS and ending inventory based on average cost

Example: If 60 units cost $900 total, and 40 units are sold, then:

COGS = $600 (40 units), Ending Inventory = $300 (20 units)

FIFO Method

• COGS assigned to oldest purchases

• Ending inventory reflects most recent purchases

LIFO Method

• COGS assigned to newest purchases

• Ending inventory reflects oldest purchases

Income and Tax Effects

• When costs are rising, LIFO results in lower taxable income and lower taxes

• FIFO provides more up-to-date inventory cost on the balance sheet

U.S. GAAP for Inventory

Key Principles

• Disclosure: Sufficient information for decision-making

• Representational Faithfulness: Proper disclosure of methods and transactions

• Consistency: Use comparable methods across periods

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

• Inventory reported at lower of historical cost or market value (net realizable value)

• Ensures assets are not overstated

Example: If inventory cost is $3,000,000 but market value is $2,000,000, report at $2,000,000.

Gross Profit, Inventory Turnover, and DIO

Gross Profit Percentage

• Key indicator of profitability

• Gross profit percentage = Gross profit / Sales

$\text{Gross Profit Percentage} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100$

Example: If sales are $88,500 and COGS is $28,500, gross profit is $60,000. Gross profit percentage =$\frac{60,000}{88,500} \times 100 = 68\%$

Inventory Turnover and Days Inventory Outstanding (DIO)

• Inventory Turnover = COGS / Average Inventory

• DIO = 365 / Inventory Turnover

• Higher turnover indicates faster sales

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

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

Cost-of-Goods-Sold Model for Management Decisions

Periodic Inventory System

• Ending inventory determined by physical count

• COGS calculated using inventory equation

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

Example: If beginning inventory is $10,500, purchases $28,000, freight-in $2,000, ending inventory $12,000:

$10,500 + 28,000 + 2,000 - 12,000 = 28,500$

Analyzing Inventory Records Using Excel

XLOOKUP Function

• Inventory identifiers: SKU, UPC, serial numbers

• XLOOKUP used to match inventory information across files

• Enables managers to combine transaction data with inventory details

Example: Use XLOOKUP to retrieve description, warehouse location, and inventory type for each transaction.

Practice Questions and Applications

Gross Profit Calculation

• Gross profit plus COGS equals sales revenue

• Sales price includes both cost and profit

Gross Margin Calculation

• Gross margin = (Net sales - COGS) / Net sales

• Example: $88,500 - 28,500 = 60,000; $60,000 / 88,500 = 68\%

COGS Calculation (Periodic System)

• COGS = Beginning inventory + Purchases + Freight-in - Ending inventory

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

Summary Table: Inventory Costing Methods

Method	Application	COGS Assignment	Ending Inventory
Specific Identification	Unique items	Actual cost per unit	Actual cost per unit
Average-Cost	Homogeneous items	Average cost	Average cost
FIFO	Any inventory	Oldest costs	Most recent costs
LIFO	Any inventory	Newest costs	Oldest costs

Additional info: Academic context was added to clarify inventory systems, costing methods, and Excel applications. Practice questions were expanded for clarity and completeness.