Inventory and Cost of Goods Sold (COGS)

What is Inventory?

Inventory refers to goods purchased by a business for resale. In retail, inventory is not manufactured but bought to be sold to customers. The cost of inventory is a key component in determining the cost of goods sold (COGS), which is an expense recognized when inventory is sold.

• Inventory as an Asset: When inventory is purchased, it is recorded as an asset on the balance sheet.

• COGS as an Expense: When inventory is sold, its cost is transferred from asset to expense (COGS) on the income statement.

• Gross Margin: The difference between sales revenue and COGS. Formula:

Situations to Handle in Inventory Accounting

• Basic Sale of Inventory: Buy at cost, hold as inventory, expense it when sold.

• Quantity Discounts: Lower unit price if you buy more. Use the discounted cost as the inventory cost.

• Purchase Discounts (Cash Discounts): Example: 3/15, n/30 means you take 3% off if you pay within 15 days; otherwise, full amount due in 30 days. If you take the discount, your inventory cost is lower.

• Purchase Returns and Allowances: Return goods at a price reduction/credit. Reduce inventory (and accounts payable) accordingly.

• Adjusting for Physical Count: Shrinkage or breakage may occur. After a physical count, adjust book inventory to match reality. The difference goes to expense.

Note: Be ready to record entries from both the buyer’s and the seller’s perspective.

Methods for Calculating Cost of Goods Sold (COGS)

When selling inventory, it is important to determine which cost to assign to the goods sold. Several methods exist:

1. Specific-Unit (Specific Identification): Match each item to its exact purchase cost. Used for unique or high-value items (e.g., guitars, laptops).

2. Weighted-Average (Moving Average under Perpetual): Used when items are indistinguishable and numerous (e.g., identical T-shirts). Each purchase updates the average cost per unit. Formula: COGS for each sale:

3. FIFO (First-In, First-Out): Assumes the oldest costs leave first. Results in lower COGS and higher ending inventory during periods of rising prices.

4. Lower of Cost and Net Realizable Value (LCNRV): Inventory must be carried at the lower of (a) its cost (from your method above) and (b) what you expect to get on sale minus finishing and selling costs (NRV). If NRV drops below cost, write it down.

Additional info: Periodic system details, Gross Margin Method, and Retail Method are skipped for this course.

Accounts Receivable and the Aging Method

Allowance for Doubtful Accounts and Net Realizable Value

Not every customer will pay their balance. To reflect expected credit losses, businesses record an Allowance for Doubtful Accounts (AFDA), a contra-asset that reduces Accounts Receivable (A/R) to its net realizable value (NRV).

• Key formula:

• Aging Method: Groups receivables by how long they have been outstanding and applies different loss rates to each group. Considered more accurate and commonly used under GAAP/IFRS.

• Percent of Sales Method: Focuses on income statement; not the focus for this course.

• Direct Write-Off Method: Not acceptable under GAAP/IFRS for financial reporting.

Debit and Credit Card Transactions

Basics of Recording Card Transactions

Understand the flow of merchant fees, timing of cash receipt, and related journal entries. No detailed calculations required unless specified in class.

Sales Taxes (VAT vs. PST)

Value-Added Taxes (VAT-type) in Canada

The federal GST/HST and Quebec’s QST are value-added taxes (VAT-style). These are collected at each stage with input tax credits for businesses.

• Provincial Sales Taxes (non-VAT): In provinces like British Columbia, Saskatchewan, and Manitoba, PST is generally a retail sales tax (not VAT). Know which system applies in examples and how to record the tax on sales/purchases.

Topics Omitted for Test 2

• Ratios

• Income statement formats

• Appendix