Inventory and Cost of Goods Sold

Overview of Inventory in Financial Accounting

Inventory is a critical component of current assets for merchandising and manufacturing companies. Unlike service businesses, which do not hold inventory, merchandising companies must account for inventory and its related expense, cost of goods sold (COGS), on their financial statements. The proper accounting for inventory affects both the balance sheet and the income statement, influencing reported assets, expenses, and net income.

• Service Businesses: No inventory account; income statement includes only service revenue and expenses.

• Merchandising Companies: Inventory is a major current asset; COGS is a significant expense deducted from sales to determine gross profit.

• Gross Profit: Calculated as sales minus COGS; not present in service-type businesses.

Inventory and Financial Statements

Inventory is reported at cost on the balance sheet. Unsold goods remain as assets, while sold goods are expensed as COGS. The relationship between inventory and COGS is fundamental to understanding financial statement impacts.

• Example: If a company has 300 hoodies at $30 each, sells 200 at $50 each, COGS is $6,000 (200 x $30), sales revenue is $10,000 (200 x $50), and gross profit is $4,000.

• Unsold Inventory: Remains on the balance sheet at cost, not at selling price.

Net Sales and Net Purchases

Retailers report net sales on the income statement, which is sales less sales returns, allowances, and discounts. Similarly, net purchases are calculated by adjusting purchases for freight, returns, allowances, and discounts.

• Sales Returns: Items returned by customers; contra-revenue.

• Sales Allowances: Price reductions for damaged or display items.

• Sales Discounts: Reductions for early payment.

• Net Purchases: Purchase price plus freight, less returns, allowances, and discounts.

Definition and Classification of Inventory

Inventory includes goods held for sale and, for manufacturers, goods in process. It is listed as a current asset, typically as the last current asset on the balance sheet.

• Merchandise Inventory: Goods purchased for resale.

• Manufacturing Inventory: Includes raw materials, work-in-process, and finished goods.

Calculation of Cost of Goods Sold

The calculation of COGS is logical and mirrors the use of supplies in earlier chapters. The formula is:

• Beginning Inventory: Inventory at the start of the period.

• Net Purchases: Total purchases adjusted for returns, allowances, discounts, and freight.

• Goods Available for Sale: Beginning Inventory + Net Purchases.

• Ending Inventory: Inventory remaining at period end.

• COGS Formula:

Inventory Errors and Their Impact

Errors in inventory valuation can significantly affect financial statements. Overstating or understating ending inventory impacts COGS, net income, assets, and stockholders' equity.

• Year 1: Ending Inventory Overstated

  • COGS understated

  • Net income overstated

  • Assets overstated

  • Stockholders' equity overstated

• Year 2: Beginning Inventory Overstated

  • COGS overstated

  • Net income understated

  • Assets unaffected (if ending inventory is correct)

  • Stockholders' equity balances out over two years

Special Inventory Problems

Inventory accounting must address goods in transit and goods on consignment.

• Goods in Transit: Ownership depends on shipping terms:

  • FOB Shipping Point: Buyer owns goods once shipped; must include in inventory even if not received.

  • FOB Destination: Seller retains ownership until goods reach buyer; seller includes in inventory until delivery.

• Goods on Consignment: Consignor owns goods held by consignee; must include in consignor's inventory.

Inventory Systems: Periodic vs. Perpetual

Companies use either periodic or perpetual inventory systems to track inventory.

• Periodic System: No detailed records; physical count required to determine inventory on hand.

• Perpetual System: Continuous, detailed records; inventory updated with each transaction.

Journal Entries for Inventory Transactions (Perpetual System)

• Purchase of Inventory:

  • Debit Inventory

  • Credit Accounts Payable

• Sale of Inventory:

  • Debit Accounts Receivable

  • Credit Sales Revenue

  • Debit Cost of Goods Sold

  • Credit Inventory

Inventory Cost Flow Methods

Inventory methods determine how costs are assigned to COGS and ending inventory. The main methods are:

• Specific Identification: Tracks exact cost of each item; used for unique, high-value items (e.g., auto dealerships).

• FIFO (First-In, First-Out): First items purchased are first sold; ending inventory at more recent costs.

• LIFO (Last-In, First-Out): Last items purchased are first sold; ending inventory at older costs.

• Weighted Average: Inventory and COGS based on average cost per unit.

FIFO Example

• Beginning Inventory: 10 units @ $10

• Purchase 1: 25 units @ $14

• Purchase 2: 25 units @ $18

• Units Sold: 40

• Ending Inventory: 20 units (valued at most recent costs)

• Ending Inventory: 20 units @ $18 = $360

• COGS: $900 (total goods available) - $360 = $540

LIFO Example

• Ending Inventory: 10 units @ $10 = $100; 10 units @ $14 = $140; Total = $240

• COGS: $900 - $240 = $660

Weighted Average Example

• Average Cost per Unit: $900 / 60 units = $15

• Ending Inventory: 20 units @ $15 = $300

• COGS: $900 - $300 = $600

Comparison of Inventory Methods

During periods of rising prices (inflation):

*Additional info: In periods of falling prices (deflation), the effects are reversed.

Advantages and Disadvantages of Inventory Methods

• FIFO:

  • Advantages: Follows physical flow; ending inventory at recent prices; better balance sheet; higher reported income during inflation.

  • Disadvantages: Not beneficial for taxes during inflation; gross profit overstated; higher taxes.

• LIFO:

  • Advantages: Matches recent revenues with recent costs; better income statement; lower taxes during inflation.

  • Disadvantages: Does not follow physical flow; ending inventory at old costs; lower reported income for financial reporting.

• Weighted Average:

  • Advantages/Disadvantages: Results are between FIFO and LIFO.

Consistency Principle

Companies must use the same inventory method year to year for comparability. Changes are allowed but must be justified and disclosed in financial statement notes.

Lower of Cost or Market (LCM) Rule

Inventory is valued at the lower of its historical cost or current market (replacement) cost, following the conservatism principle to avoid overstating assets.

• Cost: Determined by one of the four inventory methods.

• Market: Current replacement cost.

• Write-down Entry: If market is lower than cost, inventory is credited and COGS is debited.

Gross Profit Method for Estimating Inventory

The gross profit method estimates ending inventory and COGS when a physical count is not possible, often used for interim reporting or insurance claims.

• Step 1: Calculate goods available for sale (Beginning Inventory + Purchases).

• Step 2: Estimate COGS using sales and gross profit percentage.

• Step 3: Subtract estimated COGS from goods available to estimate ending inventory.

Example: If sales are \text{Estimated COGS} = 8,000 \times 0.60 = 4,800

Summary Table: Inventory Methods Comparison

*Additional info: Table summarizes effects during inflation; effects reverse during deflation.