Inventory and Cost of Goods Sold

Introduction

This chapter covers the fundamental concepts of inventory accounting, including how inventory is recorded, valued, and reported in financial statements. It also explores various inventory costing methods, their impact on financial metrics, and the application of U.S. GAAP rules.

Accounting for Inventory

Definition and Classification

• Inventory refers to goods purchased for resale, distinct from items used internally (e.g., supplies, equipment).

• Inventory is classified as an Asset because it provides future economic benefit—it will be sold for cash, which can be used in operations.

Service vs. Merchandising Companies

Merchandising companies differ from service companies in their financial statement accounts:

• Merchandisers report Cost of Goods Sold (COGS) on the income statement and Inventory on the balance sheet.

• Service companies do not report these accounts.

Exhibit: Comparison Table

Inventory and Cost of Goods Sold Relationship

• Inventory purchased is either sold (COGS) or remains as ending inventory.

• Key equation:

• Inventory shifts from asset to expense when sold.

Example

Inventory Costing Methods

Overview

The method chosen affects reported profits, taxes, and financial ratios. The main methods are:

• Specific Identification

• Average-Cost (Weighted-Average)

• First-In, First-Out (FIFO)

• Last-In, First-Out (LIFO)

Specific Identification Method

• Used for unique, high-value items (e.g., cars, antiques).

• Each item’s actual cost is assigned to COGS or ending inventory.

• Not practical for large quantities of similar, low-cost goods.

Average-Cost Method

• Calculates average cost per unit:

• COGS:

• Ending Inventory:

FIFO Method

• First costs in are the first costs out (assigned to COGS).

• Ending inventory consists of the most recent purchases.

• In periods of rising prices, FIFO results in lower COGS and higher gross profit.

LIFO Method

• Last costs in are the first costs out (assigned to COGS).

• Ending inventory consists of the oldest purchases.

• In periods of rising prices, LIFO results in higher COGS and lower gross profit.

Comparison Table: Effects of Costing Methods

U.S. GAAP for Inventory

Key Principles

• Disclosure: Financial statements must provide enough information for decision-making.

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

• Consistency: Use comparable methods across periods.

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

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

• If market value drops below cost, inventory is written down.

• Under U.S. GAAP, write-downs cannot be reversed; under IFRS, some reversals are allowed.

Example

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

Gross Profit, Inventory Turnover, and Days Inventory Outstanding (DIO)

Gross Profit Percentage

• Measures ability to sell inventory at a profit.

• Formula:

• Gross Profit = Sales - COGS

Inventory Turnover

• Indicates how rapidly inventory is sold.

• Formula:

• Average Inventory = (Beginning Inventory + Ending Inventory) / 2

Days Inventory Outstanding (DIO)

• Average number of days inventory is held before sale.

• Formula:

Cost-of-Goods-Sold (COGS) Model

Periodic Inventory System

• Physical inventory count determines ending inventory.

• COGS is calculated using:

Analyzing Inventory Records Using Excel

XLOOKUP Function

• Inventory items are tracked using identifiers (SKU, UPC, serial numbers).

• XLOOKUP in Excel can retrieve inventory details from reference files for analysis.

• Useful for matching sales transactions with inventory descriptions, locations, and types.

Summary Table: Key Inventory Formulas

Additional info: These notes are based on textbook slides and professor annotations for a college-level Financial Accounting course, focusing on inventory and cost of goods sold concepts.