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“FINANCIAL ACCOUNTING” by: Robert Libby, Patricia A. Libby, and Daniel G. Short (4th Ed.) Chapter 7 - Reporting and Interpreting Cost of Goods Sold and Inventory
BUSINESS BACKGROUND

2. BUSINESS BACKGROUND
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1. Inventory is a major concern to all merchandisers and manufacturers.
2. Beginning and ending inventories are used in the calculation of Cost of Goods Sold on the Income Statement.
3. A good accounting system is an important factor to furnish information for proper inventory management. It should provide for accurate data, timely information, and the protection of the inventory assets.

3. NATURE OF INVENTORY AND COST OF GOODS SOLD – LO 1 - ITEMS INCLUDED IN INVENTORY
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1. Inventory is tangible property held for sale in the normal course of business or that will be used in producing goods or services for sale.
2. There are various types of inventories depending on the industry of a company.
a includes goods (merchandise) held for resale in the
ordinary course of business. These goods are usually in a finished condition
when acquired.
b includes items acquired by purchase,
growth (food products) or extraction (natural resources) for processing into
finished goods. These items are included in raw materials until used, at which
point they become part of work in process inventory.
c is also known as work in progress, goods
in process, or goods in progress. It includes goods in the process of being
manufactured that are incomplete. When completed, work in process
becomes finished goods inventory.
d includes goods that have been
manufactured by a company. They are completed goods ready for sale.
Merchandise inventory
Raw materials inventory (RM)
Work in process inventory (WIP)
Finished goods inventory (FG)

4. NATURE OF INVENTORY AND COST OF GOODS SOLD - ITEMS INCLUDED IN INVENTORY (CONTINUED)
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3. Items in inventory are recorded in conformity with the cost principle. The primary basis of accounting for inventory is the cash equivalent cost, which is the price paid or consideration given to acquire an asset. Applicable expenditures and charges incurred in bringing an item to a usable or salable condition and location are part of the cost to be recorded.

5. NATURE OF INVENTORY AND COST OF GOODS SOLD – LO 1 - FLOW OF INVENTORY COSTS
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1. Merchandiser:
a. Cost to acquire – merchandiser
Price paid
Freight-in
Other costs to make it salable
b. Merchandiser activities
- increase merchandise inventory at cost
Sell merchandise inventory at cost and cost of goods sold at cost
(or cash equivalent)
(transportation)
Purchase
decrease
increase

6. NATURE OF INVENTORY AND COST OF GOODS SOLD – LO 1 - FLOW OF INVENTORY COSTS (CONTINUED)
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2. Manufacturer:
a. Costs to make - manufacturer
Raw materials used including Freight-in
Direct Labor costs for wages of persons working directly on the transformation of raw materials into finished goods.
Factory Overhead costs which include costs other than direct materials and direct labor costs that are associated with and necessary for production. These costs include such items as factory rent, factory utilities, factory supervision, and patent amortization.
b. Manufacturer activities
Raw Material Purchase - increase raw materials inventory at cost
Raw Material Use - decrease RM inventory at cost and increase WIP inventory at cost
Direct Labor incurred - increase WIP inventory at cost
Factory Overhead incurred - increase WIP inventory at cost
Manufacturing completed - decrease WIP inventory at cost and increase FG inventory at cost
Sell - decrease FG inventory at cost and increase cost of good sold at cost

7. NATURE OF INVENTORY AND COST OF GOODS SOLD – LO 1 - NATURE OF COST OF GOODS SOLD
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1. The cost of units sold should be presented on the income statement as a reduction of net sales to arrive at gross profit on sales.
2. The ending inventory of one accounting period becomes the beginning inventory of the next accounting period.
3. First, Beginning Inventory + Purchases = Goods Available for Sale
Then, Goods Available for Sale - Ending Inventory = Cost of Goods Sold.

8. INVENTORY COSTING METHODS – LO 2, 3, 4, 5 - SPECIFIC IDENTIFICATION
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a The specific item prices are traced to purchase invoices via serial numbers or detailed descriptions.
b. Special coding (such as bar codes) facilitates the use of this method.
c. This method is usually used for high cost items whose features tend to vary rather significantly. Car dealerships and jewelers commonly use this method. It is often impractical for companies selling large quantities of similar items to use this method.
This method tracks the specific items sold and on hand.

9. INVENTORY COSTING METHODS - COST FLOW ASSUMPTIONS
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1. First-In, First-Out Method
a. FIFO considers that the oldest units are sold first. Thus, the newest units
are on hand at the end of the accounting period. The oldest costs are
included in cost of goods sold while the newest costs are included in ending
inventory.
2. Last-In, First-Out Method
a. LIFO considers that the newest units are sold first. Thus, the oldest units are
on hand at the end of the accounting period. The newest costs are included in
cost of goods sold while the oldest costs are included in ending inventory.
b. LIFO is the opposite of FIFO.
(FIFO)
(LIFO)

10. INVENTORY COSTING METHODS - COST FLOW ASSUMPTIONS (CONTINUED)
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3. Average Cost Method
a. The average cost method uses an average cost per unit for determining
the unit cost to apply to units sold and units on hand at the end of the
accounting period.
Average cost per unit =
b. This method uses a weighted-average rather than a simple average.
c. This method produces results between the FIFO and LIFO methods.
Goods Available for Sale in dollars
Goods Available for Sale in units

11. INVENTORY COSTING METHODS - FINANCIAL STATEMENT EFFECTS OF INVENTORY METHODS
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a. All four methods are acceptable for GAAP and tax laws. Each is rational and systematic.
b. In times of changing prices, each method will produce differences in net income, stockholders' equity, and asset valuation amounts.
i LIFO produces lower net income, stockholders' equity and
asset valuations than FIFO.
ii LIFO produces higher net income, stockholders' equity
and asset valuations than FIFO.
iii. The average cost method produces amounts between the FIFO and LIFO
extremes.
iv. A company may use different methods for different types of inventory items.
Rising costs
Declining costs

12. INVENTORY COSTING METHODS - MANAGERS’ CHOICE OF INVENTORY METHODS
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1. Two factors contribute to the selection of accounting methods. They are net income effects and income tax effects (least-latest rule).
2. A company may choose different inventory methods for financial statement reporting and for tax reporting. However, if LIFO is used, it must be used for both types of reporting (LIFO conformity rule).
3. LIFO is This method selection is largely driven by income deferrals under the American tax system.
4. LIFO provides for matching while the balance sheet valuation presents
5. FIFO provides for but matches
6. A company should apply the method(s) consistently for comparability from one period to another. However, changes in methods may be made to improve the measurement of financial results and financial position. In this case, full disclosure requirements must be met.
widely used by U.S. companies.
current costs to current sales
older costs.
current valuations on the balance sheet,
older costs to current sales on the income statement.

13. INVENTORY COSTING METHODS - INVENTORY METHODS AND FINANCIAL STATEMENT ANALYSIS
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1. When different companies use different methods for costing inventory, comparability of those companies can be difficult and misleading.
2. A company's disclosure regarding inventory methods used allows analysts to convert the reported information to that of another inventory method.
3. The excess of FIFO over LIFO inventory
is helpful for conversions. LIFO Reserve is a contra asset for
the excess of FIFO over LIFO inventory.
Method difference for BI (LIFO to FIFO)
- Method difference for EI (LIFO to FIFO)
CGS difference (LIFO to FIFO)
Beginning LIFO Reserve
OR Ending LIFO Reserve
Note: This conversion can enhance comparability of performance for various companies.
4. Inventory costing methods used do NOT affect the real economic value of inventories.
(commonly referred to as LIFO
Reserve)

14. INVENTORY COSTING METHODS - VALUATION AT LOWER OF COST OR MARKET
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1. Inventory is initially recorded using
2. Lower of Cost or Market (LCM) is a based
a. If replacement cost is lower than actual cost, LCM must be used for balance
sheet reporting.
b. If net realizable value (selling price less costs to sell) is lower than actual cost,
LCM must be used for balance sheet reporting.
c. The application of LCM may be on the inventory in total or on each item in
inventory. The latter is a more conservative approach.
d. If a LCM adjustment is needed, the "write-down" loss is reflected currently as
an increase in cost of goods sold on the income statement.
e. Holding losses (write-downs) are recognized in the current period, but holding
gains (write-ups) are not recognized currently.
f. The LCM rule applies to all inventory methods. However, LCM may not be
applied for tax purposes if the LIFO method is used.
the cost principle.
departure from the cost principle
conservatism constraint.

15. EVALUATING INVENTORY MANAGEMENT – LO 6
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in Inventory Management
Inventory turnover measures the liquidity (nearness to cash) of inventory
Inventory turnover =
1. Ending inventory is also presented on the Balance Sheet as a current asset. Therefore, this account is used on more than one of the financial statements.
2. Inventory management is the responsibility of many managers within a company. It is a joint effort and is key to a company's survival and success.
3. A company should not have too little inventory or it may lose sales. On the other hand, a company should not have too much inventory or it will experience additional costs.
Measuring Efficiency
Cost of Goods Sold
Average inventory

16. CONTROL OF INVENTORY – LO 7
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1. Both clerical errors and fraudulent inventory amounts cause misstatements on the income statement and balance sheet. Clerical errors are unintentional mistakes. Fraud is an intentional misstatement of amounts. Erroneous amounts for inventory can have major impacts on both the income statement and balance sheet.
2. It is important to understand the two components of goods available for sale:
and
3. An ending inventory error for the current year - Income Statement (IS), Statement of Stockholders’ Equity (SSE) or Statement of Retained Earnings (SRE), and Balance Sheet (BS) are all incorrect.
4. Beginning inventory error next year - Income Statement and Statement of Stockholders' Equity are incorrect, but Balance Sheet at the end of year is correct. That is, the "error" will negate (turn around) itself by the end of the second year.
Errors in Measuring Ending Inventory
Ending Inventory
Cost of Goods Sold.

17. CONTROL OF INVENTORY - PERPETUAL INVENTORY SYSTEM
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how it works and what it does:
a. Up-to-date inventory records are kept.
b. Physical counts of inventory are performed to validate the inventory account.
The count does not need to coincide with the company's year-end. Any
discrepancies between the physical count and the accounting records will
result in an adjustment to the inventory account. These differences may result
from errors or theft.
c. The cost of goods acquired during the period is a direct increase to the
inventory account. The Purchases account is not used.
d. The cost of goods sold during the period is a direct decrease to the inventory
account. In addition, a cost of good sold account is increased for a like
amount.
e. Cost of goods sold and ending inventory have up-to-date balances throughout
the period.
Perpetual Inventory System

18. CONTROL OF INVENTORY - PERPETUAL INVENTORY SYSTEM (CONTINUED)
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how it works and what it does:
a. No up-to-date record exists for inventory.
b. Physical count of inventory at year-end is required to derive the ending
inventory amount.
c. Goods acquired during the period are accumulated in the Purchases account.
d. Cost of goods sold cannot be calculated until ending inventory is derived.
Periodic Inventory System