Chapter 7 REPORTING AND INTERPRETING COST OF GOODS SOLD AND INVENTOY UNDERTSTANDING THE BUSINESS Cost of goods sold is subtracted from net sales to produce gross profit on its income statement On the balance sheet inventory is a current asset The accounting system plays three roles in the inventory management process o First the system must provide accurate information for preparation of periodic financial statements and tax returns o Second it must provide up to date information on inventory quantities and costs to facilitate ordering and manufacturing decisions o Third since inventories are subject to theft and other forms of misuse the system must also provide the information needed to help protect these important assets NATURE OF INVENTORY AND COST OF GOODS SOLD Items Included in Inventory Inventory is a tangible property that is 1 held for sale in the normal course of business or 2 used to produce goods or services for sale Merchandise Inventory goods held for resale in the normal course of business The goods usually are acquired in a finished condition and are ready for sale without further processing Manufacturing businesses hold here types of inventory o Raw Materials Inventory items acquired for processing into finished goods Included in RMI until they are used at which point they become part of work in process inventory o Work In Process Inventory goods in the process of being manufactured but not yet complete When complete these items become finished goods inventory o Finished Goods Inventory manufactured goods that are complete and ready for sale Costs Included in Inventory Purchases Goods in inventory are initially recorded at cost In general the company should cease accumulating purchase costs when the raw materials are ready for use or when merchandise inventory is ready for shipment Chapter 7 REPORTING AND INTERPRETING COST OF GOODS SOLD AND INVENTOY Flow of Inventory Costs When merchandise is purchased the merchandise inventory account is increased When the goods are sold cost of goods sold is increased and merchandise inventory is decreased Direct labor refers to the earnings of employees who work directly on the products being manufactured Factory overhead costs include all other manufacturing costs o Manufacturing costs that are not raw material or direct labor costs There are three stages of inventory cash flow for both manufacturers and merchandisers sheet o Purchasing and or production activities o Activities result in additions to inventory accounts on the balance o The inventory items are sold and the amounts become cost of goods sold expense on the income statement Nature of Cost of Goods Sold Beginning Inventory BI inventory stock that the beginning of accounting During the accounting period new purchases are also added to the The sum of both of these amounts if the goods available for sale during that What remains unsold at the end of the period becomes ending inventory EI on the balance sheet The portion of goods available for sale that is sold becomes cost of goods sold on the income statement Cost of goods sold equation BI P EI CGS period inventory period Chapter 7 REPORTING AND INTERPRETING COST OF GOODS SOLD AND INVENTOY INVENTORY COSTING METHODS When inventory costs have changed which inventory items are treated as sold or remaining in inventory can turn profits into losses and cause companies to pay or save millions in taxes Four generally accepted inventory costing methods are available for determining cost of goods sold o Specific identification o First In First Out FIFO o Last In Last Out LIFO o Average Cost Specific Identification Method Specific Identification Method identifies the cost of the specific item that was sold The specific identification method is impractical when large quantities of similar items are stoked On the other hand when dealing with expensive unique items such as houses or fine jewelry this method is appropriate Cost Flow Assumptions First In First Out Method First In First Out method assumes that the earliest goods purchased are the first foods sold and the last goods purchased are left in ending inventory Under FIFO cost of goods sold and ending inventory are computed as if the flows are taken in and out of an inventory bin FIFO allocates the oldest unit costs to cost of goods sold and the newest unit costs to ending inventory Last In First Out Method Last In First Out Method assumes that the most recently purchased goods are sold first and the oldest units are left in ending inventory LIFO allocates the newest unit costs to cost of goods sold and the oldest unit costs to ending inventory Chapter 7 REPORTING AND INTERPRETING COST OF GOODS SOLD AND INVENTOY Average Cost Method Average cost method uses the weighted average unit cost of the goods available for sale for both cost of goods sold and ending inventory o Average cost Cost of Goods Available for Sale Number of Units Available for Sale Financial Statement Effects of Inventory Methods Each of the four alternative inventory costing methods is in conformity with GAAP and the tax law The method that gives the highest ending inventory amount also gives the lowest cost of goods sold and the highest gross profit income tax expense and income amounts that are between the FIFO and LIFE extremes When unit costs are rising LIFO produces lower income and a lower inventory valuation than FIFO When unit costs are declining LIFO produces higher income and higher inventory valuation than FIFO Chapter 7 REPORTING AND INTERPRETING COST OF GOODS SOLD AND INVENTOY Managers Choice of Inventory Methods Most managers choose accounting methods based on two factors o Net income effects o Income tax effects LIFO Conformity Rule if LIFO is used on the income tax return it must also be used to calculate inventory and cost of goods sold for the financial statements Increasing Cost Inventories For inventory with increasing costs LIFO is used on the tax return because it normally results in lower income taxes Decreasing Cost Inventories For inventory with decreasing costs FIFO is most often used for both the tax return and in financial statements Using this method produces the lowest tax payments for companies with decreasing cost inventories Consistency in the Use of Inventory methods Regardless of the physical flow of goods a company can use any of the inventory costing methods Also a company is not required to use the same inventory costing method for all inventory items and no
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