Chapter 7 Reporting and interpreting cost of goods sold and inventory Cost principle requires that inventory be recorded at the price paid or the consideration given Invoice price Inspection costs Freight in Preparation costs Beginning inventory Purchases Goods Available for Sale Goods Available for Sale Ending inventory inventory remaining Cost of goods sold inventory sold Inventory systems Perpetual Purchase transactions are recorded directly in an inventory account Sales require two entries to record 1 the retail sale and 2 the cost of goods sold Periodic end of accounting period No up to date record of inventory is maintained during the year Sales require one entry to record the retail sale Cost of goods sold is calculated Beginning Inventory Net Profit Ending inventory COGS Beginning inventory Net Profit Ending inventory COGS Perpetual inventory systems and cost flow assumptions in practice FIFO inventory and cost of goods sold are the same whether computed on a perpetual or periodic basis Accounting systems that keep track of the costs of individual items normally do so on a FIFO or average cost basis As a consequence companies that wish to report under LIFO convert the outputs of their perpetual inventory system to LIFO with an adjusting entry at the end of each period Valuation at Lower of Cost or Market Ending inventory is reported at the lower of cost or market LCM Replacement Cost The current purchase price for identical goods Conservative practice The company will recognize a holding loss in the current period rather than the period in which the item is sold Beginning Inventory Ending Inventory 2 This ratio reflects how many times average inventory was produced and sold during the period A higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence costs This ratio reflects the average time in days it takes a company to produce and deliver inventory to its customers Cost Flow Assumptions The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves Flow of inventory cost Inventory Costing Methods Specific Identification When units are sold the specific cost of the unit sold is added to cost of goods sold Goods available for sale 560 Ending inventory 260 Cost of goods sold 300 1 2 First in First out FIFO Oldest cost Recent cost COGS Ending inventory Harley Davidson Model A Leather Jacket Inventory Units Unit Total Date Beginning Inventory Purchases Jan 12 Jan 14 Goods Available for Sale 2 70 140 4 1 80 100 320 100 7 560 3 Last in First out LIFO Oldest cost Recent cost Ending inventory COGS Harley Davidson Model A Leather Jacket Inventory Units Unit Total Date Beginning Inventory Purchases Jan 12 Jan 14 Goods Available for Sale 2 70 140 4 1 80 100 320 100 7 560 Cost of Goods Available for Sale Number of Units Available for Sale Harley Davidson Model A Leather Jacket Inventory Units Unit Total Date Beginning Inventory Purchases Jan 12 Jan 14 Goods Available for Sale 2 70 140 4 1 80 100 320 100 7 560 Goods available for sale 560 Ending inventory 220 Cost of goods sold 340 4 Weighted Average When a unit is sold the average cost of each unit in inventory is assigned to cost of goods sold Goods available for sale 560 Ending inventory 240 Cost of goods sold 320 Managers Choice of Inventory Methods Net Income Effects Managers prefer to report higher earnings for their companies Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible LIFO Conformity Rule If last in first out is used to compute taxable income it must also be used to calculate inventory and cost of goods sold for financial statements Advantages of Methods First In First Out Last In First Out Weighted Average Financial statement effects of inventory costing methods Ending inventory approximates current replacement cost Better matches current costs in cost of goods sold with revenues Smooths out effects of price changes Harley DavidsonModel A Leather Jacket InventoryDateUnits UnitTotalBeginning Inventory2 70 140 Purchases Jan 124 80 320 Jan 141 100 100 Goods Available for Sale7 560 Harley DavidsonModel A Leather Jacket InventoryDateUnits UnitTotalBeginning Inventory2 70 140 Purchases Jan 124 80 320 Jan 141 100 100 Goods Available for Sale7 560 Harley DavidsonModel A Leather Jacket InventoryDateUnits UnitTotalBeginning Inventory2 70 140 Purchases Jan 124 80 320 Jan 141 100 100 Goods Available for Sale7 560 Increasing costs normal financial statement effects Cost of goods sold on income statement Net income Income taxes Inventory on balance sheet FIFO LIFO International Perspective LIFO and International Comparisons While U S GAAP allows companies to choose between FIFO LIFO and weighted average inventory methods International Financial Reporting Standards IFRS currently prohibit the use of LIFO GAAP allows different inventory accounting methods to be used for different types of inventory items IFRS requires that the same method be used for all inventory items that have a similar nature and use These differences can create comparability problems when one attempts to compare companies across international borders
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