Inventories and Cost of Goods Sold
A. Relation between Inventories & COGS
1. The items included in Inventories
a. Inventory & Inventory Accounting
Inventory: Goods that are either manufactured or purchased for resale in the normal course of business.
Merchandising Manufacturing
Cost valuation of inventory accounting: Assigning historical-cost value to ending inventories ;Total ending inventory = Historical cost per unit ×number of units remaining in inventory
b. Determining Inventory items
Inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted.
Goods in Transit 在途存货
Ownership passes to buyer here
Goods on Consignment 委托代销
Merchandise is included in the inventory of the consignor, the owner of the inventory.
Consignee 代销方 Consignor 委托方
Goods Damaged or Obsolete 损毁或过期
Damaged or obsolete goods are not counted in inventory.
Cost should be reduced to net realizable value(可实现净值).
c. Determining Inventory Costs
Include all expenditures necessary to bring an item to a salable condition and location.
+Transportation/Assembling/Warehouse/Insurance
-Purchase Discounts/Allowance & Returns
d. Inventory & COGS
Inventory: Products being held prior to sale
COGS: the expenses incurred to purchase or manufacture the merchandise sold during a period.
When the products are sold, the cost of the inventory becomes COGS in the IS
Net Sales – COGS= Gross Profit (Gross Margin)
e. The Allocation of cost between COGS & Ending Inventory Merchandising
Beginning Inventory COGS (IS)
cost of goods available for sale
Net cost of purchase Ending Inventory (BS)
Cost of Goods Available for Sale = Inventory (Beg) + Purchase
Cost of Goods Available for Sale = Inventory (End) + COGS
2. Accounting for Inventories
Two Inventory Systems
1) Perpetual:
Records are updated when a purchase or sale is made.
Records reflect total items in inventory or sold at any given time.
Most often used when each item has a relatively high value, or the cost of running out of or overstocking an item is expensive.
Perpetual Inventory:
Bar Code
Two entries: revenue & asset received ; COGS & reduction of inventory
2) Periodic:
Records are not updated when a purchase or a sale is made.
Only the dollar amount of the sale is recorded.
Used when inventory is composed of a large number of diverse items, each with a relatively low value.
*How to Write Journal Entries:
#Journal Entries for Purchases
Perpetual:
Dr. Inventory
Cr. Accounts Payable
Periodic:
Dr. Purchases
Cr. Accounts Payable
#Journal Entries for Transportation Cost
Perpetual:
Dr. Inventory
Cr. Cash
Periodic:
Dr. Freight in
Cr. Cash
#Journal Entries for Purchase Returns
Perpetual:
Dr. Accounts Payable (Cash)
Cr. Inventory
Periodic:
Dr. Accounts Payable (Cash)
Cr. Purchase Return
#Journal Entries for Purchase Discounts
Perpetual:
Dr. Inventory
Cr. Accounts Payable
Dr. Accounts Payable
Cr. Inventory
Cr. Cash
Periodic:
Dr. Purchase
Cr. Accounts Payable
Dr. Accounts Payable
Cr. Purchase Discounts
Cr. Cash
# Journal Entries for Sales
Perpetual:
Dr. Accounts Receivable
Cr. Sales Revenue
Dr.COGS
Cr. Inventories
Periodic:
Dr. Accounts Receivable
Cr. SalesRevenue
#Journal Entries for Sales Returns
Perpetual:
Dr.SalesReturns
Cr. Accounts Receivable
Dr. Inventory
Cr. Cost of Goods sold
Periodic:
Dr.SalesReturns
Cr. Accounts Receivable
#Journal Entries for Closing Entries for COGS
Perpetual：
NO Entries！
Periodic：
the purchase, freight-in, purchase discounts, and purchase returns, are closed to COGS accounts
Dr. COGS
Dr. Purchase Returns
Dr. Purchase Discounts
Cr. Freight In
Cr. Purchases
Beginning inventory is closed to COGS
Dr. COGS
Cr. Inventory
With a periodic system, a physical count is the only way to get the information about ending inventory, so as to compute COGS
Dr. Inventory
Cr. COGS
Perpetual
All journal entries are posted to the ledger.
Results in new balances for Inventory and COGS.
Numbers are verified by physical count.
Periodic
Temporary holding accounts are accumulated and added to COGS.
Beginning balance of Inventory account is transferred to COGS
Ending balance of Inventory is based on Count.
Summary of Differences:
Perpetual-All adjustments are entered directly in the Inventory account.
Periodic-All adjustments are accumulated in an array of temporary holding accounts:
Purchases/Freight In /Purchase Returns /Purchase Discounts
Remark: Detailed IS
3. Valuation
a. Four Inventory Valuation Methods
If inventory prices were not changing, all methods would produce the same COGS and ending inventory amounts.
Since prices do change, which are assigned to COGS and ending inventory?
Four methods are generally accepted:
• Specific identification - U.S. and IFRS acceptable
• First-in, first-out (FIFO) - U.S. and IFRS acceptable
• Weighted-average - U.S. and IFRS acceptable
• Last-in, first out (LIFO) - U.S. only acceptable
All about which to choose: Cost or Market Value?
Specific Identification Cost Flow
Specifically identify the cost of each unit sold.
The individual cost of each unit is charged against revenue as COGS.
To compute COGS and ending inventory, a firm must know each unit sold and its cost.
Example: Airplane, ship.
FIFO
The oldest units are sold and the newest units remain in inventory.
The cost of the oldest units purchased is transferred to COGS
LIFO
The newest units are sold and the oldest units remain in inventory.
The cost of the most recent units purchased is transferred to COGS.
Average Cost
An average cost is computed for all inventory available for sale during the period.
COGS is computed by multiplying the number of units sold by the average cost per unit.
b.Inventory Method Choice
1) Conceptual comparison between LIFO and FIFO
Assumption
Costs of more recent purchased inventories are more closed to true value of the inventories.
LIFO
Costs of more recent purchased inventories go to COGS.
Gives a better reflection of COGS in the IS.
Gives a better measure of income.
FIFO
Costs of more recent purchased inventories go to inventory account.
Gives a better measure of inventory value on the BS.
2) when there is inflation for the inventory price
FIFO LIFO
COGS Low High
Income High Low
Ending Inventory High Low
Total Assets High Low
3) Conclusion：
Periodic:
Purchase can be calculated according to information
Inv.(End.)=Inv.(Beg.)+Purchases-Sales
COGS=Inv.(Beg.)-Inv.(End.)+Purchases
Perpetual:
COGS=Inv.(Beg.)-Inv.(End.)+Purchases FIFO
c. Other Valuation Method & Analysis
Lower of Cost or Market
Ending inventory should be valued at the lower of its cost ($45) or market value ($43) (Rarely record holding gains – conservatism)
Inventory Errors
1) Types of Errors
Accidental (wrong amounts, accounts, GAAP, etc.)
Intentional
Profit pressures may cause managers to
Delay the recording of purchases/expenses
Accelerate incomplete sales orders
2) Effect of Inventory Errors
An error in inventory can lead to errors in other accounts. Because the ending inventory number is used in other computations, when ending inventory is incorrect, other numbers will also be incorrect.
A common fraud is for a company to intentionally overstate ending inventory, because it leads to higher Net Income. Sometimes ending inventory is understated.
An undiscovered inventory error usually affects
• All future periods if left undetected
• Two reporting periods if detected and correctly counted by the end of the second year
The error will cause misstated amounts in the period in which the error occurred, but the effects will then be counterbalanced by identical offsetting amounts in the following period
If ending inventory is understated, retained earnings is understated
If ending inventory is overstated, retained earnings is overstated
3) Inventory Gross Profit & Turn Over
Gross Profit Margin
GPM=GrossProfit/SalesRevenue=(SalesRevenue-COGS)/SalesRevenue
Gross profit percentage can be used to check the accuracy of the accounting records
Unusually lower percentage may mean the company has tried to avoid taxes by failing to record all sales
Some other factors that may cause a decline in the percentage are
• Price wars that reduce selling prices
• Shifting of the product mix sold
• Increase in shoplifting or embezzlement
InventoryTurnover= COGS/AverageInventory
On average inventory is being stocked/sold X times per year
Higher turnover is associated with greater efficiency (lower costs associated with stocking/handling inventory)
Effective in assessing companies in the same industry
Days In Inventory=365days/InventoryTurnover
Inventory Control
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