Chapter 6 Cost of goods sold Flashcards
Operating Cycle
Most companies have an identifiable cycle of activities that reflect the day to day operations of the business.
Retail Operating Cycle
The company acquires inventory that is, for all practical purposes, ready for sale to its customers. Initially, the inventory is carried as an asset on the retailers balance sheet, but upon the sale, the cost of the inventory is removed from the balance sheet and transferred to cost of goods sold on the income statement, to be matched with operating revenue produced by the sale.
Manufacturing Operating Cycle
More complex. Begins its operating cycle with the purchase of raw material, which then enters a production process.
Work-in-process inventory
Manufacturing Operating Cycle
The raw material is initially altered by the production-line-workers and manufacturing equipment
Finished Goods Inventory
Manufacturing Operating Cycle
When the production process is finally complete and is ready for sale
Manufacturer’s inventory
Recognized as an asset on the balance sheet. When raw material enters the manufacturing process, its value is transferred to the work-in-process inventory account. As work in progress is completed, it is transferred to the finished goods account. Upon the sale of the finished goods, the cost of the sold inventory is transferred to cost of goods sold on the income statement and replaced by cash or accounts receivable on the balance sheet.
Measuring Cost of Goods Sold and ending inventory
Inventory values on the balance sheet are charged to earnings in the period in which the inventory is sold. This is an example of the “matching” concept at work, wherein the effort is recorded in the same period during which any benefit is received by the company.
FIFO
Inventory Valuation Method
This approach assumes that the first units purchased are the first units sold. The units remaining on hand are the units purchased more recently so the company’s ending inventory would be the cost of the last unit purchased.
LIFO
Inventory Valuation Method
Last in, first out. This methods assumes that the units purchased most recently, are the first units sold.
LIFO Conformity Rule
IRS Requires businesses that use LIO for income tax purposes to also use LIFO in preparation of their audited financial reports to share holders
Average Cost Method
Inventory Valuation Method
Average of units cost
Weighted-average cost method
Inventory Valuation Method
Different from average cost method. Each inventory price is weighted by the quantity of units purchased at a given price, whereas the average cost method calculates a simple average of the various inventory purchase prices without regard to the quantities purchased.
Replacement Cost Method
Inventory Valuation Method
Valued both the unit sold and the unit on hand at the inventory’s replacement cost.
Specific identification method
Inventory Valuation Method
If the CEO could identify exactly which product was sold on a given day, then the actual price of the identified item would be charged to cost of goods sold and the cost basis of the remaining barrel would also be known.
Inventory Management System
Tool used to keep track of the inventory purchased, sold and on hand
Periodic System
Inventory Management System
Periodically updates such information as the cost and quantity of inventory on hand, but only when new goods are purchased and when a physical count on hand inventory is undertaken. Presumes that management does not need minute-by-minute information regarding the quantity of inventory on hand or its costs.
Perpetual System
Inventory Management System
Updates a firms inventory data after every purchase and every sale, providing a constant source of reliable information about the cost and quantity of goods available for sale
Inventory Count
Almost all types of inventory are subject to damage, deterioration and theft. GAAP requires that a physical inventory count be taken at least once a year so as to ensure the integrity of the inventory balances. It should be noted that any amount needed to adjust ending inventory will affect no only inventory on the balance sheet but also cost of goods sold and net income on the income statement.
Computations of Cost of Goods Sold
The adjustment of cost of goods sold and inventory can be best understood:
Beginning Inventory + Purchases = Goods available for sale - Ending inventory = COGS
Choosing an Inventory Method
Once a company has selected a particular inventory valuation method, they do not have to keep it consistent among all items.
Lower of Cost or Net Realizable Value
Companies are required to ensure that the value of ending inventory carrier on the balance sheet is recorded at an amount that does not exceed its Net Realizable Value.
- If the NRV is less than its recorded books value, the company must write the value of its inventory down to NRV.
- If the, however, the NRV is higher than its recorded book value, the inventory is not written up to the higher value but remains valued at its cost.
Net Realizable
(NVR) Measured as the estimated selling price in the ordinary course of business. minus cost of completion, disposal, and/or transportation.
LIFO Layers
Since the LIFO method assumes that the most recently purchased inventory is the first inventory to be sold, it is not unusual for a company to have multiple LIFO layers, often reflecting prices from several prior fiscal periods.
LIFO Reserve
Accounting standard-setters require that companies using LIFO disclose the value of the inventory reserve in their footnotes.
Inventory Reserve
Significant because it enables investment professionals to restate gross profit under LIFO to estimate what gross profit would have been had FIFO been used instead. It is a cumulative measure of the difference between the LIFO cost of ending inventory and the FIFO cost of ending inventory.
Liquidating LIFO Layers
Sometimes it is impossible to meet internal or external earnings expectations by increasing sales and thus managers may look for other ways to increase net income (such as cutting costs). One temporary profit-enhancing approach used by some managers of LIFO-accounted companies is the liquidation of LIFO layers.
-Liquidating a LIFO layer has the effect of lowering the reported cost of goods sold, and hence, raising gross profit because a lower cost of inventory is effectively matched with revenue.
Phantom Profit
Liquidating LIFO Layers
Although gross profit is increased, cash flow is not. In fact, the operating cash flow from LIFO price-layer liquidations is actually reduced as a consequence of the additional income taxes that must be paid on the phantom profits generated by sales.
Managing a company’s investment in inventories
When a company holds large quantities of inventory to service its customer needs, the company is required to invest its cash not only to purchase and/or manufacture the inventory, but also for warehousing and insurance on the inventory.
Days Payable Period
Customers look to the credit provided by their suppliers as a source of interest free financing for their own operation.
Days Payable Period = 365 / Cost of goods sold / Accounts Payable
This ratio indicates the average number of days that a company normally takes to pay its out-standing accounts payable.
Periodic Weighted Average Inventory
Weighted average periodic is probably the easiest of all the inventory methods. Since the calculation is done at the end of the period, we figure out the total cost of goods available for sale and divide by the number of units. It is helpful to separate the purchases from the sales.
Perpetual Weighted Average Inventory
Perpetual inventory systems require the cost of goods sold to be calculated each time there is a sale. Therefore, at the time of each sale, we must calculate the weighted average cost of the units on hand at the time of the sale
Inventory Turnover
Inventory Turnover = Cost Of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)
What is beginning inventory
Beginning inventory is the dollar value of all inventory held by a business at the start of an accounting period, and represents all the goods a business can put toward generating revenue. You can use the beginning inventory formula to better understand the value of your inventory at the start of a new accounting period.
How to calculate beginning inventory
1) Determine the cost of goods sold (COGS) using your previous accounting period’s records.
2) Multiply your ending inventory balance with the production cost of each item. Do the same with the amount of new inventory.
3) Add the ending inventory and cost of goods sold.
4) To calculate beginning inventory, subtract the amount of inventory purchased from your result.
Accounts Payable Turnover Ratio Formula
In some cases, cost of goods sold (COGS) is used in the numerator in place of net credit purchases. Average accounts payable is the sum of accounts payable at the beginning and end of an accounting period, divided by 2.
COGS / [BEGAP + EAP] / 2
