Lecture 10 Inventory Flashcards
What are inventory and COGS?
A company’s inventory includes all the goods the company holds for sale in the normal course of business.
When inventory is sold, its carrying amount is deducted from the inventory account balance and included in cost of goods sold.
What are the inventory types?
In the distributive trade (retail, wholesale), inventory is shown as a single item called merchandise inventory.
Manufacturing companies, on the other hand, distinguish between three categories of inventory.
raw materials: input goods purchased but not yet put in production.
work-in-process: items whose production has been started but has not yet been completed.
finished goods: items whose production has been completed.
What costs are included in pricing inventory?
Inventory is carried on the balance sheet at the cost incurred to acquire or produce it and to make it ready for sale.
These costs are called product costs or inventoriable costs.
Some costs are (in most cases) part of cost of goods sold but are not inventoriable, including
* fulfilment costs such as outbound freight; and
* fixed procurement costs (warehouses, procurement departments).
These are period costs and are expensed as incurred.
The following costs ARE inventoriable:
For merchandise inventory and raw materials, products costs include
* the purchase price;
* inbound freight costs; and
* any reductions related to returns, allowances and discounts.
Work-in-process and finished goods inventory also include
* direct labor costs; and
* allocated manufacturing overhead costs (indirect labor and material, depreciation, electricity, insurance, etc.).
(Allocating all fixed manufacturing costs to inventory is known as absorption costing and is the required method under GAAP.)
What are the two methods for inventory record-keeping?
There are two principal alternatives to track inventory.
- Under a perpetual inventory system, the business maintains a current record of all items in inventory. Purchases and sales are recorded as they occur.
- Under a periodic inventory system, inventory balances are only determined at the end of each period via physical counts.
How is a perpetual record-keeping system for inventory management implemented?
- Under the perpetual inventory system, purchases are recorded directly to the inventory account at the time of purchase.
DR inventory xxx
CR cash (or accounts payable) xxx - Cost of goods sold are recorded each time a sale is made.
DR cost of goods sold xxx
CR inventory xxx - If an actual physical count at the end of the period yields a difference between the counted balance and the perpetual inventory system balance (e.g., due to unrecorded breakage, theft, or obsolescence), this difference is recorded as:
DR inventory short and over xxx
CR inventory xxx
if counted balance < system balance. Debit and credit would be reversed if counted balance > system balance.
The ‘inventory short and over’ generally becomes part of cost of goods sold.
How is a periodic record-keeping system for inventory management implemented?
- Under the periodic inventory system, inventory purchases during the period are recorded in a separate ‘purchases’ account…
DR inventory purchases xxx
CR cash (or accounts payable) xxx - … and added to the inventory balance at the end of the year.
DR inventory xxx
CR inventory purchases xxx - The cost of goods sold under the periodic inventory system is computed after a physical count of the inventory at the end of the year as:
beginning inventory balance
+purchases during the period
-ending inventory balance
= Cost of Goods Sold
… and is recorded via
DR cost of goods sold xxx
CR inventory xxx
What are the common cost flow methods?
Under any inventory system, companies need to make assumptions about the cost flow, i.e., the order in which the costs of the items in inventory are taken into cost of goods sold.
- specific identification: cost of goods sold is the cost assigned in the inventory system to the specific item sold.
- first-in-first-out (FIFO): the cost of the oldest purchases currently in inventory is taken into cost of goods sold first.
- last-in-first-out (LIFO): the cost of the most recent purchases is taken into cost of goods sold first. (US GAAP only)
- (weighted or moving) average cost: cost of goods sold is determined by the average cost of all items currently in inventory.
What to remember for the specific identification cost flow method?
Identifying an item-specific cost for all items in inventory is the most accurate (and often least practical) method. Specific identification is typically used when
- the number of items in inventory is small;
- inventory items are expensive;
- the inventory consists of heterogeneous products;
- items involve substantial customization
What to remember for the FIFO (First-in-First-Out) cost flow method?
Under the first-in-first-out (FIFO) method, items are considered sold in the order in which they were bought, i.e., the oldest units are sold first.
What to remember for the LIFO (Last-in-First-Out) cost flow method?
Under the last-in-first-out (LIFO) method, items are considered sold in the reverse order in which they were bought, i.e., the most recent purchases are sold first.
The LIFO method is permitted under US GAAP but disallowed under IFRS.
How does LIFO work in practice?
In practice, LIFO is typically applied to particular groups of similar (but not necessarily identical) goods called LIFO pools. In each pool, the inventory is usually divided into layers (by purchase year).
If the amount of goods in inventory increases from one year to the next, the increase becomes a new layer, valued at the purchase price of that year. Some companies carry inventory layers from far back in history.
If the amount of goods in inventory decreases from one year to the next, the cost of goods from older layers flows into cost of goods sold. This event is called a LIFO liquidation and almost always means that cost of goods sold are lower than usual and hence profits are higher.
LIFO is usually implemented under a periodic inventory system.
What is the LIFO reserve?
Companies that apply LIFO must disclose the difference between the inventory cost at LIFO and the (hypothetical) inventory cost if the company were to use FIFO instead. This difference is called the LIFO reserve.
Always take into account differences in inventory accounting policies when comparing companies’ financial ratios.
What to remember for the Weighted Average cost flow method?
Under the (weighted or moving) average method, all units in inventory are pooled and assigned the same, overall average cost.
In a periodic inventory system, the average cost is calculated at the end of the period.
In a perpetual inventory system, the average cost is recalculated after each purchase.
What is the lower-of-Cost-or-Market Rule?
At times, we might find that some items in inventory cannot be sold at a price above their cost.
In this case, we reduce the inventory balance to the price we expect to receive and recognize the loss immediately.
This accounting treatment is called the lower-of-cost-or-market rule.
The technical term for ‘market value’ is net realizable value (both under IFRS and under US GAAP). Net realizable value equals the expected selling price of the inventory less the cost to complete and sell the item.
A write-down to market value can be reversed in later periods under IFRS but not under US GAAP.
