Chapter 7: Inventory, and Cost of Goods Sold Introduction 1

Home , Cost of goods sold, Matching principle

Mark Krilanovich ©August 30, 2013 ACCT 230 Chapter 7: Inventory, and Cost of Goods Sold Introduction 1. The account named Inventory is a current asset. It contains the goods (merchandise) held for sale to customers, or used to manufacture goods for sale to customers. 2. When we sell the goods from our inventory, the Matching Principle requires us to record all the cost(s) we had previously paid to acquire those goods, and debit them to our account Cost of Goods Sold (abbreviated COGS or CGS.) 3. At the same time, we record the revenue we receive from the sale. (We hope that revenue exceeds the Cost of Goods Sold, so that we earn a gross profit.) 4. This chapter teaches us how to count the cost of items in our Inventory, follow their flow through to Cost of Goods Sold, and record them correctly along the way. 5. This summary will use T-accounts to visually present the accounts.

Merchandising companies (p.335) Most companies we've studied and will again are merchandising companies. They buy large quantities of goods, store them in one Inventory, then sell them in smaller quantities to customers. Following is the T-account presentation of this flow of goods:

Merchandise Inventory Cost of Goods Sold (an asset account) (an expense account)

beg. balance

in purchases goods sold out in goods sold during during during the period the period the period

end. balance

beginning + purchases – ending = goods sold

Manufacturing companies (p.335) Manufacturing companies do more, so they have a more complex structure. (ACCT 240 studies them in detail.) They have 3 inventory asset accounts in this time sequence:

Raw Materials Inventory Work-in-Process Inventory Finished Goods Inventory (an asset account) (an asset account) (an asset account) beg. balance beg. balance beg. balance products products in purchases materials materials products out during used during used during completed completed sold during the period this period that period during this during that this period period labor period overhead end. balance end. balance end. balance

For each account: beginning balance + inputs – ending balance = outputs remember! ©2010-2013 by Mark Krilanovich Chapter 7, page 2 The cost of Inventory affects Net Income, and Ending Balance Inventory items are assets, and normally we record assets at their historical acquisition cost to us, plus such costs as transportation and inspection costs necessary to make them ready to use (according to the Cost Principle, p. 389-391; also p. 334). Inventory Assets are special (different from Office Supplies, for example, or Delivery Trucks) because they are merchandise we purchase to resell later for income. That income is computed on our Income Statement as: Income = Sales Revenue – Cost of Goods Sold and the Matching Principle requires that we record an item's "Sales Revenue" and "Cost of Goods Sold" in the same accounting period. Years can separate the purchase and sale of an Inventory Asset, so we must take care to align its Purchase Cost and Sales Revenue. The cost of inventory items are important above for our Income Statement, and below for our Balance Sheet. The ending balance of the Inventory account, at the end of the accounting period, goes onto our Balance Sheet as owned Assets. Suppose our inventory contains 1,500 different, antique cars, some that we purchased in past year(s) (our Beginning Inventory), plus many we purchased this year at different times, each car at a different purchase cost to us. When we sell one car, which purchase cost do we use for its COGS to subtract from its Revenue, to compute our Net Income for that car? The Matching Principle requires this, yet may be hard to answer. Four ways to count the cost of an inventory item We continually purchase inventory, spanning several accounting periods, typically at different costs, and GAAP allows us our choice of 4 different methods to figure the cost of inventory items when we sell them.

1. Specific identification of each item, keeping track of its unique purchase cost. (This would work with antique cars, each unique and with a different cost. We could glue a PostIt® on each with its unique purchase price, until it was sold. This would guarantee the Matching Principle was absolutely satisfied.) 2. Average the cost of all the items in our inventory, and use that average as the purchase cost for every item we sold. 3. FIFO: count the first item sold from inventory as the first item into inventory. 4. LIFO: count the first item sold from inventory as the last item into inventory.

The following page shows each of these four in a time line, with time flowing from left to right. In each case, we had the same 2 items in Beginning Balance, purchased the same 3 items during the period for the same purchase cost, and sold 2 items. The difference between the 4 costing methods is how we count the cost of the 2 items that we sold. The four methods show slightly different COGS (for our Income Statement) and different Ending Balances (for our Balance Sheet). Your instructor will show you an animated video with the inventory items moving in real time, making the 4 costing methods more clear.

begin balance = $10+$12 = $22 3 purchases during the year LIFO LIFO $22

$10/unit $12/unit $4/unit $9/unit $15/unit $4 $9 $9 $15 Jan. 1 June 1 July 3 Nov. 4 Dec. 31 Last In, First Out $15

ending balance = $10+$12+$4 = $26 2 sales during year = $9+$15 = $24 = COGS $26

begin balance = $10+$12 = $22 3 purchases during the year FIFO FIFO $22

$10/unit $12/unit $4/unit $9/unit $15/unit $4 $10 $9 $12 Jan. 1 June 1 July 3 Nov. 4 Dec. 31 First In, First Out $15

2 sales = $10+$12 = $22 = COGS ending balance = $4+$9+$15 = $28 $28

begin balance = $10+$12 = $22 3 purchases during the year Weighted Average Average $22

$10/unit $12/unit $4/unit $9/unit $15/unit $4 $10 $9 $10 Jan. 1 June 1 July 3 Nov. 4 Dec. 31 $15 Average of all units = ($10+$12+$4+$9+$15)/5 = $50 COGS, average= $50/5 = $10 each ending balance = $4+$9+$15 = $26 $30

begin balance = $10+$12 = $22 3 purchases during the year Spec ID, unique units Spec-ID $22

$10/unit $12/unit $7/unit $5/unit $95/unit $7 $10 $5 $95 Jan. 1 June 1 July 3 Nov. 4 Dec. 31 $95

ending balance = $12+$7+$5 = $24 2 Specific sales = $10+$95, unique units, = $105 COGS $24

Jan. 1 Dec. 31 Chapter 7, page 4 Lower of Cost or Market (LCM) Normally the Cost Principle (p. 389-391) requires us to record the cost of our assets at the cost we paid when we acquired them, no matter how long we own them, even years. An exception to that, however, is if at the end of an accounting period, we discover that our items in ending inventory could be replaced at significantly lower cost than when we purchased them. (This could happen either because of a decrease in market price, or if our items have deteriorated over time.) If we discover this cost difference, the Conservatism Constraint overrides the Cost Principle, and tells us to be careful not to overstate our inventory assets. At this point, we decrease the cost of these inventory items to the current market price. This is called the Lower of Cost or Market (LCM) process. The journal entry for this is to figure the dollar difference between our cost and the market replacement cost; call that 'X' dollars. Then at the end of the period:

Debit COGS by 'X' dollars

Credit Inventory by 'X' dollars

Perpetual and Periodic Inventory Systems We have been using "the Perpetual Inventory System," which provides an accurate value of inventories and COGS at any instant throughout the accounting period. This is because Inventories are debited whenever items are purchased into them, and debited whenever items are taken out of them. Also COGS is debited and credited immediately when it changes. Thus the balance of these accounts is always current. Another system exists, called "the Periodic Inventory System," which is seldom used today. It does not know the value of inventories or COGS until the last day of the accounting period, when people physically count the items in Inventory, and subtract the number of items that were in Inventory at the beginning of the year. This difference is what was used during the year. The same is done with COGS, at the end and beginning of the year. This was used more before computers were used in accounting.