ACCT 90004 Accounting for Decision

Making

Week Five:

Reporting and
interpreting Cost of
Goods Sold and Inventory

1
Objectives Week 5 Chapter 7

This week we look at how we ensure inventory is recorded, reported

correctly and protected. This includes:

Understanding the nature of inventory and its importance to

business

Understanding and applying appropriate accounting techniques to

address recording and reporting issues relating to inventory,
including:
the cost (and matching) principles in the accounting for inventory.
the different inventory costing methods
the lower of cost or market (LCM) rule for inventory

Evaluating inventory management using the inventory turnover ratio

and an understanding of the cash flows effects of inventory
transactions

Understanding methods for controlling and keeping track of

inventory and analysing the effects of inventory errors on financial
statements 2
The nature of inventory

Inventory is an important asset for many

companies
Definition
good held for use or resale
Several types (later)
Importance
a significant current asset
a key source of cash
valuation is crucial
risk
recording, reporting and protecting

3
Recording inventory initially at cost

The cost principle

requires that inventory be
recorded at the price paid
or the consideration
given up.

(ie Historical cost basis)

Recording inventory initially at cost

Inventory Valuation

The cost of inventory must include all amounts necessary to

obtain the inventory and prepare it in a location and state fit for
sale and/or use.
Specific items often included in the cost of inventory are, import
taxes, freight inward and installation costs

For example:
Company ABC purchases inventory, in relation to the direct cost of
the inventory, the company was required to pay freight cost of $2 200
(GST excl.) to deliver inventory to the premises.
In addition to recording the direct cost of the inventory units, the
following entry is required to record the freight (assuming a credit
purchase and the perpetual method):

Date Description Dr Cr
9-Jan-11 Inventory (+A) 2,200
GST Receivable (+A) 220
Accounts Payable (+L) 2,420
5
There are two methods of recording inventory in the
accounting records
Inventory Systems
There are two inventory recording methods:

1 A detailed inventory record is maintained, recording

each purchase and sale during the accounting period
Information on COGS and ending inventory is
Perpetual
available on a continuous (perpetual) basis
Inventory
Costly and time consuming to operate and monitor
System
Generally computerised
Inventory purchases are debited to Inventory Account

2 Ending inventory and cost of goods sold are

determined at the end of the accounting period based
on a physical count
Periodic Inventory purchases are debited to an account called
Inventory Purchases
System Purchases is part of the asset inventory
Low cost
Lack of inventory information

6
The accounting entries for purchases of inventory are
very similar under the two methods
Recording Inventory Purchases Page 396-398

Pro-forma entries for inventory purchases:

KEY CONCEPT (Inventory Purchases Perpetual v Periodic)

Date Description Dr Cr
29-Dec-10 Inventory (+A) XX
GST Receivable (+A) XX
Bank/Accounts Payable (-A/+L) XX
[Pro-forma entry for perpetual inventory method]

29-Dec-10 Purchases (+A) XX

GST Receivable (+A) XX
Bank/Accounts Payable (-A/+L) XX
[Pro-forma entry for periodic inventory method]

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Periodic versus perpetual inventory systems

Page 396-398

The systems differ in one important way. Under the

perpetual system:
Adjustments are made to inventory (and COGS) as
transactions occur
Under the periodic method, this only occurs at period end
(See p.398 text)
As a consequence, under the periodic method, closing
inventory is not known until period end when a stock count
is undertaken

There is a different quality of information available under the

perpetual system compared to the periodic system
Why would a company ever use the periodic method?

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Recording transactions involving inventory Page 393-395

Purchase Discounts & Purchase Returns/Allowances

In completing this topic, you are also required to understand and

account for purchases discounts and purchases returns and
allowances.

In doing so, several issues should be considered similar to

accounting for sales discounts and sales returns and allowances (topic
4)
See p.398 for recording entries for these types of transactions under both
periodic and perpetual methods.

Detailed discussion is not included in this lecture but you are encouraged to
review the textbook as these are still examinable
9
Several types of inventory can exist in the Page 374

accounting records
Types of Inventory

1 Goods held for resale in the ordinary course of

Merchandise business
Inventory Usually acquired in finished condition

2 Items acquired for the purpose of processing into

Raw Materials finished goods
Inventory When used, raw materials become work in process
inventory
3 Goods in the process of being manufactured but not yet
Work in Process complete
(WIP) Includes costs incurred to produce the inventory
When completed become finished good inventory
4 Manufactured goods that are complete and ready for
Finished Goods sale
Inventory

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Understanding Inventory Flows - Merchandiser

Merchandise Merchandise
Cost of goods
purchases inventory
sold

Purchasing and Inventory on the Expense on the

production activities balance sheet income statement

Note: Similar principles apply to wholesalers and retailers

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Understanding Inventory Flows - Manufacturer

The cost attributed to inventory for a manufacturer reflects the processes

involved with producing that inventory

Factory overhead costs include

all manufacturing costs other
Direct labour cost represents than raw materials or direct
the earnings of employees labour.
who work directly on the Examples: Factory supervisor
products being manufactured. salaries and the cost of heat,
light, and power for the factory

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 Inventory Flows - Manufacturer

Raw materials Raw Finished

purchases materials goods
inventory inventory

Direct labour
incurred
Work in
process
Cost of
inventory
Goods Sold
Factory overhead
incurred

Inventory on the Expense on the

balance sheet = RM + income statement
Purchasing and production
WIP + FG
activities
13
Today we will focus on managing inventory for a
merchandiser/retailer
Flow of Inventory Costs

This enables an understanding of how inventory costs flow through the

business
Stage 1 Stage 2 Stage 3

Purchasing/ Inventory on the Sales Cost of

Production Statement of Financial Position Goods Sold on
Activities is Increased P&L Statement

A. Merchandiser
Merchandise Merchandise Cost of
Focus for
Purchased Inventory Goods Sold today

B. Manufacturer
Raw Raw Work in Finished
Cost of
Materials Materials Process Goods
Goods Sold
Purchased Inventory Inventory Inventory

Direct
Labour
Purchased

Factory
Overhead
Incurred

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When sold, inventory cost becomes part of Cost of Goods
Sold (COGS)

Number of units sold unit costs = COGS

COGS is a major expense item for most

non-service businesses.

The measurement of COGS is an excellent

example of the application of the matching
principle.

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It is important to understand the relationship Page 377

between inventory, purchases and COGS

Calculating Cost of Goods Sold (1/3)

Cost of Goods sold is calculated as:

Beginning Inventory
+ Purchases
- Ending Inventory
= Cost of Goods Sold

For example, if we start the period with $40 000 worth of fabrics
in beginning inventory, purchased additional merchandise during
the period which cost $55 000 and had $35 000 left in inventory
at the end of the period. These amounts are combined to
calculate cost of goods sold of $60 000:
Beginning Inventory $40,000
+ Purchases $55,000
= Goods Available for Sale $95,000
- Ending Inventory -$35,000
= Cost of Goods Sold $60,000
16
We can get to the same result by re-constructing the
inventory ledger account
Calculating Cost of Goods Sold (2/3)

If we start the period with $40 000 worth of fabrics in beginning

inventory, purchased additional merchandise during the period
which cost $55 000 and had $35 000 left in inventory at the end of
the period. These amounts are combined to calculate cost of goods
sold of $60 000.

Merchandise Inventory (Asset)

Op Balance 40,000 COGS 60,000
Cash/AP 55,000

Cl Balance 35,000
95,000 95,000

If three of the four values are known, either the equation or ledger can be
used to solve for the fourth value
17
In the end, the goods available for sale will be spread
between ending inventory and COGS
Calculating Cost of Goods Sold (3/3)

Beginning Inventory Purchases

+
$40,000 $55,000

Goods Available for Sale

$95,000

Ending Inventory Cost of Goods Sold

$35,000 $60,000

Reported on the Reported on the Statement of

Statement of Comprehensive Income at the end of the
Financial Position accounting period
at the end of the
accounting period

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Determining the cost of inventory

Implicit in the previous slides was the

assumption that we could identify the specific
cost of the inventory that was sold;
For practical reasons, this is rarely possible.
Hence, assumptions are generally required in
order to determine COGS. These are now
discussed

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There are numerous methods for identifying Page 379-382

the value of inventory and COGS

Inventory Valuation Methods

1 Identifies the cost of the specific item that was sold

Specific Must keep track of the purchase cost of each item
Identification Appropriate for expensive, unique items
For most entities, impractical and costly to implement
2 Earliest goods purchased (the first ones in) are the first
First-in-First-Out goods sold (the first ones out)
(FIFO) The last goods purchased are left in ending inventory

3 Most recent goods purchased (the last ones in) are the
Last-in-First-out first goods sold (the first ones out)
(LIFO) The oldest goods are in ending inventory

4 Weighted average unit cost of the goods available for

Average Cost sale
Method

These methods are for cost allocation and may not reflect physical flow of goods.

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The First-in, First-out method is the most Page 380

conventional
First-in, first-out method (FIFO)

Assumes KEY CONCEPT (FIFO)

Earliest goods purchased (the first
Latest $100 Stock still on Hand
ones in) are the first goods sold (the Purchases
first ones out) $80 Ending Inventory = $260

The last goods purchased are left in $80

ending inventory
$80 Merchandise Sold

Therefore: $80 Cost of Goods Sold = $300

Oldest unit cost is assigned to COGS $70

Oldest
Most recent unit cost is assigned to Purchases $70
ending inventory

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The Last-in, First-out method has the Page 380

opposite assumptions
Last-in, first-out method (LIFO)

Assumes KEY CONCEPT (LIFO)

Most recent goods purchased (the
last ones in) are the first goods sold Latest $100 Merchandise Sold
Purchases
(the first ones out) $80 Cost of Goods Sold = $340
The oldest goods are in ending $80
inventory
$80
Therefore:
$80 Stock still on Hand
Most recent unit cost is assigned to
COGS $70 Ending Inventory = $220
Oldest
Oldest unit cost is assigned to ending Purchases $70
inventory

22
The weighted average cost method is a little Page 382

different though
Weighted Average Cost Method

Makes no assumptions about the KEY CONCEPT (Average Cost)

flow of inventory and instead takes
an average Latest $100
Purchases Average
Therefore: $80 Cost
Merchandise Stock still
Requires calculation of the average $80 ($100) Sold on Hand
+ (4 x $80)
cost of each unit $80 + (2 x $70) Cost of Ending
Uses average cost in calculating = $560 Goods Sold = Inventory =
$80 4 units x $80 3 units x
COGS and Ending Inventory $560 / 7 = = $320 $80 = $240
$70 $80 per
Oldest unit
Purchases $70

23
Selection of inventory valuation method has a real impact
on the companys cost and inventory balances
Comparison of Inventory Valuation Methods (1/2)

When unit costs are rising...

Balance FIFO LIFO
Cost of goods sold on statement of comprehensive income
Net profit
Income tax
Inventory on statement of financial position

When unit costs are falling...

Balance FIFO LIFO
Cost of goods sold on statement of comprehensive income
Net profit
Income tax
Inventory on statement of financial position

24
demonstrated here in a sample of the statement of
comprehensive income/financial position
Comparison of Inventory Valuation Methods (2/2)

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Only specific identification, FIFO and Average Cost
methods can be applied in Australia and NZ
Manager Choice of Inventory Valuation Method

LIFO is not allowed in Australia for financial reporting or

taxation purposes
Not a reliable representation of flow of inventory
That oldest goods would be in stock
Inventory value bears little resemblance to the recent cost of inventory
LIFO is allowed in some countries including the US

FIFO is generally considered more appropriate

In times of inflation this will yield a closing inventory balance more
closely resembling current costs

Managers may use more than one method

For different classes of inventory
For different purposes
Accounting standards require consistency over time
Change is allowed if it will improve reliability and relevance

26
After initial recording, further inventory Page 386

valuation issues also arise

Accounting regulations require the Lower of Cost or Market

(LCM) rule (1/2)
When reporting inventory, companies are able to depart from the cost
principle
GAAP requires recognition of a loss when replacement cost or net
realisable value drops below cost
Net realisable value: Expected sales price less selling costs (e.g. repair
and disposal costs)
WHY???
Prudence constraint
Avoids overstating assets and profits
Particularly important for:
High-tech companies (Dell Computers)
Technological advancement
Companies that sell seasonal goods (Target)
Costs drop at the end of the season

27
Lower of cost and market value rule is demonstrated
below
Lower of Cost or Market (LCM) rule (2/2)

KEY CONCEPT (Calculating LCM)

Market Historical
Cost per Value per LCM per Cost LCM
Item Quantity Item item item Valuation valuation Write-down
Outdoor Setting 1000 250 200 200 250,000 200,000 (50,000)
Tennis Racquets 400 100 110 100 40,000 40,000 -

Date Description Dr Cr
9-Jan-11 Cost of Goods Sold (+E) 50,000
Inventory (-A) 50,000

Next Period (if

Effects of LCM write-down Current Period
sold)
Cost of Goods Sold $50,000 $50,000
Income Before Tax $50,000 $50,000
Ending inventory on Statement of Financial Position $50,000 -
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The Inventory Turnover Ratio helps show Page 388

whether inventory has been managed well

Key Ratio Inventory Turnover Ratio

The inventory turnover ratio shows how many times we sell our
inventory in a year (or, if converted to days, the average length
of time we hold inventory in stock)

The inventory turnover ratio is calculated as:

Cost of Goods Sold
Average Inventory

Higher ratio
Inventory moves quickly through production to customer
Reduced storage and obsolescence costs
Less money tied up in inventory
Excess money used elsewhere

Sudden decline
Indicator of less demand for products
Sloppy production management

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The Inventory Turnover Ratio helps show Page 388

whether inventory has been managed well

Key Ratio Inventory Turnover Ratio

GOODMAN FIELDER - 2011

Cost of Goods Sold

Average Inventory

$1,620.9m
($196.2m + $166.1m) / 2

= 8.95 times p.a.

or 365 days / 8.95

= 40.78 days

Interpretation: GF hold individual stock items for an average of 41 days

30
While the inventory turnover is useful, the statement of
cash flows is a good early indicator of inventory problems
Other indicators of Inventory Problems

Usually Cash paid to suppliers is the first sign of inventory

problems in the statement of cash flows
Too many slow-selling items
Storage costs and interest costs on borrowings
Losses if inventory cannot be sold at normal prices

There is a direct relationship between changes in inventory

levels and the cash paid to suppliers reported in the statement
of cash flows, i.e.;
Purchasing inventory decreases cash
Selling inventory increases cash
Purchasing from suppliers on credit, increases accounts payable,
increases cash
Paying suppliers, decreases accounts payable, decreases cash

We will consider this relationship more formally later in the

semester.

31
Inventory is a crucial and valuable asset for many
companies... internal controls over inventory are critical
Internal Controls for Inventory

Controls typically in place include:

Limiting access to inventory to authorised employees
Separation of responsibilities for inventory accounting and physical
handling of inventory
Storage of inventory in a manner that protects it from theft and
damage
Performance of regular inventory counts to verify the quantity and
condition of goods on hand

32
At the end of the accounting period, companies perform a
physical stocktake
Inventory Stocktake

A physical stocktake involves the following activities:

Count of physical stock on hand;
Comparison with accounting stock records; and
Adjusting accounting records for the difference

Under the periodic method, the stocktake is required to establish the

number of inventory units on hand.
This enables COGS and closing stock to be determined
(see pp.398-399)

Under the perpetual method, a stocktake is still required - to check the

accuracy of the accounting records relating to inventory.
If the units on hand do not match the units counted, further adjustment is
required.

33
At the end of the accounting period, companies perform a
physical stocktake
Inventory Stocktake Stock Loss

If the physical count indicates less units on hand than the

records show, a stock loss is recorded.

KEY CONCEPT (Adjusting Journal Entry)

Date Description Dr Cr
29-Dec-10 Inventory Loss (+Ex) 240
Inventory (-A) 240
(47 45) x $120 per unit = $240

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We also need to be able to account for the case where the
stocktake reveals additional stock on hand
Inventory Stocktake Stock Gain

On occasion, a stock gain might also be recognised

KEY CONCEPT (Adjusting Journal Entry)

Date Description Dr Cr
29-Dec-10 Inventory (+A) 240
Inventory Gain (-Ex) 240
(47 49) x $120 per unit = $240

Inventory Gains and Losses form a part of Cost of Goods Sold

35
The physical stock-take has different purposes in a
perpetual v periodic accounting system
Perpetual v Periodic accounting records
Perpetual Method Periodic Method
Units at start* 10 Units at start* 10
+ Units Purchased 200 + Units Purchased 200
= Units available for use 210 = Units available for use 210
-- Units used 180 - Actual units on hand** 25
= Recorded units on hand 30 = Units used 185
-- Actual units on hand** 25
= Loss or gain (units) 5
Expense (units) 185 Expense (units) 185

* Opening Inventory
** Closing Inventory

In light of the above, the perpetual method is commonly thought of as enabling

more careful control of inventory

36
There is clear and direct relationship between inventory,
COGS and cash flows

Increase in Inventory
Add Decrease in Accounts
Payable

Cost of Goods Cash Payment

Sold to Suppliers

Decrease in Inventory
Increase in Accounts Payable

Subtract

This highlights the importance of inventory for cash flow and

37
survival. This theme will be revisited later in the semester.
Review the objectives and make sure that Chapter 7

you can cover each of these points

Objectives Week 5

This week we look at how we ensure inventory is recorded,

reported correctly and protected. This includes:

P
Understanding the nature of inventory and its importance to
business

P
Understanding and applying appropriate accounting
techniques to address recording and reporting issues relating
to inventory, including:
P
the cost (and matching) principles in the accounting for inventory.
P
the different inventory costing methods
P
the lower of cost or market (LCM) rule for inventory

P
Evaluating inventory management using the inventory turnover
ratio and an understanding of the cash flows effects of
inventory transactions

P
Understanding methods for controlling and keeping track of
inventory and analysing the effects of inventory errors on
financial statements
38