1. Financial Accounting Chapter 7. Cost of Goods Sold and Inventory

2. Objectives Definition and Types of Inventory Inventory Valuation
Costs included in Inventory cost
Timing of computation
Cost flow assumption

3. What is inventory?
Inventory is the costs of manufacturing or purchasing goods (to sell).
Merchandiser’s Inventory
is goods held for sale in the normal course of business
is ready to be sold without further processing
Manufacturer’s Inventory
is goods which are used to produce goods or services for sale
can be identified by it’s stage of production
Raw Materials – product which will be utilized in the production
Work In Process- goods in production but not yet completed, which includes Raw Materials, Direct Labor, Manufacturing Overhead
Finished Goods – completed goods ready for resale

4. Inventory Valuation
Accrual accounting capitalizes costs as assets until the benefits are realized (or sale is completed).
Q) At the end of a year, how much of the total costs should be assigned to the goods on hand and how much to the goods that have been sold?
A) This problem is called the inventory valuation. This is answered by physically counting inventory items and assigning a specific value from the historical cost records to each item.

5. Why is inventory valuation important?
Inventory Equation: COGS = B.B. of Inventory + Purchases – E.B. of Inventory
Once inventory value is determined, COGS is determined automatically.
Since gross profit is sales revenue minus COGS, the calculation for gross profit and cost of goods sold relies on the value of inventory.
Different inventory accounting practice will make it hard to compare one firm to another. By understanding theses differences, you will be better able to evaluate the profitability of different companies.

6. Inventory valuation issues
1) Costs included in inventory at acquisition → What can be included as inventory cost? 2) Timing of computation → When (How often) to recognize COGS? 3) Cost flow assumption → How to determine COGS when the same inventories were purchased at different prices?

7. Perpetual method
Perpetual method keeps a running, continuous record that tracks inventories and cost of goods sold on a day-to-day basis.
However, a physical count should be taken at least once a year to check on the accuracy of the continuous records. The physical count allows management to delete from inventory goods that are damaged or obsolete, and thus reveal inventory shrinkage (loss from theft, breakage, and loss).
Perpetual method helps managers control inventory levels and prepare interim financial statements.
When merchandise is purchased, the inventory account is increased, and when inventory is sold, the sale and the accompanying inventory reduction are recorded simultaneously. Also, purchase returns are recorded as a direct reduction of inventory.

8. Periodic method
Periodic method computes the cost of good sold only at the end of an accounting period, when a physical count of inventory is taken. Therefore, COGS can be recorded only at the end of year.
The periodic method avoids the costly process of calculating the cost of goods sold for each sale.
In periodic method, purchase account (instead of inventory) is used until the end of year. Also, a contra account called purchase return is used for recording purchase returns.

9. Cost Flow Assumption
1) Specific identification method 2) FIFO (First-in-first-out) 3) LIFO 4) Weighted average