Reporting and Interpreting Cost of Sales & Inventory

Understanding the Business

Roles of the Accounting System…
⤷ Provides accurate information
⤷ Provides up-to-date information
⤷ Provides information to help protect assets

Primary Goals of Inventory Management…

⤷ Provides sufficient quantities of high-quality inventory.
⤷ Minimizes the costs of carrying inventory.

Inventory
Inventory is a current asset that is either…
● Held for sale in the ordinary course of business
● Used in the process of production of goods for sale or rendering of services.

Items Included in Inventory

Merchandisers hold Merchandise inventory.
⤷ These are finished goods (or merchandise) held for resale in the ordinary course of business.

Manufacturing businesses hold three types of inventory…

1. Raw materials inventory (to be processed into finished goods)
2. Work-in-process inventory (process of being manufactured but not yet complete)
3. Finished goods inventory (complete and available for sale)

Costs Included in Inventory Purchases

⤷ Goods in inventory are initially recorded at cost.
⤷ The primary basis of accounting for inventory is cash-equivalent cost, which is either the price
paid or consideration given to acquire an asset.
⤷ Inventory cost includes the sum of the costs incurred in bringing an article to a usable or saleable
condition and location. (e.g., freight)
⤷ Any purchase returns and allowances or purchase discounts taken are subtracted.

Flow of Inventory Costs

⤷ Direct labour cost represents the earnings of employees who work directly on the products being
manufactured.
⤷ Factory overhead costs include all other manufacturing costs that are not raw material or direct
labour costs.

Cost of Sales Equation

Cost of sales (COS) is directly related to sales revenue.
⤷ It includes all costs of the merchandise or the finished goods sold during the period.
The sum of the cost of beginning inventory and the cost of purchases (or additions to its merchandise
inventory) is the cost of goods available for sale during that period.
⤷ What remains unsold at the end of the period becomes ending inventory(EI) on the statement of
financial position.

The portion of the cost of goods available for sale that are actually sold becomes the cost of sales on the
statement of earnings.
⤷ The ending inventory for one accounting period then becomes the beginning inventory for the
next period.
Cost of sale equation…
or Beginning inventory
+ Purchases of merchandise during the year
Cost of goods available for sale
-Ending inventory
Cost of sales
Perpetual and Periodic Inventory Systems
To calculate the cost of sales, three amounts must be known…
1. Beginning inventory
2. Purchases of merchandise, or additions to finished goods, during the period
3. Ending inventory

→ Perpetual Inventory System

⤷ In a perpetual inventory system, when each sale is recorded, a companion cost of sales entry is
made, decreasing inventory and recording cost of sales.
⤷ As a result, information on cost of sales and ending inventory is available on a continuous
(perpetual) basis.

A detailed record is maintained for each type of merchandise stocked, showing…

1. Units and cost of the beginning inventory
2. Units and cost of each purchase
3. Units and cost of the goods for each sale
4. Units and cost of the goods on hand at any point in time
Examples… Cons
● Grocery stores ● More complex than periodic
● Requires a computer system that tracks
each individual item
→ Periodic Inventory System
A physical count of the goods remaining on hand is required at the end of each period.
⤷ The number of units of each type of merchandise on hand is multiplied by their unit cost to
compute the total cost of the ending inventory.
⤷ Cost of sales is calculated by using the cost of sales equation.
⤷ Inventory purchases are instead debited to a temporary account called purchases.
⤷ Revenues are recorded at the time of each sale.
⤷ However, the cost of sales is not recorded until after the inventory count is completed.
⤷ At all other times, companies using a periodic system must estimate the value of inventory on
hand.
Purchase Returns and Allowances & Purchase Discounts
Purchase returns and allowances are treated as a reduction in the cost of inventory purchases associated
with unsatisfactory goods.
⤷ Cash discounts must be accounted for by both the buyer and the seller

Inventory Costing Methods

There are three generally accepted inventory costing methods available to determine the cost of sales…
1. Specific identification
2. First-in, first-out (FIFO)
3. Weighted average

The International Accounting Standard (IAS) requires that the inventory costing method used be rational
and systematic.

Specific Identification Method

Requires that the cost of each item sold be individually identified (unique) and recorded as cost of sales.
⤷ Not used for large quantities of items.

Examples
● Yachts ● Sports cars ● Artwork

First-in, first-out (FIFO)

Assumes that the earliest goods purchased (the first ones in) are the first ones sold (the first ones out)
and the last ones purchased remain in ending inventory.

Weighted-Average Cost Method

Requires calculating the weighted-average unit cost of the goods available for sale.
⤷ When a unit is sold, the average cost of each unit in inventory is assigned to the cost of sales.

Financial Statement Effects of Inventory Costing Methods

Advantages of Methods…
⤷ First-In, First-Out → Ending inventory approximates current replacement cost.
⤷ Weighted Average → Smooths out price changes.
International Perspective
Accounting rules require companies to apply their accounting methods on a consistent basis.

Managers Choice of Inventory Methods

Managers should choose the method that best reflects the company’s economic circumstances for
financial reporting purposes.

Most managers choose generally accepted accounting methods based on two factors…
1. Effect on net earnings (managers prefer to report higher earnings for their companies)
2. Effect on income taxes (managers prefer to pay the least amount of taxes allowed by law, as late
as possible: the least–latest rule)

Because accounting standards and tax laws differ, management must also choose an inventory costing
method to use on the company’s tax return (for tax purposes).
⤷ Most companies choose to use the same inventory costing method for both financial reporting
and tax reporting purposes.

Valuation at Lower of Cost and Net Realizable Value

Ending inventory is reported at the lower of cost or net realizable value (LCNRV).

Net Realizable Value (NRV) is the expected sales price less estimated selling costs (e.g., repair and
disposal costs).

The company will recognize a “holding” loss in the current period rather than the period in which the item
is sold. This practice is based on prudence (conservatism).

Internal Control of Inventory

The following are the most important control features…
1. Separation of responsibilities for inventory accounting and physical handling of inventory.
2. Storage of inventory in a manner that protects it from theft and damage.
3. Limiting access to inventory to authorized employees.
4. Maintaining perpetual inventory records (described below).
5. Comparing perpetual records to periodic physical counts of inventory.
The first three features protect inventory while the last two ensure the accuracy of reporting inventory costs.
Errors in Measuring Ending Inventory

Errors will normally correct themselves over periods as long as no other errors are introduced.

Key Ratio Analysis – Inventory Turnover Ratio

Analytical Question → How efficient are inventory management activities?
Ratio And Comparisons → The answer to this question is facilitated by the computation of the inventory
turnover ratio as follows…

This ratio reflects how many times average inventory was produced and sold during the period.
A higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence costs.

Key Ratio Analysis – Average Days to Sell Inventory

This ratio reflects the average time in days it takes a company to produce and deliver inventory to its customers.
End of Chapter Summary
● Inventory should include all of the items owned that are held for resale. Costs flow into inventory
when goods are purchased or manufactured.
● A company can keep track of the ending inventory and cost of sales for the period using (1) the
perpetual inventory system, which is based on the maintenance of detailed and continuous
inventory records, and (2) the periodic inventory system, which is based on a physical count of
ending inventory and uses of the cost of sales equation to determine cost of sales.
● The three inventory costing methods are specific identification, FIFO, and weighted-average cost.
● Ending inventory should be measured based on the lower of actual cost and net realizable value
(LC&NRV basis).
● Various control procedures can limit inventory theft or mismanagement.
● An error in the measurement of ending inventory affects the cost of sales on the current period’s
statement of earnings and ending inventory on the statement of financial position. It also affects
the cost of sales in the following period by the same amount, but in the opposite direction,
because this year’s ending inventory becomes next year’s beginning inventory.
● These relationships can be seen through the cost of sales equation, BI + P − EI = COS.

Learning Objectives
1. Apply the cost principle to identify the amounts that should be included in inventory, and apply the
matching process to determine the cost of sales for typical retailers, wholesalers, and
manufacturers.
2. Record inventory and cost of sales by using three inventory costing methods.
3. Select the inventory costing method that reports the most faithful representation and relevant
information to users of financial statements.
4. Report inventory at the lower of cost and net realizable value (LC&NRV).
5. Describe methods for controlling inventory, and analyze the effects of inventory reporting errors
on financial statements.
6. Evaluate inventory management by using the inventory turnover ratio, and analyze the effects of
inventory on cash flows.

Supplementary Material
7. Report inventory and cost of sales in a periodic inventory system.
8. Compare and contrast the recording of inventory transactions in periodic and perpetual inventory
systems.