In this section, we introduce the concept of inventory and demonstrate the different methods used to calculate the cost of inventory for external reporting.
Inventory includes items a company intends for sale to customers. You already are familiar with several types of inventory—clothes at TheLimited, shoes at Payless Shoe Source, grocery items at Publix Super Markets, digital equipment at Best Buy, building supplies at The Home Depot, and soon. Inventory also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer, steel at a construction firm, and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers.Companies that earn revenue by selling inventory are either manufacturing or merchandising companies.The company reports the cost of the inventory it sold as cost of goods sold in the income statement. Cost of goods sold is also referred to as cost of sales, cost of merchandise sold, or cost of products sold.
Merchandising companies purchase inventories that are primarily in finished form for resale to customers.Wholesalers resell inventory to retail companies or to professional users. Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users.Manufacturing companies manufacture the inventories they sell, rather than buying them in finished form from suppliers. Raw materials inventory includes the cost of components that will become part of the finished product but have not yet been used in production.Work-in-process inventory includesproducts that have been started in the production process but are not yet complete at the end of the period.Finished goods inventory consists of items for which the manufacturing process is complete.Service companies earn revenues by providing services to customers. Merchandising and manufacturing companies earn revenues by selling inventory to customers.
Let’s look the relationship between ending inventory in the balance sheet and cost of goods sold in the income statement. We’ll use a simple example for a local Best Buy. Assume the store begins the year with $20,000 of DVD player inventory. That amount represents how much Best Buy spent to purchase the inventory of DVD players on hand at the beginning of the year. During the year, the company purchases additional DVD players for $90,000. The total cost of inventory (DVD players) available for sale is $110,000 (= $20,000 + $90,000).Of the $110,000 in inventory available for sale, assume that by the end of the year the purchase cost of the remaining DVD players not sold equals $30,000. This is the amount reported for ending inventory. If $30,000 of the inventory available for sale was not sold, then the remaining portion of $80,000 (= $110,000 − $30,000) was sold, and will be reported as cost of goods sold.
*Amounts include those from Best Buy’s actual income statement in 2011 excluding small adjustments for equity income and non controlling interest.A single-step income statement involves essentially a single calculation—total revenues minus total expenses—to get to net income.The name multiple-step income statement is referring to the fact that the income statement reports multiple levels of income (or profitability). The reason whycompanies choose the multiple-step format is to show the revenues and expenses that arise from different types of activities. By separating revenues and expenses into their different types, investors and creditors are better able to determine the source of a company’s profitability. Understanding the components of current profitability often enables a better prediction of future profitability.Gross profit: It is the first level of profit shown in the multiple-step income statement and is calculated as net sales minus cost of goods sold.Operating income: It is gross profit reduced by operating expenses, such as selling, general, and administrative expenses, and is sometimes referred to as income from operations. It measures profitability from normal operations, a key performance measure for predicting the future profit-generating ability of the company.Income before income taxes: It reported after adjusting non-operating revenues and expenses of a company to operating income. Non-operating revenues and expenses arise from activities that are not part of the company’s primary operations. Net income: It is income before income taxes subtracted by income tax expense. Income tax expense is reported separately because it represents a significant expense. It’s also the case that most major corporations (formally referred to as C corporations) are tax-paying entities, while income taxes of sole proprietorships and partnerships are paid at the individual owner level. By separately reporting income tax expense, the income statement clearly labels the difference in profitability associated with the income taxes of a corporation.
We can determine the cost of inventory considering four methods for inventory costing:Specific identification method:It matches or identifies each unit of inventory with its actual cost. It is practicable only for companies selling unique, expensive products.First-in, first-out method (FIFO) method:It assumes the first units purchased (the first in) are the first ones sold (the first out).Last-in, first-out (LIFO) method:It assumes that the last units purchased (the last in) are the first ones sold (the first out).Weighted-average cost method:It assumes that both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.
To see how the three cost flow assumptions work, let’s look at an illustration. Mario’s Game Shop sells video game cartridges. Mario has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19. Note that the unit costs are different at the time of each purchase. There are 1,000 game cartridges available for sale.During the year, Mario sells 800 video game cartridges for $15 each. This means that 200 cartridges remain in ending inventory at the end of the year.
Using the first-in, first-out (FIFO) method, we assume that beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.Since 800 units are sold, we assume that all units from beginning inventory (100 units) and the April 25 purchase (300 units) were sold. For the final 400 units sold, we split the October 19 purchase of 600 units into two groups—400 units assumed sold and 200 units assumed not sold. So, the cost of goods sold reported in the income statement will be $7,800 ((100 × $7) + (300 × $9) + (400 × $11)) and ending inventory reportedin the balance sheet will be $2,200 (200 × $11).
Using the last-in, first-out (LIFO) method, we assume that the last units purchased (the last in) are the first ones sold (the first out). Since 800 units were sold, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory (not sold). So, the cost of goods sold reported in the income statement will be $8,400 ((200 × $9) + (600 × $11)) and ending inventory reportedin the balance sheet will be $1,600 ((100 × $7) + (100 × $9)).
Using the weighted-average cost method, we assume that both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale. We assume each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items.
800 units were sold and 200 units are still in inventory (not sold).By dividing the cost of goods available for sale by the number of units available for sale, we determine the weighted-average cost of each game cartridge is $10, even though none of the game cartridges actually cost $10. Using this amount, we calculate the cost of goods sold as $8,000 (800 × $10) and ending inventory as $2,000 (200 × $10).
This illustration shows a comparison of cost of goods sold and ending inventory under the three inventory cost flow assumptions forMario’s Game Shop.
Under FIFO,the amount for ending inventory reported (which appears in the balance sheet) better approximates the current cost of inventory. Therefore, accountants often call FIFO the balance-sheet approach. Under LIFO, the amount for cost of goods sold (which appears in the income statement) more realistically matches the current costs of inventory needed to produce current revenues.The primary benefit of choosing LIFO is tax savings. LIFO results in the lowest amount of reported profits (when inventory costs are rising). When taxable income is lower, the company owes less in taxes to the Internal Revenue Service (IRS). Companies might want to use LIFO for tax purposes and FIFO for income statement. To avoid this, the IRS established the LIFO conformity rule, which requires a company that uses LIFO for tax reporting to also use LIFO for financial reporting.
This illustration compares the FIFO, LIFO, and weighted-average cost methods for Mario’s Game Shop (assuming rising costs).When inventory costs are rising, Mario’s Game Shop will report both higher inventory in the balance sheet and higher gross profit in the income statement ifit chooses FIFO. The reason is that FIFO assumes the lower costs of the earlier purchases become cost of goods sold first, leaving the higher costs of the later purchases in ending inventory. Under the same assumption (rising inventory costs), LIFO will produce the opposite effect: LIFO will report both the lowest inventory and the lowest gross profit. The weighted-average cost method typically produces amounts that fall between the FIFO and LIFO amounts for both cost of goods sold and ending inventory.
Because of the financial statement effects of different inventory methods, companies that choose LIFO must report the difference in the amount of inventory a company would report if it used FIFO instead of LIFO. (This difference is sometimes referred to as the LIFO reserve.) For some companies that have been using LIFO for a long time or for companies that have seen dramatic increases in inventory costs, the LIFO difference can be substantial. For example, this illustration shows the effect of the LIFO difference reported by Rite Aid Corporation, which uses LIFO to account for most of its inventory.Note: When a company changes from LIFO for tax purposes, it cannot change back to LIFO until it has filed five tax returns using the non-LIFO method.
In this section, we will discuss how to record inventory transactions.
A perpetual inventory systeminvolves recording inventory purchases and sales on a perpetual (continual) basis. This information will affect decisions related to purchase orders, pricing, product development, and employee management. Because these decisions need to be made on a daily basis, maintaining inventory records on a continual basis is necessary.A periodic inventory system does not continually record inventory amounts. Instead, it calculates the balance of inventory once per period, at the end, based on a physical count of inventory on hand. Because the periodic system does not provide a useful, continuing record of inventory, very few companies actually use the periodic inventory system in practice to record inventory transactions.In this section, we will focus on how to record inventory transactions using the perpetual inventory system.
Here are the inventory transactions of Mario’s Game Shop from January 1 through December 31.
To record the purchase of new inventory, we debit Inventory (an asset) to show that the company’s balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit Cash. Or more likely, if the company made the purchase on account, we credit Accounts Payable, increasing total liabilities.This entry shows how Mario records the purchase of 300 units for $2,700 on April 25.
We make two entries to record the sale: (1) The first entry shows an increase to the asset account (in this case, Accounts Receivable) and anincrease to Sales Revenue. (2) The second entry reduces the Inventory account as it records cost of goods sold.This entry shows how Mario records revenue of $4,500 from the July 17 sale. We assume that Mario’s Game Shop uses FIFO, and calculate the cost of the first 300 units purchased as $2,500, which is $700 of beginning inventory (100 units × $7) plus $1,800 of the April 25 purchase (200 units × $9). We record this amount as the cost of goods sold for the July 17 sale. At the same time, we maintain a continual (perpetual) record of inventory by reducing the Inventory balance by the cost of the amount sold, $2,500, as shown here.
After recording all purchases and sales of inventory for the year, we can determine the ending balance of Inventory by examining the postings to the account. Thus, Mario’s ending Inventory balance is $2,200, as shown in this illustration.
In practice, virtually all companies maintain their own inventory records using the FIFO assumption, because that’s how they typically sell their actual inventory. However, as discussed earlier in the chapter, for preparing financial statements, many companies choose to report their inventory using the LIFO assumption.The adjustment to report inventory using the LIFO assumptionis referred to as the LIFO adjustment. This involves a very simple adjusting entry at the end of the year.
Mario’s ending balance of Inventory using FIFO is $2,200. Under LIFO, it is only $1,600. If Mario’s wants to adjust its FIFO inventory records to LIFO for preparing financial statements, it needs to adjust Inventory downward by $600 (decreasing the balance from $2,200 to $1,600). We do this LIFO adjustment at the end of the period through a decrease to Inventory and an increase to Cost of Goods Sold.
Now, let’s discuss three additional inventory topics.Freight charges: A significant cost associated with inventory for most merchandising companies includes freight (also called shipping or delivery) charges. This includes the cost of shipments of inventory from suppliers, as well as the cost of shipments to customers.Freight charges on incoming shipments from suppliers are commonly referred to as freight-in. This cost is added to the cost inventory purchased. Later, when that inventory is sold, those freight charges become part of the cost of goods sold.The cost of freight on shipments to customers is called freight-out. Shipping charges for outgoing inventory are reported in the income statement either as part of cost of goods sold or as an operating expense, usually among selling expenses.Purchase discounts: Sales discounts from the buyer’s point of view are purchase discounts. Purchase discounts allow buyers to trim a portion of the cost of the purchase in exchange for payment within a certain period of time. Buyers are not required to take purchase discounts, but many find it advantageous to do so.Purchase returns: Returning inventory items that are unacceptable for some reason are referred to as purchase returns. The purchase return is recorded as a reduction in both Inventory and Accounts Payable.
When goods are shipped, they are shipped with terms FOB shipping point or FOB destination. FOB stands for “free on board” and indicates when title (ownership) passes from the seller to the buyer.
Companies usually have old inventory that has likely fallen below its original cost. In such instances, should the inventory be reported at the reduced-value or the original cost? We will answer this question in this section.
When the market value of inventory falls below its original cost, companies are required to report inventory at the lower market value.Normally, the market value of inventory is considered to be the replacement cost of that inventory. This is the cost to replace the inventory item in its identical form. The cost of inventory is the amount initially recorded in the accounting records.Once both the cost and market value of inventory are determined, the company reports ending inventory in the balance sheet at the lowerof the two amounts. This is known as the lower-of-cost-or-market (LCM) method to valuing inventory.
Assume Mario’s Game Shop sells FunStation 2 and FunStation 3. This illustration providesinformation related to ending inventory at the end of 2015 and shows the calculation of lower-of-cost-or-market value to be reported.Mario reports the FunStation 2 in ending inventory at market value ($200 per unit) because that’s lower than its original cost ($300 per unit). The 15 FunStation 2s were originally reported in inventory at their cost of $4,500 (= 15 × $300). To reduce the inventory from that original cost of $4,500 to its lower market value of $3,000 (= 15 × $200), Mario records a $1,500 reduction in inventory with the this year-end adjustment.
The inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period. It is calculated as cost of goods sold divided by average inventory. The amount for cost of goods sold is obtained from the current period’s income statement; average inventory equals the average of inventory reported in this period’s and last period’s balance sheets. The more frequently a business is able to sell or “turn over” its average inventory balance, the less the company needs to invest in inventory for a given level of sales.
Average days in inventory is anothermeasure how frequently a business is able to sell its average inventory balance. This ratio indicates the approximate number of days the average inventory is held. It is calculated as 365 days divided by the inventory turnover ratio.
Another important indicator of the company’s successful management of inventory is the gross profit ratio. It measures the amount by which the sale price of inventory exceeds its cost per dollar of sales. We calculate the gross profit ratio as gross profit divided by net sales. (Net sales equal total sales revenue less sales discounts, returns, and allowances.)The higher the gross profit ratio, the higher is the “markup” a company is able to achieve on its inventories.
Let’s again look at the inventory transactions of Mario’s Game Shop from January 1 through December 31 to understand how they are recorded under the periodic inventory system.
Here, you see how the purchase and the sale are recorded under both the systems.
Here, you see how the payment of freight-in, payment of an account on credit within the credit period, and purchase returns under both the systems.
A period-end adjustment is needed under the periodic system. It:Adjusts the balance of inventory to its proper ending balance.Records the cost of goods sold for the period, to match inventory costs with the related sales revenue. Closes (or zeros out) the temporary purchases accounts (Purchases, Freight-in, Purchase Discounts, and Purchase Returns).
Errors can unknowingly occur in inventory amounts if there are mistakes in a physical count of inventory or in the pricing of inventory quantities.An error in calculating ending inventory (an asset in the balance sheet) causes an error in calculating cost of goods sold (an expense in the income statement). If cost of goods sold is misstated, gross profit will be misstated as well, but in the opposite direction. This is true because gross profit equalssales minus cost of goods sold.This table summarizes the effects of inventory errors in the current year.
Ending inventory is subtracted in calculating cost of goods sold in year 1 (the year of the inventory error). That same amount becomes beginning inventory in the following year and is added in calculating cost of goods sold. Because of this, an error in calculating ending inventory in the current year will automatically affect cost of goods sold in the following year in the opposite direction.The first table shows the correct value. The second table assume the company mistakenly reports ending inventory in 2015 as $400, instead of $500. Notice the following:The amount reported for inventory is correct by the end of the second year, $800.The total amount reported for cost of goods sold over the two-year period from 2015 to 2016 is the same ($6,800). If the combined two-year gross profit is correct, then retained earnings will also be correct by the end of 2016.