Principles of Financial Accounting

Chapter 7 COGS & Inventory

Inventory
Inventory (or Merchandise Inventory):
Products held for resale in the ordinary course of business (or for consumption in the production process or in rendering of services). Current asset on the Balance Sheet. Merchandisers / retailers have:
Merchandise inventory

Manufacturers have:
Raw materials inventory Work in process inventory Finished goods inventory

When the goods are sold, the cost of the inventory sold becomes an expense: Cost of Goods Sold (COGS).
This expense is deducted from Sales to determine Gross Profit.
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Gross Profit & Cost of Goods Sold

Balance Sheet Income Statement

Sales Minus Merchandise Purchases Merchandise Inventory Merchandise Sales Cost of Goods Sold (an expense) Equals Gross Profit Minus Selling and Administrative Expenses Equals Operating Income
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Gross Profit & Cost of Goods Sold

Sales Cost of Goods Sold = Gross Profit

Valuation of inventory & measurement of COGS affects profitability

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Inventory Accounting Systems

Two main systems for keeping merchandise inventory records:
Perpetual Inventory System
Keeps a running, continuous record of all goods bought and sold on a day-to-day basis. Inventory counted once a year.

Periodic Inventory System

Does not keep a running, continuous record of all goods bought and sold on a day-to-day basis. COGS is computed periodically. Relies solely on physical counts of the inventory.

In this class, we focus on perpetual systems!

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Perpetual Inventory System

In a perpetual system, the journal entries are:
When inventory is purchased: Dr. Inventory Cr. Accounts Payable (or Cash) When inventory is sold: Dr. Accounts Receivable (or Cash) Cr. Sales Revenue Dr. Cost of Goods Sold Cr. Inventory xxx xxx xxx xxx xxx xxx

When accounting for shrinkage (due to any difference between year end count and ending inventory balance): Dr. Shrinkage Expense (or COGS) xxx Cr. Inventory xxx
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Inventory Accounting Example

The Gap had a beginning inventory of $100,000 and purchased an additional $560,000 of inventory on account. During the period it sold $540,000 worth of inventory on account for a price of $900,000. Purchase on account: Dr. Inventory Cr. Accounts Payable Sale on account: Dr. Accounts Receivable Cr. Sales Revenue Dr. Cost of Goods Sold Cr. Inventory
Professor Lucile Faurel Principles of Financial Accounting Chapter 7 COGS & Inventory

560,000 560,000 900,000 900,000 540,000 540,000

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T- Accounts and Financial Statements

Inventory (BS) 100,000 560,000 120,000 Income Statement (partial): Sales revenue Cost of goods sold Gross profit Balance Sheet (partial): Current Assets: Cash Short-term investments Accounts receivable Inventories
Professor Lucile Faurel Principles of Financial Accounting Chapter 7 COGS & Inventory

Cost of Goods Sold (IS) 540,000

540,000

$900,000 540,000 $360,000

xxx xxx xxx 120,000

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Inventory Equation
Beginning inventory Beginning inventory $100,000 $100,000 Cost of goods available Cost of goods available for sale for sale $660,000 $660,000 Purchases Purchases $560,000 $560,000 Beginning Inventory + Purchases . Total Goods Available for Sale Ending Inventory . = Cost of Goods Sold (COGS)
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Ending inventory Ending inventory $120,000 $120,000

Cost of goods sold Cost of goods sold $540,000 $540,000

Inventory Valuation
The Cost Principle:
The cost of any asset is the sum of all the costs incurred to bring the asset to its intended use. The intended use of inventory is readiness for sale. Inventory costs include:
Purchase price Shipping cost (freight-in) Insurance in transit If manufacture yourself include material, labor and overhead

I.e. the costs included in inventory include all expenditures and charges directly or indirectly incurred in bringing an article to salable condition and location.
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Inventory Valuation
Lower-of-Cost-or-Market (LCM) Rule:
The current market price of inventory is compared with the historical cost of inventory. The lower of the two values is selected as the basis for the valuation of inventory.
When the market value is lower and is used for valuing ending inventory, cost of goods sold (COGS) is effectively increased. This is being conservative. In such case, the corresponding journal entry is:

Dr. Loss on inventory write-down (or COGS) Cr. Inventory

xxx xxx

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Applying the LCM

Current Ending Inventory is $5,000, but right now the inventory could be purchased for $4,000 in the marketplace. What is the required journal entry?
Cost = $5,000 vs. market = $4,000. The lower amount (market) is what Ending Inventory needs to equal. Dr. Loss on write-down 1,000 Cr. Merchandise inventory 1,000

What if the inventory prices rise and the inventory is now worth $4,500? Should or can we record an increase in inventory?
No, the value of the inventory is not marked up in this case. When the market value is higher then the cost, this is called a holding gain not recognized on the income statement! But it gets there somehow, eventuallyhow???
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Principal Inventory Valuation Methods

Four inventory valuation systems have been generally accepted: Specific identification First in, first out (FIFO) Last in, first out (LIFO) Weighted average
If unit prices and costs did not change, all four inventory valuation methods would show identical results The actual purchases of inventory are the same under all methods, its just the ACCOUNTING (Cost of Goods Sold and Ending Inventory) that differs

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Specific Identification
Specific identification method:
Assigns the cost of the specific unit(s) sold to Cost of Goods Sold. Concentrates on the physical tracing of the particular items sold. Used mostly when the physical flow of goods is easy to track. Works best for relatively expensive low-volume merchandise.
E.g. automobiles, jewelry.

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FIFO
FIFO (first in, first out) method:
Assigns the cost of the earliest acquired units to Cost of Goods Sold. The less recent units are deemed to be sold, regardless of which units are actually given to the customer. Under FIFO:
The cost of the less recent units is included in COGS. The cost of the most recent units is included in ending inventory.

FIFO provides a Balance Sheet perspective.

o Ending inventory closely approximates the market value of the inventory. o COGS might be low.
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LIFO
LIFO (last in, first out) method:
Assigns the cost of the most recent units to Cost of Goods Sold. The most recent units are deemed to be sold, regardless of which units are actually given to the customer. Under LIFO:
The cost of the most recent units is included in COGS. The cost of the less recent units is included in ending inventory.

LIFO provides an Income Statement perspective.

o COGS closely approximates market prices . o Ending inventory might be low.

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LIFO versus FIFO

If prices are increasing, which method will result in a greater:
Sales? Pretax Income? Accounts Payable? (pretax) Cash Flow? COGS? Net Income? Income taxes? (after-tax) Cash Flow?

What about if prices are decreasing? Why would companies prefer one method versus the other? Because LIFO usually results in reduced net income (when prices are increasing), it usually results in lower income taxes.
The Internal Revenue Code requires that if a company uses LIFO to compute its taxable income, the company must also use LIFO to compute its financial net income.
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Weighted Average
Weighted-average method:
Computes a unit cost by dividing the total acquisition cost of all items available for sale by the number of units available for sale.

Unit cost =

Cost of goods available for sale Units available for sale

Among FIFO, LIFO and Weighted Average, which method will result in a greater Gross Profit???

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Using perpetual inventory system, compute COGS & ending inventory under FIFO, LIFO and weighted average method.
Transaction Inventory (beg.) Purchase I Sale #A Purchase II Sale #B Purchase III Units 200 300 <400> 400 <300> 100 Cost $1.00 1.10 1.16 1.26 Total $200 330 464 126 COG Avail. $1,120 for Sale

Practice Problem

COGS Total number of units sold: 700. FIFO

Sale #A: 200 * 1.00 + 200 * 1.10 = 420 Sale #B: 100 * 1.10 + 200 * 1.16 = 342 Total: 420 + 342 = 762

LIFO
Sale #A: 300 * 1.10 + 100 * 1.00 = 430 Sale #B: 300 * 1.16 = 348 Total: 430 + 348 = 778

Weighted Average (WA)

Sale #A:
200 + 330 * 400 = 424 200 + 300

Sale #B:

530 424 + 464 * 300 = 342 100 + 400

Total: 424 + 342 = 766

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Professor Lucile Faurel Principles of Financial Accounting Chapter 7 COGS & Inventory

Practice Problem
Using perpetual inventory system, compute COGS & ending inventory under FIFO, LIFO and weighted average method.
Transaction Inventory (beg.) Purchase I Sale #A Purchase II Sale #B Purchase III Units 200 300 <400> 400 <300> 100 Cost $1.00 1.10 1.16 1.26 Total $200 330 464 126 COG Avail. $1,120 for Sale

Ending Inventory Total number of units remaining: 300. FIFO

100 * 1.26 + 200 * 1.16 = 358

LIFO
100 * 1.26 + 100 * 1.16 + 100 * 1.00 = 342

Weighted Average (WA)

200 * 1.14 + 126 * 300 = 354 200 + 100

530 424 + 464 = 1.14 100 + 400

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Practice Problem
In the above practice problem, total revenues amount to $1,000. Compute Gross Profit for all three methods.

FIFO
Sales revenue Cost of goods sold: Goods available for sale Ending inventory Cost of goods sold Gross profit $1,120 ______ 358 $ 238 $1,000

LIFO
$1,000 $1,120 ______ 342 $ 222

Weighted - Average
$1,000 $1,120 ______ 354 $ 234

______________________________________ 762 778 766

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Practice Problem To do at home

o o o o o Beginning inventory (1/1/06): 500 units @ 2.00 = 1,000 Purchase of inventory (1/14/06): 500 units @ 3.00 = 1,500 Sale of inventory: 1/2/06: 300 units 1/15/06: 200 units Total Sales Revenue = $2,250 The perpetual inventory system is used. Compute COGS, Ending Inventory and Gross Profit under: FIFO: COGS = 300 @ 2.00 + 200 @ 2.00 = $1,000
Ending Inv = 500 @ 3.00 = $1,500 Gross Profit = 2,250 1,000 = $1,250

LIFO: COGS = 300 @ 2.00 + 200 @ 3.00 = $1,200 Weighted Average:

Ending Inv = 200 @ 2.00 + 300 @ 3.00 = $1,300 Gross Profit = 2,250 1,200 = $1,050

COGS = 300 @ 2.00 + 200 @ [(200*2+500*3)/700] = $1,143 Ending Inv = 500 @ ((200*2+500*3)/700) = $1,357 Gross Profit = 2,250 1,143 = $1,107
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LIFO Terminology
LIFO Reserve
The difference between inventories valued (on the balance sheet) at LIFO, and what it would be under FIFO.
It measures the potential effect of LIFO liquidations. It represents the cumulative effect on gross profit over the time that the company has been applying LIFO.

LIFO Layers (or LIFO increment)

A segment of LIFO inventory at a distinct cost.

LIFO Liquidations (dipping into LIFO layers)

When the number of inventory units decline causing old LIFO layers (at low historical acquisition cost) to become COGS. This results in higher gross profit.
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LIFO Layers & LIFO Liquidations

Example: LIFO has been used for some inventory for the past 5 yrs Ending inventory: Year 1 Year 2 Year 3 100 @ $20 = $2,000 100 @ $20 (from year 1) + 10 @ $22 = $2,220 100 @ $20 (from year 1) + 10 @ $22 (from year 2) + 10 @ $23 = $2,450 100 @ $20 + 10 @ $22 + 10 @ $23 + 20 @ $25 (from year 1) (from year 2) (from year 3) = $2,950

Year 4

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LIFO Layers & LIFO Liquidations

In year 5, the cost of one unit of inventory is $30 and the sales price is $60.
What is gross profit if during year 5 we first buy 50 units and then sell 150 units?
Sales Revenue = 150 * $60 = $9,000 COGS = 50 @ $30 + 20 @ $25 + 10 @ $23 + 10 @ $22 + 60 @ $20 = $3,650 Gross Profit = 9,000 3,650 = $5,350

What is gross profit if during year 5 we first buy 10 units and then sell 150 units?
Sales Revenue = 150 * $60 = $9,000 COGS = 10 @ $30 + 20 @ $25 + 10 @ $23 + 10 @ $22 + 100 @ $20 = $3,250 Gross Profit = 9,000 3,250 = $5,750

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Adjusting from LIFO to FIFO

Why adjust? To make reliable comparisons across firms that have different costflow assumptions. How to adjust? The change in the LIFO Reserve from year-end to year-end represents the effect on gross profit for the current year.
Year 1 2 3 4 5 Ending Inv. FIFO LIFO 2,000 2,000 2,420 2,220 2,760 2,450 3,500 2,950 0 0 LIFO Reserve 0 200 310 550 0 Change in LIFO Reserve 0 200 110 240 -550 Effect on Gross Profit Current Cumulative 0 0 -200 -200* -310 -110 -550 -240 +550 0
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* In Year 2, Current Gross Profit is lower under LIFO by $200.

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Adjusting from LIFO to FIFO

Useful relationships:
FIFO Inventory = LIFO Inventory + LIFO Reserve FIFO COGS = LIFO COGS LIFO Reserve FIFO Pretax Income = LIFO Pretax Income + LIFO Reserve Using the example from above, if pretax income in Year 3 is $6,000 and net income is $3,600 using LIFO, what would pretax and net income be if FIFO were used?
FIFO Pretax Income: FIFO Net Income: $6,000 $3,600 + $110 + $66 = = $6,110 $3,666

So change in Pretax Income is 110 but change in Net Income (i.e. after-tax) is only 66 because we had to pay 44 more in taxes.
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Summary of Income Effects

When inventory unit costs are increasing & there is no LIFO liquidation
FIFO FIFO Highest ending inventory Highest ending inventory Lowest cost of goods sold Lowest cost of goods sold Highest gross profit Highest gross profit LIFO LIFO Lowest ending inventory Lowest ending inventory Highest cost of goods sold Highest cost of goods sold Lowest gross profit Lowest gross profit Weighted-Average Weighted-Average Results fall between Results fall between the extremes of the extremes of FIFO and LIFO FIFO and LIFO

However, when i) inventory unit costs are increasing & there are LIFO liquidations, or ii) when inventory unit costs are decreasing it is unclear which method will result in a smaller/greater cost of goods sold or gross profit.
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Use of Accounting Information in Decision Making

Inventory Considerations
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Gross Profit Percentage

Gross Profit Percentage = Gross Profit Total Net Sales

A 36% gross profit means that each dollar of sales generates 36 cents of gross profit (and the cost of the goods sold is 64 cents). Analysis:
Compare the companys gross profit percentage with the industry average or that of another competitor. Compare the companys gross profit percentage to historical gross profit percentages. A small downturn may signal an important drop in net income.

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Gross Profit Percentage Example

What is A&Fs gross profit percentage for 2003 and 2004? 2003: 716,944 / 1,707,810 = 42% 2004: 909,793 / 2,021,253 = 45%
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Inventory Ratios
(Times) Inventory Turnover:
Inventory Turnover = COGS Average Inventory

Indicates, on average, how many times a year is inventory sold (how efficiently a firm is managing its inventory).

Days Inventory Turnover:

Days Inventory Turnover = 365 days Inventory Turnover

Indicates after how many days, on average, is inventory sold after being purchased. Usually, industries that have high profit margins have lower turnover and vice-versa.
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Assessing Inventory Management

Consider the inventory turnover ratios for CISCO in the 3-year period, 1998-2000. Data (from 10-Ks):
1997 Ending inventory COGS 255 NA 1998 362 2,924 1999 658 4,259 2000 1,232 6,746

Times and days inventory turnover:

1998: 1999: 2000:
2,924 / {(255 + 362)/2} 4,259 / {(362 + 658)/2} = 9.48; = 8.35; 38 days 43 days 50 days

6,746 / {(658 + 1,232)/2} = 7.14;

Go to Ciscos 2002 10-k and look at the trend in Cost of Sales and Net Income (2000-02): http://www.sec.gov/Archives/edgar/data/858877/000089161802004345/f84358exv13.htm
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Assessing Inventory Management

CISCO (10-Q, April 28, 2001) NOTE 3: RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES AND PROVISION FOR INVENTORY

Provision for Inventory

The Company recorded a provision for inventory, including purchase commitments, totaling $2.36 billion during the third quarter of fiscal 2001, of which $2.25 billion related to an additional excess inventory charge. This additional excess inventory charge was due to a sudden and significant decrease in forecasted revenue and was calculated in accordance with the Company's policy, which is based on inventory levels in excess of 12-month demand for each specific product.
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Assessing Inventory Management

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Earnings Management
In the last chapter we discussed one form of earnings management called smoothing. Another example of earnings management is taking a big bath.
Firms take a bath when their earnings are so bad that they have no hope of meeting their targets. Instead, they go for broke by dumping all possible expenses into the bad period so that they will not have to record these expenses in future periods. Consequently, in future periods they will be able to show improvement.

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