Inventory & Cost of Goods Sold

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39 terms · Chapter 6

The cost of Inventory on hand= Inventory

Asset on the Balance Sheet

The cost of inventory that is being sold= Cost of Goods Sold

Expense on the Income Statement

Gross Profit:

Also called gross margin, is the excess of sales revenue over the cost of goods sold. It is called gross profit because operating expenses have not yet been subtracted.


Number of units of inventory on hand x cost per unit of inventory

Cost of Goods Sold=

Number of units of inventory sold x Cost per unit of inventory

Number of Units of Inventory:

The number of inventory units o hand is determined from the accounting records, backed up by a physical count of the goods at year end. Companies do not include in the inventory any goods they hold on consignment because those goods belong to another company, but they do include their own inventory that is out on consignment and held by another company. Companies include inventory in transit from suppliers or in transit to customers, that according to shipping terms, legally belong to them as of the year end.

FOB (free on board):

Indicate who owns the goods at a particular time, and therefore who must pay for the shipping costs.

FOB Shipping Point:

The most common business practice, legal title to the goods passes from the seller to the purchaser when the inventory leaves the seller's place of business. The company purchasing the goods must include goods in transit from suppliers as units in inventory as of the year end.

FOB Destination:

Title to the goods does not pass from the seller to the purchaser until the goods arrive at the purchaser's receiving dock. These goods are not counted in year-end inventory of the purchasing company.

2 main types of inventory accounting system:

- Periodic System
- Perpetual System

Periodic System:

Is used for inexpensive goods. A fabric store or a lumber yard won't keep a running record of every bolt of fabric or every 2 by 4. Instead, these stores count their inventory periodically, at least once a year, to determine the quantities on hand. Businesses such as restaurants and hometown nurseries also use periodic system because the accounting cost of a periodic system is low.

Perpetual System:

Uses computer software to keep running record of inventory on hand.This system achieves control over goods such as Pottery Barn furniture, automobiles, jewelry, apparel, and most other type of inventory. Most businesses use the perpetual inventory system.

Purchase Return:

Is a decrease in the cost of inventory, because the buyer returned the goods to the seller.

Purchase Allowance:

Decreases the cost of inventory, because the buyer got an allowance ( a deduction) from the amount owed.

Debit Memorandum:

Accounts payable are reduced (debited) for the amount of the return.

Purchase Discount:

Decrease in the buyer's cost of inventory earned by paying quickly.

Net purchases=

Purchases - Purchase returns and allowances - purchase discounts + freight-in

Net sales=

Sales revenue - sales returns and allowances - sales discounts.

Cost principle applied to all assets:

The cost of any asset, such as inventory, is the sum of all costs incurred to bring the asset to its intended use, less any additional discounts.

4 generally accepted inventory methods:

1. Specific unit cost
2. First-in, first-out cost (FIFO)
3. Average cost
4. Last-in, first-out cost (LIFO)

Specific Unit Cost:

Is also called specific identification method.

Average Cost:

Sometimes called weighted-average method, is based on the average cost of inventory during the period.
Average cost per unite= Cost of goods available/ # of units available

Goods available=

Beginning inventory + purchases

Cost of goods sold=

# of units sold x average cost per unit

Ending inventory=

# of units on hand x Average cost per unit

FIFO Cost:

The first costs into inventory are the first costs assigned to cost of goods sold. The cost of ending inventory is always based on the latest cost incurred.

LIFO Cost:

The last cost into inventory go immediately to cost of goods sold. The cost of ending inventory is always based on the oldest cost

Most attractive feature of LIFO:

Low Income tax payments, which is why about 1/3 of all US companies use LIFO.

FIFO income is less realistic than LIFO income.


LIFO can value inventory at very old costs because LIFO leaves the oldest prices in ending inventory.


LIFO Liquidation:

When quantities fall below the level of the previous period. To compute cost of goods sold, the company must dip into older layers of inventory cost. Under LIFO, and the prices are rising, that action shifts older, lower costs into cost of goods sold. The result is higher net income. Managers try to avoid a LIFO liquidation because it increases income taxes.

Accounting principles related to inventory:

- Consistency
- Disclosure
- Conservatism


States that businesses should use the same accounting methods and procedures from period to period. Consistency enables investors to compare a company's financial statements from one period to the next.

Disclosure Principle:

Holds that a company's financial statements should report enough info for outsiders to make informed decisions about the company. The company should report relevant and representationally faithful info about itself. This means properly disclosing inventory accounting methods, as well as the substance of all material transactions impacting the existence and proper valuation of inventory, using comparable methods from period to period.


Means reporting financial statement amounts that paint the most cautious or moderate immediate picture of the company. The goal of acctg conservatism is representational faithfulness.

Lower-of-Cost-or-Market-Rule (LCM):

Is based on acctg conservatism. Requires that inventory be reported in the financial statements at whichever is lower- the inventory's historical cost or its market value. Applied to inventories, market value generally means current replacement cost, that is, how much the business would have to pay now to replace its inventory. If the replacement cost of inventory falls below its historical cost, the business must write down the value of its goods to market value. The business reports ending inventory at its LCM value on the balance sheet.

Gross Profit percentage:

Also called gross margin percentage, is a markup stated as a percentage of sales.
Gross profit percentage= gross profit/ net sales revenue.

Gross profit=

sales - cost of goods sold. Is a key indicator of a company's ability to sell inventory at a profit.

Inventory Turnover:

The ratio of cost of goods sold to average inventory, indicates how rapidly inventory is sold.
Inventory Turnover= Cost of goods sold/ average inventory= cost of goods sold/ (beg inventory+End inventory)/2

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