Lecture 3 - Accounting for Inventory

Accounting for Inventory

In the same way we created metrics for Accounts Receivable, we create the same measures of inventory.

Inventory Turnover = Cost of Good Sold / Average Inventory

Cost of Goods Sold (COGS) is the price that the goods cost the company, not the price at which they were sold.

Similarly, Number of Days in Inventory = 365 / Inventory Turnover

In general, you want a high Inventory Turnover. However, there's a trade off in that it may result in low levels of inventory and possibly being out of stock, resulting in dissatisfied customers.

Compare these numbers against the company's historical numbers and against comparable companies in the same industry.

Inventory Systems - Perpetual vs. Periodic

A perpetual inventory system keeps track of every sale and every purchase. You are constantly up-to-date with your inventory.

For each sale, debit A/R (or Cash) and credit sales (a revenue account). Also, debit COGS (an expense account) and credit Merchandise Inventory (an asset account).

A periodic inventory system tracks sales and purchases, but doesn't dynamically update inventory. Inventory is surveyed by an actual, physical count on a periodic basis.

Beginning Inventory + Purchases = Goods available for sale

Goods available for sale - Ending Inventory = Cost of Goods Sold

Note: The year-end adjustment for periodic inventory is not being tested. We're not covering Freight and Returns nor Accounting for Discounts.

Inclusion in Inventory

If you pay for shipping, tariffs, insurance, etc then they are all considered the costs of inventory, i.e. COGS.

Goods in transit are included in your inventory if your terms of sale specify that you're responsible for it - called FOB Shipping Point. Similarly if you have the same agreement with your customers (FOB Shipping), you don't count it in inventory once it has left your shipping dock.

Goods on consignment are goods that are in your physical possession, but are not technically yours. You're holding them for sale for someone else. Consignment goods are not included in your inventory.

Cost Flow Assumptions

We don't easily know the exact cost of each item that is sold. How do we compute COGS under different cost flow assumptions - LIFO, FIFO and Weighted Average CGS?

LIFO and FIFO are accounting assumptions about the cost of inventory, but does not mean that the physical inventory moved in the LIFO or FIFO order.

In a period of rising prices, which technique results in lower net income? LIFO. Because it results in higher COGS.

Changing techniques requires disclosure as well as permission from IRS for tax purposes. You must use the same technique for both tax accounting and financial accounting. Most companies use the FIFO method.

If sales take place after all the purchases (first example), perpetual and periodic techniques are the same.

Weighted average technique is computationally complex when there are sales in between purchases.

FIFO works out the same whether you use the perpetual or periodic technique.