Lecture Notes: Inventory Management and Costing Methods

Chapter Overview

• Focus on Chapter 6: Inventory Management
• Easier than Chapter 5
• Topics: Inventory, Cost of Goods Sold (COGS), and methods of costing inventory

Basics of Inventory

• Definition: Inventory is an asset that is manufactured or purchased to be sold to customers.
• Inventory on the Balance Sheet:
  • A current asset
  • Once sold, it becomes an expense (Cost of Goods Sold) on the income statement

Types of Inventory

• Manufacturing Companies:
  • Raw Materials: Materials needed to make products
  • Work in Process (WIP): Partly finished goods
  • Finished Goods: Completed products ready for sale
• Merchandising Companies:
  • Purchase completed products for resale

Recording Inventory Transactions

• Inventory as Asset:
  • Recorded on the balance sheet until sold
• Cost of Goods Sold (COGS):
  • Expense on the income statement
  • Calculated as: Beginning Inventory + Purchases - Ending Inventory

Multiple Step Income Statement

• Shows multiple levels of profitability:
  • Gross Profit = Net Revenues - COGS
  • Operating Income = Gross Profit - Operating Expenses
  • Income Before Taxes = Operating Income + Non-Operating Revenues - Expenses
  • Net Income = All Revenues - All Expenses

Inventory Costing Methods

1. Specific Identification
   • Matches each unit with its actual cost
   • Used for unique items (e.g., jewelry, cars)
2. FIFO (First-In, First-Out)
   • First items purchased are the first sold
   • Common in businesses
3. LIFO (Last-In, First-Out)
   • Last items purchased are the first sold
   • Can affect taxes and financial reporting
4. Weighted Average Cost
   • Averages the cost of all units available

Example: Costing Methods

• Scenario: Mario's Game Shop
  • Initial inventory and two purchase transactions
  • Calculations using FIFO, LIFO, and Weighted Average

Implications of Costing Methods

• FIFO: Balance Sheet approach, more accurate asset value
• LIFO: Income Statement approach, affects tax liability
• LIFO Conformity Rule: Must be used consistently for tax and financial reporting

Inventory Errors

• Affect balance sheet and income statement
• Over time, errors balance out but cause discrepancies in individual periods

Additional Inventory Concepts

• Net Realizable Value (NRV): Estimated selling price minus costs to sell
• Inventory Write-down: Adjust books if NRV is lower than cost

Periodic vs. Perpetual Inventory System

• Perpetual: Constantly updates inventory and COGS
• Periodic: Updates inventory and COGS at the end of the period
  • Uses different accounts (Purchases, Purchase Discounts, Freight In/Out)

Practical Exercises

• Journal entries for inventory transactions
• Adjusting entries for NRV
• Inventory ratio calculations

Key Points to Remember

• Inventory methods affect financial statements and tax liabilities
• Understanding inventory flow and cost methods is crucial for accurate financial reporting

Questions?

• Open floor for any questions or clarifications needed on the topics discussed.