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Unformatted text preview: Chapter 7 Notes • Inventory – tangible property that is (1) held for sale in the normal course of business, or (2) used to produce goods or services for sale. • Manufacturing businesses hold 3 types of inventory: 1. Raw Materials Inventory – Items acquired for processing into finished goods. When they are used, they become part of work in process inventory (WIP) 2. Work In Process Inventory (WIP) – Goods in the process of being manufactured but not yet complete. When completed, work in process inventory becomes finished goods inventory 3. Finished Goods Inventory – Manufactured goods that are complete and ready for sale • Merchandising businesses (ones that do not manufacture inventory) only hold finished goods products available for sale. • Inventory should be recorded using the Cost Principle, which includes the price paid or the consideration given. Items typically included in the “cost” of inventory are: (1) Invoice price of the goods, (2) Freight charges, (3) Inspection costs, and (4) Preparation costs. Essentially, all costs associated with getting raw materials ready for use , or when the merchandise inventory is ready for shipment , should be included in the inventory cost on the balance sheet. • Cost of Goods Sold for a merchandising business is quite simple. It is simply the cost paid for the finished goods inventory + any costs associated with getting the inventory ready to sell (see the 4 items listed previously). COGS for a manufacturing business is quite different, however. The three components included in the inventory costs (COGS) of a manufacturing business are as follows: 1. Raw Materials 2. Work In Process – comprised of direct labor and factory overhead 3. Finished Goods © Scott Friend, 2007 The Cost of Goods Sold Equation is essential for figuring out certain items related to inventory transactions: Beginning Inventory + Purchases of merchandise during the year = Goods Available for Sale − Ending Inventory = Cost of Goods Sold (COGS) • This can also be demonstrated by using an Inventory T-Account • Also remember, we do not recognize COGS until we have SOLD (recognized revenue) the items in our inventory – this is a demonstration of the matching principle Four Inventory Costing Methods (Cost Flow Assumptions): Note: The choice of an inventory costing method is NOT based on the physical flow of goods on and off the shelves. Companies can opt to choose any of these methods for accounting purposes with one caveat: If they choose LIFO (Last-In, First-Out) for tax purposes, they MUST use LIFO to account for inventory on their books (LIFO Conformity Rule) (1) Specific Identification – the cost of each item sold is individually identified and recorded as COGS. Typically, this method is not used by companies...
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