Financial Accounting: In an Economic Context

SUMMARY OF KEY POINTS

Inventory and how it affects the financial statements.

Inventory includes asset items held for sale in the ordinary course of business. The ending inventory balance appears on the balance sheet and, for manufacturing and retail companies, is often the largest current asset. The methods used to account for inventory affect the allocation of the capitalized inventory cost between ending inventory and cost of goods sold. This allocation, in turn, affects net income and the ending inventory amount reported on the balance sheet. The effects of inventory accounting methods in the current and subsequent periods can be assessed by examining the following formula:

Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory

The ending inventory valuation of the current period decreases cost of goods sold, and thereby increases gross profit and net income. Ending inventory of the current period becomes beginning inventory of the subsequent period. Beginning inventory increases cost of goods sold and decreases gross profit and net income.

Inventory write-downs reduce earnings, and are added back to earnings on the statement of cash flows because they require no cash outflow. Increases (decreases) in inventory balances are subtracted (added) to earnings on the statement of cash flows because they put downward (upward) pressure on the cash balance.

Four issues ...