University of Michigan

Accounting for Decision Making

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Through this course, you will start by addressing the two “big questions” of accounting: “What do I have?” and “How did I do over time?” You will see how the two key financial statements – the balance sheet and the income statement - are designed to answer these questions and then move on to consider how individual transactions aggregate to make up these financial statements. After developing a broad understanding of accounting and financial statements, you will begin to develop a more nuanced understanding of individual components of doing business, such as making a sale or building inventory. By considering many of the more common actions of a company, you will build your understanding of accounting, and explore these concepts by applying them across various types of transactions. Once you understand these individual concepts better, you will be ready to return to the overall financial statements and use them as informational tools, including building ratios. You can do this course standalone or to qualify for the residential component of the Finance for Strategic Decision-Making Executive Education program. For more information, see the FAQ below.

From the lesson

Revenue, Accounts Receivable, Inventory and Cost of Goods Sold

In the last module we took an overview perspective to get a sense of the structure of financial statements. For the next three modules we are going to delve into the details of specific items on the accrual financial statements. We will work through the most common items on the balance sheet and income statement to develop an understanding of those items. While we will consider specific items, we will also be building a thought process that we can apply to any future accounting items - even if they are topics that we do not cover in this course. That will allow you to confidently use accounting for years to come, regardless of changes in items or in the specific accounting rules. There are two lessons in this module. The first will cover revenue and the related balance sheet item of accounts receivable. The second lesson will cover costs of goods sold and inventory. We will cover the conceptual economics of each, discuss the current accounting rules and end with a video that applies our bookkeeping tools. The readings for each lesson provide more details.

What goes into Inventory and Cost of Goods Sold14:11

Which One Did We Sell? Inventory Cost Flow Assumptions14:00

Bookkeeping for Inventory Transactions4:13

Meet the Instructors

Greg Miller
Professor
Ross School of Business

>> Welcome, in the last couple of videos, we've been discussing inventory and

cost of goods sold.

We've covered them conceptually, we've thought about assumptions that we might

make with them, and we've pointed out some differences in accounting across the US

and international financial reporting standards.

In this video I'm going to do the really easy part, we're just going to do the book

keeping so we know once we've thought about all those assumptions and

come up with informed decisions how do we get those on our books.

It's easiest to do this with a simple example,

let's imagine that you're a company, I'll say Target, and

you're purchasing books that you're going to sell in the future.

You pay $20 for each book and you buy 1,000 of those books.

Well what happens on your financial statements when you do this transaction?

It changes your assets, you've taken one asset, cash, and

gotten rid of that, and transformed it into another asset inventory.

You can see it here using the balance sheet equation,

our overall asset number hasn't changed at all, the net impact is zero.

We've just transformed the composition of our assets.

The journal entry's going to show you the same thing, we no longer have cash, and

we now have inventory.

And just for completeness purposes, here's the T accounts, which again show,

cash has gone down, inventory's gone up.

Now we're going to hold these items and

eventually we're going to sell them, so, let's take a look at that transaction.

Target sells these books for

$30 each, that's great we only paid $20 and we're going to sell them for $30.

So what happens on our financial statements?

Well, remember revenue that we did in the last module,

we recognize that we have revenue of $24,000.

Last time we weren't able to say what the expense was but now we can say there's

a related expense of $16,000, which means we've created net income of $8,000.

What's happened on our asset side?

Well we now have cash of $24,000 and our inventory has gone down by $16,000.

Notice that, unlike when we bought the books, we've got an imbalance here,

we got more asset in of 24,0000 than we gave up of 16,0000.

So where did that other 8,000 go?

Well, that's that 8,000 net income that we created, and that comes over to our

equity account to show that some of our assets came from the fact that we created

value in our ongoing interactions with our shareholders.

Maybe the journal entry will make this clearer to you.

The first part of the entry says hey revenue came in of 24,000.

There we're saying we've created some value by interacting with our

shareholders.

What form did that value come in?

Cash, the second part of the entry says

what did we have to give up to get that revenue?

Well we no longer have 16,000 of inventory,

and what did we use that inventory for?

Well, it was a good that we sold, thus, the inventive name, cost of goods sold.

For completeness purposes, let's just go ahead and

put all of this into the T account as well, I've combined entries one and two.

Here's what you should notice we started with 20,000 in cash going out,

and now we've 24,000 in cash back.

We have 4,000 more in cash, we still have 4,000 left in inventory,

we've now hit revenue and cost of goods sold as well.

So at the end of the year, what does this mean?

Our assets in total are up by 8,000, a 4,000 increase in both cash and inventory.

Our equity is up by 8,000, showing the balance between those,

where did that 8,000 come from?

It came from creating value, how did we create that value?

Our revenue of 24,000 is greater than our cost of 16,000 that

we incurred to generate that revenue.

So at the end of the period, our financial statements answer those two big questions

that we set up at the beginning of the course.

Where do we stand right now?

We have 24,000 of cash and still 4,000 of inventory left.

What happened over time?

We created 24,000 by interacting with our customers, and it only cost

us 16,000 to do that, which means net, we generated 8,000 more of value.

As you can see, the bookkeeping for inventory is pretty straightforward and

just helps us understand what's happened in the firm.

In our next module, we're going to turn to property, plant, and

equipment and think about those more complicated assets and how we use them.