Inventory Cost Flow Methods: Financial Impact Explained

1. Chapter Six Accounting for Inventories

2. Explain how different inventory cost flow methods (specific identification, FIFO, LIFO, and weighted average) affect financial statements. LO 1

3. Inventory Cost Flow Methods Specific Identification First-in, First-Out (FIFO) Four Common Inventory Cost Flow Methods Last-in, First-Out (LIFO) Weighted Average

4. Specific Identification When a company’s inventory consists of many high-priced, low-turnover goods the record keeping necessary to use specific identification is more practical.

5. Specific Identification Assume TMBC Company purchased two identical inventory items: the first for $100 and the second for $110. Using specific identification, when the first item is sold, cost of goods sold would be $100. When the second item is sold, cost of goods sold would be $110.

6. First-in, First-out The first-in, first-out cost flow method requires that the cost of the items purchased first be assigned to Cost of Goods Sold. FIFO

7. First-in, First-out Assume TMBC Company purchased two identical inventory items: the first for $100 and the second for $110. Using first-in, first-out, the cost assigned to the first item sold would be $100 (the first cost in). The cost of goods sold assigned to the second item sold would be $110.

8. Last-in, First-out The last-in, first-out cost flow method requires that the cost of the items purchased last be assigned to Cost of Goods Sold. LIFO

9. Last-in, First-out Assume TMBC Company purchased two identical inventory items: the first for $100 and the second for $110. Using last-in, first-out, the cost assigned to the first item sold would be $110 (the last cost in). The cost of goods sold assigned to the second item sold would be $100.

10. Weighted Average The weighted average cost flow method assigns the average cost of the items available to Cost of Goods Sold.

11. Total Cost $210 = = $105 Total Number 2 Weighted Average Assume TMBC Company purchased two identical inventory items: the first for $100 and the second for $110. Using weighted average, the cost assigned to the first item sold would be $105 (the average cost).

12. Physical Flow Our discussions about inventory cost flow methods pertain to the flow of costs through the accounting records, not the actual physical flow of goods. Cost flows can be done on a different basis than physical flow.

13. Effect of Cost Flow on Income Statement The cost flow method a company uses can significantly affect the gross margin reported in the income statement.

14. Effect of Cost Flow on Balance Sheet Since total product costs are allocated between costs of goods sold and ending inventory, the cost flow method used affects its balance sheet as well.

16. Demonstrate the computational procedures for FIFO, LIFO, and weighted average. LO 2

17. Inventory Cost Flow Under a Perpetual System 55Units Sold 43 bikes for $350 each First-in, First-Out (FIFO) Last-in, First-Out (LIFO) Weighted Average

18. Inventory Cost Flow Under a Perpetual System Goods Available for Sale must be allocated between the Cost of Goods Sold and Ending Inventory We use one of these three methods: First-in, First-Out (FIFO) Last-in, First-Out (LIFO) Weighted Average

19. First-in, First-out Inventory Cost Flow

20. Last-in, First-out Inventory Cost Flow

21. Total Cost $12,650 = = $230 Total Number 55 Weighted Average Inventory Cost Flow

22. Comparative Financial Statements $350 x 43 = MDSE AVAIL. $12,650 Mdse Avail – CGS = E.INV.

23. Inventory Cost Flow When Sales and Purchases Occur Intermittently In our previous examples, all purchases were made before any goods were sold. This section addresses more realistic conditions when sales transactions occur intermittently with purchases.

24. Never Stop Energy Bar This table shows beginning inventory, purchases & sales transactions for Never Stop during 2008. Let’s use FIFO to determine the cost of goods sold and inventory at the end of 2008.

25. -100 = 120 = =

26. Never Stop: First-in, First-out

27. Weighted Average and LIFO Cost Flows When maintaining perpetual inventory records, using the weighted average or LIFO cost flow methods leads to timing difficulties. Further discussion of these methods is beyond the scope of this text.

28. Apply the lower-of-cost-or-market rule to inventory valuation. LO 3

29. Inventory must be reported at lowerof cost or market. Lower of Cost or Market (LCM) Market is defined as current replacement cost (not sales price). Consistent withthe conservatismprinciple. • Applied three ways: • separately to each • individual item. • to major classes or • categories of assets. • (3) to the whole inventory.

30. To illustrate lower of cost or market, assume The Mountain Bike Company has in ending inventory 100 t-shirts purchased at a cost of $14 each. Lower of Cost or Market (LCM)

31. A company with 4 types of inventory must apply LCM:

32. Explain how fraud can be avoided through inventory control. LO 4

33. Fraud Avoidance in Merchandising Businesses Because inventory and cost of goods sold accounts are so significant, they are attractive targets for concealing fraud. Because of this, auditors and financial analysts carefully examine them for signs of fraud.

34. If Ending Inventory is overstated then Cost of Goods Sold will be understated.

35. If Cost of Goods Sold is understated, then Gross Margin is overstated. Resulting in overstatement of Net Income.

36. Then, on the balance sheet Inventory is overstated and Retained Earnings is overstated.

37. Use the gross margin method to estimate ending inventory. LO 5

38. For interim financial statements, we may need to estimate ending inventory and cost of goods sold.

39. Estimating the Ending Inventory Balance Many companies use the gross margin method to estimate the current period’s ending inventory.

40. Calculate the expected gross margin ratio using prior period’s income statement. Multiply the expected gross margin ratio by the current period’s sales to estimate the amount of gross margin. Subtract the estimated gross margin from sales to estimate cost of goods sold. Subtract the estimated cost of goods sold from the amount of goods available for sale to estimate the ending inventory. The Gross Margin Method

41. 16,500 7,100 22000 x .25=5,500 *Historically, gross margin has amounted to approximately 25 percent of sales.

42. Explain the importance of inventory turnover to a company’s profitability. LO 6

43. Cost of Goods Sold Inventory Inventory Turnover This measures how quickly a companysells its merchandise inventory. This is the first step in calculating the average number of days to sell inventory.

44. 365 Inventory Turnover Average Number of Days to Sell Inventory This measures how many days, on average, it takes to sell inventory. Other things being equal, the company with the lower average number of days to sell inventory is doing better.

46. End of Chapter Six