1. Accounting for Inventories
Chapter Six
Accounting for Inventories
In this chapter we will introduce four inventory cost flow methods.

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
Four common inventory cost flow methods are
Specific identification
First-in, first-out
Last-in, first-out and
Weighted average.
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.
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.
Assume TMBC Company purchased two identical inventory items: the first for one hundred dollars and the second for one hundred ten dollars.
Using specific identification, when the first item is sold, cost of goods sold would be one hundred dollars. When the second item is sold, cost of goods sold would be one hundred ten dollars.

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

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.
Assume TMBC Company purchased two identical inventory items: the first for one hundred dollars and the second for one hundred ten dollars.
Using first-in, first-out, the cost assigned to the first item sold would be one hundred dollars (the first cost in). The cost of goods sold assigned to the second item sold would be one hundred ten dollars.

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

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.
Assume TMBC Company purchased two identical inventory items: the first for one hundred dollars and the second for one hundred ten dollars.
Using last-in, first-out, the cost assigned to the first item sold would be one hundred ten dollars (the last cost in). The cost of goods sold assigned to the second item sold would be one hundred dollars.

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

11. 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).
Assume TMBC Company purchased two identical inventory items: the first for one hundred dollars and the second for one hundred ten dollars.
Using weighted average, the cost assigned to the first item sold would be one hundred five dollars (the average cost). The average cost is determined by taking the total cost of the inventory on hand and dividing it by the total number of units on hand.
Total Cost
Total Number =
$210 2
= $105

12. Cost flows can be done on a different basis than 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.
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.
Take a minute and review this graphic. 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.
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.

15. This exhibit illustrates the relative use of the different cost flow methods among companies in the United States.

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

17. Inventory Cost Flow Under a Perpetual System
We will use the data listed here for The Mountain Bike Company to illustrate the different inventory cost flow methods. Take a minute and review these data.
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:
The cost of goods available for sale must be allocated between the cost of goods sold and the ending inventory. We will illustrate this allocation using FIFO, LIFO and weighted average.
First-in, First-Out (FIFO)
Last-in, First-Out (LIFO)
Weighted Average

19. First-in, First-out Inventory Cost Flow
Using first-in, first-out, the cost of goods sold for the period would be nine thousand six hundred fifty dollars. Remember, Cost of Goods Sold is an expense and, thus, decreases net income.

20. Last-in, First-out Inventory Cost Flow
Using last-in, first-out, the cost of goods sold for the period would be ten thousand two hundred ten dollars.

21. Weighted Average Inventory Cost Flow
Total Cost
Total Number =
$12,650 55
= $230
Using weighted average, the cost of goods sold for the period would be nine thousand eight hundred ninety dollars.

22. Comparative Financial Statements
This graphic shows how each of the three cost flow assumptions affects the financial statements.

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.
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.
The Mountain Bike Company carries in its inventory an energy bar called Never Stop, which it sells in bulk boxes.
This table describes the beginning inventory, purchases, and sales transactions for Never Stop during Take a minute to review these transactions.
Let’s use first-in, first-out to determine the cost of goods sold and inventory for Never Stop at the end of 2008.
Let’s use FIFO to determine the cost of goods sold and inventory at the end of 2008.

25. This exhibit illustrates the effects of each transaction on the financial statements using first-in, first-out. Notice that as sales are made, the cost assigned to the inventory sold is the oldest, or first, cost that remains in inventory.

26. Never Stop: First-in, First-out
Part I
Using first-in, first-out, the cost of goods sold for the April 5th sale would be four thousand five hundred eighty dollars. Remember, Cost of Goods Sold is an expense and, thus, decreases net income.
Part II
The gross margin for the period would be five thousand one hundred thirty five dollars.

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.
When maintaining perpetual inventory records, using the weighted average or last-in, first-out cost flow methods leads to timing difficulties. Further discussion of these methods is beyond the scope of this text.
Further discussion of these methods is beyond the scope of this text.

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

29. Lower of Cost or Market (LCM)
Inventory must be reported at lower of cost or market.
Market is defined as current replacement cost (not sales price).
Consistent with the conservatism principle.
Applied three ways:
separately to each
individual item.
to major classes or
categories of assets.
(3) to the whole inventory.
Part I
When we report inventory on the balance sheet, we report it at the lower of cost or market. Cost is determined using one of the methods we just discussed: Specific identification; first-in, first-out; last-in, first-out; or weighted average. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market follows the conservatism principle by not overstating the value of assets.
Part II
We can apply the lower of cost or market concept on an individual item basis, for similar categories of inventory, or for the inventory as a whole.
Let’s see how to apply the lower of cost or market concept.

30. Lower of Cost or Market (LCM)
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.  
Part I
To illustrate lower of cost or market, assume The Mountain Bike Company has in ending inventory one hundred t-shirts purchased at a cost of fourteen dollars each.  
Part II
In situation one, market is eighteen dollars which is greater than the cost of fourteen dollars, so the inventory would be reported at the lower amount, cost.
In situation two, market is eleven dollars which is less than the cost of fourteen dollars, so the inventory would be reported at the lower amount, market.

31. A company with 4 types of inventory must apply LCM:
This exhibit illustrates computing the ending inventory value on an item-by-item basis for a company that has four different inventory items. In this case, the company would need to write down their inventory cost from thirty thousand twenty dollars to the lower of cost or market of twenty eight thousand four hundred ten dollars.

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 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.
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.
This is an example of what happens to the income statement when ending inventory is overstated by one thousand dollars.
Notice that both the income statement and balance sheet have errors The inventory, total assets, retained earnings, and total stockholders’ equity all have errors in them resulting from the single overstatement of ending inventory.

35. If Cost of Goods Sold is understated, then Gross Margin is overstated.
If Cost of Goods Sold is understated, then Gross Margin is overstated resulting in an overstatement of net income.
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.
Many companies use the gross margin method to estimate the current period’s ending inventory.

40. The Gross Margin Method
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 has the following four steps.
One, calculate the expected gross margin ratio using prior period’s income statement.
Two, multiply the expected gross margin ratio by the current period’s sales to estimate the amount of gross margin.
Three, subtract the estimated gross margin from sales to estimate cost of goods sold.
Four, subtract the estimated cost of goods sold from the amount of goods available for sale to estimate the ending inventory.

41. *Historically, gross margin has amounted to
This exhibit contains some known and some unknown information. Let’s use the gross margin method to complete this statement.
First, let’s assume that the expected gross margin ratio is twenty five percent.
Second, multiply the expected gross margin ratio of twenty five percent by the current period’s sales of twenty two thousand dollars to determine the estimate of gross margin as five thousand five hundred dollars.
Third, subtract the estimated gross margin of five thousand five hundred dollars from sales of twenty two thousand dollars to obtain an estimate of cost of goods sold of sixteen thousand five hundred dollars.
Fourth, subtract the estimated cost of goods sold of sixteen thousand five hundred dollars from the amount of goods available for sale of twenty three thousand six hundred dollars to obtain the estimate for the ending inventory of seven thousand one hundred dollars.
*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. This measures how quickly a company sells its merchandise inventory.
Inventory Turnover
This measures how quickly a company sells its merchandise inventory.
Cost of Goods Sold
Inventory
The inventory turnover ratio measures how quickly a company sells its merchandise inventory.
It is calculated as cost of goods sold divided by inventory.
This is the first step in calculating the average number of days to sell inventory.
This is the first step in calculating the average number of days to sell inventory.

44. Average Number of Days to Sell Inventory
This measures how many days, on average, it takes to sell inventory.
365
Inventory Turnover
The average number of days to sell inventory measures how many days, on average, it takes to sell inventory.
It is calculated as three hundred sixty five divided by the inventory turnover.
Other things being equal, the company with the lower average number of days to sell inventory is doing better.
Other things being equal, the company with the lower average number of days to sell inventory is doing better.

45. This exhibit shows the average number of days to sell inventory for eight real-world companies in three different industries. The wine industry takes longer to sell its inventory than the others. Why? Quality wine is aged before it is sold; time spent in inventory is actually a part of the production process. Generally, the longer wines spend in the aging process, the higher their quality.
Notice that Starbucks holds it inventory of coffee longer than Domino’s and McDonald’s. Why? It is more difficult for Starbucks to obtain coffee than it is for the other two to obtain flour, cheese and fresh vegetables. Coffee is grown and harvested seasonally and requires substantial delivery time. As a result, Starbucks must hold inventory longer than McDonald’s or Domino’s.
See if you can come up with some other explanations for the differences in inventory turnover rates between the office supplies industry and the fast food industry.

46. End of Chapter Six
In this chapter we introduced four inventory cost flow methods:
Specific identification
First-in, first-out
Last-in, first-out and
Weighted average.