1. Accounting for Inventories
Chapter 5
Accounting for Inventories
In this chapter we will learn how to determine the cost of inventory. The book refers to this chapter as cost of inventory, but this is actually an inaccurate description when it comes to getting a full understanding of the process. To better understand this, always refer to the discussion as accounting for COST OF GOODS sold. By the end of this chapter, you will be able to understand and utilize the methods that retail businesses calculate their cost of goods sold.
Wegman’s- Pepsi Inventory, Gas station- gas inventory. When these companies sell their products, how do they know what they paid for the ACTUAL product sold.

2. Determining Inventory Items
C 1
Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted.
Items requiring special attention include:
Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Additionally, as discussed last chapter, work in process, raw materials and finished goods are a way to look at this.
We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory.
Goods in Transit
Goods Damaged or Obsolete
Goods on Consignment

3. Ownership passes to the buyer here.
Goods in Transit
C 1
Public Carrier
Seller
Buyer
FOB Shipping Point
Ownership passes to the buyer here.
Transportation costs are sometimes included in the cost of Merchandise Inventory.
The FOB terms designate when title passes and who pays the transportation costs. FOB stands for Free On Board. So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that buyer will pay the transportation cost.
On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means that seller will pay the transportation cost.
So, if goods are shipped FOB Shipping Point, then the buyer owns the goods in transit and will pay the transportation costs. In this case, the transportation cost will be added to the merchandise inventory account.
FOB Destination Point
Public Carrier
Seller
Buyer

4. Thanks for selling my inventory in your store.
Goods on Consignment
C 1
Merchandise is included in the inventory of the consignor, the owner of the inventory.
Thanks for selling my inventory in your store.
Consignee
Goods on consignment are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownership of them and should include them in our inventory count.
Consignor

5. Goods Damaged or Obsolete
C 1
Damaged or obsolete goods are not counted in inventory.
Any inventory that is damaged or obsolete should be reduced to net realizable value. Net realizable value is the value we can expect to get from the damaged or obsolete inventory when it is sold.
Cost should be reduced to net realizable value.

6. Determining Inventory Costs
Include all expenditures necessary to bring an item to a salable condition and location.
Invoice Cost
Minus Discounts and Allowances
Plus Insurance
The cost of inventory includes any cost that is necessary and reasonable to get the inventory to your place of business and to get it in a salable condition.
We already know that the invoice price and transportation costs are included in the total cost of inventory. Other costs to include are insurance, storage and duties. Any purchase discounts or allowances received reduce the cost of the inventory purchased.
Plus Import Duties
Plus Storage
Plus Freight

7. Internal Controls and Taking a Physical Count
Inventory Count Tag
Counted by _______
Quantity Counted ___
Most companies take a physical count of inventory at least once each year.
When the physical count does not match the Merchandise Inventory account, an adjustment must be made.
Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in our inventory records. In reality, this is not the case. The physical count does not match our records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps us get our records up to date to reflect what we actually have on hand.
This is done regardless of method used, which can be periodic or perpetual.

8. Frequency in Use of Inventory Methods
Exh.
5.1 P1
There are three basic ways that accountants can use to determine the cost of goods sold, or the cost of the inventory that was sold, and ending inventory under a periodic or perpetual system. These are commonly referred to as FIFO, LIFO and Average Cost. Remember you buy inventory on a regular basis and never pay the same price for the goods, think of a seafood vendor that buys fish on the open market. The major issue here is to determine which price paid is recognized as your inventory sold. We need to be able to compute our cost of goods sold before we can make the journal entries illustrated in the first part of this chapter.
FIFO- First in First out; the first goods in my inventory are the first ones out. i.e. when I sell a product, the oldest goods are taken out of inventory first. Goods are costed out in the order purchased.
LIFO- Last in First out; the newest goods to be added to my inventory are the first goods to go out. Goods are costed out in the reverse order that they were purchased
Average cost- Cost of goods sold and ending inventory are computed using an average cost of all items of that type available during the year (period).
As this graph indicates, the majority of inventory methods used can be classified as first-in, first-out; last-in, first-out; and weighted average.

9. Inventory Cost Flow Assumptions
First-In, First-Out (FIFO)
Assumes costs flow in the order incurred.
Last-In, First-Out (LIFO)
Assumes costs flow in the reverse order incurred.
We must make assumptions about the inventory cost flow. First-in, first-out assumes costs flow in the order incurred. Last-in, first-out assumes costs flow in the reverse order incurred. Weighted average assumes costs flow at an average of the costs available.
Now, let’s see how these methods work in an example.
Key to remember here, this is COST flow of cost of goods sold, not necessarily the flow that actual goods flow.
Weighted Average
Assumes costs flow at an average of the costs available.

10. Specific Identification
When units are sold, the specific cost of the unit sold is added to cost of goods sold.
First, let’s look at the specific identification method. In this method, we know the specific cost of each unit that is sold. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders.

11. First-In, First-Out (FIFO)P1
Oldest Costs
Cost of Goods Sold
Recent Costs
Ending Inventory
The first-in, first-out method is abbreviated as FIFO, and pronounced as Fifo.
When using FIFO, we assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory.
Lets look at the example below to illustrate:
Consider the following: You are the owner of a liquor store and have the following transactions during the year pertaining to bottles of Scotch:
Mar. 23 Purchased 10 bottles at $4 per bottle
Nov. 17 Purchased 10 bottles at $9 per bottle
Dec. 31 Sold 10 bottles of scotch at $10 per bottle
-Under FIFO; the oldest bottles of scotch would go first, therefore if I sold 10 bottles my cost of goods sold would be $40 (10 bottles from 3/23 x $4 per bottle) and my ending inventory would be $90 (the $10 left x $9 per bottle)

12. Last-In, First-Out (LIFO)P1
Recent Costs
Cost of Goods Sold
Oldest Costs
Ending Inventory
The last-in, first-out method is abbreviated as LIFO, and pronounced as Lifo.
When using LIFO, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory.
Lets look at the example below to illustrate (same example as used for FIFO):
Consider the following: You are the owner of a liquor store and have the following transactions during the year pertaining to bottles of Scotch:
Mar. 23 Purchased 10 bottles at $4 per bottle
Nov. 17 Purchased 10 bottles at $9 per bottle
Dec. 31 Sold 10 bottles of scotch at $10 per bottle
Under LIFO; the newest bottles of scotch would go first, if I sold 10 bottles my cost of goods sold would be $90 (10 bottles x $9 per bottle) and my ending inventory would be $40 ($10 per bottle x $4 per bottle)

13. Weighted Average P1
When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.
Cost of Goods Available for Sale
Units on hand on the date of sale ÷
When using weighted average, we assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand.
Lets look at the same example below from our liquor store as we did for FIFO and LIFO.
Consider the following: You are the owner of a liquor store and have the following transactions during the year pertaining to bottles of Scotch:
Mar. 23 Purchased 10 bottles at $4 per bottle
Nov. 17 Purchased 10 bottles at $9 per bottle
Dec. 31 Sold 10 bottles of scotch at $10 per bottle
Under the weighted average method, I would need to compute my weighted average cost per bottle. In this case it would be $6.50 per bottle ( $40 + $90) / 20 bottles. If I sold 10 bottles, my cost of goods sold would be $65 and my ending inventory would be $65

14. Financial Statement Effects of Costing Methods
Because prices change, inventory methods nearly always assign different cost amounts.
This slide presents a comparison of the impact on the income statement of using the different inventory costing methods. Everything is the same in each example, except the amount of Cost of Goods Sold, and its flow through effects on Income Before Taxes, Income Tax Expense, and Net Income.
Specific Identification provides the most accurate cost of goods sold amount. But, this method is very costly to use.
In periods of rising prices, of the other three methods, FIFO will provide the lowest Cost of Goods Sold amount. This is because it uses the older costs which tend to be lower to arrive at this amount.
LIFO will provide the highest Cost of Goods Sold amount. This is because it uses the most recent costs which tend to be higher to arrive at this amount. Weighted Average will provide a Cost of Goods Sold amount that falls between FIFO and LIFO.
In periods of falling prices, the exact opposite as above occurs.
As you can see, the impact on net income is that FIFO results in the highest net income, LIFO results in the lowest net income and weighted average results in net income that falls in the middle of these two.
How could companies technically use this information to ‘manipulate’ their financial statements or save on taxes?

15. Financial Statement Effects of Costing Methods
Advantages of Methods
Weighted Average
First-In, First-Out
Last-In, First-Out
Smoothes out price changes.
Ending inventory approximates current replacement cost.
Better matches current costs in cost of goods sold with revenues.
An advantage of weighted average is that is smoothes out peaks and valleys in price changes that may occur during the period. FIFO does a great job of valuing Ending Inventory at an approximate replacement cost. This is because FIFO uses the most recent costs to value Ending Inventory. LIFO does a great job of matching current costs in Cost of Goods Sold with current revenues. This is because LIFO uses the most recent costs to determine Cost of Goods Sold.
From a tax standpoint, a company that is not concerned with reporting earnings to outsiders would want to use which method? Why?

16. Tax Effects of Costing Methods
The Internal Revenue Service (IRS) identifies several acceptable methods for inventory costing for reporting taxable income.
If LIFO is used for tax purposes, the IRS requires it be used in financial statements.
Using LIFO for tax reporting purposes makes sense because it provides the lowest net income figure, and, therefore, the lowest tax expense of the three methods. However, the Internal Revenue Service requires that if a company uses LIFO for tax reporting purposes, they must also use LIFO for financial reporting.

17. Consistency in Using Costing MethodsA1
The consistency principle requires a company to use the same accounting methods period after period so that financial statements are comparable across periods.
The consistency principle requires a company to use the same accounting methods from period to period so that financial statements are comparable across periods. Companies can change accounting methods occasionally only for good reasons.

18. Financial Statement Effects of Inventory Errors
Exh.
5.10 A2
Income Statement Effects
Take a few minutes and review this chart. It shows the impact of inventory errors on the income statement. For example, if Ending Inventory is understated, that will result in an overstatement of Cost of Goods Sold which will result in an understatement of Net Income.
This chart, and the next slide may make a great multiple choice question, or explanation question e.g. why does understatement of ending inventory overstate C/G/S and understate NI. UNDERSTAND THEM BOTH!

19. Financial Statement Effects of Inventory Errors
Exh.
5.12 A2
Balance Sheet Effects
Take a few minutes and review this chart. It shows the impact of inventory errors on the balance sheet. As we just noted on the previous slide, if Ending Inventory is understated, Cost of Goods Sold will be overstated; which will result in an understatement of Net Income. An understatement of Net Income will result in an understatement of Retained Earnings in equity. Also, if Ending Inventory is understated, then assets on the balance sheet will be understated.

20. End of Chapter 5
In this chapter we learned about several methods used to cost inventory. We also learned how to apply lower of cost or market and learned about the impact of inventory errors on the financial statements.
In the next chapter, we will learn about the accounting information system.