Chapter Five

Accounting for

Inventories

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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.

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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.

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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.

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Weighted Average

The weighted average cost flow

method assigns the average cost of the items available to

Cost of Goods Sold.

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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.

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Effect of Cost Flow on Income Statement

FIFO LIFOWeighted Average

Sales 120$ 120$ 120$ Cost of Goods Sold 100 110 105 Gross Margin 20$ 10$ 15$

The cost flow method a company uses can significantly affect the gross margin reported in the income

statement.

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Effect of Cost Flow on Balance Sheet

FIFO LIFOWeighted Average

Ending Inventory 110$ 100$ 105$

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.

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Inventory Cost Flow Under a Perpetual System

Jan. 1 Beginning Inventory 10 units at $200 = $2,000

Mar. 18 First purchase 20 units @ $220 =

$4,400

Aug. 21 Second purchase 25 units @ $250 =

$6,250

$12,650

TMBC Inventory

Total cost of 55 bikes (goods) available for sale

Goods Available for Sale

First-in, First-Out

(FIFO)

Last-in, First-Out

(LIFO)

Weighted

Average

Sold 43 bikes for $350 each

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First-in, First-out Inventory Cost Flow

Jan. 1 Beginning inventory 10 units @ 200$ = 2,000$ Mar. 18 First purchase 20 units @ 220$ = 4,400 Aug. 21 Second purchase 13 units @ 250$ = 3,250 Total cost of the 43 bikes sold 9,650$

FIFO Cost of Goods Sold

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Last-in, First-out Inventory Cost Flow

Aug. 21 Second purchase 25 units @ 250$ = 6,250$ Mar. 18 First purchase 18 units @ 220$ = 3,960 Total cost of the 43 bikes sold 10,210$

LIFO Cost of Goods Sold

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Weighted Average Inventory Cost Flow

Total cost of the 43 bikes sold 43 units @ 230$ = 9,890$ Weighted Average Cost of Goods Sold

Total CostTotal

Number

=$12,650

55= $230

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Comparative Financial Statements and the Impact of Income Taxes

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Lower of Cost or Market (LCM)

Inventory must be reported at Inventory must be reported at lowerlower of cost of cost or market.or market.

Inventory must be reported at Inventory must be reported at lowerlower of cost of cost or market.or market.

Applied three ways:(1) separately to each individual item.(2) to major classes or categories of

assets.(3) to the whole

inventory.

Applied three ways:(1) separately to each individual item.(2) to major classes or categories of

assets.(3) to the whole

inventory.

Market is defined as current

replacement cost (not sales price).Consistent with

the conservatismprinciple.

Market is defined as current

replacement cost (not sales price).Consistent with

the conservatismprinciple.

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

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If Cost of Goods Sold is understated, then Gross Margin is overstated.

Resulting in overstatement of Net Income.

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

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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.

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

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Inventory Turnover

Cost of Goods SoldInventory

This measures how quickly a company

sells its merchandise inventory.

This is the first step in calculating the average number of days to sell

inventory.

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Average Number of Days to Sell Inventory

365Inventory Turnover

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.

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End of Chapter Five

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