Chapter 5

Accounting for Inventories:

(OMIT pgs 276-277 & page 282)

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

LO 1

Determine the amount of cost of goods sold and

ending inventory using the FIFO, LIFO, weighted average,

and specific identification cost

flow methods.5-2

Inventory Cost Flow Methods

Four Acceptabl

e Inventory

“Cost Flow”

Methods

Specific Identificatio

n

First-in, First-Out

(FIFO)

Last-in, First-Out

(LIFO)

Weighted Average

5-3

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.

5-4

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. 5-5

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.

5-6

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.

5-7

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.

5-8

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.

5-9

Weighted Average

The weighted average cost flow

method assigns the average cost of the items available to

Cost of Goods Sold.

5-10

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).

Total CostTotal

Number

=$210

2= $105

5-11

Physical Flow

Note: 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.

5-12

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.

5-13

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.

5-14

5-15

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

5-16

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:

5-17

First-in, First-Out

(FIFO)

Last-in, First-Out

(LIFO)

Weighted Average

First-in, First-out Inventory Cost Flow (FIFO)

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

5-18

Last-in, First-out Inventory Cost Flow (LIFO)

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

5-19

Weighted Average Inventory Cost Flow (WAVG)

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

5-20

Comparative Financial Statements and the Impact of Income Taxes

5-21

LO 2

Apply the lower-of-cost-or-

market rule to inventory valuation.

5-22

Lower of Cost or Market (LCM)

Inventory must be reported at lower of cost or market.

Inventory must be reported at lower of cost 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.

5-23

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.  

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.  

Cost Market LCMSituation 1 14$ 18$ 14$ Situation 2 14$ 11$ 11$

5-24

5-25

LO 3

Explain how fraud can be

avoided through

inventory control.

5-26

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. 5-27

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

5-28

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

Resulting in overstatement of Net Income.

5-29

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

5-30

LO 5

Explain the importance of

inventory turnover to a company’s profitability.

5-31

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.

5-32

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.

5-33

5-34

End of Chapter Five

5-35