Chapter 5
Accounting for
Inventories:
(OMIT pgs 276-277 &
page 282)
McGraw-Hill/Irwin
McGraw-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.
5-1
Inventory Cost Flow Methods
Specific
Identification
First-in, FirstOut (FIFO)
Four
Acceptable
Inventory
“Cost Flow”
Methods
Last-in, FirstOut (LIFO)
Weighted
Average
5-2
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.
5-3
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.
5-4
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.
5-5
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.
5-6
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.
5-7
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.
5-8
Weighted Average
The weighted average
cost flow method
assigns the average
cost of the items
available to Cost of
Goods Sold.
5-9
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 Cost
$210
=
= $105
Total Number
2
5-10
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.
5-11
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.
Weighted
FIFO
LIFO
Average
Sales
$ 120 $ 120 $
120
Cost of Goods Sold
100
110
105
Gross Margin
$
20 $
10 $
15
5-12
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.
Ending Inventory
Weighted
FIFO
LIFO
Average
$ 110 $ 100 $
105
5-13
5-14
Inventory Cost Flow Under a Perpetual
System
TMBC Inventory
Jan. 1
Goods Available for Sale
Beginning Inventory 10 units at $200 =
Mar. 18 First purchase
Aug. 21 Second purchase
20 units @ $220
=25 units @ $250
=
Total cost of 55 bikes (goods) available for sale
$2,000
$4,400
$6,250
$12,650
Sold 43 bikes for $350 each
First-in,
First-Out
(FIFO)
Last-in, FirstOut (LIFO)
Weighted
Average
5-15
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, FirstOut (LIFO)
Weighted
Average
5-16
First-in, First-out Inventory Cost
Flow (FIFO)
FIFO Cost of Goods Sold
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
5-17
Last-in, First-out Inventory Cost
Flow (LIFO)
LIFO Cost of Goods Sold
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
5-18
Weighted Average Inventory
Cost Flow (WAVG)
Weighted Average Cost of Goods Sold
Total cost of the 43 bikes sold 43 units @ $ 230 = $ 9,890
Total Cost
$12,650
=
= $230
Total Number
55
5-19
Comparative Financial Statements
and the Impact of Income Taxes
5-20
LO 2
Apply the
lower-of-costor-market rule
to inventory
valuation.
5-21
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:
(1) separately to each
individual item.
(2) to major classes or
categories of assets.
(3) to the whole
inventory.
5-22
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.
Cost Market LCM
Situation 1 $ 14 $ 18 $ 14
Situation 2 $ 14 $ 11 $ 11
5-23
5-24
LO 3
Explain how
fraud can be
avoided
through
inventory
control.
5-25
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.
5-26
If Ending Inventory is overstated then
Cost of Goods Sold will be understated.
5-27
If Cost of Goods Sold is understated,
then Gross Margin is overstated.
Resulting in overstatement
of Net Income.
5-28
Then, on the balance sheet Inventory is
overstated and Retained Earnings is overstated.
5-29
LO 5
Explain the
importance of
inventory turnover
to a company’s
profitability.
5-30
Inventory Turnover
This measures how quickly a company
sells its merchandise inventory.
Cost of Goods Sold
Inventory
This is the first step in calculating
the average number of days to sell
inventory.
5-31
Average Number of Days to Sell
Inventory
This measures how many days, on
average, it takes to sell inventory.
365
Inventory Turnover
Other things being equal, the
company with the lower average
number of days to sell inventory is
doing better.
5-32
5-33
End of Chapter Five
5-34