Accounting for Inventories: Cost Flow Methods and Financial Impact

Cost Flow

The flow of costs through accounting records, which may differ from the physical flow of goods.

Physical Flow

The actual movement of goods, which may not align with accounting cost flow.

Cost of Goods Sold (COGS)

An expense account on the Income Statement that reflects the cost of inventory sold during a period.

Specific Identification Method

A method involving detailed record-keeping where the exact cost of a specific item is assigned to COGS when sold.

FIFO (First-in, First-out)

A cost flow assumption that assigns the cost of the oldest goods to COGS first.

LIFO (Last-in, First-out)

A cost flow assumption that assigns the cost of the most recent purchases to COGS first.

Weighted Average Method

A method that uses the average unit cost calculated by dividing the total cost of goods available for sale by the total number of units available.

Inventory Valuation

The method used to assign costs to inventory and COGS, which can be affected by the chosen cost flow method.

U.S. GAAP

Generally Accepted Accounting Principles in the United States that recognize four acceptable methods for inventory cost flow.

Impracticality of Specific Identification

The extensive record-keeping required for the Specific Identification Method is not practical for many low-priced, high-turnover goods.

Manipulation Potential

The ability for managers to influence reported COGS and net income by selectively selling higher-cost or lower-cost items.

Ending Inventory Balance

The value of inventory remaining after accounting for COGS, which is affected by the chosen cost flow method.

Cost of Goods Available for Sale (COGAS)

The total cost of inventory that is available to be sold during a period.

Average Cost per Unit

Calculated by dividing the total cost of goods available for sale by the total number of units available.

Cortez Company

An example company used to illustrate inventory calculation methods.

High-priced, Low-turnover Items

Inventory items that are infrequently sold and easily identifiable, often using the Specific Identification Method.

Consistency in Method Use

GAAP requires that companies consistently use the same inventory cost flow method over time.

Disclosure in Financial Statements

The requirement to report the inventory cost flow method used in financial statements.

Cost Flow Assumption

An assumption made about how costs move through inventory, which simplifies record-keeping.

Balance Sheet Asset

The Inventory account, which represents the value of goods available for sale.

Income Statement Expense

The Cost of Goods Sold (COGS) account, which reflects the cost of inventory sold.

Beginning Inventory

$100 ext{ units @ } \$60 ext{ ea} = \$6,000

Purchase #1

$150 ext{ units @ } \$68 ext{ ea} = \$10,200

Purchase #2

$200 ext{ units @ } \$72 ext{ ea} = \$14,400

Total Units Available for Sale

$100 + 150 + 200 = 450 ext{ units}

Total Cost of Goods Available for Sale (COGAS)

$\$6,000 + \$10,200 + \$14,400 = \$30,600

Units Sold During Year

$270 ext{ units}

Units in Ending Inventory

$450 - 270 = 180 ext{ units}

FIFO Calculation COGS (270 units)

$100 ext{ units from BI @ } \$60 = \$6,000

Total FIFO COGS

$\$6,000 + \$10,200 + \$1,440 = \$17,640

Ending Inventory (180 units)

$180 ext{ units from Pch #2 @ } \$72 = \$12,960

LIFO Calculation COGS (270 units)

$200 ext{ units from Pch #2 @ } \$72 = \$14,400

Total LIFO COGS

$\$14,400 + \$4,760 = \$19,160

Total LIFO Ending Inventory

$\$6,000 + \$5,440 = \$11,440

Weighted Average Cost per Unit

$ ext{Wtd Avg Cost per Unit} = \frac{ ext{COGAS}}{ ext{# Units Avail. to Sell}} = \frac{\$30,600}{450 ext{ units}} = \$68 ext{ per unit}

Weighted Average COGS

$ ext{COGS} = ext{Wtd Avg Cost per Unit} \times ext{# Units Sold} = \$68 \times 270 ext{ units} = \$18,360

Weighted Average Ending Inventory

$ ext{Ending Inventory} = ext{Wtd Avg Cost per Unit} \times ext{# Units NOT Sold} = \$68 \times 180 ext{ units} = \$12,240

Self-Check for Cost Flow Methods

$ ext{COGS} + ext{Ending Inventory} = ext{COGAS}

Effect of Cost Flow Method on Financial Statements

The inventory cost flow method determines how the Cost of Goods Available for Sale (COGAS) is allocated between Cost of Goods Sold (COGS) and Ending Inventory.

Impact on Income Statement (Under a Period of Rising Prices)

Assume sales price per chair is $\$100 and Other Operating Expenses are $\$5,000. Sales Revenue = $\$100 \times 270 = \$27,000

Sales Revenue

The total income generated from the sale of goods or services.

COGS

Cost of Goods Sold, the direct costs attributable to the production of the goods sold by a company.

Gross Margin

The difference between sales revenue and COGS.

Operating Expenses

Expenses incurred during normal business operations, excluding COGS.

Income Before Taxes

Also known as Taxable Income, it is calculated as Gross Margin minus Operating Expenses.

Income Tax Expense

The amount of tax owed, calculated as Income Before Taxes multiplied by the Tax Rate %.

Net Income

The profit of a company after all expenses, including taxes, have been deducted from revenue.

Cash Flow Statement

A financial statement that provides aggregate data regarding all cash inflows and outflows a company receives.

Cost Flow Method

An accounting method used to value inventory and determine COGS.

FIFO

First-In, First-Out, an inventory valuation method where the oldest inventory items are recorded as sold first.

LIFO

Last-In, First-Out, an inventory valuation method where the most recently produced items are recorded as sold first.

LIFO Conformity Rule

An IRS requirement that mandates if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting.

Inventory

The goods and materials a business holds for the purpose of resale.

Fraud Risk

The potential for fraud to occur, particularly in significant accounts like inventory and COGS.

Misstatement of COGS

Any error or fraud in reporting COGS that can affect gross margin, taxable income, net income, and ending inventory.

Perpetual Inventory System

An inventory management system that continuously updates inventory records for purchases and sales.

Separation of Duties

An internal control mechanism that divides responsibilities among different employees to reduce fraud risk.

Gross Margin Method

A method used to estimate ending inventory and COGS, particularly useful in cases of inventory loss.

Gross Margin Percentage (GM%)

The ratio of Gross Margin to Sales, used as an assumption for estimating inventory.

GM%

Gross Margin Percentage, calculated as Gross Margin divided by Sales.

Purchases

The total cost of inventory bought during a period.

Ending Inventory

The value of inventory remaining at the end of a period, calculated as COGAS minus COGS.

Inventory Turnover Ratio

A financial ratio that indicates how many times a company sells and replaces its inventory over a period.

Average # of days to sell inventory

Calculated as 365 divided by Inventory Turnover, indicating the average time inventory is held before sale.

Weighted Average Cost Flow

An inventory valuation method that averages the cost of all inventory available for sale during the period.

Gross Margin in dollars

Calculated as Sales multiplied by GM%.

Estimated COGS

Calculated as Sales minus Estimated Gross Margin.

Estimated Total Ending Inventory

Calculated as COGAS minus Estimated COGS.

Amount of Lost Inventory

Calculated as Estimated Total Ending Inventory minus Undamaged Inventory.

Merchandise Inventory

The total value of inventory held for sale.

Freight Costs

Expenses incurred for transporting goods.

Receivable Collection

The process of collecting payment from customers for sales made.

Sanchez Co. Sales Transaction

A specific example involving the sale of inventory by Sanchez Co.

Historical Gross Margin Percentage

The average gross margin percentage based on past sales data.

Example (Estimating Inventory Loss)

A practical scenario illustrating how to estimate inventory loss due to damage.

Example (Boardwalk Taffy vs. Beach Sweets)

A comparative analysis of two companies' inventory management and financial metrics.

Gross Margin Calculation

Amount of gross margin would be: A. $3,480 B. $3,880 C. $3,600 D. $4,000

Dorman Accounting Event

Affected financial statements as follows: Assets = Liabilities + Stockholders' Equity, Revenues - Expenses = Net Income (NA), Cash Flow = NA.

General Journal Entry Must Have Included

A. A debit to an asset account and a credit to unearned revenue. B. A credit to an asset account and a debit to a revenue account. C. A debit to cash and a credit to revenue. D. A debit to cash and a credit to accounts receivable.

Aaron Co. Inventory Purchase

Aaron Co. purchased $5,000 of inventory on account with payment terms of 2/10, n/30 (goods delivered FOB shipping point; freight costs = $200).

Inventory Account Balance

What would be the balance in the inventory account after these events? A. $4,900 B. $5,300 C. $5,100 D. $4,700

Rising Prices Inventory Cost Flow

In a period of rising prices, which inventory cost flow method results in the lowest balance of ending inventory? A. Weighted average B. FIFO C. LIFO D. Cannot tell without more information.

Zhang Co. Inventory Sale

Zhang Co. purchased $2,000 of inventory on account; sold for $3,000 cash.

Gross Margin Reported

Gross Margin Reported on Income Statement and Net Cash Inflow: A. $1,000 / $3,000 B. $3,000 / $1,000 C. $1,000 / $-0- D. $-0- / $1,000.

Rising Prices Income Tax

In a period of rising prices, which inventory cost flow method results in lowest income tax, all other things being equal? A. Weighted average B. FIFO C. LIFO D. Both answer A and answer B are correct.

Thompson Company Inventory Estimation

Sales for Quarter: $13,000; Average gross margin = 25%. Beginning Inventory: $3,500; Purchases: $7,100.

Estimated Amount of Ending Inventory

Estimated amount of ending inventory: A. $3,250 B. $850 C. $10,600 D. $9,750.

Lamar Company T-Accounts

Accounting Event: T-Accounts: Inventory: 2,000 Accounts Payable: 2,000.

Effect on Financial Statements

Assets = Liabilities + Stockholders' Equity, Revenues - Expenses = Net Income (NA).

Xu Co. Inventory Return

Event: Xu Co. returned $5,000 of inventory purchased on account.

Correct Entry for Inventory Return

Correct Entry: A. Debit purchases / credit accounts payable B. Debit cash / credit inventory C. Debit accounts payable / credit inventory D. Debit inventory / credit accounts payable.

Bacon Company Journal Entry

Entry Recorded: Accounts Payable 700 Cash 700.

False Statement

False Statement: A. Net income was unaffected. B. Assets increased. C. Stockholders' equity decreased. D. Liabilities increased.

Ares Co. Accounting Error

Entry Recorded: Ares Co. collected $9,000 from accounts receivable recorded as a debit to cash and a credit to service revenue.

Effect of the Error

Effect of the Error: A. The totals of the trial balance will not be equal. B. Retained earnings will be overstated. C. Dividends will be understated. D. The amount of cash will be overstated.

Accrued Salaries Adjusting Entry

Adjusting Entry to Record Accrued Salaries Includes: A. Credit to salaries expense and a debit to cash. B. Debit to salaries expense and a credit to salaries payable. C. Credit to salaries expense and a debit to salaries payable. D. Credit to cash and a debit to salaries expense.

Fordlane Company Net Income

Inventory Cost: $10,000 under terms 2/10, n/30; Freight costs = $500 paid in cash.

Sale of Inventory

Sale of Inventory: Sold for $13,000 on account (freight terms FOB destination).

Net income on the income statement

$2,880, $2,700, $2,380, $3,200.

Net Cash Flows from Operating Activities

$(9,800), $(10,120), $2,880, $3,200.