Detailed Notes on Accounting for Inventories

Inventory Cost Flow Methods

  • Four Acceptable Inventory Cost Flow Methods:
    • Specific Identification
    • First-in, First-out (FIFO)
    • Last-in, First-out (LIFO)
    • Weighted Average

Specific Identification

  • Utilized for high-priced, low-turnover goods where tracking specific costs is feasible.
  • Example: TMBC Company purchases:
    • Item 1: $100
    • Item 2: $110
    • Cost of Goods Sold (COGS) when sold:
    • Sell item 1: COGS = $100
    • Sell item 2: COGS = $110

First-in, First-out (FIFO)

  • COGS reflects the cost of the oldest inventory sold.
  • Example: TMBC Company purchases:
    • Item 1: $100
    • Item 2: $110
    • COGS when sold using FIFO:
    • Sell item 1: COGS = $100
    • Sell item 2: COGS = $110

Last-in, First-out (LIFO)

  • COGS reflects the cost of the newest inventory sold.
  • Example: TMBC Company purchases:
    • Item 1: $100
    • Item 2: $110
    • COGS when sold using LIFO:
    • Sell item 1: COGS = $110 (last cost in)
    • Sell item 2: COGS = $100

Weighted Average

  • COGS is derived from the average cost of all inventory.
  • Formula: Average Cost = Total Cost / Total Units
  • Example: TMBC Company purchases:
    • Item 1: $100
    • Item 2: $110
    • Average cost for COGS when sold:
    • Average = $210 / 2 = $105
    • COGS when sold = $105

Physical Flow vs. Cost Flow

  • The discussed inventory methods relate to cost records, not the actual physical flow of goods.

Effects on Financial Statements

  • Income Statement: Cost flow method affects Gross Margin.
  • Balance Sheet: Affects the allocation between COGS and Ending Inventory.

Inventory Flow Under Perpetual System

  • Inventory cost flow methods can be performed simultaneously with sales and purchases:
    • Allocate goods available for sale between COGS and Ending Inventory using FIFO, LIFO, or Weighted Average.

Lower of Cost or Market (LCM) Rule

  • Inventory reported at the lower of cost or market value.
    • Applied to individual items, categories, or whole inventory.
    • Market = Current Replacement Cost.
    • Aligns with conservatism principle to avoid overstatement.

Fraud Avoidance through Inventory Control

  • High significance of inventory leads to potential manipulation for concealing fraud.
  • Overstated ending inventory results in
    the understatement of COGS and overstatement of Net Income.

Gross Margin Method for Estimating Ending Inventory

  • Steps:
    1. Calculate expected gross margin ratio from previous periods.
    2. Multiply this ratio by current sales to estimate gross margin.
    3. Subtract estimated gross margin from sales to get COGS.
    4. Subtract estimated COGS from goods available for sale to get ending inventory.

Importance of Inventory Turnover

  • Formula: Inventory Turnover = COGS / Average Inventory
  • Indicates how quickly a company sells inventory.
  • Lower average number of days to sell inventory is indicative of better performance.

Average Days to Sell Inventory

  • Formula: Average Days = 365 / Inventory Turnover
  • Benchmarking against industry standards (e.g., Fast Food vs. Wineries).