Chapter 5: Accounting for Inventories Notes

Chapter 5: Accounting for Inventories

LO 5-1: Cost Flow Methods

• Objective: Determine the amount of cost of goods sold (COGS) and ending inventory using various methods.

• Inventory Methods:

  • Specific Identification

  • First-in, First-out (FIFO)

  • Last-in, First-out (LIFO)

  • Weighted Average Cost Flow

Physical Flow vs. Cost Flow

• Accounting discussions around inventory cost flow methods relate to:

  • The flow of costs through accounting records.

  • Note: The cost flow may differ from the physical flow of goods.

• Example:

  • While the first unit purchased may be the first sold physically, the COGS may be calculated based on the cost of the last unit purchased.

Inventory Cost Flow Methods

• Key Points:

  • When goods are sold, costs transfer from Inventory (Balance Sheet) to COGS (Income Statement).

  • Methods to determine costs:

  1. Specific Identification

  2. FIFO

  3. LIFO

  4. Weighted Average

U.S. GAAP: Acceptable Inventory Methods

• Methods include:

  • FIFO

  • LIFO

  • Weighted Average

  • Specific Identification

• Specific Identification:

  • Assigns the exact cost of an item as COGS when that specific item is sold.

  • Typically used for high-priced, low-turnover items (e.g., auto dealerships, antique dealers).

  • Importance: Understand scenarios for applicability and the pros & cons of this method.

Disadvantages of Specific Identification

• Not practical for low-priced, high-turnover goods due to extensive record-keeping.

• Possibility of manipulation in financial reporting:

  • E.g., reporting lower COGS by selecting specific items for sale.

Method Comparisons: FIFO, LIFO, & Weighted Average

• Weighted Average:

  • COGS and ending inventory derived from the same average cost per unit based on:
    Wtd ext{ Avg } Cost ext{ per Unit} = rac{COGAS}{ ext{Number of Units Available}}

• FIFO:

  • Oldest inventory sold first; current purchases in ending inventory.

• LIFO:

  • Most recent purchases are sold first; oldest inventory remains.

Cost Flow Method as Assumption

• Rules simplify record-keeping.

• GAAP does not require the cost flow method to match the physical goods flow.

  • Example: Kroger may use LIFO for accounting purposes while the physical flow resembles FIFO.

• Requirements for cost flow methods:

  • Must be consistent over time.

  • Must be disclosed in financial statements.

Example: Multiple Inventory Layers (Cortez Company)

• Scenario: Cortez sells chairs.

  • Beginning Inventory: 100 units @ $60

  • Purchases:

  • 150 units @ $68

  • 200 units @ $72

  • Sold: 270 chairs

Cost of Goods Available for Sale (COGAS)

• COGAS Formula:
  COGAS = 100 imes 60 + 150 imes 68 + 200 imes 72 = 30,600

• Available for Sale: 450 units

• Ending Inventory calculation: 450 units - 270 units = 180 units remaining.

FIFO Calculation Example

• COGAS = $30,600

• COGS Calculation:

  • 100 units @ $60 each = $6,000

  • 150 units @ $68 each = $10,200

  • 20 units @ $72 each = $1,440

• COGS = $17,640; Ending Inventory = $12,960 (180 units @ $72).

LIFO Calculation Example

• COGAS remains the same at $30,600.

• COGS Calculation:

  • 20 units @ $72 each = $1,440

  • 150 units @ $68 each = $10,200

  • 100 units @ $60 each = $6,000

• COGS = $19,160; Ending Inventory = $11,440 (80 units @ $68, 100 units @ $60).

Weighted Average Calculation Example

• Weighted Average Cost per Unit:
  Wtd ext{ Avg Cost } = rac{30,600}{450} = 68

• COGS for 270 units = 270 units x $68 = $18,360; Ending Inventory = 180 units x $68 = $12,240.

Effect of Cost Flow Method on Financial Statements

• Different methods impact:

  • COGS

  • Gross Margin

  • Net Income

• Example Result Analysis with Sales Revenue = $27,000 (for 270 chairs sold at $100 each):

  • FIFO:

  • COGS = $17,640, Gross Margin = $9,360, Net Income = $4,360.

  • LIFO:

  • COGS = $19,160, Gross Margin = $7,840, Net Income = $2,840.

  • Weighted Average:

  • COGS = $18,360, Gross Margin = $8,640, Net Income = $3,640.

• Under inflation, FIFO yields the highest net income, while LIFO yields the lowest due to the effect of rising prices.

Inventory Turnover Ratio

• Formula:
  ext{Inventory Turnover} = rac{COGS}{ ext{Average Inventory}}

• Indicates how often inventory is replenished over a period; lower days in inventory signify better inventory management.

• Average Days to Sell Inventory:
  ext{Average Days} = rac{365}{ ext{Inventory Turnover}}

Inventory Turnover Examples for Boardwalk Taffy and Beach Sweets

• Comparative metrics.

• Boardwalk Taffy uses FIFO; Beach Sweets uses LIFO.

• Metrics to compute:

  • Gross margin percentage.

  • Inventory turnover ratio and average days to sell inventory.

LO 5-3: Avoiding Fraud through Inventory Control

• Inventory is often the largest asset on the balance sheet, and COGS is usually the largest expense on the income statement.

• Misstatements of COGS can significantly affect financial reports.

• Prevention of fraud:

  • Separation of duties.

  • Regular checks of physical inventory against accounting records.

Gross Margin Method for Estimating End Inventory (LO 5-4)

• Historical GM% can be used to estimate COGS and thus ending inventory.

• Key formulas:

  • Gross Margin % = Gross Margin / Sales

  • Ending Inventory = Cost of Goods Available for Sale - COGS.

Practical Illustration using Gross Margin Method

• Example with a store's loss from a collapsed roof.

• Given values can lead to estimates of lost inventory using historical GM%.

Summary of Tax Implications under LIFO and FIFO

• Under rising prices, FIFO results in higher net income but higher taxes.

• Differences in tax implications affect cash flow indirectly due to different taxable income.

• Companies must follow IRS rules regarding inventory methods - using FIFO for financials and LIFO for tax filings is permissible, but not vice versa.

Conclusion: Importance of Inventory Control

• Proper management of inventory and COGS is paramount for accurate financial reporting and fraud prevention.

• Understanding these relationships helps in strategic decision-making regarding finances, taxes, and company value.