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Chapter Five Accounting for Inventories McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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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. 5-1

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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. 5-2

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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. 5-3

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Weighted Average The weighted average cost flow method assigns the average cost of the items available to Cost of Goods Sold. 5-4

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Physical Flow 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. 5-5

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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. 5-6

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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. 5-7

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Inventory Cost Flow Under a Perpetual System First-in, First-Out (FIFO) Last-in, First- Out (LIFO) Weighted Average Sold 43 bikes for $350 each 5-8

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First-in, First-out Inventory Cost Flow 5-9

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Last-in, First-out Inventory Cost Flow 5-10

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Weighted Average Inventory Cost Flow Total Cost Total Number = $12,650 55 = $230 5-11

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Comparative Financial Statements and the Impact of Income Taxes 5-12

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Lower of Cost or Market (LCM) 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 conservatism principle. Market is defined as current replacement cost (not sales price). Consistent with the conservatism principle. 5-13

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If Ending Inventory is overstated then Cost of Goods Sold will be understated. 5-15

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If Cost of Goods Sold is understated, then Gross Margin is overstated. Resulting in overstatement of Net Income. 5-16

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Then, on the balance sheet Inventory is overstated and Retained Earnings is overstated. 5-17

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Calculate the expected gross margin ratio using prior period’s income statement. Multiply the expected gross margin ratio by the current period’s sales to estimate the amount of gross margin. Subtract the estimated gross margin from sales to estimate cost of goods sold. Subtract the estimated cost of goods sold from the amount of goods available for sale to estimate the ending inventory. Calculate the expected gross margin ratio using prior period’s income statement. Multiply the expected gross margin ratio by the current period’s sales to estimate the amount of gross margin. Subtract the estimated gross margin from sales to estimate cost of goods sold. Subtract the estimated cost of goods sold from the amount of goods available for sale to estimate the ending inventory. The Gross Margin Method 5-18

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Inventory Turnover Cost of Goods Sold Inventory 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. 5-19

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Average Number of Days to Sell Inventory 365 Inventory 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. 5-20

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End of Chapter Five 5-21

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