©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Six Accounting for Merchandising Businesses— Advanced Topics

Inventory Cost Flow Methods Four Common Inventory Cost Flow Methods Specific Identification First-in, First- Out (FIFO) Last-in, First- Out (LIFO) Weighted Average

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.

Specific Identification Assume Baker 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.

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.

First-in, First-out Assume Baker 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.

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.

Last-in, First-out Assume Baker 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.

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

Weighted Average Assume Baker 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 Total Number = $210 2 = $105

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.

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.

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.

Inventory Cost Flow Under a Perpetual System First-in, First- Out (FIFO) Last-in, First- Out (LIFO) Weighted Average

First-in, First-out Inventory Cost Flow Cost of goods sold is an expense and, thus, decreases net income.

Last-in, First-out Inventory Cost Flow

Weighted Average Inventory Cost Flow Total Cost Total Number = $12, = $230

Inventory Cost Flow When Sales and Purchases Occur Intermittently In our previous examples, all purchases were made before any goods were sold. This section addresses more realistic conditions when sales transactions occur intermittently with purchases.

Sharon Sales Company (SSC) Let’s use FIFO to determine the cost of goods sold and inventory for SSC at the end of This table describes the beginning inventory, purchases, and sales transactions for SSC during 2008.

SSC: First-in, First-out

Weighted Average and LIFO Cost Flows When maintaining perpetual inventory records, using the weighted average or LIFO cost flow methods leads to timing difficulties. Further discussion of these methods is beyond the scope of this text.

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. individual item. (2)to major classes or categories of assets. categories of assets. (3)to the whole inventory. Applied three ways: (1)separately to each individual item. individual item. (2)to major classes or categories of assets. 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.

Lower of Cost or Market (LCM) To illustrate lower of cost or market, assume Wilson Office Supply Company has in ending inventory 100 calculators purchased at a cost of $14 each. To illustrate lower of cost or market, assume Wilson Office Supply Company has in ending inventory 100 calculators purchased at a cost of $14 each.

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.

Fraud Avoidance in Merchandising Businesses

For interim financial statements, we may need to estimate ending inventory and cost of goods sold.

Estimating the Ending Inventory Balance Many companies use the gross margin method to estimate the current period’s ending inventory.

 Calculate the expected gross margin ratio using prior period’s financials.  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 financials.  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 Profit Method

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.

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.

End of Chapter Six