Inventory and Cost of Goods Sold(Quick Test #3 with Coaching)

FIFO, LIFO, average, and others
FIFO, LIFO, average, etc. are cost flow assumptions. In other words, FIFO, LIFO, etc. indicate how the company’s inventory costs flow out of (are removed from) inventory and get reported as the cost of goods sold.

The costs that remain in inventory are reported on the balance sheet. The cost of goods sold are matched on the income statement with the current period’s sales revenues.

FIFO
FIFO is the acronym for first-in, first-out. This cost flow assumption indicates that the company is flowing or removing its first costs (oldest costs) from its inventory and is reporting those oldest costs in the cost of goods sold on the income statement. Assuming continuing inflation, the first/oldest (and therefore the lowest) costs in inventory are the first costs that are matched with the sales revenues occurring in the current accounting period. Therefore, under the FIFO cost flow assumption the more recent, higher costs will remain in inventory and will be reported on the balance sheet as the current asset Inventory.

LIFO
LIFO is the acronym for last-in, first-out. This cost flow assumption indicates that the company is flowing or removing from inventory the costs of the latest goods purchased and including reporting them as the cost of goods sold on the income statement. Assuming continuing inflation, the latest/recent (and therefore the highest) costs in inventory are the first costs being matched with sales revenues in the current accounting period. Under LIFO a company can physically ship the oldest units of product from inventory but remove its recent higher costs and match them with the current period’s sales revenue.

In the U.S., LIFO often results in a company having lower taxable income (since the cost of goods sold will be higher than using FIFO). The lower taxable income often mean less cash is paid in taxes for the current accounting period.

The following image shows two methods for calculating the cost of goods sold at a company using the periodic inventory system.

LIFO is the acronym for last-in, first-out. The LIFO cost flow assumption means the company’s latest costs in inventory are the first costs removed from inventory and matched with the current period’s sales revenues. As a result, the company’s inventory account will report the oldest costs.

Many people believe the best way to determine a company’s operating profit is to match sales revenues with the cost to replace the items sold. However, the cost to replace the items sold (NIFO, or next-in, first-out) will violate the historical cost principle. Therefore, the closest the accountants can get to replacement cost is with the LIFO method.

If FIFO is used during inflation, the first/oldest/lowest costs are the first costs matched with recent sales revenues (and the inventory account will contain the recent higher costs). Therefore, some of the “profit” from using FIFO during inflationary times results from holding inventory during an inflationary period. The additional profit resulting from matching FIFO’s old/low costs (instead of the replacement costs) with current selling prices is viewed as “illusory profit”.

Typically, FOB destination means the title of goods shipped by the seller (JKL) will transfer to the buyer/customer when the goods arrive at the buyer’s location. As a result, the seller (JKL) continues to own the goods that are in transit between December 30 and January 3. FOB destination also means that the seller (JKL) is responsible for the goods and the shipping costs until the goods reach the buyer’s location on January 3.

FOB destination also means that JKL will not have a sale of the goods until the goods arrive at the buyer’s location on January 3. Therefore, as of December 31, JKL will not have a sale nor a receivable for the December 30 shipment. The cost of the goods shipped on December 30 will be included in JKL’s inventory. Hence, no change in JKL’s inventory until January 3.

Generally, FOB shipping point means the title of goods shipped is transferred from the seller (JKL) to the buyer/customer when the goods are loaded on a common carrier (trucking company) at the seller’s (JKL’s) location. This means that on December 30, JKL will:

• Record a sale and a receivable when goods are loaded on December 30.
• Reduces its inventory for the cost of the goods shipped and increases its cost of goods sold on December 30.

[On December 30, the customer should record the purchase of goods and a payable for the goods JKL shipped on December 30. It also means that the customer owns the goods in transit between December 30 and January 3) and is responsible for these goods including the shipping costs.]

The cost of goods available for ACME’s recent year consist of the following:

• Cost of goods in the beginning inventory
• Plus: the cost of goods purchased from suppliers/vendors
• Minus: reductions or refunds from suppliers/vendors for goods returned, allowances for a variety of reasons, and early payment discounts

Assuming ACME had no returns, allowances, or discounts, the following image shows the calculation of its cost of goods available. (We also show the number of units available.)

Note that the cost of goods available is a firm, verifiable amount that will serve as a check figure after the allocation to the following:

• Cost of goods sold (an income statement expense)
• Ending inventory (a balance sheet current asset)

The allocated amounts will vary depending on the cost flow assumption the company had elected and is applied consistently from year to year. However, the total of the two amounts must add up to the cost of goods available.

Under the FIFO cost flow assumption with the periodic inventory system, the first/oldest costs from the period’s beginning inventory and purchases are the first costs to be removed from inventory and matched with the sales revenues on the current period’s income statement.

With the oldest costs on the income statement, the more recent (latest) costs are reported on the December 31 balance sheet as inventory.

The calculation of the cost of goods sold (and the inventory cost of $16,700) are shown in the following image:

The FIFO cost flow assumption using the perpetual inventory system will have the same results as the FIFO cost flow assumption using the periodic inventory system.

This means that the first/oldest costs from the goods available (beginning inventory and purchases) are the first costs removed from inventory and matched with the sales revenues on the current period’s income statement.

The following image shows the costs flowing under the perpetual inventory system. Note that the resulting cost of goods sold and inventory costs are the same as those calculated for Question 7.

The LIFO cost flow assumption using the periodic inventory system means that after the entire year is over, the most recent costs from the year’s cost of goods available (starting with the costs from the last purchases of the year) are the first costs out of inventory and matched with the current year’s sales revenues. (The oldest costs in the costs of goods available will remain in inventory and will be reported on the December 31 balance sheet.)

Under LIFO periodic the cost of items purchased at the end of December will be the first costs out of inventory even if the units of product shipped to customers were purchased much earlier in the year. This is why we state that LIFO is a cost flow assumption.

The following image illustrates how using LIFO with the periodic inventory system results in $41,200 as the cost of goods sold and $12,300 in ending inventory.

The image below illustrates how the cost of goods sold and inventory using LIFO periodic will differ from FIFO periodic. The amounts are taken from the answers to Question 9 and Question 7.

If the weighted-average cost flow method is used with the periodic inventory system, a cost per unit is calculated at the end of the accounting year by dividing the year's goods available dollars by the year's goods available units.

This weighted-average cost per unit will be used for calculating the company’s cost of goods sold and its inventory. The resulting amounts will be between the amounts calculated using FIFO and LIFO.

The calculation for the cost of goods sold (as well as the cost of the ending inventory) using the weighted-average method with a periodic inventory system is shown in the following image:

When the weighted average cost flow assumption is used with the perpetual inventory system, it is referred to as the moving average cost flow assumption or moving average method. It is a moving average since a recalculation of the products’ average unit cost occurs after each addition of purchased goods in the inventory account.

The following image shows the amounts in the Inventory account and in the Cost of Goods Sold account when the weighted average or moving average cost flow assumption is used in a perpetual inventory system.

A U.S. corporation with recent operating losses may experience more losses and may have some future income tax benefits related to those previous losses. Therefore, the corporation is motivated to report increased profits (or reduced losses) by matching old inventory costs with the new, inflated, current sales revenues.

This is achieved by continuing to use FIFO (the acronym for First-In, First-Out) cost flow assumption. During inflation this means that the oldest, lowest costs will come out of inventory first and will be matched with the current sales revenues. As a result, the corporation’s income statement will report a higher gross profit and more net income (or a smaller net loss) than would occur using LIFO.

FIFO also means that the recent, higher costs of goods purchased will be reported as inventory in the current asset section of the corporation’s balance sheet. The higher inventory amounts will also mean an improved amount of working capital and a better current ratio.

Later, when the corporation’s profitability is restored, the corporation can make the one-time election to begin using the LIFO cost flow assumption. LIFO means the recent higher cost of goods purchased will be matched with current sales revenue, and old, lower costs will remain in inventory. At that point, there will be less reported profit, but it also means less taxable income and perhaps less cash being paid for corporate income taxes.

The gross profit method is a popular way to estimate ending inventory amounts. (Another method is the retail method.)

The following image contains parts of a multiple-step income statement which is often used within a company.

The information necessary for determining a company’s ending inventory amount will likely be available from the accounting records (or from suppliers if the company’s records are not available).

In the following image, you will see the amounts that were given in Question 14 as well as the amounts that needed to be calculated.

Keep in mind the following facts:

• Inventory is recorded and reported on the balance sheet at the cost of the products.
• Sales are recorded and reported on the income statement at the products' selling prices.
• The cost of goods sold is recorded and reported on the income statement at cost.
• The inventory amount on the balance sheet is the inventory cost at the final moment or final instant of the accounting year.
• The amounts on the income statement are the cumulative amounts for the 365 days in the accounting year.

Given the above facts, to calculate the approximate and average time it takes for a company’s inventory to be sold, we need to divide the cost of goods sold for the year by the average inventory costs during the year (not just the amount at the final moment of the year).

The following image calculates the inventory turnover ratio and the number of days of sales in inventory.

There are a couple ways to compute the effect of omitting $8,000 from the asset inventory. One way is to use the accounting equation. Another way is to prepare two income statements: one with the error and one without the error.

Accounting Equation: Assets = Liabilities + Owner’s Equity.
Recall that the accounting equation must always be in balance, and there will always be two accounts/items affected because of double-entry. Therefore, if the asset inventory is too low (due to omitting $8,000 of inventory) then something else is being affected. In this case the owner’s equity will be too low (for the equation to be in balance).

Preparing two income statements
In the following image are two income statements with identical (hypothetical amounts) except for the amount of inventory. The income statement with the wrong inventory ($32,000 instead of $40,000) will report too little gross profit and too little net income. Accountants will say that the gross profit and net income is understated.

The understated net income occurs because too little of the actual $235,000 of the cost of goods available was assigned/allocated to inventory. Therefore, too much of the cost of goods available was assigned/allocated to the cost of goods sold. This caused the gross profit and the net income to be too low (or understated).

The balance sheet of a company using the FIFO cost flow assumption must report the inventory at the lower of cost or net realizable value.

Net realizable value (NRV) is defined as the estimated selling price (in the ordinary course of business) minus the estimated costs to complete, dispose, and transport the goods in inventory.

In Question 17, the cost of JKL’s inventory was given as $155,000. However, the NRV is $143,000, calculated as follows: sales value of $170,000 - commission to sell $17,000 - shipping costs of $10,000.

Since the NRV of $143,000 is lower than the cost of $155,000, JKL’s balance sheet must report the inventory at $143,000.

Double-entry accounting requires recording an adjustment (or transaction) in two general ledger accounts.

One part of the adjustment is to reduce the balance sheet asset account Inventory by $12,000 (from the cost of $155,000 to the net realizable value of $143,000).

The other part of the adjustment is to reduce the company’s net income in the year of the adjustment by $12,000. This could be achieved by debiting an income statement account such as Loss from Write-down of Inventory for $12,000.

The goods available cost will NOT include the following:

• Freight-out, which is an expense of delivering goods sold to customers when terms are FOB destination.
• Commissions expense, which is an expense to get the products sold.
• Interest expense, which is a nonoperating expense to finance the company's operations.

Manufacturing overhead (also known as factory overhead, factory burden, and indirect manufacturing costs) are the manufacturing costs other than the direct materials and direct labor. Examples of manufacturing overhead costs include:

• Compensation of the manufacturing employees’ not working directly on the production line. Examples include the supervisors, managers, workers in areas such as quality control, maintenance, etc.
• Depreciation, costs of repairs and maintenance of the manufacturing equipment, building, and systems.
• Cost of electricity, heating, sewer, water, insurance, etc.

Manufacturing overhead costs are often the largest component of the manufacturer’s product costs.

As an aside, a manufacturer’s balance sheet must report/disclose the costs included in each of the following categories of inventory:

• Raw materials
• Work-in-process
• Finished goods