Chapter 5

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ComChapter 5 Notes: Accounting for Inventories Introduction: GO TO PRACTICE PROBLEM #1 John Smith purchased two toy cars to resell. The cars were identical in every respect except that John purchased them at different times for different costs. The first car purchased cost $25. The second one purchased cost $31. John sold one of the cars for $40. John’s other operating expenses were $5. Based on this information alone, what was John’s net income? As you will learn in this chapter, when inventory is purchased at different times for different amounts the company often has to make an assumption about the order the items were sold. Companies can track the cost of every specific item or they will make a cost flow assumption each of which is described below: Inventory Cost Flow Methods:  FIFO (First-in, First-out ) - assumes that the oldest inventory (first in) is the inventory that is sold (first out)  LIFO (Last-in, first-out) – assumes that the most recent inventory (last in) is the inventory that is sold first (first out)  Weighted Average – uses the weighted average cost of all inventory and uses that cost for all units sold  Specific Identification – uses the actual product cost as each item is sold NOTE: These are methods for recording the _______________________________ through the accounting records, NOT the actual physical flow of goods . Physical Flow vs. Cost Flow  Even if a company has a physical flow that most mimics FIFO or LIFO they can choose any cost flow method they want as long as: o They must consistently use the same method every year so that financial statements of succeeding periods will be comparable. o They must disclose what method they’re using in the notes to the financial statements Effect of Cost Flow Assumption on Financial Statements: FIFO LIFO Weighte d Avg Revenue $40 $40 $40 COGS 25 31 28 Gross Margin 15 9 12 Operating Exp 5 5 5 Net Income $10 $4 $7 Ending inventory 31 25 28 Taxes 4 1.6 2.8 After tax profit 6 2.4 4.2 1

 Remember: Product costs are allocated between _______________________________ (on the income statement) and __________________ on the balance sheet (meaning it produces the highest amount of assets).  Effect on Income Statement: o Depending on whether prices increase or decrease will depend on whether LIFO or FIFO will produce the higher gross margin (see the inflation vs. deflation section below) o Companies experiencing identical economic events (same units of inventory purchased and sold) can report significantly different results in their financial statements  Effect on Balance Sheet: o FIFO transfers the first cost to the income statement leaving the last cost on the balance sheet. o By transferring the last cost to the income statement, LIFO leaves the first cost in ending inventory. o The weighted-average method bases both cost of goods sold and the ending inventory on the average cost per unit.  Effect on Cash Flow Statement: o The cash flow statement will be the ______________ under all methods  Inflation vs. Deflation; o Inflationary environment (rising inventory prices)  FIFO produces the highest gross margin, which leads to the highest net income and highest income tax expense o Deflationary environment (inventory prices are decreasing)  LIFO produces the highest gross margin, which leads to the highest net income and highest income tax expense The Income Statement vs. The Tax Return:  Companies can use one accounting method for financial reporting and a different method to compute income taxes.  If LIFO is used for tax reporting it MUST also be used for financial reporting. o A company could not, therefore, get both the lower tax benefit provided by LIFO and the financial reporting advantage offered by FIFO Use of LIFO:  LIFO is disallowed for IFRS (International Financial Reporting Standards) because it’s the most beneficial method to use (assuming inflation) with regards to tax liabilities. Practice: For each of the following situations, fill in the blank with FIFO, LIFO or weighted average. 1. _________ would produce the highest amount of net income in an inflationary environment. 2. _________ would produce the highest amount of assets (ending inventory balance) in an inflationary environment. 3. _________ would produce the lowest amount of net income in a deflationary environment. 4. _________ would produce the same unit cost for assets and cost of goods sold in an inflationary environment. 5. _________ would produce the lowest amount of net income in an inflationary environment. 2

6. _________ would produce an asset value that was the same regardless of whether the environment was inflationary or deflationary. 7. _________ would produce the lowest amount of assets in an inflationary environment. 8. _________ would produce the highest amount of assets in an deflationary environment. 9. _________ would produce the highest cost of goods sold in an inflationary environment. Practice Problem #1 Fields Inc. inventory account: Beg inventory 200 units @ $20 per unit: COGS= 4,000 Purchased 400 units @ $22 per unit: COGS= 8,800 COGS= 5,500 Purchased 600 units @ $24 per unit: COGS= 6,000 (250 @24) COGS=14,400 Sold 850 units @ $48 per unit Total COGS= 18,800 Gross margin: 22,000 with 350 @24 left in inventory Gross Margin: 20,900 with 150 @22 and 200 @20  Determine the gross margin utilizing FIFO, LIFO, and weighted average  Revenue= 40,800 (850X$48)  Revenue= 40,800  Cost of inventory= 4,000+8,800+14,400=27,200/units of inventory (1200)=$22.67  COGS= 850x 22.67=19270, GROSS MARGIN= 40,800-19,270=21,531  Determine the ending inventory using FIFO, LIFO, and weighted average  Which method would produce the higher gross margin?  Which method would produce the lowest tax liability? Practice Problem #2 Fields Inc. inventory account: Beg inventory 30 units @ $12 per unit Purchased 25 units @ $10 per unit Purchased 35 units @ $8 per unit Sold 78 units @ $15 per unit  Determine the gross margin using the FIFO, LIFO, and weighted average cost flow methods  Determine the ending inventory using the FIFO, LIFO, and weighted average cost flow methods Practice Problem #3 Fields Inc. inventory account: Beg inventory 120 units @ $9.5 per unit Purchased 130 units @ $10 per unit 3

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Purchased 140 units @ $11 per unit Sold 190 units @ $20 per unit  Determine the gross margin using the FIFO, LIFO, and weighted average methods  Determine the ending inventory using the FIFO, LIFO, and weighted average cost flow methods Practice Problem #4 Fields Inc. inventory account: Beginning Inv 100 units @ $30.00 per unit Purchase 50 units @ $31.50 per unit Sold 75 units @ $45.00 per unit Purchased 50 units @ $33.00 per unit Sold 100 units @ $48.50 per unit  Determine the gross margin assuming the company uses the FIFO cost flow method  Determine the ending inventory using the FIFO cost flow method Practice Problem #5 Fields Inc. inventory account: Beg inventory 30 units @ $10 per unit Purchased 25 units @ $9.5 per unit Sold 20 units @ $22 per unit Purchased 35 units @ $9.25 per unit Sold 40 units @ $24 per unit  Determine the gross margin assuming the company uses the FIFO cost flow method  Determine the ending inventory using the FIFO cost flow method 20@ 22= 440 and 40@ 24=960 TOTAL REVENUE; 1,400 Sale 1= 20@ 10=200 Sale 2= 10@ 10, 25@ 9.5, 5@ 9.25 TOTAL COGS= 384 REVENUE 1400- 584= GROSS MARGIN OF 816 4

Practice Problem #6 Crystal Apple Company began 2019 with cash of $2,000, inventory of $3,600 (200 units that cost $18 each), $10,000 worth of land, $2,500 of common stock, and $13,100 of retained earnings. The following events occurred during 2019. Crystal Apple Company utilizes the FIFO cost flow method. Event 1. Purchased on account 1,800 apples for $20 each. 2. Sold 1,300 apples at a selling price of $40 each for cash. 3. Purchased on account 1,200 apples for $24 each. Freight terms were FOB destination. $500 in freight charges were paid in cash. 4. Paid $40,000 cash on accounts payable for inventory purchases. 5. Sold 1,000 apples at $42 each, half for cash and half on account. Freight terms were FOB shipping point. $400 in freight charges were paid in cash. 6. Paid $6,000 cash for operating expenses. 7. Paid a $5,000 dividend. 8. Collected $14,000 from accounts receivable. 9. Sold the land for $12,000 cash. 10. Purchased 800 apples for $21 each for cash. Freight terms were FOB destination. $350 in freight charges were paid in cash. 11. Sold 500 apples for $40 each on account. Freight terms were FOB destination. $200 in freight charges were paid in cash. 12. At the end of the quarter they counted their inventory and found that they were missing 20 apples. Required: 1. Record each event in T-accounts. 2. Calculate the net cash flows from operating activities, investing activities and financing activities. 3. Prepare an income statement for 2019. 4. Prepare a statement of changes in equity for 2019. 5. Prepare a balance sheet at 12/31/19. 6. Prepare the closing entry. 7. Validate the ending inventory balance (i.e. should have ___ number of units @ $___ each). 5