Chapter 5, Problem 1DQ

Describe how costs flow from inventory to cost of goods sold for the following methods: (a) FIFO and (b) LIFO.

Summary Introduction

Inventory is a record of finished goods of a company which the can be sold to the customer, work in progress which can be transformed into finished goods and raw material which is a means of production. Inventory is also classified as current asset in the balance sheet and it is valued by FIFO, LIFO and weighted average method.

To determine: FIFO method of inventory accounting.

Answer to Problem 1DQ

FIFO method, the earliest inventories are documented as sold first

Explanation of Solution

FIFO method of inventory management stands for ‘first in first out’, means that the earliest inventory are documented as sold first but it does not mean that the same inventory has been sold first. At the time of sale the cost of earliest good acquired are reported in the financial statement. It will result in rest of the articles in the inventory being recorded for most latest incurred cost. It also result in the historical cost peered against current revenue. This mean profit margin does not reflect the proper matching of cost and revenue. As the costs of goods are increasing continuously the cost of earliest inventory will be of lower value. Lower cost of goods sold will result in higher net income. Higher net income will increase the profit margin ratio as profit margin ratio is calculated by dividing Net income by Net sales.

Summary Introduction

Introduction:

Inventory is a record of finished goods of a company which the can be sold to the customer, work in progress which can be transformed into finished goods and raw material which is a means of production. Inventory is also classified as current asset in the balance sheet and it is valued by FIFO, LIFO and weighted average method.

To determine: LIFO method of inventory accounting.

Answer to Problem 1DQ

LIFO method, the earliest inventories are documented as sold first

Explanation of Solution

LIFO method used to record inventory in the manner that the latest item is sold first. The cost of the most recent purchased item will be reported as cost of goods sold. So the older purchased item which has lower cost is reported in the inventory while the latest item which has highest cost is matched with sales in the financial statement. Issue with LIFO method is that it will use the cost of good from lasted purchase which will be highest so the net income will reduce. And lowest valued item will be recorded in current asset thus decreasing the current ratio.