CH 5 - Accounting for Inventories

Which inventory cost flow method will produce the highest income and asset values in an inflationary environment?

FIFO

True or false: A company may use LIFO or weighted average for financial reporting even if its goods flow physically on a FIFO basis. True false question.

True

Ending inventory plus cost of goods sold is always equal to ______.

cost of goods available for sale

When inventory is sold, inventory cost methods are used to determine how much cost to assign to ______.

cost of goods sold

Effect of Cost Flow on Financial Statements Effect on Income Statement The cost flow method a company uses can significantly affect the gross margin reported in the income statement. To demonstrate, assume that TMBC sold the inventory item discussed previously for $120. The amounts of gross margin using the FIFO, LIFO, and weighted-average cost flow assumptions are shown in the following table:

Even though the physical flow is assumed to be identical for each method, the gross margin reported under FIFO is double the amount reported under LIFO. Companies experiencing identical economic events (same units of inventory purchased and sold) can report significantly different results in their financial statements. Meaningful financial analysis requires an understanding of financial reporting practices.

True or false: Financial statement analysis is not affected by the inventory cost flow method used by a company.

False Reason: The cost flow method (FIFO, LIFO, etc.) a company uses determines the amount of cost of goods sold, the gross margin, net income, retained earnings, and the ending balance in the inventory account. Since these variables are used to calculate many financial ratios, the inventory cost flow method used by a company has a significant impact on financial statement analysis.

Which of the following is not an inventory cost flow method?

Next in First Out (NIFO)

A slow inventory turnover is likely to occur in ______.

upscale department stores

Benson Company had beginning inventory of 150 units that cost $200 each. During the year, Benson made two inventory purchases: Purchase 1 for 500 units that cost $210 each and Purchase 2 for 350 units that cost $220 each. During the year, Benson sold 700 units. If Benson uses FIFO, cost of goods sold equals ______.

$146,000. Reason: Beginning inventory (150 units × $200 each) + Purchase 1 (500 units × $210 each) + Purchase 2 (50 units×$220)

inventory turnover

A measure of sales volume relative to inventory levels; calculated as the cost of goods sold divided by average inventory; indicates how many times a year, on average, the inventory is sold (turned over).

LOWER-OF-COST-OR-MARKET RULE To illustrate applying the rule to individual inventory items, assume that The Mountain Bike Company (TMBC) has in ending inventory 100 T-shirts it purchased at a cost of $14 each. If the year-end replacement cost of the shirts is above $14, TMBC will report the ending inventory at cost (100 × $14 = $1,400). However, if outsourcing permits the manufacturer to reduce the unit price of the shirts to $11, then TMBC's replacement cost falls below the historical cost, and the inventory must be written down to $1,100 (100 × $11).

Conceptually, the loss should be reported as an operating expense on the income statement. However, if the amount is immaterial, it can be included in cost of goods sold.

average days to sell inventory (average days in inventory)

Financial ratio that measures the average number of days that inventory stays in stock before it is sold.

Fred's Fans purchased two identical fans for resale. Fan 1 was purchased in April and cost $76. Fan 2 was purchased in May and cost $80. One of the fans was sold in June for $100. Which inventory cost flow method would result in a $24 gross margin?

First-in, first out Reason: If FIFO is used, the $76 cost of the first fan purchased is charged to cost of goods sold. Gross margin would then be $24. ($100 revenue - $76 cost of goods sold = $24 gross margin.)

Hersey Company purchased two identical inventory items. The item purchased first cost $50. The second item cost $55. If one of the items were sold, which cost flow method would produce the lowest amount of cost of goods sold?

First-in, first-out Reason: FIFO assigns the cost of the item purchased first (lowest cost) to cost of goods sold.

A company purchased two identical items. Item 101 purchased in October cost $100. Item 102 purchased in November cost $110 If item 102 is sold to a customer for $150, which of the following cost flow methods would produce the highest gross margin?

First-in, first-out (FIFO) Reason: It does not matter whether Item 1 versus Item 2 is sold. Cost flow may differ from physical flow of merchandise. FIFO assigns the first (lowest) cost to cost of goods sold, thereby producing the highest gross margin.

INVENTORY COST FLOW METHODS Recall that when goods are sold, product costs flow (are transferred) from the Inventory account to the Cost of Goods Sold account.

Four acceptable methods for determining the amount of cost to transfer are (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted average.

first-in, first-out (FIFO) cost flow method

Inventory cost flow method in which cost of goods sold is computed as if the earliest items purchased are the first items sold.

last-in, first-out (LIFO) cost flow method

Inventory cost flow method in which cost of goods sold is computed as if the most recently purchased items are the first items sold.

weighted-average cost flow method

Inventory cost flow method in which the cost allocated between inventory and cost of goods sold is based on the weighted average cost per unit, which is determined by dividing the total cost of goods available for sale during the accounting period by the total units available for sale during the period. If the weighted average is recomputed with each successive purchase, the result is a moving average.

A company purchased two identical items. Item 101 purchased in October cost $100. Item 102 purchased in November cost $110. If item 102 is sold to a customer for $150, which of the following cost flow methods results in the lowest amount of ending inventory?

Last-in, first-out (LIFO) Reason: LIFO assigns the first (lowest cost) to ending inventory.

Multiple Layers Inflation vs. Deflation

Our illustration assumes an inflationary environment (rising inventory prices). In a deflationary environment, the impact of using LIFO versus FIFO is reversed. LIFO produces tax advantages in an inflationary environment, while FIFO produces tax advantages in a deflationary environment. Companies operating in the computer industry—where prices are falling—would obtain a tax advantage by using FIFO. In contrast, companies that sell medical supplies in an inflationary environment would obtain a tax advantage by using LIFO.

ESTIMATING THE ENDING INVENTORY BALANCE 3 Although it may seem common because of the intense publicity generated when it occurs, fraud is the exception rather than the norm. In fact, growth in the inventory account balance usually results from natural business conditions. For example, a company that is adding new stores is expected to report growth in its inventory balance. Nevertheless, significant growth in inventory that is not explained by accompanying sales growth signals the need to analyze further for evidence of manipulation. Because one year's ending inventory balance becomes the next year's beginning inventory balance, inaccuracies carry forward from one accounting period to the next. Persistent inventory overstatements result in an inventory account balance that spirals higher and higher. A fraudulently increasing inventory balance is likely to be discovered eventually.

To avoid detection, a manager who has previously overstated inventory will need to write the inventory back down in a subsequent accounting period. Therefore, significant decreases, as well as increases, in the inventory balance or the gross margin ratio should be investigated. A manager may try to justify inventory write-downs by claiming that the inventory was lost, damaged, stolen, or had declined in value below historical cost. While there are valid reasons for writing down inventory, the possibility of fraud should be investigated.

Is It a Marketing or an Accounting Decision? As suggested, overall profitability depends upon two elements: gross margin and inventory turnover. The most profitable combination would be to carry high-margin inventory that turns over rapidly. To be competitive, however, companies must often concentrate on one or the other of the elements. For example, discount merchandisers such as Costco offer lower prices to stimulate greater sales. In contrast, fashionable stores such as Neiman Marcus charge higher prices to compensate for their slower inventory turnover. These upscale stores justify their higher prices by offering superior style, quality, convenience, service, etc.

While decisions about pricing, advertising, service, and so on are often viewed as marketing decisions, effective choices require understanding the interaction between the gross margin percentage and inventory turnover.

The choice of inventory cost flow method impacts amounts reported on the ______.

balance sheet income statement

Cost of goods available for sale = ______

beginning inventory + all purchases made during an accounting period

Ratio analysis ______ significantly influenced by the accounting methods a company chooses.

can be

If the amount of ending inventory is overstated, the amount of ______.

cash flow from operating activities not be affected

Due to its relative significance, the expense which is most susceptible to fraud is ______.

cost of goods sold Reason: Cost of goods sold is usually the largest expense and therefore misstatements are less likely to be detected.

If the amount of ending inventory is overstated, the amount of ______ .

cost of goods sold will be understated Reason: Cost of goods available for sale is allocated between cost of goods sold and ending inventory. If the amount in ending inventory is overstated, then the amount in cost of goods sold has to be understated.

The amount a company would have to pay to replace its merchandise is called the ____ value.

market

Hector Company purchased two identical inventory items. The item purchased first cost less the item purchased last. The cash outflow for inventory is ______,

the same under all methods

A company purchased two identical items. Item 101 purchased in October cost $100. Item 102 purchased in November cost $110. The business uses the weighted average (WA) cost flow method. If item 101 is sold to a customer, the amount assigned to cost of goods sold is ______.

$105 Reason: Regardless of which item is sold, weighted average requires the average cost [(100 + 110) ÷ 2] to be charged to cost of goods sold.

Benson Company had beginning inventory of 150 units that cost $200 each. During the year, Benson made two inventory purchases: Purchase 1 for 500 units that cost $210 each and Purchase 2 for 350 units that cost $220 each. During the year, Benson sold 700 units. If Benson uses LIFO, cost of goods sold equals ______.

$150,500 Reason: Purchase 2 (350 units × $220) + Purchase 1 (350 units × $210 each).

Benson Company had beginning inventory of 150 units that cost $200 each. During the year, Benson made two inventory purchases: Purchase 1 for 500 units that cost $210 each and Purchase 2 for 350 units that cost $220 each. Benson's cost of goods available for sale is ______.

$212,000 Reason: Beginning inventory (150 units × $200 each) + Purchase 1 (500 units × $210 each) + Purchase 2 (350 units × $220)

Ted's Sports Center purchased two basketballs for resale. One was purchased in June at a cost of $30 and the other was purchased in July at a cost of $34. Assume Ted's uses the specific identification cost flow method. If Ted sells the ball purchased in June, the amount charged to the Cost of Goods Sold account is ______.

$30 Reason: Since the ball purchased in June was sold, the cost of goods sold would be $30.

Ted's Sports Center purchased two identical basketballs for resale. One was purchased in June at a cost of $30 and the other was purchased in July at a cost of $34. Assume Ted's uses the weighted average (WA) cost flow method. If Ted's sells one of the balls in August, which of the following amounts would be charged to the Cost of Goods Sold account?

$32 Reason: $30 +$34 = $64 $64 ÷ 2 units= $32

Ted's Sports Center purchased two identical basketballs for resale. One was purchased in June at a cost of $30 and the other was purchased in July at a cost of $34. Assume Ted's uses the last-in, first-out (LIFO) cost flow method. If Ted's sells one of the balls in August, which of the following amounts would be charged to the Cost of Goods Sold account?

$34

Ted's Sports Center purchased two basketballs for resale. One was purchased in June at a cost of $30 and the other was purchased in July at a cost of $34. Assume Ted's uses the specific identification cost flow method, If Ted sells the ball purchased in July, the amount charged to cost of goods sold is ______.

$34 Reason: Since the ball purchased in July was sold, the cost of goods sold would be $34.

Benson Company had beginning inventory of 150 units that cost $200 each. During the year, Benson made two inventory purchases: Purchase 1 for 500 units that cost $210 each and Purchase 2 for 350 units that cost $220 each. During the year, Benson sold 700 units. If Benson uses LIFO, reported ending inventory equals ______.

$61,500. Reason: Purchase 2 (350 units × $220) + purchase 1 (350 units × $210 each) = $150,500 cost of goods sold; $212,000 cost of goods available for sale - $150,500 cost of goods sold =$61,500.

Benson Company had beginning inventory of 150 units that cost $200 each. During the year, Benson made two inventory purchases. Purchase 1 consisted of 500 units at a cost of $210. Purchase 2 consisted of 350 units that cost $220 each. If Benson uses FIFO and sells 700 units of inventory during the year, ending inventory equals ______.

$66,000 Reason: 150 + 500 + 350 = 1,000 units available for sale - 700 sold = 300 in ending inventory. Under FIFO, the ending inventory comes from the second purchase. 300 × $220 = $65,000

Hector Company purchased two identical inventory items. The item purchased first cost less the item purchased last. If Hector uses the FIFO cost flow system, cost of goods sold will be ______.

-lower than if weighted average is used Reason: FIFO assigns the lowest cost (the first cost) to cost of goods sold. So cost of good sold under FIFO would be lower than the average cost. -cost of goods sold will be lower than if LIFO is used Reason: FIFO assigns the lowest cost (the first cost) to cost of goods sold. In contrast, LIFO would assign the highest (the last cost) to cost of goods sold. So FIFO would be lower than LIFO.

Inventory Cost Flow When Sales and Purchases Occur Intermittently Weighted-Average and LIFO Cost Flows When maintaining perpetual inventory records, using the weighted-average or LIFO cost flow methods leads to timing difficulties. For example, under LIFO, the cost of the last items purchased during an accounting period is the first amount transferred to cost of goods sold. When sales and purchases occur intermittently, the cost of the last items purchased isn't known at the time earlier sales occur. For example, when TMBC sold merchandise in April, it did not know what the replacement inventory purchased in September would cost.

Accountants can solve cost flow timing problems by keeping perpetual records of the quantities (number of units) of items purchased and sold separately from the related costs. Keeping records of quantities moving in and out of inventory, even though cost information is unavailable, provides many of the benefits of a perpetual inventory system. For example, management can determine the quantity of lost, damaged, or stolen goods and the point at which to reorder merchandise. At the end of the accounting period, when the cost of all inventory purchases is available, costs are assigned to the quantity data that have been maintained perpetually. Although further discussion of the weighted-average and LIFO cost flow methods is beyond the scope of this text, recognize that timing problems associated with intermittent sales are manageable.

lower-of-cost-or-market rule

Accounting principle of reporting inventory at its replacement cost (market) if replacement cost has declined below the inventory's original cost, regardless of the cause.

inventory cost flow methods

Alternative ways to allocate the cost of goods available for sale between cost of goods sold and ending inventory.

Physical Flow The preceding discussion pertains to the flow of costs through the accounting records, not the actual physical flow of goods. Goods usually move physically on a FIFO basis, which means that the first items of merchandise acquired by a company (first-in) are the first items sold to its customers (first-out). The inventory items on hand at the end of the accounting period are typically the last items in (the most recently acquired goods). If companies did not sell their oldest inventory items first, inventories would include dated, less marketable merchandise.

Cost flow, however, can differ from physical flow. For example, a company may use LIFO or weighted average for financial reporting even if its goods flow physically on a FIFO basis.

The method companies most often use for the physical flow of goods is ______.

FIFO Reason: A FIFO physical flow delivers the oldest items (those purchased first) to customers, thereby keeping the newest items (those purchased last) in the store. This practice keeps inventory from becoming out of date.

Effects of Cost Flow on Ratio Analysis Because the amounts of ending inventory and cost of goods sold are affected by the cost flow method (FIFO, LIFO, etc.) a company uses, the gross margin and inventory turnover ratios are also affected by the cost flow method used.

Further, because cost of goods sold affects the amount of net income and retained earnings, many other ratios are also affected by the inventory cost flow method that a company uses. Financial analysts must consider that the ratios they use can be significantly influenced by which accounting methods a company chooses.

Multiple Layers Full Disclosure and Consistency

Generally accepted accounting principles allow each company to choose the inventory cost flow method best suited to its reporting needs. Because results can vary considerably among methods, however, the GAAP principle of full disclosure requires that financial statements disclose the method chosen. In addition, so that a company's financial statements are comparable from year to year, the GAAP principle of consistency generally requires that companies use the same cost flow method each period. The limited exceptions to the consistency principle are described in more advanced accounting courses.

The Financial Analyst Calculate and interpret the inventory turnover ratio. Assume a grocery store sells two brands of kitchen cleansers: Zjax and Cosmos. Zjax costs $1.00 and sells for $1.25, resulting in a gross margin of $0.25 ($1.25 − $1.00). Cosmos costs $1.20 and sells for $1.60, resulting in a gross margin of $0.40 ($1.60 − $1.20). Is it more profitable to stock Cosmos than Zjax? Not if the store can sell significantly more cans of Zjax. Suppose the lower price results in higher customer demand for Zjax. If the store can sell 7,000 units of Zjax but only 3,000 units of Cosmos, Zjax will provide a total gross margin of $1,750 (7,000 units × $0.25 per unit), while Cosmos will provide only $1,200 (3,000 units × $0.40 per unit).

How fast inventory sells is as important as the spread between cost and selling price. To determine how fast inventory is selling, financial analysts calculate a ratio that measures the average number of days it takes to sell inventory.

Multiple Layers The Impact of Income Tax Based on the financial statement information, which cost flow method should TMBC use? Most people initially suggest FIFO because FIFO reports the highest gross margin and the largest balance in ending inventory.

However, other factors are relevant. FIFO produces the highest gross margin; it also produces the highest net income and the highest income tax expense. In contrast, LIFO results in recognizing the lowest gross margin, lowest net income, and the lowest income tax expense.

The Internal Revenue Service requires that companies using the _____ method(s) for income taxes purposes must use the same method for financial reporting purposes.

LIFO

Which inventory cost flow method will produce the highest income and asset values in an deflationary environment?

LIFO

Multiple Layers The Income Statement vs. the Tax Return

In some instances, companies may use one accounting method for financial reporting and a different method to compute income taxes (the tax return must explain any differences). With respect to LIFO, however, the Internal Revenue Service requires that companies using LIFO for income tax purposes must also use LIFO for financial reporting. A company could not, therefore, get both the lower tax benefit provided by LIFO and the financial reporting advantage offered under FIFO.

INVENTORY COST FLOW METHODS Weighted Average To use the weighted-average cost flow method, first calculate the average cost per unit by dividing the total cost of the inventory available by the total number of units available.

In the case of TMBC, the average cost per unit of the inventory is $105 [($100 + $110) ÷ 2]. Cost of goods sold is then calculated by multiplying the average cost per unit by the number of units sold. Using weighted average, TMBC's cost of goods sold is $105 ($105 × 1).

specific identification

Inventory costing method in which cost of goods sold and ending inventory are computed using the actual costs of the specific goods sold or those on hand at the end of the period.

Companies may use one accounting method for financial reporting and a different method to compute income taxes, unless they are using the ______ method for tax purposes.

LIFO

Which of the following statements is true regarding the impact of income taxes?

LIFO may be the preferred cost flow method even when it results in lower reported income and asset values. Reason: Income tax minimization may cause companies to choose LIFO even when this method results in lower reported income as asset values.

Benson Company purchased two identical inventory items. The item purchased first cost $40. The second item cost $42. If one of the items were sold, which cost flow method would produce the highest amount of cost of goods sold?

Last-in, first-out Reason: LIFO assigns the cost of the item purchased last (highest cost) to cost of goods sold.

A company purchased two identical items. Item 101 purchased in October cost $100. Item 102 purchased in November cost $110. If item 102 is sold to a customer for $150,which of the following cost flow methods would produce the lowest gross margin?

Last-in, first-out (LIFO) Reason: It does not matter whether Item 1 or Item 2 is sold. Cost flow may differ from the physical flow of merchandise. LIFO assigns the last (highest cost) to cost of goods sold, thereby producing the lowest gross margin.

physical flow of goods

Physical movement of goods through a business, normally on a FIFO basis so that the first goods purchased are the first goods delivered to customers, reducing the likelihood of inventory obsolescence.

Which of the following statements are true?

The most common practice is to apply lower-of-cost-or-market to each individual inventory item. GAAP requires that ending inventory be reported at lower-of-cost-or-market, regardless of the cost flow method used.

AVOIDING FRAUD IN MERCHANDISING BUSINESSES 5 Managers may be tempted to overstate the physical count of the ending inventory in order to report higher amounts of gross margin on the income statement and larger amounts of assets on the balance sheet. How can companies discourage managers from deliberately overstating the physical count of the ending inventory? The first line of defense is to assign the task of recording inventory transactions to different employees from those responsible for counting inventory.

Recall that under the perpetual system, increases and decreases in inventory are recorded at the time inventory is purchased and sold. If the records are maintained accurately, the balance in the inventory account should agree with the amount of physical inventory on hand. If a manager were to attempt to manipulate the financial statements by overstating the physical count of inventory, there would be a discrepancy between the accounting records and the physical count. In other words, a successful fraud requires controlling both the physical count and the recording process. If the counting and recording duties are performed by different individuals, fraud requires collusion, which reduces the likelihood of its occurrence. Because motives for fraud persist, even the most carefully managed companies cannot guarantee that no fraud will ever occur. As a result, auditors and financial analysts have developed tools to test for financial statement manipulation. The gross margin method of estimating the ending inventory balance is such a tool.

Allocating Cost of Goods Available for Sale The following discussion shows how to determine the cost of goods sold and ending inventory amounts using FIFO, LIFO, and weighted-average cost flow methods. We show all three methods to demonstrate how they affect the financial statements differently; TMBC would actually use only one of the methods.

Regardless of the cost flow method chosen, TMBC must allocate the cost of goods available for sale ($12,650) between cost of goods sold and ending inventory. The amounts assigned to each category will differ depending on TMBC's cost flow method. Computations for each method are shown in the next section.

gross margin method

Technique for estimating the ending inventory amount without a physical count; useful when the percentage of gross margin to sales remains relatively stable from one accounting period to the next.

Effect of Cost Flow on Financial Statements Effect on Balance Sheet Because total product costs are allocated between costs of goods sold and ending inventory, the cost flow method a company uses affects its balance sheet as well as its income statement. FIFO transfers the first cost to the income statement, so this leaves the last cost on the balance sheet. Similarly, by transferring the last cost to the income statement, LIFO leaves the first cost in ending inventory. The weighted-average method bases both cost of goods sold and ending inventory on the average cost per unit. To illustrate, the ending inventory TMBC would report on the balance sheet using each of the three cost flow methods is shown in the following table.

The FIFO, LIFO, and weighted-average methods are all used extensively in business practice. The same company may even use one cost flow method for some of its products and different cost flow methods for other products.

full disclosure

The accounting principle that financial statements should include all information relevant to an entity's operations and financial condition. Full disclosure frequently requires adding footnotes to the financial statements.

Multiple Layers with Multiple Quantities Most real-world inventories are composed of multiple cost layers with different quantities of inventory in each layer. The underlying allocation concepts, however, remain unchanged. For example, a different inventory item The Mountain Bike Company (TMBC) carries in its stores is a bike called the Eraser. TMBC's beginning inventory and two purchases of Eraser bikes are described next:

The accounting records for the period show that TMBC paid cash for all Eraser bike purchases and sold 43 bikes at a cash price of $350 each.

ESTIMATING THE ENDING INVENTORY BALANCE 2 The estimated cost of ending inventory can be computed as follows: 1. Calculate the expected gross margin ratio using financial statement data from prior periods. Accuracy may be improved by averaging gross margin and sales data over several accounting periods. For The T-Shirt Company, assume the average gross margin for the prior five years ÷ the average sales for the same five-year period = 25% expected gross margin ratio. 2. Multiply the expected gross margin ratio by the current period's sales ($22,000 × 0.25 = $5,500) to estimate the amount of gross margin. 3. Subtract the estimated gross margin from sales ($22,000 − $5,500 = $16,500) to estimate the amount of cost of goods sold. 4. Subtract the estimated cost of goods sold from the amount of goods available for sale ($23,600 − $16,500 = $7,100) to estimate the amount of ending inventory.

The estimated amount of ending inventory ($7,100) can be compared to the book balance and the physical count of inventory. If the book balance or the physical count is significantly higher than the estimated inventory balance, the analysis suggests the possibility of financial statement manipulation. Other analytical comparisons are also useful. For example, the current year's gross margin ratio can be compared to last year's ratio. If cost of goods sold has been understated (ending inventory overstated), the gross margin ratio will be inflated. If this year's ratio is significantly higher than last year's, further analysis is required.

INVENTORY COST FLOW METHODS First-In, First-Out (FIFO)

The first-in, first-out (FIFO) cost flow method requires that the cost of the items purchased first be assigned to cost of goods sold. Using FIFO, TMBC's cost of goods sold is $100.

consistency

The generally accepted accounting principle that a company should, in most circumstances, continually use the same accounting method(s) so that its financial statements are comparable across time.

INVENTORY COST FLOW METHODS Last-In, First-Out (LIFO)

The last-in, first-out (LIFO) cost flow method requires that the cost of the items purchased last be charged to cost of goods sold. Using LIFO, TMBC's cost of goods sold is $110.

LOWER-OF-COST-OR-MARKET RULE Regardless of whether a company uses FIFO, LIFO, weighted average, or specific identification, once the cost of ending inventory has been determined, generally accepted accounting principles require that the cost be compared with the end of period market value and that the inventory be reported at lower of cost or market. Market is defined as the amount the company would have to pay to replace the merchandise. If the replacement cost is less than the actual cost, regardless of whether the decline in market value is due to physical damage, deterioration, obsolescence, or a general price-level decline, the loss must be recognized in the current period.

The lower-of-cost-or-market rule can be applied to (1) each individual inventory item, (2) major classes or categories of inventory, or (3) the entire stock of inventory in the aggregate. The most common practice is the individualized application.

A look back This chapter discussed the specific identification, first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted-average inventory cost flow methods. Under specific identification, the actual cost of the goods is reported on the income statement and the balance sheet. Under FIFO, the cost of the items purchased first is reported on the income statement, and the cost of the items purchased last is reported on the balance sheet. Under LIFO, the cost of the items purchased last is reported on the income statement, and the cost of the items purchased first is reported on the balance sheet. Finally, under the weighted-average method, the average cost of inventory is reported on both the income statement and the balance sheet. Generally accepted accounting principles often allow companies to account for the same types of events in different ways. The different cost flow methods presented in this chapter—FIFO, LIFO, weighted average, and specific identification—are examples of alternative accounting procedures allowed by GAAP. Financial analysts must be aware that financial statement amounts are affected by the accounting methods that a company uses, as well as the economic activity it experiences.

This chapter also explained how to calculate the time it takes a company to sell its inventory. The measure of how fast inventory sells is called inventory turnover; it is computed by dividing cost of goods sold by inventory. The result of this computation is the number of times the balance in the inventory account is turned over each year. The average number of days to sell inventory can be determined by dividing the number of days in a year (365) by the inventory turnover ratio.

True or false: When sales and purchases occur intermittently, the cost of the items purchased is frequently unknown at the time a sale occurs. Even so, companies can still use the perpetual inventory method.

True Reason: Companies can use the perpetual inventory method even if the cost of inventory cannot be determined at the time of the sale. Specifically, records of the quantities sold can be kept at the time sales occur and then the cost data can be applied to the quantity data at the end of the accounting period when the cost of all purchases is know.

True or false: A company may use LIFO or weighted average for financial reporting even if its goods flow physically on a FIFO basis.

True Reason: Companies are permitted to expense the cost of an inventory item that is different from the one that was actually sold.

Allocating Cost of Goods Available for Sale Weighted-Average Cost Flow The weighted-average cost per unit is determined by dividing the total cost of goods available for sale by the total number of units available for sale. For TMBC, the weighted-average cost per unit is $230 ($12,650 ÷ 55). The weighted-average cost of goods sold is determined by multiplying the average cost per unit by the number of units sold ($230 × 43 = $9,890). The cost assigned to the 12 bikes in ending inventory is $2,760 (12 × $230).

We show the allocation of the cost of goods available for sale between cost of goods sold and ending inventory graphically next:

A company purchased two identical items. Item 101 purchased in October cost $100. Item 102 purchased in November cost $110 If item 102 is sold to a customer for $150, which of the following cost flow methods results in an ending inventory of $105?

Weighted average Reason: (Item 1 + Item 2) ÷ 2 = ($100 + $110) ÷ 2 = $105 average cost of ending inventory.

A company purchased two identical items. Item 101 purchased in October cost $100. Item 102 purchased in November cost $110 If item 102 is sold to a customer for $150, which of the following cost flow methods results in a gross margin of $45?

Weighted average Reason: Revenue of $150 - Cost of goods sold $105 = gross margin of $45.

INVENTORY COST FLOW METHODS Specific Identification Suppose The Mountain Bike Company (TMBC) tags inventory items so it can identify which one is sold at the time of sale. T MBC could then charge the actual cost of the specific item sold to cost of goods sold. Recall that the first inventory item TMBC purchased cost $100 and the second item cost $110. Using specific identification, cost of goods sold would be $100 if the first item purchased was sold, or $110 if the second item purchased was sold.

When a company's inventory consists of many low-priced, high-turnover goods, the recordkeeping necessary to use specific identification isn't practical. Imagine the difficulty of recording the cost of each specific food item in a grocery store. Another disadvantage of the specific identification method is the opportunity for managers to manipulate the income statement. For example, TMBC can report a lower cost of goods sold by selling the first instead of the second item. Specific identification is, however, frequently used for high-priced, low-turnover inventory items such as automobiles. For big ticket items like cars, customer demands for specific products limit management's ability to select which merchandise is sold, and volume is low enough to manage the recordkeeping.

AVOIDING FRAUD IN MERCHANDISING BUSINESSES 1 For merchandising businesses, inventory is often the largest single asset reported on the balance sheet, and cost of goods sold is normally the largest single expense reported on the income statement. For example, a recent income statement for Publix (a large grocery store chain) reported $34.8 billion of sales and approximately $25.1 billion of cost of goods sold, which means cost of goods sold for Publix was about 72 percent of revenue. In contrast, the next largest expense (operating and administrative expense) was approximately $7.0 billion, or 20 percent of revenue.

While cost of goods sold represents only one expense account, the operating and administrative expense category actually combines many, perhaps hundreds, of individual expense accounts, such as depreciation, salaries, utilities, and so on. Because the inventory and cost of goods sold accounts are so significant, they are attractive targets for concealing fraud. For example, suppose a manager attempts to perpetrate a fraud by deliberately understating expenses. The understatement is less likely to be detected if it is hidden in the $25.1 billion Cost of Goods Sold account than if it is recorded in one of the smaller operating expense accounts.

Blane Company maintains its inventory under the perpetual system and uses a LIFO cost flow. The company purchases and sells inventory intermittently throughout its accounting cycle. Based on this information alone, the amount of the cost of goods sold will be determined at the ______.

end of the accounting period Reason: When sales and purchases occur intermittently, the cost of the last items purchased is frequently unknown at the time a sale occurs. Therefore, the cost of goods sold cannot be recorded at the time the sale occurs. To solve this problem, companies only keep perpetual records of the quantities (number of units) sold at the time sales occur and then determine the amount of the cost of goods sold at the end of the accounting period when the cost of the last items purchased can be determined.

Cost of goods available for sale is allocated between ______.

ending inventory and cost of goods sold

Hector Company purchased two identical inventory items. The item purchased first cost less the item purchased last. If Hector uses the LIFO cost flow system, cost of goods sold will be ______.

higher than if FIFO is used Reason: LIFO assigns the highest (the last cost) to cost of goods sold. In contrast, FIFO would assign the lowest cost (the first cost) to cost of goods sold. So LIFO would be higher than FIFO. higher than if weighted average is used Reason: LIFO assigns the highest cost (the last cost) to cost of goods sold. So cost of good sold under LIFO would be higher than the average cost.

Overall profitability depends upon two elements: gross margin and _____.

inventory turnover

In merchandising businesses, inventory and cost of goods sold accounts are attractive targets for concealing fraud because ______.

misstatements are less likely to be detected due to their significant size