Accounting Principle – Grade 1 - FCASU – 2nd Term

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Chapter 6 - Inventories
Classifying Inventory?
Classifying inventory depends on whether the firm is a merchandiser or a manufacturer
1. In a merchandising company, inventory have two common characteristics:
a) they are owned by the company,
b) they are in a form ready for sale
In merchandisers need only one inventory classification (merchandise inventory).
2. In a manufacturing company, some inventory may not yet be ready for sale, As a result,
manufacturers usually classify inventory into three categories:
a) Raw Material: (basic goods that will be used in production but have not yet been
placed into production)
b) Work in Process: (that portion of manufactured inventory that has been placed
into the production process but is not yet complete)
c) Finished Work: (is manufactured items that are completed and ready for sale)

Apply inventory cost flow methods.

Inventory is accounted for at cost, cost includes all expenditures necessary to acquire goods and
place them in a condition ready for sale.
For example, freight costs incurred to acquire inventory are added to the cost of inventory, but
the cost of shipping goods to a customer are a selling expense.

Cost Flow Methods

1. First-in, first-out (FIFO)
2. Last-in, first-out (LIFO)
3. Average-cost
 Company management selects the appropriate cost flow method
To illustrate the three inventory cost flow methods, we will use the following example

- The cost of goods sold = (Beginning Inventory + Purchases) - Ending Inventory

= Cost of goods available for sale – Ending Inventory
- Company has 1,000 units available for sale (beginning inventory + purchases).
- The total cost of available for sale is $12,000
- At December 31 the Ending Inventory is 450 units.

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- During the period, the company sold 550 Unit (Available for Sale – Ending Inventory) “1,000 –
450”
- To determine the cost of the 550 units that were sold (the cost of goods sold), we get (Ending
Inventory and to be subtracted from Cost of Goods available for Sale) but the value of Ending
Inventory depends on the cost flow method that the company used.
Cost of Goods Sold = Cost of goods available for sale – Ending Inventory
- Note that: Whatever cost method used, the sum of (cost of goods sold + ending inventory) must
equal the cost of goods available for sale under all cost flow methods.
- Just for info: we will use a periodic inventory system in cost flow method. As companies that used
Perpetual use a cost called (Standard Cost) to record cost of goods sold at the time of sale.

1) FIRST-IN, FIRST-OUT (FIFO)

- The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to
be sold to determine cost of goods sold (this reflects the actual flow of merchandise to sell more
oldest goods first).
- Just for note: Under FIFO, the costs of the earliest goods purchased are used to determining
cost of goods sold. (This does not necessarily mean that the oldest units are sold first, but that
the costs of the oldest units are recognized first).

Assuming the given data in previous page, Calculate the Cost of Goods Sold, and Ending
Inventory Using FIFO method.
(A) First Step to calculate Ending Inventory:
- Under FIFO, since the company sell its goods from first item purchased (Cost of goods sold) so
to obtain ending inventory it will take the cost of the most recent
purchase and working backward to cost the Ending Inventory.
- In our example, the 450 units of ending inventory using the most
recent prices.
- The last purchase was 400 units at $13 on November 27 (400 x $13 =
$5,200). The remaining 50 units are priced using the second most
recent purchase, $12 (50 x $12 = $ 600)

(B) Second Step is to determine the Cost of Goods Sold:

- The cost of goods sold will equal by subtracting (ending
inventory from the cost of all goods available for sale).
Cost of Goods Sold = Cost of goods available for sale – Ending
Inventory

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Another way to calculate Cost of Goods sold as follow:
- Companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of
the first 550 units acquired.
- First 100 units will be taken from the existing
beginning inventory at cost $10 per unit
- The residual 450 unit, there is only 200 units
purchased on April 15 will be taken all at price $11
then the last 250 will be taken from units purchased
on Aug. 24 at price $12
- Cost of Goods Sold = $ 6,200

2) LAST-IN, FIRST-OUT (LIFO)

- Under LIFO method assumes that the latest goods purchased are the first to be sold this will be
used to determine Cost of Goods Sold.

(A) First Step to calculate Ending Inventory:

- Under LIFO, since it is assumed that the first goods sold were those that were most recently
purchased to determine Cost of goods sold, so ending inventory is based on the prices of the
oldest units purchased.
- Ending inventory takes the unit cost of the earliest goods available for sale and working forward
until all units of inventory have been costed.
- In this example, the 450 units of ending inventory using the earliest
prices. The beginning inventory was 100 units at $10 in the January
(100 x $10 = $1,000), Then, 200 units were purchased at $11 (200 x
$11 = $2,200). The remaining 150 units needed are priced at $12 per
unit (August 24 purchase) “150 x $12 = $1,800”

(B) Second Step is to determine the Cost of Goods Sold:

The cost of goods sold will equal by subtracting (ending
inventory from the cost of all goods available for sale).
Cost of Goods Sold = Cost of goods available for sale –
Ending Inventory

Another way to calculate Cost of Goods sold as follow:

- Companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of
the last 550 units acquired.
- The all units purchased on Nov. 27 purchased at $13 will be included (400 x $13 = $5,200) and
then the residual 150 units will be taken from unites
purchased on Aug.14 (150 x $12 = $1,800)
- Cost of goods sold = $7,000

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3) AVERAGE-COST
- The average-cost method allocates the cost of goods available for sale on the basis of the weighted-
average unit cost incurred. The average-cost method assumes that goods are similar in nature.
- The following is the computation of the weighted-average unit cost.

(A) First Step to calculate Ending Inventory:

- The company applies the weighted-average unit cost to the units on
hand to determine the cost of the ending inventory.
- Cost of Ending Inventory = Units of Ending Inventory x Weighted
Average Cost
- Cost of Ending Inventory = 450 x $12 = $5,400

(B) Second Step is to determine the Cost of Goods Sold:

The cost of goods sold will equal by subtracting (ending
inventory from the cost of all goods available for sale).
Cost of Goods Sold = Cost of goods available for sale –
Ending Inventory

Another way to calculate Cost of Goods sold as follow:

- We can calculate cost of goods sold under this method by multiplying the units sold x the
weighted-average unit cost
- Cost of Goods Sold = 550 x $12 = $6,600.

Important note in Weighted Average Method:

- This method does not use the average of the unit costs that depend on calculation the follow
- ($10 + $11 + $12 + $13 = $46, and average in this case $46 ÷ 4 = $11.5) which in incorrect to be
used in this method
- The average-cost method instead uses the average weighted by the quantities purchased at
each unit.

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Financial Statement and Tax Effects of Cost Flow Methods
- Each of the three assumed cost flow methods is acceptable for use, as you can use FIFO, LIFO or
Weighted Average subject to management decision.
- The reasons of using different inventory cost flow methods are depends on the following 3
factors:
1. income statement effects
2. balance sheet effects
3. tax effects.

 INCOME STATEMENT And Balance Sheet Effect

- To understand why companies might choose a different types of cost flow method, we need to
see the effect of 3 cost flow methods on Income Statement, assume that in our example the
company Sold 550 Units with total Sales Revenue $ 18,500, and Operating Expense $ 9,000.

- In these data the company’s Beginning Inventory Cost $ 1,000, and Total Purchases is $ 11,000
($2,200 + 3,600 + 5,200).
- But the Cost of Good Sold and Ending Inventory Cost differ from one method to another as per follow:

- In the previous table showing the difference between each method, and with increasing in
prices (Unit Cost) “Inflation” you will notice that:
o The cost of goods available for sale ($12,000) is the same under the three inventory cost flow
methods
o The ending inventories and the costs of goods sold are different under each method, this
difference is due to the unit costs that the company allocated to cost of goods sold and to ending
inventory.
o This difference will effect on Net Income, and Inventory (Total Assets) as per the following table
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In case of Inflation (Unit cost increase during the period)
Company Using FIFO Method
- FIFO produces a higher net income because
lower unit costs of first units purchases will be
sold first to generate revenue.
- Cost of Goods Sold will be (Lower) so Net
Income will be (Higher)
- While Ending Inventory will be Higher as last
purchased units with higher price will be exist
in Inventory and it will effect on Total Assets
to be Higher. (Overstated)
Company’s using LIFO Method
- LIFO produces a lower net income because
higher unit costs of the last goods purchased
will be sold first to generate revenue.
- Cost of Goods Sold will be (Higher) so Net
Income will be (Lower)
- While Ending Inventory will Lower as first
purchased units with lower price will be exist
in Inventory and it will effect on Total Assets
to be Lower (understated)

In case of Falling Prices (Deflation)

Company Using FIFO Method
- If prices are falling, FIFO will report the lowest - If prices are falling, LIFO will report the
net income, because higher unit costs of first
units purchased will be sold first to generate
revenue.
- Cost of Good Sold will be (Higher) so Net
Income will be (Lower)
- While Ending Inventory will Lower as last
purchased units with Lower price will be exist
in Inventory and it will effect on Total Assets
to be Lower.
Company’s using LIFO Method
Highest net income, because Lower unit costs
of Last units purchased will be sold first to
generate revenue.
- Cost of Good Sold will be (Lower) so Net
Income will be (Higher)
- While Ending Inventory will Higher as First
purchased units with Higher price will be exist
in Inventory and it will effect on Total Assets
to be Higher.

 While in Average Cost Method ➔ Regardless of whether prices are rising or falling, average-cost
produces net income and ending inventory between FIFO and LIFO.

Note the following Points:

- Company’s management usually search for higher net income that consider an advantage to
shows a company more favorable for External Users, and Management will get bonuses for
higher net income.
- Therefore, when prices are rising, companies tend to prefer FIFO because it results in higher net
income.
- Also LIFO presents a more realistic net income that matches the more recent costs against
current revenues to provide a better measure of net income.

 TAX EFFECTS
- As we discussed during Inflation, FIFO will result Higher Inventory in Assets section at Balance
Sheet and Higher Net Income in Income Statement.
- Although higher Net Income under FIFO with inflation, the company may select LIFO WHY??
- The reason is that LIFO results in the lowest net income before tax, and the company will pay
smaller tax than the company use FIFO that will pay Higher Tax for the Higher Net Income
Before Tax.

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