Slide 1Why is accounting for inventory so important?What is an inventory cost flow assumption?What is the FIFO inventory cost flow assumption?What is the LIFO inventory cost flow assumption?What is the weighted average inventory cost flow assumption?Slide 7Slide 8Slide 9Using inventory informationAccounting for inventoryWhy is accounting for inventory so important?For many merchandising companies, inventory is the largest asset on the balance sheet, and cost of goods sold is the largest expense on the income statement.Amounts reported for inventory and cost of goods sold generally have a material impact on a company’s financial statements.What is an inventory cost flow assumption?A company may purchase identical units of inventory at different unit costs. When this happens, the company must determine a consistent method for assigning these costs to both the units sold during the period and to the units left on hand at the end of the period. This is an inventory cost flow assumption.As an example, assume a company sells tennis rackets. At the beginning of the period, the company had one racket which cost $30 on hand. During the period, the company purchased another identical tennis racket; this racket cost the company $38. At the end of the period, the company determined that one racket was left on hand, and therefore one racket had been sold. A cost flow assumption is needed to determine which cost, $30 or $38, will be assigned to the racket sold, and which will be assigned to the racket left on hand.What is the FIFO inventory cost flow assumption?FIFO stands for First-in, first-out. This cost flow method assumes that units are sold in the same order as they are purchased; it assigns the cost of the first, or oldest items purchased to the expense category.It follows that the most recent costs are then assigned to ending inventory.Using the tennis racket example described earlier:UnitsUnit costBeginning inventory 1 $30 = unit soldPurchases 1 38 = unit left on handGoods available for sale 2 $68Cost of goods sold = 1 unit @ $30 = $30Ending inventory = 1 unit @ $38 = $38What is the LIFO inventory cost flow assumption?LIFO stands for Last-in, first-out. This cost flow method assumes that units are sold in reverse of the order purchased; it assigns the cost of the last, or most recent items purchased to the expense category.It follows that the oldest costs are then assigned to ending inventory.Using the tennis racket example described earlier:UnitsUnit costBeginning inventory 1 $30 = unit left on handPurchases 1 38 = unit soldGoods available for sale 2 $68Cost of goods sold = 1 unit @ $38 = $38Ending inventory = 1 unit @ $30 = $30What is the weighted average inventory cost flow assumption?The weighted average method assumes that all units available for sale during the period had the same “average” unit cost.Using the tennis racket example described earlier:Units Unit costBeginning inventory 1 $30 = unit left on handPurchases 1 38 = unit soldGoods available for sale 2 $68Weighted average cost per unittotal cost of goods available for sale $68 = $34 per unittotal number of units available for sale 2Cost of goods sold = 1 @ 34 = $34Ending inventory = 1 @ 34 = 34How do errors in counting ending inventory affect the financial statements?Using a periodic inventory system, an error in counting ending inventory affect both the income statement and the balance sheet in the year the error is made. The income statement for the subsequent year is also affected.Cost of goods sold is calculated based on the physical count of inventory at year-end. If this count is incorrect, both the ending inventory reported on the balance sheet and the cost of goods sold reported on the income statement will be incorrect. Additionally, since the ending inventory of one year becomes beginning inventory for the next year, the cost of goods sold calculations for the year after the error will also be affected.Effect of inventory error: assume the ending inventory for year 1 is overstated Year 1 Year 2Cost of goods sold:Beginning inventory overstated+ Net purchases and freight inGoods available for sale overstated- Ending inventory (overstated) OKCost of goods sold understated overstatedWhat methods are available to estimate the goods left in ending inventory?Companies should take a physical count of inventory at least once each year. In a periodic system the number of units left on hand is needed to determine the number of units sold. In a perpetual system, the count is needed for control purposes, to ensure that the actual units on hand agree with the company’s inventory records, and to account for any lost or stolen units.But what if the company wants to estimate the number of units on hand without taking a physical count, perhaps for interim statements? Or what is some disaster – flood, fire, or theft – destroys the inventory so that a physical count is impossible?Companies can estimate the ending that should be on hand using two different methods. One is based on the company’s historical gross profit as a percentage of sales; one is based on the relationship between inventory cost and its selling price.Using inventory informationCompanies need to keep enough inventory on hand to meet demand. However, excess inventory ties up funds that could be used elsewhere and increases storage and security costs.One measure that helps determine efficiency and effectiveness of inventory management is Inventory turnover. Inventory turnover = cost of goods sold / average