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FIFO TRAINING
AEW
By – Alok Sharma(9354392216)

Inventory Types
 Finished inventory: held by retailers and
wholesalers
 Merchandise inventory
 Materials inventory: held by manufacturers
 Raw materials
 Work-in-progress
 Finished goods
LO 1

Types of Manufacturing Costs
 Direct materials: also called raw materials
 Ingredients used in making a product
 Direct labor: amounts paid to workers to
manufacture the product
 Manufacturing overheads: all other costs that
are related to the manufacturing process but
cannot be directly matched to specific units of
output
 Example: depreciation of building and salary of
supervisor

Three Forms of Inventory
 Direct materials
 The inventory of a manufacturer before the addition
of any direct labor or manufacturing overhead
 Work in process
 Cost of unfinished products in a manufacturing
company
 Finished goods
 A manufacturer’s inventory that is complete and
ready for sale

Exhibit 5.1 Relationships between Types of
Businesses and Inventory Costs

Account for Sales of Merchandise
LO 2
 Sales revenue: representation of the inflow of
assets, either cash or accounts receivable, from
the sale of a product during the period
Gross Profit = Net Sales − Cost of Goods Sold
Net Sales = Sales −
Sales Return and
Allowances
− Sales Discount

Exhibit 5.3—Net Sales Section of
the Income Statement

Sales Returns and Allowances
 Sales returns and allowances: contra-revenue
account used to record refunds to customers
and reductions of their accounts
 Sales discounts: contra-revenue account used
to record discounts given to customers for early
payment of their accounts
 Credit terms: firm’s policy for granting credit
 Example: n/30; Net, 10 EOM; 1/10, n/30

Credit Terms and Sales Discounts
 Credit terms: firm’s policy for granting credit
 n/30: the net amount of the selling price is due
within 30 days of the date of the invoice
 Net, 10 EOM: the net amount is due anytime within
ten days after the end of the month
 1/10, n/30: the customer can deduct 1% from the
selling price if the bill is paid within ten days
 Sales discounts: contra-revenue account used to
record discounts given to customers for early
payment of their accounts

Cost of Goods Sold
 Recognition of cost of goods sold as an expense
is an excellent example of matching principle
 Sales revenue: inflow of assets, cash or accounts
receivable
 Cost of goods sold: outflow of asset, inventory
 Cost of goods available for sale
 Cost of goods sold
Beginning inventory + Cost of goods purchased
Cost of goods available for sale − Ending inventory
LO 3

Exhibit 5.4—Cost of Goods Sold
Section of the Income Statement

Exhibit 5.5—Cost of Goods Sold
Model

Inventory Systems: Perpetual and
Periodic

Example 5.3—Recording Cost of Goods
Sold in a Perpetual System
 Daisy’s sells a pair of running shoes that costs
$70. In addition to the entry to record the sale,
Daisy’s would also record an adjustment as
follows:

Exhibit 5.6—Cost of Goods
Purchased

Example 5.4—Recording Purchase
in a Periodic System
 Daisy’s buys shoes from Nike at a cost of $4,000. The
effect is to increase liabilities and increase cost of
goods sold, which is an expense

Returns in a Periodic System
 Daisy’s returns $850 of merchandise to Nike for credit
on Daisy’s account. The return decreases both
liabilities and purchases. Because a return reduces
purchases, it has the effect of reducing expenses and
increasing net income and stockholders’ equity

Discounts in a Periodic System
 On March 13,there is a purchase of merchandise for
$500, with credit terms of 1/10, n/30

Discounts in a Periodic System (continued)

Purchase Discounts
 A contra-purchases account used to record
reductions in purchase price for early payment
to a supplier

Shipping Terms and Transportation
Costs
 Cost principle: All costs necessary to prepare an
asset for its intended use should be included in
its cost
 FOB destination point: seller incurs the
transportation costs
 FOB shipping point: buyer incurs the
transportation costs
 FOB stands for ‘‘free on board’’

Example 5.7—Recording
Transportation-In in a Periodic System
 Assume that on delivery of a shipment of goods,
Daisy’s pays an invoice for $300 from Rocky
Mountain Railroad. The terms of shipment are FOB
shipping point

Example 5.8—Determining the Effect of
Shipping Terms on Purchases and Sales

The Gross Profit Ratio
 Important measure of profitability
 Indicates a company’s ability to cover operating
expenses and earn a profit
 Relationship between gross profit and net sales
—measured by the gross profit ratio—one of
the most important measures to assess the
performance of a company
LO 4
Gross Profit
Net Sales
Gross Profit Ratio =

The Ratio Analysis Model
1. How much of the sales revenue is used for the
cost of the products, and thus, how much remains
to cover other expenses and to earn net income?
2. Gather the information about net sales and cost
of goods sold
3. Calculate the gross profit ratio
4. Compare the ratio with prior years and with
competitors
5. Interpret the ratios—showing increase or
decrease

The Business Decision Model
1. If you were an investor, would you buy stock in
a company?
2. Gather information from the financial
statements and other sources
3. Compare the company's gross profit ratio with
industry averages and look at trends
4. Buy stock or find an alternative use for the
money
5. Monitor the investment periodically

Inventory Valuation and the
Measurement of Income
 Value assigned to inventory on balance sheet
determines the amount eventually recognized
as an expense on income statement
 Incorrect ending inventory will affect cost of
goods sold and net income
LO 5

Inventory Costs
 Cost: price paid or consideration given to
acquire an asset
 Includes expenditures directly or indirectly incurred in
bringing to its existing condition and location
 Examples:
 Freight costs incurred to bring inventory to the place
of business
 Cost of insurance when inventory is in transit
 Cost of storing inventory before it is ready to be sold
 Taxes paid—excise and sales taxes

Inventory Costing Methods
with a Periodic System
Specific
Identification
Weighted
Average
First-in, First-out
(FIFO)
Last-in, First-out
(LIFO)
LO 6

Specific Identification Method
 Relies on matching unit costs with the actual
units sold
 Example 5.10—Determining Ending Inventory
and Cost of Goods Sold Using Specific
Identification

Example 5.10—Determining Ending Inventory and Cost
of Goods Sold Using Specific Identification (continued)

Weighted Average Cost Method
 Assigns the same unit cost to all units available
for sale during the period
Cost of Goods Available for Sale
Units Available for Sale
Weighted Average Cost =
Ending inventory =
Weighted
Average Cost
Number of Units in
Ending Inventory
×

Example 5.11—Determining Ending Inventory
and Cost of Goods Sold Using Weighted Average

First-In, First-Out Method (FIFO)
 Assigns the most recent costs to ending
inventory
and Cost of Goods Sold Using FIFO

and Cost of Goods Sold Using FIFO (continued)

Last-In, First-Out Method (LIFO)
 Assigns the most recent costs to cost of goods
sold
and Cost of Goods Sold Using LIFO

and Cost of Goods Sold Using LIFO (continued)

Selecting an Inventory Costing
Method
 The choice of an inventory method will impact
cost of goods sold and thus net income
 A company should choose the method that
results in the most accurate measure of net
income for the period
 The primary determinant in selecting an
inventory costing method should be the ability
of the method to accurately reflect the net
income of the period
LO 7

Exhibit 5.7—Income Statements for the
Inventory Costing Methods

Example 5.14—Computing Taxes Saved
by Using LIFO Instead of FIFO
 Assume a 40% tax rate, income tax expense
under LIFO is only $2,000, compared with
$2,600 under FIFO, a savings of $600 in taxes

Result of FIFO and LIFO during a
Period of Raising Prices

LIFO Issues
 LIFO Liquidation
 The result of selling more units than are purchased
during the period
 Negative tax consequences
 LIFO Conformity rule
 If LIFO is used on a tax return, it must also be used in
reporting income to stockholders
 LIFO Reserve
 The excess of the value of a company’s inventory
stated at FIFO over the value stated at LIFO

Costing Methods and Inventory
Profits
 Replacement cost: current cost of a unit of
inventory
 Inventory profit: the portion of the gross profit
that results from holding inventory during a
period of rising prices

Example 5.16—Reconciling the Difference between Gross
Profit on a FIFO Basis and on Replacement Cost Basis

Inventory Valuation in Other
Countries
 Valuing inventory differ around the world
 GAAP in the United States allows LIFO
 IASB strictly prohibits the use of LIFO
 Survival of LIFO is not only a matter of
convergence with international standards
 LIFO allows companies with rising inventory costs to
report lower income

Inventory Errors
 If ending inventory is overstated, cost of goods
sold will be understated and thus net income
for the period overstated
 The opposite effects will occur when ending
inventory is understated
 Different types of inventory errors
 Mathematical errors
 Physical count of inventory at year-end
 Cutoff problems—in-transit—at year-end
LO 8

Example 5.17—Analyzing the Effect of an
Inventory Error on Net Income

Inventory Error on Retained Earnings

Inventory Error on the Balance Sheet

Exhibit 5.8—Summary of the Effects
of Inventory Errors

Lower-of-Cost-or Market Rule
 A conservative inventory valuation approach
 Require that inventory be written down at the
end of the period if the market value of the
inventory is less than its cost
 Can be applied to:
 Entire inventory
 Individual items
 Groups of items
LO 9

Lower-of-Cost-or-Market under
International Standards
 Required under both U.S. GAAP and IFRS
 Difference:
 U.S.GAAP
• Define market value as replacement cost, subject to a
maximum and a minimum amount
• New amount becomes basis for future adjustments
 IFRS
• Uses net realizable value with no upper or lower limits
• Write-downs of inventory can be reversed in later periods

Lower-of-Cost-or-Market under
International Standards( Continued..)
 For example, if cost is $100,000 and market value is
$85,000, the adjustment that can be identified and
analyzed as follows:

Inventory Turnover Ratio
 Measures company’s ability to sell its inventory
quickly
 Number of times inventory is sold during a
period
LO 10
Cost of Goods Sold
Average Inventory
Inventory Turnover Ratio =

Number of Days’ Sales in Inventory
 Measures of how long it takes to sell inventory
Number of Days in the Period
Inventory Turnover Ratio
=
Number of Days’ Sales
in Inventory

The Ratio Analysis Model
1. How liquid the company is?
2. Gather cost of goods sold from the income
statement and average inventory from balance
sheet at the end of the two most recent years
3. Calculate the inventory turnover ratio
4. Compare the ratio with other ratios
5. Interpret the ratios—measure of how long it
takes to sell inventory

The Business Decision Model
1. If you were an investor, would you buy stock in
the company?
2. Gather information from the financial
statements and other sources
3. Compare trends in inventory turnover ratios,
net income with industry averages
4. Buy stock or find an alternative
5. Monitor your decision periodically

Exhibit 5.10—Inventories and the
Statement of Cash Flows
LO 11

Inventory Costing Methods with the
Use of a Perpetual Inventory System
LO 12

Using FIFO with a Perpetual System

Using LIFO with a Perpetual System

Moving Average
 An average cost method when a weighted
average cost assumption is used with a
perpetual inventory system

Using Moving Average with a Perpetual System

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