Principles of Financial Accounting: Inventory - Inventory Cost, Flow Assumptions Specific Identification FIFO LIFO Weighted Average

What It Is

Inventory Cost Flow Assumptions determine how a company values its inventory for financial reporting purposes. This matters because it affects the Cost of Goods Sold (COGS) and ultimately the Gross Profit. If a company buys $10,000 of inventory at different prices, the choice of cost flow assumption will impact the COGS and Gross Profit.

Key Concepts & Formulas

• Specific Identification (SI): Assigns the actual cost of each item to its respective cost of goods sold. This method is impractical for large quantities of inventory. Example: A company buys 100 units of inventory at $100 each. If 50 units are sold, the COGS would be $5,000 (50 units * $100).
• First-In, First-Out (FIFO): Assumes that the oldest items in inventory are sold first. This method is commonly used for perishable items. Example: A company buys 100 units of inventory at $100 each, and then buys another 100 units at $120 each. If 100 units are sold, the COGS would be $10,000 (100 units * $100).
• Last-In, First-Out (LIFO): Assumes that the newest items in inventory are sold first. This method is commonly used for items with fluctuating prices. Example: A company buys 100 units of inventory at $100 each, and then buys another 100 units at $120 each. If 100 units are sold, the COGS would be $12,000 (100 units * $120).
• Weighted Average (WA): Calculates the average cost of inventory based on the total cost of goods available for sale. Example: A company buys 100 units of inventory at $100 each and 100 units at $120 each. The weighted average cost would be $110 ($10,000 + $12,000) / 200 units.
• Gross Profit = Sales – COGS: This formula calculates the gross profit of a company.
• Inventory Turnover = COGS / Average Inventory: This formula calculates the inventory turnover of a company.
• Days Inventory Outstanding (DIO) = Average Inventory / (COGS / 365): This formula calculates the days inventory outstanding of a company.

Journal Entry Examples

FIFO Example

Suppose a company buys 100 units of inventory at $100 each and sells 50 units. The journal entry would be:

Dr. Cost of Goods Sold $5,000 Cr. Inventory $5,000

LIFO Example

Suppose a company buys 100 units of inventory at $100 each and then buys another 100 units at $120 each. If 100 units are sold, the journal entry would be:

Dr. Cost of Goods Sold $12,000 Cr. Inventory $12,000

Weighted Average Example

Suppose a company buys 100 units of inventory at $100 each and 100 units at $120 each. The weighted average cost would be $110. If 100 units are sold, the journal entry would be:

Dr. Cost of Goods Sold $11,000 Cr. Inventory $11,000

Common Mistakes

• Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
• Mistake: Not considering the normal balance of an account. Correction: Always consider the normal balance of an account when making journal entries.
• Mistake: Not using the correct formula for inventory turnover. Correction: Use the formula Inventory Turnover = COGS / Average Inventory.

Exam Tips

• Tip: Remember that inventory is an asset account, so debits increase its value.
• Tip: Be careful when using the LIFO method, as it can result in a higher COGS and lower Gross Profit.
• Tip: Use the weighted average method when the prices of inventory items are fluctuating.

Quick Practice

Problem 1

A company buys 100 units of inventory at $100 each and sells 50 units. What is the adjusting entry for the Cost of Goods Sold?

Answer: Dr. Cost of Goods Sold $5,000, Cr. Inventory $5,000

Problem 2

A company uses the LIFO method and buys 100 units of inventory at $100 each and then buys another 100 units at $120 each. If 100 units are sold, what is the COGS?

Answer: $12,000

Problem 3

A company uses the weighted average method and buys 100 units of inventory at $100 each and 100 units at $120 each. What is the weighted average cost?

Answer: $110

Last-Minute Cram Sheet

• Inventory is an asset account, so debits increase its value.
• The FIFO method assumes that the oldest items in inventory are sold first.
• The LIFO method assumes that the newest items in inventory are sold first.
• The weighted average method calculates the average cost of inventory based on the total cost of goods available for sale.
• Gross Profit = Sales – COGS.
• Inventory Turnover = COGS / Average Inventory.
• Days Inventory Outstanding (DIO) = Average Inventory / (COGS / 365).
• Dividends are NOT an expense – they go directly to retained earnings.
• The LIFO method can result in a higher COGS and lower Gross Profit.
• The weighted average method is commonly used for items with fluctuating prices.