LO1 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions—perpetual.
Cost of goods available for sale must be allocated between cost of goods sold and ending inventory using a cost flow assumption. Specific identification allocates cost to units sold by using the actual cost of the specific unit sold. FIFO (first-in first-out) allocates cost to units sold by assuming the units sold were the oldest units in inventory. Weighted average allocates cost to units sold by calculating a weighted average cost per unit at the time of sale.
LO2 – Explain the impact on financial statements of inventory cost flows and errors.
As purchase prices change, particular inventory methods will assign different cost of goods sold and resulting ending inventory to the financial statements. Specific identification achieves the exact matching of revenues and costs while weighted average accomplishes an averaging of price changes, or smoothing. The use of FIFO results in the current cost of inventory appearing on the balance sheet in ending inventory. The cost flow method in use must be disclosed in the notes to the financial statements and be applied consistently from period to period. An error in ending inventory in one period impacts the balance sheet (inventory and equity) and the income statement (COGS and net income) for that accounting period and the next. However, inventory errors in one period reverse themselves in the next.
LO3 – Explain and calculate lower of cost and net realizable value inventory adjustments.
Inventory must be evaluated, at minimum, each accounting period to determine whether the net realizable value (NRV) is lower than cost, known as the lower of cost and net realizable value (LCNRV) of inventory. An adjustment is made if the NRV is lower than cost. LCNRV can be applied to groups of similar items or by item.
LO4 – Estimate merchandise inventory using the gross profit method and the retail inventory method.
Estimating inventory using the gross profit method requires that estimated cost of goods sold be calculated by, first, multiplying net sales by the gross profit ratio. Estimated ending inventory at cost is then arrived at by taking goods available for sale at cost less the estimated cost of goods sold. To apply the retail inventory method, three calculations are required:
- retail value of goods available for sale less retail value of net sales equals retail value of ending inventory,
- goods available for sale at cost divided by retail value of goods available for sale equals cost to retail ratio, and
- retail value of ending inventory multiplied by the cost to retail ratio equals estimated cost of ending inventory.
LO5 – Explain and calculate merchandise inventory turnover.
The merchandise turnover is a liquidity ratio that measures how quickly inventory is sold. It is calculated as: COGS/Average Merchandise Inventory. Average merchandise inventory is the beginning inventory balance plus the ending inventory balance divided by two.
LO6 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions—periodic.
Periodic systems assign cost of goods available for sale to cost of goods sold and ending inventory at the end of the accounting period. Specific identification and FIFO give identical results in each of periodic and perpetual. The weighted average cost, periodic, will differ from its perpetual counterpart because in periodic, the average cost per unit is calculated at the end of the accounting period based on total goods that were available for sale.