BUS103: Introduction to Financial Accounting

6a. Describe the effects of a company's choice of valuation method on its financial statements 

• What are the four main methods of costing inventory?
• How does the choice of inventory valuation method impact a company's income statement?
• How does the choice of inventory valuation method impact a company's balance sheet?
  

There are four main methods of valuing a company's inventory:

1. Specific identification: This involves attaching the actual cost to an identified unit or project. This is typically used for large, unique items.
2. FIFO (First in, First out): This method assigns the cost of the earliest items purchased to the goods sold.
3. LIFO (Last in, First out): This method assigns the cost of the latest items purchased to the goods sold.
4. Weighted average: This method assigns costs based on a weighted average unit cost.
   

The choice of inventory method will directly impact a firm's financial statements. In inflationary times, FIFO will result in a lower COGS and therefore a higher Net income, while LIFO would result in a lower Net Income. Likewise, in inflationary times, the units on the balance sheet would be at a higher dollar amount under FIFO than LIFO. This difference will impact many of the ratios calculated, which makes knowing any differences in inventory valuation methods important when comparing a company to its competitors.
 
To review, see Inventory Valuation Methods.
 

6b. Calculate COGS and ending inventory value under the various inventory costing methods 

• How do you calculate COGS and ending inventory under the FIFO method?
• How do you calculate COGS and ending inventory under the LIFO method?
• How do you calculate COGS and ending inventory under the Weighted Average method?
• How do you calculate COGS and ending inventory under the Specific Identification method?
  

To calculate the COGS under FIFO, complete the following steps:

1. Determine the number of units sold.
2. Use the costs of any units that were in the beginning inventory for the units sold.
3. If more were sold than existed in the beginning inventory, find the cost of the earliest purchases and count those for the cost of the units sold.
4. Whatever units are left (the newest purchases) will be the value of your ending inventory.
   

To calculate the COGS under LIFO, complete the following steps:

1. Determine the number of units sold.
2. Use the costs of the most recent purchases as the cost of the units sold.
3. Keep going backward to earlier purchases until all units sold have an associated cost.
4. Whatever units are left (the oldest purchases/beginning inventory) will be the value of your ending inventory.
   

To calculate the COGS under Weighted Average, complete the following steps:

1. Determine the number of units sold
2. Calculate the weighted average cost of all the units in beginning inventory and purchased during the period.
3. Multiply the number of units sold by the weighted average to get the COGS
4. Multiply the units left by the weighted average to get the value of the ending inventory.
   

To calculate the COGS under Specific Identification, complete the following steps:

1. Determine the number of units sold
2. Determine which units were sold and look up the exact cost information on them. Use this as your COGS.
3. Look up the cost of the exact units not sold – this is the value of your ending inventory.
   

To review, see:

• FIFO Method
• LIFO Method
• Average Cost Method
• Specific Cost Method

6c. Calculate the inventory turnover ratio 

• How would a company calculate its inventory turnover ratio?
• What does inventory turnover show about a company's operations?
  

The inventory turnover ratio is defined as COGS/average inventory. A company would take the total COGS for the period being analyzed and divide it by the average inventory. Average inventory is calculated by taking the beginning inventory plus the ending inventory and dividing by 2. This helps smooth out fluctuations in inventory levels at the beginning or end of a period.
 
The turnover ratio measures how efficiently the firm is managing and selling its inventory and is a measure of liquidity. Generally, the quicker a firm sells its inventory, the faster it generates cash for other uses. A low turnover rate may indicate the firm's products are not desired by customers, the firm is holding too much inventory, or that marketing efforts are not working. A high turnover rate may indicate that customers are very interested in the products but could also indicate a lack of inventory that could be exploited by competitors. Generally speaking, a firm wants to have just enough inventory to cover all the demands of the customers, but not much more, as unsold inventory ties up cash that could be used elsewhere and runs the risk of damage or obsolescence, decreasing its value.
 
To review, see Reporting and Analyzing Inventories.
 

6d. Produce journal entries for the flow of goods in inventory for merchandising and manufacturing companies 

• How are inventory transactions recorded in a merchandising company?
• How are inventory transactions recorded in a manufacturing company?
  

A merchandising company is a company that purchases products to resell to customers. When a company purchases products to resell, the accounting transaction is:

6e. Describe appropriate internal controls to safeguard inventory

• What methods can a company put in place to safeguard its inventory?
• Why do companies have to count their physical inventory if they use a perpetual inventory system that tracks purchases and sales automatically?

Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• FIFO
• inventory turnover ratio
• LIFO
• manufacturing company
• merchandising company
• specific identification
• weighted average