 Hello, and welcome to the session in which we would look at cost flow assumption. The first word I want to emphasize on is it's an assumption. It's an assumption of how inventory cost flows goes from the balance sheet to the income statement. Simply put, we have the inventory account and we have cost of goods sold. We acquire inventory and once we sell the inventory, it would leave inventory and goes to cost of goods sold. It gets expensed. Now inventory cost flow assumption is the assumption of how to account for those changes, for those transfer from inventory to cost flow. The company don't have to choose the same method that it actually matches the actual physical flow. Therefore, what we're going to be learning about is assumption. We could assume any method we want to and we're going to learn about various assumptions. The first assumption is going to be called FIFO or first and first out. We assume the inventory that we brought in first are the inventory that we got rid of first, first and first out, or we could have a life assumption. The inventory that we purchased last is the inventory that we are going to be selling first. So last in, the last inventory that we purchased is the first inventory that we get rid of. In the real world, most inventory, most inventory is FIFO, first and first out. Think of a grocery store. In a grocery store, they want to sell the apples, they want to sell the lettuce, they want to sell the pears, they want to sell the strawberry, the old one first, first and first out. Otherwise, they will go bad. And for most merchandise, you want to get rid of the old inventory first. LIFO stands for last and first out. You are assuming that the inventory that you purchased last are the inventory that you sell first. Again, those are assumptions and we have a method called the weighted average and we have another method that's not really an assumption. It's called the specific identification. I will discuss the specific identification in a separate example. Now also to learn about the cost flow assumption, you have to know our track, how do we track inventory? Remember, we have two methods to track inventory, periodic method and the perpetual method. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Now if you don't know what the periodic or the perpetual method I would strongly suggest you take a look at the previous recording because in this session I'm going to be showing you the periodic method as well as the perpetual method side by side. This topic is covered in intermediate accounting and heavily on the CPA exam so it's very important that you learn this topic inside out. The best way to illustrate this concept is to actually work an example. So we're going to be working with Adam, inventory, information and it's very important whatever's going to be on this slide as you copy it down because we're going to be using this data to illustrate all three concepts. So we're going to be working with a company with a starting beginning inventory of 5,000 units and they paid for those 5,000 units, $5 per unit. So the total cost is $25,000. This is what we call beginning inventory January 1st. Then throughout the year the company made various purchases. On January 10th they bought 1,000 units at $6. On April 22nd they purchased 3,000 units at $7. On November 15th they purchased an additional 3,000 units at $7.50 and these are the total. All in all they started with 5,000 units. They purchased 7,000 additional units. They have available unit for sale, $12,000. And the total cost, the total cost for beginning inventory plus purchases is $74,500. And we call the $74,500 goods available for sale. And you're going to see this number, the $74,500 and the $12,000 repeatedly throughout this recording. So you need to understand what these numbers are. $12,000 unit is the $12,000 unit that we have available for the whole year. That includes beginning inventory plus all purchases. And $74,500 is our cost of goods sold. Throughout the year we made three sales. We made the sale on January 15th for $3,500 unit on April 27th. For $1,500 unit in November 23,000 unit. In other words, we sold 8,000 units, 8,000 of the $12,000. The question is, which $8,000 unit we sold? Look, on January 15th we sold $3,500. Well, which $3,500 did we sell? Did we sell the $1,000 from this batch and $2,500 from this batch? Or did we sell the whole $3,500 from the $5,000? Or did we sell $500 from this, $1,000 from this, so on and so forth? So the question is, which unit did we sell? And this is where the cost flow assumption comes into effect, comes into play. And which $4,000 unit do we have left? Because if we start, if we have available of 8, I'm sorry, if we have $12,000 available, we sold 8, we must have $4,000 available. Let's take a look at this. In terms of unit, we started with 5, purchase 7. We have $12,000 unit available. Again, those $12,000 unit, $4,000 remained on hand at the end of the year. We still have $4,000 unit and we sold $8,000 unit. So notice that $12,000 will have to be split, 8 to 4, okay? Ending plus sold will equal to $12,000. This is in terms of unit. Now let's take a look in terms of dollar amount. We had $5,000 unit at $5. The beginning inventory was $25,000. $8,000 unit purchased at various prices, $49,500. Total, $12,000 unit and the total goods available for sale is $74,500. So together, the $25,000 plus the $49,500 equal to goods available for sale, the goods available for sale will have to be split between ending inventory and cost of goods sold. So again, you're going to see the $74,500 and the $12,000 unit repeatedly throughout this recording. So to start, I'm going to start to show you the various assumptions that we can make. The first assumption we can make is use average cost to assign cost of goods sold in ending inventory. So our ending inventory and cost of goods sold will be a mix and the mix will be the average cost of the goods available for sale. And we're going to starting with the periodic inventory. Remember you need to know the difference between periodic and perpetual. The periodic is easy to compute because you only have to do the computation once. At the end of the period, you compute an average price and you will assign this average price to ending inventory and to cost of goods sold. Let's take a look at the example. We started with $5,000 unit at $5. Then we purchased $49,500 worth of product, which is $8,000 unit. So the total was $74,500. This is how much we invested. This is how many units we purchased. So in the periodic, we find the periodic average, which is $74,500 divided by $12,000 unit. Our average cost is $6.20. Now what we do, we say we still have $4,000 unit at $6.20 and $8,000 unit at $6.20. Together, if you add them up, they should always add up to $74,500. So notice some of the $74,500 is ending inventory and some of it cost of goods sold. It's split between the two. Remember, if you give more to ending inventory, you're going to take away from cost of goods sold. Or if you give more to cost of goods sold, you're going to be taken away from inventory. So this is how it works. This is for the average cost using the periodic. Now let's learn about the average cost perpetual. Perpetual is a little bit different. You're going to have to compute a moving average, a changing average every time you make a purchase. So rather than having one average, notice here under the periodic, it's easy. You have to compute one average. One average, you compute the average is cost of goods available for sale divided by how many units you have available. While the moving average, you have to add the cost of the previous inventory balance to the cost of the new purchase, then divide the total cost by the number of units on hand. Let's see how the perpetual inventory works. We started with 5,000 units at $5, which is total of 25,000. Then on January the 10th, we made a purchase. Remember, as we just stated, every time you make a purchase, every time you make a purchase, you have to calculate a new average. Well, I have 25,000 from the original beginning inventory, and I invested an additional 6,000. The total invested is 31,000, and I have now 6,000 units, 5,000 from the beginning and 1,000 from January the 10th. Therefore, my new average costs should be between five and six. And my new average cost is 31,000 divided by six is $5.16, and it should be close to five because I have more units purchased at $5. Next, January 15th, I made the sale. I sold 3,500 unit. Which 3,500 unit I sold? It does not really matter. Why? Because I have an average cost of $5.16 rounded. So my cost of goods sold for that transaction is $18,083. Now I might have sold it for $10, $12 per unit. It doesn't really care. I'm not really keeping track of my sales. I'm keeping track of cost of goods sold, okay? Cost of goods sold. Well, if I had 6,000 unit and I sold 3,500, I must have left 2,500 unit at a cost, average cost of $5.16 cent rounded. This is my average inventory, 12,916. Then I purchased 3,000 unit at $7. Remember, every time I make a purchase, I have to calculate a new average. Well, my inventory, the 2,500 comes down, the 12,916 plus my 21,000 that I recently invested. My total invested is 33,916. I had, I purchased 3,000 and I had 2,500. So I have a total unit of 5,500. I'm ready to compute my average. My new average is $6.16, the average cost per unit. Then I made another sale on April the 27th. I sold 1,500 unit at $6.16. I really don't care which unit I sold. I do have a new average cost, which is my cost of goods sold is 9,250 for that transaction. And if I sold 1,500 and previously had 5,500 unit, I will have left 4,000 unit at $6.16. And this will be my average inventory. Then I made a purchase, 3,000 unit at 750. Again, every time I make a purchase, I compute a new average. And what's the average? Well, I have to do, I have to find out how much am I invested. I invested 24,666 from the previous transaction. I just purchased 22,500. I have 47,166 invested and I have 7,000 unit on hand. 4,000 come in from the previous period and 3,000 I purchased on November the 15th. Then I made a sale. It doesn't matter. First, before I make a sale, I compute my new average. My new average is $6 and 76.73 rounded to 74. That's gonna be 6.738. This is the money that's invested. This is how many units I have. Then I made a sale of 3,000 unit. Well, I'm gonna be using the new average. My sale will have a cost of goods sold of 20,215. I rounded a dollar, it's supposed to be 2014, but there's a lot of rounding going on in this example. And if I had 7,000 minus, minus 4,000, minus, if I had 7,000 unit available, minus 3, minus 3,000, I should have 4,000 unit available, which is on year end. And I do have 4,000 unit available at year end. And the cost is $6, 6.738, which is the ending inventory is $26,952. So this is the ending inventory. This is the ending inventory. Now I'm gonna compute, I'm gonna add up all my cost of goods sold. Well, which is $18,083, $9,250, and $20,215. My total cost of goods sold is $47,548. If I add to it my ending inventory, $26,952, that's gonna give me that magic number, $74,500. Remember the $74,500 will have to be split between ending inventory and cost of goods sold. Now, most likely you're saying, hold on a second, isn't that the same numbers as the periodic? And the answer is yes. Look, periodic and perpetual, I'm sorry, isn't this the same as the average? Now let's take a look at the FIFO method. FIFO method stands for first in, first out. Well, what does it first in, first out? That means the assumes the unit that you purchase first are sold first. And the ending inventory consists of the most recently acquired units. Your ending inventory consists with the units that you purchase last. Now what is the positive and negative? Or what's the advantages and disadvantages of the first and first out? Well, guess what? Your ending inventory, your ending inventory is recent. So your ending inventory is a relevant number. It's a recent number. Why? Because your ending inventory reflect the most recently purchased. Your cost of goods sold is old because you are using old cost. Well, regardless, we have to find out how to compute cost of goods sold and ending inventory using the periodic inventory. Well, remember how many units we sold? We sold 8,000 units. Again, this is based on the original data. Well, if we sold first in, first out, well, we're gonna start selling the 5,000 unit from the ending inventory. That's not gonna satisfy the 8,000. Now we're gonna assume we purchased 1,000 units in January 10th. That's also gonna be added. That's 6,000. Then we put on April 22nd, we purchased 3,000 units on April 22nd. Well, of those 3,000, we're gonna sell 2,000. So notice 5,000 plus 1,000 plus 2,000. Those were first in, they are sold first. Those the 8,000 unit that are sold. Then what we have left is 1,000 unit from April the 22nd and from November the 15th, we had 3,000 units. So notice those are all our unit, the 12,000. The first eight are sold. So the first eight are sold. The first eight are sold. So notice now we could compute cost of goods sold. 5,000 unit at $5, 1,000 unit at 6,000, 2,000 at 7. So we sold 8,000 unit and the cost of goods sold is 45,000. Now, this is what's left in ending inventory. Well, what's left is 1,000 unit at 7 and 3,000 unit at 750, total unit 4,000 and ending inventory is 29,500. So again, back to the same concept. 4,000 plus 8,000 equal to 12,000. Those 12,000 unit are split between cost of goods sold in ending inventory. Now we are assigning $45,000 to cost of goods sold in 29,500 to ending inventory. Let's add 25,000 plus 29,500 plus 45,000. That's gonna give us that magic number, 74,500. So this is how we account for FIFO periodically. Simply put, it's easy. We just wait till the end of the year and say we sold 8,000 unit and we'll start to remove the 8,000 unit from the beginning. Now let's take a look at FIFO Perpetual Inventory System. Using the same figures, starting with beginning inventory, we have 5,000 unit at $5. The total cost is 25,000. Our ending balance, 5,000 unit at $5. Total cost of inventory, 25,000. On January 10th, we made a purchase. We purchased 1,000 unit at $6. Now for the perpetual inventory, we have to be careful. We have to keep track of our inventory in chronological order. We're gonna bring down the 5,000 unit at $5. And also we're gonna bring down or add the 1,000 unit at $6. Notice the 5,000 are listed first to determine those were the inventory that we purchased first. Now the total inventory is 31,000. On January the 15th, we sold 3,500 units. Which 3,500 we sold well, we are using FIFO. FIFO stands for First and First Out. Therefore the first units, the 5,000, we're gonna sell 3,500 of those. And what's left is 1,500 of the $5. Now obviously the batch that we purchased at $6, we did not touch, we're gonna bring down. Again, keeping everything at chronological order. And basically now we have 1,500 units at $5. And 1,000 unit at $6. Total of $13,500. On April 22nd, we made another purchase. Well, we purchased 3,000 unit at $7. Now we're gonna have three layers of inventory. We're gonna have, we're gonna bring down the 1,500. We're gonna bring down the 1,000. And we're gonna add to that layer the 3,000. Therefore we have three layers in total of 34,500. Notice we are keeping those layers separately. The $5, the $6, and this is only $7, not $7,000. And this is the first, second, third, if you want to chronologically look at them. On April 27th, we sold 1,500 units. Well, which method are we using? FIFO, if we sold 1,500, we're gonna take this 1,500 out. What's left is the 1,000 and the 3,000. That's all what we have left. And the total inventory is 27,000. November 15th, we purchased an additional 3,000 at 750. Cost on us 22,500. Well, here's what's gonna happen. We're gonna bring down the 1,000 at 6, the 3,000 at 7. And we're gonna add the 3,000 at 750. Total inventory, ending inventory is 48,000 at this point. November 20th, we sold 3,000 units. Which 3,000 units we sold? First and first out. The first one is gone. And we sold 2,000 of this 3,000. If we sold 2,000, we still have 1,000 at 7. Now, we bring down the 1,000 at 7, not 7,000. And the 3,000 at 750. Well, our ending inventory now is 29,500. Well, let's add up all of cost of goods sold, 45,000. Well, if we take 45,000 plus 29,500 equal to that magic number, 74,500. You might be saying, hold on a second. When I did FIFO perpetual and FIFO periodic, I have the same figures. And that's correct. Only FIFO perpetual and FIFO periodic will give you the same number. So notice cost of goods sold is 45,000 under perpetual and ending inventory is 29,500. If we look at FIFO periodic, let's take a look at FIFO periodic. Let's take a look at FIFO periodic and we're gonna see the same figures. Just you need to know this. So if you are giving FIFO periodic and FIFO perpetual, remember that it's easier to compute it through periodic and it's gonna give you the same figure. So just FYI, just make sure you're aware of this. So notice ending inventory is 29,500. Cost of goods sold is 45,000. Same as perpetual. So FIFO it's the same, not LIFO. FIFO it's always the same. So sometimes it's a shortcut. Sometimes if you are giving the problem, it doesn't matter whether you use periodic or perpetual, you get the same cost of goods. Sold the same ending inventory. Now let's take a look at LIFO. LIFO stands for last in, first out. This method assumes the last unit acquired are sold first. Basically the opposite of FIFO. So the last unit that we purchased are the first unit that we sell. Again, this is assumes, it's an assumption. So the ending inventory consists of the first acquired, which are old units. So what is the advantage and the disadvantage of LIFO? Well, last unit reflect the latest cost. So the latest cost is being matched with the latest sales. Therefore your gross profit is accurate. Why? Because your cost of goods sold, remember gross profit sales minus cost of goods sold gives you gross profit. The cost of goods sold reflect new prices. Your ending inventory is old. So your ending inventory consists of old units that have old prices and those prices could be pretty old and you're gonna see later, FIFO is gonna give us some issues we're gonna have to deal with later. So let's illustrate this method using the same data that we used for the other two methods. Remember we sold 8,000 unit. Well, which 8,000 unit we sold, we're gonna start from last. So we're gonna assume under the periodic method we sold the 3,000 that we purchased in November, the 3,000 that we purchased in April, 1,000 that we purchased on January 1st and 1,000 that was from the beginning inventory and all of those add up to 8,000. And what's left in our inventory is the 4,000 unit that were in the beginning inventory at $5. And again, everything add up to 12,000 units. Simply put, ending inventory consists of old units, the old, old units of 4,000 unit and cost of goods sold consists of the 8,000 unit that I spoke about earlier that we purchased that we sold the 3,000 at 750, the 3,000 at 7, the 1,000 at 6 and the 1,000 at 5. Again, total of 8,000 plus 4,000 equal to 12,000 and cost of goods sold is 54,500. Again, if you take 20,000 ending inventory plus 54,500 it's gonna give us back that magic number 74,500 split between ending inventory and cost of goods sold. This is the periodic LIFO. So you do this at the end. Perpetual LIFO, it's different. Perpetual LIFO keeps your inventory up to date. We're starting with 5,000 unit at $5. Then we purchased 1,000 unit at 6. Again, the key is to keep everything in chronological order, just like LIFO. We have 5,000 unit at 5, 1,000 unit at 6. We sold 3,500 unit on January 15th. Which 3,500? We're gonna start from last. We're gonna get rid of this 1,000 and we're gonna be completing the order from the other 5,000, which is 2,500. Well, if we use 2,500 of the 5,000 we must still have 2,500 of the 5,000. And this is from beginning inventory. On April the 22nd, we purchased 3,000 unit at 7. Now we add them. 2,000 unit at 5, 3,000 unit at 7. This is our total inventory. Then we sold 1,500 unit. Which 1,500 unit we sold? We sold this from the bottom. The 3,000 at $7. We sold them for something else. Maybe we sold them for $15, $16, but this is keeping track of cost of goods sold. Well, what do we have left? We still have the 2,500 at $5 and now we still have 1,500 at 7. Then we purchased 3,000 unit at 7.50. Now we have three batches of inventory. The two that we brought in from the prior month and the 3,000 new unit. We have three batches. Then we sold 3,000 unit on November 20th. That's easy. We sold those 3,000 units last in. If we sold that batch, what's left is the 2,500 and the 1,500 which is equal to 4,000. Notice 4,000 unit, the cost of them, the cost for them is 23,000. Now let's add up cost of goods sold. 18,500, 10,500, 22,500 equal to 51,500 plus 23,000. Again, it's gonna give us that magic number, 74,500. That's a split between ending inventory and cost of goods sold. So each method gave us a different figure. For example, the average method gave us a cost of goods sold of 42,548, ending inventory 26,945. And this is the cost of goods sold for 50, 45,000. The cost of goods sold for LIFO, ending inventory is different for each method. However, the total when you add up cost of goods sold in ending inventory for all three methods, it equals to 74,500. Again, 74,500 is a split between those three figures. On the CPA exam and my exam, you have to be comfortable in understanding what difference does it make if prices are rising or prices are declining? So I'm gonna explain to you what happened here. As we were buying inventory, the cost of the inventory was increasing. The cost is rising. So what happened? If the cost is rising, this is what's happening. What's happening is you are matching sales with recent cost. The recent cost is high. Well, if you are matching sale with recent cost, if you're using LIFO, cost of goods sold will be high. So notice if cost is rising, cost of sales will be high. As a result, your net income will be low. As a result, your taxes will be low. If the opposite is true, if costs are declining and you are using LIFO, if you are using LIFO, well, guess what's gonna happen? Your cost of goods sold will be higher. Your net, sorry, your cost of goods sold will be lower because recent costs are lower. Your net income will be higher and your taxes will be higher. Okay? And the opposite is for LIFO. Whatever I said, the opposite is for LIFO because notice here, the costs were rising, LIFO gave you a low cost of goods sold. So LIFO, so LIFO, sorry, not LIFO. LIFO, if cost is rising, let's now apply the LIFO. If cost is rising, if cost is rising, LIFO is gonna give you low cost of goods sold. Why? Because you are using old cost. If you have low cost of goods sold, then what you do, your net income is higher, then your taxes are higher. You have to pay more taxes. Okay? If prices are declining, are declining, LIFO is gonna give you a higher cost of goods sold. Then you're gonna have, if a higher cost of goods sold, you're gonna have lower income and your taxes will be lower. Now generally speaking, costs don't go down, costs usually rise. So once you understand what happened when costs rise, when costs rise and you're using LIFO, cost of goods sold is lower, your net income is lower and your taxes are lower. Okay? Now if you understand this, then you'd understand the others. The average will give you some place in between LIFO and LIFO, the average numbers. Now because of that, the IRS is aware of this. The IRS, the government is aware that if you want to use LIFO, which is LIFO is not allowed for international financial reporting purposes. If you're using LIFO, they know if you would use LIFO, what you would do is you would reduce your income and you would reduce your taxes. So they have a LIFO conformity rule and basically what it says, if you use LIFO for tax purposes, if you're using LIFO for IRS for tax purposes, then you have to use LIFO for external financial reporting. So simply put, you cannot have two sets of books. You cannot say for tax, I'm going to use LIFO and for gap, I would use LIFO. You can do that. If you use LIFO for tax, you have to use LIFO for gap. Now if you use for tax, you'd use LIFO, you could use anything for gap. If for tax you would use the average, you could use anything for gap. The conformity is for LIFO. If you use LIFO for gap, for tax, you have to use it for gap because LIFO saves you taxes. You cannot save taxes, then use LIFO and show higher income because LIFO has a lower cost of goods sold. Well, LIFO has many issues we have to deal with and we're gonna be dealing with in the next few session. We're gonna have to look at LIFO reserve. We're gonna have to look at LIFO liquidation and we're gonna have to look at dollar value LIFO. Also in this session, I did not cover the specific identification method. I will cover it in a separate recording because those are assumptions.