 Hello, and welcome to this session. This is Professor Farhad. In this session, we're going to look at the cost flow of inventory, a topic that's covered in a financial accounting course, as well as the CPA exam. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, tax, and a finance lectures. If you like my lectures, please click on the like button. It doesn't cost you much. Share them. Share the lectures, especially these days with the coronavirus, everybody's home. People are looking for some quality education, and I hope I can provide it. So please share the wealth and connect with me on Instagram and subscribe to the channel. If you are looking to supplement your accounting education or your CPA exam, check out my website. Before we start this session, I would just like to warn you that this session is going to be longer than my usual session. And the reason is I want to make sure you understand all four methods at the same time, because if we skip each, if we do a video for each method, it may not all connect. So it's the best that we do all these four cost flow method in the same video, which it could take up to 45 minutes. That's what I'm guessing, hopefully shorter, but I just want to make sure. So if you are tired, stop, stop, come back later and finish. Okay, so I just want to let you know upfront. So the first thing we're going to start with is an important formula that you need to have a good understanding about. And that formula is how the cost flow in terms of the inventory. First, we start with beginning inventory. So let's assume we are selling pens, pens, we are selling pens, and pencils, let's assume we are selling pencils and each pencil we're going to buy. And to make it easy, each pencil is a dollar, the cost of each pencil is a dollar. So let's have the data on the side. The cost is $1 per pencil. And we started the year with 500 pencils. So we started with 500 pencils when we opened the store. And obviously $1 a pencil will give us beginning inventory of $500. So we have 500 pencils. And I'm using the same number just to keep this just to kind of illustrate the concepts and $500. Throughout the year, we purchase additional pencils. And let's assume we purchase an additional 1500 pencils and for each pencil is for a dollar. And also keeping it for for a dollar on purpose to keep it simple for now to illustrate a particular concept. So we purchased an additional 1500 pencil and each pencil for a dollar. Now, what we started with is 500 pencils, then we purchased 1500, then we purchased 1500 pencils. Beginning inventory plus purchases gives us a new a new number called merchandise available for sale. So we had available for sale 2000 pencils throughout the year. And the dollar amount is obviously $2000. So notice I'm keeping it simple with the dollar amount. So this is what we started with. So we started with 500 pencils, we purchased 1500, we have 2000 available. And the price per pencil is a dollar. Therefore, we have 2000 pencils. At the end of the year, the company will take an inventory count. And that inventory count will determine how many pencils that we have left. And let's assume for the sake of illustration, we still have 300 pencils. In other words, we still have 300 worth of inventory. By knowing how much we have left, by knowing how much we have left, the the assumption is the remaining are not there. So the 1700 pencils. So the remaining is cost of goods sold. So there's an important relationship here available for sale, which is 2000 will have to be split between ending inventory and cost of sales, whatever I give to ending inventory takes away from cost of sales. So if I have 400 pencils left, it means I sold 1600. If I have 500 left, it means I sold 1500. Okay, now how much I sold them for that's a different story. Maybe I sold each pen for that $2 and 50 cent. We're not concerned about the selling price for now. So the important concept is available for sale is 2000. And this number will have to be split between ending inventory and cost of sales. That's a very important concept and accounting. I'm going to take a little bit further. There is a negative relationship or there is a zero sum game between those two account. What do I mean by negative relationship? If this one goes up, cost of goods sold goes down. If ending inventory goes down, cost of goods sold goes up. So whatever you don't have, whatever you don't have, if it's not an ending inventory, the assumption it sold, this is an important concept or an important equation for this chapter. And I'm going to go back and revisit this concept again and again as I work in the example. So make sure you understand this very, very much. Now, we're going to be using the perpetual inventory system and how does the perpetual inventory system work? Basically inventory affect both the balance sheet because when we buy inventory, we put the inventory on the balance sheet. When we sell the inventory, the inventory turn into cost of goods sold and we already learn about this. So this is basically the matching principle. Now, the way the inventory, physical flow of inventory works, it doesn't have to follow. The physical flow need not to follow the cost flow. What does that mean? Well, we're going to see what does that mean in a moment, but that's an important concept. Let's assume you are selling the first item that you purchased first. So it's this first and first out. The way you do accounting, you don't have to do accounting based on that, based on the physical flow. So if you're selling your inventory first in, first out, and we'll talk about this more, but in a second. So if you are selling the inventory, the first item that you buy, you sell first. Well, that's how the physical flow is happening. For an accounting perspective, when you account for it, you don't have to use this method. You could use another method. So you do have that flexibility and this is what's going to bring us to the new concept in this chapter is the inventory costing method. There are four inventory costing method to assign inventory and cost of goods sold because you will see that depending on the method that you use, you will find different ending inventory. So we either have the specific identification, we have something called FIFO, we have something called LIFO, and we have something called the weighted average. Now in the real world, FIFO is used the most because FIFO is how the physical flow of goods work. Generally speaking, companies would like to sell the first items first. So first in, first out. And this is why most companies use FIFO because that's how the physical flow works, but it doesn't matter. Even if you're using FIFO for the physical, you could use any of the other method for the other method. So make sure, up front, I want to make sure you're aware of that. So to illustrate this concept, the best way to illustrate this inventory cost flow concept is to work examples. Now I'm going to go over this slide very slowly. If you don't have the PowerPoint slides, please copy the numbers down because we're going to be using those numbers to illustrate all concepts. So we're working with A, we're selling bikes. And here's what's happening. When we start the beginning of the period, and the beginning of the period happens to be August 1st, we had 10 units, we had 10 bikes. And each bike, we pay for it $91. Therefore, we have $910. And it's an inventory cost. And we have 10 units in inventory. Then on August 3rd, which is two days later, we purchased 15 bikes. So we made another order. And we purchased them at 106. So this is a little bit different than my example. My example was I was buying pencils at $1. So it was easy. So you're going to see when you have a different dollar amount, you're going to see that you have to be very careful in how you do things. So you purchased 15 new bicycles, bikes at 106. So the price notice, the price of the bikes went up, and you invested $1,590. And now you have your ending inventory 25 units. 11 days later, August the 14th, you sold 20 bikes. Now, you sold 20 bikes, and you sold them for 130. It doesn't matter what you sold them for. Now, if I ask you, which 20 bikes you sold? So which you sold 20, you have 25. Which 20 you sold because you need to cost them? Well, it makes a difference if you sold 15 of this and five of this. You could also sell 10 of this and 10 of this. So depending on which 20 you sold, it's going to determine your cost of goods sold. Basically, your selling is 20 times 130. That's easy. But what is your cost for that sale because you sold the 20 bikes? Well, some of them are 91, some of them 106. Which one did you sell? Well, it all depends on the inventory method that you are using, whether you are using FIFO, LIFO, or the weighted average. Therefore, we have to learn about those methods and copy this data down and we're going to work these assumptions. August the 17th, you purchased more units. You want to purchase more because, you know, you're down to five units. You purchased 20 units at 115. Again, now you're back to 25 units. Then you purchased 10 units at 119. You even purchased more. You're anticipating sales. Now you have 35 units. And as expected, you sold the 23 units. As expected, you wanted to sell more units. You sold the 23 units at 150 last day of the month, August 30th, August 30th. And you still have, since you sold 23, you still have 12 units. Now which 23 you sold? Because remember, you have 35 in total, which include bikes bought at different prices. Okay. So which 23? But regardless, here's what we have. In total, we had 55 units available for sale. So units available for sale. This beginning inventory, let me show you how we compute available for sale. Beginning inventory 10 plus purchase, plus purchase, plus three purchases, we have 55 units. And goods available for sale is beginning inventory plus all the purchases, 5,000, 5,000, let me change my pen here, 5,990. Remember, this number 5,590 will have to be split between ending inventory and cost of goods sold. So copy this number down because you're going to see it repeatedly. Also the 55 units, those 55 units, those 55 units, they will have to be split. They already told you how the split is. We sold 43 and we still have 12 units. So in terms of units, we're going to have an hour ending inventory 12 and we sold 43. So in terms of units, it's always going to be the same. In terms of the dollar amount, ending inventory and cost of goods sold, it's all going to depend on the inventory method that we are using. So now we're going to go ahead and illustrate those inventory method using this example. So if you don't have this example, take a picture of your phone and follow as I'm doing this. So we're going to, the first method we're going to be using is called FIFO, FIFO stands for first and first out. The reason I start with FIFO because it's the most intuitive because whenever you purchase first is you sell first. That's how most businesses do things. So first, the oldest cost, the oldest cost is sold first. So the oldest inventory is sold first. So it goes into cost of goods sold. So the recent cost, the recent inventory, it stays an ending inventory. So this is basically the idea behind FIFO. So your cost is old. Your inventory is no because it's the most recent you still have. So again, we're working with this example. So this is the example that you should have. This is the slide that I went over. Now let's start with FIFO. Remember, on this slide, you're going to have goods purchased, a column for goods purchased, a column for cost of goods sold, and the column for ending inventory, three columns. The first, remember August 1st, we had 10 units at $91. That's fine. On August 3rd, we purchased 15 units at $106. Now our inventory consists of two layers, one, $10 at $91, another 15 units at $106, so not $10, 10 bikes at $91, $15 bikes at $106. You have to keep those in chronological order. So the 10 units are first, you'll list them first, the 15 units are next, you'll list them next. And now the total amount invested in your inventory is $2,500. Now we're using FIFO. We sold 20 bikes on August 14th. Which 20 did we sell? Before using FIFO, we're going to sell those 10 first, so those are gone, and we're going to sell 10 of those. And of those 10, what's going to be left is five. So we sell 10 bikes in, with the cost of $91, we sell 10 bikes with the cost of $106. Now how much did we sold them for? It doesn't matter. Maybe we sold each bike for $150. It doesn't matter. It's not the selling price. We are keeping track of cost of goods sold. Now, so your cost of goods sold is $1,970 for this sale. This is your cost of goods sold. And you still have the five bikes with the cost of $106. You have to keep yourself organized here because the 10 bikes, let me, those 10 are gone. And what's left of the 15, what's left of those 15, what's left of those 15 here is only five. Okay? Now, you make another purchase. You purchase 20 bikes at 115. Remember, you're going to bring the five down because you still have those five bikes in your inventory. And now you have a new batch, 20 bikes at 115. Then, August 28th, you purchase an additional 10 bikes at 119. Now, you bring down the five. You bring down the 20 because you still have them. And now you have an additional 10 bikes at 119. So your total inventory now is 4,020. On August 30th, you sold 23 bikes. The question is, which 23 you sold? Which 23 bikes you sold? Well, depending on the method that I'm using, I'm using FIFO. That means I sold those five are gone. And I need to sell 18 of this 20. So those five are gone. If 18, what's left of those 115 is two. So five at 106, the oldest one in 18 at 115. Now, my cost of goods sold for this sale is 2,600. And I still have two bikes at 115. And the 10 bikes that I purchased last, I still have. So notice, as I told you, we're going to have 12 bikes in ending inventory. So we still have 12 units. And those 12 units, they have a cost of 1,420. Our cost of goods sold consists of 1,970 plus 2,700 equal to 4,570. And we sold 43 units. You can count them. Notice 10 plus 1020 plus 5 plus 18, 43 units. So we sold 43. We still have 12. If I add, if I add those two numbers, and I'm going to do this repeatedly, if I add cost of goods sold, the total cost of goods sold, total cost of goods sold and ending inventory, ending inventory, total cost of goods sold, I add all the cost of goods sold that I incurred plus ending inventory, they will add up to, you guessed it, 5990. We're going to repeat this number repeatedly, 5990. So this is how we do, we sell inventory using FIFO, first in, first out, the perpetual method. Now we're going to use the same example, we're going to use the same example using LIFO. LIFO stands for last in, first out, LIFO. What's LIFO? Well, last in, it means the one that you purchased last are sold first. So the recent cost, the recent inventory goes into cost, and the old inventory stays in ending inventory. So your inventory is old, but your cost of goods sold is recent. So this is recent or new, and your inventory is old. So this is the, this is the feature of LIFO. So again, we're using the same exact example for the same company. Now we're going to be using LIFO, last in, first out. Again, same thing. We started with 10 units at 91 dollars, then we purchased 15 units at 106. Again, make sure you keep yourself organized, the 10 unit comes first at 91, 15 units at 106. Then remember August the 14th, I sold at 20 units. Which 20 units I sold? Now I'm going to go and sell the 15 units first. So those are gone, and to fill the order, I need to sell five of those. So what I have, I still have five units at 91. So my cost of goods sold consists of the 15 units at 106, and the five units at 91. Now how much did I sold them for? It doesn't matter. I'm going to tell you I sold them for 150, it doesn't matter. So this is my first cost of goods sold for the 20 units. I still have five units at 91 dollars. Then I purchased 20 units at 115. I bring down my five, I still have those five bikes, and now I added more to it 20 new bikes. I even purchased more, then I purchased 10 bikes at 119. So I bring down my five, I bring down my 20, now I have another 10 units, 10 bikes. Now August 30th, I sold 23, 23 bikes. I sold 23. Which 23 did I sell? Well, I'm going to start from the bottom, last and first out. Those 10 are gone, and what's going to happen is I'm going to sell 13 of this 20. If I sold 13, I still have seven left. So I sold the 10 at 119 and 13 at 115. This is the cost. Now I still have the five unit at 91. My cost of goods sold for this sale is 2685. Notice I still have five plus seven equal to 12 units in ending inventory, with a cost of 1260. And my cost of goods sold, if I add them up, my cost of goods sold is 4730. So my ending inventory 1260, my cost of goods sold is 4730. And guess what? I'm going to do this computation, and if you add them up, they will add up to 5990. Notice I sold 43 units, and I still have 12 units. So it's the same concept, except it's given me different cost of goods sold in different ending inventory. Now we're going to look at this in terms of how does it affect your bottom line once we are done with this computation. So this is the second method. A third method is called the weighted average. Now what do we need to do under the weighted average? We all know what an average is. Average is the average number, basically taking the sum divided by the number of units. But this is a weighted average, and we're going to see what that means in a moment. Just I want you to remember this, you have to compute a new weighted average every time you make a purchase. This is important because students don't pay attention to this. If you are using the perpetual moving average, you have to compute a new average every time you make a purchase. When unit is sold, the average cost of, when the unit is sold, the average cost, whatever that cost is of each unit is inventory is assigned. So we don't care if it's first and first out. We don't care about this. All we care about is the new average. What's the new average? And we assign the new average cost to the sale. So how do we compute this? We're going to take cost of goods available for sale at any point in time, divided by the units on hand on the date of the sale. We're going to see how it works in a moment. Again, using the same exact example. So we're using the same data. That's why I keep showing you the slide to keep reminding you I'm using the same data. So first, first is, let's look at this one first. I have 10 units at $91. Remember, I start with this. If I ask you, what is my average cost? You would say $91. Now, the second thing, the second transaction for the month of August, I purchased 15 units at 106. Every time I have a purchase, I have to compute a new average cost. Remember, I have a purchase. I have a new average cost. Well, I have 10 units at 91 plus 15 units at 106. Now, the first thing you want to make sure, your average, it's going to be in between those two figures. So your average cost has to be between 91 and 106 and closer to 106 because you have 15 units at 106. How do I compute this? How do I compute this? $10 times 91. That's $910. $15 times 106 is $1590. So $910 plus $1590. My total cost available for sale is $2,500. That's my dollar amount. And I have 25 units. I will take my dollar amount, $2,500 divided by 25 unit. And my average cost is an easy answer of $100. So my average cost now is $100. After I make my next, my second purchase, I computed my cost. So I have $2,500. My average cost is $100. Now, I keep using this average cost until I make a new purchase. Now, August the 14th, I made a sale. It doesn't matter which unit I sold. I sold the 20 units. My average cost is $100. So now my cost of goods sold is $2,000. I still have five units at an average cost of $100. So it doesn't matter which one I sold. I'm going to be using the average cost. Let me erase everything on the screen and show you how I did the computation. So $2,500 divided by 25. So I don't care which five units I sold. And I still have five units at $100. Now, let's see what happened next. What happened next is I made a new purchase. Remember, I had now five units at $100. Then I made a new purchase. I purchased 20 units at $1,500. I have to do the same computation. So I have five units. My pen is acting up. I have five. I have five units at $100, which is equal to $500. And I have 20 units at $1,15, which is equal to $2,300. Now, my dollar amount is, sorry, my pen is not working properly, but the numbers are on your screen. So I have $2,800 in terms of dollar amount, and I have 25 bikes. When I take the average, $2,800 divided by $2,500, it's going to give me a new average cost of $1,12. Now, my new average is $1,12. Now, I don't care what I have the first and first out. I have 25 units, 25 bikes with an average cost of $1,12. And remember, notice the average cost has to be between $100 and $1,15. It is $1,12. So in case you want to double check your math, again, this is the computation on your screen. $2,800 I have in total cost of goods sold. I have 25 units in total inventory. $1,12 is my cost. Okay. This is how I did the computation. Part three, I made another purchase. I purchased 10 additional units at $1,9. So I'm going to show you the computation and my average cost will be $1,14. Every time I make a purchase, I compute a new average cost. Now, my inventory is my cost available for sale is $3,990. How did I know this? Well, it's $2,800. Then I added $1,190. That's $3,990. And I have 35 bikes. Now, my new average cost is $1,14. Now, I sold. The next thing I'm going to do, this is a detailed computation of I came up with $1,14. Now, I sold. Remember, I sold 23 bikes. It doesn't matter which 23 I sold. My latest average is $1,14. So this is my cost of goods sold for this transaction. I still have, if I had 35 sold 23, I still have 12, which I should. And my average cost is $1,14. Therefore, ending inventory is $1,168. Cost of goods sold is $4,622. And if you add those two figures, they will add up to $59. If you add them up, they will add up to $5,990, which is the goods available for sale. Total of goods available for sale. So this is the weighted average. This is the weighted average. And this is a summary of the weighted average. If you're going to look at the summary, again, this number plus this number equal to $59,990. And you're going to see why I keep repeating this, because it's very helpful for you. And this is the detailed computation in case you want to go back and view the computation. Again, last method is the specific identification method. The specific identification method is a method that can specifically identify which unit you sold. So you're not saying first and first out, you're not taking the average. What you are doing in this method is you are identifying somehow each unit is tagged by a serial number, by something that you can track it with. And this is the most expensive method to use, because now each unit of your bikes or each unit of your product has to be tagged. Now, in order to complete the specific identification, you have to be told. So for example, when you sold those 20 units, they have to tell you, for example, you could have sold 13 of those and 7 of those, or you could have sold 12 and 8. You could have sold 10 and 10. So under this specific identification, you have to be told which unit you have left or which unit you sold. You have to specify. So on the problem, they have to specify. So here, I'm going to solve the problem by telling you exactly what did we sell or what did we have left in ending inventory, but under the specific method, you have to be told. So to illustrate the specific identification, remember we had 59.90, the total goods available for sale. You remember, I kept using this number, is because this, when we sold the 20, you remember on August the 14th, we sold 20 units. We sold 8 for the 91 and 12 for the 106. This was the combination. So we went and we selected those 8 bikes that we purchased them for $91 and we selected specifically those 12 bikes that we purchased them at 106. On August 30th, we sold 23 bikes. Here's what we did. For the 23 bikes, we, for the 23 bikes, we sold the two units at 91. So the 91 are gone. We sold the three units at 106. We sold 15 units at 115 and three units at 119. So again, we went in there and we selected which units specifically we took out. So our total cost of goods sold is $25.82. Now, well, total cost of goods sold for both sales is $48.50. If I take goods available for sale, remember goods available for sale will have to be split between ending inventory. This is $5.09. Remember, 59.90 will have to be split between ending inventory and cost of goods sold. Now, I know my cost of goods sold is $4,500 and $82. My ending inventory must have been $14.08. They could have also gave you ending inventory is $14.08. They could have told you, you know, you're using the specific identification and you still have those units and they have a value of $14.08. The 12 units have a value of $14.08. Remember, because we still have 12 units and we sold 43. If they gave me the $14.08, I can find cost of goods sold. So under the specific identification, first know what's your total, which is goods available for sale, and they'll either have to give you the ending inventory or the cost of goods sold. Now, let's take a look at the financial statement effect of cost and goods. So let's see. First and first out, ending inventory, if you're using first and first out, the advantage of it is your ending inventory represent your current cost because your old inventory is gone. You still have your new inventory. This is an advantage of first and first out. LIFO, the advantage for LIFO is the cost of goods sold on the income statement approximate the current cost. So the cost of goods sold is most recent. Therefore, it's showing the most recent cost. Now, the disadvantage is the opposite. The disadvantage is the opposite. Under LIFO, the disadvantage is your cost of goods sold is old. Under LIFO, the disadvantage, your inventory is old. This is the disadvantage. And obviously, the weighted average is in between. Smooth price is out. Let's give you the average. Now, let's take a look at the bottom line. Basically, let's take a look at the bottom line. So here, we are using the same scenario and we sold those 43 bikes for 6050. So this is the selling price. Okay, so this 6050 is the selling price. And notice we have the specific identification, LIFO, LIFO weighted average. Okay, now let's take a look at the specific identification. Under the specific identification, cost of goods sold was 4852. Sales minus cost of goods sold gives you gross profit, minus operating expenses equal to income before taxes, minus taxes will give you net income, net income is 713. So under the specific identification, your net income is 714. And you still have inventory of 1408. Remember, if you add those two numbers, the blue numbers, they're going to give you 5990. I'm not going to do this, but you can do it. Under LIFO, your sales is the same. Your cost of goods sold is 4570. You already computed this, gives you gross profit, minus operating expenses gives you income before taxes, minus taxes gives you net income of 721. So notice your net income is higher under LIFO. It's 721. Under LIFO, your net income is 609. Under weighted average, your net income is 685. It's the same company, but if they use a different inventory method, it's going to give them a different bottom line, different bottom line. So this is what I'm trying to show you here. Now, if you are the owner of this company, if you are the owner, which method you would prefer if you are the owner of the company? Well, if you are the owner of the company, you would prefer to use LIFO last and first out. You might be asking, hold on a second, but LIFO gives you the smallest profit. Yes, it gives you the smallest profit. It also gives you the smallest tax bill. As the owner, you're interested in saving on your taxes. It gives you the smallest tax bill. Okay. If you are the manager of this division and you want to, and your bonus depending on net income, you would use LIFO. Why? Because it's going to give you the highest net income. Now, what I want to show you is this. When prices are going up, this is what will happen. When prices are going up, remember when we were buying, when we were buying those bikes, the prices after each purchase, it was going up. Each purchase, the prices were going up. As the prices go up, if you're using LIFO, it's going to give you small profit. And if you're using LIFO, it's going to give you a large profit because you are matching old, low prices with new sales. And the opposite is true. If the prices of those bikes were going down, if the prices of those spikes were going down, LIFO is going to give you the large profit and LIFO will give you the small profit. Okay. The way that average is always, it will be someplace in between. Now, since we talked about taxes, I just want to make sure you're aware of a rule that you have to use. The IRS requires that when LIFO is used for tax reporting, it must be used also for financial reporting. So simply put, if you're using LIFO for tax purposes, if you're preparing your taxes and you're using LIFO, why do you use LIFO? Remember, if prices are going up, it's going to give you the lower tax bill, lower tax bill. So if you are using LIFO to lower your tax bill, that's fine with the IRS. However, when you prepare your financial statements using GAP, you have to also use LIFO. So you cannot have a low tax bill, then go to GAP and use LIFO and have a high profit. You cannot have the best of both words. If you're using LIFO for tax, you have to use LIFO for financial. This is called the LIFO conform material. Simply put, if you're using LIFO for one, for IRS, you have to use LIFO for financial. Now, if you're using LIFO or some other method for tax purposes, you could use any method for financial, for GAP, but only LIFO for tax. If you're using LIFO for tax, they restrict you. And basically, this is it. If you like this recording, please like it, share it, subscribe. In the next session, I would look at lower of cost or market. Remember, I do have additional resources. If you're studying for your CPA exam, or if you want to supplement your education, check out my website, Study Hard Accounting is worth it. Good luck and stay safe.