 Hello and welcome to this 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 and get expense. 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 they're going to have we're going to learn about various assumptions. The first assumption it's going to be called five 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 or 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 is the first inventory that we get rid of. In the real world, most inventory most inventory is five or 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 pairs 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 life or stand 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, 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. 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 an intermediate accounting and heavily on the CPA exam so it's very important that you learn this topic inside out. Whether you are an accounting student or a CPA candidate I strongly suggest you take a look at my website far hat lectures calm. I don't replace your CPA review course you keep your CPA review course I'm a useful addition. I can add knowledge I can add 10 to 15 points to your CPA exam by helping you understand the concept behind the theory. I move much slower than your CPA exam I give you examples I give you practice multiple choice through false so I can help you prepare for your CPA prep course which will help you prepare for the CPA exam. My subscription is a nominal subscription give me a chance for a month. You find it's helpful you keep it you don't you cancel. Take a look at my website if not for anything to find out how well or not well your university doing on the CPA exam. This is a list of all the accounting courses that I have resources for advanced accounting taxation managerial accounting auditing intermediate so on and so forth. My CPA supplemental material is aligned with your backer Roger gleam and why so it's very easy to go back and forth between your CPA review course and my material and I also give you access to all the CPA previously released questions with detailed solution. Almost 1500 previously released questions if you have not connected with me on LinkedIn please do so take a look at my LinkedIn recommendation like this recording share it connect with me on Instagram Facebook Twitter and Reddit. 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 it'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 concept. So we're going to be working with a company with a starting beginning inventory of 5000 units and they paid for those 5000 unit $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 1000 unit at $6 on April 22nd they purchase 3000 unit at $7 on November 15 they purchase an additional 3000 unit at $7 and 50 cent and these are the total. All in all they started with 5000 unit they purchased 7000 additional unit they have available unit for sale $12,000. In 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 number 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 we made the sale on January 15 for 3500 unit on April 27 for 1500 unit in November 23,000 unit. In other words we sold 8,000 unit 8,000 of the 12,000. The question is which 8,000 unit we sold look on January 15 we sold 3500. Well which 3500 did we sell that we sell the 1000 from this batch and 2500 from this batch or did we sell the whole 3500 from the 5000 or did we sell you know 500 from this you know 1000 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. In which 4000 unit do we have left because if we start if we have available of eight and sorry if we have 12,000 available we sold eight. We must have 4000 available. Let's take a look at this in terms of unit we started with five purchase seven we have 12,000 unit available. Again those 12,000 unit 4000 remained on hand at the end of the year we still have 4000 unit and we sold 8,000 unit so notice that 12,000 will have to be split eight to four. 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 5000 unit at $5 the beginning inventory was 25,000 8,000 unit purchases purchased at various prices 49,500. Total 12,000 unit and the total goods available for sale is 74,500. So together the 25 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 and 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 5000 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 4000 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. 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 unit 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 5,000. I have 25,000 from the original beginning inventory and I invested in additional 6,000. The total invested is 31,000 and I have now 6,000 unit, 5,000 from the beginning and 1,000 from January the 10th. Therefore my new average cost should be between 5 and 6 and my new average cost is 31,000 divided by 6 is $5.16 and it should be closer to 5 because I have more units purchased at $5. Next January 15th I made the sale. I sold 3,500 units. Which 3,500 units 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 units and I sold 3,500 I must have left 2,500 units at an average cost of $5.16 rounded. This is my average inventory, 12,916. Then I purchased 3,000 units 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 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 units 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 units I will have left 4,000 units at $6.16. And this will be my average inventory. Then I made a purchase 3,000 units at $7.50. Again every time I make a purchase I compute a new average. And what's the average? Well I have to find out how much 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 $6.76.73 rounded to 7,400. It's going to 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 units. Well I'm going to be using the new average. My sale will have a cost of goods sold of 20,000 to 15,000. I rounded a dollar. It's supposed to be 20 to 14,000 but there's a lot of rounding going on in this example. If I had 7,000 minus 4,000, minus if I had 7,000 units available minus 3,000, I should have 4,000 units available which is on year end. I do have 4,000 units available at year end. The cost is $6.738 which is the ending inventory is $26,952. This is the ending inventory. I'm going to compute. I'm going to add up all my costs of goods sold. Well, which is $18,083,9250 and $20,215. My total cost of goods sold is $47,548. If I add to it my ending inventory, $26,952, that's going to 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 it assumes the unit that you purchased first are sold first. And the ending inventory consists of the most recently acquired units. Your ending inventory consists with the units that you purchased last. Now, what is the positive and negative? What's the advantages and disadvantages of the first in, first out? Well, guess what? Your ending inventory, your ending inventory is recent. 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 going to start selling the 5,000 unit from the ending inventory. That's not going to satisfy the 8,000. Now, we're going to assume we purchased 1,000 units in January 10th. That's also going to 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 going to sell 2,000. So notice 5,000 plus 1,000 plus 2,000. Those were first in, they are sold first. Those are the 8,000 units that are sold. Then what we have left is 1,000 units from April 22nd and from November 15th, we had 3,000 units. So notice, those are all our units, the 12,000. The first 8 are sold. So the first 8 are sold. The first 8 are sold. So notice now we could compute cost of goods sold, 5,000 units at $5, 1,000 units at 6, 2,000 at 7. So we sold 8,000 units 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 units at 7 and 3,000 units 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 units are split between cost of goods sold and 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 going to 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. Under FIFO perpetual, which is we are keeping track of our inventory constantly. It's 5,000 unit times 5, which is 25,000. Then we purchased 1,000 unit at $6. What we need to do now is to keep track of our inventory chronologically. Chronologically means list them in order. We have the 5,000 unit at 5. We have the 1,000 unit at 6. So notice the first and first out. We'll keep them separately. The 5,000 were first. Then we sold 3,500 unit. Well, if we sold 3,500 unit, we're going to be selling from this 5,000. So the cost of these 3,500 is $5. The cost of goods sold for this transaction is $17,500. Remember, this is cost of goods sold. Now, if we sold 5,000 of these units, what's going to be left is 1,500 of these. So we're going to have 1,500 left from the 5,000 and we did not touch this 1,000. It comes down. But they stay in order. That's the key. On April the 22nd, we purchased 3,000 unit at $7. Now we need to bring down our old inventory, then add to it the 3,000. Notice we bring down what we had prior. Then we add to it the 3,000. Notice I'm keeping everything in chronological order and this is the total inventory at this point. Then I sold 1,500 unit. Which 1,500 unit I sold, I'm going to start first and first out. This is the 1,500. This is gone. So notice my beginning inventory is gone because I sold 3,500 here, 1,500 here. All this beginning inventory is gone, basically gone. So if I get rid of this 1,500, what's left is those two. So I'm going to bring down those two, the 1,000 unit at 6, the 3,000 unit at 7. Then I purchased another 3,000 unit at 750. Well, again, I'm going to bring down what I have and add to it my last batch. So bring down what I have, add to it the last 3,000. Then I sold 3,000 unit. Which 3,000 unit I sold? Well, I have to start from the beginning. To fill the order, I have to get rid of this 1,000. Then I have to use 2,000 out of this one, out of this the 3,000. So what's going to happen is I'm going to have 1,000 unit left at 7 and the 3,000 unit at 750, which it makes sense. I'm supposed to have 4,000. And indeed, I still have 4,000 unit. And if I compute my 4,000 unit, it's going to give me 29,000. 1,000 unit at 7, 3,000 unit at 750. It's going to give me 29,500. Let me add up all of my cost of goods sold, 20 plus 7,500 plus 17,500. My cost of goods sold equal to 45,000. Plus my ending inventory will give me again this magic number, 74,500. Now maybe you noticed that the perpetual FIFO and the periodic FIFO gave me the same answer. And the answer is yes. And this happens to be for FIFO. For FIFO, whether you use the periodic or whether you use the perpetual, it's going to give you the same answer, the same answer. So notice 45,000 for cost of goods sold is the same 45,000 that we computed earlier for periodic FIFO. It's only for FIFO. It doesn't work for LIFO. 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 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 going to see later, FIFO, it's going to give us some issues, we're going to 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 units. Well, which 8,000 unit we sold, we're going to start from last. So we're going to 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 units. 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 going to 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 units at $5. Then we purchased 1,000 units at 6. Again, the key is to keep everything in chronological order, just like FIFO. We have 5,000 units at 5, 1,000 units at 6. We sold 3,500 units on January 15th. Which 3,500? We're going to start from last. We're going to get rid of this 1,000. And we're going to 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 22nd, we purchased 3,000 units at 7. Now we add them. 2,000 units at 5, 3,000 units at 7. This is our total inventory. Then we sold 1,500 units. Which 1,500 units we sold? We sold this from the bottom. The 3,000 at $7. We sold them for something else. 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 units 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 units. We have three batches. Then we sold 3,000 units on November 20. 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 units, 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 going to 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 5,000, 45,000. The cost of goods sold for LIFO. Ending inventory is different for each method. However, the total money 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 going to explain to you what happened here. 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're 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 going to happen? Your cost of goods sold will be higher. Your net cost of goods sold will be lower because recent costs are lower. Your net income will be higher and your taxes will be higher. And the opposite is for FIFO. Whatever I said, the opposite is for FIFO because notice here, the costs were rising. FIFO gave you a low cost of goods sold. So LIFO, sorry, not LIFO, FIFO, if cost is rising, let's now apply it to FIFO. If cost is rising, FIFO is going to 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. If prices are declining, FIFO is going to give you a higher cost of goods sold. Then you're going to have, if a higher cost of goods sold, you're going to 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, and you're using LIFO, cost of goods sold is lower, your net income is lower, and your taxes are lower. Now, if you understand this, then you'd understand the others. The average will give you some place in between FIFO and LIFO, the average numbers. Now because of that, the IRS is aware of this. 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 FIFO. 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 FIFO, 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 your taxes. You cannot save taxes, then use FIFO and show higher income, because FIFO has a lower cost of goods sold. Well, LIFO has many issues we have to deal with, and we're going to be dealing with in the next few sessions. We're going to have to look at LIFO reserve. We're going to have to look at LIFO liquidation, and we're going to 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. Again, I'm going to invite you, whether you are an accounting student or a CPA candidate, to take a look at my material, farhatlectures.com. I give you lectures, resources, multiple choice, exercises that's going to help you understand the material, which in turn will help you with your CPA exam preparation, which is with your CPA review course. I'm a useful addition to your CPA review course. I explain the material differently, slower, give you more examples. The CPA exam is a lifetime investment. Don't shortchange yourself. $30, give it a try. You like it, you keep it, you feel it's not helping you, you canceled. Invest in yourself and stay safe.