In this final episode of the first week, I'd like to say a few words about some other important concepts that we're dealing with when accounting for inventories. And these will be labeled with very well known abbreviations. FIFO, LIFO, and LCM, sort of like this. Well, so the story goes that in accounting for inventories, we have to go along with the following procedure. First of all, we identify cost. Then we select, The system for inventory records. Then we select a cost flow assumption. And finally, we apply the lower of cost of market concept. Well, that seems sort of generic. So I will delve a little bit deeper so that you will see whats going on here. First of all, let's start with the cost. We have to properly identify the cost of inventory and that means that first of all, we have to include all costs. And that goes with insurance, with transportation, with some other components, not only the purchase price. And these costs to place the inventory ready for sale. Not only do we have to properly take them into account, but then they all go to the balance sheets. So they are capitalized. Then we use a cash equivalent of the cost. So for example, if we have a discount or if we pay interest if we pay later for this inventory. Then all this interest, that goes to the income statement. So we don't capitalize that. And then also we put the cost net of all discounts. For example, if we paid earlier than we could have, and this way, we enjoyed some discount, then we create a separate, special account. So that deals with the cost. Now, these system for inventory records, cost flow assumption. They sound somewhat strange now. Let's go over them in somewhat greater detail. Now these systems, For inventory records. Basically, we talk about either a perpetual system. In this, what's going on is that after each and every transaction, we adjust the balance of inventory count. So that's kind of cumbersome, but this is a little bit more accurate. Mainly, it reduces the probability of a mistake, now it's much easier to use the system with the advanced IT technologies, but the most often used is the periodic system. In which, we basically take the period, and then we say that this is beginning inventory plus purchases as before then, minus ending inventory, and that is the cost of goods sold. That is what we do. And it is normal within this periodic system that people use the most widely applied cost flow assumptions, namely LIFO. And now we go to the cost-flow assumptions. And these are maybe basically four. First of all, specific identification. Well let's say that for each and every piece of goods in your warehouse, there's a label affixed. So when you sell it, you know exactly how it costs. But if you talk about something that is purchased in large volumes, like a truckload of timber or something else in some sacks or packages, then in this case, this is a highly unrealistic thing, and we move on to the other thing, which is weighted average. So basically, we take the overall amount when we calculate how many units in there. We divide one by the other, and we say that the average cost of this piece of goods is as such. And then, there are two more that are quite famous. This FIFO that stands for first in, first out, and then LIFO. In this case, for example, we have a batch of goods that we purchased earlier than another, later than another, later. So basically when we sell them, we, in recording, we act like as if we were selling the first things that were purchased earlier. Let's say if there is inflation, then clearly under FIFO, the cost of goods sold will be lower. And if we use LIFO, it will be higher. Now the reason I'm saying that, the examples of that are plentiful in our handouts. But for now, I would like to say that for many years people were allowed to use FIFO for income reporting and LIFO for tax purposes. And in this case, it was not quite consistent. And later, it was abolished. Now, you can choose either system, but ue one and the same one for both income reporting and for tax purposes. And then the final thing that is kind of important here is the application of lower cost market. So here the story is that we treat gains and losses asymmetrically, gains when realized. So for example, if you had an investment in stocks, you bought that at 80 bucks, then it went up to 100. But if you haven't sold that, you don't have any gain. When you did sell at 100, then you record the gain of 20. However, losses are taken into account even when potential. So basically, if, for example, you bought the stock as a short term investment at 80, now the market price went down to 60. You didn't sell it, but still, for the next period we have to put this cost as 60. So this is the result of the use of the conservatism principle. And again, examples are in handout, but for now, I would like to briefly recall the important discussion that we had in our very first course of this specialization, namely on capital markets. Remember, we talked about the S&L crisis of the 1980s. And then we talked about the so-called zombie organizations. The S and Ls, or the banklike institutions, that held most of your assets in the form of residential mortgages. And when interest rates went up sharply, then the market value of all this shrunk. And as a result, these companies were actually insolvent, but they still kept showing their assets at their cost, so they did not use this principle. And if they did, maybe the check that the taxpayers paid would be much lower than $550 billion, as you might remember. Now here, we wrap up this week and there are quite a few assignments in your handouts, and these assignments are not very difficult. They just require some time and effort, and they hopefully will provide some more insight for the things that we've covered. So I wish you all the luck with your assignments, and I see you next week.
