1.11. Accounting for inventories (3) – FIFO, LIFO, LCM

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From the course by Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

ratings

Course 3 of 5 in the Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

From the lesson

Financial Accounting – Basic Principles. Transaction Analysis. Income Recognition. Accounting for Current Assets

In Week 1 we discuss the scope of accounting and its two major areas – financial and managerial accounting. In the first part of the Course – Weeks 1 through 3 – we talk about financial accounting (FA). First, the key financial statements – the Balance Sheet (BS), the Income Statement (IS), and the Statement of Cash Flows (SCF) – are introduced, and the accounting equation is analyzed. Then we move on to the basic accounting principles, standards, and approaches – from double-entry bookkeeping to GAAP. Equipped with the general understanding of the financial accounting approach, we apply accounting procedures to transaction analysis. Then we study revenue and expense recognition, and focus on accounts receivable and bad debts. Finally, you will learn how financial accounting deals with inventories.

1.1. Why study accounting?11:17

1.2. What is accounting? Financial vs. managerial accounting11:41

1.3. Key financial statements – BS, IS, SCF17:49

1.4. Accounting principles. GAAP14:10

1.5. Double-entry bookkeeping6:57

1.6. Transaction analysis – an example15:51

1.7. Revenue and expense recognition16:34

1.8. Cash and accounts receivable14:04

1.9. Accounting for inventories (1) – cost travel13:27

1.10. Accounting for inventories (2) – cost of goods sold9:39

1.11. Accounting for inventories (3) – FIFO, LIFO, LCM9:39

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

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.

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