The financial accounting and reporting (FAR) test covers topics related to accounting transactions and generating financial statements. This test is all about the day-to-day work of accounting. About 30% of your FAR test covers financial statement accounts, including questions on inventory. This section of the test is tricky, so use these tips to perform well on these questions.
Some ground rules
Before you dive into any inventory questions, there are some ground rules you need to keep in mind. I think many CPA candidates struggle, because they don’t think about these critical points:
- Assets become expenses: Inventory is an asset, because you use inventory to make money in your business. When you sell inventory, that amount of spending becomes an expense (cost of sales). This should help you understand the flow of manufacturing costs. You buy (or make) inventory items, then convert inventory into cost of sales.
- If you can’t sell inventory, it’s no longer an asset. Say, for example, that you have $10,000 mood rings in your inventory (They were big in the 70’s). If no one buys your mood rings, you need to expense that $10,000. It’s not an asset if you can’t sell it to someone.
- Regardless of which inventory you choose, the same total dollar amount of inventory is eventually reclassified to the same total dollar amount of expense (cost of sales). The only difference between the methods is the timing of the expense. Some methods recognize more expense in early years, some in later years.
Before you start answering practice questions, think carefully through these concepts. Understanding these topics can really help you with inventory topics.
FIFO, LIFO, weighted average cost methods
Most of the inventory questions deal with inventory costing methods. The three most frequently tested methods are FIFO, LIFO and weighted average methods. Here’s an easy example to explain all three: Assume that you buy 100 units of inventory for $40/unit on April 1st, then purchase 100 more units at $60/unit on April 20th. You sell 150 units on April 25th. There is no beginning inventory. Here is your inventory cost of sales, using three different costing methods:
- First-in, first-out (FIFO) method: This method assumes that the oldest units are sold first. When you sell 150 units, you sell 100 units at $40/ unit and the remaining 50 units at $60/unit. Your cost of sales is ($4,000 + $3,000 = $7,000).
- Last-in, first-out (LIFO) method: This method assumes that the newest units get sold first. When you sell 150 units, you sell 100 units at $60/ unit and the remaining 50 units at $40/unit. Your cost of sales is ($6,000 + $2,000 = $8,000).
- Weighted average method: When you sell 150 units, you sell all of them at $50/ unit, which is the average cost of all of your purchased units. Your cost of sales is $7,500.
Now, notice the cost of sales totals. When you use the FIFO method, you sell the oldest (cheapest) units first. Since prices generally go up over time, the FAR test questions will typically present the oldest units as the cheapest. As a result, the FIFO cost of sales ($7,000) is less than the LIFO cost of sales ($8,000). LIFO assumes that you sell the newer (more expensive) inventory first. Not surprisingly, the weighted average cost of sales is between FIFO and LIFO ($7,500).
Make sure that you have a simple example that uses the same inventory assumptions for all three methods. This strategy will help you understand the differences between each of the three methods.
Use these ground rules and the inventory example to succeed on this section of the FAR test.