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Case Study: Inventory Accounting

Case Study: Inventory Accounting

Author: Evan McLaughlin

Identify when items are sold for the different types of inventory methods.

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[MUSIC PLAYING] Hey everyone, and welcome to our video today, a case study on inventory accounting.

So what's today's video about? Well we're going to learn about our subject company, Legacy Clothing, and we're going to discuss our company and inventory accounting. So we're going to look at how inventory accounting relates to our company and then we're going to do a case study of looking at the different inventory accounting methods to determine which one we should use for our subject company.

Let's start with learning a little bit about the subject company. So what type of company is it? Well it's a sole proprietorship, which is a type of company that is owned by a single individual and where the individual and the business are legally treated as the same. So what does a business do? What's its purpose? Well the business owns and operates clothing merchandise stores, they sell men's, women's, and children's clothing and other related items so they're similar to a department store. Where is, where's the business located? Well the business has locations throughout Washington DC and they have a staff of 50 people. So that's our subject company.

Now talking about our subject company, does our company need an inventory accounting method? Well of course they do they're a merchandising company they need to have an inventory accounting method, well why? They need an inventory accounting method to track inventory so it helps understand, helps the business understand where money is being spent and maintain appropriate inventory levels and record and track accurate inventory amounts which helps us in providing accurate reporting. So in order for us to produce accurate financial statements and it helps when we're performing financial statement analysis. So when we're looking at our financial statements and trying to understand what's going on with our inventory we need to have this inventory accounting method in order to perform that. So which method should we use? Should we use FIFO, LIFO or weighted average? Well that's what we're going to dive into now we're going to discuss each of those three accounting, inventory accounting methods to determine which one we should use.

So let's start with that first one, let's start with FIFO. So FIFO, that's first in, first out. What does that mean? Well which goods are the first to be sold? In FIFO the oldest goods are the first to be sold and which goods remain in ending inventory? The newest, so goods that were purchased first are the first to be sold so goods are sold oldest to newest. So why should Legacy Clothing use this method? Well FIFO resembles the physical flows of goods so the flow of our merchandise typically will mimic FIFO. So the first units that we bring in are typically going to be the first units that we sell. So that's FIFO.

Let's continue with this let's look at LIFO now for Legacy Clothing. LIFO which is last in, first out. Which goods are the first to be sold? Well those are the newest. So under LIFO the newest goods are the first to be sold and which goods remain in ending inventory? Well that's going to be the oldest goods, so goods that were purchased last are the first to be sold so the oldest goods remain in inventory. Now why should we use LIFO for Legacy Clothing? Well LIFO has a better matching-- because it matches current costs with current revenues. So it matches the cost of items that are being sold with the current revenue that's being recognized. So the most recent items that we purchased are the first to go out the door. So that's that matching of our current costs and revenue.

Now let's look at our third option, let's look at the weighted average method. So which goods are the first to be sold? Well that's of no concern in the weighted average method and which goods remain in the ending inventory the newest or the oldest? Well that's also of no concern in weighted average method. So then how is inventory determined? It's the average cost per unit. So under the weighted average method whether the goods were purchased first so they're the oldest, or whether they were our most recent purchases does not matter because for the weighted average method what you're looking at is the total cost of all the units as well as the total units that you have to determine average cost per unit. So why would Legacy Clothing want to use this method? Well it's simpler, because inventory is so complex it's difficult to know and monitor and measure the exact flow of inventory. So if those first items that you bring in really are the items that you're selling first or if those most recent purchases really are the items that your selling. So weighted average method helps to take away some of those complexities by looking at the total units and the total cost. So those are our three options so for Legacy Clothing which method should Legacy Clothing use?

Well for Legacy Clothing they're going to use FIFO, they're going to use first in, first out. Why are they going to use this? Well we spoke about it earlier but it's that physical flow of the merchandise. So Legacy Clothing being a department store is going to push sales and try to sell the first items that they get into their store as the items that they sell first. So they're going to try to sell the first items in. So they're going to want to match first in with the first ones out. So that's what Legacy Clothing is going to use for their inventory accounting.

In a nutshell let's summarize what we talked about today. We discussed our case study company Legacy Clothing and we discussed inventory accounting methods as it relates to our subject company Legacy Clothing. We looked at FIFO, we discussed LIFO, and we also discussed weighted average, and we determined that Legacy Clothing because of the physical flow of merchandise being the most important consideration is going to use FIFO for their inventory accounting.

I hope everybody enjoyed this video and I hope to see you next time.