Chapter 10: Short- Term Operating Assets
LIFO Reserve and LIFO Effect
- a firm that reports LIFO externally will often measure inventory for internal records on another basis - if costs are increasing, the firm will then use an allowance account, referred to as the LIFO reserve, to reduce the inventory to the measurement under LIFO -the balance in LIFO reserve account is difference between inventory measured using FIFO and LIFO -income statement adjustment in the LIFO reserve account is LIFO effect, which is the change in the LIFO reserve account during the year and impact on COGS
LIFO Liquidations
-as a company uses LIFO over time, it builds LIFO layers, which are annual increases in quantity of inventory - when inventory levels decline under the LIFO method and costs are increasing, the company sells older low-cost LIFO layers, reducing COGS and increasing book income -a decrease in inventory layers under LIFO method is LIFO liquidation
ending inventory
-goods in physical possession - goods in transit, items that have left the seller's place but not received by buyer
inventory costs reflect
-price paid for goods for resale -manufacturing costs (materials, labor, and allocated overhead) -freight in costs, transportation costs incurred to bring the inventory in appropriate location -packaging and handling costs -freight out costs, transportation costs incurred by the seller to move the inventory to the buyer, are expensed as a component of selling, general, and administrative expenses when incurred
Dollar-Value LIFO Computation
1. Determine the ending inventory stated in terms of base-year prices (first year) 2. Determine the increase (or decrease) in quantity at base-year prices 3. Determine the increase (or decrease) in quantity at current-year prices 4. Add all of the layers together to get the dollar-value LIFO ending inventory 5. Calculate the LIFO reserve 6. Record the journal entry to make the LIFO adjustment
Advantages of Dollar-Value LIFO
1. Firms account for dollars and not units 2. Avoids problems when there are changes in product mix 3. Can minimize the likelihood of liquidation
steps for gross profit method
1. compute COGAS from inventory records 2. Determine a historical gross profit percentage based on historical sales and COGS data. 3. Estimate COGS 4. Compute estimated ending inventory
lower-of-cost-or-market rule method
1. determine the market value of inventory 2. compare that measure to cost as determined using an inventory allocation method 3. record the write-down, if necessary
boundaries on the use of CRC
1. the CRC cannot exceed a ceiling equal to NRV 2. the CRC cannot fall below a floor value of NRV less a normal profit margin (NRV - NP)
FOB (free on board) shipping point
The title passes from the seller to the buyer when the goods are shipped, and the buyer pays the freight costs from the shipping point (factory) to the final destination. The buyer reports the goods in its inventory while in transit
FOB destination
Title passes from the seller to the buyer when the goods are received by the buyer, and seller pays the freight costs. The seller reports the goods in its inventory while in transit
periodic system
a company determines the inventory balance and cost of goods sold at the end of the accounting period
specific identification method
a company identifies each unit and tracks the cost associated with that specific unit -useful for companies that sell high-dollar products with low sales volume -impractical for most companies
conventional retail inventory method
approximates the cost of ending inventory balance by taking into consideration the requirement that firms report inventory at lower of cost or market based on the relationship between cost and selling price -approximates it by including net markups but not markdowns in the cost-to-retail ratio -this increases the denominator of the ratio which reduces the ratio thus resulting in lower reported ending inventory
First-In, First-Out Method (FIFO)
assigns the most recent costs to ending inventory and the oldest costs to the costs of goods sold -records cogs at point of each sale -for firms selling products that can perish or are subject to change
Last-In, First-Out Method (LIFO)
assigns the oldest costs to ending inventory and the most recent costs to cost of goods sold -for a company that accumulates inventory, sells units from its most recent aquisitions, and maintains a base stock such as mining company -actual inventory management at most firms does not follow this pattern
gross method
company making a purchase initially records the inventory and accounts payable at the full purchase amount on the invoice
net method
company making the purchase assumes that it will take the discount and initially records the accounts payable and inventory at the net amount
raw materials inventory
composed of inputs that the firm has not yet placed into production
work in process inventory
consists of goods currently in the manufacturing process including raw materials, cost of labor, allocated overhead costs
moving average method
determines an average cost for the units on hand and applies that average unit cost to the next sale to determine the cost of goods sold -useful for firms selling a high volume of a homogeneous product (oil and gas) -used for inventory of raw materials and supplies
comparing cost to market
firms can apply the lower of cost or market rule for inventory to the aggregate inventory, groups of inventory, or individual items in inventory if the market value is below the cost basis, the write-down amount is the difference between the two amounts
perpetual system
firms continually update inventory accounts for each purchase and each sale
cost-flow assumptions other than lifo or retail inventory
firms determine market value at net realizable value (NRV) if they use a method other than LIFO or the retail inventory method. Market = NRV NRV is the items selling price less the cost of disposal -disposal costs include packaging, shipping, commissions aka costs of completion and sale
LIFO or retail inventory cost flow assumption
firms that use LIFO or the retail inventory method to measure the cost of inventory measure the market values as the amount at which they could currently purchase or reproduce the inventory known as current replace cost. Market = CRC
formulas
gross profit percentage = (net sales - COGS)/ net sales estimated COGS = net sales x (1- gross profit percentage estimated ending inventory = GOGAS - Estimated COGS
lower-of-cost-or-market rule
if a measure of the market value of inventory falls below its cost basis, the company must report inventory at the lower of its cost or market value 1. the difference is a loss on the income statement (indirect method) or an increase to cost of goods sold (direct method) 2. the inventory is carried at the lower amount on balance sheet
finished goods inventory
includes manufactured goods that are complete and ready for sale
gross profit method
provides an approximation of the ending inventory balance. estimate- no physical count -to determine the balances of ending inventory and COGS for interim periods without performing a physical inventory count -to determine the cost of inventory that has been lost, stolen, or destroyed - in auditors testing of overall reasonableness of inventory amounts reported by clients -for budgeting and forecasting purposes
recording the write - down: indirect method
records the loss as a separate line item on the income statement within income from continuing operations and reduces the inventory account by the use of an allowance account -when firms increases the allowance, it reports a loss - when firms decreases the allowance, it records income
purchase discounts
reduce the amount that is due to sellers if the buyer pays within a certain time period ex: 2/10, n/30 - gross method -net method
goods in consignment
remain in inventory of the consigner and reported on their balance sheet
Dollar-Value LIFO
techniques to simplify LIFO computations aggregate inventory items into groups called pools and perform the LIFO computations on the inventory pool as opposed to individual items -dollar value LIFO method, which pools inventory items and uses the dollar as the common unit of measure of the inventory
basic retail method
to estimate both ending inventory at cost and COGS 1. computes its cost to retail ratio by dividing the goods available for sale at cost by the goods available for sale at retail 2. applies this ratio to ending inventory at retail to obtain ending inventory at cost 3. subtracts the computed ending inventory at cost from the cost of goods available for sale to arrive at cost of goods sold
Inventory Cost Flow Assumptions
to move the cost of the item from inventory to cost of goods sold in the accounting system, doesn't have to follow the actual selling method of inventory
recording the write - down: direct method
writes off the loss directly to the inventory account and records that loss in the cost of goods sold reported on the income statement