Chapter 6

Key Point

Companies are allowed to report inventory costs by assuming which specific units of inventory are sold and not sold, even if this does not match the actual flow. The three major inventory cost flow assumptions are FIFO (first-in, first-out), LIFO (last-in, last-out), and weighted-average cost.

Which of the following inventory accounts consists of items for which the manufacturing process is complete?

Raw Materials Inventory is the cost of components that will become finished products, Work-in-Process Inventory consists of products that are not yet complete, and Cost of Goods Sold is not an inventory account but represents the cost of inventory sold during the period. (answer = finished goods)

Inventory Purchases

The entry involves: Increasing the balance of inventory (an asset) Increasing the balance of accounts payable (a liability)

Key Point

The inventory turnover ratio indicates the number of times the firm sells, or turns over, its average inventory balance during a reporting period. The gross profit ratio measures the amount by which the sale of inventory exceeds its cost per dollar of sales.

Lower of Cost and Net Realizable Value

company must check if the value of inventory has changed form original, and if the net relizable value is lower, an adjustment is needed to inventory

•Weighted-average cost

qAssumes each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items.

•First-in, first-out (FIFO)

qAssumes first units purchased are first ones sold

Perpetual Inventory System

••Maintains a continual record of inventory ••Helps a company better manage inventory levels ••Most often used in practice

Cost of goods sold is:

Cost of goods sold is an expense account reported in the income statement.

Average Days in Inventory

Indicates the approximate number of days the average inventory is held.

Inventory Turnover Ratio

•Shows the number of times the firm sells its average inventory balance during a reporting period.

Period-End Adjustment

•Needed only under the periodic system Period-end adjustment under the periodic system: 1. Adjusts the balance of inventory to its proper ending balance 2. Records the cost of goods sold for the period 3. Closes (or zeros out) the temporary purchases accounts

Key Point

A multiple-step income statement reports multiple levels of profitability. Gross profit equals net revenues (or net sales) minus cost of goods sold. Operating income equals gross profit minus operating expenses. Income before income taxes equals operating income plus nonoperating revenues and minus nonoperating expenses. Net income equals all revenues minus all expenses.

An inventory error that understates the amount of ending inventory will result in which of the following in the current year?

An understatement of ending inventory will lead to a higher, or overstated, cost of goods sold, an understatement of net income, and an understatement in assets in the year the error was made.

Which of the following transactions would increase the balance of the inventory account for a company using the perpetual inventory system?

Costs of incoming freight charges on merchandise inventory would increase the balance of the inventory account. Returns of inventory would decrease the account balance, as would a purchase discount given for prompt payment.

Common Mistake 2

In calculating the weighted-average unit cost, be sure to use a weighted average of the unit cost instead of the simple average. In the example from the previous slide, there are three unit costs: $7, $9, and $11. A simple average of these amounts is $9 [= ($7 + $9 + $11) ÷ 3]. The simple average, though, fails to take into account that more units were purchased at $11 than at $7 or $9. So we need to weight the unit costs by the number of units purchased. We do that by taking the total cost of goods available for sale ($10,000) divided by the total number of units available for sale (1,000) for a weighted average of $10.

Key Point

In the current year, inventory errors affect the amounts reported for inventory and retained earnings in the balance sheet and amounts reported for cost of goods sold and gross profit in the income statement. At the end of the following year, the error has no effect on ending inventory or retained earnings but reverses for cost of goods sold and gross profit.

Key Point

Inventory is a current asset reported in the balance sheet and represents the cost of inventory not yet sold at the end of the period. Cost of goods sold is an expense reported in the income statement and represents the cost of inventory sold.

Common Mistake

Many students find it surprising that companies are allowed to report inventory costs using assumed amounts rather than actual amounts. Nearly all companies sell their actual inventory in a FIFO manner, but they are allowed to report it as if they sold it in a LIFO manner. Later, we'll see why that's advantageous.

Which level of profitability is considered profit from normal operations?

Operating income is measured as gross profit (sales revenue minus cost of goods sold) minus operating expenses. Income before taxes and net income include nonoperating items, which are not considered part of normal operations.

The choice of inventory method affects:

Reported ending inventory (asset) Reported cost of goods sold (expense; and therefore profit)

Inventory Sales

Sales Revenue = Selling price Cost of goods sold (expense) = Purchase cost (FIFO)

Key Point

Service companies record revenues when providing services to customers. Merchandising and manufacturing companies record revenues when selling inventory to customers.

Which inventory method or cost flow assumption most closely resembles the actual physical flow of goods?

Supermarkets, sporting goods stores, clothing shops, electronics stores, or just about any company you're familiar with generally sells its oldest inventory first (first-in, first-out).

Net sales are $100,000 and cost of goods sold is $70,000. Inventory balances for the past two years are $10,000 and $20,000. What is the inventory turnover?

The inventory turnover measures how often a company sells, or turns over, its inventory. The inventory turnover would be computed as $70,000 ÷ ([10,000 + 20,000] ÷ 2). The result is 4.67 times per year.

. FOB Destination.

Title passes at destination (when inventory arrives at Mario's). Mario would record the purchase on April 29.

FOB Shipping Point.

Title passes at shipping point (when inventory leaves the supplier's warehouse). Mario would record the purchase on April 25..

During a period of rising prices, which inventory cost flow assumption would result in the highest cost of goods sold, and thereby the lowest net income?

Using LIFO, we assume that the last units purchased (the last ones in) are the first ones sold (the first out). If prices are rising, cost of goods sold would be composed of the latest (and highest) costs using LIFO.

When a periodic inventory system and the FIFO method are used, which of the following is correct?

a.The amount of cost of goods sold will be the same under a perpetual system and the FIFO method. The periodic system and perpetual system will always produce the same amount for cost of goods sold (and ending inventory) when FIFO is used. (A periodic system does not maintain a continuously updated inventory account nor a continuously updated cost of goods sold account.)

•Last-in, first-out (LIFO)

qAssumes last units purchased are first ones sold

•Specific identification

qMatches each unit of inventory with its actual cost

LIFO Adjustment

•Companies generally maintain their own inventory records on a FIFO basis •To report using LIFO, a year-end adjustment to inventory needs to be made (LIFO adjustment) •The difference in reported inventory when using LIFO instead of FIFO is commonly referred to as the LIFO reserve •Recall that Mario's ending inventory using FIFO was $2,200 but would have been $1,600 under LIFO •Let's look at Mario's year-end LIFO adjustment on the next slide

Periodic Inventory System

•Does not continually modify inventory amounts •Periodically adjust for purchases and sales of inventory qAt the end of the reporting period qBased on a physical count of inventory on hand

Explain the financial statement effects and tax effects of inventory cost methods.

•FIFO method qMatches physical flow for most companies qEnding inventory reflects current cost qBalance-sheet approach •LIFO method qCost of goods sold reflects current cost qIncome-statement approach •LIFO conformity rule qCompanies that use LIFO for tax reporting must also use LIFO for financial reporting

Additional Inventory Transactions

•Freight charges qFreight-in (shipments from suppliers) qFreight-out (shipments to customers) •Purchase discounts qDiscount offered by seller to buyer for quick payment •Purchase returns qBuyer returns unwanted or defective inventory

Gross Profit Ratio

•Indicator of the company's successful management of inventory •Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales

Weighted-Average Cost

•Under this method, we assume: qBoth cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale qEach unit of inventory has a cost equal to the weighted-average unit cost of all inventory items qThe weighted-average cost is calculated as: cost of goods available for sale / number of sale units

Inventory

•includes items a company intends for sale to customers in the ordinary course of business. qInventory also includes items that are not yet finished products. qGenerally reported as a current asset in the balance sheet

Cost of goods sold

•is the cost of the inventory sold. qReported as an expense in the income statement

Periodic Inventory System

••Does not maintain a continual record of inventory ••Periodically adjusts for purchase and sale of inventory