Chapter 8 bottom line

Discuss the factors affecting a company's choice of inventory method

A company's choice of inventory method will be influenced by (a) how closely cost flow reflects the actual physical flow of its inventory, (b) the timing of income tax expenses, and (c) how costs are matched with revenues.

Explain which physical units of goods should be included in inventory

Generally, determining the physical quantity that should be included in inventory is a simple matter because it consists of items in the possession of the company. However, at the end of a reporting period it's important to determine the ownership of goods that are in transit between the company and its customers as well as between the company and its suppliers. Also, goods on consignment should be included in inventory of the consignor even though the company doesn't have physical possession of the goods. In addition, a company anticipating sales returns includes in inventory the cost of merchandise it estimates will be returned.

Calculate the key ratios used by analysts to monitor a company's investment in inventories.

Investors, creditors, and financial analysts can gain important insights by monitoring a company's investment in inventories. The gross profit ratio, inventory turnover ratio, and average days in inventory are designed to monitor invnetories

Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold.

Once costs are determined, the cost of goods available for sale must be allocated between cost of goods sold and ending inventory. Unless each item is specifically identified and traced through the system, the allocation requires an assumption regarding the flow of costs. First-in, first-out (FIFO) assumes that units sold are the first units acquired. Last-in, first-out (LIFO) assumes that the units sold are the most recent units purchased. The average cost method assumes that cost of goods sold and ending inventory consist of a mixture of all the goods available for sale.

Discuss the primary difference between U.S. GAAP and IFRS with respect to determining the cost of inventory.

The primary difference between U.S. GAAP and IFRS with respect to determining the cost of inventory is that IFRS does not allow the use of the LIFO method to value inventory.

Explain the types of inventory and the differences between a perpetual inventory system and a periodic inventory system

Inventory for a manufacturing company includes raw materials, work in process, and finished goods. Inventory for a merchandising company includes goods primarily in a finished form ready for sale. In a perpetual inventory system, inventory is continually adjusted for each change in inventory cost of goods sold is adjusted each time goods are sold or returned by a customer. A periodic inventory system adjusts inventory and records cost of goods sold only at the end of a reporting period.

Understand supplemental disclosures of LIFO reserves and the effect of LIFO liquidations on net income.

The LIFO conformity rule requires that if a company uses LIFO to measure taxable income, it also must use LIFO for external financial reporting. LIFO users often provide a disclosure note describing the effect on inventories of using another method for inventory valuation rather than LIFO. If a company uses LIFO and inventory quantities decline during a period, then out-of-date inventory layers are liquidated and the cost of goods sold will partially match noncurrent costs with current selling prices. If costs have been increasing (decreasing), LIFO liquidations produce higher (lower) net income than would have resulted if the liquidated inventory were included in cost of goods sold is referred to as the effect on income of liquidations of LIFO inventory.

Account for transactions that affect net purchases and prepare a cost of goods sold schedule

The cost of inventory includes all expenditures necessary to acquire the inventory and bring it to its desired condition and location for sale or use. Generally, these expenditures include the purchase price of the goods reduced by any returns and purchase discounts., plus freight-in charges.

Determine ending inventory using the dollar-value LIFO inventory method.

The dollar-value LIFO method converts ending inventory at year-end cost ot base year cost using a cost index. After identifying the layers in ending inventory with the years they were created, each year's base year cost measurement is converted to layer year cost measurement using the layer year's cost index. The layers are then summed to obtain total ending inventory at cost.