ACCT CH 6

LIFO adjustment

An adjustment used to convert a company's own inventory records maintained on a FIFO basis to LIFO basis for preparing financial statements.

Multiple-step income statement

An income statement that reports multiple levels of income (or profitability).

Average days in inventory

Approximate number of days the average inventory is held. It equals 365 days divided by the inventory turnover ratio.

Determine the cost of goods sold and ending inventory using different inventory cost methods.

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, first-out), and weighted-average cost.

Freight Out

Cost of freight on shipments to customers, which is included in the income statement either as part of cost of goods sold or as a selling expense

Freight-in

Cost to transport inventory to the company, which is included as part of inventory cost.

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

Generally, FIFO more closely resembles the actual physical flow of inventory. When inventory costs are rising, FIFO results in higher reported inventory in the balance sheet and higher reported income in the income statement. Conversely, LIFO results in a lower reported inventory and net income, reducing the company's income tax obligation.

LIFO conformity rule

IRS rule requiring a company that uses LIFO for tax reporting to also use LIFO for financial reporting.

Determine the financial statement effects of inventory errors.

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.

Weighted-average cost method

Inventory costing method that assumes both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.

First-in, first-out method (FIFO)

Inventory costing method that assumes the first units purchased (the first in) are the first ones sold (the first out).

Last-in, first-out method (LIFO)

Inventory costing method that assumes the last units purchased (the last in) are the first ones sold (the first out).

Specific identification method

Inventory costing method that matches or identifies each unit of inventory with its actual cost.

Perpetual inventory system

Inventory system that maintains a continual record of inventory purchased and sold.

Periodic inventory system

Inventory system that periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand.

Inventory

Items a company intends for sale to customers.

Gross profit ratio

Measure of the amount by which the sale of inventory exceeds its cost per dollar of sales. It equals gross profit divided by net sales.

Lower of cost and net realizable value

Method where companies report inventory in the balance sheet at the lower of cost and net realizable value, where net realizable value equals estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal, and transportation.

Income before income taxes

Operating income plus nonoperating revenues less nonoperating expenses.

Operating income

Profitability from normal operations that equals gross profit less operating expenses

Trace the flow of inventory costs from manufacturing companies to merchandising companies.

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

Net realizable value

The amount of cash the firm expects to collect.

Gross profit

The difference between net sales and cost of goods sold.

Record inventory transactions using a perpetual inventory system.

The perpetual inventory system maintains a continual—or perpetual—record of inventory purchased and sold. When companies purchase inventory using a perpetual inventory system, they increase the Inventory account and either decrease Cash or increase Accounts Payable. When companies sell inventory, they make two entries: (1) They increase an asset account (Cash or Accounts Receivable) and increase Sales Revenue, and (2) they increase Cost of Goods Sold and decrease Inventory. Nearly all companies maintain their own inventory records on a FIFO basis, and then some prepare financial statements on a LIFO basis. To adjust their FIFO inventory records to LIFO for financial reporting, companies use a LIFO adjustment at the end of the period. For most companies, freight charges are added to the cost of inventory, whereas purchase returns and purchase discounts are deducted from the cost of inventory. Some companies choose to report freight charges on outgoing shipments as part of selling expenses instead of cost of goods sold.

Analyze management of inventory using the inventory turnover ratio and gross profit ratio.

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.

Inventory turnover ratio

The number of times a firm sells its average inventory balance during a reporting period. It equals cost of goods sold divided by average inventory.

Apply the lower of cost and net realizable value rule for inventories

We report inventory at the lower of cost and net realizable value; that is, at cost (specific identification, FIFO, or weighted-average cost) or net realizable value (selling price minus cost of completion, disposal, and transportation), whichever is lower. When net realizable value falls below cost, we adjust downward the balance of inventory from cost to net realizable value.

Record inventory transactions using a periodic inventory system.

Using the periodic inventory system, we record purchases, freight-in, purchase returns, and purchase discounts to temporary accounts rather than directly to Inventory. These temporary accounts are closed in a period-end adjustment. In addition, at the time inventory is sold, we do not record a decrease in inventory sold; instead, we update the balance of Inventory in the period-end adjustment.

cost of goods sold

Cost of the inventory that was sold during the period

Understand how cost of goods sold is reported in a multiple-step income statement.

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. 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.

Net income

Difference between all revenues and all expenses for the period.