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