Week 6 Inventory EXAM 2

Which method will show the highest total assets? (assume that inventory costs are increasing over time/ period of inflation)

FIFO FIFO allocates the newest, most recent costs to ending inventory on the balance sheet. If costs are rising, these newest costs will be the most expensive thus resulting in the highest ending inventory (and thus the highest total assets).

What does the operating cycle measure?

It measures the number of days on average between buying inventory from suppliers, and collecting cash from selling inventory to customers.

What does the number of days sales in inventory measure?

It measures the number of days on average between buying the inventory from suppliers, and selling it to customers. Note: Lower is better (lower the number, the quicker we are to sell inventory, and fewer days elapsing between buying and selling our inventory).

What does gross margin measure?

It measures the percentage of the sales price of inventory that is gross profit. Note: Higher is better (the higher the rate, the more profitable our sales.)

Operating Cycle (Equation)

Operating cycle = Number of Days' Sale in Inventory + Average Collection Period Note: It measures the number of days on average between buying inventory from suppliers, and collecting cash from selling inventory to customers.

FOB (free on board) shipping point

Ownership of goods passes to buyer as soon as the goods are shipped (i.e., once the goods leave the seller's warehouse).

FOB (free on board) destination point

Ownership of goods remains with the seller until the goods actually reach the buyer (i.e., ownership transfers to the buyer only when the buyer actually receives the goods).

Net income (Equation)

Revenues - expenses = Net income Gross profit - salaries expense - freight out = net income

Gross profit (Equation)

Sales Revenue - Cost of Goods Sold = Gross Profit

Net Sales Revenue (Equation)

Sales revenue - sales discounts - sales returns & allowances = net sales revenue

The purpose of the three inventory cost flow methods....

These methods are used to calculate ending inventory on the balance sheet, and cost of goods sold on the income statement

Effects on income statement & balance sheet

cost of goods sold & gross profit income tax expense net income inventory

Freight-in

cost of transporting (shipping) inventory you have purchased to you.

Assume that XYZ Company has a beginning inventory of $20,000 and ending inventory of $50,000; cost of goods sold for 2032 of $270,000; and net sales revenue of $525,000 for 2032. Calculate the gross margin rate.

gross margin rate = gross margin / net sales revenue gross margin = sales - cost of goods sold 48.57% = 525,000 - 270,000 / 525,000

Assume that XYZ Company has a beginning inventory of $20,000 and ending inventory of $50,000; cost of goods sold for 2032 of $270,000; and net sales revenue of $525,000 for 2032. Calculate the inventory turnover ratio.

inventory turnover = cost of goods sold / average inventory Note: beginning inventory + ending inventory / 2 = average inventory 7.71 times = 270,000 / (20,000 + 50,000) / 2

Weighted Average cost per unit (equation 2)

Cost of goods available for sale / units available for sale = weighted average cost per unit

Using the weighted average method: COGS

Cost of goods sold = Units sold x Weighted average cost per unit

average inventory equation

(Beginning Inventory + Ending Inventory) / 2 = average inventory

Average accounts receivable (Equation)

(Beginning accounts receivable + Ending accounts receivable) / 2

Weighted average cost per unit equation

(cost of beginning inventory + cost of purchases) / (units in beginning inventory + units purchased) = weighted average cost per unit

Weighted Average Assumptions

1. Assumes all inventory items have the same cost. 2. Thus, it does not matter if we assume old or new units are sold since all units have the same cost. 3. This 'same cost' is called the weighted average cost per unit.

LIFO (last in, first out)

1. Assumes the most recent inventory items purchased are the first to be sold. 2. Thus, the cost of the most recently purchased inventory items make up the cost of goods sold on the income statement. 3. Ending inventory on the balance sheet consists of the cost of the oldest inventory items purchased.

Three Inventory Cost Flow Methods

1. FIFO (first-in, first-out) 2. LIFO (last-in, first-out) 3. weighted average (average cost)

two common shipping terms

1. FOB (free on board) shipping point 2. FOB (free on board) destination point

Financial Statement ratios relating to inventory are the....

1. Inventory Turnover 2. Number of Days Sales in Inventory 3. Gross Margin (Profit) Percentage

LIFO (last in, first out) - short version

1. assigns the newest inventory costs to, the cost of goods sold. 2. assigns the oldest inventory costs to, the ending inventory

FIFO (first in, first out) -short version

1. assigns the oldest inventory costs to cost of goods sold. 2. assigns the newest inventory costs to ending inventory.

Weighted Average (Short version)

1. assumes all inventory items have the same cost; thus calculate the weighted average cost per unit: Cost of beginning inventory + cost of purchases/units in beginning inventory + units purchased

FIFO (first in, first out)

1. assumes the oldest or earliest inventory items purchased are the first goods to be sold. 2. Thus, the cost of oldest inventory items purchased make up the cost of goods sold on the income statement. 3. Ending inventory on the balance sheet consists of the cost of the most recent inventory items purchased

Number of days sales in inventory (Equation)

365/inventory turnover = number of days sales in inventory

Accounts receivable turnover ratio (Equation)

Accounts receivable turnover ratio = Sales revenue ÷ Average accounts receivable

Average collection period Equation = 365 ÷ Accounts receivable turnover ratio

Average collection period = 365 / Accounts receivable turnover ratio

Why do we record the expense related to inventory only when the inventory is sold?

Because of the Matching Concept: Expenses are to be recorded in the same year they help generate revenues. Revenue is earned when the sale is made, thus the expense, cost of goods sold must be recorded in the same year.

Important inventory formula (Equation) Cogs equation

Beginning Inventory + Net Purchases = Cost of Goods Available for Sale - Ending Inventory = Cost of Goods Sold

cost of goods available for sale (Equation)

Beginning Inventory + Net Purchases = cost of goods for sale

Inventory Turnover Ratio

Cost of goods sold/Average inventory = inventory turnover Note: It measures the number of times on average the inventory is sold during a period Note: Its an Indication as to how quickly the company is selling its inventory KEYPOINT: Ratio does not give an indication as to how quickly the company is collecting cash from sales. Rather, it tells how quickly the sales are happening. Note: Higher is better (the higher the number, the faster we're able to sell our inventory).

Matching Concept:

Expenses are to be recorded in the same year they help generate revenues. Revenue is earned when the sale is made, thus the expense cost of goods sold must be recorded in the same year.

Which method shows ending inventory at its most current acquisition costs? (assume Inventory costs are decreasing over time/ period of deflation).

FIFO Answer will NOT change because the question is independent of price (i.e., FIFO will always allocate the most current costs to the balance sheet regardless of whether costs are increasing or decreasing).

Which method will give an income tax advantage? (assume Inventory costs are decreasing over time/ period of deflation).

FIFO Answer will change because all three questions are dependent on price (i.e., are the high or low-cost items being allocated to the income statement or balance sheet).

Which method will show the highest net income? (assume that inventory costs are increasing over time/ period of inflation)

FIFO FIFO allocates the oldest costs to, the costs of goods sold. If costs are rising, these oldest costs will be the cheapest thus resulting in the smallest cost of goods sold. Cost of goods sold is an expense, thus the smaller the expense, the larger the net income.

Which method shows ending inventory at its most current acquisition costs? (assume that inventory costs are increasing over time/ period of inflation).

FIFO FIFO allocates the newest, most recent costs to ending inventory, to the balance sheet. Thus, FIFO ending inventory will always reflect the most current inventory costs.

In a period of rising prices, will FIFO produce a higher or lower net income than LIFO? Why?

FIFO will produce a higher net income when prices are rising because cost of goods sold is made up of item purchases early in the year at lower prices.

In a period of rising prices, will FIFO produce a higher or lower net income than LIFO? Why?

FIFO will produce a higher net income when prices are rising because cost of goods sold is made up of items purchased early in the year at lower prices.

Identify the inventory costing method (LIFO, FIFO, or weighted average) that is being described. In a period of decreasing inventory costs (deflation), income tax expense is lowest.

FIFO, In a period of decreasing inventory costs (deflation), income tax expense is lowest.

Identify the inventory costing method (LIFO, FIFO, or weighted average) that is being described. In a period of decreasing inventory costs (deflation), the ending inventory will consist of the most recently acquired goods.

FIFO, In a period of decreasing inventory costs (deflation), the ending inventory will consist of the most recently acquired goods.

Identify the inventory costing method (LIFO, FIFO, or weighted average) that is being described. In a period of rising inventory costs (inflation), ending inventory is highest.

FIFO, In a period of rising inventory costs (inflation), the ending inventory is highest.

Goods in Transit

Goods being shipped from the seller to the buyer and are thus on board a truck, train, ship, or plane.

Gross margin rate (Or known as Gross profit rate) Equation

Gross margin / net sales revenue = gross margin rate Note: measures the percentage of the sales price of inventory that is gross profit Note: Higher is better (the higher the rate, the more profitable our sales.)

Gross profit rate (Equation)

Gross profit rate = Gross profit / sales revenue

Which financial statement accounts are affected by the sale of a product?

In the Income statement. 1. Sales revenue 2. Cost of goods sold In the Balance sheet. 1. Accounts Receivable 2. Inventory

Inventory Turnover Ratio (Equation)

Inventory turnover ratio = Cost of goods sold / Average inventory

Who owns the goods in transit and thus includes these goods as part of their inventory?

It depends on the shipping terms.

What is the inventory turnover ratio indicating?

It's an indication as to how quickly the company is selling its inventory. It measures the number of times on average the inventory is sold during a period. KEYPOINT: The Inventory turnover Ratio does not give an indication as to how quickly the company is collecting cash from sales. Rather, it tells how quickly the sales are happening. Note: Higher is better (the higher the number, the faster we're able to sell our inventory).

Which method will show the highest net income? (assume Inventory costs are decreasing over time/ period of deflation).

LIFO Answer will change because all three questions are dependent on price (i.e., are the high or low cost items being allocated to the income statement or balance sheet).

Which method will show the highest total assets? (assume Inventory costs are decreasing over time/ period of deflation).

LIFO Answer will change because all three questions are dependent on price (i.e., are the high or low cost items being allocated to the income statement or balance sheet).

Which method will give an income tax advantage? (assume that inventory costs are increasing over time/ period of inflation)

LIFO LIFO allocates the newest, most recent costs to cost of goods sold. If costs are rising, these newest costs will be the most expensive. The higher the expense, the lower the net income. However, the lower the net income, the less the company must pay in income taxes.

In a period of decreasing prices, will LIFO produce a higher or lower ending inventory than FIFO? Why?

LIFO will produce a higher ending inventory than FIFO when prices are falling because ending inventory is made up of items purchased early in the year at higher prices.

In a period of decreasing prices, will LIFO produce a higher or lower ending inventory than FIFO? Why?

LIFO will produce a higher ending inventory than FIFO when prices are falling, because ending inventory is made up of items purchased early in the year at higher prices.

Identify the inventory costing method (LIFO, FIFO, or weighted average) that is being described. In a period of rising inventory costs (inflation), cost of goods sold is highest.

LIFO, In a period of rising inventory costs (inflation), the cost of goods sold is highest.

Identify the inventory costing method (LIFO, FIFO, or weighted average) that is being described. The value of ending inventory does not include the cost of the most recently acquired goods.

LIFO, The value of ending inventory, does NOT include the cost of the most recently acquired goods.

Is freight-out NOT part of the net purchases calculation?

NO, Freight-out is NOT part of the net purchases calculation.

Does the cost flow assumption that the company follows, need to be consistent with the actual flow of goods? (Long version)

No. Just because a company calculates its cost of goods sold and ending inventory using LIFO, that doesn't mean they sell their newest items. Using FIFO does not mean that the company actually sells its oldest items. There is no correlation between the inventory cost assumption that the company follows and the actual flow of goods that are sold to our customers. These inventory methods simply assume flows of cost in order to calculate the amount of ending inventory and cost of goods sold.

Does the cost flow assumption that the company follows, need to be consistent with the actual flow of goods?

No. These cost flow assumptions do not have to be consistent with the actual flow of goods. These methods simply assume flows of costs in order to calculate the amount of ending inventory and cost of goods sold.

indicate which company should include the inventory on its December 31, 2028 balance sheet. Quarton, Inc. shipped merchandise to Filbrandt Company on December 25, 2028, terms FOB destination point. Filbrandt received the merchandise on December 31, 2028.

Title to the goods does not pass to the buyer until the goods arrive. The goods arrived at Filbrandt Company on December 31, 2028, thus Filbrandt should include the goods in its inventory at December 31, 2028.

indicate which company should include the inventory on its December 31, 2028 balance sheet. Michelson Supplies, Inc. shipped merchandise to PJ Sales on December 28, 2028, terms FOB destination point. The merchandise arrives at PJ's on January 4, 2029.

Title to the goods does not pass to the buyer until the goods arrive. Thus, Michelson should include the goods in its inventory at December 31, 2028.

indicate which company should include the inventory on its December 31, 2028 balance sheet. Hinz Company shipped merchandise to Barner, Inc. on December 24, 2028, terms FOB shipping point. The merchandise arrived at Barner's on December 29, 2028.

Title to the goods passes to the buyer as soon as the goods are shipped. Thus, Barner, Inc. should include the goods in its inventory at December 31, 2028.

indicate which company should include the inventory on its December 31, 2028 balance sheet. James Bros., Inc. shipped merchandise to Randall Company on December 27, 2028, terms FOB shipping point. Randall Company received the merchandise on January 2, 2029

Title to the goods passes to the buyer as soon as the goods are shipped. Thus, Randall Company should include the goods in its inventory at December 31, 2028.

Identify the inventory costing method (LIFO, FIFO, or weighted average) that is being described. Cost of goods sold and ending inventory will be made up of the same unit cost.

WEIGHTED AVERAGE, The Cost of goods sold and ending inventory will be made up of the same unit cost.

When do the inventory costs get expensed on the income statement.

When the inventory is sold. Inventory is considered an asset on the balance sheet until sold to customers. Only when the inventory is sold, is the cost recorded as an expense on the income statement (cost of goods sold)

Is freight-in added in the net purchases calculation?

Yes, Freight-in is added in the net purchases calculation.

is freight-out treated as an EXPENSE just like salaries expense, utilities expense, or rent expense?

Yes, Freight-out is treated as an EXPENSE just like salaries expense, utilities expense, or rent expense.

For each cost flow method.....

add the cost of goods sold and the ending inventory. It should result in the same total amount of costs allocated. It just results in a different allocation between the cost of goods sold and the ending inventory.

Cost of goods sold (Equation)

beginning inventory + net purchases - ending inventory = cost of goods sold

Effects on cash flows

cash flows are affected only because of income taxes (effect on the operating activities section).

Assume that XYZ Company has a beginning inventory of $20,000 and ending inventory of $50,000; cost of goods sold for 2032 of $270,000; and net sales revenue of $525,000 for 2032. Calculate the number of days sales in inventory.

inventory turnover = cost of goods sold / average inventory Note: beginning inventory + ending inventory / 2 = average inventory 7.71 times = 270,000 / (20,000 + 50,000) / 2 number of days sales in inventory = 365 / inventory turnover 47.34 days = 365/7.71

In order to make a change to an accounting method being used, a company must be able to....

justify any change in the method used on some basis other than saving taxes, such as better matching of costs with revenues.

Net purchases equation

purchases - purchase returns - purchase discounts + freight in = Net purchases

Purchase Discounts

represents discounts received for paying your supplier early ( same idea as a sales discount but from the buyer's perspective).

Purchase returns

represents inventory that was purchased and then returned to the seller (same idea as a sales return but from the buyer's perspective).

Freight-out

represents the cost of transporting inventory to your customers but where you have agreed to pay the shipping cost.

Consistency Principle

requires a company to use the same accounting methods period after period, so the financial statements of succeeding periods will be comparable

The choice of inventory method, the choice of LIFO, or FIFO, or WEIGHTED AVERAGE....

will depend on managements incentives, the tax laws, and the reporting company's particular economic circumstances. A company may use any inventory cost flow method it wants- the cost flow assumption used does not have to be consistent with the actual flow of goods. However, that might lead to an issue because, the choice of inventory method will significantly impact the financial statements of a company. And that might give the company an incentive to change their inventory method each year so that we could have the most favorable financial statements. But we cant do that, we have a generally accepted account principle called the consistency principle.

Think of cost of goods available for sale as....

your total inventory cost. its what we started with, plus all the inventory we bought during the accounting period