Accounting - C6 - Reporting and Analyzing Inventiry

Average Cost Method

Allocates the cost of goods available for sale on the bases of the weighted-average unit cost incurred. Note that this method does not use the average of the unit costs. The average-cost method instead uses the average weighted by the quantities purchased at each unit.

Specific Identification Method

An actual physical-flow costing method in which particular items sold and items still in inventory are specifically costed to arrive at cost of goods sold and ending inventory. Requires companies keep records of original cost of each individual inventory item--historically, items like cars, pianos, etc. Disadvantage: management may be able to manipulate net income. E.g. boost net income by selling units purchased at a low cost, or reduce net income by selling units purchased at a high cost

What method of cost do companies that use perpetual systems use to record cost of goods sold at the time of sale?

Assumed cost (called standard cost)

FOB Destination

Ownership of the goods remains with the seller until the goods reach the buyer

Balance Sheet Effects: What's the disadvantage of LIFO during a period of inflation?

The costs allocated at ending inventory may be significantly understated in terms of current costs. The understatement becomes greater over prolonged periods of inflation.

Balance Sheet Effects: What's the advantage of FIFO during a period of inflation?

The costs allocated to ending inventory will approximate their current cost.

What accounting concept is employed by valuing the inventory at the Lower-of-cost-or-net realizable value? a. Conservatism b. Full disclosure c. Expense recognition d. Revenue recognition

a. Conservatism Conservatism dictates the lower-of-cost-or-market inventory valuation.

Inventory costing methods place primary reliance on assumptions about the flow of a. costs. b. values. c. resale prices. d. goods.

a. costs. The flow of costs determine the inventory costing method.

Inventory turnover is calculated by dividing cost of goods sold by a. beginning inventory. b. ending inventory. c. 365 days. d. average inventory.

d. average inventory. Since inventory turnover is a period ratio, average inventory for the period is used.

FOB shipping point

ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller

3 Factors in choosing different inventory cost flow methods

1. Income Statement Effects 2. Balance Sheet Effects 3. Tax Effects Analyzing financial statement and tax effects helps users determine which inventory costing method best meets the company's objectives.

LCNRV Lower-of-cost-or-net realizable value

A basis whereby inventory is stated at the lower of either its cost or its net realizable value. This is an example of conservatism, which means the best choice among accounting alternatives is the method that is least likely to overstate assets and net income) Under LCNRV, net realizable value refers to the net amount that a company expects to realize (receive) from the sale of inventory. (Estimated selling price, less estimated costs to complete and sell) Uses whichever is lower: cost per unit or net realizable value per unit Companies using LIFO method or retail inventory method are not required to use LCNRV

Inventory Turnover

A ratio that indicates the liquidity of inventory by measuring the number of times average inventory sold during the period. Cost of goods sold / Average Inventory = Inventory Turnover Ratio Inventory turnover can be divided into 365 days to compute days in inventory, which indicates the average number of days inventory is held

Ending Inventory Error: How does overstated ending inventory affect the balance sheet?

Assets - overstated Liabilities - no effect Stockholders' equity - overstated Note that if the error is not corrected, the combined total net income for the two periods would be correct. Thus, total stockholders' equity reported on the balance sheet at the end of 2022 will also be correct.

Ending Inventory Error: How does understated ending inventory affect the balance sheet?

Assets - overstated Liabilities - no effect Stockholders' equity - understated Note that if the error is not corrected, the combined total net income for the two periods would be correct. Thus, total stockholders' equity reported on the balance sheet at the end of 2022 will also be correct.

Weighted-Average Unit Cost Formula

Cost of Goods Available for Sale / Total Units Available for Sale = Weighted-Average Unit Cost

What is the cost of goods sold formula in a periodic system?

Cost of Goods Sold = Beginning Inventory + Cost of Goods Purchased - Ending Inventory

When inventory error understates ending inventory, how does it affect cost of goods sold and net income?

Cost of goods sold is overstated Net Income is understated

When inventory error overstates beginning inventory, how does it affect cost of goods sold and net income?

Cost of goods sold is overstated Net income is understated

When inventory error understates beginning inventory, how does it affect cost of goods sold and net income?

Cost of goods sold is understated Net income is overstated

Income Statement Effects: In a period of inflation, how do FIFO and LIFO perform?

FIFO produces a higher net income because lower unit costs of the first units purchased are matched against revenue. LIFO produces a lower net income because higher unit costs of the last goods purchased are matched against revenue.

Income Statement Effects: In a period of falling prices, how do FIFO and LIFO perform?

FIFO will report lowest net income. LIFO will report the highest net income.

FIFO Method

First-In, First-Out Method - assumes that the earliest goods purchased are the first to be sold. Often parallels the actual physical flow of merchandise. Note: Inventory on balance sheet & net income on income statement are higher when companies use FIFO in a period of inflation

What are the 3 assumed cost flow methods?

First-in, first-out FIFO Last-in, first-out LIFO Average-cost Company management selects the appropriate cost flow method

LIFO Reserve

For a company using LIFO, the difference between inventory reported using LIFO and inventory using FIFO. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods.

Consigned Goods

Goods held for sale by one party although ownership of the goods is retained by another party. E.g. car dealer putting your car on their lot to sell for you. Ownership still belongs to you--not part of dealer's inventory

How does an error in ending inventory of the current period affect the next accounting period?

It will have a reverse effect on the net income of the next accounting period.

Tax Effects: Why do many companies select LIFO if FIFO produces higher net income in periods of inflation?

LIFO results in the lowest income taxes (because of lower net income) during times of rising prices.

LIFO Method

Last-in, First-out LIFO Method - assumes that the latest goods purchased are the first to be sold. Note: LIFO results in the lowest income taxes (because of lower net income) during times of rising prices

3 Categories of Inventory

Raw materials, Work in process, Finished goods Finished Goods - manufactured items that are completed and ready for sale Work in process - portion of manufactured inventory that has been placed into the production process but is not yet complete Raw Materials - basic goods that will be used in production but have not yet been placed into production All go under Current Assets of balance sheet

Income Statement Effects: In rising or falling prices, how does average-cost perform?

Regardless, average-costs produces net income between FIFO and LIFO

What is the LIFO conformity rule? (Tax Rule)

Requires that if companies use LIFO for tax purposes they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.

Income Statement Effects: How does the inventory cost flow method affect the income statement?

The method affects the ending inventory amount and the cost of goods sold amount. Each dollar difference in ending inventory results in a corresponding dollar difference in income before income taxes. To management, higher net income is an advantage--external users view the company more favorably. Others believe LIFO is more realistic and that not using LIFO leads to an understatement of cost of goods sold and an overstatement of net income during times of inflation.

What does high inventory turnover indicate?

This means low days in inventory, which indicates the company has minimal funds tied up in inventory--that it has a minimal amount of inventory on hand at any one time. Minimizing funds tied up in inventory is efficient, but too high might mean losing sales opportunities also because of inventory shortages.

Cecil gives goods on consignment to Jerry who agrees to try to sell them for a 25% commission. At the end of the accounting period, which of the following parties includes in its inventory the consigned goods? a. Cecil b. Jerry c. Both Cecil and Jerry d. Neither Cecil nor Jerry

a. Cecil

Which situation requires a departure from the cost basis of accounting to the lower-of-cost-or-market basis in valuing inventory? a. An increase in the value of the inventory b. A decline in the value of the inventory c. A desire for more profit d. An increase in selling price

b. A decline in the value of the inventory To comply with the concepts of conservatism, inventory should be valued at the lower-of-cost-or-market when there is a decline in inventory value.

When is a physical inventory usually taken? a. When a company has its greatest amount of inventory and when goods are not being sold or received. b. At the end of the company's fiscal year. c. When the company has its greatest amount of inventory. d. When goods are not being sold or received.

b. At the end of the company's fiscal year.

Which of the following statements is true? a. GAAP dictates the method of inventory costing method a company must use. b. Company management selects the method of inventory costing method a company will use. c. The SEC dictates the method of inventory costing method a company must use. d. The IRS dictates the method of inventory costing method a company must use.

b. Company management selects the method of inventory costing method a company will use.

Which of these transactions would cause the inventory turnover ratio to increase the most? a. Keeping the amount of inventory on hand constant but increasing sales b. Decreasing the amount of inventory on hand and increasing sales c. Keeping the amount of inventory on hand constant but decreasing sales d. Increasing the amount of inventory on hand

b. Decreasing the amount of inventory on hand and increasing sales Both an increase of sales and a decrease in inventory on hand will cause inventory turnover to increase the most.

Which of the following is not an inventory account? a. Finished goods b. Equipment c. Work in process d. Raw materials

b. Equipment

Which of the following would most likely employ the specific identification method of inventory costing? a. Hardware store b. Jewelry store c. Gasoline station d. Grocery store

b. Jewelry store Jewelry stores use the specific identification method because of the high value and uniqueness of many of the inventory items.

In periods of rising prices, what will LIFO produce? a. Higher net income than FIFO b. Lower net income than FIFO c. The same net income as FIFO d. Higher net income than average costing

b. Lower net income than FIFO Because cost of good sold includes the most recent costs which are the highest costs, net income under LIFO will be the lowest.

If a firm is using a perpetual inventory system and is using the average-cost method of valuation, when is a new average cost computed? a. At the end of the month b. At the end of the accounting period c. After each purchase d. After each sale

c. After each purchase When a firm is using a perpetual inventory system and is using the average-cost method of valuation, a new average cost is computed after each purchase.

Which one of the following is not a consideration that affects the selection of an inventory costing method? a. Income statement effects b. Tax effects c. Perpetual versus periodic inventory system d. Balance sheet effects

c. Perpetual versus periodic inventory system

Two companies report the same cost of goods available for sale, but each employs a different inventory costing method. If the price of goods has increased during the period, which statement is true? a. The company using FIFO will have the highest cost of good sold. b. The company using LIFO will have the lowest cost of goods sold. c. The company using FIFO will have the highest ending inventory. d. The company using LIFO will have the highest ending inventory.

c. The company using FIFO will have the highest ending inventory. Since the FIFO company will have the most current costs in inventory, the FIFO company will have the highest inventory value on the balance sheet during periods of rising prices.

How do the results under FIFO in a perpetual system compare to the results using a periodic system? a. FIFO cost of goods sold is higher using a periodic system. b. FIFO cost of goods sold is higher using a perpetual system. c. They are the same. d. There is not enough information to determine the answer.

c. They are the same. The results under FIFO in a perpetual system are the same as in a periodic system. Regardless of the system, the costs of first goods acquired are the costs assigned to cost of goods sold.

Which of the following is not a legitimate business reason for taking a physical inventory? a. To determine if any inventory has been lost from waste, shoplifting, or employee theft b. To determine cost of goods sold c. To verify the profitability of individual inventory items d. To check the accuracy of the perpetual inventory records

c. To verify the profitability of individual inventory items The profitability of individual inventory items cannot be assessed from counting the items in the ending inventory of a company. A more in depth analysis must be performed for this.

Ownership passes to the buyer when purchased goods are received from a public carrier if the goods are shipped a. FOB shipping point. b. FOB buyer. c. FOB shipper. d. FOB destination.

d. FOB destination. Under FOB destination, title transfers when the buyer receives the purchased goods from the public carrier, not when the public carrier accepts them from the seller.

If there is an error in the ending inventory affecting the net income of the current period, what will happen to the net income of the next accounting period? a. It will have no effect on the net income of the next accounting period. b. Cannot be determined from the information given. c. If net income was overstated in the current period, it will be overstated in the next period. d. It will have the reverse effect on the net income during the next accounting period.

d. It will have the reverse effect on the net income during the next accounting period. An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period.

Which is true if the ending inventory is overstated? a. Net income will be overstated and the stockholders' equity will be understated. b. Net income will be understated and the stockholders' equity will be understated. c. Net income will be understated and the stockholders' equity will be overstated. d. Net income will be overstated and the stockholders' equity will be overstated.

d. Net income will be overstated and the stockholders' equity will be overstated. If the ending inventory is overstated, cost of goods sold will be understated which causes net income to be overstated. Whenever net income is overstated, stockholders' equity will be overstated.

By using the LIFO method of inventory accounting, a company like Exxon: a. will report its inventory on its balance sheet at current prices. b. will overvalue its inventory on its balance sheet when prices of inputs are rising. c. will report higher earnings during rising prices of inputs and pay higher taxes. d. will report lower earnings during rising prices of inputs and pay lower taxes.

d. will report lower earnings during rising prices of inputs and pay lower taxes.

When inventory error overstates ending inventory, how does it affect cost of goods sold and net income?

Cost of goods sold is understated Net Income is overstated