Chapter 7 important concepts and key terms
Converting the INVENTORY TURNOVER RATIO to the number of DAYS TO SELL
(365)/(Inventory Turnover Ratio)
Inventory turnover ratio formula
(Cost of Goods Sold)/(Average Inventory)
Depending on whether costs are rising or falling, different methods have different effects on the financial statements
Ending Inventory and Cost of Goods Sold will be smaller or larger depending on the method used and whether costs are rising or falling.
Declining Unit Costs
Ending Inventory: FIFO ≤ WA ≤ LIFO LIFO most expensive^ Costs of Goods Sold: FIFO ≥ WA ≥ LIFO FIFO most expensive^
Rising Unit Costs
Ending Inventory: FIFO ≥ WA ≥ LIFO FIFO most expensive^ Costs of Goods Sold: FIFO ≤ WA ≤ LIFO LIFO most expensive^
Cost of goods sold formula AND Ending Inventory formula
Periodic updating: Beginning Inventory + Purchases − Ending Inventory = Cost of Goods Sold Perpetual updating: Beginning Inventory + Purchases − Cost of Goods Sold = Ending Inventory
Report the expense of an inventory write-down as Cost of Goods Sold
Most companies report the expense of an inventory write-down as Cost of Goods Sold, even though the written-down goods may not have been sold. This reporting is appropriate because writing down goods that haven't yet sold is a necessary cost of carrying the goods that did sell.
consignment inventory
Refers to goods a company is holding on behalf of the goods' owner. Consignment inventory is reported on the balance sheet of the owner, not the company holding the inventory.
weighted average cost example
May 3 $70 cost for inventory, May 5 $75 cost for inventory, May 6 $95 cost for inventory [($70+$75+$95)/3 = $80] --> if 2 items were sold then the cost of goods sold = 2 x $80 = $160
Days to Sell
Measure of the average number of days from the time inventory is bought to the time it is sold.
"Market value" in LCM/NRV
"Market value" focuses on how much the inventory would cost to replace in current market conditions (replacement cost).
"Net realizable value" in LCM/NRV
"Net realizable value" focuses on the inventory value likely to be realized when sold (selling price minus selling costs such as delivery).
Four generally accepted inventory costing methods (acceptable under GAAP in the United States)
1. Specific Identification 2. First-in, first-out (FIFO) 3. Last-in, first-out (LIFO) 4. Weighted average cost
manufacturers inventory
1. raw materials inventory 2. work in process inventory 3. finished goods inventory
Consistency in Reporting
A common question is whether managers are free to choose LIFO one period, FIFO the next, and then go back to LIFO, depending on whether unit costs are rising or declining during the period. Because this switching would make it difficult to compare financial results across periods, accounting rules discourage it. A CHANGE IN METHOD IS ALLOWED ONLY IF IT IMPROVES THE ACCURACY OF THE COMPANY'S FINANCIAL RESULTS. A company can, however, use different methods for inventories that differ in nature or use, provided the methods are used consistently over time. Tax rules also limit the methods that can be used. IN THE UNITED STATES, THE LIFO CONFORMITY RULE REQUIRES THAT IF LIFO IS USED ON THE INCOME TAX RETURN, IT ALSO MUST BE USED IN FINANCIAL STATEMENT REPORTING.
specific identification method
A method of assigning costs to inventory that identifies the cost of each specific item purchased and sold.
What a higher turnover ratio means
Analysts can assess how many times, on average, inventory has been bought and sold during the period by calculating the inventory turnover ratio. A higher ratio indicates that inventory moves more quickly from purchase to sale, reducing storage and obsolescence costs. Because less money is tied up in inventory, the excess can be invested to earn interest or reduce borrowing, which reduces interest expense. More efficient purchasing and production techniques as well as high product demand will boost this ratio. A sudden decline in the inventory turnover ratio may signal an unexpected drop in demand for the company's products or sloppy inventory management.
How an inventory write-down is determined and recorded (example)
Included in American Eagle's ending inventory are two items whose values have recently changed: vintage jeans and leather coats. The vintage jeans are recorded at their average cost of $20 per item. These jeans are expected to sell for $25 each, so they do not need to be written down because they already are reported at the lower amount (i.e., their $20 cost). However, the leather coats are estimated to have a lower value ($150) than their recorded cost ($165 each). Thus, the inventory of leather coats needs to be written down by $15 per leather coat or, in total, $15,000 ($15 × 1,000 units). Total Write-down = $15,000
Refer to Exhibit 7.7 Summary of Inventory Turnover Ratio Analyses
Look at the examples and understand how the inventory turnover and days to sell are calculated
difference in periodic FIFO method and perpetual FIFO method
The only difference is perpetual allows you to "force out" the cost of Ending Inventory so that it can be compared to the cost of goods actually on hand (to determine shrinkage). Periodic requires you to use the cost of goods in Ending Inventory to force out the Cost of Goods Sold (so you cannot determine shrinkage).
Lower of Cost or Market/Net Realizable Value (LCM/NRV)
Valuation method departing from the cost principle; recognize a loss when inventory value drops below cost. (When inventory value falls below its cost, GAAP requires the inventory to be written down to its lower value. This rule is known as reporting inventories at the LOWER COST OR MARKET/NET REALIZABLE VALUE)
Comparing turnover ratios
With inventory turnover ratios varying between industries and companies, it's most useful to compare a company's turnover with its own results from prior periods.
where is inventory reported?
as a current asset on the balance sheet
how is inventory recorded?
at cost, which is the amount paid to acquire the asset and prepare it for sale
Cost of Goods Available for Sale
beginning inventory + cost of goods purchased
Nearly half of all U.S. companies use FIFO, so even if they calculate costs under a perpetual system, it is identical to calculating costs under a periodic system.
interesting fact
Often, the company with a lower gross profit percentage has a faster inventory turnover.
interesting fact
Over the two years, these errors offset one another. Inventory errors will "self-correct" like this only if ending inventory is accurately calculated at the end of the following year and adjusted to that correct balance. (That these errors are self-correcting does not make them "OK." They are errors.)
interesting fact
merchandise inventory
merchandise inventory consists of products acquired in a finished condition, ready for sale without further processing
raw materials inventory
such as plastic, steel, or fabrics
work in process inventory
when the raw materials enter the production process - goods that are in the process of being manufactured
finished goods inventory
work in process inventory becomes finished goods inventory, which is ready for sale just like merchandise inventory
weighted average cost formula
(Cost of Goods Available for Sale)/(Number of Units Available for Sale)
The effect of a $15000 write-down on the accounting equation and the journal entry to record it are
(Step 1: Analyze) Assets = Liabilities + SE Under Assets: Inventory = -15000 Under SE: Cost of Goods Sold (+E) = -15000 (Step 2: Record) Costs of Good sold debited 15000 Inventory credited 15000
What Days to Sell tells you
- Average number of days from purchase to sale - A higher number means a longer time to sell
What the Inventory turnover ratio tells you
- The number of times inventory turns over during the period - A higher ratio means faster turnover
Reasons the value of inventory can fall below its recorded cost (two reasons):
1. It's easily replaced by identical goods at a lower cost 2. It's become outdated or damaged.
Primary goals of inventory managers
1. Maintain a sufficient quantity of inventory to meet customers' needs 2. Ensure quality meets customers' expectations and company standards 3. Minimize the costs of acquiring and carrying the inventory (including costs related to purchasing, production, storage, spoilage, theft, obsolescence, and financing)
First-in, first-out (FIFO) method (or) FIFO method
Assumes that the first goods purchased (the first in) are the first goods sold
Last-in, first-out (LIFO) method (or) LIFO method
Assumes that the most recently purchased units (the last in) are sold first
Only the LIFO and weighted average calculations differ between periodic and perpetual inventory systems.
FIFO calculations don't differ between periodic and perpetual systems.
an example of how an inventory error in year 1 affects inventory in year 2
To determine the effects of inventory errors in the current and following year, use the cost of goods sold equation. For example, assume inventory was overstated at the end of Year 1 by $10,000 due to an error that was not discovered until Year 2. This would have the following Year 1 effects: Year 1 Beginning Inventory is Accurate + Purchases is Accurate - Ending Inventory is Overstated $10,000 = Cost of Goods Sold is Understated $10,000 Because Cost of Goods Sold was understated, Gross Profit and Income before Income Tax Expense would be overstated by $10,000 in Year 1 The Year 1 ending inventory becomes the Year 2 beginning inventory, so even if Year 2 ending inventory is calculated correctly, the error in Year 1 creates an error in Year 2, as shown in the following table: Year 2 Beginning Inventory is Overstated $10,000 + Purchases is Accurate − Ending Inventory is Accurate = Cost of Goods Sold is Overstated $10,000 Because Cost of Goods Sold is overstated in Year 2, that year's Gross Profit and Income before Income Tax Expense would be understated by the same amount in Year 2. (Net Income would be understated as well, although the effects would be offset somewhat by understated Income Tax Expense.)
Weighted Average Cost Method
Uses the weighted average unit cost of goods available for sale for calculations of both the cost of goods sold and ending inventory
As mentioned earlier in the chapter, the failure to correctly apply the LCM/NRV rule to ending inventory is considered an error. Other errors can occur when using either a periodic or perpetual inventory system by using inappropriate quantities or unit costs. Regardless of the reason, errors in inventory can significantly affect both the balance sheet and the income statement. As the cost of goods sold equation indicates, a direct relationship exists between ending inventory and cost of goods sold because items not in the ending inventory are assumed to have been sold. Thus, any errors in ending inventory will affect the balance sheet (current assets) and the income statement (Cost of Goods Sold, Gross Profit, and Net Income). The effects of inventory errors are felt in more than one year because the ending inventory for one year becomes the beginning inventory for the next year.
interesting fact
companies typically adjust their records at year-end to match a physical count of the inventory on hand, so as a practical matter, these companies are in substance on a periodic costing system.
interesting fact
most LIFO companies actually use FIFO during the period and then adjust to LIFO at the end of the period. By waiting to the end of the period to calculate this LIFO adjustment, it's as if all purchases during the period were recorded before the Cost of Goods Sold is calculated and recorded. In other words, it's as if these companies use a periodic inventory system to determine their LIFO inventory numbers, even though they actually track the number of units bought and sold on a perpetual basis
interesting fact
goods in transit
inventory items being transported