Accounting Chapter 6: Inventories
Reasons that inventory errors may occur:
-Physical inventory on hand was miscounted -Costs were incorrectly assigned to inventory (FIFO, LIFO, or weighted average cost method could be incorrectly applied) -Inventory in transit was incorrectly included or excluded from inventory -Consigned inventory was incorrectly included or excluded from inventory
Primary documents used for inventory control
-Purchase Order -Receiving Report -Vendor's Invoice
Two Primary Objectives of Control of Inventory
-Safeguarding the inventory from theft -Reporting inventory in the financial statements
When would inventory be valued at something other than cost?
-The cost of replacing items in inventory is below the recorded cost -The inventory cannot be sold at normal prices due to imperfections, style changes, spoilage, damage, obsolescence, or other causes
If a business has too much inventory, what might be the results?
-ties up funds to be used to improve operations -Increases expenses (Storage and property taxes) -Increases the risk of losses due to price decreases, damage, or changes in customer taste
An example of a business that would use FIFO under the Perpetual Inventory System is:
A grocery store, Grocery stores need to sell things that have the soonest expiration dates, so the oldest products (earliest purchases) are sold first
What is the ratio of cost to retail prices used for?
A ratio of cost to retail prices is used to convert ending inventory at retail to estimate the ending inventory cost
What accounting issue arises when merchandise is purchased?
Accounting issue arises when identical units of merchandise are acquired at different unit costs during a period
Who would use the Specific Identification Inventory Cost Flow Method?
An automobile dealer may use the specific identification method because each automobile has a unique serial number
Who records any unsold merchandise shipped on consignment at years end?
Any unsold merchandise at year end is a part of the consignor's, manufacturer, physical inventory at the year's end Even though it's in the hand of the consignee, the retailer
When is the receiving report completed?
As soon as the inventory is received
When should a physical inventory be taken?
At year-end
Purchase Order
Authorizes the purchase of the inventory from an approved vendor
How do you calculate average inventory
Average inventory = (beginning inventory + ending inventory) / 2
Why is FIFO better under times of increasing costs?
Because FIFO values inventory based on the earliest purchases, the earliest purchases are less expensive. Therefore, the cost of goods sold is less, yielding a higher gross profit, yielding a higher net income.
Why is LIFO better under times of decreasing costs?
Because LIFO values inventory based on the most recent purchases, under times of decreasing costs, LIFO the cost of goods sold is less, yielding a higher gross profit, yielding a higher net income.
How does the perpetual inventory system keep inventory at proper levels?
Comparing inventory quantities with maximum and minimum levels allows for the timely reordering of inventory and prevents ordering excess inventory
Three common cost flow assumptions and their related inventory costing method
Cost flow is in the order in which the costs were incurred (First-In, First-Out Method) Cost flow is in the reverse order in which the costs were incurred (Last-In, Last-Out Method) Cost flow is an average of the cost (Weighted Average Cost)
What is cost the primary basis for?
Cost is the primary basis for valuing and reporting inventories in the financial statements
If the Beginning Inventory is understated why is the cost of goods sold understated?
Cost of goods sold is beginning inventory, plus purchases, purchases, and minus ending inventory. If beginning inventory is understated, the cost of goods available for sale is understated, therefore the cost of goods sold is understated.
Under the Weighted Average Inventory Cost Flow Method, what is the weighted average of the purchase costs?
Cost of units sold and the ending inventory is a weighted average of the purchase costs
FIFO Method Under the Perpetual Inventory System: How are costs included?
Costs are included in the cost of goods sold in the order in which they were purchases
Why is FIFO under the perpetual inventory system the most similar to the physical flow of goods?
Costs are included in the cost of goods sold in the order in which they were purchases
How does the retail method allow for management to monitor operations more closely
Department stores and similar retailers often determine gross profit and operating income each month, but may take a physical inventory only once or twice a year, the retail method provides inventory figures for preparing monthly statements
Steps in the Gross Profit Method
Determine the merchandise available for sale at cost Determine the estimated gross profit by multiplying sales by the gross profit percentage Determine the estimated cost of goods sold by deducting the estimated gross profit from the sales Estimate the ending inventory cost by deducting the estimated cost of goods sold from the merchandise available for sale.
Steps in the Retail Inventory Method
Determine the total merchandise available for sale at cost and retail Determine the ratio of the cost to retail of the merchandise available for sale Determine the ending inventory at retail by deducting the sales from the merchandise available for sale at retail Estimate the ending inventory cost by multiplying the ending inventory at retail by the cost to retail ratio
What do direct costs of disposal include?
Direct costs of disposal include selling expenses (such as special advertising or sales commissions)
How could the cost, market price, and any declines could be determined for:
Each item in the inventory Each major class or category of inventory Total inventory as a whole
The valuation at the lower of cost or market can be applied to:
Each item in the inventory Each major class or category of inventory Total inventory as a whole
What is the ending inventory made up of when using the Specific Identification Inventory Cost Flow Method?
Ending inventory is made up of the remaining units on hand
Receiving Report
Establishes an initial record of the receipt of inventory
Decreasing Costs: Highest Amount of Cost of Goods Sold
FIFO
Decreasing Costs: Lowest amount of Gross Profit
FIFO
Decreasing Costs: Lowest amount of ending inventory
FIFO
Decreasing Prices: lowest amount of net income
FIFO
Effects of Increasing Costs: Highest Amount of Ending Inventory
FIFO
Effects of Increasing Costs: Highest Amount of Gross Profit
FIFO
Effects of Increasing Costs: Highest Amount of Net Income
FIFO
Effects of Increasing Costs: Lowest Amount of Cost of Goods Sold
FIFO
The inventory costing method that reports the most current prices in ending inventory is
FIFO
What method is better under times of increasing costs?
FIFO
Which cost flow method under the Perpetual Inventory System is the most similar to the physical flow of goods?
FIFO
Which cost flow method under the Perpetual Inventory System is about the same as the specific identification method and why?
FIFO because it is the most similar to the physical flow of goods
Why does FIFO yield a lower net income during times of decreasing costs?
FIFO yields a lower gross profit under times of decreasing costs, therefore net income is lower.
Why does FIFO yield a lower amount of gross profit during times of decreasing costs?
Gross profit is made up if sales minus the cost of goods sold. Under FIFO, the cost of goods sold is made up of the earliest purchases. If prices are decreasing, FIFO yields a higher amount of cost of goods sold. Therefore, there is more to subtract from sales revenue
Why does FIFO yield a higher amount of gross profit under times of increasing costs?
Gross profit is made up of sales minus cost of goods sold. Under FIFO, the cost of goods sold is made up of the earliest purchases. If costs are increasing, the earliest costs would be the cheapest, therefore there is less to subtract from sales.
Why does LIFO yield a lower amount of gross profit under times of increasing costs?
Gross profit is made up of sales minus cost of goods sold. Under LIFO, the cost of goods sold is made up of the the most recent purchases. If costs are increasing, the most recent purchases are more expensive than the earliest purchases. Therefore, there is more to subtract from sales.
Why does LIFO yield a higher gross profit during times of decreasing costs?
Gross profit is made up of sales minus cost of goods sold. Under LIFO, the cost of goods sold is made up of the the most recent purchases. If prices are decreasing, LIFO yields the lowest cost of goods sold. Therefore, there is less to subtract from sales revenue.
If Beginning Inventory is overstated, why is net income understated?
If beginning inventory is overstated, the gross profit is understated. Therefore, when you subtract expenses from gross profit, there should have been more to subtract from in the first place.
When is the inventory purchased recorded in the accounting records
If everything on the purchase order, receiving report, and vendor's invoice agrees
If Beginning Inventory is overstated, why is gross profit understated?
If the beginning inventory is overstated, the cost of goods sold is overstated. Therefore, when you go to calculate gross profit, which is sales minus the cost of goods sold, you end up subtracting more from sales than you should have.
If Beginning Inventory is overstated, why is cost of goods sold overstated?
If the beginning inventory is overstated, there should have been less to add to the purchases. Therefore the cost of goods available for sale is higher, and after you subtract ending inventory, the cost of goods sold is overstated.
If the ending inventory is overstated, why is the cost of good sold understated?
If the ending inventory is overstated, you subtracted more than you should have from cost of goods available for sale during the period. Therefore, you should have a higher cost of goods sold
If Ending Inventory is Understated, why is cost of goods sold overstated?
If the ending inventory is understated, then you should have subtracted more from the cost of goods available for sale during the period when calculating cost of goods sold.
if a business changes its costing method, what do they need to do?
If they do, the effect of the change and the reason for the change are disclosed in the notes to the financial statements
How do you calculate inventory turnover?
Inventory Turnover = cost of goods sold/average inventory
Specific Identification Inventory Cost Flow Method
Inventory method in which the unit sold is identified with a specific purchase.
Two measures to analyze inventory management are:
Inventory turnover Number of days' sales in inventory
Decreasing Costs: Highest gross profit
LIFO
Decreasing Costs: Lowest amount of costs of goods sold
LIFO
Decreasing Costs: highest amount of ending inventory
LIFO
Decreasing Costs: highest amount of net income
LIFO
Effects of Increasing Costs Highest Amount of Cost of Goods Sold
LIFO
Effects of Increasing Costs: Lowest Amount of Ending Inventory
LIFO
Effects of Increasing Costs: Lowest Amount of Gross Profit
LIFO
Effects of Increasing Costs: Lowest Amount of Net Income
LIFO
The inventory method that assigns the most recent costs to cost of goods sold is
LIFO
What method is better under times of decreasing costs?
LIFO
Why does LIFO yield a higher net income during times of decreasing prices?
LIFO yields a higher gross profit under times of decreasing costs, therefore net income is higher.
Market, as used in the lower of cost or market, is the....
Market, as used in lower of cost or market, is the net realizable value of the inventory
What does the number of days' sales in inventory measure?
Measures the length of time it takes to acquire, sell, and replace the inventory
Consigned Inventory
Merchandise that is shipped from manufacturers to retailers, who act as the manufacturer's selling agent
Why does FIFO yield the highest amount of net income under times of increasing costs?
Net income is determined by subtracting expenses from gross profit. In times of increasing costs, FIFO yields the highest gross profit, therefore a higher net income.
Why does LIFO yield the lowest amount of net income under times of increasing costs?
Net income is determined by subtracting expenses from gross profit. In times of increasing costs, LIFO yields the lowest gross profit, therefore a lower net income.
How is the net realizable value determined
Net realizable value = estimated selling price - direct costs of disposal
Why is the Specific Identification Inventory Cost Flow Method not practical?
Not practical unless each inventory unit can be separately identified, which most businesses cannot do
How do you calculate the number of days' sales in inventory?
Number of Days' Sales in Inventory = Average Inventory / Average Daily Cost of Goods Sold
If the ending inventory is overstated, the balance sheet effects are: Inventory Current Assets Total Assets Stockholders' Equity
Overstated
If Beginning Inventory is overstated, the income statement effects are: Cost of Goods Sold Gross Profit Net Income
Overstated Understated Understated
If Ending Inventory is Understated, the income statement effects are: Cost of Goods Sold Gross Profit Net Income
Overstated Understated Understated
Under this system, only revenue is recorded when sales are made.
Periodic
When using this system, a physical inventory is necessary to determine cost of goods sold.
Periodic
Average cost is rarely used with this system.
Perpetual
This system can be costly and time consuming if not computerized.
Perpetual
What inventory system is an effective means of inventory control?
Perpetual Inventory System
A business may need to estimate the amount of inventory for the following reasons
Perpetual inventory records are not maintained A disaster such as a fire or flood has destroyed the inventory records and the inventory Monthly or quarterly financial statements are needed, but a physical inventory is taken once a year
What is the vendor's invoice compared with?
Price, quantity, and description of the item on the purchase order and receiving report is compared with the vendor's invoice
Advantages to the retail method
Provides inventory figures for preparing monthly statements Allows management to monitor operations more closely
What does the retail method of inventory costing require
Requires costs and retail prices to be maintained for the merchandise available for sale
If Ending Inventory is Understated, why is gross profit understated?
Since the cost of goods sold is overstated, you subtracted more than you should have from sales.
If Ending Inventory is Understated, why is net income understated?
Since the gross profit is understated, you should have more to subtract from when you calculate net income
If the ending inventory is overstated, why is gross profit overstated?
Since your cost of goods sold is understated, you should have subtracted more than you did from sales.
If the ending inventory is overstated, why is the net income overstated?
Since your gross profit is overstated, you should have less to subtract expenses from.
Security Measures for inventory control should include:
Storing inventory in areas that are restricted to only authorized employees Locking high-priced inventory in cabinets Using two way mirrors, cameras, security tags, and guards
What is the Weighted Average Inventory Cost Flow Method sometimes called?
The Average Cost Flow Method
Why is the perpetual inventory system an effective means of inventory control?
The amount of inventory is always available in the subsidiary inventory ledger, which keeps inventory at proper levels
How do you calculate the average daily cost of goods sold
The average daily cost of goods sold = cost of goods sold / 365
Inventory errors misstate what on the income statement?
The cost of goods sold gross profit net income
Periodic Weighted Average Cost Method: How is the cost of goods sold determined?
The cost of goods sold is determined by subtracting the ending inventory from the cost of goods available for sale during the period
Why does FIFO yield a lower amount of cost of goods sold under times of increasing costs?
The cost of goods sold under FIFO is made up of the earliest purchases, and if costs are increasing, the earliest costs are cheaper than the most recent
Why does FIFO have yield the highest amount of cost of goods sold during times of decreasing costs?
The cost of goods sold under FIFO is made up of the most earliest purchases. If prices are declining, the earliest purchases are more expensive than the most recent purchases.
Why does LIFO yield a lower amount of cost of goods sold during times of decreasing costs?
The cost of goods sold under LIFO is made up of the most recent purchases. If prices are declining, the most recent purchases are more expensive than the earliest purchases.
Moving average
The cost of sale changes every time a purchase is made
Periodic Weighted Average Cost Method: How is the cost of the ending inventory determined by?
The cost of the ending inventory is determined by multiplying the physical count of inventory by the weighted average unit cost
What is the cost of the unit sold when using LIFO under the Perpetual Inventory System?
The cost of the units sold is the cost of the most recent purchases
Why is LIFO yield higher amounts of cost of goods sold under times of increasing costs?
The costs of goods sold under LIFO is made up of the most recent purchases, and if costs are increasing, the most recent purchases are more expensive
How is the gross profit estimated when using the Gross Method of Inventory Costing Method?
The gross profit is estimated from the preceding year, adjusted for any current-period changes in the cost and sales prices
If the Beginning Inventory is understated why is gross profit overstated?
The gross profit is sales minus the cost of goods sold. If the beginning inventory is understated, so is the cost of goods sold. Therefore gross profit is understated because more cost of goods sold should have been subtracted from sales.
How can the retail method be used as an aid in taking a physical inventory
The items are counted and recorded at their retail (selling) prices instead of their costs The physical inventory at retail is the converted to cost by using the cost to retail ratio
What does a larger turnover inventory indicate?
The larger the inventory turnover the more efficient and effective the company is in managing inventory
In addition to the amount of inventory, the following are also reported on the current assets section of the balance sheet:
The method of determining the cost of inventory (FIFO, LIFO, or weighted average) The method of valuing the inventory (Cost or the lower of cost of market)
If the Beginning Inventory is understated why is net income overstated?
The net income is gross profit minus expenses. If the beginning inventory is understated, the gross profit is overstated, so the net income is overstated as well because there should have been a smaller gross profit to subtract expenses from.
What does weighted average mean?
The purchases costs are weighted by the quantities purchased at each cost
Subsidiary Ledger using the LIFO Method under the Perpetual Inventory System
The subsidiary ledger is sometimes maintained in units only Units are converted to dollars when the financial statements are prepared at the end of the period
Why does the buyer record inventory in transit at years end FOB Shipping Point
The title of the merchandise is in the buyers name
What cost flow method provides results that are most similar to the physical flow of goods under the periodic inventory system?
The weighted average cost flow method
Why does FIFO yield a lower amount of ending inventory during times of decreasing costs?
Under FIFO, ending inventory is made up of the earliest purchases. If prices are decreasing the earliest purchases are more expensive than the most recent.
Why does FIFO yield the highest amount of ending inventory under times of increasing costs?
Under FIFO, ending inventory is made up of the most recent purchases. If prices are increasing, the ending inventory, made up of the most recent purchases, would be more expensive than the earliest purchases.
Why does LIFO yield a higher amount of ending inventory during times of decreasing prices?
Under LIFO, ending inventory is made up of the most recent purchases. If costs are decreasing, the ending inventory under LIFO is less expensive because the earliest purchases are more expensive than the most recent
Why does LIFO yield the lowest amount of ending inventory under times of increasing costs?
Under LIFO, ending inventory is made up of the most recent purchases. If prices are increasing, the ending inventory, made up of the earliest purchases, would be less expensive than the most recent purchases.
If the ending inventory is understated, the balance sheet effects are: Inventory Current Assets Total Assets Stockholders' Equity
Understated
If Ending Inventory is overstated, the income statement effects are: Cost of Goods Sold Gross Profit Net Income
Understated Overstated Overstated
If the Beginning Inventory is understated the income statement effects are: Cost of Goods Sold Gross Profit Net Income
Understated Overstated Overstated
When is the valuation at lower of cost or market used?
Used to value inventory if the market is lower than the purchase cost
What does the Gross Profit Method of Inventory Costing use the estimated gross profit for?
Uses the estimated gross profit for the period to estimate the inventory at the end of the period
How was LIFO originally used under the Perpetual Inventory System?
Was originally used in those rare cases where the units sold were taken from the most recent purchased units
What is necessary when an item is sold
When an item is sold, it is necessary to determine its cost using a cost flow assumption and related inventory costing method
What is assumed when estimating the cost to retail ratio?
When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be the same as the merchandise available for sale
When must a cost flow method be used?
When identical units of an item are purchased at different costs. true regardless of whether or not a business uses a perpetual or periodic inventory system
Periodic LIFO: How is the physical inventory determined?
You take the earliest units purchased until you have the total remaining units
Periodic FIFO: How is the cost of the physical inventory determined?
You take the remaining physical units, and the last purchases are taken until you have the total physical count. for example, if you have 800 remaining units, the most recent 800 units purchased are used.
What is the preferred inventory turnover?
a larger one
If a business has too little inventory, what might be the result?
a lose in sales
When do the controls for inventory begin
as soon as the inventory is purchased
When is a physical count of inventory made under the periodic inventory system?
at the end of the accounting period
Why do effects of inventory error carry over to the next period?
because the ending inventory of one period is the beginning inventory of the next
Why does the seller include the inventory in transit at years end under FOB Destination?
because the title of the merchandise is still in the seller's name
The primary basis for valuing and reporting inventories in the financial statements
cost
What happens when the ending inventory is made up of different classes of merchandise
cost to retail ratios may be developed for each class of inventory
What is a physical inventory also called?
count of inventory
Periodic Weighted Average Cost Method: How is the weighted average unit cost determined?
dividing total cost of units available for sale by units available for sale
Weighted Average Cost Method under the Perpetual Inventory System: When is a weighted average unit cost for each item is computed?
each time a purchase is made
How much merchandise should a business keep on hand?
enough to meet its customers needs
Why is LIFO under the Perpetual Inventory System now widely used?
for tax purposes
Why is LIFO under the Perpetual Inventory System used even though it doesn't represent the physical flow of goods?
for tax purposes
What can vary when using the Specific Identification Inventory Cost Flow Method?
gross profit, cost of goods sold, and ending inventory
When does the periodic weighted average method provides results that are similar to the physical flow of goods?
if the purchases are relatively uniform during the period
Inventory errors misstate what on the balance sheet?
inventory, current assets, total assets, and stockholders' equity
It's not unusual for what type of businesses to use different costing methods for segments of its inventories
large businesses
What is the preferable number or days' sales in inventory?
lower
Where is inventory usually reported?
on the current assets section of the balance sheet
How many ways can the valuation at lower of cost or market be applied
one of three ways
Under the periodic inventory system, what is recorded when a sale is made?
only revenue, no record of the cost of goods sold
if uncorrected, the effects of inventory error do what in the next period
reverse themselves
Any errors in inventory will affect:
the balance sheet and income statement
Periodic FIFO: what is the cost of goods sold made up of?
the beginning inventory and the earliest costs
inventory in transit at year end under FOB Shipping point is included in who's year end inventory?
the buyers
Periodic Weighted Average Cost Method: What does the weighted average unit cost used to determine?
the cost of goods sold and the ending inventory
What is the physical count of inventory under the periodic inventory system used to determine?
the cost of the inventory cost of goods sold
Periodic FIFO: what is the cost of the goods on hand at the end of the accounting period made up of?
the earliest costs
Periodic LIFO: What is the cost of the ending inventory made up of?
the earliest costs
What is the ending inventory made up of under the LIFO method?
the first purchases
What units are assumed to be sold when using the FIFO method?
the first units purchased
What units are assumed to be sold when using the LIFO method?
the last units purchased are assumed to be sold
What does a lower number of days' sales in inventory indicate?
the lower of number of days' sales in inventory, the more efficient and effective the company is in managing inventory
The consignor
the manufacturer
Merchandise sold on consignment belongs to who?
the manufacturer retains the title of the good until they are sold
Periodic FIFO: what is the cost of the ending inventory made up of?
the most recent costs
Periodic FIFO: what is the cost of the goods on hand at the end of the accounting period made up of?
the most recent costs
Periodic LIFO: What is the cost of goods sold made up of?
the most recent costs
What is the ending inventory made up of under the FIFO method?
the most recent purchases
How long does is take for inventory errors to correct themselves on the income statement?
the next period
Process of reporting inventory at year-end
the physical count of inventory is taken, then the cost of inventory is assigned for reporting in the financial statements using a cost flow method
What is the receiving report compared with?
the purchase order
What does inventory turnover measure
the relationship between the cost of goods sold and the amount of inventory carried during the period The number of times inventory turned into sold goods during the year
Consignee
the retailer
inventory in transit at year end under FOB Destination is included in who's year end inventory?
the seller
Weighted Average Cost Method under the Perpetual Inventory System: What is used to determine the cost of each sale?
the unit cost
Periodic Weighted Average Cost Method: What happens if the purchases are relatively uniform during the period?
the weighted average cost method provides the results that are similar to the physical flow of goods
Why is the purchase order compared with the receiving report?
to make sure everything that was received is what was ordered
Why should a physical inventory be taken at year-end
to make sure that the quantity of inventory reported in the financial statements is accurate
Why should security measures for inventory control be used to safeguard inventory?
to prevent damage to inventory or customer or employee theft
How long does it take for inventory errors to correct themselves on the balance sheet?
two years
