Chapter 6: Reporting and Analyzing Inventory
Determining inventory quantities involves two steps
(1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.
. Which of the following should not be included in the inventory of a company using IFRS? (a) Goods held on consignment from another company. (b) Goods shipped on consignment to another company. (c) Goods in transit from another company shipped FOB shipping point. (d) None of the above.
(a) Goods held on consignment from another company.
Which of the following should not be included in the physical inventory of a company? (a) Goods held on consignment from another company. (b) Goods shipped on consignment to another company. (c) Goods in transit from another company shipped FOB shipping point. (d) All of the above should be included.
(a) Goods held on consignment from another company.
Specific identification: (a) must be used under IFRS if the inventory items are not interchangeable. (b) cannot be used under IFRS. (c) cannot be used under GAAP. (d) must be used under IFRS if it would result in the most conservative net income.
(a) must be used under IFRS if the inventory items are not interchangeable.
As a result of a thorough physical inventory, Railway Company determined that it had inventory worth $180,000 at December 31, 2014. This count did not take into consideration the following transactions: ● Rogers Consignment store currently has goods worth $35,000 on its sales floor that belong to Railway but are being sold on consignment by CityplaceRogers. The selling price of these goods is $50,000. ● Railway purchased $13,000 of goods that were shipped on December 27, FOB destination, that will be received by Railway on January 3. Determine the correct amount of inventory that Railway should report. $193,000 $230,000 $215,000 $228,000
$215,000
As a result of a thorough physical inventory, Railway Company determined that it had inventory worth $180,000 at December 31, 2014. This count did not take into consideration the following facts. Rogers Consignment store currently has goods worth $35,000 on its sales floor that belong to Railway but are being sold on consignment by Rogers. The selling price of these goods is $50,000. Railway purchased $13,000 of goods that were shipped on December 27, FOB destination, that will be received by Railway on January 3. Determine the correct amount of inventory that Railway should report. (a) $230,000. (b) $215,000. (c) $228,000. (d) $193,000.
(b) $215,000. 180,000+35,000
Carlos Company had beginning inventory of $80,000, ending inventory of $110,000, cost of goods sold of $285,000, and sales of $475,000. Carlos's days in inventory is: (a) 73 days. (b) 121.7 days. (c) 102.5 days. (d) 84.5 days.
(b) 121.7 days. (285/((80000+110000)/2)=3 365/3=121.7
Which method of inventory costing is prohibited under IFRS? (a) Specific identification. (b) LIFO. (c) FIFO. (d) Average-cost.
(b) LIFO.
Fran Company's ending inventory is understated by $4,000. The effects of this error on the current year's cost of goods sold and net income, respectively, are: (a) understated and overstated. (b) overstated and understated. (c) overstated and overstated. (d) understated and understated.
(b) overstated and understated.
Harold Company overstated its inventory by $15,000 at December 31, 2014. It did not correct the error in 2014 or 2015. As a result, Harold's stockholders' equity was: (a) overstated at December 31, 2014, and understated at December 31, 2015. (b) overstated at December 31, 2014, and properly stated at December 31, 2015. (c) understated at December 31, 2014, and understated at December 31, 2015. (d) overstated at December 31, 2014, and overstated at December 31, 2015.
(b) overstated at December 31, 2014, and properly stated at December 31, 2015.
Kam Company has the following units and costs. Units Unit Cost Inventory, Jan. 1 8,000 $11 Purchase, June 19 13,000 12 Purchase, Nov. 8 5,000 13 If 9,000 units are on hand at December 31, what is the cost of the ending inventory under FIFO? (a) $99,000. (b) $108,000. (c) $113,000. (d) $117,000.
(c) $113,000. (5,000*13)+(4,000*12)
Yang Company purchased 2,000 phones and has 400 phones in its ending inventory at a cost of $90 each and a current replacement cost of $80 each. The net realizable value of each phone in the ending inventory is $70. The ending inventory under lower-of-cost-or-net realizable value is: (a) $36,000. (b) $32,000. (c) $28,000. (d) None of the above.
(c) $28,000.
IFRS requires the following: (a) Ending inventory is written up and down to net realizable value each reporting period. (b) Ending inventory is written down to net realizable value but cannot be written up. (c) Ending inventory is written down to net realizable value and may be written up in future periods to its net realizable value but not above its original cost. (d) Ending inventory is written down to net realizable value and may be written up in future periods to its net realizable value.
(c) Ending inventory is written down to net realizable value and may be written up in future periods to its net realizable value but not above its original cost.
In periods of rising prices, LIFO will produce: (a) higher net income than FIFO. (b) the same net income as FIFO. (c) lower net income than FIFO. (d) higher net income than average-cost.
(c) lower net income than FIFO.
Kam Company has the following units and costs. Units Unit Cost Inventory, Jan. 1 8,000 $11 Purchase, June 19 13,000 12 Purchase, Nov. 8 5,000 13 what is the cost of the ending inventory under LIFO? (a) $113,000. (b) $108,000. (c) $99,000. (d) $100,000.
(d) $100,000. (8,000*11)+(1,000*12)
Davidson Electronics has the following: Units Unit Cost Inventory, Jan. 1 5,000 $ 8 Purchase, April 2 15,000 10 Purchase, Aug. 28 20,000 12 If Davidson has 7,000 units on hand at December 31, the cost of ending inventory under the average-cost method is: (a) $84,000. (b) $70,000. (c) $56,000. (d) $75,250.
(d) $75,250. (((5,000*8)+(15,000*10)+(12000*12))/40=10.75 10.75 * 7,000
When is a physical inventory usually taken? (a) When the company has its greatest amount of inventory. (b) When a limited number of goods are being sold or received. (c) At the end of the company's fiscal year. (d) Both (b) and (c).
(d) Both (b) and (c).
Which of these would cause inventory turnover to increase the most? (a) Increasing the amount of inventory on hand. (b) Keeping the amount of inventory on hand constant but increasing sales. (c) Keeping the amount of inventory on hand constant but decreasing sales. (d) Decreasing the amount of inventory on hand and increasing sales.
(d) Decreasing the amount of inventory on hand and increasing sales.
In a perpetual inventory system, (a) LIFO cost of goods sold will be the same as in a periodic inventory system. (b) average costs are based entirely on unit-cost simple averages. (c) a new average is computed under the average-cost method after each sale. (d) FIFO cost of goods sold will be the same as in a periodic inventory system.
(d) FIFO cost of goods sold will be the same as in a periodic inventory system.
Considerations that affect the selection of an inventory costing method do not include: (a) tax effects. (b) balance sheet effects. (c) income statement effects. (d) perpetual versus periodic inventory system.
(d) perpetual versus periodic inventory system.
Merchandisers have how many inventory classifications?
1
Thus, inventory errors affect the computation of cost of goods sold and net income in ______ period(s).
2 both the beginning and ending inventories appear in the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two periods.
Manufacturers have how many inventory classifications?
3 Finished goods work in process raw materials
Days in Inventory
365/Inventory Turnover (Liquidity) 365/Cost of Goods Sold/Average Inventory
The following information came from the income statement of the Wilkens Company at December 31, 2014: sales revenue $1,800,000; beginning inventory $160,000; ending inventory $240,000; and gross profit $600,000. What is Wilkens' inventory turnover ratio for 2014? 3.0 times 2.5 times 6.0 times 3.75 times
6.0 times
Lower of Cost or Market (LCM)
A basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost. LCM is an example of the accounting convention of conservatism. Conservatism means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income
If the ending inventory is overstated, what occurs? Assets are overstated and the net income is understated. Assets are overstated and the liabilities are understated. Assets are overstated and the cost of goods sold is overstated. Assets are overstated and stockholders' equity is overstated.
Assets are overstated and stockholders' equity is overstated.
Why might the company use two methods (LIFO and FIFO) to account for its inventory?
Companies are free to choose different cost flow assumptions for different types of inventory. A company might choose to use FIFO for a product that is expected to decrease in price over time. One common reason for choosing a method other than LIFO is that many foreign countries do not allow LIFO; thus, the company cannot use LIFO for its foreign operations.
Explain the lower-of-cost-or-market basis of accounting for inventories.
Companies use the lower-of-cost-or-market (LCM) basis when the current replacement cost (market) is less than cost. Under LCM, companies recognize the loss in the period in which the price decline occurs.
How is the cost flow assumption determined
Company management selects the appropriate cost flow method. There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods.
inventory turnover
Cost of Goods Sold/Average Inventory (Liquidity) It indicates the liquidity of inventory by measuring the number of times the average inventory "turns over" (is sold) during the year. Inventory turnover can be divided into 365 days to compute days in inventory, which indicates the average number of days inventory is held.
Market Cost
Current replacement cost not selling price cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities
net realizable value
Expected selling price (value) of an item minus the cost of making the sale.
The cost flow assumption must match the movement of inventory (T/F)
F There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method.
when prices are rising (which is usually the case), companies tend to prefer___________ What cost flow assumption?
FIFO because it results in higher net income. Some argue that the use of LIFO in a period of inflation reduces the likelihood that the company will report paper (or phantom) profit as economic gain.
cost flow assumptions
FIFO first-in, first-out LIFO last-in, first-out average cost,
Ownership passes to the buyer when the public carrier accepts the goods if the goods are shipped FOB shipper. FOB destination. FOB shipping point. FOB buyer.
FOB shipping point.
In a period of inflation, LIFO produces a higher net income than FIFO. True False
False
LIFO conformity rule
IRS rule requiring a company that uses LIFO for tax reporting to also use LIFO for financial reporting
The use of LIFO in a perpetual system will usually produce cost allocations that ___________ from use of LIFO in a periodic system.
In a perpetual system, the latest units purchased prior to each sale are allocated to cost of goods sold. In contrast, in a periodic system, the latest units purchased during the period are allocated to cost of goods sold. Thus, when a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous sale.
Indicate the effects of inventory errors on the financial statements.
In the income statement of the current year: (1) An error in beginning inventory will have a reverse effect on net income (e.g., overstatement of inventory results in understatement of net income, and vice versa). (2) An error in ending inventory will have a similar effect on net income (e.g., overstatement of inventory results in overstatement of net income). If ending inventory errors are not corrected in the following period, their effect on net income for that period is reversed, and total net income for the two years will be correct. In the balance sheet: Ending inventory errors will have the same effect on total assets and total stockholders' equity and no effect on liabilities.
Compute and interpret the inventory turnover.
Inventory turnover is calculated as cost of goods sold divided by average inventory. It can be converted to average days in inventory by dividing 365 days by the inventory turnover. A higher inventory turnover or lower average days in inventory suggests that management is trying to keep inventory levels low relative to its sales level.
Moving Average Method
Inventory-costing method, used by companies that use the perpetual inventory method. In this method, a company computes a new average unit cost (a "moving average") each time it makes a purchase. the same as average-cost method but for perpetual inventory system
JIT
Just in Time. A system that eliminates work-in-process (WIP) inventory by scheduling arrival of parts and assemblies for an operation at the time they are needed and not before.
In a period of falling prices, which of the following methods will give the largest net income? Average-cost Specific identification LIFO FIFO
LIFO
The major IFRS requirements related to accounting and reporting for inventories are the same as GAAP. The major differences are that IFRS prohibits the use of
LIFO cost flow assumption and determines market in the lower-of-cost-or-market inventory valuation differently.
many companies use LIFO. Why?
LIFO results in the lowest income taxes (because of lower net income) during times of rising prices.
Determine how to classify inventory and inventory quantities
Merchandisers need only one inventory classification, merchandise inventory, to describe the different items that make up total inventory. Manufacturers, on the other hand, usually classify inventory into three categories: finished goods, work in process, and raw materials. To determine inventory quantities, manufacturers (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.
Last-In, First-Out (LIFO)
Method for assigning cost to inventory that assumes costs for the most recent items purchased are sold first and charged to cost of goods sold. Most recent is recognized first LIFO seldom coincides with the actual physical flow of inventory. (Exceptions include goods stored in piles, such as coal or hay, where goods are removed from the top of the pile as they are sold.)
First-In, First-Out (FIFO)
Method to assign cost to inventory that assumes items are sold in the order acquired; earliest items purchased are the first sold. oldest units sold first the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold, regardless of which units were actually sold. Note that this does not mean that the oldest units are sold first, but that the costs of the oldest units are recognized first.
Can inventory write-downs be reversed?
Not under GAAP Under U.S. GAAP, companies cannot reverse inventory write-downs if inventory increases in value in subsequent periods. IFRS permits companies to reverse write-downs in some circumstances.
What are the arguments for and against the use of LIFO?
Proponents of LIFO argue that it is conceptually superior because it matches the most recent cost with the most recent selling price. Critics contend that it artificially understates the company's net income and consequently reduces tax payments. Also, because most foreign companies are not allowed to use LIFO, its use by U.S. companies reduces the ability of investors to compare U.S. companies with foreign companies.
goods in transit
Purchased goods not yet received. Sold goods not yet delivered.
Which of the following statements is true? FIFO inventory valuation requires physical flow of goods to be representative of the cost flow. LIFO inventory valuation requires physical flow of goods to be representative of the cost flow. Specific identification method inventory valuation requires physical flow of goods to be representative of the cost flow. All of these answer choices are correct.
Specific identification method inventory valuation requires physical flow of goods to be representative of the cost flow.
Describe the LIFO reserve and explain its importance for comparing results of different companies.
The LIFO reserve represents the difference between ending inventory using LIFO and ending inventory if FIFO were employed instead. For some companies this difference can be significant, and ignoring it can lead to inappropriate conclusions when using the current ratio or inventory turnover.
What effect does an overstatement of inventory have on a company's financial statements?
The balance sheet looks stronger because inventory and retained earnings are overstated. The income statement looks better because cost of goods sold is understated and income is overstated.
What is the underlying rationale for the lower-of-cost-or-market rule? The materiality constraint The economic entity assumption The conservatism constraint The historical cost principle
The conservatism constraint
Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
The cost of goods available for sale may be allocated to cost of goods sold and ending inventory by specific identification or by a method based on an assumed cost flow. When prices are rising, the first-in, first-out (FIFO) method results in lower cost of goods sold and higher net income than the average-cost and the last-in, first-out (LIFO) methods. The reverse is true when prices are falling. In the balance sheet, FIFO results in an ending inventory that is closest to current value, whereas the inventory under LIFO is the farthest from current value. LIFO results in the lowest income taxes (because of lower taxable income).
What steps might the companies take to avoid running out of parts with Just-in-time (JIT) Inventory with a serious disruption in the future?
The manufacturer of the piston rings should spread its manufacturing facilities across a few locations that are far enough apart that they would not all be at risk at once. In addition, the automakers might consider becoming less dependent on a single supplier as well as having weather contingency plans.
Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
The primary basis of accounting for inventories is cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost flow methods are specific identification and three assumed cost flow methods—FIFO, LIFO, and average-cost.
When the terms of a sale are FOB destination, legal title to the goods passes to the buyer when the goods reach the buyer's place of business.
True
The results under FIFO in a perpetual system are the same as in a periodic system. (T/F)
True Regardless of the system, the first costs in are the costs assigned to cost of goods sold.
Apply the inventory cost flow methods to perpetual inventory records.
Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. Under the average-cost method, a new average cost is computed after eac
The lower-of-cost-or-market rule for inventory is an example of the application of: (a) the conservatism convention. (b) the historical cost principle. (c) the materiality concept. (d) the economic entity assumption.
a) the conservatism convention.
The LIFO reserve is: (a) the difference between the value of the inventory under LIFO and the value under FIFO. (b) an amount used to adjust inventory to the lower-of-cost-or-market. (c) the difference between the value of the inventory under LIFO and the value under average-cost. (d) an amount used to adjust inventory to historical cost.
a) the difference between the value of the inventory under LIFO and the value under FIFO.
Average Cost Method
allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred cost of goods available for sale / total units available for sale = weighted average unit cost
A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will
approximate their current cost
If prices are falling, the results from the use of FIFO and LIFO
are reversed: FIFO will report the lowest net income and LIFO the highest.
raw materials
basic goods that will be used in production but have not yet been placed in production
Just-in-time (JIT) Inventory
companies manufacture or purchase goods just in time for use
LIFO reserve
companies using LIFO are required to report the difference between inventory reported using LIFO and inventory using FIFO
goods held for sale by one party although ownership of the goods is retained by another party
consigned goods
that if the error is not corrected, the combined total net income for the two periods would be
correct Over the two years, total net income is correct because the errors offset each other.
If beginning inventory is overstated cost of goods sold will be net income will be
cost of goods sold will be overstated net income will be understated An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period.
If ending inventory is understated cost of goods sold will be net income will be
cost of goods sold will be overstated net income will be understated An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period.
If beginning inventory is understated cost of goods sold will be net income will be
cost of goods sold will be understated net income will be overstated An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period.
If ending inventory is overstated cost of goods sold will be net income will be
cost of goods sold will be understated net income will be overstated An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period.
Inventory costing methods place primary reliance on assumptions about the flow of resale prices. goods. costs. values.
costs.
In a period of rising prices, average-cost
falls in the middle
consigned goods
goods held for sale by one party although ownership of the goods is retained by another party
In a period of inflation, FIFO produces a
higher net income because the lower unit costs of the first units purchased are matched against revenues
A cost flow method may be chosen based on their effect on the (3)
income statement balance sheet taxes
When inventory errors occur, they affect both the
income statement and the balance sheet.
What might level of inventory for manufacturers represent?
low levels of raw materials and high levels of finished goods suggest that management believes it has enough inventory on hand, and production will be slowing down-perhaps in anticipation of a recession. On the other hand, high levels of raw materials and low levels of finished goods probably signal that management is planning to step up production.
LCM
lower of cost or market
finsihed goods inventory
manufactured items that are completed and ready for sale
specific identification method of inventory costing
positively identify which particular units it sold and which are still in ending inventory Using this method, companies can accurately determine ending inventory and cost of goods sold. Rare
When the terms are FOB destination, ownership of the goods
remains with the seller until the goods reach the buyer.
The cost of shipping goods to the customer is a
selling expense
under LIFO, companies obtain the cost of the ending inventory by
taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed.
For FIFO, ending inventory is calculated by
taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.
fair value
the amount that a business could sell an asset for, or the amount that a business could pay to settle a liability
Convention of conservatism
the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income
High inventory turnover (low days in inventory) indicates
the company has minimal funds tied up in inventory—that it has a minimal amount of inventory on hand at any one time. too high an inventory turnover may indicate that the company is losing sales opportunities because of inventory shortages
work in process
the portion of manufactured inventory that has begun the production process but is not yet complete
For FIFO, ending inventory is based on
the prices of the most recent units purchased
under lifo, ending inventory is based on
the prices of the oldest units purchased
Inventories are taken at the end of a period because
to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period.
When the terms are FOB (free on board) shipping point, ownership of the goods passes
to the buyer when the public carrier accepts the goods from the seller.
a major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly
understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods
Inventory is classified bas on
whether the company is a merchandiser or manufacturer
