Financial Ch. 6 - Merchandise Inventory | Horngren's Accounting

Consistency Principle

States that a business should use the same accounting methods and procedures from period to period, which helps investors and creditors compare financial statements. If changes are made in accounting methods, these changes must be reported, generally in the notes to the financial statements.

Disclosure Principle

Requires that financial statements report enough information for outsiders to make knowledgeable decisions about the company. The information should be relevant and have faithful representation.

Materiality Concept

States that a company must perform strictly proper accounting only for items that are significant to the business's financial situation. Information is considered significant when it would cause someone to change a decision.

Accounting Conservatism (Reported Figures)

Means a business should report the least favorable figures in the financial statements when two or more possible options are presented.

Accounting Conservatism (Specific Rules)

Includes anticipating no gains but providing for all probable losses; recording an asset at the lowest reasonable amount; recording a liability at the highest reasonable amount; and choosing the option that undervalues, rather than overvalues, the business.

Inventory Controls (Authorization and Tracking)

Good inventory controls ensure that inventory purchases and sales are properly authorized and accounted for by ensuring inventory is purchased with proper authorization, tracking and documenting receipt of inventory, and recording damaged inventory properly.

Inventory Controls (Counting and Recording)

Includes performing physical counts of inventory annually and recording and removing inventory from Merchandise Inventory when sold.

Inventory Costing Method

An approach that approximates the flow of inventory costs in a business, used to determine the amount of cost of goods sold and ending merchandise inventory.

Four Basic GAAP Inventory Costing Methods

1. Specific identification, 2. First-in, first-out (FIFO), 3. Last-in, first-out (LIFO), and 4. Weighted-average.

Specific Identification Method

An inventory costing method based on the specific cost of particular units of inventory. This method is used for inventories that include automobiles, jewels, or real estate.

First-In, First-Out (FIFO) Assumption

Assumes the first units purchased are the first to be sold.

FIFO Cost of Goods Sold (COGS)

Cost of Goods Sold is based on the oldest purchases and includes the oldest unit costs.

FIFO Ending Inventory

Ending Inventory closely reflects current replacement cost and is calculated using the newest items in inventory.

FIFO Perpetual vs. Periodic Results

The amounts for Cost of Goods Sold and Ending Inventory are always the same for FIFO perpetual and FIFO periodic.

Last-In, First-Out (LIFO) Cost of Goods Sold (COGS)

Cost of Goods Sold will include the newest unit costs.

Last-In, First-Out (LIFO) Ending Inventory

Ending Inventory will be calculated using the oldest items in inventory.

LIFO Perpetual vs. Periodic Results

The amounts for Cost of Goods Sold and Ending Inventory are usually different for LIFO perpetual and LIFO periodic.

Weighted-Average Cost per Unit Calculation

Cost of goods available for sale (for the entire period) divided by the Number of units available.

COGS under LIFO vs. FIFO (Rising Costs)

Cost of Goods Sold is higher under LIFO than under FIFO when costs are rising.

Net Income under LIFO vs. FIFO (Rising Costs)

Net income is lower under LIFO than under FIFO when costs are rising.

Ending Inventory under FIFO vs. LIFO (Rising Costs)

When costs are increasing, FIFO inventory will be the highest, and LIFO inventory will be the lowest.

COGS under FIFO vs. LIFO (Declining Costs)

Cost of Goods Sold is highest under FIFO and lowest under LIFO during a period of declining inventory costs.

Net Income under LIFO vs. FIFO (Declining Costs)

Net income is highest under LIFO and lowest under FIFO during a period of declining inventory costs.

Lower-of-Cost-or-Market (LCM) Rule Requirement

Requires that inventory be reported in the financial statements at the lower of the inventory’s historical cost or its market value.

Definition of Market Value (LCM Rule)

Market value generally means the current replacement cost.

Impact of Inventory Error on Related Accounts

When the ending inventory number is incorrect, other related numbers will also be incorrect, such as Cost of goods sold, Gross profit, and Net income.

Cancellation of Inventory Error

An inventory error cancels out after two periods.

Inventory Turnover Formula

Cost of goods sold/Average merchandise inventory.

Interpretation of High Inventory Turnover

A high turnover rate indicates ease of selling the inventory.

Days’ Sales in Inventory Formula

365 days / Inventory turnover.

Purpose of Days' Sales in Inventory Ratio

Measures the average number of days inventory is held by the company. This measure is very important for inventory with an expiration date.

Periodic Inventory System Characteristics

Under a periodic system, inventory is not tracked continuously, the beginning inventory balance is carried until the end of the period, purchases are accumulated, and the ending inventory balance replaces the beginning balance.