Accounting Exam 2 Ch 7

2 categories of businesses with inventory

merchandising and manufacturing

merchandising business

purchase inventory ready to sell (ex: walmart, target)

manufacturing business

produce goods that are then sold to merchandisers (ex: automobile industry/dealers)

manufacturing inventory classification

-raw materials: goods to be used in the production of goods to be sold

-work in process: in process of production for sale

-finished goods: items held for sale

valuing ending inventory is important because it also affects ______ expense in the income statement

cost of good sold

inventories

reported in the balance sheet as a current asset

cost of goods sold (expense)

reported in the income statement directly after revenue

revenue - cost of goods sold=

gross profit

physical goods included in inventory

-company should record inventory when it obtains legal title to the goods

-companies required to periodically perform inventory counts to verify the quantity of inventory on hand

when ending inventory is understated

COGS is overstated, net income is understated

when ending inventory is overstated

COGS is understated, net income is overstated

product costs

costs directly connected with bringing the goods to the buyer’s place of business and converting such goods to a saleable condition

merchandiser product costs

acquisition costs, sales tax and insurance, freight chargers on purchased goods

manufacturer product costs

direct material costs, direct labor costs, manufacturing overhead costs

inventory costing methods

-first in, first out (FIFO)

-last in, first out (LIFO)

-average cost (AC)

FIFO

assumes the oldest costs recorded in inventory are the first costs transferred to cost of good sold; COGS contains earliest items purchased, ending inventory contains latest items purchased

LIFO

assumes the most recent costs recorded in inventory are the first costs transferred to cost of goods sold

average cost (AC)

assumes the cost of goods sold is the average of the cost the purchase all of the inventories available during the period

primary reason companies use LIFO is because of US tax law

-LIFO results in lower taxable income, and thus lower taxes paid

-LIFO conformity rule: tax law requires that if a company uses LIFO for tax purposes, they must also use LIFO for financial reporting purposes

an error in recording purchases or calculating ending inventory affects

1. ending inventory

2. cost of goods sold

3. net income

4. retained earnings

if company makes an error in accounting for inventories, affects:

affects COGS in IS but also retained earnings in BS because revenue and expenses are ultimately closed out to retained earnings

inventory error correction

if you make an error in valuing inventory, and it affects COGS in one year, when you correct the error and correctly count inventory in subsequent period, that automatically corrects COGS

balance sheet effects of FIFO

-latest purchases are assumed to be remaining in inventory

-approximates current value (replacement cost)

balance sheet effects of LIFO

earliest purchases are assumed to remain in inventory (not very common, sold earliest purchases first)

during periods of rising inventory costs, LIFO ending inventories are _____ compared to LIFO

understated

LIFO reserve

if companies use LIFO, required to disclose what their inventories would be if they used FIFO; the difference between inventories of FIFO and LIFO are LIFO reserves

LIFO reserve

FIFO ending inventory-LIFO ending inventory

inventory accounting records based on FIFO basis and make adjusting entries to convert FIFO inventory to a LIFO value

the adjustments are based on estimates of LIFO values

lower of cost or net realizable value rule

rule for writing down the recorded value of inventory whose market value has declined below cost

what types of inventory may be prone to declines in value

high tech companies (old tech becomes less and less valuable), fashion, electronics, food

Cost definition under the lower of cost or net realizable value (LCNRV)

the historical cost at which the inventory is carried in the balance sheet

net realizable value definition under the lower of cost or net realizable value (LCNRV)

reflects the expected sales price less expected costs to sell the inventory (selling and disposal costs)

net realizable value

a firm expects to incur a net loss on the future sale of inventory; sell the inventory at a price below cost

journal entry to record a lower of cost or net realizable value adjustment

Dr. cost of goods sold expense

Cr. inventory or LCM inventory reserve (contra asset)

can a company reverse a lower cost or net realizable value adjustment if the value of the inventory rises

no, cannot reverse

what must a company disclose

inventory cost method (FIFO,LIFO,AC), LIFO reverse (if used), amount of inventory write downs (if material), method for taking physical inventory counts

reasons for inventory disclosures

the magnitude of a company’s investment in inventory is often very large and costly, risks of inventory losses are often high, disclosures can provide insight into future performance

inventory

items a company intends to sell to customers in the ordinary course of business; includes items that are not yet finished products ready to sell

inventory on balance sheets

carried on the balance sheet as a current asset until the unit is sold, transferred to COGS on the income statement

raw materials inventory

parts and materials purchased from suppliers for use in the production process

work in process inventory

inventory of partially completed goods; includes materials, labor, and overhead costs

finished goods inventory

completed products ready for delivery to customers

cost of goods sold computation

beginning inventory

+cost of inventory purchases and/or production

=cost of goods available for sale

-ending inventory value (current period balance sheet)

=cost of goods sold (current income statement)

accounting questions at the end of each period

1. what prices should be assigned to the goods that have been sold (how do we value COGS)

2. what prices should be assigned to the goods remaining in inventory

T/F: cost flow assumption needs to match the actual physical flow of goods

false; it does NOT need to match

when sold, what does inventory become

inventory becomes cost of goods sold on the income statement

FIFO method

matches physical flow for most companies; ending inventory reflects current cost; balance sheet approach

LIFO method

cost of goods sold reflects current costs of inventory; income statement approach because through the COGS account, going to reflect the more current costs in the market

during rising costs

FIFO results in lower COGS (higher net income) and higher ending inventory than LIFO

during declining costs

FIFO will result in a higher COGS (lower net income) and lower ending inventory than LIFO

why do companies choose LIFO?

LIFO reduces income taxes in periods when prices are rising

LIFO conformity rule

if a company uses LIFO to measure taxable income, it must also use LIFO for external financial reporting

cost flow assumption can affect

reported ending inventory, reported COGS and net income, income taxes payable

companies need to evaluate their unsold inventory to

evaluate its net realizable value declining below its cost

cost

the historical cost at which the inventory is carried in the balance sheet

net realizable value

the expected sales price less expected costs to sell the inventory

lower of cost or net realizable value

if firm expects to sell the inventory at a price below cost, the loss must be recognized now

inventory write downs

reduction of assets on BS and increase in expense on IS

companies are required to state inventory at the lower of cost or net realizable value for

individual inventory items, categories of inventory, or total inventory

FIFO cogs and inventory

COGS contains the earliest items purchased/manufactured; ending inventory contains the latest items

FIFO

earliest inventory items are first ones sold; last inventory items remain in inventory

LIFO cogs and inventory

cogs contains most recent items purchased/manufactured; ending inventory contains oldest items purchased/manufactured

average cost

cost of goods sold and inventory priced based on the average cost of items available during the period

weighted average cost calculated as

(cost of goods available for sale)/(number of units available for sale)

how average is weighted

average is weighted for all goods available for sale, not a simple average of unit cost