10 Inventory

Question 1

What is the primary basis of inventory?

Answer 1

Cost which includes cash or other fair value of consideration given in exchange for it

Question 2

Inventory cost

Answer 2

Function of two variables

1) number of units included in inventory
2) costs attached to those units

Question 3

Units to be included in inventory

Answer 3

1) what is owned

2) ownership is usually determined by legal title

Question 4

What costs to include in inventory?

Answer 4

include all costs necessary to prepare the goods for sale

normal costs for freight-in, handling costs, and normal spoilage

Question 5

Manufacturing entity: inventory cost

Answer 5

1) direct materials, direct labor, both direct and indirect factory OH
2) these costs are then allocated to WIP, FG

Question 6

How is variable production overhead allocated?

Answer 6

allocated to each unit of production based on actual use of production facilities

Question 7

How is fixed production overhead allocated?

Answer 7

Allocated based on normal capacity of the production facilities

Question 8

Normal capacity of the production facilities

Answer 8

Production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance

Question 9

Range of normal capacity

Answer 9

1) Varies based on business and industry-specific factors

2) actual level of production may be used if it approximates normal capacity

Question 10

How are unallocated fixed overhead costs recognized?

Answer 10

As expense in the period in which they are incurred

Question 11

How are abnormal costs allocated to inventory?

Answer 11

Any abnormal costs for freight-in, handling costs, and spoilage are treated as current period expenses, and are not allocated to inventory

Question 12

Interest on inventories

Answer 12

Not capitalized as part of inventory cost

Question 13

What inventory costs to include for a merchandising concern?

Answer 13

1) purchase price of the goods, freight-in, insurance, warehousing, and any other costs incurred in the preparation of the goods of sale
2) amount used as purchase price for the goods will vary depending upon whether the gross or net method is used in the recording of purchases

Question 14

Gross method to record purchases

Answer 14

Any subsequent discount taken is shown as purchase discount which is netted against the purchase account in determining COGS

Question 15

Net method

Answer 15

Any purchase methods offered are assumed taken and the purchase account reflects the net price.

Question 16

In net method, what if discount is not taken subsquent to the recording of the purchases?

Answer 16

1) A purchase discounts losts account is debited
2) the balance in the purchase discounts lost account does not enter into the determination of CogS- this amount is treated as a period expense.

Question 17

How are purchases recorded?

Answer 17

Regardless of method, always recorded net of any allowable trade discounts

Question 18

Trade discounts

Answer 18

Discounts that are allowed to the entity because of its being wholesaler, a good customer, or merely the fact that the item is on sale at a reduced price.

Question 19

What about interest paid to vendors?

Answer 19

Not included in inventory

Question 20

Periodic system

Answer 20

1) Inventory is counted periodically and then priced.
2) Inventory is usually recorded in the COGS entry
3) COGS= Purchases -(change in inventory)
4) eg- if ending inventory decreases, all of the purchases and some of the beginning inventory have been sold.
5) If ending inventory increases, not all of the purchases have been sold
6) Ending inventory is debited, COGS is a plug, beginning inventory and purchases are credited

Question 21

Perpetual system

Answer 21

1) Running total is kept of the untis on hand (and possibly their value)
2) All decreases and increases are recorded as they occur
3) when inventory is purchased, the inventory account, rather than purchases, is debited
4) as inventory is sold, cogs is debited and inventory is credited

Question 22

Specific identification

Answer 22

1) seller determines which item is sold
2) example: 4 identical machines costing differently- since machines are identical- purchaser won’t care which one s/he gets
3) seller can manipulate income as s/he can sell any machine and charge the appropriate amount to COGS
4) significant dollar value items are frequently accounted for by specific identification
5) use of the specific identification method is appropriate when there is a a relatively small number of sig $ value items in inventory

Question 23

Weighted-average

Answer 23

1) Seller averages cost of all items on hand and purchased during the period
2) units in ending inventory and units sold (COGS) are costed at this average cost

Question 24

Simple average

Answer 24

1) Seller does not weight the average for units purchased or in beginning inventory
2) Method is fairly accurate if all purchases, production runs, and beginning inventory quantities are equal.

Question 25

Moving Average

Answer 25

1) average cogs on hand must be recalculated any time additional inventory is purchased at a unit cost different from the previously calculated average cogs on hand
2) sales do not chagne the unit price because they are not taken out of inventory at the average price
3) moving average may only be used with perpetual systems which account for changes in value with each change in inventory (and not with perpetual systems only accounting for changes in the number of units)

Question 26

Lower of cost or market

Answer 26

1) departure from cost basis of pricing

2) required when utility of the goods is no longer as great as its cost

Question 27

Determining lower of cost or market

Answer 27

1) Determine Market
2) Determine Cost
3) Select the lower of cost or market either for each individual item or for inventory as a whole (compute total market and total cost, select lower)

Question 28

Market

Answer 28

Market is replacement cost limited to

1) Ceiling- which is net realizable value (selling price less selling costs and costs to complete)
2) Floor- which is net realizable value less normal profit

Question 29

When is market equal to net realizable value?

Answer 29

When replacement cost is greater than net realizable value, market equals net realizable value

Question 30

What if market equals net realizable value minus normal profit?

Answer 30

This happens if replacement cost is less than net realizable value minus normal profit

Question 31

Do the floor and ceiling have anything to do with cost?

Answer 31

No

Question 32

What about more than normal profit?

Answer 32

The floor limitation on market prevents recognition of more than normal profit in future periods (if market is less than cost)

Question 33

What does the ceiling do?

Answer 33

It prevents recognition of a loss in future periods (if market is less than cost)

Question 34

What about cost or market applied to individual items?

Answer 34

1) it will always be as low as, and usually lower than, cost or market applied to inventory as a whole
2) They will be the same when all items at market or all items at cost are lower

Question 35

What happens when inventory is written down?

Answer 35

1) No recovery from writedown is possible until all units are sold
2) This is different from marketable securities where recoveries of prior write downs are required to be taken into the income statement

Question 36

What are the methods of recording a writedown?

Answer 36

If market is less than cost at the end of any period, there are two methods

1) Entry to establish ending inventory can be made using the market figure. Problem with this is that it forces the loss to be included in the COGS, thus overstating COGS sold by the amount of the loss. Therefore, the loss is not separately disclosed in this method.
2) Second is to debit the inventory account for the actual cost (not market) of goods on hand, and then to make the following entry to give separate recognition to the market decline. This is done by debiting loss due to market decline and then crediting the inventory account.

Question 37

Purchase commitments

Answer 37

result from legally enforceable contracts to purchase specific quantities of goods at fixed prices in the future

Question 38

What happens if there is a unrealized loss on PC?

Answer 38

1) When the decline in MV is below the contract price at BS date and contract cannot be cancelled, there is an unrealized loss
2) if material should be recorded in the period of decline
3) Debit estimated loss on PC (excess of PC over mkt) and credit accrued loss on PC (Excess of PC over mkt)

Question 39

What happens if there are further losses in PC?

Answer 39

1) If there are further declines, the amount of the loss to be accrued should be increased to include the additional loss
2) The loss is taken to the income statement, the accrued loss on PC is a liability account and shown on the BS
3) When the goods are subsequently received, purchases and accrued loss on PC is debited while cash is credited

Question 40

What happens if there is a partial recovery from the loss for PC?

Answer 40

If there is a partial recovery before inventory is received, accrued loss account would be reduced by the amount of the recovery. Likewise, an income statement account, “recovery on loss of PC,” would be credited

Question 41

First-in, First-out (FIFO)

Answer 41

1) goods from beginning inventory and the earliest purchases are assumed to be the goods sold first
2) period of rising prices, COGS is made up of the earlier, lower-priced goods resulting in a larger profit (relative to FIFO)
3) the ending inventory is made up of more recent purchases and thus represents a more current value (relative to LIFO) on the BS
4) FIFo can be used even when it does not match the physical flow of goods
5) whenever FIFO is used, results of inventory and CoGS are the same at the end of the period under either perpetual or periodic

Question 42

Last-in, first-out (LIFO)

Answer 42

1) most recent purchase is assumed to be sold first, thus ending inventory is composed of older goods
2) COGS contains rlatively current csots (resulting in the matching of current costs with sales)
3) does not parallel physical flow of g oods

Question 43

Advantages of LIFO

Answer 43

1) Acceptable for tax purposes and so is widely used
2) During inflation, it reduces tax liability due to lower reported income (from higher cogs)
3) smoothes out fluctuations in the income stream relative to FIFO b/c it matches current costs with current revenues

Question 44

Disadvantage of LIFO

Answer 44

1) results in large profits if inventory decreases because earlier, lower valued layers are included in COGS. Known as LIFO liquidation
2) also, the cost involved in maintaining separate LIFO records for each item in inventory

Question 45

LIFO conformity rule

Answer 45

1) If LIFO is used for tax purposes, must also be used for financial reporting
2) under current tax law, inventory layers may be added using 1) earliest acquisition costs, 2) weighted average unit cost for the period, or 3) latest acquisition costs
3) NOTE CPA EXAM: use EARLIEST acquisition cost unless otherwise noted

Question 46

LIFO reserve

Answer 46

1) sometimes co uses LIFO for external reporting purposes and another inventory method for internal purposes
2) this account is used to reduce inventory from the internal valuation to the LFIO valuation
3) it is a contra account to inventory and is adjusted up or down at year-end wiht a corresponding increase or decrease to COGS

Question 47

Dollar-value LIFO

Answer 47

1) LIFO applied to pools of inventory items rather than to individual items
2) cost of keeping inventory records is less this way

Question 48

Dollar-value LIFO and conformity rule

Answer 48

1) Must also be used for external reporting, so companies use $ value lifo to define their lifo pools so as to conform with IRS regulations
2) LIFO pool can contain all of the inventory items for a natural business unit, or a multiple pool approach can be elected whereby a business can group similarly used inventory items into several groups at once

Question 49

What is the advantage of using pools?

Answer 49

Involuntary liquidation of LIFO layers is less likely because of increased number of item si nthe pool (if level of one item decreases, it can be offset by increases in other items) and because the pools can be adjusted for changes in product composition or product mix

Question 50

Difference between $ LIFO and unit LIFO?

Answer 50

1) Both are layering methods
2) But $ value LIFO looks at increases and decreases in ending inventory in terms of dollars of the same purchasing power rather than in terms of units
3) Dollar-value seeks to determine the real dollar change in inventory

Question 51

How is the real dollar change in inventory determined?

Answer 51

1) Ending inventory is deflated to base-year cost
2) Ending inventory is divided by the curret year’s CPI
3) the resulting amount is compared with the beginning inventory which is also started in base-year dollars
4) the difference is the layer, which, after conversion must be added or subtracted to arrive at the appropriate value of ending inventory

Question 52

$ value calculation

Answer 52

1) Inventory at base-year prices x CPI

2) CPI = EI end of year price/EI at base-year price

Question 53

What happens when using CPI?

Answer 53

1) double extension technique is used, because each year, the ending inventory is extended at b oth base-year and current-year prices

Question 54

Manufacturer’s method for $ value

Answer 54

1) Compute CPI
2) Compare BI at base-year prices to EI at base-year prices to determine the a) New inventory layer added, or b) old inventory layer removed
3) if there is an increase at base-year prices, value the new layer by multiplying the layer (stated in base-year dollars) by the CPI.
4) if there is a decrease, the remaining layers are valued at the index in effect when the layer was first added

Question 55

Retailers & wholesalers method for $ value

Answer 55

1) Determine index from appropriate published source
2) divide EI by CPI to restate to base-year prices
3) Compare BI at base-year prices to EI at base-year prices to determine the a) New inventory layer added, or b) old inventory layer removed
4) if there is an increase at base-year prices, value the new layer by multiplying the layer (stated in base-year dollars) by the CPI.
5) if there is a decrease, the remaining layers are valued at the index in effect when the layer was first added

Question 56

Linkchain technique

Answer 56

1) developing single cumulative index
2) tech changei s allowed for by the method used to calculate each current year index
3) index is derived by double extending representative sample (between 50% to 75% of dollar value of the pool) at beginning and year end prices.
4) this annual index is then applied to the previous year’s cumulative index to arrive at the new current year cumulative index
5) ending inventory is divided by the cumulative index number to derive the ending inventory at base period prices.
6) An increase in base period dollars for hte period is priced using the newly derived index number

Question 57

Gross profit

Answer 57

1) Ending inventory is estimated using GP % to convert sales to COGS presumed sold
2) since EI is only estimated, gross method is not acceptable for tax or annual financial reporting purposes
3) main use is to estimate EI for internal use, interim fs, and for establishing amount of loss due to destruction by fire, flood, and other catastrophes

Question 58

Converting GP rate on cost to a markup rate

Answer 58

1) Divide GP rate on cost by 1 plus the GP rate on cost

2) example: GP rate is 50%, therefore 0.5/(1+0.5)=33.333% is the MU rate on the selling price

Question 59

Converting MU rate on selling price to a GP rate on cost

Answer 59

1) Divide MU rate on SP by 1 minus the MU Rate on the SP

2) Example: MU is 20%, then 0.2/(1-0.2)=25% GP rate on cost

Question 60

Standard cost

Answer 60

1) predetermined costs in cost accounting system
2) used for control purposes
3) can only be used if variances are reasoanble (not large)
4) large debit (unfavorable) variances would indicate inventory (and cost of sales) were undervalued whereas large credit (favorable) variances would indicate inventory is overvalued

Question 61

Direct (variable) costing

Answer 61

1) not an acceptable method for valuing inventory
2) considers only variable cost as product costs and fixed production costs as period costs.
3) in contrast, absorption costing considers both variable and fixed, manufacturing costs as well as product costs

Question 62

Market

Answer 62

1) inventory is valued at market value when market is lower than cost
2) occassionally inventory will be valued at market even if it is above cost.
3) this happens with
a) precious metals with fixed mv
b) indusries such as meatpacking wherecosts cannot be allocated and i)quoted prices exist and ii) goods are interchangeable (e.g. agricultural commodities)

Question 63

Cost apportionment by relative sales value

Answer 63

Basket purchases and similar situations require cost allocation based on relative value

Question 64

Items to include in inventory

Answer 64

1) FOB shipping point: goods in transit should be included in inventory of buyer as title is passed when carrier receives goods
2) FOB destination: goods in transit is on seller’s inventory until goods are received by buyer at final destination

Question 65

Consignment

Answer 65

1) Consignors consign their goods to consignees who are sales agents of the consignors
2) consigned goods are property of the consignor until sold
3) any unsold goods (including proportionate share of freight costs incurred in shipping goods to the consignee) must be included in consignor’s inventory

Question 66

Consignment sales revenue

Answer 66

1) recognized by consignor when consignee sells consigned goods to the ultimate customer
2) no revenue Is recognized at the time consignor ships goods to consignee

Question 67

Consignment sales commission

Answer 67

Sales commission made by consignee would be reported as a selling expense by the consignor and would not be netted against the sales revenue recognized by the consignor

Question 68

Inventory turnover

Answer 68

1) Number of times inventory was sold and reflects inventory order and policies
2) cogs/average inventory

Question 69

Number of days’ supply in average inventory

Answer 69

1) number of days inventory is held before sale; reflects on efficiency of inventory policies
2) 365/inventory turnover

Question 70

Completed contract method

Answer 70

1) recognition of contract revenue and profit at contract completion
2) all related costs are deferred until completion and then matched to revenues

Question 71

Completed contract method Advantage

Answer 71

1) preferable when estimates cannot meet the criteria for reasonable dependability
2) advantage is that it is based on results, not estimates

Question 72

Completed contract method disadvantage

Answer 72

Current performance is not reflected and income recognition may be irregular

Question 73

% of completion

Answer 73

1) recognition of contract revenue and profit during construction based on expected total profit and estimated progress towards completion in the current period
2) all related costs are recognized in the period in which they occur

Question 74

When can % completion method be used?

Answer 74

1) depends on the ability to make reasonably dependanble estimates of contract revenues, contract costs, and the extent of progress towards completion
2) for entities which normamlly operate under contracts and for whom that’s a large part of their revenue, presumption is that they have the ability to make estimates that are dependable and so they can justify the use of % completion

Question 75

When is % completion method preferable?

Answer 75

1) in circumstances where reasonably dependable estimates can be made and when the following conditions exist
2) Executed contracts must clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement
3) buyer and contractor can be expected to fulfill contract

Question 76

Advantage and disadvantage of % completion

Answer 76

Advantage: period recognition of income
Disadvantage: dependence on estimates

Question 77

% completion method

Answer 77

1) widely used is cost to cost
2) based on assumed relationship between a unit of input and productivity
3) under cost to cost, either revenue and/or profit to be determined by the formula:
revenue (profit) = (cost to date/total expected cost based on latest estimate x contract price or expected profit ) - Revenue (profit) recognized in previous periods

Question 78

% completion method revenue and profit

Answer 78

1) revenue and profit are different
2) profit is calculated by subtracting construction expenses from revenue.
3) revenue is contract price

Question 79

CIP

Answer 79

1) cost accumulation account similar to WIP for job-order costing
2) except % completion includes interim profits in the account

Question 80

billings on LT contracts

Answer 80

1) similar to unearned revenue account
2) at each fs date, CIP is netted against billings on LT contracts on a project by project basis, resulting in a net current asset and/or a net current liability

Question 81

Contract losses

Answer 81

1) % Completion, the amount of loss is the total expected loss on entire contract plus all profit previously recognized
2) completed contract, total expected losses ercognized as soon as they are estimated
3) Jes and a schedule for profit or loss recognized on the contract under % of completion method follow

Question 82

IFRS inventory cost assumptions

Answer 82

1) LIFO is not allowed in IFRS
2) specific ID is required for inventory of goods that are not interchangeable or goods that are produced and segregated for specific projects
3) FIFO and weighted average methods are acceptable methods under IFRS for other types of inventory
4) retail method can only be used for certain industries
5) GP method can only be used to estimate EI when physical count is not possible

Question 83

IFRS inventory lower of cost or market

Answer 83

1) IFRS similar to US GAAP
2) but IFRS values inventory at lower of cost or net realizable value (LCNRV)
3) calculation is different
4) LCNRV is applied on intem by item basis, but in IFRS if there are groups of similar items, then may be grouped together

Question 84

IFRS inventory capitalization of interest

Answer 84

1) US GAAP allows no capitalization

2) IFRS only allows it for items with lengthy production period to rpepare goods for sale.

Question 85

Inventory

Answer 85

“1) tangible personal property

2) held for sale in the ordinary course of business
3) in the process of production for such sale, or
4) to be used currently in the production of items for sale