Ch. 6 Inventory and Cost of Goods Sold

Question 1

Inventory

Answer 1

• Current Asset
• Items a company intends for sale to customers.
• Not yet sold (Inventory reported in the balance sheet)
• Companies that earn revenue by selling inventory are either manufacturing or merchandising companies.
• The cost of beginning inventory plus the additional purchases during the year make up the cost of inventory (cost of goods) available for sale.
• Inventory that is sold is reported as cost of goods sold expense.

Question 2

Cost of goods sold (COGS)

Answer 2

• Cost of the inventory that was sold during the period.
• Expense in the income statement. (Often the largest)
• Also referred to as cost of sales, cost of merchandise sold, or cost of products sold.

Question 3

Raw materials

Answer 3

• Components that will become part of the finished product but have not yet been used in production.
• Sometimes called direct materials.

Question 4

Work-in-process

Answer 4

Products that have started the production process but are not yet complete at the end of the period.

Question 5

Finished goods

Answer 5

Inventory items for which the manufacturing process is complete.

Question 6

Specific identification method

Answer 6

• Inventory costing method that matches or identifies each unit of inventory with its actual cost.
• Practical only for companies selling unique, expensive products with low sales volume. (automobile with a unique serial number that we can match to a invoice identifying the actual purchase price, fine jewelry, pieces of art)
• Most companies use one of the other 3 inventory cost flow assumptions (FIFO, LIFO, or weighted-average cost)

Question 7

First-in, first-out (FIFO) method

Answer 7

• Balance Sheet approach.
• Inventory costing method that ASSUMES the first units purchased (the first in) are the first ones sold (the first out).
• Assumes a particular pattern of inventory cost flows.
• We assume that beginning inventory sells first, followed by inventory from the 1st purchase during the year, followed by the 2nd purchase, and so on.
• Nearly all companies sell their actual inventory in a FIFO manner.
• FIFO matches physical flow for most companies
• FIFO generally results in higher assets and higher net income when inventory costs are rising.

Question 8

Last-in, first-out (LIFO) method

Answer 8

• Income Statement approach.
• Inventory costing method that ASSUMES that last units purchased (the last in) are the first ones sold (the first out).
• The primary benefit of choosing LIFO is tax savings.
• Companies must follow LIFO conformity rule.
• Companies that choose LIFO must report the difference in the amount of inventory between FIFO and LIFO. (Sometimes called LIFO reserve)
• LIFO is not allowed under IFRS.
• When a company changes from LIFO for tax purposes, it cannot change back to LIFO until it has filed 5 tax returns using the non-LIFO method.

Question 9

Weighted-average cost method

Answer 9

• Inventory costing method that assumes both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.
• We assume each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items.
• Weighted-average unit cost = Cost of goods available for sale divided by number of units available for sale.
• We use WEIGHTED average ($10,000 / 1,000 units) instead of SIMPLE average ((7+9+11) / 3)

Question 10

LIFO conformity rule

Answer 10

IRS rule requiring a company that uses LIFO for tax reporting to also use LIFO for financial reporting.

Question 11

Perpetual inventory system

Answer 11

• Most companies, with the help of scanners and bar codes use…
• Inventory system that maintains a continual record of inventory purchased and sold.
• Helps a company to better manage its inventory levels.

Question 12

Periodic inventory system

Answer 12

• Inventory system that periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand.
• Does not provide a useful, continuing record of inventory.
• Very few companies actually use this system in practice to maintain their own (internal) records of inventory transactions.
• You would have to do a period-end adjustment

Question 13

LIFO adjustment

Answer 13

• An adjustment used to convert a company’s own inventory records maintained on a FIFO basis to LIFO basis for preparing financial statements.
• Ending balance of inventory FIFO minus Ending balance of inventory LIFO.

Question 14

Freight-in

Answer 14

• (Freight/Shipping charge)
• Freight charges includes the cost of shipments of inventory form suppliers, as well as the cost of shipments to customers.
• Freight-in is the cost to transport inventory to the company, which is included as part of inventory cost.
• Charges on incoming shipments from suppliers.
• We add the cost of freight-in to the balance of Inventory. (charges are recorded as part of the inventory cost)

Question 15

Freight-out

Answer 15

Cost of freight on shipments to customers, which is included in the income statement either as part of costs of goods sold or as a selling expense.

Question 16

Multiple-step income statement

Answer 16

• An income statement that reports multiple levels of income (or profitability).
• Merchandisers use it (sales and purchases of inventory are the most important transactions for merchandisers. So they report revenues and expenses from these transactions separately from other revenues and expenses.)
• Multiple levels of profit include: Gross profit, operating income, income before income taxes, and net income.
• The other format is a single-step income statement and only has 2 categories (total revenues and total expenses) and only one calculation (total revenues - total expenses to get net income)

Question 17

Gross profit

Answer 17

The difference between sales revenue and cost of goods sold.

Question 18

Operating income

Answer 18

• Profitability from normal operations that equals gross profit less operating expenses.
• Recall operating expenses include salaries, utilities, advertising, supplies, rent, insurance, and bad debts.

Question 19

Income before income taxes

Answer 19

• Combining operating income with non-operating revenues and expenses.
• Operating income plus non-operating revenues less non-operating expenses.

Question 20

Net income

Answer 20

• (Bottom line)
• Difference between all revenues and all expenses for the period.
• Income before income taxes minus income tax expense.

Question 21

Replacement cost

Answer 21

• The cost to replace an inventory item in its identical form.
• The market value of inventory
• When the market value of inventory falls below its original cost, companies are required to report inventory at the lower market value.

Question 22

Lower-of-cost-or-market (LCM) method

Answer 22

• Method where companies report inventory in the balance sheet at the lower of cost or market value, where market value equals replacement cost.
• Conservatism

Question 23

Inventory turnover ratio

Answer 23

• The number o times a firm sells its average inventory balance during a reporting period. It equals cost of goods sold divided by average inventory.
• You want a high number.

Question 24

Average days in inventory

Answer 24

• Approximate number of days the average inventory is held
• You want a low number.
• Equals 365 days divided by Inventory turnover ration.

Question 25

Gross profit ratio

Answer 25

Measure of the amount by which the sale price of inventory exceeds its cost per dollar of sales. It equals gross profit divided by net sales.

Question 26

Merchandising Companies

Answer 26

• Purchase inventories that are primarily in finished form for resale to customers.
• These companies may assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install the inventory, but they do not manufacture it.
• Serve as intermediaries
• Broadly classified as wholesalers or retailers.
• Wholesalers: resell inventory to retail companies or to professional users.
• Retailers: purchase inventory form manufacturers or wholesalers and then sell this inventory to end users. (companies from which you buy products).

Question 27

Manufacturing Companies

Answer 27

• Manufacture the inventories they sell, rather than buying them in finished form from suppliers.
• Buy the inputs for the products they manufacture.
• 3 categories of inventory: Raw materials, Work in process, Finished goods.

Question 28

4 Inventory Cost Methods

Answer 28

Determine the cost of goods sold and ending inventory

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

Question 29

FOB (Free On Board) shipping point/destination

Answer 29

• Indicates WHEN title (ownership) passes from the seller to the buyer.
• FOB shipping point: means title passes when the seller ships the inventory, not when the buyer receives it.
• FOB destination: means the title does not transfer to the buyer when the inventory is shipped. It is not recorded until inventory reached its destination, the buyers location.

Question 30

Non-operating revenues and expenses

Answer 30

• Arise from activities that are not part of the company’s primary operations.
• Interest revenue and interest expense are examples, as well as gains and losses on the sale of long-term assets
• Investors focus less on non-operating items than on income form operations, as these non-operating activities often do not have long-term implications on the company’s profitability.

Question 31

Conservatism

Answer 31

• Firms are required to report the falling value of inventory, but they are not allowed to report any increasing value of inventory.
• A conservative approach in accounting implies that there is more potential harm to users of financial statements if estimated gains turn out to be wrong than if estimated losses turn out to be wrong.
• It also guides companies, when faced with a choice, to select accounting methods that are less likely to overstate assets and net income.
• Therefore companies typically do not report estimated gains.