Ch. 7: Reporting & Analysing Inventory

Question 1

Matching principle

Answer 1

Requires that expenses be recognised in the same period that the associated revenue in recognised.

Question 2

Direct association (expense recognition)

Answer 2

Any cost directly associated with a specific source of.

Recognise at the same time the related revenue is recognised.

E.g. COGS and warranty costs

Question 3

Immediate recognition (expense recognition)

Answer 3

Costs that can be associated with the revenues of an accounting period, but not with any specific sales transaction

Recognise in period incurred

E.g.:

• Most administrative costs (including insurance, utilities, salaries, etc.)
• Most marketing costs
• Research and development costs

Question 4

Systematic allocation (expense recognition)

Answer 4

Costs that benefit more than one accounting period that are not associated with specific revenues or assigned to one specific time period.

Capitalize as an asset and convert to an expense over its useful life

E.g. Depreciation expense

Question 5

Inventories for wholesalers/retailers

Answer 5

Merchandise Inventory:

• Goods held for resale.
• Goods usually acquired in a finished condition and ready for sale without further processing

Question 6

Inventories for manufacturers

Answer 6

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 cost.

Finished Goods Inventory -> Completed products ready for delivery to customers.

Question 7

What are the three inventory costing methods?

Answer 7

FIFO
LIFO
AC (Average Cost)

Question 8

FIFO in periods of rising prices

Answer 8

• Higher pretax income
• Higher income taxes
• Less cash available

Question 9

LIFO in periods of rising prices

Answer 9

• Lower pretax income
• Lower income taxes
• More cash available

Question 10

LIFO reserve

Answer 10

The LIFO reserve is the difference between LIFO cost and the current value of inventory.

Must be reported by companies using LIFO LIFO reserve
= FIFO ending inventory cost ‒ LIFO ending inventory cost

Question 11

LIFO liquidation

Answer 11

Occurs when the quantity sold exceeds the quantity purchased.

Old inventory costs from the older cost layers are transferred to cost of goods sold -> Creates larger than normal profits because older layers are usually less costly per unit when prices are rising.

Question 12

How to prevent LIFO liquidation?

Answer 12

Keep purchases equal or greater than the
quantity sold, so that older cost layers remain in
inventory

Question 13

Implications of LIFO liquidation

Answer 13

LIFO liquidation boosts gross profit because older, lower costs are matched against revenues based on current sales prices.

Reasons for material LIFO liquidation:

1. Involuntary, such as -> supply disruption due to natural disasters.
2. Intentional, such as
   - Efforts to lower costs
   - Efforts to improve efficiency
   - Earnings management

Question 14

Causes for changing gross profit margin

Answer 14

• Product line is stale
• Change in product mix
• New competitors enter the market
• General decline in economic activity
• Inventory is overstocked
• Change in pricing

Question 15

Inventory turnover

Answer 15

Indicates how quickly inventory is being sold

Inventory turnover = COGS / Avg. inventory

Question 16

Avg. inventory days outstanding

Answer 16

Indicates how long inventories are held before being sold

Avg. inventory days outstanding = Avg. inventory / Avg. daily COGS