Chapter 5: Inventories and cost of goods sold Flashcards
What are three distinct types of costs that manufacturers incur? Describe each of them.
The three distinct types of costs incurred by a manufacturer are direct materials, direct labor, and manufacturing overhead. Direct, or raw, materials are the ingredients used in making a product. Direct labor consists of the amounts paid to factory workers to manufacture the product. Manufacturing overhead includes all the other costs that are related to the manufacturing process but cannot be directly matched to specific units of output.
What is the difference between a periodic inventory system and a perpetual inventory system?
The two inventory systems differ with respect to how often the Inventory account is updated. Under the perpetual system, the Merchandise Inventory account is updated each time a sale or purchase is made. With the periodic system, the Inventory account is updated only at the end of the period. A temporary account, called Purchases, is used to keep track of the acquisitions of inventory during the period. The periodic method relies on a count of the inventory on hand at the end of the period to determine the amount to assign to ending inventory on the balance sheet and to cost of goods sold expense on the income statement.
Why are shipping terms such as FOB shipping point or FOB destination point important in deciding ownership of inventory at the end of the year?
For inventory in transit at the end of the year, the terms of shipment dictate whether the buyer should record the purchase of the inventory. FOB shipping point means that the goods belong to the buyer as soon as they are shipped, and the purchases should be recorded at this point in time. Alternatively, FOB destination point means that the goods do not belong to the buyer until they are received and therefore should not be recorded if they are in transit at year-end.
How is a company’s gross profit determined? What does the gross profit ratio tell you about a company’s performance during the year?
Gross profit is computed by deducting cost of goods sold from net sales. The gross profit ratio indicates how well the company controlled its product costs during the year. For example, a 30% gross profit ratio indicates that for every dollar of net sales, the company has a gross profit of 30 cents. That is, after deducting 70 cents on every dollar for the cost of the inventory that is sold, the company has 30 cents to cover its operating costs and earn a profit.
What is the relationship between the valuation of inventory as an asset on the balance sheet and the measurement of income?
According to the cost of goods sold model, beginning inventory plus purchases minus ending inventory equals cost of goods sold. Therefore, the amount assigned to inventory on the balance sheet has a direct effect on the measurement of cost of goods sold on the income statement. Any errors in valuing inventory will flow through to cost of goods sold and thus have an impact on the measurement of net income.
What is the significance of the adjective weighted in the weighted average cost method?
The weighted average cost method assigns more weight to unit costs at which more units were purchased
Which inventory costing method should a company use if it wants to minimize taxes? Does your response depend on whether prices are rising or falling? Explain your answers.
In a period of rising prices, the use of LIFO will result in a lower tax bill. Because the most recent purchases are charged to cost of goods sold under LIFO, in a period of rising prices, these units will be higher-priced. Thus, the result will be lower gross margin as well as lower net income before tax. Lower net income will result in a lower amount of tax to pay. If prices are declining during the period, FIFO will result in a lower tax bill.
What does the term LIFO liquidation mean? How can it lead to poor buying habits?
A LIFO liquidation occurs when a company using the LIFO inventory method sells more units during the period than it purchases. A liquidation of some or all of the older, relatively lower-priced units (assuming rising prices) will result in a low cost of goods sold amount and a correspondingly higher gross margin. If the company sells the lower-priced units, its net income will improve, but higher taxes will have to be paid. To avoid facing this situation, a company might buy inventory at the end of the year to avoid these consequences of a liquidation. Unfortunately, the somewhat forced purchase of inventory to avoid the liquidation may not be in the best interests of the company.
Baxter operates a chain of electronics stores and buys its products from a number of manufacturers around the world. Give at least three examples of costs that Baxter might incur that should be added to the purchase price of its inventory.
Examples of costs that should be added to the purchase price of inventory are freight costs on purchases, insurance during the time inventory is in transit, storage costs before inventory is ready to be sold, and various taxes such as excise and sales taxes.
Delevan Corp. uses a periodic inventory system and is counting its year-end inventory. Due to a lack of communication, two different teams count the same section of the warehouse. What effect will this error have on net income?
Ending inventory will be overstated. According to the cost of goods sold model, ending inventory is subtracted from cost of goods available to sell to arrive at cost of goods sold expense. Therefore, an overstatement of ending inventory will lead to an understatement of cost of goods sold expense. An understatement of an expense results in an overstatement of net income for the period.
What is the rationale for valuing inventory at the lower of cost or market?
The lower-of-cost-or-market rule is invoked when the utility of inventory is less than its cost to the company. It is a departure from the historical cost principle and is justified on the basis of conservatism. The rule is a reaction to uncertainty by anticipating a decline in the value of inventory and writing down the asset before it is sold.
Why is it likely that the result from applying the lower-of-cost-or-market rule using a total approach (i.e., by comparing total cost to total market value) and the result from applying the rule on an item-by-item basis will differ?
Application of the lower-of-cost-or-market rule on a total basis, compared with an item-by-item basis, will usually yield a different result. The reason is that with the total approach, increases in market value above cost are allowed to offset decreases in value. Alternatively, when the item-by-item approach is used, any increases in value are essentially ignored and it is the declines in value for each item that are recognized.
Due to a clerical error, a company overstated by $50,000 the amount of inventory on hand at the end of the year. Will net income for the year be overstated or understated? Identify the two accounts on the year-end balance sheet that will be in error and indicate whether they will be understated or overstated.
If ending inventory is overstated by $50,000, then cost of goods sold will be understated by $50,000 and gross profit will overstated by $50,000. Net income will be overstated, resulting in an overstatement of retained earnings on the balance sheet. Inventory on the balance sheet will also be overstated. This ignores the effect of taxes.
Ralston Corp.’s cost of goods sold has remained steady over the last two years. During this same time period, however, its inventory has increased considerably. What does this information tell you about the company’s inventory turnover? Explain your answer.
Inventory turnover equals cost of goods sold divided by average inventory. If the cost of goods sold remains constant while the denominator (average inventory) increases, inventory turnover will decrease. This indicates that inventory is staying on the shelf for a longer time. The company should probably evaluate the salability of its inventory.
Why is an increase in Accounts Payable added to net income when the indirect method is used to prepare the statement of cash flows?
An increase in accounts payable is an indication that during the period a company increased the amount it owes suppliers and therefore conserved its cash. Therefore, the increase in the account is added on the statement of cash flows.
