Chapter 6 Flashcards
The company purchased the inventory at 200 on July 1, 2019. The market value of the inventory is assessed to be 100 on the fiscal-year end date on December 31, 2019. Wht should be the amount of the inventory reported on the balance sheet as at December 31, 2019?
Should we report historical cost or market value? In this case we do market value of 100.
What is LCM?
Lower of Cost vs Market. We choose the lower cost between the two. Only specific to inventory
The company purchased the inventory at 200 on July 1, 2019. The market value of the inventory is assessed to be 400 on the fiscal-year end date on December 31, 2019. Wht should be the amount of the inventory reported on the balance sheet as at December 31, 2019?
We report 200, the historical cost with no journal entry
Valuation of inventory at the year end
LCM only applicable to american companies.
- Canadian companies compares historical cost with net realizable value
What is NRV?
It is the estimated retail market value of inventory
= expected selling price - sum of selling costs and costs to complete
What is a “fire” sale?
A fire sale cosnists of selling goods or assets at heavily discounted prices.
Write down of inventory
(1) Direcr method
(Dr) COGS (Cr) Inventory
(2) Indirect method
(Dr) Loss due to market decline (Cr) Inventory
T-Account for inventory?
End = beg + purchase - COGS
What events chanfe the value of inventory?
- lower sale price - Maybe due to changes in market conditions
- can incur additional costs to sell
- This will have impact on NRV
Lower of cost and NRV - Why do we have this rule?
Because of accounting conservatism (inventory write-up is not allowed)
Because of the definition of assets:
- Inventory is treated as an asset, since there is a future benefit related to it
What is the cost of the inventory will not be recovered?
Then there is no future benefit related to a portion of the cost. Hence, inventory cost should be brought down
The requirement to use the lower-of-cost-or-market (LCM) rule is a result of the application of which of the following generally accepted accounting principles?
Conservatism principle
Suppose that the beginning and ending balances of inventories are 100 during the year. Two sales transacions take place on April 1 and October 1 for the inventory value of 100 in each event. At the end of each sales event, the company repurchased 100 inventory to fully re fill store shelves. Compute the inventory turnover ratio
We have 2 sales event that sold 100 each.
2 * 100 = COGS/ 100 = average inventory
so the answer is 2
Is a higher or lower inventory turnover ratio better?
Higher
Suppose that the beginning and ending balances of inventories are 100 during the year. Twelve sales transactions take place on 15th day of each month during the year, with the inventory value of 100 on each sales event. At the end of each sales event, the company repurchased 100 inventory to fully re fill store shelves. Compute the inventory turnover ratio
12 * 100 = COGS
Average inventory = beginning inventory + ending inventory / 2 = 100
So answer is 12
Inventory turnover equation
COGS/average inventory
It is the number of times inventory is renewed each year.
Days in inventory equation?
Average inventory * 365 / COGS
Same as inventory turnover but in days. Shorter, the better, but must have inventory on shelves to sell it
A tip to memorize financial ratios
- If the denominator and the numerator come from the same financial statement, there is not need to use the average value. (e.g., current ratio, gross profit margin ratio)
- If the denominator and the numerator come from the different financial statements, we need to use the average value for B/S items (e.g., inventory turnover ratio, days in inventory)
Specific identification method
If inventory items are unique, then company will likely track cost of each item in inventory as cost for each item is different
Specific identification method t account
When item is sold, the cost of that specific item is removed from inventory:
(dr) cash (cr) sales revenue
(dr) COGS - item A (Cr) Inventory - Item A
When does Tiffany & co use specific identification method as opposed to average cost method?
When item is very expensive or unique
Can a company use multiple cost flow assumptions for different product groups of the firm?
Yes
At the beginning of 2022, Move Studio plans to make three movies in 2022. The total costs for the three movies are expected to be 555 million. So the average cost per movie is estimated to be 185 million. As a CEO would you sell one movie for 190 million?
No. Each movie is unique so we need to keep track of each movies production cost in terms of determinign the selling price and COGS during the year.
Cash slow assumption
(1) Specific identification method
(2) FIFO (first in first out)
(3) Average cost method
What is the FIFO assumption
The first tiem purchased is the first item sold during the year
What is the average cost method?
We take the average value to determine the inventory cost during the year. For this method, the calculation is different under perpetual & periodic.
Perpetual = moving average
Periodic = weighted average
What are some assumptions in FIFO
- cost of goods sold is the cost of the units purchased FIRST
- year-end inventory is the cost of the units purchased LAST
- May have nothing to do with real physical flow of merchanidse
- Cost flow assumption is nothing but an assumption for accounting purposes so it does not have to be exactly matched with physical inventory flow. But it is preferable if matched
If costs are increasing over time, FIFO gives higher or lower net income under the assumption that all else is equal (including total purchase price of the inventory during the year), compared to the case when costs are decreasing?
In order to have higher net income we need a smaller COGS expense. Inflation case will give us smaller COGS expense relative to deflation case. So smaller COGS expense gives higher net income so the answer is higher.
If costs are rising, FIFO gives?
Lower cost of goods sold,
higher gross margin,
higher net income,
higher ending inventory
Average cost method (Under perpetual)
- Calculates an average cost each time there is a new purchase of inventory with different price
- A moving average of the unit cost is maintained
- When a sale occurs, the average unit cost at that point is used in order to calculate COGS
Assume that a company adopts the perpetual inventory system. If costs are rising, Average Cost method gives a higher or lower net income, comapred to FIFO?
Lower. In FIFO the oldest purchase are the ones we’ve sold so they must be cheaper because of inflation. When inventory is sold they are cheaper than purchased so COGS wil be smaller so FIFO has a higher net income
Is FIFO or Average cost higher for COGS?
Average Cost
Is FIFO or Average cost higher for gross profit?
FIFO
Is FIFO or Average Cost higher for profit?
FIFO
Is FIFO or Average Cost higher for Cash?
The same
Is FIFO or Average Cost higher for ending inventory?
FIFO
Is FIFO or Average Cost higher for retained earnings?
FIFO
If costs are rising, Average cost method gives higher or lower net income, compared to FIFO?
Lower net income leading to lower tax payment. Compared to FIFO, average cost method gives lower net income with a higher amount of COGS in the case of rising purchase cost such as inflation.
A corporation is uding FIFO as its cost flow assumption. B Corporation is using average cost method. Prices have been steadily increasing for their inventory of commodities. Both companies are similar in all other aspects. What is a True statement about the ratios of both corporations?
The current ratio of A is larger than the current ratio of B.
Most recent purchases will be more expensive in case of inflation so for FIFO ending inventory balance will be higher. FIFO gives smaller COGS so gross profit is higher so gros profit margin is larger.
The accounting principle that requires that the inventory costing method (E.g., FIFO, Average cost) be conssitent with the phycial movement of goods is …?
Nonexistent; that is, there is no such accounting requirement
Equation for Cost of Good available for Sale?
Beginning balance + Cost of goods purchased
If all else is equal, which inventory system gives higher net income under the assumption that the costs are rising over time?
Perpetual
With perpetual we look at moving average and periodic we look at weighted average. If we assume inflation then perpetual. (Would be opposite if assuming deflation)
