Chapter 6: Accounting for Inventory

Question 1

Merchandising companies generally have one type of inventory- what is it?

Answer 1

Inventory that is finished and ready for sale

Question 2

Although merchandising companies usually only have one type of inventory, what are the three inventory categories?

Answer 2

1. Raw materials inventory
2. Work-in-progress inventory
3. Finished goods inventory

Question 3

What is “raw materials inventory”?

Answer 3

Items to be used in the production of products

Question 4

What is a “work-in-progress” inventory?

Answer 4

Items partially completed, not fully ready for sale

Question 5

What is “finished goods” inventory?

Answer 5

Items fully manufactured and ready for sale

Question 6

What is “just in case” inventory?

Answer 6

Inventory that is held as a buffer just in case unexpected problems occur

Question 7

What are the cons of just-in-case inventory?

Answer 7

Costly to maintain because of insurance, building usage, capital investing, and holding cost

Question 8

What is just-in-time inventory?

Answer 8

Inventory that seeks to eliminate, or at least minimize, the amount of inventory on hand- but is challening to obtain (ready to sell when it arrives, takes up less space, etc.)

Question 9

What does F.O.B. mean?

Answer 9

Free on board, it’s regarding the shipment of materials from retailer to merchandiser

Question 10

Who owns the inventory using a FOB Shipping point transit?

Answer 10

Once it’s shipped, it is now the buyer’s (purchaser’s) property (even on the road)

Think of the “P” in Point as “P” for Purchaser

Question 11

Who owns the inventory using FOB destination?

Answer 11

The seller owns the inventory until it is physically in the hands of the buyer.

Question 12

How is inventory calculated?

Answer 12

By physically counting what you have

Question 13

What are 4 reasons that actual inventory may differ from accounting records?

Answer 13

1. Periodic inventory method is used
2. Theft
3. Spoliage
4. Errors

Question 14

Regarding inventory costing methods, there are two types of “flow.” What are they?

Answer 14

1. Goods flow (physical flow of goods)
2. Cost flow (accounting cost flow assumption)

Question 15

What does “Goods flow” mean?

Answer 15

The actual flow of goods from acquisition to sale (order of what sells first)

Question 16

What does “cost flow” mean?

Answer 16

An assumed flow of the cost of goods from acquisition to sale

Question 17

Do goods flow and cost flow need to be equal?

Answer 17

No

Question 18

What are the 4 methods of costing inventory?

Answer 18

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

Question 19

What is the “specific identification method”?

Answer 19

The cost of specific items sold becomes the cost of goods sold amount when an item is sold.

Question 20

Which kind of manufacturers would benefit from using the specific identification method?

Answer 20

Manufacturers producing high-value products that can be easily identified separately

Question 21

How does the specific identification method look on a balance sheet?

Answer 21

The cost written on the balance sheet is the cost of specific items still on hand

Question 22

What two asusmptions does the FIFO (first-in, first-out) method have?

Answer 22

1. Assumes that the units purchased more recently remain on hand
2. Assumes the earliest units purchased are the first units sold

Question 23

What two assumptions does LIFO (last-in, first-out) method make?

Answer 23

1. Assumes that the first units purchased remain on hand
2. Assumes that the later units purchased are the first units sold

Question 24

What is the LIFO conformity rule?

Answer 24

Any company that chooses LIFO for tax reporting must also use LIFO for financial reporting

Question 25

What are the benefits of using FIFO?

Answer 25

Gross profit is larger when prices are rising- looks better for reporting to shareholders

Question 26

What are the benefits of using LIFO?

Answer 26

Gross profit is smaller when prises are rising- looks better for reporting on the company’s income tax return

Question 27

What is the weighted-average cost method?

Answer 27

A method that is in-between the FIFO and LIFO method

Question 28

How do inventory count errors affect costs?

Answer 28

The company will believe they have more or less money than they do.

Ex: If you have less money than you do, you risk spending too much and going into debt, while if you have more money than you think you do, you risk losing profit from spending that money to make money.

Question 29

The ending inventory cost must not exceed the net realizable value. T/F?

Answer 29

True

Question 30

What should you do if the net realizable value is LESS than recorded book value?

Answer 30

Write down inventory to the lower net realizable value

Question 31

What is “net realizable value”?

Answer 31

An item’s estimated selling price

Question 32

If the net realizable value is GREATER than the recorded book value, what should be done?

Answer 32

Inventory value remains at its cost.

Question 33

What is inventory turnover?

Answer 33

How many times a year, on average, a firm sells its inventory

Question 34

How is inventory turnover calculated?

Answer 34

Inventory turnover = cost of goods sold / average inventory

Question 35

Inventory turnover calculation example (for those who need it- like myself)

Answer 35

Assume Kanzu Co. maintained an average inventory level of $300, and it’s cost of goods sold for the year was $7,500. Then Kanzu’s inventory turnover would be…

Inventory turnover = $7,500 / $300 = 25 times

Question 36

What are Days’ sales in inventory?

Answer 36

A ratio that indicates how many days, on average, it takes a company to sell its inventory

Question 37

How to calculate Days’ sales in inventory?

Answer 37

Days’ sales in inventory = 365 / inventory turnover

Question 38

Example of days’ sales inventory.

Answer 38

Kanzu’s company has an inventory turnover of 25 times a year. Calculate days’ sales in inventory.

Days’ sales in inventory = 365 / 25
Days’ sales in inventory = 14.6 days

Question 39

What is the periodic inventory method?

Answer 39

Inventory balance and the cost of goods sold are only calculated at the end of the accounting period using a physical count of the ending inventory

Question 40

What is the perpetual inventory system?

Answer 40

The inventory account and the cost of goods sold are kept perpetually up-to-date, with updates occurring after every purchase and every sale

Question 41

What is the inventory reserve?

Answer 41

A measure of the difference between the value of a company’s ending inventory reported under LIFO and what the inventory would have been valued under FIFO

Question 42

Companies using LIFO must disclose the value of the inventory reserve in their financial statements. Why is this important?

Answer 42

1. Enables users to use the LIFO reserve to determine the fair market value of the LIFO ending inventory
2. Enables users to restate gross profit under LIFO

Question 43

What is the merchandising equation? (2 parts)

Answer 43

1. Sales revenue - cost of goods sold = gross profit
2. Gross profit - operating expenses = net income