Chapter 6 Cost of goods sold

Question 1

Operating Cycle

Answer 1

Most companies have an identifiable cycle of activities that reflect the day to day operations of the business.

Question 2

Retail Operating Cycle

Answer 2

The company acquires inventory that is, for all practical purposes, ready for sale to its customers. Initially, the inventory is carried as an asset on the retailers balance sheet, but upon the sale, the cost of the inventory is removed from the balance sheet and transferred to cost of goods sold on the income statement, to be matched with operating revenue produced by the sale.

Question 3

Manufacturing Operating Cycle

Answer 3

More complex. Begins its operating cycle with the purchase of raw material, which then enters a production process.

Question 4

Work-in-process inventory

Manufacturing Operating Cycle

Answer 4

The raw material is initially altered by the production-line-workers and manufacturing equipment

Question 5

Finished Goods Inventory

Manufacturing Operating Cycle

Answer 5

When the production process is finally complete and is ready for sale

Question 6

Manufacturer’s inventory

Answer 6

Recognized as an asset on the balance sheet. When raw material enters the manufacturing process, its value is transferred to the work-in-process inventory account. As work in progress is completed, it is transferred to the finished goods account. Upon the sale of the finished goods, the cost of the sold inventory is transferred to cost of goods sold on the income statement and replaced by cash or accounts receivable on the balance sheet.

Question 7

Measuring Cost of Goods Sold and ending inventory

Answer 7

Inventory values on the balance sheet are charged to earnings in the period in which the inventory is sold. This is an example of the “matching” concept at work, wherein the effort is recorded in the same period during which any benefit is received by the company.

Question 8

FIFO

Inventory Valuation Method

Answer 8

This approach assumes that the first units purchased are the first units sold. The units remaining on hand are the units purchased more recently so the company’s ending inventory would be the cost of the last unit purchased.

Question 9

LIFO

Inventory Valuation Method

Answer 9

Last in, first out. This methods assumes that the units purchased most recently, are the first units sold.

Question 10

LIFO Conformity Rule

Answer 10

IRS Requires businesses that use LIO for income tax purposes to also use LIFO in preparation of their audited financial reports to share holders

Question 11

Average Cost Method

Inventory Valuation Method

Answer 11

Average of units cost

Question 12

Weighted-average cost method

Inventory Valuation Method

Answer 12

Different from average cost method. Each inventory price is weighted by the quantity of units purchased at a given price, whereas the average cost method calculates a simple average of the various inventory purchase prices without regard to the quantities purchased.

Question 13

Replacement Cost Method

Inventory Valuation Method

Answer 13

Valued both the unit sold and the unit on hand at the inventory’s replacement cost.

Question 14

Specific identification method

Inventory Valuation Method

Answer 14

If the CEO could identify exactly which product was sold on a given day, then the actual price of the identified item would be charged to cost of goods sold and the cost basis of the remaining barrel would also be known.

Question 15

Inventory Management System

Answer 15

Tool used to keep track of the inventory purchased, sold and on hand

Question 16

Periodic System

Inventory Management System

Answer 16

Periodically updates such information as the cost and quantity of inventory on hand, but only when new goods are purchased and when a physical count on hand inventory is undertaken. Presumes that management does not need minute-by-minute information regarding the quantity of inventory on hand or its costs.

Question 17

Perpetual System

Inventory Management System

Answer 17

Updates a firms inventory data after every purchase and every sale, providing a constant source of reliable information about the cost and quantity of goods available for sale

Question 18

Inventory Count

Answer 18

Almost all types of inventory are subject to damage, deterioration and theft. GAAP requires that a physical inventory count be taken at least once a year so as to ensure the integrity of the inventory balances. It should be noted that any amount needed to adjust ending inventory will affect no only inventory on the balance sheet but also cost of goods sold and net income on the income statement.

Question 19

Computations of Cost of Goods Sold

Answer 19

The adjustment of cost of goods sold and inventory can be best understood:
Beginning Inventory + Purchases = Goods available for sale - Ending inventory = COGS

Question 20

Choosing an Inventory Method

Answer 20

Once a company has selected a particular inventory valuation method, they do not have to keep it consistent among all items.

Question 21

Lower of Cost or Net Realizable Value

Answer 21

Companies are required to ensure that the value of ending inventory carrier on the balance sheet is recorded at an amount that does not exceed its Net Realizable Value.

• If the NRV is less than its recorded books value, the company must write the value of its inventory down to NRV.
• If the, however, the NRV is higher than its recorded book value, the inventory is not written up to the higher value but remains valued at its cost.

Question 22

Net Realizable

Answer 22

(NVR) Measured as the estimated selling price in the ordinary course of business. minus cost of completion, disposal, and/or transportation.

Question 23

LIFO Layers

Answer 23

Since the LIFO method assumes that the most recently purchased inventory is the first inventory to be sold, it is not unusual for a company to have multiple LIFO layers, often reflecting prices from several prior fiscal periods.

Question 24

LIFO Reserve

Answer 24

Accounting standard-setters require that companies using LIFO disclose the value of the inventory reserve in their footnotes.

Question 25

Inventory Reserve

Answer 25

Significant because it enables investment professionals to restate gross profit under LIFO to estimate what gross profit would have been had FIFO been used instead. It is a cumulative measure of the difference between the LIFO cost of ending inventory and the FIFO cost of ending inventory.

Question 26

Liquidating LIFO Layers

Answer 26

Sometimes it is impossible to meet internal or external earnings expectations by increasing sales and thus managers may look for other ways to increase net income (such as cutting costs). One temporary profit-enhancing approach used by some managers of LIFO-accounted companies is the liquidation of LIFO layers.

-Liquidating a LIFO layer has the effect of lowering the reported cost of goods sold, and hence, raising gross profit because a lower cost of inventory is effectively matched with revenue.

Question 27

Phantom Profit

Liquidating LIFO Layers

Answer 27

Although gross profit is increased, cash flow is not. In fact, the operating cash flow from LIFO price-layer liquidations is actually reduced as a consequence of the additional income taxes that must be paid on the phantom profits generated by sales.

Question 28

Managing a company’s investment in inventories

Answer 28

When a company holds large quantities of inventory to service its customer needs, the company is required to invest its cash not only to purchase and/or manufacture the inventory, but also for warehousing and insurance on the inventory.

Question 29

Days Payable Period

Answer 29

Customers look to the credit provided by their suppliers as a source of interest free financing for their own operation.

Days Payable Period = 365 / Cost of goods sold / Accounts Payable

This ratio indicates the average number of days that a company normally takes to pay its out-standing accounts payable.

Question 30

Periodic Weighted Average Inventory

Answer 30

Weighted average periodic is probably the easiest of all the inventory methods. Since the calculation is done at the end of the period, we figure out the total cost of goods available for sale and divide by the number of units. It is helpful to separate the purchases from the sales.

Question 31

Perpetual Weighted Average Inventory

Answer 31

Perpetual inventory systems require the cost of goods sold to be calculated each time there is a sale. Therefore, at the time of each sale, we must calculate the weighted average cost of the units on hand at the time of the sale

Question 32

Inventory Turnover

Answer 32

Inventory Turnover = Cost Of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)

Question 33

What is beginning inventory

Answer 33

Beginning inventory is the dollar value of all inventory held by a business at the start of an accounting period, and represents all the goods a business can put toward generating revenue. You can use the beginning inventory formula to better understand the value of your inventory at the start of a new accounting period.

How to calculate beginning inventory

1) Determine the cost of goods sold (COGS) using your previous accounting period’s records.
2) Multiply your ending inventory balance with the production cost of each item. Do the same with the amount of new inventory.
3) Add the ending inventory and cost of goods sold.
4) To calculate beginning inventory, subtract the amount of inventory purchased from your result.

Question 34

Accounts Payable Turnover Ratio Formula

Answer 34

In some cases, cost of goods sold (COGS) is used in the numerator in place of net credit purchases. Average accounts payable is the sum of accounts payable at the beginning and end of an accounting period, divided by 2.

COGS / [BEGAP + EAP] / 2