Chapter 6: Cost of Goods Sold and Inventory Flashcards
If a company has too much inventory, this will increase what two things?
- Carrying costs (like storage and interest costs)
- The risk of obsolescence (becoming updated)
Inventory is an _______, and it can have a major effect on ____ _____.
asset; net income
All inventory accounting systems allocate the cost of inventory between what two things?
Therefore, the valuation of inventory affects ____ ____ ____ _____, which in turn affects _____ _____.
- Ending Inventory
- Cost of Goods Sold
- cost of goods sold
- net income
Less money tied up in inventory results in…
greater profits
products held for resale that are classified as current assets on the balance sheet
inventory
Cost of goods sold is an (asset/expense).
expense
- an expense that represents the outflow of resources caused by the sale of inventory.
- the cost to the seller of all inventory sold during the accounting period
cost of goods sold
How is cost of goods sold calculated?
Cost of goods available for sale - cost of ending inventory.
When companies sell their inventory to customers, the cost of the inventory becomes an (asset/expense) called the _____ ____ ____ ____.
- expense
- cost of goods sold
What is the most important expense on the income statement of companies that sell goods instead of services?
Cost of goods sold
How is gross margin (gross profit) calculated?
Sales revenue (net sales) - cost of goods sold
indicates the extent to which the resources generated by sales can be used to pay operating expenses (selling and administrative expenses) and provide for net income.
gross margin (gross profit)
What has a DIRECT effect on cost of goods sold and gross margin?
Cost of inventory
Accounting for inventories involves determining the _____ ____ _____ through the use of one of several different inventory costing methods. In addition, ______ allows certain departures from historical cost accounting for inventory.
- cost of inventory
- GAAP
The choice made by managers of which inventory costing method they use affects what three things?
- The balance sheet valuation of inventory
- The amount of reported net income
- The income taxes payable from year to year
Companies that sell inventory are either _______ or ________.
- merchandisers
- manufacturers
companies (either retailers or wholesalers) that purchase inventory in a finished condition and hold it for resale without further processing.
merchandisers
merchandisers that sell directly to consumers (ex: Walmart, Target)
retailers
merchandisers that sell to other retailers. (ex: McKesson and AmerisourceBergen are wholesalers that supply pharmaceutical products to healthcare providers)
wholesalers
the inventory held by merchandisers
- is an ASSET.
- When that asset is sold to a customer, it becomes an expense called cost of goods sold, which appears on the income statement.
merchandise inventory
companies that buy and transform raw materials into a finished product which is then sold (ex: Sony, Toyota, and Intel).
manufacturers
Manufacturing companies classify inventory into what three categories?
- Raw Materials Inventory
- Work-In Process Inventory
- Finished Goods Inventory
the account in manufacturing firms that include the basic ingredients to make a product.
raw materials inventory
- When raw materials are purchased, the Raw Materials Inventory account is (increased/decreased).
- As raw materials are used to manufacture a product, they become part of what inventory?
- increased
- work-in process inventory
- the account in manufacturing firms that consists of the raw materials that are used in production, as well as other production costs such as labor and utilities.
- These costs stay in this account until the product is complete. Once the production process is complete, these costs are moved to what account?
- Work-In Process Inventory
- Finished Goods Inventory
the account in manufacturing firms that represent the cost of the final product that is available for sale.
Finished Goods Inventory
When the finished goods inventory is sold to a customer, it becomes an (asset/expense) called ____ ____ ____ _____, which appears on the income statement.
expense; cost of goods sold
cost of goods sold is recognized as an expense in the same period as the revenue from the sale of inventory is recognized. This is consistent with what principle?
expense recognition principle
The relationship between cost of goods sold and inventory is given by the cost of goods sold model. What is the cost of goods sold model?
Beginning Inventory
+ Purchases
——————————
= Cost of Goods Available for Sale
- Ending Inventory
——————————-
= Cost of Goods Sold
How do you calculate cost of goods available for sale?
Beginning Inventory + Purchases = Cost of Goods Available for Sale
The portion of the cost of goods available for sale that remains unsold at the end of the year is the company’s ______ _______ (the ______ ______ for one period becomes the beginning inventory of the next period).
ending inventory
The portion of the cost of goods available for sale that is sold becomes the ____ _____ ____ ____.
cost of goods sold
T or F: The general structure of the cost of goods sold model can be rearranged to solve for any missing amount if the other three amounts are known.
True
What is at the heart of the operating cycle for most wholesalers and retailers?
Inventory
What are the three things of information that inventory accounting systems provide?
- Provide info needed to determine the cost of goods sold and analyze inventory.
- Signal the need to purchase additional inventory or the need to make special efforts to sell existing inventory
- Provide info necessary to safeguard the inventory from misappropriation or theft.
(In short, these systems provide the info that managers need to manage and control inventory.)
What are the two types of inventory accounting systems?
- Perpetual Inventory System
- Periodic Inventory System
- an inventory system in which balances for inventory and cost of goods sold are CONTINUALLY updated with each sale or purchase of inventory. The accounts reflect the correct inventory and cost of goods sold balances throughout the period.
- requires detailed records on a transaction-by-transaction basis for each purchase and sale of inventory.
- records both the revenue and cost side of sales transactions.
perpetual inventory system
In a perpetual inventory system, when a company makes a sale to a customer, it will not only record the sale, but also update its inventory and cost of goods sold balances by (increasing/decreasing) inventory and (increasing/decreasing) cost of goods sold.
- decreasing inventory
- increasing cost of goods sold
What two things have made perpetual inventory system use more common?
- “Point of sale” cash register systems
- Optical Bar Code Scanners
A company that uses a perpetual system should still take a physical count of inventory at least _____ a year to confirm the balance in the inventory account. Any difference between the physical count of inventory and the inventory balance provided by the accounting system could be the result of what four things?
- once
1. errors
2. waste
3. breakage
4. theft
- an inventory system where cost of goods sold are recorded only at the END of a period (only produces balances for ending inventory and cost of goods sold at the end of each accounting period)
- doesn’t require companies to keep detailed, up-to-date inventory records.
periodic inventory systems
If a company using the periodic system needs to know the balance of inventory or cost of good sold during a period, it must do either of the following two things:
- perform a physical count of inventory
- estimate the amount of inventory using an acceptable estimation technique
What is the principal advantage of a periodic system? Why is this advantage disappearing though?
It’s relatively inexpensive to operate (advantage disappearing because of technological advances)
What is the advantage of a perpetual system? What does this provide to management?
making the balances of inventory and cost of goods sold continuously available. (provides management with greater control over inventory than it would have under a periodic inventory system)
If a company can rely on its suppliers to deliver inventory on very short notice and in ready-to-use forms, very low inventory levels can be maintained. This approach to inventory management is called ____ ____ _____ and is consistent with both minimizing inventory carrying costs and “out of stock” costs.
Just In Time (JIT)
the exchange price at the time the activity occurs
historical cost
applied to inventory, the historical cost principle implies that…
inventory cost includes the purchase price of merchandise plus any cost of bringing goods to a salable condition and location
Because of the historical cost principle applied to inventory, the cost of inventory will include what the purchase price plus other “incidental” costs, such as what three things?
- freight charges to deliver the merchandise to the company’s warehouse
- insurance cost on the inventory while it’s in transit
- various taxes
T or F: A company should stop accumulating costs as a part of inventory once the inventory is ready for sale.
True
In a perpetual inventory system, the inventory account is used to record the costs associated with ________ _________.
acquiring merchandise
the cost of merchandise acquired for resale during the accounting period.
purchases
The purchase of inventory is recorded by (increasing/decreasing) the inventory account when using a perpetual inventory system.
increasing
All purchases should be supported by a ______ ________, such as an invoice that provides written evidence of the transaction as well as the relevant details of the purchase.
source document
What are 6 details included in invoices?
- Name of seller and purchases
- Invoice date
- Credit Terms
- Freight Terms
- Description of Goods
- Total Invoice Amount
Cost of purchases must include effects of what three things?
Purchase discounts, returns, and transportation charges
From the viewpoint of the customer, such price reductions (sales discounts) are called:
purchase discounts
the reduced payment period associated with purchase discounts (ex: 10 days in the example of 2/10)
discount period
If a purchase discount is taken, the purchaser (increases/decreases) the inventory account for the amount of discount taken, resulting in the inventory account reflecting the net cost of the purchase.
decreases
When payment on account is made within the discount period, the buyer will record the discount as a (increase/decrease) to the inventory account when using a perpetual inventory system.
decrease
T or F: Generally, all available discounts should be taken. Failure to pay within the discount period= equivalent to paying interest for the use of money (can be quite expensive).
True
the cost of merchandise returned to suppliers
purchase return
If the purchaser is dissatisfied with the merchandise, it’s frequently returned to the seller for _____ or for a _____ ______.
credit; cash refund
a situation in which the purchaser chooses to keep the merchandise if the seller is willing to grant a deduction (allowance) from the purchase price
purchase allowance
A purchase return or allowance is recorded by (decreasing/increasing) the inventory account when using a perpetual inventory system.
decreasing
expenditures made to move the inventory from the seller’s location to the purchaser’s location.
transportation (freight) costs
T or F: The proper recording of transportation costs depends on whether the buyer or seller is paying for transportation.
true
The point at which ownership, or title, of the inventory changes hands depends on the shipping terms of the contract. The shipping terms can either be (2):
- F.O.B (free on board) shipping point
- F.O.B. destination
ownership of the inventory passes from the seller to the buyer at the shipping point
F.O.B (free on board) shipping point
For F.O.B (free on board) shipping point shipping terms, the (buyer/seller) normally pays the transportation costs termed _____ ____.
buyer; freight-in
For F.O.B (free on board) shipping point, when using a perpetual inventory system, the buyer will (increase/decrease) the inventory account for the freight costs (These costs are considered part of the total cost of purchases)
increase
For F.O.B (free on board) shipping point, the seller would normally recognize revenue when?
at the time of shipment
ownership of the inventory passes when the goods are delivered to the buyer
F.O.B. destination
For F.O.B destination shipping terms, the (buyer/seller) normally pays the transportation costs termed _____ ____.
seller; freight-out
T or F: For F.O.B destination shipping terms, transportation costs are not considered part of inventory; instead, the seller will expense these costs as a selling expense on the income statement.
True
For F.O.B destination, the seller would normally recognize revenue when?
When delivery of the goods has occurred
The purchase price of inventory includes any cost of bringing goods to a salable ________ and _______.
condition; location
For purchase transactions under a perpetual inventory system, the inventory account is INCREASED for:
- Purchase price (invoice price)
- Transportation costs paid by buyer
For purchase transactions under a perpetual inventory system, the inventory account is DECREASED for:
- Purchase discounts
- Purchase returns
- Purchase allowances
Companies recognize sales revenue when… (2 things)
- it satisfies its performance obligations to a customer
- the collection of cash is reasonably assured
Perpetual inventory systems require two entries for recording sales revenue:
- Sales revenue is recognized (decrease cash, increase sales revenue)
- Recognizes the cost of the goods related to the products that are sold. (increases cost of goods sold and decreases merchandise inventory account)
When customers make sales returns, two entries are made:
- Decrease sales revenue (for the amount of return) and decrease cash
- Decrease cost of goods sold and increase inventory
In dealing with sales to customers, it is important to remember to record revenues at (cost/retail prices) and to record expenses (and inventory) at (cost/retail prices)
- retail prices
- cost
T or F: If the prices paid for goods are constant over time, you multiply what by what to determine the cost of ending inventory, or multiply what by what to determine the cost of goods sold?
- cost per unit x number of units on hand at year end (to determine the cost of ending inventory)
- the cost per unit x the number of units sold (to determine the cost of goods sold)
The determination of the value of ending inventory and cost of goods sold depends on management’s choice of what two things?
- Which inventory system to use (perpetual or periodic)
- Which inventory costing method to use (FIFO,LIFO, Avg. Cost)
Accountants typically use one of four inventory costing methods:
- FIFO
- LIFO
- Average Cost
- Specific Identification
What is the difference between specific identification and the other three inventory costing methods?
- Specific identification: based on a flow of goods principle
- Other three: based on a flow of cost principle
T or F: GAAP requires that the cost flow assumption be consistent with the physical flow of goods.
False; does not require
Companies disclose their choice of inventory methods in a _____ to the financial statements.
note
T or F: Many companies use more than one method in determining the total cost of inventory.
True
What are the most widely used inventory costing methods?
FIFO and LIFO
What are the three steps used for FIFO, LIFO, and Avg. Cost to allocate the cost of goods available for sale between ending inventory and cost of goods sold?
- Step 1: Calculate the cost of goods available for sale immediately prior to any sale transaction.
- Step 2: Apply the method (FIFO/LIFO/Average Cost) to determine ending inventory and COGS
- Step 3: Repeat Steps 1 and 2 for all inventory transactions during the period.
What inventory costing method does this describe:
- assigns cost based on the ACTUAL flow of inventory
- historically, was practical only for high-cost items with unique identifiers (ex: serial numbers) that were sold in low numbers (ex: cars)
- with the introduction of bar coding, electronic scanners, and RFID this method has become easier to implement, but is still rare.
specific identification
What inventory costing method does this describe?
- the earliest (oldest) purchases are assumed to be the first sold (COGS) and the more recent purchases are in ending inventory.
- Based on the assumption that costs enter and and leave the inventory in the same order.
First-In, First-Out (FIFO)
The FIFO Method cost flow assumption is an accurate representation of the physical flow of goods for businesses such as what?
Restaurants, Grocery Stores (for perishable items)
What inventory costing method does this describe?
- based on the assumption that the most recent purchases are the first to be sold.
- Most recent purchases (newest costs) → allocated to the cost of goods sold.
- The earliest purchases (oldest costs) → allocated to inventory.
- Except for companies that stockpile inventory (ex: piles of coal, stacks of hay), this cost flow assumption rarely coincides with the actual physical flow of inventory. (Companies such as Target and Chevron use this method.)
Last-In, First-Out (LIFO)
What inventory costing method does this describe?
- an inventory costing method that allocates the cost of goods available for sale between ending inventory and cost of goods sold based on a weighted average cost per unit.
- Used by companies such as Office Depot, Microsoft, and Starbucks.
Average Cost
Under the perpetual inventory system, the weighted average cost per unit (called moving-average) is calculated after each purchase of inventory as follows:
Cost of Goods Available for Sale / Units Available for Sale = Weighted Average Cost Per Unit
The weighted average of cost per unit is used to calculate ending inventory and cost of goods sold as:
- Ending Inventory= Units on Hand x Weighted Average Cost per unit
- Cost of Goods Sold: Units Sold x Weighted Average Cost per unit
The average cost method results in an allocation to ending inventory and cost of goods sold that is _______ the allocations produced by FIFO and LIFO.
between
T or F: If the prices paid for purchased inventory are stable, all inventory costing methods will yield the same amounts for ending inventory and cost of goods sold.
True
T or F: Sales, Purchases and Cost of Goods Available for sale will be the same for each inventory costing method method.
True
However, the changing purchase prices of each inventory layer result in different amounts for:
- Ending Inventory
- Cost of Goods Sold
- Gross Margin
- Net Income (income before taxes - income tax expense)
For rising purchase prices, FIFO produces:
- (highest/lowest) ending inventory
- (highest/lowest) COGS
- (highest/lowest) gross margin and net income
- highest ending inv.
- lowest COGS
- highest gross margin and net income
For rising purchases prices, LIFO produces:
- (highest/lowest) ending inventory
- (highest/lowest) COGS
- (highest/lowest) gross margin and net income
- lowest ending inventory
- highest COGS
- lowest gross margin and net income
For falling purchases prices, FIFO produces:
- (highest/lowest) ending inventory
- (highest/lowest) COGS
- (highest/lowest) gross margin and net income
- lowest ending inventory
- highest COGS
- lowest gross margin and net income
For falling purchases prices, LIFO produces:
- (highest/lowest) ending inventory
- (highest/lowest) COGS
- (highest/lowest) gross margin and net income
- highest ending inventory
- lowest COGS
- highest gross margin and net income
During periods of rising prices: expect LIFO companies to report (higher/lower) amounts for inventory cost and (lower/higher) amounts for cost of goods sold than FIFO companies.
- lower
- higher
During periods of falling prices: expect LIFO companies to report (higher/lower) amounts of inventory cost and (higher/lower) amounts for cost of goods sold than FIFO companies.
- higher
- lower
Which one describes LIFO and which describes FIFO?
1. results in a more realistic amount for income bc it matches the most current costs, which are closer to the current market value, against revenue.
2. results in the more realistic amount for inventory because it reports the most current costs, which are closer to the current market value, on the balance sheet.
- LIFO
- FIFO
In periods of rising prices, companies may choose (FIFO/LIFO/Average Cost) because it produces the lowest current taxable income and the lowest current income tax payment.
LIFO
The federal income tax code requires businesses that use LIFO for tax purposes to use LIFO for financial reporting purposes as well. This is known as the:
LIFO Conformity Rule
T or F: Once a company adopts a method for an item, it must continue to use it consistently over time. This enhances comparability and usefulness of accounting info. This permits readers of financial statements to assume that accounting methods do not change over time unless specifically indicated.
True
T or F: In cases where the selling price of inventory (inventory market value) has dropped below its original cost, GAAP permits a departure from historical cost.
True
the value at which inventory is reported under GAAP, where cost is the historical cost of the inventory and net realizable value is the estimated selling price minus the costs of disposal. (departure from the historical cost principle).
lower of cost or market value (LCM)
How do you calculate net realizable value (market value)?
estimated selling price - costs of disposal (ex: selling expenses)
Under LCM, if the NRV of a company’s inventory is lower than its cost, the company (increases/decreases) the amount recorded for its inventory to its net realizable value.
decreases
To apply LCM, a company must perform what four steps?
- Determine the cost of inventory using a costing method (FIFO,LIFO, etc.)
- Establish the net realizable value of the inventory
- Compare the NRV to historical cost (usually on an item-by-item basis) and value the inventory at the lower of the two amounts.
- If the value of the inventory computed in Step 3 is less than its cost, record a journal entry to reduce inventory to the lower amount
T or F: The lower of net realizable value or historical cost is used as the cost for the inventory on the financial statements. A company must make an adjusting journal entry to record any reduction of the cost of inventory to market value.
True
The LCM rule is an application of the ________ principle, which leads accountants to select the accounting methods/procedures that produce the lowest net income and net assets in the current period.
conservatism
Two measures of how successfully a company is managing and controlling its inventory are:
- Gross Profit Ratio
- Inventory Turnover Ratio
a measurement of the proportion of each sales dollar that is available to pay other expenses and provide profit for owners
gross profit ratio
How do you calculate gross profit ratio?
Gross Profit / Net Sales: Gross Profit Ratio
What is a key indicator of a company’s ability to sell inventory at a profit and it measures how many cents of every dollar are available to cover expenses other than COGS and to earn a profit?
Gross Profit Ratio
- a ratio that describes how quickly inventory is purchased (or produced) and sold.
- Provides an indicator of how much of the company’s funds are tied up in inventory.
Inventory Turnover Ratio
How do you calculate inventory turnover ratio?
COGS / Average Inventory = Inventory Turnover Ratio
What do high inventory turnover ratios indicate? Low?
- High: a company is rapidly selling its inventory, thus reducing inventory costs
- Low: company may be holding too much inventory or signals that demand for a company’s products has fallen
an estimate of the number of days it takes a company to sell its inventory.
Average days to sell inventory
The average days to sell inventory ratio is calculated as:
365 days/ inventory turnover ratio = average days to sell inventory
the amount that inventory would increase (or decrease) if the company had used FIFO.
LIFO Reserve
Measurement of inventory affects what two financial statements?
- Income Statement
- Balance Sheet
T or F: Even with recent technological advances, it’s easy to make errors in determining the cost of the hundreds of items in a typical ending inventory. Incorrect counts, mistakes in costing, or errors in identifying items are common.
True
T or F: Because the ending inventory of one period is the beginning inventory of the next period, errors in the measurement of ending inventory affect two accounting periods.
True
If inventory is understated, how does this affect inventory, COGS, net income, and total assets for the current period?
- Inventory: understated
- COGS: overstated
- Net Income: understated
- Total Assets: understated
If inventory is understated, how does this affect inventory, COGS, net income, and total assets for the next period?
- Inventory: Correct
- COGS: understated
- Net Income: overstated
- Total Assets: Correct
If inventory is overstated, how does this affect inventory, COGS, net income, and total assets for the current period?
- Inventory: overstated
- COGS: understated
- Net Income: overstated
- Total Assets: overstated
If inventory is overstated, how does this affect inventory, COGS, net income, and total assets for the next period?
- Inventory: Correct
- COGS: overstated
- Net Income: understated
- Total Assets: Correct
T or F: inventory errors are self-correcting over two periods
True
T or F: Under a periodic inventory system, the inventory costing methods are applied AS IF all purchases during an accounting period take place prior to any sales of the period.
(While this isn’t realistic, it does simplify the computation of the ending inventory and COGS since only one allocation needs to be made, regardless of the number of purchases and sales)
True
For periodic inventory systems, sales can be ________ because all purchases are assumed to occur prior to any sales.
combined
T or F: In a periodic inventory system while using the average cost method, the weighted average cost per unit is not continually calculated. Rather it is calculated based on the total cost of goods available for sale and the total units available for sale.
True
Because of the difference in the timing of cost allocations in a periodic vs. perpetual system, the two systems usually yield different amounts for COGS and ending inventory under what two inventory costing methods?
- LIFO
- Average Cost
T or F: FIFO amounts, are always the same under both periodic and perpetual inventory systems.
True
