Chapter 8 Flashcards
inventory overview
asset
intends to sell in the normal course of business
has in production for future sale
or
uses currently in production of goods to be sold
COGS related expense account
types of inventory
merchandise: goods purchased primarily in finished form from wholesalers and retailers
cost of merchandise inventory:
- purchase price plus any other costs necessary to get goods in condition and location for sale
manufacturing inventory: goods that are produced by a manufacturing company to be sold to wholesalers, retailers, other manufacturers or consumers
- consists of:
RM
WIP
FG
perpetual inventory system
continually adjusts the inv account for each change in inventory caused by a:
- purchase
- sale, or
- return of inventory
continually adjusts the COGS each time goods are:
- sold
- returned by a customer
this allows management to determine goods on hand on any date and to determine the number of items sold during the period
perpetual inventory system example:
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers.
The
company begins 2024 with inventory of $120,000 on hand.
The
following information relates to inventory transactions during 2024:
- Additional soft drink inventory is purchased on account at a cost of
$600,000. - Sales for the year, all on account, totaled $820,000.
- The cost of the soft drink inventory sold is $540,000.
Lothridge uses the perpetual inventory system to keep
track of both inventory quantities and inventory costs.
The
system indicates that the cost of inventory on hand at the
end of the year is $180,000
record purchase of inv:
Debit: inventory 600,000
Credit: AP 600,000
record sale account:
Debit: AR 820,000
Credit: SR 820,000
record costs of sales
Debit: COGS 540,000
Credit Inventory 540,000
perpetual inv system technology
nearly all major companies use to record transactions
tech advances help reduce burden of physical inv counts and manual record keeping
automated systems allow for continuous tracking of inv:
- barcode scanning
- radio frequency identification ((RFID) tags
periodic inv system
adjusts the inv account and record COGS only at the end of each reporting period
records merchandise purchases, purchases returns, purchase discounts, and freight-in temporary accounts
determine period’s COGS by combining temporary accounts with the inv account:
COGS = beg inv + net purchases - end inv
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2024 with inventory of $120,000 on hand. The
following information relates to inventory transactions during
2024:
1. Additional soft drink inventory is purchased on account at a cost of
$600,000.
2. Sales for the year, all on account, totaled $820,000.
Lothridge uses the periodic inventory system. After a
physical count of inventory at the end of the year, the cost of
ending inventory is determined to be $180,000.
recording purchase of inv:
Debit: purchases
Credit: AP
record sales on account
Debit: AR
Credit: Sales Revenue
no entry is required for cost of inventory sold at the time of sale (cost of inv will be recorded at the end of the year after a physical inventory count
adjusting entry and purchases account, and record COGS
Debit: COGS 540,000
Debit: Inventory (ending) 180,000
Credit: Inv (beg) 120,000
Credit: Purchases 600,000
beg inv + purchases =
cost of good available for sale
comparing perpetual and periodic inventory system: perpetual
1) COGAS is allocated by decreasing inv and increasing cost of goods sold each time goods are sold
2) facilitates the preparation of interim financial statements by providing fairly accurate info without the necessity of physical count of inv
3) more expensive to implement
4) involves the tracking of both inventory quantities and costs
comparing perpetual and periodic inventory system: periodic
1) allocates the COGAS for sale between ending inventory and COGS at the end of the period
2) requires a physical count before ending inventory and COGS can be determined –> makes the preparation of interim financial statements more costly
3) less costly to implement
4) can monitor only inv quantities
physical units included in inventory
items in the possession of the company
goods in transit
goods on consignment
anticipated sales returns
goods in transit
where goods are on the way to their destination
between the suppliers and a company or between the company and its customers
HOW TO ACCOUNT: depends on ownership of goods
goods in transit
FOB shipping point
or
FOB destination
FOB shipping point: In December 2024, the Lothridge Wholesale Beverage Company
sold goods to the Jabbar Company. The goods were shipped from
Lothridge on December 29, 2024, but the goods didn’t arrive at
Jabbar until January 3, 2025
FOB SP
- title transfers at shipping point
- lothridge wuld record sale on Dec 29, 2024
Jabbar includes these goods in its 2024 ending inventory even though the company is not in physical possession of the goods on the last day of 2024
In December 2024, the Lothridge Wholesale Beverage Company
sold goods to the Jabbar Company. The goods were shipped from
Lothridge on December 29, 2024, but the goods didn’t arrive at
Jabbar until January 3, 2025
FOB D
title transfers at destination
Lothridge includes the goods in
its 2024 ending inventory and
the sale is not recorded until
January 3, 2025, when those
goods reach Jabbar.
- Jabbar waits until 2025 to record
the purchase
`sales returns
when customers return merchandiseL
1) COGS is reduced
2) inventory is increased (also revenue and AR are reduced)
same adjustment is made at the end of the period to account for estimated sales returns in the future
sooooooo
company includes in ending inventory the cost of inventory sold that it anticipates will be returned
goods on consignment
transferor (consignor) legally retains the title of goods even though the consignee holds them in the store (consignor physically transfers the goods)
if the buyer is not found - goods are returned to the consignor
if the buyer is found - the selling price (less commission and approved expenses) is remitted to the consignor
accounting treatment:
- goods held on consignment are included in the inventory of the consignor until sold by the consignee
- sale is recorded by consignor only when the goods are sold by the consignee and title passes to the third party
journal entry for estimated return
Debit: estimated returns
Credit: Refund liability
Debit: Inventory
Credit: COGS
NOTE: differing entries depending on adjustment that needs to fix understated or overstated
transactions affecting net purchases
costs of inventory includes necessary expenditures to:
1) acquire the inv
2) bring it its desired condition and location for sale or for use in the manufacturing process
- common costs included in inv are:
1) freight charges on incoming goods
2) insurance costs during transit
3) costs of unloading, unpacking, preparing merchandise inv
purchase returns and purchase discounts REDUCE the cost of net purchases
net purchases = total purchases + freight and other costs - returns and discounts
freight-in on purchases
costs to get the inv in location for sale or use
- perpetual: ADD to inventory account
- Periodic: freight costs are added to temporary account = freight in/transportation in (later added to purchases
shipping charges on outgoing goods
costs are not included in the cost of inventory
- treated as a part of COGS or as an operating expense
- if not in COGS amounts incurred and income statement classification must be disclosed
purchase returns
buyer views a purchase return as a reduction of purchases
perpetual inv system: return of inv previously purchased on acct is recorded as:
- reduction in both inv and AP
- if original purchase was for cash, then increase cash for refund
periodic inv system:
- purchase returns acct used to accumulate the amount of return
- purchase returns are then subtracted from total purchases to calculate net purchases
purchase discounts: represents reduction in the amt to be paid by the buyer if remittance is made within a designated period of time —> Gross Method
record purchase of inv:
Debit Inventory 20,000
Credit: AP 20,000
Record payment within period:
Debit: AP 14,000
Credit: Inv 280
Credit: Cash 13720
if remaining amount is paid after discount period:
Debit: AP 6,000
Credit: Cash 6,000
purchase discounts: represents reduction in the amt to be paid by the buyer if remittance is made within a designated period of time —> Net Method
record purchase of inv:
Debit Inventory 19,600
Credit: AP 19.600
Record payment within period:
Debit: AP 13,720
Credit: Cash 13720
if remaining amount is paid after discount period:
Debit: AP 5880
Debit: purchase discount lost 120
Credit: Cash 6,000
specific identification method
refers to matching each unit sold during the period or each unit on hand at the end of the period with its actual cost
used by companies selling unique, expensive products with low sales volume
- this makes it easy and economically feasible to associate each item with its actual cost
example: automobiles with serial numbers
what are the three types of cost flow assumptions
cost flow - units of inv that have been sold and which remain in ending inventory
average cost:
- assumes inv cost is a mix of all goods available for sale
- average is weighted by number of units
first in, first out (FIFO):
-assumes units first acquired are sold first
- ending inv consists of the most recently acquired units
LIFO:
- assumes units last acquired are sold first
- ending inv consists of first acquired units
average cost - periodic
calculated only at the end of the period
example…
average cost method - perpetual
applied by computing a moving average unit cost each time additional inventory is purchased
- summing the cost of the previous inv balance and the cost of the new purchase
- dividing this total cost by the number of units on hand
FIFO - periodic
example
FIFO - perpetual inventory system
done in class
LIFO - periodic
example
LIFO - perpetual
done in class
comapring cost flow methods
average method amounts fall in between FIFO and LIFO for COGS and ending inv
during rising costs:
FIFO will be lower COGS, and higher ending inventory
during declining costs:
FIFO will be higher COGS and lower ending inventory
What methods does GAAP allow?
FIFO, LIFO, average cost
for IFRS, under IAS No. 2 –>
does not permit the use of LIFO
what are factors that influence method choice
- physical flow
- income taxes and net income
in relation to physical flow (a factor influencing method choice), companies often attempt to sell the oldest goods in inventory first
FIFO will best suit this
if inv sold comes from mixture of goods at various times, average cost may be better
- few inventories flow well with LIFO
income taxes and net income (factors that influence method choice)
if the unit cost of inventory changes, the method chosen will have an impact on:
- amount of income reported to external parties
- amount of taxes paid to:
IRS
or
state and local taxing authorities
when inv costs rise and inv quantities are decreasing:
LIFO produces higher COGS and lower net income
- lower taxable income is reported and lower taxes paid
why do many companies choose LIFO
to reduce income taxes in periods when prices are rising
taxes are not recued permanently - they are deferred
IRS requires companies to follow LIFO conformity rule
LIFO conformity rule
if a company uses LIFO to measure taxable income, it also must use LIFO for external financial reporting
what is LIFO Reserves
helps businesses see how much inv costs would change/be when using different method
when doing LIFO:
- higher COGS because recent inv costs are more due to inflation)
- lower profits (because higher COGS reduces net income)
- LIFO Reserve shows how much lower COGS would be if FIFO were used instead
sooo…
- if LIFO reserve increases, COGS under LIFO is higher than FIFO
- if LIFO reserve decreases, COGS under LIFO is lower than FIFO
companies use LIFO reserves to see how much inventory costs would change under FIFO, affecting profits and taxes
LIFO Reserve formula:
[inventory account balance under FIFO or average cost used to maintain internal records] - [inventory account balance under LIFO for external reporting and income tax purposes]
LIFO reserve is reported as a
contra account to adjust the balance of inventory from the internal method to the LIFO method for external reporting
(reducing your inventory under FIFO to be under LIFO, but increasing your COGS)
why maintain internal records other than LIFO
- high record keeping costs for LIFO
- contractual agreements such as bonus or profit-sharing plans that calculate net income with a method other than LIFO
- using FIFO or average cost information for pricing decisions
LIFO inventory =
FIFO Inv - LIFO Reserve
LIFO COGS =
FIFO COGS + increase in LIFO Reserve
net inventories
inventories (at average cost)
Less: LIFO Reserve
Net inventories (at LIFO)
what happens if you debit LIFO Reserve
shows decrease in LIFO Reserve
what happens to COGS if decrease LIFO Reserve
crediting COGS decreases expense account which increases reported profit
LIFO liquidations
have LIFO - last in first out
but in some periods, the number of units sold will be greater than the number of units purchased
because of this –> have to dip into old layers of lower cost inventory
“company is suing up its older inventory layers” – no choice but to start selling older (cheaper) inventory that was recorded at lower costs
oldest costs being matched with current selling prices
results of LIFO liquidation
1) COGS will be lower - since older inventory is cheaper, COGS is decreasing
2) higher profits - lower COGS means higher net income, which can lead to higher taxes
3) reduced LIFO Reserve - will shrink because the difference between FIFO and LIFO inv value decreases
so you are artifically boosting profits in short term (may not have actually had lower COGS or increased profits), but reduces LIFO reserve and may increase tax liabilities
with LIFO liquidation, what happens if costs have been increasing?
LIFO liquidations produce higher net income because COGS is lower (if costs decreasing, LIFO liquidations produce lower net income)
why are inventory levels closely monitored and what is the conflict
- ensure that the inventories needed to sustain operations are available
- hold the cost of ordering and carrying inventories to the lowest possible level
companies must maintain sufficient quantities of inventory to meet customer demand, maintaining inv is costl
what are tools used to balance inventory conflicts
- just in time system
- outsourcing inv component production
- computerized inv control systems
just in time system
advantages:
- low inv balances are maintained
- customer demand is quickly met
key ratios are used to monitor investment in inventories
gross profit
inventory turnover
gross profit margin ratio
percentage of each sales dollar available to cover expenses other than COGS and to provide a profit
GPR = GP/Net sales
GP = Net sales - COGS
higher the ratio, the higher the markup achieved
declining ratio:
- company is unable to offset rising costs with corresponding increases in selling price
- sales prices are declining without a commensurate reduction in costs
inventory turnover ratio
number of times the avg inv balance is sold during a reporting period
inv turnover ratio = COGS/average inventory
higher ratio –> more effect co is at managing inv
declining ratio is unfavorable for companies
methods of simplifying LIFO
LIFO inventory pools
dollar value LIFO method
what are limitations of LIFO
1) recordkeeping costs of unit LIFO can be a lot:
- when co has numerous individual units of inv
- when unit costs change often during a period
2) probability of LIFO inv layers being liquidated
LIFO inventory pools
grouping inv into pools based on physical simialrites of the individual units
in pools - all purchases during period are made at same time at same csot
individual unit costs are converted to an average cost for the pool
if the quantity of ending inv for the pool increases:
end inv = begin inv + single layer added during the period at the avg. cost of the pool
dollar value LIFO
viewed as comprising layers of dollar values from diff years
pool made up of items that are likely to face the same cost change pressures
inv is viewed as quantity of value instead of a physical quantity of goods
companies are allowed to combine a large variety of goods into one pool
DVL step process (estimation)
1) find cost index
1) covert ending inv to base year costs
2) identify the layers of end inv created each year
3) restate each layer using the cost index in the year acquired
how to calculate cost index in layer year
cost in layer year/cost in base year
Dollar value LIFO advantages:
simplifies the recordkeeping procedures
minimizes the probability of the liquidation of LIFO inv layers
acquisition of the new items is viewed as replacement of the dollar value of the old items
