Chapter 8 Flashcards
Inventories
Are asset items that a company holds for sale in the ordinary course of Business or goods that it will use or consume in production of goods to be sold
Merchandise inventory
Reports cost assigned to unsold units left on hand
Raw materials inventory
A company reports the cost assigned to goods and materials on hand but not yet placed into production
Raw materials include the following
Wood to make a baseball bat
Or
Steel to make a car
These materials can be traced directly to end product
Work in process inventory
The cost of raw material for these unfinished units plus the direct labor cost applied specifically to this material and eatable share of manufacturing overhead costs
Finished goods inventory
Companies report costs identified with completed but unsold units on hand at the end of fiscal period
Companies that sell or produce goods report what?
Inventory and cogs at the end of each accounting period
Companies use what two types of systems for maintaining accurate inventory records for these costs?
Periodic and perpetual
Inventory cost flow is
Beginning inventory plus of cost of goods purchased = cost of goods available for sale.
Inventory cost flow
as goods are sold they are assigned to?
Goods that are not sold by the end of accounting period represent?
Cogs
Ending inventory
Perpetual inventory system
Continuously tracks changes in inventory account.
Company records all purchases and sales (issues) of goods directly in the inventory account as they occur.
Periodic inventory system
Determined quantity of inventory on hand only periodically as the name implies
In order to do periodically , what does the company need to do?
- Record all acquisitions of inventory during accounting period by debuting purchase account
- Company adds total in purchase account at end of period to the cost of inventory on hand at the beginning of period. This sum determined total cost of goods a subtle for sale during sale
- To compute cogs, ending inventory is subtracted from cog available for sale
Many companies cannot afford a complete _______ system?
Perpetual
Most companies need current information regarding the inventory levels to protect against stock outs or over purchasing as a result companies use
Modified perpetual inventory system
Modified perpetual inventory system
Provides detailed inventory records of increases and decreases in quantities only not dollar amounts
Modified perpetual inventory system is a memorandum device outside double entry system that helps determine
Level of inventory at any point in time
No matter what type of inventory records companies use they all
Face the danger of loss and error
Such as waste breakage theft improper entry failure to prepare or differ from actual inventory on hand
Thus all companies need a periodic verification of
Inventory records by actual count , weight, or measurement with counts prepared with detailed inventory records
Companies correct records to
Agree with quantities actually on hand
When should companies take physical inventory?
Near the end of fiscal year to properly report inventory quantities
Goods sold or used during accounting period correspond to
The goods bought or produced during that period
Cost of all goods available for sale or use must be allocated between?
Goods that were sold or used and those still on hand
Inventory and accounts payable is recognized when?
It controls the asset
Fob shipping point
.
Fob destination
.
Transfer of legal title is is the general guideline for?
Used to determine whether the company should include an item in inventory
What are the two special sales situations that indicate the types of problems companies encounter in practice?
Sales with repurchase agreement
Sales with high rates of return
Sales with repurchase agreement
Sometimes a company finances its inventory without
Reporting either a liability or the inventory on its balance sheet
Sales with repurchase agreement , usually involves a transfer (sale) with
Either an implicit or explicit repurchase agreement
Sales with high rates of return
Informal agreement soften exist that
Permit purchasers to return inventory for a full or partial refund
Companies generally account for acquisition of
Inventories like other assets on a cost basis
Product costs
Costs that attach to the inventory
So the product costs are recorded in inventory account
Product costs are directly related to
Connected with bringing the goods to the buyers place of business and converting such goods to a salable condition
A manufacture company’s costs include
Direct materials
Direct labor
Manufacturing overhead costs
Manufacturing costs include
Indirect materials
Indirect labor
Various costs such as depreciation, taxes, insurance and utilities
Period costs
Are costs that are indirectly related to the acquisition or production of goods
Period costs such as selling expenses and under ordinary circumstances, general expenses are not included as
Part of inventory cost
Companies exclude this costs from inventoriable items
Bc companies generally consider selling expenses as more directly related to the cogs than the unsold inventory
Interest is a
Period cost
Usually expense interest costs associated with
Getting inventories ready for sale
Supporters of approach argue
Interest costs are really a cost of financing
Others contend that interest costs incurred to finance activities associated with readying inventories for sale are as much a cost of asset as materials labor and overhead
FASB ruled that companies should capitalize interest costs related to
Assets constructed for internal use or assets produced as discrete projects for sale or lease
Internalize costs for inventories should not be k
Capitalized
Purchase discounts in periodic inventory system indicates that
A company is reporting its purchases and accounts payable at gross amount
If company uses gross method, purchase discounts are reported as a deduction from
Purchases on income statement
Net of cash discounts
The company records a failure to take purchase discount within discount period in the purchase discount lost account.
Under the net of cash discounts, the purchase discounts are considered as
As a financial expense and reports it in other expenses and losses in income statement
This treatment is considered better
- Produces correct reporting of cost of asset and related liability
- It can measure management inefficiency by holding management responsible for discounts not taken
Under the cost flow assumption
There is no requirement that the cost flow assumption adopted be consistent with physical movement of goods
Specific identification
Calls for identifying each item sold and each item in inventory .
Specific identification
A company includes in cost of goods sold the costs of specific item sold
It includes in inventory then
.costs of specific items on hand
Specific identification method can be used only in
Instances where it is practical to separate physically from the different purchases made
Most companies use the specific identification method when handling
Small # of costly easily distinguishable items
Specific identification matches
Actual costs against actual revenue
Under specific identification the cost flow matched the
Physical flow of goods
Some believe that specific identification allows a company to manipulate
Income
Another problem of specific identification is
Is the arbitrary allocation of costs that some items occurs with specific inventory items
For example, face difficulty in relating shipping charges, storage costs and discounts given to inventory item
Average cost method
Prices items in the inventory on the basis of the average cost of all similar goods available during the period
Companies use average cost methods for
Practical reasons
Average method is not as subjected to manipulate
Income
FIFO
Assumes that company uses goods in the order it purchases them
FIFO method assumes that
First goods purchases are the first used or the first sold
The inventory that remains in the FIFO method represent
The most recent purchases
when FIFO is used the inventory and cogs
Would be the same at the end of the month whether a perpetual or periodic system is used.
WHY?
Bc the same costs will always be first in and first out
Objective of FIFO
Approximate the physical flow of goods
When the physical flow of goods is actually first in first out the FIFO method closely approximates
Specific identification
When FIFO closely approximates specific identification it prevents manipulation of
Income
Advantage of FIFO
Ending inventory is close to current cost
BECAUSE
first goods in are first goods out, ending inventory amount consists of most recent purchases
FIFO fails to match what?
Current costs against current revenues on income statement
Under FIFO
Company charges oldest costs against more current revenue which possibly distorts
Gross profit and net income
LIFO
Matches the cost of last goods purchased against revenue
Many companies use LIFO for
Tax and external reporting purposes
FIFO , average cost or standard costs system for
Internal reporting purposes
Reasons
- Companies often base their pricing decisions on FIFO average cost or standard cost assumption rather than lifo basis
- Record keeping on some other basis is easier bc LIFO assumption usually does not approximate physical flow of product
- Profit sharing and other bonus arrangements often depend on non LIFO inventory assumption
- The use of pure LIFO system is troublesome for intern periods which require estimates of year end quantity and prices
LIFO Reserve
Is the difference between the inventory method used for internal reporting purposes and LIFO is the allowance to reduce inventory to lifo account
LIFO effect
Is the change in allowance balance from one period to the next
Specific goods approach is often unrealistic for two reasons
- When a company has many different inventory items the accounting cost of tracking each inventory item is expensive
- Erosion of the LIFO inventory can easily occur
LIFO liquidation
Where erosion of LIFO inventory can easily occur. Which often distorts net income and leads to tax payments
Comprises cost from past periods, these costs are called
Layers (increases from period to period)
LIFO liquidation can occur frequently when using
Specific goods LIFO approach
How to alleviate LIFO liquidation
Companies can combine goods into pools
Pools
Groups items in similar nature
Instead of identical items, company combines and counts as a group
A number of similar units or products
Specified goods pooled LIFO approach results in fewer
WHY???
LIFO liquidations
WHY????
Bc the reduction of one quantity in the pool maybe offset by an increase in another
Specific goods pooled LIFO approach eliminates some of the disadvantages of
Specific goods (traditional) accounting for LIFO inventories
Specific goods pooled LIFO approach creates other problems such as
Companies continually change mix of products so companies must continually redefine the pools. ( time consuming and costly).
Second, even when practical, the approach results in erosion (LIFO Liquidation) of layers, thereby losing much of LIFO costing benefit
When does erosion of layer occur?
When a Specified good or material in the pool is replaced with another good or material
Dollar value LIFO overcomes the problems of
Redefining pools and eroding layers
Dollar value LIFO method
Determined and measures any increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in inventory pool
Dollar value LIFO has 2 important advantages over specific goods pooled approach
- Companies may include a broader range of goods in dollar value LIFO
T - Dollar value LIFO pool permits replacement of goods that are similar items similar in use or interchangeable
Dollar value LIFO techniques help protect LIFO layers from
Erosion
Companies use traditional LIFO approaches only when dealing with
Goods and expecting little change in product mix
Under dollar value LIFO method, one pool may contain the entire inventory . However companies use several pools. In general the more goods included in a poooo
The more likely that increases in the quantity of some goods will offset the decreases in other goods in the same pool
Having fewer pools means
Less cost and less chance of a reduction of LIFO layer
Note a layer forms only when?
The ending inventory at base year prices exceeds the beginning inventory at base year prices
When a decrease occurs the company
Peels off precious layers at the prices in existence when it adds the layers
In dollar value LIFO are price changes critical?
Yes
Many companies use the general price level index that the federal government
Prepares and publishes each month
Consumer price index for urban consumers is the most popular
General external price level index
When a relevant specific external price index is not readily available a company may
A company may compute it down specific internal price index and
Price index provides
A measure of change in price of cost levels between bad year and current year
Specific goods LIFO is
Unrealistic
Specific goods pooled LIFO approach reduces
record keeping and clerical costs
It is more difficult to erode layers because
The reduction of one quantity in the pool may be offset by an increase in another
Pooled approach using quantities as its measurement basis can lead to
LIFO liquidations
Most companies using LIFO system use
Dollar value LIFO
Major advantages of LIFO
Obvious advantage is that LIFO cost flow may approximate physical flow of goods in and out of inventory .
Major advantages LIFO include
Matching
- matches most recent costs against current revenues to better measure current earnings
- inventory profits occur when the inventory costs matched against sales are less than the inventory replacement cost
- LIFO matches current costs against revenue reducing inventory profits
Tax benefits/improved cash flow
- LIFO popularity stems from tax benefits
- as long as price level increases and inventory quarries do not decrease, deferral of income tax occurs. Why? Because company matches items it most recents purchased against revenues
- tax law requires that if a company uses LIFO for tax purposes t must use LIFO for financial accounting purposes referred as LIFO conformity rule
Future earnings hedge
- future price declines will not substantially effect a company’s future reported earnings
- he reason: since company records most recent inventory as sold first there is not much ending inventory at high prices vulnerable to price decline
Major disadvantages of LIFO
Reduced earning
- view lower profits under LIFO in inflationary times as distinct disadvantage
- would rather have higher reported profits than lower taxes
Inventory understated
- LIFO may have distorting effect on company balance sheet
- inventory valuation is normally outdated because the oldest costs remain in inventory
- the combined effect of rising product prices and avoidance of inventory liquidation increases the difference between inventory carrying value of LIFO and current prices of that inventory
Physical flow
- LIFO does not approximate physical flow of the items except in specific situations
- physical flow characteristics no longer determine whether a company may employs LIFO
Involuntary liquidation/ poor buying habits
- if a company eliminates the base of layers of old costs it may match old irrelevant costs against current revenues
- bc of liquidation problem, LIFO may cause poor buying habits.
- a company may simply purchase more goods and march these goods against revenue to avoid charging the old costs to expenses
- a company may attempt to manipulate its. We income at the end of year simply by altering its pattern of purchases
Basis selection of inventory method
LIFO occurs in the following instance
- If selling prices and revenues have been increasing faster than costs thereby distorting income
- In situations where LIFO has been traditional such as department store and industries where a fairly constant base stock is present
LIFO is inappropriate in the following
- Where prices tend to lag behind costs
- In situations where specific identification is traditional such as sale of automobiles, farm equipment , art jewelry
- Unit costs tend to decrease as production increases thereby nullifying tax benefit that LIFO might provide
Switching from FIFO to LIFO results in
Immediate tax benefit
Switching from LIFO to FIFO results in
Substantial tax burden
Relaxation of LIFO conformity rule has led some companies to select LIFO as inventory valuation method bc
They will be able to disclose FIFO income numbers in financial reports if so desires
