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ACCT 341 - Intermediate Financial Accounting 1 > Chapter 8 - Inventory > Flashcards

Chapter 8 - Inventory Flashcards

1
Q

What is an inventory?

A
  1. An asset that is held for sale in the ordinary course of a business
  2. An asset that is in the process of production
  3. An asset that is in the form of materials or supplies consumed on the production process
  4. An asset that is used in rendering a service.
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2
Q

What are the inventory accounts held by merchandising companies? What are the three inventory accounts help by manufacturing firms?

A

Merchandisers inventory.
WIP, Finished Goods, and Raw materials.

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3
Q

What is work in process inventory?

A

This is inventory that includes the cost of raw materials in the production process, labour costs, and overhead costs related to the processing of the raw materials.

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4
Q

What are finished goods inventory?

A

The cost of the finished product and will include the cost of the raw material, overhead, and the labour.

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5
Q

What are the five situations where a transactions did not involve a sale, but the legal title of the inventory has passed?

A
  1. Goods in transit
  2. Consigned goods
  3. Sales with a repurchase agreement
  4. Sales with high rates of return
  5. Sales with delayed payment terms (instalment sales)
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6
Q

Describe the goods in transit?

A

This is where the nature of the transaction matters. If the terms is fob shipping than the buyer has legal title once it is shipping on its way, but it is not yet physically in their possession. Under the FOB destination they do not get legal title or get the physical good until it reaches them.

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7
Q

Described the consigned goods?

A

Under the consigned goods the title of the inventory never actually passes to the consignee, but rather it is still held in the inventory of the consignor. If there is a new product, it is hard to sell it so to ensure the risks and rewards do not pass, they use the consigned goods.

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8
Q

Describe the sale with a repurchase agreement?

A

Under this situation, there are two firms where one surrenders their inventory to another, and the seller promises to buy the asset back at a future date. This is not actually a sale, and thus the seller should not remove it from their books.

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9
Q

Describe the sales with high rates of return?

A

Under this situation, the company should not derecognize it from the books until they are absolutely certain the company will take the goods, thus it is a consignment inventory.

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10
Q

Describe the sales with instalment payments

A

Under this situation, the buyer will make multiple payments and once the payments initiate the seller promises not to sell it to anyone else. The title will not pass until the payment is completed, however based on the firm they may want to derecognize it if the likelihood of collection is reasonable.

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11
Q

Describe the purchase commitments

A

This is a situation where ahead of time a company agrees to purchase goods from another company at a specified price. At this time there is no initiation of a transaction and thus no transaction needs to be recorded. However, if the fair value of the items that the company is going to buy falls below the commitment price, it is apparent that a loss will occur in the future. At this point a loss will be recorded.

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12
Q

What does ASPE / IFRS state about the purchase commitments?

A

IFRS addresses the issue, but ASPE does not.

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13
Q

What are the two types of inventory errors that occur independently of each other?

A
  1. The failure to record an invoice transaction.
  2. An inventory count error at the end of the year.
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14
Q

What is the inventory count error? Where do these errors show up?

A

At the end of each year, the company will typically record adjustments of inventory costs to actual costs after performing the inventory count affecting the inventory and the COGS. However if a count error occurs, then it may become misstated. These errors will show up in the ending inventory account, not the purchases account, to affect the COGS.

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15
Q

What is the recording error. However, what happens to the inventory account by the year end?

A

They make an error in recording an inventory purchase transaction. This will cause a misstatement of the inventory and accounts payable. At the end of the year, the staff performing the count will fix the inventory error that arose from the inventory purchase transaction error, making this inventory error correct assuming they made no errors. However, the offsetting side is an adjustment to the COGS which will then affect those accounts. The affect to COGS will occur through the purchases account.

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16
Q

What is the best way to fix these inventory errors?

A

List the components of the COGS regardless if it is a periodic of perpetual system, and determine if they have over or understated these items in error. Then you must consider how this will flow to the next items on the statement of financial position. Once we have this good understanding, we can then do adjusting entries to fix the issues.

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17
Q

Do inventory errors cause the statement of financial position to be out of balance?

A

No, even inventory errors must be in balance when they occur.

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18
Q

How do we record inventory initially? (8 points)

A

We record them at their costs which includes the original amount and other items such as:
1. Purchase discounts
2. Volume rebates
3. Product Costs
4. Borrowing Costs
5. Standard costs
6. Service providers
7. Basket purchases and joint product costs
8. Selling expenses, General and Admin

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19
Q

What are the two ways to record a purchase discount? Describe them.

A
  1. We have the net method where the company will record the discount at the time of the purchase, and if they go through with it, then just de-recognize the payable and the cash. If they do not end up taking it there will be a CR account called the purchase discount loss.
  2. Under the gross method, we will record the purchase at cost and then if they take the discount we will apply it to the transaction, if they do not then we simply de-recognize the payable and cash.
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20
Q

What is the most commonly used method and why? What are the benefits of the net method?

A

The most comply used method is the gross method due to its simplicity. The net method identifies purchase discounts lost ensuring they can measure the efficiency of staff members that are responsible for taking advantage of the discount.

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21
Q

What are volume rebates? How do we treat the rebate as the purchaser? How do we treat the rebate as the seller who got a rebate for purchasing the inventory?

A

A refund given to customers for buying a large volume of a product. We reduce the cost of the inventory purchased. We reduce the COGS

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22
Q

What should we never do with a rebate? What happens if we receive the rebate in the year following the purchase?

A

We must never treat it as a revenue. We would debit the inventory and receivable when we buy the inventory, and reduce the receivable when we get the asset.

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23
Q

What are product costs?

A

Product costs are costs that are attached to the inventory.

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24
Q

What are product costs for merchandising firms (5 points)? What are product costs for manufacturing firms?

A

Merchandising Firms: Price of inventory item, discounts, rebates, freight, and other costs associated with obtaining the asset.

Product Costs: Direct materials, labour, and overhead costs associated.

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25
Q

What must be included in the overhead allocation? What accounts are used under IFRS and ASPE?

A

There must be an allocation of both fixed and variable costs.
IFRS uses usage decommissioning and asset retirement costs. ASPE uses all types of cost in PPE

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26
Q

How do we treat interest on an inventory item that takes a significant amount of time to produce under IFRS and ASPE?

A

Under IFRS We treat it as a product cost.
Under ASPE we are permitted to capitalize the interest but we must disclose the information.

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27
Q

Under what circumstances should we not capitalize interest on inventory?

A

If the inventory is at fair value or we produce it in large quantities.

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28
Q

What is a standard cost?

A

It is a pre-determined estimate of the cost to manufacture. It is better to estimate the cost of the inventory when we produce it, then compare the actual costs to the estimated standard cost. We then allocate the variances to inventory and COGS based on the proportions of units sold or on hand.

29
Q

What are service providers?

A

We record the cost of providing a service, like overhead and supervisory costs as an inventory rather than as an expense, (like a contract asset account using the percentage of sales method.

30
Q

What are basket purchases and joint product costs?

A

When a company purchases or produces different kinds of inventory at a single cost, we must allocate the cost to each product on the relative sales value of each product.

31
Q

What are selling expenses, general and admin costs, and borrowing costs?

A

These are costs that are not directly attributable to the product thus they are period costs. Abnormal spoilage as well as storage costs are also expensed.

32
Q

What is the most commonly used inventory system? Why?

A

Perpetual is the most commonly used inventory system. They do this as it allows them to compare the perpetual inventory to the end of year count to find waste, spoilage, or theft by comparing the two records, it provides excellent control.

33
Q

How does a periodic system treat theft, spoilage, etc and why?

A

They are thrown into the COGS because it is impossible to distinguish under a periodic what is what.

34
Q

What are the five differences of periodic inventory?

A
  1. Debit purchases not inventory when making a sale
  2. Freight in, Purchase returns, and discounts are in separate accounts and not in the inventory
  3. We do not deduct COGS at each sale but rather we update it during the inventory count.
  4. Inventory is not a control account with a supporting subsidiary ledger.
  5. Record theft or spoilage in COGS as it is near impossible to identify what is what.
35
Q

What are the three measurement costs of inventory?

A
  1. FIFO
  2. Weighted (if using periodic) / Moving average (if using perpetual)
  3. Specific identification.
36
Q

What is FIFO?

A

This method assumes that the cost of the oldest inventory is the first to be allocated to COGS.

37
Q

What is weight average (periodic) / moving average (perpetual)?

A

Takes the average cost of goods available for sale and divides it by the number of units available fort sale, resulting in an average cost per unit available for sale. We then assign these costs. Under periodic however we do it at year end, whereas for perpetual it is a continuous process throughout the period.

38
Q

What is specific identification?

A

It is a situation where an inventory item is distinguishable from other items, thus we may want to allocate based on the cost of that particular item and we do not need a formula.

39
Q

T or F: The accounting of inventory cost flow does not have to be the same as the actual flow of physical goods.

A

True

40
Q

Describe how we apply the weighted average and FIFO system in a periodic system. What is the problem with this assumption?

A

We assume that all sales occurred at the end of the period, meaning all items on hand at the beginning and all the items purchased during the period provide us with the available for sale at the end of the period. It can be quite unrealistic if the sale occurs before the purchase.

41
Q

Describe how we apply the moving average and the FIFO systems in a perpetual system?

A

We calculate the COGS as we move from period to period.

42
Q

Describe what steps must be done when accounting for the purchase return.

A

We must show the effects of the discount on the unit cost and total price.

43
Q

What happens if a purchase return / sales returns occurs under the weighted average / moving average calculations?

A

We must remove the inventory at the same cost that it when it at.

44
Q

What assumption must be made with the sales returns and FIFO?

A

It affects the newest units so we keep the same assumption that the oldest units are the first to be sold.

45
Q

What happens if prices are not changing in a market, what will be the difference between FIFO and weighted average?

A

All inventory cost approaches will yield identical results.

46
Q

What are the five things that will happen between the costing methods if there is inflation?

A
  1. FIFO will result in the highest inventory
  2. FIFO will result in the lowest COGS (since more of the cost was allocated to inventory)
  3. FIFO will result in higher net income and higher taxes
  4. FIFO will result in higher retained earnings and income tax liabilities.
  5. Turnover will be lowers as the current ratio is higher.
47
Q

How do we choose the cost formula to use, and what is the CPA suggestion?

A

We use professional judgement but the CPA suggests that the best option is the specific identification, followed by the FIFO, and lastly the average.

48
Q

How do companies choose which method to use? What is the overall message?

A

They will choose a method based on:
1. Minimizing their income tax
2. Maximizing their income.
3. Following what their parent company is doing.

  • We choose the method that best follows the matching principle.
49
Q

What is LIFO?

A

LIFO is last in first out and it is only permitted in the USA, it is not permitted in Canada or under IFRS or ASPE standards as it does not follow the physical flow of the goods and they have the ability to manipulate their earnings and income. They can sell off the low cost older inventory to have higher net income.

50
Q

What do advocates of LIFO state, and when is this method permitted in Canada?

A

They state that it is a better performance reflection when prices are continually changing as it matches current revenues with previous inventory costs. Canadian companies who have their listing in the States can follow US GAAP

51
Q

How do most companies value their inventory? How do we determine if a write down is necessary?

A

They value it at the lower of cost and net realizable value. Compare the net NRV to the cost. If the cost is higher it must be written down.

52
Q

What is NRV?

A

Consideration that knowledgable, willing parties who are under no compulsion to act, would pay in an arm’s length transaction. These are estimates and subject to change over time.

53
Q

When comparing the net NRV to the cost, how is it applied?

A

It is applied to the individual items rather than the entire thing.

54
Q

What are the three situations where we are permitted to use grouping?

A
  1. Items are closely related in terms of their end use
  2. The company produces and markets items in the same area.
  3. Company cannot evaluate items separately from other items in a practical way.
55
Q

What method is used under the periodic system?

A

We can apply the direct method where the write down is applied to COGS as an expense, and reduce the inventory by the same value.

56
Q

What are the two ways to record a write down of inventory under the perpetual system?

A

Direct write off:
DR - COGS
CR - Inventory

Indirect Write off:
DR- Loss on Inventory due to Decline in NRV
CR - Allowance to reduce inventory to NRV

57
Q

What is the advantage of the indirect or allowance method?

A

The loss recorded is in a separate item below the gross profit amount on the statement of income while the contra asset account of the allowance is on the statement of financial position. It does not distort the COGS and the inventory items and we know exactly how everything is valued.

58
Q

Does ASPE and IFRS permit the reversals of write downs?

A

Yes, the reversal of write downs are permitted.

59
Q

When would it be valid to measure inventory at the NRV?

A

If the company is recognizing revenue at the point of production rather than at the point of delivery. We recognize the sale and the inventory at the fair value.

60
Q

What are the two conditions that must be present to value it at the NRV rather than the cost?

A
  1. Assurance the sale will occur and there is an active market with minimal risk for failure to sell.
  2. Estimated cost of disposal can be measured.
61
Q

When would it be valid to measure inventories at the fair value less the cost to sell?

A

Commodity brokers who trade in future contracts will carry these as inventory at the fair value less cost to sell. This is because of the commissions regarding the disposition of these types of assets.

62
Q

Which method allows for the use of the gross profit method? Why is it done?

A

The periodic inventory method is permitted to use the gross profit method in estimating inventory. It may not be feasible to count the inventory, and if they have the gross profit of the business they can make an estimate.

63
Q

What are some criticisms of the gross profit method?

A
  1. It uses historical data which may not be relevant for the current period.
  2. It assumes that the product mix has not changed or that the products will generate the same gross profit.
  3. It is an estimate which may not be reliable for replacing the count of product.
64
Q

What is the retail inventory method?

A

It is another method used to estimate the ending inventory under the periodic system where the companies carry information on the cost / retail of inventory at their beginning, purchases, and the relative sales, and the ending inventory can be derived.

65
Q

What are the advantages of the retail method?

A

We do not have to perform a physical inventory count. If we did do a physical inventory count however, we can compare the results with the estimated value to identify theft or spoilage.

66
Q

What must be presented and disclosed under both ASPE and IFRS?

A
  1. Accounting policies for measuring the inventory
  2. Amount go each type of inventory category
  3. Inventory costs recognized as an expense/
  4. Amount of inventory pledged as collateral for liabilities.
67
Q

What are additional information that must be disclosed under IFRS?

A

Inventory carried at FV - Cost to sell
Details about write downs and reversals of write downs
Movements in biological assets and agricultural products.

68
Q

What is the inventory turnover ratio? What type of inventory turnover ratio would a company want to have?

A

It is the speed at which a company can sell its inventory. (COGS / Average inventory). Companies want to strive to have a slightly higher turnover ratio.

69
Q

Why would a company not want to have super high turnover ratio? What does low inventory ratios mean?

A

Inventory shortages could arise. The product is not valued in the market.

ACCT 341 - Intermediate Financial Accounting 1 (3 decks)

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