Chapter 9: Inventories: Additional Valuation Issues

Question 1

LIFO Reserve

Answer 1

The difference between the inventory method used for internal reporting (generally FIFO, average cost or standing cost) and LIFO

LIFO inventory + LIFO reserve = FIFO inventory

Question 2

LIFO effect

Answer 2

Allowance account = contra asset = credit natural balance

the adjustment that companies must make to the accounting records in a given year

companies must disclose either LIFO reserve or replacement cost of inventory

Uses allowance to reduce inventory to LIFO account

Question 3

Last-in, First-out costing method

Answer 3

Usually results in lower net income than FIFO)

• COGS valued at the most recent purchase
• ending inventory valued by taking the unit cost of the OLDEST purchase and working down until all units are accounted for (different ending inventory / COGS under periodic vs perpetual inventory)
• not actually reflective of movement of goods except for piled items
• tends to defer income tax liability

Question 4

First-In, First-out costing method

Answer 4

FIFO
fails to match current costs with current revenue

• ending inventory valued by taking the unit cost at the most recent purchase and working backwards till all inventory is accounting for
• general good business practice? approximates actual flow, ending inventory near actual inventory
• highest income of costing methods = appealing to investors + higher taxes
• no difference between periodic + perpetual inventory COGS

Question 5

Journaling Sale of Inventory: perpetual system

Answer 5

Debit Accounts Receivable/ Cash (increase)
Credit Sales/ Revenue (increase)

ALSO

Debit COGS (increase)
     Credit Merchandise Inventory (decrease)

• happens when customer receives goods
• requires invoice receipt/ backup

any shipping costs are recording separately

Question 6

Perpetual vs Periodic inventory systems

Answer 6

Cost flow methods

PERPETUAL - record cost of good + reduce inventory at time of sale (inventory always shows current amounts)
- uses merchandise inventory account

PERIODIC - COGS recorded only at the end of the accounting period

• uses purchases account (not merchandise inventory)
• COGS determined at end of period

Question 7

Moving-average method

Answer 7

Average costing method used with perpetual system

new average unit cost calculated after any purchase is made

Question 8

Weighted Average Unit Cost

Answer 8

= Cost of goods available for sale (total) / total units available for sale

Question 9

Average Cost costing method

Answer 9

Practical - simple to apply

All units valued at weighted average unit cost

Assumes similarity of all goods

total cost of goods available for sale / total units available for sale

in perpetual system new weighted average calculated after each purchase
in periodic system weighted average only calculated at the end of a given period

usually results in a net income between FIFO (higher) and LIFO (lower)

Question 10

Specific Identification Costing Method

Answer 10

Preferred by IFRS wherever possible

• rare
• items must be individually tagged to tracked costs
• generally large, high-value items
• cost flow matches physical flow
• can be difficult to allocate costs like shipping
• can be manipulated - boost income by selling low-cost units and vise versa

Question 11

Classification of Selling Costs

Answer 11

per GAAP must be disclosed in statements

Question 12

Gross method for purchases

Answer 12

Uses a purchase discounts account

reports purchases and payables at gross amounts

Reports discounts in purchase discounts contra account when taken
- then shows up below purchases on income statement

Question 13

Net method for purchases

Answer 13

use purchase discounts forfeited account

Reports purchases at net amount (with discount)

if paid too late to get discount report amount of purchase discounts forfeited (expense account)

correct reporting of asset/ liability value

also tracks management efficiency

Question 14

Product Costs

Answer 14

Recorded to the inventory account

• cost of bringing goods into a buyer’s place of business and converting to a salable condition
  
  • freight charges
  • acquisition costs
  • labor/ production costs to time of sale

Too difficult to allocate purchasing department and storage costs so not usually included.

Question 15

Capitalizing interest costs

Answer 15

FASB ruled companies should capitalize interest costs related to assets constructed for internal use or assets produced as discrete projects for sale or lease

Question 16

Period Costs

Answer 16

Not included as inventory costs

Question 17

Sales with high rate of return

Answer 17

Formal or informal agreements that permit purchasers to return the inventory for a full or partial refund (publishing)

requires an estimated inventory return account to recognise that some inventory will be returned

if returns are unpredictable then goods NOT removed from inventory

Question 18

Sale with repurchase agreement

Answer 18

“parking transactions”

even though one company has the title the other maintains control

inventory as collateral on a loan

should be on the books of the entity with legal control

Question 19

Consigned inventory

Answer 19

Remains in consigner’s inventory

may disclose inventory on consignment in notes or as a separate inventory item if material amount

Question 20

Which goods to include in inventory

Answer 20

Control as key deciding factor: who has ability to use benefits of ownership.

Transit FOB shipping point vs destinatio

• shipping point: transfer occurs upon delivery to carrier
• destination: transfer occurs upon delivery to customer

Consignment - remains property of the consigner and in their inventory(not in the inventory of the agent)

Question 21

Periodic system cost of goods sold

Answer 21

Beginning inventory 
\+ cost of goods acquired / produced in the period
= cost of goods available for sale
- ending inventory 
= cost of goods sold

Question 22

Modified perpetual inventory system

Answer 22

Records quantity increases / decreases but does not track dollar amounts

Question 23

Inventory over/short account

Answer 23

Adjusts cost of goods sold

sometimes reported in other revenues and gains or other expenses and losses

Question 24

Journaling perpetual inventory adjustment

Answer 24

to adjust book count to match physical

short:
Debit Inventory Over/Short
Credit Inventory

Over:
Debit Inventory
Credit Inventory over/short

Question 25

Inventory accounts for manufacturing concerns

Answer 25

• Raw materials (goods / materials on hand but not yet placed into production)
• work in progress inventory (unfinished units: Raw materials costs + direct labor costs + share of overhead)
• Finished goods inventory (cost of completed but unsold units)
• Supplies inventory (non-direct materials

Question 26

Merchandise inventory

Answer 26

Single account for cost of unsold units for merchandising concerns

Question 27

Inventory

Answer 27

Asset items a company holds for sale in the ordinary course of business or goods it will use or consume in the production of goods sold

Question 28

Inventory Profits

Answer 28

When the inventory costs matched against sales are less than current replacement costs

Reduced by LIFO

Question 29

Advantages of LIFO

Answer 29

Matching: recent costs to current revenue (during inflation FIFO creates “paper profits”

Tax benefits/ improved cashflow

Future earning hedge: future price declines have less effect on earnings. Minimizes write downs of high-priced inventory

Question 30

Disadvantages of LIFO

Answer 30

Reduced earnings

understating inventory - working capital apparently diminished

Does not generally approximate physical flow

may result in poor buying habits

Question 31

LIFO conformity rule

Answer 31

Tax rule: if LIFO used for tax purposes must also be used for financial reportin

Question 32

Result of inventory misstatement on financial statements

Answer 32

if ending inventory understated:
Balance sheet:
- inventory: understated
- Retained earnings: understated
working capital: understated
Current ratio: understated
Income Statement: 
- COGS: overstated
- Net income: understated 

if ending inventory overstated:
Balance sheet:
- inventory: overstated
- Retained earnings: overstated
working capital: overstated
Current ratio: overstated
Income Statement: 
- COGS: Understated
- Net income: overstated

EFFECTS TWO years though the total will be correct

Question 33

Affect of failure to record inventory purchase on financial statements

Answer 33

Inventory + purchases understated

no affect on net income

Current ratio overstated
A/P understated

Question 34

LIFO liquidation

Answer 34

Specific goods LIFO approach leads to LIFO liquidation leads to distortion of net income

Costs from preceding periods are matched against current sales dollars

countered with pooled LIFO approach

disclose on financial statments

Question 35

Price index

Answer 35

% changes in prices from one year to another

often use CPI-U: consumer price index for urban consumers (or a specific industry index)

alternately:

Ending inventory for period @ current cost / ending inventory for the period at base year cost

Question 36

Dollar value LIFO if ending inventory @ base prices < beginning inventory @ base prices

Answer 36

Company must subtract the decrease from the most recently added layer

basically just removes one later and then calcuates as if this was that following year (using the change from the base year x the previous year’s price index)

Question 37

Dollar Value LIFO

Answer 37

Inventory at end current prices > inventory at beginning current prices

Need to know the price index: percentage prices have increased

End inventory / (1+ percent increase) = end inventory in terms of beginning prices

End inventory at beginning prices less beginning inventory = change in inventory quantity

Change (new layer) x (1 + % increase) = “real” dollar increase

Real dollar increase = new layer

Question 38

Dollar Value LIFO

Answer 38

End inventory at base year prices = total of laters at base year prices

Determines and measures and increases and decreases in a pool of inventory in terms of total dollar value, not physical quantity of goods in the inventory pool

Pools with broad range of goods

New layers only added when ending inventory (at base year prices) exceeds beginning inventory at base year prices