FAR-F3-M3-Inventory

Question 1

What are the four types of inventory cost flow assumptions?

Answer 1

Last in - First Out (LIFO), First in - First Out (FIFO), Weighted average and moving weighted average

Question 2

What is the general rule of stating inventory in the balance sheet?

Answer 2

U.S. GAAP requires that inventory be stated at its COST. In ordinary course of business, when the utility of goods is no longer as great as their cost, then the company must state those goods at either the LOWER OF COST OR MARKET or LOWER OF COST AND NET REALIZABLE VALUE, depending on the inventory cost flow method they use.

**Note that precious metals and farm products are valued at NRV.

Question 3

Under U.S. GAAP, the lower of cost and net realizable value method is used for all inventory that uses which type of inventory method?

Answer 3

FIFO and average cost methods use the lower of cost or net realizable value.

Question 4

Under U.S. GAAP, the lower of cost or market method is used when inventory is costed using which type of inventory method?

Answer 4

LIFO uses the lower of cost or market.

Question 5

With respect to the lower of cost and net realizable value, how do you calculate Net Realizable Value?

Answer 5

Net realizable value = selling price - costs of completion

Question 6

With respect to the lower of cost or market, what does the word “market” mean in this context?

Answer 6

The word MARKET in this phrase means the replacement cost, provided that it does not exceed the ceiling or fall below the floor.

Question 7

ABC’s inventory at year end has the following values:
Purchased for $100,000
Selling price $130,000
Current replacement cost $90,000
Normal Profit Margin $20,000
Costs of Completion $5,000

If ABC uses FIFO to value its inventory, what is the carrying value of ABC’s inventory?

Answer 7

FIFO uses the lower of cost or net realizable value. Cost = $100,000 and NRV = Selling price - costs of completion = $130,000 - $5,000 - $125,000. Therefore, the carrying value would be the $100,000 cost.

Using the average cost method would also use the lower of cost or NRV so the inventory would be valued at the same $100,000 historical cost.

Question 8

ABC’s inventory at year end has the following values:
Purchased for $100,000
Selling price $130,000
Current replacement cost $90,000
Normal Profit Margin $20,000
Costs of Completion $5,000

If ABC uses LIFO to value its inventory, what is the carrying value of ABC’s inventory?

Answer 8

LIFO uses the lower of cost or market. The “Cost” is the original purchase price. “Market” is the current replacement cost subject to a floor of NRV less profit margin and a ceiling of NRV, meaning we compare the replacement cost against the floor and ceiling and whichever number falls in the middle will serve as the “Market” value which we will then compare against the “cost”.

Cost= $100,000
Replacement Cost = $90,000

Ceiling = NRV = Selling Price - Costs of Completion = $130,000 - $5,000 = $125,000.
Floor = NRV - profit margin = $125,000 - $20,000 = $105,000

Therefore to reiterate:
Ceiling = $125,000
Floor = $105,000
Replacement Cost =$90,000
Because the floor falls in the middle, the $105,000 will be used as our Market value.

Lower of Cost or market therefore is the lower of Cost = $100,000 or Market = $105,000. In this case, cost is the lower of the two therefore the CARRYING VALUE OF THE INVENTORY IS $100,000

**Note that if the Market value was lower then cost (which is already what inventory is supposed to be recorded at), the company would need to record impairment loss.

Question 9

If ABC uses FIFO to value its inventory and carried their inventory at cost of $100,000 and then after an analysis, ABC determined that the NRV of its inventory was now $80,000, would ABC have to recognize an impairment loss? And if so, what is the JE that ABC would have to record?

Answer 9

Yes, if ABC is using FIFO, then it is using lower of cost or net realizable value to value its inventory. If NRV is lower then cost, then inventory will have to be revalued at the lower amount of NRV. Therefore the company will have to record an impairment loss of $100,000-$80,000 = $20,000.

JE to record an impairment loss
Dr. Loss on Inventory Write Down $20,000
Cr. Inventory ($20,000)

**Note that if ABC was using the LIFO method, then it would be using the lower of cost or market, where the market is subject to a floor and ceiling. If the Market value was lower then cost, then the inventory would have to be revalued at the lower amount of Market and an impairment loss would likewise have to be recorded. It would be the same JE as above.

Question 10

Are declines in inventory market value permanent or temporary? And in relation to interim financial statements, when are they recorded?

Answer 10

Declines in inventory are permanent declines and should be reflected in interim financial statements in the period incurred.

Question 11

U.S. GAAP requires that inventory be valued at cost. Are precious metals and farm products subject to this rule as well?

Answer 11

Precious metals and farm products are valued at NRV which is selling price - costs of disposal. If the inventory is valued at EXCESS OF COST, then this fact must be disclosed in the financial statements.

Question 12

Normally, revenue is recognized at time of sale, however do precious metals and farm products also follow this rule?

Answer 12

No, revenue is recognized at time of product and not at the time of sale since precious metals and farm products have an immediate marketability at their quoted prices.

Question 13

What are the two types of inventory systems used to count inventory?

Answer 13

The perpetual inventory system and the periodic inventory system.

Question 14

How does a periodic inventory system keep track of inventory?

Answer 14

With a periodic inventory system, the quantity of inventory is determined only by physical count. Therefore units of inventory and their associated costs are counted and valued at the end of the accounting period. The actual COGS is determined after each physical inventory count by squeezing the difference between beginning inventory PLUS purchases Less Ending Inventory.

Beginning Inventory
+Purchases
=Cost of Goods Available for Sale
-Ending Inventory (physical count)
=Cost of Goods Sold

Question 15

What is a disadvantage of the periodic inventory system as opposed to the perpetual inventory system?

Answer 15

A disadvantage of the periodic inventory system is that COGS amount used for financial reporting includes both cost of inventory sold and inventory shortages. Inventory shortages cannot be easily distinguished.

With a perpetual inventory system, perpetual records can be compared to actual inventory per a physical count and inventory shortages can be identified.

Question 16

Is the following statement true or false? A company using a periodic inventory system must estimate inventory and COGS in interim Financial statements because periodic inventory systems do not continuously update inventory amounts throughout the year. As a result, the gross profit method is a way to apply a gross profit % from previous reporting periods and apply it to current period sales to estimate COGS and back into Ending Inventory.

Answer 16

True, A company using a periodic inventory system must estimate inventory and COGS in interim Financial statements because periodic inventory systems do not continuously update inventory amounts throughout the year. As a result, the gross profit method is a way to apply a gross profit % from previous reporting periods and apply it to current period sales to estimate COGS and back into Ending Inventory.

Question 17

Does the perpetual inventory system keep a running total of inventory balances?

Answer 17

Yes, with a perpetual inventory system, each item of inventory is updated for each purchase and each sale as they occur. The actual COGS is determined and recorded with each sale.

Question 18

Briefly describe the moving average method to value inventory

Answer 18

The moving average method computes the weighted average cost AFTER EACH PURCHASE by dividing the total cost of inventory available after each purchase by the total units available after each purchase.

A perpetual inventory system is needed.

Question 19

Periodic and perpetual inventory systems will ALWAYS RESULT in the same dollar value of ENDING INVENTORY under which system?

Answer 19

UNDER FIFO, periodic and perpetual inventory systems will always result in the same dollar value of ending inventory.

LIFO and weighted average will not.

Question 20

Is the following statement true or false, under FIFO, the first costs inventoried are the first costs transferred to cost of goods sold.

Answer 20

True, under FIFO, the first costs inventoried are the first costs transferred to cost of goods sold.

Question 21

Is the following statement true or false. Under LIFO, the last costs inventoried are the first costs transferred to cost of goods sold

Answer 21

True. Under LIFO, the last costs inventoried are the first costs transferred to cost of goods sold.

Question 22

When prices are rising, does FIFO or LIFO provide the highest net income?

Answer 22

When prices are rising using FIFO, COGS is the lowest and provides the highest net income, also the highest ending inventory

Question 23

When prices are rising, does FIFO or LIFO provide the lowest net income?

Answer 23

When prices are rising using LIFO, this gives the highest COGS and lowest net income and lowest ending inventory.

Question 24

LIFO most closely approximates the current cost of?

Answer 24

LIFO must closely approximates the current cost of COGS because inventory LAST IN (most recently purchased) is FIRST OUT (expensed currently)

Question 25

FIFO most closely approximates the current cost for?

Answer 25

FIFO most closely approximates the current cost for ENDING INVENTORY because inventory FIRST IN (oldest purchases) is FIRST OUT (expensed currently) and the most recent purchases remain in ending ending inventory.

Question 26

What is the inventory equation?

Answer 26

Beginning Inventory
ADD: Purchases
EQUALS: goods available for sale
LESS: Ending Inventory
EQUALS: Cost of Goods Sold

Question 27

What is a purchase commitment?

Answer 27

Companies will enter into agreements to purchase certain amounts of certain items. If the market price of an item subject to this kind of agreement goes down, the buyer might have to recognize a loss on the purchase commitment.

Important to remember that a LOSS is only recorded under a purchase commitment in which the purchaser is obligated to purchase a fixed number of units.

Question 28

What does FOB destination stand for?

Answer 28

FOB Destination stands for free on board destination. It means that ownership (and risk of loss) of the inventory doesn’t change until it reaches its destination (the buyer’s warehouse). The seller owns the inventory unitl it reaches the buyer.

Question 29

What does FOB Shipping point stand for?

Answer 29

Free on board shipping point. As soon as the inventory is shipped, the buyer now owns it and it will include it in their inventory.

Question 30

What items are included from the cost of inventory?

Answer 30

Inventory costs include:
1. Purchase returns
2. Freight-in (shipping costs to get the inventory to the warehouse)
3. Sales tax on acquisition
4. Insurance on transit

Question 31

Is freight out or interest on purchase included in the cost of inventory?

Answer 31

No. Freight out is a selling expense and interest on purchases are a financing expense.

Question 32

What are consigned goods? Should the consignor include the consigned goods in its inventory even though the goods are already at the consignee’s warehouse?

Answer 32

In a consignment arrangement, the seller (the consider) delivers goods to an agent (the consignee) to hold and sell on the consigner’s behalf. The consignor should include the consigned goods in its inventory because title and risk of loss is retained by the consignor even though the consignee possesses the g

Question 33

What is included in the cost of consigned goods?

Answer 33

The consignor must include consigned goods (in the hands of the consignee) in his own inventory at his cost, PLUS warehousing costs of consignor before goods are transferred to consignee, PLUS shipping costs to consignee.

Question 34

With respect to Dollar Value LIFO, what is the formula for the conversion index and how is it applied?

Answer 34

When the price index is computed internally by the company the price index is Ending Inventory at current year cost / ending inventory at base year cost.

Then we use that multiplier to convert current year prices to base year prices.