FAR3 M3 - Inventory

Question 1

Types of Inventory

Answer 1

1. Retail inventory - inventory that is resold in the same form as when it was purchased
2. Raw materials inventory - inventory used in the production process
3. Work in process inventory - inventory in production, but is not complete
4. Finished goods inventory - production inventory that is complete and ready for sale

Question 2

Title

Answer 2

Whoever has title of the goods should include the inventory on the books. Legal title generally follows possession. There are a few exceptions - FOB destination.

Question 3

When does title pass?

Answer 3

It is agreed upon between seller and buyer. If not explicitly agreed upon, then title passes at the time goods are delivered.

Question 4

FOB Shipping Point

Answer 4

Title passes to the buyer when the seller delivers the goods to the common carrier. Should be included in teh buyer’s inventory upon shipment (in truck).

Question 5

FOB Destination

Answer 5

Title passes to the buyer when the buyer receives the goods from the common carrier (seller’s inv until delivered to the buyer).

Question 6

Nonconforming Goods (wrong goods)

Answer 6

If the seller ships the wrong goods, the title reverts to the seller upon rejection by the buyer. Inventory stays with seller.

Question 7

Sales with Right to Return

Answer 7

If the good are sold, the goods should be included in the seller’s inventory if the amount of goods likely to be returned CANNOT BE estimated. Sale has not been finalized.

If the goods likely to be returned can be estimated, the transaction will be recorded as a sale with an allowance for estimated returns recorded. Revenue from the sale will only be recognized when the five conditions are met:

1. Sales price is substantially fixed as of the date of the sale
2. Buyer assumes all risk of loss because the goods are in their possession
3. Buyer has paid some form of consideration
4. Product sold is substantially complete and
5. The amount of future returns can be reasonably estimated

Question 8

Cosigned Goods

Answer 8

Cosignor is the true owner. The Consignee is the sales agent and sells the good on behalf of the consignor. The title and risk of loss remains with the consignor.

Question 9

Value Inventory

Answer 9

GR: stated at cost

Cost includes freight in

Question 10

Departures/Exceptions from Cost Basis

Answer 10

1. Precious metals and farm products - NRV, net selling price less costs of disposal
2. When the utility (selling price) of the good is no longer as great as their cost (loss - immediately recognized)
3. Recognize loss in current period - if loss is immaterial include it in COGS. Otherwise, identify the loss separately in the income statement
4. Reversal of inventory write down - not allowed with GAAP, but you can with IFRS. Reversal is limited to the amount of the previous write down.

Question 11

Lower of Cost and Net Realizable Value

Answer 11

For GAAP, only used for FIFO and weighted average. IFRS uses lower of cost and NRV for all inventory methods.

Question 12

Net Realizable Value

Answer 12

Net selling price less the costs to sell inventory. Same as “market ceiling” in the lower cost or market method.

Question 13

Lower of Cost or Market (US GAAP Only)

Answer 13

Used for LIFO and Retail inventory methods. The lower of cost or market can be applied towards a single item, category or total inventory, provided the method clearly reflects periodic income.

Question 14

Market Value

Answer 14

Under GAAP, use market or lower of cost. Market value infers the MIDDLE VALUE. You want to choose the middle value between replacement, market ceiling (NRV) and market floor. For LIFO and Retail.

Question 15

Replacement Cost

Answer 15

Cost to purchase the item of inventory as of the valuation date.

Question 16

Market Ceiling

Answer 16

An item’s net selling price less the costs to sell. Also known as Net Realizable Value.

Question 17

Market Floor

Answer 17

Market ceiling less a normal profit margin. NRV - Profit

Question 18

Disclosure of Inventory Losses due to Write Down

Answer 18

• Substantial and unusual losses from the subsequent measurement should be disclosed. Small losses are included in COGS.
• Consistency of how inventory is valued
• Any change in measurement as to how inventory is valued

Question 19

*Periodic Inventory System

Answer 19

Quantity of inventory is determined only by physical count, usually at least annually. The COGS is determined a the physical inventory time as a “plug” or difference between beginning inventory, plus inventory less ending inventory, based physical count.

One JE at the time of sale

DB Cash
CR Sales

Beginning Inventory 
- Purchases
= Cost of Good Available for Sale
- Ending Inventory (physical count)
= COGS

Question 20

Perpetual Inventory System

Answer 20

Inventory is updated for each purchase and each sale as they occur. Actual COGS is determined and recorded at the time of sale.

No purchases on JE. Two JEs at the time of sale.

DB Cash
CR Sales
DB COGS
CR Inventory

Question 21

Inventory Cost Flow Assumption

Answer 21

The cost flow assumption (FIFO, LIFO, weighted average, etc.) used is not required to match how the inventory is sold (FIFO, LIFO, etc.)

Question 22

Specific Identification Method

Answer 22

Cost of each item of inventory has a unique identifier. Used for physically large or high value items.

Question 23

FIFO

Answer 23

Sell old and keep newest in stock. Ending inventory and COGS are the same whether a periodic or perpetual inventory is used.

• In periods of rising prices, FIFO results in the highest ending inventory, lowest COGS, and highest net income (current costs are not matched with current revenues). Lower COGS = Higher Profits = Higher Equity = Higher Assets (unsold expensive goods)
• *Same results with Periodic and Perpetual. Periodic will be much simpler.

Question 24

Weighted Average

Answer 24

Determined by dividing the total costs of inventory available by the total number of units inventory available. Must be used with Periodic system - one JE.

Question 25

Moving Average Method

Answer 25

Computes a weighted average cost after each purchase by dividing the total cost of inventory available after each purchase (inventory plus current purchase) by the total units available after each purchase. Must be a perpetual system.

Question 26

LIFO

Answer 26

• US GAAP only.
• Lower of cost of market value. LIFO does not generally does not represent the physical flow.
• However, LIFO is used for tax purposes, but must also be used on LIFO on FS (cannot mix and match).
• Better matches expenses against revenue because it matches current costs with current revenues.
• If sales exceed production (or purchases) for a given period, LIFO will result in a distortion of net income because old inventory costs (LIFO layers) will be matched with current revenue.
• Suspeptible to income manipulation by intentionally reducing purchases in order to use old layers at lower cost.
• In rising price environment, LIFO results in the lowest ending inventory, higher COGS, and lowest net income. Decrease in profit = decrease in equity = decrease in assets.

Question 27

LIFO Layers

Answer 27

• Unlike FIFO, LIFO periodic does equal LIFO perpetual. Do which ever one they ask you to calculate

Question 28

Dollar Value LIFO

Answer 28

• Estimate of changes in price levels required

Price index = End inv CY cost/End Inv BY cost

• Inventory is measured in dollars and adjusted for changing price levels
• To compute the LIFO layer added into the CY at dollar value LIFO, the LIFO layer at base year cost is multiplied by the internally generated price index.

Year 1: price index x base year layer = Yr 1 inv

Beg inv + Yr 1 inv = Year 1 ending inv

Year 2: price index x year 2 layer = Yr 2 Inv

Beg inv + Yr 2 Inv = Year 2 ending inv

Question 29

Gross Profit Method (quarterly reporting and periodic inventory)

Answer 29

• used for interim reports
• must be a periodic system
• inventory valued at retail, and the average gross profit % is used to determine the inventory cost for the interim FS. The gross profit % is known and used to calculate cost of sales.

Question 30

Purchase Commitment

Answer 30

• Contract to buy inventory at a future date specified price
• All of this commitments must be disclosed in the notes for FS (forward/future contracts)
• If the contract price is greater than market price, which will result in a loss. The estimated loss must be booked right away.
  Increases liability and decrease in equity