Inventory Flashcards
Ways to value inventory
- Lower of cost or net realizable value
2. Lower of cost or market
What inventory methods use lower of cost or net realizable value
FIFO
Average Cost
What inventory method uses Lower of cost or market
LIFO
Net realizable value (NRV)
Selling price - costs of completion
Lower of cost or market
This is replacement cost subject to a ceiling and floor. If replacement cost is in between the ceiling and floor, then use replacement cost
Ceiling for Lower of cost or market
NRV
Floor
NRV - Profit margin
Impairment losses on inventory
If inventory was valued at cost, meaning cost was lower than market or NRV, but then the inventory’s market price or NRV declines below cost, the inventory’s value is written down
Journal Entry:
Loss on inventory write down
Inventory
Casualty loss on inventory
A loss on inventory will be equal to the amount of loss less any sales of damaged inventory and less any insurance proceeds.
Specific identification
This is used with large items such as cars where each item has an individual cost.
FIFO
First in, first out. When prices are rising using FIFO, COGS is the lowest and provides the highest net income, also the highest ending inventory.
LIFO
Last in, First out. When prices are rising using LIFO, this gives the highest COGS and lowest net income, and lowest ending inventory.
Perpetual inventory system
A perpetual system records the purchases and sales of inventory items as they occur- in other words a computer system that tracks inventory moving in and out. Physical counts still take place to verify the inventory.
FIFO under perpetual
Costs are the same under both a perpetual and periodic system. Lowest COGS, highest net income, highest ending inventory.
LIFO under perpetual system
Under a perpetual system LIFO will have different inventory values than a periodic system because a cost is assigned after each sale. Last item purchased is the first one sold.
Highest COGS, lowest net income, lowest ending inventory. LIFO provides tax advantages because it causes lower net income. LIFO liquidation is when the oldest layer of cost is reduced because more units were sold in the current year than purchase, which taps into the older “layers” of inventory.
Dollar value LIFO
Uses LIFO ‘Pools’ to track inventory. Uses a “Conversion index” to determine inventory value for the LIFO layer added in the current year.
Conversion Index
Ending inventory in current year dollars / ending inventory in base year dollars.
Then, you use that multiplier to convert current year prices to base year prices.
Gross Margin method
Used to estimate COGS using gross margin.
Sales - cost = margin
Retail Inventory Method
Used by retailers to estimate the cost of ending inventory.
Steps of Retail Inventory Method
- Calculate ending inventory at retail prices
- Calculate the cost to retail ratio
- Apply cost to retail ratio to ending inventory at retail prices to get ending inventory at cost
Inventory equation
Beginning Inventory ADD: Purchases EQUALS: Goods available for sale LESS: Ending inventory EQUALS: Cost of goods sold
Purchase Commitments
Companies will enter into agreements to purchase certain amounts of certain items, sometimes within a certain time period
If the market price of an item of the purchase commitments goes down…
The buyer may have to recognize a loss depending on if the terms can be modified or not. If they can be modified then the potential loss can be disclosed in a footnote but doesn’t have to be recognized in the financials. If the terms cannot be modified, then the loss is probable and must be accrued and recognized on the balance sheet.
IFRS Inventory Differences
Under IFRS inventory is valued at lower of cost or net realizable value
LIFO is NOT allowed at all under IFRS
Reversal of inventory write-downs IS allowed under IFRS. This is NOT allowed under GAAP
Free on Board (FOB) destination
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 until it reaches the buyer.
Free on board (FOB) shipping point
As soon as the inventory is shipped, the buyer now owns it and will include it in their inventory.
What items are included in the cost of inventory?
Purchase returns
Freight-in (shipping costs to get the inventory to the warehouse)
Sales tax on acquisition
Insurance on transit
What items are excluded from the cost of inventory
Freight out- this is a selling expense
Interest on purchase - this is financing
