average-cost method
inventory costing method that uses the weighted-average unit cost to allocate to ending inventory and cost of goods sold the cost of goods available for sale.
conservatism
concept that dictates tht when in doubt choose the method that will be least likely to overstate assets and net income
consigned goods
goods held for sale by one party although ownership of the goods is retained by another party. SELLER DOES NOT OWN
Consistency principle
dictates that a company use the same accounting principles and methods from year to year
current replacement cost
the current cost to replace an inventory item
days in inventory
measure of the average number of days inventory is held; calculated as 365 divided by inventory turnover ratio [(beginning inventory + ending inventory)/2]
finished goods inventory
manufactured items that are completed and ready for sale
first-in, first-out method
aka FIFO: inventory costing method that assumes that the costs of the earliest goods purchased are the first to be recognized as cost of goods sold
FOB destination
free on board: freight terms indicating that onwership of the goods remains with the seller until the goods reach the buyer.
FOB shipping point
free on board: freight terms indicating that ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller
inventory turnover
a ratio that measures the number of times on average the inventory sold during the period; computed by dividing cost of goods sold by the average inventory during the period
JIT
inventory system in which companies manufacture or purchase goods just in time for use
reduces costs for storage of raw materials, can allow companies to be more responsive to the market
LIFO
lat-in, first-out method: inventory costing method that assumes the costs of the latest units purchased are the first to be allocated to cost of goods sold
LCM
lower of cost or market basis: a basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost
raw materials
basic goods that will be used in production but have not yet been placed into production
specific identification method
an actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory
weighted-average unit cost
average cost that is weighted by the number of units purchased at each unit cost
work in process
that portion of manufactured inventory that has been placed into the production process but is not yet completed
List two primary steps in determining inventory quantities
1. take a physical inventory of goods on hand 2. determine the ownership of goods in transit or on consignment
what is the primary basis of accounting for inventories?
cost
What does Cost of Goods Available for Sale include?
cost of beginning inventory + cost of goods purchased - cost of goods sold
List four inventory cost flow methods
specific identification and three assumed methods: FIFO, LIFO and average-cost
When prices are rising, what effect does the FIFO cost flow assumption have on 1. COGS 2. net income 3. ending inventory 4. taxes
When compared to all 4 inventory methods FIFO: 1. Cost of Goods Sold is lowest 2. net income is highest 3. ending inventory is is closest to current value and taxes are highest
When prices are rising, what effect does the LIFO cost flow assumption have on 1. COGS 2. net income 3. ending inventory 4. taxes
When compared to all 4 inventory methods LIFO: 1. Cost of Goods Sold is highest 2. net income is lowest 3. ending inventory is is lower than current value and taxes are lowest
explain the lower-of-cost-or market basis of accounting for inventories
aka LCM: a company may use the market price to determine inventory if market is less than cost. This is a loss. It should be recorded in the period in which the loss occured (prices declined). It is permenant and is only used when prices are not expected to rise again - not for temporary price fluxuations. Obsolete computer parts would be an example.
How will inventory errors effect a. beginning inventory/net income b. ending inventory/net income c. following period for both if not corrected d.ending inventory/balance sheet assets, owner's equity and liabilities
a. beginning inventory errors have an inverse relationship to net income b. ending inventory errors have a direct relationship to net income. c. if either type of mistake is not corrected, it will be automatically corrected the following year. d. ending inventory errors have a direct relationship to balance sheet assets and owner's equity, but no relationship to liabilities.
list three types of inventory for a manufacturing company
1. finished goods (ready for sale) 2. work in process (in production) 3. raw materials (materials before put into production)
How can knowing the 3 levels of manufacturing inventories signal production plans?
high raw materials may indicate business suggests plan for increased production. high finished goods may suggest a planned slow down in production.
how often do companies take a physical inventory
at the end of each accounting period
how does a buyer record freight costs?
they are included in inventory
how does a seller record freight costs
they are a selling expense (freight out)
What cost flow assumption do companies that use a perpetual inventory system use?
Most often they use an assumed cost to record cost at time of sale and then, at the end of the accounting period when they do a physical inventory, they recaculate cost of goods sold using periodic FIFO, LiFO or average-cost.
Periodic System cost of goods sold formula
(beginning inventory + purchases) - ending inventory = cost of goods sold
weighted average unit cost formula
cost of goods available for sale/total units available for sale = weighted average unit cost.
In periods of rising prices will FIFO, LIFO or Average-Cost provide the lowest net income?
LIFO
LIFO ending inventory, net income, balance sheet assets, owner's equity (when comparing the 3 assumption options)
ending inventory: lowest, net income: lowest, assets: lowest, owner's equity: lowest
FIFO: cost of goods sold, ending inventory, net income, balance sheet assets, owner's equity, taxes (when comparing the 3 assumption options)
cost of goods sold: lowest, ending inventory: highest, net income: highest, assets: highest, owner's equity: highest, taxes: highest
formula for cost of goods sold
beginning inventory + cost of goods purchased - ending inventory = cost of goods sold
what effect will an error in ending inventory of the current period have on the next accounting period?
If not corrected, it will have the reverse effect, actually offsetting the error.
balance sheet effects of ending inventory a. overstated b. understated
consider that overstatement of ending inventory indicates understatement of cost of goods sold and an understatement of ending inventory indicates an overstatement of costs of goods sold...
a. assets: overstated, liabilities no effect, owner's equity: overstated. b. assets understated, liabilities no effect, owner's equity: understated
formula for average inventory
(beginning inventory + ending inventory)/2
formula for inventory turnover
cost of goods sold/average inventory = inventory turnover
or
cost of goods sold/[(beginning inventory+ ending inventory)/2]
what does inventory turnover measure
the number of times on average the inventory is sold during a period (how liquid) the inventory is. Best inventory turnover rates differ by industry and product, usually higher is better - but must be careful to avoid stockouts and missed sales
Why do cost allocations differ when using periodic or perpetual LIFO?
because perpetual LIFO requires that the we use the cost of the last units purchased before the sale we are recording, but periodic LIFO requires that we use the cost of goods purchased last during the period, even if the purchase occured after the sale was recorded. During periods of rising prices, units purchased later in the period will lead to higher cost of goods sold.
gross profit method
calculate cost of ending inventory by multiplying net sales by gross profit rate and subtracting estimated cost of goods sold from goods available for sale
retail inventory method
method of estimating cost of ending inventory by applying cost-to-retail ratio to the ending inventory at retail.
List 2 reasons why companies use gross profit and retail inventory methods?
1. if inventory is destroyed 2. as a quick check of ending inventories calculations (will catch large errors)
gross profit method formulas
step 1: net sales - estimated gross profit = estimated cost of goods sold
step 2: cost of goods available for sale - estimated cost of goods sold = estimated cost of ending inventory
estimated gross profit formula
[gross profit rate (from preceeding accounting period)] x net sales = estimated gross profit
long version of gross profit method formula
([beginning inventory + cost of goods purchased] - {net sales - [net sales x gross profit rate]})= estimated cost of ending inventory
retail inventory method formula
Step 1: goods available for sale at retail - net sales = ending inventory step 2: goods available for sale at cost / goods available for sale at retail = cost to retail ratio. step 3: ending inventory at retail x cost to retail ratio = estimated cost of ending inventory
what is major disadvantage of the retail method of estimating?
because it is an averaging method it can't determine what mix of inventory if different mark-ups exist. To avoid this problem it should be applied by department or product rather than for all company inventories at once
