ch 7 Flashcards
(25 cards)
The primary goals of inventory managers are to
(1) maintain a sufficient quantity of inventory to meet customers’ needs and (2) ensure inventory quality meets customers’ expectations and company standards. At the same time, they try to (3) minimize the cost of acquiring and carrying inventory (including costs related to purchasing, production, storage, spoilage, theft, obsolescence, and financing).
merchandise inventory
which consists of products acquired in a finished condition, ready for sale without further processing.
Manufacturers often hold three types of inventory
They start with raw materials inventory such as plastic, steel, or fabrics. When these raw materials enter the production process, they become part of work in process inventory, which includes goods that are in the process of being manufactured. When completed, work in process inventory becomes finished goods inventory, which is ready for sale just like merchandise inventory.
Consignment inventory
refers to goods a company is holding on behalf of the goods’ owner. Typically, this arises when a company is willing to sell the goods for the owner (for a fee) but does not want to take ownership of the goods in the event the goods are difficult to sell. Consignment inventory is reported on the balance sheet of the owner, not the company holding the inventory.
Goods in transit
are inventory items being transported. This type of inventory is reported on the balance sheet of the owner, not the company transporting it
BALANCE SHEET AND INCOME STATEMENT REPORTING
Because inventory will be used or converted into cash within one year, it is reported on the balance sheet as a current asset. Goods placed in inventory are initially recorded at cost, which is the amount paid to acquire the asset and prepare it for sale.
When a company sells goods, it removes their cost from the Inventory account and reports the cost on the income statement as the expense Cost of Goods Sold. See Exhibit 7.2 for how HBC reports the Cost of Goods Sold (CGS) on its partial income statement. Notice that it follows directly after Net Sales. The difference between these two line items is a subtotal called Gross Profit
goods available for sale are combo of what
A company starts each accounting period with a stock of inventory called beginning inventory (BI). During the accounting period, new purchases (P) are added to the beginning inventory
cost of goods sold equation
BI+P-EI=CGS
or
BI+P-cgs=EI
specific identification
method individually identifies and records the cost of each item sold as Cost of Goods Sold. This method requires accountants to keep detailed records of the purchase cost of each item. This can be accomplished with unique identifiers such as bar coding and, in the case of cars, vehicle identification numbers (VIN). In the example just given, if the items sold were identified as the ones received on May 3 and May 6, which cost $70 and $95, the total cost of those items ($70 + $95 = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period. Companies tend to use the specific identification method when accounting for individually expensive and unique items. Bridal shops and art galleries are two examples of companies that would most likely use the specific identification method due to the uniqueness of their inventory.
The units within each HBC product line
First-in, first-out (FIFO)
assumes that the inventory costs flow out in the order the goods are received. As in Exhibit 7.4, the earliest items received, the $70 and $75 units received on May 3 and 5, become the $145 Cost of Goods Sold on the income statement and the remaining $95 unit received on May 6 becomes Ending Inventory on the balance sheet.
Weighted average cost
uses the weighted average of the costs of goods available for sale for both the cost of each item sold and those remaining in inventory. As in Exhibit 7.4, the average of the costs [($70 + $75 + $95) ÷ 3 = $80] is assigned to the two items sold, resulting in $160 as Cost of Goods Sold on the income statement. The same $80 average cost is assigned to the one item in Ending Inventory reported on the balance sheet.
Financial Statement Effects
Remember that these methods differ only in the way they split the cost of goods available for sale between ending inventory and cost of goods sold. If a cost goes into Inventory, it doesn’t go into Cost of Goods Sold. Thus, the method that assigns the highest cost to ending inventory will assign the lowest cost to cost of goods sold (and vice versa)
When costs are rising
as they are in our example, FIFO produces a higher inventory value (making the balance sheet appear to be stronger) and a lower cost of goods sold (resulting in a higher gross profit, which makes the company look more profitable)
When costs are falling,
these effects are reversed; FIFO produces a lower ending inventory value and a higher cost of goods sold—a double whammy. These are not “real” economic effects, however, because the same number of units is sold or held in ending inventory under either method. The following graphic summarizes the effects:
Tax Implications and Cash Flow Effects
Given the financial statement effects, you might wonder why a company would ever use a method that produces a lower inventory amount and a higher cost of goods sold. The answer is suggested in Exhibit 7.5, in the line called Income Tax Expense. When faced with increasing costs per unit, as in our example, a company that uses FIFO will have a higher income tax expense. This income tax effect is a real cost, in the sense that the company will actually have to pay more income taxes in the current year, thereby reducing the company’s cash.
Consistency in Reporting A common question is whether managers are free to choose one inventory costing method one period, and then switch to another inventory costing method the next period, depending on whether unit costs are rising or declining during the period.
Because this switching would make it difficult to compare financial results across periods, accounting rules discourage it. A change in method is allowed only if it improves the accuracy of the company’s financial results. A company can, however, use different methods for inventory that differ in nature or use, provided that the methods are used consistently over time.
The price that this inventory could be sold for (the value of inventory), can fall below its recorded cost for two reasons:
(1) it’s easily replaced by identical goods at a lower cost or (2) it’s become outdated or damaged. The first case is common for high-tech electronics. As companies become more efficient at making these cutting-edge products, the products become cheaper to make. The second case commonly occurs with fad items or seasonal goods such as winter parkas, which tend to drop in value at the end of the season.
lower of cost and net realizable value (LC&NRV)
when the value of inventory falls below its recorded cost, GAAP require that inventory be written down to its lower net realizable value. This rule is known as reporting inventory at the lower of cost and net realizable value (LC&NRV). It results in reporting inventory conservatively, at an amount that does not exceed its actual value. Also, by recording the write-down in the period in which a loss in value occurs, companies better match their revenues and expenses of that period.
we record all inventory-related transactions in the Inventory account. This approach is generally associated with a
perpetual inventory system Because it maintains an up-to-date balance in the Inventory account at all times.
An alternative approach, which maintains separate accounts for purchases, transportation, and so on, is generally used in a
periodic inventory system and is demonstrated in Supplement 7D near the end of this chapter.
the purchaser pays for the shipping
e FOB shipping point
If the terms are FOB destination,
the seller pays for the shipping. When the purchaser pays for the shipping, the additional cost of transporting the goods (called freight-in) is added to the Inventory account.
In general, a purchaser should include in the Inventory account any costs needed to get the inventory into a condition and location ready for sale. Costs that are incurred after the inventory has been made ready for sale, such as freight-out to deliver goods to customers, should be treated as selling expenses.
COST OF DELIVERY DECREASE INVENOTRY ACCOUNT
When goods purchased from a supplier arrive in damaged condition or fail to meet specifications, the buyer can
(1) return them for a full refund or (2) keep them and ask for a cost reduction, called an allowance.
