Chapter 6

Question 1

Who has Inventory?

What is Inventory?

Answer 1

Companies that sell products have inventory. They purchase items and then re-sell them. Inventory is a current asset on the balance sheet.

Question 2

What happens when items are sold?

Answer 2

When items are sold, the cost of the items is transferred to an expense account called “Cost of Good Sold”, which is often abbreviated COGS. It’s important to keep in mind that to make a profit, companies must sell inventory for a price higher than its cost. Revenue is based on the selling or retail price of the inventory. Cost of goods sold is the cost of the inventory items to the company that is selling them.

Question 3

What is gross profit? What is it also called? What does it represent?

Answer 3

Sales Revenue minus Cost of Goods Sold

Also called Gross Margin
Represents markup on products

“Gross” because expenses have not been deducted

Question 4

What are the two systems to account for inventory?

Answer 4

Periodic and Perpetual

Question 5

What is the Periodic system and why is it used?

Answer 5

Count items to determine quantity on hand
Used for inexpensive items
Used by small businesses
Low cost method of keeping track of inventory

Question 6

What is the Perpetual System and why is it used?

Answer 6

Running record of inventory kept by computer program
Used by large businesses
Scanners and bar codes used to record transactions
With this system, inventory is updated for every transaction that impacts it – sales, purchases, returns.

Question 7

What are the components of net cost and order of purchases?

Answer 7

Purchase price
\+ Freight-in
-Purchase returns
-Purchase allowances
-Purchase discounts

Question 8

What’s Freight in?

Answer 8

Freight-in is added to the purchase price of the items. Freight-in is the shipping costs the company paid to get the items sent.

Question 9

What is a purchase returns?

Answer 9

Purchase returns occur when customers return unwanted goods.

Question 10

What are purchase discounts?

Answer 10

Purchases discounts are when the company offers a discount if the customer pays the bill within a certain number of days.

Question 11

What are purchase allowances?

Answer 11

The goods aren’t physically returned, but the company reduces the amount owed.

Question 12

What are the two discounts, explain and describe the benefit?

Answer 12

Purchase Discounts- Company receives discount if it makes payment early
Reduces cost of inventory

Sales Discounts - Company offers discount to customers for early payment
Reduces cash received on accounts receivable

Question 13

What are the payment terms 2/10 and n/30?

Answer 13

This means the buyer can take a 2% discount for payment within 10 days, with the final amount due within 30 days. Another common credit term is “net 30,” which tells the customer to pay the full amount within 30 days.

Question 14

What are the components and order of net sales?

Answer 14

Sales Revenue

• Sales returns
• Sales allowances
• Sales Discounts

Question 15

What is sales revenue?

Answer 15

Sales revenue is the amount earning by selling products to customers. If items are returned to the company by the customer, sales returns is debited.

Question 16

What is sales allowances and what does it reduce?

Answer 16

Sales allowances are similar to returns, except the items are physically returned. The company reduces the customer’s account receivable.

Question 17

What are sales discounts?

Answer 17

Sales discounts are just like purchases discounts with the roles reversed. The company grants the customer a discount if payment is received within a specified number of days.

Question 18

What is the purpose of an inventory costing method?

Answer 18

To determine the cost of inventory sold or on hand, the units are multiplied by the unit cost

Inventory items are often purchased at different prices throughout the year
Company selects a costing method to determine which unit cost to use

Question 19

Information about Inventory Items

Answer 19

Inventory items are purchased several times throughout the year. More often than not, the cost of those items differ for each purchase.

When computing the cost of goods sold or the dollar amount of ending inventory, a company must choose a cost-flow assumption to assign a dollar amount to the units.

Question 20

What are the four inventory costing methods?

Answer 20

Specific-unit-cost
Average cost
First-in, first-out (FIFO)
Last-in, first-out (LIFO)

Question 21

Describe Specific Unit Cost and when you would use it

Answer 21

Each item in inventory can be separately identified
Used for unique items
Cars, fine jewelry

Some businesses deal in unique inventory items, such as automobiles, antique furniture, jewels, and real estate. These businesses cost their inventories at the specific cost of the particular unit. The specific-unit-cost method is also called the specific identification method. This method is too expensive to use for inventory items that have common characteristics, such as bushels of wheat, gallons of paint, or auto tires.

Question 22

What are the formulas for Average Cost Method?

Answer 22

Cost of Goods Available / Number of Units Available = Average Cost Per Unit

Average Cost Per Unit x Units Sold = Cost of Goods Sold

Average Cost Per Unit x Units on Hand = Ending Inventory

Question 23

Describe First in, First Out

and when you would use it

Answer 23

Oldest items assumed to be sold first

Ending inventory will consist of most recent items purchased

Question 24

Describe Last In, First Out and when you would use it

Answer 24

Newest items are assumed to be sold first

Ending inventory consists of oldest items in inventory

Question 25

Describe Average Cost Method and when you would use it.

Answer 25

It averages the cost of inventory items purchased during the year.

Question 26

When would the FIFO be the highest and lowest and when would the LIFO be the highest and lowest?

Answer 26

COST OF GOODS SOLD
FIFO lowest -Based on older costs
LIFO highest-Based on recent costs

ENDING INVENTORY
FIFO highest-Based on recent costs
LIFO lowest-Based on older costs

Question 27

What are the tax advantages of LIFO?

assuming inventory costs are increasing

Answer 27

Results in higher cost of goods sold. Higher Cost of Good Sold results in lower net income. Lower net income results in lower taxes. Lower taxes results in greater flow.

Question 28

Why would a company choose LIFO if it results in lower net income and lower asset value on the balance sheet?

Answer 28

To pay less income taxes

Question 29

What are the difference between LIFO and FIFO?

Answer 29

FIFO gives a more accurate balance sheet number as inventory is made up the most recent costs. However, it matches old inventory costs with current revenues. LIFO results in a less accurate balance sheet number. However, on the income statement, the COGS amount is good match with the revenue.

Question 30

What are the three accounting principles related to inventory?

Answer 30

Consistency
Disclosure
Conservatism

Question 31

Consistency Principle and what it enables, and what it doesn’t mean.

Answer 31

The consistency principle states that businesses should use the same accounting methods and procedures from period to period. Consistency enables investors to compare a company’s financial statements from one period to the next.

The consistency principle does not mean that a company is not permitted to change its accounting methods. However, a company making an accounting change must disclose the effect of the change on net income

Question 32

Disclosure principle and what kind of info this means

Answer 32

The disclosure principle holds that a company’s financial statements should report enough information for outsiders to make informed decisions about the company.

The company should report relevant, reliable, and comparable information about itself. That means disclosing inventory accounting methods. Without knowledge of the accounting method, a financial statement use could make an unwise decision.

Question 33

Conservatism

Answer 33

Companies should “write down” inventory if market price falls below cost

Conservatism in accounting means reporting financial statement amounts that paint the gloomiest immediate picture of the company.

Question 34

What is the goal of conservatism?

What advantage does conservatism give a business?

Answer 34

The goal is to present reliable data.

“anticipate no gains, but provide for all probable losses” and “if in doubt, record an asset at the lowest reasonable amount and report a liability at the highest reasonable amount.”

Conservatism
directs accountants to decrease the accounting value of an asset if it appears unrealistically high.

Question 35

What is the Lower-of- Cost-or Market?

Answer 35

Inventory should be reported at whichever is lower – historical cost or market value

If cost is lower, no adjustment needed

If market is lower, Inventory is decreased to market value and
Cost of goods sold is increased

Question 36

What is market value?

Answer 36

current replacement cost

which is how much the business would have to pay now to replace its inventory

Question 37

Error in ending inventory impacts which two periods and what are they

Answer 37

First period
Cost of goods sold
Gross Profit & Net Income

Second period
Beginning inventory
Costs of Goods sold
Gross Profit & Net Income