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Are asset items that a company holds for sale in the ordinary course of Business or goods that it will use or consume in production of goods to be sold


Merchandise inventory

Reports cost assigned to unsold units left on hand


Raw materials inventory

A company reports the cost assigned to goods and materials on hand but not yet placed into production


Raw materials include the following

Wood to make a baseball bat


Steel to make a car

These materials can be traced directly to end product


Work in process inventory

The cost of raw material for these unfinished units plus the direct labor cost applied specifically to this material and eatable share of manufacturing overhead costs


Finished goods inventory

Companies report costs identified with completed but unsold units on hand at the end of fiscal period


Companies that sell or produce goods report what?

Inventory and cogs at the end of each accounting period


Companies use what two types of systems for maintaining accurate inventory records for these costs?

Periodic and perpetual


Inventory cost flow is

Beginning inventory plus of cost of goods purchased = cost of goods available for sale.


Inventory cost flow

as goods are sold they are assigned to?

Goods that are not sold by the end of accounting period represent?


Ending inventory


Perpetual inventory system

Continuously tracks changes in inventory account.

Company records all purchases and sales (issues) of goods directly in the inventory account as they occur.


Periodic inventory system

Determined quantity of inventory on hand only periodically as the name implies


In order to do periodically , what does the company need to do?

1. Record all acquisitions of inventory during accounting period by debuting purchase account

2. Company adds total in purchase account at end of period to the cost of inventory on hand at the beginning of period. This sum determined total cost of goods a subtle for sale during sale

3. To compute cogs, ending inventory is subtracted from cog available for sale


Many companies cannot afford a complete _______ system?



Most companies need current information regarding the inventory levels to protect against stock outs or over purchasing as a result companies use

Modified perpetual inventory system


Modified perpetual inventory system

Provides detailed inventory records of increases and decreases in quantities only not dollar amounts


Modified perpetual inventory system is a memorandum device outside double entry system that helps determine

Level of inventory at any point in time


No matter what type of inventory records companies use they all

Face the danger of loss and error

Such as waste breakage theft improper entry failure to prepare or differ from actual inventory on hand


Thus all companies need a periodic verification of

Inventory records by actual count , weight, or measurement with counts prepared with detailed inventory records


Companies correct records to

Agree with quantities actually on hand


When should companies take physical inventory?

Near the end of fiscal year to properly report inventory quantities


Goods sold or used during accounting period correspond to

The goods bought or produced during that period


Cost of all goods available for sale or use must be allocated between?

Goods that were sold or used and those still on hand


Inventory and accounts payable is recognized when?

It controls the asset


Fob shipping point



Fob destination



Transfer of legal title is is the general guideline for?

Used to determine whether the company should include an item in inventory


What are the two special sales situations that indicate the types of problems companies encounter in practice?

Sales with repurchase agreement

Sales with high rates of return


Sales with repurchase agreement

Sometimes a company finances its inventory without

Reporting either a liability or the inventory on its balance sheet


Sales with repurchase agreement , usually involves a transfer (sale) with

Either an implicit or explicit repurchase agreement


Sales with high rates of return

Informal agreement soften exist that

Permit purchasers to return inventory for a full or partial refund


Companies generally account for acquisition of

Inventories like other assets on a cost basis


Product costs

Costs that attach to the inventory

So the product costs are recorded in inventory account


Product costs are directly related to

Connected with bringing the goods to the buyers place of business and converting such goods to a salable condition


A manufacture company's costs include

Direct materials
Direct labor
Manufacturing overhead costs


Manufacturing costs include

Indirect materials

Indirect labor

Various costs such as depreciation, taxes, insurance and utilities


Period costs

Are costs that are indirectly related to the acquisition or production of goods


Period costs such as selling expenses and under ordinary circumstances, general expenses are not included as

Part of inventory cost


Companies exclude this costs from inventoriable items

Bc companies generally consider selling expenses as more directly related to the cogs than the unsold inventory


Interest is a

Period cost


Usually expense interest costs associated with

Getting inventories ready for sale


Supporters of approach argue

Interest costs are really a cost of financing

Others contend that interest costs incurred to finance activities associated with readying inventories for sale are as much a cost of asset as materials labor and overhead


FASB ruled that companies should capitalize interest costs related to

Assets constructed for internal use or assets produced as discrete projects for sale or lease


Internalize costs for inventories should not be k



Purchase discounts in periodic inventory system indicates that

A company is reporting its purchases and accounts payable at gross amount


If company uses gross method, purchase discounts are reported as a deduction from

Purchases on income statement


Net of cash discounts

The company records a failure to take purchase discount within discount period in the purchase discount lost account.


Under the net of cash discounts, the purchase discounts are considered as

As a financial expense and reports it in other expenses and losses in income statement

This treatment is considered better

1. Produces correct reporting of cost of asset and related liability

2. It can measure management inefficiency by holding management responsible for discounts not taken


Under the cost flow assumption

There is no requirement that the cost flow assumption adopted be consistent with physical movement of goods


Specific identification

Calls for identifying each item sold and each item in inventory .


Specific identification

A company includes in cost of goods sold the costs of specific item sold

It includes in inventory then

.costs of specific items on hand


Specific identification method can be used only in

Instances where it is practical to separate physically from the different purchases made


Most companies use the specific identification method when handling

Small # of costly easily distinguishable items


Specific identification matches

Actual costs against actual revenue


Under specific identification the cost flow matched the

Physical flow of goods


Some believe that specific identification allows a company to manipulate



Another problem of specific identification is

Is the arbitrary allocation of costs that some items occurs with specific inventory items

For example, face difficulty in relating shipping charges, storage costs and discounts given to inventory item


Average cost method

Prices items in the inventory on the basis of the average cost of all similar goods available during the period


Companies use average cost methods for

Practical reasons


Average method is not as subjected to manipulate




Assumes that company uses goods in the order it purchases them


FIFO method assumes that

First goods purchases are the first used or the first sold


The inventory that remains in the FIFO method represent

The most recent purchases


when FIFO is used the inventory and cogs

Would be the same at the end of the month whether a perpetual or periodic system is used.



Bc the same costs will always be first in and first out


Objective of FIFO

Approximate the physical flow of goods


When the physical flow of goods is actually first in first out the FIFO method closely approximates

Specific identification


When FIFO closely approximates specific identification it prevents manipulation of



Advantage of FIFO

Ending inventory is close to current cost


first goods in are first goods out, ending inventory amount consists of most recent purchases


FIFO fails to match what?

Current costs against current revenues on income statement


Under FIFO

Company charges oldest costs against more current revenue which possibly distorts

Gross profit and net income



Matches the cost of last goods purchased against revenue


Many companies use LIFO for

Tax and external reporting purposes


FIFO , average cost or standard costs system for

Internal reporting purposes



1. Companies often base their pricing decisions on FIFO average cost or standard cost assumption rather than lifo basis

2. Record keeping on some other basis is easier bc LIFO assumption usually does not approximate physical flow of product

3. Profit sharing and other bonus arrangements often depend on non LIFO inventory assumption

4. The use of pure LIFO system is troublesome for intern periods which require estimates of year end quantity and prices


LIFO Reserve

Is the difference between the inventory method used for internal reporting purposes and LIFO is the allowance to reduce inventory to lifo account


LIFO effect

Is the change in allowance balance from one period to the next


Specific goods approach is often unrealistic for two reasons

1. When a company has many different inventory items the accounting cost of tracking each inventory item is expensive

3. Erosion of the LIFO inventory can easily occur


LIFO liquidation

Where erosion of LIFO inventory can easily occur. Which often distorts net income and leads to tax payments


Comprises cost from past periods, these costs are called

Layers (increases from period to period)


LIFO liquidation can occur frequently when using

Specific goods LIFO approach


How to alleviate LIFO liquidation

Companies can combine goods into pools



Groups items in similar nature


Instead of identical items, company combines and counts as a group

A number of similar units or products


Specified goods pooled LIFO approach results in fewer


LIFO liquidations

Bc the reduction of one quantity in the pool maybe offset by an increase in another


Specific goods pooled LIFO approach eliminates some of the disadvantages of

Specific goods (traditional) accounting for LIFO inventories


Specific goods pooled LIFO approach creates other problems such as

Companies continually change mix of products so companies must continually redefine the pools. ( time consuming and costly).

Second, even when practical, the approach results in erosion (LIFO Liquidation) of layers, thereby losing much of LIFO costing benefit


When does erosion of layer occur?

When a Specified good or material in the pool is replaced with another good or material


Dollar value LIFO overcomes the problems of

Redefining pools and eroding layers


Dollar value LIFO method

Determined and measures any increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in inventory pool


Dollar value LIFO has 2 important advantages over specific goods pooled approach

1. Companies may include a broader range of goods in dollar value LIFO
2. Dollar value LIFO pool permits replacement of goods that are similar items similar in use or interchangeable


Dollar value LIFO techniques help protect LIFO layers from



Companies use traditional LIFO approaches only when dealing with

Goods and expecting little change in product mix


Under dollar value LIFO method, one pool may contain the entire inventory . However companies use several pools. In general the more goods included in a poooo

The more likely that increases in the quantity of some goods will offset the decreases in other goods in the same pool


Having fewer pools means

Less cost and less chance of a reduction of LIFO layer


Note a layer forms only when?

The ending inventory at base year prices exceeds the beginning inventory at base year prices


When a decrease occurs the company

Peels off precious layers at the prices in existence when it adds the layers


In dollar value LIFO are price changes critical?



Many companies use the general price level index that the federal government

Prepares and publishes each month


Consumer price index for urban consumers is the most popular

General external price level index


When a relevant specific external price index is not readily available a company may

A company may compute it down specific internal price index and


Price index provides

A measure of change in price of cost levels between bad year and current year


Specific goods LIFO is



Specific goods pooled LIFO approach reduces

record keeping and clerical costs


It is more difficult to erode layers because

The reduction of one quantity in the pool may be offset by an increase in another


Pooled approach using quantities as its measurement basis can lead to

LIFO liquidations


Most companies using LIFO system use

Dollar value LIFO


Major advantages of LIFO

Obvious advantage is that LIFO cost flow may approximate physical flow of goods in and out of inventory .


Major advantages LIFO include

- matches most recent costs against current revenues to better measure current earnings
- inventory profits occur when the inventory costs matched against sales are less than the inventory replacement cost
-LIFO matches current costs against revenue reducing inventory profits

Tax benefits/improved cash flow
- LIFO popularity stems from tax benefits
- as long as price level increases and inventory quarries do not decrease, deferral of income tax occurs. Why? Because company matches items it most recents purchased against revenues
- tax law requires that if a company uses LIFO for tax purposes t must use LIFO for financial accounting purposes referred as LIFO conformity rule

Future earnings hedge
- future price declines will not substantially effect a company's future reported earnings
- he reason: since company records most recent inventory as sold first there is not much ending inventory at high prices vulnerable to price decline


Major disadvantages of LIFO

Reduced earning
- view lower profits under LIFO in inflationary times as distinct disadvantage

- would rather have higher reported profits than lower taxes

Inventory understated

- LIFO may have distorting effect on company balance sheet

- inventory valuation is normally outdated because the oldest costs remain in inventory

- the combined effect of rising product prices and avoidance of inventory liquidation increases the difference between inventory carrying value of LIFO and current prices of that inventory

Physical flow

- LIFO does not approximate physical flow of the items except in specific situations

-physical flow characteristics no longer determine whether a company may employs LIFO

Involuntary liquidation/ poor buying habits

-if a company eliminates the base of layers of old costs it may match old irrelevant costs against current revenues

- bc of liquidation problem, LIFO may cause poor buying habits.

- a company may simply purchase more goods and march these goods against revenue to avoid charging the old costs to expenses

- a company may attempt to manipulate its. We income at the end of year simply by altering its pattern of purchases


Basis selection of inventory method

LIFO occurs in the following instance

1. If selling prices and revenues have been increasing faster than costs thereby distorting income

2. In situations where LIFO has been traditional such as department store and industries where a fairly constant base stock is present


LIFO is inappropriate in the following

1. Where prices tend to lag behind costs

2. In situations where specific identification is traditional such as sale of automobiles, farm equipment , art jewelry

3. Unit costs tend to decrease as production increases thereby nullifying tax benefit that LIFO might provide


Switching from FIFO to LIFO results in

Immediate tax benefit


Switching from LIFO to FIFO results in

Substantial tax burden


Relaxation of LIFO conformity rule has led some companies to select LIFO as inventory valuation method bc

They will be able to disclose FIFO income numbers in financial reports if so desires