ACCT 201 Chapter 6
ACCT 201 Chapter 6 ACCT 201
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This 8 page Study Guide was uploaded by Amend on Tuesday August 23, 2016. The Study Guide belongs to ACCT 201 at Towson University taught by Raymond Kitson Walters in Fall 2016. Since its upload, it has received 4 views. For similar materials see Principles of Financial Accounting in Accounting (ACCT) at Towson University.
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Date Created: 08/23/16
ACCT 201 Chapter 6 Summary Learning Objective 1 – Determine how to classify inventory and inventory Quantities CLASSIFYING AND DETERMINING INVENTORY Two important steps in the reporting of inventory at the end of the accounting period are the classification of inventory based on its degree of completeness and the determination of inventory amounts. Classifying Inventory —depends on whether the firm is a merchandiser of a manufacturer. o In a merchandising company, inventory consists of many different items. o These items have two common characteristics: (1) they are owned by the company and (2) they are in a form ready for sale to customers. o Only one inventory classification, merchandise inventory, is needed to describe the many different items that make up the total inventory. In a manufacturing company, inventory is usually classified into three categories: Finished goods, Work in process, and Raw materials. o Raw materials inventory—the basic goods that will be used in production but have not yet been placed into production. o Work in process—that portion of manufactured inventory that has been placed into the production process but is not yet complete. o Finished goods inventory—items that are completed and ready for sale. By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management’s production plans. Determining Inventory QuantitiesNo matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory at year end for two purposes: (1) to check the accuracy of their perpetual inventory records and (2) to determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Companies using a period inventory system must take a physical inventory for two different purposes: (1) to determine the inventory on hand at the balance sheet date, and (2) to determine the cost of goods sold for the period. Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods. Taking a Physical Inventory—taken at the end of the accounting period. 1 ACCT 201 Chapter 6 Summary o Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. Determining Ownership of Goodstwo questions must be answered: 1. Do all of the goods included in the count belong to the company? 2. Does the company own any goods that were not included in the count? o To arrive at an accurate count, ownership of goods in transit (on board a truck, train, ship, or plane) must be determined. o Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale. When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer. o In some lines of business, it is customary to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods. Learning Objective 2 Explain the Basis of Accounting for Inventories and Apply the Inventory Cost Flow Methods under a Periodic Inventory System INVENTORY COSTINGAfter a company has determined the quantity of units of ending inventory, it applies unit costs to the quantities to determine the total cost of the ending inventory and the cost of goods sold. There are different inventory costing methods available: Specific identification method requires that companies keep records of the original cost of each individual inventory item. o A major disadvantage of this method is that management may be able to manipulate net income. Cost Flow Assumptionsother cost flow methods differ from the specific identification method in that they assume flows of costs may be unrelated to the actual physical flow of goods. There are three assumed cost flow methods. The cost of goods sold formula in a periodic system is (Beginning Inventory + Purchases) – Ending Inventory = Cost of Goods Sold. The value assigned to the ending inventory will depend on which cost flow method used. 2 ACCT 201 Chapter 6 Summary There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. One of the three cost flow assumptions may be used: o Firstin, first out (FIFO) o Lastin, first out (LIFO) o Averagecost Firstin, Firstout (FIFO) method assumes that the earliest goods purchased are the first to be sold. Under FIFO, the cost of the ending inventory is obtained by taking the unit cost of the most recent purchase and working backward until all of the units of inventory have been assigned a cost. o FIFO often parallels the actual physical flow of goods. TEACHING TIP Use the example of a bicycle shop to illustrate FIFO. Beginning inventory 0 0 Purchases: 6/2 500 @ $100 = $ 50,000 6/8 400 @ 125 = 50,000 6/25 350 @ 130 = 45,500 Goods available 1,250 $145,500 Ending inventory 250 @ 130 = 32,500 Cost of goods sold 1,000 $113,000 When using FIFO, one assumes the first units in are the first units sold. Which of the above units were sold? 500 @ $100 = $ 50,000 400 @ 125 = 50,000 100 @ 130 = 13,000 Cost of goods sold $113,000 Lastin, Firstout (LIFO) method assumes that the last goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. Under LIFO, the cost of the ending inventory is obtained by taking the unit cost of the earliest goods available for sale and working forward until all the units of inventory have been assigned a cost. o Beginning inventory is the earliest cost. 3 ACCT 201 Chapter 6 Summary TEACHING TIP Use the example of a bicycle shop to illustrate LIFO. Beginning inventory 0 0 Purchases: 6/2 500 @ $100 = $ 50,000 6/8 400 @ 125 = 50,000 6/25 350 @ 130 = 45,500 Goods available 1,250 $145,500 Ending inventory 250 @ 100 = 25,000 Cost of goods sold 1,000 $120,500 When using LIFO, one assumes the last units in are the first units sold. Which of the above units were sold? 350 @ $130 = $ 45,500 400 @ 125 = 50,000 250 @ 100 = 25,000 Cost of goods sold $120,500 Averagecost method assumes that the goods available for sale are similar in nature and allocates the cost of goods available for sale on the basis of the weightedaverage unit cost incurred. The weightedaverage unit cost is then applied to the units on hand to determine the cost of the ending inventory. 4 ACCT 201 Chapter 6 Summary TEACHING TIP Use the example of a bicycle shop to illustrate the averagecost method. 500 @ $100 = $ 50,000 400 @ 125 = 50,000 350 @ 130 = 45,500 Goods available 1,250 $145,500 $145,500 ÷ 1,250 = $116.40 per unit Beginning inventory 0 0 Purchases: 6/2 500 @ $100 = $ 50,000 6/8 400 @ 125 = 50,000 6/25 350 @ 130 = 45,500 Goods available 1,250 $145,500 Ending inventory 250 @ 116.40 = 29,100 Cost of goods sold 1,000 $116,400 When using the averagecost method, one assumes the units were similar in nature. Another way to find the cost of the units sold is to multiply the number of units sold by the average cost. Cost of goods sold 1,000 @ $116.40 = $116,400 Learning Objective 3 Explain the Financial Statement and Tax Effects of Each of the Inventory Cost Flow Assumptions FINANCIAL STATEMENT AND TAX EFFECT OF COST FLOW METHODSEach of the three assumed cost flow methods is acceptable for use under GAAP. The reasons companies adopt different inventory cost flow methods are varied, but they usually involve one of the following three factors: o Income statement effects o Balance sheet effects o Tax effects Income Statement Effects—In periods of increasing prices, FIFO reports the highest net income, LIFO the lowest net income and averagecost falls in the middle. In periods of decreasing prices, the opposite is true. FIFO will 5 ACCT 201 Chapter 6 Summary report the lowest net income, LIFO the highest, with averagecost in the middle.To management, higher net income is an advantage: o It causes external users to view the company more favorable. o Management bonuses, if based on net income, will be higher. o Thus, when prices are rising, companies tend to prefer FIFO. In a period of increasing prices, the use of LIFO enables the company to avoid reporting paper or phantom profit. Balance Sheet Effects—In a period of inflation, the costs allocated to ending inventory, using FIFO, will approximate current costs. Conversely, during a period of increasing prices, the costs allocated to ending inventory using LIFO will be significantly understated. Tax Effects—Both inventory on the balance sheet and net income on the income statement are higher when FIFO is used in a period of inflation. Many companies have switched to LIFO because it yields the lowest net income and therefore, the lowest income tax liability in a period of increasing prices. o LIFO Conformity Rule: A tax rule that requires if a company uses LIFO for tax purposes it must also use LIFO for financial reporting purposes. o Thus, if a company uses LIFO to reduce its tax bills, it must show the lower net income in its external financial statements. Using Inventory Cost Flow Methods Consistentlycompany should use the method chosen from one accounting period to another. When a company adopts a different method, it should disclose in the financial statements and its effects on net income. Learning Objective 4 Explain the LowerofCostorMarket Basis of Accounting for Inventories LOWEROFCOSTORMARKETWhen the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lowerofcostormarket (LCM) in the period in which the price decline occurs. LCM is an example of conservatism which means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income. 6 ACCT 201 Chapter 6 Summary Under the LCM basis, market is defined as current replacement cost, not the selling price. o For a merchandising company, market is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Learning Objective 5 Compute and Interpret the Inventory Turnover Ratio ANALYSIS of INVENTORYFor merchandising companies, managing inventory levels is critical. Too much inventory on hand costs money, and too little inventory results in lost sales. Inventory turnover ratio is computed by dividing cost of goods sold by average inventory. The ratio indicates how many times the inventory “turns over” (is sold) during the year. Days in inventory, computed by dividing 365 days by the inventory turnover ratio, indicates the average number of days inventory is held. o High inventory turnover (low days in inventory) indicates the company is tying up little of its funds in inventory (has minimal inventory on hand at any one time). Although minimizing the funds tied up in inventory is efficient, it may lead to lost sales due to inventory shortages. o Management should closely monitor the inventory turnover ratio to achieve the best balance between too much and too little inventory. Learning Objective 6 Describe the LIFO Reserve and Explain its Importance for Comparing Results of Different Companies ANALYSTS’ ADJUSTMENTS FOR LIFO RESERVEThe difference between inventory reported using LIFO and inventory using FIFO is referred to as the LIFO reserve. Accounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods. 7 ACCT 201 Chapter 6 Summary Learning Objective 7 (Appendix 6A) Apply the Inventory Cost Flow Methods to Perpetual Inventory Records INVENTORY COST FLOW METHODS IN PERPETUAL INVENTORY SYSTEMSEach of the inventory cost flow methods for a periodic inventory system may be used in a perpetual inventory system. FirstIn, FirstOut (FIFO)Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. LastIn, FirstOut (LIFO)Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. AverageCostUnder the averagecost method, a new average cost is computed after each purchase. Learning Objective 8 (Appendix 6B) Indicate the Effects of Inventory Errors on the Financial Statements INCOME STATEMENT EFFECTSUnder a periodic system, both the beginning and ending inventories appear in the income statement. Inventory errors affect the computation of cost of goods sold and net income in two periods. Effects of inventory errors on current year’s income statement Cost of Inventory Error Goods Sold Net Income Beginning inventory understated Understated Overstated Beginning inventory overstated Overstated Understated Ending inventory understated Overstated Understated Ending inventory overstated Understated Overstated If ending inventory errors are not corrected, in the following period their effect on net income for that period is reversed, and total net income for the two year period will be correct. BALANCE SHEET EFFECTSEnding inventory errors will have the same effect on total assets and total stockholders’ equity and no effect on liabilities. 8
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