Acfm 261 - Chap 8 Bolded Concepts + Learning Goals

Front 1

In a perpetual inventory system, determine the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. Discuss the advantages and shortcomings of each method.

Back 1

By the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold. (Debit Cost of Goods Sold: credit Inventory.) This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique. However, the method becomes cumbersome and may produce misleading results if the inventory consists of homogeneous items. The remaining three methods are flow assumptions, which should be applied only to an inventory of homogeneous items. By the average-cost method, the average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost. FIFO (first-in, first-out) is the assumption that the first units purchased are the first units sold. Thus, inventory is assumed to consist of the most recently purchased units. FIFO assigns current costs to inventory but older (and often lower) costs to the cost of goods sold. LIFO (last-in, first-out) is the assumption that the most recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In a period of inflation, LIFO usually results in lower reported profits and lower income taxes than the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.

Front 2

Explain the need for taking a physical inventory. In a perpetual inventory system

Back 2

A physical inventory is taken to adjust the inventory records for shrinkage losses. In a periodic inventory system, the physical inventory is the basis for determining the cost of the ending inventory and for computing the cost of goods sold.

Front 3

Record shrinkage losses and other year-end adjustments to inventory.

Back 3

Shrinkage losses are recorded by removing from the Inventory account the cost of the missing or damaged units. The offsetting debit may be to Cost of Goods Sold, if the shrinkage is normal in amount, or to a special loss account. If inventory is found to be obsolete and unlikely to be sold, it is written down to zero (or its scrap value, if any). If inventory is valued at the lower-of-cost-ormarket, it is written down to its current replacement cost, if at year-end this amount is substantially below the cost shown in the inventory records.

Front 4

In a periodic inventory system, determine the ending inventory and the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO.

Back 4

The cost of goods sold is determined by combining the beginning inventory with the purchases during the period and subtracting the cost of the ending inventory. Thus, the cost assigned to ending inventory also determines the cost of goods sold. By the specific identification method, the ending inventory is determined by the specific costs associated with the units on hand. By the average-cost method, the ending inventory is determined by multiplying the number of units on hand by the average cost of the units available for sale during the year. By FIFO, the units in inventory are priced using the unit costs from the most recent cost layers. By the LIFO method, inventory is priced using the unit costs in the oldest cost layers.

Front 5

Explain the effects on the income statement of errors in inventory valuation.

Back 5

In the current year, an error in the costs assigned to ending inventory will cause an opposite error in the cost of goods sold and, therefore, a repetition of the original error in the amount of gross profit. For example, understating ending inventory results in an overstatement of the cost of goods sold and an understatement of gross profit. The error has exactly the opposite effect on the cost of goods sold and the gross profit of the following year, because the error is now in the cost assigned to beginning inventory.

Front 6

Estimate the cost of goods sold and ending inventory by the gross profit method and by the retail method.

Back 6

Both the gross profit and retail methods use a cost ratio to estimate the cost of goods sold and ending inventory. The cost of goods sold is estimated by multiplying net sales by this cost ratio; ending inventory then is estimated by subtracting this cost of goods sold from the cost of goods available for sale. In the gross profit method,the cost ratio is 100 percent minus the company’s historical gross profit rate. In the retail method, the cost ratio is the percentage of cost to the retail prices of merchandise available for sale.

Front 7

Compute the inventory turnover and explain its uses.

Back 7

The inventory turnover rate is equal to the cost of goods sold divided by the average inventory. Users of financial statements find the inventory turnover rate useful in evaluating the liquidity of the company’s inventory. In addition, managers and independent auditors use this computation to help identify inventory that is not selling well and that may have become obsolete.

Front 8

Average-cost method

Back 8

(p. 342) A method of valuing all units in inventory at the same average per-unit cost, which is recomputed after every purchase.

Front 9

Consistency (in inventory valuation)

Back 9

(p. 347) An accounting principle that calls for the use of the same method of inventory pricing from year to year, with full disclosure of the effects of any change in method. Intended to make financial statements comparable.

Front 10

Cost flow assumption

Back 10

(p. 342) Assumption as to the sequence in which units are removed from inventory for the purpose of sale. Is not required to parallel the physical movement of merchandise if the units are homogeneous.

Front 11

Cost Layer

Back 11

(p. 341) Units of merchandise acquired at the same unit cost. An inventory comprised of several cost layers is characteristic of all inventory valuation methods except average cost.

Front 12

Cost Ratio

Back 12

(p. 356) The cost of merchandise expressed as a percentage of its retail selling price. Used in inventory estimating techniques, such as the gross profit method and the retail method.

Front 13

First in, First out (FIFO method)

Back 13

(p. 343) A method of computing the cost of inventory and the cost of goods sold based on the assumption that the first merchandise acquired is the first merchandise sold and that the ending inventory consists of the most recently acquired goods.

Front 14

F.O.B Destination

Back 14

(p. 351) A term meaning the seller bears the cost of shipping goods to the buyer’s location. Title to the goods remains with the seller while the goods are in transit.

Front 15

F.O.B Shipping point

Back 15

(p. 351) The buyer of goods bears the cost of transportation from the seller’s location to the buyer’s location. Title to the goods passes at the point of shipment, and the goods are the property of the buyer while in transit.

Front 16

Gross profit method

Back 16

(p. 356) A method of estimating the cost of the ending inventory based on the assumption that the rate of gross profit remains approximately the same from year to year. Used for interim valuations and for estimating losses.

Front 17

Inventory Turnover

Back 17

(p. 358) The cost of goods sold divided by the average amount of inventory. Indicates how many times the average inventory is sold during the course of the year.

Front 18

Just-in-time (JIT) Inventory system

Back 18

(p. 347) A technique designed to minimize a company’s investment in inventory. In a manufacturing company, this means receiving purchases of raw materials just in time for use in the manufacturing process and completing the manufacture of finished goods just in time to fill sales orders. Just-in-time also may be described as the philosophy of constantly striving to become more efficient by purchasing and storing less inventory.

Front 19

Last in, First out (LIFO method)

Back 19

(p. 344) A method of computing the cost of goods sold by use of the prices paid for the most recently acquired units. Ending inventory is valued on the basis of prices paid for the units first acquired.

Front 20

Lower-cost-of-market (LCM rule)

Back 20

(p. 350) A method of inventory pricing in which goods are valued at original cost or replacement cost (market), whichever is lower.

Front 21

Moving average method

Back 21

(p. 342) A method of valuing all units of inventory at the same average per-unit cost, recalculating this cost after each purchase. This method is used in a perpetual inventory system.

Front 22

Physical inventory

Back 22

(p. 349) A systematic count of all goods on hand, followed by the application of unit prices to the quantities counted and development of a dollar valuation of the ending inventory.

Front 23

Retail method

Back 23

(p. 357) A method of estimating the cost of goods sold and ending inventory. Similar to the gross profit method, except that the cost ratio is based on current costto-retail price relationships rather than on those of the prior year.

Front 24

Shrinkage losses

Back 24

(p. 349) Losses of inventory resulting from theft, spoilage, or breakage.

Front 25

Specific Identification

Back 25

(p. 342) Recording as the cost of goods sold the actual costs of the specific units sold. Necessary if each unit in inventory is unique, but not if the inventory consists of homogeneous products.

Front 26

Write-down (of an asset)

Back 26

(p. 350) A reduction in the carrying amount of an asset because it has become obsolete or its usefulness has otherwise been impaired. Involves a credit to the appropriate asset account, with an offsetting debit to a loss account.