Chp 8-11(Key Concepts)

Front 1

Inventory

Back 1

Represent s quantities of goods acquired, manufactured, or in the process of being manufactured.


Ending inventory represents cost of inventory still on hand.


For manufacturer:


1. Raw materials
2. Work in process
3. Finished goods

Front 2

Cost of Goods Sold(COGS)

Back 2

Represents the cost of inventory during an reporting period.

Front 3

Raw Materials

Back 3

Represents the cost of components purchased from other manufactures that will become part of the finished product.

Front 4

Work–in–Process

Back 4

products that are not yet complete

Front 5

Finished goods

Back 5

The costs that have accumulated in work–in–process are transferred here.

Front 6

Perpetual inventory system

Back 6

Inventory account is continually adjusted for each change in inventory, whether it's caused by a purchase, a sale, or a return of merchandise by the company to its supplier.

Front 7

Periodic Inventory System

Back 7

Is not designed to track either the quantity or cost of merchandise.



Merchandise inventory account balance is not adjusted as purchases and sales are made but only periodically at the end of a reporting period.

Front 8

F.o.b(free on board) shipping point

Back 8

The legal title to the goods changes hands at the point of shipment when the seller delivers the goods to the common carrier, and the purchaser is responsible for shipping costs and transit insurance.

Front 9

F.o.b. Destination

Back 9

Seller is responsible for shipping and legal title does not pass until goods arrive at their destination(the customer's location).

Front 10

Consignment

Back 10

Goods are physically transferred to the consignee, but the transferor retains legal title.


sale is recorded by the consignor only when the goods are sold by the consignee and title passes to the customer.

Front 11

Product costs

Back 11

Costs included in inventory; associated with products and expensed as COGS only when the related products are sold.


Expenditures necessary to bring inventory to its condition and location for sale or use.


Include purchase price of goods, freight charges on incoming goods, insurance costs, costs of unloading costs, unpacking costs, and costs of preparing merchandise inventory for sale or raw materials inventory for use.

Front 12

Freight–in or transportation–in

Back 12

In a periodic system, freight costs are added to this temporary account.


generally part of cost of inventory


added to MI under perpertual system and freight–in account for periodic system.



closed to COGS

Front 13

Purchase Return

Back 13

When buyer returns goods to seller, a reduction in net purchases is recorded.



In periodic system, purchases returns account temporarily accumulates these amounts; are subtracted from purchases when determining net purchases



under perpetual system, both inventory and A/P are reduced.

Front 14

Purchase discounts

Back 14

Represent reductions in the amount to be paid if remittance is made within a designated period of time.


Can be recorded using either the gross method or the net method.


Under gross method, discounts not taken viewed as part of cost of inventory, while under net method, they are reported as interest expense and cost of inventory includes net after–discount amount.

Front 15

Specific Identification method

Back 15

To match each unit sold during the period or each unit on hand at the end of the period with its actual cost.


Most economically feasible when selling high–cost items at a low sales volume.

Front 16

Average cost method

Back 16

Assumes that COGS and ending inventory consist of a mixture of all the goods available for sale.



Periodic Average cost: weighted average only calculated at end of the period


COGAFS(Costs of goods available for sale)/quantity AFS(Available for sale)



Perpetual Average cost:


1. moving–average unit cost
2. calculated each time additional units are purchased
3. new average determined by:
a. summing the cost of previous inventory balance and the cost of new purchase
b. dividing this total cost(COGAFS) by the number of units on hand.(inventory units AFS)

Front 17

First–in, first–out(FIFO) method

Back 17

assumes that units sold are the first units acquired.


Ending inventory consists of the most recently acquired items.


same COGS and EI amounts for both periodic and perpetual FIFO.

Front 18

LIFO(last–in, first–out) method

Back 18

Assumes that units sold are the most recent units purchased.



Ending inventory consists of the items acquired first.


generally different COGS and EI amounts between periodic and perpetual LIFO.

Front 19

LIFO conformity rule

Back 19

If a company uses LIFO to measure its taxable income, then IRS regulations require that LIFO also be used to measure income reported to investors and creditors.


lower income tax motivation may be offset by a desire to report higher net income.


permits LIFO users to report non–LIFO inventory valuations in a disclosure note, but not on the face of the income statement.

Front 20

LIFO Reserve or LIFO allowance

Back 20

Contract account, where the conversion amount(difference between the internal method and LIFO) are recorded.

Front 21

LIFO liquidation

Back 21

Inventory costs with LIFO generally are out of date because they reflect old purchase transactions; not common for LIFO inventory balance to be based on unit costs actually incurred several years earlier.


when out–of–date inventory layers are liquidated due to decline in inventory quantities, COGS will partially match noncurrent costs with current selling prices.

Front 22

Just in Time(JIT) System

Back 22

Assists company with inventory management.


Used by manufacturers to coordinate production with suppliers so that raw materials or components arrive just as they are needed in the production process.

Front 23

Gross Profit Ratio

Back 23

Gross Profit/Net sales


Gross profit is sometimes called gross margin


Indicates relationship between net sales revenue and COGS.


indicates the percentage of each sales dollar available to cover expenses other than COGS and to provide a profit.


the higher the ratio, the higher the markup a company is able to achieve on its products.

Front 24

LIFO inventory pools

Back 24

Objective is to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation.



Benefits may not be achieved, such as when a product in a pool is discontinued; the old costs that existed in prior layers of inventory would be recognized as COGS and product LIFO liquidation profit.


Even if product is replaced with another, the replacement may not be similar enough and this process of redefining inventory pools as changes in product mix occur can be expensive and time consuming.

Front 25

Dollar–Value LIFO(DVL)

Back 25

Extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool


A DVL pool is made up of items that are likely to face the same cost pressures.


Physical units are not used in calculating ending inventory, but rather the inventory is viewed as a quantity of value instead of a physical quantity of goods.


Instead of layers of units from different purchases, the DVL inventory pool is viewed as comprising layers of dollar value from different years.



Inventory pool identified in terms of economic similarity rather than physical similarity; same cost pressures.

Front 26

Inventory Turnover ratio

Back 26

COGS/Avg inventory


Inventory increases that outrun increases in COGS may indicate difficulties in generating sales.

Front 27

Lower of Cost and Net Realizable value

Back 27

GAAP requires companies to report at inventory at lower of cost or NRV.


Benefit received from inventory results from the ultimate sale of inventory; Things that compromise the salability of inventory such as, deterioration, impair the benefit it provides.



Avoids reporting at amount greater than the benefits it can provide.


losses recognized in period when inventory declines in value, rather than when sold.



People argue that it's inconsistent because increases aren't recorded and causes losses that haven't actually occurred to be recognized.


Increases in inventory prior to sale not recognized because of potential premature revenue recognition.


LCM used to be required by GAAP to value inventory, but was intended as a guide rather than a literal rule.

Front 28

Gross Profit Method or Gross margin method(Inventory estimation technique)

Back 28

Useful in situations where estimates of inventory are desirable in a variety of ways:


1. In determining the cost of inventory that has been lost, destroyed, or stolen


2. In estimating inventory and COGS for interim reports, avoiding the expense of a physical inventory count.


3. In auditors' testing of the overall reasonableness of inventory amounts reported by clients


4. In budgeting and forecasting


Not acceptable for the preparation of annual financial statements(approximation of inventory).


First step in estimating inventory is to estimate COGS, which relies on historical relationship between net sales, cogs, and gross profit

Front 29

Cost–to–retail percentage

Back 29

based on a current relationship between cost and selling price; comparing of cost of goods AFS with goods AFS at current selling prices.


Cost of goods available for sale/goods available for sale at selling price

Front 30

Applying Lower of Cost and NRV

Back 30

Can be applied to individual inventory items, logical inventory items, logical inventory categories, or the entire inventory.

Front 31

Adjusting cost to NRV

Back 31

If common place, include losses in COGS.


If significant and unusual, GAAP requires expressive disclosure, so consider including loss in separate line item such as "loss on write–down of inventory," or disclosing it in a disclosure note.



Reduced inventory because the new cost basis and can't be written back up.

Front 32

IFRS lower of cost and NRV

Back 32

Both IFRS and GAAP value inventory at lower of cost or NRV.


Differences:


1. IFRS allows reversal of write–downs, while GAAP doesn't.


2. Under GAAP, lower of cost and NRV can be applied to individual items, logical categories, or the entire inventory, whereas under IFRS, it is usually only applied to individual items; however, it is applied to logical categories under certain circumstances.

Front 33

Word of Caution(Gross Profit Method)

Back 33

The key to obtaining good estimates is the reliability of the gross profit ratio.


all available information should be used to make adjustments


Blanket ratio should not be applied in situations of different products having different markups.


Inventory should be grouped in pools of products with similar gross profit relationships, instead of applying gross profit ratio to entire inventory


Cost flow assumption should be considered


it doesn't consider possible theft or spoilage of inventory. which requires an adjustment.

Front 34

Markup on cost

Back 34

Gross profit stated as a percentage of cost instead of sales.

Gross Profit/Cost= Gross profit as% of cost

Gross profit as % of sales= Gross Profit as % of cost/1+Gross profit as % of cost

Front 35

Determining NRV

Back 35

NRV is estimated selling price of the product in the ordinary course of business less reasonably predictable costs of completion, disposal, and transportation, such as sales commission and shipping costs; net amount company expects to realize from the sale of inventory

Front 36

Applying Lower of Cost and Net Realizable(Determining NRV)

Back 36

Lower of cost and net realizable value can be applied to individual inventory items, to logical categories of inventory(major product lines), or to the entire inventory.



For income tax purposes, must be applied on an individual item basis.


Applying this to categories usually will cause a higher inventory valuation than if applied on a n item by item basis because the decreases the NRV of some items is offset by increases.

Front 37

Adjusting Cost to NRV(Determining NRV)

Back 37

–Commonplace inventory write–downs are included in COGS(losses).



–Substantial and unusual write–downs, are required by GAAP to be expressly disclosed:
1. Through a disclosure note
2. Reporting loss in separate line in the income statement , usually among operating expenses, instead of in COGS.

3. Disclosure note appropriate regardless


Regardless of approach to write–down inventory, reduced inventory value becomes new cost basis and cannot be written back up.

Front 38

The retail Inventory Method(Inventory estimation technique)

Back 38

1. Cost to retail percentage: More reliable than historical gross profit ratio

2. Retail information: records of inventory and purchases at cost and selling price
3. Estimates EI(retail) by subtracting sales(retail) from goods available for sale(retail).

4. Estimating EI(retail) is converted to cost by multiplying by the cost–to–retail percentage.
5. Like gross profit method used to estimate the cost of inventory lost, stolen, or destroyed; testing overall reasonableness of physical counts; forecasting and budgeting; as well as generating information for interim financial statements
6. Physical count of inventory still performed once a year, despite accuracy of method to detect theft, spoilage, and other irregularities.



Advantages:
1. Acceptable for external financial reporting
2. Allowed by IRS to determine COGS for income tax purposes.
3. Different cost flow methods can be explicitly incorporated into the estimation technique.


*Principle benefit similar to gross profit method is that physical count of inventory is not necessary to estimate EI and COGS.

Front 39

Retail Terminology(Retail Inventory method)

Back 39

·

Front 40

Initial Markup

Back 40

Original amount of markup from cost to selling price.

Front 41

Additional Markup

Back 41

Increase in selling price subsequent to initial markup.

Front 42

Markup cancellation

Back 42

Elimination of additional markup

Front 43

Markdown

Back 43

Reduction in selling price below the original selling price.

Front 44

Markdown Cancellation

Back 44

Elimination of markdown

Front 45

Net Markup

Back 45

Additional markup less markup cancellation

Front 46

Net Markdown

Back 46

Markdown less markdown cancellation

Front 47

Approximating Average cost

Back 47

Both net markups and net markdowns included in the determination of goods available for sale at retail.

Front 48

Conventional retail method: Approximating average lower of cost and NRV

Back 48

Markdowns excluded from the calculation of cost–to–retail percentage to approximate the lower of average cost and NRV.


Markdowns still subtracted from retail column, but only after the percentage is calculated.


Cost approximation of EI will always be less when markdowns exist.


Logic behind using this method is that a markdown is evidence of a reduction in the utility of inventory, such as through spoilage and overstocking.


Usually not used in combination with LIFO, but companies using LIFO don't ignore the lower of cost and NRV rule and write down any obsolete or slow–moving inventory that hasn't been marked down by year–end to NRV after the estimation of inventory using the retail method.



Could be applied to FIFO method.

Front 49

LIFO Retail Method

Back 49

We assume retail prices of goods remained stable during the period.


New layer is added(one per year) if inventory at retail increases.


Each layer carries its own cost–to–retail percentage.


Net markups and net markdowns included in calculation of current period's cost–to–retail percentage.

Front 50

Other issues pertaining to retail method

Back 50

Fundamental elements such as returns and allowances, discounts, freight, spoilage, and shortages can complicate retail method.

Front 51

Before calculating cost to retail percentage(Other issues pertaining to retail method)

Back 51

Freight in: Added in cost column
Purchase returns: Deducted in both the cost and retail column
Purchase discount taken(gross method used to record purchases): Deducted in cost column
Abnormal shortages(spoilage, breakage, theft): Deducted in both the cost and retail column


Abnormal shortages not anticipated and not implicit in determination of selling prices.

Front 52

After calculating the cost to retail percentage(other issues pertaining to retail method)

Back 52

Normal shortages(spoilage, breakage, theft): Deducted in the retail column
Employee Discounts: Added to net sales


Discounts added to net sales because subtracting discounts from sales would overstate inventory; sales discounts do not represent an adjustment in selling price.



Including normal shortages in cost–to–retail percentage would distort relationship between cost and retail.


Because shortage losses are anticipated, they are included implicitly in determination of selling prices.

Front 53

Dollar Value LIFO Retail Method

Back 53

Using the retail method to approximate LIFO.


Combines LIFO retail and dollar value LIFO.


Used to determine if there's been a real increase in quantity of goods in inventory by eliminating effect of any price changes before comparing EI to BI.


Step 1: Deflate ending inventory to base year retail prices
Step 2: Inventory layers at base year retail prices
Step 3: Inventory layers converted to cost

Front 54

Most Inventory Changes(change in inventory method)

Back 54

Changes in inventory methods, other than LIFO, are accounted for retrospectively(reporting all previous periods' financial statements as if the new method had been used in all previous periods)


Step 1: Revise comparative financial statements

Step 2: The affected accounts are adjusted
Step 3: A disclosure note provides additional information(provides justification for change) and indicates effect on:


a. items not reported on the face of the primary statements.
b. any per share amounts affected for the current period and prior periods
c. cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.

Front 55

Change to the LIFO method(change in inventory method)

Back 55

Accounting records usually are inadequate for company changing to LIFO to report the change retrospectively, thus most companies report the change prospectively.


Disclosure is needed to explain:
a. nature of and justification for the change
b. the effect of the change on current year's income and EPS.
c. why retrospective application was impracticable.

Front 56

Additional consideration(change to LIFO method)

Back 56

Change in principle must be justified in that it results in financial information that properly portrays operating results and financial position.


For income tax purposes, must obtain consent from IRS and file a form when adopting LIFO inventory method.


Can't change back to LIFO until five tax returns have been filed.

Front 57

Inventory Errors

Back 57

1. Over– or understatement of inventory due to a mistake in physical count or a mistake in pricing inventory quantities
2. Over– or understatement of purchases which could be caused by cutoff errors
3. Financial statements restated retrospectively if material error discovered in subsequent period to the period the error was made.
4. Prior period adjustment to beginning balance of retained earnings
5. Disclosure note needed to describe nature of error and impact of correction on net income, income before extraordinary items, and EPS.

Front 58

When inventory error is discovered in the following year

Back 58

Financial statements retrospectively restated when those statements are reported again for comparative purposes


Prior period adjustment to retained earnings and correction to inventory account.

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When the inventory error is discovered two years later

Back 59

Financial statements retrospectively restated, but inventory and retained earnings would not require adjustment because the error has self–correct



Disclosure note should describe nature of the error and the impact of its correction on each year's net income, income before extraordinary items, and EPS.

Front 60

Natural Resources

Back 60

oil, gas deposits, timber tracts, and mineral deposits

Front 61

Intangible assets

Back 61

Lack physical substance and the extent and timing of their future benefits typically are highly uncertain; goodwill, trademarks, franchises, patents, copyrights

Front 62

Property Plant and Equipment(PPE)

Back 62

land, buildings, equipment, machinery, furniture, autos, and trucks

Front 63

Land improvements

Back 63

Costs are capitalized and depreciated; parking losts, driveways, private roads, fences, lawn and garden sprinkler systems

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Natural Resources

Back 64

When bought from another company, valuation is simply purchase price plus any other costs necessary to bring it to condition and location for use.


If developed, initial valuation:


1. acquisition costs
2. exploration costs
3. development costs
4. restoration costs

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acquisition costs

Back 65

The amounts paid to acquire the rights to explore for undiscovered natural resources or to extract proven natural resources

Front 66

Exploration costs

Back 66

Expenditures such as drilling a well, excavating a mine, or any other costs associated with searching for natural resources.

Front 67

Development Costs

Back 67

Incurred after the resource has been discovered but before production begins, which includes costs such as expenditures for tunnels, wells, and shafts.

Front 68

Restoration costs

Back 68

Costs to restore land or other property to its original condition after the natural resource has been extracted.

Front 69

Asset Retirement obligations(AROs)

Back 69

Measured at fair value and is recognized as a liability and corresponding increase in asset valuation.

Front 70

Expected Cash flow approach

Back 70

Cash flows are adjusted, not the discount rate for the uncertainty or risk of cash flows; incorporates specific probabilities of cash flows into analysis


discount rate is equal to the credit–adjusted risk free rate; the higher a company's credit risk, the higher the discount rate.

Front 71

Accretion expense

Back 71

Difference between asset retirement obligation and the probability–weighted expected cash outflow; an additional expense that accrues as an operating expense over the excavation period.

Front 72

Patent

Back 72

Exclusive right to manufacture a product or to use a process.

Front 73

copyright

Back 73

exclusive right of protection given to a creator of published work, such as a song, film, painting, photograph, or book.

Front 74

Trademark(tradename)

Back 74

Exclusive right to display an emblem, symbol, or slogan, word, that distinctively identifies a company, a product, or a service.

Front 75

Franchise

Back 75

Is a contractual arrangement under which the franchisor grants the franchisee the exclusive right to use the franchisor's trademark and may include product and formula rights, within a geographical area, usually for a specified period of time.

Front 76

Capital budgeting

Back 76

Decisions related to PPE and intangible asset acquisition, which could influence a company's performance over many years.


Requires management to forecast all future net cash flows(cash inflows minus cash outflows) generated by the asset(s).



Cash flows are used in a model, such as the NPV model(which compares the present value of future net cash flows with the required initial acquisition cost of the assets)to determine if the future cash flows are sufficient to warrant the capital expenditure.

Front 77

Fixed Asset Turnover Ratio

Back 77

Net Sales/Average Fixed Assets

Front 78

Specific Interest method

Back 78

f

Front 79

Weighted–average method

Back 79

Using the weighted–average rate of all interest bearing debt, including construction loans to determine capitalizable interest.

Front 80

Start–up costs

Back 80

Costs incurred whenever a company introduces a new product or service, or commences business in a new territory or with a new customer.



Includes organization costs

Front 81

Organization costs

Back 81

Costs related to organizing a new entity, such as legal fees, and state filling fees to incorporate.

Front 82

Technological feasibility

Back 82

GAAP requires that R&D be recorded as an expense, until technological feasibility has been established, for costs they incur to develop or purchase computer software to be sold, leased, or otherwise marketed.

Front 83

Service Life or useful life(interchangeable)

Back 83

Estimated use the company expects to receive from the asset before disposing of it.


Expressed in units of time or activity


Physical life: Provides the upper bound for service life of tangible, long–lived assets. Will vary according to the purpose for which the asset is required and the environment in which it is operated.



Service life may be less than physical life for a variety of reasons, such as expected obsolescence or:


1. more efficient technology
2. market that demands new products, limiting current machinery's usefulness.
3. Economic feasibility of extraction methods
4. For intangibles, legal or contractual life is limiting factor

5. Management intent


Range of service lives for different categories of assets are disclosed by companies.

Front 84

Allocation base

Back 84

value of the usefulness that is expected to be consumed


initial value less salvage value

Front 85

Allocation method

Back 85

pattern in which the usefulness is expected to be consumed.



Should be systematic and rational and correspond to the pattern of asset use.


Objective is to allocate cost to the period in an amount that is proportional to the amount of benefits generated by the asst during the period relative to the total benefits provided by the asset during its life.

two approaches:


1. time based
2. activity based

Front 86

Salvage value or residual value

Back 86

amount the company expects to receive for the asset at the end of its service life less any anticipated disposal costs.


In certain situations, residual value can be estimated by referring to a company's prior experience or to publicly available information concerning reseal values of various types of assets.



However, estimating residual value for many assets can be very difficult due to uncertainty about the future. Thus, along with this reason and the fact that residual values are immaterial, many companies simply assume a residual value of zero.

Front 87

time based

Back 87

passage of time

Front 88

activity–based

Back 88

input or output

Front 89

Sum–of–the–years' digit (SYD) method

Back 89

Multiplies depreciable base by a declining fraction, resulting in depreciation that decreased by the amount year.


accelerates depreciation in systematic manner


denominator remains cost, while numerator decreases each year


denominator is the sum of one to n


numerator begins with value of n and decreases each year.


no logical foundation

Front 90

Straight line

Back 90

Allocates an equal amount of depreciable base to each year of the asset's service life.

Front 91

Double–declining balance(DDB) method

Back 91

When 200% is used as the multiple for the straight line rate, it's twice the straight line rate.

Front 92

Group Depreciation Method

Back 92

Defines the collection as depreciable assets that share similar service lives and other attributes, such as for a fleet of vehicles or machinery.

Front 93

Composite depreciation method

Back 93

Used when assets are physically dissimilar but are aggregated anyway to gain the convenience of a collective depreciation calculation, such as for all the depreciable assets in a manufacturing plant, even though the individual assets in the composite may have widely diverse service lives.d

Front 94

Depletion

Back 94

Allocation of cost of natural resources.


Units of production method


Service life is estimated amount natural resource to be extracted.


Depletion base is cost less residual value


Residual value could be significant if cost includes land that has a value after the natrual resource has been extracted.


Credit is usually to asset, but contra account(accumulated depletion) is acceptable as well.



Depletion is a product cost and included in the cost of the inventory of coal and when sold is included in COGS.



Excavation equipment that can be moved and used on future projects has a depreciable base that should be allocated over its useful life.



If it can't be moved, then it's depreciated over useful life or the life of the natural resource, whichever is shorter.


The units of production method often is used to determine depreciation and amortization on assets used in the extraction of natural resources; activity base same as that used for depletion of natural resources.

Front 95

Amortization

Back 95

Allocation the cost of intangible assets.



For an finite life intangible asset, we allocate its capitalized cost less any residual value to periods in which the asset is expected to contribute to the company's revenue generating activities.



1. Useful Life
2. residual value
3. allocation method

Front 96

Half Year convention

Back 96

A simplifying convention used to compute partial year's depreciation by recording one–half of a full year's depreciation in the year of acquisition and another half year in the year of disposal.

Front 97

Additions(subsequent expenditures)

Back 97

Involve adding a new major component to an existing asset and should be capitalized because future benefits are increased.



ex: security system to builidng, refrigeration unit to truck, etc.


Capitalized cost includes all necessary expenditures to bring the addition to a condition and location for use, such as tearing down and removing a wall of an existing building for a building addition.


Capitalized cost is depreciated over the remaining useful life of the original asset or its own useful life, whichever is shorter.

Front 98

Improvements(subsequent expenditures)

Back 98

Involve the replacement of a major component of an asset.



Replacement can be a new component with the same traits as the old component or a new component with enhanced operating capabilities.



In either case, it usually increases future benefits and should be capitalized by increasing the book value of the related asset and depreciated over the useful life of the improved asset.



Three methods to record cost of improvements:


·

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Rearrangements(subsequent expenditures)

Back 99

Expenditures made to restructure an asset without addition, replacement, or improvement


Objective is to create new capability for an asset and not necessarily extend useful life.


If material and clearly increase future benefits, then they're capitalized and expensed in future periods benefited.



If not material or it's not certain that future benefits have increased, they should be expensed in the period incurred.


Cost of material rearrangements should be capitalized, while immaterial rearrangements should be expensed.