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10.7: Summary

  • Page ID
    10043
  • 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions

    • The total cost of goods available for sale is a combination of the beginning inventory plus new inventory purchases. These costs relating to goods available for sale are included in the ending inventory, reported on the balance sheet, or become part of the cost of goods sold reported on the income statement.
    • Merchandise inventory is maintained using either the periodic or the perpetual updating system. Periodic updating is performed at the end of the period only, whereas perpetual updating is an ongoing activity that maintains inventory records that are approximately equal to the actual inventory on hand at any time.
    • There are four basic inventory cost flow allocation methods, which are alternative ways to estimate the cost of the units that are sold and the value of the ending inventory. The costing methods are not indicative of the flow of the goods, which often moves in a different order than the flow of the costs.
    • Utilizing different cost allocation options results in marked differences in reported cost of goods sold, net income, and inventory balances.

    10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method

    • The periodic inventory system updates inventory at the end of a fixed accounting period. During the accounting period, inventory records are not changed, and at the end of the period, inventory records are adjusted for what was sold and added during the period.
    • Companies using the periodic and perpetual method for inventory updating choose between the basic four cost flow assumption methods, which are first-in, first-out (FIFO); last-in, first-out (LIFO); specific identification (SI); and weighted average (AVG).
    • Periodic inventory systems are still used in practice, but the prevalence of their use has greatly diminished, with advances in technology and as prices for inventory management software have significantly decreased.

    10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method

    • Perpetual inventory systems maintain inventory balance in the company records in a real-time or slightly delayed, continuously updated state. No significant adjustments are needed at the end of the period, before issuing the financial statements.
    • Companies using the perpetual method for inventory updating choose between the basic four cost flow assumption methods, which are first-in, first-out (FIFO); last-in, first-out (LIFO); specific identification (SI); and weighted average (AVG).
    • Most modern inventory systems utilize the perpetual inventory system, due to the benefits it offers for efficiency, ease of operation, availability of real-time updating, and accuracy.

    10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet

    • The value for cost of the goods available for sale is dependent on accurate beginning and ending inventory numbers. Because of the interrelationship between inventory values and cost of goods sold, when the inventory values are incorrect, the associated income statement and balance sheet accounts are also incorrect.
    • Inventory errors at the beginning of a reporting period affect only the income statement. Overstatements of beginning inventory result in overstated cost of goods sold and understated net income. Conversely, understatements of beginning inventory result in understated cost of goods sold and overstated net income.
    • Inventory errors at the end of a reporting period affect both the income statement and the balance sheet. Overstatements of ending inventory result in understated cost of goods sold, overstated net income, overstated assets, and overstated equity. Conversely, understatements of ending inventory result in overstated cost of goods sold, understated net income, understated assets, and understated equity.

    10.5 Examine the Efficiency of Inventory Management Using Financial Ratios

    • Inventory ratio analysis tools help management to identify inefficient management practices and pinpoint troublesome scenarios within their inventory operations processes.
    • The inventory turnover ratio measures how fast the inventory sells, which can be useful for inter-period comparison as well as comparisons with competitor firms.
    • The number of days’ sales in inventory ratio indicates how long it takes for inventory to be sold, on average, which can help the firm identify instances of too much or too little inventory, indicating such cases as product obsolescence or excess stocking, or the reverse scenario: insufficient inventory, which could result in customer dissatisfaction and lost sales.

    Key Terms

    accounts receivable
    outstanding customer debt on a credit sale, typically receivable within a short time period
    accounts receivable turnover ratio
    how many times accounts receivable is collected during an operating period and converted to cash
    accrual accounting
    records transactions related to revenue earnings as they occur, not when cash is collected
    allowance for doubtful accounts
    contra asset account that is specifically contrary to accounts receivable; it is used to estimate bad debt when the specific customer is unknown
    allowance method
    estimates bad debt during a period based on certain computational approaches, and it matches this to sales
    bad debts
    uncollectible amounts from customer accounts
    balance sheet aging of receivables method
    allowance method approach that estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account
    balance sheet method
    (also, percentage of accounts receivable method) allowance method approach that estimates bad debt expenses based on the balance in accounts receivable
    completed contract method
    delays reporting of both revenues and expenses until the entire contract is complete
    contra account
    account paired with another account type that has an opposite normal balance to the paired account; reduces or increases the balance in the paired account at the end of a period
    direct write-off method
    delays recognition of bad debt until the specific customer accounts receivable is identified
    earnings management
    works within GAAP constraints to improve stakeholders’ views of the company’s financial position
    earnings manipulation
    ignores GAAP rules to alter earnings significantly to improve stakeholder’s views of the company’s financial position
    income statement method
    allowance method approach that estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected
    installment sale
    periodic installment payments from buyers
    interest
    monetary incentive to the lender, which justifies loan risk; interest is paid to the lender by the borrower
    interest rate
    part of a loan charged to the borrower, expressed as an annual percentage of the outstanding loan amount
    issue date
    point at which the security agreement is initially established
    matching principle
    (also, expense recognition principle) records expenses related to revenue generation in the period in which they are incurred
    maturity date
    date a bond or note becomes due and payable
    net realizable value
    amount of an account balance that is expected to be collected; for example, if a company has a balance of $10,000 in accounts receivable and a $300 balance in the allowance for doubtful accounts, the net realizable value is $9,700
    note receivable
    formal legal contract between the buyer and the company, which requires a specific payment amount at a predetermined future date, usually includes interest, and is payable beyond a company’s operating cycle
    number of days’ sales in receivables
    expected days it will take to convert accounts receivable into cash
    percentage of completion method
    percentage of work completed for the period divided by the total revenues from the contract
    principal
    initial borrowed amount of a loan, not including interest; also, face value or maturity value of a bond (the amount to be paid at maturity)
    receivable
    outstanding amount owed from a customer
    revenue recognition principle
    principle stating that company must recognize revenue in the period in which it is earned; it is not considered earned until a product or service has been provided