10.6: Summary

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