Chapter 08: Inventory

Question 1

What are the inventory estimation methods

Answer 1

Gross profit method
Conventional retail method

Question 2

Why are the inventory methods needed

Answer 2

Companies that maintain periodic inventory systems must

1. estimate inventory for interim (end of year)
2. estimate inventory for losses, insurance claims, or to record income statement losses
3. compare estimate to physical count for internal purposes

Question 3

Which method is more accurate and why

Answer 3

Conventional retail method is more accurate because it has extra information not provided from other methods, thus making it more costly and accurate

Question 4

Which method is accepted by GAAP

Answer 4

The conventional retail method because it is more accurate, thus is acceptable for both interim dates and end of the fiscal year

Question 5

Which method is not accepted by GAAP

Answer 5

Gross profit method because it relies on estimates, thus only acceptable for interim dates

Question 6

Conventional retail: Solving for estimated end inventory - retail column

Answer 6

Beg. Inv
+ Purchases
= Goods available for sale
+ Markups
= Goods available for sale including markups
- Markdowns
= Goods available for sale, including ups/downs
- Net sales
= Estimated end inv

Question 7

Two methods to adjust the estimated end inventory to ‘at cost’

Answer 7

lower-of-average-cost-or-market
average cost approach

Question 8

lower-of-average-cost-or-market

Answer 8

estimated end inv [retail] x (goods available for sale [at cost] / goods available for sale adjusted for markups [retail])

Question 9

Average cost approach

Answer 9

estimated end inv [retail] x (goods available for sale [at cost] / goods available for sale adjusted for markups and markdowns [retail])

Question 10

Gross profit method to solve for the cost of goods available for sale

Answer 10

Beg. Inv
+ purchases
- purchase returns and allowances
- purchase discounts
+ freight-in
= cost of goods available for sale

Question 11

Gross profit method to plug in and solve for the merchandise inventory

Answer 11

Sales
- Returns/allowances
= Net sales

Gross profit = (38% x net sales)
Cost of goods sold = (Net sales - gross profit)

Merchandise inventory = (cost of goods available for sale - cost of goods sold)

Question 12

Where is the gross profit information found

Answer 12

All information is found in the general ledger EXCEPT the estimated historical gross profit percentage (percentage given to us)

Question 13

Why are some industries allowed to record at NRV and not the lowe-of-cost-or-market (LCM) that is required under GAAP

Answer 13

Some industries such as metal mining, agriculture, and meatpacking companies are allowed to use the NRV due to being easier, more accurate, and makes more sense.

Question 14

What are the four theoretical reasons for using NRM instead of LCM

Answer 14

1. The market exists, easy to determine value
2. Buyers will always exists
3. Low completion cost
4. Revenue is considered earned before sale

Question 15

What are the practical reasons for using NRV and not LCM

Answer 15

1. The cost of ending inventory is too difficult to determine
2. Materiality

Question 16

What is the relative sales method

Answer 16

A group of varying units is purchased at a single lump sum price. So, we must allocate that price across all the products to match the relative value of each item

Question 17

Steps to solve for the relative sales value

Answer 17

Units x sales price = sales value + each unit + etc…

Individual sale value /Total sales value = % of each sale

% x Total lump sum cost = acquisition cost

acquisition cost/ cost per unit = cost of each unit

Question 18

Merchandise inventory turnover equation

Answer 18

Cost of goods sold / Average merchandise inventory

*measured in times

Question 19

Days in merchandise inventory

Answer 19

Operating days / Merchandise turnover

Question 20

Disclosure requirements

Answer 20

1. All inv methods must be disclosed and not be normally changed, would violate the consistency principle
2. WIP, finished goods, etc, must be disclosed
3. Unusual or significant financing arrangements must be disclosed
   - Party-related transactions
   - product financing arrangements
   - Involuntary liquidation of LIFO inventories
   - Pledging

Question 21

Inventories may be disclosed as what

Answer 21

Current value or constant-dollar, but no longer required

Question 22

Stating gross profit as a percentage of sales

Answer 22

Gross profit / Net sales

Question 23

Stating gross profit as a percentage of cost

Answer 23

Gross profit / Cost of goods sold

Question 24

Equation to go from a % of sales to a % of cost

Answer 24

GP % of sales / (1-GP % of sales)

Question 25

Equation to go from % of cost to % of sales

Answer 25

GP % of cost / (1+ GP% of cost)

Question 26

Market for LIFO and retail method

Answer 26

Replacement cost, but with a ceiling and a floor

Question 27

Market for FIFO, average, and Specific identification

Answer 27

NRV (selling price - cost to sell)

Question 28

Lower of cost or market (LCM)

Answer 28

Rule required by GAAP stating inventory must be reported at the lower cost of either the market or its cost

Question 29

Why does LCM exist

Answer 29

For conservatism

Question 30

Ceiling cost

Answer 30

Selling price - cost to sell (NRV)

Question 31

Floor cost

Answer 31

NRV - normal markup

Question 32

What does it mean if the replacement cost is greater than the ceiling cost

Answer 32

The ceiling cost becomes the new market cost

Question 33

What does it mean if the replacement cost is less than the floor cost

Answer 33

The floor cost becomes the new market cost

Question 34

What does it mean that LCM is not an optional convention

Answer 34

Even if you believe the market place drop is temporary, inventory must still be written down and can not be written back up