MUHASEBE I - Deneme Sınavı - 12

Depending on the cost flow method used the cost of ending inventory and the cost of goods sold reported are directly affected. It is in fact critical for companies to decide which cost flow method to adopt, and there are several factors that affect their decision. The first factor that limits the choice of companies is the requirements of regulatory bodies. LIFO is forbidden by most of the regulators especially by the ones in hyper-inflationary economies. The other factor which affects the decision made is the purpose of the company. In other words, if the company is planning to sell its shares in the market, then it wants to be evaluated as a profitable company and would prefer to choose the method which will show its financials in a more profitable way. On the other hand, if a company wants to pay less tax, then it would prefer to choose the method which will show the company less profitable.

Inventories can can simply be defined as asset items that a company holds for sale in the ordinary course of business, or items that will be used or consumed in the production of goods to be sold (IAS 2- Inventories). From this definition, we understand that inventories can come out as different categories in companies depending on their activities. A merchandising company usually purchases its merchandise in a form ready for sale and reports only the cost assigned to unsold units left on hand as “Merchandise Inventory” in its financial statements. A manufacturing company produces goods and usually sells them to merchandising firms. Although the products they produce may differ, manufacturers normally have three inventory accounts in their financial statements.

Although the products they produce may differ, manufacturers normally have
three inventory accounts in their financial statements: raw materials, work in process, and finished goods.
Raw Materials Inventory reports the cost of goods and materials on hand which will be used in production.
Work in Process Inventory reports the cost of goods, materials and other components of manufacturing process used for the inventory which are still in production process, in other words unfinished at the time
financial statements are prepared.
Finished Goods Inventory reports the cost of goods, materials and other components of manufacturing process used for the inventory produced and available for sale.
In other words, inventories for manufacturing companies are raw materials, work-in-process products and finished goods that are considered to be portions of a business’s assets that are ready or will be ready for sale

The consistency principle holds that companies should use the same accounting methods and procedures in each accounting period, so that the information provided will help investors and creditors to compare a company’s financial statements from one period to the next. For example, assume that you are analyzing a company’s net income over a two-year period in which there was a decrease in net income from the first year to the second. Analysis of the income statement shows that Sales Revenue was almost the same for both years, but Cost of Goods Sold increased significantly, which resulted in decreases in gross profit and operating income.

Conservatism in accounting means being careful in reporting items in the financial statements. Conservatism follows these ideas: 
• Anticipate no gains, but provide for all probable losses.
• If in doubt, record an asset the lowest reasonable amount and reliability at the highest reasonable amount.
• When there is a question, record an expense rather than an asset.
• When you are faced with a decision between two possible options, you must choose the option that undervalues, rather than overvalues, your business
The purpose of conservatism is to report realistic figures and never exaggerate assets or net income

Perpetual Inventory System is a system of tracking and recording inventory and costs of goods sold on a continual basis, so current inventory balance can be calculated on real time basis, and the accounting system can display the current inventory balance at any point in time. The perpetual inventory system keeps a running computerized record of merchandise inventory, that is, the number of inventory units and the money amounts associated with the inventory are perpetually (continuously) updated.

The specific identification method uses the specific cost of each inventory unit to determine ending inventory and cost of goods sold. Specific identification requires that companies keep records of the original cost of each individual inventory item. In the specific identification method, the company knows exactly which item was sold and exactly what the item cost. The specific identification method is impractical unless each unit can be identified accurately. This costing method is best for businesses that sell unique, easily identified inventory items, such as jeweler (a specific diamond earring), an automobile dealer (each automobile has a unique serial number) and real estate (identified by address). This method requires the business maintains detailed records of inventory sales and purchases as well as carefully identifying the inventory sold.

The First-In, First-Out (FIFO) method assumes that the earliest goods purchased arethe first to besold. Under the first-in, first-out (FIFO) method, the cost of goods sold is based on the oldest purchases – that is, the first units to come in are assumed to be the first units to go out of the warehouse (sold). FIFO costing is consistent with the physical movement of inventory (for most companies). That is, under the FIFO inventory costing method, companies sell their oldest inventory first.

Lower of Cost or Market Value Method (LCM) is a valuation method which requires inventory to be reported in financial statements at whichever is lower – its historical cost or its market value. Net Realizable Value is the estimated sales value minus estimated cost of completion and minus estimated cost of sale.

Inventory Turnover Ratio measures number of times a company sells average level of merchandise inventory during a period. Companies always try to manage their inventory levels in a way to meet their customer demand on a timely basis without making large investments. Inventory turnover ratio is used to determine how frequently merchandise inventory is sold

Organizations pay more and more attention to their inventory management systems every single day because effective inventory management is accepted as a fundamental measure of the overall health and success of a business. There are two financial ratios which are used by managers to monitor their inventory levels: Inventory Turnover Ratio and Days’ Sales in Inventory.

A company must perform strictly proper accounting only for items that are significant to the business’s financial situation according to the materiality concept requirements.

Anticipate no gains, but provide for all probable losses.If in doubt, record an asset the lowest reasonable amount and reliability at the highest reasonable amount.
• When there is a question, record an expense rather than an asset.
• When you are faced with a decision between two possible options, you must choose the option that undervalues, rather than overvalues, your business
The purpose of conservatism is to report realistic figures and never exaggerate assets or net income.

Inventory Cost Flow Method is a method of approximating the flow of inventory costs in a business that is used to determine the amount of cost of goods sold and ending merchandise inventory.

The specific identification method uses the specific cost of each inventory unit to determine ending inventory and cost of goods sold. Specific identification requires that companies keep records of the original cost of each individual inventory item. In the specific identification method, the company knows exactly which item was sold and exactly what the item cost.

In order to find out the reporting value for inventories on hand, we have to compare cost with market value. In this question, we know the cost was TL 10,000, but we have to calculate market value or net realizable value. When we deduct estimated cost of sales from estimated sales value, we find it as TL 13,500. Since the cost is lower, we keep on reporting inventories with TL 10,000.

Inventory Turnover Ratio = Cost of Goods Sold / 
Average Merchandise Inventory

Days’ Sales in Inventory ratio measures the number days that inventory is held by a company.

Net Realizable Value is the estimated sales value minus estimated cost of completion and minus estimated cost of sale.

The cost of goods sold is based on the most recent purchases (new costs) –that is, the last units in are assumed to be the first units out of the warehouse (sold). This
method is forbidden for being misleading especially in hyperinflationary economies.