Chapter 6: Inventories

Question 1

Lower-of-Cost-or-Market Rule

Answer 1

If value of ending inventory is lower than the cost the inventory must be valued at cost OR at market value (whichever is lower)

• companies must “write down” (recognize a loss on the income statement) the inventory to its market value (replacement cost, not selling price) in the period where a decline below cost occurs

(principle of conservatism)

Question 2

LIFO Conformity Rule

Answer 2

A tax rule

If LIFO is used for tax purposes it must also be used for financial reportin

Question 3

Inventory costing methods

Answer 3

methods for finding unit cost.

• Specific Identification
• First-in, First-out (FIFO) *most used
• Last-in, First-out (LIFO) *2nd most used
• Average Cost

All cost flow assumptions
should be used consistently, but it is possible to change between them.

Question 4

Cost Flow Assumptions

Answer 4

Assumptions made by company about which units of inventory were sold
various methods approximate flow of inventory costs to determine cost of goods sold

Question 5

Specific Identification Costing Method

Answer 5

Rarely used
Items must be individually tagged to track cost so generally used for large, high-value items

• can be manipulated to boost income by selling low-cost units and vv

Question 6

First-In, First-Out Costing Method

Answer 6

FIFO
Ending inventory valued by taking the unit cost at the most recent purchase and working backwards until all current inventory is accounted for.

In a period of rising prices this results in the highest net income - is appealing to investors but results in higher taxes

Question 7

Average Cost Costing Method

Answer 7

All units valued by weighted average unit cost - new weighted average calculated after each purchase?

Assumes the similarity of all goods

Total cost of goods available for sale/ total units available for sale

In period of rising prices usually results in a net income between FIFO (higher) and LIFO (lower)

Question 8

Last-In, First-Out costing method

Answer 8

COGS valued at most recent purchase price

Ending inventory valued by taking the unit cost of the oldest purchase and working down until all units are accounted for

Not actually reflective of movement of goods (except for piled items like hay and coal?)
In periods of rising prices results in lower net income than FIFO - tends to defer income tax liability

Question 9

Cost of Goods Available For Sale

Answer 9

Total cost spent on inventory that was AVAILABLE to be sold during a period

Question 10

Conservatism

Answer 10

A business should report the least favorable figures in the financial statements when two or more possible options are presented

“Anticipate no gains but provide for all probable losses”

Question 11

Materiality Concept

Answer 11

A company must perform strictly proper accounting only for items that are significant to that businesses financial situation (relative to company size)

Question 12

Ownership of Goods in Transit

Answer 12

• Purchased goods not yet received/ Sold goods not yet delivered.
• Depends on who holds the legal title

FOB Shipping Point: Ownership passes to buyer when freight carrier accepts the goods

FOB Destination- Ownership passes to buyer when the goods are delivered to buyer

Consigned goods- ownership remains with originator

Question 13

Reason for Physical Inventory

Answer 13

Perpetual System:

• Check accuracy of records
• Determine amount of loss

Periodic System:

• Determine inventory on hand
• Determine costs of good sold

Question 14

Inventory Classifications

Answer 14

Merchandising: Merchandise Inventory

Manufacturing: Raw Materials, Work in Process, and Finished Goods

All considered current Assets

Question 15

Disclosure Principle

Answer 15

A businesses financial statements must report enough information for outsiders to make knowledgeable decisions about the company

• relevant
• faithful representation

-methods and procedures should be included in the foot notes

Question 16

Consistency Principle

Answer 16

Business should use the same accounting methods and procedures from period to period

Question 17

Journaling Lower-of-Cost-or-Market inventory write-down adjustment

Answer 17

Debit (increase) COGS
Credit (decrease) Merchandise inventory
both for the amount of difference in the merchandise value
have to disclose write-down in footnotes

Question 18

Effects of inventory errors on financial statements

Answer 18

Effects two periods

Error in period one will cause the reverse error in the next period

Total income corrected over two periods (assuming error is caught in the next period)

Question 19

Effects of overstating or understating inventory

Answer 19

Beginning Inventory:

• Overstated: COGS overstated, Net Income understated
• Understated: COGS understated, Net Income overstated

Ending Inventory:

• Overstated: COGS understated, Net Income overstated, Assets and Equity Overstated
• Understated: COGS overstated, Net Income understated, Assets and Equity Understated

Question 20

Financial statement effects of FIFO and LIFO

Answer 20

• In periods of inflation FIFO best approximates ending inventory costs
• In periods of inflation LIFO may significantly understate ending inventory costs

Tax effects during inflation:

• FIFO - highest inventory cost/ income/ taxes (CHECK THIS)
• LIFO - Lower net income / taxes

Question 21

Effects of costing methods on financial statements

Answer 21

In a period of rising inventory costs:

COGS: FIFO=lowest, LIFO= highest
Net Income: FIFO=highest, LIFO=lowest
End Merchandise Inventory: FIFO= highest, LIFO=lowest

In a period of declining inventory costs:
COGS: FIFO=highest, LIFO=lowest
Net Income: FIFO=lowest, LIFO=highest
End Merchandise Inventory: FIFO= lowest, LIFO=highest

Average weighted is always in the middle
Specific ID costing always varies

Question 22

Inventory Cost (COGS)

Answer 22

Includes all expenditures necessary to acquire goods and place them in a condition for sale.

Beginning inventory 
\+ Net purchases (purchases- returns and allowances- discounts)
= Goods available for sale (AFS)
- Ending inventory
= Cost of goods sold (COGS)

Question 23

Weighted average unit cost

Answer 23

Cost of goods available for sale (total)/ total units available for sale

Question 24

Days in Inventory

Answer 24

An inventory analysis ratio

= days in year/ inventory turnover ratio

Average number of days inventory is held

Question 25

Inventory Turnover Ratio

Answer 25

An Inventory Analysis ratio

= Cost of Goods Sold/ Average inventory

Average inventory = (beginning inventory + ending inventory)/ 2

Measures the number of times inventory is sold in a period

Question 26

IFRS vs GAAP years of reporting required

Answer 26

IFRS requires 2 years of income statement information

GAAP requires 3 years

Question 27

Inventory under IFRS

Answer 27

IFRS prohibits LIFO, only allows FIFO and Average cost

• any goods held in consignment are not included in inventory
• Market value = “net realizable sales price” rather than replacement price (as it does in GAAP)

Question 28

Inventory Write-UPS GAAP vs IFRS

Answer 28

IFRS- inventory value can be written-up, but entire class must be re-valued

GAAP- Inventory can only be written DOWN, not up.