Inventories

Question 1

How does mercandise flow through an organization with respect to the financial statements for a merchandiser?

Answer 1

• Goods are purchased(purchasing activities)
• They go to merchandise inventory(inventory on the balance sheet)
• Then to COGS(Expense on the income statement)

Question 2

What is the cost flow assumptions trying to accomplish?

Answer 2

Cost flow assumptions are basically allocating costs between what’s going to be left on the balance sheet and what will go through to the income statement.

Question 3

When prices are rising, what inventory method will result in a higher gross profit?

Answer 3

FIFO gross profit will be higher, and LIFO gross profit would be lower.

Question 4

What is the primary motivator for using LIFO?

Answer 4

To pay less taxes.

Question 5

Why is tax lower under LIFO?

Answer 5

LIFO defers inclusion of holding gains in income, FIFO doesn’t.

LIFO tax savings for the year = the deferred holding gain for the year X the tax rate.

Cumulative LIFO tax savings = cumulative deferred holding gains X the tax rate.

Question 6

What would a LIFO repeal do?

Answer 6

It would trigger huge gains in the year of the repeal. It would trigger a huge tax increase, possibly even exceeding retained earnings for some businesses.

Question 7

Whats the difference between a holding gain and a trading gain?

Answer 7

A holding gain is when the replacement cost of currently held inventory goes up… if a widget bought for $100 is now worth $150, that’s a $50 holding gain.

A trading gain is the difference between the selling price of the item and the replacement cost. So if the item with a replacement cost of $150 is sold for $200, there is a $50 trading gain.

Question 8

Under FIFO, ending inventory on the balance sheet reflects ___________.

Ratios using balance sheet amounts under FIFO are __________.

Answer 8

Current costs.

Fairly stated.

Question 9

Under FIFO, COGS on the income statement reflects ___________.

Answer 9

Older costs.

Question 10

Assuming rising prices, FIFO income includes both _______ and ________.

Answer 10

Trading gains and holding gains.

Question 11

Under LIFO, ratios using balance sheet amounts could be ___________.

Answer 11

Materially misstated.

Question 12

Under LIFO, COGS on the income statement reflect _________.

Answer 12

Current costs.

Question 13

LIFO income only includes__________.

Answer 13

Trading gains.

Question 14

The cumulative holding gain is sometimes called the __________.

Answer 14

LIFO reserve.

Question 15

What happens in a LIFO liquidation?

Answer 15

When a company sells more units than it purchases and LIFO layers built up in the past are liquidated.

Question 16

What can cause an unintentional LIFO liquidation?

When would a company use an intentional LIFO liquidation?

Answer 16

• Supplier’s strike
• Unanticipated demand
• Discontinued products

To increase reported income.

Question 17

What accounts will change if you use the LIFO reserve to compute ratios?

Answer 17

• inventory
• current assets
• total assets
• stockholders’ equity

Question 18

What is FIFO’s impact on analysis?

Answer 18

Impact on Analysis FIFO

• Income includes holding & trading gains.
• Future holding gains depend on prices in product markets.
  
  • Outside of management’s control and less correlated over time.
• Future trading gains depend on strategic choices, economic and competitive environment.
  
  • Under management’s control and more correlated over time.

To assess how big of an issue this is need to split gross profit between holding and trading gains.
Firm’s don’t disclose either component, so users must estimate holding gains.

Question 19

What’s the formula to estimate a holding gain?

Answer 19

Beginning FIFO inventory X the inflation rate applicable to the firm’s products.