Inventories chapter 7

Question 1

Company X uses FIFO for its inventory
valuation and Company Y uses LIFO under
U.S.GAAP, all other respects are identical. If
the prices are rising, Company X is most
likely to have a higher:
A. Tax liability
B. Inventory turnover
C. CFO

Answer 1

Ans: A
FIFO: The cost of the first item purchased is the
cost of the first item sold. Ending inventory is
based on the cost of the most recent purchases,
thereby approximating current cost.
LIFO: The cost of the last item purchased is the
cost of the first item sold. Ending inventory is
based on the cost of the earliest items
purchased.
So when prices are rising, FIFO results in a lower
COGS. FIFO also results in lower inventory
turnover (due to lower COGS and higher inventory balances), a higher tax liability (due to
a higher pretax income) and a lower CFO (due to
the higher tax payments).

B. Company X uses FIFO so its inventory
turnover should be lower due to lower COGS and
higher inventory balances.
C. Company X uses FIFO so its CFO should be
lower due to the higher tax payments.

Question 2

Under U.s.GAAP, a LIFO liquidation occurs
when the:
A. LIFO reserve value increases.
B. Firm changes from LIFO to FIFO
C. Quantity of goods sold is greater than the
quantity produced.

Answer 2

Ans: C
Under U.S.GAAP, a LIFO inventory liquidation
occurs when more products are sold than are
purchased or produced, causing the firm to dip
into older, lee expensive inventory.
B. Changing from LIFO to FIFO is made
retrospectively. Under U.S.GAAP, the firm must
explain why the change in cost flow method is
preferable. But this change is not LIFO inventory
liquidation.

Question 3

A company currently uses LIFO inventory
valuation under U.S.GAAP. The company
reported an increase in the LIFO reserve for
the year. If the company used FIFO rather
than LIFO:
A. COGS is lower and net income is lower.
B. CFGO is lower and net income is higher.
C. COGS is higher and net income is lower.

Answer 3

Ans. B.
Under U.S.GAAP, a LIFO reserve increase
indicates that the prices were increasing and the
difference in inventory cost using LIFO and FIFO
valuation methods increased over the period.
During periods of rising prices, LIFO records a
higher COGS than FIFO because the LIFO
method uses the newer, more expensive
inventory for COGS. If COGS are higher, net
income will be lower. If the company used FIFO
rather than LIFO, the effects will be reversed.
Thus, COGS will be lower and the net income will
be higher.

Question 4

Assuming flat year-over-year sales in a
declining price environment under U.S.GAAP,
a firm might expect cash flow from
operations (CFO) and working capital (WC)
under the LIFO (rather than FIFO) inventory
method to be:
A. Lower for both CFO and WC.
B. Lower for CFO and higher for WC.
C. Higher for CFO and lower for WC.

Answer 4

Ans. B.
Under U.S.GAAP, in a declining price
environment, LIFO results in a lower COGS, a
higher gross profit margin, and higher taxable
income. Higher taxable income results in higher
tax outflows and lower after-tax cash flows from
operations (CFO). In the declining price
environment, inventory balances and working
capital reflect the higher cost of the earlier, lower
priced inventory.

Question 5

Which of the following inventory valuation
methods best matches the actual historical
cost of the inventory items to their physical
flow?
A. FIFO.
B. LIFO.
C. Specific identification.

Answer 5

Ans. C.
Specific identification best matches the physical
flow of the inventory items because it tracks the
actual units that are sold.

Question 6

For which of the following assets is it most
appropriate to test for impairment at least
annually?
A. Land.
B. A patent with a legal life of 20 years.
C. A trademark with an expected indefinite
life.

Answer 6

Ans: C.
Intangible assets with indefinite lives need to be
tested for impairment at least annually.
B and C are incorrect. PP&E (including land) and
intangibles with finite lives are only tested if
there has been a significant change or other
indication of impairment.

Question 7

Compared with using the FIFO method to
account for inventory, during a period of
rising prices, which of the following ratios is
most likely higher for a company using LIFO?
A. Current ratio
B. Gross margin
C. Inventory turnover

Answer 7

Ans: C.
During a period of rising prices, ending inventory
under LIFO will be lower than that of FIFO and
cost of goods sold higher; therefore, inventory
turnover (CGS/average inventory) will be higher.

Question 8

A company which prepares its financial
statements using IFRS wrote down its
inventory value by €20,000 in 2009. In 2010,
prices increased and the same inventory was
worth €30,000 more than its value at the end
of 2009. Which of the following statements is
most accurate? In 2010, the company’s cost
of sales:
A. was unaffected.
B. decreased by €20,000.
C. decreased by €30,000.

Answer 8

Ans: B.
Under IFRS, inventory is reported on the balance
sheet at the lower cost or net realizable value.
Net realizable value is equal to the expected
sales price less the estimated selling costs and
completion costs. If net realizable value is less
than the balance sheet value f inventory, the
inventory is “write down” to net realizable value
and the loss is recognized in the income
statement. Is there is a subsequent recovery in
value, the inventory can be “write up” and the
gain is recognized in the income statement by
reducing COGS by the amount of the recovery.
Because inventory is valued at the lower of cost
or net realizable value, inventory cannot be
written up by more than it was previously
written down
11. A company which prepares its financial
statements using IFRS wrote down its
inventory value by €20,000 in 2009. In 2010,
prices increased and the same inventory was
worth €30,000 more than its value at the end
of 2009. Which of the following statements is
most accurate? In 2010, the company’s cost
of sales:
A. was unaffected.
B. decreased by €20,000.
C. decreased by €30,000.
Ans: B.
Under IFRS, inventory is reported on the balance
sheet at the lower cost or net realizable value.
Net realizable value is equal to the expected
sales price less the estimated selling costs and
completion costs. If net realizable value is less
than the balance sheet value f inventory, the
inventory is “write down” to net realizable value
and the loss is recognized in the income
statement. Is there is a subsequent recovery in
value, the inventory can be “write up” and the
gain is recognized in the income statement by
reducing COGS by the amount of the recovery.
Because inventory is valued at the lower of cost
or net realizable value, inventory cannot be
written up by more than it was previously
written down.
In this question, the recovery of previous write-
down is limited to the amount of the original
write-down (€20,000) and is reported as a
decrease in the cost of sales.

Question 9

A review of a company’s inventory
records for the year indicates that the
following costs were incurred:
Fixed production overhead:
$500,000
Direct material and direct labor:
300,000
Storage costs incurred during production:
25,000
Abnormal waste
costs: 30,000
If the company operated at full capacity
during the year, the total capitalized
inventory cost is closest to:
A. $800,000.
B. $825,000.
C. $855,000.

Answer 9

Ans: B.
The total capitalized costs include fixed
production costs, the direct conversion costs of
material and labor, storage costs required as part
of production but not abnormal waste costs.
$500,000 + 300,000 + 25,000 = $825,000.

Question 10

In a period of rising prices, when
compared to a company that uses weighted
average cost for inventory, a company using
FIFO will most likely report higher values for
its:
A. return on sales.
B. debt-to-equity ratio.
C. inventory turnover.

Answer 10

Ans: A.
In periods of rising prices FIFO results in a
higher inventory value and a lower cost of goods
sold and therefore a higher net income. The
higher net income increases return on sales.
B is incorrect. The higher reported net income
also increases retained earnings, and therefore
results in a lower debt-to-equity ratio not a
higher one.
C is incorrect. The combination of higher
inventory and lower cost of goods sold decreases
inventory turnover (CGS/inventory).

Question 11

A company, which prepares its financial
statements in accordance with IFRS is in the
process of developing a more efficient
production process for one of its primary
products. The most appropriate accounting
treatment for those costs incurred in the
project is to:
A. expense them as incurred.
B. capitalize costs directly related to the
development.
C. expense costs until technical feasibility has
been established.

Answer 11

Ans: C.
Under IFRS research and development costs are
expensed until certain criteria are met, including
that technical feasibility has been established
and the company intends to use it.

Question 12

Due to global oversupply in the micro-
chip industry a company wrote down its 2012
inventory by €4.0 million from €12.0 million.
The following year, due to a change in
competitive forces in the industry the market
price of these chips rose sharply to 10%
above their original 2012 value. If the
company prepares its financial statements in
accordance with International Financial
Reporting Standards (IFRS), its 2013
inventory (in €-millions) will most likely be
reported as:
A. 8.0.
B. 12.0.
C. 13.2.

Answer 12

Ans: B.
Although IFRS does require write-downs, it also
allows revaluations, but not to exceed the
original value, i.e., 12. The exception to this,
where gains are allowed, is in producers of
agricultural, forest and resource products.

Question 13

Is the reversal of an inventory write-
down permitted under U.S. GAAP (generally
accepted accounting principles) and
International Financial Reporting Standards
(IFRS)?
A. No, under both
B. Yes, under both
C. Yes under IFRS but not under U.S. GAAP

Answer 13

Ans: C.
The reversal of an inventory write-down is
permitted under IFRS but not under U.S. GAAP.
Under IFRS, inventory is reported on the balance
sheet at the lower cost or net realizable value.
Net realizable value is equal to the expected
sales price less the estimated selling costs and
completion costs. If net realizable value is less
than the balance sheet value f inventory, the
inventory is “write down” to net realizable value
and the loss is recognized in the income
statement. Is there is a subsequent recovery in
value, the inventory can be “write up” and the
gain is recognized in the income statement by
reducing COGS by the amount of the recovery.
Because inventory is valued at the lower of cost
or net realizable value, inventory cannot be
written up by more than it was previously
written down.

Question 14

A company uses the LIFO inventory
method, but most of the other companies in
the same industry use FIFO. Which of the
following best describes one of the
adjustments that would be made to the
company’s financial statements to compare it
with other companies in the industry? The
amount reported for the company’s ending
inventory should be:
A. increased by the ending balance in its
LIFO reserve.
B. decreased by the ending balance in its
LIFO reserve.
C. increased by the change in its LIFO
reserve for that period.

Answer 14

Ans: A.
LIFO Reserve = FIFO Inventory – LIFO Inventory
Adding the ending balance in the LIFO reserve to
the LIFO inventory would equal the ending
balance for inventory on a FIFO basis.

Question 15

A company using the LIFO inventory
method reports a LIFO reserve at year-end of
$85,000, which is $20,000 lower than the
prior year. If the company had used FIFO
instead of LIFO in that year, the company’s
financial statements would have reported:
A. a lower cost of goods sold, but a higher
inventory balance.
B. a higher cost of goods sold, but a lower
inventory balance.
C. both a higher cost of goods sold and a
higher inventory balance.

Answer 15

Ans: C.
The negative change in the LIFO reserve would
increase the cost of goods sold under FIFO
compared to LIFO.
FIFO COGS = LIFO COGS – Change in LIFO
reserve.
The LIFO reserve has a positive balance so that
FIFO inventory would be higher than LIFO
inventory.
FIFO inventory = LIFO inventory + LIFO reserve.

Question 16

The year-end balances in a company’s
LIFO reserve are $56.8 million in the
company’s financial statements for both 2007
and 2008. For 2008, the measure that will
most likely be the same regardless of
whether the company uses the LIFO or FIFO
inventory method is the:
A. inventory turnover.
B. gross profit margin.
C. amount of working capital.

Answer 16

Ans: B.
The LIFO reserve did not change from 2007 to
2008. Without a change in the LIFO reserve, cost
of goods sold would be the same under both
methods. Sales are always the same for both; so
gross profit margin would be the same in 2008.
A is incorrect. The FIFO inventory would be
higher because the LIFO inventory and LIFO
reserve are added to compute FIFO inventory.
FIFO inventory = LIFO inventory + LIFO reserve
Because the inventory balances would be
different under FIFO, inventory turnover (COGS/
Ave. inventory) would also be different under
FIFO.
C is incorrect.
Working capital= CA-CL
Because the FIFO inventory would be higher, the
amount of working capital under FIFO would also
be higher.

Question 17

Which inventory method best matches
the actual historical cost of the inventory sold
with their physical flow if a company is using
a perpetual inventory system?
A. FIFO.
B. LIFO.
C. specific identification

Answer 17

Ans: C.
Specific identification matches the actual
historical costs of the specific inventory items to
their physical flow: the cost remain in inventory
until the actual identifiable inventory is sold

Question 18

Greene Corporation uses the LIFO
inventory method, but most of other
companies in Greene’s industry use FIFO.
Which of the following best describe one of
the adjustments that would be made to
Greene’s financial statements to compare
that company with other companies in the
industry? To adjust Greene’s inventory to the
FIFO method, the amount reported for
Greene’s ending inventory should be:
A. increase by the ending balance in Greene’s
LIFO reserve.
B. decrease by the ending balance in
Greene’s LIFO reserve.
C. increase by the change in Greene’s LIFO
reserve for that period.

Answer 18

Ans:A.
Adding the ending balance in the LIFO reserve to
the FIFO inventory would equal the ending
balance for inventory on a FIFO basis.
(LIFO Reserve = FIFO Inventory – LIFO
Inventory

Question 19

Which of the following would be the most
useful ratio from a financial analysis
perspective, rather than from an accounting
perspective, assuming a rising price
environment?
A. Calculating the current ratio by using the
current assets determined with LIFO.
B. Determining the inventory turnover by
using cost of goods sold prepared on a FIFO
basis and average inventory prepared on a
LIFO basis.
C. Determining the return on assets by using
net income prepared on a LIFO basis and
average total assets prepared on a FIFO
basis.

Answer 19

Ans: C.
In a rising environment, the most useful ratio
from a financial analysis perspective would be to
calculate the return on assets by using the lower
more conservative net income prepared on a
LIFO basis and average assets (inventory)
prepared on a FIFO basis (to include more
current cost data in the inventory).
A is incorrect. Calculating the current ratio with
current assets determined with FIFO, not LIFO,
would be most useful to a financial analyst.
B is incorrect. The best measure to obtain an
adjustment inventory turnover ratio would be to
use cost of goods sold prepared on a LIFO basis
and average inventory prepared on a FIFO basis
(highest inventory). This choice is reversed.

Question 20

If the company uses the perpetual inventory
system versus the periodic inventory system,
the gross margin would most likely be:
A. Lower.
B. Higher.
C The same

Answer 20

Ans: C.
When using the FIFO inventory method the
ending inventory, the cost of goods sold and the
gross margin are the same under either the
perpetual or periodic methods.

Question 21

An analyst can most accurately identify a
LIFO liquidation by observing a(n):
A. increase in gross margin.
B. decrease in the LIFO reserve.
C. change in inventory out of line with
change in sales.

Answer 21

Ans: B.
The most appropriate way to identify a LIFO
liquidation is by reviewing the inventory
footnotes for a decrease in the LIFO reserve.
A and C are incorrect. Although a LIFO
liquidation may result in an increase in gross
margin or changes in inventory out of line with
changes in sales, there are other factors that
could explain those changes.

Question 22

During a period of declining prices, a
company using LIFO inventory method
instead of FIFO will most likely report:
A. lower current assets and higher gross
income.
B. higher current assets and lower gross
income.
C. higher current assets and higher gross
income.

Answer 22

Ans: C.
If prices were declining, using LIFO would match
the lower (most recent) costs with current sales.
Costs of goods sold would be lower with LIFO
and gross profit (income) would be higher
compared to using FIFO. Lower cost of goods
sold means inventory balances, consisting of
older higher priced items, would be higher using
LIFO, increasing current assets relative to FIFO.

Question 23

An adjustment to operating income for
the effects of a change in LIFO reserve will
most likely be required if the change in the
LIFO reserve is the result of:
A. price declines.
B. a decrease in the number of unites held in
inventory.
C. a increase in the number of unites held in
inventory.

Answer 23

Ans: C.
A liquidation of LIFO inventory produces
unsustainable profit margins because old costs
are being matched with current revenues.

Question 24

All else, will a company’s implementation
of the accounting standard (SFAS 143)
related to asset retirement obligations
incurred because of environmental most
likely:
A. increase return on assets but decrease net
income.
B. decrease return on assets but increase net
income.
C. decrease both return on assets and net
income.

Answer 24

Ans: C.
Implementation of SFAS 143 requires that
companies record an asset and related liability
for costs involved in the remedy of
environmental damage. The increase in assets
will decrease return on assets and the increase
in depreciation and accretion expense will reduce
net income.

Question 25

During period of rising prices:
A. LIFO COGS > Weighted Average COGS >
FIFO COGS.
B. LIFO COGS > Weighted Average COGS <
FIFO COGS.
C. LIFO COGS < Weighted Average COGS <
FIFO COGS.

Answer 25

Ans: A.
During period of rising prices, the last units
purchased are more expensive than the existing
units. Under LIFO, the cost of the last units
purchased is assigned to COGS. This higher
COGS results in lower income, as compared to
the FIFO method. As the name suggests, the
weighted average method is based on
mathematical averages rather than timing of
purchase/ use. Thus, COGS using this method
falls between that of LIFO and FIFO.

Question 26

Which of the following accounting
practices is most likely to decrease reported
earnings in the current period?
A. Using the straight-line method of
depreciation instead of an accelerated
method.
B. Capitalizing advertising expenses rather
than expensing them in the current period.
C. Using LIFO inventory cost methods during
a period of rising prices.

Answer 26

Ans: C.
LIFO will result in lower net income than FIFO in
the current period, during a period of rising
prices. The other choices will tend to increase
current period earnings

Question 27

In period of rising prices and stable or
increasing inventory quantities, compared
with companies that use LIFO inventory
accounting, companies that use the FIFO
method will have:
A. higher COGS and lower taxes.
B. higher net income and higher taxes.
C. lower inventory balances and lower
working capital.

Answer 27

Ans: B.
FIFO companies have higher net income and
higher taxes

Question 28

Bao Corporation, which reports under
IFRS, wrote down its inventory of electronic
parts last period from its original cost of €
28,000 to net realizable value of €25,000.
This period, inventory at net realizable value
has increased to € 30,000. Bao should
revalue this inventory to:
A. €30,000 and report a gain of €5,000 on
the income statement.
B. €28,000 and report a gain of €3,000 on
the income statement.
C. €30,000 but report a gain of €3,000 on
the income statement

Answer 28

Ans: B.
Under IFRS, inventory values are revalued
upward only to the extent they were previously
written down. In this case, that is from €25,000
back up to the original value of €28,000. The
increase is reported as gain for the period and
will increase COGS of units sold during the
current period.

Question 29

Assuming stable inventory quantities, in
a period of:
A. rising prices, LIFO results in higher ending
inventory and FIFO results in higher gross
profit.
B. falling prices, LIFO results in higher gross
profit and FIFO results in lower COGS.
C. rising prices, LIFO results in higher COGS
and FIFO results in higher working capital.

Answer 29

Ans: C.
In a period of rising prices, LIFO results in higher
COGS, lower inventory balances, and lower gross
profit, as compared to FIFO. In a falling price
environment, these effects are the opposite.
Working capital (current assets minus current
liabilities) is higher under FIFO in a rising price
environment because inventories are higher.

Question 30

A firm uses the FIFO cost flow
assumption. Compared to gross profit with a
periodic inventory system, the firm’s gross
profit with a perpetual inventory system
would be:
A. lower.
B. higher.
C. the same.

Answer 30

Ans: C.
For a firm using FIFO, gross profit is the same
whether the firm uses a periodic or perpetual
inventory system. For a firm using LIFO or
average cost, gross profit can be different
depending on the choice of inventory system.

Question 31

Bao Inc. currently uses the FIFO method
to account for inventory. Due to significant
tax-loss carryforwards, the company has an
effective tax rate of zero. Prices are rising
and inventory quantities are stable. If the
company were to use LIFO instead of FIFO:
A. net income would be lower, and cash flows
would be higher.
B. cash flow would remain the same, and
working capital would decrease.
C. gross margin would increase, and average
stockholder’s equity would decrease

Answer 31

Ans: B.
In the absence of taxes, there is no difference in
cash flow between LIFO and FIFO. In addition,
using LIFO would result in lower working capital
(inventory is lower). Using LIFO would result in
lower net income because of a lower gross
margin (COGS is higher)

Question 32

From the point of view of a financial
analyst, when evaluating companies that use
different inventory cost assumptions, in a
period of:
A. stable prices, LIFO inventory is preferred
to FIFO inventory.
B. decreasing prices, FIFO inventory is
preferred to LIFO inventory.
C. increasing prices, FIFO cost of sales is
preferred to LIFO cost of sales.

Answer 32

Ans: B.
The most useful estimates of inventory and cost
of sales are those that best approximate current
cost. Whether prices are increasing or
decreasing, FIFO provides a better estimate of
inventory values, and LIFO produces a better
estimate of cost of sales. If prices are table,
there is no difference between LIFO and FIFO
estimates of inventory or cost of sales.

Question 33

A company that reports under U.S.GAAP
and changes its inventory cost assumption
from weighted average cost to LIFO is
required to apply this change in accounting
principle:
A. retrospectively, and disclose the new cost
flow method being used.
B. prospectively, and explain the reasons for
the change in the financial statement
disclosures.
C. retrospectively, and explain the reasons
for the change in the financial statement
disclosures.

Answer 33

Ans: B.
Under U.S.GAAP, a change to LIFO from another
inventory cost method is an exception to the
requirement of retrospective application of
changes in an accounting principle. Instead of
restating prior years’ data, the firm uses the
carrying value of inventory at the time of the
change as the firm LIFO layer. U.S.GAAP requires
a company that is changing its inventory cost
assumption to explain, in its financial statement
disclosures, why the new method is preferable to
the old method.

Question 34

During a period of falling costs of
manufacturing, which of the following
inventory cost formulas would result in the
greatest reported net income?
A. LIFO.
B. FIFO.
C. Average cost.

Answer 34

Ans: A.
With LIFO, more recent, lower costs would be
used for COGS. A reduction is COGS will increase
gross profit and net income, other things equal.