INSTANT DOWNLOAD WITH ANSWERS
ANSWERS TO QUESTIONS – CHAPTER 5
- (1) Specific Identification – The inventory cost flow method that assigns cost to cost of goods sold based on the specific cost of each unit sold.
(2) First In, First Out – The inventory cost flow method that assumes that the first items purchased are the first items sold for the purpose of computing cost of goods sold and inventory.
(3) Last In, First Out – The inventory cost flow method that assumes that the last items purchased are the first items sold for the purpose of computing cost of goods sold and inventory.
(4) Weighted Average – The inventory cost flow method that allocates cost between cost of goods sold and inventory based on an average cost per unit.
- One advantage of the specific identification method is that both the inventory account and cost of goods sold reflect the actual amounts on hand and sold. This method is usually required for high cost items such as automobiles, boats, etc. One disadvantage of this method is that recordkeeping can become burdensome for high-volume, lower-priced items.
- FIFO allocates the cost of the first units purchased to the first units sold; consequently, in a period of rising prices, this would produce a higher net income. This may be an advantage for the purpose of financial reporting if reporting a higher profit is desired. However, this is a disadvantage for tax reporting because a higher profit means paying more tax. FIFO also tends to best match physical flow for most products. However, FIFO may present a disadvantage because a higher ending inventory and lower CGS would produce a lower inventory turnover.
- LIFO allocates the cost of the last units purchased to the first units sold; consequently, in a period of rising prices, this would produce a lower net income. This may be a disadvantage for the purpose of financial reporting if reporting a higher profit is desired. However, for tax reporting, a lower profit means paying less tax. LIFO also matches current cost with current revenues. For financial statement analysis, there may be an advantage because higher cost of goods sold and lower ending inventory would produce a higher inventory turnover.
- In an inflationary period, i.e., a period where prices are consistently rising, FIFO will produce the highest amount of income. This is true because the items purchased first (and at the lowest cost) are the items that are deemed sold first whose cost is charged to expense. The highest cost items remain in the asset account inventory. Since the lowest cost items have been expensed, net income will be higher than it would be assuming a LIFO flow.
- In an inflationary period, FIFO will produce the largest amount of total assets. (Refer to the discussion for Question 5.) The unsold items, inventory, are the highest cost items. Consequently, assuming rising prices, FIFO flow produces a higher inventory amount than would be the case under a LIFO flow.
- Flow of costs refers to the assumption that is made for the purpose of determining the cost of inventory items that are sold when preparing financial statements. The cost flow assumption that a business makes may have nothing to do with the actual flow of inventory into and out of the business. The physical flow of goods refers to the actual timing of when goods are sold. For example, a grocery store may use a FIFO cost flow assumption for financial statement purposes and this may reflect the physical flow of some inventory items but not others. The grocer will put the newer items at the back on the shelf and pull the oldest items to the front for the customer to purchase (FIFO) but the customer may look for the freshest item at the back of the shelf (e.g. milk) to purchase (LIFO).
- In a world where there is no income tax, the choice of cost flow method would not affect the statement of cash flows because it is simply allocating some of the cost of inventory purchased to expense and the remainder to assets. The statement of cash flows is affected when cash is received for goods sold and when cash is paid for goods purchased. However, most businesses do face income tax consequences. In that situation, the difference in tax paid based on each cost flow assumption would cause a difference in the cash flow statement. In a period of rising prices, LIFO would produce a smaller cash outflow for the payment of tax, because a smaller amount of income tax would be paid on a smaller amount of income.
- Key Company (first year of operations):
Beginning inventory $ -0-
Merchandise purchased 1,000 units @ $25 25,000
Cost of Goods Sold 850 units @ $25 21,250
Ending Inventory 150 units @ $25 3,750
Cost of goods sold will be the same for all methods because all items were purchased for the same cost. Consequently, it will not make any difference whether the first unit sold is assumed to be the first or last purchased. Weighted average will also be the same.
- The amount of cost of goods sold for Key Company will be different using different cost flow assumptions because the units purchased during the second year have a different cost than those purchased the previous year.
Beginning inventory 150 units @ $25 $ 3,750
Merchandise purchased 1,500 units @ $27 40,500
Total 1,650 $44,250
Units sold 1,500
FIFO: 150 units @ $25 $ 3,750
1,350 units @ $27 36,450
Cost of Goods Sold 1,500 $40,200
LIFO 1,500 units @ $27 $40,500
Cost of Goods Sold $40,500
Weighted Average: Total Cost ¸ Total Units = Cost per unit
44,250 ¸ 1,650 = $26.82 per unit
Cost of Goods Sold: 1,500 units @ $26.82 = $40,230
- Since the prices of the inventory are increasing, it may be advantageous to use FIFO for financial statement purposes because it produces the smallest cost of goods sold and consequently, the highest gross margin and net income. It also produces the largest amount of assets. However, a larger net income produces a higher income tax expense, so LIFO would be more desirable strictly from an income tax perspective in that the cost of goods sold would be higher, and consequently the net income and income tax paid will be lower. Since each cost flow method is desirable for a specific group of users, the cost flow assumptions chosen must be the best for the business overall. A part of that consideration is the ease of applying each method.
- In an inflationary period, for a business subject to income tax, LIFO would produce the larger amount of cash flow because the lower net income (higher cost of goods sold) would result in a smaller amount of income tax being paid.
- A deflationary period, i.e., a period of falling prices, would produce results opposite of those for an inflationary period. FIFO would produce the lowest amount of net income, because the goods purchased first would cost more than the goods purchased last. This would cause a larger amount of cost to be expensed resulting in a lower net income. LIFO would produce the highest net income.
- “Lower of cost or market” is an accounting convention that helps to reduce overstating inventory (assets) when the market value of certain items has fallen below the original cost. It is a conservative accounting measure that helps to prevent any material overstatement of the asset inventory.
- For merchandise that has declined in value, the “lower-of-cost-or-market” rule will cause a reduction in the asset account inventory and result in an overall reduction of total assets. This causes more cost to be shifted to cost of goods sold, thus causing net income to be lower.
- In certain situations, it is not possible or practical to take a complete inventory. One such situation is when the inventory or part of it has been destroyed by some disaster or similar event. Another situation where it is not practical to take inventory is when monthly or quarterly financial statements are prepared when the periodic inventory method is used. It is not cost effective to physically count inventory of any size on a regular basis. In a third situation, when the periodic method is used, inventory may be estimated on a monthly or weekly basis to provide information for insurance coverage.
- It is generally easier to manipulate net income when a periodic inventory system is used. There is no accounting for inventory at the time it is sold. There is very little control over the inventory (as far as the accounting records are concerned) except at the end of the year. The only measurement available is the amount of inventory still on hand. There is no control over the amount that was sold, damaged, or stolen. In addition, if the inventory is counted wrong or priced wrong, the amount of cost of goods sold will also be determined incorrectly. For a business owner wishing to manipulate profit, it is easy to either overstate or understate the amount of ending inventory.
- Goods Available for Sale $123,000
Less: Estimated Gross Margin ($130,000 x .25) (32,500)
Cost of Goods Sold (97,500)
Estimated Ending Inventory $ 25,500
- When using the periodic method, ending inventory that is overstated at the end of Year 1, but is corrected at the end of Year 2 will result in the following:
Year 1 Income Statement:
Cost of goods sold is understated
Net income is overstated
Year 1 Balance Sheet:
Assets are overstated
Retained Earnings is overstated
Year 2 Income Statement:
Cost of goods sold is overstated
Net income is understated
Year 2 Balance Sheet:
Assets are correct
Retained Earnings is correct
- The inventory turnover tells the user how many times on average inventory has been sold during the year.
- Discount merchandisers such as Walmart and Kmart should have a high inventory turnover.
Specialty stores such as exclusive jewelers and antique shops will have a low inventory turnover.