Test Bank for Financial Accounting: Tools for Business Decision Making, Eighth Edition
FOR INSTRUCTOR USE ONLY
CHAPTER LEARNING OBJECTIVES
1. Discuss how to classify and determine inventory. Merchandisers need only one inventory
classification, merchandise inventory, to describe the different items that make up total
inventory. Manufacturers, on the other hand, usually classify inventory into three categories:
finished goods, work in process and raw materials. To determine inventory quantities,
manufacturers (1) take a physical inventory of goods on hand and (2) determine the
ownership of goods in transit or on consignment.
2. Apply inventory cost flow methods and discuss their financial effects. The primary
basis of accounting for inventories is cost. Cost includes all expenditures necessary to
acquire goods and place them in a condition ready for sale. Cost of goods available for sale
includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost
flow methods are: specific identification and three assumed cost flow methods—FIFO, LIFO,
The cost of goods available for sale may be allocated to cost of goods sold and ending
inventory by specific identification or by a method based on an assumed cost flow. When
prices are rising, the first-in, first-out (FIFO) method results in lower cost of goods sold and
higher net income than the average-cost and the last-in, first-out (LIFO) methods. The
reverse is true when prices are falling. In the balance sheet, FIFO results in an ending
inventory that is closest to current value, whereas the inventory under LIFO is the farthest
from current value. LIFO results in the lowest income taxes (because of lower taxable
3. Explain the statement presentation and analysis of inventory. Companies use the lower-
of-cost-or-market (LCM) basis when the current replacement cost (market) is less than cost.
Under LCM, companies recognize the loss in the period in which the price decline occurs.
Inventory turnover is calculated as cost of goods sold divided by average inventory. It can be
converted to average days in inventory by dividing 365 days by the inventory turnover. A
higher inventory turnover or lower average days in inventory suggests that management is
trying to keep inventory levels low relative to its sales level.
The LIFO reserve represents the difference between ending inventory using LIFO and
ending inventory if FIFO were employed instead. For some companies this difference can be
significant, and ignoring it can lead to inappropriate conclusions when using the current ratio
or inventory turnover.
*4. Apply inventory cost flow methods to perpetual inventory records. Under FIFO, the cost
of the earliest goods on hand prior to each sale is charged to cost of goods sold. Under
LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold.
Under the average-cost method, a new average cost is computed after each purchase.
*5. Indicate the effects of inventory errors on the financial statements. In the income
statement of the current year: (1) An error in beginning inventory will have a reverse effect on
net income (e.g. overstatement of inventory results in understatement of net income, and
vice versa). (2) An error in ending inventory will have a similar effect on net income (e.g.
overstatement of inventory results in overstatement of net income). If ending inventory errors
are not corrected in the following period, their effect on net income for that period is reversed,
and total net income for the two years will be correct. In the balance sheet: Ending inventory
errors will have the same effect on total assets and total stockholders’ equity and no effect on