978-1118334324 Chapter 6 Lecture Note Part 2

a. LCM is an example of the accounting convention of conservatism,

which means that the approach adopted among accounting

alternatives is the method that is least likely to overstate assets and

net income.

b. Under the LCM basis, market is defined as current replacement cost,

usual quantities.

3. Companies apply LCM to the items in inventory after they have used one

of the cost flow methods to determine cost.

H. Inventory Errors.

1. The effects of inventory errors on net income of the current year are:

income).

b. An error in ending inventory will have a similar effect on net income

income for the two years will be correct.

2. Errors in ending inventory have no effect on liabilities and have the same

I. Statement Presentation and Analysis.

1. Inventory is classified as a current asset immediately below receivables

in a multiple–step income statement.

2. There should be disclosure in the notes to the financial statements of:

a. the major inventory classifications.

b. the basis of accounting (cost, or lower of cost or market).

c. the costing method (FIFO, LIFO, or average cost).

is sold during the period.

4. A variant of the inventory turnover is to compute the number of days

turnover.

*J Inventory Cost Flow Methods in Perpetual Inventory Systems.

1. Under FIFO, companies charge to cost of goods sold the cost of the

earliest goods on hand prior to each sale. The results under FIFO in a

perpetual system are the same as in a periodic system.

2. Under LIFO, companies charge to cost of goods sold the cost of the most

recent purchase prior to sale. In a perpetual LIFO system, the company

allocates the latest units purchased prior to each sale to cost of goods sold.

3. Under the moving-average (average cost) method and a perpetual system,

companies compute a new average cost after each purchase. The aver-

age cost is computed by dividing the cost of goods available for sale by

the units on hand.

*K Estimating Inventories—Gross Profit and Retail Inventory Methods.

1. Two circumstances explain why companies sometimes estimate inventories:

a. A casualty such as a fire, flood, or earthquake may make it impossible

to take a physical inventory.

b. Managers may want monthly or quarterly financial statements, but

a physical inventory is taken only annually.

2. There are two widely used methods of estimating inventories:

a. The gross profit method is used in preparing monthly financial state-

ments under a periodic system.

(1) Step 1: Net sales less estimated gross profit equals estimated

cost of goods sold.

(2) Step 2: Cost of goods available for sale less estimated cost of

goods sold (from Step 1) equals the estimated cost of ending

inventory.

(3) The gross profit method is based on the assumption that the

gross profit rate will remain constant.

(4) Companies should not use the gross profit method to prepare

financial statements at the end of the year.

b. When a store has many different types of merchandise at low unit

costs, the retail inventory method is often used.

(1) Under the retail inventory method, a company’s records must show

both the cost and retail value of the goods available for sale.

(2) Step 1: Goods available for sale at retail less net sales equals

ending inventory at retail.

(4) Step 3: Ending inventory at retail multiplied by the cost–to-retail

ratio equals the estimated cost of ending inventory.

A Look at IFRS

market inventory valuation differently.

KEY POINTS

 The requirements for accounting for and reporting inventories are more

lines in inventory accounting.

 The definitions for inventory are essentially similar under IFRS and GAAP.

Both define inventory as assets held-for-sale in the ordinary course of

business, in the process of production for sale (work in process), or to be

consumed in the production of goods or services (e.g., raw materials).

GAAP.

 Both GAAP and IFRS permit specific identification where appropriate. IFRS

actually requires that the specific identification method be used where the

inventory items are not interchangeable (i.e., can be specifically identified).

If the inventory items are not specifically identifiable, a cost flow

identification must be used.

 A major difference between IFRS and GAAP relates to the LIFO cost flow

assumption. GAAP permits the use of LIFO for inventory valuation. IFRS

prohibits its use. FIFO and average-cost are the only two acceptable cost

flow assumptions permitted under IFRS.

value is the best estimate of the net amounts that inventories are expected

to realize. GAAP, on the other hand, defines market as essentially

replacement cost.

 Under GAAP, if inventory is written down under the lower-of-cost-or-market

valuation, the new basis is now considered its cost. As a result, the

inventory may not be written back up to its original cost in a subsequent

period. Under IFRS, the write-down may be reversed in a subsequent

period up to the amount of the previous write-down. Both the write-down

and any subsequent reversal should be reported on the income statement

as an expense. An item–by-item approach is generally followed under

IFRS.

 Unlike property, plant, and equipment, IFRS does not permit the option of

original cost.

 Similar to GAAP, certain agricultural products and mineral products can be

reported at net realizable value using IFRS.

 IFRS allows companies to report inventory at standard cost if it does not

differ significantly from actual cost.

LOOKING TO THE FUTURE

income.

20 MINUTE QUIZ

Circle the correct answer.

True/False

1. When prices are rising, FIFO results in a higher ending inventory than LIFO.

True False

sold first.

True False

3. Goods in transit would be included in the ending inventory of the buyer and the seller.

True False

8. Inventory turnover is computed by dividing the cost of goods sold by the ending

inventory.

True False

*9. The gross profit method estimates the cost of ending inventory by applying a gross profit

rate to net sales.

True False

*10. The retail inventory method and the gross profit method are both methods of inventory

estimation.

True False

Multiple Choice

1. The cost flow method that results in the lowest income taxes when prices are rising is

a. average cost.

b. FIFO.

c. LIFO.

d. specific identification.

2. The data below are for Parrett Enterprises:

Beginning inventory 150 units at $2.00

Purchase—August 375 units at $1.50

Purchase—October 150 units at $3.00

inventory under FIFO?

a. $570

b. $743

c. $593

d. $720

a. understated tax liability.

b. overstated cost of goods sold.

c. overstated net income.

d. understated beginning inventory for the next period.

*4. A retail company has goods available for sale of $300,000 at retail and $210,000 at cost,

a. $220,000

b. $154,000

c. $210,000

d. $56,000

*5. Which method might be used to estimate inventory costs when physical inventories are

not taken?

a. First-in, first-out

b. Last-in, first-out

c. Average cost method

d. Gross profit method

ANSWERS TO QUIZ

True/False

Multiple Choice