Subject 1. Inventory and changing price levels

There are two basic issues of inventory accounting:

  • Determine the cost of goods available for sale: Beginning Inventory + Purchases.
  • Allocate the cost of total inventory costs (cost of goods available for sale) between two components: COGS on the income statement and the ending inventory on the balance sheet. Note that COGS = (Beginning Inventory + Purchases) - Ending Inventory.

There are two inventory systems:

  • Perpetual inventory system updates inventory accounts after each purchase or sale. Inventory quantities are updated continuously. When there is a sale, inventory is reduced and COGS is calculated.
  • Periodic inventory system records inventory purchase or sale in "Purchases" account. "Inventory" account is updated on a periodic basis, at the end of each accounting period (e.g., monthly, quarterly). Cost of goods sold or cost of sale is computed from the ending inventory figure.

In some cases, it's possible to specifically identify which inventory items have been sold and which remain. By the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold. This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique. However, in most cases companies may be unable to determine exactly which items are sold and which items remain in ending inventory.

The remaining three methods are flow assumptions, which should be applied only to an inventory of homogeneous items. The cost flow assumption may or may not reflect the physical flow of inventory.

Weighted Average Cost

The average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost.

  • Average cost = (beginning inventory + purchases) / units available for sale.
  • Ending inventory = Average cost x Units of ending inventory.
  • COGS = Cost of goods available for sale - ending inventory.

FIFO

FIFO is the assumption that the first units purchased are the first units sold. Thus inventory is assumed to consist of the most recently purchased units. FIFO assigns current costs to inventory but older (and often lower) costs to the cost of goods sold.

LIFO

LIFO is the assumption that the most recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In a period of inflation, LIFO usually results in lower reported profits and lower income taxes than the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.

LIFO is not allowed under IFRS. In the U.S., however, LIFO is used by approximately 30 percent of U.S. companies because of potential income tax savings.

The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic). This is also true is the specific identification method is used.

Using the LIFO/weighted average cost methods the two systems will generally result in different allocations to cost of sales and ending inventory.

Comparison of Inventory Accounting Methods

Inventory data is useful if it reflects the current cost of replacing the inventory. COGS data is useful if it reflects the current cost of replacing the inventory items to continue operations.

During periods of stable prices, all four methods will generate the same results for inventory, COGS and earnings.

During periods of rising prices and stable or growing inventories, FIFO measures assets better (the most useful inventory data), but LIFO measures income better.

  • Under LIFO, the cost of ending inventory is based on the earliest purchase prices, and thus is well below current replacement cost. For many firms using LIFO, their cost of inventory may be decades old and almost useless for analysis purposes. However, cost of goods sold is based on the most recent purchase prices, and thus closely reflects current replacement cost. As a result, LIFO provides a better measurement of current income and future profitability.

  • Under FIFO, the cost of ending inventory is based on the most recent purchase prices, and thus closely reflects current replacement cost. However, costs of goods sold are based on the earliest purchase prices, and this is well below the current replacement cost. The gain is actually holding gain or inventory profit. It is debatable whether it should be considered income, or at least analysts can say the underestimated COGS leads to inflated net income.

In an environment of declining inventory unit costs and constant or increasing inventory quantities the opposite is true.

The usefulness of inventory data reported using the average-cost method lies between LIFO and FIFO.

Practice Question 1

What does the FIFO inventory method assume about the first units purchased?

A. They are the first units sold.
B. They are the units that remain in ending inventory.
C. They are the only units used in computing average cost.
Correct Answer: A

FIFO treats the first units purchased as though they are the first unit sold.

Practice Question 2

When calculating ending inventory using the average cost method, which of the following is CORRECT?

A. The numerator is the beginning inventory balance plus purchases.
B. The denominator is the number of units remaining.
C. The denominator is the number of units purchased.
Correct Answer: A

The average cost is calculated by taking the beginning inventory balance plus purchases divided by the total number of units in inventory, which is the number in the beginning balance plus the number purchased.

Practice Question 3

SportsTrader began operations on January 1, 2006. It has been using FIFO since then for inventory accounting. The following stock record card for footballs was taken from the records at the end of 2011.
  • 01/01/2011 Beginning inventory 10 units, at $20 each, and total $200
  • 05/09/2011 30 footballs purchased, at $22 each, and total $660
  • 08/08/2011 15 footballs purchased, at $25 each, and total $375
  • 12/31/2011 Ending inventory: 25 footballs.
What is the COGS for the year?

A. $530.
B. $640.
C. $595.
Correct Answer: B

10 x $20 + 20 x $22 = $640.

Practice Question 4

Which of the following results from using the LIFO method of inventory cost flows during a period of inflation?

A. understated cost of goods sold.
B. overvalued inventory.
C. currently valued cost of goods sold.
D. currently valued inventory.
Correct Answer: C

LIFO matches current costs with current revenues. During a period of inflation, LIFO results in currently valued cost of goods sold.

Practice Question 5

Which inventory method generally results in costs allocated to ending inventory that will approximate current costs?

A. LIFO
B. FIFO
C. average cost method
Correct Answer: B

FIFO allocates the most recent costs to inventory.

Practice Question 6

Under U.S. GAAP, a company that uses the LIFO method to compute taxable income must use the ______ method for financial reporting.

A. FIFO
B. average cost
C. LIFO
Correct Answer: C

The tax law requires a company that uses LIFO for tax purposes also use LIFO for financial reporting purposes.

Practice Question 7

Under which cost flow assumption is the ending inventory composed of the earliest purchased merchandise?

A. FIFO
B. LIFO
C. Average Cost
Correct Answer: B

Under the LIFO (Last-In, First-Out) cost flow assumption, inventory is sold from the most recent purchases, leaving the earliest purchased inventory on hand.

Practice Question 8

If inventory costs remain relatively constant from period to period, which inventory method is the most appropriate one in the allocation of cost flow between COGS and inventory carrying value?

I. Specific identification method.
II. FIFO.
III. Weighted average method.
IV. LIFO.
Correct Answer: All of them

Given relatively constant prices, the allocation of costs between COGS and ending inventory would be very similar under each of the four methods.

Practice Question 9

Which methods are based on cost flow assumptions?

I. Specific identification.
II. FIFO.
III. LIFO.
IV. Weighted Average Cost.
Correct Answer: II, III and IV

I is based on physical flow. The flow of costs does not have to correspond with the physical flow of units. The costs can flow differently than the goods. In other words, if a firm uses LIFO, it may sell the oldest (first) item to a customer, but can report the cost of goods sold of the price of the last purchase.

Practice Question 10

Which inventory valuation method is not permitted under IFRS?

A. LIFO.
B. FIFO.
C. Specific Identification.
Correct Answer: A

LIFO is permitted only under U.S. GAAP.

Practice Question 11

Beginning inventory 10 units @ $5 per unit
First sale 4 units
First purchase 10 units @ $6 per unit
Second purchase 12 units @ $7 per unit
Second Sale 20 units

What is the value of the ending inventory, using a perpetual inventory system and a FIFO cost flow assumption?

A. $26
B. $36
C. $56
Correct Answer: C

Only 8 units remain after the second sale. On a FIFO perpetual basis, the 8 units will be assigned the most recent purchase price of $7 ($7 x 8 = $56).

Practice Question 12

Beginning inventory 10 units @ $10 per unit
First purchase 35 units @ $11 per unit
Second purchase 40 units @ $12 per unit
Third purchase 15 units @ $13 per unit

If 83 units are sold, what is the value of the ending inventory under a periodic inventory system and a FIFO cost flow assumption?

A. $219
B. $905
C. $177
Correct Answer: A

The ending inventory (17 units) would be composed of the most recent purchases (newest layers) of 15 X $13 plus 2 X $12, or $195 + $24.

Practice Question 13

Which inventory cost flow assumption normally will yield the highest cost of goods sold during a period of declining prices?

A. weighted average
B. FIFO
C. LIFO
Correct Answer: B

The older, higher inventory purchases will be the costs that go into cost of goods sold under FIFO.

Practice Question 14

Zealous Ltd. and Eager Ltd. are identical companies in every respect except that Zealous uses the LIFO method for inventory costing while Eager uses FIFO costing. The companies operate in an industry in which costs have been increasing over the past several years. Compared to Zealous, which of the following could be said about Eager?

A. Eager has a lower earnings per share.
B. Eager has a higher cost of goods sold.
C. Eager has a lower ending inventory.
D. Eager has higher total assets.
Correct Answer: D

If prices are increasing, FIFO would provide higher ending inventory, since the goods on hand would be recorded at the most recent purchase prices.

Practice Question 15

Which of the following is an advantage of LIFO inventory valuation over FIFO during periods of falling prices (assuming not all inventory is sold)?

A. Ending inventory on the balance sheet is reported at its current replacement cost.
B. Tax savings associated with lower reported earnings
C. It more closely adheres to the matching principle.
D. It more closely parallels the physical flow of goods sold.
Correct Answer: C

LIFO costing uses the most recent costs to compute cost of goods sold. Assuming costs are changing, these costs more closely match a firm's revenue, which is usually matching the trend of cost changes.

Practice Question 16

In a period of declining prices, which of the following statements would be true?

A. LIFO would produce higher gross profit margin percentages than would average costs.
B. FIFO would produce higher gross profit margin percentages than would LIFO.
C. Average costs would produce higher gross profit margin percentages than would LIFO.
D. FIFO would produce higher gross profit margin percentages than would average costs.
Correct Answer: A

If prices are declining, LIFO would provide lower cost of goods sold, since lower costs would be allocated to the items sold.

Practice Question 17

Prices have been rising during the past few years. Companies Ashley and Taylor are in the same industry and use the same accounting methods except for inventory valuation. Ashley uses FIFO, and Taylor uses LIFO. Which of the following statements is true?

A. The inventory on Taylor's books closely approximates current market prices
B. The cost of goods sold for Taylor more closely approximates current replacement values
C. The inventory for Taylor and Ashley are the same
Correct Answer: B

Because Taylor uses LIFO, the more recent costs will be the costs in costs of goods sold. The more recent costs are the higher costs, as costs have been rising.

Practice Question 18

Which of the following is true in periods of rising prices?

A. Working capital under FIFO will appear to be better than under LIFO.
B. Cash flows under FIFO will be better than LIFO.
C. Cash flows will be the same under FIFO and LIFO.
Correct Answer: A

The inventory under FIFO will be much higher than the inventory under LIFO. While cash flows will be lower (due to the tax differences), the effect on the inventory is usually greater; thus the working capital under FIFO will appear to be better even though cash flows under LIFO are better.

Practice Question 19

Which of the following statements is (are) true under U.S. GAAP?

I. If a LIFO inventory layer is depleted in one period, it can always be replenished by an identical layer in the next period
II. In periods of rising prices, cost of goods sold under LIFO will be greater than under FIFO
III. The use of LIFO increases inventory holding profits during periods of rising prices
IV. A company may use LIFO inventory procedures for tax purposes and another cost method for financial reporting purposes
Correct Answer: II

When LIFO is used in a period of rising prices, the latest and higher costs will go into cost of goods sold. When FIFO is used in a period of rising prices, the older and lower costs will go into costs of goods sold.

IV is false. Under the “LIFO conformity rule,” the U.S. tax code requires that companies using the LIFO method for tax purposes must also use the LIFO method for financial reporting.

Practice Question 20

Which of the following statements is true in a period of rising prices?

A. The use of FIFO will lead to a useful inventory turnover
B. The use of FIFO will tend to understate income
C. The use of FIFO will tend to understate the debt-to-equity ratio
D. The use of FIFO will improve cash flows
Correct Answer: C

The use of FIFO will generate a lower cost of goods sold, because the earlier, lower costs will be included in cost of goods sold. The lower cost of goods sold will result in a higher income. The higher income will be included in stockholders' equity, which will cause the debt-to-equity ratio to be lower.

Practice Question 21

Which of the following statements is true in an inflationary environment?

A. Under FIFO, income will tend to be understated
B. Under LIFO, working capital may be distorted
C. Under FIFO, cash flows will be increased
D. The use of FIFO will cause debt-to-equity ratios to be overstated
Correct Answer: B

When LIFO is used, inventory shown under current assets will be very low, as it will be using older, lower costs. While cash flows will be higher under LIFO, the increase in cash flows is usually not enough to counteract the effect of the low inventory, and thus working capital will tend to be lower under LIFO.

Practice Question 22

When price levels have been increasing throughout the period, a company using the LIFO inventory valuation method instead of the FIFO inventory valuation method would have:

A. higher equities
B. lower net income
C. higher net income
Correct Answer: B

In a period of rising prices, LIFO will yield a lower income because its cost of goods sold is higher, since it uses newer, and higher, costs.

Practice Question 23

During a period of rising prices, which of the following is lower using FIFO rather than LIFO?

A. Income before tax.
B. Income tax.
C. Cost of goods sold.
D. Net income.
Correct Answer: C

Practice Question 24

Assume that prices are rising and inventories balances are increasing, which method will generate the highest cash flow?

A. Average cost.
B. LIFO.
C. FIFO.
Correct Answer: B

As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs, thus generating higher cash flows (tax must be paid in cash).

Practice Question 25

During a time of increasing inventory and rising prices, FIFO will result in ______ than LIFO.

A. higher COGS
B. higher taxes
C. lower net income
D. lower working capital
Correct Answer: B

Practice Question 26

During a time of increasing inventory and rising prices, LIFO will result in ______ than FIFO.

A. higher inventory balance
B. higher taxes
C. higher COGS
D. higher net income
Correct Answer: C

Practice Question 27

An inventory write-down has a positive effect on:

A. liquidity ratios.
B. profitability ratios.
C. activity ratios.
Correct Answer: C

Activity ratios such as inventory turnover will be positively affected because the asset base (denominator) is reduced.

Practice Question 28

Diane Corporation had 400 units of inventory on hand at July 1, 2011, costing $20 each. Purchases and sales of goods during the month of July were as follows:

July 12, 2011 Sales 200 units @ $40
July 15, 2011 Purchases 100 units @ $26
July 25, 2011 Purchases 300 units @ $28
July 30, 2011 Sales 200 units @ $40

Assume Diane Corporation does not maintain perpetual inventory records. According to a physical count, 400 units were on hand on July 31, 2011.

The cost of ending inventory using the FIFO cost method is:

A. $11,000
B. $9,000
C. $8,000
Correct Answer: A

The cost of inventory is the ending inventory value on the balance sheet on July 31, 2011. Using FIFO, the costs allocated to ending inventory will be the most recent costs. Therefore, if 400 units are remaining, the ending inventory value will be 300 @$28 + 100 @$26.

Practice Question 29

Diane Corporation had 400 units of inventory on hand at July 1, 2011, costing $20 each. Purchases and sales of goods during the month of July were as follows:

July 12, 2011 Sales 200 units @ $40
July 15, 2011 Purchases 100 units @ $26
July 25, 2011 Purchases 300 units @ $28
July 30, 2011 Sales 200 units @ $40

Assume Diane Corporation does not maintain perpetual inventory records. According to a physical count, 400 units were on hand on July 31, 2011.

The cost of inventory at July 31, 2011, using the LIFO cost method, is:

A. $11,000
B. $8,000
C. $9,500
Correct Answer: B

Using LIFO, the costs allocated to ending inventory will be the oldest costs. Therefore, if 400 units are remaining, the ending inventory value will be 400 @ $20 = $8,000.

Practice Question 30

If companies have identical inventoriable costs, but use different inventory flow assumptions when the price of goods has not been constant, then the:

A. net income of the companies will be identical.
B. ending inventory of the companies will be identical.
C. cost of goods available for sale of the companies will be identical.
Correct Answer: C

The cost of goods available for sale will be the same if beginning inventory and purchases are the same, but if different methods are used, cost of goods sold and net income will be different, as different methods give a different value for ending inventory.

Practice Question 31

Which of the following flow assumptions is not acceptable under generally accepted accounting principles?

A. FIFO/LIFO.
B. Next-in, first-out.
C. Average cost.
Correct Answer: B

Practice Question 32

Which statement(s) is (are) true?

I Under the FIFO method of inventory valuation, the assignment of costs to merchandise sold is in the same order in which the merchandise was purchased.
II. The FIFO method of inventory valuation is based on an assumption that the most recent costs incurred should be charged against current-year revenues.
III. The FIFO method of inventory valuation is based on the assumption that costs should be charged against revenues in the same order in which the costs were incurred.
IV. LIFO is considered the most conservative inventory pricing method.

A. I, II and III
B. I, II and IV
C. I, III and IV
Correct Answer: C

I. FIFO means 'first-in, first-out'--the first items purchased are the first items sold. Inventory costs are assigned to the merchandise sold in the same order in which the purchases of merchandise were made.
II. Under FIFO, costs are charged in the order in which they occur, but the most recent inventory costs (purchases) are assigned to ending inventory. Inventory does not become a 'cost' until it is sold.
III. FIFO means 'first-in, first-out', in other words, the cost of the first items purchased become the cost of the first items sold.
IV. With a LIFO pricing system the inventory is valued at the oldest costs (usually the lowest because of inflation) and the values of the recent purchases (slightly higher costs) are assigned to the cost of goods sold. With higher costs of goods there will be a lower net income.

Practice Question 33

Under which cost flow assumption is the ending inventory composed of the most recently purchased merchandise?

A. FIFO.
B. LIFO.
C. Average Cost.
Correct Answer: A

Under the FIFO (First-In, First-Out) cost flow assumption, the inventory on hand is considered to be composed of the most recent items purchased.

Practice Question 34

Which of the following statements related to the LIFO method of inventory valuation is false?

A. Despite the many benefits of LIFO, it is used by fewer U.S. companies than both FIFO and weighted average.
B. The LIFO conformity rule is a tax ruling prohibiting the use of LIFO for tax purposes unless it is also used for external financial reporting purposes.
C. Under LIFO, companies can manage earnings at the end of an accounting period by purchasing additional inventory.
Correct Answer: A

LIFO is more commonly used than weighted average for inventory valuation purposes.

Practice Question 35

Every-Day Clothing had a November 1 merchandise inventory balance of $45,000. It made purchases of $80,000 and recorded sales of $130,000, during November. Its estimated gross profit on sales was 25%. On November 30, the store was destroyed by fire. What was the value of the merchandise inventory loss?

A. $ 27,500
B. $125,000
C. $ 97,500
Correct Answer: A

The cost of goods sold is equal to sales less the gross profit on sales, or $97,500 ($130,000 X (1 -.25)). The lost inventory will be estimated as inventory available at cost less the cost of goods sold.

Practice Question 36

The goods available for sale, at retail prices, total $200,000. If the cost ratio for the period totals 60%, and the net sales at retail for the period total $120,000, what is the ending inventory at cost?

A. $ 48,000
B. $ 24,000
C. $ 72,000
Correct Answer: A

Reducing total goods available for sale at retail ($200,000) by sales at retail ($120,000) leaves a remainder (ending inventory at retail) of $80,000. If the cost of the ending inventory is 60% of ending inventory at retail value, the cost of the ending inventory at cost is $48,000 ($80,000 x 60%).

Practice Question 37

Czech Ltd. shipped goods to a customer on December 30, 2010. Since Czech used the shipping company requested by the customer, the customer took the risk of the goods not being delivered by the shipping company. The customer received the goods on January 6, 2011. The selling price of the goods was $57,000. The sale was recorded by Czech on January 2, 2011. Czech had paid $42,000 for the goods and used the periodic method to account for its inventory. Which of the following statements with respect to this transaction is true?

A. Income for 2010 is understated by $42,000.
B. Income for 2011 is overstated by $15,000.
C. Revenues for 2010 are understated by $57,000.
Correct Answer: C

The revenue should be recorded in 2010 since the goods were shipped before the year end.

Practice Question 38

Greenbelt Processors had a beginning inventory of 798 units valued at a cost of 34,895. It purchased 4,474 units of new inventory worth 195,402 during the year. A year-end audit revealed that it had 853 units on hand.

If Greenbelt uses the FIFO method, what was its COGS for the year?

A. 193,000
B. 193,042
C. 193,027
Correct Answer: B

Since Greenbelt has 853 units on hand at year-end, under FIFO they all belong to purchases made during the year.

Unit price of purchases = 195,402 / 4,474 = 43.675
Ending inventory = 853 x 43.675 = 37,255
COGS = BI + Purchases - EI = 34,895 + 195,402 - 37,255 = 193,042.

Practice Question 39

Greenbelt Processors had a beginning inventory of 798 units valued at a cost of 34,895. It purchased 4,474 units of new inventory worth 195,402 during the year. A year-end audit revealed that it had 853 units on hand.

If Greenbelt uses the weighted average cost method, what was its COGS for the year?

A. 193,000
B. 193,027
C. 193,035
Correct Answer: C

Under average cost method, we price all units including those in beginning inventory and purchased during the year at an average price.

Average price = [34,895 + 195,402] / [798 + 4,474] = 43.683
Ending inventory = 853 x 43.683 = 37,262
COGS = BI + Purchases - EI = 34,895 + 195,402 - 37,262 = 193,035.

Practice Question 40

Greenbelt Processors had a beginning inventory of 798 units valued at a cost of 34,895. It purchased 4,474 units of new inventory worth 195,402 during the year. A year-end audit revealed that it had 853 units on hand.

If the average unit price was 43.65 at the end of the year, what COGS would Greenbelt report?

A. 193,064
B. 193,035
C. 193,027
Correct Answer: A

If the ending price is 43.65, which is less than all three unit prices calculated under FIFO, LIFO or Average Cost Method, the conservative principle of "lower of cost or market" needs to be applied. At this price,

Ending inventory = 853 x 43.65 = 37,233
COGS = BI + Purchases - EI = 34,895 + 195,402 - 37,233 = 193,064.

Practice Question 41

When comparing FIFO with LIFO, which of these arguments is INCORRECT (Assume rising prices.)

A. FIFO more closely follows the actual physical flow of many inventory items.
B. The dollar amount reported as cost of goods sold under FIFO more closely approximates current cost of goods sold.
C. The dollar amount reported as ending inventory under FIFO more closely approximates the current cost of inventory.
Correct Answer: B

A is correct because the FIFO method more closely follows the actual physical flow of most inventory items. B is incorrect because LIFO, not FIFO, reports the more recent, higher-priced goods as cost of goods sold. C is correct because ending inventory under FIFO is comprised of the newer, higher-priced goods, which is a closer approximation of current costs.

Practice Question 42

Which of the following statements is not true in regard to the LIFO inventory cost flow assumption?

A. The LIFO cost flow assumption does not normally reflect the usual physical flow of inventory units.
B. For balance sheet purposes, the cost of inventory will approximate the current replacement cost under the LIFO assumption.
C. If a company uses LIFO for tax purposes, it must also use LIFO for external financial reporting purposes.
Correct Answer: B

Under LIFO, the inventory on the balance sheet will consist of older costs, usually from a previous period, and will not represent the latest costs.

Practice Question 43

Given equal circumstances, which inventory method is the best to use for tax purposes (assume prices are rising)?

A. Average cost.
B. FIFO.
C. LIFO.
Correct Answer: C

LIFO reduces taxable income and thus reduces taxes.

Practice Question 44

Date Quantity Per Unit Total Cost
Jan 1, Beginning Inventory 100 $18.00 $ 1,800.00
Mar 4, Purchase 400 19.00 7,600.00
May 8, Purchase 800 18.25 14,600.00
Nov 3, Purchase 500 20.40 10,200.00
Merchandise Available 1,800 34,200.00

Five hundred units are unsold. Using the average cost method under a periodic inventory system, how much is the cost assigned to the ending merchandise inventory?

A. $ 9,400
B. $ 9,800
C. $ 9,500
Correct Answer: C

Using the average cost method, the ending inventory would be calculated as: $34,200 / 1,800 = $19 per unit cost. 500 X $19 = $9,500.

Practice Question 45

In periods of rising prices and stable or increasing inventory quantities, the impact of LIFO and FIFO on income before taxes is:

A. LIFO results in lower income.
B. FIFO results in lower income.
C. The choice of LIFO vs. FIFO does not affect income.
Correct Answer: A

LIFO retains (earlier) lower cost inventory, thereby increasing COGS, and thereby decreasing income. FIFO results in the opposite.

Practice Question 46

In a period of rising prices, many firms adopt the periodic LIFO method of accounting for inventory cost for tax purposes. When compared with periodic FIFO or average cost:

A. LIFO allocates older and therefore smaller inventory costs to cost of goods sold.
B. LIFO allocates the newest and therefore the largest inventory costs to cost of goods sold.
C. LIFO produces an inventory valuation on the balance sheet that is always closer to replacement cost.
Correct Answer: B

The latest costs, which are the highest costs, will be allocated to cost of goods sold. The higher cost of goods sold will cause income before taxes to be lower, and thus income taxes will be lower.

Practice Question 47

Which of the following statements is true concerning the use of LIFO in a period of rising prices?

A. The use of LIFO will lead to a useful working capital number and inventory turnover.
B. The debt-to-equity ratio will be higher than under FIFO.
C. The use of LIFO will lead to lower cash flows.
Correct Answer: B

When FIFO is used, the cost of goods sold is lower, income is higher, and retained earnings is higher. This makes the equity higher; thus the debt-to-equity ratio under FIFO will be lower than under LIFO.

Practice Question 48

Which of the following statements concerning inventory valuation is INCORRECT?

A. LIFO is superior for income statement purposes whereas FIFO is superior for balance sheet purposes.
B. In order to adjust balance sheet values for a company using LIFO, an analyst would add LIFO reserve to the reported inventory value.
C. During periods of rising input prices, LIFO would underestimate gross profit.
Correct Answer: C

LIFO reports proper income or profit when prices are rising. FIFO would overestimate it.

Practice Question 49

Comparing with FIFO, LIFO results in (during periods of rising prices)

A. higher COGS and higher inventory balance.
B. higher COGS and lower inventory balance.
C. lower COGS and higher inventory balance.
Correct Answer: B

Practice Question 50

Comparing with FIFO, LIFO results in (during periods of rising prices)

A. higher taxes and lower cash flows.
B. lower taxes and higher cash flows.
C. lower taxes and lower cash flows.
Correct Answer: B

Practice Question 51

When prices are rising, comparing with LIFO, FIFO results in

A. lower working capital and higher cash flows.
B. higher working capital and higher cash flows.
C. higher working capital and lower cash flows.
Correct Answer: C

Practice Question 52

Comparing with LIFO, FIFO results in ______ when prices are rising.

A. lower inventory balance and lower net income.
B. lower inventory balance and higher net income.
C. higher inventory balance and higher net income.
Correct Answer: C

Practice Question 53

Swimsuit Shop uses FIFO inventory method. During a time of rising prices and constant inventory level (in terms of quantity), Swimsuit Shop would experience

A. higher taxes.
B. higher cash flows.
C. higher cost of goods sold (COGS) and lower net income.
Correct Answer: A

The sequence is: lower COGS --> higher net income --> higher taxes --> lower cash flows.

Practice Question 54

Which statement(s) is (are) FALSE?

I. Under the LIFO method of inventory valuation, the ending merchandise inventory would be valued at the purchase price of the most recent purchases.
II. During extended periods of rising prices, the FIFO method of inventory valuation will yield a higher cost of goods sold and a lower ending merchandise inventory, when compared to the LIFO method of inventory valuation.
III. The accounting principle of consistency prohibits any changes in the method of inventory valuation.
IV. JIT means just in time and is an inventory method where the raw materials for production are purchased in smaller quantities after orders have been taken for the manufactured products.

A. I, II and III
B. I, II and IV
C. II, III and IV
Correct Answer: A

I. LIFO means 'last-in, first-out'--the cost of the last items purchased are charged to the most recent sales. The merchandise inventory at the end of the year is considered to be from the oldest purchases.
II. The FIFO method will result in a lower cost of goods sold and a higher ending merchandise inventory (valued at first-in costs).
III. While consistency should be maintained, legitimate changes are allowed. However, the nature, justification, and effect of the change on net income must be disclosed (full-disclosure principle).
IV. JIT inventory systems require reliable suppliers and efficient handling and shipping of materials.

Practice Question 55

If ending inventory is understated by $2,000 and beginning inventory is overstated by $3,000, the net income will be

A. understated by $5,000.
B. overstated by $1,000.
C. overstated by $5,000.
Correct Answer: A

COGS = BI + Purchase - EI.
If BI is higher, the COGS is higher.
If EI is lower, the COGS is higher.
Based on the relationship, the COGS is overstated by $2,000 + $3,000.
The net income is understated by $5,000.

Practice Question 56

If prices of a product are falling the use of LIFO rather than FIFO will lead to:

A. higher working capital and higher net income.
B. higher working capital and lower net income.
C. lower working capital and higher net income.
Correct Answer: A

COGS will be lower under LIFO in a period of falling prices leading to higher net income and higher tax payments. Working capital will be higher since the higher inventory value will outweigh the lower cash balance due to higher tax payments.

Practice Question 57

An inventory write-down has a negative effect on:

I. liquidity ratios.
II. profitability ratios.
III. activity ratios.
IV. solvency ratios.

A. I, II and III
B. I, II and IV
C. All of them
Correct Answer: B

An inventory write-down will positively affect activity ratios such as inventory turnover because the asset base (denominator) is reduced. However, all other ratios will be negatively affected as both the profit and the carrying amount of inventory are reduced.