CHAPTER 7: REPORTING AND

ANALYZING INVENTORY
Q7-1. When company A purchases inventory from company B, the buyer and seller
must agree on which firm is responsible for the transportation costs. The
terminology “freight on board shipping point” or FOB is used to indicate the
buyer assumes responsibility for the transportation cost once notice of delivery
to the shipper is received. In addition, the buyer assumes responsibility for any
delay or damage during transit.
When goods are shipped FOB, the seller normally can recognize revenue
unless the seller has not fulfilled all requirements of the purchase agreement.
An example is when an equipment installation and/or up-and-running properly
is part of that agreement.
Q7-2. If stable purchase prices prevail, the dollar amount of inventories (beginning or
ending) tends to be approximately the same under different inventory costing
methods and the choice of method does not materially affect net income. To see
this, remember that FIFO profits include holding gains on inventories. If the
inflation rate is low (or inventories turn quickly), there will be less holding
(inflationary) profit in inventory.
Q7-3. FIFO holding gains occur when the costs of earlier inventory acquisitions are
matched against current selling prices. Holding gains on inventories increase with
an increase in the inflation rate and a decrease in the inventory turnover rate.
Conversely, if the inflation rate is low or inventories turn quickly, there will be less
holding (inflationary) profit in inventory.
Q7-4. (a) Last-in, first-out, (b) Last-in, first-out, (c) First-in, first-out, (d) First-in, first-out,
(e) Last-in, first-out.
Q7-5. A significant tax benefit results from using LIFO when costs are consistently
rising. LIFO results in lower pretax income and, therefore, lower taxes payable,
than other inventory costing methods.
Q7-6. Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule.
When the replacement cost for inventory falls below its (FIFO or LIFO)
historical cost, the inventory must be written down to the lower replacement
costs (market value).
Q7-7. The various inventory costing methods would produce the same results (inventory
values and cost of goods sold) if prices were stable. The inventory costing
methods produce differing results when prices are changing.
Q7-8. Inventory “shrink” refers to the loss of inventory due to theft, spoilage, damage,
etc. Shrink costs are part of cost of goods sold but do not represent goods that
were actually sold.

©Cambridge Business Publishers, 2017

Solutions Manual, Chapter 7 7-1
 CHAPTER 7: REPORTING AND
ANALYZING INVENTORY
Q7-9. The “LIFO reserve” is the difference between the cost of inventory determined
using the last-in, first-out (LIFO) method and the cost determined using another
method (either FIFO or average cost). Companies that report inventory cost
using the LIFO method must also report the LIFO reserve. This allows the
financial statement reader to convert from LIFO to another method for comparison
purposes.
The LIFO reserve represents the difference between the historical, LIFO cost of
inventory and its current cost. This disparity between the book value and the
current value represents a gain from holding the inventory that has not yet been
recognized in income or in equity ̶ an unrealized holding gain.
Q7-10. Because LIFO assigns the last units purchased during the year to cost of goods
sold (COGS), changing prices can make it difficult to forecast earnings.
Companies have discretion as to when and how much inventory they purchase
during an accounting period. LIFO is always applied on a periodic, annual basis,
so a purchase made during the final days of the year will end up in COGS and
affect current earnings. However, if that purchase is delayed until the first week of
the next year, it could be several years before those units are transferred to
COGS. Unlike other inventory methods, LIFO requires that the quantity and price
of inventory purchases be predicted to make accurate earnings forecasts.
Q7-11A. LIFO liquidation is involuntary when it is caused by events that are beyond
management’s control. Examples of such events include labor strikes, natural
disasters, or wars which could interrupt the delivery of inventory by suppliers or
shut down production facilities.
Q7-12A. In periods of rising prices, LIFO liquidation results in older, lower-cost goods being
expensed as cost of goods sold, yielding higher profits. This may be the result of
a management decision to reduce inventory levels for efficiency purposes.
However, it may also be an earnings management tactic. Management may be
trying to avoid violating bond covenants, or it may be trying to manipulate
management compensation. In any case, this practice is costly, in that the
additional profits lead to higher income taxes.

©Cambridge Business Publishers, 2017

7-2 Financial Accounting, 5th Edition