Financial Accounting

Review and Practice

1. Discuss how to classify and determine inventory.

Manufacturers usually classify inventory into three categories: finished goods, work in
process, and raw materials. The steps in determining inventory quantities are (1) taking a
physical inventory of goods on hand and (2) determining the ownership of goods in transit
or on consignment.
2. Explain the accounting for inventories and apply the inventory cost flow methods.
The primary basis of accounting for inventories is cost. The cost of goods available for sale
includes (a) the cost of beginning inventory and (b) the cost of goods purchased. The
inventory cost flow methods are specifi c identification, and two assumed cost flow
methods—FIFO and average-cost.
3. Explain the economic effects of the inventory cost flow assumptions.
Companies may allocate the cost of goods available for sale to the cost of goods sold and
ending inventory by specific identification or by a method based on an assumed cost flow.
When prices rise, the first-in, first-out (FIFO) method results in a lower cost of goods sold
and higher net income than the average cost. The reverse is true when prices are falling. In
the statement of financial position, FIFO results in an ending inventory closer to the current
value. The list under average-cost is further from the current value—average-cost results
in lower income taxes.
4. Explain the lower-of-cost-or-net realizable value basis of accounting for inventories.
Companies use the lower-of-cost-or-net realizable value (LCNRV) basis when the
potential net worth is less than the cost. Under LCNRV, companies recognize the loss in
the period in which the price decline occurs.
5. Indicate the effects of inventory errors on the financial statements.
The current year’s income statement: (a) If the beginning inventory is understated, net
income is overstated. The reverse occurs if the beginning inventory is overstated. (b) If the
ending list is overstated, net income is overstated. If the ending list is understated, net
income is understated. In the following period, its effect on the net income for that period
is reversed, and the total net income for the two years will be correct.
 In the statement of financial position: Ending inventory errors will have the same effect on
total assets and equity and no impact on liabilities.
6. Discuss the presentation and analysis of inventory.
Inventory is classified in the statement of financial position as a current asset and is shown
immediately above receivables. There also should be a disclosure of (1) the major
inventory classifications, (2) the basis of accounting, and (3) the cost method. The
inventory turnover is the cost of goods sold divided by the average inventory. To convert
it to average days in inventory, divide 365 days by the inventory turnover.
7. Apply the inventory cost flow methods to perpetual inventory records.
Under FIFO and a perpetual inventory system, companies charge the cost of goods sold
and the cost of the earliest goods before each sale. Under the moving-average (average-
cost) method and a perpetual system, companies compute a new average price after each
purchase.
8. Describe the two methods of estimating inventories.
The two methods of estimating inventories are the gross profit method and the retail
inventory method. Under the gross profit method, companies apply a gross profit rate to
net sales to determine the estimated cost of goods sold. They then subtract the estimated
cost of goods sold from the cost of goods available for purchase to determine the estimated
cost of the ending inventory.
Under the retail inventory method, companies com put a cost-to-retail ratio by dividing
the cost of goods available for sale by the retail value of the goods available for sale. They
then apply this ratio to the ending inventory at retail to determine its estimated cost.
9. Apply the LIFO inventory costing method.
The LIFO (last-in, first-out) method assumes that the latest goods purchased are the first to
be sold. LIFO seldom coincides with the actual physical flow of goods. This method
matches the costs of the most recently purchased items with revenues in the period. In
periods of rising prices, the use of the LIFO method results in lower income taxes and
higher cash flow