Discussion Questions

1. Benefits of Using a Cost Flow Assumption

Other Than Specific Identification Method
Employing a cost flow assumption (FIFO, LIFO, or weighted average) rather than the specific
identification method has many benefits:

 Efficiency: Cost flow assumptions are less time-consuming and easier to apply compared to
tracking individual items, particularly in companies with large or homogeneous inventory items.
 Consistency: They ensure consistent use of accounting principles, which makes financial
statements easy to compare for periods.
 Usability: Specific identification is not possible for companies with high inventory turnover or
homogeneous items (e.g., bulk merchandise).
 Compliance: Cost flow assumptions are GAAP compliant and enable companies to estimate costs
of inventory where individual tracking is not feasible.

2. Cases Under Which an Inventory Cost Flow

Assumption Can Be Used
 GAAP Compliance: Generally Accepted Accounting Principles allow cost flow assumptions such
as FIFO, LIFO, or weighted average where specific identification is not feasible or not necessary.
 Physical Movement Parallel to Cost Flow: A cost flow assumption does not necessarily have to be
identical to physical movement, e.g., of goods. For instance:
 FIFO (first-in, first-out) assumes sale of oldest inventory, which in most instances is parallel to
physical flow in perishable goods.
 LIFO (last-in, first-out) assumes sale of most recent inventory, which may not be parallel to
physical flow but can be compatible with tax planning in the event of inflation.

3. Appropriate Inventory Valuation for an Art

Gallery
Recommended Method: The specific identification method is most suitable for an art gallery.

Reasons:

 Each painting is unique and has a different cost and value.

 Inventory items with high values (e.g., artwork worth $100,000 or more) need to be traced to
the last detail to determine the costs and profits.
 Specific identification offers the most precise matching of inventory costs with revenues because
each item's cost can be linked directly to its sale.
4. Inventory Cost Flow Assumption during
Inflationary Periods
Highest Reported Profits: During periods of rising costs:

 FIFO (First-In, First-Out) reports the highest reported profits because the older, lower-cost
inventory matches sales, and the higher-cost inventory is in ending inventory.

Lowest Taxable Income:

 LIFO (Last-In, First-Out) reports the lowest taxable income because the most recent, higher-cost
inventory is matched with sales, reducing gross profit.

Closest to Replacement Cost:

 Weighted Average Cost provides inventory valuation closest to current replacement cost because
it averages the cost of all inventory on hand.

5. Just-In-Time (JIT) Inventory System

Characteristics:
 JIT minimizes inventory levels by accepting goods only when needed for production or sales,
reducing carrying costs.
 It relies on good timing, good supplier relationships, and efficient logistics.

Advantages:
 Reduces storage costs and waste.
 Improves cash flow by minimizing inventory investment.
 Encourages efficiency in production and operations.

Risks:
 Prone to supply chain disruptions (e.g., delays from suppliers).
 Requires good demand forecasts and good suppliers.
 Can cause production halts if inventory is not present.

6. Why Do Firms Maintaining Perpetual

Inventory Systems Conduct Annual Physical
Inventories?
Although a perpetual inventory system records inventory in real time through purchases and sales, the
following are the reasons firms always conduct an annual physical inventory:
  Correctness Verification: To check on the correctness of the records in the perpetual inventory
system. Sometimes, errors occur in the form of theft, spoilt, shrinkages, or recording errors.
 Compliance with Accounting Standards: It ensures the financial statements to be accurate
regarding the actual inventory on hand.
 Loss Prevention: It helps in identifying and correcting the losses that are not accounted for in the
system, which could be either theft or fraud.
 Reconciliation: Any discrepancies between the physical count and the system records can be
investigated and reconciled.
 Planning and Control: A physical count affords an accurate count of the on hand stock for
smoother planning, including restocking or dropping of the underperforming products.

When Is the Physical Inventory Usually Taken, and Why?

When: The physical inventory is usually performed at year's end or when business has slowed.

Why:

 Reduce Interruptions: The count will not interfere as much with business during slower periods.
 Alignment with Financial Reporting: Counting near the fiscal year-end ensures accurate reporting
of inventory on the balance sheet and income statement.
 Easier Counting: Low levels of inventory at off-peak times make the counting process easier and
faster.

Annual physical count ensures that company records are reliable and meet the operational and financial
requirements.
Short Exercise 8.1: FIFO Inventory
Smalley, Inc. purchased inventory as follows:

- Jan. 4: 100 units @ $2.00

- Jan. 23: 120 units @ $2.25

Smalley sold 50 units on January 28. Calculate the cost of goods sold (COGS) under the FIFO method.

Solution:

- FIFO stands for First-In, First-Out; that is, the oldest purchased inventory is assumed to be sold first.

- COGS for 50 units:

• 50 units come from the Jan. 4 purchase @ $2.00 each.

- COGS = 50 × $2.00 = $100

Brief Exercise 8.2: LIFO Inventory

Wasson Company purchased inventory as follows:

- Dec. 2: 50 units @ $20

- Dec. 12: 12 units @ $21

Wasson sold 15 units on December 20. Compute the COGS under the LIFO method.

Solution:

- LIFO (Last-In, First-Out) assumes the newest inventory is sold first.

- COGS for 15 units:

- 12 units from the Dec. 12 purchase @ $21 each: 12 × $21 = $252

- 3 units from the Dec. 2 purchase @ $20 each: 3 × $20 = $60

- Total COGS = $252 + $60 = $312

Brief Exercise 8.3: Average-Cost Inventory

Fox Company purchased inventory as follows:
- May 3: 100 units @ $3.05

- May 10: 150 units @ $3.10

- May 15: 50 units @ $3.15

By the end of May, Fox sold 125 units. Compute the ending inventory using the average-cost method.

Solution:

1. Calculate the total cost and quantity of inventory:

- Total cost = (100 × $3.05) + (150 × $3.10) + (50 × $3.15) = $305 + $465 + $157.50 = $927.50

- Units in total = 100 + 150 + 50 = 300 units

- Average per unit cost = Total cost ÷ Units in total = $927.50 ÷ 300 = $3.09/unit

2. Calculate the ending inventory:

- Units sold = 125

- Units left = 300 - 125 = 175

- Ending inventory = 175 * $3.09 = $540.75

Brief Exercise 8.4: FIFO and LIFO Inventory

Murray, Inc. acquired inventory as follows:

Apr. 5: 100 units @ $5.00

Apr. 15: 100 units @ $5.05

By April 30, 75 units had been sold. Calculate:

(a) Ending inventory using LIFO, and

(b) How much would differ if FIFO were used?

(a) Ending Inventory Using LIFO:

LIFO assumes the newest inventory is sold first.

Units sold = 75:

- 75 units purchased on Apr. 15 @ $5.05 each.

- Ending inventory:
 - Balance of 25 units purchased on Apr. 15 @ $5.05 each: 25 × $5.05 = $126.25

- 100 units purchased on Apr. 5 @ $5.00 each: 100 × $5.00 = $500.00

- Total ending inventory = $126.25 + $500.00 = $626.25

(b) Ending Inventory Using FIFO:

- FIFO Assumes that the oldest units sold, and have been placed at the bottom of the inventory, are sold
first

- Units sold = 75:

- 75 units that were bought on Apr. 5 @ $5.00 each

- Ending inventory:

- Remaining 25 units from the Apr. 5 purchase @ $5.00 each: 25 × $5.00 = $125.00

- 100 units from the Apr. 15 purchase @ $5.05 each: 100 × $5.05 = $505.00

- Total ending inventory = $125.00 + $505.00 = $630.00

Difference Between LIFO and FIFO:

- FIFO ending inventory = $630.00

- LIFO ending inventory = $626.25

- Difference = $630.00 − $626.25 = $3.75

BRIEF EXERCISE 8.5 FIFO and Average-Cost

Inventory
United Co. had 10 units of inventory at the beginning of the year, each costing $10. During the year, 20
additional units were purchased:

- 20 units @ $12

At year-end, 15 units were sold. Determine the ending inventory under:

(a) LIFO, and

(b) Average-Cost methods.

(a) Ending Inventory Using LIFO:

- LIFO assumes that the newest inventory is sold first.

- Units sold = 15:

- 15 units come from the 20 purchased @ $12 each.

- Ending inventory:

- 5 units from the 20 bought @ $12 each: 5 × $12 = $60

- 10 units from the initial stock @ $10 each: 10 × $10 = $100

- Total ending inventory = $60 + $100 = $160

(b) Ending Inventory Using Average-Cost:

1. Compute the total cost and quantity of inventory:

- Total cost = (10 × $10) + (20 × $12) = $100 + $240 = $340

- Total units = 10 + 20 = 30

- Average cost per unit = Total cost ÷ Total units = $340 ÷ 30 = $11.33/unit

Calculate the ending inventory:

- Units remaining = 30 − 15 = 15

- Ending inventory = 15 × $11.33 = $169.95