Inventory Valuation Methods

Question 1

Inventory valuation methods

Answer 1

FIFO
LIFO
Specific identification
Weighted average
Moving average
Dollar-value LIFO

Question 2

What is IVM

Answer 2

Determines which costs are associated to the endings inventory

Question 3

What method would a small company that sells unique items use

Answer 3

Specific identification

Question 4

What method would a company with fewer specific items use

Answer 4

Specific identification

Question 5

What are cost flow assumptions

Answer 5

A method of putting a dollar value on an actual number of inventory

Question 6

Criteria for selecting a cost flow method

Answer 6

1. Provide information: Investment/ credit decisions, assessing future cash flow, and about the entities economic resources/uses
2. No rules when selecting, just has to be systematic and rational

Question 7

Specific Identification

Answer 7

The specific cost of each item sold and each item left in inventory. Used when companies handle relatively small, costly items that are easily distinguishable. This method matches the physical flow of goods by matching actual costs against actual revenue. It may be used for both periodic and perpetual systems, but more so for perpetual.

Question 8

Arguments against Specific identification

Answer 8

1. Allows companies to manipulate net income: If seller buys product at differing prices, then they can sell product for either the higher or lower price
2. Results in arbitrary allocation costs: Relating shipping, holding, etc costs to exact items

Question 9

Using Specific identification COGS equal the what

Answer 9

The actual cost of the specific units that were sold during the period regardless of whether the cost of goods sold was recorded at the time of each sale or computed at the end of the period

Question 10

Using Specific identification ending inventory equals the what

Answer 10

The actual cost of the specific units that are on hand at the time of the current accounting period regardless of whether this is wha tis shown in the “merchandise inv” account in the general ledger

Question 11

Solving for merchandise inventory valuation using specific identification

Answer 11

Beg inventory/ Purchased items - each amount sold for each item

Question 12

Under specific method the count of physical inventory is taken in what

Answer 12

Units

Question 13

Weighted average cost

Answer 13

Tracks inventory items on the basis of the average cost of all similar goods available during the period. This is used for the period method.

Question 14

Computing weighted average cost per unit

Answer 14

Total cost of goods available for sale/ Total units available for sale = A

Question 15

Computing weighted average ending inventory cost

Answer 15

Ending inventory in units x weighted average cost per unit

Question 16

Computing weighted average COGS

Answer 16

Cost of goods available for sale - Ending inventory cost

Question 17

Moving average cost

Answer 17

Is only used for the perpetual method, so this is done whenever goods are sold. This is used typically for practical reasons, not conceptual because it is easy to apply and are not subject to income manipulation

Question 18

Computing moving average cost

Answer 18

March 2: Purchase 200 @ $2 = 400 = $2, Per unit cost
March 5: Purchase 300 @ $5 = 1500 = (1500+400)/(300+200) = A, per unit cost
March 10: Sold 100 @ A
ETC

Question 19

FIFO

Answer 19

Assumes company sells goods in the order the purchase it, so beginning inventory is the first to be sold. This may be either perpetual or periodic.

Using the periodic: only total purchases/sales are examined at the end of the period.

Using perpetual: the individual purchases/ transactions must be examined and a continuing track of the merchandise level is kept.

Question 20

FIFO results using periodic and perpetual

Answer 20

Will result in the same endings merchandise and COGS value always

Question 21

Rise on merch price for FIFO

Answer 21

1. Reasonable approximation of the true physical flow of merchandise
2. More likely to be written down due to the lower-of-cost of market-value

Question 22

Fall on merch price for FIFO

Answer 22

1. Reasonable approximation of the true physical flow of merchandise
2. Result in better cash flow (greater COGS = lower taxable income)

Question 23

Explain the income tax effect for FIFO

Answer 23

If inventory prices rise, FIFO results in higher income tax because older/cheaper items move to COGS, making a higher income. This results in higher tax payments, reducing cash flow.

If inventory prices fall, FIFO results in lower income tax because older/ more expensive items are moving to COGS, resulting in higher income and taxes, thus increase cash flow

Question 24

Explain the Earnings impact got FIFO

Answer 24

If inventory prices rise FIFO results in higher reported earnings due to selling more expensive older products.

If inventory prices fall FIFO results in lower reported earnings due to selling older/ cheaper items.

Question 25

Explain inventory on the balance sheet for FIFO

Answer 25

It reflects current inventory costs because first items in are assumed to be sold. This might be seen as a disadvantage because inventory is more vulnerable to declines in value, leading to a write-down.

Question 26

LIFO

Answer 26

The assumption that the most recent purchased goods is the cost of the total quantity sold. This is used for either periodic or perpetual systems. Likely ending inventory and COGS will not be the same for period and perpetual.

Question 27

LIFO reporting

Answer 27

If you use the LIFO for tax purposes yo must also you it for financial reporting purposes. This is required because of the "LIFO Conformity" which prevents companies from showing high income to investors while low income the IRS

Question 28

Arguments for LIFO

Answer 28

1. Closely follows the matching principle (both inflation and delation) 2. Results in tax benefits, thus better cash flow when there is a rise in merch prices. (opposite for decline) 3. Future earnings hedge: A fall in market prices will not result in a loss being reported because of lower-of-cost-or-market-value, due to the inventory being valued at a value so much lower than the cost of inventory.

Question 29

Arguments against LIFO

Answer 29

1. If a rise in market price occurs this results in lower financial earnings, negatively impacting stock prices 2. Merchandise inventory on the balance sheet represent older/ cheaper items because the newer ones are assumed to be sold, so it understates the account. 3. Does not reflect the physical flow of goods

Question 30

Impacts of understated merchandise from LIFO

Answer 30

1. Results in inventory profits: when you sell older/cheaper products for the price of the rising market: Price sold at - OG price 2. Permits company to artificially raise reports/ manipulate because it appears like they are selling more, while in fact are just selling cheaper items for a greater cost.

Question 31

LIFO reserve

Answer 31

Companies use different inventory valuation methods, which make it difficult to compare them, so LIFO was created to make that comparison easier. Companies that use LIFO for tax and financial reporting purposes often maintain a FIFO or average-cost system for internal reporting purposes. Companies should disclose the LIFO reserve in the financial statements notes.

Question 32

Why do companies that use LIFO for tax and financial reporting purposes often maintain a FIFO or average-cost system for internal reporting purposes

Answer 32

1. Base their sale pricing decisions on a FIO or average cost assumption, not LIFO because LIFO costs are too low and outdates for the real world. 2. Harder to record keep given doesn't follow the physical flow of goods 3. Profit sharing often depends on non LIFO assumptions 4. Troublesome for interim periods, which require estimations of year end quantities.

Question 33

Adjustment made to better compare LIFO to FIFO

Answer 33

LIFO inv + LIFO reserve = FIFO inventory

Question 34

LIFO liquidation

Answer 34

When a rapid decline in companies LIFO inventory levels occur this results in older inventory being matched with current revenues, which distort net income and lead to substantial tax payments. This might occur frequently when using a specific goods LIFO approach

Question 35

To alleviate the LIFO liquidation

Answer 35

Companies create pool LIFO's: Merchandise inventory is pooled into groups where the UNITS have similar costs and the UNITS have relatively similar costs and the groups have a relatively consistent inventory mix. This results in fewer LIFO liquidations because the reduction of one quantity in the pool may be offset by an increase in another.

Question 36

Pooled LIFO alleviates some of the problems of....

Answer 36

Unit (regular) LIFO, but it is not as efficient not effective as dollar-value LIFO, so not used much today

Question 37

Two issued that arise when using pool LIFO

Answer 37

1. Companies are continuously changing materials, products and production, which results in a constant need to change the pools 2. Even when practical it often results in erosion of the layers: when a specific good/ material is replaced by another. This leads to a loss in the LIFO cost benefits

Question 38

Pooled example if a layer of inventory has increased

Answer 38

(based on this years weighted average cost) Pool increased by 10,000 units and the periods purchase cost totaled $800,000 from 100,000 units. The layer added to this year: 80,000 (10,000 x 800,000/100,000) = 80,000

Question 39

Disclosing LIFO methods

Answer 39

Companies disclose the LIFO methods in foot note #1 , but do not disclose which one they are using

Question 40

Dollar-Value LIFO

Answer 40

The method that determines and measures an increases and decreases I a pool in terms of total dollar value, NOT physical quantity. It may be used only for the periodic system

Question 41

Reasons for using the dollar-value LIFO method

Answer 41

1. Physical inventory count is able to be counted much quicker due to being in dollars and at end-of-year costs. 2. Taking count is easier and does not result in a material difference if taken in units 3. Only a single layer is added to the inventory layers when inventory increases because it assumed to have been bought on the last day of the account period 4. Inventory decreases will not result in as significant profits.

Question 42

What must be known to compute the dollar-value of LIFO

Answer 42

1. End of current year accounting period price index 2. Ending inventory at end-of-the-current-accounting-period costs obtained by taking a physical count of inventory

Question 43

Why do companies use multiple Pooles when using the dollar-value method when they could just use one

Answer 43

1. The more goods in a pool, the more likely the increases in quantities of some goods will offset decreases in other goods in the same pool, which will avoid liquidation of the LIFO layers 2. fewer pools mean less cost and less chance of a reduction of a LIFO layer