Ch.5- Accounting for inventories

Which inventory cost flow method produces the highest amount of net income in a deflationary period?

A deflationary period, i.e., a period of falling prices, would produce results opposite of those for an inflationary period. FIFO would produce the lowest amount of net income, because the goods purchased first would cost more than the goods purchased last. This would cause a larger amount of cost to be expensed resulting in a lower net income. LIFO would produce the highest net income.

How can a company protect against inventory manipulation?

By separating physical counting and recording duties. Fraud now requires collusion which reduces the likelihood of its occurrence.

How can management manipulate net income using inventory fraud?

Cost of goods sold manipulations. By understating cost of good sold by overstating inventory gross margin increases for that year.

What are some advantages or disadvantages of using FIFO method of inventory valuation?

FIFO allocates the cost of the first units purchased to the first units sold; consequently, in a period of rising prices, this would produce a higher net income. This may be an advantage for the purpose of financial reporting if reporting a higher profit is desired. However, this is a disadvantage for tax reporting because a higher profit means paying more tax. FIFO also tends to best match physical flow for most products.

What is the difference between the flow of costs and the physical flow of goods?

Flow of costs refers to the assumption that is made for the purpose of determining the cost of inventory items that are sold when preparing financial statements. The cost flow assumption that a business makes may have nothing to do with the actual flow of inventory into and out of the business. The physical flow of goods refers to the actual timing of when goods are sold. For example, a grocery store may use a FIFO cost flow assumption for financial statement purposes and this may reflect the physical flow of some inventory items but not others. The grocer will put the newer items at the back on the shelf and pull the oldest items to the front for the customer to purchase (FIFO) but the customer may look for the freshest item at the back of the shelf (e.g. milk) to purchase (LIFO).

In an inflationary period, which inventory cost flow method will produce the largest amount of total assets on the balance sheet? Explain.

In an inflationary period, FIFO will produce the largest amount of total assets. (Refer to the discussion for Question 31.) The unsold items, inventory, are the highest cost items. Consequently, assuming rising prices, FIFO flow produces a higher inventory amount than would be the case under a LIFO flow.

In an inflationary period, which cost flow method, FIFO or LIFO, produces the largest cash flow? Explain.

In an inflationary period, for a business subject to income tax, LIFO would produce the larger amount of cash flow because the lower net income (higher cost of goods sold) would result in a smaller amount of income tax being paid.

In an inflationary period, which inventory cost flow method will produce the highest net income? Explain.

In an inflationary period, i.e., a period where prices are consistently rising, FIFO will produce the highest amount of income. This is true because the items purchased first (and at the lowest cost) are the items that are deemed sold first whose cost is charged to expense. The highest cost items remain in the asset account inventory. Since the lowest cost items have been expensed, net income will be higher than it would be assuming a LIFO flow.

What are some advantages and disadvantages of using the LIFO method of inventory valuation?

LIFO allocates the cost of the last units purchased to the first units sold; consequently, in a period of rising prices, this would produce a lower net income. This may be a disadvantage for the purpose of financial reporting if reporting a higher profit is desired. However, for tax reporting, a lower profit means paying less tax. LIFO also matches current cost with current revenues.

What are some advantages and disadvantages of the specific identification method of accounting for inventory?

One advantage of the specific identification method is that both the inventory account and cost of goods sold reflect the actual amounts on hand and sold. This method is usually required for high cost items such as automobiles, boats, etc. One disadvantage of this method is that record keeping can become burdensome for high-volume, lower-priced items.