CHAP TER

Why Does a Company Need

a Cost Flow Assumption in
Reporting Inventory?
Video Clip
In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 9.

View the video online at: http://bit.ly/hoyle9-1

1. THE NECESSITY OF ADOPTING A COST FLOW

ASSUMPTION
L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Understand that accounting rules tend to be standardized so that companies must often report
events according to one set method.
2. Know that the selection of a particular cost ow assumption is necessary when inventory items
are bought at more than one cost.
3. Apply each of the following cost ow assumptions to determine reported balances for ending
inventory and cost of goods sold: specic identication, FIFO, LIFO, and averaging.

1.1 Accounting for Inventory When Costs Vary Over Time

Question: In the coverage of nancial accounting to this point, general standardization has been evident.
Most transactions are reported in an identical fashion by all companies. This dened structure (created
by U.S. GAAP or IFRS) helps ensure understandable communication. It also enhances the ability of decision makers to compare results from one year to the next and from one company to another. For example, inventoryexcept in unusual circumstancesappears on a balance sheet at historical cost unless
its value is lower. Consequently, experienced decision makers should be well aware of the normal meaning of a reported inventory gure.
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

250

FINANCIAL ACCOUNTING VERSION 2.0

However, an examination of the notes to nancial statements for several well-known businesses
shows an interesting inconsistency in the reporting of inventory (emphasis added).
Mitsui & Co. (U.S.A.)as of March 31, 2011: Commodities and materials for resale are stated at
the lower of cost or market. Cost is determined using the specic identication method or average cost.
Johnson & Johnsonas of January 2, 2011: Inventories are stated at the lower of cost or market determined by the rst-in, rst-out method.
Safeway Inc.as of January 1, 2011: Merchandise inventory of $1,685 million at year-end 2010
and $1,629 million at year-end 2009 is valued at the lower of cost on a last-in, rst-out (LIFO) basis or
market value.
Bristol-Myers Squibbas of December 31, 2010: Inventories are stated at the lower of average cost
or market.
Specic-identication method, rst-in, rst-out method, last-in, rst-out basis, average
costthese are cost ow assumptions. What information do these terms provide about reported inventory balances? Why are such methods necessary? Why are all four of these businesses using dierent cost
ow assumptions? In the nancial reporting of inventory, what is the signicance of disclosing that a
company applies rst-in, rst-out, last-in, rst-out, or the like?
Answer: In the previous chapter, the cost of all inventory items was kept constant over time. The
rst bicycle cost $260 and every bicycle purchased thereafter also had a cost of $260. This consistency
helped simplify the introductory presentation of accounting issues in the coverage of inventory.
However, such stability is hardly a realistic assumption. For example, the retail price of gasoline has
moved up and down like a yo-yo in recent years. The costs of some commodities, such as bread and
soft drinks, have increased gradually for many decades. In other industries, prices actually tend to fall
over time. New technology products often start with a high price that drops as the manufacturing process ramps up and becomes more ecient. Several years ago, personal computers cost tens of thousands of dollars and now sell for hundreds.
A key event in accounting for inventory is the transfer of cost from the inventory T-account to cost
of goods sold as the result of a sale. The inventory balance is reduced and the related expense is increased. For large organizations, such transactions take place thousands of times each day. If each item
has an identical cost, no problem exists. This established amount is reclassied from asset to expense to
reect the sale (either at the time of sale in a perpetual system or when nancial statements are produced in a periodic system).
However, if inventory items are acquired at dierent costs, a problem is created: Which of these
costs is moved from asset to expense to reect a sale? To resolve that question, a cost ow assumption
must be selected by company ocials to identify the cost that remains in inventory and the cost that
moves to cost of goods sold. This choice can have a signicant and ongoing impact on both income
statement and balance sheet gures. Investors and creditors cannot properly analyze the reported net
income and inventory balance of a company such as ExxonMobil without knowing the cost ow assumption that has been utilized.

1.2 Applying Cost Flow Assumptions

Question: To illustrate, assume a mens retail clothing store holds $120 in cash. Numbers will be kept
articially low in this example so that the impact of the various cost ow assumptions is easier to visualize. On December 2, Year One, one blue dress shirt is bought for $50 in cash and added to inventory.
Later, near the end of the year, this style of shirt suddenly becomes especially popular and prices skyrocket. On December 29, Year One, the store manager buys a second shirt exactly like the rst but this time at
a cost of $70. Cash on hand has been depleted ($120 less $50 and $70), but the company holds two shirts
in its inventory.
On December 31, Year One, a customer buys one of these two shirts by paying cash of $110. Regardless of the cost ow assumption, the company retains one blue dress shirt in inventory at the end of the
year and cash of $110. It also reports sales revenue of $110. Those facts are not in dispute.
From an accounting perspective, only two questions must be resolved: (1) what is the cost of goods
sold reported for the one shirt that was sold, and (2) what is the cost remaining in inventory for the one
item still on hand?
Should the $50 or $70 cost be reclassied to cost of goods sold? Should the $50 or $70 cost remain in
ending inventory? In nancial accounting, the importance of the answers to those questions cannot be
overemphasized. If the shirts are truly identical, answers cannot be determined by any type of inspection;
thus, a cost ow assumption is necessary. What are the various cost ow assumptions, and how are they
applied to inventory?
Answer:
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

251

Specic Identication. In a literal sense, specic identication is not a cost ow assumption.

Companies that use this method are not making an assumption because they know which item was
sold. In some way, the inventory conveyed to the customer can be identied so that the actual cost is
reclassied to expense to reect the sale.
For some types of inventory, such as automobiles held by a car dealer, specic identication is relatively easy to apply. Each vehicle tends to be somewhat unique and can be tracked through identication numbers. Unfortunately, for many other types of inventory, no practical method exists for determining the physical ow of specic goods from seller to buyer.
Thus, if the mens retail store maintains a system where individual shirts are coded when acquired,
it will be possible to know whether the $50 shirt or the $70 shirt was actually conveyed to the rst customer. That cost can then be moved from inventory to cost of goods sold.
However, for identical items like shirts, cans of tuna sh, bags of coee beans, hammers, packs of
notebook paper and the like, the idea of maintaining such precise records is ludicrous. What informational benet could be gained by knowing whether the rst blue shirt was sold or the second? In most
cases, unless merchandise items are both expensive and unique, the cost of creating such a meticulous
record-keeping system far outweighs any potential advantages.
First-in, rst-out (FIFO). The FIFO cost ow assumption is based on the premise that selling the
oldest item rst is most likely to mirror reality. Stores do not want inventory to lose freshness. The oldest items are often displayed on top in hopes that they will sell before becoming stale or damaged.
Therefore, although the identity of the actual item sold is rarely known, the assumption is made in applying FIFO that the rst (or oldest) cost is moved from inventory to cost of goods sold when a sale
occurs.
Note that it is not the oldest item that is necessarily sold but rather the oldest cost that is reclassied rst. No attempt is made to determine which shirt was purchased by the customer. Consequently, an assumption is necessary.
Here, because the rst shirt cost $50, the entry in Figure 9.1 is made to reduce the inventory and
record the expense.

specic identication
Inventory cost ow method
in which a company
physically identies both its
remaining inventory and the
inventory that was sold to
customers.

FIFO
Inventory cost ow
assumption based on the
oldest costs being transferred
rst from inventory to cost of
goods sold so that the most
recent costs remain in ending
inventory.

FIGURE 9.1 Journal EntryReclassification of the Cost of One Piece of Inventory Using FIFO

After the sale is recorded, the following nancial information is reported by the retail story but only if
FIFO is applied. Two shirts were bought for ($50 and $70), and one shirt was sold for $110.
FIFO
Cost of Goods Sold (one unit soldthe cost of the rst one)

$50

Gross Prot ($110 sales price less $50 cost)

$60

Ending Inventory (one unit remainsthe cost of the last one) $70

In a period of rising prices, the earliest (cheapest) cost moves to cost of goods sold and the latest (more
expensive) cost remains in ending inventory. For this reason, in inationary times, FIFO is associated
with a higher reported net income as well as a higher reported inventory total on the companys balance sheet. Not surprisingly, these characteristics help make FIFO a popular choice.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

252

FINANCIAL ACCOUNTING VERSION 2.0

T E S T

Y O U R S E L F

Question:
A hardware store buys a lawn mower on Monday for $120, another identical model on Tuesday for $125, another on Wednesday for $132, and a nal one on Thursday for $135. One is then sold on Friday for $180 in
cash. The company uses the FIFO cost ow assumption for inventory. Because an identication number was
left on the lawn mower bought on Tuesday, company ocials know that this lawn mower was actually the
one sold to the customer. In the accounting system, that specic cost is moved from inventory to cost of
goods sold. Which of the following is true?
a.
b.
c.
d.

Reported inventory is too high by $5.

Gross prot is too high by $5.
Working capital is too low by $5.
Net income is correctly stated.

Answer:
The correct answer is choice c: Working capital is too low by $5.
Explanation:
Because FIFO is applied, the rst cost ($120) should be moved from inventory to cost of goods sold instead of
$125 (the cost of the Tuesday purchase). Cost of goods sold is too high by $5 and inventory is too low by the
same amount. Working capital (current assets less current liabilities) is understated because the inventory balance within the current assets is too low. Because the expense is too high, both gross prot and net income
are understated (too low).

LIFO (last in rst out)

Inventory cost ow
assumption based on the
most recent costs being
transferred rst from
inventory to cost of goods
sold so that the oldest costs
remain in ending inventory.

Last-in, rst-out (LIFO). LIFO is the opposite of FIFO: The most recent costs are moved to expense as
sales are made.
Theoretically, the LIFO assumption is often justied as more in line with the matching principle.
Shirt One was bought on December 2 whereas Shirt Two was not acquired until December 29. The
sales revenue was generated on December 31. Proponents of LIFO argue that matching the December
29 cost with the December 31 revenue is more appropriate than using a cost incurred several weeks
earlier. According to this reasoning, income is more properly determined with LIFO because a relatively current cost is shown as cost of goods sold rather than a gure that is out-of-date.
The dierence in reported gures is especially apparent in periods of high ination which makes
this accounting decision even more important. By matching current costs against current sales, LIFO
produces a truer picture of income; that is, the quality of income produced by the use of LIFO is higher
because it more nearly approximates disposable income.[1] Note 1 to the 2010 nancial statements for
ConocoPhillips reiterates that point: LIFO is used to better match current inventory costs with current revenues.
The last cost incurred in buying blue shirts was $70 so this amount is reclassied to expense at the
time of the rst sale as shown in Figure 9.2.
FIGURE 9.2 Journal EntryReclassification of the Cost of One Piece of Inventory Using LIFO

Although the physical results of these transaction are the same (one unit was sold, one unit was retained, and the company holds $110 in cash), the nancial picture painted using the LIFO cost ow assumption is quite dierent from that shown previously in the FIFO example.
LIFO
Cost of Goods Sold (one unit soldthe cost of the last one)

$70

Gross Prot ($110 sales price less $70 cost)

$40

Ending Inventory (one unit remainsthe cost of the rst one) $50

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

253

Characteristics commonly associated with LIFO can be seen in this example. When prices rise, LIFO
companies report lower net income (the most recent and, thus, the most costly purchases are moved to
expense) and a lower inventory account on the balance sheet (the earlier, cheaper costs remain in the
inventory T-account). As will be discussed in a subsequent section, LIFO is popular in the United
States because it helps reduce the amount many companies must pay in income taxes.
T E S T

Y O U R S E L F

Question:
A hardware store buys a lawn mower on Monday for $120, another identical model on Tuesday for $125, another on Wednesday for $132, and a nal one on Thursday for $135. One is sold on Friday for $180 in cash. The
company applied FIFO although company ocials had originally argued for the use of LIFO. Which of the following statements are true?
a. If the company had applied LIFO, its net income would have been $10 lower than is being reported.
b. If the company had applied LIFO, gross prot would have been $15 lower than is being reported.
c. If the company had applied LIFO, inventory on the balance sheet would have been $15 higher than is
being reported.
d. If the company had applied LIFO, cost of goods sold would have been $10 higher than is being reported.
Answer:
The correct answer is choice b: If the company had applied LIFO, gross prot would have been $15 lower than
is being reported.
Explanation:
In FIFO, the $120 cost is removed from inventory and added to cost of goods sold because it is the rst cost
acquired. Under LIFO, the $135 cost of the last lawn mower would have been reclassied. Thus, in using LIFO,
cost of goods sold is $15 higher so that both gross prot and net income are $15 lower. Because the higher
(later) cost is removed from inventory, this asset balance will be $15 lower under LIFO.

Averaging. Because the identity of the items conveyed to buyers is unknown, this nal cost ow assumption holds that averaging all costs is the most logical solution. Why choose any individual cost if
no evidence exists of its validity? The rst item received might have been sold or the last. Selecting
either is an arbitrary decision. If items with varying costs are held, using an average provides a very appealing logic. In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60
($120/2 units).
FIGURE 9.3 Journal EntryReclassification of the Cost of One Piece of Inventory Using Averaging

averaging
Inventory cost ow
assumption based on the
average cost being
transferred from inventory to
cost of goods sold so that this
same average cost remains in
ending inventory.

Although no shirt actually cost $60, this average serves as the basis for reporting both cost of goods
sold and the item still on hand. Therefore, all costs are included in arriving at each of these gures.
Averaging
Cost of Goods Sold (one unit soldthe cost of the average one) $60
Gross Prot ($110 sales price less $60 cost)

$50

Ending Inventory (one unit remainsthe cost of the last one)

$60

Averaging has many supporters. However, it can be a rather complicated system to implement especially if inventory costs change frequently. In addition, it does not oer the benets that make FIFO
(higher reported income) and LIFO (lower taxes in the United States) so appealing. Company ocials
often arrive at practical accounting decisions based more on an evaluation of advantages and disadvantages rather than on theoretical merit.
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

254

FINANCIAL ACCOUNTING VERSION 2.0

T E S T

Y O U R S E L F

Question:
A hardware store buys a lawn mower on Monday for $120, another identical model on Tuesday for $125, another on Wednesday for $132, and a nal one on Thursday for $135. One is sold on Friday for $180 in cash.
Company ocials are trying to decide whether to select FIFO, LIFO, or averaging as the cost ow assumption.
Which of the following statements is true?
a.
b.
c.
d.

Gross prot under FIFO is $7 higher than under averaging.

Gross prot under averaging is $7 higher than under LIFO.
Gross prot under averaging is $7 lower than under FIFO.
Gross prot under LIFO is $7 lower than under FIFO.

Answer:
The correct answer is choice b: Gross prot under averaging is $7 higher than under LIFO.
Explanation:
With FIFO, $120 (the rst cost) is moved out of inventory and into cost of goods sold. Gross prot is $60 ($180
less $120). For LIFO, $135 (the last cost) is transferred to expense to gross prot is $45 ($180 less $135). In averaging, an average of $128 is calculated ([$120 + $125 + $132 + $135]/4 units). That cost is then reclassied
from inventory to cost of goods sold so that gross prot is $52 ($180 less $128). FIFO is $8 higher than averaging; averaging is $7 higher than LIFO.

K E Y

T A K E A W A Y

U.S. GAAP tends to apply standard reporting rules to many transactions to make resulting nancial statements
more easily understood by decision makers. The application of an inventory cost ow assumption is one area
where signicant variation does exist. A company can choose to use specic identication, rst-in, rst-out
(FIFO), last-in, rst-out (LIFO), or averaging. In each of these assumptions, a dierent cost is moved from inventory to cost of goods sold to reect the sale of merchandise. The reported inventory balance as well as the expense on the income statement (and, hence, net income) are dependent on the cost ow assumption that is
selected. In periods of ination, FIFO reports a higher net income than LIFO and a larger inventory balance.
Consequently, LIFO is popular because it is often used to reduce income tax costs.

2. THE SELECTION OF A COST FLOW ASSUMPTION FOR

REPORTING PURPOSES
L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Appreciate that reported inventory and cost of goods sold balances are not intended to be
right or wrong but rather in conformity with U.S. GAAP, which permits the use of several dierent cost ow assumptions.
2. Recognize that three cost ow assumptions (FIFO, LIFO, and averaging) are particularly popular in the United States.
3. Understand the meaning of the LIFO conformity rule and realize that use of LIFO in the United
States largely stems from the presence of this tax law.
4. Know that U.S. companies prepare nancial statements according to U.S. GAAP but their income tax returns are based on the Internal Revenue Code so that signicant dierences often
exist.

2.1 Presenting Inventory Balances Fairly

Question: FIFO, LIFO, and averaging can present radically dierent portraits of identical events. Is the
gross prot for this mens clothing store really $60 (FIFO), $40 (LIFO), or $50 (averaging) following the
sale of one blue dress shirt? Analyzing inventory numbers presented by most companies can be dicult if
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

255

not impossible without understanding the implications of the cost ow assumption that was applied.
Which cost ow assumption is viewed as most appropriate in producing fairly presented nancial
statements?
Answer: Because specic identication reclassies the cost of the actual unit that was sold, nding
theoretical fault with that approach is dicult. Unfortunately, specic identication is nearly impossible to apply unless easily distinguishable dierences exist between similar inventory items. For a
vast majority of companies, that leaves FIFO, LIFO, and averaging. Arguments over their merits and
their problems have raged for decades. Ultimately, information in nancial statements must be presented fairly based on the cost ow assumption that is utilized.
In a previous chapter, an important clarication was made about the report of the independent
auditor. It never assures decision makers that nancial statements are presented fairly. That is a
hopelessly abstract concept like truth and beauty. Instead, the auditor states that the statements
present fairlyin conformity with accounting principles generally accepted in the United States of
America. That is a substantially more objective standard. Thus, for this mens clothing store, all the
numbers in Figure 9.4 are presented fairly but only in conformity with the specic cost ow assumption that was applied.
FIGURE 9.4 Results of Possible Cost Flows Assumptions Used by Clothing Store

2.2 Most Popular Cost Flow Assumptions

Question: Since company ocials are allowed to select a cost ow assumption, which of these methods
is most typically found in the nancial reporting of companies operating in the United States?
Answer: To help interested parties gauge the usage of various accounting methods and procedures,
a survey is carried out annually of the nancial statements of 500 large companies. The resulting information allows accountants, auditors, and decision makers to weigh the validity of a particular
presentation. For 2009, this survey found the following frequency for the various cost ow assumptions. Some companies actually use multiple assumptions: one for a particular portion of its inventory
and a dierent one for the remainder. Thus, the total here is above 500 even though 98 of the surveyed
companies did not report having inventory or mention a cost ow assumption (inventory was probably
an immaterial amount). As will be discussed later in this chapter, applying multiple assumptions is especially common when a U.S. company owns subsidiaries that are located internationally.
Inventory Cost Flow Assumptions500 Companies Surveyed[2]
First-in, First-out (FIFO)

325

Last-in, First-out (LIFO)

176

Averaging

147

Other

18

Interestingly, individual cost ow assumptions tend to be more prevalent in certain industries. In this
same survey, 92 percent of the nancial statements issued by food and drug stores made use of LIFO
whereas only 11 percent of the companies labeled as computers, oce equipment had adopted this
same approach. This dierence is likely caused by the presence of ination or deation in those industries. Prices of food and drugs tend to escalate consistently over time while computer prices often fall as
technology advances.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

256

FINANCIAL ACCOUNTING VERSION 2.0

2.3 The LIFO Conformity Rule

Question: In periods of ination, FIFO reports a higher gross prot (and, hence, net income) and a higher
inventory balance than does LIFO. Averaging presents gures that normally fall between these two extremes. Such results are widely expected by the readers of nancial statements who understand the impact
of the various cost ow assumptions.
In the United States, all of these methods are permitted for nancial reporting. Why is FIFO not the
obvious choice for every organization that anticipates ination in its inventory costs? Ocials must prefer
to report gures that make the company look stronger and more protable. With every rise in prices,
FIFO shows a higher income because the earlier (cheaper) costs are transferred to cost of goods sold. Likewise, FIFO reports a higher total for ending inventory because the later (higher) cost gures are retained
in the inventory T-account. The company is no dierent physically as a result of this decision but FIFO
makes it look better. Why does any company voluntarily choose LIFO, an approach that reduces reported income and total assets when prices rise?
LIFO conformity rule
A United States income tax
rule that requires LIFO to be
used for nancial reporting
purposes if it is adopted for
taxation purposes.

Answer: LIFO might well have faded into oblivion because of its negative impact on key reported
gures (during inationary periods) except for a U.S. income tax requirement known as the LIFO
conformity rule. Although this tax regulation is not part of U.S. GAAP and looks rather innocuous, it
has a huge impact on the way inventory and cost of goods sold are reported in this country.
If costs are increasing, companies prefer to apply LIFO for tax purposes because this assumption
reduces reported income and, hence, required cash payments to the government. In the United States,
LIFO has come to be universally equated with the saving of tax dollars. When LIFO was rst proposed
as a tax method in the 1930s, the United States Treasury Department appointed a panel of three experts
to consider its validity. The members of this group were split over a nal resolution. They eventually
agreed to recommend that LIFO be allowed for income tax purposes but only if the company was also
willing to use LIFO for nancial reporting. At that point, tax rules bled over into U.S. GAAP.
The rationale behind this compromise was that companies were allowed the option but probably
would not choose LIFO for their tax returns because of the potential negative eect on the gures reported to investors, creditors, and others. During inationary periods, companies that apply LIFO do
not look as nancially healthy as those that adopt FIFO. Eventually this recommendation was put into
law and the LIFO conformity rule was born. It is a federal law and not an accounting principle. If LIFO
is used on a companys income tax return, it must also be applied on the nancial statements.
However, as the previous statistics on usage point out, this requirement did not prove to be the deterrent that was anticipated. Actual use of LIFO has remained popular for decades. For many companies, the money saved in income tax dollars more than outweighs the problem of having to report numbers that make the company look weaker. Figure 9.5 shows that both methods have advantages and disadvantages. Company ocials must weigh the options and make a decision.
As discussed later in this chapter, IFRS does not permit the use of LIFO. Therefore, if IFRS is ever
mandated in the United States, a signicant tax advantage will be lost unless the LIFO conformity rule
is abolished.
FIGURE 9.5 Advantages and Disadvantages of FIFO and LIFO
*Assumes a rise in prices over time.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

T E S T

257

Y O U R S E L F

Question:
The Cucina Company buys and sells widgets in a highly inationary market. Prices tend to go up quickly. An
analyst is studying the company and notes that LIFO has been selected as the companys cost ow assumption. Which of the following is not likely to be true?
a.
b.
c.
d.

Cost of goods sold will come closest to reecting current costs.

The inventory balance will be below market value for the items being held.
The company will have more cash because tax payments will be lower.
Net income will be inated.

Answer:
The correct answer is choice d: Net income will be inated.
Explanation:
With LIFO, the latest costs are moved to cost of goods sold; thus, this expense is more reective of current
prices. These costs are high during ination so the resulting gross prot and net income are lower. That allows
the company to save tax dollars since payments are reduced. The earliest (cheapest) costs remain in inventory,
which means this asset is reported at below its current value. LIFO, during ination, is known for low inventory
costs, low income, and low tax payments.

2.4 Two Sets of Books

Question: The LIFO conformity rule requires companies that apply LIFO for income tax purposes to also
use that same cost ow assumption in conveying nancial information to investors and creditors. Are the
balances submitted to the government for income tax purposes not always the same as that presented
to decision makers in a set of nancial statements? Reporting dierent numbers to dierent parties
seems unethical.
Answer: In both jokes and editorials, businesses are often derisively accused of keeping two sets of
books. The implication is that one is skewed toward making the company look good (for external reporting purposes) whereas the other makes the company look bad (for taxation purposes). However,
the existence of separate accounting records is a practical necessity. One set is based on applicable tax
laws while the other enables the company to prepare nancial statements according to U.S. GAAP.
With two dierent sets of rules, the outcomes have to look dierent.
In ling income taxes with the United States government, a company must follow the regulations
of the Internal Revenue Code.[3] Those laws have several underlying objectives that inuence their
development.
First, income tax laws are designed to raise money for the operation of the federal government.
Without adequate funding, the government could not provide hospitals, build roads, maintain a military and the like.
Second, income tax laws enable the government to help regulate the health of the economy. Simply
by raising or lowering tax rates, the government can take money out of the economy (and slow public
spending) or leave money in the economy (and increase public spending). For example, in a recent
year, a signicant tax break was passed by Congress to aid rst-time home buyers. This move was designed to stimulate the housing market by encouraging individuals to consider making a purchase.
Third, income tax laws enable the government to assist certain members of society who are viewed
as deserving help. For example, taxpayers who encounter high medical costs or casualty losses are entitled to a tax break. Donations conveyed to an approved charity can also reduce a taxpayers tax bill.
The rules and regulations were designed to provide assistance for specied needs.
In contrast, in the United States, external nancial reporting is governed by U.S. GAAP, a system
designed to achieve the fair presentation of accounting information. That is the reason U.S. GAAP exists. Because the goals are dierent, nancial data reported according to U.S. GAAP will not necessarily
correspond to the tax gures submitted by the same company to the Internal Revenue Service (IRS). At
places, though, agreement can be found between the two sets of rules. For example, both normally recognize a cash sale of merchandise as revenue at the time of sale. However, many dierences do exist
between the two. A loss on the sale of an investment in equity securities is just one example of a transaction that is handled quite dierently for taxes and nancial reporting.
Although separately developed, nancial statements and income tax returns are tied together at
one signicant spot: the LIFO conformity rule. If a company chooses to use LIFO in ling its United
States income tax return, it must do the same for nancial reporting. Without that legal requirement,
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

258

FINANCIAL ACCOUNTING VERSION 2.0

many companies would likely use FIFO in creating their nancial statements and LIFO for their income tax returns. Much of the popularity of LIFO is undoubtedly derived from this tax requirement
rather than from any theoretical merit.
K E Y

T A K E A W A Y

Information found in nancial statements is required to be presented fairly in conformity with U.S. GAAP. Because several inventory cost ow assumptions are allowed, reported numbers can vary signicantly from one
company to another and still be appropriate. FIFO, LIFO, and averaging are all popular in the United States.
Understanding and comparing nancial statements is quite dicult without knowing the implications of the
method selected. LIFO, for example, tends to produce low net income gures in a period of ination. This cost
ow assumption probably would not be used extensively except for the LIFO conformity rule. That tax law
prohibits the use of LIFO for tax purposes unless also applied on the companys nancial statements. Typically,
nancial reporting and the preparation of income tax returns are unrelated because two sets of rules are used
with radically diering objectives. However, the LIFO conformity rule joins these two at this one key spot.

3. PROBLEMS WITH APPLYING LIFO

L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Recognize that theoretical and practical problems with LIFO have led the creators of IFRS rules
to prohibit its use.
2. Explain that the most obvious problem associated with LIFO is an inventory balance that can
show costs from years (or even decades) earlier, costs that are totally irrelevant today.
3. Identify the cause of a LIFO liquidation and the reason that it is viewed as a theoretical concern
by accountants.

3.1 Reporting Ending Inventory Using LIFO

Question: As a result of the LIFO conformity rule in the tax laws, this cost ow assumption is widely used
in the United States. LIFO, though, is not allowed in many other areas of the world. It is not simply unpopular in those locations; its application is strictly forbidden by IFRS. Thus, international companies are
often forced to resort to alternatives in reporting their foreign subsidiaries. For example, a note to the
2010 nancial statements of American Biltrite Inc. explains that cost is determined by the last-in, rstout (LIFO) method for approximately 47% of the Companys domestic inventories. The use of LIFO results in a better matching of costs and revenues. Cost is determined by the rst-in, rst-out (FIFO) method
for the Companys foreign inventories.
Why is LIFO not accepted in most countries outside the United States?
Answer: Although LIFO can be supported as providing a better matching of expenses (cost of
goods sold) with revenues, a number of serious problems arise from its application. The most common
accusation made against LIFO is that it often presents a balance sheet gure that is out-of-date and
completely useless. When applying this assumption, the latest costs are moved to cost of goods sold so
that earlier costs remain in the inventory accountpossibly for years and even decades. After some
period of time, this asset balance is likely to report a number that has no relevance to todays prices.
For example, in its 2010 nancial statements, ExxonMobil reported inventory on its balance sheet
of approximately $13.0 billion based on applying the LIFO cost ow assumption. In the notes to those
nancial statements, the company disclosed that the current cost to acquire this same inventory was actually $21.3 billion higher than the number being reported. The asset was shown as $13.0 billion but
the price to obtain that merchandise on the balance sheet date was $34.3 billion ($13.0 billion plus
$21.3). What is the possible informational value of reporting an asset (one that is being held for sale) at
an amount more than $21 billion below its current replacement cost?[4] That is the essential problem
attributed to LIFO.
To illustrate, assume that a convenience store begins operations and has a tank that holds ten
thousand gallons of gasoline. On January 1, 1972, the tank is lled at a cost of $1 per gallon. Almost immediately the price of gasoline jumps to $2 per gallon. During the remainder of 1972, the store buys
and sells gas. The tank is lled one nal time at the very end of the year bringing total purchases to one
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

259

million gallons. The rst 10,000 gallons were bought at $1.00 per gallon; the next one million gallons
cost $2.00 per gallon.
LIFO and FIFO report these results as follows:
LIFO
Cost of Goods Sold1,000,000 gallons at last cost of $2 per gallon $2,000,000
Ending Inventory10,000 gallons at rst cost of $1 per gallon

10,000

FIFO
Cost of Goods Soldrst 10,000 gallons at $1 per gallon and next 990,000 gallons at $2 per gallon $1,990,000
Ending Inventory10,000 gallons at last cost of $2 per gallon

20,000

After just this initial period, the ending inventory balance shown for LIFO (10,000 gallons at $1 per gallon) already diers signicantly from the current cost of $2 per gallon.
If this convenience store continues to nish each year with a full tank of 10,000 gallons (certainly
not an unreasonable assumption), LIFO will report this inventory at $1 per gallon for the following
decades regardless of current prices. The most recent costs get transferred to cost of goods sold every
period leaving the rst costs ($1 per gallon) in inventory. The tendency to report this asset at a cost expended years in the past is the single biggest reason that LIFO is viewed as an illegitimate cost ow assumption in many countries. That same sentiment would probably exist in the United States except for
the LIFO conformity rule.
T E S T

Y O U R S E L F

Question:
The Lenoir Corporation sells paperback books and boasts in its ads that it holds over one million volumes.
Prices have risen over the years and, at the present time, books like those obtained by Lenoir cost between $4
and $5 each. Sandy Sanghvi is thinking about buying shares of the ownership stock of Lenoir and picks up a
set of nancial statements to help evaluate the company. The inventory gure on the companys balance
sheet is reported as $832,000 based on the application of LIFO. Which of the following is Sanghvi most likely
to assume?
a. Lenoir has many subsidiaries in countries outside of the United States.
b. Lenoir ocials prefer to minimize tax payments rather than looking especially healthy in an economic
sense.
c. Lenoirs net income is likely to be slightly inated because of the impact of ination.
d. Lenoir is likely to use dierent cost ow assumptions for nancial reporting and income tax purposes.
Answer:
The correct answer is choice b: Lenoir ocials prefer to minimize tax payments rather than looking especially
healthy in an economic sense.
Explanation:
Knowledge of nancial accounting provides a decision maker with an understanding of many aspects of the
information reported by a company. Here, the inventory balance is signicantly below current cost, which is
common for LIFO, an assumption that often serves to reduce taxable income in order to decrease tax payments. Because of the LIFO conformity rule, use of that assumption for tax purposes requires that it also be adopted for nancial reporting purposes. It is normally not used by foreign companies.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

260

FINANCIAL ACCOUNTING VERSION 2.0

3.2 LIFO Liquidation

LIFO liquidation
A decrease in the quantity of
inventory on hand when LIFO
is applied so that costs
incurred in a previous period
are mismatched with
revenues of the current
period; if ination has
occurred, it can cause a
signicant increase in
reported net income.

Question: In discussions of nancial reporting, LIFO is also criticized because of the possibility of an event
known as a LIFO liquidation. What is a LIFO liquidation and why does it create a theoretical problem for accountants?
Answer: As demonstrated above, costs from much earlier years often remain in the inventory Taccount over a long period of time if LIFO is applied. With that cost ow assumption, a convenience
store that opens in 1972 and ends each year with a full tank of 10,000 gallons of gasoline reports ending
inventory at 1972 costs for years or even decades. Every balance sheet will show inventory as $10,000
(10,000 gallons in ending inventory at $1.00 per gallon).
However, if the quantity of inventory is ever allowed to decrease (accidentally or on purpose),
some or all of those 1972 costs move to cost of goods sold. For example, if the convenience store ends
2012 with less than 10,000 gallons of gasoline, the reduction means that costs sitting in the inventory Taccount since 1972 are recognized as an expense in the current year. Costs from 40 years earlier are
matched with revenue in 2012. That is a LIFO liquidation and it can articially inate reported earnings if those earlier costs are especially low.
To illustrate, assume that this convenience store starts 2012 with 10,000 gallons of gasoline. LIFO
has been applied over the years so that this inventory is reported at the 1972 cost of $1.00 per gallon. In
2012, gasoline costs the store $3.35 per gallon to buy and is then sold to the public for $3.50 per gallon
creating a gross prot of $0.15 per gallon. That is the amount of income the store is making this year.
At the beginning of 2012, the convenience store sells its entire stock of 10,000 gallons of gasoline at
the market price of $3.50 and then ceases to carry this product (perhaps the owners want to focus on
groceries or automobile parts). Without any replacement of the inventory, the cost of the gasoline
bought in 1972 for $1.00 per gallon is shifted from inventory to cost of goods sold in 2012. Instead of
recognizing the normal prot margin of $0.15 per gallon or $1,500 for the 10,000 gallons, the store reports gross prot of $2.50 per gallon ($3.50 sales price minus $1.00 cost of goods sold) or $25,000 in
total. The reported prot ($25,000) does not reect the reality of current market conditions. This LIFO
liquidation allows the store to look overly protable.
In a LIFO liquidation, costs from an earlier period are matched with revenues of the present year.
Revenue is measured in 2012 dollars but cost of goods sold is stated in 1972 prices. Although the reported gures are technically correct, the implication that this store earned a gross prot of $2.50 per gallon is misleading.
To warn decision makers of the impact that a LIFO liquidation has on reported net income, disclosure in the notes to the nancial statements is needed whenever costs are mismatched in this manner. According to a note in the 2010 nancial statements for Alcoa Inc. (all numbers in millions),
During the three-year period ended December 31, 2010, reductions in LIFO inventory quantities
caused partial liquidations of the lower cost LIFO inventory base. These liquidations resulted in the recognition of income of $27 ($17 after-tax) in 2010, $175 ($114 after-tax) in 2009, and $38 ($25 aftertax) in 2008.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

T E S T

261

Y O U R S E L F

Question:
Margaret Besseler is studying the nancial statements produced by Associated Chemicals of Rochester. Besseler notices that the footnotes indicate that a LIFO liquidation took place during the most recent year. Which of
the following is least likely to be true?
a.
b.
c.
d.

Inventory quantities decreased during the year.

Reported net income was inated by the LIFO liquidation.
The company converted from the use of LIFO to that of FIFO (or some other cost ow assumption).
Cost of goods sold was below the current cost of the inventory sold.

Answer:
The correct answer is choice c: The company converted from the use of LIFO to that of FIFO (or some other
cost ow assumption).
Explanation:
A LIFO liquidation is a decrease in the quantity of inventory held by a company that applies LIFO so that a cost
(often a much cheaper cost) from an earlier time period is moved from inventory to cost of goods sold. That
articially reduces this expense and, hence, increases both reported gross prot and net income. A LIFO liquidation is viewed unfavorably by accountants because an old, out-of-date (often much cheaper) cost is matched
with current revenues.

Talking with an Independent Auditor about International Financial Reporting

Standards (Continued)
Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting rm
PricewaterhouseCoopers.
Question: Companies in the United States are allowed to choose FIFO, LIFO, or averaging as an inventory cost
ow assumption. Over the years, many U.S. companies have adopted LIFO, in part because of the possibility of
reducing income taxes during a period of ination. However, IFRS rules do not recognize LIFO as appropriate.
Why does such strong resistance to LIFO exist outside the United States? If the United States adopts IFRS will
all of these companies that now use LIFO have to switch their accounting systems to FIFO or averaging? How
much trouble will that be?
Rob Vallejo: The International Accounting Standards Board revised International Accounting Standard No. 2, Inventories (IAS 2), in 2003. The issue of accounting for inventories using a LIFO costing method was debated
and I would encourage anyone seeking additional information to read their basis for conclusion which accompanies IAS 2. The IASB did not believe that the LIFO costing method was a reliable representation of actual inventory ows. In other words, in most industries, older inventory is sold to customers before newer inventory.
The standard specically precludes the use of LIFO, but allows for the use of the FIFO or weighted average
costing methods as the board members view these as better representations of actual inventory ows.
Therefore, when U.S. companies have to adopt IFRS, the inventory balances and the related impact on shareholders equity will be restated as if FIFO or average costing had been used for all periods presented. Most
companies keep their books on a FIFO or weighted average cost basis and then apply a LIFO adjustment, so
the switch to an alternative method should not be a big issue in a mechanical sense. However, the reason
most companies apply the LIFO costing method relates to U.S. tax law. Companies that want to apply LIFO for
income tax purposes are required to also present their nancial information under the LIFO method. The big
question still being debated is whether or not U.S. tax law will change to accommodate the move to IFRS. This
is very important to U.S. companies, as generally, applying LIFO has had a cumulative impact of deferring the
payment of income taxes. If companies must change to FIFO or weighted average costing methods for tax
purposes, that could mean substantial cash payments to the IRS. This continues to be a very hot topic for accountants and U.S. government ocials, as the cash tax implications are signicant for many companies.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

262

FINANCIAL ACCOUNTING VERSION 2.0

K E Y

T A K E A W A Y

LIFO is used by many companies in the United States because of the LIFO conformity rule. However, troubling
theoretical problems do exist. These concerns are so serious that LIFO is prohibited in many places in the
world because of the rules established by IFRS. The most recent costs are reclassied to cost of goods sold so
earlier costs remain in the inventory account. Consequently, this asset can continue to show inventory costs
from years or even decades earliera number that would be of little use to any decision maker. In addition, if
these earlier costs are ever transferred to cost of goods sold because of shrinkage in the quantity of inventory,
a LIFO liquidation is said to occur. Although revenues are from the current year, the related cost of goods sold
reects very old cost numbers. Reported net income is articially inated. Thus, information about LIFO liquidations appears in the notes to the nancial statements so readers can weigh the impact.

4. MERGING PERIODIC AND PERPETUAL INVENTORY

SYSTEMS WITH A COST FLOW ASSUMPTION
L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Merge a cost ow assumption (FIFO, LIFO, and averaging) with a method of monitoring inventory (periodic or perpetual) to arrive at six dierent systems for determining reported inventory
gures.
2. Understand that a cost ow assumption is only applied when determining the cost of ending
inventory in a periodic system but is used for each reclassication from inventory to cost of
goods sold in a perpetual system.
3. Calculate ending inventory and cost of goods sold using both a periodic and a perpetual FIFO
system.
4. Recognize that periodic and perpetual FIFO systems will arrive at identical account balances.

4.1 Cost Flow Assumptions and Inventory Systems

Question: In the previous chapter, periodic and perpetual inventory systems were introduced. FIFO,
LIFO, and averaging have now been presented. How does all of this material come together for reporting
purposes? How does the application of a cost ow assumption impact the operation of a periodic or a
perpetual inventory system?
Answer: Each company that holds inventory must develop a mechanism to both (a) monitor the
balances and (b) allow for the creation of nancial statements. If a periodic system is used, ocials
simply wait until nancial statements are to be produced before taking a physical count. Then, a formula (beginning inventory plus all purchase costs less ending inventory) is applied to derive cost of
goods sold.
In contrast, a perpetual system maintains an ongoing record of the goods that remain on hand and
those that have been sold. As noted, both of these systems have advantages and disadvantages.
Companies also select a cost ow assumption to specify the cost that is transferred from inventory
to cost of goods sold (and, hence, the cost that remains in the inventory T-account). For a periodic system, the cost ow assumption is only applied when the physical inventory count is taken and the cost
of the ending inventory is determined. In a perpetual system, the cost ow assumption is used each
time a sale is made to identify the cost to be reclassied to cost of goods sold. That can occur thousands
of times each day.
Therefore, companies normally choose one of six systems to monitor their merchandise balances
and determine the cost assignment between ending inventory and cost of goods sold:
Periodic FIFO
Perpetual FIFO
< Periodic LIFO
< Perpetual LIFO
< Periodic averaging (also called weighted averaging)
< Perpetual averaging (also called moving averaging)
<
<

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

263

4.2 Periodic and Perpetual FIFO

Question: To illustrate, assume that the Mayberry Home Improvement Store starts the new year with
four bathtubs (Model WET-5) in its inventory, costing $110 each ($440 in total) when bought on December 9 of the previous period. The following events then take place during the current year.
On February 2, three of these bathtubs are sold for $200 each. (revenue $600)
< On February 6, three new bathtubs of this model are bought for $120 each. (cost $360)
< On June 8, three of these bathtubs are sold for $250 each. (revenue $750)
< On June 13, three new bathtubs of this model are bought for $130 each. (cost $390)
< On September 9, two of these bathtubs are sold for $300 each. (revenue $600)
< On September 22, two new bathtub of this model are bought for $149. (cost $298)
<

At the end of the year, on December 31, a physical inventory is taken that nds that four bathtubs, Model
WET-5, are in stock (4 3 + 3 3 + 3 2 + 2). None were stolen, lost, or damaged during the period.
How does a periodic FIFO system dier from a perpetual FIFO system in maintaining accounting records and reporting inventory totals?
Answer: Regardless of the inventory system in use, several pieces of information are established in
this example. These gures are factual, not impacted by accounting.
The FactsPurchase and Sale of WET-5 Bathtubs
Revenue: Eight units were sold for $1,950 ($600 + $750 + $600)
Beginning Inventory: Four units costing $110 each or $440 in total
< Purchases: Eight units were bought during the year costing a total of $1,048 ($360 + $390 + $298)
< Ending Inventory: Four units are still held according to the physical inventory
<
<

Periodic FIFO. In a periodic system, the cost of all new purchases is the focus of the record keeping.
Then, at the end of the period, the accountant must count and also determine the cost of the items held
in ending inventory. When using FIFO, the rst costs are transferred to cost of goods sold so the cost of
the last four bathtubs remain in the inventory T-account. That is the FIFO assumption. The rst costs
are now in cost of goods sold while the most recent costs remain in the asset account.
In this illustration, the last four costs (starting at the end of the period and moving forward) are
two units at $149 each and two units at $130 each for a total of $558. Only after that cost is assigned to
the ending inventory units can cost of goods sold be calculated as shown in Figure 9.6.
FIGURE 9.6 Periodic FIFOBathtub Model WET-5

Under FIFO, the last costs for the period remain in ending inventory; the rst costs have all been transferred to cost of goods sold. Based on the application of FIFO, Mayberry reports gross prot from the
sale of bathtubs during this year of $1,020 (revenue of $1,950 minus the cost of goods sold gure of
$930 calculated in Figure 9.6).
Perpetual FIFO. Perpetual accounting systems are constructed so that costs can be moved from inventory to cost of goods sold at the time of each new sale. With modern computer processing, that is a
relatively simple task. In Figure 9.7, one format is shown that provides the information needed for this
store about the cost and quantity of its inventory of bathtubs. In this gure, at points A, B, and C, costs
are moved from inventory on hand to cost of goods sold based on FIFO. The cost of the rst goods in
the inventory on hand is reclassied to cost of goods sold at each of those three points in time.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

264

FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 9.7 Perpetual FIFOBathtub Model WET-5

On this perpetual inventory spreadsheet, the nal cell in the inventory on hand column ($558 or two
units @ $130 and two units at $149) provides the cost of the ending inventory to be reported on the
balance sheet. However, it is the summation of the entire cost of goods sold column that arrives at the
expense for the period ($930 or $330 + $350 + $250).
One important characteristic of FIFO should be noted here. Under both periodic and perpetual
FIFO, ending inventory is $558 and cost of goods sold is $930. The reported numbers are identical. The
rst cost for the period is always the rst cost regardless of when the assignment to expense is made.
Thus, the resulting amounts are the same when using either FIFO system.
For that reason, many companies that apply FIFO maintain perpetual records to track the units on
hand throughout the period but ignore the costs. Later, when nancial statements are prepared, a periodic computation is used to determine the cost of ending inventory in order to calculate cost of goods
sold. That allows these companies to monitor their inventory quantities every day without the expense
and eort of identifying the specic cost associated with each new sale.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

T E S T

265

Y O U R S E L F

Question:
The Hastings Widget Company starts the year with 27,000 widgets costing $2 each. During the year, the company bought another 450,000 widgets for a total of $1,243,000. Within these gures was the acquisition of
20,000 widgets for $3.10 each on December 26 and 15,000 widgets for $3.00 each on December 18. Those
were the last two purchases of the year. On December 31, the company took a physical count and found
22,000 widgets still on hand. If a FIFO cost ow assumption is applied, what is cost of goods sold?
a.
b.
c.
d.

$1,229,000
$1,233,200
$1,243,000
$1,245,800

Answer:
The correct answer is choice a: $1,229,000.
Explanation:
Beginning inventory is $54,000 (27,000 units at $2 each) while purchases are $1,243,000, a total cost of
$1,297,000. With FIFO, the remaining 22,000 units had the cost of the last purchases: 20,000 at $3.10 ($62,000)
plus 2,000 bought for $3.00 each ($6,000). Ending inventory cost $68,000 ($62,000 + $6,000). Subtracting this
cost from the goods available gives cost of goods sold of $1,229,000 ($1,297,000 less $68,000). The use of periodic or perpetual has no impact since FIFO was used.

K E Y

T A K E A W A Y

Companies that sell inventory will choose a cost ow assumption such as FIFO, LIFO, or averaging. In addition,
a monitoring system (either periodic or perpetual) must be installed to record inventory balances . Six combinations (periodic FIFO, perpetual FIFO, periodic LIFO, and the like) can result from these two decisions. With any
periodic system, the cost ow assumption is only used to determine the cost of ending inventory units so that
cost of goods sold for the period can be calculated. For a perpetual inventory system, the reclassication of
costs from asset to expense is performed each time that a sale is made and is based on the selected cost ow
assumption. Periodic FIFO and perpetual FIFO systems arrive at the same reported balances because the earliest cost is always the rst to be transferred regardless of the method applied.

5. APPLYING LIFO AND AVERAGING TO DETERMINE

REPORTED INVENTORY BALANCES
L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Determine ending inventory and cost of goods sold using a periodic LIFO system.
2. Monitor inventory on an ongoing basis through a perpetual LIFO system.
3. Understand the reason that periodic LIFO and perpetual LIFO usually arrive at dierent gures.
4. Use a weighted average system to determine the cost of ending inventory and cost of goods
sold.
5. Calculate reported inventory balances by applying a moving average inventory system.

5.1 Applying LIFO

Question: LIFO reverses the FIFO cost ow assumption so that the last costs incurred are the rst reclassied to cost of goods sold. How is LIFO applied to the inventory of an actual business? If the Mayberry Home Improvement Store adopted LIFO, how would the reported gures for its inventory have been
aected by this decision?
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

266

FINANCIAL ACCOUNTING VERSION 2.0

Answer: Periodic LIFO. In a periodic system, only the computation of the ending inventory is directly aected by the choice of a cost ow assumption.[5] Thus, for this illustration, beginning inventory
remains $440 (4 units at $110 each), and the number of units purchased is still eight with a cost of
$1,048. The gure that changes is the cost of the ending inventory. Four bathtubs remain in stock at the
end of the year. According to LIFO, the last (most recent) costs are transferred to cost of goods sold.
Only the cost of the rst four units remains in ending inventory. That is $110 per unit or $440 in total.
FIGURE 9.8 Periodic LIFOBathtub Model WET-5
*If the number of units bought during a period equals the number of units sold (as is seen in this example), the
quantity of inventory remains unchanged. In a periodic LIFO system, beginning inventory ($440) is then the same as
ending inventory ($440) so that cost of goods sold ($1,048) equals the amount spent during the period to purchase
inventory ($1,048). For that reason, company ocials can easily keep track of gross prot during the year by
subtracting purchases from revenues.

If Mayberry Home Improvement Store uses a periodic LIFO system, gross prot for the year will be reported as $902 (revenue of $1,950 less cost of goods sold of $1,048).
Note here that the anticipated characteristics of LIFO are present. Ending inventory of $440 is
lower than that reported by FIFO ($558). Cost of goods sold ($1,048) is higher than under FIFO ($930)
so that reported gross prot (and, hence, net income) is lower by $118 ($1,020 for FIFO versus $902 for
LIFO).
T E S T

Y O U R S E L F

Question:
The Lowenstein Widget Company starts the year with 24,000 widgets costing $3 each. During the year, the
company bought another 320,000 widgets for a total of $1,243,000. Within these gures was the acquisition of
20,000 widgets for $4.10 each on December 26 and 15,000 widgets for $4.00 each on December 18. Those
were the last two purchases of the year. On December 31, the company took a physical count and found
21,000 widgets still on hand. If a periodic LIFO cost ow assumption is applied, what amount is reported on
the income statement for cost of goods sold?
a.
b.
c.
d.

$1,249,000
$1,252,000
$1,256,000
$1,264,000

Answer:
The correct answer is choice b: $1,252,000.
Explanation:
Beginning inventory is $72,000 (24,000 units at $3 each) and purchases total $1,243,000. Cost of goods available is the total or $1,315,000. With LIFO, the 21,000 units on hand had the $3 cost of the rst items. Total cost
for ending inventory is $63,000. Subtracting this balance from goods of available for sale ($1,315,000 less
$63,000) gives cost of goods sold of $1,252,000. A LIFO liquidation took place since the inventory declined.
That has no impact on the answer but is disclosed.

Perpetual LIFO. The mechanical structure for a perpetual LIFO system is the same as that demonstrated previously for perpetual FIFO except that the most recent costs are moved into cost of goods
sold at the time of each sale (points A, B, and C).
2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

267

FIGURE 9.9 Perpetual LIFOBathtub Model WET-5

Once again, the last cell at the bottom of the inventory on hand column contains the asset gure to be
reported on the balance sheet (a total of $538) while the summation of the cost of goods sold column
provides the amount to be shown on the income statement ($950).
As can be seen here, periodic and perpetual LIFO do not necessarily produce identical numbers.
periodic LIFO: ending inventory $440 and cost of goods sold $1,048
perpetual LIFO: ending inventory $538 and cost of goods sold $950
Although periodic and perpetual FIFO always arrive at the same results, balances reported by periodic
and perpetual LIFO frequently dier. The rst cost incurred in a period (the cost transferred to expense
under FIFO) is the same regardless of the date of sale. However, the identity of the last or most recent
cost (expensed according to LIFO) depends on the perspective.
To illustrate, note that two bathtubs were sold on September 9 by the Mayberry Home Improvement Store. Perpetual LIFO immediately determines the cost of this sale and reclassies the amount to
expense. On that date, the cost of the most recent two units ($130 each) came from the June 13 purchase. In contrast, a periodic LIFO system makes this same determination but not until December 31.
As viewed from years end, the last bathtubs had a cost of $149 each. Although these items were bought
on September 22, after the nal sale, their costs are included in cost of goods sold when applying periodic LIFO.
Two bathtubs were sold on September 9, but the identity of the specic costs to be transferred
(when using LIFO) depends on the date on which the determination is made. A periodic system views
the costs from the perspective of the end of the year. A perpetual system determines the expense immediately when each sale is made.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

268

FINANCIAL ACCOUNTING VERSION 2.0

T E S T

Y O U R S E L F

Question:
A company starts the year with 100 units of inventory costing $9 each. Those units are all sold on June 23.
Another 100 are bought on July 6 for $11 each. On November 18, 70 of these units are sold. On December 16,
fty units are bought for $15 each bringing the total to eighty (100 100 + 100 70 + 50). If a perpetual LIFO
system is used, what is the cost of these eighty units in ending inventory?
a.
b.
c.
d.

$720
$960
$1,080
$1,200

Answer:
The correct answer is choice c: $1,080.
Explanation:
In a perpetual LIFO system, the entire opening cost is transferred to cost of goods sold on June 23. On November 18, the cost of seventy units bought on July 6 is also transferred. That leaves thirty units at $11 each ($330)
plus the December 16 purchase of fty units at $15 each or $750. Ending inventory then has a total of $1,080
($330 plus $750). The reclassication takes place each time at the point of the sale.

In practice, many companies are unlikely to use perpetual LIFO inventory systems. They are costly to
maintain and, as has been discussed previously, provide gures of dubious usefulness. For that reason,
companies often choose to maintain a perpetual FIFO system for internal decision making and then
use the periodic LIFO formula at the end of the year to convert the numbers for external reporting
purposes.
For example, The Kroger Co. presented the following balances on its January 29, 2011, balance
sheet:
<
<

FIFO inventory: $5,793 million

LIFO reserve: (827) million

Kroger apparently monitors its inventory on a daily basis using FIFO and arrived at a nal cost of
$5,793 million. However, at the end of that year, the company took a physical inventory and applied
the LIFO cost ow assumption to arrive at a reported balance that was $827 million lower. The reduced
gure was used for reporting purposes because of the LIFO conformity rule. However, investors and
creditors could still see that ending inventory actually had a current cost of $5,793 million.

5.2 Applying Averaging as a Cost Flow Assumption

Question: Not surprisingly, averaging follows a path similar to that of the previous examples. Costs are
either moved to cost of goods sold at the end of the year (periodic or weighted average) or at the time of
each new sale (perpetual or moving average). The only added variable to this process is the calculation of
average cost. In the operation of an averaging system, when and how is the average cost of inventory
determined?
Answer: Periodic (weighted) average. In the problem being examined here, Mayberry Home Improvement Store eventually held twelve bathtubs. Four of these units were on hand at the start of the
year and the other eight were acquired during the period. The beginning inventory cost $440 and the
new purchases were bought for a total of $1,048.
These twelve units had a total cost of $1,488 ($440 + $1,048) or $124 per bathtub ($1,488/12 units).
When applying a weighted average system, this single average for the entire period is the basis for both
the ending inventory and cost of goods sold to be reported in the nancial statements. No item actually
cost $124 but that average is applied to all units.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

269

FIGURE 9.10 Periodic (Weighted) AverageBathtub Model WET-5

Perpetual (moving) average. In this nal approach to maintaining and reporting inventory, each time
that a company buys inventory at a new price, the average cost is recalculated. Therefore, a moving average system must be programmed to update the average whenever additional merchandise is acquired.
In Figure 9.11, a new average is computed at points D, E, and F. This gure is found by dividing
the number of units on hand after the new purchase into the total cost of those items. For example, at
point D, the company now has four bathtubs. One cost $110 while the other three were newly acquired
for $120 each or $360 in total. Total cost was $470 ($110 + $360) for these four units for an updated average of $117.50 ($470/4 units). That average is used until the next purchase is made on June 13. The
applicable average at the time of sale is transferred from inventory to cost of goods sold at points A
($110.00), B ($117.50), and C ($126.88).
FIGURE 9.11 Perpetual (Moving) AverageBathtub Model WET-5

Summary. The six inventory systems shown here for Mayberry Home Improvement Store provide a
number of distinct pictures of ending inventory and cost of goods sold. As stated earlier, these numbers
are all fairly presented but only in conformity with the specied principles being applied. Interestingly,
gross prot ranges from $902.00 to $1,020.00 based on the system applied by management.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

270

FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 9.12 Reported Balances for Six Inventory Systems

T E S T

Y O U R S E L F

Question:
A company begins the new year with twenty-ve units of inventory costing $12 each. In February, fteen of
these units are sold. At the beginning of May, fty new units are acquired at $15 each. Finally, in August, forty
more units are sold. On December 31, a physical inventory count is taken and twenty units are still on hand.
Thus, no units were lost or stolen (25 units 15 sold + 50 bought 40 sold = 20 units remaining). If a
weighted average system is used, what is the cost to be reported for those twenty units of inventory?
a.
b.
c.
d.

$250
$260
$270
$280

Answer:
The correct answer is choice d: $280.
Explanation:
In a weighted (or periodic) averaging system, the average for the year is not determined until nancial statements are to be produced. Beginning inventory was $300 (twenty-ve units for $12 each) and purchases were
$750 (fty units for $15 each) for a total of seventy-ve units costing $1,050 ($300 + $750). That gives an average of $14 per unit ($1,050 cost/75 units). With this assumption, the cost assigned to the ending inventory of
20 units is $280 (20 units at $14 each).

T E S T

Y O U R S E L F

Question:
A company begins the new year with twenty-ve units of inventory costing $12 each. In February, fteen of
these units are sold. At the beginning of May, fty new units are acquired at $15 each. Finally, in August, forty
more units are sold. On December 31, a physical inventory count is taken and twenty units are still on hand.
Thus, no units were lost or stolen (25 units 15 sold + 50 bought 40 sold = 20 units remaining). If a moving
average system is used, what is the cost to be reported for those twenty units?
a.
b.
c.
d.

$260
$270
$280
$290

Answer:
The correct answer is choice d: $290.
Explanation:
In a moving average system, a new average is determined at the time of each purchase. The company starts
with twenty-ve units and sells fteen. That leaves ten with a unit cost of $12 or $120 in total. Then, fty are
bought (bringing the total to sixty) with a cost of $15 each or $750 (bringing total cost up to $120 + $750 or
$870). The average has now moved to $14.50 ($870 cost for sixty units). Eventually, twenty units remain. The
ending inventory is $290 (twenty units at $14.50 each).

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

K E Y

271

T A K E A W A Y

A periodic LIFO inventory system begins by computing the cost of ending inventory at the end of each year
and then uses that gure to calculate cost of goods sold. Perpetual LIFO also transfers the most recent cost
from inventory to cost of goods sold but makes that reclassication at the time of the sale. Companies frequently maintain inventory records on a FIFO basis for internal decision making and then use a periodic LIFO
calculation to convert for year-end reporting. A weighted average inventory system determines a single average for the entire period and applies that to both ending inventory and cost of goods sold. A moving average
system computes a new average cost each time that additional merchandise is acquired. This average is used
to reclassify costs from inventory to cost of goods sold at the time of sale until the next purchase is made (and
a new average is computed).

6. ANALYZING REPORTED INVENTORY FIGURES

L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Use information found in the nancial statement disclosure notes to convert LIFO income
statement numbers into their FIFO or current cost equivalents.
2. Compute a companys gross prot percentage and explain the relevance of this gure.
3. Calculate the average number of days that inventory is held and provide reasons why companies worry if this gure starts to rise unexpectedly.
4. Determine the inventory turnover and explain its meaning.

6.1 Making Comparisons When LIFO Is Applied

Question: The point has been made several times in this chapter that LIFO provides a lower reported net
income than does FIFO when prices are rising. In addition, the inventory gure shown on the balance
sheet will be below current cost if LIFO is applied during ination. Comparison between companies that
are similar can become dicult, if not impossible, when one uses LIFO and the other FIFO.
For example, Rite Aid, the drug store giant, applies LIFO while its rival CVS Caremark applies FIFO
to the inventory held in its pharmacies. How can an investor or creditor possibly evaluate these two companies to assess which has the brightest nancial future? In this situation, the utility of the available information seems limited. How do experienced decision makers manage to compare companies that apply LIFO to other companies that do not?
Answer: Signicant variations in reported balances frequently result from the application of dierent cost ow assumptions. Because of the potential detrimental eects, companies that use LIFO often
provide additional information to help interested parties understand the impact of this choice. For example, in discussing the use of LIFO, a note to the nancial statements for Rite Aid explains (numbers
are in thousands): At February 26, 2011 and February 27, 2010, inventories were $875,012 and
$831,113, respectively, lower than the amounts that would have been reported using the rst-in, rstout (FIFO) method.
Here, the reader is informed that the companys reported inventory balance would be nearly $900
million higher if FIFO was applied. That one sentence allows for a better comparison with a company
like CVS Caremark that uses FIFO. The dampening impact of LIFO on reported assets can be removed
by the reader as shown in Figure 9.13. Restatement of nancial statements in this manner is a common
technique relied on by investment analysts around the world to make available information more
usable.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

272

FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 9.13 Adjusted Rite Aids Inventory Balances from LIFO to FIFO

Adjusting Rite Aids inventory balance from LIFO to FIFO is not dicult because the relevant information is available. However, restating the companys income statement to numbers in line with FIFO is
a bit more challenging. Rite Aid reported an overall net loss for the year ended February 26, 2011, of
$555,424,000. How would this number have been dierent with the application of FIFO?
As seen in the periodic inventory formula, beginning inventory is added to purchases in determining cost of goods sold while ending inventory is subtracted. With the LIFO gures reported by Rite
Aid, $3,238,644,000 (beginning inventory) was added in arriving at this expense and then
$3,158,145,000 (ending inventory) was subtracted. Together, the net eect is an addition of $80,499,000
in computing cost of goods sold for the year ended February 26, 2011. The resulting expense was
$80,499,000 higher than the amount of inventory purchased.
If FIFO had been used by Rite Aid, $4,069,757,000 (beginning inventory) would have been added
with $4,033,157,000 (ending inventory) subtracted. These two balances produce a net eect on cost of
goods sold of adding $36,600,000.
LIFO: cost of goods sold = purchases + $80.499 million
FIFO: cost of goods sold = purchases + $36.600 million
Under LIFO, cost of goods sold is the purchases for the period plus $80,499,000. Using FIFO, cost of
goods sold is the purchases plus only $36,600,000. The purchase gure is the same in both equations.
Thus, cost of goods sold will be $43,899,000 lower according to FIFO ($80,499,000 less $36,600,000) so
that net income is $43,899,000 higher. If FIFO had been used, Rite Aids net loss for the period would
have been $511,525,000 instead of $555,424,000. Knowledgeable decision makers can easily make this
adjustment to help in evaluating a company. They can determine the amount of net income to be reported if FIFO had been selected and can use that gure for comparison purposes.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

T E S T

273

Y O U R S E L F

Question:
Two companies in the same industry each report sales of $1 million. Company F reports a gross prot of
$400,000 while Company L reports a gross prot of only $300,000. A potential investor is looking at both companies and believes Company F is better because of the higher gross prot. However, according to the footnotes, Company F applied FIFO and Company L applied LIFO so that the two gross prot gures are not directly comparable. Company L reported inventory of $200,000 on January 1 and $208,000 at December 31.
However, if FIFO had been used, those gures would have $450,000 (January 1) and $553,000 (December 31).
Which of the following statements is true?
a.
b.
c.
d.

Under FIFO, Company L would still have a lower gross prot than Company F by $5,000.
Under FIFO, Company L would have a higher gross prot than Company F by $5,000.
Under FIFO, Company L would still have a lower gross prot than Company F by $3,000.
Under FIFO, Company L would have a higher gross prot than Company F by $3,000.

Answer:
The correct answer is choice a: Under FIFO, Company L would still have a lower gross prot than Company F
by $5,000.
Explanation:
In computing cost of goods sold under LIFO, $200,000 (beginning inventory) is added and $208,000 (ending
inventory) is subtracted for a net decrease of $8,000. Had FIFO been used, $450,000 (beginning inventory) is
added and $553,000 (ending inventory) is subtracted for a net decrease of $103,000. In using FIFO, computation of this expense has a $95,000 ($103,000 less $8,000) larger decrease. Thus, cost of goods sold for Company L is smaller by $95,000. If that change is applied, gross prot reported by Company L goes up from
$300,000 to $395,000. That adjusted gure is still $5,000 lower than the number reported by Company F.

6.2 Analyzing Vital Signs for Inventory

Question: When examining receivables in a previous chapter, the assertion was made that companies
have vital signs that can be studied as an indication of nancial well-being. These are ratios or other computed amounts considered to be of particular signicance. In that coverage, the age of receivables and the
receivable turnover were both calculated and explained. For inventory, do similar vital signs exist that decision makers should consider? What vital signs should be determined in connection with inventory
when analyzing the nancial health and future prospects of a company?
Answer: No denitive list of ratios and relevant amounts can be identied because dierent people
tend to have their own personal preferences. However, several gures are widely computed and discussed in connection with inventory and cost of goods sold when the nancial condition of a company
and the likelihood of its prosperity are being evaluated.
Gross prot percentage. The rst of these vital signs is the gross prot percentage, which is
found by dividing the gross prot for the period by net sales.
sales sales returns and discounts = net sales
net sales cost of goods sold = gross prot
gross prot/net sales = gross prot percentage

Formula measuring
protability calculated by
dividing gross prot (sales
less cost of goods sold) by
sales.
gross prot

As has been mentioned, gross prot is also commonly referred to as gross margin or markup. In
simplest terms, it is the dierence between the amount paid to buy (or manufacture) inventory and the
amount received from an eventual sale. The gross prot percentage is often used to compare one company to another or one time period to the next. If one book store manages to earn a gross prot percentage of 35 percent and another only 25 percent, questions should be raised about this dierence and
which percentage is better? One company is making more prot on each sale but, possibly because of
higher sales prices, it might be making signicantly fewer sales.
For the year ended January 29, 2011, Macys Inc. reported a gross prot percentage of 40.7 percent
and reported net income for the year of $847 million on sales of approximately $25 billion. At the same
time, Walmart earned a gross prot percentage of only 24.7 percent but managed to generate net income of nearly $17 billion on sales of just under $419 billion. With these companies, a clear dierence
in pricing strategy can be seen.
2013 Flat World Knowledge, Inc. All rights reserved.

gross prot percentage

Dierence between sales and

cost of goods sold; also called
gross margin or markup.
net sales
Sales less sales returns and
discounts.

Created exclusively for [email protected]

274

FINANCIAL ACCOUNTING VERSION 2.0

The gross prot percentage is also watched closely from one year to the next. For example, if this
gure falls from 37 percent to 34 percent, analysts will be quite interested in the reason. A mere 1 percent drop in the gross prot percentage for Walmart in the previous year would have reduced gross
prot by over $4 billion ($419 billion 1 percent).
Such changes have a cause and any individual studying the company needs to consider the
possibilities.
Are costs rising more quickly than the sales price of the merchandise?
Has a change occurred in the types of inventory being sold?
< Was the reduction in the gross prot oset by an increase in sales?
<
<

number of days inventory

is held
Measures the average
number of days that a
company takes to sell its
inventory items; computed
by dividing average inventory
for the period by the cost of
inventory sold per day.

Amazon.com Inc., for example, reports that its gross prot was 22.6 percent in 2009 and 22.3 percent
in 2010. That is certainly one piece of information to be included in a detailed investigation of this
company.
Number of days inventory is held. A second vital sign is the number of days inventory is held
on average. Companies want to turn their merchandise into cash as quickly as possible. Holding inventory for a length of time can lead to several unfortunate repercussions. The longer it sits in stock the
more likely the goods are to get damaged, stolen, or go out of fashion. Such losses can be avoided
through quick sales. Furthermore, as long as merchandise is sitting on the shelves, it is not earning any
prot. Money is tied up with no return until a sale takes place.
Consequently, decision makers (both internal and external to the company) watch this gure
closely. A change (especially any lengthening of the time required to sell merchandise) is often a warning of problems.
The number of days inventory is held is found in two steps. First, the cost of inventory that is sold
each day on the average is determined.[6]
cost of goods sold/365 days = cost of inventory sold per day
Second, this daily cost gure is divided into the average amount of inventory held during the period.
The average amount of inventory can be based on beginning and ending totals, monthly balances, or
other available gures.
average inventory/cost of inventory sold per day = number of days inventory is held

inventory turnover
Ratio used to measure the
speed at which a company
sells inventory; computed by
dividing cost of goods sold
by average inventory for the
period.

If a company sells inventory costing $40,000 each day and holds an average inventory during the period of $520,000, the average item takes thirteen days ($520,000/$40,000) to be sold. Again, the signicance of that gure depends on the type of inventory, a comparison to results reported by similar
companies, and any change seen in recent periods of time.
Inventory turnover. A third vital sign that is often analyzed is the inventory turnover, which is
simply another way to measure the speed by which a company sells inventory.
cost of goods sold/average inventory = inventory turnover
The resulting turnover gure indicates the number of times during the period that an amount equal to
the average inventory was sold. The larger the turnover number, the faster inventory is selling. For example, Best Buy Co. Inc. recognized cost of goods sold for the year ending February 26, 2011, of
$37,611 million. The company also reported beginning inventory for that period of $5,486 million and
ending inventory of $5,897 million. Hence, the inventory turnover for this retail electronics giant was
6.61 times during that year.
($5,486 + $5,897)/2 = average inventory of $5,691.5 million
$37,611/$5,691.5 = inventory turnover of 6.61 times

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

T E S T

275

Y O U R S E L F

Question:
The Hayweather Company starts the year with inventory costing $130,000 and ends the year with inventory
costing $150,000. During the period, purchases amounted to $695,250. What was the average number of days
required to sell an item of the companys inventory?
a.
b.
c.
d.

68.9 days
72.4 days
75.7 days
80.8 days

Answer:
The correct answer is choice c: 75.7 days.
Explanation:
Cost of goods sold for Hayweather was $675,250 ($130,000 beginning inventory plus $695,250 in purchases
less $150,000 ending inventory). That means the company sells inventory costing $1,850 ($675,250/365 days)
on the average each day. Average inventory for the period is $140,000 ([$130,000 + $150,000]/2). The average
age of the inventory is 75.7 days ($140,000/$1,850).

T E S T

Y O U R S E L F

Question:
The Ostrich Company starts the year with inventory costing $150,000 and ends the year with inventory costing $130,000. During the period, purchases amounted to $1,030,000. What was the inventory turnover for this
period?
a.
b.
c.
d.

6.8 times
7.1 times
7.5 times
7.9 times

Answer:
The correct answer is choice c: 7.5 times.
Explanation:
Inventory turnover is cost of goods sold divided by the average inventory (which is $140,000 here). Cost of
goods sold for Ostrich was $1,050,000 ($150,000 beginning inventory plus $1,030,000 in purchases less
$130,000 ending inventory). Therefore, inventory turnover for the period is 7.5 times ($1,050,000/$140,000).

K E Y

T A K E A W A Y

Companies that apply LIFO (probably for income tax reasons) often hope decision makers will convert their reported numbers to FIFO for comparison purposes. Disclosure of FIFO gures can be included in the notes to
the nancial statements to make this conversion possible. In addition, analysts frequently determine several
amounts and ratios to help illuminate trends and events happening inside a company. The gross prot percentage reects the average markup on each sale. It demonstrates pricing policies and uctuations often indicate policy changes or shifts in the market. The average number of days in inventory and the inventory
turnover both help decision makers learn the length of time a company takes to sell its merchandise. Traditionally, a slowing down of sales is bad because inventory is more likely to become damaged, lost, or stolen.
Plus, inventory generates no prot until sold.

Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

276

FINANCIAL ACCOUNTING VERSION 2.0

Question: Companies that sell inventory instead of services must select a cost ow assumption for reporting
purposes. Many companies use FIFO but a number of other companies use LIFO. What are your thoughts
when you are analyzing two similar companies and discover that one has applied FIFO while the other LIFO?
Kevin Burns: Truthfully, it is easy to get distracted by issues such as FIFO and LIFO that probably make no dierence in the long run. I rarely like to trade stocks quickly. For example, assume a company sells a commodity of
some type (jewelry, for example). The commodity uctuates dramatically in price so that when the price is falling you have paid more for the item than the market will now pay you for the nished good. When prices are
rising, you reap the benet by selling at an even greater price than you expected. So if you have two companies dealing with the same issues and one uses LIFO and the other FIFO, the reported results could be dramatically dierent. However, the underlying facts do not change. Over an extended period of time, the two companies probably end up in the same position regardless of whether they apply LIFO or FIFO. I am much more
interested in how they are investing their cash inows and the quality of the management. On the other hand,
a person who trades stocks quickly could well be interested in reported results that might impact stock prices
for a short period of time. For example, the trader may well wish to see a company use FIFO as reported prots
will be higher for the short term if there is ination and may believe that he can capitalize on that short-term
phenomenon.

Video Clip
Professor Joe Hoyle talks about the ve most important points in Chapter 9.

View the video online at: http://bit.ly/hoyle9-2

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

277

7. END-OF-CHAPTER EXERCISES

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

278

FINANCIAL ACCOUNTING VERSION 2.0

Q U E S T I O N S
1. In the nancial accounting for inventory, what is a cost ow assumption?
2. In calculating cost of goods sold for a company, under what condition is a cost ow assumption not
needed?
3. A hardware store buys a refrigerator for $700. Later, the same store buys another refrigerator for $730 and
then a nal item for $790. Eventually, one of these refrigerators is sold for $1,200. If specic identication is
used, how is cost of goods sold determined?
4. A hardware store buys a refrigerator for $700. Later, the same store buys another refrigerator for $730 and
then a nal item for $790. Eventually, one of these refrigerators is sold for $1,200. If FIFO is used, how is
cost of goods sold determined?
5. A hardware store buys a refrigerator for $700. Later, the same store buys another refrigerator for $730 and
then a nal item for $790. Eventually, one of these refrigerators is sold for $1,200. If LIFO is used, how is cost
of goods sold determined?
6. A hardware store buys a refrigerator for $700. Later, the same store buys another refrigerator for $730 and
then a nal item for $790. Eventually, one of these refrigerators is sold for $1,200. If averaging is used, how
is cost of goods sold determined?
7. What characteristics are attributed to FIFO and to LIFO in a period of ination?
8. Tax laws are designed to raise revenues so that a government can aord to operate. What are the other
major uses made of income tax laws?
9. The Hawkins Company maintains one set of nancial records for nancial reporting purposes. Separate
records are also kept for tax compliance purposes. Why is that necessary?
10. What is the LIFO conformity rule? What is the practical impact of the LIFO conformity rule?
11. IFRS does not permit the use of LIFO. What are the theoretical problems associated with the application of
LIFO?
12. A grocery store has been in operation for several decades. One rack contains 100 loaves of bread. Each
evening a local bakery restocks this rack so that the store always starts the next day with 100 loaves of
bread. If the company uses LIFO, what is reported for this inventory?
13. Notes to the nancial statements of the KaiKayle Corporation indicate that a LIFO liquidation occurred last
year. What does this mean? What is the nancial impact of that event?
14. The Petrakellon Company reports FIFO inventory of $900,000 but also reports a $300,000 negative gure
labeled as a LIFO reserve. What information do these balances convey to a decision maker?
15. In a periodic inventory system, when is the cost ow assumption applied? In a perpetual inventory system,
when is the cost ow assumption applied?
16. A company maintains a perpetual FIFO inventory system and determines its cost of goods as $874,400.
Why would cost of goods sold be the same if the company had used a periodic FIFO inventory system?
17. A company buys two units of inventory for $80 each. It sells one for $200. The company then buys three
more units for $90 each. What is cost of goods sold if a periodic LIFO system is in use? What is cost of
goods sold if a perpetual LIFO system is in use?
18. A company is using averaging to determine cost of goods sold. In a periodic (weighted) averaging system,
when is the average cost determined? In a perpetual (moving) averaging system, when is the average cost
determined?
19. The Pitt Corporation reports cost of goods sold as $300,000 using LIFO. Beginning inventory was $44,000
and ending inventory was $48,000. However, if FIFO had been used, beginning inventory would have
been $76,000 and ending inventory would have been $114,000. What would cost of goods sold have
been for the Pitt Corporation if FIFO had been used?
20. How is the gross prot percentage calculated and what does it tell a user about a company?
21. How is the number of days in inventory calculated and why would a decision maker want to know this
number? What is the problem if the number begins to increase?
22. The Boston Company starts the current year with inventory of $300,000. During the year, purchases of
$800,000 are made. A physical count at the end of the year nds that $400,000 is still on hand. What is the
inventory turnover for this period?
23. The Ames Company has exactly $60 in cash. The company buys three pieces of inventory which are all
exactly the same. Because it is a highly inationary market, the rst one cost $16, the second cost $19, and
the third cost $25. Shortly thereafter, one of these three is sold for $40. Answer each of the following
questions.
a.
b.
c.
d.

If FIFO is applied, how many units are now on hand?

If LIFO is applied, how many units are now on hand?
If FIFO is applied, how much cash is the company holding?
If LIFO is applied how much cash is the company holding?

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

279

e. If FIFO is applied, what appears on the income statement and the balance sheet?
f. If LIFO is applied, what appears on the income statement and the balance sheet?

T R U E

O R

F A L S E

1. ____ Using the LIFO cost ow assumption will always result in a lower net income than using the FIFO
cost ow assumption.
2. ____ LIFO tends to provide a better matching of expenses with revenues than does FIFO.
3. ____ The LIFO conformity rule states that if a company uses LIFO on its nancial statements it must also
use LIFO on its federal income tax return.
4. ____ It is impossible for decision makers to compare a company that uses LIFO with one that uses FIFO.
5. ____ A jewelry store or boat dealership would normally be able to use the specic identication method.
6. ____ The underlying rationale for FIFO is that the earliest inventory purchased would normally be sold rst
by a company.
7. ____ A company starts Year Two with 3,000 pieces of inventory costing $9 each. In Year Two, 1,000 units
are sold and then 2,000 more units are bought for $12 each. Later, another 1,000 units are sold and 2,000
more units are bought for $14 each. On the last day of the year, one nal unit is purchased for $16. If a
perpetual LIFO system is used, this December 31 transaction has no impact on reported net income.
8. ____ A company starts Year Two with 3,000 pieces of inventory costing $9 each. In Year Two, 1,000 units
are sold and then 2,000 more units are bought for $12 each. Later, another 1,000 units are sold and 2,000
more units are bought for $14 each. If a FIFO system is in use, the 5,000 units on hand at the end of the
year have a reported cost of $58,000.
9. ____ A company starts Year Two with 3,000 pieces of inventory costing $9 each. In Year Two, 1,000 units
are sold and then 2,000 more units are bought for $12 each. Later, another 1,000 units are sold and 2,000
more units are bought for $14 each. On the last day of the year, one nal unit is bought for $16. If a
periodic LIFO system is used, this December 31 transaction reduces reported gross prot by $2.
10. ____ A decision maker is analyzing a set of nancial statements and nds a note about a LIFO liquidation
that occurred during a long period of ination. From this information, the decision maker knows that the
company has manipulated its inventory balances to reduce the amount of income taxes to be paid in the
current year.
11. ____ A company applies a periodic FIFO system and buys and sells inventory all during the year. Early in
the year, the company bought some inventory and paid an additional $21,000 in connection with the
purchase. The cost was recorded in the inventory account but should have been expensed. Despite this
error, reported net income for that year does not require adjustment.
12. ____ The gross prot percentage can help decision makers determine how long it takes a company to sell
inventory after the purchase date.
13. ____ A company starts Year Two with 3,000 pieces of inventory costing $9 each. In Year Two, 1,000 units
are sold and then 2,000 more units are bought for $12 each. Later, another 3,000 units are sold and 2,000
more units are bought for $14 each. If a periodic FIFO system is used, the number of days that inventory is
held on the average is 285.6.
14. ____ A company starts Year Two with 4,000 pieces of inventory costing $8 each. In Year Two, 1,000 units
are sold and then 3,000 more units are bought for $10 each. Later, another 5,000 units are sold and 2,000
more units are bought for $14 each. If a periodic LIFO system is used, the number of days that inventory is
held on the average is 136.8.
15. ____ A company starts Year Two with 10,000 pieces of inventory costing $10 each. During the year, the
company buys 40,000 additional pieces of inventory for $15 each. At the end of the year, a physical
inventory is taken and 11,000 units are still on hand. If periodic LIFO is used, the inventory turnover for Year
Two is 6.44 times.
16. ____ A company starts Year Two with 10,000 pieces of inventory costing $10 each. During the year, the
company buys 40,000 additional pieces of inventory for $15 each. At the end of the year, a physical
inventory is taken and 11,000 units are still on hand. If periodic FIFO is used, the inventory turnover for Year
Two is 4.04 times.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

280

FINANCIAL ACCOUNTING VERSION 2.0

M U L T I P L E

C H O I C E

1. Which of the following provides the best matching of expenses with related revenues?
a.
b.
c.
d.

Specic Identication
FIFO
LIFO
Averaging

2. Milby Corporation purchased three hats to sell during the year. The rst, purchased in February, cost $5.
The second, purchased in April, cost $6. The third, purchased in July, cost $8. If Milby sells two hats during
the year and uses the FIFO method, what is cost of goods sold for the year?
a.
b.
c.
d.

$11
$13
$14
$19

3. Which of the following is not a typical reason that a company would choose to use LIFO for nancial
reporting when prices are rising?
a.
b.
c.
d.

The company wishes to use LIFO for tax purposes.

The company wants net income to be as high as possible to impress investors.
The company would like to match the most current costs with current revenues.
The company operates in an industry with a high rate of ination.

4. Traylor Corporation began the year with three items in beginning inventory, each costing $4. During the
year Traylor purchased ve more items at a cost of $5 each and then two more items at a cost of $6.50
each. Traylor sold eight items for $9 each. If Traylor uses a periodic LIFO system, what would be Traylors
gross prot for this year?
a.
b.
c.
d.

$30
$35
$42
$72

5. The Greene Company uses a periodic LIFO system for its inventory and starts o the current year with 10
units costing $8 each. Seven units are sold for $16 each, followed by the purchase of 10 additional units at
$10 each. Then, 7 more units are sold for $20 each. Finally, 10 units are bought for $13 each. On December
31 of that year, a customer oers to buy one of the units still in inventory but is only willing to pay $12. If
Greene takes that oer, what is the impact of that sale on reported net income?
a.
b.
c.
d.

Net income will not change.

Net income will go down by $1.
Net income will go up by $2.
Net income will go up by $4.

6. The Bleu Company uses a perpetual LIFO system for its inventory and starts o the current year with 10
units costing $8 each. Seven units are sold for $16 each, followed by the purchase of 10 additional units at
$10 each. Then, 7 more units are sold for $20 each. Finally, 10 units are bought for $13 each. On December
31 of that year, a customer oers to buy one of the units still in inventory but is only willing to pay $12. If
Bleu takes that oer, what is the impact of that sale on reported net income?
a.
b.
c.
d.

Net income will not change.

Net income will go down by $1.
Net income will go up by $2.
Net income will go up by $4.

7. The Whyte Company uses a FIFO system for its inventory and starts o the current year with 10 units
costing $8 each. Seven units are sold for $16 each, followed by the purchase of 10 additional units at $10
each. Then, 7 more units are sold for $20 each. Finally, 10 units are bought for $13 each. On December 31
of that year, a customer oers to buy one of the units still in inventory but is only willing to pay $12. If
Whyte takes that oer, what is the impact of that sale on reported net income?
a.
b.
c.
d.

Net income will not change.

Net income will go down by $1.
Net income will go up by $2.
Net income will go up by $4.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

281

8. The Osborne Company starts the current year with 30 units of inventory costing $20 each. A few weeks
later, 20 of these units are sold for $40 each. Then, 20 units are bought to restock inventory at $24.50 each.
Later, 20 more units are sold for $50 each and the company buys 20 new units but again at $24.50 each.
Late in the year, 20 nal units are sold for $60 each. What is the reported cost of the ending inventory if a
moving average (perpetual) system is used?
a.
b.
c.
d.

$220
$226
$230
$240

9. A decision maker is studying a company that has applied LIFO for over 20 years during a period of
ination. The decision maker is looking at the most recent nancial statements and notices a note that
indicates that a LIFO liquidation occurred. What information is most likely being conveyed by this note?
a.
b.
c.
d.

Inventory on the balance sheet is worth more than is reported.

Inventory on the balance sheet is worth less than is reported.
The company may be reporting an articially high net income.
The company has attempted to reduce its income tax payment by a signicant amount this year.

10. Bualo Inc. buys inventory items for $300 each and sells them for $400 each. During the year, the
company bought and sold hundreds of these items. The company uses a perpetual system. One unit was
sold near the end of the year. The recording was a debit to cash for $400, a credit to inventory for $300,
and a credit to gain on sale of inventory for $100. No other entry or correction was made. Which of the
following statements is true about Bualos reported information for the period?
a.
b.
c.
d.

Gross prot was correct, net income was overstated, and inventory was understated.
Gross prot was understated, net income was understated, and inventory was correct.
Gross prot was understated, net income was correct, and inventory was correct.
Gross prot was correct, net income was understated, and inventory was overstated.
The following information pertains to multiple-choice questions 11, 12, 13, and 14: A company
produces nancial statements each year. It is started in Year One and has the following
transactions:

Year One
Bought 10 units of inventory for $12 each
Sold 8 units of inventory
Bought 10 units of inventory for $13 each

<
<
<

Year Two
<
<
<
<

Sold 8 units of inventory

Bought 10 units of inventory for $15 each
Sold 8 units of inventory
Bought 10 units of inventory for $16 each

11. Based on the previous information, the company holds 16 units at the end of Year Two. What is reported
for this inventory if a FIFO system is used?
a.
b.
c.
d.

$206
$230
$240
$250

12. Based on the previous information, the company holds 16 units at the end of Year Two. What is reported
for this inventory if a periodic LIFO system is used?
a.
b.
c.
d.

$206
$230
$240
$250

13. Based on the previous information, the company holds 16 units at the end of Year Two. What is reported
for this inventory if a perpetual LIFO system is used?
a. $206
b. $230

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

282

FINANCIAL ACCOUNTING VERSION 2.0

c. $240
d. $250
14. Based on the previous information, the company holds 16 units at the end of Year Two. What is reported
for this inventory if a weighted average (periodic) system is used?
a.
b.
c.
d.

$206
$230
$240
$250

15. A company buys and sells inventory and ends each year with approximately 50 units kept in stock at all
time. It pays $10 per unit in Year One, $8 per unit in Year Two, and $7 per unit in Year Three. Which of the
following statements is true about the Year Three nancial statements if LIFO is used rather than FIFO?
a.
b.
c.
d.

Cost of goods sold will be lower

Net income will be lower
Income tax expense will be lower
Ending inventory will be lower

16. During the year, Hostel Company had net sales of $4,300,000 and cost of goods sold of $2,800,000.
Beginning inventory was $230,000 and ending inventory was $390,000. Which of the following would be
Hostels inventory turnover for the year?
a.
b.
c.
d.

4.84 times
7.18 times
9.03 times
13.87 times

17. During the year, the Brighton Corporation had net sales of $4,800,000 and inventory purchases of
$3,600,000. Beginning inventory for the year was $280,000 and ending inventory was $320,000. Which of
the following would be Brightons inventory turnover for the year?
a.
b.
c.
d.

10.67 times
11.87 times
13.33 times
14.67 times

18. Ace Company starts the year with 30,000 units costing $8 each. During the year, Ace bought 100,000 more
units at $12 each. A count of the ending inventory nds 40,000 units on hand. If the company uses
periodic FIFO, what is the inventory turnover for the year?
a.
b.
c.
d.

2.67 times
3.00 times
3.20 times
3.67 times

19. During the year, the Trenton Company had net sales of $3,200,000 and cost of goods sold of $2,920,000.
Beginning inventory was $250,000 and ending inventory was $390,000. What was the average number of
days during the year that Trenton held its inventory items?
a.
b.
c.
d.

40 days
45 days
52 days
54 days

20. During the year, the Wyglio Corporation had net sales of $5,100,000 and inventory purchases of
$4,340,000. Beginning inventory for the year was $320,000 and ending inventory was $280,000. What was
the average number of days during the year that Wyglio held its inventory items?
a.
b.
c.
d.

22 days
24 days
25 days
28 days

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

V I D E O

283

P R O B L E M S

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.
1. Your roommate is an English major. The roommates parents own a chain of ice cream shops throughout
Florida. One day, while walking over to the science building for a general education class, your roommate
poses this question: Dairy prices have been going up over the last couple of years which has caused a
steady rise in the price of the ice cream that my parents buy. I was talking with them recently and they
were telling me that they use an accounting system called last-in, rst-out in recording their inventory.
This makes no sense to me. Everyone knows that all stores always sell their oldest ice cream rst so it wont
begin to melt and start losing avor. I dont understand how they could possibly be using a last-in, rst-out
system. In this case, the accounting sounds like a work of ction. What is going on? How would you
respond?

View the video online at: http://bit.ly/hoyle9-3

2. Your uncle and two friends started a small oce supply store several years ago. The company has
expanded and now has several large locations. Your uncle knows that you are taking a nancial
accounting class and asks you the following question: When we rst got started, our accountant told us
to use LIFO for our inventory. We were paying her a lot of money so we followed that advice. One of our
biggest customers is owned by a company located in Italy. Recently, the manager for that company was
telling me that their accounting is based on IFRS rather than U.S. GAAP and that IFRS apparently believes
that LIFO is theoretically awed. Why are we using a awed system? I dont even what impact LIFO has on
our nancial statements. I know that we started out this year with 100,000 units that cost $5 each and then
we bought another 400,000 units for $8.00. At the end of the year, because of our sales during the period,
we only had 100,000 units left. What dierence did LIFO make? How would you respond?

View the video online at: http://bit.ly/hoyle9-4

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

284

FINANCIAL ACCOUNTING VERSION 2.0

P R O B L E M S
1. SuperDuper Company sells top of the line skateboards. SuperDuper is concerned about maintaining high
earnings and has chosen to use the periodic FIFO method of inventory costing. At the beginning of the
year, SuperDuper had 5,000 skateboards in inventory, each costing $20. In April, SuperDuper purchased
2,000 skateboards at a cost of $22 and in August, purchased 4,000 more at a cost of $23. During the year,
SuperDuper sold 9,000 skateboards for $40 each.
a. Record each purchase SuperDuper made.
b. Assuming there is no breakage or theft, how many skateboards are on hand at the end of the
year?
c. Determine SuperDupers cost of goods sold using FIFO.
2. Assume the same facts as problem 1, except that SuperDuper is more concerned with minimizing taxes
and uses periodic LIFO. Determine SuperDupers cost of goods sold.
3. Assume the same facts as problem 1, except that SuperDuper has decided to use averaging as a
compromise between FIFO and LIFO. Determine SuperDupers cost of goods sold.
4. Ulysses Company uses the LIFO cost ow assumption. This year, the company reported beginning
inventory of $20,000,000 and ending inventory of $21,500,000. If FIFO were used to value inventory,
beginning inventory would have been $23,000,000 (current cost at that time) and ending inventory would
have been $28,700,000 (also current cost). Cost of goods sold using LIFO was $34,900,000. Determine the
reported cost of goods sold if Ulysses had used FIFO.
5. A company starts operations on October 1, Year One, holding 400 units of inventory which lls its store.
This inventory cost $10 per unit. After that, enough inventory is bought on the last day of each month to
bring the quantity on hand back to exactly 400 units. In October, 140 units were sold; in November, 150
units were sold; and in December, 180 units were sold. On October 31, the company bought units for $12
each; on November 30, the company bought units for $13 each; on December 31, the company bought
units for $15 each.
a. What is the companys cost of goods sold if a periodic LIFO system is used?
b. What is the companys cost of goods sold if a perpetual LIFO system is used?
6. Paulas Parkas sells NorthPlace jackets. At the beginning of the year, Paulas had 20 jackets in stock, each
costing $35 and selling for $60. The following table details the purchases and sales made during January:

FIGURE 9.14

Assume that Paulas Parkas uses the perpetual FIFO method to maintain its inventory records.
a. Determine Paulas Parkas cost of goods sold and ending inventory for January.
b. Determine Parkas gross prot for January.
7. Assume the same facts as in problem 6 except that Paulas Parkas uses the perpetual LIFO method.
a. Determine Paulas Parkas cost of goods sold and ending inventory for January.
b. Determine Parkas gross prot for January.
8. Assume the same facts as in problem 6 above except that Paulas Parkas uses the moving average
method.
a. Determine Paulas Parkas cost of goods sold and ending inventory for January.
b. Determine Parkas gross prot for January.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

285

9. In Year One, the Major Corporation had the following inventory transactions:
<
<
<
<
<

March 1: Buy 1,000 units at $7 each.

May 1: Sell 800 units for $12 each.
August 1: Buy 1,000 units at $8 each.
October 1: Sell 700 units for $14 each.
December 1: Buy 1,000 units for $10 each.

In Year Two, the company had the following inventory transactions:

<
<
<
<
<

April 1: Sell 700 units for $17 each.

June 1: Buy 1,000 units for $11 each.
September 1: Sell 900 units for $20 each.
November 1: Buy 1,000 units for $12 each.
December 1: Sell 700 units for $22 each.
a. What amount of gross prot should this company recognize in Year One and also in
Year Two if a periodic LIFO system is in use?
b. What amount of gross prot should this company recognize in Year One and also in
Year Two if a perpetual LIFO system is in use?

10. A company starts the year with 20 units of inventory costing $20 each. In January, 10 of these units are
sold for $40 each. Then, 10 new units are bought for $22 each. Shortly thereafter, 10 units are sold for $50
each. Then, 10 units are bought for $27 each. Finally, near the end of the year, 10 units are sold for $60
each.
a. What is reported as the cost of ending inventory if a weighted average (periodic) system is in
use?
b. What is reported as the cost of ending inventory if a moving average (perpetual) system is in use?
11. The Quiqqley Company is started in Year One and buys 400 pieces of inventory for $4 each on June 1. The
company sells 300 of these units on September 1 for $20 each. The company buys another 400 units for
$7 each on November 1 and nishes Year One with 500 units in stock.
In Year Two, on February 1, the company sells 300 units for $20 each. On July 1, Year Two, the
company buys 200 more units for $9 each. On August 1, Year Two, the company sells 100 units for $25
each. Finally, on December 1, Year Two, the company buys another 100 units for $10 each.
a. Assume the company uses a perpetual FIFO system. What is the cost of goods sold gure to be
reported for Year Two?
b. Assume the company uses a perpetual LIFO system. What is the cost of goods sold gure to be
reported for Year Two?
12. A company applies LIFO and reports net income for Year Four of $328,000. Reported inventory at January
1 was $32,000 and at December 31 was $35,000. A note to the nancial statements indicates that the
beginning inventory would have been $52,000 and ending inventory would have been $78,000 if FIFO
had been used. What would this company have reported as its net income for Year Four if FIFO has been
applied as the cost ow assumption?
13. The Montana Company and the Florida Company are identical in every way. They have exactly the same
transactions. In Year One, they both started with 10,000 units of inventory costing $6 per unit. During Year
One, they both bought 20,000 additional units for $8 per unit and sold 20,000 units. During Year Two, they
both bought 30,000 units for $9 per unit and sold 30,000 units. The Montana Company uses a periodic
FIFO system and the Florida Company uses a periodic LIFO system. If the Montana Company reports net
income in Year Two of $100,000, what will the Florida Company report as its net income?
14. The Furn Store sells home furnishings, including bean bag chairs. Furn currently uses the periodic FIFO
method of inventory costing, but is considering implementing a perpetual system. It will cost a good deal
of money to start and maintain, so Furn would like to see the dierence, if any, between the two and is
using its bean bag chair inventory to do so. Here is the rst quarter information for bean bag chairs:

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

286

FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 9.15

Each bean bag chair sells for $40.

a. Determine Furns cost of goods sold and ending inventory under periodic FIFO.
b. Determine Furns cost of goods sold and ending inventory under perpetual FIFO.
15. Rollrbladz Inc. is trying to decide between a periodic or perpetual LIFO system. Management would like to
see the eect of each on cost of goods sold and ending inventory for the year. The following is
information concerning purchases and sales of its specialty line of rollerblades:

FIGURE 9.16

a. Determine Rollrbladzs cost of goods sold and ending inventory under periodic LIFO.
b. Determine Rollrbladzs cost of goods sold and ending inventory under perpetual LIFO.
16. Highlander Corporation sells swords for decorative purposes. It would like to know the dierence in cost
of goods sold and ending inventory if it uses the weighted average method or the moving average
method. Use the following information to help determine these amounts for the second quarter.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

287

FIGURE 9.17

Swords retail for $120 each.

a. Determine Highlanders cost of goods sold and ending inventory under weighted average.
b. Determine Highlanders cost of goods sold and ending inventory under moving average.
17. During the year, the California Corporation had net sales of $11,000,000 and inventory purchases of
$7,500,000. Beginning inventory for the year was $1,030,000 but ending inventory was only $500,000
because the company wanted to reduce the amount of money tied up in inventory. What was the
average number of days during the year that California held its inventory items before making a sale?
18. Deuce Company starts the year with 80,000 units costing $10 each. During the year, Deuce bought
100,000 more units at $12 each and then another 120,000 at $13 each. A count of the ending inventory
nds 70,000 units on hand. If the company uses periodic FIFO, what is the inventory turnover for the year?
19. During the current year, the Decker Company had net sales of $15,700,000 and cost of goods sold of
$9,200,000. Beginning inventory was $420,000 and ending inventory was $500,000. What was the
inventory turnover for that year?
20. In Chapter 4, Heather Miller started her own business, Sew Cool. The nancial statements for December
were presented in Chapter 7 and are shown again below. For convenience, assume the business was
started on January 1, 20X8 with no assets.

FIGURE 9.18

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

288

FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 9.19

FIGURE 9.20

Based on the nancial statements determine the following:

a. Gross prot percentage
b. Number of days inventory is held
c. Inventory turnover

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

C O M P R E H E N S I V E

289

P R O B L E M

This problem will carry through over several chapters to enable students to build their accounting skills using
knowledge gained in previous chapters.
In Chapter 8, nancial statements were prepared for Webworks for August 31 and the month then ended.
Those nancial statements are included here as a starting point for the nancial reporting for September.

FIGURE 9.21

FIGURE 9.22

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

290

FINANCIAL ACCOUNTING VERSION 2.0

The following events occur during September:

a. Webworks purchases supplies worth $120 on account.
b. At the beginning of September, Webworks held 19 keyboards costing $100 each and 110 ash drives
costing $10 each. Webworks has decided to use periodic FIFO to cost its inventory.
c. Webworks purchases 30 additional keyboards on account for $105 each and 50 ash drives for $11 each.
d. Webworks starts and completes ve more Web sites and bills clients for $3,000.
e. Webworks pays Nancy Po (the company employee hired in June) $500 for her work during the rst three
weeks of September.
f. Webworks sells 40 keyboards for $6,000 and 120 ash drives for $2,400 cash.
g. Webworks collects $2,500 in accounts receivable.
h. Webworks pays o its salaries payable from August.
i. Webworks pays o $5,500 of its accounts payable.
j. Webworks pays o $5,000 of its outstanding note payable.
k. Webworks pays Leon Jackson (owner of the company) salary of $2,000.
l. Webworks pays taxes of $795 in cash.
Required:
A.
B.
C.
D.

Prepare journal entries for the previous events.

Post the journal entries to T-accounts.
Prepare an unadjusted trial balance for Webworks for September.
Prepare adjusting entries for the following and post them to your T-accounts.

m. Webworks owes Nancy Po $300 for her work during the last week of September.
n. Leons parents let him know that Webworks owes $275 toward the electricity bill. Webworks will pay them
in October.
o. Webworks determines that it has $70 worth of supplies remaining at the end of September.
p. Prepaid rent should be adjusted for Septembers portion.
q. Webworks is continuing to accrue bad debts so that the allowance for doubtful accounts is 10 percent of
accounts receivable.
r. Record cost of goods sold.
E. Prepare an adjusted trial balance.
F. Prepare nancial statements for September.

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

CHAPTER 9

WHY DOES A COMPANY NEED A COST FLOW ASSUMPTION IN REPORTING INVENTORY?

R E S E A R C H

291

A S S I G N M E N T

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for
that rm is currently looking at the possibility of investing in Deere & Company. The partner is interested in
the impact of the recession on a company that is so closely tied to the agriculture industry. The partner is especially interested in the speed with which the company is able to sell its inventory and also the impact of recording most inventory using LIFO. The partner asks you to look at the 2010 nancial statements for Deere &
Company by following this path:
<
<

<
<
<
<
<

Go to http://www.deere.com.
At the upper right side of the screen, click on Our Company and then on Investor Relations. (If youre
using a browser other than Internet Explorer, you may need to select your country before you can click on
Our Company.)
On the left side of the next screen, click on Annual Report.
In the middle of the next screen, click on 2010 Annual Report to download.
Go to page 24 and nd the 2008, 2009, and 2010 income statements.
Go to page 25 and nd the balance sheets for the years ended October 31, 2009 and 2010.
Go to page 41 and read note 15 titled Inventories.

a. Using the gures found on the 2010 income statement and the two balance sheets, determine the
number of days that inventory was held by Deere & Company during 2010. Does the number seem
particularly high or particularly low?
b. Using the gures found on the 2010 income statement and the information provided in note 15 of the
nancial statements, determine the change in cost of sales that would have occurred if the company had
applied FIFO to all of its reported inventory. What was the monetary amount of the dierence between
this gure and the amount actually reported?

2013 Flat World Knowledge, Inc. All rights reserved.

Created exclusively for [email protected]

292

FINANCIAL ACCOUNTING VERSION 2.0

ENDNOTES
1.

Clayton T. Rumble, So You Still Have Not Adopted LIFO, Management Accountant,
October 1983, 50.

2.

Matthew C. Calderisi, senior editor, Doug Bowman, senior technical manager, and
David Cohen, developmental editor, Accounting Trends & Techniques, 64th edition
(New York: American Institute of Certied Public Accountants, 2010), 169.

3.

Many states and some cities also charge a tax on income. Those governments have
their own unique set of laws although they often resemble the tax laws applied by
the federal government.

2013 Flat World Knowledge, Inc. All rights reserved.

4.

As will be seen in the next chapter, similar arguments are made in connection with
property and equipmentthe reported amount and the value can vary greatly.
However, those assets are not normally held for resale purpose so that their current
worth is of less interest to decision makers.

5.

Because ending inventory for one period becomes the beginning inventory for the
next, application of a cost ow assumption does change that gure also. However,
the impact is only indirect because the number is simply carried forward from the
previous period. No current computation of beginning inventory is made based on
the cost ow assumption in use.

6.

Some analysts prefer to use 360 instead of 365 days to make this computation
simpler.

Created exclusively for [email protected]