Chapter 8 - Summary
In a perpetual inventory system, determine the cost of goods sold using (a)
specific identification, (b) average cost, (c) FIFO, and (d) LIFO. Discuss the
advantages and shortcomings of each method.
By the specific identification method, the actual costs of the specific
units sold are transferred from inventory to the cost of goods sold. (Debit
Cost of Goods Sold; credit Inventory.) This method achieves the proper matching
of sales revenue and cost of goods sold when the individual units in the inventory
are unique. However, the method becomes cumbersome and may produce misleading
results if the inventory consists of homogeneous items.
The remaining three methods are flow assumptions, which should be applied only
to an inventory of homogeneous items.
By the average-cost method, the average cost of all units in the inventory
is computed and used in recording the cost of goods sold. This is the only method
in which all units are assigned the same (average) per-unit cost.
FIFO (first-in, first-out) is the assumption that the first units purchased
are the first units sold. Thus inventory is assumed to consist of the most recently
purchased units. FIFO assigns current costs to inventory but older (and often
lower) costs to the cost of goods sold.
LIFO (last-in, first-out) is the assumption that the most recently
acquired goods are sold first. This method matches sales revenue with relatively
current costs. In a period of inflation, LIFO usually results in lower reported
profits and lower income taxes than the other methods. However, the oldest purchase
costs are assigned to inventory, which may result in inventory becoming grossly
understated in terms of current replacement costs.
Explain the need for taking a physical inventory.
In a perpetual inventory system, a physical inventory is taken to adjust the
inventory records for shrinkage losses. In a periodic inventory system, the
physical inventory is the basis for determining the cost of the ending inventory
and for computing cost of goods sold.
Record shrinkage losses and other year-end adjustments to inventory.
Shrinkage losses are recorded by removing from the Inventory account the cost
of the missing or damaged units. The offsetting debit may be to Cost of Goods
Sold, if the shrinkage is normal in amount, or to a special loss account. If
inventory is found to be obsolete or unsalable, it is written down to zero (or
its scrap value, if any). If inventory is valued at the lower-of-cost-or-market,
it is written down to its current replacement cost, if at year-end this amount
is substantially below the cost shown in the inventory records.
In a periodic inventory system, determine the ending inventory and the cost
of goods sold using (a)specific identification, (b)average cost, (c)FIFO, and
The cost of goods sold is determined by combining the beginning inventory with
the purchases during the period and subtracting the cost of the ending inventory.
Thus the cost assigned to ending inventory also determines the cost of goods
By the specific identification method, the ending inventory is determined by
the specific costs associated with the units on hand. By the average-cost method,
the ending inventory is determined by multiplying the number of units on hand
by the average cost of the units available for sale during the year. By FIFO,
the units in inventory are priced using the unit costs from the most recent
cost layers. By the LIFO method, inventory is priced using the unit costs in
the oldest cost layers.
Explain the effects on the income statement of errors in inventory valuation.
In the current year, an error in the costs assigned to ending inventory will
cause an opposite error in the cost of goods sold and, therefore, a repetition
of the original error in the amount of gross profit. For example, understating
ending inventory results in an overstatement of the cost of goods sold and an
understatement of gross profit.
The error has exactly the opposite effects on the cost of goods sold and the
gross profit of the following year, because the error is now in the cost assigned
to beginning inventory.
Estimate the cost of goods sold and ending inventory by the gross profit method
and by the retail method.
Both the gross profit and retail methods use a cost ratio to estimate the cost
of goods sold and ending inventory. The cost of goods sold is estimated by multiplying
net sales by this cost ratio; ending inventory then is estimated by subtracting
this cost of goods sold from the cost of goods available for sale.
In the gross profit method, the cost ratio is 100% minus the company's historical
gross profit rate. In the retail method, the cost ratio is the percentage of
cost to the retail prices of merchandise available for sale.
Compute the inventory turnover rate and explain its uses.
The inventory turnover rate is equal to the cost of goods sold divided by the
average inventory. Users of financial statements find the inventory turnover
rate useful in evaluating the liquidity of the company's inventory. In addition,
managers and independent auditors use this computation to help identify inventory
that is not selling well and that may have become obsolete.
Define a "LIFO reserve" and explain its implications to users of
A LIFO reserve is the amount by which the current replacement cost of inventory
exceeds the LIFO cost shown in the accounting records.
If a company has a large LIFO reserve, neither its inventory nor its cost of
goods sold are comparable to those of a company using FIFO. Also, a LIFO reserve
may cause earnings to increase dramatically if inventory falls below normal
levels. Notes accompanying the financial statements provide the statement users
with information useful in evaluating the implications of a LIFO reserve.
In this chapter we have seen that different inventory valuation methods can
have significant effects on net income as reported in financial statements and
on income tax returns as well. In the following chapter, we will see that a
similar situation exists with respect to the alternative methods used in depreciating
plant and equipment.