Brief Exercise:
Due to a clerical error, a company overstated by $50,000 the amount of inventory on hand at the end of the year. Will net income for the year be overstated or understated? Identify the two accounts on the year-end balance sheet that will be in error and indicate whether they will be understated or overstated.
Evaluation of Inventory Costing Methods
Write the letter of the method that is most applicable to each statement.
a. Specific identification
b. Average cost
c. First-in, first-out (FIFO)
d. Last-in, first-out (LIFO)
_______ 1. Is the most realistic ending inventory
_______ 2. Results in cost of goods sold being closest to current product costs
_______ 3. Results in highest income during periods of inflation
_______ 4. Results in highest ending inventory during periods of inflation
_______ 5. Smooths out costs during periods of inflation
_______ 6. Is not practical for most businesses
_______ 7. Puts more weight on the cost of the larger number of units purchased
_______ 8. Is an assumption that most closely reflects the physical flow of goods for most businesses
_______ 9. Is not an acceptable method under IFRS
Problem 1 Inventory Costs in Various Businesses
Businesses incur various costs in selling goods and services. Each business must decide which costs are expenses of the period and which should be included in the cost of the inventory. The following table lists various types of businesses along with certain types of costs they incur:
Accounting Treatment
Business Types of Costs Expense of Inventory Other
the period cost Treatment
Retail shoe store
Shoes for sale
Shoe boxes
Advertising signs
Grocery store
Canned goods on the shelves
Produce
Cleaning supplies
Cash registers
Frame shop
Wooden frame supplies
Nails
Glass
Walk-in print shop
Paper
Copy machines
Toner cartridges
Restaurant
Frozen food
China and silverware
Prepared food
Spices
Fill in the table to indicate the correct accounting for each type of cost by placing an X in the appropriate column. For any costs that receive other treatment, explain what the appropriate treatment is for accounting purposes.
Problem 2: Evaluation of Inventory Costing Methods
Users of financial statements rely on the information available to them to decide whether to invest in a company or lend it money. As an investor, you are comparing three companies in the same industry. The cost to purchase inventory is rising in the industry. Assume that all expenses incurred by the three companies are the same except for cost of goods sold. The companies use the following methods to value ending inventory:
Company A-weighted average cost
Company B-first-in, first-out (FIFO)
Company C-last-in, first-out (LIFO)
Required
1. Which of the three companies will report the highest net income? Explain your answer.
2. Which of the three companies will pay the least in income taxes? Explain your answer.
3. Which method of inventory costing do you believe is superior to the others in providing information to potential investors? Explain.
4. Explain how your answers to parts (1), (2), and (3) would change if the costs to purchase inventory had been falling instead of rising.