Reporting and Analyzing Inventories
(a) FIFO: The cost of the first (earliest) items purchased in inventory flow to
cost of goods sold first. (b) LIFO: The cost of the last (most recent) items
purchased in inventory flow to cost of goods sold first.
Merchandise inventory is disclosed on the balance sheet as a current asset.
It is also sometimes reported in the income statement as part of the
calculation of cost of goods sold.
Incidental costs sometimes are ignored in computing the cost of inventory
because the expense of tracking such costs on a precise basis can outweigh
the benefits gained from the increased accuracy.
The principle of
permits such practices when the effects on the financial statements are not
significant (that is, when such practices do not impact business decisions).
LIFO will result in the lower cost of goods sold when costs are declining
because it assigns the most recent, lower cost purchases to cost of goods
The full-disclosure principle requires that the nature of the accounting
change, the justification for the change, and the effect of the change on net
income be disclosed in the notes or in the body of a company's financial
No; changing the inventory method each period would violate the accounting
principle of consistency.
No; the consistency principle does not preclude changes in accounting
methods from ever being made.
Instead, a change from one acceptable
method to another is allowed if the company justifies the change as an
improvement in financial reporting.
Many people make important business decisions based on period-to-period
fluctuations in a company's financial numbers, including gross profit and net
As such, inventory errors—which can substantially impact gross
profit, net income, current assets, and cost of sales—should not be permitted
to cause such fluctuations and impair business decisions.
(Note: Since such
errors are “self-correcting,” they will distort net income in only two
consecutive accounting periods—the period of the error and the next period.)
An inventory error that causes an understatement (or overstatement) for net
income in one accounting period, if not corrected, will cause an
overstatement (or understatement) in the next. Since an understatement
(overstatement) of one period offsets the overstatement (understatement) in
the next, such errors are said to
Market usually means replacement cost of inventory when applied in the
The principle of conservatism guides preparers of accounting reports to
select the less optimistic estimate in uncertain situations where two
estimates of amounts are about equally likely.
Users of information must
also be cognizant of the potential conservatism in accounting reports when
making business decisions.
This is the end of the preview. Sign up
access the rest of the document.