Chapter 5 Reporting and Analyzing Inventories QUESTIONS 1. (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. 2. 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. 3. 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 materiality permits such practices when the effects on the financial statements are not significant (that is, when such practices do not impact business decisions). 4. 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 sold. 5. 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 statements. 6. No; changing the inventory method each period would violate the accounting principle of consistency. 7. 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. 8. Many people make important business decisions based on period-to-period fluctuations in a company's financial numbers, including gross profit and net income. 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.)
9. 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 correct themselves . 10. Market usually means replacement cost of inventory when applied in the LCM. 11. 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. 12.
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