2 explain the accounting for inventories and apply

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2 Explain the accounting for inventories and apply the inventory cost flow methods. The primary basis of ac- counting for inventories is cost. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased.The inventory cost flow methods are: spe- cific identification and three assumed cost flow methods— FIFO, LIFO, and average-cost. 3 Explain the financial effects of the inventory cost flow assumptions. Companies may allocate the cost of goods available for sale to cost of goods sold and ending inventory by specific identification or by a method based on an as- sumed cost flow.When prices are rising, the first-in, first-out (FIFO) method results in lower cost of goods sold and higher net income than the other methods.The reverse is true when prices are falling. In the balance sheet, FIFO results in an ending inventory that is closest to current value; inventory under LIFO is the farthest from current value. LIFO results in the lowest income taxes. 4 Explain the lower-of-cost-or-market basis of account- ing for inventories. Companies may use the lower-of- cost-or-market (LCM) basis when the current replace- ment cost (market) is less than cost. Under LCM, companies recognize the loss in the period in which the price decline occurs. 5 Indicate the effects of inventory errors on the finan- cial statements. In the income statement of the current year: (a) An error in beginning inventory will have a reverse effect on net income. (b) An error in ending inventory will have a similar effect on net income.In the following period,its effect on net income for that period is reversed, and total net in- come for the two years will be correct. In the balance sheet: Ending inventory errors will have the same effect on total assets and total stockholders’ eq- uity and no effect on liabilities. 6 Compute and interpret the inventory turnover ratio. The inventory turnover ratio is cost of goods sold divided by average inventory. To convert it to average days in inventory, divide 365 days by the inventory turnover ratio. GLOSSARY Average-cost method Inventory costing method that uses the weighted average unit cost to allocate to ending inventory and cost of goods sold the cost of goods available for sale.(p.258). Conservatism Concept that dictates that when in doubt, choose the method that will be least likely to overstate assets and net income. (p. 263). Consigned goods Goods held for sale by one party al- though ownership of the goods is retained by another party. (p. 253). Consistency principle Dictates that a company use the same accounting principles and methods from year to year.(p.262). Current replacement cost The current cost to replace an inventory item. (p. 263). Days in inventory Measure of the average number of days inventory is held; calculated as 365 divided by inventory turnover ratio. (p. 267).
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