Chapter 8 - Solution Manual

The use of lifo is based on the assumption that

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The use of LIFO is based on the assumption that current costs should be matched against it. Although LIFO does not use current cost, the most recent costs are used to calculate cost of sales; hence, LIFO yields the closest approximation to current value of any cost based method of inventory valuation. As such, it provides the closest historical cost measure of “real income” and is consistent with the concept of physical capital maintenance. In addition, LIFO may eliminate inventory holding gains when the inventory remains stable from year to year, and the use of LIFO when prices are rising reduces taxable income and hence, the payment of income tax. LIFO is better than FIFO because during inflation, FIFO results in matching older, lower cost against revenues. The result is inflated profits that could be misleading to inventors, creditors and other users. Inflated profits can result in the payment of additional income taxes and it makes it appear as though the company has more available to distribute in dividends than it should. Team 2 Defend FIFO Cost of goods sold under FIFO would be the same regardless of whether the inventory were purchased in 19x8 or 19x9 because sales would be calculated using old costs, and would not be affected by recent purchases. The following calculations are made under the assumption that the inventory layers result from the application of FIFO. Cost of goods sold if the purchase is postponed until 19x9: Beginning Inventory: First Layer 10,000 x $15 $150,000 Second Layer 22,000 x $18 396,000 Purchases 250,000 x $20 5,000,000 Available 282,000 $5,546,000 Sold (245,000) Ending Inventory 37,000 740,000
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163 Cost of Goods Sold $4,806,000 Cost of goods sold if the purchase is made in 19x8: Available from above 282,000 $5,546,000 Additional Purchase 40,000 x $17 680,000 Available 322,000 $6,226,000 Sold ( 245,000) Ending Inventory 77,000 1,42000 Cost of Goods Sold $4,806,000 Difference $ 0 Calculation of ending inventory: Purchase in 19x8 19x9 37,000 x $20 $ 740,000 $ 740,000 40,000 x $17 680,000 Ending Inventory $1,420,000 $ 740,000 Cost of sales Purchase in 19x8 19x9 10,000 x $15 $ 150,000 $ 150,000 22,000 x $18 396,000 396,000 213,000 x $20 4,260,000 4,260,000 $4,860,000 $4,860,000 The use of FIFO satisfies the historical cost principle. The valuation of flows is consistent with the typical actual flow of goods. It also satisfies the matching principle since the historical cost is matched with revenue. And, inventory valuation on the balance sheet more closely resembles replacement cost because it comprises recent prices. This allows users to better evaluate future cash flows to replace the inventory. An added advantage of FIFO over LIFO is demonstrated by this case. It is not possible to manipulate cost of sales by the use of FIFO, while manipulation is obviously possible under LIFO. Hence, the use of FIFO would satisfy the qualitative characteristic of neutrality. Debate 8-2 Components of working capital Team 1 A company’s working capital is the net short-term investment needed to carry on day-to-day activities.
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