Chapter 8 - Solution Manual

During periods of sharp price movements lifo has a

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During periods of sharp price movements, LIFO has a stabilizing effect upon reported profit figures because it eliminates paper profits and losses on inventory and smoothens the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figure can be artificially influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction. Case 8-9 a. According to SFAC 5, net realizable value is the nondiscounted amount of cash, or its equivalent, into which an asset is expected to be converted in the future net of direct costs, if any, necessary to make the conversion. b.i. The balance sheet approach to estimating bad debts provides the better estimate of net realizable value. Aging reports receivables measured in terms of how much is expected to be collected from subsets of the receivables categorized by age. Older receivables would be expected to yield proportionately less cash than more recent receivables. The income statement approach does not purport to measure how much is expected to be collected from the receivables. Rather it measures how much is expected to be uncollectible from a given years sales.
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151 ii. Liquidity is the ability to pay current debt and continue operations. Working capital is the difference between current assets and current liabilities. The balance sheet approach to measuring bad debts would be more useful in providing a measure of liquidity. As stated above this approach provides a better estimate of net realizability and hence the amount of cash that would be available to pay current liabilities. iii. The income statement approach provides better matching. The matching concept implies that revenues should be matched with the cost of generating them. Estimating bad debts based on net sales attempts to subtract from sales those that will not be collected thereby matching them with cost, those that will not realize cash. iv. The balance sheet approach is more consistent with the definition of comprehensive income. Comprehensive income is the change in net assets occurring during the accounting period for non-owner transactions. The balance sheet approach provides a direct measure of those changes and hence a direct measure of the effect of those changes on comprehensive income. v. The income statement approach is more consistent with financial capital maintenance. It provides a direct measure of the effect of transactions, sales, on future cash flows. vi. The balance sheet approach is more consistent with physical capital maintenance because it provides balance sheet measures which are closer to current value.
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