Chapter 6 Part 2

INCOME STATEMENT EFFECTS In periods of rising prices, FIFO reports the highest net income, LIFO the lowest and average cost falls in the middle. The reverse is true when prices are falling. When prices are constant, all cost flow methods will yield the same results.

FIFO produces the best balance sheet valuation since the inventory costs are closer to their current, or replacement, costs. BALANCE SHEET EFFECTS

USING INVENTORY COST FLOW METHODS CONSISTENTLY A company needs to use its chosen cost flow method consistently from one accounting period to another. Such consistent application enhances the comparability of financial statements over successive time periods. When a company adopts a different cost flow method, the change and its effects on net income should be disclosed in the financial statements.

Both beginning and ending inventories appear on the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Inventory errors affect the determination of cost of goods sold and net income. INVENTORY ERRORS - INCOME STATEMENT EFFECTS

FORMULA FOR COST OF GOODS SOLD + = Beginning Inventory Cost of Goods Purchased Ending Inventory Cost of Goods Sold _ The effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data.

EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S INCOME STATEMENT An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. Understate beginning inventory Understated Overstated Overstate beginning inventory Overstated Understated Understate ending inventory Overstated Understated Overstate ending inventory Understated Overstated

The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation: Assets = Liabilities + Owner’s Equity ENDING INVENTORY ERROR – BALANCE SHEET EFFECTS Overstated Overstated None Overstated Understated Understated None Understated

When the value of inventory is lower than the cost, the inventory is written down to its market value. This is known as the lower of cost and market (LCM) method. Market is defined as replacement cost or net realizable value. VALUING INVENTORY AT THE LOWER OF COST AND MARKET

ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTS The common practice is to use total inventory rather than individual items or major categories in determining the LCM valuation.