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.
BALANCE SHEET EFFECTS
FIFO produces the best balance sheet
valuation since the inventory costs are
closer to their current, or replacement,
costs.
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.
INVENTORY ERRORS - INCOME
STATEMENT EFFECTS
• 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.
FORMULA FOR
COST OF GOODS SOLD
Beginning
Inventory
Cost of _ Ending
Cost of
+
= Goods
Goods
Inventory
Purchased
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
Inventory Error
Cost of
Goods Sold
Understate beginning inventory
Overstate beginning inventory
Understate ending inventory
Overstate ending inventory
Net Income
Understated
Overstated
Overstated
Understated
Overstated
Understated
Understated
Overstated
An error in ending inventory of the current period
will have a reverse effect on net income of the next
accounting period.
ENDING INVENTORY ERROR –
BALANCE SHEET EFFECTS
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
Overstated
Understated
Assets
Overstated
Understated
Liabilities
None
None
Owner’s Equity
Overstated
Understated
VALUING INVENTORY AT THE
LOWER OF COST AND MARKET
•
•
•
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.
ALTERNATIVE LOWER OF COST AND
MARKET (LCM) RESULTS
Cost
Television sets
Consoles
$
Portables
Total
Video equipment
Recorders
Movies
Total
Total inventory
$
60,000
45,000
105,000
48,000
15,000
63,000
168,000
Market
$
$
LCM
55,000
52,000
107,000
45,000
14,000
59,000
166,000
$ 166,000
The common practice is to use total inventory
rather than individual items or major categories
in determining the LCM valuation.