Chapter 8
Knowledge Check – page 396
 Describe the three subcategories of inventory that manufacturing firms would
usually report in their financial statements.
1. Raw materials inventory: the inputs into the production process of a
manufacturer or processor.
2. Work-in-process inventory or WIP: inventory that is partially completed on
the financial statement date.
3. Finished goods inventory: inventory that has been completed and is ready for
sale.
 Describe the two inventory control systems that are used to keep track of
inventory transactions. How do the two differ?
A perpetual inventory control system keeps an ongoing tally of purchases and
sales of inventory, with the Inventory account adjusted to reflect changes as they
occur. When inventory is purchased or sold, the Inventory account is immediately
debited or credited to record the change. When inventory is sold, Cost of Sales is
debited immediately.
With a periodic inventory control system, the Inventory account is not adjusted
whenever a transaction affects inventory. The balance in the Inventory account at
the end of a period is determined by actually counting the inventory. Purchases of
inventory are not recorded directly to the Inventory account but instead are
accumulated in a separate “Purchases” account. With a periodic inventory control
system, cost of sales is determined indirectly using the equation: Cost of sales =
Beginning inventory + Purchases – Ending inventory.
 Trenche Ltd. provides you with the following information about its inventory:
Inventory on December 31, 2008
$175,000
Purchases during 2009
1,245,000
Inventory on December 31, 2009
210,000
Trenche uses a periodic inventory control system. Use this information to
calculate Trenche’s cost of sales for 2009.
Cost of sales
= Beginning inventory
+ Purchases
– Ending inventory
= $175,000
+ $1,245,000
– $210,000
= $1,210,000
Knowledge Check – page 402
 What are cost flow assumptions and why are they necessary for inventory
accounting?
Cost flow assumptions are methods for moving costs through the Inventory
account to Cost of Sales without regard for the actual physical movement of the
inventory. Cost flow assumptions are necessary because it’s not practical or even
possible in many cases for accountants to keep track of the costs associated with
individual units of inventory. Without cost flow assumptions it wouldn’t be
possible or would be very expensive to determine ending inventory and cost of
sales and therefore to prepare financial statements.
 Identify and explain the four main cost flow assumptions used in Canada.
The four main cost flow assumptions are:
1. Specific identification—assigns the actual cost of a particular unit of
inventory to that unit of inventory.
2. Average cost—the average cost of all inventory on hand during the period
is calculated and that average is used to calculate cost of sales and the balance
in ending inventory.
3. First in, first out (FIFO)—the cost associated with the inventory that was
purchased or produced first is expensed first. For raw materials that are used
in a manufacturing process, the cost associated with the raw materials that
were purchased first is the cost that is charged to the production process first.
4. Last in, first out (LIFO)—the cost associated with the inventory that was
purchased or produced most recently is matched to revenue (expensed) first.
For raw materials that are used in a manufacturing process, the cost associated
with the raw materials that were purchased last or most recently is the cost
that is charged to the production process first.
Knowledge Check – page 414
 In times of rising prices, which inventory cost flow assumption will provide the
highest inventory valuation and the highest net income? Which will provide the
lowest inventory valuation and net income? Explain
In times of rising prices FIFO provides the highest inventory valuation and the
highest net income Under FIFO the costs associated with the most recently
acquired, higher priced inventory is reported on the balance (and so results in the
highest inventory valuation). FIFO provides also provides the highest net income
because the costs associated with the oldest inventory (the least expensive
inventory) is expensed first so cost of goods sold will be lower and net income
higher compared with LIFO and average cost. LIFO provides the lowest inventory
and net income for the opposite reasons described above. Under LIFO the costs
associated with highest priced, most recently acquired inventory is expensed first
(higher cost of goods sold, lower net income) and the costs associated with the
oldest, lowest price inventory is reported on the balance sheet (lowest inventory
valuation).
 What is the lower of cost and market rule (LCM), and why is it used?
The lower of cost and market (LCM) rule requires that when the market value of
inventory at the end of a reporting period is lower than its cost, the inventory must
be reported on the balance sheet at its market value.
 What are the most commonly used definitions of market for LCM and what do
they mean?
The definitions most commonly used for market are replacement cost and net
realizable value.
• Replacement cost is the amount that an entity would have to pay to replace its
existing inventory (or other asset).
• Net realizable value (NRV) is the amount that the entity would receive from
selling the inventory (or other asset) less any additional selling costs that would
have to be incurred.