CH 08

Copyright 2012 John Wiley & Sons, Inc.
. Kieso, Intermediate Accounting, 14/e Instructors Manual (For Instructor Use Only) 8-1
CHAPTER 8
Valuation of Inventories: A Cost-Basis Approach
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics
Questions
Brief
Exercises Exercises Problems
Concepts
for Analysis
1. Inventory accounts;
determining quantities,
costs, and items to be
included in inventory;
the inventory equation;
balance sheet disclosure.
1, 2, 3, 4,
5, 6, 8, 9
1, 3 1, 2, 3,
4, 5, 6
1, 2, 3 1, 2, 3, 5
2. Perpetual vs. periodic. 2 9, 13,
17, 20
4, 5, 6
3. Recording of discounts. 10, 11 7, 8 3 4
4. Inventory errors. 7 4 5, 10,
11, 12
2
5. Flow assumptions. 12, 13, 16,
18, 20
5, 6, 7 9, 13, 14,
15, 16, 17,
18, 19, 20,
21, 22
1, 4, 5,
6, 7
5, 6, 7, 8, 11
6. Inventory accounting
changes.
18 7 6, 7, 10
7. Dollar-value LIFO
methods.
14, 15, 17,
18, 19
8, 9 22, 23, 24,
25, 26
1, 8, 9,
10, 11
8, 9

8-2 Copyright 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructors Manual (For Instructor Use Only)
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives
Brief
Exercises Exercises Problems
1. Identify major classifications of inventory. 1
2. Distinguish between perpetual and periodic
inventory systems.
2 4, 9, 13,
17, 20
4, 5, 6
3. Identify the effects of inventory errors
on the financial statements.
4 5, 10, 11, 12 2
4. Understand the items to include as inventory cost. 3 1, 2, 3, 4,
5, 6, 7, 8
1, 2, 3
5. Describe and compare the cost flow assumptions
used to account for inventories.
5, 6, 7 9, 13, 14, 15,
16, 17, 18,
19, 20, 22
1, 4, 5, 6, 7
6. Explain the significance and use of a LIFO reserve. 21
7. Understand the effect of LIFO liquidations.
8. Explain the dollar-value LIFO method. 8, 9 22, 23, 24,
25, 26
1, 8, 9,
10, 11
9. Identify the major advantages and disadvantages
of LIFO.
10. Understand why companies select given inventory
methods.

Copyright 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructors Manual (For Instructor Use Only) 8-3
ASSIGNMENT CHARACTERISTICS TABLE
Item Description
Level of
Difficulty
Time
(minutes)
E8-1 Inventoriable costs. Moderate 1520
E8-2 Inventoriable costs. Moderate 1015
E8-3 Inventoriable costs. Simple 1015
E8-4 Inventoriable costsperpetual. Simple 1015
E8-5 Inventoriable costserror adjustments. Moderate 1520
E8-6 Determining merchandise amountsperiodic. Simple 1020
E8-7 Purchases recorded net. Simple 1015
E8-8 Purchases recorded, gross method. Simple 2025
E8-9 Periodic versus perpetual entries. Moderate 1015
E8-10 Inventory errors, periodic. Simple 1015
E8-11 Inventory errors. Simple 1015
E8-12 Inventory errors. Moderate 1520
E8-13 FIFO and LIFOperiodic and perpetual. Moderate 1520
E8-14 FIFO, LIFO and average cost determination. Moderate 2025
E8-15 FIFO, LIFO, average cost inventory. Moderate 1520
E8-16 Compute FIFO, LIFO, average costperiodic. Moderate 1520
E8-17 FIFO and LIFOperiodic and perpetual. Simple 1015
E8-18 FIFO and LIFO; income statement presentation. Simple 1520
E8-19 FIFO and LIFO effects. Moderate 1520
E8-20 FIFO and LIFOperiodic. Simple 1015
E8-21 LIFO effect. Moderate 1015
E8-22 Alternate inventory methodscomprehensive. Moderate 2530
E8-23 Dollar-value LIFO. Simple 510
E8-24 Dollar-value LIFO. Simple 1520
E8-25 Dollar-value LIFO. Moderate 2025
E8-26 Dollar-value LIFO. Moderate 1520
P8-1 Various inventory issues. Moderate 3040
P8-2 Inventory adjustments. Moderate 2535
P8-3 Purchases recorded gross and net. Simple 2025
P8-4 Compute FIFO, LIFO, and average cost. Complex 4055
P8-5 Compute FIFO, LIFO, and average cost. Complex 4055
P8-6 Compute FIFO, LIFO, and average costperiodic
and perpetual.
Moderate 2535
P8-7 Financial statement effects of FIFO and LIFO. Moderate 3040
P8-8 Dollar-value LIFO. Moderate 3040
P8-9 Internal indexesdollar-value LIFO. Moderate 2535
P8-10 Internal indexesdollar-value LIFO. Complex 3035
P8-11 Dollar-value LIFO. Moderate 4050

ASSIGNMENT CHARACTERISTICS TABLE (Continued)
Item Description
Level of
Difficulty
Time
(minutes)
CA8-1 Inventoriable costs. Moderate 1520
CA8-4 Accounting treatment of purchase discounts. Simple 1525
CA8-5 General inventory issues. Moderate 2025
CA8-6 LIFO inventory advantages. Simple 1520
CA8-7 Average cost, FIFO, and LIFO. Simple 1520
CA8-8 LIFO application and advantages. Moderate 2530
CA8-9 Dollar-value LIFO issues. Moderate 2530
CA8-10 FIFO and LIFO. Moderate 3035
CA8-11 LIFO ChoicesEthical Issues. Moderate 2025

LEARNING OBJECTIVES
1. Identify major classifications of inventory.
2. Distinguish between perpetual and periodic inventory systems.
3. Identify the effects of inventory errors on the financial statements.
4. Understand the items to include as inventory cost.
5. Describe and compare the cost flow assumptions used to account for inventories.
6. Explain the significance and use of a LIFO reserve.
7. Understand the effect of LIFO liquidations.
8. Explain the dollar-value LIFO method.
9. Identify the major advantages and disadvantages of LIFO.
10. Understand why companies select given inventory methods.

CHAPTER REVIEW
1. Careful attention is given to the inventory account by many business organizations because
it represents one of the most significant assets held by the enterprise. Inventories are of
particular importance to merchandising and manufacturing companies because they
represent the primary source of revenue for the organization. Inventories are also
significant because of their impact on both the balance sheet and the income statement.
Chapter 8 initiates the discussion of the basic issues involved in recording, classifying,
and valuing items classified as inventory.
Inventory Issues
2. (L.O. 1) Inventories are asset items held for sale in the ordinary course of business or
goods that will be used or consumed in the production of goods to be sold. Merchandise
inventory refers to the goods held for resale by a merchandising concern. The inventory
of a manufacturing firm is composed of three separate items: raw materials, work in
process, and finished goods.
3. (L.O. 2) Inventory records may be maintained on a perpetual or periodic inventory system
basis. A perpetual inventory system provides a means for generating up-to-date records
related to inventory quantities. Under this inventory system, data are available at any time
relative to the quantity of material or type of merchandise on hand. In a perpetual inventory
system, purchases and sales of goods are recorded directly in the Inventory account as
they occur. A Cost of Goods Sold account is used to accumulate the issuances from
inventory. The balance in the Inventory account at the end of the year should represent
the ending inventory amount.
4. When the inventory is accounted for on a periodic inventory system, the acquisition of
inventory is debited to a Purchases account. Cost of goods sold must be calculated when
a periodic inventory system is in use. The computation of cost of goods sold is made by
adding beginning inventory to net purchases and then subtracting ending inventory.
Ending inventory is determined by a physical count at the end of the year under a periodic
inventory system. Even in a perpetual inventory system, a physical inventory count at
year-end is normally taken due to the potential for loss, error, or shrinkage of inventory
during the year.
5. Inventory planning and control is of vital importance to the success of a merchandising
or manufacturing concern. If an excessive amount of inventory is accumulated, there is
the danger of loss owing to obsolescence. If the supply of inventory is inadequate, the
potential for lost sales exists. This dilemma makes inventory an asset to which manage-
ment must devote a great deal of attention.
6. Reconciliation between the recorded inventory amount and the actual amount of inventory
on hand is normally performed at least once a year. This is called a physical inventory
and involves counting all inventory items and comparing the amount counted with the
amount shown in the detailed inventory records. Any errors in the records are corrected
to agree with the physical count.

7. The cost of goods sold during any accounting period is defined as all the goods
available for sale during the period less any unsold goods on hand at the end of the
period (ending inventory). The process of computing cost of goods sold is complicated
by the determination of (a) the physical goods to be included in inventory, (b) the costs to
be included in inventory, and (c) the cost flow assumption to be used.
Physical Goods to be Included in Inventory
8. Normally, goods are included in inventory when they are received from the supplier.
However, at the end of the period, proper accounting requires that all goods to which the
company has legal title be included in ending inventory. Goods in transit at the end of the
period, shipped f.o.b. shipping point, should be included in the buyers ending inventory.
If goods are shipped f.o.b. destination, they belong to the seller until actually received by
the buyer. Inventory out on consignment belongs to the consignors inventory.
9. In actual practice a few exceptions exist regarding the general rule that inventory is recorded
by the company that has legal title to the merchandise. These exceptions are known as
special sale agreements. Three of the more common special sale agreements are (a) sales
with buy back agreement, (b) sales with high rates of return, and (c) sales on installment.
Effect of Inventory Errors
10. (L.O. 3) Errors in recording inventory can affect the balance sheet, the income statement, or
both, because inventory is used in the preparation of both financial statements. For
example, the failure to include certain inventory items in a year-end physical inventory count
would result in the following items being overstated (O) or understated (U): ending inventory
(U); working capital (U); cost of goods sold (O); and net income (U). If merchandise was not
recorded as a purchase nor counted in the ending inventory, the result would be an under-
statement of inventory and accounts payable in the balance sheet and an understatement of
purchases and inventory in the income statement. Net income would be unaffected by this
omission as purchases and ending inventory would be misstated by the same amount.
Costs Included in Inventory
11. (L.O. 4) Inventories are recorded at cost when acquired. Cost in terms of inventory
acquisition includes all expenditures necessary in acquiring the goods and converting
them to a saleable condition. Product costs are those costs that attach to the inventory
and are recorded in the inventory account. These costs include freight charges on goods
purchased, other direct costs of acquisition, and labor and other production costs incurred
in processing the goods up to the time of sale. Period costs, such as selling expenses
and general and administrative expenses, are not considered inventoriable costs. The
reason these costs are not included as a part of the inventory valuation concerns the fact
that, in most instances, these costs are unrelated to the immediate production process.
12. The accounting profession allows for the capitalization of interest costs related to assets
constructed for internal use or assets produced as discrete projects (such as ships or real
estate projects) for sale or lease. In the case of inventories that are routinely manufac-
tured or produced in large quantities on a repetitive basis, interest costs should not be
capitalized.

Purchase Discounts
13. When purchases are recorded net of discounts, failure to pay within the discount period
results in the treatment of lost discounts as a financial expense. If the gross method is
used, purchase discounts should be reported as a deduction from purchases on the
income statement. If the net method is used, purchase discounts lost should be con-
sidered a financial expense and reported in the other expense and loss section of the
income statement.
Cost Flow Assumptions
14. Determining the specific cost of inventory items that have been sold as well as those
remaining in ending inventory is sometimes a difficult process. This is due, in part, to the
fact that there is no requirement that the cost flow assumption adopted be consistent with
the physical flow of the goods through the inventory account. Thus, it is important when
accounting for inventory costs that a company make consistent use of a cost flow
assumption. The major objective in selecting a method should be to choose the one which
most clearly reflects periodic income.
15. (L.O. 5) Inventory cost flow assumptions include (a) specific identification, (b) average
cost, (c) first-in, first-out (FIFO), (d) last-in, first-out (LIFO), and (e) dollar-value LIFO. It
should be remembered that these assumptions relate to the flow of costs and not the
physical flow of inventory items into and out of the company.
16. Specific identification calls for identifying each item sold and each item in inventory.
The costs of the specific items sold are included in cost of goods sold, and the costs of
the specific items on hand are included in inventory. The average cost method prices
items in the inventory on the basis of the average cost of all similar goods available
during the period.
FIFO
17. Use of the FIFO inventory method assumes that the first goods purchased are the first
used or sold. In all cases where FIFO is used, the inventory and cost of goods sold would
be the same at the end of the month whether a perpetual or periodic system is used.
A major advantage of the FIFO method is that the ending inventory is stated in terms of
an approximate current cost figure. However, because FIFO tends to reflect current costs
on the balance sheet, a basic disadvantage of this method is that current costs are not
matched against current revenues on the income statement.
LIFO
18. Use of the LIFO inventory method assumes that the most recent inventory costs are the
first costs recorded for goods manufactured or sold. When inventory records are kept on
a periodic basis, the ending inventory would be priced by using the total units as a basis
of computation, disregarding the exact dates of purchases. The calculation of ending
inventory and cost of goods sold changes somewhat when the LIFO method is used in
connection with perpetual inventory records.

LIFO Reserve
19. (L.O. 6) Many companies use LIFO for tax and external reporting purposes, but maintain
a FIFO, average cost, or standard cost system for internal reporting purposes. The
difference between the inventory method used for internal reporting purposes and LIFO is
referred to as the Allowance to Reduce Inventory to LIFO or the LIFO Reserve. The
change in the allowance balance from one period to the next must be made each year.
LIFO Liquidation
20. (L.O. 7) When the LIFO inventory method is used, many companies combine inventory
items into natural groups or pools. Each pool is assumed to be one unit for the purpose
of costing the inventory. Any increment above beginning inventory is normally identified
as a new inventory layer and priced at the average cost of goods purchased during the
year. When the inventory is decreased, the most recently added inventory layer is the first
layer eliminated (last-in, first-out). The specific-goods pooled LIFO approach reduces
record keeping and, accordingly, the cost of utilizing the LIFO inventory method.
Dollar-Value LIFO
21. (L.O. 8) Use of the specific-goods pooled approach can result in problems for companies
that often change the mix of their products, materials, and production methods. To
overcome these problems, the dollar-value LIFO method has been developed. The
important feature of the dollar-value LIFO method is that increases and decreases in a
pool are determined and measured in terms of total dollar value, not the physical quantity
of the goods as is done in the traditional LIFO pool approach.
22. In computing inventory under the dollar-value LIFO method, the ending inventory is first
priced at the most current cost. Current cost is then restated to prices prevailing when
LIFO was adopted. This is accomplished by using a price index. A new inventory layer is
formed when the ending inventory, stated in base-year costs, exceeds the base-year
costs of beginning inventory. Increases are priced at current cost. If the ending inventory,
stated at base-year costs, is less than beginning inventory, the decrease is subtracted
from the most recently added layer. A price index for the current year is computed by
dividing Ending Inventory for the Period at Current-Year Costs by Ending Inventory for
the Period at Base-Year Costs. The dollar-value method is a more practical way of valuing
a complex, multiple-item inventory than the traditional LIFO method.
Advantages and Disadvantages of LIFO
23. (L.O. 9) Proponents of the LIFO method advocate its use on the basis of its (a) proper
matching of recent costs with current revenue, (b) tax benefits, (c) improved cash flow,
and (d) future earnings hedge. Those opposed to the LIFO method claim that it (a) lowers
reported earnings, (b) reports outdated costs on the balance sheet, (c) is contrary to
normal physical flow, (d) creates involuntary liquidation problems, and (e) invites poor
buying habits.

Selection of Inventory Method
24. (L.O. 10) LIFO is generally preferable to FIFO when: (a) selling prices and revenues
have been increasing faster than costs, and (b) LIFO has been traditional, such as
department stores and industries where a fairly constant base stock is present. LIFO
would not be preferable when: (a) prices tend to lag behind costs, (b) specific identi-
fication is traditional, and (c) unit costs tend to decrease as production increases, thereby
nullyifying the tax benefit that LIFO might provide.

LECTURE OUTLINE
This chapter can be covered in three to four class sessions. Students should have had
previous exposure to inventory accounting topics except for dollar-value LIFO and the modified
perpetual system (perpetual records kept in units only).
A. (L.O. 1) Inventory Classification.
1. Among the most significant assets of many enterprises, inventories are asset items held
for sale in the ordinary course of business or goods that will be used or consumed in
the production of goods to be sold.
2. For manufacturing companies the inventory amount may be broken down into raw
materials, work in process, and finished goods.
B. (L.O. 2) Inventory Cost Flow.
TEACHING TIP
Contrast the accounting procedures under the perpetual and periodic inventory systems by
using Illustration 8-1. This example is based on Illustration 8-4 in the textbook on page 438.
1. Perpetual inventory systemThe costs of purchases and sales are recorded directly
in the Inventory account (perpetual record kept in units and dollars).
2. Periodic inventory systemThe cost of purchases is recorded in a Purchases (nominal
or temporary) account. The balance in the Inventory account remains unchanged
during the period. No record is kept at the time of sale of the number or cost of the
units sold. At the end of the period, the quantity of goods on hand is determined by
physical count and the cost of ending inventory is recorded. Cost of goods sold is
determined by adding the beginning inventory to the purchases and deducting the
ending inventory.
3. Modified perpetual inventory systemThe cost of purchases is recorded directly in
the Inventory account. The cost of sales is not recorded at the time of sale, but
a record is kept of the number of units sold (perpetual record kept in units only).
C. (L.O. 2) Basic Issues in Inventory Valuation. These include the determination of the
(1) physical goods to be include in inventory, (2) the costs to include in inventory, and (3)
the cost flow assumption to adopt.
D. (L.O. 2) Goods to be Included in Inventory. Technically, purchases should be recorded when
legal title passes to the buyer. The following items require careful judgment:
1. Goods in Transit: If the goods are shipped f.o.b. shipping point, title passes to the
buyer when the seller delivers the goods to the common carrier. If the goods are shipped
f.o.b. destination, title passes when the buyer receives the goods.

2. Consigned Goods: Goods out on consignment remain the property of the consignor.
3. Special Sales Agreements in which the transfer of legal title may not be accompanied
by a transfer of the risks of ownership. (The concept of revenue realization can be
discussed in connection with these special arrangements.)
a. Sales with buyback agreement.
(1) In essence, the seller finances the cost of the inventory by transferring legal
title to a third party and receiving payment. The seller then agrees to buy
the inventory back at a specified price over a specified future period.
(2) These transactions are often described as parking transactions because
the seller simply parks the inventory on another firms balance sheet and uses
it as a financing device.
(3) In these arrangements, the inventory and related liability from the repurchase
agreement should remain on the sellers books. No sale should be recorded.
b. Sales with high rates of return.
(1) When the amount of returns can be reasonably estimated, the goods should be
considered sold.
(2) If returns are unpredictable, the goods should not be removed from the sellers
inventory accounts.
c. Installment sales. The goods should be excluded from the sellers inventory (i.e.,
considered sold) if the percentage of bad debts can be reasonably estimated.
4. (L.O. 3) Effect of inventory Errors.
a. The three most common types of inventory errors:
(1) Correct recording of purchases but incorrect computing and recording of ending
inventory count.
(2) Recording purchase transactions in the wrong accounting period. However,
ending inventory is computed and recorded correctly.
(3) Failure to include an item as a recorded purchase combined with failure to
include and record the item in the ending inventory count.
b. Corrections of inventory errors may involve two procedures:
(1) Preparation of correcting journal entries. Generally, a purchase is recorded
when the invoice arrives. If this does not coincide with passage of legal title by
the end of the accounting period, correcting entries may be required to prevent
cut-off errors. (See Exercises 8-4 and 8-5 in the textbook).

(2) Computation of the correct amounts of inventory and related items including
purchases, cost of goods sold, net income, retained earnings, accounts payable,
working capital, and the current ratio.
(i) This is a good place to reinforce understanding of the basic inventory
equation:
Beginning Inventory + Purchases Ending Inventory = Cost of Goods Sold.
(ii) Point out the obvious, but useful, fact that the ending inventory of one
period is the beginning inventory of the next period.
c. Discuss the impact of inventory errors on the affected accounts.
TEACHING TIP
Illustration 8-2 demonstrates the effects of inventory errors on the income statement by
emphasizing the debit or credit balance of the affected items.
Illustration 8-3 summarizes the effects of inventory errors on the income statement and the
balance sheet.
E. (L.O. 4) Costs Included in Inventory.
1. Distinguish between product costs and period costs. Product costs are those costs
directly connected with bringing goods to the buyers place of business and converting
them to a saleable condition. Period costs such as selling and general and adminis-
trative expenses are not considered to be directly related to the acquisition or production
of goods.
2. Manufacturing Costs. Includes all costs which are traceable to the production of the
product. These costs are classified as direct materials, direct labor, and manufacturing
overhead.
3. Interest costs associated with getting inventories ready for sale are usually expensed
as incurred. However, SFAS No. 34 requires capitalization of interest cost related to
construction of discrete projects such as ships or real estate projects.
4. Purchase Discounts. Discuss the gross and net methods.
a. Gross method. Purchases and accounts payable are recorded at the gross amount.
Purchase discounts taken are credited to the Purchase Discounts account which
is reported in the income statement as a reduction of Purchases.
b. Net method (considered more appropriate than the gross method). Purchases and
accounts payable are recorded at the net amount. Purchase discounts not taken
are debited to the Purchase Discounts Lost account which is reported in the other
expense section of the income statement.

F. (L.O. 5) Choice of Cost Flow Assumption. This problem arises when numerous purchases
have been made at different prices and it is necessary to identify which goods remain on
hand and which have been sold.
TEACHING TIP
Illustration 8-4 provides a comparison of ending inventory computations under FIFO, LIFO,
and average cost under periodic and perpetual systems.
1. Specific Identification: Used where a small number of costly, distinctive items are sold.
It matches actual costs against actual revenue, but offers the opportunity to manipulate
income.
2. Average Cost: Items in the ending inventory and items sold are priced at the average
cost of goods available during the period. Either weighted-average (periodic) or
moving-average (perpetual) procedures may be used.
3. First-In, First-Out: Assumes goods are used in the order purchased. While this method
presents ending inventory at approximately current cost, it does not match current
costs against current revenues.
a. Ending Inventory and cost of goods sold will be the same under both periodic and
perpetual inventory systems.
4. Last-In, First-Out: Assumes that the last goods purchased are used or sold first.
G. (L.O. 6) LIFO Reserve (or the Allowance to Reduce Inventory to LIFO). Used when a
company maintains a FIFO, average cost, or standard cost system for internal reporting
purposes and LIFO for tax and external reporting purposes. The change in the allowance
balance from one period to the next is the LIFO effect.
H. (L.O. 7) Effect of LIFO Liquidations.
1. LIFO Liquidations. A frequent occurrence when specific-goods LIFO is used. When
the inventory balance is reduced (liquidated), the cost of the old inventory layers is
included in cost of goods sold, resulting in higher net income.
2. Specific-goods pooled LIFO approach. Inventory items are combined in pools of
similar items. This approach may help prevent LIFO liquidations because decreases in
one quantity may be offset by increases in another quantity.

I. (L.O. 8) Dollar-value LIFO. This differs from specific-goods pooled LIFO in that increases
and decreases in a pool are measured in terms of the total dollar value and not the physical
quantity of goods in the inventory pool.
1. Discuss the steps involved in the dollar-value LIFO approach.
TEACHING TIP
Illustration 8-5, which is based on the Enrico Company data in the textbook, shows a
straightforward for presenting the dollar-value LIFO computations.
a. Compute the quantity of ending inventory at current cost. (This approximates FIFO.)
b. Divide (a) by the current price index to obtain the ending inventory at base-year cost.
c. Split (b) into layers depending on the year the items were acquired.
d. Multiply each layer in (c) by the appropriate price index (price index in the year of
acquisition) to obtain the ending inventory at dollar-value LIFO cost.
TEACHING TIP
Under certain circumstances the dollar-value LIFO approach produces the same inventory
cost as the specific goods LIFO approach. This can be demonstrated by using the example
in Illustration 8-6.
2. Discuss the computation of a price index.
a. Many companies may be able to use published external price indices.
b. Some companies must compute internal price indices. The double-extension
method is discussed in the chapter. The price index for the current year is
computed as follows:
Ending Inventory for the Period at Current Cost
Ending Inventory for the Period at Base-Year Cost
J. (L.O. 9) Major Advantages and Disadvantages of LIFO.
1. Advantages of LIFO.
a. Matching. LIFO matches more recent costs against current revenues to provide a
better measure of current earnings.
b. Tax benefits/Improved cash flow. During times of rising prices, LIFO provides
a deferral of income taxes payable.
c. Future earnings hedge. With LIFO, future price declines will not substantially
affect a companys future reported earnings.

2. Disadvantages of LIFO.
a. Reduced earnings. During times of rising prices, reported earnings under LIFO
are less than they would be under FIFO. However, because the IRS has now
relaxed the LIFO conformity rule, companies are permitted to make supplementary
disclosure of non-LIFO income numbers in the financial statements.
b. Inventory understated. Under LIFO, the oldest costs (which are the lowest costs
if prices are rising) remain in inventory.
c. Physical flow. LIFO does not approximate the actual physical flow of items except
in unusual situations.
d. Involuntary liquidation. If layers of old costs are eliminated, distortions in re-
ported income can occur.
e. Poor buying habits. A company may adopt an uneconomic pattern of purchases
in order to avoid the liquidation problem or in order to manipulate net income.
K. (L.O. 10) Why companies select given inventory methods.
1. LIFO will be the preferred method if:
a. Selling prices and revenues have been increasing faster than costs, and
b. A company has a fairly constant base stock.
2. LIFO would not be the preferred method if:
a. Prices tend to lag behind costs.
b. Specific identification is traditional.
c. Unit costs tend to decrease as production increases, thereby nullifying the tax
benefit that LIFO might provide.

ILLUSTRATION 8-1
INVENTORY RECORDING SYSTEMS

ILLUSTRATION 8-2
ADJUSTING AND CLOSING THE INVENTORY ACCOUNTS

ILLUSTRATION 8-3
EFFECT OF INVENTORY ERRORS

ILLUSTRATION 8-4
COMPUTATION OF ENDING INVENTORY

ILLUSTRATION 8-5
DOLLAR-VALUE LIFO

ILLUSTRATION 8-6
COMPARISON OF UNIT LIFO AND DOLLAR-VALUE LIFO

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