Page 309 - Accounting Principles (A Business Perspective)

7. Measuring and reporting inventories

this average unit cost is applied to each item. Under the weighted-average method, in a period of rising prices
net income is usually higher than income under LIFO and lower than income under FIFO.

• Specific identification: Advantages: (1) States cost of goods sold and ending inventory at the actual cost
of specific units sold and on hand, and (2) provides the most precise matching of costs and revenues.
Disadvantage: Income manipulation is possible.
• FIFO: Advantages: (1) FIFO is easy to apply, (2) the assumed flow of costs often corresponds with the
normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for
inventory is likely to approximate the current market value. Disadvantages: (1) Recognizes paper profits, and
(2) tax burden is heavier if used for tax purposes when prices are rising.

• LIFO: Advantages: (1) LIFO reports both sales revenue and cost of goods sold in current dollars, and (2)
lower income taxes result if used for tax purposes when prices are rising. Disadvantages: (1) Often matches the
cost of goods not sold against revenues, (2) grossly understates inventory, and (3) permits income
manipulation.
• Weighted-average: Advantages: Due to the averaging process, the effects of year-end buying or not
buying are lessened. Disadvantage: Manipulation of income is possible.
• Perpetual inventory procedure requires an entry to Merchandise Inventory whenever goods are purchased,
returned, sold, or otherwise adjusted, so that inventory records reflect actual units on hand at all times. Thus,
an entry is required to record cost of goods sold for each sale.

• Companies should not carry goods in inventory at more than their net realizable value. Net realizable value
is the estimated selling price of an item less the estimated costs incurred in preparing the item for sale and
selling it. Inventory items are written down to market value when the market value is less than the cost of the
items. If market value is greater than cost, the increase in value is not recognized. LCM may be applied to each
inventory item, each inventory class, or total inventory.
• The steps in calculating ending inventory under the gross margin method are:
a. Estimate gross margin (based on net sales) using the same gross margin rate experienced in prior

accounting periods.
b. Determine estimated cost of goods sold by deducting estimated gross margin from net sales.
c. Determine estimated ending inventory by deducting estimated cost of goods sold from cost of goods
available for sale.
• The retail inventory method estimates the cost of the ending inventory by applying a cost/retail price ratio
to ending inventory stated at retail prices. To find the cost/retail price ratio, divide the cost of goods available
for sale by the retail price of the goods available for sale.
Costof goodssold
• Inventory turnover ration=
 Averageinventory 
• Inventory turnover measures the efficiency of the firm in managing and selling inventory. It gauges the
liquidity of the firm's inventory.

Demonstration problem
Demonstration problem A Following are data related to Adler Company's beginning inventory, purchases,
and sales:
Beginning Inventory Sales

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