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# which cost flow assumption generally results in the highest reported amount of net income in periods of rising inventory costs?

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## Comparison Between Different Cost Flow Assumptions

Written by True Tamplin, BSc, CEPF®

Updated on September 17, 2021

This article compares the effect of different cost flow assumptions—FIFO, average cost, and LIFO—on ending inventory, cost of goods sold, and gross margin for the Cerf Company.

As shown in the table below, the highest gross margin and ending inventory, as well as the lowest cost of goods sold, resulted when FIFO was used. The lowest gross margin and ending inventory and highest cost of goods sold resulted when LIFO was used.

The average cost fell between these two extremes for all three accounts. This is because the acquisition price of the inventory consistently rises during the year, from \$4.10 to \$4.70.

We deliberately constructed this example to reflect rising prices. This is because, in today’s economy, rising prices are more common than falling prices. However, in some sectors of the economy, such as electronics, prices have been falling.

In this case, the income statement and balance sheet effects of LIFO and FIFO would be the opposite of the rising-price situation. That is, LIFO would produce the highest gross margin and the highest ending inventory cost.

Note: The figures in this table are taken from the example shown in the article entitled “Application of different cost flow assumptions.”

## Rising Prices and FIFO

In a period of rising prices, FIFO produces the highest gross margin and the highest ending inventory. The high gross margin is produced because the earliest (and, therefore, the lowest) costs are allocated to the cost of goods sold.

Thus, cost of goods sold is the lowest of the three inventory costing methods, and gross margin is correspondingly the highest of the three methods.

Ending inventory reflects the highest cost under FIFO because the latest and highest costs are allocated to ending inventory. These results are logical, given the relationship between ending inventories and gross margin.

On the one hand, many accountants approve of using FIFO because ending inventories are recorded at costs that approximate their current acquisition or replacement cost. Thus, inventories are realistically valued on the firm’s balance sheet.

On the other hand, other accountants criticize FIFO because it matches the earliest cost against sales and results in the highest gross margin.

Some accountants argue that these profits are overstated because, in order to stay in business, a going concern must replace its inventory at current acquisition prices or replacement costs. These overstated profits are often referred to as inventory profits.

## Example

To illustrate the concept of inventory profits, suppose that a firm enters into the following transactions:

2 January: Purchases one unit of inventory at \$60

15 December: Purchases another unit of inventory at \$85

31 December: Sells one unit at \$100—current replacement cost of inventory at \$85

On a FIFO basis, the firm reports a gross margin of \$40 (\$100 — \$60). However, if it is to stay in business, the firm will not have \$40 available to cover operating

expenses. This is because it must replace the inventory at a cost of at least \$85.

Therefore, in reality, the firm has only \$15 (\$100 — \$85) available to cover its operating expenses. The \$25 difference between the \$85 replacement cost and the \$60 historical cost is the inventory profit.

The inventory profit is considered a holding gain caused by the increase in the acquisition price of the inventory between the time that the firm purchased and then sold the item.

This holding gain is not available to cover operating costs because it must be used to repurchase inventory at new, higher prices.

## Rising Prices and LIFO

In an economy where prices are rising, LIFO results in the lowest gross margin and the lowest ending inventory.

The low gross margin results when the latest and highest costs are allocated to cost of goods sold. Thus, cost of goods sold is the highest of the three inventory costing methods, and gross margin is the lowest of the three methods.

Also, under LIFO, the ending inventory is recorded at the lowest cost of the three methods because the earliest and lowest prices are allocated to it.

In fact, if a company switched to LIFO 20 years ago, the original LIFO layers, if unsold, would be costed at 20-year-old prices.

In terms of its effects on the balance sheet and income statement, LIFO has the opposite effect of FIFO. Consequently, LIFO is criticized because the inventory cost on the balance sheet is often unrealistically low.

Therefore, working capital, the current ratio, and current assets tend to be understated. The potential consequences may be drastic, as illustrated by the following excerpt from the 2019 Safeway annual report:

Consolidated working capital increased to \$303 million in 2019 from \$231 million and \$218 million in 2018 and 2017, respectively. The current ratio increased to 1.19 from 1.15 and 1.16 in those years.

Had the company valued its inventories using FIFO, its current ratio would have been 1.40, 1.35, and 1.36, and working capital would have been \$621 million, \$520 million, and \$508 million at the year-ends of 2019, 2018, and 2017, respectively.

Source : learn.financestrategists.com

## Solved Which cost flow assumption generally results in the

Answer to Solved Which cost flow assumption generally results in the

## Question: Which Cost Flow Assumption Generally Results In The Highest Reported Amount Of Net Income In Periods Of Rising Inventory Costs? Multiple Choice LIFO. FIFO. Weighted-Average. Income Will Be The Same Under Each Assumption. Which Cost Flow Assumption Must Be Used For Financial Reporting If It Is Also Used For Tax Reporting? Multiple

Which cost flow assumption generally results in the highest reported amount of net income in periods of rising inventory costs?

Multiple Choice LIFO. FIFO. Weighted-average.

Income will be the same under each assumption.

Which cost flow assumption must be used for financial reporting if it is also used for tax reporting?

Multiple Choice LIFO. FIFO. Weighted-average.

Under a perpetual inventory system:

Multiple Choice

Cost of good sold is recorded with a period-end adjusting entry.

Purchase discounts are not recorded.

Inventory purchases are recorded only at the end of the period.

Inventory records for Dunbar Incorporated revealed the following:

Date Transaction Number

of Units Unit Cost

Apr. 1 Beginning inventory 430 \$ 2.17

Apr. 20 Purchase 330 2.70

Dunbar sold 620 units of inventory during the month. Ending inventory assuming LIFO would be: (Do not round your intermediate calculations. Round your answer to the nearest dollar amount.)

Multiple Choice \$304. \$933. \$378. \$891.

Inventory records for Dunbar Incorporated revealed the following:

Inventory records for Dunbar Incorporated revealed the following:

Date Transaction Number

of Units Unit Cost

Apr. 1 Beginning inventory 550 \$ 2.34

Apr. 20 Purchase 330 2.64

Dunbar sold 650 units of inventory during the month. Ending inventory assuming weighted-average cost would be: (Round weighted-average unit cost to 4 decimal places and final answer to the nearest dollar amount.)

Multiple Choice \$564. \$624. \$573. \$532.

The following information pertains to Julia & Company:

March 1 Beginning inventory = 26 units @ \$5.80

March 3 Purchased 21 units @ 4.00

March 9 Sold 30 units @ 8.40

What is the cost of goods sold for Julia & Company assuming it uses LIFO? (Do not round your intermediate calculations. Round your answer to the nearest dollar amount.)

Multiple Choice \$122. \$136. \$120.

Inventory records for Marvin Company revealed the following:

Date Transaction Number

of Units Unit Cost

Mar. 1 Beginning inventory 980 \$ 7.19

Mar. 10 Purchase 590 7.62

Mar. 16 Purchase 710 8.12

Mar. 23 Purchase 540 8.52

Marvin sold 1,890 units of inventory during the month. Cost of goods sold assuming FIFO would be: (Do not round your intermediate calculations. Round your answer to the nearest dollar amount.)

Multiple Choice \$14,590. \$16,103. \$15,221.

A company's sales equal \$60,000 and cost of goods sold equals \$20,000. Its beginning inventory was \$1,600 and its ending inventory is \$2,400. The company's inventory turnover ratio equals:

Multiple Choice 5 times. 10 times. 20 times. 30 times.

Anthony Corporation reported the following amounts for the year:

Net sales \$ 296,000

Cost of goods sold 138,000

Average inventory 50,000

Anthony's average days in inventory is: (Round to the nearest whole day.)

Multiple Choice 170 days. 114 days. 132 days. 151 days.

Anthony Corporation reported the following amounts for the year:

Net sales \$ 296,000

Cost of goods sold 138,000

Average inventory 50,000

Anthony's gross profit ratio is:

Multiple Choice 53.4%. 51.9%. 50.3%

92%

Question 1 Correct answer--------------FIFO . In…

Source : www.chegg.com

## Chapter 6 Accounting Flashcards

Study with Quizlet and memorize flashcards terms like Inventory is defined as:, Which of the following represents the balance of Cost of Goods Sold at the end of the year?, Which of following best describes a merchandising company? and more.

## Chapter 6 Accounting

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Inventory is defined as:

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Items a company intends for sale to customers.

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Which of the following represents the balance of Cost of Goods Sold at the end of the year?

Click card to see definition 👆

The cost of inventory sold during the year.

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1/45 Created by chase_dale1

### Terms in this set (45)

Inventory is defined as:

Items a company intends for sale to customers.

Which of the following represents the balance of Cost of Goods Sold at the end of the year?

The cost of inventory sold during the year.

Which of following best describes a merchandising company?

A company that purchases products that are primarily in finished form for resale to customers.

Gross profit is defined as:

Sales Revenue minus Cost of Goods Sold.

Operating income is defined as:

Gross Profit minus Operating Expenses.

A multiple-step income statement provides the advantage of:

Separating revenues and expenses based on their different types of activities.

Net income is defined as:

All revenues minus all expenses.

At the beginning of the year, Johnson Supply has inventory of \$5,200. During the year, the company purchases an additional \$20,000 of inventory. An inventory count at the end of the year reveals remaining inventory of \$3,000. What amount will Bennett report for cost of goods sold?

\$22,200

Which of the following levels of profitability in a multiple-step income statement represents all revenues less all expenses?

Net income.

Snow Company has the following inventory transactions for the year:

Date Transaction Numbers of Units Unit Cost

Jan. 1 Beginning inventory 200 \$ 4.00

Apr. 20 Purchase 800 4.25

Sep. 8 Purchase 400 4.50

Assuming Snow sells 1,000 units, calculate ending inventory under FIFO.

\$1,800.

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ACCOUNTING

Hoya Corporation reports the following amounts: Assets = \$18,000; Liabilities =\$3,000; Stockholders' equity = \$15,000; Dividends =\$3,000; Revenues = \$17,000; and Expenses =\$12,000. What amount is reported for net income?