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Chapter 19

Chapter 19. Difficulties in Measuring Net Income. Describe the four major methods of accounting for inventories. Learning Objective 1. Major Inventory Methods. LIFO (last-in, first-out). Specific identification. FIFO (first-in, first-out). Weighted average. Major Inventory Methods.

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Chapter 19

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  1. Chapter 19 Difficulties in Measuring Net Income

  2. Describe the four major methods of accounting for inventories. Learning Objective 1

  3. Major Inventory Methods LIFO (last-in, first-out) Specific identification FIFO (first-in, first-out) Weighted average

  4. Major Inventory Methods January 2 20 units @ $20 = $ 400 May 19 55 units @ $30 = $1,650 October 23 25 units @ $31 = $ 775 Total units 100 Units sold 70 Units left 30

  5. Units Sold and in Ending Inventory Units sold by date: Jan 5 17 May 19 33 Oct 23 20 Total sales 70 30 units left in inventory

  6. Specific Identification 20 Units @ $31 5 Units @ $31 Cost of Goods Sold Oct 23 $ 620 May 19 990 Jan 5 340 Total $1,950 33 Units @ $30 22 Units @ $30 17 Units @ $20 3 Units @ $20

  7. First-In, First-Out 25 Units @ $31 (Oct) Cost of Goods Sold Jan $ 400 May 1,500 Total $1,900 5 Units @ $30 (May) 50 Units @ $30 20 Units @ $20 (Jan)

  8. Last-In, First-Out 25 Units @ $31 (Oct) Cost of Goods Sold Oct $ 775 May 1,350 Total $2,125 45 Units @ $30 (May) 10 Units @ $30 20 Units @ $20 (Jan)

  9. Weighted Average 25 Units @ $31 (Oct) = $ 775 = 1,650 = 400 = $2,825 Total Cost 55 Units @ $30 (May) 20 Units @ $20 (Jan) 100 Total Units

  10. Weighted Average $2,825 total cost/100 units = $28.25/unit Cost of goods sold = 70 × $28.25 = $1,977.50

  11. Compare FIFO and LIFO, and explain why most U.S. firms use LIFO. Learning Objective 2

  12. Comparison of FIFO and LIFO FIFO associates the most recent costs with inventories, whereas LIFO treats the most recent costs as cost of goods sold. Many accountants believe that LIFO provides a more realistic income number because net income measured using LIFO combines current sales prices and current acquisition costs.

  13. Comparison of FIFO and LIFO In contrast , LIFO inventory values on the balance sheet are less realistic because they are older costs.

  14. Comparison of FIFO and LIFO In a period of rising prices and constant or growing inventories, LIFO yields lower net income than the other inventory methods.

  15. Comparison of FIFO and LIFO Inflationary periods often cause firms to change from FIFO to LIFO. A lower net income under the LIFO method means that lower income is reported to taxing authorities and lower taxes are paid.

  16. Comparison of FIFO and LIFO LIFO disadvantages It permits management to influence income by the timing of purchases of inventory items. Income can soar when inventories are depleted.

  17. LIFO Layers Under LIFO, inventory consists of LIFO layers (or LIFO increments), which are separately identifiable additions to inventory. All units in a particular LIFO layer have the same cost.

  18. Explain the lower-of-cost- or-market method. Learning Objective 3

  19. Choice of Inventory Methods In choosing an inventory method, it is important to recognize the link between the cost of goods sold and the valuation of ending inventory.

  20. Lower-of-Cost-or-Market (LCM)Method Accountants must decrease the inventory value if the inventory’s market price drops below its acquisition cost.

  21. Lower-of-Cost-or-Market (LCM) Method Current market price of inventory is compared with its cost (derived by specific identification, FIFO, LIFO, or weighted average). The lower of the two is selected as the basis for the valuation of goods at a specific inventory date.

  22. Distinguish between financial capital maintenance and physical capital maintenance. Learning Objective 4

  23. Financial Capital Maintenance Most accountants and managers believe that income emerges after investors recover their financial resources, a concept called financial capital maintenance.

  24. Physical Capital Maintenance On the other hand, some accountants believe that income emerges only after recovering an amount that allows physical operating capability to be maintained, called physical capital maintenance.

  25. Measurement Alternatives Under Inflation Inflation , a general rise in prices causing a decline in the purchasing power of the monetary unit, has caused accountants to consider two types of changes in financial reporting.

  26. Measurement Alternatives Under Inflation • Switch from measuring transactions in nominal dollars to constant dollars. • Instead of reporting the historical cost of an asset, use the current cost.

  27. Nominal Dollars • Transactions measured in nominal dollars are not restated for fluctuations in the general purchasing power of the monetary unit.

  28. Constant Dollars • Transactions measured in constant dollars are nominal dollar transactions restated in terms of current purchasing power.

  29. Cost Historical cost is the amount originally paid to acquire an asset. Current cost is the cost to replace an asset, as opposed to its historical cost.

  30. Explain and illustrate four methods of measuring income: historical cost/nominal dollars, current cost/nominal dollars, historical cost/constant dollars, and current cost/constant dollars. Learning Objective 5

  31. Methods of Measuring Income • There are four methods of measuring income. • Historical cost/Nominal dollars • Current cost/Nominal dollars • Historical cost/Constant dollars • Current cost/Constant dollars

  32. Historical Cost/Nominal Dollars This is the most popular approach to income measurement and is commonly called the historical-cost method. Operating income is the excess of revenue over the original acquisition costs of assets used in obtaining that revenue.

  33. Current Cost/Nominal Dollars This method is a measurement method that uses current costs and nominal dollars. The focus of the current-cost method is on operating income.

  34. Current Cost/Nominal Dollars • Operating income is defined as the excess of revenue over the current costs of the assets consumed in obtaining that revenue. • The current-cost method stresses a separation between operating income and holding gains (or losses).

  35. Holding Gains (or Losses) Holding gains (or losses) are increases (or decreases) in the replacement costs of the assets held during the current period.

  36. Revaluation Equity • Advocates of a physical concept of capital maintenance claim that all holding gains should be excluded from income and become a part of stockholders’ equity called revaluation equity.

  37. Historical Cost/Constant Dollars The historical cost/constant dollars method uses general price indexes to restate the amounts of the historical cost/nominal dollar method.

  38. General Price Index A general price index compares the average price of a group of goods and services at one date with the average price of a similar group at another date. Gross National Product Implicit Price Deflator CPI for All Urban Consumers

  39. Specific Price Indexes Do not confuse general indexes with specific indexes. Sometimes specific price indexes are used to approximate the current costs of particular assets or types of assets.

  40. Current Cost/Constant Dollars This method applies general index numbers to current cost.

  41. Understand why and how managers and investors adjust their financial statements to account for changes in prices paid for inventories. Learning Objective 6

  42. Adjusting for Changes in Prices Paid for Inventories Financial statements that ignore inflation disregard an important economic factor affecting companies. If financial statements do not adjust for inflation, users should at least recognize the potential weaknesses in the statements.

  43. End of Chapter 19

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