Chapter 5 : Accounting for and Presentation of Current Assets Learning Objective : The alternative inventory cost-flow assumptions and

their respective effects on the income statement and balance sheet when price level are changing. Cost-flow assumption an assumption made for accounting purposes that identifies how cost flow from the Inventory Account to the Cost of Goods Sold Account. Cost of Goods Sold model Beginning Inventory + Purchases Cost of goods available for sale -Ending Inventory Cost of goods sold The Impact of selecting cost-flow assumption ; It will probably differ from the physical flow of the product. Difference cost-flow assumptions, result in difference COGS (impact to Income Statement) & Ending Inventory Cost (impact to BS) Difference quantity changes.

Accurate accounting for inventories must be achieved if the financial statement to be meaningful to users. 1. The Impact of selecting an Inventory Cost-Flow Assumption by the influence of inflation; (a) Using FIFO Inflation rate is low Inflation rate is high Beginning Stock = 1,500 Sold = 2,000 COGS = 1,500 Revenue = 2,000 1,500 = 500 Tax rate = 30% Net Income = Revenue Tax amount = 500 (500 x 30%) = 350. COGS reported at lower cost & at higher net income. Ending Inventory at high cost. Beginning Stock = 1,500 Sold = 2,000 Current cost replacing = 1,850 (inflation) COGS = 1,500 (FIFO assumption) Revenue = 2,000 1,500 = 500 Tax rate = 30% Net Income = Revenue Tax amount = 500 (500 x 30%) = 350. Firms real economic profitability cash flow = 2,000 1,850 150 = 0.

Result inventory profit. Mislead about firms real economic profitability. FIFO assumption not accurate when inflation rate is high. (b) LIFO suggested to use when inflation rate is high. Effects to Balance Sheet & Income Statement (a) Ending Inventories reported at older cost (delayed the recognition of

inventory profit) (b) Consistent with the original accounting concept Asset reported in BS does not reflect the current values of assets. (c) Contradict with consistency concept accounting alternative selected for one year should be used for subsequent financial reporting. (d)If firm need to change, it must be disclosed in the FS notes.
1. The Impact of Inventory Accounting System Alternatives

In practice the system to account for inventory cost flow quiet complex because of high volumes & varieties of inventories item. 2 principal inventory accounting system applied; Perpetual system Record every purchase & every sales (day to day basis) Continuous record of quantity and cost each item inventory. Periodical System Count of inventory on hand is made periodically (physical inventory counting stock take) End of fiscal year, monthly, quarterly. Ending inventory cost depends on cost-flow assumption use such as FIFO, LIFO or weighted

When a perpetual inventory system is used , it is appropriate to periodically system verify that the quantity of inventories shown by perpetual inventory record = quantity actually on hand. Under FIFO ending inventories & COGS under the 2 system produce same results. Cost flow from inventories to COGS based strictly on the chronological order of purchase transaction.

Under LIFO it will be different amount. Under perpetual system The cost of the most recently purchased inventory items is assigned to COGS, Ending inventory redefined by the cost of new items of inventories purchased. Under periodical system, COGS relate to those inventory items that are purchased toward the end of the year. Ending inventory redefined by the cost of older items of inventories purchased.

1. The impact of inventory errors on the balance sheet & income statement; The amount of goods available for sale during the period must either remain on hand as ending inventory (asset) or flow to the income statement as cost of goods sold (expenses). An error in the ending inventory affects COGS in opposite direction. If the ending inventory is understated, COGS will be overstated and affects income statement reported at lower profit (understated) The error will affect COGS & net income for the subsequent year because the ending inventory for one period will be the beginning inventory for next period.

Eg. January Sales COGS : Beginning Inventory Cost of goods purchased Cost of goods available for sale (-) Ending Inventory 1,200 4,100 5,300 (900) (4,400) 900 5,500 6,400 (1,400) (5,000) 6,000 February 8,000

COGS Gross Profit (-) operating expenses Net Income 1,600 (1,000) 600 3,000 (1,000) 2,000

(a) Assume ending inventory for January understated RM100, COGS overstated RM100. Net income will understated by RM100. (b)Next subsequent period, the beginning period will be understated by RM100, COGS understated by RM100. Net Income will overstated by RM100.