Vol. 3 LM5 Inventory Management

Question 1

Inventory disclosures

US GAAP vs IFRS

p. 286

Answer 1

• US GAAP do not permit the reversal of prior-year inventory write-downs.
• US GAAP require disclosure of significant estimates applicable to inventories and any material amount of income resulting from a LIFO liquidation

Question 2

List

inventory management ratios

p. 286

Answer 2

• inventory turnover
• days of inventory on hand
• gross profit margin

Question 3

describe

inventory turnover ratio

p. 286

Answer 3

measures the number of times during the year a company sells (i.e., turns over) its inventory.

Question 4

Describe

Days of inventory on hand

p. 286

Answer 4

can be calculated as days in the period divided by inventory turnover

Question 5

What does it indicate

• high inventory turnover ratio
• low number of days of inventory on hand

p. 286

Answer 5

highly effective inventory management

Question 6

What does it indicate

• high inventory ratio
• low number of days of inventory on hand

p. 286

Answer 6

could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values

Question 7

What does it indicate

• low inventory turnover ratio
• high number of days of inventory on hand relative to industry norms

p. 286

Answer 7

slow-moving or obsolete inventory

Question 8

What does it indicate

a significant increase (attributable to increases in unit volume rather than increases in unit cost) in raw materials and/or work-in-progress inventories

p. 287

Answer 8

• may signal that the company expects an increase in demand for its products
• it suggests an anticpated increase in sales and profit

Question 9

What does it indicate

• substantial increase in finished goods inventories
• raw materials and work-in-progress inventories are declining

p. 287

Question 10

What are the components of the total cost of inventories?

Answer 10

• all costs of purchase,
• costs of conversion,
• and other costs incurred in bringing the inventories to their present location and condition.

Storage costs of finished inventory and abnormal costs are typically treated as period expenses.

Question 11

Which inventory valuation methods are allowed under IFRS and US GAAP?

Answer 11

IFRS allows first-in, first-out (FIFO); weighted average cost; and specific identification.
US GAAP allows these methods plus the last-in, first-out (LIFO) method.

Question 12

How does the choice of inventory valuation method affect financial statements?

Answer 12

• It affects the carrying amounts of inventory and cost of sales,
• impacting current assets, total assets, gross profit, net income, and financial ratios derived from these figures.

Question 13

What is LIFO liquidation and its impact?

Answer 13

• LIFO liquidation occurs when ending inventory units decline from the beginning of the year.
• If unit costs have risen, this leads to an inventory-related increase in gross profits.

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Question 14

P1

inventory cost is least likely to includue:
A. production-related storage costs
B. costs incurred as a result of normal waste of materials
C. transportation costs of shipping inventory to customers

Answer 14

C is correct.

Transportation costs incurred to ship inventory to customers are an
expense and may not be capitalized in inventory. (Transportation costs incurred to bring inventory to the business location can be capitalized in inventory.)
Storage costs required as part of production, as well as costs incurred as a result of normal waste of materials, can be capitalized in inventory. (Costs incurred as a result of abnormal waste must be expensed.)

Question 15

P11

Cinnamon Corp. started business in 2017 and uses the weighted average cost
method. During 2017, it purchased 45,000 units of inventory at €10 each and sold
40,000 units for €20 each. In 2018, it purchased another 50,000 units at €11 each
and sold 45,000 units for €22 each. Its 2018 cost of sales (€ thousands) was closest
to:
€490
€491
€495

Answer 15

B is correct.
Cinnamon uses the weighted average cost method, so in 2018, 5,000
units of inventory were 2017 units at €10 each and 50,000 were 2008 purchases at €11.
* The weighted average cost of inventory during 2008 was thus (5,000 × 10) + (50,000 × 11) = 50,000 + 550,000 = €600,000, and
* the weighted average cost was approximately €10.91 = €600,000/55,000.
* Cost of sales was €10.91 × 45,000, which is approximately €490,950.

Question 16

Zimt AG started business in 2017 and uses the FIFO method. During 2017, it purchased 45,000 units of inventory at €10 each and sold 40,000 units for €20 each. In 2018, it purchased another 50,000 units at €11 each and sold 45,000 units for €22 each. Its 2018 ending inventory balance (€ thousands) was closest to:
€105
€109
€110

Answer 16

C is correct.
* Zimt uses the FIFO method, and thus the first 5,000 units sold in 2018 depleted the 2017 inventory.
* Of the inventory purchased in 2018, 40,000 units were sold and 10,000 remain, valued at €11 each, for a total of €110,000.

Question 17

P13

Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices, the cost of sales reported by

Answer 17

A is correct.
* Zimt uses the FIFO method, so its cost of sales represents units
purchased at a (no longer available) lower price.
* Nutmeg uses the LIFO method, so its cost of sales is approximately equal to the current replacement cost of inventory.

Question 18

P14

Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices the ending inventory balance reported by:
A. Zimt is too high.
B. Nutmeg is too low
C. Nutmeg is too high.

Answer 18

B is correct.
* Nutmeg uses the LIFO method, and thus some of the inventory on the balance sheet was purchased at a (no longer available) lower price.
* Zimt uses the FIFO method, so the carrying value on the balance sheet represents the most recently purchased units and thus approximates the current replacement cost.

Question 19

P15

Like many technology companies, TechnoTools operates in an environment of declining prices. Its reported profits will tend to be highest if it accounts for inventory using the:
A. FIFO method.
B. LIFO method.
C. weighted average cost method.

Answer 19

B is correct.
* In a declining price environment, the newest inventory is the
lowest-cost inventory.
* In such circumstances, using the LIFO method (selling the newer, cheaper inventory first) will result in lower cost of sales and higher profit.

Question 20

P16

Compared to using the weighted average cost method to account for inventory, during a period in which prices are generally rising, the current ratio of a company using the FIFO method would most likely be:
A. lower.
B. higher.
C. dependent upon the interaction with accounts payable.

Answer 20

B is correct.
* In a rising price environment, inventory balances will be higher for the company using the FIFO method.
* Accounts payable are based on amounts due to suppliers, not the amounts accrued based on inventory accounting.

Question 21

P17

Zimt AG wrote down the value of its inventory in 2017 and reversed the
write-down in 2018. Compared to the ratios that would have been calculated if the write-down had never occurred, Zimt’s reported 2017:
A. current ratio was too high.
B. gross margin was too high.
C. inventory turnover was too high.

Answer 21

C is correct.
* The write-down reduced the value of inventory and increased cost of sales in 2017.
* The higher numerator and lower denominator mean that the inventory turnover ratio as reported was too high.
* Gross margin and the current ratio were both too low.

Question 22

P18

Zimt AG wrote down the value of its inventory in 2017 and reversed the
write-down in 2018. Compared to the results the company would have reported if the write-down had never occurred, Zimt’s reported 2018:
A. profit was overstated.
B. cash flow from operations was overstated.
C. year-end inventory balance was overstated.

Answer 22

A is correct.

• The reversal of the write-down shifted cost of sales from 2018 to
  2017.
• The 2017 cost of sales was higher because of the write-down, and the 2018 cost of sales was lower because of the reversal of the write-down. As a result, the reported 2018 profits were overstated. Inventory balance in 2018 is the same because the write-down and reversal cancel each other out. Cash flow from operations is not affected by the non-cash write-down, but the higher profits in 2018 likely resulted in higher taxes and thus lower cash flow from operations.

Question 23

P19

Compared to a company that uses the FIFO method, during periods of rising prices a company that uses the LIFO method will most likely appear more:
A. liquid.
B. efficient.
C. profitable.

Answer 23

B is correct.
* LIFO will result in lower inventory and higher cost of sales. Gross margin (a profitability ratio) will be lower, the current ratio (a liquidity ratio) will be lower, and inventory turnover (an efficiency ratio) will be higher.

Question 24

P20

Nutmeg, Inc. uses the LIFO method to account for inventory. During years in which inventory unit costs are generally rising and in which the company purchases more inventory than it sells to customers, its reported gross profit margin will most likely be:
A. lower than it would be if the company used the FIFO method.
B. higher than it would be if the company used the FIFO method.
C. about the same as it would be if the company used the FIFO method.

Answer 24

A is correct.
* LIFO will result in lower inventory and higher cost of sales in
periods of rising costs compared to FIFO. Consequently, LIFO results in a lower gross profit margin than FIFO.

Question 25

P21

Compared to using the FIFO method to account for inventory, during periods of rising prices, a company using the LIFO method is most likely to report higher:

A. net income.
B. cost of sales.
C. income taxes.

Answer 25

B is correct.
* The LIFO method increases cost of sales, thus reducing profits and the taxes thereon.

Question 26

P22

Carey Company adheres to US GAAP, whereas Jonathan Company adheres to IFRS. It is least likely that:

A. Carey has reversed an inventory write-down.
B. Jonathan has reversed an inventory write-down.
C. Jonathan and Carey both use the FIFO inventory accounting method.

Answer 26

A is correct.
* US GAAP do not permit inventory write-downs to be reversed.