Learning Questions and Answers for Financial Accounting, Lesson 9.1 – Mastery Level

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Repeat the following questions until you can answer each one easily. You want to persevere until you achieve a strong level of understanding. Speed is not important. Take your time and learn them all. You can do it. Most students go through an assignment once and whether they have learned the material or not, they assert, “Okay, I’ve got that assignment finished.” Don’t do that – it doesn’t lead to success. Keep working until you know the material.

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(1) – Ace Clothing Store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. Apparently, the cost of these shirts is rising rapidly. The company then sells one of the shirts. Someone asks the company president which shirt was sold and which shirt was retained. What is the answer?

(2) – Ace Clothing Store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. However, for financial reporting, Ace needs to report one shirt in cost of goods sold and one shirt in ending inventory. If the company does not know which shirt was sold and which shirt is still present, what does Ace do?

(3) – When inventory is sold, the reporting company must make a cost flow assumption to determine the cost of goods sold and the cost of ending inventory. What are the three common cost flow assumptions?

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(4) – A clothing store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. If FIFO is applied, what is reported as cost of goods sold? What is reported as ending inventory? What is the logic underlying FIFO?

(5) – A clothing store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. If LIFO is applied, what is reported as cost of goods sold? What is reported as ending inventory? What is the logic that underlies LIFO?

(6) – A clothing store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. If averaging is applied, what is reported as cost of goods sold? What is reported as ending inventory? What is the theoretical justification for averaging?

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(7) – Assume, using the three previous questions, that the inventory acquisition process is experiencing inflation (rising costs). What reporting characteristics would you expect to see with each of the cost flow assumptions?

(8) – Assume in (7) that the one blue shirt was sold for $53. What gross profit is recognized if a FIFO cost flow assumption is used? What if a LIFO cost flow assumption is used? What if averaging is used as the cost flow assumption?

(9) – If a company is experiencing inflation in the acquisition of its inventory, what characteristics are associated with FIFO and LIFO?

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(10) – Is specific identification a cost flow assumption?

(11) – What group creates U.S. GAAP? What is the purpose of those rules?

(12) – What group creates U.S. tax laws? What is the purpose of those rules?

(13) – Is there any reason for U.S. GAAP and U.S. tax laws to be the same?

(14) – What is the one place where a company’s financial statements and its income tax return must legally be the same?

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(15) – Why was the LIFO conformity rule ever passed by the U.S. Congress?

(16) – What would happen if the U.S. Congress eliminated the LIFO conformity rule?

(17) – The U.S. Congress is not likely to remove a tax law like the LIFO conformity rule that has been a law now for more than 80 years. However, if it did, what action might FASB take in connection with LIFO and U.S. GAAP?

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FIFO and LIFO (and averaging) have a significant effect on the reporting of inventory and cost of goods sold. The above questions are intended to help you understand the reason that an inventory cost flow assumption is needed and the effects that decision has on a company’s financial reporting.

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Now, read the questions again and, this time, also read the answers and make sure you know and understand each one.

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(1) – Ace Clothing Store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. Apparently, the cost of these shirts is rising rapidly. The company then sells one of the shirts. Someone asks the company president which shirt was sold and which shirt was retained. What is the answer?

The simple answer is that the company does not know (nor care) which shirt was sold and which shirt was retained. They were identical. From a practical perspective, it does not matter. For operational purposes, why waste time and money trying to determine which blue shirt was sold?

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(2) – Ace Clothing Store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. However, for financial reporting, Ace needs to report one shirt in cost of goods sold and one shirt in ending inventory. If the company does not know which shirt was sold and which shirt is still present, what does Ace do?

Companies sell identical products all the time. Every gallon of milk is the same. Each school desk might be an identical size and color. Every hammer of a particular type or brand looks the same. As long as costs never change, the reporting is based on that one number. However, costs do vary, often frequently. At that point, for reporting, an assumption must be made as to which shirt (or desk or hammer) was sold and which was kept. These are just assumptions for financial reporting purposes.

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(3) – When inventory is sold, the reporting company must make a cost flow assumption to determine the cost of goods sold and the cost of ending inventory. What are the three common cost flow assumptions?

The common cost flow assumptions are (a) first-in, first-out which is known as FIFO, (b) last-in, first-out which is known as LIFO, and (c) averaging.

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(4) – A clothing store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. If FIFO is applied, what is reported as cost of goods sold? What is reported as ending inventory? What is the logic underlying FIFO?

FIFO (first-in, first-out) assumes the earliest costs are always moved to cost of goods sold. That leaves the latest (most recent) costs in ending inventory. That makes sense. Here, cost of goods sold is reported as one unit with a cost of $20. Ending inventory is reported as one unit at a cost of $30. That does not mean that the first item was actually sold first. FIFO is an assumption that is used so that financial statements can be prepared. The logic of FIFO is that it most closely resembles reality. Most companies sell their oldest units first so they do not get damaged or become out-of-date.

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(5) – A clothing store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. If LIFO is applied, what is reported as cost of goods sold? What is reported as ending inventory? What is the logic that underlies LIFO?

LIFO (last-in, first-out) assumes that the last (most recent) costs are moved to cost of goods sold. That leaves the earliest costs in ending inventory. Here, cost of goods sold reports one unit with a cost of $30. Ending inventory reports one unit at a cost of $20. That does not mean that the last item was literally sold first. LIFO is merely an assumption that is used so that financial statements can be prepared. Many accountants argue that LIFO has no theoretical justification and should be eliminated as an accepted method because of its reporting weaknesses. Some of those weaknesses will be explored later in this chapter.

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(6) – A clothing store buys one blue shirt for $20. A few days later, the company buys an identical blue shirt for $30. The company sells one of the shirts but has no idea which shirt was sold. If averaging is applied, what is reported as cost of goods sold? What is reported as ending inventory? What is the theoretical justification for averaging?

Averaging assumes that the average cost is moved to cost of goods sold and the same average cost remains in ending inventory. Here, the average cost here is ($20 + $30)/2 units or $25. Cost of goods sold reports one unit with a cost of $25. Ending inventory reports one unit at a cost of $25. No purchased inventory had an actual cost of $25. It is an assumption that is used so that financial statements can be prepared. Proponents of averaging argue that if a company does not know which item was sold, it is only logical to use an average of all costs rather than pick either the first or the last unit arbitrarily.

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(7) – Assume, using the three previous questions, that the inventory acquisition process is experiencing inflation (rising costs). What reporting characteristics would you expect to see with each of the cost flow assumptions?

When costs are rising, decision-makers expect to see the following characteristics:

FIFO High reported inventory ($30) Low reported cost of goods sold ($20)

LIFO Low reported inventory ($20) High reported cost of goods sold ($30)

Averaging In-between reported inventory ($25) In-between reported cost of goods sold ($25)

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(8) – Assume in (7) that the one blue shirt was sold for $53. What gross profit is recognized if a FIFO cost flow assumption is used? What if a LIFO cost flow assumption is used? What if averaging is used as the cost flow assumption?

With FIFO, the company will report its gross profit as $33 ($53 less $20). With LIFO, the company will report its gross profit as $23 ($53 less $30). With averaging the company will report its gross profit as $28 ($53 less $25). Because the inventory items are identical, a cost flow assumption is required and that decision affects reported profits. The situation is the same in all three cases (two shirts were bought and one was sold) but the reported figures are quite different.

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(9) – If a company is experiencing inflation in the acquisition of its inventory, what characteristics are associated with FIFO and LIFO?

During inflation, FIFO reports higher income (because cost of goods sold is lower) and a higher ending inventory balance. LIFO reports lower income (because cost of goods sold is higher) and a lower ending inventory balance. The companies can be exactly the same but the reported figures will appear different based on the cost flow assumption.

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(10) – Is specific identification a cost flow assumption?

When a company uses specific identification, it knows which item of inventory is sold (probably because of a serial number or some distinctive characteristic). Therefore, the actual cost of that item is moved from inventory to cost of goods sold. No assumption is needed. The actual cost is known. Specific identification is rarely used unless each inventory item (such as the cars at a car dealer) is clearly different.

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(11) – What group creates U.S. GAAP? What is the purpose of those rules?

FASB (Financial Accounting Standards Board) produces U.S. GAAP. The purpose is to create a set of rules that can be used to prepare financial statements and other financial information that are presented fairly according to those official rules so that decision makers are able to make wise decisions about the reporting entity.

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(12) – What group creates U.S. tax laws? What is the purpose of those rules?

The U.S. Congress prepares U.S. tax laws. These laws are then interpreted and implemented by the Internal Revenue Service and the U.S. Tax Courts. Tax laws have many purposes including the obvious one of helping the government to raise money for its operations and other activities. In addition, tax laws allow the government a means of helping manage the economy. Public spending, for example, can be speeded up or slowed down by slight changes in income tax rates. In addition, tax laws enable the government to address social needs. For example, some health care costs, if relatively high, can be tax deductible. Likewise, some of the costs of adopting children or making charitable gifts can be used to reduce tax payments because they address society needs.

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(13) – Is there any reason for U.S. GAAP and U.S. tax laws to be the same?

No, they are two different sets of rules with vastly differing purposes. At points, they do overlap so that some rules are identical but there is no requirement for that to happen. A company follows U.S. GAAP when preparing its financial statements and then follows U.S. tax laws when filing its income tax return. The resulting numbers can be, and often are, significantly different.

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(14) – What is the one place where a company’s financial statements and its income tax return must legally be the same?

The LIFO conformity rule was passed by Congress many decades ago. It states that if a company uses LIFO on its income tax return then it must also use LIFO on its financial statements. This is the one place where a government law requires a specific method of reporting on a company’s financial statements. Otherwise, FASB is in charge of financial reporting.

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(15) – Why was the LIFO conformity rule ever passed by the U.S. Congress?

Apparently, Congress wanted to allow companies to use LIFO on their income tax returns during periods of high inflation but also hoped to discourage too many companies from taking this option. In hindsight, that seems like a poor reason to manipulate a company’s financial reporting. However, once a law is created, such rules can be hard to remove.

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(16) – What would happen if the U.S. Congress eliminated the LIFO conformity rule?

It is hard to anticipate the reaction but many companies would likely use LIFO for their income taxes because it reports a lower income in times of inflation but then use FIFO on its financial statements to appear more prosperous. Without the LIFO conformity rule, this reaction would seem reasonable if inflation were anticipated.

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(17) – The U.S. Congress is not likely to remove a tax law like the LIFO conformity rule that has been a law now for more than 80 years. However, if it did, what action might FASB take in connection with LIFO and U.S. GAAP?

Without the LIFO conformity rule, enthusiasm for LIFO would wane. In times of inflation, it reports less profits and it has many significant theoretical deficiencies. IFRS (International Financial Reporting Standards) does not even recognize LIFO as a legitimate rule. One guess is that without the LIFO conformity rule, FASB would eliminate the use of LIFO for financial reporting purposes.

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When you can easily answer these questions, you are ready to move on because you have a strong underlying knowledge of cost flow assumptions.

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