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    Inventory Methods Explanations

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    Discussion Questions
    1) Distinguish between the periodic and perpetual methods. Expand on response
    2) Discuss the inventory cost flow methods. Which is the most accurate? Why? Expand on response
    3) Define the LCM rule. Is it more or less applicable in 2016. Explain.

    Introduction to Financial Accounting, 11/E, Charles T. Horngren, Stanford University, Gary L. Sundem, University of Washington, John A. Elliott, Baruch College, The City University of New York, Donna Philbrick, Portland State University,ISBN-10: 0133489361 | ISBN-13: 9780133489361 ©2014 • Prentice Hall • Cloth, 648 pp

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    1) The periodic system of inventory means occasional physical count of inventory to ascertain the ending inventory balance. In contrast the perpetual method means continuous calculation of inventory balances. Specifically the inventory account and cost of goods sold accounts are continuously updated in the perpetual system but in the periodic inventory system they are updated only at the end of the period. In the periodic inventory system closing entries are required but these are not required in the perpetual system. Further, whenever there is sales transaction, in the perpetual system there are two journal entries one recording the sale value of inventory, and the other recording the cost of goods sold. In periodic system one entry is required. In the periodic system, the balance is constant, it does not include cost of purchases, and need a physical inventory at least once a year. In contrast in the perpetual system, the inventory account is debited when there is purchase; credit for cost of items sold, and has its balance perpetually changing. In the perpetual system physical inventory is required to correct errors. Both the systems however require a cash flow assumption.

    2. The inventory cost flow assumption is that the cost of inventory item changes from when it is acquired or built and when it is sold. This means that a formal system is required for assigning costs to inventory as they move to sellable goods. The first method is the FIFO method or the first in first out method. according to this assumption, the first item purchased is also the first one sold. The second is the LIFO cost low method. This means last in, first out method. It is assumed that the last item purchased is also the first one sold. If the last purchased item is the highest cost item, the profits would be lowest under LIFO. The cost of goods sold would be inflated. The third method is the specific identification method. Under this method, it is assumed that the accountant can physically identify which specific items are purchased and sold. The cost flow moves with the actual item sold. This method is difficult because in several situations it is difficult to identify the specific items. The fourth method is the weighted average cost flow method. Under this method, the cost of goods sold is the average cost of units under each of the three methods. The purpose of this method is to get a mid-range cost, and a mid-range profit.
    The most accurate method is the specific identification method. This method is most accurate because the cost flows with the actual item sold.

    3. The LCM rule is the method of valuing inventory and securities. . Under this rule, the reported value of inventory or eligible securities at the end of the accounting period is the lower of cost or value in the market. The LCM rule is used to reset asset value. The lower of cost or market value rule is used for adjusting the balance sheet value of certain inventories and securities assets when the market value of these assets changes. In the context of inventories the market value means the replacement cost of inventories. Replacement cost can be purchase cost or manufacturing cost. This is the cost that has to be paid to acquire inventory of same quality and quantity through purchase or through manufacturing.
    It is less applicable in 2016. According the Accounting Research Bulletin No 43, the accountant should use the conservatism principle. If the value of the item purchased in 2015 has declined in replacement cost, then the loss should be reported as a loss in 2015 and not in 2016. According to ARB 43, it should not be reported as a reduction in profits in 2016.

    1. Christensen, Theodore E., Richard E. Baker, and David M. Cottrell. Advanced Financial Accounting. The McGraw-Hill Companies, Inc, 2014.
    2. Weil, Roman L., Katherine Schipper, and Jennifer Francis. Financial accounting: an introduction to concepts, methods and uses. Cengage Learning, 2013.

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