 In this presentation we will take a look at multiple choice questions related to inventory and cost flow assumptions. First question. Which method is closest to the cost flow a company would generally want? A. Specific identification method B. Average cost method C. First in first out method D. Weighted average method E. Last in first out lifo method Once again we will read the question and see if we can eliminate some of the options. Which method is closest to the cost flow a company would generally want? So when we think about these cost flow methods, most of them are assumptions, they are not the actual flow and therefore we can think of which flow method might a company desire to have to mirror what they hope the physical flow actually is. So if we look through these A. Specific identification method Now the specific identification method really isn't a assumption method that would be specifically identifying the inventory that was sold and would be the case if we had large inventory such as cars or forklifts or something custom made. Those types of things we would typically have serial numbers identified the inventory specifically and when we sell it we would know specifically which one was sold. So I don't think it's going to be A. B. Average cost method Now an average is going to be a cost flow assumption where we kind of just say yeah we're just going to have the average between the high and the low of the costs that they could have had meaning if the rising prices were the case then the older inventory would be cheaper the newer inventory would be more expensive even though it's the same thing and we would just say yeah it's about the average of whatever. In other words that's not really a flow assumption as it is basically taking the middle ground of the high and the low costs so I don't think that's going to be it. First and first out would mean that the inventory first going into the companies what we assume would be the first that would be leaving the company in terms of sales so I'm going to keep that one for now. D. Weighted average method that sounds a lot like the average method where they weighted probably a bit more specific. The fact that we have these two once again would possibly eliminate them because we can't have them both and it's an average so the average would be not really a flow assumption but taking that average the weighted average. E says the last and first out method that's assuming that we sold the last units that we received first. Now if we're thinking about once again the question is which method is closest to the cost flow a company would generally want and I'm interpreting that to mean what flow is assumed to be what a company would want the actual physical flow to be and that would be either first and first out or last and first out. First and first out would be similar to how you would think you would stock the shelves meaning you would probably want to put the older items up front hopefully hoping to sell them first and then have the newer items in back meaning the physical flow of first and first out is typically what we would assume a company would strive for for the selling. Last and first out would mean that if you were stocking the shelves you would put all the new stuff up front and just keep selling the new stuff and never sell the old stuff which from a flow assumption of inventory you would think would not be good even if it's a perishable thing that would be very bad because the older stuff would spoil but even if it's non-perishable you would think we'd want to make some attempt to sell the older stuff first. So I would think that the answer would be C here so once again which method is closest to the cost flow a company would generally want C first and first out. Next question. Which method results in lowest taxes when costs rise? A specific identification method. B average cost method. C first and first out method. D weighted average method. Or E last and first out method. Once again question will read it and then go over some of these and see if we can eliminate a few. Which method results in the lowest taxes when costs rise? So first point note that costs are rising that's going to be the normal condition. I would think of that as the default normal conditions costs rising due to if nothing else inflation and then we're talking about taxes here now we haven't spent a lot of time on taxes but we know that the better you do the more the tax collector wants so in some way or another so usually the default position is for a company they want to look good do well and that there's an exception however when we go to the tax person we typically don't want to look good. So in other words if we lower net income typically that will lower the taxes. So this question you can read it similarly as saying which method results in the lowest net income which will result in the lowest taxes typically. So if we think of it like that and read through these specific identification method that one really isn't a flow assumption again that's kind of a specific identification method we don't have a lot of control if we use that we would use that if we're dealing with companies of luck that deal with larger amounts of inventory or custom items. So I don't think that's it. The average cost method you would think that would be somewhere in the middle we're looking for the lowest net income we're looking to look as bad as possible the lowest net income so you wouldn't think it would be the average that would be somewhere in the middle. So I'm going to say it's probably not the average. First in first out that's going to be a cost flow assumption one of the extremes I'll keep that one for now. Next one says weighted average. Once again sounds very similar to average so we might be able to eliminate B and D because they're pretty much the same type of thing and or they're both averages. So it's not going to be an average because that would be somewhere in the middle you would think. And then E says last in first out so we're left in once again with first in first out last in first out those typically be in the extremes and often when we talk about these answers of the highest net income lowest net income highest assets or inventory lowest assets or inventory we're typically going to be narrowing down to either FIFO or LIFO. So once again question which method results in the lowest taxes when costs rise. So lowest taxes were interpreting also as lowest net income and costs rising being the kind of the default. So first in first out that this is what I would typically this is a very common question. So I would typically think of the first in first out under normal conditions rising prices to make you look better and last in first out to make you look worse. And so if you could do this this is just a memory tactic then if it was possible which it's not because the code the tax code tries to eliminate this in the U.S. at least which would be you'd want to be on first in first out for bookkeeping purposes so that you can report the higher values for the asset and the net income and be on a last in first out for tax purposes resulting in a lower total assets and net income resulting in lower taxes. That's kind of the default and you might think typically when most people hear LIFO it doesn't sound like that it doesn't flow with the cost for assumption. So you can think of why would someone use LIFO possibly look worse possibly to pay less taxes but that would only be the case if the costs were rising. So that's kind of the default just to memorize this first in first out under rising prices makes you look better that means that the accounts involved the asset account of inventory would be higher than LIFO and the cost of goods sold account would be lower resulting in net income being higher. LIFO typically makes you look the worst which means that the under rising prices which means that the net income would mean that the inventory would be lower cost of goods sold would be higher net income then would be lower. So the answer then if we had rising prices that LIFO would be the least taxes and so that's going to be the answer there. So once again which method results in the lowest taxes when costs rise? E. LIFO. Next question. When cost to purchase inventory decline which method will result in the lowest cost of goods sold? A. Specific identification method B. Average cost method C. First in first out FIFO method D. Weighted average method or E. Last in first out LIFO method. Once again we'll read through this and then we'll take a look at the option see if we can eliminate some of them. When cost to purchase inventory decline which method will result in the lowest cost of goods sold? So notice we have the declining cost meaning that inventory as we purchase it is going down. That's I would think of that as not the default the default would be increasing and then the so I would think of the terms first in terms of increasing prices and then reverse that in order to deal with the decline situation we have here. So let's first read through these and see if we can eliminate some of them. First we have the specific identification method and we're looking for the lowest cost of goods sold. So the specific identification method we really don't have control over what it will be the lowest or not. We don't really know it just depends on what they specifically identify. It's not really a cost flow assumption. It's specific identity specifically identify the inventory. So I don't think that's going to be it. The average method once again it's somewhere in the middle the average. So whenever we talk about these extremes the lowest cost of goods sold you would think the average wouldn't be it. That would be the average between the two. So I'm going to think it's not average first in first out. That's one of the extremes typically D says weighted average. So once again it's an average and it's going to be the same as be up here or similar to it. So that might be another reason that we can cross those two out. And then E says last in first out. So once again when we're talking about these extremes we're typically going to get down to last in first out and first in first out. And notice there's many different ways they can ask pretty much the same question here. We're saying you know what we can ask what happened to inventory. What happened to net income. What happened to gross profit. What happened to cost of goods sold. We're all related and we can ask any of those questions with either increasing prices as costs go up or declining prices. So the way to think about these the default way I would go about all of these is first to say in your mind know that the increasing in prices prices going up due to typically inflation is the default setting. Memorize that when that is the case that when prices increase then first in first out usually makes you look better. Last in first out usually makes you look worse in normal times when prices are increasing. And then you can flip that for unusual times like this when prices are decreasing. So if if first in first out usually makes you look better under normal increasing prices it'll make you look worse under decreasing prices. And if LIFO typically makes you look worse because it's typically better for taxes under normal time when we have increasing prices it'll make you look better if prices are decreasing in relation to first in first out. So then then once that's the case you can say well cost of goods sold that's a kind of expense net income is calculated as revenue less these expenses including cost of goods sold to get to net income. So if if the we want then to have cost of goods sold to look good we'd want to have cost goods sold to be lower that would bring a net income up and if the cost of goods sold was higher would bring net income down. So we're going to say we're looking for the lowest cost of goods sold which would make net income higher and make us look better. So in a period of decline we would think that LIFO would actually do that because it would make us look better. So again the thought process on that and this you just kind of have to kind of organize this in your mind because there's a lot of different ways they can ask this question. My thought process would be the quickest way to think about this otherwise you can go through the thought process of the flows and try to figure out what exactly the flows are first in first out. That means the first ones going in are going to be the first ones going out and if we're talking about declining prices the older ones actually cost more than the newer ones. And therefore when we sell something we're selling the old ones which means cost of goods sold is higher under declining prices. But that can take a lot of time under a test situation like this and it's worth doing if you have the time. So if you might want to think of a shortcut I think the shortcut would be first to think of a normal time period of increasing prices and then go to the default and just know that first in first out will make you look better and last in first out will make you look worse when the prices are increasing and then you can go through whatever they ask you cost of goods sold going up or down does that make you look better or worse. And then you can figure out which method if they ask you about inventory is it going up or down does that make you look better or worse. And then if they ask you about gross profit same thing net income same thing does it make you look better or worse. And you can just apply that rule to it and obviously anything that increases if it's if it's a higher asset and makes you look better if it increases net income it makes you look better. The opposite would make you look worse and then reverse all of those in a period of declining prices. The opposite will be true meaning first in first out will make you look worse and last in first out will make you look better. Go through whatever account they ask you and see which one would make you look better.