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6-1
6-2
REPORTING AND ANALYZING INVENTORY
Financial Accounting, Sixth Edition
6
6-3
1. Describe the steps in determining inventory quantities.
2. Explain the basis of accounting for inventories and apply the
inventory cost flow methods under a periodic inventory system.
3. Explain the financial statement and tax effects of each of the
inventory cost flow assumptions.
4. Explain the lower-of-cost-or-market basis of accounting for
inventories.
5. Compute and interpret the inventory turnover ratio.
6. Describe the LIFO reserve and explain its importance for
comparing results of different companies.
Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives
6-4
Classifying Classifying InventoryInventory
Classifying Classifying InventoryInventory
MerchandisingMerchandising
ManufacturingManufacturing
Just-in-timeJust-in-time
Inventory Inventory turnover ratioturnover ratio
LIFO reserveLIFO reserve
Specific Specific identificationidentification
Cost flow Cost flow assumptionsassumptions
Financial Financial statement and statement and tax effectstax effects
Consistent useConsistent use
Lower-of-cost-Lower-of-cost-or-marketor-market
Taking a Taking a physical physical inventoryinventory
Determining Determining ownership of ownership of goodsgoods
Determining Determining Inventory Inventory QuantitiesQuantities
Determining Determining Inventory Inventory QuantitiesQuantities
Inventory Inventory CostingCosting
Inventory Inventory CostingCosting
Analysis of Analysis of InventoryInventory
Analysis of Analysis of InventoryInventory
Reporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing Inventory
6-5
Classifying InventoryClassifying InventoryClassifying InventoryClassifying Inventory
One Classification:
Merchandise
Inventory
Three Classifications:
Raw Materials
Work in Process
Finished Goods
Merchandising Company
Manufacturing Company
Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
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6-7
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw
materials, shoplifting, or employee theft).
Periodic System
1. Determine the inventory on hand
2. Determine the cost of goods sold for the period.
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
SO 1 Describe the steps in determining inventory quantities.SO 1 Describe the steps in determining inventory quantities.
6-8
Involves counting, weighing, or measuring each kind of inventory on hand.
Taken,
when the business is closed or business is slow.
at end of the accounting period.
Taking a Physical Inventory
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
SO 1 Describe the steps in determining inventory quantities.SO 1 Describe the steps in determining inventory quantities.
6-9
6-10
Goods in Transit
Purchased goods not yet received.
Sold goods not yet delivered.
Determining Ownership of Goods
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
SO 1 Describe the steps in determining inventory quantities.SO 1 Describe the steps in determining inventory quantities.
Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is
determined by the terms of sale.
6-11
Illustration 6-1 Terms of sale
Ownership of the goods passes to the buyer when the
public carrier accepts the goods from the seller.
Ownership of the goods remains with the seller until the goods reach the buyer.
Goods in Transit
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
6-12
Goods in transit should be included in the inventory of
the buyer when the:
a. public carrier accepts the goods from the seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.
Review Question
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
SO 1 Describe the steps in determining inventory quantities.SO 1 Describe the steps in determining inventory quantities.
6-13
Consigned Goods
Goods held for sale by one party although ownership of the goods is retained by another party.
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
SO 1 Describe the steps in determining inventory quantities.SO 1 Describe the steps in determining inventory quantities.
Determining Ownership of Goods
6-14
$
6-15
Unit costs can be applied to quantities on hand
using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Average-cost
Inventory CostingInventory CostingInventory CostingInventory Costing
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
Cost Flow Assumptions
6-16
Illustration: Assume that Crivitz TV Company purchases
three identical 50-inch TVs on different dates at costs of $700,
$750, and $800. During the year Crivitz sold two sets at $1,200
each. These facts are summarized below.
Inventory CostingInventory CostingInventory CostingInventory Costing
Illustration 6-2
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
6-17
“Specific Identification”
Inventory CostingInventory CostingInventory CostingInventory Costing
If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is $1,500 ($700 + $800), and its
ending inventory is $750.
Illustration 6-3
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
6-18
Actual physical flow costing method in which items still
in inventory are specifically costed to arrive at the total
cost of the ending inventory.
Practice is relatively rare.
Most companies make assumptions (Cost Flow
Assumptions) about which units were sold.
Inventory CostingInventory CostingInventory CostingInventory Costing
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
“Specific Identification”
6-19
Inventory CostingInventory CostingInventory CostingInventory Costing
Illustration 6-11Use of cost flow methods in
major U.S. companies
Cost Flow
Assumption
does not need to equal
Physical Movement of
Goods
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
6-20
Illustration: Data for Houston Electronics’ Astro condensers.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
Illustration 6-4
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
6-21
Earliest goods purchased are first to be sold.
Often parallels actual physical flow of
merchandise.
Generally good business practice to sell oldest
units first.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
“First-In-First-Out (FIFO)”
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Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
Illustration 6-5
SO 2 SO 2
“First-In-First-Out (FIFO)”
6-23
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
Illustration 6-5
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
“First-In-First-Out (FIFO)”
6-24
Latest goods purchased are first to be sold.
Seldom coincides with actual physical flow of
merchandise.
Exceptions include goods stored in piles, such as
coal or hay.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
“Last-In-First-Out (LIFO)”
6-25
Illustration 6-7
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
6-26
Illustration 6-7
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
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Allocates cost of goods available for sale on the
basis of weighted-average unit cost incurred.
Assumes goods are similar in nature.
Applies weighted-average unit cost to the units
on hand to determine cost of the ending
inventory.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
“Average-Cost”
6-28
Illustration 6-10
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
“Average-Cost”
6-29
Illustration 6-10
SO 2 SO 2 Explain the basis of accounting for inventories and apply the Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.inventory cost flow methods under a periodic inventory system.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
“Average-Cost”
6-30
FIFO
Sales $9,000 $9,000$9,000
Cost of goods sold 6,200 6,6007,000
Gross profit 2,800 2,4002,000
Admin. & selling expense 330 330330
Income before taxes 2,470 2,0701,670
Income tax expense 140 120110
Net income $2,330 $1,950$1,560
Inventory balance $5,800 $5,400$5,000
LIFOAverage
Comparative Financial Statement Summary
LO 3 LO 3 Explain the financial statement and tax effects of Explain the financial statement and tax effects of each of the inventory cost flow assumptions.each of the inventory cost flow assumptions.
Financial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax Effects
6-31
FIFO
Sales $9,000 $9,000$9,000
Cost of goods sold 6,200 6,6007,000
Gross profit 2,800 2,4002,000
Admin. & selling expense 330 330330
Income before taxes 2,470 2,0701,670
Income tax expense 140 120110
Net income $2,330 $1,950$1,560
Inventory balance $5,800 $5,400$5,000
LIFOAverage
In Period of Rising Prices, FIFO Reports:
Highest
Lowest
LO 3 LO 3 Explain the financial statement and tax effects of Explain the financial statement and tax effects of each of the inventory cost flow assumptions.each of the inventory cost flow assumptions.
Financial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax Effects
6-32
FIFO
Sales $9,000 $9,000$9,000
Cost of goods sold 6,200 6,6007,000
Gross profit 2,800 2,4002,000
Admin. & selling expense 330 330330
Income before taxes 2,470 2,0701,670
Income tax expense 140 120110
Net income $2,330 $1,950$1,560
Inventory balance $5,800 $5,400$5,000
LIFOAverage
In Period of Rising Prices, LIFO Reports:
Lowest
Highest
LO 3 LO 3 Explain the financial statement and tax effects of Explain the financial statement and tax effects of each of the inventory cost flow assumptions.each of the inventory cost flow assumptions.
Financial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax EffectsFinancial Statement and Tax Effects
6-33
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
Review Question
LO 3 LO 3 Explain the financial statement and tax effects of Explain the financial statement and tax effects of each of the inventory cost flow assumptions.each of the inventory cost flow assumptions.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
6-34
In a period of inflation, the cost flow method that
results in the lowest income taxes is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
LO 3 LO 3 Explain the financial statement and tax effects of Explain the financial statement and tax effects of each of the inventory cost flow assumptions.each of the inventory cost flow assumptions.
Inventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow AssumptionsInventory Cost Flow Assumptions
Review Question
6-35
6-36
Using Cost Flow Methods Consistently
Inventory CostingInventory CostingInventory CostingInventory Costing
Method should be used consistently, enhances
comparability.
Although consistency is preferred, a company may
change its inventory costing method.Illustration 6-14Disclosure of change in cost flow method
LO 3 LO 3 Explain the financial statement and tax effects of Explain the financial statement and tax effects of each of the inventory cost flow assumptions.each of the inventory cost flow assumptions.
6-37
Lower-of-Cost-or-Market
Inventory CostingInventory CostingInventory CostingInventory Costing
SO 4 Explain the lower-of-cost-or-market SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.basis of accounting for inventories.
When the value of inventory is lower than its cost
Companies can “write down” the inventory to its
market value in the period in which the price decline
occurs.
Market value = Replacement Cost
Example of conservatism.
6-38
Inventory CostingInventory CostingInventory CostingInventory Costing
SO 4 Explain the lower-of-cost-or-market SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.basis of accounting for inventories.
Illustration: Assume that Ken Tuckie TV has the following
lines of merchandise with costs and market values as
indicated.
Lower-of-Cost-or-Market
Illustration 6-15
6-39
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying
costs (e.g., investment, storage, insurance,
obsolescence, and damage).
2. Low Inventory Levels – may lead to stockouts and
lost sales.
SO 5 Compute and interpret the inventory turnover ratio.SO 5 Compute and interpret the inventory turnover ratio.
6-40
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
SO 5 Compute and interpret the inventory turnover ratio.SO 5 Compute and interpret the inventory turnover ratio.
Inventory Turnover RatioIllustration 6-16
6-41
Illustration: Data available for Wal-Mart.
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
SO 5 Compute and interpret the inventory turnover ratio.SO 5 Compute and interpret the inventory turnover ratio.
Illustration 6-16
6-42
6-43
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
Companies using LIFO are required to report the amount that inventory would increase (or occasionally decrease) if the company had instead been using FIFO. This amount is referred to as the LIFO reserve.
Analysts’ Adjustments for LIFO Reserve
SO 6 SO 6 Describe the LIFO reserve and explain its importance Describe the LIFO reserve and explain its importance for comparing results of different companies.for comparing results of different companies.
Illustration 6-17
6-44
Analysis of InventoryAnalysis of InventoryAnalysis of InventoryAnalysis of Inventory
The LIFO reserve can have a significant effect on ratios analysts commonly use.
SO 6 SO 6 Describe the LIFO reserve and explain its importance Describe the LIFO reserve and explain its importance for comparing results of different companies.for comparing results of different companies.
Illustration 6-19
Analysts’ Adjustments for LIFO Reserve
6-45
Illustration:
SO 7 Apply the inventory cost flow methods to perpetual inventory records.SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.
Illustration 6A-1
appendix 6APerpetual Inventory System
6-46SO 7 Apply the inventory cost flow methods to perpetual inventory records.SO 7 Apply the inventory cost flow methods to perpetual inventory records.
“First-In-First-Out (FIFO)”
Cost of Goods Sold
Ending Inventory
Illustration 6A-2
appendix 6APerpetual Inventory System
6-47SO 7 Apply the inventory cost flow methods to perpetual inventory records.SO 7 Apply the inventory cost flow methods to perpetual inventory records.
“Last-In-First-Out (LIFO)”
Cost of Goods Sold
Ending Inventory
Illustration 6A-3
appendix 6APerpetual Inventory System
6-48 SO 7 Apply the inventory cost flow methods to perpetual inventory records.SO 7 Apply the inventory cost flow methods to perpetual inventory records.
“Average-Cost”Illustration 6A-4
Cost of Goods Sold
Ending Inventory
appendix 6APerpetual Inventory System
6-49
Inventory Errors
SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.
Common Cause:
Failure to count or price inventory correctly.
Not properly recognizing the transfer of legal title to
goods in transit.
Errors affect both the income statement and
balance sheet.
appendix 6B Inventory Errors
6-50 SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.
Inventory errors affect the computation of cost of goods sold and net income.
Income Statement Effects
Illustration 6-B2
Illustration 6-B1
appendix 6B Inventory Errors
6-51 SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.
Inventory errors affect the computation of cost of goods sold and net income in two periods.
An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.
Over the two years, the total net income is correct because the errors offset each other.
Ending inventory depends entirely on the accuracy of taking and costing the inventory.
Income Statement Effects
appendix 6B Inventory Errors
6-52 SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.
Incorrect Correct Incorrect Correct
Sales 80,000$ 80,000$ 90,000$ 90,000$
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income 22,000$ 25,000$ 13,000$ 10,000$
2011 2012
($3,000)Net Income understated
$3,000Net Income overstated
Combined income for 2-year period is correct.
Illustration 6-B3
appendix 6B Inventory Errors
6-53
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.
Review QuestionReview Question
SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.
appendix 6B Inventory Errors
6-54 SO 8 Indicate the effects of inventory errors on the financial statements.SO 8 Indicate the effects of inventory errors on the financial statements.
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:
Balance Sheet Effects
Illustration 6-B1
Illustration 6-B4
appendix 6B Inventory Errors
6-55
Key Points
The requirements for accounting for and reporting
inventories are more principles-based under IFRS. That is,
GAAP provides more detailed guidelines in inventory
accounting.
The definitions for inventory are essentially similar under
IFRS and GAAP. Both define inventory as assets held-for-
sale in the ordinary course of business, in the process of
production for sale (work in process), or to be consumed in
the production of goods or services (e.g., raw materials).
6-56
Key Points
Who owns the goods—goods in transit or consigned goods
—as well as the costs to include in inventory, are accounted
for the same under IFRS and GAAP.
Both GAAP and IFRS permit specific identification where
appropriate. IFRS actually requires that the specific
identification method be used where the inventory items are
not interchangeable (i.e., can be specifically identified). If the
inventory items are not specifically identifiable, a cost flow
assumption is used. GAAP does not specify situations in
which specific identification must be used.
6-57
Key Points
A major difference between IFRS and GAAP relates to the
LIFO cost flow assumption. GAAP permits the use of LIFO
for inventory valuation. IFRS prohibits its use. FIFO and
average-cost are the only two acceptable cost flow
assumptions permitted under IFRS.
IFRS requires companies to use the same cost flow
assumption for all goods of a similar nature. GAAP has no
specific requirement in this area.
6-58
Key Points
In the lower-of-cost-or-market test for inventory valuation,
IFRS defines market as net realizable value. Net realizable
value is the estimated selling price in the ordinary course of
business, less the estimated costs of completion and
estimated selling expenses. In other words, net realizable
value is the best estimate of the net amounts that
inventories are expected to realize. GAAP, on the other
hand, defines market as essentially replacement cost.
6-59
Key Points
Under GAAP, if inventory is written down under the lower-of-
cost-or-market valuation, the new value becomes its cost
basis. As a result, the inventory may not be written back up
to its original cost in a subsequent period. Under IFRS, the
write-down may be reversed in a subsequent period up to
the amount of the previous write-down. Both the write-down
and any subsequent reversal should be reported on the
income statement as an expense. An item-by-item approach
is generally followed under IFRS.
6-60
Key Points
Unlike property, plant, and equipment, IFRS does not permit
the option of valuing inventories at fair value. As indicated
above, IFRS requires inventory to be written down, but
inventory cannot be written up above its original cost.
Similar to GAAP, certain agricultural products and mineral
products can be reported at net realizable value using IFRS.
6-61
Looking into the Future
One convergence issue relates to the use of the LIFO cost flow
assumption. IFRS specifically prohibits its use. Conversely, the
LIFO cost flow assumption is widely used in the United States
because of its favorable tax advantages. With a new conceptual
framework being developed, it is highly probable that the use of
the concept of conservatism will be eliminated. Similarly, the
concept of “prudence” in the IASB literature will also be
eliminated. This may ultimately have implications for the
application of the lower-of-cost-or-net realizable value.
6-62
Which of the following should not be included in the
inventory of a company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB
shipping point.
d) None of the above.
6-63
Which method of inventory costing is prohibited under
IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.
6-64
Specific identification:
a) must be used under IFRS if the inventory items are not
interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most
conservative net income.
6-65
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