Prerequisite Reading 12:

International Trade and Capital

Flows
International trade and currency exchange rates are key topics for both Level I and Level II. First,
learn how comparative advantage results in a welfare gain from international trade and the two
models of the sources of comparative advantage. For the balance of payments, focus on how a
surplus or deficit in the broadly defined capital account must offset a deficit or surplus in the
merchandise trade account. Finally, pay attention to how the difference between domestic income
and expenditures and the difference between domestic savings and investment are related to a
country’s balance of trade.

MODULE 12.1: INTERNATIONAL TRADE

PROFESSOR’S NOTE
To be prepared for the Level I main curriculum and exam, you must become familiar with
the following terminology.

Imports: Goods and services that firms, individuals, and governments purchase from producers in
other countries.

Exports: Goods and services that firms, individuals, and governments from other countries purchase
from domestic producers.

Autarky or closed economy: A country that does not trade with other countries.

Free trade: A government places no restrictions or charges on import and export activity.

Trade protection: A government places restrictions, limits, or charges on exports or imports.

World price: The price of a good or service in world markets for those to whom trade is not
restricted.

Domestic price: The price of a good or service in the domestic country, which may be equal to the
world price if free trade is permitted or different from the world price when the domestic country
restricts trade.

Net exports: The value of a country’s exports minus the value of its imports over some period.

Trade surplus: Net exports are positive; the value of the goods and services a country exports are
greater than the value of the goods and services it imports.
Trade deficit: Net exports are negative; the value of the goods and services a country exports is less
than the value of the goods and services it imports.

Terms of trade: The ratio of an index of the prices of a country’s exports to an index of the prices of
its imports expressed relative to a base value of 100. If a country’s terms of trade are currently 102,
the prices of the goods it exports have risen relative to the prices of the goods it imports since the
base period.

Foreign direct investment: Ownership of productive resources (land, factories, natural resources) in
a foreign country.

Multinational corporation: A firm that has made foreign direct investment in one or more foreign
countries, operating production facilities and subsidiary companies in foreign countries.

LOS 12.a: Compare gross domestic product and gross national product.

Gross domestic product over a period, typically a year, is the total value of goods and services
produced within a country’s borders. Gross national product is similar but measures the total value
of goods and services produced by the labor and capital of a country’s citizens. The difference is due
to non-citizen incomes of foreigners working within a country, the income of citizens who work in
other countries, the income of foreign capital invested within a country, and the income of capital
supplied by its citizens to foreign countries. The income to capital owned by foreigners invested
within a country is included in the domestic country’s GDP but not in its GNP. The income of a
country’s citizens working abroad is included in its GNP but not in its GDP.

GDP is more closely related to economic activity within a country and so to its employment and
growth.

LOS 12.b: Describe benefits and costs of international trade.

The benefits of trade are not difficult to understand. As an example, consider China, and really Asia
as a whole, which has had rapidly growing exports to the United States and other countries. The
benefit to the importing countries has been lower-cost goods, from textiles to electronics. The
benefits to the Chinese economy have been in increasing employment, increasing wages for workers,
and the profits from its export products.

The costs of trade are primarily borne by those in domestic industries that compete with imported
goods. Textile workers who have lost their jobs in the United States, as more and more textiles are
imported, are certainly worse off in the short run. As other industries, such as health care, have
grown, these workers have had to retrain to qualify for the new jobs in those fields. At the same
time, U.S. firms that produce textile products using capital and technology intensive production
methods have expanded.

Overall, economics tells us that the benefits of trade are greater than the costs for economies as a
whole, so the winners could conceivably compensate the losers and still be better off.

LOS 12.c: Contrast comparative advantage and absolute advantage.

A country is said to have an absolute advantage in the production of a good if it can produce the
good at a lower resource cost than another country. A country is said to have a comparative
advantage in the production of a good if it has a lower opportunity cost in the production of that
good, expressed as the amount of another good that could have been produced instead. Economic
analysis tells us that, regardless of which country has an absolute advantage, there are potential gains
from trade as long as the countries’ opportunity costs of one good in terms of another are different.

This analysis is credited to David Ricardo who presented it in 1817. He used the example of the
production of cloth and wine in England and Portugal. A hypothetical example of the amounts of
cloth and wine these countries can produce per day of labor is presented in Figure 12.1.

Figure 12.1: Output per Unit of Labor

Yards of Cloth Bottles of Wine

Portugal 100 110
England 90 80

Ricardo argued that, in the absence of trading costs, England could trade cloth for wine, and
Portugal could trade wine for cloth, and both countries could have more of both wine and cloth as a
result. Because in Portugal a worker-day can be used to produce either 100 yards of cloth or 110
bottles of wine, its opportunity cost of a yard of cloth is 110 / 100 = 1.1 bottles of wine and its
opportunity cost of a bottle of wine is 100 / 110 = 0.91 yards of cloth. England’s opportunity cost of
a yard of cloth is 80 / 90 = 0.89 bottles of wine and its opportunity cost of a bottle of wine is 90 / 80
= 1.125 yards of cloth.

Portugal has a comparative advantage in the production of wine as its opportunity cost is 0.91 yards
of cloth compared to England’s opportunity cost of 1.125 yards of cloth. As must be the case, if
Portugal has a comparative advantage in wine production, England has a comparative advantage in
cloth production.

To illustrate the benefits of trade, consider the output change if Portugal shifts 8 worker-days from
cloth production to wine production and England shifts 10 worker-days from wine production to
cloth production.

 The change in Portugal’s production is 8 × 110 = +880 wine and –8 × 100 = –800 cloth.

 The change in England’s production is –10 × 80 = –800 wine and 10 × 90 = +900 cloth.

Total production by the two countries will have increased by 80 bottles of wine and 100 yards of
cloth; these are the gains from trade. The negotiated terms of trade will determine how the two
countries share these gains. The important result is that total output has increased through trade, there’s
greater specialization by Portugal in wine production, and there’s greater specialization by England
in cloth production.

Note that Portugal has an absolute advantage in the production of both goods. However, because
the countries’ opportunity costs of production differ, each has a comparative advantage in one of the
goods, and trade can make both countries better off.

In our simple example, we assume constant opportunity costs. As a country specializes and
increases the production of an export good, increasing costs (e.g., using more marginal land for
grape growing) will increase the opportunity cost of the export good. The production possibility
frontier shown in Figure 12.2 illustrates such a situation and shows all combinations of food and
machinery that an economy can produce. The slope of the frontier measures the opportunity cost of
machinery in terms of food at each possible combination of food and machinery. Over a range of
possible output choices around 12 million tons of food and 18 million machines, we show the slope
is –3 and the opportunity cost of each million machines is 3 million tons of food. If the country were
to increase the production of machinery, the amount of food production foregone would increase, as
shown by the increasingly negative slope of the frontier.

Figure 12.2: A Production Possibility Frontier

LOS 12.d: Compare the Ricardian and Heckscher–Ohlin models of trade and the source(s) of
comparative advantage in each model.

The Ricardian model of trade has only one factor of production—labor. The source of differences in
production costs in Ricardo’s model is differences in labor productivity due to differences in technology.

Heckscher and Ohlin presented a model in which there are two factors of production—capital and
labor. The source of comparative advantage (differences in opportunity costs) in this model is
differences in the relative amounts of each factor the countries possess. We can view the England and
Portugal example in these terms by assuming that England has more capital (machinery) compared
to labor than Portugal. Additionally, we need to assume that cloth production is more capital
intensive than wine production. The result of their analysis is that the country that has more capital
will specialize in the capital intensive good and trade for the less capital intensive good with the
country that has relatively more labor and less capital.

In the Heckscher-Ohlin model, there is a redistribution of wealth within each country between labor
and the owners of capital. The price of the relatively less scarce (more available) factor of production
in each country will increase so that owners of capital will earn more in England, and workers will
earn more in Portugal compared to what they were without trade. This is easy to understand in the
context of prices of the two goods. The good a country imports will fall in price (that is why they
import it), and the good a country exports will rise in price. In our example, this means that the price
of wine falls, and the price of cloth rises in England. Because with trade, more of the capital-
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intensive good, cloth, is produced in England, demand for capital and the price of capital will
increase in England. As a result, capital receives more income at the expense of labor in England. In
Portugal, increasing the production of wine (which is labor intensive) increases the demand for and
price of labor, and workers gain at the expense of the owners of capital.

PROFESSOR’S NOTE
Remember that the model named after one economist has one factor of production, and the
model named after two economists has two factors of production.

MODULE QUIZ 12.1

1. The income from a financial investment in Country P by a citizen of Country Q is

most likely included in:
A. Country P’s GDP but not its GNP.
B. Country Q’s GNP and GDP.
C. Country P’s GDP and GNP.

2. Which of the following effects is most likely to occur in a country that increases its
openness to international trade?
A. Increased prices of consumer goods.
B. Greater specialization in domestic output.
C. Decreased employment in exporting industries.

3. Which of the following statements about international trade is least accurate? If

two countries have different opportunity costs of production for two goods, by
engaging in trade:
A. each country gains by importing the good for which it has a comparative
advantage.
B. each country can achieve a level of consumption outside its domestic
production possibility frontier.
C. the low opportunity cost producer of each good will export to the high
opportunity cost producer of that good.

4. Regarding the Ricardian and Heckscher-Ohlin models of international trade, the

amount of capital relative to labor within a country is a factor in:
A. both of these models.
B. neither of these models.
C. only one of these models.
MODULE 12.2: BALANCE OF PAYMENTS
LOS 12.e: Describe the balance of payments accounts including their components.

When a country’s firms and individuals pay for their purchases of foreign goods, services, and
financial assets, they must buy the currencies of the foreign countries in order to accomplish those
transactions. Similarly, payment for sales of goods, services, and financial assets to foreigners
requires them to purchase the currency of the domestic country. With adjustment for changes in
foreign debt to the domestic country and domestic debt to foreign countries, these amounts must
balance each other.

According to the U.S. Federal Reserve, “The BOP [balance of payments] includes the current
account, which mainly measures the flows of goods and services; the capital account, which
consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets;
and the financial account, which records investment flows.” 1

Drawing on the N.Y. Fed’s explanation, the items recorded in each account are as follows.

Current Account
The current account comprises three sub-accounts:

 Merchandise and services. Merchandise consists of all raw materials and manufactured
goods bought, sold, or given away. Services include tourism, transportation, and business
and engineering services, as well as fees from patents and copyrights on new technology,
software, books, and movies.

 Income receipts include foreign income from dividends on stock holdings and interest on
debt securities.

 Unilateral transfers are one-way transfers of assets, such as money received from those
working abroad and direct foreign aid. In the case of foreign aid and gifts, the capital account
of the donor nation is debited.

Capital Account
The capital account comprises two sub-accounts:

 Capital transfers include debt forgiveness and goods and financial assets that migrants bring
when they come to a country or take with them when they leave. Capital transfers also
include the transfer of title to fixed assets and of funds linked to the purchase or sale of fixed
assets, gift and inheritance taxes, death duties, and uninsured damage to fixed assets.

 Sales and purchases of non-financial assets that are not produced assets include rights to
natural resources and intangible assets, such as patents, copyrights, trademarks, franchises,
and leases.

1 Federal Reserve Bank of New York, Fedpoints, May 2009. Emphasis added.
Financial Account
The financial account comprises two sub-accounts:

 Government-owned assets abroad include gold, foreign currencies, foreign securities,

reserve position in the International Monetary Fund, credits and other long-term assets,
direct foreign investment, and claims against foreign banks.

 Foreign-owned assets in the country are divided into foreign official assets and other
foreign assets in the domestic country. These assets include domestic government and
corporate securities, direct investment in the domestic country, domestic country currency,
and domestic liabilities to foreigners reported by domestic banks.

A country that has imports valued more than its exports is said to have a current account (trade) deficit,
while countries with more exports than imports are said to have a current account surplus. For a
country with a trade deficit, it must be balanced by a net surplus in the capital and financial
accounts. As a result, investment analysts often think of all financing flows as a single capital
account that combines items in the capital and financial accounts. Thinking in this way, any deficit
in the current account must be made up by a surplus in the combined capital account. That is, the
excess of imports over exports must be offset by sales of assets and debt incurred to foreign entities.
A current account surplus is similarly offset by purchases of foreign physical or financial assets.

LOS 12.f: Explain how decisions by consumers, firms, and governments affect the balance of
payments.

The primary influences referred to here are on the current account deficit or surplus. If a country’s
net savings (both government savings and private savings) are less than the amount of investment in
domestic capital, this investment must be financed by foreign borrowing. Foreign borrowing results
in a capital account surplus, which means there is a trade deficit.

We can write the relation between the trade deficit, saving, and domestic investment as:

X − M = private savings + government savings − investment

Lower levels of private saving, larger government deficits, and high rates of domestic investment all
tend to result in or increase a current account deficit. The intuition here is that low private or
government savings in relation to private investment in domestic capital requires foreign investment
in domestic capital.

We can make a distinction, however, between a trade deficit resulting from high government or
private consumption and one resulting from high private investment in capital. In the first case,
borrowing from foreign countries to finance high consumption (low savings) increases the domestic
country’s liabilities without any increase to its future productive power. In the second case,
borrowing from foreign countries to finance a high level of private investment in domestic capital,
the added liability is accompanied by an increase in future productive power because of the
investment in capital.
MODULE QUIZ 12.2

1. Which of the following is least likely a component of the current account?

A. Unilateral transfers.
B. Payments for fixed assets.
C. Payments for goods and services.

2. A current account deficit is most likely to decrease because of an increase in:

A. domestic savings.
B. private investment.
C. the fiscal budget deficit.
Key Concepts
LOS 12.a

Gross domestic product is the total value of goods and services produced within a country’s borders.
Gross national product measures the total value of goods and services produced by the labor and
capital supplied by a country’s citizens, regardless of where the production takes place.

LOS 12.b

Free trade among countries increases overall economic welfare. Countries can benefit from trade
because one country can specialize in the production of an export good and benefit from economies
of scale. Economic welfare can also be increased by greater product variety, more competition, and a
more efficient allocation of resources.

Costs of free trade are primarily losses to those in domestic industries that lose business to foreign
competition, especially less efficient producers who leave an industry. While other domestic
industries will benefit from freer trade policies, unemployment may increase over the period in
which workers are retrained for jobs in the expanding industries. Some argue that greater income
inequality may result, but overall the gains from liberalization of trade policies are thought to exceed
the costs, so that the winners could conceivably compensate the losers and still be better off.

LOS 12.c

A country is said to have an absolute advantage in the production of a good if it can produce the
good at lower cost in terms of resources relative to another country.

A country is said to have a comparative advantage in the production of a good if its opportunity cost
in terms of other goods that could be produced instead is lower than that of another country.

LOS 12.d

The Ricardian model of trade has only one factor of production—labor. The source of differences in
production costs and comparative advantage in Ricardo’s model is differences in labor productivity
due to differences in technology.

Heckscher and Ohlin presented a model in which there are two factors of production—capital and
labor. The source of comparative advantage (differences in opportunity costs) in this model is
differences in the relative amounts of each factor that countries possess.

LOS 12.e

The balance of payments refers to the fact that increases in a country’s assets and decreases in its
liabilities must equal (balance with) decreases in its assets and increases in its liabilities. These
financial flows are classified into three types:

 The current account includes imports and exports of merchandise and services, foreign
income from dividends on stock holdings and interest on debt securities, and unilateral
transfers such as money received from those working abroad and direct foreign aid.
  The capital account includes debt forgiveness, assets that migrants bring to or take away
from a country, transfer of funds for the purchase or sale of fixed assets, and purchases of
non-financial assets, including rights to natural resources, patents, copyrights, trademarks,
franchises, and leases.

 The financial account includes government-owned assets abroad such as gold, foreign
currencies and securities, and direct foreign investment and claims against foreign banks.
The financial account also includes foreign-owned assets in the country, domestic
government and corporate securities, direct investment in the domestic country, and
domestic country currency.

Overall, any surplus (deficit) in the current account must be offset by a deficit (surplus) in the capital
and financial accounts.

LOS 12.f

In equilibrium, we have the relationship:

exports − imports = private savings + government savings − domestic investment

When total savings is less than domestic investment, exports must be less than imports so that there
is a deficit in the current account. Lower levels of private saving, larger government deficits, and
high rates of domestic investment all tend to result in or increase a current account deficit. The
intuition here is that low private or government savings in relation to private investment in domestic
capital requires foreign investment in domestic capital.

Module Quiz Answers

Module Quiz 12.1
1. a The income from a financial investment in Country P of a citizen of Country Q is included in
Country P’s GDP but not its GNP. It is included in Country Q’s GNP but not its GDP.

(Module 12.1, LOS 12.a)

2. b Openness to international trade increases specialization as production shifts to those products

in which domestic producers have a comparative advantage. Greater competition from imports will
tend to decrease prices for consumer goods. Increasing international trade is likely to increase
profitability and employment in exporting industries but may decrease profitability and employment
in industries that compete with imported goods. (Module 12.1, LOS 12.b)

3. a Each country gains by exporting the good for which it has a comparative advantage.

(Module 12.1, LOS 12.c)

4. c In the Ricardian model, labor is the only factor of production considered. In the Heckscher-Ohlin
model, comparative advantage results from the relative amounts of labor and capital available in
different countries. (Module 12.1, LOS 12.d)
Module Quiz 12.2
1. b Purchases and sales of fixed assets are recorded in the capital account. Goods and services trade
and unilateral transfers are components of the current account. (Module 12.2, LOS 12.e)

2. a Other things equal, an increase in domestic savings would tend to decrease the current account
deficit, while an increase in private investment or an increase in the fiscal budget deficit would tend
to increase the current account deficit. (Module 12.2, LOS 12.f)
Question #1 of 110 Question ID: 1590225

Which of the following ratio levels would suggest that a company is holding obsolete
inventory?

A) Low inventory turnover ratio.

B) Low number of days in inventory.
C) Low inventory value compared to cost of goods sold.

Explanation

Low inventory turnover (high number of days in inventory) may be a sign of slow-
moving or obsolete inventory, especially when coupled with low or declining revenue
growth compared to the industry. Low inventory value compared to cost of goods
sold, however, implies a high inventory turnover ratio. This suggests much less risk of
obsolescence.

(Module 18.5, LOS 18.k)

Question #2 of 110 Question ID: 1590194

An analyst is comparing a company that uses the LIFO inventory cost method to
companies that use FIFO for inventories. The analyst should adjust the LIFO firm's
inventories by adding the:

A) change in the LIFO reserve.

B) LIFO reserve.
C) LIFO reserve, net of tax.

Explanation

FIFO inventory equals LIFO inventory plus the LIFO reserve.

(Module 18.3, LOS 18.f)

Question #3 of 110 Question ID: 1590230

Selected financial data from Krandall, Inc.'s balance sheet for the year ended December
31 was as follows (in $):

Cash $1,100,000 Accounts Payable $400,000

Accounts Receivable 300,000 Deferred Tax Liability 700,000

Inventory 2,400,000 Long-term Debt 8,200,000

Property, Plant & Eq. 8,000,000 Common Stock 1,000,000

Total Assets 11,800,000 Retained Earnings 1,500,000

Total Liabilities & Equity 11,800,000

LIFO Reserve at Jan. 1 600,000

LIFO Reserve at Dec. 31 900,000

Krandall uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is
40%. If Krandall used first in, first out (FIFO) instead of LIFO and paid any additional tax
due, its assets-to-equity ratio would be closest to:

A) 3.73.
B) 4.06.
C) 4.18.

Explanation
With FIFO instead of LIFO:

Inventory would be higher by $900,000, the amount of the ending LIFO reserve.
Cumulative pretax income would also be higher by $900,000, so taxes paid
would be higher by 0.40($900,000) = $360,000. Therefore cash would be lower
by $360,000.
Cumulative retained earnings would be higher by (1 − 0.40)($900,000) =
$540,000.

So assets under FIFO would be $11,800,000 + $900,000 - $360,000 = $12,340,000 and

equity would be $1,000,000 + $1,500,000 + $540,000 = $3,040,000. The assets-to-
equity ratio would be $12,340,000 / $3,040,000 = 4.06.

(Module 18.5, LOS 18.k)

Question #4 of 110 Question ID: 1590132

Costs that are included in the balance sheet value of inventory most likely include:

A) Administrative overhead.
B) Manufacturing overhead.
C) Selling costs.

Explanation

Product costs that are capitalized to inventory include purchase cost, conversion or
manufacturing costs (including labor and overhead), and other costs to bring
inventory to its present state and location. Period costs recognized as expenses when
incurred include abnormal waste, storage costs not required for production, selling
costs, and administrative overhead.

(Module 18.1, LOS 18.a)

Question #5 of 110 Question ID: 1590229

Selected information from Jenner, Inc.'s financial statements for the year ended
December 31 included the following (in $):

Cash $200,000 Accounts Payable $300,000

Accounts Receivable 300,000 Deferred Tax Liability 600,000

Inventory 1,500,000 Long-term Debt 8,100,000

Property, Plant & Equip. 11,000,000 Common Stock 2,200,000

Total Assets 13,000,000 Retained Earnings 1,800,000

Total Liabilities & Equity $13,000,000

LIFO Reserve at Jan. 1 400,000

LIFO Reserve at Dec. 31 600,000

Net Income (after 40% tax rate) 800,000

Jenner uses the last in, first out (LIFO) inventory cost flow assumption. If Jenner had
used first in, first out (FIFO), return on total equity would:

A) increase to 23.0%.
B) decrease to 18.3%.
C) increase to 21.1%.

Explanation
Return on total equity (net income / total equity) was $800,000 / ($2,200,000 +
$1,800,000) = 20%. Under FIFO, net income increases by the increase in the LIFO
reserve multiplied by (1 – tax rate). FIFO net income was $800,000 + ($600,000 –
$400,000) (1 – 0.40) = $920,000. Total equity increases by the amount of accumulated
FIFO profits that are added to retained earnings, which is calculated by multiplying the
amount of the ending LIFO reserve by (1 – tax rate) for an increase of ($600,000) × (1 –
0.40) = $360,000. Total equity is $2,200,000 + $1,800,000 + $360,000 = $4,360,000.
FIFO return on total equity is $920,000 / $4,360,000 = 21.1%.

(Module 18.5, LOS 18.k)

Question #6 of 110 Question ID: 1590162

The choice of perpetual versus periodic inventory system is most likely to result in
different values for gross profit when the inventory valuation method used is:

A) specific identification.
B) first in, first out.
C) last in, first out.

Explanation

Under the LIFO or weighted average cost inventory valuation methods, perpetual and
periodic inventory accounting systems can result in different values for cost of sales,
ending inventory, and gross profit. Under FIFO or specific identification, these values
are the same for a periodic or perpetual system.

(Module 18.1, LOS 18.c)

Question #7 of 110 Question ID: 1590218

Which of the following statements about inventory presentation and disclosures is most
accurate?

An analyst must determine which inventory cost method was used by

A)
examining the firm’s current and historical inventory values.
Changing from FIFO to LIFO is a change in accounting principle that must be
B)
applied retrospectively.
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 IFRS permits reversals of inventory writedowns but the firm must disclose
C)
the circumstances of the reversal in its financial statements.

Explanation

IFRS requires a firm that reverses an inventory writedown to discuss the

circumstances that led to the reversal. Both IFRS and U.S. GAAP require firms to
disclose the inventory cost flow method they use. While a change to LIFO from
another inventory cost method is a change in accounting principle, under U.S. GAAP
this change is not applied retrospectively. The carrying value of inventory is
considered to be the first LIFO layer.

(Module 18.4, LOS 18.i)

Question #8 of 110 Question ID: 1590212

A company purchased inventory on January 1, 20X2, for $600,000. On December 31,

20X2, the inventory had a net realizable value (NRV) of $550,000 and a replacement cost
of $525,000, which is also the NRV less the normal profit margin. What would be the
carrying value of the inventory on the company's December 31, 20X2, balance sheet
using:

lower of cost or NRV?: lower of cost or market?

A) $525,000; $525,000

B) $525,000; $550,000

C) $550,000; $525,000

Explanation

Lower of cost or NRV is $550,000. Using lower of cost or market, the replacement cost
of $525,000 would be used because it is below NRV and equal to the NRV less the
normal profit margin.

(Module 18.4, LOS 18.g)

Question #9 of 110 Question ID: 1590234

For balance sheet purposes, inventories based on:

FIFO are preferable to those based on LIFO, as they more closely reflect
A)
current costs.
LIFO are preferable to those based on average cost, as they more closely
B)
reflect the current costs.
LIFO are preferable to those based on FIFO, as they more closely reflect the
C)
current costs.

Explanation

The inventories based on FIFO are preferable to those presented under LIFO or
average cost for balance sheet purposes. Under FIFO, the older inventories are taken
out first, and the ending inventory balance consists of the recent purchases and thus
most closely reflect the current (economic) value.

(Module 18.5, LOS 18.l)

Question #10 of 110 Question ID: 1590210

Judah GmbH. prepares its financial statements under IFRS. On December 31, 20X8,
Judah has inventory of manufactured goods with a cost of €720,000. The estimated
selling cost of that inventory is €50,000 and its market value is €740,000. By January 31,
20X9, none of the inventory has been sold but its market value has increased to
€810,000. Selling costs remain the same. Which of the following entries is most likely
permissible under IFRS?

A) Make no adjustments to the valuation of inventory on either date.

Write down inventory by €30,000 on December 31, 20X8 and write up
B)
inventory by €30,000 on January 31, 20X9.
Write down inventory by €30,000 on December 31, 20X8 and write up
C)
inventory by €70,000 on January 31, 20X9.

Explanation
IFRS rules require inventory to be valued at the lower of cost or net realizable value
(NRV). NRV is calculated as estimated sales price less estimated selling costs. At
December 31, 20X8, NRV = €740,000 – €50,000 = €690,000. Since cost is €720,000,
then the lower of cost or NRV is €690,000 and a €30,000 writedown is required.

At January 31, 20X9, NRV = €810,000 – €50,000 = €760,000. Under IFRS, when
inventory recovers in value after being written down, it may be "written up" and a gain
recognized in the income statement. The amount of such gain, however, is limited to
the amount previously recognized as a loss. Under IFRS it is not permissible to report
inventory on the balance sheet at an amount that exceeds original cost, except in the
case of some agricultural and mineral products. Since cost is €720,000, the lower of
cost of NRV is €720,000.

(Module 18.4, LOS 18.g)

Question #11 of 110 Question ID: 1590158

Inventory, cost of sales, and gross profit can be different under periodic and perpetual
inventory systems if a firm uses which inventory cost method?

A) LIFO or FIFO, but not weighted average cost.

B) FIFO or weighted average cost, but not LIFO.
C) LIFO or weighted average cost, but not FIFO.

Explanation

The LIFO and weighted average cost methods can provide different values for
inventory, cost of sales, and gross profit depending on whether the firm uses a
periodic or perpetual inventory system. FIFO produces the same values from either a
periodic or perpetual inventory system.

(Module 18.1, LOS 18.c)

Question #12 of 110 Question ID: 1590211

Barber Inc., which uses LIFO inventory accounting under U.S. GAAP, sells DVD recorders.
On October 14, it purchased a large number of recorders at a cost of $90 each. Due to
an oversupply of recorders remaining in the marketplace due to lower than anticipated
demand during the Christmas season, the selling price at December 31 is $80 and the
replacement cost is $73. The normal profit margin is 5 percent of the selling price and
the selling costs are $2 per recorder. What is the value of the recorders on December
31?

A) $74.
B) $73.
C) $78.

Explanation

Under U.S. GAAP, a LIFO firm values inventory at the lower of cost or market. Market
is equal to the replacement cost subject to replacement cost being within a specific
range. The upper bound is net realizable value (NRV), which is equal to selling price
($80) less selling costs ($2) for an NRV of $78. The lower bound is NRV ($78) less
normal profit (5% of selling price = $4) for a net amount of $74. Since replacement
cost ($73) is less than NRV minus normal profit ($74), then market equals NRV minus
normal profit ($74). As well, we have to use the lower of cost ($90) or market ($74)
principle so the recorders should be recorded at the lower amount of $74.

(Module 18.4, LOS 18.g)

Question #13 of 110 Question ID: 1590207

Using the lower of cost or market principle under U.S. GAAP, if the market value of
inventory falls below its historical cost, the minimum value at which the inventory can
be reported in the financial statements is the:

A) market price minus selling costs minus normal profit margin.

B) net realizable value.
C) net realizable value minus selling costs.

Explanation
When inventory is written down to market, the replacement cost of the inventory is its
market value, but the "market value" must fall between net realizable value (NRV) and
NRV less normal profit margin. NRV is the market price of the inventory less selling
costs. Therefore the minimum value is the market price minus selling costs minus
normal profit margin.

(Module 18.4, LOS 18.g)

Question #14 of 110 Question ID: 1590160

A firm booked revenue of $2.25 million during 20X6 on unit sales of 150. The
replacement cost per unit of inventory is currently $9,300.

Inventory purchases:

Date Quantity Unit Cost

Begin inventory 50 units $7,000

4/1/X6 80 units 7,500

7/1/X6 30 units 8,100

10/1/X6 20 units 8,700

Assuming the FIFO inventory costing method and a perpetual inventory system are
used, the firm's gross profit and ending inventory are closest to:

Ending
Gross profit
inventory

A) $1,112,000 $279,000

B) $1,138,000 $255,000

C) $1,138,000 $279,000

Explanation