PorterSM05final_FinAcc

CHAPTER 5

Inventories andCost of Goods Sold

OVERVIEW OF EXERCISES, PROBLEMS, AND CASESEstimated

Time inLearning Outcomes Exercises Minutes Level

1. Identify the forms of inventory held by different types of 1 10 Easybusinesses and the types of costs incurred. 2 10 Mod

2. Show that you understand how wholesalers and retailers 3 25 Modaccount for sales of merchandise. 4 10 Easy

20* 25 Mod21* 15 Mod

3. Show that you understand how wholesalers and retailers 5 15 Easyaccount for cost of goods sold. 6 20 Mod

7 25 Mod8 20 Mod9 15 Mod

20* 25 Mod21* 15 Mod

4. Use the gross profit ratio to analyze a company’s ability to cover its operating expenses and earn a profit.

5. Explain the relationship between the valuation of inventory 10 15 Modand the measurement of income. 23* 20 Mod

6. Apply the inventory costing methods of specific identification, 11 20 Easyweighted average, FIFO, and LIFO using a periodic system. 22* 25 Mod

7. Analyze the effects of the different costing methods on 12 15 Modinventory, net income, income taxes, and cash flow. 22* 25 Mod

24* 40 Mod

8. Analyze the effects of an inventory error on various financial 13 25 Modstatement items. 14 20 Mod

9. Apply the lower-of-cost-or-market rule to the valuation of 23* 20 Modinventory.

10. Explain why and how the cost of inventory is estimated in 15 20 Modcertain situations.

5-1

5-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EstimatedTime in

Learning Outcomes (Continued) Exercises Minutes Level

11. Analyze the management of inventory. 16 20 Mod

12. Explain the effects that inventory transactions have on the 17 10 Easystatement of cash flows. 18 15 Mod

19 15 Mod

13. Explain the differences in the accounting for periodic and 24* 40 Modperpetual inventory systems and apply the inventory costing methods using a perpetual system. (Appendix)

*Exercise, problem, or case covers two or more learning outcomesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD 5-3

Problems Estimatedand Time in

Learning Outcomes Alternates Minutes Level

1. Identify the forms of inventory held by different types of 1 25 Modbusinesses and the types of costs incurred. 15* 20 Mod

2. Show that you understand how wholesalers and retailers 8* 45 Modaccount for sales of merchandise. 9* 40 Mod

10* 40 Mod

3. Show that you understand how wholesalers and retailers 8* 45 Modaccount for cost of goods sold. 9* 40 Mod

10* 40 Mod

4. Use the gross profit ratio to analyze a company’s ability to cover its operating expenses and earn a profit. 2 25 Mod

9* 40 Mod

5. Explain the relationship between the valuation of inventory 11* 45 Modand the measurement of income. 12* 60 Diff

13* 30 Mod14* 30 Mod

6. Apply the inventory costing methods of specific identification, 11* 45 Modweighted average, FIFO, and LIFO using a periodic system. 13* 30 Mod

14* 30 Mod


12* 60 Diff13* 30 Mod14* 30 Mod15* 20 Mod16* 20 Mod

8. Analyze the effects of an inventory error on various financial 4 45 Diffstatement items.

9. Apply the lower-of-cost-or-market rule to the valuation of 15* 20 Modinventory. 16* 20 Mod

10. Explain why and how the cost of inventory is estimated in 5 20 Modcertain situations.

11. Analyze the management of inventory. 6 30 Mod

12. Explain the effects that inventory transactions have on the 7 25 Modstatement of cash flows. 8* 45 Mod

13. Explain the differences in the accounting for periodic and 12* 60 Diffperpetual inventory systems and apply the inventory costing methods using a perpetual system. (Appendix)



EstimatedTime in

Learning Outcomes Cases Minutes Level

1. Identify the forms of inventory held by different types of 1* 25 Modbusinesses and the types of costs incurred. 3* 25 Mod

2. Show that you understand how wholesalers and retailers 1* 25 Modaccount for sales of merchandise. 4* 20 Mod

5* 20 Mod9 30 Mod

3. Show that you understand how wholesalers and retailers 1* 25 Modaccount for cost of goods sold. 4* 20 Mod

5* 20 Mod6 25 Mod

4. Use the gross profit ratio to analyze a company’s ability 4* 20 Modto cover its operating expenses and earn a profit. 5* 20 Mod

5. Explain the relationship between the valuation of inventoryand the measurement of income.

6. Apply the inventory costing methods of specific identification, 3* 25 Modweighted average, FIFO, and LIFO using a periodic system. 7* 40 Mod


10 30 Mod

8. Analyze the effects of an inventory error on various financial 8 30 Modstatement items.

9. Apply the lower-of-cost-or-market rule to the valuation of 3* 25 Modinventory. 11 30 Mod

10. Explain why and how the cost of inventory is estimated in certain situations.

11. Analyze the management of inventory.

12. Explain the effects that inventory transactions have on the statement of cash flows.

13. Explain the differences in the accounting for periodic and perpetual inventory systems and apply the inventory costing methods using a perpetual system. (Appendix)



Q U E S T I O N S

1. The three distinct types of costs incurred by a manufacturer are direct materials, di-rect labor, and manufacturing overhead. Direct, or raw, materials are the ingredients used in making a product. Direct labor consists of the amounts paid to factory work-ers to manufacture the product. Manufacturing overhead includes all the other costs that are related to the manufacturing process but cannot be directly matched to spe-cific units of output.

2. The use of a contra revenue account to record cash refunds and other types of al-lowances allows a company to monitor the size and frequency of these occurrences. For example, a relatively large amount of returns in any one period may be an indi-cation that the quality of the product has slipped. The information provided by the use of these contra revenue accounts would be lost if all returns and allowances were recorded as reductions of the Sales Revenue account. Also, if this practice were followed, the actual amount of sales would be understated for the period to the extent of any returns and allowances.

3. Terms of 3/20, net 60, mean that the customer may deduct 3% from the selling price if the bill is paid within twenty days. Otherwise, the full amount is due within 60 days of the date of the invoice. Assuming a sale for $1,000, a 3% discount would save the customer $30, resulting in a net amount due of $970. The amount saved is the result of paying 40 days earlier than is required by the 60-day term. Assuming 360 days in a year, there are 360/40, or 9 periods of 40 days each, in a year. Thus, a savings of $30 for 40 days is equivalent to a savings of $30 × 9, or $270 for the year. This is equivalent to an annual return of $270/$970, or 27.8%.

4. The two inventory systems differ with respect to how often the inventory account is updated. Under the perpetual system, the account is updated each time a sale or purchase is made. With the periodic system, the inventory account is updated only at the end of the period. A temporary account, called Purchases, is used to keep track of the acquisitions of inventory during the period. The periodic method relies on a count of the inventory on hand at the end of the period to determine the amount to assign to ending inventory on the balance sheet and to cost of goods sold expense on the income statement.

5. A point-of-sale terminal gives the merchandiser the ability to update the inventory records each time a sale is made. As an item is run over the sensing glass, a bar code on the product is read by the computer. In this way, the unit can be removed from the inventory at the point of sale. In some instances, however, merchandisers use the terminals only to update the quantity of units on hand, not necessarily the dollar amount.

6. The Purchases account is neither an asset nor an expense account. It is simply a temporary holding account for the purchases of merchandise, which is closed at the end of the period. The effect of purchases made during the period is to increase the cost of goods sold expense.


7. For inventory in transit at the end of the year, the terms of shipment dictate whether the buyer should record the purchase of the inventory. FOB shipping point means that the goods belong to the buyer as soon as they are shipped, and the purchases should be recorded at this point in time. Alternatively, FOB destination point means that the goods do not belong to the buyer until they are received and therefore should not be recorded if they are in transit at year end.

8. Transportation-in represents the freight costs incurred on purchases of merchandise and is therefore added to the purchases of the period in determining cost of goods sold expense. Alternatively, transportation-out indicates the freight costs incurred in selling merchandise and is therefore reported as a selling expense on the income statement in the period of sale.

9. Gross profit is computed by deducting cost of goods sold from net sales. The gross profit ratio indicates how well the company controlled its product costs during the year. For example, a 30% gross profit ratio indicates that for every dollar of sales the company has a gross profit of 30 cents. That is, after deducting 70 cents on every dollar for the cost of the inventory that is sold, the company has 30 cents to cover its operating costs and earn a profit.

10. According to the cost of goods sold model, beginning inventory plus purchases mi-nus ending inventory equals cost of goods sold. Therefore, the amount assigned to inventory on the balance sheet has a direct effect on the measurement of cost of goods sold on the income statement. Any errors in valuing inventory will flow through to cost of goods sold and thus have an impact on the measurement of net income.

11. The justification for treating freight costs on incoming inventory as a cost incurred in acquiring the asset, rather than as an expense of the period, is the matching princi-ple. Freight costs are necessary to put the inventory into a position to be sold and should therefore be included in the cost of the asset. This is a significant decision, since the cost will become an expense only at the time the inventory is sold. If freight costs are not included in the cost of the inventory, they are expensed immediately as they are incurred. Thus, if the inventory is not sold at the end of the period, the deci -sion to treat freight costs as a cost of the inventory will result in higher net income than if the costs had been included as an expense of the period.

12. The specific identification method is appropriate only for certain types of inventory. It is normally used for situations in which the inventory is relatively high-priced and subject to a low amount of turnover. Although it is not a necessary condition, each unit of inventory is often unique. For example, an automobile dealer uses the spe-cific identification method, as would a jewelry company.


13. When used on an inventory of identical units, the specific identification can lead to the manipulation of income. Because all units are identical, management can select which units to sell based on the relative high or low cost of the units on hand. For ex-ample, in a bad year a company might be tempted to select for sale all units that had a relatively low unit cost, regardless of when they were acquired. The use of a cost flow assumption, such as weighted average, FIFO, or LIFO, eliminates the ability of management to select units for sale based solely on the effect this decision will have on the income of the period.

14. The weighted average cost method does not rely on a simple arithmetic average of the unit cost for the various purchases of the period. Instead, more weight is as-signed to unit costs for which more units were purchased. For example, assume that beginning inventory consists of 100 units with a unit cost of $10 per unit. Assume that during the period, 100 units were purchased at $15 per unit, and 200 units were purchased at $20 per unit. The arithmetic average unit cost for the period would be ($10 + $15 + $20)/3 = $15. However, the weighted average unit cost would be [100($10) + 100 ($15) + 200($20)]/400 units, or $16.25. The acquisition of twice as many units at $20 as opposed to those purchased at $10 and $15 drives the weighted average up to $16.25.

15. The FIFO method more nearly approximates the physical flow of products in most businesses. This is particularly true for perishable products, such as fresh fruits and vegetables. Most businesses prefer as a matter of good customer relations to sell their goods on a first-in, first-out basis. This minimizes the likelihood that units of in-ventory will become obsolete and spoiled.

16. The use of LIFO will have the effect of maximizing net income if a company is expe-riencing a decline in the unit cost of inventory. Last-in, first-out charges the most re-cent purchases to cost of goods sold. If prices are declining, the amounts charged to cost of goods sold will be less than if either the weighted average method or FIFO was used. Because less is charged to cost of goods sold, net income will be higher.

17. In a period of rising prices, the use of LIFO will result in a lower tax bill. Because the most recent purchases are charged to cost of goods sold under LIFO, in a period of rising prices, these units will be higher-priced, and thus the result will be lower gross margin as well as lower net income before tax. Lower net income will result in a lower amount of tax to pay. If prices are declining during the period, FIFO will result in a lower tax bill.

18. No, the president should not be enthralled with the new controller. The controller is suggesting something that is not allowed under the tax law. The Internal Revenue Service’s LIFO conformity rule requires that a company that wants to use LIFO for tax purposes must also use it in preparing its income statement.


19. A LIFO liquidation occurs when a company using the LIFO inventory method sells more units during the period than it purchases. A liquidation of some or all of the older, relatively lower priced units (assuming rising prices) will result in a low cost of goods sold amount and a correspondingly higher gross margin. This may present a dilemma to a company. If the company sells the lower-priced units, its net income will improve, but higher taxes will have to be paid. To avoid facing this situation, a company might buy inventory at the end of the year to avoid these consequences of a liquidation. Unfortunately, the somewhat forced purchase of inventory to avoid the liquidation may not be in the best interests of the company.

20. In a period of rising prices, FIFO can result in significant inventory profits. In compar-ison with LIFO, the use of FIFO charges less to cost of goods sold because it is the older, lower-priced units that are assumed to be sold. However, in a period of signifi-cant inflation, there may be a large difference between the gross margin that results from using FIFO and the much smaller amount that would result from using the cur-rent cost of the inventory (replacement cost). This difference, called inventory profit, is simply the result of holding the units during a period of inflation.

21. No, it is not acceptable for a company to indicate to its stockholders that it is switch-ing to LIFO to save on taxes. While the ability to save taxes may be an important re-sult of the change, the company must be able to demonstrate that LIFO does a bet-ter job of matching costs with revenues. This is normally the justification offered in the annual report for a company’s change to LIFO.

22. Because a certain section of the warehouse is double-counted, ending inventory will be overstated. According to the cost of goods sold model, ending inventory is sub-tracted from cost of goods available to sell to arrive at cost of goods sold expense. Therefore, an overstatement of ending inventory will lead to an understatement of cost of goods sold expense. An understatement of an expense results in an over-statement of net income for the period.

23. The lower-of-cost-or-market rule is invoked when the utility of inventory is less than its cost to the company. It is a departure from the historical cost principle and is justi-fied on the basis of conservatism. The rule is a reaction to uncertainty by anticipating a decline in the value of inventory and writing down the asset currently before it is sold.

24. Application of the lower-of-cost-or-market rule on a total basis, compared with an item-by-item basis, will usually yield a different result. The reason is that with the to-tal approach, increases in market value above cost are allowed to offset decreases in value. Alternatively, when the item-by-item approach is used, any increases in value are essentially ignored, and it is the declines in value for each item that are recognized.

25. A company using the periodic inventory system could undoubtedly save money by estimating its year-end inventory and thus avoiding the expense of counting it. How-ever, the inventory must be based on actual cost, not an estimate, for purposes of the annual report.


26. A retailer can save time and money at the end of the year by simply counting the number of units of each item of inventory and multiplying each of these counts by the price marked on the units (that is, the retail price). This process gives the com-pany an amount that represents the value of the inventory at retail. The retail method is then used to convert this amount to cost. It would be prohibitive for many retailers, particularly mass merchandisers, to trace the unit cost of each item of inventory to purchase invoices.

27. Inventory turnover equals cost of goods sold (cost of sales) divided by average in-ventory. If the cost of sales remains constant while the denominator (average inven-tory) increases, inventory turnover will decrease. This indicates that inventory is staying on the shelf for a longer time. The company should probably evaluate the salability of its inventory.

28. When a perpetual inventory system is used, the dollar amount of inventory is calcu-lated after each sale. Thus, when it is used in conjunction with the weighted average costing method, a new average cost is calculated after each sale. The weighted av-erage changes each time a sale is made, and therefore the unit cost is called a mov-ing average.

E X E R C I S E S

LO 1 EXERCISE 5-1 CLASSIFICATION OF INVENTORY COSTS

Raw Work in Finished MerchandiseInventory Item Material Process Goods InventoryFabric XLumber XUnvarnished tables XChairs on the showroom floor XCushions X X*Decorative knobs XDrawers XSofa frames XChairs in the plant warehouse XChairs in the retail storeroom X

*Cushions produced by the company would be work in process, but if purchased from a supplier, they would be raw materials.


LO 1 EXERCISE 5-2 INVENTORIABLE COSTS

List price: $100 × 200 units $20,000Less: 10% volume discount (2,000)Freight costs 56Insurance for goods in transit 32

Total cost $18,088

Under the cost principle, all of these costs are necessary to put the inventory into a po-sition where it can be sold.Other classifications:

The phone charges and purchasing department salary would both be difficult to match directly with the sale of any particular product and therefore should be treated as operating expenses of the period. The labeling supplies are immaterial in amount and should also be reported as operating expenses. The interest paid to suppliers is a fi-nancing cost and would be reported as interest expense on the income statement.

LO 2 EXERCISE 5-3 PERPETUAL AND PERIODIC INVENTORY SYSTEMS

1. Company A is using a perpetual inventory system because it has the account Cost of Goods Sold. Company B is using the periodic inventory system because it uses the accounts Purchases, Purchase Discounts, and Purchase Returns and Al-lowances.

2. Company A’s end of the year inventory is the balance in its merchandise inventory account, $12,000. Its cost of goods sold is $38,000, the balance in that account.

3. Cost of goods sold in a periodic system is computed as: Beginning inventory + net purchases – ending inventory. Company B’s merchandise inventory account repre-sents beginning inventory. Ending inventory is obtained by conducting a physical count. Because you are not given the ending inventory figure, you cannot compute cost of goods sold.


LO 2 EXERCISE 5-4 PERPETUAL AND PERIODIC INVENTORY SYSTEMS

Perpetual—Appliance store

Perpetual—Car dealership

Periodic—Drugstore

Perpetual—Furniture store

Periodic—Grocery store

Periodic—Hardware store

Perpetual—Jewelry store

Changes in technology may lessen the costs of maintaining perpetual inventory sys-tems. Merchandisers will convert to perpetual inventory systems when the benefits of maintaining such systems exceed the costs.

LO 3 EXERCISE 5-5 MISSING AMOUNTS IN COST OF GOODS SOLD MODEL

Case 1:

(a) Beginning inventory: cost of goods available for sale – cost of goods purchased = $7,110 – ($6,230 – $470 – $200 + $150) = $7,110 – $5,710 = $1,400

(b) Ending inventory: cost of goods available for sale – cost of goods sold = $7,110 – $5,220 = $1,890

Case 2: (must first solve d, then c)

(d) Cost of goods available for sale: cost of goods sold + ending inventory = $5,570 + $1,750 = $7,320

(c) Purchase discounts:

1. Cost of goods available for sale – beginning inventory = cost of goods purchased = $7,320 – $2,350 = $4,970

2. Gross purchases – purchase returns and allowances – purchase discounts + transportation-in = cost of goods purchased; $5,720 – $800 – purchase discounts + $500 = $4,970; purchase discounts = $5,420 – $4,970 = $450


Case 3:

(e) Gross purchases:

1. Cost of goods purchased = cost of goods available for sale – beginning inventory = $8,790 – $1,890 = $6,900

2. Gross purchases – purchase returns and allowances – purchase discounts + transportation-in = cost of goods purchased; gross purchases – $550 – $310 + $420 = $6,900; gross purchases = $6,900 + $550 + $310 – $420 = $7,340

(f) Cost of goods sold = cost of goods available for sale – ending inventory = $8,790 – $1,200 = $7,590

LO 3 EXERCISE 5-6 PURCHASE DISCOUNTS

July 3 Purchases 3,500Accounts Payable 3,500

To record purchases of merchandise on credit.

Assets = Liabilities + Owners’ Equity+3,500 –3,500

July 6 Purchases 7,000Accounts Payable 7,000

To record purchases of merchandise on credit.


July 12 Accounts Payable 3,500Cash 3,465Purchase Discounts 35

To record payment on account: $3,500 – 0.01($3,500) = $3,465.

Assets = Liabilities + Owners’ Equity–3,465 –3,500 +35

August 5 Accounts Payable 7,000Cash 7,000

To record payment on account.

Assets = Liabilities + Owners’ Equity–7,000 –7,000


LO 3 EXERCISE 5-7 PURCHASES—PERIODIC SYSTEM

March 3 Purchases 2,500Accounts Payable 2,500

To record purchases on credit.


March 3 Transportation-in 250Cash 250

To record payment of freight costs.

Assets = Liabilities + Owners’ Equity–250 –250




March 12 Accounts Payable 2,500Cash 2,450Purchase Discount 50

To record payment for purchases on credit:$2,500 – 0.02($2,500) = $2,450.

Assets = Liabilities + Owners’ Equity–2,450 –2,500 +50

March 15 Accounts Payable 500Purchase Returns and Allowances 500

To record credit on defective merchandise.

Assets = Liabilities + Owners’ Equity–500 +500





March 22 Accounts Payable 400Purchase Returns and Allowances 400

To record credit on returned merchandise.

Assets = Liabilities + Owners’ Equity–400 +400

April 6 Accounts Payable 900Cash 900

To record payment for purchases on credit: $1,400 – $500.


April 18 Accounts Payable 1,200Cash 1,200

To record payment for purchases on credit: $1,600 – $400.

Assets = Liabilities + Owners’ Equity–1,200 –1,200

LO 3 EXERCISE 5-8 SHIPPING TERMS AND TRANSFER OF TITLE

1. The seller pays shipping costs when merchandise is shipped FOB destination point. Miller Wholesalers pays the freight bill and is responsible for the merchandise until it gets to Michael’s warehouse.

2. The inventory should not be included as an asset on Michael’s December 31, 2007, balance sheet because the terms of shipment indicate that the merchandise does not legally belong to Michael until it arrives, and this is after the end of the year. Like-wise, Miller should not include the sale on its 2007 income statement, since the goods are not considered sold until they reach the buyer’s business.

3. If the terms of shipment were FOB shipping point, the answers to both questions in 2. above would change. Under these terms, the inventory belongs to Michael as soon as it is shipped, and because this is on December 23, 2007, the asset should be recognized on the year-end balance sheet. Similarly, Miller would record a sale in 2007.


LO 3 EXERCISE 5-9 TRANSFER OF TITLE TO INVENTORY

Purchases of merchandise that are in transit from vendors to Cameron Companies on December 31, 2007:Record during December 2007—Shipped FOB shipping pointRecord during January 2008—Shipped FOB destination point

Sales of merchandise that are in transit to customers of Cameron Companies on De-cember 31, 2007:Record during December 2007—Shipped FOB shipping pointRecord during January 2008—Shipped FOB destination point

LO 4 EXERCISE 5-10 INVENTORY AND INCOME MANIPULATION

By ignoring the large order at year-end, and thus including the inventory in the year-end count, the company will overstate ending inventory. This in turn will lead to an under-statement of cost of goods sold and an overstatement of net income. The effects on next year’s income are the opposite. Because beginning inventory will be overstated, cost of goods sold will also be overstated, and net income understated. The accountant has an obligation to the financial statement users to convince the president to make the necessary adjustments to reduce the inventory balance.

LO 6 EXERCISE 5-11 INVENTORY COSTING METHODS

1. Ending inventory:(65 – 55) × $20 = $ 200(50 – 35) × $22 = 330(60 – 45) × $23 = 345(45 – 5) × $24 = 960

80 units $1,835

Cost of goods sold:55 × $20 = $1,10035 × $22 = 77045 × $23 = 1,035

5 × $24 = 120 140 units $3,025


2. Ending inventory:45 × $24 = $1,08035 × $23 = 805 80 units $1,885

Cost of goods sold:65 × $20 = $1,30050 × $22 = 1,100

25 × $23 = 575 140 units $2,975

3. Ending inventory:65 × $20 = $1,30015 × $22 = 330 80 units $1,630

Cost of goods sold:45 × $24 = $1,08060 × $23 = 1,380

35 × $22 = 770 140 units $3,230

4. Cost of goods available for sale and units available:65 × $20 = $1,30050 × $22 = 1,10060 × $23 = 1,380

45 × $24 = 1,080 220 units $4,860

Weighted average cost = $4,860/220 = $22.09/unit

Ending inventory: 80 × $22.09 = $1,767.20

Cost of goods sold: 140 × $22.09 = $3,092.60

Note: Does not total $4,860 because of rounding of average cost.

LO 7 EXERCISE 5-12 EVALUATION OF INVENTORY COSTING METHODS

1. a 5. b

2. d 6. a

3. c 7. b

4. c 8. c


LO 8 EXERCISE 5-13 INVENTORY ERRORS

Retained Cost of NetInventory Earnings Goods Sold Income

1. U U O U2. O O U O3. U U O U

LO 8 EXERCISE 5-14 TRANSFER OF TITLE TO INVENTORY

1. Michelson should include the costs in its inventory, since the merchandise had not arrived at its destination, PJ’s, by the end of the year.

2. Filbrandt should include the costs of the merchandise in its inventory, since it has re-ceived the shipment by the end of the year.

3. Randall would include the merchandise in its inventory, since the shipment left James Bros. before the end of the year.

4. Barner should include the merchandise in its inventory. It is both shipped by Hinz and received by Barner before the end of the year.

LO 10 EXERCISE 5-15 GROSS PROFIT METHOD

(1) Net sales $105,300× estimated gross profit ratio 0.25 Estimated gross profit $ 26,325

(2) Net sales $105,300– estimated gross profit 26,325 Estimated cost of goods sold $ 78,975

(3) Beginning inventory $ 15,400Add: Purchases 84,230 Cost of goods available for sale $ 99,630Estimated cost of goods sold 78,975 Estimate of inventory destroyed $ 20,655

Assets = Liabilities + Owners’ EquityCash +10,000 Loss on insurance settlement –

10,655Inventory –20,655


LO 11 EXERCISE 5-16 INVENTORY TURNOVER FOR BEST BUY

1. Inventory turnover = cost of goods sold/average inventory $20,938/[($2,851 + $2,607)/2] = $20,938/$2,729 = 7.67 times.

2. The average length of time it takes to sell an item of inventory can be estimated by dividing the number of times inventory turns over in a year into the number of days in a year:

(assuming 360 days in a year): 360/7.67 times = 46.9, or approximately 47 days.

3. It is difficult to determine from the information given whether 47 days is reasonable as the average length of time it takes to sell inventory. Other information needed to make this determination includes:

The historical average number of days. The industry norms for large, national retailers. Any recent changes in types of inventory, customer base, markets for the prod-

ucts, and other relevant factors.

LO 12 EXERCISE 5-17 IMPACT OF TRANSACTIONS INVOLVING INVENTORIES ON STATEMENT OF CASH FLOWS

Increase in accounts payable: Added to net incomeDecrease in accounts payable: Deducted from net incomeIncrease in inventories: Deducted from net incomeDecrease in inventories: Added to net income

LO 12 EXERCISE 5-18 EFFECTS OF TRANSACTIONS INVOLVING INVENTORIES ON THE STATEMENT OF CASH FLOWS—DIRECT METHOD

Cash payments for inventory to be reported in the operating activities of Masthead’s 2007 statement of cash flows (direct method):

Inventory, December 31, 2006 $ 180,400Plus: Purchases during 2007 XLess: Cost of goods sold during 2007 (1,200,000 )Inventory, December 31, 2007 $ 241,200 $180,400 + X – $1,200,000 = $241,200X = $1,260,800

Accounts payable, December 31, 2006 $ 85,400Plus: Purchases during 2007 (from above) 1,260,800Less: Cash payments during 2007 (X )Accounts payable, December 31, 2007 $ 78,400 $85,400 + $1,260,800 – X = $78,400X = $1,267,800


LO 12 EXERCISE 5-19 EFFECTS OF TRANSACTIONS INVOLVING INVENTORIES ON THE STATEMENT OF CASH FLOWS—INDIRECT METHOD

Cash flows from operating activities:

Net income $ xx,xxxAdjustments to reconcile net income to net cash

provided by operating activities:Increase in inventory ($241,200 – $180,400) $(60,800)Decrease in accounts payable ($78,400 – $85,400) (7,000 ) (67,800 )

Cash flows from operating activities $ xx,xxx

MULTI-CONCEPT EXERCISES

LO 2,3 EXERCISE 5-20 INCOME STATEMENT FOR A MERCHANDISER

a. Sales – Net sales = Sales returns and allowances

$125,600 – $122,040 = $3,560

b. Do c. first. Net purchases + Purchase discounts = Purchases

$74,600 + $1,300 = $75,900

c. Cost of goods purchased – Transportation-in = Net purchases

$81,150 – $6,550 = $74,600

d. Net sales – Gross margin = Cost of goods sold

$122,040 – $38,600 = $83,440

e. Cost of goods available for sale – Cost of goods sold = Ending inventory

$104,550 – $83,440 = $21,110

f. Gross margin – Income before tax = Operating expenses

$38,600 – $26,300 = $12,300

g. Income before tax – Income tax expense = Net income

$26,300 – $10,300 = $16,000


LO 2,3 EXERCISE 5-21 PARTIAL INCOME STATEMENT—PERIODIC SYSTEM

LAPINE COMPANYINCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2007

Sales $80,000Less: Sales returns and allowances $ 500

Sales discounts 1,200 1,700 Net sales $78,300Less cost of goods sold:

Beginning inventory $ 4,000Purchases $30,000Less: Purchase returns and allowances 400

Purchase discounts 800 Net purchases $28,800Add: Transportation-in 1,000 Cost of goods purchased 29,800 Cost of goods available for sale $33,800Less: Ending inventory 3,800 Cost of goods sold 30,000

Gross margin $48,300

The gross profit ratio is 61.7%.($48,300/$78,300)

LO 6,7 EXERCISE 5-22 INVENTORY COSTING METHODS—PERIODIC SYSTEM

1. a. Weighted average method:

Cost of goods available for sale and units available:

200 × $10 = $ 2,000300 × $11 = 3,300400 × $12 = 4,800250 × $13 = 3,250

150 × $15 = 2,250 1,300 $15,600

Weighted average cost = $15,600/1,300 = $12 per unit

Units available 1,300Units sold 1,000Units in ending inventory 300

Cost of ending inventory = 300($12) = $3,600Cost of goods sold = 1,000($12) = $12,000


b. FIFO method:

Ending inventory cost:150 × $15 = $2,250150 × $13 = 1,950 300 $4,200

Cost of goods sold:200 × $10 = $ 2,000300 × $11 = 3,300400 × $12 = 4,800

100 × $13 = 1,300 1,000 $11,400

(OR: $15,600 – $4,200 = $11,400)

c. LIFO method:

Ending inventory cost:200 × $10 = $2,000100 × $11 = 1,100 300 $3,100

Cost of goods sold:150 × $15 = $ 2,250250 × $13 = 3,250400 × $12 = 4,800

200 × $11 = 2,200 1,000 $12,500

(OR: $15,600 – $3,100 = $12,500)

2. LIFO cost of goods sold $12,500FIFO cost of goods sold 11,400 Difference in expenses $ 1,100× tax rate 0.30 Difference in taxes $ 330

Conclusion: Because FIFO results in less cost of goods sold, a higher income and thus more taxes, $330, will be reported with this method than if LIFO were used.

LO 5,9 EXERCISE 5-23 LOWER-OF-COST-OR-MARKET RULE

Conservatism is the rationale for carrying inventory on the balance sheet at an amount less than its cost. It is a departure from the historical cost principle and is used when the utility of the inventory, as measured by the cost to replace it, is less than original cost.

Two accounts are affected by the application of the lower of cost or market rule. An income statement account, such as Loss on Decline in Value of Inventory, is debited, and the Inventory account on the balance sheet is credited or reduced.


The effect of writing down inventory is to reduce the income of the current year by the amount debited to the loss account. In future years, however, income will be higher because of the write-down. This occurs because cost of goods sold will be lower in the future when the inventory that was written down to a lower amount is eventually sold.

LO 7,13 EXERCISE 5-24 INVENTORY COSTING METHODS—PERPETUAL SYSTEM (Appendix)

1. a. Moving average:

Purchases Sales Balance Unit Total Unit Total Unit

Date Units Cost Cost Units Cost Cost Units Cost Balance1/1 200 $10 $2,0002/12 150 $10 $1,500 50 10 5003/5 300 $11 $3,300 350 10.8571 $3,8004/30 200 10.857 2,171 150 10.857 1,6296/12 400 12 4,800 550 11.6892 6,4297/7 200 11.689 2,338 350 11.689 4,0918/23 250 13 3,250 600 12.2353 7,3419/6 300 12.235 3,670 300 12.235 3,67110/2 150 15 2,250 450 13.1584 5,92112/3 150 13.158 1,974 300 13.158 $3,947

Cost of goods sold $11,653 Ending inventory

All amounts rounded to agree with total cost.1. 50 × $10 = $ 500

300 × 11 = 3,300

350 $3,800; $3,800/350 = $10.857

2. 150 × $10.857 = $1,629

400 × 12 = 4,800

550 $6,429; $6,429/550 = $11.689

3. 350 × $11.689 = $4,091

250 × 13 = 3,250

600 $7,341; $7,341/600 = $12.235

4. 300 × $12.235 = $3,671

150 × 15 = 2,250

450 $5,921; $5,921/450 = $13.158


1. b. FIFO:


Date Units Cost Cost Units Cost Cost Units Cost Balance1/1 200 $10 $2,0002/12 150 $10 $1,500 50 10 5003/5 300 $11 $3,300 50 10

300 11 3,8004/30 50 10 500

150 11 1,650 150 11 1,6506/12 400 12 4,800 150 11

400 12 6,4507/7 150 11 1,650

50 12 600 350 12 4,2008/23 250 13 3,250 350 12

250 13 7,4509/6 300 12 3,600 50 12

250 13 3,85010/2 150 15 2,250 50 12

250 13150 15 6,100

12/3 50 12 600 150 13100 13 1,300 150 15 $4,200



1. c. LIFO:


Date Units Cost Cost Units Cost Cost Units Cost Balance1/1 $200 $10 $2,0002/12 150 $10 $1,500 50 10 5003/5 300 $11 $3,300 50 10

300 11 3,8004/30 200 11 2,200 50 10

100 11 1,6006/12 400 12 4,800 50 10

100 11400 12 6,400

7/7 200 12 2,400 50 10100 11200 12 4,000

8/23 250 13 3,250 50 10100 11200 12250 13 7,250

9/6 250 13 3,250 50 1050 12 600 100 11

150 12 3,40010/2 150 15 2,250 50 10

100 11150 12150 15 5,650

12/3 150 15 2,250 50 10100 11150 12 $3,400


2. EXERCISE 5-22: EXERCISE 5-24:E/I C/G/S E/I C/G/S

Average cost $3,600 $12,000 $3,947 $11,653 DifferentFIFO 4,200 11,400 4,200 11,400 SameLIFO 3,100 12,500 3,400 12,200 Different


3. Cost of goods sold: LIFO $12,200FIFO 11,400 Difference in expense $ 800× tax rate 0.30 Difference in taxes $ 240

Conclusion: LIFO results in a higher cost of goods sold and therefore a lower tax-able income and lower income tax by $240.

P R O B L E M S

LO 1 PROBLEM 5-1 INVENTORY COSTS IN VARIOUS BUSINESSES

Accounting Treatment Expense of Inventory Other

Business Types of Costs the Period Cost TreatmentRetail shoe store Shoes for sale X

Shoe boxes XAdvertising signs X

Grocery store Canned goods XProduce XCleaning supplies X*Cash registers X**

Frame shop Wooden frame supplies XNails XGlass X

Print shop Paper XCopy machines X**Toner cartridges X*

Restaurant Frozen food XChina and silverware X**Prepared food XSpices X

*Record as an asset and charge to expense as used.**Record as an asset and depreciate over estimated useful life.


LO 4 PROBLEM 5-2 CALCULATION OF GROSS PROFIT FOR WAL-MART AND TARGET

1. Gross profit ratios (dollar amounts in millions):

Wal-Mart: 2004: ($285,222 – $219,793)/$285,222 = $65,429/$285,222 = 22.9%2003: ($256,329 – $198,747)/$256,329 = $57,582/$256,329 = 22.5%

Target: 2004: ($45,682 – $31,445)/$45,682 = $14,237/$45,682 = 31.2%2003: ($40,928 – $28,389)/$40,928 = $12,539/$40,928 = 30.6%

2. In terms of the gross profit ratio, Target appears to be performing better, given a sig-nificantly higher ratio in each year. The mix of products sold by the two companies and the normal markups on the various products could certainly affect the ratios. A comparison with prior years and industry averages would also be important to con-sider.

LO 7 PROBLEM 5-3 EVALUATION OF INVENTORY COSTING METHODS

1. Company B will have the newest costs in inventory because it uses first-in, first-out. Because costs are rising, it will have the lowest costs of goods sold and thus the highest net income.

2. Company C will have the oldest costs in inventory because it uses last-in, first-out. Because costs are rising, it will have the highest cost of goods sold and thus the low-est income before taxes. Company C will pay the least in taxes.

3. This question does not lend itself to an easy answer. LIFO matches the most recent costs with the most recent revenue and thus may be a better indicator of future po-tential to investors. Inventory profits are not a major concern with LIFO as they are with FIFO, because the newer (most recent) costs are assigned to cost of sales.

4. Company C would have the oldest costs in inventory because it uses LIFO. Because costs are falling, it will have the lowest cost of goods sold and the highest net in-come.

Company B will have the newest costs in inventory because it uses FIFO. Be-cause costs are falling, it will have the highest cost of goods sold and the lowest in-come before taxes. Company B will pay the least in taxes.

The answer to Question 3. is still not easy. There are advantages and disadvan-tages in all methods. The important point is to choose one method and stay with it for consistency.


LO 8 PROBLEM 5-4 INVENTORY ERROR

1. Revised income statements: 2007 2006Revenues $20,000 $15,000Cost of goods sold* 13,600 9,400

Gross profit $ 6,400 $ 5,600Operating expenses 3,000 2,000

Net income $ 3,400 $ 3,600

*Because ending inventory in 2006 was understated, cost of goods sold was over-stated. Because beginning inventory in 2007 was understated, cost of goods sold was understated.

Revised balance sheets: 12/31/07 12/31/06Cash $ 1,700 $ 1,500Inventory 4,200 4,100Other current assets 2,500 2,000Long-term assets 15,000 14,000 Total assets $23,400 $21,600Liabilities $ 8,500 $ 7,000Capital stock 5,000 5,000Retained earnings 9,900 9,600 Total liabilities and owners’ equity $23,400 $21,600

2. Net income for two years, before revision: $3,000 + $4,000 = $7,000Net income for two years, after revision: $3,600 + $3,400 = $7,000Thus, there is no net over- or understatement.

Retained earnings at December 31, 2007, before the revision: $9,900Retained earnings at December 31, 2007, after the revision: $9,900Thus, there is no over- or understatement.

3. Even though the error counterbalances over the two-year period, it is still important to restate the statements for the two years. It is important for comparative purposes that the correct amount of net income be known for each of the two years. The com-pany needs to restate the income statements for each of the two years and restate the balance sheets at the end of each year.


LO 10 PROBLEM 5-5 GROSS PROFIT METHOD OF ESTIMATING INVENTORY LOSSES

1. (1) Net sales $113,500× estimated gross profit ratio 0.40 Estimated gross profit $ 45,400

(2) Net sales $113,500– estimated gross profit 45,400 Estimated cost of goods sold $ 68,100

(3) Beginning inventory $ 3,200Add: Purchases 164,000 Cost of goods available for sale $167,200Estimated cost of goods sold 68,100 Estimate of inventory at time of explosion $ 99,100Inventory saved 4,500 Estimate of inventory destroyed $ 94,600

2. Journal entry:

August 1 Loss on Insurance Settlement 29,600Cash* 65,000

Inventory 94,600To record insurance settlement from explosion.

*Debit should be to a Receivable from Insurance Company if cash has not yet been received.

Assets = Liabilities + Owners’ Equity+65,000 –29,600–94,600


LO 11 PROBLEM 5-6 INVENTORY TURNOVER FOR APPLE COMPUTER AND DELL COMPUTER

1. Gross profit ratios:

Apple Computer Dell Computer(in millions) (in millions)

2004 2003 2005 2004 Sales/Product revenue $ 8,279 $ 6,207 $49,205 $ 41,444Less: Cost of sales/revenue 6,020 4,499 40,190 33,892 Gross profit $ 2,259 $ 1,708 $ 9,015 $ 7,552Divided by sales ÷ 8,279 ÷ 6,207 ÷ 49,205 ÷ 41,444 Gross profit ratio 27.3% 27.5% 18.3% 18.2%

2. Inventory turnover ratios:

Apple Computer:$6,020/[($101 + $56)/2] = $6,020/78.5 = 76.69 times

Dell Computer$40,190/[($459 + $327)/2] = $40,190/$393 = 102.26 times

3. Both companies’ gross profit ratios have remained about the same in the two years. The two companies’ turnover ratios are very different. Another factor to consider is the number of days’ sales in inventory.

Apple Computer:360/76.69 = 4.7days

Dell Computer:360/102.26 = 3.5 days

It takes Apple an average of less than five days to sell an item of inventory, and Dell requires only three and a half days.

On the basis of the gross profit, Apple appears to be performing better, although Dell does have a better inventory turnover and days’ sales in inventory.

It would be helpful to measure all of these statistics—gross profit ratio, inventory turnover, and days’ sales in inventory—with the same measures for prior years. It would also be helpful to compare these measures with the industry averages.


LO 12 PROBLEM 5-7 EFFECTS OF CHANGES IN INVENTORY AND ACCOUNTS PAYABLE BALANCES ON STATEMENT OF CASH FLOWS

1. Statement of cash flows:

COPELAND ANTIQUESSTATEMENT OF CASH FLOWS


Net loss $(33,200)Adjustments to reconcile net loss to net cash provided by

operating activities:Decrease in inventory ($192,600 – $214,800) 22,200Increase in accounts payable ($123,900 – $93,700) 30,200

Cash flows from operating activities $ 19,200Cash, December 31, 2006 46,100 Cash, December 31, 2007 $ 65,300

2. Memorandum to the president:

TO: President of Copeland Antiques

FROM: Student’s name

DATE: January 20, 2008

SUBJECT: Cash Flows

You recently questioned the increase in the company’s cash balance in light of this year’s net loss. My thoughts and a copy of the company’s 2007 statement of cash flows follow.

Copeland Antiques was able to generate a significant amount of cash from oper-ations even though the company incurred an accrual basis net loss of $33,200 dur-ing 2007. First, the amount of inventory on hand decreased by $22,200 during the year from $214,800 to $192,600; this reduction in inventory generated cash for the company. Second, the amount owed to the company’s suppliers increased by $30,200 during the year from $93,700 to $123,900; the related bills have not yet been paid.

Operating expenses need to be decreased relative to gross profit if we are to im-prove the company’s bottom line. I look forward to discussing our plans to turn things around.


MULTI-CONCEPT PROBLEMS

LO 2,3,12 PROBLEM 5-8 PURCHASES AND SALES OF MERCHANDISE, CASH FLOWS

1. Journal entries:

April 1 Purchases 500Accounts Payable 500

To record purchase of merchandise on account.

Assets = Liabilities + Owners’ Equity+500 –500

April 10 Accounts Payable 500Cash 485Purchase Discounts 15

To record payment on account:$500 × (1 – 0.03) = $485.

Assets = Liabilities + Owners’ Equity–485 –500 +15

April 15 Cash 200Sales Revenue 200

To record cash sale.

Assets = Liabilities + Owners’ Equity+200 +200

April 18 Purchases 900Accounts Payable 900



April 25 Cash 600Sales Revenue 600

To record cash sales: 3 × $200.



April 28 Accounts Payable 900Cash 873Purchase Discount (900 × 3%) 27



2. Net income for April:Sales revenue: $200 + $600 $ 800Cost of goods sold:

Beginning inventory $ 0Purchases: $500 + $900 $1,400Less: Purchase discounts $15 + $27 42 Net purchases 1,358

Cost of goods available for sale $1,358Less: Ending inventory 967

Cost of goods sold 391 Gross margin $ 409Operating expenses:

Rent expense $ 100Miscellaneous expense 50

Total operating expenses 150 Net income $ 259

3. Net cash flow from operating activities for April:Cash collected from sales: $200 + $600 $ 800Cash paid for:

Inventory: $485 + $873 $1,358Rent 100Miscellaneous 50 1,508

Net cash flow from operating activities $ (708 )

OR:Net income $ 259Deduct: Increase in inventory balance (967 )Net cash flow from operating activities $ (708 )

4. Net income is $259. Net cash flow from operating activities is a negative $708. The difference of $967 is attributable to inventory that has not been sold. That is, the company has paid for $1,358 of inventory (a cash outlay) but has only recognized cost of goods sold expense of $391. The difference is $967.


LO 2,3,4 PROBLEM 5-9 GAP INC.’S SALES, COST OF GOODS SOLD, AND GROSS PROFIT

1. Apparently, Gap Inc. does not sell its merchandise on account. If customers want to pay on credit for their purchases they would use one of the various credit cards that Gap accepts.

2. Summary journal entry for sales during the year ended 1/29/05 (millions of dollars):

Cash 16,267Sales 16,267

Assets = Liabilities + Owners’ Equity+16,267 +16,267

3. Gap Inc. would deduct sales returns and allowances from sales to arrive at the amount of net sales reported on its income statement. Since Gap Inc. does not have any accounts receivable on its balance sheet, it is unlikely that it offers sales dis-counts to its customers. Either because they do not feel the amounts are material enough or they would rather not divulge information about returns and allowances to competitors, some companies choose not to separately report them.

4. Cost of goods sold section of 2004 income statement (millions of dollars):

Merchandise inventory, 1/31/04 $ 1,704Cost of goods purchased* 9,996 (2)Cost of goods available for sale $11,700 (1)Less merchandise inventory, 1/29/05 (1,814 )Cost of goods sold** $ 9,886

*Including occupancy expenses.**Described as cost of goods sold and occupancy expenses.(1) $9,886 + $1,814 = $11,700.(2) $11,700 – $1,704 = $9,996.


(millions of dollars) 2004 2003Sales $ 16,267 $ 15,854Less cost of sales 9,886 9,885 Gross profit $ 6,381 $ 5,969Divided by sales ÷ $16,267 ÷ $15,854 Gross margin ratio 39.2% 37.6%

Gap Inc.’s gross profit ratio increased by 1.6% from 2003 to 2004. Factors affecting Gap Inc.’s gross profit ratio might include changes in the selling prices of merchan-dise, changes in the costs of goods purchased, and/or changes in the mix of mer-chandise sold (that is, a slight shift between selling products that have higher gross profit ratios and selling those with lower gross profit ratios).


LO 2,3 PROBLEM 5-10 FINANCIAL STATEMENTS

1. Cost of goods sold for 2007:Beginning inventory $ 6,400Purchases $40,200Less: Purchase discounts 800

Net purchases $39,400Add: Transportation-in 375

Cost of goods purchased 39,775 Cost of goods available for sale $46,175

Less: Ending inventory 7,500 Cost of goods sold $38,675

2. Net income for 2007:Sales $84,364Less: Sales returns 780

Net sales $83,584Cost of goods sold (from Part 1) 38,675

Gross profit $44,909Operating expenses:

Salaries $25,600Advertising 4,510Utilities 3,600Depreciation 2,300

Total operating expenses 36,010 Income before tax $ 8,899

Income tax expense 3,200 Net income $ 5,699


3. MAPLE INC.BALANCE SHEET

AT DECEMBER 31, 2007

AssetsCurrent assets:

Cash $ 590Accounts receivable 2,359Inventory 7,500Interest receivable 100

Total current assets $10,549Property, plant, and equipment:

Land $20,000Building and equipment, net 55,550

Total property, plant, and equipment 75,550 Total assets $86,099

LiabilitiesCurrent liabilities:

Salaries payable $ 650Income tax payable 3,200

Total liabilities $ 3,850

Stockholders’ EquityCapital stock $50,000Retained earnings 32,249 * 82,249 Total liabilities and stockholders’ equity $86,099

*Beginning retained earnings + Net income – Dividends$32,550 + $5,699 – $6,000


LO 5,6,7 PROBLEM 5-11 COMPARISON OF INVENTORY COSTING METHODS—PERI-ODIC SYSTEM

1. Cost of EndingGoods Sold Inventory Total

a. Weighted average $11,084 $4,988 $16,072b. FIFO 10,776 5,296 16,072c. LIFO 11,452 4,620 16,072

a. Beginning inventory 600 × $5.00 = $ 3,000Oct. 8 800 × 5.40 = 4,320Oct. 18 700 × 5.76 = 4,032Oct. 29 800 × 5.90 = 4,720

2,900 $16,072

Weighted average cost = $16,072/2,900 = $5.542

Units sold: 500 + 700 + 800 = 2,000 units

Units available – units sold = ending inventory

2,900 – 2,000 = 900 units

Ending inventory = 900 × $5.542 = $4,988

Cost of goods sold = 2,000 × $5.542 = $11,084

b. Ending inventory—FIFO:800 × $5.90 = $4,720100 × 5.76 = 576 900 $5,296

Cost of goods sold—FIFO:600 × $5.76 = $ 3,456800 × 5.40 = 4,320

600 × 5.00 = 3,000 2,000 $10,776

c. Ending inventory—LIFO:600 × $5.00 = $3,000300 × 5.40 = 1,620 900 $4,620

Cost of goods sold—LIFO:500 × $5.40 = $ 2,700700 × 5.76 = 4,032

800 × 5.90 = 4,720 2,000 $11,452


2. The Total column represents the pool of costs (beginning inventory plus purchases) to be distributed between an asset, ending inventory on the balance sheet, and an expense, cost of goods sold on the income statement. In accounting, this pool of costs is called cost of goods available for sale.

3. Income statements for the month of October:

WeightedAverage FIFO LIFO

Sales* $20,800 $20,800 $20,800Cost of goods sold 11,084 10,776 11,452 Gross margin $ 9,716 $10,024 $ 9,348Operating expenses 3,000 3,000 3,000 Income before taxes $ 6,716 $ 7,024 $ 6,348Income tax expense (30%) 2,015 2,107 1,904 Net income $ 4,701 $ 4,917 $ 4,444

*Sales = 500($10) + 700($10) + 800($11) = $20,800

4. The company will pay $203 more in taxes if it uses FIFO:

FIFO tax $2,107LIFO tax 1,904 Difference $ 203

LO 5,7,13 PROBLEM 5-12 COMPARISON OF INVENTORY COSTING METHODS—PERPET-UAL SYSTEM (Appendix)


a. Moving average $10,785 $5,287 $16,072b. FIFO 10,776 5,296 16,072c. LIFO 10,852 5,220 16,072


a. Moving average:


Date Units Cost Cost Units Cost Cost Units Cost Balance10/1 600 $5 $3,00010/4 500 $5 $2,500 100 5 50010/8 800 $5.40 $4,320 900 5.3561 4,82010/9 700 5.356 3,749 200 5.356 1,07110/18 700 5.76 4,032 900 5.672 5,10310/20 800 5.67 4,536 100 5.67 56710/29 800 5.90 4,720 900 5.8743 $5,287


1. 100 × $5.00 = $ 500

800 × 5.40 = 4,320

900 $4,820; $4,820/900 = $5.356

2. 200 × $5.356 = $1,071

700 × 5.76 = 4,032

900 $5,103; $5,103/900 = $5.67

3. 100 × $5.67 = $ 567

800 × 5.90 = 4,720

900 $5,287; $5,287/900 = $5.874

b. FIFO:


Date Units Cost Cost Units Cost Cost Units Cost Balance10/1 600 $5 $3,00010/4 500 $5 $2,500 100 5 50010/8 800 $5.40 $4,320 100 5

800 5.40 4,82010/9 100 5 500

600 5.40 3,240 200 5.40 1,08010/18 700 5.76 4,032 200 5.40

700 5.76 5,11210/20 200 5.40 1,080

600 5.76 3,456 100 5.76 57610/29 800 5.90 4,720 100 5.76

800 5.90 $5,296



c. LIFO:


Date Units Cost Cost Units Cost Cost Units Cost Balance10/1 600 $5 $3,00010/4 500 $5 $2,500 100 5 50010/8 800 $5.40 $4,320 100 5

800 5.40 4,82010/9 700 5.40 3,780 100 5

100 5.40 1,04010/18 700 5.76 4,032 100 5

100 5.40700 5.76 5,072

10/20 700 5.76 4,032100 5.40 540 100 5 500

10/29 800 5.90 4,720 100 5800 5.90 $5,220


2. The Total column represents the pool of costs (beginning inventory plus purchases) to be distributed between an asset, ending inventory on the balance sheet, and an expense, cost of goods sold, on the income statement. In accounting, this pool of costs is called cost of goods available for sale.

3. Income statements for the month of October:

MovingAverage FIFO LIFO

Sales* $20,800 $20,800 $20,800Cost of goods sold 10,785 10,776 10,852 Gross margin $10,015 $10,024 $ 9,948Operating expenses 3,000 3,000 3,000 Income before taxes $ 7,015 $ 7,024 $ 6,948Income tax expense (30%) 2,105 2,107 2,084 Net income $ 4,910 $ 4,917 $ 4,864

*Sales = 500($10) + 700($10) + 800($11) = $20,800


FIFO tax $2,107LIFO tax 2,084 Difference $ 23


LO 5,6,7 PROBLEM 5-13 INVENTORY COSTING METHODS—PERIODIC SYSTEM

1. Units in beginning inventory 200Add: units purchased (250 + 220 + 150 + 200) 820 Units available 1,020Less: units sold (300 + 380 + 110) 790 Units in ending inventory 230

Ending Cost ofInventory Goods Sold Total

a. FIFO $4,410 $14,663 $19,073b. LIFO 4,155 14,918 19,073c. Weighted average 4,301 14,772 19,073

a. Ending inventory—FIFO:200 × $19.20 = $3,840 30 × 19.00 = 570 230 $4,410

Cost of goods sold—FIFO:200 × $18.00 = $ 3,600250 × 18.50 = 4,625220 × 18.90 = 4,158120 × 19.00 = 2,280 790 $14,663

b. Ending inventory—LIFO:200 × $18.00 = $3,600 30 × 18.50 = 555 230 $4,155

Cost of goods sold—LIFO:220 × $18.50 = $ 4,070220 × 18.90 = 4,158150 × 19.00 = 2,850200 × 19.20 = 3,840 790 $14,918

c. Beginning inventory 200 × $18.00 = $ 3,600Nov. 4 250 × 18.50 = 4,625Nov. 13 220 × 18.90 = 4,158Nov. 18 150 × 19.00 = 2,850Nov. 24 200 × 19.20 = 3,840

1,020 $19,073


Ending inventory = 230 × $18.699 = $4,301

Cost of goods sold = 790 × $18.699 = $14,772


2. WeightedFIFO LIFO Average

Sales* $33,480 $33,480 $33,480Cost of goods sold 14,663 14,918 14,772 Gross profit $18,817 $18,562 $18,708Operating expenses:

Selling and administrative expenses 10,800 10,800 10,800

Depreciation 4,000 4,000 4,000 Income before taxes $ 4,017 $ 3,762 $ 3,908Income tax expense (35%) 1,406 1,317 1,368 Net income $ 2,611 $ 2,445 $ 2,540

*Sales = (300 × $42) + (380 × $42.50) + (110 × $43) = $33,480

3. Oxendine pays the least taxes under the last-in, first-out method, since it has the highest cost of goods sold.

LO 5,6,7 PROBLEM 5-14 INVENTORY COSTING METHODS—PERIODIC SYSTEM

1. a. Weighted average:Beginning inventory 5,000 × $10 = $ 50,000Feb. 4 3,000 × 9 = 27,000April 12 4,000 × 8 = 32,000Sept. 10 2,000 × 7 = 14,000Dec. 5 1,000 × 6 = 6,000

15,000 $129,000


Units available for sale 15,000Units sold 12,500Ending inventory 2,500 × 8.60 = $1,500

Cost of goods sold 12,500 × 8.60 = $107,500

b. FIFO:

Ending inventory 1,000 × $ 6 = $ 6,0001,500 × 7 = 10,500 2,500 $ 16,500

Cost of goods sold 500 × $ 7 = $ 3,5004,000 × 8 = 32,0003,000 × 9 = 27,000

5,000 × 10 = 50,000 12,500 $112,500


c. LIFO:

Ending inventory 2,500 × $10 = $ 25,000

Cost of goods sold 2,500 × $10 = $ 25,0003,000 × 9 = 27,0004,000 × 8 = 32,0002,000 × 7 = 14,000

1,000 × 6 = 6,000 12,500 $104,000

2. Income statements for the year ended December 31, 2007:


Sales* $150,000 $150,000 $150,000Cost of goods sold 107,500 112,500 104,000 Gross margin $ 42,500 $ 37,500 $ 46,000Operating expenses 20,000 20,000 20,000 Income before taxes $ 22,500 $ 17,500 $ 26,000Income tax expense (30%) 6,750 5,250 7,800 Net income $ 15,750 $ 12,250 $ 18,200

*Sales = 12,500 × $12 = $150,000

3. Weaver can minimize its tax bill by using FIFO. In a period of declining prices, FIFO results in the highest amount of cost of goods sold, the least amount of income be-fore taxes, and thus the least amount of income tax expense.

4. A company is not free to change inventory methods from year to year to take advan-tage of changing patterns in the level of prices. It must be able to justify any change in the method used on some basis other than saving taxes, such as a better match-ing of costs with revenues.

LO 1,7,9 PROBLEM 5-15 INTERPRETING TRIBUNE COMPANY’S INVENTORY ACCOUNTING POLICY

1. Newsprint costs are comparable to raw materials in a manufacturing company. A newspaper company, however, does not keep an inventory of finished goods. Its newspapers either are sold within hours after being printed or become worthless if not sold.

2. Some companies use more than one method to value different types of inventory. The methods should be chosen because they provide the most accurate matching of costs with the revenues generated. Apparently, LIFO provides the most accurate matching of costs with revenue for Tribune Company’s newsprint.


LO 7,9 PROBLEM 5-16 INTERPRETING SEARS’ INVENTORY ACCOUNTING POLICY

1. No, the use of the last-in, first-out method for its domestic merchandise inventories does not mean that Sears always sells its newest merchandise first in the U.S. Actu-ally, the physical flow of merchandise in most stores like Sears is normally on a first-in, first-out basis. However, the use of a cost flow assumption such as LIFO or FIFO for accounting purposes is independent of the actual physical flow of products.

2. No, Sears uses the retail method to account for inventories in its stores. This is a method that allows the company to convert its inventory from a retail value to a cost basis for financial statement purposes.

A L T E R N A T E P R O B L E M S

LO 1 PROBLEM 5-1A INVENTORY COSTS IN VARIOUS BUSINESSES

1. Classification of an item as inventory depends on the company’s intent. DVDs of-fered by the company for resale should be classified as part of inventory and charged to cost of goods sold at the time they are sold. Alternatively, rental DVDs are income-producing assets and should not be classified as inventory. They should be classified as current assets because it is unlikely that any DVDs will be kept as rentals for more than one year.

2. When DVDs are transferred because they will be offered for resale, the asset ac-count DVD Rentals would be credited, and the asset account DVD Inventory would be debited.

LO 4 PROBLEM 5-2A CALCULATION OF GROSS PROFIT FOR BEST BUY AND CIRCUIT CITY

1. Gross profit ratios (dollar amounts in millions):

Best Buy: 2005: ($27,433 – $20,938)/$27,433 = $6,495/$27,433 = 23.7%2004: ($24,548 – $18,677)/$24,548 = $5,871/$24,548 = 23.9%

Circuit City: 2005: ($10,472 – $7,904)/$10,472 = $2,568/$10,472 = 24.5%2004: ($9,857 – $7,573)/$9,857 = $2,284/$9,857 = 23.2%

2. In terms of the gross profit ratios, the two companies appear to be very similar. The mix of products sold by the two companies and the normal markups on the various products could certainly affect the ratios. A comparison with prior years and industry averages would also be important to consider.


LO 7 PROBLEM 5-3A EVALUATION OF INVENTORY COSTING METHODS

1. No, the three companies will not be equally pleased with the decline in prices. If the decline continues, Company Y (FIFO) will begin to show lower gross profit than Company Z (LIFO). Because gross profit will be lower, Company Y will report lower income before tax and thus have less tax to pay.

2. It should be noted that it is not acceptable for a company to change inventory valua-tion methods to save taxes. An acceptable explanation of the justification for the change is this:

During the year recently completed, the company changed its method of valuing inventory on the balance sheet and recognizing cost of sales on the income statement. The company changed from the LIFO to FIFO method because it be-lieves that the latter results in a better matching of cost of sales with the rev-enues of the period.

LO 8 PROBLEM 5-4A INVENTORY ERROR

1. Revised income statements: 2007 2006Revenues $35,982 $26,890Cost of goods sold* 12,094 10,412

Gross profit $23,888 $16,478Operating expenses 13,488 10,578

Net income $10,400 $ 5,900

*Because ending inventory in 2006 was overstated, cost of goods sold was under-stated. Because beginning inventory in 2007 was overstated, cost of goods sold was overstated.

Revised balance sheets: 12/31/07 12/31/06Cash $ 9,400 $ 4,100Inventory 4,500 4,900Other current assets 1,600 1,250Long-term assets, net 24,500 24,600 Total assets $40,000 $34,850Current liabilities $ 9,380 $10,600Capital stock 18,000 18,000Retained earnings 12,620 6,250 Total liabilities and owners’ equity $40,000 $34,850


2. Current ratio:

Before revision:

= = 1.01 to 1

After revision: = = 0.97 to 1

If the lender required a current ratio of at least 1 to 1, Planter would not be eligible for the loan. However, the bank might not consider a current ratio of 0.97 to 1 to be materially different from a current ratio of 1 to 1 and might be willing to grant the loan.

3. Net income for two years, before revision: $6,400 + $9,900 = $16,300.

Net income for two years, after revision: $5,900 + $10,400 = $16,300.

Thus, there is no net over- or understatement of net income for the two-year period.

Retained earnings at December 31, 2007, before the revision: $12,620.

Retained earnings at December 31, 2007, after the revision: $12,620.

Thus, there is no over- or understatement of retained earnings at December 31, 2007.

4. Even though the error counterbalances over the two-year period, it is still important to restate the statements for the two years. It is important for comparative purposes that the correct amount of net income be known for each of the two years. The com-pany needs to restate the income statements for each of the two years and restate the balance sheets at the end of each year.


LO 10 PROBLEM 5-5A GROSS PROFIT METHOD OF ESTIMATING INVENTORY LOSSES

1. (1) Net sales $93,500× estimated gross profit ratio 0.70 Estimated gross profit $65,450

(2) Net sales $93,500– estimated gross profit 65,450 Estimated cost of goods sold $28,050

(3) Beginning inventory $14,200Add: Purchases 77,000 Cost of goods available for sale $91,200Estimated cost of goods sold 28,050 Estimate of inventory at time of explosion $63,150Inventory saved 4,500 Estimate of inventory destroyed $58,650

2. Journal entry:

July 1 Loss on Insurance Settlement 8,650Cash* 50,000

Inventory 58,650To record insurance settlement from explosion.

Assets = Liabilities + Owners’ Equity+50,000 –8,650–58,650

*Debit should be to a Receivable from Insurance Company if cash has not yet been received.


LO 11 PROBLEM 5-6A INVENTORY TURNOVER FOR WAL-MART AND TARGET

1. Inventory turnover ratios:

Wal-Mart:$219,793/[($29,447 + $26,612)/2] = $219,793/$28,029.5 = 7.84 times

Target:$31,445/[($5,384 + $4,531)/2] = $31,445/$4,957.5 = 6.34 times

2. Wal-Mart’s inventory turnover is higher than Target’s during the most recent fiscal year, 7.84 versus 6.34. Another factor to consider is the number of days’ sales in in-ventory:

Wal-Mart:360/7.84 = 45.9 days

Target:360/6.34 = 56.8 days

It takes Wal-Mart an average of 46 days to sell an item of inventory; Target requires an average of 57 days. On the basis of inventory turnover and days’ sales in inven-tory, Wal-Mart appears to be performing slightly better.

It would be helpful to measure these statistics—inventory turnover and days’ sales in inventory, along with the companies’ gross profit ratios—with the same mea-sures for prior years. It would also be helpful to compare these measures with the in-dustry averages.


LO 12 PROBLEM 5-7A EFFECTS OF CHANGES IN INVENTORY AND ACCOUNTS PAYABLE BALANCES ON STATEMENT OF CASH FLOWS

1. Statement of cash flows:

CARPETLAND CITYSTATEMENT OF CASH FLOWS


Net income $ 78,500Adjustments to reconcile net income to net cash

provided by operating activities:Increase in inventory ($105,500 – $84,900) $(20,600)Decrease in accounts payable

($23,900 – $93,700) (69,800 ) (90,400 )Cash flows from operating activities $(11,900)

Cash, December 31, 2006 26,300 Cash, December 31, 2007 $ 14,400

2. Memorandum to the president:

TO: President of Carpetland City


DATE: January 20, 2008

SUBJECT: Cash Flows

You recently expressed concern about the decrease in the company’s cash bal-ance in spite of the profitable year that was reported on this year’s income state-ment. My thoughts and a copy of the company’s 2007 statement of cash flows fol-low.

Although net income on an accrual basis was $78,500, the company’s cash bal-ance declined by $11,900 during the year for two reasons. Most importantly, the amount owed to the company’s suppliers decreased by $69,800 during the year from $93,700 to $23,900; this decrease in accounts payable drained our cash bal-ance. In addition, the amount of inventory on hand increased by $20,600 during the year from $84,900 to $105,500; this increase in inventory required an additional out-flow of cash.

We can better manage our cash flow by carefully timing the payment of bills to coincide with the due dates on invoices. In addition, we can improve cash flow by closely monitoring our inventory levels and only adding to inventory levels when in-creases in sales warrant an addition.


ALTERNATE MULTI-CONCEPT PROBLEMS

LO 2,3,12 PROBLEM 5-8A PURCHASES AND SALES OF MERCHANDISE, CASH FLOWS

1. Journal entries:

Oct. 1 Purchases 249Accounts Payable 249



Oct. 10 Accounts Payable 249Cash 244Purchase Discounts 5



Oct. 15 Cash 200Sales Revenue 200

To record cash sale.


Oct. 18 Purchases 800Accounts Payable 800



Oct. 25 Cash 600Sales Revenue 600

To record cash sales: 3 × $200.


Oct. 30 Accounts Payable 800Cash 800

To record payment on account.



2. Units on hand on October 31:October 1 purchase 3 unitsOctober 15 sale (1)October 18 purchase 10October 25 sale (3)Ending inventory 9 units

3. Cash balance at end of month:Beginning cash balance $2,000October 10 payment (244)October 15 sale 200October 25 sale 600October 30 payment (800 )Cash balance at end of month $1,756

The cash balance decreased during the month even though the company reported a profit because cash outflows exceeded expenses. This was the case because the entire inventory purchased (and paid for) was not yet sold (expensed).

LO 2,3,4 PROBLEM 5-9A WALGREEN’S SALES, COST OF GOODS SOLD, AND GROSS PROFIT

1. Summary journal entries for the year ended 8/31/04: (in millions)

Cash 1,017.8Accounts Receivable 1,017.8

To record collection of beginning accounts receivable.

Assets = Liabilities + Owners’ Equity+1,017.8–1,017.8

Accounts Receivable 37,508.2Sales 37,508.2

To record sales on account.

Assets = Liabilities + Owners’ Equity+37,508.2 +37,508.2

Cash 36,339.1Sales 36,339.1

To record cash collections: $37,508.2 – $1,169.1.

Assets = Liabilities + Owners’ Equity+36,339.1 +36,339.1


2. Walgreen’s would deduct sales returns and allowances, and the amount of any sales discounts taken by its customers from sales, to arrive at the amount of net sales re-ported on its income statement. Either because they do not feel the amounts are material enough or they would rather not divulge information about returns and al-lowances to competitors, some companies choose not to separately report them.

3. Cost of goods sold section of 2004 income statement: (in millions)Merchandise inventory, August 31, 2003 $ 4,202.7Cost of goods purchased 27,846 .3 (2)Cost of goods available for sale $32,049.0 (1)Less merchandise inventory, August 31, 2004 (4,738 .6 )Cost of goods sold $27,310 .4

(1) $27,310.4 + $4,738.6 = $32,049.0.(2) $32,049.0 – $4,202.7 = $27,846.3.


(In millions) 2004 2003Net sales $ 37,508.2 $ 32,505.4Cost of sales 27,310.4 23,706.2 Gross profit $ 10,197.8 $ 8,799.2Divided by net sales ÷ 37,508.2 ÷ 32,505.4 Gross profit ratio 27.2% 27.1%

Walgreen’s gross profit ratio was virtually unchanged from 2003 to 2004. Factors af-fecting Walgreen’s gross profit ratio include changes in the selling prices of mer-chandise, changes in the costs of goods purchased, and/or changes in the mix of merchandise sold (that is, a slight shift from selling products that have higher gross profit ratios to selling those with lower gross profit ratios).

LO 2,4 PROBLEM 5-10A FINANCIAL STATEMENTS

1. Cost of goods sold for 2007:Beginning inventory $ 6,400Purchases $62,845Less: Purchase discounts 1,237 Net purchases $61,608Add: Transportation-in 375 Cost of goods purchased 61,983 Cost of goods available for sale $68,383Less: Ending inventory 5,900

Cost of goods sold $62,483


2. Net income for 2007:Sales $112,768Less: Sales returns 1,008

Net sales $111,760Cost of goods sold (from Part 1) 62,483

Gross profit $ 49,277Operating expenses:

Wages and salaries expense $ 23,000Advertising expense 12,900Utilities expense 1,800

Total operating expenses 37,700 Income before tax $ 11,577

Income tax expense 1,450 Net income $ 10,127

3. LLOYD INC.BALANCE SHEET

AT DECEMBER 31, 2007

AssetsCash $22,340Accounts receivable 56,359Inventory 5,900

Total assets $84,599

LiabilitiesSalaries payable $ 650Wages payable 120Income tax payable 1,450 Total liabilities $ 2,220

Stockholders’ EquityCapital stock $50,000Retained earnings 32,379 *

Total stockholders’ equity 82,379 Total liabilities and stockholders’ equity $84,599

*Beginning retained earnings + Net income – Dividends$28,252 + $10,127 – $6,000


LO 5,6,7 PROBLEM 5-11A COMPARISON OF INVENTORY COSTING METHODS—PERI-ODIC SYSTEM


a. Weighted average $5,120 $4,655 $9,775b. FIFO 4,875 4,900 9,775c. LIFO 5,375 4,400 9,775

a. Beginning inventory 300 × $4.00 = $1,200Nov. 8 500 × 4.50 = 2,250Nov. 18 700 × 4.75 = 3,325Nov. 29 600 × 5.00 = 3,000

2,100 $9,775


Units sold: 200 + 500 + 400 = 1,100 units

Units available – units sold = ending inventory

2,100 – 1,100 = 1,000 units

Ending inventory = 1,000 × 4.655 = $4,655

Cost of goods sold = 1,100 × 4.655 = $5,120*

*Rounded to agree with total cost.

b. Ending inventory—FIFO:600 × $5.00 = $3,000

400 × 4.75 = 1,900 1,000 $4,900

Cost of goods sold—FIFO:300 × $4.00 = $1,200500 × 4.50 = 2,250

300 × 4.75 = 1,425 1,100 $4,875

c. Ending inventory—LIFO:300 × $4.00 = $1,200500 × 4.50 = 2,250

200 × 4.75 = 950 1,000 $4,400

Cost of goods sold—LIFO:600 × $5.00 = $3,000

500 × 4.75 = 2,375 1,100 $5,375


2. The Total column represents the pool of costs (beginning inventory plus purchases) to be distributed between an asset, ending inventory on the balance sheet, and an expense, cost of goods sold on the income statement. In accounting, the pool of costs is called cost of goods available for sale.

3. Income statements for the month of November:


Sales* $10,100 $10,100 $10,100Cost of goods sold 5,120 4,875 5,375 Gross margin $ 4,980 $ 5,225 $ 4,725Operating expenses 2,000 2,000 2,000 Income before taxes $ 2,980 $ 3,225 $ 2,725Income tax expense (25%) 745 806 681 Net income $ 2,235 $ 2,419 $ 2,044

*Sales = 200($9) + 500($9) + 400($9.50) = $10,100


FIFO tax $806LIFO tax 681 Difference $125

LO 5,7,13 PROBLEM 5-12A COMPARISON OF INVENTORY COSTING METHODS—PER-PETUAL SYSTEM (Appendix)


a. Moving average $4,892 $4,883 $9,775b. FIFO 4,875 4,900 9,775c. LIFO 4,950 4,825 9,775


a. Moving average:


Date Units Cost Cost Units Cost Cost Units Cost Balance11/1 300 $4 $1,20011/4 200 $4 $ 800 100 4 40011/8 500 $4.50 $2,250 600 4.4171 2,65011/9 500 4.417 2,209 100 4.417 44111/18 700 4.75 3,325 800 4.7082 3,76611/20 400 4.708 1,883 400 4.708 1,88311/29 600 5.00 3,000 1,000 4.8833 $4,883


All amounts rounded to agree with total cost.1. 100 × $4.00 = $ 400

500 × 4.50 = 2,250 600 $2,650; $2,650/600 = $4.417

2. 100 × $4.417 = $ 441700 × 4.75 = 3,325 800 $3,766; $3,766/800 = $4.708

3. 400 × $4.708 = $1,883 600 × 5.00 = 3,000 1,000 $4,883; $4,883/1,000 = $4.883

b. FIFO:


Date Units Cost Cost Units Cost Cost Units Cost Balance11/1 300 $4 $1,20011/4 200 $4 $ 800 100 4 40011/8 500 $4.50 $2,250 100 4

500 4.50 2,65011/9 100 4 400

400 4.50 1,800 100 4.50 45011/18 700 4.75 3,325 100 4.50

700 4.75 3,77511/20 100 4.50 450

300 4.75 1,425 400 4.75 1,90011/29 600 5.00 3,000 400 4.75

600 5.00 $4,900



c. LIFO:


Date Units Cost Cost Units Cost Cost Units Cost Balance11/1 300 $4 $1,20011/4 200 $4 $ 800 100 4 40011/8 500 $4.50 $2,250 100 4

500 4.50 2,65011/9 500 4.50 2,250 100 4 40011/18 700 4.75 3,325 100 4

700 4.75 3,72511/20 400 4.75 1,900 100 4

300 4.75 1,82511/29 600 5.00 3,000 100 4

300 4.75600 5 $4,825


2. The Total column represents the pool of costs (beginning inventory plus purchases) to be distributed between an asset, ending inventory on the balance sheet, and an expense, cost of goods sold on the income statement. In accounting, this pool of costs is called cost of goods available for sale.

3. Income statements for the month of November:

MovingAverage FIFO LIFO

Sales* $10,100 $10,100 $10,100Cost of goods sold 4,892 4,875 4,950 Gross margin $ 5,208 $ 5,225 $ 5,150Operating expenses 2,000 2,000 2,000 Income before taxes $ 3,208 $ 3,225 $ 3,150Income tax expense (25%) 802 806 788 Net income $ 2,406 $ 2,419 $ 2,362

*Sales = 200($9) + 500($9) + 400($9.50) = $10,100


FIFO tax $806LIFO tax 788 Difference $ 18


LO 5,6,7 PROBLEM 5-13A INVENTORY COSTING METHODS—PERIODIC SYSTEM

1. Units in beginning inventory 300Add: units purchased (375 + 330 + 225 + 300) 1,230Units available 1,530Less: units sold (450 + 570 + 165) 1,185Units in ending inventory 345

Ending Cost of Inventory Goods Sold Total

a. FIFO $8,643 $31,190 $39,833b. LIFO 9,293 30,540 39,833c. Weighted average 8,982 30,851 39,833

a. Ending inventory—FIFO:300 × $25.00 = $7,500 45 × 25.40 = 1,143 345 $8,643

Cost of goods sold—FIFO:300 × $27.00 = $ 8,100375 × 26.50 = 9,938330 × 26.00 = 8,580

180 × 25.40 = 4,572 1,185 $31,190

b. Ending inventory—LIFO:300 × $27.00 = $8,100 45 × 26.50 = 1,193 345 $9,293

Cost of goods sold—LIFO:300 × $25.00 = $ 7,500225 × 25.40 = 5,715330 × 26.00 = 8,580

330 × 26.50 = 8,745 1,185 $30,540


c. Beginning inventory 300 × $27.00 = $ 8,100Nov. 4 375 × 26.50 = 9,938Nov. 13 330 × 26.00 = 8,580Nov. 18 225 × 25.40 = 5,715Nov. 24 300 × 25.00 = 7,500

1,530 $39,833


Ending inventory = units in ending inventory × average cost = 345 × $26.035 = $8,982

Cost of goods sold = units sold × average cost = 1,185 × $26.035 = $30,851

2. WeightedFIFO LIFO Average

Sales* $75,330 $75,330 $75,330Cost of goods sold 31,190 30,540 30,851 Gross profit $44,140 $44,790 $44,479Operating expenses:

Selling and administrative expenses 16,200 16,200 16,200

Depreciation 6,000 6,000 6,000 Income before taxes $21,940 $22,590 $22,279

Income tax expense (35%) 7,679 7,907 7,798 Net income $14,261 $14,683 $14,481

*Sales = (450 × $63) + (570 × $63.75) + (165 × $64.50) = $75,330

3. Story pays the least taxes under the first-in, first-out method, since it has the highest cost of goods sold.

LO 5,6,7 PROBLEM 5-14A INVENTORY COSTING METHODS—PERIODIC SYSTEM

1. a. Weighted average:Beginning inventory 4,000 × $20 = $ 80,000Feb. 4 2,000 × 18 = 36,000April 12 3,000 × 16 = 48,000Sept. 10 1,000 × 14 = 14,000Dec. 5 2,500 × 12 = 30,000

12,500 $208,000


Units available for sale 12,500Units sold 11,000Ending inventory 1,500 × 16.64 = $ 24,960

Cost of goods sold 11,000 × 16.64 = $183,040


b. FIFO:Ending inventory 1,500 × $12 = $ 18,000


1,000 × 12 = 12,000 11,000 $190,000

c. LIFO:Ending inventory 1,500 × $20 = $ 30,000


2,500 × 20 = 50,000 11,000 $178,000

2. Income statements for the year ended December 31, 2007:


Sales* $330,000 $330,000 $330,000Cost of goods sold 183,040 190,000 178,000 Gross profit $146,960 $140,000 $152,000Operating expenses 60,000 60,000 60,000 Income before taxes $ 86,960 $ 80,000 $ 92,000Income tax expense (30%) 26,088 24,000 27,600 Net income $ 60,872 $ 56,000 $ 64,400

*Sales = 11,000 × $30 = $330,000

3. Fees can minimize its tax bill by using FIFO. In a period of declining prices, FIFO re-sults in the highest cost of goods sold, the least amount of income before taxes, and thus the least amount of income tax expense.

4. A company is not free to change inventory methods from year to year to take advan-tage of changing patterns in the level of prices. It must be able to justify any change in the method used on some basis other than saving taxes, such as a better match-ing of costs with revenues.


LO 1,7,9 PROBLEM 5-15A INTERPRETING THE NEW YORK TIMES COMPANY’S FINANCIAL STATEMENTS

1. The company carries two types of inventory: newsprint and other. These costs are comparable to raw materials in a manufacturing company. A newspaper company, however, does not keep an inventory of finished goods. Its newspapers either are sold within hours after being printed or become worthless if not sold.

2. Some companies use different methods to value different types of inventory. The methods should be chosen because they provide the most accurate matching of costs with the revenues generated. Apparently, LIFO provides the most accurate matching of costs with revenue for the company’s newsprint.

LO 7,9 PROBLEM 5-16A INTERPRETING HOME DEPOT’S FINANCIAL STATEMENTS

1. No, the use of the first-in, first-out inventory method does not mean that a company always sells its oldest merchandise first. Although the physical flow in many busi-nesses is on a first-in first-out basis, the use of a cost flow assumption such as FIFO for accounting purposes is independent of the actual physical flow of products. In fact, some businesses do use a LIFO (last-in, first-out) assumption even though the physical flow is on a first-in, first-out basis.

2. No, Home Depot states in its note that it uses the retail inventory method to account for inventories in its stores. This is a method that allows a company to convert its in-ventory from a retail value to a cost basis for financial statement purposes.

D E C I S I O N C A S E S

READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1,2,3 DECISION CASE 5-1 READING LIFE TIME FITNESS’S FINANCIAL STATEMENTS

1. Life Time Fitness is primarily a service provider.

2. The company reports inventories on its balance sheet because it sells some nutri-tional products in its LifeCafes. The amounts of inventories on December 31, 2004, was $4,971,000 and this represents less than one percent of total assets.


3. Life Time Fitness does not report cost of goods sold on its income statement. As the costs related to inventory expire they would be reported on the income statement, likely as part of the operating expense called “Sports, fitness and family recreation center operations.” Revenue from sale of the nutritional products would likely be in-cluded in “In-center revenue” on the income statement.

LO 7 DECISION CASE 5-2 READING AND INTERPRETING J.C.PENNEY’S FINANCIAL STATEMENTS

1. J.C.Penney uses LIFO. A business should employ the method that most accurately matches inventory costs with the revenues of the period. J.C.Penney may use LIFO because prices change frequently and it wants to match the most recent costs with revenues generated in the current period.

2. The LIFO reserve is $25 million at year-end 2004, and $43 million at year-end 2003.

3. The LIFO reserve decreased during 2004, from $43 million to $25 million, or $18 mil-lion. The reserve decreases because inventory costs are decreasing and cost of goods sold on a LIFO basis is less than cost of goods sold on a FIFO basis. Thus, a decrease in the reserve during a period indicates that prices are falling.

LO 1,6,9 DECISION CASE 5-3 READING AND INTERPRETING CIRCUIT CITY’S INVENTORY NOTE

1. Circuit City uses the average cost method. Given the large volume of consumer electronics products sold by Circuit City, the average cost method seems appropri-ate.

2. The company defines market as estimated realizable value. In estimating market value, the company considers such factors as forecasted consumer demand, market conditions and obsolescence.

3. The company includes the statement about the possibility of being exposed to losses in excess of amounts recorded as a way to alert the statement reader that if various factors result in a decline in the value of its inventory the company would need to write it down and recognize a loss.


MAKING FINANCIAL DECISIONS

LO 2,3,4 DECISION CASE 5-4 GROSS PROFIT FOR A MERCHANDISER

1. According to the income statement prepared by the controller, Emblems’ gross profit ratio is $6,750/$15,000, or 45%.

2. Emblems should not lower its selling price. On the surface, it appears that it should, given that the industry standard for gross margin is 40%. Emblems’ real gross profit, however, is not 45%. The reason is that the controller failed to include two important product costs in cost of sales: shipping and labeling. In error, the controller is ex-pensing all shipping and labeling costs as incurred, rather than treating them as product costs. The correct gross profit is as follows:

Selling price $ 20.00 per unitCosts per unit:

Purchase price $10.00Tax (10%) 1.00Shipping 0.50Labeling 0.75

Total cost per unit 12.25 Gross profit per unit $ 7.75× number of units sold 750 Gross profit $5,812.50

Thus, the correct gross profit ratio is $5,812.50/$15,000, or 38.75%. On the basis of this new ratio, Emblems is slightly under the industry standard of 40%, and it should not lower its selling price.

LO 2,3,4 DECISION CASE 5-5 PRICING DECISION

1. Cost per pound $5.00Add: sales tax (5% × $5.00) 0.25 Gross cost $5.25Less: purchase discount (2% × 5.25) 0.11 Net cost $5.14Add: shipping 0.05

box 0.70 Total cost $5.89

2. Selling price – $5.89 = 40% (selling price)

60% (selling price) = $5.89

Selling price = $9.82


3. Before deciding whether this is a sufficient profit, Caroline’s Candy should check in-dustry averages and the price its local competition is charging. If the price charged is too much higher than that of the competition, even if its product is superior, Caro-line’s may not generate as many sales as it needs to cover other costs, such as wages and commissions for employees, rent, utilities, insurance, advertising, and a return on owners’ investment. If its prices are much lower than that of the competi-tion, it may not be generating as much profit as it reasonably could.

LO 3 DECISION CASE 5-6 USE OF A PERPETUAL INVENTORY SYSTEM

1. Memo to Darrell:

The purpose of this memo is to clarify for you the costs and benefits of a perpetual inventory system. The purpose of a perpetual system is to provide a continuously updated record of the number of units and cost of all inventory items. A perpetual system is more costly to maintain because of the need to update the records each time purchases and sales are made. It is likely that you will want to consider a com-puterized inventory system. Numerous software packages are available, and one should be chosen that is particularly suitable to your business.

As mentioned earlier, a perpetual inventory system is considerably more costly to implement and maintain than a periodic system. A perpetual system would involve an investment in a scanning device and the other necessary hardware and software. The next step would be to explore the options available to us and the cost of each. Please call me at your convenience to set up an appointment to discuss these mat-ters further.

2. The suitability of a perpetual inventory system is certainly dependent on the type of products a company sells. The system is ideally suited to a product such as automo-biles, since there is a relatively low volume of sales. On the other hand, it might not be well suited to the needs of a landscaper selling trees, shrubs, and plants. The turnover of products is very high, and it may not be practical to update the records each time a sale takes place.

LO 6,7 DECISION CASE 5-7 INVENTORY COSTING METHODS

1. Georgetown must use the periodic inventory system at least for the first year be-cause it did not keep a record of the cost of the units sold as each sale was made.

2. Units on hand at the end of the year:Jan. 1,000March 1,200Oct. 1,500Available 3,700Sold 3,000On hand 700


3. Unless a company specifically identifies the cost of each unit sold, it must adopt an assumption about which particular units were sold. Each of the inventory costing methods takes the pool of costs (cost of goods available for sale) and makes an as-sumption about which units were sold and which units remain on hand.

Because inventory costs have increased during the first year, the company could minimize taxes paid by adopting LIFO. A comparison of partial income statements with the use of FIFO and LIFO highlights the taxes that could be saved in the first year:

FIFO LIFOSales revenue* $45,000 $45,000Cost of goods sold** 24,800 25,500 Gross profit $20,200 $19,500

*3,000 units sold at $15 each.

** 1,000 × $8 = $ 8,0001,200 × 8 = 9,6001,500 × 9 = 13,500

Available 3,700 $31,100

Ending inventory:FIFO 700 × $9 = $6,300LIFO 700 × $8 = $5,600

Cost of goods sold:FIFO $31,100 – $6,300 = $24,800LIFO $31,100 – $5,600 = $25,500

Conclusion: All expenses other than cost of goods sold are not affected by the use of one inventory method rather than another. Thus, the lower gross profit with the use of the LIFO method will result in income before taxes that is $20,200 – $19,500, or $700 less than if FIFO was used. Because the expected tax rate is 35%, the company will save $700 × 0.35 or $245 by using LIFO.

LO 8 DECISION CASE 5-8 INVENTORY ERRORS

The first error resulted in an overstatement of the ending inventory in 2005 by $45,600. Thus, cost of goods sold in 2005 was understated, and gross profit was overstated by the same amount. The effect on net income would be less than the amount of overstate-ment of gross profit because of the effect of taxes.

The second error was the result of not applying the lower of cost or market rule to the inventory at the end of 2006. If the cost of certain inventory was $6,000 higher than its replacement cost, the inventory should have been written down and a loss recog-nized.


The error that was made in the second quarter of the current year can be corrected before the release of the 2007 financial statements. The company should explain the nature of the error in the annual report: that an understatement of inventory at the end of the second quarter led to an understatement of the income reported in that quarter. The first two errors, if material in amount, require a restatement of the financial state-ments of the years involved.

ETHICAL DECISION MAKING

LO 2 DECISION CASE 5-9 SALES RETURNS AND ALLOWANCES

1. The sales manager is interested in reporting the maximum amount of sales. Al-though the net amount of sales will be the same regardless of whether returns are recorded separately or simply netted against sales revenue, the manager would pre-fer not to call attention to the level of returns. It is unlikely that the manager truly feels the present practice is a waste of time.

2. The sales manager’s recommendation might save a small amount of bookkeeping time, but at the same time it would sacrifice certain information. Management needs to be aware of unreasonably high levels of returns of merchandise so that it can make whatever adjustments are necessary. If Sales Revenue is simply reduced for the amount of returns, this information will not be available.

3. Memo to the sales manager:

I received your suggestion that we save time and effort by treating sales returns as a direct reduction of sales rather than a separate item in our financial statements. I ap-preciate your interest in saving the company money, but we would lose valuable in-formation by not tracking sales returns. It is imperative that we know whether our customers are satisfied with their purchases, and separate accounting recognition for sales returns is an important control feature in this respect. Please call me if I can answer any questions you might have concerning this matter.

LO 7 DECISION CASE 5-10 SELECTION OF AN INVENTORY METHOD

1. The CEO is primarily concerned with reporting the highest amount of income possi-ble. Thus, the CEO will be satisfied if the company uses the FIFO method. This method recognizes as cost of goods sold the oldest costs, and because prices are rising, the costs charged to cost of goods sold will be less than if LIFO is used.

2. It would be difficult to state definitively which method is truly in the best interests of the stockholders. The LIFO method minimizes the amount of income taxes paid in the first year, since this method would report the highest cost of goods sold and thus the lowest income before taxes. From a cash flow perspective, LIFO is the most ad-vantageous method in a period of rising prices.


3. Memo to the CEO:

TO: CEO


DATE: 12/31/XX

SUBJECT: Inventory methods

As we end our first year of operations, I am aware of the need to present a favorable impression to our stockholders. In this regard, I would like to address the selection of an inventory valuation method.

I can appreciate your interest in maximizing income whenever possible. How-ever, a method of inventory valuation that addresses this objective will not necessar-ily satisfy our other concerns. Certainly one of our primary concerns should be to minimize the payment of taxes whenever possible.

Because our inventory purchase costs are rising, FIFO will result in the lowest amount reported as cost of goods sold and thus an income number that is higher than if LIFO was used. For this reason, however, the use of FIFO will result in a higher amount of taxes payable than if LIFO was used. It is my opinion that we should attempt to conserve cash whenever possible, and thus I believe we should adopt the LIFO method of inventory valuation.

Thank you for the opportunity to present my views on this important matter. Please call if I can be of any further assistance.

LO 9 DECISION CASE 5-11 WRITE-DOWN OF OBSOLETE INVENTORY

1. The write-off of the inventory that has become obsolete would reduce the current year’s income. The amount of the reduction depends on the extent of the write-off. If the inventory is written off completely, the reduction in income will be equal to the book value of the inventory. If the inventory is written down to a lower amount, net income will be reduced by the amount of the write-down. This analysis ignores the effect of taxes.

2. If the inventory is not adjusted, total assets on the year-end balance sheet will be overstated.

3. The materiality of the obsolete inventory should be a major factor in a decision to persist in the argument that the inventory be written down. If the inventory in ques-tion is not material relative to the total assets of the company, the write-down may be unnecessary. The materiality of the loss that would be recognized from the write-down, relative to the income of the period, should also be considered.

4. If the inventory is not written down, readers do not have reliable information. Under the lower-of-cost-or-market rule, readers assume that if inventory is worth less than its cost, the inventory has in fact been written down to this lower amount.


REAL WORLD PRACTICE 5.1

Based on the nature of its products, The Finish Line would likely use a periodic inven-tory system. The company has a relatively high volume of sales at relatively low prices.

REAL WORLD PRACTICE 5.2

The Finish Line is a large merchandiser of athletic footwear and other apparel. The na-ture of this business requires the company to continually monitor its inventory for obso-lete products. If market is less than cost, the company should write down the inventory to reflect market value. The company uses the weighted-average method for determin-ing cost.

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