Inventories and Cost of Goods Sold parison

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					                                         CHAPTER 5

                                Inventories and
                               Cost of Goods Sold
 OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
                                                                                  Estimated
                                                                                   Time in
 Learning Outcomes                                                    Exercises    Minutes    Level
 1. Identify the forms of inventory held by different types of             1          10      Easy
    businesses and the types of costs incurred.                            2          10      Mod

 2. Show that you understand how wholesalers and retailers                 3          25      Mod
    account for sales of merchandise.                                      4          10      Easy
                                                                          20*         25      Mod
                                                                          21*         15      Mod

 3. Show that you understand how wholesalers and retailers                 5          15      Easy
    account for cost of goods sold.                                        6          20      Mod
                                                                           7          25      Mod
                                                                           8          20      Mod
                                                                           9          15      Mod
                                                                          20*         25      Mod
                                                                          21*         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      Mod
    and the measurement of income.                                        23*         20      Mod

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

 7. Analyze the effects of the different costing methods on               12          15      Mod
    inventory, 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      Mod
    statement items.                                                      14          20      Mod

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

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




                                                                                                  5-1
 5-2     FINANCIAL ACCOUNTING SOLUTIONS MANUAL



                                                                                  Estimated
                                                                                   Time 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      Easy
    statement of cash flows.                                              18          15      Mod
                                                                          19          15      Mod

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

 *Exercise, problem, or case covers two or more learning outcomes
  Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
                                                         CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD          5-3

                                                                            Problems     Estimated
                                                                               and        Time in
 Learning Outcomes                                                          Alternates    Minutes     Level
 1. Identify the forms of inventory held by different types of                 1           25             Mod
    businesses and the types of costs incurred.                               15*          20             Mod

 2. Show that you understand how wholesalers and retailers                     8*          45             Mod
    account for sales of merchandise.                                          9*          40             Mod
                                                                              10*          40             Mod

 3. Show that you understand how wholesalers and retailers                     8*          45             Mod
    account 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             Mod
    and the measurement of income.                                            12*          60             Diff
                                                                              13*          30             Mod
                                                                              14*          30             Mod

 6. Apply the inventory costing methods of specific identification,           11*          45             Mod
    weighted average, FIFO, and LIFO by using a periodic system.              13*          30             Mod
                                                                              14*          30             Mod

 7. Analyze the effects of the different costing methods on                    3           20             Mod
    inventory, net income, income taxes, and cash flow.                       11*          45             Mod
                                                                              12*          60             Diff
                                                                              13*          30             Mod
                                                                              14*          30             Mod
                                                                              15*          20             Mod
                                                                              16*          20             Mod

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

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

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

11. Analyze the management of inventory.                                        6          30             Mod

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

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

  *Exercise, problem, or case covers two or more learning outcomes
   Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
 5-4     FINANCIAL ACCOUNTING SOLUTIONS MANUAL



                                                                              Estimated
                                                                               Time in
 Learning Outcomes                                                    Cases    Minutes    Level
 1. Identify the forms of inventory held by different types of           1*       25      Mod
    businesses and the types of costs incurred.

 2. Show that you understand how wholesalers and retailers               4*       20      Mod
    account for sales of merchandise.                                    5*       20      Mod
                                                                         9        30      Mod


 3. Show that you understand how wholesalers and retailers               1*       25      Mod
    account for cost of goods sold.                                      4*       20      Mod
                                                                         5*       20      Mod
                                                                         6        25      Mod

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

 5. Explain the relationship between the valuation of inventory
    and the measurement of income.

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

 7. Analyze the effects of the different costing methods on              2        25      Mod
    inventory, net income, income taxes, and cash flow.                  3*       25      Mod
                                                                         7*       40      Mod
                                                                        10        30      Mod

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

 9. Apply the lower-of-cost-or-market rule to the valuation of           3*       25      Mod
    inventory.                                                          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).

 *Exercise, problem, or case covers two or more learning outcomes
  Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-5


                                    QUESTIONS


1. The three distinct types of costs incurred by a manufacturer are direct materials,
   direct labor, and manufacturing overhead. Direct, or raw, materials are the ingre-
   dients used in making a product. Direct labor consists of the amounts paid to factory
   workers to manufacture the product. Manufacturing overhead includes all the other
   costs that are related to the manufacturing process but cannot be directly matched
   to specific units of output.
2. The use of a contra revenue account to record cash refunds and other types of
   allowances allows a company to monitor the size and frequency of these occur-
   rences. For example, a relatively large amount of returns in any one period may be
   an indication 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.
 5-6    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




 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 prin-
    ciple. 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 specif-
    ic identification method, as would a jewelry company.
                                                 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-7


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
    example, 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 abili-
    ty 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 at 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 low-
    er 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.
 5-8    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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.
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-9


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 sa-
    lability 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.
5-10   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




                                     BRIEF EXERCISES



LO 1       BRIEF EXERCISE 5-1 TYPES AND FORMS OF INVENTORY COSTS FOR A
           MANUFACTURER

The three types of cost incurred by a manufacturer are direct or raw materials, direct
labor and manufacturing overhead. The three forms that inventory can take are direct or
raw materials, work in process or work in progress, and finished goods.


LO 2       BRIEF EXERCISE 5-2 NET SALES


Sales revenue                                  $ 85,000
Less: Sales returns and allowances                6,500
       Sales discounts                            6,500
Net sales                                      $ 72,000


LO 3       BRIEF EXERCISE 5-3 COST OF GOODS SOLD


Purchases: I
Beginning inventory: I
Purchase discounts: D
Transportation-in: I
Ending inventory: D
Purchase returns and allowances: D


LO 4       BRIEF EXERCISE 5-4 GROSS PROFIT RATIO


Gross profit ratio: ($50,000 – $30,000)/$50,000 = 40%


LO 5       BRIEF EXERCISE 5-5 VALUATION OF INVENTORY AND MEASUREMENT OF
           INCOME

Examples of costs that should be added to the purchase price of inventory are: freight
costs on purchases, insurance during the time inventory is in transit, storage costs be-
fore inventory is ready to be sold, and various taxes such as excise and sales taxes.
                                                CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-11


LO 6         BRIEF EXERCISE 5-6 INVENTORY COSTING METHODS


FIFO: 500 × $6 = $3,000
LIFO: 500 × $5 = $2,500


LO 7         BRIEF EXERCISE 5-7 SELECTING AN INVENTORY COSTING METHOD


Cost of goods sold: L
Gross profit: H
Income before taxes: H
Income taxes: H
Cash outflow: L


LO 8         BRIEF EXERCISE 5-8 INVENTORY ERROR


Net income will be overstated if the company overstated its ending inventory. Both in-
ventory and retained earnings on the balance sheet will be overstated.


LO 9         BRIEF EXERCISE 5-9 LOWER-OF-COST-OR-MARKET RULE


Loss on Decline in Value of Inventory                                       20,000
   Inventory                                                                                 20,000
To record decline in value of inventory.
                     BALANCE SHEET                                  INCOME STATEMENT
       Assets            =   Liabilities   + Stockholders’ Equity + Revenues – Expenses

 Inventory    (20,000)                                              Loss on Decline in
                                                                      Value of Inventory     (20,000)
5-12    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




LO 10       BRIEF EXERCISE 5-10 GROSS PROFIT METHOD


(1)    Net sales                                                 $100,000
       × estimated gross profit ratio                                0.25
       Estimated gross profit                                    $ 25,000
(2)    Net sales                                                 $100,000
       – estimated gross profit                                    25,000
       Estimated cost of goods sold                              $ 75,000
(3)    Beginning inventory                                       $ 20,000
       Add: Purchases                                              70,000
       Cost of goods available for sale                          $ 90,000
       Estimated cost of goods sold                                75,000
       Estimate of inventory destroyed                           $ 15,000


LO 11       BRIEF EXERCISE 5-11 INVENTORY TURNOVER


Company A’s inventory turnover is $10,000,000/$100,000 or 100 times. Company B’s
turnover is $10,000,000/$1,000,000 or 10 times. Company A with the much higher turn-
over is the wholesaler of fresh fruits and vegetables. Company B is the car dealer be-
cause its inventory would not turn over nearly as often given the nature of its products.


LO 12       BRIEF EXERCISE 5-12 CASH FLOW EFFECTS


The increase in inventory would be deducted from net income on the statement of cash
flows prepared using the indirect method since the buildup of inventory required cash
outflow. The increase in accounts payable would be added to net income since this in-
dicates a net cash inflow.


LO 13       BRIEF EXERCISE 5-13 INVENTORY METHODS USING A PERPETUAL SYSTEM


Yes, the dollar amount assigned to ending inventory will differ when a company uses
the average cost method, depending on whether a periodic or perpetual system is used.
This is because when the average method is applied in a perpetual system a new aver-
age has to be computed each time a purchase is made, resulting in a moving average.
                                                CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-13


                                    EXERCISES



LO 1      EXERCISE 5-1 CLASSIFICATION OF INVENTORY COSTS


                                      Raw            Work in          Finished Merchandise
Inventory Item                       Material        Process           Goods    Inventory
Fabric                                  X
Lumber                                  X
Unvarnished tables                                        X
Chairs on the showroom floor                                                                 X
Cushions                                X                X*
Decorative knobs                        X
Drawers                                                   X
Sofa frames                                               X
Chairs in the plant warehouse                                              X
Chairs 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                     $20,000
Less: 10% volume discount                         (2,000)
Freight costs                                         56
Insurance 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.
5-14   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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 Allow-
   ances.
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
   represents beginning inventory. Ending inventory is obtained by conducting a physi-
   cal count. Because you are not given the ending inventory figure, you cannot com-
   pute 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
                                                       CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD     5-15


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                                                               3,500
                Accounts Payable                                                                        3,500
             To record purchases of merchandise on credit.
                    BALANCE SHEET                                          INCOME STATEMENT
         Assets      =         Liabilities        + Stockholders’ Equity + Revenues – Expenses

                         Accounts Payable    3,500                         Purchases            (3,500)

July 6       Purchases                                                               7,000
                Accounts Payable                                                                        7,000
             To record the purchase of merchandise on credit.

                    BALANCE SHEET                                          INCOME STATEMENT
         Assets      =         Liabilities        + Stockholders’ Equity + Revenues – Expenses

                         Accounts Payable 7,000                            Purchases            (7,000)
5-16   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




July 12    Accounts Payable                                                            3,500
              Cash                                                                                      3,465
              Purchase Discounts                                                                           35
           To record payment on account:
           $3,500 – 0.01($3,500) = $3,465.

                     BALANCE SHEET                                           INCOME STATEMENT
       Assets            =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

Cash            (3,465) Accounts Payable (3,500)                             Purchase Discounts       35


August 5 Accounts Payable                                                              7,000
            Cash                                                                                        7,000
         To record payment on account.

                     BALANCE SHEET                                           INCOME STATEMENT
       Assets            =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

Cash            (7,000) Accounts Payable (7,000)



LO 3       EXERCISE 5-7 PURCHASES—PERIODIC SYSTEM


March 3      Purchases                                                                 2,500
                Accounts Payable                                                                        2,500
             To record purchases on credit.

                     BALANCE SHEET                                           INCOME STATEMENT
       Assets            =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

                             Accounts Payable    2,500                       Purchases            (2,500)


March 3      Transportation-in                                                           250
                Cash                                                                                        250
             To record payment of freight costs.

                     BALANCE SHEET                                           INCOME STATEMENT
       Assets            =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

Cash             (250)                                                       Transportation-in      (250)


March 7      Purchases                                                                 1,400
                Accounts Payable                                                                        1,400
             To record purchases on credit.

                     BALANCE SHEET                                           INCOME STATEMENT
       Assets            =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

                             Accounts Payable    1,400                       Purchases            (1,400)
                                                        CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD     5-17


March 12       Accounts Payable                                                       2,500
                  Cash                                                                                   2,450
                  Purchase Discounts                                                                        50
               To record payment for purchases on credit:
               $2,500 – 0.02($2,500) = $2,450.

                      BALANCE SHEET                                         INCOME STATEMENT
          Assets       =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

 Cash              (2,450) Accounts Payable (2,500)                         Purchase Discounts       50


March 15       Accounts Payable                                                         500
                  Purchase Returns and Allowances                                                          500
               To record credit on defective merchandise.

                      BALANCE SHEET                                         INCOME STATEMENT
          Assets       =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

                           Accounts Payable    (500)                        Purchase Returns
                                                                             and Allowances         500


March 18       Purchases                                                              1,600
                  Accounts Payable                                                                       1,600
               To record purchases on credit.

                      BALANCE SHEET                                         INCOME STATEMENT
          Assets       =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

                           Accounts Payable    1,600                        Purchases            (1,600)


March 22       Accounts Payable                                                         400
                  Purchase Returns and Allowances                                                          400
               To record credit on returned merchandise.

                      BALANCE SHEET                                         INCOME STATEMENT
          Assets       =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

                           Accounts Payable    (400)                        Purchase Returns
                                                                              and Allowances        400


April 6        Accounts Payable                                                         900
                  Cash                                                                                     900
               To record payment for purchases on
               credit: $1,400 – $500.

                      BALANCE SHEET                                         INCOME STATEMENT
          Assets       =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

 Cash              (900) Accounts Payable      (900)
5-18   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




April 18     Accounts Payable                                                   1,200
                Cash                                                                          1,200
             To record payment for purchases on
             credit: $1,600 – $400.

                     BALANCE SHEET                                     INCOME STATEMENT
       Assets         =       Liabilities      + Stockholders’ Equity + Revenues – Expenses

Cash            (1,200) Accounts Payable (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, 2008,
   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.
   Likewise, Miller should not include the sale on its 2008 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, 2008, the asset should
   be recognized on the year-end balance sheet. Similarly, Miller would record a sale in
   2008.


LO 3       EXERCISE 5-9 TRANSFER OF TITLE TO INVENTORY


Purchase of merchandise that is in transit from vendors to Cameron Companies on De-
cember 31, 2008:
D: Shipped FOB shipping point
J: Shipped FOB destination point

Sale of merchandise that is in transit to customers of Cameron Companies on Decem-
ber 31, 2008:
D: Shipped FOB shipping point
J: Shipped FOB destination point
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-19


LO 5      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 unders-
tatement 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 neces-
sary 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           = $1,100
      35 × $22           =    770
      45 × $23           = 1,035
        5 × $24          =    120
     140 units             $3,025

2. Ending inventory:
      45 × $24           = $1,080
      35 × $23           =    805
      80 units             $1,885
   Cost of goods sold:
      65 × $20 = $1,300
      50 × $22 = 1,100
      25 × $23 =          575
     140 units         $2,975
5-20    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




3. Ending inventory:
      65 × $20              = $1,300
      15 × $22              =    330
      80 units                $1,630
     Cost of goods sold:
        45 × $24 = $1,080
        60 × $23 = 1,380
        35 × $22 =          770
       140 units         $3,230

4. Cost of goods available for sale and units available:
      65 × $20 = $1,300
      50 × $22 = 1,100
      60 × $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: Ending inventory and cost of goods sold do not total $4,860 because of round-
     ing 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             Net
          Inventory                Earnings        Goods Sold         Income
1.            U                       U                O                 U
2.            O                       O                U                 O
3.            U                       U                O                 U
                                                 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-21


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 and it belongs to Michelson un-
   til arrival.
2. Filbrandt should include the costs of the merchandise in its inventory, since it has
   received the shipment by the end of the year.
3. Randall should include the merchandise in its inventory, since the shipment left
   James Bros. before the end of the year and it belongs to Randall upon shipment.
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                                                $ 15,400
       Add: Purchases                                                       84,230
       Cost of goods available for sale                                   $ 99,630
       Estimated cost of goods sold                                         78,975
       Estimate of inventory destroyed                                    $ 20,655

                       BALANCE SHEET                                 INCOME STATEMENT
        Assets          =     Liabilities   + Stockholders’ Equity + Revenues – Expenses

 Cash             10,000                                             Loss on Insurance
 Inventory       (20,655)                                             Settlement             (10,655)



LO 11        EXERCISE 5-16 INVENTORY TURNOVER FOR BEST BUY


1. Inventory turnover = cost of goods sold/average inventory $27,165/[($4,028 +
$3,338)/2] = $27,165/$3,683 = 7.38 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): 360/7.38 times = 48.8, or approximately 49 days.
5-22    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




3. It is difficult to determine from the information given whether 49 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 STA-
            TEMENT OF CASH FLOWS

Increase in accounts payable: Added to net income
Decrease in accounts payable: Deducted from net income
Increase in inventories: Deducted from net income
Decrease 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
2008 statement of cash flows (direct method):
        Inventory, December 31, 2007                                 $   180,400
        Plus: Purchases during 2008                                            X
        Less: Cost of goods sold during 2008                          (1,200,000)
        Inventory, December 31, 2008                                 $ 241,200
        $180,400 + X – $1,200,000 = $241,200
        X = $1,260,800
        Accounts payable, December 31, 2007                          $    85,400
        Plus: Purchases during 2008 (from above)                       1,260,800
        Less: Cash payments during 2008                                       (X)
        Accounts payable, December 31, 2008                          $    78,400
        $85,400 + $1,260,800 – X = $78,400
        X = $1,267,800
                                          CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-23


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,xxx
   Adjustments 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
5-24   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




                            MULTICONCEPT 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 profit = 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 profit – 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
                                                 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-25


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


                                LaPINE COMPANY
                              INCOME STATEMENT
                     FOR THE YEAR ENDED DECEMBER 31, 2008
Sales                                                                                        $80,000
Less: Sales returns and allowances                                          $     500
      Sales discounts                                                           1,200          1,700
Net sales                                                                                    $78,300
Less cost of goods sold:
   Beginning inventory                                                      $ 4,000
   Purchases                                              $30,000
   Less: Purchase returns and allowances                      400
          Purchase discounts                                  800
   Net purchases                                          $28,800
   Add: Transportation-in                                   1,000
   Cost of goods purchased                                                  29,800
   Cost of goods available for sale                                        $33,800
   Less: Ending inventory                                                    3,800
   Cost of goods sold                                                                         30,000
Gross profit                                                               $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   =   $ 2,000
           300   ×   $11   =     3,300
           400   ×   $12   =     4,800
           250   ×   $13   =     3,250
           150   ×   $15   =     2,250
         1,300                 $15,600
       Weighted average cost = $15,600/1,300 = $12 per unit
       Units available                   1,300
       Units sold                        1,000
       Units in ending inventory           300
       Cost of ending inventory = 300($12) = $3,600
       Cost of goods sold = 1,000($12) = $12,000
5-26   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




   b. FIFO method:
       Ending inventory cost:
         150 × $15 = $2,250
         150 × $13 = 1,950
         300             $4,200
       Cost of goods sold:
          200 × $10 = $ 2,000
          300 × $11 = 3,300
          400 × $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 = $2,000
         100 × $11 = 1,100
         300             $3,100
       Cost of goods sold:
          150 × $15 = $ 2,250
          250 × $13 = 3,250
          400 × $12 = 4,800
          200 × $11 = 2,200
        1,000           $12,500
       (OR: $15,600 – $3,100 = $12,500)

2. LIFO cost of goods sold                                    $12,500
   FIFO 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, higher income will be
   reported, and thus, higher taxes, $330, will be due using FIFO rather than LIFO.


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.
                                                      CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-27


    The effect of writing down inventory is the reduction of 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 Balance
1/1                                                                          200      $10       $2,000
2/12                                        150 $10          $1,500           50       10          500
                                                                                              1
3/5         300     $11    $3,300                                            350       10.857   $3,800
4/30                                        200    10.857      2,171         150       10.857    1,629
                                                                                              2
6/12        400      12     4,800                                            550       11.689    6,429
7/7                                         200    11.689      2,338         350       11.689    4,091
                                                                                              3
8/23        250      13     3,250                                            600       12.235    7,341
9/6                                         300    12.235      3,670         300       12.235    3,671
                                                                                              4
10/2        150      15     2,250                                            450       13.158    5,921
12/3                                        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
5-28   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




1. b. FIFO:
            Purchases                            Sales                      Balance
               Unit Total                         Unit     Total             Unit
Date    Units Cost Cost                  Units   Cost      Cost     Units    Cost Balance
1/1                                                                  200      $10   $2,000
2/12                                      150    $10       $1,500     50       10      500
3/5      300     $11    $3,300                                        50       10
                                                                     300       11    3,800
4/30                                       50        10       500
                                          150        11     1,650   150         11     1,650
6/12     400      12     4,800                                      150         11
                                                                    400         12     6,450
7/7                                       150        11     1,650
                                           50        12       600   350         12     4,200
8/23     250      13     3,250                                      350         12
                                                                    250         13     7,450
9/6                                       300        12     3,600    50         12
                                                                    250         13     3,850
10/2     150      15     2,250                                       50         12
                                                                    250         13
                                                                    150         15     6,100
12/3                                       50        12       600   150         13
                                          100        13     1,300   150         15    $4,200
                                Cost of goods sold        $11,400       Ending inventory
                                                  CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-29


1. c. LIFO:
             Purchases                         Sales                                Balance
                Unit Total                    Unit   Total                           Unit
Date     Units Cost Cost            Units     Cost   Cost               Units        Cost Balance
1/1                                                                     $200          $10   $2,000
2/12                                 150      $10        $1,500           50           10      500
3/5       300   $11   $3,300                                              50           10
                                                                         300           11    3,800
4/30                                 200          11       2,200          50           10
                                                                         100           11    1,600
6/12      400    12    4,800                                              50           10
                                                                         100           11
                                                                         400           12    6,400
7/7                                  200          12       2,400          50           10
                                                                         100           11
                                                                         200           12    4,000
8/23      250    13    3,250                                              50           10
                                                                         100           11
                                                                         200           12
                                                                         250           13    7,250
9/6                                  250          13       3,250          50           10
                                      50          12         600         100           11
                                                                         150           12    3,400
10/2      150    15    2,250                                              50           10
                                                                         100           11
                                                                         150           12
                                                                         150           15    5,650
12/3                                 150          15       2,250          50           10
                                                                         100           11
                                                                         150           12   $3,400
                             Cost of goods sold         $12,200               Ending inventory

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 Different
      FIFO              4,200    11,400                       4,200    11,400 Same
      LIFO              3,100    12,500                       3,400    12,200 Different
5-30   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




3. Cost of goods sold:
     LIFO                                                      $12,200
     FIFO                                                       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 taxa-
  ble income and lower income tax by $240.
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-31


                                    PROBLEMS


LO 1         PROBLEM 5-1 INVENTORY COSTS IN VARIOUS BUSINESSES


                                                      Accounting Treatment
                                                Expense of  Inventory      Other
Business             Types of Costs             the Period     Cost     Treatment
Retail shoe store    Shoes for sale                             X
                     Shoe boxes                                 X
                     Advertising signs              X
Grocery store        Canned goods                               X
                     Produce                                    X
                     Cleaning supplies                                      X*
                     Cash registers                                         X**
Frame shop           Wooden frame supplies                      X
                     Nails                                      X
                     Glass                                      X
Print shop           Paper                                      X
                     Copy machines                                          X**
                     Toner cartridges                                       X*
Restaurant           Frozen food                                X
                     China and silverware                                   X**
                     Prepared food                  X
                     Spices                         X
 *Record as an asset and charge to expense as used.
**Record as an asset and depreciate over estimated useful life.
5-32   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


1. Gross profit ratios (dollar amounts in millions):
   Wal-Mart: 2006: ($344,992 – $264,152)/$344,992 = $80,840/$344,992 = 23.4%
             2005: ($308,945 – $237,649)/$308,945 = $71,296/$308,945 = 23.1%
   Target:       2006: ($57,878 – $39,399)/$57,878 = $18,479/$57,878 = 31.9%
                 2005: ($51,271 – $34,927)/$51,271 = $16,344/$51,271 = 31.9%

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
   lowest 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.
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-33


LO 8      PROBLEM 5-4 INVENTORY ERROR


1. Revised income statements:                                     2008                      2007
     Revenues                                                   $20,000                   $15,000
     Cost of goods sold*                                         13,600                     9,400
         Gross profit                                           $ 6,400                   $ 5,600
     Operating expenses                                           3,000                     2,000
         Net income                                             $ 3,400                   $ 3,600
   *Because ending inventory in 2007 was understated, cost of goods sold was over-
    stated. Because beginning inventory in 2008 was understated, cost of goods sold
    was understated.
   Revised balance sheets:                                     12/31/08                  12/31/07
     Cash                                                       $ 1,700                   $ 1,500
     Inventory                                                    4,200                     4,100
     Other current assets                                         2,500                     2,000
     Long-term assets                                            15,000                    14,000
     Total assets                                              $23,400                   $21,600
     Liabilities                                                $ 8,500                   $ 7,000
     Capital stock                                                5,000                     5,000
     Retained earnings                                            9,900                     9,600
     Total liabilities and stockholders’ equity                $23,400                   $21,600

2. Net income for two years, before revision: $3,000 + $4,000 = $7,000
   Net income for two years, after revision: $3,600 + $3,400 = $7,000
   Thus, there is no net over- or understatement.
   Retained earnings at December 31, 2008, before the revision: $9,900
   Retained earnings at December 31, 2008, after the revision: $9,900
   Thus, 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.
5-34    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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

2. Journal entry:
   August 1 Loss on Insurance Settlement                                        29,600
            Cash*                                                               65,000
               Inventory                                                                          94,600
            To record insurance settlement
            from explosion.
   *Debit should be to a Receivable from Insurance Company if cash has not yet been
    received.

                       BALANCE SHEET                                    INCOME STATEMENT
        Assets          =      Liabilities      + Stockholders’ Equity + Revenues – Expenses

Cash              65,000                                                Loss on Insurance
Inventory        (94,600)                                                Settlement            (29,600)
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-35


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

1. Gross profit ratios:
                                  Apple Computer                          Hewlett-Packard
                                     (in millions)                          (in millions)
                                 2006            2005                     2006         2005
   Net sales/revenue           $ 19,315        $ 13,931                 $ 91,658      $ 86,696
   Less: Cost of sales/product 13,717             9,889                   55,248        52,550
   Gross profit                $ 5,598         $ 4,042                  $ 36,410      $ 34,146
   Divided by sales            ÷ 19,315        ÷ 13,931                 ÷ 91,658      ÷ 86,696
   Gross profit ratio            29.0%           29.0%                    39.7%         39.4%

2. Inventory turnover ratios:
   Apple Computer:
     $13,717/[($270 + $165/2] = $13,717/217.5 = 63.07 times
   Hewlett-Packard:
     $55,248/[($7,750 + $6,877)/2] = $55,248/$7,313.5 = 7.55 times

3. Apple’s gross profit ratio remained about the same in the two years and Hewlett-
   Packard’s ratio varied only slightly. The two companies’ turnover ratios are very dif-
   ferent. Another measure to consider is the number of days’ sales in inventory.
   Apple Computer:
     360/63.07 = 5.7 days
   Hewlett-Packard:
     360/7.55 = 47.7 days
   It takes Apple an average of less than six days to sell an item of inventory, whereas
   Hewlett-Packard requires nearly 48 days.
        On the basis of the gross profit ratio, Hewlett-Packard appears to be performing
   better, although Apple’s turnover ratio is much higher. However, the higher turnover
   ratio for Apple may be largely due to the nature of some of the products that Apple
   sells, such as its iPods which would be expected to turn over more quickly than
   computers.
        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.
5-36    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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 ANTIQUES
                             STATEMENT OF CASH FLOWS
                        FOR THE YEAR ENDED DECEMBER 31, 2008
   Net loss                                                                 $(33,200)
   Adjustments to reconcile net loss to net cash provided by
      operating activities:
          Decrease in inventory ($192,600 – $214,800)                         22,200
          Increase in accounts payable ($123,900 – $93,700)                   30,200
   Cash flows from operating activities                                     $ 19,200
   Cash, December 31, 2007                                                    46,100
   Cash, December 31, 2008                                                  $ 65,300

2. Memorandum to the president:
   TO:            President of Copeland Antiques
   FROM:          Student’s name
   DATE:          January 20, 2009
   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 2008 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 2008. 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.
                                                           CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD     5-37



                                MULTICONCEPT PROBLEMS


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


1. Journal entries:
   April 1      Purchases                                                                  500
                   Accounts Payable                                                                           500
                To record purchase of merchandise
                on account.

                    BALANCE SHEET                                              INCOME STATEMENT
       Assets           =         Liabilities         + Stockholders’ Equity + Revenues – Expenses

                            Accounts Payable    500                            Purchases              (500)


   April 10     Accounts Payable                                                           500
                   Cash                                                                                       485
                   Purchase Discounts                                                                          15
                To record payment on account:
                $500 × (1 – 0.03) = $485.

                    BALANCE SHEET                                              INCOME STATEMENT
       Assets           =         Liabilities         + Stockholders’ Equity + Revenues – Expenses

Cash             (485) Accounts Payable         (500)                          Purchase Discounts       15


   April 15     Cash                                                                       200
                   Sales Revenue                                                                              200
                To record cash sale.

                    BALANCE SHEET                                              INCOME STATEMENT
       Assets           =         Liabilities         + Stockholders’ Equity + Revenues – Expenses

Cash              200                                                          Sales Revenue           200


   April 18     Purchases                                                                  900
                   Accounts Payable                                                                           900
                To record purchase of merchandise
                on account.

                    BALANCE SHEET                                              INCOME STATEMENT
       Assets           =         Liabilities         + Stockholders’ Equity + Revenues – Expenses

                            Accounts Payable    900                            Purchases              (900)
5-38   FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-8 (Continued)

   April 25     Cash                                                                   600
                   Sales Revenue                                                                        600
                To record cash sales: 3 × $200.

                    BALANCE SHEET                                          INCOME STATEMENT
       Assets           =     Liabilities          + Stockholders’ Equity + Revenues – Expenses

Cash              600                                                      Sales Revenue          600


   April 28     Accounts Payable                                                       900
                   Cash                                                                                 873
                   Purchase Discounts (900 × 3%)                                                         27
                To record payment on account:
                $900 × (1 – 0.03) = $873.

                    BALANCE SHEET                                          INCOME STATEMENT
       Assets           =     Liabilities          + Stockholders’ Equity + Revenues – Expenses

Cash             (873) Accounts Payable        (900)                       Purchase Discounts      27

2. Net income for April:
      Sales revenue: $200 + $600                                                                   $ 800
      Cost of goods sold:
          Beginning inventory                                                      $       0
          Purchases: $500 + $900                                   $1,400
          Less: Purchase discounts $15 + $27                           42
          Net purchases                                                            1,358
             Cost of goods available for sale                                     $1,358
          Less: Ending inventory                                                     967
             Cost of goods sold                                                                      391
   Gross profit                                                                                    $ 409
   Operating expenses:
      Rent expense                                                                 $ 100
      Miscellaneous expense                                                           50
          Total operating expenses                                                                   150
   Net income                                                                                      $ 259
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD     5-39

PROBLEM 5-8 (Concluded)

3. Net cash flow from operating activities for April:
      Cash collected from sales: $200 + $600                                                    $ 800
      Cash paid for:
         Inventory: $485 + $873                                            $1,358
         Rent                                                                 100
         Miscellaneous                                                         50                1,508
      Net cash flow from operating activities                                                   $ (708)
   OR:
     Net income                                                                                 $ 259
     Deduct: 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.
5-40   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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 2/3/07 (millions of dollars):
   Cash                                                                            15,943
     Sales                                                                                       15,943

                     BALANCE SHEET                                        INCOME STATEMENT
       Assets            =    Liabilities         + Stockholders’ Equity + Revenues – Expenses
Cash            15,943                                                    Sales              15,943


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 2006 income statement (millions of dollars):
       Merchandise inventory, 1/28/06                                             $ 1,696
       Cost of goods purchased*                                                    10,394 (2)
       Cost of goods available for sale                                           $12,090 (1)
       Less merchandise inventory, 2/3/07                                          (1,796)
       Cost of goods sold**                                                       $10,294
    *Including occupancy expenses.
   **Described as cost of goods sold and occupancy expenses.
   (1) $10,294 + $1,796 = $12,090.
   (2) $12,090 – $1,696 = $10,394.
5. Gross profit ratios:
   (millions of dollars)                       2006              2005
   Sales                                    $ 15,943          $ 16,023
   Less cost of sales                           10,294            10,154
   Gross profit                             $ 5,649           $ 5,869
   Divided by sales                         ÷ $15,943         ÷ $16,023
   Gross profit ratio                         35.4%             36.6%
   Gap Inc.’s gross profit ratio decreased by 126% from 2005 to 2006. 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 lower gross
   profit ratios and selling those with higher gross profit ratios).
                                            CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-41


LO 2,3     PROBLEM 5-10 FINANCIAL STATEMENTS


1. Cost of goods sold for 2008:
     Beginning inventory                                                                $ 6,400
     Purchases                                                        $40,200
     Less: Purchase discounts                                             800
         Net purchases                                                $39,400
     Add: 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 2008:
      Sales                                                           $84,364
      Less: Sales returns                                                 780
          Net sales                                                                     $83,584
      Cost of goods sold (from Part 1)                                                   38,675
          Gross profit                                                                  $44,909
      Operating expenses:
          Salaries                                                    $25,600
          Advertising                                                   4,510
          Utilities                                                     3,600
          Depreciation                                                  2,300
              Total operating expenses                                                   36,010
   Income before tax                                                                    $ 8,899
      Income tax expense                                                                  3,200
   Net income                                                                           $ 5,699
5-42    FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-10 (Concluded)


3.                                         MAPLE INC.
                                         BALANCE SHEET
                                      AT DECEMBER 31, 2008
        Assets
     Current assets:
        Cash                                                 $     590
        Accounts receivable                                      2,359
        Inventory                                                7,500
        Interest receivable                                        100
            Total current assets                                         $10,549
     Property, plant, and equipment:
        Land                                                 $20,000
        Building and equipment, net                           55,550
            Total property, plant, and equipment                          75,550
     Total assets                                                        $86,099
        Liabilities
     Current liabilities:
        Salaries payable                                     $     650
        Income tax payable                                       3,200
           Total liabilities                                             $ 3,850
        Stockholders’ Equity
     Capital stock                                           $50,000
     Retained earnings                                        32,249*     82,249
     Total liabilities and stockholders’ equity                          $86,099
     *Beginning retained earnings + Net income – Dividends
             $32,550              + $5,699     – $6,000
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-43


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

1.                                              Cost of               Ending
                                              Goods Sold             Inventory               Total
     a. Weighted average                       $11,084                 $4,988              $16,072
     b. FIFO                                    10,776                  5,296               16,072
     c. LIFO                                    11,452                  4,620               16,072
     a. Beginning inventory     600   × $5.00 = $ 3,000
        Oct. 8                  800   × 5.40 =    4,320
        Oct. 18                 700   × 5.76 =    4,032
        Oct. 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 = $4,720
         100 × 5.76 =          576
         900                $5,296
       Cost of goods sold—FIFO:
         600 × $5.76 = $ 3,456
         800 × 5.40 =       4,320
         600 × 5.00 =       3,000
       2,000              $10,776
     c. Ending inventory—LIFO:
         600 × $5.00 = $3,000
         300 × 5.40 =        1,620
         900                $4,620
       Cost of goods sold—LIFO:
         500 × $5.40 = $ 2,700
         700 × 5.76 =       4,032
         800 × 5.90 =       4,720
       2,000              $11,452
5-44    FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-11 (Concluded)

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:
                                                      Weighted
                                                      Average        FIFO           LIFO
     Sales*                                           $20,800      $20,800        $20,800
     Cost of goods sold                                11,084       10,776         11,452
     Gross profit                                     $ 9,716      $10,024        $ 9,348
     Operating expenses                                 3,000        3,000          3,000
     Income before taxes                              $ 6,716      $ 7,024        $ 6,348
     Income 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                   $2,107
     LIFO tax                    1,904
     Difference                 $ 203


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

1.                                                Cost of     Ending
                                                Goods Sold   Inventory         Total
     a. Moving average                           $10,785       $5,287        $16,072
     b. FIFO                                      10,776        5,296         16,072
     c. LIFO                                      10,852        5,220         16,072
                                                        CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD    5-45

PROBLEM 5-12 (Continued)

   a. Moving average:
             Purchases                               Sales                                Balance
                Unit Total                          Unit   Total                            Unit
Date     Units Cost Cost                  Units     Cost   Cost                Units       Cost Balance
10/1                                                                            600       $5      $3,000
10/4                                      500      $5          $2,500           100        5         500
10/8         800 $5.40    $4,320                                                900        5.3561         4,820
10/9                                      700       5.356        3,749          200        5.356          1,071
10/18        700   5.76    4,032                                                900        5.672          5,103
10/20                                     800       5.67         4,536          100        5.67             567
10/29        800   5.90    4,720                                                900        5.8743        $5,287
                               Cost of goods sold             $10,785               Ending inventory
        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:
             Purchases                               Sales                                Balance
                Unit Total                          Unit   Total                            Unit
Date     Units Cost Cost                  Units     Cost   Cost                Units       Cost Balance
10/1                                                                            600       $5      $3,000
10/4                                      500      $5          $2,500           100        5         500
10/8         800 $5.40    $4,320                                                100        5
                                                                                800        5.40    4,820
10/9                                      100       5              500
                                          600       5.40         3,240          200        5.40           1,080
10/18        700   5.76    4,032                                                200        5.40
                                                                                700        5.76           5,112
10/20                                     200       5.40         1,080
                                          600       5.76         3,456          100        5.76            576
10/29        800   5.90    4,720                                                100        5.76
                                                                                800        5.90          $5,296
                               Cost of goods sold             $10,776               Ending inventory
5-46    FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-12 (Concluded)

   c. LIFO:
             Purchases                              Sales                     Balance
                Unit Total                         Unit   Total                 Unit
Date     Units Cost Cost                  Units    Cost   Cost      Units      Cost Balance
10/1                                                                 600      $5      $3,000
10/4                                       500    $5      $2,500     100       5         500
10/8      800 $5.40      $4,320                                      100       5
                                                                     800       5.40    4,820
10/9                                       700    5.40      3,780    100       5
                                                                     100       5.40    1,040
10/18     700    5.76     4,032                                      100       5
                                                                     100       5.40
                                                                     700       5.76    5,072
10/20                                      700    5.76      4,032
                                           100    5.40        540    100       5           500
10/29     800    5.90     4,720                                      100       5
                                                                     800       5.90    $5,220
                                 Cost of goods sold      $10,852        Ending inventory

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:
                                                   Moving
                                                  Average             FIFO              LIFO
   Sales*                                         $20,800           $20,800           $20,800
   Cost of goods sold                              10,785            10,776            10,852
   Gross profit                                   $10,015           $10,024           $ 9,948
   Operating expenses                               3,000             3,000             3,000
   Income before taxes                            $ 7,015           $ 7,024           $ 6,948
   Income 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

4. The company will pay $23 more in taxes if it uses FIFO:
   FIFO tax                     $2,107
   LIFO tax                      2,084
   Difference                   $ 23
                                          CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-47


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


1. Units in beginning inventory                                                              200
   Add: units purchased (250 + 220 + 150 + 200)                                              820
   Units available                                                                         1,020
   Less: units sold (300 + 380 + 110)                                                        790
   Units in ending inventory                                                                 230
                                            Ending              Cost of
                                           Inventory          Goods Sold                Total
  a. FIFO                                    $4,410            $14,663                $19,073
  b. LIFO                                     4,155             14,918                 19,073
  c. 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 = $ 3,600
       250 × 18.50 =        4,625
       220 × 18.90 =        4,158
       120 × 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 = $ 4,070
       220 × 18.90 =        4,158
       150 × 19.00 =        2,850
       200 × 19.20 =        3,840
       790                $14,918
  c. Beginning inventory     200   × $18.00 = $ 3,600
     Nov. 4                  250   × 18.50 =    4,625
     Nov. 13                 220   × 18.90 =    4,158
     Nov. 18                 150   × 19.00 =    2,850
     Nov. 24                 200   × 19.20 =    3,840
                           1,020              $19,073
      Weighted average cost = $19,073/1,020 = $18.699
      Ending inventory = 230 × $18.699 = $4,301
      Cost of goods sold = 790 × $18.699 = $14,772
5-48    FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-13 (Concluded)

2.                                                                     Weighted
                                                           FIFO          LIFO     Average
     Sales*                                              $33,480       $33,480    $33,480
     Cost of goods sold                                   14,663        14,918     14,772
     Gross profit                                        $18,817       $18,562    $18,708
     Operating 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    $ 3,908
     Income 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 =   $ 50,000
      Feb. 4                                     3,000   ×   9 =     27,000
      April 12                                   4,000   ×   8 =     32,000
      Sept. 10                                   2,000   ×   7 =     14,000
      Dec. 5                                     1,000   ×   6 =      6,000
                                                15,000             $129,000
        Weighted average cost = $129,000/15,000 = $8.60
        Units available for sale                15,000
        Units sold                              12,500
        Ending inventory                         2,500 × 8.60 =     $21,500
        Cost of goods sold                      12,500 × 8.60 =    $107,500

     b. FIFO:
        Ending inventory                         1,000 × $ 6 =     $  6,000
                                                 1,500 ×   7 =       10,500
                                                 2,500             $ 16,500
        Cost of goods sold                         500   × $7 =    $  3,500
                                                 4,000   ×  8 =      32,000
                                                 3,000   ×  9 =      27,000
                                                 5,000   × 10 =      50,000
                                                12,500             $112,500
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-49

PROBLEM 5-14 (Concluded)

   c. LIFO:
      Ending inventory                 2,500 × $10 =           $ 25,000
      Cost of goods sold              2,500    × $10 =        $ 25,000
                                      3,000    ×   9 =          27,000
                                      4,000    ×   8 =          32,000
                                      2,000    ×   7 =          14,000
                                      1,000    ×   6 =           6,000
                                     12,500                   $104,000

2. Income statements for the year ended December 31, 2008:
                                            Weighted
                                            Average                 FIFO                 LIFO
   Sales*                                   $150,000               $150,000             $150,000
   Cost of goods sold                         107,500               112,500              104,000
   Gross profit                              $ 42,500              $ 37,500             $ 46,000
   Operating expenses                          20,000                20,000               20,000
   Income before taxes                       $ 22,500              $ 17,500             $ 26,000
   Income 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 GANNETT CO.’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. Although Gannett has determined FIFO is ap-
   propriate for most of its inventories, it does use LIFO for certain U.S. newspapers.
5-50   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


1. No, the use of the last-in, first-out method for some of its merchandise inventories
   does not mean that Sears always sells its newest merchandise first. Actually, the
   physical flow of merchandise in most stores like Sears and Kmart 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.
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-51


                            ALTERNATE PROBLEMS


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 DVDs for Rent 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:     2007: ($35,934 – $27,165)/$35,934 = $8,769/$35,934 = 24.4%
                 2006: ($30,848 – $23,122)/$30,848 = $7,726/$30,848 = 25.0%
   Circuit City: 2007: ($12,430 – $9,501)/$12,430 = $2,929/$12,430 = 23.6%
                 2006: ($11,514 – $8,704)/$11,514 = $2,810/$11,514 = 24.4%

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.
5-52   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


1. No, the three companies will not be equally affected by 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 reve-
       nues of the period.


LO 8       PROBLEM 5-4A INVENTORY ERROR


1. Revised income statements:                                 2008              2007
     Revenues                                               $35,982           $26,890
     Cost of goods sold*                                     12,094            10,412
         Gross profit                                       $23,888           $16,478
     Operating expenses                                      13,488            10,578
         Net income                                         $10,400           $ 5,900
   *Because ending inventory in 2007 was overstated, cost of goods sold was unders-
    tated. Because beginning inventory in 2008 was overstated, cost of goods sold was
    overstated.
   Revised balance sheets:                                  12/31/08          12/31/07
     Cash                                                   $ 9,400           $ 4,100
     Inventory                                                4,500             4,900
     Other current assets                                     1,600             1,250
     Long-term assets, net                                   24,500            24,600
     Total assets                                           $40,000           $34,850
     Current liabilities                                    $ 9,380           $10,600
     Capital stock                                           18,000            18,000
     Retained earnings                                       12,620             6,250
     Total liabilities and stockholders’ equity             $40,000           $34,850
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-53

PROBLEM 5-4A (Concluded)

2. Current ratio:

                        Cash + Inventory + Other currentassets
   Before revision:
                                   Currentliabilities

                      $4,100 + $5,400 + 1,250   $10,750
                                              =         = 1.01 to 1
                              $10,600           $10,600

                      $4,100 + $4,900 + 1,250   $10,250
   After revision:                            =         = 0.97 to 1
                              $10,600           $10,600

   Yes, if the lender required a current ratio of at least 1 to 1, Planter would have been
   eligible for the loan with the error. After the correction, however, Planter would not
   have been eligible for the loan. The company should notify the bank of the error.
   Practically, 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, 2008, before the revision: $12,620.
   Retained earnings at December 31, 2008, after the revision: $12,620.
   Thus, there is no over- or understatement of retained earnings at December 31,
   2008.

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.
5-54    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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

2. Journal entry:
   July 1        Loss on Insurance Settlement                                    8,650
                 Cash*                                                          50,000
                    Inventory                                                                   58,650
                 To record insurance settlement
                 from explosion.

                     BALANCE SHEET                                      INCOME STATEMENT
        Assets        =        Liabilities      + Stockholders’ Equity + Revenues – Expenses

Cash 50,000                                                             Loss on Insurance
Inventory (58,650)                                                       Settlement         (8,650)

   *Debit should be to a Receivable from Insurance Company if cash has not yet been
    received.
                                            CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-55


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



1. Inventory turnover ratios:
   Wal-Mart:
     $264,152/[($33,685 + $31,910)/2] = $264,152/$32,797.5 = 8.05 times
   Target:
      $39,399/[($6,254 + $5,838)/2] = $39,399/$6,046 = 6.52 times

2. Wal-Mart’s inventory turnover is higher than Target’s during the most recent fiscal
   year, 8.05 versus 6.52. Another measure to consider is the number of days’ sales in
   inventory:
   Wal-Mart:
     360/8.05 = 44.7 days
   Target:
      360/6.52 = 55.2 days

   It takes Wal-Mart an average of 45 days to sell an item of inventory; Target requires
   an average of 55 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—with the same measures for prior years. It would also be helpful
   to compare these measures with the industry averages.
5-56    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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

1. Statement of cash flows:
                                  CARPETLAND CITY
                             STATEMENT OF CASH FLOWS
                        FOR THE YEAR ENDED DECEMBER 31, 2008
   Net income                                                                  $ 78,500
   Adjustments 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, 2007                                                      26,300
   Cash, December 31, 2008                                                    $ 14,400

2. Memorandum to the president:
   TO:              President of Carpetland City
   FROM:            Student’s name
   DATE:            January 20, 2009
   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 2008 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.
                                                         CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD       5-57


                 ALTERNATE MULTICONCEPT PROBLEMS


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


1. Journal entries:
   Oct. 1       Purchases                                                                249
                   Accounts Payable                                                                           249
                To record purchase of merchandise
                on account.

                    BALANCE SHEET                                            INCOME STATEMENT
       Assets           =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

                            Accounts Payable     249                         Purchases              (249)


   Oct. 10      Accounts Payable                                                         249
                   Cash                                                                                       244
                   Purchase Discounts                                                                           5
                To record payment on account:
                $249 × (1 – 0.02) = $244.

                    BALANCE SHEET                                            INCOME STATEMENT
       Assets           =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

Cash             (244) Accounts Payable         (249)                        Purchase Discounts           5


   Oct. 15      Cash                                                                     200
                   Sales Revenue                                                                              200
                To record cash sale.

                    BALANCE SHEET                                            INCOME STATEMENT
       Assets           =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

Cash              200                                                        Sales Revenue           200


   Oct. 18      Purchases                                                                800
                   Accounts Payable                                                                           800
                To record purchase of merchandise
                on account.

                    BALANCE SHEET                                            INCOME STATEMENT
       Assets           =         Liabilities       + Stockholders’ Equity + Revenues – Expenses

                            Accounts Payable     800                         Purchases                (800)
5-58   FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-8A (Concluded)

   Oct. 25      Cash                                                                  600
                   Sales Revenue                                                                        600
                To record cash sales: 3 × $200.

                    BALANCE SHEET                                          INCOME STATEMENT
       Assets           =     Liabilities          + Stockholders’ Equity + Revenues – Expenses

Cash              600                                                      Sales Revenue          600


   Oct. 30      Accounts Payable                                                      800
                   Cash                                                                                 800
                To record payment on account.

                    BALANCE SHEET                                          INCOME STATEMENT
       Assets           =     Liabilities          + Stockholders’ Equity + Revenues – Expenses

Cash             (800) Accounts Payable        (800)


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

3. Cash balance at end of month:
     Beginning cash balance                                                       $2,000
     October 10 payment                                                             (244)
     October 15 sale                                                                 200
     October 25 sale                                                                 600
     October 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).
                                                    CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD     5-59


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 8/31/06: (in millions)
   Cash                                                                           1,396.3
      Accounts Receivable                                                                            1,396.3
   To record collection of beginning accounts receivable.

                      BALANCE SHEET                                     INCOME STATEMENT
       Assets          =         Liabilities   + Stockholders’ Equity + Revenues – Expenses

Cash                    1,396.3
Accounts Receivable    (1,396.3)


   Accounts Receivable                                                          47,409.0
      Sales                                                                                      47,409.0
   To record sales on account.

                      BALANCE SHEET                                     INCOME STATEMENT
       Assets          =         Liabilities   + Stockholders’ Equity + Revenues – Expenses

Accounts Receivable   47,409.0                                          Sales               47,409.0


   Cash                                                                         45,346.3
      Sales                                                                                      45,346.3
   To record cash collections: $47,409.0 – $2,062.7

                      BALANCE SHEET                                     INCOME STATEMENT
       Assets          =         Liabilities   + Stockholders’ Equity + Revenues – Expenses

Cash                  45,346.3                                          Sales               45,346.3

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 2006 income statement: (in millions)
     Merchandise inventory, August 31, 2005                                            $ 5,592.7
     Cost of goods purchased                                                            34,698.1 (2)
     Cost of goods available for sale                                                  $40,290.8 (1)
     Less merchandise inventory, August 31, 2006                                        (6,050.4)
     Cost of goods sold                                                                $34,240.4
   (1) $34,240.4 + $6,050.4 = $40,290.8.
   (2) $40,290.8 – $5,592.7 = $34,698.1.
5-60   FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-9A (Concluded)

4. Gross profit ratios:
   (In millions)                                        2006                 2005
   Net sales                                         $ 47,409.0           $ 42,201.6
   Cost of sales                                       34,240.4             30,413.8
   Gross profit                                      $ 13,168.6           $ 11,787.8
   Divided by net sales                              ÷ 47,409.0           ÷ 42,201.6
   Gross profit ratio                                  27.8%                27.9%
   Walgreen’s gross profit ratio was virtually unchanged from 2005 to 2006. 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 2,3       PROBLEM 5-10A FINANCIAL STATEMENTS


1. Cost of goods sold for 2008:
     Beginning inventory                                                 $ 6,400
     Purchases                                              $62,845
     Less: Purchase discounts                                 1,237
     Net purchases                                          $61,608
     Add: Transportation-in                                     375
     Cost of goods purchased                                              61,983
     Cost of goods available for sale                                    $68,383
     Less: Ending inventory                                                5,900
         Cost of goods sold                                              $62,483

2. Net income for 2008:
      Sales                                               $112,768
      Less: Sales returns                                    1,008
          Net sales                                                     $111,760
      Cost of goods sold (from Part 1)                                    62,483
          Gross profit                                                  $ 49,277
      Operating expenses:
          Wages and salaries expense                       $ 23,000
          Advertising expense                                12,900
          Utilities expense                                   1,800
              Total operating expenses                                    37,700
      Income before tax                                                 $ 11,577
          Income tax expense                                               1,450
      Net income                                                        $ 10,127
                                                  CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-61

PROBLEM 5-10A (Concluded)

3.                                     LLOYD INC.
                                     BALANCE SHEET
                                  AT DECEMBER 31, 2008
        Assets
     Cash                                                           $22,340
     Accounts receivable                                             56,359
     Inventory                                                        5,900
        Total assets                                                                 $84,599
        Liabilities
     Salaries payable                                               $     650
     Wages payable                                                        120
     Income tax payable                                                 1,450
     Total liabilities                                                               $ 2,220
        Stockholders’ Equity
     Capital stock                                                  $50,000
     Retained 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
5-62    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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

1.                                               Cost of        Ending
                                                Goods Sold     Inventory    Total
     a. Weighted average                          $5,120         $4,655    $9,775
     b. FIFO                                       4,875          4,900     9,775
     c. LIFO                                       5,375          4,400     9,775
     a. Beginning inventory                       300   × $4.00 = $1,200
        Nov. 8                                    500   × 4.50 = 2,250
        Nov. 18                                   700   × 4.75 = 3,325
        Nov. 29                                   600   × 5.00 = 3,000
                                                2,100             $9,775
        Weighted average cost = $9,775/2,100 = $4.655
        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 = $1,200
         500 ×     4.50 =    2,250
         300 ×     4.75 =    1,425
       1,100                $4,875
     c. Ending inventory—LIFO:
          300 × $4.00 = $1,200
          500 ×     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
                                            CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-63

PROBLEM 5-11A (Concluded)

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:
                                             Weighted
                                             Average                FIFO                  LIFO
     Sales*                                  $10,100              $10,100               $10,100
     Cost of goods sold                        5,120                4,875                 5,375
     Gross profit                            $ 4,980              $ 5,225               $ 4,725
     Operating expenses                        2,000                2,000                 2,000
     Income before taxes                     $ 2,980              $ 3,225               $ 2,725
     Income tax expense (25%)                    745                  806                   681
     Net income                              $ 2,235              $ 2,419               $ 2,044
     *Sales = 200($9) + 500($9) + 400($9.50) = $10,100

4. The company will pay $125 more in taxes if it uses FIFO:
      FIFO tax               $806
      LIFO tax                681
      Difference             $125


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

1.                                       Cost of              Ending
                                        Goods Sold           Inventory                Total
     a. Moving average                    $4,892               $4,883                $9,775
     b. FIFO                               4,875                4,900                 9,775
     c. LIFO                               4,950                4,825                 9,775
5-64    FINANCIAL ACCOUNTING SOLUTIONS MANUAL



PROBLEM 5-12A (Continued)

   a. Moving average:
             Purchases                               Sales                         Balance
                Unit Total                            Unit    Total                  Unit
Date     Units Cost Cost                   Units     Cost     Cost         Units    Cost Balance
11/1                                                                        300    $4      $1,200
11/4                                       200      $4       $ 800          100     4         400
11/8         500 $4.50    $2,250                                            600     4.4171    2,650
11/9                                       500       4.417    2,209         100     4.417       441
11/18        700   4.75    3,325                                            800     4.7082    3,766
11/20                                      400       4.708    1,883         400     4.708     1,883
11/29        600   5.00    3,000                                           1,000    4.8833   $4,883
                                 Cost of goods sold          $4,892            Ending inventory
        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 = $ 441
             700 ×     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:
             Purchases                               Sales                         Balance
                Unit Total                            Unit    Total                  Unit
Date     Units Cost Cost                   Units     Cost     Cost         Units    Cost Balance
11/1                                                                        300    $4      $1,200
11/4                                       200      $4       $ 800          100     4         400
11/8         500 $4.50    $2,250                                            100     4
                                                                            500     4.50    2,650
11/9                                       100       4          400
                                           400       4.50     1,800         100     4.50          450
11/18        700   4.75    3,325                                            100     4.50
                                                                            700     4.75      3,775
11/20                                      100       4.50       450
                                           300       4.75     1,425         400     4.75      1,900
11/29        600   5.00    3,000                                            400     4.75
                                                                            600     5.00     $4,900
                                 Cost of goods sold          $4,875            Ending inventory
                                                    CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-65

PROBLEM 5-12A (Concluded)

   c. LIFO:
             Purchases                          Sales                                 Balance
                Unit Total                       Unit       Total                       Unit
Date     Units Cost Cost               Units    Cost        Cost           Units       Cost Balance
11/1                                                                        300       $4      $1,200
11/4                                   200     $4          $ 800            100        4         400
11/8      500 $4.50    $2,250                                               100        4
                                                                            500        4.50    2,650
11/9                                   500     4.50          2,250          100        4         400
11/18     700   4.75    3,325                                               100        4
                                                                            700        4.75    3,725
11/20                                  400     4.75          1,900          100        4
                                                                            300        4.75    1,825
11/29     600   5.00    3,000                                               100        4
                                                                            300        4.75
                                                                            600        5      $4,825
                             Cost of goods sold            $4,950               Ending inventory

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:
                                                      Moving
                                                     Average                FIFO                  LIFO
   Sales*                                            $10,100              $10,100               $10,100
   Cost of goods sold                                  4,892                4,875                 4,950
   Gross margin                                      $ 5,208              $ 5,225               $ 5,150
   Operating expenses                                  2,000                2,000                 2,000
   Income before taxes                               $ 3,208              $ 3,225               $ 3,150
   Income tax expense (25%)                              802                  806                   788
   Net income                                        $ 2,406              $ 2,419               $ 2,362
   *Sales = 200($9) + 500($9) + 400($9.50) = $10,100

4. The company will pay $18 more in taxes if it uses FIFO:
       FIFO tax                 $806
       LIFO tax                  788
       Difference               $ 18
5-66   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


1. Units in beginning inventory                                                300
   Add: units purchased (375 + 330 + 225 + 300)                              1,230
   Units available                                                           1,530
   Less: units sold (450 + 570 + 165)                                        1,185
   Units in ending inventory                                                   345
                                                Ending       Cost of
                                               Inventory   Goods Sold     Total
  a. FIFO                                        $8,643     $31,190     $39,833
  b. LIFO                                         9,293      30,540      39,833
  c. 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 = $ 8,100
         375 × 26.50 =       9,938
         330 × 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 = $ 7,500
         225 × 25.40 =       5,715
         330 × 26.00 =       8,580
         330 × 26.50 =       8,745
       1,185               $30,540
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-67

PROBLEM 5-13A (Concluded)

     c. Beginning inventory                  300    × $27.00 = $ 8,100
        Nov. 4                               375    × 26.50 =    9,938
        Nov. 13                              330    × 26.00 =    8,580
        Nov. 18                              225    × 25.40 =    5,715
        Nov. 24                              300    × 25.00 =    7,500
                                           1,530               $39,833
        Weighted average cost = $39,833/1,530 = $26.035
        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.                                                                                      Weighted
                                                  FIFO                 LIFO              Average
     Sales*                                     $75,330              $75,330             $75,330
     Cost of goods sold                          31,190               30,540              30,851
     Gross profit                               $44,140              $44,790             $44,479
     Operating 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.
5-68   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


1. a. Weighted average:
      Beginning inventory                       4,000   × $20 =    $ 80,000
      Feb. 4                                    2,000   × 18 =       36,000
      April 12                                  3,000   × 16 =       48,000
      Sept. 10                                  1,000   × 14 =       14,000
      Dec. 5                                    2,500   × 12 =       30,000
                                               12,500              $208,000
       Weighted average cost = $208,000/12,500 = $16.64
       Units available for sale         12,500
       Units sold                       11,000
       Ending 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
       Cost of goods sold                       4,000   × $20 = $ 80,000
                                                2,000   × 18 =    36,000
                                                3,000   × 16 =    48,000
                                                1,000   × 14 =    14,000
                                                1,000   × 12 =    12,000
                                               11,000           $190,000
  c. LIFO:
     Ending inventory                           1,500 × $20 = $ 30,000
       Cost of goods sold                       2,500   × $12 = $ 30,000
                                                1,000   × 14 =    14,000
                                                3,000   × 16 =    48,000
                                                2,000   × 18 =    36,000
                                                2,500   × 20 =    50,000
                                               11,000           $178,000
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-69

PROBLEM 5-14A (Concluded)

2. Income statements for the year ended December 31, 2008:
                                             Weighted
                                             Average                FIFO                 LIFO
   Sales*                                    $330,000              $330,000             $330,000
   Cost of goods sold                         183,040               190,000              178,000
   Gross profit                              $146,960              $140,000             $152,000
   Operating expenses                          60,000                60,000               60,000
   Income before taxes                       $ 86,960              $ 80,000             $ 92,000
   Income 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. Newsprint costs
   are comparable to raw materials in a manufacturing company. A newspaper compa-
   ny, 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 a majority of the company’s inventory.
5-70   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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.
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-71


                                DECISION CASES


             READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1,3       DECISION CASE 5-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:
             KELLOGG’S AND GENERAL MILLS

1. Kellogg’s and General Mills are both manufacturers or producers.
2. Kellogg’s inventories amount to $823.9 million which represents $823.9/$10,714.0 or
   7.7% of its total assets. General Mills’ inventories amount to $1,055 million which
   represents $1,055/$18,207 or 5.8% of its total assets.
3. Kellogg’s uses the average cost method to value its inventory. One of the major ad-
   vantages of this method is its ease of use.
4. General Mills uses the LIFO and FIFO methods. The fact that Kellogg’s and General
   Mills use different methods does make it more difficult to compare the two compa-
   nies but not impossible. The reader of the statements needs to be aware that the
   companies are using different methods.
5. Although the inventory system used by companies is not disclosed in the annual re-
   port, it is possible that the two companies use a perpetual system, given the ability to
   maintain computerized records.



LO 7      DECISION CASE 5-2 READING AND INTERPRETING JCPENNEY’S FINANCIAL
          STATEMENTS

1. JCPenney uses LIFO. A business should employ the method that most accurately
   matches inventory costs with the revenues of the period. JCPenney 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 $8 million at year-end 2006, and $24 million at year-end 2005.
3. The LIFO reserve decreased during 2006, from $24 million to $8 million, or $16 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.
5-72   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




LO 7,9         DECISION CASE 5-3 READING AND INTERPRETING GAP INC’S INVENTORY
               NOTE

1. Prior to the 2006 fiscal year Gap Inc. used the FIFO method.
2. Beginning with the 2006 fiscal year Gap Inc. changed to the weighted average cost
   method. A company changes its inventory method when it believes that the new me-
   thod is a more appropriate method given the nature of its inventory.
3. Market is defined as future estimated selling price. The company takes into account
   slow-moving merchandise and items no longer in stock in a sufficient range of sizes
   in deciding whether to write down its inventory.


                               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 unit
       Costs per unit:
          Purchase price                       $10.00
          Tax (10%)                              1.00
          Shipping                               0.50
          Labeling                               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.
                                                 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-73


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


1. Cost per pound                                                     $5.00
   Add: sales tax (5% × $5.00)                                         0.25
   Gross cost                                                         $5.25
   Less: purchase discount (2% × 5.25)                                 0.11
   Net cost                                                           $5.14
   Add: 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 local competitors are 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 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.
5-74    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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 auto-
   mobiles, 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.                                       1,000
      March                                      1,200
      Oct.                                       1,500
      Available                                  3,700
      Sold                                       3,000
      On 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 me-
   thods 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             LIFO
   Sales revenue*                                              $45,000          $45,000
   Cost of goods sold**                                         24,800           25,500
   Gross profit                                                $20,200          $19,500
    *3,000 units sold at $15 each.
   **            1,000 ×          $8 = $ 8,000
                 1,200 ×           8 =   9,600
                 1,500 ×           9 = 13,500
       Available 3,700                 $31,100
       Ending inventory:
         FIFO 700 × $9 = $6,300
         LIFO 700 × $8 = $5,600
       Cost of goods sold:
         FIFO       $31,100 – $6,300 = $24,800
         LIFO       $31,100 – $5,600 = $25,500
                                                CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-75


    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 2006 by $45,600.
Thus, cost of goods sold in 2006 was understated, and gross profit was overstated by
the same amount. The effect on net income would be less than the amount of over-
statement 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 2007. 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 2008 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 be-
   lieves 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.
5-76   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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
   appreciate your interest in saving the company money, but we would lose valuable
   information 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 chief executive officer is primarily concerned with reporting the highest amount
   of income possible. Thus, the chief executive officer 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 higher cost of goods sold and thus
   the lower 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 Chief Executive Officer:
   TO:           Chief Executive Officer
   FROM:         Student’s name
   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 appreciate your interest in maximizing income whenever possible. However, a
   method of inventory valuation that addresses this objective will not necessarily satis-
   fy 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 lower
   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.
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-77


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

Because annual reports do not disclose the inventory system used, it is not possible to
say for certain whether Gap Inc. uses a perpetual or a periodic system. However, it is
possible that the company uses a perpetual system given the ability to maintain compu-
terized records.


REAL WORLD PRACTICE 5.2

Kellogg’s is a producer of a variety of food products. The nature of this business re-
quires the company to continually monitor its inventory for products that can no longer
be sold, due to spoilage and other factors. If market is less than cost, the company
should write down the inventory to reflect market value. The company uses the average
method for determining cost.

				
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