Docstoc

Chapter 5 Inventories and Cost of Goods Sold CHAPTER 5

Document Sample
Chapter 5 Inventories and Cost of Goods Sold CHAPTER 5 Powered By Docstoc
					                                         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 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 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.                          3*       25      Mod

 2. Show that you understand how wholesalers and retailers               1*       25      Mod
    account for sales of merchandise.                                    4*       20      Mod
                                                                         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,      3*       25      Mod
    weighted average, FIFO, and LIFO 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.                  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, di-
   rect labor, and manufacturing overhead. Direct, or raw, materials are the ingredients
   used in making a product. Direct labor consists of the amounts paid to factory work-
   ers to manufacture the product. Manufacturing overhead includes all the other costs
   that are related to the manufacturing process but cannot be directly matched to spe-
   cific units of output.
2. The use of a contra revenue account to record cash refunds and other types of al-
   lowances allows a company to monitor the size and frequency of these occurrences.
   For example, a relatively large amount of returns in any one period may be an indi-
   cation that the quality of the product has slipped. The information provided by the
   use of these contra revenue accounts would be lost if all returns and allowances
   were recorded as reductions of the Sales Revenue account. Also, if this practice
   were followed, the actual amount of sales would be understated for the period to the
   extent of any returns and allowances.
3. Terms of 3/20, net 60, mean that the customer may deduct 3% from the selling price
   if the bill is paid within twenty days. Otherwise, the full amount is due within 60 days
   of the date of the invoice. Assuming a sale for $1,000, a 3% discount would save the
   customer $30, resulting in a net amount due of $970. The amount saved is the result
   of paying 40 days earlier than is required by the 60-day term. Assuming 360 days in
   a year, there are 360/40, or 9 periods of 40 days each, in a year. Thus, a savings of
   $30 for 40 days is equivalent to a savings of $30 × 9, or $270 for the year. This is
   equivalent to an annual return of $270/$970, or 27.8%.
4. The two inventory systems differ with respect to how often the inventory account is
   updated. Under the perpetual system, the account is updated each time a sale or
   purchase is made. With the periodic system, the inventory account is updated only
   at the end of the period. A temporary account, called Purchases, is used to keep
   track of the acquisitions of inventory during the period. The periodic method relies on
   a count of the inventory on hand at the end of the period to determine the amount to
   assign to ending inventory on the balance sheet and to cost of goods sold expense
   on the income statement.
5. A point-of-sale terminal gives the merchandiser the ability to update the inventory
   records each time a sale is made. As an item is run over the sensing glass, a bar
   code on the product is read by the computer. In this way, the unit can be removed
   from the inventory at the point of sale. In some instances, however, merchandisers
   use the terminals only to update the quantity of units on hand, not necessarily the
   dollar amount.
6. The Purchases account is neither an asset nor an expense account. It is simply a
   temporary holding account for the purchases of merchandise, which is closed at the
   end of the period. The effect of purchases made during the period is to increase the
   cost of goods sold expense.
 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 for which more units were purchased. For example, assume that
    beginning inventory consists of 100 units with a unit cost of $10 per unit. Assume
    that during the period, 100 units were purchased at $15 per unit, and 200 units were
    purchased at $20 per unit. The arithmetic average unit cost for the period would be
    ($10 + $15 + $20)/3 = $15. However, the weighted average unit cost would be
    [100($10) + 100 ($15) + 200($20)]/400 units, or $16.25. The acquisition of twice as
    many units at $20 as opposed to those purchased at $10 and $15 drives the
    weighted average up to $16.25.
15. The FIFO method more nearly approximates the physical flow of products in most
    businesses. This is particularly true for perishable products, such as fresh fruits and
    vegetables. Most businesses prefer as a matter of good customer relations to sell
    their goods on a first-in, first-out basis. This minimizes the likelihood that units of in-
    ventory will become obsolete and spoiled.
16. The use of LIFO will have the effect of maximizing net income if a company is expe-
    riencing a decline in the unit cost of inventory. Last-in, first-out charges the most re-
    cent purchases to cost of goods sold. If prices are declining, the amounts charged to
    cost of goods sold will be less than if either the weighted average method or FIFO
    was used. Because less is charged to cost of goods sold, net income will be higher.
17. In a period of rising prices, the use of LIFO will result in a lower tax bill. Because the
    most recent purchases are charged to cost of goods sold under LIFO, in a period of
    rising prices, these units will be higher-priced, and thus the result will be lower gross
    margin as well as lower net income before tax. Lower net income will result in a 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.



                                      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.
5-10   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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.


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.
                                            CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-11


LO 2      EXERCISE 5-4 PERPETUAL AND PERIODIC INVENTORY SYSTEMS


Perpetual—Appliance store
Perpetual—Car dealership
Periodic—Drugstore
Perpetual—Furniture store
Periodic—Grocery store
Periodic—Hardware store
Perpetual—Jewelry store

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


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


Case 1:
(a) Beginning inventory: cost of goods available for sale – cost of goods purchased =
    $7,110 – ($6,230 – $470 – $200 + $150) = $7,110 – $5,710 = $1,400
(b) Ending inventory: cost of goods available for sale – cost of goods sold = $7,110 –
    $5,220 = $1,890
Case 2: (must first solve d, then c)
(d) Cost of goods available for sale: cost of goods sold + ending inventory = $5,570 +
    $1,750 = $7,320
(c) Purchase discounts:
   1. Cost of goods available for sale – beginning inventory = cost of goods purchased
      = $7,320 – $2,350 = $4,970
   2. Gross purchases – purchase returns and allowances – purchase discounts +
      transportation-in = cost of goods purchased; $5,720 – $800 – purchase discounts
      + $500 = $4,970; purchase discounts = $5,420 – $4,970 = $450
5-12     FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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.
                     Assets            =         Liabilities   +   Owners’ Equity
                                                  +3,500              –3,500
July 6       Purchases                                                  7,000
                Accounts Payable                                                    7,000
             To record purchases of merchandise on credit.
                     Assets            =         Liabilities   +   Owners’ Equity
                                                  +7,000              –7,000
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.
                     Assets            =         Liabilities   +   Owners’ Equity
                     –3,465                       –3,500                 +35
August 5 Accounts Payable                                               7,000
            Cash                                                                    7,000
         To record payment on account.
                     Assets            =         Liabilities   +   Owners’ Equity
                     –7,000                       –7,000
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-13


LO 3       EXERCISE 5-7 PURCHASES—PERIODIC SYSTEM


March 3     Purchases                                                      2,500
               Accounts Payable                                                               2,500
            To record purchases on credit.
                Assets         =       Liabilities         +       Owners’ Equity
                                        +2,500                        –2,500
March 3     Transportation-in                                                250
               Cash                                                                            250
            To record payment of freight costs.
                Assets         =       Liabilities         +       Owners’ Equity
                 –250                                                  –250
March 7     Purchases                                                      1,400
               Accounts Payable                                                               1,400
            To record purchases on credit.
                Assets         =       Liabilities         +       Owners’ Equity
                                        +1,400                        –1,400
March 12    Accounts Payable                                               2,500
               Cash                                                                           2,450
               Purchase Discount                                                                 50
            To record payment for purchases on credit:
            $2,500 – 0.02($2,500) = $2,450.
                Assets         =       Liabilities         +       Owners’ Equity
                –2,450                  –2,500                           +50
March 15    Accounts Payable                                                 500
               Purchase Returns and Allowances                                                 500
            To record credit on defective merchandise.
                Assets         =       Liabilities         +       Owners’ Equity
                                          –500                         +500
March 18    Purchases                                                      1,600
               Accounts Payable                                                               1,600
            To record purchases on credit.
                Assets         =       Liabilities         +       Owners’ Equity
                                        +1,600                        –1,600
5-14      FINANCIAL ACCOUNTING SOLUTIONS MANUAL




March 22        Accounts Payable                                          400
                   Purchase Returns and Allowances                                     400
                To record credit on returned merchandise.
                      Assets            =         Liabilities   +   Owners’ Equity
                                                     –400               +400
April 6         Accounts Payable                                          900
                   Cash                                                                900
                To record payment for purchases on
                credit: $1,400 – $500.
                      Assets            =         Liabilities   +   Owners’ Equity
                       –900                          –900
April 18        Accounts Payable                                         1,200
                   Cash                                                              1,200
                To record payment for purchases on
                credit: $1,600 – $400.
                      Assets            =         Liabilities   +   Owners’ Equity
                      –1,200                       –1,200


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


1. The seller pays shipping costs when merchandise is shipped FOB destination point.
   Miller Wholesalers pays the freight bill and is responsible for the merchandise until it
   gets to Michael’s warehouse.
2. The inventory should not be included as an asset on Michael’s December 31, 2007,
   balance sheet because the terms of shipment indicate that the merchandise does
   not legally belong to Michael until it arrives, and this is after the end of the year.
   Likewise, Miller should not include the sale on its 2007 income statement, since the
   goods are not considered sold until they reach the buyer’s business.
3. If the terms of shipment were FOB shipping point, the answers to both questions in
   2. above would change. Under these terms, the inventory belongs to Michael as
   soon as it is shipped, and because this is on December 23, 2007, the asset should
   be recognized on the year-end balance sheet. Similarly, Miller would record a sale in
   2007.
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-15


LO 3      EXERCISE 5-9 TRANSFER OF TITLE TO INVENTORY


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

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


LO 4      EXERCISE 5-10 INVENTORY AND INCOME MANIPULATION


By ignoring the large order at year-end, and thus including the inventory in the year-end
count, the company will overstate ending inventory. This in turn will lead to an 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
5-16   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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

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


LO 7       EXERCISE 5-12 EVALUATION OF INVENTORY COSTING METHODS


1. a                                           5. b
2. d                                           6. a
3. c                                           7. b
4. c                                           8. c
                                                CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-17


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


LO 8        EXERCISE 5-14 TRANSFER OF TITLE TO INVENTORY


1. Michelson should include the costs in its inventory, since the merchandise had not
   arrived at its destination, PJ’s, by the end of the year.
2. Filbrandt should include the costs of the merchandise in its inventory, since it has
   received the shipment by the end of the year.
3. Randall would include the merchandise in its inventory, since the shipment left
   James Bros. before the end of the year.
4. Barner should include the merchandise in its inventory. It is both shipped by Hinz
   and received by Barner before the end of the year.



LO 10       EXERCISE 5-15 GROSS PROFIT METHOD


(1)    Net sales                                                         $105,300
       × estimated gross profit ratio                                        0.25
       Estimated gross profit                                            $ 26,325
(2)    Net sales                                                         $105,300
       – estimated gross profit                                            26,325
       Estimated cost of goods sold                                      $ 78,975
(3)    Beginning inventory                                               $ 15,400
       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
          Assets        =     Liabilities   +     Owners’ Equity
        Cash +10,000                              Loss on insurance settlement –10,655
      Inventory –20,655
5-18    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




LO 11       EXERCISE 5-16 INVENTORY TURNOVER FOR BEST BUY


1. Inventory turnover = cost of goods sold/average inventory $20,938/[($2,851 +
   $2,607)/2] = $20,938/$2,729 = 7.67 times.
2. The average length of time it takes to sell an item of inventory can be estimated by
   dividing the number of times inventory turns over in a year into the number of days in
   a year:
   (assuming 360 days in a year): 360/7.67 times = 46.9, or approximately 47 days.
3. It is difficult to determine from the information given whether 47 days is reasonable
   as the average length of time it takes to sell inventory. Other information needed to
   make this determination includes:
       The historical average number of days.
       The industry norms for large, national retailers.
       Any recent changes in types of inventory, customer base, markets for the prod-
        ucts, and other relevant factors.

LO 12       EXERCISE 5-17 IMPACT OF TRANSACTIONS INVOLVING INVENTORIES ON 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
2007 statement of cash flows (direct method):
        Inventory, December 31, 2006                                  $   180,400
        Plus: Purchases during 2007                                             X
        Less: Cost of goods sold during 2007                           (1,200,000)
        Inventory, December 31, 2007                                  $ 241,200
        $180,400 + X – $1,200,000 = $241,200
        X = $1,260,800
        Accounts payable, December 31, 2006                           $    85,400
        Plus: Purchases during 2007 (from above)                        1,260,800
        Less: Cash payments during 2007                                        (X)
        Accounts payable, December 31, 2007                           $    78,400
        $85,400 + $1,260,800 – X = $78,400
        X = $1,267,800
                                            CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-19


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


                            MULTI-CONCEPT EXERCISES

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


a. Sales – Net sales = Sales returns and allowances
   $125,600 – $122,040 = $3,560

b. Do c. first. Net purchases + Purchase discounts = Purchases
   $74,600 + $1,300 = $75,900

c. Cost of goods purchased – Transportation-in = Net purchases
   $81,150 – $6,550 = $74,600

d. Net sales – Gross margin = Cost of goods sold
   $122,040 – $38,600 = $83,440

e. Cost of goods available for sale – Cost of goods sold = Ending inventory
   $104,550 – $83,440 = $21,110

f. Gross margin – Income before tax = Operating expenses
   $38,600 – $26,300 = $12,300

g. Income before tax – Income tax expense = Net income
   $26,300 – $10,300 = $16,000
5-20   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


                                  LAPINE COMPANY
                                INCOME STATEMENT
                       FOR THE YEAR ENDED DECEMBER 31, 2007
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 margin                                                                 $48,300

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


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


1. a. Weighted average method:
       Cost of goods available for sale and units available:
           200   ×   $10   =    $ 2,000
           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
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-21


   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, a higher income and
   thus more taxes, $330, will be reported with this method than if LIFO were used.


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


Conservatism is the rationale for carrying inventory on the balance sheet at an amount
less than its cost. It is a departure from the historical cost principle and is used when the
utility of the inventory, as measured by the cost to replace it, is less than original cost.
     Two accounts are affected by the application of the lower of cost or market rule. An
income statement account, such as Loss on Decline in Value of Inventory, is debited,
and the Inventory account on the balance sheet is credited or reduced.
5-22   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


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

1. a. Moving average:
            Purchases                               Sales                         Balance
               Unit Total                            Unit    Total                  Unit
Date    Units Cost Cost                 Units       Cost     Cost        Units     Cost 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
                                                CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD    5-23


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
5-24     FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-25


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.



                                    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.
5-26   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: 2004: ($285,222 – $219,793)/$285,222 = $65,429/$285,222 = 22.9%
             2003: ($256,329 – $198,747)/$256,329 = $57,582/$256,329 = 22.5%
   Target:       2004: ($45,682 – $31,445)/$45,682 = $14,237/$45,682 = 31.2%
                 2003: ($40,928 – $28,389)/$40,928 = $12,539/$40,928 = 30.6%

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


LO 7         PROBLEM 5-3 EVALUATION OF INVENTORY COSTING METHODS


1. Company B will have the newest costs in inventory because it uses first-in, first-out.
   Because costs are rising, it will have the lowest costs of goods sold and thus the
   highest net income.
2. Company C will have the oldest costs in inventory because it uses last-in, first-out.
   Because costs are rising, it will have the highest cost of goods sold and thus the
   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   5-27


LO 8      PROBLEM 5-4 INVENTORY ERROR


1. Revised income statements:                                    2007                      2006
     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 2006 was understated, cost of goods sold was over-
    stated. Because beginning inventory in 2007 was understated, cost of goods sold
    was understated.
   Revised balance sheets:                                    12/31/07                  12/31/06
     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 owners’ 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, 2007, before the revision: $9,900
   Retained earnings at December 31, 2007, 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.
5-28    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.
                   Assets             =         Liabilities   +   Owners’ Equity
                  +65,000                                           –29,600
                  –94,600
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-29


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

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

2. Inventory turnover ratios:
   Apple Computer:
     $6,020/[($101 + $56)/2] = $6,020/78.5 = 76.69 times
   Dell Computer
      $40,190/[($459 + $327)/2] = $40,190/$393 = 102.26 times

3. Both companies’ gross profit ratios have remained about the same in the two years.
   The two companies’ turnover ratios are very different. Another factor to consider is
   the number of days’ sales in inventory.
   Apple Computer:
     360/76.69 = 4.7days
   Dell Computer:
      360/102.26 = 3.5 days
   It takes Apple an average of less than five days to sell an item of inventory, and Dell
   requires only three and a half days.
        On the basis of the gross profit, Apple appears to be performing better, although
   Dell does have a better inventory turnover and days’ sales in inventory.
        It would be helpful to measure all of these statistics—gross profit ratio, inventory
   turnover, and days’ sales in inventory—with the same measures for prior years. It
   would also be helpful to compare these measures with the industry averages.
5-30    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, 2007
   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, 2006                                                    46,100
   Cash, December 31, 2007                                                  $ 65,300

2. Memorandum to the president:
   TO:            President of Copeland Antiques
   FROM:          Student’s name
   DATE:          January 20, 2008
   SUBJECT: Cash Flows
   You recently questioned the increase in the company’s cash balance in light of this
   year’s net loss. My thoughts and a copy of the company’s 2007 statement of cash
   flows follow.
       Copeland Antiques was able to generate a significant amount of cash from oper-
   ations even though the company incurred an accrual basis net loss of $33,200 dur-
   ing 2007. First, the amount of inventory on hand decreased by $22,200 during the
   year from $214,800 to $192,600; this reduction in inventory generated cash for the
   company. Second, the amount owed to the company’s suppliers increased by
   $30,200 during the year from $93,700 to $123,900; the related bills have not yet
   been paid.
       Operating expenses need to be decreased relative to gross profit if we are to im-
   prove the company’s bottom line. I look forward to discussing our plans to turn things
   around.
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-31


                            MULTI-CONCEPT 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.
                 Assets        =      Liabilities           +       Owners’ Equity
                                         +500                           –500
   April 10   Accounts Payable                                                500
                 Cash                                                                          485
                 Purchase Discounts                                                             15
              To record payment on account:
              $500 × (1 – 0.03) = $485.
                 Assets        =      Liabilities           +       Owners’ Equity
                  –485                   –500                             +15
   April 15   Cash                                                            200
                 Sales Revenue                                                                 200
              To record cash sale.
                 Assets        =      Liabilities           +       Owners’ Equity
                  +200                                                  +200
   April 18   Purchases                                                       900
                 Accounts Payable                                                              900
              To record purchase of merchandise
              on account.
                 Assets        =      Liabilities           +       Owners’ Equity
                                         +900                           –900
   April 25   Cash                                                            600
                 Sales Revenue                                                                 600
              To record cash sales: 3 × $200.
                 Assets        =      Liabilities           +       Owners’ Equity
                  +600                                                  +600
5-32   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




   April 28    Accounts Payable                                               900
                  Cash                                                                   873
                  Purchase Discount (900 × 3%)                                            27
               To record payment on account:
               $900 × (1 – 0.03) = $873.
                   Assets            =         Liabilities     +      Owners’ Equity
                    –873                          –900                      +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 margin                                                                        $ 409
   Operating expenses:
      Rent expense                                                        $ 100
      Miscellaneous expense                                                  50
          Total operating expenses                                                       150
   Net income                                                                          $ 259

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


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

1. Apparently, Gap Inc. does not sell its merchandise on account. If customers want to
   pay on credit for their purchases they would use one of the various credit cards that
   Gap accepts.
2. Summary journal entry for sales during the year ended 1/29/05 (millions of dollars):
   Cash                                                                     16,267
     Sales                                                                                   16,267
                 Assets        =       Liabilities            +       Owners’ Equity
                +16,267                                                 +16,267
3. Gap Inc. would deduct sales returns and allowances from sales to arrive at the
   amount of net sales reported on its income statement. Since Gap Inc. does not have
   any accounts receivable on its balance sheet, it is unlikely that it offers sales dis-
   counts to its customers. Either because they do not feel the amounts are material
   enough or they would rather not divulge information about returns and allowances to
   competitors, some companies choose not to separately report them.
4. Cost of goods sold section of 2004 income statement (millions of dollars):
       Merchandise inventory, 1/31/04                                     $ 1,704
       Cost of goods purchased*                                             9,996 (2)
       Cost of goods available for sale                                   $11,700 (1)
       Less merchandise inventory, 1/29/05                                 (1,814)
       Cost of goods sold**                                               $ 9,886
    *Including occupancy expenses.
   **Described as cost of goods sold and occupancy expenses.
   (1) $9,886 + $1,814 = $11,700.
   (2) $11,700 – $1,704 = $9,996.
5. Gross profit ratios:
   (millions of dollars)              2004                2003
   Sales                           $ 16,267            $ 15,854
   Less cost of sales                   9,886               9,885
   Gross profit                    $ 6,381             $ 5,969
   Divided by sales                ÷ $16,267           ÷ $15,854
   Gross margin ratio                39.2%               37.6%
   Gap Inc.’s gross profit ratio increased by 1.6% from 2003 to 2004. Factors affecting
   Gap Inc.’s gross profit ratio might include changes in the selling prices of merchan-
   dise, changes in the costs of goods purchased, and/or changes in the mix of mer-
   chandise sold (that is, a slight shift between selling products that have higher gross
   profit ratios and selling those with lower gross profit ratios).
5-34   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




LO 2,3       PROBLEM 5-10 FINANCIAL STATEMENTS


1. Cost of goods sold for 2007:
     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 2007:
      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
                                                  CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-35


3.                                     MAPLE INC.
                                     BALANCE SHEET
                                  AT DECEMBER 31, 2007
        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
5-36    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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
                                            CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-37


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 margin                           $ 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
5-38    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




   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
                                                                                        1
10/8         800 $5.40    $4,320                                          900     5.356    4,820
10/9                                       700       5.356     3,749      200     5.356    1,071
                                                                                      2
10/18        700   5.76    4,032                                          900     5.67     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
                                                  CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD    5-39


   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 margin                              $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
5-40   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-41


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 =               $1,500
        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
5-42   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




   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, 2007:
                                                    Weighted
                                                    Average          FIFO        LIFO
   Sales*                                           $150,000        $150,000    $150,000
   Cost of goods sold                                 107,500        112,500     104,000
   Gross margin                                      $ 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 TRIBUNE COMPANY’S INVENTORY
               ACCOUNTING POLICY

1. Newsprint costs are comparable to raw materials in a manufacturing company. A
   newspaper company, however, does not keep an inventory of finished goods. Its
   newspapers either are sold within hours after being printed or become worthless if
   not sold.
2. Some companies use more than one method to value different types of inventory.
   The methods should be chosen because they provide the most accurate matching of
   costs with the revenues generated. Apparently, LIFO provides the most accurate
   matching of costs with revenue for Tribune Company’s newsprint.
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-43


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


1. No, the use of the last-in, first-out method for its domestic merchandise inventories
   does not mean that Sears always sells its newest merchandise first in the U.S. Ac-
   tually, the physical flow of merchandise in most stores like Sears is normally on a
   first-in, first-out basis. However, the use of a cost flow assumption such as LIFO or
   FIFO for accounting purposes is independent of the actual physical flow of products.
2. No, Sears uses the retail method to account for inventories in its stores. This is a
   method that allows the company to convert its inventory from a retail value to a cost
   basis for financial statement purposes.



                            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 DVD Rentals would be credited, and the asset account DVD Inventory would
   be debited.


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

1. Gross profit ratios (dollar amounts in millions):
   Best Buy:     2005: ($27,433 – $20,938)/$27,433 = $6,495/$27,433 = 23.7%
                 2004: ($24,548 – $18,677)/$24,548 = $5,871/$24,548 = 23.9%
   Circuit City: 2005: ($10,472 – $7,904)/$10,472 = $2,568/$10,472 = 24.5%
                 2004: ($9,857 – $7,573)/$9,857 = $2,284/$9,857 = 23.2%

2. In terms of the gross profit ratios, the two companies appear to be very similar. The
   mix of products sold by the two companies and the normal markups on the various
   products could certainly affect the ratios. A comparison with prior years and industry
   averages would also be important to consider.
5-44   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


1. No, the three companies will not be equally pleased with the decline in prices. If the
   decline continues, Company Y (FIFO) will begin to show lower gross profit than
   Company Z (LIFO). Because gross profit will be lower, Company Y will report lower
   income before tax and thus have less tax to pay.
2. It should be noted that it is not acceptable for a company to change inventory valua-
   tion methods to save taxes. An acceptable explanation of the justification for the
   change is this:
       During the year recently completed, the company changed its method of valuing
       inventory on the balance sheet and recognizing cost of sales on the income
       statement. The company changed from the LIFO to FIFO method because it be-
       lieves that the latter results in a better matching of cost of sales with the reve-
       nues of the period.


LO 8       PROBLEM 5-4A INVENTORY ERROR


1. Revised income statements:                                 2007              2006
     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 2006 was overstated, cost of goods sold was unders-
    tated. Because beginning inventory in 2007 was overstated, cost of goods sold was
    overstated.
   Revised balance sheets:                                  12/31/07          12/31/06
     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 owners’ equity                   $40,000           $34,850
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-45


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

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

3. Net income for two years, before revision: $6,400 + $9,900 = $16,300.
   Net income for two years, after revision: $5,900 + $10,400 = $16,300.
   Thus, there is no net over- or understatement of net income for the two-year period.
   Retained earnings at December 31, 2007, before the revision: $12,620.
   Retained earnings at December 31, 2007, after the revision: $12,620.
   Thus, there is no over- or understatement of retained earnings at December 31,
   2007.

4. Even though the error counterbalances over the two-year period, it is still important
   to restate the statements for the two years. It is important for comparative purposes
   that the correct amount of net income be known for each of the two years. The com-
   pany needs to restate the income statements for each of the two years and restate
   the balance sheets at the end of each year.
5-46    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.
                   Assets             =         Liabilities   +     Owners’ Equity
                  +50,000                                              –8,650
                  –58,650
   *Debit should be to a Receivable from Insurance Company if cash has not yet been
    received.
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-47


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


1. Inventory turnover ratios:
   Wal-Mart:
     $219,793/[($29,447 + $26,612)/2] = $219,793/$28,029.5 = 7.84 times
   Target:
      $31,445/[($5,384 + $4,531)/2] = $31,445/$4,957.5 = 6.34 times

2. Wal-Mart’s inventory turnover is higher than Target’s during the most recent fiscal
   year, 7.84 versus 6.34. Another factor to consider is the number of days’ sales in in-
   ventory:
   Wal-Mart:
     360/7.84 = 45.9 days
   Target:
      360/6.34 = 56.8 days

   It takes Wal-Mart an average of 46 days to sell an item of inventory; Target requires
   an average of 57 days. On the basis of inventory turnover and days’ sales in inven-
   tory, Wal-Mart appears to be performing slightly better.
        It would be helpful to measure these statistics—inventory turnover and days’
   sales in inventory, along with the companies’ gross profit ratios—with the same
   measures for prior years. It would also be helpful to compare these measures with
   the industry averages.
5-48    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, 2007
   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, 2006                                                      26,300
   Cash, December 31, 2007                                                    $ 14,400

2. Memorandum to the president:
   TO:              President of Carpetland City
   FROM:            Student’s name
   DATE:            January 20, 2008
   SUBJECT:         Cash Flows
       You recently expressed concern about the decrease in the company’s cash bal-
   ance in spite of the profitable year that was reported on this year’s income state-
   ment. My thoughts and a copy of the company’s 2007 statement of cash flows fol-
   low.
       Although net income on an accrual basis was $78,500, the company’s cash bal-
   ance declined by $11,900 during the year for two reasons. Most importantly, the
   amount owed to the company’s suppliers decreased by $69,800 during the year
   from $93,700 to $23,900; this decrease in accounts payable drained our cash bal-
   ance. In addition, the amount of inventory on hand increased by $20,600 during the
   year from $84,900 to $105,500; this increase in inventory required an additional out-
   flow of cash.
       We can better manage our cash flow by carefully timing the payment of bills to
   coincide with the due dates on invoices. In addition, we can improve cash flow by
   closely monitoring our inventory levels and only adding to inventory levels when in-
   creases in sales warrant an addition.
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-49


                      ALTERNATE MULTI-CONCEPT 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.
                Assets        =      Liabilities           +       Owners’ Equity
                                        +249                           –249
   Oct. 10   Accounts Payable                                                249
                Cash                                                                          244
                Purchase Discounts                                                              5
             To record payment on account:
             $249 × (1 – 0.02) = $244.
                Assets        =      Liabilities           +       Owners’ Equity
                 –244                   –249                              +5
   Oct. 15   Cash                                                            200
                Sales Revenue                                                                 200
             To record cash sale.
                Assets        =      Liabilities           +       Owners’ Equity
                 +200                                                  +200
   Oct. 18   Purchases                                                       800
                Accounts Payable                                                              800
             To record purchase of merchandise
             on account.
                Assets        =      Liabilities           +       Owners’ Equity
                                        +800                           –800
   Oct. 25   Cash                                                            600
                Sales Revenue                                                                 600
             To record cash sales: 3 × $200.
                Assets        =      Liabilities           +       Owners’ Equity
                 +600                                                  +600
   Oct. 30   Accounts Payable                                                800
                Cash                                                                          800
             To record payment on account.
                Assets        =      Liabilities           +       Owners’ Equity
                 –800                   –800
5-50   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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).


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

1. Summary journal entries for the year ended 8/31/04: (in millions)
   Cash                                                                1,017.8
      Accounts Receivable                                                          1,017.8
   To record collection of beginning accounts receivable.
                  Assets             =         Liabilities   +   Owners’ Equity
                 +1,017.8
                 –1,017.8
   Accounts Receivable                                              37,508.2
      Sales                                                                       37,508.2
   To record sales on account.
                 Assets              =         Liabilities   +   Owners’ Equity
               +37,508.2                                          +37,508.2
   Cash                                                             36,339.1
      Sales                                                                       36,339.1
   To record cash collections: $37,508.2 – $1,169.1.
                 Assets              =         Liabilities   +   Owners’ Equity
               +36,339.1                                          +36,339.1
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-51


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

3. Cost of goods sold section of 2004 income statement: (in millions)
     Merchandise inventory, August 31, 2003                                     $ 4,202.7
     Cost of goods purchased                                                     27,846.3 (2)
     Cost of goods available for sale                                           $32,049.0 (1)
     Less merchandise inventory, August 31, 2004                                 (4,738.6)
     Cost of goods sold                                                         $27,310.4
   (1) $27,310.4 + $4,738.6 = $32,049.0.
   (2) $32,049.0 – $4,202.7 = $27,846.3.

4. Gross profit ratios:
   (In millions)                                         2004                       2003
   Net sales                                          $ 37,508.2                 $ 32,505.4
   Cost of sales                                        27,310.4                   23,706.2
   Gross profit                                       $ 10,197.8                 $ 8,799.2
   Divided by net sales                               ÷ 37,508.2                 ÷ 32,505.4
   Gross profit ratio                                   27.2%                      27.1%
   Walgreen’s gross profit ratio was virtually unchanged from 2003 to 2004. Factors af-
   fecting Walgreen’s gross profit ratio include changes in the selling prices of mer-
   chandise, changes in the costs of goods purchased, and/or changes in the mix of
   merchandise sold (that is, a slight shift from selling products that have higher gross
   profit ratios to selling those with lower gross profit ratios).


LO 2,4      PROBLEM 5-10A FINANCIAL STATEMENTS


1. Cost of goods sold for 2007:
     Beginning inventory                                                        $ 6,400
     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
5-52    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




2. Net income for 2007:
      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

3.                                         LLOYD INC.
                                         BALANCE SHEET
                                      AT DECEMBER 31, 2007
        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
                                                CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-53


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
5-54    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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 margin                                  $ 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
                                                        CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD    5-55


   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
                                                                                                 1
11/8         500 $4.50    $2,250                                                600        4.417    2,650
11/9                                      500       4.417        2,209          100        4.417      441
                                                                                                 2
11/18        700   4.75    3,325                                                800        4.708    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
5-56    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




   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
                                          CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-57


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
5-58    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




     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.


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
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-59


  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

2. Income statements for the year ended December 31, 2007:
                                              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.
5-60   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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

1. The company carries two types of inventory: newsprint and other. These costs are
   comparable to raw materials in a manufacturing company. A newspaper company,
   however, does not keep an inventory of finished goods. Its newspapers either are
   sold within hours after being printed or become worthless if not sold.
2. Some companies use different methods to value different types of inventory. The
   methods should be chosen because they provide the most accurate matching of
   costs with the revenues generated. Apparently, LIFO provides the most accurate
   matching of costs with revenue for the company’s newsprint.


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


1. No, the use of the first-in, first-out inventory method does not mean that a company
   always sells its oldest merchandise first. Although the physical flow in many busi-
   nesses is on a first-in first-out basis, the use of a cost flow assumption such as FIFO
   for accounting purposes is independent of the actual physical flow of products. In
   fact, some businesses do use a LIFO (last-in, first-out) assumption even though the
   physical flow is on a first-in, first-out basis.
2. No, Home Depot states in its note that it uses the retail inventory method to account
   for inventories in its stores. This is a method that allows a company to convert its in-
   ventory from a retail value to a cost basis for financial statement purposes.



                                     DECISION CASES


              READING AND INTERPRETING FINANCIAL STATEMENTS


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


1. Life Time Fitness is primarily a service provider.
2. The company reports inventories on its balance sheet because it sells some nutri-
   tional products in its LifeCafes. The amounts of inventories on December 31, 2004,
   was $4,971,000 and this represents less than one percent of total assets.
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-61


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


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

1. J.C.Penney uses LIFO. A business should employ the method that most accurately
   matches inventory costs with the revenues of the period. J.C.Penney may use LIFO
   because prices change frequently and it wants to match the most recent costs with
   revenues generated in the current period.
2. The LIFO reserve is $25 million at year-end 2004, and $43 million at year-end 2003.
3. The LIFO reserve decreased during 2004, from $43 million to $25 million, or $18 mil-
   lion. The reserve decreases because inventory costs are decreasing and cost of
   goods sold on a LIFO basis is less than cost of goods sold on a FIFO basis. Thus, a
   decrease in the reserve during a period indicates that prices are falling.


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

1. Circuit City uses the average cost method. Given the large volume of consumer
   electronics products sold by Circuit City, the average cost method seems appropri-
   ate.
2. The company defines market as estimated realizable value. In estimating market
   value, the company considers such factors as forecasted consumer demand, market
   conditions and obsolescence.
3. The company includes the statement about the possibility of being exposed to
   losses in excess of amounts recorded as a way to alert the statement reader that if
   various factors result in a decline in the value of its inventory the company would
   need to write it down and recognize a loss.
5-62   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




                               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.


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
                                              CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-63


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


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


1. Memo to Darrell:
   The purpose of this memo is to clarify for you the costs and benefits of a perpetual
   inventory system. The purpose of a perpetual system is to provide a continuously
   updated record of the number of units and cost of all inventory items. A perpetual
   system is more costly to maintain because of the need to update the records each
   time purchases and sales are made. It is likely that you will want to consider a com-
   puterized inventory system. Numerous software packages are available, and one
   should be chosen that is particularly suitable to your business.
       As mentioned earlier, a perpetual inventory system is considerably more costly to
   implement and maintain than a periodic system. A perpetual system would involve
   an investment in a scanning device and the other necessary hardware and software.
   The next step would be to explore the options available to us and the cost of each.
   Please call me at your convenience to set up an appointment to discuss these mat-
   ters further.
2. The suitability of a perpetual inventory system is certainly dependent on the type of
   products a company sells. The system is ideally suited to a product such as 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
5-64    FINANCIAL ACCOUNTING SOLUTIONS MANUAL




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


LO 8        DECISION CASE 5-8 INVENTORY ERRORS


The first error resulted in an overstatement of the ending inventory in 2005 by $45,600.
Thus, cost of goods sold in 2005 was understated, and gross profit was overstated by
the same amount. The effect on net income would be less than the amount of 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 2006. If the cost of certain inventory was $6,000 higher than
its replacement cost, the inventory should have been written down and a loss recog-
nized.
                                               CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-65


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


                             ETHICAL DECISION MAKING

LO 2      DECISION CASE 5-9 SALES RETURNS AND ALLOWANCES


1. The sales manager is interested in reporting the maximum amount of sales. Al-
   though the net amount of sales will be the same regardless of whether returns are
   recorded separately or simply netted against sales revenue, the manager would pre-
   fer not to call attention to the level of returns. It is unlikely that the manager truly
   feels the present practice is a waste of time.
2. The sales manager’s recommendation might save a small amount of bookkeeping
   time, but at the same time it would sacrifice certain information. Management needs
   to be aware of unreasonably high levels of returns of merchandise so that it can
   make whatever adjustments are necessary. If Sales Revenue is simply reduced for
   the amount of returns, this information will not be available.
3. Memo to the sales manager:
   I received your suggestion that we save time and effort by treating sales returns as a
   direct reduction of sales rather than a separate item in our financial statements. I
   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 CEO is primarily concerned with reporting the highest amount of income possi-
   ble. Thus, the CEO will be satisfied if the company uses the FIFO method. This me-
   thod recognizes as cost of goods sold the oldest costs, and because prices are ris-
   ing, the costs charged to cost of goods sold will be less than if LIFO is used.
2. It would be difficult to state definitively which method is truly in the best interests of
   the stockholders. The LIFO method minimizes the amount of income taxes paid in
   the first year, since this method would report the highest cost of goods sold and thus
   the lowest income before taxes. From a cash flow perspective, LIFO is the most ad-
   vantageous method in a period of rising prices.
5-66   FINANCIAL ACCOUNTING SOLUTIONS MANUAL




3. Memo to the CEO:
   TO:           CEO
   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 can appreciate your interest in maximizing income whenever possible. Howev-
   er, a method of inventory valuation that addresses this objective will not necessarily
   satisfy our other concerns. Certainly one of our primary concerns should be to mi-
   nimize the payment of taxes whenever possible.
       Because our inventory purchase costs are rising, FIFO will result in the lowest
   amount reported as cost of goods sold and thus an income number that is higher
   than if LIFO was used. For this reason, however, the use of FIFO will result in a
   higher amount of taxes payable than if LIFO was used. It is my opinion that we
   should attempt to conserve cash whenever possible, and thus I believe we should
   adopt the LIFO method of inventory valuation.
       Thank you for the opportunity to present my views on this important matter.
   Please call if I can be of any further assistance.


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


1. The write-off of the inventory that has become obsolete would reduce the current
   year’s income. The amount of the reduction depends on the extent of the write-off. If
   the inventory is written off completely, the reduction in income will be equal to the
   book value of the inventory. If the inventory is written down to a lower amount, net
   income will be reduced by the amount of the write-down. This analysis ignores the
   effect of taxes.
2. If the inventory is not adjusted, total assets on the year-end balance sheet will be
   overstated.
3. The materiality of the obsolete inventory should be a major factor in a decision to
   persist in the argument that the inventory be written down. If the inventory in ques-
   tion is not material relative to the total assets of the company, the write-down may be
   unnecessary. The materiality of the loss that would be recognized from the write-
   down, relative to the income of the period, should also be considered.
4. If the inventory is not written down, readers do not have reliable information. Under
   the lower-of-cost-or-market rule, readers assume that if inventory is worth less than
   its cost, the inventory has in fact been written down to this lower amount.
                                             CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD   5-67


REAL WORLD PRACTICE 5.1

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


REAL WORLD PRACTICE 5.2

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

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:295
posted:9/3/2011
language:English
pages:67