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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and InventoryChapter 7Reporting and Interpreting Cost of Goods Sold and InventoryANSWERS TO QUESTIONS1.Inventory often is one of the largest amounts listed under assets on the balance sheet which means that it represents a significant amount of the resources available to the business. The inventory may be excessive in amount, which is a needless waste of resources; alternatively it may be too low, which may result in lost sales. Therefore, for internal users inventory control is very important. On the income statement, inventory exerts a direct impact on the amount of income. Therefore, statement users are interested particularly in the amount of this effect and the way in which inventory is measured. Because of its impact on both the balance sheet and the income statement, it is of particular interest to all statement users.2.Fundamentally, inventory should include those items, and only those items, legally owned by the business. That is, inventory should include all goods that the company owns, regardless of their particular location at the time.3.The cost principle governs the measurement of the ending inventory amount. The ending inventory is determined in units and the cost of each unit is applied to that number. Under the cost principle, the unit cost is the sum of all costs incurred in obtaining one unit of the inventory item in its present state.4.Goods available for sale is the sum of the beginning inventory and the amount of goods purchased during the period. Cost of goods sold is the amount of goods available for sale less the ending inventory. 5.Beginning inventory is the stock of goods on hand (in inventory) at the start of the accounting period. Ending inventory is the stock of goods on hand (in inventory) at the end of the accounting period. The ending inventory of one period automatically becomes the beginning inventory of the next period. 6.(a)Average costThis inventory costing method in a periodic inventory system is based on a weighted-average cost for the entire period. At the end of the accounting period the average cost is computed by dividing the goods available for sale in units into the cost of goods available for sale in dollars. The computed unit cost then is used to determine the cost of goods sold for the period by multiplying the units sold by this average unit cost. Similarly, the ending inventory for the period is determined by multiplying this average unit cost by the number of units on hand.(b)FIFOThis inventory costing method views the first units purchased as the first units sold. Under this method cost of goods sold is costed at the oldest unit costs, and the ending inventory is costed at the newest unit costs.(c)LIFOThis inventory costing method assumes that the last units purchased are the first units sold. Under this method cost of goods sold is costed at the newest unit costs and the ending inventory is costed at the oldest unit costs.(d)Specific identificationThis inventory costing method requires that each item in the beginning inventory and each item purchased during the period be identified specifically so that its unit cost can be determined by identifying the specific item sold. This method usually requires that each item be marked, often with a code that indicates its cost. When it is sold, that unit cost is the cost of goods sold amount. It often is characterized as a pick-and-choose method. When the ending inventory is taken, the specific items on hand, valued at the cost indicated on each of them, is the ending inventory amount.7.The specific identification method of inventory costing is subject to manipulation. Manipulation is possible because one can, at the time of each sale, select (pick and choose) from the shelf the item that has the highest or the lowest (or some other) unit cost with no particular rationale for the choice. The rationale may be that it is desired to influence, by arbitrary choice, both the amount of income and the amount of ending inventory to be reported on the financial statements. To illustrate, assume item A is stocked and three are on the shelf. One cost $100; the second one cost $115; and the third cost $125. Now assume that one unit is sold for $200. If it is assumed arbitrarily that the first unit is sold, the gross profit will be $100; if the second unit is selected, the gross profit will be $85; or alternatively, if the third unit is selected, the gross profit will be $75. Thus, the amount of gross profit (and income) will vary significantly depending upon which one of the three is selected arbitrarily from the shelf for this particular sale. This assumes that all three items are identical in every respect except for their unit costs. Of course, the selection of a different unit cost, in this case, also will influence the ending inventory for the two remaining items.8.LIFO and FIFO have opposite effects on the inventory amount reported under assets on the balance sheet. The ending inventory is based upon either the oldest unit cost or the newest unit cost, depending upon which method is used. Under FIFO, the ending inventory is costed at the newest unit costs, and under LIFO, the ending inventory is costed at the oldest unit costs. Therefore, when prices are rising, the ending inventory reported on the balance sheet will be higher under FIFO than under LIFO. Conversely, when prices are falling the ending inventory on the balance sheet will be higher under LIFO than under FIFO.9.LIFO versus FIFO will affect the income statement in two ways: (1) the amount of cost of goods sold and (2) income. When the prices are rising, FIFO will give a lower cost of goods sold amount and hence a higher income amount than will LIFO. In contrast, when prices are falling, FIFO will give a higher cost of goods sold amount and, as a result, a lower income amount.10.When prices are rising, LIFO causes a lower taxable income than does FIFO. Therefore, when prices are rising, income tax is less under LIFO than FIFO. A lower tax bill saves cash (reduces cash outflow for income tax). The total amount of cash saved is the difference between LIFO and FIFO inventory amounts multiplied by the income tax rate.11.LCM is applied when market (defined as current replacement cost) is lower than the cost of units on hand. The ending inventory is valued at market (lower), which (a) reduces net income and (b) reduces the inventory amount reported on the balance sheet. The effect of applying LCM is to include the holding loss on the income statement (as a part of CGS) in the period in which the replacement cost drops below cost rather than in the period of actual sale.12.When a perpetual inventory system is used, the unit cost must be known for each item sold at the date of each sale because at that time two things happen: (a) the units sold and their costs are removed from the perpetual inventory record and the new inventory balance is determined; (b) the cost of goods sold is determined from the perpetual inventory record and an entry in the accounts is made as a debit to Cost of Goods Sold and a credit to Inventory. In contrast, when a periodic inventory system is used the unit cost need not be known at the date of each sale. In fact, the periodic system is designed so that cost of goods sold for each sale is not known at the time of sale. At the end of the period, under the periodic inventory system, cost of goods sold is determined by adding the beginning inventory to the total goods purchased for the period and subtracting from that total the ending inventory amount. The ending inventory amount is determined by means of a physical inventory count of the goods remaining on hand and with the units valued on a unit cost basis in accordance with the cost principle (by applying an appropriate inventory costing method).ANSWERS TO MULTIPLE CHOICE1. c)2. d)3. a)4. a)5. c)6. c)7. a)8. c)9. c)10. a)Authors Recommended Solution Time(Time in minutes)Mini-exercisesExercisesProblemsAlternate ProblemsCases and ProjectsNo.TimeNo.TimeNo.TimeNo.TimeNo.Time151151301301202522023024022035320340335320410410440440420555155455406561565062075730740730858308408*9109309351030102011151220Continuing Case1315130142015201620172018201915202021252225* Due to the nature of these cases and projects, it is very difficult to estimate the amount of time students will need to complete the assignment. As with any open-ended project, it is possible for students to devote a large amount of time to these assignments. While students often benefit from the extra effort, we find that some become frustrated by the perceived difficulty of the task. You can reduce student frustration and anxiety by making your expectations clear. For example, when our goal is to sharpen research skills, we devote class time to discussing research strategies. When we want the students to focus on a real accounting issue, we offer suggestions about possible companies or industries. MINI-EXERCISESM71.Type of BusinessType of InventoryMerchandisingManufacturingWork in process XFinished goodsXMerchandiseXRaw materialsXM72.To record the purchase of 90 new shirts in accordance with the cost principle (perpetual inventory system):Inventory (+A)2,150Cash (-A)2,150Cost: $1,800 + $185 + $165 = $2,150.The $108 interest expense is not a proper cost of the merchandise; it is recorded as prepaid interest expense and later as interest expense.M73. (1) Part of inventory(2) Expense as incurreda. Wages of factory workersXb. Costs of raw materials purchased Xc. Sales salaries Xd. Heat, light, and power for the factory buildingXe. Heat, light, and power for the headquarters office buildingXM74.Computation:Simply rearrange the basic inventory model (BI + P EI = CGS):Cost of goods sold $11,042 million+Ending inventory 2,916 millionBeginning inventory (3,213) millionPurchases $10,745 millionM75.(a)Declining costs Highest net incomeLIFOHighest inventoryLIFO(b)Rising costs Highest net incomeFIFO Highest inventoryFIFOM76.LIFO is often selected when costs are rising because it reduces the companys tax liability which increases cash and benefits shareholders. However, it also reduces reported net income.M77.QuantityCost per ItemReplacement Cost per ItemLower of Cost or MarketReported on Balance SheetItem A70$ 110$100$10070 x $100 = $7,000Item B3060856030 x $60 = $1,800Total$8,800M78.+ (a)Parts inventory delivered daily by suppliers instead of weekly.NE (b)Extend payments for inventory purchases from 15 days to 30 days.+ (c)Shorten production process from 10 days to 8 days.M79.Understatement of the 2014 ending inventory by $50,000 caused 2014 pretax income to be understated and 2015 pretax income to be overstated by the same amount. Overstatement of the 2014 ending inventory would have the opposite effect; that is, 2014 pretax income would be overstated by $50,000 and 2015 pretax income understated by $50,000. Total pretax income for the two years combined would be correct. EXERCISESE71ItemAmountExplanationEnding inventory (physical count on December 31, 2014)$34,500Per physical inventory.a.Goods purchased and in transit+ 700Goods purchased and in transit, F.O.B. shipping point, are owned by the purchaser.b.Samples out on trial to customer+ 1,800Samples held by a customer on trial are still owned by the vendor; no sale or transfer of ownership has occurred.c.Goods in transit to customerGoods shipped to customers, F.O.B. shipping point, are owned by the customer because ownership passed when they were delivered to the transportation company. The inventory correctly excluded these items.d.Goods sold and in transit+ 1,500Goods sold and in transit, F.O.B. destination, are owned by the seller until they reach destination.Correct inventory, December 31, 2014$38,500E72.(Italics for missing amounts only.)Case ACase BCase CNet sales revenue $7,500$4,800$5,000Beginning inventory$11,200$ 7,000$ 4,000Purchases 4,500 8,050 9,500Goods available for sale 15,70015,05013,500Ending inventory9,00011,050 9,300Cost of goods sold 6,700 4,000 4,200Gross profit 800 800 800Expenses 300 1,000 700Pretax income$ 500$ (200)$ 100 E73. (Italics and bold for missing amounts only.)CaseSales RevenueBeg. Inven-toryPur-chasesTotal Avail-ableEnding InventoryCost of Goods SoldGross ProfitEx-pensesPretax Income or (Loss)A$ 650$100$700$800$500$300$350$200$150B1,100 200 9001,100 300 800 300150 150C 600 150 350 500 300 200 400100 300D800 150 550 700 300 400 400200 200E1,000 200 9001,100 600 500 500550 (50)E74.Computations:Simply rearrange the cost of goods sold equationBI + P EI = CGSP = CGS BI + EICost of goods sold $1,639,188,000Beginning inventory (385,857,000)+Ending inventory 569,818,000Purchases $1,823,149,000E7-5AverageUnitsFIFOLIFOCostCost of goods sold:Beginning inventory ($5)2,000$10,000$10,000$10,000Purchases (March 21) ($6)5,00030,00030,00030,000 (August 1) ($8) 3,000 24,000 24,000 24,000Goods available for sale10,00064,00064,00064,000Ending inventory* 4,000 30,000 22,000 25,600Cost of goods sold* 6,000 $34,000$42,000$38,400*Ending inventory computations:FIFO:(3,000 units $8) + (1,000 units $6) = $30,000.LIFO:(2,000 units $5) + (2,000 units $6) = $22,000.Average:(2,000 units $5) + (5,000 units $6) + (3,000 units $8) =$64,000 10,000 units = $6.40 per unit.4,000 units $6.40 = $25,600.*Cost of goods sold computations:FIFO:(2,000 units $5) + (4,000 units $6) = $34,000.LIFO: (3,000 units $8) + (3,000 units $6) = $42,000.Average:(2,000 units $5) + (5,000 units $6) + (3,000 units $8) =$64,000 10,000 units = $6.40 per unit.6,000 units $6.40 = $38,400.Financial Accounting, 8/e 7-59 2014 by McGraw-Hill Global Education Holdings, LLC. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.E76AverageUnitsFIFOLIFOCostCost of goods sold:Beginning inventory ($5)2,000$10,000$10,000$10,000Purchases (March 21) ($4)6,00024,00024,00024,000 (August 1) ($2) 4,000 8,000 8,000 8,000Goods available for sale12,00042,00042,00042,000Ending inventory* 3,000 6,000 14,000 10,500Cost of goods sold 9,000$36,000 $28,000$31,500*Ending inventory computations:FIFO:(3,000 units $2) = $6,000.LIFO:(2,000 units $5) + (1,000 units $4) = $14,000.Average:(2,000 units $5) + (6,000 units $4) + (4,000 units $2) =$42,000 12,000 units = $3.50 per unit.3,000 units $3.50 = $10,500.*Cost of goods sold computations:FIFO:(2,000 units $5) + (6,000 units $4) + (1,000 units $2) = $36,000.LIFO: (4,000 units $2) + (5,000 units $4) = $28,000.Average:(2,000 units $5) + (6,000 units $4) + (4,000 units $2) =$42,000 12,000 units = $3.50 per unit.9,000 units $3.50 = $31,500.E77.Req. 1BROADHEAD COMPANYIncome StatementFor the Year Ended December 31, 2015Case ACase BFIFOLIFOSales revenue1$500,000$500,000Cost of goods sold:Beginning inventory $ 27,000 $ 27,000 Purchases 195,000195,000 Goods available for sale2 222,000 222,000 Ending inventory3 125,000 87,000 Cost of goods sold4 97,000 135,000Gross profit 403,000 365,000 Expenses 195,000 195,000 Pretax income$208,000$170,000Computations:(1)Sales: (10,000 units $50) = $500,000(2)Goods available for sale (for both cases):UnitsUnit CostTotal CostBeginning inventory 3,000$9$ 27,000Purchase, April 11, 2015 9,000 10 90,000Purchase, June 1, 2015 7,00015 105,000Goods available for sale19,000$222,000(3)Ending inventory (19,000 available 10,000 units sold = 9,000 units):Case AFIFO:(7,000 units $15 = $105,000) +(2,000 units $10 = $20,000) = $125,000.Case BLIFO:(3,000 units $9 = $27,000)+(6,000 units $10 = $60,000) = $87,000.E77. (continued)Req. 1 (continued)(4) Cost of goods sold (10,000 units sold):Case A FIFO:(3,000 units $9 = $27,000) +(7,000 units $10 = $70,000) = $97,000Case B LIFO:(7,000 units $15 = $105,000) +(3,000 units $10 = $30,000) = $135,000Req. 2 Comparison of AmountsCase ACase BFIFOLIFOPretax Income$208,000$170,000Difference$38,000Ending Inventory125,00087,000Difference38,000The above tabulation demonstrates that the pretax income difference between the two cases is exactly the same as the inventory difference. Differences in inventory have a dollar-for-dollar effect on pretax income.Req. 3LIFO may be preferred for income tax purposes because it reports less taxable income (when prices are rising) and hence (a) reduces income tax and (b) as a result reduces cash outflows for the period.E78. Req. 1BECK INC.Income StatementFor the Year Ended December 31, 2015Case ACase BFIFOLIFOSales revenue1$704,000$704,000Cost of goods sold:CHANGEDBeginning inventory $ 35,000 $ 35,000 Purchases 281,000 281,000 Goods available for sale2 316,000 316,000 Ending inventory3 128,000 80,000 Cost of goods sold4 188,000 236,000Gross profit 516,000 468,000 Expenses 500,000 500,000 Pretax income$16,000$(32,000)Computations:(1)Sales: (8,000 units $28) + (16,000 units $30) = $704,000(2)Goods available for sale (for both cases):UnitsUnit CostTotal CostBeginning inventory 7,000$5$ 35,000Purchase, March 5, 2015 19,000 9 171,000Purchase, September 19, 2015 10,00011 110,000Goods available for sale36,000$316,000(3)Ending inventory (36,000 available 24,000 units sold = 12,000 units):Case AFIFO:(10,000 units $11 = $110,000) +(2,000 units $9 = $18,000) = $128,000.Case BLIFO:(7,000 units $5 = $35,000)+(5,000 units $9 = $45,000) = $80,000.E78. (continued)Req. 1 (continued)(4) Cost of goods sold (24,000 units sold):Case A FIFO:(7,000
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