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CHAPTER 7

7-1 Sales transactions are accompanied by recording of the cost of goods sold (or cost of sales). This is literally true under the perpetual system and conceptually descriptive under the periodic system.

7-2 The two steps are obtaining (1) a physical count and (2) a cost valuation.

7-3 Perpetual systems provide continuous inventory and cost of goods sold records. Periodic systems rely on physical inventory taking to record cost of goods sold at the end of the period.

7-4 It is true that the periodic method requires a physical count to measure cost of goods sold and the perpetual method does not. However, for control purposes, it is important to undertake at least annual physical counts of inventory under the perpetual method, as well.

7-5 F.O.B. destination means the shipper pays the freight bill.

F.O.B shipping point means the customer bears the cost of the freight bill. F.O.B. stands for "free on board."

7-6 Freight out is not shown as a direct offset to sales. Unlike sales discounts and returns, freight out is not a part of gross revenue that never gets collected. Instead, it is an expense, entailing ordinary cash disbursements.

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1. Specific identification – charges the actual cost of the specific item sold.

2. FIFO – items purchased first are assumed to be sold first.

3. LIFO – items purchased most recently are assumed to be sold first.

4. Weighted average – the average cost of all items available is charged for each item sold.

7-8 The specific identification method is normally used for low volume, high value items. Therefore, we would expect this to be used for a, b, d, and f.

7-9 Yes. Under FIFO the oldest costs are assigned to the cost of goods sold first, so the timing of purchases cannot affect cost flows.

7-10 The good news is that LIFO reduces taxes in times of rising prices. The bad news is that reported profit is lower.

7-11 Yes. Purchases under LIFO can affect income immediately, because the unit costs of the latest purchases are assigned to units sold.

7-12 No. The weighted average must take into account the number of units purchased at each price. For Gamma Company, the weighted average unit cost of inventory is: [(2 x $4.00) + (3 x

$5.00)]

÷

5 = $4.60.

7-13 Ending inventory is lower under LIFO in a period of rising prices and constant or growing inventory. FIFO produces the higher ending inventory value.

(3)

7-14 Falling prices reverse the normal relation, so FIFO produces higher cost of goods sold and, therefore, lower net earnings.

This helps explain why computer and electronics firms typically use FIFO in order to lower their taxes.

7-15 Consistency requires the maintaining of constant accounting methods from period to period. Switching accounting methods hinders comparisons of current results to those of preceding periods.

7-16 Companies have adopted LIFO primarily because it saves income taxes during times of rising prices by reporting higher cost of goods sold and lower profits.

7-17 An inventory profit is fictitious because, for a going concern, it represents an amount necessary for replenishing inventory and is therefore not "available" in the form of cash for distribution as dividends. It arose from change in unit costs of the products purchased, not from the company's value added activities.

7-18 LIFO inventory valuations can be absurd because inventory valuation is based on older and older costs as the years pass.

7-19 Conservatism does result in lower immediate profits, but higher profits are then shown in later periods.

7-20 This convention is called conservatism.

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the physical inventory.

7-22 The inconsistency is the willingness of accountants to have replacement costs used as a basis for write-downs below historical costs, even though a market exchange has not occurred, but their unwillingness to have replacement costs used as a basis for write-ups above historical costs.

7-23 Many inventory errors do counterbalance. For example, an ending inventory that is overstated will overstate current income. But the same overstated inventory becomes the beginning inventory the next year; hence, next year's income will be understated. To show this you might use the following schematic:

Year 1 Year 2

BI OK Too Large

+ Purchase OK OK

Goods Available OK Too Large

–Ending Inventory Too Large OK Cost of Goods Sold Too Small Too Large

This exercise stresses the fact that the ending inventory of one year becomes the beginning inventory of the subsequent year and the errors correct themselves.

7-24 Cost of goods sold = Beginning inventory + Purchases – Ending inventory.

7-25 Past gross profit percentages are sometimes applied to current revenue as interim estimates of gross profit for a

(5)

7-26 Grocery stores have a low profit margin. If the profit margin is 2%, a savings of $100 in shrinkage would be equivalent to a

$5,000 increase in sales.

7-27 Your boss has a point. This is a cost benefit question. If we do not give the discount, we may lose customers to competitors of ours that treat them better. But if it is not currently a custom in the industry, you may not have to do it. If offering the discount does not cause customers to buy more, it is giving money away. However, if it is not an industry custom and it attracts new customers, that may lead to a different conclusion. Compare how much your operating income would rise from newly attracted customers versus the discounts received by existing customers.

7-28 Phar Mor overstated its assets by overstating inventories. This means that either liabilities or stockholders’ equity must also be overstated (to keep the balance sheet equation in balance).

Most likely Phar Mor used a periodic inventory method, so that overstating ending inventory would reduce cost of goods sold and increase pretax profit. If the company used a perpetual inventory system, management must have made inappropriate credits to cost of goods sold or some other expense account to offset the additional debits to the inventory account.

7-29 Under the FIFO method, the cost of sales will be based on old acquisition costs. Under the LIFO method, the cost of sales will be based on the most recent acquisition costs. Thus, under LIFO, if additional units are acquired on the last day of the year, the cost of those units will be included in cost of sales. Thus,

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allows a continuous tracking of inventories, allowing better control of inventory. It provides an up-to-date measure of cost of goods sold without having to take a physical count. Its biggest disadvantage is cost; a periodic inventory system is simpler and less costly. However, with the use of optical scanning and computers the cost of a perpetual inventory system has come down quickly. If the Zen Bootist is willing to invest in a system that codes each individual product and tracks its progress through the inventories, then many advantages of a perpetual inventory system can be achieved.

7-31 (10-15 min.)

GOODMAN’S JEWELRY WHOLESALERS Schedule of Gross Profit

For the Year Ended December 31, 20X8 (In Thousands)

Gross sales $985

Deduct: Sales returns and allowances $40

Cash discounts on sales 5 45

Net sales 940

Cost of goods sold:

Inventory, December 31, 20X7 $103

Add: Gross purchases $650

Deduct: Purchase returns

and allowances $27

Cash discounts on purchases 6 33

Net purchases 617

Add Freight-in 50

Cost of merchandise acquired 667

Cost of goods available for sale 770

(7)

7-32 (20 min.)

Sales $71,200

Sales returns 2,300

Net sales $68,900

Cost of goods sold:

Inventory, January 1* x = $39,864

Purchases $54,000

Purchase returns 2,000

Net purchases $52,000

Freight in 500 52,500

Cost of goods available for sale $92,364

Inventory, January 15 40,000

Cost of goods sold, .76 x $68,900 52,364

Gross margin, .24 x $68,900 $16,536

* $52,364 + $40,000 – 52,500 = $39, 864 or:

Cost of goods sold (.76 x 68,900) $52,364

Cost of goods purchased 52,500

Inventory increase $ 136

Beginning Balance = Ending Balance + Change =

$40,000 - $136 $39,864

(8)

Perpetual Periodic Accounts receivable* 19 Accounts receivable 19

Sales revenue 19 Sales revenue 19 Cost of goods sold 15 No entry

Merchandise

inventory 15

* Could be a debit to cash if sales were for cash.

7-34 (10-15 min.)

Cost of Goods Available = £21,400

(8,000 + 4,200 + 4,400 + 2,300 + 2,500)

LIFO Ending Inventory = (4,000 @

£

2) + (1,500 @

£

2.10) = £11,150 FIFO Ending Inventory = 1,000 @

£

2.50 = £ 2,500

1,000 @

£

2.30 = 2,300 2,000 @

£

2.20 = 4,400 1,500 @

£

2.10 = 3,150

5,500 £12,350

Weighted average = £21,400/10,000 = £ 2.14 per unit Ending inventory 5,500 @

£

2.14 = £11,770

Cost of Goods Sold Calculation:

Weighted

LIFO FIFO Average

Cost of goods available £21,400 £21,400 £21,400 Less Ending Inventory (11,150) (12,350) (11,770)

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7-35 (10-15 min.)

This is straightforward. Answers are in Swiss francs.

Aug. 2 Purchases 350,000

Accounts payable 350,000

Aug. 3 Freight-in 15,000

Cash 15,000

Aug. 7 Accounts payable 30,000

Purchase returns

and allowances 30,000

Aug. 11 Accounts payable 320,000

Cash discounts on purchases 6,400

Cash 313,600

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1. Invoice price $200,000

Add: Freight-in 10,000

Deduct: Purchase allowance (15,000) Deduct: Cash discount (3,700)*

Total cost of steel acquired $191,300

*2% x ($200,000 – $15,000)

2. Purchases (or Inventory)* 200,000

Accounts payable 200,000

*The debit is to Purchases under the periodic inventory method and to Inventory under the perpetual inventory system.

Freight-in 10,000

Accounts payable (or cash) 10,000

Accounts payable 15,000

Purchase returns and allowances 15,000

Accounts payable 185,000

Cash discounts on purchases 3,700

Cash 181,300

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7-37 (15 min.) Amounts are in thousands of dollars.

See Exhibit 7-37 for the balance sheet equation. Although not required, the balance sheet equation provides a good framework for understanding.

Journal Entries

Perpetual System

a. Gross purchase: Inventory 960

Accounts payable 960

b. Returns and allowances: Accounts payable 80

Inventory 80

c. As goods are sold: Cost of goods sold 890

Inventory 890

d1. and d2. No entry

Periodic System

a. Gross purchase: Purchases 960

Accounts payable 960

b. Returns and allowances: Accounts payable 80 Purchase returns

and allowances 80

c. As goods are sold: No entry

d1. Transfer to cost of

goods sold: Cost of goods sold 990

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(13)

EXHIBIT 7-37

Entries are in thousands of dollars.

A = L + SE

Accounts Retained

PERPETUAL SYSTEM Inventory Payable Earnings

Balance, 12/31/X7 +110 = + 110

a. Gross purchases +960 = + 960

b. Returns and allowances – 80 = – 80

c. As goods are sold –890 –890





Sold Goods of

Cost Increase

Closing the accounts at end of period:

d1. No entry d2. No entry

____ ____

Ending balances, 12/31/X8 +100 = +990 –890

(14)

A = L + SE Purchase

Returns and Accounts Retained PERIODIC SYSTEM Inventory Purchases Allowances Payable Earnings

Balance, 12/31/X7 +110 = + 110

a. Gross purchases +960 = + 960

b. Returns and allowances –80 = – 80

c. As goods are sold (no entry) Closing the accounts at

end of period:

d1. Transfer to cost of goods sold–110 –960 +80 = – 990





Sold Goods of

Cost Increase

d2. Recognize ending inventory +100 = + 100





Sold Goods of

Cost Decrease

___ ___ ___

Ending balances, 12/31/X8 +100 0 0 = +990 – 890

(15)
(16)

This is straightforward.

1. Purchases 880,000

Accounts payable 880,000

2. Accounts payable 50,000

Purchase returns and allowances 50,000

3. Freight-in 74,000

Cash 74,000

4. Accounts payable 830,000

Cash 812,000

Cash discounts on purchases 18,000

7-39 (10 min.)

The entries could be compounded.

Accounts receivable (or Cash) 1,250,000

Sales 1,250,000

Cost of goods sold 957,000

Purchase returns and allowances 50,000 Cash discounts on purchases 18,000

Purchases 880,000

Freight-in 74,000

Inventory 71,000

Inventory 120,000

Cost of goods sold 120,000

(17)

7-40 (10-15 min.)

Compound entries could be prepared. (Amounts are in millions.)

Purchases 130

Accounts payable 130

Accounts receivable 239

Sales 239

Sales returns and allowances 5

Accounts receivable 5

Accounts payable 6

Purchase returns and allowances 6

Freight-in 14

Cash 14

Accounts payable 124

Cash discounts on purchases 1

Cash 123

Cash 226

Cash discounts on sales 8

Accounts receivable 234

Cost of goods sold 162

Purchase returns and allowances 6 Cash discounts on purchases 1

Inventory 25

Purchases 130

(18)

7-41 (5 min.) Amounts are in millions of dollars.

Beginning inventory $ 45

Purchases 4,510

Cost of goods available 4,555

Ending inventory (56)

Cost of goods sold $4,499

(19)

7-42 (15-20 min.)

This problem develops familiarity with the gross profit section.

The answer, $51,200, is computed by filling in the gross profit section and solving for the unknown, or: $192,000 – 55%($256,000)

= $51,200.

Gross sales $280,000

Deduct: Sales returns

and allowances 24,000

Net sales $256,000

Cost of goods sold:

Inventory, December 31, 20X7 $38,000

Gross purchases $160,000

Deduct: Purchase returns

and allowances $8,000

Cash discounts

on purchases 2,000 (10,000)

Net purchases 150,000

Inward transportation 4,000

Cost of goods acquired 154,000

Cost of goods available

for sale 192,000

Inventory, May 3, 20X8* x = 51,200 Cost of goods sold,

55% of $256,000 140,800

Gross profit, 45% of $256,000 $115,200

* Calculated as the difference between cost of goods available for sale,

$192,000, and cost of goods sold $140,800.

(20)

Sales $200,000 Cost of goods sold:

Inventory, January 1 $65,000

Purchases $195,000

Purchase returns and allowance 10,000

Net purchases $185,000

Freight-in 15,000 200,000

Cost of goods available for sale $265,000

Inventory, March 9* x = 105,000

Cost of goods sold,

80% of $200,000 160,000

Gross margin, 20% of $200,000 $ 40,000

* The answer, $105,000, is obtained by filling in the schedule of cost of goods sold and solving for the unknown, or: $265,000 – 80%($200,000) = $265,000 – $160,000 = $105,000.

7-44 (10-15 min.)

Beginning inventory $ 55,000

Purchases 200,000

Cost of goods available for sale $255,000 Less estimated cost of goods sold:

75%* of $280,000 210,000

Estimated ending inventory $ 45,000

*100% – 25% = 75%

The difference between $45,000 and the amount of inventory remaining is an estimate of the amount missing.

(21)

7-45 (10-15 min.)

1 & 2. To calculate the effect use the following approach:

20X5 20X6

Beginning inventory OK Too low $20,000

+ Purchases OK OK

Goods available OK Too low $20,000

−Ending inventory Too low $20,000 OK

Cost-of-goods sold Too high $20,000 Too low $20,000

Cost-of-goods sold is too high by $20,000 in 20X5 so taxable income will be too low by $20,000. Taxes will be too low by $8,000 so net income and retained earnings will be too low by $12,000.

Taxable income for 20X6 will be overstated by $20,000 and taxes will be $8,000 too high. Net income in 20X6 will be too high by $12,000 and retained earnings will be correct again at December 31, 20X6.

(22)

1. Inventory turnover = cost of goods sold* ÷ average inventory

= $1,080,000 ÷ $1,080,000

= 1.00

*Cost of goods sold = $2,400,000 – $1,320,000 = $1,080,000 2. The gross profit would fall from $1,320,000 to $1,260,000, so a

change in pricing strategy would be undesirable for Custom Gems. The current 20X3 data follow:

Inventory turnover 1.0

Gross profit percentage:

$1,320,000 ÷ $2,400,000 55%

This percentage is not unusual.

If prices are cut 20 percent in 20X4 without affecting inventory turnover, new sales would be .8 x $2,400,000 = $1,920,000.

Cost of goods sold on those sales would still be $1,080,000.

Therefore Mr. Siegl would be reducing his gross profit from

$1,320,000 to $1,920,000 - $1,080,000 = $840,000 and its gross profit percentage to 44% [($1,920,000

$1,080,000) ÷

$1,920,000]. However, an increase in inventory turnover to 1.5 would produce the following:

Sales, $1,920,000 x 1.5 $2,880,000

Cost of goods sold, $1,080,000 x 1.5 1,620,000

Gross profit $1,260,000

Gross profit would be only $60,000 below the 20X3 level.

(23)

7-47 (15-20 min.) 1. LIFO Method:

Inventory shows: 1,100 tons on hand at July 31.

Costs: 1,000 tons @ $ 9.00 $ 9,000

100 tons @ $10.00 1,000

July 31 inventory cost. $10,000

FIFO Method:

Inventory shows: 1,100 tons on hand at July 31.

Costs: 900 tons @ $12.00 $10,800

200 tons @ $11.00 2,200

July 31 inventory cost. $13,000

2. Purchases:

5,000 tons @ $10 $50,000

1,000 tons @ $11 11,000

900 tons @ $12 10,800 Total purchases $71,800 Beginning inventory:

1,000 tons @ $ 9 9,000

LIFO FIFO Cost of goods available for sale $80,800 $ 80,800 $ 80,800 Less ending inventory (10,000) (13,000)

Cost of goods sold $ 70,800 $ 67,800

Sales $102,000 $102,000

Cost of goods sold 70,800 67,800

Gross profit $ 31,200 $ 34,200

(24)

The inventory would be written down from $200,000 to

$185,000 on December 31, 20X1. The new $185,000 valuation is

"what's left" of the original $200,000 cost. In other words, the

$185,000 is the unexpired cost and may be thought of as the new cost of the inventory for future accounting purposes. Thus, because subsequent replacement values exceed the $185,000 cost, and write-ups above "cost" are not acceptable accounting practice, the valuation remains at $185,000 until it is written down to $180,000 on the following December 31, 20X2.

7-49 (10-15 min.) Amounts are in millions of dollars.

The cost of inventory acquired during the year ending August 31, 2003, can be calculated as follows.

Beginning Inventory $ 3,127

Purchases X = 37,537

Cost of goods available Y = 40,664

Ending inventory (3,339)

Cost of merchandise sold $37,325 Y = 37,325 + 3,339 = 40,664

X = 40,664 – 3,127 = 37,537

(25)

7-50 (10 min.) Dollar amounts are in millions.

2003: ($11,305 − $7,799) ÷ $11,305 = 31.01%

2002: ($11,019 − $7,604) ÷ $11,019 = 30.99%

2001: ($11,332 − $7,815) ÷ $11,332 = 31.04%

The gross profit percentage was very steady over these three years, with just a slight dip in 2002 followed by a small recovery.

Though not in the problem, it might be interesting to note that the gross profit percentage has ranged for 27% to 31% over the past ten years.

7-51 (10-15 min.)

1. ISLAND BUILDING SUPPLY

Statement of Gross Profit

For the Year Ended December 31, 20X1

Sales $1,200,000

Cost of goods sold:

Inventory, beginning $ 240,000

Add net purchases 1,035,000

Cost of goods available for sale $1,275,000 Deduct ending inventory (330,000)

Cost of goods sold 945,000

Gross profit $255,000

(26)

The detailed income statement is in the accompanying exhibit.

Note the classification of operating expenses into a selling category and a general and administrative category. The list of accounts in the problem contained one item that belongs in a balance sheet rather than an income statement, the Allowance for Bad Debts (an offset to Accounts Receivable).

The delivery expenses and the bad debts expense are shown under selling expenses. Some accountants prefer to show the bad debts expense as an offset to gross sales or as administrative expenses.

(27)

7-52 (continued)

BACKBAY BATHROOM SUPPLY COMPANY Income Statement

For the Year Ended December 31, 20X5 (In Thousands)

Revenues:

Gross sales $1,091

Deduct: Sales returns and allowances $ 50

Cash discounts on sales 16 66

Net sales $1,025

Cost of goods sold:

Inventory, December 31, 20X4 $200

Add purchases $600

Less: Purchase returns

and allowances $40

Cash discounts on purchases 15 55

Net purchases $545

Add Freight in 50

Cost of merchandise acquired 595

Cost of goods available for sale $795

Deduct: Inventory, December 31, 20X5 300

Cost of goods sold 495

Gross profit from sales $ 530

Operating expenses:

Selling expenses:

Sales salaries and commissions $160

Rent expense, selling space 90

Advertising expense 45

Depreciation expense, trucks

and store fixtures 29

Bad debts expense 8

Delivery expenses 20

Total selling expenses $352

General and administrative expenses:

Office salaries 46

Rent expense, office space 10

(28)
(29)

7-53 (15-25 min.)

Under the FIFO cost-flow assumption, the periodic and perpetual procedures give identical results. The ending inventory will be valued on the basis of the last purchases during the period.

Units $ Beginning Inventory 120 600

Purchases 290 2,050

Goods available 410 2,650

Units sold 255 1,465**

Units in ending Inventory 155 1,185*

* 155 units remain in ending inventory

100 will be valued at the $8 cost from the October 21 purchase and the remaining 55 will be valued at the $7 cost from the May 9 purchase

100 x $8 = $ 800 55 x $7 = 385

$1,185 Ending inventory

** Reconciliation: Cost of Goods Sold:

255 Units: 120 x $5 = $ 600 80 x $6 = 480 55 x $7 = 385

$1,465

(30)

1. Gross profit percentage = $1,600,000 ÷ $4,000,000 = 40%

Inventory turnover = $2,400,000 ÷

2

750,000

$850,000+

= 3 times

2. Inventory turnover = $2,400,000 ÷ $600,000 = 4 times, a 1/3 increase in turnover.

3. With a lower average inventory and constant inventory turnover, cost of sales must fall. Total cost of goods sold =

$600,000 x 3 = $1,800,000. To achieve a gross profit of

$1,600,000, total sales must be $1,800,000 + $1,600,000, or

$3,400,000. The gross profit percentage must be $1,600,000 ÷

$3,400,000 = 47.1%. Requirements 2 & 3 show that if inventory levels are reduced you must increase either inventory turnover or margins to maintain profitability.

4. Summary (computations are shown below):

Succeeding Year Given Year 4a 4b

Sales $4,000,000 $3,857,143 $4,125,000

Cost of goods sold 2,400,000 2,160,000 2,640,000 Gross profit $1,600,000 $1,697,143 $1,485,000

(31)

7-54 (continued)

a. New gross profit percentage, 40% + .10(40%) = 44%

New inventory turnover, 3 – .10(3) = 2.7

New cost of goods sold, $800,000 x 2.7 = $2,160,000 New sales = $2,160,000 ÷ (1 – .44)

= $2,160,000 ÷ .56

= $3,857,143

Note that this is a more profitable alternative, assuming that the gross profit percentage and the inventory turnover can be achieved. In contrast, alternative 4b is less attractive than the original 40% gross profit and turnover of 3.

b. New gross profit percentage, 40% – .10(40%) = 36%

New inventory turnover, 3 + .10(3) = 3.3

New cost of goods sold, $800,000 x 3.3 = $2,640,000 New sales = $2,640,000 ÷ (1 −.36)

= $2,640,000 ÷ .64

= $4,125,000

5. Retailers find these ratios (and variations thereof) helpful for a variety of operating decisions, too many to enumerate here.

An obvious help is the quantifying of the options facing management regarding what and how much inventory to carry, and what pricing policies to follow. You may want to stress that this analysis ignores one benefit of higher inventory turnover—

the firm reduces its investment in inventory and reduces storage and display requirements.

(32)

The detailed income statement is in the accompanying exhibit.

Some accountants prefer to show the provision for uncollectible accounts as an offset to gross sales. The data for the allowance for doubtful accounts does not affect the income statement.

SEARS, ROEBUCK & COMPANY Income Statement

For the Year Ended December 31, 2002 (In Millions)

Revenues:

Gross revenues (Plug) $44,316

Deduct: Sales returns and allowances $ 2,100

Cash discounts on sales 850 2,950

Net revenues $41,366

Cost of goods sold:

Inventory, December 31, 2001 $4,912

Add purchases $26,124

Less: Purchase returns

and allowances $1,200

Cash discounts on

purchases 180 1,380

Net purchases $24,744

Add Freight in 1,100

Cost of merchandise acquired 25,844

Cost of goods available for sale $30,756

Deduct: Inventory, December 31, 2002 5,115

Cost of sales 25,646

Gross profit $15,720

Operating expenses:

Selling and administrative $9,249

Provision for uncollectible accounts 2,261

Depreciation 875

Other operating expenses 111 12,496

Operating income $ 3,224

Interest expense 1,143

Other income, net (372)

Income before tax $ 2,453

(33)

7-56 (20-30 min.)

1. CONTRACTOR SUPPLY CO.

Comparison of Inventory Methods

Statement of Gross Profit of Kemtone Cooktops For the Year Ended December 31, 20X8

(In Dollars)

FIFO LIFO

Weighted Average

Sales, 260 units 26,200 26,200 26,200

Deduct cost of goods sold:

Inventory, December 31,

20X7, 110 @ $50 5,500 5,500 5,500

Purchases, 300 units 21,200 21,200 21,200

Cost of goods available for

sale, 410 units 26,700 26,700 26,700

Deduct: Inventory, December 31, 20X8, 150 units:

100 @ $80 8,000

50 @ $70 3,500 11,500

110 @ $50 5,500

40 @ $60* 2,400 7,900

150 @ ($26,700 ÷ 410),

150 @ $65.12 9,768

Cost of goods sold,

260 units 15,200 18,800 16,932

Gross profit 11,000 7,400 9,268

* This is a periodic LIFO. Students are using perpetual LIFO if they answer 20 @ $60 plus 20 @

$80 = $2,800.

2. Income taxes would be lower by .40($11,000 – $7,400) = $1,440.

The income tax rate is assumed to be identical at all levels of taxable income. Some students will wonder why no

(34)

There would be no effect on gross profit, net income, or income taxes under FIFO, although the balance sheet would show ending inventory as $8,000 higher. The income statement would show purchases and ending inventory as higher by $8,000, so the net effect on cost of goods sold would be zero.

LIFO would show a lower gross profit, $6,000, as compared with $7,400, a decrease of $1,400. Hence, the impact of the late purchase on income taxes would be a savings of 40% of $1,400 =

$560.

The tabulation below compares the results under LIFO (in dollars):

Without Late Purchase With Late Purchase

Sales, 260 Units 26,200 26,200

Deduct: Cost of goods sold:

Inventory, December 31, 20X7,

110 @ $50 5,500

5,500 Purchases, 300 units at various

costs 21,200

21,200

100 units @ $80 8,000

Cost of goods available for sale 26,700 34,700 Deduct: Inventory, December

31, 20X8:

First layer (pool) 110 @ $50 5,500 5,500 Second layer (pool) 40 @ $60 2,400 7,900

Second layer (pool) 80 @ $60 4,800

Third layer (pool) 60 @ $70 4,200 14,500

Cost of goods sold, 260 units 18,800 20,200

Gross profits 7,400 6,000

Income taxes @ 40% 2,960 2,400

(35)

7-57 (continued)

Although purchases are $8,000 higher than before, the new LIFO ending inventory is only $14,500 – $7,900 = $6,600 higher. The

$1,400 difference in gross profit is explained by the fact that the late purchase resulted in changes to both ending inventory and cost of goods sold. LIFO cost of goods sold is $1,400 higher ($20,200 –

$18,800).

To see this from another angle, compare layers. Without the late purchase, the second layer had 40 units @ $60. With the late purchase:

Late purchase released as expense, 100 @ $80 $8,000 Second layer is 40 units higher @ $60 = $2,400

Third layer is 60 units @ $70 = 4,200 Amount held as ending inventory that

would otherwise have been released as

expense in the form of cost of goods sold 6,600

Difference in cost of goods sold $1,400

7-58 (15 min.)

1. LIFO: 100 units @ $10 $1,000

20 units @ $12 240

$1,240 2. Replacement cost: 120 units @ $12 = $1,440.

LIFO is lower than replacement cost. Therefore, no inventory write-down takes place, and the balance sheet shows $1,240.

3. FIFO: 20 units @ $12 $ 240

(36)

the $100 inventory write-down as an increase in cost of sales.

(37)

7-59 (10-15 min.)

1. O is used for overstated, U for understated, and N for not affected.

(In Thousands) 20X1 20X2

Beginning inventory* N O $15

Ending inventory* O $15 N

Cost of goods sold U 15 O 15

Gross margin O 15 U 15

Income before income taxes O 15 U 15

Income tax expense O 6 U 6

Net income O 9 U 9

*The ending inventory for 20X1 becomes the beginning inventory for 20X2.

2. Retained earnings would be overstated by $9,000 at the end of the first year. However, the error would be offset in the second year, assuming no change in the 40% income tax rate.

Therefore, retained earnings would be correct at the end of the second year.

7-60 (20-30 min.)

1. See Exhibit 7-60 on the following page.

2. LIFO results in more cash by the difference in income tax effects. LIFO results in a lower cash outflow of .40 x ($116,000 – $96,000) = $8,000.

3. FIFO results in more cash when inventory prices are falling. Why?

Because income tax cash outflow would be more under LIFO by .40($144,000 – $124,000) = $8,000.

(38)

Purchases @ $12 Unit Purchases @ $8 Unit

Requirement a Requirement b FIFO LIFO FIFO LIFO

Sales, 12,000 @ $20 $240,000 $240,000 $240,000$240,000

Deduct cost of goods sold:

Inventory, December 31, 20X1, 10,000 @ $10 100,000 100,000 100,000 100,000 Purchases: 13,000 @ $12 and $8, respectively 156,000 156,000 104,000 104,000 Cost of goods available for sale 256,000 256,000 204,000 204,000 Deduct: Inventory, December 31, 20X2,

11,000 units:

11,000 @ $12 = 132,000

or

10,000 @ $10 = $100,000

1,000 @ $12 = 12,000 112,000

or

11,000 @ $ 8 = 88,000

or

10,000 @ $10 = $100,000

1,000 @ $ 8 = 8,000 108,000

Cost of goods sold 124,000 144,000 116,000 96,000

Gross margin $116,000 $ 96,000 $124,000$144,000

(39)

7-61 (20 min.) 1.

Units LIFO FIFO

Sales 30,000 £330,000 £330,000

Cost of goods sold:

Inventory, December 31, 20X7 14,000 84,000 84,000

Purchases 52,000 394,000 394,000

Cost of goods available for sale 66,000 478,000 478,000 Inventory, December 31, 20X8 36,000 238,000* 282,000**

Cost of goods sold 30,000 240,000 196,000 Gross margin or gross profit £ 90,000 £134,000

* 14,000 @ £6 = £ 84,000 22,000 @ £7 = 154,000 36,000 £238,000

** 30,000 @ £8 = £240,000 6,000 @ £7 = 42,000 36,000 £282,000

2. Gross margin is higher under FIFO. However, cash will be higher under LIFO by .40(£134,000 – £90,000) = .40 x £44,000 =

£17,600. Cash payments for inventory and cash receipts from sales are unaffected by the cost flow assumption. Only the effect on tax obligations affects cash flow.

(40)

1. (Dollars In Thousands)

Lastin Company Firstin Company

(LIFO) (FIFO)

Sales $4,500 $4,500

Deduct cost of goods sold:

Beginning inventory:

10,000 tons @ $50 $ 500 $ 500

Purchases:

30,000 tons @ $60 $1,800

20,000 tons @ $70 1,400 3,200 3,200

Cost of goods

available for sale $3,700 $3,700

Ending inventory:

10,000 tons @ $50 $ 500 15,000

5,000 tons @ $60 300 800 @ $70 1,050

Cost of goods sold 2,900 2,650

Gross profit $1,600 $1,850

Other expenses 600 600

Income before

income taxes $ 1,000 $1,250

Income taxes at 40% 400 500

Net income $ 600 $ 750

(41)

7-62 (continued)

2. Note first that the underlying events are identical, but the inventory method chosen will yield radically different results.

When prices are rising, and if she had a choice, the manager would choose the method that is most harmonious with her objectives. Clearly the company is better off economically under the LIFO method, even though reported earnings are less. LIFO saved $100 thousand in income taxes:

LIFO FIFO Cash receipts:

Sales $4,500 $4,500

Cash disbursements:

Purchases $3,200

Other expenses 600 $3,800 $3,800

Income taxes 400 500

Total disbursements $4,200 $4,300

Net increase in cash $ 300 $ 200

On the other hand, reported net income is dramatically better under FIFO, $750 versus $600. In times of rising prices and stable or increasing inventory levels, the general guide is that LIFO saves income taxes and results in a better cash position;

nevertheless, FIFO shows the higher reported net income.

(42)

1.

20X1 20X2 20X3 20X4 20X5 Total FIFO:

Sales $5,000 $5,000 $5,000 $5,000 $20,000 $40,000 Cost of goods sold 1,000 2,000 2,000 2,500 13,000 20,500 Income before taxes 4,000 3,000 3,000 2,500 7,000 19,500 Income taxes 1,600 1,200 1,200 1,000 2,800 7,800 Net income $2,400 $1,800 $1,800 $1,500 $ 4,200 $11,700 LIFO:

Sales $5,000 $5,000 $5,000 $5,000 $20,000 $40,000 Cost of goods sold 2,000 2,500 3,000 4,000 9,000 20,500 Income before taxes 3,000 2,500 2,000 1,000 11,000 19,500 Income taxes 1,200 1,000 800 400 4,400 7,800 Net income $1,800 $1,500 $1,200$ 600 $ 6,600 $11,700 2. LIFO is most advantageous because it defers tax payments.

This provides additional cash and reduces the need for borrowing. One way to think about the benefit is to think of the interest saved each year. For example, assume that if higher taxes were paid, that amount would be borrowed at an interest rate of 10%.

20X1 20X2 20X3 20X4 20X5 Total FIFO tax $1,600 $1,200 $1,200 $1,000 $2,800 $7,800 LIFO tax 1,200 1,000 800 400 4,400 7,800 Annual cash benefit /(loss) $ 400 $ 200 $ 400 $ 600 $(1,600)$ 0 Cumulative cash benefit $ 400 $ 600 $1,000 $1,600 – – Interest saved @ 10% $ 40 $ 60 $ 100 $ 160 – $ 360 This analysis does not consider the time value of money in that interest savings are simply added together, but it does provide

(43)

7-64 (30-40 min.)

1, 2. FIFO LIFO

1(a) 2(a) 1(b) 2(b) Sales, 5,000 units $120,000 $96,000 $120,000 $96,000 Less cost of goods sold:

Purchase cost, $118,000 $118,000

Less ending inventory:

FIFO: 4,000 @ $15 60,000

LIFO:

2,000 @ $10 = $20,000 1,000 @ $11 = 11,000

1,000 @ $13 = 13,000 44,000

Cost of goods sold $ 58,000 $60,000 $ 74,000 $44,000 Other expenses 30,000 30,000 30,000 30,000 Total deductions $ 88,000 $90,000 $104,000 $74,000 Income before taxes $ 32,000 $ 6,000 $ 16,000 $22,000 Income taxes @ 40% $ 12,800 $ 2,400 $ 6,400 $ 8,800

Net income $ 19,200 $ 3,600 $ 9,600 $13,200

3. FIFO LIFO

1(a) 2(a) 1(b) 2(b) Sales, 5,000 units $120,000 $96,000 $120,000 $96,000 Less cost of goods sold:

Purchase cost* $ 58,000 $60,000 $ 58,000 $60,000 Other expenses 30,000 30,000 30,000 30,000 Total deductions $ 88,000 $90,000 $ 88,000 $90,000 Income before taxes $ 32,000 $ 6,000 $ 32,000 $ 6,000 Income taxes @ 40% $ 12,800 $ 2,400 $ 12,800 $ 2,400

Net income $ 19,200 $ 3,600 $ 19,200 $ 3,600

The timing of purchases does not affect FIFO income but affects LIFO income. LIFO cost of goods sold declined from $74,000

(44)

The major point here is to demonstrate that changes in LIFO reserves can be used as a shortcut measure of the differences in cost of goods sold under FIFO and LIFO. (All amounts are in dollars.)

LIFO

1. (1) (2) Reserve

FIFO LIFO (1) – (2) Beginning inventory, 2 @ $20,

2 @ $16 40 32 8

Purchases:

3 @ $24 + 3 @ $28 = 156 156 Cost of goods available for sale 196 188 8 Ending inventory, 2 @ $28,

2 @ $16 56 32 24

Cost of goods sold 140 156 (16)

2. a. Beginning inventory 40 32 8

Purchases (as above) 156 156 Cost of goods available for sale 196 188 8 Ending inventory

3 @ $28 + 1 @ $24 108

2 @ $16 + 2 @ $24 ___ 80 28

Cost of goods sold 88 108 (20)

b. Beginning inventory 40 32 8

Purchases 156 156

Available for sale 196 188 8

Ending inventory 0 0 0

Cost of goods sold 196 188 8

(45)

7-65 (continued)

3. From Part 1, the beginning LIFO Reserve is 8, the difference between FIFO inventory of 40 and LIFO inventory of 32. At year end the LIFO Reserve is 24, an increase of 16. This 16 is exactly the difference between FIFO cost of goods sold of 140 and LIFO cost of goods sold of 156. If prices are rising, cost of goods sold includes more of these recent higher costs under LIFO than under FIFO. Hence, if physical quantities are held constant, the LIFO reserve will rise by the difference between the cost of goods sold. Why? Because old LIFO unit costs will still be held in ending inventory, whereas recent higher unit costs will apply to the ending FIFO inventory.

If physical quantities of ending inventory rise along with rises in unit prices, the LIFO difference in higher cost of goods sold becomes larger. Compare 2a. with 1.

If the older LIFO layers are liquidated, the LIFO cost of goods sold becomes less than FIFO cost of goods sold. As 2b.

demonstrates, the total liquidation of inventories will result in FIFO cost of goods sold exceeding LIFO cost of goods sold by the amount of the LIFO reserve at the start of the year.

(46)

1. O is used for overstated; U is used for understated:

(In Millions)

20X3 20X2 20X1 Beginning inventory* Correct O $10 Correct Cost of goods available Correct O 10 Correct Ending inventory* U $5 Correct O $10 Cost of goods sold O 5 O 10 U 10 Gross margin U 5 U 10 O 10 Income before income taxes U 5 U 10 O 10 Income tax expense U 2 U 4 O 4 Net income U 3 U 6 O 6

* The ending inventory for a given year becomes the beginning inventory for the following year.

2. Retained earnings would be overstated by $6 million at the end of 20X1. However, the error would be offset in the second year.

Therefore, retained earnings would be correct at the end of 20X2. Retained earnings is understated by $3 million at the end of 20X3.

7-67 (30-40 min.)

1. See Exhibit 7-67 on the following page.

2. a. Income before income taxes will be lower under LIFO than under FIFO: $149,000 – $124,000 = $25,000. The income tax will be lower by .40 x $25,000 = $10,000.

b. Income before income taxes will be lower under LIFO than

(47)

EXHIBIT 7-67

Weighted Specific

FIFO LIFO Average Identification

Net revenue from sales

(150 @ $900) + (160 @ $1,000) $295,000 $295,000 $295,000 $295,000 Deduct cost of products sold:

Inventory, February 1, 2002,

100 @ $400 40,000 40,000 40,000 40,000

Purchases (200 @ $500) + (160 @ $600) 196,000 196,000 196,000 196,000 Cost of goods available for sale, 460 units 236,000 236,000 236,000 236,000 Deduct: Inventory, January 31, 2003, 150 units:

150 @ $600 90,000

or

100 @ $400 =$40,000

50 @ $500 = 25,000 65,000

or

150 @ ($236,000 ÷ 460) or 150 @ $513 76,950

or

100 @ $400 =$40,000

50 @ $500 = 25,000 65,000

Cost of goods sold 146,000 171,000 159,050 171,000

Gross margin $149,000 $124,000 $135,950 $124,000

(48)

There would be no effect on gross margin, income taxes, or net income under FIFO. The balance sheet would show a higher inventory by $42,000. A detailed income statement would show both purchases and ending inventory as higher by $42,000, so the net effect on cost of goods sold would be zero.

LIFO would show a lower gross margin, $112,000, as compared with $124,000, a decrease of $12,000. Hence, the impact of the late purchase would be a savings of income taxes of 40% of $12,000 =

$4,800. For details, see the following tabulation.

Without Late With Late

Purchase Purchase

Net revenues from sales as

before $295,000 $295,000

Deduct cost of goods sold:

Inventory, February 1, 2002,

100 @ $400 $ 40,000 $ 40,000

Purchases, 360 units, as before,

and 420 units 196,000 238,000*

Cost of goods available for sale $236,000 $278,000 Ending inventory:

First layer 100 @ $400 plus

second layer 50 @ $500 65,000 First layer 100 @ $400 plus

second layer 110 @ $500 95,000

Cost of goods sold 171,000 183,000

Gross margin $124,000 $112,000

*360 units, as before $196,000 60 units @ $700 42,000

$238,000

(49)

7-68 (continued)

Although purchases are $42,000 higher than before, the new LIFO ending inventory is only $95,000 – $65,000 = $30,000 higher. The cost of sales is $183,000 – $171,000 = $12,000 higher.

To see this another way, compare the ending inventories:

Late purchase added to cost of

goods available for sale: 60 @ $700 = $42,000 Deduct 60-unit increase in ending inventory:

Second layer is 110 – 50 = 60 units higher @ $500 = 30,000

Cost of sales is higher by: 60 @ ($700 - $500) = $12,000

7-69 (30-40 min.)

See Exhibit 7-69 on the following page.

(50)

1. TEXAS INSTRUMENTS

Comparison of Inventory Methods Income Statement

For the Year Ended December 31, 2002

FIFO LIFO Weighted

Average

Net sales, 200 units $2,380 $2,380 $2,380

Deduct cost of sales:

Beginning inventory, 80 @ $5 $ 400 $ 400 $ 400

Purchases, 220 units* 1,580 1,580 1,580

Available for sale, 300 units** $1,980 $1,980 $1,980 Ending inventory, 100 units:

90 @ $8 $720

10 @ $7 70 790

or

80 @ $5 $400

20 @ $6 120 520

or

100 @ ($1,980 ÷ 300), or

100 @ $6.60 660

Cost of sales, 200 units 1,190 1,460 1,320

Gross margin $1,190 $ 920 $1,060

Other expenses 600 600 600

Pretax income $ 590 $ 320 $ 460

Income taxes at 40% 236 128 184

Net income $ 354 $ 192 $ 276

(51)

** These amounts will not be equal across the three methods usually, because the beginning inventories will generally be different. The amounts are equal here only because beginning inventories are assumed to be equal.

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