“Where Is That Spare Bulldozer Blade?”
Let's talk inventory—big, bulldozer-size inventory. Caterpillar Inc. is the world's largest manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. It sells its products in over 200 countries, making it one of the most successful U.S. exporters. More than 70% of its productive assets are located domestically, and nearly 50% of its sales are foreign.
In the past, Caterpillar's profitability suffered, but today it is very successful. A big part of this turnaround can be attributed to effective management of its inventory. Imagine what it costs Caterpillar to have too many bulldozers sitting around in inventory—a situation the company definitely wants to avoid. Conversely, Caterpillar must make sure it has enough inventory to meet demand.
At one time during a 7-year period, Caterpillar's sales increased by 100%, while its inventory increased by only 50%. To achieve this dramatic reduction in the amount of resources tied up in inventory, while continuing to meet customers’ needs, Caterpillar used a two-pronged approach. First, it completed a factory modernization program, which greatly increased its production efficiency. The program reduced by 60% the amount of inventory the company processed at any one time. It also reduced by an incredible 75% the time it takes to manufacture a part.
Second, Caterpillar dramatically improved its parts distribution system. It ships more than 100,000 items daily from its 23 distribution centers strategically located around the world (10 million square feet of warehouse space—remember, we're talking bulldozers). The company can virtually guarantee that it can get any part to anywhere in the world within 24 hours.
After these changes, Caterpillar had record exports, profits, and revenues. It would seem that things couldn't be better. But industry analysts, as well as the company's managers, thought otherwise. In order to maintain Caterpillar's position as the industry leader, management began another major overhaul of inventory production and inventory management processes. The goal: to cut the number of repairs in half, increase productivity by 20%, and increase inventory turnover by 40%.
Scan Learning Objectives
Read Feature Story
Read Preview
Read text and answer DO IT! p. 280 p. 286 p. 291 p. 294
Work Comprehensive DO IT! 1 p. 294 2 p. 299
Review Summary of Learning Objectives
Answer Self-Test Questions
Complete Assignments
Go to WileyPLUS for practice and tutorials
Read A Look at IFRS p. 324
After studying this chapter, you should be able to:
[1] Determine how to classify inventory and inventory quantities.
[2] Explain the accounting for inventories and apply the inventory cost flow methods.
[3] Explain the financial effects of the inventory cost flow assumptions.
[4] Explain the lower-of-cost-or-market basis of accounting for inventories.
[5] Indicate the effects of inventory errors on the financial statements.
[6] Compute and interpret the inventory turnover.
In short, Caterpillar's ability to manage its inventory has been a key reason for its past success, and inventory management will very likely play a huge part in its ability to succeed in the future.
Preview of Chapter 6
In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual inventory system. In this chapter, we explain the methods used to calculate the cost of inventory on hand at the balance sheet date and the cost of goods sold.
The content and organization of this chapter are as follows.
Classifying and Determining Inventory
Two important steps in the reporting of inventory at the end of the accounting period are the classification of inventory based on its degree of completeness and the determination of inventory amounts.
Classifying Inventory
How a company classifies its inventory depends on whether the firm is a merchandiser or a manufacturer. In a merchandising company, such as those described in Chapter 5, inventory consists of many different items. For example, in a grocery store, canned goods, dairy products, meats, and produce are just a few of the inventory items on hand. These items have two common characteristics: (1) They are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers need only one inventory classification, merchandise inventory, to describe the many different items that make up the total inventory.
In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: finished goods, work in process, and raw materials. Finished goods inventory is manufactured items that are completed and ready for sale. Work in process is that portion of manufactured inventory that has been placed into the production process but is not yet complete. Raw materials are the basic goods that will be used in production but have not yet been placed into production.
For example, Caterpillar classifies earth-moving tractors completed and ready for sale as finished goods. It classifies the tractors on the assembly line in various stages of production as work in process. The steel, glass, tires, and other components that are on hand waiting to be used in the production of tractors are identified as raw materials. Illustration 6-1 shows an excerpt from Note 7 of Caterpillar's annual report, which shows the significant increases in each type of Caterpillar's inventory levels as the economy began to recover during this period.
Helpful Hint Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
Illustration 6-1
Composition of Caterpillar's inventory
By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management's production plans. For example, low levels of raw materials and high levels of finished goods suggest that management believes it has enough inventory on hand, and production will be slowing down—perhaps in anticipation of a recession. On the other hand, high levels of raw materials and low levels of finished goods probably signal that management is planning to step up production.
Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, companies manufacture or purchase goods just in time for use. Dell is famous for having developed a system for making computers in response to individual customer requests. Even though it makes each computer to meet each customer's particular specifications, Dell is able to assemble the computer and put it on a truck in less than 48 hours. The success of the JIT system depends on reliable suppliers. By integrating its information systems with those of its suppliers, Dell reduced its inventories to nearly zero. This is a huge advantage in an industry where products become obsolete nearly overnight.
The accounting concepts discussed in this chapter apply to the inventory classifications of both merchandising and manufacturing companies. Our focus here is on merchandise inventory. Additional issues specific to manufacturing companies are discussed later in the managerial section of this textbook (Chapters 19–26).
ACCOUNTING ACROSS THE ORGANIZATION 
A Big Hiccup
JIT can save a company a lot of money, but it isn't without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced just such a disruption when a 6.8-magnitude earthquake caused major damage to the company that produces 50% of their piston rings. The rings themselves cost only $1.50, but without them you cannot make a car. No other supplier could quickly begin producing sufficient quantities of the rings to match the desired specifications. As a result, the automakers were forced to shut down production for a few days—a loss of tens of thousands of cars.
Similarly, a major snowstorm halted production at Canadian plants of General Motors and Ford. A Ford spokesperson said, “Because the plants run with just-in-time inventory, we don't have large stockpiles of parts sitting around. When you have a somewhat significant disruption, you can pretty quickly run out of parts.”
Source: Amy Chozick, “A Key Strategy of Japan's Car Makers Backfires,” Wall Street Journal (July 20, 2007); Kate Linebaugh, “Canada Military Evacuates Motorists Stranded by Snow,” Wall Street Journal (December 15, 2010).
What steps might the companies take to avoid such a serious disruption in the future? (See page 324.)
Determining Inventory Quantities
No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory for the following reasons:
1. To check the accuracy of their perpetual inventory records.
2. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.
Companies using a periodic inventory system take a physical inventory for two different purposes: to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period.
Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.
TAKING A PHYSICAL INVENTORY
Companies take a physical inventory at the end of the accounting period. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In many companies, taking an inventory is a formidable task. Retailers such as Target, True Value Hardware, or Home Depot have thousands of different inventory items. An inventory count is generally more accurate when goods are not being sold or received during the counting. Consequently, companies often “take inventory” when the business is closed or when business is slow. Many retailers close early on a chosen day in January—after the holiday sales and returns, when inventories are at their lowest level—to count inventory. Wal-Mart Stores, Inc., for example, has a year-end of January 31.
Ethics Note 
In a famous fraud, a salad oil company filled its storage tanks mostly with water. The oil rose to the top, so auditors thought the tanks were full of oil. The company also said it had more tanks than it really did: It repainted numbers on the tanks to confuse auditors.
ETHICS INSIGHT
Falsifying Inventory to Boost Income 
Managers at women's apparel maker Leslie Fay were convicted of falsifying inventory records to boost net income—and consequently to boost management bonuses. In another case, executives at Craig Consumer Electronics were accused of defrauding lenders by manipulating inventory records. The indictment said the company classified “defective goods as new or refurbished” and claimed that it owned certain shipments “from overseas suppliers” when, in fact, Craig either did not own the shipments or the shipments did not exist.
What effect does an overstatement of inventory have on a company's financial statements? (See page 324.)
DETERMINING OWNERSHIP OF GOODS
One challenge in computing inventory quantities is determining what inventory a company owns. To determine ownership of goods, two questions must be answered: Do all of the goods included in the count belong to the company? Does the company own any goods that were not included in the count?
GOODS IN TRANSIT A complication in determining ownership is goods in transit (on board a truck, train, ship, or plane) at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count, the company must determine ownership of these goods.
Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale, as shown in Illustration 6-2 and described below.
1. When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
2. When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.
If goods in transit at the statement date are ignored, inventory quantities may be seriously miscounted. Assume, for example, that Hargrove Company has 20,000 units of inventory on hand on December 31. It also has the following goods in transit:
1. Sales of 1,500 units shipped December 31 FOB destination.
2. Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.
Hargrove has legal title to both the 1,500 units sold and the 2,500 units purchased. If the company ignores the units in transit, it would understate inventory quantities by 4,000 units (1,500 + 2,500).
As we will see later in the chapter, inaccurate inventory counts affect not only the inventory amount shown on the balance sheet but also the cost of goods sold calculation on the income statement.
CONSIGNED GOODS In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods.
For example, you might have a used car that you would like to sell. If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold. Under this agreement, the dealer would not take ownership of the car, which would still belong to you. Therefore, if an inventory count were taken, the car would not be included in the dealer's inventory because the dealer does not own it.
Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell. Today, even some manufacturers are making consignment agreements with their suppliers in order to keep their inventory levels low.
ANATOMY OF A FRAUD
Ted Nickerson, CEO of clock manufacturer Dally Industries, was feared by all of his employees. Ted also had expensive tastes. To support his expensive tastes, Ted took out large loans, which he collateralized with his shares of Dally Industries stock. If the price of Dally's stock fell, he was required to provide the bank with more shares of stock. To achieve target net income figures and thus maintain the stock price, Ted coerced employees in the company to alter inventory figures. Inventory quantities were manipulated by changing the amounts on inventory control tags after the year-end physical inventory count. For example, if a tag said there were 20 units of a particular item, the tag was changed to 220. Similarly, the unit costs that were used to determine the value of ending inventory were increased from, for example, $125 per unit to $1,250. Both of these fraudulent changes had the effect of increasing the amount of reported ending inventory. This reduced cost of goods sold and increased net income.
Total take: $245,000
THE MISSING CONTROL
Independent internal verification. The company should have spot-checked its inventory records periodically, verifying that the number of units in the records agreed with the amount on hand and that the unit costs agreed with vendor price sheets.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 502–509.
Rules of Ownership
Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. As a new member of Hasbeen's accounting department, you have been given the information listed below. Discuss how this information affects the reported cost of inventory.
1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.
2. The company did not include in the count purchased goods of $10,000 which were in transit (terms: FOB shipping point).
3. The company did not include in the count sold inventory with a cost of $12,000 which was in transit (terms: FOB shipping point).
Action Plan
Apply the rules of ownership to goods held on consignment.
Apply the rules of ownership to goods in transit.
Solution
The goods of $15,000 held on consignment should be deducted from the inventory count. The goods of $10,000 purchased FOB shipping point should be added to the inventory count. Sold goods of $12,000 which were in transit FOB shipping point should not be included in the ending inventory. Thus, inventory should be carried at $195,000 ($200,000 − $15,000 + $10,000).
Related exercise material: BE6-1, E6-1, E6-2, and DO IT! 6-1.
Inventory Costing
Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are added to the cost of inventory, but the cost of shipping goods to a customer are a selling expense.
After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold. This process can be complicated if a company has purchased inventory items at different times and at different prices.
For example, assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700, $750, and $800. During the year, Crivitz sold two sets at $1,200 each. These facts are summarized in Illustration 6-3.
Illustration 6-3
Data for inventory costing example
Cost of goods sold will differ depending on which two TVs the company sold. For example, it might be $1,450 ($700 + $750), or $1,500 ($700 + $800), or $1,550 ($750 + $800). In this section, we discuss alternative costing methods available to Crivitz.
Specific Identification
If Crivitz can positively identify which particular units it sold and which are still in ending inventory, it can use the specific identification method of inventory costing. For example, if Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 + $800), and its ending inventory is $750 (see Illustration 6-4). Using this method, companies can accurately determine ending inventory and cost of goods sold.
Illustration 6-4
Specific identification method
Specific identification requires that companies keep records of the original cost of each individual inventory item. Historically, specific identification was possible only when a company sold a limited variety of high-unit-cost items that could be identified clearly from the time of purchase through the time of sale. Examples of such products are cars, pianos, or expensive antiques.
Today, bar coding, electronic product codes, and radio frequency identification make it theoretically possible to do specific identification with nearly any type of product. The reality is, however, that this practice is still relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost flow assumptions, about which units were sold.
Ethics Note
A major disadvantage of the specific identification method is that management may be able to manipulate net income. For example, it can boost net income by selling units purchased at a low cost, or reduce net income by selling units purchased at a high cost.
Cost Flow Assumptions
Because specific identification is often impractical, other cost flow methods are permitted. These differ from specific identification in that they assume flows of costs that may be unrelated to the physical flow of goods. There are three assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Last-in, first-out (LIFO)
3. Average-cost
There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method.
To demonstrate the three cost flow methods, we will use a periodic inventory system. We assume a periodic system because very few companies use perpetual LIFO, FIFO, or average-cost to cost their inventory and related cost of goods sold. Instead, companies that use perpetual systems often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average-cost as shown in this chapter and adjust cost of goods sold to this recalculated number.1
To illustrate the three inventory cost flow methods, we will use the data for Houston Electronics’ Astro condensers, shown in Illustration 6-5.
Illustration 6-5
Data for Houston Electronics
The cost of goods sold formula in a periodic system is:
(Beginning Inventory + Purchases) − Ending Inventory = Cost of Goods Sold
Houston Electronics had a total of 1,000 units available to sell during the period (beginning inventory plus purchases). The total cost of these 1,000 units is $12,000, referred to as cost of goods available for sale. A physical inventory taken at December 31 determined that there were 450 units in ending inventory. Therefore, Houston sold 550 units (1,000 − 450) during the period. To determine the cost of the 550 units that were sold (the cost of goods sold), we assign a cost to the ending inventory and subtract that value from the cost of goods available for sale. The value assigned to the ending inventory will depend on which cost flow method we use. No matter which cost flow assumption we use, though, the sum of cost of goods sold plus the cost of the ending inventory must equal the cost of goods available for sale—in this case, $12,000.
FIRST-IN, FIRST-OUT (FIFO)
The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow of merchandise. That is, it generally is good business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. (This does not necessarily mean that the oldest units are sold first, but that the costs of the oldest units are recognized first. In a bin of picture hangers at the hardware store, for example, no one really knows, nor would it matter, which hangers are sold first.) Illustration 6-6 shows the allocation of the cost of goods available for sale at Houston Electronics under FIFO.
Illustration 6-6
Allocation of costs—FIFO method
Helpful Hint Note the sequencing of the allocation: (1) Compute ending inventory, and (2) determine cost of goods sold.
Helpful Hint Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.
Under FIFO, since it is assumed that the first goods purchased were the first goods sold, ending inventory is based on the prices of the most recent units purchased. That is, under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the most recent prices. The last purchase was 400 units at $13 on November 27. The remaining 50 units are priced using the unit cost of the second most recent purchase, $12, on August 24. Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale.
Illustration 6-7 demonstrates that companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of the first 550 units acquired. Note that of the 300 units purchased on August 24, only 250 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 50 of these units were assumed unsold and thus included in ending inventory.
Illustration 6-7
Proof of cost of goods sold
LAST-IN, FIRST-OUT (LIFO)
The last-in, first-out (LIFO) method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. (Exceptions include goods stored in piles, such as coal or hay, where goods are removed from the top of the pile as they are sold.) Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining cost of goods sold. Illustration 6-8 shows the allocation of the cost of goods available for sale at Houston Electronics under LIFO.
Illustration 6-8
Allocation of costs—LIFO method
Helpful Hint Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here.
Under LIFO, since it is assumed that the first goods sold were those that were most recently purchased, ending inventory is based on the prices of the oldest units purchased. That is, under LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the earliest prices. The first purchase was 100 units at $10 in the January 1 beginning inventory. Then, 200 units were purchased at $11. The remaining 150 units needed are priced at $12 per unit (August 24 purchase). Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale.
Illustration 6-9 demonstrates that companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of the last 550 units acquired. Note that of the 300 units purchased on August 24, only 150 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 150 of these units were assumed unsold and thus included in ending inventory.
Illustration 6-9
Proof of cost of goods sold
Under a periodic inventory system, which we are using here, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.
AVERAGE-COST
The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. The average-cost method assumes that goods are similar in nature. Illustration 6-10 presents the formula and a sample computation of the weighted-average unit cost.
Illustration 6-10
Formula for weighted-average unit cost
The company then applies the weighted-average unit cost to the units on hand to determine the cost of the ending inventory. Illustration 6-11 shows the allocation of the cost of goods available for sale at Houston Electronics using average-cost.
Illustration 6-11
Allocation of costs—average-cost method
We can verify the cost of goods sold under this method by multiplying the units sold times the weighted-average unit cost (550 × $12 = $6,600). Note that this method does not use the average of the unit costs. That average is $11.50 ($10 + $11 + $12 + $13 = $46; $46 ÷ 4). The average-cost method instead uses the average weighted by the quantities purchased at each unit cost.
DO IT!
Cost Flow Methods
The accounting records of Shumway Ag Implements show the following data.
| Beginning inventory | 4,000 units at $ 3 |
| Purchases | 6,000 units at $ 4 |
| Sales | 7,000 units at $12 |
Determine the cost of goods sold during the period under a periodic inventory system using (a) the FIFO method, (b) the LIFO method, and (c) the average-cost method.
Action Plan
Understand the periodic inventory system.
Allocate costs between goods sold and goods on hand (ending inventory) for each cost flow method.
Compute cost of goods sold for each method.
Solution
Cost of goods available for sale = (4,000 × $3) + (6,000 × $4) = $36,000
Ending inventory = 10,000 − 7,000 = 3,000 units
(a) FIFO: $36,000 − (3,000 × $4) = $24,000
(b) LIFO: $36,000 − (3,000 × $3) = $27,000
(c) Average cost per unit: [(4,000 @ $3) + (6,000 @ $4)] ÷ 10,000 = $3.60
Average-cost: $36,000 − (3,000 × $3.60) = $25,200
Related exercise material: BE6-3, BE6-4, BE6-5, E6-3, E6-4, E6-5, E6-6, E6-7, E6-8, and DO IT! 6-2.
Financial Statement and Tax Effects of Cost Flow Methods
Each of the three assumed cost flow methods is acceptable for use. For example, Reebok International Ltd. and Wendy's International currently use the FIFO method of inventory costing. Campbell Soup Company, Krogers, and Walgreen Drugs use LIFO for part or all of their inventory. Bristol-Myers Squibb, Starbucks, and Motorola use the average-cost method. In fact, a company may also use more than one cost flow method at the same time. Stanley Black & Decker Manufacturing Company, for example, uses LIFO for domestic inventories and FIFO for foreign inventories. Illustration 6-12 (in the margin) shows the use of the three cost flow methods in 500 large U.S. companies.
The reasons companies adopt different inventory cost flow methods are varied, but they usually involve one of three factors: (1) income statement effects, (2) balance sheet effects, or (3) tax effects.
INCOME STATEMENT EFFECTS
To understand why companies might choose a particular cost flow method, let's examine the effects of the different cost flow assumptions on the financial statements of Houston Electronics. The condensed income statements in Illustration 6-13 assume that Houston sold its 550 units for $18,500, had operating expenses of $9,000, and is subject to an income tax rate of 30%.
Illustration 6-12
Use of cost flow methods in major U.S. companies
Illustration 6-13
Comparative effects of cost flow methods
Note the cost of goods available for sale ($12,000) is the same under each of the three inventory cost flow methods. However, the ending inventories and the costs of goods sold are different. This difference is due to the unit costs that the company allocated to cost of goods sold and to ending inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes. For Houston, an $800 difference exists between FIFO and LIFO cost of goods sold.
In periods of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income. In most instances, prices are rising (inflation). In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues. In a period of rising prices (as is the case in the Houston example), FIFO reports the highest net income ($2,310) and LIFO the lowest ($1,750); average-cost falls in the middle ($2,030). If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the lowest net income and LIFO the highest.
To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income.
Some argue that the use of LIFO in a period of inflation enables the company to avoid reporting paper (or phantom) profit as economic gain. To illustrate, assume that Kralik Company buys 200 units of a product at $20 per unit on January 10 and 200 more on December 31 at $24 each. During the year, Kralik sells 200 units at $30 each. Illustration 6-14 shows the results under FIFO and LIFO.
Illustration 6-14
Income statement effects compared
Under LIFO, Kralik Company has recovered the current replacement cost ($4,800) of the units sold. Thus, the gross profit in economic terms is real. However, under FIFO, the company has recovered only the January 10 cost ($4,000). To replace the units sold, it must reinvest $800 (200 × $4) of the gross profit. Thus, $800 of the gross profit is said to be phantom or illusory. As a result, reported net income is also overstated in real terms.
BALANCE SHEET EFFECTS
A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost. For example, for Houston Electronics, 400 of the 450 units in the ending inventory are costed under FIFO at the higher November 27 unit cost of $13.
Conversely, a major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods. For example, Caterpillar has used LIFO for more than 50 years. Its balance sheet shows ending inventory of $14,544 million. But the inventory's actual current cost if FIFO had been used is $16,966 million.
TAX EFFECTS
We have seen that both inventory on the balance sheet and net income on the income statement are higher when companies use FIFO in a period of inflation. Yet, many companies have selected LIFO. Why? The reason is that LIFO results in the lowest income taxes (because of lower net income) during times of rising prices. For example, at Houston Electronics, income taxes are $750 under LIFO, compared to $990 under FIFO. The tax savings of $240 makes more cash available for use in the business.
Helpful Hint A tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.
Using Inventory Cost Flow Methods Consistently
Whatever cost flow method a company chooses, it should use that method consistently from one accounting period to another. This approach is often referred to as the consistency concept, which means that a company uses the same accounting principles and methods from year to year. Consistent application enhances the comparability of financial statements over successive time periods. In contrast, using the FIFO method one year and the LIFO method the next year would make it difficult to compare the net incomes of the two years.
Although consistent application is preferred, it does not mean that a company may never change its inventory costing method. When a company adopts a different method, it should disclose in the financial statements the change and its effects on net income. Illustration 6-15 shows a typical disclosure, using information from recent financial statements of Quaker Oats (now a unit of PepsiCo).
Illustration 6-15
Disclosure of change in cost flow method
Is LIFO Fair?
ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its inventory for financial reporting and tax purposes. In one recent year, this resulted in a cost of goods sold figure that was $5.6 billion higher than under FIFO. By increasing cost of goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say that LIFO provides an unfair “tax dodge.” As Congress looks for more sources of tax revenue, some lawmakers favor the elimination of LIFO. Supporters of LIFO argue that the method is conceptually sound because it matches current costs with current revenues. In addition, they point out that this matching provides protection against inflation.
International accounting standards do not allow the use of LIFO. Because of this, the net income of foreign oil companies such as BP and Royal Dutch Shell are not directly comparable to U.S. companies, which makes analysis difficult.
Source: David Reilly, “Big Oil's Accounting Methods Fuel Criticism,” Wall Street Journal (August 8, 2006), p. C1.
What are the arguments for and against the use of LIFO? (See page 324.)
Lower-of-Cost-or-Market
The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to changes in technology or fashions. These circumstances sometimes call for inventory valuation methods other than those presented so far. For example, at one time purchasing managers at Ford decided to make a large purchase of palladium, a precious metal used in vehicle emission devices. They made this purchase because they feared a future shortage. The shortage did not materialize, and by the end of the year the price of palladium had plummeted. Ford's inventory was then worth $1 billion less than its original cost. Do you think Ford's inventory should have been stated at cost, in accordance with the historical cost principle, or at its lower replacement cost?
International Note 
Under U.S. GAAP, companies cannot reverse inventory write-downs if inventory increases in value in subsequent periods. IFRS permits companies to reverse write-downs in some circumstances.
As you probably reasoned, this situation requires a departure from the cost basis of accounting. This is done by valuing the inventory at the lower-of-cost-or-market (LCM) in the period in which the price decline occurs. LCM is a basis whereby inventory is stated at the lower of either its cost or market value as determined by current replacement cost. LCM is an example of the accounting convention of conservatism. Conservatism means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income.
Companies apply LCM to the items in inventory after they have used one of the cost flow methods (specific identification, FIFO, LIFO, or average-cost) to determine cost. Under the LCM basis, market is defined as current replacement cost, not selling price. For a merchandising company, current replacement cost is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Current replacement cost is used because a decline in the replacement cost of an item usually leads to a decline in the selling price of the item.
To illustrate the application of LCM, assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. LCM produces the results shown in Illustration 6-16 (page 290). Note that the amounts shown in the final column are the lower-of-cost-or-market amounts for each item.
Illustration 6-16
Computation of lower-of-cost-or-market
Inventory Errors
Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because companies do not properly recognize the transfer of legal title to goods that are in transit. When errors occur, they affect both the income statement and the balance sheet.
Income Statement Effects
Under a periodic inventory system, both the beginning and ending inventories appear in the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two periods.
The effects on cost of goods sold can be computed by entering incorrect data in the formula in Illustration 6-17 and then substituting the correct data.
Illustration 6-17
Formula for cost of goods sold
If the error understates beginning inventory, cost of goods sold will be understated. If the error understates ending inventory, cost of goods sold will be overstated. Illustration 6-18 shows the effects of inventory errors on the current year's income statement.
Illustration 6-18
Effects of inventory errors on current year's income statement
Ethics Note
Inventory fraud increases during recessions. Such fraud includes pricing inventory at amounts in excess of its actual value, or claiming to have inventory when no inventory exists. Inventory fraud usually overstates ending inventory, thereby understating cost of goods sold and creating higher income.
So far, the effects of inventory errors are fairly straightforward. Now, though, comes the (at first) surprising part: An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. Illustration 6-19 shows this effect. As you study the illustration, you will see that the reverse effect comes from the fact that understating ending inventory in 2013 results in understating beginning inventory in 2014 and overstating net income in 2014.
Over the two years, though, total net income is correct because the errors offset each other. Notice that total income using incorrect data is $35,000 ($22,000 + $13,000), which is the same as the total income of $35,000 ($25,000 + $10,000) using correct data. Also note in this example that an error in the beginning inventory does not result in a corresponding error in the ending inventory for that period. The correctness of the ending inventory depends entirely on the accuracy of taking and costing the inventory at the balance sheet date under the periodic inventory system.
Illustration 6-19
Effects of inventory errors on two years’ income statements
Balance Sheet Effects
Companies can determine the effect of ending inventory errors on the balance sheet by using the basic accounting equation: Assets = Liabilities + Owner's Equity. Errors in the ending inventory have the effects shown in Illustration 6-20.
Illustration 6-20
Effects of ending inventory errors on balance sheet
The effect of an error in ending inventory on the subsequent period was shown in Illustration 6-19. Recall that if the error is not corrected, the combined total net income for the two periods would be correct. Thus, total owner's equity reported on the balance sheet at the end of 2014 will also be correct.
DO IT!
LCM Basis; Inventory Errors
(a) Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.
Determine the value of the company's inventory under the lower-of-cost-or-market approach.
Action Plan
Determine whether cost or market value is lower for each inventory type.
Sum the lowest value of each inventory type to determine the total value of inventory.
Solution
The lowest value for each inventory type is gas $79,000, wood $250,000, and pellet $101,000. The total inventory value is the sum of these amounts, $430,000.
(b) Visual Company overstated its 2013 ending inventory by $22,000. Determine the impact this error has on ending inventory, cost of goods sold, and owner's equity in 2013 and 2014.
Action Plan
An ending inventory error in one period will have an equal and opposite effect on cost of goods sold and net income in the next period.
After two years, the errors have offset each other.
Solution
Related exercise material: BE6-7, BE6-8, E6-9, E6-10, E6-11, E6-12, and DO IT! 6-3.
Statement Presentation and Analysis
Presentation
As indicated in Chapter 5, inventory is classified in the balance sheet as a current asset immediately below receivables. In a multiple-step income statement, cost of goods sold is subtracted from sales. There also should be disclosure of (1) the major inventory classifications, (2) the basis of accounting (cost, or lower-of-cost-or-market), and (3) the cost method (FIFO, LIFO, or average-cost).
Wal-Mart Stores, Inc., for example, in its January 31, 2011, balance sheet reported inventories of $36,318 million under current assets. The accompanying notes to the financial statements, as shown in Illustration 6-21, disclosed the following information.
Illustration 6-21
Inventory disclosures by Wal-Mart
As indicated in this note, Wal-Mart values its inventories at the lower-of-cost-or-market using LIFO and FIFO.
Analysis
The amount of inventory carried by a company has significant economic consequences. And inventory management is a double-edged sword that requires constant attention. On the one hand, management wants to have a great variety and quantity on hand so that customers have a wide selection and items are always in stock. But, such a policy may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). On the other hand, low inventory levels lead to stock-outs and lost sales. Common ratios used to manage and evaluate inventory levels are inventory turnover and a related measure, days in inventory.
Inventory turnover measures the number of times on average the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. The inventory turnover is computed by dividing cost of goods sold by the average inventory during the period. Unless seasonal factors are significant, average inventory can be computed from the beginning and ending inventory balances. For example, Wal-Mart reported in its 2011 annual report a beginning inventory of $32,713 million, an ending inventory of $36,318 million, and cost of goods sold for the year ended January 31, 2011, of $315,287 million. The inventory turnover formula and computation for Wal-Mart are shown below.
Illustration 6-22
Inventory turnover formula and computation for Wal-Mart
A variant of the inventory turnover is days in inventory. This measures the average number of days inventory is held. It is calculated as 365 divided by the inventory turnover. For example, Wal-Mart's inventory turnover of 9.1 times divided into 365 is approximately 40.1 days. This is the approximate time that it takes a company to sell the inventory once it arrives at the store.
There are typical levels of inventory in every industry. Companies that are able to keep their inventory at lower levels and higher turnovers and still satisfy customer needs are the most successful.
ACCOUNTING ACROSS THE ORGANIZATION
Too Many TVs or Too Few?
Financial analysts closely monitored the inventory management practices of companies during the recent recession. For example, some analysts following Sony expressed concern because the company built up its inventory of televisions in an attempt to sell 25 million liquid crystal display (LCD) TVs—a 60% increase over the prior year. A year earlier, Sony had cut its inventory levels so that its quarterly days in inventory was down to 38 days, compared to 61 days for the same quarter a year before that. But now, as a result of its inventory build-up, days in inventory rose to 59 days. While management was saying that it didn't think that Sony's inventory levels were now too high, analysts were concerned that the company would have to engage in very heavy discounting in order to sell off its inventory. Analysts noted that the losses from discounting can be “punishing.”
Source: Daisuke Wakabayashi, “Sony Pledges to Corral Inventory,” Wall Street Journal Online (November 2, 2010).
For Sony, what are the advantages and disadvantages of having a low days in inventory measure? (See page 324.)
Inventory Turnover
Early in 2014, Westmoreland Company switched to a just-in-time inventory system. Its sales revenue, cost of goods sold, and inventory amounts for 2013 and 2014 are shown below.
Determine the inventory turnover and days in inventory for 2013 and 2014. Discuss the changes in the amount of inventory, the inventory turnover and days in inventory, and the amount of sales across the two years.
Action Plan
To find the inventory turnover, divide cost of goods sold by average inventory.
To determine days in inventory, divide 365 days by the inventory turnover.
Just-in-time inventory reduces the amount of inventory on hand, which reduces carrying costs. Reducing inventory levels by too much has potential negative implications for sales.
Solution
The company experienced a very significant decline in its ending inventory as a result of the just-in-time inventory. This decline improved its inventory turnover and its days in inventory. However, its sales declined by 10%. It is possible that this decline was caused by the dramatic reduction in the amount of inventory that was on hand, which increased the likelihood of “stock-outs.” To determine the optimal inventory level, management must weigh the benefits of reduced inventory against the potential lost sales caused by stock-outs.
Related exercise material: BE6-9, E6-13, E6-14, and DO IT! 6-4.
Gerald D. Englehart Company has the following inventory, purchases, and sales data for the month of March.
The physical inventory count on March 31 shows 500 units on hand.
Under a periodic inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under (a) FIFO, (b) LIFO, and (c) average-cost.
Action Plan
Compute the total goods available for sale, in both units and dollars.
Compute the cost of ending inventory under the periodic FIFO method by allocating to the units on hand the latest costs.
Compute the cost of ending inventory under the periodic LIFO method by allocating to the units on hand the earliest costs.
Compute the cost of ending inventory under the periodic average-cost method by allocating to the units on hand a weighted-average cost.
Solution to Comprehensive DO IT! 1
SUMMARY OF LEARNING OBJECTIVES
1 Determine how to classify inventory and inventory quantities. Merchandisers need only one inventory classification, merchandise inventory, to describe the different items that make up total inventory. Manufacturers, on the other hand, usually classify inventory into three categories: finished goods, work in process, and raw materials. To determine inventory quantities, manufacturers (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.
2 Explain the accounting for inventories and apply the inventory cost flow methods. The primary basis of accounting for inventories is cost. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost flow methods are specific identification and three assumed cost flow methods—FIFO, LIFO, and average-cost.
3 Explain the financial effects of the inventory cost flow assumptions. Companies may allocate the cost of goods available for sale to cost of goods sold and ending inventory by specific identification or by a method based on an assumed cost flow. When prices are rising, the first-in, first-out (FIFO) method results in lower cost of goods sold and higher net income than the other methods. The reverse is true when prices are falling. In the balance sheet, FIFO results in an ending inventory that is closest to current value. Inventory under LIFO is the farthest from current value. LIFO results in the lowest income taxes.
4 Explain the lower-of-cost-or-market basis of accounting for inventories. Companies use the lower-of-cost-or-market (LCM) basis when the current replacement cost (market) is less than cost. Under LCM, companies recognize the loss in the period in which the price decline occurs.
5 Indicate the effects of inventory errors on the financial statements. In the income statement of the current year: (a) An error in beginning inventory will have a reverse effect on net income. (b) An error in ending inventory will have a similar effect on net income. In the following period, its effect on net income for that period is reversed, and total net income for the two years will be correct.
In the balance sheet: Ending inventory errors will have the same effect on total assets and total owner's equity and no effect on liabilities.
6 Compute and interpret the inventory turnover. The inventory turnover is cost of goods sold divided by average inventory. To convert it to average days in inventory, divide 365 days by the inventory turnover.
GLOSSARY
Average-cost method Inventory costing method that uses the weighted-average unit cost to allocate to ending inventory and cost of goods sold the cost of goods available for sale. (p. 285).
Consigned goods Goods held for sale by one party although ownership of the goods is retained by another party. (p. 279).
Consistency concept Dictates that a company use the same accounting principles and methods from year to year. (p. 288).
Current replacement cost The current cost to replace an inventory item. (p. 289).
Days in inventory Measure of the average number of days inventory is held; calculated as 365 divided by inventory turnover. (p. 293).
Finished goods inventory Manufactured items that are completed and ready for sale. (p. 276).
First-in, first-out (FIFO) method Inventory costing method that assumes that the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. (p. 282).
FOB (free on board) destination Freight terms indicating that ownership of the goods remains with the seller until the goods reach the buyer. (p. 278).
FOB (free on board) shipping point Freight terms indicating that ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. (p. 278).
Inventory turnover A ratio that measures the number of times on average the inventory sold during the period; computed by dividing cost of goods sold by the average inventory during the period. (p. 293).
Just-in-time (JIT) inventory Inventory system in which companies manufacture or purchase goods just in time for use. (p. 276).
Last-in, first-out (LIFO) method Inventory costing method that assumes the costs of the latest units purchased are the first to be allocated to cost of goods sold. (p. 284).
Lower-of-cost-or-market (LCM) A basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost.(p. 289).
Raw materials Basic goods that will be used in production but have not yet been placed into production. (p. 276).
Specific identification method An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory. (p. 281).
Weighted-average unit cost Average cost that is weighted by the number of units purchased at each unit cost. (p. 285).
Work in process That portion of manufactured inventory that has been placed into the production process but is not yet complete. (p. 276).
APPENDIX 6A Inventory Cost Flow Methods in Perpetual Inventory Systems
What inventory cost flow methods do companies employ if they use a perpetual inventory system? Simple—they can use any of the inventory cost flow methods described in the chapter. To illustrate the application of the three assumed cost flow methods (FIFO, LIFO, and average-cost), we will use the data shown in Illustration 6A-1 and in this chapter for Houston Electronics’ Astro condensers.
LEARNING OBJECTIVE 7
Apply the inventory cost flow methods to perpetual inventory records.
Illustration 6A-1
Inventoriable units and costs
First-In, First-Out (FIFO)
Under perpetual FIFO, the company charges to cost of goods sold the cost of the earliest goods on hand prior to each sale. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 24. Illustration 6A-2 shows the inventory under a FIFO method perpetual system.
Illustration 6A-2
Perpetual system—FIFO
The ending inventory in this situation is $5,800, and the cost of goods sold is $6,200 [(100 @ $10) + (200 @ $11) + (250 @ $12)].
Compare Illustrations 6-6 (page 283) and 6A-2. You can see that the results under FIFO in a perpetual system are the same as in a periodic system. In both cases, the ending inventory is $5,800 and cost of goods sold is $6,200. Regardless of the system, the first costs in are the costs assigned to cost of goods sold.
Last-In, First-Out (LIFO)
Under the LIFO method using a perpetual system, the company charges to cost of goods sold the cost of the most recent purchase prior to sale. Therefore, the cost of the goods sold on September 10 consists of all the units from the August 24 and April 15 purchases plus 50 of the units in beginning inventory. Illustration 6A-3 shows the computation of the ending inventory under the LIFO method.
Illustration 6A-3
Perpetual system—LIFO
The use of LIFO in a perpetual system will usually produce cost allocations that differ from those using LIFO in a periodic system. In a perpetual system, the company allocates the latest units purchased prior to each sale to cost of goods sold. In contrast, in a periodic system, the latest units purchased during the period are allocated to cost of goods sold. Thus, when a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous sale. Compare Illustrations 6-8 (page 284) and 6A-3. Illustration 6-8 shows that the 400 units at $13 purchased on November 27 applied to the sale of 550 units on September 10. Under the LIFO perpetual system in Illustration 6A-3, the 400 units at $13 purchased on November 27 are all applied to the ending inventory.
The ending inventory in this LIFO perpetual illustration is $5,700, and cost of goods sold is $6,300, as compared to the LIFO periodic Illustration 6-8 (on page 284) where the ending inventory is $5,000 and cost of goods sold is $7,000.
Average-Cost
The average-cost method in a perpetual inventory system is called the moving-average method. Under this method, the company computes a new average after each purchase, by dividing the cost of goods available for sale by the units on hand. The average cost is then applied to (1) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determine the ending inventory amount. Illustration 6A-4 shows the application of the moving-average cost method by Houston Electronics.
Illustration 6A-4
Perpetual system—average-cost method
As indicated, Houston Electronics computes a new average each time it makes a purchase. On April 15, after it buys 200 units for $2,200, a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand. The average unit cost is $10.667 ($3,200 ÷ 300). On August 24, after Houston Electronics buys 300 units for $3,600, a total of 600 units costing $6,800 ($1,000 + $2,200 + $3,600) are on hand, at an average cost per unit of $11.333 ($6,800 ÷ 600). Houston Electronics uses this unit cost of $11.333 in costing sales until it makes another purchase, when the company computes a new unit cost. Accordingly, the unit cost of the 550 units sold on September 10 is $11.333, and the total cost of goods sold is $6,233. On November 27, following the purchase of 400 units for $5,200, there are 450 units on hand costing $5,767 ($567 + $5,200) with a new average cost of $12.816 ($5,767 ÷ 450).
Compare this moving-average cost under the perpetual inventory system to Illustration 6-11 (on page 285) showing the average-cost method under a periodic inventory system.
Comprehensive DO IT! 2
Comprehensive DO IT! 1 on page 294 showed cost of goods sold computations under a periodic inventory system. Now let's assume that Gerald D. Englehart Company uses a perpetual inventory system. The company has the same inventory, purchases, and sales data for the month of March as shown earlier:
The physical inventory count on March 31 shows 500 units on hand.
Instructions
Under a perpetual inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under (a) FIFO, (b) LIFO, and (c) moving-average cost.
Action Plan
Compute the cost of goods sold under the perpetual FIFO method by allocating to the goods sold the earliest cost of goods purchased.
Compute the cost of goods sold under the perpetual LIFO method by allocating to the goods sold the latest cost of goods purchased.
Compute the cost of goods sold under the perpetual average-cost method by allocating to the goods sold a moving-average cost.
Solution to Comprehensive DO IT! 2
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 6A
7 Apply the inventory cost flow methods to perpetual inventory records. Under FIFO and a perpetual inventory system, companies charge to cost of goods sold the cost of the earliest goods on hand prior to each sale. Under LIFO and a perpetual system, companies charge to cost of goods sold the cost of the most recent purchase prior to sale. Under the moving-average (average cost) method and a perpetual system, companies compute a new average cost after each purchase.
APPENDIX 6B Estimating Inventories
LEARNING OBJECTIVE 8
Describe the two methods of estimating inventories.
In the chapter, we assumed that a company would be able to physically count its inventory. What if it cannot? What if the inventory were destroyed by fire or flood, for example? In that case, the company would use an estimate.
Two circumstances explain why companies sometimes estimate inventories. First, a casualty such as fire, flood, or earthquake may make it impossible to take a physical inventory. Second, managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually. The need for estimating inventories occurs primarily with a periodic inventory system because of the absence of perpetual inventory records.
There are two widely used methods of estimating inventories: (1) the gross profit method, and (2) the retail inventory method.
Gross Profit Method
The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales. This method is relatively simple but effective. Accountants, auditors, and managers frequently use the gross profit method to test the reasonableness of the ending inventory amount. It will detect large errors.
To use this method, a company needs to know its net sales, cost of goods available for sale, and gross profit rate. The company then can estimate its gross profit for the period. Illustration 6B-1 shows the formulas for using the gross profit method.
Illustration 6B-1
Gross profit method formulas
To illustrate, assume that Kishwaukee Company wishes to prepare an income statement for the month of January. Its records show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. In the preceding year, the company realized a 30% gross profit rate. It expects to earn the same rate this year. Given these facts and assumptions, Kishwaukee can compute the estimated cost of the ending inventory at January 31 under the gross profit method as follows.
Illustration 6B-2
Example of gross profit method
The gross profit method is based on the assumption that the gross profit rate will remain constant. But, it may not remain constant, due to a change in merchandising policies or in market conditions. In such cases, the company should adjust the rate to reflect current operating conditions. In some cases, companies can obtain a more accurate estimate by applying this method on a department or product-line basis.
Note that companies should not use the gross profit method to prepare financial statements at the end of the year. These statements should be based on a physical inventory count.
Retail Inventory Method
A retail store such as Home Depot, Ace Hardware, or Wal-Mart has thousands of different types of merchandise at low unit costs. In such cases, it is difficult and time-consuming to apply unit costs to inventory quantities. An alternative is to use the retail inventory method to estimate the cost of inventory. Most retail companies can establish a relationship between cost and sales price. The company then applies the cost-to-retail percentage to the ending inventory at retail prices to determine inventory at cost.
Under the retail inventory method, a company's records must show both the cost and retail value of the goods available for sale. Illustration 6B-3 presents the formulas for using the retail inventory method.
Illustration 6B-3
Retail inventory method formulas
We can demonstrate the logic of the retail method by using unit-cost data. Assume that Ortiz Inc. has marked 10 units purchased at $7 to sell for $10 per unit. Thus, the cost-to-retail ratio is 70% ($70 ÷ $100). If four units remain unsold, their retail value is $40 (4 × $10), and their cost is $28 ($40 × 70%). This amount agrees with the total cost of goods on hand on a per unit basis (4 × $7).
Illustration 6B-4 shows application of the retail method for Valley West. Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time.
Illustration 6B-4
Application of retail inventory method
Helpful Hint In determining inventory at retail, companies use selling prices of the units.
The retail inventory method also facilitates taking a physical inventory at the end of the year. Valley West can value the goods on hand at the prices marked on the merchandise, and then apply the cost-to-retail ratio to the goods on hand at retail to determine the ending inventory at cost.
The major disadvantage of the retail method is that it is an averaging technique. Thus, it may produce an incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale. Assume, for example, that the cost-to-retail ratio of 75% for Valley West consists of equal proportions of inventory items that have cost-to-retail ratios of 70%, 75%, and 80%. If the ending inventory contains only items with a 70% ratio, an incorrect inventory cost will result. Companies can minimize this problem by applying the retail method on a department or product-line basis.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 6B
8 Describe the two methods of estimating inventories. The two methods of estimating inventories are the gross profit method and the retail inventory method. Under the gross profit method, companies apply a gross profit rate to net sales to determine estimated cost of goods sold. They then subtract estimated cost of goods sold from cost of goods available for sale to determine the estimated cost of the ending inventory. Under the retail inventory method, companies compute a cost-to-retail ratio by dividing the cost of goods available for sale by the retail value of the goods available for sale. They then apply this ratio to the ending inventory at retail to determine the estimated cost of the ending inventory.
GLOSSARY FOR APPENDIX 6B
Gross profit method A method for estimating the cost of the ending inventory by applying a gross profit rate to net sales and subtracting estimated cost of goods sold from cost of goods available for sale. (p. 301).
Retail inventory method A method for estimating the cost of the ending inventory by applying a cost-to-retail ratio to the ending inventory at retail. (p. 302).
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are available for practice in WileyPLUS.
*Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
SELF-TEST QUESTIONS
Answers are on page 324.
(LO 1)
1. Which of the following should not be included in the physical inventory of a company?
(a) Goods held on consignment from another company.
(b) Goods shipped on consignment to another company.
(c) Goods in transit from another company shipped FOB shipping point.
(d) None of the above.
(LO 1)
2. As a result of a thorough physical inventory, Railway Company determined that it had inventory worth $180,000 at December 31, 2014. This count did not take into consideration the following facts: Rogers Consignment store currently has goods worth $35,000 on its sales floor that belong to Railway but are being sold on consignment by Rogers. The selling price of these goods is $50,000. Railway purchased $13,000 of goods that were shipped on December 27, FOB destination, that will be received by Railway on January 3. Determine the correct amount of inventory that Railway should report.
(a) $230,000.
(b) $215,000.
(c) $228,000.
(d) $193,000.
3. Cost of goods available for sale consists of two elements: beginning inventory and
(LO 2)
(a) ending inventory.
(b) cost of goods purchased.
(c) cost of goods sold.
(d) All of the above.
4. Poppins Company has the following:
If Poppins has 9,000 units on hand at December 31, the cost of the ending inventory under FIFO is:
(a) $99,000.
(b) $108,000.
(c) $113,000.
(d) $117,000.
(LO 2)
5. Using the data in Question 4 above, the cost of the ending inventory under LIFO is:
(a) $113,000.
(b) $108,000.
(c) $99,000.
(d) $100,000.
(LO 2)
6. Hansel Electronics has the following:
If Hansel has 7,000 units on hand at December 31, the cost of ending inventory under the average-cost method is:
(a) $84,000.
(b) $70,000.
(c) $56,000.
(d) $75,250.
(LO 3)
7. In periods of rising prices, LIFO will produce:
(a) higher net income than FIFO.
(b) the same net income as FIFO.
(c) lower net income than FIFO.
(d) higher net income than average-cost.
(LO 3)
8. Factors that affect the selection of an inventory costing method do not include:
(a) tax effects.
(b) balance sheet effects.
(c) income statement effects.
(d) perpetual vs. periodic inventory system.
(LO 4)
9. Norton Company purchased 1,000 widgets and has 200 widgets in its ending inventory at a cost of $91 each and a current replacement cost of $80 each. The ending inventory under lower-of-cost-or-market is:
(a) $91,000.
(b) $80,000.
(c) $18,200.
(d) $16,000.
(LO 5)
10. Falk Company's ending inventory is understated $4,000. The effects of this error on the current year's cost of goods sold and net income, respectively, are:
(a) understated, overstated.
(b) overstated, understated.
(c) overstated, overstated.
(d) understated, understated.
11. Pauline Company overstated its inventory by $15,000 at December 31, 2013. It did not correct the error in 2013 or 2014. As a result, Pauline's owner's equity was:
(LO 4)
(a) overstated at December 31, 2013, and understated at December 31, 2014.
(b) overstated at December 31, 2013, and properly stated at December 31, 2014.
(c) understated at December 31, 2013, and understated at December 31, 2014.
(d) overstated at December 31, 2013, and overstated at December 31, 2014.
12. Santana Company had beginning inventory of $80,000, ending inventory of $110,000, cost of goods sold of $285,000, and sales of $475,000. Santana's days in inventory is:
(LO 5)
(a) 73 days.
(b) 121.7 days.
(c) 102.5 days.
(d) 84.5 days.
13. Which of these would cause the inventory turnover to increase the most?
(LO 6)
(a) Increasing the amount of inventory on hand.
(b) Keeping the amount of inventory on hand constant but increasing sales.
(c) Keeping the amount of inventory on hand constant but decreasing sales.
(d) Decreasing the amount of inventory on hand and increasing sales.
*14. In a perpetual inventory system:
(LO 7)
(a) LIFO cost of goods sold will be the same as in a periodic inventory system.
(b) average costs are a simple average of unit costs incurred.
(c) a new average is computed under the average-cost method after each sale.
(d) FIFO cost of goods sold will be the same as in a periodic inventory system.
*15. King Company has sales of $150,000 and cost of goods available for sale of $135,000. If the gross profit rate is 30%, the estimated cost of the ending inventory under the gross profit method is:
(LO 8)
(a) $15,000.
(b) $30,000.
(c) $45,000.
(d) $75,000.
Go to the book's companion website, www.wiley.com/college/weygandt, for additional Self-Test Questions.
QUESTIONS
1. “The key to successful business operations is effective inventory management.” Do you agree? Explain.
2. An item must possess two characteristics to be classified as inventory by a merchandiser. What are these two characteristics?
3. Your friend Theo Dolan has been hired to help take the physical inventory in Silker Hardware Store. Explain to Theo Dolan what this job will entail.
4. (a) Rochelle Company ships merchandise to Jay Company on December 30. The merchandise reaches the buyer on January 6. Indicate the terms of sale that will result in the goods being included in (1) Rochelle's December 31 inventory, and (2) Jay's December 31 inventory.
(b) Under what circumstances should Rochelle Company include consigned goods in its inventory?
5. Katz Hat Shop received a shipment of hats for which it paid the wholesaler $2,970. The price of the hats was $3,000 but Katz was given a $30 cash discount and required to pay freight charges of $50. In addition, Katz paid $130 to cover the travel expenses of an employee who negotiated the purchase of the hats. What amount will Katz record for inventory? Why?
6. Explain the difference between the terms FOB shipping point and FOB destination.
7. Kyle Ebert believes that the allocation of inventoriable costs should be based on the actual physical flow of the goods. Explain to Kyle why this may be both impractical and inappropriate.
8. What is a major advantage and a major disadvantage of the specific identification method of inventory costing?
9. “The selection of an inventory cost flow method is a decision made by accountants.” Do you agree? Explain. Once a method has been selected, what accounting requirement applies?
10. Which assumed inventory cost flow method:
(a) usually parallels the actual physical flow of merchandise?
(b) assumes that goods available for sale during an accounting period are identical?
(c) assumes that the latest units purchased are the first to be sold?
11. In a period of rising prices, the inventory reported in Gumby Company's balance sheet is close to the current cost of the inventory. Pokey Company's inventory is considerably below its current cost. Identify the inventory cost flow method being used by each company. Which company has probably been reporting the higher gross profit?
12. Davey Company has been using the FIFO cost flow method during a prolonged period of rising prices. During the same time period, Davey has been paying out all of its net income as dividends. What adverse effects may result from this policy?
13. Josh Kuchin is studying for the next accounting midterm examination. What should Josh know about (a) departing from the cost basis of accounting for inventories and (b) the meaning of “market” in the lower-of-cost-or-market method?
14. Taylor Music Center has 5 CD players on hand at the balance sheet date. Each cost $400. The current replacement cost is $380 per unit. Under the lower-of-cost-or-market basis of accounting for inventories, what value should be reported for the CD players on the balance sheet? Why?
15. Bonnie Stores has 20 toasters on hand at the balance sheet date. Each costs $27. The current replacement cost is $30 per unit. Under the lower-of-cost-or-market basis of accounting for inventories, what value should Bonnie report for the toasters on the balance sheet? Why?
16. Kuzu Company discovers in 2014 that its ending inventory at December 31, 2013, was $7,000 understated. What effect will this error have on (a) 2013 net income, (b) 2014 net income, and (c) the combined net income for the 2 years?
17. Ryder Company's balance sheet shows Inventory $162,800. What additional disclosures should be made?
18. Under what circumstances might inventory turnover be too high? That is, what possible negative consequences might occur?
19. What inventory cost flow does Apple use for its inventories? (Hint: You will need to examine the notes for Apple's financial statements.)
*20. “When perpetual inventory records are kept, the results under the FIFO and LIFO methods are the same as they would be in a periodic inventory system.” Do you agree? Explain.
*21. How does the average-cost method of inventory costing differ between a perpetual inventory system and a periodic inventory system?
*22. When is it necessary to estimate inventories?
*23. Both the gross profit method and the retail inventory method are based on averages. For each method, indicate the average used, how it is determined, and how it is applied.
*24. Wiggins Company has net sales of $400,000 and cost of goods available for sale of $300,000. If the gross profit rate is 35%, what is the estimated cost of the ending inventory? Show computations.
*25. Emporia Shoe Shop had goods available for sale in 2014 with a retail price of $120,000. The cost of these goods was $84,000. If sales during the period were $80,000, what is the ending inventory at cost using the retail inventory method?
BRIEF EXERCISES
BE6-1 Farley Company identifies the following items for possible inclusion in the taking of a physical inventory. Indicate whether each item should be included or excluded from the inventory taking.
Identify items to be included in taking a physical inventory.
(LO 1)
(a) Goods shipped on consignment by Farley to another company.
(b) Goods in transit from a supplier shipped FOB destination.
(c) Goods sold but being held for customer pickup.
(d) Goods held on consignment from another company.
Identify the components of goods available for sale.
(LO 2)
BE6-2 Wilbur Company has the following items: (a) Freight-In, (b) Purchase Returns and Allowances, (c) Purchases, (d) Sales Discounts, and (e) Purchase Discounts. Identify which items are included in goods available for sale.
Compute ending inventory using FIFO and LIFO.
(LO 2)
BE6-3 In its first month of operations, Bethke Company made three purchases of merchandise in the following sequence: (1) 300 units at $6, (2) 400 units at $7, and (3) 200 units at $8. Assuming there are 360 units on hand, compute the cost of the ending inventory under the (a) FIFO method and (b) LIFO method. Bethke uses a periodic inventory system.
Compute the ending inventory using average-cost.
(LO 2)
BE6-4 Data for Bethke Company are presented in BE6-3. Compute the cost of the ending inventory under the average-cost method, assuming there are 360 units on hand.
Explain the financial statement effect of inventory cost flow assumptions.
(LO 3)
BE6-5 The management of Svetlana Corp. is considering the effects of inventory-costing methods on its financial statements and its income tax expense. Assuming that the price the company pays for inventory is increasing, which method will:
(a) Provide the highest net income?
(b) Provide the highest ending inventory?
(c) Result in the lowest income tax expense?
(d) Result in the most stable earnings over a number of years?
Explain the financial statement effect of inventory cost flow assumptions.
(LO 3)
BE6-6 In its first month of operation, Franklin Company purchased 120 units of inventory for $6, then 200 units for $7, and finally 140 units for $8. At the end of the month, 180 units remained. Compute the amount of phantom profit that would result if the company used FIFO rather than LIFO. Explain why this amount is referred to as phantom profit. The company uses the periodic method.
Determine the LCM valuation using inventory categories.
(LO 4)
BE6-7 Central Appliance Center accumulates the following cost and market data at December 31.
Compute the lower-of-cost-or-market valuation for the company's total inventory.
Determine correct income statement amounts.
(LO 5)
BE6-8 Pettit Company reports net income of $90,000 in 2014. However, ending inventory was understated $7,000. What is the correct net income for 2014? What effect, if any, will this error have on total assets as reported in the balance sheet at December 31, 2014?
Compute inventory turnover and days in inventory.
(LO 6)
BE6-9 At December 31, 2014, the following information was available for A. Kamble Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for A. Kamble Company.
Apply cost flow methods to perpetual inventory records.
(LO 7)
*BE6-10 Gregory Department Store uses a perpetual inventory system. Data for product E2-D2 include the following purchases.
On June 1, Gregory sold 26 units, and on August 27, 40 more units. Prepare the perpetual inventory schedule for the above transactions using (a) FIFO, (b) LIFO, and (c) moving-average cost.
Apply the gross profit method.
(LO 8)
*BE6-11 At May 31, Suarez Company has net sales of $330,000 and cost of goods available for sale of $230,000. Compute the estimated cost of the ending inventory, assuming the gross profit rate is 35%.
Apply the retail inventory method.
(LO 8)
*BE6-12 On June 30, Calico Fabrics has the following data pertaining to the retail inventory method. Goods available for sale: at cost $38,000; at retail $50,000; net sales $40,000; and ending inventory at retail $10,000. Compute the estimated cost of the ending inventory using the retail inventory method.
DO IT! 6-1 Gomez Company just took its physical inventory. The count of inventory items on hand at the company's business locations resulted in a total inventory cost of $300,000. In reviewing the details of the count and related inventory transactions, you have discovered the following.
Apply rules of ownership to determine inventory cost.
(LO 1)
1. Gomez has sent inventory costing $26,000 on consignment to Kako Company. All of this inventory was at Kako's showrooms on December 31.
2. The company did not include in the count inventory (cost, $20,000) that was sold on December 28, terms FOB shipping point. The goods were in transit on December 31.
3. The company did not include in the count inventory (cost, $17,000) that was purchased with terms of FOB shipping point. The goods were in transit on December 31.
Compute the correct December 31 inventory.
DO IT! 6-2 The accounting records of Old Towne Electronics show the following data.
Compute cost of goods sold under different cost flow methods.
(LO 2)
| Beginning inventory | 3,000 units at $5 |
| Purchases | 8,000 units at $7 |
| Sales | 9,400 units at $10 |
Determine cost of goods sold during the period under a periodic inventory system using (a) the FIFO method, (b) the LIFO method, and (c) the average-cost method. (Round unit cost to nearest tenth of a cent.)
DO IT! 6-3 (a) Moberg Company sells three different categories of tools (small, medium, and large). The cost and market value of its inventory of tools are as follows.
Compute inventory value under LCM.
(LO 4)
Determine the value of the company's inventory under the lower-of-cost-or-market approach.
(b) Janus Company understated its 2013 ending inventory by $31,000. Determine the impact this error has on ending inventory, cost of goods sold, and owner's equity in 2013 and 2014.
DO IT! 6-4 Early in 2014, Chien Company switched to a just-in-time inventory system. Its sales, cost of goods sold, and inventory amounts for 2013 and 2014 are shown below.
Compute inventory turnover and assess inventory level.
(LO 6)
Determine the inventory turnover and days in inventory for 2013 and 2014. Discuss the changes in the amount of inventory, the inventory turnover and days in inventory, and the amount of sales across the two years.
EXERCISES
E6-1 Tri-State Bank and Trust is considering giving Josef Company a loan. Before doing so, management decides that further discussions with Josef's accountant may be desirable. One area of particular concern is the inventory account, which has a year-end balance of $297,000. Discussions with the accountant reveal the following.
Determine the correct inventory amount.
(LO 1)
1. Josef sold goods costing $38,000 to Sorci Company, FOB shipping point, on December 28. The goods are not expected to arrive at Sorci until January 12. The goods were not included in the physical inventory because they were not in the warehouse.
2. The physical count of the inventory did not include goods costing $95,000 that were shipped to Josef FOB destination on December 27 and were still in transit at year-end.
3. Josef received goods costing $22,000 on January 2. The goods were shipped FOB shipping point on December 26 by Solita Co. The goods were not included in the physical count.
4. Josef sold goods costing $35,000 to Natali Co., FOB destination, on December 30. The goods were received at Natali on January 8. They were not included in Josef's physical inventory.
5. Josef received goods costing $44,000 on January 2 that were shipped FOB destination on December 29. The shipment was a rush order that was supposed to arrive December 31. This purchase was included in the ending inventory of $297,000.
Instructions
Determine the correct inventory amount on December 31.
Determine the correct inventory amount.
(LO 1)
E6-2 Rachel Warren, an auditor with Laplante CPAs, is performing a review of Schuda Company's inventory account. Schuda did not have a good year, and top management is under pressure to boost reported income. According to its records, the inventory balance at year-end was $740,000. However, the following information was not considered when determining that amount.
1. Included in the company's count were goods with a cost of $250,000 that the company is holding on consignment. The goods belong to Harmon Corporation.
2. The physical count did not include goods purchased by Schuda with a cost of $40,000 that were shipped FOB destination on December 28 and did not arrive at Schuda warehouse until January 3.
3. Included in the inventory account was $14,000 of office supplies that were stored in the warehouse and were to be used by the company's supervisors and managers during the coming year.
4. The company received an order on December 29 that was boxed and sitting on the loading dock awaiting pick-up on December 31. The shipper picked up the goods on January 1 and delivered them on January 6. The shipping terms were FOB shipping point. The goods had a selling price of $40,000 and a cost of $28,000. The goods were not included in the count because they were sitting on the dock.
5. On December 29, Schuda shipped goods with a selling price of $80,000 and a cost of $60,000 to Reza Sales Corporation FOB shipping point. The goods arrived on January 3. Reza Sales had only ordered goods with a selling price of $10,000 and a cost of $8,000. However, a sales manager at Schuda had authorized the shipment and said that if Reza wanted to ship the goods back next week, it could.
6. Included in the count was $40,000 of goods that were parts for a machine that the company no longer made. Given the high-tech nature of Schuda's products, it was unlikely that these obsolete parts had any other use. However, management would prefer to keep them on the books at cost, “since that is what we paid for them, after all.”
Instructions
Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, saying why you did or did not make an adjustment for each item.
Calculate cost of goods sold using specific identification and FIFO.
(LO 2, 3)
E6-3 On December 1, Marzion Electronics Ltd. has three DVD players left in stock. All are identical, all are priced to sell at $150. One of the three DVD players left in stock, with serial #1012, was purchased on June 1 at a cost of $100. Another, with serial #1045, was purchased on November 1 for $90. The last player, serial #1056, was purchased on November 30 for $80.
Instructions
(a) Calculate the cost of goods sold using the FIFO periodic inventory method assuming that two of the three players were sold by the end of December, Marzion Electronics’ year-end.
(b) If Marzion Electronics used the specific identification method instead of the FIFO method, how might it alter its earnings by “selectively choosing” which particular players to sell to the two customers? What would Marzion's cost of goods sold be if the company wished to minimize earnings? Maximize earnings?
(c) Which of the two inventory methods do you recommend that Marzion use? Explain why.
E6-4 Linda's Boards sells a snowboard, Xpert, that is popular with snowboard enthusiasts. Information relating to Linda's purchases of Xpert snowboards during September is shown below. During the same month, 121 Xpert snowboards were sold. Linda's uses a periodic inventory system.
Compute inventory and cost of goods sold using FIFO and LIFO.
(LO 2)
Instructions
(a) Compute the ending inventory at September 30 and cost of goods sold using the FIFO and LIFO methods. Prove the amount allocated to cost of goods sold under each method.
(b) For both FIFO and LIFO, calculate the sum of ending inventory and cost of goods sold. What do you notice about the answers you found for each method?
E6-5 Xiong Co. uses a periodic inventory system. Its records show the following for the month of May, in which 65 units were sold.
Compute inventory and cost of goods sold using FIFO and LIFO.
(LO 2)
Instructions
Compute the ending inventory at May 31 and cost of goods sold using the FIFO and LIFO methods. Prove the amount allocated to cost of goods sold under each method.
E6-6 Kaleta Company reports the following for the month of June.
Compute inventory and cost of goods sold using FIFO and LIFO.
(LO 2, 3)
Instructions
(a) Compute the cost of the ending inventory and the cost of goods sold under (1) FIFO and (2) LIFO.
(b) Which costing method gives the higher ending inventory? Why?
(c) Which method results in the higher cost of goods sold? Why?
E6-7 Lisa Company had 100 units in beginning inventory at a total cost of $10,000. The company purchased 200 units at a total cost of $26,000. At the end of the year, Lisa had 80 units in ending inventory.
Compute inventory under FIFO, LIFO, and average-cost.
(LO 2, 3)
Instructions
(a) Compute the cost of the ending inventory and the cost of goods sold under (1) FIFO, (2) LIFO, and (3) average-cost.
(b) Which cost flow method would result in the highest net income?
(c) Which cost flow method would result in inventories approximating current cost in the balance sheet?
(d) Which cost flow method would result in Lisa paying the least taxes in the first year?
E6-8 Inventory data for Kaleta Company are presented in E6-6.
Compute inventory and cost of goods sold using average-cost.
(LO 2, 3)
Instructions
(a) Compute the cost of the ending inventory and the cost of goods sold using the average-cost method.
(b) Will the results in (a) be higher or lower than the results under (1) FIFO and (2) LIFO?
(c) Why is the average unit cost not $6?
Determine ending inventory under LCM.
(LO 4)
E6-9 Optix Camera Shop uses the lower-of-cost-or-market basis for its inventory. The following data are available at December 31.
Instructions
Determine the amount of the ending inventory by applying the lower-of-cost-or-market basis.
Compute lower-of-cost-or-market.
(LO 4)
E6-10 Serebin Company applied FIFO to its inventory and got the following results for its ending inventory.
| Cameras | 100 units at a cost per unit of $65 |
| DVD players | 150 units at a cost per unit of $75 |
| iPods | 125 units at a cost per unit of $80 |
The cost of purchasing units at year-end was cameras $71, DVD players $67, and iPods $78.
Instructions
Determine the amount of ending inventory at lower-of-cost-or-market.
Determine effects of inventory errors.
(LO 5)
E6-11 Hamid's Hardware reported cost of goods sold as follows.
Hamid's made two errors: (1) 2013 ending inventory was overstated $3,000, and (2) 2014 ending inventory was understated $6,000.
Instructions
Compute the correct cost of goods sold for each year.
Prepare correct income statements.
(LO 5)
E6-12 Rulix Watch Company reported the following income statement data for a 2-year period.
Rulix uses a periodic inventory system. The inventories at January 1, 2013, and December 31, 2014, are correct. However, the ending inventory at December 31, 2013, was overstated $6,000.
Instructions
(a) Prepare correct income statement data for the 2 years.
(b) What is the cumulative effect of the inventory error on total gross profit for the 2 years?
(c) 
Explain in a letter to the president of Rulix Watch Company what has happened, i.e., the nature of the error and its effect on the financial statements.
E6-13 This information is available for Quick's Photo Corporation for 2012, 2013, and 2014.
Compute inventory turnover, days in inventory, and gross profit rate.
(LO 6)
Instructions
Calculate inventory turnover, days in inventory, and gross profit rate (from Chapter 5) for Quick's Photo Corporation for 2012, 2013, and 2014. Comment on any trends.
E6-14 The cost of goods sold computations for Alpha Company and Omega Company are shown below.
Compute inventory turnover and days in inventory.
(LO 6)
Instructions
(a) Compute inventory turnover and days in inventory for each company.
(b) Which company moves its inventory more quickly?
*E6-15 Bufford Appliance uses a perpetual inventory system. For its flat-screen television sets, the January 1 inventory was 3 sets at $600 each. On January 10, Bufford purchased 6 units at $660 each. The company sold 2 units on January 8 and 4 units on January 15.
Apply cost flow methods to perpetual records.
(LO 7)
Instructions
Compute the ending inventory under (1) FIFO, (2) LIFO, and (3) moving-average cost.
*E6-16 Kaleta Company reports the following for the month of June.
Calculate inventory and cost of goods sold using three cost flow methods in a perpetual inventory system.
(LO 7)
Instructions
(a) Calculate the cost of the ending inventory and the cost of goods sold for each cost flow assumption, using a perpetual inventory system. Assume a sale of 440 units occurred on June 15 for a selling price of $8 and a sale of 360 units on June 27 for $9.
(b) How do the results differ from E6-6 and E6-8?
(c) Why is the average unit cost not $6 [($5 + $6 + $7) ÷ 3 = $6]?
*E6-17 Information about Linda's Boards is presented in E6-4. Additional data regarding Linda's sales of Xpert snowboards are provided below. Assume that Linda's uses a perpetual inventory system.
Apply cost flow methods to perpetual records.
(LO 7)
Instructions
(a) Compute ending inventory at September 30 using FIFO, LIFO, and moving-average cost.
(b) Compare ending inventory using a perpetual inventory system to ending inventory using a periodic inventory system (from E6-4).
(c) Which inventory cost flow method (FIFO, LIFO) gives the same ending inventory value under both periodic and perpetual? Which method gives different ending inventory values?
Use the gross profit method to estimate inventory.
(LO 8)
*E6-18 Brenda Company reported the following information for November and December 2014.
Brenda's ending inventory at December 31 was destroyed in a fire.
Instructions
(a) Compute the gross profit rate for November.
(b) Using the gross profit rate for November, determine the estimated cost of inventory lost in the fire.
Determine merchandise lost using the gross profit method of estimating inventory.
(LO 8)
*E6-19 The inventory of Hauser Company was destroyed by fire on March 1. From an examination of the accounting records, the following data for the first 2 months of the year are obtained: Sales Revenue $51,000, Sales Returns and Allowances $1,000, Purchases $31,200, Freight-In $1,200, and Purchase Returns and Allowances $1,400.
Instructions
Determine the merchandise lost by fire, assuming:
(a) A beginning inventory of $20,000 and a gross profit rate of 40% on net sales.
(b) A beginning inventory of $30,000 and a gross profit rate of 30% on net sales.
Determine ending inventory at cost using retail method.
(LO 8)
*E6-20 Gepetto Shoe Store uses the retail inventory method for its two departments, Women's Shoes and Men's Shoes. The following information for each department is obtained.
Instructions
Compute the estimated cost of the ending inventory for each department under the retail inventory method.
EXERCISES: SET B AND CHALLENGE EXERCISES
Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
PROBLEMS: SET A
Determine items and amounts to be recorded in inventory.
(LO 1)
P6-1A Austin Limited is trying to determine the value of its ending inventory as of February 28, 2014, the company's year-end. The following transactions occurred, and the accountant asked your help in determining whether they should be recorded or not.
(a) On February 26, Austin shipped goods costing $800 to a customer and charged the customer $1,000. The goods were shipped with terms FOB shipping point and the receiving report indicates that the customer received the goods on March 2.
(b) On February 26, Louis Inc. shipped goods to Austin under terms FOB shipping point. The invoice price was $450 plus $30 for freight. The receiving report indicates that the goods were received by Austin on March 2.
(c) Austin had $650 of inventory isolated in the warehouse. The inventory is designated for a customer who has requested that the goods be shipped on March 10.
(d) Also included in Austin's warehouse is $700 of inventory that Ryhn Producers shipped to Austin on consignment.
(e) On February 26, Austin issued a purchase order to acquire goods costing $900. The goods were shipped with terms FOB destination on February 27. Austin received the goods on March 2.
(f) On February 26, Austin shipped goods to a customer under terms FOB destination. The invoice price was $350; the cost of the items was $200. The receiving report indicates that the goods were received by the customer on March 2.
Instructions
For each of the above transactions, specify whether the item in question should be included in ending inventory, and if so, at what amount.
P6-2A Express Distribution markets CDs of the performing artist Fishe. At the beginning of October, Express had in beginning inventory 2,000 of Fishe's CDs with a unit cost of $7. During October, Express made the following purchases of Fishe's CDs.
Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost with analysis.
(LO 2, 3)
During October, 10,900 units were sold. Express uses a periodic inventory system.
Instructions
(a) Determine the cost of goods available for sale.
(b)(2) Cost of goods sold:
| FIFO | $ 94,500 |
| LIFO | $108,700 |
| Average | $101,370 |
(b) Determine (1) the ending inventory and (2) the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods.
(c) Which cost flow method results in (1) the highest inventory amount for the balance sheet and (2) the highest cost of goods sold for the income statement?
P6-3A Ziad Company had a beginning inventory on January 1 of 150 units of Product 4-18-15 at a cost of $20 per unit. During the year, the following purchases were made.
1,000 units were sold. Ziad Company uses a periodic inventory system.
Determine cost of goods sold and ending inventory, using FIFO, LIFO, and average-cost with analysis.
(LO 2, 3)
Instructions
(a) Determine the cost of goods available for sale.
(b) Determine (1) the ending inventory, and (2) the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods.
(b)(2) Cost of goods sold:
| FIFO | $23,400 |
| LIFO | $24,900 |
| Average | $24,160 |
(c) Which cost flow method results in (1) the highest inventory amount for the balance sheet, and (2) the highest cost of goods sold for the income statement?
P6-4A The management of Felipe Inc. is reevaluating the appropriateness of using its present inventory cost flow method, which is average-cost. The company requests your help in determining the results of operations for 2014 if either the FIFO or the LIFO method had been used. For 2014, the accounting records show these data:
Compute ending inventory, prepare income statements, and answer questions using FIFO and LIFO.
(LO 2, 3)
Purchases were made quarterly as follows.
Operating expenses were $130,000, and the company's income tax rate is 40%.
Instructions
(a) Prepare comparative condensed income statements for 2014 under FIFO and LIFO. (Show computations of ending inventory.)
(a) Gross profit:
| FIFO | $312,900 |
| LIFO | $303,000 |
(b) Answer the following questions for management.
(1) Which cost flow method (FIFO or LIFO) produces the more meaningful inventory amount for the balance sheet? Why?
(2) Which cost flow method (FIFO or LIFO) produces the more meaningful net income? Why?
(3) Which cost flow method (FIFO or LIFO) is more likely to approximate the actual physical flow of goods? Why?
(4) How much more cash will be available for management under LIFO than under FIFO? Why?
(5) Will gross profit under the average-cost method be higher or lower than FIFO? Than LIFO? (Note: It is not necessary to quantify your answer.)
Calculate ending inventory, cost of goods sold, gross profit, and gross profit rate under periodic method; compare results.
(LO 2, 3)
P6-5A You are provided with the following information for Najera Inc. for the month ended June 30, 2014. Najera uses the periodic method for inventory.
(a) (iii) Gross profit:
| LIFO | $4,215 |
| FIFO | $4,645 |
| Average | $4,414.60 |
Instructions
(a) Calculate (i) ending inventory, (ii) cost of goods sold, (iii) gross profit, and (iv) gross profit rate under each of the following methods.
(1) LIFO.
(2) FIFO.
(3) Average-cost.
(b) Compare results for the three cost flow assumptions.
Compare specific identification, FIFO, and LIFO under periodic method; use cost flow assumption to justify price increase.
(LO 2, 3)
P6-6A You are provided with the following information for Barton Inc. Barton Inc. uses the periodic method of accounting for its inventory transactions.
| March 1 | Beginning inventory 2,000 liters at a cost of 60¢ per liter. |
| March 3 | Purchased 2,500 liters at a cost of 65¢ per liter. |
| March 5 | Sold 2,300 liters for $1.05 per liter. |
| March 10 | Purchased 4,000 liters at a cost of 72¢ per liter. |
| March 20 | Purchased 2,500 liters at a cost of 80¢ per liter. |
| March 30 | Sold 5,200 liters for $1.25 per liter. |
Instructions
(a) Prepare partial income statements through gross profit, and calculate the value of ending inventory that would be reported on the balance sheet, under each of the following cost flow assumptions. (Round ending inventory and cost of goods sold to the nearest dollar.)
(a) Gross profit:
(1) Specific identification
$3,715
(1) Specific identification method assuming:
(i) The March 5 sale consisted of 1,000 liters from the March 1 beginning inventory and 1,300 liters from the March 3 purchase; and
(ii) The March 30 sale consisted of the following number of units sold from beginning inventory and each purchase: 450 liters from March 1; 550 liters from March 3; 2,900 liters from March 10; 1,300 liters from March 20.
(2) FIFO $3,930
(2) FIFO.
(3) LIFO $3,385
(3) LIFO.
(b) How can companies use a cost flow method to justify price increases? Which cost flow method would best support an argument to increase prices?
Compute ending inventory, prepare income statements, and answer questions using FIFO and LIFO.
(LO 2, 3)
P6-7A The management of Sherlynn Co. asks your help in determining the comparative effects of the FIFO and LIFO inventory cost flow methods. For 2014, the accounting records provide the following data.
| Inventory, January 1 (10,000 units) | $ 45,000 |
| Cost of 100,000 units purchased | 532,000 |
| Selling price of 80,000 units sold | 700,000 |
| Operating expenses | 140,000 |
Units purchased consisted of 35,000 units at $5.10 on May 10; 35,000 units at $5.30 on August 15; and 30,000 units at $5.60 on November 20. Income taxes are 30%.
Instructions
(a) Prepare comparative condensed income statements for 2014 under FIFO and LIFO. (Show computations of ending inventory.)
(a) Net income
FIFO $105,700
LIFO $91,000
(b) Answer the following questions for management.
(1) Which inventory cost flow method produces the most meaningful inventory amount for the balance sheet? Why?
(2) Which inventory cost flow method produces the most meaningful net income? Why?
(3) Which inventory cost flow method is most likely to approximate actual physical flow of the goods? Why?
(4) How much additional cash will be available for management under LIFO than under FIFO? Why?
(5) How much of the gross profit under FIFO is illusory in comparison with the gross profit under LIFO?
*P6-8A Mercer Inc. is a retailer operating in British Columbia. Mercer uses the perpetual inventory method. All sales returns from customers result in the goods being returned to inventory; the inventory is not damaged. Assume that there are no credit transactions; all amounts are settled in cash. You are provided with the following information for Mercer Inc. for the month of January 2014.
Calculate cost of goods sold and ending inventory under LIFO, FIFO, and moving-average cost under the perpetual system; compare gross profit under each assumption.
(LO 7)
Instructions
(a) For each of the following cost flow assumptions, calculate (i) cost of goods sold, (ii) ending inventory, and (iii) gross profit.
(a)(iii) Gross profit:
| LIFO | $2,160 |
| FIFO | $2,560 |
| Average | $2,421 |
(1) LIFO.
(2) FIFO.
(3) Moving-average cost.
(b) Compare results for the three cost flow assumptions.
*P6-9A Terando Co. began operations on July 1. It uses a perpetual inventory system. During July, the company had the following purchases and sales.
Determine ending inventory under a perpetual inventory system.
(LO 7)
Instructions
(a) Ending inventory
| FIFO | $1,029 |
| Avg. | $994 |
| LIFO | $958 |
(a) Determine the ending inventory under a perpetual inventory system using (1) FIFO, (2) moving-average cost, and (3) LIFO.
(b) Which costing method produces the highest ending inventory valuation?
Compute gross profit rate and inventory loss using gross profit method.
(LO 8)
*P6-10A Suzuki Company lost all of its inventory in a fire on December 26, 2014. The accounting records showed the following gross profit data for November and December.
Suzuki is fully insured for fire losses but must prepare a report for the insurance company.
Instructions
(a) Gross profit rate 38%
(a) Compute the gross profit rate for November.
(b) Using the gross profit rate for November, determine the estimated cost of the inventory lost in the fire.
Compute ending inventory using retail method.
(LO 8)
*P6-11A Dixon Books uses the retail inventory method to estimate its monthly ending inventories. The following information is available for two of its departments at October 31, 2014.
At December 31, Dixon Books takes a physical inventory at retail. The actual retail values of the inventories in each department are Hardcovers $790,000 and Paperbacks $335,000.
Instructions
(a) Hardcovers: End. Inv. $520,000
(a) Determine the estimated cost of the ending inventory for each department at October 31, 2014, using the retail inventory method.
(b) Compute the ending inventory at cost for each department at December 31, assuming the cost-to-retail ratios for the year are 65% for Hardcovers and 75% for Paperbacks.
PROBLEMS: SET B
Determine items and amounts to be recorded in inventory.
(LO 1)
P6-1B Weber Limited is trying to determine the value of its ending inventory at February 28, 2014, the company's year-end. The accountant counted everything that was in the warehouse as of February 28, which resulted in an ending inventory valuation of $48,000. However, she didn't know how to treat the following transactions so she didn't record them.
(a) On February 26, Weber shipped to a customer goods costing $800. The goods were shipped FOB shipping point, and the receiving report indicates that the customer received the goods on March 2.
(b) On February 26, Gretel Inc. shipped goods to Weber FOB destination. The invoice price was $350. The receiving report indicates that the goods were received by Weber on March 2.
(c) Weber had $500 of inventory at a customer's warehouse “on approval.” The customer was going to let Weber know whether it wanted the merchandise by the end of the week, March 4.
(d) Weber also had $400 of inventory on consignment at a Roslyn craft shop.
(e) On February 26, Weber ordered goods costing $750. The goods were shipped FOB shipping point on February 27. Weber received the goods on March 1.
(f) On February 28, Weber packaged goods and had them ready for shipping to a customer FOB destination. The invoice price was $350; the cost of the items was $250. The receiving report indicates that the goods were received by the customer on March 2.
(g) Weber had damaged goods set aside in the warehouse because they are no longer saleable. These goods cost $400 and Weber originally expected to sell these items for $600.
Instructions
For each of the above transactions, specify whether the item in question should be included in ending inventory and, if so, at what amount. For each item that is not included in ending inventory, indicate who owns it and in what account, if any, it should have been recorded.
P6-2B Xinxin Distribution markets CDs of the performing artist Carly. At the beginning of March, Xinxin had in beginning inventory 1,500 Carly CDs with a unit cost of $7. During March Xinxin made the following purchases of Carly CDs.
During March, 12,000 units were sold. Xinxin uses a periodic inventory system.
Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost with analysis.
(LO 2, 3)
Instructions
(a) Determine the cost of goods available for sale.
(b) Determine (1) the ending inventory and (2) the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods.
(b)(2) Cost of goods sold:
| FIFO | $105,000 |
| LIFO | $116,000 |
| Average | $110,321 |
(c) Which cost flow method results in (1) the highest inventory amount for the balance sheet and (2) the highest cost of goods sold for the income statement?
P6-3B Walz Company had a beginning inventory of 400 units of Product Ribo at a cost of $8 per unit. During the year, purchases were:
Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost with analysis.
(LO 2, 3)
Walz Company uses a periodic inventory system. Sales totaled 1,500 units.
Instructions
(a) Determine the cost of goods available for sale.
(b) Determine (1) the ending inventory and (2) the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods.
(b) Cost of goods sold:
| FIFO | $13,600 |
| LIFO | $15,200 |
| Average | $14,475 |
(c) Which cost flow method results in (1) the lowest inventory amount for the balance sheet, and (2) the lowest cost of goods sold for the income statement?
P6-4B The management of Patel Co. is reevaluating the appropriateness of using its present inventory cost flow method, which is average-cost. They request your help in determining the results of operations for 2014 if either the FIFO method or the LIFO method had been used. For 2014, the accounting records show the following data.
Compute ending inventory, prepare income statements, and answer questions using FIFO and LIFO.
(LO 2, 3)
Purchases were made quarterly as follows.
Operating expenses were $147,000, and the company's income tax rate is 34%.
(a) Net income
FIFO $108,504
LIFO $98,472
(a) Prepare comparative condensed income statements for 2014 under FIFO and LIFO. (Show computations of ending inventory.)
(b) Answer the following questions for management.
(b)(4) $5,168
(1) Which cost flow method (FIFO or LIFO) produces the more meaningful inventory amount for the balance sheet? Why?
(2) Which cost flow method (FIFO or LIFO) produces the more meaningful net income? Why?
(3) Which cost flow method (FIFO or LIFO) is more likely to approximate actual physical flow of the goods? Why?
(4) How much additional cash will be available for management under LIFO than under FIFO? Why?
(5) Will gross profit under the average-cost method be higher or lower than (i) FIFO and (ii) LIFO? (Note: It is not necessary to quantify your answer.)
Calculate ending inventory, cost of goods sold, gross profit, and gross profit rate under periodic method; compare results.
(LO 2, 3)
P6-5B You are provided with the following information for Perkins Inc. for the month ended October 31, 2014. Perkins uses a periodic method for inventory.
Instructions
(a)(iii) Gross profit:
| LIFO | $3,050 |
| FIFO | $3,230 |
| Average | $3,141 |
(a) Calculate (i) ending inventory, (ii) cost of goods sold, (iii) gross profit, and (iv) gross profit rate under each of the following methods.
(1) LIFO.
(2) FIFO.
(3) Average-cost.
(b) Compare results for the three cost flow assumptions.
Compare specific identification, FIFO and LIFO under periodic method; use cost flow assumption to influence earnings.
(LO 2, 3)
P6-6B You have the following information for Princess Diamonds. Princess Diamonds uses the periodic method of accounting for its inventory transactions. Princess only carries one brand and size of diamonds—all are identical. Each batch of diamonds purchased is carefully coded and marked with its purchase cost.
| March | 1 | Beginning inventory 150 diamonds at a cost of $300 per diamond. |
| March | 3 | Purchased 200 diamonds at a cost of $360 each. |
| March | 5 | Sold 180 diamonds for $600 each. |
| March | 10 | Purchased 350 diamonds at a cost of $380 each. |
| March | 25 | Sold 400 diamonds for $650 each. |
Instructions
(a) Gross profit:
(1) Maximum $163,600
(a) Assume that Princess Diamonds uses the specific identification cost flow method.
(1) Demonstrate how Princess Diamonds could maximize its gross profit for the month by specifically selecting which diamonds to sell on March 5 and March 25.
(2) Minimum $154,000
(2) Demonstrate how Princess Diamonds could minimize its gross profit for the month by selecting which diamonds to sell on March 5 and March 25.
(b) Assume that Princess Diamonds uses the FIFO cost flow assumption. Calculate cost of goods sold. How much gross profit would Princess Diamonds report under this cost flow assumption?
(c) Assume that Princess Diamonds uses the LIFO cost flow assumption. Calculate cost of goods sold. How much gross profit would the company report under this cost flow assumption?
(d) Which cost flow method should Princess Diamonds select? Explain.
Compute ending inventory, prepare income statements, and answer questions using FIFO and LIFO.
(LO 2, 3)
P6-7B The management of Chelsea Inc. asks your help in determining the comparative effects of the FIFO and LIFO inventory cost flow methods. For 2014, the accounting records provide the following data.
| Inventory, January 1 (10,000 units) | $ 35,000 |
| Cost of 120,000 units purchased | 504,500 |
| Selling price of 100,000 units sold | 665,000 |
| Operating expenses | 130,000 |
Units purchased consisted of 35,000 units at $4.00 on May 10; 60,000 units at $4.20 on August 15; and 25,000 units at $4.50 on November 20. Income taxes are 28%.
Instructions
(a) Prepare comparative condensed income statements for 2014 under FIFO and LIFO. (Show computations of ending inventory.)
(a) Gross profit:
| FIFO | $259,000 |
| LIFO | $240,500 |
(b) Answer the following questions for management in the form of a business letter.
(1) Which inventory cost flow method produces the most meaningful inventory amount for the balance sheet? Why?
(2) Which inventory cost flow method produces the most meaningful net income? Why?
(3) Which inventory cost flow method is most likely to approximate the actual physical flow of the goods? Why?
(4) How much more cash will be available for management under LIFO than under FIFO? Why?
(5) How much of the gross profit under FIFO is illusionary in comparison with the gross profit under LIFO?
*P6-8B Minsoo Ltd. is a retailer operating in Edmonton, Alberta. Minsoo uses the perpetual inventory method. All sales returns from customers result in the goods being returned to inventory; the inventory is not damaged. Assume that there are no credit transactions; all amounts are settled in cash. You are provided with the following information for Minsoo Ltd. for the month of January 2014.
Calculate cost of goods sold and ending inventory for FIFO, moving-average cost, and LIFO under the perpetual system; compare gross profit under each assumption.
(LO 7)
Instructions
(a) For each of the following cost flow assumptions, calculate (i) cost of goods sold, (ii) ending inventory, and (iii) gross profit.
(a)(iii) Gross profit:
| LIFO | $6,540 |
| FIFO | $7,780 |
| Average | $7,354 |
(1) LIFO.
(2) FIFO.
(3) Moving-average cost.
(b) Compare results for the three cost flow assumptions.
*P6-9B Buffet Appliance Mart began operations on May 1. It uses a perpetual inventory system. During May, the company had the following purchases and sales for its Model 25 Sureshot camera.
Determine ending inventory under a perpetual inventory system.
(LO 7)
Instructions
(a) Determine the ending inventory under a perpetual inventory system using (1) FIFO, (2) moving-average cost, and (3) LIFO.
| (a) FIFO | $925 |
| Average | $874 |
| LIFO | $790 |
(b) Which costing method produces (1) the highest ending inventory valuation and (2) the lowest ending inventory valuation?
Estimate inventory loss using gross profit method.
(LO 8)
*P6-10B Liis Company lost 70% of its inventory in a fire on March 25, 2014. The accounting records showed the following gross profit data for February and March.
Liis Company is fully insured for fire losses but must prepare a report for the insurance company.
Instructions
(a) Compute the gross profit rate for the month of February.
(a) Gross profit rate 45%
(b) Using the gross profit rate for February, determine both the estimated total inventory and inventory lost in the fire in March.
Compute ending inventory using retail method.
(LO 8)
*P6-11B Belden Department Store uses the retail inventory method to estimate its monthly ending inventories. The following information is available for two of its departments at August 31, 2014.
At December 31, Belden Department Store takes a physical inventory at retail. The actual retail values of the inventories in each department are Sporting Goods $95,000 and Jewelry and Cosmetics $44,000.
Instructions
(a) Determine the estimated cost of the ending inventory for each department on August 31, 2014, using the retail inventory method.
(b) Compute the ending inventory at cost for each department at December 31, assuming the cost-to-retail ratios are 60% for Sporting Goods and 64% for Jewelry and Cosmetics.
(b) Sporting Goods: End. Inv. $63,000
PROBLEMS: SET C
Visit the book's companion website, at www.wiley.com/college/weygandt, and choose the Student Companion site to access Problem Set C.
COMPREHENSIVE PROBLEM
CP6 On December 1, 2014, Matthias Company had the account balances shown below.
The following transactions occurred during December.
| Dec. | 3 | Purchased 4,000 units of inventory on account at a cost of $0.72 per unit. |
| 5 | Sold 4,400 units of inventory on account for $0.90 per unit. (It sold 3,000 of the $0.60 units and 1,400 of the $0.72.) | |
| 7 | Granted the December 5 customer $180 credit for 200 units of inventory returned costing $120. These units were returned to inventory. | |
| 17 | Purchased 2,200 units of inventory for cash at $0.80 each. | |
| 22 | Sold 2,000 units of inventory on account for $0.95 per unit. (It sold 2,000 of the $0.72 units.) |
Adjustment data:
1. Accrued salaries payable $400.
2. Depreciation $200 per month.
Instructions
(a) Journalize the December transactions and adjusting entries, assuming Matthias uses the perpetual inventory method.
(b) Enter the December 1 balances in the ledger T-accounts and post the December transactions. In addition to the accounts mentioned above, use the following additional accounts: Cost of Goods Sold, Depreciation Expense, Salaries and Wages Expense, Salaries and Wages Payable, Sales Revenue, and Sales Returns and Allowances.
(c) Prepare an adjusted trial balance as of December 31, 2014.
(d) Prepare an income statement for December 2014 and a classified balance sheet at December 31, 2014.
(e) Compute ending inventory and cost of goods sold under FIFO, assuming Matthias Company uses the periodic inventory system.
(f) Compute ending inventory and cost of goods sold under LIFO, assuming Matthias Company uses the periodic inventory system.
CONTINUING COOKIE CHRONICLE
(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 5.)
CCC6 Natalie is busy establishing both divisions of her business (cookie classes and mixer sales) and completing her business degree. Her goals for the next 11 months are to sell one mixer per month and to give two to three classes per week.
The cost of the fine European mixers is expected to increase. Natalie has just negotiated new terms with Kzinski that include shipping costs in the negotiated purchase price (mixers will be shipped FOB destination). Natalie must choose a cost flow assumption for her mixer inventory.
Go to the book's companion website, www.wiley.com/college/weygandt, to see the completion of this problem.
Broadening Your Perspective
Financial Reporting and Analysis
Financial Reporting Problem: Apple Inc.
BYP6-1 The notes that accompany a company's financial statements provide informative details that would clutter the amounts and descriptions presented in the statements. Refer to the financial statements of Apple Inc. in Appendix A as well as its annual report. Instructions for accessing and using the company's complete annual report, including the notes to the financial statements, are also provided in Appendix A.
Instructions
Answer the following questions. Complete the requirements in millions of dollars, as shown in Apple's annual report.
(a) What did Apple report for the amount of inventories in its consolidated balance sheet at September 25, 2010? At September 24, 2011?
(b) Compute the dollar amount of change and the percentage change in inventories between 2010 and 2011. Compute inventory as a percentage of current assets at September 24, 2011.
(c) How does Apple value its inventories? Which inventory cost flow method does Apple use? (See Notes to the Financial Statements.)
(d) What is the cost of sales (cost of goods sold) reported by Apple for 2011, 2010, and 2009? Compute the percentage of cost of sales to net sales in 2011.
Comparative Analysis Problem:
PepsiCo, Inc. vs. The Coca-Cola Company
BYP6-2 PepsiCo's financial statements are presented in Appendix B. Financial statements of The Coca-Cola Company are presented in Appendix C. Instructions for accessing and using the complete annual reports of PepsiCo and Coca-Cola, including the notes to the financial statements, are also provided in Appendices B and C, respectively.
Instructions
(a) Based on the information contained in these financial statements, compute the following 2011 ratios for each company.
(1) Inventory turnover.
(2) Days in inventory.
(b) What conclusions concerning the management of the inventory can you draw from these data?
Comparative Analysis Problem:
Amazon.com, Inc. vs. Wal-Mart Stores, Inc.
BYP6-3 Amazon.com, Inc.'s financial statements are presented in Appendix D. Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E. Instructions for accessing and using the complete annual reports of Amazon and Wal-Mart, including the notes to the financial statements, are also provided in Appendices D and E, respectively.
Instructions
(a) Based on the information contained in these financial statements, compute the following 2011 ratios for each company.
(1) Inventory turnover.
(2) Days in inventory.
(b) What conclusions concerning the management of the inventory can you draw from these data?
Real-World Focus
BYP6-4 A company's annual report usually will identify the inventory method used. Knowing that, you can analyze the effects of the inventory method on the income statement and balance sheet.
Address: www.cisco.com, or go to www.wiley.com/college/weygandt
Instructions
Answer the following questions based on the current year's annual report on Cisco's website.
(a) At Cisco's fiscal year-end, what was the inventory on the balance sheet?
(b) How has this changed from the previous fiscal year-end?
(c) How much of the inventory was finished goods?
(d) What inventory method does Cisco use?
Critical Thinking
Decision-Making Across the Organization
BYP6-5 On April 10, 2014, fire damaged the office and warehouse of Corvet Company. Most of the accounting records were destroyed, but the following account balances were determined as of March 31, 2014: Inventory (January 1, 2014), $80,000; Sales Revenue (January 1–March 31, 2014), $180,000; Purchases (January 1–March 31, 2014), $94,000.
The company's fiscal year ends on December 31. It uses a periodic inventory system.
From an analysis of the April bank statement, you discover cancelled checks of $4,200 for cash purchases during the period April 1–10. Deposits during the same period totaled $18,500. Of that amount, 60% were collections on accounts receivable, and the balance was cash sales.
Correspondence with the company's principal suppliers revealed $12,400 of purchases on account from April 1 to April 10. Of that amount, $1,600 was for merchandise in transit on April 10 that was shipped FOB destination.
Correspondence with the company's principal customers produced acknowledgments of credit sales totaling $37,000 from April 1 to April 10. It was estimated that $5,600 of credit sales will never be acknowledged or recovered from customers.
Corvet Company reached an agreement with the insurance company that its fire-loss claim should be based on the average of the gross profit rates for the preceding 2 years. The financial statements for 2012 and 2013 showed the following data.
Inventory with a cost of $17,000 was salvaged from the fire.
Instructions
With the class divided into groups, answer the following.
(a) Determine the balances in (1) Sales Revenue and (2) Purchases at April 10.
*(b) Determine the average gross profit rate for the years 2012 and 2013. (Hint: Find the gross profit rate for each year and divide the sum by 2.)
*(c) Determine the inventory loss as a result of the fire, using the gross profit method.
Communication Activity
BYP6-6 You are the controller of Small Toys Inc. Marta Johns, the president, recently mentioned to you that she found an error in the 2013 financial statements which she believes has corrected itself. She determined, in discussions with the Purchasing Department, that 2013 ending inventory was overstated by $1 million. Marta says that the 2014 ending inventory is correct. Thus, she assumes that 2014 income is correct. Marta says to you, “What happened has happened—there's no point in worrying about it anymore.”
Instructions
You conclude that Marta is incorrect. Write a brief, tactful memo to Marta, clarifying the situation.
Ethics Case
BYP6-7 R. J. Graziano Wholesale Corp. uses the LIFO method of inventory costing. In the current year, profit at R. J. Graziano is running unusually high. The corporate tax rate is also high this year, but it is scheduled to decline significantly next year. In an effort to lower the current year's net income and to take advantage of the changing income tax rate, the president of R. J. Graziano Wholesale instructs the plant accountant to recommend to the purchasing department a large purchase of inventory for delivery 3 days before the end of the year. The price of the inventory to be purchased has doubled during the year, and the purchase will represent a major portion of the ending inventory value.
Instructions
(a) What is the effect of this transaction on this year's and next year's income statement and income tax expense? Why?
(b) If R. J. Graziano Wholesale had been using the FIFO method of inventory costing, would the president give the same directive?
(c) Should the plant accountant order the inventory purchase to lower income? What are the ethical implications of this order?
All About You
BYP6-8 Some of the largest business frauds ever perpetrated have involved the misstatement of inventory. Two classics were at Leslie Fay and McKesson Corporation.
Instructions
There is considerable information regarding inventory frauds available on the Internet. Search for information about one of the two cases mentioned above, or inventory fraud at any other company, and prepare a short explanation of the nature of the inventory fraud.
BYP6-9 If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following.
Instructions
(a) The primary basis for accounting for inventories is cost. How is cost defined in the Codification?
(b) What does the Codification state regarding the use of consistency in the selection or employment of a basis for inventory?
(c) What does the Codification indicate is a justification for the use of the lower-of-cost-or-market for inventory valuation?
Answers to Chapter Questions
Answers to Insight and Accounting Across the Organization Questions
p. 277 A Big Hiccup Q: What steps might the companies take to avoid such a serious disruption in the future? A: The manufacturer of the piston rings should spread its manufacturing facilities across a few locations that are far enough apart that they would not all be at risk at once. In addition, the automakers might consider becoming less dependent on a single supplier as well as having weather contingency plans.
p. 278 Falsifying Inventory to Boost Income Q: What effect does an overstatement of inventory have on a company's financial statements? A: The balance sheet looks stronger because inventory and retained earnings are overstated. The income statement looks better because cost of goods sold is understated and income is overstated.
p. 289 Is LIFO Fair? Q: What are the arguments for and against the use of LIFO? A: Proponents of LIFO argue that it is conceptually superior because it matches the most recent cost with the most recent selling price. Critics contend that it artificially understates the company's net income and consequently reduces tax payments. Also, because most foreign companies are not allowed to use LIFO, its use by U.S. companies reduces the ability of investors to compare U.S. companies with foreign companies.
p. 293 Too Many TVs or Too Few? Q: For Sony, what are the advantages and disadvantages of having a low days in inventory measure? A: If Sony has a low days in inventory, it reduces the amount of cash it has tied up in inventory. It also minimizes the risk it will be stuck with excess inventory that could force it to provide big discounts, resulting in punishing losses. Sony also faces the risk that the TVs will become obsolete before they are sold. However, Sony increases the risk that it will encounter “stock-outs,” that is, it will not have adequate inventory to meet customer demand.
Answers to Self-Test Questions
1. a 2. b ($180,000 + $35,000) 3. b 4. c [(5,000 × $13) + (4,000 × $12)] 5. d [(8,000 × $11) + (1,000 × $12)] 6. d ((5,000 × $8) + (15,000 × $10) + (20,000 × $12)) ÷ 40,000 − $10.75; $10.75 × 7,000 7. c 8. d 9. d (200 × $80) 10. b 11. b 12. b $285,000 ÷ [($80,000 + $110,000) ÷ 2] = 3; 365 ÷ 3 13. d *14. d *15. b [$150,000 − (30% × $150,000)] = $105,000; $135,000 − $105,000
A Look at IFRS
LEARNING OBJECTIVE 9
Compare the accounting procedures for inventories under GAAP and IFRS.
The major IFRS requirements related to accounting and reporting for inventories are the same as GAAP. The major differences are that IFRS prohibits the use of the LIFO cost flow assumption and determines market in the lower-of-cost-or-market inventory valuation differently.
Key Points
- The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.
- The definitions for inventory are essentially similar under IFRS and GAAP. Both define inventory as assets held-for-sale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).
- Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.
- Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.
- A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS.
- IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.
- In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost.
- Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.
- An example of the use of lower-of-cost-or-net realizable value (LCNRV) under IFRS follows.
- Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost.
- Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.
- IFRS allows companies to report inventory at standard cost if it does not differ significantly from actual cost. Standard cost is addressed in managerial accounting courses.
Looking to the Future
One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.
IFRS Practice
IFRS Self-Test Questions
1. Which of the following should not be included in the inventory of a company using IFRS?
(a) Goods held on consignment from another company.
(b) Goods shipped on consignment to another company.
(c) Goods in transit from another company shipped FOB shipping point.
(d) None of the above.
2. Which method of inventory costing is prohibited under IFRS?
(a) Specific identification.
(b) LIFO.
(c) FIFO.
(d) Average-cost.
3. Yang Company purchased 2,000 widgets and has 400 widgets in its ending inventory at a cost of $90 each and a current replacement cost of $80 each. The net realizable value of each unit in the ending inventory is $70. The ending inventory under lower-of-cost-or-net realizable value is:
(a) $36,000.
(b) $32,000.
(c) $28,000.
(d) None of the above.
4. Specific identification:
(a) must be used under IFRS if the inventory items are not interchangeable.
(b) cannot be used under IFRS.
(c) cannot be used under GAAP.
(d) must be used under IFRS if it would result in the most conservative net income.
5. IFRS requires the following:
(a) Ending inventory is written up and down to net realizable value each reporting period.
(b) Ending inventory is written down to net realizable value but cannot be written up.
(c) Ending inventory is written down to net realizable value and may be written up in future periods to its net realizable value but not above its original cost.
(d) Ending inventory is written down to net realizable value and may be written up in future periods to its net realizable value.
IFRS Exercises
IFRS6-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for inventories.
IFRS6-2 LaTour Inc. is based in France and prepares its financial statements (in euros) in accordance with IFRS. In 2014, it reported cost of goods sold of €578 million and average inventory of €154 million. Briefly discuss how analysis of LaTour's inventory turnover (and comparisons to a company using GAAP) might be affected by differences in inventory accounting between IFRS and GAAP.
IFRS6-3 Franklin Company has the following four items in its ending inventory as of December 31, 2014. The company uses the lower-of-cost-or-net realizable value approach for inventory valuation following IFRS.
Compute the lower-of-cost-or-net realizable value.
International Financial Reporting Problem: Zetar plc
IFRS6-4 The financial statements of Zetar plc are presented in Appendix F. Instructions for accessing and using the company's complete annual report, including the notes to its financial statements, are also provided in Appendix F.
Instructions
Using the notes to the company's financial statements, answer the following questions.
(a) What cost flow assumption does the company use to value inventory?
(b) What was the amount of expense that the company reported for inventory write-downs during 2011?
(c) What amount of raw materials, work in process, and finished goods inventory did the company report at April 30, 2011?
Answers to IFRS Self-Test Questions
Remember to go back to The Navigator box on the chapter opening page and check off your completed work.
__________
1Also, some companies use a perpetual system to keep track of units, but they do not make an entry for perpetual cost of goods sold. In addition, firms that employ LIFO tend to use dollar-value LIFO, a method discussed in upper-level courses. FIFO periodic and FIFO perpetual give the same result. Therefore, companies should not incur the additional cost to use FIFO perpetual. Few companies use perpetual average-cost because of the added cost of recordkeeping. Finally, for instructional purposes, we believe it is easier to demonstrate the cost flow assumptions under the periodic system, which makes it more pedagogically appropriate.