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    Chapter 08 - Inventories and The Cost of Goods Sold

    8 INVENTORIES ANDTHE COST OF GOODS SOLD

    Chapter Summary

    The chapter is a detailed introduction to the cost flow assumptions used to value inventories andmeasure the cost of goods sold.

    Application of specific identification, average cost, I! and "I! is first e#amined within theconte#t of a perpetual inventor$ s$stem. The impact of the flow assumption emplo$ed on income ta#es isdiscussed in detail. The need for a ph$sical inventor$ to assess inventor$ shrin%age is also reviewed as are

    the accounting procedures necessar$ to record inventor$ shrin%age. A &rief presentation of lower-of-cost-or-mar%et write downs concludes the discussion of perpetual s$stems.

    Application of the flow assumptions within a periodic s$stem is ne#t e#plained. 'e alsodemonstrate that restatement of ending inventor$ &$ the periodic method results in the ma#imum ta#advantage from the "I! flow assumption.

    The chapter covers a num&er of additional issues surrounding inventor$ accounting. Theseinclude( the financial statement effects of inventor$ errors) the retail and gross profit methods for estimatingending inventor$) and, an anal$sis of the inventor$ turnover ratio.

    Learning Objectives

    1. In a p er pe t u al inv en to r$ s$s te m , d et er m in e th e cos t of goo ds sold usin g *a+s pec i fi c i dent i f ica t i o n , *&+ av er a g e co st , * c+ FIFO , a nd *d+ LIFO. iscusst he adv an tag es and sh or tco mi n g s of each met h o d.

    2. #plain the need for ta%ing a ph$sical inventor$.

    3. ecord s hr in k a g e lo s s e s and o ther $ear -end ad/us tments to inven tor$.

    4. In a per iodic inventor$ s$s tem, determine the ending inventor$ and the cos t o fgoods sold using

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    goods sold using

    Chapter 08 - Inventories and The Cost of Goods Sold

    6 irst-in, first-out method

    7 "ast-in, first-out method# valuation of the methodsa Specific identification$ Average costc irst-in, first-outd "ast-in, first-out

    % o inventor$ methods reall$ affect performance1& The principle of consistenc$11 2ust-in-time *2IT+ inventor$ s$stem - see Case in Point*page 34#+

    ' Ta%ing a ph$sical inventor$1 ecording shrin%age losses2 "C3 and other write-downs of inventor$

    a The lower-of-cost-or-mar%et *"C3+ rule3 The $ear-end cutoff of transactions

    a 3atching revenue and the cost of goods sold$ Goods in transit - see Your Turn*page 351+

    4 4eriodic inventor$ s$stemsa Appl$ing flow assumption in a periodic s$stem$ Specific identificationc Average costd I!e "I! - see Case in Point*page 353+f eceiving the ma#imum ta# &enefit from the "I! methodg 4ricing the $ear-end inventor$ &$ computer

    5 International inancial eporting Standards6 Importance of an accurate valuation of inventor$

    a ffects of an error in valuing ending inventor$$ Inventor$ errors affect two $earsc ffects of errors in inventor$ valuation( a summar$

    7 Techni5ues for estimating the cost of goods sold and the ending inventor$# The gross profit method

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    Chapter 08 - Inventories and The Cost of Goods Sold

    Topical coverage and suggested assignment

    *ome+ork "ssignment,-o 'e (ompleted rior to (lass/

    (lass0eetings on

    (hapter

    -opicalO!tline

    (overage)isc!ssion!estions

    'riefercises ercises ro$lems

    (ritical-hinking

    (ases

    1 A 1, 7, 1, 7, 7, 17 9 :, ;,

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    Chapter 08 - Inventories and The Cost of Goods Sold

    General comments

    As in the previous edition, we emphasie the perpetual inventor$ s$stem primaril$ &ecause this is themethod now in predominant use. Teaching with an emphasis on perpetual inventor$ s$stems has a num&erof &enefits in the classroom.

    !f greatest importance, a perpetual s$stem shifts the focal point of cost assignment from endinginventor$ to the cost of goods sold. As a result, the names of the flow assumptions finall$ ?mean what the$sa$.? or e#ample, ?first-in, first-out? means that the first costs are used in the cost assignment process)?last-in, first-out? means that the last costs are used. Bnder a periodic s$stem, the reverse is true.*#perienced instructors will remem&er tr$ing to e#plain to students that ?first-in, first-out? actuall$ means

    that the latest costs are assigned to inventor$, whereas ?last-in, first-out? reall$ means the first costs areassigned.+ot onl$ do students more 5uic%l$ grasp the concepts underl$ing the flow assumptions when we

    assume a perpetual inventor$ s$stem, &ut the$ also 5uic%l$ grasp the effects of using different assumptionsduring a period of rising prices. This ena&les us to emphasie the effects of different methods uponearnings, income ta# considerations, and even the implications of "I! reserves.

    'e use #ercise 2to illustrate the &asic cost-flow assumptions and follow it with a discussion of#ercise 11 to demonstrate the effects of using alternative methods. #ercise 12 presents a morechallenging anal$sis of the same points. 'e also discuss in class such topics as ?/ust-in-time? s$stems,

    inventor$ shrin%age, and the factors management should consider in determining the optimal sie of acompan$@s inventor$. These discussions portra$ inventor$ as ph$sical goods moving in and out of the&usiness, rather than merel$ as a dollar amount. 'e find that these discussions contri&ute to students@interest, and also to their understanding of the importance of inventories to accountants, managers, andinvestors.

    Supplemental Exercises

    Business WeekExercises

    Detailers vs. 9u$ers( 'ho 'ill 9lin% irstE, Business Week, ecem&er 1:, 700, discusses theconse5uences of retailers %eeping stoc%s low for the 700 Fuletide season, while consumers are awaitingsales #plain how e#cessive inventories can hurt a retailers &ottom line

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    Chapter 08 - Inventories and The Cost of Goods Sold

    (*"- # 8"0 9

    1 &: 0I8;- ;I< " =(-IO8

    Indicate the &est answer for each 5uest ion in the space provided.

    1 The primar$ purpose of an inventor$ flow assumption is to(a Increase inventor$ turnover.$ Increase gross profit.c etermine which uni t cost s are ass igned to inven tor$ and which

    are assigned to the cost of goods sold.d 3inimie ta#a&le income during periods of rising prices.

    2 uring a period of s teadi l$ rising prices , which of the followinginven tor$ valua tion methods is li%el$ to resul t in the lowes t cost ofgoods solda "I!.$ I!.c The retail method.d The gross profit met hod.

    3 The primar$ reason for the populari t$ of the "I! flow assumption isthat this method(a Is most appropriate when each i tem in inventor$ is uni5ue.$ Tends to minimie ta#a&le income.c Causes inventor$ to &e reporte d at or near its current

    replacement cost.

    d educes the amount of mone$ Dtied upE in inventor$.

    4 In a periodic inventor$ s$stem, the cost of goods sold is determined &$(a 3ultipl$ing net sales for the period &$ a cost ratio.

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    Chapter 08 - Inventories and The Cost of Goods Sold

    (*"- # 8"0 9

    1 &: 0I8;- ;I< ' =(-IO8

    Ace S$st e ms , Inc. us es a per pe tu al inve nt or $ s$s te m. The co mp an $ s&eginni ng inven tor$ of a particular prod uct an d its purchases during themonth of 2anuar$ were as follows(

    !ant i t ;ni t (o st -o ta l

    (ost

    9eginning inventor$ *2an. 1+ .................. 10 J7;.:0 J7;:4urchase *2an. 1:+ ..................................... 1: J78.00 J>704urch as e *2an. 7+ ..................................... : J7: Total ......................................................... 0 J8>0

    !n 2anuar$ 78, Ace S$s tems sell s 18 uni ts of thi s product . The other 17units remain in inventor$ at 2anuar$ 1.

    1 Re fer to abov e da ta . Assuming that Ace S$s tems uses the average

    cost flow assumption, the cost of goods sold to &e recorded at 2anuar$78 is(a J:0>. c J>

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    Chapter 08 - Inventories and The Cost of Goods Sold

    (*"- # 8"0 9

    1 &: 0I8;- ;I< ( =(-IO8

    Canfield uses a perpetual inventor$ s$stem. The compan$s &eginning inventor$ of aparticul ar product an d its purc hases during the mo nth of 2anua r$ were as follows (

    !an ti t ;nit (ost

    -otal (ost

    9eginning inventor$ *2an. 1+ ...................................... :0 J= J004urchase *2an. 10+ ......................................................... 7: J; J1;:4urch as e *2an. 77+ ......................................................... 7: J8 J700 Total ......................................................................... 100 J=;:

    !n 2anuar$ 7:, Canfield sells :: uni ts of this product. The other >: units remain ininventor$ at 2anuar$ 1.

    a etermine the cost of goods sold using each of the following flow assum ption s(

    *1+ "I! JKKKKKKKKKKKKK

    *7+ I! JKKKKKKKKKKKKK

    *+ Average cost JKKKKKKKKKKKKK

    $ etermine the cost of the >: uni ts in inventor$ a t 2anuar$ 1 using each of thefollowing flow ass um pti ons (

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    Chapter 08 - Inventories and The Cost of Goods Sold

    (*"- # 8"0 9

    1 &: 0I8;- ;I< ) =(-IO8

    Sherman lec tri c uses a per iodic inven tor$ s$s tem. The &eg inning inven tor$ of aparticul ar product, and the purchases during the curr ent $ear, were as follows (

    2an. 1 9eginning inve nt or $ ..................... =0 units L J10: M J =,003ar. 8 4urc ha se ........................................... 0 units L J11 : M , >: 0Aug. 11 4urchase ........................................... oods =old

    a Average cost JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK

    $ irst -in, first -ou t JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK

    c "ast -in, first -ou t JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK

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    Chapter 08 - Inventories and The Cost of Goods Sold

    =OL;-IO8= -O (*"- # 1&: 0I8;- ;I

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    Chapter 08 - Inventories and The Cost of Goods Sold

    Assignment Guide to Ch!te" 8

    'rief

    ercisesercises ro$l e m s (ase s 8et

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    ! si n g , a/ s p e c if i c id e n ti f ic a t i o n ? , $/

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