© The McGraw-Hill Companies, Inc., 2010Overview

CHAPTER 8INVENTORIES AND THECOST OF GOODS SOLD

Brief LearningExercises Topic Objectives Skills

B. Ex. 8.1 FIFO inventory 1, 4 AnalysisB. Ex. 8.2 Specific cost identification inventory 1, 4 AnalysisB. Ex. 8.3 Weighted average cost inventory 4 AnalysisB. Ex. 8.4 4 Analysis

B. Ex. 8.5 4 Analysis

B. Ex. 8.6 Inventory shrinkage 3 AnalysisB. Ex. 8.7 Inventory error 5 AnalysisB. Ex. 8.8 Inventory error 5 AnalysisB. Ex. 8.9 Inventory turnover 7 AnalysisB. Ex. 8.10 Inventory turnover 7 Analysis

Exercises Topic Skills8.1 Accounting terminology 1–7 Analysis8.2 Cost flow assumptions 1 Analysis8.3 Physical flows vs. cost flows 4 Analysis8.4 Effects of different cost flows 4 Analysis8.5 Transfer of title 2 Analysis8.6 Inventory write-downs 3 Analysis8.7 Periodic inventory systems 4 Analysis8.8 Inventory errors 5 Analysis8.9 Gross profit method 6 Analysis8.10 Retail method 6 Analysis8.11 7 Analysis

7 Analysis, communication

8.13 7

OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL THINKING CASES

FIFO and weighted average cost inventory

FIFO and weighted average cost inventory

Learning Objectives

Real World: Li & Fung Limited Inventory turnover

8.12  Real World: Marks & Spencer Inventory analysis

Real World: adidas AG Examining an annual report

Analysis, communication, judgment

© The McGraw-Hill Companies, Inc., 2010Overview

CHAPTER 8INVENTORIES AND THECOST OF GOODS SOLD

Skills

AnalysisAnalysisAnalysis

Analysis

AnalysisAnalysisAnalysis

SkillsAnalysisAnalysisAnalysisAnalysisAnalysisAnalysisAnalysisAnalysisAnalysisAnalysisAnalysis

Analysis, communication

OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL THINKING

Analysis, communication, judgment

© The McGraw-Hill Companies, Inc., 2010Overview(p.2)

ProblemsSets A, B Topic Skills8.1 A,B Inventory valuation 1 Analysis, judgment

8.2 A,B Cost flow assumptions: Perpetual 1 Analysis, judgment

8.3 A,B Cost flow assumptions: Periodic 4 Analysis, judgment8.4 A,B Inventory shrinkage 1–3 Analysis, communication, judgment8.5 A,B Periodic inventory systems 4 Analysis, judgment8.6 A,B Effects of inventory errors 5 Analysis, communication8.7 A,B Retail method 2, 3, 6 Analysis8.8 A 6, 7 Analysis, communication, judgment

8.8 B 1, 7 Analysis, communication, judgment

Critical Thinking Cases 8.1 Inventory errors ### 5 Analysis, communication, judgment8.2 Dealing with the bank 3 Analysis, communication, judgment

8.3 7

Learning Objectives

Real World: Marks & Spencer Retail method and ratio analysis

Real World: Wing On FIFO vs. weighted average cost comparisons

(Ethics, fraud & corporate governance) Real World: Chow Sang Sang and Sa Sa. Inventory turnover rates (Internet)

Analysis, communication, technology

© The McGraw-Hill Companies, Inc., 2010Description Problems

DESCRIPTIONS OF PROBLEMS ANDCRITICAL THINKING CASES

Problems (Sets A and B)8.1 A,B BassTrack/Dome, Inc. (Perpetual) 35 Medium

8.2 A,B Speed World Cycles/Sea Travel (Perpetual) 30 Strong

8.3 A,B Speed World Cycles/Sea Travel (Periodic) 20 Medium

8.4 A,B Mario’s Nursery/Sam's Lawn Mowers 20 Medium

8.5 A,B Tokyo Audio/Roman Sound 25 Easy

8.6 A,B Hexagon Health Foods/City Software 20 Medium

8.7 A,B Between the Ears/Sing Along 25 Medium

8.8 A Marks & Spencer 20 Strong

Below are brief descriptions of each problem and case. These descriptions are accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the partially filled-in working papers.

A comprehensive problem calling for measurement of the cost of goods sold and valuation of inventory by specific cost identification and two different flow assumptions. Requires both journal entries and maintenance of inventory subsidiary ledger records.

Compute the cost of goods sold and ending inventory by two different flow assumptions, and answer questions regarding the characteristics of these assumptions.

Computations similar to those in Problem 8-2 except that periodic costing procedures are used in place of a perpetual inventory system.E

xer Adjustments under various flow assumptions to reflect the taking of a

physical inventory. Also requires a write-down of the remaining inventory to a net realisable value below cost.

FIFO and weighted average cost in a periodic inventory system. Students also are asked to answer questions about the characteristics of these flow assumptions.

A series of income statements for a business being offered for sale indicates a rising trend in gross profit. The student is given information on errors in inventory and asked to prepare revised income statements and to evaluate the trend of gross profit.

Illustration of the retail method and its use in estimating inventory shrinkage.

Using data compiled from the company's financial statements under retail method, students compute several financial ratios. Requires a review of ratios introduced in previous chapters. Student is also asked to estimate the ending inventory at retail prices.

© The McGraw-Hill Companies, Inc., 2010Desc. of Cases

Critical Thinking Cases8.1 Inventory Errors 30 Strong

8.2 Dealing with the Bank 15 MediumEthics, Fraud & Corporate Governance

8.3 Chow Sang Sang and Sa Sa No time limitInternet Strong

While interviewing for a position as controller, the job applicant learns that the employer has an inventory “problem.” Inventories have been understated consistently in past profits tax returns.

Students are required to evaluate ethical implications of manipulating financial statement information in order to be in compliance with bank covenants. Also requires analytical understanding of working capital relationships.

Requires an analytical interpretation of inventory performance measures reported by Chow Sang Sang, a jewellery retail chain, and Sa Sa, a cosmetics products retail chain.

© The McGraw-Hill Companies, Inc., 2010Q1-7

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1.

2.

3.

4. a.

b.

5.

6.

7.

The cost of goods acquired represents an asset—inventory—until the goods is sold. At the date of sale, the cost of the goods is reclassified as an expense—cost of goods sold—which is “matched” against the related sales revenue.

The use of a cost flow assumption eliminates the need for separately identifying each unit sold and looking up its cost. Thus, the time and effort involved in recording the cost of goods sold can be reduced significantly.

IFRS permit the use of inventory cost flow assumptions whenever the items comprising the inventory are similar in terms of cost, function, and sales price.

In measuring the results of operations, accountants consider the flow of costs to be more important than the physical flow of specific units of goods. Therefore, a cost flow assumption need not correspond to the physical movement of the company's goods.

Under the weighted average cost method, all units in the inventory are valued at the same average cost. (The weighted average cost is recomputed after every purchase transaction.) Therefore, the cost of goods sold is based upon this weighted average cost per unit.

The FIFO flow assumption means “first-in, first-out.” Therefore, each sale is assumed to consist of the oldest units in the inventory, and the unit costs in the oldest cost layers are transferred to the cost of goods sold.

The specific cost identification method should be used by the art gallery. Each item is unique and prices vary widely. Therefore, the gross profit on a sale can be determined logically only by a method that offsets the cost of a specific painting against its sales price. The ending inventory will be stated at the cost incurred for the individual paintings on hand at the end of the year.

During a period of rising purchase costs, FIFO results in the highest reported profits, as the costof goods sold is measured using the oldest (and lowest) costs. The weighted average cost method results in the lowest taxable profits, as the cost of goods sold consists of the more recent (and higher) purchase costs.

As the FIFO method assigns the oldest costs to the cost of goods sold, the most recent purchase costs remain in the Inventory account. Therefore, FIFO results in a valuation of inventory that is closest to current replacement costs.

Under these unusual circumstances of unchanging purchase prices throughout the year, FIFO and weighted average cost method would produce exactly the same results in the financial statements. The ending inventory under both methods would be equal to the number of units on hand at year-end multiplied by the same unit price.

© The McGraw-Hill Companies, Inc., 2010Q8-13

8.

9.

10.

11.

12.

13.

Beginning Inventory+ Purchases Cost of Goods Available for Sale- Ending Inventory Cost of Goods Sold

No, Apex is not violating the accounting principle of consistency by using different accounting methods for different segments of its inventories. The varying nature of inventory items explains in part why several methods of valuation are generally acceptable. The principle of consistency is violated when a company changes inventory methods from one year to the next, because such changes cause profit to differ from what it would have been if the change in accounting method had not occurred. Consistency is an important aid in making financial statements comparable from one year to the next.

The phrase “just-in-time inventory system” relates primarily to the management of inventories within manufacturing companies. With respect to purchase of raw materials, just-in-time means that materials arrive just in time for use in the production process. With respect to finished goods, the just-in-time concept means that goods are shipped to customers (sold) immediately upon completion of production.

An advantage of the just-in-time concept is that it reduces or eliminates the amounts of the manufacturer's inventories of materials and finished goods. This reduces the amount of capital that the business must invest in these inventories and also any related costs such as storage and insurance. The primary risk of the just-in-time approach for goods to be shipped to customers is that promised delivery dates may not be met due to unavoidable production delays.

The primary reason for taking a physical inventory is to adjust the perpetual inventory records for shrinkage losses such as theft, spoilage, or breakage. The physical inventory usually is taken near the end of the fiscal year, so that the balance sheet will reflect the correct amount of inventory on hand, and the income statement will reflect the shrinkage losses for the year.

A company might write down its inventory to a carrying amount below cost if the inventory has become obsolete (or otherwise unsalable), or to reflect a net realizable value below historical cost.

A cutoff of transactions means determining that transactions occurring near year-end are recorded in the proper accounting period.

If goods are in transit at year-end, the ownership of these goods is determined by the terms of shipment. If the terms are F.O.B. destination, the goods belong to the seller until they reach their destination. If the terms of shipment are F.O.B. shipping point, the goods in transit belongs to the buyer.

In a periodic inventory system, the cost of goods purchased during the year is debited to a Purchases account, rather than to the Inventory account. When goods are sold, an entry is made recognizing the sales revenue, but no entry is made reducing the Inventory account or recognizing the cost of goods sold.

The inventory on hand and the cost of goods sold are not determined until year-end. At the end of the year, a complete physical inventory is taken to determine the amount of inventory on hand. The cost of goods sold then is determined by a computation, as shown below:

© The McGraw-Hill Companies, Inc., 2010Q14-19

14. a.

b.

15.

16.

17.

18.

19.

The weighted average cost method begins with a determination of the weighted average per-unit cost of all units available for sale during the year (cost of goods available for sale divided by the number of units available for sale). The units in the year-end inventory then are priced at this weighted average per-unit cost.

Under the FIFO flow assumption, the oldest goods (first-in) are assumed to be the first sold. Therefore, the ending inventory is assumed to consist of the most recently purchased units.

Errors in the valuation of ending inventory are said to be “counterbalancing” or “self-correcting” because these errors have opposite effects upon the gross profit (and profit) reported in each of two successive years. The cumulative amount of gross profit reported over the two-year period will be correct, and the balance sheet will be correct at the end of the second year.

This “counterbalancing” effect stems from the fact that an error in the valuation of the ending inventory of one year represents an error in the beginning inventory of the following year. Ending and beginning inventory amounts have opposite effects on the calculation of cost of goods sold.

Under the gross profit method, the cost of goods sold is estimated by applying the historical cost ratio (100% minus the gross profit rate) to the net sales of the current period. Subtracting this estimated cost of goods sold from the cost of goods available for sale (beginning inventory plus purchases) provides an estimate of ending inventory.

Companies that use a periodic inventory system find the gross profit method useful in preparing interim financial statements. These companies also may use this method in estimating the inventory on hand at the date of a fire, theft, or other casualty. The method also may be used to confirm the reasonableness of the amount determined by a year-end physical inventory.

Ending inventory $56,000, computed as follows: $40,000 + $100,000 - ($112,000 ´ .75) = $56,000.

No. The inventory must be presented in the balance sheet at cost. The inventory stated at retail price will be reduced to a cost basis by applying the cost percentage, which is the ratio prevailing between cost and selling price during the current period.

The inventory turnover is computed by dividing the cost of goods sold by the average amount of inventory maintained during the period. The higher the inventory turnover, the more efficient is management's use of the asset to generate sales. This measurement is of interest to short-term creditors because it indicates how quickly the company is able to sell its goods. This is a major step in converting the inventory into cash, which, in turn, can be used to pay the short-term creditors' claims.

© The McGraw-Hill Companies, Inc., 2010Q20-22

20. a.

b.

c.

21. a.

b.

22. a.

b.

c.

Using weighted average cost method during a period of rising costs should result in a lower profit than would be reported under the FIFO method. Weighted average cost method assigns the more recent purchase costs to the cost of goods sold. When costs are rising, the more recent costs also tend to be highercosts.

Weighted average cost method assigns the more recent (higher) costs to the cost of goods sold, and the older (lower) costs to inventory. The inventory turnover rate is computed by dividing the cost of goods sold by the average inventory. Therefore, use of the weighted average cost method method should indicate a higher inventory turnover rate than would the FIFO method.

By assigning the more recent (higher) purchase prices to the cost of goods sold, weighted average cost method minimizes taxable profit and income taxes expense. This is, perhaps, the primary reason for the popularity of the weighted average cost method method.

In a period of declining prices, use of the FIFO method will minimize the reported rate of gross profit. This is because the oldest (and therefore highest) purchase costs will be assigned to the cost of goods sold.

The net cash from operating activities will be higher than if Computer Products had used weighted average cost method. This is because the flow assumption in use has no effect upon the cash receipts from customers or cash payments to suppliers, but it does affect income taxes. By using FIFO in this period of declining prices, the older and higher costs will be assigned to the cost of goods sold, thereby minimizing taxable profit. This, in turn, will minimize income tax payments—a cash outflow that enters into the determination of net cash from operating activities.

(Note to instructor: In the more common situation of rising replacement costs, it would be weighted average cost method that would minimize the gross profit rate and increase net cash from operating activities.)

The first company is using the more conservative method—weighted average cost—in pricing its inventory. The weighted average cost method of pricing inventory assigns older costs to inventory and more recent costs to the cost of goods sold. The FIFO method (first-in, first-out), in contrast, assigns the more recent costs to inventory and the older costs to the cost of goods sold. Thus, during a period of rising prices, the weighted average cost method results in a lower valuation of inventory and a higher valuation of the cost of goods sold than does the FIFO method.

Again the answer is the first company. As weighted average cost minimizes profit during a period of rising prices, it also minimizes the amount of income taxes that a company must pay. Tax authorities require a company to use the same method — e.g. weighted average cost method— in both its profits tax returns and in its financial statements. By using FIFO in its financial statements, the second company is normally precluded from using the weighted average cost method in its profits tax returns.

No. An inventory flow assumption affects only the allocation of costs between ending inventory and the cost of goods sold. It has no effect upon the amounts of cash, either collected from customers or paid to the suppliers.

© The McGraw-Hill Companies, Inc., 2010Q20-22

Using weighted average cost method during a period of rising costs should result in a lower profit than would be reported under the FIFO method. Weighted average cost method assigns the more recent purchase costs to the cost of goods sold. When costs are rising, the more recent costs also tend to be

Weighted average cost method assigns the more recent (higher) costs to the cost of goods sold, and the older (lower) costs to inventory. The inventory turnover rate is computed by dividing the cost of goods sold by the average inventory. Therefore, use of the weighted average cost method method should

inventory turnover rate than would the FIFO method.

By assigning the more recent (higher) purchase prices to the cost of goods sold, weighted average cost method minimizes taxable profit and income taxes expense. This is, perhaps, the primary reason for the

minimize the reported rate of gross profit. (and therefore highest) purchase costs will be assigned to the cost of goods

than if Computer Products had used weighted no effect upon the cash receipts

affect income taxes. By using FIFO in this period of declining prices, the older and higher costs will be assigned to the cost of goods sold, thereby minimizing taxable profit. This, in turn, will minimize income tax payments—a cash outflow that

replacement costs, it would be weighted average cost that would minimize the gross profit rate and increase net cash from operating activities.)

The first company is using the more conservative method—weighted average cost—in pricing its inventory. The weighted average cost method of pricing inventory assigns older costs to inventory and more recent costs to the cost of goods sold. The FIFO method (first-in, first-out), in contrast, assigns the more recent costs to inventory and the older costs to the cost of goods sold. Thus, during a period of rising prices, the weighted average cost method results in a lower valuation of inventory and a higher valuation of the cost of goods sold than does the FIFO method.

Again the answer is the first company. As weighted average cost minimizes profit during a period of rising prices, it also minimizes the amount of income taxes that a company must pay. Tax authorities require a company to use the same method — e.g. weighted average cost method— in both its profits tax returns and in its financial statements. By using FIFO in its financial statements, the second company is normally precluded from using the weighted average cost method in its profits tax returns.

of costs between ending inventory and upon the amounts of cash, either collected from customers or

© The McGraw-Hill Companies, Inc., 2010BE8.1,2,3,4,5,6,7,8

SOLUTIONS TO BRIEF EXERCISES

B.Ex. 8.1 50 units @ $2.00 = $100 (the oldest costs)

B.Ex. 8.2 (15 units @ $20) = $300

B.Ex. 8.3 100 units @ $3.05 = $ 305150 units @ $3.10 = 465

$1,148/370 units = $3.10 per unit

Ending inventory: (370 units - 125 units) x $3.10 = $760

B.Ex. 8.4 Units in ending inventory: 100 + 100 - 75 = 125 unitsWeighted average cost:

200 $1005

$1,005/200 = $5.025

Weighted average cost: 125 @ $5.025 = $628.13FIFO: (25 @ $5.00) + (100 @ $5.05) = $630.00

B.Ex. 8.5 Units in ending inventory: 10 + 20 - 25 = 5 unitsWeighted average cost: 10 @ $10 = $100

30 $320

$320/30 = $10.67

FIFO inventory: 5 units @ $11 = $55 (recent costs)

Weighted average cost inventory: 5 units @ $10.67 = $53.35 (weighted average cost)

B.Ex. 8.6 Inventory Shrinkage Loss 50,000Inventory 50,000

($1,000,000 x 5%)

B.Ex. 8.7 Sales $990,000Cost of goods sold (460,000)

120 units @ $3.15 = 378370 $1,148

100 @ $5.00 = $500100 @ $5.05 = 505

The difference is only $1.87 due to the relatively small difference in price of the two purchases ($.05).

20 @ $11 = 220

© The McGraw-Hill Companies, Inc., 2010BE8.1,2,3,4,5,6,7,8

Gross profit $530,000

B.Ex. 8.8 Rather than ending inventory being $670,000, it is correctly restated at $620,000 ($670,000 - $50,000). Correction of this error will cause cost of goods sold to increase by $50,000.

© The McGraw-Hill Companies, Inc., 2010BE8.1,2,3,4,5,6,7,8

SOLUTIONS TO BRIEF EXERCISES

(15 units @ $20) = $300

The difference is only $1.87 due to the relatively small difference in price of the two purchases

© The McGraw-Hill Companies, Inc., 2010BE8.1,2,3,4,5,6,7,8

Rather than ending inventory being $670,000, it is correctly restated at $620,000 ($670,000 - $50,000). Correction of this error will cause cost of goods sold to increase by $50,000.

© The McGraw-Hill Companies, Inc., 2010BE8.9,10

B.Ex. 8.9 Inventory turnover: $5,000,000 / $1,280,000 = 3.91

Average number of days to sell inventory: 365 / 3.91 = 93.35

B.Ex. 8.10 Inventory turnover for 2009: $85 / $27 = 3.15Inventory turnover for 2010: $90 / $35 = 2.57

Average days to sell inventory:2009 365 / 3.15 = 115.92010 365 / 2.57 = 142.0

The inventory turnover is higher in 2009, indicating that management did a better job of managing its inventory in 2009 than in 2010. This same relationship can be seen by calculating the average number of days to sell inventory, which is lower in 2009, as indicated below:

© The McGraw-Hill Companies, Inc., 2010E8.1,2

SOLUTIONS TO EXERCISESEx. 8.1 a. Flow assumption

b. Weighted average cost methodc. Specific cost identification methodd. LIFO methode. FIFO methodf. Retail method

Ex. 8.2 a. Cost of Goods Sold …………………………………………… 1,378,000 Inventory ………………………………………

62 @ $15,000 ……………… $930,000 28 @ $16,000 ……………… 448,000Cost of goods sold ………… $1,378,000

b. Cost of Goods Sold …………………………………………… 1,377,000 Inventory ……………………………………

c. Cost of Goods Sold …………………………………………… 1,370,000 Inventory …………………………………………

70 @ $15,000 …………… $1,050,000 20 @ $16,000 ……………… 320,000Cost of goods sold ……… $1,370,000

d.

To record the cost of 90 Millenium computers sold to Apex Publishers. Cost determined by the specific cost identification method:

To record the cost of 90 Millenium computers sold to Apex Publishers. Cost determined by the weighted average cost method:

90 @ $15,300 ($1,530,000 ¸ 100 units)

To record the cost of 90 Millenium computers sold to Apex Publishers. Cost determined by the FIFO flow assumption:

Under FIFO, the cost of goods sold is based on the oldest costs. Thus, relative to using weighted average cost method, the FIFO method will result in higher profit during periods of rising prices, which will increase a company's income tax liability. In the balance sheet, the FIFO method reports inventory at the most current costs. The weighted average cost method method, on the other hand, reports the same inventory at older, more conservative costs.

© The McGraw-Hill Companies, Inc., 2010E8.1,2

SOLUTIONS TO EXERCISES

1,378,000

1,377,000

1,370,000

Under FIFO, the cost of goods sold is based on the oldest costs. Thus, relative to using weighted average cost method, the FIFO method will result in higher profit during periods of rising prices, which will increase a company's income tax liability. In the balance sheet, the FIFO method reports inventory at the most current costs. The weighted average cost method method, on the other hand, reports the same inventory at older,

© The McGraw-Hill Companies, Inc., 2010E8.3

Ex. 8.3 a. 1.

2.

3.

b.

c.

As heating oil is purchased and put into storage tanks, it mixes completely with the heating oil remaining in these tanks from prior purchases. As oil is pumped into the company’s delivery trucks, it actually represents a blend of multiple purchase costs. Thus, the weighted average cost method appears to best describe the physical flow of the heating oil inventory.

The company’s large coal storage bins are loaded and emptied from the top by giant machines, making the most recent coal acquired the most recent coal sold. Thus, relative to the FIFO method, the weighted average cost method method best describes the physical flow of the coal inventory.

The kerosene inventory is stored on shelves in 5-gallon containers. Management probably “rotates” this stock on a regular basis. Thus, the FIFO method best describes the physical flow of the keroseneinventory.

The weighted average cost method would probably result in the lowest income tax liability for the company (assuming that fuel prices are rising). The weighted average cost method allocates the more recent purchase prices to the cost of goods sold for the period. Thus, in periods of rising prices, the weighted average cost method usually results in a higher cost of goods sold and, consequently, a lower taxable profit than FIFO method.

In order for a company to account for its entire inventory as a single, combined, “pool,” all items should be relatively homogeneous. Obviously, the physical properties of heating oil, coal, and kerosene differ significantly. Keeping separate inventory records for each fuel type makes the reported figures more meaningful and gives management more control over the operations of the business. If management determined, for example, that one of its product lines is unprofitable, it might decide to discontinue selling that product and focus attention on the profitable products.

© The McGraw-Hill Companies, Inc., 2010E8.4,5

Ex. 8.4 a.

b. Dollar amounts stated in thousands:

1. Profit before taxes (as reported under FIFO) …………….

been in use ($1,865,000 - $1,850,000)………………………………………….Profit before taxes (assuming weighted average cost) ……………………….. 2. Income taxes expense under weighted average cost ($110,000

3.

Profit (assuming weighted average cost) …………………………………………

4. Net cash from operating activities (as reported) under FIFO)…………………………………………………………..

paid, minus $44,000 from part 2)…………………………….Net cash from operating activities (assuming LIFO) …….

Ex. 8.5

The weighted aver

Because the weighted average cost method assigns the older (lower) costs to inventory, it is reasonable to expect that the weighted average cost inventory would be lower than that resulting from FIFO valuation, not higher.

Less: Additional cost of goods sold had weighted average cost ……………………

profit before taxes x 40%)……………………………………………………………

Profit before taxes (weighted average cost basis, part 1) ……………………Less: Income taxes expense under weighted average cost (part 2) ………………….

Add: Income tax savings had weighted average cost been in use ($52,500 paid,

The inventory at 31 December amounts to $7,250,000, computed by adding the $1,250,000 inbound shipment of goods to $6,000,000 of inventory on hand. Terms of the $1,250,000 shipment were F.O.B. shipping point; therefore, title passed at the point of shipment on 28 December and the goods were the property of the buyer (Ma) while in transit.

The $950,000 outbound shipment was correctly handled. Title to these goods passed to the customer on 30 December when the goods were shipped, so they are not part of the Ma's inventory at 31 December. This shipment was billed on 30 December, so the account receivable is properly included in the balance sheet.

In addition to the $1,250,000 increase in inventory, accounts payable should be increased by $1,250,000. Ma owns the goods at 31 December and has a liability to pay for it.

© The McGraw-Hill Companies, Inc., 2010E8.4,5

$125,000

15,000$110,000

$44,000

$110,000 44,000

$66,000

$123,250

8,500$131,750

Because the weighted average cost method assigns the older (lower) costs to inventory, it is reasonable to expect that the weighted average cost inventory would be lower than that resulting

The inventory at 31 December amounts to $7,250,000, computed by adding the $1,250,000 inbound shipment of goods to $6,000,000 of inventory on hand. Terms of the $1,250,000 shipment were F.O.B. shipping point; therefore, title passed at the point of shipment on 28 December and the goods were the

The $950,000 outbound shipment was correctly handled. Title to these goods passed to the customer on 30 December when the goods were shipped, so they are not part of the Ma's inventory at 31 December. This shipment was billed on 30 December, so the account receivable is properly included in the balance

In addition to the $1,250,000 increase in inventory, accounts payable should be increased by $1,250,000.

© The McGraw-Hill Companies, Inc., 2010E8.6

Ex. 8.6 a. 1. Loss from Write-down of Inventory …………………………… 2,400Inventory ……………………………………………

Cost ……………………………………. $9,400 Net realiszable value 7,000 Reduction in carrying amount …… $2,400

2. Cash ……………………………………………………………… 5,250Sales …………………………………………………..

Cost of Goods Sold ………………………………………. 3,750Inventory ……………………………………………….

b. 1. Cost of Goods Sold ………………………………………………. 1,200Inventory ……………………………………………….

2. Cost of Goods Sold …………………………………………….. 1007Inventory ……………………………………………

3.

To write down the inventory of 28 units of WordCrafter to the lower-of-cost-and-net-realizable-value:

To recognize the sales revenue from the sale of 15 WordCrafter programs @ $350, cash.

To record cost of 15 WordCrafter programs sold on 9 January using the FIFO flow assumption. (All units are carried in inventory at $250 following the year-end reduction to the lower-of-cost-and-net-realiszable-value.)

To record shrinkage loss of 3 units of WordCrafter software using the FIFO flow assumption (3 units @ $400).

To record shrinkage loss of 3 units of WordCrafter software using the weighted average cost flow assumption, 3 units @ $335.7 ($9,400 / 28).

Using the FIFO method would result in a $193 lower profit figure than using the weighted average cost method ($1,200 - $1,007 = $193). This is due to the reduction in price paid for the second purchase. Although the company would report a lower profit figure using FIFO, it would not really be any less efficient in conducting operations. An inventory valuation method affects only the allocation of costs between ending inventory and cost of goods sold. It has no effect upon the total costs actually incurred in purchasing or manufacturing inventory.

© The McGraw-Hill Companies, Inc., 2010E8.6

2,400

5,250

3,750

1,200

1007

Using the FIFO method would result in a $193 lower profit figure than using the $1,007 = $193). This is due to the reduction in

price paid for the second purchase. Although the company would report a lower profit in conducting operations. An

inventory valuation method affects only the allocation of costs between ending inventory and cost of goods sold. It has no effect upon the total costs actually incurred in

© The McGraw-Hill Companies, Inc., 2010E8.7,8

Ex. 8.7 a.

b.

c.

Ex. 8.8 a. Compute corrected net income figures: 2010

Profit as reported ……………………………………………….. $ 3,500,000 Correction of understatement of inventory at end of 2009 …… (400,000)Profit as corrected …………………………………………….. $ 3,100,000

b. Compute gross profit amounts and gross profit percentagesfor each year based on corrected data:

For 2009: Adjusted gross profit ($6,000,000 + $400,000) ……………………….

For 2010:

c. Correction of owner's equity:

Weighted average cost $79.60 (20 units @ $3.98). (Weighted average cost = $438/110 units = $3.98)

FIFO, $99.00 (19 units @ $5.00 + 1 unit @ $4.00).

Only the FIFO method results in the same ending inventory valuation in both periodic and perpetual costing environments. Under the weighted average cost method, periodic and perpetual systems usually result in different valuations due to the timing of inventory purchases and sales. Under FIFO, the value assigned to ending inventory is the same using periodic or perpetual procedures, regardless of when purchases or sales occur during the period.

Gross profit rate ($6,400,000 ¸ $15,000,000) ………………….Adjusted gross profit ($7,500,000 - $400,000) ……………………………Gross profit rate ($7,100,000 ¸ $20,000,000) ……………………

Owner’s equity at the end of 2009 should be increased by $400,000 to $5,400,000. At the end of 2010 the owner's equity of $5,800,000 requires no correction because the inventory error counterbalanced, as evidenced by the fact that the combined profit for the two years was $6,000,000, both before and after the correction of profit for the individual years.

© The McGraw-Hill Companies, Inc., 2010E8.7,8

Compute corrected net income figures:2009

$ 2,500,000 400,000 $ 2,900,000

Compute gross profit amounts and gross profit percentagesfor each year based on corrected data:

$6,400,000 42.67%

$710,000 35.50%

(20 units @ $3.98). (Weighted average cost = $438/110 units =

Only the FIFO method results in the same ending inventory valuation in both periodic and perpetual costing environments. Under the weighted average cost method, periodic and

timing of inventory purchases and sales. Under FIFO, the value assigned to ending inventory is the same using periodic or perpetual procedures, regardless of when purchases or sales occur during the period.

Owner’s equity at the end of 2009 should be increased by $400,000 to $5,400,000. At the end of 2010 the owner's equity of $5,800,000 requires no correction because the inventory error counterbalanced, as evidenced by the fact that the combined profit for the two years was $6,000,000, both before and after the correction of profit for the individual years.

© The McGraw-Hill Companies, Inc., 2010E8.9,10

Ex. 8.9 a. Inventory at time of theft is $915,000, computed as follows:Beginning inventory, 1 January ………………… Net purchases, 1–29 January………………………

Cost of goods available for sale…………… Deduct: Estimated cost of goods sold:

Net sales…………………………………………………… $ 700,000 Cost percentage (100% - 45%)……………………… 55% Estimated cost of goods sold…………………… Estimated ending inventory (at cost):……

b.

Ex. 8.10 a.

Estimated ending inventory (at cost): Cost of goods available for sale during July ……………………… Less: Estimated cost of goods sold (above) …………………………… Estimated ending inventory …………………………………………

b.

Cha must use the periodic inventory method. Had the perpetual method been used, Cha would have had the actual inventory figure at 29 January, making it unnecessary to compute an estimated figure using the gross profit method.

Cost ratio during July ($522,000 ¸ $900,000) …………………………………

Estimated cost of goods sold ($600,000 ´ 58%) ………………………………

It appears that the cost of Phillips’ inventory as a percentage of retail sales in July is lower than it was in June. At 30 June, the percentage was 60% ($300,000 ¸ $500,000). During July, however, the percentage was only 55.5%, based upon Phillips' purchases ($222,000 ¸ $400,000).

© The McGraw-Hill Companies, Inc., 2010E8.9,10

$ 500,000 800,000 $ 1,300,000

385,000 $ 915,000

58%

$348,000

$522,000 348,000

$174,000

Cha must use the periodic inventory method. Had the perpetual method been used, inventory figure at 29 January, making it

unnecessary to compute an estimated figure using the gross profit method.

It appears that the cost of Phillips’ inventory as a percentage of retail sales in July is lower than it was in June. At 30 June, the percentage was 60% ($300,000 ¸ $500,000). During July, however, the percentage was only 55.5%, based upon

© The McGraw-Hill Companies, Inc., 2010E8.11

Ex. 8.11 a. Inventory turnover rate (dollar amounts in millions):

Cost of Goods Sold $99,119.1 = $99,119.1 =Average Inventory ($2,059.6 + $2,328.9) ÷ 2 $2,194.3

b. Number of days required to sell the average amount of inventory:Days in Year 365 = 8.1 days

Inventory Turnover Rate 45.2

c. Operating cycle: Days Required to Sell Days Required to Collect

Amount of Avg. Inventory Amount of Avg. Receivable 8.1 days 47 days =

d.

=

=

+

You would like to have two types of information: 1. The historical pattern for Li & Fung. Is the operating cycle in this year longer, shorter, or the same as recent years? 2. The operating cycle of Li & Fung's competitors. Is Li & Fung's operating cycle longer, shorter or about the same as competing companies?

© The McGraw-Hill Companies, Inc., 2010E8.11

Inventory turnover rate (dollar amounts in millions):

45.2 times

Number of days required to sell the average amount of inventory:

55.1 days

You would like to have two types of information: 1. The historical pattern for Li & Fung. Is the operating cycle in this year longer, shorter, or the same as recent years? 2. The operating cycle of Li & Fung's competitors. Is Li & Fung's operating cycle longer,

© The McGraw-Hill Companies, Inc., 2010E8.12

* Ex. 8.12 a. Inventory turnover:

Year ended 28 March 2009:

Year ended 28 March 2008:

Cost of goods sold (£5,535.2 million)/Inventory [(£488.9 million - £416.3 million)/2] =12.23

b. Average number of days required to sell inventory:

Year ended 28 March 2009:

365 days / 11.1 = 32.88

Year ended 28 March 2008:

365 days / 12.23 = 29.84

c.

Cost of goods sold (£5,690 million)/Inventory [(£536 million - £488.9 million )/2] = 11.1

The company was less efficient in managing its inventory in the year ended 28 March 2009. The inventory turnover in 2009 was 11.1, compared to 12.23 in the previous year. This resulted in an average number of days required to sell inventory being approximately two days more in the current year (32.88) compared to the most recent prior year (29.84). The longer the time required to sell inventory, the less efficient the company is.

* Supplemental Topic, "LIFO Reserves."

© The McGraw-Hill Companies, Inc., 2010E8.12

Cost of goods sold (£5,535.2 million)/Inventory [(£488.9 million - £416.3 million)/2] =12.23

Average number of days required to sell inventory:

Year ended 28 March 2008:

5,690 million)/Inventory [(£536 million - £488.9 million )/2] = 11.1

The company was less efficient in managing its inventory in the year ended 28 March 2009. The inventory turnover in 2009 was 11.1, compared to 12.23 in the previous year. This resulted in an average number of days required to sell inventory being approximately two days more in the current year (32.88) compared to the most recent prior year (29.84). The longer the time required to sell inventory, the less efficient the

© The McGraw-Hill Companies, Inc., 2010E8.13

Ex. 8.13 a. (1) Cost of sales year ended 31 Dec 2009 € 5,669,000,000 Inventories 31 Dec 2008 1,995,000,000 Inventories 31 Dec 2009 1,471,000,000

€ 3,466,000,000 ÷ 2

(2) Average inventories year ended 31 Dec 2008 € 1,733,000,000(3) Inventory turnover (1) ÷ (2) 3.27 times

b. (1) Days in a year 365 days

111.58 days

c. Average days goods are in inventory (see b) 111.58 daysAverage days receivables remain outstanding 53.68 days Days in operating cycle 165.26 days

* The average days a receivable remains outstanding is computed as follows:

(1) Net sales year ended 31 Dec 2009 € 10,381,000,000 Accounts receivable 31 Dec 2008 1,624,000,000 Accounts receivable 31 Dec 2009 1,429,000,000

€ 3,053,000,000 ÷ 2

(2) Average receivable year ended 31 Dec 2008 € 1,526,500,000 Receivables turnover rate (1) ÷ (2) 6.8 times

Average days outstanding 365 ÷ 6.8 53.68 days

Average days in inventory (365 ÷ 3.27)

Given an operating cycle of approximately 165 days, inventory accounts for almost 68% of the company's total operating cycle. Accounts receivable days account for only about 32% of the total time in the operating cycle. Thus, the accounts receivable turnover influences the company's operating cycle much less than does its inventory turnover.

© The McGraw-Hill Companies, Inc., 2010E8.13

*

* The average days a receivable remains outstanding is computed as follows:

Given an operating cycle of approximately 165 days, inventory accounts for almost 68% of the company's total operating cycle. Accounts receivable days account for only about 32% of the total time in the operating cycle. Thus, the accounts receivable turnover influences the company's

© The McGraw-Hill Companies, Inc., 2010P8.1A

SOLUTIONS TO PROBLEM SET A35 Minutes, Medium PROBLEM 8.1A

BASSTRACK a.

General Journal

2010 (1) Specific cost identification method:

15 Jan Cost of Goods Sold 305,000 Inventory 305,000

To record cost of 1,000 Ace-5 reels sold to Angler's Warehouse: 500 units @ $290; 500 units @$320.

(2) Weighted average cost method:

15 Jan Cost of Goods Sold 308,000 Inventory 308,000 To record cost of 1,000 Ace-5 reels sold to Angler's

units @$308 ($462,000 total cost, divided by 1,500 units).

(3) First-in, First-out (FIFO) method:

15 Jan Cost of Goods Sold 302,000 Inventory 302,000 To record cost of 1,000 Ace-5 reels sold to Angler's

Warehouse. Cost determined by the FIFO flow assumption: 600 units @$290, plus 400 units @ $320 = $302,000.

Exercises

Warehouse by the weighted average cost method: 1,000

© The McGraw-Hill Companies, Inc., 2010P8.1A (p.2)

b. Inventory subsidiary ledger records: PROBLEM 8.1A(1) Specific cost identification method: BASSTRACK (continued) PURCHASED SOLD BALANCE

Unit Unit Cost of Unit Date Units Cost Total Units Cost Goods Sold Units Cost Balance

12 Dec 09 600 $ 290 $ 174,000 600 $ 290 $ 174,000 09 Jan 10 900 320 $ 288,000 600 290

900 320 462,000 15 Jan 10 500 $ 290 100 290

500 320 $ 305,000 400 320 157,000 (2) Weighted average cost method: PURCHASED SOLD BALANCE

Unit Unit Cost of Unit Date Units Cost Total Units Cost Goods Sold Units Cost Balance 12 Dec 09 600 $ 290 $ 174,000 600 $ 290 $ 174,000 09 Jan 10 900 320 288,000 1,500 308 462,000

15-Jan-10 1,000 $ 308 $ 308,000 500 308 154,000 * $462,000 total cost ÷ 1,500 units = $308 weighted average unit cost.

(3) First-in, first-out (FIFO) method: PURCHASED SOLD BALANCE

Unit Unit Cost of Unit Date Units Cost Total Units Cost Goods Sold Units Cost Balance 12 Dec 10 600 $ 290 $ 174,000 600 $ 290 $ 174,000 09 Jan 10 900 320 288,000 600 290

900 320 462,000 15 Jan 10 600 $ 290

400 320 $ 302,000 500 320 160,000

© The McGraw-Hill Companies, Inc., 2010P8.1A (p.3)

PROBLEM 8.1ABASSTRACK (concluded)

c. No. As shown in part a, the weighted average cost method resulted in the highest cost of

goods sold figure, whereas the FIFO method resulted in the lowest. If the weighted average cost method is used for tax purposes, income tax regulations require that it also be used for financial reporting purposes.

© The McGraw-Hill Companies, Inc., 2010P8.2A

30 Minutes, Strong PROBLEM 8.2ASPEED WORLD CYCLES: PERPETUAL SYSTEM

a. Cost of goods sold and ending inventory

(1) Weighted average cost method: (a) Cost of goods sold on 28 July:

$ 49,800 Cost of goods sold (4 units @ $49,800) (b) Ending inventory (4 units) at 30 September: Average unit cost following August 3 purchase: 1 unit at 22 July weighted average cost of $49,800 $ 49,800 3 units purchased on 3 August 153,000 Total $ 202,800

$ 50,700 Ending inventory, 30 September (4 units @ $50,700)

(2) First-in, first-out (FIFO) method: (a) Cost of goods sold on 28 July: 2 units from 1 July purchase @ $49,500 2 units from 22 July purchase @ $50,000 Cost of goods sold (4 units)

(b) Ending inventory (4 units) at 30 September: 1 unit from 22 July purchase @$50,000 $ 50,000 3 units from 3 August purchase @ $51,000 153,000 Ending inventory, 30 September

Weighted average cost (as of 22 July; $249,000 ÷ 5 units)

Weighted average unit cost as of 3 August ($202,800 ÷ 4 units)

© The McGraw-Hill Companies, Inc., 2010P8.2A

PROBLEM 8.2ASPEED WORLD CYCLES: PERPETUAL SYSTEM

a. Cost of goods sold and ending inventory

$ 199,200

$ 202,800

$ 99,000 100,000 $ 199,000

$ 203,000

© The McGraw-Hill Companies, Inc., 2010P8.2A(p.2)

Problem 8.2ASPEED WORLD CYCLES: PERPETUAL SYSTEM (concluded)

b. (1)

(2)

(3)

The FIFO method will result in the highest profit, as it assigns the oldest (lowest) costs to the cost of goods sold. FIFO will result in the highest profit whenever the oldest purchase costs are also the lowest—that is, in the common situation of rising prices.

In this situation, the weighted average cost method will minimize profits taxes, as it assigns higher costs to the cost of goods sold. The higher cost of goods sold, in turn, reduces taxable profit. The weighted average cost method will minimize taxes whenever the more recent purchase costs are higher, which, as mentioned above, is the normal situation in an inflationary environment.

No. Speed World may not use FIFO in its financial statements and weighted average cost in its profits tax returns. Normally a company is not allowed to use different accounting methods in its financial statements and profits tax returns.

© The McGraw-Hill Companies, Inc., 2010P8.3A

20 Minutes, Medium PROBLEM 8.3ASPEED WORLD CYCLES: PERIODIC SYSTEM

a. Cost of goods sold and ending inventory

(1) Weighted average cost method: Ending inventory at 30 September:

$ 50,250 Ending inventory (4 units @ $50,250) $ 201,000 Cost of goods sold through 30 September: Cost of goods available for sale $ 402,000 Less: Ending inventory at 30 September(above) 201,000 Cost of goods sold $ 201,000 (2) First-in, first-out (FIFO) method: Ending inventory (4 units) at 30 September: 3 units from purchase on 3 August (@$51,000) $ 153,000 1 unit from purchase on 22 July (@$50,000) 50,000

$ 203,000

Cost of goods sold through 30 September: Cost of goods available for sale $ 402,000 Less: Ending inventory at 30 September (above) 203,000 Cost of goods sold $ 199,000

b.

Weighted average cost ($402,000 ÷ 8 units)

No. If the company selects the FIFO method for income tax reporting, it is required to choose the same method for financial reporting purposes.

© The McGraw-Hill Companies, Inc., 2010P8.4A

20 Minutes, Medium PROBLEM 8.4AMARIO'S NURSERY

a. Shrinkage loss - 40 trees

Weighted average cost method: Cost of Goods Sold 12,080 Inventory 12,080 To record shrinkage loss of 40 trees using weighted average

b. Shrinkage loss and LCNRV adjustment

(1) Shrinkage loss, first-in, first-out (FIFO) method:

Cost of Goods Sold 10,000 Inventory 10,000 To record shrinkage loss of 40 trees using the FIFO flow assumption (40 trees @ $250).

(2) Write-down of inventory to LCNRV:

Cost of Goods Sold 33,700 Inventory 33,700 To write down inventory to a NRV below cost: Cost (after shrinkage loss: $105,700 - $10,000) $ 95,700 NRV (310 trees x $200 per tree) 62,000 Loss from write-down to NRV $ 33,700

c.

cost of $302 ($105,700 ÷ 350 trees = $302 per tree).

The only unethical act in this situation was committed by the employee against his employer. There is nothing unethical about using a hidden security camera to protect one’s assets. The camera was not used to entice (or entrap) the employee. In short, he made a conscious decision to steal trees from his employer and should be held completely responsible for doing so.

© The McGraw-Hill Companies, Inc., 2010P8.5A

25 Minutes, Easy PROBLEM 8.5ATOKYO AUDIO

Units Unit Costa. Inventory and cost of goods sold:

(1) FIFO: Inventory: Fourth purchase (18 Dec.) 19 $ 3,200 Third purchase (4 Oct.) 2 3,150 Ending inventory, FIFO 21 Cost of goods sold: Cost of goods available for sale Less: Ending inventory, FIFO Cost of goods sold, FIFO

(2) Weighted average cost: Inventory:

Total goods available for sale 72 Weighted average unit cost

($223,400 ÷ 72 units) $ 3,102.80 Ending inventory, weighted average of $3102.8 per unit 21 3,102.80 Cost of goods sold, weighted

average of $3102.8 per unit 51 3,102.80

b.

The FIFO method, by assigning the costs of the most recent purchases to inventory, provides the most realistic year-end amount for inventory in terms of NRV. A weakness in the FIFO method, however, is that the costs assigned to the cost of goods sold are relatively old costs. Because the costs of the units has been rising throughout the year, the FIFO method tends to understate the cost of goods sold in terms of the costs actually being incurred by Tokyo to replenish its inventory. The inventory method using weighted average cost assigns the more recent costs to the cost of goods sold and therefore provides a more realistic measure of profit, in terms of NRV, than does the FIFO method.

© The McGraw-Hill Companies, Inc., 2010P8.5A

PROBLEM 8.5ATOKYO AUDIO

Total Cost $ 60,800 6,300 $ 67,100 $ 223,400 67,100 $ 156,300

$ 223,400

$ 65,158

$ 158,242

The FIFO method, by assigning the costs of the most recent purchases to inventory, provides the most realistic year-end amount for inventory in terms of NRV. A weakness in the FIFO method, however, is that the costs assigned to the cost of goods sold are relatively old costs. Because the costs of the units has been rising throughout the year, the FIFO method tends to understate the cost of goods sold in terms of the costs actually being incurred by Tokyo to replenish its inventory. The inventory method using weighted average cost assigns the more recent costs to the cost of goods sold and therefore provides a more realistic measure of profit, in terms of NRV,

© The McGraw-Hill Companies, Inc., 2010P8.6A

20 Minutes, Medium PROBLEM 8.6AHEXAGON HEALTH FOODS

a. 2010 2009Net sales $ 8,750,000 $ 8,400,000 Cost of goods sold 5,630,000 5,272,000 Gross profit on sales $ 3,120,000 $ 3,128,000 Gross profit percentage 35.66% 37.24% Cost of Goods Sold: 2008: $4,800,000 - $400,000 = $4,400,000 2009: 2010:

b.

$4,872,000 + $400,000 = $5,272,000 $4,812,500 + $817,500 = $5,630,000

The current owners of this business have no reason to be enthusiastic over the trend of gross profit or gross profit rate. After correction of the inventory errors, it is apparent that both the dollar amount of gross profit and the gross profit rate have declined, rather than increased, during the last three years.

© The McGraw-Hill Companies, Inc., 2010P8.6A

PROBLEM 8.6AHEXAGON HEALTH FOODS

2008 $ 8,200,000 $ 4,400,000 $ 3,800,000

46.34%

The current owners of this business have no reason to be enthusiastic over the trend of gross profit or gross profit rate. After correction of the inventory errors, it is apparent that both the dollar amount of gross profit and the gross profit rate have declined, rather than increased,

© The McGraw-Hill Companies, Inc., 2010P8.7A

25 Minutes, Medium PROBLEM 8.7ABETWEEN THE EARS

a.

(1) Estimated cost of goods sold: Cost ratio for the current year: Cost of goods available for sale $ 4,620,000 Retail prices of goods available for sale 8,400,000 55% Estimated cost of goods sold (net sales, $7,440,000 x cost ratio, 55%) $ 4,092,000 (2) Estimated ending inventory: Cost of goods available for sale (given) $ 4,620,000 Less: Estimated cost of goods sold (above) 4,092,000 Estimated ending inventory $ 528,000

b. (1) Restating physical inventory from retail prices to cost: Physical inventory stated in retail prices $ 844,800 55% Ending inventory at cost ($844,800 x 55%) $ 464,640 (2) Estimated shrinkage losses at cost: Estimated ending inventory per part a $ 528,000 Physical count of ending inventory, restated

464,640 Estimated shrinkage loss, stated at cost $ 63,360 (3) Computation of gross profit: Net sales $ 7,440,000 Cost of goods sold: Cost of goods available for sale $ 4,620,000 Less: Ending inventory per physical count, at cost 464,640 4,155,360

Gross profit $ 3,284,640

c.

Cost ratio ($4,620,000 ÷ $8,400,000)

Exercises

Cost ratio (per part a, above)

at cost (per part b)

Tapes and CDs can easily fit into someone’s pocket and “walk out of the warehouse.” Thus, it is important that effective controls be in place to reduce inventory shrinkage. Four common controls include: (1) security cameras, (2) security personnel, (3) shelves for safeguarding employee handbags while they work, and (4) magnetic sensor strips to sound an alarm if someone leaves the warehouse in possession of a tape or CD. The sensor strips would be deactivated when units of inventory are packed for shipment to customers.

© The McGraw-Hill Companies, Inc., 2010P8.8A

20 Minutes, Strong PROBLEM 8.8AMarks & Spencer

a. Computations based on retail method valuation of inventory:

(in millions) (1) Inventory turnover rate: Cost of Goods Sold = £5,690.00 11.10 times Average inventory £512.50 (2) Current ratio: Current Assets = £1,389.80 0.60 : 1 Current Liabilities £2,306.90 (3) Gross profit rate: Gross Profit = £3,371.90 37.21% Net Sales £9,062.10

b. Average inventory at cost (in millions) * £512.50Cost ratio 63.00%Estimated ending inventory at retail prices (in millions) £813.49

*Assume average inventory is very close to the ending inventory

© The McGraw-Hill Companies, Inc., 2010P8.8A(p.2)

PROBLEM 8.8AMarks & Spencer (concluded)

c. The average days required to collect outstanding receivables is computed by dividing 365 days by a company's trade receivable turnover rate. The turnover rate is computed by dividing net sales by average trade receivable. Thus, the lower a company's average trade receivable, the higher its trade receivable turnover rate will be, and the lower its average collection time will be.

Marks & Spencer turns over its trade receivable at a rate of 107.35 times per year (365 days ¸ 122 times = 3.4 days average collection time). In short, the company's impressive collection performance results from its trade receivable being very low relative to its total sales. This makes sense, given that most of Marks & Spencer's revenue is in the form of cash sales or credit card sales which are quickly turned into cash.

© The McGraw-Hill Companies, Inc., 2010P8.1B

SOLUTIONS TO PROBLEMS SET B35 Minutes, Medium PROBLEM 8.1B

DOME, LIMITED a.

General Journal

2010 (1) Specific cost identification method:

22 Jan Cost of Goods Sold 148,000 Inventory 148,000

To record cost of 700 cartridges sold to Maxine Supplies: 300 units @ $200; 400 units @ $220.

(2) Weighted average cost method:

22 Jan Cost of Goods Sold 150,500 Inventory 150,500 To record cost of 700 cartridges sold to Maxine

Supplies by theweighted average cost method: 700 units @$215 ($344,000 total cost, divided by 1,600 units).

(3) First-in, First-out (FIFO) method:

22 Jan Cost of Goods Sold 146,000 Inventory 146,000 To record cost of 700 cartridges sold to Maxine

Supplies by the FIFO flow assumption: 400 units @$200, plus 300 units @ $220.

Exercises

© The McGraw-Hill Companies, Inc., 2010P8.1B (p.2)

b. Inventory subsidiary ledger records: PROBLEM 8.1B(1) Specific cost identification method: DOME, INC. (continued) PURCHASED SOLD BALANCE

Unit Unit Cost of Unit Date Units Cost Total Units Cost Goods Sold Units Cost Balance

12 Dec 09 400 $ 200 $ 80,000 400 $ 200 $ 80,000 16 Jan 10 1,200 220 264,000 400 200

1,200 220 344,000 22 Jan10 300 $ 200 100 200

400 220 $ 148,000 800 220 196,000

(2) Weighted average cost method: PURCHASED SOLD BALANCE

Unit Unit Cost of Unit Date Units Cost Total Units Cost Goods Sold Units Cost Balance 12 Dec 09 400 $ 200 $ 80,000 400 $ 200 $ 80,000 16 Jan 10 1,200 220 264,000 1,600 $ 215 344,000

22-Jan-10 700 $ 215 $ 150,500 900 $ 215 193,500 * $344,000 total cost ÷ 1,600 units = $215 weighted average unit cost.

(3) First-in, first-out (FIFO) method: PURCHASED SOLD BALANCE

Unit Unit Cost of Unit Date Units Cost Total Units Cost Goods Sold Units Cost Balance 12 Dec 09 400 $ 200 $ 80,000 400 $ 200 $ 80,000 16 Jan 10 1,200 220 264,000 400 200

1,200 220 344,000 22 Jan10 400 $ 200

300 220 $ 146,000 900 220 198,000

© The McGraw-Hill Companies, Inc., 2010P8.1B (p.3)

PROBLEM 8.1BDOME, INC. (concluded)

c. No. As shown in part a, the weighted average cost method resulted in the highest cost of

goods sold figure, whereas the FIFO method resulted in the lowest. If the FIFO method is used for tax purposes, income tax regulations require that it also be used for financial reporting purposes.

© The McGraw-Hill Companies, Inc., 2010P8.2B

30 Minutes, Strong PROBLEM 8.2BSEA TRAVEL: PERPETUAL SYSTEM

a. Cost of goods sold and ending inventory

(1) Weighted average cost method: (a) Cost of goods sold on 28 April:

$ 81,111 Cost of goods sold (5 units @ $81,111) (b) Ending inventory (7 units) at 30 June: Weighted average unit cost following 19 April purchase: 4 units at 19 April weighted average cost of $81,111 $ 324,445 3 units purchased on 8 May at $85,000 each 255,000 Total $ 579,445

$ 82,778 Ending inventory, 30 June (7 units @ $82,778)

(2) First-in, first-out (FIFO) method: (a) Cost of goods sold on 28 April: 4 units from 1 April purchase @ $80,000 1 unit from 19 April purchase @ $82,000 Cost of goods sold (5 units)

(b) Ending inventory (7 units) at 30 June: 4 units from 19 April purchase @ $82,000 $ 328,000 3 units from 8 May purchase @ $85,000 255,000 Ending inventory, 30 June

Weighted average cost (as of 28 April; $730,000 ÷ 9 units)

Weighted average unit cost as of 8 May ($579,445 ÷ 7 units)

© The McGraw-Hill Companies, Inc., 2010P8.2B

PROBLEM 8.2BSEA TRAVEL: PERPETUAL SYSTEM

a. Cost of goods sold and ending inventory

$ 405,555

$ 579,445

$ 320,000 82,000 $ 402,000

$ 583,000

© The McGraw-Hill Companies, Inc., 2010P8.2B(p.2)

Problem 8.2BSEA TRAVEL: PERPETUAL SYSTEM

(concluded)b. (1)

(2)

(3)

The weighted average cost method will result in the lowest profit, as it assigns higher costs to the cost of goods sold. Weighted average cost will result in the lowest profit whenever the most recent purchase costs are also the highest—that is, in the common situation of rising prices.

In this situation, the FIFO method will maximize profits taxes, as it assigns the oldest (and lowest) costs to the cost of goods sold. The low cost of goods sold, in turn, increases taxable profit. The FIFO method will increase taxes whenever the oldest purchase costs are the lowest, which as mentioned above is the normal situation in an inflationary environment.

No, Sea Travel may not use weighted average cost in its financial statements and FIFO in its profits tax returns. Normally a company is not allowed to use different accounting methods in its financial statements and profits tax returns.

© The McGraw-Hill Companies, Inc., 2010P8.3B

20 Minutes, Medium PROBLEM 8.3BSEA TRAVEL: PERIODIC SYSTEM

a. Cost of goods sold and ending inventory

(1) Weighted average cost method: Ending inventory at 30 June:

$ 82,083.30 Ending inventory (7 units @ $82,083.3) $ 574,583 Cost of goods sold through 30 June: Cost of goods available for sale $ 985,000 Less: Ending inventory at 30 June (above) 574,583 Cost of goods sold $ 410,417 (2) First-in, first-out (FIFO) method: Ending inventory at 30 June: 3 units from purchase on 8 May (@ $8,500) $ 255,000 4 units from purchase on 19 April (@$8,200) 328,000

$ 583,000

Cost of goods sold through 30 June: Cost of goods available for sale $ 985,000 Less: Ending inventory at 30 June (above) 583,000 Cost of goods sold $ 402,000

b.

Weighted average cost ($985,000 ÷ 12 units)

No. If the company selects the weighted average cost method for profits tax reporting, it is required to choose the same method for financial reporting purposes.

© The McGraw-Hill Companies, Inc., 2010P8.4B

20 Minutes, Medium PROBLEM 8.4BSAM'S LAWN MOWERS

a. Shrinkage loss-one lawn mower

Weighted average cost method: Cost of Goods Sold 1,070 Inventory To record shrinkage loss of one lawn mower using weighted

b. Shrinkage loss and LCNRV adjustment

(1) Shrinkage loss, first-in, first-out (FIFO) method:

Cost of Goods Sold 1,000 Inventory To record shrinkage loss of one lawn mower using the FIFO flow assumption (one mower @ $1,000).

(2) Write-down of inventory to the lower-of-cost-and-NRV:

Cost of Goods Sold 33,900 Inventory To write down inventory to a NRV below cost: Cost (after shrinkage loss: $214,000 - $1,000) $ 213,000 Market (199 mowers @ $900 per lawn mower) 179,100 Loss from write-down to NRV $ 33,900

c.

average cost of $1,070 ($214,000 ÷ 200 mowers = $1,070 per mower).

The only unethical act in this situation was committed by the employee against his employer. There is nothing unethical about using a hidden security camera to protect one’s assets. The camera was not used to entice (or entrap) the employee. In short, he made a conscious decision to steal lawn mowers from his employer and should be held completely responsible for doing so.

© The McGraw-Hill Companies, Inc., 2010P8.4B

PROBLEM 8.4BSAM'S LAWN MOWERS

1,070

1,000

33,900

The only unethical act in this situation was committed by the employee against his employer. There is nothing unethical about using a hidden security camera to protect one’s assets. The

(or entrap) the employee. In short, he made a conscious decision to steal lawn mowers from his employer and should be held completely responsible for doing so.

© The McGraw-Hill Companies, Inc., 2010P8.5B

25 Minutes, Easy PROBLEM 8.5BROMAN SOUND

Units Unit Costa. Inventory and cost of goods sold:

(1) FIFO: Inventory: Fourth purchase 15 $ 1,100 Third purchase 5 1,060 Ending inventory, FIFO 20

Cost of goods sold: Cost of goods available for sale Less: Ending inventory, FIFO Cost of goods sold, FIFO

(2) Weighted average cost: Inventory:

Total goods available for sale 100 Weighted average unit cost

($103,700 ÷ 100 units) $ 1,037 Ending inventory, weighted average of $1037 per unit 20 $ 1,037 Cost of goods sold, weighted average cost $1037 per unit 80 $ 1,037

b.

The FIFO method, by assigning the costs of the most recent purchases to inventory, provides the most realistic year end amount for inventory in terms of NRV. A weakness of the FIFO method, however, is that the costs assigned to the cost of goods sold are relatively old costs. Because the costs of the units has been rising throughout the year, the FIFO method tends to understate the cost of goods sold in terms of the costs actually being incurred by Roman Sound to replenish its inventory. The inventory method using weighted average cost assigns the more recent costs to the cost of goods sold and therefore provides a more realistic measure of profit, in terms of NRV, than does the FIFO method.

© The McGraw-Hill Companies, Inc., 2010P8.5B

PROBLEM 8.5BROMAN SOUND

Total Cost $ 16,500 5,300 $ 21,800

$ 103,700 21,800 $ 81,900

$ 103,700

$ 20,740

$ 82,960

The FIFO method, by assigning the costs of the most recent purchases to inventory, provides the most realistic year end amount for inventory in terms of NRV. A weakness of the FIFO method, however, is that the costs assigned to the cost of goods sold are relatively old costs. Because the costs of the units has been rising throughout the year, the FIFO method tends to understate the cost of goods sold in terms of the costs actually being incurred by Roman Sound to replenish its inventory. The inventory method using weighted average cost assigns the more recent costs to the cost of goods sold and therefore provides a more realistic measure of profit,

© The McGraw-Hill Companies, Inc., 2010P8.6B

20 Minutes, Medium PROBLEM 8.6BCITY SOFTWARE

a. 2010 2009 2008Net sales $ 10,000,000 $ 9,200,000 $ 8,400,000 Cost of goods sold 6,800,000 5,904,000 $ 5,260,000 Gross profit on sales $ 3,200,000 $ 3,296,000 $ 3,140,000 Gross profit percentage 32% 35.83% 37.38% Cost of Goods Sold: 2008: $5,460,000 - $200,000 = $5,260,000 2009: 2010:

b.

$5,704,000 + $200,000 = $5,904,000 $6,000,000 + $800,000 = $6,800,000

The current owners of this business have no reason to be enthusiastic over the trend of gross profit or gross profit rate. After correction of the inventory errors, it is apparent that both the dollar amount of gross profit and the gross profit rate have declined, rather than increased, during the last three years.

© The McGraw-Hill Companies, Inc., 2010P8.7B

25 Minutes, Medium PROBLEM 8.7BSING ALONG

a.

(1) Estimated cost of goods sold: Cost ratio for the current year: Cost of goods available for sale $ 3,300,000 Retail prices of goods available for sale 6,000,000 55% Estimated cost of goods sold (net sales, $5,200,000 x cost ratio, 55%) $ 2,860,000 (2) Estimated ending inventory: Cost of goods available for sale (given) $ 3,300,000 Less: Estimated cost of goods sold (above) 2,860,000 Estimated ending inventory $ 440,000

b. (1) Restating physical inventory from retail prices to cost: Physical inventory stated in retail prices $ 750,000 55% Ending inventory at cost ($750,000 x 55%) $ 412,500 (2) Estimated shrinkage losses at cost: Estimated ending inventory (per part a) $ 440,000 Physical count of ending inventory, restated

412,500 Estimated shrinkage loss, stated at cost $ 27,500 (3) Computation of gross profit: Net sales $ 5,200,000 Cost of goods sold: Cost of goods available for sale $ 3,300,000 Less: Ending inventory per physical count, at cost 412,500 2,887,500

Gross profit $ 2,312,500

c.

Cost ratio ($3,300,000 ÷ $6,000,000)

Exercises

Cost ratio (per part a, above)

at cost (per part b)

Tapes and CDs can easily fit into someone’s pocket and “walk out of the store.” Thus, it is important that effective controls be in place to reduce inventory shrinkage. Four common controls include: (1) security cameras, (2) security personnel, (3) shelves for safeguarding employee handbags while they work, and (4) magnetic sensor strips to sound an alarm if someone leaves the store in possession of a tape or CD. The sensor strips would be deactivated when units of inventory are sold to customers.

© The McGraw-Hill Companies, Inc., 2010P8.8B

20 Minutes, Strong PROBLEM 8.8BWing On

a. Computations based on weighted average cost valuation of inventory:

(1) Inventory turnover rate: Cost of Goods Sold = $ 599,112 Average inventory $ 79,724 (2) Current ratio: Current Assets = $ 1,550,211 Current Liabilities $ 341,360 (3) Gross profit rate: Gross Profit = $ 501,747 Net Sales $ 1,100,859

b.

c. You would expect the ratios to be different under FIFO as follows: Inventory turnover rate: Cost of goods sold lower, inventory higher, turnover lower Current ratio: Inventory would be higher, current ratio higher Gross profit rate: Gross profit higher (due to lower cost of goods sold).

Gross profit rate higher.

The company must have encountered increasing replacement costs for its inventory during the year.

© The McGraw-Hill Companies, Inc., 2010P8.8B

PROBLEM 8.8BWing On

7.51 times

4.54 : 1

45.6%

Inventory turnover rate: Cost of goods sold lower, inventory higher, turnover lower

The company must have encountered increasing replacement costs for its inventory during

© The McGraw-Hill Companies, Inc., 2010P8.8B(p.2)

PROBLEM 8.8BWing On (concluded)

d. The average days required to collect outstanding receivables is computed by dividing 365 days by a company's trade receivable turnover rate. The turnover rate is computed by dividing net sales by average trade receivable. Thus, the lower a company's average trade receivable, the higher its trade receivable turnover rate will be, and the lower its average collection time will be.

Wing On turned over its trade receivables at a rate of every 0.5 days or 730 times per year (365 days/0.5). The company's impressive performance in this area results from its trade receivable being very low relative to its sales. This is explained by the fact that most of the company's sales are for cash or on bank credit cards which are quickly turned into cash for the retailer.

© The McGraw-Hill Companies, Inc., 2010Case 8.1

SOLUTIONS TO CASES

30 Minutes, Strong CASE 8.1OUR LITTLE SECRET

a.

b.

c.

Lee confronts three related ethical issues. The first is that Our Little Secret’s past tax practices have been both unethical and illegal. Lee cannot be involved in such practices or, if she is in a position of responsibility, allow them to continue.

Second, Lee has good reason to question the basic integrity of her prospective employer.Is Simon’s statement that “no one knows how this all got started, or who wasresponsible” really true? After all, Simon is suggesting that the fraud continue after Amycomes “on board.”

Third, there is the issue of confidentiality. Both CPAs and CMAs are ethically bound to treat as confidential all information obtained in the course of their professional activities. This means that the accountant should not disclose confidential information without the employer’s (or client’s) permission.

Technically, Our Little Secret is neither Lee’s employer nor client. Nonetheless, theseauthors would consider a job interview as part of an accountant’s “professionalactivities.” Thus, we believe that Lee should treat what she has learned about thecompany’s inventory “problem” as confidential information. Thus, she should not take itupon herself to notify the Inland Revenue Department or any other third party about thecompany’s actions.

The solution proposed by Simon is unacceptable. To knowingly understate inventory in a profits tax return would be unethical and illegal. Lee may not be a party to such action.

Lee basically has two ethical courses of action to consider. First, she may decide that she does not wish to associate herself with the company. Therefore, she simply may decline the job. If she chooses this course, she should treat Simon’s disclosures during this interview as confidential information.

A second course of action would be to accept the position contingent upon the company agreeing to take immediate steps to rectify the problem. This would include filing amended profits tax returns for any years known to be in error, and taking steps to ensure that inventory is reported properly in future returns. A consideration in making this decision should be whether this is an isolated instance or symptomatic of a recurring pattern of unethical behavior.

A third course of action would be to be certain that inventory was correctly stated in the next year’s tax return, but not amend any returns already filed. This would cause an overstatement of 2011 taxable profit which would offset the understatement of taxable profit in all past years. These authors can see the practical appeal of such a “simple solution,” but we cannot support it. Our Little Secret owes not only profits taxes on its understated taxable profit, but also interest and penalties for failing to report this profit in prior years. Saying nothing and allowing the error to “flow through” is, in essence, a scheme for evading these interest charges and penalties.

© The McGraw-Hill Companies, Inc., 2010Case 8.2

15 Minutes, Medium CASE 8.2 DEALING WITH THE BANK

ETHICS, FRAUD & CORPORATE GOVERNANCEa.

b.

c.

The inventory has been lost. It would be unethical to delay recognition of this loss in the hope that it may someday be reduced by an insurance settlement. At present, recovery from the insurance company appears too uncertain to be considered a receivable.

It is impossible for the company to increase its current ratio from 0.8 to 1 to 1.2 to 1 by purchasing more inventory on account. Purchasing inventory on account will increase the current ratio only when it is below 1 to 1. If the current ratio exceeds 1 to 1, the purchase of additional inventory on account would decrease the ratio.

The company should be open and honest in dealing with the bank. Most banks work hard to foster ongoing relationships with their clients and, therefore, are willing to be flexible in situations such as these.

© The McGraw-Hill Companies, Inc., 2010Case 8.3

No time limit, Strong CASE 8.3INVENTORY TURNOVER RATES

INTERNET

Turnover rates of those companies vary, depending on the year of the most recent annual reports used. The inventory turnover rate for Sa Sa often averages between 3.9 and 4.4 times per year, whereas that of Chow Sang Sang averages only between 2.8 and 3.6 times per year. The fact is, both companies manage their inventories well, given the industries in which they operate. Sa Sa's rate is higher because cosmetics products, on average, sell more quickly than jewellery products.