Accounting Systems, Internal Control

CHAPTER 7 INVENTORIES

DISCUSSION QUESTIONS

1. The receiving report should be reconciled to 6. LIFO. In periods of rising prices, the use of the initial purchase order and the vendor’s LIFO will result in the lowest net income and invoice before recording or paying for inven- thus the lowest income tax expense. tory purchases. This procedure will verify 7. Net realizable value (estimated selling price that the inventory received matches the type less any direct cost of disposition, such as and quantity of inventory ordered. It also sales commissions). verifies that the vendor’s invoice is charging the company for the actual quantity of inven- 8. a. Gross profit for the year was understat- tory received at the agreed-upon price. ed by $23,950. 2. A physical inventory should be taken period- b. Merchandise inventory and owner’s eq- ically to test the accuracy of the perpetual uity were understated by $23,950. records. In addition, a physical inventory will 9. Mistletoe Company. Since the merchandise identify inventory shortages or shrinkage. was shipped FOB shipping point, title 3. No, they are not techniques for determining passed to Mistletoe Company when it was physical quantities. The terms refer to cost shipped and should be reported in Mistletoe flow assumptions, which affect the determi- Company’s financial statements at October nation of the cost prices assigned to items in 31, the end of the fiscal year. the inventory. 10. Manufacturer’s; The manufacturer retains ti- 4. a. LIFO c. LIFO tle until the goods are sold. Thus, any un- sold merchandise at the end of the year is b. FIFO d. FIFO part of the manufacturer’s (consignor’s) in- 5. FIFO ventory, even though the merchandise is in the hands of the retailer (consignee).

PE 7–1A

Gross Profit Ending Inventory July July 31 a. First-in, first-out (FIFO) $65 ($225 – $160) $344 ($168 + $176) b. Last-in, first-out (LIFO) $49 ($225 – $176) $328 ($160 + $168) c. Average cost $57 ($225 – $168) $336 ($168 × 2)

PE 7–1B

Gross Profit Ending Inventory April April 30 a. First-in, first-out (FIFO) $19 ($29 – $10) $26 ($12 + $14) b. Last-in, first-out (LIFO) $15 ($29 – $14) $22 ($10 + $12) c. Average cost $17 ($29 – $12) $24 ($12 × 2)

PE 7–2A a. Cost of merchandise sold (August 28): 20 units @ $80 $1,600 5 units @ $85 425 25 $2,025 b. Inventory, August 31: $2,975 = 35 units × $85

PE 7–2B a. Cost of merchandise sold (March 24): 12 units @ $15 $ 180 63 units @ $18 1,134 75 $1,314 b. Inventory, March 31: $1,116 = 62 units × $18

202 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PE 7–3A a. Cost of merchandise sold (November 26): $5,040 = (84 units × $60) b. Inventory, November 30: 18 units @ $50 $ 900 16 units @ $60 960 34 $1,860

PE 7–3B a. Cost of merchandise sold (January 27): $1,440 = (80 units × $18) b. Inventory, January 31: 15 units @ $17 $ 255 45 units @ $18 810 60 $1,065

PE 7–4A a. First-in, first-out (FIFO) method: $594 = 11 units × $54 b. Last-in, first-out (LIFO) method: $495 = 11 units × $45 c. Average cost method: $550 (11 units × $50), where average cost = $50 = $2,250/45 units

PE 7–4B a. First-in, first-out (FIFO) method: $2,722 = (20 units × $119) + (3 units × $114) b. Last-in, first-out (LIFO) method: $2,682 = (10 units × $120) + (13 units × $114) c. Average cost method: $2,645 (23 units × $115), where average cost = $115 = $18,400/160 units

A B C D E F G 1 Unit Unit Total 2 Inventory Cost Market Lower 3 Commodity Quantity Price Price Cost Market of C or M 4 IA17 200 $40 $38 $ 8,000 $ 7,600 $ 7,600 5 TX24 150 55 60 8,250 9,000 8,250

6 Total $16,250 $15,850 $16,60 0

PE 7–5B

A B C D E F G 1 Unit Unit Total 2 Inventory Cost Market Lower 3 Commodity Quantity Price Price Cost Market of C or M 4 MT22 1,500 $ 7 $ 4 $10,500 $ 6,000 $ 6,000 5 WY09 900 22 25 19,800 22,500 19,800 6 Total $30,300 $28,500 $25,800

PE 7–6A

Amount of Misstatement Overstatement (Understatement) Balance Sheet: Merchandise inventory understated*...... $(7,525) Current assets understated...... (7,525) Total assets understated...... (7,525) Owner’s equity understated...... (7,525) Income Statement: Cost of merchandise sold overstated...... $ 7,525 Gross profit understated...... (7,525) Net income understated...... (7,525)

*$90,700 – $83,175 = $7,525

Amount of Misstatement Overstatement (Understatement) Balance Sheet: Merchandise inventory overstated*...... $35,000 Current assets overstated...... 35,000 Total assets overstated...... 35,000 Owner’s equity overstated...... 35,000 Income Statement: Cost of merchandise sold understated...... $(35,000) Gross profit overstated...... 35,000 Net income overstated...... 35,000 *($580,000 – $545,000 = $35,000)

PE 7–7A a. Inventory Turnover 2012 2011 Cost of merchandise sold... $882,000 $680,000 Inventories: Beginning of year...... $200,000 $140,000 End of year...... $290,000 $200,000 Average inventory...... $245,000 $170,000 [($200,000 + $290,000) ÷ 2] [($140,000 + $200,000) ÷ 2] Inventory turnover...... 3.6 4.0 ($882,000 ÷ $245,000) ($680,000 ÷ $170,000) b. Number of Days’ Sales in Inventory 2012 2011 Cost of merchandise sold... $882,000 $680,000 Average daily cost of merchandise sold...... $2,416.4 $1,863.0 ($882,000 ÷ 365 days) ($680,000 ÷ 365 days) Average inventory...... $245,000 $170,000 [($200,000 + $290,000) ÷ 2] [($140,000 + $200,000) ÷ 2] Number of days’ sales in inventory...... 101.4 days 91.3 days ($245,000 ÷ $2,416.4) ($170,000 ÷ $1,863.0)

205 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PE 7–7A (Concluded) c. The decrease in the inventory turnover from 4.0 to 3.6 and the increase in the number of days’ sales in inventory from 91.3 days to 101.4 days indicate unfa- vorable trends in managing inventory.

PE 7–7B a. Inventory Turnover 2012 2011 Cost of merchandise sold... $1,800,000 $1,428,000 Inventories: Beginning of year...... $570,000 $450,000 End of year...... $630,000 $570,000 Average inventory...... $600,000 $510,000 [($570,000 + $630,000) ÷ 2] [($450,000 + $570,000) ÷ 2] Inventory turnover...... 3.0 2.8 ($1,800,000 ÷ $600,000) ($1,428,000 ÷ $510,000) b. Number of Days’ Sales in Inventory 2012 2011 Cost of merchandise sold... $1,800,000 $1,428,000 Average daily cost of merchandise sold...... $4,931.5 $3,912.3 ($1,800,000 ÷ 365 days) ($1,428,000 ÷ 365 days) Average inventory...... $600,000 $510,000 [($570,000 + $630,000) ÷ 2] [($450,000 + $570,000) ÷ 2] Number of days’ sales in inventory...... 121.7 days 130.4 days ($600,000 ÷ $4,931.5) ($510,000 ÷ $3,912.3) c. The increase in the inventory turnover from 2.8 to 3.0 and the decrease in the number of days’ sales in inventory from 130.4 days to 121.7 days indicate fa- vorable trends in managing inventory.

Ex. 7–1

Switching to a perpetual inventory system will strengthen A4A Hardware’s internal controls over inventory, since the store managers will be able to keep track of how much of each item is on hand. This should minimize shortages of good- selling items and excess inventories of poor-selling items. On the other hand, switching to a perpetual inventory system will not eliminate the need to take a physical inventory count. A physical inventory must be taken to verify the accuracy of the inventory records in a perpetual inventory system. In addition, a physical inventory count is needed to detect shortages of inventory due to damage or theft.

Ex. 7–2 a. Appropriate. The inventory tags will protect the inventory from customer theft. b. Inappropriate. The control of using security measures to protect the inventory is violated if the stockroom is not locked. c. Inappropriate. Good controls include a receiving report, prepared after all inventory items received have been counted and inspected. Inventory purchased should only be recorded and paid for after reconciling the receiving report, the initial purchase order, and the vendor’s invoice.

Portable Video Players Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost June 1 75 40 3,000 6 60 40 2,400 15 40 600 14 90 42 3,780 15 40 600 90 42 3,780 19 15 40 600 55 42 2,310 35 42 1,470 25 20 42 840 35 42 1,470 30 80 45 3,600 35 42 1,470 80 45 3,600 30 Balances 5,310 5,070

b. Since the prices rose from $40 for the June 1 inventory to $45 for the purchase on June 30, we would expect that under last-in, first-out the inventory would be lower.

Note to Instructors: Exercise 7–4 shows that the inventory is $5,040 under LIFO.

Portable Video Players Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost June 1 75 40 3,000 6 60 40 2,400 15 40 600 14 90 42 3,780 15 40 600 90 42 3,780 19 50 42 2,100 15 40 600 40 42 1,680 25 20 42 840 15 40 600 20 42 840 30 80 45 3,600 15 40 600 20 42 840 80 45 3,600 30 Balances 5,340 5,040

Prepaid Cell Phones Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost July 1 800 45 36,000 10 500 50 25,000 800 45 36,000 500 50 25,000 12 500 50 25,000 600 45 27,000 200 45 9,000 14 300 45 13,500 300 45 13,500 20 450 52 23,400 300 45 13,500 450 52 23,400 31 250 52 13,000 300 45 13,500 200 52 10,400 31 Balances 60,500 23,900

b. Since the prices rose from $45 for the July 1 inventory to $52 for the purchase on July 20, we would expect that under first-in, first-out the inventory would be higher.

Note to Instructors: Exercise 7–6 shows that the inventory is $25,900 under FIFO.

210 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ex. 7–6 Prepaid Cell Phones Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost July 1 800 45 36,000 10 500 50 25,000 800 45 36,000 500 50 25,000 12 700 45 31,500 100 45 4,500 500 50 25,000 14 100 45 4,500 200 50 10,000 300 50 15,000 20 450 52 23,400 300 50 15,000 450 52 23,400 31 250 50 12,500 50 50 2,500 450 52 23,400 31 Balances 58,500 25,900

211 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ex. 7–7 a. $15,540 ($84 × 185 units) b. $15,100 [($80 × 60 units) + ($82 × 100 units) + ($84 × 25 units)] = $4,800 + $8,200 + $2,100

Ex. 7–8 a. $7,812 (12 units at $495 plus 4 units at $468) = $5,940 + $1,872 b. $6,138 (9 units at $360 plus 7 units at $414) = $3,240 + $2,898 c. $7,056 (16 units at $441; $26,460/60 units = $441) Cost of merchandise available for sale: 9 units at $360...... $ 3,240 18 units at $414...... 7,452 21 units at $468...... 9,828 12 units at $495...... 5,940 60 units (at average cost of $441)...... $26,460

Cost Merchandise Merchandise Inventory Method Inventory Sold a. FIFO...... $4,986 $ 9,639 b. LIFO...... 4,365 10,260 c. Average cost...... 4,680 9,945 Cost of merchandise available for sale: 21 units at $180...... $ 3,780 29 units at $195...... 5,655 10 units at $204...... 2,040 15 units at $210...... 3,150 75 units (at average cost of $195)...... $14,625 a. First-in, first-out: Merchandise inventory: 15 units at $210...... $3,150 9 units at $204...... 1,836 24 units...... $4,986 Merchandise sold: $14,625 – $4,986...... $9,639 b. Last-in, first-out: Merchandise inventory: 21 units at $180...... $3,780 3 units at $195...... 585 24 units...... $4,365 Merchandise sold: $14,625 – $4,365...... $10,260 c. Average cost: Merchandise inventory: 24 units at $195 ($14,625/75 units)...... $4,680 Merchandise sold: $14,625 – $4,680...... $9,945

213 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ex. 7–10 a. 1. FIFO inventory > (greater than) LIFO inventory 2. FIFO cost of goods sold < (less than) LIFO cost of goods sold 3. FIFO net income > (greater than) LIFO net income 4. FIFO income tax > (greater than) LIFO income tax b. In periods of rising prices, the income shown on the company’s tax return would be lower than if FIFO were used; thus, there is a tax advantage of using LIFO.

Note to Instructors: The federal tax laws require that if LIFO is used for tax purposes, LIFO must also be used for financial reporting purposes. This is known as the LIFO conformity rule. Thus, selecting LIFO for tax purposes means that the company’s reported income will also be lower than if FIFO had been used. Com- panies using LIFO believe the tax advantages from using LIFO outweigh any neg- ative impact of reporting a lower income to shareholders.

Ex. 7–11

A B C D E F G 1 Unit Unit Total 2 Inventory Cost Market Lower 3 Commodity Quantity Price Price Cost Market of C or M 4 AL65 40 $28 $30 $ 1,120 $ 1,200 $ 1,120 5 CA22 50 70 65 3,500 3,250 3,250 6 LA98 110 6 5 660 550 550 7 SC16 30 40 30 1,200 900 900 8 UT28 75 60 62 4,500 4,650 4,500 9 Total $10,980 $10,550 $10,320

Ex. 7–12

The merchandise inventory would appear in the Current Assets section, as follows: Merchandise inventory—at lower of cost (FIFO) or market...... $10,320 Alternatively, the details of the method of determining cost and the method of val- uation could be presented in a note.

214 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ex. 7–13 a. Balance Sheet Merchandise inventory...... $11,350* understated Current assets...... $11,350 understated Total assets...... $11,350 understated Owner’s equity...... $11,350 understated *$11,350 = $451,000 – $439,650 b. Income Statement Cost of merchandise sold...... $11,350 overstated Gross profit...... $11,350 understated Net income...... $11,350 understated c. Income Statement Cost of merchandise sold...... $11,350 understated Gross profit...... $11,350 overstated Net income...... $11,350 overstated d. The December 31, 2013, balance sheet would be correct, since the 2012 inventory error reverses itself in 2013.

Ex. 7–14 a. Balance Sheet Merchandise inventory...... $12,000* overstated Current assets...... $12,000 overstated Total assets...... $12,000 overstated Owner’s equity...... $12,000 overstated *$12,000 = $350,000 – $338,000 b. Income Statement Cost of merchandise sold...... $12,000 understated Gross profit...... $12,000 overstated Net income...... $12,000 overstated c. Income Statement Cost of merchandise sold...... $12,000 overstated Gross profit...... $12,000 understated Net income...... $12,000 understated d. The December 31, 2013, balance sheet would be correct, since the 2012 inventory error reverses itself in 2013.

When an error is discovered affecting the prior period, it should be corrected. In this case, the merchandise inventory account should be debited and the owner’s capital account credited for $18,000. Failure to correct the error for 2011 and purposely misstating the inventory and the cost of merchandise sold in 2012 would cause the income statements for the two years to not be comparable. The balance sheet at the end of 2012 would be correct, however, since the 2011 inventory error reverses itself in 2012.

Ex. 7–16 a. Apple: 48.5 {$23,397,000,000/[($455,000,000 + $509,000,000)/2]} American Greetings: 3.9 {$809,956,000/[($203,873,000 + $216,671,000)/2]} b. Lower. Although American Greetings’ business is seasonal in nature, with most of its revenue generated during the major holidays, much of its nonholi- day inventory may turn over very slowly. Apple, on the other hand, turns its inventory over very fast because it maintains a low inventory, which allows it to respond quickly to customer needs. Additionally, Apple’s computer prod- ucts can quickly become obsolete, so it cannot risk building large inventories.

Average Inventory a. Number of Days’ Sales in Inventory = Cost of Goods Sold/365

$4,859  $4,855/ 2 $4,857 Kroger,   30 days $58,564/365 160.4

$2,591  $2,798/ 2 $2,694.5 Safeway,   31 days $31,589/365 86.5

$665  $649/ 2 $657 Winn-Dixie,   46 days $5,269/365 14.4

Cost of Goods Sold Inventory Turnover = Average Inventory

$58,564 Kroger,  12.1 ($4,859  $4,855)/2

$31,589 Safeway,  11.7 ($2,591 $2,798)/2

$5,269 Winn-Dixie,  8.0 ($665  $649)/2 b. The number of days’ sales in inventory and inventory turnover ratios are rela- tively the same for Kroger and Safeway. Winn-Dixie has significantly higher number of days sales in inventory and significantly lower inventory turnover than Kroger and Safeway. These results suggest that Kroger and Safeway are more efficient than Winn-Dixie in managing inventory.

217 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ex. 7–17 (Concluded) c. If Winn-Dixie matched Kroger’s days’ sales in inventory, then its hypothetical ending inventory would be determined as follows, Average Inventory Number of Days’ Sales in Inventory = Cost of Goods Sold/365

X 30 days = $5,269/365

X = 30 × ($5,269/365) = 30 × $14.4 per day X = $432 Thus, the additional cash flow that would have been generated is the difference between the actual average inventory and the hypothetical average inventory, as follows: Actual average inventory...... $657 million Hypothetical average inventory...... 432 Positive cash flow potential...... $225 million That is, a lower average inventory amount would have required less cash than actually was required.

Appendix Ex. 7–18

$507,000 ($780,000 × 65%)

Appendix Ex. 7–19

$380,000 ($475,000 × 80%)

Appendix Ex. 7–20

$648,000 ($900,000 × 72%)

A B C 1 Cost Retail 2 Merchandise inventory, November 1 $ 300,000 $ 400,000 3 Purchases in November (net) 2,100,000 2,800,000 4 Merchandise available for sale $2,400,000 $3,200,000 $2,400,000 5 Ratio of cost to retail price:  75% $3,200,000 6 Sales for November (net) 2,750,000 7 Merchandise inventory, November 30, at retail price $ 450,000 Merchandise inventory, November 30, 8 $ 337,500 at estimated cost ($450,000 × 75%)

Appendix Ex. 7–22 a. A B C 1 Cost 2 Merchandise inventory, January 1 $ 500,000 3 Purchases (net), January 1–December 11 4,280,000 4 Merchandise available for sale $4,780,000 5 Sales (net), January 1–December 11 $6,500,000 6 Less estimated gross profit ($6,500,000 × 36%) 2,340,000 7 Estimated cost of merchandise sold 4,160,000 8 Estimated merchandise inventory, December 11 $ 620,000 b. The gross profit method is useful for estimating inventories for monthly or quarterly financial statements. It is also useful in estimating the cost of merchandise destroyed by fire or other disasters.

Appendix Ex. 7–23

Merchandise available for sale...... $3,380,000 Less cost of merchandise sold [$5,260,000 × (100% – 40%)]...... 3,156,000 Estimated ending merchandise inventory...... $ 224,000

Appendix Ex. 7–24

Merchandise available for sale...... $1,400,000 Less cost of merchandise sold [$2,080,000 × (100% – 37%)]...... 1,310,400 Estimated ending merchandise inventory...... $ 89,600

Prob. 7–1A

1. Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost Mar. 1 300 20 6,000 10 500 21 10,500 300 20 6,000 500 21 10,500 28 300 20 6,000 100 21 2,100 400 21 8,400 30 250 21 5,250 150 21 3,150 Apr. 5 80 21 1,680 70 21 1,470 10 450 22 9,900 70 21 1,470 450 22 9,900 16 70 21 1,470 180 22 3,960 270 22 5,940 28 150 22 3,300 120 22 2,640 May 5 175 24 4,200 120 22 2,640 175 24 4,200 14 120 22 2,640 40 24 960 135 24 3,240 25 150 25 3,750 135 24 3,240 150 25 3,750 30 135 24 3,240 5 25 125 145 25 3,625 31 Balances 30,725 3,625

2. Accounts Receivable...... 59,450 Sales...... 59,450 Cost of Merchandise Sold...... 30,725 Merchandise Inventory...... 30,725

3. $28,725 ($59,450 – $30,725)

4. $3,625 (145 units × $25)

5. Since the prices rose from $20 for the March 1 inventory to $25 for the purchase on May 25, we would expect that under last-in, first-out the inventory would be lower.

Note to Instructors: Problem 7–2A shows that the inventory is $3,110 under LIFO.

1. Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost Mar. 1 300 20 6,000 300 20 6,000 10 500 21 10,500 500 21 10,500 300 20 6,000 28 400 21 8,400 100 21 2,100 100 21 2,100 30 150 20 3,000 150 20 3,000 Apr. 5 80 20 1,600 70 20 1,400 70 20 1,400 10 450 22 9,900 450 22 9,900 70 20 1,400 16 250 22 5,500 200 22 4,400 70 20 1,400 28 150 22 3,300 50 22 1,100 70 20 1,400 May 5 175 24 4,200 50 22 1,100 175 24 4,200 70 20 1,400 14 160 24 3,840 50 22 1,100 15 24 360 70 20 1,400 50 22 1,100 25 150 25 3,750 15 24 360 150 25 3,750 Continued

Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost 70 20 1,400 50 22 1,100 May 30 140 25 3,500 15 24 360 10 25 250 31 Balances 31,240 3,110

2. Total sales...... $59,450 Total cost of merchandise sold...... 31,240 Gross profit...... $28,210

3. $3,110 = [(70 units × $20) + (50 units × $22) + (15 units × $24) + (10 units × $25)] = $1,400 + $1,100 + $360 + $250

1. First-In, First-Out Method Model Quantity Unit Cost Total Cost AZ09 4 $ 38 $ 152 1 35 35 GA85 6 92 552 1 85 85 HI71 5 70 350 KS32 9 259 2,331 MS17 13 90 1,170 ND52 3 130 390 2 128 256 WV63 7 180 1,260 1 175 175 Total...... $6,756

2. Last-In, First-Out Method Model Quantity Unit Cost Total Cost AZ09 4 $ 32 $ 128 1 35 35 GA85 7 88 616 HI71 3 75 225 2 65 130 KS32 7 242 1,694 2 250 500 MS17 12 80 960 1 82 82 ND52 2 108 216 2 110 220 1 128 128 WV63 5 160 800 3 170 510 Total...... $ 6,244

3. Average Cost Method Model Quantity Unit Cost* Total Cost AZ09 5 $ 35 $ 175 GA85 7 87 609 HI71 5 69 345 KS32 9 253 2,277 MS17 13 86 1,118 ND52 5 121 605 WV63 8 172 1,376 Total...... $6,505

*Computations of unit costs: AZ09: $35 = [(4 × $32) + (4 × $35) + (4 × $38)] ÷ (4 + 4 + 4) GA85: $87 = [(8 × $88) + (4 × $79) + (3 × $85) + (6 × $92)] ÷ (8 + 4 + 3 + 6) HI71: $69 = [(3 × $75) + (3 × $65) + (15 × $68) + (9 × $70)] ÷ (3 + 3 + 15 + 9) KS32: $253 = [(7 × $242) + (6 × $250) + (5 × $260) + (10 × $259)] ÷ (7 + 6 + 5 + 10) MS17: $86 = [(12 × $80) + (10 × $82) + (16 × $89) + (16 × $90)] ÷ (12 + 10 + 16 + 16) ND52: $121 = [(2 × $108) + (2 × $110) + (3 × $128) + (3 × $130)] ÷ (2 + 2 + 3 + 3) WV63: $172 = [(5 × $160) + (4 × $170) + (4 × $175) + (7 × $180)] ÷ (5 + 4 + 4 + 7)

4. a. During periods of rising prices, the LIFO method will result in a lower cost of inventory, a greater amount of cost of merchandise sold, and a lesser amount of net income than the other two methods. For Bulldog Appli- ances, the LIFO method would be preferred for the current year, since it would result in a lesser amount of income tax. b. During periods of declining prices, the FIFO method will result in a lesser amount of net income and would be preferred for income tax purposes.

A B C D E F G Inventory Sheet 1 December 31, 2012 2 Unit Unit Total 3 Inventory Cost Market Lower 4 Description Quantity Price Price Cost Market of C or M 5 Alpha 38 30 $ 60 $ 57 $ 1,800 $ 1,710 6 8 59 $ 57 472 456 7 2,272 2,166 $ 2,166 8 Beta 20 175 180 3,500 3,600 3,500 9 Charlie 30 20 130 125 2,600 2,500 10 10 129 125 1,290 1,250 11 3,890 3,750 3,750 12 Echo 125 24 26 3,000 3,250 3,000 13 Frank 18 10 565 550 5,650 5,500 14 8 560 550 4,480 4,400 15 10,130 9,900 9,900 16 George 75 15 17 1,125 1,275 1,125 17 Killo 5 385 390 1,925 1,950 1,925 18 Quebec 375 8 6 3,000 2,250 2,250 19 Romeo 90 80 22 18 1,760 1,440 20 10 21 18 210 180 21 1,970 1,620 1,620 22 Sierra 6 5 250 235 1,250 1,175 23 1 260 235 260 235 24 1,510 1,410 1,410 25 Whiskey 140 100 21 20 2,100 2,000 26 40 19 20 760 800 27 2,860 2,800 2,800 28 X-Ray 15 10 750 745 7,500 7,450 29 5 745 745 3,725 3,725 30 11,225 11,175 11,175 31 Total $46,407 $45,146 $44,621

1. A B C 1 MYRINA CO. 2 Cost Retail 3 Merchandise inventory, May 1 $ 130,000 $ 185,000 4 Net purchases 1,382,000 1,975,000 5 Merchandise available for sale $1,512,000 $2,160,000 $1,512,000 Ratio of cost to retail price:  70% 6 $2,160,000 7 Sales $1,950,000 8 Less sales returns and allowances 40,000 9 Net sales 1,910,000 10 Merchandise inventory, May 31, at retail $ 250,000 Merchandise inventory, at estimated cost 11 ($250,000 × 70%) $ 175,000

A B C 1 LEMNOS CO. 2 a. Cost 3 Merchandise inventory, July 1 $ 280,000 4 Net purchases 3,400,000 5 Merchandise available for sale $3,680,000 6 Sales $5,300,000 7 Less sales returns and allowances 100,000 8 Net sales $5,200,000 9 Less estimated gross profit ($5,200,000 × 35%) 1,820,000 10 Estimated cost of merchandise sold 3,380,000 11 Estimated merchandise inventory, September 30 $ 300,000 12 13 b. 14 Estimated merchandise inventory, September 30 $ 300,000 15 Physical inventory count, September 30 269,750 Estimated loss due to theft or damage, 16 July 1–September 30 $ 30,250

1. Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost July 3 75 1,500 112,500 8 150 1,800 270,000 75 1,500 112,500 150 1,800 270,000 11 75 1,500 112,500 135 1,800 243,000 15 1,800 27,000 30 45 1,800 81,000 90 1,800 162,000 Aug. 8 125 2,000 250,000 90 1,800 162,000 125 2,000 250,000 10 90 1,800 162,000 105 2,000 210,000 20 2,000 40,000 19 80 2,000 160,000 25 2,000 50,000 28 100 2,200 220,000 25 2,000 50,000 100 2,200 220,000 Sept. 5 25 2,000 50,000 35 2,200 77,000 65 2,200 143,000 16 50 2,200 110,000 15 2,200 33,000 21 180 2,400 432,000 15 2,200 33,000 180 2,400 432,000 28 15 2,200 33,000 75 2,400 180,000 105 2,400 252,000 30 Balances 1,032,500 252,000

228 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2. Accounts Receivable...... 1,675,000 Sales...... 1,675,000 Cost of Merchandise Sold...... 1,032,500 Merchandise Inventory...... 1,032,500

3. $642,500 ($1,675,000 – $1,032,500)

4. $252,000 (105 units × $2,400)

5. Since the prices rose from $1,500 for the July 3 inventory to $2,400 for the purchase on September 21, we would expect that under last-in, first-out the inventory would be lower.

Note to Instructors: Problem 7–2B shows that the inventory is $238,500 under LIFO.

1. Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost July 3 75 1,500 112,500 8 150 1,800 270,000 75 1,500 112,500 150 1,800 270,000 11 90 1,800 162,000 75 1,500 112,500 60 1,800 108,000 30 45 1,800 81,000 75 1,500 112,500 15 1,800 27,000 Aug. 8 125 2,000 250,000 75 1,500 112,500 15 1,800 27,000 125 2,000 250,000 10 110 2,000 220,000 75 1,500 112,500 15 1,800 27,000 15 2,000 30,000 19 15 2,000 30,000 1 15 1,800 27,000 50 1,500 75,000 25 1,500 37,500 28 100 2,200 220,000 25 1,500 37,500 100 2,200 220,000 Continued

Purchases Cost of Merchandise Sold Inventory Unit Total Unit Total Unit Total Date Quantity Cost Cost Quantity Cost Cost Quantity Cost Cost Sept. 5 60 2,200 132,000 25 1,500 37,500 40 2,200 88,000 16 40 2,200 88,000 15 1,500 22,500 10 1,500 15,000 21 180 2,400 432,000 15 1,500 22,500 180 2,400 432,000 28 90 2,400 216,000 15 1,500 22,500 90 2,400 216,000 30 Balances 1,046,000 238,500

2. Total sales...... $1,675,000 Total cost of merchandise sold...... 1,046,000 Gross profit...... $ 629,000

3. $238,500 = [(15 units × $1,500) + (90 units × $2,400)] = $22,500 + $216,000

1. First-In, First-Out Method Model Quantity Unit Cost Total Cost AK82 3 $535 $ 1,605 2 530 1,060 CO62 6 225 1,350 6 222 1,332 DE03 1 70 70 1 65 65 FL12 4 317 1,268 ME09 6 542 3,252 1 549 549 NM57 2 232 464 TN33 5 39 195 Total...... $11,210

2. Last-In, First-Out Method Model Quantity Unit Cost Total Cost AK82 3 $520 $ 1,560 2 527 1,054 CO62 9 213 1,917 3 215 645 DE03 2 60 120 FL12 4 305 1,220 ME09 6 520 3,120 1 531 531 NM57 2 222 444 TN33 4 35 140 1 36 36 Total...... $10,787

3. Average Cost Method Model Quantity Unit Cost* Total Cost AK82 5 $528 $ 2,640 CO62 12 218 2,616 DE03 2 63 126 FL12 4 311 1,244 ME09 7 534 3,738 NM57 2 227 454 TN33 5 37 185 Total...... $11,003

*Computations of unit costs: AK82: $528 = [(3 × $520) + (3 × $527) + (3 × $530) + (3 × $535)] ÷ (3 + 3 + 3 + 3) CO62 $218 = [(9 × $213) + (7 × $215) + (6 × $222) + (6 × $225)] ÷ (9 + 7 + 6 + 6) DE03: $63 = [(5 × $60) + (3 × $65) + (1 × $65) + (1 × $70)] ÷ (5 + 3 + 1 + 1) L100: $311 = [(6 × $305) + (3 × $310) + (3 × $316) + (4 × $317)] ÷ (6 + 3 + 3 + 4) ME09: $534 = [(6 × $520) + (8 × $531) + (4 × $549) + (6 × $542)] ÷ (6 + 8 + 4 + 6) NM57: $227 = [(4 × $222) + (4 × $232)] ÷ (4 + 4) TN33: $37 = [(4 × $35) + (6 × $36) + (8 × $37) + (7 × $39)] ÷ (4 + 6 + 8 + 7)

4. a. During periods of rising prices, the LIFO method will result in a lower cost of inventory, a greater amount of the cost of merchandise sold, and a lesser amount of net income than the other two methods. For Artic Ap- pliances, the LIFO method would be preferred for the current year, since it would result in a lesser amount of income tax. b. During periods of declining prices, the FIFO method will result in a lesser amount of net income and would be preferred for income tax purposes.

A B C D E F G Inventory Sheet 1 December 31, 2012 2 Unit Unit Total 3 Inventory Cost Market Lower 4 Description Quantity Price Price Cost Market of C or M 5 Alpha 38 30 $ 60 $ 57 $ 1,800 $ 1,710 6 8 59 57 472 456 7 2,272 2,166 $ 2,166 8 Beta 20 170 180 3,400 3,600 3,400 9 Charlie 30 20 130 125 2,600 2,500 10 10 128 125 1,280 1,250 11 3,880 3,750 3,750 12 Echo 125 25 26 3,125 3,250 3,125 13 Frank 18 6 550 550 3,300 3,300 14 12 540 550 6,480 6,600 15 9,780 9,900 9,780 16 George 75 16 17 1,200 1,275 1,200 17 Killo 5 395 390 1,975 1,950 1,950 18 Quebec 375 6 6 2,250 2,250 2,250 19 Romeo 90 75 25 18 1,875 1,350 20 15 26 18 390 270 21 2,265 1,620 1,620 22 Sierra 6 5 250 235 1,250 1,175 23 1 260 235 260 235 24 1,510 1,410 1,410 25 Whiskey 140 100 17 20 1,700 2,000 26 40 16 20 640 800 27 2,340 2,800 2,340 28 X-Ray 15 10 750 745 7,500 7,450 29 5 740 745 3,700 3,725 30 11,200 11,175 11,175 31 Total $45,197 $45,146 $44,166

1. A B C 1 SEGAL CO. 2 Cost Retail 3 Merchandise inventory, March 1 $ 298,000 $ 375,000 4 Net purchases 4,850,000 6,225,000 5 Merchandise available for sale $5,148,000 $6,600,000 $5,148,000 Ratio of cost to retail price:  78% 6 $6,600,000

7 Sales $6,320,000 8 Less sales returns and allowances 245,000 9 Net sales 6,075,000 10 Merchandise inventory, March 31, at retail $ 525,000 Merchandise inventory, at estimated cost 11 ($525,000 × 78%) $ 409,500

A B C 1 IROQUOIS CO. 2 a. Cost 3 Merchandise inventory, January 1 $ 300,000 4 Net purchases 4,150,000 5 Merchandise available for sale $4,450,000 6 Sales $6,900,000 7 Less sales returns and allowances 175,000 8 Net sales $6,725,000 9 Less estimated gross profit ($6,725,000 × 40%) 2,690,000 10 Estimated cost of merchandise sold 4,035,000 11 Estimated merchandise inventory, March 31 $ 415,000 12 13 b. 14 Estimated merchandise inventory, March 31 $ 415,000 15 Physical inventory count, March 31 396,500 Estimated loss due to theft or damage, 16 January 1–March 31 $ 18,500

CP 7–1

Since the title to merchandise shipped FOB shipping point passes to the buyer when the merchandise is shipped, the shipments made before midnight, July 31, 2012, should properly be recorded as sales for the fiscal year ending July 31, 2012. Hence, Mark Irwin is behaving in a professional manner. However, Mark should realize that recording these sales in 2012 precludes them from being rec- ognized as sales in 2013. Thus, accelerating the shipment of orders to increase sales of one period will have the effect of decreasing sales of the next period.

CP 7–2

In developing a response to Gary’s concerns, you should probably first emphasize the practical need for an assumption concerning the flow of cost of goods purchased and sold. That is, when identical goods are frequently purchased, it may not be practical to specifically identify each item of inventory. If all the identical goods were purchased at the same price, it wouldn’t make any difference for financial reporting purposes which goods we assumed were sold first, second, etc. However, in most cases, goods are purchased over time at different prices, and, hence, a need arises to determine which goods are sold so that the price (cost) of those goods can be matched against the revenues to determine operating income. Next, you should emphasize that accounting principles allow for the fact that the physical flow of the goods may differ from the flow of costs. Specifically, accounting principles allow for three cost flow assumptions: first-in, first-out; last-in, first-out; and average. Each of these methods has advantages and disad- vantages. One primary advantage of the last-in, first-out method is that it better matches current costs (the cost of goods purchased last) with current revenues. Therefore, the reported operating income is more reflective of current operations and what might be expected in the future. Another reason that the last-in, first-out method is often used is that it tends to minimize taxes during periods of price increases. Since for most businesses prices tend to increase, the LIFO method will generate lower taxes than will the alternative cost flow methods. The preceding explanation should help Gary better understand LIFO and its impact on the financial statements and taxes.

236 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CP 7–3 1. a. First-in, first-out method: 16,000 units at $16.00...... $256,000 16,000 units at $14.95...... 239,200 25,600 units at $14.50...... 371,200 6,400 units at $14.25...... 91,200 64,000 units...... $ 957,600 b. Last-in, first-out method: 62,000 units at $12.20...... $756,400 2,000 units at $13.00...... 26,000 64,000 units...... $ 782,400 c. Average cost method: 64,000 units at $13.58*...... $ 869,120 *($5,432,000/400,000) = $13.58 2. Average FIFO LIFO Cost Sales...... $5,200,000 $5,200,000 $5,200,000 Cost of merchandise sold*...... 4,474,400 4,649,600 4,562,880 Gross profit...... $ 725,600 $ 550,400 $ 637,120 *Cost of merchandise available for sale...... $5,432,000 $5,432,000 $5,432,000 Less ending inventory...... 957,600 782,400 869,120 Cost of merchandise sold...... $4,474,400 $4,649,600 $4,562,880

3. a. The LIFO method is often viewed as the best basis for reflecting income from operations. This is because the LIFO method matches the most current cost of merchandise purchases against current sales. The matching of current costs with current sales results in a gross profit amount that many consider to best reflect the results of current operations. For White Dove Company, the gross profit of $550,400 reflects the matching of the most current costs of the product of $4,649,600 against the current period sales of $5,200,000. This matching of current costs with current sales also tends to minimize the effects of price trends on the results of operations. The LIFO method will not match current sales and the current cost of merchandise sold if the current-period quantity of sales exceeds the curren- t-period quantity of purchases. In this case, the cost of merchandise sold will include a portion of the cost of the beginning inventory, which may have a unit cost from purchases made several years prior to the current period. The results of operations may then be distorted in the sense of the current matching concept. This situation occurs rarely in most businesses because of consistently increasing quantities of year-end inventory from year to year.

While the LIFO method is often viewed as the best method for matching revenues and expenses, the FIFO method is often consistent with the physical movement of merchandise in a business, since most businesses tend to dispose of commodities in the order of their acquisition. To the ex- tent that this is the case, the FIFO method approximates the results that will be attained by a specific identification of costs. The average cost method is, in a sense, a compromise between LIFO and FIFO. The effect of price trends is averaged, both in determining net income and in determining inventory cost. Which inventory costing method best reflects the results of operations for White Dove Company depends upon whether one emphasizes the impor- tance of matching revenues and expenses (the LIFO method) or whether one emphasizes the physical flow of merchandise (the FIFO method). The average cost method might be considered best if one emphasizes the matching and physical flow of goods concepts equally.

b. The FIFO method provides the best reflection of the replacement cost of the ending inventory for the balance sheet. This is because the amount reported on the balance sheet for merchandise inventory will be assigned costs from the most recent purchases. For most businesses, these costs will reflect purchases made near the end of the period. For example, White Dove Company’s ending inventory on December 31, 2012, is assigned costs totaling $957,600 under the FIFO method. These costs represent purchases made during the period of August through December. This FIFO inventory amount ($957,600) more closely approximates the replacement cost of the ending inventory than either the LIFO ($782,400) or the average cost ($869,120) figures. c. During periods of rising prices, such as shown for White Dove Company, the LIFO method will result in a lesser amount of net income than the other two methods. Hence, for White Dove Company, the LIFO method would be preferred for the current year, since it would result in a lesser amount of income tax. During periods of declining prices, the FIFO method will result in a lesser amount of net income and would be preferred for income tax purposes.

d. The advantages of the perpetual inventory system include the following: (1) A perpetual inventory system provides an effective means of control over inventory. A comparison of the amount of inventory on hand with the balance of the subsidiary account can be used to determine the ex- istence and seriousness of any inventory shortages. (2) A perpetual inventory system provides an accurate method for determining inventories used in the preparation of interim statements. (3) A perpetual inventory system provides an aid for maintaining inven- t-ories at optimum levels. Frequent review of the perpetual inventory records helps management in the timely reordering of merchandise, so that loss of sales and excessive accumulation of inventory are avoided. An analysis of White Dove Company’s purchases and sales, as shown below, indicates that the company may have accumulated excess inventory from May through August because the amount of month-end inventory increased materially, while sales remained rela- tively constant for the period. Increase Next (Decrease) in Inventory at Month’s Month Purchases Sales Inventory End of Month Sales April 62,000 units 32,000 units 30,000 units 30,000 units 32,000 units May 66,000 32,000 34,000 64,000 40,000 June 80,000 40,000 40,000 104,000 48,000 July 80,000 48,000 32,000 136,000 56,000 August 54,400 56,000 (1,600) 134,400 56,000 September — 56,000 (56,000) 78,400 36,000 October 25,600 36,000 (10,400) 68,000 20,000 November 16,000 20,000 (4,000) 64,000 16,000 December 16,000 16,000 0 64,000 —

It appears that during April through July, the company ordered inventory without regard to the accumulation of excess inventory. A perpetual inventory system might have prevented this excess accumulation from occurring. The primary disadvantage of the perpetual inventory system is the cost of maintaining the necessary inventory records. However, computers may be used to reduce this cost.

Cost of Goods Sold a. Inventory Turnover = Average Inventory

Average Inventory Number of Days’ Sales in Inventory = Cost of Goods Sold/365

Dell $50,144 $50,144 Inventory Turnover:   49.0 ($1,180  $867)/2 $1,023.5

$1,180  $867/ 2 $1,023.5 Days’ Sales in Inventory:   7.4 days $50,144/365 137.4

Hewlett-Packard $87,524 $87,524 Inventory Turnover:   12.5 ($7,879  $6,128)/2 $7,003.5

$7,879  $6,128/ 2 $7,003.5 Days’ Sales in Inventory:   29.2 days $87,524/365 239.8 b. Dell builds its computers primarily to a customer order, called a build-to-order strategy. Customers place their orders on the Internet. Dell then builds and delivers the computer, usually in a matter of days. HP, in contrast, builds computers before actual orders are received. This is called a build-to-stock strategy. HP must forecast the type of computers customers want before it re- ceives the orders. This strategy results in greater inventory for HP, since the computers are built before there is a sale. HP has significant finished goods inventory, while Dell has less finished goods. It also explains the difference in their inventory efficiency ratios.

Note to Instructors: While Dell sells most of its computers online, it has also begun selling its computers through Best Buy. As a result, Dell’s inventory turnover has decreased and its days’ sales in inventory has increased from prior years.

240 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CP 7–5 a. Number of Days’ Sales Inventory Turnover in Inventory

Tiffany Co. 0.85 427.03 Amazon.com 11.46 31.84 Computations: Tiffany Co. Cost of Goods Sold Inventory Turnover = Average Inventory

$1,215 Inventory Turnover = , or 0.85 $1,601 $1,242/ 2

Average Inventory Number of Days’ Sales in Inventory = Cost of Goods Sold / 365

$1,601 $1,242/ 2 Number of Days’ Sales in Inventory = , or 427.03 days $1,215 / 365

Amazon.com Cost of Goods Sold Inventory Turnover = Average Inventory

$14,896 Inventory Turnover = , or 11.46 $1,399  $1,200/ 2

Average Inventory Number of Days’ Sales in Inventory = Cost of Goods Sold / 365

$1,399  $1,200/ 2 Number of Days’ Sales in Inventory = , or 31.84 days $14,896 / 365 b. Amazon.com has a smaller investment in inventory for its volume than does Tiffany. Amazon.com’s inventory turnover is faster (larger), and the number of days’ sales in inventory is shorter (smaller). This is due to the fact that Amazon.com uses a different business model than Tiffany. That is, Amazon.com sells through the Internet, while Tiffany uses the traditional retail store model which requires Tiffany to stock more inventory.

241 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CP 7–6 a. Costco Wal-Mart JCPenney 1. Cost of merchandise sold...... $ 62,335 $ 306,158 $ 11,571 Merchandise inventory, beginning...... $ 5,039 $ 35,180 $ 3,641 Merchandise inventory, ending...... 5,405 34,511 3,259 Total...... $ 10,444 $ 69,691 $ 6,900

2. Average merchandise inventory (Total/2)...... $ 5,222.0 $ 34,845.5 $ 3,450.0 Inventory turnover ...... 11.9 8.8 3.4 b. Costco Wal-Mart JCPenney 1. Average merchandise inventory [from part (a)]...... $ 5,222.0 $ 34,845.5 $ 3,450.0 Cost of merchandise sold...... $ 62,335 $ 306,158 $ 11,571 2. Average daily cost of merchandise sold (COMS/365)...... $ 170.8 $ 838.8 $ 31.7 Number of day’s sales in inventory..... 30.6 41.5 108.8 c. Both the inventory turnover ratio and the number of day’s sales in inventory reflect the merchandising approaches of the three companies. Costco is a club warehouse. Its approach is to hold only mass appeal items that are sold quickly off the shelf. Most items are sold in bulk quantities at very attractive prices. Costco couples thin margins with very fast inventory turnover. Wal-Mart has a traditional discounter approach. It has attractive pricing, but the inventory moves slower than would be the case at a club warehouse. For example, many purchases made at Wal-Mart would not be packaged in the same bulk as would be the case at Costco. JCPenney is a traditional department store with a wider assortment of goods that will not necessarily appeal to the mass market. That is, some of the merchandise items will be more specialized and unique. As such, its inventory moves slower, but at a higher price (and margin).