Porter SM Ch. 05 - 2pp

CHAPTER 5
Inventories and
Cost of Goods Sold
OVERVIEW OF EXERCISES, PROBE!S, A"# CASES
Esti$ated
Ti$e in
earnin% O&t'o$es E(er'ises !in&tes evel
)* Identify the forms of inventory held by different types of 1 10 Easy
businesses and the types of costs incurred. 2 10 Mod
+* Show that you understand how wholesalers and retailers 3 25 Mod
account for sales of merchandise. 10 Easy
20! 25 Mod
21! 15 Mod
,* Show that you understand how wholesalers and retailers 5 15 Easy
account for cost of "oods sold. # 20 Mod
$ 25 Mod
% 20 Mod
& 15 Mod
20! 25 Mod
21! 15 Mod
-* 'se the "ross profit ratio to analy(e a company)s ability
to cover its operatin" e*penses and earn a profit.
5* E*plain the relationship between the valuation of inventory 10 15 Mod
and the measurement of income. 23! 20 Mod
.* +pply the inventory costin" methods of specific identification, 11 20 Easy
wei"hted avera"e, -I-., and /I-. usin" a periodic system. 22! 25 Mod
/* +naly(e the effects of the different costin" methods on 12 15 Mod
inventory, net income, income ta*es, and cash flow. 22! 25 Mod
2! 0 Mod
0* +naly(e the effects of an inventory error on various financial 13 25 Mod
statement items. 1 20 Mod
1* +pply the lower0of0cost0or0mar1et rule to the valuation of 23! 20 Mod
inventory.
)2* E*plain why and how the cost of inventory is estimated in 15 20 Mod
certain situations.
53)
53+ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
Esti$ated
Ti$e in
earnin% O&t'o$es 4Con'l&ded5 E(er'ises !in&tes evel
))* +naly(e the mana"ement of inventory. 1# 20 Mod
)+* E*plain the effects that inventory transactions have on the 1$ 10 Easy
statement of cash flows. 1% 15 Mod
1& 15 Mod
),* E*plain the differences in the accountin" for periodic and 2! 0 Mod
perpetual inventory systems and apply the inventory
costin" methods usin" a perpetual system 6+ppendi*7.
!E*ercise, problem, or case covers two or more learnin" outcomes
/evel 8 9ifficulty levels: Easy; Moderate 6Mod7; 9ifficult 69iff7
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Pro6le$s Esti$ated
and Ti$e in
earnin% O&t'o$es Alternates !in&tes evel
)* Identify the forms of inventory held by different types of 1 25 Mod
businesses and the types of costs incurred. 15! 20 Mod
+* Show that you understand how wholesalers and retailers %! 5 Mod
account for sales of merchandise. &! 0 Mod
10! 0 Mod
,* Show that you understand how wholesalers and retailers %! 5 Mod
account for cost of "oods sold. &! 0 Mod
10! 0 Mod
-* 'se the "ross profit ratio to analy(e a company)s ability
to cover its operatin" e*penses and earn a profit. 2 25 Mod
&! 0 Mod
5* E*plain the relationship between the valuation of inventory 11! 5 Mod
and the measurement of income. 12! #0 9iff
13! 30 Mod
1! 30 Mod
.* +pply the inventory costin" methods of specific identification, 11! 5 Mod
wei"hted avera"e, -I-., and /I-. usin" a periodic system. 13! 30 Mod
1! 30 Mod
inventory, net income, income ta*es, and cash flow. 11! 5 Mod
12! #0 9iff
13! 30 Mod
1! 30 Mod
15! 20 Mod
1#! 20 Mod
0* +naly(e the effects of an inventory error on various financial 5 9iff
statement items.
inventory. 1#! 20 Mod
)2* E*plain why and how the cost of inventory is estimated in 5 20 Mod
certain situations.
))* +naly(e the mana"ement of inventory. # 30 Mod
)+* E*plain the effects that inventory transactions have on the $ 25 Mod
statement of cash flows. %! 5 Mod
),* E*plain the differences in the accountin" for periodic and 12! #0 9iff
53- -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
Esti$ated
Ti$e in
earnin% O&t'o$es Cases !in&tes evel
)* Identify the forms of inventory held by different types of 1! 30 Mod
businesses and the types of costs incurred. 3! 25 Mod
+* Show that you understand how wholesalers and retailers ! 20 Mod
account for sales of merchandise. 5! 20 Mod
& 30 Mod
,* Show that you understand how wholesalers and retailers 1! 30 Mod
account for cost of "oods sold. ! 20
Mod
5! 20 Mod
# 25 Mod
-* 'se the "ross profit ratio to analy(e a company)s ability ! 20 Mod
to cover its operatin" e*penses and earn a profit. 5! 20 Mod
5* E*plain the relationship between the valuation of inventory
and the measurement of income.
.* +pply the inventory costin" methods of specific identification, 3! 25 Mod
wei"hted avera"e, -I-., and /I-. usin" a periodic system. $! 0 Mod
inventory, net income, income ta*es, and cash flow. $! 0 Mod
10 30 Mod
0* +naly(e the effects of an inventory error on various financial % 30 Mod
statement items.
inventory. 11 30 Mod
)2* E*plain why and how the cost of inventory is estimated in
certain situations.
))* +naly(e the mana"ement of inventory.
)+* E*plain the effects that inventory transactions have on the
statement of cash flows.
),* E*plain the differences in the accountin" for periodic and
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78ESTI O"S
)* 4he three distinct types of costs incurred by a manufacturer are direct materials,
direct labor, and manufacturin" overhead. 9irect, or raw, materials are the
in"redients used in ma1in" a product. 9irect labor consists of the amounts paid to
factory wor1ers to manufacture the product. Manufacturin" overhead includes all the
other costs that are related to the manufacturin" process but cannot be directly
matched to specific units of output.
+* 4he use of a contra0revenue account to record cash refunds and other types of
allowances allows a company to monitor the si(e and freAuency of these
occurrences. -or e*ample, a relatively lar"e amount of returns in any one period
may be an indication that the Auality of the product has slipped. 4he information
provided by the use of these contra0revenue accounts would be lost if all returns and
allowances were recorded as reductions of the Sales >evenue account. +lso, if this
practice were followed, the actual amount of sales would be understated for the
period to the e*tent of any returns and allowances.
,* 4erms of 3B20, nB#0 mean that the customer may deduct 3C from the sellin" price if
the bill is paid within 20 days. .therwise, the full amount is due within #0 days of the
date of the invoice. +ssumin" a sale for D1,000, a 3C discount would save the
customer D30, resultin" in a net amount due of D&$0. 4he amount saved is the result
of payin" 0 days earlier than is reAuired by the #00day term. +ssumin" 3#0 days in
a year, there are 3#0B0, or & periods of 0 days each, in a year. 4hus, a savin"s of
D30 for 0 days is eAuivalent to a savin"s of D30 E &, or D2$0 for the year. 4his is
eAuivalent to an annual return of D2$0BD&$0, or 2$.%C.
-* 4he two inventory systems differ with respect to how often the inventory account is
updated. 'nder the perpetual system, the account is updated each time a sale or
purchase is made. Fith the periodic system, the inventory account is updated only
at the end of the period. + temporary account, called =urchases, is used to 1eep
trac1 of the acAuisitions of inventory durin" the period. 4he periodic method relies on
a count of the inventory on hand at the end of the period to determine the amount to
assi"n to endin" inventory on the balance sheet and to cost of "oods sold e*pense
on the income statement.
5* + point0of0sale terminal "ives the merchandiser the ability to update the inventory
records each time a sale is made. +s an item is run over the sensin" "lass, a bar
code on the product is read by the computer. In this way, the unit can be removed
from the inventory at the point of sale. In some instances, however, merchandisers
use the terminals only to update the Auantity of units on hand, not necessarily the
dollar amount.
.* 4he =urchases account is neither an asset nor an e*pense account. It is simply a
temporary holdin" account for the purchases of merchandise, which is closed at the
end of the period. 4he effect of purchases made durin" the period is to increase the
cost of "oods sold e*pense.
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/* -or inventory in transit at the end of the year, the terms of shipment dictate whether
the buyer should record the purchase of the inventory. -.G shippin" point means
that the "oods belon" to the buyer as soon as they are shipped, and the purchases
should be recorded at this point in time. +lternatively, -.G destination point means
that the "oods do not belon" to the buyer until they are received and therefore
should not be recorded if they are in transit at year0end.
0* 4ransportation0in represents the frei"ht costs incurred on purchases of merchandise
and is therefore added to the purchases of the period in determinin" cost of "oods
sold e*pense. +lternatively, transportation0out indicates the frei"ht costs incurred in
sellin" merchandise and is therefore reported as a sellin" e*pense on the income
statement in the period of sale.
1* 5ross profit is computed by deductin" cost of "oods sold from net sales. 4he "ross
profit ratio indicates how well the company controlled its product costs durin" the
year. -or e*ample, a 30C "ross profit ratio indicates that for every dollar of sales the
company has a "ross profit of 30 cents. 4hat is, after deductin" $0 cents on every
dollar for the cost of the inventory that is sold, the company has 30 cents to cover its
operatin" costs and earn a profit.
)2* +ccordin" to the cost of "oods sold model, be"innin" inventory plus purchases
minus endin" inventory eAuals cost of "oods sold. 4herefore, the amount assi"ned
to inventory on the balance sheet has a direct effect on the measurement of cost of
"oods sold on the income statement. +ny errors in valuin" inventory will flow throu"h
to cost of "oods sold and thus have an impact on the measurement of net income.
))* 4he Hustification for treatin" frei"ht costs on incomin" inventory as a cost incurred in
acAuirin" the asset, rather than as an e*pense of the period, is the matchin"
principle. -rei"ht costs are necessary to put the inventory into a position to be sold
and should therefore be included in the cost of the asset. 4his is a si"nificant
decision, since the cost will become an e*pense only at the time the inventory is
sold. If frei"ht costs are not included in the cost of the inventory, they are e*pensed
immediately as they are incurred. 4hus, if the inventory is not sold at the end of the
period, the decision to treat frei"ht costs as a cost of the inventory will result in
hi"her net income than if the costs had been included as an e*pense of the period.
)+* 4he specific identification method is appropriate only for certain types of inventory. It
is normally used for situations in which the inventory is relatively hi"h0priced and
subHect to a low amount of turnover. +lthou"h it is not a necessary condition, each
unit of inventory is often uniAue. -or e*ample, an automobile dealer uses the
specific identification method, as would a Hewelry company.
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),* Fhen used on an inventory of identical units, the specific identification can lead to
the manipulation of income. Gecause all units are identical, mana"ement can select
which units to sell based on the relative hi"h or low cost of the units on hand. -or
e*ample, in a bad year a company mi"ht be tempted to select for sale all units that
had a relatively low unit cost, re"ardless of when they were acAuired. 4he use of a
cost flow assumption, such as wei"hted avera"e, -I-., or /I-., eliminates the
ability of mana"ement to select units for sale based solely on the effect this decision
will have on the income of the period.
)-* 4he wei"hted avera"e cost method does not rely on a simple arithmetic avera"e of
the unit cost for the various purchases of the period. Instead, more wei"ht is
assi"ned to unit costs for which more units were purchased. -or e*ample, assume
that be"innin" inventory consists of 100 units with a unit cost of D10 per unit.
+ssume that durin" the period, 100 units were purchased at D15 per unit, and 200
units were purchased at D20 per unit. 4he arithmetic avera"e unit cost for the period
would be 6D10 I D15 I D207B3 8 D15. <owever, the wei"hted avera"e unit cost would
be J1006D107 I 1006D157 I 2006D207KB00 units, or D1#.25. 4he acAuisition of twice
as many units at D20 as opposed to those purchased at D10 and D15 drives the
wei"hted avera"e up to D1#.25.
)5* 4he -I-. method more nearly appro*imates the physical flow of products in most
businesses. 4his is particularly true for perishable products, such as fresh fruits and
ve"etables. Most businesses prefer as a matter of "ood customer relations to sell
their "oods on a first0in, first0out basis. 4his minimi(es the li1elihood that units of
inventory will become obsolete and spoiled.
).* 4he use of /I-. will have the effect of ma*imi(in" net income if a company is
e*periencin" a decline in the unit cost of inventory. /ast0in, first0out char"es the most
recent purchases to cost of "oods sold. If prices are declinin", the amounts char"ed
to cost of "oods sold will be less than if either the wei"hted avera"e method or -I-.
was used. Gecause less is char"ed to cost of "oods sold, net income will be hi"her.
)/* In a period of risin" prices, the use of /I-. will result in a lower ta* bill. Gecause the
most recent purchases are char"ed to cost of "oods sold under /I-., in a period of
risin" prices, these units will be hi"her0priced, and thus the result will be lower "ross
mar"in as well as lower net income before ta*. /ower net income will result in a
lower amount of ta* to pay. If prices are declinin" durin" the period, -I-. will result
in a lower ta* bill.
)0* 2o, the president should not be enthralled with the new controller. 4he controller is
su""estin" somethin" that is not allowed under the ta* law. 4he Internal >evenue
Service)s /I-. conformity rule reAuires that a company that wants to use /I-. for
ta* purposes must also use it in preparin" its income statement.
530 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
)1* + /I-. liAuidation occurs when a company usin" the /I-. inventory method sells
more units durin" the period than it purchases. + liAuidation of some or all of the
older, relatively lower0priced units 6assumin" risin" prices7 will result in a low cost of
"oods sold amount and a correspondin"ly hi"her "ross mar"in. 4his may present a
dilemma to a company. If the company sells the lower0priced units, its net income
will improve, but hi"her ta*es will have to be paid. 4o avoid facin" this situation, a
company mi"ht buy inventory at the end of the year to avoid these conseAuences of
a liAuidation. 'nfortunately, the somewhat forced purchase of inventory to avoid the
liAuidation may not be in the best interests of the company.
+2* In a period of risin" prices, -I-. can result in si"nificant inventory profits. In
comparison with /I-., the use of -I-. char"es less to cost of "oods sold because it
is the older, lower0priced units that are assumed to be sold. <owever, in a period of
si"nificant inflation, there may be a lar"e difference between the "ross mar"in that
results from usin" -I-. and the much smaller amount that would result from usin"
the current cost of the inventory 6replacement cost7. 4his difference, called inventory
profit, is simply the result of holdin" the units durin" a period of inflation.
+)* 2o, it is not acceptable for a company to indicate to its stoc1holders that it is
switchin" to /I-. to save on ta*es. Fhile the ability to save ta*es may be an
important result of the chan"e, the company must be able to demonstrate that /I-.
does a better Hob of matchin" costs with revenues. 4his is normally the Hustification
offered in the annual report for a company)s chan"e to /I-..
++* Gecause a certain section of the warehouse is double0counted, endin" inventory will
be overstated. +ccordin" to the cost of "oods sold model, endin" inventory is
subtracted from cost of "oods available to sell to arrive at cost of "oods sold
e*pense. 4herefore, an overstatement of endin" inventory will lead to an
understatement of cost of "oods sold e*pense. +n understatement of an e*pense
results in an overstatement of net income for the period.
+,* 4he lower0of0cost0or0mar1et rule is invo1ed when the utility of inventory is less than
its cost to the company. It is a departure from the historical cost principle and is
Hustified on the basis of conservatism. 4he rule is a reaction to uncertainty by
anticipatin" a decline in the value of inventory and writin" down the asset currently
before it is sold.
+-* +pplication of the lower0of0cost0or0mar1et rule on a total basis, compared with an
item0by0item basis, will usually yield a different result. 4he reason is that with the
total approach, increases in mar1et value above cost are allowed to offset decreases
in value. +lternatively, when the item0by0item approach is used, any increases in
value are essentially i"nored, and it is the declines in value for each item that are
reco"ni(ed.
+5* + company usin" the periodic inventory system could undoubtedly save money by
estimatin" its year0end inventory and thus avoidin" the e*pense of countin" it.
<owever, the inventory must be based on actual cost, not an estimate, for purposes
of the annual report.
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+.* + retailer can save time and money at the end of the year by simply countin" the
number of units of each item of inventory and multiplyin" each of these counts by
the price mar1ed on the units 6that is, the retail price7. 4his process "ives the
company an amount that represents the value of the inventory at retail. 4he retail
method is then used to convert this amount to cost. It would be prohibitive for many
retailers, particularly mass merchandisers, to trace the unit cost of each item of
inventory to purchase invoices.
+/* Inventory turnover eAuals cost of "oods sold 6cost of sales7 divided by avera"e
inventory. If the cost of sales remains constant while the denominator 6avera"e
inventory7 increases, inventory turnover will decrease. 4his indicates that inventory
is stayin" on the shelf for a lon"er time. 4he company should probably evaluate the
salability of its inventory.
+0* Fhen a perpetual inventory system is used, the dollar amount of inventory is
calculated after each sale. 4hus, when it is used in conHunction with the wei"hted
avera"e costin" method, a new avera"e cost is calculated after each sale. 4he
wei"hted avera"e chan"es each time a sale is made, and therefore the unit cost is
called a movin" avera"e.
EXERCI SES
/. 1
EXERCISE 53) CASSIFICATIO" OF I"VE"TOR9 COSTS
Classifi'ation
Ra: Wor; in Finis<ed !er'<andise
Inventor= Ite$ !aterial Pro'ess Goods Inventor=
-abric L
/umber L
'nvarnished tables L
3hairs on the showroom floor L
3ushions L L!
9ecorative 1nobs L
9rawers L
Sofa frames L
3hairs in the plant warehouse L
3hairs in the retail storeroom L
!3ushions produced by the company would be wor1 in process, but if purchased from a
supplier, they would be raw materials.
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/. 1
EXERCISE 53+ I"VE"TORIABE COSTS
/ist price: D100 200 units D20,000
/ess: 10C volume discount 62,0007
-rei"ht costs 5#
Insurance for "oods in transit 32
4otal cost D1%,0%%
'nder the cost principle, all of these costs are necessary to put the inventory into a
position where it can be sold.
.ther classifications:
4he phone char"es and purchasin" department salary would both be difficult to
match directly with the sale of any particular product and therefore should be treated as
operatin" e*penses of the period. 4he labelin" supplies are immaterial in amount and
should also be reported as operatin" e*penses. 4he interest paid to suppliers is a
financin" cost and would be reported as interest e*pense on the income statement.
/. 2
EXERCISE 53, PERPET8A A"# PERIO#IC I"VE"TOR9 S9STE!S
)* 3ompany + is usin" a perpetual inventory system because it has the account 3ost of
5oods Sold. 3ompany G is usin" the periodic inventory system because it uses the
accounts =urchases, =urchase 9iscounts, and =urchases >eturns and +llowances.
+* 3ompany +)s end of the year inventory is the balance in its merchandise inventory
account, D12,000. Its cost of "oods sold is D3%,000, the balance in that account.
,* 3ost of "oods sold in a periodic system is computed as: Ge"innin" inventory I net
purchases M endin" inventory. 3ompany G)s merchandise inventory account
represents be"innin" inventory. Endin" inventory is obtained by conductin" a
physical count. Gecause you are not "iven the endin" inventory fi"ure, you cannot
compute cost of "oods sold.
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/. 2
EXERCISE 53- PERPET8A A"# PERIO#IC I"VE"TOR9 S9STE!S
=erpetualN+ppliance store
=erpetualN3ar dealership
=eriodicN9ru"store
=erpetualN-urniture store
=eriodicN5rocery store
=eriodicN<ardware store
=erpetualNOewelry store
3han"es in technolo"y may lessen the costs of maintainin" perpetual inventory
systems. Merchandisers will convert to perpetual inventory systems when the benefits
of maintainin" such systems e*ceed the costs.
/. 3
EXERCISE 535 !ISSI"G A!O8"TS I" COST OF GOO#S SO# !O#E
Case )>
4a5 Ge"innin" inventory: cost of "oods available for sale M cost of "oods purchased 8
D$,110 M 6D#,230 M D$0 M D200 I D1507 8 D$,110 M D5,$10 8 D1,00
465 Endin" inventory: cost of "oods available for sale M cost of "oods sold 8 D$,110 M
D5,220 8 D1,%&0
Case +> 6must first solve d, then '7
4d5 3ost of "oods available for sale: cost of "oods sold I endin" inventory 8 D5,5$0 I
D1,$50 8 D$,320
4'5 =urchase discounts:
)* 3ost of "oods available for sale M be"innin" inventory 8 cost of "oods purchased
8 D$,320 M D2,350 8 D,&$0
+* 5ross purchases M purchase returns and allowances M purchase discounts I
transportation0in 8 cost of "oods purchased; D5,$20 M D%00 M purchase discounts
I D500 8 D,&$0; purchase discounts 8 D5,20 M D,&$0 8 D50
53)+ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
EXERCISE 535 4Con'l&ded5
Case ,>
4e5 5ross purchases:
)* 3ost of "oods purchased 8 cost of "oods available for sale M be"innin" inventory
8 D%,$&0 M D1,%&0 8 D#,&00
+* 5ross purchases M purchase returns and allowances M purchase discounts I
transportation0in 8 cost of "oods purchased; "ross purchases M D550 M D310 I
D20 8 D#,&00; "ross purchases 8 D#,&00 I D550 I D310 M D20 8 D$,30
4f5 3ost of "oods sold 8 cost of "oods available for sale M endin" inventory 8 D%,$&0 M
D1,200 8 D$,5&0
/. 3
EXERCISE 53. P8RCHASE #ISCO8"TS

BAA"CE SHEET I"CO!E STATE!E"T
Assets ? ia6ilities @ Sto';<oldersA EB&it= @ Reven&es C E(Denses
$B3 +ccounts =urchases 63,5007
=ayable 3,500
$B# +ccounts =urchases 6$,0007
=ayable $,000
$B12 3ash 63,#57 +ccounts =urchase
60.&& 3,5007 =ayable 63,5007 9iscounts 35
%B5 3ash 6$,0007 +ccounts
=ayable 6$,0007
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53),
/. 3
EXERCISE 53/ P8RCHASESEPERIO#IC S9STE!

3B3 +ccounts 2,500 =urchases 62,5007
=ayable
3B3 3ash 62507 4ransportation0in 62507
3B$ +ccounts =urchases 61,007
=ayable 1,00
3B12 3ash 62,507 +ccounts =urchase
60.&% 2,5007 =ayable 62,5007 9iscounts 50
3B15 +ccounts =urchase >eturns
=ayable 65007 and +llowances 500
3B1% +ccounts =urchases 61,#007
=ayable 1,#00
3B22 +ccounts =urchase >eturns
=ayable 6007 and +llowances 00
B# 3ash 6&007 +ccounts
=ayable 6&007
61,00 M 5007
B1% 3ash 61,2007 +ccounts
=ayable 61,2007
61,#00 M 007
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/. 3
EXERCISE 530 SHIPPI"G TER!S A"# TRA"SFER OF TITE
)* 4he seller pays shippin" costs when merchandise is shipped -.G destination point.
Miller Fholesalers pays the frei"ht bill and is responsible for the merchandise until it
"ets to Michael)s warehouse.
+* 4he inventory should not be included as an asset on Michael)s 9ecember 31, 200$,
balance sheet because the terms of shipment indicate that the merchandise does
not le"ally belon" to Michael until it arrives, and this is after the end of the year.
/i1ewise, Miller should not include the sale on its 200$ income statement, since the
"oods are not considered sold until they reach the buyer)s business.
,* If the terms of shipment were -.G shippin" point, the answers to both Auestions in
part 627 would chan"e. 'nder these terms, the inventory belon"s to Michael as soon
as it is shipped, and because this is on 9ecember 23, 200$, the asset should be
reco"ni(ed on the year0end balance sheet. Similarly, Miller would record a sale in
200$.
/. 3
EXERCISE 531 TRA"SFER OF TITE TO I"VE"TOR9
=urchases of merchandise that are in transit from vendors to 3ameron 3ompanies on
9ecember 31, 200$:
>ecord durin" 9ecember 200$NShipped -.G shippin" point
>ecord durin" Oanuary 200%NShipped -.G destination point
Sales of merchandise that are in transit to customers of 3ameron 3ompanies on
9ecember 31, 200$:
>ecord durin" 9ecember 200$NShipped -.G shippin" point
>ecord durin" Oanuary 200%NShipped -.G destination point
/. 5
EXERCISE 53)2 I"VE"TOR9 A"# I"CO!E !A"IP8ATIO"
Gy i"norin" the lar"e order at year0end, and thus includin" the inventory in the year0end
count, the company will overstate endin" inventory. 4his in turn will lead to an
understatement of cost of "oods sold and an overstatement of net income. 4he effects
on ne*t year)s income are the opposite. Gecause be"innin" inventory will be overstated,
cost of "oods sold will also be overstated, and net income understated. 4he accountant
has an obli"ation to the financial statement users to convince the president to ma1e the
necessary adHustments to reduce the inventory balance.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53)5
P
/. #
EXERCISE 53)) I"VE"TOR9 COSTI"G !ETHO#S
)* Endin" inventory:
6#5 M 557 D20 8 D 200
650 M 357 D22 8 330
6#0 M 57 D23 8 35
65 M 57 D2 8 &#0
%0 units D1,%35
3ost of "oods sold:
55 D20 8 D1,100
35 D22 8 $$0
5 D23 8 1,035
5 D2 8 120
10 units D3,025
+* Endin" inventory:
5 D2 8 D1,0%0
35 D23 8 %05
%0 units D1,%%5
3ost of "oods sold:
#5 D20 8 D1,300
50 D22 8 1,100
25 D23 8 5$5
10 units D2,&$5
,* Endin" inventory:
#5 D20 8 D1,300
15 D22 8 330
%0 units D1,#30
3ost of "oods sold:
5 D2 8 D1,0%0
#0 D23 8 1,3%0
35 D22 8 $$0
10 units D3,230
53). -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
EXERCISE 53)) 4Con'l&ded5
-* 3ost of "oods available for sale and units available:
#5 D20 8 D1,300
50 D22 8 1,100
#0 D23 8 1,3%0
5 D2 8 1,0%0
220 units D,%#0
Fei"hted avera"e cost 8 D,%#0B220 8 D22.0&Bunit
Endin" inventory: %0 D22.0& 8 D1,$#$.20
3ost of "oods sold: 10 D22.0& 8 D3,0&2.#0
"ote> 9oes not total D,%#0 because of roundin" of avera"e cost.
/. $
EXERCISE 53)+ EVA8ATIO" OF I"VE"TOR9 COSTI"G !ETHO#S
)* a 5* b
+* d .* a
,* c /* b
-* c 0* c
/. %
EXERCISE 53), I"VE"TOR9 ERRORS
Balan'e S<eet In'o$e State$ent
Retained Cost of "et
Inventor= Earnin%s Goods Sold In'o$e
)* ' ' . '
+* . . ' .
,* ' ' . '
/. %
EXERCISE 53)- TRA"SFER OF TITE TO I"VE"TOR9
)* Michelson should include the costs in its inventory, since the merchandise had not
arrived at its destination, =O)s, by the end of the year.
+* -ilbrandt should include the costs of the merchandise in its inventory, since it has
received the shipment by the end of the year.
,* >andall would include the merchandise in its inventory, since the shipment left
Oames Gros. before the end of the year.
-* Garner should include the merchandise in its inventory. It is both shipped by <in(
and received by Garner before the end of the year.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53)/
/. 10
EXERCISE 53)5 GROSS PROFIT !ETHO#
4)5 2et sales D105,300
Estimated "ross profit ratio 0.25
Estimated "ross profit D 2#,325
4+5 2et sales D105,300
M Estimated "ross profit 2#,325
Estimated cost of "oods sold D $%,&$5
4,5 Ge"innin" inventory D 15,00
+dd: =urchases %,230
3ost of "oods available for sale D &&,#30
Estimated cost of "oods sold $%,&$5
Estimate of inventory destroyed D 20,#55

3ash! 10,000 /oss on
Inventory 620,#557 Insurance
Settlement 610,#557
!.r, if cash has not been received, >eceivable from Insurance 3ompany.
/. 11
EXERCISE 53). I"VE"TOR9 T8R"OVER FOR BEST B89
)* Inventory turnover 8 cost of "oods soldBavera"e inventory D20,&3%BJ6D2,%51 I
D2,#0$7B2K 8 D20,&3%BD2,$2& 8 $.#$ times.
+* 4he avera"e len"th of time it ta1es to sell an item of inventory can be estimated by
dividin" the number of times inventory turns over in a year into the number of days in
a year:
6assumin" 3#0 days in a year7: 3#0B$.#$ times 8 #.&, or appro*imately $ days.
,* It is difficult to determine from the information "iven whether $ days is reasonable
as the avera"e len"th of time it ta1es to sell inventory. .ther information needed to
ma1e this determination includes:
4he historical avera"e number of days.
4he industry norms for lar"e, national retailers.
+ny recent chan"es in types of inventory, customer base, mar1ets for the
products, and other relevant factors.
53)0 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 12
EXERCISE 53)/ I!PACT OF TRA"SACTIO"S I"VOVI"G I"VE"TORIES O"
STATE!E"T OF CASH FOWS
Increase in accounts payable: +dded to net income
9ecrease in accounts payable: 9educted from net income
Increase in inventories: 9educted from net income
9ecrease in inventories: +dded to net income
/. 12
EXERCISE 53)0 EFFECTS OF TRA"SACTIO"S I"VOVI"G I"VE"TORIES O" THE
STATE!E"T OF CASH FOWSE#IRECT !ETHO#
3ash payments for inventory to be reported in the operatin" activities of Masthead)s
200$ statement of cash flows 6direct method7:
Inventory, 9ecember 31, 200# D 1%0,00
=lus: =urchases durin" 200$ L
/ess: 3ost of "oods sold durin" 200$ 61,200,0007
Inventory, 9ecember 31, 200$ D 21,200
D1%0,00 I L M D1,200,000 8 D21,200
L 8 D1,2#0,%00
+ccounts payable, 9ecember 31, 200# D %5,00
=lus: =urchases durin" 200$ 6from above7 1,2#0,%00
/ess: 3ash payments durin" 200$ 6L7
+ccounts payable, 9ecember 31, 200$ D $%,00
D%5,00 I D1,2#0,%00 M L 8 D$%,00
L 8 D1,2#$,%00
/. 12
EXERCISE 53)1 EFFECTS OF TRA"SACTIO"S I"VOVI"G I"VE"TORIES O" THE
STATE!E"T OF CASH FOWSEI"#IRECT !ETHO#
3ash flows from operatin" activities:
2et income D **,***
+dHustments to reconcile net income to net cash
provided by operatin" activities:
Increase in inventory 6D21,200 M D1%0,007 D6#0,%007
9ecrease in accounts payable 6D$%,00 M D%5,007 6$,0007 6#$,%007
3ash flows from operatin" activities D **,***
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53)1
!8TI 3 CO"CEPT EXERCI SES
/. 2,3
EXERCISE 53+2 I"CO!E STATE!E"T FOR A !ERCHA"#ISER
a* Sales M 2et sales 8 Sales returns and allowances
D125,#00 M D122,00 8 D3,5#0
6* 9o c. first. 2et purchases I =urchase discounts 8 =urchases
D$,#00 I D1,300 8 D$5,&00
'* 3ost of "oods purchased M 4ransportation0in 8 2et purchases
D%1,150 M D#,550 8 D$,#00
d* 2et sales M 5ross mar"in 8 3ost of "oods sold
D122,00 M D3%,#00 8 D%3,0
e* 3ost of "oods available for sale M 3ost of "oods sold 8 Endin" inventory
D10,550 M D%3,0 8 D21,110
f* 5ross mar"in M Income before ta* 8 .peratin" e*penses
D3%,#00 M D2#,300 8 D12,300
%* Income before ta* M Income ta* e*pense 8 2et income
D2#,300 M D10,300 8 D1#,000
53+2 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 2,3
EXERCISE 53+) PARTIA I"CO!E STATE!E"TEPERIO#IC S9STE!
API"E CO!PA"9
I"CO!E STATE!E"T
FOR THE 9EAR E"#E# #ECE!BER ,), +22/
Sales D%0,000
/ess: Sales returns and allowances D 500
Sales discounts 1,200 1,$00
2et sales D$%,300
/ess cost of "oods sold:
Ge"innin" inventory D ,000
=urchases D30,000
/ess: =urchase returns and allowances 00
=urchase discounts %00
2et purchases D2%,%00
+dd: 4ransportation0in 1,000
3ost of "oods purchased 2&,%00
3ost of "oods available for sale D33,%00
/ess: Endin" inventory 3,%00
3ost of "oods sold 30,000
5ross mar"in D%,300
4he "ross profit ratio is #1.$C.
6D%,300BD$%,3007
/. #,$
EXERCISE 53++ I"VE"TOR9 COSTI"G !ETHO#SEPERIO#IC S9STE!
)* a* Fei"hted avera"e method:
3ost of "oods available for sale and units available:
200 D10 8 D 2,000
300 D11 8 3,300
00 D12 8 ,%00
250 D13 8 3,250
150 D15 8 2,250
1,300 D15,#00
Fei"hted avera"e cost 8 D15,#00B1,300 8 D12 per unit
'nits available 1,300
'nits sold 1,000
'nits in endin" inventory 300
3ost of endin" inventory 8 3006D127 8 D3,#00
3ost of "oods sold 8 1,0006D127 8 D12,000
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53+)
EXERCISE 53++ 4Con'l&ded5
6* -I-. method:
Endin% inventor= 'ost>
150 D15 8 D2,250
150 D13 8 1,&50
300 D,200
Cost of %oods sold>
200 D10 8 D 2,000
300 D11 8 3,300
00 D12 8 ,%00
100 D13 8 1,300
1,000 D11,00
6OR> D15,#00 M D,200 8 D11,007
'* /I-. method:
Endin% inventor= 'ost>
200 D10 8 D2,000
100 D11 8 1,100
300 D3,100
Cost of %oods sold>
150 D15 8 D 2,250
250 D13 8 3,250
00 D12 8 ,%00
200 D11 8 2,200
1,000 D12,500
6OR> D15,#00 M D3,100 8 D12,5007
+* /I-. cost of "oods sold D12,500
-I-. cost of "oods sold 11,00
9ifference in e*penses D 1,100
4a* rate 0.30
9ifference in ta*es D 330
Con'l&sion> Gecause -I-. results in less cost of "oods sold, a hi"her income and
thus more ta*es, D330, will be reported with this method than if /I-. were used.
53++ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 5,&
EXERCISE 53+, OWER3OF3COST3OR3!ARFET R8E
3onservatism is the rationale for carryin" inventory on the balance sheet at an amount
less than its cost. It is a departure from the historical cost principle and is used when the
utility of the inventory, as measured by the cost to replace it, is less than ori"inal cost.
4wo accounts are affected by the application of the lower0of0cost0or0mar1et rule. +n
income statement account, such as /oss on 9ecline in @alue of Inventory, is debited,
and the Inventory account on the balance sheet is credited or reduced.
4he effect of writin" down inventory is to reduce the income of the current year by
the amount debited to the loss account. In future years, however, income will be hi"her
because of the write0down. 4his occurs because cost of "oods sold will be lower in the
future when the inventory that was written down to a lower amount is eventually sold.
/. $,13
EXERCISE 53+- I"VE"TOR9 COSTI"G !ETHO#SEPERPET8A S9STE!
4ADDendi(5
)* a* Movin" avera"e:
P&r'<ases Sales Balan'e
8nit Total 8nit Total 8nit
#ate 8nits Cost Cost 8nits Cost Cost 8nits Cost Balan'e
1B1 200 D10 D2,000
2B12 150 D10 D 1,500 50 10 500
3B5 300 D11 D3,300 350 10.%5$
)
3,%00
B30 200 10.%5$ 2,1$1 150 10.%5$ 1,#2&
#B12 00 12 ,%00 550 11.#%&
+
#,2&
$B$ 200 11.#%& 2,33% 350 11.#%& ,0&1
%B23 250 13 3,250 #00 12.235
,
$,31
&B# 300 12.235 3,#$0 300 12.235 3,#$1
10B2 150 15 2,250 50 13.15%
-
5,&21
12B3 150 13.15% 1,&$ 300 13.15% D3,&$
3ost of "oods sold D11,#53 Endin" inventory
+ll amounts rounded to a"ree with total cost.
)*
50 D10 8 D 500
300

11 8 3,300
350 D3,%00; D3,%00B350 8 D10.%5$
+*
150

D10.%5$ 8 D1,#2&
00

12 8 ,%00
550 D#,2&; D#,2&B550 8 D11.#%&
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53+,
EXERCISE 53+- 4Contin&ed5
,*
350

D11.#%& 8 D,0&1
250

13 8 3,250
#00 D$,31; D$,31B#00 8 D12.235
-*
300
E
D12.235 8 D3,#$1
150 E 15 8 2,250
50 D5,&21; D5,&21B50 8 D13.15%
)* 6* -I-.:
1B1 200 D10 D2,000
2B12 150 D10 D 1,500 50 10 500
3B5 300 D11 D3,300 50 10
300 11 3,%00
B30 50 10 500
150 11 1,#50 150 11 1,#50
#B12 00 12 ,%00 150 11
00 12 #,50
$B$ 150 11 1,#50
50 12 #00 350 12 ,200
%B23 250 13 3,250 350 12
250 13 $,50
&B# 300 12 3,#00 50 12
250 13 3,%50
10B2 150 15 2,250 50 12
250 13
150 15 #,100
12B3 50 12 #00 150 13
100 13 1,300 150 15 D,200
3ost of "oods sold D11,00 Endin" inventory
53+- -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
EXERCISE 53+- 4Contin&ed5
)* '* /I-.:
1B1 D200 D10 D2,000
2B12 150 D10 D 1,500 50 10 500
3B5 300 D11 D3,300 50 10
300 11 3,%00
B30 200 11 2,200 50 10
100 11 1,#00
#B12 00 12 ,%00 50 10
100 11
00 12 #,00
$B$ 200 12 2,00 50 10
100 11
200 12 ,000
%B23 250 13 3,250 50 10
100 11
200 12
250 13 $,250
&B# 250 13 3,250 50 10
50 12 #00 100 11
150 12 3,00
10B2 150 15 2,250 50 10
100 11
150 12
150 15 5,#50
12B3 150 15 2,250 50 10
100 11
150 12 D3,00
3ost of "oods sold D12,200 Endin" inventory
+* EXERCISE 53++> EXERCISE 53+->
EGI CGGGS EGI CGGGS
+vera"e cost D3,#00 D12,000 D3,&$ D11,#53 9ifferent
-I-. ,200 11,00 ,200 11,00 Same
/I-. 3,100 12,500 3,00 12,200 9ifferent
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53+5
EXERCISE 53+- 4Con'l&ded5
,* 3ost of "oods sold:
/I-. D12,200
-I-. 11,00
9ifference in e*pense D %00
4a* rate 0.30
9ifference in ta*es D 20
Con'l&sion> /I-. results in a hi"her cost of "oods sold and therefore a lower
ta*able income and lower income ta* by D20.
PROBE!S
/. 1
PROBE! 53) I"VE"TOR9 COSTS I" VARIO8S B8SI"ESSES
A''o&ntin% Treat$ent
E(Dense of Inventor= Ot<er
B&siness T=Des of Costs t<e Period Cost Treat$ent
>etail shoe store Shoes for sale L
Shoe bo*es L
+dvertisin" si"ns L
5rocery store 3anned "oods on the shelves L
=roduce L
3leanin" supplies L!
3ash re"isters L!!
-rame shop Fooden frame supplies L
2ails L
5lass L
Fal10in print shop =aper L
3opy machines L!!
4oner cartrid"es L!
>estaurant -ro(en food L
3hina and silverware L!!
=repared food L
Spices L
!>ecord as an asset and char"e to e*pense as used.
!!>ecord as an asset and depreciate over estimated useful life.
53+. -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/.
PROBE! 53+ CAC8ATIO" OF GROSS PROFIT FOR WA3!ART A"# TARGET
)* 5ross profit ratios 6dollar amounts in millions7:
Fal0Mart: 200: 6D2%5,222 M D21&,$&37BD2%5,222 8 D#5,2&BD2%5,222 8 22.&C
2003: 6D25#,32& M D1&%,$$7BD25#,32& 8 D5$,5%2BD25#,32& 8 22.5C
4ar"et: 200: 6D5,#%2 M D31,57BD5,#%2 8 D1,23$BD5,#%2 8 31.2C
2003: 6D0,&2% M D2%,3%&7BD0,&2% 8 D12,53&BD0,&2% 8 30.#C
+* In terms of the "ross profit ratio, 4ar"et appears to be performin" better, "iven a
si"nificantly hi"her ratio in each year. 4he mi* of products sold by the two
companies and the normal mar1ups on the various products could certainly affect
the ratios. + comparison with prior years and industry avera"es would also be
important to consider.
/. $
PROBE! 53, EVA8ATIO" OF I"VE"TOR9 COSTI"G !ETHO#S
)* 3ompany G will have the newest costs in inventory because it uses first0in, first0out.
Gecause costs are risin", it will have the lowest costs of "oods sold and thus the
hi"hest net income.
+* 3ompany 3 will have the oldest costs in inventory because it uses last0in, first0out.
Gecause costs are risin", it will have the hi"hest cost of "oods sold and thus the
lowest income before ta*es. 3ompany 3 will pay the least in ta*es.
,* 4his Auestion does not lend itself to an easy answer. /I-. matches the most recent
costs with the most recent revenue and thus may be a better indicator of future
potential to investors. Inventory profits are not a maHor concern with /I-. as they are
with -I-., because the newer 6most recent7 costs are assi"ned to cost of sales.
-* 3ompany 3 would have the oldest costs in inventory because it uses /I-.. Gecause
costs are fallin", it will have the lowest cost of "oods sold and the hi"hest net
income.
3ompany G will have the newest costs in inventory because it uses -I-..
Gecause costs are fallin", it will have the hi"hest cost of "oods sold and the lowest
income before ta*es. 3ompany G will pay the least in ta*es.
4he answer to part 637 is still not easy. 4here are advanta"es and disadvanta"es
in all methods. 4he important point is to choose one method and stay with it for
consistency.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53+/
/. %
PROBE! 53- I"VE"TOR9 ERROR
)* Revised in'o$e state$ents> +22/ +22.
>evenues D20,000 D15,000
3ost of "oods sold! 13,#00 &,00
5ross profit D #,00 D 5,#00
.peratin" e*penses 3,000 2,000
2et income D 3,00 D 3,#00
!Gecause endin" inventory in 200# was understated, cost of "oods sold was
overstated. Gecause be"innin" inventory in 200$ was understated, cost of "oods
sold was understated.
Revised 6alan'e s<eets> )+G,)G2/ )+G,)G2.
3ash D 1,$00 D 1,500
Inventory ,200 ,100
.ther current assets 2,500 2,000
/on"0term assets 15,000 1,000
4otal assets D23,00 D21,#00
/iabilities D %,500 D $,000
3apital stoc1 5,000 5,000
>etained earnin"s &,&00 &,#00
4otal liabilities and stoc1holders) eAuity D23,00 D21,#00
+* 2et income for two years, before revision: D3,000 I D,000 8 D$,000
2et income for two years, after revision: D3,#00 I D3,00 8 D$,000
4hus, there is no net over0 or understatement.
>etained earnin"s at 9ecember 31, 200$, before the revision: D&,&00
>etained earnin"s at 9ecember 31, 200$, after the revision: D&,&00
4hus, there is no over0 or understatement.
,* Even thou"h the error counterbalances over the two0year period, it is still important
to restate the statements for the two years. It is important for comparative purposes
that the correct amount of net income be 1nown for each of the two years. 4he
company needs to restate the income statements for each of the two years and
restate the balance sheets at the end of each year.
53+0 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 10
PROBE! 535 GROSS PROFIT !ETHO# OF ESTI!ATI"G I"VE"TOR9 OSSES
)* 4)5 2et sales D113,500
Estimated "ross profit ratio 0.0
Estimated "ross profit D 5,00
4+5 2et sales D113,500
M Estimated "ross profit 5,00
Estimated cost of "oods sold D #%,100
4,5 Ge"innin" inventory D 3,200
+dd: =urchases 1#,000
3ost of "oods available for sale D1#$,200
Estimated cost of "oods sold #%,100
Estimate of inventory at time of e*plosion D &&,100
Inventory saved ,500
Estimate of inventory destroyed D &,#00
+* To record insuance settlement from explosion.

3ash! #5,000 /oss on
Inventory 6&,#007 Insurance
Settlement 62&,#007
!.r, if cash has not yet been received, >eceivable from Insurance 3ompany.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53+1
/. 11
PROBE! 53. I"VE"TOR9 T8R"OVER FOR APPE CO!P8TER A"# #E
CO!P8TER
)* 5ross profit ratios:
ADDle Co$D&ter #ell Co$D&ter
4in $illions5 4in $illions5
+22- +22, +225 +22-
SalesB=roduct revenue D %,2$& D #,20$ D&,205 D 1,
/ess: 3ost of salesBrevenue #,020 ,&& 0,1&0 33,%&2
5ross profit D 2,25& D 1,$0% D &,015 D $,552
9ivided by sales Q %,2$& Q #,20$ Q &,205 Q 1,
5ross profit ratio 2$.3C 2$.5C 1%.3C 1%.2C
+* Inventory turnover ratios:
ADDle Co$D&ter>
D#,020BJ6D101 I D5#7B2K 8 D#,020B$%.5 8 $#.#& times
#ell Co$D&ter
D0,1&0BJ6D5& I D32$7B2K 8 D0,1&0BD3&3 8 102.2# times
,* Goth companies) "ross profit ratios have remained about the same in the two years.
4he two companies) turnover ratios are very different. +nother factor to consider is
the number of days) sales in inventory.
ADDle Co$D&ter>
3#0B$#.#& 8 .$days
#ell Co$D&ter>
3#0B102.2# 8 3.5 days
It ta1es +pple an avera"e of less than five days to sell an item of inventory, and 9ell
reAuires only three and a half days.
.n the basis of the "ross profit, +pple appears to be performin" better, althou"h
9ell does have a better inventory turnover and days) sales in inventory.
It would be helpful to measure all of these statisticsN"ross profit ratio, inventory
turnover, and days) sales in inventoryNwith the same measures for prior years. It
would also be helpful to compare these measures with the industry avera"es.
53,2 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 12
PROBE! 53/ EFFECTS OF CHA"GES I" I"VE"TOR9 A"# ACCO8"TS PA9ABE
BAA"CES O" STATE!E"T OF CASH FOWS
)* Statement of cash flows:
COPEA"# A"TI78ES
2et loss D633,2007
+dHustments to reconcile net loss to net cash provided by
operatin" activities:
9ecrease in inventory 6D1&2,#00 M D21,%007 22,200
Increase in accounts payable 6D123,&00 M D&3,$007 30,200
3ash flows from operatin" activities D 1&,200
3ash, 9ecember 31, 200# #,100
3ash, 9ecember 31, 200$ D #5,300
+* !e$orand&$ to t<e Dresident>
4.: =resident of 3opeland +ntiAues
->.M: Student)s name
9+4E: Oanuary 20, 200%
S'GOE34: 3ash -lows
Rou recently Auestioned the increase in the company)s cash balance in li"ht of this
year)s net loss. My thou"hts and a copy of the company)s 200$ statement of cash
flows follow.
3opeland +ntiAues was able to "enerate a si"nificant amount of cash from
operations even thou"h the company incurred an accrual basis net loss of D33,200
durin" 200$. -irst, the amount of inventory on hand decreased by D22,200 durin"
the year from D21,%00 to D1&2,#00; this reduction in inventory "enerated cash for
the company. Second, the amount owed to the company)s suppliers increased by
D30,200 durin" the year from D&3,$00 to D123,&00; the related bills have not yet
been paid.
.peratin" e*penses need to be decreased relative to "ross profit if we are to
improve the company)s bottom line. I loo1 forward to discussin" our plans to turn
thin"s around.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53,)
!8TI 3 CO"CEPT PROBE!S
/. 2,3,12
PROBE! 530 P8RCHASES A"# SAES OF !ERCHA"#ISE, CASH FOWS
)* Effect of transactions on the accountin" eAuation:

B1 +ccounts =urchases 65007
=ayable 500
B10 3ash 6%57 +ccounts =urchase 9iscounts 15
6500 M 157 =ayable 65007 6500 .037
B15 3ash 200 Sales >evenue 200
B1% +ccounts =urchases 6&007
=ayable &00
B25 3ash #00 Sales >evenue #00
B2% 3ash 6%$37 +ccounts =urchase 9iscounts 2$
6&00 M 2$7 =ayable 6&007 6&00 .037
+* 2et income for +pril:
Sales revenue: D200 I D#00 D %00
3ost of "oods sold:
Ge"innin" inventory D 0
=urchases: D500 I D&00 D1,00
/ess: =urchase discounts D15 I D2$ 2
2et purchases 1,35%
3ost of "oods available for sale D1,35%
/ess: Endin" inventory &#$
3ost of "oods sold 3&1
5ross mar"in D 0&
.peratin" e*penses:
>ent e*pense D 100
Miscellaneous e*pense 50
4otal operatin" e*penses 150
2et income D 25&
,* 2et cash flow from operatin" activities for +pril:
3ash collected from sales: D200 I D#00 D %00
3ash paid for:
Inventory: D%5 I D%$3 D1,35%
>ent 100
Miscellaneous 50 1,50%
2et cash flow from operatin" activities D 6$0%7
53,+ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 530 4Con'l&ded5
OR>
2et income D 25&
9educt: Increase in inventory balance 6&#$7
2et cash flow from operatin" activities D 6$0%7
-* 2et income is D25&. 2et cash flow from operatin" activities is a ne"ative D$0%. 4he
difference of D&#$ is attributable to inventory that has not been sold. 4hat is, the
company has paid for D1,35% of inventory 6a cash outlay7 but has only reco"ni(ed
cost of "oods sold e*pense of D3&1. 4he difference is D&#$.
/. 2,3,
PROBE! 531 GAP I"C*AS SAES, COST OF GOO#S SO#, A"# GROSS
PROFIT
)* +pparently, 5ap Inc. does not sell its merchandise on account. If customers want to
pay on credit for their purchases, they would use one of the various credit cards that
5ap accepts.
+* Effect of sales on the accountin" eAuation:

3ash 1#,2#$,000,000 Sales 1#,2#$,000,000
,* 5ap Inc. would deduct sales returns and allowances from sales to arrive at the
amount of net sales reported on its income statement. Since 5ap Inc. does not have
any accounts receivable on its balance sheet, it is unli1ely that it offers sales
discounts to its customers. Either because they do not feel the amounts are material
enou"h or they would rather not divul"e information about returns and allowances to
competitors, some companies choose not to separately report them.
-* 3ost of "oods sold section of 200 income statement 6millions of dollars7:
Merchandise inventory, 1B31B0 D 1,$0
3ost of "oods purchased! &,&&# 627
3ost of "oods available for sale D11,$00 617
/ess merchandise inventory, 1B2&B05 61,%17
3ost of "oods sold!! D &,%%#
!Includin" occupancy e*penses.
!!9escribed as cost of "oods sold and occupancy e*penses.
617 D&,%%# I D1,%1 8 D11,$00.
627 D11,$00 M D1,$0 8 D&,&&#.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53,,
PROBE! 531 4Con'l&ded5
5* 5ross profit ratios:
4$illions of dollars5 +22- +22,
Sales D 1#,2#$ D 15,%5
/ess cost of sales &,%%# &,%%5
5ross profit D #,3%1 D 5,&#&
9ivided by sales Q D1#,2#$ Q D15,%5
5ross mar"in ratio 3&.2C 3$.#C
5ap Inc.)s "ross profit ratio increased by 1.#C from 2003 to 200. -actors affect
in" 5ap Inc.)s "ross profit ratio mi"ht include chan"es in the sellin" prices of
merchandise, chan"es in the cost of "oods purchased, andBor chan"es in the mi* of
merchandise sold 6that is, a sli"ht shift between sellin" products that have hi"her
"ross profit ratios and sellin" those with lower "ross profit ratios7.
/. 2,3
PROBE! 53)2 FI"A"CIA STATE!E"TS
)* 3ost of "oods sold for 200$:
Ge"innin" inventory D #,00
=urchases D0,200
/ess: =urchase discounts %00
2et purchases D3&,00
+dd: 4ransportation0in 3$5
3ost of "oods purchased 3&,$$5
3ost of "oods available for sale D#,1$5
/ess: Endin" inventory $,500
3ost of "oods sold D3%,#$5
+* 2et income for 200$:
Sales D%,3#
/ess: Sales returns $%0
2et sales D%3,5%
3ost of "oods sold Jfrom part 617K 3%,#$5
5ross profit D,&0&
.peratin" e*penses:
Salaries D25,#00
+dvertisin" ,510
'tilities 3,#00
9epreciation 2,300
4otal operatin" e*penses 3#,010
Income before ta* D %,%&&
Income ta* e*pense 3,200
2et income D 5,#&&
53,- -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 53)2 4Con'l&ded5
,* !APE I"C*
BAA"CE SHEET
AT #ECE!BER ,), +22/
Assets
3urrent assets:
3ash D 5&0
+ccounts receivable 2,35&
Inventory $,500
Interest receivable 100
4otal current assets D10,5&
=roperty, plant, and eAuipment:
/and D20,000
Guildin" and eAuipment, net 55,550
4otal property, plant, and eAuipment $5,550
4otal assets D%#,0&&
ia6ilities
3urrent liabilities:
Salaries payable D #50
Income ta* payable 3,200
4otal liabilities D 3,%50
Sto';<oldersA EB&it=
3apital stoc1 D50,000
>etained earnin"s 32,2&! %2,2&
4otal liabilities and stoc1holders) eAuity D%#,0&&
!Ge"innin" retained earnin"s I 2et income M 9ividends
D32,550 I D5,#&& M D#,000
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53,5
/. 5,#,$
PROBE! 53)) CO!PARISO" OF I"VE"TOR9 COSTI"G !ETHO#SE
PERIO#IC S9STE!
)* Cost of Endin%
Goods Sold Inventor= Total
a* Fei"hted avera"e D11,0% D,&%% D1#,0$2
6* -I-. 10,$$# 5,2&# 1#,0$2
'* /I-. 11,52 ,#20 1#,0$2
3alculations:
a* Ge"innin" inventory #00 D5.00 8 D 3,000
.ct. % %00 5.0 8 ,320
.ct. 1% $00 5.$# 8 ,032
.ct. 2& %00 5.&0 8 ,$20
2,&00 D1#,0$2
Fei"hted avera"e cost 8 D1#,0$2B2,&00 8 D5.52
'nits sold: 500 I $00 I %00 8 2,000 units
'nits available M units sold 8 endin" inventory
2,&00 M 2,000 8 &00 units
Endin" inventory 8 &00 D5.52 8 D,&%%
3ost of "oods sold 8 2,000 D5.52 8 D11,0%
6* Endin" inventoryN-I-.:
%00 D5.&0 8 D,$20
100 5.$# 8 5$#
&00 D5,2&#
3ost of "oods soldN-I-.:
#00 D5.$# 8 D 3,5#
%00 5.0 8 ,320
#00 5.00 8 3,000
2,000 D10,$$#
'* Endin" inventoryN/I-.:
#00 D5.00 8 D3,000
300 5.0 8 1,#20
&00 D,#20
3ost of "oods soldN/I-.:
500 D5.0 8 D 2,$00
$00 5.$# 8 ,032
%00 5.&0 8 ,$20
2,000 D11,52
53,. -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53,/
PROBE! 53)) 4Con'l&ded5
+* 4he 4otal column represents the pool of costs 6be"innin" inventory plus purchases7
to be distributed between an asset, endin" inventory on the balance sheet, and an
e*pense, cost of "oods sold on the income statement. In accountin", this pool of
costs is called cost of "oods available for sale.
,* Income statements for the month of .ctober:
Wei%<ted
Avera%e FIFO IFO
Sales! D20,%00 D20,%00 D20,%00
3ost of "oods sold 11,0% 10,$$# 11,52
5ross mar"in D &,$1# D10,02 D &,3%
.peratin" e*penses 3,000 3,000 3,000
Income before ta*es D #,$1# D $,02 D #,3%
Income ta* e*pense 630C7 2,015 2,10$ 1,&0
2et income D ,$01 D ,&1$ D ,
!Sales 8 5006D107 I $006D107 I %006D117 8 D20,%00
-* 4he company will pay D203 more in ta*es if it uses -I-.:
-I-. ta* D2,10$
/I-. ta* 1,&0
9ifference D 203
/. 5,$,13
PROBE! 53)+ CO!PARISO" OF I"VE"TOR9 COSTI"G !ETHO#SE
PERPET8A S9STE! 4ADDendi(5
)* Cost of Endin%
a* Movin" avera"e D10,$%5 D5,2%$ D1#,0$2
6* -I-. 10,$$# 5,2&# 1#,0$2
'* /I-. 10,%52 5,220 1#,0$2
53,0 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 53)+ 4Contin&ed5
a* Movin" avera"e:
10B1 #00 D5 D3,000
10B 500 D5 D 2,500 100 5 500
10B% %00 D5.0 D,320 &00 5.35#
)
,%20
10B& $00 5.35# 3,$& 200 5.35# 1,0$1
10B1% $00 5.$# ,032 &00 5.#$
+
5,103
10B20 %00 5.#$ ,53# 100 5.#$ 5#$
10B2& %00 5.&0 ,$20 &00 5.%$
,
D5,2%$
3ost of "oods sold D10,$%5 Endin" inventory
)*
100 E D5.00 8 D 500
%00 E 5.0 8 ,320
&00 D,%20; D,%20B&00 8 D5.35#
+*
200 E D5.35# 8 D1,0$1
$00 E 5.$# 8 ,032
&00 D5,103; D5,103B&00 8 D5.#$
,*
100 E D5.#$ 8 D 5#$
%00 E 5.&0 8 ,$20
&00 D5,2%$; D5,2%$B&00 8 D5.%$
6* -I-.:
10B1 #00 D5 D3,000
10B 500 D5 D 2,500 100 5 500
10B% %00 D5.0 D,320 100 5
%00 5.0 ,%20
10B& 100 5 500
#00 5.0 3,20 200 5.0 1,0%0
10B1% $00 5.$# ,032 200 5.0
$00 5.$# 5,112
10B20 200 5.0 1,0%0
#00 5.$# 3,5# 100 5.$# 5$#
10B2& %00 5.&0 ,$20 100 5.$#
%00 5.&0 D5,2&#
3ost of "oods sold D10,$$# Endin" inventory
PROBE! 53)+ 4Con'l&ded5
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53,1
'* /I-.:
10B1 #00 D5 D3,000
10B 500 D5 D2,500 100 5 500
10B% %00 D5.0 D,320 100 5
%00 5.0 ,%20
10B& $00 5.0 3,$%0 100 5
100 5.0 1,00
10B1% $00 5.$# ,032 100 5
100 5.0
$00 5.$# 5,0$2
10B20 $00 5.$# ,032
100 5.0 50 100 5 500
10B2& %00 5.&0 ,$20 100 5
%00 5.&0 D5,220
3ost of "oods sold D10,%52 Endin" inventory
e*pense, cost of "oods sold, on the income statement. In accountin", this pool of
,* Income statements for the month of .ctober:
!ovin%
Avera%e FIFO IFO
Sales! D20,%00 D20,%00 D20,%00
3ost of "oods sold 10,$%5 10,$$# 10,%52
5ross mar"in D10,015 D10,02 D &,&%
.peratin" e*penses 3,000 3,000 3,000
Income before ta*es D $,015 D $,02 D #,&%
Income ta* e*pense 630C7 2,105 2,10$ 2,0%
2et income D ,&10 D ,&1$ D ,%#
!Sales 8 5006D107 I $006D107 I %006D117 8 D20,%00
-I-. ta* D2,10$
/I-. ta* 2,0%
9ifference D 23
53-2 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 5,#,$
PROBE! 53), I"VE"TOR9 COSTI"G !ETHO#SEPERIO#IC S9STE!
)* 'nits in be"innin" inventory 200
+dd: 'nits purchased 6250 I 220 I 150 I 2007 %20
/ess: 'nits sold 6300 I 3%0 I 1107 $&0
Endin% Cost of
Inventor= Goods Sold Total
a* -I-. D,10 D1,##3 D1&,0$3
6* /I-. ,155 1,&1% 1&,0$3
'* Fei"hted avera"e ,301 1,$$2 1&,0$3
3alculations:
a* Endin" inventoryN-I-.:
200 D1&.20 8 D3,%0
30 1&.00 8 5$0
230 D,10
200 D1%.00 8 D 3,#00
250 1%.50 8 ,#25
220 1%.&0 8 ,15%
120 1&.00 8 2,2%0
$&0 D1,##3
6* Endin" inventoryN/I-.:
200 D1%.00 8 D3,#00
30 1%.50 8 555
230 D,155
220 D1%.50 8 D ,0$0
220 1%.&0 8 ,15%
150 1&.00 8 2,%50
200 1&.20 8 3,%0
$&0 D1,&1%
'* Ge"innin" inventory 200 D1%.00 8 D 3,#00
2ov. 250 1%.50 8 ,#25
2ov. 13 220 1%.&0 8 ,15%
2ov. 1% 150 1&.00 8 2,%50
2ov. 2 200 1&.20 8 3,%0
1,020 D1&,0$3
Fei"hted avera"e cost 8 D1&,0$3B1,020 8 D1%.#&&
Endin" inventory 8 230 D1%.#&& 8 D,301
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53-)
3ost of "oods sold 8 $&0 D1%.#&& 8 D1,$$2
53-+ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 53), 4Con'l&ded5
+* Wei%<ted
FIFO IFO Avera%e
Sales! D33,%0 D33,%0 D33,%0
3ost of "oods sold 1,##3 1,&1% 1,$$2
5ross profit D1%,%1$ D1%,5#2 D1%,$0%
.peratin" e*penses:
Sellin" and administrative
e*penses 10,%00 10,%00 10,%00
9epreciation ,000 ,000 ,000
Income before ta*es D ,01$ D 3,$#2 D 3,&0%
Income ta* e*pense 635C7 1,0# 1,31$ 1,3#%
2et income D 2,#11 D 2,5 D 2,50
!Sales 8 6300 D27 I 63%0 D2.507 I 6110 D37 8 D33,%0
,* .*endine pays the least ta*es under the last0in, first0out method, since it has the
hi"hest cost of "oods sold.
/. 5,#,$
PROBE! 53)- I"VE"TOR9 COSTI"G !ETHO#SEPERIO#IC S9STE!
)* a* Fei"hted avera"e:
Ge"innin" inventory 5,000 D10 8 D 50,000
-eb. 3,000 & 8 2$,000
+pril 12 ,000 % 8 32,000
Sept. 10 2,000 $ 8 1,000
9ec. 5 1,000 # 8 #,000
15,000 D12&,000
Fei"hted avera"e cost 8 D12&,000B15,000 8 D%.#0
'nits available for sale 15,000
'nits sold 12,500
Endin" inventory 2,500 D%.#0 8 D21,500
3ost of "oods sold 12,500 D%.#0 8 D10$,500
6* -I-.:
Endin" inventory 1,000 D # 8 D #,000
1,500 $ 8 10,500
2,500 D 1#,500
3ost of "oods sold 500 D $ 8 D 3,500
,000 % 8 32,000
3,000 & 8 2$,000
5,000 10 8 50,000
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53-,
12,500 D112,500
53-- -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 53)- 4Con'l&ded5
'* /I-.:
Endin" inventory 2,500 D10 8 D 25,000
3ost of "oods sold 2,500 D10 8 D 25,000
3,000 & 8 2$,000
,000 % 8 32,000
2,000 $ 8 1,000
1,000 # 8 #,000
12,500 D10,000
+* Income statements for the year ended 9ecember 31, 200$:
Wei%<ted
Avera%e FIFO IFO
Sales! D150,000 D150,000 D
150,000
3ost of "oods sold 10$,500 112,500 10,000
5ross mar"in D 2,500 D 3$,500 D #,000
.peratin" e*penses 20,000 20,000 20,000
Income before ta*es D 22,500 D 1$,500 D 2#,000
Income ta* e*pense 630C7 #,$50 5,250 $,%00
2et income D 15,$50 D 12,250 D 1%,200
!Sales 8 12,500 D12 8 D150,000
,* Feaver can minimi(e its ta* bill by usin" -I-.. In a period of declinin" prices, -I-.
results in the hi"hest amount of cost of "oods sold, the least amount of income
before ta*es, and thus the least amount of income ta* e*pense.
-* + company is not free to chan"e inventory methods from year to year to ta1e
advanta"e of chan"in" patterns in the level of prices. It must be able to Hustify any
chan"e in the method used on some basis other than savin" ta*es, such as a better
matchin" of costs with revenues.
/. 1,$,&
PROBE! 53)5 I"TERPRETI"G TRIB8"E CO!PA"9AS I"VE"TOR9
ACCO8"TI"G POIC9
)* 2ewsprint costs are comparable to raw materials in a manufacturin" company. +
newspaper company, however, does not 1eep an inventory of finished "oods. Its
newspapers either are sold within hours after bein" printed or become worthless if
not sold.
+* Some companies use more than one method to value different types of inventory.
4he methods should be chosen because they provide the most accurate matchin" of
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53-5
costs with the revenues "enerated. +pparently, /I-. provides the most accurate
matchin" of costs with revenue for 4ribune 3ompany)s newsprint.
53-. -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. $,&
PROBE! 53). I"TERPRETI"G SEARSA I"VE"TOR9 ACCO8"TI"G POIC9
)* 2o, the use of the last0in, first0out method for its domestic merchandise inventories
does not mean that Sears always sells its newest merchandise first in the 'nited
States. +ctually, the physical flow of merchandise in most stores li1e Sears is
normally on a first0in, first0out basis. <owever, the use of a cost flow assumption
such as /I-. or -I-. for accountin" purposes is independent of the actual physical
flow of products.
+* 2o, Sears uses the retail method to account for inventories in its stores. 4his is a
method that allows the company to convert its inventory from a retail value to a cost
basis for financial statement purposes.
ATER"ATE PROBE!S
/. 1
PROBE! 53)A I"VE"TOR9 COSTS I" VARIO8S B8SI"ESSES
)* 3lassification of an item as inventory depends on the company)s intent. 9@9s
offered by the company for resale should be classified as part of inventory and
char"ed to cost of "oods sold at the time they are sold. +lternatively, rental 9@9s
are income0producin" assets and should not be classified as inventory. 4hey should
be classified as current assets because it is unli1ely that any 9@9s will be 1ept as
rentals for more than one year.
+* Fhen 9@9s are transferred because they will be offered for resale, the asset
account 9@9 >entals would be credited, and the asset account 9@9 Inventory
would be debited.
/.
PROBE! 53+A CAC8ATIO" OF GROSS PROFIT FOR BEST B89 A"# CIRC8IT
CIT9
)* 5ross profit ratios 6dollar amounts in millions7:
Gest Guy: 2005: 6D2$,33 M D20,&3%7BD2$,33 8 D#,&5BD2$,33 8 23.$C
200: 6D2,5% M D1%,#$$7BD2,5% 8 D5,%$1BD2,5% 8 23.&C
3ircuit 3ity: 2005: 6D10,$2 M D$,&07BD10,$2 8 D2,5#%BD10,$2 8 2.5C
200: 6D&,%5$ M D$,5$37BD&,%5$ 8 D2,2%BD&,%5$ 8 23.2C
+* In terms of the "ross profit ratios, the two companies appear to be very similar. 4he
mi* of products sold by the two companies and the normal mar1ups on the various
products could certainly affect the ratios. + comparison with prior years and industry
avera"es would also be important to consider.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53-/
/. $
PROBE! 53,A EVA8ATIO" OF I"VE"TOR9 COSTI"G !ETHO#S
)* 2o, the three companies will not be eAually pleased with the decline in prices. If the
decline continues, 3ompany R 6-I-.7 will be"in to show lower "ross profit than
3ompany S 6/I-.7. Gecause "ross profit will be lower, 3ompany R will report lower
income before ta* and thus have less ta* to pay.
+* It should be noted that it is not acceptable for a company to chan"e inventory
valuation methods to save ta*es. +n acceptable e*planation of the Hustification for
the chan"e is this:
9urin" the year recently completed, the company chan"ed its method of valuin"
inventory on the balance sheet and reco"ni(in" cost of sales on the income
statement. 4he company chan"ed from the /I-. to -I-. method because it
believes that the latter results in a better matchin" of cost of sales with the
revenues of the period.
/. %
PROBE! 53-A I"VE"TOR9 ERROR
)* Revised in'o$e state$ents> +22/ +22.
>evenues D35,&%2 D2#,%&0
3ost of "oods sold! 12,0& 10,12
5ross profit D23,%%% D1#,$%
.peratin" e*penses 13,%% 10,5$%
2et income D10,00 D 5,&00
!Gecause endin" inventory in 200# was overstated, cost of "oods sold was
understated. Gecause be"innin" inventory in 200$ was overstated, cost of "oods
sold was overstated.
Revised 6alan'e s<eets> )+G,)G2/ )+G,)G2.
3ash D &,00 D ,100
Inventory ,500 ,&00
.ther current assets 1,#00 1,250
/on"0term assets, net 2,500 2,#00
4otal assets D0,000 D3,%50
3urrent liabilities D &,3%0 D10,#00
3apital stoc1 1%,000 1%,000
>etained earnin"s 12,#20 #,250
4otal liabilities and stoc1holders) eAuity D0,000 D3,%50
53-0 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 53-A 4Con'l&ded5
+* 3urrent ratio:
Before revision>
s liabilitie 3urrent
assets current .ther I Inventory I 3ash
D10,#00
D1,250 I D5,00 I D,100
8
D10,#00
D10,$50
8 1.01 to 1
After revision>
D10,#00
D1,250 I D,&00 I D,100
8
D10,#00
D10,250
8 0.&$ to 1
If the lender reAuired a current ratio of at least 1 to 1, =lanter would not be eli"ible
for the loan. <owever, the ban1 mi"ht not consider a current ratio of 0.&$ to 1 to be
materially different from a current ratio of 1 to 1 and mi"ht be willin" to "rant the
loan.
,* 2et income for two years, before revision: D#,00 I D&,&00 8 D1#,300.
2et income for two years, after revision: D5,&00 I D10,00 8 D1#,300.
4hus, there is no net over0 or understatement of net income for the two0year period.
>etained earnin"s at 9ecember 31, 200$, before the revision: D12,#20.
>etained earnin"s at 9ecember 31, 200$, after the revision: D12,#20.
4hus, there is no over0 or understatement of retained earnin"s at 9ecember 31,
200$.
-* Even thou"h the error counterbalances over the two0year period, it is still important
to restate the statements for the two years. It is important for comparative purposes
that the correct amount of net income be 1nown for each of the two years. 4he
company needs to restate the income statements for each of the two years and
restate the balance sheets at the end of each year.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53-1
/. 10
PROBE! 535A GROSS PROFIT !ETHO# OF ESTI!ATI"G I"VE"TOR9 OSSES
)* 4)5 2et sales D&3,500
Estimated "ross profit ratio 0.$0
Estimated "ross profit D#5,50
4+5 2et sales D&3,500
M Estimated "ross profit #5,50
Estimated cost of "oods sold D2%,050
4,5 Ge"innin" inventory D1,200
+dd: =urchases $$,000
3ost of "oods available for sale D&1,200
Estimated cost of "oods sold 2%,050
Estimate of inventory at time of e*plosion D#3,150
Inventory saved ,500
Estimate of inventory destroyed D5%,#50
+* 4o record insurance settlement from e*plosion.

$B1 3ash! 50,000 /oss on
Inventory 65%,#507 Insurance
Settlement 6%,#507
!>eceivable from Insurance 3ompany is increased instead of 3ash if cash has not yet
been received.
5352 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 11
PROBE! 53.A I"VE"TOR9 T8R"OVER FOR WA3!ART A"# TARGET
)* Inventory turnover ratios:
Wal3!art>
D21&,$&3BJ6D2&,$ I D2#,#127B2K 8 D21&,$&3BD2%,02&.5 8 $.% times
Tar%et>
D31,5BJ6D5,3% I D,5317B2K 8 D31,5BD,&5$.5 8 #.3 times
+* Fal0Mart)s inventory turnover is hi"her than 4ar"et)s durin" the most recent fiscal
year, $.% versus #.3. +nother factor to consider is the number of days) sales in
inventory:
Wal3!art>
3#0B$.% 8 5.& days
Tar%et>
3#0B#.3 8 5#.% days
It ta1es Fal0Mart an avera"e of # days to sell an item of inventory; 4ar"et reAuires
an avera"e of 5$ days. .n the basis of inventory turnover and days) sales in
inventory, Fal0Mart appears to be performin" sli"htly better.
It would be helpful to measure these statisticsNinventory turnover and days)
sales in inventory, alon" with the companies) "ross profit ratiosNwith the same
measures for prior years. It would also be helpful to compare these measures with
the industry avera"es.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 535)
/. 12
PROBE! 53/A EFFECTS OF CHA"GES I" I"VE"TOR9 A"# ACCO8"TS PA9ABE
BAA"CES O" STATE!E"T OF CASH FOWS
)* Statement of cash flows:
CARPETA"# CIT9
2et income D $%,500
+dHustments to reconcile net income to net cash
provided by operatin" activities:
Increase in inventory 6D105,500 M D%,&007 D620,#007
9ecrease in accounts payable
6D23,&00 M D&3,$007 6#&,%007 6&0,007
3ash flows from operatin" activities D611,&007
3ash, 9ecember 31, 200# 2#,300
3ash, 9ecember 31, 200$ D 1,00
+* Memorandum to the president:
4.: =resident of 3arpetland 3ity
9+4E: Oanuary 20, 200%
S'GOE34: 3ash -lows
Rou recently e*pressed concern about the decrease in the company)s cash
balance in spite of the profitable year that was reported on this year)s income
statement. My thou"hts and a copy of the company)s 200$ statement of cash flows
follow.
+lthou"h net income on an accrual basis was D$%,500, the company)s cash
balance declined by D11,&00 durin" the year for two reasons. Most importantly, the
amount owed to the company)s suppliers decreased by D#&,%00 durin" the year
from D&3,$00 to D23,&00; this decrease in accounts payable drained our cash
balance. In addition, the amount of inventory on hand increased by D20,#00 durin"
the year from D%,&00 to D105,500; this increase in inventory reAuired an additional
outflow of cash.
Fe can better mana"e our cash flow by carefully timin" the payment of bills to
coincide with the due dates on invoices. In addition, we can improve cash flow by
closely monitorin" our inventory levels and only addin" to inventory levels when
increases in sales warrant an addition.
535+ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
ATER"ATE !8TI 3 CO"CEPT PROBE!S
/. 2,3,12
PROBE! 530A P8RCHASES A"# SAES OF !ERCHA"#ISE, CASH FOWS
)* 4o record purchase of merchandise on account.

10B1 +ccounts =urchases 62&7
=ayable 2&
4o record payment on account: D2& 61 M .027 8 D2.

10B10 3ash 627 +ccounts =urchase 9iscounts 5
=ayable 62&7
4o record cash sale.

10B15 3ash 200 Sales >evenue 200
4o record purchase of merchandise on account.

10B1% +ccounts =urchases 6%007
=ayable %00
4o record cash sales: 3 D200.

10B25 3ash #00 Sales >evenue #00
4o record payment on account.

10B30 3ash 6%007 +ccounts
=ayable 6%007
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 535,
535- -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 530A 4Con'l&ded5
+* 'nits on hand on .ctober 31:
.ctober 1 purchase 3 units
.ctober 15 sale 617
.ctober 1% purchase 10
.ctober 25 sale 637
Endin" inventory & units
,* 3ash balance at end of month:
Ge"innin" cash balance D2,000
.ctober 10 payment 627
.ctober 15 sale 200
.ctober 25 sale #00
.ctober 30 payment 6%007
3ash balance at end of month D1,$5#
4he cash balance decreased durin" the month even thou"h the company reported a
profit because cash outflows e*ceeded e*penses. 4his was the case because the
entire inventory purchased 6and paid for7 was not yet sold 6e*pensed7.
/. 2,3,
PROBE! 531A WAGREE"AS SAES, COST OF GOO#S SO#, A"# GROSS
PROFIT
)* 4he effect of sales and the collection of accounts receivable durin" 200 on the
accountin" eAuation for Fal"reen 3o. is 6in millions7:

+ccounts >eceivable 3$,50%.2 Sales 3$,50%.2
3ash 3$,35#.&!
+ccounts >eceivable 63$,35#.&7
!1,01$.% I 3$,50%.2 M 1,1#&.1
+* Fal"reen 3o. would deduct sales returns and allowances, and the amount of any
sales discounts ta1en by its customers from sales, to arrive at the amount of net
sales reported on its income statement. Either because they do not feel the amounts
are material enou"h or they would rather not divul"e information about returns and
allowances to competitors, some companies choose not to separately report them.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 5355
PROBE! 531A 4Con'l&ded5
,* 3ost of "oods sold section of 200 income statement 6in millions7:
Merchandise inventory, +u"ust 31, 2003 D ,202.$
3ost of "oods purchased 2$,%# .3 627
3ost of "oods available for sale D32,0&.0 617
/ess merchandise inventory, +u"ust 31, 200 6,$3% .#7
3ost of "oods sold D2$,310 .
617 D2$,310. I D,$3%.# 8 D32,0&.0.
627 D32,0&.0 M D,202.$ 8 D2$,%#.3.
-* 5ross profit ratios:
4In $illions5 +22- +22,
2et sales D 3$,50%.2 D 32,505.
3ost of sales 2$,310. 23,$0#.2
5ross profit D 10,1&$.% D %,$&&.2
9ivided by net sales Q 3$,50%.2 Q 32,505.
5ross profit ratio 2$.2C 2$.1C
Fal"reen)s "ross profit ratio was virtually unchan"ed from 2003 to 200. -actors
affectin" Fal"reen)s "ross profit ratio include chan"es in the sellin" prices of
merchandise, chan"es in the cost of "oods purchased, andBor chan"es in the mi* of
merchandise sold 6that is, a sli"ht shift from sellin" products that have hi"her "ross
profit ratios to sellin" those with lower "ross profit ratios7.
/. 2,3
PROBE! 53)2A FI"A"CIA STATE!E"TS
)* 3ost of "oods sold for 200$:
Ge"innin" inventory D #,00
=urchases D#2,%5
/ess: =urchase discounts 1,23$
2et purchases D#1,#0%
+dd: 4ransportation0in 3$5
3ost of "oods purchased #1,&%3
3ost of "oods available for sale D#%,3%3
/ess: Endin" inventory 5,&00
3ost of "oods sold D #2,%3
535. -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 53)2A 4Con'l&ded5
+* 2et income for 200$:
Sales D112,$#%
/ess: Sales returns 1,00%
2et sales D111,$#0
3ost of "oods sold Jfrom part 617K #2,%3
5ross profit D &,2$$
.peratin" e*penses:
Fa"es and salaries e*pense D 23,000
+dvertisin" e*pense 12,&00
'tilities e*pense 1,%00
4otal operatin" e*penses 3$,$00
Income before ta* D 11,5$$
Income ta* e*pense 1,50
2et income D 10,12$
,* O9# I"C*
BAA"CE SHEET
AT #ECE!BER ,), +22/
Assets
3ash D22,30
+ccounts receivable 5#,35&
Inventory 5,&00
4otal assets D %,5&&
ia6ilities
Salaries payable D #50
Fa"es payable 120
Income ta* payable 1,50
4otal liabilities D 2,220
Sto';<oldersA EB&it=
3apital stoc1 D50,000
>etained earnin"s 32,3$&!
4otal stoc1holders) eAuity %2,3$&
4otal liabilities and stoc1holders) eAuity D %,5&&
!Ge"innin" retained earnin"s I 2et income M 9ividends
D2%,252 I D10,12$ M D#,000
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 535/
/. 5,#,$
PROBE! 53))A CO!PARISO" OF I"VE"TOR9 COSTI"G !ETHO#SE
PERIO#IC S9STE!
)* Cost of Endin%
a* Fei"hted avera"e D5,120 D,#55 D&,$$5
6* -I-. ,%$5 ,&00 &,$$5
'* /I-. 5,3$5 ,00 &,$$5
3alculations:
a* Ge"innin" inventory 300 D.00 8 D1,200
2ov. % 500 .50 8 2,250
2ov. 1% $00 .$5 8 3,325
2ov. 2& #00 5.00 8 3,000
2,100 D&,$$5
Fei"hted avera"e cost 8 D&,$$5B2,100 8 D.#55
'nits sold: 200 I 500 I 00 8 1,100 units
'nits available M units sold 8 endin" inventory
2,100 M 1,100 8 1,000 units
Endin" inventory 8 1,000 D.#55 8 D,#55
3ost of "oods sold 8 1,100 D.#55 8 D5,120!
!>ounded to a"ree with total cost.
6* Endin" inventoryN-I-.:
#00 D5.00 8 D3,000
00 .$5 8 1,&00
1,000 D,&00
300 D.00 8 D1,200
500 .50 8 2,250
300 .$5 8 1,25
1,100 D,%$5
'* Endin" inventoryN/I-.:
300 D.00 8 D1,200
500 .50 8 2,250
200 .$5 8 &50
1,000 D,00
#00 D5.00 8 D3,000
500 .$5 8 2,3$5
5350 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
1,100 D5,3$5
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 5351
PROBE! 53))A 4Con'l&ded5
e*pense, cost of "oods sold on the income statement. In accountin", the pool of
,* Income statements for the month of 2ovember:
Wei%<ted
Avera%e FIFO IFO
Sales! D10,100 D10,100 D10,100
3ost of "oods sold 5,120 ,%$5 5,3$5
5ross mar"in D ,&%0 D 5,225 D ,$25
.peratin" e*penses 2,000 2,000 2,000
Income before ta*es D 2,&%0 D 3,225 D 2,$25
Income ta* e*pense 625C7 $5 %0# #%1
2et income D 2,235 D 2,1& D 2,0
!Sales 8 2006D&7 I 5006D&7 I 006D&.507 8 D10,100
-I-. ta* D%0#
/I-. ta* #%1
9ifference D125
/. 5,$,13
PROBE! 53)+A CO!PARISO" OF I"VE"TOR9 COSTI"G !ETHO#SE
PERPET8A S9STE! 4ADDendi(5
)* Cost of Endin%
a* Movin" avera"e D,%&2 D,%%3 D&,$$5
6* -I-. ,%$5 ,&00 &,$$5
'* /I-. ,&50 ,%25 &,$$5
53.2 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
PROBE! 53)+A 4Contin&ed5
a* Movin" avera"e:
11B1 300 D D1,200
11B 200 D D %00 100 00
11B% 500 D.50 D2,250 #00 .1$
)
2,#50
11B& 500 .1$ 2,20& 100 .1$ 1
11B1% $00 .$5 3,325 %00 .$0%
+
3,$##
11B20 00 .$0% 1,%%3 00 .$0% 1,%%3
11B2& #00 5.00 3,000 1,000 .%%3
,
D,%%3
3ost of "oods sold D,%&2 Endin" inventory
+ll amounts rounded to a"ree with total cost.
)*
100 E D.00 8 D 00
500 E .50 8 2,250
#00 D2,#50; D2,#50B#00 8 D.1$
+*
100 E D.1$ 8 D 1
$00 E .$5 8 3,325
%00 D3,$##; D3,$##B%00 8 D.$0%
,*
00 E D.$0% 8 D1,%%3
#00 E 5.00 8 3,000
1,000 D,%%3; D,%%3B1,000 8 D.%%3
6* -I-.:
11B1 300 D D1,200
11B 200 D D %00 100 00
11B% 500 D.50 D2,250 100
500 .50 2,#50
11B& 100 00
00 .50 1,%00 100 .50 50
11B1% $00 .$5 3,325 100 .50
$00 .$5 3,$$5
11B20 100 .50 50
300 .$5 1,25 00 .$5 1,&00
11B2& #00 5.00 3,000 00 .$5
#00 5.00 D,&00
3ost of "oods sold D,%$5 Endin" inventory
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53.)
PROBE! 53)+A 4Con'l&ded5
'* /I-.:
11B1 300 D D1,200
11B 200 D D %00 100 00
11B% 500 D.50 D2,250 100
500 .50 2,#50
11B& 500 .50 2,250 100 00
11B1% $00 .$5 3,325 100
$00 .$5 3,$25
11B20 00 .$5 1,&00 100
300 .$5 1,%25
11B2& #00 5.00 3,000 100
300 .$5
#00 5 D,%25
3ost of "oods sold D,&50 Endin" inventory
e*pense, cost of "oods sold on the income statement. In accountin", this pool of
,* Income statements for the month of 2ovember:
!ovin%
Avera%e FIFO IFO
Sales! D10,100 D10,100 D10,100
3ost of "oods sold ,%&2 ,%$5 ,&50
5ross mar"in D 5,20% D 5,225 D 5,150
.peratin" e*penses 2,000 2,000 2,000
Income before ta*es D 3,20% D 3,225 D 3,150
Income ta* e*pense 625C7 %02 %0# $%%
2et income D 2,0# D 2,1& D 2,3#2
!Sales 8 2006D&7 I 5006D&7 I 006D&.507 8 D10,100
-* 4he company will pay D1% more in ta*es if it uses -I-.:
-I-. ta* D%0#
/I-. ta* $%%
9ifference D 1%
53.+ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 5,#,$
PROBE! 53),A I"VE"TOR9 COSTI"G !ETHO#SEPERIO#IC S9STE!
)* 'nits in be"innin" inventory 300
+dd: 'nits purchased 63$5 I 330 I 225 I 3007 1,230
/ess: 'nits sold 650 I 5$0 I 1#57 1,1%5
Endin% Cost of
Inventor= Goods Sold Total
a* -I-. D%,#3 D31,1&0 D3&,%33
6* /I-. &,2&3 30,50 3&,%33
'* Fei"hted avera"e %,&%2 30,%51 3&,%33
3alculations:
a* Endin" inventoryN-I-.:
300 D25.00 8 D$,500
5 25.0 8 1,13
35 D%,#3
300 D2$.00 8 D %,100
3$5 2#.50 8 &,&3%
330 2#.00 8 %,5%0
1%0 25.0 8 ,5$2
1,1%5 D31,1&0
6* Endin" inventoryN/I-.:
300 D2$.00 8 D%,100
5 2#.50 8 1,1&3
35 D&,2&3
300 D25.00 8 D $,500
225 25.0 8 5,$15
330 2#.00 8 %,5%0
330 2#.50 8 %,$5
1,1%5 D30,50
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53.,
PROBE! 53),A 4Con'l&ded5
'* Ge"innin" inventory 300 D2$.00 8 D %,100
2ov. 3$5 2#.50 8 &,&3%
2ov. 13 330 2#.00 8 %,5%0
2ov. 1% 225 25.0 8 5,$15
2ov. 2 300 25.00 8 $,500
1,530 D3&,%33
Fei"hted avera"e cost 8 D3&,%33B1,530 8 D2#.035
Endin" inventory 8 units in endin" inventory avera"e cost 8 35 E D2#.035 8
D%,&%2
3ost of "oods sold 8 units sold avera"e cost 8 1,1%5 D2#.035 8 D30,%51
+* Wei%<ted
FIFO IFO Avera%e
Sales! D$5,330 D$5,330 D$5,330
3ost of "oods sold 31,1&0 30,50 30,%51
5ross profit D,10 D,$&0 D,$&
.peratin" e*penses:
Sellin" and administrative
e*penses 1#,200 1#,200 1#,200
9epreciation #,000 #,000 #,000
Income before ta*es D21,&0 D22,5&0 D22,2$&
Income ta* e*pense 635C7 $,#$& $,&0$ $,$&%
2et income D1,2#1 D1,#%3 D1,%1
!Sales 8 650 E D#37 I 65$0 E D#3.$57 I 61#5 E D#.507 8 D$5,330
,* Story pays the least ta*es under the first0in, first0out method, since it has the hi"hest
cost of "oods sold.
/. 5,#,$
PROBE! 53)-A I"VE"TOR9 COSTI"G !ETHO#SEPERIO#IC S9STE!
)* a* Fei"hted avera"e:
Ge"innin" inventory ,000 D20 8 D %0,000
-eb. 2,000 1% 8 3#,000
+pr. 12 3,000 1# 8 %,000
Sept. 10 1,000 1 8 1,000
9ec. 5 2,500 12 8 30,000
12,500 D20%,000
Fei"hted avera"e cost 8 D20%,000B12,500 8 D1#.#
'nits available for sale 12,500
'nits sold 11,000
Endin" inventory 1,500 D1#.# 8 D 2,&#0
53.- -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
3ost of "oods sold 11,000 D1#.# 8 D1%3,00
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53.5
PROBE! 53)-A 4Con'l&ded5
6* -I-.:
Endin" inventory 1,500 D12 8 D 1%,000
3ost of "oods sold ,000 D20 8 D %0,000
2,000 1% 8 3#,000
3,000 1# 8 %,000
1,000 1 8 1,000
1,000 12 8 12,000
11,000 D1&0,000
'* /I-.:
Endin" inventory 1,500 D20 8 D 30,000
3ost of "oods sold 2,500 D12 8 D 30,000
1,000 1 8 1,000
3,000 1# 8 %,000
2,000 1% 8 3#,000
2,500 20 8 50,000
11,000 D1$%,000
+* Income statements for the year ended 9ecember 31, 200$:
Wei%<ted
Avera%e FIFO IFO
Sales! D330,000 D330,000 D330,000
3ost of "oods sold 1%3,00 1&0,000 1$%,000
5ross profit D1#,&#0 D10,000 D152,000
.peratin" e*penses #0,000 #0,000 #0,000
Income before ta*es D %#,&#0 D %0,000 D &2,000
Income ta* e*pense 630C7 2#,0%% 2,000 2$,#00
2et income D #0,%$2 D 5#,000 D #,00
!Sales 8 11,000 D30 8 D330,000
,* -ees can minimi(e its ta* bill by usin" -I-.. In a period of declinin" prices, -I-.
results in the hi"hest cost of "oods sold, the least amount of income before ta*es,
and thus the least amount of income ta* e*pense.
-* + company is not free to chan"e inventory methods from year to year to ta1e
advanta"e of chan"in" patterns in the level of prices. It must be able to Hustify any
chan"e in the method used on some basis other than savin" ta*es, such as a better
matchin" of costs with revenues.
53.. -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. 1,$,&
PROBE! 53)5A I"TERPRETI"G THE "EW 9ORF TI!ES CO!PA"9AS
FI"A"CIA STATE!E"TS
)* 4he company carries two types of inventory: newsprint and other. 4hese costs are
comparable to raw materials in a manufacturin" company. + newspaper company,
however, does not 1eep an inventory of finished "oods. Its newspapers either are
sold within hours after bein" printed or become worthless if not sold.
+* Some companies use different methods to value different types of inventory. 4he
methods should be chosen because they provide the most accurate matchin" of
costs with the revenues "enerated. +pparently, /I-. provides the most accurate
matchin" of costs with revenue for the company)s newsprint.
/. $,&
PROBE! 53).A I"TERPRETI"G HO!E #EPOTAS FI"A"CIA STATE!E"TS
)* 2o, the use of the first0in, first0out inventory method does not mean that a company
always sells its oldest merchandise first. +lthou"h the physical flow in many
businesses is on a first0in first0out basis, the use of a cost flow assumption such as
-I-. for accountin" purposes is independent of the actual physical flow of products.
In fact, some businesses do use a /I-. 6last0in, first0out7 assumption even thou"h
the physical flow is on a first0in, first0out basis.
+* 2o, <ome 9epot states in its note that it uses the retail inventory method to account
for inventories in its stores. 4his is a method that allows a company to convert its
inventory from a retail value to a cost basis for financial statement purposes.
#ECI SI O" CASES
REA#I"G A"# I"TERPRETI"G FI"A"CIA STATE!E"TS
/. 1,3
#ECISIO" CASE 53) CO!PARI"G TWO CO!PA"IES I" THE SA!E I"#8STR9>
FI"ISH I"E A"# FOOT OCFER
)* Goth -inish /ine and -oot /oc1er are merchandisers.
+* -inish /ine reports TMerchandise inventories, netU on its -ebruary 25, 200#, balance
sheet of D2#%,5&0,000 and they account for D2#%,5&0,000BD#2$,%1#,000, or 2.%C
of total assets. -oot /oc1er)s TMerchandise inventoriesU at Oanuary 2%, 200#,
amount to D1,25,000,000, which represents D1,25,000,000BD3,312,000,000, or
3$.&C of total assets.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53./
#ECISIO" CASE 53) 4Con'l&ded5
,* +ccordin" to 2ote 1, -inish /ine uses the wei"hted avera"e cost method to value
inventories. 4he company indicates that this appro*imates the first0in, first0out
method. 4he wei"hted avera"e method is relatively easy to use.
-* +ccordin" to 2ote 1, -oot /oc1er uses /I-. for domestic inventories and -I-. for
international inventories. 4he inventories of the company)s 9irect0to03ustomers
business are valued usin" the wei"hted avera"e method, which appro*imates
-I-.. It is not unusual for companies in the same industry to use different methods,
and it is helpful in tryin" to compare the companies to be aware of this fact.
5* Gecause companies usually do not disclose in their annual report which inventory
system they use, it is not possible to 1now for certain whether they use periodic or
perpetual. 4he ability of merchandisers to use the perpetual system has certainly
improved with advances in technolo"y, such as the advent of point0of0sale
terminals.
/. $
#ECISIO" CASE 53+ REA#I"G A"# I"TERPRETI"G H*C*PE""E9AS FI"A"CIA
STATE!E"TS
)* O.3.=enney uses /I-.. + business should employ the method that most accurately
matches inventory costs with the revenues of the period. O.3.=enney may use /I-.
because prices chan"e freAuently, and it wants to match the most recent costs with
revenues "enerated in the current period.
+* 4he /I-. reserve is D25 million at year0end 200 and D3 million at year0end 2003.
,* 4he /I-. reserve decreased durin" 200, from D3 million to D25 million, or D1%
million. 4he reserve decreases because inventory costs are decreasin" and cost of
"oods sold on a /I-. basis is less than cost of "oods sold on a -I-. basis. 4hus, a
decrease in the reserve durin" a period indicates that prices are fallin".
/. 1,#,&
#ECISIO" CASE 53, REA#I"G A"# I"TERPRETI"G CIRC8IT CIT9AS
I"VE"TOR9 "OTE
)* 3ircuit 3ity uses the avera"e cost method. 5iven the lar"e volume of consumer
electronics products sold by 3ircuit 3ity, the avera"e cost method seems
appropriate.
+* 4he company defines Tmar1etU as estimated reali(able value. In estimatin" mar1et
value, the company considers such factors as forecasted consumer demand, mar1et
conditions, and obsolescence.
53.0 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
#ECISIO" CASE 53, 4Con'l&ded5
,* 4he company includes the statement about the possibility of bein" e*posed to
losses in e*cess of amounts recorded as a way to alert the statement reader that if
various factors result in a decline in the value of its inventory the company would
need to write it down and reco"ni(e a loss.
!AFI"G FI"A"CIA #ECISIO"S
/. 2,3,
#ECISIO" CASE 53- GROSS PROFIT FOR A !ERCHA"#ISER
)* +ccordin" to the income statement prepared by the controller, Emblems) "ross profit
ratio is D#,$50BD15,000, or 5C.
+* Emblems should not lower its sellin" price. .n the surface, it appears that it should,
"iven that the industry standard for "ross mar"in is 0C. Emblems) real "ross profit,
however, is not 5C. 4he reason is that the controller failed to include two important
product costs in cost of sales: shippin" and labelin". In error, the controller is
e*pensin" all shippin" and labelin" costs as incurred, rather than treatin" them as
product costs. 4he correct "ross profit is as follows:
Sellin" price D 20.00 per unit
3osts per unit:
=urchase price D10.00
4a* 610C7 1.00
Shippin" 0.50
/abelin" 0.$5
4otal cost per unit 12.25
5ross profit per unit D $.$5
2umber of units sold $50
5ross profit D5,%12.50
4hus, the correct "ross profit ratio is D5,%12.50BD15,000, or 3%.$5C. .n the basis of
this new ratio, Emblems is sli"htly under the industry standard of 0C, and it should
not lower its sellin" price.
/. 2,3,
#ECISIO" CASE 535 PRICI"G #ECISIO"
)* 3ost per pound D5.00
+dd: Sales ta* 65C D5.007 0.25
5ross cost D5.25
/ess: =urchase discount 62C 5.257 0.11
2et cost D5.1
+dd: Shippin" 0.05
Go* 0.$0
4otal cost D5.%&
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53.1
#ECISIO" CASE 535 4Con'l&ded5
+* Sellin" price M D5.%& 8 0C 6sellin" price7
#0C 6sellin" price7 8 D5.%&
Sellin" price 8 D&.%2
,* Gefore decidin" whether this is a sufficient profit, 3aroline)s 3andy should chec1
industry avera"es and the price its local competition is char"in". If the price char"ed
is too much hi"her than that of the competition, even if its product is superior,
3aroline)s may not "enerate as many sales as it needs to cover other costs, such as
wa"es and commissions for employees, rent, utilities, insurance, advertisin", and a
return on owners) investment. If its prices are much lower than that of the
competition, it may not be "eneratin" as much profit as it reasonably could.
/. 3
#ECISIO" CASE 53. 8SE OF A PERPET8A I"VE"TOR9 S9STE!
)* !e$o to #arrell>
4he purpose of this memo is to clarify for you the costs and benefits of a perpetual
inventory system. 4he purpose of a perpetual system is to provide a continuously
updated record of the number of units and cost of all inventory items. + perpetual
system is more costly to maintain because of the need to update the records each
time purchases and sales are made. It is li1ely that you will want to consider a
computeri(ed inventory system. 2umerous software pac1a"es are available, and
one should be chosen that is particularly suitable to your business.
+s mentioned earlier, a perpetual inventory system is considerably more costly to
implement and maintain than a periodic system. + perpetual system would involve
an investment in a scannin" device and the other necessary hardware and software.
4he ne*t step would be to e*plore the options available to us and the cost of each.
=lease call me at your convenience to set up an appointment to discuss these
matters further.
+* 4he suitability of a perpetual inventory system is certainly dependent on the type of
products a company sells. 4he system is ideally suited to a product such as
automobiles, since there is a relatively low volume of sales. .n the other hand, it
mi"ht not be well suited to the needs of a landscaper sellin" trees, shrubs, and
plants. 4he turnover of products is very hi"h, and it may not be practical to update
the records each time a sale ta1es place.
53/2 -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. #,$
#ECISIO" CASE 53/ I"VE"TOR9 COSTI"G !ETHO#S
)* 5eor"etown must use the periodic inventory system at least for the first year
because it did not 1eep a record of the cost of the units sold as each sale was made.
+* 'nits on hand at the end of the year:
Oanuary 1,000
March 1,200
.ctober 1,500
+vailable 3,$00
Sold 3,000
.n hand $00
,* 'nless a company specifically identifies the cost of each unit sold, it must adopt an
assumption about which particular units were sold. Each of the inventory costin"
methods ta1es the pool of costs 6cost of "oods available for sale7 and ma1es an
assumption about which units were sold and which units remain on hand.
Gecause inventory costs have increased durin" the first year, the company could
minimi(e ta*es paid by adoptin" /I-.. + comparison of partial income statements
with the use of -I-. and /I-. hi"hli"hts the ta*es that could be saved in the first
year:
FIFO IFO
Sales revenue! D5,000 D5,000
3ost of "oods sold!! 2,%00 25,500
5ross profit D20,200 D1&,500
!3,000 units sold at D15 each.
!! 1,000 D% 8 D %,000
1,200 % 8 &,#00
1,500 & 8 13,500
+vailable 3,$00 D31,100
Endin" inventory:
-I-. $00 D& 8 D#,300
/I-. $00 D% 8 D5,#00
3ost of "oods sold:
-I-. D31,100 M D#,300 8 D2,%00
/I-. D31,100 M D5,#00 8 D25,500
Con'l&sion> +ll e*penses other than cost of "oods sold are not affected by the use
of one inventory method rather than another. 4hus, the lower "ross profit with the
use of the /I-. method will result in income before ta*es that is D20,200 M
D1&,500, or D$00 less than if -I-. was used. Gecause the e*pected ta* rate is
35C, the company will save D$00 E 0.35, or D25, by usin" /I-..
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53/)
/. %
#ECISIO" CASE 530 I"VE"TOR9 ERRORS
4he first error resulted in an overstatement of the endin" inventory in 2005 by D5,#00.
4hus, cost of "oods sold in 2005 was understated, and "ross profit was overstated by
the same amount. 4he effect on net income would be less than the amount of
overstatement of "ross profit because of the effect of ta*es.
4he second error was the result of not applyin" the lower0of0cost0or0mar1et rule to
the inventory at the end of 200#. If the cost of certain inventory was D#,000 hi"her than
its replacement cost, the inventory should have been written down and a loss
reco"ni(ed.
4he error that was made in the second Auarter of the current year can be corrected
before the release of the 200$ financial statements. 4he company should e*plain the
nature of the error in the annual report: that an understatement of inventory at the end
of the second Auarter led to an understatement of the income reported in that Auarter.
4he first two errors, if material in amount, reAuire a restatement of the financial
statements of the years involved.
ETHICA #ECISIO" !AFI"G
/. 2
#ECISIO" CASE 531 SAES RET8R"S A"# AOWA"CES
)* 4he sales mana"er is interested in reportin" the ma*imum amount of sales.
+lthou"h the net amount of sales will be the same re"ardless of whether returns are
recorded separately or simply netted a"ainst sales revenue, the mana"er would
prefer not to call attention to the level of returns. It is unli1ely that the mana"er truly
feels the present practice is a waste of time.
+* 4he sales mana"er)s recommendation mi"ht save a small amount of boo11eepin"
time, but at the same time it would sacrifice certain information. Mana"ement needs
to be aware of unreasonably hi"h levels of returns of merchandise so that it can
ma1e whatever adHustments are necessary. If Sales >evenue is simply reduced for
the amount of returns, this information will not be available.
,* !e$o to t<e sales $ana%er>
I received your su""estion that we save time and effort by treatin" sales returns as a
direct reduction of sales rather than a separate item in our financial statements. I
appreciate your interest in savin" the company money, but we would lose valuable
information by not trac1in" sales returns. It is imperative that we 1now whether our
customers are satisfied with their purchases, and separate accountin" reco"nition
for sales returns is an important control feature in this respect. =lease call me if I can
answer any Auestions you mi"ht have concernin" this matter.
53/+ -I2+23I+/ +33.'24I25 S./'4I.2S M+2'+/
/. $
#ECISIO" CASE 53)2 SEECTIO" OF A" I"VE"TOR9 !ETHO#
)* 4he 3E. is primarily concerned with reportin" the hi"hest amount of income
possible. 4hus, the 3E. will be satisfied if the company uses the -I-. method. 4his
method reco"ni(es as cost of "oods sold the oldest costs, and because prices are
risin", the costs char"ed to cost of "oods sold will be less than if /I-. is used.
+* It would be difficult to state definitively which method is truly in the best interests of
the stoc1holders. 4he /I-. method minimi(es the amount of income ta*es paid in
the first year, since this method would report the hi"hest cost of "oods sold and thus
the lowest income before ta*es. -rom a cash flow perspective, /I-. is the most
advanta"eous method in a period of risin" prices.
,* !e$o to t<e CEO>
4.: 3E.
9+4E: 12B31BLL
S'GOE34: Inventory methods
+s we end our first year of operations, I am aware of the need to present a favorable
impression to our stoc1holders. In this re"ard, I would li1e to address the selection of
an inventory valuation method.
I can appreciate your interest in ma*imi(in" income whenever possible.
<owever, a method of inventory valuation that addresses this obHective will not
necessarily satisfy our other concerns. 3ertainly, one of our primary concerns should
be to minimi(e the payment of ta*es whenever possible.
Gecause our inventory purchase costs are risin", -I-. will result in the lowest
amount reported as cost of "oods sold and thus an income number that is hi"her
than if /I-. was used. -or this reason, however, the use of -I-. will result in a
hi"her amount of ta*es payable than if /I-. was used. It is my opinion that we
should attempt to conserve cash whenever possible, and thus I believe we should
adopt the /I-. method of inventory valuation.
4han1 you for the opportunity to present my views on this important matter.
=lease call if I can be of any further assistance.
/. &
#ECISIO" CASE 53)) WRITE3#OW" OF OBSOETE I"VE"TOR9
)* 4he write0off of the inventory that has become obsolete would reduce the current
year)s income. 4he amount of the reduction depends on the e*tent of the write0off. If
the inventory is written off completely, the reduction in income will be eAual to the
boo1 value of the inventory. If the inventory is written down to a lower amount, net
income will be reduced by the amount of the write0down. 4his analysis i"nores the
effect of ta*es.
3<+=4E> 5 ? I2@E24.>IES +29 3.S4 .- 5..9S S./9 53/,
#ECISIO" CASE 53)) 4Con'l&ded5
+* If the inventory is not adHusted, total assets on the year0end balance sheet will be
overstated.
,* 4he materiality of the obsolete inventory should be a maHor factor in a decision to
persist in the ar"ument that the inventory be written down. If the inventory in
Auestion is not material relative to the total assets of the company, the write0down
may be unnecessary. 4he materiality of the loss that would be reco"ni(ed from the
write0down, relative to the income of the period, should also be considered.
-* If the inventory is not written down, readers do not have reliable information. 'nder
the lower0of0cost0or0mar1et rule, readers assume that if inventory is worth less than
its cost, the inventory has in fact been written down to this lower amount.
REA WOR# PRACTICE 5*)
Gecause companies usually do not disclose in their annual report which inventory
system they use, it is not possible to 1now for certain whether -inish /ine uses periodic
or perpetual. 4he ability of merchandisers to use the perpetual system has certainly
improved with advances in technolo"y, such as the advent of point0of0sale terminals.
REA WOR# PRACTICE 5*+
-inish /ine is a lar"e merchandiser of athletic footwear and other apparel. 4he nature of
this business reAuires the company to continually monitor its inventory for obsolete
products. If mar1et is less than cost, the company should write down the inventory to
reflect mar1et value. 4he company uses the wei"hted avera"e method for determinin"
cost.

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CHAPTER 5

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