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When you are finished studying this chapter, you should be able to: l. Calculate and record the purchaseand sale of inventory. 2. Explain the two methods of inventory record keeping. 3" Define and calculate inventory using the four major inventory cost flow assumptions and explain how thesemethods affect the financial statements. 4. Analyze transactionsand preparefinancial statementswith the purchaseand sale of inventory. 5, Explain the lower-of-cost-or-marketrule for valuing inventory. 6. Define and calculate the gross profit ratio and the inventory turnover ratio. 7" Describe the risks associatedwith inventory and the controls that minimize those risks. S. (Appendix 5A) Describe and calculate the effect of inventory errors on the financial statements. 9" (Appendix 5B) Estimate inventory using the gross profit method.

209

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from inventory theft. Individual firms Firmslosebillionsof dollars will Target, and Costco, not talk about the suchasBloomingdale's, gathersthe but the NationalRetailFederation numberspublicly, The bad news is that employee data from hundredsof retailers. for theft accounts almosthalf of the over $30 billionannuallosses of from the disappearance inventory. What doesthat mean for a firm? PrestonTurco,the owner of grocerystoresin New York, uses elaboratesecurityin his storestwo specialty hidden cameras, store despecialfraud detection software for cashregisters, tectives, and an employee handprint identification device to clock his in employees and out, He has some other adviceabout reducinginventory theft: Hire and keep a happyand loyalstaff. Theywere Jeff Skilling, and BernieEbbers. We haveall readabout Ken Lay, at the very top level of managementat the firms they looted. But very few of higherpricetagsfor lower ones us havereadabout the deli clerkwho switched to and tried to bribe a cashier look the other way.That clerkis now in prison, of accordingto Mr. Turco.lt turns out that ethicsmatter at all levels a business.

[,"{}.1 Calculate record and the purchase sale and of inventory,

Merchandise Acquiring Selling and

An OperatingCycle
The operatingcycle for a merchandisingfirm is a seriesofbusiness activities that describes how a company takes cash and turns it into more cash.Exhibit 5.1 showsthe operating cycle for a typical merchandisingfirm. For example, Target starts with cash,buys inventory, sells that inventory to customers,often creating accountsreceivable,and then collects the cashfrom the customers.A firm's goal is to end up with more cash than it startedwith. For Target'snet income for the fiscal year endedJanuary31,2005, was over $3.1 bilexample, lion, and the firm generatedover $3.8 billion ofnet cashfrom operating activities. It was a very good year for Target.

for Merchandise Sale Acquiring

Now that you know about the operating cycle of a business,we will focus on the activity of purchasingthe inventory. Acquiring goods to sell is an important activity for merchandising firms. Stroll down the aisle of Staplesor Office Max and imagine keeping track of all that merchandise.All goods owned and held for sale in the regular course of businessare consideredmerchandiseinventory. In contrast, supplies and equipment are used by most firms rather than sold by thosefirms, in which casethey would not be consideredinventory. Only the items a firm sells are consideredinventory.Most large corporationshavelarge purchasing departmentsdedicatedexclusively to acquiring inventory. Regardlessof their size, firms must keep meticulous track of their inventory purchasesthrough their information systems.An information system refers to the way the firm records and reports its transactions, including inventory and sales. A merchandisingfirm records the inventory as a current assetuntil it is sold. Accordin ing to the matching principle, inventory should be expensed the period in which it is sold. So when it is sold, inventory becomesan expense-cost of goods sold. The salesof particular goodsand the cost of those goods sold during the period are matched-put on the same You can seethat the value of the inventory affects both the balancesheet income statement. and the income statement.Does the value of inventory matter? On its February 28,2004, balance sheet,Best Buy had over $2.6 billion worth of inventory, making up over 30Voof That is a signifrcant amount of the frrm's assets. the company's total assets.

C H A P T E5 . A C Q U I R I N G N D S E L L I N G E R C H A N D I S E R A M

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x His g T . s 5
An Operating Cycle
This diagram shows a typical operating cycle of a merchandising firm. The firm begins with cash, then it purchasesinventory, sells the inventory, and ends with the collection of cash.

1. Cash

2. Inventory

3. SaIe

We will look at the proceduresfor acquiring inventory and then focus on how to do the related record keeping.

Acquisition Process Inventory for

The processof acquiring inventory begins when someonein a firm decidesto order merchandisefor the inventory. The person requestingthe purchasesendsa document,called a purchaserequisition, to the company's purchasingagent.For example, supposethat Office Depot needsto order paper.The managerof the appropriatedepartmentwould submit a purchaserequisition in either hard copy or electronic form to the purchasing agent. The purchasing agent selectsa vendor to provide the paper,basedon the vendor's prices, quality of goods or servicesneeded,and the ability to deliver them in a timely manner.The purchasing agent specifiesin a purchase order-a record of the company's requestto a vendor for goods or services-what is needed,the prices, and the delivery time. A copy of the purchase order is sent to the vendor, and Office Depot keeps severalcopies for internal record keeping. An exampleof a purchase order is shownin Exhibit 5.2. Office Depot's purchasingagent sendsone copy of the purchaseorder to the receiving departmentand one to the accountspayable department.The receiving departmentwill let the accountspayabledepartmentknow when the goodshave arrived.Accounts payablewill pay for the goods when it receivesan invoice from the vendor to match with the purchase order. The processcan be much more complicated, but it always includes cooperationbetween departmentsso that the company pays for only the goods ordered and received. Modem technology has provided shorterand more efficient ways to manageinventory. At Wal-Mart, for example, no one explicitly orders merchandisewhen it is needed.Using bar codesat the cashregistersas eachitem is sold, the computerizedinventory systemis programmed to recognizewhen Wal-Mart should acquire more inventory, and the information

A purchaseorder is a record of the company'srequestto a vendor for goods or services. It may be referred to as a P.O.

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AND SALEOF I N V E N T O R Y CHAPTER . THE PURCHASE 5 I

TakingCareof Business
I Phone: 555-555-5555 Fax: 555-555-5555 E-mail:someone examole.com @

EXHIBIT5.2 Purchase Order from Office Depot

Purchase Order
BiLI To: Road ship Tot 22oA AId Germantown Defr ay Beac h FL 33445 offi c e D epot W ar ehous e 2510 D epot R oad
nal r. 1 r E a : -h

F L 33445

Order #: Purchase Date: lD: Vendor HP6501

goesdirectly to the vendor's computerizedsystem.Even when the processis automated,the underlying transactionis the same:Inventory is acquiredfrom a vendor to be availableto sell to a firm's customers,and the firm wants to be sure it pays for only the merchandiseit has received. Recording Purchases. Now that you are familiar with the proceduresfor purchasinginventory, you are ready to leam to account for its cost. The cost of acquiring inventory includesall coststhe companyincurs to purchasethe items and get them ready for sale.Many people in the firm need details about the cost of inventory including the person requesting the goods, the CFO, and the CEO. This inventory information is also neededfor the financial statements. There are two ways for firms to record their inventory transactions-perpetual and periodic. Thesetwo different methodsdescribethe timing of the firm's inventory recordkeeping. When a companyusesa perpetual inventory system, the firm recordsevery purchaseof inventory directly to the inventory accountat the time of the purchase.Similarly, eachtime an item is sold, the firm will remove the cost of the item-the cost of goods sold-from the inventory account. That is the way Tom's Wear keepstrack of its inventory. In the example that follows, Quality Lawn Mowers, a fictitious firm, will also use a perpetualinventory recordkeeping system.We will discussthe periodic inventory system of record keeping-one in which the inventory accountis updatedonly at the end of the period-later in the chapter. We will use Quality Lawn Mowers for an example of how to account for the costs of inventory. Keep in mind that the company uses a perpetual inventory record-keepingsystem. Supposethat on June 1, Quality Lawn Mowers purchased 100 lawn mowers on account for $150 eachfrom Black & Decker, a manufacturerof power tools and lawn mowers. This is how the transactionwould be recordedin the accounting equation:

The perpetual inventory system is a method of record keepingthat involves updatingthe accounting records the time of every at purchase, sale,and return. The periodic inventory system is a method of recordkeeping updatingthe that involves accountingrecords only at the end of the accountingperiod.

Assets

Liabilities

equity Shareholders' Contributed + Retained

15.000 inventorv

15,000accounts payable

Who Pays the Freight Costs to Obtain lnventory? The cost a companyrecordsin its inventory account is not always the amount quoted by the vendor. One reason is shipping costs.Rememberthat the cost of inventory includes all the costs to obtain the merchandise and get it ready to sell. When a merchandisingfirm pays for transportationcosts for goods

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213

EXHIBIT5.3 Shipping Terms

Shipping terms determine who owns the goods, and at what point the owner pays the shipping costs.The firm that owns the goods while they are in transit must include the cost of those goods in its inventory.

Title passeshere at FOB shipping point...or...Title passeshere at FOB d,estination.

FOB shipping point: title changes hands at the shipping point, and purchaser owns the goods while they are in transit. So, the purchaser pays the shipping costs.

FOB destination: title changes hands at the destination point, and the seller owns the goods while they are in transit. So, the seller pays the shipping costs.

.Buyer pays the shipping cost; the cost is recorded IN the INVENTORY account. oVendor DOES NOT pay the shipping cost.

.Buyer DOES NOT pay the shipping cost. .Vendor pays the shipping cost, which is recorded as an operating expense.

purchased,the freight cost is called freight-in and is consideredpart of the cost of the inventory. The shipping terms are negotiatedbetween the buyer and the vendor. If the terms of purchaseare FOB (free on board) shipping point, title to the goods passes the buyer at the shipping point (the vendor's warehouse),and the buyer is responto sible for the cost of the transportationfrom that point on. If the terms are FOB destination, the vendor-Black & Decker-pays for the transportationcosts until the goods reach their destination,when title passesto the buyer. When you are the vendor and you pay the shipping costs for goods to be delivered to your customers,the expensegoes on your income statementas freight-out or delivery expense.Freight-out is an operating expense,whereasfreight-in is part of the cost of the inventory. Exhibit 5.3 showsthe relationshipsamong the FOB selling point, FOB destination, buyer, and vendor. The details of inventory purchases,such as the shipping terms, can affect the cost of the inventory. A company must pay attention to thesecosts becausesuch costs can make a difference in the profitability of the company Suppose shippingcost for the 100 lawn mowerspurchased Quality Lawn Mowers the by was $343. If the shipping terms were FOB destination, then Black & Decker paid the shipping cost; and thereis no record of the shippingcost in the books of Quality Lawn Mowers. However, supposethe terms were FOB shipping point. That meanstitle changeshands at the point of shipping-the vendor's warehouse. BecauseQuality Lawn Mowers then owns the goods while they are in transit, Quality Lawn Mowers will pay the shipping costs.The $343 will be included as part of the cost of the inventory. Shipping costs are usually paid to the shipping company in cash. Here is how the transaction would be recorded in the accounting equation:

FOB(free on board) shipping point meansthe buyingfirm paysthe shippingcosts. The amount is calledfreight-in and is includedin the costof the inventory. FOB(free on board) destinationmeansthat the vendor (selling firm) paysthe shippingcosts, the buyer so has no freight-in cost.

Assets

Liabilities

Shareholders'equity Contributed + Retained

capital earnings

343inventory (343)cash

21 4

AND SALEO F I N V E N T O R Y CHAPTER o THE PURCHASE 5

Your Turn 5-l

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In each separatesituation, calculatethe cost of the inventory purchased. 1. Company A purchased merchandise FOB destination for $10,000' n/30 and payment was made in 8 days. Freightcost Termswere 2110, was $90. 2. Company B purchasedmerchandiseFOBshipping point for $10,000. Termswere2110,n/30 and payment was made in 29 days. Freightcost was $90. 3. Company C purchasedmerchandiseFOBshipping point for $10,000. Termswere 2110,n/30 and payment was made in 8 days. Freightcost was $90.
Purchase Returns and Allowances. Somegoodsmay needto be returnedto the vendor becausethe firm orderedtoo much inventory, ordered the wrong items, or found the goods slightly damaged.When a firm returns goods,the transactionis called apurchase return.In the frrm's accountingsystem,the amount of purchasereturns will be deductedfrom the cost of the inventory. Becausethe company puts the cost of the items in the inventory account, when goods are returned. The details of the the balance in that account will be decreased returns will be noted in anotherpafi of the company's information system.The firm wants to know exactly how much merchandiseit is returning in any given accounting period. A the firm should be sureit understands vendor's return policy. Often, nearthe end of the year, a vendor will institute a very liberal return policy to make a sale. Nevertheless,the firm should buy only the amount of inventory it actually needs,not alatger amount with the idea ofreturning it when the next accounting period starts. Goods damagedor defective may be kept by the purchaserwith a cost reduction called a purchase allowance. When a company has a purchaseallowance, it is like getting a discounted purchaseprice so the inventory account will be reduced.A purchaseallowance is different from a purchasereturn becausethe goods are kept by the purchaserin the caseof a purchaseallowance. When an item is returned, accountspayable, which shows the amount a firm owes its becausethe goods have vendors,will be reduced.The inventory accountwill be decreased they beenreturned.Suppose Quality Lawn Mowers returnedtwo of the lawn mowersbecause were defective.This is how the transactionwould be recordedin the accountingequation:

Assets

Liabilities

equity Shareholders' Contributed + Retained capital earnings

(300)inventory

(300)accounts payable

Purchase returns and allowances are amountsthat decrease costof inventory the due to returnedor damaged merchandise. A purchase discountis a reductionin the priceof an inventorypurchase for prompt paymentaccording to terms specified the vendor. by

Similarly, if a vendor gives the firm a purchaseallowance,the amount owed to the venis reduced by subtracting the amount from accountspayable. There will also be a redor duction in the balancein the inventory accountto reflect the reducedcost. Purchasereturns and purchaseallowancesare often grouped together in one expression-purchase returns and allowances. Purchase Discounts. In addition to purchasereturns and allowances,purchasediscounts can also causea difference between the vendor's quoted price and the cost to the purchasing firm. A purchase discount is a reduction in the purchaseprice in return for prompt payment. For example, a vendor offering a purchase discount for prompt payment from a customer would describeit in terms like this: 2lI0.nl30 This term is read as "two-ten, net thirty" and meansthe vendor will give a 2Vo discount if the buyer pays for the entire purchasewithin 10 days of the invoice date. If not, the full amount is due within 30 days. A vendor may set any discount terms. What does3115,n/45 mean?The vendor will give a3Vo discountif payment is made within 15 days. Otherwise,

5. G C H A P TE R A C QU IR INA N D S E LLINME R C H A N D TSE215 G full payment must be made within 45 days. The number of days a customer has to pay an invoice startson the day after the date ofthe invoice. For example,an invoice datedJune 15 with the terms 2/lO, n/30 gives the customeruntil June 25 to pay with the discount applied. The full amount is due by July 15. A firm should take advantageof purchasediscount offers from vendorsbecauseit can amount to significant savings.If a vendor offers the terms 2/10, n/30, the vendor is actually charging the firm 36Voannualinterest to use the money if the frrm does not pay within the discount period and waits until the last day,the 30th day.Here is how we calculatedthe high interest rate of 36Vo.If the discount period expires, and the firm has not paid until the 30th day after the invoice date, the firm is "borrowing" the money from the vendor for an additional 20 days. Becausethe firm did not pay within the discount period, the vendor has earned2Voin20 days. And, 2Vointereston a "loan" over 20 days is the same as a36Vo annual rate, determinedwith the help of a simple ratio: 2 V o+ 2 0 d a y s = x + 360 Solve for x and you get x : 36Voannualinterest-if you consider a year ashaving 360 days. Some companiesborrow the money from the bank (at l}Vo or I2Vo aniltal interest) to take advantageof purchasediscounts. SupposeBlack & Decker offers Quality Lawn Mowers the terms l/10, n/30. Quality takes advantageof this discount and pays for the inventory on June 9. Recall that it purchasedthe inventory on June 1, so the payment is made within the discount period. Quality Lawn Mowers owes the vendor $14,700 because$300 worth of merchandisefrom the original purchase $15,000was returned.Thel%odiscountamountsto $147.That means of that the companywill pay the vendor$14,553($14,700- $147).Here is the way the transaction would be recordedin the accounting equation:

Assets

Liabilities

Shareholders' equity Contributed + Retained capital earnings

(14,553) cash (147)inventory

(14,700) accounts payable

Before the payment,the balancein accountspayablewas $14,700.So the entire $14,700 must be subtracted of accountspayable.Becauseonly $14,553 was actually paid, this is out the amount deductedfrom the cashaccount.That leavesthe discount amount to balancethe accountingequation.This decreases inventory accountbecauseinventory purchasewas the recordedat $14,700,which turned out not to be the cost of the inventory.The reduction of $147 adjuststhe inventory accountbalanceto the actualcost of the goodspurchased. If Quality Lawn Mowers did not pay within the discountperiod, the payment would be recordedwith areductionin accounts payablefor $14,700and areductionin cashfor $14,700. Surnmary of Purrhaser for Quality Lawn Mowers. Let us review the activity in the inventory account for Quality Lawn Mowers. First, the original purchase of the 100 lawn mowers was recordedwith an increasein inventory for $15,000.Then, Quality Lawn Mowers paid the shipping costs of 9343. Next, Quality returned two lawn mowers-9300 worth of inventory. Finally, the company took advantageof the purchasediscount. That reduced the value ofthe inventory by $1a7. The balancein the inventory accountis now $14,896 for 98 lawn mowers. That is $152 per unit. This amount is called the cost of goods available for sale. If Quality had startedthe period with a beginning inventory cost of goods available for sale would have included the amount of the beginning inventory. A simple way to think about the calculation of cost of eoods available for sale is: Beginning inventory * Net purchases(this is total purchasesless returns and allowances and discounts)15,000 -300 -I47 + Shipping costs (freight-in) : Cost ofgoods available for sale

$0
14 55?

Cost of goods available for sale is the total of beginning inventoryplusthe net purchases made during the period (plusany freight-in costs).

343 $ 14,896

216

AND SALEOF I N V E N T O R Y CHAPTER . THE PURCHASE 5

Your Turn 5-2 %rur fue"ss

Jaden's Coffee Hut purchased100 pounds of Columbianroast coffee beansto The coffee cost $5 per pound, and Jaden's packageand sell to its customers. paid $100for the bags in which to packagethe beans.When Jaden'sreceived the invoice for $500 from the coffee importer, the accountant noticed that the n/30. The coffee beanswere shipped FOB payment terms were given as211O, accountantpaid the cofdestination,and the shippingcostswere $75.Jaden's fee importer 5 days after the date on the invoice.The paper company that the bags did not offer a discount,so Jaden'spaid that firm a few sold Jaden's weeks after receivingthe invoicefor $100.How much did Jaden'srecordin its inventory account related to these purchases?

SellingMerchandise
You now know how a company records the transactionsrelated to the purchaseof inventory. Now, we will look at what happenswhen the company sells the inventory. Sales are reported net of returns, allowances,and any discounts given to customers. What you just learned about purchasinginventory also applies to selling the inventory, but everything is reversed.Instead of purchasereturns and allowances,there will be sales rcturns and allowances.Instead ofpurchase discounts,there will be sales discounts. The following arethe typical businessactivitiesthat takeplace when a firm makesa sale. l. 2. 3. 4. 5. 6. A customerplaces an order. The company approvesthe order. The warehouseselectsthe goods for shipment. The companyshipsgoods. The company bills the customer for the goods. The company receivespayment for the goods.

Computers can perform some of these steps.Whether a firm performs the stepsmanually or with a computer, the objectives of those stepsare the same. . to ensurethat the firm sells its goods or servicesto customerswho will pay . to ensurethat the goods or servicesdelivered are what the customersordered . to ensurethat the customersare correctly billed and payment is received Sales Process. For sales,revenueis typically recognized when the goods are shipped or when they are delivered, depending on the shipping terms. For example, when Intel ships computer chips to IBM with the terms FOB shipping point, the time the shipment leaves Intel will be the point at which Intel recognizesthe revenue,not when the order is placed You know that the shipment of the goods is preand not when IBM pays for the purchase. planning, marketing, and securing orders.Yet, no cededby many crucial activities such as revenueis recognizeduntil it is actually earned. Exhibit 5.4 shows part of the note that IBM has included in the financial statements about its revenuerecognition. Does payment need to be received before revenueis recognized at IBM? NO! Remember,GAAP is accrual accounting.

EXHIBIT5.4 How Does IBM RecognizeRevenue?

This is just a small part of IBM's note on revenuerecognition.

The company recognizes revenue when it is realized or realizable and earned. The company considers revenue realized or realizable and earned when it has persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Delivery does not occw until products have been shipped or services have been provided to the client, the risk of loss has transferred to the client and client acceptance has been obtained, client acceptance provisions have lapsed, or the company has objective evidence that the criteria specifled in the client acceptance provisions have been satisfied. The sale price is not considered to be fixed or determinable until all contingencies related to the sale have been resolved.

C H A P TE R A C QU IR INA N D S E LLINME R C H A N D IS E 217 5o G G Recording Sales. When a sale is made, it is recorded as an increasein salesrevenue,often simply called sales.Continuing our example with Quality Lawn Mowers, supposethe company sold 10 lawn mowers to Sam's Yard Service for $4,000 on account. This is the transactionin the accounting equation:

Assets

Liabilities

Shareholders' equity

Contributed capital
4,000 accounts receivable

Retained earnings 4,000sales revenue

When a saleis made,the inventory will be reduced.BecauseQuality Lawn Mower has sold 10 lawn mowers, the cost of those mowers will be deductedfrom the balancein the inventory account. Recall that each lawn mower had a cost of $152. Removing the 10 mowers frominventorywillreducetheinventoryby$1,520($lSZx10).Costofgoodssold,anexpenseaccount,will increaseby $1,520. This is the transactionin the accounting equation:

Assets

Liabilities

(1,520) inventory

Shareholders' equity Contributed Retained capital earnings (1,520) cost

of eoods sold

Sales Returns and Allowances. A company'scustomers may returnitems,and the company may provide allowanceson items it sells. These amountswill be recorded either as a reduction to salesrevenue or in a separateaccount called sales returns and allowances. This account is an example of a contra-revenue, which will be deductedfrom salesrevenue for the income statement.Often, you will simply seethe term net sales on the income statement. This is grosssalesminus the amount of returns and allowances.When a customer returns an item to the company,the customer's accountreceivablewill be reduced (or cash will be reducedif the refund is made in cash).The salesreturns and allowancesaccountwill be increased,and the balancein the accountwill eventually be deductedfrom salesrevenue. SupposeSam'sYard Service,the company that purchasedthe 10 lawn mowers, discovers that one of them is dented and missing a couple of screws. Sam's Yard Service calls Quality Lawn Mowers to complain, and the salesmanfor Quality Lawn Mowers offers Sam'sYard Service an allowance of $100 on the damagedlawn mower. Sam'sYard Service agreesand will keep the lawn mower. Here is the transaction that Quality Lawn Mowers will record to adjust the amount of the sale and the amount Sam'sYard Service owes Quality Lawn Mowers:

Salesreturns and allowances is an accountthat holds amountsthat reducesales due to customer returns or allowances damaged for merchandise. A contra-revenueis an account that is an offset to a revenueaccountand therefore deducted from the revenuefor the financial statements.

Assets

Liabilities

(100) accounts receivable

Shareholders' equity Contributed Retained capital earnings (100)sales returns and allowances

Sales Discounts and Shipping Terms. The terms of salesdiscounts,reductionsin the sales price for prompt payment, are expressedexactly like the terms you learned for purchases.A company will offer sales discounts to its customersto motivate them to pay promptly. SupposeQuality Lawn Mowers offers Sam'sYard Service the terms 2llo, nJ30for the sale. If Sam's Yard Service pays its account within 10 days of the invoice date, Quality Lawn Mowers will reduce the amount due by 2Vo.This is an offer Sam'sYard Service should not refuse. Sam'sYard Service will pay $3,822, which is 987oof the amount of the invoice of $3,900. Recall the earlier $100 sales allowance that reduced the amount from $4,000to $3,900.

A salesdiscountis a reduction priceof a product in the sales offered to customersfor prompt payment.

218

O AN CHA P T E5 . T H EP U R C H AS E D SA L E F IN V E N TOR Y R Just as with salesreturns and allowances,the amount of a salesdiscount could be subtracted direct$ from the salesrevenue account, reducing the balance by $78. Whether or not you use a separateaccount to keep track of salesdiscounts,the income statementwill show the net amount of sales.In this example, the calculation for net salesis Salesrevenue Salesallowancegiven Salesdiscounts Net sales $4,000 (100) (78) $3,822

Here is how the collection of cash from the customer is recorded in the accounting equation:

Assets

Liabilities

Shareholders' equity

Contributed capital 3,822cash (3,900) accounts receivable

Retained earnings (78) sales discounts

Notice two important things about the way the payment from Sam's Yard Service is recorded. 1. Sales discounts is a contra-revenueaccount like sales returns and allowances. The amount in the salesdiscountsaccountwill be subtractedfrom salesrevenuealong with any salesreturns and allowancesto get net sales for the income statement. 2. Accounts receivable must be reduced by the full amount that Quality Lawn Mowers has recorded as Sam's Yard Service's accountsreceivable balance. Even though the cashcollected is lessthan this balance,Sam'sYard Service'saccountis paid in full with this payment, so the entire balance in Quality Lawn Mowers' accounting records for accountsreceivablefor Sam'sYard Service must be removed. In addition to salesreturns and allowancesand salesdiscounts,a company will be concerned with shipping costs.You already learned about identifying the firm that pays for shipping by examining the shipping terms: FOB destinationand FOB shipping point. When paying the shipping costs,the vendor will likely set prices high enough to cover the shipping. When the vendor pays the shipping costs, those costs are classified as operating expenses.Look back over Exhibit 5.3 on page 00. When you are working an accounting problem with shipping costs,be careful to properly identify your company as the purchaser or the vendor of the goods being shipped. $ummary of Purchases and Sales for Quality Lawn Mowers. A firm startswith beginning inventory, purchasesadditional inventory, and then sells some of the inventory.The calculation below showswhat happenedwith Quality Lawn Mowers, providing a summary of the purchaseand salestransactions. Beginninginventory (net) Purchases ($ 1 s ,0 0 0 -3 0 0 - 147) F re i g h t-i n Costof goods availablefor sale Costof goods sold Ending inventory

$o
14,553 343

14,895 1,520 $ i3,376

Sales Taxes. In addition to collecting salesrevenue,most retail firms must also collect a salestax for the state government.A salestax is a percentageof the salesprice. Suppose that Quality Lawn Mowers sold a mower to a customer for $400 and the salestax rate is 4Vo. Qu;alitycollects the salestax on behalf of the government, so it will owe the govern-

IN Y: AL S C H A PT E R R EC O R D IN GV E N TORP E R P E TU V E R S UP E R IOD ICE C ORK E E P IN G 5. R D ment whateverit collects. Here is how Quality Lawn Mowers would record receipt of $416 cash from the customer:

Assets

Liabitities

416cash

16 sales taxes payable

equity Shareholders' Contributed + Retained capital earnings 400 sales revenue

Fedcosold $3,000worth of merchandise a customerfor cash.The salestax to was 5%. How much cash did Fedco receive?How much sales revenue did Fedcoearn?

Your Turn 5-3

Wmmsr ffiws'wm
L.().? Explain two methods the of inventory record keeping.

Recording Inventory: Perpetual Versus Periodic Record Keeping

We have discussedbuying and selling inventory. In our examplesso far, the company used a perpetual inventory record-keeping system.With every transaction related to inventory, the inventory records were updated.As you learned earlier in the chapter,this is called a perpetual inventory system because it requires a continuous updating of the inventory records at the time ofevery purchase,every return, and every sale. The other method, mentioned briefly earlier in the chapter,is called periodic. When a f,rrm uses a periodic inventory system, the firm's accountantwaits until the end of an accounting period to adjust the balancein the inventory account.The accounting systemuses lots of different accountsto keep track of transactionsrather than recording the transactions directly to the inventory account. Becauseof technology advances,an increasing number of companiesare using perpetual inventory systems.For example, when you go shopping at Target and take your cart to the checkout counter, the cashier scanseach of your items. The perpetual record-keeping system enablesTarget and stores such as Kroger, Safeway, and Macy's to do the equivalentof making the cost of goods sold adjustmentat the time of sale.Of course,much more information is capturedfor the information system at the same time. Many companieshave systemsso sophisticatedthat the supplier of specific items will have accessto the company's inventory via the Internet so that the supplying company is able to deliver goods to the purchasingcompany automatically.For example,Wal-Mart has many suppliers that automatically deliver goods when Wal-Mart's inventory records show that the inventory has fallen to some presetlevel.

Differences between Perpetual Periodic Systems and lnventory

One of the primary advantagesof a perpetual system is that inventory records are always current, and a physical count can be comparedto the recordsto seeifthere is any inventory shrinkage.Inventory shrinkage is a reduction in the inventory by damage,loss, or theft by either employeesor customers.A perpetualsystemallows a company to identify shrinkage.

how inventory shrinkage happens the retail in industry:

--

I I I I
-r--.

I L

Employee theft Shoplifting Administrative errors Vendor fraud

46o/o 31o/ o

17%
6o/o

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OF AN CHA P T E5 . T H EPU R C H A SE D SA L E IN V E N TOR Y R However, a perpetual systemmay be too cumbersomefor firms that do not have up-to-date computerized support.A company may keep the physical count of its inventory current by recording eachreduction in the amount of inventory sold without actually recording the cost of goods sold. That is a way to monitor the inventory for potential shrinkagewithout actually using a perpetual system for the accountingrecords. When a companyusesa periodic system,the accountingrecordsare updatedonly at the end of the period. The firm must count the ending inventory and then calculate the amount for cost of goods sold. In other words, if the inventory is gone, it must have been sold. That meansthat any inventory shrinkageis not separatelyidentified from the inventory sold. All missing inventory is consideredinventory sold, and its cost will be included in the firm's cost of goods sold expensefor the period.

Your Turn 5-4

' ,,.'

about inventorytheft. Which methodof a Suppose firm is very concerned for be the bestchoice this firm? Explain. would keeping record

[".{}"3 D ef ineand c alc ul a te i n v ent or yus ingt h e fo u r major inventorycostflow a s s um pt ions e x p l a i n and how these methodsaffect s th e f i nanc ial t at e m e n ts .

CostFlowAssumptions Inventory
So far in this chapter,you have learned about the costs that must be included in the inventory. All costs to preparethe inventory for salebecomepart of the cost of the inventory and then, when the goods are sold, become part of the cost of goods sold expense.That is just the beginning of the story. Inventory costing gets more complicated when the cost of the merchandisechangeswith different purchases. Hut. The costto Sunto Oakley ships120pairsofits new sunglasses Sunglass Suppose glass Hut is $50 per pair. Then, supposethat just a month later, SunglassHut needsmore and buys another 120 pairs. This time, however, Oakley charges of the popular sunglasses during the month to its $55 per pair. If SunglassHut sold 140 pairs of Oakley sunglasses customers,which ones did it sell? The problem is how to divide the cost of the inventory between the period's cost ofgoods sold and the ending (unsold) inventory' We could determinethe cost of goods sold if we knew how many pairs costing $50 were sold and how many pairs costing $55 were sold. SupposeSunglassHut has no method of keeping track of that information. The store simply knows 140 pairs were sold and 100 pairs are left in inventory. There were 240 pairs available for sale at a total cost o f $ 1 2 .6 0 0 . (120 pairs @ $50 per pair) + (I20 pairs @ $55 per pair) : $12,600cost of goodsavailablefor sale How should the store allocate that amount-$12,600-between the 140 pairs sold (cost of goods sold) and the 100 pairs not sold (ending inventory) for the month? flowed out of SunglassHut will make an assumptionabout which pairs of sunglasses inventory to customersand which pairs remain in inventory. Did the store sell all of the $50 pairs and some of the $55 pairs? Or did the store sell all of the $55 pairs and some of the $50 pairs?The assumptionthe storemakesis called an inventory cost flow assumption,and it is made to calculate the cost of goods sold for the income statementand the cost of ending inventory for the balance sheet.The actual physical flow of the goods does not need to be consistentwith the inventory cost flow assumption.The inventory managercould actually know that all of the $50 pairs could not have been sold becauseof the way shipments are storedbelow the display counter,yet the store is still allowed to use the assumptionthat the $50 pairs were sold first in calculating cost of goods sold. In accounting, we are conwith the goodsthat cernedwith inventory cost flow-that is, the flow of the costsassociated passthrough a company-rather than with the actual physical movement of goods. Generally acceptedaccounting principles (GAAP) allow a company to select one of severalinventory cost flow assumptions.Studying severalof these methods will help you even understandhow accountingchoicescan affect the amountson the financial statements,

C H A P T E 5 o I N V E N T O R Y O S TF L O W A S S U M P T I O N S R C

221

when the transactionsare identical. There are four basic inventory cost flow assumptions used to calculate the cost of goods sold and the cost of ending inventory. 1. 2. 3. 4. Specific identihcation Weighted averagecost First-in, first-out (FIFO) Last-in, first-out (LIFO)

Specific ldentification
The specific identification method is one way of assigning the dollar amounts to cost of goods sold and ending inventory. Insteadof assumingwhich inventory items are sold, a firm that uses specific identification actually keepstrack of which goods were sold becausethe firm records the actual cost of the specific goods sold. With the specific identification method, each item sold must be identified as coming from a specific purchaseof inventory, at a specific unit cost. Specific identification can be used for determining the cost of each item of a small quantity of large, luxury items such as cars or yachts. However, this method would take too much time and money to use to determine the cost of eachitem of many identical items, like pairs of identical sunglasses. Companiesthat specializein large, one-of-a-kindproducts,suchas Boeing's 767-300ERairplane deliveredto Ethiopian Airlines in June2004, will definitely use specific identification. However, when you go into Foot Locker to buy a pair of Nike running shoes,the store accountant will not know exactly what the store paid Nike for that specific pair of shoes.The cost of goods sold will be determinedby a method other than specific identification. We will use a simple example to show how specific identification works. Exhibit 5.5 showshow a car dealershipidentifies the cost of eachcar sold, which is the amountthe dealership paid the car manufacturer.Supposeyou own a Volkswagencar dealership.You buy one Volkswagen for $22,000, a second for $23,000, and a third for $25,000. These three items for the inventory may look identical to a customer,but each car actually has its own unique VIN (vehicle identification number). You will know exactly what your dealership paid the manufacturerfor eachcar. Supposeyou sold two cars during the accountingperiod. What is the cost of goods sold?You will specifically identify the cars sold and their cost. If you sold the $22,000car and the $25,000car,thencost of goodssold would be $47,000and ending inventory would be $23,000.However, if you sold the $23,000 car and the $25,000 car, then cost of goods sold would be $48,000 and ending inventory would be $22,000.
The specificidentification method is the inventorycost flow method in which the actualcostof the soecific goodssold is recordedas cost of goodssold.

WeightedAverageCost
Few firms use specific identification becauseit is costly to keep track of each individual item in inventory. Instead, most firms use one of the other inventory cost flow assumptions: weightedaverage cost,FIFO, or LIFO. A firm that usesweighted averagecost averagesthe cost of the items available for sale and then uses that weighted averagecost to value both cost of goods sold and the ending inventory. An averageunit cost is calculated

Weighted average cost is the inventorycostflow method in which the weighted average costof the goodsavailable for saleis usedto calculate the costof goods sold and the ending inventory.

EXHIBIT5.5 Inventory Cost Using Specificldentification

Each car's cost to the dealership is identified as the car is sold. The cost of goodssold will reflect the cost of each specific car sold.

$22,000
I

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AND SALEO F I N V E N T O R Y 5 CHAPTER . THE PURCHASE

EXHIBIT5.6 Weighted Average Inventory Costing

Cost of each item availablefor sale... Purchase I

is averaged together to get a single average unit cost...

which is then used as the cost of each unit.

DD/

\ $50 each Purchase 2

$57

lCost of goods sold

$60

AII the costs are averaged to compute a single unit cost: [(2x$50)+$60+$68] +4=$228+4=$57.

Cost of goods sold $57

$68

Endinginventory$57

by dividing the total cost of goods available for sale by the total number of units available for sale. This averageunit cost is weighted becausethe number of units at each different price is used to weight the unit costs.The calculated averageunit cost is applied to all units sold to get cost of goods sold and applied to all units remaining to get a value for ending and Chico's usethe weightedavsuchas Best Buy, Intel, Starbucks, inventory.Companies erage cost method to calculate the cost of goods sold and the cost of ending inventory. Exhibit 5.6 shows how the weighted average cost method works for a shop that sells sunglasses. shown in Exhibit 5.6. The store purchasedfour pairs from the Consider the sunglasses manufacturer.The first two pairs cost $50, the third pair cost $60, and the fourth pair cost $68. The total cost of goods available for sale is

(2 x $ 5 0 )+ $ 6 0 + $ 6 8 = $ 2 2 8
Averagedover four pairs, the weighted avetagecost per pair is $57' $228+ 4 = $57 If the store now sold three pairs to customers,the cost of goods sold would be 3x$57= $171 The ending inventory would be $57. Notice that the cost of goods sold of $ 171 plus the ending inventory of $57 addsup to $228, the cost of goods available for sale. $171 cost of goodssold * 57 ending inventory $228 cost of goods available for sale

Your Turn 5-s

Wkwmer'ffisss-sw

A firm startswith 10 units in its beginning inventory at a cost of $1 each.Dur20 ing the first day of March,the firm purchases units at a cost of $2 each.No Betweenthe 2nd and 31st of the month, the firm were made. other purchases sold 15 units. How much was the cost of goods sold if the firm usesweighted averagecost as its inventory cost flow assumption?

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223

The actual order of the items sold is not necessarily lcrown, but the costs flow "as if" this were the flow of the goods: Cost of goods available for sale Purchase I Cost of goods sold Ending inventory

EXHIBIT5.7 FIFOInventory Cost Flow Method

Wd
$50 each

Purchase 2

$60
Purchase 3

$68

8228
First-ln, First-Out Method (FIFO)

$ r6 0

$68

The first-in, first-out (FIFO) method is the common assumption in inventory cost flow that the first items purchasedare the first ones sold. The cost ofthe first goods purchasedis assignedto the first goods sold. The cost of the goods on hand at the end of a period is determined from the most recent purchases. Apple Computers,Barnes & Noble, and Wendy's useFIFO. We will use the four pairs of sunglasseswe used earlier for the weighted average method to seehow FIFO works. Supposethe glasseswere purchasedin the order shown in Exhibit 5.7. No matter which oneswere actually sold first, the costsof the oldest purchases will becomecost of goods sold. If the store sold three pairs, the cost of goods sold would be

First-in, first-out (FIFO) the is inventory cost flow method that assumes f irst items the purchased the first items are sold.

$s0+$s0+$60= $ 1 6 0
The ending inventory would be $68. Again notice that the cost of goods sold of $160 plus the ending inventoryof$68 equals$228,the cost ofgoods availablefor sale. $160 cost of goodssold * 68 ending inventory $228 cost of goods available for sale

Last-ln, First-Out Method (tlFO)

The last-in, first-out (LIFO) method is the inventory cost flow assumptionthat the most recently purchasedgoods are sold first. The cost ofthe last goods purchasedis assignedto the cost of goods sold, so the cost of the ending inventory is assumedto be the cost of the goods purchasedearliest. Firms from diverse industries use LIFO: Caterpillar, manufacturer of machinery and engines;Pepsico,the owner of PepsiCo BeveragesNorth America and Frito-Lay; and McKesson Corporation, a pharmaceuticaland health care company.
Last-in,first-out (LIFO)is the inventory cost flow method that assumes last items the purchased the first items are sold.

224

CHAPTER . THE PURCHASE 5 AND SALEo F I N V E N T o R Y

EXHIBIT5.8 LIFOlnventory Cost Flow Method

The actual order ofthe items sold is not necessarily lanown, but the costs flow "as if" this were the flow of the goods: Cost of goods available for sale Cost of goods sold Ending inventory

$50 each Purchase 2

$60
Purchase 3

$68 $228 $178 $50

We will use the four pairs of sunglasses again to seehow LIFO works. Supposethe glasses were purchasedin the order shown in Exhibit 5.8. No matter which oneswere actually sold first, the costs of the most recent purchases will becomecost of goods sold. If the store sold threepairs,the cost of goodssold would be:

$68+$60+$50=$178
The ending inventory would be $50. Again notice that the cost of goods sold of $178 plus the ending inventory of $50 equals $228, the cost of goods available for sale. $178costofgoods sold f 50 ending inventory $228 cost of goods available for sale Firms that use LIFO must provide extra disclosures in their financial statements. Exhibit 5.9 shows an example of the disclosure about inventory provided by Tootsie Roll Industries.Although TootsieRoll usesLIFO, it disclosesinformation about the current cost

EXHIBIT5.9

FYom Note 1 in Tootsie Roll Industries' 2005 Annual Report (dollars in millions)

LIFO Disclosure Notes in Inventories: t o th e Fin a n cial Inventories are stated at cost, not to exceed market. The cost of substantially Statements

all of the Company'sinventories ($51,969and $54,794at December 31, 2005 and2004, respectively) has been determined by the last-in, first-out (LIFO) method. The excess of current cost over LIFO cost of inventories approximates $6,530arrd $5,868at December 31, 2005 and2004,respectively.

C H A P T E 5 o I N V E N T O R Y O S TF L O W A S S U M P T I O N S R C

EXH|BtT5.10 Purchases Cost of goods sold Ending inventory A Comparisonof Weighted Average Cost, FIFO, and LIFO
This exhibit compares three methodsfor calculatingthe cost of goods sold and the cost of ending inventory-weighted averagecost. FIFO. LTFOusingthe examplewith four pairs of sunglasses. The three pairs of sunglasses sold and the pair left in ending inventory are not identifrable here to emphasize that the actual physical flow of goods doesnot matter to the inventory cost flow method.

$50 each

Weighted average cost FIFO LIFO

$57+$57+$57:$ l7 l $50+$50+$60:$ 1 6 0 $68+$60+$50:$ 1 7 8

$57 $68 $50

of the ending inventory. Remember that LIFO inventory will be valued at the oldest costs becausethe more recent costshave gone to the income statementas cost of goods sold. The old inventory is often described as old "LIFO" layers. When a LIFO firm keeps a safety stock of inventory, never selling its entire inventory, those LIFO layers may be there for a long time. LIFO is controversialbecausea firm can make an extra purchaseof inventory at the end of the period and change its cost of goods sold without making another sale. Whether or not it is ethical to buy extra inventory for the sole purpose of changing the period's cost of goods sold is somethingyou should think about. Even if you believe it is not ethical, you should be aware that it can be done when using LIFO. Take a look at Exhibit 5.10 for a comparison of three methods for calculating the cost of goods sold and the cost of ending inventory-weighted averagecost, FIFO, and LIFO.

Jayne's Jewelry Store purchased three diamond and emerald braceletsduring March.The price of diamonds has fluctuated wildly during the month, causing the supplying firm to change the price of the braceletsit sellsto Jayne's Jewelry Store. a. On March 5, the first braceletcost $4,600. b. On March 15, the secondbraceletcost $5,100. c. On March 20, the third braceletcost $3,500. SupposeJayne's Jewelry Store sold two of these braceletsfor $7,000each. 1. Using FIFO, What is the what is the cost of goods sold for these sales? gross profit? 2. Using LIFO, What is the what is the cost of goods sold for these sales? gross profit? 3. Using weighted averagecost,what is the cost of goods sold?

Your Turn 5-6

',Hkwffi'sm* Whw,w.w,

226

AND SALEO F I N V E N T O R Y CHAPTER . THE PURCHASE 5

Statements Affect the Financial How InventoryCostFlowAssumptions

Did you notice that the sameset of facts and economic transactionsin the examplesyou just for studiedresulted in different numbers on the financial statements cost of goods sold and sections,you will learn how the firm's choice of infor ending inventory? In the following ventory cost flow assumptionsaffects the hnancial statements. Differences in Reported Inventory and Cost of Goods Sold Under Different Cost Flow Assumptions. Exhibit 5.11 shows inventory for Kaitlyn's Photo Shop. The shop sells a unique type of disposablecamerathat is relatively inexpensive.We will calculatethe cost of goods sold and ending inventory for the month of Januaryusing weighted average cost, FIFO, and LIFO, first using periodic record keeping. Then, we will do eachusing perpetual record keeping. No matter which method a company selects,the cost of goods available for salebeginning inventory plus purchases-is the same. Here is a calculation for cost of goods available for sale. Cost ofgoods available for sale : Beginning inventory * purchases For Kaitlyn's Photo Shop for January,the cost of goods available for sale is $238. : $238 + + $98 $60 $80 (7 camerasX $14 each) (8 camerasx $10 each) * (5 camerasx $12 each) * The inventory cost flow assumptionand record-keepingmethod determine how that dollar amount of cost of goods available for sale is divided between cost of goods sold and ending inventory. Recall that a firm can update its accountingrecords with every sale-perpetual record keeping-or at the end of the accounting period-periodic record keeping. To keep the number of calculations to a minimum as you learn about inventory cost flow, we will start with periodic record keeping for the first examples.Then, we will repeat the examplesusing perpetualrecord keeping. No matter which record-keepingmethod a firm uses,the concept of cost flow differencesbetween FIFO, LIFO, and weighted averagecost is the same. Weighted Average Cost-Periodic When the firm chooses a periodic record-keeping system,the computationsfor this method of keeping track of inventory are the simplest of to all methods.Kaitlyn addsup beginning inventory and all purchases get the cost of goods available for sale. Kaitlyn previously calculatedthat amount to be $238. Then, she divides $238 by the total number of camerasavailable for sale-that is the number of camerasthat comprised the $238-to get a weighted averagecost per camera.Kaitlyn had a total of 20 (8 + 5 -l 7) cameras availablefor sale.Dividing $238 by 20 camerasgives $11.90 per camera.That weighted averageunit cost is used to compute cost of goods sold and ending inventory: 11 (Number of camerassold) 9 (Number of camerasin ending inventory) x X = $11.90 (per unit cost) : $11.90 (per unit cost) costof goodssold $130.90 endinginventory $107.10

Cost of goodssold ($130.90)and endinginventory($107.10)add up to $238. At the end of the month, Kaitlyn's knows the total number of cameras FIFO-Periodic sold in January was 11. Using FIFO, Kaitlyn's counts the oldest camerasin the inventory

EXHtBtT5.11 Inventory Records for Kaitlyn'sPhoto Shop

1 J a n u ary I J a n u ary 16 J a n u ary 20 January 30 J a n u ary

lnventory Beginning S al es P urchase S al es Purchase

8 cameras 3 cameras 5 cameras 8 cameras 7 cameras

@ $10 each each @$50 each @$12 each @ $55 each @ $14

5. C H A P TE R IN V E N TOR Y T C OS FLOW S S U MP TION S 227 A as sold. The frrst items to go in the inventory are the first to go out to the income statement as cost of goods sold. So the firm counts the beginning inventory of 8 camerasat $10 each as the first part of cost of goods sold. On January 16, Kaitlyn's purchased5 cameras,so the firm will include 3 of those as paft of cost of goods sold, too. That makes 11 camerassold during the month. The income statementwill show $116 as expense,or cost of goods sold. 8 camerasx $10 perunit : $ 80 3 camerasX $12 perunit : $ 36 : $116 Cost of goodssold What is left in inventory on the balance sheet? x 2 c a me ra s $ l 2 p e ru n i t :$ 24 7 camerasx $14 per unit : $ 98 :$122 Endinginventory Notice that the cost of goods sold plus the ending inventory equals$238-the cost of goods available for sale during January. Exhibit 5.12 shows the FIFO inventory cost flow for Kaitlyn's Photo. LIFO-Periodic When you use any inventory cost flow method with periodic record keeping, you start by calculating the total number of camerassold during the month. We know that in January,Kaitlyn's Photo sold 11 cameras.Using LIFO, Kaitlyn countscamerasfrom the latestpurchaseas thosesold first. The cost of the last items put in the inventory is the fnst

EXHIBIT5.12

Beginning inventory
8 cameras @ $10 each

ilEE
trtt

FIFO Inventory Cost FlowAssumption for Kaitlyn's PhotoShop Costof goodssold

Even though an inventory cost flow assumptiondoes not need to mimic the physical flow of goods,it is a useful way to visualize what is happening. In this exhibit, think of each color of cameraas representingthe particular cost of a camerain that purchase.The green cameras cost $10 each;the red cameras cost $12 each;and the blue cameras cost $14 each.Kaitlyn's Photo starts with 8 cameras, purchases5 more and then 7 more, and sells 11 cameras. That leaves9 camerasin the endine lnventory.

purchase
5 cameras @ $12 each

Cost of goods sold = (8x$10)+(3x$12)=$116

Ending inventory

+ purchase
7 cameras @ $14 each

Ending inventory = (2 x $12) (7 x $r4)--$r22 +

ffi

228

CHAPTER . THE PURCHASE 5 AND SALEOF I N V E N T O R Y to go to the income statementas cost of goods sold. For LIFO, we start at the bottom of the in list of purchases the sequence which the cameraswere purchased. in The purchaseon January30 was 7 cameras,so Kaitlyn's counts the cost of those aspart of cost of goods sold frrst. The purchaseon January 16 was 5 cameras,so the firm will count 4 of them in the cost of goods sold to get the total of 11 camerassold. X 7 cameras $ l4 per unit : $ e 8 X 4 cameras $ l2 per unit : $ 4 8 : $146 Cost of goodssold What is left in inventory on the balance sheet? 1 cameraX $12 per unit : $12 x 8 cameras $l0perunit : $80 : $92 Ending inventory Notice that the cost of goods sold ($146) plus the ending inventory ($92) equalscost of goods available for sale ($2:S;. Exhibit 5.13 shows the LIFO inventory cost flow for Kaitlyn's Photo. Weighted Average Cost-Perpetual When a firm uses a perpetual inventory system,the inventory is reduced each time a sale is made. Technology makes it easy for a firm to use the perpetual system,but the calculations are a bit more complicated. Carefully trace the datesof the purchasesand salesas you work through theseexamples.

E XH|BTT 5.13 LIFO Inventory Cost FlowAssumption for Kaitlyn's PhotoShop

Even though an inventory cost flow assumptiondoes not need to mimic the physical flow of goods,it is a useful way to visualize what is happening. In this exhibit, think of each color of camera as representingthe particular cost of a camerarn that purchase.The green cameras cost $10 each,the red cameras cost $12 each,and the blue cameras cost $14 each.Kaitlyn's Photo startswith 8 cameras, purchases5 more and then 7 more, and sells 11 cameras.That leaves9 camerasin the endins mventory.

Beginning inventory
8 cameras @ $10 each

Ending inventory (8 x $10)+ (1 x $12)= $92

+ purehase
5 cameras @ $12 each

purehase
7 cameras @ $14 each

Cost ofgoods sold (7 x $14)+ (a x $12)-$146

C H A P TE R IN V E N TOR Y T 5 o C OS FLOW S S U MP TION S 229 A If a company were to selectperpetualrecord keeping with the weighted averageinventory cost flow assumption,the accountant would calculate a new weighted averagecost every time a purchaseis made and every time a sale is made. The method is often called moving weighted avetagebecausethe averagechangeswith every transaction.A modern hrm's computer systemcan handle this record keeping with ease.However, it can be pretty messy to use the weighted averageperpetual system with only a calculator. When Kaitlyn's Photo sells three camerason January 8, the weighted averagecost of a camerais simply the cost carried in the beginning inventory. So the cost of goods sold for the January8 saleis $30. That leavesfive camerasat a cost of $10 eachin the inventory. On January 16, Kaitlyn's purchasesfive camerasat $12 each.The weighted averagecost for a camerals now (5 x $ 1 0 ) + (5 x $ 1 2 ) : 10 total $11 each

On January20, Kaitlyn's Photo sells eight cameras.The cost of goods sold is $88, and there are two camerasleft in the inventory at a weighted averagecost of $11 each. When the purchaseof sevencamerasat $14 eachoccurs on January30, a new weighted average cost must be computed. (2 x $ 1 1 ) + (7 x $ 1 4 ): 9 total $13.33each

The cost of goodssold for the period is $88 + $30 : $1 18. The ending inventoryfor the period is $120 (9 camerasx $13.33each,rounded). FlFO-Perpetual When a perpetualrecord-keepingsystemis used,the cost of goods sold for each salemust be calculatedand recorded atthe time of the sale. Only the camerasfrom the purchasesas of the date of a sale-meaning prior and up to the date of a sale-are available to becomepart of the cost of goods sold. Perpetualrecord keeping requires you to pay attention to the dateson which goods are purchasedand sold. Kaitlyn's first sale is on January 8. Only camerasfrom the beginning inventory are availablefor Kaitlyn's to use to calculate the cost of goods sold for the January 8 sale.The other purchasesare in the future, and Kaitlyn's does not know anything about them on January 8. The cost ofgoods sold for the January8 saleis 3 camerasx $10 per camera: $30 Next, eight cameraswere sold on January20. Becausethe inventory cost flow assumption is FIFO, Kaitlyn's usesthe camerasleft in the beginning inventory as part of the cost of goods sold. So the cost of goods sold for the January20 salemust start with the five cameras remaining in the beginning inventory-that will be 5 x $tO each : $50. To get the other three neededto make the total of eight sold, Kaitlyn's will count three from the January 16 purchase. That is 3 x $tZ each : $36. So the total cost of goodssold for the January 20 saleis $86 ($50 + $36). To summarizethe cost of soods sold: x $10 each 3 "u-..u, 5 camerasX $10 each 3 camerasX $12 each Total cost of goodssold What is left in ending inventory? 2 camerasX $12 each 7 camerasx $14 each Total ending inventory : $ Z+ : $ qS : $122 : : : : $ 30 $ 50 $ 36 $1 16

If you refer back to the FIFO periodic example, you will notice that doing all of the work to figure out the cost of goods sold using FIFO perpetual gives the same amount as FIFO periodic, which is much easierto calculate. Is this coincidence, or is there a predictable pattem here?Look at the particular cameras that were assumedto be sold under the two methods.You will seethat it is more than

AND SALEO F I N V E N T O R Y CHAPTER . THE PURCHASE 5

coincidence. No matter how the company does the actual record keeping, either FIFO method-perpetual or periodic-will give the samedollar amount of cost of goods sold and the same dollar amount of ending inventory for the period. Unfortunately, this is not true for LIFO. LlFO-Perpetual Choosing LIFO perpetual makes life a bit more difficult for the accounting system than choosing FIFO. Each time a sale is made, the cost of goods sold is determined by using the last purchaseas of the date of the sale. The amounts may differ slightly between LIFO periodic and LIFO perpetualbecauseof timing differencesbetween salesand purchases. Kaitlyn's first sale is on January 8. Only camerasfrom the beginning inventory are available for Kaitlyn's to use to calculatethe cost of goods sold for the January 8 sale.The other purchasesare in the future, and Kaitlyn's doesnot know aaything about them on JanX 8 uary 8!Thecostof goodssoldfortheJanuary saleis3 cameras $l0percamera: $30. eight cameraswere sold on January20. Becausethe inventory cost flow assumpNext, tion is LIFO, Kaitlyn's usesthe camerasfrom the most recent purchaseas of January20 to determine the cost of goods sold. So the cost of goods sold for the January 20 sale starts with the five camerasfrom the January 16 purchase.That is 5 X $12 each : $60. To get the remaining three camerassheneedsfor the total eight sold on January20, Kaitlyn's will need to pick up three from the beginning inventory: 3 x $10 each : $30. So the total cost ofgoods sold for the January20 saleis $90 ($60 + $30). To summarizethe cost of eoods sold: 3 camerasX $10 each 5 camerasX $12 each 3 camerasX $10 each Total cost of goods sold What is left in the ending inventory? 2 cameras X $10each 7 cameras X $14each Total

= $ 30 Saleon January 8 = $ 60 Saleon January 20 { :$ 30 |. : $120 : $ 20 : $ 98 : $119

If you look back at the example of LIFO periodic, you will see that it resulted in a slightly higher cost of goods sold, $146. That is because,under periodic record keeping, Kaitlyn's was allowed to "pretend" to have sold the inventory purchasedon January 30. That is, the inventory cost flow assumptionallowed an assumedflow of goods that could not possibly have taken place. Conclusions About Inventory Cost Flow Assumptions. Firms use all of the combinations of the three inventory cost flow assumptions-weighted average,FIFO, and LIFOand two record-keeping methods-perpetual and periodic. Accountants and frms have modified thesemethodsto meet the needsof specific industries.Sometimesfirms keep perpetual records of inventory in units but wait until the end of the period to calculatethe cost of goods sold using the periodic method.You can seefrom the exampleswe have done that the method a company selectsto accountfor inventory can make a difference in the reported cost of goods sold, inventory, and net income. The cost of goods sold and ending inventory are shown in Exhibit 5.14 for weighted FIFO, and LIFO, all using periodic record keeping. In every case,notice that cost ayerage,

EXH tBtT 5.14 Summary Kaitlyn's of Photo InventoryData

lnventory Cost Flow Assumption Cost goods of sold Ending inventory

Note: Amowts

Weighted Average

16 $1 $122
doUM.

$146 $92

$131 $r07

@re round,ed, to the nryest

5. A C H A P TE R IN V E N TOR Y T C OS FLOW S S U MP TION S 231 of goods sold and ending inventory together total $238, the cost of the goods available for sale.That is true for FIFO, LIFO, and weighted ayerageusing either a perpetual or a periodic system.You can read about how a frm makes this important calculation in the notes to the hnancial statements.

duringAugust2008: Jones had Saddle Company the followingtransactions Purchased units@$20per unit on August10,2008. 30 Purchased units@ S21per 20 unit on August15,2008. Purchased units@$23per unit on August21,2008. 20 Sold35 units@$30per unit on August30,2008. costflow asCalculate costof goodssoldusingeach theseinventory the of (1) (2) cost.(ln this case, sumptions: FIFO, LIFO, and (3)weightedaverage perpetual all because purchases and periodicproduce the sameanswers were madebeforeany sales.)

Your Turn 5-7

*flmgpe. ffisw-gru

Income Tax Effects of LIFO and FIFO. You seethat the inventorycost flow assumption makes a difference in the amountsreported on the income statementfor cost of goods sold and on the balancesheetfor inventory.What effect do you think the inventory cost flow assumption has on the statementof cash flows? We will look at the income statementand the statementof cash flows for Kaitlyn's Photo for an explanation of what could make a company prefer one assumptionover another.First, review Exhibit 5.14, which summarizesthe calculation cost of goods sold under the three common methods. are Salesrevenueand operating expenses the sameno matter what inventory cost flow assumption is used. Earlier we learned that salesrevenue amounted to $590, and operating expenses, addition to cost of goods sold, were $50 for the period. Now, look at in paid in Exhibit 5.15. Notice that we have addedtwo new numbers:Operatingexpenses, for cash,of $50 and the income taxes of 307o.Bxhibit 5.15 showsthe income statement eachinventory cost flow assumption. Before you decidethat FIFO is bestbecause provides a higher net income, notice that it this is true only in a period of increasing inventory costs. Additionally, we really need to look at the statementof cashflows to seewhat effect the inventory cost flow method has on cashflows. Exhibit 5.16 showsthe statementsof cashflow under each inventory cost flow assumption. If you compareExhibits 5. 15 and 5 . 16, you will notice that although LIFO produces the lowest net income, it producesthe largest net cash flow from operating activities. That is a direct result of the income tax savingsfrom the lower net income. LIFO will yield the largest net cash flow in a period of rising costs of inventory. If Kaitlyn's uses LIFO instead of FIFO, she will save $9 on income taxes and have that money to spend on advertising or hiring new workers. Think of these savings in millions. Firms often savemillions of dollars by using LIFO when inventory costs are rising. The disadvan- EXHIBIT5.15 tage of using LIFO is that net income will be lower than it would have been with FIFO Income Statementsfor or weighted averagecost.

Inventory Cost Flow Assumption

Sale s* Cost goods of sold 0perating expenses In co me efor eax es b t Income taxes(30%) Netincome
*(3x$50) + (8x$55) = $590

FIFO $590 l t6 50 424 127 $297

LIFO $590 146 50 394 1r8 $276

Weighted Average $590 131 50 409 123 $286

Kaitlyn'sPhoto using PeriodicInventory with VariousCost Flow Assumptions

Recall that the cost of the inventory has been rising. That meansLIFO will yield a higher cost of goods sold and a lower taxable income. Cost of Goods Sold and Income taxes are highlighted becausethose amounts are why LIFO income is lower than FIFO income.

232

AND SALEOF I N V E N T O R Y CHAPTER o THE PURCHASE 5 lnventory Gost Flow Assumption fromcustomers Cash collected paidfor inventory Cash paidfor operating expenses Cash income taxes Cash inflowbefore taxes Cash oaidfor income activities Net cashfromoperating Weighted Average

EXHIBIT5.16 Statements of Cash Flow for Kaitlyn'sPhoto Using Various Inventory Cost Flow Assumptions
All inventory methods produce the same cash flows for all items except income taxes.

FIFO $590 238 50 302 127 $125

LIFO $590 238 50 302 118 $184

$590 238 50 302 123 $179

How Do Firms Choose an Inventory Cost Flow Method? Now, think aboutsomeof the factors that might influence a firm's choice of inventory cost flow assumptions. l, Compatibility with similar companies.A firm will often choose a method that other firms in the sameindustry use.Then, a managercan easily compareinventory levels to thoseof the competition. Also, investorslike to comparesimilar companieswithout the complication of different inventory methods.Best Buy, for example,usesweighted averagecost to value its inventory. Circuit City, a similar firm and competitor of Best Buy, also usesweighted averagecost. 2, Maximize tax savings and cashflows. A frrm may want to maximize tax savingsand cash flows. As you saw in our analysisof Kaitlyn's Photo with various inventory methods, when inventory costsare rising, cost of goods sold is larger when a companyusesLIFO the rather than FIFO. There is a differencebecause higher costs of the more recentpuras go chases to the income statement cost of goodssold, and the older,lower costsareleft resultsin a lower net on the balancesheetin inventory.Higher cost of goodssold expense income. Although financial accounting and tax accounting are usually quite different, the IRS requiresany companythat usesLIFO for income tixes to alsouseLIFO for its finanThis is calledthe LIFO conformity rule. So, if a firm wantsto take advancial statements. tageof lower income taxeswhen inventorycostsare rising, the firm must also be willing Reducingincome taxesis the major reato report a lower net income to its shareholders. Business. son films selectLIFO. Readmore aboutLIFO and taxesin Understanding 3. Maximizenet income.In a period of rising prices,a higher net income will come from using FIFO. That is becauseolder, lower costs will go to the income statementas cost of goods sold. Supposeyou are a CFO whose bonus dependson reaching a specific level of earnings.You may forego the tax benefits of LIFO to keep your net income higher with FIFO. Whatever inventory cost flow method a firm uses,the method should be used consistently so that financial statementsfrom one period can be compared to those from the previous period. A firm can change inventory cost flow methods only if the change improves the measurementof the firm's performance or financial position. Exhibit 5.17 gives an example of the type of disclosure a firm must make if it changesinventory cost flow methods.

E XH IBTT s.17
Disclosure a Change of in Inventory Cost Flow Methods Thisisjustpartof theinventory
disclosure made by Books-AMillion in the notes to its January 29, 2005 financial statements. Notice the justification for the changein inventory methods,highlighted.

Inventories method. Market determined is or using of are at Inventories valued thelower cost market, theretail method, store realizable Using retail value, the cost on of based thelower replacement or estimated ratio value of by a cost inventories valued applyingcalculated to retail to theretail are and warehouse inventories. (FlF0) first-out method of changed thefirst-in, from 2, the Ef{ective February2003, Company (LlF0) believes change this method. Management tothe lirst-out accounting inventories last;in, for The and of appropriate matching fevenues expenses. impact in a waspreferablethatit achievesmore "Costs Products intheconsolidated statements of Sold" of change to increase was ofthisaccounting years 29,2005 Janu ar y and 31, fi ended January and mi forthe scal o p e ra ti ob y $ 0 .4 i l l i on $0.7 l l i on ns m per to of million $0.01 or in decrease netincome $0.3 This 2004, respectively. resulted anafter-tax per of$0.4 million or$0.02 diluted decrease netincome to forfiscal and after-tax 2005 an diluted share principle theFlF0 from method in effect 2004. cumulative ofa change accounting The share fiscal for for has accounted prospectively. Accordingly, change been such is to LlF0 method notdeterminable.

I A T CHAPT E 5 . A P P L Y I N G N V E N T O R Y S S U M P T I O N S O T O M 'S WE A R R

233

t luI i ii'iil[ii;i:\i,i lq,rBusingss

InventoryCostFlowAssumptions and Taxes
(GAAP) principles Generally allow accepted accounting firmsquitea bit of latitude selectingmethod acin a of (LIFO) procounting inventory for costs. Last-in, first-out vides tax benefit-lower first-out a taxes thanfirst-in, (FIFO)-in period rising prices. a of Thisis a realeconomic benefit results fromanaccounting choice. In that the pastcentury, costshavebeenrising, it would so make sense a company takeadvantage thistax for to of savings choosing for its inventory by LIFO method. Yet, practices, the most recentsurvey accounting reof (2006), portedin Accounting reTrends Techniques & ports many for that onlyabout38% of firmsuseLIFO, onlypartof theirinventories. factors What influence a firms choice inventory of methods why woulda and firm choose to useLIFO? not Lower Earnings lf a firm uses LIFO taxes. firm mustalso LIFO for the use for financial reporting. iscalled LIFO This the conformity rule. This an exception thegeneral thata firm is rule to may use one accounting methodfor financial statements a different and method taxes. for With respect to inventory, required this means that choosconsistency prices result ing LIFO taxes a period rising for in will of profits both taxes in lowerreported for and financial statements. isthat a problem? Why Managers worrythat lowerearnings have may will a negative effecton the firm'sstockprice. Managers mayhave compensation a contract istiedto earnthat ings; lower so earnings mean smaller may a bonus. Record-Keeping Costs records Inventory associated LIFO more with are complicatedto keepthan inventory records associated with lf FIFO.thetaxbenef of using it LIFO small, might is it not be worththe trouble. Whatwouldcause tax benethe fit to be small evennonexistent? or . A firm maynot be paying muchin taxes-dueto losses prioryears in that reduce taxes special or tax breaks. asinvestment credits. such tax . Theinventory may levels fluctuate lot,sothatold a layers LIFO of inventory would haveto be sold, causing reversal anytax benefit. a of . Thefirm mayturn overthe inventory rapidly, very sothattheinventorv method wouldnothave much effecton taxes. . Costs some in industries decreasing,FIFO has are so the tax advantage those in cases. Most thetime, choice anaccounting of the of method is difficult traceto specific to economic consequences. With inventoryhowever, the choice of accounting method make significant can a economic difference a to firm-realdollars. makes That selecting inventory an cost flow method imoortant an business decision.

Explainthe LIFOconformity rule. What is the usual relationshipbetween accountingunder GAAPand the IRSrules?

Your Turn 5-8

lrfiilx,q,p 1i lr 1q'"'lil; 1r'-"$,

Applying Wear Inventory to Assumptions Tom's

Tom's Wear beganin January2006 and has now completed 4 months of operations.As the company completes its transactions for May, inventory prices are changing. For Tom's Wear, that meansit must select an inventory cost flow assumption.If you look back at the first 4 months of transactions,you will see that inventory prices were constant at $4 per shirt. When inventory prices a"re constant,there is no needfor a cost flow assumption.Every method producesthe identical valuesfor inventory and cost of goods sold.You will also recall that Tom's Wear recordedthe reduction in inventory at the sametime as the related sale. You have now learned that this method is called perpetual record keeping. L"{}.4 A nal yzetransacti ons and preparefi nanci al with a record statements keepi ngand costfl ow assumpti on.

AND SALEOF I N V E N T O R Y 5 CHAPTER . THE PURCHASE

EXHIBIT5.18 BalanceSheet for Tom's Wear at May 1,2006 Tom's Wear Balance Sheet at May 1, 2006

t0m'$wGal

Assets cash Accounts receivable Inventory Prepai{ insurance Prepaidrent Total current assets ' Equipment (net of $925 accumulated depreciation)

"""

3'295 8,000 1,100 25 1'800 14'220 33,075

...' .

Totalassets
Liabilities & Shareholder's Equity Liabilities Accounts payable Interest payable Short-term notes payable Total current liabilities Long-term notes payable Shareholder's Equity Common stock . Retained earnings Total liabilities and shareholder's equity

'

gnw

4,000 310 3,000 7,310 30,000 5,000 4,985 $47,295

I,2006,i sshow ni nE xhi bi t5.18.A syouknow ,i tist hesam e T h e b a l a n c esheetatMay as the balance sheet at April 30,2006, from Exhibit 4.15. The transactionsfor May are shown in Exhibit 5.19. First, we will record each transaction in the accounting equation. Then, we will review the records to identify any neededadjustments. Transaction 1: Paymentfor insurance Tom's Wear pays cash for insurancepremium, $300 for 3 months; coveragestartsMay 15.The firm recordsall insurancepayments to prepaid insurance.The expensewill be recorded as an adjustment at the end of the month.

Assets

Liabilities

equity Shareholder's Contributed + Retained earnings capital

(300)cash insurance 300prepaid

Transaction2: Collection on accountsreceivableTom's Wear collects $7,900 from customerswho purchasedshirts in prior months. No revenueis recognizedbecause the revenuewas alreadyrecognizedwhen the salewas originally made.This collection simply exchangesone asset-accounts receivable-for another---+ash.

Assets

Liabilities

equity Shareholder's Contributed + Retained earnings capital

7,900 cash (7,900)accounts receivable

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AND SALEO F I N V E N T O R Y CHAPTER . THE PURCHASE 5

Transaction3: Paymenton accountspayable Tom's Wear makes a payment of $4,000 on accountspayable. This pays off the current amount of the obligation.

Assets

Liabilities

Shareholder's equity

Contributed capital (4,000) cash

(4,000) accounts payable

Retained earnings

Transaction 4: Purchase of inventory Tom's Wear purchases1,100 shirts at $4 each for cash.

Assets

Liabilities

Shareholder's equity Contributed + Retained capital earnings

(4,400) cash 4,400inventory

Transaction5: Receipt of unearned revenueTom's Wear agreesto sell the local school system900 shirts for $11 each.Tom's Wear collectscash of $9,900in advanceof delivery, Half the shirts will be delivered on May 30, and the other half will be delivered in June.

Assets

Liabilities

Shareholder's equity Contributed + Retained capital earnings

9,900
9,900cash
unearned revenue

Transaction6: SalesTom's Wear sells 800 shirts at $11 each, all on account.That means the company extendedcredit to its customers,and Tom's Wear will collect later.

Assets

Liabilities

8,800accounts receivable

equity Shareholder's Contributed + Retained capital earnrngs sales 8,800 revenue

At the sametime salesrevenueis recorded,Tom's Wear recordsthe reduction in inventory. As you know, the reduction in inventory is an expensecalled cost of goods sold. At this point, all of the items in inventory cost the same amount-$4. Tom's Wear has decided to use FIFO, but there is no actual impact of that choice for this transaction. All of the shirtsTom's Wear sold cost $4, so cost of goodssold is $3,200.There were 275 shirts at $4 each in the beginning inventory, so those are assumedto be sold first. The remaining 525 shirts come from the recent purchase of 1,100 shirts at $4 each, leaving 575 shirts in the inventory.

Assets

Liabilities

Shareholder's equity

Contributed capital

Retained earnings

(3,200)
inventory

(3,200) cost
ofgoods sold

TO W AS 5. G C H AP TE R A P P LY ININ V E N TOR Y S U MP TION S TOM' S E A R Transaction7: Payment Webdesign andfor 6 months' worth of maintenanceTom's for Wear hires Web designersto start a Web page for the hrm. The firm pays $200 for Web design and $300 for 6 months' worth of maintenancefees. A full month of maintenancewill be chargedfor May.

Assets

Liabilities

Shareholder's equity

Contributed capital 300prepaid Webservice (500)cash

Retained earnings

(200) miscellaneous expenses operating

Transaction 8: Purchase of inventory Tom's Wear purchases1,000 shirts at a cost of 54.20 each.on account.

Assets

Liabilities

Shareholder's equity

Contributed capital

Retained earnings

4,200
inventory

4.200
accountspayable

Transaction9: Repaymentof note with interest Tom's Wear startedthe month with a short-termnote payableof $3,000.It was issuedon March 1, so 3 months' worth of interest is also paid. The interest rate on the note is l2%o.Previously,at the end of March and again at the end of April, the interestfor the month was accrued.That is, and eachmonth $30 of interestexpense interestpayablewas recorded.So the payment of interesthere for 3 months is $90, $60 of which was interestpayableand $30 will be recorded as interest expensefor May. The payment of the note and the payment of of it the interestare shown separately because will be easierto constructthe statement The cashflows if theseare separate. repaymentof the note is a financing cashoutflow, whereasthe interestpaymentis an operatingcashflow. Interestpaymentsandreceipts of are always classifiedas cashfrom operatingactivities on the statement cashflows.

Assets

Liabilities

equity Shareholder's Contributed + Retained earnings capital

(30) interest expense

(3,000) cash
(90) cash

(3,000) Short-term notespayable

(60) interest payable

All of theseroutine transactionsare recorded in the accounting equation worksheet in Exhibit 5.19. Now, Tom's Wear must make severaladjustmentsbefore it can preparethe financial statementsfor May. To do this, the additional information that the van was driven 6,000 miles in May is needed.As you read about each adjustment,identify the entry in the accounting equation worksheet. Adjustment 1.' Insurance expenseneedsto be recorded. The total expensefor May is $75. That is the total of $25 from the fust half of the month (which usesup the beginning balance in prepaid insurance) and $50 for the second half of the month (from the new policy at $100 per month, beginning May 15). Adjustment 2.' Rent expenseneedsto be recorded.The amount is $1,200 for the month. Adjustment 3: The Web service of $50 for May needsto be recorded. Adjustment 4: Depreciation expenseon the van (which was driven 6,000 miles during May) needsto be recorded(6,000miles X $0.145per mile : $870). toberecordedonthecomputer, Adjustment Depreciation 5: expenseneeds $100permonth. Adjustment 6: Half of the 900 shirts were delivered to the schools, so half of the unearned revenue needs to be recosnized. That is, $4,950 in revenue should be

234

AND SALEOF I N V E N T O R Y CHAPTER . THE PURCHASE 5

recorded.The reduction in inventory must also be recorded.Recall that Tom's Wear is using FIFO. There are 575 shins left that cost $4 each and,a recent purchaseof 1,000 shirts at $4.20 each. Using FIFO, the 450 shirts that fere delivered (half of the 900 the school paid for in advance)are assumedto be from the oldest inventory, so the cost of goodssold is 450 x $+ : $1,800. Adjustment 7: Sam Cubbie's salary for May needsto be accrued, and the employer's portion of the payroll taxes also needsto be accrued.You will learn more about this in the next chapter,so for now we will simply record $211 as the amount withheld from the employee's check. This amount will be passedon by Tom's Wear to the (for Social Securityand income taxes).We will also record a$77 paygovernment roll tax expensefor Tom's Wear becausethe employer is also required to pay Social Security for its employees.No cashhas been disbursedrelated to this work done by Cubbie. His salary for May is $1,000 per month and will be paid on the 5th of June. Adjustment 8; Interest expenseon the van note needsto be recorded. Recall that the noteis $30,000with an annualinterestrate of I07o. Onemonth'sinterest: $30,000 x 0 .1 0 x l/12: $250. After the adjustmentsare made, the financial statementscan be prepared.Make sure you can trace each amount on the financial statementsin Exhibit 5.20to the accounting equationworksheetin Exhibit 5.19.

[,"(),s
Explainthe lower-of-costo r-m ar k etr ule f or v a l u i n g inventory.

lnventory: in Complications Valuing rket le Lower-of-Cost-or-Ma Ru

Inventory is an asseton the balancesheet,recordedat cost. As you have seen,that assetcan GAAP requirescombe a significant amount.To make surethat inventory is not overstated, paniesto comparethe cost of their inventory at the end of the period with the market value of that inventory, basedon either individual items or total inventory. For the financial statements, the company must use the lower of either the cost or the market value of its inventory. This is called the lower-of-cost-or-market (LCM) rule. When you study any company's annualreport, the note about inventory methodswill almost always mention that the lower-of-cost-or-marketvaluation rule has been applied. Estimating the market value of inventory is the difficult part of the LCM rule. The market value usedis replacement cost. That is the cost to buy similar inventory items from the supplier to replace the inventory. A company comparesthe cost of the inventory as it is recordedin the accounting records, to the replacementcost at the date of the financial statementsand usesthe lower of the two values for the balance sheet.Although there are a few more complications in applying this rule, the concept is straightforward. Inventory must not be overstated.When the inventory value is reduced,the adjustmentto reducethe inventory also reducesnet income. Comparing the cost of inventory to its current replacementcost is more than a simple accountingrequirement.Information about the current replacement cost of inventory is important for formulating sales strategiesrelated to various items in inventory and for decisions. inventory-purchasing It is common for the inventory of companiessuch as T-Mobile and Sony to lose value or quickly become obsoletebecauseof new technology.These companiescannot know the value of the inventory with certainty, so they will often estimatethe reduction in inventory. Sometimesthis is shown on the financial statementsas an "allowance for obsolescence." Knowing how a company values its inventory is essentialfor analyzing a company's f,rnancial statements, and you will find this information in the notes to the financial statements.

The lower-of-cost-or-market (LCM)rule isthe rule that requires firms to usethe lower of either the costor the market value (replacement cost) of its inventory on the date of the balance sheet. Replacementcost is the cost t o buy similaritemsin inventoryfrom the supplierto replace the inventory.

[,.L]"6 D ef ineand c alc ul a te e th grossprofit ratio and the inventoryturnover ratio.

Analysis Financial Statement

Profit Ratio Gross
Each of the four financial statementsis useful to investors and other users. For example, the balance sheettells investors about a firm's financial position and its ability to meet its shortterm obligations. The current ratio, quick ratio, and the amount of working capital you studied

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24O

CHAPTER . THE PURCHASE 5 AND SALEO F I N V E N T O R Y

EXHtBTT 5.21 Target Corporation: Consol idated Statement of Operations

Target's year-end for its fiscal year 2005 was January 28,2006. Even though only a year is given at the top, you can find the exact date of the firm's year end on the balance sheet(not shown here). Sales . Net credit card revenues Total revenues Cost of sales SeIIing,general and administrative expenses Credit card expenses Depreciation and amortization Earnings from continuing operations before interest expense and income taxes Net interest exoense Earning from continuing operations before income taxes Provision for income taxes . Earnings from continuing operations Earnings from discontinued operations, net of taxes of $46 and $116 Gain on disposal of discontinued operations, net of taxes of $761 Net earnings

Target Corporation Consolidated Statements of Operations (partial)

For fiscal years 2005 2004 2003

$ 51,27r $ 45,682$ 40,928 L,349 I,I57 I,097 52,620 34,927 11,185 776 I,409 4,323 463
3,860 I,452 2,408

.. r

46,839 42,025 31,445 28,389 9,797 8,657 737 722 I,259 1,098 3,601 570
3,031 I,146 1,885

3,159 556
2,603 984 1,619

75 t,238

190

$ 2,408 $ 3,198 $ 1,809

Grossprofit ratio is equal to the grossprofit (sales minus costof goodssold)divided by sales. is a ratio for lt evaluatingfirm performance.

in earlierchapters calculatedfrom amountson the balancesheet.In additionto an analysis are of a frm's financial position and ability to meet its short-termobligations,investorsare very interestedin a firm's perfofinance. That information comes from the income statement.An importantratio for measuringa firm's performance the gross profit ratio, also calledthe gross is margin ratio.You know that grossprofit equalssales minus cost of goodssold.The grossprofit ratio is definedas grossprofit divided by sales. The ratio measures portion of salesdollars the a company has left after paying for the goods sold. The remaining amount must cover all other operatingcosts,such as salary expenseand insuranceexpense, and be large enoughto have something left over for profit. We will calculate the gross profit ratio for Target from its income statementshown in Exhibit 5.2l.For its fiscal year endedJanuary28,2006 (fiscal 2005),Target'sgrossprofit was $16,344(57,271 - 34,927)-dollars in millions. The grossprofit ratio-gross profit as a percentof sales-was 31.97o. This ratio is very important to a retail company.As with all ratios, it is useful to comparethis ratio acrossseveralyears.Look at Target'sincome statement, and computethe gross profit ratio for its fiscal year endedJanuary29,2005 (fiscal 2004). Divide the grossprofit of grossmargin $14,231by salesof $45,682 (dollars in millions). You should seethat Tiarget's ratio has improved. For that fiscal year it was 3l .27o,so it has increasedby a small amount. When an income statementis presentedin a multiple-step format, calculating the gross profit ratio is straightforward. Look at the partial income statementsof Barnes & Noble in Exhibit 5.22. From fiscal year 2003 to 2004, the gross proht increased,but sales also increased.Calculating the gross profit ratio for each year helps us evaluatea firm's performance. As shown in the last row of Exhibit 5.22, the gross profit ratio appearsrelatively constant-although a quarter percent could be a big improvement for the firm.

ANALYSIS CHAPTER . FINANCIALSTATEMENT 5

241

Barnes & Noble, Inc. Consolidated Statements of Operations (partial) For the flscal year ended
(in thousands)

EXHTBTT 5.22 Partial lncome Statementsfor Barnes & Noble

Feb. 1, 2003 The income statements for Barnes & Noble are multiplestep statements,showing a subtotal for gross profit. That makes it easy to calculate the gross prof,rtratio.

Jan.29, 2005 FiscalYear 2004

Jan. 31, 2004

2003

2002

Sales .. $4.829.b9b $4,372,177$3,916,544 Costofsales ... 3,386,619 3,060,462 2,73r,588 Grossproflt. .... 1,486,976 1,311,715 1,184,956 Sales and administrative expenses 8t6,597 r,052,345 9r0,448 De pre cia tion andam or t iz at ion. . . . . . . . . . . 166,825 154,844 18 1 , 5 5 3 R 66R 11,933 Pre-opening expenses 8,862 25,328 lmpairment charge .

BARilESEilOBtE
B OOK S E LLE R S

Operatingproflt.....
Grossprofitratio.....

....$ 244,216 $ 225,774 $ 176,254

.. 30.51o/o 30.000/o

A retail company is particularly interestedin its gross profit ratio and how it compares to that of prior years or that of competitors.When managerstalk about a product's margins, they are talking about the grossprofit. There is no specific amount that signifies an acceptable or good grossprofit. For example,the margin on a grocery storeitem is usually smaller than that of a new car becausea grocery store turns over its inventory more frequently than does a car dealership.When a grocery store such as Kroger or Whole Foods Market buys a grocery item, such as a gallon of milk, the salesprice of that item is often not much higher than its cost. Becausea grocery store sells so many different items and a large quantity of each,the grossprofit on eachitem doesnot need to be very big to accumulateinto a sizable grossprofit for the store. However, when a company sells larger items, such as cars,televisions, or clothing, and not so many of them, it needsto have a larger gross profit on each item. For its fiscal year endedSeptember 2005, Whole Food's grossprofit ratiowas35%io, 25, whereasChico's, with fiscal year-end,January 28,2006 had a gross profit ratio of6IVo.

Inventory Turnover Ratio

Merchandising companiesmake a profit by selling their inventory.The faster they sell their inventory, the more profit they make. Buying inventory and then selling it makesthe inventory "turn over." After a company sells its inventory, it must purchasenew inventory. The more often this happens,the more profit a company makes.Financial analystsand investors are very interestedin how quickly a company turns over its inventory. Inventory turnover rates vary a greatdeal from industry to industry. Industries with small gross margins, such as the candy industry, usually turn over their inventories more quickly than industries with large gross margins, such as the auto industry.

paidoff for the movie of Technica Have DVDs According KenFisher ARS to studios? (http://arstechnica.com), margins DVD profit Io20-3oo/o sales 50-60%,compared are on whereas forVHS ln revenues approximately billion, were business.2004, theater U.S. $9.4 DVD sales were$15billion.

CHAPTER . THE PURCHASE 5 AND SALEOF I N V E N T O R Y

EXHTBtT 5.23
(dnums in thnusmd$)

Inventory Turnover Ratios Whole for Foods and Chicos

For fiscal year ended (1) Sales (2) Cost of goods sold . .

Whole Foods Market, Inc. September 25, 2005

Chico's FAS January 28, 2006

..

$ 4,701,289 3,052,184

$ r,404,575

(4) Inventory beginning of the year January 29,200b (5) Inventory, end of the year January 28, 2006 (6) Average inventory (( ) + (5)) - 2 Inventory turnover ratio (2) - (6)

152,912 t74,848
163,880 18.62times

73,223 95,421
84,322 6.49 times

The inventory turnover ratio is defined as costof goods sold divided by average inventory. is a measure lt of how quicklya firm sellsits inventory.

inThe inventory turnover ratio is definedas cost of goodssold divided by the average ventory on hand during the year. The ratio measureshow many times a frm turns over its inventory during the year-how quickly a firm is selling its inventory. We will compare the inventory turnoverratio for Whole Foods,a large grocery chain, with that for Chico's FAS, a smaller specialtyclothes store chain. The year's cost of goods sold for eachfirm is found on inventory can be calculatedfrom the beginning and ending and average its income statement, To we inventory amountsshown on comparativebalancesheets. get the average, will just add the year-endinventory balancesand divide by two. The data and calculationsare shown in Exhibit 5.23. Notice that although Whole Foods has a much lower gross profit ratio than Chico's, the firm tums over its inventory many more times eachyea.rthan doesChico's. Although managerswant to turn over inventory rapidly, they also want enough inventory on hand to meet customer demand.Managers can monitor inventory by using the inventory turnover ratio to find out the number of days items stay in inventory, For Whole Foods, 365 (days in a year) divided by 18.62 (inventory turnover ratio) : 19.6 days. For Chico's, the averagenumber of days in inventory is just over 56 days (365 + 6.49). Managersclosely watch both the inventory turnover ratio and averagedays in inventory.

and on Your Turn 5-g Safewayreportedinventoryof $2,766.0 52,740.7 its balancesheetsat 'Wk.ww*ww. Duringthe 2005 respectively. the end of the fiscalyears2005and 2004, Wfu-m'm.,w.w(endedon the SaturdaynearestDecember the company's fiscal year 31), cost of (Numbers in millions,) ingoodssoldwas 527,301.1. are What was Safeway's did ventoryturnoverratio for the year?How manydays,on average, merremainin the inventory? chandise
L.0.7 Describe risks the associated inventorv with andthe controls that minimize risks. those

and Business Control, Ethics Risk,

Inventory is a very important assetand ties up alarge percentageof a firm's cash.The firm must evaluateand control the risk of losing inventory. Have you everread how much money retail companieslose from shoplifting? The 17th Annual Retail Theft Survey reported that over $4.7 billion was lost from shoplifting and employee theft in just 27 U .5. retail companies in 2004.Itis no surprisethat retail firms such as Macy's and Targetare very concerned about inventory theft. All consumerspay for that loss in higher merchandiseprices; therefore, good controls on inventory are important to both the company and the consumer. Like any of a company's assets,the inventory must be protected from damage and theft. with the acThe policies and procedureswe havediscussedcan help reducethe risks associated tual purchaseof the inventory-selecting a reliable vendor and making surethe items received are the ones ordered. To safeguardinventory from theft, companies can use conffols such as locking storagerooms and limiting accessto the inventory. When you buy clothes from Abercrombie & Fitch or the GAP, you might notice a sensorattachedto the clothing that the salesclerk must removebefore you leavethe store.You may haveexperiencedthe unpleasantbeeping of a sensorif a storeclerk forgets to remove the device. Other items such asCDs and DVDs will set off a beeperif you try to leave the store without having the cashier de-sensorthem.

AND ETHICS RISK, CONTROL 5 CHAPTER . BUSINESS Inventory Obsolescence Reserve

E X Ht B t r5 . 2 4
Tweeter Home Entertainment Group's Note About the Riskof Inventory Obsolescence
Tweeter Home Entertainment Group sells cutting-edge technologiesthat are at most risk for having obsolete inventory. The company, therefore, has an extensive note about inventory obsolescence.

Our profltability and viability Inventory represents a significant portion of our assets (38.1olo). is highly dependent on the demand for our products. An imbalance between purchasing Ievels and sales could cause rapid and material obsolescence,and loss of competitive price advantage and market share. We believe that our product mix has provided sufflcient diversification to mitigate this risk. At the end of each reporting period, we reduce the value by our estimate of what we believe to be obsolete, and we recognize an expense of the same amount, which is included in Cost of Sales in our consolidated statement of operations.

Segregationof duties is a control that helps companiesminimize the risk of losing inventory to error or theft. The personwho keepsthe inventory recordsshould not be the same person who has physical conffol of the inventory. This separationof record keeping and physical control of assetsmakes it impossible for a single individual to steal the inventory and cover it up with false record keeping.When this control is in place and functioning properly, it would take collusion-two or more people getting together on the plan-to lose inventory in this way. Large retail firms such as Target have extensive inventory controls. There are many places-from the receiving dock to the front door of the store-where Targetmust keep an eye on its inventory. When goods arrive at the receiving dock, a clerk will make a record of the type and amount of merchandisethat has arrived on a copy of the original purchaseorder without any quantities listed. The firm wants the receiving clerk to independently check the type and amount of goods that have been received. This record will be sent to the accountspayable department, where a clerk in that departmentwill compare the record of the goods received with the original purchaseorder, which was sent over earlier from the purchasing department. Do you seethe controls in place to safeguardthe incoming shipmentsof merchandise?Severaldifferent departmentsare keeping a record of the goods ordered and received.The receiving clerk sendsthe merchandiseto the inventory department,where physical custody of the goodsis separate from the record keeping, which we have seenis verified by severaldepartments. Inventory is such an important assetto a firm that financial analystsand investors are In very concernedthat it is properly reported on the financial statements. addition to protecting inventory from damageand theft, firms risk losing inventory as a result of obsolescence. If you were the manager of Best Buy, you would hate to have a warehousefull of VHS tapes when DVDs are available. If you were the managerof CompUSA, you would hate to have an inventory full of Pentium 3 computerswhen Pentium 4, a much faster and more effrcient model, becameavailable. Firms that deal with cutting-edgetechnologiesare at most risk for having obsoleteinventory. Sprint PCS or T-Mobile would not want to have a huge inventory of analog-only phones now that digital phones are the better choice. With the new Bluetooth technology, the cell phone businessis at risk with its old inventories.Each yeat, acompany's inventory at is evaluatedfor obsolescence the sametime the lower-of-cost-or-marketrule is applied. Inventory must be written off, which will increasethe cost of goods sold, when it is deemed Tweeter Home Enterto be obsolete.For example, in the notes to its financial statements, tainment Group, the owner of HiFi Buys, Electronic Interiors, ShowcaseHome Entertainshown in ment, and Sound Advice, has an extensive note about inventory obsolescence, Exh1bit5.24. Inventory losseshave an ethical component.The obvious one is that unethical people may steal a firm's inventory. Less obvious is the opportunity that inventory provides for Failure to write down inventory that has lost value misstating the value of the frrm's assets. means that earnings will be overstatedby the amount of the decline in inventory. As you that do not produce any revenue, know by now, managersrarely want to recognizeexpenses and they often look for ways to boost earnings. Inventory valuation is an area where the flexibility of accounting standardscan lead to manipulation of earnings.When you study a be firm's financial statements, sure to read the notes to the financial statementsabout the hrm's policy on writing down its obsoleteinventory.

AND SALEO F I N V E N T O R Y CHAPTER . THE PURCHASE 5

Points Summary Chapter

A firm records the purchaseof inventory at cost. That includes all costs to get the inventory ready for sale. Shipping costs, purchasediscounts, and purchasereturns and allowancesall must be consideredin calculating the cost of inventory. When a firm sells the inventory, the firm must consider salesdiscounts and salesreturns and allowanceswhen calculating net salesrevenue. Inventory record keeping can be done at the time of eachsale-perpetual inventory system, or the record keeping can be done at the end of the period-periodic inventory system. If a firm does not specifically identify the inventory item sold at the time of the sale, to the firm will selectone of three common cost flow assumptions value inventory sold. is necessary inventory costsare not constantand when Making a cost flow assumption the specifrc identification of inventory units sold is too costly. The three methods are weighted averagecost; first-in, first-out (FIFO); and last-in, first-out (LIFO). When costs of inventory are changing, these methods most often will produce different amountsfor cost of goods sold. To avoid overvaluing inventory, firms must compare the cost of their inventory to the market value of the inventory and value the inventory at the lower of the two. This is called the lower-of-cost-or-marketrule for valuing inventory. The gross profit ratio and the inventory turnover ratio are both useful in evaluating a firm's performance with respect to inventory. Gross profit ratio is equal to the gross profit divided by sales.The inventory turnover ratio is equal to cost of goods sold divided by averageinventory. Firms face the risk of inventory being lost, damaged,and stolen.Controls include physically guarding the inventory (security services,locks, and alarms) and regular record keeping to identify potential problems. Many firms, high-tech firms in particular, run and sales the risk of having obsoleteinventory. Again, regular monitoring of purchases will help control this risk.

Problems Summary Chapter

in for a methods TV Heaven, retailfirm thatspecializes high-end the To compare inventory will apply simple.Our results we televisions, will look at a singleitem to keeptheanalysis Marchwith an inTV started to the otheritemsin the inventoryaswell. Suppose Heaven ventory of 50 plasmaTVs that cost $2,010each,for a total beginninginventoryof DuringMarch,the firm madethefollowingpurchases: $100,500. March2 March10 March2} March29 each 2OO TVs for $2,000 each 150TVs for $1,800 each 100TVs for $1,500 each 50 TVs for $1,000

DuringMarch,the firm madethe following sales: each March5 110TVs for $4,000 each March 12 160TVs for $4,000 each March25 150TVs for $4,000

Instructions
l. IJsingperiodic inventory record keeping,calculatethe cost of goods sold for the month and the inventory at the end of the month. Do these calculationsusing three methods: weighted averagecost, FIFO, and LIFO. All other operating expensesamounted to $250,000.Assume theseare the only transactionsfor the period. Calculate net income using eachof the three methods.Which method provides the highestnet income?What is causingthis method to produce the highest net income?

P C H A P TE R C H A P TES U MMA R Y R OB LE MS 245 5 . R 2. Using perpetual iwentory record keeping, calculate the cost of goods sold for the month and the inventory at the end of the month. Do these calculations using three methods: weighted average cost, FIFO, and LIFO. All other operating expenses amountedto $250,000.Assume these are the only transactionsfor the period. Calculate net income using each of the three methods.Which method provides the highest net income? Explain why weighted averagecost and LIFO produce different amounts under perpetual than they do under periodic.

Solution L. Periodic Inventory

Cost of Goods Sold No. of Units B eginning e n to ry inv P ur c has es ar 2 M M ar 1 0 M ar 2 0 Mar 29 G oodsav ailab l e r s a l e fo Unit ss old Costof goods sold: Weighted averagecost Costof goods sold : FIFO Unit Cost Total Cost

50 200 150 100 50 550 420

$2,010 $2,000 $1,800 $1,500

$t,ooo

$1oo,5oo $40o,ooo $27o,ooo $1s0,000 $ so,ooo $97o,soo

+ $970,500 550 420x $1,765 s0 x 200x 150x 20 x = $2,010 : $2,000 $1,800: : $1,s00 420 $t,000: = $1,500 $1,800: $2,000: 420 Net lncome
Weighted Average Cost

= $ 1,765

= I?41,t99
s00 $100, $400,000 $270,000

E ndi ngInventory: 130 x $1,76s:

$229,4s0

$ go,ooo
$800,s00 $ s0,000 $150,000 $270,000 $240,000 $710,000

Costof goods sold LI F O

: 80 x $1,800 -50 x $1,000 Ending Inventory

$120,000

$so,ooo
$170,000

50 x 100x 150x 120x

Costof goods sold

= 80 x $2,000 : 50 x $2,010 Inventory Ending

$160,000 $100,s00 $260,s00

FIFO

LIFO

revenue Sales Costof goods sold Grossprofit Other operating expenses Net income

$1,580,000 741,300 938,700 250,000 $ 688,700

$1,680,000 800,500 879,500 250,000 $ 629,500

$1,680,000 710,000 970,000 250,000 $ 720,ooo

Net income is highest using LIFO becausethe cost of the inventory is going down. More often, costs go up so companiesuse LIFO to minimize net income. In this case, the technology advancesare likely driving down the cost of plasma TVs

CHAPTER . THE PURCHASE 5 AND SALEO F I N V E N T O R Y

2. Perpetual Inventory Cost of Goods Sold No. of Units Be g i n n i n gi n ventory Mar 2 Purchases M a r 10 M a r 20 M a r 29 for G o o d sa v a i l abl e sal e U n i tss o l d M a r 5 M a r 12 M a r 25 Ending inventory Weighted average (WA) cost WA cost on March 5 s0 200 150 100 s0 550 110 160 150 130

UnitCost
$2,010 $2,000 $ 1,800 $1,s00 $ 1,000

Total Cost

$100,s00 $40o,ooo $27o,ooo s0,000 $1 $ so,ooo $97o,soo

Average unit cost 50@$2,010 $500,500250: + 200@$2,000 $2,002 avg.cost +290: $550,280 140@52,002 $1,898 avg.cost (rounded) 150@$1,800 + $396,740 230= 130@$1,898 $l,lZSavg.cost (rounded) 100@$1,500

Costof goods sold 110unitsx : $2,002 $220,220 160unitsx $t,gge: $303,680 150unitsx $l,lZS= $ZSA,ZSO $782,6s0 $188,000

WA cost on March 12

WA cost on March 25 Total cost of goods sold (Endinginventory)

+ 80 @$1,72s $188,000 130= per 50@51,000 51,446 unit (rounded)

Note: Under WA perpetual,the ending inventoryplus cost of goods sold is $150 for Thi m o re th a n g oodsavai l abl e sal e. sdi fferenti ali s due to roundi ng.l f you you w i l l el i mi natethi s to deci malpl aces, c a rryo u t th e cal cul ati ons several rounding error.Thistype of calculationis typicallydone in a computer program th a t w i l l n o t r ound as w e havedone here. F IF O Sa l eo n M a rc h5 (110uni ts) Sa l eo n M a rc h 12 (160uni ts) Sa l eo n M a rc h25 (150uni ts) Costof goods sold F IF O n d i n g i nventory e L IF O Sa l eo n M a rc h5 (110uni ts) Sa l eo n M a rc h 12 (160uni ts) Sa l eo n M a rc h25 (150uni ts) Costof goods sold

s0 @$2,010 60 @$2,000 140@$2,000 20 @$1,800 130@$1,800 20 @$1,s00 80 @$220,000 s0 @$1,000 110@$2,000 1s0@$1,800 10 @$2,000 100 $1,500 @ s0 @$2,000

$220,500 6,ooo $31 $254,000

$800,s00 $170,000 $220,000 $290,ooo $2s0,000 $760.000

T C H A P T E 5 . A N S WE R S O Y O U R T U R N Q U E S T I O N S R

247 "

' ',

LI F O ending inv e n to ry

s0 @$1,000 30 @$2,000 s0 @$2,010

Weighted Average Cost $ 1 ,6 8 0 ,0 0 0 FIFO $1,680,000

$210,s00

Net Income Sales revenue Costof goods sold

LIFO $1,680,000

profit Gross Otheroperating expenses Net income

782,650 897,350 250,000 $ iM,ZSO

800,500 879,500 250,000 $ 629,500

760,000 920,000 250,000 $ 670.000

to When a firm usesperpetualrecordkeeping,it cannotassume havesold units that were not purchasedby the date of the sale. On the other hand, when a firm uses periodic record keeping, every purchasemade during the period-no matter how the purchase datesmatch up to the salesdates-is part of the calculation of cost of goods sold. For weighted averagecost, the average different becauseof the late purchase.For LIFO, is purchasecan be countedin the cost of goods sold. (Under perpetthat last and cheapest ual, it could not be used because had not been purchasedat the time of the last sale.) it

KeyTerms Chapter for 5

(p.217) Contra-revenue Cost of goods available for sale (p.215) First-in, first-out (FIFO) (p.223) FOB destination(p. 213) FOB shippingpoint (p. 213) Grossprofit ratio (p. 240) Inventory turnover ratio @.2a1) Last-in, first-out (LIFO) (p.223) Lower-of-cost-or-market (LCM) rule (p. 238) Periodicinventorysystem (p.212) Perpetualinventory system (p.212) Purchasediscount (p.214) Purchase order(p. 211) returnsand Purchase (p.214) allowances Replacement cost (p. 238) Salesdiscount(p.217) Salesreturnsand (p.211) allowances identification Specific method(p.221) Weighted averagecost (p.221)

Answers YOUR to TURN Questions

Chapter5 Your Turn 5-1 1. $9,800 the discount; vendorpaid freight] [$10,000 ZVo 2. $10,090 expired; buyerpaidthefreight] [Discount i 3. $9,890 [$10,000 27odiscount $90freight] Your Turn 5-2 Coffee Bags Totalinventory cost of 987o $500 $490 100 $590

Your Turn 5-3 Cash collected: $3,150 Revenue: $3,000 Your Turn 5-4 account bereduced. will the Thefirm should perpetual. thetimeof each At sale, inventory use between inventory the Whentheperiodis overandtheinventory counted, difference is any by countof the amount amount identifred a physical shown therecords theinventory in and

244

CHAPTER . THE PURCHASE 5 AND SALEoF I N V E N T o R Y

inventory will be the amountof inventory shrinkage.If the firm useda periodic system,all inventory not presentat the end of the period is assumed be parl of cost of goods sold. to

Your Turn 5-5

Theweighted average of a unit is: [($10+ $40y30]: $1.66661 unit cost per : Costofgoods sold: 15unitsx $1.66667 $25 Your Turn 5-6 1. Costof goods soldis $4,600+ $5,100: $9,ZOO; the gross and profit is $14,000 : $9,700 $4,300. 2. Costof goods soldis $3,500+ $5,100: $8,600; the gross and profit is $14,000 : $8,600 $5,400. : 3. Weighted average of thebracelets $13,200/3 $4,400. costof goods cost is The sold : for thesale two bracelets of wouldbe 2 X $4.400 $8.800. Your Turn 5-7 1. FIFO:$705[(30x $20)+ (5 x $21)] x 2. LIFO:$7'751(20 $23)+ (15 x $21)l (rounded) 35 : $740 x 3. $21.143 Your Turn 5-8 The LIFO conformityrule saysthat if a firm uses LIFO for tax purposes, mustalsouse it (GAAP) purposes. is unusual accounting tax rulesto overLIFO for accounting It for and lap.Usuallyaccounting rules(GAAP) do not follow tax law. Your Turn 5-9 Inventory turnover ratio = 27,301.1 [(2,766.0 2,740.7) 2] : 9.92 + + + Average daysin inventory: 365+ 9.92 : 36.79days Questions point andFOB destination. 1. ExplainthetermsFOB shipping What arethe accounting and business implications the shippingterms? of Why is it importantto know who ownsgoods duringshipping? 2. Whatis the difference freight-inandfreight-out? between 3. What is the difference between purchase a returnanda purchase allowance? What is the effectof purchase returnsand allowances the overallcost of inventoryto the on buyer? 4. Whatis a purchase discount? What is the effectof a purchase discount the overall on costof inventory thebuyer? to 5. Explainthetermsof a purchase described 2/I5, n/30.Wouldyou takeadvantage as of this offer?Why or why not? 6. Whatis a contra-revenue account? Givetwo examples contra-revenue of accounts. 7. What is a sales discount? What is the effectof a sales discount the total sales on revenue ofthe seller? 8. Whatis thedifference between periodicandperpetual a inventorysystem? 9. Whatis inventory shrinkage? 10. Whatis thedifference the between physical flow of inventory theinventory flow? and cost 11. What arethe commoncostflow methods accounting inventory? for for Describe the differences. (FIFO,LIFO, or weighted 12. If inventory costsarerising,whichmethod average cost)resultsin thehighest income? net Explainyour answer. (FIFO,LIFO, or weighted 13. If inventory costs rising,whichmethod are ayera1e cost)resultsin thelowestnetincome? Explainyour answer. 14. DoesLIFO or FIFO give thebest-most current-balancesheet valuefor the ending inventory? Why? 15. How do taxesaffectthe choicebetween LIFO andFIFO?

C H A P TE R MU LTIP LE -C H OIC E S TION S 249 5. QU E 16. Does the periodic or perpetual choice affect the choice of a cost flow (LIFO versus FIFO) method?Explain. 17. What is the lower-of-cost-or-markefrule and why is it necessary? 18. What does the gross profit percentagemeasure?How is it calculated? 19. What does the inventory turnover ratio measure? What does average-days-ininventory mean? 20. What are some of the risks associatedwith inventory? How do managersminimize theserisks?

Multiple-Choice Questions it as 1. Wheninventory purchased, is recorded a(n) is

it becomesa(n) a. liability, withdrawal b. asset, expense c. liability, asset d. asset, contra-asset

and when sold

Use the following information to answer the questions2 through 5. Inventory data for Newman & Frith MerchandisersInc. is provided here. Salesfor the period were 2,800 units. Each sold for $8. The companymaintainsa periodic inventory system. Number of Units Unit Cost Total Cost Date

January February March April

inventory Beginning Purchases Purchases Purchases

1,000 500 800 1,200

$3.00 $3.50 $4.00 $4.25

$ $ $ $

3,000 2,100 3,200 5,100

rotals

1609

$l_1199

the 2. Determinethe ending inventoryassuming companyusesthe FIFO cost flow method. a. $3,400 b. $2,400 c. $9,200 d. $10,000 the 3. Determinethe cost of goodssold assuming companyusesthe FIFO cost flow method. a. $3,400 b. $10,000 c. $10,200 d. $2,400 the average cost uses weighted 4. Determine endinginventory assuming company the the flow method. a. $2,300 b. $3,300 c. $9,800 d. $2,976 profit assuming company uses LIFO costflow method. the 5. Determine gross the the a. $11,400 b. $14,400 c. $22,400 d. $19,700 6. UsingLIFO will produce lowernetincomethanusingFIFO underwhich of thefola lowingconditions? a. Inventory costsaredecreasing. b. Inventory costsareincreasing. c. Inventory costsarenot changing. pricesaredecreasing. d. Sales

250

CHAPTER . THE PURCHASE 5 AND SALEO F I N V E N T O R Y Use the following information to answer questions 7 through 10.

7.

8.

9.

10.

Salesrevenue $480,000 Costofgoods sold 300,000 20,000 Salesdiscounts Salesreturns and allowances 15,000 Operating expenses 85,000 Interest revenue 5.000 What is the net salesrevenue? a. $400.000 b. $445.000 c. $415,000 d. $455,000 What is the gross profit? a. $145,000 b. $10s,000 c. $140,000 d. $90,000 What is the net income? a. $60,000 b. $65,000 c. $55,000 d. $180,000 What is the gross profit percentage? a. l3.54%o b . 1 4 .6 l % o c. 3258Vo d . 2 l .6 7 % o

Short Exercises SE5-1. Calculatecost of inventory.(LO l) Celebration Coordinators Corporation beganoperationson April 1. The following transactions took place in the month of April. a. Cashpurchases merchandise of during April were $300,000. b. Purchases merchandiseon account during April were $400,000. of c. The cost of freight to deliver the merchandise Celebration to was $25,000;the terms were FOB shipping point. The freight bill was paid in April. returned$22,000ofmerchandisepurchased part a to the supplier d. Celebration in for a full refund. e. The store manager'ssalary was $3,000 for the month. Calculate the amount that Celebration Coordinators Corporation should record for the total cost of merchandiseinventory purchasedin April. (LO I,2) SE5-2.Recordpurchaseof merchandise inventory:perpetual inventorysystem. Using the data from SE5-1, enter each of the transactionsinto the accounting equation for the month of April, assumingCelebration CoordinatorsCorporation usesa perpetualinventory system. SE5-3. Calculatecost of inventory.(LO 1) For each of the following independentsituations, calculatethe amount that the purchasing company would record as the cost of each inventory purchase. a. Invoice price of goods is $5,000. Purchaseterms are 2/70, n/30 and the invoice is paid in the week of receipt. The shipping terms are F.O.B. shipping point, and the shipping costs amount to $200. b. Invoice price of goodsis $3,000.Purchase terms are 4110, nl30 and the invoice is paid in the week of receipt. The shipping terms are F.O.B. destination,and the shippingcostsamountto $250.

5. E C H A P TE R S H OR T X E R C IS ES 251 c. Invoiceprice of goodsis $2,500.Purchase terms are 2/10, nl30 and the invoice is paid 15 days after receipt. The shipping terms are F.O.B. shipping point, and the shipping costsamountto $250. (LO 1,2) SE5-4.Recordsale of merchandise inventory:perpetual inventorysystem. Brenda Bailey's Textiles Inc. uses a perpetual inventory system.Enter each of the following transactions the accounting into equation. on 1. On February12,BrendaBailey's sold $500,000of merchandise accountwith terms 2110,n130. The cost of the merchandise sold was $230,000. purchased Februon 2. On February16,the customerretumed$100,000of the merchandise returnedwas $46,000. ary 12 because was the wrong style.The cost of the merchandise it 3. On February20, the customerpaid the balancedue BrendaBailey's. SE5-5. Calculate grossprofit and grossprofit ratio. (LO 1, 6) Brenda Bailey's startedthe month of February with $300,000of inventory. Using the information in SE5-4, calculate the net salesrevenue,cost of goods sold, and gross profit that would appearon Brenda Bailey's Textiles Inc. income statementfor the month of February. cost.(LO 3) SE5-6. Calculatecost of goodssold and ending iwentory: weighted-average Calculatethe cost of goods sold and the cost of the ending inventory using the weighted averagecost flow assumption. Assumeperiodic recordkeeping. Sales Beginninginventory Purchases 100 units at $15 per unit 90 units at $6 per unit 60 units at $9 per unit

SE5-7. Calculatecost of goodssold and ending inventory:FIFO. (LO 3) Using the datafrom SE5-6,calculatethe cost of goodssold and the cost of the ending inventory using the FIFO periodic cost flow assumption. SE5-8. Calculate cost of goods sold and ending inventory: LIFO. (LO 3) Using the datafrom SE5-6,calculatethe cost of goodssold and the cost of the ending inventory using the LIFO periodic cost flow assumption. SE5-9.Analyzeffict of costflow methodon net income.(LO 3) Given the following information, calculate the amount by which net income would differ between FIFO and LIFO. Beginninginventory Purchases Units sold 3,000units at $100 per unit 8,000units at $130 per unit 6,000 units at$225 per unit

SE5-10.Analyzeeffectof costflow methodon grossprofit. (LO 3, 4) Given the following information, calculate the amount by which gross profit would differ betweenFIFO and LIFO. Beginninginventory Purchases Units sold 1,500units at $55 per unit 2,750 units at $58 per unit 2,250 units at $99 per unit

SE5-11.Apply the lower-of-cost-or-market rule. (LO 5) The following information pertainsto item #007SSof inventory of MarineAquatic SalesInc. Cost Replacementcost Selling price

Perunit $180 181 t95

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CHAPTER . THE PURCHASE 5 AND SALEoF I N V E N T o R Y

The physical inventory indicates2,000 units of item #007SS on hand. What amount will be reported on The Marine Aquatic SalesInc.'s balance sheetfor this inventory item? SE5-12. Apply the lower-of-cost-or-market rule. (LO 5) In each case,selectthe correct amount for the inventory on the year-endbalancesheet. a. Ending inventory at cost $24,500 Ending inventory at replacementcost $23,000 b. Ending inventory at cost $27,000 Ending inventory atreplacement cost $28,500 In addition to the amountsfor the financial statements, what information doesthe comparison between cost and market provide to a company's management? SE5-13. Calculate the grossprffit ratio, inventory turnover ratio, and average days in inventory. GO 6) Using the following information, calculateinventory turnover ratio, the average days in inventory, and the gross profit ratio for Barkley Company for the year ended December 31, 2012. (Roundto two decimalplaces.) Sales Cost of goodssold Ending inventory,December3I,20ll Ending inventory;December31,2012 Net income $ 125,000 75,000 15,275 18,750 26,500

SE5-14. Identifu risk and conrrol. (LO 7) What is obsoleteinventory? Name two things a firm can do to protect itself from the associatedrisk. SE5-15. (Appendix A) Calculate inventory errors. (LO 8) How would each of the following inventory errors affect net income for the year? Assume each is the only error during the year. a. Ending inventory is overstatedby $3,000. b. Ending inventory is understatedby $ 1,500. c. Beginninginventoryis understated $3,000. by d. Beginning inventory is overstatedby $ 1,550. SE5-16. (Appendix B) Estimate inventory. (LO 9) FantasyGamesInc. wants to estimateits ending inventory balancefor its quarterly financial statements the first quarter of the year. Given the following, what is your best estimate? for Beginninginventory Net sales Net purchases Gross profit ratio $75,800 $92,500 $50,500 20Vo

Exercises-Set A
Es-lA. Recordmerchandising perpetual inventorysystem. transactions: (LO 1,2) Assumethe following transactions Clark's AppliancesInc. took placeduring May. Clark's for Appliancesusesa perpetualinventory system.Enter eachof the transactions into the accounting equation. May 2 May 9 May 16 May 22 May 24 Purchasedrefrigerators on account at a total cost of $500,000; terms I/70, n/30 Paid freight of $800 on refrigerators purchasedfrom GE Returned refrigerators to GE becausethey were damaged;received a credit of $5,000from GE Sold refrigerators costing$100,000for $180,000toPizzeia Number 1 on account,terms n/30 Gave a credit of $3,000 toPizzeriaNumber 1 for the return of a refrigerator not ordered; Clark's cost was $1,200

. CHAPTER5 EXERCISES 253

(LO 1, 2) perpetual inventorysystem. E5-2A. Recordmerchandising transactions: The FedoraCompany had a beginning inventory balanceof $25,750 and engagedin the following transactionsduring the month of June. Jlune 2 Purchased$4,000 of merchandiseinventory on account from Plumes Incorporated with terms 2/10, nl30 and FOB destination.Freight costs associated with this purchase were $225. Returned $400 of damagedmerchandiseto Plumes Incorporated Sold $7,000of merchandise FancyCapson account,terms 1/15,n/30 to and FOB shippingpoint. Freight costswere $125.The cost of the inventorysold was $3,500. Paid the amount owed to Plumes Incorporated The Fedora Company granted Fancy Caps an allowance on the June 6 saleof $300 for minor damagefound on severalpiecesof merchandise. Receivedtotal payment owed from Fancy Caps Paidsales salaries of$1,850 Paid the rent on the showroomof $1,200

June 4 June 6

June 9 June 10

June22 June24 June25

Enter eachof the transactionsfor the FedoraCompany into the accountingequation,assuming they use a perpetualinventory system. E5-3A. Calculatecost of goodssold and ending inventory:periodic FIFO. (LO 3,4) Name Brand TV Salesand Service beganthe month of May with two television setsin inventory,Model # TV5684; eachunit cost $125. During May, five additionaltelevisionsets of the samemodel were purchased. May May May May May May 10 13 16 18 23 24 Purchased two units at$127 each Sold two units at $225 each Purchased unit at $ 130 one Sold one unit at $225 Sold two units at $225 each Purchased two units at $135 each

Assume Name Brand usesa periodic inventory system and the FIFO cost flow method. a. Calculatethe cost of goodssold that will appearon Name Brand's income statementfor the month of May. b. Determine the cost of inventory that will appearon Name Brand's balance sheet at the end of Mav. E5-4A. Calculatecost of goodssold and ending inventory:periodic LIFO. (LO 3,4) Use the datain E5-3A to answerthe following questions. Assume Name Brand usesa periodic inventory system and the LIFO cost flow method. a. Calculatethe cost of goodssold that will appearon Name Brand's income statementfor the month of May. b. Determine the cost of inventory that will appearon Name Brand's balance sheet at the end of May. E5-5A. Calculatecost of goodssold and ending inventory:perpetualFIFO. (LO 3,4) Use the datain E5-3A to answerthe following questions. Assume Name Brand usesa perpetual inventory system and the FIFO cost flow method. a. Calculatethe cost of goodssold that will appearon Name Brand's income statementfor the month of May. b. Determine the cost of inventory that will appearon Name Brand's balance sheet at the end of Mav. E5-6A. Calculatecost of goodssold and ending iwentory: perpetualLIFO. (LO 3,4) Use the datain E5-3A to answerthe following questions.

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CHAPTER . THE PURCHASE 5 AND SALEOF I N V E N T O R Y

Assume Name Brand usesa perpetual inventory system and the LIFO cost flow method. a. Calculate the cost of goods sold that will appearon Name Brand's income statementfor the month of May. b. Determine the cost of inventory that will appearon Name Brand's balance sheet at the end of May. E5-7A. Calculate cost of goods sold and ending inventory: periodic weightedaveragecost. (L O 3 ,4 ) The For Fish Company sells commercial fish tanks. The company began 2006 with 1,000 units of inventory on hand. These units cost $150 each.The following transactionsrelated to the company's merchandiseinventory occurred during the first quarter of 2006. January20 February 18 March 28 Total purchases Purchased500 units for $160 each Purchased600 units for $170 each 400 units for $180 each Purchased 1,500units

price andfreight charges paid by For Fish. During the quarAll unit costsinclude the purchase ter ending March 3I,2006, salestotaled 1,700units, leaving 800 units in ending inventory. Assume For Fish usesa periodic inventory system and the weighted averagecost flow method. a. Calculatethe cost of goodssold that will appearon For Fish Company'sincome statementfor the quafier ending March 31. b. Determine the cost of inventory that will appearon For Fish Company's balance sheetat the end of March. E5-8A. Calculate cost of goods sold and ending inventory: perpetual weighted average cost.(LO 3,4) Advanced Music Technology Inc. sells MP3 players. The company beganthe third quarter of the year on July l, 2008, with 750 units of inventoryon hand.Theseunits cost $50 each. The following transactionsrelated to the company's merchandiseinventory occurred during the third quarterof 2008. July 15 August 29 September15 28 September September 30 Sold 450 units for $150 each Purchased 500 units for $90 each Sold 450 units for $200 each 500 units for $1 17.50each Purchased Sold 800 units for $250 each

All unit costs include the purchase price and freight charges paid by Advanced Music Technology. Assume Advanced Music Technology uses a perpetual inventory system and the weighted averagecost flow method. a. Calculate the cost of goods sold that will appearon Advanced Music Technology's income statementfor the quarter ending September30. b. Determine the cost of inventory that will appearon Advanced Music Technology's balance sheetat the end of September. E5-9A. Apply the lower-of-cost-or-market rule. (LO 5) Use the following data to answer the following questron. Ending inventoryat cost,December3l,20Il Ending inventory at replacementcost, December 37,2071, Cost of goodssold, balanceat December3l,20lI balanceat December3l,20fI Salesrevenue, Cash,balanceat December3I,2011 17,095 16,545 250,165 535,780 165,340

What inventory amount will this firm report on its balance sheetat December 31,2011?

C H A P T E 5 o E X E R C I S E S 255 R

E5-10A. Apply the lower-of-cost-or-market rule. (LO 5) In each case,indicate the correct amount to be reported for the inventory on the year-end balancesheet. a. Ending inventory at cost $125,000 Ending inventory at market $r2r,7 5 0 b. Ending inventory at cost $117,s00 Ending inventory at market $120,250 E5-11A. Calculate grossprofit and grossprofit percentage: FIFO and LIFO. (LO 6) Given the following information, calculate the gross profit and gross profrt ratio under (a) FIFO periodic and under (b) LIFO periodrc. Sales Beginning inventory Purchases 200 units at $50 per unit 60 units at $40 per unit 175 units at $45 per unit

E5-12A. Calculatethe inventoryturnover ratio. (LO 6) A company calculated its inventory turnover for the past 2 years. This year the inventory turnover is 6.3, and last year the inventory turnover was 7.5. Use this data to answerthe following questions. a. Will this changein the inventory turnover ratio be viewed as good news or bad news?Explain your answer. b. Does the changeindicate that more or less capital has been tied up in inventory this year comparedto last year? E5-13A. Identify risk and control. (LO 7) Supposean unethical managerwanted to keep his firm's net income as high as possible for a particular quarter to make sure he would get his bonus. The inventory manager has informed him that some obsolete inventory should be written off. What effect does writing down the value of the inventory have on net income? How will the managerrespondto the inventory manager? E5-14A. (Appendix A) Calculate inventory errors. (LO 8) Ian's Small Appliancesreportedcost of goodssold as follows. B eginninginv e n to ry Purchases Costof goods availablefor sale E ndinginv ento ry Costof goods sold Ian's madetwo errors: l. 2005 ending inventory was understatedby 95,000. 2. 2006 ending inventory was overstatedby $2,000. Calculate the correct cost of goods sold for 2005 and2006. E5-15A. (Appendix B) Estimate inventory. (LO 9) The following information is availablefor the AizonaChemical Supply Company. Inventory January l, 2006 Net purchasesfor the month of January Net salesfor the month of January Gross profit ratio (historical)

200s $130,000 275,000 405,000 s0,000 $3ss,000

2006 s0,000 $ 240,000 290,000 40,000 $2s0,000

$240,000 750,000 950,000 4O7o

Estimatethe cost ofgoods sold for January and the ending inventory at January 31,2006.

256

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B Exercises-Set
(LO I,2) perpetual inventorysystem. transactions: E5-1B. Recordmerchandising following transactionsfor Jennifer's Fix-It-Up Inc. took place during March. Assume the Jennifer'susesa perpetualinventory system.Enter eachof the transactionsinto the accounting equation. March 3 March 8 March 16 March22 March 28 Purchasedtelevisions from Sanyo on account at a total cost of $650,000,tetms 2/10, n/25 purchased from Sanyo Paid freight of $1,000on televisions Returnedtelevisions to Sanyo becausethey were damaged.Received a credit of $ 15,000 from Sanyo. costing $125,000for $225,000to Joe'sSport'sBar Sold televisions & Grille on account,terms n/15 Gave a credit of $2,800to Joe'sSport'sBar & Grille for the return of a televisionnot ordered.Jennifer'scost was $1,600.

(LO I,2) perpetual inventorysystem. trdnsactions: E5-2B. Recordmerchandising in Inc. had a beginninginventorybalanceof $85,450and engaged the folDiscountWines during the month of October. lowing transactions October 2 Purchased$15,000 of merchandiseinventory on account from Joe's Winery with terms 2/10, nl30 and FOB destination.Freight costs for were $750. this purchase 100 of damagedmerchandiseto Joe's Returned$ to Sold $18,000of merchandise TastyCateringServiceon account, n/30 and FOB shippingpoint. Freight costswere $155. terms2115, The cost of the inventorysold was $10,500. Paid the amountowed to Joe's DiscountgrantedTastyan allowanceon the October6 saleof $200 for somesouredwine. Receivedpayment from Tasty of Paid salessalaries $ 1,500 of on the warehouse $ 1,450 Paid the rent

October 5 October6

October l0 October 10 October 23 October29 October3 1

equation,assumfor Enter eachof the transactions DiscountWinesInc. into the accounting system. ing they use a perpetualinventory periodic weightedaveragecost. E5-3B. Calculatecost of goodssold and endinginventory: (L O 3 ,4 ) The company'sfiscal yearbeSandy'sCleanCarpetCompanysellscommercialvacuums. 30, 2007. Sandy'sbeganthe year with 1,500units of ingins July 1,2006, and endsJune related to the ventory on hand. These units cost $200 each. The following transactions occurred during the first quarter of the year' company's merchandiseinventory July 15 August 28 10 September Total purchases 450 units for $195 each Purchased 575 units for $190 each Purchased 600 units for $185 each Purchased 1,625units

All unit costsinclude the purchaseprice and freight chargespaid by Sandy's Clean Carpet. During the quarter ending September30, 2006, salesin units totaled 1,950 units. Assume Sandy's Clean Carpet uses a periodic inventory system and the weighted averagecost flow method. a. Calculate the cost of goods sold that will appearon Sandy's Clean Carpet Company's income statementfor the quarter ending September30. b. Determine the cost of inventory that will appearon Sandy's Clean Carpet Company's balance sheetat the end of September. E5-48. Calculate cost of goods sold and ending inventory:perpetual weightedaverage cost.(LO 3,4) Cutting Edge Enterprises Inc. sells flat-screen televisions. The company began the last qua.rter the year on October I,2009, with 750 units of inventory on hand. Theseunits of

o CHAPTER5 EXERCISES 257

cost $1,000 each.The following transactionsrelated to the company's merchandiseinventory occurred during the last quarter of2009. October 15 October29 November 15 December28 December30 Sold 450 units for $3,000each Purchased 500 units for $1,800each Sold 450 units for 94,000 each Purchased500 units for 92,350 each Sold 800 units for $5,000each

All unit costsinclude the purchase price andfreight charges paid by Cutting EdgeEnterprises. Assume Cutting Edge usesa perpetualinventory systemand the weighted averagecost flow method. a. Calculate the cost of goods sold that will appearon Cutting Edge Enterprises' income statementfor the quarter ending December 3I,2009. b. Determine the cost of inventory that will appearon Cutting Edge Enterprises' balance sheetat the end of December. E5-5B. Calculate cost of goods sold and ending inventory: periodic FIFO. (LO 3,4) Radio Tech. Sales& ServiceInc. beganthe month of April with three top-of-the-line radios in inventory, Model # RD58V6Q; each unit cost $235. During April, nine additional radios of the samemodel were purchased. April 9 April 11 April 17 April 18 April20 April 28 Purchasedthree units at $230 each Sold five units at $350 each Purchased two units at $195 each Sold one unit at $350 Sold two units at $350 each Purchased four units at $180 each

Assume Radio Tech. usesa periodic inventory system and the FIFO cost flow method. a. Calculate the cost of goods sold that will appearon Radio Tech.'sincome statementfor the month of April. b. Determine the cost of inventory that will appearon Radio Tech.'sbalance sheet at the end of April. E5-68. Calculatecost of goodssold and ending inventory:periodic LIFO. (LO 3,4) Use the datain E5-5B to answerthe following questions. Assume Radio Tech. usesa periodic inventory system and the LIFO cost flow method. a. Calculate the cost of goods sold that will appearon Radio Tech.'sincome statementfor the month of April. b. Determine the cost of inventory that will appearon Radio Tech.'sbalance sheet at the end of April. E5-7B. Calculatecost of goodssold and ending irwentory:perpetualFIFO. (LO 3,4) Use the data in E5-5B to answer the followrng questlons. Assume Radio Tech. usesa perpetual inventory system and the FIFO cost flow method. a. Calculate the cost of goods sold that will appearon Radio Tech.'sincome statementfor the month of April. b. Determine the cost of inventory that will appearon Radio Tech.'sbalance sheet at the end of April. E5-88. Calculate cost of goods sold and ending inventory: perpetual LIFO. (LO 3,4) Use the data in E5-5B to answer the following questions. Assume Radio Tech. usesa perpetualinventory system and the LIFO cost flow method. a. Calculate the cost of goods sold that will appearon Radio Tech.'sincome statementfor the month of April. b. Determine the cost of inventory that will appearon Radio Tech.'sbalancesheet at the end of April.

E5-9B. Apply the lower-of-cost-or-market rule. (LO 5) Use the following data to answer the following question. Ending inventoryat cost,June30, 2010 cost,June30, 2010 Ending inventoryat replacement Cost of goodssold,balanceat June30, 2010 balanceat June30, 2010 Salesrevenue, Cash,balanceat June30,2010

$25,180
25,130

150,550
)75 6)5

285,5 i5

ASB Hardware Inc. uses a perpetual inventory system and the FIFO cost flow method to accountfor its inventory. What inventory amount will ASB Hardware report on its balance sheetat June30, 2010? rule. (LO 5) E5-10B. Apply the lower'of-cost-or-market amount to be reported for the inventory on the year-end In each case,indicate the correct balancesheet. $275,000 a. Ending inventoryat cost Ending inventory at market $271,250 $185,250 b. Ending inventoryat cost $187,550 Ending inventoryat market prffit ratio: FIFO and LIFO. (LO 6) E5-118. Calculate grossprofit and gross Given the following information, calculate the gross profit and gross profit ratio under (a) FIFO periodic and under (b) LIFO periodic' Sales Beginninginventory Purchases 225 units at $30 per unit 105 units at $20 per unit 180 units at $32 Per unit

E5-128. Calculatethe inventoryturnover ratio. (LO 6) A company calculated its inventory turnover for the past 2 years. This year the inventory turnoveris7.2, andlastyear the inventoryturnoverwas 8.3.Use this datato answerthe following questions. a. Will this changein the inventory turnover ratio be viewed as good news or bad news?Explain your answer. b. Does the changeindicate that more or less capital has been tied up in inventory this year comparedto last Year? E5-138. Identify risk and control. (LO 7) For and (3) obsolescence. with inventory include (1) theft, (2) damage, Risks associated you believe is seriously faced with this risk and each item, give an example of a company explain why. E5-148. (AppendixA) Calculateinventoryerrors. (LO 8) Tire Pro Company's recordsreported the following at the end of the fiscal year. Beginninginventory Ending inventory Cost of goodssold $ 80,000 85,000 295,000

A physical inventory count showedthat the ending inventory was actually $78,000. If this error is not corrected,what effect would it have on the income statementfor this hscal year and the following fiscal Year?

,,

related inrormariontoinventory ii;1??;lfiff"!i:,:1":;:J3:":;',:T:J;tk3il,.*,"g

destroyedin Hurricane Frances. Inventory, beginning of period to Purchases date of hurricane Net salesto dateof hurricane Gross Profit ratio $300,000 140,000 885'000 557o

I '

CHAPTER5. PROBLEMS

259

The company needsto file a claim for lost inventory with its insurance company.What is the estimatedvalue of the lost inventory? Problems-Set A P5-1A. Analyzepurchasesof merchandiseinventory. (LO l) Guppies & Mollies Inc. made the following purchasesin July of the current year. July 3 Purchased terms IllO, n/30, FOB shippingpoinr $7,500of merchandise, July 6 Purchased terms 2/15, n/45, FOB shippingpoint $4,100of merchandise, July 11 Purchased terms 3/5, n/15, FOB destination $8,600of merchandise,

Required
a. For each of the purchaseslisted, how many days does the company have to take advantageof the purchasediscount? b. What is the amount of the cash discount allowed in each case? c. Assumethe freight charges $250 on eachpurchase. are What is the amountof freight that Guppies & Mollies must pay for each purchase? d. What is the total cost of inventory for Guppies & Mollies for the month of July, assumingthat all discountswere taken? P5-2A. Anctlyze purchasesof merchandiseinventory. GO l) Carrie & Runnels Bikes Plus Inc. made the following purchasesin December of the current year. December 5 December14 December24 Purchased terms 3/10, n130, FOB destination $2,600of merchandise, Purchased terms l/10, n160, FOB shippingpoint $6,150of merchandise, Purchased terms 2105, n/20, FOB destination $8,375of merchandise,

Required
a. For each purchase,by what date is the payment due, assumingthe company takes advantage the discount? of b. For each purchase,when is the payment due if the company does not take advantageof the discount? c. In eachcase,what is the amountof the cashdiscountallowed? d. Assumethe freight charges $365 on eachpurchase. are For which purchase(s) is Bikes Plus responsible the freight charges? for e. What is the total cost of inventory for Bikes Plus for the month of December, assumingthat all discountswere taken? P5-3A. Record merchandising transactions,prepare financial statements,and calculate grossprofit ratio: perpetual inventorysystem. (LO 1, 2,4,6) At the beginning of February,Ace Distribution Company Inc. startedwith a contribution of $10,000cashin exchange common stockfrom its shareholders. companyengaged for The in the following transactionsduring the month of February. February 2 February 5 February 6 February 8 February 10 February 12 February 14 February 16 February 17 Purchasedmerchandiseon account from Enter Supply Co. for $7,100, terms2/ 10,nl45 Sold merchandise accountto Exit Companyfor $6,000,terms2/10, on n/30 andFOB destination. The costof the merchandise sold was 94,500. Paid $100 freight on the sale to Exit Company Receivedcredit from Enter Supply Co. for merchandisereturned for $500 Paid Enter Supply Co. in full Receivedpayment from Exit Company for sale made on February 5 Purchasedmerchandisefor cash for $5,200 Receivedrefund from supplier for returned merchandiseon February14 cashpurchase $350 of Purchasedmerchandiseon account from Inware Distributors for $3.800.terms 1/10.n/30

25O

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February 18 February21 February 24 February25 February 27 February 28

Paid $250 freight on February 17 purchase for Sold merchandise cashfor $10,350.The cost of the merchandise sold was $8,200. Purchasedmerchandisefor cash for $2,300 Paid Inware Distributorsfor purchaseon February 17 Gave refund of $200 to customerfrom February 2I.The cost of the was $135. returnedmerchandise Sold merchandiseof $3,000 on account with the terms 2/10, n/30. cost $2.300. The merchandise

Required a. Enter each transactioninto the accounting equation, assumingAce Distribution Company usesa perpetualinventory system.Start with the opening balancesin cash and common stock describedat the beginning of the problem. b. Calculate the balancein the inventory account at the end of February. c. Preparethe four financial statements(including multiple-step income statement) for the month of FebruarY. d. Calculatethe grossprofit ratio. P5-4A. Record merchandising transactions and prepare multi-step financial statement: (LO 1, 2,4,6) perpetualinventory system. transactionsoccurred during March 2007 at the Five Oaks Tennis Club. The following March 3 March 4 March 6 March 10 March 11 March 13 March 14 March 15 March 18 March22 March24 March26 March 30 March 30 Required a. Supposethe Five Oaks Tennis Club startedthe month with cash of $8,000, inventoryof $2,000,and common stock of $10,000.Enter each merchandise transactioninto the accounting equation, assumingFive Oaks Tennis Club usesa perpetual inventorY system. b. Calculate the cost of goods sold for March and the ending balance in inventory. c. Preparethe multiple-step income statement,and the statementof changesin shareholders'equity for the month of March, and the balance sheetat March 31. d. Calculate the gross profit ratio for Five Oaks. Explain what the ratio measures. (LO 1,2,4) and preparecorrectedincomestatement. P5-5A. Analyzeaccountingmethods You are the accountantfor Baldwin Company, and your assistanthas preparedthe followins income statementfor the year ended September30,2001 . Purchasedracquetsand balls on credit from Spaulding Company for $700. with terms 3/05, n/30 Paid freight of $50 on the March 3 purchase to Sold merchandise memberson credit for $400, terms n/30. The sold cost $300. merchandise Receivedcredit of $40 from Spaulding for a damagedracquet that was returned tennisshoesfrom Reebokfor cashfor $3,000 Purchased Paid SpauldingCompanyin full Purchasedtennis shirts and shorts from Nike Sportswearon credit for $5,000, terms 2/lO, nl45 Receivedcredit of $50 from Nike Sportswearfor damaged merchandise to Sold merchandise memberson account,$950,terms ni30. The sold was $500. cost of the merchandise Received$650 in cash payment on account from members Paid Nike Sportswearin full Granted an allowance of $30 to membersfor tennis clothing that faded when washed.(Customerskept the clothes') Received$320 in cash payments on account from members of Paid cash operating expenses $300 for the month

C H A P T E5 o P R O B L E M S R

261

Baldwin Company IncomeStatement For the year ended September30,2007 Sales revenue Sales returnsand allowances Freightcosts Net sales Exoenses Costof goods sold S elling p e n s e s ex I ns ur anc e x p e n s e Ad m i n istrativeexpenses Div idends Total expenses Net income You have uncoveredthe following errors: 1,. Salesrevenueincludes $5,000 of items that have been back-ordered.(The items have not been delivered to the customers,and the customershave not been billed for the items.) 2. Selling expensesincludes $250 of allowances that were given to customerswho received damagedproducts. 3. Insurance expense includes$100 worth of insurance that appliesto 2008. 4. Administrative expensesinclude a loan made to worker who had some serious financial trouble and needed $500 to pay a hospital bill. The worker plans to repay the money by the end of December.

$8s0,000 s00 $22, 14,300 (36,800) 813,200

540,000 150,000 20,000 40,000 8,000 758,000

$ ss,zoo

Required
a. Preparea correctedmultistep income statementfor the year. Baldwin shows sales as the net amount only on its income statement. b. Write a memo to your assistantexplaining why each error you found is incorrect and what the correct accounting treatment should be. P5-6A. Analyze results of physical count of iwentory and calculate cost of goods sold. (L O 1, 2, 7, 9) Beard company uses a perpetual inventory system. The company's accounting records showed the followine related to June 2006 transactions.

B eginni n gi n v e n to ryJ u n e 1 , P ur c has ed u ri n g J u n e s G oodsav a i l a b l e r s a l e fo Costof goods sold E ndingin v e n to ryJ u n e3 0 ,

Units 200 1,700 1,900 1,500 400

Cost

$ ooo
5,1 00 $ 5,700 4,500 $ 1,200

On June 30,2006, Beard conducteda physical count of its inventory aad discoveredthere were only 375 units of inventory actually on hand.

Required
a. Using the information from the physical count, correct Beard's cost of goods sold for June. b. (Appendix A) How would this correction change the financial statementsfor the year? c. What are some possible causesof the difference between the inventory amounts in Beard's accounting records and the inventory amount from the physical count? P5-7A. Calculate cost of goods sold and ending iwentory and analyze effect of each methodonfinancial statements. (LO 3,4)

Jefferson Company had the following sales and purchasesduring 2006, its first year of business. January5 February15 April 10 June30 August 15 November28 each 40 Purchased units at $.100 15 units at $150 each Sold Sold 10 units at $150 each 30 Purchased units at $105 each Sold 25 units at $150 each 30 Purchased units at $110 each

Required
Calculate the ending inventory, the cost of goods sold, and the gross profit for the December 31. 2006. hnancial statementsunder each of the following assumptions: a. FIFO periodic b. LIFO periodic c. Weighted averagecost Periodic d. How will the differencesbetween the methods affect the income statementand balance sheetfor the Year? P5-8A. Calculate cost of goods sold and ending inventory; analyze effectsof each method rule; calculate inventoryturnover apply lower-of-cost-or-market onfinancial statements; (L o 3 , 4 ,5 , 6) ra ti o . The following seriesoftransactions occurred during 2007. January1 January15 February 4 March 10 April 15 June30 August 4 October 1 December5 Beginninginventorywas 70 units at $10 each 100 units at $1 1 each Purchased Sold 60 units at $20 each 50 Purchased units at $12 each Sold 70 units at $20 each 100 units at $13 each Purchased I 10 units at $20 each Sold 80 Purchased units at $14 each Sold 50 units at $21 each

Required
a. Calculate the value of the ending inventory and cost of goods sold, assumingthe company usesa periodic inventory system and the FIFO cost flow assumption. b. Calculate the value of the ending inventory and cost of goods sold, assumingthe company usesa periodic inventory system and the LIFO cost flow assumption. c. Calculate the value of the ending inventory and cost of goods sold, assumingthe company usesa periodic inventory system and the weighted averagecost flow assumption. d. Which of the three methods will result in the highest cost of goods sold for the year endedDecember3I,2007? e. Which of the three methods will provide the most curent ending inventory value for the balance sheetat December 3I,200'7? f. How will the differencesbetween the methods affect the income statementfor the year and the balance sheetat year end? g. At the end of the year, the current replacementcost of the inventory is $ 1,100. Indicate at what amount the company's inventory will be reported using the lower-of-cost-or-marketrule for each method (FIFO, LIFO, and weighted cost). average h. Calculate the company's inventory turnover ratio and days in inventory for the year for each method in items a, b, and c. P5-9A. Calculatecost of goodssold, ending inventory,andinventory turnover ratio. (LO 3, 6) The following merchandiseinventory transactionsoccurred during the month of June for the Furlong Corporation. June 1 June7 Inventory on hand was 1,000 units at $8.00 each Sold 750 units at $10.50each

o CHAPTER5 PROBLEMS

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June 18 June21 Jwe2'7 Required

Purchased 2,000 units at $8.80 each Sold2,225 units at $10.50each Purchased 2,500 units at $10.00each

a. Assume Furlong usesa periodic inventory system and compute the cost of goods sold for the month endedJune 30 and ending inventory at June 30 using each of the following cost flow methods: 1. FIFO 2. LIFO 3. Weighted averagecost b. Using the information for item a, calculate the inventory turnover ratio and days in inventory for the month of June for each method. c. Assume Furlong usesthe perpetualinventory system and compute the cost of goods sold for the month endedJune 30 and ending inventory at June 30 using each of the following cost flow methods: 1. FIFO 2. LTFO P5-L04. Analyze ffict of costflow method onfinancial statementsand inventory turnover ra ti o .( LO 2, 4, 6) Green Bay CheeseCompany is considering changing inventory cost flow methods.Green Bay's primary objective is to maximize profits. Currently, the firm uses weighted average cost. Data for 2006 are provided. B eginning e n to ry(1 0 ,0 0 0 n i ts ) inv u Purchases 60, 000unit sa t $ 1 .5 0e a c h 50,000units at $1.60each 70, 000unitsa t $ 1 .7 0e a c h S ales 130, 000 unit sa t $ 3 .0 0e a c h Operatingexpenses were $120,000and the company'stax rate is 30Vo. $ 1 4,500 $ S O ,OOO 80,000 6 5 ,000

Required
a. Preparethe multiple-step income statementfor 2006 using each of the following methods: 1. FIFO periodic 2. LIFO periodic b. Which method provides the more current balance sheetinventory balance at December 31,2006? Explain your answer. c. Which method provides the more current cost of goods sold for the year ended December 31,2006? Explain your answer. d. Which method provides the better inventory turnover ratio for the year? Explain your answer. e. In order to meet Green Bay's goal, what is your recommendationto Green Bay CheeseCompany?Explain your answer. P5-11A. Calculate cost of goods sold and ending inventory; analyzeeffectsof each method on financial statements;apply lower-of-cost-or-market rule; calculate inventory turnover ra ti o.( LO 3, 4, 5, 6) The following information is for Manuel's Pharmacy Supply Inc. for the year ending December31,2010. AtJanuary I,2010: . . . . Cashamountedto $19.375. Beginninginventorywas $16,000(160 units at 9100 each). Contributedcapitalwas $15,000. Retainedearningswas $20,375.

264

AND SALEOF I N V E N T O R Y 5 CHAPTER . THE PURCHASE

during 2010: Transactions . purchased150 units at 9110 each . purchased190 more units at $120 each . Cashsalesof 390 units at $200 each . Paid $11,500cashfor operatingexpenses . Paid cash for income tax at a rate of 30Voof net income

Required
a. Compute the cost of goods sold for the year and ending inventory at December31, 2010, using eachof the following cost flow methods: 1. FIFO periodic 2. LIFO periodic 3. Weighted averagecost periodic b. For eachmethod,preparethe balancesheetat December31,2010, a multistep in of of statement cashflows, and statement changes shareholder's income statement, equify for Manuel for the year endedDecember31,2010. c. What is income before taxes and net income after taxes under each of the three What observationscan you make about net inventory cost flow assumptions? income from the analysis of the three methods? d. At the end of the year,the current replacementcost of the inventory is $ 12,750. Indicate at what amount the company'sinventory will be reportedusing the lowerrule for eachmethod (FIFO, LIFO, and weighted averagecost). of-cost-or-market e. For each method, calculate the inventory turnover ratio and averagedays in inventory for the year ended December 3I,2010. 'atioand inventoryturnover ratio. (LO 6) the financial statementsof Afua's International Pasta

(a mo u n ts n thousands) i (domestic) Sales Costof sales Inventory

j une 30, 2009 $416,049 92,488 17,030

June30, 2008 $429,813 98,717 16,341

June30, 2007 $44s,849 110,632 12,659

Required
a. Calculate the gross profit ratio for the last 2 years shown. b. Calculate the inventory turnover ratio for the last 2 years shown. c. What information do thesecomparisonsprovide? P5-13A. (Appendix B) Estimate inventory. GO 9) Hines Fruit Corp. sells fresh fruit to tourists on Interstate75 in Florida. A tornado destroyed the entire inventory in late June.In order to file an insuranceclaim, Hazel and Euglenia,the ownersof the company,must estimatethe value of the lost inventory.Recordsfrom JanuaryI though the date of the tomado in Juneindicatedthat Hines Fruit Corp. starledthe year with for $4,000 worth of inventory on hand. Purchases the year amountedto $9,000,and salesup has to the dateof the tornadowere $16,000.Grossprofit percentage traditionally been3OVo.

Required
a. How much should Hazel and Euglenia requestfrom the insurancecompany? b. Supposethat one caseof fruit was sparedby the tornado. The cost of that case was $700. How much was the inventory loss under theseconditions? Problems-Set B P5-18. Analyze purchasesof merchandiseinventory. GO 1) Deborah Hartranft's ProfessionalCostumersInc. made the following purchasesin November of the curent yea"r. November7 terms 3/15, n/Z0,FOB Purchased $2,500of merchandise, shipping point

C H A P T E5 . P R O B L E M S R

265

November 12 November 16

Purchased terms l/05,nl25,FOB $4,300of merchandise, destination Purchased terms 2/10, n/4},FOB $6,200of merchandise, shipping point

Required a. For each of the listed purchases,how many days does the company have to take advantageof the purchasediscount? b. What is the amount of the cash discount allowed in each case? c. Assumethe freight charges $115 on eachpurchase. are What is the amountof freight that ProfessionalCostumersmust pay for eachpurchase? d. What is the total cost of inventory for ProfessionalCostumersfor the month of November, assumingthat all discounts were taken? P5-2B. Analyze purchasesof merchandiseinventory. (LO 1) International SportsMerchandising Inc. made the following purchases August of the curin rent year. August 5 August 14 August 19 Purchased terms l/I5, nlz\,FOB $12,200of athleticshoes, destination Purchased 1,600of training gear,terms 2/10, n/15, FOB shipping $1 pornt Purchased $3,500of tennisracketsand tennisballs, terms 3/05. n/10. FOB destination

Required
a. For eachpurchase, what dateis the paymentdue, assumingthe companytakes by advantage the discount? of b. For each purchase,when is the payment due if the company does not take advantage the discount? of c. In eachcase,what is the amountof the cashdiscountallowed? d. Assumethe freight charges $170 on eachpurchase. are For which purchases is International Sports Merchandising responsiblefor the freight charges? e. What is the total amount of inventory costs for the month of August, assuming that all discounts were taken? P5'3B. Record merchandising transactions, prepare financial statements,and calculate grossprofit ratio: perpetual inventorT (LO 1, 2,4,6) system. At the beginning of April, Morgan Parts Company Inc. started with a contribution of $20,000 cash in exchangefor common stock from its shareholders. The company engaged in the following transactionsduring the month of April. April 3 April 4 April 7 April 8 April April April April 10 15 16 17 Purchasedmerchandiseon account from Thompson Supply Co. for $5,000,terms 1/10,n/30 Sold merchandise accountto Brown Companyfor $3,500,terms on 2/10,n130.The cosr of the merchandise sold was 91,500. Paid $100 freight on the saleto Brown Company Receivedcredit from Thompson Supply Co. for merchandisereturned for $500 Paid ThompsonSupply Co. in full Receivedpayment from Brown Company for sale made on April 4 Purchased merchandise cashfor $3,200 for Receivedrefund from supplier for returned merchandiseon April 16 cashpurchase $350 of Purchasedmerchandiseon account from Kelsey Distributors for $4,100,terms 2/10, n/30 Paid $350 freight on April 19 purchase

April 19 April 20

266

O AN CHA P T E5 . T H EP U R C H AS E D S AL E F IN V E N TOR Y R Apnl2l Apr1l24 April 25 Aprtl27 April 30 Required a. Enter each transactioninto the accounting equation, assumingMorgan Parts Company Inc. usesa perpetual inventory system.Start with the opening balances in cash and common stock describedat the beginning of the problem. b. Calculate the balancein the inventory account at the end of April. c. Preparethe four financial statements(including multiple-step income statement) for the month of April. (Balance sheetat April 30.) d. Calculate the gross profit ratio. P5-48. Record merchandising transactions and prepare single-step and multiple-step in(LO 1, 2, 4,6) perpetual inventorysystem. comestatement: FOXX Supplier Inc. sells plant food to retail landscapingand gardening stores.At the beginning of May, FOXX Supplierhad a $15,000balancein cash and $15,000in common stock. During the month of May, the following transactionstook place. May 3 Purchased500 pounds of plant food on account from the manufacturerfor $20 per pound. The terms were 1/10, n/30, FOB shippingpoint. Freight costswere $90. Sold 50 pounds of plant food to Center Street Garden Supply for $35 per pound on account, with terms 2110,n/30, FOB destination' Freight costswere $15. Paid the manufacturerfor the May 3 purchase Receivedpayment in full from Center Street Garden Supply Sold 200 pounds of plant food to Perry's Plants on account for $34 FOB shippingpoint. Freight costs per pound, with terms I/10, n130, were $100. Returned 10 pounds of spoiled plant food to the manufacturerand received cashpayment of $20 per pound Purchased300 pounds of plant food on account from the manufacturerfor $20 per pound. Terms were n/30, FOB destination. Freight costs were $50. Sold 150 poundsof plant food to Sam'sPestControl for $24 eachfor cash. Sam's picked up the order, so there were no shipping costs. Paid for the purchaseon May 20 Declared and paid cash dividends of $ 150 Sold merchandisefor cashfor $12,110. The cost of the merchandise sold was for $9,500. Purchasedmerchandisefor cash for $5,300 Paid Kelsey Distributorsfor purchaseon April 19 Gave refund of $800 to customerfrom April 2l. The cost of the returned merchandisewas $535. Sold merchandiseof $2,000 on account with the terms 2/10, n/30. The cost $1,200. merchandise

May 6

May 10 May 15 May 17

May 19 May 20

May 24 May 31 May 3 1

Required
a. Enter each transactioninto the accounting equation, assumingFOXX Supplier Inc. usesa perpetual inventory system.Start with the opening balancesin cash and common stock describedat the beginning of the problem' b. Calculate the cost of goods sold for May and the ending balancein inventory. c. Preparethe multiple-step income statementand the statementof changesin shareholders'equity for the month of May, and the balance sheetat May 3 1. d. Calculate the gross profit ratio for FOXX Supplier. Explain what the ratio measures. (LO 1,2, 4) P5-58. Anatyzeaccountingmethodsand prepare correctedincomestatement. and your assistanthas preparedthe folYou are the accountantfor Celebration Company, lowing income statementfor the year ended December 31,2006.

C H A P T E5 . P R O B L E M S R

267

Celebration Company lncomeStatement 31, F o rth e y e a r e n d e d D e c ember 2010 Sales revenue S ales et ur n sa n d a l l o w a n c e s r Freightexpenses S elling pe n s e s ex Net sales Exoenses Costof goods sold Salaryexpenses Rent exoense Administrativeexpenses Div idends Total exDenses Net inc om e You have uncoveredthe following facts: 1. Salesrevenueincludes $6,000 of items that have been back-ordered.(The items have not been delivered to the customers,although the customershave paid for the items.) 2. Selling expenses includes $4,000 of allowancesthat were given to customerswho received damagedproducts. 3. Rent expense includes$400 worth ofrent that appliesto 2011. for 4. Salaryexpenses include $10,000loanedto one ofthe executives a boat. a. Preparea correctedmultistep income statementfor the year. Celebration shows salesas the net amount only on its income statement. b. Write a memo to your assistantexplaining why each effor you found is incorrect and what the correct accountins treatment should be. P5-68. Analyze resultsof physical count of inventoryand calculate cost of goods sold. (L O 1 , 2, 7, 8) Barney's Flowerpot Company usesa perpetualinventory system,so the cost of goods sold is recordedand the inventory records are updated at the time of every sale.The company's accounting records showedthe following related to May 2008 transactions' Units + Beginninginventory,May 1 P ur c has e su ri n g J u n e d fo G oodsav a i l a b l e r s a l e Costof goods sold E ndingin v e n to ry Ma y 3 1 , 300 4 ,0 00 4 ,3 00 3,300 1 ,0 00

$6so,ooo
$18,100 2,000 48,300 350,000 82,000 10,000 23,500 4,000
(68,400) s81,600

Cost

$ eoo
8.000 $8,600

On May 31, 2008, Barney conducteda physical count of its inventory and discoveredthere were actually 900 units of inventory on hand. Required a. Using the information from the physical count, correct Barney's cost of goods sold for June. b. (AppendixA) How would this correction change the financial statementsfor the year? c. What are some possible causesof the difference between the inventory amounts in Barney's accountingrecords and the inventory amount from the physical count? P5-7B. Calculate cost of goods sold and ending inventory and analyze effect of each method on thefinancial statements.(LO 3, 4)

268

CHA P T ER . T H EP U R C H AS E D SA L E F IN V E N TOR Y 5 AN O Washington Company had the following salesand purchasesduring 2009, its first year of business. January8 February20 April 13 June28 August 2 November24 Required a. Calculatethe ending inventory,the cost of goods sold, and the grossprofit for the under eachof the following assumptions: December3I,2009, financial statements 1. FIFO periodic 2. LIFOperiodic cost periodic 3. Weightedaverage b. How will the differencesbetween the methods affect the income statementand balance sheetfor the year? P5-8B. Calculate cost of goods sold and ending inventory; analyze effectsof each method rule; calculateinventoryturnover apply lower-of-cost-or-market onfinancial statements; (L O 3 ,4 , 5 ,6) ra ti o . Hillary's Diamoniquebuys andthenresellsa singleproduct.Here is someinformationconcerning Hillary's inventory activity during the month of August 2008. 125 units at $100 each Purchased Sold 75 units at $150 each Sold 35 units at $150 each 235 units at $105 each Purchased Sold 175 units at $150 each 140 units at $110 each Purchased

August 2 August 6 August 8 August12 August 15 August 21 August 24 August 31

860unitson handat a totalvalueof $10.320 Sold400unitsat $14perunit 640 Purchased unitsat $11perunit 425 Purchased unitsat $10perunit Sold600unitsat $12perunit 300 Purchased unitsat $9 perunit Sold800unitsat $16perunit 100 Purchased unitsat $8 perunit

Hillary's usesa periodic inventorysystem.

Required
a. Calculate the value of the ending inventory and cost of goods sold, assumingthe company usesa periodic inventory system and the FIFO cost flow assumption. b. Calculatethe value of the ending inventoryand cost of goodssold, assumingthe company usesa periodic inventory system and the LIFO cost flow assumption. c. Calculatethe value of the ending inventoryand cost of goodssold, assumingthe company usesa periodic inventory system and the weighted averagecost flow assumption. d. Which of the threemethodswill result in the highestcost of goods sold for August? e. Which of the three methods will provide the most current ending inventory value for Hillary's balancesheetat August 31,2008? f. How would the differencesbetween the methods affect Hillary's income for statement August and balancesheetat August 31, 2008? g. At the end of the year, the current replacementcost of the inventory is $6,730. Indicate at what amount the company'sinventory will be repofted using the lowerof-cost-or-marketrule for eachmethod (FIFO, LIFO, and weighted averagecost). h. Calculate the company's inventory turnover ratio and days in inventory for the month for each method in items a. b. and c. P5-98. Calculatecost of goodssold, ending inventory,and inventoryturnover ratio. (LO 3, 6) The following merchandiseinventory transactionsoccurredduring the month of November for Party Heaven Inc. November 5 November 12 Inventory on hand was 2,000 units at a cost $4.00 each Sold 1.500units at $6.00 each

P -H A P TE R 5. R OB LE MS 269 November 16 November23 November29 Required a. Assume Pafiy Heavenusesa periodic inventory system and compute the cost of goods sold for the month endedNovember 30 and ending inventory at November 30 using each of the following cost flow methods: 1. FIFO 2, LIFO 3. Weighted averagecost b. Using the information for item a, calculate the inventory turnover ratio and days in inventory for the month of November for each method. c. Assume Party Heavenusesthe perpetual inventory system and compute the cost of goods sold for the month endedNovember 30 and ending inventory at November30 using eachof the following cost flow methods: 1. FIFO 2, LIFO P5-10B.Analyzeeffectof costflow methodonfinancial statements and inventoryturnover ra ti o.( LO 2, 4, 6) CastanaCompany is considering changing inventory cost flow methods.Castana'sprimary objective is to minimize their tax liability. Currently, the firm uses weighted averagecost. Data for 2007 areprovided. B eginning e n to ry(2 ,0 0 0 n i ts ) inv u Purchases 5,000units at $6 each 4,000units at $5.50each 6,000units at $7 each S ales 15, 000 unit sat $ 1 0 e a c h $ 1 5 0 ,000 Operatingexpenses were $12,000and the company'stax rate is 25Vo. $30,000 26,000 42,000 $ 1 0 , 000 Purchased4,000 units at $4.40 each Sold 4,300 units at $6.00 each Purchased 5,000 units at $5.00 each

Required
a. Preparethe income statementfor 2007 using each of the following methods: 1. FIFO 2. LIFO b. Which method provides the more cunent balance sheetinventory balance at December31,2007? Explain your answer. c. Which method provides the more current cost of goods sold for the year ended December 37, 2007? Explain your answer. d. Which method provides the better inventory turnover ratio for the year? Explain youf answer. goal, what is your recommendation Castana to e. In order to meet Castana's Company?Explain your answer. P5-118. Calculate cost of goods sold and ending inventory; analyzeeffectsof each method onfinancial statements; rule; calculateinventoryturnover apply lower-of-cost-or-market ra ti o.( LO 3, 4, 5, 6) The following information is for Decades of Music Corporation for the year ended Jlune 3O,200'7. At July 01,2006: . . . . Cashamounted $27,000. to Beginninginventorywas $30,000(750 units at $40 each). Contributedcapitalwas $12,000. Retainedearningswas $45,000.

rl

OF AN CHAPTER . T H EPU R C H A SE D S AL E IN V E N TOR Y 5 Transactionsduring 2006 and20O1 . . . . . Purchased825 units at $41 each purchased375 more units at $43 each Sold 1,150units at $56 each Paid $8,500cashfor operatingexpenses Paid cash for income taxes at arcte of 407oof net income a. Compute the cost of goods sold and ending inventory at June 30, 2007, using each of the following cost flow methods: 1. FIFO periodic 2. LIFO periodic 3. Weighted averagecost Periodic b. For each method, preparethe balance sheetat June 30, 2007, a multiple-step income statement,and statementof cash flows for Decadesfor the fiscal year endedJune 30,2007. c. What is income before taxes and net income after taxes under each of the three What observationscan you make about net inventory cost flow assumptions? of the three methods? income from the analysis d. At the end of the year, the current replacementcost of the inventory is $33,000. Indicate at what amountthe company'sinventory will be reportedusing the lowerof-cost-or-marketrule for eachmethod (FIFO, LIFO, and weighted averagecost). e. For each method, calculate the inventory turnover ratio and averagedays in inventory for the fiscal year ended June 30,2007. P5-12B. Calculate the grossprofit ratio and inventory turnover ratio. (LO 6) The following information is from the f,rnancialstatementsof Toys for Toddlers Company' 31, D ecember D ecember 31, D ecember 1, 3 For year ended 2005 2006 (amounts thousands) 2007 in Sales Costof goods sold Inventory

Required

$2,534,13s 1,634,562 s4,353

52,187,438 1,383,655 47,433

$1,925,319 1,229,277 45,334

Required
a. Calculate the gross profit ratio for the last 2 years shown. b. Calculate the inventory turnover ratio for the last 2 years shown. c. What information do thesecomparisonsprovide? P5-138. (Appendix B) Estimate inventory. GO 9) Cynthia's Cotton Candy Company sells cotton candy to visitors at a traveling county fair. During a drought a fire destroyedthe entire inventory in late July. In order to file an insurance claim, Cynthia, the owner of the company,must estimatethe value of the lost inventory. Records from January 1 through the date of the fire in July indicated that Cynthia's Cotton Candy Company startedthe year with $4,250 worth of inventory on hand. Purchases for the year amounted to $8,000, and salesup to the date of the fire were $17,500. Gross profit percentagehas traditionally been 35Vo. Required a. How much should Cynthia requestfrom the insurancecompany? b. Supposethat one bag of cotton candy mix was sparedby the fire. The cost of that bag was $50. How much was the inventory loss under theseconditions?

AnalYsis Statement Financial

(LO 6) FSA5-1. Analyzeincomestatement. income statementsforWilliams-Sonoma Inc. for the fiscal years ended Jantary 29, The 2006, andJanuary 30,2005, are shown here. Compare the company's performancefor the

C H A P T E5 . F I N A N C I A L T A T E M E N T N A L Y S I S R S A

271

2 years. Is the company controlling its cost of inventory? Is the company controlling its other expenseswell? Be able to support your answers.

Williams-Sonoma, Inc. Consolidated Statements of Earnings

Fiscal Yer Ended

(DoLLMs irL thousmd,s)

Jan.29, 2006

Jan 30, 2005

Net revenues Cost of goods sold Gross margin Selling, general and administrative expenses Interest income Interest expense Earnings before income taxes Income taxes Net earnings

$ 3,538,947 2,103,465 1,435,482 1,090,392 (5,683) r,975 348,798 133,932

$ 3,136,931 1,865,786 1,27L,145 961,176 (1,939) 1,703 310,205 118,971 q__rypq9_ 191,234 $

FSA5-2. Analyze inventory management (LO 6) Use the information from Wet Seal Inc. to analyzethe firm's inventory management.Calculate the grossprofit ratio and the inventory turnover ratio for eachyear.How do you think Wet Seal is managing its inventory? What other information would be useful in answering this question?Do you think the firm's increasinglossesare attributable to increasing costs of the goods the firm sells or increasesin other operating costs?

The Wet Seal,Inc. Consolidated Statements of Operations

(In thousand.s)

January28, 2006

Fiscal YearsEnded January29, 2005

January3l, 2004

Net sales Cost of sales Gross margin Selling, general and administrative expenses Store closure costs . Asset impairment Operating loss Interest (expense) income, net Loss before provision (benefit) for income taxes . . Provision (benefit) for income taxes . Loss from continuing operations Loss from discontinued operations, net of income taxes Net loss Accretion of non-cash dividends on convertible preferred stock (Note 7) Net loss attributable to common stockholders

$ 500,807 339,356 16l,45l L72,r54 4,5L7 989 (16,209) (13,000) (29,209) 330 (29,539) (29,539)

$ 435,582 377,664 57,918 161,956 16,398 41,378 (16r,714)

$ 517,870 420,520 97,350 159,181 (61,831) 1,550 (60,281) (21,498) (38,783) (8,300) (47,083) $ (47,083)

(2,rrr)

(163,825) 27,509 (191,334) (6,967) (198,301) $ (198,301)

272

CHAPTER . THE PURCHASE 5 AND SALEOF I N V E N T O R Y

From the balancesheetat Januarv 28.2006 Inventory $25,475(in thousands) From the balance sheetat Januarv 29.2005 Inventory $18.372 From the balance sheetat Januarv 31.2004 Inventory $29,054 From the balance sheetat February I,2003 Inventory $30,886 FSA5-3. Analyzeinventorymanagement(LO 7) Use the information given to analyzeAmazon.com's inventory management. (i n mi l l i o n s ) Sa l e s Costof sales Net income Inventory(at year end) Forthe year ended Forthe year ended

De c . 3 1 ,0 0 5 2 a,+go $
6,451

$3se
$ S00

Dec.31, 2004 a,zgt $ 5,31 9 s88 $ $ 480

At Dec.31,2003

5 294

Write a short report for Amazon.com's shareholders with your comments about its inventory management.

Critical Thinking Problems

Risks and Controls
In this chapter,you learned that retail firms are at risk that their inventory will become obsolete.What can a firm do to minimize this risk? What types of firms are most at risk? Least at risk? (LO 6)

Ethics
Jim's Music Company uses LIFO for inventory, and the company's profits are quite high this year.The cost ofthe inventory hasbeen steadily rising all year, and Jim is worried about his taxes.His accountanthas suggestedthat the company make a large purchaseof inventory to be received during the last week in December.The accountanthas explained to Jim that this would reducehis income significantly.(LO 3, 5) a. Jim does not understandthe logic of the accountant'ssuggestion.Explain how the purchasewould affect taxable income. b. Is this ethical?Jim is uncertain about the appropriateness this action from a legal and of an ethical standpoint.

GroupAssignment
Selecta retail firm that you think might be concernedabout obsoleteinventory and another that you believe would not be very concerned.Then, find the frnancial statementsand calculate the inventory turnover ratio of thesetwo firms for the past two f,rscalyears.Are your resultswhat you expected? Explain what you expected find and your results.(LO 6,7) to

InternetExercise: GAP
Gap Inc. was founded in 7969 by Donald and Doris Fisher in San Francisco, California, with a single store and a handful of employees.Today, they are one of the world's largest specialty retailers with three of the most recognized brands in the apparel industry (Gap, Banana Republic, and Old Navy). Gap Inc. has more than 150,000 employeessupporting about 3,000 storesin the United States,United Kingdom, Canada,France, and Japan. Go to www.gapinc.com.

GA EX C H A P TE R IN TE R N E T E R C IS E P 5. IE5-1. Click on "Investors," followed by "Financials," and then "Annual Reports and Proxy." Download the latest annual report. a. Which inventory cost flow assumptionis used to measurethe cost of inventory? Does Gap Inc. value inventory at the lower-of-cost-or-marketvalue? If so, how is market value determined?Does this policy comply with GAAP? b. For the three most recent years, list the amountsreported for Net Salesand Gross Is Profit. Is Net Salesincreasing or decreasing? Gross Profit increasing or decreasing? Are thesetrends favorable or unfavorable?Explain your answer. calculate the inventory turnover ratio for the three c. Using the financial statements, What most recent years. Did the inventory turnover ratio increaseor decrease? What does Gap Inc. do to identify inventory that is slow does this measure? moving and how is this inventory treated? d. For cost of goodssold, Gap Inc. usesCost of GoodsSold and Occupancy Expenses.What is included in this amount? IE5-2. Go back to "GAP Inc. homepage" and click on "Social Responsibility." a. Does Gap Inc. do anything to ensureits garment workers are treated fairly? If so, why is this important for Gap Inc. to do? Go back to "About GAP Inc." b. Click on "How Our Clothes Are Made." List and briefly describeGap Inc.'s five stepsof their product life cycle. Pleasenote: Internet Web sites are constantly being updated.Therefore, if the information is not found where indicated,pleaseexplorethe annualreport further to find the information.

273

Appendlx 5A
i,.{}.H Des c r ibe th and c alc u l a te e equalsthe cost You know that the cost of the beginning inventory plus the cost of purchases effect of inventoryerrors of goods availablefor sale.The cost of goods availablefor sale is then divided between the o n t he f inanc ials ta te me n ts . cost of goods sold and the ending inventory. That is, Beginning inventory f Purchases : Cost of goods available for sale - Ending inventory : Cost of goodssold errorsin the calcuinventorydirectly affectscost ofgoods sold, a major expense, Because lation of beginning inventory or ending inventory will affect net income. Tracing the effects of errors requires slow, focused deliberation. To show how inventory errors can affect income, here is a simple numerical example that shows an ending inventory error and a beginning inventory error. Read each description below and study the related examples.

Errors Inventory

Errors Inventory Ending

Supposea firm has the correct amount for beginning inventory and the correct amount for purchases. Then, cost of goods available for sale is correct. Ifthe ending inventory is overendinginventoryand cost of Why? Because cost of goodssold must be understated. stated, for goodssold arethe two partsof cost of goodsavailable sale.Cost of goodssold is an expense.If the expensedeductedfrom salesis too small, the result is that net income will be too large. Supposeyou have correctly calculatedthe cost ofgoods availablefor sale (beginto ning inventory * purchases) be $10. Thosegoodswill eitherbe sold-and becomepart of cost of goods sold-or they will not be sold-and will still be part of the inventory. So, the cost of goodsavailablefor sale consistsof two parts-cost of goodssold and ending inventory. Supposethe correct ending inventory is $2, but you effoneously give it a value of $3. If ending inventoryis incorrectlyvaluedat $3, then cost of goodssold will be the valued at $7. Remember, ending inventoryand cost of goodssold must add up to $10 in this example.What is wrong with cost of goods sold? If ending inventory is actually $2, You understate cost of goodssold then cost of goodssold shouldbe $8. Seewhat happens? when you overstatethe ending inventory. Anytime you understatean expense,you will overstatenet lncome. If ending inventory is too small-understated, cost of goods sold must be too largeLet The result is that net income will be understated. us use the sameexample,in overstated. which the cost of goodsavailablefor salewas correctly computedat $10. If ending inventory it is actually $2 but you erroneouslyunderstate as $1, then cost of goods sold will be valued in as $9. It shouldbe $8. So, an understatement endinginventoryhascausedan overstatement net then you will understate income. of cost of goods sold. If you overstatean expense,

Errors Inventory Beginning

in Ifending inventoryis overstated 2006,then beginninginventory in2001 will be overstated. After all, it is the samenumber. Errors in the ending inventory will, therefore, affect two consecutiveyears-ending inventory one year and beginning inventory the following year.If beginning inventory is overstated,then the cost of goods available for sale is overstated.If 274

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275

Amounts Calculated
from prior year error) Be ginning ent or y I nv $ 1 (understated + Pu r c has es +$ 1 5 Cost Goods of Available Sale $ 1 6 for - Ending Inventory $6 Cost Goods of Sold $10

Gorrect Amounts
OZ

EXHIBIT 54.1 Error in the Beginning Inventory

+ $15 $17 $6 $11

ending inventory is counted correctly, then cost of goods sold will be overstated.So, net income will be understated. Let us continue the previous example.If you value beginning inventory at $3 (and the correct value is $2) and you correctly add the purchasesfor the secondyear-say, $15 worth-then, the cost of goodsavailablefor salewill be $18. Keep in mind, the correct amount is $17. At year-end,you count the ending inventory correctly at $6. The calculated cost of goodssold would be $12. Ending inventoryand cost of goods sold must total $18. However,we know that the true cost of goodsavailablefor saleis $17. If the correct ending inventory is $6, then the correct cost of goods sold is $ I i . The calcuthen net inis lated cost of goodssold was overstated $1. When an expense overstated, by come will be understated. then the cost of goods availablefor saleis underIf beginning inventory is understated, stated.Ifending inventory is countedcorrectly, then cost ofgoods sold will be understated. So, net income will be overstated.Try thinking about the example in the format given in Exhibit 5A.1. As you can see, when you understatethe beginning inventory, you will naturally unof derstatecost of goods sold. This understatedexpensewill result in an overstatement net lncome. Note that over a period of 2 yearsthe errors will counterbalance-they will cancel each other out. However, it is important that the financial statementsbe correct each year, not every other year, so a company will correct inventory errors if they are discovered,rather than wait for the errors to cancel each other out.

31,2007. at BerryCorporation miscounted endinginventory December the worth of but Thebalance inventory $360,000, $25,000 of sheetreported net of itemswere omittedfrom that amount.Berryreported income errorhaveon Berry's for What effectdid this inventory $742,640 the year. for net costof goodssoldfor the year?What is the correct income the year endedDecember 2007? 3'1,
Answer: Ending inventory was understated, so cost of goods sold was overstated. Too much expense was deducted, so net income should have been higher by $25,000 for a correct net income of $767,640.

Your Turn 5A-l

Appendix 5B
8,.ffi"I Estimateinventoryusing the grossprofit method.

Gross ProfitMethodof Estimating Ending Inventory

There are times when a company might want to estimatethe cost of the ending inventory rather than counting the units to calculate the cost. For example, if a company prepares monthly or quarterly financial statements,GAAP allows ending inventory to be estimated for reporting on those financial statements. This savesa company the trouble of counting the inventory every quarter.Also, if the inventory is destroyedor stolen, the company will have a reliable estimate of the cost of the destroyedinventory for the insuranceclaim. First, you must know the usual gross profit percentage-the gross profit ratio you learned about in Chapter 5-for the company. Gross profit percentageis gross profit divided by sales.You can calculatethe grossprofit ratio using prior years' salesand cost data. Then, you multiply that percentageby the salesfor the period, which gives the estimated grossprofit. You then subtractthe estimatedgrossprofrt from salesto get the estimatedcost of goods sold. Becauseyou know (a) beginning inventory (from the last period's financial (b) (from your records),and (c) an estimatefor cost of goodssold, statements), purchases you can estimateending inventory. For example,supposeSuperSoapCompany lost its entire inventory in a flood on April 16. Super Soaphad prepareda set of financial statements March 3 1, when the inventory on on handwas valuedat $2,500.During the first part of April, purchases amounted $3,500. to The usualgrossprofit percentage this business 407o.If SuperSoaphad salesof $8,200 in is during the first l6 daysof April, how much inventorywas lost? 1. If saleswere $8,200and the usualgrossprofit percentage 40V0, is then the grossprofit would be $3,280. 2. If saleswere $8,200 and gross profit is $3,280, then cost of goods sold would be is then the other 60% must $4,920.In other words, if the grossprofit percentage 40Vo, be the cost ofgoods sold. So 607oof $8,200 : cost ofgoods sold : $4,920. 3. Beginninginventory * purchases cost ofgoods sold : endinginventory.$2,500 + $3,500 - $4,920 : $1,080.This is our bestestimateof the lost inventory.

Your Turn 58-t

',t',1*,t'"1+il" ffil1lt'lr,t$ili[:l$- $8,000worth of inventory during the first half of May. Salesfor the first tI half
of May amounted to $12,000.

SupposeBaseCompanybegan May with inventory of $2,000and purchased

Then, a fire destroyedthe remaining inventory. BaseCompanyhas had a gross profit ratio of approximately 3oo/o the first 4 months of the year. for Approximately how much inventory did BaseCompanylose in the fire?
Answer: $12,000 x 0.7 : Cost of goods sold $8,400 worth of inventory has been sold. $10,000 - $8,400 = $1,600 worth of inventory must have been lost in the fire.

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