CHAPTER 6INVENTORIES

DISCUSSION QUESTIONS

1.The receiving report should be reconciled to the initial purchase order and the vendor’s invoice before recording or paying for inventory purchases. This procedure will verify that the inventory received matches the type and quantity of inventory ordered. It also verifies that the vendor’s invoice is charging the company for the actual quantity of inventory received at the agreed-upon price.

2.A physical inventory should be takenperiodically to test the accuracy of the perpetual records. In addition, a physical inventory will identify inventory shortages or shrinkage.

3.No, they are not techniques for determining physical quantities. The terms refer to cost flow assumptions, which affect the determination of the cost prices assigned to items in the inventory.

4.a.LIFOc.LIFO

b.FIFOd.FIFO

5.FIFO

6.LIFO. In periods of rising prices, the use of LIFO will result in the lowest net income and thus the lowest income tax expense.

7.Net realizable value (estimated selling price less any direct cost of disposition, such as sales commissions).

8.a.Gross profit for the year was understated by $23,950.

b.Merchandise inventory and stockholders’ equity (retained earnings) were understated by $23,950.

9.Mistletoe Company. Since the merchandise was shipped FOB shipping point, title passed to Mistletoe Company when it was shipped and should be reported in MistletoeCompany’s financial statements at October 31, the end of the fiscal year.

10.Manufacturer’s; The manufacturer retains title until the goods are sold. Thus, any unsold merchandise at the end of the year is part of the manufacturer’s (consignor’s) inventory, even though the merchandise is in the hands of the retailer (consignee).

PRACTICE EXERCISES

PE 6–1A

Gross Profit Ending Inventory

JulyJuly 31

a.First-in, first-out (FIFO)$65 ($225– $160)$344 ($168 + $176)

b.Last-in, first-out (LIFO)$49 ($225– $176)$328 ($160 + $168)

c.Average cost$57 ($225– $168)$336 ($168× 2)

PE 6–1B

Gross Profit Ending Inventory

April April 30

a.First-in, first-out (FIFO)$19 ($29– $10)$26 ($12 + $14)

b.Last-in, first-out (LIFO)$15 ($29– $14)$22 ($10 + $12)

c.Average cost$17 ($29– $12)$24 ($12× 2)

PE 6–2A

a.Cost of merchandise sold (August 28):

20 units @ $80$ 1,600
5 units @ $85 425
25$2,025

b.Inventory, August 31:$2,975 = 35 units × $85

PE 6–2B

a.Cost of merchandise sold (March 24):

12 units @ $15 $ 180
63 units @ $18 1,134
75 $1,314

b.Inventory, March 31:$1,116 = 62 units × $18

PE 6–3A

a.Cost of merchandise sold (November 26):

$5,040 = (84 units × $60)

b.Inventory, November 30:

18 units @ $50$ 900
16 units @ $60 960
34$1,860

PE 6–3B

a.Cost of merchandise sold (January 27):

$1,440 = (80 units × $18)

b.Inventory, January 31:

15 units @ $17$ 255

45 units @ $18 810

60$1,065

PE 6–4A

a.First-in, first-out (FIFO) method: $594 = 11 units × $54

b.Last-in, first-out (LIFO) method: $495 = 11 units × $45

c.Average cost method: $550 (11 units × $50), where average cost = $50 = $2,250/45 units

PE 6–4B

a.First-in, first-out (FIFO) method: $2,722 = (20 units × $119) + (3 units × $114)

b.Last-in, first-out (LIFO) method: $2,682 = (10 units × $120) + (13 units × $114)

c.Average cost method: $2,645 (23 units × $115), where average cost = $115 = $18,400/160 units

PE 6–5A

A / B / C / D / E / F / G
1 / Unit / Unit / Total
2 / Inventory / Cost / Market / Lower
3 / Commodity / Quantity / Price / Price / Cost / Market / of C or M
4 / IA17 / 200 / $40 / $38 / $ 8,000 / $ 7,600 / $ 7,600
5 / TX24 / 150 / 55 / 60 / 8,250 / 9,000 / 8,250
6 / Total / $16,250 / $16,600 / $15,850

PE 6–5B

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

PE 6–6A

Amount of Overstatement
(Understatement)

Balance Sheet:

Merchandise inventory understated*...... $(7,525)

Current assets understated...... (7,525)

Total assets understated...... (7,525)

Stockholders’ equity understated...... (7,525)

Income Statement:

Cost of merchandise sold overstated...... $ 7,525

Gross profit understated...... (7,525)

Net income understated...... (7,525)

*$90,700 – $83,175 = $7,525

PE 6–6B

Amount of Overstatement
(Understatement)

Balance Sheet:

Merchandise inventory overstated*...... $35,000

Current assets overstated...... 35,000

Total assets overstated...... 35,000

Stockholders’ equity overstated...... 35,000

Income Statement:

Cost of merchandise sold understated.... $(35,000)

Gross profit overstated...... 35,000

Net income overstated...... 35,000

*($580,000 – $545,000 = $35,000)

PE 6–7A

a.Inventory Turnover20122011

Cost of merchandise sold. $882,000 $680,000

Inventories:

Beginning of year...... $200,000 $140,000

End of year...... $290,000 $200,000

Average inventory...... $245,000 $170,000

[($200,000 + $290,000) ÷ 2][($140,000 + $200,000) ÷ 2]

Inventory turnover...... 3.6 4.0

($882,000 ÷ $245,000)($680,000÷ $170,000)

b.Number of Days’ Sales in
Inventory20122011

Cost of merchandise sold. $882,000 $680,000

Average daily cost of
merchandise sold...... $2,416.4 $1,863.0

($882,000 ÷ 365 days)($680,000 ÷ 365 days)

Average inventory...... $245,000 $170,000

[($200,000 + $290,000) ÷ 2][($140,000 + $200,000) ÷ 2]

Number of days’ sales in
inventory...... 101.4 days 91.3 days

($245,000 ÷ $2,416.4)($170,000 ÷ $1,863.0)

PE 6–7A(Concluded)

c.The decrease in the inventory turnover from 4.0 to 3.6 and the increase in the number of days’ sales in inventory from 91.3 days to 101.4 days indicate unfavorable trends in managing inventory.

PE 6–7B

a.Inventory Turnover20122011

Cost of merchandise sold. $1,800,000 $1,428,000

Inventories:

Beginning of year...... $570,000 $450,000

End of year...... $630,000 $570,000

Average inventory...... $600,000 $510,000

[($570,000 + $630,000) ÷ 2][($450,000 + $570,000) ÷ 2]

Inventoryturnover...... 3.0 2.8

($1,800,000 ÷ $600,000)($1,428,000÷ $510,000)

b.Number of Days’ Sales in
Inventory20122011

Cost of merchandise sold.$1,800,000$1,428,000

Average daily cost of
merchandise sold...... $4,931.5$3,912.3

($1,800,000 ÷ 365 days)($1,428,000 ÷ 365 days)

Average inventory...... $600,000$510,000

[($570,000 + $630,000) ÷ 2][($450,000 + $570,000) ÷ 2]

Number of days’ sales
in inventory...... 121.7 days130.4 days

($600,000 ÷ $4,931.5)($510,000 ÷ $3,912.3)

c.The increase in the inventory turnover from 2.8 to 3.0 and the decrease in the number of days’ sales in inventory from 130.4 days to 121.7 days indicate favorable trends in managing inventory.

Exercises

Ex. 6–1

Switching to a perpetual inventory system will strengthen A4A Hardware’s internal controls over inventory, since the store managers will be able to keep track of how much of each item is on hand. This should minimize shortages of good-selling items and excess inventories of poor-selling items.

On the other hand, switching to a perpetual inventory system will not eliminate the need to take a physical inventory count. A physical inventory must be taken to verify the accuracy of the inventory records in a perpetual inventory system. In addition, a physical inventory count is needed to detect shortages of inventory due to damage or theft.

Ex. 6–2

a.Appropriate. The inventory tags will protect the inventory from customer theft.

b.Inappropriate. The control of using security measures to protect the inventory is violated if the stockroom is not locked.

c.Inappropriate. Good controls include a receiving report, prepared after all inventory items received have been counted and inspected. Inventory purchased should only be recorded and paid for after reconciling the receiving report, the initial purchase order, and the vendor’s invoice.

Ex. 6–3

a.

Portable Video Players
Purchases / Cost of Merchandise Sold / Inventory
Date /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost
June1 / 75 / 40 / 3,000
6 / 60 / 40 / 2,400 / 15 / 40 / 600
14 / 90 / 42 / 3,780 / 15
90 / 40
42 / 600
3,780
19 / 15
35 / 40
42 / 600
1,470 / 55 / 42 / 2,310
25 / 20 / 42 / 840 / 35 / 42 / 1,470
30 / 80 / 45 / 3,600 / 35
80 / 42
45 / 1,470
3,600
30 / Balances / 5,310 / 5,070

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

Note to Instructors: Exercise 6–4 shows that the inventory is $5,040 under LIFO.

Ex. 6–4

Portable Video Players
Purchases / Cost of Merchandise Sold / Inventory
Date /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost
June1 / 75 / 40 / 3,000
6 / 60 / 40 / 2,400 / 15 / 40 / 600
14 / 90 / 42 / 3,780 / 15
90 / 40
42 / 600
3,780
19 / 50 / 42 / 2,100 / 15
40 / 40
42 / 600
1,680
25 / 20
/ 42
/ 840
/ 15
20 / 40
42 / 600
840
30 / 80 / 45 / 3,600 / 15
20
80 / 40
42
45 / 600
840
3,600
30 / Balances / 5,340 / 5,040

Ex. 6–5

a.

Prepaid Cell Phones
Purchases / Cost of Merchandise Sold / Inventory
Date /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost
July1 / 800 / 45 / 36,000
10 / 500 / 50 / 25,000 / 800
500 / 45
50 / 36,000
25,000
12 / 500
200 / 50
45 / 25,000
9,000 / 600
/ 45
/ 27,000
14 / 300 / 45 / 13,500 / 300 / 45 / 13,500
20 / 450 / 52 / 23,400 / 300
450 / 45
52 / 13,500
23,400
31 / 250 / 52 / 13,000 / 300
200 / 45
52 / 13,500
10,400
31 / Balances / 60,500 / 23,900

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

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

Ex. 6–6

Prepaid Cell Phones
Purchases / Cost of Merchandise Sold / Inventory
Date /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost /
Quantity / Unit
Cost / Total
Cost
July1 / 800 / 45 / 36,000
10 / 500 / 50 / 25,000 / 800
500 / 45
50 / 36,000
25,000
12 / 700 / 45 / 31,500 / 100
500 / 45
50 / 4,500
25,000
14 / 100
200 / 45
50 / 4,500
10,000 / 300 / 50 / 15,000
20 / 450 / 52 / 23,400 / 300
450 / 50
52 / 15,000
23,400
31 / 250
/ 50
/ 12,500
/ 50
450 / 50
52 / 2,500
23,400
31 / Balances / 58,500 / 25,900

Ex. 6–7

a.$15,540 ($84 × 185 units)

b.$15,100 [($80 × 60 units) + ($82 × 100 units) + ($84 × 25 units)] = $4,800 + $8,200 + $2,100

Ex. 6–8

a.$7,812 (12 units at $495 plus 4 units at $468) = $5,940 + $1,872

b.$6,138 (9 units at $360 plus 7 units at $414) = $3,240 + $2,898

c.$7,056 (16 units at $441; $26,460/60 units = $441)

Cost of merchandise available for sale:

9units at $360...... $3,240

18units at $414...... 7,452

21units at $468...... 9,828

12...... units at $4955,940

60...... units (at average cost of $441)$26,460

Ex. 6–9

Cost

MerchandiseMerchandise

Inventory MethodInventorySold

a.FIFO...... $4,986$9,639

b.LIFO...... 4,36510,260

c.Average cost....4,6809,945

Cost of merchandise available for sale:

21units at $180...... $3,780

29units at $195...... 5,655

10units at $204...... 2,040

15units at $210...... 3,150

75units (at average cost of $195)...... $14,625

a.First-in, first-out:

Merchandise inventory:

15units at $210...... $3,150

9units at $204...... 1,836

24units...... $4,986

Merchandise sold:

$14,625 – $4,986...... $9,639

b.Last-in, first-out:

Merchandise inventory:

21units at $180...... $3,780

3units at $195...... 585

24units...... $4,365

Merchandise sold:

$14,625 – $4,365...... $10,260

c.Average cost:

Merchandise inventory:

24units at $195 ($14,625/75 units)...... $4,680

Merchandise sold:

$14,625 – $4,680...... $9,945

Ex. 6–10

a.1.FIFO inventory> (greater than)LIFO inventory

2.FIFO cost of goods sold< (less than)LIFO cost of goods sold

3.FIFO net income> (greater than)LIFO net income

4.FIFO income tax> (greater than)LIFO income tax

b.In periods of rising prices, the income shown on the company’s tax return would be lower than if FIFO were used; thus, there is a tax advantage of using LIFO.

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

Ex. 6–11

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

Ex. 6–12

The merchandise inventory would appear in the Current Assets section, as follows:

Merchandise inventory—at lower of cost (FIFO) or market.....$10,320

Alternatively, the details of the method of determining cost and the method of valuation could be presented in a note.

Ex. 6–13

a.Balance Sheet

Merchandise inventory...... $11,350* understated

Current assets...... $11,350 understated

Total assets...... $11,350 understated

Stockholders’ equity
(retained earnings)...... $11,350 understated

*$11,350 = $451,000 – $439,650

b.Income Statement

Cost of merchandise sold....$11,350 overstated

Gross profit...... $11,350 understated

Net income...... $11,350 understated

c.Income Statement

Cost of merchandise sold....$11,350 understated

Gross profit...... $11,350 overstated

Net income...... $11,350 overstated

d.The December 31, 2013, balance sheet would be correct, since the 2012 inventory error reverses itself in 2013.

Ex. 6–14

a.Balance Sheet

Merchandise inventory...... $12,000* overstated

Current assets...... $12,000 overstated

Total assets...... $12,000 overstated

Stockholders’ equity
(retained earnings)...... $12,000 overstated

*$12,000 = $350,000 – $338,000

b.Income Statement

Cost of merchandise sold....$12,000 understated

Gross profit...... $12,000 overstated

Net income...... $12,000 overstated

c.Income Statement

Cost of merchandise sold....$12,000 overstated

Gross profit...... $12,000 understated

Net income...... $12,000 understated

d.The December 31, 2013, balance sheet would be correct, since the 2012 inventory error reverses itself in 2013.

Ex. 6–15

When an error is discovered affecting the prior period, it should be corrected. In this case, the merchandise inventory account should be debited and the retained earnings account credited for $18,000.

Failure to correct the error for 2011 and purposely misstating the inventory and the cost of merchandise sold in 2012 would cause the income statements for the two years to not be comparable. The balance sheet at the end of 2012 would be correct, however, since the 2011 inventory error reverses itself in 2012.

Ex. 6–16

a.Apple: 48.5 {$23,397,000,000/[($455,000,000 + $509,000,000)/2]}

American Greetings: 3.9 {$809,956,000/[($203,873,000 + $216,671,000)/2]}

b.Lower. Although American Greetings’ business is seasonal in nature, with most of its revenue generated during the major holidays, much of its non-holiday inventory may turn over very slowly. Apple, on the other hand, turns its inventory over very fast because it maintains a low inventory, which allows it to respond quickly to customer needs. Additionally, Apple’s computer products can quickly become obsolete, so it cannot risk building large inventories.

Ex. 6–17

a.Number of Days’ Sales in Inventory =

Kroger, 30 days

Safeway, 31 days

Winn-Dixie, 46 days

Inventory Turnover =

Kroger, 12.1

Safeway, 11.7

Winn-Dixie, 8.0

b.The number of days’ sales in inventory and inventory turnover ratios are relatively the same for Kroger and Safeway. Winn-Dixie has significantly higher number of days sales in inventory and significantly lower inventory turnover than Kroger and Safeway. These results suggest that Kroger and Safeway are more efficient than Winn-Dixie in managing inventory.

Ex. 6–17(Concluded)

c.If Winn-Dixie matched Kroger’s days’ sales in inventory, then its hypothetical ending inventory would be determined as follows,

Number of Days’ Sales in Inventory =

30 days =

X = 30 × ($5,269/365) = 30 × $14.4 per day

X = $432

Thus, the additional cash flow that would have been generated is the difference between the actual average inventory and the hypothetical average inventory, as follows:

Actual average inventory...... $657 million

Hypothetical average inventory...... 432

Positive cash flow potential...... $225 million

That is, a lower average inventory amount would have required less cash than actually was required.

Appendix Ex. 6–18

$507,000 ($780,000 × 65%)

Appendix Ex. 6–19

$380,000 ($475,000× 80%)

Appendix Ex. 6–20

$648,000 ($900,000× 72%)

Appendix Ex. 6–21

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

Appendix Ex. 6–22

a.

A / B / C
1 / Cost
2 / Merchandise inventory, January 1 / $ 500,000
3 / Purchases (net), January 1–December 11 / 4,280,000
4 / Merchandise available for sale / $4,780,000
5 / Sales (net), January 1–December 11 / $6,500,000
6 / Less estimated gross profit ($6,500,000× 36%) / 2,340,000
7 / Estimated cost of merchandise sold / 4,160,000
8 / Estimated merchandise inventory, December 11 / $ 620,000

b.The gross profit method is useful for estimating inventories for monthly or quarterly financial statements. It is also useful in estimating the cost of merchandise destroyed by fire or other disasters.

Appendix Ex. 6–23

Merchandise available for sale...... $3,380,000

Less cost of merchandise sold [$5,260,000 × (100% – 40%)]...... 3,156,000

Estimated ending merchandise inventory...... $ 224,000

Appendix Ex. 6–24

Merchandise available for sale...... $1,400,000

Less cost of merchandise sold [$2,080,000 × (100% – 37%)]...... 1,310,400

Estimated ending merchandise inventory...... $ 89,600