CHAPTER 7 - INVENTORY PROBLEM SOLUTIONS
Assessing Your Recall
7.1 Under GAAP, inventory is carried at the lower of cost and market. Market is most commonly either replacement cost or net realizable value. When the calculated cost figure is materially different from recent cost figures, companies should be applying the lower of cost and market valuation method.
7.2 The lower of cost and market rule can be applied to individual items, to pools of similar items or to the inventory as a whole. Because it is not practical to apply it on an individual basis, most companies use either pools of inventory or the whole inventory. The cost of the inventory which has been assigned using either specific identification, FIFO, LIFO or weighted average is compared to the market value (usually either replacement cost or net realizable value). The lower value is used. If the market value is used because it is lower, then subsequent recoveries can be recognized to the extent of the write-down(s). This treatment is similar to that of temporary investments, in which recoveries are also recorded back to the original cost, if subsequent increases in market value occur.
7.3 Replacement cost is the price at which an item could be replaced in inventory. This price is sometimes referred to as an entry price since it describes the price at which units of inventory enter the company. Net realizable value is the selling price of an item less any costs necessary to complete and sell the item. This price is sometimes referred to as an exit price since it describes the price at which units exit the company.
7.4 In a perpetual inventory system, when a new inventory item is purchased, it is added to the inventory account. When an inventory item is sold, the cost of the item that is sold is immediately identified and deducted from the inventory account. Because of this the inventory account is perpetually kept up to date with the changes in inventory. In a periodic system when a new inventory item is purchased it is added to a purchases account. When an inventory item is sold, no entry is made to the inventory account until the end of the period when the ending inventory is counted and costed. The cost of the ending inventory is then used to calculate the amount that should be removed from the inventory account for the sales during the period. During the period the inventory account retains its beginning or period balance. See the answer to Question 7.5 for the advantages and disadvantages of the two methods.
7.5 The advantage of the perpetual system over the periodic system is that management has continuously updated information available concerning inventories and cost of goods sold. This is very important for inventory management purposes. The disadvantage is that perpetual systems are more costly to implement. Prior to the advent of low-cost computing power perpetual systems were only used for low-volume, high unit cost types of inventories (such as in a car dealership). Another advantage of the perpetual system is that inventory shrinkage can be independently determined by combining the perpetual information with a physical count. An additional cost of the perpetual system is that the company also has to count its inventory periodically to verify shrinkage and to assess the integrity of the perpetual information.
The advantage of the periodic system is that it is less costly. However, management does not have updated information about inventory levels. It also has a difficult time determining the amount of inventory shrinkage. The cost of goods sold is determined by adding the purchases for the period to the beginning inventory and then subtracting the inventory cost determined from the physical count. It is assumed that any inventory that is not there to be counted has been sold.
7.6 The three major cost flow assumptions are FIFO, LIFO and weighted average. FIFO (first-in, first-out) assumes that the cost of the first unit purchased is the first cost to appear in the income statement (in Cost of goods sold). LIFO (last-in, last-out) assumes that the cost of the last unit purchased is the first cost to appear in the income statement. Weighted average computes an average cost for all units in beginning inventory and the purchases during the period and assigns this average cost to the units sold during the period. It is important to remember that cost flow does not have to match the physical flow of goods. In fact, in most cases inventory physically flows in a FIFO manner as companies rotate their inventory and attempt to sell older items first.
7.7 For reporting purposes management typically has an incentive to report the highest possible income, particularly if there is a management incentive program based on reported income. Therefore, management would probably like to report the lowest amount of cost of goods sold so as to produce the highest net income. This incentive is obviously at odds with the incentive for tax purposes.
For tax purposes a company typically would like to choose the cost flow assumption that would result in the highest cost of goods sold since that would produce the lowest taxable income and the lowest amount of taxes paid. In Canada, Revenue Canada will not allow LIFO to be used for tax purposes. This narrows the choice of methods that companies can use to achieve a low taxable income. The actual choice of methods for tax purposes would depend on whether prices are increasing or decreasing and whether inventory levels are expected to remain stable, increase, or decrease. Expected future changes in tax rates might also have some influence on the decision.
The choice of inventory methods is constrained because a company cannot switch back and forth between inventory methods at will. The accounting characteristic, consistency, discourages companies from switching methods frequently and a company’s auditors would object to frequent switches for reporting purposes.
7.8 A holding gain in the context of inventory is a gain that is experienced by the company as it holds inventory. If the inventory is then sold the company realizes this holding gain in income. If the company continues to hold the inventory the holding gain is unrealized. Under LIFO most holding gains are unrealized since the cost shown in income is the current cost. Ending inventory is carried at older prices and thus contains most of the holding gains. Under FIFO most holding gains are realized (included in income) since the cost of goods sold figure is based on older unit prices. Whereas ending inventory is carried at the most recent prices. The weighted average cost flow assumption would produce results closer to FIFO but some holding gains would remain in ending inventory and be unrealized.
7.9 The three main reasons that a company would need to estimate cost of goods sold or inventory would be: a) the inventory has been destroyed or stolen and it is impossible to count it; 2) the company wants to prepare monthly financial statements but does not want to incur the cost of counting the inventory; and 3) the company wants to have an estimate of the inventory it has before it begins the physical count so that it can determine whether goods have been lost or stolen.
7.10 Assuming a trend of rising prices LIFO will produce balance sheet values of inventory that are significantly lower than those under FIFO. The cost of goods sold under LIFO will generally be higher than that under FIFO in any given year. The effect on balance sheet ratios, such as the current ratio are that a LIFO company will report a lower inventory value (relative to a FIFO company) and therefore a lower current ratio (all other things held constant). Ratios that involve total assets (such as Return on assets) will also be affected by the choice of LIFO versus FIFO.
The inventory turnover ratio is directly impacted by the choice of LIFO versus FIFO. The inventory turnover matches units sold in the numerator with average units on hand in the denominator. The ideal ratio would be to compute the ratio using the unit figures. Unfortunately this information is not available in the annual report. The cost futures are therefore used. Under LIFO the cost of goods in the numerator is based on new unit cost, however, the denominator is based on old unit costs (sometimes very old depending on how long ago the first inventory was purchased). The ratio is therefore distorted and typically is biased upward (in periods of rising prices). Under FIFO, on the other hand the numerator is based on slightly old unit prices, whereas the denominator is based on current prices. The bias under FIFO is not as severe as that under LIFO because the disparity between unit prices in the numerator and denominator is not as great.
7.11 a) Weighted average
Total units purchased /Unit cost
/ Total cost8,000 / $18.00 / $144,000
4,000 / 17.50 / 70,000
12,000 / 15.00 / 180,000
6,000 / 14.50 / 87,000
30,000 / $481,000
Average cost = $481,000 / 30,000 = $16.03 per unit
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = 20,000 x $16.03 = $320,066.67
b) FIFO
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = (8,000 x $18.00) + (4,000 x $17.50 ) + (8,000 x $15.00) = $334,000
c) LIFO
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = (6,000 x $14.50 ) + (12,000 x $15.00 )+ (2,000 x $17.50) = $302,000
d) Because unit costs of purchases have been declining, LIFO produces the greatest net income for August and FIFO produces the smallest net income for August.
d) LIFO results in the largest inventory balance at August 31, because the high cost purchases made at the beginning of August are assigned to inventory. FIFO results in the smallest inventory balance at August 31 because the low cost purchases made at the end of August are assigned to inventory.
7.12 a) FIFO
Ending inventory = $19,000 + 1500 x (42,500 / 2,500)
= $44,500
b) LIFO
Ending inventory = 30,000 + 500 (45,000/3,000)
= $37,500
c) Weighted average
Ending inventory = 2,500 x [(30,000 + 45,000 + 16,000 + 66,000 + 42,500 + 19,000) / 13,500]
= $40,462.96
7.13 a) FIFO
Total units sold = 270
Cost of Goods sold = (60 x 4) + (200 x 5) + (10 x 9)
= $1,330
Gross profit = (100 x 9) + (170 x 10) - 1,330
= $1,270
b) LIFO
Total units sold = 270
Cost of goods sold = (60 x 7) + (40 x 9) + (170 x 5)
= $1,630
Gross profit = (100 x 9) + (170 x 10) - 1,630
= $970
c) LIFO provides the most conservative estimate of the carrying value of
inventory because it assigns lower costs from earlier purchases to ending inventory. Because inventory is stated at a lower amount under LIFO, there is less risk of overstatement, and a more conservative value results. LIFO also provides the best estimate of the current cost of replacing the inventory because cost of goods sold under this method reflects the cost of more recent purchases. As a result, gross profit is more representative of true profits, after allowing for the replacement of goods sold at their current costs.
d) LIFO provides the most conservative estimate of reported income,
provided that prices are rising. If prices are in fact falling, FIFO provides the most conservative estimate of reported income.
7.14 a)
Average cost / Specific IdentificationCost of goods sold / $11,200 / $8,800
Ending inventory / $ 5,600 / $8,000
Average cost
(1,800 + 6,000 + 2,800 + 3,000 + 2,000 + 1,200) / 6 = $2,800
Cost of goods sold = 4 x 2,800 = $11,200
Ending inventory = 2 x 2,800 = $5,600
Specific Identification
Cost of goods sold = 1,800 + 2,800 + 3,000 + 1,200 = $8,800
Ending inventory = 6,000 + 2,000 = $8,000
b) For specific identification to be used, it must be possible to keep track of each batch of units received and the cost of that particular batch of units. In general, this is feasible only if the units are high-priced, so that such a tracking system can be justified based on the additional information that the system provides.
c) Specific identification best represents the operating results for Exquisite Jewelers because cost of goods sold represents the actual cost of the physical units sold during the period.
7.15 a) FIFO
Total units sold
= 11,500
Cost of goods sold
= $60,000 + $44,000 + 1,500($60,000 / 5,000)
= $122,000
Ending inventory
= 3,500 x (60,000 / 5,000)
= $42,000
b) LIFO
Total units sold
= 11,500
Cost of goods sold
= $60,000 + $44,000 + 2,500($60,000 / 6,000)
= $129,000
Ending inventory
= 3,500 x ($60,000 / 6,000)
= $35,000
c) Weighted average
Total units sold
= 11,500
Average cost
= ($60,000 + $44,000 + $60,000) / 15,000
= $10.93
Cost of goods sold = 11,500 x $10.93
= $125,733.33
Ending inventory
= $38,266.67
7.16 a) Computation of Cost of Goods Sold
Beginning inventory / 200 / $17.00 / $ 3,400
Purchases:
Jan. 1 / 1,500 / 17.10 / 25,650
Jan. 10 / 200 / 20.00 / 4,000
Jan. 12 / 800 / 22.00 / 17,600
Jan. 14 / 200 / 23.00 / 4,600
Transportation-in:
Jan. 1 purchase / 1,500
Jan. 14 purchase / 400
Goods available for sale / 2,900 / 57,150
Ending inventory / 900 / ( 20,000)
Cost of goods sold / 2,000 / $37,150
Composition of ending inventory
Jan. 14 purchase / 200 / 23 / $ 4,600Jan. 12 purchase / 700 / 22 / 15,400
$20,000
b) LIFO
Cost of goods sold
= (200 x $23) + (800 x $22) + (200 x $20) + (800 x