You are on page 1of 19

Chapter 8

Inventories: Measurement

QUESTIONS FOR REVIEW OF KEY TOPICS


Question 8-1
Inventory for a manufacturing company consists of (1) raw materials, (2) work in process, and (3) finished goods. Raw materials represent the cost, primarily purchase price plus freight charges, of goods purchased from other manufacturers that will become part of the finished product. Work-inprocess inventory represents the products that are not yet complete. The cost of work in process includes the cost of raw materials used in production, the cost of labor that can be directly traced to the goods in process, and an allocated portion of other manufacturing costs, called manufacturing overhead. When the manufacturing process is completed, these costs that have been accumulated in work in process are transferred to finished goods.

Question 8-2
Beginning inventory plus net purchases for the period equals cost of goods available for sale. The main difference between a perpetual and a periodic system is that the periodic system allocates cost of goods available for sale to ending inventory and cost of goods sold only at the end of the period. The perpetual system accomplishes this allocation by decreasing inventory and increasing cost of goods sold each time goods are sold.

Question 8-3
Perpetual System (1) purchase of merchandise (2) sale of merchandise (3) return of merchandise (4) payment of freight debit inventory debit cost of goods sold; credit inventory credit inventory debit inventory Periodic System debit purchases no entry credit purchase returns debit freight-in

Question 8-4
Inventory shipped f.o.b. shipping point is included in the inventory of the purchaser when the merchandise reaches the common carrier. Laetner Corporation records the purchase in 2003 and includes the shipment in its ending inventory. Bockner Company records the sale in 2003. Inventory shipped f.o.b. destination is included in the inventory of the seller until it reaches the purchasers location. Bockner would include the merchandise in its 2003 ending inventory and the sale/purchase would be recorded in 2004.
The McGraw-Hill Companies, Inc., 2004 8-1

Solutions Manual, Vol.1, Chapter 8

Answers to Questions (continued) Question 8-5


A consignment is an arrangement under which goods are physically transferred to another company (the consignee), but the transferor (consignor) retains legal title. If the consignee cant find a buyer, the goods are returned to the consignor. Goods held on consignment are included in the inventory of the consignor until sold by the consignee.

Question 8-6
By the gross method purchase discounts not taken are viewed as part of inventory cost. By the net method purchase discounts not taken are considered interest expense, because they are viewed as compensation to the seller for providing financing to the buyer.

Question 8-7
1. Beginning inventory 2. Purchases 3. Ending inventory 4. Purchase returns 5. Freight-in increase increase decrease decrease increase

Question 8-8
Four methods of assigning cost to ending inventory and cost of goods sold are (1) specific identification, (2) first-in, first-out (FIFO), (3) last-in, first-out (LIFO), and (4) average cost. The specific identification method requires each unit sold during the period or each unit on hand at the end of the period to be traced through the system and matched with its actual cost. First-in, first-out (FIFO) assumes that units sold are the first units acquired. The last-in, first-out (LIFO) method assumes that the units sold are the most recent units purchased. The average cost method assumes that cost of goods sold and ending inventory consist of a mixture of all the goods available for sale. The average unit cost applied to goods sold or ending inventory is an average unit cost weighted by the number of units acquired at the various unit prices.

Question 8-9
When costs are declining, LIFO will result in a lower cost of goods sold and higher income than FIFO. This is because LIFO will include in cost of goods sold the most recently purchased lower cost merchandise. LIFO also will provide a higher ending inventory in the balance sheet.

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-2

Answers to Questions (concluded) Question 8-10


Proponents of LIFO argue that it provides a better match of revenues and expenses because cost of goods sold includes the costs of the most recent purchases. These are matched with sales that reflect a current selling price. On the other hand, inventory costs in the balance sheet generally are out of date because they are derived from old purchase transactions. It is conceivable that a companys LIFO inventory balance could be based on unit costs actually incurred several years earlier. When inventory quantity declines during a period, then these out-of-date inventory layers will be liquidated and cost of goods sold will match noncurrent costs with current selling prices.

Question 8-11
Many companies choose the LIFO inventory method to reduce income taxes in periods when prices are rising. In periods of rising prices, LIFO results in a higher cost of goods sold and therefore a lower net income than the other methods. The companies income tax returns will report lower taxable incomes using LIFO and lower taxes will be paid currently. If a company uses LIFO to measure its taxable income, IRS regulations require that LIFO also be used to measure income reported to investors and creditors.

Question 8-12
A LIFO inventory pool groups inventory units into pools based on physical similarities of the individual units. The average cost for all of a pools beginning inventory and for all of a pools purchases during the period is used instead of individual unit costs. If the quantity of ending inventory for the pool increases, then ending inventory will consist of the beginning inventory plus a layer added during the period at the average acquisition cost for the pool.

Question 8-13
The dollar-value LIFO method has important advantages. First, it simplifies the recordkeeping procedures compared to unit LIFO because no information is needed about unit flows. Second, it minimizes the probability of the liquidation of LIFO inventory layers, even more so than the use of pools alone, through the aggregation of many types of inventory into larger pools. In addition, firms that do not replace units sold with new units of the same kind can use the method.

Question 8-14
After determining ending inventory at year-end cost, the following steps remain: 1. Convert ending inventory valued at year-end cost to base year cost. 2. Identify the layers in ending inventory with the years they were created. 3. Convert each layers base year cost measurement to layer year cost measurement using the layer years cost index and then sum the layers.

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-3

EXERCISES
Exercise 8-1
1. To record the purchase of inventory on account and the payment of freight charges.

Inventory........................................................................................ Accounts payable ...................................................................... Inventory........................................................................................ Cash...........................................................................................

4,000 4,000 300 300

2.

To record purchase returns.

Accounts payable........................................................................... Inventory ...................................................................................

600 600

3.

To record cash sales and cost of goods sold.

Cash ............................................................................................... Sales revenue ............................................................................ Cost of goods sold ......................................................................... Inventory ...................................................................................

5,000 5,000 2,800 2,800

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-4

Exercise 8-2
1. To record the purchase of inventory on account and the payment of freight charges.

Purchases ....................................................................................... Accounts payable ...................................................................... Freight-in ....................................................................................... Cash...........................................................................................

4,000 4,000 300 300

2.

To record purchase returns.

Accounts payable........................................................................... Purchase returns ........................................................................

600 600

3.

To record cash sales.

Cash ............................................................................................... Sales revenue ............................................................................ NO ENTRY IS MADE FOR THE COST OF GOODS SOLD.

5,000 5,000

Exercise 8-3
Requirement 1 Beginning inventory Plus net purchases: Purchases Less: Purchase discounts Less: Purchases returns Plus: Freight-in Cost of goods available for sale Less: Ending inventory Cost of goods sold $ 32,000 $230,000 (6,000) (8,000) 16,000

232,000 264,000 (40,000) $224,000

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-5

Requirement 2

Cost of goods sold (above)............................................................ Inventory (ending) ........................................................................ Purchase discounts......................................................................... Purchase returns............................................................................. Inventory (beginning) .............................................................. Purchases .................................................................................. Freight-in ..................................................................................

224,000 40,000 6,000 8,000 32,000 230,000 16,000

Exercise 8-8
Requirement 1 Purchase price = 100 units x $500 = $50,000 x .70 = $35,000

November 17, 2003 Purchases ....................................................................................... Accounts payable ......................................................................

35,000 35,000

November 26, 2003 Accounts payable .......................................................................... Purchase discounts (2% x $35,000).......................................... Cash (98% x $35,000) .............................................................. Requirement 2

35,000 700 34,300

November 17, 2003 Purchases ....................................................................................... Accounts payable ......................................................................

35,000 35,000

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-6

Exercise 8-8 (concluded)


December 15, 2003 Accounts payable........................................................................... Cash........................................................................................... Requirement 3 Requirement 1: 35,000 35,000

November 17, 2003 Purchases (98% x $35,000) ........................................................... Accounts payable ......................................................................

34,300 34,300

November 26, 2003 Accounts payable........................................................................... Cash...........................................................................................

34,300 34,300

Requirement 2:

November 17, 2003 Purchases (98% x $35,000) ........................................................... Accounts payable ......................................................................

34,300 34,300

December 15, 2003 Accounts payable........................................................................... Interest expense (2% x $35,000) ................................................... Cash...........................................................................................

34,300 700 35,000

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-7

Exercise 8-10
Inventory balance before additional transactions Add: Merchandise on consignment with Joclyn Corp. Deduct: Merchandise shipped to Raymond f.o.b. destination on December 26 Merchandise held on consignment from the Harrison Company Correct inventory balance $220,000 15,000 (30,000) (12,000) $193,000

Exercise 8-11
Cost of goods available for sale: Beginning inventory (2,000 x $6.10) Purchases: 10,000 x $5.50 6,000 x $5.00 Cost of goods available (18,000 units) First-in, first-out (FIFO) Cost of goods available for sale (18,000 units) Less: Ending inventory (determined below) Cost of goods sold Cost of ending inventory: Date of purchase August 18 Units Unit cost Total cost 3,000 $5.00 $15,000 $97,200 (15,000) $82,200 $12,200 $55,000 30,000 85,000 $97,200

Last-in, first-out (LIFO) Cost of goods available for sale (18,000 units) Less: Ending inventory (determined below) Cost of goods sold Cost of ending inventory: Date of purchase BI August 8 Units Unit cost Total cost 2,000 $6.10 $12,200 1,000 5.50 5,500 Total $17,700
The McGraw-Hill Companies, Inc., 2004 8-8

$97,200 (17,700) $79,500

Solutions Manual, Vol.1, Chapter 8

Exercise 8-11 (concluded) Average cost Cost of goods available for sale (18,000 units) Less: Ending inventory (determined below) Cost of goods sold Cost of ending inventory: $97,200 Weighted-average unit cost = 18,000 units 3,000 units x $5.40 = $16,200 * Alternatively, could be determined by multiplying the units sold by the average cost: 15,000 units x $5.40 = $81,000 = $5.40 $97,200 (16,200) $81,000 *

Exercise 8-12
First-in, first-out (FIFO) Cost of goods sold: Date of sale Aug. 14 Aug. 25 Total Units sold 2,000 (from BI) 6,000 (from 8/8 purchase) 4,000 (from 8/8 purchase) 3,000 (from 8/18 purchase) 15,000 Cost of Units Sold $6.10 5.50 5.50 5.00 Total Cost $12,200 33,000 22,000 15,000 $82,200

Ending inventory = 3,000 units x $5.00 = $15,000

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-9

Last-in, first-out (LIFO) Date Purchased Beginning inventory August 8 2,000 @ $6.10 = $12,200 10,000 @ $5.50 = $55,000

Sold

Balance 2,000 @ $6.10 $12,200 2,000 @ $6.10 10,000 @ $5.50 $67,200

August 14

8,000 @ $ 5.50 = $44,000 6,000 @ $5.00 = $30,000

2,000 @ $6.10 2,000 @ $5.50 $23,200 2,000 @ $6.10 2,000 @ $5.50 $53,200 6,000 @ $5.00

August 18

August 25

Total cost of goods sold

6,000 @ $5.00 = 2,000 @ $6.10 $30,000 1,000 @ $5.50 1,000 @ $5.50 = $ $17,700 5,500 Ending inventory = $79,500

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-10

Exercise 8-12 (concluded) (Note: the perpetual inventory LIFO results are the same as periodic LIFO results would be, due to the timing of sales and purchases. The same LIFO layers are on hand at the end of the period under each method. This is unusual. LIFO perpetual and LIFO periodic normally produce different results for ending inventory and cost of goods sold.) Average cost Date Beginning inventory August 8 Purchased 2,000 @ $6.10 = $12,200 10,000 @ $5.50 = $55,000 $67,200 = $5.60/unit 12,000 units August 14 August 18 6,000 @ $5.00 = $30,000 $52,400 = $5.24/unit 10,000 units August 25 7,000 @ $5.24 = 3,000 @ $5.24 $36,680 $15,720 Ending inventory Total cost of goods sold = $81,480 8,000 @ $5.60 = 4,000 @ $5.60 $44,800 $22,400 Sold Balance 2,000 @ $6.10 $12,200

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-11

Exercise 8-14
Requirement 1 Cost of goods available for sale: Beginning inventory (5,000 x $10.00) Purchases: 3,000 x $10.40 8,000 x $10.75 Cost of goods available (16,000 units)

$ 50,000 $31,200 86,000 117,200 $167,200

Cost of goods available for sale (16,000 units) Less: Ending inventory (below) Cost of goods sold Cost of ending inventory: Weighted-average unit cost = $167,200 = $10.45 16,000 units

$167,200 (73,150) $ 94,050*

7,000 units x $10.45 = $73,150 * Alternatively, could be determined by multiplying the units sold by the average cost: 9,000 units x $10.45 = $94,050

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-12

Exercise 8-14 (concluded) Requirement 2 Date Beginning inventory Purchased 5,000 @ $10.00 = $50,000 Sold Balance 5,000 @ $10.00 $50,000

September 7 3,000 @ $10.40 = $31,200 $81,200 = $10.15/unit 8,000 units September 10 September 25 8,000 @ $10.75 = $86,000 $126,600 = $10.55/unit 12,000 units September 29 Total cost of goods sold 5,000 @ $10.55 = 7,000 @ $10.55 $52,750 $73,850 Ending inventory = $93,350 4,000 @ $10.15 = 4,000 @ $10.15 $40,600 $40,600

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-13

Exercise 8-17
Requirement 1 Cost of goods sold: 50,000 units x $9 = 6,000 units x $7 =

$450,000 42,000 $492,000

Requirement 2 When inventory quantity declines during a period, liquidation of LIFO inventory layers carried at lower costs prevailing in prior years results in noncurrent costs being matched with current selling prices. If the resulting effect on income is material, it must be disclosed. In this case, the effect of the LIFO layer liquidation is to increase income (ignoring taxes) by $12,000 [6,000 units liquidated x $2 ($9 current year cost per unit - $7 LIFO layer cost per unit)].

Exercise 8-18
MAYTAG Gross profit ratio Inventory turnover Average days in inventory = = = 1,146 4,248 3,102 406.5 365 7.63 = 27% = 7.63 = 48 days WHIRLPOOL 2,487 10,325 7,838 1,092 365 7.18 = 24% = 7.18 = 51 days

Maytag's gross profit ratio (27%) is slightly higher than Whirlpool's (24%). Maytags turnover ratio also is higher (7.63 compared to 7.18).

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-14

Exercise 8-20
Date Ending Inventory at Base Year Cost Inventory Layers at Base Year Cost $200,000 (base) Inventory Layers Converted to Cost Ending Inventory DVL Cost $200,000

12/31/03 $200,000 = $200,000 1.00 12/31/04 $231,000 = $220,000 Index

$200,000 x 1.00 = $200,000

Index = 1.05 $200,000 (base) $200,000 x 1.00 = $200,000 20,000 (2004) 20,000 x 1.05 = 21,000 221,000

12/31/05 $299,000 = $260,000 Index

Index = 1.15 $200,000 (base) $200,000 x 1.00 = $200,000 20,000 (2004) 20,000 x 1.05 = 21,000 40,000 (2005) 40,000 x 1.15 = 46,000

267,000

12/31/06 $300,000 = $250,000 Index

Index = 1.20 $200,000 (base) $200,000 x 1.00 = $200,000 20,000 (2004) 20,000 x 1.05 = 21,000 30,000 (2005) 30,000 x 1.15 = 34,500

255,500

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-15

Exercise 8-22
List A i l a c g h k e f b j d 1. Perpetual inventory system 2. Periodic inventory system 3. F.o.b. shipping point 4. Gross method 5. Net method 6. Cost index 7. F.o.b. destination 8. FIFO 9. LIFO 10. Consignment 11. Average cost 12. IRS conformity rule List B a. Legal title passes when goods are delivered to common carrier. b. Goods are transferred to another company but title remains with transferor. c. Purchase discounts not taken are included in inventory cost. d. If LIFO is used for taxes, it must be used for financial reporting. e. Items sold are those acquired first. f. Items sold are those acquired last. g. Purchase discounts not taken are considered interest expense. h. Used to convert ending inventory at year-end cost to base year cost. i. Continuously records changes in inventory. j. Items sold come from a mixture of goods acquired during the period. k. Legal title passes when goods arrive at location. l. Adjusts inventory at the end of the period.

Problem 8-4
Requirement 1 Beginning inventory (10,000 x $8.00) Net purchases: Purchases (50,000* units x $10.00) Less: Returns (1,000 units x $10.50) Less: Purchase discounts ($500,000 x 60% x 2%) Plus: Freight-in (50,000 units x $.50) Cost of goods available (59,000 units) Less: Ending inventory (below) Cost of goods sold $ 80,000 $500,000 (10,500) (6,000) 25,000 508,500 588,500 (122,000) $466,500

* The 5,000 units purchased on December 28 are not included. The merchandise was shipped f.o.b. destination and did not arrive at Johnsons warehouse until 2004. Cost of ending inventory:
The McGraw-Hill Companies, Inc., 2004 8-16

Solutions Manual, Vol.1, Chapter 8

Date of purchase BI 2003 Total

Units Unit cost Total cost 10,000 $ 8.00 $ 80,000 4,000 10.50** 42,000 14,000 $122,000

** Includes freight charge of $.50 per unit. Requirement 2 Sales (45,000 units x $18.00) Less: Cost of goods sold (above) Other operating expenses Income before income taxes $810,000 $466,500 150,000 (616,500) $193,500

Problem 8-10
Date 1/1/03 Ending Inventory at Base Year Cost $400,000 = $400,000 1.00 12/31/03 $441,000 = $420,000 1.05 12/31/04 $487,200 = $435,000 1.12 12/31/05 $510,000 = $425,000 1.20 $400,000 (base) $400,000 x 1.00 = $400,000 20,000 (2003) 20,000 x 1.05 = 21,000 $400,000 (base) $400,000 x 1.00 = $400,000 20,000 (2003) 20,000 x 1.05 = 21,000 15,000 (2004) 15,000 x 1.12 = 16,800 $400,000 (base) $400,000 x 1.00 = $400,000 20,000 (2003) 20,000 x 1.05 = 21,000 5,000 (2004) 5,000 x 1.12 = 5,600 $400,000(base) $400,000 x 1.00 = $400,000 $400,000 Inventory Layers at Base Year Cost Inventory Layers Converted to Cost Ending Inventory DVL Cost

421,000

437,800

426,600

Judgment Case 8-1


Advance warning of the company's impending bankruptcy existed at the date of the financial statements. As a rule, inventories should rise in tandem with sales. If inventories rise faster, it may be
Solutions Manual, Vol.1, Chapter 8 The McGraw-Hill Companies, Inc., 2004 8-17

because the goods simply aren't selling. This is particularly true of companies in faddish or seasonal businesses Merry-Go-Round's world. The company's report showed that inventories on January 30 were $82.2 million, up 37 percent from $60 million a year earlier. That's well above the 15 percent sales growth in the same period, to $877.5 million from $761.2 million. This alone should have been a major cause for concern. It indicated the company's goods simply weren't selling as rapidly as it expected, causing its inventories to bulge. The increase in receivables from $6,195 to over $6 million should also have been cause for concern.

Judgment Case 8-5


At the end of a reporting period it is important to ensure that a proper inventory cutoff is made. A proper cutoff involves the determination of the ownership of goods that are in transit between the company and its customers as well as the company and its suppliers. If the shipment is made f.o.b. shipping point, then ownership is transferred to the buyer when the goods reach the common carrier. If the shipment is made f.o.b. destination, then ownership is transferred to the buyer when the goods arrive at the buyers location. In this case, John is incorrect if the goods were shipped f.o.b. destination. If so, even though the company is not in physical possession of the goods, they should be included in ending inventory because the shipment had not reached the buyer's location by the end of the reporting period.

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-18

Ethics Case 8-6


Requirement 1 Without purchase of the additional units: Sales (35,000 @ $60) Cost of goods sold (35,000 x $30) Gross profit Due Jim Lester ($1,050,000 x 20%) = $210,000 With purchase of the additional units: Sales Cost of goods sold: 20,000 x $40 $800,000 15,000 x $30 450,000 Gross profit Due Jim Lester ($850,000 x 20%) = $170,000 Requirement 2 Discussion should include these elements. Facts: If Moncrief purchases the additional units at year end under a periodic LIFO inventory system, the transaction results in a reduced payment to Jim Lester, reduced profits to shareholders, and reduced income tax payments to government entities. By purchasing the additional units of Zelenex, Moncrief reduces Jim Lester's payment by $40,000 ($210,000 - $170,000) and decreases gross profit by $200,000 ($1,050,000 - $850,000). The net effect on before-tax income is a decrease of $160,000 ($200,000 $40,000). Since Moncrief does not intend to sell the units until 2004, the only logical reason for purchasing more costly inventory at year-end is profit manipulation. Ethical Dilemma: Should Moncrief exercise its right to purchase inventory at will, resulting in a reduction in net income, or recognize the rights of Jim Lester to receive profit for the sale of his product, shareholders' rights to have their investment appreciate through positive earnings, and government entities' rights to collect tax on economic net income? $2,100,000 (1,250,000) $ 850,000

$2,100,000 (1,050,000) $1,050,000

Solutions Manual, Vol.1, Chapter 8

The McGraw-Hill Companies, Inc., 2004 8-19