Financial Accounting 05 PDF

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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
210
CHAPTER5 . THE PURCHASE

AND SALEO F I N V E N T O R Y
'#yg
Firmslosebillionsof dollarsfrom inventorytheft. Individualfirms
Target,and Costco,will not talk about the
suchasBloomingdale's,
numberspublicly,but the NationalRetailFederationgathersthe
data from hundredsof retailers.The bad news is that employee
theft accountsfor almosthalf of the over $30 billionannuallosses
of inventory.
from the disappearance
What doesthat mean for a firm? PrestonTurco,the owner of
two specialtygrocerystoresin New York, useselaboratesecurityin his storesspecialfraud detection software for cashregisters,hidden cameras,store detectives, and an employee handprint identification device to clock his
employeesin and out, He has some other adviceabout reducinginventory
theft: Hire and keep a happyand loyalstaff.
Theywere
We haveall readabout Ken Lay,Jeff Skilling,and BernieEbbers.
at the very top level of managementat the firms they looted. But very few of
us havereadabout the deli clerkwho switchedhigherpricetagsfor lower ones
and tried to bribe a cashierto look the other way.That clerkis now in prison,
accordingto Mr. Turco.lt turns out that ethicsmatter at all levelsof a business.
[,"{}.1
Calculate
and recordthe
purchase
andsaleof
inventory,
Acquiring
andSellingMerchandise
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
example,Target'snet income for the fiscal year endedJanuary31,2005, was over $3.1 billion, and the firm generatedover $3.8 billion ofnet cashfrom operating activities. It was a
very good year for Target.
for Sale
AcquiringMerchandise
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. According to the matching principle, inventory should be expensedin 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
income statement.You can seethat the value of the inventory affects both the balancesheet
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
the company's total assets.That is a signifrcant amount of the frrm's assets.
C H A P T E5
R . A C Q U I R I N GA N D S E L L I N GM E R C H A N D I S E
211
x His g T5 . s
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.
AcquisitionProcessfor Inventory
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 purchaseorder 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.
212
AND SALEOF I N V E N T O R Y
EXHIBIT5.2
TakingCareof Business
PurchaseOrder
from Office Depot
I
Phone: 555-555-5555
Fax: 555-555-5555
E-mail:someone@examole.com
Purchase Order
BiLI
ship
To:
22oA AId Germantown

Defr ay Beac h
FL 33445
Tot
offi c e
D epot W ar ehous e
2510 D epot R oad
Road
nal
r. 1 r
E a : -h
F L 33445
Order#:
Purchase
Date:
VendorlD: 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 finan-
The perpetual inventory

system is a method of record
keepingthat involves
updatingthe accounting
recordsat the time of every
purchase,sale,and return.
The periodic inventory system
is a method of recordkeeping
that involvesupdatingthe
accountingrecordsonly at the
end of the accountingperiod.
cial 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:
Assets
15.000 inventorv
Liabilities
Shareholders'equity
Contributed + Retained
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
C H A P T E5
R . A C Q U I R I N GA N D S E L L I N GM E R C H A N D I S E
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.
.Buyer DOES NOT pay the shipping cost.

.Vendor pays the shipping cost, which is recorded
as an operating expense.
oVendor DOES NOT pay the shipping cost.
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
passesto the buyer at the shipping point (the vendor's warehouse),and the buyer is responsible 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
Supposethe shippingcost for the 100 lawn mowerspurchasedby Quality Lawn Mowers
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:
Assets
Liabilities
Shareholders'equity
capital
343inventory
(343)cash
earnings
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 (sellingfirm) paysthe
shippingcosts,so the buyer
has no freight-in cost.
21 4
CHAPTER5 o THE PURCHASE
Your Turn 5-l

'fl###g""fl,,s#"ge
In each separatesituation, calculatethe cost of the inventory purchased.

1. Company A purchased merchandise FOB destination for $10,000'
Termswere 2110,n/30 and payment was made in 8 days. Freightcost
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,
the balance in that account will be decreasedwhen goods are returned. The details of the
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
firm should be sureit understandsthe 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
vendors,will be reduced.The inventory accountwill be decreasedbecausethe goods have
beenreturned.SupposeQuality Lawn Mowers returnedtwo of the lawn mowersbecausethey
were defective.This is how the transactionwould be recordedin the accountingequation:
Assets
(300)inventory
Purchasereturns and
allowancesare amountsthat
decreasethe costof inventory
due to returnedor damaged
merchandise.
A purchasediscountis a
reductionin the priceof an
inventorypurchasefor
prompt paymentaccordingto
terms specifiedby the vendor.
Liabilities
Shareholders'equity
capital
earnings
(300)accounts
payable
Similarly, if a vendor gives the firm a purchaseallowance,the amount owed to the venis
dor reduced by subtracting the amount from accountspayable. There will also be a reduction 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,
C H A P TE5R. A C QU IR INAGN D S E LLINME

G R C H A N D TSE215
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 purchaseof $15,000was returned.Thel%odiscountamountsto $147.That means
that the companywill pay the vendor$14,553($14,700- $147).Here is the way the transaction would be recordedin the accounting equation:
Assets
(14,553)
cash
(147)inventory
Liabilities
Shareholders'equity
capital
earnings
(14,700)
accounts
payable
Before the payment,the balancein accountspayablewas $14,700.So the entire $14,700

must be subtractedout of accountspayable.Becauseonly $14,553 was actually paid, this is
the amount deductedfrom the cashaccount.That leavesthe discount amount to balancethe
accountingequation.This decreasesthe inventory accountbecauseinventory purchasewas
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 accountspayablefor $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
allowancesand discounts)15,000 -300 -I47
+ Shipping costs (freight-in)
: Cost ofgoods available for sale
$0
14 55?
343
$ 14,896
Cost of goods available for

sale is the total of beginning
inventoryplusthe net
purchases
made during the
period (plusany freight-in
costs).
216
Your Turn 5-2

%rur fue"ss
Jaden'sCoffee Hut purchased100 pounds of Columbianroast coffee beansto

packageand sell to its customers.The coffee cost $5 per pound, and Jaden's
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
payment terms were given as211O,n/30. The coffee beanswere shipped FOB
destination,and the shippingcostswere $75.Jaden'saccountantpaid the coffee importer 5 days after the date on the invoice.The paper company that
sold Jaden'sthe bags did not offer a discount,so Jaden'spaid that firm a few
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
and not when IBM pays for the purchase.You know that the shipment of the goods is precededby many crucial activities such as planning, marketing, and securing orders.Yet, no
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 TE5Ro A C QU IR INAGN D S E LLINME

G R C H A N D IS E 217
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'scustomersmay 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:
Assets
(100) accounts
receivable
Liabilities
Salesreturns and allowances

is an accountthat holds
amountsthat reducesalesdue
to customer returns or
allowancesfor damaged
merchandise.
A contra-revenueis an
account that is an offset to a
revenueaccountand
therefore deducted from the
revenuefor the financial
statements.
Shareholders'equity
Contributed
Retained
capital
earnings
(100)sales
returnsand
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 $3,900.
A salesdiscountis a reduction
in the salespriceof a product
offered to customersfor
prompt payment.
218
E D SA L EO F IN V E N TOR Y
CHA P T E5R . T H EP U R C H ASAN
Just as with salesreturns and allowances,the amount of a salesdiscount could be subtracted direct$ 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
Shareholders' equity
Liabilities
Contributed
capital
Retained
earnings
(78) sales
discounts
3,822cash
(3,900)accounts
receivable
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-
GV E N TORP
YE
: R P E TU V
AE
L R S UPSE R IOD IC
C H A PT E5R. R EC O R D ININ
R E C ORK
DE E P IN G
ment whateverit collects. Here is how Quality Lawn Mowers would record receipt of $416
cash from the customer:
Assets
416cash
Liabitities
16 sales
taxes payable
Shareholders'equity
capital
earnings
400 sales
revenue
Your Turn 5-3
Fedcosold $3,000worth of merchandiseto a customerfor cash.The salestax

was 5%. How much cash did Fedco receive?How much sales revenue did
Fedcoearn?
Wmmsr
ffiws'wm
Recording
Inventory:Perpetual
Versus
PeriodicRecordKeeping
L.().?
Explainthe two methodsof
inventoryrecordkeeping.
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
betweenPerpetual
andPeriodiclnventorySystems
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.
I
I
I
I
how inventory
shrinkage
happens
in the retailindustry:
-r--.
--
I
L
Employee
theft
Shoplifting
Administrative
errors
Vendorfraud
46o/o
31o/ o
17%
6o/o
A N D SA L EOF IN V E N TOR Y
CHA P T E5R . T H EPU R C H A SE
220
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

'
,,.'
[".{}"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
and e x p l a i n
how these methodsaffect
th e f i nanc ials t at e m e n ts .
Supposea firm is very concernedabout inventorytheft. Which methodof

recordkeepingwould be the bestchoicefor this firm? Explain.
InventoryCostFlowAssumptions
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.
to SunglassHut. The costto SunSupposeOakley ships120pairsofits new sunglasses
glass Hut is $50 per pair. Then, supposethat just a month later, SunglassHut needsmore
of the popular sunglassesand buys another 120 pairs. This time, however, Oakley charges
$55 per pair. If SunglassHut sold 140 pairs of Oakley sunglassesduring the month to its
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?
SunglassHut will make an assumptionabout which pairs of sunglassesflowed out of
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 concernedwith inventory cost flow-that is, the flow of the costsassociatedwith the goodsthat
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
understandhow accountingchoicescan affect the amountson the financial statements,even
C H A P T E5
R o I N V E N T O R YC O S TF L O W A S S U M P T I O N S
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)
Specificldentification
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
Weighted average cost is the

inventorycostflow method in
which the weighted average
costof the goodsavailablefor
saleis usedto calculatethe
costof goods sold and the
ending inventory.
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: weightedaveragecost,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
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
222
EXHIBIT5.6
Cost of each item

availablefor sale...
Weighted Average
Inventory Costing
is averaged together to
get a single average
unit cost...
which is then used as

the cost of each unit.
Purchase I
DD/
\
$50 each
$57
lCost of goods sold
Purchase 2
$60
AII the costs are

averaged to compute
a single unit cost:
Cost of goods sold $57
[(2x$50)+$60+$68]
+4=$228+4=$57.
Endinginventory$57
$68
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
inventory.Companiessuchas Best Buy, Intel, Starbucks,and Chico's usethe weightedaverage 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.
Consider the sunglassesshown in Exhibit 5.6. The store purchasedfour pairs from the
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
A firm startswith 10 units in its beginning inventory at a cost of $1 each.During the first day of March,the firm purchases20 units at a cost of $2 each.No
other purchaseswere made. Betweenthe 2nd and 31st of the month, the firm
sold 15 units. How much was the cost of goods sold if the firm usesweighted
averagecost as its inventory cost flow assumption?
Wkwmer'ffisss-sw
CHAPTE5
EXHIBIT5.7
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
223
FIFOInventory Cost
Flow Method
Cost of goods sold
Ending inventory
$ r6 0
$68
Purchase I
Wd
$50 each
Purchase2
$60
Purchase 3
$68
8228
First-ln,First-OutMethod (FIFO)
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)is the

inventory cost flow method
that assumes
the f irst items
purchasedare the first items
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
Last-ln,First-OutMethod (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
the last items
purchasedare the first items
sold.
224

AND SALEo F I N V E N T o R Y
EXHIBIT5.8
The actual order ofthe

items sold is not
necessarily lanown, but
the costs flow "as if"
this were the flow of
the goods:
LIFOlnventory Cost
Flow Method
Cost of goods
available for sale
Cost of goods sold
Ending inventory
$178
$50
$50 each
Purchase 2
$60
Purchase 3
$68
$228
We will use the four pairs of sunglassesagain 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 purchaseswill 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
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)
LIFODisclosure
in Notes
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 E5
EXH|BtT5.10
Purchases
Cost of goods sold
Ending inventory
This exhibit comparesthree

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
sunglassessold 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
A Comparisonof
Weighted Average Cost,
FIFO,and LIFO
$57+$57+$57:$ l7 l
$57
FIFO
$50+$50+$60:$ 1 6 0
$68
LIFO
$68+$60+$50:$ 1 7 8
$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'sJewelry Store purchasedthree 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'sJewelry Store sold two of these braceletsfor $7,000each.
1. Using FIFO,what is the cost of goods sold for these sales?What is the
gross profit?
2. Using LIFO,what is the cost of goods sold for these sales?What is the
gross profit?
3. Using weighted averagecost,what is the cost of goods sold?
Your Turn 5-6

',Hkwffi'sm*
Whw,w.w,
226
How InventoryCostFlowAssumptionsAffect the FinancialStatements

Did you notice that the sameset of facts and economic transactionsin the examplesyou just
studiedresulted in different numbers on the financial statementsfor cost of goods sold and
for ending inventory? In the following sections,you will learn how the firm's choice of inventory 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
X
cameras $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
all methods.Kaitlyn addsup beginning inventory and all purchasesto 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) camerasavailablefor 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)
=
$11.90
(per unit cost)
$130.90costof goodssold
9
(Number of camerasin
ending inventory)
:
$11.90
(per unit cost)
$107.10endinginventory
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 Recordsfor
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
@$50each
@$12each
each
@ $55
each
@ $14
C H A P TE5R. IN V E N TORCYOS TFLOWA S S U MP TION S 227

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?
2 c a me ra sx $ 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
FIFOInventoryCost
FlowAssumptionfor
Kaitlyn'sPhotoShop
ilEE
trtt
Costof
goodssold
purchase
Cost of goods sold =
(8x$10)+(3x$12)=$116
5 cameras
@ $12 each
Ending
inventory
+
purchase
7 cameras
@ $14 each
Ending inventory =
(2 x $12)+ (7 x $r4)--$r22
ffi
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
camerascost $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.
228
CHAPTER
5 . THE PURCHASE
to go to the income statementas cost of goods sold. For LIFO, we start at the bottom of the
list of purchasesin the sequencein which the cameraswere purchased.
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.
7 camerasX $ l4 per unit : $ e 8
4 camerasX $ l2 per unit : $ 4 8
: $146
Cost of goodssold
What is left in inventory on the balance sheet?
1 cameraX $12 per unit : $12
8 camerasx $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
LIFOInventoryCost
FlowAssumptionfor
Kaitlyn'sPhotoShop
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
camerascost $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
Ending
inventory
(8 x $10)+
(1 x $12)=
$92
8 cameras
@ $10 each
+
purehase
5 cameras
@ $12 each
purehase
7 cameras
@ $14 each
Cost ofgoods
sold
(7 x $14)+
(a x $12)-$146
C H A P TE5Ro IN V E N TORCYOS TFLOWA S S U MP TION S 229

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
averagecost 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
:
:
:
:
$ 30
$ 50
$ 36
$1 16
What is left in ending inventory?

2 camerasX $12 each
7 camerasx $14 each
Total ending inventory
: $ Z+
: $ qS
: $122
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
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 January 8!Thecostof goodssoldfortheJanuary8 saleis3 camerasX $l0percamera: $30.
Next, eight cameraswere sold on January20. Becausethe inventory cost flow assumption 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
= $ 30 Saleon January8
= $ 60 Saleon January20
{
:$ 30 |.
: $120
What is left in the ending inventory?

2 cameras X $10each
7 cameras X $14each
Total
: $ 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
ayerage,FIFO, and LIFO, all using periodic record keeping. In every case,notice that cost
EXH tBtT5.14
Summaryof Kaitlyn's
Photo InventoryData
lnventory
Cost Flow
Assumption
Costof goods
sold
Ending
inventory
Note: Amowts
Weighted
Average
$116
$122
@re round,ed, to the nryest
doUM.
$146
$92
$131
$r07
C H A P TE5R. IN V E N TORCYOS TFLOWA 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:
JonesSaddleCompanyhadthe followingtransactions
Purchased
30 units@$20per unit on August10,2008.
Purchased
20 units@ S21perunit on August15,2008.
Purchased
20 units@$23per unit on August21,2008.
Sold35 units@$30per unit on August30,2008.
Your Turn 5-7

*flmgpe.
ffisw-gru
Calculate
the costof goodssoldusingeachof theseinventorycostflow assumptions:(1) FIFO,(2) LIFO,and (3)weightedaveragecost.(ln this case,
perpetualand periodicproducethe sameanswersbecauseall purchases
were madebeforeany sales.)
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.
Salesrevenueand operating expensesare the sameno matter what inventory cost flow
assumption is used. Earlier we learned that salesrevenue amounted to $590, and operating expenses,in addition to cost of goods sold, were $50 for the period. Now, look at
Exhibit 5.15. Notice that we have addedtwo new numbers:Operatingexpenses,paid in
cash,of $50 and the income taxes of 307o.Bxhibit 5.15 showsthe income statementfor
eachinventory cost flow assumption.
Before you decidethat FIFO is bestbecauseit provides a higher net income, notice that
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
FIFO
LIFO
Weighted
Average
Sale s*
Costof goodssold
0peratingexpenses
In co meb efor et ax es
Incometaxes(30%)
Netincome
$590
l t6
50
424
127
$297
$590
146
50
394
1r8
$276
$590
131
50
409
123
$286
*(3x$50) + (8x$55) = $590
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
CHAPTER5 o THE PURCHASE
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.
lnventory
Gost Flow Assumption
FIFO
LIFO
fromcustomers
Cashcollected
Cashpaidfor inventory
expenses
Cashpaidfor operating
Cashinflowbeforeincometaxes
Cashoaidfor incometaxes
activities
Net cashfromoperating
$590
238
50
302
127
$125
$590
238
50
302
118
$184
Weighted
Average
$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
rather than FIFO. There is a differencebecausethe higher costs of the more recentpurchasesgo to the income statementas cost of goodssold, and the older,lower costsareleft
on the balancesheetin inventory.Higher cost of goodssold expenseresultsin a lower net
income. Although financial accounting and tax accounting are usually quite different, the
IRS requiresany companythat usesLIFO for income tixes to alsouseLIFO for its financial statements.This is calledthe LIFO conformity rule. So, if a firm wantsto take advantageof lower income taxeswhen inventorycostsare rising, the firm must also be willing
to report a lower net income to its shareholders.Reducingincome taxesis the major reason films selectLIFO. Readmore aboutLIFO and taxesin UnderstandingBusiness.
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
Inventories
Disclosureof a Change
in Inventory Cost Flow
Methods
Thisisjustpartof theinventory
Market
is determined
using
theretailmethod.
arevalued
atthelowerof costor market,
Inventories
store
realizable
value,
Using
theretailmethod,
costor estimated
onthelowerof replacement
based
byapplying
a calculated
costto retailratioto theretailvalueof
inventories
arevalued
andwarehouse
inventories.
disclosure made by Books-AMillion in the notes to its

January 29, 2005 financial
statements.Notice the
justification for the changein
inventory methods,highlighted.
(FlF0)
first-out
method
of
changed
fromthefirst-in,
2,2003,
theCompany
Ef{ective
February
(LlF0)
believes
thischange
method.
Management
tothelast;in,
lirst-out
accounting
forinventories
Theimpact
andexpenses.
of fevenues
matching
inthatit achieves
a moreappropriate
waspreferable
"Costs
statements
of
Sold"intheconsolidated
of Products
change
wasto increase
ofthisaccounting
yearsended
29,2005
andJanu ar31,
y
forthefi scal
January
mi l l i on
m i l l i on
and$0.7
o p e ra ti obnys$ 0 .4
per
to netincome
of$0.3million
or$0.01
inanafter-tax
decrease
Thisresulted
2004,
respectively.
perdiluted
of$0.4
million
or$0.02
decrease
to netincome
forfiscal
2005
andanafter-tax
diluted
share
principle
fromtheFlF0method
inaccounting
effectofa change
Thecumulative
share
forfiscal2004.
forprospectively.
hasbeenaccounted
Accordingly,
suchchange
is notdeterminable.
to LlF0method
T O T O M 'S WE A R
CHAPT E 5
R . A P P L Y I N GI N V E N T O R YA S S U M P T I O N S
233
t i,iluIlq,rBusingss
i ii'iil[ii;i:\
InventoryCostFlowAssumptions
and Taxes
(GAAP)
principles
Generally
allow
accepted
accounting
firmsquitea bit of latitudein selecting
a methodof acprocounting
for inventory
costs.Last-in,
first-out(LIFO)
videsa tax benefit-lowertaxesthanfirst-in,first-out
(FIFO)-ina periodof risingprices.Thisis a realeconomicbenefitthatresults
fromanaccounting
choice.
In
the pastcentury,costshavebeenrising,so it would
makesense
for a company
to takeadvantage
of thistax
savings
by choosing
LIFOfor its inventory
method.Yet,
the most recentsurveyof accountingpractices,
re(2006),reportedin Accounting
Trends& Techniques
portsthat onlyabout38% of firmsuseLIFO,
manyfor
onlypartof theirinventories.
Whatfactorsinfluence
a
firms choiceof inventory
methodsand why woulda
firm choosenot to useLIFO?
Lower Earnings
lf a firm usesLIFOfor taxes.thefirm mustalsouseLIFO
for financial
reporting.
Thisiscalledthe LIFO
conformity
rule.Thisisan exception
rulethata firm
to thegeneral
may use one accounting
methodfor financialstatementsanda differentmethodfor taxes.
With respect
to
inventory,
thisrequired
meansthat choosconsistency
ing LIFOfor taxesin a periodof risingpriceswill result
in lowerreportedprofitsfor both taxesand financial
statements.
Whyisthat a problem?
Managers
mayworrythat lowerearnings
will have
a negative
effecton the firm'sstockprice.Managers
mayhavea compensation
contractthat istiedto earnings;so lowerearnings
maymeana smaller
bonus.
Record-Keeping Costs
records
Inventory
associated
with LIFO
aremorecomplicatedto keepthan inventory
records
associated
with
lf thetaxbenef
FIFO.
it of usingLIFO
issmall,
it mightnot
be worththe trouble.Whatwouldcausethe tax benefit to be smallor evennonexistent?
. A firm maynot be payingmuchin taxes-dueto
losses
in prioryearsthat reduce
taxesor special
tax
breaks.
suchasinvestment
taxcredits.
. Theinventory
mayfluctuate
levels
a lot,sothatold
layersof LIFOinventory
would haveto be sold,
causing
a reversal
of anytax benefit.
. Thefirm mayturn overthe inventory
veryrapidly,
sothattheinventorv
methodwouldnothavemuch
effecton taxes.
. Costsin someindustries
has
aredecreasing,
soFIFO
the tax advantage
in thosecases.
Mostof thetime,thechoice
of anaccounting
method
is difficultto traceto specific
economic
consequences.
With inventoryhowever,the choice of accounting
methodcanmakea significant
economic
difference
to a
firm-realdollars.
Thatmakes
selecting
an inventory
cost
flow methodan imoortant
business
decision.
Explainthe LIFOconformity rule. What is the usual relationshipbetween

accountingunder GAAPand the IRSrules?
Your Turn 5-8

lrfiilx,q,p
1q'"'lil;
1i1r'-"$,
lr
ApplyingInventoryAssumptions
to Tom'sWear
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"reconstant,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
statementswith a record
keepi ngand costfl ow
assumpti on.
EXHIBIT5.18
Tom's Wear
Balance Sheet
at May 1, 2006
BalanceSheet for Tom's

Wear at May 1,2006
t0m'$wGal
Assets
cash
Accounts receivable
Inventory
Prepai{ insurance
Prepaidrent
Total current assets '
"""
Equipment (net of $925 accumulated depreciation)
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
3'295
8,000
1,100
25
1'800
14'220
33,075
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
Shareholder'sequity
earnings
capital
(300)cash
300prepaidinsurance
Transaction2: Collection on accountsreceivableTom's Wear collects $7,900 from
customerswho purchasedshirts in prior months. No revenueis recognizedbecause
the revenuewas alreadyrecognizedwhen the salewas originally made.This collection simply exchangesone asset-accounts receivable-for another---+ash.
Assets
7,900 cash
(7,900)accounts
receivable
Liabilities
Shareholder'sequity
earnings
capital
o
I
O?J
:.r
=3
tr ?
E.<'';xv
E;
:-'
3 s5s3
*cc!*
oF:s
6#Z E
*
n;
_rd
nv
P9
I
t5
6
=
o
e9
o
o
3
J^
E
o
o
o
vt
J
qs
E
f
o
=
c
.9
G
J
o
F
Iri
F
E
xUJ
ct
IJI
cD
c
c
=
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idini+ r j <i
ts odoi
iN6$h@
<<<t++
235
236
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
Retained
earnings
(4,000) accounts
payable
Transaction 4: Purchase of inventory Tom's Wear purchases1,100 shirts at $4 each

for cash.
Assets
Liabilities
Shareholder'sequity
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'sequity
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
Shareholder'sequity
capital
earnrngs
8,800sales
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
Contributed
capital
Retained
earnings
(3,200)
(3,200)cost
inventory
ofgoods sold
TO
S TOM' SW E A R
G V E N TORAYS S U MP TION
C H AP TE5R. A P P LY ININ
Transaction7: Paymentfor Webdesign andfor 6 months' worth of maintenanceTom's
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
Contributed
capital
Retained
earnings
(200)
miscellaneous
operatingexpenses
300prepaid
Webservice
(500)cash
Transaction 8: Purchase of inventory Tom's Wear purchases1,000 shirts at a cost of

54.20 each.on account.
Assets
Liabilities
Contributed
capital
4,200
4.200
inventory
accountspayable
Retained
earnings
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,
eachmonth $30 of interestexpenseandinterestpayablewas 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
the interestare shown separatelybecauseit will be easierto constructthe statementof
cashflows if theseare separate.The repaymentof the note is a financing cashoutflow,
whereasthe interestpaymentis an operatingcashflow. Interestpaymentsandreceipts
are always classifiedas cashfrom operatingactivities on the statementof cashflows.
Assets
(3,000)cash
(90) cash
Liabilities
(3,000)Short-term
notespayable
(60) interest payable
Shareholder'sequity
earnings
capital
(30) interest
expense
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,$100permonth.
Adjustment5: Depreciationexpenseneeds
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
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
government(for Social Securityand income taxes).We will also record a$77 payroll 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.
The lower-of-cost-or-market
(LCM)rule isthe rule that
requiresfirms to usethe
lower of either the costor the
market value (replacement
cost) of its inventory on the
date of the balancesheet.
Replacementcost is the cost
t o buy similaritemsin
inventoryfrom the supplierto
replacethe inventory.
[,.L]"6
D ef ineand c alc ul a teth e
grossprofit ratio and the
inventoryturnover ratio.
in Valuinglnventory:
Complications
rket Rule
Lower-of-Cost-or-Ma
Inventory is an asseton the balancesheet,recordedat cost. As you have seen,that assetcan
be a significant amount.To make surethat inventory is not overstated,GAAP requirescompaniesto 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 replacementcost 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.
Analysis
Financial
Statement
GrossProfit Ratio
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

EXHtBTT5.21
Target Corporation
Consolidated Statements of Operations (partial)
Target Corporation:
Consolidated 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).
For fiscal years

2005
2004
2003
Sales .
Net credit card revenues
..
r
Total revenues
Cost of sales
SeIIing,general and administrative expenses
Credit card expenses
Depreciation and amortization
52,620
34,927
11,185
776
I,409
Earnings from continuing operations

before interest expense and income taxes
Net interest exoense
4,323
463
3,601
570
3,159
556
Earning from continuing operations before income taxes

Provision for income taxes .
3,860
I,452
3,031
I,146
2,603
984
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
2,408
1,885
1,619
75
190
Net earnings
Grossprofit ratio is equal to

the grossprofit (salesminus
costof goodssold)divided by
sales.lt is a ratio for
evaluatingfirm performance.
$ 51,27r $ 45,682$ 40,928

L,349 I,I57
I,097
46,839 42,025
31,445 28,389
9,797 8,657
737
722
I,259
1,098
t,238
$ 2,408 $ 3,198 $ 1,809
in earlierchaptersare calculatedfrom amountson the balancesheet.In additionto an analysis

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 performanceis the gross profit ratio, also calledthe gross
margin ratio.You know that grossprofit equalssalesminus cost of goodssold.The grossprofit
ratio is definedas grossprofit divided by sales.The ratio measuresthe portion of salesdollars
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
$14,231by salesof $45,682 (dollars in millions). You should seethat Tiarget'sgrossmargin
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
5 . FINANCIALSTATEMENT
EXHTBTT
5.22
Barnes & Noble, Inc.

Consolidated Statements of Operations (partial)
For the flscal year ended
Partial lncome
Statementsfor Barnes
& Noble
(in thousands)
FiscalYear
Jan.29,
2005
Jan. 31,
2004
Feb. 1,
2003
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 .
Operatingproflt.....
Grossprofitratio.....
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.
BARilESEilOBtE
....$ 244,216 $ 225,774 $ 176,254

..
30.51o/o
241
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 endedSeptember25, 2005, Whole Food's grossprofit ratiowas35%io,
whereasChico's, with fiscal year-end,January 28,2006 had a gross profit ratio of6IVo.
InventoryTurnover
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.
of ARSTechnica
HaveDVDspaidoff for the moviestudios?
According
to KenFisher
(http://arstechnica.com),
profitmargins
Io20-3oo/o
on DVDsalesare50-60%,compared
whereas
forVHSbusiness.
ln 2004,U.S.theaterrevenues
wereapproximately
$9.4billion,
DVDsales
were$15billion.
B OOK S E LLE R S

EXHTBtT5.23
For fiscal year ended
Whole Foods Market, Inc.

September 25, 2005
(1) Sales
(2) Cost of goods sold . .
..
(dnums
InventoryTurnover
Ratiosfor Whole
Foodsand Chicos
in thnusmd$)
(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)
The inventory turnover ratio

is defined as costof goods
sold divided by average
inventory.lt is a measureof
how quicklya firm sellsits
inventory.
$ 4,701,289
3,052,184
152,912
t74,848
163,880
18.62times
Chico's FAS
January 28, 2006
$ r,404,575
73,223
95,421
84,322
6.49 times
The inventory turnover ratio is definedas cost of goodssold divided by the averageinventory 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
its income statement,and averageinventory can be calculatedfrom the beginning and ending
inventory amountsshown on comparativebalancesheets.To get the average,we 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.
Your Turn 5-g Safewayreportedinventoryof $2,766.0and52,740.7on its balancesheetsat

'Wk.ww*ww.
Duringthe 2005fiscal
the end of the fiscalyears2005and 2004,respectively.
Wfu-m'm.,w.w
year (endedon the SaturdaynearestDecember31),the company'scost of
(Numbersare in millions,)What was Safeway's
ingoodssoldwas 527,301.1.
ventoryturnoverratio for the year?How manydays,on average,did merchandiseremainin the inventory?
L.0.7
Describe
the risks
associated
with inventorv
andthe controls
that
minimize
thoserisks.
Business
Risk,Control,andEthics
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.
The policies and procedureswe havediscussedcan help reducethe risks associatedwith the actual 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.
RISK,CONTROLAND ETHICS
5 . BUSINESS
CHAPTER
Inventory
Obsolescence Reserve
Inventory represents a significant portion of our assets (38.1olo).Our profltability and viability
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
very concernedthat it is properly reported on the financial statements.In 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
is evaluatedfor obsolescenceat 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
to be obsolete.For example, in the notes to its financial statements,Tweeter Home Entertainment Group, the owner of HiFi Buys, Electronic Interiors, ShowcaseHome Entertainment, and Sound Advice, has an extensive note about inventory obsolescence,shown in
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
misstating the value of the frrm's assets.Failure to write down inventory that has lost value
means that earnings will be overstatedby the amount of the decline in inventory. As you
know by now, managersrarely want to recognizeexpensesthat do not produce any revenue,
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
firm's financial statements,be sure to read the notes to the financial statementsabout the
hrm's policy on writing down its obsoleteinventory.
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.
Points
ChapterSummary
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,
the firm will selectone of three common cost flow assumptionsto value inventory sold.
Making a cost flow assumptionis necessarywhen inventory costsare not constantand
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
the risk of having obsoleteinventory. Again, regular monitoring of purchasesand sales
will help control this risk.
Problems
ChapterSummary
in high-end
To comparetheinventorymethodsfor TV Heaven,a retailfirm thatspecializes
televisions,we will look at a singleitem to keeptheanalysissimple.Our resultswill apply
to the otheritemsin the inventoryaswell. SupposeTV HeavenstartedMarchwith an inventory of 50 plasmaTVs that cost $2,010each,for a total beginninginventoryof
$100,500.DuringMarch,the firm madethefollowingpurchases:
March2
March10
March2}
March29
2OOTVs for $2,000each

150TVs for $1,800each
100TVs for $1,500each
50 TVs for $1,000each
DuringMarch,the firm madethe following sales:

March5 110TVs for $4,000each
March 12 160TVs for $4,000each
March25 150TVs for $4,000each
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 R OB LE MS 245
C H A P TE5R. C H A P TESRU MMA R Y
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. PeriodicInventory
Cost of Goods Sold
No. of Units
50
200
150
100
50
B eginninginv e n to ry
P ur c has es
M ar 2
M ar 1 0
M ar 2 0
Mar 29
Unit ss old
FIFO
+ 550
$970,500
420x $1,765
s0 x
200x
150x
20 x
Costof goods sold

LI F O
Costof goods sold
$2,010
$2,000
$1,800
$1,500
$t,ooo
50 x
100x
150x
120x
=
$2,010
$2,000:
$1,800:
$1,s00:
420
$t,000:
=
$1,500
$1,800:
$2,000:
420
Total Cost
$1oo,5oo
$40o,ooo
$27o,ooo
$1s0,000
$ so,ooo
$97o,soo
550
420
G oodsav ailab l efo r s a l e
Costof goods sold:

Costof goods sold :
Unit Cost
= $ 1,765
= I?41,t99
$100,s00
$400,000
$270,000
E ndi ngInventory:
130 x $1,76s:
$120,000
$800,s00
80 x $1,800:
-50 x $1,000
EndingInventory
$ s0,000
$150,000
$270,000
$240,000
$710,000
80 x $2,000=
:
50 x $2,010
EndingInventory
$160,000
$100,s00
$260,s00
$ go,ooo
Net lncome
Weighted
Average Cost
Salesrevenue
Costof goods sold
Grossprofit
Other operating expenses
Net income
$1,580,000
741,300
938,700
250,000
$ 688,700
$229,4s0
FIFO
LIFO
$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
$so,ooo
$170,000

2. Perpetual Inventory
Cost of Goods Sold
No. of Units
Be g i n n i n gi n ventory
Mar 2
Purchases
s0
$2,010
200
$2,000
$ 1,800
M a r 10
150
M a r 20
100
M a r 29
s0
G o o d sa v a i l abl efor sal e
550
U n i tss o l d M a r 5
110
M a r 12
150
Ending inventory
130
WA cost on March 5
WA cost on March 12
WA cost on March 25
Total Cost
$100,s00
$40o,ooo
$27o,ooo
$1s0,000
$ so,ooo
$97o,soo
$1,s00
$ 1,000
160
M a r 25
Weighted average (WA) cost
UnitCost
Averageunit cost
110unitsx
:
$2,002
$220,220
160unitsx
$t,gge:
$303,680
150unitsx
$l,lZS=
$ZSA,ZSO
$782,6s0
50@$2,010 $500,500
+ 250:
200@$2,000 $2,002avg.cost
+290:
$550,280
140@52,002 $1,898avg.cost
(rounded)
150@$1,800
+ 230=
$396,740
130@$1,898 $l,lZSavg.cost
(rounded)
100@$1,500
Total cost of goods sold

(Endinginventory)
Costof
goodssold
+ 130=
80 @$1,72s $188,000
perunit
50@51,000 51,446
(rounded)
$188,000
Note: Under WA perpetual,the ending inventoryplus cost of goods sold is $150

m o re th a n g oodsavai l abl efor sal e.Thi sdi fferenti ali s due to roundi ng.l f you
to severaldeci malpl aces,you w i l l el i mi natethi s
c a rryo u t th e cal cul ati ons
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)
s0 @$2,010
60 @$2,000
$220,500
Sa l eo n M a rc h 12 (160uni ts)
140@$2,000
20 @$1,800
$316,ooo
130@$1,800
20 @$1,s00
$254,000
Costof goods sold

F IF Oe n d i n g i nventory
L IF O
80 @$220,000
s0 @$1,000
$800,s00
$170,000
110@$2,000
$220,000
Sa l eo n M a rc h 12 (160uni ts)
1s0@$1,800
10 @$2,000
$290,ooo
100@$1,500
s0 @$2,000
$2s0,000
Costof goods sold
$760.000
C H A P T E5
R . A N S WE R ST O Y O U R T U R N Q U E S T I O N S
247
"
s0 @$1,000
30 @$2,000
s0 @$2,010
LI F Oending inv e n to ry
Net Income
$210,s00
Weighted
Average Cost
FIFO
LIFO
Salesrevenue
$ 1 ,6 8 0 ,0 0 0
$1,680,000
$1,680,000
Costof goods sold
782,650
897,350
250,000
$ iM,ZSO
800,500
879,500
250,000
$ 629,500
760,000
920,000
250,000
$ 670.000
Grossprofit
Otheroperatingexpenses
Net income
When a firm usesperpetualrecordkeeping,it cannotassumeto 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 averageis different becauseof the late purchase.For LIFO,
that last and cheapestpurchasecan be countedin the cost of goods sold. (Under perpetual, it could not be used becauseit had not been purchasedat the time of the last sale.)
KeyTermsfor Chapter5
Contra-revenue(p.217)
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)
Purchaseorder(p. 211)
Purchasereturnsand
allowances(p.214)
Replacementcost (p. 238)
Salesdiscount(p.217)
Salesreturnsand
allowances(p.211)
Specific identification
method(p.221)
(p.221)
Answersto YOUR
TURNQuestions
Chapter5
Your Turn 5-1
1. $9,800[$10,000- ZVodiscount;
vendorpaidthefreight]
2. $10,090[Discountexpired;buyerpaidthefreight]
3. $9,890[$10,000- 27odiscounti $90freight]
Your Turn 5-2
Coffee
Bags
Totalinventorycost
987oof $500
$490
100
$590
Your Turn 5-3

Cashcollected:
$3,150
Revenue:
$3,000
Your Turn 5-4
Thefirm shoulduseperpetual.
At thetimeof eachsale,theinventoryaccountwill bereduced.
Whentheperiodis overandtheinventoryis counted,anydifferencebetweentheinventory
amountshownin therecordsandtheinventoryamountidentifredby a physicalcountof the
' ',
244

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 assumedto be parl of cost of goods sold.
Your Turn 5-5

Theweightedaverage
costof a unit is: [($10+ $40y30]: $1.66661
perunit
: $25
Costofgoodssold: 15unitsx $1.66667
Your Turn 5-6
1. Costof goodssoldis $4,600+ $5,100: $9,ZOO;
andthe grossprofit is $14,000$9,700: $4,300.
2. Costof goodssoldis $3,500+ $5,100: $8,600;andthe grossprofit is $14,000$8,600: $5,400.
3. Weightedaverage
costof thebracelets
is $13,200/3: $4,400.Thecostof goodssold
for thesaleof two bracelets
wouldbe 2 X $4.400: $8.800.
Your Turn 5-7
1. FIFO:$705[(30x $20)+ (5 x $21)]
x $23)+ (15 x $21)l
2. LIFO:$7'751(20
(rounded)
x 35 : $740
3. $21.143
Your Turn 5-8
The LIFO conformityrule saysthat if a firm usesLIFO for tax purposes,
it mustalsouse
LIFO for accounting(GAAP) purposes.
It is unusualfor accountingandtax rulesto overlap.Usuallyaccountingrules(GAAP) do not follow tax law.
Your Turn 5-9
Inventoryturnoverratio = 27,301.1+ [(2,766.0+ 2,740.7)+ 2] : 9.92
Averagedaysin inventory: 365+ 9.92 : 36.79days
Questions
1. ExplainthetermsFOB shippingpoint andFOB destination.What arethe accounting
and businessimplicationsof the shippingterms?Why is it importantto know who
ownsgoodsduringshipping?
2. Whatis the differencebetweenfreight-inandfreight-out?
3. What is the differencebetweena purchasereturnanda purchaseallowance?
What is
the effectof purchasereturnsand allowanceson the overallcost of inventoryto the
buyer?
4. Whatis a purchasediscount?What is the effectof a purchasediscounton the overall
costof inventoryto thebuyer?
5. Explainthetermsof a purchasedescribedas2/I5, n/30.Wouldyou takeadvantage
of
this offer?Why or why not?
6. Whatis a contra-revenue
account?Givetwo examplesof contra-revenue
accounts.
7. What is a salesdiscount?What is the effectof a salesdiscounton the total salesrevenueofthe seller?
8. Whatis thedifferencebetweena periodicandperpetualinventorysystem?
9. Whatis inventoryshrinkage?
10. Whatis thedifference
thephysicalflow of inventoryandtheinventorycostflow?
between
11. What arethe commoncostflow methodsfor accountingfor inventory?Describethe
differences.
12. If inventorycostsarerising,whichmethod(FIFO,LIFO, or weightedaveragecost)resultsin thehighestnetincome?Explainyour answer.
13. If inventorycostsarerising,whichmethod(FIFO,LIFO, or weightedayera1e
cost)resultsin thelowestnetincome?Explainyour answer.
14. DoesLIFO or FIFO give thebest-most current-balancesheetvaluefor the ending
inventory?Why?
15. How do taxesaffectthe choicebetweenLIFO andFIFO?
C H A P TE5R. MU LTIP LE -C H OIC

QUEE S TION S 249
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 is recordedasa(n)
1. Wheninventoryis purchased,
and when sold
it becomesa(n)
a. liability, withdrawal
b. asset,expense
c. liability, asset
d. asset,contra-asset
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
rotals
inventory
Beginning
Purchases
Purchases
Purchases
1,000
500
800
1,200
1609
$3.00
$3.50
$4.00
$4.25
$
$
$
$
3,000
2,100
3,200
5,100
$l_1199
2. Determinethe ending inventoryassumingthe companyusesthe FIFO cost flow

method.
a. $3,400
b. $2,400
c. $9,200
d. $10,000
3. Determinethe cost of goodssold assumingthe companyusesthe FIFO cost flow
method.
a. $3,400
b. $10,000
c. $10,200
d. $2,400
4. Determinetheendinginventoryassuming
thecompanyusestheweightedaveragecost
flow method.
a. $2,300
b. $3,300
c. $9,800
d. $2,976
5. Determinethe grossprofit assumingthecompanyusestheLIFO costflow method.
a. $11,400
b. $14,400
c. $22,400
d. $19,700
6. UsingLIFO will producea lowernetincomethanusingFIFO underwhich of thefollowingconditions?
a. Inventorycostsaredecreasing.
b. Inventorycostsareincreasing.
c. Inventorycostsarenot changing.
d. Salespricesaredecreasing.
250

Use the following
7.
8.
9.
10.
information to answer questions 7 through 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. Cashpurchasesof merchandiseduring April were $300,000.
b. Purchasesof merchandiseon account during April were $400,000.
c. The cost of freight to deliver the merchandiseto Celebrationwas $25,000;the
terms were FOB shipping point. The freight bill was paid in April.
d. Celebrationreturned$22,000ofmerchandisepurchasedin part a to the supplier
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.
SE5-2.Recordpurchaseof merchandiseinventory:perpetual inventorysystem.(LO I,2)
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.Purchaseterms 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.
E X E R C IS ES 251
C H A P TE5R. S H OR T
c. Invoiceprice of goodsis $2,500.Purchaseterms 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.
SE5-4.Recordsale of merchandiseinventory:perpetual inventorysystem.(LO 1,2)
Brenda Bailey's Textiles Inc. uses a perpetual inventory system.Enter each of the following transactions
into the accountingequation.
1. On February12,BrendaBailey's sold $500,000of merchandiseon accountwith terms
2110,n130.The cost of the merchandisesold was $230,000.
2. On February16,the customerretumed$100,000of the merchandisepurchasedon February 12 becauseit was the wrong style.The cost of the merchandisereturnedwas $46,000.
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

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

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

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
252

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 averagedays 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 understatedby $3,000.
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
statementsfor the first quarter of the year. Given the following, what is your best estimate?
Beginninginventory
Net sales
Net purchases
Gross profit ratio
$75,800
$92,500
$50,500
20Vo
Exercises-Set
A
Es-lA. Recordmerchandisingtransactions:perpetual inventorysystem.(LO 1,2)
Assumethe following transactionsfor Clark's AppliancesInc. took placeduring May. Clark's
Appliancesusesa perpetualinventory system.Enter eachof the transactionsinto 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 refrigeratorscosting$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
C H A P T E R 5. E X E R C I S E S 2 5 3
E5-2A. Recordmerchandisingtransactions:perpetual inventorysystem.(LO 1, 2)

The FedoraCompany had a beginning inventory balanceof $25,750 and engagedin the following transactionsduring the month of June.
Jlune 2
June 4
June 6
June 9
June 10
June22
June24
June25
Purchased$4,000 of merchandiseinventory on account from Plumes

Incorporated with terms 2/10, nl30 and FOB destination.Freight costs
associatedwith this purchasewere $225.
Returned $400 of damagedmerchandiseto Plumes Incorporated
Sold $7,000of merchandiseto FancyCapson account,terms 1/15,n/30
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
Paidsalessalariesof$1,850
Paid the rent on the showroomof $1,200
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
Purchasedtwo units at$127 each

Sold two units at $225 each
Purchasedone unit at $ 130
Sold one unit at $225
Purchasedtwo 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.
at the end of May.
E5-5A. Calculatecost of goodssold and ending inventory:perpetualFIFO. (LO 3,4)
Assume Name Brand usesa perpetual inventory system and the FIFO cost flow method.
at the end of Mav.
E5-6A. Calculatecost of goodssold and ending iwentory: perpetualLIFO. (LO 3,4)
254

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
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

1,500units
All unit costsinclude the purchaseprice andfreight chargespaid by For Fish. During the quarter 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
September28
September30
Sold 450 units for $150 each

Purchased500 units for $1 17.50each
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
Salesrevenue,balanceat December3l,20fI
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?
CHAPTE5
R o E X E R C I S E S 255
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
$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

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
200s
$130,000
275,000
405,000
s0,000
$3ss,000
2006
s0,000
$
240,000
290,000
40,000
$2s0,000
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)
$240,000
750,000
950,000
4O7o
Estimatethe cost ofgoods sold for January and the ending inventory at January 31,2006.
256
B
Exercises-Set
E5-1B. Recordmerchandisingtransactions:perpetual inventorysystem.(LO I,2)
Assume the following transactionsfor Jennifer's Fix-It-Up Inc. took place during March.
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
Paid freight of $1,000on televisionspurchasedfrom Sanyo
Returnedtelevisions to Sanyo becausethey were damaged.Received
a credit of $ 15,000 from Sanyo.
Sold televisionscosting $125,000for $225,000to Joe'sSport'sBar
& 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.
E5-2B. Recordmerchandisingtrdnsactions:perpetual inventorysystem.(LO I,2)

DiscountWines Inc. had a beginninginventorybalanceof $85,450and engagedin the following transactionsduring the month of October.
October 2
October 5
October6
October l0
October 10
October 23
October29
October3 1
Purchased$15,000 of merchandiseinventory on account from Joe's

Winery with terms 2/10, nl30 and FOB destination.Freight costs for
this purchasewere $750.
Returned$ 100 of damagedmerchandiseto Joe's
Sold $18,000of merchandiseto TastyCateringServiceon account,
terms2115,n/30 and FOB shippingpoint. Freight costswere $155.
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
Paid salessalariesof $ 1,500
Paid the rent on the warehouseof $ 1,450
Enter eachof the transactionsfor DiscountWinesInc. into the accountingequation,assuming they use a perpetualinventory system.
E5-3B. Calculatecost of goodssold and endinginventory:periodic weightedaveragecost.
(L O 3 ,4 )
Sandy'sCleanCarpetCompanysellscommercialvacuums.The company'sfiscal yearbegins July 1,2006, and endsJune 30, 2007. Sandy'sbeganthe year with 1,500units of inventory on hand. These units cost $200 each. The following transactionsrelated to the
company's merchandiseinventory occurred during the first quarter of the year'
July 15
August 28
September10
Total purchases

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.rterof the year on October I,2009, with 750 units of inventory on hand. Theseunits
C H A P T E R 5o E X E R C I S E S 2 5 7
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

Purchased500 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 purchaseprice andfreight chargespaid 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
Purchasedtwo units at $195 each
Sold one unit at $350
Purchasedfour 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.
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.
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.
b. Determine the cost of inventory that will appearon Radio Tech.'sbalancesheet
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
Ending inventoryat replacementcost,June30, 2010
Cost of goodssold,balanceat June30, 2010
Salesrevenue,balanceat June30, 2010
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?
E5-10B. Apply the lower'of-cost-or-marketrule. (LO 5)
In each case,indicate the correct amount to be reported for the inventory on the year-end
balancesheet.
$275,000
a. Ending inventoryat cost
$271,250
$185,250
b. Ending inventoryat cost
$187,550
Ending inventoryat market
E5-118. Calculate grossprofit and grossprffit ratio: FIFO and LIFO. (LO 6)
Given the following information, calculate the gross profit and gross profit ratio under
(a) FIFO periodic and under (b) LIFO periodic'
Sales
Beginninginventory
Purchases

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
Risks associatedwith inventory include (1) theft, (2) damage,and (3) obsolescence.
this
risk
and
you
faced
with
believe is seriously
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
toinventory
inrormarion
ii;1??;lfiff"!i:,:1":;:J3:":;',:T:J;tk3il,.*,"g
destroyedin Hurricane Frances.
I '
Inventory, beginning of period

Purchasesto date of hurricane
Net salesto dateof hurricane
Gross Profit ratio
$300,000
140,000
885'000
557o
CHAPTER5. PROBLEMS
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$7,500of merchandise,terms IllO, n/30, FOB shippingpoinr
July 6 Purchased$4,100of merchandise,terms 2/15, n/45, FOB shippingpoint
July 11 Purchased$8,600of merchandise,terms 3/5, n/15, FOB destination
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 chargesare $250 on eachpurchase.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. Anctlyzepurchasesof merchandiseinventory. GO l)
Carrie & Runnels Bikes Plus Inc. made the following purchasesin December of the current year.
December 5
December14
December24
Purchased$2,600of merchandise,terms 3/10, n130,FOB destination

Purchased$6,150of merchandise,terms l/10, n160,FOB shippingpoint
Purchased$8,375of merchandise,terms 2105,n/20, FOB destination
Required
a. For each purchase,by what date is the payment due, assumingthe company takes
advantageof the discount?
b. For each purchase,when is the payment due if the company does not take
c. In eachcase,what is the amountof the cashdiscountallowed?
d. Assumethe freight chargesare $365 on eachpurchase.For which purchase(s)is
Bikes Plus responsiblefor the freight charges?
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 exchangefor common stockfrom its shareholders.
The companyengaged
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 merchandiseon accountto Exit Companyfor $6,000,terms2/10,
n/30 andFOB destination.The costof the merchandisesold 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 cashpurchaseof $350
Purchasedmerchandiseon account from Inware Distributors
for $3.800.terms 1/10.n/30
259
25O
CHAPTER5 O THE PURCHASE
February 18
February21
February 24
February25
February 27
February 28
Paid $250 freight on February 17 purchase

Sold merchandisefor cashfor $10,350.The cost of the merchandise
sold was $8,200.
Paid Inware Distributorsfor purchaseon February 17
Gave refund of $200 to customerfrom February 2I.The cost of the
returnedmerchandisewas $135.
Sold merchandiseof $3,000 on account with the terms 2/10, n/30.
The merchandisecost $2.300.
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:
perpetualinventorysystem.(LO 1, 2,4,6)
The following transactionsoccurred during March 2007 at the Five Oaks Tennis Club.
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
Purchasedracquetsand balls on credit from Spaulding Company

for $700. with terms 3/05, n/30
Paid freight of $50 on the March 3 purchase
Sold merchandiseto memberson credit for $400, terms n/30. The
merchandisesold cost $300.
Receivedcredit of $40 from Spaulding for a damagedracquet that
was returned
Purchasedtennisshoesfrom Reebokfor cashfor $3,000
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
Sold merchandiseto memberson account,$950,terms ni30. The
cost of the merchandisesold was $500.
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
Paid cash operating expensesof $300 for the month
Required
a. Supposethe Five Oaks Tennis Club startedthe month with cash of $8,000,
merchandiseinventoryof $2,000,and common stock of $10,000.Enter each
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.
P5-5A. Analyzeaccountingmethodsand preparecorrectedincomestatement.(LO 1,2,4)
You are the accountantfor Baldwin Company, and your assistanthas preparedthe followins income statementfor the year ended September30,2001 .
C H A P T E5
R o PROBLEMS
Baldwin Company
IncomeStatement
For the year ended September30,2007
Salesrevenue
Salesreturnsand allowances
Freightcosts
Net sales
Exoenses
Costof goods sold
S ellingex p e n s e s
I ns ur anc e x p e n s e
Ad m i n istrativeexpenses
Div idends
$8s0,000
$22,s00
14,300
(36,800)
813,200
540,000
150,000
20,000
40,000
8,000
Total expenses
Net income
758,000
$ ss,zoo
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. Insuranceexpenseincludes$100 worth of insurancethat 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.
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 edsu ri n g J u n e
G oodsav a i l a b l efo r s a l e
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
5,100
$ 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)
261
Jefferson Company had the following sales and purchasesduring 2006, its first year of
business.
January5
February15
April 10
June30
August 15
November28
Purchased40 units at $.100each

Sold 15 units at $150 each
Purchased30 units at $105 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
onfinancial statements;apply lower-of-cost-or-market
(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

Purchased100 units at $1 1 each
Sold I 10 units at $20 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
averagecost).
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
C H A P T E R 5o P R O B L E M S
June 18
June21
Jwe2'7
Purchased2,000 units at $8.80 each

Sold2,225 units at $10.50each
Purchased2,500 units at $10.00each
Required
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 eginninginv e n to ry(1 0 ,0 0 0u n i ts )
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
$ 1 4,500
$ S O ,OOO
80,000
6 5 ,000
S ales
130, 000unit sa t $ 3 .0 0e a c h
Operatingexpenseswere $120,000and the company'stax rate is 30Vo.
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.
253
264
Transactionsduring 2010:
. 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
income statement,statementof cashflows, and statementof changesin shareholder's
equify for Manuel for the year endedDecember31,2010.
c. What is income before taxes and net income after taxes under each of the three
inventory cost flow assumptions?What observationscan you make about net
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 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 year ended December 3I,2010.
'atioand inventoryturnover ratio. (LO 6)
the financial statementsof Afua's International Pasta
(a mo u n tsi n thousands)
Sales(domestic)
Costof sales
Inventory
j une 30, 2009
June30, 2008
June30, 2007
$416,049
92,488
17,030
$429,813
98,717
16,341
$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
$4,000 worth of inventory on hand. Purchasesfor the year amountedto $9,000,and salesup
to the dateof the tornadowere $16,000.Grossprofit percentagehas 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
Purchased$2,500of merchandise,terms 3/15, n/Z0,FOB

shipping point
C H A P T E5
R . PROBLEMS
November 12
November 16
Purchased$4,300of merchandise,terms l/05,nl25,FOB

destination
Purchased$6,200of merchandise,terms 2/10, n/4},FOB
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 chargesare $115 on eachpurchase.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 purchasesin August of the current year.
August 5
August 14
August 19
Purchased$12,200of athleticshoes,terms l/I5, nlz\,FOB

destination
Purchased$1 1,600of training gear,terms 2/10, n/15, FOB shipping
pornt
Purchased$3,500of tennisracketsand tennisballs, terms 3/05.
n/10. FOB destination
Required
a. For eachpurchase,by what dateis the paymentdue, assumingthe companytakes
b. For each purchase,when is the payment due if the company does not take
c. In eachcase,what is the amountof the cashdiscountallowed?
d. Assumethe freight chargesare $170 on eachpurchase.For which purchasesis
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 inventorTsystem.(LO 1, 2,4,6)
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
April 19
April 20
Purchasedmerchandiseon account from Thompson Supply Co. for

$5,000,terms 1/10,n/30
Sold merchandiseon accountto Brown Companyfor $3,500,terms
2/10,n130.The cosr of the merchandisesold 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
Purchasedmerchandisefor cashfor $3,200
Receivedrefund from supplier for returned merchandiseon April 16
cashpurchaseof $350
Purchasedmerchandiseon account from Kelsey Distributors for
$4,100,terms 2/10, n/30
Paid $350 freight on April 19 purchase
265
266
E D S AL EO F IN V E N TOR Y
CHA P T E5R . T H EP U R C H ASAN
Apnl2l
Apr1l24
April 25
Aprtl27
April 30
Sold merchandisefor cashfor $12,110. The cost of the merchandise

sold was for $9,500.
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
merchandisecost $1,200.
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 incomestatement:perpetual inventorysystem.(LO 1, 2, 4,6)
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
May 6
May 10
May 15
May 17
May 19
May 20
May 24
May 31
May 3 1
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
per pound, with terms I/10, n130,FOB shippingpoint. Freight costs
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
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.
P5-58. Anatyzeaccountingmethodsand prepare correctedincomestatement.(LO 1,2, 4)
You are the accountantfor Celebration Company, and your assistanthas preparedthe following income statementfor the year ended December 31,2006.
C H A P T E5
R . PROBLEMS
Celebration Company
lncomeStatement
F o rth e y e a r e n d e d D e c ember31, 2010
Salesrevenue
S alesr et ur n sa n d a l l o w a n c e s
Freightexpenses
S ellingex pe n s e s
Net sales
Exoenses
Costof goods sold
Salaryexpenses
Rent exoense
Administrativeexpenses
Div idends
Total exDenses
Net inc om e
$6so,ooo
$18,100
2,000
48,300
(68,400)
s81,600
350,000
82,000
10,000
23,500
4,000
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 expensesincludes $4,000 of allowancesthat were given to customerswho received damagedproducts.
3. Rent expenseincludes$400 worth ofrent that appliesto 2011.
4. Salaryexpensesinclude $10,000loanedto one ofthe executivesfor 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 edsu ri n g J u n e
G oodsav a i l a b l efo r s a l e
Costof goods sold
E ndingin v e n to ry Ma
, y 31
300
4 ,0 00
4 ,3 00
3,300
1 ,0 00
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)
267
268
CHA P T ER
5 . T H EP U R C H ASAN
E D SA L EO F IN V E N TOR Y
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
December3I,2009, financial statementsunder eachof the following assumptions:
1. FIFO periodic
2. LIFOperiodic
3. Weightedaveragecost periodic
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
(L
O
ra ti o .
3 ,4 , 5 ,6)
Hillary's Diamoniquebuys andthenresellsa singleproduct.Here is someinformationconcerning Hillary's inventory activity during the month of August 2008.
August 2
August 6
August 8
August12
August15
August21
August24
August31
860unitson handat a totalvalueof $10.320

Sold400unitsat $14perunit
640unitsat $11perunit
Purchased
425unitsat $10perunit
Purchased
300unitsat $9 perunit
Purchased
100unitsat $8 perunit
Purchased
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
statementfor 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
-H A P TE R 5.P R OB LE MS 269
November 16
November23
November29

Sold 4,300 units at $6.00 each
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 statementsand 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 eginninginv e n to ry(2 ,0 0 0u n i ts )
$ 1 0 , 000
Purchases
5,000units at $6 each
4,000units at $5.50each
6,000units at $7 each
$30,000
26,000
42,000
S ales
15, 000unit sat $ 1 0 e a c h
$ 1 5 0 ,000
Operatingexpenseswere $12,000and the company'stax rate is 25Vo.
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.
e. In order to meet Castana'sgoal, what is your recommendationto Castana
Company?Explain your answer.
P5-118. Calculate cost of goods sold and ending inventory; analyzeeffectsof each method
rule; calculateinventoryturnover
ra ti o.( LO 3, 4, 5, 6)
The following information is for Decades of Music Corporation for the year ended
Jlune3O,200'7.
At July 01,2006:
.
.
.
.
Cashamountedto $27,000.
Beginninginventorywas $30,000(750 units at $40 each).
Contributedcapitalwas $12,000.
Retainedearningswas $45,000.
rl
AN D S AL EOF IN V E N TOR Y
CHAPTER5 . T H EPU R C H A SE
Transactionsduring 2006 and20O1
.
.
.
.
.

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
Required
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
inventory cost flow assumptions?What observationscan you make about net
income from the analysis of the three methods?
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'
D ecember31,
D ecember31,
D ecember3 1,
For year ended
2005
2006
(amountsin thousands)
2007
Sales
Costof goods sold
Inventory
$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
FSA5-1. Analyzeincomestatement.(LO 6)
The income statementsforWilliams-Sonoma Inc. for the fiscal years ended Jantary 29,
2006, andJanuary 30,2005, are shown here. Compare the company's performancefor the
C H A P T E5
R . F I N A N C I A LS T A T E M E N T
ANALYSIS
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
Jan.29,
2006
(DoLLMs irL thousmd,s)
Jan 30,
2005
$ 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
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
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)
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
January28,
2006
Fiscal YearsEnded
January29,
2005
$ 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)
January3l,
2004
$ 517,870
420,520
97,350
159,181
(163,825)
27,509
(191,334)
(61,831)
1,550
(60,281)
(21,498)
(38,783)
(6,967)
(198,301)
(8,300)
(47,083)
$ (198,301)
$ (47,083)
(2,rrr)
271
272

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 )
Forthe year ended Forthe year ended
Sa l e s
De c . 3 12,0 0 5
$ a,+go
Costof sales
6,451
Net income
Inventory(at year end)
$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 shareholderswith your comments about its inventory management.
CriticalThinkingProblems
Risksand 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 appropriatenessof this action from a legal and
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 expectedto find and your results.(LO 6,7)
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
EP
C H A P TE5R. IN TE R N EETX E R C IS
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
Profit. Is Net Salesincreasing or decreasing?Is Gross Profit increasing or
decreasing?Are thesetrends favorable or unfavorable?Explain your answer.
c. Using the financial statements,calculate the inventory turnover ratio for the three
most recent years. Did the inventory turnover ratio increaseor decrease?What
does this measure?What does Gap Inc. do to identify inventory that is slow
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
InventoryErrors
i,.{}.H
Des c r ibeand c alc u l a teth e
You know that the cost of the beginning inventory plus the cost of purchasesequalsthe cost
effect of inventoryerrors
o n t he f inanc ials ta te me n ts . of goods availablefor sale.The cost of goods availablefor sale is then divided between the
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
Becauseinventorydirectly affectscost ofgoods sold, a major expense,errorsin the calculation 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.
EndingInventoryErrors
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 overWhy? Becauseendinginventoryand cost of
stated,cost of goodssold must be understated.
goodssold arethe two partsof cost of goodsavailablefor 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 (beginning inventory * purchases)to 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
valued at $7. Remember,the 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,
then cost of goodssold shouldbe $8. Seewhat happens?You understatecost of goodssold
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 largeoverstated.The result is that net income will be understated.Let us use the sameexample,in
which the cost of goodsavailablefor salewas correctly computedat $10. If ending inventory
is actually $2 but you erroneouslyunderstateit as $1, then cost of goods sold will be valued
as $9. It shouldbe $8. So, an understatementin endinginventoryhascausedan overstatement
of cost of goods sold. If you overstatean expense,then you will understatenet income.
BeginningInventoryErrors
Ifending inventoryis overstatedin 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
APPENDIX
5 A . I N V E N T O R YE R R O R S
CalculatedAmounts
Be ginning
I nv ent or y
$ 1 (understatedfrom prior year error)
+ Pu r c has es
+$ 1 5
Costof Goods
Available
forSale $ 1 6
- Ending
Inventory
$6
CostofGoods
Sold
$10
Gorrect
Amounts
OZ
+ $15
$17
$6
$11
275
EXHIBIT 54.1
Error in the Beginning
Inventory
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 calculatedcost 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 calculated cost of goodssold was overstatedby $1. When an expenseis overstated,then net income will be understated.
If beginning inventory is understated,then the cost of goods availablefor saleis understated.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 understatecost of goods sold. This understatedexpensewill result in an overstatementof 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.
BerryCorporationmiscounted
the endinginventoryat December
worth of
but $25,000
Thebalancesheetreportedinventoryof $360,000,
itemswere omittedfrom that amount.Berryreportednet incomeof
for the year.What effectdid this inventoryerrorhaveon Berry's
$742,640
costof goodssoldfor the year?What is the correctnet incomefor the year
endedDecember3'1,2007?
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.
GrossProfitMethodof Estimating
EndingInventory
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
statements),(b) purchases(from your records),and (c) an estimatefor cost of goodssold,
you can estimateending inventory.
For example,supposeSuperSoapCompany lost its entire inventory in a flood on April
16. Super Soaphad prepareda set of financial statementson March 3 1, when the inventory
on handwas valuedat $2,500.During the first part of April, purchasesamountedto $3,500.
The usualgrossprofit percentagein this businessis 407o.If SuperSoaphad salesof $8,200
during the first l6 daysof April, how much inventorywas lost?
1. If saleswere $8,200and the usualgrossprofit percentageis 40V0,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
$4,920.In other words, if the grossprofit percentageis 40Vo,then the other 60% must
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
SupposeBaseCompanybegan May with inventory of $2,000and purchased
',t',1*,t'"1+il"
worth of inventory during the first half of May. Salesfor the first
ffil1lt'lr,t$ili[:l$tI $8,000
half
of May amounted to $12,000.
Then, a fire destroyedthe remaining inventory. BaseCompanyhas had a

gross profit ratio of approximately 3oo/ofor the first 4 months of the year.
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.
276

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ThePurrhsse

CHAPTER5 . THE PURCHASE

22oA AId Germantown

goesdirectly to the vendor's computerizedsystem.Even when the processis automated,the

The perpetual inventory

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

FOB shipping point: title changes hands at the shipping

FOB destination: title changes hands at the destination

.Buyer pays the shipping cost; the cost

.Buyer DOES NOT pay the shipping cost.

oVendor DOES NOT pay the shipping cost.

FOB(free on board) shipping

Your Turn 5-l

In each separatesituation, calculatethe cost of the inventory purchased.

C H A P TE5R. A C QU IR INAGN D S E LLINME

Before the payment,the balancein accountspayablewas $14,700.So the entire $14,700

Cost of goods available for

Your Turn 5-2

Jaden'sCoffee Hut purchased100 pounds of Columbianroast coffee beansto

The company recognizes revenue when it is realized or realizable and

C H A P TE5Ro A C QU IR INAGN D S E LLINME

Salesreturns and allowances

Your Turn 5-3

Fedcosold $3,000worth of merchandiseto a customerfor cash.The salestax

Your Turn 5-4

Supposea firm is very concernedabout inventorytheft. Which methodof

Weighted average cost is the

Cost of each item

which is then used as

lCost of goods sold

AII the costs are

Cost of goods sold $57

Your Turn 5-s

The actual order of the

Cost of goods sold

First-in,first-out (FIFO)is the

Last-in,first-out (LIFO)is the

CHAPTER5 . THE PURCHASE

The actual order ofthe

Cost of goods sold

all of the Company'sinventories ($51,969and $54,794at December 31, 2005

Cost of goods sold

This exhibit comparesthree

Jayne'sJewelry Store purchasedthree diamond and emerald braceletsduring

Your Turn 5-6

How InventoryCostFlowAssumptionsAffect the FinancialStatements

Cost of goodssold ($130.90)and endinginventory($107.10)add up to $238.

C H A P TE5R. IN V E N TORCYOS TFLOWA S S U MP TION S 227

Even though an inventory cost

C H A P TE5Ro IN V E N TORCYOS TFLOWA S S U MP TION S 229

The cost of goodssold for the period is $88 + $30 : $1 18.

What is left in ending inventory?

What is left in the ending inventory?

@re round,ed, to the nryest

C H A P TE5R. IN V E N TORCYOS TFLOWA S S U MP TION S 231

Your Turn 5-7

*(3x$50) + (8x$55) = $590

disclosure made by Books-AMillion in the notes to its

Explainthe LIFOconformity rule. What is the usual relationshipbetween

Your Turn 5-8

BalanceSheet for Tom's

Equipment (net of $925 accumulated depreciation)

Liabilities & Shareholder's Equity