CHAPTER 7

7-1 Sales transactions are accompanied by recording of the cost

of goods sold (or cost of sales). This is literally true under the
perpetual system and conceptually descriptive under the
periodic system.

7-2 The two steps are obtaining (1) a physical count and (2) a cost
valuation.

7-3 Perpetual systems provide continuous inventory and cost of

goods sold records. Periodic systems rely on physical
inventory taking to record cost of goods sold at the end of the
period.

7-4 It is true that the periodic method requires a physical count to

measure cost of goods sold and the perpetual method does
not. However, for control purposes, it is important to undertake
at least annual physical counts of inventory under the
perpetual method, as well.

7-5 F.O.B. destination means the shipper pays the freight bill.
F.O.B shipping point means the customer bears the cost of the
freight bill. F.O.B. stands for "free on board."

7-6 Freight out is not shown as a direct offset to sales. Unlike sales
discounts and returns, freight out is not a part of gross
revenue that never gets collected. Instead, it is an expense,
entailing ordinary cash disbursements.

298
7-7 The four methods are:
1. Specific identification – charges the actual cost of the
specific item sold.
2. FIFO – items purchased first are assumed to be sold first.
3. LIFO – items purchased most recently are assumed to be
sold first.
4. Weighted average – the average cost of all items
available is charged for each item sold.

7-8 The specific identification method is normally used for low

volume, high value items. Therefore, we would expect this to
be used for a, b, d, and f.

7-9 Yes. Under FIFO the oldest costs are assigned to the cost of
goods sold first, so the timing of purchases cannot affect cost
flows.

7-10 The good news is that LIFO reduces taxes in times of rising
prices. The bad news is that reported profit is lower.

7-11 Yes. Purchases under LIFO can affect income immediately,

because the unit costs of the latest purchases are assigned to
units sold.

7-12 No. The weighted average must take into account the number
of units purchased at each price. For Gamma Company, the
weighted average unit cost of inventory is: [(2 x $4.00) + (3 x
$5.00)] ÷ 5 = $4.60.

7-13 Ending inventory is lower under LIFO in a period of rising prices

and constant or growing inventory. FIFO produces the higher
ending inventory value.

Chapter 7 Inventories and Cost of Goods Sold 299

7-14 Falling prices reverse the normal relation, so FIFO produces
higher cost of goods sold and, therefore, lower net earnings.
This helps explain why computer and electronics firms typically
use FIFO in order to lower their taxes.

7-15 Consistency requires the maintaining of constant accounting

methods from period to period. Switching accounting
methods hinders comparisons of current results to those of
preceding periods.

7-16 Companies have adopted LIFO primarily because it saves

income taxes during times of rising prices by reporting higher
cost of goods sold and lower profits.

7-17 An inventory profit is fictitious because, for a going concern, it

represents an amount necessary for replenishing inventory
and is therefore not "available" in the form of cash for
distribution as dividends. It arose from change in unit costs of
the products purchased, not from the company's value added
activities.

7-18 LIFO inventory valuations can be absurd because inventory

valuation is based on older and older costs as the years pass.

7-19 Conservatism does result in lower immediate profits, but higher

profits are then shown in later periods.

7-20 This convention is called conservatism.

300
7-21 "Market" generally means cost of replacement at the date of
the physical inventory.

7-22 The inconsistency is the willingness of accountants to have

replacement costs used as a basis for write-downs below
historical costs, even though a market exchange has not
occurred, but their unwillingness to have replacement costs
used as a basis for write-ups above historical costs.

7-23 Many inventory errors do counterbalance. For example, an

ending inventory that is overstated will overstate current
income. But the same overstated inventory becomes the
beginning inventory the next year; hence, next year's income
will be understated. To show this you might use the following
schematic:

Year 1 Year 2
BI OK Too Large
+ Purchase OK OK
Goods Available OK Too Large
–Ending Inventory Too Large OK
Cost of Goods Sold Too Small Too Large

This exercise stresses the fact that the ending inventory of one
year becomes the beginning inventory of the subsequent year
and the errors correct themselves.

7-24 Cost of goods sold = Beginning inventory + Purchases –

Ending inventory.

7-25 Past gross profit percentages are sometimes applied to

current revenue as interim estimates of gross profit for a
month or quarter. Thus, the time and cost of taking physical
inventories can be saved.

Chapter 7 Inventories and Cost of Goods Sold 301

7-26 Grocery stores have a low profit margin. If the profit margin is
2%, a savings of $100 in shrinkage would be equivalent to a
$5,000 increase in sales.

7-27 Your boss has a point. This is a cost benefit question. If we do

not give the discount, we may lose customers to competitors
of ours that treat them better. But if it is not currently a custom
in the industry, you may not have to do it. If offering the
discount does not cause customers to buy more, it is giving
money away. However, if it is not an industry custom and it
attracts new customers, that may lead to a different
conclusion. Compare how much your operating income would
rise from newly attracted customers versus the discounts
received by existing customers.

7-28 Phar Mor overstated its assets by overstating inventories. This

means that either liabilities or stockholders’ equity must also be
overstated (to keep the balance sheet equation in balance).
Most likely Phar Mor used a periodic inventory method, so that
overstating ending inventory would reduce cost of goods sold
and increase pretax profit. If the company used a perpetual
inventory system, management must have made inappropriate
credits to cost of goods sold or some other expense account
to offset the additional debits to the inventory account.

7-29 Under the FIFO method, the cost of sales will be based on old
acquisition costs. Under the LIFO method, the cost of sales will
be based on the most recent acquisition costs. Thus, under
LIFO, if additional units are acquired on the last day of the year,
the cost of those units will be included in cost of sales. Thus,
under LIFO, additional purchases would produce higher cost of
goods sold in this instance and lower evaluations for the
purchasing officer. Thus, under LIFO he would be less likely to
purchase additional oil on the last day of the year.

302
7-30 There are many advantages to a perpetual inventory system. It
allows a continuous tracking of inventories, allowing better
control of inventory. It provides an up-to-date measure of cost
of goods sold without having to take a physical count. Its
biggest disadvantage is cost; a periodic inventory system is
simpler and less costly. However, with the use of optical
scanning and computers the cost of a perpetual inventory
system has come down quickly. If the Zen Bootist is willing to
invest in a system that codes each individual product and
tracks its progress through the inventories, then many
advantages of a perpetual inventory system can be achieved.

7-31 (10-15 min.)

GOODMAN’S JEWELRY WHOLESALERS
Schedule of Gross Profit
For the Year Ended December 31, 20X8
(In Thousands)
Gross sales $985
Deduct: Sales returns and allowances $40
Cash discounts on sales 5 45
Net sales 940
Cost of goods sold:
Inventory, December 31, 20X7 $103
Add: Gross purchases $650
Deduct: Purchase returns
and allowances $27
Cash discounts on purchases 6 33
Net purchases 617
Add Freight-in 50
Cost of merchandise acquired 667
Cost of goods available for sale 770
Deduct: Inventory, December 31, 20X8 185
Cost of goods sold 585
Gross profit $355

Chapter 7 Inventories and Cost of Goods Sold 303

7-32 (20 min.)

Sales $71,200
Sales returns 2,300
Net sales $68,900
Cost of goods sold:
Inventory, January 1* x = $39,864
Purchases $54,000
Purchase returns 2,000
Net purchases $52,000
Freight in 500 52,500
Cost of goods available for sale $92,364
Inventory, January 15 40,000
Cost of goods sold, .76 x $68,900 52,364
Gross margin, .24 x $68,900 $16,536
* $52,364 + $40,000 – 52,500 = $39, 864

or:

Cost of goods sold (.76 x 68,900) $52,364

Cost of goods purchased 52,500
Inventory increase $ 136
Beginning Balance = Ending Balance + Change =
$40,000 - $136 $39,864

304
7-33 (5 min.) Amounts are in millions of dollars.

Perpetual Periodic
Accounts receivable* 19 Accounts receivable 19
Sales revenue 19 Sales revenue 19

Cost of goods sold 15 No entry

Merchandise
inventory 15
* Could be a debit to cash if sales were for cash.

7-34 (10-15 min.)

Cost of Goods Available = £21,400

(8,000 + 4,200 + 4,400 + 2,300 + 2,500)

LIFO Ending Inventory = (4,000 @ £2) + (1,500 @ £2.10) = £11,150

FIFO Ending Inventory = 1,000 @ £2.50 = £ 2,500
1,000 @ £2.30 = 2,300
2,000 @ £2.20 = 4,400
1,500 @ £2.10 = 3,150
5,500 £12,350
Weighted average = £21,400/10,000 = £ 2.14 per unit
Ending inventory 5,500 @ £2.14 = £11,770

Cost of Goods Sold Calculation:

Weighted
LIFO FIFO Average
Cost of goods available £21,400 £21,400 £21,400
Less Ending Inventory (11,150) (12,350) (11,770)
Cost of Goods Sold £10,250 £ 9,050 £ 9,630

Chapter 7 Inventories and Cost of Goods Sold 305

7-35 (10-15 min.)

This is straightforward. Answers are in Swiss francs.

Aug. 2 Purchases 350,000

Accounts payable 350,000

Aug. 3 Freight-in 15,000

Cash 15,000

Aug. 7 Accounts payable 30,000

Purchase returns
and allowances 30,000

Aug. 11 Accounts payable 320,000

Cash discounts on purchases 6,400
Cash 313,600

306
7-36 (10-15 min.)

1. Invoice price $200,000

Add: Freight-in 10,000
Deduct: Purchase allowance (15,000)
Deduct: Cash discount (3,700)*
Total cost of steel acquired $191,300
*2% x ($200,000 – $15,000)

2. Purchases (or Inventory)* 200,000

Accounts payable 200,000
*The debit is to Purchases under the periodic inventory
method and to Inventory under the perpetual inventory
system.

Freight-in 10,000
Accounts payable (or cash) 10,000

Accounts payable 15,000

Purchase returns and allowances 15,000

Accounts payable 185,000

Cash discounts on purchases 3,700
Cash 181,300

Chapter 7 Inventories and Cost of Goods Sold 307

7-37 (15 min.) Amounts are in thousands of dollars.
See Exhibit 7-37 for the balance sheet equation. Although not
required, the balance sheet equation provides a good framework for
understanding.
Journal Entries
Perpetual System
a. Gross purchase: Inventory 960
Accounts payable 960

b. Returns and allowances: Accounts payable 80

Inventory 80

c. As goods are sold: Cost of goods sold 890

Inventory 890

d1. and d2. No entry

Periodic System
a. Gross purchase: Purchases 960
Accounts payable 960

b. Returns and allowances: Accounts payable 80

Purchase returns
and allowances 80

c. As goods are sold: No entry

d1. Transfer to cost of

goods sold: Cost of goods sold 990
Purchase returns
and allowances 80
Purchases 960
Inventory 110

d2. Recognize ending inventory: Inventory 100

308
 Cost of goods sold 100

Chapter 7 Inventories and Cost of Goods Sold 309

EXHIBIT 7-37

Entries are in thousands of dollars.

A = L + SE
Accounts Retained
PERPETUAL SYSTEM Inventory Payable Earnings

Balance, 12/31/X7 +110 = + 110

a. Gross purchases +960 = + 960
b. Returns and allowances – 80 = – 80
c. As goods are sold –890 –890 of
Increase Cost 
Goods Sold 
 
Closing the accounts at end of period:

d1. No entry

d2. No entry
____ ____
Ending balances, 12/31/X8 +100 = +990 –890

310
EXHIBIT 7-37 (continued)

A = L + SE
Purchase
Returns and Accounts Retained
PERIODIC SYSTEM Inventory Purchases Allowances Payable Earnings

Balance, 12/31/X7 +110 = + 110

a. Gross purchases +960 = + 960
b. Returns and allowances –80 = – 80
c. As goods are sold (no entry)

Closing the accounts at

end of period:
d1. Transfer to cost of goods sold–110 –960 +80 = – 990 of
Increase Cost 
 Goods Sold 

d2. Recognize ending inventory +100 = + 100 Decrease Cost 

Sold 
 of Goods
___ ___ ___
Ending balances, 12/31/X8 +100 0 0 = +990 – 890

Chapter 7 Inventories and Cost of Goods Sold 311

7-38 (10 min.)
This is straightforward.
1. Purchases 880,000
Accounts payable 880,000
2. Accounts payable 50,000
Purchase returns and allowances 50,000
3. Freight-in 74,000
Cash 74,000
4. Accounts payable 830,000
Cash 812,000
Cash discounts on purchases 18,000

7-39 (10 min.)

The entries could be compounded.
Accounts receivable (or Cash) 1,250,000
Sales 1,250,000

Cost of goods sold 957,000

Purchase returns and allowances 50,000
Cash discounts on purchases 18,000
Purchases 880,000
Freight-in 74,000
Inventory 71,000
Inventory 120,000
Cost of goods sold 120,000

Chapter 7 Inventories and Cost of Goods Sold 313

7-40 (10-15 min.)

Compound entries could be prepared. (Amounts are in

millions.)

Purchases 130
Accounts payable 130
Accounts receivable 239
Sales 239
Sales returns and allowances 5
Accounts receivable 5
Accounts payable 6
Purchase returns and allowances 6
Freight-in 14
Cash 14
Accounts payable 124
Cash discounts on purchases 1
Cash 123
Cash 226
Cash discounts on sales 8
Accounts receivable 234
Cost of goods sold 162
Purchase returns and allowances 6
Cash discounts on purchases 1
Inventory 25
Purchases 130
Freight-in 14
Inventory 45
Cost of goods sold 45
Other expenses 80

314
 Cash (or other accounts) 80

7-41 (5 min.) Amounts are in millions of dollars.

Beginning inventory $ 45
Purchases 4,510
Cost of goods available 4,555
Ending inventory (56)
Cost of goods sold $4,499

Chapter 7 Inventories and Cost of Goods Sold 315

7-42 (15-20 min.)

This problem develops familiarity with the gross profit section.

The answer, $51,200, is computed by filling in the gross profit
section and solving for the unknown, or: $192,000 – 55%($256,000)
= $51,200.

Gross sales $280,000

Deduct: Sales returns
and allowances 24,000
Net sales $256,000
Cost of goods sold:
Inventory, December 31, 20X7 $38,000
Gross purchases $160,000
Deduct: Purchase returns
and allowances $8,000
Cash discounts
on purchases 2,000 (10,000)
Net purchases 150,000
Inward transportation 4,000
Cost of goods acquired 154,000
Cost of goods available
for sale 192,000
Inventory, May 3, 20X8* x= 51,200
Cost of goods sold,
55% of $256,000 140,800
Gross profit, 45% of $256,000 $115,200

* Calculated as the difference between cost of goods available for sale,

$192,000, and cost of goods sold $140,800.

316
7-43 (15 min.)

Sales $200,000
Cost of goods sold:
Inventory, January 1 $65,000
Purchases $195,000
Purchase returns and allowance 10,000
Net purchases $185,000
Freight-in 15,000 200,000
Cost of goods available for sale $265,000
Inventory, March 9* x = 105,000
Cost of goods sold,
80% of $200,000 160,000
Gross margin, 20% of $200,000 $ 40,000

* The answer, $105,000, is obtained by filling in the schedule of

cost of goods sold and solving for the unknown, or: $265,000 –
80%($200,000) = $265,000 – $160,000 = $105,000.

7-44 (10-15 min.)

Beginning inventory $ 55,000

Purchases 200,000
Cost of goods available for sale $255,000
Less estimated cost of goods sold:
75%* of $280,000 210,000
Estimated ending inventory $ 45,000
*100% – 25% = 75%

The difference between $45,000 and the amount of inventory

remaining is an estimate of the amount missing.

Chapter 7 Inventories and Cost of Goods Sold 317

7-45 (10-15 min.)

1 & 2. To calculate the effect use the following approach:

20X5 20X6
Beginning inventory OK Too low $20,000
+ Purchases OK OK
Goods available OK Too low $20,000
−Ending inventory Too low $20,000 OK
Cost-of-goods sold Too high $20,000 Too low $20,000

Cost-of-goods sold is too high by $20,000 in 20X5 so taxable

income will be too low by $20,000. Taxes will be too low by $8,000 so
net income and retained earnings will be too low by $12,000.
Taxable income for 20X6 will be overstated by $20,000 and taxes will
be $8,000 too high. Net income in 20X6 will be too high by $12,000
and retained earnings will be correct again at December 31, 20X6.

318
7-46 (10-15 min.)

1. Inventory turnover = cost of goods sold* ÷ average

inventory
= $1,080,000 ÷ $1,080,000
= 1.00

*Cost of goods sold = $2,400,000 – $1,320,000 = $1,080,000

2. The gross profit would fall from $1,320,000 to $1,260,000, so a

change in pricing strategy would be undesirable for Custom
Gems. The current 20X3 data follow:

Inventory turnover 1.0

Gross profit percentage:
$1,320,000 ÷ $2,400,000 55%
This percentage is not unusual.

If prices are cut 20 percent in 20X4 without affecting inventory

turnover, new sales would be .8 x $2,400,000 = $1,920,000.
Cost of goods sold on those sales would still be $1,080,000.
Therefore Mr. Siegl would be reducing his gross profit from
$1,320,000 to $1,920,000 - $1,080,000 = $840,000 and its gross
profit percentage to 44% [($1,920,000 − $1,080,000) ÷
$1,920,000]. However, an increase in inventory turnover to 1.5
would produce the following:

Sales, $1,920,000 x 1.5 $2,880,000

Cost of goods sold, $1,080,000 x 1.5 1,620,000
Gross profit $1,260,000

Gross profit would be only $60,000 below the 20X3 level.

Chapter 7 Inventories and Cost of Goods Sold 319

7-47 (15-20 min.)

1. LIFO Method:
Inventory shows: 1,100 tons on hand at July 31.
Costs: 1,000 tons @ $ 9.00 $ 9,000
100 tons @ $10.00 1,000
July 31 inventory cost. $10,000

FIFO Method:
Inventory shows: 1,100 tons on hand at July 31.
Costs: 900 tons @ $12.00 $10,800
200 tons @ $11.00 2,200
July 31 inventory cost. $13,000

2. Purchases:
5,000 tons @ $10 $50,000
1,000 tons @ $11 11,000
900 tons @ $12 10,800
Total purchases $71,800
Beginning inventory:
1,000 tons @ $ 9 9,000

LIFO FIFO
Cost of goods available for sale $80,800 $ 80,800 $ 80,800
Less ending inventory (10,000) (13,000)
Cost of goods sold $ 70,800 $ 67,800

Sales $102,000 $102,000

Cost of goods sold 70,800 67,800
Gross profit $ 31,200 $ 34,200

320
7-48 (5-10 min.)
The inventory would be written down from $200,000 to
$185,000 on December 31, 20X1. The new $185,000 valuation is
"what's left" of the original $200,000 cost. In other words, the
$185,000 is the unexpired cost and may be thought of as the new
cost of the inventory for future accounting purposes. Thus,
because subsequent replacement values exceed the $185,000 cost,
and write-ups above "cost" are not acceptable accounting practice,
the valuation remains at $185,000 until it is written down to $180,000
on the following December 31, 20X2.

7-49 (10-15 min.) Amounts are in millions of dollars.

The cost of inventory acquired during the year ending August
31, 2003, can be calculated as follows.
Beginning Inventory $ 3,127
Purchases X = 37,537
Cost of goods available Y = 40,664
Ending inventory (3,339)
Cost of merchandise sold $37,325
Y = 37,325 + 3,339 = 40,664
X = 40,664 – 3,127 = 37,537

Chapter 7 Inventories and Cost of Goods Sold 321

7-50 (10 min.) Dollar amounts are in millions.
2003: ($11,305 − $7,799) ÷ $11,305 = 31.01%
2002: ($11,019 − $7,604) ÷ $11,019 = 30.99%
2001: ($11,332 − $7,815) ÷ $11,332 = 31.04%
The gross profit percentage was very steady over these three
years, with just a slight dip in 2002 followed by a small recovery.
Though not in the problem, it might be interesting to note that
the gross profit percentage has ranged for 27% to 31% over the past
ten years.

7-51 (10-15 min.)

1. ISLAND BUILDING SUPPLY

Statement of Gross Profit
For the Year Ended December 31, 20X1

Sales $1,200,000
Cost of goods sold:
Inventory, beginning $ 240,000
Add net purchases 1,035,000
Cost of goods available for sale $1,275,000
Deduct ending inventory (330,000)
Cost of goods sold 945,000
Gross profit $255,000

2. Inventory turnover = Cost of goods sold ÷ Average inventory

= $945,000 ÷ [1/2 x (240,000 + 330,000)]
= 945,000 ÷ 285,000
= 3.3 times

322
7-52 (30-40 min.)

The detailed income statement is in the accompanying exhibit.

Note the classification of operating expenses into a selling category
and a general and administrative category. The list of accounts in
the problem contained one item that belongs in a balance sheet
rather than an income statement, the Allowance for Bad Debts (an
offset to Accounts Receivable).

The delivery expenses and the bad debts expense are shown
under selling expenses. Some accountants prefer to show the bad
debts expense as an offset to gross sales or as administrative
expenses.

Chapter 7 Inventories and Cost of Goods Sold 323

7-52 (continued)
BACKBAY BATHROOM SUPPLY COMPANY
Income Statement
For the Year Ended December 31, 20X5
(In Thousands)
Revenues:
Gross sales $1,091
Deduct: Sales returns and allowances $ 50
Cash discounts on sales 16 66
Net sales $1,025
Cost of goods sold:
Inventory, December 31, 20X4 $200
Add purchases $600
Less: Purchase returns
and allowances $40
Cash discounts on purchases 15 55
Net purchases $545
Add Freight in 50
Cost of merchandise acquired 595
Cost of goods available for sale $795
Deduct: Inventory, December 31, 20X5 300
Cost of goods sold 495
Gross profit from sales $ 530
Operating expenses:
Selling expenses:
Sales salaries and commissions $160
Rent expense, selling space 90
Advertising expense 45
Depreciation expense, trucks
and store fixtures 29
Bad debts expense 8
Delivery expenses 20
Total selling expenses $352
General and administrative expenses:
Office salaries 46
Rent expense, office space 10
Depreciation expense, office equipment 3
Office supplies used 6
Miscellaneous expenses 13
Total general and administrative expenses 78
Total operating expenses 430
Income before income tax $ 100
Income tax expense 42

324
Net income $ 58

Chapter 7 Inventories and Cost of Goods Sold 325

7-53 (15-25 min.)
Under the FIFO cost-flow assumption, the periodic and
perpetual procedures give identical results. The ending inventory
will be valued on the basis of the last purchases during the period.

Units $
Beginning Inventory 120 600
Purchases 290 2,050

Goods available 410 2,650

Units sold 255 1,465**

Units in ending Inventory 155 1,185*

* 155 units remain in ending inventory

100 will be valued at the $8 cost from the October 21 purchase and
the remaining 55 will be valued at the $7 cost from the May 9
purchase

100 x $8 = $ 800
55 x $7 = 385
$1,185 Ending inventory

** Reconciliation: Cost of Goods Sold:

255 Units: 120 x $5 = $ 600
80 x $6 = 480
55 x $7 = 385
$1,465

326
7-54 (30-35 min.)

1. Gross profit percentage = $1,600,000 ÷ $4,000,000 = 40%

$850,000 + 750,000
Inventory turnover = $2,400,000 ÷
2

= 3 times

2. Inventory turnover = $2,400,000 ÷ $600,000 = 4 times, a 1/3

increase in turnover.

3. With a lower average inventory and constant inventory

turnover, cost of sales must fall. Total cost of goods sold =
$600,000 x 3 = $1,800,000. To achieve a gross profit of
$1,600,000, total sales must be $1,800,000 + $1,600,000, or
$3,400,000. The gross profit percentage must be $1,600,000 ÷
$3,400,000 = 47.1%. Requirements 2 & 3 show that if inventory
levels are reduced you must increase either inventory turnover
or margins to maintain profitability.

4. Summary (computations are shown below):

Succeeding Year
Given Year 4a 4b
Sales $4,000,000 $3,857,143 $4,125,000
Cost of goods sold 2,400,000 2,160,000 2,640,000
Gross profit $1,600,000 $1,697,143 $1,485,000

Chapter 7 Inventories and Cost of Goods Sold 327

7-54 (continued)

a. New gross profit percentage, 40% + .10(40%) = 44%

New inventory turnover, 3 – .10(3) = 2.7
New cost of goods sold, $800,000 x 2.7 = $2,160,000
New sales = $2,160,000 ÷ (1 – .44)
= $2,160,000 ÷ .56
= $3,857,143

Note that this is a more profitable alternative, assuming that the

gross profit percentage and the inventory turnover can be
achieved. In contrast, alternative 4b is less attractive than the
original 40% gross profit and turnover of 3.

b. New gross profit percentage, 40% – .10(40%) = 36%

New inventory turnover, 3 + .10(3) = 3.3
New cost of goods sold, $800,000 x 3.3 = $2,640,000
New sales = $2,640,000 ÷ (1 −.36)
= $2,640,000 ÷ .64
= $4,125,000

5. Retailers find these ratios (and variations thereof) helpful for a

variety of operating decisions, too many to enumerate here.
An obvious help is the quantifying of the options facing
management regarding what and how much inventory to carry,
and what pricing policies to follow. You may want to stress that
this analysis ignores one benefit of higher inventory turnover—
the firm reduces its investment in inventory and reduces
storage and display requirements.

328
7-55 (25-35 min.)
The detailed income statement is in the accompanying exhibit.
Some accountants prefer to show the provision for uncollectible
accounts as an offset to gross sales. The data for the allowance for
doubtful accounts does not affect the income statement.
SEARS, ROEBUCK & COMPANY
Income Statement
For the Year Ended December 31, 2002
(In Millions)
Revenues:
Gross revenues (Plug) $44,316
Deduct: Sales returns and allowances $ 2,100
Cash discounts on sales 850 2,950
Net revenues $41,366
Cost of goods sold:
Inventory, December 31, 2001 $4,912
Add purchases $26,124
Less: Purchase returns
and allowances $1,200
Cash discounts on
purchases 180 1,380
Net purchases $24,744
Add Freight in 1,100
Cost of merchandise acquired 25,844
Cost of goods available for sale $30,756
Deduct: Inventory, December 31, 2002 5,115
Cost of sales 25,646
Grossprofit $15,720
Operating expenses:
Selling and administrative $9,249
Provision for uncollectible accounts 2,261
Depreciation 875
Other operating expenses 111 12,496
Operating income $ 3,224
Interest expense 1,143
Other income, net (372)
Income before tax $ 2,453

Chapter 7 Inventories and Cost of Goods Sold 329

7-56 (20-30 min.)
1. CONTRACTOR SUPPLY CO.
Comparison of Inventory Methods
Statement of Gross Profit of Kemtone Cooktops
For the Year Ended December 31, 20X8
(In Dollars)
Weighted
FIFO LIFO Average

Sales, 260 units 26,200 26,200 26,200

Deduct cost of goods sold:
Inventory, December 31,
20X7, 110 @ $50 5,500 5,500 5,500
Purchases, 300 units 21,200 21,200 21,200
Cost of goods available for
sale, 410 units 26,700 26,700 26,700
Deduct: Inventory, December
31, 20X8, 150 units:
100 @ $80 8,000
50 @ $70 3,500 11,500
110 @ $50 5,500
40 @ $60* 2,400 7,900
150 @ ($26,700 ÷ 410),
150 @ $65.12 9,768
Cost of goods sold,
260 units 15,200 18,800 16,932
Gross profit 11,000 7,400 9,268

* This is a periodic LIFO. Students are using perpetual LIFO if they answer 20 @ $60 plus 20 @
$80 = $2,800.

2. Income taxes would be lower by .40($11,000 – $7,400) = $1,440.

The income tax rate is assumed to be identical at all levels of
taxable income. Some students will wonder why no
information is given regarding other expenses and net income.
Such information is unnecessary because other expenses,
whatever their amounts, will be common among all inventory
methods. Thus gross profits provide sufficient information to
measure the differences in income taxes among various
inventory methods.

330
7-57 (15-20 min.)

There would be no effect on gross profit, net income, or

income taxes under FIFO, although the balance sheet would show
ending inventory as $8,000 higher. The income statement would
show purchases and ending inventory as higher by $8,000, so the
net effect on cost of goods sold would be zero.

LIFO would show a lower gross profit, $6,000, as compared

with $7,400, a decrease of $1,400. Hence, the impact of the late
purchase on income taxes would be a savings of 40% of $1,400 =
$560.

The tabulation below compares the results under LIFO (in

dollars):

Without Late Purchase With Late Purchase

Sales, 260 Units 26,200 26,200
Deduct: Cost of goods sold:
Inventory, December 31, 20X7,
110 @ $50 5,500 5,500
Purchases, 300 units at various
costs 21,200 21,200
100 units @ $80 − 8,000
Cost of goods available for sale 26,700 34,700
Deduct: Inventory, December
31, 20X8:
First layer (pool) 110 @ $50 5,500 5,500
Second layer (pool) 40 @ $60 2,400 7,900
Second layer (pool) 80 @ $60 4,800
Third layer (pool) 60 @ $70 4,200 14,500
Cost of goods sold, 260 units 18,800 20,200
Gross profits 7,400 6,000
Income taxes @ 40% 2,960 2,400

Chapter 7 Inventories and Cost of Goods Sold 331

7-57 (continued)

Although purchases are $8,000 higher than before, the new

LIFO ending inventory is only $14,500 – $7,900 = $6,600 higher. The
$1,400 difference in gross profit is explained by the fact that the late
purchase resulted in changes to both ending inventory and cost of
goods sold. LIFO cost of goods sold is $1,400 higher ($20,200 –
$18,800).

To see this from another angle, compare layers. Without the

late purchase, the second layer had 40 units @ $60. With the late
purchase:

Late purchase released as expense, 100 @ $80 $8,000

Second layer is 40 units higher @ $60 = $2,400
Third layer is 60 units @ $70 = 4,200
Amount held as ending inventory that
would otherwise have been released as
expense in the form of cost of goods sold 6,600
Difference in cost of goods sold $1,400

7-58 (15 min.)

1. LIFO: 100 units @ $10 $1,000

20 units @ $12 240
$1,240

2. Replacement cost: 120 units @ $12 = $1,440.

LIFO is lower than replacement cost. Therefore, no inventory
write-down takes place, and the balance sheet shows $1,240.
3. FIFO: 20 units @ $12 $ 240
100 units @ $13 1,300
$1,540
4. Replacement cost is $1,440 (see Requirement 2). Because
replacement cost is lower than FIFO, the balance sheet should

332
 include the lower amount, $1,440. Most companies would treat
the $100 inventory write-down as an increase in cost of sales.

Chapter 7 Inventories and Cost of Goods Sold 333

7-59 (10-15 min.)
1. O is used for overstated, U for understated, and N for not
affected.
(In Thousands)
20X1 20X2
Beginning inventory* N O $15
Ending inventory* O $15 N
Cost of goods sold U 15 O 15
Gross margin O 15 U 15
Income before income taxes O 15 U 15
Income tax expense O 6 U 6
Net income O 9 U 9
*The ending inventory for 20X1 becomes the beginning
inventory for 20X2.
2. Retained earnings would be overstated by $9,000 at the end of
the first year. However, the error would be offset in the second
year, assuming no change in the 40% income tax rate.
Therefore, retained earnings would be correct at the end of the
second year.

7-60 (20-30 min.)

1. See Exhibit 7-60 on the following page.

2. LIFO results in more cash by the difference in income tax effects. LIFO
results in a lower cash outflow of .40 x ($116,000 – $96,000) = $8,000.

3. FIFO results in more cash when inventory prices are falling. Why?
Because income tax cash outflow would be more under LIFO by
.40($144,000 – $124,000) = $8,000.

334
EXHIBIT 7-60

Purchases @ $12 Unit Purchases @ $8

Unit
Requirement a Requirement b
FIFO LIFO FIFO LIFO

Sales, 12,000 @ $20 $240,000 $240,000 $240,000$240,000

Deduct cost of goods sold:
Inventory, December 31, 20X1, 10,000 @ $10 100,000 100,000 100,000 100,000
Purchases: 13,000 @ $12 and $8, respectively 156,000 156,000 104,000 104,000
Cost of goods available for sale 256,000 256,000 204,000 204,000
Deduct: Inventory, December 31, 20X2,
11,000 units:
11,000 @ $12 = 132,000
or
10,000 @ $10 = $100,000
1,000 @ $12 = 12,000 112,000
or
11,000 @ $ 8 = 88,000
or
10,000 @ $10 = $100,000
1,000 @ $ 8 = 8,000 108,000
Cost of goods sold 124,000 144,000 116,000 96,000
Gross margin $116,000 $ 96,000 $124,000$144,000

Chapter 7 Inventories and Cost of Goods Sold 335

7-61 (20 min.)

1.
Units LIFO FIFO

Sales 30,000 £330,000 £330,000

Cost of goods sold:
Inventory, December 31, 20X7 14,000 84,000 84,000
Purchases 52,000 394,000 394,000
Cost of goods available for sale 66,000 478,000 478,000
Inventory, December 31, 20X8 36,000 238,000* 282,000**
Cost of goods sold 30,000 240,000 196,000
Gross margin or gross profit £ 90,000 £134,000

* 14,000 @ £6 = £ 84,000
22,000 @ £7 = 154,000
36,000 £238,000

** 30,000 @ £8 = £240,000
6,000 @ £7 = 42,000
36,000 £282,000

2. Gross margin is higher under FIFO. However, cash will be

higher under LIFO by .40(£134,000 – £90,000) = .40 x £44,000 =
£17,600. Cash payments for inventory and cash receipts from
sales are unaffected by the cost flow assumption. Only the
effect on tax obligations affects cash flow.

336
7-62 (35 min.)

1. (Dollars In Thousands)
Lastin Company Firstin Company
(LIFO) (FIFO)
Sales $4,500 $4,500
Deduct cost of goods sold:
Beginning inventory:
10,000 tons @ $50 $ 500 $ 500
Purchases:
30,000 tons @ $60 $1,800
20,000 tons @ $70 1,400 3,200 3,200
Cost of goods
available for sale $3,700 $3,700
Ending inventory:
10,000 tons @ $50 $ 500 15,000
5,000 tons @ $60 300 800 @ $70 1,050
Cost of goods sold 2,900 2,650
Gross profit $1,600 $1,850
Other expenses 600 600
Income before
income taxes $ 1,000 $1,250
Income taxes at 40% 400 500
Net income $ 600 $ 750

Chapter 7 Inventories and Cost of Goods Sold 337

7-62 (continued)

2. Note first that the underlying events are identical, but the
inventory method chosen will yield radically different results.
When prices are rising, and if she had a choice, the manager
would choose the method that is most harmonious with her
objectives. Clearly the company is better off economically
under the LIFO method, even though reported earnings are
less. LIFO saved $100 thousand in income taxes:

LIFO FIFO
Cash receipts:
Sales $4,500 $4,500
Cash disbursements:
Purchases $3,200
Other expenses 600 $3,800 $3,800
Income taxes 400 500
Total disbursements $4,200 $4,300
Net increase in cash $ 300 $ 200

On the other hand, reported net income is dramatically better

under FIFO, $750 versus $600. In times of rising prices and
stable or increasing inventory levels, the general guide is that
LIFO saves income taxes and results in a better cash position;
nevertheless, FIFO shows the higher reported net income.

338
7-63 (30 min.)

1.
20X1 20X2 20X3 20X4 20X5 Total
FIFO:
Sales $5,000 $5,000 $5,000 $5,000 $20,000 $40,000
Cost of goods sold 1,000 2,000 2,000 2,500 13,000 20,500
Income before taxes 4,000 3,000 3,000 2,500 7,000 19,500
Income taxes 1,600 1,200 1,200 1,000 2,800 7,800
Net income $2,400 $1,800 $1,800 $1,500 $ 4,200 $11,700

LIFO:
Sales $5,000 $5,000 $5,000 $5,000 $20,000 $40,000
Cost of goods sold 2,000 2,500 3,000 4,000 9,000 20,500
Income before taxes 3,000 2,500 2,000 1,000 11,000 19,500
Income taxes 1,200 1,000 800 400 4,400 7,800
Net income $1,800 $1,500 $1,200$ 600 $ 6,600 $11,700

2. LIFO is most advantageous because it defers tax payments.

This provides additional cash and reduces the need for
borrowing. One way to think about the benefit is to think of the
interest saved each year. For example, assume that if higher
taxes were paid, that amount would be borrowed at an interest
rate of 10%.

20X1 20X2 20X3 20X4 20X5 Total

FIFO tax $1,600 $1,200 $1,200 $1,000 $2,800 $7,800
LIFO tax 1,200 1,000 800 400 4,400 7,800
Annual cash benefit /(loss) $ 400 $ 200 $ 400 $ 600 $(1,600)$ 0
Cumulative cash benefit $ 400 $ 600 $1,000 $1,600 – –
Interest saved @ 10% $ 40 $ 60 $ 100 $ 160 – $ 360

This analysis does not consider the time value of money in that
interest savings are simply added together, but it does provide
a vivid illustration of the concept.

Chapter 7 Inventories and Cost of Goods Sold 339

7-64 (30-40 min.)

1, 2. FIFO LIFO
1(a) 2(a) 1(b) 2(b)
Sales, 5,000 units $120,000 $96,000 $120,000 $96,000
Less cost of goods sold:
Purchase cost, $118,000 $118,000
Less ending inventory:
FIFO: 4,000 @ $15 60,000
LIFO:
2,000 @ $10 = $20,000
1,000 @ $11 = 11,000
1,000 @ $13 = 13,000 44,000
Cost of goods sold $ 58,000 $60,000 $ 74,000 $44,000
Other expenses 30,000 30,000 30,000 30,000
Total deductions $ 88,000 $90,000 $104,000 $74,000
Income before taxes $ 32,000 $ 6,000 $ 16,000 $22,000
Income taxes @ 40% $ 12,800 $ 2,400 $ 6,400 $ 8,800
Net income $ 19,200 $ 3,600 $ 9,600 $13,200

3. FIFO LIFO
1(a) 2(a) 1(b) 2(b)
Sales, 5,000 units $120,000 $96,000 $120,000 $96,000
Less cost of goods sold:
Purchase cost* $ 58,000 $60,000 $ 58,000 $60,000
Other expenses 30,000 30,000 30,000 30,000
Total deductions $ 88,000 $90,000 $ 88,000 $90,000
Income before taxes $ 32,000 $ 6,000 $ 32,000 $ 6,000
Income taxes @ 40% $ 12,800 $ 2,400 $ 12,800 $ 2,400
Net income $ 19,200 $ 3,600 $ 19,200 $ 3,600

The timing of purchases does not affect FIFO income but

affects LIFO income. LIFO cost of goods sold declined from $74,000
to $58,000 as a result of the delay in purchase. Managers can
directly influence LIFO net income by choices to replenish inventory.
* In this example all purchases are sold each year and no inventories
accumulate. Therefore, FIFO and LIFO give identical results.

340
7-65 (20-30 min.)

The major point here is to demonstrate that changes in LIFO

reserves can be used as a shortcut measure of the differences in
cost of goods sold under FIFO and LIFO. (All amounts are in
dollars.)

LIFO
1. (1) (2) Reserve
FIFO LIFO (1) – (2)
Beginning inventory, 2 @ $20,
2 @ $16 40 32 8
Purchases:
3 @ $24 + 3 @ $28 = 156 156
Cost of goods available for sale 196 188 8
Ending inventory, 2 @ $28,
2 @ $16 56 32 24
Cost of goods sold 140 156 (16)

2. a. Beginning inventory 40 32 8
Purchases (as above) 156 156
Cost of goods available for sale 196 188 8
Ending inventory
3 @ $28 + 1 @ $24 108
2 @ $16 + 2 @ $24 ___ 80 28
Cost of goods sold 88 108 (20)

b. Beginning inventory 40 32 8
Purchases 156 156
Available for sale 196 188 8
Ending inventory 0 0 0
Cost of goods sold 196 188 8

Chapter 7 Inventories and Cost of Goods Sold 341

7-65 (continued)

3. From Part 1, the beginning LIFO Reserve is 8, the difference

between FIFO inventory of 40 and LIFO inventory of 32. At year
end the LIFO Reserve is 24, an increase of 16. This 16 is
exactly the difference between FIFO cost of goods sold of 140
and LIFO cost of goods sold of 156. If prices are rising, cost of
goods sold includes more of these recent higher costs under
LIFO than under FIFO. Hence, if physical quantities are held
constant, the LIFO reserve will rise by the difference between
the cost of goods sold. Why? Because old LIFO unit costs will
still be held in ending inventory, whereas recent higher unit
costs will apply to the ending FIFO inventory.

If physical quantities of ending inventory rise along with rises in

unit prices, the LIFO difference in higher cost of goods sold
becomes larger. Compare 2a. with 1.

If the older LIFO layers are liquidated, the LIFO cost of goods
sold becomes less than FIFO cost of goods sold. As 2b.
demonstrates, the total liquidation of inventories will result in
FIFO cost of goods sold exceeding LIFO cost of goods sold by
the amount of the LIFO reserve at the start of the year.

342
7-66 (15-20 min.)
1. O is used for overstated; U is used for understated:
(In Millions)
20X3 20X2 20X1
Beginning inventory* Correct O $10 Correct
Cost of goods available Correct O 10 Correct
Ending inventory* U $5 Correct O $10
Cost of goods sold O 5 O 10 U 10
Gross margin U 5 U 10 O 10
Income before income taxes U 5 U 10 O 10
Income tax expense U 2 U 4 O 4
Net income U 3 U 6 O 6

* The ending inventory for a given year becomes the beginning

inventory for the following year.

2. Retained earnings would be overstated by $6 million at the end

of 20X1. However, the error would be offset in the second year.
Therefore, retained earnings would be correct at the end of
20X2. Retained earnings is understated by $3 million at the end
of 20X3.

7-67 (30-40 min.)

1. See Exhibit 7-67 on the following page.

2. a. Income before income taxes will be lower under LIFO than

under FIFO: $149,000 – $124,000 = $25,000. The income
tax will be lower by .40 x $25,000 = $10,000.
b. Income before income taxes will be lower under LIFO than
under weighted-average: $135,950 – $124,000 = $11,950.
The income tax will be lower by .40 x $11,950 = $4,780.

Chapter 7 Inventories and Cost of Goods Sold 343

EXHIBIT 7-67
Weighted Specific
FIFO LIFO Average Identification
Net revenue from sales
(150 @ $900) + (160 @ $1,000) $295,000 $295,000 $295,000 $295,000
Deduct cost of products sold:
Inventory, February 1, 2002,
100 @ $400 40,000 40,000 40,000 40,000
Purchases (200 @ $500) + (160 @ $600) 196,000 196,000 196,000 196,000
Cost of goods available for sale, 460 units 236,000 236,000 236,000 236,000
Deduct: Inventory, January 31, 2003, 150 units:
150 @ $600 90,000
or
100 @ $400 =$40,000
50 @ $500 = 25,000 65,000
or
150 @ ($236,000 ÷ 460) or 150 @ $513 76,950
or
100 @ $400 =$40,000
50 @ $500 = 25,000 65,000
Cost of goods sold 146,000 171,000 159,050 171,000
Gross margin $149,000 $124,000 $135,950 $124,000

344
7-68 (20-30 min.) This problem explores the effects of LIFO layers.

There would be no effect on gross margin, income taxes, or

net income under FIFO. The balance sheet would show a higher
inventory by $42,000. A detailed income statement would show both
purchases and ending inventory as higher by $42,000, so the net
effect on cost of goods sold would be zero.

LIFO would show a lower gross margin, $112,000, as compared

with $124,000, a decrease of $12,000. Hence, the impact of the late
purchase would be a savings of income taxes of 40% of $12,000 =
$4,800. For details, see the following tabulation.

Without Late With Late

Purchase Purchase
Net revenues from sales as
before $295,000 $295,000
Deduct cost of goods sold:
Inventory, February 1, 2002,
100 @ $400 $ 40,000 $ 40,000
Purchases, 360 units, as before,
and 420 units 196,000 238,000*
Cost of goods available for sale $236,000 $278,000
Ending inventory:
First layer 100 @ $400 plus
second layer 50 @ $500 65,000
First layer 100 @ $400 plus
second layer 110 @ $500 95,000
Cost of goods sold 171,000 183,000
Gross margin $124,000 $112,000

*360 units, as before $196,000

60 units @ $700 42,000
$238,000

Chapter 7 Inventories and Cost of Goods Sold 345

7-68 (continued)

Although purchases are $42,000 higher than before, the new

LIFO ending inventory is only $95,000 – $65,000 = $30,000
higher. The cost of sales is $183,000 – $171,000 = $12,000
higher.

To see this another way, compare the ending inventories:

Late purchase added to cost of

goods available for sale: 60 @ $700 = $42,000
Deduct 60-unit increase in ending inventory:
Second layer is 110 – 50 = 60 units higher @ $500 =
30,000
Cost of sales is higher by: 60 @ ($700 - $500) = $12,000

7-69 (30-40 min.)

See Exhibit 7-69 on the following page.

346
EXHIBIT 7-69

1. TEXAS INSTRUMENTS
Comparison of Inventory Methods
Income Statement
For the Year Ended December 31, 2002

FIFO LIFO Weighted

Average
Net sales, 200 units $2,380 $2,380 $2,380
Deduct cost of sales:
Beginning inventory, 80 @ $5 $ 400 $ 400 $ 400
Purchases, 220 units* 1,580 1,580 1,580
Available for sale, 300 units** $1,980 $1,980 $1,980
Ending inventory, 100 units:
90 @ $8 $720
10 @ $7 70 790
or
80 @ $5 $400
20 @ $6 120 520
or
100 @ ($1,980 ÷ 300), or
100 @ $6.60 660
Cost of sales, 200 units 1,190 1,460 1,320
Gross margin $1,190 $ 920 $1,060
Other expenses 600 600 600
Pretax income $ 590 $ 320 $ 460
Income taxes at 40% 236 128 184
Net income $ 354 $ 192 $ 276
* Always equal across all three methods.

Chapter 7 Inventories and Cost of Goods Sold 347

** These amounts will not be equal across the three methods usually, because the beginning
inventories will generally be different. The amounts are equal here only because beginning
inventories are assumed to be equal.

348
7-69 (continued)

2. Income taxes would be lower under LIFO by .40($590 − $320) =

.40($270) = $108.

3. a b
Cost of goods available for sale $1,980 $1,980
Ending inventory
(90 @ $8) + (10 @ $7) 790
(60 @ $5) + (40 @ $8) 620
Cost of sales $1,190 $1,360
Sales 2,380 2,380
Gross Margin $1,190 $1,020

The specific identifications are often cumbersome, although

technology has reduced the cost of using them. They
obviously affect income and income taxes. This method
permits the most latitude in determining income for a given
period.

7-70 (15-20 min.)

This problem explores the effects of LIFO layers.
There would be no effect on gross margin, income before
income taxes, or income taxes under FIFO. The balance sheet
would show a higher inventory by $400. A detailed income
statement would show both purchases and ending inventory as
higher by $400, so the net effect on cost of goods sold would be
zero.
LIFO would show a lower income before income taxes, $240, as
compared with $320, a decrease of $80. Hence, the impact of the
late purchase would be a savings of income taxes of 40% of $80 =
$32. For details, see the accompanying tabulation.

Chapter 7 Inventories and Cost of Goods Sold 349

7-70 (continued)
The tabulation given below compares the results under LIFO:
Without Late With Late
Purchase Purchase
Net sales, 200 units $2,380 $2,380
Deduct cost of sales:
Beginning inventory 80 @ $5 $ 400 $ 400
Purchases, 220 units
and 270 units 1,580 1,980*
Available for sale $1,980 $2,380
Ending inventory:
First layer (pool) 80 @ $5 $400
Second layer (pool)
20 @ $6 120 520
First layer (pool) 80 @ $5 $400
Second layer (pool)
50 @ $6 300
Third layer (pool) 20 @ $7 140 840
Cost of sales 1,460 1,540
Gross margin 920 840
Other expenses 600 600
Pretax income 320 240
Income taxes 128 96
Net income $ 192 $ 144

*Purchases for 220 units $1,580

New purchases, 50 units 400
$1,980

350
7-70 (continued)

Although purchases are $400 higher than before, the new LIFO
ending inventory is only $840 – $520 = $320 higher. The cost of
sales is $1,540 – $1,460 = $80 higher.

To see this from another angle, compare the ending

inventories:

Late purchase added to cost of goods

available for sale $400
Deduct 50-unit increase in ending inventory:
Second layer is 50 – 20 = 30
units higher @ $6 = $180
Third layer is 20 – 0 = 20
units higher @ $7 = 140 320
Cost of sales is higher by $ 80

7-71 (20-30 min.)

This is a classic problem. Knowledge of discounted cash flow

is not necessary.

The discounted cash flow model implies that, other things

being equal, it is always desirable to take a tax deduction earlier
rather than later. Moreover, if prices rise, LIFO will generate earlier
tax deductions than FIFO. By switching from LIFO to FIFO, Chrysler
deliberately boosted its tax bills by $53 million in exchange for real or
imagined benefits in terms of its credit rating and the attractiveness
of its common stock as compared with its competitors in the auto
industry.

Chapter 7 Inventories and Cost of Goods Sold 351

7-71 (continued)

Was this a wise decision? Many critics thought it harmed

rather than helped stockholders because the supposed benefits
were illusory. For example, these critics maintain that mounting
evidence about efficient stock markets shows that the investment
community is not fooled by whether a company is on LIFO or FIFO --
that its stock price will be unaffected. An American Accounting
Association committee (Accounting Review, Supplement to Vol.
XLVIII, p. 248) commented: "If the capital markets are efficient in the
semi-strong form, this change was totally unnecessary and, from
the point of view of Chrysler's shareholders, constitutes a waste of
resources."

In sum, Chrysler gave up badly needed cash in the form of

higher income taxes in exchange for a higher current ratio (FIFO
inventory would be much higher than LIFO inventory) and higher
reported net income. In light of Chrysler's deteriorating cash
position in the late 1970s, Chrysler's tradeoff was unwise.

352
7-72 (40-60 min.)
1. LIFO
Buy
Do Not Buy(a) More Units(b)
Sales: 1,100,000 @ $5 $5,500,000 $5,500,000
Cost of goods sold (LIFO basis):
300,000 units, @ $3 = $ 900,000
800,000 units, @ $2 = 1,600,000 2,500,000
or
400,000 units, @ $4 = $1,600,000
300,000 units, @ $3 = 900,000
400,000 units, @ $2 = 800,000 3,300,000
Gross profit $3,000,000 $2,200,000
Other expenses 1,400,000 1,400,000
Income before taxes $1,600,000$ 800,000
Income taxes 800,000 400,000
Net income $ 800,000 $ 400,000
Earnings per share $ 8.00 $ 4.00

(a) Ending inventory, 100,000 units @ $2, $ 200,000

(b) Ending inventory, 500,000 units @ $2, $1,000,000

2. FIFO
Buy
Do Not Buy(c)More Units(d)
Sales: 1,100,000 @ $5 $5,500,000 $5,500,000
Cost of goods sold (FIFO basis):
900,000 units, @ $2 = $1,800,000
200,000 units, @ $3 = 600,000 2,400,000 2,400,000
Gross profit $3,100,000 $3,100,000
Other expenses 1,400,000 1,400,000
Income before taxes $1,700,000 $1,700,000
Income taxes 850,000 850,000
Net income $ 850,000 $ 850,000
Earnings per share $ 8.50 $ 8.50

(c) Ending inventory, 100,000 units @ $3 $ 300,000

(d) Ending inventory, 400,000 units @ $4 1,600,000
100,000 units @ $3 300,000
Total $1,900,000

Chapter 7 Inventories and Cost of Goods Sold 353

7-72 (continued)

3. Consider this question from a strict financial management

standpoint – ignoring earnings per share. When prices are
rising, it may be advantageous – subject to prudent restraint as
to maximum and minimum inventory levels – to buy unusually
heavy amounts of inventory at year-end, particularly if income
tax rates are likely to fall. Under LIFO, the current year tax
savings would be a handsome $400,000. This is at least a
deferral of the tax effect. The effects on later years' taxes will
depend on inventory levels, prices, and tax rates.

Tax savings can be generated because LIFO permits

management to influence immediate net income by its
purchasing decisions. In contrast, FIFO results would be
unaffected by this decision.

However, if management buys the 400,000 units and uses

LIFO, the first year earnings per share would be only $4.00.
Note too that LIFO will show less earnings per share than FIFO
($8.00 as compared to $8.50), even if the 400,000 units are not
bought. Such results may cause management to reject LIFO.
Earnings per share (EPS) is a critical number, and many
managements are reluctant to adopt accounting policies that
hurt EPS.

The shame of the matter is that the same business events can
dramatically affect measures of performance, depending on
whether LIFO or FIFO is adopted ($4.00 versus $8.50).
Although, the smart decision would be to adopt LIFO and buy
the 400,000 units, this decision produces the worst earnings
record!

4a. The income statement for year two would show the same net
income and earnings per share whether additional inventory is
purchased or not, because prices do not change.

354
Chapter 7 Inventories and Cost of Goods Sold 355
7-72 (continued)

LIFO FIFO
In year 2 Do not Buy Buy Do not Buy Buy
Sales $5,500,000 $5,500,000 $5,500,000 $5,500,000
Cost of goods sold 4,400,000(a) 4,400,000(b) 4,300,000 (c)
4,300,000(d)
Gross profit $1,100,000 $1,100,000 $1,200,000 $1,200,000
Other expenses 800,000 800,000 800,000 800,000
Income before taxes $ 300,000 $ 300,000 $ 400,000 $ 400,000
Income taxes 120,000 120,000 160,000 160,000
Net income $ 180,000 $ 180,000 $ 240,000 $ 240,000
Earnings per share $ 1.80 $ 1.80 $ 2.40 $ 2.40

Year 2 Cost of Goods Sold Calculations

(a) (b) (c) (d)
Beginning inventory,
see parts (1) and (2) $ 200,000 $1,000,000 $ 300,000 $1,900,000
Purchases:
1,700,000 units @ $4 6,800,000 6,800,000
1,300,000 units @ $4 5,200,000 5,200,000
Available for sale $7,000,000 $6,200,000 $7,100,000 $7,100,000
Ending inventory:
100,000 units @ $2 = $ 200,000
600,000 units @ $4 = 2,400,000 2,600,000
500,000 units @ $2 = 1,000,000
200,000 units @ $4 = 800,000 1,800,000
700,000 units @ $4 = 2,800,000 2,800,000

Cost of goods sold $4,400,000 $4,400,000 $4,300,000 $4,300,000

4b. FIFO shows $100,000 higher income before taxes ($60,000

after taxes) because 100,000 units of old, lower-cost inventory
is in Cost of Goods Sold:
LIFO FIFO
1,000,000 units @ $4 = $4,000,000
100,000 units @ $3 = 300,000
1,100,000 units @ $4 = $4,400,000 $4,300,000

356
7-72 (continued)

4c. The ending LIFO inventory is $800,000 higher in column (a)

because the 400,000 more units in ending inventory are priced
at $4 a unit when the inventory is not replenished at the end of
year one. In column (b), the 400,000 units purchased @ $4
near the end of the first year were charged immediately to Cost
of Goods Sold, leaving 400,000 more of the ending inventory
units at the old unit cost of $2. Under the LIFO assumption,
this inventory is regarded as untouched in the second year, so
the old $2 unit cost applies to the ending inventory of the
second year.

4d.
Alternatives
a b c d
Income tax for the two years $920,000 $520,000 $1,010,000 $1,010,000

Unless the LIFO layers are depleted, the adoption of LIFO will
result in permanent postponement of income taxes. However, if
the layers are invaded, these low-cost layers will cause higher
tax payments in later years than under FIFO.

4e. As far as the financial decision is concerned, the computations

in part (4) substantiate the conclusions in part (3). As far as EPS
is concerned, note that all EPS numbers decline in the second
year.

Chapter 7 Inventories and Cost of Goods Sold 357

7-73 (30 min.)

This problem highlights the fact that LIFO theory of matching

current costs against current revenues breaks down when the so-
called LIFO-base inventory is invaded. Then the costs matched
against current revenue are a conglomeration of old (often ancient)
costs and current costs. If prices have been rising for a long time,
the income tax liability can be unusually severe:

Requirement (1) Requirement (2)

Sales, 500,000
units @ $3.00 $1,500,000 $1,500,000
Cost of goods sold:
340,000 @ $2.00 = $680,000 500,000 @ $2.00 1,000,000
30,000 @ 1.20 = 36,000
50,000 @ 1.10 = 55,000
80,000 @ 1.00 = 80,000 851,000
Gross profit 649,000 500,000
Operating expenses 500,000 500,000
Net income before taxes 149,000 −
Income taxes @ 60% 89,400 −
Net income $ 59,600 $ −

358
7-74 (15-20 min.)
1. Figures are in millions of dollars.
Lower of LIFO
LIFO Cost Cost or Market
2003 2004 2003 2004
Sales 20 8 20 8
Cost of goods sold 14 13 14 8
Write-down of ending inventory – – 5 –
Total costs charged
against sales 14 13 19 8
Gross margins without write-down 6 (5)
Gross margin after write-down 1* 0

* Accountants use various formats for presenting the effects of write-

downs. Some deduct the write-down as a special loss immediately
after gross margin rather than having it affect gross margin. Thus,
under LIFO some would calculate the standard LIFO gross margin
and then adjust it.

Gross margin 5
Write-down 4
Gross margin less inventory write-down 1
The total gross margin for the two years combined is the same
for LIFO and lower-of-LIFO-or-market. The lower-of-cost-or-
market method is labeled as more conservative because it
shows gloomier results earlier in a series of periods.
2. If replacement cost were $9 million on January 31, 2004, no
restoration of the December write-down would be permitted. In
brief, the $8 million December 31 valuation became the "new
cost" of the inventory. Inasmuch as only write-downs below
cost are allowed in historical cost accounting for inventories,
no subsequent write-ups are allowed.

Chapter 7 Inventories and Cost of Goods Sold 359

7-75 (15-20 min.)
1. The change in the LIFO reserve is the annual effect on cost of
goods sold; in this instance $86.094 million – $83.829 million =
$2.265 million. Because the LIFO reserve rose, the use of LIFO
in this year decreased pretax income by $2.265 million.
Therefore, using FIFO, pretax income would have been
$359.495 million + $2.265 million = $361.760 million.
2. LIFO = .34 x $359,495,000 = 122,228,300
FIFO = .34 x $361,760,000 = 122,998,400
Difference = 770,100
Difference = .34 x 2,265,000 = 770,100
3. Yes. LIFO use reduced taxes in the current year by $770,100.
Historically the cumulative effect can be estimated by
multiplying the tax rate times the LIFO Reserve. .34 x $86.094
million = $29.272 million. Think of this as an interest free loan
from the government.

360
7-76 (15-20 min.)
1. Increasing. FIFO reports the most recent costs on the balance
sheet; LIFO reports older costs. Because FIFO amounts
exceed LIFO amounts, the most recent costs must be higher
than older costs. Therefore, costs have been increasing.
2. Amounts in millions:

(a) (b)
LIFO FIFO
Sales revenue $700.0 $700.0
Cost of goods sold 546.9 632.6*
Gross profit $153.1 $ 67.4
* $546.9 + $85.7 = $632.6
Gross profit is higher under LIFO. Old LIFO layers are charged
as cost of goods sold. Because prices have been increasing,
the cost of old LIFO layers is less than more recent costs.
Therefore, LIFO cost of goods sold is less than FIFO cost of
goods sold, resulting in more gross profit under LIFO when
existing inventories are completely liquidated.

Chapter 7 Inventories and Cost of Goods Sold 361

7-77 (10-15 min.)
O is used for overstated, U for understated, and N for not
affected. All amounts are $10 million unless otherwise indicated.

1. Effects of Fiscal Year

2002 2001
Beginning inventory O N
Ending inventory N O
Cost of sales O U
Gross profit U O
Income before taxes U O
Taxes on income U by $4mil* O by $4 mil*
Net income U by $6 mil** O by $6 mil**

*. 40 x $10 million = $4 million

** (1 – .40) x $10 million = $6 million
2. Retained earnings would be overstated by $6 million at the end
of fiscal 2001. However, the error would be offset in the next
year assuming no change in the 40% rate of income tax.
Therefore, retained earnings would be correct at the end of
fiscal 2002.

362
7-78 (20-30 min.)

1. Lancaster Colony’s cost of goods sold would have been $7.1

million more (charging the more recent costs) and its pretax
income $7.1 million less if it had replenished its inventories,
resulting in pretax income of $180.8 million - $7.1 million =
$173.7 million.
2. Because the LIFO reserve declines, LIFO earnings are higher
than FIFO rather than the opposite. The pre-tax difference is
merely the change in the LIFO reserve = $14.5 million – $7.4
million = $7.1 million.
FIFO pretax earnings = $180.8 million – $7.1 million = $173.7
million.
3. The LIFO liquidation per se increased earnings by $7.1 million
in 2003. The net change in the reserve incorporates both
decreases due to liquidations and increases ( or decreases)
due to rising (or falling) prices.

Chapter 7 Inventories and Cost of Goods Sold 363

7-79 (10-15 min.)

1. Cost of goods sold:

With the purchase, $380 x 8,000 $3,040,000
Without the purchase, $250 x 8,000 2,000,000
Difference $1,040,000
Income tax savings, .40 x $1,040,000 $ 416,000

2. This is an actual case. The only change is that the original

numbers were $300 and $160 rather than the $380 and $250
used here. The Tax Court held that raw materials may be
entered as inventory only if they have been acquired for the
purpose of sale in the ordinary course of business or for the
purpose of being physically incorporated into merchandise
intended for sale. Therefore, the taxpayer's cost of goods sold
should have included the cost of the lower-priced inventory
instead of the higher-priced year-end purchase.

364
7-80 (15-20 min.)

Gross Profit Percentage Inventory Turnover

Penney 03 $9,774÷$32,347 = .302 $22,573÷$4,938 = 4.57

00 $9,136÷$32,510 = .281 $23,374÷$6,004 = 3.89
95 $6,410÷$20,380 = .315 $13,970÷$3,711 = 3.76

Kmart 03 $4,504÷$30,762 = .146 $26,258÷$5,311 = 4.94

00 $7,823÷$35,925 = .218 $28,102÷$6,819 = 4.12
95 $8,033÷$34,025 = .236 $25,992÷$7,317 = 3.55

J.C. Penney has a consistently higher gross profit percentage

than Kmart. J.C. Penney generated higher inventory turnover than
Kmart in 1995 but not in 2000 or 2003. For J.C. Penney, gross profit
percentage fell while inventory turnover improved in 2000 compared
to 1995, but both ratios improved significantly by 2003. Kmart
consistently improved its inventory turnover but had a significant
decline in gross profit percentage.

Penney's higher gross margin percentage no doubt reflects its

chosen market niche which places more emphasis on style and
fashion and less on price. It is strange, however, that given Kmart's
low price strategy that Kmart's turnover was lower than J.C.
Penney's in 1995. In 2000 and 2003 Kmart’s inventory turnover
exceeded that of J.C. Penney, as one would normally expect. It is
instructive to relate these values to those for a company like The
Gap. The Gap’s 2002 gross profit percentage was about 34% and
inventory turnover was about 5.

Chapter 7 Inventories and Cost of Goods Sold 365

7-81 (15 min.) Amounts are in millions.

2003: Gross profit = KRW 59,569 − KRW 36,952 = KRW 22,617

Gross profit percentage = KRW 22,617 ÷ KRW 59,569 = 38.0%
Inventory turnover = KRW 36,952 ÷KRW 3,954 = 9.3

2002: Gross profit = KRW 46,444 − KRW 32,657 = KRW 13,787

Gross profit percentage = KRW 13,787 ÷ KRW 46,444 = 29.7%
Inventory turnover = KRW 32,657 ÷ KRW 3,611 = 9.0

The gross profit percentage increased from 29.7% to 38.0%,

and the inventory turnover increased from 9.0 to 9.3. Both of these
are good news to Samsung. The large increase in gross profit
percentage is especially significant.

366
7–82 (15 min.)

1. If the purchase were made in 2005, the cost of goods sold for
this instrument in 2004 would be:

30,000 units @ $60 = $1,800,000

+ 2,500 units @ $50 = 125,000
Total cost-of-goods sold = $1,925,000

If the purchase were made in 2004, the cost-of-goods sold for

this instrument in 2004 would be:

15,000 units @ $70 = $1,050,000

+ 17,500 units @ $60 = 1,050,000
Total cost-of-goods sold = $2,100,000

Therefore, if the purchase is made in 2004 instead of 2005,

cost-of-goods sold will be $2,100,000 – $1,925,000 = $175,000
higher, pretax income will be $175,000 lower, and taxes will be
$175,000 x .45 = $78,750 lower.

Chapter 7 Inventories and Cost of Goods Sold 367

7–82 (continued)

2. The LIFO inventory method allows managers and accountants

to manipulate income by purchases made near the end of the
year. A manager in Yokohama may want to maximize net
income, even if it results in higher taxes for the company.
Perhaps the manager has a bonus that depends on the
company’s net income. Such a manager might prefer the
purchase to be delayed until 2005.

It is not clear whether a 2004 or 2005 purchase (if either) is best

for Yokohama. The savings in taxes by purchasing in 2004,
which will be offset by higher taxes in subsequent years, is
beneficial because it defers the taxes, giving Yokohama the
$78,750 to use in the meantime. However, maybe there is a
debt covenant that may be violated if the extra $175,000 of
pretax income (and, therefore, an extra $96,250 net income) is
not generated in 2004. Or maybe the current ratio will drop
below an acceptable level if purchase is delayed to 2005.

Although there is not enough information to decide what is the

best decision for Yokohama, it is clear that manipulation of
income is possible under LIFO. This is likely to create ethical
dilemmas for managers whose performance evaluations (and
possibly personal wealth) may be linked to financial results or
who envision reported earnings affecting share price or debt
covenants.

368
7-83 (15 min.)

1.

Inventory
Balance 135,000 590,000
630,000
Balance X

Let X be the ending inventory balance:

X = Beginning balance + Purchases − Cost of goods sold

X = $135,000 + $630,000 − $590,000
= $175,000

2. Inventory shrinkage = $175,000 − $140,000 = $35,000

Inventory shrinkage expense 35,000
Inventory 35,000

Cost of goods sold = $590,000 + $35,000

= $625,000

3. Inventory shrinkage as a percent of sales is $35,000 ÷ $700,000

= 5.0%. This is high. Lola should look for ways that inventory
might be stolen, either by employees or by others. She also
may want to examine the new perpetual inventory system to
make sure that all costs of goods sold are being recorded.

Chapter 7 Inventories and Cost of Goods Sold 369

7-84 (15-20 min.)

1. An understatement of ending inventories overstates cost of

goods sold and understates taxable income by $500,000.
Taxes evaded would be .40 x $500,000 = $200,000.

2. This news story provides a good illustration of why a basic

knowledge of accounting is helpful in understanding the
business press. The news story is incomplete or misleading in
one important respect. The business owner's understated
ending inventory becomes the understated beginning
inventory of the next year. If no other manipulations occur, the
owner will understate cost of goods sold during the next year,
overstate taxable income, and pay an extra $200,000 in income
taxes. Thus, the owner will have postponed paying income
taxes for one year, paying no interest on the money
"borrowed" from the government.

To continue to evade the $200,000 of income taxes of year

one, the ending inventory of the second year must be
understated by $500,000 again. However, if only the $500,000
understatement persists year after year, the owner is enjoying a
perpetual loan of $200,000 (based on a 40% tax rate) from the
government. Data follow (in dollars):

370
7-84 (continued)

Honest Reporting Dishonest Reporting

First Year Second Year First Year Second Year
Beginning inventory 3,000,000 2,500,000 3,000,000 2,000,000
Purchases 10,000,000 10,000,000 10,000,000 10,000,000
Available for sale 13,000,000 12,500,000 13,000,000 12,000,000
Ending inventory 2,500,000 2,500,000 2,000,000 2,000,000
Cost of goods sold 10,500,000 10,000,000 11,000,000 10,000,000
Income tax savings @ 40% 4,200,000 4,000,000 4,400,000 4,000,000
Income tax savings for
two years together 8,200,000 8,400,000

Some students may incorrectly reason that understating

inventory each year has a cumulative effect. You may wish to
emphasize that the second year has the same cost of goods
sold in each column, because in the "dishonest" case both
beginning and ending inventory are understated by the same
amount. To evade an additional $200,000 of income taxes in
the second year, the ending inventory must be understated by
$1,000,000 (not $500,000) in the second year.

Chapter 7 Inventories and Cost of Goods Sold 371

7-85 (15-20 min.)

1. Raw material used = 1,500 shirts @ $3 = $4,500

Wages paid = 1 month = 1,600
Depreciation = 1,500 units
@ [$5,000 ÷ 10,000 = .50] = 750
Studio rent = 500
Total production costs $7,350
Cost per unit produced = $7,350 ÷ 1,500 =$ 4.90
Cost of goods sold = 1,200 x $4.90 = $5,880
Ending inventory:
Raw material available 500 shirts @ $3 = $1,500
Finished goods 1,500 – 1,200 =
300 shirts @ $4.90 = 1,470
Total inventory $2,970

2. SAM’S T-SHIRTS
Income Statement for January

Revenue 1,200 shirts @ $9 $10,800

Cost of goods sold 5,880
Income before tax 4,920
Tax expense 1,476
Net Income $ 3,444

372
7-86 (60 min. or more)

The purpose of this exercise is to develop an understanding of

inventory methods and to be able to explain an inventory method to
others. An individual student could compute the operating income
using all three methods, but using a team has two main advantages:

1. Each student can become thoroughly familiar with one

inventory method; students do not need to spend time making
calculations for all methods.

2. Explaining the computations involved with one inventory

method requires a deeper understanding than merely carrying
out the calculations.

A good starting point is to examine the 1987 and 1988 T-

accounts for inventory under LIFO and FIFO (amounts are in
thousands):
1987:
Inventory (FIFO) Inventory(LIFO)
Beg. Bal. 151,918 CGS 533,355* Beg. Bal. 140,918 CGS 533,555
Purchases 562,125 Purchases 562,125
End. Bal. 180,688 End. Bal. 169,488
* FIFO CGS is $200,000 less than LIFO CGS because FIFO inventory increased $200,000 more than did
LIFO inventory in 1997.

1988:
Inventory (FIFO) Inventory(LIFO)
Beg. Bal. 180,688 CGS 559,883 Beg. Bal. 169,488 CGS 560,233
Purchases 560,233 Purchases 560,233
End. Bal. 181,088 End. Bal. 169,488

The operating income statements for each inventory method

are:

Chapter 7 Inventories and Cost of Goods Sold 373

7-86 (continued)

FIFO:
Sales $1,015,198
Cost of goods sold (using FIFO) 559,833
Other operating expenses 417,283
Operating income $ 38,082

LIFO:
Sales $1,015,198
Cost of goods sold (using LIFO) 560,233
Other operating expenses 417,283
Operating income $ 37,682

Specific identification:
There is not enough information to compute a definitive profit
under specific identification. Probably the physical flow of
merchandise is closest to FIFO, so operating income would be close
to $46,716. However, to the extent that a strict FIFO flow is not
maintained, operating income would fall short of $38,082. Why?
Because some of the recent purchases, which cost 5% more than
earlier purchases, would be sold and the earlier purchases would
remain in inventory, boosting cost of goods sold and decreasing
inventory from the FIFO levels.

7–87 (45-60 min.)

Each solution will be unique and will change each year. The
purpose of this problem is to recognize different inventory
methods and their relationship to gross profit percentage and
inventory turnover.

374
7–88 (35-45 min.) Amounts are in thousands.

Inventory Calculation
1. Inventory Beginning + Purchases – Sales = Ending
263,174 263,174 + Purchases – 1,348,742 = 342,944

1,428,512 1,348,742*
Purchases = 342,944 + 1,348,742 – 263,174
342,944
Purchases = $1,428,512
*$1,685,928 x .8 = $1,348,742

2. Inventory turnover = Cost of sales ÷ average inventory

Inventory turnover = $1,348,742 ÷ ($342,944 + $263,174) ÷
2
= $1,348,742 ÷ $303,059
= 4.45

3. $4,075,522 − $1,348,742
Error! = .67 2003
$4,075,522

$3,288,908 − $1,080,009
= .67 2002
$3,288,908

$2,648,980 − $890,228
= .66 2001
$2,648,980

The gross margin percentage has risen very slightly over the
three years.

Gross margins for Starbucks are high. This is because of the

industry and Starbucks’ strategy. Starbucks charges a
premium price for its coffee and other drinks.

Chapter 7 Inventories and Cost of Goods Sold 375

7-89 (30-60 min.)

NOTE TO INSTRUCTOR. This solution is based on the web site as it

was in late 2004. Be sure to examine the current web site before
assigning this problem, as the information there may have changed.

1. In 2003 Teva represented 60.1% of Deckers’ sales. This

percentage has dropped steadily in the last 5 years from 72.9% in
1999, even though total sales of Tevas have increased.

2. Inventories are reported at the lower of FIFO cost or market.

The costs of inventories are probably not increasing fast enough to
give LIFO a large tax advantage. Using LCM is important to a
company such as Deckers because shoes can become out-of-style
and therefore have market values below cost. In 2003 Deckers has
a write-down of inventory of $882,000.

3. In 2003 the gross profit was $51,345,000, up from $41,530,000

in 2002. The gross profit percentage increased from 41.9% to 42.4%
over the same year. Management indicated that “The increase in
gross margin was due to several factors, including an above
average gross margin at the newly acquired Internet and catalog
retailing business, the favorable impact of the strong Euro, and
lower production overhead costs per pair, partially offset by an
increase in close-out sales.”

376