CHAPTER 6

COST OF SALES AND INVENTORIES
Changes from Eleventh Edition
Editorial and updated changes have been made.
Approach
This chapter can be assigned in two parts, if the instructor wishes to spend several sessions on these
topics. The second assignment can begin with the section titled “Inventory Costing Methods.”
By now, students will have had to deduce cost of goods sold if they have tackled the cases in previous
chapters. Nevertheless, for some students this deduction process is a difficult one to grasp, and it is
important that it be understood. Also, the mechanics of flows through a manufacturing company are
difficult to grasp. Students will encounter this topic again in Chapter 17, however, so it doesn’t matter too
much if they don’t get it here. This is another one of the topics that seems to be mastered only after drill
with a number of problems.
The choice between LIFO and FIFO also causes problems, perhaps because LIFO obviously does not
match the physical flow of goods. It should perhaps be emphasized that, regardless of the conceptual
merit of one method or the other, LIFO defers incomes taxes, and it defers them forever in an inflationary
economy. The discussion also provides a way of highlighting the fact that accounting focuses on the
measurement of income, even though the result is an unrealistic balance sheet (as is the case with LIFO
inventories).
Cases
Browning Manufacturing Company requires recording a complete cycle of transactions in a
manufacturing company. It is straightforward.
Lewis Corporation is a problem that contrasts FIFO and LIFO in a clear-cut way.
Morgan Manufacturing deals with the adjustment, comparison, and interpretation of financial statements
for two firms, one prepared using LIFO and the other using FIFO.
Joan Holtz (B) is the second set of discrete problems, from which the instructor can select those he or she
wants to discuss in class.
VAL Corporation deals with accounting for mileage programs.

Problems
Problem 6-1
The completed table is shown below. Each deduction involves the basic inventory equation.
Ending inventory = Beginning Inventory + Purchase – Shipments (COGS)
as well as the basic relationships inherent in any income statement, that is:,

1

............. 135........................ Sales.............. $ 900 $ 500 $ 150 $ (50) Problem 6-2 The required income statement is reproduced below.................................................................................................... Inventory............ 1...................................................................... Y Co.............................................................. $167...................250 $1........................................ 1.......................................................... W Co......................... Z Sales...350 cr..............................................................................................................................350 cr..................................................... Beginning inventory....................................000 Plus: Purchase...................................................................................................................000 cr..........................000 cr....................... 8........ 135................................................................................................................................................................................500 cr.................... dr...................................................................... 135......................... 325.................... 300 400 150 800 Net income (Loss)................................ dr.............................................................................................. dr........................................050 900 1.................... 167............................................ 28... 28............................... dr.........350 $2.............................................................................................................................................................500 g..................................................................... 28..................500 f..................................................................................................................100 Cost of goods sold:....................................... X Co.................... The closing entries are: a. Inventory.......................... Inventory.............................................................000 j..................................... dr..............................................................................................................................................................................................................................................................200 Less: Ending inventory....................................... 225 300 300 150 Cost of good sold................................................... $ 50.........................................................................................000 e...................000 h............................................................................................................................................................. Beginning inventory....................... Purchases..........................................................000 2 ................................350 Gross margin.............................................................................................................................000 Cost of goods sold:............................................... Cost of Goods Sold.............................350 i............000 d.................000 cr.........................................................................................................................................................................................................800 $1......................... Freight-in............................... 135..................000 b................................................................................................................................ Income Summary... 8..500 cr......................................... 28........................000 c.............................................................................350 GARDNER PHARMACY Income Statement for the Year ----............................. Income Summary........................................... dr......... 4. 300 225 500 300 Plus: Purchases................................................................ 325. Income Summary.....................200 900 300 750 Period expenses......................... Beginning inventory balance is $50............... 95............................ Inventory........................................................................ Other Expenses.......................................................................................000 cr......... Cost of Goods Sold.................................... Taxes Payable........................................................................................................................................................................000 cr............... 167.................. dr..................................................................................... $2................................................................ Tax expense................ Returns (to Suppliers)..............................................................050 1.................................................................... Income Summary......... 95......................................................... gross............ Tax Expense. 975 975 850 1............................................... dr... 4.........Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant Income = Revenues – Expenses Co.................................................................. dr............... Sales............................... $325..............................................................................

.000 Income before taxes............................................................................................................©2007 McGraw-Hill/Irwin Chapter 6 Freight-in......................................................................................................................................................................350 Net income...............................................................................................................800 Gross margin............................. 85...........................760 c.......................................................000 Goods available for sale...............560 Cost of goods sold.....................................500 dr...........................................................................................................................500 Other expenses................... 1..........................800 + 80 = 653 units............. GOULD’S COMPANY Income Statement Gross sales.................................. Sales......................................... $133.......................................................................................... ........................................................................ 133.........200 b.400 Less: Sales returns............. 85................840 Net sales..................................... 94.......................... 1.....................................500 Income tax expense........................................................................................................700 – 5............................................. $ 45............150 Problem 6-3 a.............. 1...........................500 Cost of goods sold.......... 85................ 135............ 28.................................. 645 The inventory shrinkage entry reduces gross margin by $645 (or shrinkage could be shown below the gross margin line as a general expense).................................... Inventory.............................200 cr....................................................................................................................... 66.............. 133..................................400 cr...........000 171..............................000 Less: Ending inventory........... 1................................................................. Cash (or Receivables).................................80 = $ 700 900 $1........................................600 3 ............................................................................... 4.......................................................... Problem 6-4 Purchases: 50 units @ 75 units @ Avg: 125 units @ Sales: 100 units $14 = $12 = $12................................................ Inventory Shrinkage 645 .. Inventory shrinkage has therefore been 653 – 610 = 43 units................840 Inventory.................... dr............ 213............................... dr.....................840 Cost of Goods Sold..................................................... 189........................................................................................................................................................ $131............... Cash (or Receivables).................. 163...........................................................................................................500 Gross margin............................................400 dr............... 1..................... Sales Returns....................................................................................................... Inventory...................................................................................................... The perpetual inventory records indicate ending inventory should have been 673 + 5...........................................................................................................................................................................................................................................000 Less: Purchase returns........................................................................................ cr.......................................................... 8.................................. Cash (or Payables)..............................................000 Net purchases............................................................................................................................ 95........................................................................................................................................................... 77........................................500 cr...................................................

......................................... 1..........................................................................................000 $ 134...................................................815 $25...........................................................................................020 $13..............035.................................. Cost Lifo Pretax cash flow................ Cost Lifo Sales.......... Fifo Av.............................................................. d..... After-tax cash flow...............................................465 $21.........250 Available for sale........... 14.......................................................................................................465 ($52........................................... Cost Fifo Lifo July 31 inventory................................000 Property taxes.................................... 565....................................... 872................................................... $ 320 $ 300 $ 350 Cost of goods sold....................... 27......... 47.550 ..............000 2........... producing the highest taxable gross margin of the three methods................................................................................................................................................................................................................................................................000 Depreciation–factory.............. $24...............600 1...................................................................................000 (5) Finished goods–transfers....................................................600 Problem 6-5 a.............. $52.........................................................................................000 (3) Materials transfer................................................................................................................................ 22.....................................943 $13.........522 7................................ ________ (2................................. $ 100..................................................000 $ 94......................................................................................000 (4) Indirect labor........................................................ Problem 6-6 a...........125 .......6% 48.........................................035...915 The tax payment in 30 percent of the gross margin dollars......000 (1) Purchases................ (900..000 Cost of goods sold........................................000 $ 370......................................$30...................................................1% 48.......000 (2) Direct labor.165 Fifo Av.............. Cost Lifo b.................................053 26....................................................................................... 27.... $21....................................................... --(2.............................................................000) 900...................................................................002.......... The cash flow using Fifo for tax purposes is the lowest of the three after tax cash flow amounts because the unit cost of computers is falling...............................................960 Gross margin.........................................3% c......................................................................................................................................................................... Ending inventory balances are: Materials Work in Finished Inventory Process Goods Beginning balance...............000 b..... Gross margin percentage.............................................Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant Ending inventory: 25 units Avg........ 46.......................................................... Fifo Av..............000 Factory utilities........................095.........................................................................................125 $52................................................... 147.........445 7................................ 46....................310 27......000 Factory supplies....................................................................... ...................................................125 Cost of goods sold....000 $ 60.......................................000 Delivery charge..........................................000) Ending balance............... $14...............................465 $21...........125 $52.............................................................................000 Depreciation–Mfg........... Net cash flow = $21.........................................280 1............465 Tax payment 7........................................................................000 134.................................. 4 .................................................................... 1..........600 1........................................................300 1...000 $ 93....................................................... 54....... Gross margin was 23 percent........................................................................................................000) 2...........072 $25............................................... $ 94....................................................................................660) No change in pretax cash flow figure using different inventory methods........................................

.........200 * This Teaching note was prepared by Robert N..................... placing the T-accounts side-by-side (if board space permits) and using arrows to denote flows from one inventory account to another........................................................................... this case is a miniature practice set and can be treated as such if desired............................................................... Approach This is a straightforward complete accounting cycle in a manufacturing company........... Tracing through these entries is intended to give the student an understanding of what goes on in a manufacturing company and how these events are reflected in the accounts....................................... It is a key case.................... it is desirable that some time be left for Question 3............... .......................... 5 .................................. I make a concerted attempt to link the problem’s numbers to Illustrations 6-3 and 6-4 in the text..........200 Sales Discounts (R/E).............................................................................. Anthony.......................562.................... 2...................................200 Accounts Receivable.................................©2007 McGraw-Hill/Irwin Chapter 6 Sales........000 Cost of goods sold............................................. Students may find it helpful to refer back to the journal entries described in the text as a guide........................................600................................................................ Simply because of its length... two days may be necessary for this case. Copyright © Robert N..002................................................. Accounts Receivable........................000 Gross margin..............................................................000 Sales (Retained Earnings)..................... Accounts Receivable................................. Anthony............................................................... which asks the students to use the information they have built up.. 2. In any event..................000 Sales Returns and Allowances (R/E) 19...........................................562................................................. In effect..................................200 ................ 49................................ 19............. 49.............000 Problem 6-7 Item A B C D Units 30 40 20 40 Valuation Basis/Unit $145 173 131 113 Historical Cost/Unit $150 183 134 113 Total adjustment Total Adjustment $150 400 60 0 $610 Cases Case 6-1: Browning Manufacturing Company* Note: This case is updated from the Eleventh Edition....... Comments on Questions Question 1 1.......................................................................... $2............ $ 598........... 2.. although it is considerably longer than previous cases of the same type.............................................

............. the following entry should be made....................................000 Cash.000 Accounts Payable....................................................................400 Income Taxes Payable (2005)....400 Cash......................................... 874....................... and Light....................................000 Accounts Payable...........................................000 Cash..................................................................... 7...................................................................................................................................................000 Finished Goods Inventory....................... 78............................................................................................................................................... 61...000 Indirect Manufacturing Labor ...................................................... 788...................... 1....................................400 Accumulated Depreciation......................................................................................Accounting: Text and Cases 12e – Instructor’s Manual 2.....................................................................................................................................952 Cost of Goods Sold (R/E).............. inventory is assumed to increase in value by the amounts spent to convert materials into salable products....................................000 Indirect Manufacturing Labor..........600 Selling and Administrative Expense (R/E)..........................400 Work in Process Inventory..............624 Cash...........................................................901..........901....................................................................................................................................................................................................................................................................400 Cash . 66........................................................................................................................000 Cash................................................................................................. (a) (b) Anthony/Hawkins/Merchant Manufacturing Plant Equipment.............................................. 2................................................................................................................ 140.........200 Work in Process Inventory................................200 Supplies Inventory.................................. 300.......... 38....................................................... or the debit entry above could have been made to Work in Process Inventory directly............... 135.............. 811.................................................... 61.........................................................................................................000 Notes Payable.............................................................000 Accounts Receivable....................................................800 Prepaid Taxes and Insurance................................................ 264......................................................................................................... 144......................................... 135........................................ 1...................800 Direct Manufacturing Labor..............................................................................000 Social Security Taxes..........................................................................................................................................000 Estimated Federal Income Taxes Expense (R/E) 58........................200 Power.....................000 (2006)...................................................................000 Cash..................................................................................................................................................................... Work in process inventory................................ Heat.................................................................................................................000 Accounts Payable...... 492...... 6 .. 78...................................................................................................200 Power.....952 Work in Process Inventory...............000 Work in Process Inventory... 198.................................................................................... 2.................. 8..... 1.......................................000 Materials Inventory............................................................................................... 522................. 52................... 5......... 811................................................ 52...........604....... 4........................................ 264....................................... 9..............................................................................................000 Direct Manufacturing Labor...... 522.................... 9... 874......................... 198................................. 49..........................................................................................................................................................................................................................................................................................................................................................................000 Social Security Taxes......................................................................................................................................... 66.................604.................................................................................806....................................................... 300... 788................................................................................................................................................................................................................................................................................................................................. Heat................................................................................. 9.............................................................................................800 Work in Process Inventory..................................................................................400 Cash.....................................................................................................................000 Notes Payable.............................................................................................................................................................................. 492.....................................000 Prepaid Taxes and Insurance............ as is done in the T-accounts to follow..000 Cash................. 38.........................................806................................................................................................. 49................................................................................................................................. 825............................................................................................................................ 825......... 1........................................000 Interest Expense (R/E)....800 Since in a manufacturing company...............................600 Cash............................................ 6......... 144.................000 Materials Inventory....................................... (c) 3................................... and Light.. 140............................................624 Finished Goods Inventory.................................................................................................................................................................000 Supplies Inventory........................................................................................

......200 (1) 2........112.... Why the slowdown (about 13 days’ increase)? Bal......200 22..... It is expected that more funds will be tied up in inventories.... 352................562.280 . relative to the sales increase. Net sales are expected to increase 11..040 (5) 1.......) Question 3 1.. Cash. (2) (3) (3) (3) (3) Bal..200 (7) 2. Chapter 6 Income taxes payable (2006)........55 times for 2006.440 Bal........... (2) Accounts Receivable (Net) Bal............. 30........... Materials Inventory 110.. Gross profit margin is expected to decrease slightly from 29...... 52..........952 874...........520 (3) 811..520 935.......4 percent increase in selling and administrative expenses..6 percent...640 144..000 .......©2007 McGraw-Hill/Irwin 10.. 2....760 (1) 19.................000 874... it is projected at 2............ 3.....000 ________ Bal.... The net effect of the foregoing is an anticipated decrease in profit before taxes........... 210..... 201.. 5............800 61.. Profit would be increased by judicious reductions in the anticipated selling and administrative expense...448 140.............000 (2) 2......200 30.....400 52....... 2.000 52...............104......952 Bal................................200 Dividends (Retained Earnings) 30....000 ________ 2.. 311.....873.806.........080 83..000 (2) (2) (6) (6) (8) (8) (9) (10) ________ Bal.........800 Bal........000 (1) 49........873........400 9...080 61..............5 percent in 2006........901..520 935. (6) (7) Bal....604...800 522..............000 Bal...200 811.368 Bal..440 149...000 Question 2 (see pages 102 ...000 Bal..... 83...........280 (3) 66....624 1..986.... This seems high..520 Bal..................... 124..................604.......760 Bal...400 Bal..............000 825........000 149.......200 (1) 1.448 Bal.. 5......280 22................901..............360 2............. ... 7 Supplies Inventory 17.....................400 788......640 2....8 percent of net sales in 2005 to 27.........800 Cash..760 2...000 38. Cash 118........ Inventory turnover in 2005 was 2.................. There is a l9........ perhaps R&D expense in increasing........ 4.........000 300.82 times.....400 2.. 210..112............520 124....000 78.... or by actions to restore (or improve) the gross margin percentage...986. (4) Finished Goods Inventory 257....360 Work in Process Inventory 172..440 (2) 264............... 201.... (2) Bal.....

.....................391..... 868.......................360 Capital Stock Bal.............................920 144.....Accounting: Text and Cases 12e – Instructor’s Manual Bal................. Accumulated Depreciation 1..................................800 78.....368 8 ......760 1.800 14..200 Bal..000 Bal...047. 91............................. Additions to plant are slightly greater than depreciation expense..400 58...........................200 (1) 2. (2) Prepaid Taxes and Insurance 66....................158.................. 2.....520 Work in process....................806.... $ 449.......................822......................840 Fed......... (6) Bal.......600 Bal...............400 2...............760 288........... 2.....720 (3) 52...400 Bal. 252.... 829......360 Inventories:....................350 (2) 825......................000 ________ (2) 66..512......992 352. (1) (1) (2) (5) (6) (9) (10) Bal..047.................... 1..136 ________ 3.624 38...........720 144.200 ________ (3) 140.840 264.......448 Finished goods................................ 1...... 201. 7.................... Materials.............800 Retained Earnings 19............400 Notes Payable 300........ Is the collection department being overly optimistic about collections on account? BROWNING MANUFACTURING CORPORATION Projected Balance Sheet as of December 2006 Assets Current Assets Cash and marketable securities...... 91.........076..............000 30........000 Manufacturing Plant 2........................720 Bal..822.368 Anthony/Hawkins/Merchant 2... 210......... (8) Ba1......600 1........400 144..........000 552..... 907.... 9.....560 49.047.............. (2) Bal............800 Bal.000 Bal.......... This is not unusual in an inflationary era..........560 Bal...............076........047.......822..000 1.....640 Accounts receivable (net)...... The accounts receivable balance will decline by about 35 percent even though there is an expected increase in sales............................... $124......... Bal...................... Accounts Payable 788............. 288... Taxes Payable 9...... 352. Whether this is wise may depend on the notes payable interest vis-à-vis the return being earned on marketable securities..800 5..........400 1..........400 2........000 522....000 ________ 2................400 Bal....562.........678.........600 (8) Bal.................136 6.000 1. 5... 185......800 (9) 14..000 Bal............. 288...........840 252.391........000 5. Inc..560 3........920 Bal.....600 Bal..822.......... 8....840 (6) 552...158.840 Bal...000 868... It is planned to reduced notes payable...992 Bal..760 Bal...................

.......................562..................................000 Shareholders’ equity: Capital stock 1................................................................................................................... 1/1/06........................ 2..........000 Plus: Factory expenses:........................................................................................512.................................... 686..................................200 Materials inventory......................................................800 Total current liabilities $ 547.............................................................416 ........................................360 Notes payable 252........976 Less: Selling and administrative expense.........................................520 Materials used ....................©2007 McGraw-Hill/Irwin Chapter 6 Supplies 22.................. $2............................................................................ $ 172.......................................................................................................................................................................................................................136 Liabilities and Shareholders’ Equity Current liabilities Accounts payable $ 288........................400 Net sales..............................600 Less: Cost of goods sold (per schedule)..............................................................................................................................................................................576 Less: Estimated income tax expense 58...................................................... 164.............. ... ................................800 Total assets................................................................................... $19.............................................927................................................047...927....................................136 2........................................................200 Sales discount allowed.................................................................. 1................... 126.. $ 257.......................400 Income before federal income tax............ $ 68............ 124.........................400 Less: Accumulated depreciation...................................................... 2....................................................................................................................................................................................136 Total Liabilities and Shareholders’ Equity $2..200 68........................................................................... $2..493...................920 Total current assets.................................................. 811.520 Plus: Purchases...................................................................................................452.............. Prepaid taxes and insurance....................................................... 1/1/06............... 9 .........600) 1........................000 Retained earnings 868......................336 Manufacturing plant..........................................................................................520 Less: Materials inventory 12/31/06..................... $1.........................840 Income taxes payable 5.............. 91............................................................................... 825..................................624 Gloss margin.........................................................................000 Less: Sales returns and allowances............................................. l/1/06........................000 Operating income................................................................................................................................................................380............................................. 49...040 Work in process inventory...........................774.................................................................................................................................................................576 BROWNING MANUFACTURING CORPORATION Projected 2006 Statement of Cost of Goods Sold Finished goods inventory..................................................................................000 935....................080 709............ $ 38.......................................................................................................................... 522....................................................................................................... $110........................................................................................ ( 1........806...........976 Less: Interest expense..............................136 BROWNING MANUFACTURING CORPORATION Projected 2006 Income Statement Sales.............................................................................................................................................................................................................................................. Net income...000 ..............................822..................................................................

.................................................................................. 49........................................................................................000 Factory overhead:.806................................... 61..................... $198......................................................................................................000 Power........................................................................... 352.....................................112.........400 Less: Work in process inventory................................................. Indirect manufacturing labor..400 Social security taxes................................448 Cost of goods manufactured....... heat..............952 2......................................368 Cost of goods sold. factory......................................................................................... $1............................................................. 140......................... 210...................200 637............................................................................................................................................................................ 52......................600 Depreciation of plant.................................................................................................................................................................................................................. 1...........................................................................901....................... 12/31/06.........................................................992 Less: Finished goods inventory.........200 Taxes and insurance................................... and light.....................................................................................................................................624 10 .................................................Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant Direct manufacturing labor........ 12/31/06................. 135..........................................................................................................................158...................800 Supplies............................................... 492.............200 2.................

Via Question 3.00 * This Teaching note was prepared by Robert N. the student can see the impact of a sales decline causing a “stripping off” of LIFO layers with the result that LIFO reports a lower cost of goods sold.00 $56.00 7. one reason some companies continue to use FIFO in circumstances when LIFO would improve cash flows is that their managements do not believe that EMH premise that the lower reported earnings from LIFO would not diminish shareholder value.00 16.300.500. Students can discover that the LIFO reserve is useful in analyzing financial statements.020 @ @ @ 21.00 21.150.50 21. For those who wish to do so.50 = = = 8. rather than only read about the differences among these methods.00 420 400 200 1.620. the LIFO reserve can be used to adjust the LIFO financial statements to a FIFO basis.820 @ @ @ @ $20.00 20. is applied year-by-year. than would FIFO. Invent + Purchases = COGS + End Invent. and then the equation Beg. with an emphasis on the income tax—hence.800. Calculations for Questions Question 1 The approach below reflects how most students perform these calculations. It can be used to estimate the cumulative tax savings realized by adopting LIFO.25 21.25 21.800. This case presents that opportunity. 11 . Anthony. and when trying to compare the financial performance of a company using LIFO to another using FIFO. this discussion can bring in the Efficient Markets Hypothesis.00 200 400 800 600 @ @ @ @ $21.00 = = = $36. class time allows showing only a couple of years for FIFO and LIFO.820.150.500. In our view.00 4.25 = = = = $4.980.25 21. and one year for average cost.00 20.00 8. Question 5 presents the opportunity to challenge the widely held notion that almost all companies use LIFO (the instructor can update the text footnote on LIFO usage by referring to the latest edition of Accounting Trends & Techniques and to discuss the reasons for many companies’ use of FIFO. FIFO: COGS Inventory LIFO: COGS 2005 1. Anthony.00 $21. With the more detailed approach students take. Approach We have found it useful for students to perform some comparative FIFO/LIFO average cost calculations.840 600 380 2.00 8. Question 4 introduces the significance of the LIFO reserve. At some point I show them (to their chagrin) that a lot of effort can be saved if the amount of each year’s purchases is calculated first.00 12. and thus would result in higher income taxes that year.00 12. cash flow—implications of the choice of a method. This adjustment will be explored in more detail in Case 6-3 Finally. Copyright © Robert N.300.©2007 McGraw-Hill/Irwin Chapter 6 Case 6-2: Lewis Corporation* Note: Updated from Eleventh Edition.930.

00 = 16.00 20.300.00 Inventory 40 1.00 COGS 2.500.75 23.00 $23.000 1.50 21.820 @ $20.456 = $20.72 Inventory 1.400.250.00 14.820 @ 20.509 = $66. which is the sum of the beginning inventory and purchases (i.247.00 22.00 22.12 Note in all three cases that the sum of the cost of goods sold and ending inventory amounts is the same: $78.25 21.00 8.00 15.00 $66.150.00 14.400.520.00 15.00 = $20.830.25 22.92 Inventory 1.00 15.e.450.400.00 15.620.050.400.456 = $57.130.685.00 4.385.925.020 @ 20.190 12 880.50 = = = = $22.00 = = = = = = $ 8.820..00 $27.00 .00 22.040 @ @ @ 22.080 @ $21.080 @ @ @ @ $ 22. FIFO: LIFO: AVERAGE COST: FIFO: 2006 420 400 200 700 700 660 3.50 21.00 Inventory 20 1.500.250.00 22.270. available for sale).040 @ 21.950 @ @ @ @ @ $ 22.320.00 Inventory 1.00 $66.00 $58.25 = = $ COGS 1.00 21.25 22.50 20.250.00 20.00 22.50 22.080 @ @ @ @ @ @ $ 21.Accounting: Text and Cases 12e – Instructor’s Manual AVERAGE COST: Anthony/Hawkins/Merchant 820 2.865.000 1.020 @ 20.00 = = = $ COGS 3.040 @ @ @ $ 21.830.00 $20.000 700 210 2.020 1.50 21.50 22.050.00 430.050.369.00 21.000 700 700 680 3.00 23.00 = = = = = $ @ @ 23.509 = $22.720.36 2007 40 1.00 15.50 = = $11.00 4.240.00 COGS COGS Inventory 490 700 1.00 $67.550 (slightly different with average cost because of rounding errors).00 880.00 16.

.......150 Gross Margin......... 17....150 67......................50 37.........................................................50 = = 430......................................................................880 COGS.. 66.......240 66...........................925................00 19....547 = $24............ this difference is really irrelevant for deciding what to do in future years.........................674 2007 Sales..........240 67........................................... $ 23.00 $67.......275 LIFO $ 58.........950 1...........00 = $16........................00 $20................... 15..........................................................................©2007 McGraw-Hill/Irwin LIFO: Chapter 6 COGS 700 700 700 850 2....00 $66....22 Question 2 The calculation of the $1............................................406 13 ............205..... 38................... 15.........................110 COGS.........65 Inventory 1..............................75 22....600 24......... 43................................93 Inventory AVERAGE COST: COGS Inventory 2005 2006 2007 2007 Check on Calculations FIFO $ 56..............00 15.....717....638 Sales...513.................00 22...........880 $95...........................................600.............00 15..........................................................65 26.............................00 Net Income ............................................320 67.......................................................................COST $ 57................................................................ 56.110 $110................50 COGS......................................................145................190 @ 22.................................092 Net Income........................ 39......................446.......50 $105....................385 27................. 66...462...................................................190 2........00 Gross Muffin..........................93 $217..00 3..547 = $26........50 $ 22...........790 Tax Expense...................400................600.........................462...............278...........862......... $ 26...............................................................275 AVG......................................................................................................................870 42......385....................00 20 150 @ @ 21..........125...........950 @ $22..................020 @ @ @ @ $23... 2005 2006 FIFO LIFO Sales..........50 = = = = @ 20.................................077....513..................92 66..72 66........720 $217.............930 66.......685.......116 Net Income............................................... However................370 $22..... $105..............................................................322 $ 25.........................00 67................00 16....50 Tax Expense...205 $217.....................580 15..320 Gross Margin.........................247.................... $110..830......................00 COGS 1................450....................730 Tax Expense...548 17.. $23..50 23..................... $95...........................................................................930 58..........50 22.............50 Total Tax Expense Savings: 2005 $ 488 2006 432 2007 486 $1........................830....................406 tax difference for 2005-07 is shown below..375......100..........................................950 37........631.........

............525 $96..........50 24..... Similarly....130 - LIFO Inventory $20.......840 3.700 sales + 400 ending inventory ......$56.300) is equal to the sum of the differences between LIFO and FIFO cost of goods sold for 2005 and 2000.....................................792 Net income ......565 34.......000 FIFO LIFO 2008 Sales (2......045 Gross margin.190 beginning inventory = 1.................. * 2. 14 .910 150 20 620 2.375 430 12............270 16.. the LIFO reserve ($1........................................... is realizing that the threeyear COGS difference is equal to the difference in 2007 year-end inventories ($27................................525 COGS............... in 2000..................910..830 Another way to look at the LIFO reserve is that it represents the cumulative difference between LIFO cost of goods sold and FIFO cost of goods sold...................00 = = = = $45.........539 $20..220) is equal to the difference between LIFO cost of goods sold and FIFO cost of goods sold ($58........................026 13..... is to note that the three-year difference in COGS is $3.00 = $9....930 = $1.620 $23..............1.............................450 36..............480 Tax expense ...... the LIFO reserve ($2...600 1..400 $62.................... as shown on the next page. LIFO would cause an increase in tax expense of $766................ Question 4 The LIFO reserve is the difference between inventory calculated under the FIFO method.............00 = $8..........150 ........ and 40 percent of this is $1........515)................ $19.............. We can see that in 2005.406..........................515.....220).................220 $2...00 22.........720 ....50 21....Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant An easier approach.............400 $20.......00 23..205 = $3.......50 20.................................... and inventory calculated under the LIFO method......$24........00 = = = $11............75)............ Even easier.700 @ @ @ $23... which most students will overlook.. Question 3 Purchases for 2008 forecasted at 1............... 63.........910* cartons @ 24..960 400 @ $24..............510 2.........960 62..300 = = = FIFO Inventory $21.... but much more subtle.............................................700 @ $35............. 13..................... $96.. 32..........688 In 2008................ 2005 2006 LIFO Reserve $1................700 @ @ @ @ $24.........................240 $63....................045 400 @ 20.00 FIFO COGS Inventory LIFO: COGS Inventory 490 700 1........

.. Copyright © Julie H.. and net income than FIFO.............. Answers to questions: 1.. but the financial measures of performance of the firm using the LIFO method will look worse than the financial measures of the firm using the FIFO method (or the underlying economic performance of the LIFO firm might be even better than that of the FIFO firm..... for two companies to have identical underlying economic performance........ Morgan Manufacturing may not require a full class for discussion.... 3......320 FIFO cost of goods sold. Westwood’s gross margin percentage = $900 divided by $2........930 66................... and the LIFO firm’s financial measures can still look worse!)............. Hertenstein.............. gross margin............ pretax net income... owners’ equity....... This case extends the learning developed in question 4 of Case 6-2... and the instructor may want to assign it in conjunction with Lewis Corporation......... 2...... Lewis Corporation...... therefore...............300 Therefore......LIFO reserve (year X-l)] Tax savings (year X) = [LIFO reserve (year X) ................. 15 ... Understanding the significance of the LIFO reserve can be very useful when trying to compare the financial performance of companies using different inventory accounting methods..080 = $2.. pretax return on sales = $300 divided by $2.. assuming the norm of continuing inflation and growing inventory.................[LIFO reserve (year X) .........LIFO reserve (year X-1)] *(1 – tax rate) Cumulative tax savings due to the use of LIFO = LIFO reserve (year X) Most companies on LIFO report the LIFO reserve in their financial statements...... if you are given LIFO cost of goods sold and inventory.............©2007 McGraw-Hill/Irwin Chapter 6 2005 2006 LIFO cost of goods sold. Morgan Manufacturing is a straightforward case to illustrate how information on the LIFO Reserve can be used to adjust the results of a company on LIFO to make them more comparable to those of a company on FIFO..... often in the inventory footnote.. * This teaching note was prepared by Julie H......... For example......... you can estimate the following: FIFO inventory (year X) = LIFO inventory (year X) + LIFO reserve (year X) FIFO COGS (year X) = LIFO COGS (year X) ......... plus comments earlier in this note...... and you are also given the LIFO reserve for that year (year X) and the previous year (year X-1).. Typically. Hertenstein......... LIFO produces higher cost of goods sold and lower inventory... to have to guide them to recognize what other accounts and financial items are also affected.. If cost of goods sold is affected...240 = 13. 56..... Case 6-3: Morgan Manufacturing* Note: Updated from Eleventh Edition..000 = 15%................ however........ Question 5 See “Why More LIFO?” section of the text.... tax expense and net income will also be affected............000 = 45%......240 Difference..................... tax expense........150 $67........... pretax net income........... It is possible...... $ 1.......... $58. then clearly items such as gross margin.........4%....... then some other balance sheet account must be affected to keep the balance sheet balanced................ Adjustment to 2006 inventory: $100 LIFO inventory + $70 LIFO reserve = $170 FIFO inventory. Students will quickly recognize that both the inventory and the cost of goods sold accounts are affected........... pretax return on assets = $300 divided by $2....................... if inventory is affected.... Students will likely conclude it must be retained earnings or owners’ equity..........220 + $ 1. You are likely...........

Thus. it is also the adjustment to total assets. one is trying to compare “apples and oranges.$60 = $1. you would like to get the companies on a common basis. In Chapter 5. these affect financial measures. The first point regarding the adjustments is that you have LIFO reserve information.5% Adjusted pretax return on assets $350 divided by $2. You may want to raise the issue of what to do if you want to compare after-tax results. (and since there is not an analogous FIFO reserve).6% 4. you may wish to first discuss.050 Adjustment to 2006 gross margin: $890 + $60 = $950 Adjustment to 2006 pretax net income: $290 + $60 = $350 Adjusted gross margin percentage = $950 divided by $2. which is frequently available in the inventory footnote or elsewhere in the annual report of a firm using LIFO. how you can adjust results to make them more comparable.170 + $70 = $2. as well. You can write them on the board. As indicated in the answer to question 2. The LIFO reserve represents not only the difference between LIFO and FIFO inventory. students encountered different revenue recognition choices which produce different financial results for the same underlying economic events.5% Adjusted pretax return on sales $350 divided by $2. instead of the pretax measures that the case suggests. In addition. Some students may want to adjust the tax expense of the LIFO firm. Morgan has paid less in taxes than Westwood. and put up Westwood’s for comparison when students answer question 1.240 = 15. which allows you to make adjustments to the income statement as well.000 = 17. conceptually. Morgan’s performance exceeds Westwood’s on each of the three measures. Once adjusted to FIFO.Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant Adjustment to 2006 total assets: $2. When firms choose different inventory accounting methods. but also the cumulative difference between LIFO and FIFO cost of goods sold. it can be used directly to adjust inventory. When trying to compare one company on LIFO with another on FIFO. of course.000 = 47.240 Amount to adjust COGS: $70 -10 $60 2006 LIFO reserve 2005 LIFO reserve Difference between 2006 LIFO and FIFO COGS Adjustment to 2006 COGS: $1. allows you to make adjustments to achieve a common basis for comparison. for example.110 . The three key measures for Morgan are given in the case. the LIFO reserve for two consecutive years can be used to compute the difference between LIFO and FIFO cost of goods sold for the more recent of the two years. you must adjust the LIFO company to a FIFO basis. a comparable adjustment can be made to owners’ equity to keep the balance sheet in balance. this issue. as shown in the first two lines of Exhibit 1. using the same ratio of tax expense to pretax net income as shown on the LIFO income 16 . Since the LIFO reserve is the difference between the LIFO and FIFO inventory. and how this choice affects the financial statement reader’s ability to compare the two companies. The LIFO reserve. as shown in Exhibit 1. Pedagogical Approach You can begin with a general discussion of why we often want to compare the financial performance of different companies and how our ability to compare companies is affected by the different accounting choices that they make.” For purposes of comparison. is much broader than simply the choice of LIFO or FIFO. you may need to draw students out on which accounts and measures will be affected by the choice of inventory accounting method. and similarly. Before proceeding to the calculations in question 3.

....... Exhibit 1 Gross Margin % Pretax Return on Sales Pretax Return on Assets Morgan (LIFO).... 47.... LIFO is based on a belief about economic flows.... Of course... There should be a credit to Inventory....... reflecting the fact that the LIFO company paid lower taxes due to its choice of the LIFO inventory accounting method.................0% 15....... Others may argue that the tax expense should be unchanged.. and hence the gross margin percentage............... Copyright © Robert N...4% Westwood (LIFO).0% 13......... and discounts not taken decrease income in what is perhaps a later period. and the economics of the operations of the hardware dealer are best reflected by the LIFO method. The debit may be either to Cost of Goods Sold or to an operating expense item... 3. and affect net income in the period in which the goods are sold.. students will quickly observe that Morgan’s performance was better on all three measures... The case is unchanged from the Eleventh Edition.... cost of goods sold reflects the full amount of the discount. LIFO advocates know that physically the goods tend to move on a FIFO basis....... a true economic difference between the two firms...... they affect net income in an earlier period than in the first method............ The practice of debiting of Cost of Goods Sold is often followed..4% Morgan (Adjusted)........... so the above differences often are not material 2....... Joan Holtz (B) is an extension of Joan Holtz (A) in Chapter 5...... is the same under all three methods...... reflected in Morgan’s financial performance measures..... Literally.......... Following the conceptual discussion.... wherever it is reported................ Anthony.................5% 17.. Anthony............ it might regard the income tax savings as being more important than a correct showing of economic income....... 1... to reduce it to the amount found from the physical inventory. 45.... The ultimate effect................ If discounts not taken are recorded as an expense... over the life of an entity......... the actual calculations can be examined and the results posted on the board..... It is incorrect to say that the LIFO method “assumes” anything about the physical flow of the goods............... differs under each of these methods.. the economics of the operations of the automobile dealer are best reflected by the FIFO method (or even better by the specific identification method.... the methods result in different net income.................. Another difference is that cost of goods sold..... If reported as other income of the period.6% Case 6-4: Joan Holtz (B)* Note: In discussing some of these questions... perhaps related to the illustrations in the text.......... 17 .. the amounts involved are usually small......... For a given accounting period.......................... the automobile dealer would not necessarily be wrong to use LIFO...... 44. In the examples given....... For management purposes............... the shrinkage cost could not have been a cost of the goods that actually were sold.... From these results... it may be useful to construct simple numerical examples...... it is desirable to identify the amount of shrinkage....5% 14.... they reduce the net purchase costs..............©2007 McGraw-Hill/Irwin Chapter 6 statement............................... which probably approximates FIFO).... * This teaching note was prepared by Robert N.............. They may also conclude that the productivity improvements that Charles Crutchfield had implemented were.................... for these goods were not sold.......5% 13.. indeed.. as shown in Exhibit 1..5% 15...... however........ as explained in the text.. however. Even so... If purchase discounts are deducted from purchases............ 4.........

000 Interest @ $0.......... rather....... Therefore it does not affect the ratios used above... movies...000) is perhaps better due to the belief that at least $300.. The argument against including these costs in inventory is that they are not costs of producing whiskey...... In the first full year. this generalization is valid.......... 20.... 8........... unless these costs are included in inventory.......................... and disregarding the present value of money...000 On each gallon added to inventory............ and interest are charged to expense..........000)........ The contrary argument is that these costs are incurred in order to bring the whiskey to a salable condition and they therefore should be included as inventory cost.... Although the LIFO inventory as a whole will normally be reported at less than current costs.000 $625....... the ratio to be used in the second year would be 1/2 ($300.. profits will decrease at the very time that the increase in production indicates that the company is prospering.. 18 ......) In any event................ Yet..... warehousing costs. This is therefore not a capitalizable cost and should be expensed in the period incurred.. The 10/16 ratio ($625.......500 of cost matched against the final $300.................... the warehousing and interest costs would cumulate for four years...... These items should be written down.....V..000 additional gallons would be: Barrels @ $0. c.............. 7... these amounts of 200... and next strong for the warehousing costs....10......000 of revenue.......... 40... This generalization is valid............. However...... There is now a rule (from FASB-53) for determining cost of sales for T... and since barrels.....000)].000 in revenue will come from reruns.000 Warehousing @ $0......... The new ratio is then applied to unrecovered film costs......... The $100.......... This argument is strongest for the barrels....20..... b..... $140...000 spent on advertising and promotion of the initial showing does not benefit the future showings of the film........ 6. it is a cost of financing... if this were a four-year construction project rather than aging whiskey...000............. any such generalization about LIFO may not be valid if the physical size of the inventory is reduced so that the original “LIFO layers” are carried to Cost of Goods Sold............ GAAP would require capitalization of construction debt financing costs... Many people argue that in no circumstances can interest be considered a cost of production.... It is to amortize film cost in the ratio of Gross revenue for the film for the current period Anticipated total gross revenues for the film from the beginning of the current period until the end of its useful life The denominator of this ratio must be reviewed periodically to reflect current information. Correspondingly....... it can easily happen that individual items are worth less than their LIFO cost because of obsolescence or damage.70.......000/$600. profit would be reduced by the amount of these additional costs..... as indicated in the text....... and that the physical size of the inventory remains unchanged.Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 5................ This would result in amortization of $187..............500 in year two [1/2 x ($1.. Arguments can be made for ratios of 10/13 or 10/16 in the first year........ (This is not described in the text until Chapter 7....... Since there would be no additional revenue for four years........ This generalization is usually valid..... with the final $187....... and profits would be decreased correspondingly. The production process has been completed before the whiskey is stored.... Assuming that income tax rates remain unchanged......... a..

Sign up to vote on this title
UsefulNot useful