Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

Chapter 07 Reporting and Interpreting Cost of Goods Sold and Inventory

ANSWERS TO Q ESTIONS
1. Inventory often is one of the largest amounts listed under assets on the balance sheet which means that it represents a significant amount of the resources available to the business. The inventory may be excessive in amount, which is a needless waste of resources; alternatively it may be too low, which may result in lost sales. Therefore, for internal users inventory control is very important. On the income statement, inventory exerts a direct impact on the amount of income. Therefore, statement users are interested particularly in the amount of this effect and the way in which inventory is measured. Because of its impact on both the balance sheet and the income statement, it is of particular interest to all statement users. !undamentally, inventory should include those items, and only those items, legally owned by the business. That is, inventory should include all goods that the company owns, regardless of their particular location at the time. The cost principle governs the measurement of the ending inventory amount. The ending inventory is determined in units and the cost of each unit is applied to that number. #nder the cost principle, the unit cost is the sum of all costs incurred in obtaining one unit of the inventory item in its present state. %oods available for sale is the sum of the beginning inventory and the amount of goods purchased during the period. &ost of goods sold is the amount of goods available for sale less the ending inventory. Beginning inventory is the stoc( of goods on hand )in inventory* at the start of the accounting period. +nding inventory is the stoc( of goods on hand )in inventory* at the end of the accounting period. The ending inventory of one period automatically becomes the beginning inventory of the next period.

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7-1

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

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)a*

Average !ost-This inventory costing method in a periodic inventory system is based on a weighted.average cost for the entire period. /t the end of the accounting period the average cost is computed by dividing the goods available for sale in "nits into the cost of goods available for sale in dollars. The computed unit cost then is used to determine the cost of goods sold for the period by multiplying the units sold by this average unit cost. 0imilarly, the ending inventory for the period is determined by multiplying this average unit cost by the number of units on hand. #I#O-This inventory costing method views the first units purchased as the first units sold. #nder this method cost of goods sold is costed at the oldest unit costs, and the ending inventory is costed at the newest unit costs. $I#O-This inventory costing method assumes that the last units purchased are the first units sold. #nder this method cost of goods sold is costed at the newest unit costs and the ending inventory is costed at the oldest unit costs. Spe!ifi! identifi!ation-This inventory costing method re1uires that each item in the beginning inventory and each item purchased during the period be identified specifically so that its unit cost can be determined by identifying the specific item sold. This method usually re1uires that each item be mar(ed, often with a code that indicates its cost. 2hen it is sold, that unit cost is the cost of goods sold amount. It often is characteri3ed as a pic(.and.choose method. 2hen the ending inventory is ta(en, the specific items on hand, valued at the cost indicated on each of them, is the ending inventory amount.

)b*

)c*

)d*

4.

The specific identification method of inventory costing is sub5ect to manipulation. 6anipulation is possible because one can, at the time of each sale, select )pic( and choose* from the shelf the item that has the highest or the lowest )or some other* unit cost with no particular rationale for the choice. The rationale may be that it is desired to influence, by arbitrary choice, both the amount of income and the amount of ending inventory to be reported on the financial statements. To illustrate, assume item / is stoc(ed and three are on the shelf. One cost 7188; the second one cost 711'; and the third cost 71 '. 9ow assume that one unit is sold for 7 88. If it is assumed arbitrarily that the first unit is sold, the gross profit will be 7188; if the second unit is selected, the gross profit will be 7:'; or alternatively, if the third unit is selected, the gross profit will be 74'. Thus, the amount of gross profit )and income* will vary significantly depending upon which one of the three is selected arbitrarily from the shelf for this particular sale. This assumes that all three items are identical in every respect except for their unit costs. Of course, the selection of a different unit cost, in this case, also will influence the ending inventory for the two remaining items.

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

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$I#O and #I#O have opposite effects on the inventory amount reported under assets on the balance sheet. The ending inventory is based upon either the oldest unit cost or the newest unit cost, depending upon which method is used. #nder #I#O, the ending inventory is costed at the newest unit costs, and under $I#O, the ending inventory is costed at the oldest unit costs. Therefore, when prices are rising, the ending inventory reported on the balance sheet will be higher under #I#O than under $I#O. &onversely, when prices are falling the ending inventory on the balance sheet will be higher under $I#O than under #I#O. $I#O versus #I#O will affect the income statement in two ways< )1* the amount of cost of goods sold and ) * income. 2hen the prices are rising, #I#O will give a lower cost of goods sold amount and hence a higher income amount than will $I#O. In contrast, when prices are falling, #I#O will give a higher cost of goods sold amount and, as a result, a lower income amount. 2hen prices are rising, $I#O causes a lower taxable income than does #I#O. Therefore, when prices are rising, income tax is less under $I#O than #I#O. / lower tax bill saves cash )reduces cash outflow for income tax*. The total amount of cash saved is the difference between $I#O and #I#O inventory amounts multiplied by the income tax rate. =&6 is applied when mar(et )defined as current replacement cost* is lower than the cost of units on hand. The ending inventory is valued at mar(et )lower*, which )a* reduces net income and )b* reduces the inventory amount reported on the balance sheet. The effect of applying =&6 is to include the holding loss on the income statement )as a part of &%0* in the period in which the replacement cost drops below cost rather than in the period of actual sale. 2hen a perpetual inventory system is used, the unit cost must be (nown for each item sold at the date of each sale because at that time two things happen< )a* the units sold and their costs are removed from the perpetual inventory record and the new inventory balance is determined; )b* the cost of goods sold is determined from the perpetual inventory record and an entry in the accounts is made as a debit to &ost of %oods 0old and a credit to Inventory. In contrast, when a periodic inventory system is used the unit cost need not be (nown at the date of each sale. In fact, the periodic system is designed so that cost of goods sold for each sale is not (nown at the time of sale. /t the end of the period, under the periodic inventory system, cost of goods sold is determined by adding the beginning inventory to the total goods purchased for the period and subtracting from that total the ending inventory amount. The ending inventory amount is determined by means of a physical inventory count of the goods remaining on hand and with the units valued on a unit cost basis in accordance with the cost principle )by applying an appropriate inventory costing method*.

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18.

11.

1 .

7-3

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

ANSWERS TO % $TI&$E C'OICE

1. a* ,. c* . d* 4. a* ". a* :. c* $. b* ;. c* '. c* 18. a*

A"thors( Re!o))ended Sol"tion Ti)e

*Ti)e in )in"tes+ Mini-exercises No. Time 1 ' ' " ' $ 18 ' ' , ' 4 ' : ' ; 18 Exercises No. Time 1 1' 8 " 8 $ 18 ' 1' , 1' 4 "8 : "8 ; "8 18 "8 11 1' 1 8 1" 1' 1$ 8 1' 1' 1, 8 14 8 1: 8 1; ' 8 8 1 ' ' Problems No. Time 1 "8 "8 " $8 $ $8 ' $' , '8 4 $8 : $8 ; "' 18 8 Alternate Problems No. Time 1 "8 $8 " "' $ $8 Cases and Projects No. Time 1 8 8 " 8 $ 8 ' $8 , 8 4 "8 : >

> ?ue to the nature of these cases and pro5ects, it is very difficult to estimate the amount of time students will need to complete the assignment. /s with any open.ended pro5ect, it is possible for students to devote a large amount of time to these assignments. 2hile students often benefit from the extra effort, we find that some become frustrated by the perceived difficulty of the tas(. @ou can reduce student frustration and anxiety by ma(ing your expectations clear. !or example, when our goal is to sharpen research s(ills, we devote class time to discussing research strategies. 2hen we want the students to focus on a real accounting issue, we offer suggestions about possible companies or industries.

7-4

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

%INI,E-ERCISES
%7./0 Type of Inventory 2or( in process !inished goods 6erchandise Baw materials Type of Business Merchandising Manufacturing A A A A

%7.10 To record the purchase of ;8 new shirts in accordance with the cost principle )perpetual inventory system*< Inventory )C/*................................................................ &ash )/*............................................................ &ost< 7 , '8 C 71:' C 71,' D 7 ,,88. The 71"' interest expense is not a proper cost of the merchandise; it is recorded as prepaid interest expense and later as interest expense. %7.20 */+ &art of inventory a. b. c. d. e. 2ages of factory wor(ers &osts of raw materials purchased 0ales salaries Eeat, light, and power for the factory building Eeat, light, and power for the head1uarters office building A A A A A *1+ E3pense as in!"rred ,,88 ,,88

7-5

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

%7.40 Computation< 0imply rearrange the basic inventory model )BI C F - +I D &%0*< 711,'41 million ", '; million )",,$1* million 711,1:; million

&ost of goods sold .................................................. C +nding inventory ................................................. - Beginning inventory ................................................ Furchases ........................................................... %7.50 )a* )b* ?eclining costs Eighest net income Eighest inventory Bising costs Eighest net income Eighest inventory =I!O =I!O !I!O !I!O

%7.60 =I!O is often selected when costs are rising because it reduces the companyGs tax liability which increases cash and benefits shareholders. Eowever, it also reduces reported net income. %7.70 Q"antity Item / Item B Total %7.:0 C 9+ C )a * )b * )c* Farts inventory delivered daily by suppliers instead of wee(ly. +xtend payments for inventory purchases from 1' days to "8 days. 0horten production process from 18 days to : days. 48 "8 Cost per Ite) 7 :' ,8 Repla!e)ent $o7er of Cost Reported on Cost per Ite) or %ar8et 9alan!e Sheet 7188 7:' 48 x 7:' D 7',;'8 '' '' "8 x 7'' D 71,,'8 74,,88

7-6

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

%7.;0 #nderstatement of the 811 ending inventory by 7188,888 caused 811 pretax income to be understated and 81 pretax income to be overstated by the same amount. Overstatement of the 811 ending inventory would have the opposite effect; that is, 811 pretax income would be overstated by 7188,888 and 81 pretax income understated by 7188,888. Total pretax income for the two years combined would be correct.

7-7

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E-ERCISES
E7./ Ite) +nding inventory )physical count on ?ecember "1, 811* a. %oods purchased and in transit A)o"nt 7"$,'88 C 488 E3planation Fer physical inventory. %oods purchased and in transit, !.O.B. shipping point, are owned by the purchaser. 0amples held by a customer on trial are still owned by the vendor; no sale or transfer of ownership has occurred. %oods shipped to customers, !.O.B. shipping point, are owned by the customer because ownership passed when they were delivered to the transportation company. The inventory correctly excluded these items. C 1,'88 7":,'88 %oods sold and in transit, !.O.B. destination, are owned by the seller until they reach destination.

b.

0amples out on trial to customer

C 1,:88

c.

%oods in transit to customer

d.

%oods sold and in transit

&orrect inventory, ?ecember "1, 811 E7.10 )Italics for missing amounts only.*

Case A 9et sales revenue........... Beginning inventory........ Furchases ................... %oods available for sale. +nding inventory............. &ost of goods sold.......... %ross profit ................... +xpenses ................... Fretax income................. 74,'88 711, 88 ',888 16,200 18, 88 6,000 1,500 $88 7 1,188

Case 9 75,500 7 ,,'88 8,550 1',8'8 11,8'8 4,000 1,'88 1,900 7 )$88*

Case C 7,,888 7 $,888 ;,'88 1",'88 9,000 $,'88 1,500 488 7 :88

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.20 )Italics for missing amounts only.*

9eg0 Sales Inven, &"r, ase Reven"e tory !hases Total Avail, a<le Ending Inventory Cost of Goods Sold Gross &rofit E3, penses &reta3 In!o)e or *$oss+

/ B & ? + E7.40

7 ,'8 1,188 600 :88 1,888

7188 88 1'8 150 200

7488 ;88 "50 ''8 ;88

!800 1,100 500 #00 1,188

7'88 "00 "88 "88 600

!"00 800 88 400 500

!"50 "00 $88 400 '88

7 88 1'8 188 88 550

!150 1'8 "00 88 )'8*

Computations: 0imply rearrange the cost of goods sold e1uation BI C F - +I D &%0 F D &%0 - BI C +I &ost of goods sold ..................................... 71,14:,':$,888 - Beginning inventory ................................... )""",1'",888* C +nding inventory ........................................ "4 ,$ ,888 Furchases ................................................. 71, 14,:'",888 E7,5 nits &ost of goods sold< Beginning inventory )7'*............. ,888 Furchases )6arch 1* )74*......... ',888 )/ugust 1* )7:*.......... ",888 %oods available for sale... 18,888 +nding inventory>........................ $,888 &ost of goods sold............ ,,888 #I#O 18,888 "',888 $,888 ,;,888 "1,888 ":,888 $I#O 18,888 "',888 $,888 ,;,888 $,888 $',888 Average Cost 18,888 "',888 $,888 ,;,888 4,,88 $1,$88

>+nding inventory computations< !I!O< )",888 units H 7:* C )1,888 units H 74* D 7"1,888. =I!O< ) ,888 units H 7'* C ) ,888 units H 74* D 7 $,888. /verage< I) ,888 units H 7'* C )',888 units H 74* C )",888 units H 7:*J D 7,;,888 K 18,888 units D 7,.;8 per unit. $,888 units H 7,.;8 D 7 4,,88.

7-!

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.6 nits &ost of goods sold< Beginning inventory )7'*............. ,888 Furchases )6arch 1* )7$*......... ,,888 )/ugust 1* )7 *.......... $,888 %oods available for sale... 1 ,888 +nding inventory>........................ ",888 &ost of goods sold............ ;,888 #I#O 718,888 $,888 :,888 $ ,888 ,,888 7",,888 $I#O 718,888 $,888 :,888 $ ,888 1$,888 7 :,888 Average Cost 718,888 $,888 :,888 $ ,888 18,'88 7"1,'88

>+nding inventory computations< !I!O< )",888 units H 7 * D 7,,888. =I!O< ) ,888 units H 7'* C )1,888 units H 7$* D 71$,888. /verage< I) ,888 units H 7'* C ),,888 units H 7$* C )$,888 units H 7 *J D 7$ ,888 K 1 ,888 units D 7".'8 per unit. ",888 units H 7".'8 D 718,'88. E7.70 Be1. 1 E$E%ENT CO%&AN= In!o)e State)ent #or the =ear Ended >e!e)<er 2/? 10/1 ase $ %I%& 0ales revenue1............................... &ost of goods sold< Beginning inventory................ Furchases............................... %oods available for sale +nding inventory"................... &ost of goods sold........... %ross profit .................................. +xpenses .................................. 7''8,888 7 ",,888 18,888 $,,888 1"8,888 11,,888 $"$,888 1;',888 7 ";,888 7 ",,888 18,888 $,,888 ;,,888 1'8,888 $88,888 1;',888 7 8',888 ase B 'I%& 7''8,888

Fretax income................................. &omputations< )1* 0ales< )11,888 units H 7'8* D 7''8,888

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.70 (continued) ) * %oods available for sale )for both cases*< *nits ",888 ;,888 :,888 8,888 *nit ost 71 18 1' Tota+ ost 7 ",,888 ;8,888 1 8,888 7 $,,888

Beginning inventory Furchase, /pril 11, 81 Furchase, Lune 1, 81 %oods available for sale )"*

+nding inventory ) 8,888 available - 11,888 units sold D ;,888 units*< &ase / %I%&, ):,888 units H 71' D 71 8,888* C )1,888 units H 718 D 718,888* D 71"8,888. 'I%&, )",888 units H 71 D 7",,888*C ),,888 units H 718 D 7,8,888* D 7;,,888.

&ase B

Be1. o-parison of $-ounts ase $ ase B %I%& 'I%& Fretax Income ?ifference +nding Inventory ?ifference 7 ";,888 7"$,888 1"8,888 "$,888 ;,,888 7 8',888

The above tabulation demonstrates that the pretax income difference between the two cases is exactly the same as the inventory difference. ?ifferences in inventory have a dollar.for.dollar effect on pretax income. Be1. " =I!O may be preferred for income tax purposes because it reports less taxable income )when prices are rising* and hence )a* reduces income tax and )b* as a result reduces cash outflows for the period.

7-11

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.:0 Be1. 1 9EC@ INC0 In!o)e State)ent #or the =ear Ended >e!e)<er 2/? 10/1 ase $ %I%& 0ales revenue1............................... &ost of goods sold< Beginning inventory.............. Furchases............................... %oods available for sale +nding inventory"................... &ost of goods sold........... %ross profit .................................. +xpenses .................................. 748$,888 7 "',888 :1,888 "1,,888 1 :,888 1::,888 '1,,888 '88,888 71,,888 7 "',888 :1,888 "1,,888 :8,888 ",,888 $,:,888 '88,888 7)" ,888* ase B 'I%& 748$,888

C"#$G%&

Fretax income.................................

&omputations< )1* 0ales< ):,888 units H 7 :* C )1,,888 units H 7"8* D 748$,888 ) * %oods available for sale )for both cases*< *nits Beginning inventory Furchase, 6arch ', 81 Furchase, 0eptember 1;, 81 %oods available for sale )"* 4,888 1;,888 18,888 ",,888 *nit ost 7' ; 11 Tota+ ost

7 "',888 141,888 118,888 7"1,,888

+nding inventory )",,888 available - $,888 units sold D 1 ,888 units*< &ase / %I%&, )18,888 units H 711 D 7118,888* C ) ,888 units H 7; D 71:,888* D 71 :,888. 'I%&, )4,888 units H 7' D 7"',888*C )',888 units H 7; D 7$',888* D 7:8,888.

&ase B

7-12

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.:0 *!ontin"ed+ Be1. o-parison of $-ounts ase $ ase B %I%& 'I%& Fretax Income ?ifference +nding Inventory ?ifference 71,,888 7$:,888 1 :,888 $:,888 :8,888 7)" ,888*

The above tabulation demonstrates that the pretax income difference between the two cases is exactly the same as the inventory difference. ?ifferences in inventory have a dollar.for.dollar effect on pretax income. Be1. " =I!O may be preferred for income tax purposes because it reports less taxable income )when prices are rising* and hence )a* reduces income tax and )b* as a result reduces cash outflows for the period.

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.;0 Be1. 1 nits #I#O Cost of goods sold< Beginning inventory..................... ,888 7 4,,888 Furchases.................................... :,888 " 8,888 %oods available for sale... 18,888 ";,,888 +nding inventory>........................ 1,:88 4 ,888 &ost of goods sold............ :, 88 7" $,888 In!o)e state)ent 0ales revenue........................................ &ost of goods sold................................. %ross profit .......................................... +xpenses .......................................... Fretax income........................................ Income tax expense )"8M*......... 9et income .......................................... #I#O 7,1',888 " $,888 ;1,888 1;$,'88 ;,,'88 :,;'8 7 ,4,''8 $I#O 7 4,,888 " 8,888 ";,,888 ,:,$88 7" 4,,88 $I#O 7,1',888 " 4,,88 :4,$88 1;$,'88 ; ,;88 4,:48 7 ,',8"8 Average Cost 7 4,,888 " 8,888 ";,,888 41, :8 7" $,4 8 Average Cost 7,1',888 " $,4 8 ;8, :8 1;$,'88 ;',4:8 :,4"$ 7 ,4,8$,

>+nding inventory computations< !I!O< 1,:88 units H 7$8 D 74 ,888. =I!O< 1,:88 units H 7": D 7,:,$88. /verage< I) ,888 units H 7":* C ):,888 units H 7$8*J K 18,888 units D 7";,,888 K 18,888 units D 7";.,8 per unit. 7";.,8 x 1,:88 units D 741, :8. Be1. !I!O produces a more favorable )higher* net income because when prices are rising it gives a lower cost of goods sold amount. !I!O allocates the old )lower* unit costs to cost of goods sold. =I!O produces a more favorable cash flow than !I!O because, when prices are rising, it produces a higher cost of goods sold amount and lower taxable income and, therefore, lower income tax expense for the period. &ash outflow is less under =I!O by the amount of income tax reduction. =I!O causes these comparative effects because it allocates the new )higher* unit costs to cost of goods sold. Be1. " 2hen prices are falling, the opposite effect occurs-=I!O produces higher net income and less favorable cash flow than does !I!O.

7-14

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./00 Be1. 1 %I%& &ost of goods sold< Beginning inventory )$88 units H 7 :*... 711, 88 Furchases )$4' units H 7",*.................. 14,188 %oods available for sale.......................... :,"88 +nding inventory )'$' units*>.................. 1;,8,8 &ost of goods sold )""8 units*................. 7 ;, $8 'I%& 711, 88 14,188 :,"88 1,,$ 8 711,::8 $verage ost 711, 88 14,188 :,"88 14,, ' 7 18,,4'

>&omputation of ending inventory< #I#O< )$4' units x 7",* C )48 units x 7 :* D 71;,8,8 $I#O< )$88 units x 7 :* C )1$' units x 7",* D 71,,$ 8 2eighted /verage< *nits $88 $4' :4' ost 711, 88 14,188 7 :,"88 D weighted.average unit cost of 7" ."$.

'$' units x 7" ."$ D 714,, ' Be1. %I%& 0ales revenue )7'8 x ""8*................................ 71,,'88 &ost of goods sold.............................................. ;, $8 %ross profit ...................................................... 4, ,8 +xpenses ...................................................... 1,488 Fretax income..................................................... 7 ',',8 'I%& 71,,'88 11,::8 $,, 8 1,488 7 ,; 8 $verage ost 71,,'88 18,,4' ',: ' 1,488 7 $,1 '

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./00 (continued) Be1. " Ban(ing in order of favorable cash flow< The higher ran(ings are given to the methods that produce the lo7er income tax expense because the lower the income tax expense the higher the cash savings. )1* ) * )"* =I!O-produces the lowest pretax income, hence the lowest amount of cash to be paid for income tax. 2eighted average-produces next lower pretax income. !I!O-produces the highest pretax income and as a result the highest income tax. This result causes the lowest cash savings on income tax.

The above comparative effects occurred because prices were rising. If prices were falling the three methods would have produced the opposite ran(ing.

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.//0 Ite) Q"antity / B & ? + '8 :8 18 48 "'8 Total x x x x x Total Cost 71' "8 $: ' 18 D D D D D 7 4'8 ,$88 $:8 1,4'8 ",'88 7:,::8 x x x x x Total %ar8et 71 $8 ' "8 ' D D D D D 7,88 ", 88 ' 8 ,188 1,4'8 7:,148 $C% Aal"ation 7,88 ,$88 $:8 1,4'8 1,4'8 7,,;:8 7,,;:8

Inventory valuation that should be used )=&6* E7./10 Be1. 1 Ite) Q"antity / B & ? 8 '' "' 18 Total x x x x Total Cost 718 $8 '4 4 D D D D 88 , 88 1,;;' 48 7$,,,' 7 x x x x Total %ar8et 71' $$ '' " D D D D 7"88 ,$ 8 1,; ' " 8 7$,;,'

$C% Aal"ation 7 88 , 88 1,; ' 48 7$,';' 7$,';'

Inventory valuation that should be used )=&6* Be1.

The write.down to lower of cost or mar(et will increase cost of goods sold expense by the amount of the write.down, 748< Total &ost =&6 Naluation D 2rite.down 7$,,,' 7$,';' D 748 2rite.down

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./20 Be1. 1 Inventory turnover D &ost of %oods 0old /verage Inventory D 7'8,1$$ )71,1:8C7:,4*O D $:.;;

/verage days to sell inventory D ",' O inventory turnover D ",' O $:.;; D 4.' days Be1. The inventory turnover ratio reflects how many times average inventory was produced and sold during the period. Thus, ?ell produced and sold its average inventory nearly $; times during the year. The average days to sell inventory indicates the average time it ta(es the company to produce and deliver inventory to customers. Thus, ?ell ta(es an average of about 4.' days to produce and deliver its computer inventory to its customers.

7-1

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./40 &/0+ / - !I!O< %oods available for sale for !I!O< #nits )1; C ' C '8*....................................................... /mount )7"8$ C "'8 C ;'8*.......................................... +nding inventory< ;$ units - ,: units D ,. +nding inventory ) , units x 71;*.................................. &ost of goods sold )71,,8$ - 7$;$*.............................. Inventory turnover D &ost of %oods 0old D /verage Inventory 71,118 )7"8$C7$;$*O 7 $;$ 71,118 D .4: ;$ 71,,8$

&/0+ B - =I!O< %oods available for sale for =I!O< #nits )1; C ' C '8*....................................................... /mount )7 : C "'8 C ;'8*.......................................... +nding inventory< ;$ units - ,: units D ,. +nding inventory )1; units x 71 * C )4 units x 71$*...... &ost of goods sold )71,' : - 7" ,*.............................. Inventory turnover D &ost of %oods 0old D /verage Inventory 71, 8 )7 :C7" ,*O 7 " , 71, 8 D $."$ ;$ 71,' :

The !I!O inventory turnover ratio is normally thought to be a more accurate indicator when prices are changing because =I!O can include very old inventory prices in ending inventory balances.

7-1!

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./50 Inventory /OF C"rrent =ear &revio"s =ear ,:1",:'8 8,:":,141 ;,$, ,::" ;,81',"4, D D Change 1,;4',,4; $$4,'84

Increases in inventory cause cash flow from operations to decrease by 71,;4',,4;. This amount is subtracted in the computation of cash flow from operations. !irst Team 0ports was able to offset some of this by increasing its /OF by 7$$4,'84, which increases cash flow from operations. This amount is added in the computation of cash flow from operations. +ffectively, the &ompany is letting its suppliers finance a portion of its growing inventories. E7./60 Be1. 1 The reported ending inventory for !ord was 7:,,1: million. If !I!O were used exclusively, the ending inventory would have been 7:;1 million higher than reported, or 7;,'8; million. Be1. The restated cost of goods sold amount must reflect the restatement of both beginning and ending inventory< Beginning inventory ................................................ =ess< +nding inventory ............................................ Impact on &O%0 ..................................................... 71,188 million :;1 million 7 8; million

If !I!O had been used exclusively, cost of goods sold would have been 71 4,18" C 7 8; D 71 4,"1 million. In this case, !I!O cost of goods sold is greater than =I!O cost of goods sold. This is li(ely the result of falling prices andOor a reduction in inventory 1uantities. Be1. " 2hen costs are rising, =I!O normally produces lower net income before taxes and lower current tax payments.

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Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./70 Be1. 1 9et Income for 811 will be Overstated. /n understatement of purchases produces an understatement of cost of goods sold which produces an overstatement of the current periodGs income. BI C F . +I D #nderstate Be1. &%0 #nderstate

9et Income for 81 will be #nderstated. /n overstatement of purchases produces an overstatement of cost of goods sold which produces an understatement of the current periodGs income. BI C F . +I D Overstate &%0 Overstate

Be1. " Betained +arnings for ?ecember "1, 811, will be Overstated because of the overstatement of 9et Income for 811. Be1. $ Betained +arnings for ?ecember "1, 81 , will be &orrect because the overstatement of 9et Income for 811 and understatement of 9et Income for 81 will offset one another.

7-21

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./:0 Be1. 1 2hen the ending inventory is overstated, cost of goods sold is understated which in turn results in an overstatement of net income. %ibsonGs income from operations should be reduced by 7:,:8,,888 and tax expense should be reduced by 7",$,8,4': )i.e., 7:,:8,,888 x 8.";"*. Therefore, net income should be< /s reported<......................................................... Increase in cost of good sold............................... Beduction in tax expense.................................... &orrected income................................................ Be1. The incorrect accounts can be summari3ed as follows< $ccount Beginning inventory &ost of goods sold +nding inventory Income tax expense 9et income Betained earnings Taxes payable> (a) .ear of 2rror correct understated overstated overstated overstated overstated overstated (/) 0u/se1uent .ear overstated overstated correct understated understated correct understated 7 ',:' ,888 ):,:8,,888* ",$,8,4': 7 8,'8,,4':

>The income tax payable for each year is incorrect by the same amount; therefore the total income tax paid was correct.

7-22

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7./;0 Be1. 1 The 7,88 understatement of ending inventory produced pretax income amounts that were incorrect by the amount of 7,88 for each 1uarter. Eowever, the effect on pretax income for each 1uarter was opposite )i.e., the first 1uarter pretax income was understated by 7,88, and in the second 1uarter it was overstated by 7,88*. This self. correcting produces a correct combined income for the two 1uarters. Be1. The error caused the pretax income for each 1uarter to be incorrect Isee )1* aboveJ; therefore, it produced incorrect +F0 amounts for each 1uarter. Be1. " #irst Q"arter 0ales revenue.......................................... &ost of goods sold< Beginning inventory...................... 7$,888 Furchases..................................... ",888 %oods available for sale.... 4,888 +nding inventory........................... $,$88 &ost of goods sold............. %ross profit ........................................... +xpenses ........................................... Fretax income.......................................... Be1. $ /st Q"arter
In!orre!t Beginning inventory +nding inventory &ost of goods sold %ross profit Fretax income 7$,888 ",:88 ", 88 4,:88 ,:88 Corre!t 7$,888 $,$88 ,,88 :,$88 ",$88 Error 9o error 7,88 under ,88 over ,88 under ,88 under In!orre!t 7",:88 ;,888 4,:88 18, 88 $, 88

Se!ond Q"arter 71:,888 7 $,$88 1",888 14,$88 ;,888

711,888

,,88 :,$88 ',888 7",$88

:,$88 ;,,88 ,,888 7",,88

1nd Q"arter
Corre!t 7$,$88 ;,888 :,$88 ;,,88 ",,88 Error 7,88 under 9o error ,88 under ,88 over ,88 over

7-23

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.100 *S"pple)ent A+ Be1. 1 This actual footnote from &onocoFhillips illustrates the impact of Pdipping into a =I!O layer.QQ #nder =I!O, the cost of recently purchased items is assigned to cost of goods sold. 2hen prices are rising, cost of goods sold, under =I!O, will include unit costs that are much higher than the unit costs assigned to ending inventory. This process will continue year after year so that the unit costs assigned to the ending inventory often will be significantly less than unit costs assigned to cost of goods sold. 2hen a business permits inventory 1uantity to decline, old )and often very low* costs are allocated to cost of goods sold and are matched with revenues that usually are based on the current )higher* costs. /s a result, a decline in =I!O inventory 1uantity often will produce a dramatic increase in net income for the company. Be1. 2hen !I!O is used, a decline in inventory 1uantity will not result in the dramatic increase in net income that was discussed in re1uirement )1* because !I!O inventory costs are represented by the most recent purchases. E7.1/0 *S"pple)ent 9+ Be1. 1 /ccounts receivable )C/* ..................................................... ;88 0ales )CB, C0+*.............................................................. ,88 &ost of goods sold )C+, 0+*............................................... Inventory )/*.................................................................. Be1. &ash )C/* )7;88 x 8.;:*....................................................... :: 0ales discounts )CAB, B, 0+* )7;88 x 8.8 *................... 1: /ccounts receivable )/*................................................ &ash )C/*.............................................................................. ;88 /ccounts receivable )/*................................................ Inventory )C/*....................................................................... :,$88 /ccounts payable )C=*.................................................... :,$88 /ccounts payable )=*.......................................................... Inventory )/* )7:,$88 x 8.8"*........................................ &ash )/* )7:,$88 x 8.;4*.............................................. :,$88 /ccounts payable )=*.......................................................... &ash )/* ....................................................................... ;88 ,88

;88 ;88 :,$88 ' :,1$:

Be1. " Be1. $ Be1. '

Be1. ,

:,$88

7-24

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

E7.110 *S"pple)ent C+ &/0+ /< Ferpetual inventory system< Lanuary 1$ /ccounts receivable )C/*...................................................... ;'8 0ales )CB, C0+* ) 8 units at 7$4.'8*.............................. $88 &ost of goods sold )C+, 0+*............................................... Inventory )/* ) 8 units at 7 8*...................................... /pril ; 0eptember Inventory )C/* )1' units at 7 8*............................................ "88 /ccounts payable )C=*.................................................... /ccounts receivable )C/*...................................................... , '8 0ales )CB, C0+* )$' units at 7'8*................................... ;88 &ost of goods sold )C+, 0+*............................................... Inventory )/* )$' units at 7 8*...................................... +nd of year 9o year.end ad5usting entry needed. ;'8 $88 "88 , '8 ;88

&/0+ B< Feriodic inventory system< Lanuary 1$ /pril ; 0eptember +nd of year /ccounts receivable )C/*...................................................... ;'8 0ales )CB, C0+* ) 8 units at 7$4.'8*.............................. Furchases )C/* )1' units at 7 8*.......................................... "88 /ccounts payable )C=*.................................................... /ccounts receivable )C/*...................................................... , '8 0ales )CB, C0+* )$' units at 7'8*................................... ,"88 &ost of goods sold )C+, 0+* )goods avail. for sale*........... Furchases )/* ............................................................... Inventory )/* )Beginning< 188 units at 7 8*................. Inventory )C/* )+nding< '8 units at 7 8*............................. 1,888 &ost of goods sold )+, C0+*.......................................... &alculation of cost of goods sold< Beginning inventory )188 units at 7 8* /dd purchases %oods available for sale +nding inventory )physical countR'8 units at 7 8* &ost of goods sold 7 ,888 "88 ,"88 1,888 71,"88 ;'8 "88 , '8 "88 ,888 1,888

7-25

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&RO9$E%S
&7./0 Ite) +nding inventory )physical count on ?ecember "1, 811* a. %oods out on trial to customer A)o"nt E3planation

7,',888 Fer physical inventory. C 4'8 %oods held by a customer on trial are still owned by the vendor; no sale or transfer of ownership has occurred. %oods shipped by a supplier, !.O.B. destination, are owned by the supplier until delivery at destination. %oods shipped to customers, !.O.B. shipping point, are owned by the customer because ownership passed when they were delivered to the transportation company. The inventory correctly excluded these items.

b.

%oods in transit from supplier

c.

%oods in transit to customer

d.

%oods held for customer pic(up - 1,';8 The goods sold, but held for customer pic(up, are owned by the customer. Ownership has passed. %oods purchased and in transit C ",''8 %oods purchased and in transit, !.O.B. shipping point, are owned by the purchaser. C :'8 %oods sold and in transit, !.O.B. destination, are owned by the seller until they reach destination.

e.

f.

%oods sold and in transit

g.

%oods held on consignment

&orrect inventory, ?ecember "1, 811

- ',488 %oods held on consignment are owned by the consignor )the manufacturer*, not by the consignee. 7, ,:,8

7-26

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.10 a* %oods available for sale for all methods< nits Lanuary 1, 81 -Beginning inventory Lanuary "8, 81 -Furchase 6ay 1, 81 -Furchase %oods available for sale $88 ,88 $,8 1,$,8 nit Cost 7".88 ". 8 ".'8 7$,4"8 Total Cost

+nding inventory< 1,$,8 units - )1,8 C 488* D ,88 units b* and c* 1. /verage cost< /verage unit cost +nding inventory &ost of goods sold !irst.in, first.out< +nding inventory &ost of goods sold ". =ast.in, first.out< +nding inventory &ost of goods sold $. 0pecific identification< +nding inventory 7$,4"8 K 1,$,8 D 7". $ ),88 units x 7". $* )7$,4"8 - 71,;$$* )$,8 units x 7".'8* C )1$8 units x 7". 8* )7$,4"8 - 7 ,8':* )$88 units x 7".88* C ) 88 units x 7". 8* )7$,4"8 - 71,:$8* ) 8 units x 7".88* C ) '8$ units x 7". 8* C ) ;, units x 7".'8* )7$,4"8 - 71,;$;*

71,;$$ 7 ,4:,

7 ,8': 7 ,,4

71,:$8 7 ,:;8

71,;$; 7 ,4:1

&ost of goods sold

7-27

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.20 Be1. 1 >ONNER CO%&AN= &artial In!o)e State)ent #or the %onth Ended Ban"ary 2/? 10// *a+ Average Cost 0ales revenue> &ost of goods sold>> %ross profit &omputations< >, 8 units H 71, D 7;,; 8. >>&ost of goods sold< nits Beginning inventory Furchases )net*>>> %oods available for sale +nding inventory>>>> &ost of goods sold >>>Furchases< Lanuary 1 Lanuary , Totals ,88 1,8 4,8 '88 4,8 1, ,8 ,$8 , 8 units H 7, units H 7: Average Cost 7 ,'88 $,::8 4,":8 ",4'8 7",,"8 #I#O 7 ,'88 $,::8 4,":8 $,1,8 7", 8 $I#O 7 ,'88 $,::8 4,":8 ","$8 7$,8$8 Spe!ifi! Identifi!ation 7 ,'88 $,::8 4,":8 $,8"8 7","'8 7;,; 8 ",,"8 7 ,, ;8 *<+ #I#O 7;,; 8 ", 8 7 ,,488 *!+ $I#O 7;,; 8 $,8$8 7 ',::8 *d+ Spe!ifi! Identifi!ation 7;,; 8 ","'8 7 ,,'48

D 7",,88 D 1, :8 7$,::8 /mount 7 ,'88 $,::8 74,":8

>>>>+nding inventory< a. /verage cost< Beginning inventory Furchases )per above*

#nits '88 4,8 1, ,8

/verage cost< 74,":8 K 1, ,8 units D 7'.:, +nding inventory< ,$8 units x 7'.:, D 7",4'8

7-2

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.20 *!ontin"ed+ Be1. 1 )continued* b. %I%&< 1,8 $:8 ,$8 '88 1$8 ,$8 units H 7: D units H 7, D units H 7' D units H 7, D 71, :8 ,::8 7$,1,8 7 ,'88 :$8 7","$8 7 ,'8 ,188 1, :8 7$,8"8

c.

'I%&,

d.

0pecific identification< 1"8 units H 7' D "'8 units H 7, D 1,8 units H 7: D ,$8

Be1. !I!O reports a higher pretax income than =I!O because )1* prices are rising and ) * !I!O allocates the old )lower* unit costs to cost of goods sold. !or the same reason, !I!O will report a higher +F0 amount because it produces a higher pretax income than =I!O. Be1. " Because =I!O reports a lower pretax income than !I!O for the reasons given in Be1uirement ) *, the former will derive less income tax by )7,,488 - 7',::8* x "8M D 7 $,. Be1. $ =I!O will provide a more favorable cash flow than !I!O of 7 $, because less cash will be paid for income tax in the current year than would be paid under !I!O )for the reasons given in Be1uirements and "*.

7-2!

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.40 Be1. 1 0ales revenue &ost of goods sold> )$ H 718,888* C )' H 711,'88* %ross profit +xpenses Fretax income >+nding inventory )1' H 711,'88* Be1. 0ales revenue &ost of goods sold>> ) 8 H 7;,'88* C ) 4 H 718,888* %ross profit +xpenses Fretax income >>+nding inventory ) 8 H 711,'88* C )1' H 718,888* Be1. " Fretax income increased by 714,'88 because of the decision to purchase the additional units at the end of the year. This decision provided lower cost units to allocate to cost of goods sold, which increased pretax income. There is evidence of deliberate income manipulation. /lthough no information is provided as to expected future sales, nor the time to order and receive units, the timing of the purchase of the additional units is suspect because the cost of the e1uipment will be decreased again during the first 1uarter of next year. )Instructional 9ote-This problem illustrates the way that income can be manipulated under =I!O by buying, or not buying, at year.end. This opportunity to manipulate income is not available under weighted average or !I!O.* 71,1'1,'88 $,8,888 ,;1,'88 "88,888 7 ";1,'88 7 ":8,888 71,1'1,'88 $44,'88 ,4$,888 "88,888 7 "4$,888 7 14 ,'88

7-30

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.50 Be1. 1 &ri!es Rising A 9 #I#O $I#O 71',888 71',888 ","88 $,:88 :,188 ,$88 )a* ',488 ;,"88 $,888 ',"88 1,';8 7",418 ","88 $,:88 :,188 , 88 )b* ',;88 ;,188 $,888 ',188 1,'"8 7",'48 7 ,$88 , 88 , 88 ,$88 &ri!es #alling C > #I#O $I#O 71',888 71',888 ",,88 $,$88 :,888 , 88 )c* ',:88 ;, 88 $,888 ', 88 1,',8 7",,$8 ",,88 $,$88 :,888 ,$88 )d* ',,88 ;,$88 $,888 ',$88 1,, 8 7",4:8

0ales revenue )'88 units* &ost of goods sold< Beginning inventory )"88 units* Furchases )$88 units* %oods available for sale +nding inventory ) 88 units*> &ost of goods sold )'88 units* %ross profit +xpenses Fretax income Income tax expense )"8M* 9et income

>Inventory computations< )a* !I!O< 88 units H 71 .88 D )b* =I!O< 88 units H 711.88 D )c* !I!O< 88 units H 711.88 D )d* =I!O< 88 units H 71 .88 D Be1.

The above tabulation demonstrates that when prices are rising, !I!O gives a higher net income than =I!O. 2hen prices are falling, the opposite effect results. The difference in pretax income )as between !I!O and =I!O* is the same as the difference in cost of goods sold but in the opposite direction. The difference in net income )i.e., after tax* is e1ual to the difference in cost of goods sold multiplied by one minus the income tax rate. Be1. " 2hen prices are rising, =I!O derives a more favorable cash position )than !I!O* e1ual to the difference in income tax. In contrast, when prices are falling, !I!O derives a more favorable cash position e1ual to the difference in income tax.

7-31

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.50 *!ontin"ed+ Be1. $ +ither method can be defended reasonably. If one focuses on current income and +F0, !I!O derives a more favorable result )higher than =I!O when prices are rising*. /lternatively, if one focuses on income tax expense and cash position, when prices are rising, =I!O derives more favorable results )lower taxes, better cash position*. Eowever, these comparative results will reverse if prices fall. !I!O provides a better balance sheet valuation )higher current asset value* but on the income statement does not match current expense )cost of goods sold* with current revenues. /lternatively, =I!O better matches expenses with revenues but produces a less relevant inventory valuation on the balance sheet. &7.60 Be1. 1 'ARAE= CO%&AN= In!o)e State)ent *$C% <asis+ #or the =ear Ended >e!e)<er 2/? 10// 0ales revenue &ost of goods sold< Beginning inventory Furchases %oods available for sale +nding inventory &ost of goods sold %ross profit Operating expenses Fretax income Income tax expense )7":,:'8 x "8M* 9et income >&omputation of ending inventory on =&6 basis< 7 :8,888 7 "",888 1:$,888 14,888 "4,:'8> 14;,1'8 188,:'8 , ,888 ":,:'8 11,,'' 7 4,1;'

7-32

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

Ite) Q"antity / B & ? ",8'8 1,'88 4,188 ", 88 Total

Original Cost x 7" x ' x1.' x , D 7 ;,1'8 D 4,'88 D 18,,'8 D 1;, 88 7$,,'88

Repla!e)ent Cost *%ar8et+ x 7$ x".' x".' x $ D D D D 71 , 88 ', '8 $,:'8 1 ,:88 7'',188

$C% Aal"ation 7 ;,1'8 ', '8 18,,'8 1 ,:88 7"4,:'8 A)o"nt of Change *>e!rease+ )7:,,'8* :,,'8 ) :,,'8* ) :,,'8* ) ,';'* ) ,,8''*

=&6 inventory valuation Be1. Ite) Changed +nding inventory &ost of goods sold %ross profit Fretax income Income tax expense 9et income &7.60 *!ontin"ed+ Be1. )continued* #I#O Cost 9asis 7 $,,'88 148,'88 18;,'88 $4,'88 1$, '8 "", '8 $C% 9asis 7 "4,:'8 14;,1'8 188,:'8 ":,:'8 11,,'' 4,1;'

/nalysis +nding inventory, cost of goods sold, gross profit, and pretax income each changed by the change in the valuation of the ending inventory. Income tax expense decreased because the increase in expense reduced pretax income. 9et income was reduced by 7:,,'8 )increased expense of 7:,,'8* less the income tax savings of 7 ,';' D 7,,8''. Be1. " The inventory costing methods )average cost, !I!O, =I!O, and specific identification* apply the cost and matching principles. &ost of goods sold, under these principles, is the actual cost incurred for the merchandise sold during the period; this cost is matched with sales revenue of the period.

7-33

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

=&6 is an exception to the cost principle. &onceptually, =&6 is based on the view that when replacement is less than the cost incurred for the merchandise, any such goods on hand should be valued at the lower replacement )mar(et* price. The effect is to include the holding loss )i.e., the drop from cost to mar(et* in the cost of goods sold amount for the period in which the replacement cost dropped. =&6 recogni3es holding losses in this manner; however, it does not recogni3e holding gains. Be1. $ =&6 reduced pretax income and income tax expense. There was a cash savings of 7 ,';' for 811 )assuming the =&6 results are included on the income tax return*. In subse1uent periods pretax income will be greater by the 7:,,'8 and hence, income tax and cash outflow will be more. The only real gain to the company would be the time value of money between 811 and the subse1uent periods when increased income taxes must be paid )of course, a change in tax rates would affect this analysis*. &7.70 Be1. 1 &roCe!ted !hange Inventory Turnover D &ost of %oods 0old /verage Inventory 74,88:,;:$ D 1$. 7$;',88'> No !hange fro) <eginning of year 74,88:,;:$ D 11.: 7';',488>>

> )7';',488 C 7";$,"18* K >> )7';',488 C 7';',488* K Be1. Fro5ected decrease in inventory D 7';',488 - 7";$,"18 D 7 81,";8 / 7 81,";8 increase in cash flow from operating activities, because a decrease in inventory would increase cash, all other items held constant. Be1. " /n increase in the inventory turnover ratio indicates an increase in the number of times average inventory was produced and sold during the period. / higher ratio indicates that inventory moves more 1uic(ly through the production process to the ultimate customer. /s a conse1uence, the company can maintain less inventory on hand, all other things being e1ual. This can benefit the company because less money is tied up in inventory and as a result, cash flow from operations will be higher. The excess cash can be invested, earning interest income, or used to reduce borrowings, reducing interest expense.

7-34

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.:0 Be1. 1 / change that increases beginning inventory will decrease net income while a change that increases ending inventory will increase net income. I-pact on 3M net inco-e (in -i++ions) &hange in ending inventory &hange in beginning inventory Increase in pretax income Increase in taxes )"8M* Increase in net income 7 ,844.1 )1,4:$.'* ; ., ):4.:* 7 8$.:

#se of !I!O would result in an increase of 7 8$.: million in %6 reported net income. The change would result in an increase in income taxes because the =I!O conformity rule precludes use of =I!O for tax purposes if a method other than =I!O were used for financial reporting. Beported net income Increase !I!O net income Be1. If !I!O had been used, the ending inventory would have been 7 ,844.1 million higher. Instead =I!O was used and the 7 ,844.1 million was allocated to cost of goods sold in earlier accounting periods )including the current year*. Thus, the cumulative difference between =I!O pretax income and !I!O pretax income was 7 ,844.1 million, or a difference of 71,$'$ million after taxes )7 ,844.1 x .4*. Therefore, retained earnings on a !I!O basis would have been 71,,4;$ million )i.e., 71',"$8 C 71,$'$*. Be1. " The reduction in taxes )compared to !I!O* was 7:4.: million )calculated in Be1. 1*. 7" 8.' 8$.: 7' '."

7-35

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7.;0 Be1. 1 10// 0ales revenue &ost of goods sold %ross profit +xpenses Fretax income Income tax expense )"8M* 9et income 7 ,8 ',888 1,'8',888 ' 8,888 $;8,888 "8,888 ;,888 7 1,888 10/1 10/2 10/4 7 ,;4',888 ,11",888 :, ,888 '$ ,888 " 8,888 ;,,888 7 $,888 7 ,$'8,888 7 ,488,888 1,,$',888> 1,4,$,888> :8',888 ;",,888 '1",888 '":,888 ; ,888 ";:,888 :4,,88 11;,$88 7 8$,$88 7 4:,,88

>There was an overstatement of the ending inventory in 81 by 71:,888; this caused cost of goods sold for 81 to be understated and 81 net income to be overstated. 0imilarly, because this error was carried over automatically to 81" as the beginning inventory, cost of goods sold for 81" was overstated and 81" net income understated. The amounts for 811 and 81$ were not affected. This is called a self. correcting or counterbalancing error. &umulative net income for the four.year period was not affected. Be1. 10// %ross profit ratio )gross profit K sales*< Before correction< 7' 8,888 K 7 ,8 ',888 D . , 7: ",888 K 7 ,$'8,888 D 7;1:,888 K 7 ,488,888 D 7:, ,888 K 7 ,;4',888 D /fter correction< 9o change 7:8',888 K 7 ,$'8,888 D 7;",,888 K 7 ,488,888 D 9o change Be1. " The effect of the error on income tax expense was< Income tax expense reported &orrect income tax expense Income tax expense overstatement )understatement* 10/1 7;",888 :4,,88 7 ',$88 10/2 711$,888 11;,$88 7)',$88* . , ."" ."' . ; 10/1 10/2 10/4

."$ ."$ . ;

7-36

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

&7./00 *S"pple)ent A+ Be1. 1 Fretax operating profit )loss* for the current year had !I!O accounting been employed instead of =I!O. ?ifference in beginning inventory> )=I!O to !I!O* =ess< ?ifference in ending inventory> )=I!O to !I!O* ?ifference in cost of goods sold )=I!O to !I!O* ?ifference in Fretax 9et Income D 71'8 increase )>The differences are the beginning and ending =I!O Beserve.* Be1. 0ince prices are rising, =I!O li1uidations increase net income before taxes. The change in pretax operating profit during the current year is given in the footnote as 7 " million. /s a conse1uence, net income before taxes would be 7 " million lower had there been no inventory 1uantity reduction. 7 ,84, , , 7 )1'8*

7-37

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

A$TERNATE &RO9$E%S
A&7 /0 a* %oods available for sale for all methods< nits Lanuary 1, 811-Beginning inventory !ebruary 8, 811-Furchase Lune "8, 811-Furchase %oods available for sale ";8 488 $,8 1,''8 nit Cost 7" "$ "4 Total Cost 71 ,$:8 ",:88 14,8 8 7'","88

+nding inventory< 1,''8 units - )48 C 4'8* D 4"8 units b* and c* 1. /verage cost< /verage unit cost +nding inventory &ost of goods sold !irst.in, first.out< +nding inventory &ost of goods sold ". =ast.in, first.out< +nding inventory &ost of goods sold $. 0pecific identification< +nding inventory &ost of goods sold 7'","88 K 1,''8D7"$.";. )4"8 units x 7"$.";* )7'","88 - 7 ',18'* )$,8 units x 7"4* C ) 48 units x 7"$* )7'","88 - 7 ,, 88* )";8 units x 7" * C )"$8 units x 7"$* )7'","88 - 7 $,8$8* ),': units x 7"$* C )4 units x 7"4* )7'","88 - 7 ',8",*

7 ',18' 7 :,1;'

7 ,, 88 7 4,188

7 $,8$8 7 ;, ,8

7 ',8", 7 :, ,$

7-3

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

A&7.10 Be1. 1 NEWRI>GE CO%&AN= &artial In!o)e State)ent #or the %onth Ended Ban"ary 2/? 10/1 *a+ Average Cost 0ales revenue> &ost of goods sold>> %ross profit 7",:$8 , ', 71,':$ *<+ #I#O 7",:$8 ,8$8 71,:88 *!+ $I#O 7",:$8 ,',8 71, :8 *d+ Spe!ifi! Identifi!ation 7",:$8 ,8,8 71,4:8 C"#$G%&

Co)p"tationsD ESales reven"e F 140 "nits G H/6 F H2?:400 EECost of Goods Sold A)o"ntsD a* Average Cost 9umber of #nits 1 8 ":8 88 488 D &ost of %oods 0old x x x x #nit &ost D 7: D ; D 11 D Total &ost 7 ;,8 ",$ 8 , 88 7,,':8

/vailable for 0ale 7,,':8 488 units D

7;.$8 per unit

D 7;.$8 x $8 units D 7 , ', nit nit s Cost 1 8 7: 1 8 ; $8 88 $8 $8 711 ; Total Cost 7 ;,8 1,8:8 7 ,8$8 7 , 88 ",8 7 ,',8

Cost of Goods Sold b* #I#O !irst #nits in )Beginning Inventory* 9ext #nits in )Lanuary 1 * Total &ost of %oods 0old )!I!O* c* $I#O =ast #nits in )Lanuary ,* 9ext #nits in )Lanuary 1 * Total &ost of %oods 0old )=I!O*

7-3!

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

A&7.10 *!ontin"ed+ Cost of Goods Sold d* Spe!ifi! !irst sale Identifi!ation 0econd sale Total &ost of %oods 0old nit s 188 1$8 $8 nit Cost 7 : ; Total Cost 7 :88 1, ,8 7 ,8,8

Cost of Ending Inventory A)o"ntsD a* Average Cost +nding Inventory

D D

7;.$8 x $,8 units 7$," $ nit Cost Total Cost 711 7 , 88 ; ,"$8 7$,'$8 7: ; 7 ;,8 ",8,8 7$,8 8

b*

Ending Inventory #I#O =ast #nits in )Lanuary ,* 9ext #nits in )Lanuary 1 * Total +nding Inventory !I!O $I#O !irst #nits in )Beginning Inventory* 9ext #nits in )Lanuary 1 * Total +nding Inventory =I!O

nits 88 ,8 $,8 1 8 "$8 $,8

c*

Ending Inventory d* Spe!ifi! Beginning Identifi!ation Lanuary 1 Lanuary , Total +nding Inventory )0pec.* Be1.

nit s 8 $8 88 $,8

nit Cost 7 : ; 11

Total Cost 7 1,8 ,1,8 , 88 7$,' 8

!I!O reports a higher pretax income than =I!O because )1* prices are rising and ) * !I!O allocates the old )lower* unit costs to cost of goods sold. !or the same reason, !I!O will report a higher +F0 amount because it produces a higher pretax income than =I!O.

7-40

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

A&7.10 *!ontin"ed+ Be1. " Because =I!O reports a lower pretax income than !I!O for the reasons given in Be1uirement ) *, =I!O will result in lower income tax by )71,:88 - 71, :8* x "8M D 71',. Be1. $ =I!O will provide a more favorable cash flow than !I!O of 71', because less cash will be paid for income tax than would be paid under !I!O )for the reasons given in Be1uirements and "*.

7-41

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

A&7.20 Be1. 1 &ri!es Rising A 9 #I#O $I#O 71", ,8 71", ,8 ",8,8 $,188 4,1,8 ,$88 )a* $,4,8 :,'88 ',888 ",'88 1,8'8 7 ,$'8 ",8,8 $,188 4,1,8 ,1,8 )b* ',888 :, ,8 ',888 ", ,8 ;4: 7 , : 7 ,$88 ,1,8 ,1,8 ,$88 &ri!es #alling C > #I#O $I#O 71", ,8 71", ,8 ",$88 ",,;8 4,8;8 ,1,8 )c* $,;"8 :,""8 ',888 ",""8 ;;; 7 ,""1 ",$88 ",,;8 4,8;8 ,$88 )d* $,,;8 :,'48 ',888 ",'48 1,841 7 ,$;;

0ales revenue )'18 units* &ost of goods sold< Beginning inventory )"$8 units* Furchases )$18 units* %oods available for sale +nding inventory ) $8 units*> &ost of goods sold )'18 units* %ross profit +xpenses Fretax income Income tax expense )"8M* 9et income

>Inventory computations< )a* !I!O< $8 units H 718.88 D )b* =I!O< $8 units H 7;.88 D )c* !I!O< $8 units H 7;.88 D )d* =I!O< $8 units H 718.88 D

Be1. The above tabulation demonstrates that when prices are rising, !I!O gives a higher net income than =I!O. 2hen prices are falling, the opposite effect results. The difference in pretax income )as between !I!O and =I!O* is the same as the difference in cost of goods sold but in the opposite direction. The difference in net income )i.e., after tax* is e1ual to the difference in cost of goods sold multiplied by one minus the income tax rate. Be1. " 2hen prices are rising, =I!O derives a more favorable cash position )than !I!O* e1ual to the difference in income tax. In contrast, when prices are falling, !I!O derives a more favorable cash position e1ual to the difference in income tax.

7-42

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

A&7.20 (continued) Be1. $ +ither method can be defended reasonably. If one focuses on current income and +F0, !I!O derives a more favorable result )higher than =I!O when prices are rising*. /lternatively, if one focuses on income tax expense and cash position, when prices are rising, =I!O derives more favorable results )lower taxes, better cash position*. Eowever, these comparative results will reverse if prices fall. !I!O provides a better balance sheet valuation )higher current asset value* but on the income statement does not match current expense )cost of goods sold* with current revenues. /lternatively, =I!O better matches expenses with revenues but produces a less relevant inventory valuation on the balance sheet.

A&7.40 Be1. 1 CO$CA CO%&AN= In!o)e State)ents Corre!ted 10// 0ales revenue &ost of goods sold %ross profit +xpenses Fretax income 7,8,888 ";,888 1,888 1,,888 7 ',888 10/1 7,",888 $1,888> ,888 14,888 7 ',888 10/2 7,',888 $,,888> 1;,888 14,888 7 ,888 10/4 7,:,888 $,,888 ,888 1;,888 7 ",888

> Increase in the ending inventory in 81 by 7 ,888 causes a decrease in cost of goods sold by the same amount. Therefore, cost of goods sold for 81 is 7$",888 7 ,888 D 7$1,888. Because the 81 ending inventory is carried over as the 81" beginning inventory, cost of goods sold for 81" was understated by 7 ,888. Thus, the correct cost of goods sold amount for 81" is 7$$,888 C 7 ,888 D 7$,,888.

7-43

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

A&7.40 (continued) Be1. 10// %ross profit ratio )gross profit K sales*< Before correction< 7 1,888 K 7,8,888 D ."' 7 8,888 K 7,",888 D 7 1,888 K 7,',888 D 7 ,888 K 7,:,888 D /fter correction< 9o change 7 ,888 K 7,",888 D 71;,888 K 7,',888 D 9o change ."' ."' . ; ." 10/1 10/2 10/4

." ." ."

Be1. " The error would have the following effect on income tax expense< 81 Before correction: 81 < 7",888 x "8M D 81"< 7$,888 x "8M D After correction: 81 < 7',888 x "8M D 81"< 7 ,888 x "8M D ?ifference 7;88 71, 88 1,'88 7 ),88* ,88 7 ,88 81"

The income tax expense would have been understated by 7,88 in 81 and overstated by 7,88 in 81".

7-44

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

CASES AN> &ROBECTS

ANN A! "EP#"T CA$E$ C&7./ Be1. 1 The company held 7 ;$,; : thousand of merchandise inventory at the end of the current year. This is disclosed on the balance sheet. Be1. The company purchased 71,: ", 8: thousand during the current year. The beginning and ending inventory balances are disclosed on the balance sheet and cost of goods sold is disclosed on the income statement. Furchases during the year can be computed by rearranging the basic inventory e1uation )BI C F - +I D &%0* or using a T.account< &ost of goods sold .............................................. 71,:1$,4,' thousand C +nding inventory ............................................ ;$,; : thousand Beginning inventory ........................................... ) :,,$:'* thousand Furchases .......................................................... 71,: ", 8: thousand Inventory Beg. Balance Furchases +nd. Balance Be1. " The company uses the average cost method to determine the cost of its inventory. This is disclosed in 9ote under P6erchandise Inventory.S It indicates that inventory is valued at the lower of average cost or mar(et. Be1. $ A)eri!an Eagle O"tfitters Inventory D Turnover &ost of %oods 0old /verage Inventory 71,:1$,4,' D ,. $ ;8,48,.'> :,,$:' 1,: ", 8: ;$,; : 1,:1$,4,' &ost of goods sold

>) :,,$:' C 7 ;$,; :* O It indicates how many times the average inventory was purchased and sold during the year.

7-45

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

C&7.10 Be1. 1 %iven the general trend of little or no inflation every year, it would be unli(ely that the replacement cost of #rban OutfittersG inventory would be lower than its current boo( value. /nd, unless a severe mar(et downturn )or extreme change in fashion* too( place, it would be unli(ely that the net reali3able value of the companyGs current season inventory would drop below its original cost. 0ince the end of the year coincides with the end of the selling season for winter clothes, only these remaining goods are li(ely to have a net reali3able value below original cost. Therefore, it is li(ely that only these items would re1uire a writedown at the end of the year, because the companyGs boo( value for other inventory items will be lower than both replacement cost and net reali3able value. Be1. The company uses the first.in, first.out method to determine the cost of its inventory. This is disclosed in 9ote under PInventories.S Be1. " If the company had overstated its ending inventory by 718 million, its income before income taxes would be overstated by 718 million. Becall that ending inventory reduces cost of goods sold, which is an expense. Therefore, cost of goods sold would be 718 million lower and income before income taxes would be 718 million higher )i.e., 7"8;,$;8,888 reported instead of the correct amount of 7 ;;,$;8,*. Be1. $ r<an O"tfitters Inventory D Turnover &ost of %oods 0old /verage Inventory 71,1 1,1$8 D ,.', 148,:11.'>

> )141,; ' C 71,;,,;:* O It indicates how many times the average inventory was purchased and sold during the year.

7-46

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

C&7.2 Be1. 1 A)eri!an Eagle O"tfitters Inventory D Turnover &ost of %oods 0old /verage Inventory 71,:1$,4,' D ,. $ ;8,48,.'> r<an O"tfitters 71,1 1,1$8 D ,.', 148,:11.'>>

> )7 :,,$:' C 7 ;$,; :* O >> )7141,; ' C 71,;,,;:* O #rban Outfitters has a higher inventory turnover ratio than /merican +agle Outfitters. This higher ratio implies that #rban Outfitters was more successful than /merican +agle in moving inventory 1uic(ly through the purchasing and sales processes to the ultimate customer. Be1. Ind"stry Average '.; A)eri!an Eagle O"tfitters ,. $ r<an O"tfitters ,.',

Both /merican +agle Outfitters and #rban Outfitters have a higher inventory turnover than the industry average. That means that they are doing a better 5ob at managing inventory levels, and moving inventory 1uic(ly through the purchasing and sales processes to the ultimate customer.

7-47

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

%&NANC&A! "EP#"T&N' AN( ANA!)$&$ CA$E$ C&7.40 Be1. 1 Froduction costs included in inventory become cost of goods sold expense on the income statement in the period the goods are sold. Be1. 0ince some of the current yearGs production is still not sold, some of these production.related costs that were added to wor(.in.process inventory during the production process are still in wor(.in.process inventory or in finished goods. This increases total inventory. 0ince the items have not been sold, the amounts have not been included in cost of goods sold expense. Thus total expenses are lower which in turn increases net income.

C&7.50 Be1. 1 Caterpillar Inventories . =I!O Flus< =I!O Beserve Inventories . !I!O &ost of goods sold< =I!O C Beginning =I!O Beserve . +nding =I!O Beserve &ost of goods sold< !I!O 100: 7:,4:1 ",1:" 711,;,$ 7":,$1' ,,14 ",1:" 7"4,:$; 1007 74, 8$ ,,14 7;,: 1 7" ,, , ,$8" ,,14 7" ,$1 1006 7,,"'1 ,$8" 7:,4'$

7-4

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

88: =I!O Inventory turnover D 88: !I!O Inventory turnover D 7"4,:$; D )7;,: 1 C 711,;,$* K ".' 7":,$1' )74, 8$ C 7:,4:1* K D $.:

884 =I!O Inventory turnover D 884 !I!O Inventory turnover D 7" ,$1 )7:,4'$ C 7;,: 1* K D ".' 7" ,, , )7,,"'1 C 74, 8$* K D $.:

C&7.50 *!ontin"ed+ >EERE *as provided+ 88: =I!O 88: !I!O Be1. In all three cases, the ratio is higher under =I!O than !I!O. The =I!O beginning and ending inventory numbers )the denominator* are artificially small because they reflect old lower costs. =I!O cost of goods sold )the numerator* reflects the new higher costs. Thus, the numerator in the =I!O calculation does not relate in a meaningful way to the denominator. 4." $.;

7-4!

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

Be1. " The !I!O inventory turnover ratio is normally thought to be a more accurate indicator when prices are changing because =I!O can include very old inventory prices in ending inventory balances. /ccording to the !I!O ratios, &aterpillar has used inventory no more efficiently during the current period than the prior period. Eowever, it is less efficient than Lohn ?eere. 0uch comparisons should also consider any changes in inventory mix between periods or companies, which may also affect the ratio.

7-50

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

C"&T&CA! T*&N+&N' CA$E$ C&7.60 1. The press release states that management believes =I!O is more appropriate because it better matches current costs with current revenues, and also mentions that there are tax benefits to adopting =I!O for tax purposes. . The decrease in pre.tax income was 7 :,1,',888. Thus, ending inventory was decreased by 7 :,1,',888 and cost of goods sold was increased by 7 :,1,',888. 0ince the company is in the "'M tax brac(et, this resulted in a decrease in tax expense of ."' x 7 :,1,',888 D 7;,:':,888 )rounded to the nearest thousand* and a decrease in net income of 7 1:,"84,888. ". This 7;,:':,888 tax postponement is significant and is li(ely to be the main reason that management adopted =I!O. / decrease in net income is normally a negative sign to analysts, since it normally implies a decline in future cash flows. In this case, however, the change had a positive cash flow effect. 6ost analysts would loo( favorably on a change, the only effect of which is to provide the company with an additional 7;,:':,888 in cash.

7-51

Chapter 07 - Reporting and Interpreting Cost of Goods Sold and Inventory

C&7.70 To< The !iles !rom< The 9ew 0taff 6ember Be< +ffect of restatement 1. The &ompany understated purchases by 7$4." million. This causes cost of goods sold to be understated and pre.tax income to be overstated by 7$4." million. 9et income is overstated by that amount times 1 - tax rate< 7$4." x )1 - .$8$* D 7 :. million overstatement . The restatement of the purchases caused the board to rescind managementGs bonuses. /ccordingly, pre.tax income will increase by 7 . million, and net income will increase by that amount times 1 - tax rate. 7 . x )1 - .$8$* D 71." million increase ". If it is assumed that bonuses are a fixed portion of net income, the bonus rate can be roughly estimated using the amounts computed in parts 1 and . &hange in bonus &hange in net income 7 . million 7 :. million $. The Board li(ely tied management compensation to net income to align the interests of management with that of shareholders. Typically, increases in net income will fuel a rise in the stoc( price. This type of compensation scheme does create the possibility that unethical management may alter the financial results to receive higher bonuses. D Bonus rate per dollar of net income

7.84: per dollar of net income )or 4.:M*

%&NANC&A! "EP#"T&N' AN( ANA!)$&$ P"#,ECT$ C&7.:0 The solution to this case will depend on the company andOor accounting period selected for analysis.

7-52