CHAPTER 5

Inventories and
Cost of Goods Sold
QUESTIONS

1. The three distinct types of costs incurred by a manufacturer are direct materials,
direct labor, and manufacturing overhead. Direct, or raw, materials are the ingredients
used in making a product. Direct labor consists of the amounts paid to factory workers
to manufacture the product. Manufacturing overhead includes all the other costs that
are related to the manufacturing process but cannot be directly matched to specific
units of output.
2. The use of a contra-revenue account to record cash refunds and other types of
allowances allows a company to monitor the size and frequency of these occurrences.
For example, a relatively large amount of returns in any one period may be an indica-
tion that the quality of the product has slipped. The information provided by the use of
these contra-revenue accounts would be lost if all returns and allowances were rec-
orded as reductions of the Sales Revenue account. Also, if this practice were followed,
the actual amount of sales would be understated for the period to the extent of any
returns and allowances.
3. Terms of 3/20, n/60 mean that the customer may deduct 3% from the selling price if
the bill is paid within 20 days. Otherwise, the full amount is due within 60 days of the
date of the invoice. Assuming a sale for $1,000, a 3% discount would save the
customer $30, resulting in a net amount due of $970. The amount saved is the result
of paying 40 days earlier than is required by the 60-day term. Assuming 360 days in
a year, there are 360/40, or 9 periods of 40 days each, in a year. Thus, a savings of
$30 for 40 days is equivalent to a savings of $30 × 9, or $270 for the year. This is
equivalent to an annual return of $270/$970, or 27.8%. Conclusion: The customer
should pay in the first 20 days unless another investment can be found offering a
return in excess of 27.8%.
4. The two inventory systems differ with respect to how often the Inventory account is
updated. Under the perpetual system, the Merchandise Inventory account is updated
each time a sale or purchase is made. Therefore, the perpetual system continuously
shows the inventory on hand and cost of goods sold. With the periodic system, the
Inventory account is updated only at the end of the period. A temporary account, called
Purchases, is used to keep track of the acquisitions of inventory during the period.
The periodic method relies on a count of the inventory on hand at the end of the period
to determine the amount to assign to ending inventory on the balance sheet and to
cost of goods sold expense on the income statement.

5-1
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 5-2 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

5. A point-of-sale terminal gives the merchandiser the ability to update the inventory rec-
ords each time a sale is made. As an item is slid over the sensing glass, a bar code
on the product is read by the computer. In this way, the unit can be removed from the
inventory at the point of sale. In some instances, however, merchandisers use the
terminals only to update the quantity of units on hand, not necessarily the dollar
amount.
6. The Purchases account is neither an asset nor an expense account. It is simply a
temporary holding account for the purchases of merchandise, which is closed at the
end of the period. The effect of purchases made during the period is to increase the
cost of goods sold expense. It is included in the income statement as an integral part
of the calculation of cost of goods sold and is therefore shown as a reduction of stock-
holders’ equity in the accounting equation.
7. For inventory in transit at the end of the year, the terms of shipment dictate whether
the buyer should record the purchase of the inventory. FOB shipping point means that
the goods belong to the buyer as soon as they are shipped, and the purchases should
be recorded at this point in time. Alternatively, FOB destination point means that the
goods do not belong to the buyer until they are received and therefore should not be
recorded if they are in transit at year-end.
8. Transportation-in represents the freight costs incurred on purchases of merchandise
and is therefore added to the purchases of the period in determining cost of goods
sold expense. Alternatively, transportation-out indicates the freight costs incurred in
selling merchandise and is therefore reported as a selling expense on the income
statement in the period of sale.
9. Gross profit is computed by deducting cost of goods sold from net sales. The gross
profit ratio indicates how well the company controlled its product costs during the year.
For example, a 30% gross profit ratio indicates that for every dollar of net sales, the
company has a gross profit of 30 cents. That is, after deducting 70 cents on every
dollar for the cost of the inventory that is sold, the company has 30 cents to cover its
operating costs and earn a profit.
10. According to the cost of goods sold model, beginning inventory plus purchases minus
ending inventory equals cost of goods sold. Therefore, the amount assigned to
inventory on the balance sheet has a direct effect on the measurement of cost of
goods sold on the income statement. Any errors in valuing inventory will flow through
to cost of goods sold and thus have an impact on the measurement of net income.
11. The justification for treating freight costs on incoming inventory as a cost incurred in
acquiring the asset, rather than as an expense of the period, is the matching principle.
Freight costs are necessary to put the inventory into a position to be sold and should
therefore be included in the cost of the asset. This is a significant decision, since the
cost will become an expense only at the time the inventory is sold. If freight costs are
not included in the cost of the inventory, they are expensed immediately as they are
incurred. Thus, if the inventory is not sold at the end of the period, the decision to treat
freight costs as a cost of the inventory will result in higher net income than if the costs
had been included as an expense of the period.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD 5-3

12. The specific identification method is appropriate only for certain types of inventory. It
is normally used for situations in which the inventory is relatively high-priced and
subject to a low amount of turnover. Although it is not a necessary condition, each unit
of inventory is often unique. For example, an automobile dealer uses the specific
identification method, as would a jewelry company.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 5-4 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

13. When used on an inventory of identical units, the specific identification can lead to the
manipulation of income. Because all units are identical, management can select which
units to sell based on the relative high or low cost of the units on hand. For example,
in a bad year, a company might be tempted to select for sale all units that had a
relatively low unit cost, regardless of when they were acquired. The use of a cost flow
assumption, such as weighted average, FIFO, or LIFO, eliminates the ability of
management to select units for sale based solely on the effect this decision will have
on the income of the period.
14. The weighted average cost method does not rely on a simple arithmetic average of
the unit cost for the various purchases of the period. Instead, more weight is assigned
to unit costs at which more units were purchased. For example, assume that beginning
inventory consists of 100 units with a unit cost of $10 per unit. Assume that during the
period, 100 units were purchased at $15 per unit and 200 units were purchased at
$20 per unit. The arithmetic average unit cost for the period would be ($10 + $15 +
$20)/3 = $15. However, the weighted average unit cost would be [100($10) + 100($15)
+ 200($20)]/400 units, or $16.25. The acquisition of twice as many units at $20 as
opposed to those purchased at $10 and $15 drives the weighted average up to
$16.25.
15. The FIFO method more nearly approximates the physical flow of products in most
businesses. This is particularly true for perishable products such as fresh fruits and
vegetables. Most businesses prefer as a matter of good customer relations to sell their
goods on a first-in, first-out basis. This minimizes the likelihood that units of inventory
will become obsolete and spoiled.
16. The use of LIFO will have the effect of maximizing net income if a company is
experiencing a decline in the unit cost of inventory. Last-in, first-out charges the most
recent purchases to cost of goods sold. If prices are declining, the amounts charged
to cost of goods sold will be less than if either the weighted average method or FIFO
is used. Because less is charged to cost of goods sold, net income will be higher.
17. In a period of rising prices, the use of LIFO will result in a lower tax bill. Because the
most recent purchases are charged to cost of goods sold under LIFO, in a period of
rising prices, these units will be higher-priced. Thus, the result will be lower gross
margin as well as lower net income before tax. Lower net income will result in a lower
amount of tax to pay. If prices are declining during the period, FIFO will result in a
lower tax bill.
18. No, the president should not be enthralled with the new controller. The controller is
suggesting something that is not allowed under the tax law. The Internal Revenue
Service’s LIFO conformity rule requires that a company that wants to use LIFO for tax
purposes must also use it in preparing its income statement. Note that this rule applies
only to the use of LIFO on the tax return. A company is free to use different methods
in preparing its tax return and its income statement as long as the method used for
the tax return is not LIFO.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD 5-5

19. A LIFO liquidation occurs when a company using the LIFO inventory method sells
more units during the period than it purchases. A liquidation of some or all of the older,
relatively lower-priced units (assuming rising prices) will result in a low cost of goods
sold amount and a correspondingly higher gross margin. This may present a dilemma
to a company. If the company sells the lower-priced units, its net income will improve,
but higher taxes will have to be paid. To avoid facing this situation, a company might
buy inventory at the end of the year to avoid these consequences of a liquidation.
Unfortunately, the somewhat forced purchase of inventory to avoid the liquidation may
not be in the best interests of the company.
20. FIFO, LIFO, and weighted average are all cost-based methods to value inventory.
These three methods assign historical costs to inventory. Many accountants argue
that the use of historical cost in valuing inventory leads to what is called inventory
profit, particularly when FIFO is used in a period of rising prices. In a period of rising
prices, FIFO can result in significant inventory profits. In comparison with LIFO, the
use of FIFO in a period of rising prices charges less to cost of goods sold because it
is the older, lower-priced units that are assumed to be sold. However, in a period of
significant inflation, there may be a large difference between the gross margin that
results from using FIFO and the much smaller amount that would result from using the
current cost of the inventory (replacement cost). This difference, called inventory
profit, is simply the result of holding the units during a period of inflation. However, a
replacement cost approach is not acceptable under the profession’s current stand-
ards, although many believe it provides more relevant information to users.
21. No, it is not acceptable for a company to indicate to its stockholders that it is switching
to LIFO to save on taxes. While the ability to save taxes may be an important
result of the change, the company must be able to demonstrate that LIFO does a
better job of matching costs with revenues. This is normally the justification offered in
the annual report for a company’s change to LIFO.
22. Because a certain section of the warehouse is double-counted, ending inventory will
be overstated. According to the cost of goods sold model, ending inventory is sub-
tracted from cost of goods available to sell to arrive at cost of goods sold expense.
Therefore, an overstatement of ending inventory will lead to an understatement of cost
of goods sold expense. An understatement of an expense results in an overstatement
of net income for the period.
23. The lower-of-cost-or-market rule is invoked when the utility of inventory is less than its
cost to the company. It is a departure from the historical cost principle and is justified
on the basis of conservatism. The rule is a reaction to uncertainty by anticipating a
decline in the value of inventory and writing down the asset before it is sold.
24. Application of the lower-of-cost-or-market rule on a total basis, compared with an item-
by-item basis, will usually yield a different result. The reason is that with the total
approach, increases in market value above cost are allowed to offset decreases in
value. Alternatively, when the item-by-item approach is used, any increases in value
are essentially ignored and it is the declines in value for each item that are recognized.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 5-6 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

25. Inventory turnover equals cost of goods sold (cost of sales) divided by average
inventory. If the cost of sales remains constant while the denominator (average
inventory) increases, inventory turnover will decrease. This indicates that inventory is
staying on the shelf for a longer time. The company should probably evaluate the
salability of its inventory.
26. When a perpetual inventory system is used, the dollar amount of inventory is calcu-
lated after each sale. Thus, when it is used in conjunction with the weighted average
cost method, a new average cost is calculated after each sale. The weighted average
changes each time a sale is made; therefore, the unit cost is called a moving average.

BRIEF EXERCISES

LO 1 BRIEF EXERCISE 5-1 TYPES AND FORMS OF INVENTORY COSTS FOR A

MANUFACTURER

The three types of cost incurred by a manufacturer are direct or raw materials, direct
labor, and manufacturing overhead. The three forms that inventory can take for a
manufacturer are direct or raw materials, work in process or work in progress, and finished
goods.

LO 2 BRIEF EXERCISE 5-2 NET SALES

Sales revenue $ 85,000

Less: Sales returns and allowances 6,500
Sales discounts 6,500
Net sales $ 72,000

LO 3 BRIEF EXERCISE 5-3 COST OF GOODS SOLD

Purchases: I
Beginning inventory: I
Purchase discounts: D
Transportation-in: I
Ending inventory: D
Purchase returns and allowances: D

LO 4 BRIEF EXERCISE 5-4 GROSS PROFIT RATIO

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD 5-7

Gross profit ratio: ($50,000 – $30,000)/$50,000 = 40%

LO 5 BRIEF EXERCISE 5-5 VALUATION OF INVENTORY AND MEASUREMENT OF

INCOME

Examples of costs that should be added to the purchase price of inventory are freight
costs on purchases, insurance during the time inventory is in transit, storage costs before
inventory is ready to be sold, and various taxes such as excise and sales taxes.

LO 6 BRIEF EXERCISE 5-6 INVENTORY COSTING METHODS

Ending Inventory:
FIFO: 500 × $6 = $3,000
LIFO: 500 × $5 = $2,500

LO 7 BRIEF EXERCISE 5-7 SELECTING AN INVENTORY COSTING METHOD

Cost of goods sold: L

Gross profit: H
Income before taxes: H
Income taxes: H
Cash outflow: H

LO 8 BRIEF EXERCISE 5-8 INVENTORY ERROR

If ending inventory is overstated by $50,000, then cost of goods sold will be understated
by $50,000 and gross profit will overstated by $50,000. Net income will be overstated, but
the effect of the overstatement will not be for the same amount because of the effect of
taxes. Retained earnings will also be overstated.

Hint: To summarize, if ending inventory is overstated, then cost of goods sold will be
understated and both net income and retained earnings will be overstated. On the other
hand, if ending inventory is understated, then cost of goods sold is overstated and both
net income and retained earnings will be understated.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
5-8 USING FINANCIAL ACCOUNTING INFORMATION SOLUTIONS MANUAL

LO 9 BRIEF EXERCISE 5-9 LOWER-OF-COST-OR-MARKET RULE

The effect of the adjustment can be identified and analyzed as follows:

Identify ACTIVITY: Operating

And ACCOUNTS: Inventory Decrease
Analyze Loss on Decline in Value of Inventory Increase
STATEMENT[S]: Balance Sheet and Income Statement
Balance Sheet Income Statement
STOCKHOLDERS’ NET
ASSETS = LIABILITIES + EQUITY REVENUES – EXPENSES = INCOME
Inventory (20,000) Loss on Decline (20,000)
(20,000) in Value of
Inventory 20,000

LO 10 BRIEF EXERCISE 5-10 INVENTORY TURNOVER

Company A’s inventory turnover is $10,000,000/$100,000, or 100 times. Company B’s

turnover is $10,000,000/$1,000,000, or 10 times. Company A with the much higher
turnover is the wholesaler of fresh fruits and vegetables. Company B is the car dealer
because its inventory would not turn over nearly as often given the nature of its products.

LO 11 BRIEF EXERCISE 5-11 CASH FLOW EFFECTS

The increase in inventory would be deducted from net income on the statement of cash
flows prepared using the indirect method since the buildup of inventory required cash
outflow. The increase in accounts payable would be added to net income since this
indicates a net cash inflow.

LO 12 BRIEF EXERCISE 5-12 INVENTORY METHODS USING A PERPETUAL SYSTEM

Yes, the dollar amount assigned to ending inventory will differ when a company uses the
average cost method, depending on whether a periodic or perpetual system is used. This
is because when the average method is applied in a perpetual system a new average has
to be computed each time a purchase is made, resulting in a moving average.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD 5-9

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.