Chapter 5

CHAPTER 5
Inventories and
Cost of Goods Sold
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Estimated
Time in
Learning Outcomes Exercises Minutes Level
1. Identify the forms of inventory held by different types of 1 10 Easy
businesses and the types of costs incurred. 2 10 Mod
2. Show that you understand how wholesalers and retailers 3 25 Mod

account for sales of merchandise. 4 10 Easy
20* 25 Mod
21* 15 Mod
3. Show that you understand how wholesalers and retailers 5 15 Easy

account for cost of goods sold. 6 20 Mod
7 25 Mod
8 20 Mod
9 15 Mod
20* 25 Mod
21* 15 Mod
4. Use the gross profit ratio to analyze a company’s ability

to cover its operating expenses and earn a profit.
5. Explain the relationship between the valuation of inventory 10 15 Mod

and the measurement of income. 23* 20 Mod
6. Apply the inventory costing methods of specific identification, 11 20 Easy

weighted average, FIFO, and LIFO using a periodic system. 22* 25 Mod
7. Analyze the effects of the different costing methods on 12 15 Mod

inventory, net income, income taxes, and cash flow. 22* 25 Mod
24* 40 Mod
8. Analyze the effects of an inventory error on various financial 13 25 Mod

statement items. 14 20 Mod
9. Apply the lower-of-cost-or-market rule to the valuation of 23* 20 Mod

inventory.
10. Explain why and how the cost of inventory is estimated in 15 20 Mod
certain situations.
5-1
5-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Estimated
Time in
Learning Outcomes (Concluded) Exercises Minutes Level
11. Analyze the management of inventory. 16 20 Mod
12. Explain the effects that inventory transactions have on the 17 10 Easy
statement of cash flows. 18 15 Mod
19 15 Mod
13. Explain the differences in the accounting for periodic and 24* 40 Mod
perpetual inventory systems and apply the inventory
costing methods using a perpetual system (Appendix).
*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
CHAPTER 5 • INVENTORIES AND COST OF GOODS SOLD 5-3
Problems Estimated
and Time in
Learning Outcomes Alternates Minutes Level
1. Identify the forms of inventory held by different types of 1 25 Mod
businesses and the types of costs incurred. 15* 20 Mod
2. Show that you understand how wholesalers and retailers 8* 45 Mod

account for sales of merchandise. 9* 40 Mod
10* 40 Mod

account for cost of goods sold. 9* 40 Mod
10* 40 Mod
4. Use the gross profit ratio to analyze a company’s ability

to cover its operating expenses and earn a profit. 2 25 Mod
9* 40 Mod
5. Explain the relationship between the valuation of inventory 11* 45 Mod

and the measurement of income. 12* 60 Diff
13* 30 Mod
14* 30 Mod
6. Apply the inventory costing methods of specific identification, 11* 45 Mod

14* 30 Mod

12* 60 Diff
13* 30 Mod
14* 30 Mod
15* 20 Mod
16* 20 Mod
8. Analyze the effects of an inventory error on various financial 4 45 Diff

statement items.

inventory. 16* 20 Mod
10. Explain why and how the cost of inventory is estimated in 5 20 Mod
certain situations.
11. Analyze the management of inventory. 6 30 Mod
12. Explain the effects that inventory transactions have on the 7 25 Mod
statement of cash flows. 8* 45 Mod
13. Explain the differences in the accounting for periodic and 12* 60 Diff

Estimated
Time in
Learning Outcomes Cases Minutes Level
1. Identify the forms of inventory held by different types of 1* 30 Mod
businesses and the types of costs incurred. 3* 25 Mod

account for sales of merchandise. 5* 20 Mod
9 30 Mod

account for cost of goods sold. 4* 20
Mod
5* 20 Mod
6 25 Mod
4. Use the gross profit ratio to analyze a company’s ability 4* 20 Mod

to cover its operating expenses and earn a profit. 5* 20 Mod
5. Explain the relationship between the valuation of inventory

and the measurement of income.
6. Apply the inventory costing methods of specific identification, 3* 25 Mod


10 30 Mod
8. Analyze the effects of an inventory error on various financial 8 30 Mod

statement items.

inventory. 11 30 Mod
10. Explain why and how the cost of inventory is estimated in

certain situations.
11. Analyze the management of inventory.
12. Explain the effects that inventory transactions have on the

statement of cash flows.
13. Explain the differences in the accounting for periodic and


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 indication 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 recorded 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%.
4. The two inventory systems differ with respect to how often the inventory account is
updated. Under the perpetual system, the account is updated each time a sale or
purchase is made. 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. A point-of-sale terminal gives the merchandiser the ability to update the inventory
records each time a sale is made. As an item is run 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.
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 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.
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.
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 for 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
was 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, and 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.
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. In a period of rising prices, FIFO can result in significant inventory profits. In
comparison with LIFO, the use of FIFO 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.
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
subtracted 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 currently
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.
25. A company using the periodic inventory system could undoubtedly save money by
estimating its year-end inventory and thus avoiding the expense of counting it.
However, the inventory must be based on actual cost, not an estimate, for purposes
of the annual report.
26. A retailer can save time and money at the end of the year by simply counting the
number of units of each item of inventory and multiplying each of these counts by
the price marked on the units (that is, the retail price). This process gives the
company an amount that represents the value of the inventory at retail. The retail
method is then used to convert this amount to cost. It would be prohibitive for many
retailers, particularly mass merchandisers, to trace the unit cost of each item of
inventory to purchase invoices.
27. 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.
28. When a perpetual inventory system is used, the dollar amount of inventory is
calculated after each sale. Thus, when it is used in conjunction with the weighted
average costing method, a new average cost is calculated after each sale. The
weighted average changes each time a sale is made, and therefore the unit cost is
called a moving average.
EXERCISES
LO 1 EXERCISE 5-1 CLASSIFICATION OF INVENTORY COSTS
Classification
Raw Work in Finished Merchandise
Inventory Item Material Process Goods Inventory
Fabric X
Lumber X
Unvarnished tables X
Chairs on the showroom floor X
Cushions X X*
Decorative knobs X
Drawers X
Sofa frames X
Chairs in the plant warehouse X
Chairs in the retail storeroom X
*Cushions produced by the company would be work in process, but if purchased from a
supplier, they would be raw materials.
LO 1 EXERCISE 5-2 INVENTORIABLE COSTS
List price: $100  200 units $20,000

Less: 10% volume discount (2,000)
Freight costs 56
Insurance for goods in transit 32
Total cost $18,088
Under the cost principle, all of these costs are necessary to put the inventory into a
position where it can be sold.
Other classifications:
The phone charges and purchasing department salary would both be difficult to
match directly with the sale of any particular product and therefore should be treated as
operating expenses of the period. The labeling supplies are immaterial in amount and
should also be reported as operating expenses. The interest paid to suppliers is a
financing cost and would be reported as interest expense on the income statement.
LO 2 EXERCISE 5-3 PERPETUAL AND PERIODIC INVENTORY SYSTEMS
1. Company A is using a perpetual inventory system because it has the account Cost of
Goods Sold. Company B is using the periodic inventory system because it uses the
accounts Purchases, Purchase Discounts, and Purchases Returns and Allowances.
2. Company A’s end of the year inventory is the balance in its merchandise inventory
account, $12,000. Its cost of goods sold is $38,000, the balance in that account.
3. Cost of goods sold in a periodic system is computed as: Beginning inventory + net
purchases – ending inventory. Company B’s merchandise inventory account
represents beginning inventory. Ending inventory is obtained by conducting a
physical count. Because you are not given the ending inventory figure, you cannot
compute cost of goods sold.
LO 2 EXERCISE 5-4 PERPETUAL AND PERIODIC INVENTORY SYSTEMS
Perpetual—Appliance store
Perpetual—Car dealership
Periodic—Drugstore
Perpetual—Furniture store
Periodic—Grocery store
Periodic—Hardware store
Perpetual—Jewelry store
Changes in technology may lessen the costs of maintaining perpetual inventory

systems. Merchandisers will convert to perpetual inventory systems when the benefits
of maintaining such systems exceed the costs.
LO 3 EXERCISE 5-5 MISSING AMOUNTS IN COST OF GOODS SOLD MODEL
Case 1:
(a) Beginning inventory: cost of goods available for sale – cost of goods purchased =
$7,110 – ($6,230 – $470 – $200 + $150) = $7,110 – $5,710 = $1,400
(b) Ending inventory: cost of goods available for sale – cost of goods sold = $7,110 –
$5,220 = $1,890
Case 2: (must first solve d, then c)
(d) Cost of goods available for sale: cost of goods sold + ending inventory = $5,570 +
$1,750 = $7,320
(c) Purchase discounts:
1. Cost of goods available for sale – beginning inventory = cost of goods purchased
= $7,320 – $2,350 = $4,970
2. Gross purchases – purchase returns and allowances – purchase discounts +
transportation-in = cost of goods purchased; $5,720 – $800 – purchase discounts
+ $500 = $4,970; purchase discounts = $5,420 – $4,970 = $450
EXERCISE 5-5 (Concluded)
Case 3:
(e) Gross purchases:
1. Cost of goods purchased = cost of goods available for sale – beginning inventory
= $8,790 – $1,890 = $6,900
2. Gross purchases – purchase returns and allowances – purchase discounts +
transportation-in = cost of goods purchased; gross purchases – $550 – $310 +
$420 = $6,900; gross purchases = $6,900 + $550 + $310 – $420 = $7,340
(f) Cost of goods sold = cost of goods available for sale – ending inventory = $8,790 –
$1,200 = $7,590
LO 3 EXERCISE 5-6 PURCHASE DISCOUNTS
BALANCE SHEET INCOME STATEMENT

Assets = Liabilities + Stockholders’ Equity + Revenues – Expenses
7/3 Accounts Purchases (3,500)

Payable 3,500

Payable 7,000
7/12 Cash (3,465) Accounts Purchase

(0.99  3,500) Payable (3,500) Discounts 35
8/5 Cash (7,000) Accounts

Payable (7,000)
LO 3 EXERCISE 5-7 PURCHASES—PERIODIC SYSTEM

3/3 Accounts 2,500 Purchases (2,500)

Payable
3/3 Cash (250) Transportation-in (250)

Payable 1,400
3/12 Cash (2,450) Accounts Purchase

(0.98  2,500) Payable (2,500) Discounts 50
3/15 Accounts Purchase Returns

Payable (500) and Allowances 500

Payable 1,600
3/22 Accounts Purchase Returns

Payable (400) and Allowances 400
4/6 Cash (900) Accounts

Payable (900)
(1,400 – 500)
4/18 Cash (1,200) Accounts

Payable (1,200)
(1,600 – 400)
LO 3 EXERCISE 5-8 SHIPPING TERMS AND TRANSFER OF TITLE
1. The seller pays shipping costs when merchandise is shipped FOB destination point.
Miller Wholesalers pays the freight bill and is responsible for the merchandise until it
gets to Michael’s warehouse.
2. The inventory should not be included as an asset on Michael’s December 31, 2007,
balance sheet because the terms of shipment indicate that the merchandise does
not legally belong to Michael until it arrives, and this is after the end of the year.
Likewise, Miller should not include the sale on its 2007 income statement, since the
goods are not considered sold until they reach the buyer’s business.
3. If the terms of shipment were FOB shipping point, the answers to both questions in
part (2) would change. Under these terms, the inventory belongs to Michael as soon
as it is shipped, and because this is on December 23, 2007, the asset should be
recognized on the year-end balance sheet. Similarly, Miller would record a sale in
2007.
LO 3 EXERCISE 5-9 TRANSFER OF TITLE TO INVENTORY
Purchases of merchandise that are in transit from vendors to Cameron Companies on

December 31, 2007:
Record during December 2007—Shipped FOB shipping point
Record during January 2008—Shipped FOB destination point
Sales of merchandise that are in transit to customers of Cameron Companies on

December 31, 2007:
Record during December 2007—Shipped FOB shipping point
Record during January 2008—Shipped FOB destination point
LO 5 EXERCISE 5-10 INVENTORY AND INCOME MANIPULATION
By ignoring the large order at year-end, and thus including the inventory in the year-end
count, the company will overstate ending inventory. This in turn will lead to an
understatement of cost of goods sold and an overstatement of net income. The effects
on next year’s income are the opposite. Because beginning inventory will be overstated,
cost of goods sold will also be overstated, and net income understated. The accountant
has an obligation to the financial statement users to convince the president to make the
necessary adjustments to reduce the inventory balance.
LO 6 EXERCISE 5-11 INVENTORY COSTING METHODS
1. Ending inventory:
(65 – 55)  $20 = $ 200
(50 – 35)  $22 = 330
(60 – 45)  $23 = 345
(45 – 5)  $24 = 960
80 units $1,835
Cost of goods sold:
55  $20 = $1,100
35  $22 = 770
45  $23 = 1,035
5  $24 = 120
140 units $3,025
45  $24 = $1,080
35  $23 = 805
80 units $1,885
Cost of goods sold:
65  $20 = $1,300
50  $22 = 1,100
25  $23 = 575
140 units $2,975
65  $20 = $1,300
15  $22 = 330
80 units $1,630
Cost of goods sold:
45  $24 = $1,080
60  $23 = 1,380
35  $22 = 770
140 units $3,230
4. Cost of goods available for sale and units available:

65  $20 = $1,300
50  $22 = 1,100
60  $23 = 1,380
45  $24 = 1,080
220 units $4,860
Weighted average cost = $4,860/220 = $22.09/unit
Ending inventory: 80  $22.09 = $1,767.20
Cost of goods sold: 140  $22.09 = $3,092.60
Note: Does not total $4,860 because of rounding of average cost.
LO 7 EXERCISE 5-12 EVALUATION OF INVENTORY COSTING METHODS
1. a 5. b
2. d 6. a
3. c 7. b
4. c 8. c
LO 8 EXERCISE 5-13 INVENTORY ERRORS
Balance Sheet Income Statement

Retained Cost of Net
Inventory Earnings Goods Sold Income
1. U U O U
2. O O U O
3. U U O U
LO 8 EXERCISE 5-14 TRANSFER OF TITLE TO INVENTORY
1. Michelson should include the costs in its inventory, since the merchandise had not
arrived at its destination, PJ’s, by the end of the year.
2. Filbrandt should include the costs of the merchandise in its inventory, since it has
received the shipment by the end of the year.
3. Randall would include the merchandise in its inventory, since the shipment left
James Bros. before the end of the year.
4. Barner should include the merchandise in its inventory. It is both shipped by Hinz
and received by Barner before the end of the year.
LO 10 EXERCISE 5-15 GROSS PROFIT METHOD
(1) Net sales $105,300

 Estimated gross profit ratio 0.25
Estimated gross profit $ 26,325
(2) Net sales $105,300
– Estimated gross profit 26,325
Estimated cost of goods sold $ 78,975
(3) Beginning inventory $ 15,400
Add: Purchases 84,230
Cost of goods available for sale $ 99,630
Estimated cost of goods sold 78,975
Estimate of inventory destroyed $ 20,655

Cash* 10,000 Loss on

Inventory (20,655) Insurance
Settlement (10,655)
*Or, if cash has not been received, Receivable from Insurance Company.
LO 11 EXERCISE 5-16 INVENTORY TURNOVER FOR BEST BUY
1. Inventory turnover = cost of goods sold/average inventory $20,938/[($2,851 +

$2,607)/2] = $20,938/$2,729 = 7.67 times.
2. The average length of time it takes to sell an item of inventory can be estimated by
dividing the number of times inventory turns over in a year into the number of days in
a year:
(assuming 360 days in a year): 360/7.67 times = 46.9, or approximately 47 days.
3. It is difficult to determine from the information given whether 47 days is reasonable
as the average length of time it takes to sell inventory. Other information needed to
make this determination includes:
 The historical average number of days.
 The industry norms for large, national retailers.
 Any recent changes in types of inventory, customer base, markets for the
products, and other relevant factors.
LO 12 EXERCISE 5-17 IMPACT OF TRANSACTIONS INVOLVING INVENTORIES ON

STATEMENT OF CASH FLOWS
Increase in accounts payable: Added to net income

Decrease in accounts payable: Deducted from net income
Increase in inventories: Deducted from net income
Decrease in inventories: Added to net income
LO 12 EXERCISE 5-18 EFFECTS OF TRANSACTIONS INVOLVING INVENTORIES ON THE

STATEMENT OF CASH FLOWS—DIRECT METHOD
Cash payments for inventory to be reported in the operating activities of Masthead’s

2007 statement of cash flows (direct method):
Inventory, December 31, 2006 $ 180,400
Plus: Purchases during 2007 X
Less: Cost of goods sold during 2007 (1,200,000)
Inventory, December 31, 2007 $ 241,200
$180,400 + X – $1,200,000 = $241,200
X = $1,260,800
Accounts payable, December 31, 2006 $ 85,400
Plus: Purchases during 2007 (from above) 1,260,800
Less: Cash payments during 2007 (X)
Accounts payable, December 31, 2007 $ 78,400
$85,400 + $1,260,800 – X = $78,400
X = $1,267,800
LO 12 EXERCISE 5-19 EFFECTS OF TRANSACTIONS INVOLVING INVENTORIES ON THE

STATEMENT OF CASH FLOWS—INDIRECT METHOD
Cash flows from operating activities:

Net income $ xx,xxx
Adjustments to reconcile net income to net cash
provided by operating activities:
Increase in inventory ($241,200 – $180,400) $(60,800)
Decrease in accounts payable ($78,400 – $85,400) (7,000) (67,800)
Cash flows from operating activities $ xx,xxx
M U LT I - C O N C E P T E X E R C I S E S
LO 2,3 EXERCISE 5-20 INCOME STATEMENT FOR A MERCHANDISER
a. Sales – Net sales = Sales returns and allowances

$125,600 – $122,040 = $3,560
b. Do c. first. Net purchases + Purchase discounts = Purchases

$74,600 + $1,300 = $75,900
c. Cost of goods purchased – Transportation-in = Net purchases

$81,150 – $6,550 = $74,600
d. Net sales – Gross margin = Cost of goods sold

$122,040 – $38,600 = $83,440
e. Cost of goods available for sale – Cost of goods sold = Ending inventory
$104,550 – $83,440 = $21,110
f. Gross margin – Income before tax = Operating expenses

$38,600 – $26,300 = $12,300
g. Income before tax – Income tax expense = Net income

$26,300 – $10,300 = $16,000
LO 2,3 EXERCISE 5-21 PARTIAL INCOME STATEMENT—PERIODIC SYSTEM
LAPINE COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2007
Sales $80,000
Less: Sales returns and allowances $ 500
Sales discounts 1,200 1,700
Net sales $78,300
Less cost of goods sold:
Beginning inventory $ 4,000
Purchases $30,000
Less: Purchase returns and allowances 400
Purchase discounts 800
Net purchases $28,800
Add: Transportation-in 1,000
Cost of goods purchased 29,800
Cost of goods available for sale $33,800
Less: Ending inventory 3,800
Cost of goods sold 30,000
Gross margin $48,300
The gross profit ratio is 61.7%.

($48,300/$78,300)
LO 6,7 EXERCISE 5-22 INVENTORY COSTING METHODS—PERIODIC SYSTEM
1. a. Weighted average method:

Cost of goods available for sale and units available:
200  $10 = $ 2,000
300  $11 = 3,300
400  $12 = 4,800
250  $13 = 3,250
150  $15 = 2,250
1,300 $15,600
Weighted average cost = $15,600/1,300 = $12 per unit
Units available 1,300
Units sold 1,000
Units in ending inventory 300
Cost of ending inventory = 300($12) = $3,600
Cost of goods sold = 1,000($12) = $12,000
b. FIFO method:
Ending inventory cost:
150  $15 = $2,250
150  $13 = 1,950
300 $4,200
Cost of goods sold:
200  $10 = $ 2,000
300  $11 = 3,300
400  $12 = 4,800
100  $13 = 1,300
1,000 $11,400
(OR: $15,600 – $4,200 = $11,400)
c. LIFO method:
Ending inventory cost:
200  $10 = $2,000
100  $11 = 1,100
300 $3,100
Cost of goods sold:
150  $15 = $ 2,250
250  $13 = 3,250
400  $12 = 4,800
200  $11 = 2,200
1,000 $12,500
(OR: $15,600 – $3,100 = $12,500)
2. LIFO cost of goods sold $12,500

FIFO cost of goods sold 11,400
Difference in expenses $ 1,100
 Tax rate 0.30
Difference in taxes $ 330
Conclusion: Because FIFO results in less cost of goods sold, a higher income and
thus more taxes, $330, will be reported with this method than if LIFO were used.
LO 5,9 EXERCISE 5-23 LOWER-OF-COST-OR-MARKET RULE
Conservatism is the rationale for carrying inventory on the balance sheet at an amount
less than its cost. It is a departure from the historical cost principle and is used when the
utility of the inventory, as measured by the cost to replace it, is less than original cost.
Two accounts are affected by the application of the lower-of-cost-or-market rule. An
income statement account, such as Loss on Decline in Value of Inventory, is debited,
and the Inventory account on the balance sheet is credited or reduced.
The effect of writing down inventory is to reduce the income of the current year by
the amount debited to the loss account. In future years, however, income will be higher
because of the write-down. This occurs because cost of goods sold will be lower in the
future when the inventory that was written down to a lower amount is eventually sold.
LO 7,13 EXERCISE 5-24 INVENTORY COSTING METHODS—PERPETUAL SYSTEM

(Appendix)
1. a. Moving average:
Purchases Sales Balance
Unit Total Unit Total Unit
Date Units Cost Cost Units Cost Cost Units Cost Balance
1/1 200 $10 $2,000
2/12 150 $10 $ 1,500 50 10 500
3/5 300 $11 $3,300 350 10.8571 3,800
4/30 200 10.857 2,171 150 10.857 1,629
6/12 400 12 4,800 550 11.6892 6,429
7/7 200 11.689 2,338 350 11.689 4,091
3
8/23 250 13 3,250 600 12.235 7,341
9/6 300 12.235 3,670 300 12.235 3,671
10/2 150 15 2,250 450 13.1584 5,921
12/3 150 13.158 1,974 300 13.158 $3,947
Cost of goods sold $11,653 Ending inventory
All amounts rounded to agree with total cost.
1.
50  $10 = $ 500
300  11 = 3,300
350 $3,800; $3,800/350 = $10.857
2. 150  $10.857 = $1,629
400  12 = 4,800
550 $6,429; $6,429/550 = $11.689
EXERCISE 5-24 (Continued)
3. 350  $11.689 = $4,091

250  13 = 3,250
600 $7,341; $7,341/600 = $12.235
4. 300 × $12.235 = $3,671
150 × 15 = 2,250
450 $5,921; $5,921/450 = $13.158
1. b. FIFO:
1/1 200 $10 $2,000
2/12 150 $10 $ 1,500 50 10 500
3/5 300 $11 $3,300 50 10
300 11 3,800
4/30 50 10 500
150 11 1,650 150 11 1,650
6/12 400 12 4,800 150 11
400 12 6,450
7/7 150 11 1,650
50 12 600 350 12 4,200
8/23 250 13 3,250 350 12
250 13 7,450
9/6 300 12 3,600 50 12
250 13 3,850
10/2 150 15 2,250 50 12
250 13
150 15 6,100
12/3 50 12 600 150 13
100 13 1,300 150 15 $4,200
EXERCISE 5-24 (Continued)
1. c. LIFO:
1/1 $200 $10 $2,000
2/12 150 $10 $ 1,500 50 10 500
3/5 300 $11 $3,300 50 10
300 11 3,800
4/30 200 11 2,200 50 10
100 11 1,600
6/12 400 12 4,800 50 10
100 11
400 12 6,400
7/7 200 12 2,400 50 10
100 11
200 12 4,000
8/23 250 13 3,250 50 10
100 11
200 12
250 13 7,250
9/6 250 13 3,250 50 10
50 12 600 100 11
150 12 3,400
10/2 150 15 2,250 50 10
100 11
150 12
150 15 5,650
12/3 150 15 2,250 50 10
100 11
150 12 $3,400
2. EXERCISE 5-22: EXERCISE 5-24:

E/I C/G/S E/I C/G/S
Average cost $3,600 $12,000 $3,947 $11,653 Different
FIFO 4,200 11,400 4,200 11,400 Same
LIFO 3,100 12,500 3,400 12,200 Different
3. Cost of goods sold:

LIFO $12,200
FIFO 11,400
Difference in expense $ 800
 Tax rate 0.30
Difference in taxes $ 240
Conclusion: LIFO results in a higher cost of goods sold and therefore a lower
taxable income and lower income tax by $240.
PROBLEMS
LO 1 PROBLEM 5-1 INVENTORY COSTS IN VARIOUS BUSINESSES
Accounting Treatment
Expense of Inventory Other
Business Types of Costs the Period Cost Treatment
Retail shoe store Shoes for sale X
Shoe boxes X
Advertising signs X
Grocery store Canned goods on the shelves X
Produce X
Cleaning supplies X*
Cash registers X**
Frame shop Wooden frame supplies X
Nails X
Glass X
Walk-in print shop Paper X
Copy machines X**
Toner cartridges X*
Restaurant Frozen food X
China and silverware X**
Prepared food X
Spices X
*Record as an asset and charge to expense as used.
**Record as an asset and depreciate over estimated useful life.
LO 4 PROBLEM 5-2 CALCULATION OF GROSS PROFIT FOR WAL-MART AND TARGET
1. Gross profit ratios (dollar amounts in millions):

Wal-Mart: 2004: ($285,222 – $219,793)/$285,222 = $65,429/$285,222 = 22.9%
2003: ($256,329 – $198,747)/$256,329 = $57,582/$256,329 = 22.5%
Target: 2004: ($45,682 – $31,445)/$45,682 = $14,237/$45,682 = 31.2%
2003: ($40,928 – $28,389)/$40,928 = $12,539/$40,928 = 30.6%
2. In terms of the gross profit ratio, Target appears to be performing better, given a
significantly higher ratio in each year. The mix of products sold by the two
companies and the normal markups on the various products could certainly affect
the ratios. A comparison with prior years and industry averages would also be
important to consider.
LO 7 PROBLEM 5-3 EVALUATION OF INVENTORY COSTING METHODS
1. Company B will have the newest costs in inventory because it uses first-in, first-out.
Because costs are rising, it will have the lowest costs of goods sold and thus the
highest net income.
2. Company C will have the oldest costs in inventory because it uses last-in, first-out.
Because costs are rising, it will have the highest cost of goods sold and thus the
lowest income before taxes. Company C will pay the least in taxes.
3. This question does not lend itself to an easy answer. LIFO matches the most recent
costs with the most recent revenue and thus may be a better indicator of future
potential to investors. Inventory profits are not a major concern with LIFO as they are
with FIFO, because the newer (most recent) costs are assigned to cost of sales.
4. Company C would have the oldest costs in inventory because it uses LIFO. Because
costs are falling, it will have the lowest cost of goods sold and the highest net
income.
Company B will have the newest costs in inventory because it uses FIFO.
Because costs are falling, it will have the highest cost of goods sold and the lowest
income before taxes. Company B will pay the least in taxes.
The answer to part (3) is still not easy. There are advantages and disadvantages
in all methods. The important point is to choose one method and stay with it for
consistency.
LO 8 PROBLEM 5-4 INVENTORY ERROR
1. Revised income statements: 2007 2006

Revenues $20,000 $15,000
Cost of goods sold* 13,600 9,400
Gross profit $ 6,400 $ 5,600
Operating expenses 3,000 2,000
Net income $ 3,400 $ 3,600
*Because ending inventory in 2006 was understated, cost of goods sold was
overstated. Because beginning inventory in 2007 was understated, cost of goods
sold was understated.
Revised balance sheets: 12/31/07 12/31/06
Cash $ 1,700 $ 1,500
Inventory 4,200 4,100
Other current assets 2,500 2,000
Long-term assets 15,000 14,000
Total assets $23,400 $21,600
Liabilities $ 8,500 $ 7,000
Capital stock 5,000 5,000
Retained earnings 9,900 9,600
Total liabilities and stockholders’ equity $23,400 $21,600
2. Net income for two years, before revision: $3,000 + $4,000 = $7,000
Net income for two years, after revision: $3,600 + $3,400 = $7,000
Thus, there is no net over- or understatement.
Retained earnings at December 31, 2007, before the revision: $9,900
Retained earnings at December 31, 2007, after the revision: $9,900
Thus, there is no over- or understatement.
3. Even though the error counterbalances over the two-year period, it is still important
to restate the statements for the two years. It is important for comparative purposes
that the correct amount of net income be known for each of the two years. The
company needs to restate the income statements for each of the two years and
restate the balance sheets at the end of each year.
LO 10 PROBLEM 5-5 GROSS PROFIT METHOD OF ESTIMATING INVENTORY LOSSES
1. (1) Net sales $113,500

Estimated gross profit $ 45,400
(2) Net sales $113,500
Estimated cost of goods sold $ 68,100
(3) Beginning inventory $ 3,200
Estimate of inventory at time of explosion $ 99,100
Inventory saved 4,500
Estimate of inventory destroyed $ 94,600
2. To record insuance settlement from explosion.

Cash* 65,000 Loss on

Settlement (29,600)
*Or, if cash has not yet been received, Receivable from Insurance Company.
LO 11 PROBLEM 5-6 INVENTORY TURNOVER FOR APPLE COMPUTER AND DELL

COMPUTER
1. Gross profit ratios:

Apple Computer Dell Computer
(in millions) (in millions)
2004 2003 2005 2004
Sales/Product revenue $ 8,279 $ 6,207 $ 49,205 $ 41,444
Less: Cost of sales/revenue 6,020 4,499 40,190 33,892
Gross profit $ 2,259 $ 1,708 $ 9,015 $ 7,552
Divided by sales ÷ 8,279 ÷ 6,207 ÷ 49,205 ÷ 41,444
Gross profit ratio 27.3% 27.5% 18.3% 18.2%
2. Inventory turnover ratios:

Apple Computer:
$6,020/[($101 + $56)/2] = $6,020/78.5 = 76.69 times
Dell Computer
$40,190/[($459 + $327)/2] = $40,190/$393 = 102.26 times
3. Both companies’ gross profit ratios have remained about the same in the two years.
The two companies’ turnover ratios are very different. Another factor to consider is
the number of days’ sales in inventory.
Apple Computer:
360/76.69 = 4.7days
Dell Computer:
360/102.26 = 3.5 days
It takes Apple an average of less than five days to sell an item of inventory, and Dell
requires only three and a half days.
On the basis of the gross profit, Apple appears to be performing better, although
Dell does have a better inventory turnover and days’ sales in inventory.
It would be helpful to measure all of these statistics—gross profit ratio, inventory
turnover, and days’ sales in inventory—with the same measures for prior years. It
would also be helpful to compare these measures with the industry averages.
LO 12 PROBLEM 5-7 EFFECTS OF CHANGES IN INVENTORY AND ACCOUNTS PAYABLE

BALANCES ON STATEMENT OF CASH FLOWS
1. Statement of cash flows:

COPELAND ANTIQUES
Net loss $(33,200)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Decrease in inventory ($192,600 – $214,800) 22,200
Increase in accounts payable ($123,900 – $93,700) 30,200
Cash flows from operating activities $ 19,200
Cash, December 31, 2006 46,100
Cash, December 31, 2007 $ 65,300
2. Memorandum to the president:

TO: President of Copeland Antiques
FROM: Student’s name
DATE: January 20, 2008
SUBJECT: Cash Flows
You recently questioned the increase in the company’s cash balance in light of this
year’s net loss. My thoughts and a copy of the company’s 2007 statement of cash
flows follow.
Copeland Antiques was able to generate a significant amount of cash from
operations even though the company incurred an accrual basis net loss of $33,200
during 2007. First, the amount of inventory on hand decreased by $22,200 during
the year from $214,800 to $192,600; this reduction in inventory generated cash for
the company. Second, the amount owed to the company’s suppliers increased by
$30,200 during the year from $93,700 to $123,900; the related bills have not yet
been paid.
Operating expenses need to be decreased relative to gross profit if we are to
improve the company’s bottom line. I look forward to discussing our plans to turn
things around.
M U LT I - C O N C E P T P R O B L E M S
LO 2,3,12 PROBLEM 5-8 PURCHASES AND SALES OF MERCHANDISE, CASH FLOWS
1. Effect of transactions on the accounting equation:

4/1 Accounts Purchases (500)

Payable 500
4/10 Cash (485) Accounts Purchase Discounts 15

(500 – 15) Payable (500) (500  .03)
4/15 Cash 200 Sales Revenue 200

Payable 900

(900 – 27) Payable (900) (900  .03)
2. Net income for April:

Sales revenue: $200 + $600 $ 800
Cost of goods sold:
Beginning inventory $ 0
Purchases: $500 + $900 $1,400
Less: Purchase discounts $15 + $27 42
Net purchases 1,358
Less: Ending inventory 967
Cost of goods sold 391
Gross margin $ 409
Operating expenses:
Rent expense $ 100
Miscellaneous expense 50
Total operating expenses 150
Net income $ 259
3. Net cash flow from operating activities for April:

Cash collected from sales: $200 + $600 $ 800
Cash paid for:
Inventory: $485 + $873 $1,358
Rent 100
Miscellaneous 50 1,508
Net cash flow from operating activities $ (708)
PROBLEM 5-8 (Concluded)
OR:
Net income $ 259
Deduct: Increase in inventory balance (967)
Net cash flow from operating activities $ (708)
4. Net income is $259. Net cash flow from operating activities is a negative $708. The
difference of $967 is attributable to inventory that has not been sold. That is, the
company has paid for $1,358 of inventory (a cash outlay) but has only recognized
cost of goods sold expense of $391. The difference is $967.
LO 2,3,4 PROBLEM 5-9 GAP INC.’S SALES, COST OF GOODS SOLD, AND GROSS
PROFIT
1. Apparently, Gap Inc. does not sell its merchandise on account. If customers want to
pay on credit for their purchases, they would use one of the various credit cards that
Gap accepts.
2. Effect of sales on the accounting equation:

Cash 16,267,000,000 Sales 16,267,000,000
3. Gap Inc. would deduct sales returns and allowances from sales to arrive at the
amount of net sales reported on its income statement. Since Gap Inc. does not have
any accounts receivable on its balance sheet, it is unlikely that it offers sales
discounts to its customers. Either because they do not feel the amounts are material
enough or they would rather not divulge information about returns and allowances to
competitors, some companies choose not to separately report them.
4. Cost of goods sold section of 2004 income statement (millions of dollars):
Merchandise inventory, 1/31/04 $ 1,704
Cost of goods purchased* 9,996 (2)
Cost of goods available for sale $11,700 (1)
Less merchandise inventory, 1/29/05 (1,814)
Cost of goods sold** $ 9,886
*Including occupancy expenses.
**Described as cost of goods sold and occupancy expenses.
(1) $9,886 + $1,814 = $11,700.
(2) $11,700 – $1,704 = $9,996.

(millions of dollars) 2004 2003
Sales $ 16,267 $ 15,854
Less cost of sales 9,886 9,885
Gross profit $ 6,381 $ 5,969
Divided by sales ÷ $16,267 ÷ $15,854
Gross margin ratio 39.2% 37.6%
Gap Inc.’s gross profit ratio increased by 1.6% from 2003 to 2004. Factors affect
ing Gap Inc.’s gross profit ratio might include changes in the selling prices of
merchandise, changes in the cost of goods purchased, and/or changes in the mix of
merchandise sold (that is, a slight shift between selling products that have higher
gross profit ratios and selling those with lower gross profit ratios).
LO 2,3 PROBLEM 5-10 FINANCIAL STATEMENTS
1. Cost of goods sold for 2007:

Purchases $40,200
Less: Purchase discounts 800
Net purchases $39,400
Add: Transportation-in 375
Cost of goods sold $38,675
2. Net income for 2007:

Sales $84,364
Less: Sales returns 780
Net sales $83,584
Cost of goods sold [from part (1)] 38,675
Gross profit $44,909
Operating expenses:
Salaries $25,600
Advertising 4,510
Utilities 3,600
Depreciation 2,300
Total operating expenses 36,010
Income before tax $ 8,899
Income tax expense 3,200
Net income $ 5,699
3. MAPLE INC.
BALANCE SHEET
AT DECEMBER 31, 2007
Assets
Current assets:
Cash $ 590
Accounts receivable 2,359
Inventory 7,500
Interest receivable 100
Total current assets $10,549
Property, plant, and equipment:
Land $20,000
Building and equipment, net 55,550
Total property, plant, and equipment 75,550
Total assets $86,099
Liabilities
Current liabilities:
Salaries payable $ 650
Income tax payable 3,200
Total liabilities $ 3,850
Stockholders’ Equity
Capital stock $50,000
Retained earnings 32,249* 82,249
Total liabilities and stockholders’ equity $86,099
*Beginning retained earnings + Net income – Dividends
$32,550 + $5,699 – $6,000
LO 5,6,7 PROBLEM 5-11 COMPARISON OF INVENTORY COSTING METHODS—

PERIODIC SYSTEM
1. Cost of Ending
Goods Sold Inventory Total
a. Weighted average $11,084 $4,988 $16,072
b. FIFO 10,776 5,296 16,072
c. LIFO 11,452 4,620 16,072
Calculations:
a. Beginning inventory 600  $5.00 = $ 3,000
Oct. 8 800  5.40 = 4,320
Oct. 18 700  5.76 = 4,032
Oct. 29 800  5.90 = 4,720
2,900 $16,072
Weighted average cost = $16,072/2,900 = $5.542
Units sold: 500 + 700 + 800 = 2,000 units
Units available – units sold = ending inventory
2,900 – 2,000 = 900 units
Ending inventory = 900  $5.542 = $4,988
Cost of goods sold = 2,000  $5.542 = $11,084
b. Ending inventory—FIFO:
800  $5.90 = $4,720
100  5.76 = 576
900 $5,296
Cost of goods sold—FIFO:
600  $5.76 = $ 3,456
800  5.40 = 4,320
600  5.00 = 3,000
2,000 $10,776
c. Ending inventory—LIFO:
600  $5.00 = $3,000
300  5.40 = 1,620
900 $4,620
Cost of goods sold—LIFO:
500  $5.40 = $ 2,700
700  5.76 = 4,032
800  5.90 = 4,720
2,000 $11,452
2. The Total column represents the pool of costs (beginning inventory plus purchases)
to be distributed between an asset, ending inventory on the balance sheet, and an
expense, cost of goods sold on the income statement. In accounting, this pool of
costs is called cost of goods available for sale.
3. Income statements for the month of October:
Weighted
Average FIFO LIFO
Sales* $20,800 $20,800 $20,800
Cost of goods sold 11,084 10,776 11,452
Gross margin $ 9,716 $10,024 $ 9,348
Operating expenses 3,000 3,000 3,000
Income before taxes $ 6,716 $ 7,024 $ 6,348
Income tax expense (30%) 2,015 2,107 1,904
Net income $ 4,701 $ 4,917 $ 4,444
*Sales = 500($10) + 700($10) + 800($11) = $20,800
4. The company will pay $203 more in taxes if it uses FIFO:
FIFO tax $2,107
LIFO tax 1,904
Difference $ 203
LO 5,7,13 PROBLEM 5-12 COMPARISON OF INVENTORY COSTING METHODS—

PERPETUAL SYSTEM (Appendix)
1. Cost of Ending
a. Moving average $10,785 $5,287 $16,072
b. FIFO 10,776 5,296 16,072
c. LIFO 10,852 5,220 16,072
PROBLEM 5-12 (Continued)
a. Moving average:
10/1 600 $5 $3,000
10/4 500 $5 $ 2,500 100 5 500
10/8 800 $5.40 $4,320 900 5.3561 4,820
10/9 700 5.356 3,749 200 5.356 1,071
10/18 700 5.76 4,032 900 5.672 5,103
10/20 800 5.67 4,536 100 5.67 567
3
10/29 800 5.90 4,720 900 5.874 $5,287
1. 100 × $5.00 = $ 500
800 × 5.40 = 4,320
900 $4,820; $4,820/900 = $5.356
2. 200 × $5.356 = $1,071
700 × 5.76 = 4,032
900 $5,103; $5,103/900 = $5.67
3. 100 × $5.67 = $ 567
800 × 5.90 = 4,720
900 $5,287; $5,287/900 = $5.874
b. FIFO:
10/1 600 $5 $3,000
10/4 500 $5 $ 2,500 100 5 500
10/8 800 $5.40 $4,320 100 5
800 5.40 4,820
10/9 100 5 500
600 5.40 3,240 200 5.40 1,080
10/18 700 5.76 4,032 200 5.40
700 5.76 5,112
10/20 200 5.40 1,080
600 5.76 3,456 100 5.76 576
10/29 800 5.90 4,720 100 5.76
800 5.90 $5,296
c. LIFO:
10/1 600 $5 $3,000
10/4 500 $5 $2,500 100 5 500
10/8 800 $5.40 $4,320 100 5
800 5.40 4,820
10/9 700 5.40 3,780 100 5
100 5.40 1,040
10/18 700 5.76 4,032 100 5
100 5.40
700 5.76 5,072
10/20 700 5.76 4,032
100 5.40 540 100 5 500
10/29 800 5.90 4,720 100 5
800 5.90 $5,220
expense, cost of goods sold, on the income statement. In accounting, this pool of
3. Income statements for the month of October:
Moving
Average FIFO LIFO
Sales* $20,800 $20,800 $20,800
Gross margin $10,015 $10,024 $ 9,948
Net income $ 4,910 $ 4,917 $ 4,864
*Sales = 500($10) + 700($10) + 800($11) = $20,800

FIFO tax $2,107
LIFO tax 2,084
Difference $ 23
LO 5,6,7 PROBLEM 5-13 INVENTORY COSTING METHODS—PERIODIC SYSTEM
1. Units in beginning inventory 200

Add: Units purchased (250 + 220 + 150 + 200) 820
Less: Units sold (300 + 380 + 110) 790
Ending Cost of
Inventory Goods Sold Total
a. FIFO $4,410 $14,663 $19,073
b. LIFO 4,155 14,918 19,073
c. Weighted average 4,301 14,772 19,073
Calculations:
a. Ending inventory—FIFO:
200  $19.20 = $3,840
30  19.00 = 570
230 $4,410
200  $18.00 = $ 3,600
250  18.50 = 4,625
220  18.90 = 4,158
120  19.00 = 2,280
790 $14,663
b. Ending inventory—LIFO:
200  $18.00 = $3,600
30  18.50 = 555
230 $4,155
220  $18.50 = $ 4,070
220  18.90 = 4,158
150  19.00 = 2,850
200  19.20 = 3,840
790 $14,918
c. Beginning inventory 200  $18.00 = $ 3,600
Nov. 4 250  18.50 = 4,625
Nov. 13 220  18.90 = 4,158
Nov. 18 150  19.00 = 2,850
Nov. 24 200  19.20 = 3,840
1,020 $19,073
Ending inventory = 230  $18.699 = $4,301
Cost of goods sold = 790  $18.699 = $14,772
2. Weighted
FIFO LIFO Average
Sales* $33,480 $33,480 $33,480
Gross profit $18,817 $18,562 $18,708
Operating expenses:
Selling and administrative
expenses 10,800 10,800 10,800
Depreciation 4,000 4,000 4,000
Net income $ 2,611 $ 2,445 $ 2,540
*Sales = (300  $42) + (380  $42.50) + (110  $43) = $33,480
3. Oxendine pays the least taxes under the last-in, first-out method, since it has the
highest cost of goods sold.
LO 5,6,7 PROBLEM 5-14 INVENTORY COSTING METHODS—PERIODIC SYSTEM
1. a. Weighted average:
Beginning inventory 5,000  $10 = $ 50,000
Feb. 4 3,000  9 = 27,000
April 12 4,000  8 = 32,000
Sept. 10 2,000  7 = 14,000
Dec. 5 1,000  6 = 6,000
15,000 $129,000
Units available for sale 15,000
Units sold 12,500
Ending inventory 2,500  $8.60 = $21,500
Cost of goods sold 12,500  $8.60 = $107,500
b. FIFO:
Ending inventory 1,000  $ 6 = $ 6,000
1,500  7 = 10,500
2,500 $ 16,500
Cost of goods sold 500  $7 = $ 3,500
4,000  8 = 32,000
3,000  9 = 27,000
5,000  10 = 50,000
12,500 $112,500
c. LIFO:
Ending inventory 2,500  $10 = $ 25,000
Cost of goods sold 2,500  $10 = $ 25,000
3,000  9 = 27,000
4,000  8 = 32,000
2,000  7 = 14,000
1,000  6 = 6,000
12,500 $104,000
2. Income statements for the year ended December 31, 2007:

Weighted
Average FIFO LIFO
Sales* $150,000 $150,000 $
150,000
Gross margin $ 42,500 $ 37,500 $ 46,000
Net income $ 15,750 $ 12,250 $ 18,200
*Sales = 12,500  $12 = $150,000
3. Weaver can minimize its tax bill by using FIFO. In a period of declining prices, FIFO
results in the highest amount of cost of goods sold, the least amount of income
before taxes, and thus the least amount of income tax expense.
4. A company is not free to change inventory methods from year to year to take
advantage of changing patterns in the level of prices. It must be able to justify any
change in the method used on some basis other than saving taxes, such as a better
matching of costs with revenues.
LO 1,7,9 PROBLEM 5-15 INTERPRETING TRIBUNE COMPANY’S INVENTORY

ACCOUNTING POLICY
1. Newsprint costs are comparable to raw materials in a manufacturing company. A

newspaper company, however, does not keep an inventory of finished goods. Its
newspapers either are sold within hours after being printed or become worthless if
not sold.
2. Some companies use more than one method to value different types of inventory.
The methods should be chosen because they provide the most accurate matching of
costs with the revenues generated. Apparently, LIFO provides the most accurate
matching of costs with revenue for Tribune Company’s newsprint.
LO 7,9 PROBLEM 5-16 INTERPRETING SEARS’ INVENTORY ACCOUNTING POLICY
1. No, the use of the last-in, first-out method for its domestic merchandise inventories
does not mean that Sears always sells its newest merchandise first in the United
States. Actually, the physical flow of merchandise in most stores like Sears is
normally on a first-in, first-out basis. However, the use of a cost flow assumption
such as LIFO or FIFO for accounting purposes is independent of the actual physical
flow of products.
2. No, Sears uses the retail method to account for inventories in its stores. This is a
method that allows the company to convert its inventory from a retail value to a cost
basis for financial statement purposes.
A LT E R N AT E P R O B L E M S
LO 1 PROBLEM 5-1A INVENTORY COSTS IN VARIOUS BUSINESSES
1. Classification of an item as inventory depends on the company’s intent. DVDs

offered by the company for resale should be classified as part of inventory and
charged to cost of goods sold at the time they are sold. Alternatively, rental DVDs
are income-producing assets and should not be classified as inventory. They should
be classified as current assets because it is unlikely that any DVDs will be kept as
rentals for more than one year.
2. When DVDs are transferred because they will be offered for resale, the asset
account DVD Rentals would be credited, and the asset account DVD Inventory
would be debited.
LO 4 PROBLEM 5-2A CALCULATION OF GROSS PROFIT FOR BEST BUY AND CIRCUIT
CITY
1. Gross profit ratios (dollar amounts in millions):

Best Buy: 2005: ($27,433 – $20,938)/$27,433 = $6,495/$27,433 = 23.7%
2004: ($24,548 – $18,677)/$24,548 = $5,871/$24,548 = 23.9%
Circuit City: 2005: ($10,472 – $7,904)/$10,472 = $2,568/$10,472 = 24.5%
2004: ($9,857 – $7,573)/$9,857 = $2,284/$9,857 = 23.2%
2. In terms of the gross profit ratios, the two companies appear to be very similar. The
mix of products sold by the two companies and the normal markups on the various
products could certainly affect the ratios. A comparison with prior years and industry
averages would also be important to consider.
LO 7 PROBLEM 5-3A EVALUATION OF INVENTORY COSTING METHODS
1. No, the three companies will not be equally pleased with the decline in prices. If the
decline continues, Company Y (FIFO) will begin to show lower gross profit than
Company Z (LIFO). Because gross profit will be lower, Company Y will report lower
income before tax and thus have less tax to pay.
2. It should be noted that it is not acceptable for a company to change inventory
valuation methods to save taxes. An acceptable explanation of the justification for
the change is this:
During the year recently completed, the company changed its method of valuing
inventory on the balance sheet and recognizing cost of sales on the income
statement. The company changed from the LIFO to FIFO method because it
believes that the latter results in a better matching of cost of sales with the
revenues of the period.
LO 8 PROBLEM 5-4A INVENTORY ERROR
1. Revised income statements: 2007 2006

Revenues $35,982 $26,890
Cost of goods sold* 12,094 10,412
Gross profit $23,888 $16,478
Operating expenses 13,488 10,578
Net income $10,400 $ 5,900
*Because ending inventory in 2006 was overstated, cost of goods sold was
understated. Because beginning inventory in 2007 was overstated, cost of goods
sold was overstated.
Revised balance sheets: 12/31/07 12/31/06
Cash $ 9,400 $ 4,100
Inventory 4,500 4,900
Other current assets 1,600 1,250
Long-term assets, net 24,500 24,600
Total assets $40,000 $34,850
Current liabilities $ 9,380 $10,600
Capital stock 18,000 18,000
Retained earnings 12,620 6,250
Total liabilities and stockholders’ equity $40,000 $34,850
PROBLEM 5-4A (Concluded)
2. Current ratio:
Cash + Inventory + Other current assets

Before revision:
Current liabilities
$4,100 + $5,400 + $1,250 $10,750

$10,600
= = 1.01 to 1
$10,600
$4,100 + $4,900 + $1,250 $10,250

After revision: $10,600
= = 0.97 to 1
$10,600
If the lender required a current ratio of at least 1 to 1, Planter would not be eligible
for the loan. However, the bank might not consider a current ratio of 0.97 to 1 to be
materially different from a current ratio of 1 to 1 and might be willing to grant the
loan.
3. Net income for two years, before revision: $6,400 + $9,900 = $16,300.
Net income for two years, after revision: $5,900 + $10,400 = $16,300.
Thus, there is no net over- or understatement of net income for the two-year period.
Retained earnings at December 31, 2007, before the revision: $12,620.
Retained earnings at December 31, 2007, after the revision: $12,620.
Thus, there is no over- or understatement of retained earnings at December 31,
2007.
4. Even though the error counterbalances over the two-year period, it is still important
to restate the statements for the two years. It is important for comparative purposes
that the correct amount of net income be known for each of the two years. The
company needs to restate the income statements for each of the two years and
restate the balance sheets at the end of each year.
LO 10 PROBLEM 5-5A GROSS PROFIT METHOD OF ESTIMATING INVENTORY LOSSES
1. (1) Net sales $93,500

Estimated gross profit $65,450
(2) Net sales $93,500
Estimated cost of goods sold $28,050
(3) Beginning inventory $14,200
Estimate of inventory at time of explosion $63,150
Inventory saved 4,500
Estimate of inventory destroyed $58,650
2. To record insurance settlement from explosion.

7/1 Cash* 50,000 Loss on

Settlement (8,650)
*Receivable from Insurance Company is increased instead of Cash if cash has not yet
been received.
LO 11 PROBLEM 5-6A INVENTORY TURNOVER FOR WAL-MART AND TARGET
1. Inventory turnover ratios:

Wal-Mart:
$219,793/[($29,447 + $26,612)/2] = $219,793/$28,029.5 = 7.84 times
Target:
$31,445/[($5,384 + $4,531)/2] = $31,445/$4,957.5 = 6.34 times
2. Wal-Mart’s inventory turnover is higher than Target’s during the most recent fiscal
year, 7.84 versus 6.34. Another factor to consider is the number of days’ sales in
inventory:
Wal-Mart:
360/7.84 = 45.9 days
Target:
360/6.34 = 56.8 days
It takes Wal-Mart an average of 46 days to sell an item of inventory; Target requires

an average of 57 days. On the basis of inventory turnover and days’ sales in
inventory, Wal-Mart appears to be performing slightly better.
It would be helpful to measure these statistics—inventory turnover and days’
sales in inventory, along with the companies’ gross profit ratios—with the same
measures for prior years. It would also be helpful to compare these measures with
the industry averages.
LO 12 PROBLEM 5-7A EFFECTS OF CHANGES IN INVENTORY AND ACCOUNTS PAYABLE

BALANCES ON STATEMENT OF CASH FLOWS
1. Statement of cash flows:

CARPETLAND CITY
Net income $ 78,500
Adjustments to reconcile net income to net cash
provided by operating activities:
Increase in inventory ($105,500 – $84,900) $(20,600)
Decrease in accounts payable
($23,900 – $93,700) (69,800) (90,400)
Cash flows from operating activities $(11,900)
Cash, December 31, 2006 26,300
Cash, December 31, 2007 $ 14,400
2. Memorandum to the president:

TO: President of Carpetland City
DATE: January 20, 2008
SUBJECT: Cash Flows
You recently expressed concern about the decrease in the company’s cash
balance in spite of the profitable year that was reported on this year’s income
statement. My thoughts and a copy of the company’s 2007 statement of cash flows
follow.
Although net income on an accrual basis was $78,500, the company’s cash
balance declined by $11,900 during the year for two reasons. Most importantly, the
amount owed to the company’s suppliers decreased by $69,800 during the year
from $93,700 to $23,900; this decrease in accounts payable drained our cash
balance. In addition, the amount of inventory on hand increased by $20,600 during
the year from $84,900 to $105,500; this increase in inventory required an additional
outflow of cash.
We can better manage our cash flow by carefully timing the payment of bills to
coincide with the due dates on invoices. In addition, we can improve cash flow by
closely monitoring our inventory levels and only adding to inventory levels when
increases in sales warrant an addition.
A LT E R N AT E M U LT I - C O N C E P T P R O B L E M S
LO 2,3,12 PROBLEM 5-8A PURCHASES AND SALES OF MERCHANDISE, CASH FLOWS
1. To record purchase of merchandise on account.


Payable 249
To record payment on account: $249  (1 – .02) = $244.


Payable (249)
To record cash sale.

To record purchase of merchandise on account.


Payable 800
To record cash sales: 3  $200.

To record payment on account.

10/30 Cash (800) Accounts

Payable (800)
2. Units on hand on October 31:

October 1 purchase 3 units
October 15 sale (1)
October 18 purchase 10
October 25 sale (3)
Ending inventory 9 units
3. Cash balance at end of month:

Beginning cash balance $2,000
October 10 payment (244)
October 15 sale 200
October 25 sale 600
October 30 payment (800)
Cash balance at end of month $1,756
The cash balance decreased during the month even though the company reported a
profit because cash outflows exceeded expenses. This was the case because the
entire inventory purchased (and paid for) was not yet sold (expensed).
LO 2,3,4 PROBLEM 5-9A WALGREEN’S SALES, COST OF GOODS SOLD, AND GROSS
PROFIT
1. The effect of sales and the collection of accounts receivable during 2004 on the
accounting equation for Walgreen Co. is (in millions):

Accounts Receivable 37,508.2 Sales 37,508.2
Cash 37,356.9*
Accounts Receivable (37,356.9)
*1,017.8 + 37,508.2 – 1,169.1
2. Walgreen Co. would deduct sales returns and allowances, and the amount of any
sales discounts taken by its customers from sales, to arrive at the amount of net
sales reported on its income statement. Either because they do not feel the amounts
are material enough or they would rather not divulge information about returns and
allowances to competitors, some companies choose not to separately report them.
3. Cost of goods sold section of 2004 income statement (in millions):

Merchandise inventory, August 31, 2003 $ 4,202.7
Cost of goods purchased 27,846.3 (2)
Cost of goods available for sale $32,049.0 (1)
Less merchandise inventory, August 31, 2004 (4,738.6)
Cost of goods sold $27,310.4
(1) $27,310.4 + $4,738.6 = $32,049.0.
(2) $32,049.0 – $4,202.7 = $27,846.3.

(In millions) 2004 2003
Net sales $ 37,508.2 $ 32,505.4
Cost of sales 27,310.4 23,706.2
Gross profit $ 10,197.8 $ 8,799.2
Divided by net sales ÷ 37,508.2 ÷ 32,505.4
Gross profit ratio 27.2% 27.1%
Walgreen’s gross profit ratio was virtually unchanged from 2003 to 2004. Factors
affecting Walgreen’s gross profit ratio include changes in the selling prices of
merchandise, changes in the cost of goods purchased, and/or changes in the mix of
merchandise sold (that is, a slight shift from selling products that have higher gross
profit ratios to selling those with lower gross profit ratios).
LO 2,3 PROBLEM 5-10A FINANCIAL STATEMENTS
1. Cost of goods sold for 2007:

Purchases $ 62,845
Less: Purchase discounts 1,237
Net purchases $ 61,608
Add: Transportation-in 375
Cost of goods available for sale $ 68,383
Cost of goods sold $ 62,483
2. Net income for 2007:

Sales $112,768
Less: Sales returns 1,008
Net sales $111,760
Cost of goods sold [from part (1)] 62,483
Gross profit $ 49,277
Operating expenses:
Wages and salaries expense $ 23,000
Advertising expense 12,900
Utilities expense 1,800
Total operating expenses 37,700
Income before tax $ 11,577
Income tax expense 1,450
Net income $ 10,127
3. LLOYD INC.
BALANCE SHEET
AT DECEMBER 31, 2007
Assets
Cash $ 22,340
Accounts receivable 56,359
Inventory 5,900
Total assets $ 84,599
Liabilities
Salaries payable $ 650
Wages payable 120
Income tax payable 1,450
Total liabilities $ 2,220
Stockholders’ Equity
Capital stock $ 50,000
Retained earnings 32,379*
Total stockholders’ equity 82,379
Total liabilities and stockholders’ equity $ 84,599
*Beginning retained earnings + Net income – Dividends
$28,252 + $10,127 – $6,000
LO 5,6,7 PROBLEM 5-11A COMPARISON OF INVENTORY COSTING METHODS—

PERIODIC SYSTEM
1. Cost of Ending
a. Weighted average $5,120 $4,655 $9,775
b. FIFO 4,875 4,900 9,775
c. LIFO 5,375 4,400 9,775
Calculations:
a. Beginning inventory 300  $4.00 = $1,200
Nov. 8 500  4.50 = 2,250
Nov. 18 700  4.75 = 3,325
Nov. 29 600  5.00 = 3,000
2,100 $9,775
Units sold: 200 + 500 + 400 = 1,100 units
Units available – units sold = ending inventory
2,100 – 1,100 = 1,000 units
Ending inventory = 1,000  $4.655 = $4,655
Cost of goods sold = 1,100  $4.655 = $5,120*
*Rounded to agree with total cost.
b. Ending inventory—FIFO:
600  $5.00 = $3,000
400  4.75 = 1,900
1,000 $4,900
300  $4.00 = $1,200
500  4.50 = 2,250
300  4.75 = 1,425
1,100 $4,875
c. Ending inventory—LIFO:
300  $4.00 = $1,200
500  4.50 = 2,250
200  4.75 = 950
1,000 $4,400
600  $5.00 = $3,000
500  4.75 = 2,375
1,100 $5,375
expense, cost of goods sold on the income statement. In accounting, the pool of
3. Income statements for the month of November:

Weighted
Average FIFO LIFO
Sales* $10,100 $10,100 $10,100
Gross margin $ 4,980 $ 5,225 $ 4,725
Income tax expense (25%) 745 806 681
Net income $ 2,235 $ 2,419 $ 2,044
*Sales = 200($9) + 500($9) + 400($9.50) = $10,100

FIFO tax $806
LIFO tax 681
Difference $125
LO 5,7,13 PROBLEM 5-12A COMPARISON OF INVENTORY COSTING METHODS—

PERPETUAL SYSTEM (Appendix)
1. Cost of Ending
a. Moving average $4,892 $4,883 $9,775
b. FIFO 4,875 4,900 9,775
c. LIFO 4,950 4,825 9,775
PROBLEM 5-12A (Continued)

a. Moving average:
11/1 300 $4 $1,200
11/4 200 $4 $ 800 100 4 400
11/8 500 $4.50 $2,250 600 4.4171 2,650
11/9 500 4.417 2,209 100 4.417 441
2
11/18 700 4.75 3,325 800 4.708 3,766
11/20 400 4.708 1,883 400 4.708 1,883
11/29 600 5.00 3,000 1,000 4.8833 $4,883
All amounts rounded to agree with total cost.
1.
100 × $4.00 = $ 400
500 × 4.50 = 2,250
600 $2,650; $2,650/600 = $4.417
2.
100 × $4.417 = $ 441
700 × 4.75 = 3,325
800 $3,766; $3,766/800 = $4.708
3.
400 × $4.708 = $1,883
600 × 5.00 = 3,000
1,000 $4,883; $4,883/1,000 = $4.883
b. FIFO:
11/1 300 $4 $1,200
11/4 200 $4 $ 800 100 4 400
11/8 500 $4.50 $2,250 100 4
500 4.50 2,650
11/9 100 4 400
400 4.50 1,800 100 4.50 450
11/18 700 4.75 3,325 100 4.50
700 4.75 3,775
11/20 100 4.50 450
300 4.75 1,425 400 4.75 1,900
11/29 600 5.00 3,000 400 4.75
600 5.00 $4,900
c. LIFO:
11/1 300 $4 $1,200
11/4 200 $4 $ 800 100 4 400
11/8 500 $4.50 $2,250 100 4
500 4.50 2,650
11/9 500 4.50 2,250 100 4 400
11/18 700 4.75 3,325 100 4
700 4.75 3,725
11/20 400 4.75 1,900 100 4
300 4.75 1,825
11/29 600 5.00 3,000 100 4
300 4.75
600 5 $4,825
expense, cost of goods sold on the income statement. In accounting, this pool of
3. Income statements for the month of November:

Moving
Average FIFO LIFO
Sales* $10,100 $10,100 $10,100
Gross margin $ 5,208 $ 5,225 $ 5,150
Income tax expense (25%) 802 806 788
Net income $ 2,406 $ 2,419 $ 2,362
*Sales = 200($9) + 500($9) + 400($9.50) = $10,100

FIFO tax $806
LIFO tax 788
Difference $ 18
LO 5,6,7 PROBLEM 5-13A INVENTORY COSTING METHODS—PERIODIC SYSTEM
1. Units in beginning inventory 300

Add: Units purchased (375 + 330 + 225 + 300) 1,230
Less: Units sold (450 + 570 + 165) 1,185
Ending Cost of
Inventory Goods Sold Total
a. FIFO $8,643 $31,190 $39,833
b. LIFO 9,293 30,540 39,833
c. Weighted average 8,982 30,851 39,833
Calculations:
a. Ending inventory—FIFO:
300  $25.00 = $7,500
45  25.40 = 1,143
345 $8,643
300  $27.00 = $ 8,100
375  26.50 = 9,938
330  26.00 = 8,580
180  25.40 = 4,572
1,185 $31,190
b. Ending inventory—LIFO:
300  $27.00 = $8,100
45  26.50 = 1,193
345 $9,293
300  $25.00 = $ 7,500
225  25.40 = 5,715
330  26.00 = 8,580
330  26.50 = 8,745
1,185 $30,540
c. Beginning inventory 300  $27.00 = $ 8,100

Nov. 4 375  26.50 = 9,938
Nov. 13 330  26.00 = 8,580
Nov. 18 225  25.40 = 5,715
Nov. 24 300  25.00 = 7,500
1,530 $39,833
Ending inventory = units in ending inventory  average cost = 345 × $26.035 =
$8,982
Cost of goods sold = units sold  average cost = 1,185  $26.035 = $30,851
2. Weighted
FIFO LIFO Average
Sales* $75,330 $75,330 $75,330
Gross profit $44,140 $44,790 $44,479
Operating expenses:
Selling and administrative
expenses 16,200 16,200 16,200
Depreciation 6,000 6,000 6,000
Income before taxes $21,940 $22,590 $22,279
Net income $14,261 $14,683 $14,481
*Sales = (450 × $63) + (570 × $63.75) + (165 × $64.50) = $75,330
3. Story pays the least taxes under the first-in, first-out method, since it has the highest
cost of goods sold.
LO 5,6,7 PROBLEM 5-14A INVENTORY COSTING METHODS—PERIODIC SYSTEM
1. a. Weighted average:
Beginning inventory 4,000  $20 = $ 80,000
Feb. 4 2,000  18 = 36,000
Apr. 12 3,000  16 = 48,000
Sept. 10 1,000  14 = 14,000
Dec. 5 2,500  12 = 30,000
12,500 $208,000
Units available for sale 12,500
Units sold 11,000
Ending inventory 1,500  $16.64 = $ 24,960
Cost of goods sold 11,000  $16.64 = $183,040
b. FIFO:
2,000  18 = 36,000
3,000  16 = 48,000
1,000  14 = 14,000
1,000  12 = 12,000
11,000 $190,000
c. LIFO:
1,000  14 = 14,000
3,000  16 = 48,000
2,000  18 = 36,000
2,500  20 = 50,000
11,000 $178,000
2. Income statements for the year ended December 31, 2007:

Weighted
Average FIFO LIFO
Sales* $330,000 $330,000 $330,000
Gross profit $146,960 $140,000 $152,000
Net income $ 60,872 $ 56,000 $ 64,400
*Sales = 11,000  $30 = $330,000
3. Fees can minimize its tax bill by using FIFO. In a period of declining prices, FIFO
results in the highest cost of goods sold, the least amount of income before taxes,
and thus the least amount of income tax expense.
4. A company is not free to change inventory methods from year to year to take
advantage of changing patterns in the level of prices. It must be able to justify any
change in the method used on some basis other than saving taxes, such as a better
matching of costs with revenues.
LO 1,7,9 PROBLEM 5-15A INTERPRETING THE NEW YORK TIMES COMPANY’S

FINANCIAL STATEMENTS
1. The company carries two types of inventory: newsprint and other. These costs are
comparable to raw materials in a manufacturing company. A newspaper company,
however, does not keep an inventory of finished goods. Its newspapers either are
sold within hours after being printed or become worthless if not sold.
2. Some companies use different methods to value different types of inventory. The
methods should be chosen because they provide the most accurate matching of
costs with the revenues generated. Apparently, LIFO provides the most accurate
matching of costs with revenue for the company’s newsprint.
LO 7,9 PROBLEM 5-16A INTERPRETING HOME DEPOT’S FINANCIAL STATEMENTS
1. No, the use of the first-in, first-out inventory method does not mean that a company
always sells its oldest merchandise first. Although the physical flow in many
businesses is on a first-in first-out basis, the use of a cost flow assumption such as
FIFO for accounting purposes is independent of the actual physical flow of products.
In fact, some businesses do use a LIFO (last-in, first-out) assumption even though
the physical flow is on a first-in, first-out basis.
2. No, Home Depot states in its note that it uses the retail inventory method to account
for inventories in its stores. This is a method that allows a company to convert its
inventory from a retail value to a cost basis for financial statement purposes.
DECISION CASES
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 1,3 DECISION CASE 5-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:
FINISH LINE AND FOOT LOCKER
1. Both Finish Line and Foot Locker are merchandisers.
2. Finish Line reports “Merchandise inventories, net” on its February 25, 2006, balance
sheet of $268,590,000 and they account for $268,590,000/$627,816,000, or 42.8%
of total assets. Foot Locker’s “Merchandise inventories” at January 28, 2006,
amount to $1,254,000,000, which represents $1,254,000,000/$3,312,000,000, or
37.9% of total assets.
DECISION CASE 5-1 (Concluded)
3. According to Note 1, Finish Line uses the weighted average cost method to value
inventories. The company indicates that this approximates the first-in, first-out
method. The weighted average method is relatively easy to use.
4. According to Note 1, Foot Locker uses LIFO for domestic inventories and FIFO for
international inventories. The inventories of the company’s Direct-to-Customers
business are valued using the weighted average method, which approximates
FIFO. It is not unusual for companies in the same industry to use different methods,
and it is helpful in trying to compare the companies to be aware of this fact.
5. Because companies usually do not disclose in their annual report which inventory
system they use, it is not possible to know for certain whether they use periodic or
perpetual. The ability of merchandisers to use the perpetual system has certainly
improved with advances in technology, such as the advent of point-of-sale
terminals.
LO 7 DECISION CASE 5-2 READING AND INTERPRETING J.C.PENNEY’S FINANCIAL

STATEMENTS
1. J.C.Penney uses LIFO. A business should employ the method that most accurately
matches inventory costs with the revenues of the period. J.C.Penney may use LIFO
because prices change frequently, and it wants to match the most recent costs with
revenues generated in the current period.
2. The LIFO reserve is $25 million at year-end 2004 and $43 million at year-end 2003.
3. The LIFO reserve decreased during 2004, from $43 million to $25 million, or $18
million. The reserve decreases because inventory costs are decreasing and cost of
goods sold on a LIFO basis is less than cost of goods sold on a FIFO basis. Thus, a
decrease in the reserve during a period indicates that prices are falling.
LO 1,6,9 DECISION CASE 5-3 READING AND INTERPRETING CIRCUIT CITY’S

INVENTORY NOTE
1. Circuit City uses the average cost method. Given the large volume of consumer
electronics products sold by Circuit City, the average cost method seems
appropriate.
2. The company defines “market” as estimated realizable value. In estimating market
value, the company considers such factors as forecasted consumer demand, market
conditions, and obsolescence.
3. The company includes the statement about the possibility of being exposed to
losses in excess of amounts recorded as a way to alert the statement reader that if
various factors result in a decline in the value of its inventory the company would
need to write it down and recognize a loss.
MAKING FINANCIAL DECISIONS
LO 2,3,4 DECISION CASE 5-4 GROSS PROFIT FOR A MERCHANDISER
1. According to the income statement prepared by the controller, Emblems’ gross profit
ratio is $6,750/$15,000, or 45%.
2. Emblems should not lower its selling price. On the surface, it appears that it should,
given that the industry standard for gross margin is 40%. Emblems’ real gross profit,
however, is not 45%. The reason is that the controller failed to include two important
product costs in cost of sales: shipping and labeling. In error, the controller is
expensing all shipping and labeling costs as incurred, rather than treating them as
product costs. The correct gross profit is as follows:
Selling price $ 20.00 per unit
Costs per unit:
Purchase price $10.00
Tax (10%) 1.00
Shipping 0.50
Labeling 0.75
Total cost per unit 12.25
Gross profit per unit $ 7.75
 Number of units sold 750
Gross profit $5,812.50
Thus, the correct gross profit ratio is $5,812.50/$15,000, or 38.75%. On the basis of
this new ratio, Emblems is slightly under the industry standard of 40%, and it should
not lower its selling price.
LO 2,3,4 DECISION CASE 5-5 PRICING DECISION
1. Cost per pound $5.00

Add: Sales tax (5%  $5.00) 0.25
Gross cost $5.25
Less: Purchase discount (2%  5.25) 0.11
Net cost $5.14
Add: Shipping 0.05
Box 0.70
Total cost $5.89
2. Selling price – $5.89 = 40% (selling price)

60% (selling price) = $5.89
Selling price = $9.82
3. Before deciding whether this is a sufficient profit, Caroline’s Candy should check
industry averages and the price its local competition is charging. If the price charged
is too much higher than that of the competition, even if its product is superior,
Caroline’s may not generate as many sales as it needs to cover other costs, such as
wages and commissions for employees, rent, utilities, insurance, advertising, and a
return on owners’ investment. If its prices are much lower than that of the
competition, it may not be generating as much profit as it reasonably could.
LO 3 DECISION CASE 5-6 USE OF A PERPETUAL INVENTORY SYSTEM
1. Memo to Darrell:
The purpose of this memo is to clarify for you the costs and benefits of a perpetual
inventory system. The purpose of a perpetual system is to provide a continuously
updated record of the number of units and cost of all inventory items. A perpetual
system is more costly to maintain because of the need to update the records each
time purchases and sales are made. It is likely that you will want to consider a
computerized inventory system. Numerous software packages are available, and
one should be chosen that is particularly suitable to your business.
As mentioned earlier, a perpetual inventory system is considerably more costly to
implement and maintain than a periodic system. A perpetual system would involve
an investment in a scanning device and the other necessary hardware and software.
The next step would be to explore the options available to us and the cost of each.
Please call me at your convenience to set up an appointment to discuss these
matters further.
2. The suitability of a perpetual inventory system is certainly dependent on the type of
products a company sells. The system is ideally suited to a product such as
automobiles, since there is a relatively low volume of sales. On the other hand, it
might not be well suited to the needs of a landscaper selling trees, shrubs, and
plants. The turnover of products is very high, and it may not be practical to update
the records each time a sale takes place.
LO 6,7 DECISION CASE 5-7 INVENTORY COSTING METHODS
1. Georgetown must use the periodic inventory system at least for the first year
because it did not keep a record of the cost of the units sold as each sale was made.
2. Units on hand at the end of the year:
January 1,000
March 1,200
October 1,500
Available 3,700
Sold 3,000
On hand 700
3. Unless a company specifically identifies the cost of each unit sold, it must adopt an
assumption about which particular units were sold. Each of the inventory costing
methods takes the pool of costs (cost of goods available for sale) and makes an
assumption about which units were sold and which units remain on hand.
Because inventory costs have increased during the first year, the company could
minimize taxes paid by adopting LIFO. A comparison of partial income statements
with the use of FIFO and LIFO highlights the taxes that could be saved in the first
year:
FIFO LIFO
Sales revenue* $45,000 $45,000
Cost of goods sold** 24,800 25,500
Gross profit $20,200 $19,500
*3,000 units sold at $15 each.
** 1,000  $8 = $ 8,000
1,200  8 = 9,600
1,500  9 = 13,500
Available 3,700 $31,100
Ending inventory:
FIFO 700  $9 = $6,300
LIFO 700  $8 = $5,600
Cost of goods sold:
FIFO $31,100 – $6,300 = $24,800
LIFO $31,100 – $5,600 = $25,500
Conclusion: All expenses other than cost of goods sold are not affected by the use
of one inventory method rather than another. Thus, the lower gross profit with the
use of the LIFO method will result in income before taxes that is $20,200 –
$19,500, or $700 less than if FIFO was used. Because the expected tax rate is
35%, the company will save $700 × 0.35, or $245, by using LIFO.
LO 8 DECISION CASE 5-8 INVENTORY ERRORS
The first error resulted in an overstatement of the ending inventory in 2005 by $45,600.
Thus, cost of goods sold in 2005 was understated, and gross profit was overstated by
the same amount. The effect on net income would be less than the amount of
overstatement of gross profit because of the effect of taxes.
The second error was the result of not applying the lower-of-cost-or-market rule to
the inventory at the end of 2006. If the cost of certain inventory was $6,000 higher than
its replacement cost, the inventory should have been written down and a loss
recognized.
The error that was made in the second quarter of the current year can be corrected
before the release of the 2007 financial statements. The company should explain the
nature of the error in the annual report: that an understatement of inventory at the end
of the second quarter led to an understatement of the income reported in that quarter.
The first two errors, if material in amount, require a restatement of the financial
statements of the years involved.
ETHICAL DECISION MAKING
LO 2 DECISION CASE 5-9 SALES RETURNS AND ALLOWANCES
1. The sales manager is interested in reporting the maximum amount of sales.

Although the net amount of sales will be the same regardless of whether returns are
recorded separately or simply netted against sales revenue, the manager would
prefer not to call attention to the level of returns. It is unlikely that the manager truly
feels the present practice is a waste of time.
2. The sales manager’s recommendation might save a small amount of bookkeeping
time, but at the same time it would sacrifice certain information. Management needs
to be aware of unreasonably high levels of returns of merchandise so that it can
make whatever adjustments are necessary. If Sales Revenue is simply reduced for
the amount of returns, this information will not be available.
3. Memo to the sales manager:
I received your suggestion that we save time and effort by treating sales returns as a
direct reduction of sales rather than a separate item in our financial statements. I
appreciate your interest in saving the company money, but we would lose valuable
information by not tracking sales returns. It is imperative that we know whether our
customers are satisfied with their purchases, and separate accounting recognition
for sales returns is an important control feature in this respect. Please call me if I can
answer any questions you might have concerning this matter.
LO 7 DECISION CASE 5-10 SELECTION OF AN INVENTORY METHOD
1. The CEO is primarily concerned with reporting the highest amount of income
possible. Thus, the CEO will be satisfied if the company uses the FIFO method. This
method recognizes as cost of goods sold the oldest costs, and because prices are
rising, the costs charged to cost of goods sold will be less than if LIFO is used.
2. It would be difficult to state definitively which method is truly in the best interests of
the stockholders. The LIFO method minimizes the amount of income taxes paid in
the first year, since this method would report the highest cost of goods sold and thus
the lowest income before taxes. From a cash flow perspective, LIFO is the most
advantageous method in a period of rising prices.
3. Memo to the CEO:
TO: CEO
DATE: 12/31/XX
SUBJECT: Inventory methods
As we end our first year of operations, I am aware of the need to present a favorable
impression to our stockholders. In this regard, I would like to address the selection of
an inventory valuation method.
I can appreciate your interest in maximizing income whenever possible.
However, a method of inventory valuation that addresses this objective will not
necessarily satisfy our other concerns. Certainly, one of our primary concerns should
be to minimize the payment of taxes whenever possible.
Because our inventory purchase costs are rising, FIFO will result in the lowest
amount reported as cost of goods sold and thus an income number that is higher
than if LIFO was used. For this reason, however, the use of FIFO will result in a
higher amount of taxes payable than if LIFO was used. It is my opinion that we
should attempt to conserve cash whenever possible, and thus I believe we should
adopt the LIFO method of inventory valuation.
Thank you for the opportunity to present my views on this important matter.
Please call if I can be of any further assistance.
LO 9 DECISION CASE 5-11 WRITE-DOWN OF OBSOLETE INVENTORY
1. The write-off of the inventory that has become obsolete would reduce the current
year’s income. The amount of the reduction depends on the extent of the write-off. If
the inventory is written off completely, the reduction in income will be equal to the
book value of the inventory. If the inventory is written down to a lower amount, net
income will be reduced by the amount of the write-down. This analysis ignores the
effect of taxes.
2. If the inventory is not adjusted, total assets on the year-end balance sheet will be
overstated.
3. The materiality of the obsolete inventory should be a major factor in a decision to
persist in the argument that the inventory be written down. If the inventory in
question is not material relative to the total assets of the company, the write-down
may be unnecessary. The materiality of the loss that would be recognized from the
write-down, relative to the income of the period, should also be considered.
4. If the inventory is not written down, readers do not have reliable information. Under
the lower-of-cost-or-market rule, readers assume that if inventory is worth less than
its cost, the inventory has in fact been written down to this lower amount.
REAL WORLD PRACTICE 5.1
Because companies usually do not disclose in their annual report which inventory
system they use, it is not possible to know for certain whether Finish Line uses periodic
or perpetual. The ability of merchandisers to use the perpetual system has certainly
improved with advances in technology, such as the advent of point-of-sale terminals.
REAL WORLD PRACTICE 5.2
Finish Line is a large merchandiser of athletic footwear and other apparel. The nature of
this business requires the company to continually monitor its inventory for obsolete
products. If market is less than cost, the company should write down the inventory to
reflect market value. The company uses the weighted average method for determining
cost.

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CHAPTER 5

2. Show that you understand how wholesalers and retailers 3 25 Mod

3. Show that you understand how wholesalers and retailers 5 15 Easy

4. Use the gross profit ratio to analyze a company’s ability

5. Explain the relationship between the valuation of inventory 10 15 Mod

6. Apply the inventory costing methods of specific identification, 11 20 Easy

7. Analyze the effects of the different costing methods on 12 15 Mod

8. Analyze the effects of an inventory error on various financial 13 25 Mod

9. Apply the lower-of-cost-or-market rule to the valuation of 23* 20 Mod

*Exercise, problem, or case covers two or more learning outcomes

2. Show that you understand how wholesalers and retailers 8* 45 Mod

3. Show that you understand how wholesalers and retailers 8* 45 Mod

4. Use the gross profit ratio to analyze a company’s ability

5. Explain the relationship between the valuation of inventory 11* 45 Mod

6. Apply the inventory costing methods of specific identification, 11* 45 Mod

7. Analyze the effects of the different costing methods on 3 20 Mod

8. Analyze the effects of an inventory error on various financial 4 45 Diff

9. Apply the lower-of-cost-or-market rule to the valuation of 15* 20 Mod

11. Analyze the management of inventory. 6 30 Mod

*Exercise, problem, or case covers two or more learning outcomes

2. Show that you understand how wholesalers and retailers 4* 20 Mod

3. Show that you understand how wholesalers and retailers 1* 30 Mod

4. Use the gross profit ratio to analyze a company’s ability 4* 20 Mod

5. Explain the relationship between the valuation of inventory

6. Apply the inventory costing methods of specific identification, 3* 25 Mod

7. Analyze the effects of the different costing methods on 2 25 Mod

8. Analyze the effects of an inventory error on various financial 8 30 Mod

9. Apply the lower-of-cost-or-market rule to the valuation of 3* 25 Mod

10. Explain why and how the cost of inventory is estimated in

11. Analyze the management of inventory.

12. Explain the effects that inventory transactions have on the

13. Explain the differences in the accounting for periodic and

*Exercise, problem, or case covers two or more learning outcomes

LO 1 EXERCISE 5-1 CLASSIFICATION OF INVENTORY COSTS

LO 1 EXERCISE 5-2 INVENTORIABLE COSTS

List price: $100  200 units $20,000

LO 2 EXERCISE 5-3 PERPETUAL AND PERIODIC INVENTORY SYSTEMS

LO 2 EXERCISE 5-4 PERPETUAL AND PERIODIC INVENTORY SYSTEMS

Changes in technology may lessen the costs of maintaining perpetual inventory

LO 3 EXERCISE 5-5 MISSING AMOUNTS IN COST OF GOODS SOLD MODEL

EXERCISE 5-5 (Concluded)

LO 3 EXERCISE 5-6 PURCHASE DISCOUNTS

BALANCE SHEET INCOME STATEMENT

7/3 Accounts Purchases (3,500)

7/6 Accounts Purchases (7,000)

7/12 Cash (3,465) Accounts Purchase

8/5 Cash (7,000) Accounts

LO 3 EXERCISE 5-7 PURCHASES—PERIODIC SYSTEM

BALANCE SHEET INCOME STATEMENT

3/3 Accounts 2,500 Purchases (2,500)

3/3 Cash (250) Transportation-in (250)

3/7 Accounts Purchases (1,400)

3/12 Cash (2,450) Accounts Purchase

3/15 Accounts Purchase Returns

3/18 Accounts Purchases (1,600)

3/22 Accounts Purchase Returns

4/6 Cash (900) Accounts