1. Calculate cost of goods sold and ending inventory using the LIFO method.
Cost of goods available for sale = Cost of
goods sold +Ending
inventory
Beginning
inventory
and
purchases
Number
of units
xUnit
cost
=Total
Cost
Jan. 1{50 $20 $1,000 Not Sold $1,000
150 $20 $3,000 Sold
last
450
units
$3,000
Jun. 15 300 $25 $7,500 $7,500
500 $11,500 =$10,500 +$1,000
2. Calculate cost of goods sold and ending inventory using the average cost method.
Weighted-average unit cost = $11,500 =$23
500
Cost of goods sold = 450 sold X $23 = $10,350
Ending inventory = 50 not sold X $23 = $ 1,150
500 $11,500
Alternate Let’s Review
Problem #2
A company accounts for its inventory using FIFO with a perpetual system. At the beginning of
March, the company has inventory of $40,000.
Required:
Record the following transactions for the company for the month of March.
1. On March 7, the company purchases additional inventory for $65,000 on account, terms
3/10, n/30.
Inventory 65,000
Accounts Payable 65,000
2. On March 10, inventory that cost $5,000 arrived damaged and was returned for a full
refund.
Accounts Payable 5,000
Inventory 5,000
3. On March 16, the company makes full payment for inventory purchased on March 7,
excluding inventory returned and the discount received.
Accounts Payable 60,000
Cash 58,200
Inventory 1,800
($1,800 = $60,000 x 3%)
4. During the month of March, revenue from inventory sales totals $85,000. All sales are
for cash. The cost of inventory sold is $35,000.
Cash 85,000
Sales Revenue 85,000
Cost of goods sold 35,000
Inventory 35,000
Alternate Let’s Review
Problem #3
J-Lo Fashions provides year-around specialty jeans. At December 31, the company’s records
show the following amounts in ending inventory for each item.
Inventory items Quantity
Cost
Per unit
Market
per unit
Fall jeans 50 $100 $ 70
Winter jeans 200 120 140
Spring jeans 300 150 180
Required:
1. Determine ending inventory using the lower-of-cost-or-market method.
Inventory items Quantity
Cost
per unit
Market
per unit
Per unit lower
of cost or
market
Total lower
of cost or
market
Fall jeans 50 $100 $ 70 $ 70 $ 3,500
Winter jeans 200 120 140 120 24,000
Spring jeans 300 150 180 150 45,000
$72,500
2. Record any necessary year-end adjustment associated with the lower-of-cost-or-market
method.
December 31 Debit Credit
Cost of Goods Sold 1,500
Inventory 1,500
(50 fall jeans x $30 = $1,500)
Key Points by Learning Objective
LO6-1 Trace the flow of inventory costs from manufacturing companies to merchandising
companies.
Service companies earn revenues by providing services to customers. Manufacturing and
merchandising companies earn revenues by selling inventory to customers.
LO6-2 Understand how cost of goods sold is reported in a multiple-step income statement.
Inventory is a current asset reported in the balance sheet and represents the cost of inventory not
yet sold at the end of the period. Cost of goods sold is an expense reported in the income
statement and represents the cost of inventory sold.
A multiple-step income statement reports multiple levels of profitability. Gross profit equals net
sales minus cost of goods sold. Operating income equals gross profit minus operating expenses.
Income before income taxes equals operating income plus non-operating revenues and minus
non-operating expenses. Net income equals all revenues minus all expenses.
LO6-3 Determine the cost of goods sold and ending inventory using different inventory cost
methods.
Companies are allowed to report inventory costs by assuming which units of inventory are sold
and not sold, even if this does not match the actual flow. The three major inventory cost flow
assumptions are FIFO (first-in, first-out), LIFO (last-in, first-out), and weighted-average cost.
LO6-4 Explain the financial statement effects and tax effects of inventory cost flow
assumptions.
Generally, FIFO more closely resembles the actual physical flow of inventory. When inventory
costs are rising, FIFO results in higher reported inventory in the balance sheet and higher
reported income in the income statement. Conversely, LIFO results in a lower reported inventory
and net income, reducing the company’s income tax obligation.
LO6-5 Record inventory transactions using a perpetual inventory system.
The perpetual inventory system maintains a continual—or perpetual —record of inventory
purchased and sold. When companies purchase inventory using a perpetual inventory system,
they increase the Inventory account and either decrease Cash or increase Accounts Payable.
When companies sell inventory, they make two entries: (1) They increase an asset account
(Cash or Accounts Receivable) and increase Sales Revenue, and (2) they increase Cost of
Goods Sold and decrease Inventory.
Nearly all companies maintain their own inventory records on a FIFO basis, and then some
prepare financial statements on a LIFO basis. To adjust their FIFO inventory records to LIFO for
financial reporting, companies use a simple LIFO adjustment at the end of the period.
For most companies, freight charges are added to the cost of inventory, whereas purchase returns
and purchase discounts are deducted from the cost of inventory. Some companies choose to
report freight charges on outgoing shipments as part of selling expenses instead of cost of goods
sold.
LO6-6 Apply the lower-of-cost-or-market method for inventories.
We report inventory at the lower-of-cost-or-market; that is, at cost (specific identification,
FIFO, LIFO, or weighted-average cost) or market value (normally, replacement cost), whichever
is lower. When market value falls below cost, we adjust downward the balance of inventory from
cost to market value.
Analysis
LO6-7 Analyze management of inventory using the inventory turnover ratio and gross
profit ratio.
The inventory turnover ratio indicates the number of times the firm sells, or turns over, its
average inventory balance during a reporting period. The gross profit ratio measures the amount
by which the sale price of inventory exceeds its cost per dollar of sales.
Appendixes
LO6-8 Record inventory transactions using a periodic inventory system.
Using the periodic inventory system, we record purchases of inventory, freight-in, purchase
returns, and purchase discounts to temporary accounts rather than directly to Inventory. These
temporary accounts are closed in a period-end adjustment. In addition, at the time inventory is
sold, we do not record a decrease in inventory sold; instead, we update the balance of inventory
in the period-end adjustment.
LO6-9 Determine the financial statement effects of inventory errors.
In the current year, inventory errors affect the amounts reported for inventory and retained
earnings in the balance sheet and amounts reported for cost of goods sold and gross profit in the
income statement. At the end of the following year, the error has no effect on ending inventory or
retained earnings but reverses for cost of goods sold and gross profit.
Common Mistakes
Common Mistake
Many students find it surprising that companies are allowed to report
inventory costs using assumed amounts rather than actual amounts. Nearly all
companies sell their actual inventory in a FIFO manner, but they are allowed
to report it as if they sold it in a LIFO manner. Later, we’ll see why that’s
advantageous.
Common Mistake
In calculating the weighted-average unit cost, be sure to use a weighted
average of the unit cost instead of the simple average. In the example above,
there are three unit costs: $7, $9, and $11. A simple average of these amounts
is $9 [= (7 + 9 + 11) ÷ 3]. The simple average, though, fails to take into
account that several more units were purchased at $11 than at $7 or $9. So we
need to weight the unit costs by the number of units purchased. We do that by
taking the total cost of goods available for sale ($10,000) divided by total
number of units available for sale (1,000) for a weighted average of $10.
Common Mistake
FIFO and LIFO more directly the calculation of cost of goods sold, rather
than ending inventory. For example, FIFO (first-in, first-out) directly suggests
which inventory units are assumed sold (the first ones in) and therefore used
to calculate cost of goods sold. It is implicit that the inventory units not sold
are the last ones in and are used to calculate ending inventory.
Common Mistake
Many students use ending inventory rather than average inventory in
calculating the inventory turnover ratio. Generally, when you calculate a ratio
that includes an income statement item (an amount generated over a period)
with a balance sheet item (an amount at a particular date), the balance sheet
item needs to be converted to an amount over the same period. This is done
by averaging the beginning and ending balances of the balance sheet item.
Decision Points
Question Accounting
Information
Analysis & Decision
When comparing
inventory
amounts between
two companies,
does the choice of
inventory method
matter?
The LIFO difference
reported in the notes to
the financial statements
When inventory costs are
rising, FIFO results in a higher
reported inventory. The LIFO
difference can be used to
compare inventory of two
companies if one uses FIFO
and the other uses LIFO.
Question Accounting
Information
Analysis & Decision
Is the company
effectively
managing its
inventory?
Inventory turnover ratio
and average days in
inventory
A high inventory turnover ratio
(or low average days in
inventory) generally indicates
that the company’s inventory
policies are effective.
Question Accounting
Information
Analysis & Decision
For how much is
a company able to
sell a product
above its cost?
Gross profit and sales
revenue
The ratio of gross profit to net
sales indicates how much the
sales price exceeds inventory
cost for each $1 of sales.
Career Corner
Career Corner
Many career opportunities are available in tax accounting. Because tax laws
constantly change and are complex, tax accountants provide services to their
clients not only through income tax statement preparation but also by
formulating tax strategies to minimize tax payments. The choice of LIFO
versus FIFO is one such example. Tax accountants need a thorough
understanding of legal matters, business transactions, and the tax code. Large
corporations increasingly are looking to hire individuals with both an
accounting and a legal background in tax. For example, someone who is a
Certified Public Accountant (CPA) and has a law degree is especially
desirable in the job market. In addition, people in non-accounting positions
also benefit greatly from an understanding of tax accounting. Whether you
work in a large corporation or own a small business, virtually all business
decisions have tax consequences.
Ethical Dilemma
Ethical Dilemma
Diamond Computers, which is owned and operated by Dale Diamond,
manufactures and sells different types of computers. The company has
reported profits every year since its inception in 2000 and has applied for a
bank loan near the end of 2015 to upgrade manufacturing facilities. These
upgrades should significantly boost future productivity and profitability.
In preparing the financial statements for the year, the chief accountant,
Sandy Walters, mentions to Dale that approximately $80,000 of computer
inventory has become obsolete and a write-down of inventory should be
recorded in 2015.
Dale understands that the write-down would result in a net loss being
reported for company operations in 2015. This could jeopardize the
company’s application for the bank loan, which would lead to employee
layoffs. Dale is a very kind, older gentleman who cares little for his personal
wealth but who is deeply devoted to his employees’ wellbeing. He truly
believes the loan is necessary for the company’s sustained viability. Dale
suggests Sandy wait until 2016 to write down the inventory so that profitable
financial statements can be presented to the bank this year.
Explain how failing to record the write-down in 2015 inflates profit in that
year. How would this type of financial accounting manipulation potentially
harm the bank? Can Sandy justify the manipulation based on Dale’s kind
heart for his employees?
Key issues
Writing off inventory reduces net income and total assets in the year of the write-off. By
delaying the write-off, the company shifts profits from the following year to the current
year, overstating current performance.
Proper reporting vs. the long-term care of the company and its employees.
Option 1: Wait to book the write-off
Booking the write-off could be very damaging to the long-term health of the company
and its employees. Missing out on the loan could damage the profitability of future years,
leading to layoffs.
Dale should be commended for his attentiveness to his employees’ careers.
Accounting rules can be bent a little to help the company and employees, and five years
from now it will not matter whether the write-off was booked in 2010 or 2011.
As an employee, Sandy should do whatever her boss asks her to do. Any responsibility
for wrongdoing would fall on Dale.
Option 2: Book the write-off now
The company is in the situation they are in concerning the obsolete inventory because of
business decisions and circumstances over the past few years. Bad decision making
should not be corrected via creative accounting.
Despite the possible increased productivity that would be generated from the loan that
will fund upgrades, there is no guarantee that these increases will lead to enough profits
to offset the write-off if postponed to 2011. Then the company will be in a similar
situation a year later.
Sandy should realize that her responsibility is to present accurate financial statements, not
please Dale’s good intentions. If this write-off is postponed and then later discovered by
auditors, then she has lost her credibility and may personally lose her own job despite
saving the job of many others.