CHAPTER 6
Reporting and Analyzing Inventory
Learning Objectives
1. Discuss how to classify and determine inventory.
2. Apply inventory cost flow methods and discuss their financial effects.
3. Explain the statement presentation and analysis of inventory.
*4. Apply inventory cost flow methods to perpetual inventory records.
*5. Indicate the effects of inventory errors on the financial statements.
Summary of Questions by Learning Objectives and Bloom’s Taxonomy
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Brief Exercises
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DO IT! Exercises
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Problems: Set A
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*Continuing Cookie Solutions for this chapter are available online.
ASSIGNMENT CHARACTERISTICS TABLE
Problem
Number
Description
Difficulty
Level
Time
Allotted (min.)
1A
Determine items and amounts to be recorded in inventory.
Moderate
15–20
2A
Determine cost of goods sold and ending inventory using
FIFO, LIFO, and average-cost with analysis.
Moderate
30–40
3A
Determine cost of goods sold and ending inventory using
FIFO, LIFO, and average-cost in a periodic inventory
system and assess financial statement effects.
Moderate
30–40
4A
Compute ending inventory, prepare income statements,
and answer questions using FIFO and LIFO.
Moderate
30–40
5A
Calculate ending inventory, cost of goods sold, gross
profit, and gross profit rate under periodic method;
compare results.
Moderate
30–40
6A
Compare specific identification, FIFO, and LIFO under
periodic method; use cost flow assumption to influence
earnings.
Moderate
20–30
7A
Compute inventory turnover and days in inventory;
compute current ratio based on LIFO and after adjusting
for LIFO reserve.
Moderate
20–30
*8A
Calculate cost of goods sold, ending inventory, and gross
profit for LIFO, FIFO, and moving-average under the
perpetual system; compare results.
Difficult
30–40
*9A
Determine ending inventory under a perpetual inventory
system.
Difficult
30–40
ANSWERS TO QUESTIONS
1. Agree. Effective inventory management is frequently the key to successful business operations.
Management attempts to maintain sufficient quantities and types of goods to meet expected
customer demand. It also seeks to avoid the cost of carrying inventories that are clearly in ex–
cess of anticipated sales.
LO 1 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA PC: Communication
2. Inventory items have two common characteristics: (1) they are owned by the company and (2) they
are intended to be sold to customers in the ordinary course of business.
LO 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: None AICPA PC: Communication
3. Just–in–time inventory management is the practice of manufacturing or purchasing inventory “just–in–
time” to fill a sales order. Since inventory quantities are kept at very low amounts, just-in-time man–
agement reduces the costs associated with carrying inventory as well as the risk of obsolescence.
LO 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: None AICPA PC: Communication
4. Taking a physical inventory involves actually counting, weighing, or measuring each kind of
inventory on hand. Retailers, such as hardware stores, generally have thousands of different
items to count. This is normally done when the store is closed. Will will probably count items and
mark the quantity, description, and inventory number on prenumbered inventory tags.
LO 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: None AICPA PC: Communication
5. (a) (1) The goods will be included in Bonita Company’s inventory if the terms of sale are FOB
destination.
(2) The goods will be included in Myan Corporation’s inventory if the terms of sale are
FOB shipping point.
(b) Bonita Company should include goods shipped to a consignee in its inventory. Goods held
by Bonita Company on consignment should not be included in inventory.
LO 1 BT: C Difficulty: Medium TOT: 3 min. AACSB: None AICPA PC: Communication
6. Inventoriable costs are $3,015 (invoice cost $3,000 + freight charges $75 − purchase discounts $60).
LO 1 BT: AP Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA FC: Reporting
7. The primary basis of accounting for inventories is cost in accordance with the historical cost
principle.
LO 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: None AICPA PC: Communication
8. Actual physical flow may be impractical because many items are indistinguishable from one
another. Actual physical flow may be inappropriate because management may be able to manipu-
late net income through specific identification of items sold.
LO 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
9. The major advantage of the specific identification method is that it tracks the actual physical flow
of the goods available for sale. The major disadvantage is that management could manipulate
net income.
LO 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
10. No. Selection of an inventory costing method is a management decision. However, once a method
has been chosen, it should be consistently applied.
LO 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
11. (a) FIFO, (b) Average-cost, (c) LIFO.
LO 2 BT: K Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
Questions Chapter 6 (Continued)
12. Short Company is using the FIFO method of inventory costing, and King Company is using the
LIFO method. Under FIFO, the latest goods purchased remain in inventory. Thus, the inventory
on the balance sheet should be close to current costs. The reverse is true of the LIFO method.
Short Company will have the higher gross profit because cost of goods sold will include a higher
proportion of goods purchased at earlier (lower) costs.
LO 2 BT: C Difficulty: Medium TOT: 2 min. AACSB: None AICPA FC: Measurement & Reporting
AICPA PC: Communication
13. Mamosa Corporation may experience severe cash shortages if this policy continues. All of its net
income is being paid out as dividends, yet some of the earnings must be reinvested in inventory
to maintain inventory levels. Some earnings must be reinvested because net income is computed
with cost of goods sold based on older, lower costs while the inventory must be replaced at
current, higher costs. Because of this factor, net income under FIFO is sometimes referred to as
including “phantom profits.” In addition, Mamosa is also depleting cash more quickly under FIFO
because FIFO results in higher income tax payments.
LO 2 BT: AN Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA FC: Reporting AICPA PC:
Communication
14. Oscar is partially correct. In a period of inflation, FIFO produces higher net income because the
lower unit costs of the first units purchased is matched against revenues. A switch from LIFO to
FIFO will thus produce higher net income and a larger bonus for Oscar, which he perceives as
being “better off”. It is more difficult to determine if the company would be “better off” if it used
FIFO instead of LIFO. Using FIFO would mean higher reported income and higher inventory
values which investors usually interpret as “better” results. On the other hand, the higher net
income reported with FIFO would mean higher bonus and income tax expenses. Since both of
these items require cash, switching to FIFO may leave the company with an inadequate amount
of cash to meet normal operating needs.
LO 2 BT: C Difficulty: Hard TOT: 4 min. AACSB: None AICPA FC: Reporting AICPA PC:
Communication
15. When prices are increasing, LIFO results in higher cost of goods sold, and lower income relative
to FIFO. Because LIFO income is lower the company pays lower taxes, which results in higher
cash flows. The quality of earnings ratio is net cash provided by operating activities divided by
income. The use of LIFO will increase the numerator (net cash provided by operating activities)
and decrease the denominator (net income), both of which increase the value of the ratio.
LO 2 BT: C Difficulty: Medium TOT: 3 min. AACSB: None AICPA FC: Reporting AICPA PC:
Communication
16. Hank should know the following:
(a) A departure from the cost basis of accounting for inventories is justified when the value of
the goods is no longer as great as its cost. The writedown to market should be recognized in
the period in which the price decline occurs.
(b) Market means current replacement cost, not selling price. For a merchandising company,
market is the cost at the present time from the usual suppliers in the usual quantities.
LO 3 BT: C Difficulty: Medium TOT: 3 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
17. Jackson Music Center should report the TVs at $350 each for a total of $1,750. $350 is the
current replacement cost under the lower-of-cost-or-market (LCM) basis of accounting for
inventories. A decline in replacement cost usually leads to a decline in the selling price of the
item. Valuation at LCM is conservative.
LO 3 BT: AP Difficulty: Medium TOT: 3 min. AACSB: Analytic AICPA FC: Measurement & Reporting
AICPA PC: Communication
18. Lower-of-cost-or-market can be applied after any of the cost flow assumptions has been used,
including LIFO, FIFO, average-cost, or specific identification.
LO 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
19. Freight-out expense is not a cost associated with purchasing goods, so it should not affect cost
of goods sold. It is an expense incurred to sell goods already purchased, so it should be reported
as a selling expense.
LO 3 BT: C Difficulty: Easy TOT: 1 min. AACSB: None AICPA FC: Reporting AICPA PC:
Communication
Questions Chapter 6 (Continued)
20. Tilton Company should disclose (1) the major inventory classifications, (2) the basis of accounting
(cost or lower-of–cost–or-market), and (3) the costing method (FIFO, LIFO, or average).
LO 3 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting AICPA PC:
Communication
21. An inventory turnover that is too high may indicate that the company is losing sales opportunities
because of inventory shortages. Inventory outages may also cause customer ill will and result in
lost future sales.
LO 3 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA PC: Communication
22. The LIFO reserve is a required disclosure for companies that employ LIFO. It is the difference
between ending inventory using LIFO and ending inventory if FIFO were used instead. Ignoring a
large LIFO reserve when analyzing a company can distort any comparisons that an analyst might
try to make with a company’s competitors that used FIFO.
LO 3 BT: K Difficulty: Medium TOT: 2 min. AACSB: None AICPA PC: Communication
*23. Disagree. The results under the FIFO method are the same but the results under the LIFO method
may be different. The reason is that the pool of inventoriable costs (costs of goods available for
sale) is not the same. Under a periodic system, the pool of costs is the goods available for sale
for the entire period, whereas under a perpetual system, the pool is the goods available for sale
up to the date of sale.
LO 4 BT: C Difficulty: Medium TOT: 3 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
*24. In a perpetual inventory system, the average is a moving average of goods available for sale after
each purchase. In a periodic inventory system, the average is a weighted average based on total
goods available for sale for the period.
LO 4 BT: C Difficulty: Medium TOT: 2 min. AACSB: None AICPA FC: Measurement AICPA PC:
Communication
*25. (a) Albert Company’s 2016 net income will be understated $5,000; (b) 2017 net income will be
overstated $5,000; and (c) the combined net income for the two years will be correct.
LO 5 BT: AP Difficulty: Medium TOT: 2 min. AACSB: Analytic AICPA FC: Reporting AICPA PC:
Communication
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 6-1
(a) Ownership of the goods belongs to the owner (Peete). Thus, these goods
should be included in Peete’s inventory.
BRIEF EXERCISE 6-2
(a) The ending inventory under FIFO consists of 200 units at $9 for a total
allocation of $1,800.
BRIEF EXERCISE 6-3
Average unit cost is $7.917 computed as follows:
300 X $6 = $1,800
BRIEF EXERCISE 6-4
(a) FIFO would result in the highest net income.
(b) FIFO would result in the highest ending inventory.
BRIEF EXERCISE 6-5
Cost of goods sold under:
LIFO
FIFO
Purchases
$6 X 100
$6 X 100
$7 X 200
$7 X 200
$8 X 140
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
Since the cost of goods sold is $240 ($1,960 – $1,720) less under FIFO that
is the amount of the phantom profit. It is referred to as “phantom profit”
because FIFO matches current selling prices with old inventory costs. To
BRIEF EXERCISE 6-6
(a) LIFO results in a higher quality of earnings ratio.
BRIEF EXERCISE 6-7
Inventory Categories Cost Market LCM
Cameras $12,500 $13,400 $12,500
BRIEF EXERCISE 6-8
Inventory turnover:
$349,114
($119,035+$155,377) ÷2 =$349,114
$137,206 =2.54 times
BRIEF EXERCISE 6-9
2017 ending inventory using LIFO ……………………….. $46,850,000
*BRIEF EXERCISE 6-10
(1) FIFO
Cost of Goods Sold
June 1 sale: 25 units @ $10 = $250
(2) LIFO
Cost of Goods Sold
June 1 sale: 25 units @ $10 = $250
(3) MOVING-AVERAGE
Cost of Goods Sold
June 1 sale: 25 units @ $10 = $250
LO 4 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Measurement and Reporting
*BRIEF EXERCISE 6-11
The understatement of ending inventory caused cost of goods sold to be
overstated $7,000 and net income to be understated $7,000. The correct net
SOLUTIONS TO DO IT! EXERCISES
DO IT! 6-1
Inventory per physical count …………………………………………… $300,000
Inventory out on consignment ………………………………………… 28,000
DO IT! 6-2
Cost of goods available for sale = (3,000 X $5) + (8,000 X $7) = $71,000
Ending inventory = 3,000 + 8,000 – 9,400 = 1,600 units
DO IT! 6-3a
DO IT! 6-3b
2016
2017
Inventory
$1,200,000
= 6.3
$1,425,000
= 9.5
turnover
($170,000 + $210,000)/2
($210,000 + $90,000)/2
SOLUTIONS TO EXERCISES
EXERCISE 6-1
Ending inventory⎯physical count …………………………………………. $275,000
1. No effect−title passes to purchaser upon shipment
when terms are FOB shipping point …………………………. 0
EXERCISE 6-2
Ending inventory-as reported ………………………………………………..
$740,000
1.
Subtract from inventory: The goods belong
2.
Add to inventory: The goods belong to
Ryder as soon as they are shipped
(December 28). ………………………………………………………………..
40,000
3.
Subtract from inventory: Office supplies should
4.
Add to inventory: The goods belong to Ryder
until they are shipped (Jan. 1). ………………………………………….
29,000
EXERCISE 6-2 (Continued)
5.
Subtract from inventory: GAAP requires that
inventory be valued at the lower of cost or
EXERCISE 6-3
(a) Do not include—Gato does not own items held on consignment.
(b) Include in inventory—Gato still owns the items as they were only
shipped on consignment.
EXERCISE 6-4
FIFO
Beginning inventory (12 X $100) ……………………………. $ 1,200
Purchases
Sept. 12 (45 X $103) ………………………………………… $4,635
PROOF
Date Units Unit Cost Total Cost
9/1 12 $100 $ 1,200
LIFO
Cost of goods available for sale …………………………..……….. $13,135
PROOF
Date Units Unit Cost Total Cost
9/26 20 $105 $ 2,100
AVERAGE-COST
$13,135 ÷ 127 = $103.425 weighted-average unit cost
Cost of goods available for sale …………………………..……….. $13,135
PROOF
Units Unit Cost Total Cost
EXERCISE 6-5
(a)
FIFO
Beginning inventory (30 X $9) …………………………………… $270
Purchases
May 15 (25 X $10) ……………………………………………….. $250
PROOF
Date Units Unit Cost Total Cost
5/1 30 $ 9 $270
(b)
LIFO
Cost of goods available for sale ………………………………………….. $938
PROOF
Date Units Unit Cost Total Cost
5/24 38 $11 $418
EXERCISE 6-5 (Continued)
(c)
AVERAGE-COST
$938 ÷ 93 = $10.086 weighted-average unit cost
Cost of goods available for sale …………………………..………………. $938.00
PROOF
Units Unit Cost Total Cost
EXERCISE 6-6
(a) FIFO Cost of Goods Sold
(b) It could choose to sell specific units purchased at specific costs if it
wished to impact earnings selectively. If it wished to minimize earnings
(c) The FIFO method provides a more appropriate balance sheet valuation
and reduces the opportunity to manipulate earnings.
EXERCISE 6-7
(a) (1) FIFO
Beginning inventory (120 X $5) ……………………………. $ 600
Purchases
June 12 (370 X $6) ………………………………………… $2,220
(2) LIFO
Cost of goods available for sale ………………………….. $4,220
(3) AVERAGE-COST
Cost of Goods Total Units Weighted-Average
Available for Sale ÷ Available for Sale = Unit Cost
(b) The FIFO method will produce the highest ending inventory because costs
have been rising. Under this method, the earliest costs are assigned to
cost of goods sold, and the latest costs remain in ending inventory.
(c) The average-cost ending inventory ($1,407) is higher than LIFO ($1,260)
(d) The simple average would be (($5 + $6 + $7)/3) = $6. However, the average
EXERCISE 6-8
LIFO FIFO
(a) Sales …………………………………………………………….. $86,000 $86,000
Cost of goods sold ……………………………………….. 38,000 29,000
LIFO FIFO
(b) Sales …………………………………………………………….. $86,000 $86,000
Less: Cash paid for inventory purchases ………. 32,000 32,000
Cash paid for operating expenses
LIFO FIFO
(c) Net cash provided by operating activities ………. $30,700 $28,000
EXERCISE 6-9
Cost/Unit
Market
Value/Unit
Lower-of-Cost-
or-Market
Units
Inventory at
Lower-of-Cost-
or-Market
Cameras:
Minolta
$170
$158
$158
5
$ 790
Canon
145
152
145
7
1,015
Light Meters:
Vivitar
125
114
114
1,368
Kodak
120
135
120
Total
$4,373
EXERCISE 6-10
Type of Bean
Quantity
Unit
Cost
Total
Cost
Market
Total
Market
LCM
Coffea arabica
13,000 bags
$5.60
$72,800
$5.55
$72,150
$72,150
Coffea robusta
$89,800
$89,650
$89,150
EXERCISE 6-11
2015
2016
2017
(a) Inventory
turnover
$18,038
($1,926+$2,290)÷2
$20,351
($2,290+$2,522)÷2
$20,099
($2,522+$2,618)÷2
EXERCISE 6-11 (Continued)
(d) The inventory turnover decreased by approximately 10% from 2015 to
2017 while the days in inventory increased by a similar amount (10%)
EXERCISE 6-12
Inventory Turnover (2017):
$1,552,000
($553,000 + $568,000) ÷ 2
= 2.8 times
(b) In 2017, Zoe’s Activewear experienced a deterioration in liquidity and
profitability. The liquidity has been deteriorated due to the increase in