Chapter 7
Reporting and Interpreting Cost of Goods Sold
and Inventory
ANSWERS TO QUESTIONS
1. Inventory often is one of the largest amounts listed under assets on the balance
sheet which means that it represents a significant amount of the resources
available to the business. The inventory may be excessive in amount, which is a
2. Fundamentally, inventory should include those items, and only those items,
3. The cost principle governs the measurement of the ending inventory amount.
The ending inventory is determined in units and the cost of each unit is applied to
that number. Under the cost principle, the unit cost is the sum of all costs
incurred in obtaining one unit of the inventory item in its present state.
5. Beginning inventory is the stock of goods on hand (in inventory) at the start of the
accounting period. Ending inventory is the stock of goods on hand (in inventory)
at the end of the accounting period. The ending inventory of one period
automatically becomes the beginning inventory of the next period.
goods sold for the period by multiplying the units sold by this average unit
cost. Similarly, the ending inventory for the period is determined by
multiplying this average unit cost by the number of units on hand.
(d) Specific identification–This inventory costing method requires that each
item in the beginning inventory and each item purchased during the period
be identified specifically so that its unit cost can be determined by
identifying the specific item sold. This method usually requires that each
item be marked, often with a code that indicates its cost. When it is sold,
that unit cost is the cost of goods sold amount. It often is characterized as
a pick-and-choose method. When the ending inventory is taken, the
specific items on hand, valued at the cost indicated on each of them, is the
ending inventory amount.
7. The specific identification method of inventory costing is subject to manipulation.
Manipulation is possible because one can, at the time of each sale, select (pick
and choose) from the shelf the item that has the highest or the lowest (or some
other) unit cost with no particular rationale for the choice. The rationale may be
8. LIFO and FIFO have opposite effects on the inventory amount reported under
assets on the balance sheet. The ending inventory is based upon either the
Financial Accounting, 9/e 7-3
9. LIFO versus FIFO will affect the income statement in two ways: (1) the amount of
cost of goods sold and (2) income. When the prices are rising, FIFO will give a
lower cost of goods sold amount and hence a higher income amount than will
LIFO. In contrast, when prices are falling, FIFO will give a higher cost of goods
sold amount and, as a result, a lower income amount.
10. When prices are rising, LIFO causes a lower taxable income than does FIFO.
Therefore, when prices are rising, income tax is less under LIFO than FIFO. A
11. LCM is applied when market (defined as current replacement cost) is lower than
the cost of units on hand. The ending inventory is valued at market (lower),
12. When a perpetual inventory system is used, the unit cost must be known for each
item sold at the date of each sale because at that time two things happen: (a) the
units sold and their costs are removed from the perpetual inventory record and
the new inventory balance is determined; (b) the cost of goods sold is determined
ANSWERS TO MULTIPLE CHOICE
Authors’ Recommended Solution Time
(Time in minutes)
Mini-exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
No.
Time
No.
Time
No.
Time
No.
Time
No.
Time
1
5
1
15
1
30
1
30
1
20
2
5
2
20
2
30
2
40
2
20
3
5
3
20
3
40
3
35
3
20
4
10
4
10
4
40
4
40
4
5
5
5
15
5
45
5
40
6
5
6
15
6
50
6
20
7
5
7
30
7
40
7
30
8
5
8
30
8
40
8
9
10
9
30
9
35
10
30
10
20
11
30
12
15
Problem
13
20
1
30
14
15
15
20
16
20
17
20
18
20
19
20
20
21
20
22
25
23
25
* Due to the nature of these cases and projects, it is very difficult to estimate the
amount of time students will need to complete the assignment. As with any open-ended
project, it is possible for students to devote a large amount of time to these
assignments. While students often benefit from the extra effort, we find that some
become frustrated by the perceived difficulty of the task. You can reduce student
MINI-EXERCISES
M7–1.
Type of Business
Type of Inventory Merchandising Manufacturing
Work in process X
M7–2.
To record the purchase of 90 new shirts in accordance with the cost principle (perpetual
inventory system):
M7–3.
(1) Part of
inventory
(2) Expense
as incurred
X
X
d. Heat, light, and power for the factory building
X
M7–4.
Computation: Simply rearrange the basic inventory model (BI + P – EI = CGS):
M7–5.
(a)
Declining costs
(b)
Rising costs
M7–6.
LIFO is often selected when costs are rising because it reduces the company’s tax
liability which increases cash and benefits shareholders. However, it also reduces
reported net income.
M7–7.
Quantity
Item A
Item B
Total
Cost per
Net Realizable
Lower of Cost
Reported on
M7–8.
+
(a)
Parts inventory delivered daily by suppliers instead of weekly.
NE
(b)
Extend payments for inventory purchases from 15 days to 30 days.
+
(c)
Shorten production process from 10 days to 8 days.
M7–9.
Understatement of the prior year ending inventory by $50,000 caused prior year pretax
income to be understated and current year pretax income to be overstated by the same
EXERCISES
E7–1
Item
Amount
Explanation
Ending inventory (physical count on
December 31 of the current year)
$34,500
Per physical inventory.
a.
Goods purchased and in transit
+ 700
Goods purchased and in transit,
F.O.B. shipping point, are owned
by the purchaser.
customer
trial are still owned by the vendor;
no sale or transfer of ownership
has occurred.
c.
Goods in transit to customer
Goods shipped to customers,
F.O.B. shipping point, are owned
by the customer because
ownership passed when they were
delivered to the transportation
company. The inventory correctly
excluded these items.
d.
Goods sold and in transit
+ 1,500
Goods sold and in transit, F.O.B.
destination, are owned by the seller
until they reach destination.
Correct inventory, December 31,
current year
$38,500
E7–2.
(Italics for missing amounts only.)
Case A Case B Case C
Net sales revenue ………. $7,500 $4,800 $5,000
Beginning inventory …….. $11,200 $ 7,000 $ 4,000
Financial Accounting, 9/e 7-9
E7–3.
(Italics and bold for missing amounts only.)
Case
Sales
Revenue
Beg.
Inven-
tory
Pur-
chases
Total
Avail-
able
Ending
Inventory
Cost of
Goods
Sold
Gross
Profit
Ex–
penses
Pretax
Income
or
(Loss)
A
$ 650
$100
$700
$800
$500
$300
$350
$200
$150
E7–4.
Computations:
Simply rearrange the cost of goods sold equation
BI + P – EI = CGS
P = CGS – BI + EI
B
C
D
(50)
E7-5
Average
Units FIFO LIFO Cost
Cost of goods sold:
Beginning inventory ($5) …………. 2,000 $10,000 $10,000 $10,000
*Ending inventory computations:
FIFO: (3,000 units @ $8) + (1,000 units @ $6) = $30,000.
LIFO: (2,000 units @ $5) + (2,000 units @ $6) = $22,000.
Average: [(2,000 units @ $5) + (5,000 units @ $6) + (3,000 units @ $8)] =
$64,000 ÷ 10,000 units = $6.40 per unit.
4,000 units @ $6.40 = $25,600.
Financial Accounting, 9/e 7-11
E7–6
Average
Units FIFO LIFO Cost
Cost of goods sold:
*Ending inventory computations:
FIFO: (3,000 units @ $2) = $6,000.
**Cost of goods sold computations:
FIFO: (2,000 units @ $5) + (6,000 units @ $4) + (1,000 units @ $2) = $36,000.
E7–7.
Req. 1
BROADHEAD COMPANY
Income Statement
For the Year Ended December 31, current year
Case A Case B
FIFO LIFO
Sales revenue1 ………………………… $500,000 $500,000
Cost of goods sold:
Beginning inventory ……………. $ 27,000 $ 27,000
Computations:
(1) Sales: (10,000 units @ $50) = $500,000
(2) Goods available for sale (for both cases):
Units Unit Cost Total Cost
(3) Ending inventory (19,000 available – 10,000 units sold = 9,000 units):
Case A FIFO:
(7,000 units @ $15 = $105,000) +
(2,000 units @ $10 = $20,000) = $125,000.
Financial Accounting, 9/e 7-13
E7–7. (continued)
Req. 1 (continued)
(4) Cost of goods sold (10,000 units sold):
Case A FIFO:
(3,000 units @ $9 = $27,000) +
(7,000 units @ $10 = $70,000) = $97,000
Req. 2
Comparison of Amounts
Case A Case B
FIFO LIFO
The above tabulation demonstrates that the pretax income difference between the two
cases is exactly the same as the inventory difference. Differences in inventory have a
dollar-for-dollar effect on pretax income.
Req. 3
E7–8.
Req. 1
BECK INC.
Income Statement
For the Year Ended December 31, current year
Case A Case B
FIFO LIFO
Sales revenue1 ………………………… $704,000 $704,000
Cost of goods sold:
Beginning inventory ……………. $ 77,000 $ 77,000
Purchases ………………………… 221,000 221,000
Computations:
(1) Sales: (8,000 units @ $28) + (16,000 units @ $30) = $704,000
(2) Goods available for sale (for both cases):
Units Unit Cost Total Cost
Beginning inventory 7,000 $11 $ 77,000
(3) Ending inventory (36,000 available – 24,000 units sold = 12,000 units):
Case A FIFO:
(10,000 units @ $5 = $50,000) +
Financial Accounting, 9/e 7-15
E7–8. (continued)
Req. 1 (continued)
(4) Cost of goods sold (24,000 units sold):
Case A FIFO:
(7,000 units @ $11 = $77,000) +
(17,000 units @ $9 = $153,000) = $230,000
Req. 2
Comparison of Amounts
Case A Case B
FIFO LIFO
The above tabulation demonstrates that the pretax income difference between the two
cases is exactly the same as the inventory difference. Differences in inventory have a
dollar-for-dollar effect on pretax income.
Req. 3
E7–9.
Req. 1
Average
FIFO LIFO Cost
Cost of goods sold:
Beginning inventory (400 units @ $28) … $11,200 $11,200 $11,200
*Computation of ending inventory:
FIFO: (475 units x $35) + (50 units x $28) = $18,025
LIFO: (400 units x $28) + (125 units x $35) = $15,575
Average: [(400 units @ $28) + (475 units @ $35)] ÷ 875 units =
$27,825 ÷ 875 units = $31.80 per unit.
$31.80 x 525 units = $16,695.
Req. 2
Average
FIFO LIFO Cost
Financial Accounting, 9/e 7-17
E7–9. (continued)
Req. 3
Ranking in order of favorable cash flow: The higher rankings are given to the methods
that produce the lower income tax expense because the lower the income tax expense
the higher the cash savings.
(1) LIFO–produces the lowest pretax income, hence the lowest amount of cash to be
paid for income tax.
E7–10.
Req. 1
Average
FIFO LIFO Cost
Cost of goods sold:
Beginning inventory (400 units @ $30) … $12,000 $12,000 $12,000
Purchases (400 units @ $20) …………….. 8,000 8,000 8,000
Goods available for sale ……………………. 20,000 20,000 20,000
Ending inventory (500 units)*……………… 11,000 14,000 12,500
Cost of goods sold (300 units)** …………. $ 9,000 $ 6,000 $ 7,500
**Cost of goods sold computations:
FIFO: (300 units @ $30) = $9,000.
Req. 2
Average
FIFO LIFO Cost
Sales revenue ($50 x 300) …………………………. $15,000 $15,000 $15,000
Financial Accounting, 9/e 7-19
E7–10. (continued)
Req. 3
Ranking in order of favorable cash flow: The higher rankings are given to the methods
that produce the lower income tax expense because the lower the income tax expense
the higher the cash savings.
(1) FIFO–produces the lowest pretax income and as a result the lowest income tax.
This result causes the highest cash savings on income tax.
E7–11.
Req. 1
Average
Units FIFO LIFO Cost
Cost of goods sold:
Beginning inventory ……………….. 2,000 $ 76,000 $ 76,000 $ 76,000
Average
Income statement FIFO LIFO Cost
Sales revenue ………………………………… $615,000 $615,000 $615,000
Cost of goods sold…………………………... 324,000 327,600 324,720
Gross profit ………………………………….. 291,000 287,400 290,280
**Cost of goods sold computations:
FIFO: (2,000 units @ $38) + (6,200 units @ $40) = $324,000.
LIFO: (8,000 units @ $40) + (200 units @ $38) = $327,600.
Average: [(8,000 units @ $38) + (8,000 units @ $40)] =
$396,000 ÷ 10,000 units = $39.60 per unit.
8,200 units @ $39.60 = $324,720.
Req. 2