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CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
3. Calculate the Ratio. Inventory turnover ratio =
Cost of Goods Sold
Average Inventory
= 5.3 times
• Using the Business Decision Model:
1. Formulate the Question. Would you buy stock in Gap?
2. Gather Information from the Financial Statements and Other Sources. Information will come
from a variety of sources, including, but not limited to:
The balance sheet (liquidity), income statement (profitability), and statement of cash
flows.
3. Analyze the Information Gathered.
Compare inventory turnover ratio with competitors, and industry averages.
Look at trends over time in inventory turnover ratio.
Module 4
LO 11
How Inventories Affect the Cash Flows Statement
Operating section of statement of cash flows:
◼ Direct method:
INSTRUCTOR’S MANUAL
5-16
Appendix
MODULE 5 INVENTORY COSTING METHODS WITH A
PERPETUAL SYSTEM
Module 5
LO 12
Inventory Costing Methods with a Perpetual System
Inventory costing systems are LIFO, FIFO, specific identification, and weighted average.
FIFO Costing with a Perpetual System
◼ A schedule which illustrates the FIFO method on a perpetual basis shows the first units purchased
are still assumed to be the first sold. (Example 5-19)
LIFO Costing with a Perpetual System
◼ A schedule which illustrates the LIFO method on a perpetual basis shows the first units purchased
are still assumed to be the first sold. (Example 5-20)
Moving Average with a Perpetual System
◼ When a weighted cost assumption is applied with a perpetual system, it is sometimes called a
moving average.
• Each time a purchase is made, a new weighted average cost must be computed.
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
5-17
Lecture Suggestions
Module 1
LO 1
Module 1
LO 3
Make a simple comparison between the grocer (retailer) who buys lemons, sugar, bottled water,
and paper cups, and sells them as is; and the “manufacturer” who buys these items from the
grocer, makes lemonade at home, and sells it (in the cups) at the fair. The manufacturer is a
retailer, too, but has to make the product before selling it.
Use an example of selling pencils to illustrate the computation of cost of goods. The example uses
number of pencils, rather than dollar amounts, to illustrate the concept:
Module 2
LO 6
To keep the discussion well anchored in reality, ask students for examples of merchandisers or
businesses that would lend themselves to each type of inventory valuation. Don’t let the discussion
drift into confusing costing methods with methods of monitoring physical flow, which students do
very easily. Play devil’s advocate and ask why a business they suggest as a LIFO candidate could
not be accounted for by specific identification, for example.
Module 2
LO 7
Review Exhibit 5-5 in class, then complement with the questions in Problem 5-3. Students use
what they’ve learned to answer the questions.
INSTRUCTOR’S MANUAL
5-18
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
5-19
Projects and Activities
Module 2
LO 5
Inventory Valuation and the Measurement of Income
In-class discussion: Labor costs and inventories
Pratt & Whitney is a world leader in the design, manufacture and service of aircraft engines, space
propulsion systems and industrial gas turbines.
◼ Where would Pratt & Whitney classify labor costs?
◼ How does this differ from the way a retailer such as Wal-Mart accounts for workers’ pay?
Solution
This question addresses the fundamental difference between inventory for a manufacturer and inventory for
Module 2
LO 6
Inventory Costing Methods with a Periodic System
In-class discussion: Inventory for an airline?
The December 31, 2014, Balance Sheet for American Airlines, Inc., lists inventories of $1,771
million.1
A footnote indicates that these inventories are carried at average acquisition cost and expensed when
incurred in operations.
◼ Why does an airline have inventory? What might these items be?
◼ Few companies favor the average method of costing inventory. Why might this be true? What
characteristics of inventory costs make average costing, on the other hand, convenient (its
principle advantage), and mitigate any disadvantage?
◼ The $1,771 million is net of an “allowance for obsolescence”. What is this allowance? What
accounting principle(s) cause(s) its use?
Solution
These may be difficult questions for students.
INSTRUCTOR’S MANUAL
5-20
Aircraft Fuel, Spare Parts, and Supplies, Net
o Aircraft fuel, spare parts, and supplies, net are recorded at net realizable value based on
average costs. These items are expensed when used. An allowance for obsolescence is
provided for aircraft spare parts and supplies.23
Module 2
LO 7
Selecting an Inventory Costing Method
In-class discussion: Effect of year-end purchase
Using the set of data in Examples 5-10 through 5-14, assume for the sake of discussion that the company
made one additional inventory purchase on December 20, of 100 units at $15. No additional sales were
made. Thus the ending inventory will contain 700 instead of 600 units.
◼ Without making any calculations for the moment, explain what the effect of this purchase will
be on net income (increase, decrease, or no change) under each of the costing methods:
weighted average, FIFO, and LIFO. Explain your answer.
◼ If you want to compare the dollar effect on LIFO and FIFO, do you have to recalculate the
entire income statement? What is the dollar effect on FIFO net income? What about on LIFO?
Solution
◼ The additional purchase will have no effect at all on FIFO net income, since for that method
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
Explain in your own words what is meant by this footnote.
Solution
Ethical decision: Inventory stock-up
During the last month of the fiscal year, a company experienced excellent sales, and severely depleted its
base stock of merchandise. Since the company accounts for inventory using LIFO, the controller realized
that cost of goods sold will be reduced by a large amount, inflating net income. This effect will be
increased by the fact that the purchasing department negotiated some very good prices on merchandise
during the year. The controller decided that a last-minute inventory purchase, at current higher prices, was
the answer to the problem, and asked the purchasing department to check the inventory files and stock up
on as many items as possible to be sure that the company did not have to “liquidate the LIFO layers.”
◼ Is this ethical? Explain your answer, noting any reservations you might put on it.
Solution
The practice is frequently done by companies who do not wish to liquidate LIFO stocks. As long as the
record an order as inventory.
Module 3
LO 8
Other Inventory Issues
In-class discussion: Freight costs
We are all familiar with Amazon.Com, Inc. Amazon offers many shipping deals to its customers, and for
Amazon Prime Members, shipping is free.
Do shipping costs determine if you will buy a product or not? How many times do you decide not to place
an internet order because of the shipping costs? What would happen if the company would simply increase
the cost of the product and not charge you specifically for the shipping? Is free shipping really free?
INSTRUCTOR’S MANUAL
We expect our net cost of shipping to continue to increase to the extent our customers accept and use our
shipping offers at an increasing rate, our product mix shifts to the electronics and other general
merchandise category, we reduce shipping rates, we use more expensive shipping methods, and we offer
additional services. We seek to mitigate costs of shipping over time in part through achieving higher sales
volumes, optimizing placement of fulfillment centers, negotiating better terms with our suppliers, and
achieving better operating efficiencies. We believe that offering low prices to our customers is fundamental
to our future success, and one way we offer lower prices is through shipping offers.6
◼ Would the above be considered freight-in or freight-out? What is the difference between the
two?
◼ Is free freight really “free”?
◼ What are the disadvantages to a buyer of being charged freight as incurred on your shipment?
If the tables were turned—that is, the publisher paid the freight—might publishers name any
of these same disadvantages?
Solution
◼ Freight in, if charged, becomes a part of cost of goods sold. If the pass-through makes freight
In-class discussion: Crazy Eddie: Not exactly an error
In a well-publicized case that is a classic example of fraud, electronics retailer Edward “Crazy Eddie”
Antar was charged with a variety of crimes including that of defrauding his stockholders. The case centered
on misrepresentation of inventory.
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
5-23
proceeds of massive sales of stock in the company, about $80 million. A number of the company’s
executives, including accountants involved in the inventory manipulation, were left to face the music, and
the stockholders held nearly worthless paper.
Ultimately, Antar was found overseas and extradited back to the United States for trial, but the wealth he’d
accumulated was by no means all accounted for.9 Consider the following questions:
◼ How easy do you think it might be for an executive, working with a cooperative company
accountant, to change physical inventory records? If you do not know exactly how inventory
counts are recorded, find out. Call a local retailer, or find a classmate who has actually
participated in inventory-taking.
◼ What effect would an increase in ending inventory have on the balance sheet? What about the
income statement? What would happen the year following the “adjustment?” What do you
think the company did then?
◼ Why would the gross profit rate be a place to look if you suspected inventory manipulation?
◼ Think about what you have learned of the role and activities of outside auditors. How do you
think the inventory changes, in the first year in particular, escaped their notice? Shouldn’t
they have been checking the count?
Solution
◼ Doctoring inventory counts is not at all difficult. A “1” in the “quantity” column could be
changed to “10” or “21” with no trouble at all by an enterprising person who had the original
sheets in his or her control.
INSTRUCTOR’S MANUAL
Module 3
LO 9
Valuing Inventory at Lower of Cost or Market
In-class discussion: Best Buy and inventory
Best Buy is a specialty retailer of consumer electronics, home office products, entertainment software,
appliances and related services. Its 2015 10-K states11:
Our success depends on our vendors' and our ability to successfully introduce new products, services and
technologies to consumers, including, among other factors, the frequency of product and service
innovations, how accurately we predict consumer preferences, the level of consumer demand, the
availability of merchandise, the related impact on the demand for existing products and the competitive
environment. Consumers continue to have a wide variety of choices in terms of how and where they
purchase the products and services we sell. Failure to accurately predict and adapt to constantly changing
technology and consumer preferences, spending patterns and other lifestyle decisions, could have a material
adverse effect on our revenues and results of operations.
◼ What does this statement mean to you? Do you think obsolesce and rapidly changing
technology affect Best Buy?
◼ How can a company protect itself from being stuck with too much obsolete inventory? What
are the warning signs?
◼ Once the inventory is marked down to LCM, can it be written back up to the original cost or
higher?
Solution
◼ When analyzing the world of electronics, the fall in prices of DVD players, digital televisions,
In-class discussion: Obsolete inventory
A small trucking company had an inventory of repair parts that it used to fix their fleet of trucks. Since the
company had recently acquired several new trucks, many of the old repair parts in inventory were no longer
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
needed. At year end, about $30,000 of these parts were in the stockroom and were counted in ending
inventory. The $30,000 represents the purchase price of these repair parts.
◼ Should the items be included in the ending inventory? If so, at what amount?
Solution
◼ The items should be included in inventory if they have a value. Although inventory is
Module 4
LO 10
Analyzing the management of inventory
Outside assignment: Inventory turnover
Divide students into teams. Have each team select two companies in the same industry and research the
companies using the Internet. Each team should answer the following questions for the two companies.
◼ What kinds of companies have been selected? Based on your answer, what is the likely
composition of each company’s inventories?
◼ Calculate inventory turnover and days in inventory for the last two years. Comment on each
company’s efficiency in handling inventories.
◼ How is efficiency in the use of inventories different for a manufacturer than for a retailer?
Why is this important? What other figures might you like to have to assess the companies’
position?
Solution
Solutions will vary.
◼ This introduces students to some of the considerations they will encounter in managerial
accounting. A manufacturer measures manufacturing cycle efficiency, the time it takes for a
INSTRUCTOR’S MANUAL
5-26
Decision
Models
Analyzing the management of inventory
Assume that you are a loan officer at National Bank. ABC Grocery Store is interested in obtaining
a loan from your bank. You do some research and determine that for a small grocery store, the
average inventory turnover ratio is around 17.5. Your bank will not lend money to ABC unless
their turnover ratio equals or exceeds the industry average. While reviewing the 2016 financial
data and other information that ABC has supplied you with, you note the following:
Cash $175,000
Accounts Receivable $335,000
Accounts Payable $430,000
Inventory, January 1, 2016 $240,000
Inventory, December 31, 2016 $260,000
Sales $7,500,000
Cost of Goods Sold $4,000,000
2015 inventory turnover 17.0 times
Using the Ratio Analysis Model and the Business Decision Model, determine if the bank should lend
money to ABC Grocery.
Solution
You may want to discuss with the student’s the bank’s policy of not lending money if the turnover is below
Ratio Analysis Model
1 Formulate the Question. What is the inventory turnover ratio for ABC Grocery?
2 Gather the Information From the Financial Statements. The cost of goods sold is obtained
from the income statement and the inventory numbers are obtained from the two most recent
CHAPTER 5 INVENTORIES AND COST OF GOODS SOLD
5-27
5 Interpret the Ratios.
It appears that ABC Grocery’s inventory turnover has decreased from the prior years. The
bank should talk to ABC to see why they think this could be occurring – there may be
Using the Business Decision Model
1 Formulate the Question. Should the bank give ABC Grocery a loan?
2 Gather Information from the Financial Statements and Other Sources. This information
will come from a variety of sources, including, but not limited to:
• The balance sheet which provides information about liquidity.
• The income statement which provides information regarding profitability.
indicate the grocery store is involved in litigation or other difficulties.
3 Analyze the Information Gathered.
• Use the Ratio Analysis Model to compute and analyze the inventory turnover ratio.
Can management give any reasons why the turnover ratio is declining or is below
industry average?
• Are there other liquidity ratios that can be computed?
• How much other debt does the company have?
• What is the outlook for interest rates during the term of the loan?
