INVENTORY



INVENTORY

Inventory Ownership—Introduction

Inventory refers to goods

1. Held for sale in the ordinary course of business

2. To be (or being) used in the production of finished goods (or services) to be available for sale later.

Merchandising firms have merchandise inventory, which refers to items being held for sale. Manufacturing firms have raw materials, work in process, and finished goods.

Inventory includes goods in transit and goods out on consignment.

Goods in transit have been shipped out by the seller but have not yet been received by the buyer. Goods in transit can be FOB shipping or FOB destination (FOB means “free on board”).

FOB shipping means the title to (that is, ownership of) the goods passes from the buyer to the seller the moment the items leave the seller’s premises. Thus, if the truck carrying the goods left the seller’s warehouse on December 29 and are in transit as of December 31, if the terms of sale are FOB shipping, even though the truck has not yet reached the buyer, the goods belong to the buyer.

FOB destination means the title to (that is, ownership of) the goods passes from the buyer to the seller only when the items reach the buyer. Thus, if the truck carrying the goods left the seller’s warehouse on December 29 and are in transit as of December 31, if the terms of sale are FOB destination, the goods do not belong to the buyer — but are the property of the seller.

When goods are sent on consignment, the consignor (the person sending the goods) sends the items to the consignee (the person who receives the goods). The consignee acts as an agent by selling the goods to customers and sending the cash collected from sales to the consignor. In return for this service, the consignee receives a commission. So if Company X has sent goods on consignment to Agent Y, the goods still belong to Company X because Agent Y does not own the goods.

Perpetual and Periodic Systems

Perpetual System

Inventory can be valued using either the perpetual or the periodic system. Perpetual means continuous, so in theory, the value of inventory on hand and cost of goods sold for the period can be determined after every transaction involving inventory. Under the perpetual inventory system, the journal entries are as follows:

When goods are bought:

Debit Inventory

Credit Accounts Payable

When goods are sold:

Debit Accounts Receivable

Credit Sales

and

Debit Cost of Goods Sold

Credit Inventory

One of the difficulties of the perpetual system was that the calculation of inventory values could get complex very quickly. However, the decrease in the cost of computing power and the widespread use of computers have led to the increasing use of the perpetual inventory system.

Periodic System

In contrast, under the periodic system, the value of inventory on hand and the cost of goods sold for the period are determined at the end of each period. Under the periodic inventory system, when goods are purchased they are recorded in the purchases account. In the perpetual inventory system, the journal entries are as follows:

When goods are bought:

Debit Purchases

Credit Accounts Payable

When goods are sold:

Debit Accounts Receivable

Credit Sales

At the end of the period, ending inventory is determined by a physical count. The cost of goods sold can be calculated by using information about the beginning inventory, ending inventory, and purchases.

Inventory Cost Flows

Inventory cost can be determined using any one of several cost flow assumptions. Some of the available methods are specific identification, first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost. Note that these are cost flow assumptions, not physical flow assumptions.

Assume that Lucas Company had 100 units in beginning inventory on July 1, 2002, and that the cost of these units was $10 each. During the month, the inventory transactions were as follows:

|Date |Activity |Number of units |Cost per unit |

|July 6 |Purchase |50 |$11 |

|July 12 |Purchase |80 |$12 |

|July 19 |Sale |120 | |

|July 24 |Purchase |90 |$14 |

|July 28 |Sale |60 | |

What are

1. The cost of goods sold for the month?

2. The ending inventory for the month?

The first step involves computing the number of units sold and the number of units in ending inventory. Note that the physical number of units sold during the period and the number of units left in ending inventory do not change as a result of the specific cost flow assumption or the inventory system (perpetual or periodic) used during the period.

At the beginning of the period, there were 100 units.

During the period, a total of 220 units (50 + 80 + 90) were purchased, and a total of 180 units (120 + 60) were sold.

Thus, units in ending inventory is determined as follows: 100 + 220 – 180 = 140.

Another thing that stays the same across different methods and systems is the total cost of goods available for sale.

Beginning inventory = $1,000 (100 x $10)

Purchases = $2,770 (50 x $11) + (80 x $12) + (90 x $14)

Thus, cost of goods available for sale during the period is calculated as $3,770 ($1,000 + $2,770)

LIFO

In the last-in, first-out method, it is assumed that the units that came in last (that is, the newest available units) are sold first. Thus, the units remaining in inventory are those that came earliest, or first.

Periodic System and LIFO

Under periodic LIFO, the 180 units sold must be ones that came last –in this case, the 90 units purchased on July 24, the 80 units purchased on July 12, and an additional 10 units (from the total 50 units) purchased on July 6. The cost of goods sold for the month equals the cost of these 180 units.

Cost of goods sold = (90 x $14) + (80 x $12) + (10 x $11) = $2,330

The ending inventory of 140 units must be those units that came first –in this case, the beginning inventory of 100 units and 40 units from the lot bought on July 6.

Ending inventory = (100 x $10) + (40 X $11) = $1,440

You can also calculate the ending inventory as follows:

Ending inventory = Cost of goods available for sale – Cost of goods sold

= $3,770 - $2,330 = $1,440

Perpetual System and LIFO

Under the perpetual system, we do not wait until the end of the period to calculate the cost of goods sold. Each time a sale is made, the cost of goods sold for that sale is calculated. Hence, each sale must be separately considered.

Considering the sale on July 19, the latest 120 units with respect to this sale are the 80 units purchased on July 12 and 40 units purchased on July 6.

The cost of the goods sold on July 19 is calculated as follows:

(80 x $12) + (40 x $11) = $1,400

Thus, after the sale on July 19, the inventory on hand includes 10 units purchased on July 6 at $11 each and the beginning inventory of 100 units at $10 each. Thus, inventory on hand after the sale on July 19 is calculated as follows:

(10 x $11 + 100 x $10) = $1,110

Considering the sale on July 28, the latest 60 units with respect to this sale must come from the 90 units purchased on July 24.

The cost of the goods sold on July 24 is determined:

$840 (60 x $14)

Thus, the total cost of goods sold during the month is

($1,400 + $840) = $2,240

Thus, at the end of the month, the inventory on hand includes the following: 30 units from the July 24 purchase, 10 units from the July 6 purchase, and the beginning inventory of 100 units.

Ending inventory = (30 x $14 + 10 x $11 + 100 x $10) = $1,530

You can also calculate the ending inventory as follows:

Ending inventory = Cost of goods available for sale – cost of goods sold

= $3,770 - $2,240 = $1,530

FIFO

Under the first-in, first-out (FIFO) method, it is assumed that the units that came in first (that is, the oldest available units) are sold first. Thus, the units remaining in inventory are those that came last.

The Periodic System and FIFO

At the beginning of the period, there were 100 units.

During the period, a total of 220 units (50 + 80 + 90) were purchased, and a total of 180 units (120 + 60) were sold. Thus, units in ending inventory are determined:

100 + 220 – 180 = 140.

Under FIFO, the 180 units sold must be those that came first –in this case, the 100 units in beginning inventory, then an additional 50 units bought on July 6, and last an additional 30 (from the 80 total units) bought on July 12.

Hence, the cost of goods sold for the month equals the cost of these 180 units:

(100 x $10) + (50 x $11) + (30 x $12) = $1,910

Also, the ending inventory of 140 units must be those units that came last –in this case, the remaining 50 units from the lot bought on July 12 and the 90 units bought on July 24 is calculated as follows:

(50 x $12) + (90 X $14) = $1,860.

You can also calculate the ending inventory as follows:

Beginning inventory = $1,000 (100 x $10)

Purchases = $2,770: (50 x $11) + (80 x $12) + (90 x $14)

Thus, cost of goods available for sale = $3,770: ($1,000 + $2,770)

Ending inventory = Cost of goods available for sale – cost of goods sold

= $3,770 - $1,910 = $1,860

The Perpetual System and FIFO

The ending inventory and cost of goods sold if Lucas Company had used the perpetual system and FIFO give the same results as when using the periodic system and FIFO. You can do the calculations to see that this is so. You will find that by using the calculations the perpetual system gives the same results as the periodic system.

Average Cost Method

The average cost method assigns the same cost to each unit, irrespective of the price at which it was purchased.

Periodic System and Average Cost Method

When using periodic system and the average cost, the average cost of units needs to be calculated only once (at the end) per period.

Beginning inventory had 100 units, at a total cost of $1,000.

Total purchases during the period were 220 units for at total cost of $2,770.

Thus, total available inventory equals 320 units, at a total cost of $3,770 ($1,000 + $2,770).

This means the average cost per unit is $11.78125.

Cost of goods sold = cost of 180 units = 180 x 11.78125 = $2,120.63

Cost of ending inventory = cost of 140 units = 140 x 11.78125 = $1,649.37

Perpetual System and Average Cost Method

When using the perpetual system and the average cost method, the average cost of units must be calculated each time a sales transaction occurs.

Just before the sale on July 19, 230 are units in inventory (100 + 50 + 80). The average cost of the 230 inventory units is calculated as follows:

([100 x 10] + [50 x11] + [80 x 12])/230 = (1,000 + 550 + 960)/230 = 10.9130 (rounded)

Thus, the cost of goods sold on July 19 = 120 x 10.9130 = $1,309.57 (rounded)

Similarly, just before the sale on July 28, there are 200 units in inventory (110 left after sale on July 19 plus 90 units bought on July 24). The average cost of the 200 inventory units is calculated as follows:

([110 x 10.9130] + [90 x 14])/200 = (1,200.43 + 1,260)/200 = $12.3022 (rounded).

Thus, the cost of goods sold on July 28 is 60 x 12.3022 = $738.13 (rounded).

Total cost of goods sold for the period = $1,309.57 + $738.13 = $2,047.70

Ending inventory = 140 x 12.3022 = $1,722.30

Comparison of Different Costing Methods

Under GAAP, companies have the freedom to choose the inventory method that is most appropriate. Furthermore, GAAP does not require that the cost flow assumption be the same as the actual physical flow of goods.

If the cost of inventory does not change over time, then FIFO, LIFO, or weighted average all give the same results. However, the prices of most items tend to increase with time. This means that LIFO, FIFO, and weighted average can have different effects on the numbers reported in financial statements.

Assuming rising prices, the impact of choosing different inventory costing methods on financial statements is usually as follows:

| |FIFO |LIFO |Average Cost |

|Net income |Highest |Lowest |Average |

|Income taxes |Highest |Lowest |Average |

|Ending inventory |Highest |Lowest |Average |

|Cost of goods sold |Lowest |Highest |Average |

However, the results could be different if there is “LIFO liquidation,” which is discussed later.

Review Question—1

1. In the FIFO method, items remaining in inventory are assumed to be the units that came _____.

2. In the LIFO method, items remaining in inventory are assumed to be the units that came _____.

3. If inventory items are in transit and the terms of shipping are FOB shipping, the title to the goods belongs to _____.

4. If inventory items are in transit and the terms of shipping are FOB destination, the title to the goods belongs to _____.

5. In times of rising prices, the ____ inventory method will lead to higher profits.

6. In times of declining prices, the ____ inventory method will lead to higher values of inventory.

Answers:

1. last 2. first 3. buyer

4. seller 5. FIFO 6. LIFO

LIFO Layers and LIFO Reserve

LIFO Layers

Jones Company uses the periodic LIFO method. The following data are for Jones Company for the years 2001 through 2003:

| |2001 |2002 |2003 |

|Purchases |100 units @ $10 |120 units @ $12 |150 units @ $14 |

|Sales |80 units @ $12 |110 units @ $15 |125 units @ $17 |

The ending inventory of 2001 includes 20 units purchased in 2001.

The number of units available for sale in 2002 is 140 (20 from beginning inventory and 120 units purchased in 2002). Since 110 units were sold in 2002, the ending inventory of 2002 includes 30 units. The use of LIFO means that the earliest available units are in ending inventory. Hence, the ending inventory on 12/31/2002 includes 10 units purchased in 2002 and 20 units from beginning inventory.

Similarly, the number of units available for sale in 2003 is 180, as follows: 30 units in beginning inventory (consisting of 10 units bought in 2002 and 20 units bought in 2001) and 150 units bought in 2003. Since 125 units were sold, the ending inventory on 12/31/2003 includes a total of 55 units as follows: 25 units purchased in 2003 and 30 units from beginning inventory (which include 10 units purchased in 2002 and 20 units purchased in 2001).

Thus, we have different LIFO Layers of inventory from different periods. These LIFO layers are created in any year when the number of units purchased (or produced) exceeds the number of units sold. The cost of ending inventory each year is determined as follows:

| |2001 |2002 |2003 |

|Ending |20 units @ $10 = $200 |20 units @ $10 + |20 units @ $10 + |

|inventory | |10 units @ $12 = $320 |10 units @ $12 + |

| | | |25 units @ $14 = $670 |

LIFO Reserve

What would be the value of the inventory on 12/31/2002 if FIFO had been used?

The number of units in ending inventory under FIFO is the same as under LIFO –30 units. However, under FIFO, these would the latest units purchased. The last 30 units were purchased in 2002 and cost $12 each. Thus, the value of the ending inventory on 12/31/2002 under FIFO would have been $360 (30 x $12).

Thus, there is a difference between the ending values of inventory calculated using LIFO and FIFO. This difference is known as the LIFO Reserve. Companies using LIFO also include details about their LIFO reserve in the footnotes to the financial statements. (The LIFO reserve is the difference between current cost and the LIFO value, but usually this means the difference between the FIFO inventory value and the LIFO inventory value.) The disclosure of LIFO reserve facilitates comparison of companies using different inventory accounting methods.

The LIFO reserve as of 12/31/2002 is $40 (360 – 320).

What is the LIFO reserve as of 12/31/2003?

If the company had used FIFO, the ending inventory would have consisted of the last 55 units –which were purchased in 2003 at $14 each. Thus, the ending inventory on 12/31/2003 under FIFO would have been $770 (55 x $14).

Thus, LIFO reserve on 12/31/2003 = $100 (770 – 670).

LIFO Liquidation

Continuing with the Jones Company example, let’s assume that in 2004 the company bought 100 units at $16 each and sold 150 units at $20 per unit. The company is able to sell 150 units because it has 55 units from beginning inventory.

The gross profit for 2004 is calculated as follows:

Sales revenue = $3,000 (150 x $20)

Cost of goods sold is calculated as follows:

100 units @ $16 (purchased in 2004) +

25 units @ $14 (from beginning inventory, purchased in 2003) +

20 units @ $12 (from beginning inventory, purchased in 2002) +

5 units @ $10 (from beginning inventory, purchased in 2003)

= $2,240 (1,600 + 350 + 240 + 50).

Gross profit = $760 (3,000 – 2,240)

If the company had used FIFO, the cost of goods sold for 2004 would have been as follows:

100 units @ $16 (purchased in 2004) +

50 units @ $14 (purchased in 2003)

= $2,300

Thus, the gross profit for 2004 under FIFO would have been = $700 (3,000 – 2,300).

Thus, in this instance, the gross profit under LIFO is higher than the gross profit under FIFO. This happens because there has been a liquidation of LIFO Layers from earlier years, and these layers are at lower cost. The lower cost of these earlier layers leads to higher gross profit.

Dollar-Value LIFO

As we have seen, LIFO liquidation can lead to some problems, primarily because it leads to sudden increases in net income and, hence, large increases in tax liabilities. This is particularly true if each individual item is costed on a LIFO basis (this is known as the specific goods LIFO approach).

To avoid such LIFO liquidation problems, the Specific Goods Pooled LIFO may be used. Under this method, inventory items are combined into natural groups, or pools. Each pool is assumed to be one unit for costing purposes. Changes in the quantity of goods in the pool are usually priced at the average cost of goods purchased in the pool. This method simplifies recordkeeping, and LIFO liquidations are less likely to occur under this method than under the specific goods LIFO method.

The specific goods pooled LIFO method also has problems, however. In particular, items in pools having to be changed creates problems. To overcome this problem, the Dollar-Value LIFO method is used. In this method, the pools consist of dollars, not physical units. LIFO layers are determined based on total dollar changes, not quantity changes. This method has a broader range of goods in the pool, and the items in a pool can be replaced. This also means LIFO liquidations are less likely to occur.

The dollar-value LIFO method is illustrated with the following example:

Assume that the inventory of Logan Company was as follows:

|12/31/2000 |$10,000 |

|12/31/2001 |11,660 |

|12/31/2002 |14,170 |

Assume that the price index in 2001 was 1.06 and that the price index in 2002 was 1.09. This means that the prices as of 12/31/2001 were 106% of the prices as of 12/31/2000, and the prices as of 12/31/2002 were 109% of the prices as of 12/31/2000.

The total inventory as of 12/31/2001 is $11,660. However, this includes a price rise of 6% in 2001. The inventory must be revalued at base year prices. In our example, the base year is 2000.

Step 1: Divide the total inventory as of 12/31/2001 by the current price index to obtain the quantity in ending inventory at base-year cost.

At base-year prices, total inventory as of 12/31/2001 is $11,660/1.06 = $11,000.

Step 2: Split the amount calculated in Step 1 into layers, depending on the year the items were purchased.

In our example, $10,000 of the inventory is from 2000. Therefore, $1,000 at base-year prices ($11,000 – $10,000) of inventory is from the 2001 layer.

Step 3: Multiply each layer in Step 2 by the appropriate price index.

The $10,000 from 2000 is from the base year, so it is multiplied by 1.00.

This gives $10,000.

The $1,000 from 2001 must be multiplied by the price index for 2001, which is 1.06.

This gives $1,060 ($1,000 x 1.06).

Now add the amounts for each year to find the total dollar-value LIFO.

Dollar-value LIFO inventory as of 12/31/2001 = $10,000 + $1,060 = $11,060

We now repeat the calculations for 2002:

Total inventory as of 12/31/2002 = $14,170

Step 1: Divide by price index.

At base-year prices, inventory as of 12/31/2002 is $14,170/1.09, or $13,000.

Step 2: Split the amount calculated in Step 1 into layers, depending on when the items were purchased.

From earlier calculations, we know that the 2000 layer is $10,000 and the 2001 layer is $1,000. This means the 2002 layer must be $2,000 ($13,000 – $11,000).

Step 3: Multiply each year’s layer by appropriate price index:

| |Inventory at base- year prices | | |

|Layer | |Price Index |Dollar-value LIFO |

|2000 |$10,000 |1.00 |$10,000 |

|2001 |1,000 |1.06 |1,060 |

|2002 |2,000 |1.09 |2,180 |

|Total | | |$23,240 |

Lower of Cost or Market (LCM)

ARB No. 43 states that inventory should be valued at the lower of cost or market, with market limited to an amount that is not more than net realizable value or less than net realizable value less a normal profit.

Understanding LCM valuation involves the use of some specialized terms, which are defined below.

Replacement cost is the cost to replace the item by purchase or reproduction.

Net Realizable Value is the estimated selling price less the estimated costs yet to be incurred involved in selling the item.

Ceiling value is the net realizable value (NRV).

Floor value equals the net realizable value (NRV) less normal profit.

To calculate the LCM value of an inventory item, the first step is to find its market value. Market value cannot be (a) higher than the ceiling value or (b) lower than the floor value. Thus, market value is the middle value of replacement cost, the ceiling (NRV), and the floor (NRV minus normal profit).

The second step is to compare the “market value” to cost. The lower of these two is the value of the inventory.

For example, assume the following for an inventory item:

|Historical cost |$190 |

|Replacement cost |180 |

|Estimated selling price |250 |

|Selling costs |50 |

|Normal profit |20% of selling price |

Net realizable value (NRV) = Selling price – Selling costs = $250 – $50 = $200

NRV – Normal profit = $200 – (0.20 x 250) = $200 – $50 = $150

Market value is the “middle value” of replacement cost, NRV, and NRV minus normal profit. Thus, it is the middle of $180, $200, and $150. So market value is $180.

Historical cost is given to be $190, and while market value was calculated to be $180.

Thus, LCM value of the item is $180, which is a loss of $10 from the historical cost.

The journal entry for this is as follows:

Debit Loss from Decline of Inventory $10

Credit Inventory $10

Gross Profit Method

The Gross Profit Method is used to calculate estimated inventory values when actual physical count is not possible. This method is based on the relationship between sales and cost of goods sold, which is assumed to be fairly stable. Thus, if we know the sales revenue, we can calculate cost of goods sold. Then, if we know the initial inventory and purchases during the period, we can calculate the value of inventory on hand.

The gross profit method is useful to calculate the extent of loss due to theft, shrinkage, or natural calamities such as earthquakes and floods. An important assumption when using this method is that the relationship between sales and cost of goods sold (that is, the gross profit percent) has not changed significantly in the current year. Furthermore, in the case of multiple products, the gross profit method requires an assumption that the sales mix of the products has not changed significantly during the current year.

Example

Assume that a fire destroyed a warehouse containing inventory on March 15, 2002. From the accounting records, the following data are known:

|Beginning inventory |$20,000 |

|Purchases |35,000 |

|Sales revenue, 1/1/2002 to 3/15/2002 |60,000 |

|Normal gross profit |20% of selling price |

If the salvage value of the inventory after the fire was $2,000, what was the amount of the inventory loss?

Gross profit = Sales – Cost of goods sold

Hence, if gross profit is 20% of sales, cost of goods sold must be 80% of sales.

Cost of goods sold = 80% of $60,000 = $48,000

Ending inventory = Beginning inventory + Purchases – Cost of goods sold

= $20,000 + $35,000 - $48,000

= $7,000

Since the actual value of the ending inventory is only $1,000, inventory loss due to fire must be $6,000 ($7,000 – $1,000).

What if this problem had stated that the gross profit was 25% of cost, as opposed to 20% of selling price?

Sales – Cost of goods sold = Gross profit

Let S represent sales and C represent cost of goods sold.

Then, S – C = 0.25C (since gross profit is now given to be 25% of C)

S = 1.25C

This means the gross profit rate is calculated as follows:

= Gross profit/Sales = 0.25C/1.25C = 20%

The retail inventory method is similar to the gross profit method and is used by retail firms. If the value of the inventory at retail prices is known, the relationship between retail price and cost can be used to calculate the value of the inventory at cost.

Miscellaneous

Purchase Discounts

There are different types of purchase discounts including trade discounts and cash discounts.

Companies usually have list prices, which are the prices at which the items appear in catalogs. Buyers may be charged lower prices than the prices listed; this difference is known as a trade discount. Purchases should be recorded at the net price, so there will be no record of a trade discount.

Cash discounts are given to encourage buyers to pay promptly. Two methods can be used to account for cash discounts. In the gross method, inventory is recorded at invoice price and if the cash discounts are taken, the inventory value is reduced by the amount of the cash discount. In the net method, the inventory is initially recorded at the amount that would be paid if the cash discount is taken; if the cash discount is not taken, then that amount is expensed as a finance charge (with a corresponding credit to cash or accounts payable).

Purchase Commitments are noncancelable contracts to purchase materials. They represent a commitment to buy inventory in the future at a set price. The are also called executory contracts. At the time of signing such a contract, no journal entry is required. However, journal entries may be required at the end of the accounting period and are required at the time of actual purchase.

Similar to the lower-of-cost-or-market rule, if the market price of the contracted item is less than the contract price at the end of the fiscal period, a journal entry recording this decline in price is required. A loss account is debited, and an estimated liability account is credited. Later, when the item is actually purchased, the journal entries involve the following:

(a) A credit to cash (or accounts payable), for the actual price paid under the contract.

(b) A debit to eliminate the estimated liability account (since the contract has now been fulfilled, there is no more liability related to the contract).

(c) A debit to purchases, which is a “plug” number for the difference.

Note that if there are further declines in market price of the item from the fiscal year-end to the actual date of purchase, then journal entry (c) is another debit to the loss on purchase commitments account, and the last entry is the debit to purchases. (Thus, the debit to purchases is again a “plug” number to make debits equal to credits.)

If the market price of the item has increased from the fiscal year end, a credit entry is made to “recovery of loss on purchase commitment.” However, this amount cannot be more than the amount of the loss initially recorded in the prior period –that is, a gain on purchase commitments cannot be recognized.

Inventory Errors

Errors in inventory may occur due to the following:

1. Incorrect quantities.

2. Incorrect valuation.

3. Improper accounting.

If such errors occur with the ending inventory of the first period, but do not continue to occur in the second period, the results of both periods are incorrect. However, the error of the first period will be exactly offset by the error of the second period.

The effect of inventory errors is best understood by focusing on the following:

Beginning inventory + Purchases = Cost of goods available for sale

= Cost of goods sold + Ending inventory

Hence, if the beginning inventory of a period (that is, the ending inventory of the previous period) is understated, the cost of goods available for sale is understated. If the ending inventory is correct, the cost of goods sold is understated or the net income for the current period is overstated. (The net income of the previous period is understated by exactly the same amount.)

Similarly, if the ending inventory of a period is overstated, the cost of goods sold is understated or net income is overstated.

Review Questions—2

1. The _______ method reduces the likelihood of LIFO liquidations.

2. The ______ method requires that the relationship between sales and cost of goods sold be stable.

3. Estimated selling price less estimated costs yet to be incurred involved in selling the item is called ______.

4. Market value cannot be higher than ______.

5. The difference between list price and the price actually charged is known as a _____.

6. A ______ is given to encourage buyers to pay promptly.

Answers:

1. dollar-value LIFO 2. gross profit 3. net realizable value

4. ceiling value 5. trade discount 6. cash discount

Glossary

Average cost method assigns the same cost to each unit, regardless of the price at which it was purchased.

Cash discounts are given to encourage buyers to pay promptly.

Ceiling value is the net realizable value (NRV).

Consignee acts as an agent by selling the goods to customers and sending the cash collected from sales to the consignor.

Consignor is the owner of goods sent on consignment.

Dollar-Value LIFO method uses pools consisting of dollars rather than physical units. LIFO layers are determined based on total dollar changes, not quantity changes

FIFO (first-in, first-out) method assumes that the units that came in first are sold first. Units remaining in inventory came in last.

Floor value equals net realizable value less normal profit.

FOB destination passes the title to (that is, ownership of) the goods from the buyer to the seller only when the items reach the buyer.

FOB shipping passes the title to (that is, ownership of) the goods from the buyer to the seller the moment the items leave the seller’s premises.

Gross profit method is used to calculate estimated inventory values based on the relationship between sales and cost of goods sold.

Inventory refers to goods held for sale or used in production of finished goods to be available for sale.

LIFO (last-in, first-out) method assumes that the units that came in last are sold first. Units remaining in inventory came in earliest, or first.

LIFO layers are created in any year when the number of units purchased (or produced) exceeds the number of units sold.

LIFO reserve is the difference between current cost and the LIFO value. Usually, this is the difference between FIFO inventory value and LIFO inventory value.

LIFO liquidation arises when LIFO inventory from earlier years at lower cost is sold. The lower cost of these earlier layers leads to higher gross profit.

Net realizable value equals estimated selling price less estimated costs yet to be incurred involved in selling the item.

Periodic inventory system determines cost of goods sold only at the end of each period. Purchases are recorded in the purchases account, and ending inventory is determined by physical count.

Perpetual inventory system records every purchase and sales transaction in the inventory account. Cost of goods sold can be calculated for each transaction, and the value of inventory on hand can be determined after any transaction.

Purchase commitments are noncancelable executory contracts to purchase inventory in the future at a set price.

Replacement cost is the cost to replace an item by purchase of reproduction.

Retail inventory method is used by retail firms to determine the cost of inventory using the value of the inventory at retail prices, and the relationship between retail price and cost.

Specific goods pooled LIFO is used to avoid LIFO liquidation problems. Under this method, inventory items are combined into natural groups or pools, and each pool is assumed to be one unit for costing purposes.

Trade discount is the difference between the list price and the price actually charged.

Demonstration Problem 1

Weber Company—Perpetual Inventory System

Information about the beginning inventory and purchases of an item by Weber Company for July 2002 is given here. Compute the cost of goods sold and ending inventory for July 2002 using the perpetual system under LIFO and perpetual FIFO.

|Date |Description |Units |Price |

|July 1 |Beginning Inventory | 60 |$24 |

|July 3 |Sale | 50 |40 |

|July 8 |Purchases |120 |25 |

|July 15 |Sale | 90 |40 |

|July 22 |Purchases | 80 |28 |

|July 29 |Sale | 80 |40 |

Solution to Demonstration Problem 1, Weber Company

LIFO method—Perpetual System

Under LIFO, the last goods purchased are assumed to be sold first. Under the perpetual system, cost of goods sold is calculated as sales are made. Thus, the phrase “last units” refers to the last units in inventory at the time of each specific sale.

Cost of goods sold for July:

|Sale on July 3 |50 units @ $24 (from beginning inventory) |$1,200 |

|Sale on July 15 |90 units @ $25 (from the July 8 purchase) |2,250 |

|Sale on July 29 |80 units @ $28 (from the July 22 purchase). |2,240 |

|Total |220 units |$5,690 |

Ending inventory:

10 units @ $24 (from beginning inventory) $240

30 units @ $25 (from the July 8 purchase) 750

Total (40 units) $990

FIFO method—Perpetual System

Under FIFO, the goods purchased first are assumed to be sold first.

Cost of goods sold for July:

|Sale on July 3 |50 units @ $24 (from beginning inventory) |$1,200 |

|Sale on July 15 |10 units @ $24 (from beginning inventory) plus | |

| |80 units @ $25 (from July 8 purchase) |2,240 |

|Sale on July 29 |40 units @ $25 (from July 8 purchase) plus | |

| |40 units @ $28 (from July 22 purchase) |2,120 |

|Total |220 units |$5,560 |

Ending Inventory:

40 units @ $28 (from the Nov. 18 purchase) $1,120

Demonstration Problem 2

Smith Company

Smith Company adopted dollar-value LIFO on 12/31/2000. The following inventory data are available for the years 2000 through 2003. Calculate the inventory amounts for the years 2000 through 2003 using dollar-value LIFO.

| |Inventory at year-end prices |Year-end price index |

|Year ending | | |

|12/31/2000 |$250,000 |1.00 |

|12/31/2001 |297,000 |1.10 |

|12/31/2002 |322,000 |1.15 |

|12/31/2003 |372,000 |1.20 |

Solution to Demonstration Problem 2, Smith Company

| | | |Inventory at | | | |

| |Inventory at |Year-end price |base-year prices |Layers in | |Dollar-value LIFO |

| |year-end prices |index | |base-year prices |Price index | |

|Date | | | | | | |

|A |B |C |D = B/C |E |F |G = E*F |

|12/31/2000 |$250,000 |1.00 |250,000 |250,000 |1.00 |$250,000 |

|12/31/2001 |297,000 |1.10 |270,000 |250,000 |1.00 |250,000 + |

| | | | |20,000 |1.10 |22,000 = |

| | | | | | |$272,000 |

|12/31/2002 |322,000 |1.15 |280,000 |250,000 |1.00 |250,000 + |

| | | | |20,000 |1.10 |22,000 + |

| | | | |10,000 |1.15 |11,500 = |

| | | | | | |$283,500 |

|12/31/2003 |372,000 |1.20 |310,000 |250,000 |1.00 |250,000 + |

| | | | |20,000 |1.10 |22,000 + |

| | | | |10,000 |1.15 |11,500 + |

| | | | |30,000 |1.20 |36,000 = |

| | | | | | |$319,500 |

Demonstration Problem 3

Miller Company

Miller Company started operations on 1/1/2002. On 5/25/2003, a fire damaged the inventory warehouse. Some items were salvaged; and the cost of the salvaged items was $8,000. Details about operations in 2002 and 2003 are given here. The gross profit margin in 2003 was the same as in 2002. What is the amount of the inventory loss due to the fire?

| |2002 |2003 |

|Beginning inventory | $ 0 | $ 8,000 |

|Purchases |143,000 |106,000 |

|Purchase returns |5,000 |3,000 |

|Sales |207,000 |124,000 |

|Sales returns & allowances |7,000 |4,000 |

Solution to Demonstration Problem #, Miller Company

Net sales in 2002 = $200,000 (207,000 – 7,000)

Net sales in 2003 = $120,000 (124,000 – 4,000)

Net purchases in 2002 = $138,000 (143,000 – 5,000)

Net purchases in 2003 = $103,000 (106,000 – 3,000)

Cost of goods sold in 2002:

|Beginning inventory | $ 0 |

|+ Net purchases |138,000 |

|= Cost of goods available for sale |138,000 |

|– Ending inventory |8,000 |

|= Cost of goods sold |$130,000 |

Gross profit percent in 2002:

|Sales in 2002 |$200,000 |100% |

|Cost of goods sold in 2002 |130,000 | 65 |

|Gross profit in 2002 |70,000 | 35 |

Gross profit percent in 2003 remains same as in 2002, gross profit percent in 2003 equals 35%.

Net sales in 2003 = $120,000

Thus, gross profit in 2003 is $42,000 (120,000 x 0.35).

Therefore, cost of goods sold in 2003 is $78,000 (120,000 – 42,000).

Cost of goods available for sale in 2003 = $8,000 + $103,000 = $111,000.

Thus, ending inventory as of 5/25/2003 is $33,000 (111,000 – 78,000)

However, value of inventory after the fire is $8,000, the inventory loss due to fire is $25,000 (33,000 – 8,000).

Demonstration Problem 4

Brown Company

Brown Company carries four items in inventory. The following data are available about the items in inventory as of 12/31/2002. Determine the proper inventory value using the lower-of-cost-or-market method on an item-by-item basis.

| |Number |Historical |Replacement cost |Estimated | |Profit margin (% of |

|Item |of units |cost | |selling price |Selling cost |sales) |

|A |150 |$15 |$16 |$20 |$3 |15% |

|B |200 |6 |5 |10 |2 | 10 |

|C |100 |18 |21 |30 |4 | 20 |

|D |125 |30 |28 |40 |5 | 25 |

Solution to Demonstration Problem 4, Brown Company

Net realizable value (NRV) = Estimated selling price – Selling Cost

Step 1: Calculation of market value

| |Replacement |Net realizable |NRV less normal profit | |

|Item |cost |value (NRV) | |Market |

|A |$16 |$17 |$14 |$16 |

|B |5 |8 |7 |7 |

|C |21 |26 |20 |21 |

|D |28 |35 |25 |28 |

Step 2: Calculation of LCM value

| | | |Lower of cost or market |Number of units |Total inventory value |

|Item |Cost |Market | | | |

|A |$15 |$16 |$15 |150 |$2,250 |

|B |6 |7 |6 |200 |1,200 |

|C |18 |21 |18 |100 |1,800 |

|D |30 |28 |28 |125 |3,500 |

Total inventory value = $2,250 + $1,200 + $1,800 + $3,500 = $8,750

Practice Problem 1

Weber Company—Periodic Inventory System

Information about the beginning inventory and purchases of a certain item by Weber Company for July 2002 follows. Compute the cost of goods sold and ending inventory for July 2002 using the periodic LIFO and periodic FIFO systems.

|Date |Description |Units |Price |

|July 1 |Beginning Inventory | 60 |$24 |

|July 3 |Sale | 50 |40 |

|July 8 |Purchases |120 |25 |

|July 15 |Sale | 90 |40 |

|July 22 |Purchases | 80 |28 |

|July 29 |Sale | 80 |40 |

Solution to the Practice Problem1, Weber Company

LIFO Method—Periodic System

Under LIFO, the goods purchased latest are assumed to be sold first.

Total number of units sold in July = 220 (50 + 90 + 80)

Cost of the latest 220 units:

| 80 units @ $28 (from the July 22 purchase) |$2,240 |

|120 units @ $25 (from the July 8 purchase) |3,000 |

| 20 units @ $24 (from beginning inventory) |480 |

|Total cost of goods sold |$5,720 |

The ending inventory has 40 units left from the beginning inventory.

Cost of ending inventory = 40 x 24 = $960

FIFO Method—Periodic System

Under FIFO, the goods purchased earliest are assumed to be sold first.

Total number of units sold in July = 220 (50 + 90 + 80)

Cost of the latest 220 units:

| 60 units @ $24 (from beginning inventory) |$1,440 |

|120 units @ $25 (from the July 8 purchase) |3,000 |

| 40 units @ $28 (from the July 22 purchase) |1,120 |

|Total cost of goods sold |$5,560 |

The ending inventory has 40 units left from the last purchase.

Cost of ending inventory = 40 x 28 = $1,120

Practice Problem 2

Thomas Company

Thomas Company adopted dollar-value LIFO on 12/31/2000. The following inventory data are available for the years 2000 through 2003. Calculate the inventory amounts for the years 2000 through 2003 using dollar-value LIFO.

| |Inventory at year-end prices |Year-end price index |

|Year ending | | |

|12/31/2000 |$200,000 |1.00 |

|12/31/2001 |220,500 |1.05 |

|12/31/2002 |252,000 |1.12 |

|12/31/2003 |264,000 |1.20 |

Solution to Practice Problem2, Thomas Company

| | | |Inventory at | | | |

| |Inventory at |Year-end price |base-year prices |Layers in | |Dollar-value LIFO |

| |year-end prices |index | |base-year prices |Price index | |

|Date | | | | | | |

|A |B |C |D = B/C |E |F |G = E*F |

|12/31/2000 |$200,000 |1.00 |200,000 |200,000 |1.00 |$200,000 |

|12/31/2001 |220,500 |1.05 |210,000 |200,000 |1.00 |200,000 + |

| | | | |10,000 |1.05 |10,500 = |

| | | | | | |$210,500 |

|12/31/2002 |252,000 |1.12 |225,000 |200,000 |1.00 |200,000 + |

| | | | |10,000 |1.05 |10,500 + |

| | | | |15,000 |1.12 |16,800 = |

| | | | | | |$227,300 |

|12/31/2003 |264,000 |1.20 |220,000 |200,000 |1.00 |200,000 + |

| | | | |10,000 |1.05 |10,500 + |

| | | | |10,000 |1.12 |11,200 + |

| | | | |0 |1.20 |0 = |

| | | | | | |$221,700 |

Practice Problem 3

Frank Company

Frank Company started operations on 1/1/2002. The company had a successful first year, and on 1/1/2003 management decided to maintain to adopt a pricing policy such that the gross profit percent in 2003 would be the same as in 2002. On 6/15/2003, an earthquake damaged the inventory warehouse. Some items were salvaged; the cost of the salvaged items was $10,000. Details about operations in 2002 and 2003 are given here.

| |2002 |2003 |

|Beginning inventory |$ 0 |$ 25,000 |

|Purchases |280,000 |160,000 |

|Purchase returns |15,000 |10,000 |

|Sales |310,000 |185,000 |

|Sales returns & allowances |10,000 |5,000 |

What is the amount of the inventory loss due to the earthquake?

Solution to Practice Problem 3, Frank Company

Net sales in 2002 = $300,000 (310,000 – 10,000)

Net sales in 2003 = $180,000 (185,000 – 5,000)

Net purchases in 2002 = $265,000 (280,000 – 15,000)

Net purchases in 2003 = $150,000 (160,000 – 10,000)

Cost of goods sold in 2002:

|Beginning inventory | $ 0 |

|+ Net purchases |265,000 |

|= Cost of goods available for sale |265,000 |

|– Eniding inventory |25,000 |

|= Cost of goods sold |$240,000 |

Gross profit percent in 2002:

|Sales in 2002 |$300,000 |100% |

|Cost of goods sold in 2002 |240,000 | 80 |

|Gross profit in 2002 |60,000 | 20 |

Gross profit percent in 2003 remains same as in 2002, so gross profit percent in 2003 equals 20%.

Net sales in 2003 = $180,000

Thus, gross profit in 2003 is $36,000 (180,000 x 0.2).

Therefore, cost of goods sold in 2003 is $144,000 (180,000 – 36,000).

Cost of goods available for sale in 2003 = $25,000 + $150,000 = $175,000

Thus, ending inventory as of 6/15/2003 is $31,000 (175,000 – 144,000).

However, value of inventory after earthquake is $10,000, so the inventory loss due to earthquake is $21,000 (31,000 – 10,000).

Practice Problem 4

Klein Company

Klein Company carries four items in inventory. The following data are available about the items in inventory as of 12/31/2002. Determine the proper inventory value using the lower-of-cost-or-market method as applied to the entire inventory.

| |Number |Historical |Replacement cost |Estimated | |Profit margin (% of |

|Item |of units |cost | |selling price |Selling cost |sales) |

|A |150 |$140 |$145 |$200 |$25 |8% |

|B |200 |110 |102 |120 |15 | 10 |

|C |100 |135 |130 |160 |20 | 15 |

|D |125 |170 |200 |250 |30 | 14 |

Solution to Practice Problem 4

Net realizable value (NRV) = Estimated selling price – Selling cost

Step 1: Calculation of market value

| | |Net realizable |NRV less normal |Market price per | |Total market value|

| |Replacement |value (NRV) |profit |unit |Number of units | |

|Item |cost | | | | | |

|A |$145 |$175 |$159 |$159 |150 |$23,850 |

|B |102 |105 |93 |102 |200 |20,400 |

|C |130 |140 |116 |130 |100 |13,000 |

|D |200 |220 |185 |200 |125 |25,000 |

Total market value = $23,850 + $20,400 + $13,000 + $25,000 = $82,250

Step 2: Calculation of historical cost

| | |Number of units | |

|Item |Cost per unit | |Total cost |

|A |$140 |150 |$21,000 |

|B |110 |200 |22,000 |

|C |135 |100 |13,500 |

|D |170 |125 |21,250 |

Total historical cost = $21,000 + $22,000 + $13,500 + 21,250 = $77,750

The LCM rule is to be applied to the overall inventory.

Hence, inventory value is the lower of cost ($77,750) or market ($82,250).

Thus, inventory value is $77,750.

Practice Problem 5

1. Which of the following items are not included in inventory?

a. raw materials purchased by a manufacturing firm

b. land bought by a real estate firm for resale

c. work-in-process inventory of a manufacturing firm

d. machines bought by a firm for use in the production process

2. Thomas Company has sent some goods out on consignment to Souter Company. The goods will be included in the inventory of

a. Souter Company.

b. Thomas Company.

c. Souter Company if the terms are FOB shipping.

d. Thomas Company if the terms are FOB shipping.

3. James Company uses the periodic inventory system. When the company purchases inventory on credit, the correct journal entry is to

a. debit accounts payable and credit inventory.

b. debit inventory and credit accounts payable.

c. debit purchases and credit accounts payable.

d. debit accounts payable and credit purchases.

4. In periods of rising prices, if a firm’s inventory level increases each year, the LIFO method will normally lead to

a. lower profits and lower ending inventory value.

b. higher profits and lower ending inventory value.

c. lower profits and higher ending inventory value.

d. higher profits and higher ending inventory value.

5. In a period of falling prices, if a firm’s inventory level does not decline, which method will lead to the lowest cost of goods sold?

a. FIFO

b. LIFO

c. specific identification

d. weighted average

6. The replacement cost of an item is $1,000, and the selling expenses are $250. It can be sold for $1,500. The normal profit margin is 10 percent. What is the market value of the item?

a. $1,250

b. $1,125

c. $1,000

d. $1,100

7. The gross profit method assumes that

a. the amount of inventory in the current year is the same as in the prior year.

b. the amount of sales in the current year is the same as in the prior year.

c. the cost of goods sold in the current year is the same as in the prior year.

d. the relationship between sales and cost of goods sold in the current year is the same as in the prior year.

8. An increase in inventory turnover may indicate

a. a higher likelihood of inventory becoming obsolete.

b. efficient management of inventory.

c. decline in sales in the current period.

d. efficient management of inventory and decline in sales in the current period.

Homework Problem 1

Edward Company

Edward Company sells washers and dryers. Information about the beginning inventory and purchases of one type of washer for the year 2002 follow. Calculate the ending inventory and cost of goods sold using

a) Perpetual LIFO method.

b) Periodic FIFO method.

|Date |Description |Units |Price |

|1/1/2002 |Beginning Inventory |20 |$420 |

|March 1 |Purchases |10 | 428 |

|April 6 |Sale |22 | 480 |

|June 7 |Purchases |8 | 432 |

|August 3 |Purchases |4 | 436 |

|December 5 |Sale |10 | 480 |

Solution to Homework Problem 1, Edward Company

The beginning inventory of 20 plus the purchases of 22 units gives a total of 42 units available for sale. Since a total of 32 units has been sold, the ending inventory must have 10 washers.

LIFO Method —Perpetual

Under LIFO, the last goods purchased are assumed to be sold first. Under the perpetual system, cost of goods sold is calculated as sales are made. Thus, the phrase “last units” refer to the last units in inventory at the time of each specific sale.

Cost of goods sold for July:

|Sale on April 6 |10 units @ $428 (from March 1 purchase ) + | |

| |12 units @ $420 (from beginning inventory) |$ 9,320 |

|Sale on December 5 |4 units @ $436 (from August 3 purchase) + | |

| |6 units @ 432 (from June 7 purchase) |4,336 |

|Total | |$13,656 |

Ending inventory:

8 units @ $420 (from beginning inventory) $3,360

2 units @ $432 (from the June 7 purchase) __ 864

Total (40 units) $4,224

FIFO Method —Periodic

Under FIFO, the goods purchased first are assumed to be sold first. Because we are using FIFO, the cost flow assumption is that the 10 units in ending inventory are the units purchased last. Hence, the ending inventory is assumed to include the four units purchased on August 3 and six of the eight units purchased on June 7.

Cost of ending inventory = (4 x $436) + (6 x $432) = $4,336

Cost of goods sold = (20 x $420) + (10 x $428) + (2 x $432) = $13,544

Homework Problem 2

Curtis Company

Curtis Company adopted dollar-value LIFO on 12/31/2000. The following inventory data are available for the years 2000 through 2003. Calculate the inventory amounts for the years 2000 through 2003 using dollar-value LIFO.

| |Inventory at year-end prices |Year-end price index |

|Year ending | | |

|12/31/2000 |$300,000 |1.00 |

|12/31/2001 |336,000 |1.05 |

|12/31/2002 |341,000 |1.10 |

|12/31/2003 |390,000 |1.20 |

Solution to Homework Problem 2, Curtis Company

| | | |Inventory at | | | |

| |Inventory at |Year-end price |base-year prices |Layers in | |Dollar-value LIFO |

| |year-end prices |index | |base-year prices |Price index | |

|Date | | | | | | |

|A |B |C |D = B/C |E |F |G = E*F |

|12/31/2000 |$300,000 |1.00 |300,000 |300,000 |1.00 |$300,000 |

|12/31/2001 |336,000 |1.05 |320,000 |300,000 |1.00 |300,000 + |

| | | | |20,000 |1.05 |21,000 = |

| | | | | | |$321,000 |

|12/31/2002 |341,000 |1.10 |310,000 |300,000 |1.00 |300,000 + |

| | | | |10,000 |1.05 |10,500 + |

| | | | |0 |1.10 |0 = |

| | | | | | |$310,500 |

|12/31/2003 |390,000 |1.20 |325,000 |300,000 |1.00 |300,000 + |

| | | | |10,000 |1.05 |10,500 + |

| | | | |0 |1.10 |0 + |

| | | | |15,000 |1.20 |18,000 = |

| | | | | | |$328,500 |

Homework Problem 3

Price Company

Price Company started operations on 1/1/2002. On 6/30/2003, the company received an anonymous complaint about employee theft, and a spot check of inventory revealed that $5,000 of inventory was in the warehouse. Details about operations in 2002 and 2003 follow. The gross profit margin in 2003 was the same as in 2002. What is the amount of the inventory lost to employee theft?

| |2002 |2003 |

|Beginning inventory |$ 0 |$ 9,000 |

|Purchases |117,000 |77,000 |

|Purchase returns |3,000 |2,000 |

|Sales |156,000 |108,000 |

|Sales returns & allowances |6,000 |3,000 |

Solution to Homework Problem 3, Price Company

Net sales in 2002 = $150,000 (156,000 – 6,000)

Net sales in 2003 = $105,000 (108,000 – 3,000)

Net purchases in 2002 = $114,000 (117,000 – 3,000)

Net purchases in 2003 = $75,000 (77,000 – 2,000)

Cost of goods sold in 2002:

|Beginning inventory | $ 0 |

|+ Net purchases |114,000 |

|= Cost of goods available for sale |114,000 |

|– Ending inventory |9,000 |

|= Cost of goods sold |$105,000 |

Gross profit percent in 2002:

|Sales in 2002 |$150,000 |100% |

|Cost of goods sold in 2002 |105,000 | 70 |

|Gross profit in 2002 |45,000 | 30 |

Gross profit percent in 2003 remains same as in 2002, so gross profit percent in 2003 equals 30%.

Net sales in 2003 = $105,000.

Thus, gross profit in 2003 is $31,500 (105,000 x 0.30).

Therefore, cost of goods sold in 2003 is $73,500 (105,000 – 31,500).

Cost of goods available for sale in 2003 = $9,000 + $75,000 = $84,000.

Thus, inventory as of 6/30/2003 is = $10,500 (84,000 – 73,500).

However, actual value of inventory on 6/30/2003 is $5,000, so the inventory loss due to theft is $5,500 (10,500 – 5,000).

Homework Problem 4

Read Company

Read Company carries four items in inventory. The following data are available about the items in inventory as of 12/31/2002. Determine the proper inventory value for each item when using the lower-of-cost-or-market method.

| Item |Historical |Replacement cost |Estimated | Selling cost |Profit margin (% of |

| |cost | |selling price | |sales) |

|A |$1,100 |$1,300 |$1,500 |$140 |8% |

|B |750 |800 |1,200 |150 | 9 |

|C |1,300 |1,250 |1,400 |160 | 6 |

|D |1,950 |1,800 |2,500 |350 | 12 |

Solution to Homework Problem 4, Read Company

Net realizable value (NRV) = Estimated selling price – Selling cost

Step 1: Calculation of market value

| |Replacement |Net realizable |NRV less normal profit| |

|Item |cost |value (NRV) | |Market price |

|A |$1,300 |$1,360 |$1,240 |$1,300 |

|B |800 |1,050 |942 |942 |

|C |1,250 |1,240 |1,156 |1,240 |

|D |1,800 |2,150 |1,850 |1,850 |

Step 2: Calculation of LCM

| |Historical | | |

|Item |cost |Market price |LCM value |

|A |$1,100 |$1,300 |$1,100 |

|B |750 |942 |750 |

|C |1,300 |1,240 |1,240 |

|D |1,950 |1,850 |1,850 |

Homework Problem 5

1. Title to inventory in transit belongs to the buyer if the goods are

a. shipped FOB shipping point.

b. shipped FOB destination.

c. sent on consignment.

d. sent FOB destination on consignment.

2. The inventory of a merchandising firm includes

a. raw materials inventory.

b. purchased goods inventory.

c. work-in-process inventory.

d. all of the above.

3. Jones Company uses the perpetual inventory system. When the company purchases inventory on credit, the correct journal entry is to

a. Debit accounts payable and credit inventory.

b. Debit inventory and credit accounts payable.

c. Debit purchases and credit accounts payable.

d. Debit accounts payable and credit purchases.

4. In periods of declining prices, if a firm’s inventory level increases each year, the FIFO method will normally lead to

a. higher profits and lower ending inventory value.

b. lower profits and higher ending inventory value.

c. higher profits and higher ending inventory value.

d. lower profits and lower ending inventory value.

5. Which inventory method leads to the most precise matching of cost and physical flow?

a. FIFO

b. LIFO

c. specific identification

d. weighted average

6. Which method of LCM valuation leads to the lowest inventory value on the balance sheet?

a. application to inventory as a whole

b. application to categories of items

c. application to individual items

d. All three methods give the same result.

7. The gross profit method of inventory valuation should not be used when

a. gross margin percent has changed significantly during the current year.

b. the quantity of inventory has changed significantly during the current year.

c. the cost of goods sold has changed significantly during the current year.

d. sales revenue has changed significantly during the current year.

8. If the ending inventory is overstated,

a. net income for the period will be understated.

b. net income for the period will be overstated.

c. inventory turnover will be overstated.

d. cost of goods sold for the period will be overstated.

Homework Problem 6

1. Hatch Company has sent $10,000 of goods on consignment to Bauer Company. In addition, it has sold $5,000 of goods to Forbes Company. The terms of sale are FOB destination, and the truck carrying the items is in transit on December 31, 2002. When preparing the balance sheet as of 12/31/2002, Hatch Company’s inventory should

a. include goods sent to Bauer Company but exclude goods sent to Hatch Company.

b. exclude goods sent to Bauer Company but include goods sent to Hatch Company.

c. exclude goods sent to both Bauer Company and Hatch Company.

d. include goods sent to both Bauer Company and Hatch Company.

2. Gore Company has received some goods on consignment from Bush Company. The goods will be included in the inventory of

a. Bush Company.

b. Gore Company.

c. Bush Company if the terms are FOB shipping.

d. Gore Company if the terms are FOB shipping.

3. Jill Company uses the perpetual inventory system. When the company sells some items on credit, the correct journal entries are to

a. debit Inventory and credit cost of goods sold.

b. debit purchases and credit cost of goods sold.

c. debit cost of goods sold and credit inventory.

d. debit cost of goods sold and credit purchases.

4. In a period of rising prices, if a company’s inventory level increases each year, the average cost method leads to

a. lower ending inventory than under LIFO.

b. greater net income than under FIFO.

c. lower net income than under FIFO.

d. lower ending inventory than under LIFO and greater inventory than under FIFO.

5. Which of the following inventory cost flow method(s) will provide the same results regardless of whether a periodic or perpetual system is used?

a. LIFO

b. FIFO

c. both LIFO and FIFO

d. neither FIFO nor LIFO

6. The assumption that the sales mix of multiple products has not changed during the current year is required for applying the

a. gross profit method.

b. LCM method.

c. retail inventory method.

d. gross profit method and retail inventory method.

7. Galvin Company has purchased 1,000 units of an item for $10 each from a manufacturer. The replacement cost is $11 each, and the item can be sold for $13 each. If the normal profit margin is $2.50 per unit, the inventory value on the balance sheet should be

a. $10,500.

b. $11,000.

c. $ 7,500.

d. $10,000

8. If the beginning inventory is understated but the ending inventory is correctly valued,

a. net income for the period will be understated.

b. net income for the period will be overstated.

c. cost of goods sold for the period will be overstated.

d. net income for the period will be understated and cost of goods sold for this period will be overstated.

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