Horngren-financial accounting(9e)-solutions-7

CHAPTER 7

COVERAGE OF LEARNING OBJECTIVES

Chapter 7 Inventories and Cost of Goods Sold 227

CHAPTER 7

7-1 Sales transactions are accompanied by recording of the cost of goods sold (or cost of sales). This is literally true under the perpetual system and conceptually descriptive under the periodic system.

7-2 The two steps are obtaining (1) a physical count and (2) a cost valuation.

7-3 Perpetual systems provide continuous inventory and cost of goods sold records. Periodic systems rely on taking a physical inventory to calculate and record cost of goods sold at the end of the period.

7-4 It is true that the periodic method requires a physical count to measure cost of goods sold and the perpetual method does not. However, for control purposes, it is important to undertake at least annual physical counts of inventory under the perpetual method, as well.

The difference between what the accounting records show and the physical count will be due to theft, spoilage, or other unrecorded changes.

7-5 F.O.B. destination means the shipper pays the freight bill. F.O.B shipping point means the customer bears the cost of the freight bill. F.O.B. stands for ―free on board.‖The terms also describe whether the seller or buyer ―owns‖ the goods while they a re in transit.

7-6 Freight out is not shown as a direct offset to sales. Unlike sales discounts and returns, freight out is not a part of gross revenue that never gets collected. Instead, it is an expense, entailing ordinary cash disbursements.

7-7 The four methods are:

1. Specific identification – charges the actual cost of the specific item sold.

2. FIFO – items purchased first are assumed to be sold first.

3. LIFO – items purchased most recently are assumed to be sold first.

4. Weighted average –the average cost of all items available is charged for each

item sold.

7-8 The specific identification method is normally used for low volume, high value items.

Therefore, we would expect this to be used for a, b, d, and f.

7-9 Yes. Under FIFO the oldest costs are assigned to the cost of goods sold first, so the same cost of goods sold arises whether the costs are assigned at year end or as the sales occur. 7-10 The good news is that LIFO reduces taxes in times of rising prices. The bad news is that reported profit is lower.

7-11 Yes. Purchases under LIFO can affect income immediately, because the unit costs of the latest purchases in the period are assigned to units sold even if the purchases occur after the sales.

228

7-12 No. The weighted average must take into account the number of units purchased at each price. For Gamma Company, the weighted average unit cost of inventory is: [(2 × $4.00) + (3 × $5.00)] 5 = $4.60.

7-13 Ending inventory is lower under LIFO in a period of rising prices and constant or growing inventory. FIFO produces the higher ending inventory value.

7-14 Falling prices reverse the normal relation, so FIFO produces higher cost of goods sold and, therefore, lower net earnings. This helps explain why computer and electronics firms typically use FIFO in order to lower their taxes.

7-15 Consistency requires the maintaining of constant accounting methods from period to period. Switching accounting methods hinders comparisons of current results to those of preceding periods.

7-16 Companies have adopted LIFO primarily because it saves income taxes during times of rising prices by reporting higher cost of goods sold and lower profits.

7-17 An inventory profit is fictitious because, for a going concern, it represents an amount necessary for replenishing inventory and is therefore not ―available‖ in the form of cash for distribution as dividends. It arose from change in unit costs of the products purchased, not from the company’s value-added activities.

7-18 LIFO inventory valuations can be absurd because inventory valuation is based on older and older costs as the years pass.

7-19 Conservatism does result in lower immediate profits, but higher profits are then shown in later periods.

7-20 This convention is called conservatism.

7-21 Under IFRS the market price is the net realizable value – the net amount the company expects to receive for the inventory. Under U. S. GAAP it is usually the current replacement cost – what it would cost to buy the inventory item today.

7-22 The inconsistency is the willingness of accountants to have replacement costs used as a basis for write-downs below historical costs, even though a market exchange has not occurred, but their unwillingness to have replacement costs used as a basis for write-ups above historical costs.

Chapter 7 Inventories and Cost of Goods Sold 229

7-23 Many inventory errors do counterbalance. For example, an ending inventory that is overstated will overstate current income. But the same overstated inventory becomes the beginning inventory the next year; hence, next year’s income will be understated. To show this you might use the following schematic:

Year 1 Year 2

BI OK

+ Purchase OK

Goods Available OK

– Ending Inventory Too Large

Cost of Goods Sold Too Small

This exercise stresses the fact that the ending inventory of one year becomes the

beginning inventory of the subsequent year and the errors correct themselves.

7-24 Cost of goods sold = Beginning inventory + Purchases – Ending inventory.

7-25 Past gross profit percentages are sometimes applied to current revenue as interim

estimates of gross profit for a month or quarter. Thus, the time and cost of taking

physical inventories can be saved.

7-26 Grocery stores have a low profit margin. If the profit margin is 2%, a savings of $100 in

shrinkage would be equivalent to a $5,000 increase in sales.

7-27 The inventory holding gain is an increase in the value of inventory due to price changes

that occur while the inventory is held.

7-28 When LIFO layers are liquidated, older, generally lower cost items are reflected in cost of

goods sold and high profits are reported in the income statement. In other words, the

inventory holding gains are realized.

7-29 Manufacturing companies have raw material, work in process, and finished goods

inventories. The size of the various inventories will vary from industry to industry and

from season to season in many industries. Most often finished goods will be the largest

inventories and work in process will be the smallest inventories.

7-30 Your boss has a point. This is a cost benefit question. If the company does not give the

discount, it may lose customers to competitors that treat them better. But if it is not

currently a custom in the industry, the company may not have to do it. If offering the

discount does not cause customers to buy more, it is giving money away. However, if it

is not an industry custom and it attracts new customers, this may lead to a different

conclusion. Compare how much your operating income would rise from newly attracted

customers versus the discounts received by existing customers.

230

7-31 Phar Mor overstated its assets by overstating inventories. This means that either liabilities or stockholders’ equity must also be overstated (to keep the balance sheet equation in balance). Most likely Phar Mor used a periodic inventory method, so that overstating ending inventory would reduce cost of goods sold and increase pretax profit.

If the company used a perpetual inventory system, management must have made inappropriate credits to cost of goods sold or some other expense account to offset the additional debits to the inventory account.

7-32 Under the FIFO method, the cost of sales will be based on old acquisition costs. Under the LIFO method, the cost of sales will be based on the most recent acquisition costs.

Thus, under LIFO, if additional units are acquired on the last day of the year, the cost of those units will be included in cost of sales. Thus, under LIFO, additional purchases would produce higher cost of goods sold in this instance and lower evaluations for the purchasing officer. Thus, under LIFO he would be less likely to purchase additional oil on the last day of the year.

7-33 There are many advantages to a perpetual inventory system. It allows a continuous tracking of inventories, allowing better control of inventory. This could include tracking of sizes, colors, and other product characteristics, which could help manage production.

Its biggest disadvantage is cost; a periodic inventory system is simpler and less costly.

However, with the use of optical scanning and computers, the cost of a perpetual inventory system has come down quickly. If the Zen Bootist is willing to invest in a system that codes each individual product and tracks its progress through the inventories, then many advantages of a perpetual inventory system can be achieved.

7-34 (10–15 min.)

GOODMAN’S JEWELRY WHOLESALERS

Schedule of Gross Profit

For the Year Ended December 31, 20X8

(In Thousands)

Gross sales $995 Deduct: Sales returns and allowances $ 50 Cash discounts on sales 5 55 Net sales 940 Cost of goods sold:

Inventory, December 31, 20X7 $103

Add: Gross purchases $650

Deduct: Purchase returns and allowances $27

Cash discounts on purchases 6 33

Net purchases 617

Add Freight-in 50

Cost of merchandise acquired 667

Cost of goods available for sale 770

Deduct: Inventory, December 31, 20X8 185

Cost of goods sold 585 Gross profit $355 Chapter 7 Inventories and Cost of Goods Sold 231

7-35 (20 min.)

Sales $71,200 Sales returns 2,300 Net sales $68,900 Cost of goods sold:

Inventory, January 1* x = $39,864

Cost of goods purchased:

Purchases $54,000

Purchase returns 1,000

Net purchases $53,000

Freight in 500 53,500 Cost of goods available for sale $93,364

Inventory, January 15 41,000

Cost of goods sold, .76 × $68,900 52,364 Gross margin, .24 × $68,900 $16,536 * $52,364 + $41,000 – 53,500 = $39, 864

or:

Cost of goods sold (.76 × 68,900) $52,364 Cost of goods purchased 53,500 Inventory increase $ 1,136 Ending Balance = Beginning Balance + Increase (or – decrease) =

$41,000 = Beginning Balance – $1,136

Beginning Balance = $39,864 7-36 (5 min.) Amounts are in millions of dollars.

Perpetual Periodic Accounts receivable* 19 Accounts receivable 19 Sales revenue 19 Sales revenue 19 Cost of goods sold 16 No entry

Merchandise inventory 16

* Could be a debit to cash if sales were for cash.

232

Cost of Goods Available = ￡19,400

(6,000 + 4,200 + 4,400 + 2,300 + 2,500)

LIFO Ending Inventory = (3,000 @ ￡2) + (1,500 @ ￡2.10) = ￡9,150

FIFO Ending Inventory = 1,000 @ ￡2.50 = ￡ 2,500

1,000 @ ￡2.30 = 2,300

2,000 @ ￡2.20 = 4,400

500 @ ￡2.10 = 1,050

4,500 ￡10,250 Weighted average = ￡19,400/9,000 = ￡ 2.16 per unit

Ending inventory 4,500 @ ￡2.16 = ￡9,720*

* With no rounding error on the unit cost this would be ￡9,700.

Cost of Goods Sold Calculation:

Weighted

LIFO FIFO Average Cost of goods available ￡19,400 ￡19,400 ￡19,400 Less Ending Inventory (9,150) (10,250) (9,720) Cost of Goods Sold ￡10,250 ￡ 9,150 ￡ 9,680* * Or ￡9,700 with no rounding error.

7-38 (10–15 min.)

This is straightforward. Answers are in Swiss francs.

Aug. 2 Purchases 350,000

Accounts payable 350,000 Aug. 3 Freight-in 16,000

Cash 16,000 Aug. 7 Accounts payable 32,000

Purchase returns and allowances 32,000 Aug. 11 Accounts payable 318,000

Cash discounts on purchases 6,360

Cash 311,640 Chapter 7 Inventories and Cost of Goods Sold 233

1. Invoice price $195,000

Add: Freight-in 10,000

Deduct: Purchase allowance (10,000)

Deduct: Cash discount (3,700)*

Total cost of steel acquired $191,300

*2% × ($195,000 – $10,000)

2. Purchases (or Inventory)* 195,000

Accounts payable 195,000 *The debit is to Purchases under the periodic inventory method and to Inventory under the perpetual inventory system.

Freight-in 10,000

Accounts payable (or cash) 10,000

Accounts payable 10,000

Purchase returns and allowances 10,000

Accounts payable 185,000

Cash discounts on purchases 3,700

Cash 181,300 234

7-40 (15 min.) Amounts are in thousands of dollars.

See Exhibit 7-40 for the balance sheet equation. Although not required, the balance sheet equation provides a good framework for understanding.

Journal Entries

Perpetual System

a. Gross purchase: Inventory 950

Accounts payable 950

b. Returns and allowances: Accounts payable 70

Inventory 70

c. As goods are sold: Cost of goods sold 890

Inventory 890 d1. and d2. No entry

Periodic System

a. Gross purchase: Purchases 950

Accounts payable 950

b. Returns and allowances: Accounts payable 70

Purchase returns

and allowances 70

c. As goods are sold: No entry

d1. Transfer to cost of goods sold: Cost of goods sold 990

Purchase returns

and allowances 70

Purchases 950

Inventory 110 d2. Recognize ending inventory: Inventory 100

Cost of goods sold 100 Chapter 7 Inventories and Cost of Goods Sold 235

EXHIBIT 7-40

Entries are in thousands of dollars.

A = L + SE

Purchase

Returns and Accounts Retained

Inventory Purchases Allowances Payable Earnings PERPETUAL SYSTEM

Balance, 12/31/X7 +110 = + 110

a. Gross purchases +950 = + 950

b. Returns and allowances – 70 = – 70

c. As goods are sold –890 = –890 [Increase Cost of

Goods Sold] Closing the accounts at end of period:

d1. No entry

d2. No entry ____ ____

Ending balances, 12/31/X8 +100 = +990 –890

PERIODIC SYSTEM

Balance, 12/31/X7 +110 = + 110

a. Gross purchases +950 = + 950

b. Returns and allowances –70 = – 70

c. As goods are sold (no entry)

Closing the accounts at

end of period:

d1. Transfer to cost of goods sold –110 –950 +70 = – 990 [Increase Cost of

Goods Sold] d2. Recognize ending inventory +100 = + 100 [Decrease Cost of

___ ___ ___ Goods Sold] Ending balances, 12/31/X8 +100 0 0 = +990 – 890

236

7-41 (10 min.)

This is straightforward.

1. Purchases 900,000

Accounts payable 900,000

2. Accounts payable 50,000

Purchase returns and allowances 50,000

3. Freight-in 74,000

Cash 74,000

4. Accounts payable 850,000

Cash 832,000

Cash discounts on purchases 18,000 7-42 (10 min.)

The entries could be compounded.

Accounts receivable (or Cash) 1,250,000

Sales 1,250,000 Cost of goods sold 977,000

Purchase returns and allowances 50,000

Cash discounts on purchases 18,000

Purchases 900,000

Freight-in 74,000

Inventory 71,000

Inventory 120,000

Cost of goods sold 120,000 Chapter 7 Inventories and Cost of Goods Sold 237

Compound entries could be prepared. (Amounts are in millions.)

Purchases 140

Accounts payable 140 Accounts receivable 239

Sales 239 Sales returns and allowances 5

Accounts receivable 5 Accounts payable 6

Purchase returns and allowances 6 Freight-in 14

Cash 14 Accounts payable 134

Cash discounts on purchases 1

Cash 133 Cash 226

Cash discounts on sales 8

Accounts receivable 234 Cost of goods sold 162

Purchase returns and allowances 6

Cash discounts on purchases 1

Inventory 15

Purchases 140

Freight-in 14 Inventory 45

Cost of goods sold 45 Other expenses 80

Cash (or other accounts) 80 7-44 (5 min.) Amounts are in millions of dollars.

Beginning inventory $ 346

Purchases (or production costs) 21,497

Cost of goods available 21,843

Ending inventory (509)

Cost of goods sold $21,334

238

This problem develops familiarity with the gross profit section. The answer, $53,760, is computed by filling in the gross profit section and solving for the unknown, or: $192,000 – (54% × $256,000) = $53,760

Gross sales $280,000 Deduct: Sales returns and allowances 24,000 Net sales $256,000 Cost of goods sold:

Inventory, December 31, 20X7 $38,000

Gross purchases $159,000

Deduct: Purchase returns

and allowances $7,000

Cash discounts

on purchases 2,000 (9,000)

Net purchases 150,000

Inward transportation 4,000

Cost of goods acquired 154,000

Cost of goods available for sale 192,000

Inventory, May 3, 20X8* x = 53,760

Cost of goods sold,

54% of $256,000 138,240 Gross profit, 46% of $256,000 $117,760

* Calculated as the difference between cost of goods available for sale, $192,000, and cost of goods sold, $138,240.

7-46 (15 min.)

Sales $200,000 Cost of goods sold:

Inventory, January 1 $65,000

Purchases $190,000

Purchase returns and allowance 10,000

Net purchases $180,000

Freight-in 15,000 195,000

Cost of goods available for sale $260,000

Inventory, March 9* x = 100,000

Cost of goods sold, 80% of $200,000 160,000 Gross margin, 20% of $200,000 $ 40,000 * The answer, $100,000, is obtained by filling in the schedule of cost of goods sold and solving for the unknown, or: $260,000 – 80%($200,000) = $260,000 – $160,000 = $100,000.

Chapter 7 Inventories and Cost of Goods Sold 239

Beginning inventory $ 55,000

Purchases 200,000

Cost of goods available for sale $255,000

Less estimated cost of goods sold:

75%* of $300,000 225,000 Estimated ending inventory $ 30,000

*100% – 25% = 75%

The difference between $30,000 and the amount of inventory remaining is an estimate of the amount missing.

7-48 (10–15 min.)

1 & 2. To calculate the effect use the following approach:

20X5 20X6

Beginning inventory OK

Too low $10,000

+ Purchases OK OK

Goods available OK Too low $10,000 Ending inventory Too low $10,000 OK

Cost-of-goods sold Too high $10,000 Too low $10,000 Cost-of-goods sold is too high by $10,000 in 20X5 so taxable income will be too low by $10,000. Taxes will be too low by $4,000 so net income and retained earnings will be too low by $6,000. Taxable income for 20X6 will be overstated by $10,000 and taxes will be $4,000 too high. Net income in 20X6 will be too high by $6,000 and retained earnings will be correct again at December 31, 20X6.

240

1. Inventory turnover = cost of goods sold* ÷ average inventory

= $1,080,000 ÷ $1,000,000

= 1.08

*Cost of goods sold = $2,400,000 – $1,320,000 = $1,080,000

2. The gross profit would increase from $1,320,000 to $1,500,000, so a change in pricing

strategy would be desirable for Custom Gems. The current 20X3 data follow:

Inventory turnover 1.08

Gross profit percentage:

$1,320,000 ÷ $2,400,000 55% This percentage is not unusual.

If prices are cut 10 percent in 20X4 without affecting inventory turnover, new sales would be .9 ×$2,400,000 = $2,160,000. Cost of goods sold on those sales would still be $1,080,000. Therefore Mr. Siegl would be reducing his gross profit from $1,320,000 to $2,160,000 –$1,080,000 = $1,080,000 and its gross profit percentage to 50% [($2,160,000 $1,080,000) ÷ $2,160,000].

However, an increase in inventory turnover to 1.5 would produce the following:

Sales, $2,160,000 × ($1,500,000 ÷ $1,080,000)* $3,000,000

Cost of goods sold, $1,000,000 × 1.5 1,500,000

Gross profit $1,500,000

* This could also use the ratio of the turnover ratios: $2,160 × (1.5 ÷1.08)

Gross profit would be $180,000 above the 20X3 level.

Chapter 7 Inventories and Cost of Goods Sold 241

1. LIFO Method:

Inventory shows: 1,100 tons on hand at July 31.

Costs: 1,000 tons @ $ 9.00 $ 9,000

100 tons @ $10.00 1,000 July 31 inventory cost $10,000 FIFO Method:

Inventory shows: 1,100 tons on hand at July 31.

Costs: 800 tons @ $12.00 $9,600

300 tons @ $11.00 3,300 July 31 inventory cost $12,900

2. Purchases:

5,000 tons @ $10 $50,000

1,000 tons @ $11 11,000

800 tons @ $12 9,600

Total purchases $70,600

Beginning inventory:

1,000 tons @ $ 9 9,000

LIFO FIFO Cost of goods available for sale $79,600 $ 79,600 $ 79,600 Less ending inventory (10,000) (12,900) Cost of goods sold $ 69,600 $ 66,700 Sales $102,000 $102,000 Cost of goods sold 69,600 66,700 Gross profit $ 32,400 $ 35,300

242

U. S. GAAP: The inventory would be written down from $200,000 to $185,000 on December 31, 20X1. The new $185,000 valuation is ―what’s left‖ of the original $200,000 cost. In other words, the $185,000 is the unexpired cost and may be thought of as the new cost of the inventory for future accounting purposes. Thus, because subsequent replacement values exceed the $185,000 cost, and write-ups above ―cost‖are not acceptable accounting practice, the valuation remains at $185,000 until it is written down to $175,000 on the following December 31, 20X2.

IFRS: The inventory would be written down from $200,000 to $195,000 on December 1, 20X1. It would be written back up to $200,000 on April 30, 20X2. It would remain at $200,000 until December 31, 20X2, when it would be written down to $190,000.

7-52 (10–15 min.) Amounts are in millions of dollars.

The cost of inventory acquired during the year ending August 31, 2008, can be calculated as follows.

Beginning Inventory $ 4,879

Purchases X = 63,663

Cost of goods available Y = 68,542

Ending inventory (5,039)

Cost of merchandise sold $63,503

Y = 63,503 + 5,039 = 68,542

X = 68,542 – 4,879 = 63,663

7-53 (10 min.) Dollar amounts are in millions.

2009: ($13,724 - $8,976) ÷ $13,724 = 34.60%

2008: ($13,794 - $8,987) ÷ $13,794 = 34.85%

2007: ($13,050 - $8,638) ÷ $13,050 = 33.81%

The gross profit percentage was relatively steady over these three years, with an increase in 2008 followed by a modest dip in 2009.

Although not in the problem, it might be interesting to note that the gross profit percentage ranged from 27% to 31% for the ten years from 1994 to 2003. Specifically from 2001–2003 the values were significantly lower: 31.04%, 30.99% and 31.01%.

Chapter 7 Inventories and Cost of Goods Sold 243

1. ISLAND BUILDING SUPPLY

Statement of Gross Profit

For the Year Ended December 31, 20X9

Sales $1,200,000

Cost of goods sold:

Inventory, beginning $ 240,000

Add net purchases 1,035,000

Cost of goods available for sale $1,275,000

Deduct ending inventory (300,000)

Cost of goods sold 975,000

Gross profit $225,000

2. Inventory turnover = Cost of goods sold ÷ Average inventory

= $975,000 ÷ [1/2 × (240,000 + 300,000)]

= 975,000 ÷ 270,000

= 3.61 times

7-55 (30–40 min.)

The detailed income statement is in the accompanying exhibit on the following page. Note the classification of operating expenses into a selling category and a general and administrative category. The list of accounts in the problem contained one item that belongs in a balance sheet rather than an income statement, the Allowance for Bad Debts (an offset to Accounts Receivable).

The delivery expenses and the bad debts expense are shown under selling expenses. Some accountants prefer to show the bad debts expense as an offset to gross sales or as administrative expenses.

244

BACKBAY BATHROOM SUPPLY COMPANY

Income Statement

For the Year Ended December 31, 20X5

(In Thousands)

Revenues:

Gross sales $1,091 Deduct: Sales returns and allowances $ 50

Cash discounts on sales 16 66 Net sales $1,025 Cost of goods sold:

Inventory, December 31, 20X4 $200

Add purchases $600

Less: Purchase returns and allowances $40

Cash discounts on purchases 15 55

Net purchases $545

Add Freight in 55

Cost of merchandise acquired 600

Cost of goods available for sale $800

Deduct: Inventory, December 31, 20X5 300

Cost of goods sold 500 Gross profit from sales $ 525 Operating expenses:

Selling expenses:

Sales salaries and commissions $160

Rent expense, selling space 90

Advertising expense 45

Depreciation expense, trucks and store fixtures 29

Bad debts expense 8

Delivery expenses 20

Total selling expenses $352

General and administrative expenses:

Office salaries 46

Rent expense, office space 10

Depreciation expense, office equipment 3

Office supplies used 6

Miscellaneous expenses 13

Total general and administrative expenses 78

Total operating expenses 430 Income before income tax $ 95 Income tax expense 42 Net income $ 53 Chapter 7 Inventories and Cost of Goods Sold 245

Under the FIFO cost-flow assumption, the periodic and perpetual procedures give identical results. The ending inventory will be valued on the basis of the last purchases during the period.

Units $

Beginning Inventory 110 550

Purchases 290 2,050

Goods available 400 2,600

Units sold 255 1,485**

Units in ending inventory 145 1,115*

* 145 units remain in ending inventory

100 will be valued at the $8 cost from the October 21 purchase and the remaining 45 will be valued at the $7 cost from the May 9 purchase

100 × $8 = $ 800

45 × $7 = 315

$1,115 Ending inventory

** Reconciliation: Cost of Goods Sold:

255 Units: 110 × $5 = $ 550

80 × $6 = 480

65 × $7 = 455

$1,485

246