Porter SM Ch. 05_2pp.doc

8/10/2019 Porter SM Ch. 05_2pp.doc

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CHAPTER 5

Inventories andCost of Goods Sold

OVERVIEW OF EXERCISES, PROBE!S, A"# CASES

Esti$atedTi$e in

earnin% O&t'o$es E(er'ises !in&tes evel

)* Identify the forms of inventory held by different types of 1 10 Easybusinesses and the types of costs incurred. 2 10 Mod

+* Show that you understand how wholesalers and retailers 3 25 Modaccount for sales of merchandise. 10 Easy20! 25 Mod21! 15 Mod

* Show that you understand how wholesalers and retailers 5 15 Easyaccount for cost of "oods sold. # 20 Mod

$ 25 Mod% 20 Mod& 15 Mod

20! 25 Mod21! 15 Mod

-* 'se the "ross profit ratio to analy(e a company)s ability

to cover its operatin" e*penses and earn a profit.

5* E*plain the relationship between the valuation of inventory 10 15 Modand the measurement of income. 23! 20 Mod

.* +pply the inventory costin" methods of specific identification, 11 20 Easywei"hted avera"e, -I-, and /I- usin" a periodic system. 22! 25 Mod

/* +naly(e the effects of the different costin" methods on 12 15 Modinventory, net income, income ta*es, and cash flow. 22! 25 Mod

2! 0 Mod

0* +naly(e the effects of an inventory error on various financial 13 25 Mod

statement items. 1 20 Mod

1* +pply the lowerofcostormaret rule to the valuation of 23! 20 Modinventory.

)2* E*plain why and how the cost of inventory is estimated in 15 20 Modcertain situations.

53)


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Esti$atedTi$e in

earnin% O&t'o$es 4Con'l&ded E(er'ises !in&tes evel

))* +naly(e the mana"ement of inventory. 1# 20 Mod

)+* E*plain the effects that inventory transactions have on the 1$ 10 Easy

statement of cash flows. 1% 15 Mod1& 15 Mod

)* E*plain the differences in the accountin" for periodic and 2! 0 Modperpetual inventory systems and apply the inventorycostin" methods usin" a perpetual system 6+ppendi*7.

!E*ercise, problem, or case covers two or more learnin" outcomes/evel 8 9ifficulty levels: Easy; Moderate 6Mod7; 9ifficult 69iff7


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Pro6le$s Esti$atedand Ti$e in

earnin% O&t'o$es Alternates !in&tes evel

)* Identify the forms of inventory held by different types of 1 25 Modbusinesses and the types of costs incurred. 15! 20 Mod

+* Show that you understand how wholesalers and retailers %! 5 Modaccount for sales of merchandise. &! 0 Mod10! 0 Mod

* Show that you understand how wholesalers and retailers %! 5 Modaccount for cost of "oods sold. &! 0 Mod

10! 0 Mod

-* 'se the "ross profit ratio to analy(e a company)s abilityto cover its operatin" e*penses and earn a profit. 2 25 Mod

&! 0 Mod

5* E*plain the relationship between the valuation of inventory 11! 5 Modand the measurement of income. 12! #0 9iff

13! 30 Mod1! 30 Mod

.* +pply the inventory costin" methods of specific identification, 11! 5 Modwei"hted avera"e, -I-, and /I- usin" a periodic system. 13! 30 Mod

1! 30 Mod

/* +naly(e the effects of the different costin" methods on 3 20 Modinventory, net income, income ta*es, and cash flow. 11! 5 Mod

12! #0 9iff 13! 30 Mod1! 30 Mod15! 20 Mod

1#! 20 Mod

0* +naly(e the effects of an inventory error on various financial 5 9iffstatement items.

1* +pply the lowerofcostormaret rule to the valuation of 15! 20 Modinventory. 1#! 20 Mod

)2* E*plain why and how the cost of inventory is estimated in 5 20 Modcertain situations.

))* +naly(e the mana"ement of inventory. # 30 Mod

)+* E*plain the effects that inventory transactions have on the $ 25 Modstatement of cash flows. %! 5 Mod

)* E*plain the differences in the accountin" for periodic and 12! #0 9iff perpetual inventory systems and apply the inventorycostin" methods usin" a perpetual system 6+ppendi*7.



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Esti$atedTi$e in

earnin% O&t'o$es Cases !in&tes evel

)* Identify the forms of inventory held by different types of 1! 30 Modbusinesses and the types of costs incurred. 3! 25 Mod

+* Show that you understand how wholesalers and retailers ! 20 Modaccount for sales of merchandise. 5! 20 Mod& 30 Mod

* Show that you understand how wholesalers and retailers 1! 30 Modaccount for cost of "oods sold. ! 20

Mod5! 20 Mod# 25 Mod

-* 'se the "ross profit ratio to analy(e a company)s ability ! 20 Modto cover its operatin" e*penses and earn a profit. 5! 20 Mod

5* E*plain the relationship between the valuation of inventoryand the measurement of income.

.* +pply the inventory costin" methods of specific identification, 3! 25 Modwei"hted avera"e, -I-, and /I- usin" a periodic system. $! 0 Mod

/* +naly(e the effects of the different costin" methods on 2 25 Modinventory, net income, income ta*es, and cash flow. $! 0 Mod

10 30 Mod

0* +naly(e the effects of an inventory error on various financial % 30 Modstatement items.

1* +pply the lowerofcostormaret rule to the valuation of 3! 25 Mod

inventory. 11 30 Mod

)2* E*plain why and how the cost of inventory is estimated incertain situations.

))* +naly(e the mana"ement of inventory.

)+* E*plain the effects that inventory transactions have on thestatement of cash flows.

)* E*plain the differences in the accountin" for periodic andperpetual inventory systems and apply the inventorycostin" methods usin" a perpetual system 6+ppendi*7.



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7 8 E S T I O " S

)* 4he three distinct types of costs incurred by a manufacturer are direct materials,direct labor, and manufacturin" overhead. 9irect, or raw, materials are the

in"redients used in main" a product. 9irect labor consists of the amounts paid tofactory worers to manufacture the product. Manufacturin" overhead includes all theother costs that are related to the manufacturin" process but cannot be directlymatched to specific units of output.

+* 4he use of a contrarevenue account to record cash refunds and other types ofallowances allows a company to monitor the si(e and freAuency of theseoccurrences. -or e*ample, a relatively lar"e amount of returns in any one periodmay be an indication that the Auality of the product has slipped. 4he informationprovided by the use of these contrarevenue accounts would be lost if all returns andallowances were recorded as reductions of the Sales >evenue account. +lso, if thispractice were followed, the actual amount of sales would be understated for theperiod to the e*tent of any returns and allowances.

* 4erms of 3B20, nB#0 mean that the customer may deduct 3C from the sellin" price ifthe bill is paid within 20 days. therwise, the full amount is due within #0 days of thedate of the invoice. +ssumin" a sale for D1,000, a 3C discount would save thecustomer D30, resultin" in a net amount due of D&$0. 4he amount saved is the resultof payin" 0 days earlier than is reAuired by the #0day term. +ssumin" 3#0 days ina year, there are 3#0B0, or & periods of 0 days each, in a year. 4hus, a savin"s ofD30 for 0 days is eAuivalent to a savin"s of D30 &, or D2$0 for the year. 4his iseAuivalent to an annual return of D2$0BD&$0, or 2$.%C.

-* 4he two inventory systems differ with respect to how often the inventory account isupdated. 'nder the perpetual system, the account is updated each time a sale orpurchase is made. Fith the periodic system, the inventory account is updated onlyat the end of the period. + temporary account, called =urchases, is used to eeptrac of the acAuisitions of inventory durin" the period. 4he periodic method relies ona count of the inventory on hand at the end of the period to determine the amount toassi"n to endin" inventory on the balance sheet and to cost of "oods sold e*penseon the income statement.

5* + pointofsale terminal "ives the merchandiser the ability to update the inventoryrecords each time a sale is made. +s an item is run over the sensin" "lass, a barcode on the product is read by the computer. In this way, the unit can be removed

from the inventory at the point of sale. In some instances, however, merchandisersuse the terminals only to update the Auantity of units on hand, not necessarily thedollar amount.

.* 4he =urchases account is neither an asset nor an e*pense account. It is simply atemporary holdin" account for the purchases of merchandise, which is closed at theend of the period. 4he effect of purchases made durin" the period is to increase thecost of "oods sold e*pense.


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/* -or inventory in transit at the end of the year, the terms of shipment dictate whetherthe buyer should record the purchase of the inventory. -G shippin" point meansthat the "oods belon" to the buyer as soon as they are shipped, and the purchasesshould be recorded at this point in time. +lternatively, -G destination point meansthat the "oods do not belon" to the buyer until they are received and therefore

should not be recorded if they are in transit at yearend.0* 4ransportationin represents the frei"ht costs incurred on purchases of merchandise

and is therefore added to the purchases of the period in determinin" cost of "oodssold e*pense. +lternatively, transportationout indicates the frei"ht costs incurred insellin" merchandise and is therefore reported as a sellin" e*pense on the incomestatement in the period of sale.

1* ross profit is computed by deductin" cost of "oods sold from net sales. 4he "rossprofit ratio indicates how well the company controlled its product costs durin" theyear. -or e*ample, a 30C "ross profit ratio indicates that for every dollar of sales thecompany has a "ross profit of 30 cents. 4hat is, after deductin" $0 cents on every

dollar for the cost of the inventory that is sold, the company has 30 cents to cover itsoperatin" costs and earn a profit.

)2* +ccordin" to the cost of "oods sold model, be"innin" inventory plus purchasesminus endin" inventory eAuals cost of "oods sold. 4herefore, the amount assi"nedto inventory on the balance sheet has a direct effect on the measurement of cost of"oods sold on the income statement. +ny errors in valuin" inventory will flow throu"hto cost of "oods sold and thus have an impact on the measurement of net income.

))* 4he Hustification for treatin" frei"ht costs on incomin" inventory as a cost incurred inacAuirin" the asset, rather than as an e*pense of the period, is the matchin"principle. -rei"ht costs are necessary to put the inventory into a position to be sold

and should therefore be included in the cost of the asset. 4his is a si"nificantdecision, since the cost will become an e*pense only at the time the inventory issold. If frei"ht costs are not included in the cost of the inventory, they are e*pensedimmediately as they are incurred. 4hus, if the inventory is not sold at the end of theperiod, the decision to treat frei"ht costs as a cost of the inventory will result inhi"her net income than if the costs had been included as an e*pense of the period.

)+* 4he specific identification method is appropriate only for certain types of inventory. Itis normally used for situations in which the inventory is relatively hi"hpriced andsubHect to a low amount of turnover. +lthou"h it is not a necessary condition, eachunit of inventory is often uniAue. -or e*ample, an automobile dealer uses the

specific identification method, as would a Hewelry company.


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)* Fhen used on an inventory of identical units, the specific identification can lead tothe manipulation of income. Gecause all units are identical, mana"ement can selectwhich units to sell based on the relative hi"h or low cost of the units on hand. -ore*ample, in a bad year a company mi"ht be tempted to select for sale all units thathad a relatively low unit cost, re"ardless of when they were acAuired. 4he use of a

cost flow assumption, such as wei"hted avera"e, -I-, or /I-, eliminates theability of mana"ement to select units for sale based solely on the effect this decisionwill have on the income of the period.

)-* 4he wei"hted avera"e cost method does not rely on a simple arithmetic avera"e ofthe unit cost for the various purchases of the period. Instead, more wei"ht isassi"ned to unit costs for which more units were purchased. -or e*ample, assumethat be"innin" inventory consists of 100 units with a unit cost of D10 per unit.

+ssume that durin" the period, 100 units were purchased at D15 per unit, and 200units were purchased at D20 per unit. 4he arithmetic avera"e unit cost for the periodwould be 6D10 D15 D207B3 8 D15. evenueService)s /I- conformity rule reAuires that a company that wants to use /I- forta* purposes must also use it in preparin" its income statement.


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)1* + /I- liAuidation occurs when a company usin" the /I- inventory method sellsmore units durin" the period than it purchases. + liAuidation of some or all of theolder, relatively lowerpriced units 6assumin" risin" prices7 will result in a low cost of"oods sold amount and a correspondin"ly hi"her "ross mar"in. 4his may present adilemma to a company. If the company sells the lowerpriced units, its net income

will improve, but hi"her ta*es will have to be paid. 4o avoid facin" this situation, acompany mi"ht buy inventory at the end of the year to avoid these conseAuences ofa liAuidation. 'nfortunately, the somewhat forced purchase of inventory to avoid theliAuidation may not be in the best interests of the company.

+2* In a period of risin" prices, -I- can result in si"nificant inventory profits. Incomparison with /I-, the use of -I- char"es less to cost of "oods sold because itis the older, lowerpriced units that are assumed to be sold.


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+.* + retailer can save time and money at the end of the year by simply countin" thenumber of units of each item of inventory and multiplyin" each of these counts bythe price mared on the units 6that is, the retail price7. 4his process "ives thecompany an amount that represents the value of the inventory at retail. 4he retailmethod is then used to convert this amount to cost. It would be prohibitive for many

retailers, particularly mass merchandisers, to trace the unit cost of each item ofinventory to purchase invoices.

+/* Inventory turnover eAuals cost of "oods sold 6cost of sales7 divided by avera"einventory. If the cost of sales remains constant while the denominator 6avera"einventory7 increases, inventory turnover will decrease. 4his indicates that inventoryis stayin" on the shelf for a lon"er time. 4he company should probably evaluate thesalability of its inventory.

+0* Fhen a perpetual inventory system is used, the dollar amount of inventory iscalculated after each sale. 4hus, when it is used in conHunction with the wei"htedavera"e costin" method, a new avera"e cost is calculated after each sale. 4he

wei"hted avera"e chan"es each time a sale is made, and therefore the unit cost iscalled a movin" avera"e.

E X E R C I S E S

/ 1 EXERCISE 53) CASSIFICATIO" OF I"VE"TOR9 COSTS

Classifi'ationRa: Wor; in Finis


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/ 1 EXERCISE 53+ I"VE"TORIABE COSTS

/ist price: D100 200 units D20,000/ess: 10C volume discount 62,0007

-rei"ht costs 5#Insurance for "oods in transit 324otal cost D1%,0%%

'nder the cost principle, all of these costs are necessary to put the inventory into aposition where it can be sold.ther classifications:

4he phone char"es and purchasin" department salary would both be difficult tomatch directly with the sale of any particular product and therefore should be treated asoperatin" e*penses of the period. 4he labelin" supplies are immaterial in amount andshould also be reported as operatin" e*penses. 4he interest paid to suppliers is a

financin" cost and would be reported as interest e*pense on the income statement.

/ 2 EXERCISE 53 PERPET8A A"# PERIO#IC I"VE"TOR9 S9STE!S

)* ompany + is usin" a perpetual inventory system because it has the account ost ofoods Sold. ompany G is usin" the periodic inventory system because it uses theaccounts =urchases, =urchase 9iscounts, and =urchases >eturns and +llowances.

+* ompany +)s end of the year inventory is the balance in its merchandise inventoryaccount, D12,000. Its cost of "oods sold is D3%,000, the balance in that account.

* ost of "oods sold in a periodic system is computed as: Ge"innin" inventory netpurchases endin" inventory. ompany G)s merchandise inventory accountrepresents be"innin" inventory. Endin" inventory is obtained by conductin" aphysical count. Gecause you are not "iven the endin" inventory fi"ure, you cannotcompute cost of "oods sold.


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/ 2 EXERCISE 53- PERPET8A A"# PERIO#IC I"VE"TOR9 S9STE!S

=erpetualN+ppliance store

=erpetualNar dealership

=eriodicN9ru"store

=erpetualN-urniture store

=eriodicNrocery store

=eriodicN6must first solve d, then '7

4d ost of "oods available for sale: cost of "oods sold endin" inventory 8 D5,5$0 D1,$50 8 D$,320

4' =urchase discounts:

)* ost of "oods available for sale be"innin" inventory 8 cost of "oods purchased8 D$,320 D2,350 8 D,&$0

+* ross purchases purchase returns and allowances purchase discounts transportationin 8 cost of "oods purchased; D5,$20 D%00 purchase discounts D500 8 D,&$0; purchase discounts 8 D5,20 D,&$0 8 D50


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EXERCISE 535 4Con'l&ded

Case >

4e ross purchases:

)* ost of "oods purchased 8 cost of "oods available for sale be"innin" inventory8 D%,$&0 D1,%&0 8 D#,&00

+* ross purchases purchase returns and allowances purchase discounts transportationin 8 cost of "oods purchased; "ross purchases D550 D310 D20 8 D#,&00; "ross purchases 8 D#,&00 D550 D310 D20 8 D$,30

4f ost of "oods sold 8 cost of "oods available for sale endin" inventory 8 D%,$&0 D1,200 8 D$,5&0

/ 3 EXERCISE 53. P8RCHASE #ISCO8"TS

BAA"CESHEET I"CO!ESTATE!E"T

Assets ? ia6ilities @ Sto';


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/ 3 EXERCISE 53/ P8RCHASESPERIO#IC S9STE!


Assets ? ia6ilities @ Sto';eturns=ayable 65007 and +llowances 500

3B1% +ccounts =urchases 61,#007=ayable 1,#00

3B22 +ccounts =urchase >eturns=ayable 6007 and +llowances 00

B# ash 6&007 +ccounts=ayable 6&00761,00 5007

B1% ash 61,2007 +ccounts=ayable 61,2007

61,#00 007


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/ 3 EXERCISE 530 SHIPPI"G TER!S A"# TRA"SFER OF TITE

)* 4he seller pays shippin" costs when merchandise is shipped -G destination point.Miller Fholesalers pays the frei"ht bill and is responsible for the merchandise until it

"ets to Michael)s warehouse.+* 4he inventory should not be included as an asset on Michael)s 9ecember 31, 200$,

balance sheet because the terms of shipment indicate that the merchandise doesnot le"ally belon" to Michael until it arrives, and this is after the end of the year./iewise, Miller should not include the sale on its 200$ income statement, since the"oods are not considered sold until they reach the buyer)s business.

* If the terms of shipment were -G shippin" point, the answers to both Auestions inpart 627 would chan"e. 'nder these terms, the inventory belon"s to Michael as soonas it is shipped, and because this is on 9ecember 23, 200$, the asset should bereco"ni(ed on the yearend balance sheet. Similarly, Miller would record a sale in

200$.

/ 3 EXERCISE 531 TRA"SFER OF TITE TO I"VE"TOR9

=urchases of merchandise that are in transit from vendors to ameron ompanies on9ecember 31, 200$:>ecord durin" 9ecember 200$NShipped -G shippin" point>ecord durin" Oanuary 200%NShipped -G destination point

Sales of merchandise that are in transit to customers of ameron ompanies on

9ecember 31, 200$:>ecord durin" 9ecember 200$NShipped -G shippin" point>ecord durin" Oanuary 200%NShipped -G destination point

/ 5 EXERCISE 53)2 I"VE"TOR9 A"# I"CO!E !A"IP8ATIO"

Gy i"norin" the lar"e order at yearend, and thus includin" the inventory in the yearendcount, the company will overstate endin" inventory. 4his in turn will lead to anunderstatement of cost of "oods sold and an overstatement of net income. 4he effectson ne*t year)s income are the opposite. Gecause be"innin" inventory will be overstated,cost of "oods sold will also be overstated, and net income understated. 4he accountanthas an obli"ation to the financial statement users to convince the president to mae thenecessary adHustments to reduce the inventory balance.


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P

/ # EXERCISE 53)) I"VE"TOR9 COSTI"G !ETHO#S

)* Endin" inventory:6#5 557 D20 8 D 200

650 357 D22 8 330

6#0 57 D23 8 3565 57 D2 8

%0 units D1,%35

ost of "oods sold:55 D20 8 D1,100

35 D22 8 $$0

5 D23 8 1,035

5 D2 8 12010 units D3,025

+* Endin" inventory:5 D2 8 D1,0%0

35 D23 8 %05%0 units D1,%%5

ost of "oods sold:#5 D20 8 D1,300

50 D22 8 1,100

25 D23 8 5$510 units D2,&$5

* Endin" inventory:#5 D20 8 D1,300

15 D22 8 330%0 units D1,#30

ost of "oods sold:5 D2 8 D1,0%0

#0 D23 8 1,3%0

35 D22 8 $$010 units D3,230


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EXERCISE 53)) 4Con'l&ded

-* ost of "oods available for sale and units available:#5 D20 8 D1,300

50 D22 8 1,100

#0

D23 8 1,3%05 D2 8 1,0%0220 units D,%#0

Fei"hted avera"e cost 8 D,%#0B220 8 D22.0&Bunit

Endin" inventory: %0 D22.0& 8 D1,$#$.20

ost of "oods sold: 10 D22.0& 8 D3,0&2.#0

"ote>9oes not total D,%#0 because of roundin" of avera"e cost.

/ $ EXERCISE 53)+ EVA8ATIO" OF I"VE"TOR9 COSTI"G !ETHO#S

)* a 5* b

+* d .* a

* c /* b

-* c 0* c

/ % EXERCISE 53) I"VE"TOR9 ERRORS

Balan'e S


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/ 10 EXERCISE 53)5 GROSS PROFIT !ETHO#

4) et sales D105,300Estimated "ross profit ratio 0.25Estimated "ross profit D 2#,325

4+ et sales D105,300 Estimated "ross profit 2#,325Estimated cost of "oods sold D $%,&$5

4 Ge"innin" inventory D 15,00+dd: =urchases %,230ost of "oods available for sale D &&,#30Estimated cost of "oods sold $%,&$5Estimate of inventory destroyed D 20,#55


Assets ? ia6ilities @ Sto';eceivable from Insurance ompany.

/ 11 EXERCISE 53). I"VE"TOR9 T8R"OVER FOR BEST B89

)* Inventory turnover 8 cost of "oods soldBavera"e inventory D20,&3%BJ6D2,%51

D2,#0$7B2K 8 D20,&3%BD2,$2& 8 $.#$ times.

+* 4he avera"e len"th of time it taes to sell an item of inventory can be estimated bydividin" the number of times inventory turns over in a year into the number of days ina year:

6assumin" 3#0 days in a year7: 3#0B$.#$ times 8 #.&, or appro*imately $ days.

* It is difficult to determine from the information "iven whether $ days is reasonableas the avera"e len"th of time it taes to sell inventory. ther information needed tomae this determination includes:

4he historical avera"e number of days. 4he industry norms for lar"e, national retailers. +ny recent chan"es in types of inventory, customer base, marets for the

products, and other relevant factors.


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/ 12 EXERCISE 53)/ I!PACT OF TRA"SACTIO"S I"VOVI"G I"VE"TORIES O"STATE!E"T OF CASH FOWS

Increase in accounts payable: +dded to net income9ecrease in accounts payable: 9educted from net income

Increase in inventories: 9educted from net income9ecrease in inventories: +dded to net income

/ 12 EXERCISE 53)0 EFFECTS OF TRA"SACTIO"S I"VOVI"G I"VE"TORIES O" THESTATE!E"T OF CASH FOWS#IRECT !ETHO#

ash payments for inventory to be reported in the operatin" activities of Masthead)s200$ statement of cash flows 6direct method7:

Inventory, 9ecember 31, 200# D 1%0,00

=lus: =urchases durin" 200$ L/ess: ost of "oods sold durin" 200$ 61,200,0007Inventory, 9ecember 31, 200$ D 21,200D1%0,00 L D1,200,000 8 D21,200L 8 D1,2#0,%00

+ccounts payable, 9ecember 31, 200# D %5,00=lus: =urchases durin" 200$ 6from above7 1,2#0,%00/ess: ash payments durin" 200$ 6L7

+ccounts payable, 9ecember 31, 200$ D $%,00D%5,00 D1,2#0,%00 L 8 D$%,00L 8 D1,2#$,%00

/ 12 EXERCISE 53)1 EFFECTS OF TRA"SACTIO"S I"VOVI"G I"VE"TORIES O" THESTATE!E"T OF CASH FOWSI"#IRECT !ETHO#

ash flows from operatin" activities:

et income D **,***+dHustments to reconcile net income to net cash

provided by operatin" activities:Increase in inventory 6D21,200 D1%0,007 D6#0,%007

9ecrease in accounts payable 6D$%,00 D%5,007 6$,0007 6#$,%007ash flows from operatin" activities D **,***


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! 8 T I 3 C O " C E P T E X E R C I S E S

/ 2,3 EXERCISE 53+2 I"CO!E STATE!E"T FOR A !ERCHA"#ISER

a* Sales et sales 8 Sales returns and allowances

D125,#00 D122,00 8 D3,5#0

6* 9o c. first. et purchases =urchase discounts 8 =urchases

D$,#00 D1,300 8 D$5,&00

'* ost of "oods purchased 4ransportationin 8 et purchases

D%1,150 D#,550 8 D$,#00

d* et sales ross mar"in 8 ost of "oods sold

D122,00 D3%,#00 8 D%3,0

e* ost of "oods available for sale ost of "oods sold 8 Endin" inventory

D10,550 D%3,0 8 D21,110

f* ross mar"in Income before ta* 8 peratin" e*penses

D3%,#00 D2#,300 8 D12,300

%* Income before ta* Income ta* e*pense 8 et income

D2#,300 D10,300 8 D1#,000


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/ 2,3 EXERCISE 53+) PARTIA I"CO!E STATE!E"TPERIO#IC S9STE!

API"E CO!PA"9I"CO!E STATE!E"T

FOR THE 9EAR E"#E# #ECE!BER ), +22/Sales D%0,000/ess: Sales returns and allowances D 500

Sales discounts 1,200 1,$00et sales D$%,300/ess cost of "oods sold:

Ge"innin" inventory D ,000=urchases D30,000/ess: =urchase returns and allowances 00

=urchase discounts %00et purchases D2%,%00

+dd: 4ransportationin 1,000ost of "oods purchased 2&,%00ost of "oods available for sale D33,%00/ess: Endin" inventory 3,%00ost of "oods sold 30,000

ross mar"in D%,300

4he "ross profit ratio is #1.$C.6D%,300BD$%,3007

/ #,$ EXERCISE 53++ I"VE"TOR9 COSTI"G !ETHO#SPERIO#IC S9STE!

)* a* Fei"hted avera"e method:

ost of "oods available for sale and units available:

200 D10 8 D 2,000

300 D11 8 3,300

00 D12 8 ,%00

250 D13 8 3,250

150 D15 8 2,250

1,300 D15,#00Fei"hted avera"e cost 8 D15,#00B1,300 8 D12 per unit

'nits available 1,300'nits sold 1,000'nits in endin" inventory 300

ost of endin" inventory 8 3006D127 8 D3,#00ost of "oods sold 8 1,0006D127 8 D12,000


21/73

5 ? I@E4>IES +9 S4 - 9S S/9 53+)

EXERCISE 53++ 4Con'l&ded

6* -I- method:

Endin% inventor= 'ost>

150 D15 8 D2,250

150 D13 8 1,&50300 D,200

Cost of %oods sold>

200 D10 8 D 2,000

300 D11 8 3,300

00 D12 8 ,%00

100 D13 8 1,3001,000 D11,00

6OR>D15,#00 D,200 8 D11,007

'* /I- method:

Endin% inventor= 'ost>

200 D10 8 D2,000

100 D11 8 1,100300 D3,100

Cost of %oods sold>

150 D15 8 D 2,250

250 D13 8 3,250

00 D12 8 ,%00

200 D11 8 2,2001,000 D12,500

6OR>D15,#00 D3,100 8 D12,5007

+* /I- cost of "oods sold D12,500-I- cost of "oods sold 11,009ifference in e*penses D 1,1004a* rate 0.309ifference in ta*es D 330

Con'l&sion>Gecause -I- results in less cost of "oods sold, a hi"her income andthus more ta*es, D330, will be reported with this method than if /I- were used.


22/73

53++ -I+I+/ +'4I S/'4IS M+'+/

/ 5,& EXERCISE 53+ OWER3OF3COST3OR3!ARET R8E

onservatism is the rationale for carryin" inventory on the balance sheet at an amountless than its cost. It is a departure from the historical cost principle and is used when theutility of the inventory, as measured by the cost to replace it, is less than ori"inal cost.

4wo accounts are affected by the application of the lowerofcostormaret rule. +nincome statement account, such as /oss on 9ecline in @alue of Inventory, is debited,and the Inventory account on the balance sheet is credited or reduced.

4he effect of writin" down inventory is to reduce the income of the current year bythe amount debited to the loss account. In future years, however, income will be hi"herbecause of the writedown. 4his occurs because cost of "oods sold will be lower in thefuture when the inventory that was written down to a lower amount is eventually sold.

/ $,13 EXERCISE 53+- I"VE"TOR9 COSTI"G !ETHO#SPERPET8A S9STE!4ADDendi(

)* a* Movin" avera"e:

P&r'


23/73

5 ? I@E4>IES +9 S4 - 9S S/9 53+

EXERCISE 53+- 4Contin&ed

* 350

D11.#%& 8 D,0&1

250

13 8 3,250

#00 D$,31; D$,31B#00 8 D12.235

-* 300 D12.235 8 D3,#$1

150 15 8 2,250

50 D5,&21; D5,&21B50 8 D13.15%

)* 6* -I-:

P&r'


24/73

53+- -I+I+/ +'4I S/'4IS M+'+/

EXERCISE 53+- 4Contin&ed

)* '* /I-:

P&r' EXERCISE 53+->EI CGS EI CGS

+vera"e cost D3,#00 D12,000 D3,&$ D11,#53 9ifferent-I- ,200 11,00 ,200 11,00 Same/I- 3,100 12,500 3,00 12,200 9ifferent


25/73

5 ? I@E4>IES +9 S4 - 9S S/9 53+5

EXERCISE 53+- 4Con'l&ded

* ost of "oods sold:/I- D12,200-I- 11,009ifference in e*pense D %004a* rate 0.309ifference in ta*es D 20

Con'l&sion> /I- results in a hi"her cost of "oods sold and therefore a lowerta*able income and lower income ta* by D20.

P R O B E ! S

/ 1 PROBE! 53) I"VE"TOR9 COSTS I" VARIO8S B8SI"ESSES

A''o&ntin% Treat$entE(Dense of Inventor= Otestaurant -ro(en food Lhina and silverware L!!=repared food LSpices L

!>ecord as an asset and char"e to e*pense as used.!!>ecord as an asset and depreciate over estimated useful life.


26/73

53+. -I+I+/ +'4I S/'4IS M+'+/

/ PROBE! 53+ CAC8ATIO" OF GROSS PROFIT FOR WA3!ART A"# TARGET

)* ross profit ratios 6dollar amounts in millions7:

FalMart: 200: 6D2%5,222 D21&,$&37BD2%5,222 8 D#5,2&BD2%5,222 8 22.&C

2003: 6D25#,32& D1&%,$$7BD25#,32& 8 D5$,5%2BD25#,32& 8 22.5C

4ar"et: 200: 6D5,#%2 D31,57BD5,#%2 8 D1,23$BD5,#%2 8 31.2C2003: 6D0,&2% D2%,3%&7BD0,&2% 8 D12,53&BD0,&2% 8 30.#C

+* In terms of the "ross profit ratio, 4ar"et appears to be performin" better, "iven asi"nificantly hi"her ratio in each year. 4he mi* of products sold by the twocompanies and the normal marups on the various products could certainly affectthe ratios. + comparison with prior years and industry avera"es would also beimportant to consider.

/ $ PROBE! 53 EVA8ATIO" OF I"VE"TOR9 COSTI"G !ETHO#S

)* ompany G will have the newest costs in inventory because it uses firstin, firstout.Gecause costs are risin", it will have the lowest costs of "oods sold and thus thehi"hest net income.

+* ompany will have the oldest costs in inventory because it uses lastin, firstout.Gecause costs are risin", it will have the hi"hest cost of "oods sold and thus thelowest income before ta*es. ompany will pay the least in ta*es.

* 4his Auestion does not lend itself to an easy answer. /I- matches the most recent

costs with the most recent revenue and thus may be a better indicator of futurepotential to investors. Inventory profits are not a maHor concern with /I- as they arewith -I-, because the newer 6most recent7 costs are assi"ned to cost of sales.

-* ompany would have the oldest costs in inventory because it uses /I-. Gecausecosts are fallin", it will have the lowest cost of "oods sold and the hi"hest netincome.

ompany G will have the newest costs in inventory because it uses -I-.Gecause costs are fallin", it will have the hi"hest cost of "oods sold and the lowestincome before ta*es. ompany G will pay the least in ta*es.

4he answer to part 637 is still not easy. 4here are advanta"es and disadvanta"es

in all methods. 4he important point is to choose one method and stay with it forconsistency.


27/73

5 ? I@E4>IES +9 S4 - 9S S/9 53+/

/ % PROBE! 53- I"VE"TOR9 ERROR

)* Revised in'o$e state$ents> +22/ +22.>evenues D20,000 D15,000

ost of "oods sold! 13,#00 &,00ross profit D #,00 D 5,#00peratin" e*penses 3,000 2,000

et income D 3,00 D 3,#00

!Gecause endin" inventory in 200# was understated, cost of "oods sold wasoverstated. Gecause be"innin" inventory in 200$ was understated, cost of "oodssold was understated.

Revised 6alan'e s )+)2/ )+)2.ash D 1,$00 D 1,500Inventory ,200 ,100

ther current assets 2,500 2,000/on"term assets 15,000 1,0004otal assets D23,00 D21,#00

/iabilities D %,500 D $,000apital stoc 5,000 5,000>etained earnin"s &,&00 &,#00

4otal liabilities and stocholders) eAuity D23,00 D21,#00

+* et income for two years, before revision: D3,000 D,000 8 D$,000et income for two years, after revision: D3,#00 D3,00 8 D$,0004hus, there is no net over or understatement.

>etained earnin"s at 9ecember 31, 200$, before the revision: D&,&00>etained earnin"s at 9ecember 31, 200$, after the revision: D&,&004hus, there is no over or understatement.

* Even thou"h the error counterbalances over the twoyear period, it is still importantto restate the statements for the two years. It is important for comparative purposesthat the correct amount of net income be nown for each of the two years. 4hecompany needs to restate the income statements for each of the two years andrestate the balance sheets at the end of each year.


28/73

53+0 -I+I+/ +'4I S/'4IS M+'+/

/ 10 PROBE! 535 GROSS PROFIT !ETHO# OF ESTI!ATI"G I"VE"TOR9 OSSES

)*4) et sales D113,500Estimated "ross profit ratio 0.0

Estimated "ross profit D 5,004+ et sales D113,500

Estimated "ross profit 5,00Estimated cost of "oods sold D #%,100

4 Ge"innin" inventory D 3,200+dd: =urchases 1#,000ost of "oods available for sale D1#$,200Estimated cost of "oods sold #%,100Estimate of inventory at time of e*plosion D &&,100Inventory saved ,500Estimate of inventory destroyed D &,#00

+* To record insuance settlement from explosion.


Assets ? ia6ilities @ Sto';eceivable from Insurance ompany.


29/73

5 ? I@E4>IES +9 S4 - 9S S/9 53+1

/ 11 PROBE! 53. I"VE"TOR9 T8R"OVER FOR APPE CO!P8TER A"# #ECO!P8TER

)* ross profit ratios:

ADDle Co$D&ter #ell Co$D&ter 4in $illions 4in $illions

+22- +22 +225 +22-SalesB=roduct revenue D %,2$& D #,20$ D &,205 D 1,/ess: ost of salesBrevenue #,020 ,&& 0,1&0 33,%&2ross profit D 2,25& D 1,$0% D &,015 D $,5529ivided by sales Q %,2$& Q #,20$ Q &,205 Q 1,ross profit ratio 2$.3C 2$.5C 1%.3C 1%.2C

+* Inventory turnover ratios:

ADDle Co$D&ter>

D#,020BJ6D101 D5#7B2K 8 D#,020B$%.5 8 $#.#& times#ell Co$D&ter

D0,1&0BJ6D5& D32$7B2K 8 D0,1&0BD3&3 8 102.2# times

* Goth companies) "ross profit ratios have remained about the same in the two years.4he two companies) turnover ratios are very different. +nother factor to consider isthe number of days) sales in inventory.

ADDle Co$D&ter>3#0B$#.#& 8 .$days

#ell Co$D&ter>

3#0B102.2# 8 3.5 days

It taes +pple an avera"e of less than five days to sell an item of inventory, and 9ellreAuires only three and a half days.

n the basis of the "ross profit, +pple appears to be performin" better, althou"h9ell does have a better inventory turnover and days) sales in inventory.

It would be helpful to measure all of these statisticsN"ross profit ratio, inventoryturnover, and days) sales in inventoryNwith the same measures for prior years. Itwould also be helpful to compare these measures with the industry avera"es.


30/73

532 -I+I+/ +'4I S/'4IS M+'+/

/ 12 PROBE! 53/ EFFECTS OF CHA"GES I" I"VE"TOR9 A"# ACCO8"TS PA9ABEBAA"CES O" STATE!E"T OF CASH FOWS

)* Statement of cash flows:

COPEA"# A"TI78ESSTATE!E"T OF CASH FOWSFOR THE 9EAR E"#E# #ECE!BER ), +22/

et loss D633,2007+dHustments to reconcile net loss to net cash provided by

operatin" activities:9ecrease in inventory 6D1&2,#00 D21,%007 22,200Increase in accounts payable 6D123,&00 D&3,$007 30,200

ash flows from operatin" activities D 1&,200ash, 9ecember 31, 200# #,100ash, 9ecember 31, 200$ D #5,300

+* !e$orand&$ to t

4: =resident of opeland +ntiAues

->M: Student)s name

9+4E: Oanuary 20, 200%

S'GOE4: ash -lows

Rou recently Auestioned the increase in the company)s cash balance in li"ht of thisyear)s net loss. My thou"hts and a copy of the company)s 200$ statement of cashflows follow.

opeland +ntiAues was able to "enerate a si"nificant amount of cash fromoperations even thou"h the company incurred an accrual basis net loss of D33,200durin" 200$. -irst, the amount of inventory on hand decreased by D22,200 durin"the year from D21,%00 to D1&2,#00; this reduction in inventory "enerated cash forthe company. Second, the amount owed to the company)s suppliers increased byD30,200 durin" the year from D&3,$00 to D123,&00; the related bills have not yetbeen paid.

peratin" e*penses need to be decreased relative to "ross profit if we are toimprove the company)s bottom line. I loo forward to discussin" our plans to turnthin"s around.


31/73

5 ? I@E4>IES +9 S4 - 9S S/9 53)

! 8 T I 3 C O " C E P T P R O B E ! S

/ 2,3,12 PROBE! 530 P8RCHASES A"# SAES OF !ERCHA"#ISE, CASH FOWS

)* Effect of transactions on the accountin" eAuation:


Assets ? ia6ilities @ Sto';evenue 200

B1% +ccounts =urchases 6&007 =ayable &00

B25 ash #00 Sales >evenue #00

B2% ash 6%$37 +ccounts =urchase 9iscounts 2$ 6&00 2$7 =ayable 6&007 6&00 .037

+* et income for +pril:Sales revenue: D200 D#00 D %00ost of "oods sold:

Ge"innin" inventory D 0=urchases: D500 D&00 D1,00

/ess: =urchase discounts D15 D2$ 2et purchases 1,35%

ost of "oods available for sale D1,35%/ess: Endin" inventory $

ost of "oods sold 3&1ross mar"in D 0&peratin" e*penses:

>ent e*pense D 100Miscellaneous e*pense 50

4otal operatin" e*penses 150et income D 25&

* et cash flow from operatin" activities for +pril:ash collected from sales: D200 D#00 D %00ash paid for:

Inventory: D%5 D%$3 D1,35%>ent 100Miscellaneous 50 1,50%

et cash flow from operatin" activities D 6$0%7


32/73

53+ -I+I+/ +'4I S/'4IS M+'+/

PROBE! 530 4Con'l&ded

OR>et income D 25&9educt: Increase in inventory balance 6$7

et cash flow from operatin" activities D 6$0%7

-* et income is D25&. et cash flow from operatin" activities is a ne"ative D$0%. 4hedifference of D$ is attributable to inventory that has not been sold. 4hat is, thecompany has paid for D1,35% of inventory 6a cash outlay7 but has only reco"ni(edcost of "oods sold e*pense of D3&1. 4he difference is D$.

/ 2,3, PROBE! 531 GAP I"C*S SAES, COST OF GOO#S SO#, A"# GROSSPROFIT

)* +pparently, ap Inc. does not sell its merchandise on account. If customers want topay on credit for their purchases, they would use one of the various credit cards thatap accepts.

+* Effect of sales on the accountin" eAuation:




33/73

5 ? I@E4>IES +9 S4 - 9S S/9 53

PROBE! 531 4Con'l&ded

5* ross profit ratios:

4$illions of dollars +22- +22Sales D 1#,2#$ D 15,%5

/ess cost of sales &,%%# &,%%5ross profit D #,3%1 D 5,&9ivided by sales Q D1#,2#$ Q D15,%5ross mar"in ratio 3&.2C 3$.#C

ap Inc.)s "ross profit ratio increased by 1.#C from 2003 to 200. -actors affectin" ap Inc.)s "ross profit ratio mi"ht include chan"es in the sellin" prices ofmerchandise, chan"es in the cost of "oods purchased, andBor chan"es in the mi* ofmerchandise sold 6that is, a sli"ht shift between sellin" products that have hi"her"ross profit ratios and sellin" those with lower "ross profit ratios7.

/ 2,3 PROBE! 53)2 FI"A"CIA STATE!E"TS

)* ost of "oods sold for 200$:Ge"innin" inventory D #,00=urchases D0,200/ess: =urchase discounts %00

et purchases D3&,00+dd: 4ransportationin 3$5

ost of "oods purchased 3&,$$5ost of "oods available for sale D#,1$5

/ess: Endin" inventory $,500ost of "oods sold D3%,#$5

+* et income for 200$:Sales D%,3#/ess: Sales returns $%0

et sales D%3,5%ost of "oods sold Jfrom part 617K 3%,#$5

ross profit D,&0&peratin" e*penses:

Salaries D25,#00

+dvertisin" ,510'tilities 3,#009epreciation 2,300

4otal operatin" e*penses 3#,010Income before ta* D %,%&&

Income ta* e*pense 3,200et income D 5,#&&


34/73

53- -I+I+/ +'4I S/'4IS M+'+/

PROBE! 53)2 4Con'l&ded

* !APE I"C*BAA"CE SHEET

AT #ECE!BER ), +22/

Assetsurrent assets:

ash D 5&0+ccounts receivable 2,35&Inventory $,500Interest receivable 100

4otal current assets D10,5&=roperty, plant, and eAuipment:

/and D20,000Guildin" and eAuipment, net 55,550

4otal property, plant, and eAuipment $5,550

4otal assets D%#,0&&

ia6ilitiesurrent liabilities:

Salaries payable D #50Income ta* payable 3,200

4otal liabilities D 3,%50

Sto';etained earnin"s 32,2&! %2,2&

4otal liabilities and stocholders) eAuity D%#,0&&

!Ge"innin" retained earnin"s et income 9ividendsD32,550 D5,#&& D#,000


35/73

5 ? I@E4>IES +9 S4 - 9S S/9 535

/ 5,#,$ PROBE! 53)) CO!PARISO" OF I"VE"TOR9 COSTI"G !ETHO#SPERIO#IC S9STE!

)* Cost of Endin%Goods Sold Inventor= Total

a* Fei"hted avera"e D11,0% D,&%% D1#,0$26* -I- 10,$$# 5,2 1#,0$2'* /I- 11,52 ,#20 1#,0$2

alculations:

a* Ge"innin" inventory #00 D5.00 8 D 3,000

ct. % %00 5.0 8 ,320

ct. 1% $00 5.$# 8 ,032

ct. 2& %00 5.&0 8 ,$202,&00 D1#,0$2

Fei"hted avera"e cost 8 D1#,0$2B2,&00 8 D5.52

'nits sold: 500 $00 %00 8 2,000 units

'nits available units sold 8 endin" inventory

2,&00 2,000 8 &00 units

Endin" inventory 8 &00 D5.52 8 D,&%%

ost of "oods sold 8 2,000 D5.52 8 D11,0%

6* Endin" inventoryN-I-:%00 D5.&0 8 D,$20

100 5.$# 8 5$#&00 D5,2

ost of "oods soldN-I-:#00 D5.$# 8 D 3,5#

%00 5.0 8 ,320

#00 5.00 8 3,0002,000 D10,$$#

'* Endin" inventoryN/I-:#00 D5.00 8 D3,000

300 5.0 8 1,#20&00 D,#20

ost of "oods soldN/I-:500 D5.0 8 D 2,$00

$00 5.$# 8 ,032

%00 5.&0 8 ,$202,000 D11,52


36/73

53. -I+I+/ +'4I S/'4IS M+'+/


37/73

5 ? I@E4>IES +9 S4 - 9S S/9 53/

PROBE! 53)) 4Con'l&ded

+* 4he 4otal column represents the pool of costs 6be"innin" inventory plus purchases7to be distributed between an asset, endin" inventory on the balance sheet, and ane*pense, cost of "oods sold on the income statement. In accountin", this pool of

costs is called cost of "oods available for sale.* Income statements for the month of ctober:

Wei%


38/73

530 -I+I+/ +'4I S/'4IS M+'+/

PROBE! 53)+ 4Contin&ed

a* Movin" avera"e:

P&r'


39/73

5 ? I@E4>IES +9 S4 - 9S S/9 531

'* /I-:

P&r'


40/73

53-2 -I+I+/ +'4I S/'4IS M+'+/

/ 5,#,$ PROBE! 53) I"VE"TOR9 COSTI"G !ETHO#SPERIO#IC S9STE!

)* 'nits in be"innin" inventory 200+dd: 'nits purchased 6250 220 150 2007 %20'nits available 1,020

/ess: 'nits sold 6300 3%0 1107 $&0'nits in endin" inventory 230

Endin% Cost of Inventor= Goods Sold Total

a* -I- D,10 D1,##3 D1&,0$36* /I- ,155 1,&1% 1&,0$3'* Fei"hted avera"e ,301 1,$$2 1&,0$3

alculations:

a* Endin" inventoryN-I-:200 D1&.20 8 D3,%0

30 1&.00 8 5$0230 D,10

ost of "oods soldN-I-:200 D1%.00 8 D 3,#00

250 1%.50 8 ,#25

220 1%.&0 8 ,15%

120 1&.00 8 2,2%0$&0 D1,##3

6* Endin" inventoryN/I-:200 D1%.00 8 D3,#00

30 1%.50 8 555230 D,155

ost of "oods soldN/I-:220 D1%.50 8 D ,0$0

220 1%.&0 8 ,15%

150 1&.00 8 2,%50

200 1&.20 8 3,%0$&0 D1,&1%

'* Ge"innin" inventory 200 D1%.00 8 D 3,#00

ov. 250 1%.50 8 ,#25ov. 13 220 1%.&0 8 ,15%

ov. 1% 150 1&.00 8 2,%50

ov. 2 200 1&.20 8 3,%01,020 D1&,0$3

Fei"hted avera"e cost 8 D1&,0$3B1,020 8 D1%.#&&

Endin" inventory 8 230 D1%.#&& 8 D,301


41/73

5 ? I@E4>IES +9 S4 - 9S S/9 53-)

ost of "oods sold 8 $&0 D1%.#&& 8 D1,$$2


42/73

53-+ -I+I+/ +'4I S/'4IS M+'+/

PROBE! 53) 4Con'l&ded

+* Wei%


43/73

5 ? I@E4>IES +9 S4 - 9S S/9 53-

12,500 D112,500


44/73

53-- -I+I+/ +'4I S/'4IS M+'+/

PROBE! 53)- 4Con'l&ded

'* /I-:

Endin" inventory 2,500 D10 8 D 25,000

ost of "oods sold 2,500

D10 8 D 25,0003,000 & 8 2$,000

,000 % 8 32,000

2,000 $ 8 1,000

1,000 # 8 #,00012,500 D10,000

+* Income statements for the year ended 9ecember 31, 200$:

Wei%


45/73

5 ? I@E4>IES +9 S4 - 9S S/9 53-5

costs with the revenues "enerated. +pparently, /I- provides the most accuratematchin" of costs with revenue for 4ribune ompany)s newsprint.


46/73

53-. -I+I+/ +'4I S/'4IS M+'+/

/ $,& PROBE! 53). I"TERPRETI"G SEARS I"VE"TOR9 ACCO8"TI"G POIC9

)* o, the use of the lastin, firstout method for its domestic merchandise inventoriesdoes not mean that Sears always sells its newest merchandise first in the 'nited

States. +ctually, the physical flow of merchandise in most stores lie Sears isnormally on a firstin, firstout basis.


47/73

5 ? I@E4>IES +9 S4 - 9S S/9 53-/

/ $ PROBE! 53A EVA8ATIO" OF I"VE"TOR9 COSTI"G !ETHO#S

)* o, the three companies will not be eAually pleased with the decline in prices. If thedecline continues, ompany R 6-I-7 will be"in to show lower "ross profit than

ompany 6/I-7. Gecause "ross profit will be lower, ompany R will report lowerincome before ta* and thus have less ta* to pay.

+* It should be noted that it is not acceptable for a company to chan"e inventoryvaluation methods to save ta*es. +n acceptable e*planation of the Hustification forthe chan"e is this:

9urin" the year recently completed, the company chan"ed its method of valuin"inventory on the balance sheet and reco"ni(in" cost of sales on the incomestatement. 4he company chan"ed from the /I- to -I- method because itbelieves that the latter results in a better matchin" of cost of sales with therevenues of the period.

/ % PROBE! 53-A I"VE"TOR9 ERROR

)* Revised in'o$e state$ents> +22/ +22.>evenues D35,&%2 D2#,%&0ost of "oods sold! 12,0& 10,12ross profit D23,%%% D1#,$%peratin" e*penses 13,%% 10,5$%

et income D10,00 D 5,&00

!Gecause endin" inventory in 200# was overstated, cost of "oods sold was

understated. Gecause be"innin" inventory in 200$ was overstated, cost of "oodssold was overstated.

Revised 6alan'e s )+)2/ )+)2.ash D &,00 D ,100Inventory ,500 ,&00ther current assets 1,#00 1,250/on"term assets, net 2,500 2,#00

4otal assets D0,000 D3,%50urrent liabilities D &,3%0 D10,#00apital stoc 1%,000 1%,000

>etained earnin"s 12,#20 #,2504otal liabilities and stocholders) eAuity D0,000 D3,%50


48/73

53-0 -I+I+/ +'4I S/'4IS M+'+/

PROBE! 53-A 4Con'l&ded

+* urrent ratio:

Before revision>

sliabilitie3urrent

assetscurrent.therInventory3ash

D10,#00

D1,250D5,00D,1008

D10,#00

D10,$508 1.01 to 1

After revision>D10,#00

D1,250D,&00D,1008

D10,#00

D10,2508 0.&$ to 1

If the lender reAuired a current ratio of at least 1 to 1, =lanter would not be eli"iblefor the loan. etained earnin"s at 9ecember 31, 200$, before the revision: D12,#20.

>etained earnin"s at 9ecember 31, 200$, after the revision: D12,#20.

4hus, there is no over or understatement of retained earnin"s at 9ecember 31,200$.

-* Even thou"h the error counterbalances over the twoyear period, it is still importantto restate the statements for the two years. It is important for comparative purposesthat the correct amount of net income be nown for each of the two years. 4hecompany needs to restate the income statements for each of the two years andrestate the balance sheets at the end of each year.


49/73

5 ? I@E4>IES +9 S4 - 9S S/9 53-1

/ 10 PROBE! 535A GROSS PROFIT !ETHO# OF ESTI!ATI"G I"VE"TOR9 OSSES

)*4) et sales D&3,500Estimated "ross profit ratio 0.$0

Estimated "ross profit D#5,504+ et sales D&3,500

Estimated "ross profit #5,50Estimated cost of "oods sold D2%,050

4 Ge"innin" inventory D1,200+dd: =urchases $$,000ost of "oods available for sale D&1,200Estimated cost of "oods sold 2%,050Estimate of inventory at time of e*plosion D#3,150Inventory saved ,500Estimate of inventory destroyed D5%,#50

+* 4o record insurance settlement from e*plosion.


Assets ? ia6ilities @ Sto';eceivable from Insurance ompany is increased instead of ash if cash has not yetbeen received.


50/73

5352 -I+I+/ +'4I S/'4IS M+'+/

/ 11 PROBE! 53.A I"VE"TOR9 T8R"OVER FOR WA3!ART A"# TARGET

)* Inventory turnover ratios:

Wal3!art>

D21&,$&3BJ6D2&,$ D2#,#127B2K 8 D21&,$&3BD2%,02&.5 8 $.% times

Tar%et>D31,5BJ6D5,3% D,5317B2K 8 D31,5BD,&5$.5 8 #.3 times

+* FalMart)s inventory turnover is hi"her than 4ar"et)s durin" the most recent fiscalyear, $.% versus #.3. +nother factor to consider is the number of days) sales ininventory:

Wal3!art>3#0B$.% 8 5.& days

Tar%et>

3#0B#.3 8 5#.% days

It taes FalMart an avera"e of # days to sell an item of inventory; 4ar"et reAuiresan avera"e of 5$ days. n the basis of inventory turnover and days) sales ininventory, FalMart appears to be performin" sli"htly better.

It would be helpful to measure these statisticsNinventory turnover and days)sales in inventory, alon" with the companies) "ross profit ratiosNwith the samemeasures for prior years. It would also be helpful to compare these measures withthe industry avera"es.


51/73

5 ? I@E4>IES +9 S4 - 9S S/9 535)

/ 12 PROBE! 53/A EFFECTS OF CHA"GES I" I"VE"TOR9 A"# ACCO8"TS PA9ABEBAA"CES O" STATE!E"T OF CASH FOWS

)* Statement of cash flows:

CARPETA"# CIT9STATE!E"T OF CASH FOWSFOR THE 9EAR E"#E# #ECE!BER ), +22/

et income D $%,500+dHustments to reconcile net income to net cash

provided by operatin" activities:Increase in inventory 6D105,500 D%,&007 D620,#0079ecrease in accounts payable

6D23,&00 D&3,$007 6#&,%007 6&0,007ash flows from operatin" activities D611,&007

ash, 9ecember 31, 200# 2#,300

ash, 9ecember 31, 200$ D 1,00

+* Memorandum to the president:

4: =resident of arpetland ity

->M: Student)s name

9+4E: Oanuary 20, 200%

S'GOE4: ash -lows

Rou recently e*pressed concern about the decrease in the company)s cashbalance in spite of the profitable year that was reported on this year)s income

statement. My thou"hts and a copy of the company)s 200$ statement of cash flowsfollow.

+lthou"h net income on an accrual basis was D$%,500, the company)s cashbalance declined by D11,&00 durin" the year for two reasons. Most importantly, theamount owed to the company)s suppliers decreased by D#&,%00 durin" the yearfrom D&3,$00 to D23,&00; this decrease in accounts payable drained our cashbalance. In addition, the amount of inventory on hand increased by D20,#00 durin"the year from D%,&00 to D105,500; this increase in inventory reAuired an additionaloutflow of cash.

Fe can better mana"e our cash flow by carefully timin" the payment of bills tocoincide with the due dates on invoices. In addition, we can improve cash flow by

closely monitorin" our inventory levels and only addin" to inventory levels whenincreases in sales warrant an addition.


52/73

535+ -I+I+/ +'4I S/'4IS M+'+/

A TE R " A T E ! 8 T I 3 C O " C E P T P R O B E ! S

/ 2,3,12 PROBE! 530A P8RCHASES A"# SAES OF !ERCHA"#ISE, CASH FOWS

)* 4o record purchase of merchandise on account.




53/73

5 ? I@E4>IES +9 S4 - 9S S/9 535


54/73

535- -I+I+/ +'4I S/'4IS M+'+/

PROBE! 530A 4Con'l&ded

+* 'nits on hand on ctober 31:ctober 1 purchase 3 unitsctober 15 sale 617ctober 1% purchase 10ctober 25 sale 637Endin" inventory & units

* ash balance at end of month:Ge"innin" cash balance D2,000ctober 10 payment 627ctober 15 sale 200ctober 25 sale #00ctober 30 payment 6%007ash balance at end of month D1,$5#

4he cash balance decreased durin" the month even thou"h the company reported aprofit because cash outflows e*ceeded e*penses. 4his was the case because theentire inventory purchased 6and paid for7 was not yet sold 6e*pensed7.

/ 2,3, PROBE! 531A WAGREE"S SAES, COST OF GOO#S SO#, A"# GROSSPROFIT

)* 4he effect of sales and the collection of accounts receivable durin" 200 on theaccountin" eAuation for Fal"reen o. is 6in millions7:

BAA"CESHEET I"CO!ESTATE!E"TAssets ? ia6ilities @ Sto';eceivable 3$,50%.2 Sales 3$,50%.2

ash 3$,35#.&!+ccounts >eceivable 63$,35#.&7

!1,01$.% 3$,50%.2 1,1#&.1

+* Fal"reen o. would deduct sales returns and allowances, and the amount of anysales discounts taen by its customers from sales, to arrive at the amount of net

sales reported on its income statement. Either because they do not feel the amountsare material enou"h or they would rather not divul"e information about returns andallowances to competitors, some companies choose not to separately report them.


55/73

5 ? I@E4>IES +9 S4 - 9S S/9 5355

PROBE! 531A 4Con'l&ded

* ost of "oods sold section of 200 income statement 6in millions7:Merchandise inventory, +u"ust 31, 2003 D ,202.$ost of "oods purchased 2$,%# .3 627ost of "oods available for sale D32,0&.0 617/ess merchandise inventory, +u"ust 31, 200 6,$3% .#7ost of "oods sold D2$,310 .

617 D2$,310. D,$3%.# 8 D32,0&.0.627 D32,0&.0 D,202.$ 8 D2$,%#.3.

-* ross profit ratios:

4In $illions +22- +22et sales D 3$,50%.2 D 32,505.ost of sales 2$,310. 23,$0#.2ross profit D 10,1&$.% D %,$&&.29ivided by net sales Q 3$,50%.2 Q 32,505.ross profit ratio 2$.2C 2$.1C

Fal"reen)s "ross profit ratio was virtually unchan"ed from 2003 to 200. -actorsaffectin" Fal"reen)s "ross profit ratio include chan"es in the sellin" prices ofmerchandise, chan"es in the cost of "oods purchased, andBor chan"es in the mi* ofmerchandise sold 6that is, a sli"ht shift from sellin" products that have hi"her "rossprofit ratios to sellin" those with lower "ross profit ratios7.

/ 2,3 PROBE! 53)2A FI"A"CIA STATE!E"TS

)* ost of "oods sold for 200$:Ge"innin" inventory D #,00=urchases D#2,%5/ess: =urchase discounts 1,23$et purchases D#1,#0%

+dd: 4ransportationin 3$5ost of "oods purchased #1,&%3ost of "oods available for sale D#%,3%3

/ess: Endin" inventory 5,&00ost of "oods sold D #2,%3


56/73

535. -I+I+/ +'4I S/'4IS M+'+/

PROBE! 53)2A 4Con'l&ded

+* et income for 200$:Sales D112,$#%/ess: Sales returns 1,00%

et sales D111,$#0ost of "oods sold Jfrom part 617K #2,%3

ross profit D &,2$$peratin" e*penses:

Fa"es and salaries e*pense D 23,000+dvertisin" e*pense 12,&00'tilities e*pense 1,%00

4otal operatin" e*penses 3$,$00Income before ta* D 11,5$$

Income ta* e*pense 1,50et income D 10,12$

* O9# I"C*BAA"CE SHEET

AT #ECE!BER ), +22/

Assetsash D22,30

+ccounts receivable 5#,35&Inventory 5,&00

4otal assets D %,5&&

ia6ilitiesSalaries payable D #50Fa"es payable 120Income ta* payable 1,50

4otal liabilities D 2,220

Sto';etained earnin"s 32,3$&!

4otal stocholders) eAuity %2,3$&4otal liabilities and stocholders) eAuity D %,5&&

!Ge"innin" retained earnin"s et income 9ividendsD2%,252 D10,12$ D#,000


57/73

5 ? I@E4>IES +9 S4 - 9S S/9 535/

/ 5,#,$ PROBE! 53))A CO!PARISO" OF I"VE"TOR9 COSTI"G !ETHO#SPERIO#IC S9STE!

)* Cost of Endin%Goods Sold Inventor= Total

a* Fei"hted avera"e D5,120 D,#55 D&,$$56* -I- ,%$5 ,&00 &,$$5'* /I- 5,3$5 ,00 &,$$5

alculations:

a* Ge"innin" inventory 300 D.00 8 D1,200

ov. % 500 .50 8 2,250

ov. 1% $00 .$5 8 3,325

ov. 2& #00 5.00 8 3,0002,100 D&,$$5

Fei"hted avera"e cost 8 D&,$$5B2,100 8 D.#55'nits sold: 200 500 00 8 1,100 units

'nits available units sold 8 endin" inventory

2,100 1,100 8 1,000 units

Endin" inventory 8 1,000 D.#55 8 D,#55

ost of "oods sold 8 1,100 D.#55 8 D5,120!

!>ounded to a"ree with total cost.

6* Endin" inventoryN-I-:#00 D5.00 8 D3,000

00 .$5 8 1,&001,000 D,&00

ost of "oods soldN-I-:300 D.00 8 D1,200

500 .50 8 2,250

300 .$5 8 1,251,100 D,%$5

'* Endin" inventoryN/I-:

300 D.00 8 D1,200500 .50 8 2,250

200 .$5 8 &501,000 D,00

ost of "oods soldN/I-:#00 D5.00 8 D3,000

500 .$5 8 2,3$5


58/73

5350 -I+I+/ +'4I S/'4IS M+'+/

1,100 D5,3$5


59/73

5 ? I@E4>IES +9 S4 - 9S S/9 5351

PROBE! 53))A 4Con'l&ded

+* 4he 4otal column represents the pool of costs 6be"innin" inventory plus purchases7to be distributed between an asset, endin" inventory on the balance sheet, and ane*pense, cost of "oods sold on the income statement. In accountin", the pool ofcosts is called cost of "oods available for sale.

* Income statements for the month of ovember:

Wei%


60/73

53.2 -I+I+/ +'4I S/'4IS M+'+/

PROBE! 53)+A 4Contin&ed

a* Movin" avera"e:

P&r'


61/73

5 ? I@E4>IES +9 S4 - 9S S/9 53.)

PROBE! 53)+A 4Con'l&ded

'* /I-:

P&r'


62/73

53.+ -I+I+/ +'4I S/'4IS M+'+/

/ 5,#,$ PROBE! 53)A I"VE"TOR9 COSTI"G !ETHO#SPERIO#IC S9STE!

)* 'nits in be"innin" inventory 300+dd: 'nits purchased 63$5 330 225 3007 1,230

'nits available 1,530/ess: 'nits sold 650 5$0 1#57 1,1%5'nits in endin" inventory 35

Endin% Cost ofInventor= Goods Sold Total

a* -I- D%,#3 D31,1&0 D3&,%336* /I- &,2&3 30,50 3&,%33'* Fei"hted avera"e %,&%2 30,%51 3&,%33

alculations:

a* Endin" inventoryN-I-:

300 D25.00 8 D$,500 5 25.0 8 1,1335 D%,#3

ost of "oods soldN-I-:300 D2$.00 8 D %,100

3$5 2#.50 8 &,&3%

330 2#.00 8 %,5%0

1%0 25.0 8 ,5$21,1%5 D31,1&0

6* Endin" inventoryN/I-:300 D2$.00 8 D%,100

5 2#.50 8 1,1&335 D&,2&3

ost of "oods soldN/I-:300 D25.00 8 D $,500

225 25.0 8 5,$15

330 2#.00 8 %,5%0

330 2#.50 8 %,$51,1%5 D30,50


63/73

5 ? I@E4>IES +9 S4 - 9S S/9 53.

PROBE! 53)A 4Con'l&ded

'* Ge"innin" inventory 300 D2$.00 8 D %,100

ov. 3$5 2#.50 8 &,&3%

ov. 13 330 2#.00 8 %,5%0

ov. 1% 225 25.0 8 5,$15ov. 2 300 25.00 8 $,500

1,530 D3&,%33

Fei"hted avera"e cost 8 D3&,%33B1,530 8 D2#.035

Endin" inventory 8 units in endin" inventory avera"e cost 8 35 D2#.035 8D%,&%2

ost of "oods sold 8 units sold avera"e cost 8 1,1%5 D2#.035 8 D30,%51

+* Wei%


64/73

53.- -I+I+/ +'4I S/'4IS M+'+/

ost of "oods sold 11,000 D1#.# 8 D1%3,00


65/73

5 ? I@E4>IES +9 S4 - 9S S/9 53.5

PROBE! 53)-A 4Con'l&ded

6* -I-:Endin" inventory 1,500 D12 8 D 1%,000

ost of "oods sold ,000 D20 8 D %0,000

2,000 1% 8 3#,0003,000 1# 8 %,000

1,000 1 8 1,000

1,000 12 8 12,000

11,000 D1&0,000

'* /I-:Endin" inventory 1,500 D20 8 D 30,000

ost of "oods sold 2,500 D12 8 D 30,000

1,000 1 8 1,000

3,000 1# 8 %,0002,000 1% 8 3#,000

2,500 20 8 50,00011,000 D1$%,000

+* Income statements for the year ended 9ecember 31, 200$:

Wei%


66/73

53.. -I+I+/ +'4I S/'4IS M+'+/

/ 1,$,& PROBE! 53)5A I"TERPRETI"G THE "EW 9OR TI!ES CO!PA"9SFI"A"CIA STATE!E"TS

)* 4he company carries two types of inventory: newsprint and other. 4hese costs arecomparable to raw materials in a manufacturin" company. + newspaper company,

however, does not eep an inventory of finished "oods. Its newspapers either aresold within hours after bein" printed or become worthless if not sold.

+* Some companies use different methods to value different types of inventory. 4hemethods should be chosen because they provide the most accurate matchin" ofcosts with the revenues "enerated. +pparently, /I- provides the most accuratematchin" of costs with revenue for the company)s newsprint.

/ $,& PROBE! 53).A I"TERPRETI"G HO!E #EPOTS FI"A"CIA STATE!E"TS

)* o, the use of the firstin, firstout inventory method does not mean that a companyalways sells its oldest merchandise first. +lthou"h the physical flow in manybusinesses is on a firstin firstout basis, the use of a cost flow assumption such as-I- for accountin" purposes is independent of the actual physical flow of products.In fact, some businesses do use a /I- 6lastin, firstout7 assumption even thou"hthe physical flow is on a firstin, firstout basis.

+* o,


67/73

5 ? I@E4>IES +9 S4 - 9S S/9 53./

#ECISIO" CASE 53) 4Con'l&ded

* +ccordin" to ote 1, -inish /ine uses the wei"hted avera"e cost method to valueinventories. 4he company indicates that this appro*imates the firstin, firstoutmethod. 4he wei"hted avera"e method is relatively easy to use.

-* +ccordin" to ote 1, -oot /ocer uses /I- for domestic inventories and -I- forinternational inventories. 4he inventories of the company)s 9irecttoustomersbusiness are valued usin" the wei"hted avera"e method, which appro*imates-I-. It is not unusual for companies in the same industry to use different methods,and it is helpful in tryin" to compare the companies to be aware of this fact.

5* Gecause companies usually do not disclose in their annual report which inventorysystem they use, it is not possible to now for certain whether they use periodic orperpetual. 4he ability of merchandisers to use the perpetual system has certainlyimproved with advances in technolo"y, such as the advent of pointofsale

terminals.

/ $ #ECISIO" CASE 53+ REA#I"G A"# I"TERPRETI"G *C*PE""E9S FI"A"CIASTATE!E"TS

)* O..=enney uses /I-. + business should employ the method that most accuratelymatches inventory costs with the revenues of the period. O..=enney may use /I-because prices chan"e freAuently, and it wants to match the most recent costs withrevenues "enerated in the current period.

+* 4he /I- reserve is D25 million at yearend 200 and D3 million at yearend 2003.

* 4he /I- reserve decreased durin" 200, from D3 million to D25 million, or D1%million. 4he reserve decreases because inventory costs are decreasin" and cost of"oods sold on a /I- basis is less than cost of "oods sold on a -I- basis. 4hus, adecrease in the reserve durin" a period indicates that prices are fallin".

/ 1,#,& #ECISIO" CASE 53 REA#I"G A"# I"TERPRETI"G CIRC8IT CIT9SI"VE"TOR9 "OTE

)* ircuit ity uses the avera"e cost method. iven the lar"e volume of consumerelectronics products sold by ircuit ity, the avera"e cost method seemsappropriate.

+* 4he company defines TmaretU as estimated reali(able value. In estimatin" maretvalue, the company considers such factors as forecasted consumer demand, maretconditions, and obsolescence.


68/73

53.0 -I+I+/ +'4I S/'4IS M+'+/

#ECISIO" CASE 53 4Con'l&ded

* 4he company includes the statement about the possibility of bein" e*posed tolosses in e*cess of amounts recorded as a way to alert the statement reader that ifvarious factors result in a decline in the value of its inventory the company wouldneed to write it down and reco"ni(e a loss.

!AI"G FI"A"CIA #ECISIO"S

/ 2,3, #ECISIO" CASE 53- GROSS PROFIT FOR A !ERCHA"#ISER

)* +ccordin" to the income statement prepared by the controller, Emblems) "ross profitratio is D#,$50BD15,000, or 5C.

+* Emblems should notlower its sellin" price. n the surface, it appears that it should,"iven that the industry standard for "ross mar"in is 0C. Emblems) real "ross profit,however, is not 5C. 4he reason is that the controller failed to include two important

product costs in cost of sales: shippin" and labelin". In error, the controller ise*pensin" all shippin" and labelin" costs as incurred, rather than treatin" them asproduct costs. 4he correct "ross profit is as follows:

Sellin" price D 20.00 per unitosts per unit:

=urchase price D10.004a* 610C7 1.00Shippin" 0.50/abelin" 0.$5

4otal cost per unit 12.25ross profit per unit D $.$5umber of units sold $50ross profit D5,%12.50

4hus, the correct "ross profit ratio is D5,%12.50BD15,000, or 3%.$5C. n the basis ofthis new ratio, Emblems is sli"htly under the industry standard of 0C, and it shouldnot lower its sellin" price.

/ 2,3, #ECISIO" CASE 535 PRICI"G #ECISIO"

)* ost per pound D5.00+dd: Sales ta* 65C D5.007 0.25

ross cost D5.25/ess: =urchase discount 62C 5.257 0.11et cost D5.1

+dd: Shippin" 0.05Go* 0.$0

4otal cost D5.%&


69/73

5 ? I@E4>IES +9 S4 - 9S S/9 53.1

#ECISIO" CASE 535 4Con'l&ded

+* Sellin" price D5.%& 8 0C 6sellin" price7

#0C 6sellin" price7 8 D5.%&

Sellin" price 8 D&.%2

* Gefore decidin" whether this is a sufficient profit, aroline)s andy should checindustry avera"es and the price its local competition is char"in". If the price char"edis too much hi"her than that of the competition, even if its product is superior,aroline)s may not "enerate as many sales as it needs to cover other costs, such aswa"es and commissions for employees, rent, utilities, insurance, advertisin", and areturn on owners) investment. If its prices are much lower than that of thecompetition, it may not be "eneratin" as much profit as it reasonably could.

/ 3 #ECISIO" CASE 53. 8SE OF A PERPET8A I"VE"TOR9 S9STE!

)* !e$o to #arrell>

4he purpose of this memo is to clarify for you the costs and benefits of a perpetualinventory system. 4he purpose of a perpetual system is to provide a continuouslyupdated record of the number of units and cost of all inventory items. + perpetualsystem is more costly to maintain because of the need to update the records eachtime purchases and sales are made. It is liely that you will want to consider acomputeri(ed inventory system. umerous software paca"es are available, andone should be chosen that is particularly suitable to your business.

+s mentioned earlier, a perpetual inventory system is considerably more costly toimplement and maintain than a periodic system. + perpetual system would involvean investment in a scannin" device and the other necessary hardware and software.4he ne*t step would be to e*plore the options available to us and the cost of each.=lease call me at your convenience to set up an appointment to discuss thesematters further.

+* 4he suitability of a perpetual inventory system is certainly dependent on the type ofproducts a company sells. 4he system is ideally suited to a product such asautomobiles, since there is a relatively low volume of sales. n the other hand, itmi"ht not be well suited to the needs of a landscaper sellin" trees, shrubs, andplants. 4he turnover of products is very hi"h, and it may not be practical to update

the records each time a sale taes place.


70/73

53/2 -I+I+/ +'4I S/'4IS M+'+/

/ #,$ #ECISIO" CASE 53/ I"VE"TOR9 COSTI"G !ETHO#S

)* eor"etown must use the periodic inventory system at least for the first yearbecause it did not eep a record of the cost of the units sold as each sale was made.

+* 'nits on hand at the end of the year:Oanuary 1,000March 1,200ctober 1,500

+vailable 3,$00Sold 3,000n hand $00

* 'nless a company specifically identifies the cost of each unit sold, it must adopt anassumption about which particular units were sold. Each of the inventory costin"methods taes the pool of costs 6cost of "oods available for sale7 and maes an

assumption about which units were sold and which units remain on hand.Gecause inventory costs have increased durin" the first year, the company could

minimi(e ta*es paid by adoptin" /I-. + comparison of partial income statementswith the use of -I- and /I- hi"hli"hts the ta*es that could be saved in the firstyear:

FIFO IFOSales revenue! D5,000 D5,000ost of "oods sold!! 2,%00 25,500ross profit D20,200 D1&,500

!3,000 units sold at D15 each.

!! 1,000 D% 8 D %,0001,200 % 8 &,#00

1,500 & 8 13,500+vailable 3,$00 D31,100

Endin" inventory:-I- $00 D& 8 D#,300

/I- $00 D% 8 D5,#00

ost of "oods sold:-I- D31,100 D#,300 8 D2,%00

/I- D31,100 D5,#00 8 D25,500Con'l&sion>+ll e*penses other than cost of "oods sold are not affected by the useof one inventory method rather than another. 4hus, the lower "ross profit with theuse of the /I- method will result in income before ta*es that is D20,200 D1&,500, or D$00 less than if -I- was used. Gecause the e*pected ta* rate is35C, the company will save D$00 0.35, or D25, by usin" /I-.


71/73

5 ? I@E4>IES +9 S4 - 9S S/9 53/)

/ % #ECISIO" CASE 530 I"VE"TOR9 ERRORS

4he first error resulted in an overstatement of the endin" inventory in 2005 by D5,#00.4hus, cost of "oods sold in 2005 was understated, and "ross profit was overstated bythe same amount. 4he effect on net income would be less than the amount of

overstatement of "ross profit because of the effect of ta*es.4he second error was the result of not applyin" the lowerofcostormaret rule to

the inventory at the end of 200#. If the cost of certain inventory was D#,000 hi"her thanits replacement cost, the inventory should have been written down and a lossreco"ni(ed.

4he error that was made in the second Auarter of the current year can be correctedbefore the release of the 200$ financial statements. 4he company should e*plain thenature of the error in the annual report: that an understatement of inventory at the endof the second Auarter led to an understatement of the income reported in that Auarter.4he first two errors, if material in amount, reAuire a restatement of the financialstatements of the years involved.

ETHICA #ECISIO" !AI"G

/ 2 #ECISIO" CASE 531 SAES RET8R"S A"# AOWA"CES

)* 4he sales mana"er is interested in reportin" the ma*imum amount of sales.+lthou"h the net amount of sales will be the same re"ardless of whether returns arerecorded separately or simply netted a"ainst sales revenue, the mana"er wouldprefer not to call attention to the level of returns. It is unliely that the mana"er truly

feels the present practice is a waste of time.+* 4he sales mana"er)s recommendation mi"ht save a small amount of booeepin"

time, but at the same time it would sacrifice certain information. Mana"ement needsto be aware of unreasonably hi"h levels of returns of merchandise so that it canmae whatever adHustments are necessary. If Sales >evenue is simply reduced forthe amount of returns, this information will not be available.

* !e$o to t

I received your su""estion that we save time and effort by treatin" sales returns as adirect reduction of sales rather than a separate item in our financial statements. I

appreciate your interest in savin" the company money, but we would lose valuableinformation by not tracin" sales returns. It is imperative that we now whether ourcustomers are satisfied with their purchases, and separate accountin" reco"nitionfor sales returns is an important control feature in this respect. =lease call me if I cananswer any Auestions you mi"ht have concernin" this matter.


72/73

53/+ -I+I+/ +'4I S/'4IS M+'+/

/ $ #ECISIO" CASE 53)2 SEECTIO" OF A" I"VE"TOR9 !ETHO#

)* 4he E is primarily concerned with reportin" the hi"hest amount of incomepossible. 4hus, the E will be satisfied if the company uses the -I- method. 4hismethod reco"ni(es as cost of "oods sold the oldest costs, and because prices arerisin", the costs char"ed to cost of "oods sold will be less than if /I- is used.

+* It would be difficult to state definitively which method is truly in the best interests ofthe stocholders. 4he /I- method minimi(es the amount of income ta*es paid inthe first year, since this method would report the hi"hest cost of "oods sold and thusthe lowest income before ta*es. -rom a cash flow perspective, /I- is the mostadvanta"eous method in a period of risin" prices.

* !e$o to t

4: E

->M: Student)s name

9+4E: 12B31BLL

S'GOE4: Inventory methods

+s we end our first year of operations, I am aware of the need to present a favorableimpression to our stocholders. In this re"ard, I would lie to address the selection ofan inventory valuation method.

I can appreciate your interest in ma*imi(in" income whenever possible.


73/73

5 ? I@E4>IES +9 S4 - 9S S/9 53/

#ECISIO" CASE 53)) 4Con'l&ded

+* If the inventory is not adHusted, total assets on the yearend balance sheet will beoverstated.

* 4he materiality of the obsolete inventory should be a maHor factor in a decision to

persist in the ar"ument that the inventory be written down. If the inventory inAuestion is not material relative to the total assets of the company, the writedownmay be unnecessary. 4he materiality of the loss that would be reco"ni(ed from thewritedown, relative to the income of the period, should also be considered.

-* If the inventory is not written down, readers do not have reliable information. 'nderthe lowerofcostormaret rule, readers assume that if inventory is worth less thanits cost, the inventory has in fact been written down to this lower amount.

REA WOR# PRACTICE 5*)

Gecause companies usually do not disclose in their annual report which inventorysystem they use, it is not possible to now for certain whether -inish /ine uses periodicor perpetual. 4he ability of merchandisers to use the perpetual system has certainlyimproved with advances in technolo"y, such as the advent of pointofsale terminals.

REA WOR# PRACTICE 5*+

-inish /ine is a lar"e merchandiser of athletic footwear and other apparel. 4he nature of

this business reAuires the company to continually monitor its inventory for obsoleteproducts. If maret is less than cost, the company should write down the inventory toreflect maret value. 4he company uses the wei"hted avera"e method for determinin"cost.

Documents

Porter SM Ch. 05_2pp.doc