6.12: Solutions

Discussion Questions

1. 1. The amount of inventory on hand is important to management for two reasons. First, management wants to ensure there is ample inventory to meet all customers' orders. Second, because the cost of carrying inventory (for instance, rental of warehouse space, insurance) can be quite high, management wants to keep the inventory as low as possible.
   2. Investors and creditors are concerned with the inventory because inventory is a large asset. They will want to assess its current amount and trends compared to other years and competitors' levels to help determine the financial strength of the company before investing or lending money, or for use as collateral, for instance.
2. Accountants must ensure the inventory is not obsolete or unsalable and that it is properly counted and valued, using an acceptable inventory cost flow assumption that is applied consistently from year to year.
3. The laid-down cost of inventory is the invoice price of the goods less purchase discounts, plus transportation-in, insurance while in transit, and any other expenditure made by the purchaser to get the merchandise to the place of business and ready for sale.
4. Flow of goods is the physical movement of the goods themselves as they enter the firm and are sold, especially when dealing with similar items, while the flow of costs is the costs assigned to the flow of goods in the firm using specific identification, FIFO, or average cost bases.

   GAAP does not require that the flow of costs basis be similar to the physical flow of goods, except when individual units of inventory can be identified by, for example, serial numbers. However, it does require that once the cost basis is selected, that it be followed consistently from period to period.

5. Two factors are considered in costing inventory: the quantity and the assigned value per unit. Assigning the value is often the more difficult aspect, as this involves tracking the laid-down costs of many items. Physical quantities can be tracked by computerised accounting systems and verified or determined by physical count at year-end.
6. Consistency in inventory costing is necessary for comparing a company's performance from year to year. GAAP does allow a company to change its inventory valuation method; however, the company must restate inventory and cost of goods sold effects on prior years using the new method. In practise this change is rarely made.
7. If the ending inventory is overstated at the end of 2018, then cost of goods sold is understated; therefore, the 2018 net income is overstated by $5,000. In 2019, the opening inventory would be overstated and cost of goods sold would be overstated; therefore, the net income would be understated by $5,000.
8. Inventory should be valued at less than cost when the lower of cost and net realisable value (LCNRV) principle is applied, perhaps due to factors such as physical deterioration, obsolescence, or changes in price levels.
9. The primary reason for the use of the LCNRV method of inventory valuation is to prevent overstatement. If the likely value of inventory has declined below cost, it is prudent to recognize the loss immediately, rather than when the goods are eventually sold. Net realisable value is the expected selling cost of inventory, less any applicable costs related to the sale.
10. When inventory is valued at LCNRV, cost refers to the laid-down cost.
11. The inventory cost flow assumptions permissible under GAAP are specific identification, FIFO or average cost.
12. Estimating inventory is useful for two reasons:
    1. It is useful for inventory control. When a total inventory amount is calculated under a periodic inventory system through physical count and valuation, an estimate can help check the accuracy.
    2. It is useful for the preparation of interim financial statements. Under a periodic inventory system, inventory on hand at any point in time is not readily available. To take a physical count often would be costly and inconvenient. An estimate offers a way of determining a company's inventory at any point in time in a cost-effective manner.
13. Under the gross profit method, the percentage of profit remaining after accounting for cost of goods sold (the gross profit percentage) is assumed to remain the same from year to year. By applying the rate to sales, gross profit and then cost of goods sold can be estimated. Opening inventory and purchases will be known from the accounting records, so cost of goods available for sale can be determined. The difference between the cost of goods sold and cost of goods available for sale is the ending inventory amount.

    Under the retail inventory method, mark-up on goods purchases then sold is considered to be constant. Both cost and selling prices of goods acquired are then valued at retail by using the mark-up amount. From this, the ending inventory at retail is calculated. By applying the cost percentage (costs of goods available for sale divided by retail costs of goods available for sale) to the retail ending inventory, its value at cost can be calculated.

    1. Example – gross profit method:

       Sales		$100
       Cost of Goods Sold:
       Opening Inventory (from records)	80
       Purchases (from records)	70
       Cost of Goods Available for Sale	150
       Ending Inventory	(a)?	(b)?
       Gross Profit		$(c)?

       If the gross profit percentage average is 25%, the following can be estimated:

       (c) Gross profit	= 25% of $100	= $25
       (b) Cost of goods sold	= $100 − $25 (c)	= $75
       (a) Ending inventory	= $150 − $75 (b)	= $75

       Ending inventory (a) would be $75.

    2. Example – retail inventory method; assumed mark-up = 200%:

       	At Retail		At Cost
       Sales		$500		$500
       Cost of Goods Sold:
       Opening Inventory (records)	$(b)		$80
       Purchases (records)	(b)		300
       Cost of Goods Available for Sale	(c)		380
       Ending Inventory	(d)?		(e)?
       Cost of Goods Sold		(a)?		(f)?
       Gross Profit (same as Sales)		$-0-		(g)?

       (a) Cost of Goods restated at retail to equal sales	= $500
       (b) Opening Inventory and Purchases re-stated at retail	= $300 × 200% = $600;
       	= 80 × 200% = 160
       (c) Cost of Goods Available at retail	= $600 (b) + 160 (b)
       	= $760
       (d) Ending Inventory at retail	= $760 (c) − 500 (a)
       = Cost of Goods Available at retail − Cost of Goods Sold at retail	= $260
       (e) Inventory at cost = Inventory at retail/200%	= $260 (c)/200%
       	= $130
       (f) Cost of Goods Sold at cost	= $380 − 130(e) = $250
       (e) Gross Profit at cost	= $500 − $250(e) = $250

14. The gross profit method is particularly useful in cases where goods have been stolen or lost in a fire; in such cases it is not possible to determine the balance in the ending inventory by a physical count when the periodic inventory system is used.
15. The retail inventory method assumes an average inventory cost flow assumption because the cost percentage used to calculate ending inventory and cost of goods sold is based on a constant mark-up.

Exercises

EXERCISE 6–1

EXERCISE 6–2

EXERCISE 6–3

Weighted Average (per unit costs must be rounded to two decimal places)

		Purchased (Sold)					Balance
Date		Units		Unit Cost		COGS	Units	Unit Cost	Total Cost
Jan. 1	Opening Inventory						2,000	$0.50	$1,000
5	Sales #1	(1,200)	×	$0.50		($600)	800		400
6	Purchase #1	1,000	×	2.00			1,800	1.33\(^{1}\)	2,400
10	Purchase #2	500	×	1.00			2,300	1.26\(^{2}\)	2,900
16	Sale #2	(2,000)	×	1.26	=	(2,520)	300		380
21	Purchase #3	1,000	×	2.50			1,300	2.22\(^{3}\)	$2,880

\(^{1}\)[$400 + (1,000 × $2)]/(800 + 1,000) = $1.33/unit (rounded)

\(^{2}\)[$2,400 + (500 × 1)]/(1,800 + 500) = $1.26/unit (rounded)

\(^{3}\)[$380 + (1,000 × 2.50)]/(300 + 1,000) = $2.22/unit (rounded)

1. The entry for the January 5 sale:

   General Journal
   Date	Account/Explanation	F	Debit	Credit
   Jan. 5	Accounts Receivable		6,000
   	Sales			6,000
   	Cost of Goods Sold		600
   	Merchandise Inventory			600
   	To record Jan. 5 sales: 1,200 units × $5.00/unit selling price = $6,000.

2. The entry for the January 16 sale:

   General Journal
   Date	Account/Explanation	F	Debit	Credit
   Jan. 16	Accounts Receivable		12,000
   	Sales			12,000
   	Cost of Goods Sold		2,520
   	Merchandise Inventory			2,520
   	To record Jan. 16 sales: 2,000 units × $6.00/unit selling price = $12,000.

3. Per the above table, there are 1,300 units on hand @ $2.22 (rounded), for a total ending inventory cost of $2,880. Be careful to note that the total ending inventory cost of $2,880 is NOT calculated as 1,300 units × the average unit cost of $2.22. The $2,880 is calculated as the inventory balance of $380 on January 16 plus the January 21 purchase of $2,500.

EXERCISE 6–4

N/E = No Effect; O = Overstated; U = Understated

	2016 Statements				2017 Statements
Errors	Opening Invent.	Ending Invent.	2016 Total Assets	2016 Net Income	Opening Invent.	Ending Invent.	2017 Total Assets	2017 Net Income
1. Goods purchased in 2016 were included in the December 31, 2016 inventory, but the transaction was not recorded until early 2017.	N/E	U	U	U	U	N/E	N/E	O
2. Goods purchased in 2017 were included in December 31, 2016 inventory, and the transaction was recorded in 2016.	N/E	O	O	O	O	N/E	N/E	U

EXERCISE 6–5

1. 1. Ending inventory for 2021 was understated by $2,000. Thus, cost of goods sold should have been $18,000 and gross profit, $12,000. Because of this mistake, the 2022 opening inventory was also understated by $2,000, causing cost of goods sold to be understated by $2,000 and gross profit overstated by $2,000; gross profit in 2022 should have been $15,000. There is no impact on 2023 as a result of the error.
   2. The 2023 ending inventory was overstated by $5,000. Thus, cost of goods sold should have been $30,000 and gross profit, $20,000. This error does not impact 2021 or 2022.
2. For 2021, the merchandise inventory on the balance sheet was understated by $2,000. Thus, the total assets were $2,000 less than they should have been. For 2022, there is no effect on the balance sheet, as the error is in opening inventory. For 2023, the ending inventory in the balance sheet is overstated by $5,000, which means that total assets were overstated by $5,000.

EXERCISE 6–6

1. LCNRV on a unit-by-unit basis: (2 × $50) + (3 × $75) + (4 × $20) = $405

   Therefore, LCNRV = $405 on a unit-by-unit basis.

2. LCNRV on a group inventory basis: Total cost of the group: (2 × $50) + (3 × $150) + (4 × $25) = $650 Total NRV of the group: (2 × $60) + (3 × $75) + (4 × $20) = $425

   Therefore, LCNRV = $425 on a group inventory basis.

EXERCISE 6–7

1. Estimated amount of inventory lost in the fire:

   Sales		$300,000	100%
   Cost of Goods Sold:
   Opening Inventory	$80,000
   Purchases	150,000
   Cost of Goods Available	230,000
   Ending Inventory (estimated)	(iii)
   Cost of Goods Sold		(ii)	65%
   Gross Profit		(i)	35%

   (i)	Gross Profit	= 35% of Sales
   		= 35% × $300,000
   		= $105,000

   (ii)	Cost of Goods Sold	= Sales − Gross Profit
   		= $300,000 − 105,000
   		= $195,000

   (iii)	Estimated Ending Inventory	= Cost of Goods Available − Total Cost of Goods Sold
   		= $230,000 − 195,000
   		= $35,000

2. Balton lost about $35,000 of inventory in the fire and is claiming $45,000. This does not appear reasonable.

EXERCISE 6–8

1. Merchandise inventory turnover for each of the years 2022 to 2025:

   	2025	2024	2023	2022	2021
   Cost of Goods Sold	370,000	400,000	420,000	440,000	450,000
   Merchandise Inventory	120,000	111,250	88,750	111,250	88,750
   Merchandise Inventory Turnover	3.2	4	4.2	4.4

2. The change in Able Corp.'s Merchandise Inventory Turnover ratio is unfavourable because inventory is being sold at a slower rate from 2022 to 2025, from 4.4 times per year in 2022 to 3.2 times per year in 2025.

Problems

PROBLEM 6–1

1. Weighted Average Cost Flow Assumption:

   Product A
   		Purchased (Sold)					Balance
   Date		Units		Unit Cost		COGS	Units		Unit Cost		Total Cost
   Jan. 1	Opening Inventory						4,000	×	$11.90	=	$47,600
   Jan. 7	Purchase #1	8,000	×	$12.00			12,000	×	11.97\(^{1}\)	=	143,600
   Mar. 30	Sale #1	(9,000)	×	11.97	=	($107,730)	3,000	×		=	35,870
   May 10	Purchase #2	12,000	×	12.10			15,000	×	12.07\(^{2}\)	=	181,070
   Jul. 4	Sale #2	(14,000)	×	12.07	=	(168,980)	1,000	×		=	$12,090

   \(^{1}\)[$47,600 + (8,000 × $12)]/(4,000 + 8,000) = $11.97/unit (rounded)

   \(^{2}\)[$35,870 + (12,000 × $12.10)]/(3,000 + 12,000) = $12.07/unit (rounded)

   Product B
   		Purchased (Sold)					Balance
   Date		Units		Unit Cost		COGS	Units		Unit Cost		Total Cost
   Jan. 1	Opening Inventory						2,000	×	$13.26	=	$26,520
   Jan. 13	Purchase #1	5,000	×	$13.81			7,000	×	13.65\(^{3}\)	=	95,570
   Jul. 15	Sale #1	(1,000)	×	13.65	=	($13,650)	6,000	×		=	81,920
   May 10	Purchase #2	7,000	×	14.21			13,000	×	13.95\(^{4}\)	=	181,390
   Dec. 14	Sale #2	(8,000)	×	13.95	=	(111,600)	5,000	×		=	$69,790

   \(^{3}\)[$26,520 + (5,000 × $13.81)]/(2,000 + 5,000) = $13.65/unit (rounded)

   \(^{4}\)[$81,920 + (7,000 × $14.21)]/(6,000 + 7,000) = $13.95/unit (rounded)

2. Total ending inventory at December 31, 2020:

   Product A	$12,090
   Product B	69,790
   Total	$81,880

3. Gross profit percentage earned:

   	Product A		Product B
   Mar. 30 Sale	144,000	Jul. 15 Sale	20,000
   Jul. 04 Sale	238,000	Dec. 14 Sale	168,000
   Total Sales	382,000	Total Sales	188,000
   COGS	276,710	COGS	125,250
   Gross Profit	105,290	Gross Profit	62,750
   Gross Profit %	27.56	Gross Profit %	33.38

PROBLEM 6–2

1. Inventory Record – FIFO

   		Purchases/Shipping costs/ Purchase returns, discounts and allowances			Cost of Goods Sold/ Returns to Inventory			Balance in Inventory
   Date	Description	Units	Cost/Unit	Total	Units	Cost/Unit	Total	Units	Cost/Unit	Total
   Jan 1	Inventory, opening							500	$ 10	5,000
   4	Sale of 100 units @ $20				100	$ 10	1,000	400	$ 10	4,000
   								400	$ 10	4,000
   6	Purchase	200	$ 11	2,200				200	$ 11	2,200
   								400	$ 10	4,000
   8	Purchase return (from Jan 6 purchase)	(10)	$ 11	(110)				190	$ 11	2,090
   9	Sale of 200 unit @ $22				200	$ 10	2,000	200	$ 10	2,000
   								190	$ 11	2,090
   10	Sales return from customer from Jan 4 sale				(15)	$10	(150)	215	$ 10	2,150
   	(returned to inventory)							190	$ 11	2,090
   15	Sale of 150 units @ $23				150	$ 10	1,500	65	$ 10	650
   								190	$ 11	2,090
   								65	$ 10	650
   								190	$ 11	2,090
   17	Purchase	300	$ 9	2,700				300	$ 9	2,700
   19	Sales return from customer from Jan 15 sale (beyond repair, disposed)				no entry disposed			65	$ 10	650
   								190	$ 11	2,090
   								300	$ 9	2,700
   20	Sale of 400 units @ $21				65	$ 10	650	0	$ 10	–
   					190	$ 11	2,090	0	$ 11	–
   					145	$ 9	1,305	155	$ 9	1,395
   	Total				835		8,395	155	$ 9	1,395

2. Sales:

   Sale of 100 units @ $20	$	2,000.00
   Sale of 200 unit @ $22	$	4,400.00
   Sales return of 15 units @ $20	$	(300.00)
   Sale of 150 units @ $23	$	3,450.00
   Sales return of 2 units @ $20	$	(40.00)
   Sale of 400 units @ $21	$	8,400.00
   Total sales	$	17,910.00
   Cost of goods sold	$	8,395.00
   Gross profit	$	9,515.00
   Gross profit %		53.13%

3. Ending inventory balance, Jan 20, 2016: $1,395.00

PROBLEM 6–3

1. Weighted Average Cost

   		Purchases/Shipping costs/Purchase returns, discounts and allowances			Cost of Goods Sold/Returns to Inventory			Balance in Inventory
   Date	Description	Units	Cost/Unit	Total	Units	Cost/Unit	Total	Units	Cost/Unit	Total
   Feb 1	Opening inventory							75	$ 12.00	900
   5	Sale				70	$12.00	840	5	$ 12.00	60
   7	Purchase	300	$ 11.00	3,300				305	$ 11.02	3,360
   12	Sale				180	$11.02	1,984	125	$ 11.01	1,376
   14	Purchase return from Feb 7	(10)	$ 11.00	(110)				115	$ 11.01	1,266
   17	Sale				100	$11.01	1,101	15	$ 11.00	165
   19	Purchase	400	$ 9.00	3,600				415	$ 9.07	3,765
   23	Sale				80	$ 9.07	726	335	$ 9.07	3,039
   	Total				430		4,651	335	$ 9.07	3,039

2. Sales:

   430 units × $24	$	10,320
   Cost of goods sold	$	4,651
   Gross profit	$	5,669
   Gross profit %		54.93%

3. Ending inventory balance, Jan 20, 2016: $1,395

PROBLEM 6–4

2015

If ending inventory was overstated by $45,000, then COGS is understated causing net income to be overstated. This will cause equity to also be overstated.

	COGS	Net Income	Total Assets	Equity
Unadjusted balance	$ 500,000	$ 250,000	$ 1,500,000	$ 1,400,000
Correction	45,000	(45,000)	(45,000)	(45,000)
Corrected balance	$ 545,000	$ 205,000	$ 1,455,000	$ 1,355,000

2016

If ending inventory was overstated by $45,000 in 2015, then opening inventory will also be overstated in 2016. This will cause COGS to be overstated in 2016 causing net income to be understated. Since equity was overstated in 2015, this overstatement for 2016 will cancel out the previous year's error and equity will no longer contain any errors.

	COGS	Net Income	Total Assets	Equity
Unadjusted balance	$ 660,000	$ 350,000	$ 1,400,000	$ 1,300,000
Correction	(45,000)	45,000	0	0
Corrected balance	$ 615,000	$ 395,000	$ 1,400,000	$ 1,300,000

PROBLEM 6–5

2015

If ending inventory was understated by $30,000, then COGS is overstated causing net income to be understated. This will cause equity and total assets to also be understated.

	COGS	Net Income	Total Assets	Equity
Unadjusted balance	$ 500,000	$ 250,000	$ 1,500,000	$ 1,400,000
Correction	(30,000)	30,000	30,000	30,000
Corrected balance	$ 470,000	$ 280,000	$ 1,530,000	$ 1,430,000

2016

If ending inventory was understated by $30,000 in 2015, then opening inventory will also be understated in 2016. This will cause COGS to be understated in 2016 causing net income to be overstated. Since equity was overstated in 2015, this understatement for 2016 will cancel out the previous year's error and equity will no longer contain any errors. There are no errors in the ending inventory for 2016, so there are no mis-statements for assets.

	COGS	Net Income	Total Assets	Equity
Unadjusted balance	$ 660,000	$ 350,000	$ 1,400,000	$ 1,300,000
Correction	30,000	(30,000)	0	0
Corrected balance	$ 690,000	$ 320,000	$ 1,400,000	$ 1,300,000

PROBLEM 6–6

2. 						LCNRV	LCNRV
   Ceramic Wall Tiles:	# of Units	Cost/Unit	NRV/Unit	Total Cost	Total NRV	by Group	by Product
   White	1,025	$ 5.00	$ 6.00	$ 5,125.00	$ 6,150.00		5,125
   Black	875	4.50	4.25	3,937.50	3,718.75		3,719
   Slate	645	7.00	7.11	4,515.00	4,585.95		4,515
   Beige	325	2.00	2.25	650.00	731.25		650
   				14,227.50	15,185.95	$ 14,228
   Marble Flooring:
   Cordoba	10,000	9.25	9.35	92,500.00	93,500.00		92,500
   Carrerra	12,000	10.50	10.50	126,000.00	126,000.00		126,000
   Maricha	8,000	11.50	11.45	92,000.00	91,600.00		91,600
   				310,500.00	311,100.00	310,500
   Shower Waterproofing:
   Novo	10,035	9.85	9.50	98,844.75	95,332.50		95,333
   Deetra	15,000	6.75	7.15	101,250.00	107,250.00		101,250
   				200,094.75	202,582.50	200,095
   Totals				$ 524,822.25		$ 524,822	$ 520,692

3. No entry required by group.

   By individual product:

   General Journal
   Date	Account/Explanation	F	Debit	Credit
   	Cost of goods sold		4,130
   	Merchandise inventory			4,130
   	($524,822−520,692)

PROBLEM 6–7

1. Goods available for sale:
   Inventory, opening balance		$ 420,364
   Purchases	1,323,280
   Purchase returns	(18,270)
   Transportation-in	9,660	1,314,670
   Goods available for sale:		$1,735,034
   Sales	1,667,610
   Sales returns	(13,230)
   Net sales	1,654,380
   Estimated COGS
   ($1,654,380 × (1 − 34%))		(1,091,891)
   Estimated March 31, 2017 inventory		$ 643,143

2. Varane Ltd. Income Statement for the First Quarter ending March 31, 2017
   Sales	$ 1,667,610
   Less: Sales returns and allowances	13,230
   Net sales	1,654,380
   Cost of goods sold	1,091,891
   Gross profit from sales	562,489	34%
   Operating expenses
   Total operating expenses	130,500
   Income before tax	431,989
   Income tax expense	129,597
   Net income	$ 302,392

PROBLEM 6–8

1. 		At Cost	At Retail
   Goods available for sale:
   Inventory, opening balance		$ 659,890	$ 1,298,010
   Purchases		4,660,362	8,958,180
   Purchase returns		(73,920)	(167,090)
   Goods available for sale:		$ 5,246,332	$ 10,089,100
   Sales	$ 7,693,980
   Sales returns	(62,440)		$ 7,631,540
   Ending inventory at retail			$ 2,457,560
   Ratio of Cost to retail ($5,246,332÷$10,089,100)×100			52.00%
   Ending inventory at cost			$ 1,277,931

2. Ceabane Ltd. Income Statement for the Six Months ending June 30, 2017
   Sales	$ 7,693,980
   Less: Sales returns and allowances	62,440
   Net sales	7,631,540
   Cost of goods sold\(^{*}\)	3,968,401
   Gross profit from sales	3,663,139
   Operating expenses
   Total operating expenses	1,500,000
   Income before tax	2,163,139
   Income tax expense	648,942
   Net income	$ 1,514,197

   \(^{*}\) $5,246,332−1,277,931=3,968,401

PROBLEM 6–9

1. Ending inventory for 2016 was overstated by $2,000. Thus, cost of goods sold should have been $2,000 higher, or $22,000 and gross profit $2,000 lower, or $28,000. Because of this mistake, the 2017 opening inventory was also overstated by $2,000, causing cost of goods sold to be overstated by $2,000 and gross profit to be understated by $2,000. Gross profit should have been $29,000.
2. 2016 total and net assets were overstated by $2,000. 2017 total assets and net assets were correct.

PROBLEM 6–10

	2017			2018
	Cost	Market	Unit Basis (LCNRV)	Cost	Market	Unit Basis (LCNRV)
Product X	$14,000	$15,000	$14,000	$15,000	$16,000	$15,000
Product Y	12,500	12,000	12,000	12,000	11,500	11,500
Product Z	11,000	11,500	11,000	10,500	10,000	10,000
Total	$37,500	$38,500	$37,000	$37,500	$37,500	$36,500