# 6.12: Solutions


## Discussion Questions

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.
1. 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.
2. 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.
3. 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.

4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. When inventory is valued at LCNRV, cost refers to the laid-down cost.
10. The inventory cost flow assumptions permissible under GAAP are specific identification, FIFO or average cost.
11. 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.
12. 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
13. 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.
14. 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 6–3

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.
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. 1. 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)

#### 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

1.  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
2. No entry required by group.

By individual product:

#### 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

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