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3 Purchased 8 bicycles costing $250 each.
5 Sold 12 bicycles, $400 each.
18 Purchased 16 bicycles costing $300 each.
20 Purchased 10 bicycles costing $320 each.
25 Sold 16 bicycles, $400 each.

When a perpetual system is used and sales occur during the period, the identification of the last
in units must be evaluated at the time of each individual sale, as follows:
September 5 sale of 12 bicycles, identification of last in units:
8 bicycles purchased on September 3, $250 each . . . . . . . . . . . . . . . . . . $2,000
4 bicycles in beginning inventory, $200 each . . . . . . . . . . . . . . . . . . . . . . 800
$2,800

September 25 sale of 16 bicycles, identification of last in units:
10 bicycles purchased on September 20, $320 each. . . . . . . . . . . . . . . . . $3,200
6 bicycles purchased on September 18, $300 each . . . . . . . . . . . . . . . . . 1,800
5,000
Total perpetual LIFO cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . $7,800

This $7,800 amount for LIFO cost of goods sold under a perpetual inventory system com-
pares to the $8,500 LIFO cost of goods sold computed earlier in the chapter assuming a peri-
odic inventory system. Again, the difference arises because the last in units are identified at
the end of the period with a periodic system; with a perpetual system, the last in units are
identified at the time of each individual sale.
A similar difference arises with the average cost method because, with a perpetual system,
a new average cost per unit must be determined at the time each individual sale is made. This
process is illustrated as follows:
September 5 sale of 12 bicycles, determination of average cost:
10 bicycles in beginning inventory, $200 each . . . . . . . . . . . . . . . . . . . . . $2,000
8 bicycles purchased on September 3, $250 each . . . . . . . . . . . . . . . . . . 2,000
Total cost of goods available for sale on September 5. . . . . . . . . . . . . . . $4,000

Average cost on September 5: $4,000 18 bicycles $222.22 per bicycle
September 5 cost of goods sold:
12 bicycles $222.22 per bicycle $2,667 (rounded)

September 25 sale of 16 bicycles, determination of average cost:
6 (18 12) bicycles; remaining cost ($4,000 $2,667). . . . . . . . . . . . . . . $1,333
16 bicycles purchased on September 18, $300 each. . . . . . . . . . . . . . . . . 4,800
10 bicycles purchased on September 20, $320 each. . . . . . . . . . . . . . . . . 3,200
Total cost of goods available for sale on September 25 . . . . . . . . . . . . . . $9,333

Average cost on September 25: $9,333 32 bicycles $291.66 per bicycle
September 25 cost of goods sold:
16 bicycles $291.66 per bicycle $4,667 (rounded)
Total cost of goods sold: $2,667 $4,667 $7,334

This $7,334 cost of goods sold under the perpetual average method compares with $7,636
cost of goods sold under the periodic average method. Again, the difference is that one overall
average cost for all goods available for sale during the period is used with a periodic system; with
a perpetual system, a new average cost is computed at the time of each sale.
By the way, no complications arise in using FIFO with a perpetual system. This is be-
cause, no matter when sales occur, the first in units are always the same ones. So, FIFO
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periodic and FIFO perpetual yield the same numbers for cost of goods sold and ending in-
ventory.
Because of the complications associated with computing perpetual LIFO and perpetual av-
erage cost, many businesses that use average cost or LIFO for financial reporting purposes use
a simple FIFO assumption in maintaining their day-to-day perpetual inventory records. The
perpetual FIFO records are then converted to periodic average cost or LIFO for the financial
reports.




to summarize
Using the average cost and LIFO inventory cost flow assumptions with a per-
petual inventory system leads to some complications. These complications
arise because the identity of the last in units changes with each new inven-
tory purchase, as does the average cost of units purchased up to that point.




8 REPORTING INVENTORY AT AMOUNTS BELOW
COST
Apply the lower-of-cost-or-
market method of
accounting for inventory.
All the inventory costing alternatives we have discussed in this chapter have one thing in com-
mon: they report inventory at cost. Occasionally, however, it becomes necessary to report in-
ventory at an amount that is less than cost. This happens when the future value of the inven-
tory is in doubt when it is damaged, used, or obsolete, or when it can be replaced new at a
price that is less than its original cost.

Inventory Valued at Net Realizable Value
When inventory is damaged, used, or obsolete, it should be reported at no more than its net
net realizable value The
selling price of an item less realizable value. This is the amount the inventory can be sold for, minus any selling costs. Sup-
reasonable selling costs. pose, for example, that an automobile dealer has a demonstrator car that originally cost $18,000
and now can be sold for only $16,000. The car should be reported at its net realizable value. If
a commission of $500 must be paid to sell the car, the net realizable value is $15,500, or $2,500
less than cost. This loss is calculated as follows:
Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,000
Estimated selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000
Less selling commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 15,500
Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,500

To achieve a good matching of revenues and expenses, a company must recognize this es-
timated loss as soon as it is determined that an economic loss has occurred (even before the car
is sold). The journal entry required to recognize the loss and reduce the inventory amount of
the car is:

Loss on Write-Down of Inventory (Expense) . . . . . . . . . . . . . . . . . . . . . . 2,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
To write down inventory to its net realizable value.


By writing down inventory to its net realizable value, a company recognizes a loss when
it happens and shows no profit or loss when the inventory is finally sold. Using net realizable
values means that assets are not being reported at amounts that exceed their future economic
benefits.
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Inventory Valued at Lower of Cost or Market
Inventory must also be written down to an amount below cost if it can be replaced new at a
price that is less than its original cost. In the electronics industry, for instance, the costs of com-
puters and compact disc players have fallen dramatically in recent years. When goods remain-
ing in ending inventory can be replaced with identical goods at a lower cost, the lower unit cost
must be used in valuing the inventory (provided that the replacement cost is not higher than
net realizable value or lower than net realizable value minus a normal profit). This is known as
the lower-of-cost-or-market (LCM) rule. (In a sense, a more precise name would be the lower-
lower-of-cost-or-market
(LCM) rule A basis for valu- of-actual-or-replacement-cost rule.)
ing inventory at the lower The ceiling, or maximum market amount at which inventory can be carried on the books,
of original cost or current
is equivalent to net realizable value, which is the selling price less estimated selling costs. The
market value.
ceiling is imposed because it makes no sense to value an inventory item above the amount that
ceiling The maximum mar- can be realized upon sale. For example, assume that a company purchased an inventory item for
ket amount at which inven- $10 and expected to sell it for $14. If the selling costs of the item amounted to $3, the ceiling
tory can be carried on the
or net realizable value would be $11 ($14 $3).
books; equal to net realiz-
The floor is defined as the net realizable value minus a normal profit. Thus, if the inven-
able value.
tory item costing $10 had a normal profit margin of 20%, or $2, the floor would be $9 (net
floor The minimum market realizable value of $11 less normal profit of $2). This is the lowest amount at which inventory
amount at which inventory
should be carried in order to prevent showing losses in one period and large profits in subse-
can be carried on the
quent periods.
books; equal to net realiz-
In applying this LCM rule, you can follow certain basic guidelines:
able value minus a normal
profit.
1. Define market value as:
a. replacement cost, if it falls between the ceiling and the floor.
b. the floor, if the replacement cost is less than the floor.
c. the ceiling, if the replacement cost is higher than the ceiling.
(As a practical matter, when replacement cost, ceiling, and floor are compared, market is
always the middle value.)
2. Compare the defined market value with the original cost and choose the lower amount.

The following chart gives four separate examples of the application of the LCM rule; the re-
sulting LCM amount is highlighted in each case.


Market

Number Net Net Realizable
of Original Realizable Value Minus
Items in Cost (LIFO, Replacement Value Normal Profit
Item Inventory FIFO, etc.) Cost (Ceiling) (Floor)

A 10 $17 $16 $15 $10
B 8 21 18 23 16
C 30 26 21 31 22
D 20 19 16 34 25



The LCM rule can be applied in one of three ways: (1) by computing cost and market fig-
ures for each item in inventory and using the lower of the two amounts in each case, (2) by
computing cost and market figures for the total inventory and then applying the LCM rule to
that total, or (3) by applying the LCM rule to categories of inventory. For a clothing store, cat-
egories of inventory might be all shirts, all pants, all suits, or all dresses.
To illustrate, we will use the above data to show how the LCM rule would be applied to
each inventory item separately and to total inventory. (The third method is similar to the sec-
ond, except that it may involve several totals, one for each category of inventory.)
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Number of LCM for
Items in Individual
Item Inventory Original Cost Market Value Items

A 10 $17 10 units $ 170 $15 10 units $ 150 $ 150
B 8 $21 8 units 168 $18 8 units 144 144
C 30 $26 30 units 780 $22 30 units 660 660
D 20 $19 20 units 380 $25 20 units 500 380
$1,498 $1,454 $1,334

$44
$164




Using the first method, applying the LCM rule to individual items, inventory is valued at
$1,334, a write-down of $164 from the original cost. With the second method, using total in-
ventory, the lower of total cost ($1,498) or total market value ($1,454) is used for a write-
down of $44. The write-down is smaller when total inventory is used because the increase in
market value of $120 in item D offsets decreases in items A, B, and C. In practice, each of the
three methods is acceptable, but once a method has been selected, it should be followed con-
sistently.
The journal entry to write down the inventory to the lower of cost or market applying the
LCM rule to individual items is:


Loss on Write-Down of Inventory (Expense) . . . . . . . . . . . . . . . . . . . . . . . . 164
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
To write down inventory to lower of cost or market.



The amount of this entry would have been $44 if the LCM rule had been applied to total in-
ventory.
The LCM rule has gained wide acceptance because it reports inventory on the balance sheet
at amounts that are consistent with future economic benefits. With this method, losses are rec-
ognized when they occur, not necessarily when a sale is made.




to summarize
The recorded amount of inventory should be written down (1) when it is
damaged, used, or obsolete and (2) when it can be replaced (purchased new)
at an amount that is less than its original cost. In the first case, inventory is
reported at its net realizable value, an amount that allows a company to break
even when the inventory is sold. In the second case, inventory is written
down to the lower of cost or market. When using the lower-of-cost-or-market
rule, market is defined as falling between the ceiling and floor. Ceiling is de-
fined as the net realizable value; floor is net realizable value minus a normal
profit margin. In no case should inventory be reported at an amount that ex-
ceeds the ceiling or is less than the floor. These reporting alternatives are
attempts to show assets at amounts that reflect realistic future economic
benefits.
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9 METHOD OF ESTIMATING INVENTORIES
Explain the gross margin
We have assumed that the number of inventory units on hand is known by a physical count
method of estimating
inventories. that takes place at the end of each accounting period. For the periodic inventory method, this
physical count is the only way to determine how much inventory is on hand at the end of a pe-
riod. For the perpetual inventory method, the physical count verifies the quantity on hand or
indicates the amount of inventory shrinkage or theft. There are times, however, when a com-
pany needs to know the dollar amount of ending inventory, but a physical count is either im-
possible or impractical. For example, many firms prepare quarterly, or even monthly, financial
statements, but it is too expensive and time-consuming to count the inventory at the end of
each period. In such cases, if the perpetual inventory method is being used, the balance in the
inventory account is usually assumed to be correct. With the periodic inventory method, how-
ever, some estimate of the inventory balance must be made. A common method of estimating
the dollar amount of ending inventory is the gross margin method.


The Gross Margin Method
With the gross margin method, a firm uses available information about the dollar amounts of
gross margin method A
procedure for estimating beginning inventory and purchases, and the historical gross margin percentage to estimate the
the amount of ending in- dollar amounts of cost of goods sold and ending inventory.
ventory; the historical rela-
To illustrate, we will assume the following data for Payson Brick Company:
tionship of cost of goods
sold to sales revenue is
Net sales revenue, January 1 to March 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
used in computing ending
inventory. Inventory balance, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Net purchases, January 1 to March 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
Gross margin percentage
(historically determined percentage of net sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . 40%


With this information, the dollar amount of inventory on hand on March 31 is estimated as
follows:


Percentage
Dollars of Sales

Net sales revenue . . . . . . . . . . . . . . . . . . . . . . . $100,000 100%
Cost of goods sold:
Beginning inventory. . . . . . . . . . . . . . . . . . . . $15,000
Net purchases . . . . . . . . . . . . . . . . . . . . . . . . 65,000
Total cost of goods available for sale . . . . . . . $80,000
Ending inventory ($80,000 $60,000) . . . . . . 20,000 (3)*
Cost of goods sold ($100,000 $40,000) . . . . . . 60,000 (2)* 60%
Gross margin ($100,000 0.40) . . . . . . . . . . . . $ 40,000 (1)* 40%

*The numbers indicate the order of calculation.


In this example, gross margin is first determined by calculating 40% of sales (step 1). Next,
cost of goods sold is found by subtracting gross margin from sales (step 2). Finally, the dollar
amount of ending inventory is obtained by subtracting cost of goods sold from total cost of
goods available for sale (step 3). Obviously, the gross margin method of estimating cost of goods
sold and ending inventory assumes that the historical gross margin percentage is appropriate for
the current period. This assumption is a realistic one in many fields of business. In cases where
the gross margin percentage has changed, this method should be used with caution.
The gross margin method of estimating ending inventories is also useful when a fire or other
calamity destroys a company s inventory. In these cases, the dollar amount of inventory lost must
be determined before insurance claims can be made. The dollar amounts of sales, purchases, and
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beginning inventory can be obtained from prior years financial statements and from customers,
suppliers, and other sources. Then the gross margin method can be used to estimate the dollar
amount of inventory lost.



to summarize
The gross margin method is a common technique for estimating the dollar
amount of inventory. The historical gross margin percentage is used in con-
junction with sales to estimate cost of goods sold. This estimated cost of goods
sold amount is subtracted from cost of goods available for sale to yield an es-
timate of ending inventory.




review of learning objectives

Identify what items and costs should be included in in ending inventory on reported cost of goods sold. Ob-
1 inventory and cost of goods sold. Inventory is com- taining an accurate inventory amount involves counting the
posed of goods held for sale in the normal course of business. physical units and then properly computing the cost of those
Cost of goods sold is the cost of inventory sold during the pe- units. Special care must be taken in dealing with goods in tran-
riod. For a manufacturing firm, the three types of inventory sit and consigned goods. When a perpetual inventory system
are raw materials, work in process, and finished goods. All costs is used, the ending inventory count provides an opportunity
incurred in producing and getting inventory ready to sell to compute inventory shrinkage. When ending inventory is
should be added to inventory cost. The costs associated with not correctly counted, both cost of goods sold and net income
the selling effort itself are operating expenses of the period. In- will be reported incorrectly. For example, an overstatement in
ventory should be recorded on the books of the company hold- ending inventory leads to an overstatement in reported net in-
ing legal title. Goods in transit belong to the company paying come.
for the shipping. Goods on consignment belong to the sup-
plier/owner, not to the business holding the inventory for pos- Apply the four inventory cost flow alternatives: spe-
4
sible sale. At the end of an accounting period, the total cost cific identification, FIFO, LIFO, and average cost.
of goods available for sale during the period must be allocated The four major costing methods used in accounting for in-
between ending inventory and cost of goods sold. ventories are specific identification, FIFO, LIFO, and average
cost. Each of these may result in different dollar amounts of
Account for inventory purchases and sales using both ending inventory, cost of goods sold, gross margin, and net
2 a perpetual and a periodic inventory system. With a income. A firm may choose any costing alternative without re-
perpetual inventory system, the inventory account is adjusted gard to the way goods physically flow through that firm. With
for every sale or purchase transaction. Discounts on purchases, FIFO, the oldest units are assumed to be sold first; with LIFO,
returns of merchandise, and the cost of transporting goods in- the newest units are assumed to be sold first. LIFO matches
tended for resale into the firm are also adjustments made di- current revenues and current expenses in the income state-
rectly to the inventory account. With a periodic inventory sys- ment; FIFO results in current values being reported in the bal-
tem, inventory-related items are recorded in temporary holding ance sheet. During an inflationary period, LIFO provides the
accounts that are closed to Inventory at the end of the period. lowest reported income and, therefore, lower taxes.
The closing entries for a periodic system involve closing Pur-
chases, Freight In, Purchase Returns, and Purchase Discounts Use financial ratios to evaluate a company s inven-
5
to Inventory, and then adjusting the inventory account bal- tory level. Companies assess how well their inventory is
ance to reflect the appropriate amount given the results of the being managed by using two ratios: (1) inventory turnover and
ending inventory physical count. (2) number of days sales in inventory. Inventory turnover is
computed as cost of goods sold divided by average inventory;
Calculate cost of goods sold using the results of an it tells how many times during the period the company turned
3 inventory count and understand the impact of errors over, or replenished, its inventory. The number of days sales
325
f326 Inventory
Part 2 EOC Operating Activities


in inventory is computed by dividing 365 by the inventory sumptions with a perpetual inventory system leads to some
turnover value. A company s choice of inventory cost flow as- complications. These complications arise because the identity
sumption can significantly affect the values of these inventory of the last in units changes with each new inventory pur-
ratios. The sum of the average collection period and the num- chase, as does the average cost of units purchased up to that
ber of days sales in inventory is the length of time between point.
the purchase of inventory and the collection of cash from the
sale of that inventory. Comparing this sum to the number of Apply the lower-of-cost-or-market method of ac-
8
days purchases in accounts payable reveals how much of a counting for inventory. Sometimes inventory must be
company s operating cycle it must finance through external fi- reported at amounts below cost. This occurs (1) when inven-
nancing. tory is damaged, used, or obsolete, or (2) when the replace-
ment cost drops below the original inventory cost. In the first
case, inventory is valued at a net realizable value; in the sec-
ond, it is valued at the lower of cost or market. When lower-
of-cost-or-market valuation is used, market is defined as the
Analyze the impact of inventory errors on reported
6 replacement cost of the inventory; in no case can the value be
cost of goods sold. Inventory errors can have a signifi- greater than the item s net realizable value (the ceiling) or less
cant effect on reported cost of goods sold, gross margin, and than net realizable value minus a normal profit (the floor).
net income. In addition, a misstatement of an ending inven-
tory balance affects net income, both in the current year and Explain the gross margin method of estimating in-
9
in the next year. Errors in beginning and ending inventory ventories. Although most firms take a physical count of
have the opposite effect on cost of goods sold, gross margin, inventory at the end of each year, they sometimes need to es-
and net income. Errors in inventory correct themselves after timate the value of inventory prior to year-end. The gross mar-
two years if the physical count at the end of the second year gin method is a common technique for estimating the dollar
shows the correct amount of ending inventory for that period. amount of inventory. The historical gross margin percentage
is used in conjunction with sales to estimate cost of goods sold.
Describe the complications that arise when LIFO or
7 This estimated cost of goods sold amount is subtracted from
average cost is used with a perpetual inventory sys- cost of goods available for sale to yield an estimate of ending
tem. Using the average cost and LIFO inventory cost flow as- inventory.




key terms and concepts

average cost 308 inventory shrinkage 305 specific identification 309
consignment 297 inventory turnover 313 work in process 296
cost of goods available for sale 298 LIFO (last in, first out) 308
cost of goods sold 295 net purchases 304
FIFO (first in, first out) 308 number of days purchases in
accounts payable 315 ceiling 322
finished goods 296
number of days sales in inventory floor 322
FOB (free-on-board) destination
313
297 gross margin method 324
periodic inventory system 299
FOB (free-on-board) shipping point lower-of-cost-or-market (LCM) rule
297 perpetual inventory system 299 322
inventory 295 raw materials 296 net realizable value 321
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review problem

Inventory Cost Lehi Wholesale Distributors buys printers from manufacturers and sells them to office supply
Flow Alternatives stores. During January 2003, its periodic inventory records showed the following:
Jan. 1 Beginning inventory consisted of 26 printers at $200 each.
10 Purchased 10 printers at $220 each.
15 Purchased 20 printers at $250 each.
28 Purchased 9 printers at $270 each.
31 Sold 37 printers.
Calculate ending inventory and cost of goods sold, using:
Required:
1. FIFO inventory.
2. LIFO inventory.
3. Average cost.
Solution When computing ending inventory and cost of goods sold, it is usually easiest to get an overview
first. The following calculations are helpful:
Beginning inventory, 26 units at $200 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,200
Purchases: 10 units at $220 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,200
20 units at $250 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
9 units at $270 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,430
Total purchases (39 units). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,630
Cost of goods available for sale (65 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,830
Less ending inventory (28 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Cost of goods sold (37 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?

Given a beginning inventory, only ending inventory and cost of goods sold will vary with the
different inventory costing alternatives. Because ending inventory and cost of goods sold are
complementary numbers whose sum must equal total goods available for sale, you can calculate
only one of the two missing numbers in each case and then compute the other by subtracting
the first number from goods available for sale. Thus, in the calculations that follow, we will al-
ways calculate ending inventory first.

1. FIFO Inventory
Since we know that 28 units are left in ending inventory, we look for the last 28 units purchased
because the first units purchased would all be sold. The last 28 units purchased were:
9 units at $270 each on January 28 $2,430
19 units at $250 each on January 15 4,750
Ending inventory . . . . . . . . . . . . . . $7,180

Ending inventory is $7,180, and cost of goods sold is $7,650 ($14,830 $7,180).

2. LIFO Inventory
The first 28 units available would be considered the ending inventory (since the last ones pur-
chased are the first ones sold). The first 28 units available were:
Beginning inventory: 26 units at $200 $5,200
January 10 purchase: 2 units at $220 440
Ending inventory . . . . . . . . . . . . . . . $5,640

Thus,
Cost of goods available for sale . . . . . $14,830
Ending inventory . . . . . . . . . . . . . . . . 5,640
Cost of goods sold . . . . . . . . . . . . . . . $ 9,190
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3. Average Cost
The total cost of goods available for sale is divided by total units available for sale to get a
weighted average cost:

Cost of Goods Available for Sale $14,830
$228.15 per Unit
Units Available for Sale 65

Cost of goods available for sale . . . . . . . . . . . . . $14,830
Less ending inventory (28 units at $228.15) . . . . 6,388
Cost of goods sold (37 units at $228.15) . . . . . . $ 8,442
Note: With the average cost alternative, the computed amounts may vary slightly due to rounding.




Using the above example, we assume Lehi Wholesale Distributors buys printers from manufac-
Perpetual Inventory Cost
turers and sells them to office supply stores. During January 2003, its inventory records showed
Flow Alternatives
the following:
Jan. 1 Beginning inventory consisted of 26 printers at $200 each.
10 Purchased 10 printers at $220 each.
12 Sold 15 printers.
15 Purchased 20 printers at $250 each.
17 Sold 14 printers.
19 Sold 8 printers.
28 Purchased 9 printers at $270 each.
Calculate ending inventory and cost of goods sold, using:
Required:
1. Perpetual FIFO inventory.
2. Perpetual LIFO inventory.
3. Perpetual average cost.
Solution When computing ending inventory and cost of goods sold, it is usually easiest to get an overview
first. The following calculations are helpful:
Beginning inventory, 26 units at $200 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,200
Purchases: 10 units at $220 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,200
20 units at $250 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
9 units at $270 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,430
Total purchases (39 units). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,630
Cost of goods available for sale (65 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,830
Less ending inventory (28 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Cost of goods sold (37 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?

Given a beginning inventory, only ending inventory and cost of goods sold will vary with the
different inventory costing alternatives. Because ending inventory and cost of goods sold are
complementary numbers whose sum must equal total goods available for sale, you can calculate
only one of the two missing numbers in each case, and then compute the other by subtracting
the first number from goods available for sale. Thus, in the calculations that follow, we will al-
ways calculate ending inventory first.

1. Perpetual FIFO Inventory
With this alternative, records must be maintained throughout the period, as shown. The final
calculation is:
Cost of goods available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,830
Ending inventory [(19 $250) (9 $270)] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,180
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,650
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PERPETUAL FIFO CALCULATIONS
Purchased Sold Remaining

Number Total Number Total Number Total
Date of Units Unit Cost Cost of Units Unit Cost Cost of Units Unit Cost Cost

Beginning
inventory 26 $200 $5,200
January 10 10 $220 $2,200 36 26 at $200 $7,400
10 at $220
12 15 15 at $200 $3,000 21 11 at $200 $4,400
10 at $220
15 20 $250 5,000 41 11 at $200 $9,400
10 at $220
20 at $250
17 14 11 at $200 2,860 27 7 at $220 $6,540
3 at $220 20 at $250
19 8 7 at $220 1,790 19 19 at $250 $4,750
1 at $250
28 9 $270 2,430 28 19 at $250 $7,180
9 at $270
Totals 39 $9,630 37 $7,650




2. Perpetual LIFO Inventory
With this alternative, as shown below, the calculation is:
Cost of goods available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,830
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,230
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,600




PERPETUAL LIFO CALCULATIONS
Purchased Sold Remaining

Number Total Number Total Number Total
Date of Units Unit Cost Cost of Units Unit Cost Cost of Units Unit Cost Cost
Beginning
inventory 26 $200 $5,200
January 10 10 $220 $2,200 36 26 at $200 $7,400
10 at $220
12 15 10 at $220 $3,200 21 21 at $200 $4,200
5 at $200
15 20 $250 5,000 41 21 at $200 $9,200
20 at $250
17 14 14 at $250 3,500 27 21 at $200 $5,700
6 at $250
19 8 6 at $250 1,900 19 19 at $200 $3,800
2 at $200
28 9 $270 2,430 28 19 at $200 $6,230
9 at $270
Totals 39 $9,630 37 $8,600
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3. Perpetual Average Cost
With this alternative, a new average cost of inventory items must be calculated each time a pur-
chase is made, as shown in the following table:
Cost of goods available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,830
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,748
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,082



PERPETUAL AVERAGE COST CALCULATIONS
Purchased Sold Remaining Computations

Beginning
inventory 26 units at $200.00
$5,200
January 10 10 units at $220 36 units at $205.56 $5,200 $2,200 $7,400;
$2,200 $7,400 $7,400 36 $205.56
12 15 units at $205.56 21 units at $205.56
$3,083 $4,317
15 20 units at $250 41 units at $227.24 $4,317 $5,000 $9,317;
$5,000 $9,317 $9,317 41 $227.24
17 14 units at $227.24 27 units at $227.24
$3,181 $6,135
19 8 units at $227.24 19 units at $227.24
$1,818 $4,318
28 9 units at $270 28 units at $241.00 $4,318 $2,430 $6,748;
$2,430 $6,748 $6,748 28 $241.00




discussion questions

1. In wholesale and retail companies, inventory is com- 10. Why are the closing entries for inventory under a peri-
posed of the items that have been purchased for resale. odic system more complicated than those for a perpet-
What types of inventory does a manufacturing firm ual system?
have? 11. Why is it necessary to physically count inventory when
2. What comprises the cost of inventory? the perpetual inventory method is being used?
3. Why is it more difficult to account for the inventory of a 12. What adjusting entries to Inventory are required when
manufacturing firm than for that of a merchandising firm? the perpetual inventory method is used?
4. Who owns merchandise during shipment under the 13. What is the effect on net income when goods held on
terms FOB shipping point? consignment are included in the ending inventory bal-
5. When is the cost of inventory transferred from an asset ance?
to an expense? 14. Explain the difference between cost flow and the move-
6. Which inventory method (perpetual or periodic) pro- ment of goods.
vides better control over a firm s inventory? 15. Which inventory cost flow alternative results in paying
7. Is the accounting for purchase discounts and purchase the least amount of taxes when prices are rising?
returns the same with the perpetual and the periodic in- 16. Would a firm ever be prohibited from using one inven-
ventory methods? If not, what are the differences? tory costing alternative for tax purposes and another for
8. Are the costs of transporting inventory into and out of financial reporting purposes?
a firm treated the same way? If not, what are the differ- 17. Why is it necessary to know which inventory cost flow
ences? alternative is being used before the financial perfor-
9. Why is it usually important to take advantage of pur- mances of different firms can be compared?
chase discounts? 18. What can the inventory turnover ratio tell us?
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22. When should inventory be valued at its net realizable
value?
23. When should inventory be valued at the lower of cost
19. Is net income under- or overstated when purchased or market?
merchandise is counted and included in the inventory 24. When firms cannot count their inventory, how do they
balance but not recorded as a purchase? determine how much inventory is on hand for the fi-
20. Is net income under- or overstated if inventory is sold nancial statements?
and shipped but not recorded as a sale?
21. Why do the LIFO and average cost inventory cost flow
assumptions result in different inventory numbers for
the perpetual and periodic inventory methods?




discussion cases


CASE 7-1 WHY USE A PERPETUAL SYSTEM?
You are a consultant for the ABC Consulting Company. You have been hired by Eddie s Elec-
tronics, a company that owns 25 electronics stores selling radios, televisions, compact disc play-
ers, stereos, and other electronic equipment. Since the company began business ten years ago,
it has been using a periodic inventory system. However, Mark Eddie just returned from a sem-
inar where some of his competitors told him he should be using the perpetual inventory method.
Mr. Eddie is not sure he should believe his competitors. He wants you to advise him about his
inventory choices and make a recommendation about the inventory method he should use.

SHOULD WE REDUCE INVENTORY?
CASE 7-2
It has now been two years since you advised Mr. Eddie to switch to the perpetual inventory
method. He is very happy with the additional information he has about inventory levels and
theft. He has hired you for advice once again. This time, Mr. Eddie has been to an inventory
management seminar where he heard that most companies have too much money tied up in in-
ventory. He wonders if his company could be much more profitable if it reduced its inventory
levels. What would you tell him?




exercises


EXERCISE 7-1 GOODS ON CONSIGNMENT
Company A has consignment arrangements with Supplier B and with Customer C. In partic-
ular, Supplier B ships some of its goods to Company A on consignment, and Company A
ships some of its goods to Customer C on consignment. At the end of 2003, Company A s
accounting records showed:
Goods on consignment from Supplier B. . . . . . . $ 8,000
Goods on consignment with Customer C . . . . . . $10,000

1. If a physical count of inventory reveals that $30,000 of goods are on hand, what amount
of ending inventory should be reported?
2. If the amount of the beginning inventory for the year was $27,000 and purchases during
the year were $59,000, then what is the cost of goods sold for the year? (Assume the end-
ing inventory from question 1.)
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3. If, instead of these facts, Company A had only $4,000 of goods on consignment with
Customer C, but had $10,000 of consigned goods from Supplier B, and physical goods
on hand totaled $36,000, what would the correct amount of the ending inventory be?
4. With respect to question 3, if beginning inventory totaled $24,000 and the cost of goods
sold was $47,500, what were the purchases?

EXERCISE 7-2 RECORDING SALES TRANSACTIONS PERPETUAL INVENTORY
METHOD
On June 24, 2003, Hansen Company sold merchandise to Jill Selby for $80,000 with terms
2/10, n/30. On June 30, Selby paid $39,200, receiving the cash discount on her payment,
and returned $16,000 of merchandise, claiming that it did not meet contract terms.
Assuming that Hansen uses the perpetual inventory method, record the necessary journal
entries on June 24 and June 30. The cost of merchandise to Hansen Company is 70% of its
selling price.

EXERCISE 7-3 PERPETUAL INVENTORY METHOD
Oakwood Furniture purchases and sells dining room furniture. Its management uses the per-
petual method of inventory accounting. Journalize the following transactions that occurred
during April 2003:
Apr. 2 Purchased on account $15,000 of inventory with payment terms 2/10, n/30, and
paid $250 in cash to have it shipped from the vendor s warehouse to the Oakwood
showroom.
5 Sold inventory costing $3,000 for $5,400 on account.
10 Paid $6,860 on account (from April 2 purchase).
14 Returned two damaged tables purchased on April 2 (costing $800 each) to the
vendor.
19 Received payment of $1,000 from customers.
20 Paid the balance of the account from April 2 purchase.
22 Sold inventory costing $6,000 for $7,000 on account.
26 A customer returned a dining room set that she decided didn t match her home. She
paid $2,500 for it, and its cost to Oakwood was $1,500.
Assuming the balance in the inventory account is $8,000 on April 1, and no other transac-
tions relating to inventory occurred during the month, what is the inventory balance at the
end of April?

EXERCISE 7-4 ADJUSTING INVENTORY (PERPETUAL METHOD)
Deer Company s perpetual inventory records show an inventory balance of $120,000. Deer
Company s records also show cost of goods sold totaling $240,000. A physical count of in-
ventory on December 31, 2003, showed $92,000 of ending inventory.
Adjust the inventory records assuming that the perpetual inventory method is used.

EXERCISE 7-5 RECORDING SALES TRANSACTIONS PERIODIC INVENTORY
METHOD
On June 24, 2003, Mowen Company sold merchandise to Jack Simpson for $80,000 with
terms 2/10, n/30. On June 30, Simpson paid $39,200, receiving the cash discount on his
payment, and returned $16,000 of merchandise, claiming that it did not meet contract terms.
Assuming that Mowen Company uses the periodic inventory method, record the neces-
sary journal entries on June 24 and June 30.

EXERCISE 7-6 ADJUSTING INVENTORY AND CLOSING ENTRIES (PERIODIC
METHOD)
As of December 31, 2003, Deer Company had the following account balances:
Inventory (beginning) . . . . . . $120,000
Purchases . . . . . . . . . . . . . . 220,000
Purchase returns . . . . . . . . . 4,000
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A physical count of inventory on December 31, 2003, showed $92,000 of ending inventory.
Prepare the closing entries that are needed to adjust the inventory records and close the re-
lated purchases accounts, assuming that the periodic inventory method is used.

EXERCISE 7-7 COST OF GOODS SOLD CALCULATION
The accounts of Meeks Company have the following balances for 2003:
Purchases . . . . . . . . . . . . . . . . . . . $260,000
Inventory, January 1, 2003 . . . . . . 40,000
Purchase returns. . . . . . . . . . . . . . 7,640
Purchase discounts . . . . . . . . . . . . 880
Freight in . . . . . . . . . . . . . . . . . . . 12,400
Freight out (selling expense) . . . . . 2,400
Cash . . . . . . . . . . . . . . . . . . . . . . . 4,000

The inventory count on December 31, 2003, is $48,000. Using the information given, com-
pute the cost of goods sold for Meeks Company for 2003.

EXERCISE 7-8 COST OF GOODS SOLD CALCULATIONS
Complete the Cost of Goods Sold section for the income statements of the following five
companies:

Able Baker Carter Delmont Eureka
Company Company Company Company Company

Beginning inventory . . . . . . . . . . $16,000 $24,800 _______ _______ $19,200
Purchases . . . . . . . . . . . . . . . . . . 26,500 _______ $43,000 $89,500 _______
Purchase returns . . . . . . . . . . . . . _______ 1,000 1,800 200 2,200
Cost of goods available for sale. . 42,100 _______ 58,300 _______ 81,500
Ending inventory . . . . . . . . . . . . . _______ 22,200 15,200 28,800 _______
Cost of goods sold . . . . . . . . . . . 33,400 67,200 _______ 93,400 68,400


EXERCISE 7-9 JOURNALIZING INVENTORY TRANSACTIONS
Fleming Machinery uses the periodic method of inventory accounting.
1. Journalize the following transactions relating to the company s purchases in 2003:
Jan. 21 Purchased $8,000 of inventory on credit, terms 2/10, n/30.
30 Paid $7,840 to pay off the debt from the January 21 purchase.
Mar. 14 Purchased $125,000 of inventory on credit, terms 2/10, n/30. Paid $500 in cash
for transportation.
Apr. 1 Returned defective machinery worth $20,000 to manufacturer.
13 Paid $105,000 to pay off the debt from the March 14 purchase.
2. Assuming these were the only purchases in 2003, compute the cost of goods sold. Begin-
ning inventory was $13,000 and ending inventory was $22,000.

EXERCISE 7-10 ADJUSTING INVENTORY RECORDS FOR PHYSICAL COUNTS
Spartacas, Inc., which uses the perpetual inventory method, recently had an agency count its
inventory of frozen chickens. The agency left the following inventory sheet:

Type of Date Quantity Unit Inventory
Merchandise Purchased on Hand Cost Amount

Chicken grade A 2/12/03 30 $5.00 (a)
Chicken grade B 2/18/03 16 (b) $54.40
Chicken grade C 2/08/03 (c) $2.50 $60.00
Chicken grade D 2/15/03 46 (d) $52.90
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Complete the inventory calculations for Spartacas (items a d) and provide the journal entry
necessary to adjust ending inventory, if necessary. The balance in Inventory before the physi-
cal count was $305.05.

EXERCISE 7-11 SPECIFIC IDENTIFICATION METHOD
E s Diamond Shop is computing its inventory and cost of goods sold for November 2003. At
the beginning of the month, these items were in stock:

Quantity Cost Total

Ring A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 $600 $ 4,800
Ring A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 650 6,500
Ring B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 300 1,500
Ring B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 350 2,100
Ring B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 450 1,350
Ring C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 200 1,400
Ring C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 250 2,000
$19,650



During the month, the shop purchased four type A rings at $600, two type B rings at $450,
and five type C rings at $300 and made the following sales:


Ring Type Quantity Sold Price Cost

A 2 $1,000 $600
A 3 1,050 600
A 1 1,200 650
B 2 850 450
B 2 800 350
C 4 450 200
C 3 500 250
C 1 550 250



Because of the high cost per item, E s uses specific identification inventory costing.
1. Calculate the cost of goods sold and ending inventory balances for November.
2. Calculate the gross margin for the month.

EXERCISE 7-12 INVENTORY COSTING METHODS
For each of the descriptions listed below, identify the inventory costing method to which it
applies. The costing methods are: average cost, LIFO, and FIFO.
1. The value of ending inventory does not include the cost of the most recently acquired
goods.
2. In a period of rising prices, cost of goods sold is highest.
3. In a period of rising prices, ending inventory is highest.
4. Ending inventory is between the levels of the other two methods.
5. The balance of the inventory account may be unrealistic because inventory on hand is
valued at old prices.

EXERCISE 7-13 FIFO AND LIFO INVENTORY COSTING
Jefferson s Jewelry Store is computing its inventory and cost of goods sold for November
2003. At the beginning of the month, the following jewelry items were in stock (rings were
purchased in the order listed):
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Quantity Cost Total

Ring A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 $600 $ 4,800
Ring A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 650 6,500
Ring B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 300 1,500
Ring B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 350 2,100
Ring B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 450 1,350
Ring C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 200 1,400
Ring C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 250 2,000
$19,650



During the month, the following rings were purchased: four type A rings at $600, two type B
rings at $450, and five type C rings at $300. Also during the month, these sales were made:


Ring Type Quantity Sold Price

A 2 $1,000
A 3 1,050
A 1 1,200
B 2 850
B 2 800
C 4 450
C 3 500
C 1 550


Jefferson s uses the periodic inventory method. Calculate the cost of goods sold and ending
inventory balances for November using FIFO and LIFO.

FIFO, LIFO, AND AVERAGE COST CALCULATIONS (PERIODIC
EXERCISE 7-14
INVENTORY METHOD)
The following transactions took place with respect to Model M computers in Alpha s Com-
puter Store during April 2003:
April 1 Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 computers at $1,200
5 Purchase of Model M computers. . . . . . . . . . . . . . . . . . . . . . . 15 computers at $1,300
11 Purchase of Model M computers. . . . . . . . . . . . . . . . . . . . . . . 16 computers at $1,350
24 Purchase of Model M computers. . . . . . . . . . . . . . . . . . . . . . . 10 computers at $1,400
30 Sale of Model M computers . . . . . . . . . . . . . . . . . . . . . . . . . . 32 computers at $3,000

Assuming the periodic inventory method, compute cost of goods sold and ending inventory
using the following inventory costing alternatives: (a) FIFO, (b) LIFO, and (c) average cost.

EXERCISE 7-15 INVENTORY RATIOS
The following data are available for 2003, regarding the inventory of two companies:

Atkins Computers Burbank Electronics

Beginning inventory . . . . . . . . . . . . . . . . . $ 40,000 $ 80,000
Ending inventory. . . . . . . . . . . . . . . . . . . . 48,000 95,000
Cost of goods sold . . . . . . . . . . . . . . . . . . 690,000 910,000



Compute inventory turnover and number of days sales in inventory for both companies.
Which company is handling its inventory more efficiently?
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EXERCISE 7-16 INVENTORY ERRORS
As the accountant for Mt. Pleasant Enterprises, you are in the process of preparing the in-
come statement for the year ended December 31, 2003. In doing so, you have noticed that
merchandise costing $2,000 was sold for $4,000 on December 31.
Before the effects of the $4,000 sale were taken into account, the relevant income state-
ment figures were:
Sales revenue . . . . . . . . . . . . . $80,000
Beginning inventory. . . . . . . . . 18,000
Purchases . . . . . . . . . . . . . . . . 44,000
Ending inventory . . . . . . . . . . . 13,000

1. Prepare a partial income statement through gross margin under each of the following
three assumptions:
a. The sale is recorded in the 2003 accounting record; the inventory is included in the
ending physical inventory count.
b. The sale is recorded in 2003; the inventory is not included in ending inventory.
c. The sale is not recorded in the 2003 accounting records; the merchandise is not in-
cluded in the ending inventory count.
2. Under the given circumstances, which of the three assumptions is correct?
3. Which assumption overstates gross margin (and therefore net income)?


EXERCISE 7-17 FIFO, LIFO, AND AVERAGE COST CALCULATIONS (PERPETUAL
INVENTORY METHOD)
The July 2003 inventory records of Mario s Bookstore showed the following:
July 1 Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 at $2.00 $56,000
5 Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
13 Purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 at $2.25 13,500
17 Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
25 Purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 at $2.50 20,000
27 Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
$89,500

1. Using the perpetual inventory method, compute the ending inventory and cost of goods
sold balances with (a) FIFO, (b) LIFO, and (c) average cost. Compute unit costs to the
nearest cent.
2. Which of the three alternatives is best? Why?


LOWER OF COST OR MARKET
EXERCISE 7-18
Prepare the necessary journal entries to account for the purchases and year-end adjustments of
the inventory of Payson Manufacturing Company. All purchases are made on account. Payson
uses the periodic inventory method.
1. Purchased 50 standard widgets for $8 each to sell at $14 per unit.
2. Purchased 15 deluxe widgets at $20 each to sell for $30 per unit.
3. At the end of the year, the standard widgets could be purchased for $9 and are selling for
$15.
4. At the end of the year, the deluxe widgets could be purchased for $10 and are selling for
$16 per unit. Selling costs are $4 per unit, and normal profit is $6 per unit. Inventory is
15 units.
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5. At the end of the second year, standard widgets could be purchased for $6 and are selling
for $8. Selling costs are $1 per widget, and normal profit is $2 per widget. Inventory is
50 units.
6. At the end of the second year, the deluxe widgets could be purchased for $9 and are sell-
ing for $20. Selling costs and normal profit remain as in (4). Inventory is 15 units.

EXERCISE 7-19 LOWER OF COST OR MARKET
Broderick Company sells lumber. Inventory cost data per 1,000 board feet of lumber for the
Broderick Company are as follows:


Item Plywood Oak Pine Redwood

Quantity on hand. . . . . . . . . . . . . . . . . . . . . . . . 25 20 43 12
Original cost . . . . . . . . . . . . . . . . . . . . . . . . . . . $600 $2,000 $800 $1,400
Current replacement cost. . . . . . . . . . . . . . . . . . 600 1,800 700 1,800
Net realizable value . . . . . . . . . . . . . . . . . . . . . . 500 1,900 800 1,600
Net realizable value minus normal profit . . . . . . 400 1,850 600 1,300



1. By what amount, if any, should each item (considered separately) be written down?
2. Make the appropriate journal entry (or entries):
a. Assuming that each inventory item is considered separately.
b. Assuming that LCM is applied to total inventory.

GROSS MARGIN METHOD OF ESTIMATING INVENTORY
EXERCISE 7-20
Jason Company needs to estimate the inventory balance for its quarterly financial statements.
The periodic inventory method is used. Records show that quarterly sales totaled $400,000,
beginning inventory was $80,000, and net purchases totaled $280,000; the historical gross
margin percentage has averaged approximately 40%.
1. What is the approximate amount of ending inventory?
2. If a physical count shows only $100,000 in inventory, what could be the explanation for
the difference?

EXERCISE 7-21 ESTIMATING INVENTORY AMOUNTS
Sandra s Boutique was recently destroyed by fire. For insurance purposes, she must determine
the value of the destroyed inventory. She knows the following information about her 2003
operations before the fire occurred:
Beginning inventory . . . . . . $11,500
Net purchases . . . . . . . . . . 62,000
Sales . . . . . . . . . . . . . . . . . 84,500
Profit margin . . . . . . . . . . . 30%

Estimate the cost of Sandra s destroyed inventory.

EXERCISE 7-22 ESTIMATING INVENTORY
Ted Smyth manages an electronics store. He suspects that some employees are stealing items
from inventory. Determine the cost of the missing inventory. The following information is
available from the accounting records:
Beginning inventory . . . . . . . . . $ 300,000
Sales . . . . . . . . . . . . . . . . . . . . 2,000,000
Net purchases. . . . . . . . . . . . . . 1,600,000
Actual ending inventory . . . . . . 450,000
Historical profit margin . . . . . . . 30%
337
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EXERCISE 7-23 ANALYSIS OF THE OPERATING CYCLE
The following information was taken from the records of Dallen Company for the year
2004:
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . $600,000
Beginning inventory . . . . . . . . . . . . . . 114,000
Ending inventory. . . . . . . . . . . . . . . . . 87,000
Beginning accounts receivable . . . . . . 68,000
Average collection period . . . . . . . . . . 44 days
Beginning accounts payable . . . . . . . . 36,000
Ending accounts payable . . . . . . . . . . 42,000
Gross profit percentage. . . . . . . . . . . . 37%

1. Compute the number of days sales in inventory.
2. Compute the ending balance in Accounts Receivable.
3. Compute the number of days purchases in accounts payable.
4. How many days elapse, on average, between the time Dallen must pay its suppliers for
inventory purchases and the time Dallen collects cash from its customers for the sale of
that same purchased inventory?
5. Repeat the computations in (1), (2), (3), and (4) using the end-of-year balance sheet bal-
ances rather than the average balances.




problems


WHAT SHOULD BE INCLUDED IN INVENTORY?
PROBLEM 7-1
Demetrius is trying to compute the inventory balance for the December 31, 2002, financial
statements of his automotive parts shop. He has computed a tentative balance of $52,600 but
suspects that several adjustments still need to be made. In particular, he believes that the fol-
lowing could affect his inventory balance:

a. A shipment of goods that cost $3,000 was received on December 28, 2002. It was prop-
erly recorded as a purchase in 2002 but not counted with the ending inventory.
b. Another shipment of goods (FOB destination) was received on January 2, 2003, and cost
$800. It was properly recorded as a purchase in 2003 but was counted with 2002 s end-
ing inventory.
c. A $2,800 shipment of goods to a customer on January 3 was recorded as a sale in 2003
but was not included in the December 31, 2002, ending inventory balance. The goods
cost $2,000.
d. The company had goods costing $6,000 on consignment with a customer, and $5,000 of
merchandise was on consignment from a vendor. Neither amount was included in the
$52,600 figure.
e. The following amounts represent merchandise that was in transit on December 31, 2002,
and recorded as purchases and sales in 2002 but not included in the December 31 inven-
tory.
1. Ordered by Demetrius, $1,800, FOB destination.
2. Ordered by Demetrius, $600, FOB shipping point.
3. Sold by Demetrius, cost $4,000, FOB shipping point.
4. Sold by Demetrius, cost $4,600, FOB destination.
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1. Determine the correct amount of ending inventory at December 31, 2002.
Required:
2. Assuming net purchases (before any adjustment, if any) totaled $86,400 and beginning
inventory (January 1, 2002) totaled $31,600, determine the cost of goods sold in 2002.

PROBLEM 7-2 PERPETUAL AND PERIODIC JOURNAL ENTRIES
The following transactions for Goodmonth Tire Company occurred during the month of March
2003:
a. Purchased 500 automobile tires on account at a cost of $40 each for a total of
$20,000.
b. Purchased 300 truck tires on account at a cost of $80 each for a total of $24,000.
c. Paid cash of $1,300 for separate shipping costs on the automobile tires purchased in (a).
The supplier of the truck tires included the shipping costs in the $80 price.
d. Returned 12 automobile tires to the supplier because they were defective.
e. Paid for the automobile tires. A 1% discount was given on the amount owed. (HINT:
Remember that some of the automobile tires were returned.) Payment terms were 1/20,
n/30.
f. Paid for half the truck tires, receiving a discount of 2%. Terms were 2/10, n/30.
g. Paid the remaining balance owed on the truck tires. No discount was received because
payment was made after the discount period.
h. Sold on account 400 automobile tires at a price of $90 each for a total of $36,000.
i. Sold on account 200 truck tires at a price of $150 each for a total of $30,000.
j. Accepted return of 7 automobile tires from dissatisfied customers.

Required: 1. Prepare journal entries to account for the above transactions assuming a periodic inven-
tory system.
2. Prepare journal entries to account for the above transactions assuming a perpetual inven-
tory system.
3. Assume that inventory levels at the beginning of March (before these transactions) were
100 automobile tires that cost $40 each and 70 truck tires that cost $80 each. Also, as-
sume that a physical count of inventory at the end of March revealed that 184 auto-
mobile tires and 164 truck tires were on hand. Given these inventory amounts, prepare
the closing entries to account for inventory and related accounts as of the end of
March.

PROBLEM 7-3 INCOME STATEMENT CALCULATIONS
Waukesha Company has gross sales of 160% of cost of goods sold. It has also provided the fol-
lowing information for the calendar year 2003:
Inventory balance, January 1, 2003. . . . . . . . $100,000
Total cost of goods available for sale . . . . . . 300,000
Sales returns . . . . . . . . . . . . . . . . . . . . . . . . 13,000
Purchase returns . . . . . . . . . . . . . . . . . . . . . 5,000
Freight in . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Sales (net of returns) . . . . . . . . . . . . . . . . . . 407,000
Operating expenses . . . . . . . . . . . . . . . . . . . 27,000

Required: Using the available information, compute the following. (Ignore income taxes.)

1. Gross sales for 2003.
2. Net purchases and gross purchases for 2003.
3. Cost of goods sold for 2003.
4. Inventory balance at December 31, 2003.
5. Gross margin for 2003.
6. Net income for 2003.
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Part 2 EOC Operating Activities



PROBLEM 7-4 INCOME STATEMENT CALCULATIONS


Company A Company B Company C Company D

Sales revenue. . . . . . . . . . . $2,000 (4) ______ $480 $1,310
Beginning inventory . . . . . . 200 76 0 600
Purchases. . . . . . . . . . . . . . (1) ______ 423 480 249
Purchase returns . . . . . . . . (20) (19) (0) (8) ______
Ending inventory . . . . . . . . 300 110 (6) ______ 195
Cost of goods sold . . . . . . . 1,200 370 (7) ______ (9) ______
Gross margin . . . . . . . . . . . (2) ______ (5) ______ 155 (10) ______
Operating expenses . . . . . . 108 22 34 129
Net income. . . . . . . . . . . . . (3) ______ 107 121 546


Required: Complete the income statement calculations by filling in all missing numbers.

PROBLEM 7-5 INVENTORY COST FLOW ALTERNATIVES
Stocks, Inc., sells weight-lifting equipment. The sales and inventory records of the company for
January through March 2003 were as follows:

Weight Sets Unit Cost Total Cost

Beginning inventory, Jan. 1 . . . . . . . . . . . 460 $30 $13,800
Purchase, Jan. 16 . . . . . . . . . . . . . . . . . . . 110 32 3,520
Sale, Jan. 25 ($45 per set). . . . . . . . . . . . . 216
Purchase, Feb. 16 . . . . . . . . . . . . . . . . . . . 105 36 3,780
Sale, Feb. 27 ($40 per set). . . . . . . . . . . . . 307
Purchase, March 10 . . . . . . . . . . . . . . . . . 150 28 4,200
Sale, March 30 ($50 per set) . . . . . . . . . . . 190


Required: 1. Determine the amounts for ending inventory, cost of goods sold, and gross margin under
the following costing alternatives. Use the periodic inventory method, which means that
all sales are assumed to occur at the end of the period no matter when they actually oc-
curred. Round amounts to the nearest dollar.
a. FIFO
b. LIFO
c. Average cost
2. Interpretive Question: Which alternative results in the highest gross margin? Why?

PROBLEM 7-6 PERIODIC INVENTORY COST FLOW METHOD
Dudley Wholesale buys peaches from farmers and sells them to canneries. During August 2003,
Dudley s inventory records showed the following:

Cases Price

August 1 Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,100 $10.50
4 Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 11.00
9 Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950 19.95
13 Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 11.00
19 Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,450 19.95
26 Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 11.50
30 Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 19.95
340 f341
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Inventory


Dudley Wholesale uses the periodic inventory method to account for its inventory, which means
that all sales are assumed to occur at the end of the period no matter when they actually oc-
curred.
Required: Calculate the cost of goods sold and ending inventory using the following cost flow alternatives.
(Calculate unit costs to the nearest cent.)
1. FIFO
2. LIFO
3. Average cost


PROBLEM 7-7 CALCULATING AND INTERPRETING INVENTORY RATIOS
Captain Geech Boating Company sells fishing boats to fishermen. Its beginning and ending in-
ventories for 2003 are $462 million and $653 million, respectively. It had cost of goods sold of
$1,578 million for the year ended December 31, 2003. Merchant Marine Company also sells
fishing boats. Its beginning and ending inventories for the year 2003 are $120 million and $90
million, respectively. It had cost of goods sold of $1,100 million for the year ended December
31, 2003.
Required: 1. Calculate the inventory turnover and number of days sales in inventory for the two com-
panies.
2. Interpretive Question: Are the results of these ratios what you expected? Which com-
pany is managing its inventory more efficiently?




PROBLEM 7-8 THE EFFECT OF INVENTORY ERRORS
The accountant for Steele Company reported the following accounting treatments for several
purchase transactions (FOB shipping point) that took place near December 31, 2003, the com-
pany s year-end:


Was the Purchase Was the Inventory
Recorded in the Counted and Included
Date Inventory Books on or before in Inventory Balance on
Was Shipped December 31, 2003? Amount December 31, 2003?

2003:
December 26 . . . . . . . . . Yes $1,100 Yes
December 29 . . . . . . . . . Yes 800 No
December 31 . . . . . . . . . No 1,800 Yes

2004:
January 1 . . . . . . . . . . . . No 300 Yes
January 1 . . . . . . . . . . . . Yes 3,000 No
January 1 . . . . . . . . . . . . No 600 No



Required: 1. If Steele Company s records reported purchases and ending inventory balances of
$80,800 and $29,800, respectively, for 2003, what would the proper amounts in these
accounts have been?
2. What would be the correct amount of cost of goods sold for 2003, if the beginning in-
ventory balance on January 1, 2003, was $20,200?
3. By how much would cost of goods sold be over- or understated if the corrections in
question (1) were not made?
341
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Part 2 EOC Operating Activities



PROBLEM 7-9 CORRECTION OF INVENTORY ERRORS
The annual reported income for Salazar Company for the years 2000 2003 is shown here. How-
ever, a review of the inventory records reveals inventory misstatements.


2000 2001 2002 2003

Reported net income . . . . . . . . . . . . . . . . . . . . $30,000 $40,000 $35,000 $45,000
Inventory overstatement, end of year . . . . . . . . 3,000 2,000
Inventory understatement, end of year . . . . . . . 4,000 1,000


Required: Using the data provided, calculate the correct net income for each year.

PROBLEM 7-10 THE EFFECT OF INVENTORY ERRORS
You have been hired as the accountant for Tracy Company, which uses the periodic inventory
method. In reviewing the firm s records, you have noted what you think are several accounting
errors made during the current year, 2003. These potential mistakes are listed as follows:
a. A $43,000 purchase of merchandise was properly recorded in the purchases account, but
the related accounts payable account was credited for only $2,000.
b. A $3,500 shipment of merchandise received just before the end of the year was properly
recorded in the purchases account but was not physically counted in the inventory and,
hence, was excluded from the ending inventory balance.
c. A $6,700 purchase of merchandise was erroneously recorded as a $7,600 purchase.
d. A $500 purchase of merchandise was not recorded either as a purchase or as an account
payable.
e. During the year, $1,200 of defective merchandise was sent back to a supplier. The origi-
nal purchase had been recorded, but the merchandise return entry was not recorded.
f. During the physical inventory count, inventory that cost $400 was counted twice.

Required: 1. If the previous accountant had tentatively computed the 2003 gross margin to be
$10,000, what would be the correct gross margin for the year?
2. If these mistakes are not corrected, by how much will the 2004 net income be in error?

PROBLEM 7-11 UNIFYING CONCEPTS: INVENTORY COST FLOW
ALTERNATIVES
Stan s Wholesale buys canned tomatoes from canneries and sells them to retail markets. During
August 2003, Stan s inventory records showed the following:


Cases Price

August 1 Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,100 $10.50
4 Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 11.00
9 Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950 19.95
13 Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 11.00
19 Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,450 19.95
26 Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 11.50
30 Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900 19.95



Even though it requires more computational effort, Stan s uses the perpetual inventory method
because management feels that the advantage of always having current knowledge of inventory
levels justifies the extra cost.
Required: Calculate the cost of goods sold and ending inventory using the following cost flow alternatives.
(Calculate unit costs to the nearest cent.)
342 f343
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Inventory


1. FIFO
2. LIFO
3. Average cost

PROBLEM 7-12 PERPETUAL INVENTORY COST FLOW ALTERNATIVES
Pump-It, Inc., sells weight-lifting equipment. The sales and inventory records of the company
for January through March 2003 were as follows:


Weight Sets Unit Cost Total Cost

Beginning inventory, Jan. 1 . . . . . . . . . . . 460 $30 $13,800
Purchase, Jan. 16 . . . . . . . . . . . . . . . . . . . 110 32 3,520
Sale, Jan. 25 ($45 per set). . . . . . . . . . . . . 216
Purchase, Feb. 16 . . . . . . . . . . . . . . . . . . . 105 36 3,780
Sale, Feb. 27 ($40 per set). . . . . . . . . . . . . 307
Purchase, March 10 . . . . . . . . . . . . . . . . . 150 28 4,200
Sale, March 30 ($50 per set) . . . . . . . . . . . 190



Required: 1. Determine the amounts for ending inventory, cost of goods sold, and gross margin under
the following costing alternatives. Use the perpetual inventory method. Round amounts
to the nearest dollar.
a. FIFO
b. LIFO
c. Average cost (calculate unit costs to the nearest cent)
2. Interpretive Question: Which alternative results in the highest gross margin? Why?

PROBLEM 7-13 UNIFYING CONCEPTS: INVENTORY ESTIMATION METHOD
Jamestown Clothing Store has the following information available:


Cost Selling Price Other

Purchases during January 2003 . . . . . . . . . . . . . . . . . . . $120,000 $170,000
Inventory balance January 1, 2003 . . . . . . . . . . . . . . . . . 48,000 62,000
Sales during January . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000
Average gross margin rate for the last three years . . . . . 25%



1. On the basis of this information, estimate the cost of inventory on hand at January 31,
Required:
2003, using the gross margin method. Round to the nearest whole percent.
2. How accurate do you think this method is?
343
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Part 2 CEO Operating Activities



competency enhancement opportunities




LLL
LLLL



Analyzing Real Company Information The Debate
International Case Cumulative Spreadsheet Project
Ethics Case Internet Search
Writing Assignment




The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
skills, experience with electronic research, and teamwork through group and
business activities.
L




ANALYZING REAL COMPANY INFORMATION
Analyzing 7-1 (Microsoft)
Using MICROSOFT s 1999 annual report in Appendix A, answer the following
questions:
1. What type of items compose Microsoft s inventory?
2. Review Microsoft s balance sheet to determine the amount of inventory on
hand on June 30, 1999. Does this mean Microsoft has absolutely no in-
ventory? Where would Microsoft s inventory probably be disclosed?
3. Review the management s discussion note disclosure on operating ex-
penses, specifically the discussion relating to cost of revenue. Does this
discussion help explain what might make up some of Microsoft s inven-
tory?

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