Friedlan4e SM Ch07

8/10/2019 Friedlan4e SM Ch07

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John Friedlan,Financial Accounting: A Critical Approach, 4thedition Page 7-1Solutions Manual Copyright 2013 McGraw-Hill Ryerson Ltd.

CHAPTER 7

Inventory

QUESTIONS

Q7-1.a. Prescription and non-prescription drugs, cosmetics, toiletries, food items.b. Toiletries, food and drinks.c. Ore, unrefined gold and gold.d. Photocopy paper, exam booklets, stationary, textbooks in the bookstore, food for

cafeteria, clothing items for sale with the university logo.e. Auto parts, partially finished cars (work-in-progress), finished cars.f. Cola in various stagesof production, raw materials including flavouring, corn syrup and

aspartame.g. Hamburger patties, French fries etc., packaging materials, napkins.

Q7-2.a. Raw materials include computer parts; work-in-process would include computers that arepartially assembled; and finished goods would be comprised of fully assembledcomputers that are ready for sale.

b. Raw materials include potatoes, cooking oil, and packaging;work-in-processis cutfriesthat are being prepared but havent been cooked, and finished goods are fries that arepackaged and ready to be sold.

c. Raw materials includes lumber, glue and screws, fabric, and paint; work in processincludes partially created furniture, and finished goods would include furniture that isfully built and ready for sale.

d. Raw materials include ore; work-in-process is unrefined gold; and finished goods aregold bars ready for sale.

Q7-3.Conservatism (or prudence) is an underlying principle in IFRS and ASPE intended to limit theoptions available to managers that would result in overly optimistic financial statements.Conservatism introducesa degree of caution to the judgements made by managers when preparingfinancial statements. Conservatism is the basis for ensuring assets and revenues arentoverstatedand liabilities and expenses arent understated.


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Q7-4.If inventory is written down by $250,000 or $350,000 the balance sheet inventory account willbe reduced by this amount. As a result the current ratio will be lower, which may affect loancovenants based on financial statements ending 2017. Cost of goods sold in 2017 will alsoincrease by the same amount of the write-down which reduces net income for 2017. Profit

margin the profit margin ratio will also decline, indicating that the company may not beperforming as well when compared to previous and future years. If given the choice between$250,000 and $350,000 management could use conservatism to justify a larger writedown(assuming adequate uncertainty surrounding the actual NRV). In 2018 when the written downinventory is sold the net income will better reflect the economic reality for that year and cost ofgoods sold will be the carrying amount reflected on the balance sheet in the inventory accountfor the year starting 2018. The amount of the writedown in 2017 will affect the amount of grossmargin and profit in 2018 (assuming the selling price in 2018 isnt affected by the amount of thewritedown.

Q7-5.

A periodic inventory system doesntkeep track of goods removed from inventory. As a result, atany point in time cost of goods sold isntknown. Only by counting inventory and keeping trackof purchases is it possible to calculate cost of goods sold using the equation beginning inventory+ purchasesending inventory = cost of goods sold. Notice that beginning and ending inventoryare determined by physically counting it.

Q7-6.

Raw materials are the inputs to production, such as iron ore to a steel company or potatoes fora company making frozen French fries.

Work-in-process is inventory that is partially completed, such as automobiles on the assemblyline or a suit that hasnt been finished.

Finished goods is inventory ready for sale to the customer, such as a house ready to move into

or a television that is in the box ready to ship. Supplies include other materials that are required by the manufacturing process but that arent

part of the finished product, such as lubricants for the machines. Supplies can also includeincidental materials used by an entity such as office supplies (photocopy paper) or cleaningsupplies.

Q7-7.When a periodic inventory system is used, goods sold arent recorded.Cost of goods sold isdetermined by counting the inventory at the end of a period and using the formulabeginninginventory + purchasesending inventory.As a result the only the cost and quantity of goodsconsumed in a period is known. Whether the goods consumed were sold or stolen cant bedetermined.


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Q7-8A perpetual inventory system keeps an ongoing tally of purchases and sales of inventory, withthe inventory account adjusted to reflect changes as they occur. When inventory is purchased orsold, the inventory account is immediately debited or credited to record the transaction. Wheninventory is sold, cost of sales is debited immediately. With a perpetual system itspossible to

determine cost of sales at any time. With a periodic inventory system, the inventory account isntadjusted whenever a transaction affects inventory. The balance in the inventory account at theend of a period is determined by actually counting the inventory. Purchases of inventory arentrecorded in the Inventory account but instead are accumulated in a separate "Purchases" account.With a periodic inventory system, cost of sales is determined indirectly using the followingequation:

Cost of sales = Beginning inventory + Purchases Ending inventoryThe perpetual system has many benefits for inventory management as inventory on hand

can be determined without physically checking the stock. However a perpetual system will bemore costly to maintain and operate.

Q7-9.Cost formulas are needed because for most goods that are sold it would be very costly todetermine which physical item was sold. For some types of goods, crude oil for example, itwould be impossible to determine the cost oil acquired at different prices once its mixedtogether. Itsmuch more efficient to account for the cost of goods sold under an assumed flow.

Q7-10.Cost of sales plus ending inventory is the same under all historical cost inventory valuationmethods because the cost of goods available for sale is the same under all alternatives. Thedifferent methods allocate the cost of goods available for sale between ending inventory and costof goods sold. All the cost-based methods deal with costs. So the issue is how much of theavailable cost goes to the income statement and how much goes to the balance sheet.

Q7-11.Under FIFO, when prices are rising, the most recent (more costly) purchases are included inending inventory and the oldest (less expensive) purchases are expensed. In contrast underaverage cost, when prices are rising, the average cost of inventory is used which includes bothless expensive, older inventory, and more expensive, new inventory. As a result FIFO gives alower cost of sales and higher ending inventory than average cost.

Q7-12.Under all three systems, the cost of units purchased is added to inventory when they areacquired.

FIFO: the costs associated with units purchased earliest are expensed first. New costs arereported on the balance sheet.

Average cost: the average cost of the goods available for sale during the period is used todetermine ending inventory and the cost of sales.

Specific identification: the cost of the actual unit sold is known and becomes cost of saleswhen the unit is sold.


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Q7-13.The lower of cost and NRV rule requires that inventory be reported at cost or NRV, whichever islower. Itsused to ensure that inventory reported on a balance sheet isntoverstatedreported atan amount greater than its carrying amount (its value on the balance sheet date). NRV can bedefined as the amount the company is able to sell the inventory for less selling costs. The lower

of cost and NRV rule is an application of conservatism.

Q7-14.The net realizable value of items that are infrequently sold or unique, such as an antiques, maybe hard to determine reliably. Also, the market value of intermediate productsproducts that areproduced by an entity and then used in its production processmay be difficult to determine ifthere is market for the product. The NRV of work-in-process may also be difficult to determinebecause there wouldnt be markets for partially completed goods.

cost formulaQ7-15.Perpetual inventory record keeping doesntcapture all events that might reduce inventory. Theft

and loss wontbe recorded. Errors are also possible: some transactions might not be recorded(sales may be forgotten, returns not recorded) and the inventory records might be adjustedincorrectly (the wrong inventory category might be adjusted). As a result itsnecessary to countthe inventory to determine the actual amount of inventory on hand. With a periodic inventorysystem, the inventory account isntadjusted whenever a transaction affects inventory so a countis necessary to determine the amount of inventory on hand and to calculate cost of sales.

Q7-16.With the specific identification method, the cost of each specific unit is recorded and assigned tocost of goods sold when that unit is sold. The method is difficult (sometimes impossible) to usewhen there are many identical, relatively low cost units of each inventory item in stock. Forcostly or unique items identifying and accounting for each item provides more control over theinventory (management will know whats there and whats not there). Manipulation is possiblebecause management can select the specific unit being sold. For example, a car dealer mightchoose to sell a less costly vehicle to boost income in a period.

Q7-17.The choice of the inventory cost formula is important for tax purposes because the method thatsused by a firm for financial reporting purposes will usually be used for tax purposes. The choiceof inventory cost formula affects income, which in turn affects the amount of tax an entity pays,which has cash flow implications for the entity.

Q7-18.It isntpossible to satisfy both objectives at the same time (at a maximum level) since the samecost formula is usually used for both tax and financial reporting. Achieving one objective meanssacrificing the other. In periods of rising prices average cost will produce the lowest incomewhile FIFO produces the highest income.

Q7-19.


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No inventory method will always result in higher earnings than an alternative but if it is believedthat FIFO will result in higher earnings in the near future, prices must be rising and therefore itwill also result in the highest balance sheet values. Thus if management needs higher income inthe short term FIFO is a better choicefor example to increase the bonus to be received by themanagers. Average cost in the short term would have the opposite effect, lowering income and

reducing the bonus. The stock price argument is more dubious because given the efficient markethypothesis, it seems unlikely that stock prices would be affected by a disclosed accountingmethod. However, the managers may believe that higher net income is advantageous for stockvaluation and may pursue that strategy. The downside of the choice is that FIFO will result in thecompany paying more taxes because income will be higher. Average cost will result in a lowertax burden.

Q7-20.No, if the price of inventory is constant, all methods provide the same income and balance sheet,since the earliest purchases are at the same price as the most recent.

Q7-21.Different cost formulas result in different inventory valuations on the balance sheet and differentcosts of sales on the income statement. These differences will affect financial ratios. Forexample, higher inventory values will result in higher current assets with no effect on currentliabilities so the current ratio will be higher. The inventory turnover ratio is determined by bothinventory and cost of sales so the ratio will also be affected. However, the actual inventoryturnover (which is really more appropriately expressed in units) and the actual liquidity of acompany arentaffected by the cost formula. The measurements change depending on theaccounting method but the underlying economic characteristic being measured isntaffected.

Q7-22.Inventory turnover is the ratio of cost of goods sold for the year to the average inventory for theyear. It indicates how quickly the inventory is sold each period. A higher inventory turnover ratiois preferable to a lower one because it means that the entity is able to support a particular level ofsales with less inventory. It means that the entity is able to sell its inventory more quickly. In theterminology of Chapter 6, the inventory holding period is shorter. A decreasing inventoryturnover ratio can be the result of slowing sales, the accumulation of merchandise that is difficultto sell, or expansion into product lines that tend to move more slowly. For example, a roadsidefruit market will turn over inventory very quickly. If the owner decides to sell books andsouvenirs along with fresh produce, the overall turnover ratio will undoubtedly decline. Aninventory turnover ratio can increase by reducing inventory levels or by eliminating slow-moving product lines or by increasing sales without increasing inventory.

Q7-23.It isntpossible to say that one cost formula is best. The question must be assessed in the contextof the information needs of stakeholders and the objectives of financial reporting of the entity.For tax minimization with rising prices, average cost is best in Canada. To put recent prices onthe balance sheet, FIFO is best. If a bank loan is based on the amount of inventory on hand, FIFOwill be preferred when prices are rising. The different cost formulasprovide differentmeasurements of the same underlying economic construct.


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Q7-24.The cash paid for inventory is the payments made to suppliers of inventory during the period.The amount of cash that is spent in a period is the same regardless of the valuation method used.The cost formulas allocate the cost of inventory available for sale between the balance sheet and

the income statement in different ways. So even if the inventory amount and cost of goods soldmay differ depending on the cost formula, the amount of cash expended on inventory is thesame.

Q7-25Biological assets are living animals or plants, for example, dairy cows, forests, apple trees andapples on the trees, and beef cattle. What makes them different is that they are alive, they grow,and they reproduce. Biological assets are valued on the balance sheet at fair value less cost tosell. Biological assets are valued at fair value less cost to sell when they are harvestedand theyare carried at that amount thereafter.

Q7-26Under ASPE apples during the growing season wouldntbe reflected on the balance sheet. UnderIFRS the apples are valued at fair value less cost to sell on the balance sheet date. The differenceis that IFRS would capture the increased value caused by biological growth (and reflect incomeon the income statement).

Q7-27Inventory of an accounting firm is the accumulation of the cost of services performed for clients;for example,cost of work done by employees, travel cost, documentation, preparation costs, andother administrative costs. This appears on the balance sheet because it represents anaccumulation of costs inventoriedfor internal control. These costs are expensed when theengagement is complete and revenue is recognized.

Q7-28In 2017 the inventory carrying amount on the balance sheet will be overstated by the amount ofthe double counted inventory. This will increase the current ratio and decrease the inventoryturnover ratio. Net income for the year will be overstated because cost of sales will beunderstated. (cost of sales = beginning inventory + purchasesending inventoryif endinginventory is higher thancosts of sales is lower). (This will also be the case for a perpetual systembecause the physical count is the basis for determining the amount of inventory on hand.)

In 2018 when the yearend inventory is counted correctly the carrying amount of inventory on thebalance sheet will be correct but the cost of sales will be overstated causing net income to beunderstated. This reverses the impact of the error in 2017.


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EXERCISES

E7-1.The inventory on the December 31, 2017 balance sheet is overstated by $200,000 and net incomewill be overstated by the same amount. Also, cost of sales will be understated by $200,000. The

reason is that the physical count will show $200,000 more inventory than is really there($1,900,000). With a periodic system cost of sales is determined using the equation:cost of sales = beginning inventory + purchasesending inventory

If ending inventory is overstated cost of sales must be understated.

E7-2.The company purchased a total of 5,650 units and sold 4,800 units, leaving 850 units in endinginventory.

Note: Answers may vary depending on rounding.

FIFO

Price paidper unit

Number of

UnitsExpensed

ExpensedFIFO

Number of

Units in

Inventory on

Oct. 31, 2018

Ending

Inventory

on Oct. 31,

2018

8-Oct-18 $8 2,200 $17,600 0

17-Oct-18 $9 1,650 $14,850 0

25-Oct-18 $10 950 $9,500 850 $8,500

Total 4,800 $41,950 850 $8,500

Average Cost

Number of Units Price paid

purchased per unit Total

8-Oct-18 2,200 $8 $17,600

17-Oct-18 1,650 $9 $14,850

25-Oct-18 1,800 $10 $18,000

Total 5,650 $50,450

Average Cost=$50,450/5,650

=$ 8.929

Price paid

per unit

Number of

UnitsExpensed

Expensed

AverageCost

Number of

Units in

Inventory onOct. 31, 2018

Ending

Inventory

on Oct. 31,2018

$8.929 4,800 $42,860 850 $7,590

E7-3.The company had an opening balance of 500 units, and purchased an additional 800 units for atotal of1,300 units.Jaffray sold 500 units, leaving 800 units in ending inventory.


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FIFO

Price paid

per unit

Number of Units

Expensed

Number of Units

on Hand on

June 30, 2017

Ending

InventoryCOGS

1-Jun $10 500 $5,000 0 $0

12-Jun 11 0 0 350 3,850

22-Jun 12 0 0 450 5,40030-Jun Balance 500 $5,000 800 $9,250

Average Cost

Number of Units

purchased

Price paid

per unitTotal

1-Jun 500 $10 $5,000

12-Jun 350 $11 3,850

22-Jun 450 $12 5,400

Total 1300 $14,250

Average cost=($14,250)/(1300)$10.96

Price paid

per unit

Number of Units

ExpensedCOGS

Number of Units

on Hand

Ending

InventoryBalance

30-Jun $10.96 500 $5,481 800 $8,769

***Answers may vary depending on rounding.


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E7-4.The company had an opening balance of 35,000 units, and purchased 32,900 units for a total of67,900 units. Kinistino Inc. sold 52,000 units, leaving 15,900 units in ending inventory.


FIFO

Price paid

per unit

Number

of Units

Expensed COGS

Number

of Units

on Hand

on

30-Nov

Ending

Inventory

1-Nov $4.50 35,000 $157,500 0 $0

13-Nov 4.90 17,000 83,300 4,100 20,090

21-Nov 5.25 - $0 11,800 61,950

30-Nov Balance 52,000 $240,800 15,900 $82,040

Average Cost

Number

of Units

purchased

Price

paid per

unit Total

1-Nov 35,000 $4.50 $157,500

13-Nov 21,100 4.90 103,390

21-Nov 11,800 5.25 61,950

Total 67,900 $322,840

Average cost=($322,840)/(67,900)$4.75

Price paid

per unit

Number

of Units

Expensed COGS

Number

of Units

on Hand

on

30-Nov

Ending

InventoryBalance

30-Nov $4.75 52,000 $247,241 15,900 $75,599


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E7-5.The company had an opening balance of 8,500 units, and purchased an additional 12,800 unitsfor a total of 21,300 units. Lucan Ltd. sold 16,900 units, leaving 4,400 units in ending inventory.


FIFO

Price paid

per unit

Number

of Units

Expensed COGS

Number

of Units

on Hand

on

31-Jul

Ending

Inventory

30-Jun $8.50 8,500 $72,250 0 $0

8-Jul 9.00 2,400 21,600 0 0

20-Jul 9.50 4,400 41,800 0 0

29-Jul 9.75 1,600 15,600 4,400 42,900

31-Jul Balance 16,900 $151,250 4,400 $42,900

Average Cost

Number

of Units

Price

paid

Totalpurchased per unit

30-Jun 8,500 $8.50 $72,250

5-Jul 2,400 9.00 21,600

15-Jul 4,400 9.50 41,800

22-Jul 6,000 9.75 58,500

Total 21,300 $194,150

Average cost=($194,150)/(21,300)

$9.12

Price paid

Number

of Units

COGS

Number

of Units Ending

per unit Expensed

on Hand

on Inventory

Balance 31-Jul

31-Jul $9.12 16,900 $154,044 4,400 $40,106


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E7-6.a. Raw materialsthe lumber is used to make the furniture.b. Work-in-processthis is partially made furniture.c. Tools are equipment, not inventory, since they are used in the production of inventory but

will never be part of the finished product.

d. Raw materials- used to make seatse. Supplies because sandpaper is used in the production of the furniture but doesntbecomepart of the furniture. Itsincluded in supplies because it is used in the production processbut is not a capital asset like equipment.

f. Finished goodsgoods ready for sale.g. Supplies because packaging is used up in the sale of inventory but is not a capital asset

like equipment.h. The storage containers for the parts wouldntbe classified as inventory because they

arentused up in production of the product or available for sale. They will be used formany periods and should be classified as a capital asset.

E7-7.a. Wrapping for the burgers would be considered inventory because the wrappings willbecome part of the final productthe burgersor other food that is sold to the customerand is physically consumed when the product is sold.

b. Plastic cutlery would be considered product inventory. Itspart of the final product that issold to the customer. Its physically consumed when the productissold.

c. Mops and brooms are used on an ongoing basis to keep the restaurant clean. They arecleaning equipment (capital assets), not inventory.

d. Oil for cooking the French fries would be considered part of the supplies inventory.Itisntpart the final product and the oil isntsold to the customer.Oil is used in theproduction of the food but doesntbecome part of the food.

e. Raw meat is product inventory. When cooked it will be part of the product that is sold tocustomers.

f. Cooking implements are equipment, not inventory because they are used in theproduction of inventory but arentpart of the finished product.

g. Ketchup, mustard, and relish are added to the burgers and would be considered productinventory because they become part of the final product that is sold to customers.

h. Unused cleaning supplies are supplies inventory. Restaurants arentin the business ofselling cleaning supplies but they are required to maintain a clean establishment thus theyare used up in operating the business.


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E7-8.

a. A bank wouldntconsider cash as inventory on the F/S. They arentin the business ofselling money. They lend it out but they expect it back. On the other hand, a coincollector who buys and sells coins would consider his cash or money as inventory

because he is selling it.b. A chain saw to a rental store wouldntbe considered inventory unless they were sellingthe chain saw. Rental equipment is a capital asset because the equipment will contributeto earnings for more than one period and remains in the ownership of the rental store.

c. A shopping center owned by commercial real estate developer may or may not beinventory. If the building was built or being built and the developer intends on selling theshopping center then it is inventory. If the developerintends on operating the shoppingcentre then the shopping center is considered a capital asset. If the shopping center werebeing constructed for another entity then all the expenses associated with constructionwould be recognized as inventory until revenue is recognized at the time of sale.

E7-9.a. A custom furniture maker would use specific identification because each piece offurniture is unique and identifiable and traceable to specific orders.

b. Car dealership would use specific identification because each car will have a vehicleidentification number (VIN), each is unique (have specific features) and identifiable buteach also represents a high dollar amount.

c. A lumber yard wouldnt use specific identification because the lumber will be relativelylarge quantities of homogeneousitems, which isnt conducive for specific identification.A lumber yard would likely use FIFO or average cost.

d. High-end audio visual store can sell a wide range of merchandise and may select to usedifferent cost assumptions. For example cables and accessories can be either FIFO oraverage cost since the items are lower cost and homogeneous. Forhigh ticket items thestore may use specific identification because each piece of inventory is identifiable (has aserial number) and would be valuable for control purposes.

e. An orange juice producer would use a cost formula: average cost and FIFO. Specificidentification would be impossible since orange juice may blend oranges that wereobtained at different costs.


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E7-10.a.

FIFO

Price paid

per unit

Number

of Units

Expensed

Number

of Units

on Hand

Ending

InventoryCOGS

1-Jan-17 $5.00 50,000 $250,000 - $0

Purchases during 2017 $5.00 140,000 700,000 60,000 300,000

2017 Total $190,000 $950,000 60,000 $300,000

1-Jan-18 $5.00 60,000 $300,000 - $0

Purchases during 2018 $5.00 210,000 1,050,000 40,000 200,000

2018 Total $270,000 $1,350,000 40,000 $200,000

Average cost in 2017 and 2018: $5.00

Cost per

unit

Number

of Units

ExpensedCOGS

Number of Units

on Hand on Dec.

31

Ending

Inventory

Dec. 31, 2017 $5.00 190,000 $950,000 60,000 $300,000

Dec. 31, 2018 $5.00 270,000 $1,350,000 40,000 $200,000

Gross margin per unit $6 ($11$5)Gross margin percentage 54.5% ($6/$11)

b.

All values are the same regardless of the inventory cost formula used. When cost and sellingprices per unit are constant over time the inventory and gross margin amounts are the same forall three methods (including specific identification). This observation differs from typicalaccounting text questions but would reflect reality for many companies when inflation is verylow.


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E7-11.The effects on gross margin and ending inventory using specific identification if a certain vehiclewere sold are as follows.

VIN#

2X346782N 3K786281L 8T492711K 4U787412Q

Sales $32,000 $32,000 $32,000 $32,000

COGS 21,200 19,800 22,900 20,150

Gross Margin $10,800 $12,200 $9,100 $11,850

Remaining ininventory $19,800 $21,200 $21,200 $21,200

22,900 22,900 19,800 19,800

20,150 20,150 20,150 22,900

Ending Inventory $62,850 $64,250 $61,150 $63,900

a.

If Fermeuse wanted to minimize profit on the sale, it would sell the car that cost the most,(8T492711K). The higher expense will result in a lower net income. The impact on grossmargin and ending inventory of VIN# 8T492711Kand a comparison with the other vasesare shown in the above chart. (GM = $9,100 and Ending Inventory = $61,150)

b. If Fermeuse wanted to maximize profit on the sale it would sell the car that cost the least,3K786281L. The lower expense will result in a higher net income. The impact on grossmargin and ending inventory of VIN# 3K786281Land a comparison with the other carsare shown in the above chart.(GM = $12,200 and EndingInventory = $64,250)

c. By expensing the most expensive car as in part a,Fermeusewill have a lower amountrecorded in itsinventory account.The opposite is true if Fermeuse expenses the leastexpensive car. Reasons Fermeusesmanagement might want to maximize profit include:increase their bonus, avoid violation in terms of contract compliance, try to influencestock prices (if it were a public company), to get a loan, inflate selling price, or to presentthemselves as good managers. The higher selling price would also result in a higherinventory valuation and if the amount of a loan was based on inventory valuationmanagement might choose to sell the least expensive item if it needed maximize the loan.Reasons Fermeuses management might want to minimize profit include:it is an ownermanagement situation and the manager wants to delay paying his or her taxes.

Yes, in reality Fermeuses management would have the opportunity to manage thefinancial statements in this way. Specific identification is the best cost formula to use toachieve ones objective. Management has control over which inventory item is physicallysold, which determines gross margin and net income. Using the other cost formulasrequires application of a mechanical formula.


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E7-12.

Cost of sales 27,050,000

Opening Inventory 6,900,000

Ending Inventory 7,800,000

Average inventory 7,350,000

a. Inventory turnover ratio

Cost of sales/average inventory

=$27,050,000 $7,350,000 = 3.68

b. Average number of days inventory on hand

365/inventory turnover ratio

= 365 3.68 = 99.18

c.We cantassess whether the turnover is satisfactory without having benchmarks. Informationthat could be helpful includes the typical turnover for a company in the same industry and theturnover for this company in recent years, to identify trends. Also, any changes in the accountingenvironment that might explain or affect the turnover period would be useful.Knowing the natureof the inventory would also be helpful.

E7-13.a.The inventory should be written down if NRV is less than cost. In this case NRV is less than costby $90,000 ($1,125,000-$1,035,000)so a write down of $90,000 is necessary.

b.Dr. Cost of sales 90,000

Cr. Inventory 90,000

c. The inventory should be reported on the balance sheet at the amount lower of cost andNRV,which is $1,035,000.


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E7-14.a.The inventory should be written down if NRV is less than cost. In this case NRV is less than costby $187,500 ([(4.754.00) x 250,000]) so a write down of $187,500 is necessary.

b.Dr. Cost of sales 187,500Cr. Inventory 187,500

c. The inventory should be presented on the balance sheet at the amount lower of cost andNRVwhich is $1,000,000.

d.

31-Mar-18

Inventory (units) on hand 70,000

Recovered amount per item $0.30 (4.30-4.00)

Write-up $21,000

e.Dr. Inventory 21,000

Cr. Cost of Sales 21,000

f. The inventory should be presented on the balance sheet at the amount lower of cost and NRVwhich is $301,000 (70,000 x 4.30).


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E7-15.

Cost of sales

(COS)

Average inventory

(AI)

Inventory turnover ratio

(ITR)

Average number of

days on hand (#d)

a $625,000.00 $78,938.36 7.92 46.10

b $20,568,240.00 $4,312,000.00 4.77 76.52

c $5,046,954.55 $152,100.00 33.18 11.00

d $4,875,000.00 $2,900,000.00 1.68 217.13

Inventory turnover ratio = cost of sales/ average inventoryCost of sales = inventory turnover ratio * average inventoryAverage inventory = cost of sales / inventory turnover ratio

Average number of days inventory on hand = 365/ inventory turnover ratioInventory turnover ratio = 365 / average number of days on hand

a ITR = 365/#d = 7.92 b.

ITR = COS/AICOS = ITR*AI=$20,568,240.00

AI = COS/ITR = $78,938.36 #d = 365/ ITR = 76.52

c. ITR = 365/#d = 33.18 d. ITR = COS/ AI = 1.68

COS = AI * ITR = $5,046,954.55 #d = 365/ ITR = 217.13

E7-16.

Dec. 31, Dec. 31, Dec. 31, Dec. 31,

2016 2017 2018 2019

Beginning inventory $100,000 $150,000 $125,000 $200,000

Purchases 950,000 775,000 1,200,000 1,300,000

Ending inventory 150,000 125,000 200,000 190,000

Cost of sales 900,000 800,000 1,125,000 1,310,000

Ending inventory from current year is equal to the beginning inventory in the next year.


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E7-17.a.

Cash $140,000

Accounts receivable 367,000 FIFO Average

Prepaid assets 25,000 Inventory $247,000 $229,000

Other current assets $532,000 Other current assets 532,000 532,000

Bank loan $148,000 Total current assets $779,000 $761,000

Accounts payable and accrued liabilities 318,000 Current liabilities $466,000 $466,000

Current liabilities $466,000 Current ratio (CA/CL) 1.672 1.633

b.The lower the value of inventory, the lower the current assets and the lower the current ratio.

Different inventory cost formulas will yield different carrying amounts for inventory andtherefore different current ratios, if prices are changing.

c.The current ratio is a method of measuring the liquidity of an entity. It is a representation of thateconomic characteristic and will vary with the assumptions that go into the measurement. Themeasure isntthe actual economic characteristic. Assuming that the user of the financialstatements doesntrealize the impact of the particular inventory policy, average costwould resultin a perception that the company is less liquid than if FIFOhad been chosen. However, while themeasurement of liquidity varies how inventory is valued, the actual liquidity of the entity isntaffected by the different measurements (notwithstanding secondary effects (tax for example) of

different choices).

d.FIFO provides the valuation that is nearest to replacement cost and the replacement cost wouldprovide the best basis for determining the NRV of the inventory. For liquidity purposes the issueis how much cash can the entity receive for its inventory. Recent inventory prices would be mostinformative for that purpose.


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E7-18.a.Cost formula Average Inventory

(Beg+End)/2

Cost of goods sold

for 2018

Inventory

Turnover

Average Days

In Inventory

FIFO $613,500 $2,475,000 4.03 90.48

Average cost 579,500 2,506,000 4.32 84.40

b.Price of inventory is rising causing the carrying amount of inventory to be higher under the FIFOcost formula. As a result the average value of inventory is higher than under the average costmethod. COGS under FIFO is lower than under average cost. The combined effects lead to alower turnover and higher average days in inventory under the FIFO cost formula. It should benoted that average days of inventory is more accurately calculated using physical units ratherthan dollar value.

c.

Based on cost formula, inventory turnover is quicker under the average cost method. The realturnover of inventory isnt affected by the cost formula; the ratio is a representation of the actualeconomic activity. The real physical turnover of the inventory is the same if the measure is basedon physical units rather than cost assumptions.

E7-19.

Current

Ratio

Quick

Ratio

Gross

Margin

Percentage

Inventory

Turnover

Ratio

Profit

Margin

Percentage

Debt-to-

equity ratio

a.* Decrease No effect Decrease Increase Decrease Increase

b.** Increase Increase Increase Increase Increase Decrease

c. No effect No effect No Effect No Effect No effect No effectd. Decrease Decrease No effect Decrease No effect Increase

*Assumesthat for inventory turnover ratio items a. the costs associated with the write-down areincluded in cost of goods sold.**For the purposes of the PM% this analysis assumes that the margin on the products sold isgreater than the margin on other products sold.


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E7-20.a.Dr. Allowance for sales returns (contra asset) 8,000

Cr. Accounts receivable 8,000Dr. Inventory 5,000

Cr. Cost of Sales 5,000Under a perpetual system inventory and cost of sales are immediately accounted for.With a periodic system no entry is made to inventory and cost of sales and the impact isreflected at the end of the period.

b.Dr. Cost of sales 20,000

Cr. Inventory 20,000The loss is debited to cost of goods sold and the balance in inventory is reduced. If theamount of the write down were material, it could be reported separately instead of beingincluded in cost of sales.

c.

Dr. Purchases 15,000Cr. Cash 15,000For a periodic inventory system.

Or

Dr. Inventory 15,000Cr. Cash 15,000

For a perpetual system.d.Dr. Cash 22,000

Cr. Sales 22,000No entry involving inventory is necessary under a periodic system at the time of the sale.

e.Dr. Accounts receivable 20,000

Cr. Sales 20,000

Dr. Cost of goods sold 8,000Cr. Inventory 8,000A journal entry to record cost of sales and adjust inventory is required under a perpetualsystem.

f.Dr. Cost of sales 193,000Dr. Inventory (ending) 32,000

Cr. Inventory (beginning) 25,000Cr. Purchases 200,000According to cost formula Cost of Sales = Beg. Inventory + PurchasesEndingInventory = $25,000+$200,000-$32,000=$193,000

g.Dr. Cost of sales 15,000


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Cr. Inventory 15,000The inventory must be written down under Lower of cost and NRV assuming that GAAPis a constraint.

E7-21.a.Number

of Units

Purchased

Price paid

per unit COGAFS

Number

of Units

sold

Price sold

Per Unit

Sales

Revenue

Open Inventory 70 $950 $66,500

1-Oct-16 144 900 $129,600

2-Jan-17 108 860 $92,880

1-Apr-17 84 810 $68,040

2-Jul-17 170 775 $131,750

October-December, 2016 162 $1,710 $277,020

January-March, 2017 116 1,620 $187,920April-June, 2017 86 1,550 $133,300

July-September, 2017 158 1,390 $219,620

Total 576 $488,770 522 $817,860

COGAFS- cost of goods available for sale

FIFO

Price paid

per unit

Number

of Units

Expensed COGS

Number

of Units

on Hand

Ending

Inventory

Open Inventory $950 70 $66,500 - $0

1-Oct-16 900 144 $129,600 $02-Jan-17 860 108 $92,880 $0

1-Apr-17 810 84 $68,040 $0

2-Jul-17 775 116 $89,900 54 $41,850

30-Sep-17 Balance 522 $446,920 54 $41,850

Average Cost

Number

of Units Price paid

purchased per unit COGAFSOpen Inventory 70 $950 $66,500

1-Oct-16 144 900 $129,600

2-Jan-17 108 860 $92,880

1-Apr-17 84 810 $68,040

2-Jul-17 170 775 $131,750

Total 576 $488,770


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Average Price=(488,770)/(576)

$848.56

Price paid

Number

of Units

Number

of Units EndingBalance per unit Expensed COGS on Hand Inventory

30-Sep-17 $848.56 522 $442,948 54 $45,822

Periodic

SystemFIFO Average

September 30, 2017

Sales $817,860 $817,860

COGS 446,920 442,948

Gross Margin 370,940 374,912

Ending Inventory 41,850 45,822

b. To maximize income you would choose average cost. It has the lowest expense (COGS),which will result in the highest net income.

c. To minimize taxes you would choose FIFO because under FIFO cost of sales is largestthus lowest net income.

d. When prices are rising, the effects of the two methods are reversed. Rising prices mean

the average cost of inventory on hand will be lower than FIFO because the inventory onhand under will have newer, higher prices (the average will capture older, lower prices).This means COGS will be higher for average cost and lower for FIFO. Under averagecost the cost of inventory expensed is an average of high and low costs while FIFOexpenses the older, lower priced inventory first.

e. NRV of inventory is 54 units x (1390-120) = 68,580

Ending Inventory FIFO Average

Cost $41,850 $45,822

NRV (selling price -selling cost) 68,580 68,580

Lower of cost and NRV 41,850 45,822

In both cases cost is lower than NRV less cost to sell so cost is used to value ending inventoryand no write down is necessary.


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E7-22.Number

of Units Price paid COGAFS

Number

of Units Price sold Sales

Purchased per unit sold Per Unit Revenue

Open Inventory 24,000 $5.00 $120,000

4-Sep-16 16,000 $5.50 $88,0004-Dec-16 20,000 $6.00 $120,000

6-Mar-17 30,000 $6.30 $189,000

7-Jun-17 14,000 $6.60 $92,400

During 82,000 $12.00 $984,000

Total 104,000 $609,400 82,000 $984,000

COGAFS- cost of goods available for sale

Number of Uni ts Sold = Opening inventory + Purchases -Endi ng I nventory

(24,000) + (16,000+20,000+30,000+14,000) - (22,000)

82,000 Units

FIFO

Price paid

Number

of Units

Number

of Units Ending

per unit Expensed COGS on Hand Inventory

Open Inventory $5.00 24,000 $120,000 - $0

4-Sep-16 $5.50 16,000 $88,000 $0

4-Dec-16 $6.00 20,000 $120,000 $0

6-Mar-17 $6.30 22,000 $138,600 8,000 $50,400

7-Jun-17 $6.60 - $0 14,000 $92,400

30-Jun-17 Balance 82,000 $466,600 22,000 $142,800

Average Cost

Number

of Units Price paid

purchased per unit COGAFS

Open Inventory 24,000 $5.00 $120,000

4-Sep-16 16,000 $5.50 $88,000

4-Dec-16 20,000 $6.00 $120,000

6-Mar-17 30,000 $6.30 $189,000

7-Jun-17 14,000 $6.60 $92,400Total 104,000 $609,400

Average Price=(609,400)/(104,000)

$5.86

Price paid

Number

of Units

Number

of Units Ending


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Balance per unit Expensed COGS on Hand Inventory

30-Jun-17 $5.86 82,000 $480,488 22,000 $128,912

Warspite Ltd.

Income Statement

For the Year Ended June 30, 2017

FIFO Average

Sales $984,000 $984,000

COGS 466,600 480,488

Gross Margin 517,400 503,512

Other Expenses 400,000 400,000

Income before taxes 117,400 103,512

Income Taxes (20%) 23,480 20,702

Net Income $93,920 $82,810


b.Average cost provides lower income and therefore lower income taxes when prices are rising andis preferred when tax postponement is the objective.

c.Warspite would use another method if the primary objective wasnttax minimization. Perhaps

the bank will use the statements and rely on the balance sheet to assess liquidity and collateral, orthe amount of the loan is in part based on the amount of inventory outstanding. The managersmight have bonuses based on net income, which would establish incentives for them tomaximize, not minimize, net income. Other objectives could also come into play.


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E7-23.a. The equipment should be written off because it can no longer provide future benefit to the

company. Conservatism requires that assets not be overstate assets.

Dr. Loss on equipment (I/S) 25,000

Cr. Equipment (assets) 25,000

b. The inventory should be written down to its net realizable value. Otherwise assets areoverstated.

Dr. Loss on impaired inventory (I/S) 40,000Cr. Inventory (assets) 40,000

c. The existing equipment is probably impaired and should be written down.The amount of thewritedown cant be determined with the information provided.The journal entry would looklike this:

Dr. Loss on impairmentof equipment (I/S)Cr. Accumulated depreciation (contra-assets+) or equipment (assets)

d. The loss on the investment should be recognized when it is known. The declaration ofbankruptcy is clear evidence that little if anything will ever be received for the shares.

Dr. Loss on loan (I/S) 300,000Cr. Investment in loan (assets) 300,000

E7-24.

a. Ending inventory is overstated since Lamline doesntown the inventory.b.

Cost of goods sold (COGS) is understated as a result of overstating ending inventory.(COGS = Beg. Inventory + PurchasesEnd. Inventory)

c. Gross Margin is overstated as a result of understating COGS. (SalesCOGS = GrossMargin)

d. Overstatinggross margin results in the overstatement of net income.

E7-25.a. Ending inventory is counted so it isntaffected assuming the count is correct. However

purchases will be understated for the year.b. Cost of goods sold (COGS) is understated as a result of understating purchases. (COGS =

Beg. Inventory + PurchasesEnd. Inventory)c.

Gross Margin is overstated as a result of understating COGS. (SalesCOGS = GrossMargin)

d.

Overstating gross margin results in the overstatementof net income.


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E7-26.a. Ending inventorycarrying amount for Company A would be higher than Company B by

$50,000.The number of physical units wouldbe the same.b. Current assets includes inventory so Company As current assets would be $50,000

greater than Company Bs.

c.

Overall, Company B would have expensed $50,000 more than Company A (Company Bexpensed the full $100,000 in 2017, while A expensed $50,000). Company As $50,000would be in cost of goods sold while Bs $100,000 expense wouldbe included belowgross margin.

d. Net income would be higher in Company A than in Company B by $50,000 because Aonly recognized 50% of the overhead cost as an expense in 2017 while Company Bexpensed the entire amount.

E7-27.

a. Write Down =Inventory CostNRV = ($400,000)($245,000) = $155,000

b.

The write down resulted in a lower gross margin, gross margin percentage, net incomeand profit margins.

Hemlo Inc.Summarized Income StatementFor year Ended December, 2017

With Without

Writedown Write Down

Sales $3,450,000 $3,450,000

Cost of sales 1,207,500 1,052,500

Gross margin 2,242,500 2,397,500

Other expenses 1,897,500 1,897,500

Net income 345,000 500,000

Gross Margin % 65.00% 69.49%

Profit Margin % 10.00% 14.49%

c.

For the 2018 income statement COGS would be calculated using the carrying amount ofthe inventory on December 31, 2017 ($245,000). As a result net income and gross marginwill be higher than it would have been had there been no writedown in 2017 because partof the cost was expensed in 2017. This example demonstrates how conservatism can beused to manipulate financial statements to achieve managements objectives. The grossmargin would have been $155,000 higher in 2017 if the write-down did not occur.


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25 00

Nov.30 Balance 480

$6,362.50 300

$4,170.00

Average Cost

# of Unitspurchased

Costper unit

COGAF

S

Opening 250 $13.00

$3,250.00

Nov.10 200 13.50

$2,700.00

Nov.20 150 13.75

$2,062.50

Nov.25 180 14.00

$2,520.00

Total 780$10,532.

50

average cost=($10,532.50)/(780)= $13.503

Price paid

per unit

Number of Units

Expensed COGSNumber of Units

on Hand

Ending

Invento

ry

Balan

ce

Nov.30 13.503 480

$6,481.50 300

$4,051.00

Note that exact answers may vary due to rounding.

P7-2.a.

Cardigan

(FIFO)

Huskisson

(Average)

Current Assets (CA) $2,165,700 $1,759,950

Current liabilities (CL) 1,455,000 1,455,000

Current ratio = CA/CL 1.49 1.21

Quick Assets (QA) 520,200 520,200

Current liabilities (CL) 1,455,000 1,455,000

Quick ratio = QA/CL 0.36 0.36

Beg inventory 1,432,650 1,345,500

End inventory 1,582,500 1,176,750

Average inventory (AI) (beg+end)/2 1,507,575 1,261,125

cost of sales (COS) 2,548,800 2,867,400

Inventory turnover ratio = COS/AI 1.69 2.54

Average Number days = 365/ITR 215.89 143.35

Gross margin (GM) 2,761,200 2,442,600

Sales 5,310,000 5,310,000


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Gross margin % = (GM)/Sales 52% 46%

Net Income (NI) 586,200 267,600

Sales 5,310,000 5,310,000

Profit margin % =- NI/Sales 11.04% 5.04%

b.The current ratio indicates that Cardigan is the most liquid but in fact they are all equally liquid.Huskisson seems to have stronger liquidity as a result of its better inventory management(inventory turns over faster). The quick ratio is the same for both firms. However, in reality theliquidity of both firms is the same despite the differences in the measurements in the table. Theapparent differences are purely a result of the different ways that inventory is accounted for anddo not reflect any real economic differences among the firms.

c.Cardigan appears to be the most profitable because it has a higher profit margin percentage andhigher net income. However, in reality the profitability of both firms is the same despite the

differences in the measurements in the table. The apparent differences are purely a result of thedifferent ways that inventory is accounted for and do not reflect any real economic differencesamong the firms.

d.Huskisson appears to manage its inventory better than the other firm because it has a higherinventory turnover ratio, but they both manage inventory equally well. The apparent differencesare purely a result of the different ways that inventory is accounted for and do not reflect any realeconomic differences among the firms.

e.

Whether both firms have a different likelihood of obtaining a loan from their banks depends onwhether the lending officers are able to fully unravel the impact of accounting choices. Since theterms described in the question indicate that the loans are based on accounts receivable andinventory, Cardigan will obtain the largest loan because it reports the most inventory (accountsreceivable is the same for both). Both firms are equally risky despite what the numbers show.Since the firms are described to be identical in every respect they must be equally risky (thisassumes they both have similar customers, operate in similar markets, etc.). So while Cardiganwill receive the largest loan both firms are equally risky and it could be justified that the sameloans should be given to each.


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P7-3.

Weybridge

(FIFO)

Kennetcook

(average)

Current Assets (CA) 360,950 293,326

Current liabilities (CL) 242,500 242,500

Current ratio = CA/CL 1.49 1.21Quick Assets (QA) 86,700 86,700

Current liabilities (CL) 242,500 242,500

Quick ratio = QA/CL 0.36 0.36

Beg inventory 240,000 241,406

End inventory 263,750 196,126

Average inventory (AI) (beg+end)/2 251,875 218,766

cost of sales (COS) 552,240 621,270

Inventory turnover ratio = COS/AI 2.19 2.84

Average Number days = 365/ITR 166.48 128.53

Gross margin (GM) 332,760 263,730

Sales 885,000 885,000Gross margin % = (GM)/Sales 38% 30%

Net Income (NI) 90,760 21,730

Sales 885,000 885,000

Profit margin % =- NI/Sales 10.26% 2.46%

b.The current ratio indicates that Weybridge is the most liquid but in fact they are all equallyliquid. Kennetcook seems to have stronger liquidity as a result of its better inventorymanagement (inventory turns over faster). The quick ratio is the same for both firms. However,

in reality the liquidity of both firms is the same despite the differences in the measurements inthe table. The apparent differences are purely a result of the different ways that inventory isaccounted for and do not reflect any real economic differences among the firms.

c.Weybridge appears to be the most profitable because it has a higher profit margin percentage andhigher net income. However, in reality the profitability of both firms is the same despite thedifferences in the measurements in the table. The apparent differences are purely a result of thedifferent ways that inventory is accounted for and do not reflect any real economic differencesamong the firms.

d.Kennetcook appears to manage its inventory better than the other firm because it has a higherinventory turnover ratio, but they both manage inventory equally well. The apparent differencesare purely a result of the different ways that inventory is accounted for and do not reflect any realeconomic differences among the firms.

e.


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Whether both firms have a different likelihood of obtaining a loan from their banks depends onwhether the lending officers are able to fully unravel the impact of accounting choices. Since theterms described in the question indicate that the loans are based on accounts receivable andinventory Weybridge will obtain the largest loan because it reports the most inventory (accountsreceivable is the same for both). Both firms are equally risky despite what the numbers show.

Since the firms are described to be identical in every respect they must be equally risky (thisassumes the three have similar customers, operate in similar markets, etc.). So while Weybridgewill receive the largest loan both firms are equally risky and it could be justified that the sameloans should be given to each.

P7-4.Note: This question is designed to get students thinking about the basis for making accountingchoices. Accounting choices arentmade in a vacuum. Managers will (should) consider theimpact of the choices. In this question there are two inventory accounting choices to consider:the cost formula and periodic versus perpetual inventory control. To provide a good answer,

students must consider the information provided, the reporting objectives of the variousstakeholders, and the nature of the business. It is important to recognize that there is no onecorrect answer (though there can be many poor ones). The quality of an answer is based on astudents ability to interpret the scenario and provide recommendations that make sensethatare consistent with the scenario. For example, in this problem it would be reasonable to arguethat tax minimization is most important or that given the ongoing cash shortage, providinginformation attractive to the bank might be more appropriate. Students should play the role whenresponding, meaning that a report to management should be written. Explanations should be tiedto the objectives of reporting. The discussion below outlines the considerations a student canbring to a response:

Considerations:

Objectives: The most likely objectives are tax minimization or increasing income and assets tosupport additional financing from the bank. Tax minimization makes sense because Riondel isprivately owned, all owners are involved in management (no external shareholders), there is debtoutstanding and the bank loan is personally guaranteed, which suggests that the bank is also akey user. In support of income and asset maximization is that the company is short of cash,which means that additional financing may be needed and the owners might want to show theincome earning potential of the company and available assets as collateral (high inventoryvalue). Reducing taxes, however, will help conserve needed cash.

Facts: The computer business is marked by rapid change and declining inventory values as newproducts replace old. Obsolete inventory is a concern. Many parts are expensive, as are finishedgoods.

Accounting Issues

Cost formula: For tax minimization FIFO may be the best choice because computer businessestend to operate in falling price environments. With FIFO the oldest, highest costs will be


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expensed first, lowering net income and taxes. For bank loan purposes average cost would bemore appropriate since there will be higher inventory values and higher net income.

Perpetual versus periodic control: Many inventory items are expensive (even though thecompany tries to keep the laptop prices as low as possible) and so good control over parts, work-

in-process, and ending inventory is important. A perpetual inventory system would beappropriate in these circumstances.

Lower of cost and NRV: For finished goods, net realizable value makes sense since there will bea market for finished goods. It may be more difficult to determine the NRV of parts soreplacement cost would be more functional. Since CRA allows application of the lower of costand market for tax purposes, Tesseralik should take advantage of write downs when available toreduce taxes (assuming a tax minimization objective). While CRA uses lower of costs andmarket for accounting purposes lower of cost and NRV includes a further reduction of sellingcosts. Therefore from a tax bases market value and replacement costs outside of selling cost can

be used as a bases for inventory valuation.

Given an objective of tax postponement, you will want to select accounting policies that reduceending inventory to the lowest acceptable value. Direct costing is permitted by Canada RevenueAgency and will ensure that all fixed overhead costs are expensed as early as possible. In yourindustry, prices tend to fall continuously, so FIFO will result in delaying income. Since lower ofcost and market is permitted by CRA, you will also benefit from writing down cost to market.

P7-5.Note: This question is designed to get students thinking about the basis for making accountingchoices. Accounting choices arentmade in a vacuum. Managers will (should) consider theimpact of the choices. In this question there are two inventory accounting choices to consider:the cost formula and periodic versus perpetual inventory control. To provide a good answer,students must consider the information provided, the reporting objectives of the variousstakeholders and the nature of the business. It is important to recognize that there is no onecorrect answer (though there can be many poor ones). The quality of an answer is based on astudents ability to interpret the scenario and provide recommendations that make sensethatare consistent with the scenario. For example, in this problem the circumstances point tomanagement wanting to smooth earnings (to appear less risky) or maximize earnings tomaximize its initial public offering (IPO) and attract new shareholders (who may rely onfinancial statements to assess management and performance before investing) and creditors.There is also the management bonus which creates incentives for management to increaseincome. Liquidity measurement is also an issue because Ormiston pays surplus cash out to theshareholders. Being aware of the cash requirements is crucial for determining surplus cash.Students should play the role when responding, meaning that a report to management should bewritten. Explanations should be tied to the objectives of reporting. The discussion below outlinesthe considerations a student can bring to a response:


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Objectives: The minimization of taxes is a consideration since the shareholders are obviouslyquite cash conscious since they receive distributions when there is surplus cash. Minimizingtaxes would create more surplus cash. However, an important use of the financial statements isfor reporting to the investors who arentinvolved in the management of the company and willrequire information for assessing the performance of the business and management. It is possible

that management may choose between either income smoothing to appear less risky to attract themost investors or income maximization to achieve the highest stock price when the companygoes public with its IPO. The use of net income to determine management bonuses requires thatit reflect the results of management decisions. The bank will require the financial statements toassess the ability of the firm to meet its obligations and to determine the maximum amount thatthe firm can borrow. It is likely that the latter uses will dominate managements concerns and soan income smoothing or income maximizing strategy will prevail.

Facts: There is a question of whether the accounting policies need to comply with IFRS. IFRS isautomatically required for public companies and may be needed to add credibility to thestatements. The absent shareholders, as well as the bank, along with the IPO IFRS compliant

statements will be required.

Lumber prices are quite volatile. For many companies, prices are either rising over time orfalling, but that is not the case for Ormiston. Because of changing market conditions, prices canbe rising or falling in any given period.

Cost formula: Given the volatility of the price of lumber it is difficult to choose an inventoryvaluation method that will consistently meet the objectives. Good discussions should integratethe volatility of lumber prices and its impact on reporting. FIFO will provide more useful balancesheet valuation because the most recent costs will appear on the balance sheet. Average cost mayprovide some smoothing effect, which could be desirable to management.

Periodic versus perpetual: Ormistons inventory is shingles (large number of similar, low priceditems) and inputs into the production of shingles. Control over quantities of inventory isimportant for inventory management and for insuring that adequate raw materials are on hand.However, a perpetual costing system may not be cost effective.

Lower of cost and NRV: Market for finished goods is best method of valuation of the inventory.since the main raw material is a commodity the market value is readily available. Selling costmay need estimations from management to complete the NRV calculation.


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P7-6.

Net

income

Cost of

sales

Total

assets

Owners

equity

Current

ratio

Inventory

turnover

Debt to

equity

a. Overstated Understated Overstated Overstated Overstated Understated Understated

b. Understated No effect Understated Understated Understated Overstated Overstated

b.(1) Understated Understated Understated Understated Understated Ambiguous Overstated

c. Understated Overstated Understated Understated Understated Overstated Overstated

d. Overstated Understated Overstated Overstated Overstated Understated Understated

e. Understated Overstated Understated Understated Understated Overstated Overstated

a. Decrease in cost of sales and an increase in the value of the inventory that should not havehappened.

b Assuming the costs were excluded from inventory at the end of the period therefore an increasein other expenses and a decrease in inventory that should not have happened.

b (1) Assuming the costs were excluded from inventory during the period therefore an increasein other expenses. During the period some of the inventory would have been sold resulting incost of sales being lower than it otherwise would have (because the cost is no longer ininventory). The result for inventory turnover is ambiguous in the scenario because the missingcost that was excluded from inventory gets allocated between inventory and cost of sales.Initially, the reducedvalue of inventory would result in the ITO to be overstated. As theinventory is sold the cost of sales would be proportionately understated and ultimately ITO isunderstated. As a result the ITO could be overstated or understated.

c. By not counting the inventory assets was understated resulting in ending inventory beingunderstated as well. Assuming a periodic system cost of sales was overstated based on Cost ofSales = Beginning. Inventory + PurchasesEnding. Inventory.

d. Should have been a write down on the inventory thus inventory is overstated and COS isunderstated.

e. Assuming it was not appropriate to recognizethe revenue (FOB Destination) net income, costof sales, owners equity and the debtto equity ratio would all be affected. Total assets would beunderstated as inventory title as not changed hands. Therefore the current ratio would also be

understated. ITO would be overstated due to inventory being understated.


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P7-7.

Net income Cost of

sales

Total

assets

Owners equity Current

ratio

Inventory

turnover

Deb

a. Overstated Overstated Overstated Overstated Overstated Overstated U

b. Understated Overstated Understated Understated Understated Overstated O

c. Understated Overstated Understated Understated Understated Overstated O

d. Overstated Understated Overstated Overstated Overstated Understated U

a. Assuming that inventory is sold for a profit. The year-end count will be low thus, a lowerinventory amount in assets and higher COGS then what should be recorded. Sales andreceivables would be overstated (resulting in an overall overstatement of total assets asreceivables would be overstated by a larger amount than the inventory understatement). As aresult net income and owners equity would be overstated and thedebt to equity ratio would beunderstated. Inventory turnover would be overstated due to the increase in COGS and decreasein inventory.

b Not counting inventory would result in less ending inventory resulting is a higher cost of sales.(Cost of Sales = Beginning Inventory + Purchases.Ending Inventory)

c. Assuming that the subsequent write-up would have been included in COGS (as a gain) netincome and equity would be understated, COGS and the debt to equity ratio would be overstated.The overstatement of COGS also results the ITO being overstated because COGS should belower and inventory higher. Total assets is also understated due to the decreased inventorybalance. Therefore the current ratio is also understated.

d. Inventory on consignment belongs to on the suppliers records therefore counting it as part ofthe companys asset is increasing inventory that doesntbelong in the companys books. Thiswill result in COGS being lower and assets being too high.

P7-8.To the management of Enterprise Inc.:

I have examined the information that you have provided to me and make the following estimateof the inventory destroyed by flood on August 19, 2017.

Beginning inventory $1,125,000Purchases 325,000Cost of goods available for sale $1,450,000

Sales at Retail $980,000Sales at cost = 65% of 980,000 = 637,000Estimated inventory at time of fire $813,000

Since the deductible is $20,000, the claim should be for $793,000. This represents the cost of theinventory lost at the time of the fire.


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This estimate is based on the assumption that there was no theft or spoilage during the period andthat the gross margin for the merchandise that was sold was the usual 35%. It is also assumedthat there was no obsolete inventory on hand. If these assumptions arentvalid, the estimatewontbe correct.

P7-9.

Category 1 Category 2Beginning inventory $325,000 $525,000Purchases 300,000 285,000Cost of goods available for sale $625,000 $810,000

Sales at Retail $610,000& $595,000Sales at cost = 35% of 610,000 = 213,500

52% of 595,000 = 309,400Estimated inventory at time of the robbery $411,500 $500,600

The claim should be for a total of $912,100.

This estimate is based on the following assumptions

No losses due to other theft, damage, or spoilage during the period

Gross margins for the merchandise sold were the usual percentages.

There was no obsolete inventory on hand and there were no accounting errors in therecords.

If these assumptions arentvalid, the estimate wontbe correct.

P7-10.

Inventory category Cost Net realizable value Lower of Cost or NRV

Category 1 $168,000 $187,500 $168,000

Category 2 346,500 322,500 $322,500

Category 3 111,750 112,800 $111,750

Category 4 147,150 117,750 $117,750

Category 5 220,500 228,000 $220,500

Total $993,900 $968,550 $940,500

a.When Lower of Cost and NRV is determined on an item by item basis, the amount to recognizeas inventory on the balance sheet is $940,500.


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b.A write down of inventory of $53,400 would be needed.

c.

Dr. Loss on inventory $53,400Cr. Inventory $53,400To record the loss in inventory value.

P7-11.

Category Total cost NRV Lower of cost and NRV

Category 1 $276,178 $679,874 $276,178

Category 2 $480,291 $1,099,918 $480,291

Category 3 $685,125 $599,760 $599,760

Category 4 $315,549 $740,230 $315,549Category 5 $175,828 $161,143 $161,143

Total $1,932,972 $3,280,925 $1,832,921

a.The lower of cost and NRVdetermined on an item-by-item basis should be displayed on thebalance sheet: $1,832,921.

b. A write-down of $100,051(1,932,9721,832,921) is required.

c. Dr. Loss on inventory $100,051Cr. Inventory $100,051

To record the decline in inventory value.

d. Category 3 and 5 were written down to NRV and now average cost is lower than NRVtherefore we must reverse the write down on the units remaining back to their original cost.

Category

Number

of units

that were

on hand

on

December

31, 2017

Carrying

amount of

units on

Dec. 31,

2017

NRV on

March 31,

2018

Increase

inNRV per

unit

Write up

Amount

Category 3 21,520 $15.23 $17.40 $2.17 $46,698

Category 5 8,104 $8.59 $9.10 $0.51 $4,133

Total $50,831

Note: numbers are rounded


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Dr. Inventory $50,831Cr. Gain on Inventory $50,831Reversing previous write down of inventory

e.The carrying amount of inventory on March 31, 2018 should be $1,908,883.This is pre-

adjustment amount of all the inventory ($1,858,052) plus the reversal of the writedown onDecember 31, 2017 (50,831).

P7-12.a.

Beginning inventory 3,279,706

Purchases 1,244,550

Cost of goods available for sale 4,524,256

Cost of sales 1,319,320

Cost of damaged merchandise 15,688

Estimated inventory at time of theft 3,189,248

Actual inventory count 3,066,896

Estimated loss due to theft $122,352

Another approach to the same solution; this approach compares the actual amount of cost ofgoods sold with the amount that is recorded in the accounting system.

Inventory Actual Amt

End (=) beginning (+) Purchases (-) COGS 1

3,066,896 3,279,706 1,244,550 ?

1,457,360

Recorded Amt COGS 2 (=) 1,319,320

Loss 138,040 Loss = COGS 1 - COGS 2

Less damaged 15,688

Estimated stolen 122,352

b.

Itspossible that some portion of the estimated loss is due to thefts that occurred at another time,was due to damage in addition to the amount estimated, or was the result of accounting errorssomewhere in the accounting system. Another possible explanation is errors in the inventorycount.

c.


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There is no other way to know with certainty how much inventory is on hand. Any other methodcould be incorrect. The purpose is to compare the actual amount of inventory on hand with theamount that shouldbe on hand if there were no inventory losses, errors, etc.

P7-13.

Beginning inventory 1,910,000

Purchases 802,500

Cost of goods available for sale 2,712,500

Cost of sales* 975,000

Cost of returned merchandise 81,000

Estimated ending inventory 1,656,500

Actual inventory count 1,440,000

Estimated loss due to theft $216,500

*Cost of sales = Sales * (100%-25%)=$1,300,000 * 75%=$975,000

b.Itspossible that some portion of the estimated loss is due to thefts that occurred at another time,was returned to suppliers in addition to the amount estimated, or was the result of accountingerrors somewhere in the accounting system. Another possible explanation is errors in theinventory count.

c. There is no other way to know with certainty how much inventory is on hand. Any other

method could be incorrect. The purpose is to compare the actual amount of inventory on handwith the amount that should be on hand if there were no inventory losses, errors, etc.

d.Yes, the inventory would still need to be counted because itsnecessary to determine the actualamount of inventory on hand. A perpetual inventory control system doesntrecord consumptionof inventory caused by theft, loss, damage, or accounting errors. The physical count providesinformation about the effectiveness of the controls over inventory.


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P7-14.a. and b.

Porcelain Toys Linens Total

Revenue $862,500 $692,750 $405,750 1,961,000

Cost of sales 345,000 415,750 202,875 963,625

Gross margin (GM) 517,500 277,000 202,875 997,375

Sales 862,500 692,750 405,750 1,961,000

Gross margin % = (GM)/Sales 60% 40% 50% 51%

Beg inventory (2017) 146,250 168,750 102,500 417,500

End inventory (2018) 159,500 126,250 147,500 433,250

Average inventory (AI) (beg+end)/2 152,875 147,500 125,000 425,375

cost of sales (COS) 345,000 415,750 202,875 963,625

Inventory turnover ratio = COS/AI 2.26 2.82 1.62 2.27

Average Number days = 365/ITR 162 129 225 161

c.By examining the aggregate and segmented ratios, we can see that the porcelain category has thehighest gross profit percentage while the inventory of toys turns over most frequently. Thedetailed information enables us to know which products are more profitable. From amanagement perspective, the results suggest that the inventory of linens might be reduced toboost the turnover.

d.The aggregated information conceals valuable information. If we know that sales of figurines arean increasing proportion of total sales, for example, we know that the implications for profits aregreater than if more toys were to be sold. We also might be concerned if the turnover was low in

a category that was subject to obsolescence. Over time it could be difficult to interpret changes inthese measurements. Any changes could be due to differences in performance but they could alsobe due to changes in the relative weights of the three lines of business. Also, it would be difficultto compare Xenas performance with other companies because the composition of its businessactivities would likely be unique.

P7-15.a. and b.

Perishable Packaged Household Total

Revenue $2,375,000 $2,013,000 $2,625,000 7,013,000

Cost of sales 2,000,000 1,650,000 1,925,000 5,575,000

Gross margin (GM) 375,000 363,000 700,000 1,438,000

Sales 2,375,000 2,013,000 2,625,000 7,013,000

Gross margin % = (GM)/Sales 16% 18% 27% 21%

Beg inventory (2016) 50,000 183,500 437,500 671,000

End inventory (2017) 42,500 306,000 525,000 873,500

Average inventory (AI) (beg+end)/2 46,250 244,750 481,250 772,250

cost of sales (COS) 2,000,000 1,650,000 1,925,000 5,575,000

Inventory turnover ratio = COS/AI 43.24 6.74 4.00 7.22

Average Number days = 365/ITR 8 54 91 51


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c.Although the sales of the three product categories are fairly similar, there is a difference in theprofitability of the products and a very large difference in the turnover of inventory. We maywant to examine the cost of holding inventory to identify whether the higher margins on

packaged goods and household items are more than offset by higher inventory holding costs. Agreat deal of valuable insight is available from the detailed breakdown that is not obtainable fromaggregated information. We may wish to allocate more store space to product lines that are moreprofitable. The turnover for perishable items makes sense. Meat, dairy products, fruits, andvegetables have to be sold quickly or disposed of when (or as) they spoil. Packaged andhousehold items have much longer shelf lives. While it might be attractive to focus on the mostprofitable items, the stores must still provide enough breadth of products to satisfy customerdemandfailure to do so might drive customers elsewhere. Also, the lower gross margin of theperishables may be overcome by the high turnover.

P7-16.

a.

FIFO

Cost

per unit

Number

of Units

sold COGS

Number of Units on

Hand on Dec. 31,

2017

Ending

Inventory

OpeningInventory $6.00 5,000 $30,000 - $0

First Quarter $6.15 4,000 $24,600 $0SecondQuarter $6.45 5,500 $35,475 $0

Third Quarter $6.60 9,500 $62,700 $0Fourth Quarter $6.80 1,000 $6,800 2,500 $17,000

31-Dec-17 Balance 25,000 $159,575 2,500 $17,000

Average Cost

Number of

Units

purchased

Cost

per unit COGAFS

OpeningInventory 5,000 $6.00 $30,000

First Quarter 4,000 $6.15 $24,600SecondQuarter 5,500 $6.45 $35,475

Third Quarter 9,500 $6.60 $62,700

Fourth Quarter 3,500 $6.80 $23,800

Total 27,500 $176,575

Average cost=$176,575/27,500

= $6.42


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Cost

per unit

Number

of Units

sold COGS

Number of Units on

Hand on Dec. 31,

2017

Ending

Inventory

31-Dec-17 6.42 25,000 $160,523 2,500 $16,052

SummaryFor the Year ended Dec. 31, 2017

Periodic System FIFO Average

Sales $281,750 $281,750

COGS 159,575 160,523

Gross Margin 122,175 121,227


b.The amount of cash paid for inventory in 2017 was $146,575 and is the same under all costformulas. The cost formulas have no effect on the cash paid to suppliers. They only determinethe costs that are expensed each period and the costs included in inventory.

c.If the objective of the entity were to minimize taxes, the preferred method would be average cost,which results in the highest cost of goods sold, at $160,523.

d.FIFO yields the lowest cost of goods sold and therefore the highest income, which would providethe largest bonus to the CEO.

e.The highest balance sheet value is provided by FIFO. If the loan is affected by the amount ofinventory reported, a higher inventory value is preferred because it results in a larger loan.

f.

FIFO Average

Ending Inventory $17,000 $16,052

NRV per unit 6.25 6.25

Quantity at year end 2,500 2,500

NRV on Dec. 31, 2017 15,625 15,625

Write down 1,375 427

Inventory on Dec., 2017balance sheet 15,625 15,625

At $6.25, the total net realizable value of the inventory would be $15,625. With either alternativecost would exceed market and inventory should be written down to $15,625. Its assumed thatthe NRV of $6.25 includes selling costs. If it doesnt the writedown in both cases would begreater.


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g.In this particular case, there is very little difference in income between the alternatives. Endinginventory under average cost $16,052 and $17,000 under FIFO, a difference of less than $1,000,which for most purposes isnt material. Further, after applying lower of cost and NRV the

methods provide the same valuation. In general, the choice of accounting method can matter alot. Outcomes that are based on accounting numbers such as bonuses, bank loans, compliancewith covenants, and taxes can be affected by accounting measurements. However, regardless ofthe different measurements that can be used, the underlying economic activity being measured isthe same.

P7-17.

a.

FIFO

Cost

per unit

Number of Units

sold COGS

Number of

Units on Hand

on

April. 30, 2018

Ending

Inventory

Open Inventory $5.50 150,000 $825,000 - $0

First Quarter $7.00 180,000 $1,260,000 $0

Second Quarter $8.00 102,000 $816,000 $0

Third Quarter $8.50 124,000 $1,054,000 16,000 $136,000

Fourth Quarter $7.40 $0 160,000 $1,184,000

30-Apr-18 Balance 556,000 $3,955,000 176,000 $1,320,000

Average Cost

Number of

Units

purchased

Cost

per unit COGAFS

Open Inventory 150,000 $5.50 $825,000

First Quarter 180,000 $7.00 $1,260,000

Second Quarter 102,000 $8.00 $816,000

Third Quarter 140,000 $8.50 $1,190,000

Fourth Quarter 160,000 $7.40 $1,184,000

Total 732,000 $5,275,000

COGAFS- cost of goods available for saleAverage cost=$5,275,000/732,000

=7.206

Price paid

Number of

Units

Number of

Units Ending

Balance per unit Expensed COGS on Hand Inventory

30-Apr-18 $7.206 556,000 $4,006,694 176,000 $1,268,306


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SummaryFor the Year ended April 30, 2018

Periodic System FIFO Average

Sales $8,896,000 $8,896,000

COGS 3,955,000 4,006,694

Gross Margin 4,941,000 4,889,306

Ending Inventory 1,320,000 1,268,306

b.The amount of cash paid for inventory in fiscal 2018 was $4,450,000 and is the same under bothcost assumptions. The cost formulas have no effect on the cash paid to suppliers. They onlydetermine the costs that are expensed each period and the costs included in inventory.

c.

If the objective of the entity is to minimize taxes, the preferred method in this case would beaverage which results in the highest cost of goods sold, at $4,006,694.

d.FIFO yields the lowest cost of goods sold and therefore the highest income, whi

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