Chap 006

1. Chapter 06 - Cost of Sales and Inventories
CHAPTER 6
COST OF SALES AND INVENTORIES
Changes from Twelfth Edition
Editorial and updated changes have been made. The VAL accounting for mileage program topic is now
covered in the Kim Park case (Case 8-5). VAL Corporation has been dropped.
Approach
This chapter can be assigned in two parts, if the instructor wishes to spend several sessions on these
topics. The second assignment can begin with the section titled “Inventory Costing Methods.”
By now, students will have had to deduce cost of goods sold if they have tackled the cases in previous
chapters. Nevertheless, for some students this deduction process is a difficult one to grasp, and it is
important that it be understood. Also, the mechanics of flows through a manufacturing company are
difficult to grasp. Students will encounter this topic again in Chapter 17, however, so it doesn’t matter too
much if they don’t get it here. This is another one of the topics that seems to be mastered only after drill
with a number of problems.
The choice between LIFO and FIFO also causes problems, perhaps because LIFO obviously does not
match the physical flow of goods. It should perhaps be emphasized that, regardless of the conceptual
merit of one method or the other in an inflationary economy, LIFO defers payment of incomes taxes, and
it defers them forever in an inflationary economy. The discussion also provides a way of highlighting the
fact that accounting focuses on the measurement of income, even though the result is an unrealistic
balance sheet (as is the case with LIFO inventories).
Cases
Browning Manufacturing Company requires recording a complete cycle of transactions in a
manufacturing company. It is straightforward.
Lewis Corporation is a problem that contrasts FIFO and LIFO in a clear-cut way.
Morgan Manufacturing deals with the adjustment, comparison, and interpretation of financial statements
for two firms, one prepared using LIFO and the other using FIFO.
Joan Holtz (B) is the second set of discrete problems, from which the instructor can select those he or she
wants to discuss in class.
Problems
Problem 6-1
The completed table is shown below. Each deduction involves the basic inventory equation.
Ending inventory = Beginning Inventory + Purchase – Shipments (COGS)
as well as the basic relationships inherent in any income statement, that is:,
Income = Revenues – Expenses
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2. Chapter 06 - Cost of Sales and Inventories
Co. W Co. X Co. Y Co. Z
Sales.......................................................................................................................................................................................$2,250 $1,800 $1,350 $2,100
Cost of goods sold:................................................................................................................................................................
Beginning inventory..........................................................................................................................................................300 225 500 300
Plus: Purchases..................................................................................................................................................................975 975 850 1,200
Less: Ending inventory......................................................................................................................................................225 300 300 150
Cost of good sold..........................................................................................................................................................1,050 900 1,050 1,350
Gross margin..........................................................................................................................................................................1,200 900 300 750
Period expenses......................................................................................................................................................................300 400 150 800
Net income (Loss)..................................................................................................................................................................$ 900 $ 500 $ 150 $ (50)
Problem 6-2
The required income statement is reproduced below.
The closing entries are:
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3. Chapter 06 - Cost of Sales and Inventories
a. Beginning inventory balance is $50,000
b. dr. Inventory............................................................................................................................................167,000
cr. Purchases........................................................................................................................................167,000
c. dr. Inventory............................................................................................................................................4,000
cr. Freight-in........................................................................................................................................4,000
d. dr. Returns (to Suppliers).........................................................................................................................8,000
cr. Inventory........................................................................................................................................8,000
e. dr. Cost of Goods Sold.............................................................................................................................135,500
cr. Inventory..........................................................................................................................................135,500
f. dr. Income Summary................................................................................................................................135,500
cr. Cost of Goods Sold........................................................................................................................135,500
g. dr. Income Summary................................................................................................................................95,000
cr. Other Expenses...............................................................................................................................95,000
h. dr. Tax expense........................................................................................................................................28,350
cr. Taxes Payable.................................................................................................................................28,350
i. dr. Sales...................................................................................................................................................325,000
cr. Income Summary...........................................................................................................................325,000
j. dr. Income Summary................................................................................................................................28,350
cr. Tax Expense...................................................................................................................................28,350
GARDNER PHARMACY
Income Statement for the Year ----.
Sales...................................................................................................................................................................$325,000
Cost of goods sold:............................................................................................................................................
Beginning inventory....................................................................................................................................$ 50,000
Plus: Purchase, gross............................................................................................................................$167,000
Freight-in....................................................................................................................................4,000
171,000
Less: Purchase returns..........................................................................................................................8,000
Net purchases...............................................................................................................................................163,000
Goods available for sale...............................................................................................................................213,000
Less: Ending inventory........................................................................................................................77,500
Cost of goods sold..............................................................................................................................135,500
Gross margin......................................................................................................................................................189,500
Other expenses...................................................................................................................................................95,000
Income before taxes...........................................................................................................................................94,500
Income tax expense............................................................................................................................................28,350
Net income.........................................................................................................................................................66,150
Problem 6-3
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4. Chapter 06 - Cost of Sales and Inventories
a. dr. Inventory....................................................................................................................................................85,500
cr. Cash (or Payables)..................................................................................................................................85,500
dr. Cash (or Receivables).................................................................................................................................133,400
cr. Sales.......................................................................................................................................................133,400
dr. Sales Returns..............................................................................................................................................1,840
Inventory.....................................................................................................................................................1,200
cr. Cash (or Receivables).............................................................................................................................1,840
Cost of Goods Sold.................................................................................................................................1,200
b. GOULD’S COMPANY
Income Statement
Gross sales.......................................................................................................................................................$133,400
Less: Sales returns.....................................................................................................................................1,840
Net sales..............................................................................................................................................$131,560
Cost of goods sold.....................................................................................................................................85,800
Gross margin.............................................................................................................................................$ 45,760
c. The perpetual inventory records indicate ending inventory should have been 673 + 5,700 – 5,800
+ 80 = 653 units. Inventory shrinkage has therefore been 653 – 610 = 43 units.
dr. Inventory Shrinkage.........................................................................................................................................................645
cr. Inventory.....................................................................................................................................................................645
The inventory shrinkage entry reduces gross margin by $645 (or shrinkage could be shown below the
gross margin line as a general expense).
Problem 6-4
Purchases:
50 units @ $14 = $ 700
75 units @ $12 = 900
Avg: 125 units @ $12.80 = $1,600
Sales: 100 units
Ending inventory: 25 units
Avg. Cost Fifo Lifo
July 31 inventory.............................................................................................................................................................................$ 320 $ 300 $ 350
Cost of goods sold...........................................................................................................................................................................1,280 1,300 1,250
Available for sale............................................................................................................................................................................1,600 1,600 1,600
Problem 6-5
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5. Chapter 06 - Cost of Sales and Inventories
Fifo Av. Cost Lifo
a. Sales.........................................................................................................................................................................$52,125 $52,125 $52,125
Cost of goods sold....................................................................................................................................................27,310 27,053 26,960
Gross margin............................................................................................................................................................$24,815 $25,072 $25,165
Fifo Av. Cost Lifo
b. Gross margin percentage..........................................................................................................................................47.6% 48.1% 48.3%
c. Net cash flow = $21,465 ($52,125 - $30,660)
No change in pretax cash flow figure using different inventory methods.
d. Fifo Av. Cost Lifo
Pretax cash flow.......................................................................................................................................................$21,465 $21,465 $21,465
Tax payment.............................................................................................................................................................7,445 7,522 7,550
After-tax cash flow...................................................................................................................................................$14,020 $13,943 $13,915
The tax payment in 30 percent of the gross margin dollars. The cash flow using Fifo for tax purposes is
the lowest of the three after tax cash flow amounts because the unit cost of computers is falling,
producing the highest taxable gross margin of the three methods.
Problem 6-6
a. Ending inventory balances are:
Materials
Inventory
Work in
Process
Finished
Goods
Beginning balance............................................................................................................................................$ 100,000 $ 370,000 $ 60,000
(1) Purchases..........................................................................................................................................................872,000
Delivery charge................................................................................................................................................22,000
(2) Direct labor......................................................................................................................................................565,000
(3) Materials transfer.............................................................................................................................................(900,000) 900,000
(4) Indirect labor....................................................................................................................................................27,000
Factory supplies...............................................................................................................................................46,000
Depreciation–factory........................................................................................................................................54,000
Factory utilities................................................................................................................................................147,000
Depreciation–Mfg............................................................................................................................................46,000
Property taxes...................................................................................................................................................14,000
(5) Finished goods–transfers..................................................................................................................................________ (2,035,000) 2,035,000
$ 94,000 134,000 2,095,000
Cost of goods sold............................................................................................................................................-- -- (2,002,000)
Ending balance.................................................................................................................................................$ 94,000 $ 134,000 $ 93,000
b. Gross margin was 23 percent.
Sales.................................................................................................................................................................$2,600,000
Cost of goods sold............................................................................................................................................2,002,000
Gross margin....................................................................................................................................................$ 598,000
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6. Chapter 06 - Cost of Sales and Inventories
Problem 6-7
Item Units
Valuation
Basis/Unit
Historical
Cost/Unit
Total
Adjustment
A 30 $145 $150 $150
B 40 173 183 400
C 20 131 134 60
D 40 113 113 0
Total adjustment $610
Cases
Case 6-1: Browning Manufacturing Company
Note: This case is updated from the Twelfth Edition. Please see the printed Instructor’s Resource Manual
for the Harvard Teaching Notes.
Case 6-2: Lewis Corporation*
Note: Updated from Twelfth Edition.
Approach
We have found it useful for students to perform some comparative FIFO/LIFO average cost calculations,
rather than only read about the differences among these methods. This case presents that opportunity,
with an emphasis on the income tax—hence, cash flow—implications of the choice of a method. Via
Question 3, the student can see the impact of a sales decline causing a “stripping off” of LIFO layers with
the result that LIFO reports a lower cost of goods sold, and thus would result in higher income taxes that
year, than would FIFO.
Question 4 introduces the significance of the LIFO reserve. Students can discover that the LIFO reserve is
useful in analyzing financial statements. It can be used to estimate the cumulative tax savings realized by
adopting LIFO; and when trying to compare the financial performance of a company using LIFO to
another using FIFO, the LIFO reserve can be used to adjust the LIFO financial statements to a FIFO
basis. This adjustment will be explored in more detail in Case 6-3
Finally, Question 5 presents the opportunity to challenge the widely held notion that almost all companies
use LIFO (the instructor can update the text footnote on LIFO usage by referring to the latest edition of
Accounting Trends & Techniques and to discuss the reasons for many companies’ use of FIFO. For those
who wish to do so, this discussion can bring in the Efficient Markets Hypothesis. In our view, one reason
some companies continue to use FIFO in circumstances when LIFO would improve cash flows is that
their managements do not believe that EMH premise that the lower reported earnings from LIFO would
not diminish shareholder value.
*
This Teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.
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7. Chapter 06 - Cost of Sales and Inventories
Calculations for Questions
Question 1
The approach below reflects how most students perform these calculations. At some point I show them
(to their chagrin) that a lot of effort can be saved if the amount of each year’s purchases is calculated first,
and then the equation Beg. Invent + Purchases = COGS + End Invent. is applied year-by-year. With the
more detailed approach students take, class time allows showing only a couple of years for FIFO and
LIFO, and one year for average cost.
2009
FIFO: COGS 1,840 @ $20.00 = $36,800.00
600 @ 20.25 = 12,150.00
380 @ 21.00 = 7,980.00
2,820 @ $56,930.00
Inventory 420 @ 21.00 = 8,820.00
400 @ 21.25 = 8,500.00
200 @ 21.50 = 4,300.00
1,020 $21,620.00
LIFO: COGS 200 @ $21.50 = $4,300.00
400 @ 21.25 = 8,500.00
800 @ 21.00 = 16,800.00
600 @ 20.25 = 12,150.00
820 @ 20.00 = 16,400.00
2,820 $58,150.00
Inventory 1,020 @ 20.00 = $20,400.00
AVERAGE COST: COGS 2,820 @ $20.456 = $57,685.92
Inventory 1,020 @ 20.456 = $20,865.12
Note in all three cases that the sum of the cost of goods sold and ending inventory amounts is the same:
$78,550 (slightly different with average cost because of rounding errors), which is the sum of the
beginning inventory and purchases (i.e., available for sale).
2010
FIFO: COGS 420 @ $ 21.00 = $ 8,820.00
400 @ 21.25 = 8,500.00
200 @ 21.50 = 4,300.00
700 @ 21.50 = 15,050.00
700 @ 21.50 = 15,050.00
660 @ 22.00 = 14,520.00
3,080 $66,240.00
Inventory 40 @ 22.00 = $ 880.00
1,000 @ 22.25 = 22,250.00
1,040 @ $23,130.00
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8. Chapter 06 - Cost of Sales and Inventories
LIFO: COGS 1,000 @ $ 22.25 = $22,250.00
700 @ 22.00 = 15,400.00
700 @ 21.50 = 15,050.00
680 @ 21.50 = 14,620.00
3,080 $67,320.00
Inventory 20 @ $ 21.50 = $ 430.00
1,020 @ 20.00 = 20,400.00
1,040 @ 20.00 = $20,830.00
AVERAGE COST: COGS 3,080 @ $21.509 = $66,247.72
Inventory 1,040 @ 21.509 = $22,369.36
2011
FIFO: COGS 40 @ $ 22.00 = $ 880.00
1,000 @ 22.25 = 22,250.00
1,000 @ 22.50 = 22,500.00
700 @ 22.75 = 15,925.00
210 @ 23.00 = 4,830.00
2,950 $66,385.00
Inventory 490 @ 23.00 = $11,270.00
700 @ 23.50 = 16,450.00
1,190 $27,720.00
LIFO: COGS 700 @ $23.50 = $16,450.00
700 @ 23.00 = 16,100.00
700 @ 22.75 = 15,925.00
850 @ 22.50 = 19,125.00
2,950 $67,600.00
1,020 @ 20.00 = $20,400.00
Inventory 20 @ 21.50 = 430.00
150 @ 22.50 = 3,375.00
1,190 $24,205.00
AVERAGE COST: COGS 2,950 @ $22.547 = $66,513.65
Inventory 1,190 @ 22.547 = $26,830.93
Check on Calculations
FIFO LIFO AVG.COST
COGS 2009 $ 56,930 $ 58,150 $ 57,685.92
2010 66,240 67,320 66,247.72
2011 66,385 67,600 66,513.65
Inventory 2011 27,720 24,205 26,830.93
$217,275 $217,275 $217,278.22
Question 2
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9. Chapter 06 - Cost of Sales and Inventories
The calculation of the $1,406 tax difference for 2005-07 is shown below. However, this difference is
really irrelevant for deciding what to do in future years.
FIFO LIFO
2009 Sales.............................................................................................................................................................$95,880 $95,880
COGS...........................................................................................................................................................56,930 58,150
Gross Margin................................................................................................................................................38,950 37,730
Tax Expense.................................................................................................................................................15,580 15,092
Net Income...................................................................................................................................................$23,370 $22,638
2010 Sales.............................................................................................................................................................$110,110 $110,110
COGS...........................................................................................................................................................66,240 67,320
Gross Margin................................................................................................................................................43,870 42,790
Tax Expense.................................................................................................................................................17,548 17,116
Net Income...................................................................................................................................................$ 26,322 $ 25,674
2011 Sales.............................................................................................................................................................$105,462.50 $105,462.50
COGS...........................................................................................................................................................66,385.00 67,600.00
Gross Muffin................................................................................................................................................39,077.50 37,862.50
Tax Expense.................................................................................................................................................15,631.00 15,145.00
Net Income ..................................................................................................................................................$ 23,446.50 $ 22,717.50
Total Tax Expense Savings:
2009 $ 488
2010 432
2011 486
$1,406
An easier approach, which most students will overlook, is to note that the three-year difference in COGS
is $3,515, and 40 percent of this is $1,406. Even easier, but much more subtle, is realizing that the three-
year COGS difference is equal to the difference in 2011 year-end inventories ($27,720 - $24,205 =
$3,515).
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10. Chapter 06 - Cost of Sales and Inventories
Question 3
Purchases for 2012 forecasted at 1,910*
cartons @ 24.00
FIFO COGS 490 @ $23.00 = $11,270
700 @ 23.50 = 16,450
1,510 @ 24.00 = 36,240
2,700 $63,960
Inventory 400 @ $24.00 = $9,600
LIFO: COGS 1,910 @ $24.00 = $45,840
150 @ 22.50 = 3,375
20 @ 21.50 = 430
620 @ 20.00 = 12,400
2,700 $62,045
Inventory 400 @ 20.00 = $8,000
FIFO LIFO
2012 Sales (2,700 @ $35.75)...................................................................................................................................................$96,525 $96,525
COGS................................................................................................................................................................................63,960 62,045
Gross margin......................................................................................................................................................................32,565 34,480
Tax expense ......................................................................................................................................................................13,026 13,792
Net income ........................................................................................................................................................................$19,539 $20,688
In 2012, LIFO would cause an increase in tax expense of $766.
Question 4
The LIFO reserve is the difference between inventory calculated under the FIFO method, and inventory
calculated under the LIFO method.
LIFO Reserve = FIFO Inventory - LIFO Inventory
2009 $1,220 = $21,620 - $20,400
2010 $2,300 = $23,130 - $20,830
Another way to look at the LIFO reserve is that it represents the cumulative difference between LIFO cost
of goods sold and FIFO cost of goods sold. We can see that in 2009, the LIFO reserve ($1,220) is equal to
the difference between LIFO cost of goods sold and FIFO cost of goods sold ($58,150 - $56,930 =
$1,220). Similarly, in 2010, the LIFO reserve ($2,300) is equal to the sum of the differences between
LIFO and FIFO cost of goods sold for 2009 and 2010, as shown on the next page.
*
2,700 sales + 400 ending inventory - 1,190 beginning inventory = 1,910.
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11. Chapter 06 - Cost of Sales and Inventories
2009 2010
LIFO cost of goods sold..............................................................................................................................................$58,150 $67,320
FIFO cost of goods sold..............................................................................................................................................56,930 66,240
Difference....................................................................................................................................................................$ 1,220 + $ 1,080 = $2,300
Therefore, if you are given LIFO cost of goods sold and inventory, and you are also given the LIFO
reserve for that year (year X) and the previous year (year X-1), you can estimate the following:
FIFO inventory (year X) = LIFO inventory (year X) + LIFO reserve (year X)
FIFO COGS (year X) = LIFO COGS (year X) - [LIFO reserve (year X) - LIFO reserve (year X-l)]
Tax savings (year X) = [LIFO reserve (year X) - LIFO reserve (year X-1)] *(1 – tax rate)
Cumulative tax savings due to the use of LIFO = LIFO reserve (year X)
Companies on LIFO report the LIFO reserve in their financial statements, often in the inventory footnote.
Understanding the significance of the LIFO reserve can be very useful when trying to compare the
financial performance of companies using different inventory accounting methods.
Question 5
See “Why Not More LIFO?” section of the text, plus comments earlier in this note.
Case 6-4: Joan Holtz (B)*
Note: In discussing some of these questions. it may be useful to construct simple numerical examples,
perhaps related to the illustrations in the text. Joan Holtz (B) is an extension of Joan Holtz (A) in
Chapter 5. The case is unchanged from the Eleventh Edition.
1. The ultimate effect, over the life of an entity, is the same under all three methods. For a given
accounting period, however, the methods result in different net income. If purchase discounts are
deducted from purchases, they reduce the net purchase costs, and affect net income in the period in
which the goods are sold. If reported as other income of the period, they affect net income in an
earlier period than in the first method. If discounts not taken are recorded as an expense, cost of goods
sold reflects the full amount of the discount, and discounts not taken decrease income in what is
perhaps a later period.
Another difference is that cost of goods sold, and hence the gross margin percentage, differs under
each of these methods.
Of course, the amounts involved are usually small, so the above differences often are not material
2. There should be a credit to Inventory, to reduce it to the amount found from the physical inventory.
The debit may be either to Cost of Goods Sold or to an operating expense item. Literally, the
shrinkage cost could not have been a cost of the goods that actually were sold, for these goods were
not sold. The practice of debiting of Cost of Goods Sold is often followed, however. For management
purposes, it is desirable to identify the amount of shrinkage, wherever it is reported.
3. It is incorrect to say that the LIFO method “assumes” anything about the physical flow of the goods.
LIFO advocates know that physically the goods tend to move on a FIFO basis. LIFO is based on a
*
This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.
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12. Chapter 06 - Cost of Sales and Inventories
belief about economic flows, as explained in the text.
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13. Chapter 06 - Cost of Sales and Inventories
4.
5. In the examples given, the economics of the operations of the automobile dealer are best reflected by
the FIFO method (or even better by the specific identification method, which probably approximates
FIFO), and the economics of the operations of the hardware dealer are best reflected by the LIFO
method. Even so, the automobile dealer would not necessarily be wrong to use LIFO; it might regard
the income tax savings as being more important than a correct showing of economic income.
6. a. This generalization is valid.
b. This generalization is usually valid, as indicated in the text. However, any such generalization
about LIFO may not be valid if the physical size of the inventory is reduced so that the original
“LIFO layers” are carried to Cost of Goods Sold.
c. Assuming that income tax rates remain unchanged, and that the physical size of the inventory
remains unchanged, and disregarding the present value of money, this generalization is valid.
7. Although the LIFO inventory as a whole will normally be reported at less than current costs, it can
easily happen that individual items are worth less than their LIFO cost because of obsolescence or
damage. These items should be written down.
8. Since there would be no additional revenue for four years, and since barrels, warehousing costs, and
interest are charged to expense, profit would be reduced by the amount of these additional costs. In
the first full year, these amounts of 200,000 additional gallons would be:
Barrels @ $0.70..............................................................................................................................$140,000
Warehousing @ $0.20....................................................................................................................40,000
Interest @ $0.10.............................................................................................................................20,000
On each gallon added to inventory, the warehousing and interest costs would cumulate for four years,
and profits would be decreased correspondingly.
The argument against including these costs in inventory is that they are not costs of producing
whiskey. The production process has been completed before the whiskey is stored. The contrary
argument is that these costs are incurred in order to bring the whiskey to a salable condition and they
therefore should be included as inventory cost. This argument is strongest for the barrels, and next
strong for the warehousing costs. Many people argue that in no circumstances can interest be
considered a cost of production; rather, it is a cost of financing. Yet, if this were a four-year
construction project rather than aging whiskey, GAAP would require capitalization of construction
debt financing costs. (This is not described in the text until Chapter 7.) In any event, unless these
costs are included in inventory, profits will decrease at the very time that the increase in production
indicates that the company is prospering.
9. There is a rule (from FASB Statement No.-53) for determining cost of sales for T.V. movies. It is to
amortize film costs in the ratio of
Gross revenue for the film for the current period
Anticipated total gross revenues for the film from
the beginning of the current period until the end
of its useful life
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14. Chapter 06 - Cost of Sales and Inventories
The denominator of this ratio must be reviewed periodically to reflect current information. The new
ratio is then applied to unrecovered film costs. Arguments can be made for ratios of 10/13 or 10/16 in
the first year. The 10/16 ratio ($625,000) is perhaps better due to the belief that at least $300,000 in
revenue will come from reruns. Correspondingly, the ratio to be used in the second year would be 1/2
($300,000/$600,000). This would result in amortization of $187,500 in year two [1/2 x ($1,000,000 -
$625,000)], with the final $187,500 of cost matched against the final $300,000 of revenue. The
$100,000 spent on advertising and promotion of the initial showing does not benefit the future
showings of the film. This is therefore not a capitalizable cost and should be expensed in the period
incurred. Therefore it does not affect the ratios used above.
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