Chapter 8
Reporting and Interpreting Cost of Sales and
Inventory
Revised: April 27, 2014
ANSWERS TO QUESTIONS
1.
Inventory often is one of the largest amounts listed under assets on the statement of
financial position, which means that inventory represents a significant amount of the
resources available to the business. The inventory may be excessive in amount, which
is a needless waste of resources; alternatively it may be too low, which may result in
lost sales. Therefore, for internal users inventory control is very important. On the
statement of earnings, inventory exerts a direct impact on the amount of income.
Therefore, statement users are interested particularly in the amount of this effect and
the way in which inventory is measured. Because of its impact on both the statement
of financial position and the statement of earnings, inventory is of particular interest to
all statement users.
2.
Fundamentally, inventory should include those items, and only those items, legally
owned by the business. That is, inventory should include all goods ready for sale and
in saleable condition that the company owns, regardless of their particular location at
the time.
3.
The cost principle governs the measurement of the ending inventory amount. The
ending inventory is determined in units and the cost of each unit is applied to that
number. Under the cost principle, the unit cost is the sum of all costs incurred in
obtaining one unit of the inventory item in its present state.
4.
The cost of goods available for sale is the sum of the beginning inventory and the cost
of goods purchased during the period. Cost of sales is the cost of goods available for
sale less the ending inventory.
5.
Beginning inventory is the stock of goods on hand (in inventory) at the start of the
accounting period. Ending inventory is the stock of goods on hand (in inventory) at
the end of the accounting period. The ending inventory of one period automatically
becomes the beginning inventory of the next period.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-1
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
6.
When a perpetual inventory system is used, the unit cost must be known for each
item sold at the date of each sale for the following reasons. First, the units sold and
their costs are removed from the perpetual inventory record and the new inventory
balance is determined. Second, an up-to-date cost of sales figure is determined from the
perpetual inventory record and an entry in the accounts is made as a debit to Cost of
sales and a credit to Inventory. In contrast, when a periodic inventory system is used
the unit cost need not be known at the date of each sale. In fact, the periodic system is
designed so that cost of sales for each sale is not known at the time of sale. At the end
of the period, under the periodic inventory system, cost of sales is determined by
adding the beginning inventory to the total goods purchased for the period and
subtracting from that total the ending inventory amount. The ending inventory
amount is determined by means of a physical count of the inventory of goods
remaining on hand, where the units are valued on a unit cost basis in accordance with
the cost principle (by applying an appropriate inventory costing method).
7.
The periodic inventory model reflects the way in which that system operates. Under
this system the beginning inventory and purchases (during the period) are
accumulated, the sum of which is goods available for sale. It is necessary, therefore,
that the ending inventory be determined by actual inventory count at the end of the
period. Cost of sales is computed by subtracting the ending inventory from goods
available for sale. The model: BI + P – EI = COS reflects the fact that, under the periodic
inventory model, cost of sales is computed as a residual amount.
In contrast, the perpetual inventory system involves maintaining a continuous
(running or perpetual) inventory record during the accounting period. The beginning
inventory, each purchase during the period, and each sale during the period, are
entered in the perpetual inventory record in units and dollars of cost. The cost of each
sale is also recorded on an ongoing basis. The difference between the goods available
less cost of sales is the ending inventory. Thus, the perpetual inventory model: BI + P –
COS = EI, reflects the fact that ending inventory is computed as a residual amount in
the inventory record.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-2
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
8.
(a) Weighted-average cost – This inventory costing method in a periodic inventory
system is based on a weighted-average cost for the entire period. At the end of the
accounting period the average cost is computed by dividing the number of units
available for sale into the cost of goods available for sale. The computed average unit
cost then is used to determine the cost of sales for the period by multiplying the units
sold by this average unit cost. Similarly, the ending inventory for the period is
determined by multiplying this average unit cost by the number of units on hand. If a
perpetual inventory system is used, which is typically the case, then a weightedaverage cost is computed after each purchase of merchandise because the cost of sales
is determined and recorded at the time of the sale.
(b) FIFO – This inventory costing method views the first units purchased as the first
units sold. Under this method, cost of sales is measured at the oldest unit costs (since
the items purchased first are presumed to be the items sold first), and the ending
inventory is measured at the newest unit costs (since the items still on hand are
presumed to be the ones purchased most recently).
(c) Specific identification – This inventory costing method requires that each item in
the beginning inventory and each item purchased during the period be identified
specifically so that its unit cost can be determined by identifying the specific item sold.
This method usually requires that each item be marked, often with a code that
indicates its cost. When it is sold, that unit cost is the cost of sales. It often is
characterized as a pick-and-choose method. When the ending inventory is taken, the
specific items on hand, valued at the cost indicated on each item, represent the ending
inventory amount.
9.
The specific identification method of inventory costing is subject to manipulation when
the units are identical. Manipulation is possible because one can, at the time of each
sale, select (pick and choose) from the shelf the item that has the highest or the lowest
(or some other) unit cost with no particular rationale for the choice. This may be done
with the objective of increasing or decreasing both the amount of net earnings and the
amount of ending inventory to be reported on the financial statements. To illustrate,
assume item A is stocked and three are on the shelf. One cost $100; the second one cost
$115; and the third cost $125. Now assume that one unit is sold for $200. If it is
assumed arbitrarily that the first unit is sold, the gross profit will be $100; if the second
unit is selected, the gross profit will be $85; or alternatively, if the third unit is selected,
the gross profit will be $75. Thus, the amount of gross profit (and net earnings) will
vary significantly depending upon which one of the three is selected arbitrarily from
the shelf for this particular sale. This assumes that all three items are identical in
every respect except for their unit costs. Of course, the selection of a different unit
cost, in this case, also will influence the cost of the ending inventory, i.e., cost of the two
remaining items.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-3
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
10. Weighted Average and FIFO have different effects on the inventory amount reported
under assets on the statement of financial position. The ending inventory is based
upon either a mix of unit costs or the newest unit costs, depending upon which method
is used. Under FIFO, the ending inventory is measured at the latest unit costs, and
under Weighted Average, the ending inventory is measured at a mix of unit costs.
Therefore, when prices are rising, the ending inventory reported on the statement of
financial position will be higher under FIFO than under Weighted Average. Conversely,
when prices are falling, the ending inventory on the statement of financial position will
be higher under Weighted Average than under FIFO.
11. Weighted Average and FIFO will affect the statement of earnings in two ways: (1) the
amount of cost of sales and (2) net earnings. When the prices are rising, FIFO will give
a lower cost of sales and hence a higher net earnings than will Weighted Average. In
contrast, when prices are falling, FIFO will give a higher cost of sales and, as a result,
lower net earnings.
12. When prices are rising, the FIFO method gives a lower cost of sales than the weighted
average method. As a result, pretax earnings are higher under FIFO than weighted
average. Consequently, the income tax expense and the related cash outflow will be
greater under FIFO than the weighted average cost method. The reverse is true if
prices are falling.
13. The lower of cost or net realizable value (LCNRV) is applied when the net realizable
value of the inventory item is lower than its cost. The ending inventory is then valued
at the net realizable value, which (a) reduces net earnings and (b) reduces the
inventory amount reported on the statement of financial position. The effect of
applying LCNRV is to include the loss on inventory valuation on the statement of
earnings (as a part of the cost of sales) in the period in which the market value drops
rather than in the period of actual sale.
14. When the net realizable value of inventory is less than its cost the inventory is written
down to the net realizable value. If the value increases the write down is reversed up
to the original cost. In contrast a holding gain is the increase in market value of
inventory during the period it is held by the company. IFRS does not permit
recognition of holding gains.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-4
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
Authors' Recommended Solution Time
(Time in minutes)
Exercises
No.
Time
1
5E
2
15 E
3
20 E
4
15 E
5
15 E
6
15 M
7
20 M
8
20 M
9
25 D
10
20 E
11
25 M
12
35 M
13
35 M
14
20 M
15
20 E
16
20 M
17
30 D
18
15 E
19
20 E
20
20 M
21
20 M
E = Easy
Problems
No.
Time
1
30 M
2
40 M
3
30 M
4
40 M
5
45 M
6
45 M
7
45 M
8
50 M
9
30 M
10
30 M
M = Moderate
Alternate
Problems
No.
Time
1
40 M
2
30 M
3
35 M
4
45 M
5
30 M
Cases and
Projects
No.
Time
1
30 M
2
20 M
3
20 M
4
60 D
5
30 M
6
30 M
7
30 D
8
60 D
9
40 D
10
*
D = Difficult
* Due to the nature of these cases and projects, it is very difficult to estimate the amount of
time students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While students
often benefit from the extra effort, we find that some become frustrated by the perceived
difficulty of the task. You can reduce student frustration and anxiety by making your
expectations clear. For example, when our goal is to sharpen research skills, we devote
class time discussing research strategies. When we want the students to focus on a real
accounting issue, we offer suggestions about possible companies or industries.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-5
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
EXERCISES
E8–1
To record the purchase of 80 new shirts in accordance with the cost principle (perpetual
inventory system):
Inventory (+A) ...................................................................................
Cash (–A) ................................................................................
2,500
2,500
Cost: $2,180 + $175 + $145 = $2,500.
The $120 interest amount is not included in the cost of the merchandise; it is initially
recorded as prepaid interest expense and later as interest expense.
E8–2
Item
Amount
Explanation
Ending inventory (physical count on
December 31, 2013)
$50,000
Per physical inventory
a. Goods purchased and in transit
+ 300
Goods purchased and in transit, F.O.B.
shipping point, are owned by the
purchaser.
b. Samples out on trial to customer
+ 400
Samples held by a customer on trial
are still owned by the vendor; no sale
or transfer of ownership has occurred.
c. Goods in transit to customer
Goods shipped to customers, F.O.B.
shipping point, are owned by the
customer because ownership passed
when they were delivered to the
transportation company. The
inventory correctly excluded these
items.
d. Goods sold and in transit
+ 1,000
Correct inventory, December 31, 2013
$51,700
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-6
Goods sold and in transit, F.O.B.
destination, are owned by the seller
until they reach destination.
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–3
(Underscore for missing amounts only.)
Case
Sales
Revenue
A
B
C
D
E
$1,300
900
1,200
800
2,000
Beg.
Inventory
$200
200
300
100
400
Purchases
Total
Available
Ending
Inventory
$1,400
800
700
600
1,800
$1,600
1,000
1,000
700
2,200
$1,000
250
600
250
1,200
Cost of
Sales
Gross
Profit
$ 600 $ 700
750
150
400
800
450
350
1,000 1,000
Pretax
Operating Earnings
Expenses or (Loss)
$ 400
150
200
250
1,100
$ 300
0
600
100
(100)
E8–4
(Bold for missing amounts only.)
Sales revenue ...........................................................
Sales returns and allowances .............................
Net sales revenue ....................................................
Beginning inventory ..............................................
Purchases
...........................................................
Transportation-in ...................................................
Purchase returns .....................................................
Cost of goods available for sale ..........................
Ending inventory.....................................................
Cost of sales ...........................................................
Gross profit ...........................................................
Expenses (operating) ............................................
Pretax earnings (loss) ...........................................
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-7
Case A
Case B
Case C
$ 8,000
150
7,850
11,000
5,000
100
350
15,750
10,000
5,750
2,100
1,300
$ 800
$6,000
500
5,500
6,500
8,770
120
600
14,790
10,740
4,050
1,450
1,950
$ (500)
$ 6,195
275
5,920
4,000
9,420
170
220
13,370
7,970
5,400
520
520
$ -0-
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–5
The amount of purchases and cost of sales can be determined from the available
information using the following relationships among various components of the income
statement.
Computations (in thousands):
Cost of sales
Revenue ......................................................................
– Gross profit ...............................................................
= Cost of sales ...............................................................
Purchases:
$302,700
206,562
$ 96,138
Simply rearrange the basic inventory model (BI + P – EI = COS):
P = COS + EI - BI
Cost of sales (see above) .......................................
+ Ending inventory ....................................................
– Beginning inventory ..............................................
= Purchases ...................................................................
$ 96,138
119,325
(91,773)
$123,690
E8–6
Req. 1
Net earnings for 2014 will be overstated. An understatement of purchases produces an
understatement of cost of sales, which, in turn, produces an overstatement of the current
period’s income.
BI + P - EI =
COS;
both P and COS are understated
Req. 2
Net earnings for 2015 will be understated. An overstatement of purchases produces an
overstatement of cost of sales, which in turn, produces an understatement of the current
period’s income.
BI + P - EI =
COS;
both P and COS are overstated
Req. 3
Retained Earnings at December 31, 2014, will be overstated because of the overstatement
of net earnings for 2014.
Req. 4
Retained Earnings at December 31, 2015, will be correct because the overstatement of net
earnings for 2014 and understatement of net earnings for 2015 will offset one another.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-8
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–7
CASE A: Perpetual inventory system:
January 14
Trade receivables (+A) ............................................................................
2,400
Sales (+R  +SE) (60 units at $40) .............................................
2,400
1,200
Cost of sales (+E  -SE) ..........................................................................
Inventory (−A) (60 units at $20) ..................................................
1,200
April 9
Inventory (+A) (45 units at $20) .........................................................900
Trade payables (+L) ..........................................................................
900
September 2
Trade receivables (+A) ............................................................................
6,750
Sales (+R  +SE) (135 units at $50)...........................................
6,750
2,700
Cost of sales (+E  -SE) ..........................................................................
Inventory (–A) (135 units at $20) ................................................
2,700
End of year
No year-end adjusting entry needed because the
number of units left at year end is 300 – 60 + 45 – 135
= 150, which is equal to the physical count of units
available at year end.
CASE B: Periodic inventory system:
January 14
Trade receivables (+A) ............................................................................
2,400
Sales (+R  +SE) (60 units at $40) .............................................
2,400
April 9
Purchases (+T) (45 units at $20) .........................................................900
Trade payables (+L) ..........................................................................
900
September 2
Trade receivables (+A) ............................................................................
6,750
Sales (+R  +SE) (135 units at $50)...........................................
6,750
End of year
6,900
Cost of sales (+E  –SE) .........................................................................
Purchases (–T) ....................................................................................
Inventory (–A) (Beginning: 300 units at $20) .........................
900
6,000
Inventory (+A) (Ending: 150 units at $20) .....................................
3,000
Cost of sales (−E  +SE) ..................................................................
3,000
Calculation of cost of sales:
Beginning inventory (300 units at $20)
Add purchases
Cost of goods available for sale
Ending inventory (physical count—150 units at $20)
Cost of sales
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-9
$6,000
900
$6,900
3,000
$3,900
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–8
Req. 1
When the ending inventory is overstated, cost of sales is understated which in turn results
in an overstatement of net earnings. Gibson’s earnings from operations should be reduced
by $8,806,000 and tax expense should be reduced by $3,460,758 (i.e., $8,806,000 x 0.393).
Therefore, net earnings should be:
As reported:............................................................................
Increase in cost of sales .....................................................
Reduction in tax expense ..................................................
Corrected net earnings ......................................................
$25,852,000
(8,806,000)
3,460,758
$20,506,758
Req. 2
The incorrect accounts can be summarized as follows:
Account
Year of
Error
Beginning inventory
Cost of sales
Ending inventory
Net earnings
Retained earnings
Income taxes payable
Income tax expense
correct
understated
overstated
overstated
overstated
overstated
overstated
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-10
Subsequent
Year
overstated
overstated
correct
understated
correct
understated
understated
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–9
Req. 1
The $400 understatement of ending inventory produced pretax earnings amounts that
were incorrect by $400 for each quarter. However, the effect on pretax earnings for each
quarter was opposite (i.e., the first quarter pretax earnings was understated by $400, and
in the second quarter it was overstated by $400). This self-correcting effect produces
correct combined net earnings for the two quarters.
Req. 2
The error caused the pretax earnings for each quarter to be incorrect [see (1) above];
therefore, the EPS for the first quarter was understated, and the EPS for the second quarter
was overstated.
Req. 3
First Quarter 2014
Sales revenue .........................................................
Cost of sales:
Beginning inventory ....................................
Purchases .........................................................
Cost of goods available for sale ........
Ending inventory...........................................
Cost of sales ..............................................
Gross profit ........................................................
Expenses
........................................................
Pretax earnings
Second Quarter 2014
$11,000
4,000
3,000
7,000
4,200
$18,000
4,200
13,000
17,200
9,000
2,800
8,200
5,000
$3,200
8,200
9,800
6,000
$3,800
Req. 4
First Quarter 2014
Second Quarter 2014
Incorrect
Amount
Correct
Amount
Error
(if any)
$4,000
$4,000
No error
Ending inventory
3,800
4,200
400 under
Cost of sales
3,200
2,800
400 over
Gross profit
7,800
8,200
Pretax earnings
2,800
3,200
Beginning inventory
Correct
Amount
Error
(if any)
3,800
$4,200
$400 under
$9,000
9,000
No error
7,800
8,200
400 under
400 under
10,200
9,800
400 over
400 under
4,200
3,800
400 over
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-11
Incorrect
Amount
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–10
Units
Cost of sales:
Beginning inventory ($8) ................. 3,000
Purchases (March 31) ($9) .............. 5,000
(August 1) ($7) ................ 2,000
Goods available for sale ...... 10,000
Ending inventory* ............................... 4,000
Cost of sales ............................. 6,000
FIFO
Weighted
Average
$24,000
45,000
14,000
83,000
32,000
$51,000
$24,000
45,000
14,000
83,000
33,200
$49,800
*Ending inventory computations:
FIFO:
(2,000 units @ $7) + (2,000 units @ $9) = $32,000
Average:
$83,000 ÷ 10,000 units = $8.30 per unit
4,000 units @ $8.30 = $33,200
E8–11
Req. 1
LUNAR COMPANY
Statement of Earnings (Partial)
For the Year Ended December 31, 2014
Case A
FIFO
Case B
Weighted Average
Sales revenue1 ............................................................ $330,000
Cost of sales:
Beginning inventory ......................................
36,000
Purchases ..........................................................
194,000
Cost of goods available for sale2 ......
230,000
3
..........................................
Ending inventory
114,000
Cost of sales..............................................
116,000
Gross profit .............................................................
214,000
Expenses (operating) ..............................................
85,000
Pretax earnings .......................................................... $129,000
$330,000
36,000
194,000
230,000
103,500
126,500
203,500
85,000
$118,500
Computations:
1. Sales: (5,000 units @ $30) + (6,000 units @ $30) = $330,000
2. Cost of goods available for sale (for both cases):
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-12
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–11 (continued)
Beginning inventory
Purchase, April 11, 2014
Purchase, June 1, 2014
Cost of goods available for sale
3.
Units
Unit Cost
3,000
9,000
8,000
20,000
$12
10
13
Total Cost
$ 36,000
90,000
104,000
$230,000
Ending inventory = 20,000 units available – 11,000 units sold = 9,000 units
Case A FIFO:
(8,000 units @ $13 = $104,000) +
(1,000 units @ $10 = $10,000) = $114,000
Case B Weighted Average:
$230,000 ÷ 20,000 units = $11.50 per unit
9,000 units @ $11.50 = $103,500
Req. 2 (See Requirement 1 for figures)
Comparison of Amounts
Case A
Case B
FIFO
Weighted Average
Pretax earnings
Difference
Ending Inventory
Difference
$129,000
$10,500
$118,500
114,000
10,500
103,500
The above tabulation demonstrates that the difference in pretax earnings between the two
cases is the same as the difference in ending inventory, i.e., the cost of the beginning
inventory and purchases were the same in both cases. Differences in inventory have a
dollar-for-dollar effect on pretax earnings.
Req. 3
Weighted Average may be preferred for income tax purposes because it reports less
taxable income (when prices are rising) and hence (a) reduces income tax and (b) as a
result reduces cash outflows for the period.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-13
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–11 (continued)
Req. 4
b.
Purchases (+T) (9,000 x $10) ................................................................
Trade payables (+L) ...........................................................................
90,000
c.
Trade receivables (+A) ............................................................................ 150,000
150,000
Sales (+R  +SE) (5,000 X $30) ....................................................
d.
Purchases (+T) (8,000 x $13) ................................................................ 104,000
Trade payables (+L) ...........................................................................
104,000
e.
Trade receivables (+A) ............................................................................ 180,000
Sales (+R  +SE) (6,000 X $30) ....................................................
f.
Operating expenses (+E  –SE) ...........................................................
Cash (–A) and/or Accrued liabilities (+L) .................................
90,000
180,000
85,000
85,000
Dec.31 Cost of sales (+E  –SE) .......................................................................... 230,000
Inventory (–A) (beginning) ...........................................................
36,000
Purchases (–T) .....................................................................................
194,000
Inventory (+A) (ending) .......................................................................... 114,000
114,000
Cost of sales (−E  +SE) ..................................................................
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-14
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–12
Req. 1
SCORESBY, INC.
Statement of Earnings
For the Year Ended December 31, 2015
Case A
FIFO
Sales revenue1 ..........................................
Cost of sales:
Beginning inventory .....................
Purchases .........................................
Goods available for sale2 ...
Ending inventory3 ........................
Cost of sales.............................
Gross profit ............................................
Expenses
............................................
Pretax earnings .........................................
Case B
Weighted Average
$786,000
56,000
259,000
315,000
88,000
227,000
559,000
500,000
$ 59,000
$786,000
56,000
259,000
315,000
75,920
239,080
546,920
500,000
$ 46,920
Computations:
(1)
Sales: (10,000 units @ $29) + (16,000 units @ $31) = $786,000
(2)
Goods available for sale (for both cases):
Beginning inventory
Purchase, March 5, 2012
Purchase, September 19, 2012
Goods available for sale
(3)
Units
7,000
19,000
8,000
34,000
Unit Cost
$8
9
11
Total Cost
$ 56,000
171,000
88,000
$315,000
Ending inventory (34,000 available – 26,000 units sold = 8,000 units):
Case A – FIFO:
8,000 units @ $11 = $88,000
Case B – Weighted Average:
WA1 = ($56,000 + $171,000) ÷ (7,000 + 19,000) units = $8.73 per unit
WA2 = ($227,000 – 10,000 x $8.73 + $88,000) ÷ (26,000 – 10,000 + 8,000) units
= $9.49 per unit
Cost of ending inventory = 8,000 units @ $9.49 = $75,920
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-15
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–12 (continued)
Req. 2
Pretax earnings
Difference
Ending Inventory
Difference
Comparison of Amounts
Case A
Case B
FIFO
Weighted Average
$59,000
$46,920
$12,080
88,000
12,080
75,920
The above tabulation demonstrates that the pretax earnings difference between the two
cases is exactly the same as the inventory difference. Differences in inventory have a
dollar-for-dollar effect on pretax earnings.
Req. 3
The weighted average cost method may be preferred for income tax purposes because it
reports less taxable income (when prices are rising) and hence (a) reduces income tax and
(b) as a result reduces cash outflows for the period.
Req. 4
b.
Inventory (+A) (19,000 x $9) ................................................................. 171,000
Trade payables (+L) ...........................................................................
171,000
c.
Trade receivables (+A) ............................................................................ 290,000
290,000
Sales (+R  +SE) (10,000 X $29) ..................................................
Cost of sales (+E  –SE) (7,000 x $8 + 3,000 * $9) ....................... 83,000
Inventory (–A) .....................................................................................
83,000
d.
Inventory (+A) (8,000 x $11) .................................................................
Trade payables (+L) ...........................................................................
e.
Trade receivables (+A) ............................................................................ 496,000
Sales (+R  +SE) (16,000 X $31) ..................................................
Cost of sales (+E  –SE) (16,000 x $9) .............................................. 144,000
Inventory (–A) .....................................................................................
f.
88,000
88,000
496,000
144,000
Operating expenses (+E  –SE) ........................................................... 500,000
Cash (–A) and/or Accrued liabilities (+L) .................................
500,000
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-16
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–13
Req. 1
Summarized Statement of Earnings
Sales revenue (@ $70) .....................................
Cost of sales:
Beginning inventory (@ $35) .................
Purchases (@ $38) .....................................
Cost of goods available for sale ......
Ending inventory** ....................................
Cost of sales ............................................
Gross profit ...........................................................
Expenses (operating) .......................................
Pretax earnings ...................................................
Income tax expense (30%)......................
Net earnings .........................................................
Inventory Costing Method
Weighted
Units
FIFO
Average
12,300* $861,000
$861,000
3,000
12,000
15,000
2,700
12,300
105,000
456,000
561,000
100,980
460,020
400,980
213,000
187,980
56,394
$131,586
105,000
456,000
561,000
102,600
458,400
402,600
213,000
189,600
56,880
$132,720
*Units sold = 3,000 + 12,000 – 2,700 = 12,300
**Inventory computations:
FIFO:
2,700 units @ $38 = $102,600
Average: Cost of goods available for sale [(3,000 units @ $35) + (12,000 units
@ $38)] ÷ 15,000 units
= $561,000 ÷ 15,000 units = $37.40 per unit
$37.40 x 2,700 units = $100,980
Req. 2
When prices are rising (as they are in this problem) the use of FIFO results in higher net
earnings (compared to Weighted average) because FIFO allocates older (lower) unit costs
to cost of sales first, i.e., cost of sales is lower under FIFO compared to Weighted average.
Weighted average may be preferred for income tax purposes because it reports less taxable
income (when prices are rising) and hence reduces income tax and cash outflows for the
period.
Req. 3
When prices are falling, the use of weighted average cost produces higher net earnings
(compared to FIFO) because FIFO allocates the old (higher) unit costs to cost of sales first.
However, FIFO may be preferred for income tax purposes because it reports less taxable
income than the weighted average cost method.
E8–14
Req. 1
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-17
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
FIFO
Cost of sales:
Beginning inventory (400 units @ $34*) ...
$13,600
Purchases (475 units @ $36*) ........................
17,100
Cost of goods available for sale (875 units*) 30,700
Ending inventory (545 units)** .....................
19,480
Cost of sales (330 units) ....................................
$11,220
Weighted
Average
$13,600
17,100
30,700
19,122
$11,578
* By inference
**Computation of ending inventory:
FIFO: (475 units x $36) + (70 units x $34) = $19,480
Weighted Average:
Cost per unit = ($13,600 + $17,100) / (875) = $35.086 (rounded)
Req. 2
Sales revenue ($50 x 330*) ............................................
Cost of sales:
Beginning inventory ...........................................
Purchases ................................................................
Cost of Goods available for sale........
Ending inventory (per above).........................
Cost of sales .............................................
Gross profit ......................................................................
Expenses
......................................................................
Pretax earnings ...................................................................
FIFO
$16,500
Weighted
Average
$16,500
13,600
17,100
30,700
19,480
11,220
5,280
1,700
$ 3,580
13,600
17,100
30,700
19,122
11,578
4,922
1,700
$ 3,222
* The number of units is the same as computed in requirement 1.
Req. 3
From a cash flow perspective, use of the weighted-average method results in lower pretax
earnings and lower income tax. (If prices were falling, the use of FIFO would result in a
lower income tax burden.)
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-18
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–15
Item Quantity
A
B
C
D
E
50
80
10
30
350
Total
Total Cost
x
x
x
x
x
$15
30
45
25
10
=
=
=
=
=
Total Market
$ 750
2,400
450
750
3,500
$7,850
x
x
x
x
x
$12
40
52
30
5
=
=
=
=
=
$ 600
3,200
520
900
1,750
$6,970
Inventory valuation that should be used (LCNRV)
LCNRV
Valuation
$ 600
2,400
450
750
1,750
$5.950
$5,950
Req. 2
The write-down to lower of cost or net realizable value will increase cost of sales by the
amount of the write-down:
Write down = Total Cost  LCNRV Valuation = $7,850  $5,950 = $1,900
Req. 3
The book value of the 20 units, $100 (20 x $5), should be increased to $150 (20 x $7.50).
The difference of $50 is a reversal of the write-down that was made in the previous year.
This will effectively reduce the cost of sales for the year 2015 by $50, and increase the cost
of ending inventory by $50.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-19
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–16
Req. 1
The table below provides the necessary computations.
Item
Leather jackets
Model 154
Model 160
Model 165
Subtotal
Handbags
Model 11
Model 12
Model 13
Subtotal
Total
Quantity
20
15
10
Cost per
Item
Cost per
Model
Net
Realizable
Value (NRV)
per Item
$100
180
250
$ 2,000
2,700
2,500
$120
168
260
$ 7,200
60
40
25
30
45
65
$ 1,800
1,800
1,625
5,225
$12,425
35
42
63
Net
Realizable
Value (NRV)
per Model
Lower of
Cost and
NRV per
Model
$ 2,400
2,520
2,600
$ 2,000
2,520
2,500
$ 7,520
$ 7,020
$ 2,100
1,680
1,575
$ 1,800
1,680
1,575
5,355
$12,875
5,055
$12,075
a. If the LCNRV rule is applied on an item-by-item basis, the value of ending inventory will
be $12,075.
b. If the LCNRV rule is applied per major category, the value of ending inventory will be
$12,425 ($7,200 + $5,225).
c. If the LCNRV rule is applied to the total inventory, the value of ending inventory will be
$12,425.
Req. 2
The LCNRV on a item-by-item basis results in the lowest value of ending inventory, the
highest value for cost of sales, and the lowest value for net earnings for 2014.
Req. 3
IFRS require that the LCNRV be applied to individual item. This rule can be applied to
major categories or the total inventory only in specific circumstances. As indicated above,
the valuation based on major categories or on the total inventory result in higher values for
ending inventory and net earnings compared to the individual item basis. The lower
valuation of individual items that have net realizable values below their cost is offset by the
higher valuations on other items. If this is done, it would be not be consistent with the
concept of prudence.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-20
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–17
Req. 1
Raw materials inventory consists of items acquired by purchase, growth (such as food
products), or extraction (natural resources) for processing into finished goods. Work-inprocess inventory comprises goods in the process of being manufactured but not yet
complete. Finished goods inventory refers to manufactured goods that are complete and
available for sale. Finally, Finished goods in transit includes good that have been purchased
and owned by Le Château, but have not arrived to the Company’s warehouse or stores.
Req. 2
Cost of sales (+E  –SE) .........................................................................
Raw materials inventory (–A) ......................................................
6,900,000
6,900,000
Req. 3
The carrying amount of the raw materials should be increased to their original cost of $2.3
million even though their net realizable value is greater than their original cost. IFRS does
not permit recognition of the holding gain (i.e., the increase above the original cost). The
result of this would be a reduction in the cost of sales on the 2013 statement of earnings
and an increase in the inventory on the statement of financial position.
Raw materials inventory (+A) ($2,300,000 – $1,700,000)........
Cost of sales (−E  +SE) .................................................................
600,000
600,000
E8–18
Req. 1 (in billions of yen)
Inventory turnover =
Cost of sales
Average Inventory
=
¥4,831
(¥710 + ¥707)/2
= 6.81
Average days to sell inventory = 365/inventory turnover = 365/6.81 = 54 days (rounded)
Req. 2
The inventory turnover ratio reflects how many times average inventory was produced and
sold during the period. Thus, Sony produced and sold its average inventory about seven
times during the year.
The average number of days to sell inventory indicates the average time it takes the
company to produce and deliver inventory to customers. Thus, Sony takes an average of
about 54 days to produce and deliver its computer inventory to its customers.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-21
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–18 (continued)
Req. 3
a. If parts inventory are delivered daily instead of weekly, then Sony need not stock large
amounts of inventory. This reduces the average inventory and increases the turnover
ratio.
b. Extending the payment period from 30 days to 45 days would not affect the cost of sales,
nor would such action affect the inventory levels. As a result, inventory turnover would
not change.
c. If the production process is shortened by two days, then finished products would be
completed sooner and stocked in the warehouse. This will increase the average
inventory. The cost of sales would not be affected by the shortened production process.
Consequently, the turnover ratio is likely to decrease.
E8–19
CASE A – FIFO:
Cost of goods available for sale for FIFO:
Units (19 + 25 + 50) .........................................................................
Amount ($228 + $375 + $800) ....................................................
94
$1,403
Ending inventory: 94 units – 40 units – 28 units = 26 units.
Ending inventory (26 units x $16) .............................................
Cost of sales ($1,403 – $416) .......................................................
Inventory turnover =
Cost of sales
Average Inventory
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-22
=
$987
($228 + $416)/2
$ 416
$ 987
= 3.07
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–19 (continued)
CASE B – Weighted Average:
Goods available for sale for Weighted Average:
Units (19 + 25) ...................................................................................
Amount ($190 + 375) ......................................................................
44
$565
Cost per unit = $565 ÷ 44 = $12.84
Cost of sales 40 @ $12.84 = $513.60
Inventory 4 @ $12.84 = $51.36
Goods available for sale for Weighted Average:
Units (4 + 50) ......................................................................................
Amount ($51 + 800) ........................................................................
54
$851
Cost per unit = $851 ÷ 54 = $15.76
Cost of sales 28 @ $15.76 = $441
Inventory 26 @ $15.76 = $410
Ending inventory: 26 units (see Case A).
Ending inventory (26 units x $15.76) .......................................
Cost of sales ($514 + $441) ...........................................................
Inventory turnover =
Cost of sales
Average Inventory
=
$955
($190 + $410)/2
$ 410 (rounded)
$ 955
= 3.18
The FIFO inventory turnover ratio is normally thought to be a better indicator when prices
are changing because the weighted-average cost can include very old inventory prices in
ending inventory balances. This is less of a concern with a perpetual inventory system as
the average cost is updated more frequently.
E8–20 (amounts in thousands of dollars):
Current Year
Inventory
$91,202
–
Trade payables
$33,519
–
Previous Year
$54,211 =
$16,548 =
Change
$36,991
$16,971
Increases in inventory cause cash flow from operations to decrease by $36,911. This
amount is subtracted in the computation of cash flow from operations. Bauer Performance
Sports was able to offset some of this by increasing its trade payables by $16,971, which
increases cash flow from operations. This amount is added in the computation of cash flow
from operations. Effectively, the Company is financing a portion of its growing inventories
through supplier credit.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-23
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
E8–21 (Appendix 8A)
Req. 1
Trade receivables (+A) ...........................................................................
1,600
Sales (+R  +SE) ................................................................................
1,600
Cost of sales (+E  –SE) .........................................................................900
Inventory (–A) .....................................................................................
900
Cash (+A) ($1,600 x 0.98) .......................................................................
1,568
Sales discounts (+XR  –SE) ($1,600 x 0.02) ................................ 32
Trade receivables (–A) .....................................................................
1,600
Req. 2 (b)
Cash (+A).......................................................................................................
1,600
Trade receivables (–A) .....................................................................
1,600
Req. 3
Inventory (+A) ............................................................................................
7,920
Trade payables (+L) ($8,000 x 0.99)...........................................
7,920
Req. 4 (a)
Trade payables (–L) ..................................................................................
7,920
Cash (–A) ...............................................................................................
7,920
Req. 4 (b)
Trade payables (–L) ..................................................................................
7,920
80
Purchase discounts lost (+E → −SE)………………..
Cash (–A) ..............................................................................................
8,000
Req. 2 (a)
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-24
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
PROBLEMS
P8–1
Item
Amount
Explanation
Ending inventory (physical count on
December 31, 2014)
$65,000
Per physical inventory.
a.
Goods out on trial to customer
+
Goods held by a customer on trial
are still owned by the vendor; no
sale or transfer of ownership has
occurred.
b.
Goods in transit from supplier
Goods shipped by a supplier, F.O.B.
destination, are owned by the
supplier until delivery at destination.
The physical inventory correctly
excluded these items.
c.
Goods in transit to customer
Goods shipped to a customer, F.O.B.
shipping point, are owned by the
customer because ownership passed
when they were delivered to the
transportation company. The
physical inventory correctly
excluded these items.
d.
Goods held for customer pickup
– 1,590
Goods sold, but held for customer
pick-up, are owned by the customer.
Ownership has passed.
e.
Goods purchased and in transit
+ 2,550
Goods purchased and in transit,
F.O.B. shipping point, are owned by
the purchaser.
f.
Goods sold and in transit
+ 850
Goods sold and in transit, F.O.B.
destination, are owned by the seller
until they reach destination.
g.
Goods held on consignment
– 4,750
Goods held on consignment are
owned by the consignor (the
manufacturer), not by the consignee.
Correct inventory, December 31, 2014
750
$62,810
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-25
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–2 (amounts in thousands of dollars)
Req. 1
PRUITT COMPANY
Corrected Statement of Earnings
Sales revenue
Cost of sales
Gross profit
Operating expenses
Pretax earnings
Income tax expense (30%)
Net earnings
2015
2014
$2,025
1,505
520
490
30
9
$ 21
$2,450
1,649*
801
513
288
86
$ 202
2013
$2,700
1,760*
940
538
402
121
$ 281
2012
$2,975
2,113
862
542
320
96
$ 224
* Decrease in the ending inventory in 2013 by $22 causes an increase in cost of sales by
the same amount. Therefore, cost of sales for 2013 is $1,782 – $22 = $1,760. Because
the 2013 ending inventory is carried over as the 2014 beginning inventory, cost of sales
for 2014 was understated by $22. Thus, the correct cost of sales amount for 2014 is
$1,627 + $22 = $1,649.
Req. 2
There was an understatement of the ending inventory in 2013 by $22; this caused cost of
sales for 2013 to be overstated and 2013 net earnings to be understated by $15. Similarly,
because this error was carried over automatically to 2014 as the beginning inventory, cost
of sales for 2014 was understated and 2014 net earnings were overstated by the same
amount, $15. The amounts for 2012 and 2015 were not affected. This is called a selfcorrecting or counterbalancing error. Cumulative net earnings for the four-year period
were not affected.
Req. 3
The effect of the error on income tax expense was:
Income tax expense reported (pretax earnings x 30%)
Correct income tax expense (revised pretax earnings x 30%)
Income tax expense overstatement (understatement)
2014
2013
$93
86
$ 7
$114
121
$ (7)
Alternatively, the amount of over (under)statement may be computed directly:
$22 x 30% = $6.60 (rounded to $7).
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-26
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–3
Req. (a) Cost of goods available for sale for all methods:
Units
January 1, 2015 – Beginning inventory
February 20, 2015 – Purchase
June 30, 2015 – Purchase
Cost of goods available for sale
400
600
500
1,500
Unit
Cost
Total
Cost
$30
32
36
$12,000
19,200
18,000
$49,200
Ending inventory: 1,500 units – (700 + 100 – 20) units = 720 units
Req. (b) and (c)
1.
Weighted-average cost:
Average unit cost
Ending inventory
Cost of sales
2.
First-in, first-out:
Ending inventory
Cost of sales
3.
Specific identification
Ending inventory
Cost of sales
$49,200 ÷ 1,500 = $32.80
(720 units x $32.80)
$23,616
($49,200 – $23,616)
$25,584
(500 units x $36)
+ (220 units x $32)
($49,200 – $25,040)
$25,040
$24,160
[(400 – 2/5 x 700) units x $30]
+ [(600 – 3/5 x 700) units x $32]
+ [(500 – 100 + 20) units x $36] $24,480
($49,200 – $24,480)
$24,720
As a shareholder, I prefer the weighted-average method because it results in the highest
cost of sales. This reduces pretax earnings, income tax payable and future cash outflows.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-27
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–4
Req. 1
Sales revenue*
Cost of sales**
Gross profit
REGINA COMPANY
Partial Statement of Earnings
For the Month Ended January 31, 2015
(a)
Weighted
Average
$12,600
3,758
$ 8,842
(b)
FIFO
$12,600
3,700
$ 8,900
(c)
Specific
Identification
$12,600
3,800
$ 8,800
Computations:
*(400 + 300) units @ $18 = $12,600
**Cost of sales:
The cost of goods available for sale = $2,500 + 3,600 + 1,280 = $7,380
Weighted average
The total cost of sales is the sum of the cost of sales on January 10 and the cost of sales on
January 17.
January 10 sale:
Weighted-average cost = $2,500/500 = $5
Cost of sale = 400 units x $5 = $2,000
January 17 sale:
Weighted-average cost = ($2,500 – $2,000 + $3,600) / (500 – 400 + 600) = $5.86
Cost of sale = 300 units x $5.86 = $1,758
Total cost of sales = $2,000 + $1,758 = $3,758
FIFO
Cost of sales = (400 x $5) + (100 x $5 + 200 x $6) = $3,700
Specific Identification
Cost of sales = (400 x $5) + (300 x $6) = $3,800
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-28
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–4 (continued)
Req. 2a
The FIFO method reports the highest pretax earnings (see gross profit calculation per Req.
1 above).
Req. 2b
Because the specific identification method cost reports the lowest pretax earnings (see
gross profit calculation per Req. 1 above) this method would produce the lowest income
tax expense.
Req. 2c
The specific identification method will provide a more favourable cash flow because less
cash will be paid for income tax than would be paid under the other two methods (for the
reasons given in Req. 2b).
Req. 3
January 10
Trade receivables (+A) ...........................................................................
7,200
Sales (+R  +SE) ................................................................................
2,000
Cost of sales (+E  –SE) .........................................................................
Inventory (–A) .....................................................................................
January 12
Inventory (+A) ............................................................................................
3,600
Trade payables (+L) ..........................................................................
January 17
Trade receivables (+A) ...........................................................................
5,400
Sales (+R  +SE) ..................................................................................
1,700
Cost of sales (+E  –SE) .........................................................................
Inventory (–A) .....................................................................................
(100 units @ $5 + 200 units @ $6)
January 26
Inventory (+A) ............................................................................................
1,280
Trade payables (+L) ..........................................................................
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-29
7,200
2,000
3,600
5,400
1,700
1,280
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–5
Req. 1
Prices Rising
Case A
Case B
Weighted
FIFO
Average
Prices Falling
Case C
Case D
Weighted
FIFO
Average
Sales revenue (500 units)
$15,000
$15,000
$15,000
$15,000
Cost of sales:
Beginning inventory (300 units) 3,300
3,300
3,600
3,600
Purchases (400 units)
4,800
4,800
4,400
4,400
Cost of goods available for sale
8,100
8,100
8,000
8,000
Ending inventory (200 units)*
2,400 (a)
2,314 (b)
2,200 (c)
2,286 (d)
Cost of sales (500 units)
5,700
5,786
5,800
5,714
Gross profit
9,300
9,214
9,200
9,286
Expenses (operating)
4,000
4,000
4,000
4,000
Pretax earnings
5,300
5,214
5,200
5,286
Income tax expense (30%)
1,590
1,564
1,560
1,586
Net earnings
$ 3,710
$ 3,650
$ 3,640
$ 3,700
*Inventory computations:
(a) FIFO: 200 units @ $12.00 = $2,400
(b) W.A.: 200 units @ ($8,100 ÷ 700) = $2,314
(c) FIFO: 200 units @ $11.00 = $2,200
(d) W.A.: 200 units @ ($8,000 ÷ 700) = $2,286
Req. 2
The above tabulation demonstrates that when prices are rising, the use of FIFO results in
higher net earnings than would be the case under Weighted Average. This is because FIFO
allocates the older (lower) unit costs to cost of sales whereas Weighted Average combines
the impact of lower and higher unit costs in computing the cost of sales. When prices are
falling, the opposite effect results. The difference in pretax earnings (as between FIFO and
Weighted Average) is the same as the difference in cost of sales but in the opposite direction.
The difference in net earnings (i.e., after tax) is equal to the difference in cost of sales
multiplied by one minus the income tax rate.
Req. 3
Because pretax earnings is higher under FIFO than under Weighted Average when prices
are rising, the FIFO method will result in a higher cash outflow resulting from the increase
in income tax payable. The opposite is true when prices are falling. We assume here that
the company can choose which of these two methods to use for tax purposes.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-30
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–5 (continued)
Req. 4
Either method can be defended reasonably. If one focuses on current net earnings and
earnings per share, FIFO derives a more favorable result (higher than Weighted Average)
when prices are rising. However, these comparative results will reverse if prices fall.
FIFO provides a better statement of financial position valuation (inventories are valued at
more recent prices), but FIFO does not match current expense (cost of sales) with current
revenues very well on the statement of earnings, especially in periods of changing unit
costs of inventory items. Alternatively, Weighted Average better matches expenses with
revenues but it produces an inventory value that does not reflect recent prices to the same
extent as FIFO.
With regard to cash flows, Weighted Average results in lower tax payments than FIFO when
prices are rising, and vice versa if prices are falling.
P8–6
Req. 1
The cost of ending inventory is the balance of the Inventory account at the end of the
period taking into consideration the beginning inventory, the purchases during the year
and the cost of sales on January 24 and March 16. The calculations are presented in the
summary table below.
Cost of Sales Calculation (Weighted-Average Perpetual)
Cost of units purchased and sold
Date
January 1
January 24
February 8
Transaction
Beginning inventory
Sale
Purchase
Number of units available for sale (NUAS) =
March 16
June 11
Sale
Purchase
Number of units available for sale (NUAS) =
First weighted-average cost per unit =
Units
500
(300)
200
600
800
(560)
240
300
540
COGAS
NUAS
x
x
x
x
Cost
$2.50
$2.50
$2.50
$2.60
x
x
x
$2.575
$2.575
$2.75
=
$2,060
800
=
Total
$ 1,250
(750)
500
1,560
$2,060 COGAS
(1,442)
618
825
$1,443 Cost of ending inventory
= $2.575
Cost of ending inventory = $1,443
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-31
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–6 (continued)
Req. 2
Sales
$3,552 (a)
Cost of sales
2,186 (b)
Gross profit (FIFO) $1,366
(a) (300 @ $4) + (560 @ $4.20) = $3,552
(b) (300 @ $2.50) + (200 @ $2.50 + 360 @ $2.60) = $2,186
Req. 3
In this case unit costs are rising steadily. One should therefore expect gross profit to be
lower under the weighted average costing method compared to FIFO since more recent
(higher) purchase costs are included in cost of sales under the weighted average method,
and older (lower) costs are included in cost of sales under FIFO.
Req. 4
January 24
Trade receivables (+A) ............................................................................1,200
Sales (+R  +SE) .................................................................................
1,200
Cost of sales (+E  –SE) .......................................................................... 750
Inventory (–A) ......................................................................................
750
February 8
Inventory (+A) ............................................................................................1,560
Trade payables (+L) ...........................................................................
1,560
March 16
Trade receivables (+A) ............................................................................2,352
Sales (+R  +SE) .................................................................................
2,352
Cost of sales (+E  –SE) ..........................................................................1,442
Inventory (–A) ......................................................................................
1,442
Inventory (+A) ............................................................................................ 825
Trade payables (+L) ...........................................................................
825
June 11
Req. 5
a) The ending inventory is currently reported at a cost of $1,449 (= 300 @$2.75 + 240 @
$2.60). A reduction of 100 units in inventory will cause a reduction of $260 (100 @
$2.60) in inventory cost. Hence, the cost of sales is overstated by $260.
b) Current assets (inventory) would be understated by $260 (as calculated above).
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-32
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–7
Req. 1
Sales
$1,440
Less: Sales returns and allowances
240
Net sales
$1,200
Cost of sales:
Beginning inventory
$ 450
Purchases
1,045
Cost of goods available for sale 1,495
Ending inventory
380
Cost of sales
1,115
Gross profit
$ 85
[(3 + 4 + 5) units x $120]
[(5 – 3 +11 – 4 – 5) x $95]
Req. 2
Inventory turnover =
Cost of sales
Average Inventory
=
$1,115
($450 + $380)/2
= 2.69
Average days to sell inventory = 365/inventory turnover = 365/2.69 = 136 days (rounded)
The inventory turnover ratio reflects how many times average inventory was produced and
sold during the period. Thus, Kramer sold its average merchandise inventory less than
three times during the year.
The average number of days to sell inventory indicates the average time it takes Kramer to
sell inventory to its customers. It takes Kramer 136 days on average to sell its entire
inventory to its customers.
Req. 3
Jan. 6
Purchases (+T) ...........................................................................................
Trade payables (+L) ...........................................................................
1,045
Jan. 8
Trade receivables (+A) .............................................................................
Sales (+R  +SE) .................................................................................
480
Jan. 15 Sales returns and allowances (+XR  –R  –SE) .........................
Trade receivables (–A) ......................................................................
240
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-33
1,045
480
240
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–7 (continued)
Req. 4
Weighted average cost method
The total cost of sales is the sum of the cost of sales on January 3, 8, and 9.
January 3 sale:
Weighted-average cost = $90
Cost of sale = 3 x $90 = $270
January 8 and 9 sales:
Weighted-average cost = (2 units x $90 + 11 units x $95) / 13 units = $94.23
Cost of sales = 9 units x $94.23 = $848 rounded
Total cost of sales = $270 + $848 = $1,118
P8–8
Req. 1
SMART COMPANY
Statement of Earnings (LCM basis)
For the Year Ended December 31, 2014
Sales revenue
Cost of sales:
Beginning inventory
Purchases
Cost of goods available for sale
Ending inventory
Cost of sales
Gross profit
Operating expense
Pretax earnings
Income tax expense ($40,850 x 30%)
Net earnings
$ 31,000
184,000
215,000
37,850*
*Computation of ending inventory on LCNRV basis:
Item Quantity
A
B
C
D
3,050
1,500
7,100
3,200
Total
Original Cost
x $3
x 5
x 1.50
x 6
= $ 9,150
= 7,500
= 10,650
= 19,200
$46,500
LCNRV inventory valuation
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-34
x
x
x
x
Net
Realizable
Value
$4 =
3.50 =
3.50 =
4 =
$12,200
5,250
24,850
12,800
$55,100
$280,000
177,150
102,850
62,000
40,850
12,255
$ 28,595
LCNRV Valuation
$9,150
5,250
10,650
12,800
$37,850
$37,850
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–8 (continued)
Req. 2
Item Changed
Ending inventory
Cost of sales
Gross profit
Pretax earnings
Income tax expense
Net earnings
FIFO
Cost Basis
$ 46,500
168,500
111,500
49,500
14,850
34,650
LCNRV
Basis
$ 37,850
177,150
102,850
40,850
12,255
28,595
Amount of
Change
(Decrease)
($8,650)
8,650
(8,650)
(8,650)
(2,595)
(6,055)
Analysis
Ending inventory, cost of sales, gross profit, and pretax earnings each changed by $8,650,
which is the change in the valuation of the ending inventory. Income tax expense decreased
because the increase in cost of sales reduced pretax earnings.
Net earnings were reduced by $6,055, which is the increase in cost of sales, $8,650, less the
income tax savings of $2,595.
Req. 3
LCNRV is an exception to the cost principle. Conceptually, LCNRV is based on the view that
when market value (in this case, net realizable value) is less than the cost incurred for the
merchandise, any such goods on hand should be valued at the lower market price. The
effect is to include the holding loss (i.e., the drop from the recorded cost to the currently
lower market value) in the cost of sales amount of the period in which the market price fell
so that net earnings are not overstated. LCNRV recognizes holding losses in this manner;
however, it does not recognize holding gains.
Req. 4
LCNRV reduced pretax earnings and income tax expense. There was cash savings of $2,595
for 2014 (assuming the LCNRV results are included on the income tax return). In
subsequent periods pretax earnings will be greater by the $8,650 and hence, income tax
and cash outflow will be more. The only real gain to the company would be the time value
of money between 2014 and the subsequent periods when increased income taxes must be
paid (of course, a change in tax rates would affect this analysis).
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-35
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–9 (Dollars are in thousands)
Req. 1
Inventory
Turnover
=
Cost of sales
Average Inventory
Projected change
No change from
beginning of year
$7,008,984 = 17.5
$400,005*
$7,008,984 = 14.1
$495,700**
* ($495,700 + $304,310) ÷ 2
** ($495,700 + $495,700) ÷ 2
Req. 2
Projected decrease in inventory = $495,700 – $304,310 = $191,390
There would be a $191,390 increase in cash flow from operating activities, because a
decrease in inventory would increase cash, all other items held constant.
Req. 3
An increase in the inventory turnover ratio indicates an increase in the number of times
average inventory was produced and sold during the period. If sales and cost of sales
remain unchanged, then the higher ratio reflects a decrease in inventory on hand which
means that less cash is tied up in inventory. Alternatively, a higher ratio could result from
an increase in sales, indicating that inventory is moving more quickly through the
production process to the ultimate customer. As a consequence, the increase in sales is
likely to result in increased collections from customers, which increase cash flow from
operations. The excess cash can, for example, be invested to earn interest income, or used
to reduce borrowings, thereby reducing interest expense. In reality an increase could be a
result of both a reduction in inventory levels and an increase in sales.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-36
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
P8–10 (Appendix 8A)
(a)
Cash (+A) ......................................................................................................
Sales (+R  +SE) ................................................................................
275,000
Cost of sales (+E  –SE) .........................................................................
Inventory (−A) .....................................................................................
137,500
Sales returns and allowances (+XR  –SE) ...................................
Cash (−A)................................................................................................
1,600
Inventory (+A) ............................................................................................
Cost of sales (−E  +SE) ..................................................................
800
(c1)
Inventory (+A) ...........................................................................................
Trade payables (+L)...........................................................................
5,000
(c2)
Inventory (+A) ...........................................................................................
Trade payables (+L)...........................................................................
120,000
(d)
Store equipment (+A) ..............................................................................
Cash (–A) ................................................................................................
2,200
(e)
Office supplies inventory (+A) .............................................................
Cash (–A) ................................................................................................
700
(f)
Inventory (+A) ...........................................................................................
Cash (–A) ................................................................................................
400
(g1)
Trade payables (–L) .................................................................................
Cash (–A) ................................................................................................
5,000
(g2)
Trade payables (–L) .................................................................................
Cash (–A) (120,000 x 0.97) .............................................................
Inventory (–A) (120,000 x 0.03) ...................................................
120,000
(b)
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-37
275,000
137,500
1,600
800
5,000
120,000
2,200
700
400
5,000
116,400
3,600
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
ALTERNATE PROBLEMS
AP8–1
Req. 1
Sales revenue
Cost of sales
Gross profit
Operating expenses
Pretax earnings
1
2016
2015
2014
2013
$58,000
37,000
21,000
12,000
9,000
$62,000
46,000 2
16,000
14,000
2,000
$51,000
32,000 1
19,000
12,000
7,000
$50,000
32,500
17,500
10,000
7,500
$35,000 – $3,000 = $32,000.
Req. 2
2
$43,000 + $3,000 = $46,000.
2016
Gross profit percentage (gross profit ÷ sales):
Before correction:
$21,000 ÷ $58,000 =
.36
$19,000 ÷ $62,000 =
$16,000 ÷ $51,000 =
$17,500 ÷ $50,000 =
After correction:
No change
$16,000 ÷ $62,000 =
$19,000 ÷ $51,000 =
No change
.36
2015
.31
.26
2014
.31
.37
2013
.35
.35
The corrected ratios are less consistent than the original ratios but the original ratios are
both below those of 2013 and 2016. After correction, the ratio for 2014 is consistent with
the ratios for 2013 and 2016 but the reduced ratio for 2015 warrants further investigation.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-38
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
AP8–1 (continued)
Req. 3
The effect of the error on income tax expense was:
Income tax expense reported (pretax earnings x 30%)
Correct income tax expense (revised pretax earnings x 30%)
Income tax expense overstatement (understatement)
2015
2014
$1,500
600
$ 900
$1,200
2,100
$ (900)
Alternatively, the amount of over (under)statement may be computed directly:
$3,000 x 30% = $900.
Income tax expense for the years 2013 and 2016 is not affected by this error.
AP8–2
Req. (a)
Cost of goods available for sale for all methods:
Unit
Cost
Units
January 1, 2015 – Beginning inventory
January 30, 2015 – Purchase
May 1, 2015 – Purchase
Goods available for sale
1,800
2,500
1,200
5,500
$2.50
3.10
4.00
Total
Cost
$ 4,500
7,750
4,800
$17,050
Ending inventory: 5,500 units – (1,450 + 1,900) units = 2,150 units
Req. (b) and (c)
1.
2.
Weighted-average cost:
Average unit cost
Ending inventory
Cost of sales
First-in, first-out:
Ending inventory
Cost of sales
3.
Specific identification:
Cost of sales
Ending inventory
4.
$17,050 ÷ 5,500 = $3.10
(2,150 units x $3.10)
($17,050 – $6,665)
$6,665
$10,385
(1,200 units x $4.00) +
(950 units x $3.10)
($17,050 – $7,745)
$7,745
$9,305
[(2/5 x 1,450 x $2.50 + 3/5 x 1,450 x $3.10)
+ (3/5 x 1,800) x $2.50
+ (1,900 – 3/5 x 1,800) x $4.00]
($17,050 – $9,917)
$9,917
$7,133
As a shareholder, I prefer the weighted-average method because it results in the
highest cost of sales. This reduces pretax earnings, income tax payable and future
cash outflows.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-39
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
AP8–3
Req. 1
Units (cartons) sold = 500 + 700 = 1,200
Cost of sales (FIFO, perpetual) consists of the following:
Cost of sale on Jan. 5 = 500 x $20 ($16,000 / 800) =
Cost of sale on Jan. 21 = (300 x $20) + [400 x $22 ($13,200 / 600)] =
Total cost
$10,000
14,800
$24,800
Req. 2
The weighted average cost per unit should be computed twice, once after the purchase on
January 19, and the second computation is after the purchase on January 29.
WAC1 = $16,000 + $13,200 – (500 x $20) = $19,200 = $21.33 (rounded)
800 + 600 – 500
900
WAC2 = (900 x $21.33) + $11,000 = $30,200 = $21.57
900 + 500
1,400
Units in ending inventory = 1,900 – 500 – 700 = 700
Cost of ending inventory = 700 x $21.57 = $15,099
Req. 3
Using FIFO, the cost of sales would not change if a periodic inventory system were used
instead of perpetual system.
Under a periodic inventory system, the weighted average unit cost is computed once, at the
end of the accounting period, whereas the moving weighted average unit cost changes after
each purchase of merchandise. The WAC under a periodic system would be:
WAC = $16,000 + $13,200 + $11,000 = $40,200 = $21.16 (rounded)
800 + 600 + 500
1,900
A unit cost of $21.16 would be used to compute ending inventory compared to $21.57
under the moving average method.
Ending inventory = 700 units x $21.16 = $14,812
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-40
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
AP8–4
Req. 1
Seema Company uses first-in-first-out (FIFO) method. The table shows that the oldest
items are recorded as sold first, and the recently purchased items are recorded as being left
in the inventory.
Req. 2
Aug. 20
Inventory (+A) ...........................................................................................
Cash (–A) ................................................................................................
3,300
Dec. 21
Cash (+A).......................................................................................................
Sales (+R  +SE) ................................................................................
3,600
3,300
3,600
Req. 3
Inventory turnover =
Cost of sales
Average Inventory
=
$8,350*
($2,700 + $1,650**)/2
= 3.84
* Cost of sales = (300 x $9) + (400 x $10) + $(150 x $11) = $8,350
**Ending inventory = units in inventory x FIFO cost per unit
= (300 + 400 – 300 + 300 – 350 – 200) x $11 = $1,650
The inventory turnover ratio reflects how many times average inventory was sold during
the period. The ratio indicates that Seema’s inventory was sold about four times during
2014.
Req. 4
The product’s cost is $11 per unit but its net realizable value dropped to $9.50 per unit.
Hence, there is a holding loss of $1.50 per unit or a total loss of $225 (150 units x $1.50).
The journal entry to record this loss is:
Dec. 31
Cost of sales (−E  +SE)
Allowance for write-down of inventory to NRV (+XA  −A)
225
225
Alternatively, the Inventory account could be reduced directly by $225.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-41
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
AP8–4 (continued)
Req. 5
Weighted average cost method
The total cost of sales is the sum of the cost of sales on April 7, November 29, and December
21.
April 7 sale:
Weighted-average cost = (300 units x $9 + 400 units x $10) / 700 units = $9.57
Cost of sale = 300 x $9.57 = $2,871
Sales of November 29 and December 21:
Weighted-average cost = (400 units x $9.57 + 300 units x $11) / 700 units = $10.18
Cost of sales = (350 units + 200 units) x $10.18 = $5,599
Total cost of sales = $2,871 + $5,599 = $8,470
AP8–5 (Appendix 8A)
(a)
Cash (+A) ......................................................................................................
Trade receivables (+A) ...........................................................................
Sales (+R  +SE) ................................................................................
228,000
72,000
Cost of sales (+E  –SE) .........................................................................
Inventory (–A) .....................................................................................
150,000
Sales returns and allowances (+XR  –SE) ...................................
Cash (−A)................................................................................................
Trade receivables (–A) .....................................................................
5,000
Inventory (+A) ...........................................................................................
Cost of sales (−E  +SE) ..................................................................
2,500
(c1)
Inventory (+A) ...........................................................................................
Trade payables (+L)...........................................................................
4,000
(c2)
Inventory (+A) ...........................................................................................
Trade payables (+L)...........................................................................
68,000
(d)
Inventory (+A) ............................................................................................
Cash (–A) ................................................................................................
1,500
(e)
Cash (+A) .......................................................................................................
Trade receivables (–A) .....................................................................
36,000
(b)
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-42
300,000
150,000
3,000
2,000
2,500
4,000
68,000
1,500
36,000
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
AP8–5 (continued)
(f1)
Trade payables (–L) .................................................................................
Cash (–A) ................................................................................................
4,000
(f2)
Trade payables (–L) .................................................................................
Cash (–A) ................................................................................................
Inventory (–A) .....................................................................................
68,000
(g)
Office equipment (+A) ............................................................................
Cash (–A) ................................................................................................
1,000
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-43
4,000
66,640
1,360
1,000
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CASES AND PROJECTS
FINDING AND INTERPRETING FINANCIAL INFORMATION
CP8–1
This response is based on the financial statements for the year ended December 30, 2012.
Req. 1
The company owned $890.4 million of inventories as at December 30, 2012. This
information is disclosed on the statement of financial position.
Req. 2
It is estimated that the company purchased (and produced) goods at a total cost of $3,594.9
million during the year. The beginning and ending inventory balances are disclosed on the
statement of financial position and cost of sales is disclosed on the statement of earnings.
Purchases during the year can be computed by rearranging the basic inventory equation
(BI + P – EI = COS):
Cost of sales (note 5.1) ...............................................................
+ Ending inventory ........................................................................
– Beginning inventory ..................................................................
= Purchases........................................................................................
$3,544.8
890.4
(840.3)
$3,594.9
Req. 3
Note 3 – Significant Accounting Policies, part (d) Inventory Valuation includes the following
information:
Inventory is valued at the lower of cost and net realizable value. Cost is determined using the
weighted average cost method.
The cost of inventories comprises all costs of purchases and other costs incurred in
bringing the inventory to its present location and condition, including realized gains or
losses on qualifying cash flow hedges of foreign currency inventory purchases. Inventory is
comprised mainly of finished goods.
Net realizable value is the estimated selling price in the ordinary course of business less
any applicable estimated selling expenses.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-44
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–1 (continued)
Req. 4
Inventory
Turnover
=
Cost of sales
Average Inventory
$3,544.8
$865.4*
= 4.1
* ($840.3 + $890.4) ÷ 2
The inventory turnover indicates approximately how many times the company sells or
turns over it inventory in a one-year period. RONA sold its inventory 4 times during fiscal
year 2012.
Req. 5
According to Note 8 – Cash Flow Information, the increase in Inventories resulted in a
decrease in cash by $44.425 million. This amount does not correspond to the decrease
in the carrying amount of inventories reported on the statement of financial position
because of the write-down of inventories disclosed in Note 6.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-45
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–2
Req. 1
Note 3 – Significant accounting policies states that:
Merchandise inventories are carried at the lower of cost or net realizable value.
…
The cost of merchandise inventories are determined based on weighted average cost and
includes costs incurred in bringing the merchandise inventories to their present location
and condition. All inventories are finished goods.
Net realizable value is the estimated selling price of inventory during the normal course of
business less estimated selling expenses.
Req. 2
Canadian Tire did not disclose any information related to impairment of its inventories.
Req. 3
The inventory turnover ratio for Canadian Tire is computed as follows (amounts in
millions):
Inventory =
Turnover
Cost of sales
=
Average Inventory
$7,929.3
($1,448.6 + $1,503.3) / 2
= 5.37
The inventory turnover indicates approximately how many times the company sells or
turns over it inventory in a one-year period. Canadian Tire sold its inventory 5 times
during fiscal year 2012 or once per month, on average.
Req. 4
Earnings before income taxes are $677.2 million as presented in the statement of earnings.
If inventory is overstated, then the cost of sales must be understated, the earnings from
operations (operating income) must be overstated and earnings before income taxes must
also be overstated. Therefore an overstatement of inventory by $10 million would mean
that earnings before income taxes should be $667.2 million.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-46
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–3
Req. 1
(Dollars are in millions.)
Canadian Tire
Inventory
Turnover
=
Cost of sales
Average Inventory
$7,929.3 = 5.37
$1,475.9*
RONA
$3,544.8
$865.4**
= 4.1
*($1,448.6 + $1,503.3) ÷ 2 **($840.3 + $890.4) ÷ 2
Canadian Tire’s ratio is higher than RONA’s, indicating that Canadian Tire may be managing
its inventories better than RONA. The main reason for the differences in the turnover
ratios is the nature and sale price of the products that are sold by these companies which
cause their customers to return to the store.
Req. 2
The industry average for the inventory turnover ratio reported in Appendix B is 5.99.
However, this ratio is calculated as Sales / Inventory, not as Cost of Sales /Inventory. A
ratio based on cost of sales must be a lower value. Given that the industry consists of only
three companies: Canadian Tire, RONA and Richelieu Hardware, the average inventory
turnover ratio (or industry ratio) can be easily computed. For 2012, the industry average is
4.49. This means that Canadian Tire has a higher turnover ratio than its competitors.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-47
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–4
The solution to this case is adapted from the solution to Paper II of the 2005 Uniform
Evaluation for the Chartered Accountant designation, retrieved from “Filling the GAAP to
IFRS: Teaching Supplements for Canada’s Accounting Academics, CD3–Questions and
Answers Pack, Canadian Institute of Chartered Accountants: Toronto, 2008.
Req. 1
The areas of concern are as follows.
Revenues
There is no control over the cash portion of the revenues. Cash sales represent 25% of the
sales, which is a material amount in relation to the financial statements. Marco stated that
he sometimes pockets cash sales rather than recording the sale on the register (the amount
reported to us is approximately $10,000). In addition, some of the employees are also in a
position to pocket cash sales as they are left in the store unattended. Therefore, it will be
difficult to establish the total amount of cash sales.
Control over credit sales also seems weak. Amounts owed by customers are recorded at the
time of delivery on a specially designated sheet of paper kept by the cash register. As cash
is received, their balance is reduced. There is no sign of pre-numbered invoices being used
to control the invoicing process. It is possible that some credit sales were never recorded
on the list or that some account balances on the list have already been paid but have not
been removed from the list. There is no easy way to make sure that the trade receivables
list is reasonably accurate. Credit sales represent a significant portion of MPP’s revenue
(50% of total revenue). It will therefore be very difficult to ensure that the revenue amount
related to credit sales is complete.
Trade receivables
When Carla prepared the statement of earnings, she included a bad debt expense estimated
at 17% of the trade receivables. We will have to make sure that this estimate is reasonable
and is based on her best estimate of the unrecoverable amounts. Given that 50% of sales
are on credit, that there is no policy for granting credit and that customers usually do not
pay on time, we may need to increase the provision for, or even write off, unrecoverable
balances. As it is already six months after year-end, we should be able to determine
whether the bad debt expense recorded is plausible based on subsequent receipts.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-48
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–4 (continued)
Inventory
Marco determined the value of the inventory by writing up a list of what was in the stock
room on December 31 and applying prices obtained from current supplier price lists to the
quantities noted. Current prices should not be used, as inventory should be valued at the
lower of cost and net realizable value. However, since the inventory turnover seems to be
high, the misstatement is likely not material.
We should also find out if there is any obsolete inventory. But here again, obsolescence is
unlikely since the inventory turnover seems high.
Expense cut-off
Marco has a corporate credit card on which he makes MPP’s purchases. Items purchased on
the credit card are expensed in the year as long as a statement is received from the credit
card company in time to be included in the financial statements. If the statement comes in
too late, the expenses get picked up the following year. In other words, we have a cut-off
problem which can easily be resolved by reviewing the credit card statements received
after year-end and identifying the purchases that relate to the previous fiscal year.
Marco sometimes makes personal purchases on the corporate credit card. Marco estimates
that he charged about $4,000 of personal expenses to the corporate credit card in each of
the last two years. We will have to review the credit card statements to determine the
amount of personal expenses incurred.
Req. 2
Dear Mr. Douga,
Your business has performed far better than your draft statement of earnings shows. I
recalculated the balances of specific elements of the statements of earnings, found below, in
accordance with the accrual basis of accounting. Based on my calculations, your business
earned a profit in both 2013 and 2012. This is good news because being profitable will
make it easier to obtain a bank loan. Unfortunately, MPP was also profitable in 2013 for tax
purposes, and as a result taxes will have to be paid to the taxation authorities.
These statements are based on the information you provided me, which I have assumed to
be accurate. The statements of earnings, therefore, give a reasonable indication of the
actual performance of the company. The adjustments made to the statements thus far are
as follows:
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-49
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–4 (continued)
Marco Professional Print Shop Ltd.
Statement of Earnings
For the year ended December 31
Sales
Cost of merchandise sold
Gross profit
Operating expenses:
Selling, general & administrative expenses
Salaries
Advertising and promotion
Utilities
Rent
Bad debt expense
Other expenses
Earnings from Operations
Non-operating expenses:
Bank charges
Interest on loans from relatives
Earnings before depreciation and income taxes
2013
2012
Note 1
Note 2
$375,242
120,962
254,280
$281,539
88,012
193,527
Note 3
Note 4
38,204
65,099
34,727
18,300
22,000
2,754
16,618
197,702
56,578
31,249
58,740
29,503
17,900
22,000
1,955
12,444
173,791
19,736
2,000
5,000
$ 49,578
1,500
5,000
$ 13,236
Notes
1. Sales
$10,000 has been added to Sales each year to account for the cash sales that you put in your
pocket rather than in the cash register. Sales have also been adjusted for trade receivables.
MPP currently uses the cash basis of accounting for recording sales but, under IFRS, accrual
accounting must be followed. According to IAS1.27 and 28, “An entity shall prepare its
financial statements, except for cash flow information, using the accrual basis of
accounting. When the accrual basis of accounting is used, items are recognized as assets,
liabilities, equity, income and expenses (the elements of financial statements) when they
satisfy the definitions and recognition criteria for those elements in the Framework.”
Therefore, as long as the sales on credit meet the definition of revenue, they have to be
recorded as well. That means the closing amount of trade receivables each year must be
added to that year’s sales. For 2013, the ending amount of trade receivables for 2012 is
deducted from Sales for 2013.
2013 Sales: $360,547 + $10,000 + $16,200 – $11,505 = $375,242
2012 Sales: $260,034 + $10,000 + $11,505 = $281,539
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-50
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–4 (continued)
2. Cost of merchandise sold
The value of the inventory you calculated could be wrong, as the prices you used may not
be the same as the prices you paid when you bought the items (i.e., their cost). Per IAS2.9,
“Inventories shall be measured at the lower of cost and net realizable value.” You should
attempt to “cost out” the inventory based on the historical prices you paid for the items. If
the prices have been fairly consistent over time, the adjustment from current prices to cost
may not be significant.
Cost of merchandise sold is too high in your statement of earnings. MPP has expensed the
cost of all the supplies and the merchandise purchased whereas only the cost of the items
actually used or sold should be expensed. To determine the correct amount of inventory
sold, I have subtracted the ending inventory at cost from purchases each year. For 2013, I
added 2012’s ending inventory since that amount would have been sold in 2013.
2013 Cost of merchandise sold: $124,984 + $8,200 – $12,222 = $120,962
2012 Cost of merchandise sold: $96,212 – $8,200 = $88,012
3. Selling, general, and administrative expenses
Selling, general, and administrative expenses have been reduced by $4,000 each year, your
estimate of the personal expenses that you charged to MPP’s corporate credit card. The
nature of the amounts should be determined. The amounts could be an expense (i.e.,
salary), a dividend (if so, it would be excluded from net earnings) or a loan to you, the
shareholder.
4. Payments to employees
The Payments to employees account has been replaced with Salaries and reduced by
$25,000 each year for the money you took out of the company for personal expenses. Carla
included these amounts in the Payments to employees account on the statement of
earnings. As in the case the $4,000 discussed above, the $25,000 could be a salary, a
dividend, or a loan to you.
Also, employees are paid their gross earnings by cheque at the end of each week. It is not
clear whether MPP remits to the government the employer’s contributions related to the
payroll. I will need more information before adjusting the salary expense for MPP’s
contributions.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-51
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–4 (continued)
5. Computers, printers, copiers, scanners, furniture and fixtures
Carla included in the statement of earnings the costs of the printing and scanning
equipment, furniture and fixtures. Those items are property, plant and equipment assets as
they meet the requirements set out in IAS16.7, “The cost of an item of property, plant and
equipment shall be recognized as an asset if, and only if: it is probable that future economic
benefits associated with the item will flow to the entity and the cost of the item can be
measured reliably.” Therefore, the cost of these assets should be capitalized and recognized
over their useful lives for the business. This is called deprecation. I need more information
to determine the useful lives of these assets in order to decide on the appropriate
depreciation policy. For tax purposes, they can be depreciated on a different basis from
that used for accounting purposes.
Req. 3
From our discussion, the controls surrounding cash seem to be an area of concern. I suggest
that you make improvements as soon as possible, although they are not as pressing as
preparing the financial statements for the bank. The suggestions I have are as follows.

Control of cash––In my view MPP has some serious cash control issues that need
attention. The problem is that you and Carla have no way to check whether cash is
adequately protected. You often leave your employees in charge of the store which
gives them the opportunity to take cash, either from the cash register or in the same
way you do, by putting cash from cash sales directly into their pockets. If you happen to
hire a dishonest employee, you could easily be out of pocket. The fact that only you, or
Carla, control the cash when you are in the store shows that you understand the
importance of cash controls. You need to take steps to tighten the controls over cash
when you are not there. One step would be to make employees aware that you are
monitoring cash. For example, you could count the cash in the register before you leave
the store and again once you return. You should insist that your employees give
customers their receipts, so employees (and you) have to ring up all sales transactions
on the cash register. You could install surveillance cameras, ostensibly to protect
employees but they would also serve to monitor the actions of employees in your
absence.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-52
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–4 (continued)

Purchasing and inventory control—from your description of the business it appears that
you have a very casual way of keeping track of your inventory. Running short of
inventory or carrying too much inventory can be costly. If you run out of inventory you
may be unable to meet the needs of your customers. And if you have too much
inventory, you have cash tied up in inventory that could be used for other purposes. You
visually survey your inventory regularly, but you still seem to run out of things from
time to time. In those instances you are required to purchase the materials at retail
which is more costly than paying wholesale prices from your suppliers. You should
consider negotiating a supply arrangement to take advantage of potential discounts and
regular periodic deliveries.
With better inventory controls, it might be possible to determine whether the use of
inventory is reasonable given the revenues that are being earned. If there seem to be
significant shortfalls in inventory relative to the cash collected, that might be an
indication of theft.

Collection of trade receivables—you ask your credit customers to pay within 10 days,
but you do not seem to do very much to ensure that your customers comply. A quick
calculation indicates that the average collection period for your receivables is over 22
days [365/(credit sales/average trade receivables)], more than twice as long as the
period you supposedly allow. Trade receivables tie up your cash, so it is important to
collect from customers as quickly as possible. You should keep better track of who owes
you money and call customers to ask for payment once an amount is overdue, especially
customers who regularly pay late.
In addition, you may want to develop a better system for recording trade receivables as
the designated sheet maintained by the register is accessible to all employees and
would be easy to alter. A simple spreadsheet could be created to keep track of
outstanding balances, and access to the spreadsheet could be restricted.

Payments to suppliers—currently you pay your suppliers as soon as you receive the
invoice. While it is a good strategy to pay your bills on time, paying them too early or
not taking advantage of available discounts comes at a cost. Some companies offer
discounts for prompt payment (for example, a 2% discount for paying within 10 days).
It is not clear whether your suppliers offer these discounts or whether you take
advantage of them.

Separation of personal expenses from business expenses––You should also make sure
your personal expenses are segregated from your business expenses. Recording all the
transactions on the cash register (as recommended above) as well as always using a
separate credit card for your personal expenses will help solve that problem.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-53
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–5 (amounts in thousands of dollars)
Req. 1
Gross Profit = Net sales – Cost of sales
2011:
$157,621 – $71,333 = $86,288
2012:
$148,219 – $71,513 = $76,706
Inventory
Turnover
=
Cost of sales
Average Inventory
2011
2012
$71,333 = 2.57
$27,751.5*
$71,513
= 2.66
$26,927.5**
*($26,539 + $28,964) ÷ 2
**($28,964 + $24,891) ÷ 2
Req. 2
The table below shows that gross profit is highest for each of these two years in the second
quarter, followed by the third quarter, then the fourth quarter, and finally the first quarter.
Time Period
Fiscal year 2011
First quarter 2011
Second quarter 2011
Third quarter 2011
Fourth quarter 2011
Fiscal year 2012
First quarter 2012
Second quarter 2012
Third quarter 2012
Fourth quarter 2012
Net Sales
Cost of Sales
Gross Profit
$ 23,427
61,442
46,039
26,713
$ 11,161
25,500
22,827
11,845
$12,266
35,942
23,212
14,868
22,091
59,487
39,131
27,510
10,401
26,328
20,364
14,420
11,690
33,159
18,767
13,090
Req. 3
The inventory balances indicates that they are relatively high at the end of the first two
quarters in anticipation of sales in the second and third quarters, which is the busiest
seasons of the year. The inventory levels show a decreasing trend afterwards that
corresponds to the sales activity in the remaining quarters.
The end of Danier’s fiscal year corresponds with the lowest level of inventory. If Danier
chooses a different year-end date, then its inventory levels are likely to be higher which
reduces its inventory turnover.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-54
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–5 (continued)
Req. 4
Inventory
Turnover
=
Cost of sales
Average Inventory
$71,513
$32,459.5*
= 2.20
* ($39,775 + $36,789 + $28,383 + $24,891) ÷ 4
The ratio decreased from 2.66 to 2.20, a difference of 0.46 or 17 percent of the initial value.
This decrease occurred because the annual inventory values at the end of the fourth
quarter are lowest among the four quarters, which results in a higher value for the
inventory turnover ratio.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-55
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–6 (amounts in millions of U.S. dollars)
Req. 1
a.
Collections from customers = Revenues + Beginning trade receivables – Ending trade
receivables
2011:
2012:
$18,550.4 + 252.7 – 315.5 = $18,487.6
$22,997.5 + 315.5– 375.2 = $22,937.8
b. Merchandise purchases = Cost of sales + Ending inventory – Beginning inventory
2011:
2012:
c.
Payments to suppliers = Merchandise purchases + Beginning trade payables – Ending
trade payables
2011:
2012:
d.
$15,804.7+ 526.0 – 469.9 = $15,860.8
$20,028.4 + 543.9 – 526.0 = $20,046.3
$15,860.8 + 618.2 – 701.7 = $15,777.3
$20,046.3 + 701.7 – 812.7 = $19,935.3
Trade receivables turnover = Revenues / Average net trade receivables
2011:
2012:
$18,550.4 / [(252.7 + 315.3)/2] = 65.32
$22,997.5/ [(315.5 + 375.2)/2] = 66.59
Average collection period = 365 / Trade receivables turnover
2011:
2012:
e.
365 / 65.32 = 5.59 days
365 / 66.59 = 5.48 days
Inventory turnover = Cost of sales / Average inventory
2011:
2012:
$15,804.7/ [(526.0 + 469.9)/2] = 31.74
$20,028.4/ [(543.9 + 526.0)/2] = 37.44
Average days to sell inventory = 365 / Inventory turnover
2011:
2012:
f.
365 / 31.74 = 11.50 days
365 / 37.44 = 9.75 days
Average period to convert inventory to cash = Average days to sell inventory
+ Average collection period
2011:
11.50 days + 5.59 days = 17.09 days
2012:
9.75 days + 5.48 days = 15.23 days
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-56
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
Req. 2
The changes in trade receivables, inventory and trade payables are reported on the
statement of cash flows as adjustments to net earnings as follows:
Operating activities:
Net earnings
($603.9 – 146.3)
Adjustments for items that do not affect cash:
Increase in trade receivables
Increase in inventory
Increase in trade payables
$457.6
$(59.7)
(17.9)
111.0
Req. 3
Assuming that the costs of units purchased have increased during fiscal year 2012, the cost
of sales would be higher if the weighted average costing method is used instead of FIFO.
This is because the FIFO costs would include earlier costs that are lower. This would result
in a lower net earnings figure.
Req. 4
The purchased merchandise should be included in ending inventory because it belongs to
the company as of that date even if it is not in the company’s warehouse yet. An increase in
ending inventory will reduce the cost of sales, increase gross profit, pretax earnings,
income tax expense, and net earnings. The increase in net earnings would be $1.4 million x
[1 – 146.3 / 603.9)] = $1.06 million. This amount is a relatively small percentage of net
earnings, $1.06/$457.6 = 0.23%. As such, its omission may not affect users’ decisions.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-57
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–7 (amounts in millions of euro).
Req. 1
a.
Collections from customers = Net sales + Beginning trade receivables – Ending trade
receivables
2011:
2012:
b.
Merchandise purchases = Cost of sales + Ending inventory – Beginning inventory
2011:
2012:
c.
€478.1 + 196.6 – 172.1 = €502.6
€410.5 + 209.2 – 196.6 = €423.1
Payments to suppliers = Merchandise purchases + Beginning trade payables – Ending
trade payables
2011:
2012:
d.
€887.3 + 124.5 – 154.2 = €857.6
€807.6 + 154.2 – 145.5 = €816.3
€502.6 + 117.8 – 133.0 = €487.4
€423.1 + 133.0 – 162.6 = €393.5
Trade receivables turnover = Net sales / Average trade receivables
2011:
2012:
€887.3 / [(124.5 + 154.2)/2] = 6.37
€807.6 / [(154.2 + 145.5)/2] = 5.39
Average collection period = 365 / Trade receivables turnover
2011:
2012:
e.
365 / 6.37 = 57 days (rounded)
365 / 5.39 = 68 days (rounded)
Inventory turnover = Cost of sales / Average inventory
2011:
2012:
€478.1 / [(172.1 + 196.6)/2] = 2.59
€410.5 / [(196.6 + 209.2)/2] = 2.02
Average days to sell inventory = 365 / Inventory turnover
2011:
2012
365 / 2.59 = 141 days (rounded)
365 / 2.02 = 181 days (rounded)
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-58
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–7 (continued)
f.
Average period to convert inventory to cash = Average days to sell inventory
+ Average collection period
2011:
2012:
141 days + 57 days = 198 days
181 days + 68 days = 249 days
Req. 2
The changes in trade receivables, inventory and trade payables are reported on the
statement of cash flows as adjustments to net earnings as follows:
Operating activities:
Net earnings
(€20.0 – 7.7)
Adjustments for items that do not affect cash:
Decrease in trade receivables
Increase in inventory
Increase in trade payables
€12.3
8.7
(12.6)
29.6
Req. 3
Assuming that the costs of units purchased have increased during fiscal year 2012, the cost
of sales would be lower if the FIFO inventory costing method is used instead of the
weighted average costing method. This would result in a higher net earnings figure.
Req. 4
The purchased merchandise should not be included in ending inventory because it does not
belong to the company until it arrives at the company’s warehouse. A decrease in ending
inventory will increase the cost of sales, decrease gross profit, pretax earnings, income tax
expense, and net earnings. The decrease in net earnings would be €1,200,000 x [1 – 7.7 /
20.0)] = €738,000. This amount is a relatively small percentage of net earnings,
€738,000/€22,300,000 = 3.3%. As such, its omission may not affect users’ decisions.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-59
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CRITICAL THINKING CASES
CP8–8
Req. 1 and Req. 2
Financial
Calculators
Programmable
Calculators
Number of units in inventory on December 31 per physical count……
19,600
7,600
Number of units purchased from January 1 to April 30………………..
15,600
9,000
Total number of units available for sale…………………………………
35,200
16,600
Number of units in inventory on April 30………………………………..
6,400
3,900
Number of units that were presumably sold…………………………….
28,800
12,700
Cost of sales using weighted average cost:
Financial calculators: 28,800 x $8.40………………………………….
$241,920
$376,644
Programmable calculators: 12,700 x $29.657………………………..
(7,600 x $29.25 + 9,000 x $30.00) / 16,600
Sales revenue based on units taken from the warehouse
Financial calculators: Cost of sales / 0.70 ……………………
345,600
502,192
Programmable calculators: Cost of sales / 0.75……………….
Actual sales revenue………………………………………………………
Difference ………………………………………………………………….
343,200
496,400
2,400
5,792
Average sales price
Financial calculators: Average cost / 0.70…………………………….
12
39.54
Programmable calculators: Average cost* / 0.75…………………….
*Average cost per unit sold = $376,644 / 12,700
Number of missing calculators (= Difference / Average sales price)
200
146
Apparent loss due to the theft of calculators = $2,400 + $5,792 = $8,192
Req. 3
The loss per year would be $8,192 x 3 periods of 4 months each = $24,576.
The cost of installing a new inventory system and quarterly physical inventory counts
would be $4,000 + (4 x $1,000) = $8,000.
The net savings would equal $16,576. The company should definitely proceed with these
additional expenditures. This assumes the system would entirely eliminate the thefts.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-60
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
CP8–9 (amounts in millions of dollars).
Req. 1
To:
The Files
From: The New Staff Member
Re:
Effect of restatement
The overstatement of the value of inventory affects the following accounts: Inventories,
Cost of Sales, Income Tax Expense, and Income Tax Payable. Inventories were written
down by US$17 million. The effects of this writedown on the various accounts would be
recorded as follows (in millions of US dollars):
Cost of sales
……………………………………………………
Inventories ……………………………………………….…
17
Income tax payable (17 x 30%) ……………………….
Income tax expense …………………………………….
5.1
17
5.1
Req. 2
The effect of the writedown on goodwill is a reduction of net earnings and a reduction of
the bonuses payable to both the CEO and CFO. Cash bonuses based on reported net
earnings motivate key management personnel to work hard for their own benefit as well as
the benefit of shareholders. At the same time, offering bonuses to key management
personnel may cause them to engage in activities that result in increasing net earnings
without necessarily increasing cash flows that form the basis for the valuation of
shareholders’ investment.
When Caterpillar announced the alleged fraud in November of 2012, the share price
temporarily dropped to about $82 per share. (Ref.:
http://www.caterpillar.com/investors/stock-information/stock-quote/stock-chart)
Overall, according to Caterpillar’s own press releases and the Management Discussion and
Analysis in the annual filing (10K) for 2012, the external economic slowdown affected the
net earnings more than did the alleged fraud.
When Caterpillar reported the writedown of goodwill, the stock price actually increased by
1.8 percent instead of decreasing, which indicates that investors had already incorporated
the effect of the writedown in pricing the Company’s shares.
References:
http://www.accountingweb.com/article/accounting-fraud-prompts-580-million-write-down-cat/220829
http://www.accountingweb.co.uk/article/new-twist-caterpillar-accounting-scandal/537249
http://www.cnbc.com/id/100408972
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-61
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.
http://www.reuters.com/article/2013/01/28/caterpillar-resultsidUSL1N0AX1FW20130128?type=companyNews&feedType=RSS&feedName=companyNews&rpc=31
http://business.financialpost.com/2013/01/28/caterpillar-profit-hit-by-china-fraud-high-inventory/
http://www.forbes.com/sites/simonmontlake/2013/01/21/alleged-fraud-at-caterpillars-chineseacquisition-puts-spotlight-on-u-s-principals/
http://www.globalpost.com/dispatch/news/business/companies/130128/caterpillar-earnings-china-fraudUS-companies
http://ntdtv.org/en/news/china/2013-01-29/caterpillar-ceo-takes-blame-for-china-fraud.html
http://www.bnn.ca/News/2013/1/28/Caterpillar-profit-drops-on-weak-demand-for-heavy-equipment.aspx
http://www.businessweek.com/articles/2013-03-15/caterpillars-chinese-lessons#p2
http://chainamagazine.com/2013/05/caterpillar-settles-with-principals-of-troubled-chinese-acquisition/
http://www.bloomberg.com/news/2013-01-24/wrong-way-to-admit-you-blew-millions-of-dollars.html
http://www.caterpillar.com/investors/financial-information/sec-filings
FINANCIAL REPORTING AND ANALYSIS TEAM PROJECT
CP8–10
The solution to this case will depend on the company and/or accounting period selected for
analysis.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing
8-62
© 2014 McGraw-Hill Ryerson Limited. All rights reserved.