6-1Sales Transactions Are Accompanied by Recording of the Cost of Goods Sold (Or Cost

CHAPTER 6

6-1Sales transactions are accompanied by recording of the cost of goods sold (or cost of sales).

6-2The two steps are obtaining (1) a physical count and (2) a cost valuation.

6-3Perpetual systems provide continuous inventory and cost of goods sold records. Periodic systems rely on physical inventory taking to record cost-of-goods sold at the end of the period.

6-4It is true that the periodic method requires a physical count to measure cost of goods sold and the perpetual method does not. However, for control purposes, it is important to undertake at least annual physical counts of inventory under the perpetual method, as well.

6-5F.O.B. destination means the shipper pays the freight bill. F.O.B shipping point means the customer bears the cost of the freight bill. F.O.B. stands for "free on board."

6-6Freight out is not shown as a direct offset to sales. Unlike discounts and returns, freight out is not a part of gross revenue that never gets collected. Instead, it is an expense, entailing ordinary cash disbursements.

6-7The four methods are:

1.Specific identification – charges the actual cost of the specific item sold.

2.FIFO – items purchased first are assumed to be sold first.

3.LIFO – items purchased most recently are assumed to be sold first.

4.Weighted average – the average cost of all items available is charged for each item sold.

6-8The perpetual system is normally used with specific identification for low volume, high value items. Therefore, we would expect this to be used for a, b, d, and f.

6-9Yes. Under FIFO the oldest costs are assigned to sales first, so the timing of purchases cannot affect cost flows.

6-10The good news is that LIFO reduces taxes in times of rising prices. The bad news is that reported profit is lower.

6-11Yes. Purchases under LIFO can affect income immediately, because the unit costs of the latest purchases are assigned to units sold.

6-12No. The weighted average must take into account the number of units purchased at each price. For Gamma Company, the weighted average unit cost of inventory is: [(2 x $4.00) + (3 x $5.00)]  5 = $4.60.

6-13Ending inventory is lower under LIFO in a period of rising prices and constant or growing inventory. FIFO produces the higher ending inventory value.

6-14Falling prices reverse the normal relation, so FIFO produces higher cost of goods sold and, therefore, lower net earnings. This helps explain why computer and electronics firms typically use FIFO in order to lower their taxes.

6-15Consistency requires the maintaining of constant accounting methods from period to period. Switching accounting methods hinders comparisons of current results to those of preceding periods.

6-16Companies have adopted LIFO primarily because it saves income taxes during times of rising prices by reporting higher cost-of-goods sold and lower profits.

6-17An inventory profit is fictitious because, for a going concern, it represents an amount necessary for replenishing inventory and is therefore not "available" in the form of cash for distribution as dividends. It arose from change in unit costs of the products purchased, not from the company's value added.

6-18LIFO inventory valuations can be absurd because inventory valuation is based on older and older costs as the years pass.

6-19Conservatism does result in lower immediate profits, but higher profits are then shown in later periods.

6-20This convention is called conservatism.

6-21"Market" generally means cost of replacement at the date of the physical inventory.

6-22The inconsistency is the willingness of accountants to have replacement costs used as a basis for write-downs below historical costs, even though a market exchange has not occurred, but their unwillingness to have replacement costs used as a basis for write-ups above historical costs.

6-23Inventory errors do counterbalance. For example, an ending inventory that is overstated will overstate current income. But the same overstated inventory becomes the beginning inventory the next year; hence, next year's income will be understated. To show this you might use the following schematic:

This exercise stresses the fact that the ending inventory of one year becomes the beginning inventory of the subsequent year and the errors correct themselves.

6-24Cost of goods sold = Beginning inventory + Purchases – Ending inventory.

6-25Past gross profit percentages are sometimes applied to current revenue as interim estimates of gross profit for a month or quarter. Thus, the time and cost of taking physical inventories can be saved.

6-26 Grocery stores have a low profit margin. If the profit margin is 2%, a savings of $100 in shrinkage would be equivalent to a $5,000 increase in sales.

6-27 Your boss has a point. This is a cost benefit question. If we do not give the discount, we may lose customers to competitors of ours that treat them better. But if it is not currently a custom in the industry, you may not have to do it. If offering the discount does not cause customers to buy more, it is giving money away. However, if it is not an industry custom and it attracts new customers, that may lead to a different conclusion. Compare how much your operating income would rise from newly attracted customers versus the discounts received by existing customers.

6-28 There are two key issues. The profit is overstated although we cannot know exactly how much. The promotional advertising revenue should only be recognized as the ads are published. Thus, there is at least two months of such revenue that should currently be treated as liability. In addition, the receivables are quite high. Weekly advertising newspapers have a broad range of advertisers and usually collect in advance from many of them. There would be concern that some of these sales might never be collected and therefore, the revenue may be overstated.

6-29 Under the FIFO method, the cost of sales will be based on old acquisition costs. Under the LIFO method, the cost of sales will be based on the most recent acquisition costs. Thus, under LIFO if additional units are acquired on the last day of the year, the cost of those units will be included in cost of sales. Thus, under LIFO, additional purchases would produce higher cost of goods sold in this instance and lower evaluations for the purchasing officer. Thus, under LIFO he would be less likely to purchase additional oil on the last day of the year.

6-30 When merchandise is delivered, a number of things may remain to be done. An account receivable may need to be collected, discounts may occur because of prompt payment, quantity purchases or rebates due to the condition of the merchandise, additional post delivery services may have to be delivered and the possibility of return exists. If these are potentially material, we will typically provide for them by estimating their future amounts and recording that at the time of sale using an allowance. Sales returns and allowances is an example of such a practice.

6-31(10-15 min.)

PRAG’s JEWELRY WHOLESALERS

Statement of Gross Profit

For the Year Ended December 31, 20X8

(In Thousands)

Gross sales $1,000

Deduct: Sales returns and allowances $40

Cash discounts on sales 5 45

Net sales 955

Cost of goods sold:

Inventory, December 31, 20X7 $103

Add: Gross purchases $650

Deduct: Purchase returns

and allowances $27

Cash discounts on purchases 6 33

Net purchases 617

Add Freight-in 50

Cost of merchandise acquired 667

Cost of goods available for sale 770

Deduct: Inventory, December 31, 19X8 170

Cost of goods sold 600

Gross profit $355

6-32(20 min.)

Sales $71,200

Sales returns 2,300

Net sales $68,900

Cost of goods sold:

Inventory, January 1 (Plug) x = $40,553

Purchases $54,000

Purchase returns 2,000

Net purchases $52,000

Freight in 500 52,500

Cost of goods available for sale $93,053

Inventory, January 15 40,000

Cost of goods sold, .77 x $68,900 53,053

Gross margin, .23 x $68,900 $15,847

or:

Cost of goods sold (.77 x 68,900) $53,053

Cost of goods purchased 52,500

Inventory decrease $ 553

Beginning Balance = Ending Balance + Change =

$40,000 + $553 $40,553

6-33(5 min.) Amounts are in millions of dollars.

Perpetual Periodic

Accounts receivable 20 Accounts receivable 20

Sales revenue 20 Sales revenue 20

Cost of goods sold15No entry

Merchandise

inventory15

6-34(10-15 min.)

Cost of Goods Available = £21,300

(8,000 + 4,200 + 4,400 + 2,300 + 2,400)

LIFO Ending Inventory=(4,000 @ £2) + (1,500 @ £2.10) = £11,150

FIFO Ending Inventory= 1,000 @ 2.40 = £ 2,400

1,000 @ 2.30 = 2,300

2,000 @ 2.20 = 4,400

1,500 @ 2.10 = 3,150

5,500 £12,250

Weighted average=£21,300/10,000= £ 2.13 per unit

Ending inventory5,500 @ £2.13=£11,715

Cost of Goods Sold Calculation:

LIFOFIFOAverage

Goods available £21,300 £21,300 £21,300

Less Ending Inventory (11,150) (12,250) (11,715)

Cost of Goods Sold £10,150 £ 9,050 £ 9,585

6-35(10-15 min.)

This is straightforward. Answers are in Swiss francs.

Aug. 2Purchases 300,000

Accounts payable 300,000

Aug. 3Freight-in 10,000

Cash 10,000

Aug. 7Accounts payable 30,000

Purchase returns

and allowances 30,000

Aug. 11Accounts payable 270,000

Cash discounts on purchases 5,400

Cash 264,600

6-36(10-15 min.)

1.Invoice price $160,000

Add: Freight-in 10,000

Deduct: Purchase allowance (15,000)

Deduct: Cash discount (2,900)*

Total cost of steel acquired $152,100

*2% x ($160,000 – $15,000)

2.Purchases 160,000

Accounts payable 160,000

Freight-in 10,000

Accounts payable (or cash) 10,000

Accounts payable 15,000

Purchase allowances 15,000

Accounts payable 145,000

Cash discounts on purchases 2,900

Cash 142,100

6-37(15 min.) Amounts are in thousands of dollars.

See Exhibit 6-37 on the second page following for the balance sheet equation. Although not required, the balance sheet equation provides a good framework for understanding.

Journal Entries

The journal entries for the perpetual and periodic records follow:

Perpetual System

a.Gross purchase:Inventory 960

Accounts payable 960

b.Returns and allowances:Accounts payable 80

Inventory 80

c.As goods are sold:Cost of goods sold890

Inventory 890

d1. and d2. No entry

6-37(continued)

Periodic System

a.Gross purchase:Purchases 960

Accounts payable 960

b.Returns and allowances:Accounts payable 80

Purchase Returns 80

c.As goods are sold:No entry

d1.Transfer to cost of

goods sold:Cost of goods sold 1,090

Purchase returns

and allowances 80

Purchases 960

Inventory 210

d2.Recognize ending inventory: Inventory 200

Cost of goods sold 200

1

Chapter 6Inventories and Cost of Goods Sold

EXHIBIT 6-37

Entries are in thousands of dollars.

A = L + SE

AccountsStockholder's

PERPETUAL SYSTEMInventoryPayable Equity

Balance, 12/31/X7 +210 =+ 210

a.Gross purchases +960 = + 960

b.Returns and allowances – 80 = – 80

c.As goods are sold –890 –890

Closing the accounts at end of period:

d1.No entry

d2.No entry

______

Ending balances, 12/31/X8 +200 = +1,090 –890

1

Chapter 6Inventories and Cost of Goods Sold

EXHIBIT 6-37(continued)

A =L + SE

Purchase

Returns andAccountsStockholder's

PERIODIC SYSTEMInventoryPurchasesAllowancesPayableEquity

Balance, 12/31/X7 +210 =+ 210

a.Gross purchases +960 = + 960

b.Returns and allowances –80= – 80

c.As goods are sold (no entry)

Closing the accounts at

end of period:

d1.Transfer to cost of goods sold –210 –960 +80 = –1,090

d2.Recognize ending inventory +200 = + 200

______

Ending balances, 12/31/X8 +200 0 0= +1,090 – 890

1

Chapter 6Inventories and Cost of Goods Sold

6-38(10 min.)

This is straightforward.

1.Purchases 900,000

Accounts payable 900,000

2.Accounts payable 50,000

Purchase returns and allowances 50,000

3.Freight-in 72,000

Cash 72,000

4.Accounts payable 850,000

Cash 832,000

Cash discounts on purchases 18,000

6-39(10 min.)

The entries could be compounded.

Accounts receivable 1,250,000

Sales 1,250,000

Cost of goods sold 81,000

Inventory 81,000

Cost of goods sold 904,000

Purchase returns and allowances 50,000

Cash discounts on purchases 18,000

Purchases 900,000

Freight-in 72,000

Inventory 130,000

Cost of goods sold 130,000

6-40(10-15 min.)

Compound entries could be prepared. (Amounts are in millions.)

a.Sales returns and allowances 5

Cash discounts on sales 8

Accounts receivable 226

Sales 239

b.Cost of goods sold 157

Purchase returns and allowances 6

Cash discounts on purchases 1

Inventory 25

Purchases 125

Freight-in 14

c.Inventory 40

Cost of goods sold 40

d.Other expenses 80

Cash 80

6-41(5 min.) Amounts are in millions of dollars.

Beginning inventory $ 20

Purchases 1,282

Goods available 1,302

Ending inventory (5)

Cost of goods sold $1,297

6-42(15-20 min.)

This problem develops familiarity with the gross profit section. The answer, $25,600, is computed by filling in the gross profit section and solving for the unknown, or: $96,000 – 55%($128,000) = $25,600.

Gross sales $140,000

Deduct: Sales returns

and allowances 12,000

Net sales $128,000

Cost of goods sold:

Inventory, December 31, 20X7 $19,000

Gross purchases $80,000

Deduct: Purchase returns

and allowances $4,000

Cash discounts

on purchases 1,000 (5,000)

Net purchases 75,000

Inward transportation 2,000

Cost of goods acquired 77,000

Cost of goods available

for sale 96,000

Inventory, May 3, 20X8* x = 25,600

Cost of goods sold,

55% of $128,000 70,400

Gross profit, 45% of $128,000 $ 57,600

* Calculated as the difference between cost of goods available for sale, $96,000, and cost of goods sold $70,400.

6-43(15 min.)

Sales $200,000

Cost of goods sold:

Inventory, January 1 $65,000

Purchases $195,000

Purchase returns and allowance 10,000

Net purchases $185,000

Freight-in 20,000 205,000

Cost of goods available for sale $270,000

Inventory, March 9 (Plug) x = 110,000

Cost of goods sold,

80% of $200,000 160,000

Gross margin, 20% of $200,000 $ 40,000

The answer, $110,000, is obtained by filling in the schedule of cost of goods sold and solving for the unknown, or: $270,000 – 80%($200,000) = $270,000 – $160,000 = $110,000.

6-44(10-15 min.)

Beginning inventory $ 60,000

Purchases 200,000

Cost of goods available for sale $260,000

Less estimated cost of goods sold:

75%* of $280,000 210,000

Estimated ending inventory $ 50,000

*100% – 25% = 75%

6-45(10-15 min.)

To calculate the effect use the following approach:

Cost-of-goods sold is too high by $10,000 in 20X8 so taxable income will be too low by $10,000. Taxes will be too low by $4,000 so net income and retained earnings will be too low by $6,000. Taxable income for 20X9 will be overstated by $10,000 and taxes will be $4,000 too high. Net income in 20X9 will be too high by $6,000 and retained earnings will be correct again at December 31, 20X9.

6-46(10-15 min.)

1.Turnover=cost of goods sold* ÷ average inventory

=$720,000 ÷ $720,000

=1.00

*Cost of goods sold = $1,600,000 – $880,000 = $720,000

2.The gross profit would fall from $880,000 to $840,000, so a change in pricing strategy would be undesirable for Genuine Gems. The current 20X3 data follow:

Turnover 1.0

Gross profit percentage:

$880,000 ÷ $1,600,000 55%

This percentage is not unusual.

If prices are cut 20 percent without affecting turnover, new sales would be .8 x $1,600,000 = $1,280,000. Cost of goods sold on those sales would still be $720,000. Therefore Mr. Siegl would be reducing his gross profit percentage to 44% ($1,280,000  $720,000). However, an increase in turnover to 1.5 would produce the following:

Sales, $1,280,000 x 1.5 $1,920,000

Cost of goods sold, $720,000 x 1.5 1,080,000

Gross profit $ 840,000

6-47(15-20 min.)

1.LIFO Method:

Inventory shows: 1,200 tons on hand at July 31.

Costs:1,000 tons @ $ 9.00 $ 9,000

100 tons @ $10.00 1,000

July 31 inventory cost. $10,000

FIFO Method:

Inventory shows:1,200 tons on hand at July 31.

Costs:900tons @ $12.00 $10,800

200tons @ $11.00 2,200

July 31 inventory cost. $13,000

2.Purchases:

5,000 tons @ $10$50,000

1,000 tons @ $1111,000

900 tons @ $12 10,800

Total purchases$71,800

Beginning inventory:

1,000 tons @ $ 9 9,000

LIFO FIFO

Cost available for sale $80,800 $ 80,800 $ 80,800

Less ending inventory (10,000) (13,000)

Cost of goods sold $ 70,800 $ 67,800

Sales $98,000 $98,000

Cost of goods sold 70,800 67,800

Gross profit $27,200 $30,200

6-48(5-10 min.)

The inventory would be written down from $200,000 to $180,000 on December 31, 20X1. The new $180,000 valuation is "what's left" of the original $200,000 cost. In other words, the $180,000 is the unexpired cost and may be thought of as the new cost of the inventory for future accounting purposes. Thus, because subsequent replacement values exceed the $180,000 cost, and write-ups above "cost" are not acceptable accounting practice, the valuation remains at $180,000 until it is written down to $175,000 on the following December 31, 20X2.

6-49(10-15 min.) Amounts are in thousand of dollars.

The cost of inventory acquired during the year ending January 1, 2000, was calculated as follows.

Beginning Inventory $ 71,292

Purchases X = 299,070

Goods availableY= 370,362

Ending inventory (76,414)

Cost of goods sold $293,948

Y= 293,948 + 76,414 = 370,362

X= 370,362 – 71,292 = 299,070

6-50(10 min.)

2000:($11,862  $8,321)  $11,862 = 29.9%

1999:($11,170  $8,191)  $11,170 = 26.7%

1998:($11,038  $7,710)  $11,038 = 30.2%

The gross profit percentage improved in 2000 compared with 1999, but it was still below the level of 1998.

Though not in the problem, it might be interesting to note the slight downward pressure over time. Values were 30.6, 30.1, and 31.3 in 1997, 1996, and 1995.

6-51(10-15 min.)

1.ZEKE’S BUILDING SUPPLY

Statement of Gross Profit

For the Year Ended December 31, 20X1

Sales $800,000

Cost of goods sold:

Inventory, beginning $ 160,000

Add net purchases 690,000

Cost of goods available for sale $ 850,000

Deduct ending inventory (220,000)

Cost of goods sold 630,000

Gross profit $170,000

2.Inventory turnover=Cost of goods sold ÷ Average inventory

=$630,000 ÷ [1/2 * (160,000 + 220,000)]

= 630,000 ÷ 190,000

= 3.3 times

6-52(30-40 min.)

This problem is very similar to the Summary Problem for Your Review for this chapter. The detailed income statement is in the accompanying exhibit. Note the classification of operating expenses into a selling category and a general and administrative category. The list of accounts in the problem contained one item that belongs in a balance sheet rather than an income statement, the Allowance for Bad Debts (an offset to Accounts Receivable).

The delivery expenses and the bad debts expense are shown under selling expenses. Some accountants prefer to show the bad debts expense as an offset to gross sales or as administrative expenses.

6-52(continued)

MARCHESI KITCHEN SUPPLY COMPANY

Income Statement

For the Year Ended December 31, 20X5

(In Thousands)

Revenues:

Gross sales $1,085

Deduct: Sales returns and allowances $ 50

Cash discounts on sales 10 60

Net sales $1,025

Cost of goods sold:

Inventory, December 31, 20X4 $200

Add purchases $600

Less: Purchase returns

and allowances $40

Cash discounts on purchases 15 55

Net purchases $545

Add Freight in 50

Cost of merchandise acquired 595

Cost of goods available for sale $795

Deduct: Inventory, December 31, 20X5 300

Cost of goods sold 495

Gross profit from sales $ 530

Operating expenses:

Selling expenses:

Sales salaries and commissions $160

Rent expense, selling space 90

Advertising expense 45

Depreciation expense, trucks

and store fixtures 29

Bad debts expense 8

Delivery expenses 20

Total selling expenses $352

General and administrative expenses:

Office salaries 46

Rent expense, office space 10

Depreciation expense, office equipment 3

Office supplies used 6

Miscellaneous expenses 13

Total general and administrative expenses 78

Total operating expenses 430

Income before income tax $ 100

Income tax expense 40

Net income $ 60

6-53(15-25 min.)

Under the FIFO cost-flow assumption, the periodic and perpetual procedures give identical results. The ending inventory will be valued on the basis of the last purchases during the period.

*145units remain in ending inventory

100will be valued at the $8 cost from the October 21 purchase and the remaining 45 will be valued at the $7 cost from the May 9 purchase

100 x $8= $ 800

45 x $7= 315

$1,115 Ending inventory

**Reconciliation: Cost of Goods Sold:

255 Units:110 x $5= $ 550

80 x $6= 480

65 x $7= 455

$1,485

6-54(30-35 min.)

1.Gross profit percentage=$1,200,000 ÷ $3,000,000 = 40%

Inventory turnover=$1,800,000 ÷

=3 times

2.Inventory turnover = $1,800,000 ÷ $450,000 = 4 times, a 1/3 increase in turnover.

3.With a lower average inventory and constant turnover, cost of sales must fall. Total cost of goods sold = $450,000 x 3 = $1,350,000. To achieve a gross profit of $1,200,000, total sales must be $1,350,000 + $1,200,000, or $2,550,000. The gross profit percentage must be $1,200,000 ÷ $2,550,000 = 47.1%. Requirements 2 & 3 show that if inventory levels are reduced you must increase either turnover or margins to maintain profitability.