Chapter 7 - Libby, Libby & Short - Financial Accounting

Which of the following costs would not affect cost of goods sold (would not be an inventory cost)? Inventory inspection costs. Inventory preparation costs. Inventory-related selling costs. Freight charges incurred to bring inventory to the warehouse (terms FOB shipping point).

Any costs to delivery inventory to our company, costs of inspecting inventory and costs of preparing inventory for sale would be added to the cost to buy the inventory; however, any costs of "selling" inventory is not included in inventory. Selling costs are not part of cost of goods sold but rather are listed as part of selling, general and administrative expenses.

Tinker's 2015 cost of goods sold was $750,000 and 2014 cost of goods sold was $770,000. The inventory at the end of 2015 was $188,000 and $208,000 at the end of 2014. Compute Tinker's average days to sell its inventory during 2015.

Before the average days to sell inventory can be calculated, the inventory turnover ratio must be calculated. The formula for inventory turnover takes cost of goods sold and divides it by "average" inventory. For 2015, the numerator would be $750,000 cost of goods sold (we do not use the prior year's cost of goods sold) and the denominator would be the average of ending inventory for both 2015 and 2014 which is $198,000 ($188,000 plus $208,000 then divided by 2). The inventory turnover ratio is 3.79 (750,000/198,000). The turnover ratio is then divided into 365 days in a year to compute 96.3 days to sell inventory. Note: Whenever a ratio uses a balance sheet number (merchandise inventory) and compares it to an income statement number (cost of goods sold) or a statement of cash flow number, the balance sheet item must be "averaged". The income statement and statement of cash flows reflects numbers for a period of time typically a year whereas the balance sheet represents an amount at a moment in time. By averaging the balance sheet item, it simulates the amount over the period of time.

Laurer Corporation uses the periodic inventory system and has provided the following information about one of its laptop computers: Date Transaction Units Cost/unit 1/1 Beg. inventory 100 $ 800 5/5 Purchase 200 900 8/10 Purchase 300 1,000 10/15 Purchase 200 1,100 During the year, Lauer sold 750 laptop computers. What was cost of goods sold using the FIFO cost flow assumption?

First we have to calculate the total cost of beginning inventory and each of the three purchases. Beginning inventory is $80,000 ($800 X 100), the first purchase is $180,000 ($900 X 200), the second purchase is $300,000 ($1,000 X 300), and the third purchase is $220,000 ($1,100 X 200). We then add the four costs to compute goods available for sale of $780,000. The total units available for sale is 800 units (100 + 200 + 300 + 200). Since 750 units were sold only 50 units remain in ending inventory. Under FIFO cost flow the ending inventory would be the most recent unit costs which is the third batch purchased at a unit cost of $1,100 X 50 would equal ending inventory of $55,000. We can then subtract the ending inventory from goods available for sale to derive cost of goods sold of $725,000 ($780,000 - $55,000).

Which of the following statements is correct when inventory unit costs are "increasing"? LIFO will result in lower net income and a higher inventory valuation than will FIFO. LIFO will result in higher net income and lower inventory valuation than will FIFO. FIFO will result in lower net income and a lower inventory valuation than will LIFO. FIFO will result in higher net income and a higher inventory valuation than will LIFO.

First, it is important to understand that the companies' replacement costs are rising (inflation) so the more recent costs are the higher unit costs and the older costs are lower. In statement one, LIFO will result in lower net income but will report "lower" not higher inventory valuation so that statement is incorrect. In statement two, LIFO will not result in "higher" net income but will have lower inventory valuation so that statement is incorrect. In statement three, FIFO will not result in "lower" net income or "lower" inventory valuation so that statement is incorrect. In statement four, FIFO will result in higher net income and higher inventory valuation than LIFO so that statement is correct.

Which of the following statements is false? Companies do not have to use the same inventory method for all items of inventory. Companies do not have to consistently use the same inventory costing methods. Use of the LIFO inventory method during a period of increasing unit costs may create a conflict of interest between the owners and managers. A company choosing to maximize stockholders' equity during the period of increasing unit costs should use the FIFO inventory method.

For statement one, it is true that companies can use different inventory cost flow assumptions for different types of inventory; they do not have to use just one cost flow assumption for all inventory. Statement two is false because once an inventory cost flow assumption is adopted for inventory costing, that method must be used "consistently" from one year to the next. In statement three, use of LIFO inventory method may create conflict between owners and managers. Owners want to report the highest earnings which tends to increase the stocks' value while managers want to pay the least amount of taxes thereby preserving cash. LIFO costing during inflation will report the lowest amount of net income but will lead to paying the lowest amount of taxes. This occurs because LIFO assigns the older, lower costs to ending inventory and the more recent, higher costs to cost of goods sold. In statement four, use of FIFO during a period of inflation will lead to reporting higher net income because the older, lower unit costs are assigned to cost of goods sold which will maximize stockholders' equity since net income is closed to retained earnings. Statement four is true.

Wilmington Company reported pretax income of $25,000 during 2014 and $30,000 during 2015. Later it was discovered that the ending inventory for 2014 was understated by $2,000 (and was not corrected in 2014). What is the correct pretax income for each year?

In 2014, reported income was $25,000 but because ending inventory was "understated", cost of goods sold was overstated making net income understated so the correct net income for 2014 should be $27,000. In 2015, reported income was $30,000 which means it is overstated by $2,000 so net income is $28,000. This is because the understated ending inventory would become beginning inventory which would cause cost of goods sold to be understated and net income was overstated.

Coleman Company has provided the following information: beginning inventory, $100,000; cost of goods sold, $450,000; and ending inventory, $80,000. How much were Coleman's inventory purchases?

In this problem, you have to work backwards but the formula to calculate COGS is: Beginning inventory + Purchases = Goods available for sale - Ending inventory = Cost of goods sold. Since we know cost of goods sold is $450,000 and ending inventory is $80,000, we will add these two amounts (reverse the mathematical function) to back into goods available for sale which is $530,000. We then deduct beginning inventory $100,000 from goods available for sale $530,000 to get $430,000 of purchases. To prove the answer plug in numbers to the regular formula: BI 100,000 + Purchases 430,000 = Goods available for sale 530,000 - EI 80,000 = Cost of goods sold 450,000.

Which of the following statements is correct when inventory unit costs are decreasing? LIFO will result in lower net income and a higher inventory valuation than will FIFO. LIFO will result in higher net income and a higher inventory valuation than will FIFO. FIFO will result in higher net income and a higher inventory valuation than will LIFO. FIFO will result in higher net income and a lower inventory valuation than will LIFO.

It is important to understand that the company is experiencing decreasing replacement costs (deflation); this means that the more recent unit costs are the lower costs while the older unit costs are the higher costs. In statement one, LIFO will not result in "lower" net income but will have a higher inventory value so statement one is incorrect. In statement two, LIFO will result in higher net income and a higher inventory valuation than will FIFO so statement two is correct. In statement three, FIFO will not result in "higher" net income and "higher" inventory valuation so statement three is incorrect. In statement four, FIFO will not result in "higher" net income but will have a lower inventory valuation than LIFO so statement four is incorrect.

Which of the following statements is incorrect for a manufacturing entity? Inventory is transferred from work in process to finished goods. Raw materials are transferred into work in process. Finished goods inventory eventually becomes cost of goods sold. Cost of goods sold is recognized when the manufacturing process is completed.

Manufacturing companies have three inventory accounts: Raw material, work in process and finished goods. Raw material records the cost of purchased components/parts and then when parts are send to the manufacturing departments, it is transferred to work in process so the second statement is correct. When the products are completed and leave the factory, costs are transferred from work in process into finished goods so statement one is correct. When the completed goods are sold, finished goods inventory becomes cost of goods sold so statement three is correct. However, statement four is incorrect because cost of goods sold is not recognized until the product is sold.

What is the effect on net income in 2015 if the following occurred; beginning inventory is overstated by $1,300 while ending inventory is understated by $700?

Since beginning inventory is overstated by $1,300, it will be added to purchases which will make goods available for sale be overstated by $1,300. Since ending inventory would be deducted from goods available for sale, a $700 understatement would be added to the $1,300 overstatement of beginning inventory making cost of goods sold overstated by $2,000; this in turn will make net income "understated" by $2,000.

A company using the periodic inventory system correctly recorded a purchase of merchandise, but the merchandise was not included in the physical inventory count at the end of the accounting period. What effect will the error cause on net income and ending inventory?

Since, the items were not included in the physical count in a "periodic" system, the ending inventory will be understated causing cost of goods sold to be overstated. When cost of goods sold is overstated, net income will be understated. Therefore, both ending inventory and net income are understated.

Moore Company purchased an item for inventory that cost $20 per unit and was priced to sell at $30. It was determined that the replacement cost is $18 per unit. Using the lower of cost or market rule, what amount should be reported on the balance sheet for for each unit in inventory.

The actual cost paid for the units in inventory is $20 per unit; under lower of cost or market rule (LCM) we would compare that $20 cost to its replacement cost (entrance value) and its selling price (exit value). Since the exit value of $30 what it can be sold for is greater than the actual cost of $20, that value would not be used. However, the replacement cost of $18 is below the actual $20 cost so the units would be assigned a cost of $18 per unit in order to apply conservatism and not overstate the value of our asset.

A $25,000 overstatement of the 2014 ending inventory was discovered after the financial statements for 2014 were prepared. Which of the following describes the effect of the inventory error on the 2015 financial statements? Net income and stockholders' equity are both understated. Net income is understated and stockholders' equity is correct. Net income and stockholders' equity are both overstated. Net income and stockholders' equity are both unaffected.

The effect of the $25,000 overstatement of ending inventory in 2014 would cause cost of goods sold to be "understated" and therefore would cause gross profit and net income to be "overstated". Since income is closed to retained earnings, it would cause an overstatement of retained earnings in 2014. The overstated ending inventory will roll over and become "beginning" inventory for 2015 and since we add purchases to beginning inventory to compute goods available for sale, goods available for sale will be overstated. If ending inventory in 2015 is correct when it is deducted from goods available for sale, cost of goods sold in 2015 will be "overstated" which will cause net income to be understated. When the understated net income is closed to retained earnings is will offset the overstated amount in retained earnings from the end of 2014. Statement one is incorrect because stockholders' equity will not be understated in 2014; it will be correct. Statement two is correct because while net income is understated, stockholders' equity is correct. Statement three is incorrect because neither net income nor stockholders' equity will be overstated. Statement four is incorrect because net income is understated.

Which of the following statements does not accurately describe the lower of cost or market (LCM) valuation method? The journal entry to write-down inventory decreases gross profit. The journal entry to write-down inventory decreases current assets. The journal entry to write-down inventory does not affect pretax income. The journal entry to write-down inventory increases cost of goods sold.

The journal entry to write-down inventory under LCM includes a debit to cost of goods sold (+E, -SE) and a credit to merchandise inventory (-A). Statement one is true since the debit increases cost of goods sold and since sales minus cost of goods sold equals gross profit, the write-down would decrease gross profit. Statement two is true since the credit to merchandise inventory reduces that "current" asset. Statement three is false because the write-down of inventory reduces gross profit which means all the subsequent profit measures all the way through net income would decrease; therefore, it would affect pretax income. Statement four is true since we debit cost of goods sold causing that expense to increase.

During the audit of Montane Company's 2015 financial statements, the auditors discovered that 2015 ending inventory had been overstated by $8,000 and the 2015 beginning inventory was overstated by $5,000. Before the effect of these errors, 2015 pretax income had been computed as $100,000. What should be reported as the correct 2015 pretax income?

The overstatement of beginning inventory would overstate cost of goods sold but the overstatement of ending inventory would understate cost of goods sold. So we would take the $8,000 error minus the $5,000 error to get "overstated" cost of goods sold equal to $3,000. The pretax income would be reported at $97,000 ($100,000 minus $3,000).

Laurer Corporation uses the periodic inventory system and has provided the following information about one of its laptop computers: Date Transaction Units Cost/unit 1/1 Beg. inventory 100 $ 800 5/5 Purchase 200 900 8/10 Purchase 300 1,000 10/15 Purchase 200 1,100 During the year, Lauer sold 750 laptop computers. How much is cost of goods sold under weighted average cost flow assumption.

We would do the exact first steps of computing the total cost of the beginning inventory and the three purchases to derive $780,000 of goods available for sale and 800 units available for sale. Since 750 units were sold, units in ending inventory is 50 units. The weighted average unit cost is computed by taking $780,000 goods available for sale divided by the 800 units available for sale to get $975 cost per unit. We can then multiply the units sold 750 times the $975 per unit to get cost of goods sold of $731,250. The same unit cost of $975 would be multiplied times the 50 units in ending inventory to get the dollar amount in inventory which is $48,750.

Laurer Corporation uses the periodic inventory system and has provided the following information about one of its laptop computers: Date Transaction Units Cost/unit 1/1 Beg. inventory 100 $ 800 5/5 Purchase 200 900 8/10 Purchase 300 1,000 10/15 Purchase 200 1,100 During the year, Lauer sold 750 laptop computers. What was ending inventory using the LIFO cost flow assumption?

We would do the exact first steps of computing the total cost of the beginning inventory and the three purchases to derive $780,000 of goods available for sale and 800 units available for sale. Since 750 units were sold, units in ending inventory is 50 units. Under LIFO cost flow, the ending inventory units would reflect the oldest unit costs which are those from beginning inventory. Ending inventory will equal $40,000 (50 X $800).

QV-TV, Inc. provided the following items in its notes to the financial statements for the year-end 2015: Cost of goods sold was $22 billion under FIFO costing and the inventory value under FIFO costing was $2.1 billion. The LIFO Reserve for year-end, 2014 was $0.6 billion and at year-end 2015 it had increased to $0.8 billion. How much is the 2015 LIFO cost of goods sold?

When the LIFO Reserve figure increases by $0.2 billion from 2014 to 2015 ($0.8 minus $0.6), it means the LIFO cost of goods sold has to be greater than the FIFO cost of goods sold by the "increase" in the reserve. So FIFO cost of goods sold which is $22 billion would have the $0.2 billion added to it to compute LIFO cost of goods sold of $22.2 billion.