Chapter 06 - Cost of Sales and Inventories

CHAPTER 6
COST OF SALES AND INVENTORIES
Changes from Twelfth Edition
Editorial and updated changes have been made. The VAL accounting for mileage program topic is now
covered in the Kim Park case (Case 8-5). VAL Corporation has been dropped.
Approach
This chapter can be assigned in two parts, if the instructor wishes to spend several sessions on these
topics. The second assignment can begin with the section titled Inventory Costing Methods.
By now, students will have had to deduce cost of goods sold if they have tackled the cases in previous
chapters. Nevertheless, for some students this deduction process is a difficult one to grasp, and it is
important that it be understood. Also, the mechanics of flows through a manufacturing company are
difficult to grasp. Students will encounter this topic again in Chapter 17, however, so it doesnt matter too
much if they dont get it here. This is another one of the topics that seems to be mastered only after drill
with a number of problems.
The choice between LIFO and FIFO also causes problems, perhaps because LIFO obviously does not
match the physical flow of goods. It should perhaps be emphasized that, regardless of the conceptual
merit of one method or the other in an inflationary economy, LIFO defers payment of incomes taxes, and
it defers them forever in an inflationary economy. The discussion also provides a way of highlighting the
fact that accounting focuses on the measurement of income, even though the result is an unrealistic
balance sheet (as is the case with LIFO inventories).
Cases
Browning Manufacturing Company requires recording a complete cycle of transactions in a
manufacturing company. It is straightforward.
Lewis Corporation is a problem that contrasts FIFO and LIFO in a clear-cut way.
Morgan Manufacturing deals with the adjustment, comparison, and interpretation of financial statements
for two firms, one prepared using LIFO and the other using FIFO.
Joan Holtz (B) is the second set of discrete problems, from which the instructor can select those he or she
wants to discuss in class.

Problems
Problem 6-1
The completed table is shown below. Each deduction involves the basic inventory equation.
Ending inventory = Beginning Inventory + Purchase Shipments (COGS)
as well as the basic relationships inherent in any income statement, that is:,
Income = Revenues Expenses

6-1

Chapter 06 - Cost of Sales and Inventories

Co. W
Co. X
Co. Y
Co. Z
Sales.......................................................................................................................................................................................
$2,250
$1,800
$1,350
$2,100
Cost of goods sold:................................................................................................................................................................
Beginning inventory..........................................................................................................................................................
300
225
500
300
Plus: Purchases..................................................................................................................................................................
975
975
850
1,200
Less: Ending inventory......................................................................................................................................................
225
300
300
150
Cost of good sold..........................................................................................................................................................
1,050
900
1,050
1,350
Gross margin..........................................................................................................................................................................
1,200
900
300
750
Period expenses......................................................................................................................................................................
300
400
150
800
Net income (Loss)..................................................................................................................................................................
$ 900
$ 500
$ 150
$ (50)
Problem 6-2
The required income statement is reproduced below.
The closing entries are:

6-2

Chapter 06 - Cost of Sales and Inventories

a.

Beginning inventory balance is $50,000

b.

dr. Inventory............................................................................................................................................
167,000
cr. Purchases........................................................................................................................................
167,000

c.

dr. Inventory............................................................................................................................................
4,000
cr. Freight-in........................................................................................................................................
4,000

d.

dr. Returns (to Suppliers).........................................................................................................................

8,000
cr. Inventory........................................................................................................................................
8,000

e.

dr. Cost of Goods Sold.............................................................................................................................

135,500
cr. Inventory..........................................................................................................................................
135,500

f.

dr. Income Summary................................................................................................................................

135,500
cr. Cost of Goods Sold........................................................................................................................
135,500

g.

dr. Income Summary................................................................................................................................

95,000
cr. Other Expenses...............................................................................................................................
95,000

h.

dr. Tax expense........................................................................................................................................

28,350
cr. Taxes Payable.................................................................................................................................
28,350

i.

dr. Sales...................................................................................................................................................
325,000
cr. Income Summary...........................................................................................................................
325,000

j.

dr. Income Summary................................................................................................................................

28,350
cr. Tax Expense...................................................................................................................................
28,350

GARDNER PHARMACY
Income Statement for the Year ----.
Sales...................................................................................................................................................................
$325,000
Cost of goods sold:............................................................................................................................................
Beginning inventory....................................................................................................................................
$ 50,000
Plus: Purchase, gross............................................................................................................................
$167,000
Freight-in....................................................................................................................................
4,000
171,000
Less: Purchase returns..........................................................................................................................
8,000
Net purchases...............................................................................................................................................
163,000
Goods available for sale...............................................................................................................................
213,000
Less: Ending inventory........................................................................................................................
77,500
Cost of goods sold..............................................................................................................................
135,500
Gross margin......................................................................................................................................................
189,500
Other expenses...................................................................................................................................................
95,000
Income before taxes...........................................................................................................................................
94,500
Income tax expense............................................................................................................................................
28,350
Net income.........................................................................................................................................................
66,150
Problem 6-3

6-3

Chapter 06 - Cost of Sales and Inventories

a.

dr. Inventory....................................................................................................................................................
85,500
cr. Cash (or Payables)..................................................................................................................................
85,500

dr. Cash (or Receivables).................................................................................................................................

133,400
cr. Sales.......................................................................................................................................................
133,400

dr. Sales Returns..............................................................................................................................................

1,840
Inventory.....................................................................................................................................................
1,200
cr. Cash (or Receivables).............................................................................................................................
1,840
Cost of Goods Sold.................................................................................................................................
1,200
b.

GOULDS COMPANY
Income Statement
Gross sales.......................................................................................................................................................
$133,400
Less: Sales returns.....................................................................................................................................
1,840
Net sales..............................................................................................................................................
$131,560
Cost of goods sold.....................................................................................................................................
85,800
Gross margin.............................................................................................................................................
$ 45,760

c. The perpetual inventory records indicate ending inventory should have been 673 + 5,700 5,800
+ 80 = 653 units. Inventory shrinkage has therefore been 653 610 = 43 units.

dr. Inventory Shrinkage.........................................................................................................................................................

645
cr. Inventory.....................................................................................................................................................................
645
The inventory shrinkage entry reduces gross margin by $645 (or shrinkage could be shown below the
gross margin line as a general expense).
Problem 6-4
Purchases:

50 units @
$14 = $ 700
75 units @
$12 =
900
Avg:
125 units @ $12.80 = $1,600
Sales: 100 units
Ending inventory: 25 units
Avg. Cost
Fifo
Lifo
July 31 inventory.............................................................................................................................................................................
$ 320
$ 300
$ 350
Cost of goods sold...........................................................................................................................................................................
1,280
1,300
1,250
Available for sale............................................................................................................................................................................
1,600
1,600
1,600
Problem 6-5

6-4

Chapter 06 - Cost of Sales and Inventories

a.

Fifo
Av. Cost
Lifo
Sales.........................................................................................................................................................................
$52,125
$52,125
$52,125
Cost of goods sold....................................................................................................................................................
27,310
27,053
26,960
Gross margin............................................................................................................................................................
$24,815
$25,072
$25,165

Fifo
Av. Cost
Lifo
b.
Gross margin percentage..........................................................................................................................................
47.6%
48.1%
48.3%
c. Net cash flow = $21,465 ($52,125 - $30,660)
No change in pretax cash flow figure using different inventory methods.
d.

Fifo
Av. Cost
Lifo
Pretax cash flow.......................................................................................................................................................
$21,465
$21,465
$21,465
Tax payment.............................................................................................................................................................
7,445
7,522
7,550
After-tax cash flow...................................................................................................................................................
$14,020
$13,943
$13,915

The tax payment in 30 percent of the gross margin dollars. The cash flow using Fifo for tax purposes is
the lowest of the three after tax cash flow amounts because the unit cost of computers is falling,
producing the highest taxable gross margin of the three methods.
Problem 6-6
a. Ending inventory balances are:

Materials
Work in
Finished
Inventory
Process
Goods
Beginning balance............................................................................................................................................
$ 100,000
$ 370,000
$ 60,000
(1) Purchases..........................................................................................................................................................
872,000
Delivery charge................................................................................................................................................
22,000
(2) Direct labor......................................................................................................................................................
565,000
(3) Materials transfer.............................................................................................................................................
(900,000)
900,000
(4) Indirect labor....................................................................................................................................................
27,000
Factory supplies...............................................................................................................................................
46,000
Depreciationfactory........................................................................................................................................
54,000
Factory utilities................................................................................................................................................
147,000
DepreciationMfg............................................................................................................................................
46,000
Property taxes...................................................................................................................................................
14,000
(5) Finished goodstransfers..................................................................................................................................
________
(2,035,000)
2,035,000
$ 94,000
134,000
2,095,000
Cost of goods sold............................................................................................................................................
--(2,002,000)
Ending balance.................................................................................................................................................
$ 94,000
$ 134,000
$ 93,000
b. Gross margin was 23 percent.
Sales.................................................................................................................................................................
$2,600,000
Cost of goods sold............................................................................................................................................
2,002,000
Gross margin....................................................................................................................................................
$ 598,000

6-5

Chapter 06 - Cost of Sales and Inventories

Problem 6-7
Item
A
B
C
D

Units
30
40
20
40

Valuation
Basis/Unit
$145
173
131
113

Historical
Cost/Unit
$150
183
134
113
Total adjustment

Total
Adjustment
$150
400
60
0
$610

Cases
Case 6-1: Browning Manufacturing Company
Note: This case is updated from the Twelfth Edition. Please see the printed Instructors Resource Manual
for the Harvard Teaching Notes.
Case 6-2: Lewis Corporation*
Note: Updated from Twelfth Edition.
Approach
We have found it useful for students to perform some comparative FIFO/LIFO average cost calculations,
rather than only read about the differences among these methods. This case presents that opportunity,
with an emphasis on the income taxhence, cash flowimplications of the choice of a method. Via
Question 3, the student can see the impact of a sales decline causing a stripping off of LIFO layers with
the result that LIFO reports a lower cost of goods sold, and thus would result in higher income taxes that
year, than would FIFO.
Question 4 introduces the significance of the LIFO reserve. Students can discover that the LIFO reserve is
useful in analyzing financial statements. It can be used to estimate the cumulative tax savings realized by
adopting LIFO; and when trying to compare the financial performance of a company using LIFO to
another using FIFO, the LIFO reserve can be used to adjust the LIFO financial statements to a FIFO
basis. This adjustment will be explored in more detail in Case 6-3
Finally, Question 5 presents the opportunity to challenge the widely held notion that almost all companies
use LIFO (the instructor can update the text footnote on LIFO usage by referring to the latest edition of
Accounting Trends & Techniques and to discuss the reasons for many companies use of FIFO. For those
who wish to do so, this discussion can bring in the Efficient Markets Hypothesis. In our view, one reason
some companies continue to use FIFO in circumstances when LIFO would improve cash flows is that
their managements do not believe that EMH premise that the lower reported earnings from LIFO would
not diminish shareholder value.

This Teaching note was prepared by Robert N. Anthony. Copyright Robert N. Anthony.

6-6

Chapter 06 - Cost of Sales and Inventories

Calculations for Questions

Question 1
The approach below reflects how most students perform these calculations. At some point I show them
(to their chagrin) that a lot of effort can be saved if the amount of each years purchases is calculated first,
and then the equation Beg. Invent + Purchases = COGS + End Invent. is applied year-by-year. With the
more detailed approach students take, class time allows showing only a couple of years for FIFO and
LIFO, and one year for average cost.
FIFO:

LIFO:

AVERAGE COST:

COGS

2009
1,840
600
380
2,820

@
@
@
@

$20.00
20.25
21.00

=
=
=

$36,800.00
12,150.00
7,980.00
$56,930.00

Inventory

420
400
200
1,020

@
@
@

21.00
21.25
21.50

=
=
=

8,820.00
8,500.00
4,300.00
$21,620.00

COGS

200
400
800
600
820
2,820

@
@
@
@
@

$21.50
21.25
21.00
20.25
20.00

=
=
=
=
=

$4,300.00
8,500.00
16,800.00
12,150.00
16,400.00
$58,150.00

Inventory

1,020

20.00

$20,400.00

COGS

2,820

$20.456 =

$57,685.92

Inventory
1,020 @
20.456 =
$20,865.12
Note in all three cases that the sum of the cost of goods sold and ending inventory amounts is the same:
$78,550 (slightly different with average cost because of rounding errors), which is the sum of the
beginning inventory and purchases (i.e., available for sale).
FIFO:

COGS

Inventory

2010
420
400
200
700
700
660
3,080

@
@
@
@
@
@

$ 21.00
21.25
21.50
21.50
21.50
22.00

=
=
=
=
=
=

$ 8,820.00
8,500.00
4,300.00
15,050.00
15,050.00
14,520.00
$66,240.00

40
1,000
1,040

@
@
@

22.00
22.25

=
=

$ 880.00
22,250.00
$23,130.00

6-7

Chapter 06 - Cost of Sales and Inventories

LIFO:

AVERAGE COST:

FIFO:

COGS

1,000
700
700
680
3,080

@
@
@
@

$ 22.25
22.00
21.50
21.50

=
=
=
=

$22,250.00
15,400.00
15,050.00
14,620.00
$67,320.00

Inventory

20
1,020
1,040

@
@
@

$ 21.50
20.00
20.00

=
=
=

$ 430.00
20,400.00
$20,830.00

COGS

3,080

$21.509

$66,247.72

Inventory

1,040

21.509

$22,369.36

2011
40
1,000
1,000
700
210
2,950

@
@
@
@
@

$ 22.00
22.25
22.50
22.75
23.00

=
=
=
=
=

COGS

LIFO:

Inventory

490
700
1,190

@
@

23.00
23.50

=
=

$11,270.00
16,450.00
$27,720.00

COGS

700
700
700
850
2,950
1,020

@
@
@
@

$23.50
23.00
22.75
22.50

=
=
=
=

20.00

$16,450.00
16,100.00
15,925.00
19,125.00
$67,600.00
$20,400.00

20
150

@
@

21.50
22.50

=
=

430.00
3,375.00

COGS

1,190
2,950

$22.547

$24,205.00
$66,513.65

Inventory

1,190

22.547

$26,830.93

Inventory

AVERAGE COST:

COGS
Inventory

2009
2010
2011
2011

880.00
22,250.00
22,500.00
15,925.00
4,830.00
$66,385.00

Check on Calculations
FIFO
$ 56,930
66,240
66,385
27,720
$217,275

Question 2

6-8

LIFO
$ 58,150
67,320
67,600
24,205
$217,275

AVG.COST
$ 57,685.92
66,247.72
66,513.65
26,830.93
$217,278.22

Chapter 06 - Cost of Sales and Inventories

The calculation of the $1,406 tax difference for 2005-07 is shown below. However, this difference is
really irrelevant for deciding what to do in future years.
2009

2010

FIFO
LIFO
Sales.............................................................................................................................................................
$95,880
$95,880
COGS...........................................................................................................................................................
56,930
58,150
Gross Margin................................................................................................................................................
38,950
37,730
Tax Expense.................................................................................................................................................
15,580
15,092
Net Income...................................................................................................................................................
$23,370
$22,638

Sales.............................................................................................................................................................
$110,110
$110,110
COGS...........................................................................................................................................................
66,240
67,320
Gross Margin................................................................................................................................................
43,870
42,790
Tax Expense.................................................................................................................................................
17,548
17,116
Net Income...................................................................................................................................................
$ 26,322
$ 25,674

2011

Sales.............................................................................................................................................................
$105,462.50
$105,462.50
COGS...........................................................................................................................................................
66,385.00
67,600.00
Gross Muffin................................................................................................................................................
39,077.50
37,862.50
Tax Expense.................................................................................................................................................
15,631.00
15,145.00
Net Income ..................................................................................................................................................
$ 23,446.50
$ 22,717.50
Total Tax Expense Savings:
2009
$ 488
2010
432
2011
486
$1,406
An easier approach, which most students will overlook, is to note that the three-year difference in COGS
is $3,515, and 40 percent of this is $1,406. Even easier, but much more subtle, is realizing that the threeyear COGS difference is equal to the difference in 2011 year-end inventories ($27,720 - $24,205 =
$3,515).

6-9

Chapter 06 - Cost of Sales and Inventories

Question 3
Purchases for 2012 forecasted at 1,910* cartons @ 24.00
FIFO

COGS

Inventory
LIFO:

COGS

Inventory

490
700
1,510
2,700

@
@
@

$23.00
23.50
24.00

=
=
=

$11,270
16,450
36,240
$63,960

400

$24.00

$9,600

1,910
150
20
620
2,700

@
@
@
@

$24.00
22.50
21.50
20.00

=
=
=
=

$45,840
3,375
430
12,400
$62,045

400

20.00

$8,000

FIFO
LIFO
2012 Sales (2,700 @ $35.75)...................................................................................................................................................
$96,525
$96,525
COGS................................................................................................................................................................................
63,960
62,045
Gross margin......................................................................................................................................................................
32,565
34,480
Tax expense ......................................................................................................................................................................
13,026
13,792
Net income ........................................................................................................................................................................
$19,539
$20,688
In 2012, LIFO would cause an increase in tax expense of $766.
Question 4
The LIFO reserve is the difference between inventory calculated under the FIFO method, and inventory
calculated under the LIFO method.
2009
2010

LIFO Reserve
$1,220
$2,300

=
=
=

FIFO Inventory
$21,620
$23,130

LIFO Inventory
$20,400
$20,830

Another way to look at the LIFO reserve is that it represents the cumulative difference between LIFO cost
of goods sold and FIFO cost of goods sold. We can see that in 2009, the LIFO reserve ($1,220) is equal to
the difference between LIFO cost of goods sold and FIFO cost of goods sold ($58,150 - $56,930 =
$1,220). Similarly, in 2010, the LIFO reserve ($2,300) is equal to the sum of the differences between
LIFO and FIFO cost of goods sold for 2009 and 2010, as shown on the next page.

2,700 sales + 400 ending inventory - 1,190 beginning inventory = 1,910.

6-10

Chapter 06 - Cost of Sales and Inventories

2009
2010
LIFO cost of goods sold..............................................................................................................................................
$58,150
$67,320
FIFO cost of goods sold..............................................................................................................................................
56,930
66,240
Difference....................................................................................................................................................................
$ 1,220 +
$ 1,080 = $2,300
Therefore, if you are given LIFO cost of goods sold and inventory, and you are also given the LIFO
reserve for that year (year X) and the previous year (year X-1), you can estimate the following:
FIFO inventory (year X) = LIFO inventory (year X) + LIFO reserve (year X)
FIFO COGS (year X) = LIFO COGS (year X) - [LIFO reserve (year X) - LIFO reserve (year X-l)]
Tax savings (year X) = [LIFO reserve (year X) - LIFO reserve (year X-1)] *(1 tax rate)
Cumulative tax savings due to the use of LIFO = LIFO reserve (year X)
Companies on LIFO report the LIFO reserve in their financial statements, often in the inventory footnote.
Understanding the significance of the LIFO reserve can be very useful when trying to compare the
financial performance of companies using different inventory accounting methods.
Question 5
See Why Not More LIFO? section of the text, plus comments earlier in this note.
Case 6-3: Morgan Manufacturing*
Note: Updated from Twelfth Edition.
Morgan Manufacturing is a straightforward case to illustrate how information on the LIFO Reserve can
be used to adjust the results of a company on LIFO to make them more comparable to those of a company
on FIFO. This case extends the learning developed in question 4 of Case 6-2, Lewis Corporation. Morgan
Manufacturing may not require a full class for discussion, and the instructor may want to assign it in
conjunction with Lewis Corporation.
Answers to questions:
1. Westwoods gross margin percentage = $900 divided by $2,000 = 45%; pretax return on sales = $300
divided by $2,000 = 15%; pretax return on assets = $300 divided by $2,240 = 13.4%.
2. Students will quickly recognize that both the inventory and the cost of goods sold accounts are
affected. You are likely, however, to have to guide them to recognize what other accounts and
financial items are also affected. For example, if inventory is affected, then some other balance sheet
account must be affected to keep the balance sheet balanced. Students will likely conclude it must be
retained earnings or owners equity. If cost of goods sold is affected, then clearly items such as gross
margin, pretax net income, tax expense and net income will also be affected. Typically, assuming the
norm of continuing inflation and growing inventory, LIFO produces higher cost of goods sold and
lower inventory, owners equity, gross margin, pretax net income, tax expense, and net income than
FIFO. It is possible, therefore, for two companies to have identical underlying economic
performance, but the financial measures of performance of the firm using the LIFO method will look
worse than the financial measures of the firm using the FIFO method (or the underlying economic
performance of the LIFO firm might be even better than that of the FIFO firm, and the LIFO firms
financial measures can still look worse!).
*

This teaching note was prepared by Julie H. Hertenstein. Copyright Julie H. Hertenstein.

6-11

Chapter 06 - Cost of Sales and Inventories

3. Adjustment to 2010 inventory: $100 LIFO inventory + $70 LIFO reserve = $170 FIFO inventory.
Adjustment to 2010 total assets: $2,170 + $70 = $2,240
Amount to adjust COGS:

$70
-10
$60

2006 LIFO reserve

2005 LIFO reserve
Difference between 2006 LIFO and FIFO COGS

Adjustment to 2010 COGS: $1,110 - $60 = $1,050

Adjustment to 2010 gross margin: $890 + $60 = $950
Adjustment to 2010 pretax net income: $290 + $60 = $350
Adjusted gross margin percentage = $950 divided by $2,000 = 47.5%
Adjusted pretax return on sales $350 divided by $2,000 = 17.5%
Adjusted pretax return on assets $350 divided by $2,240 = 15.6%
4. Once adjusted to FIFO, Morgans performance exceeds Westwoods on each of the three measures,
as shown in Exhibit 1. In addition, Morgan has paid less in taxes than Westwood.
Pedagogical Approach
You can begin with a general discussion of why we often want to compare the financial performance of
different companies and how our ability to compare companies is affected by the different accounting
choices that they make; this issue, of course, is much broader than simply the choice of LIFO or FIFO. In
Chapter 5, students encountered different revenue recognition choices which produce different financial
results for the same underlying economic events. When firms choose different inventory accounting
methods, these affect financial measures, as well. When trying to compare one company on LIFO with
another on FIFO, one is trying to compare apples and oranges. For purposes of comparison, you would
like to get the companies on a common basis. The LIFO reserve, which is frequently available in the
inventory footnote or elsewhere in the annual report of a firm using LIFO, allows you to make
adjustments to achieve a common basis for comparison.
The three key measures for Morgan are given in the case. You can write them on the board, and put up
Westwoods for comparison when students answer question 1, as shown in the first two lines of Exhibit 1.
As indicated in the answer to question 2, you may need to draw students out on which accounts and
measures will be affected by the choice of inventory accounting method, and how this choice affects the
financial statement readers ability to compare the two companies.
Before proceeding to the calculations in question 3, you may wish to first discuss, conceptually, how you
can adjust results to make them more comparable. The first point regarding the adjustments is that you
have LIFO reserve information, (and since there is not an analogous FIFO reserve), you must adjust the
LIFO company to a FIFO basis. Since the LIFO reserve is the difference between the LIFO and FIFO
inventory, it can be used directly to adjust inventory, and similarly, it is also the adjustment to total assets;
a comparable adjustment can be made to owners equity to keep the balance sheet in balance. The LIFO
reserve represents not only the difference between LIFO and FIFO inventory, but also the cumulative
difference between LIFO and FIFO cost of goods sold. Thus, the LIFO reserve for two consecutive years
can be used to compute the difference between LIFO and FIFO cost of goods sold for the more recent of
the two years, which allows you to make adjustments to the income statement as well.

6-12

Chapter 06 - Cost of Sales and Inventories

You may want to raise the issue of what to do if you want to compare after-tax results, instead of the
pretax measures that the case suggests. Some students may want to adjust the tax expense of the LIFO
firm, for example, using the same ratio of tax expense to pretax net income as shown on the LIFO income
statement. Others may argue that the tax expense should be unchanged, reflecting the fact that the LIFO
company paid lower taxes due to its choice of the LIFO inventory accounting method, a true economic
difference between the two firms.
Following the conceptual discussion, the actual calculations can be examined and the results posted on
the board, as shown in Exhibit 1. From these results, students will quickly observe that Morgans
performance was better on all three measures. They may also conclude that the productivity
improvements that Charles Crutchfield had implemented were, indeed, reflected in Morgans financial
performance measures.

Exhibit 1
Gross Margin %
Pretax Return on Sales Pretax Return on Assets
Morgan (LIFO)..................................................................................................................................................................
44.5%
14.5%
13.4%
Westwood (LIFO)..............................................................................................................................................................
45.0%
15.0%
13.4%
Morgan (Adjusted).............................................................................................................................................................
47.5%
17.5%
15.6%
Case 6-4: Joan Holtz (B)*
Note: In discussing some of these questions. it may be useful to construct simple numerical examples,
perhaps related to the illustrations in the text. Joan Holtz (B) is an extension of Joan Holtz (A) in
Chapter 5. The case is unchanged from the Eleventh Edition.
1. The ultimate effect, over the life of an entity, is the same under all three methods. For a given
accounting period, however, the methods result in different net income. If purchase discounts are
deducted from purchases, they reduce the net purchase costs, and affect net income in the period in
which the goods are sold. If reported as other income of the period, they affect net income in an
earlier period than in the first method. If discounts not taken are recorded as an expense, cost of goods
sold reflects the full amount of the discount, and discounts not taken decrease income in what is
perhaps a later period.
Another difference is that cost of goods sold, and hence the gross margin percentage, differs under
each of these methods.
Of course, the amounts involved are usually small, so the above differences often are not material
2. There should be a credit to Inventory, to reduce it to the amount found from the physical inventory.
The debit may be either to Cost of Goods Sold or to an operating expense item. Literally, the
shrinkage cost could not have been a cost of the goods that actually were sold, for these goods were
not sold. The practice of debiting of Cost of Goods Sold is often followed, however. For management
purposes, it is desirable to identify the amount of shrinkage, wherever it is reported.
3. It is incorrect to say that the LIFO method assumes anything about the physical flow of the goods.
LIFO advocates know that physically the goods tend to move on a FIFO basis. LIFO is based on a
belief about economic flows, as explained in the text.

This teaching note was prepared by Robert N. Anthony. Copyright Robert N. Anthony.

6-13

Chapter 06 - Cost of Sales and Inventories

4.
5. In the examples given, the economics of the operations of the automobile dealer are best reflected by
the FIFO method (or even better by the specific identification method, which probably approximates
FIFO), and the economics of the operations of the hardware dealer are best reflected by the LIFO
method. Even so, the automobile dealer would not necessarily be wrong to use LIFO; it might regard
the income tax savings as being more important than a correct showing of economic income.
6. a. This generalization is valid.
b. This generalization is usually valid, as indicated in the text. However, any such generalization
about LIFO may not be valid if the physical size of the inventory is reduced so that the original
LIFO layers are carried to Cost of Goods Sold.
c. Assuming that income tax rates remain unchanged, and that the physical size of the inventory
remains unchanged, and disregarding the present value of money, this generalization is valid.
7. Although the LIFO inventory as a whole will normally be reported at less than current costs, it can
easily happen that individual items are worth less than their LIFO cost because of obsolescence or
damage. These items should be written down.
8. Since there would be no additional revenue for four years, and since barrels, warehousing costs, and
interest are charged to expense, profit would be reduced by the amount of these additional costs. In
the first full year, these amounts of 200,000 additional gallons would be:

Barrels @ $0.70...........................................................................................................................................
$140,000
Warehousing @ $0.20.................................................................................................................................
40,000
Interest @ $0.10..........................................................................................................................................
20,000
On each gallon added to inventory, the warehousing and interest costs would cumulate for four years,
and profits would be decreased correspondingly.
The argument against including these costs in inventory is that they are not costs of producing
whiskey. The production process has been completed before the whiskey is stored. The contrary
argument is that these costs are incurred in order to bring the whiskey to a salable condition and they
therefore should be included as inventory cost. This argument is strongest for the barrels, and next
strong for the warehousing costs. Many people argue that in no circumstances can interest be
considered a cost of production; rather, it is a cost of financing. Yet, if this were a four-year
construction project rather than aging whiskey, GAAP would require capitalization of construction
debt financing costs. (This is not described in the text until Chapter 7.) In any event, unless these
costs are included in inventory, profits will decrease at the very time that the increase in production
indicates that the company is prospering.
9. There is a rule (from FASB Statement No.-53) for determining cost of sales for T.V. movies. It is to
amortize film costs in the ratio of
Gross revenue for the film for the current period
Anticipated total gross revenues for the film from
the beginning of the current period until the end
of its useful life

6-14

Chapter 06 - Cost of Sales and Inventories

The denominator of this ratio must be reviewed periodically to reflect current information. The new
ratio is then applied to unrecovered film costs. Arguments can be made for ratios of 10/13 or 10/16 in
the first year. The 10/16 ratio ($625,000) is perhaps better due to the belief that at least $300,000 in
revenue will come from reruns. Correspondingly, the ratio to be used in the second year would be 1/2
($300,000/$600,000). This would result in amortization of $187,500 in year two [1/2 x ($1,000,000 $625,000)], with the final $187,500 of cost matched against the final $300,000 of revenue. The
$100,000 spent on advertising and promotion of the initial showing does not benefit the future
showings of the film. This is therefore not a capitalizable cost and should be expensed in the period
incurred. Therefore it does not affect the ratios used above.

6-15