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CHAPTER 6

COST OF SALES AND INVENTORIES


Changes from Eleventh Edition
Editorial and updated changes have been made.
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, LIFO defers 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.
VAL Corporation deals with accounting for mileage programs.

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:,

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

Income = Revenues Expenses

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:
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

2007 McGraw-Hill/Irwin

Chapter 6

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
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 @
75 units @
Avg:
125 units @
Sales: 100 units

$14 =
$12 =
$12.80 =

$ 700
900
$1,600

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

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
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.
4

2007 McGraw-Hill/Irwin

Chapter 6

Sales................................................................................................................................................................
$2,600,000
Cost of goods sold...........................................................................................................................................
2,002,000
Gross margin...................................................................................................................................................
$ 598,000

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 Eleventh Edition.
Approach
This is a straightforward complete accounting cycle in a manufacturing company, although it is
considerably longer than previous cases of the same type. Students may find it helpful to refer back to the
journal entries described in the text as a guide. Tracing through these entries is intended to give the
student an understanding of what goes on in a manufacturing company and how these events are reflected
in the accounts. I make a concerted attempt to link the problems numbers to Illustrations 6-3 and 6-4 in
the text, placing the T-accounts side-by-side (if board space permits) and using arrows to denote flows
from one inventory account to another.
Simply because of its length, two days may be necessary for this case. In any event, it is desirable that
some time be left for Question 3, which asks the students to use the information they have built up.
In effect, this case is a miniature practice set and can be treated as such if desired. It is a key case.
Comments on Questions
Question 1
1.

Accounts Receivable...........................................................................................................................
2,562,000
Sales (Retained Earnings).............................................................................................................
2,562,000
Sales Returns and Allowances (R/E)
19,200
..............................................................................
............................................................................................................................................................
Accounts Receivable....................................................................................................................
19,200
Sales Discounts (R/E).........................................................................................................................
49,200
Accounts Receivable....................................................................................................................
49,200

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

Accounting: Text and Cases 12e Instructors Manual

2.

(a)

(b)

Anthony/Hawkins/Merchant

Manufacturing Plant Equipment......................................................................................................................


144,000
Cash...........................................................................................................................................................
144,000
Prepaid Taxes and Insurance...........................................................................................................................
78,000
Cash...........................................................................................................................................................
78,000
Materials Inventory.........................................................................................................................................
825,000
Accounts Payable......................................................................................................................................
825,000
Supplies Inventory...........................................................................................................................................
66,000
Accounts Payable......................................................................................................................................
66,000
Direct Manufacturing Labor............................................................................................................................
492,000
Indirect Manufacturing Labor .........................................................................................................................
198,000
Social Security Taxes......................................................................................................................................
49,200
Power, Heat, and Light....................................................................................................................................
135,600
Cash...........................................................................................................................................................
874,800

Since in a manufacturing company, inventory is assumed to increase in value by the amounts spent to
convert materials into salable products, the following entry should be made; or the debit entry above
could have been made to Work in Process Inventory directly, as is done in the T-accounts to follow.

(c)
3.

4.
5.
6.

7.
8.

9.

Work in process inventory.......................................................................................................................................


874,800
Direct Manufacturing Labor..............................................................................................................................
492,000
Indirect Manufacturing Labor............................................................................................................................
198,000
Social Security Taxes........................................................................................................................................
49,200
Power, Heat, and Light......................................................................................................................................
135,600
Selling and Administrative Expense (R/E)..............................................................................................................
522,000
Cash...................................................................................................................................................................
522,000
Work in Process Inventory......................................................................................................................................
140,400
Accumulated Depreciation................................................................................................................................
140,400
Work in Process Inventory......................................................................................................................................
52,800
Prepaid Taxes and Insurance.............................................................................................................................
52,800
Work in Process Inventory......................................................................................................................................
61,200
Supplies Inventory.............................................................................................................................................
61,200
Work in Process Inventory......................................................................................................................................
811,000
Materials Inventory............................................................................................................................................
811,000
Finished Goods Inventory........................................................................................................................................
1,901,952
Work in Process Inventory................................................................................................................................
1,901,952
Cost of Goods Sold (R/E)........................................................................................................................................
1,806,624
Finished Goods Inventory..................................................................................................................................
1,806,624
Cash.........................................................................................................................................................................
264,000
Notes Payable....................................................................................................................................................
264,000
Notes Payable..........................................................................................................................................................
300,000
Cash...................................................................................................................................................................
300,000
Interest Expense (R/E).............................................................................................................................................
38,400
Cash...................................................................................................................................................................
38,400
Cash ........................................................................................................................................................................
2,604,000
Accounts Receivable.........................................................................................................................................
2,604,000
Accounts Payable....................................................................................................................................................
788,400
Cash...................................................................................................................................................................
788,400
Income Taxes Payable (2005)..................................................................................................................................
9,000
Cash...................................................................................................................................................................
9,000
Estimated Federal Income Taxes Expense (R/E)
58,000
(2006)....................................................................................................................................................................

2007 McGraw-Hill/Irwin

10.

Chapter 6

Income taxes payable (2006)................................................................................................................


5,800
Cash......................................................................................................................................................
52,200
Dividends (Retained Earnings)
30,000
..............................................................................
....................................................................................................................................................................
Cash......................................................................................................................................................
30,000

Question 2 (see pages 102 - 104.)


Question 3
1. Net sales are expected to increase 11.6 percent.
2. Gross profit margin is expected to decrease slightly from 29.8 percent of net sales in 2005 to 27.5
percent in 2006.
3. There is a l9.4 percent increase in selling and administrative expenses. This seems high, relative to
the sales increase; perhaps R&D expense in increasing.
4. The net effect of the foregoing is an anticipated decrease in profit before taxes. Profit would be
increased by judicious reductions in the anticipated selling and administrative expense, or by actions
to restore (or improve) the gross margin percentage.
5. It is expected that more funds will be tied up in inventories. Inventory turnover in 2005 was 2.82
times; it is projected at 2.55 times for 2006. Why the slowdown (about 13 days increase)?
Bal.
(6)
(7)

Bal.

Cash
118,440
(2)
264,000
(2)
2,604,000
(2)
(2)
(6)
(6)
(8)
(8)
(9)
(10)
________
Bal.
2,986,440
149,640

144,000
78,000
874,800
522,000
300,000
38,400
788,400
9,000
52,200
30,000
149,640
2,986,440

Bal.

Materials Inventory
110,520
(3)
811,000
825,000 Bal.
124,520
935,520
935,520
124,520

Bal.
(4)

Finished Goods Inventory


257,040
(5) 1,806,624
1,901,952 Bal.
352,368

Bal.
(2)

Accounts Receivable (Net)


Bal.
311,760
(1)
19,200
(1)
2,562,000
(1)
49,200
(7) 2,604,000
________
Bal.
201,360
2,873,760
2,873,760
Bal.
201,360
Work in Process Inventory
172,200
(1) 1,901,952
874,800 Bal.
210,448
140,400
52,800
61,200
811,000
________
2,112,400
2,112,400
Bal.
210,448
Bal.
(2)
(3)
(3)
(3)
(3)

Bal.
(2)
Bal.

Supplies Inventory
17,280
(3)
66,000 Bal.
83,280
22,080

61,200
22,080
83,280

Accounting: Text and Cases 12e Instructors Manual

Bal.

2,158,992
352,368

Anthony/Hawkins/Merchant

2,158,992
Bal.
(2)

Prepaid Taxes and Insurance


66,720
(3)
52,800
78,000 Bal.
91,920
144,720
144,720
Bal.
91,920
Bal.
(2)

Bal.

(8)
Ba1.

Bal.
(6)
Bal.

Accumulated Depreciation
1,047,600 Bal.
907,200
________
(3)
140,400
1,047,600
1,047,600
Bal. 1,047,600

(8)
Bal.

Accounts Payable
788,400 Bal.
185,760
288,350
(2)
825,000
________
(2)
66,000
1,076,760
1,076,760
Bal.
288,360
Capital Stock
Bal.

(1)
(1)
(2)
(5)
(6)
(9)
(10)
Bal.

1,512,000

Manufacturing Plant
2,678,400 Bal. 2,822,400
144,000
________
2,822,400
2,822,400
2,822,400
Notes Payable
300,000 Bal.
252,840
(6)
552,840
Bal.

288,840
264,000
552,840
252,840

Fed. Inc. Taxes Payable


9,000 Bal.
5,800
(9)
14,800
Bal.

9,000
5,800
14,800
5,800

Retained Earnings
19,200 Bal.
829,560
49,200
(1) 2,562,000
522,000
1,806,624
38,400
58,000
30,000
868,136
________
3,391,560
3,391,560
Bal.
868,136

6. It is planned to reduced notes payable. Whether this is wise may depend on the notes payable interest
vis--vis the return being earned on marketable securities.
7. Additions to plant are slightly greater than depreciation expense. This is not unusual in an inflationary
era.
8. The accounts receivable balance will decline by about 35 percent even though there is an expected
increase in sales. Is the collection department being overly optimistic about collections on account?
BROWNING MANUFACTURING CORPORATION
Projected Balance Sheet as of December 2006
Assets

Current Assets
Cash and marketable securities................................................................................................................................................
$ 449,640
Accounts receivable (net)........................................................................................................................................................
201,360
Inventories:..............................................................................................................................................................................
Materials............................................................................................................................................................................
$124,520
Work in process.................................................................................................................................................................
210,448
Finished goods..................................................................................................................................................................
352,368

2007 McGraw-Hill/Irwin

Chapter 6

Supplies
22,080
709,416
........................................................................
..............................................................................................................................................................................
Prepaid taxes and insurance.........................................................................................................................................
91,920
Total current assets...............................................................................................................................................
$1,452,336
Manufacturing plant....................................................................................................................................................
2,822,400
Less: Accumulated depreciation...........................................................................................................................
( 1,047,600)
1,774,800
Total assets.....................................................................................................................................................
$2,927,136
Liabilities and Shareholders Equity
Current liabilities
Accounts payable
$ 288,360
Notes payable
252,840
Income taxes payable
5,800
Total current liabilities
$ 547,000
Shareholders equity:
Capital stock
1,512,000
Retained earnings
868,136
2,380,136
Total Liabilities and Shareholders Equity
$2,927,136

BROWNING MANUFACTURING CORPORATION


Projected 2006 Income Statement
Sales..................................................................................................................................................................................
$2,562,000
Less: Sales returns and allowances..............................................................................................................................
$19,200
Sales discount allowed.......................................................................................................................................
49,200
68,400
Net sales............................................................................................................................................................................
2,493,600
Less: Cost of goods sold (per schedule)......................................................................................................................
1,806,624
Gloss margin......................................................................................................................................................................
686,976
Less: Selling and administrative expense....................................................................................................................
522,000
Operating income..............................................................................................................................................................
164,976
Less: Interest expense..................................................................................................................................................
$ 38,400
Income before federal income tax......................................................................................................................................
126,576
Less: Estimated income tax expense
58,000
...................................................................................................
....................................................................................................................................................................................
Net income........................................................................................................................................................................
$ 68,576

BROWNING MANUFACTURING CORPORATION


Projected 2006 Statement of Cost of Goods Sold
Finished goods inventory, 1/1/06.......................................................................................................................................
$ 257,040
Work in process inventory, 1/1/06.....................................................................................................................................
$ 172,200
Materials inventory, l/1/06.................................................................................................................................................
$110,520
Plus: Purchases............................................................................................................................................................
825,000
935,520
Less: Materials inventory 12/31/06.............................................................................................................................
124,520
Materials used ...................................................................................................................................................................
811,000
Plus: Factory expenses:...............................................................................................................................................

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

Direct manufacturing labor................................................................................................................................................


492,000
Factory overhead:....................................................................................................................................................................
Indirect manufacturing labor.............................................................................................................................................
$198,000
Power, heat, and light........................................................................................................................................................
135,600
Depreciation of plant.........................................................................................................................................................
140,400
Social security taxes..........................................................................................................................................................
49,200
Taxes and insurance, factory.............................................................................................................................................
52,800
Supplies.............................................................................................................................................................................
61,200
637,200
2,112,400
Less: Work in process inventory, 12/31/06..............................................................................................................................
210,448
Cost of goods manufactured.................................................................................................................................................
1,901,952
2,158,992
Less: Finished goods inventory, 12/31/06................................................................................................................................
352,368
Cost of goods sold..........................................................................................................................................................................
$1,806,624

10

2007 McGraw-Hill/Irwin

Chapter 6

Case 6-2: Lewis Corporation*


Note: Updated from Eleventh 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.
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:

COGS

Inventory

LIFO:

COGS

2005
1,840
600
380
2,820

@
@
@
@

$20.00
20.25
21.00

=
=
=

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

420
400
200
1,020

@
@
@

21.00
21.25
21.50

=
=
=

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

200
400
800
600

@
@
@
@

$21.50
21.25
21.00
20.25

=
=
=
=

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

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

11

Accounting: Text and Cases 12e Instructors Manual

AVERAGE COST:

Anthony/Hawkins/Merchant

820
2,820

20.00

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:

LIFO:

AVERAGE COST:

FIFO:

2006
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

Inventory

40
1,000
1,040

@
@
@

22.00
22.25

=
=

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

=
=
=

COGS

3,080

$21.509

$66,247.72

Inventory

1,040

21.509

$22,369.36

2007
40
1,000
1,000
700
210
2,950

@
@
@
@
@

$ 22.00
22.25
22.50
22.75
23.00

=
=
=
=
=

@
@

23.00
23.50

=
=

$11,270.00
16,450.00
$27,720.00

COGS

COGS

Inventory

490
700
1,190

12

880.00
22,250.00
$23,130.00

430.00
20,400.00
$20,830.00

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

2007 McGraw-Hill/Irwin

LIFO:

Chapter 6

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

2005
2006
2007
2007

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

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

Question 2
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.
2005

2006

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

2007

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:
2005
$ 488
2006
432
2007
486
$1,406

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Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

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 2007 year-end inventories ($27,720 - $24,205 =
$3,515).
Question 3
Purchases for 2008 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
2008 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 2008, 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.
2005
2006

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 2005, 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 2000, the LIFO reserve ($2,300) is equal to the sum of the differences between
LIFO and FIFO cost of goods sold for 2005 and 2000, as shown on the next page.

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

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2007 McGraw-Hill/Irwin

Chapter 6

2005
2006
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)
Most 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 More LIFO? section of the text, plus comments earlier in this note.
Case 6-3: Morgan Manufacturing*
Note: Updated from Eleventh 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!).
3. Adjustment to 2006 inventory: $100 LIFO inventory + $70 LIFO reserve = $170 FIFO inventory.
*

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

15

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

Adjustment to 2006 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 2006 COGS: $1,110 - $60 = $1,050


Adjustment to 2006 gross margin: $890 + $60 = $950
Adjustment to 2006 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.
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

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2007 McGraw-Hill/Irwin

Chapter 6

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.
4. 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.
*

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

17

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

5. 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.
6. 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.
7. 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.
8. There is now a rule (from FASB-53) for determining cost of sales for T.V. movies. It is to amortize
film cost 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
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.

18