Friedlan4e SM Ch07

CHAPTER 7
Inventory
QUESTIONS
Q7-1.
a.
b.
c.
d.
e.
f.
g.
Prescription and non-prescription drugs, cosmetics, toiletries, food items.

Toiletries, food and drinks.
Ore, unrefined gold and gold.
Photocopy paper, exam booklets, stationary, textbooks in the bookstore, food for
cafeteria, clothing items for sale with the university logo.
Auto parts, partially finished cars (work-in-progress), finished cars.
Cola in various stagesof production, raw materials including flavouring, corn syrup and
aspartame.
Hamburger patties, French fries etc., packaging materials, napkins.
Q7-2.
a.
Raw materials include computer parts; work-in-process would include computers that are
partially assembled; and finished goods would be comprised of fully assembled
computers that are ready for sale.
b.
Raw materials include potatoes, cooking oil, and packaging;work-in-processis cutfries

that are being prepared but havent been cooked, and finished goods are fries that are
packaged and ready to be sold.
c.
Raw materials includes lumber, glue and screws, fabric, and paint; work in process
includes partially created furniture, and finished goods would include furniture that is
fully built and ready for sale.
d.
Raw materials include ore; work-in-process is unrefined gold; and finished goods are
gold bars ready for sale.
Q7-3.
Conservatism (or prudence) is an underlying principle in IFRS and ASPE intended to limit the
options available to managers that would result in overly optimistic financial statements.
Conservatism introduces a degree of caution to the judgements made by managers when preparing
financial statements. Conservatism is the basis for ensuring assets and revenues arent overstated
and liabilities and expenses arent understated.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Solutions Manual
Page 7-1
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q7-4.
If inventory is written down by $250,000 or $350,000 the balance sheet inventory account will
be reduced by this amount. As a result the current ratio will be lower, which may affect loan
covenants based on financial statements ending 2017. Cost of goods sold in 2017 will also
increase by the same amount of the write-down which reduces net income for 2017. Profit
margin the profit margin ratio will also decline, indicating that the company may not be
performing as well when compared to previous and future years. If given the choice between
$250,000 and $350,000 management could use conservatism to justify a larger writedown
(assuming adequate uncertainty surrounding the actual NRV). In 2018 when the written down
inventory is sold the net income will better reflect the economic reality for that year and cost of
goods sold will be the carrying amount reflected on the balance sheet in the inventory account
for the year starting 2018. The amount of the writedown in 2017 will affect the amount of gross
margin and profit in 2018 (assuming the selling price in 2018 isnt affected by the amount of the
writedown.
Q7-5.
A periodic inventory system doesnt keep track of goods removed from inventory. As a result, at
any point in time cost of goods sold isnt known. Only by counting inventory and keeping track
of purchases is it possible to calculate cost of goods sold using the equation beginning inventory
+ purchases ending inventory = cost of goods sold. Notice that beginning and ending inventory
are determined by physically counting it.
Q7-6.
Raw materials are the inputs to production, such as iron ore to a steel company or potatoes for
a company making frozen French fries.
Work-in-process is inventory that is partially completed, such as automobiles on the assembly
line or a suit that hasnt been finished.
Finished goods is inventory ready for sale to the customer, such as a house ready to move into
or a television that is in the box ready to ship.
Supplies include other materials that are required by the manufacturing process but that arent
part of the finished product, such as lubricants for the machines. Supplies can also include
incidental materials used by an entity such as office supplies (photocopy paper) or cleaning
supplies.
Q7-7.
When a periodic inventory system is used, goods sold arent recorded.Cost of goods sold is
determined by counting the inventory at the end of a period and using the formulabeginning
inventory + purchases ending inventory.As a result the only the cost and quantity of goods
consumed in a period is known. Whether the goods consumed were sold or stolen cant be
determined.

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Q7-8
A perpetual inventory system keeps an ongoing tally of purchases and sales of inventory, with
the inventory account adjusted to reflect changes as they occur. When inventory is purchased or
sold, the inventory account is immediately debited or credited to record the transaction. When
inventory is sold, cost of sales is debited immediately. With a perpetual system its possible to
determine cost of sales at any time. With a periodic inventory system, the inventory account isnt
adjusted whenever a transaction affects inventory. The balance in the inventory account at the
end of a period is determined by actually counting the inventory. Purchases of inventory arent
recorded in the Inventory account but instead are accumulated in a separate "Purchases" account.
With a periodic inventory system, cost of sales is determined indirectly using the following
equation:
Cost of sales = Beginning inventory + Purchases Ending inventory
The perpetual system has many benefits for inventory management as inventory on hand
can be determined without physically checking the stock. However a perpetual system will be
more costly to maintain and operate.
Q7-9.
Cost formulas are needed because for most goods that are sold it would be very costly to
determine which physical item was sold. For some types of goods, crude oil for example, it
would be impossible to determine the cost oil acquired at different prices once its mixed
together. Its much more efficient to account for the cost of goods sold under an assumed flow.
Q7-10.
Cost of sales plus ending inventory is the same under all historical cost inventory valuation
methods because the cost of goods available for sale is the same under all alternatives. The
different methods allocate the cost of goods available for sale between ending inventory and cost
of goods sold. All the cost-based methods deal with costs. So the issue is how much of the
available cost goes to the income statement and how much goes to the balance sheet.
Q7-11.
Under FIFO, when prices are rising, the most recent (more costly) purchases are included in
ending inventory and the oldest (less expensive) purchases are expensed. In contrast under
average cost, when prices are rising, the average cost of inventory is used which includes both
less expensive, older inventory, and more expensive, new inventory. As a result FIFO gives a
lower cost of sales and higher ending inventory than average cost.
Q7-12.
Under all three systems, the cost of units purchased is added to inventory when they are
acquired.
FIFO: the costs associated with units purchased earliest are expensed first. New costs are
reported on the balance sheet.
Average cost: the average cost of the goods available for sale during the period is used to
determine ending inventory and the cost of sales.
Specific identification: the cost of the actual unit sold is known and becomes cost of sales
when the unit is sold.

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Q7-13.
The lower of cost and NRV rule requires that inventory be reported at cost or NRV, whichever is
lower. Its used to ensure that inventory reported on a balance sheet isnt overstatedreported at
an amount greater than its carrying amount (its value on the balance sheet date). NRV can be
defined as the amount the company is able to sell the inventory for less selling costs. The lower
of cost and NRV rule is an application of conservatism.
Q7-14.
The net realizable value of items that are infrequently sold or unique, such as an antiques, may
be hard to determine reliably. Also, the market value of intermediate productsproducts that are
produced by an entity and then used in its production processmay be difficult to determine if
there is market for the product. The NRV of work-in-process may also be difficult to determine
because there wouldnt be markets for partially completed goods.
cost formulaQ7-15.
Perpetual inventory record keeping doesnt capture all events that might reduce inventory. Theft
and loss wont be recorded. Errors are also possible: some transactions might not be recorded
(sales may be forgotten, returns not recorded) and the inventory records might be adjusted
incorrectly (the wrong inventory category might be adjusted). As a result its necessary to count
the inventory to determine the actual amount of inventory on hand. With a periodic inventory
system, the inventory account isnt adjusted whenever a transaction affects inventory so a count
is necessary to determine the amount of inventory on hand and to calculate cost of sales.
Q7-16.
With the specific identification method, the cost of each specific unit is recorded and assigned to
cost of goods sold when that unit is sold. The method is difficult (sometimes impossible) to use
when there are many identical, relatively low cost units of each inventory item in stock. For
costly or unique items identifying and accounting for each item provides more control over the
inventory (management will know whats there and whats not there). Manipulation is possible
because management can select the specific unit being sold. For example, a car dealer might
choose to sell a less costly vehicle to boost income in a period.
Q7-17.
The choice of the inventory cost formula is important for tax purposes because the method thats
used by a firm for financial reporting purposes will usually be used for tax purposes. The choice
of inventory cost formula affects income, which in turn affects the amount of tax an entity pays,
which has cash flow implications for the entity.
Q7-18.
It isnt possible to satisfy both objectives at the same time (at a maximum level) since the same
cost formula is usually used for both tax and financial reporting. Achieving one objective means
sacrificing the other. In periods of rising prices average cost will produce the lowest income
while FIFO produces the highest income.
Q7-19.

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Page 7-4
No inventory method will always result in higher earnings than an alternative but if it is believed
that FIFO will result in higher earnings in the near future, prices must be rising and therefore it
will also result in the highest balance sheet values. Thus if management needs higher income in
the short term FIFO is a better choicefor example to increase the bonus to be received by the
managers. Average cost in the short term would have the opposite effect, lowering income and
reducing the bonus. The stock price argument is more dubious because given the efficient market
hypothesis, it seems unlikely that stock prices would be affected by a disclosed accounting
method. However, the managers may believe that higher net income is advantageous for stock
valuation and may pursue that strategy. The downside of the choice is that FIFO will result in the
company paying more taxes because income will be higher. Average cost will result in a lower
tax burden.
Q7-20.
No, if the price of inventory is constant, all methods provide the same income and balance sheet,
since the earliest purchases are at the same price as the most recent.
Q7-21.
Different cost formulas result in different inventory valuations on the balance sheet and different
costs of sales on the income statement. These differences will affect financial ratios. For
example, higher inventory values will result in higher current assets with no effect on current
liabilities so the current ratio will be higher. The inventory turnover ratio is determined by both
inventory and cost of sales so the ratio will also be affected. However, the actual inventory
turnover (which is really more appropriately expressed in units) and the actual liquidity of a
company arent affected by the cost formula. The measurements change depending on the
accounting method but the underlying economic characteristic being measured isnt affected.
Q7-22.
Inventory turnover is the ratio of cost of goods sold for the year to the average inventory for the
year. It indicates how quickly the inventory is sold each period. A higher inventory turnover ratio
is preferable to a lower one because it means that the entity is able to support a particular level of
sales with less inventory. It means that the entity is able to sell its inventory more quickly. In the
terminology of Chapter 6, the inventory holding period is shorter. A decreasing inventory
turnover ratio can be the result of slowing sales, the accumulation of merchandise that is difficult
to sell, or expansion into product lines that tend to move more slowly. For example, a roadside
fruit market will turn over inventory very quickly. If the owner decides to sell books and
souvenirs along with fresh produce, the overall turnover ratio will undoubtedly decline. An
inventory turnover ratio can increase by reducing inventory levels or by eliminating slowmoving product lines or by increasing sales without increasing inventory.
Q7-23.
It isnt possible to say that one cost formula is best. The question must be assessed in the context
of the information needs of stakeholders and the objectives of financial reporting of the entity.
For tax minimization with rising prices, average cost is best in Canada. To put recent prices on
the balance sheet, FIFO is best. If a bank loan is based on the amount of inventory on hand, FIFO
will be preferred when prices are rising. The different cost formulasprovide different
measurements of the same underlying economic construct.
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Page 7-5
Q7-24.
The cash paid for inventory is the payments made to suppliers of inventory during the period.
The amount of cash that is spent in a period is the same regardless of the valuation method used.
The cost formulas allocate the cost of inventory available for sale between the balance sheet and
the income statement in different ways. So even if the inventory amount and cost of goods sold
may differ depending on the cost formula, the amount of cash expended on inventory is the
same.
Q7-25
Biological assets are living animals or plants, for example, dairy cows, forests, apple trees and
apples on the trees, and beef cattle. What makes them different is that they are alive, they grow,
and they reproduce. Biological assets are valued on the balance sheet at fair value less cost to
sell. Biological assets are valued at fair value less cost to sell when they are harvestedand they
are carried at that amount thereafter.
Q7-26
Under ASPE apples during the growing season wouldnt be reflected on the balance sheet. Under
IFRS the apples are valued at fair value less cost to sell on the balance sheet date. The difference
is that IFRS would capture the increased value caused by biological growth (and reflect income
on the income statement).
Q7-27
Inventory of an accounting firm is the accumulation of the cost of services performed for clients;
for example,cost of work done by employees, travel cost, documentation, preparation costs, and
other administrative costs. This appears on the balance sheet because it represents an
accumulation of costs inventoried for internal control. These costs are expensed when the
engagement is complete and revenue is recognized.
Q7-28
In 2017 the inventory carrying amount on the balance sheet will be overstated by the amount of
the double counted inventory. This will increase the current ratio and decrease the inventory
turnover ratio. Net income for the year will be overstated because cost of sales will be
understated. (cost of sales = beginning inventory + purchases ending inventory if ending
inventory is higher thancosts of sales is lower). (This will also be the case for a perpetual system
because the physical count is the basis for determining the amount of inventory on hand.)
In 2018 when the yearend inventory is counted correctly the carrying amount of inventory on the
balance sheet will be correct but the cost of sales will be overstated causing net income to be
understated. This reverses the impact of the error in 2017.

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EXERCISES
E7-1.
The inventory on the December 31, 2017 balance sheet is overstated by $200,000 and net income
will be overstated by the same amount. Also, cost of sales will be understated by $200,000. The
reason is that the physical count will show $200,000 more inventory than is really there
($1,900,000). With a periodic system cost of sales is determined using the equation:
cost of sales = beginning inventory + purchases ending inventory
If ending inventory is overstated cost of sales must be understated.
E7-2.
The company purchased a total of 5,650 units and sold 4,800 units, leaving 850 units in ending
inventory.
Note: Answers may vary depending on rounding.
FIFO
Price paid
per unit
8-Oct-18
17-Oct-18
25-Oct-18
Number of
Units
Expensed
$8
$9
$10
Total
2,200
1,650
950
4,800
Average Cost
Number of Units
purchased
8-Oct-18
2,200
17-Oct-18
1,650
25-Oct-18
1,800
5,650
Total
Price paid
per unit
$8
$9
$10
Expensed
FIFO
$17,600
$14,850
$9,500
$41,950
Number of
Units in
Inventory on
Oct. 31, 2018
0
0
850
850
Ending
Inventory
on Oct. 31,
2018
Number of
Units in
Inventory on
Oct. 31, 2018
850
Ending
Inventory
on Oct. 31,
2018
$7,590
$8,500
$8,500
Total
$17,600
$14,850
$18,000
$50,450
Average Cost=$50,450/5,650
=$ 8.929
Price paid
per unit
Number of
Units
Expensed
Expensed
Average
Cost
$8.929
4,800
$42,860
E7-3.
The company had an opening balance of 500 units, and purchased an additional 800 units for a
total of1,300 units.Jaffray sold 500 units, leaving 800 units in ending inventory.

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FIFO
Price paid
per unit
Number of Units
Expensed
COGS
$10
11
12
Balance
500
0
0
500
$5,000
0
0
$5,000
Average Cost
Number of Units
purchased
1-Jun
500
12-Jun
350
22-Jun
450
1300
Total
Price paid
per unit
$10
$11
$12
1-Jun
12-Jun
22-Jun
30-Jun
Number of Units
on Hand on
June 30, 2017
0
350
450
800
Ending
Inventory
$0
3,850
5,400
$9,250
Total
$5,000
3,850
5,400
$14,250
Average cost=($14,250)/(1300)
$10.96
Balance
30-Jun
Price paid
per unit
$10.96
Number of Units
Expensed
500
COGS
$5,481
Number of Units
on Hand
800
Ending
Inventory
$8,769
***Answers may vary depending on rounding.

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E7-4.
The company had an opening balance of 35,000 units, and purchased 32,900 units for a total of
67,900 units. Kinistino Inc. sold 52,000 units, leaving 15,900 units in ending inventory.
FIFO
1-Nov
Price paid
per unit
$4.50
Number
of Units
Expensed
35,000
COGS
$157,500
Number
of Units
on Hand
on
30-Nov
0
13-Nov
4.90
17,000
83,300
4,100
20,090
21-Nov
5.25
$0
11,800
61,950
30-Nov
Balance
52,000
$240,800
15,900
$82,040
Average Cost
Number
of Units
purchased
1-Nov
35,000
Price
paid per
unit
$4.50
Total
$157,500
Number
of Units
on Hand
on
30-Nov
15,900
Ending
Inventory
$75,599
13-Nov
21,100
4.90
103,390
21-Nov
11,800
5.25
61,950
Total
67,900
Ending
Inventory
$0
$322,840
Average cost=($322,840)/(67,900)
$4.75
Balance
30-Nov
Price paid
per unit
$4.75
Number
of Units
Expensed
52,000
COGS
$247,241

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E7-5.
The company had an opening balance of 8,500 units, and purchased an additional 12,800 units
for a total of 21,300 units. Lucan Ltd. sold 16,900 units, leaving 4,400 units in ending inventory.
FIFO
30-Jun
Price paid
per unit
$8.50
Number
of Units
Expensed
8,500
COGS
$72,250
Number
of Units
on Hand
on
31-Jul
0
8-Jul
9.00
2,400
21,600
20-Jul
9.50
4,400
41,800
29-Jul
9.75
1,600
15,600
4,400
42,900
31-Jul
Balance
16,900
$151,250
4,400
$42,900
Average Cost
Number
of Units
Ending
Inventory
$0
Price
paid
30-Jun
purchased
8,500
per unit
$8.50
Total
$72,250
5-Jul
2,400
9.00
21,600
15-Jul
4,400
9.50
41,800
22-Jul
6,000
9.75
58,500
Total
21,300
$194,150
Average cost=($194,150)/(21,300)
$9.12
Balance
31-Jul
Price paid
Number
of Units
per unit
Expensed
$9.12
16,900
COGS
$154,044
Number
of Units
on Hand
on
Inventory
31-Jul
4,400
$40,106

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Ending
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E7-6.
a.
Raw materialsthe lumber is used to make the furniture.
b.
Work-in-processthis is partially made furniture.
c.
Tools are equipment, not inventory, since they are used in the production of inventory but
will never be part of the finished product.
d.
Raw materials- used to make seats
e.
Supplies because sandpaper is used in the production of the furniture but doesnt become
part of the furniture. Its included in supplies because it is used in the production process
but is not a capital asset like equipment.
f.
Finished goodsgoods ready for sale.
g.
Supplies because packaging is used up in the sale of inventory but is not a capital asset
like equipment.
h.
The storage containers for the parts wouldnt be classified as inventory because they
arent used up in production of the product or available for sale. They will be used for
many periods and should be classified as a capital asset.
E7-7.
a.
Wrapping for the burgers would be considered inventory because the wrappings will
become part of the final productthe burgersor other food that is sold to the customer
and is physically consumed when the product is sold.
b.
Plastic cutlery would be considered product inventory. Its part of the final product that is
sold to the customer. Its physically consumed when the productissold.
c.
Mops and brooms are used on an ongoing basis to keep the restaurant clean. They are
cleaning equipment (capital assets), not inventory.
d.
Oil for cooking the French fries would be considered part of the supplies inventory.It
isntpart the final product and the oil isnt sold to the customer.Oil is used in the
production of the food but doesnt become part of the food.
e.
Raw meat is product inventory. When cooked it will be part of the product that is sold to
customers.
f.
Cooking implements are equipment, not inventory because they are used in the
production of inventory but arent part of the finished product.
g.
Ketchup, mustard, and relish are added to the burgers and would be considered product
inventory because they become part of the final product that is sold to customers.
h.
Unused cleaning supplies are supplies inventory. Restaurants arent in the business of
selling cleaning supplies but they are required to maintain a clean establishment thus they
are used up in operating the business.

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E7-8.
a. A bank wouldnt consider cash as inventory on the F/S. They arent in the business of
selling money. They lend it out but they expect it back. On the other hand, a coin
collector who buys and sells coins would consider his cash or money as inventory
because he is selling it.
b. A chain saw to a rental store wouldnt be considered inventory unless they were selling
the chain saw. Rental equipment is a capital asset because the equipment will contribute
to earnings for more than one period and remains in the ownership of the rental store.
c. A shopping center owned by commercial real estate developer may or may not be
inventory. If the building was built or being built and the developer intends on selling the
shopping center then it is inventory. If the developerintends on operating the shopping
centre then the shopping center is considered a capital asset. If the shopping center were
being constructed for another entity then all the expenses associated with construction
would be recognized as inventory until revenue is recognized at the time of sale.
E7-9.
a.
A custom furniture maker would use specific identification because each piece of
furniture is unique and identifiable and traceable to specific orders.
b.
Car dealership would use specific identification because each car will have a vehicle
identification number (VIN), each is unique (have specific features) and identifiable but
each also represents a high dollar amount.
c.
A lumber yard wouldnt use specific identification because the lumber will be relatively
large quantities of homogeneousitems, which isnt conducive for specific identification.
A lumber yard would likely use FIFO or average cost.
d.
High-end audio visual store can sell a wide range of merchandise and may select to use
different cost assumptions. For example cables and accessories can be either FIFO or
average cost since the items are lower cost and homogeneous. Forhigh ticket items the
store may use specific identification because each piece of inventory is identifiable (has a
serial number) and would be valuable for control purposes.
e.
An orange juice producer would use a cost formula: average cost and FIFO. Specific
identification would be impossible since orange juice may blend oranges that were
obtained at different costs.

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E7-10.
a.
FIFO
Price paid
per unit
$5.00
Number
of Units
Expensed
50,000
COGS
$250,000
$5.00
140,000
700,000
60,000
300,000
$190,000
$950,000
60,000
$300,000
$5.00
60,000
$300,000
$5.00
210,000
1,050,000
40,000
200,000
2018 Total
$270,000
$1,350,000
40,000
$200,000
Average cost in 2017 and 2018:
$5.00
1-Jan-17
Purchases during 2017
2017 Total
1-Jan-18
Purchases during 2018
Dec. 31, 2017
$5.00
Number
of Units
Expensed
190,000
Dec. 31, 2018
$5.00
270,000
Cost per
unit
Gross margin per unit

Gross margin percentage
Number
of Units
on Hand
-
$950,000
Number of Units
on Hand on Dec.
31
60,000
$1,350,000
40,000
COGS
Ending
Inventory
$0
$0
Ending
Inventory
$300,000
$200,000
$6 ($11 $5)
54.5% ($6/$11)
b.
All values are the same regardless of the inventory cost formula used. When cost and selling
prices per unit are constant over time the inventory and gross margin amounts are the same for
all three methods (including specific identification). This observation differs from typical
accounting text questions but would reflect reality for many companies when inflation is very
low.

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E7-11.
The effects on gross margin and ending inventory using specific identification if a certain vehicle
were sold are as follows.
VIN#
2X346782N
$32,000
3K786281L
$32,000
8T492711K
$32,000
4U787412Q
$32,000
21,200
19,800
22,900
20,150
Gross Margin
$10,800
$12,200
$9,100
$11,850
Remaining in
inventory
$19,800
$21,200
$21,200
$21,200
22,900
22,900
19,800
19,800
20,150
20,150
20,150
22,900
$62,850
$64,250
$61,150
$63,900
Sales
COGS
Ending Inventory
a. If Fermeuse wanted to minimize profit on the sale, it would sell the car that cost the most,
(8T492711K). The higher expense will result in a lower net income. The impact on gross
margin and ending inventory of VIN# 8T492711Kand a comparison with the other vases
are shown in the above chart. (GM = $9,100 and Ending Inventory = $61,150)
b. If Fermeuse wanted to maximize profit on the sale it would sell the car that cost the least,
3K786281L. The lower expense will result in a higher net income. The impact on gross
margin and ending inventory of VIN# 3K786281Land a comparison with the other cars
are shown in the above chart.(GM = $12,200 and EndingInventory = $64,250)
c. By expensing the most expensive car as in part a,Fermeusewill have a lower amount
recorded in itsinventory account.The opposite is true if Fermeuse expenses the least
expensive car. Reasons Fermeuses management might want to maximize profit include:
increase their bonus, avoid violation in terms of contract compliance, try to influence
stock prices (if it were a public company), to get a loan, inflate selling price, or to present
themselves as good managers. The higher selling price would also result in a higher
inventory valuation and if the amount of a loan was based on inventory valuation
management might choose to sell the least expensive item if it needed maximize the loan.
Reasons Fermeuses management might want to minimize profit include:it is an owner
management situation and the manager wants to delay paying his or her taxes.
Yes, in reality Fermeuses management would have the opportunity to manage the
financial statements in this way. Specific identification is the best cost formula to use to
achieve ones objective. Management has control over which inventory item is physically
sold, which determines gross margin and net income. Using the other cost formulas
requires application of a mechanical formula.

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E7-12.
Cost of sales
Opening Inventory
Ending Inventory
Average inventory
27,050,000
6,900,000
7,800,000
7,350,000
a. Inventory turnover ratio

Cost of sales/average inventory
=$27,050,000 $7,350,000 = 3.68
b. Average number of days inventory on hand
365/inventory turnover ratio
= 365 3.68 = 99.18
c.
We cant assess whether the turnover is satisfactory without having benchmarks. Information
that could be helpful includes the typical turnover for a company in the same industry and the
turnover for this company in recent years, to identify trends. Also, any changes in the accounting
environment that might explain or affect the turnover period would be useful.Knowing the nature
of the inventory would also be helpful.
E7-13.
a.
The inventory should be written down if NRV is less than cost. In this case NRV is less than cost
by $90,000 ($1,125,000-$1,035,000)so a write down of $90,000 is necessary.
b.
Dr.
Cost of sales
Cr.
Inventory
90,000
90,000
c.
The inventory should be reported on the balance sheet at the amount lower of cost and
NRV,which is $1,035,000.

Solutions Manual
Page 7-15
E7-14.
a.
The inventory should be written down if NRV is less than cost. In this case NRV is less than cost
by $187,500 ([(4.75 4.00) x 250,000]) so a write down of $187,500 is necessary.
b.
Dr.
Cost of sales
Cr.
Inventory
187,500
187,500
c. The inventory should be presented on the balance sheet at the amount lower of cost andNRV
which is $1,000,000.
d.
31-Mar-18
Inventory (units) on hand
70,000
Recovered amount per item
$0.30 (4.30-4.00)
Write-up
$21,000
e.
Dr.
Inventory
Cr.
Cost of Sales
21,000
21,000
f. The inventory should be presented on the balance sheet at the amount lower of cost and NRV
which is $301,000 (70,000 x 4.30).

Solutions Manual
Page 7-16
E7-15.
Cost of sales
(COS)
Average inventory
(AI)
Inventory turnover ratio

(ITR)
Average number of
days on hand (#d)
$625,000.00
$78,938.36
7.92
46.10
$20,568,240.00
$4,312,000.00
4.77
76.52
$5,046,954.55
$152,100.00
33.18
11.00
$4,875,000.00
$2,900,000.00
1.68
217.13
Inventory turnover ratio = cost of sales/ average inventory

Cost of sales = inventory turnover ratio * average inventory
Average inventory = cost of sales / inventory turnover ratio
Average number of days inventory on hand = 365/ inventory turnover ratio
Inventory turnover ratio = 365 / average number of days on hand
ITR = 365/#d = 7.92
b.
AI = COS/ITR = $78,938.36
c.
ITR = COS/AI
COS = ITR*AI
=$20,568,240.00
#d = 365/ ITR = 76.52
ITR = 365/#d = 33.18
d.
COS = AI * ITR = $5,046,954.55
ITR = COS/ AI = 1.68

#d = 365/ ITR = 217.13
E7-16.
Beginning inventory
Purchases
Ending inventory
Cost of sales
Dec. 31,
2016
$100,000
950,000
150,000
900,000
Dec. 31,
2017
$150,000
775,000
125,000
800,000
Dec. 31,
2018
$125,000
1,200,000
200,000
1,125,000
Dec. 31,
2019
$200,000
1,300,000
190,000
1,310,000
Ending inventory from current year is equal to the beginning inventory in the next year.

Solutions Manual
Page 7-17
E7-17.
a.
Cash
Accounts receivable
Prepaid assets
$140,000
367,000
25,000
FIFO
Inventory
Average
$247,000
$229,000
Other current assets
$532,000
Other current assets
532,000
532,000
Bank loan
$148,000
Total current assets
$779,000
$761,000
Current liabilities
$466,000
$466,000
1.672
1.633
Accounts payable and accrued liabilities

Current liabilities
318,000
$466,000
Current ratio (CA/CL)
b.
The lower the value of inventory, the lower the current assets and the lower the current ratio.
Different inventory cost formulas will yield different carrying amounts for inventory and
therefore different current ratios, if prices are changing.
c.
The current ratio is a method of measuring the liquidity of an entity. It is a representation of that
economic characteristic and will vary with the assumptions that go into the measurement. The
measure isnt the actual economic characteristic. Assuming that the user of the financial
statements doesnt realize the impact of the particular inventory policy, average costwould result
in a perception that the company is less liquid than if FIFOhad been chosen. However, while the
measurement of liquidity varies how inventory is valued, the actual liquidity of the entity isnt
affected by the different measurements (notwithstanding secondary effects (tax for example) of
different choices).
d.
FIFO provides the valuation that is nearest to replacement cost and the replacement cost would
provide the best basis for determining the NRV of the inventory. For liquidity purposes the issue
is how much cash can the entity receive for its inventory. Recent inventory prices would be most
informative for that purpose.

Solutions Manual
Page 7-18
E7-18.
a.
Cost formula
Average Inventory
(Beg+End)/2
Cost of goods sold

for 2018
Inventory
Turnover
Average Days
In Inventory
$613,500
$2,475,000
4.03
90.48
579,500
2,506,000
4.32
84.40
FIFO
Average cost
b.
Price of inventory is rising causing the carrying amount of inventory to be higher under the FIFO
cost formula. As a result the average value of inventory is higher than under the average cost
method. COGS under FIFO is lower than under average cost. The combined effects lead to a
lower turnover and higher average days in inventory under the FIFO cost formula. It should be
noted that average days of inventory is more accurately calculated using physical units rather
than dollar value.
c.
Based on cost formula, inventory turnover is quicker under the average cost method. The real
turnover of inventory isnt affected by the cost formula; the ratio is a representation of the actual
economic activity. The real physical turnover of the inventory is the same if the measure is based
on physical units rather than cost assumptions.
E7-19.
a.*
b.**
c.
d.
Current
Ratio
Quick
Ratio
Decrease
Increase
No effect
Decrease
No effect
Increase
No effect
Decrease
Gross
Margin
Percentage
Decrease
Increase
No Effect
No effect
Inventory
Profit
Turnover
Margin
Ratio
Percentage
Increase
Decrease
Increase
Increase
No Effect
No effect
Decrease
No effect
Debt-toequity ratio
Increase
Decrease
No effect
Increase
*Assumesthat for inventory turnover ratio items a. the costs associated with the write-down are
included in cost of goods sold.
**For the purposes of the PM% this analysis assumes that the margin on the products sold is
greater than the margin on other products sold.

Solutions Manual
Page 7-19
E7-20.
a.
Dr.
Allowance for sales returns (contra asset)
8,000
Cr.
Accounts receivable
8,000
Dr.
Inventory
5,000
Cr.
Cost of Sales
5,000
Under a perpetual system inventory and cost of sales are immediately accounted for.
With a periodic system no entry is made to inventory and cost of sales and the impact is
reflected at the end of the period.
b.
Dr.
Cost of sales
20,000
Cr.
Inventory
20,000
The loss is debited to cost of goods sold and the balance in inventory is reduced. If the
amount of the write down were material, it could be reported separately instead of being
included in cost of sales.
c.
Dr.
Purchases
15,000
Cr.
Cash
15,000
For a periodic inventory system.
Or
Dr.
Inventory
15,000
Cr.
Cash
15,000
For a perpetual system.
d.
Dr.
Cash
22,000
Cr.
Sales
22,000
No entry involving inventory is necessary under a periodic system at the time of the sale.
e.
Dr.
Accounts receivable
20,000
Cr.
Sales
20,000
Dr.
f.
Dr.
Dr.
g.
Dr.
Cost of goods sold

8,000
Cr.
Inventory
8,000
A journal entry to record cost of sales and adjust inventory is required under a perpetual
system.
Cost of sales
193,000
Inventory (ending)
32,000
Cr.
Inventory (beginning)
25,000
Cr.
Purchases
200,000
According to cost formula Cost of Sales = Beg. Inventory + Purchases Ending
Inventory = $25,000+$200,000-$32,000=$193,000
Cost of sales
15,000

Solutions Manual
Page 7-20
Cr.
Inventory
15,000
The inventory must be written down under Lower of cost and NRV assuming that GAAP
is a constraint.
E7-21.
a.
Open Inventory
Number
of Units
Purchased
70
Price paid
per unit
$950
Number
of Units
sold
COGAFS
$66,500
Price sold
Per Unit
1-Oct-16
144
900
$129,600
2-Jan-17
108
860
$92,880
1-Apr-17
84
810
$68,040
2-Jul-17
170
775
$131,750
October-December, 2016
162
$1,710
January-March, 2017
116
April-June, 2017
Total
158
$277,020
1,620 $187,920
1,550 $133,300
1,390 $219,620
522
$817,860
86
July-September, 2017
576
$488,770
Sales
Revenue
COGAFS- cost of goods available for sale

FIFO
Open Inventory
Price paid
per unit
$950
Number
of Units
Expensed
70
1-Oct-16
900
144
2-Jan-17
860
108
1-Apr-17
810
84
2-Jul-17
775
116
$66,500
$129,600
$92,880
$68,040
$89,900
30-Sep-17
Balance
522
$446,920
COGS
Number
of Units
on Hand
-
Ending
Inventory
54
$0
$0
$0
$0
$41,850
54
$41,850
Average Cost
Number
of Units
Price paid
Open Inventory
purchased
70
per unit
$950
COGAFS
$66,500
1-Oct-16
144
900
$129,600
2-Jan-17
108
860
$92,880
1-Apr-17
84
810
$68,040
2-Jul-17
170
775
$131,750
Total
576
$488,770

Solutions Manual
Page 7-21
Average Price=(488,770)/(576)
$848.56
Balance
30-Sep-17
Periodic
System
Price paid
Number
of Units
per unit
$848.56
Expensed
522
FIFO
Average
Number
of Units
COGS
$442,948
on Hand
54
Ending
Inventory
$45,822
September 30, 2017

Sales
COGS
Gross Margin
Ending Inventory
$817,860
446,920
$817,860
442,948
370,940
374,912
41,850
45,822
b.
To maximize income you would choose average cost. It has the lowest expense (COGS),
which will result in the highest net income.
c.
To minimize taxes you would choose FIFO because under FIFO cost of sales is largest
thus lowest net income.
d.
When prices are rising, the effects of the two methods are reversed. Rising prices mean
the average cost of inventory on hand will be lower than FIFO because the inventory on
hand under will have newer, higher prices (the average will capture older, lower prices).
This means COGS will be higher for average cost and lower for FIFO. Under average
cost the cost of inventory expensed is an average of high and low costs while FIFO
expenses the older, lower priced inventory first.
e.
NRV of inventory is 54 units x (1390-120) = 68,580
Ending Inventory
Cost
NRV (selling price -selling cost)
Lower of cost and NRV
FIFO
$41,850
68,580
Average
$45,822
68,580
41,850
45,822
In both cases cost is lower than NRV less cost to sell so cost is used to value ending inventory
and no write down is necessary.

Solutions Manual
Page 7-22
E7-22.
Number
of Units
Price paid
Purchased
24,000
per unit
$5.00
$120,000
4-Sep-16
16,000
$5.50
$88,000
4-Dec-16
20,000
$6.00
$120,000
6-Mar-17
30,000
$6.30
$189,000
7-Jun-17
14,000
$6.60
$92,400
Open Inventory
COGAFS
During
Number
of Units
Price sold
Sales
sold
Per Unit
Revenue
82,000
Total
104,000
$609,400
$12.00
82,000
$984,000
$984,000

Number of Units Sold =
Opening inventory + Purchases -Ending Inventory

(24,000) + (16,000+20,000+30,000+14,000) - (22,000)
82,000
Units
FIFO
Price paid
Number
of Units
per unit
$5.00
Expensed
24,000
COGS
$120,000
4-Sep-16
$5.50
16,000
$88,000
$0
4-Dec-16
$6.00
20,000
$120,000
$0
6-Mar-17
$6.30
22,000
$138,600
8,000
$50,400
7-Jun-17
$6.60
$0
14,000
$92,400
30-Jun-17
Balance
$466,600
22,000
$142,800
Open Inventory
82,000
Number
of Units
Ending
on Hand
-
Inventory
$0
Average Cost
Open Inventory
Number
of Units
Price paid
purchased
24,000
per unit
$5.00
COGAFS
$120,000
4-Sep-16
16,000
$5.50
$88,000
4-Dec-16
20,000
$6.00
$120,000
6-Mar-17
30,000
$6.30
$189,000
7-Jun-17
14,000
$6.60
$92,400
Total
104,000
$609,400
Average Price=(609,400)/(104,000)
$5.86
Price paid
Number
of Units

Solutions Manual
Number
of Units
Ending
Page 7-23
Balance
30-Jun-17
per unit
$5.86
Expensed
82,000
COGS
$480,488
on Hand
22,000
Inventory
$128,912
Warspite Ltd.
Income Statement
For the Year Ended June 30, 2017
FIFO
Average
$984,000
$984,000
COGS
466,600
480,488
Gross Margin
517,400
503,512
Other Expenses
400,000
400,000
Income before taxes
117,400
103,512
Income Taxes (20%)
23,480
20,702
Net Income
$93,920
$82,810
Ending Inventory
142,800
128,912
Sales
b.
Average cost provides lower income and therefore lower income taxes when prices are rising and
is preferred when tax postponement is the objective.
c.
Warspite would use another method if the primary objective wasnt tax minimization. Perhaps
the bank will use the statements and rely on the balance sheet to assess liquidity and collateral, or
the amount of the loan is in part based on the amount of inventory outstanding. The managers
might have bonuses based on net income, which would establish incentives for them to
maximize, not minimize, net income. Other objectives could also come into play.

Solutions Manual
Page 7-24
E7-23.
a. The equipment should be written off because it can no longer provide future benefit to the
company. Conservatism requires that assets not be overstate assets.
Dr.
Loss on equipment (I/S )

Cr.
Equipment (assets )
25,000
25,000
b. The inventory should be written down to its net realizable value. Otherwise assets are
overstated.
Dr.
Loss on impaired inventory (I/S )

Cr.
Inventory (assets )
40,000
40,000
c. The existing equipment is probably impaired and should be written down.The amount of the
writedown cant be determined with the information provided. The journal entry would look
like this:
Dr.
Loss on impairmentof equipment (I/S )

Cr.
Accumulated depreciation (contra-assets+) or equipment (assets )
d. The loss on the investment should be recognized when it is known. The declaration of
bankruptcy is clear evidence that little if anything will ever be received for the shares.
Dr.
Loss on loan (I/S )
300,000
Cr.
Investment in loan (assets )
300,000
E7-24.
a.
b.
c.
d.
Ending inventory is overstated since Lamline doesnt own the inventory.

Cost of goods sold (COGS) is understated as a result of overstating ending inventory.
(COGS = Beg. Inventory + Purchases End. Inventory)
Gross Margin is overstated as a result of understating COGS. (Sales COGS = Gross
Margin)
Overstatinggross margin results in the overstatement of net income.
E7-25.
a. Ending inventory is counted so it isnt affected assuming the count is correct. However
purchases will be understated for the year.
b. Cost of goods sold (COGS) is understated as a result of understating purchases. (COGS =
Beg. Inventory + Purchases End. Inventory)
c. Gross Margin is overstated as a result of understating COGS. (Sales COGS = Gross
Margin)
d. Overstating gross margin results in the overstatementof net income.

Solutions Manual
Page 7-25
E7-26.
a. Ending inventorycarrying amount for Company A would be higher than Company B by
$50,000.The number of physical units wouldbe the same.
b. Current assets includes inventory so Company As current assets would be $50,000
greater than Company Bs.
c. Overall, Company B would have expensed $50,000 more than Company A (Company B
expensed the full $100,000 in 2017, while A expensed $50,000). Company As $50,000
would be in cost of goods sold while Bs $100,000 expense would be included below
gross margin.
d. Net income would be higher in Company A than in Company B by $50,000 because A
only recognized 50% of the overhead cost as an expense in 2017 while Company B
expensed the entire amount.
E7-27.
a. Write Down =Inventory Cost NRV = ($400,000) ($245,000) = $155,000
b. The write down resulted in a lower gross margin, gross margin percentage, net income
and profit margins.
Hemlo Inc.
Summarized Income Statement
For year Ended December, 2017
With
Writedown
$3,450,000
1,207,500
2,242,500
Without
Write Down
$3,450,000
1,052,500
2,397,500
1,897,500
1,897,500
Net income
345,000
500,000
Gross Margin %
Profit Margin %
65.00%
10.00%
69.49%
14.49%
Sales
Cost of sales
Gross margin
Other expenses
c. For the 2018 income statement COGS would be calculated using the carrying amount of
the inventory on December 31, 2017 ($245,000). As a result net income and gross margin
will be higher than it would have been had there been no writedown in 2017 because part
of the cost was expensed in 2017. This example demonstrates how conservatism can be
used to manipulate financial statements to achieve managements objectives. The gross
margin would have been $155,000 higher in 2017 if the write-down did not occur.

Solutions Manual
Page 7-26
PROBLEMS
P7-1.
In this question students must provide a reasoned explanation for the method selected. The
purpose is not to calculate all possible ending inventory and cost of goods sold values. The basis
of the choice must be the objectives of financial reporting. Assumptions are necessary regarding
Mr. Averys objectives. For example, for a small business tax minimization might be the most
important objective, in which case average cost would be the preferred choice. If Mr. Avery
needs financing from the bank he may prefer reporting high income and higher inventory
(perhaps the banker will be impressed with the higher net income or perhaps the loan will be
based on the amount of inventory), in this case, he would want to use FIFO. It would also be
appropriate to discuss whether a periodic or perpetual inventory system should be used. Since
students should select one or the other, a reason for the choice should be provided. The high cost
of the inventory might suggest that a perpetual system would be appropriate to provide better
control over the inventory. Students should not do well in the question if there is no discussion of
objectives. Calculations are shown below for information purposes. While the discussion of
perpetual versus periodic is appropriate students should only be expected to calculate ending
inventory and COGS using the periodic method.
Number of
Units
Purchased
Openi
ng
Nov.
10
Nov.
20
Nov.
25
Nov.
12
Nov.
22
Cost
per unit
250
$13.00
200
13.50
150
13.75
180
14.00
COGAF
S
$3,250.0
0
$2,700.0
0
$2,062.5
0
$2,520.0
0
$10,532.
50
780
Total
Price
sold
Per
Unit
Number of Units
sold
160
30.00
320
60.00
480
Reven
ue
$4,800
$19,20
0
$24,00
0
FIFO
Cost
per unit
Openi
ng
Nov.
10
Nov.
20
Nov.
Number of
UnitsExpensed
$13.00
250
13.50
200
13.75
14.00
30
COGS
$3,250.0
0
$2,700.0
0
$412.50
$0

Solutions Manual
Number of Units onHand on

Nov. 30
Ending
Invento
ry
$0
120
180
$0
$1,650.
00
$2,520.
Page 7-27
25
Nov.
30
Average Cost
# of Units
purchased
Openi
ng
250
Nov.
10
200
Nov.
20
150
Nov.
25
180
Total
480
Balance
Cost
per unit
$13.00
13.50
13.75
14.00
780
$6,362.5
0
300
00
$4,170.
00
300
Ending
Invento
ry
$4,051.
00
COGAF
S
$3,250.0
0
$2,700.0
0
$2,062.5
0
$2,520.0
0
$10,532.
50
average cost=($10,532.50)/(780)
= $13.503
Balan
ce
Nov.
30
Price paid
per unit
Number of Units
Expensed
13.503
480
COGS
$6,481.5
0
Number of Units
on Hand
Note that exact answers may vary due to rounding.
P7-2.
a.
Current Assets (CA)

Current liabilities (CL)
Current ratio = CA/CL
Quick Assets (QA)
Quick ratio = QA/CL
Beg inventory
End inventory
Average inventory (AI) (beg+end)/2
cost of sales (COS)
Inventory turnover ratio = COS/AI
Average Number days = 365/ITR
Gross margin (GM)
Sales
Cardigan
(FIFO)
$2,165,700
1,455,000
1.49
520,200
1,455,000
0.36
1,432,650
1,582,500
1,507,575
2,548,800
1.69
Huskisson
(Average)
$1,759,950
1,455,000
1.21
520,200
1,455,000
0.36
1,345,500
1,176,750
1,261,125
2,867,400
2.54
215.89
2,761,200
5,310,000
143.35
2,442,600
5,310,000

Solutions Manual
Page 7-28
Gross margin % = (GM)/Sales

Net Income (NI)
Sales
Profit margin % =- NI/Sales
52%
586,200
5,310,000
11.04%
46%
267,600
5,310,000
5.04%
b.
The current ratio indicates that Cardigan is the most liquid but in fact they are all equally liquid.
Huskisson seems to have stronger liquidity as a result of its better inventory management
(inventory turns over faster). The quick ratio is the same for both firms. However, in reality the
liquidity of both firms is the same despite the differences in the measurements in the table. The
apparent differences are purely a result of the different ways that inventory is accounted for and
do not reflect any real economic differences among the firms.
c.
Cardigan appears to be the most profitable because it has a higher profit margin percentage and
higher net income. However, in reality the profitability of both firms is the same despite the
differences in the measurements in the table. The apparent differences are purely a result of the
different ways that inventory is accounted for and do not reflect any real economic differences
among the firms.
d.
Huskisson appears to manage its inventory better than the other firm because it has a higher
inventory turnover ratio, but they both manage inventory equally well. The apparent differences
are purely a result of the different ways that inventory is accounted for and do not reflect any real
economic differences among the firms.
e.
Whether both firms have a different likelihood of obtaining a loan from their banks depends on
whether the lending officers are able to fully unravel the impact of accounting choices. Since the
terms described in the question indicate that the loans are based on accounts receivable and
inventory, Cardigan will obtain the largest loan because it reports the most inventory (accounts
receivable is the same for both). Both firms are equally risky despite what the numbers show.
Since the firms are described to be identical in every respect they must be equally risky (this
assumes they both have similar customers, operate in similar markets, etc.). So while Cardigan
will receive the largest loan both firms are equally risky and it could be justified that the same
loans should be given to each.

Solutions Manual
Page 7-29
P7-3.
Current Assets (CA)

Current ratio = CA/CL
Quick Assets (QA)
Quick ratio = QA/CL
Beg inventory
End inventory
cost of sales (COS)
Gross margin (GM)
Sales
Net Income (NI)
Sales
Profit margin % =- NI/Sales
Weybridge
(FIFO)
360,950
242,500
1.49
86,700
242,500
0.36
240,000
263,750
251,875
552,240
2.19
Kennetcook
(average)
293,326
242,500
1.21
86,700
242,500
0.36
241,406
196,126
218,766
621,270
2.84
166.48
332,760
885,000
38%
90,760
885,000
10.26%
128.53
263,730
885,000
30%
21,730
885,000
2.46%
b.
The current ratio indicates that Weybridge is the most liquid but in fact they are all equally
liquid. Kennetcook seems to have stronger liquidity as a result of its better inventory
management (inventory turns over faster). The quick ratio is the same for both firms. However,
in reality the liquidity of both firms is the same despite the differences in the measurements in
the table. The apparent differences are purely a result of the different ways that inventory is
accounted for and do not reflect any real economic differences among the firms.
c.
Weybridge appears to be the most profitable because it has a higher profit margin percentage and
higher net income. However, in reality the profitability of both firms is the same despite the
differences in the measurements in the table. The apparent differences are purely a result of the
different ways that inventory is accounted for and do not reflect any real economic differences
among the firms.
d.
Kennetcook appears to manage its inventory better than the other firm because it has a higher
inventory turnover ratio, but they both manage inventory equally well. The apparent differences
are purely a result of the different ways that inventory is accounted for and do not reflect any real
economic differences among the firms.
e.

Solutions Manual
Page 7-30
Whether both firms have a different likelihood of obtaining a loan from their banks depends on
whether the lending officers are able to fully unravel the impact of accounting choices. Since the
terms described in the question indicate that the loans are based on accounts receivable and
inventory Weybridge will obtain the largest loan because it reports the most inventory (accounts
receivable is the same for both). Both firms are equally risky despite what the numbers show.
Since the firms are described to be identical in every respect they must be equally risky (this
assumes the three have similar customers, operate in similar markets, etc.). So while Weybridge
will receive the largest loan both firms are equally risky and it could be justified that the same
loans should be given to each.
P7-4.
Note: This question is designed to get students thinking about the basis for making accounting
choices. Accounting choices arent made in a vacuum. Managers will (should) consider the
impact of the choices. In this question there are two inventory accounting choices to consider:
the cost formula and periodic versus perpetual inventory control. To provide a good answer,
students must consider the information provided, the reporting objectives of the various
stakeholders, and the nature of the business. It is important to recognize that there is no one
correct answer (though there can be many poor ones). The quality of an answer is based on a
students ability to interpret the scenario and provide recommendations that make sensethat
are consistent with the scenario. For example, in this problem it would be reasonable to argue
that tax minimization is most important or that given the ongoing cash shortage, providing
information attractive to the bank might be more appropriate. Students should play the role when
responding, meaning that a report to management should be written. Explanations should be tied
to the objectives of reporting. The discussion below outlines the considerations a student can
bring to a response:
Considerations:
Objectives: The most likely objectives are tax minimization or increasing income and assets to
support additional financing from the bank. Tax minimization makes sense because Riondel is
privately owned, all owners are involved in management (no external shareholders), there is debt
outstanding and the bank loan is personally guaranteed, which suggests that the bank is also a
key user. In support of income and asset maximization is that the company is short of cash,
which means that additional financing may be needed and the owners might want to show the
income earning potential of the company and available assets as collateral (high inventory
value). Reducing taxes, however, will help conserve needed cash.
Facts: The computer business is marked by rapid change and declining inventory values as new
products replace old. Obsolete inventory is a concern. Many parts are expensive, as are finished
goods.
Accounting Issues
Cost formula: For tax minimization FIFO may be the best choice because computer businesses
tend to operate in falling price environments. With FIFO the oldest, highest costs will be
Solutions Manual
Page 7-31
expensed first, lowering net income and taxes. For bank loan purposes average cost would be
more appropriate since there will be higher inventory values and higher net income.
Perpetual versus periodic control: Many inventory items are expensive (even though the
company tries to keep the laptop prices as low as possible) and so good control over parts, workin-process, and ending inventory is important. A perpetual inventory system would be
appropriate in these circumstances.
Lower of cost and NRV: For finished goods, net realizable value makes sense since there will be
a market for finished goods. It may be more difficult to determine the NRV of parts so
replacement cost would be more functional. Since CRA allows application of the lower of cost
and market for tax purposes, Tesseralik should take advantage of write downs when available to
reduce taxes (assuming a tax minimization objective). While CRA uses lower of costs and
market for accounting purposes lower of cost and NRV includes a further reduction of selling
costs. Therefore from a tax bases market value and replacement costs outside of selling cost can
be used as a bases for inventory valuation.
Given an objective of tax postponement, you will want to select accounting policies that reduce
ending inventory to the lowest acceptable value. Direct costing is permitted by Canada Revenue
Agency and will ensure that all fixed overhead costs are expensed as early as possible. In your
industry, prices tend to fall continuously, so FIFO will result in delaying income. Since lower of
cost and market is permitted by CRA, you will also benefit from writing down cost to market.
P7-5.
Note: This question is designed to get students thinking about the basis for making accounting
choices. Accounting choices arent made in a vacuum. Managers will (should) consider the
impact of the choices. In this question there are two inventory accounting choices to consider:
the cost formula and periodic versus perpetual inventory control. To provide a good answer,
students must consider the information provided, the reporting objectives of the various
stakeholders and the nature of the business. It is important to recognize that there is no one
correct answer (though there can be many poor ones). The quality of an answer is based on a
students ability to interpret the scenario and provide recommendations that make sensethat
are consistent with the scenario. For example, in this problem the circumstances point to
management wanting to smooth earnings (to appear less risky) or maximize earnings to
maximize its initial public offering (IPO) and attract new shareholders (who may rely on
financial statements to assess management and performance before investing) and creditors.
There is also the management bonus which creates incentives for management to increase
income. Liquidity measurement is also an issue because Ormiston pays surplus cash out to the
shareholders. Being aware of the cash requirements is crucial for determining surplus cash.
Students should play the role when responding, meaning that a report to management should be
written. Explanations should be tied to the objectives of reporting. The discussion below outlines
the considerations a student can bring to a response:

Solutions Manual
Page 7-32
Objectives: The minimization of taxes is a consideration since the shareholders are obviously
quite cash conscious since they receive distributions when there is surplus cash. Minimizing
taxes would create more surplus cash. However, an important use of the financial statements is
for reporting to the investors who arent involved in the management of the company and will
require information for assessing the performance of the business and management. It is possible
that management may choose between either income smoothing to appear less risky to attract the
most investors or income maximization to achieve the highest stock price when the company
goes public with its IPO. The use of net income to determine management bonuses requires that
it reflect the results of management decisions. The bank will require the financial statements to
assess the ability of the firm to meet its obligations and to determine the maximum amount that
the firm can borrow. It is likely that the latter uses will dominate managements concerns and so
an income smoothing or income maximizing strategy will prevail.
Facts: There is a question of whether the accounting policies need to comply with IFRS. IFRS is
automatically required for public companies and may be needed to add credibility to the
statements. The absent shareholders, as well as the bank, along with the IPO IFRS compliant
statements will be required.
Lumber prices are quite volatile. For many companies, prices are either rising over time or
falling, but that is not the case for Ormiston. Because of changing market conditions, prices can
be rising or falling in any given period.
Cost formula: Given the volatility of the price of lumber it is difficult to choose an inventory
valuation method that will consistently meet the objectives. Good discussions should integrate
the volatility of lumber prices and its impact on reporting. FIFO will provide more useful balance
sheet valuation because the most recent costs will appear on the balance sheet. Average cost may
provide some smoothing effect, which could be desirable to management.
Periodic versus perpetual: Ormistons inventory is shingles (large number of similar, low priced
items) and inputs into the production of shingles. Control over quantities of inventory is
important for inventory management and for insuring that adequate raw materials are on hand.
However, a perpetual costing system may not be cost effective.
Lower of cost and NRV: Market for finished goods is best method of valuation of the inventory.
since the main raw material is a commodity the market value is readily available. Selling cost
may need estimations from management to complete the NRV calculation.

Solutions Manual
Page 7-33
P7-6.
a.
b.
b.(1)
c.
d.
e.
Net
income
Cost of
sales
Total
assets
Owners
equity
Current
ratio
Inventory
turnover
Debt to
equity
Overstated
Understated
Overstated
Overstated
Overstated
Understated
Understated
Understated
No effect
Understated
Understated
Understated
Overstated
Overstated
Understated
Understated
Understated
Understated
Understated
Ambiguous
Overstated
Understated
Overstated
Understated
Understated
Understated
Overstated
Overstated
Overstated
Understated
Overstated
Overstated
Overstated
Understated
Understated
Understated
Overstated
Understated
Understated
Understated
Overstated
Overstated
a. Decrease in cost of sales and an increase in the value of the inventory that should not have
happened.
b Assuming the costs were excluded from inventory at the end of the period therefore an increase
in other expenses and a decrease in inventory that should not have happened.
b (1) Assuming the costs were excluded from inventory during the period therefore an increase
in other expenses. During the period some of the inventory would have been sold resulting in
cost of sales being lower than it otherwise would have (because the cost is no longer in
inventory). The result for inventory turnover is ambiguous in the scenario because the missing
cost that was excluded from inventory gets allocated between inventory and cost of sales.
Initially, the reducedvalue of inventory would result in the ITO to be overstated. As the
inventory is sold the cost of sales would be proportionately understated and ultimately ITO is
understated. As a result the ITO could be overstated or understated.
c. By not counting the inventory assets was understated resulting in ending inventory being
understated as well. Assuming a periodic system cost of sales was overstated based on Cost of
Sales = Beginning. Inventory + Purchases Ending. Inventory.
d. Should have been a write down on the inventory thus inventory is overstated and COS is
understated.
e. Assuming it was not appropriate to recognizethe revenue (FOB Destination) net income, cost
of sales, owners equity and the debt to equity ratio would all be affected. Total assets would be
understated as inventory title as not changed hands. Therefore the current ratio would also be
understated. ITO would be overstated due to inventory being understated.

Solutions Manual
Page 7-34
P7-7.
a.
b.
c.
d.
Net income
Cost of
sales
Total
assets
Owners equity
Current
ratio
Inventory
turnover
Debt to equi
Overstated
Overstated
Overstated
Overstated
Overstated
Overstated
Understated
Understated
Overstated
Understated
Understated
Understated
Overstated
Overstated
Understated
Overstated
Understated
Understated
Understated
Overstated
Overstated
Overstated
Understated
Overstated
Overstated
Overstated
Understated
Understated
a. Assuming that inventory is sold for a profit. The year-end count will be low thus, a lower
inventory amount in assets and higher COGS then what should be recorded. Sales and
receivables would be overstated (resulting in an overall overstatement of total assets as
receivables would be overstated by a larger amount than the inventory understatement). As a
result net income and owners equity would be overstated and the debt to equity ratio would be
understated. Inventory turnover would be overstated due to the increase in COGS and decrease
in inventory.
b Not counting inventory would result in less ending inventory resulting is a higher cost of sales.
(Cost of Sales = Beginning Inventory + Purchases. Ending Inventory)
c. Assuming that the subsequent write-up would have been included in COGS (as a gain) net
income and equity would be understated, COGS and the debt to equity ratio would be overstated.
The overstatement of COGS also results the ITO being overstated because COGS should be
lower and inventory higher. Total assets is also understated due to the decreased inventory
balance. Therefore the current ratio is also understated.
d. Inventory on consignment belongs to on the suppliers records therefore counting it as part of
the companys asset is increasing inventory that doesnt belong in the companys books. This
will result in COGS being lower and assets being too high.
P7-8.
To the management of Enterprise Inc.:
I have examined the information that you have provided to me and make the following estimate
of the inventory destroyed by flood on August 19, 2017.
Beginning inventory
Purchases
Cost of goods available for sale
Sales at Retail
$980,000
Sales at cost = 65% of 980,000 =
Estimated inventory at time of fire
$1,125,000
325,000
$1,450,000
637,000
$813,000
Since the deductible is $20,000, the claim should be for $793,000. This represents the cost of the
inventory lost at the time of the fire.

Solutions Manual
Page 7-35
This estimate is based on the assumption that there was no theft or spoilage during the period and
that the gross margin for the merchandise that was sold was the usual 35%. It is also assumed
that there was no obsolete inventory on hand. If these assumptions arent valid, the estimate
wont be correct.
P7-9.
Category 1
$325,000
300,000
$625,000
Beginning inventory
Purchases
Sales at Retail $610,000& $595,000
Sales at cost = 35% of 610,000 =
52% of 595,000 =
Estimated inventory at time of the robbery
Category 2
$525,000
285,000
$810,000
213,500
309,400
$500,600
$411,500
The claim should be for a total of $912,100.

This estimate is based on the following assumptions
No losses due to other theft, damage, or spoilage during the period
Gross margins for the merchandise sold were the usual percentages.
There was no obsolete inventory on hand and there were no accounting errors in the
records.
If these assumptions arent valid, the estimate wont be correct.
P7-10.
Inventory category
Cost
Net realizable value
Lower of Cost or NRV
Category 1
$168,000
$187,500
$168,000
Category 2
346,500
322,500
$322,500
Category 3
111,750
112,800
$111,750
Category 4
147,150
117,750
$117,750
Category 5
220,500
228,000
$220,500
$993,900
$968,550
$940,500
Total
a.
When Lower of Cost and NRV is determined on an item by item basis, the amount to recognize
as inventory on the balance sheet is $940,500.

Solutions Manual
Page 7-36
b.
A write down of inventory of $53,400 would be needed.
c.
Dr.
Loss on inventory
$53,400
Cr.
Inventory
$53,400
To record the loss in inventory value.
P7-11.
Category
Total cost
NRV
Lower of cost and NRV
Category 1
$276,178
$679,874
$276,178
Category 2
$480,291
$1,099,918
$480,291
Category 3
$685,125
$599,760
$599,760
Category 4
$315,549
$740,230
$315,549
Category 5
$175,828
$161,143
$161,143
$1,932,972 $3,280,925
$1,832,921
Total
a.
The lower of cost and NRVdetermined on an item-by-item basis should be displayed on the
balance sheet: $1,832,921.
b. A write-down of $100,051(1,932,972 1,832,921) is required.
c. Dr. Loss on inventory
$100,051
Cr. Inventory
$100,051
To record the decline in inventory value.
d. Category 3 and 5 were written down to NRV and now average cost is lower than NRV
therefore we must reverse the write down on the units remaining back to their original cost.
Category
Number
of units
that were
on hand
on
December
31, 2017
Category 3
21,520
$15.23
$17.40
$2.17
$46,698
Category 5
8,104
$8.59
$9.10
$0.51
$4,133
Carrying
amount of
units on
Dec. 31,
2017
NRV on
March 31,
2018
Increase
inNRV per
unit
Total
Write up
Amount
$50,831
Note: numbers are rounded

Solutions Manual
Page 7-37
Dr. Inventory
$50,831
Cr. Gain on Inventory
$50,831
Reversing previous write down of inventory
e.The carrying amount of inventory on March 31, 2018 should be $1,908,883.This is preadjustment amount of all the inventory ($1,858,052) plus the reversal of the writedown on
December 31, 2017 (50,831).
P7-12.
a.
Beginning inventory
Purchases
Cost of sales
Cost of damaged merchandise
Estimated inventory at time of theft
Actual inventory count
Estimated loss due to theft
3,279,706
1,244,550
4,524,256
1,319,320
15,688
3,189,248
3,066,896
$122,352
Another approach to the same solution; this approach compares the actual amount of cost of
goods sold with the amount that is recorded in the accounting system.
Inventory
End
(=)
3,066,896
Actual Amt
beginning
(+)
3,279,706
Purchases
(-)
1,244,550
COGS 1
?
1,457,360
Recorded Amt
Loss
Less damaged
Estimated stolen
COGS 2
138,040
15,688
122,352
(=)
1,319,320
Loss = COGS 1 - COGS 2
b.
Its possible that some portion of the estimated loss is due to thefts that occurred at another time,
was due to damage in addition to the amount estimated, or was the result of accounting errors
somewhere in the accounting system. Another possible explanation is errors in the inventory
count.
c.

Solutions Manual
Page 7-38
There is no other way to know with certainty how much inventory is on hand. Any other method
could be incorrect. The purpose is to compare the actual amount of inventory on hand with the
amount that should be on hand if there were no inventory losses, errors, etc.
P7-13.
Beginning inventory
Purchases
Cost of sales*
Cost of returned merchandise
Estimated ending inventory
Actual inventory count
Estimated loss due to theft
1,910,000
802,500
2,712,500
975,000
81,000
1,656,500
1,440,000
$216,500
*Cost of sales = Sales * (100%-25%)

=$1,300,000 * 75%
=$975,000
b.
Its possible that some portion of the estimated loss is due to thefts that occurred at another time,
was returned to suppliers in addition to the amount estimated, or was the result of accounting
errors somewhere in the accounting system. Another possible explanation is errors in the
inventory count.
c. There is no other way to know with certainty how much inventory is on hand. Any other
method could be incorrect. The purpose is to compare the actual amount of inventory on hand
with the amount that should be on hand if there were no inventory losses, errors, etc.
d.Yes, the inventory would still need to be counted because its necessary to determine the actual
amount of inventory on hand. A perpetual inventory control system doesnt record consumption
of inventory caused by theft, loss, damage, or accounting errors. The physical count provides
information about the effectiveness of the controls over inventory.

Solutions Manual
Page 7-39
P7-14.
a. and b.
Revenue
Cost of sales
Gross margin (GM)
Sales
Beg inventory (2017)
End inventory (2018)
cost of sales (COS)
Porcelain
$862,500
345,000
517,500
862,500
60%
146,250
159,500
152,875
345,000
2.26
162
Toys
$692,750
415,750
277,000
692,750
40%
168,750
126,250
147,500
415,750
2.82
129
Linens
$405,750
202,875
202,875
405,750
50%
102,500
147,500
125,000
202,875
1.62
225
Total
1,961,000
963,625
997,375
1,961,000
51%
417,500
433,250
425,375
963,625
2.27
161
c.
By examining the aggregate and segmented ratios, we can see that the porcelain category has the
highest gross profit percentage while the inventory of toys turns over most frequently. The
detailed information enables us to know which products are more profitable. From a
management perspective, the results suggest that the inventory of linens might be reduced to
boost the turnover.
d.
The aggregated information conceals valuable information. If we know that sales of figurines are
an increasing proportion of total sales, for example, we know that the implications for profits are
greater than if more toys were to be sold. We also might be concerned if the turnover was low in
a category that was subject to obsolescence. Over time it could be difficult to interpret changes in
these measurements. Any changes could be due to differences in performance but they could also
be due to changes in the relative weights of the three lines of business. Also, it would be difficult
to compare Xenas performance with other companies because the composition of its business
activities would likely be unique.
P7-15.
a. and b.
Revenue
Cost of sales
Gross margin (GM)
Sales
Beg inventory (2016)
End inventory (2017)
cost of sales (COS)
Perishable
$2,375,000
2,000,000
375,000
2,375,000
16%
50,000
42,500
46,250
2,000,000
43.24
8
Packaged
$2,013,000
1,650,000
363,000
2,013,000
18%
183,500
306,000
244,750
1,650,000
6.74
54

Solutions Manual
Household
$2,625,000
1,925,000
700,000
2,625,000
27%
437,500
525,000
481,250
1,925,000
4.00
91
Total
7,013,000
5,575,000
1,438,000
7,013,000
21%
671,000
873,500
772,250
5,575,000
7.22
51
Page 7-40
c.
Although the sales of the three product categories are fairly similar, there is a difference in the
profitability of the products and a very large difference in the turnover of inventory. We may
want to examine the cost of holding inventory to identify whether the higher margins on
packaged goods and household items are more than offset by higher inventory holding costs. A
great deal of valuable insight is available from the detailed breakdown that is not obtainable from
aggregated information. We may wish to allocate more store space to product lines that are more
profitable. The turnover for perishable items makes sense. Meat, dairy products, fruits, and
vegetables have to be sold quickly or disposed of when (or as) they spoil. Packaged and
household items have much longer shelf lives. While it might be attractive to focus on the most
profitable items, the stores must still provide enough breadth of products to satisfy customer
demandfailure to do so might drive customers elsewhere. Also, the lower gross margin of the
perishables may be overcome by the high turnover.
P7-16.
a.
FIFO
Cost
per unit
Opening
Inventory
First Quarter
Second
Quarter
Third Quarter
Fourth Quarter
31-Dec-17
Number
of Units
sold
COGS
Number of Units on
Hand on Dec. 31,
2017
Ending
Inventory
$6.00
$6.15
5,000
4,000
$30,000
$24,600
$0
$0
$6.45
$6.60
$6.80
5,500
9,500
1,000
$35,475
$62,700
$6,800
2,500
$0
$0
$17,000
Balance
25,000
$159,575
2,500
$17,000
Number of
Units
purchased
Cost
per unit
COGAFS
5,000
4,000
$6.00
$6.15
$30,000
$24,600
5,500
9,500
3,500
27,500
$6.45
$6.60
$6.80
$35,475
$62,700
$23,800
$176,575
Average Cost
Opening
Inventory
First Quarter
Second
Quarter
Third Quarter
Fourth Quarter
Total
Average cost=$176,575/27,500
= $6.42
Solutions Manual
Page 7-41
31-Dec-17
Cost
per unit
6.42
Number
of Units
sold
25,000
COGS
$160,523
Number of Units on
Hand on Dec. 31,
2017
2,500
Ending
Inventory
$16,052
Summary
For the Year ended Dec. 31, 2017
FIFO
Average
Periodic System
$281,750
$281,750
Sales
159,575
160,523
COGS
122,175
121,227
Gross Margin
Ending Inventory
17,000
16,052
b.
The amount of cash paid for inventory in 2017 was $146,575 and is the same under all cost
formulas. The cost formulas have no effect on the cash paid to suppliers. They only determine
the costs that are expensed each period and the costs included in inventory.
c.
If the objective of the entity were to minimize taxes, the preferred method would be average cost,
which results in the highest cost of goods sold, at $160,523.
d.
FIFO yields the lowest cost of goods sold and therefore the highest income, which would provide
the largest bonus to the CEO.
e.
The highest balance sheet value is provided by FIFO. If the loan is affected by the amount of
inventory reported, a higher inventory value is preferred because it results in a larger loan.
f.
Ending Inventory
NRV per unit
Quantity at year end
NRV on Dec. 31, 2017
Write down
Inventory on Dec., 2017
balance sheet
FIFO
$17,000
6.25
2,500
15,625
1,375
Average
$16,052
6.25
2,500
15,625
427
15,625
15,625
At $6.25, the total net realizable value of the inventory would be $15,625. With either alternative
cost would exceed market and inventory should be written down to $15,625. Its assumed that
the NRV of $6.25 includes selling costs. If it doesnt the writedown in both cases would be
greater.
Solutions Manual
Page 7-42
g.
In this particular case, there is very little difference in income between the alternatives. Ending
inventory under average cost $16,052 and $17,000 under FIFO, a difference of less than $1,000,
which for most purposes isnt material. Further, after applying lower of cost and NRV the
methods provide the same valuation. In general, the choice of accounting method can matter a
lot. Outcomes that are based on accounting numbers such as bonuses, bank loans, compliance
with covenants, and taxes can be affected by accounting measurements. However, regardless of
the different measurements that can be used, the underlying economic activity being measured is
the same.
P7-17.
a.
FIFO
Open Inventory
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
30-Apr-18
Cost
per unit
$5.50
$7.00
$8.00
$8.50
$7.40
Balance
Number of Units
sold
150,000
180,000
102,000
124,000
COGS
$825,000
$1,260,000
$816,000
$1,054,000
$0
$3,955,000
556,000
Number of
Units on Hand
on
April. 30, 2018
-
16,000
160,000
176,000
Ending
Inventory
$0
$0
$0
$136,000
$1,184,000
$1,320,000
Average Cost
Open Inventory
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
Total
Number of
Units
purchased
150,000
180,000
102,000
140,000
160,000
732,000
Cost
per unit
$5.50
$7.00
$8.00
$8.50
$7.40
COGAFS
$825,000
$1,260,000
$816,000
$1,190,000
$1,184,000
$5,275,000

Average cost=$5,275,000/732,000
=7.206
Balance
30-Apr-18
Price paid
per unit
$7.206
Number of
Units
Expensed
556,000

Solutions Manual
COGS
$4,006,694
Number of
Units
on Hand
176,000
Ending
Inventory
$1,268,306
Page 7-43
Summary
For the Year ended April 30, 2018
FIFO
Average
Periodic System
$8,896,000
$8,896,000
Sales
3,955,000
4,006,694
COGS
4,941,000
4,889,306
Gross Margin
Ending Inventory
1,320,000
1,268,306
b.
The amount of cash paid for inventory in fiscal 2018 was $4,450,000 and is the same under both
cost assumptions. The cost formulas have no effect on the cash paid to suppliers. They only
determine the costs that are expensed each period and the costs included in inventory.
c.
If the objective of the entity is to minimize taxes, the preferred method in this case would be
average which results in the highest cost of goods sold, at $4,006,694.
d.
FIFO yields the lowest cost of goods sold and therefore the highest income, which would provide
the largest bonus to the CEO.
e.
The highest balance sheet value is provided with FIFO. If the loan is affected by the amount of
inventory reported, a higher inventory valuation is preferred because it will result in a larger
loan.
f.
The NRV of the inventory (most recent selling price is $16 per unit) is greater than most recent
cost per unit or the average cost per unit. Therefore no writedown is required since NRV exceeds
both the FIFO and average cost. This analysis doesnt include selling cost per unit (which isnt
provided). If selling costs are greater than about $9 per unit then a writedown would be
necessary.
g.
In this case, the cost of merchandise has fluctuated, with the result that no predictable
relationship exists among the cost formulas with respect to income effects. Additionally, the
differences are minimal among the methods in 2018. There is therefore no basis for preferring
one method over another except for the balance sheet effect, which is also probably not material.
In general, the choice of accounting method can matter a lot. Outcomes that are based on
accounting numbers such as bonuses, bank loans, compliance with covenants, and taxes can be
affected by accounting measurements. However, regardless of the different measurements that
can be used, the underlying economic activity being measured is the same.

Solutions Manual
Page 7-44
P7-18.
Note: The purpose of this question is to get students thinking about changes in the business
environment, in this case growth, as it relates to inventory control. Students should consider the
type of inventory control, periodic versus perpetual, as well as cost formulas. Another factor to
consider is the valuation of the inventory to see if trends that are not selling are written-down to
lower of cost and NRV. For a proper analysis information learned to this point should be used to
access the situation such as accounts receivable turnover to fully assess the situation for Punichy.
The discussion below outlines the calculations/analysis a student can bring to their answer:
Preliminary Calculations (Considering year over year changes should help in the analysis
however the analysis should not stop here):
Sales
2017
2016
2015
2014
2013
$41,072,051
$35,406,941
$31,613,340
$27,731,000
$25,210,000
16%
Change in Sales
14%
12%
Cost of sales
26,080,753
22,306,373
10%
19,853,178
17%
Change in cost of sales
17,331,875
15%
12%
Accounts receivable
5,748,969
4,905,259
11%
4,185,098
17%
Change in A/R
3,869,256
13,632,775
11,206,037
23%
9,072,483
22%
Change in inventory
3,151,250
8%
17%
Inventory
15,630,200
8,191,149
6,252,080
11%
24%
31%
Change from Year 1

and 5
Sales
63%
Cost of sales
67%
Accounts receivable
82%
Inventory
118%
From the preliminary calculations growth in A/R and inventory is out pacing sales. Comparing
year 1 and 5 the results are more staggering. This demonstrates he need for a further analysis.
Primary Analysis (This is where students should focus their discussion on):
2017
2016
2015
2014
2013
$41,072,051
$35,406,941
$31,613,340
$27,731,000
$25,210,000
Cost of sales
26,080,753
22,306,373
19,853,178
17,331,875
15,630,200
Gross Margin
14,991,298
13,100,568
11,760,162
10,399,125
9,579,800
36%
37%
37%
38%
38%
Sales
Gross Margin %

Solutions Manual
Page 7-45
Accounts receivable
5,748,969
4,905,259
4,185,098
3,869,256
7.710
7.790
7.850
7.900
47.341
46.855
46.497
46.203
Inventory
13,632,775
11,206,037
9,072,483
8,191,149
Average Inventory
12,419,406
10,139,260
8,631,816
7,221,615
2.10
2.20
2.30
2.40
173.81
165.91
158.70
152.08
ARTO
Average collection
Period
ITO
Days in inventory
3,151,250
6,252,080
While Punnichy has been able to predict trends with great success his forecast for demand
appears to be overly optimistic. This has translated to the excess production of styles that may
not be selling and as a result is just sitting on the shelves. The fashion industry is volatile within
itself with trends changing more than once in an operating cycle. This is a choice that Punnichy
must make in terms of reducing the amount of inventory he carries and the risk of not having
immediate inventory of the items that his customers want. Furthermore the value of Punnichys
inventory is in question as to whether or not it has been written down to lower of cost and net
realizable value. From the results the controls in place to manage inventory is weak and is the
primary concern. A breakdown of each issue and recommendation is as follows:
Accounts receivable: Accounts receivable turnover has not changed much year over year and
depending on what Punnichys payment terms are they maybe reflective of the actual situation.
To improve this ratio Punnichy may want to consider trade discounts for early payment and/or
decrease their current payment terms. For example provide a 2% discount if payment is made
within 10 days and/or even reducing payment terms from 30 days.
Inventory: There is not enough information to determine which cost formula to use at this point
without receiving further information. The choices that exist include, FIFO, average cost and
specific identification. However the selection of cost formulas will not affect the economic
reality of whether or not the inventory is selling but rather only affect the presentation of the
carrying value of inventory on hand in the balance sheet and subsequent ratio calculations.
With the inventory value increasing year over year it has translated to a lowering turnover and
increasing the days the goods are sitting in inventory (from 152 to 174 days). The concern here
is that inventory on hand is growing and with barcode technology being standard, Punnichy may
want to consider a perpetual inventory system to track the inventory. This way quantities on hand
of each style in inventory is readily available. A periodic inventory system is only updated at the
end of each financial statement date and may not be as effective at providing immediate
information for the company. A perpetual inventory system will help Punnichy to see which
styles are sitting accumulating in inventory and are not selling as much as forecasted. This
information will lead to better decision making in production of other styles in the future.
Punnichy at this point will need to consider the valuation of the inventory on hand as the
carrying value of inventory may no longer reflect what the company can receive for it. In some
incidences Punnichy may need to sell them below cost hence a valuation of lower of cost and net
realizable value is needed, especially given the industry the company is in. Writing down
Solutions Manual
Page 7-46
inventory will better match the income earned in each period and also serves as a tax reduction
on income earned in that year. To help inventory turns Punnichy may also want to consider
volume discounts, or immediate mark-down of prices after the initial release of styles to
encourage the sale of inventory remaining.
Gross Margin and gross margin percentage: This appears to be stable year over year but we need
to confirm that inventory has been written down to NRV. If there has not been annual
writedowns cost of sale is understated and gross margin is overstated. While gross margin is
decreasing by a nominal percentage year over year writing-down inventory will have a major
impact on the net income in the upcoming year.
P7-19.
December 31,
2018
2017
2016
2015
2014
Sales
$473,664
$459,868
$453,071
$444,188
$431,250
Cost of sales
$329,695
$317,015
$311,409
$302,928
$293,250
Gross Margin
$143,969
$142,853
$141,663
$141,260
$138,000
Inventory
$148,358
$138,651
$130,804
$124,338
$117,300
GM%
Average inventory
ITO
Average number days in
inventory
30%
31%
31%
32%
32%
$143,505
$134,728
$127,571
$120,819
$115,540
2.3
2.35
2.44
2.51
2.54
158.87
155.12
149.52
145.58
143.81
2013
$
$113,780
Problems, consequences, explanations, solutions

Dear Mr. Champlain,
Given the information that you have provided I have identified the following trends:
The gross margin percentage has been slowly declining. This is likely due to increased
competitive pressures that are having a downward effect on prices. If this trend
continues, it may be difficult to operate in a profitable manner if you are unable to
decrease other expenses.
Average inventory on hand has been increasing steadily. Combined with the decreasing
inventory turnover rate and the increasing amount for the average number of days that
inventory is on hand it would appear that inventory is slowly building up. This is likely
due to increased competition in the industry.
These trends indicate that cost of sales and inventory are growing at a faster rate than sales.
Unless changes are made to increase sales revenue or decrease costs, profitability will continue
to decline. Additionally, you face the risk of obsolescence (books may become less popular over
time and their market price may decline) and increased holding costs due to the increasing
inventory levels and declining turnover rate.

Solutions Manual
Page 7-47
Again, these trends can likely be explained by the competitive pressures that your company faces
which have most likely damaged market share and deflated market prices.
In order to improve your business you may consider decreasing the amount of inventory you
hold. This is a risky practice as you want to ensure that customers do not leave if they cannot
find the book they are looking for so balancing this risk against cost benefits will be important.
Additionally, you may try to use different marketing techniques that could increase sales
volumes and keep inventory moving. Perhaps having a buy-one-get-one half off sale on older
books or offering customers the chance to purchase a discount card which allows them to
purchase books for the year at a reduced rate could help to get inventory moving faster and
improve customer loyalty.
Please note that in order to perform a full analysis additional information would be required such
as a balance sheet, income statement, and statement of cash flows. Furthermore, industry data
would also be helpful to determine how your company is fairing in comparison to other similar
companies.
Please contact me if you have any further questions or concerns.
P17-20.
2017
$2,073,883
2016
$1,723,880
2015
$1,639,806
2014
$1,572,000
Total Current Assets
4,497,883
3,378,680
2,881,806
2,659,200
Total current liabilities
4,509,600
3,120,000
2,532,000
2,202,000
Quick ratio
0.46
0.55
0.65
0.71
Current ratio
1.00
1.08
1.14
1.21
GM%
47%
45%
45%
N/A
$2,002,200
$1,413,000
$1,126,800
N/A
2.06
2.87
3.37
N/A
177.03
127.05
108.37
N/A
Total quick assets
Average inventory
ITO
Average Number days in inventory
Overall assessment:
PCME faces the difficult challenge of constantly estimating what amount of inventory to keep on
hand to ensure that retailers requirements are met. It also must wait 60 days for payment, which
puts a strain on the companys cash flows. In a deteriorating economy, waiting 60 days could
prove difficult. Additionally, maintaining profitability and liquidity during a deteriorating
economy may be challenging.
Liquidity Assessment:
PCMEs gross margin improved which is a positive sign given the current economy. It means
that its making more per item sold. Sales have been increasing (by almost 12 percent since
2015), definitely good news in a declining economy. Inventory has been increasing as well but at
Solutions Manual
Page 7-48
a much faster rate. This is reflected in the decrease in inventory turnover. Both the quick and
current ratios have also declined which indicates increasing liquidity issues. Accounts receivable
have also been increasing, also at a rate much faster than sales and cash is at its lowest level over
the last four years. The short-term bank loan and accounts payable have also been increasing
quickly. If the economy continues to deteriorate a serious liquidity problem is possible if
receivables become less collectable and inventory less saleable.
a. PCME could increase its inventory turnover by reducing prices to move older inventory.
It could also provide volume discounts to customers to encourage them to purchase in
greater quantities which could help to move the additional inventory that is on hand.
Another suggestion would be for PCME to charge an additional fee for special orders,
which could help reduce the extra inventory that PCME has to carry in the event that
special orders do occur. However, this practice is risky as an additional fee could cause
customers to look for another supplier. PCME should take a careful look at its product
line and consider whether there are items that could be discontinued. As a matter of
practice the company should not just keep adding products each year without removing
older ones. Otherwise, the amount of inventory on hand will proportionally grow.
Whether or not these suggestions can be reasonably achieved depends on the market
conditions and their relationships with customers. Volume discounts or discounts in
general of slow moving inventory are likely the more reasonable option for PCME given
the information available. Paring the product line is essential.
b. An improvement in company liquidity would help it to operate more securely by ensuring
that cash was available to pay suppliers and employees and obtain financing in the event
that loans are required. A reduction in inventory turnover implies less inventory (in this
case), which frees up cash for other operating purposes, including having a larger cash
reserve and reducing the bank loan.
c. ITO is an important indicator of liquidity as it shows how many times inventory turns
over in a year and therefore how long it will take for cash to be generated by the
inventory that is on hand. Having a decreasing ITO indicates a weakening liquidity
position as cash is tied up in items that may not be selling.
P17-21.
Note: While there may be more than one approach to this discussion the discussion should be
relevant to the current and past chapters studied.
Facts: Freshwater is in the industry of widgets and with increased competition from foreign
competitors, it is affecting Freshwaters business negatively. Freshwater is the only domestic
manufacturer and other companies have been squeezed out by the foreign competition. While
they are able to stay in business based on their high quality widgets their profits are declining.
The purpose of the loan is to improve the companys liquidity position with no mention of
investment in things like new technology to improve efficiency and reduce cost. As it stands
while sales are increasing profits are not. As a bank whether or not to grant the loan should be
based on a risk analysis of the business and the facts presented by Freshwater.

Solutions Manual
Page 7-49
Additional information: In order to grant the loan the bank must first look at the financial
statements; the Balance Sheet to access financial position, Income Statement to assess
profitability and Cash flow statement to assess the management of cash and liquidity. Since
Freshwater is a family run business their financial statements may not be prepared according to
accounting standards such as IFRS or ASPE. As a result prior to granting any loans, financial
statements should be audited according to standard prior to beginning any analysis.
Assessment of risk: In order to grant the line of credit there are a few things that need to be
considered in order to assess the riskiness of the loan. Risk can be looked at from the following
perspectives:
Market Condition Risks: Observe market trends to see if the demand for widgets are increasing
internationally or diminishing. Freshwater only makes widgets and if the market is shrinking,
granting a long term loan may not be a good idea. Freshwater does not have another product line
it can rely on to mitigate this risk. The competition and the quality of their widgets must also be
looked at. Are Freshwaters widgets that much more superior to sustain current market share or
increase market share? Has the impact of foreign competition caused Freshwater to reduce the
selling price of their widgets? If Freshwater has been forced to reduce prices to maintain market
share how will this affect the business profitability in the next 2, 3 or even 10 years? All these
questions need to be asked and assessed. The analysis of current and future market conditions
can help the bank decide if repayment can be assured in the future.
Operational Risks: Inventory is a major concern along with the cost of manufacturing. Some
questions to ask may include: Are the funds of the company tied to inventory that are not selling?
Hence instead of looking at their current ratio may be the quick ratio is more reflective of their
ability to meet current obligations. Is Freshwater writing down inventory to lower of cost and
NRV year over year? If inventory is a major balance sheet item on Freshwaters financial
statement then adoption to IFRS or ASPE will require write-downs that further reduce the
companys liquidity position. At this point the valuation of Freshwaters assets is a major concern
with focus on inventory. Manufacturing processes that are not cost effective may cause carrying
value of inventory to be elevated and if obsolescence is not accounted it will lead to the
overstatement of inventory. This stresses the importance of valuating inventory at lower of cost
and NRV.
Business Risks: Is Fresh water a going concern? This is a very important question to ask. If
Freshwater ceases to be a going concern then the possibility of loan repayment is not likely.
Hence the nature and extent of Freshwaters current financial position must be assessed to
determine if Freshwater can still remain in business. Because Freshwater is a corporation, that is
ran by family members, the responsibility of the loan does not affect the owners personally,
hence a good idea maybe to have any loans granted be guaranteed by the owners themselves.
Furthermore the financial positions of the owners should also be looked at as well if such steps
are needed.
Management Risks: With sales increasing year over year for the last 20 years, this is a positive
sign. However the diminishing profits maybe a sign of poor management. Some questions to ask
are: What is managements compensation program, are their bonuses and raises tied to revenue
Solutions Manual
Page 7-50
growth or profit growth? Is management compensation excessive compared to industry? Are

dividend payouts excessive causing the poor liquidity position? Management stewardship
objectives maybe lacking given the corporation is ran as an owner-manager relationship.
Recommendations: All the above will determine whether or not Freshwater should be granted
the loan. When risks are high then the bank may choose to decline the loan. Granting a loan in a
high risk situation will require a higher than average interest rate, securing the loan against other
owned assets or with the owners, and potentially shortening the time frame of the line of credit.
It should be noted that securing the loan against assets would require appraisal from an
independent third party and securing against inventory should be valued at lower of cost or NRV.

Solutions Manual
Page 7-51
USING FINANCIAL STATEMENTS

Note: Dollar amounts in this question are in thousands of dollars.
FS7-1.
MHR reported $6,123 in inventory on its December 31, 2011 statement of financial position,
which was 9.8% of current assets or 6.6% of total assets. MHRs inventory has ranged from a
low of $5,370 in 2010 to a high of $6,123 in 2011. This is a relatively small dollar amount (less
than $1 million) but in percentage terms inventory decreased by almost 13% in 2010 and then
increased by 14% in 2011. The proportion of inventory to current and total assets is very close in
2009 and 2011, but somewhat lower in 2010. MHRs inventory includes: Canadian product
inventory along with imported and agency products. The inventory is probably for the most part
not very liquid. Textbook purchases are tied to particular times of the year and it would probably
be difficult to quickly convert it to cash if there was an urgent need.
FS7-2.
MHRs inventory is valued at the lower of cost and NRV on a first in first out basis.
Management reviews the inventory on an annual basis and makes adjustments for obsolescence.
The costs that are included in Canadian products are paper, print and binding costs. Net
realizable value is the amount the entity would receive from selling the inventory less any
additional costs to complete (if its work-in-process inventory) and less selling costs that would
have to be incurred to complete the sale. MHR wouldnt know the exact NRV of its inventory
but it would have a fairly good idea. Since MHR is in the publishing and distribution business
that deals mainly in educational and professional products, prices in the marketplace can easily
be determined.
FS7-3.
The cost of goods sold by MHR in 2011 was $29,470 and in 2010 was $30,866. In 2011,
$21,507 of inventory was expensed and $23,316 was expensed in 2010. Cost of goods sold
differs from the amount expensed because there were inventory write downs along with reversals
and provisions taken in each year.
Sales
Cost of goods sold
Gross margin
Gross margin %
2011
2010
$78,953
$78,249
29,470
52,562
62.67%
30,866
50,159
60.55%
There was an improvement in gross margin from 2010 to 2011 this can be due to the change in
the sales mix as MHR cost of goods sold was lower despite higher sales. Management estimates
may also account for the improvement in gross margin percentage. Note that other income and
rental income are excluded from sales in the table since these are probably not related to cost of
goods sold. Gross margin percentages including all revenues were 64.07% and 61.91% in 2011
and 2010 respectively.

Solutions Manual
Page 7-52
FS7-4.
A write-down is a reduction in the carrying value of an asset to reflect an impairment of the
asset. MHR must write-down inventory when it becomes impaired or obsolete and cant be sold
at full price (or at all). MHR wrote down $765 of inventory in 2011 and $501 in 2010. However
there were also reversals of write-downs in 2011 of $336 and $315 in 2010. The amount of the
write-down is included in the cost of goods sold during the year.
The write-down doesnt impact MHRs cash flow since it doesnt involve any cash (its simply a
reduction in the carrying amount of the inventory), but it does indicate that future cash flows will
be lower because the inventory on hand wont generate as much revenue. The write-down
decreased the gross margin because cost of because sold has increased. The impact is relatively
small, with write downs representing about 2.5% of the cost of inventory expensed during the
year. Although the write-downs require professional judgment, management at MHR is likely
able to make informed estimates for obsolescence using historical information. Historical
information can also be used to predict sales and how much inventory to carry to mitigate the
amount of write-downs needed. Text books for past editions for example would be biggest risk
of obsolescence since once a new book comes into print the old editions have little value. Also, if
a title is replaced in the marketplace by another book a particular title could become impaired.
The journal entry for the write-down in 2011 would be
DR Cost of goods sold
CR Inventory
765
765
FS7-5.
Cash flow from operations was $17,029 in 2011 while net income was $8,757. Cash flow was
different from net income in 2011 mainly because of two items: the amortization and
depreciation expenses, offset a bit by the net change in non-cash working capital. From Note 15
inventory increased by $753. An increase in inventory reduces cash from operations because it
costs the company money to buy or produce inventory. The increased cash investment in
inventory is reflected in the increase in the inventory account on the balance sheet.

Solutions Manual
Page 7-53
FS7-6.
2011
2010
2009
Inventory
$6,123 $5,370 $6,052
Cost of goods sold (inventory only)
21,507 23,316
Inventory turnover ratio (COGS / average inventory)
3.74
4.08
Number of days inventory (365 / inventory turnover) 97.53 89.40
There was a decline in inventory turnover from 2010 to 2011 resulting in the number of days in
inventory to increase by 8 days. This decrease in inventory turnover suggests the company is
carrying too much inventory. However, less money was spent on COGS inventory this year, this
change could be a result of MHR sales mix changing as more books transition to the digital
platform affecting sales forecast and increasing inventory on hand of physical books.
Note: the calculations could also be done using cost of goods sold instead of inventory. Using the
inventory amount is better but total COGS would be acceptable. In that case:
2011
2010
2009
Inventory
$6,123 $5,370
$6,052
Cost of goods sold
29,470
30,866
Inventory turnover ratio (COGS / average inventory)
5.13
5.40
Number of days inventory (365 / inventory turnover)
71.17
67.53
FS7-7.
Some of the challenges that MGH faces with respect to managing its textbook inventory include:
School enrolment rates that will dictate demand; Edition changes that will make previous edition
inventory obsolete; changes in textbooks used; seasonality of demand throughout the year with
high demand during fall; and lastly students preference to purchasing e-books or used books.
Management must decide how many books to produce, when to produce, and how much safety
stock is needed to meet fluctuations in demand. MGH faces risks of curriculum changes that
result in the change in textbook offered by another publisher, timing of new editions etc.

Solutions Manual
Page 7-54
FS7-8.
The note informs stakeholders that, in accordance with IFRS (and accrual accounting), estimates
have to be made to prepare the financial statements. Estimates are necessary because of
uncertainties that exist on the financial statement date. Its important for stakeholders to
understand this note so they recognize the uncertainties that exist in accounting information and
the role management plays in the determination of the estimates. Management may introduce
bias into financial statement measurements, which could create economic consequences for
stakeholders. As well, by their nature, estimates can be wrong. With respect to inventory,
management must estimate write-downs in relation to obsolescence.
FS7-9.
It is absolutely possible to have too much inventory especially for a company like MHR. MHRs
product is sold to schools and post-secondary students and there is a ceiling on the quantity that
can be sold. In addition, textbooks go out of date, which means that having too much inventory
might result in inventory becoming unsalable. The consequence of carrying too much inventory
is increased cost associated with carrying the inventory along will large expense to writedown
the inventory to lower of cost and NRV when the inventory is impaired. The types of analytical
tools that a stakeholder could use to determine when inventory carrying amount is too large
include historical analysis of inventory amount, inventory as a proportion of assets, and
inventory as a proportion of sales (inventory should raise proportionally with sales). Also
information on writedowns and recoveries would be valuable.

Solutions Manual
Page 7-55

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CHAPTER 7

Prescription and non-prescription drugs, cosmetics, toiletries, food items.

Raw materials include potatoes, cooking oil, and packaging;work-in-processis cutfries

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

***Answers may vary depending on rounding.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Average cost in 2017 and 2018:

Dec. 31, 2017

Dec. 31, 2018

Gross margin per unit

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

a. Inventory turnover ratio

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Inventory turnover ratio

Inventory turnover ratio = cost of sales/ average inventory

ITR = 365/#d = 7.92

ITR = 365/#d = 33.18

COS = AI * ITR = $5,046,954.55

ITR = COS/ AI = 1.68

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Other current assets

Other current assets

Total current assets

Accounts payable and accrued liabilities

Current ratio (CA/CL)

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Cost of goods sold

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Cost of goods sold

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

COGAFS- cost of goods available for sale

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

September 30, 2017

NRV of inventory is 54 units x (1390-120) = 68,580

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

COGAFS- cost of goods available for sale

Opening inventory + Purchases -Ending Inventory

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Income before taxes

Income Taxes (20%)

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Loss on equipment (I/S )

Loss on impaired inventory (I/S )

Loss on impairmentof equipment (I/S )

Ending inventory is overstated since Lamline doesnt own the inventory.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Number of Units onHand on

Note that exact answers may vary due to rounding.

Current Assets (CA)

John Friedlan, Financial Accounting: A Critical Approach, 4th edition

Gross margin % = (GM)/Sales

Cost of sales = Sales (100%-25%)