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Chapter 7
Merchandise Inventory
Multiple Choice Questions
1. Portland Supplies Co. mistakenly excluded $3,000 of goods from its December 31, 2010
physical inventory count. Its December 31, 2011 inventory amount was correct. As a result of
this error,
a. 2010 income is overstated by $3,000.
b. 2010 ending inventory is overstated by $3,000.
c. 2011 income is overstated by $3,000.
d. 2011 cost of goods sold is overstated by $3,000.
Answer: C
2. Which one of the following expenditures should not be included in the cost of inventory?
a. Transportation-out
b. Purchase cost
c. Packaging cost
d. Transportation-in
Answer: A
3. Michael Manufacturers fraudulently overstated its December 31, 2010 and December 31,
2011 inventory by $3,000 and $6,000, respectively. As a result of these overstatements,
a. 2010 income is overstated by $3,000 and 2011 income is overstated by $3,000.
b. 2010 income is overstated by $3,000 and 2011 income is overstated by $6,000.
c. 2010 income is overstated by $3,000 and 2011 income is accurate.
d. 2010 and 2010 incomes are not affected.
Answer: A

4. Jackson Roper fraudulently overstated its December 31, 2010 inventory by $8,000. As a
result of this overstatement,
a. the 2010 earnings per share is overstated.
b. the 2010 current ratio is understated.
c. the 2010 cost of goods sold amount is overstated.
d. net income is overstated for 2011, and net income for 2010 is correct.
Answer: A
5. If a company desires to increase its inventory, then it should:
a. sell more goods than it purchases during the period.
b. purchase more goods than it sells during the period.
c. purchase the same amount of goods that it sells.
d. increase its selling prices to a level that customers would not be willing to purchase.
Answer: B
6. Cagey Trading Inc. counted $2,000 of inventory twice during its December 31, 2010
physical inventory count. Its December 31, 2011 inventory amount is correct. As a result of
this error,
a. 2010 ending inventory is overstated by $2,000.
b. 2010 income is understated by $2,000.
c. 2011 income is overstated by $2,000.
d. 2011 cost of goods sold is understated by $2,000.
Answer: A
7. Washington Co. mistakenly omitted $4,000 of merchandise from its inventory on
December 31, 2010. Its December 31, 2011, inventory is correct. As a result of this error,
a. earnings per share is overstated for 2010 and overstated for 2011.
b. total income for 2010 and 2011 combined is correct.

c. the current ratio is overstated on December 31, 2010 and is correct on December 31, 2011.
d. ending inventory is understated at December 31, 2011.
Answer: B
8. Parker Books purchased 200 books, paying $10 each. Parker paid the $40 shipping costs
and $30 binding repair fees so that those books could be sold. How much is the cost of
inventory?
a. $2,000
b. $2,040
c. $2,030
d. $2,070
Answer: D
9. A company deliberately and inappropriately included interest costs on its December 31
inventory. Which one of the following statements is True for the company’s December 31
financial statements?
a. Earnings per share is understated.
b. Inventory turnover ratio is understated.
c. The current ratio is understated.
d. Cost of goods sold is overstated.
Answer: B
10. Dole Produce Ltd. counted $700 of inventory twice in its December 31, 2010 inventory.
On December 31, 2011, it mistakenly omitted $200 of merchandise from its inventory. As a
result of these errors:
a. net income is overstated by $700 in 2010 and understated by $200 in 2011.
b. net income in understated by $700 in 2010 and overstated by $200 in 2011.
c. net income is overstated by $700 in 2010 and understated by $900 in 2011.
d. total net income for 2010 and 2011 is correct.

Answer: C
11. Kemp Clothing has cost of goods sold of $14,000 with beginning and ending inventories
of $4,000 and $2,000, respectively. Purchases during the period are:
a. $ 8,000.
b. $ 9,000.
c. $10,000.
d. $11,000.
e. $12,000.
Answer: E
$14,000 + $2,000 - $4,000 = $12,000
12. Which one of the following expenditures should not be included in the cost of inventory?
a. Purchase cost
b. Transportation-in
c. Packaging cost
d. Capitalized equipment cost
Answer: D
13. Mars Hardware sold 20 drills for $8 each. Each drill cost $4. Which journal entry is
required at the time of sale under a perpetual inventory system?

Answer: C
14. Wood Inc. sells automobiles at $6,000 above its costs and uses the specific identification
method for inventory. Below are the cars and the costs Wood paid for the inventory before the
sale.

If Wood sells Auto 3 and Auto 5 for cash, which of the following would be included in the
journal entries it uses to record the sale and recognize the cost of the inventory?
a. A debit to Cost of Goods Sold for $45,500.
b. A credit to Sales for $45,500.
c. A credit to Inventory for $57,500.
d. A credit to Sales for $12,000.
Answer: A
15. Vic’s Produce purchased 50 boxes of tomatoes for a total of $400. It paid $20 for shipping
tomatoes to a customer and $15 for repackaging them into smaller boxes. The cost of these
tomatoes is:
a. $400.
b. $420.
c. $415.
d. $435.
Answer: C
16. Simon Cereal purchased 100 pounds of cornflakes for $100. Transportation cost to
Simon’s production facility was $25 for the barrel of cornflakes shipped FOB destination.
Simon paid $60 for 100 one-pound biodegradable plastic bags into which the cornflakes were
placed. The cost of each one-pound bag of cornflakes is:

a. $1.00.
b. $1.25.
c. $1.60.
d. $1.75.
Answer: C
17. Beginning inventory is valued at $7,000, purchases are $15,000 and ending inventory is
valued at $9,000. Cost of goods sold is:
a. $23,000.
b. $16,000.
c. $30,000.
d. $13,000.
e. $16,000.
Answer: D
18. Victoria Fashions Clothing Store uses the perpetual method of accounting for inventory.
During the current year, purchases are $30,000 and cost of goods sold is $25,000. Beginning
inventory is valued at $4,000 and ending inventory was taken on December 31 and valued at
$6,000. Inventory shortage expense for the current year is:
a. $0.
b. $2,000.
c. $3,000.
d. $5,000.
Answer: C
19. During a year of decreasing prices and decreasing inventory, which cost flow assumption
would measure the greatest net income?
a. FIFO
b. LIFO

c. Averaging
d. Both a and c are correct.
Answer: B
20. During a year of rising prices and increasing inventory, which cost flow assumption
would yield the greatest current ratio?
a. Averaging
b. LIFO
c. FIFO
d. Both a and c are correct.
Answer: C
21. During a year of rising prices and increasing inventory, which cost flow assumption
would measure the smallest net income?
a. LIFO
b. FIFO
c. Averaging
d. All methods measure income the same.
Answer: A
22. During a year of rising prices and increasing inventory, which cost flow assumption
would measure the smallest working capital ratio?
a. FIFO
b. LIFO
c. Averaging
d. Working capital is not sensitive to inventory cost flow assumptions.
Answer: B

23. The President and CEO of Quinn Manufacturing receives a cash bonus equal to 1% of
audited net income during the current year. During a period of rising prices and increasing
inventory, which inventory cost flow assumption would measure the smallest compensation
expense and greatest cash position for Quinn Manufacturing?
a. FIFO
b. NIFO
c. Averaging
d. LIFO
Answer: D
24. Unusually high income resulted when Vincent Inc. cut back its inventory levels. This
effect is:
a. backed by the LIFO elimination rule.
b. expected in most industries.
c. achieved through using the lower-of-cost-or-market rule.
d. called LIFO liquidation.
Answer: D
25. During a year of rising prices and increasing inventory, which cost flow assumption
would measure the largest inventory turnover ratio?
a. FIFO
b. LIFO
c. Averaging
d. The inventory turnover ratio is not sensitive to inventory cost flow assumptions.
Answer: B
26. During a period of rising prices and increasing inventory, which cost flow assumption
used on both federal income tax returns and financial reports would provide a company with
the greatest cash position?

a. FIFO
b. LIFO
c. Averaging
d. TIFO
Answer: B
27. During a year of falling prices, which cost flow assumption would measure the strongest
cash flow position?
a. LIFO
b. FIFO
c. Averaging
d. Net income will remain the same under all methods.
Answer: B
28. During a year of falling prices, which cost flow assumption would yield the greatest
current ratio?
a. FIFO
b. LIFO
c. Averaging
d. Lower-of-cost or market
Answer: B
29. If a company uses the LIFO cost flow assumption on its federal income tax return in order
to minimize its tax payment, then it:
a. must use LIFO on its financial statements.
b. must use FIFO on its financial statements.
c. may use any cost flow assumption permitted by GAAP on its financial statements.
d. must correct the error at the beginning of the next accounting period.

Answer: A
30. An excessively low inventory turnover ratio may reveal that:
a. customers are delaying their payments on account.
b. the selling price of inventory is too high.
c. sales returns have decreased significantly.
d. the company is selling too much inventory.
Answer: B
31. Carmelo Inc. has an inventory turnover ratio of 25. Carmelo’s average number of day’s
inventory is:
e. Less than 10.
f. Between 10 and 12.
g. More than 12.
h. Unable to be determined based on this limited information.
Answer: C
365 / 25 = 14.6 days
32. Under generally accepted accounting principles, a company can choose a cost flow
assumption for valuing cost of goods sold that can result in different income measurement.
However, it can’t frequently change the cost flow assumption adopted in order to measure the
highest income possible because of the:
a. conservativism principle.
b. going concern principle.
c. stable-dollar principle.
d. consistency principle.
Answer: D
33. During an extended period of constant prices, which cost flow assumption would
generally measure the largest earnings per share?

a. FIFO
b. LIFO
c. Weighted average
d. All of the above assumptions would result in equal earnings per share during an extended
period of constant prices.
Answer: D
34. At which point in accounting for inventory in a perpetual system is determining the cost
of goods sold amount an issue?
a. When the inventory is acquired.
b. As the inventory is carried in the warehouse and held for sale.
c. As the ending inventory is counted.
d. As the inventory is sold.
Answer: D
35. Items should be included in the company’s inventory if they are:
a. being used in the production of income.
b. held in anticipation of an increase in value.
c. being held for sale.
d. sold during the period.
Answer: C
36. Which one of the following should be included in Camden’s inventory at December 31,
2010?
a. Goods shipped FOB shipping point on December 31, 2010, from Camden to a customer.
b. Goods in the Camden’s warehouse on December 31, 2010, waiting to be shipped to a
customer.
c. Goods ordered from one of Camden’s suppliers on December 31, 2010, shipped FOB
destination on December 31, 2010, which arrived January 2, 2011.

d. Goods sold and shipped to a customer on December 31, 2010, terms FOB destination,
which were delivered on December 31, 2011.
Answer: B
37. Which one of the following companies would likely carry the largest percentage of
inventory as compared to its other assets?
a. Ernst & Young, CPAs
b. Merrill Lynch Investment Brokers
c. The Magic Kingdom at Disney World
d. Jim’s Ford Dealership
Answer: D
38. When prices remain the same, which cost flow assumption would generally measure the
largest current ratio?
a. FIFO
b. LIFO
c. Averaging
d. All of the above assumptions would result in equal current ratios during an extended period
of constant prices.
Answer: D
39. When accounting for inventory consignments, the issue which helps determine whether or
not the inventory cost should be included on a company’s balance sheet is:
a. whether the inventory is physically located in the company’s warehouse.
b. who actually owns title to the inventory.
c. who will ultimately sell the inventory to the consumer.
d. when the inventory will be sold.
Answer: B
40. Specific identification is a method of accounting for inventory:

a. which eliminates the need for tracking the cost of inventory items.
b. that allocates the oldest cost to the first units sold.
c. that often allows a manager to manipulate net income and the ending inventory value.
d. commonly used in periods of rising prices.
Answer: C
41. Selecting an inventory cost flow assumption will most likely be impacted by which one of
the following?
a. The physical flow of the inventory goods.
b. The cost of the company’s plant and equipment.
c. Income taxes.
d. The cost flow assumptions most often used by other companies.
Answer: C
42. All of the following are typically associated with Japanese business inventory accounting
except:
a. the use of the average assumption for inventory cost.
b. shared business risks.
c. slow inventory turnover.
d. lower levels of inventory.
Answer: C
43. Inventory reported on the balance sheet of a manufacturing company consists of:
a. raw materials and the cost of labor to convert the raw materials to finished products.
b. raw materials, the cost of labor to convert the raw materials, and an allocated portion of
manufacturing overhead cost.
c. the cost of the raw materials used.

d. raw materials, the cost of labor to convert the raw materials, and all major corporate
overhead costs.
Answer: B
44. The LIFO conformity rule requires a company that uses:
a. the LIFO assumption for computing cost of goods sold on its tax return to also use the
LIFO assumption in preparing its financial statements.
b. any inventory cost assumption to use the LIFO cost assumption for tax purposes.
c. the LIFO assumption for computing cost of goods sold on its financial statements to also
use LIFO on its tax return.
d. the LIFO assumption to avoid paying taxes on inventory profits.
Answer: A
45. During a period of rising prices and inventories, a company whose current ratio is
dangerously close to the minimum specified by agreement with a major creditor would prefer
which cost flow assumption?
a. FIFO
b. LIFO
c. Averaging
d. The company would be indifferent as to which cost flow assumption is adopted.
Answer: A
46. Selling more inventory than was purchased during the current period may often cause old,
smaller costs that were carried as part of the company's beginning inventory, to be moved to
the income statement and reported as cost of goods sold. This is called:
a. the LIFO conformity rule.
b. LIFO liquidation.
c. the LIFO reserve rule.
d. lower-of-cost-or-market accounting.

Answer: B
47. During a period of rising prices and inventories, a company whose debt/equity ratio is
dangerously close to the minimum specified by agreement with a major creditor would prefer
which cost flow assumption?
a. FIFO
b. LIFO
c. Averaging
d. The company would be indifferent as to which cost flow assumption is adopted.
Answer: A
48. During a period of changing inventory prices, which of the following is NOT
immediately sensitive to the particular cost flow assumption adopted?
a. Net income
b. Current ratio
c. Gross profit
d. Working capital
e. Quick ratio
Answer: E
49. Under the lower-of-cost-or-market rule, market is:
a. the selling price of inventory items.
b. the original cost paid for inventory.
c. used to value inventory if it is less than its recorded cost.
d. the amount of cash the company expects to collect from the sale of an inventory item.
Answer: C
50. Which of the following policies would increase a firm's current inventory turnover ratio?
a. Reduction of the average inventory that supports a constant amount of sales

b. An decrease in the units of inventory sold while holding average inventory constant
c. Increase of inventory by adopting a Just-in-Time production schedule
d. Saving new purchases of inventory until the following year instead of this year
Answer: A
51. If the market value of inventory is greater than its cost, then the application of the lowerof-cost-or-market rule would:
a. decrease both the current ratio and net income.
b. decrease the current ratio but not change net income.
c. not change the current ratio but decrease net income.
d. change neither the current ratio nor net income.
Answer: D
52. During a period of rising prices and inventories, which method causes cash flows to be
stronger?
a. FIFO
b. LIFO
c. Averaging
d. The company would be indifferent as to which cost flow assumption is adopted.
Answer: B
53. Which of the following should not be included in inventory cost for a car dealership?
a. The costs of transporting the cars from the factory to the dealership
b. Cost of new car preparation for customers
c. The salary and commission of the salesman who sells the vehicle
d. The cost of adding a CD player to the vehicles before the vehicle is offered for sale
Answer: C

54. If the market value of inventory is less than its cost, then application of the lower-of-costor-market rule would:
a. increase earnings and decrease the current ratio.
b. decrease earnings and increase the current ratio.
c. decrease earnings and decrease the current ratio.
d. cause no change to earnings or the current ratio.
Answer: C
55. What is the impact on the financial statements of an overstatement of ending inventory?
a. Next year’s ending inventory will be overstated.
b. Next year’s net income will be overstated.
c. Current year’s net income will be overstated.
d. Next year’s ending inventory will be understated.
Answer: C
56. The following information comes from the annual reports of Devin Designs.

What is the Purchases amount for 2010?
a. $4,713
b. $2,397
c. $81
d. $10,649
Answer: D
57. The following information comes from the annual reports of Devin Designs.

What is the ending inventory amount for 2010?
a. $4,713
b. $2,409
c. $81
d. $10,583
Answer: B
58. The following information comes from the annual reports of Devin Designs.

What is the beginning inventory amount for 2011?
a. $2,409
b. $13,570
c. $10,502
d. $8,246
Answer: A
59. The following information comes from the annual reports of Devin Designs.

What is the amount of purchases for 2011?
a. $8,246
b. $11,161
c. $13,570
d. $10,643
Answer: B
60. The following information comes from the annual reports of Devin Designs.

What is the amount of goods available for sale for 2011?
a. $8,246
b. $11,173
c. $13,570
d. $10,643
Answer: C
61. The following information comes from the annual reports of Devin Designs.

What is the beginning inventory amount for 2012?
a. $439
b. $8,246
c. $10,908
d. $2,662
Answer: D
62. The following information comes from the annual reports of Devin Designs.

What is the amount of goods available for sale for 2012?
a. $11,347
b. $15,314
c. $13,957
d. $24,865
Answer: B
63. The following information comes from the annual reports of Devin Designs.

What is the ending inventory amount for 2012?
a. $24,865
b. $3,101
c. $2,223
d. $15,314
Answer: B
64. Forrest’s Crab House purchased Florida stone crab on account on November 10, 2009, for
a gross price of $87,000. Forrest also purchased farm-raised catfish on account on November
11, 2009 for a gross price of $25,000. The terms of both sales were 2/15, n/30. Forrest paid
for the first purchase on November 19, 2009, and for the second purchase on November 30. If
he uses the perpetual inventory method, his journal entry for November 19 would include:
a. a debit to Inventory for $1,740.
b. a debit to Inventory for $85,260.
c. a credit to Inventory for $1,740.
d. a credit to Accounts Payable for $87,000
Answer: C

65. Forrest’s Crab House purchased Florida stone crab on account on November 10, 2010, for
a gross price of $87,000. Forrest also purchased farm-raised catfish on account on November
11, 2010 for a gross price of $25,000. The terms of both sales were 2/15, n/30. Forrest paid
for the first purchase on November 19, 2010, and for the second purchase on November 30. If
he uses the perpetual inventory method, which of the following journal entries would Forrest
make for November 30?

Answer: B
66. Gump Supplies has the following information:

An inventory count taken at year end indicates that inventory with a cost of $56,000 is on
hand as of December 31, 2010. Assume that inventory purchases and transportation-in are
both reflected in the inventory account, which shows an ending balance of $59,000. What is
the amount of the cost of goods sold?
a. $123,300
b. $83,300
c. $60,700
d. $100,700
Answer: B
With the perpetual method, the balance in the Cost of Goods Sold account is perpetually
updated for sales of inventory, as is the balance in the Inventory account for sales and
acquisitions of inventory. This implies that the balance in Cost of Goods Sold should
correspond to a balance in the Inventory account of $59,000, and that no entry is necessary at
the end of the year to record Cost of Goods Sold.
Ending Inventory = Beginning Inventory + Net Purchases – Cost of Goods Sold
$59,000 = $39,000 + ($92,000 + $11,300) – COGS
Cost of Goods Sold = $83,300
67. Gump Supplies has the following information:

Beginning inventory $39,000
Inventory purchases 92,000
Transportation-in 11,300
An inventory count taken at year end indicates that inventory with a cost of $56,000 is on
hand as of December 31, 2010. Assume that inventory purchases and transportation-in are
both reflected in the inventory account, which shows an ending balance of $59,000. Which of
the following would be the best adjusting journal entry to make at the end of the period with
respect to this information?

Answer: A
Since the physical count indicates that Gump has $3,000 less inventory than is recorded in its
Inventory account, the following adjusting entry is necessary at the end of the year.

68. Dakota Industries has two items in inventory as of December 31, 2010. Each item was
purchased for $52. Company management chose to write down Item #1 to $39, which at
year-end was assessed to be its market value. Management did not write down Item #2
because its market value was estimated to be greater than $52. During 2010, each item was
sold for $63 cash.
The journal entry for the write down of Item #1 would include which of the following?

Answer: C
69. Dakota Industries has two items in inventory as of December 31, 2010. Each item was
purchased for $52. Company management chose to write down Item #1 to $39, which at
year-end was assessed to be its market value. Management did not write down Item #2
because its market value was estimated to be greater than $52. During 2010, each item was
sold for $63 cash.
If Dakota uses the perpetual inventory method, which of the following would be included in
the entry or entries to record the sale of Item #1?
a. A debit to Sales for $63.
b. A credit to Inventory for $52.
c. A debit to Cost of Goods Sold for $39.
d. A credit to Cost of Goods Sold for $52.
Answer: C
70. Grey Manufacturing had the following transaction:
Grey received an order to sell inventory with a cost of $50,000, and debited Accounts
Receivable and credited Sales. The goods were shipped to the customer on December 31,
2010, and received on January 2, 2011.
If the terms of the sale were FOB shipping point and Grey included all these items in its
ending inventory of 12/31/10, which of the following is the best statements regarding this
treatment?
a. Grey made no mistake and rightfully included the items in its inventory until January 2,
2011.

b. Grey made a mistake and wrongly understated ending inventory.
c. Grey made a mistake and wrongly understated Cost of Goods Sold.
d. Grey made a mistake and wrongly understated Retained Earnings.
Answer: C
71. Grey Manufacturing had the following transaction:
Grey ordered $67,000 of inventory on December 30, 2010. The inventory was shipped on
December 31, 2010, with the terms FOB destination. Grey received the inventory on January
3, 2011.
If Grey included all these items in it ending inventory of 12/31/10, which of the following is
the best statement regarding this treatment?
a. Grey made no mistake and rightfully included the items in its ending inventory for
12/31/10.
b. Grey made a mistake and wrongly overstated Inventory.
c. Grey made a mistake and wrongly overstated Cost of Goods Sold.
d. Grey made a mistake and wrongly overstated Retained Earnings.
Answer: B
Matching Questions
1. For each cost numbered 1 through 8 below, identify which accounting treatment (a
through c) would most likely be used in accounting for the cost. You may use each
letter more than once or not at all.

Answer:
1. a
2. c
3. a
4. b
5. a
6. a
7. a
8. a
2. For each item listed in 1 through 4, place the letter of the accounting effect (a through e) in
the space provided. You may use each letter more than once or not at all.

____ 1. During a period of increasing inventory and rising prices, a company decides to use
FIFO instead of LIFO.
____ 2. During a period of increasing inventory and rising prices, a company decides to use
averaging instead of FIFO.

____ 3. During a period of static prices, a company decides to use FIFO instead of LIFO.
____ 4. A company applies lower-of-cost-or-market for valuing ending inventory when
market price is less than cost.
Answer: 1. a
2. e
3. b
4. e
3. For each item listed in 1 through 2, place the letter of the accounting effect (a through e) in
the space provided. You may use each letter more than once or not at all.

____ 1. A company applies lower-of-cost-or-market for valuing ending inventory when cost
is greater than market price.
____ 2. During an extended period of constant prices, a company uses LIFO instead of FIFO.
Answer: 1. b
2. e
4. For each item listed in 1 through 7, place the letter (a through e) of the accounting effect in
the space provided. You may use each letter more than once or not at all.

____ 1. During a period of increasing inventory and rising prices, a company decides to use
FIFO instead of LIFO.

____ 2. During a period of increasing inventory and rising prices, a company decides to use
averaging instead of FIFO.
____ 3. During a period of increasing inventory and increasing prices, a company uses the
LIFO method, which creates the largest cost of goods sold.
____ 4. A company applies lower-of-cost-or-market for valuing ending inventory when
market price is less than cost.
____ 5. A company applies lower-of-cost-or-market for valuing ending inventory when cost
is less than market price.
____ 6. During an extended period of constant prices, a company adopts LIFO instead of
FIFO.
Answer: 1. a
2. b
3. b
4. b
5. e
6. e
Short Problems
1. Bisbee Ltd. has been fraudulently overstating its inventory in order to "pump up" a lagging
income. It started this practice on January 1, 2010 and overstated the 2010 income by $9,000.
By what amount will they have to overstate December 31, 2011 inventory in order to
overstate 2011 income by $14,000?
Answer: ($9,000) – $14,000 = $23,000
Use the information that follows concerning Bradley Corporation to answer problems 2- 5.
Bradley Corporation began business on January 1. During January, Bradley reported the
following:

2. Determine the amount of inventory to report on Bradley’s balance sheet at January 31
under the FIFO cost flow assumption.
Answer: 50 x $14 = $700
3. Determine the amount of inventory to report on Bradley’s balance sheet at January 31
under the LIFO cost flow assumption.
Answer: 50 x $10 = $500
4. Determine the amount of the inventory valuation on January 31 under the averaging cost
flow assumption.
Answer: [(100 x $10) + (150 x $14)]/250 = $12.40 per unit
50 x $12.40 = $620
5. Determine the amount of cost of goods sold under the FIFO cost flow assumption for the
month of January.
Answer: (100 x $10) + (100 x $14) = $2,400
6. Warren Trading pays for its inventory purchases with cash. Beginning inventory is $3,000,
purchases were $19,000, and cost of goods sold is $18,000. Determine the cost of Warren’s
ending inventory.
Answer: $3,000 + $19,000 – $18,000 = $4,000
Use the information that follows concerning Cinci Corporation to answer problems 7 and 8.
Cinci Company began business on March 1. During March, Cinci made the following
purchases.

7. How much will Cinci report as cost of goods sold using LIFO during March?
Answer: (200 x $10) + (40 x $8) = $2,320
8. Calculate cost of goods sold during March under the averaging cost flow assumption.
Answer: $2,800/300 = $9.33 per unit; $9.33 x 240 = $2,240

9. The management of Dayton Ltd. erroneously understated its inventory during 2010 by
$28,000. Using the information below and assuming there are no distributions of retained
earnings: (1) present a brief analysis with the accurate numbers and the numbers in error and
(2) explain whether retained earnings would be overstated, understated, or be indifferent to
the error at the end of 2011.
2010 Sales: $60,000
2010 Purchases: $50,000
2010 Cost of Goods Sold (before inventory error) $20,000
2011 Sales: $210,000
2011 Purchases: $60,000
2011 Cost of Goods Sold (based on error numbers): $68,000
Answer:

(2) Since errors in inventory misstate net income in the subsequent period by an equal dollar
amount in the opposite direction, retained earnings should be correctly stated at the end of
2011, if no further errors occur.
Accurate Incomes = $40,000 + $140,000 = $180,000 Retained earnings
Incomes associated with error = $38,000 + $142,000 = $180,000 Retained earnings
10. Yale Co. has valued its beginning and ending inventories at $4,000 and $7,000,
respectively, during a period where cost of goods sold was $22,000. An auditor found an error

in the valuation of the ending inventory and insisted that it be restated to $6,000. Calculate
the adjusted cost of goods sold resulting from the inventory restatement.
Answer: $22,000 + $1,000 = $23,000
11. Summers Company began business on August 1, 2010. During August, Summers made
the following purchases:

Calculate Summers’ August 31 ending inventory under the FIFO and LIFO cost flow
assumptions.
Answer:
FIFO = 50 x $20 = $1,000
LIFO = 50 x $10 = $500
12. Yogi Company began operations on July 1. Below is its July income statement and the
current portion of its balance sheet dated July 31. Each unit is sold for $80. Under the LIFO
method of inventory, Yogi reported the following:

Complete the following income statement and current portion of the balance sheet for Yogi
for July using the FIFO cost flow assumption instead of LIFO.
Sales revenue . . . . . . . . . . . . . . . . . _______ _______ _______
Cost of goods sold . . . . . . . . . . . . . ._______ _______ _______
Gross profit . . . . . . . . . . . . . . . . . . . _______ _______ _______
Answer:

13. A firm fraudulently overstated its December 31, 2009 and 2010 inventories by $4,000 and
$7,000, respectively. What is the amount of 2009 and 2010 overstatements of cost of goods
sold which results from these inventory overstatements?
Answer: 2009 cost of goods sold is understated by $4,000.
2010 cost of goods sold is understated by $3,000.
Use the information that follows concerning Yarley’s Gift Store to answer problems 14-17.
Grandma’s Gift Store inventory and purchase information for July is as follows:

14. Grandma’s Gift Store uses the FIFO cost flow assumption. Calculate its cost of goods
sold for the month of July and its ending inventory at July 31.
Answer: Cost of goods sold = (500 x $4) + (500 x $5) = $4,500
Ending inventory = 300 x $5 = $1,500
15. Grandma’s Gift Store uses the LIFO cost flow assumption. Calculate its cost of goods
sold for July and its ending inventory at July 31.
Answer: Cost of goods sold = (800 x $5) + (200 x $4) = $4,800
Ending inventory = 300 x $4 = $1,200
16. Grandma’s Gift Store uses the averaging cost flow assumption. Calculate its cost of goods
sold for July and its inventory at July 31.
Answer: Cost of goods sold = $4.6153846 x 1,000 = $4,615.38
Ending inventory = $4.6153846 x 300 = $1,384.62
17. By what amount would Grandma’s working capital on July 31 under FIFO exceed
working capital using LIFO?
Answer: ($5 x 300) – ($4 x 300) = $300

Use the information that follows concerning Ruby Company to answer problems 18 through
20.
Ruby Company sells office supplies. Below is a list of purchases and sales for the month of
January:

18. Ruby uses the FIFO cost flow assumption. Calculate its January cost of goods sold.
Answer: (10 x $6) + (40 x $7) + (20 x $8) = $500
19. Ruby uses the LIFO cost flow assumption. Calculate its January cost of goods sold.
Answer: (40 x $8) + (30 x $7) = $530
20. Ruby uses the averaging cost flow assumption. Calculate its January cost of goods sold.
Answer: [(10 x $6) + (40 x $7) + (40 x $8)]/90 = $7.33; 70 x $7.33 = $513
21. Toyz’s Retail Store sold $900 of merchandise to Ebony Inc. on April 3, terms, 2/10 EOM.
On April 8, Ebony returned $200 of the merchandise that was defective. The original
merchandise sold cost Toyz $600 with terms N30, but of this amount, $70 was returned. Toyz
received payment from Ebony on April 10. What amount of sales and cost of goods sold
should Toyz record for these transactions?
Answer: Sales = ($900 – $200) x .98 = $686
Cost of goods sold = $530
Use the information that follows concerning Edward Company to answer problems 22 and
23.

22. Calculate Edward’s January earnings per share under the FIFO and LIFO cost flow
assumptions.
Answer: FIFO net income: $12,800 - [(100 x $30) + (220 x $20)] - $800 = $4,600
LIFO net income: $12,800 - [320 x $20] - $800 = $5,600
FIFO EPS: $4,600/300 = $15.33 per share
LIFO EPS: $5,600/300 = $18.67 per share
23. Calculate Edward’s January current ratio under the FIFO and LIFO cost flow
assumptions.
Answer: FIFO: ($11,000 + $3,600)/$6,000 = 2.43; LIFO: ($11,000 + $4,600)/$6,000 = 2.60
24. Nokia Inc. reported beginning inventory of $90,000, ending inventory of $23,000,
purchases of $128,000, purchase returns of $2,000, and transportation-in of $3,000. Calculate
cost of goods sold.
Answer: $90,000 + $128,000 – $2,000 + $3,000 – $23,000 = $196,000
25. Ramiro Co. has valued its beginning and ending inventories at $4,000 and $5,000,
respectively, during a period where purchases totaled $150,000. An auditor found errors in
the ending inventory valuation and insisted that it be restated to $6,000. Calculate the
adjusted cost of goods sold resulting from the inventory restatement.
Answer: [$4,000 + $150,000 – $5,000] – $1,000 = $148,000
26. Morrie Produce began operations on July 1. Below is its income statement for the month
of July and the current portion of its balance sheet dated July 31.

Answer:

27. Mamma’s Cafe assigned the following costs to inventory on December 31:

Determine the correct December 31 inventory and recalculate current net income that is
appropriate under generally accepted accounting principles. Justify your new valuation of
inventory.
Answer: The cost of inventory is the cash or cash equivalent price of the asset plus all
expenditures necessary to get the asset in place and ready for its intended use. Those
expenditures for the inventory include:

Short Essay Questions
1. Please explain the statement that “a LIFO liquidation creates ‘phantom’ income”.
Answer: A LIFO liquidation occurs when the current year’s higher-priced inventory is all sold
off causing penetration (i.e., sale) of the LIFO inventory layers that had accumulated in prior
years. Since the prior year layers had lower costs associated with them, the cost of goods sold
for the goods in by these lower-cost layers is less than the current cost of inventory. The sale
of inventory having these artificially low costs creates an artificially high gross profit. This
extra gross profit is what is referred to by some as “phantom” income.
2. Identify the options a manager has in measuring the cost of inventory as it flows through
the accounting system.
Answer: Four cost flow options exist: specific identification, averaging, FIFO, and LIFO. The
inventory cost of individual items sold is moved from the balance sheet to the income
statement at the point-of-sale based on one of these assumptions.
3. What effect does management's perception of the ‘capital market’ have on selecting an
inventory costing method?
Answer: Investors in the capital market prefer companies with higher net income amounts
and larger amounts of assets. In periods of rising prices, FIFO reports a lower cost of goods
sold, which results in higher net income, and leaves the cost of the new or more expensive
inventory on the balance sheet. However, the validity of this reasoning is open to question.
Some research studies suggest that the stock market “looks through” a company’s accounting

methods and values the company on the basis of underlying cash flows. Since using LIFO
usually saves taxes, these studies suggest that LIFO companies are more highly valued by the
market than the FIFO companies. However, evidence is mixed and conclusions are still
tentative.
4. If an entity overstates its ending inventory for the current year, what are the effects on
assets, cost of goods sold, retained earnings, and total stockholders’ equity for the current
year?
Answer: If ending inventory is overstated at the end of the year, assets will be overstated and
cost of goods sold will be understated. When this occurs, expenses are less than expected,
which causes net income to be overstated. When net income is overstated, the amount closed
to retained earnings at the end of the accounting period is more than what it should be. This
creates an overstatement of retained earnings. Since retained earnings is part of stockholders’
equity, this amount also will be overstated.
5. During a period of rapidly rising inventory prices and a significant increase in inventory, a
financial analyst made the following statement:
"I rank a company's earning power by using earnings per share. You do not need to be a
rocket scientist and know all that accounting mumbo-jumbo in order to compare earnings per
share of two companies to obtain a ranking of their earnings power."
Respond to the statement made by the financial analyst concerning the implications of
choosing an inventory valuation method.
Answer: During a period of significantly increasing prices and inventory, the choice of FIFO
or LIFO inventory valuation methods can significantly influence measured current assets and
income for corporations that carry significant inventory and whose cost of goods sold is a
major expense. Under these conditions, the firm that uses FIFO will have a greater income
number than that of the firm that uses LIFO. Thus, when their earnings per share are
compared, adjustments for this difference should be made. These adjustments may involve an
approximation of the difference in the EPS figure caused by the use of LIFO or FIFO. As a
minimum, the user should realize the direction of the "bias" caused by the differing inventory
valuation methods and digest the EPS numbers accordingly. However, if inventory and cost
of goods sold are not a significant component of the firm's financial statements, or prices do
not change significantly, then perhaps the financial analyst's position would be justified.

6. How do inventories of manufacturing companies differ from inventories of merchandising
companies?
Answer: Manufacturing companies have three inventories: raw materials, work in process,
and finished goods. Three costs make up these inventories: direct materials, labor, and
manufacturing overhead costs. A merchandising company has only one inventory account—
often called merchandise inventory. This account is used for goods that are ready to sell.
7. Explain the concept of hidden reserves as it applies to the lower-of-cost-or-market rule.
Answer: The lower-of-cost-or-market rule recognizes price decreases immediately, but price
increases are not recognized until the inventory is sold in an actual transaction. While this
treatment is conservative, it is not consistent. The downward adjustment of inventory creates
a 'hidden reserve' that is easily manipulated by managers. When management recognizes a
price decrease in the current period, i.e., a loss, which is followed by a price increase in a
subsequent period, the inventory can be sold for a larger profit. By reporting a larger profit in
a different accounting period, management has manipulated income by deferring the gain.
8. The chief investment officer of a large mutual fund made the following statement:
"I prefer to use the debt/equity ratio instead of the debt/asset ratio because the latter ratio is
sensitive to the measure of inventory where accountants can choose LIFO, FIFO, or weighted
averaging. Therefore, I use the debt/equity ratio so that I do not have to worry about which
inventory valuation method the accountant used when I run comparisons between
companies."
Comment on the preceding statement.
Answer: Although it is True that the particular inventory valuation method does influence the
measure of assets and, therefore, the debt/asset ratio, it is not True that the debt/equity ratio is
unaffected. If the choice of an inventory valuation method results in greater (smaller)
measure of assets, it measures a greater (smaller) income. Thus, the amount of retained
earnings and stockholders' equity is influenced by the inventory valuation method used and
by the same amount that measured assets are affected. For example, if the application of
FIFO measures assets $10,000 more than that under LIFO, then FIFO stockholders' equity
will also be $10,000 greater than that resulting from the use of LIFO.
9. Why is the lower-of-cost-or-market rule necessary in accounting?

Answer: When the market value of inventory, its replacement cost, is lower than the original
cost of the inventory, the inventory amount reported on the balance sheet will be overstated.
Conservatism justifies reducing the inventory value on the balance sheet to the lower of the
two amounts.
10. After studying a financial accounting text, your roommate asserts that what is interesting
about accountants is that they always measure what actually happens. Having studied
inventory, you disagree with your roommate's assertion. Present an argument refuting your
roommate's position that accountants measure what actually happens in context of knowledge
acquired after reading the chapter entitled "Merchandise Inventory."
Answer: Accountants measure cost of goods sold and inventory by applying a cost flow
assumption. Accountants may choose to represent inventory cost flows as First-In, First-Out
(FIFO), Last-In, First-Out (LIFO), or a weighted averaging. The choice of a cost flow
assumption is independent of the actual physical flow of inventory through the business. This
is why the assumptions are referred to as cost flow instead of physical flow assumptions. The
only time that accountants respect the actual flow of inventory through the business is when
they use specific identification to value inventory. Therefore, with respect to inventory,
accountants do not measure what actually happens.
11. If an entity understates its ending inventory for the current period, what is the effect on
cost of goods sold and inventory carry over to the next year. Explain why.
Answer: If ending inventory is understated at the end of the year, cost of goods sold will be
overstated for that year. Ending inventory from the first year then becomes the beginning
inventory of the second year. This creates an equal, but opposite effect on financial statement
items during the second accounting year.
12. Explain the relationship between the valuation of inventory and income measurement.
Answer: Inventory costs are capitalized on the balance sheet as assets because they provide
future economic benefits. The dollar amount at which the inventory is carried on the books is
the valuation of the inventory. Most often, original cost is the valuation, but in some cases,
the lower-of-cost-or-market rule applies. When goods are sold, the accountant must measure
cost of goods sold and ending inventory by applying a cost flow assumption. Cost flow
assumptions include FIFO, LIFO, averaging, and specific identification.

Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt, Michael F. Peters
9780470635292, 9781119537571, 9781119444367

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