Chapter 7, Problem 3P

1. (a), (b), (c) and (d)

To determine

Prepare an income statement through gross profit for the month of January under the following methods:

1. a. Average cost,
2. b. FIFO,
3. c. LIFO,
4. d. Specific identification method.

Explanation of Solution

Periodic Inventory System:

Periodic inventory system is a system, in which the inventory is updated in the accounting records on a periodic basis such as at the end of each month, quarter or year. In other words, it is an accounting method which is used to determine the amount of inventory at the end of each accounting period.

First-in-First-Out:

In First-in-First-Out method, the costs of the initially purchased items are considered as cost of goods sold, for the items which are sold first. The value of the ending inventory consists of the recent purchased items.

Last-in-First-Out:

In Last-in-First-Out method, the costs of last purchased items are considered as the cost of goods sold, for the items which are sold first. The value of the closing stock consists of the initial purchased items.

Weighted-average cost method:

Under Weighted average cost method, the company calculates a new average cost after every purchase is made. It is determined by dividing the cost of goods available for sale by the units on hand.

Specific identification method:

This method can be said as identifying the items precisely which are being sold and those which are being stored as closing inventory. The companies are required to keep perfect records of the original cost of each and every individual items of the inventory.

Cost of goods sold:

Cost of goods sold is the accumulate total of all direct cost incurred in manufacturing the goods or the products which has been sold during a period. Cost of goods sold involves direct material, direct labor, and manufacturing overheads.

Income statement:

The income statement is a financial statement that shows the net income earned or net loss suffered by a company through reporting all the revenues earned, and expenses incurred by the company over a specific period of time.

Prepare an income statement through gross profit for the month of January under the following methods:

COMPANY D
Partial Income Statement
For the Month Ended January 31, (current year)
Particulars	Average cost	FIFO	LIFO	Specific Identification
					(a)	(b)	(c)	(d)
Sales revenue (1)	$9,920	$9,920	$9,920	$9,920
Less: Cost of goods sold Table (2)	3,565	3,085	4,040	3,250.10
Gross profit	$6,355	$6,835	$5,880	$6,669.90

Table (1)

Working notes:

(1) Compute the amount of sales revenue:

$\begin{array}{c}\text{Sales}\text{revenue}=\text{Units}\text{sold}\times \text{Sales}\text{per}\text{unit}\\ \text{=}\left(\text{370Units}+\text{250Units}\right)\times \text{\$16}\\ =\$9,920\end{array}$

Compute the cost of goods sold under each method:

Particulars	Units	Average cost	FIFO	LIFO	Specific Identification
Beginning inventory						500	$2,365	$2,365	$2,365	$2,365
Add: Purchases (net)	760	4,880	4,880	4,880	4,880
Goods available for sale Table (3)	1,260	7,245	7,245	7,245	7,245
Less: Ending inventory	640	3,680 (2)	4,160 Table (4)	3,205 Table (5)	3,994.90 Table (6)
Cost of goods sold	620	$3,565	$3,085	$4,040	$3,250.10

Table (2)

Compute the goods available for sale:

Date	Particulars	Units ($)	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
January 1	Beginning inventory	500	4.73	2,365
January 12	Purchased	600	6	3,600
January 26	Purchased	160	8	1,280
	Total	1,260		$7,245
	Less: Goods sold	620
	Ending inventory	640

Table (3)

Compute the amount of ending inventory under average cost:

$\begin{array}{c}\text{Ending}\text{Inventory}=\left[\begin{array}{l}\text{Units of ending invenotry}\\ \times \text{average cost per unit}\end{array}\right]\\ =\text{640}\text{units}\times \left[\frac{\$7,245}{1,260\text{Units}}\right]\\ =\text{640}\text{units}\times \$5.75\\ =\$3,680\end{array}$

Compute the amount of ending inventory under FIFO:

Date	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
January 12	Purchased	480	6	2,880
January 26	Purchased	160	8	1,280
	Ending inventory	640		$4,160

Table (4)

Compute the amount of ending inventory under LIFO:

Date	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
January 12	Purchased	140	6	840
January 26	Purchased	500	4.73	2,365
	Ending inventory	640		$3,205

Table (5)

Compute the amount of ending inventory under specific identification method:

Date	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
January 1	Beginning balance	130	4.73	614.9
January 12	Purchased	350	6	2,100
January 26	Purchased	160	8	1,280
	Ending inventory	640		$3,994.9

Table (6)

2.

To determine

Describe the method that results in the higher pre-tax income and higher EPS.

Explanation of Solution

First-in-First-Out:

In First-in-First-Out method, the costs of the initially purchased items are considered as cost of goods sold, for the items which are sold first. The value of the ending inventory consists of the recent purchased items.

The FIFO method reports a higher pre-tax income than LIFO method. This is due to the following:

• The rise in price.
• FIFO allocates the lower unit costs to the cost of goods sold.

Similarly, for the EPS amount the FIFO method reports a higher EPS amount than LIFO method. This is because it produces a higher pretax income than LIFO.

3.

To determine

Describe the method that results in the lower income tax expense. Assume that the average tax rate is 30%.

Answer to Problem 3P

LIFO results in the lower income tax expense. This is because LIFO reports a lower pretax income than FIFO method.  The LIFO will derive lesser income tax than FIFO method by $286.5.

Explanation of Solution

Last-in-Last-Out:

In Last-in-First-Out method, the costs of last purchased items are considered as the cost of goods sold, for the items which are sold first. The value of the closing stock consists of the initial purchased items.

Compute the amount of income tax:

$\begin{array}{c}\text{Income tax expenses}=\left[\begin{array}{l}\text{Gross profit of FIFO}-\\ \text{Gross profit of LIFO}\end{array}\right]\times \text{30\%}\\ =\left(\text{\$6,835}-\text{\$5,880}\right)\times \text{30\%}\\ =\text{\$286}\text{.5}\end{array}$

4.

To determine

Determine the method that produces the most favorable cash flow.

Explanation of Solution

The LIFO method produces the most favorable cash flow by $286.5. This is because Under LIFO method the income tax expenses paid for the current year would be less than that of the FIFO method.