Chapter 7, Problem 7.3P

Evaluating Four Alternative Inventory Methods Based on Income and Cash Flow (AP7-2)

At the end of January of the current year, the records of Donner Company showed the following for a particular item that sold at SI6 per unit:

Transactions	Units	Amount
Inventory, January 1	500	$2,365
Purchase, January 12	600	3,600
Purchase, January 26	160	1,280
Sale	(370)
Sale	(250)

Required:

1. 1. Assuming the use of a periodic inventory system, prepare a summarized income statement through gross profit for the month of January under each method of inventory: (a) average cost, (b) FIFO, (c) LIFO, and (d) specific identification. For specific identification, assume that the first sale was selected from the beginning inventory and the second sale was selected from the January 12 purchase. Round the average cost per unit to the nearest cent. Show the inventory' computations in detail.
2. 2. Of FIFO and LIFO, which method results in the higher pretax income? Which method results in the higher KPS?
3. 3. Of FIFO and LIFO, which method results in the lower income tax expense? Explain, assuming a 30 percent average tax rate.
4. 4. Of FIFO and LIFO, which method produces the more favorable cash flow? Explain.

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.

Answer to Problem 7.3P

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)

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-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.

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 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. An income statement is also known as an operation statement, an earnings statement, a revenue statement, or a profit and loss statement. The net income is the excess of revenue over expenses.

Working notes:

Determine the amount of sales revenue:

$\begin{array}{c}\text{Sales}\text{revenue}=\text{Units}\text{sold}\times \text{Sales}\text{per}\text{unit}\\ \text{=}\left(\text{370Units}+\text{250Units}\right)\times \text{\$16}\\ =\$9,920\end{array}$ (1)

Determine 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)

Determine 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)

Determine the amount of ending inventory under average cost:

$\begin{array}{c}\text{Ending}\text{Inventory}=\left[\begin{array}{l}\text{Units of ending invenotry}\\ \times \text{average cost per unit}\end{array}\right]\\ =\text{640}\text{units}\times \left[\frac{\$7,245}{1,260\text{Units}}\right]\\ =\text{640}\text{units}\times \$5.75\\ =\$3,680\end{array}$ (2)

Determine 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)

Determine 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)

Determine 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	2,150		$3,994.9

Table (6)

Conclusion

Therefore, the income statement is prepared through gross profit for the month of January.

To determine

Describe the method that results in the higher pretax 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 pretax 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.

To determine

Describe the method that results in the lower income tax expense, assuming a 30% average tax rate.

Answer to Problem 7.3P

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.

Determine the amount of income tax:

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

To determine

Explain 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.