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Chapter 6
Inventories
O. Problems
P6-1. Suggested solution:
Potential benefit True / False

A perpetual system is less costly than a periodic system. F
A perpetual system produces information that is more useful for inventory
T
management.
A perpetual system helps to estimate expected amounts of inventory at year-end. T
A perpetual system allows a company to avoid conducting costly inventory counts. F
A perpetual system is required by IFRS and ASPE. F
A perpetual system helps to determine the amount of shrinkage. T
Feasible to track Benefit of Costs of tracking

inventory continuous inventory
continuously inventory tracking continuously Recommendation
Medium—with
High—helps to barcode scanning
determine the technology,
a. Supermarket Yes amount of spoilage continuous Perpetual
and theft, and when tracking is
to reorder. reasonably
affordable.
No—each unit of
inventory cannot Low—low risk of
b. Ice cream
be tracked due to theft or overcon- n/a Periodic
store
the inconsistent sumption by staff
sizes of servings
High—helps to
Low—items are
c. Car identify models that
Yes high value and Perpetual
dealership sell better or worse
easy to track
for future purchases
High—helps to
determine the
amount of theft or Low—items are
d. Electronics damage and to medium to high
Yes Perpetual
store identify products value and easy to
that sell better or track
worse for future
purchases
Copyright © 2020 Pearson Canada Inc.

6-158
Chapter 6: Inventories
a. A department store—Perpetual. A department store has a wide range of products that

need to be tracked to identify products that sell well versus others that do not. Theft is al-
so a significant concern, so information about the amount of shrinkage is valuable.
b. A furniture manufacturer—Periodic. Making furniture requires many different compo-
nents (wood, nails, screws, fabric) that have low value (although the finished product
may have high value). Trying to track how much of these raw materials are being used
for the manufacture of each item has little benefit but high cost in slowing down the pro-
duction process.
c. A restaurant—Periodic. It is not possible to track all the ingredients that go into the
preparation of meals served by the restaurant. Even if it were possible, there would be lit-
tle benefit to the information in terms of supply management.
d. A post office—Perpetual. Postage stamps are essentially pieces of paper that store value,
so they are similar to paper money. It is important for the post office to maintain tight
control over this inventory, so a perpetual system would be beneficial.
Item Product Period

a. Invoice cost of purchased inventory. √
b. Non-refundable tariffs on imported inventory. √
c. Cost of shelves and racks at retail store. √
d. Cost of shipping from distributor to warehouse. √
e. Transportation from warehouse to retail store. √
f. Cost to courier products to VIP customers. √
g. Rent for warehouse. √
h. Rent for retail store. √
i. Wages of staff at retail store. √
j Salary of purchasing manager. √
Include in
Item inventories Expensed
a. Raw materials. √
b. Salary for production line supervisor. √
c. Salary for sales manager. √
d. Pension benefits for assembly line workers. √
e. Electricity used in production plant. √
f. Production accountant (who tracks costs and variances). √
g. Cost of shipping to company’s warehouse prior to sale. √
h. Heating cost for production plant during operating hours. √
i. Heating cost for production plant during off-hours. √
j. Depreciation on production plant. √

6-159
ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fourth Edition
a. Dr. Inventory (purchase price) 1,700,000

Dr. HST recoverable* ($1,700,000 × 10%) 170,000
Cr. Cash ($1,700,000 + $170,000) 1,870,000
Dr. Inventory (freight in) 30,000

Cr. Cash 30,000
*The HST paid on the purchase is recoverable by Zoe and accordingly will not be
included in the cost of inventory to be allocated.
b. Costs to be allocated ($1,700,000 + $30,000) = $1,730,000

# Sales Total Factor Allocated
price
2 person spa 200 $5,000 $1,000,000 1,000 / 2,515 × 1,730,000 $ 687,873
4 person spa 140 6,000 840,000 840 / 2,515 × 1,730,000 577,813
6 person spa 90 7,500 675,000 675 / 2,515 × 1,730,000 464,314
$2,515,000 $1,730,000
a. To compute cost of goods sold and ending inventory, first compute the cost of goods
available for sale (COGAS). Since this is the first year of operations, COGAS equals the
current year’s production costs. (Later years would also need to include the cost of beginning
inventory.)
Product costs Amount

Opening raw materials $ 20,000
Raw materials purchases 140,000
Raw materials inventory, December 31 (30,000)
Raw materials used in production 130,000
Plant supplies 13,000
Direct labour 60,000
Production manager’s salary 75,000
Utilities expense ($40,000 × 85% for manufacturing facility) 34,000
Property taxes ($8,000 × 70% for manufacturing facility) 5,600
Depreciation – manufacturing facility 22,000
Depreciation – equipment 14,000
Total production cost = COGAS 353,600
a. Cost of goods sold ($353,600 COGAS × 85% sold) 300,560
b. Ending finished goods inventory ($353,600 COGAS × 15% remaining) $53,040

6-160
a. To compute cost of goods sold and ending inventory, first compute the cost of goods available
for sale (COGAS). Since this is the first year of operations, COGAS equals the current year’s
production costs. (Later years would also need to include the cost of beginning inventory.)
Product costs Amount
Raw materials purchases $123,500
Raw materials inventory, ending balance (14,600)
Raw materials used in production 108,900
Miscellaneous plant supplies 12,400
Direct labour 62,000
Supervisory salaries, production manager 65,000
Utilities expense (9/10 for plant) 18,000
Property taxes (4/5 of $5,000 for plant building) 4,000
Amortization, plant equipment 10,000
Total production cost = COGAS 280,300
Cost of goods sold (80% of COGAS) 224,240
Ending finished goods inventory (20% of COGAS) $ 56,060
b. Using the amounts for COGS and ending inventory from (a), and the other information
given, the income statement that results would be as follows:
Inventive Controls
Income Statement
For the year ended December 31, 2019
Sales $527,000
Cost of goods sold 224,240
Gross profit 302,760
Sales commissions 75,000
General administration expenses 38,800
Executive salaries 100,000
Utilities expense (1/10 related to the office) 2,000
Property taxes (1/5 for office building) 1,000
Amortization, office building 8,000
Income before tax $ 77,960
Potential reason for requirement to capitalize under IFRS and ASPE: Yes / No
The fixed overhead is relatively constant, which contributes to stable values of
N
earnings and inventories.
Fixed overhead contributes to the production of goods that have future benefits. Y
Capitalizing fixed overhead into inventories helps to match costs to revenues. Y
Capitalizing fixed overhead into inventories helps to smooth earnings. N
Fixed overhead costs are reliable and verifiable. N
Capitalizing fixed overhead is consistent with the going-concern assumption. Y
Fixed overhead costs are measurable and are usually material. N

6-161
The correct answer is (b). When actual production exceeds normal, the fixed overhead rate is
reduced so as not to overallocate fixed overhead to inventory. The total overhead cost of $10,000
is allocated over 1,250 units of actual production, resulting in $8/unit.
The correct answer is (a). When actual production is significantly below normal, the fixed
overhead rate is not increased, but remains at $20/unit. For 500 units produced, the amount of
fixed overhead capitalized in inventory is 500 units × $20/unit = $10,000. The remaining fixed
overhead ($10,000) would be directly expensed.
Amount Amount
Production capitalized into directly
level inventories expensed Explanation
120,000 units $500,000 $ 0 At or above normal production level.
110,000 units 500,000 0 Capitalize all fixed overhead. Per unit fixed
100,000 units 500,000 0 overhead rate would be adjusted.
98,000 units 500,000 0 Within range (+/–5%) of normal production.
90,000 units 450,000 50,000
Significantly below normal production.
80,000 units 400,000 100,000
Capitalize at $5/unit and expense remainder.
0 units 0 500,000

6-162
# units for
Fixed fixed
Production overhead Total fixed overhead
level allocation rate = overhead ÷ allocation Explanation
50,000 units $ 80.00 $4,000,000 50,000 units When production is at or
above normal level, fixed
46,000 units 86.96 $4,000,000 46,000 units overhead rate should be
42,000 units 95.24 $4,000,000 42,000 units adjusted downward using
actual production volume so
40,000 units 100.00 $4,000,000 40,000 units as not to over-capitalize
overhead.
Within normal range (+/–
39,000 units 102.56 $4,000,000 39,000 units 10%) of normal production
level.
Significantly below normal
30,000 units 100.00 $4,000,000 40,000 units
production. Use normal
production level to allocate
costs so that cost per unit is
0 units 100.00 $4,000,000 40,000 units
not overstated.
a. This question indicates that the actual production volume approximated normal levels, so
all material production variances should be adjusted through inventories (rather than ex-
pensed).
Inventory
Item Standard cost Variance amount
Raw materials $ 210,000 $15,000 U $ 225,000
Production wages 670,000 20,000 F 650,000
Variable production overhead 180,000 3,000 F 177,000
Fixed production overhead 350,000 50,000 U 400,000
Total production cost $1,410,000 $42,000 U $1,452,000
b. If actual volume exceeded normal, the fixed cost per unit would need to be lowered so
that total fixed cost absorbed by production equals total fixed costs. If actual volume is
significantly lower than normal, the unallocated fixed cost would be expensed.

6-163
The standard rate for fixed overhead has been determined based on a normal production level of
750 batches. Since the actual production volume of 900 batches exceeded this level, the fixed
overhead rate needs to be recomputed (i.e., reduced) so as not to overallocate fixed overhead.
Total fixed overhead, which comprises depreciation on storage silos, is $300/batch × 750 batches
= $225,000.
Cost of goods sold is then computed as follows:

Cost per
batch # batches Amount
Variable costs $2,200 900 $1,980,000
Fixed production costs $ 250 900 225,000
Total production cost to include in inventories $2,450 900 $2,205,000
Add: Opening inventory (raw materials) 1,200,000
Cost of goods available for sale 3,405,000
Less: Ending inventory (raw materials) ( 900,000)
Cost of goods sold $2,505,000
Total fixed overhead equals 500 units × $20,000/unit = $10,000,000.

Cost per unit # units Amount
Variable costs $70,000 320 $22,400,000
Fixed production costs $20,000 320 6,400,000
Total production cost to include in inventories $90,000 $28,800,000
Fixed overhead $20,000 500 $10,000,000

Fixed overhead allocated (see above) 6,400,000
Unallocated fixed overhead to be expensed $ 3,600,000
Sales $42,000,000
Cost of sales
From opening inventory 40 ( 3,600,000)
From current year production $90,000 240 (21,600,000)
Unallocated fixed overhead
( 3,600,000)
($10,000,000 – $6,400,000)
Gross profit $13,200,000

6-164
a. Using normal production volume of 20,000 units of each production line, the total fixed
cost of $5 million equals $125/unit. If the two product lines were treated separately, the
following amounts would result:
Economy line Cost per unit # units Amount
Variable costs $300 16,000 $4,800,000
Fixed production costs $125 16,000 2,000,000
Total production costs $425 $6,800,000
Fixed overhead $125 20,000 $2,500,000

Fixed overhead allocated (see above) 2,000,000
Unallocated fixed overhead to be expensed $ 500,000
Cost of sales
From opening inventory $425 4,000 $1,700,000
From current-year production $425 11,000 4,675,000
Unallocated fixed overhead (see above) 500,000
Total cost of sales—Economy line $458.33 15,000 $6,875,000
Deluxe line Cost per unit # batches Amount
Variable costs $400 24,000 $9,600,000
Fixed production costs $104.17 24,000 2,500,000
Total production costs $504.17 24,000 $12,100,000
Cost of sales
From opening inventory $525.00 4,000 $ 2,100,000
From current-year production 504.17 21,000 10,587,500
Cost of goods sold—Deluxe line 507.50 25,000 $12,687,500
Thus, the cost of goods sold for Variety Appliances = $6,875,000 + 12, 687,500 =
$19,562,500.
b. If both production lines were considered together, the below-normal production of the
Economy line would be offset by the above-normal production of the Deluxe line. That
is, production of both lines taken as a whole approximated normal production levels. The
following amounts would result.
Economy line Cost per unit # units Amount
Variable costs $300 16,000 $4,800,000
Cost of sales
From opening inventory $425 4,000 $1,700,000
From current-year production $425 11,000 4,675,000
Total cost of sales—Economy line $425 15,000 $6,375,000

6-165
Deluxe line Cost per unit # batches Amount

Variable costs $400 24,000 $9,600,000
Cost of sales
From opening inventory $525.00 4,000 $ 2,100,000
From current-year production 525.00 21,000 11,025,000
Cost of goods sold—Deluxe line 525.00 25,000 $13,125,000
Total cost of goods sold for both lines combined = $6,375,000 + 13,125,000 = $19,500,000.
This amount is $62,500 lower than that obtained in part (a) because there was a cost reduc-
tion resulting from not having to expense $500,000 of unallocated overhead on the Economy
line, partially offset by a $20.83 higher fixed overhead rate on the Deluxe line that resulted in
$20.83/unit × 21,000 units = $437,500 of additional fixed overhead expensed through COGS.
c. Either approach (a) or (b) is acceptable, and professional judgment is necessary. One
could argue that the two product lines are distinct and therefore the overhead allocation
needs to be made separately. For Variety Appliances, the production process suggests
that the two product lines are manufactured through the same production process, so there
is an argument to treat them both together for the purpose of allocating fixed overhead.
Doing so has the advantage that a change in product mix will not result in unallocated
overhead in one product while there is a need to reduce overhead rates for another prod-
uct line to prevent overallocation.
a.
Inventory quantity 2020
Beginning balance 1,540 mbf Given
Production 3,230 mbf Solve
Units sold 2,820 mbf Given
Ending balance 1,950 mbf Given
Production cost = 90,000/mbf  3,230 mbf + $120,000,000

= $410,700,000
Cost per mbf = $410,700,000 / 3,230 mbf
= $127,152/mbf

6-166
b.
Units × Unit cost = Total cost
Opening inventory 1,540 mbf $216,000,000
Current-period production 3,230 mbf $127.152/mbf 410,700,000
Goods available for sale 4,770 mbf $626,700,000
Weighted-average cost per unit 131.384/mbf
Cost of goods sold (2,820 mbf) 131.384/mbf ($370,501,887)
Ending inventory 1,950 mbf 131.384/mbf $256,198,113
c.
d. The inventory turnover ratio indicates how fast the inventory is being sold; that is, how
many times the inventory is sold in a period.
e. With a single product, there is sufficient information here to compute an inventory

turnover ratio based on physical quantities rather than dollar value. (When there are mul-
tiple products, this computation would not be possible.)
f. Cost of goods sold using variable costing is computed as follows:

Variable costing COGS = units sold  variable cost/unit
= 2,820 mbf  $90,000/mbf
= $253,800,000
Ending inventory = 2,500 units × $11/unit = $27,500.

COGS = COGAS – ending inventory = $132,000 – $27,500 = $104,500.

6-167
P6-19. Alternative solution:
Compute COGS first, then ending inventory.

COGS = $25,000 + $36,000 +$27,000 + (1,500 units × $11/unit)
= $25,000 + $36,000 + $27,000 + $16,500
= $104,500.
Ending inventory = COGAS – COGS = $132,000 – $104,500 = $27,500.
a. WAC = COGAS / # units available for sale = $132,000 / 11,000 = $12.00.

b. Number of units sold = 11,000 – 2,500 = 8,500.
COGS = 8,500 units × $12 / unit = $102,000.
Ending inventory = 2,500 units × $12 / unit = $30,000.
Compute ending inventory value first, then COGS.

Cost per
# units unit Total cost
Beginning inventory, January 1 300 $200 $ 60,000
Purchase, January 7 200 $210 42,000
Purchase, January 22 400 $205 82,000
Goods available for sale 900 184,000
Ending inventory, January 31 (200) $205 41,000
Goods sold 700 $143,000
P6-21. Alternative solution:
Compute COGS first, then ending inventory.

Units to
Cost per include in
# units unit Total cost COGS Total $
Beginning inventory, January 1 300 $200 $60,000 300 $60,000
Purchase, January 7 200 $210 42,000 200 42,000
Purchase, January 22 400 $205 82,000 200 41,000
Goods available for sale 900 184,000
Goods sold (700) 143,000 700 143,000
Ending inventory, January 31 200 $205 $41,000

6-168
Cost per
Beginning inventory, January 1 3,000 $5.00 $ 15,000
Purchase, January 4 5,000 5.10 25,500
Sales, month of January (12,000)
Purchase, February 14 8,000 5.00 40,000
Sales, month of February (7,000)
Purchases, March 7 4,000 4.95 19,800
Purchases, March 21 5,000 5.10 25,500
Sales, month of March (11,000) -
Cost of goods available for sale - $156,700
Ending inventory 1,000
Cost of ending inventory = 1,000 units × $5.10/unit (latest purchase) = $5,100.

COGS = COGAS – ending inventory = $156,700 – $5,100 = $151,600.
Cost per
Beginning inventory, January 1 3,000 $5.00 $15,000
Goods available for sale 14,000 $71,400
Weighted-average cost 5.10
Sales, month of January (12,000) 5.10 (61,200)
Ending inventory, January 31 2,000 5.10 $10,200

Sales, month of February (7,000) 5.02 (35,140)
Ending inventory, February 28 3,000 5.02 15,060
Purchases, March 7 4,000 4.95 19,800

Purchases, March 21 5,000 5.10 25,500
Goods available for sale 12,000 60,360
Sales, month of March (11,000) 5.03 (55,330)
Ending inventory, March 31 1,000 5.03 $ 5,030
COGS = $61,200 + $35,140 + $55,330 = $151,670.
Cost of ending inventory = 1,000 units × $5.03/unit = $5,030.

6-169
Cost per
Beginning inventory, January 1 3,000 $5.00 $15,000
Sales, month of January (12,000) 61,400*
Ending inventory, January 31 2,000 5.00 $10,000

Sales, month of February (7,000) $35,000
Ending inventory, February 28 3,000 5.00 $15,000
Purchases, March 7 4,000 4.95 19,800

Purchases, March 21 5,000 5.10 25,500
Sales, month of March (11,000) 55,300*
Ending inventory, March 31 1,000 5.00 $ 5,000
COGS, January $ 61,400

COGS, February 35,000
COGS, March 55,300
Total COGS, January – March $151,700
*Calculation of COGS:
COGS (January) = $30,900 + $25,500 + 1,000 units × $5.00/unit= $61,400.
Or = COGAS – Ending inventory = $71,400 – $10,000 = $61,400.
COGS (February) =7,000 units × $5.00/unit (from Feb. 14 purchase) = $35,000.
COGS (March) = $25,500 + $19,800 + 2,000 units × $5.00/unit= $61,400.
P6-25. Suggested solution
To answer this question, we need to calculate the ending inventory using each of the three
methods and find the amount that matches the reported amount of $67,200.
FIFO LIFO Weighted average
Ending inventory units 320 320 320
Per unit cost × 508,000 / 2400 × $80,000 / 400 × 588,000 / 2800
Ending inventory value = $67,733 = $64,000 = $67,200
The amount obtained using the weighted-average calculation matches the reported inventory
value, so we conclude that the company uses the weighted-average cost flow assumption.

6-170
a. The lower of cost and market method does not apply matching. Rather, it is a method to
value the ending inventory and the amount of expense that would result does not neces-
sarily match the revenue recognized in the period.
b. The highest income corresponds to the lowest cost of goods sold. Since 2020 is the first
year of operations, the lowest cost of goods sold occurs when the ending inventory is the
highest. Thus, the answer is the FIFO method. Although not required, numerical proof is
as follows:
Spec. ID FIFO Avg. cost LOCM
Opening inventory $ 0 $ 0 $ 0 $ 0
+ Purchases 600,000 600,000 600,000 600,000
− Ending inventory (212,000) (220,000) (216,000) (196,000)
= Cost of goods sold $388,000 $380,000 $384,000 $404,000
c. The cost of goods sold for the second year under FIFO would be $732,000, calculated as
follows:
FIFO
Opening inventory $220,000
+ Purchases 700,000
− Ending inventory (188,000)
= Cost of goods sold $732,000
The best answer is (d): the last-in, first-out (LIFO) periodic system will tend to have the lowest
year-end inventory value. When the purchase price is rising, the oldest inventory costs tend to be
the lowest (on a per unit basis). The LIFO system expenses the newest costs to cost of goods sold
(COGS) and retains the oldest costs as inventory, which would be the lowest costs.
The first-in, first-out (FIFO) method has the opposite effect, expensing the oldest costs to COGS
and retaining in inventory the newest costs, which tend to be the highest. The perpetual system
for FIFO produces the same result as the periodic system.
The specific identification method would produce results similar to FIFO if the flow of goods is
similar to the flow of costs (i.e., oldest units are sold first). It is unlikely for a firm that uses the
specific identification method to retains the oldest products in inventory.
The weighted average cost method produces results in-between LIFO and FIFO so this method
will not produce the lowest inventory values.

6-171
a. The periodic FIFO ending inventory would be $120,000, calculated as follows:

Ending inventory from purchase #2 3,000 $28 $ 84,000
Ending inventory from purchase #1 1,000 $36 36,000
Total (# units given) 4,000 $120,000
b. The periodic weighted-average cost of goods sold would be $174,667, calculated as

follows:
Opening inventory 3,600 $40 $144,000
Purchase #1 2,400 $36 86,400
Purchase #2 3,000 $28 84,000
Total 9,000 $314,400
Weighted-average cost per unit
$34.9333
($314,400 / 9,000)
Cost of goods sold 5,000 $34.9333 $174,667
c. The perpetual weighted-average ending inventory would be $136,960, calculated as

follows:
Opening inventory 3,600 $40 $144,000
Purchase #1 2,400 $36 86,400
Sub-total 6,000 230,400
Weighted-average cost per unit $38.40
Cost of sale #1 (1,500) $38.40 (57,600)
Purchase #2 3,000 $28 84,000
Subtotal 7,500 $256,800
Cost of sale #2 3,500 $34.24 (119,840)
Ending inventory 4,000 $34.24 $136,960
First, calculate cost of goods available for sale (COGAS), which is the same for all three cost
flow assumptions.
Opening inventory 3,000 $8.00 $24,000
Purchase #1 2,000 $7.65 15,300
Purchase #2 4,000 $7.50 30,000
Total available for sale 9,000 $69,300

6-172
a. Weighted average, periodic

Units × Unit cost Total cost
$7.70
(COGAS / # units available for sale)
b. FIFO, perpetual [Note: perpetual and periodic systems yield the same results under
FIFO.]
Ending inventory from purchase #2 4,000 $7.50 $ 30,000
Ending inventory from purchase #1 1,000 $7.65 7,650
Total ending inventory 5,000 $37,650
Cost of goods sold (COGAS—end inv.) $31,650
c. Weighted average, perpetual

Purchase #1 2,000 $7.65 15,300
Subtotal 5,000 39,300
Sale #1 (1,500) $7.86 (11,790)
Purchase #2 4,000 $7.50 30,000
Subtotal 7,500 57,510
Sale #2 (2,500) $7.668 (19,170)
Cost of goods sold (COGAS—end inv.) $30,960
First, calculate cost of goods available for sale (COGAS), which is the same for all three cost
flow assumptions.
Opening inventory 10,000 $16.00 $ 160,000
Purchase #1 5,000 17.50 87,500
Purchase #2 4,000 17.25 69,000
Purchase #3 6,000 16.75 100,500

6-173
a. FIFO, periodic [Note: under FIFO, perpetual and periodic systems will produce the same
results.]
Ending inventory from purchase #3 500 $16.75 $8,375
Total ending inventory 500 $8,375
Cost of goods available for sale $417,000

Less: Ending inventory (8,375)
Cost of goods sold $408,625
b. Weighted average, periodic

$16.68
(COGAS / # units available for sale)
Ending inventory 500 $16.68 $8,340

c. Weighted average, perpetual

Purchase #1 5,000 17.5000 87,500
Subtotal 15,000 247,500
Weighted-average cost per unit 16.5000
Sale #1 (500) 16.5000 (8,250)
Purchase #2 4,000 17.2500 69,000
Subtotal 18,500 308,250
Sale #2 (11,000) 16.6622 (183,284)
Purchase #3 6,000 16.7500 100,500
Subtotal 13,500 225,466
Sale #3 (13,000) 16.7012 (217,116)
Ending inventory (rounded) 500 16.7012 $ 8,350


6-174
a.i. To record the purchase of the inventory

P#1 Dr. Inventory* 87,500
Cr. Accounts payable 87,500


a.ii. To record the sale of the inventory

S#1 Dr. Cash (500 × $24.00) 12,000
Cr. Sales 12,000
Dr. Cost of goods sold* 8,250
Cr. Inventory 8,250
S#2 Dr. Cash (11,000 × $26.00) 286,000

Cr. Sales 286,000
Cr. Inventory 183,284
S#3 Dr. Cash (13,000 × $25.50) 331,500

Cr. Sales 331,500
a.iii. To record payment of the trade payables account

I#1 Dr. Accounts payable* 87,500
Cr. Cash ($87,500 - $1,750) 85,750
Cr. Purchase discounts ($87,500 × 2%) 1,750

Cr. Cash 69,000

Cr. Cash 100,500
*See the solution to P6-29 To determine how these amounts were calculated
b. $629,500 ($12,000 + $286,000 + $331,500) would be reported as a cash inflow from the sale
of inventory. $255,250 ($85,750 + $69,000 + $100,500) would be reported as a cash outflow
from the purchase of inventory on GFF’s Statement of Cash Flows.

6-175
Regular products: retail price = cost × 200%  cost = 50% of retail price.
Discounted products: retail price = cost × 200% × (1 – 30%)  cost = retail price / (200% ×
70%) = 71.4% of retail price.
Mark-up = 50% on cost  retail price = 150% of cost  cost = 2/3 of retail price.
Cost of goods sold = $330,000 × 2/3 = $220,000.
Ending inventory = BI + P – COGS = $160,000 + $200,000 – $220,000 = $140,000.
Mark-down Estimated
(% of Retail price Cost as % cost
Product Mark-up regular per dollar of retail Retail value (cost % ×
category (% on cost) price) of cost price of inventory retail value)
Regular 100% — 2.00 50% $2,860,000 $1,430,000
Discounted 100% 35% 1.30 76.92% 520,000 400,000
Total $3,380,000 $1,830,000
COGS = Beginning inventory + Purchases – Ending inventory

= $1,790,000 + $13,700,000 – $1,830,000
= $13,660,000
a. No. FG NRV exceeds FG cost, so RM does not need to be examined.

b. No. FG NRV is below FG cost, so RM needs to be examined. RM replacement cost exceeds
RM cost so no write down.
c. Yes. FG NRV is below cost, so need to examine RM for write-down. RM replacement cost is
below RM actual cost so write-down is required.
d. No. FG NRV exceeds FG cost, so RM does not need to be examined. WIP NRV being below
WIP cost is irrelevant.
Write-
Net down per
realizable unit
Selling value required Total
costs (price – (cost – write-
Cost per Selling (10% of selling NRV) or down for
Product # Units unit price price) cost) 0 product

6-176
A 200 $ 40 $ 80 $8 $ 72 $ 0 $ 0
B 100 150 120 $12 108 42 4,200
C 300 60 100 $10 90 0 0
D 200 100 100 $10 90 10 2,000
E 300 65 70 $7 63 2 600
Total $6,800

6-177
Net Write-
Cost per Replace- realizable down?
Inventory item unit ment cost value (Yes / No)
Finished good A $100 — $200 No
Raw material A $50 $50 — No
Finished good B $100 — $220 No

Raw material B $50 $45 — No
Finished good C $100 — $80 Yes

Raw material C $50 $50 — No
Finished good D $100 — $80 Yes

Raw material D $50 $45 — Yes
For B, even though the raw materials replacement cost is below cost in the books, the finished
product has NRV exceeding cost, so neither the finished product nor the raw material needs to be
written down.
a. The finished product’s NRV < cost. Therefore, it needs to be written down by $20 per
unit on 300 units, for a total of $6,000.
The raw materials need to be evaluated together, not individually, because they are both
required to produce the finished product.
Total
Cost per Replace- replace- Write-
Inventory item # Units unit ment cost Total cost ment cost down
Raw material A 200 $ 20 $ 25 $4,000 $5,000
Raw material B 100 50 45 5,000 4,500
Total $9,000 $9,500 nil
b. If the replacement cost of raw material A were to be $21 per unit, the answer would
change even though $21 is higher than cost. This is because the raw materials need to be
evaluated together as they are jointly used in production. The amount of write-down is
determined as follows:
Total
Raw material A 200 $ 20 $ 21 $4,000 $4,200
Raw material B 100 50 45 5,000 4,500
Total $9,000 $8,700 $300

6-178
Alphas
Finished goods: NRV ($425) < cost ($450), so Alphas need to be written down.
Raw materials need to be evaluated for impairment.
Betas
Finished goods: NRV ($600) > cost ($520), so Betas are not impaired.
Raw materials do not need to be evaluated for impairment because the final product is not
impaired.
The inventory write-down computations for Alphas and its raw materials are as follows. Note
that the three types of raw materials need to be considered together because they are all required
to produce Alphas.
Total
Raw material A 50 $ 30 $ 20 $1,500 $1,000
Raw material B 100 10 11 1,000 1,100
Raw material C 80 50 40 4,000 3,200
Total $6,500 $5,300 $1,200
a. The costs related to production should be included in the inventory account (work-in-
process). Non-product (period) costs should be expensed. Storage and interest costs are
period costs; all other costs are product costs. The journal entry to correct the error is as
follows:
Debit Credit
Dr. Inventory (WIP) 175,000
Dr. Storage expense 4,000
Dr. Interest expense 3,000
Cr. Production expense 182,000
b. Assuming the periodic FIFO method, the cost of goods sold and ending inventory are
computed as follows:
# pairs Cost per pair Total
Opening inventory 5,000 $2.40 $ 12,000
Production during year 70,000 $2.50 175,000
Cost of goods available for sale 75,000 $187,000
Cost of goods sold—from opening inv. 5,000 $2.40 $ 12,000

Cost of goods sold—from production 64,000 $2.50 160,000
Cost of goods sold—total 69,000 $172,000
Ending inventory 6,000 $2.50 $ 15,000

6-179
c. Assuming the periodic weighted average cost method, the cost of goods sold and ending
inventory are computed as follows:
# pairs Cost per pair Total
Cost of goods available for sale (see (b)) 75,000 $187,000
Weighted average cost
$2.4933
(COGAS/units available for sale)
Ending inventory 6,000 $2.4933 $ 14,960
a. The puppy inventory needs to be written down to the lower of cost and market. “Market”
should be net realizable value, or $100 each. The replacement cost of $40 each is not rel-
evant. Since the purchases had been recorded at $150 each, the inventory value needs to
be written down by $50 per puppy.
Dr. Loss on write-down of inventory (or cost of sales) 4,500
Cr. Inventories (90 puppies × $50 / puppy) 4,500
b. Inventory, December 31, 2020: overstated by $4,500

Cost of goods sold, year 2020: understated by $4,500
Cost of goods sold, year 2021: overstated by $4,500
2020 income 2021 income 2021 end R/E

a. Inventory count error overstated $15,000 understated $15,000 correct
b. Invoice recorded too
overstated $24,000 understated $24,000 correct
late
c. Incorrect inclusion of
consignment goods in correct overstated $37,000 overstated $37,000
inventory
a. Dr. Retained earnings (re: cost of goods sold for 2020) 15,000
Cr. Cost of goods sold 15,000
b. Dr. Retained earnings (re: cost of goods sold for 2020) 24,000
Cr. Cost of goods sold* 24,000
c. Dr. Cost of goods sold 37,000

* This amount may be recorded in purchases if the purchases account has not yet been closed for
the year.

6-180
Year 1 Year 2
Scenario Inventory Income Inventory Income
a. $25,000 overstated $25,000 overstated correct $25,000 understated
b. 8,000 overstated 8,000 overstated correct 8,000 understated
c. correct 15,000 overstated correct 15,000 understated
d. correct correct correct correct
a. Use the cost of goods sold equation: COGS = BI + P – EI. Ending inventory in Year 1 is
overstated by $25,000, so COGS is understated and income overstated. Beginning inventory
in Year 2 is overstated, so COGS is overstated and income understated in Year 2.
b. Reasoning similar to (a).
c. Ending inventory is correct according to year-end count. Since purchase was not recorded,
COGS = BI + P – EI is understated, so income is overstated in Year 1. Recording the pur-
chase incorrectly in Year 2 overstated COGS and understated income in Year 2.
a.
WA cost per unit = COGAS / units available = $540,000 / 250 units = $2,160/unit
Ending inventory = 90 units  $2,160/unit = $194,400
COGS = 160 units  $2,160/unit = $345,600
Or COGS = COGAS – ending inv = $540,000 - $194,400 = $345,600
b.
Direction
(overstated or understated) Amount ($)
2019 Cost of goods sold understated $10,000
2019 Ending retained earnings overstated $10,000
2020 Cost of goods sold overstated $10,000
2020 Ending retained earnings correct 0
c.
Production Total variable Per unit cost of production for
volume costs Fixed costs financial reporting purposes
250 units $300,000 $200,000 $2,000
200 units $240,000 $200,000 $2,200
100 units $120,000 $200,000 $2,200*
*Per unit fixed cost is not increased due to abnormally low production volume.

6-181
a. The inventory account included $800,000 too much cost. The $300,000 salary of the
company president and the $500,000 cost of advertising and promotion are not part of the
production process, so they cannot be included in inventories. The corrected amount
should be $13,580,000 – $800,000 = $12,780,000.
b. To determine the ending value of inventory and cost of goods sold, first determine the
per-unit cost of the bikes manufactured in the year. Correcting for the error in part (a), to-
tal cost is $12,780,000. Production was 50,000 bikes, so cost per bike is $12,780,000 /
50,000 = $255.60.
Beginning inventory 6,000 bikes × $250 / bike $ 1,500,000
Cost of goods manufactured 12,780,000
Cost of goods available for sale $14,280,000
Ending inventory 4,000 bikes × $255.60 / bike – 1,022,400
Cost of goods sold $13,257,600
c. If the error in inventory costing has not been corrected as per part (a), the inventory
would be overstated by $64,000, computed as follows:
Uncorrected cost per unit produced $13,580,000 / 50,000 bikes $271.60 / bike
Uncorrected ending inventory 4,000 bikes × $271,60 $1,086,400
Corrected inventory From part (b) 1,022,400
$ 64,000
In this particular scenario, this amount can also be computed more directly using the $800,000 of
overstatement:
$800,000 / 50,000 units of production = $16 / unit
$16 / unit × 4,000 units of ending inventory = $64,000
Note that this computation works in this case because the company uses FIFO and the ending
inventory costs all derive from production during the year. If the number of units in ending
inventory exceeds the number of units in beginning inventory, then this computation would be
incorrect.
d. The correcting journal entry is as follows. Note that the effect of the error needs to be
allocated between units sold and units remaining in inventory.
Dr. Salary and wages expense 300,000
Dr. Advertising and promotion expense 500,000
Cr. Inventory (from part c, $16 / bike × 4,000 units) 64,000
Cr. Cost of goods sold ($16 / bike × 46,000 units) 736,000
e. If the company had used the weighted-average cost method, the ending inventory and COGS
would be as follows:
Cost of goods available for sale (from part a) $14,280,000
Units available for sale 56,000 bikes
Weighted-average cost per unit $255 / bike
Ending inventory 4,000 bikes × $255 / bike $1,020,000
Cost of goods sold $14,280,000 – $1,020,000 $13,260,000

6-182
It is important to note that a change from FIFO to weighted-average cost would be a change in
accounting policy. Such changes must be reflected retrospectively, the same as would be for an
accounting error. Recognizing this fact, we begin with re-computing figures for 2020 and
carrying through the changes to the current year 2021. (Note that the information indicates that
prices were stable prior to 2020, so FIFO and WA cost numbers would not be materially
different.)
Be-
gin- Purchas- Units Units COGS or Units
ning es or avail. sold or cost of in
inven- transfers for pro- goods inven- Ending
tory in* COGAS sale WA cost cessed processed tory inventory
Column A B C D E F G H I
Calculation A+B C/D E×F E×H
2020 $ $ $ # $ # $ # $
Glass 2,500 53,500 56,000 1,377 40.67 1,302 52,950 75 3,050
Aluminum 1,600 33,500 35,100 1,377 25.49 1,302 33,188 75 1,912
WIP 4,600 312,338 316,938 1,325 239.20 1,300 310,958 25 5,980
Fin. goods 24,200 310,958 335,158 1,421 235.86 1,301 306,855 120 28,303
2021 $ $ $ # $ # $ # $
Glass 3,050 74,700 77,750 1,310 59.35 1,250 74,189 60 3,561
Aluminum 1,912 50,700 52,612 1,310 40.16 1,250 50,202 60 2,410
WIP 5,980 340,491 346,471 1,275 271.74 1,260 342,395 15 4,076
Fin. goods 28,303 342,395 370,698 1,380 268.62 1,230 330,405 150 40,293
* Note that transfers into WIP and finished goods need to be adjusted for changes in cost in
earlier stages of inventory:
WIP transfer in (@WA cost) = WIP transfer in (@ FIFO)
+ change in cost of raw materials processed
2020 WIP transfer in (@WA cost) = $311,800 + (52,950 – 52,600) + (33,188 – 33,000)
= $312,338
2021 WIP transfer in (@WA cost) = $339,100 + (74,189 – 73,200) + (50,202 – 49,800)
= $340,491

6-183
With this information in hand, we can restate the financial statements.

2021 2020
Original Revised Original Revised
FIFO WA Cost Change FIFO WA Cost Change
Cash $ 8,900 $ 8,900 $ 0 $ 7,600 $ 7,600 $ 0
Accounts receivable 42,600 42,600 0 40,900 40,900 0
Inventories: raw materials 7,900 5,971 -1,929 5,500 4,962 -538
Inventories: work-in-process 5,100 4,076 -1,024 6,200 5,980 -220
Inventories: finished goods 48,400 40,293 -8,107 29,400 28,303 -1,097
Other assets 320,000 320,000 0 310,000 310,000 0
Total assets $432,900 $421,888 -11,060 $399,600 $397,745 -1,855
Total liabilities $113,800 $113,800 0 $137,900 $137,900 0
Contributed capital 5,000 5,000 0 5,000 5,000 0
Retained earnings 314,100 302,288 -11,060 256,700 254,845 -1,855
Total liabilities and equity $432,900 $421,888 -11,060 $399,600 $397,745 -1,855
Sales $561,000 $561,000 $ 0 $529,000 $529,000 $ 0

Cost of goods sold 321,200 330,405 +9,205 305,000 306,855 +1,855
Gross margin $239,800 $230,596 -9,205 $224,000 $222,145 -1,855
Operating expenses 182,600 182,600 0 178,300 178,300 0
Net income $ 57,200 $ 47,996 -9,205 $ 45,700 $ 43,845 -1,855
The cumulative effect on income over the two years is -$1,855 – $9,205 = -$11,060, which is the
amount by which retained earnings decreases. As the owner of Oculus speculated, using the
weighted-average cost method would reduce income by just over 10% of the income over the
two years ($11,060 / ($45,700 +$ 57,200)).
a. The company only has finished goods, which makes sense for a retailer.
b. Inventory cost includes purchase cost plus inbound shipping costs.
c. The company uses the weighted-average cost flow assumption.
d. Net realizable value is the estimated normal selling price less estimated selling expenses.
Note 3 on Significant Accounting Policies contains the above information.
e. Days of inventory = merchandise inventory / cost of sales = $1,448.6 m / $6,916.7 × 365

days = 76.4 days. Merchandise inventory is obtained from the balance sheet while cost of
sales is from Note 33. In 2010, this figure is $901.0 m / $6016.2m × 365 days = 54.7 days.

6-184
The increase in days of inventory is mostly a result of the acquisition of Forzani Group
Ltd. (FGL): the purchase was completed on August 18, 2011 (Note 1 and Note 8 of the fi-
nancial statements on pages 88 and 110), so the 2011 financial statements include only
about 4.5 months of FGL sales and cost of sales, but all of the FGL inventories at Decem-
ber 31, 2011. Note 8 also shows that FGL had $455.9 million of inventories on the date of
purchase. While the company does not disclose the cost of sales for FGL, it does indicate
that FGL contributed $645.6 million of revenue From August 19 to December 31, 2011. To
make the ratio comparable between the two years, one of two adjustments can be made: (i)
remove an estimated amount of inventory and cost of sales related to FGL, or (ii) increase
the cost of sales by extrapolating FGL sales and cost of sales to a full year.
a. The balance sheet shows inventories at $5,844 million. Note 17 on page 176 shows three
components comprising this amount, being: Aerospace programs ($3,187m), work-in-
process on long-term contracts for production ($1,538m) and service ($215m), and finished
products ($904m).
b. Work-in-progress on long-term contracts reflects the contracted price and the percentage
completed, in accordance with the percentage-of-completion method (see Chapter 4). That
is, the inventory amount includes not only costs, but also the profit margin on the contract.
See excerpt of accounting policy disclosure from page 147 shown below.

6-185
c. To determine the cost of inventories and cost of sales for aircraft, the company uses the
“unit cost method” (see excerpt below). This term is not standard terminology and is not
defined / explained elsewhere in the annual report. In context of aircraft (high value item),
it is likely to mean the specific identification method (i.e., the cost specifically identified
with each unit). This method is in contrast to the moving average method used for spare
parts.
a. Note 10 on page 77 indicates that inventories on hand at December 31, 2016 totalled $1,760
million of which $1673 million was classified as current with the remaining $87 million
classified as long term. The four components comprising this amount were: supplies ($586m),
raw materials ($204m), work-in-process ($521m), and finished products ($449m).

6-186
b. Long term inventory consisted of ore stockpiles and other in-process materials that the
company does not expect to be processed within one year. The long-term portion of the
inventory was included in the “Financial and other assets” category on the balance sheet (see
Note 11on page 78.)
c. As per the inventory section of Note 3 on page 66, the company includes “all direct costs
incurred in production, including direct labour and materials, freight, depreciation and amor-
tization and directly attributable overhead costs. Production stripping costs that are not capi-
talized are included in the cost of inventories as incurred. Depreciation and amortization of
capitalized production stripping costs are included in the cost of inventory.”
d. Teck Resources Limited uses the weighted average cost flow assumption as identified in
Note 3 above.

6-187
P. Mini-Cases
Case 1: Rocky Dilemma. Suggested solution:
a. First note that this is the first year of operations, so the cost of goods available for sale
(COGAS) is equal to purchases (19,000 units with cost of $249,600).
There are 4,000 units in ending inventory. We can either first calculate the cost of ending
inventory, or the cost of goods sold. The following shows the former method.
FIFO ending inventory = 3,200 units × $16/unit + 800 units × $13/unit = $51,200 +
$10,400 = $61,600.
Weighted-average cost per unit = $249,600 / 19,000 units = $13.13684/unit.

Weighted-average ending inventory = 4,000 units × $13.13684/unit = $52,547.
Specific ID ending inventory = 3,500 units × $11/unit + 500 units × $13/unit = 38,500 + 6,500 =
$45,000.
Weighted
FIFO average Specific ID
Cost of goods available for sale $249,600 $249,600 $249,600
Ending inventory 61,600 52,547 45,000
Cost of goods sold $188,000 $197,053 $204,600

6-188
b. Using the given information and the results from part (a), we can calculate the relevant
ratios.
Weighted
FIFO average Specific ID
Current assets, excluding inventory $ 10,000 $ 10,000 $ 10,000
Ending inventory 61,600 52,547 45,000
Current assets 71,600 62,547 55,000
Non-current assets 107,000 107,000 107,000
Total assets $178,600 $169,547 $162,000
Current liabilities $ 32,600 $ 32,600 $ 32,600

Long-term bank loan 50,000 50,000 50,000
Total liabilities $ 82,600 $ 82,600 $ 82,600
Sales $284,000 $284,000 $284,000

Cost of goods sold (188,000) (197,053) (204,600)
Expenses, other than cost of goods sold (40,000) (40,000) (40,000)
Net income before bonuses $ 56,000 $ 46,947 $ 39,400
Ratio calculations:
Current assets 71,600 62,547 55,000
Current liabilities 32,600 32,600 32,600
Current ratio (2 to 1 preferred) 2.196 1.919 1.687
Total liabilities 82,600 82,600 82,600

Total assets 178,600 169,547 162,000
Total debt to total assets (<50% required) 46.2% 48.7% 51.0%
Net income before bonuses 56,000 46,947 39,400

Ending total assets 178,600 169,547 162,000
Return on ending total assets 31.4% 27.7% 24.3%
(prefer <25%)
RDL’s choice of cost flow assumption has economic (cash flow) consequences because the
choice affects ratios that determine (implicit and explicit) contractual outcomes. The FIFO
method results in the highest current ratio and lowest debt-to-assets ratio, which are prefera-
ble. However, this method would result in a bonus payment of $6,000 since ROA is 6.4%
above the threshold of 25%.
The weighted average method meets the debt-to-assets ratio requirement of <50%. It also
reduces the bonus payment (relative to FIFO) to $2,000. However, the current ratio falls
below 2, so future purchases will cost more. In the past year, purchases were almost
$250,000. If this amount is representative of purchases this coming year, a 10% increase in
cost would amount to $25,000.

6-189
The specific identification method results in no bonus payment because ROA is below 25%.
However, the current ratio is below 2, and the debt-to-assets ratio is above 50%. The latter is
particularly problematic since the bank could put the company into bankruptcy.
My recommendation is to use the FIFO method because it minimizes the cost of the different
contracts. Bankruptcy is of course a very undesirable outcome and the 10% increase in cost
of purchases would be substantial; these two costs greatly outweigh the additional $6,000 of
bonuses for the general manager.
Case 2: Eastern Pacific Lumber. Suggested solution:
The controller indicated that cost of goods sold per unit declined by 2.4%, which, on the surface,
is a good sign. This 2.4% is obtained as follows:
2021 cost of goods sold $ 176,642,000

Less: export tariffs $ (17,700,000)
2021 COGS excluding tariffs 600,000 $ 158,942,000 264.90
2020 cost of goods sold $ 164,203,000

Less: export tariffs $ (28,500,000)
2020 COGS excluding tariffs 500,000 $ 135,703,000 271.41
Decrease in COGS per unit -2.40%
While COGS per unit has decreased, it is not conclusive evidence that production costs have
decreased, because cost of goods sold is based on absorption costing and this method of costing
can have anomalous results due to the inclusion of fixed costs.
In fact, we can show that variable costs have actually increased from 2020 to 2021. To show this,
we need to determine the production volume for the two years. The following inventory
continuity schedule reconciles inventory on the balance sheet with production and sales
information. Calculated figures are in bold, while unbolded figures have been given.
# Units Total cost Cost/unit

Dec. 31, 2019 Inventory 170,404 $ 46,053,000 $ 270.26
+ 2020 production 502,574 136,700,000 272.00
- 2020 sales (500,000) (135,703,000) 271.41
Dec. 31, 2020 inventory 172,978 47,050,000 272.00
+ 2021 production 705,580 184,862,000 262.00
- 2021 sales (600,000) (158,942,000) 264.90
= Dec. 31, 2021 inventory 278,511 72,970,000 262.00

6-190
Using the production figures of 502,574 Mbf and 705,580 Mbf, we can determine the variable
costs per unit. While fixed costs per unit are not meaningful, they are also shown in the
following table to demonstrate the source of the decline in total cost per unit.
Costs # Units Cost/unit

2020 Production costs $ 136,700,000 502,574 $ 272.00
- Fixed costs (34,000,000) 502,574 (67.65)
Variable costs 102,700,000 502,574 204.35
2021 Production costs $ 184,862,000 705,580 $ 262.00

- Fixed costs (34,000,000) 705,580 (48.19)
Variable costs 150,862,000 705,580 213.81
Thus, variable costs per unit actually increased by $9.46. The decline in per unit production costs
is entirely due to the decrease in fixed costs per unit, which is due to the higher production
volume. By definition, fixed costs do not increase with production volume; by increasing
production, a fixed amount of cost is being spread over more units.
The production volume of more than 700,000 Mbf appears to be excessive given that sales in
2021 was only 600,000 Mbf. This has contributed to the inventory balance ballooning from $47
million to almost $73 million. This ties up valuable capital and increases storage costs.
The excessive production could be due to the incentive plan the company has in place. The
production manager receives $20,000 for each dollar that production costs fall below $280/Mbf.
By increasing production volume (without regard to the amount being sold), the production
manager maximizes his bonus. Furthermore, the chief operating officer receives a bonus based
on net income; lower cost per unit will benefit him as well, although he may become concerned
with the high level of inventory and the cost that entails.
There may be good reason for stockpiling the inventory that I am not aware of, such as in
anticipation of a big order to be filled soon after year-end. In any case, the board of directors
should consider revising the incentive plan for the production manager so that he is rewarded
based on variable costs, which he controls and is not subject to manipulation using production
volume. The board might also consider revising the incentive plan for the chief operating officer,
but that change is not as compelling. The COO’s responsibilities are more global and net income
is arguably a good enough measure.

6-191
Case 3: Mountain Mines Lubrication. Suggested solution:
To: Partner
From: CA
Re: Mountain Mine Lubrication Engagement
Overview
This engagement poses a number of risks for our firm. MML is a new review client, and the bank
will be relying on the financial statements in deciding whether to extend a new line of credit to
MML. These facts, combined with the fact that MML has liquidity problems that call into
question whether it is a going concern, make the risk of the engagement quite high.
MML has implemented a new method of revenue and expense recognition this year for some of
its clients. The change appears to have been implemented incorrectly, with the result that the
2020 financial statements are misstated. The new method has implications for the amounts
reported on the financial statements for inventory, cost of goods sold, and net income. Inventory
is of particular concern because it is a material item.
Misstatement of financial statements

For three of its customers MML recognizes revenue on the basis of hours of machine use. The
mining machines of these customers have been equipped with meters that measure that number
of hours that a machine operates. Each week the customers advise MML of the meter readings,
and MML bills the customer based on the number of hours of use. Revenue is recognized based
on the meter readings. However, the cost of the lubricant is fully expensed when MML is
notified that a new tub of lubricant has been poured into the machine. As a result, it could be
argued that a portion of the cost of the lubricant is being recognized before the revenue is
recognized. The result is that cost of goods sold is overstated and inventory understated because
too much lubricant is expensed at the time a machine is filled. MML should expense only that
portion of the cost of the lubricant that has been used since that is the basis of revenue recogni-
tion. If 20% of a tub of lubricant has been billed to the customer, only 20% of the cost should be
expensed.
Given the new billing arrangement that MML now uses for three of its customers, recognizing
revenue when lubricant is used is reasonable, although it is also possible to make an argument
for recognizing the revenue when the lubricant is poured into the machine. The critical event for
revenue recognition is actual usage of the machine. Alternatively, the new method can be viewed
simply as a billing arrangement. Once lubricant is put into a machine, it probably cannot be
returned to MML and the customer will ultimately have to pay for it. Under this approach
revenue recognition can be advanced to the point when the lubricant is put into a machine. In my
opinion, both approaches are acceptable. Deferring revenue and expense recognition to when the
lubricant is actually used is a more conservative approach. Either method would correct the error.
The effect on the revenue and expenses can be seen from the effect on the gross margins:

6-192
Slip Coat Maximum Guard

Gross Gross
Calculation Margin Calculation Margin
Gross margin per unit (16.00 – 13.50) / 16.00 15.6% (22.50 – 18.25) / 22.50 18.9%
Gross margin per the
$18,067 / $136,000 13.3% $31,892 / $200,250 15.9%
income statement
As the table shows, the gross margin per unit is greater than the gross margin per the income
statement. They should be the same. The error occurs because the method MML uses expenses
the cost of lubricant before all the related revenue is recognized, thereby increasing the cost of
sales and decreasing the gross margin. Because this billing method is new this year, last year’s
financial statements will not have any errors as a result of this method.
To calculate the amount of the error, we must determine the amount of lubricant that was most
recently put into machines that has been used up. This calculation is done using the number of
hours a machine has been used since the last top-up. The calculation is:
Amount of lubricant proportion of tub

× cost per kilogram ×
put in machine used1
1
Proportion of tub used is calculated on the basis of 28 days.
The cost of the remaining amount of lubricant is the amount by which inventory is understated
and cost of sales is overstated. The exact amounts are:
Cost of
lubricant put Remaining
into machine % used Amount used amount
Scorched Earth
Slip Coat $675.00 21.4% $145.00 $ 530
Maximum Guard 912.50 21.4% 195.50 717
Moon Crater
Slip Coat 675.00 64.2% 433.00 242
Maximum Guard 912.50 64.2% 585.50 327
Big Scar
Slip Coat 2,700.00 10.7% 289.00 2,411
5,475.00 4,889
Maximum Guard 10.7% 586.00
The cost of the amount remaining in the machines, $9,116, is the amount by which inventory is
understated and cost of sales is overstated. These errors are large, and they result in the financial
statements being materially misstated. The gross margin per the income statement and per unit
can be made the same by adjusting inventory and cost of sales.

6-193
The adjustment will increase net income and, as a result, the amount of tax that must be paid.
The amount of extra tax that MML will have to pay using the effective tax rate on the income
statement of 27.7% is $2,525. Given MML’s liquidity problem, this extra demand on cash flows
exacerbates the situation. It is likely that MML will want to do whatever it can to conserve cash
by minimizing taxes, and this may be the motivation behind the “error.”
Adjustment of the error is straightforward since MML already has estimates of the hourly usage
rates of lubricant. However, we must review the method used for determining the usage rate to
ensure it is reasonable. If MML has used very crude rules of thumb to estimate usage, the above
calculations may be significantly in error. Constant usage rates have been used across all
customers, and usage rates may vary depending on the equipment and conditions.
It must be made clear to MML that if the error is not corrected we will not be able to give
negative assurance on the financial statements.
There are a number of minor questions that need to be addressed so that we can have confidence
in the amount of revenue and expense that is recognized. First, is it possible for a customer to
buy lubricant from another supplier? If lubricant is purchased from another supplier, how does
this affect MML? Second, can the meters be tampered with or incorrect information conveyed to
MML? If they can be tampered with, does MML have policies in place to detect whether the
meters have been tampered with or if usage is otherwise under reported.
Potential theft of lubricant

There are inconsistencies in the information provided about the consumption of lubricant at
Scorched Earth Mine that may be the result of problems ranging from equipment breakdown to
the theft of MML’s product. The mine seems to be using large amounts of lubricant, as evi-
denced by the fact it is running low on lubricant even though it received a large shipment in the
spring. Yet Ms. Verhan has advised us that Scorched Earth’s meter reading was low, indicating
that the equipment is operating well below capacity. On the other hand, Mr. Mulholland told us
that the mine was working at capacity recently. We do not have enough information to explain
the inconsistency, but there are many possible explanations that need to be investigated so that
we can rule out explanations that have an impact on reporting. Mr. Mulholland’s information
may simply be incorrect, which would explain the low meter readings but not the high usage of
lubricant, unless the machines at the mine are very inefficient.
Scorched Earth may be using lubricant from other suppliers and only reporting usage of MML’s
lubricant. Another possibility is that the meter is broken and Scorched Earth has not noticed.
However, given that Scorched Earth is in financial trouble, we cannot easily rule out the
possibility of theft. We need to notify Mr. Mulholland immediately of our concerns so that he
can take his own steps to investigate. We should advise MML to consider not making further
shipments to Scorched Earth until payment is assured.
Cash crunch
Despite having higher net income in 2020 than in 2019, MML has a serious liquidity problem.
Inventory, plant, property and equipment, and accounts receivable have each increased signifi-
cantly over last year—inventory by almost 50%, plant, property and equipment by 29% and

6-194
receivables by almost 18%. These increases have been financed by suppliers through accounts
payable and by a sizable bank overdraft. MML’s current ratio has fallen from 2.66 in 2019 to
1.25 in 2020 and it has no cash reserves on hand.
Unless MML is able to generate a significant amount of cash, it may be unable to pay its short-
term obligations. Mr. Mulholland appears to be aware of the problem because he is attempting to
obtain a new line of credit from the bank. However, MML’s financial position is not strong, and
there is some doubt as to whether it can continue as a going concern. MML may be able to
increase the amount of bank financing it obtains by correcting the inventory misstatement
because the correction will increase inventory and thereby increase the amount of collateral
available to the bank.
Most of MML’s current assets are inventory. It is not clear why there has been such a large build
up of inventory. However, MML must be concerned about how long it will take for the inventory
to be converted to cash and whether it can be sold quickly to raise cash if needed. Compounding
any problems with selling inventory quickly is the fact that most of it is at mine sites that are far
from any major commercial centre. The implication is that it will be time consuming and costly
to recover and sell the inventory at these distant mine sites. However, despite the fact that the
inventory is at customer locations, it does belong to MML so if a customer does not pay, MML is
entitled to get its inventory back. Since the inventory belongs to MML, it should be insured even
if held at distant mine sites to protect MML’s investment in the inventory. The inventory at the
mine sites also poses an environmental risk: any damage caused by leakage or spillage may be
MML’s responsibility. While this is not an engagement issue at this time based on the infor-
mation available to us, we should advise the client to take steps to ensure that these potential
environmental problems do not occur.
One final point on the inventory: Two of the mines have very large quantities of inventory on
site. Assuming that lubricant in a machine lasts about four weeks, there is a 40-month supply at
Moon Crater and 17.5-month supply at Big Scar. While there is nothing inherently wrong with
having that much inventory at the mine sites, it does seem an inefficient use of resources,
especially when cash is so tight. However, transportation costs may justify this approach.
It is also not clear how collectable MML’s receivables are, given that one of its customers is in
financial trouble and another may have troubles (given the possibility that it may be stealing
lubricant from MML). I do not know at this point whether MML has made an allowance for
uncollectible accounts in its 2020 income statement. If no allowance has been made, the amount
of receivables may be overstated.
There are some steps that MML can take to improve its liquidity position in addition to obtaining
additional bank financing. It should try to refinance the $60,000 current portion of its long-term
debt. That alone would relieve a lot of the pressure on MML. It might also seek out new long-
term financing, either debt or equity, to finance its growth. In 2020 it financed its acquisitions of
plant, property and equipment through current liabilities. It is usually appropriate to finance
long-lived assets with long-term liabilities.

6-195
Case 4: James Television Inc. Suggested Solution:
a. Under ASPE, absorption costing has to be used for manufactured goods for external
financial reporting. The difference between absorption costing and variable costing is that
absorption costing includes the cost of fixed inventory overhead as product costs while
variable costing expenses fixed overhead costs in the period they are incurred. If all units
are sold in the current period, absorption and variable costing methods should result in
the same level of expenses. However, given that this is a new product and the company is
unlikely to sell all of its 20 units, absorption costing would result in lower inventory ex-
penses. In this case, one should note it is also debatable whether the company is manufac-
turing these products through Global Manufacturing Inc., or it is simply buying these
products from the other company. If it is the latter, then the goods should be accounted
for as purchased goods.
b. A perpetual inventory system is one that constantly keeps track of additions to and sales
of inventory while a periodic inventory system does not keep track of inventory and
COGS. In this case, considering the high price of each unit of inventory and its low sales
volume, it is beneficial for the company to account for its inventory using the perpetual
inventory system. FIFO is a cost flow assumption that uses the oldest costs in the compu-
tation of cost of sales. Considering the price of inventory is rising due to currency appre-
ciation of the Yen, FIFO would result in higher ending inventory on the balance sheet,
and COGS is relatively lower when older inventory items are assumed to be sold first. If
the company has an objective to increase net income, then FIFO is the preferred costing
method.
c. As price of buying the televisions from the Japanese manufacturers is increasing, it might
be a good idea to consider a new line of products. Provided that retail prices of televi-
sions remain rigid in Canada, currency appreciation of the Yen would reduce the profit
margin of the company. The downside of ordering the lower-cost televisions, however,
would be the uncertainty associated with selling these lower-cost products with little
brand recognition, and the possibility of this new line of products undercutting the sales
of the higher-end televisions. From a financial standpoint, if the company manages to sell
all its products, it would have sold more televisions than before and would be able to rec-
ord higher revenue. But it is hard to determine if retailers are willing to buy the lower-
cost televisions from the company, so the risk of inventory obsolescence and the chance
of inventory write-down are higher.

6-196
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P6-1. Suggested solution:

Potential benefit True / False

P6-2. Suggested solution:

Feasible to track Benefit of Costs of tracking

Copyright © 2020 Pearson Canada Inc.

P6-3. Suggested solution:

a. A department store—Perpetual. A department store has a wide range of products that

P6-4. Suggested solution:

Item Product Period

P6-5. Suggested solution:

Copyright © 2020 Pearson Canada Inc.

P6-6. Suggested solution:

a. Dr. Inventory (purchase price) 1,700,000

Dr. Inventory (freight in) 30,000

b. Costs to be allocated ($1,700,000 + $30,000) = $1,730,000

P6-7. Suggested solution:

Product costs Amount

Copyright © 2020 Pearson Canada Inc.

P6-8. Suggested solution:

P6-9. Suggested solution:

Copyright © 2020 Pearson Canada Inc.

P6-10. Suggested solution:

P6-11. Suggested solution:

P6-12. Suggested solution:

Copyright © 2020 Pearson Canada Inc.

P6-13. Suggested solution:

P6-14. Suggested solution:

Copyright © 2020 Pearson Canada Inc.

P6-15. Suggested solution:

Cost of goods sold is then computed as follows:

P6-16. Suggested solution:

Total fixed overhead equals 500 units × $20,000/unit = $10,000,000.

Fixed overhead $20,000 500 $10,000,000

Copyright © 2020 Pearson Canada Inc.

P6-17. Suggested solution:

Fixed overhead $125 20,000 $2,500,000

Copyright © 2020 Pearson Canada Inc.

Deluxe line Cost per unit # batches Amount

P6-18. Suggested solution:

Production cost = 90,000/mbf  3,230 mbf + $120,000,000

Copyright © 2020 Pearson Canada Inc.

e. With a single product, there is sufficient information here to compute an inventory

f. Cost of goods sold using variable costing is computed as follows:

P6-19. Suggested solution:

Ending inventory = 2,500 units × $11/unit = $27,500.

Copyright © 2020 Pearson Canada Inc.

P6-19. Alternative solution:

Compute COGS first, then ending inventory.