Chapter 7: Reporting and
Interpreting Cost of Goods Sold
and Inventory
Extra Questions with Solutions
Question 1
Shakespeare Company uses a periodic inventory system. At the end of the annual accounting period, December 31
of the current year, the accounting records provided the following information for product 2:
Units Unit Cost
Inventory, December 31, prior year 4,000 $ 10
For the current year:
Purchase, April 15 10,000 12
Purchase, June 10 8,000 17
Sales ($60 each) 11,000
Operating expenses (excluding income tax expense) $200,000
Required:
1. Prepare a separate income statement through pre-tax income that details cost of goods sold for (a) Case A: FIFO
and (b) Case B: LIFO. For each case, show the computation of the ending inventory and cost of goods sold.
2. Compare the pre-tax income and the ending inventory amounts between the two cases. Explain the similarities
and differences.
3. Which inventory costing method may be preferred for income tax purposes? Explain.
Answer to Question 1
Requirement 1
Cost of Goods Sold Calculation FIFO LIFO
Beginning inventory (4,000 units at $10 each) $ 40,000 $ 40,000
+ Purchases (10,000 units at $12 each) 120,000 120,000
(8,000 units at $17 each) 136,000 136,000
Goods available for sale (22,000 units) 296,000 296,000
− Ending inventory (3,000 units at $12 each, (4,000 units at $10 each,
172,000 124,000
8,000 units at $17 each) 7,000 units at $12 each)
Cost of goods sold (4,000 units at $10 each, (8,000 units at $17 each, $124,000 $172,000
7,000 units at $12 each) 3,000 units at $12 each)
Income statement FIFO LIFO
Sales $660,000 $660,000
Cost of goods sold 124,000 172,000
Gross profit 536,000 488,000
Operating expenses 200,000 200,000
Income before income taxes $336,000 $288,000
Answer to Question 1 (Continued)
Requirement 2
FIFO LIFO
Pretax income $ 336,000 $288,000
Ending inventory $ 172,000 $124,000
The methods differ only in the dollar amount of goods available for sale, allocated to cost of goods sold versus
ending inventory. For this reason, the method that gives higher ending inventory amount also gives lower cost
of goods sold, higher gross profit, income tax expense, net income amounts, and vice versa.
Requirement 3
When unit costs are rising, LIFO produces lower net income and a lower inventory valuation than FIFO, resulting
in less tax liability. In circumstances where inventory cost is decreasing, the FIFO method—in which the oldest,
most expensive goods become cost of goods sold—produces higher cost of goods sold and lower pretax
earnings, thus resulting in lower income tax liability.
So, the costing method may be preferred depending on the trend of the cost of inventories. However, in the
long run, costs are inflationary in nature and therefore the most preferable costing method for income tax
purposes is LIFO.
Question 2
Newton Company was formed on January 1, Year 1 and is preparing the annual financial statements dated
December 31, Year 1. Ending inventory information about the four major items stocked for regular sale follows:
ENDING INVENTORY, YEAR 1
Quantity Unit Cost When Net Realizable Value
Item
on Hand Acquired (FIFO) (Market) at Year-End
A 40 $ 20 $ 30
B 110 80 88
C 70 114 110
D 20 54 64
Required:
1. Compute the valuation that should be used for Year 1 ending inventory using the lower of cost or net
realizable value applied on an item-by-item basis.
2. What will be the effect of the write-down of inventory to lower of cost or net realizable value on cost of
goods sold for the year ended December 31, Year 1?
Answer to Question 2
Requirement 1
Lower of Cost
Item Quantity Total Cost Total Net Realizable Value or NRV
A 40 x $ 20 = $ 800 x $ 30 = $ 1,200 $ 800
B 110 x 80 = 8,800 x 88 = 9,680 8,800
C 70 x 114 = 7,980 x 110 = 7,700 7,700
D 20 x 54 = 1,080 x 64 = 1,280 1,080
Total $18,660 $19,860 $18,380
Inventory valuation using lower of cost or NRV = $18,380
Requirement 2
The write-down to the lower of cost or net realizable value will increase cost of goods sold expense by the
amount of the write-down, which is $280.
Total cost − Lower of cost or NRV = Write-down value
$18,660 − $18,380 = $280
Question 3
Smith Company is preparing the annual financial statements dated December 31, Year 1.
Ending inventory information about the five major items stocked for regular sale follows:
ENDING INVENTORY, YEAR 1
Quantity on Unit Cost When Net Realizable Value
Item Hand Acquired (FIFO) (Market) at Year-End
A 100 $ 30 $ 24
B 160 60 80
C 20 96 104
D 140 50 60
E 700 20 10
Required:
Compute the valuation that should be used for Year 1 ending inventory using lower of cost or net
realizable value applied on an item-by-item basis. (Hint: Set up columns for Item, Quantity, Total
Cost, Total Net Realizable Value, and Lower of Cost or NRV.)
Answer to Question 3
Total Net Realizable Lower of
Item Quantity Total Cost Value Cost or NRV
A 100 x $ 30 = $ 3,000 x $ 24 = $ 2,400 $ 2,400
B 160 x 60 = 9,600 x 80 = 12,800 9,600
C 20 x 96 = 1,920 x 104 = 2,080 1,920
D 140 x 50 = 7,000 x 60 = 8,400 7,000
E 700 x 20 = 14,000 x 10 = 7,000 7,000
Total $35,520 $32,680 $27,920
Inventory valuation using lower of cost or net realizable value = $27,920
