Question

Eddie’s Galleria sells billiard tables. The company has the following purchases and sales for 2021.

 

Eddie is worried about the company’s financial performance. He has noticed an increase in the purchase cost of billiard tables, but at the same time, competition from other billiard table stores and other entertainment choices have prevented him from increasing the sales price. Eddie is worried that if the company’s profitability is too low, stockholders will demand he be replaced. Eddie does not want to lose his job. Since 60 of the 400 billiard tables sold have not yet been picked up by the customers as of December 31, 2021, Eddie decides incorrectly to include these tables in ending inventory. He appropriately includes the sale of these 60 tables as part of total revenues in 2021.

 

Required:

1. What amount will Eddie calculate for ending inventory and cost of goods sold using FIFO, assuming he erroneously reports that 110 tables remain in ending inventory?

2. What amount would Eddie calculate for cost of goods sold using FIFO if he correctly reports that only 50 tables remain in ending inventory?

3. What effect will the inventory error have on reported amounts for

(a) Ending inventory,

(b) Retained earnings,

(c) Cost of goods sold, 

(d) Net income (ignoring tax effects) in 2021?

4. Assuming that ending inventory is correctly counted at the end of 2022, what effect will the inventory error in 2021 have on reported amounts for

(a) Ending inventory,

(b) Retained earnings,

(c) Cost of goods sold,

(d) Net income (ignoring tax effects) in 2022?

Answer 1

Net sales:

Net sales is the difference between the sales revenue and the sum total of sales discount, Sales return and allowances. Net sales amount is calculated by deducting the amount of sales discount and sales return and allowances from the total sales revenue.

 

Cost of goods sold:

Sold Cost of goods sold includes all costs related to manufacturing the products like direct material, direct labor direct overheads etc. In case of a retailer or whole seller it includes the cost of merchandise purchases plus beginning inventory amount less ending inventory amount.

 

Gross profit:

The gross profit of a company is calculated by deducting the cost of goods sold from the sales revenue. Cost of goods sold includes all costs related to manufacturing the products like direct material, direct labor, direct overheads etc. A company earns gross profit when its sale revenue is higher than the cost of goods sold.

 

First in, first out:

By name it is First-In-First-Out. It means that the inventory units purchased first will be sold first. Hence, the cost of goods sold includes the cost of earlier units and the cost of most recent units will be left in ending inventory.

 

Last in, first out:

By name it is Last-In-First-Out. It means that the inventory units purchased last or recently will be sold first. Hence, the cost of goods sold includes the cost of recent units and the cost of earlier purchased units will be left in ending inventory.

 

Weighted Average Method:

Under this method of valuing inventory, average cost is calculated for the inventory in hand. Thus, the stock moving out is valued at such average cost and the value of stock in hand is automatically at the weighted average.

 

(1)

In FIFO, i.e. first in first out method, it is assumed that the units that are purchased first will be sold out first and the new units will be remain in stock. This concept is treated as a logical one as if the oldest goods are sold, there will be lesser risk of obsolescence.

 

During a year, firm sells 340 units. The total units including beginning and purchased are 340 units. So, as per FIFO, the first purchases were considered for sale and the ending inventory will be for 110 units that were purchased in August and October months i.e. last purchases with a unit cost of $600 and $640 respectively.

 

Date	Transaction	Number of Units	Unit Cost ($)	Ending Inventory ($)
22-Aug	Purchase	30	600	18,000
29-Oct	Purchase	80	640	51,200
		110		69,200

 

Hence, the ending inventory is $69,200.

 

It is assumed that the firm has sold 340 units during the year. As per the units that are purchased first will be sold out first and the new units will be remaining in stock. So, the beginning inventory of 150 units will be sold first, then 120 units that were purchased on March 8, 70 units that were purchased on August 22.

 

Date	Transaction	Number of Units	Unit Cost ($)	Ending Inventory ($)
1-Jan	Beginning inventory	150	540	81,000
8-Mar	Purchase	120	570	81,000
22-Aug	Purchase	70	600	42,000
		340		191,400

 

Hence, the cost of goods sold is $191,400.

 

(2)

During a year, it is assumed that firm sells 290 units (including 60 lost units). The total units including beginning and purchased are 340 units. So, as per FIFO, the first purchases were considered for sale and the ending inventory will be for 50 units that were purchased in October month i.e. last purchase with a unit cost of $640.

 

Date	Transaction	Number of Units	Unit Cost ($)	Ending Inventory ($)
29-Oct	Purchase	50	640	32,000

 

The ending inventory is $32,000.

 

It is assumed that the firm has sold 400 units during the year. As per the units that are purchased first will be sold out first and the new units will be remaining in stock. So, the beginning inventory of 150 units will be sold first, then 120 units that were purchased on March 8, 100 units that were purchased on August 22 and last 30 units from October 29.

 

Date	Transaction	Number of Units	Unit Cost ($)	Ending Inventory ($)
1-Jan	Beginning inventory	150	540	81,000
8-Mar	Purchase	120	570	68,400
22-Aug	Purchase	100	600	60,000
29-Oct	Purchase	30	640	19,200
		400		228,600

 

The cost of goods sold is $228,600.

 

(3)

The ending inventory is recorded in Balance sheet as an asset and costs of goods sold is recorded as an expense in Income statement. So, when there is an error in calculating ending inventory, it will also affect costs of goods sold as well as gross profit. When ending inventory is overstated, the costs of goods sold will be understated and Net profit will be overstated and retained earnings will be overstated.

 

(4)

Also in next/following year there will be an opposite effect i.e. when ending inventory is overstated in current year, in following year the costs of goods sold will be overstated and Net profit will be understated but there will be no effect on ending inventory and retained earnings in following year.

Net sales:

Net sales is the difference between the sales revenue and the sum total of sales discount, Sales return and allowances. Net sales amount is calculated by deducting the amount of sales discount and sales return and allowances from the total sales revenue.