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Chapter 8: Q19Q. (page 422)

In an article that appeared in the Wall Street Journal, the phrases “phantom (paper) profits” and “high LIFO profits” through involuntary liquidation were used. Explain the sephrases.

Short Answer

Expert verified

Phantom profit is a result of FIFO inventory in an inflationary period. Involuntary liquidation is the result of layer reduction of base year reduction.

Step by step solution

01

Phantom (paper) profits

Phantom (paper) profit is the result of using the FIFO method during an inflationary period. In the FIFO method, ending inventory is valued at recent prices, and COGS is valued at historical prices. So during the inflation period, COGS seems to be very low. As a result, the profits are overvalued, and it is reflected only as a paper profit and not a real profit.

02

 Step 2: High inventory profits through involuntary liquidation

This is the problem that happens when the LIFO base year or layer is forcibly reduced. The LIFO base or layer is reduced due to the reduction in ending inventory at base cost in the subsequent year. Thus, as a result, irrelevant and old costs are matched with the current revenues leading to the problem of net income distortion.

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Most popular questions from this chapter

Explain the following terms.

(a) LIFO layer.

(b) LIFO reserve.

(c) LIFO effect.

Question: Craig Company asks you to review its December 31, 2017, inventory values and prepare the necessary adjustments to the books. The following information is given to you.

1. Craig uses the periodic method of recording inventory. A physical count reveals \(234,890 of inventory on hand at December 31, 2017.

2. Not included in the physical count of inventory is \)13,420 of merchandise purchased on December 15 from Browser. This merchandise was shipped f.o.b. shipping point on December 29 and arrived in January. The invoice arrived and was recorded on December 31.

3. Included in inventory is merchandise sold to Champy on December 30, f.o.b. destination. This merchandise was shipped after it was counted. The invoice was prepared and recorded as a sale on account for \(12,800 on December 31. The merchandise cost \)7,350, and Champy received it on January 3.

4. Included in inventory was merchandise received from Dudley on December 31 with an invoice price of \(15,630. The merchandise was shipped f.o.b. destination. The invoice, which has not yet arrived, has not been recorded.

5. Not included in inventory is \)8,540 of merchandise purchased from Glowser Industries. This merchandise was received on December 31 after the inventory had been counted. The invoice was received and recorded on December 30.

6. Included in inventory was \(10,438 of inventory held by Craig on consignment from Jackel Industries.

7. Included in inventory is merchandise sold to Kemp f.o.b. shipping point. This merchandise was shipped on December 31 after it was counted. The invoice was prepared and recorded as a sale for \)18,900 on December 31. The cost of this merchandise was \(10,520, and Kemp received the merchandise on January 5.

8. Excluded from inventory was a carton labeled “Please accept for credit.” This carton contains merchandise costing \)1,500 which had been sold to a customer for $2,600. No entry had been made to the books to reflect the return, but none of the returned merchandise seemed damaged; Craig will honor the return.

Instructions

(a) Determine the proper inventory balance for Craig Company at December 31, 2017.

(b) Prepare any correcting entries to adjust inventory to its proper amount at December 31, 2017. Assume the books have not been closed.

You are asked to travel to Milwaukee to observe and verify the inventory of the Milwaukee branch of one of your clients. You arrive on Thursday, December 30, and find that the inventory procedures have justbeen started. You spot a railway car on the sidetrack at the unloading door and ask the warehouse superintendent, Buck Rogers,how he plans to inventory the contents of the car. He responds, “We are not going to include the contents in the inventory.”

Later in the day, you ask the bookkeeper for the invoice on the carload and the related freight bill. The invoice lists the variousitems, prices, and extensions of the goods in the car. You note that the carload was shipped December 24 from Albuquerque,f.o.b. Albuquerque, and that the total invoice price of the goods in the car was \(35,300. The freight bill called for a payment of\)1,500. Terms were net 30 days. The bookkeeper affirms the fact that this invoice is to be held for recording in January.

Instructions

(a) Does your client have a liability that should be recorded at December 31? Discuss.

(b) Prepare a journal entry(ies), if required, to reflect any accounting adjustment required. Assume a perpetual inventory

system is used by your client.

(c) For what possible reason(s) might your client wish to postpone recording the transaction?

Ehlo Company is a multiproduct firm. Presented below is information concerning one of its products, the Hawkeye.

Date Transaction Quantity Price/Cost

1/1 Beginning inventory 1,000 $12

2/4 Purchase 2,000 18

2/20 Sale 2,500 30

4/2 Purchase 3,000 23

11/4 Sale 2,200 33

Instructions

Compute cost of goods sold, assuming Ehlo uses:

(a) Periodic system, FIFO cost flow. (d) Perpetual system, LIFO cost flow.

(b) Perpetual system, FIFO cost flow. (e) Periodic system, weighted-average

cost flow.

(c) Periodic system, LIFO cost flow. (f) Perpetual system, moving-average

cost flow.

Bienvenu Enterprises reported cost of goods sold for 2017 of \(1,400,000 and retained earnings of \)5,200,000 at December 31, 2017. Bienvenu later discovered that its ending inventories at December 31, 2016 and 2017, were overstated by\(110,000 and \)35,000, respectively. Determine the corrected amounts for 2017 cost of goods sold and December 31, 2017,retained earnings.
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