Chapter 8 Inventories: Measurement 1 Question 8-1 Question 8-2 Question 8-3 Perpetual System Periodic System (1) purchase of merchandise debit inventory debit purchases (2) sale of merchandise debit cost of goods sold; credit inventory no entry (3) return of merchandise credit inventory credit purchase returns Question 8-4 Chapter 8 Inventories: Measurement QUESTIONS FOR REVIEW OF KEY TOPICS Inventory for a manufacturing company consists of (1) raw materials, (2) work in process, and (3) finished goods. Raw materials represent the cost, primarily purchase price plus freight charges, of goods purchased from other manufacturers that will become part of the finished product. Work-in-process inventory represents the products that are not yet complete. The cost of work in process includes the cost of raw materials used in production, the cost of labor that can be directly traced to the goods in process, and an allocated portion of other manufacturing costs, called manufacturing overhead. When the manufacturing process is completed, these costs that have been accumulated in work in process are transferred to finished goods. Beginning inventory plus net purchases for the period equals cost of goods available for sale. The main difference between a perpetual and a periodic system is that the periodic system allocates cost of goods available for sale to ending inventory and cost of goods sold only at the end of the period. The perpetual system accomplishes this allocation by decreasing inventory and increasing cost of goods sold each time goods are sold. (4) payment of freight debit inventory debit freight-in Inventory shipped f.o.b. shipping point is included in the inventory of the purchaser when the merchandise reaches the common carrier. Laetner Corporation records the purchase in 2006 and includes the shipment in its ending inventory. Bockner Company records the sale in 2006. Inventory shipped f.o.b. destination is included in the inventory of the seller until it reaches the purchaser’s location. Bockner would include the merchandise in its 2006 ending inventory and the sale/purchase would be recorded in 2007. 2 Answers to Questions (continued) Question 8-5 Question 8-6 Question 8-7 Question 8-8 Question 8-9 A consignment is an arrangement under which goods are physically transferred to another company (the consignee), but the transferor (consignor) retains legal title. If the consignee can’t find a buyer, the goods are returned to the consignor. Goods held on consignment are included in the inventory of the consignor until sold by the consignee. By the gross method purchase discounts not taken are viewed as part of inventory cost. By the net method purchase discounts not taken are considered interest expense, because they are viewed as compensation to the seller for providing financing to the buyer. 1. Beginning inventory — increase 2. Purchases — increase 3. Ending inventory — decrease 4. Purchase returns — decrease 5. Freight-in — increase Four methods of assigning cost to ending inventory and cost of goods sold are (1) specific identification, (2) first-in, first-out (FIFO), (3) last-in, first-out (LIFO), and (4) average cost. The specific identification method requires each unit sold during the period or each unit on hand at the end of the period to be traced through the system and matched with its actual cost. First- in, first-out (FIFO) assumes that units sold are the first units acquired. The last-in, first-out (LIFO) method assumes that the units sold are the most recent units purchased. The average cost method assumes that cost of goods sold and ending inventory consist of a mixture of all the goods available for sale. The average unit cost applied to goods sold or ending inventory is an average unit cost weighted by the number of units acquired at the various unit prices. When costs are declining, LIFO will result in a lower cost of goods sold and higher income than FIFO. This is because LIFO will include in cost of goods sold the most recently purchased lower cost merchandise. LIFO also will provide a higher ending inventory in the balance sheet. 3 Answers to Questions (continued) Question 8-10 Question 8-11 Question 8-12 Question 8-13 Question 8-14 Proponents of LIFO argue that it provides a better match of revenues and expenses because cost of goods sold includes the costs of the most recent purchases. These are matched with sales that reflect a current selling price. On the other hand, inventory costs in the balance sheet generally are out of date because they are derived from old purchase transactions. It is conceivable that a company’s LIFO inventory balance could be based on unit costs actually incurred several years earlier. When inventory quantity declines during a period, then these out- of-date inventory layers will be liquidated and cost of goods sold will match noncurrent costs with current selling prices. Many companies choose the LIFO inventory method to reduce income taxes in periods when prices are rising. In periods of rising prices, LIFO results in a higher cost of goods sold and therefore a lower net income than the other methods. The companies’ income tax returns will report lower taxable incomes using LIFO and lower taxes will be paid currently. If a company uses LIFO to measure its taxable income, IRS regulations require that LIFO also be used to measure income reported to investors and creditors. The gross profit, inventory turnover, and average days inventory ratios are designed to monitor inventories. The gross profit ratio is calculated by dividing gross profit (net sales minus cost of goods sold) by net sales. Inventory turnover is calculated by dividing cost of goods sold by average inventory, and we compute average days inventory by dividing the number of days in the period by the inventory turnover ratio. A LIFO inventory pool groups inventory units into pools based on physical similarities of the individual units. The average cost for all of a pool’s beginning inventory and for all of a pool’s purchases during the period is used instead of individual unit costs. If the quantity of ending inventory for the pool increases, then ending inventory will consist of the beginning inventory plus a layer added during the period at the average acquisition cost for the pool. The dollar-value LIFO method has important advantages. First, it simplifies the recordkeeping procedures compared to unit LIFO because no information is needed about unit flows. Second, it minimizes the probability of the liquidation of LIFO inventory layers, even more so than the use of pools alone, through the aggregation of many types of inventory into larger pools. In addition, firms that do not replace units sold with new units of the same kind can use the method. 4 Answers to Questions (concluded) Question 8-15 After determining ending inventory at year-end cost, the following steps remain: 1. Convert ending inventory valued at year-end cost to base year cost. 2. Identify the layers in ending inventory with the years they were created. 3. Convert each layer’s base year cost measurement to layer year cost measurement using the layer year’s cost index and then sum the layers. 5 Brief Exercise 8-1 Beginning inventory $186,000 Plus: Purchases 945,000 Less: Cost of goods sold (982,000) Ending inventory $149,000 Brief Exercise 8-2 To record the purchase of inventory on account. Inventory ......................................................................... 845,000 Accounts payable ........................................................ 845,000 To record sales on account and cost of goods sold. Accounts receivable ........................................................ 1,420,000 Sales revenue .............................................................. 1,420,000 Cost of goods sold .......................................................... 902,000 Inventory ..................................................................... 902,000 Brief Exercise 8-3 BRIEF EXERCISES 6 Both shipments should be included in inventory. The goods shipped to a customer f.o.b. destination did not arrive at the customer’s location until after the fiscal year-end. They belong to Kelly until they arrive at the customer’s location. Title to the goods shipped from a supplier to Kelly on December 30, f.o.b. shipping point, changed hands on December 30. Brief Exercise 8-4 Purchase price = 10 units x $25,000 = $250,000 December 28, 2006 Inventory ......................................................................... 250,000 Accounts payable ........................................................ 250,000 January 6, 2007 Accounts payable ............................................................ 250,000 Cash (99% x $250,000) .................................................. 247,500 Purchase discounts (1% x $250,000) ............................. 2,500 Brief Exercise 8-5 December 28, 2006 7 Inventory (98% x $250,000) ............................................... 247,500 Accounts payable ....................................................... 247,500 January 6, 2007 Accounts payable ............................................................ 247,500 Cash ............................................................................ 247,500 8 Brief Exercise 8-6 Cost of goods available for sale: Beginning inventory (200 x $25) $5,000 Purchases: 100 x $28 $2,800 200 x $30 6,000 8,800 Cost of goods available (500 units) $13,800 First-in, first-out (FIFO) Cost of goods available for sale (500 units) $13,800 Less: Ending inventory (determined below) (8,100) Cost of goods sold $5,700 Cost of ending inventory: Date of purchase Units Unit cost Total cost January 8 75 $28 $2,100 January 19 200 30 6,000 Total $8,100 Average cost Cost of goods available for sale (500 units) $13,800 Less: Ending inventory (determined below) (7,590) Cost of goods sold $6,210 * Cost of ending inventory: $13,800 Weighted-average unit cost = = $27.60 500 units 275 units x $27.60 = $7,590 * Alternatively, could be determined by multiplying the units sold by the average cost: 225 units x $27.60 = $6,210 9 Brief Exercise 8-7 First-in, first-out (FIFO) Cost of goods sold: Date of Cost of sale Units sold Units Sold Total Cost January 10 125 (from Beg. Inv.) $25 $3,125 January 25 75 (from Beg. Inv.) 25 1,875 25 (from 1/8 purchase) 28 700 Total 225 $5,700 Ending inventory: Date of purchase Units Unit cost Total cost January 8 75 $28 $2,100 January 19 200 30 6,000 Total $8,100 10 Brief Exercise 8-7 (concluded) Average cost Date Purchased Sold Balance Beginning inventory 200 @ $25 = $5,000 200 @ $25 $5,000 January 8 100 @ $28 = $2,800 $7,800 = $26/unit 300 units January 10 125 @ $26 = $3,250 175 @ $26 $4,550 January 19 200 @ $30 = $6,000 $10,550 = $28.133/unit 375 units January 25 100 @ $28.133 = $2,813 275 @ $28.133 $7,737 Ending inventory Total cost of goods sold = $6,063 11 Brief Exercise 8-8 Cost of goods available for sale: Beginning inventory (20,000 x $25) $ 500,000 Purchases: 80,000 x $30 2,400,000 Cost of goods available (100,000 units) 2,900,000 Less: Ending inventory (15,000 units) 375,000* Cost of goods sold $2,525,000 15,000 units x $25 each = $375,000 Brief Exercise 8-9 64,000 units were sold. Cost of goods sold without year-end purchase: Units purchased during the year: 60,000 x $18 $1,080,000 Plus units from beginning inventory: 4,000 x $15 60,000 Cost of goods sold 1,140,000 Cost of goods sold with year-end purchase: 64,000 units x $18 1,152,000 Difference $ 12,000 Cost of goods sold would be $12,000 higher and income before income taxes $12,000 lower if the year-end purchase is made. If FIFO were used instead of LIFO, the year-end purchase would have no effect on income before income taxes. FIFO cost of goods sold with or without the purchase would consist of the 10,000 units from beginning inventory and 54,000 units purchased during the year at $18: 10,000 units x $15 $ 150,000 Plus: 54,000 units x $18 972,000 Cost of goods sold $1,122,000 12 Brief Exercise 8-10 Units liquidated 5,000 Difference in cost ($30 – 25) x $5 Before tax LIFO liquidation profit $25,000 Tax effect ($25,000 x 40%) (10,000) LIFO liquidation profit $15,000 Brief Exercise 8-11 Cost of goods sold for 2004 would have been $13 million higher had Albertsons used FIFO for its entire inventory. While beginning inventory would have been $589 million higher, ending inventory also would have been higher by $576 million. An increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. Purchases for 2004 are the same regardless of the inventory valuation method used. Cost of goods sold as reported $25,306 million Increase if all FIFO 13 million Cost of goods sold, all FIFO $25,319 million 13 Brief Exercise 8-12 Average inventory = ($60,000 + 48,000) ÷ 2 = $54,000 Cost of goods sold ÷ Average inventory = Inventory turnover Cost of goods sold ÷ $54,000 = 5 Cost of goods sold = $54,000 x 5 Cost of goods sold = $270,000 Gross profit ratio = 40%, therefore cost percentage = 60% Sales x .60 = $270,000 Sales = $270,000 ÷ .60 = $450,000 Brief Exercise 8-13 Ending Inventory Inventory Layers Inventory Layers Inventory Date at Base Year Cost at Base Year Cost Converted to Cost DVL Cost 1/1/06 $1,400,000 = $1,400,000 $1,400,000 (base) $1,400,000 x 1.00 =$1,400,000 $1,400,000 1.00 12/31/06 $1,664,000 = $1,600,000 $1,400,000 (base) $1,400,000 x 1.00 = $1,400,000 1.04 200,000 (2006) 200,000 x 1.04 = 208,000 $1,608,000 14 Exercise 8-1 1. To record the purchase of inventory on account and the payment of freight charges. Inventory ......................................................................... 5,000 Accounts payable ........................................................ 5,000 Inventory ......................................................................... 300 Cash ............................................................................ 300 2. To record purchase returns. Accounts payable ............................................................ 600 Inventory ..................................................................... 600 3. To record cash sales and cost of goods sold. Cash ................................................................................ 5,200 Sales revenue .............................................................. 5,200 Cost of goods sold .......................................................... 2,800 Inventory ..................................................................... 2,800 EXERCISES 15 Exercise 8-2 1. To record the purchase of inventory on account and the payment of freight charges. Purchases ........................................................................ 5,000 Accounts payable ........................................................ 5,000 Freight-in ........................................................................ 300 Cash ............................................................................ 300 2. To record purchase returns. Accounts payable ............................................................ 600 Purchase returns .......................................................... 600 3. To record cash sales. Cash ................................................................................ 5,200 Sales revenue .............................................................. 5,200 NO ENTRY IS MADE FOR THE COST OF GOODS SOLD. 16 Exercise 8-3 Requirement 1 Beginning inventory $ 32,000 Plus net purchases: Purchases $240,000 Less: Purchase discounts (6,000) Less: Purchases returns (10,000) Plus: Freight-in 17,000 241,000 Cost of goods available for sale 273,000 Less: Ending inventory (40,000) Cost of goods sold $233,000 Requirement 2 Cost of goods sold (above) .............................................. 233,000 Inventory (ending) ............................................................ 40,000 Purchase discounts .......................................................... 6,000 Purchase returns .............................................................. 10,000 Inventory (beginning) ................................................... 32,000 Purchases .................................................................... 240,000 Freight-in .................................................................... 17,000 17 Exercise 8-4 PERPETUAL SYSTEM PERIODIC SYSTEM ($ in 000s) Purchases Inventory 155 Purchases 155 Accounts payable 155 Accounts payable 155 Freight Inventory 10 Freight-in 10 Cash 10 Cash 10 Returns Accounts payable 12 Accounts payable 12 Inventory 12 Purchase returns 12 Sales Accounts receivable 250 Accounts receivable 250 Sales revenue 250 Sales revenue 250 Cost of goods sold 148 No entry Inventory 148 End of period No entry Cost of goods sold (below) 148 Inventory (ending) 30 Purchase returns 12 Inventory (beginning) 25 Purchases 155 Freight-in 10 Cost of goods sold: Beginning inventory $25 Purchases $155 Less: Returns (12) Plus: Freight-in 10 Net purchases 153 Cost of goods available 178 Less: Ending inventory (30) Cost of goods sold $148 18 Exercise 8-5 2006 2007 2008 Beginning inventory 275 (1) 249 (3) 225 Cost of goods sold 627 621 584 (6) Ending inventory 249 (2) 225 216 Cost of goods available for sale 876 846 (4) 800 Purchases (gross) 630 610 (5) 585 Purchase discounts 18 15 12 (7) Purchase returns 24 30 14 Freight-in 13 32 16 Net purchases = Purchases(gross) - Purchase returns - Purchase discounts + Freight-in Beginning inventory + Net purchases = Cost of goods available for sale Cost of goods available for sale - Ending inventory = Cost of goods sold 2006: (1) Cost of goods available for sale - Net purchases = Beginning inventory 876 - (630 - 18 - 24 + 13) = 275 = Beginning inventory (2) Cost of goods available for sale - Cost of goods sold = Ending inventory 876 - 627 = 249 = Ending inventory 2007: (3) 2007 beginning inventory = 2006 ending inventory = 249 (4) Cost of goods sold + Ending inventory = Cost of goods available for sale 621 + 225 = 846 = Cost of goods available for sale (5) Cost of goods available for sale - Beginning inventory = Net purchases 846 - 249 = 597 = Net purchases Net purchases + Purchases discounts + Purchase returns - Freight-in = Purchases(gross) 597 + 15 + 30 - 32 = 610 = Purchases (gross) 2008: (6) Cost of goods available for sale - Ending inventory = Cost of goods sold 800 - 216 = 584 = Cost of goods sold 19 Exercise 8-5 (concluded) (7) Cost of goods available for sale - Beginning inventory = Net purchases 800 - 225 = 575 = Net purchases Purchases(gross) - Purchase returns + Freight-in - Net purchases = Purchase discounts 585 - 14 + 16 - 575 = 12 = Purchase discounts 20 Exercise 8-6 Requirement 1 Purchase price = 1,000 units x $50 = $50,000 July 15, 2006 Purchases ........................................................................ 50,000 Accounts payable ........................................................ 50,000 July 23, 2006 Accounts payable ............................................................ 50,000 Cash (98% x $50,000) .................................................... 49,000 Purchase discounts (2% x $50,000) ............................... 1,000 Requirement 2 August 15, 2006 Accounts payable ............................................................ 50,000 Cash ............................................................................ 50,000 Requirement 3 The July 15 entry would include a debit to the inventory account instead of to purchases, and the July 23 entry would include a credit to the inventory account instead of to purchases discounts. 21 Exercise 8-7 Requirement 1 July 15, 2006 Purchases (98% x $50,000) ................................................ 49,000 Accounts payable ....................................................... 49,000 July 23, 2006 Accounts payable ............................................................ 49,000 Cash ............................................................................ 49,000 Requirement 2 August 15, 2006 Accounts payable ............................................................ 49,000 Interest expense .............................................................. 1,000 Cash ............................................................................ 50,000 Requirement 3 The July 15 entry would include a debit to the inventory account instead of to purchases. 22 Exercise 8-8 Requirement 1 Purchase price = 100 units x $500 = $50,000 x .70 = $35,000 November 17, 2006 Purchases ........................................................................ 35,000 Accounts payable ........................................................ 35,000 November 26, 2006 Accounts payable ........................................................... 35,000 Purchase discounts (2% x $35,000) ............................... 700 Cash (98% x $35,000) .................................................... 34,300 Requirement 2 December 15, 2006 Accounts payable ............................................................ 35,000 Cash ............................................................................ 35,000 23 Exercise 8-8 (concluded) Requirement 3 Requirement 1: November 17, 2006 Purchases (98% x $35,000) ................................................ 34,300 Accounts payable ........................................................ 34,300 November 26, 2006 Accounts payable ............................................................ 34,300 Cash ............................................................................ 34,300 Requirement 2: December 15, 2006 Accounts payable ............................................................ 34,300 Interest expense (2% x $35,000) ........................................ 700 Cash ............................................................................ 35,000 24 Exercise 8-9 Inventory balance before additional transactions $165,000 Add: Goods shipped to Kwok f.o.b. shipping point on Dec. 28 17,000 Goods shipped to customer f.o.b. destination on December 27 22,000 Correct inventory balance $204,000 Exercise 8-10 Inventory balance before additional transactions $210,000 Add: Merchandise on consignment with Joclyn Corp. 15,000 Deduct: Merchandise shipped to Raymond f.o.b. destination on December 26 (30,000) Merchandise held on consignment from the Harrison Company (14,000) Correct inventory balance $181,000 25 Exercise 8-11 Cost of goods available for sale: Beginning inventory (2,000 x $6.10) $12,200 Purchases: 10,000 x $5.50 $55,000 6,000 x $5.00 30,000 85,000 Cost of goods available (18,000 units) $97,200 First-in, first-out (FIFO) Cost of goods available for sale (18,000 units) $97,200 Less: Ending inventory (determined below) (15,000) Cost of goods sold $82,200 Cost of ending inventory: Date of purchase Units Unit cost Total cost August 18 3,000 $5.00 $15,000 Last-in, first-out (LIFO) Cost of goods available for sale (18,000 units) $97,200 Less: Ending inventory (determined below) (17,700) Cost of goods sold $79,500 Cost of ending inventory: Date of purchase Units Unit cost Total cost Beg. Inv. 2,000 $6.10 $12,200 August 8 1,000 5.50 5,500 Total $17,700 26 Exercise 8-11 (concluded) Average cost Cost of goods available for sale (18,000 units) $97,200 Less: Ending inventory (determined below) (16,200) Cost of goods sold $81,000 * Cost of ending inventory: $97,200 Weighted-average unit cost = = $5.40 18,000 units 3,000 units x $5.40 = $16,200 * Alternatively, could be determined by multiplying the units sold by the average cost: 15,000 units x $5.40 = $81,000 27 Exercise 8-12 First-in, first-out (FIFO) Cost of goods sold: Date of Cost of sale Units sold Units Sold Total Cost Aug. 14 2,000 (from Beg. Inv.) $6.10 $12,200 6,000 (from 8/8 purchase) 5.50 33,000 Aug. 25 4,000 (from 8/8 purchase) 5.50 22,000 3,000 (from 8/18 purchase) 5.00 15,000 Total 15,000 $82,200 Ending inventory = 3,000 units x $5.00 = $15,000 Last-in, first-out (LIFO) Date Purchased Sold Balance Beginning inventory 2,000 @ $6.10 = $12,200 2,000 @ $6.10 $12,200 August 8 10,000 @ $5.50 = $55,000 2,000 @ $6.10 10,000 @ $5.50 $67,200 August 14 8,000 @ $ 5.50 = $44,000 2,000 @ $6.10 2,000 @ $5.50 $23,200 August 18 6,000 @ $5.00 = $30,000 2,000 @ $6.10 2,000 @ $5.50 $53,200 6,000 @ $5.00 August 25 6,000 @ $5.00 = $30,000 1,000 @ $5.50 = $ 5,500 2,000 @ $6.10 1,000 @ $5.50 $17,700 Ending inventory Total cost of goods sold = $79,500 28 Exercise 8-12 (concluded) (Note: the perpetual inventory LIFO results are the same as periodic LIFO results would be, due to the timing of sales and purchases. The same LIFO layers are on hand at the end of the period under each method. This is unusual. LIFO perpetual and LIFO periodic normally produce different results for ending inventory and cost of goods sold.) Average cost Date Purchased Sold Balance Beginning inventory 2,000 @ $6.10 = $12,200 2,000 @ $6.10 $12,200 August 8 10,000 @ $5.50 = $55,000 $67,200 = $5.60/unit 12,000 units August 14 8,000 @ $5.60 = $44,800 4,000 @ $5.60 $22,400 August 18 6,000 @ $5.00 = $30,000 $52,400 = $5.24/unit 10,000 units August 25 7,000 @ $5.24 = $36,680 3,000 @ $5.24 $15,720 Ending inventory Total cost of goods sold = $81,480 29 Exercise 8-13 Requirement 1 LIFO will result in the highest cost of goods sold figure because both the cost of merchandise and the quantity of merchandise rose during the period. FIFO will result in the highest ending inventory balance for the same reasons. Requirement 2 Cost of goods available for sale: Beginning inventory (600 x $80) $ 48,000 Purchases: 1,000 x $ 95 $95,000 800 x $100 80,000 175,000 Cost of goods available (2,400 units) $223,000 First-in, first-out (FIFO) Cost of goods available for sale (2,400 units) $223,000 Less: Ending inventory (below) (80,000) Cost of goods sold $143,000 Cost of ending inventory: Date of purchase Units Unit cost Total cost January 21 800 $100 $80,000 Last-in, first-out (LIFO) Cost of goods available for sale (2,400 units) $223,000 Less: Ending inventory (below) (67,000) Cost of goods sold $156,000 Cost of ending inventory: Date of purchase Units Unit cost Total cost Beg. Inv. 600 $80 $48,000 January 15 200 95 19,000 Total $67,000 30 Exercise 8-14 Requirement 1 Cost of goods available for sale: Beginning inventory (5,000 x $10.00) $ 50,000 Purchases: 3,000 x $10.40 $31,200 8,000 x $10.75 86,000 117,200 Cost of goods available (16,000 units) $167,200 Cost of goods available for sale (16,000 units) $167,200 Less: Ending inventory (below) (73,150) Cost of goods sold $ 94,050* Cost of ending inventory: $167,200 Weighted-average unit cost = = $10.45 16,000 units 7,000 units x $10.45 = $73,150 * Alternatively, could be determined by multiplying the units sold by the average cost: 9,000 units x $10.45 = $94,050 31 Exercise 8-14 (concluded) Requirement 2 Date Purchased Sold Balance Beginning inventory 5,000 @ $10.00 = $50,000 5,000 @ $10.00 $50,000 September 7 3,000 @ $10.40 = $31,200 $81,200 = $10.15/unit 8,000 units September 10 4,000 @ $10.15 = $40,600 4,000 @ $10.15 $40,600 September 25 8,000 @ $10.75 = $86,000 $126,600 = $10.55/unit 12,000 units September 29 5,000 @ $10.55 = $52,750 7,000 @ $10.55 $73,850 Ending inventory Total cost of goods sold = $93,350 32 Exercise 8-15 Requirement 1 FIFO cost of goods sold: 10,000 units @ $5.00 = $50,000 + 10,000 units @ $6.00 (determined below) = 60,000 $110,000 Requirement 2 LIFO cost of goods sold: 20,000 units @ $6.00 (determined below) = $120,000 Calculations to determine cost per unit of year 2006 purchases: Cost of goods sold = Weighted-average cost per unit Number of units sold $115,000 = $5.75 per unit 20,000 units $5.75 x 40,000 units = $230,000 = Cost of goods available for sale $230,000 - $50,000 (beginning inventory) = $180,000 = Cost of purchases $180,000 = $6 = Cost per unit of year 2006 purchases 30,000 units purchased Cost of goods available for sale: Beginning inventory (10,000 x $5.00) $ 50,000 Purchases (30,000 x $6.00) 180,000 Cost of goods available (40,000 units) $230,000 Exercise 8-16 1. d 33 2. b 3. b 4. a Exercise 8-17 Requirement 1 Cost of goods sold: 50,000 units x $8.50 = $425,000 4,000 units x $7.00 = 28,000 $453,000 Requirement 2 When inventory quantity declines during a period, liquidation of LIFO inventory layers carried at lower costs prevailing in prior years results in noncurrent costs being matched with current selling prices. If the resulting effect on income is material, it must be disclosed. In this case, the effect of the LIFO layer liquidation is to increase income (ignoring taxes) by $6,000 [4,000 units liquidated x $1.50 ($8.50 current year cost per unit - $7 LIFO layer cost per unit)]. Exercise 8-18 ($ in millions) MAYTAG WHIRLPOOL Gross profit ratio = 860 = 18% 2,769 = 23% 4,792 12,176 Inventory turnover = 3,932 = 8.40 9,407 = 7.75 468 1,214.5 Average days = 365 = 43 days 365 = 47 days in inventory 8.40 7.75 Maytag's gross profit ratio (18%) is lower than Whirlpool's (23%). However, Maytag’s turnover ratio is slightly higher (8.40 compared to 7.75). 34 Exercise 8-19 Ending Ending Inventory Inventory Layers Inventory Layers Inventory Date at Base Year Cost at Base Year Cost Converted to Cost DVL Cost 1/1/06 $660,000 = $660,000 $660,000 (base) $660,000 x 1.00 = $660,000 $660,000 1.00 12/31/06 $690,000 = $663,462 $660,000 (base) $660,000 x 1.00 = $660,000 1.04 3,462 (2006) 3,462 x 1.04 = 3,600 663,600 12/31/07 $760,000 = $703,704 $660,000 (base) $660,000 x 1.00 = $660,000 1.08 3,462 (2006) 3,462 x 1.04 = 3,600 40,242 (2007) 40,242 x 1.08 = 43,461 707,061 35 Exercise 8-20 Ending Ending Inventory Inventory Layers Inventory Layers Inventory Date at Base Year Cost at Base Year Cost Converted to Cost DVL Cost 12/31/06 $200,000 = $200,000 $200,000 (base) $200,000 x 1.00 = $200,000 $200,000 1.00 12/31/07 $231,000 = $220,000 Index = 1.05 Index $200,000 (base) $200,000 x 1.00 = $200,000 20,000 (2007) 20,000 x 1.05 = 21,000 221,000 12/31/08 $299,000 = $260,000 Index = 1.15 Index $200,000 (base) $200,000 x 1.00 = $200,000 20,000 (2007) 20,000 x 1.05 = 21,000 40,000 (2008) 40,000 x 1.15 = 46,000 267,000 12/31/09 $300,000 = $250,000 Index = 1.20 Index $200,000 (base) $200,000 x 1.00 = $200,000 20,000 (2007) 20,000 x 1.05 = 21,000 30,000 (2008) 30,000 x 1.15 = 34,500 255,500 Exercise 8-21 1. b 2. c 36 Exercise 8-22 List A List B i 1. Perpetual inventory system a. Legal title passes when goods are delivered to common carrier. l 2. Periodic inventory system b. Goods are transferred to another company but title remains with transferor. a 3. F.o.b. shipping point c. Purchase discounts not taken are included in inventory cost. c 4. Gross method d. If LIFO is used for taxes, it must be used for financial reporting. g 5. Net method e. Items sold are those acquired first. h 6. Cost index f. Items sold are those acquired last. k 7. F.o.b. destination g. Purchase discounts not taken are considered interest expense. e 8. FIFO h. Used to convert ending inventory at year-end cost to base year cost. f 9. LIFO i. Continuously records changes in inventory. b 10. Consignment j. Items sold come from a mixture of goods acquired during the period. j 11. Average cost k. Legal title passes when goods arrive at location. d 12. IRS conformity rule l. Adjusts inventory at the end of the period. 37 Exercise 8-23 1. c. The company began March with 3,200 units in inventory at $64.30 each. The March 4 purchase added 3,400 additional units at $64.75 each. Under FIFO, the 3,600 units sold on March 14 were the oldest units. That sale eliminated all of the 3,200 units priced at $64.30 and 400 of the units priced at $64.75, leaving an inventory of 3,000 units at $64.75 prior to the March 25 purchase. On March 25, 3,500 units were acquired at $66. The 3,450 units sold on March 28 were the 3,000 remaining units priced at $64.75 and 450 units priced at $66. The ending inventory consists of 3,050 units at $66 each, or $201,300. The answer would have been the same under the periodic FIFO method. 2. a. The ending inventory consists of 3,050 units (beginning inventory plus purchases, minus sales). Under the periodic LIFO method, those units are valued at the oldest prices for the period, which is $64.30 of the beginning inventory. Multiplying $64.30 times 3,050 units produces a total inventory value of $196,115. 3. a. Under the perpetual LIFO method, the company begins with 3,200 units at $64.30. To this is added the March 4 purchase of 3,400 units at $64.75. The March 14 sale uses all of the March 4 purchase and 200 of the original inventory units. Thus, the firm is left with 3,000 units at $64.30. The March 25 purchase of 3,500 at $66 is added to the previous 3,000 units. The March 28 sale of 3,450 units comes entirely from the March 25 purchase, leaving just 50 of those units at $66 each. Thus, at the end of the month, the inventory consists of two layers: 3,000 units at $64.30 ($192,200), and 50 units at $66 ($3,300). Adding the two together produces a total ending inventory of $196,200. 38 Problem 8-1 Requirement 1 a. To record the purchase of inventory on account and the payment of freight charges. October 12, 2006 Purchases (98% x $22,000) ................................................ 21,560 Accounts payable ....................................................... 21,560 Freight-in ........................................................................ 500 Cash ............................................................................ 500 b. To record purchase returns. October 18, 2006 Accounts payable ............................................................ 3,000 Purchase returns .......................................................... 3,000 c. To record payment of accounts payable. October 31, 2006 Accounts payable ............................................................ 21,560 Interest expense .............................................................. 440 Cash ............................................................................ 22,000 PROBLEMS 39 Problem 8-1 (continued) d. To record sales on account. October, 2006 Accounts receivable ........................................................ 28,000 Sales revenue .............................................................. 28,000 No entry is made for the cost of goods sold. Cost of goods sold: Beginning inventory $15,000 Plus net purchases: Purchases $21,560 Less: Purchases returns (3,000) Plus: Freight-in 500 19,060 Cost of goods available for sale 34,060 Less: Ending inventory (16,060) Cost of goods sold $18,000 Adjusting entry: October 31, 2006 Cost of goods sold (above) ............................................... 18,000 Inventory (ending) ............................................................ 16,060 Purchase returns .............................................................. 3,000 Inventory (beginning) .................................................... 15,000 Purchases .................................................................... 21,560 Freight-in .................................................................... 500 40 Problem 8-1 (concluded) Requirement 2 a. To record the purchase of inventory on account and the payment of freight charges. October 12, 2006 Inventory (98% x $22,000) ................................................. 21,560 Accounts payable ....................................................... 21,560 Inventory ......................................................................... 500 Cash ............................................................................ 500 b. To record purchase returns. October 18, 2006 Accounts payable ............................................................ 3,000 Inventory ..................................................................... 3,000 c. To record payment of accounts payable. October 31, 2006 Accounts payable ............................................................ 21,560 Interest expense .............................................................. 440 Cash ............................................................................ 22,000 d. To record sales on account. October, 2006 Accounts receivable ........................................................ 28,000 Sales revenue .............................................................. 28,000 Cost of goods sold .......................................................... 18,000 Inventory ..................................................................... 18,000 41 Problem 8-2 1. The transaction is not correctly accounted for. Inventory held on consignment by another company should be included in the inventory of the consignor. Rasul should include this merchandise in its 2006 ending inventory. 2. The transaction is not correctly accounted for. Legal title to merchandise shipped f.o.b. shipping point changes hands when the goods are shipped. Rasul should record the purchase and corresponding account payable in 2006 and include the merchandise in its 2006 ending inventory. 3. The transaction is not correctly accounted for. Since the merchandise was shipped f.o.b. destination and did not arrive at the customer's location until 2007, it should be included in Rasul’s 2006 ending inventory. The sale should be recorded in 2007. 4. The transaction is correctly accounted for. Merchandise held on consignment from another company belongs to the consignor and should be excluded from the inventory of the consignee. 5. The transaction is correctly accounted for. Since the merchandise was shipped f.o.b. destination and did not arrive at Rasul’s location until 2007, it should not be included in Rasul’s 2006 ending inventory. The purchase is correctly recorded in 2007. Problem 8-3 Accounts Inventory Payable Sales Initial amounts $1,250,000 $1,000,000 $9,000,000 Adjustments - increase (decrease): 1. (155,000) (155,000) NONE 2. (22,000) NONE NONE 3. NONE NONE 40,000 4. 210,000 NONE NONE 5. 25,000 25,000 NONE 6. 2,000 2,000 NONE 7. (5,300) (5,300) NONE Total adjustments 54,700 (133,300) 40,000 Adjusted amounts $1,304,700 $ 866,700 $9,040,000 42 Problem 8-4 Requirement 1 Beginning inventory (10,000 x $8.00) $ 80,000 Net purchases: Purchases (50,000* units x $10.00) $500,000 Less: Returns (1,000 units x $10.50) (10,500) Less: Purchase discounts ($500,000 x 60% x 2%) (6,000) Plus: Freight-in (50,000 units x $.50) 25,000 508,500 Cost of goods available (59,000 units) 588,500 Less: Ending inventory (below) (122,000) Cost of goods sold $466,500 * The 5,000 units purchased on December 28 are not included. The merchandise was shipped f.o.b. destination and did not arrive at Johnson’s warehouse until 2007. Cost of ending inventory: Date of purchase Units Unit cost Total cost Beg. Inv. 10,000 $ 8.00 $ 80,000 2006 4,000 10.50** 42,000 Total 14,000 $122,000 ** Includes freight charge of $.50 per unit. Requirement 2 Sales (45,000 units x $18.00) $810,000 Less: Cost of goods sold (above) $466,500 Other operating expenses 150,000 (616,500) Income before income taxes $193,500 43 Problem 8-5 Cost of goods available for sale for periodic system: Beginning inventory (6,000 x $8.00) $ 48,000 Purchases: 5,000 x $ 9.00 $45,000 6,000 x $10.00 60,000 105,000 Cost of goods available (17,000 units) $153,000 1. FIFO, periodic system Cost of goods available for sale (17,000 units) $153,000 Less: Ending inventory (determined below) (78,000) Cost of goods sold $ 75,000 Cost of ending inventory: Date of purchase Units Unit cost Total cost Jan. 18 6,000 $10.00 $60,000 Jan. 10 2,000 9.00 18,000 Totals 8,000 $78,000 2. LIFO, periodic system Cost of goods available for sale (17,000 units) $153,000 Less: Ending inventory (determined below) (66,000) Cost of goods sold $ 87,000 Cost of ending inventory: Date of purchase Units Unit cost Total cost Beg. Inv. 6,000 $8.00 $48,000 Jan. 10 2,000 9.00 18,000 Totals 8,000 $66,000 44 Problem 8-5 (continued) 3. LIFO, perpetual system Date Purchased Sold Balance Beginning inventory 6,000 @ $8.00 = $48,000 6,000 @ $8.00 $48,000 January 5 3,000 @ $8.00 = $24,000 3,000 @ $8.00 $24,000 January 10 5,000 @ $9.00 = $45,000 3,000 @ $8.00 5,000 @ $9.00 $69,000 January 12 2,000 @ $9.00 = $18,000 3,000 @ $8.00 3,000 @ $9.00 $51,000 January 18 6,000 @ $10.00 = $60,000 3,000 @ $8.00 3,000 @ $9.00 $111,000 6,000 @ $10.00 January 20 4,000 @ $10.00 = $40,000 3,000 @ $8.00 3,000 @ $9.00 2,000 @ $10.00 $71,000 Ending inventory Total cost of goods sold = $82,000 4. Average cost, periodic system Cost of goods available for sale (17,000 units) $153,000 Less: Ending inventory (below) (72,000) Cost of goods sold $ 81,000* Cost of ending inventory: $153,000 Weighted-average unit cost = = $9.00 17,000 units 8,000 units x $9.00 = $72,000 * Alternatively, could be determined by multiplying the units sold by the average cost: 9,000 units x $9.00 = $81,000 45 Problem 8-5 (concluded) 5. Average cost, perpetual system Date Purchased Sold Balance Beginning inventory 6,000 @ $8.00 = $48,000 6,000 @ $8.00 $48,000 January 5 3,000 @ $8.00 = $24,000 3,000 @ $8.00 $24,000 January 10 5,000 @ $9.00 = $45,000 $69,000 = $8.625/unit 8,000 units January 12 2,000 @ $8.625 = $17,250 6,000 @ $8.625 $51,750 January 18 6,000 @ $10.00 = $60,000 $111,750 = $9.3125/unit 12,000 units January 20 4,000 @ $9.3125 = $37,250 8,000 @ $9.3125 $74,500 Ending inventory Total cost of goods sold = $78,500 46 Problem 8-6 Requirement 1 Cost of goods available for sale for periodic system: Purchases: 5,000 x $4.00 $20,000 12,000 x $4.50 54,000 17,000 x $5.00 85,000 Cost of goods available (34,000 units) $159,000 a. FIFO Cost of goods available for sale (34,000 units) $159,000 Less: Ending inventory (determined below) (70,000) Cost of goods sold $ 89,000 Cost of ending inventory: Date of purchase Units Unit cost Total cost March 22 14,000 5.00 70,000 b. LIFO Cost of goods available for sale (34,000 units) $159,000 Less: Ending inventory (determined below) (60,500) Cost of goods sold $ 98,500 Cost of ending inventory: Date of purchase Units Unit cost Total cost Jan. 7 5,000 $4.00 $20,000 Feb. 16 9,000 4.50 40,500 Totals 14,000 $60,500 47 Problem 8-6 (concluded) c. Average cost Cost of goods available for sale (34,000 units) $159,000 Less: Ending inventory (below) (65,471) Cost of goods sold $ 93,529* Cost of ending inventory: $159,000 Weighted-average unit cost = = $4.6765 34,000 units 14,000 units x $4.6765 = $65,471 * Alternatively, could be determined by multiplying the units sold by the average cost: 20,000 units x $4.6765 = $93,530 (rounding) Gross Profit ratio: FIFO: $51,000* % $140,000** = 36% LIFO: $41,500 % $140,000 = 30% Average: $46,471 % $140,000 = 33% *Sales less cost of goods sold **20,000 units x $7 sales price = sales Requirement 2 In situations when costs are rising, LIFO results in a higher cost of goods sold and, therefore, a lower gross profit ratio than FIFO. 48 Problem 8-7 Requirement 1 Beginning inventory ($60,000 + 60,000 + 63,000) $183,000 Purchases: 211 $63,000 212 63,000 213 64,500 214 66,000 215 69,000 216 70,500 217 72,000 218 72,300 219 75,000 615,300 Cost of goods available 798,300 Ending inventory: 213 $64,500 216 70,500 219 75,000 (210,000) Cost of goods sold $588,300 Requirement 2 Cost of goods available for sale $798,300 Less: Ending inventory (below) (219,300) Cost of goods sold $579,000 Cost of ending inventory (3 autos): Car ID Cost 219 $ 75,000 218 72,300 217 72,000 Total $219,300 49 Problem 8-7 (concluded) Requirement 3 Cost of goods available for sale $798,300 Less: Ending inventory (below) (183,000) Cost of goods sold $615,300 Cost of ending inventory (3 autos): Car ID Cost 203 $ 60,000 207 60,000 210 63,000 Total $183,000 Requirement 4 Cost of goods available for sale (12 units) $798,300 Less: Ending inventory (below) (199,575) Cost of goods sold $598,725* Cost of ending inventory: $798,300 Weighted-average unit cost = = $66,525 12 units 3 units x $66,525 = $199,575 * Alternatively, could be determined by multiplying the units sold by the average cost: 9 units x $66,525 = $598,725 50 Problem 8-8 Requirement 1 The note indicates that if the company had used FIFO, inventory would have been higher by $2,124 million and $1,863 million at the end of 2004 and 2003, respectively. Therefore, 2004 cost of goods sold would have been lower (and income before tax higher) by $261 million ($2,124 – 1,863). The note also indicates that net income for 2004 would have been higher by $191 million if FIFO had been used. This means that the tax effect of the difference between LIFO and FIFO was $70 million ($261 - 191). The effective tax rate is therefore approximately 27% ($70 % $261). Requirement 2 The information might be useful to a financial analyst interested in comparing Caterpillar’s performance with another company using the FIFO inventory method exclusively. Requirement 3 Retained earning would have been higher by approximately $1,551 million [$2,124 million x (1 - .27)]. 51 Problem 8-9 Requirement 1 Beginning inventory $ 450,000 Purchases: 30,000 units @ $25 750,000 Cost of goods available for sale 1,200,000 Less: Ending inventory (below) (250,000) Cost of goods sold $ 950,000 Cost of ending inventory: Date of purchase Units Unit cost Total cost Beg. Inv. 10,000 $15 $150,000 Beg. Inv. 5,000 20 100,000 Totals 15,000 $250,000 Requirement 2 Cost of goods sold assuming all units purchased at the year 2006 price: 40,000 units x $25.00 = $1,000,000 Less: LIFO cost of goods sold (950,000) LIFO liquidation profit before tax 50,000 Multiplied by 1 - .40 x .60 LIFO liquidation profit $ 30,000 Requirement 3 $50,000 x 40% = $20,000 52 Problem 8-10 Ending Ending Inventory Inventory Layers Inventory Layers Inventory Date at Base Year Cost at Base Year Cost Converted to Cost DVL Cost 1/1/06 $400,000 = $400,000 $400,000 (base) $400,000 x 1.00 = $400,000 $400,000 1.00 12/31/06 $441,000 = $420,000 $400,000 (base) $400,000 x 1.00 = $400,000 1.05 20,000 (2006) 20,000 x 1.05 = 21,000 421,000 12/31/07 $487,200 = $435,000 $400,000 (base) $400,000 x 1.00 = $400,000 1.12 20,000 (2006) 20,000 x 1.05 = 21,000 15,000 (2007) 15,000 x 1.12 = 16,800 437,800 12/31/08 $510,000 = $425,000 $400,000 (base) $400,000 x 1.00 = $400,000 1.20 20,000 (2006) 20,000 x 1.05 = 21,000 5,000 (2007) 5,000 x 1.12 = 5,600 426,600 Problem 8-11 Ending Ending Inventory Inventory Layers Inventory Layers Inventory Date at Base Year Cost at Base Year Cost Converted to Cost DVL Cost 1/1/06 $150,000 = $150,000 $150,000 (base) $150,000 x 1.00 = $150,000 $150,000 1.00 12/31/06 $200,000 = $185,185 $150,000 (base) $150,000 x 1.00 = $150,000 1.08 35,185 (2006) 35,185 x 1.08 = 38,000 188,000 12/31/07 $245,700 = $210,000 $150,000 (base) $150,000 x 1.00 = $150,000 1.17 35,185 (2006) 35,185 x 1.08 = 38,000 24,815 (2007) 24,815 x 1.17 = 29,034 217,034 12/31/08 $235,980 = $207,000 $150,000 (base) $150,000 x 1.00 = $150,000 1.14 35,185 (2006) 35,185 x 1.08 = 38,000 21,815 (2007) 21,815 x 1.17 = 25,524 213,524 12/31/09 $228,800 = $208,000 $150,000 (base) $150,000 x 1.00 = $150,000 1.10 35,185 (2006) 35,185 x 1.08 = 38,000 21,815 (2007) 21,815 x 1.17 = 25,524 1,000 (2009) 1,000 x 1.10 = 1,100 214,624 53 Problem 8-12 Ending Ending Inventory Inventory Layers Inventory Layers Inventory Date at Base Year Cost at Base Year Cost Converted to Cost DVL Cost 1/1/06 $260,000 = $260,000 $260,000 (base) $260,000 x 1.00 = $260,000 $260,000 1.00 12/31/06 $340,000 = $333,333 $260,000 (base) $260,000 x 1.00 = $260,000 1.02 73,333 (2006) 73,333 x 1.02 = 74,800 334,800 12/31/07 $350,000 = $330,189 $260,000 (base) $260,000 x 1.00 = $260,000 1.06 70,189 (2006) 70,189 x 1.02 = 71,593 331,593 12/31/08 $400,000 = $373,832 $260,000 (base) $260,000 x 1.00 = $260,000 1.07 70,189 (2006) 70,189 x 1.02 = 71,593 43,643 (2008) 43,643 x 1.07 = 46,698 378,291 12/31/09 $430,000 = $390,909 $260,000 (base) $260,000 x 1.00 = $260,000 1.10 70,189 (2006) 70,189 x 1.02 = 71,593 43,643 (2008) 43,643 x 1.07 = 46,698 17,077 (2009) 17,077 x 1.10 = 18,785 397,076 54 Judgment Case 8-1 Advance warning of the company's impending bankruptcy existed at the date of the financial statements. As a rule, inventories should rise in tandem with sales. If inventories rise faster, it may be because the goods simply aren't selling. This is particularly true of companies in faddish or seasonal businesses — Merry-Go- Round's world. The company's report showed that inventories on January 30 were $82.2 million, up 37 percent from $60 million a year earlier. That's well above the 15 percent sales growth in the same period, to $877.5 million from $761.2 million. This alone should have been a major cause for concern. It indicated the company's goods simply weren't selling as rapidly as it expected, causing its inventories to bulge. The increase in receivables from $6,195 to over $6 million should also have been cause for concern. CASES 55 Judgment Case 8-2 1. a. The specific identification method requires each unit to be clearly distinguished from similar units either by description, identification number, location, or other characteristic. Costs are accumulated for specific units and expensed as the units are sold. Thus, the specific identification method results in recognized cost flows being identical to actual physical flows. Ideally, each unit is relatively expensive and the number of units relatively few so that recording costs is not burdensome. Under the specific identification method, if similar items have different costs, cost of goods sold is influenced by the specific units sold. b. It is appropriate for Happlia to use the specific identification method because each appliance is expensive, and easily identified by number and description. The specific identification method is feasible because Happlia already maintains records of its units held by individual retailers. Management’s ability to manipulate cost of goods sold is minimized because once the inventory is in the retailer’s hands, Happlia’s management cannot influence the units selected for sale. 2. a. Happlia should include in inventory carrying amounts all necessary and reasonable costs to get an appliance into a useful condition and place for sale. Common (or joint) costs should be allocated to individual units. Such costs exclude the excess costs incurred in transporting refrigerators to Minneapolis and their reshipment to Kansas City. These units costs should only include normal freight costs from Des Moines to Kansas City. In addition, costs incurred to provide time utility to the goods, i.e. ensuring that they are available when required, will also be included in inventory carrying amounts. b. Examples of inventoriable costs include the unit invoice price, plus an allocated proportion of the port handling fees, import duties, freight costs to Des Moines and to retailers, insurance costs, repackaging, and warehousing costs. 3. The 2006 income statement should report in cost of goods sold all inventory costs related to units sold in 2006, regardless of when cash is received from retailers. Excess freight costs incurred for shipping the refrigerators from Minneapolis to Kansas City should be included in determining operating income. 56 Communication Case 8-3 Suggested Grading Concepts and Grading Scheme: Content (70%) _______ 20 Describes the differential effect on ending inventory and cost of goods sold of using FIFO versus LIFO when _____ Prices are increasing. _____ Prices are decreasing. _______ 25 Discusses the various motivating factors that might influence the choice of inventory method. ______ The actual physical flow of product. ______ The better match of expenses with revenues provided by LIFO. ______ The effect on the balance sheet. ______ The effect on reported income and income taxes. ______ The cost of implementation of LIFO. _______ 10 Discusses briefly the methods available to simplify LIFO. _______ 15 Discusses the IRS conformity rule with respect to LIFO and the relaxation of the rule that allows a a company using LIFO to present supplemental non-LIFO disclosures. ______ _______ 70 points Writing (30%) _______ 6 Terminology and tone appropriate to the audience of a company president. _______ 12 Organization permits ease of understanding. _____ Introduction that states purpose. _____ Paragraphs that separate main points. _______ 12 English _____ Sentences grammatically clear and well organized, concise. _____ Word selection. _____ Spelling. _____ Grammar and punctuation. ______ _______ 30 points 57 Communication Case 8-4 LIFO produces a higher cost of goods sold, lower taxable income and therefore lower income taxes currently payable than FIFO only in periods when the costs of the company’s products are rising. When costs are decreasing, LIFO results in lower cost of goods sold, higher taxable income, and a higher current tax liability than FIFO. In the case of the electronics client, you would explain this to the intern concluding that the costs of the client's products must be decreasing, as frequently occurs in this industry. Judgment Case 8-5 At the end of a reporting period it is important to ensure that a proper inventory cutoff is made. A proper cutoff involves the determination of the ownership of goods that are in transit between the company and its customers as well as the company and its suppliers. If the shipment is made f.o.b. shipping point, then ownership is transferred to the buyer when the goods reach the common carrier. If the shipment is made f.o.b. destination, then ownership is transferred to the buyer when the goods arrive at the buyer’s location. In this case, John is incorrect if the goods were shipped f.o.b. destination. If so, even though the company is not in physical possession of the goods, they should be included in ending inventory because the shipment had not reached the buyer's location by the end of the reporting period. 58 Ethics Case 8-6 Requirement 1 Without purchase of the additional units: Sales (35,000 @ $60) $2,100,000 Cost of goods sold (35,000 x $30) (1,050,000) Gross profit $1,050,000 Due Jim Lester ($1,050,000 x 20%) = $210,000 With purchase of the additional units: Sales $2,100,000 Cost of goods sold: 20,000 x $40 $800,000 15,000 x $30 450,000 (1,250,000) Gross profit $ 850,000 Due Jim Lester ($850,000 x 20%) = $170,000 Requirement 2 Discussion should include these elements. Facts: If Moncrief purchases the additional units at year end under a periodic LIFO inventory system, the transaction results in a reduced payment to Jim Lester, reduced profits to shareholders, and reduced income tax payments to government entities. By purchasing the additional units of Zelenex, Moncrief reduces Jim Lester's payment by $40,000 ($210,000 - $170,000) and decreases gross profit by $200,000 ($1,050,000 - $850,000). The net effect on before-tax income is a decrease of $160,000 ($200,000 - $40,000). Since Moncrief does not intend to sell the units until 2007, the only logical reason for purchasing more costly inventory at year-end is profit manipulation. Ethical Dilemma: Should Moncrief exercise its right to purchase inventory at will, resulting in a reduction in net income, or recognize the rights of Jim Lester to receive profit for the sale of his product, shareholders' rights to have their investment appreciate through positive earnings, and government entities' rights to collect tax on economic net income? 59 Real World Case 8-7 Requirement 1 In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures. These disclosures allow a company using LIFO to report, in a note, the difference between inventory valued using LIFO and inventory valued as if another method had been used. Safeway's note provides this supplemental information. Requirement 2 2004 Ending Beginning Inventory Inventory ($ in millions) Inventory as stated $2,741 $2,642 Add: Increase in LIFO inventory 49* 64** FIFO inventory balances $2,790 $2,706 * $1,992 million – 1,943 million ** $1,967 million – 1,903 million Requirement 3 Cost of goods sold for 2004 would have been $15 million higher had Safeway used FIFO for its entire inventory. While beginning inventory would have been $64 million higher, ending inventory also would have been higher by $49 million. An increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. Purchases for 2004 are the same regardless of the inventory valuation method used. 60 Real World Case 8-8 Requirement 3 The following is based on Whole Food's 2004 financial statements. Answers will vary depending on the financial statement dates chosen. a. Whole Foods uses the last-in, first-out (LIFO) method for over 90% of its inventories and FIFO for the remainder. b. Assuming that current cost approximates FIFO cost, the inventory disclosure note indicates that, if FIFO had been used to value LIFO inventories, inventories would have been higher than reported by $11.2 million at the end of 2004 and $9.1 million at the end of 2003. Cost of goods sold for 2004 would have been $2.1 million lower had Whole Foods used FIFO. Beginning inventory would have been $9.1 million higher and ending inventory also would have been higher by $11.2 million. An increase in beginning inventory causes an increase in cost of goods sold, while an increase in ending inventory causes a decrease in cost of goods sold. Purchases for 2004 are the same regardless of the inventory valuation method used. c. Inventory turnover = cost of sales divided by average inventory (dollars in millions) Inventory turnover = $2,522 = 18.2 $138.5 * *($153 + 124) ÷ 2 International Case 8-9 As stated in Heineken's disclosure note, stocks (inventories) are valued at replacement cost. This policy is significantly different from GAAP in the U.S. where inventories are valued at the lower of cost or market. 61 Communication Case 8-10 The dollar-value LIFO inventory estimation technique begins with the determination of the current year’s ending inventory valued in terms of year-end costs. It is not necessary for a company using DVL to track the cost of purchases during the year. All that is needed is to take the physical quantities of goods on hand at the end of the year and apply year-end costs. The next step is to convert the ending inventory from year-end costs to base year costs. This usually is accomplished by dividing the ending inventory at year- end costs by the year’s cost index. The cost index reflects the change in cost from a base year to the current year. The ending inventory has been deflated for cost changes from the base year to the end of the current year. The next step in the procedure is to identify the layers in ending inventory with the years they were created by comparing ending inventory at base year cost to the beginning inventory at base year cost. Applying the LIFO concept, if inventory has increased, ending inventory at base year cost consists of the beginning inventory layer plus a current year layer. The final step converts the layers identified to cost by multiplying the layers at base year cost by the layer’s cost index. The costs are totaled to obtain ending inventory at DVL cost. 62 Research Case 8-11 Requirement 1 SFAS No. 49, “Accounting for Product Financing Arrangements,” provides authoritative guidance on this issue. Product financing arrangements include agreements in which a sponsor (Balboa Lumber in this case): a. Sells the product to another entity and in a related transaction agrees to repurchase the product; b. Arranges for another entity to purchase the product on the sponsor’s behalf and, in a related transaction, agrees to purchase the product from the other entity; or c. Controls the disposition of the product that has been purchased by another entity in accordance with the arrangements described in either (a) or (b) above. The appropriate accounting treatment for this type of arrangement is for the sponsor to record a liability at the time the proceeds are received from the other entity. The sponsor does not record the transaction as a sale and does not remove the product from its inventory. The cost of the repurchase amount in excess of the originally recorded liability represents financing and holding costs. These costs are accounted for in accordance with the sponsor’s accounting policies applicable to other financing and holding costs. Notice that this is an example of “substance (a loan) over form (a sale).” Requirement 2 Journal entry to record the “sale” (cash receipt): Cash ................................................................................ 160,000 Liability – product financing arrangement ................. 160,000 Journal entry to record the repurchase: Liability – product financing arrangement .................... 160,000 Holding and financing costs* ........................................ 4,000 Cash ............................................................................ 164,000 63 64 Research Case 8-11 (concluded) *The treatment of these costs depends on the accounting policies of the sponsor. For example, if these costs are normally expensed as period costs, then the debit in this case would be to an expense account (or accounts). Analysis Case 8-12 Requirement 1 ($ in millions) GM FORD Gross profit ratio = 33,566 = 17% 11,278 = 8% 193,517 147,134 Inventory turnover = 159,951 = 14.1 135,856 = 13.6 11,338.5 9,958 Average days = 365 = 26 days 365 = 27 days in inventory 14.1 13.6 General Motors has a much higher gross profit ratio (17% versus 8%). GM’s ratio is slightly less than the industry average. The inventory turnover ratios for the two companies are similar. On average, it takes 27 days for Ford to sell its inventory compared to 26 days for GM. Both companies turn over their inventory quicker than the industry average of 32 days. Requirement 2 The objective of this requirement is to motivate students to obtain hands-on familiarity with actual annual reports and to apply the techniques learned in the chapter. You may wish to provide students with multiple copies of the same annual reports and compare responses. Another approach is to divide the class into teams who evaluate reports from a group perspective. 65 Trueblood Accounting Case 8-13 A solution and extensive discussion materials can be obtained from the Deloitte Foundation. Analysis Case 8-14 Requirement 1 FedEx Corporation earns revenue by providing services to its customers, rather than by selling goods. That is why there are no merchandise inventories listed in the company's balance sheet. The balance sheet reports an inventory of "spare parts, supplies and fuel." Requirement 2 Note 1 indicates that spare parts are stated principally at weighted-average cost; supplies and fuel are stated principally at standard cost which approximates actual cost on a first-in, first-out (FIFO) basis. Many manufacturing companies use a standard costing system for inventory valuation. A standard cost is an ideal or expected cost. A standard costing system helps control costs by allowing for a comparison between standards and actual costs. Standard costs are allowed for inventory valuation only if they approximate actual costs. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482
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