10
Cost Chapter of Goods Sold and Inventory
SOLUTIONS 1. a. b. c. d. e. f. inventory no; classified as property, plant, and equipment no; classified as office supplies inventory no; classified as property, plant, and equipment inventory
2.
Raw materials are goods acquired in a relatively undeveloped state that will eventually compose a major part of the finished product. Work in process consists of partly finished products. Finished goods are the completed products waiting for sale. When goods are shipped FOB destination, the seller owns the goods while in transit. The accounting difficulty associated with consigned goods is that inventory that is in the hands of a dealer may actually belong to the supplier; consigned goods should be reported as inventory in the balance sheet of the supplier/owner, not in the balance sheet of the dealer where the goods are located. Auditing consigned inventory presents the auditor with a special set of problems. Inventory that is on the premises may not belong to the company because the company is holding it on consignment. The cost of goods acquired for resale by a merchandising firm includes the purchase price, freight, and receiving costs. The cost of work-in-process inventory is the sum of the cost of the raw materials, the cost of the production labor, and some share of the cost of the manufacturing overhead required to keep the factory running. The purpose of activity-based costing (ABC) is to have better information for internal decisionmaking. ABC systems strive to allocate overhead based on clearly identified cost drivers-- characteristics of the production process (e.g., number of required machine reconfigurations or average frequency of production glitches requiring management intervention) that are known to create overhead costs. Inventory purchased or produced during a period will be found on the Balance Sheet as part of Inventory (inventory not yet sold) or on the Income Statement as part of Cost of Goods Sold (inventory sold during the period). A perpetual inventory system tracks changes in inventory levels on a continuous basis, recording each individual purchase and sale to maintain a running total of the inventory balance. A periodic inventory system relies on periodic inventory counts (i.e., once a quarter or once a year) to reveal which inventory items have been sold. Yes, the physical count can be compared to the recorded inventory balance to see whether any inventory has been lost or stolen.
3. 4.
5. 6.
7.
8.
9.
10.
Chapter 10 1
11.
Overstating the amount of ending inventory increases Net Income. This effect can be seen by analyzing the computation: Beginning Inventory + Purchases = Goods Available for Sale Ending Inventory = Cost of Goods Sold By overstating Ending Inventory, Cost of Goods Sold is understated, which in turn overstates Net Income and makes the manager look good.
12.
To assign a value to both ending inventory and cost of goods sold, cost flow assumptions must be made regarding which items were sold. When items are purchased, they often become indistinguishable from other items in the inventory; therefore, costs associated with specific items cannot easily be determined. Thus, the company makes assumptions concerning which goods have been sold and which remain in inventory. The three primary inventory valuation assumptions are: (1) FIFO (first-in, first-out)The costs of the first items purchased are the costs of the first items sold, and the ending inventory consists of the last items purchased. The cost of goods sold will be the costs associated with the earlier purchases. (2) LIFO (last-in, first-out)The costs of the last items purchased are the costs of the first items that were sold, and the ending inventory consists of the earliest purchases. The cost of goods sold will be the costs associated with the last purchases. (3) Average costA weighted cost, based on the total number of items purchased and the total purchase price for all items, is assigned both to inventory items and to items that were sold. All goods have the same average unit price. In a period of rising prices, the FIFO (first-in, first-out) cost method will result in the higher Net Income because cost of goods sold is lower. FIFO will also report a higher current ratio. In a period of declining prices, the LIFO (last-in, first-out) cost method will result in the highest gross profit and ending inventory and the lowest cost of goods sold. If management chooses to adopt the LIFO method for tax purposes, then the Internal Revenue Code requires LIFO to be used for financial reporting purposes as well. Therefore, in a period of rising prices, there is a trade-off between increasing cash flows due to lower tax payments under LIFO and a higher net income and higher inventory figure on the balance sheet under FIFO. Computation of average cost and LIFO under a perpetual system is complicated because the average cost of units available for sale changes every time a purchase is made, and the identification of the "last in" units also changes with every purchase. A LIFO layer represents the number of units purchased in a certain year that exceeds the number of units sold. LIFO layers are included as part of ending inventory. The difference between the LIFO ending inventory amount and the amount obtained using another inventory valuation method (such as FIFO or average cost) is called the LIFO reserve. Under the LIFO method of inventory valuation, the effect of such a large purchase would be to increase the reported cost of goods sold and reduce the taxable income. If the firm were using FIFO, there would be no impact on the reported cost of goods sold and the taxable income of a purchase at year-end.
13.
14. 15. 16.
17.
18.
19.
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20.
Inventory estimation techniques are used to generate inventory values when a physical inventory count is not practical and to provide an independent check of the validity of the inventory figures generated by the accounting system. The gross profit method is based on the observation that the relationship between sales and cost of goods sold is usually fairly stable. To be useful, the gross profit percentage used must be a reliable measure of current experience. In developing a reliable rate, reference is made to past rates, and these are adjusted for changes in current circumstances. The accounting concept behind the lower-of-cost-or-market rule is the concept of conservatism. An inventory turnover of 10 means that the company "turned over" or replenished its inventory 10 times during the year. The number of days' sales in inventory is 36.5 days (365/10). Knowledge of the amounts and timing of cash outlays is critical for effective cash control and planning. A cash disbursement's budget allows management to view the amounts and timing of the cash outlays.
21.
22. 23. 24.
EXERCISES E 10-1 Determining Ownership of Inventory in Transit Shipped To Malone From Malone From Malone To Malone Terms FOB Destination FOB Shipping Point FOB Destination FOB Shipping Point Included in Inventory Count? No No No No Should be in Ending Inventory? No No Yes Yes
The correct amount of inventory on December 31, 2006 is $232,895 ($216,540 + $4,575 + $11,780). E10-2 Goods on Consignment and in Transit 1. The correct amount of Inventory is $721,970 ($714,555 $17,525 + $6,540 + $18,400). Each item impacts the correct amount of inventory as follows: a. Inventory on consignment, though on the premises, should not be included in ending inventory. b. Goods shipped to Fuller FOB Shipping Point belong to Fuller as soon as they are shipped. So, even though the goods had not arrived by December, they should still be included in ending inventory. c. Goods shipped by Fuller FOB Shipping Point before year end do not belong in ending inventory. These goods were properly excluded from inventory. d. The consigned inventory belongs to Fuller even though it is not on the premises. These goods should be included in ending inventory.
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2.
If Fuller doesn't adjust inventory, the inventory will be understated by $7,415, which will overstate Cost of Goods Sold by $7,415.
E 10-3 Identification of Inventory Costs and Categories 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. I, MOH E I, RM I, MOH E I, PL I, MOH I, MOH E I, MOH
E 10-4 Computing Cost of Goods Sold 1. Costs of Goods Sold and Gross Profit Inventory, 1/1/06 Purchases Cost of goods available for sale Ending inventory, 12/31/06 Cost of goods sold Sales Cost of goods sold Gross profit 2. $ 800,000 1,440,000 $2,240,000 620,000 $1,620,000 $2,000,000 1,620,000 $ 380,000
If ending inventory is overstated by $75,000, then cost of goods sold is understated by $75,000. If cost of goods sold is understated by $75,000, then gross profit is overstated by $75,000.
E 10-5 Determining Purchases for a Period 1. By using the following equation and working backwards to solve for purchases, we discover that purchases for the period amounted to $938,450: Beginning Inventory + Purchases Goods Available for Sale Ending Inventory = Cost of Goods Sold 2. $ 117,500 ???? $1,055,950 131,250 $ 924,700
Purchases for the period amounted to $928,450: Beginning Inventory + Purchases Goods Available for Sale Ending Inventory = Cost of Goods Sold $ 117,500 ???? $1,045,950 121,250 $ 924,700
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E 10-6 Perpetual and Periodic Inventory Systems 1. Beginning Inventory (150 units @ $15) Purchases (750 units @ $15) Cost of goods available for sale Less: Ending inventory (225 units @ $15) Cost of goods sold Cost of goods sold (according to inventory count) Cost of goods sold (according to perpetual system) Inventory shrinkage $ 2,250 11,250 $13,500 3,375 $10,125 $10,125 9,375 $ 750
2.
3.
If the company were using a periodic system, then there wouldn't be any way to determine the actual shrinkage. The $750 in shrinkage would be imbedded in total reported cost of goods sold of $10,125.
E 10-7 Using FIFO, LIFO, and Average Cost Quantity Cost per Unit 60 units $130 110 $125 90 $122 80 $120 340 Total cost of goods available for sale 1. Cost Data FIFO a. Cost of goods available for sale b. Cost of ending inventory: 80 units $120 5 units $122 c. Cost of goods sold Cost of goods available for sale Less: Ending inventory Cost of goods sold LIFO a. Cost of goods available for sale b. Cost of ending inventory: 60 units $130 25 units $125 = Total Cost $ 7,800 13,750 10,980 9,600 $42,130
$42,130 $9,600 610 $10,210 $42,130 (10,210) $31,920 $42,130 $7,800 3,125 $10,925 $42,130 (10,925) $31,205
c. Cost of goods sold Cost of goods available for sale Less: Ending inventory Cost of goods sold
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Average Cost a. Cost of goods available for sale b. Weighted average cost ($42,130/340) Cost of ending inventory (85 units $123.91) c. Cost of goods sold Cost of goods available for sale Less: Ending inventory Cost of goods sold 2.
$42,130 $123.91/unit $10,532 $42,130 (10,532) $31,598
The cost of goods sold under the FIFO method is the highest of the three because the prices are declining; therefore, the higher costs are allocated to the goods sold. Under the LIFO method, the cost is lower because the lower-priced items were purchased last and these are the ones that were assumed to have been sold. The average cost value is a middle value, because it is an average of all costs, and the quantity purchased was about equally divided between the first two and last two purchases.
E 10-8 Ending Inventory Using FIFO, LIFO, and Average Cost 2,400 units available for sale 2,000 units sold = 400 units in ending inventory 1. 2. FIFO: Most recent purchase....................................................... LIFO: Oldest costs ..................................................................... Next oldest costs ............................................................. Average: Beginning inventory ........................................................ Purchases ......................................................................... Total ................................................................................ $43,350/1,200 = $36.125 per unit Ending inventory valuation: 200 units $36.125 (average unit cost) = $7,225 E 10-9 Inventory Computation Using Different Cost Flows Units Available for Sale 100 260 160 520
200 units @ $36.50 150 units @ $35.00 50 units @ $36.00 200 units 150 units @ $35.00 450 units @ $36.00 600 units @ $36.50 1,200 units
= = = = = =
$ 7,300 $ 5,250 1,800 $ 7,050 $ 5,250 16,200 21,900 $43,350
3.
Unit Cost $13.20 $15.00 $16.00
=
Total Cost $1,320 3,900 2,560 $7,780
Units Sold
335
Ending inventory: 520 335 = 185 units Ending Inventory a. FIFO: 160 $16.00 = 25 $15.00 = 185 $2,560 375 $2,935
Cost of Goods Sold
$7,780 $2,935 = $4,845
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b. LIFO:
100 $13.20= 85 $15.00= 185
$1,320 1,275 $2,595
$7,780 $2,595 = $5,185
c. Average Cost: $7,780/520 = $14.96/unit 185 $14.96 = $2,768 E 10-10 Inventory Cost Flow Assumptions Beginning inventory June 4 purchase June 10 purchase June 18 purchase June 30 purchase June Available for sale Ending inventory Units sold Ending Inventory 1. FIFO: 600 $8.40 = 250 $8.25 = 850 350 $8.00 = 500 $8.15 = 850 $5,040 2,063 $7,103 $2,800 4,075 $6,875
$7,780 $2,768 = $5,012 Unit Cost $8.00 $8.15 $8.15 $8.25 $8.40 Total Cost $ 2,800 6,520 5,705 4,455 5,040 $24,520
Quantity 350 units 800 700 540 600 2,990 units 850 units 2,140
Cost of Goods Sold
$24,520 $7,103 = $17,417
2. LIFO:
$24,520 $6,875 = $17,645
3. Average Cost: $24,520/2,990 = $8.20/unit 850 $8.20 = $6,970 E 10-11 Inventory Valuation Using Specific Identification 1. Cost of Ending Inventory 3 2 5 6 16 2. Sales (56 $200) Cost of goods sold Gross profit
*Cost of goods sold: (10 3 = 7) $120.00 = (15 2 = 13) $130.00 = (12 5 = 7) $124.50 = (20 0 = 20) $122.00 = (15 6 = 9) $128.00 = 56 $840.00 1,690.00 871.50 2,440.00 1,152.00 $6,993.50
$24,520 $6,970 = $17,550
units
$120.00 $130.00 $124.50 $128.00
= $360.00 = 260.00 = 622.50 = 768.00 $2,010.50 Gross Profit $11,200.00 6,993.50* $ 4,206.50
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3.
If the entire inventory were from the items purchased at $122, the gross profit would be: Sales $11,200 Cost of goods sold: (10) $120.00 = $1,200 (15) $130.00 = 1,950 (12) $124.50 = 1,494 (20 16 = 4) $122.00 = 488 7,052 (15) $128.00 = 1,920 Gross profit $ 4,148 This result suggests that management can control profits by deciding which items it sells rather than allowing profits to be a function of the quantity of sales.
4.
E 10-12 FIFO, LIFO, and Specific Identification 1. a. $11,000 ($75,000 $64,000) b. $6,500 ($75,000 $68,500) c. $15,000 ($75,000 $60,000) Theoretically, specific identification should be used in every case. However, there are many instances where the costs of using the specific identification method far exceed the benefits. In cases where the inventory item can be easily identified and the resulting information is beneficial, the use of specific identification is warranted. Expensive items such as automobiles and houses are typically accounted for using specific identification. In this case, by carefully choosing the semitrailer to sell, Spearman has managed to maximize reported income if specific identification is used. Thus, there is some potential for income manipulation.
2.
E 10-13 Inventory Valuation and the Effect on Income 1. Inventory Costing Method Showing Highest Net Income 2004: Under FIFO, net income is highest because the ending inventory and gross profit move in the same direction. 2005: Under LIFO, net income is highest because the lowest net decrease in inventory results in the lowest cost of sales. 2006: Under LIFO, net income is highest because the highest net increase in inventory results in the lowest cost of goods sold. Inventory Costing Method Showing Lowest Net Income 2004: LIFO, 2005: FIFO, 2006: FIFO (These methods result in the highest cost of goods sold. See (1) above for explanations.)
2.
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E 10-14 Creation of LIFO Layers Cost of goods available for sale from purchases: 2005 2006 150 $4.00 = $ 600 200 $4.70 = $ 940.00 100 $4.20 = 420 1,200 $4.80 = 5,760.00 250 $4.40 = 1,100 800 $4.76 = 3,808.00 566.40 200 $4.40 = 880 120 $4.72 = 160 $4.50 = 720 140 $4.60 = 644 2,320 $11,074.40 $4,364 1,000 2005 ending inventory: 1,000 720 = 280 units 2006 ending inventory: 280 + 2,320 2,400 = 200 units 1. FIFO 2005 Ending Inventory 140 $ 4.60 = $644 140 $ 4,148 = 630 $1,274 280 2006 Ending Inventory 120 $ 4.72 = $566.40 80 $ 4.76 = 380.80 $ 947.20 200 2005 Ending Inventory 150 $ 4.00 = $600 100 $ 4.20 = 420 30 $ 4.40 = 132 $1,152 280 2006 Ending Inventory 150 $ 4.00 = $600 50 $ 4.20 = 210 $810 200 2005 Cost of Goods Sold
$4,364 $1,274 = $3,090 2006 Cost of Goods Sold
FIFO
$1,274 + $11,074.40 $947.2 = $11,401.20 2005 Cost of Goods Sold
2. LIFO
$4,364 $1,152 = $3,212 2006 Cost of Goods Sold
LIFO
$1,152 + $11,074.40 $810 = $11,416.40
3.
LIFO reserve as of December 31, 2006: $947.20 (FIFO cost) $810 (LIFO cost) = $137.20
E 10-15 The Impact of LIFO Liquidation 1. Gross Profit With Purchase Sales (50,800 $50) Cost of goods sold (2,000 $40 = $80,000, and 48,800 $35 = $1,708,000) Gross profit $2,540,000
$
1,788,000 752,000
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2.
Gross Profit Without Purchase Sales (50,800 $50) Cost of goods sold (50,000 $35 = $1,750,000, and 800 $5 = $4,000) Gross profit $2,540,000
1,754,000 $ 786,000
3.
If the purchase is made, Monday Corporation will pay $13,600 less in taxes [($786,000 $752,000) 0.40]. Since the units need to be replaced sooner or later, it is advisable to replace them now and benefit from the decreased tax liability.
E 10-16 Estimating Inventory Using the Gross Profit Method Estimated Inventory as of August 17, 2006: Inventory, January 1 Purchases Merchandise available for sale Estimated cost of goods sold, $2,430,000 0.68* Estimated inventory, August 17, 2006 * Average gross profit percentage of sales: 32% Cost of goods sold as percentage of sales: 100% 32% = 68% E 10-17 Estimating Inventory Using the Gross Profit Method 1. Estimated Inventory as of September 16: Inventory, January 1 Purchases Merchandise available for sale Estimated cost of goods sold, $4,500,000 0.65* Estimated ending inventory * Gross profit percentage of sales last year: 35% Cost of goods sold as percentage of sales: 100% 35% = 65% 2. Estimated Inventory as of September 16: Inventory, January 1 Purchases Merchandise available for sale Estimated cost of goods sold, $4,500,000 0.60* Estimated ending inventory * Gross profit percentage of sales two years ago: 40% Cost of goods sold as percentage of sales: 100% 40% = 60% 3. The perpetual inventory records do not appear to be reasonable. When compared with the estimated ending inventory using the gross profit percentage, the perpetual records appear to be understated by $425,000 to $650,000. Alternatively, the gross profit percentage may have decreased significantly from the level in the past two years. $900,000 5,250,000 $6,150,000 2,700,000 $3,450,000 $900,000 5,250,000 $6,150,000 2,925,000 $3,225,000 $375,000 1,385,000 $1,760,000 1,652,400 $ 107,600
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E 10-18 Valuing Inventory at the Lower of Cost or Market Item A B C Original Cost $ 500 $ 800 $1,100 Net Realizable Value $ 650 $ 740 $1,150 Replacement Cost $ 440 $ 780 $1,200 Value of Ending Inventory $ 440 $ 740 $1,100
E 10-19 Analysis of Inventory 1. Inventory turnover: 2005: $1,200,000/([$150,000 + $200,000]/2) = 6.86 2006: $1,400,000/([$200,000 + $300,000]/2) = 5.60 Number of days' sales in inventory: 2005: 53 days [$175,000/($1,200,000/365 days)] 2006: 65 days [$250,000/($1,400,000/365 days)] 2. From this information, one can only conclude that inventory is taking longer to sell in 2006 than in 2005. One might mistakenly conclude that an increase in the number of days' sales in inventories is bad. However, the appropriate number of days depends not only on historical trends but on industry averages, economic conditions, and other conditions beyond the control of management. If this company were in the business of selling fresh fruits and vegetables, customers may begin to wonder just how fresh the produce is. For firms in this industry, an increase in the days in inventory measure would be bad news. On the other hand, in the housing market an increase in the number of days required to sell a house must be measured against the possible increase in selling price from waiting. If the 53-day figure was achieved by lowering prices, then 65 days may be a desirable wait for selling a house. E 10-20 Analysis of the Operating Cycle 1. Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold $ 57,000 176,250 $233,250 (43,500) $189,750
Inventory turnover = (Cost of goods sold)/(Average inventory) = $189,750/[($57,000 + $43,500)/2] = 3.78 times Number of days' sales in inventory: 365/3.78 = 97 days 2. Accounts receivable turnover = Sales/Average Receivables = ($300,000/[($33,750 + $39,000)/2] = 8.25 times Average collection period: 365/8.25 = 44 days 3. Purchases turnover = Purchases/Average Accounts Payable = $176,250/[($18,000 + $21,000)/2] = 9.04 times Number of days' purchases in accounts payable: 365/9.04 = 40 days
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4. Number of Days' Sales in Inventory Average Collection Period 97 days 44 days |--------------------------------------------------------------------|------------------------------------------| |------------------------------------------------------141 days----------------------------------------------| |---------------------------------------------|--Time between 101 days-----------------------------------| 40 days Number of Days' Purchases in Accounts Payable 101 days elapse on average between the time Jenks must pay suppliers and the time they collect cash from customers. E 10-21 Budgeting Cash Disbursements Inventory Purchase Month November December January February March Sales $300,000 $500,000 $100,000 $ 50,000 $200,000 Cost of Goods Sold (60% of Sales) $180,000 $300,000 $ 60,000 $ 30,000 $120,000 Purchases (Constant Inventory) $180,000 $300,000 $ 60,000 $ 30,000 $120,000
Hane Company Cash Disbursements Budget for Inventory Purchases For January, February, and March 2007 January November Purchases (0.2 $180,000) December Purchases (0.5 $300,000) (0.2 $300,000) January Purchases (0.3 $60,000) (0.5 $60,000) (0.2 $60,000) February Purchases (0.3 $30,000) (0.5 $30,000) March Purchases (0.3 $120,000) Total Disbursements $36,000 150,000 $60,000 18,000 30,000 $12,000 9,000 15,000 36,000 $204,000 $99,000 $63,000 February March
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PROBLEMS P 10-22 Are Inventory Summaries Enough? 1. Detailed information as to the make-up of inventory permits investors and creditors to detect trends. In this case, there appears to be a build-up of raw materials inventory while the amount of finished goods inventory is declining. This, coupled with the fact that work in process has remained relatively unchanged, may indicate a decrease in demand for the product. If only summary totals were provided, this analysis could not be made. ANALYSIS: In almost every case, investors and creditors will argue for more detailed information. They can ignore the information if they so desire. They cannot, however, always obtain information that is not presented. It should be noted that there is a danger associated with receiving too much information. If investors and creditors do not have the sophistication to interpret accounting information, they may be overloaded and attach importance to irrelevant information. Thus, the providers of information must make some decisions as to what information is relevant for decisionmaking. In this example, the detailed disclosure reveals the differing trends in raw materials and finished goods inventory, trends that could not be detected using summary data.
2.
P 10-23 Goods in Transit 1. a. The goods were shipped FOB shipping point, so the buyer owned the goods while in transit. The amount of inventory should not have been included in ending inventory because the goods were owned by the buyer. Ending inventory was overstated, so cost of goods sold was understated by $9,000. Also, the sale should have been recorded when the goods were shipped, so sales were understated by $12,100. b. The goods were shipped FOB destination, so Coby Company didn't own the goods until they were received. The amount of inventory should not have been included in ending inventory because the goods were not received until January 2, 2007. Ending inventory was overstated, so cost of goods sold was understated by $1,500. The purchase was recorded correctly in 2007. Correct Net Income = $80,000 + $12,100 $9,000 $1,500 = $81,600 2. ANALYSIS: For a seller, the terms FOB destination cause more accounting problems because the sale (and inventory reduction) should not be recorded until the goods are received by the customer. This date is more difficult to determine than is the actual shipment date. For a buyer, the terms FOB shipping point cause more accounting problems because inventory must be recorded as being purchased before it has ever arrived.
P 10-24 Inventory Errors 1. Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold Sales Cost of goods sold Gross profit $ 480,000 1,344,000 $1,824,000 (612,000) $1,212,000 $1,920,000 (1,212,000) $708,000
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2. 3.
The discovered error means that ending inventory was overstated, so cost of goods sold was understated by $180,000. Gross profit will decrease by $180,000 to $528,000. ANALYSIS: The existence of an earnings-based bonus plan is intended to encourage managers to work harder and smarter to improve the performance of the company. However, such a plan also increases the incentive of managers to manipulate reported earnings. In fact, one of the factors looked at by auditors in evaluating the risk of financial statement fraud in a company is whether the company has an earnings-based management bonus plan.
P 10-25 Inventory Costing Using Different Assumptions 1. 2005 Goods available for sale Ending inventory* Cost of goods sold a. FIFO $2,740.00 1,057.50 $1,682.50 b. LIFO $2,740 950 $1,790 c. Average Cost $2,740.00 1,002.25 $1,737.75
*Ending inventory: FIFO: (400 $2.25) + (75 $2.10) = $1,057.50 LIFO: (475 $2.00) = $950 Average cost: $2,740/1,300 = $2.11 $2.11 475 = $1,002.25 2006 Beginning inventory 2006 purchases Goods available for sale Ending inventory* Cost of goods sold a. FIFO $1,057.50 $ 4,470.00 $5,527.50 950.00 $4,577.50 b. LIFO 950 4,470 $5,420 600 $4,820 c. Average Cost $1,002.25 4,470.00 $5,472.25 852.00 $4,620.25
*Ending inventory: FIFO: (200 $3.20) + (100 $3.10) = $950 LIFO: (300 $2.00) = $600 Average cost: $5,472.25/1,925 = $2.84 $2.84 300 = $852 2. ANALYSIS: It sounds very much as if Corey Snyder is using the LIFO inventory method. When LIFO is used, reduction in inventory levels results in the liquidation of old LIFO layers. If those layers were created when the cost of inventory was lower, then the LIFO liquidation will result in artificially inflated profits and higher tax payments. In this case, the controller was concerned that the JIT system would reduce inventory levels to the extent that LIFO liquidation would increase the income tax payments. You can verify this by calculating what Snyder's cost of goods sold in 2006 would have been if enough inventory had been purchased at the end of 2006 to avoid the LIFO liquidation.
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P 10-26 Computing Ending Inventory and Cost of Goods Sold 1. 2005 Goods available for sale Ending inventory* Cost of goods sold a. FIFO $12,055.00 4,142.50 $ 7,912.50 b. LIFO $12,055.00 3,250.00 $ 8,805.00 c. Average Cost $12,055.00 3,874.50 $ 8,180.50
*Ending inventory: FIFO: (400 $9.20) + (50 $9.25) = $4,142.50 LIFO: (200 $5.00) + (250 $9.00) = $3,250.00 Average cost: $12,055/1,400 = $8.61 $8.61 450 = $3,874.50 2006 Beginning inventory 2006 purchases Goods available for sale Ending inventory* Cost of goods sold a. FIFO $ 4,142.50 12,860.00 $17,002.50 4,110.00 $12,892.50 b. LIFO $ 3,250.00 12,860.00 $16,110.00 2,800.00 $13,310.00 c. Average Cost $3,874.50 12,860.00 $16,734.50 3,824.00 $12,910.50
*Ending inventory: FIFO: (300 $10.20) + (100 $10.50) = $4,110.00 LIFO: (200 $5.00) + ($200 $9.00) = $2,800.00 Average cost: $16,734.50/1,750 = $9.56 $9.56 400 = $3,824 2. ANALYSIS: Ekbog can lock in the purchase price of its inventory in at least two ways. First, Ekbog can just purchase a large amount of inventory now, at the existing price, and stockpile that inventory for later use. The risks associated with this action are that the inventory will be damaged in the interim, the costs of storing the inventory may be high, and the actual price of inventory may decline. Ekbog can also enter into a purchase commitment now, where Ekbog agrees to purchase inventory in the future at a price that is set now. The advantage of this approach is that Ekbog does not actually have to take delivery of the inventory now, saving on storage costs. The risks associated with this approach are that the price may decline in the future and that the premium Ekbog pays to lock in the price now may be expensive.
P10-27 Computing LIFO and FIFO Cost of goods sold Cost of goods sold = Average inventory Inventory turnover = [($250,000 + $300,0000)/2] 4 = $1,100,000 FIFO cost of goods sold
$1,100,000 125% = $1,375,500 LIFO cost of goods sold
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1. Sales Cost of goods sold Gross profit on sales Operating expenses Income before taxes Taxes (30%) Net income 2.
Net Income FIFO $2,000,000 1,100,000 $ 900,000 95,000 $ 805,000 241,500 $ 563,500 LIFO $2,000,000 1,375,000 $ 625,000 95,000 $ 530,000 159,000 $ 371,000
The difference between the statements for the two methods results from the way costs are allocated between ending inventory and cost of goods sold. Under FIFO, the higher costs are in the inventory. The cost of sales is therefore lower, causing a higher gross profit and net income. Taxes also are higher. LIFO assigns a higher cost to goods sold, in this case, resulting in a lower income. FIFO Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold Purchases = $1,150,000 LIFO Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold 250,000 ?????? $ 1,400,000 (300,000) $ 1,100,000 $
3.
$250,000 1,150,000 $1,400,000 (??????) $1,375,000
Ending Inventory = $25,000 This low amount of ending inventory suggests that the chief financial officer's estimate that LIFO cost of goods sold is 125% of FIFO cost of goods sold is mistaken. 4. ANALYSIS: The fact that the chief financial officer thinks that LIFO cost of goods sold is higher than FIFO cost of goods sold suggests that inventory purchase prices have increased during the year. LIFO yields higher cost of goods sold in times of increasing prices.
P 10-28 Inventory Costing and Tax Effects 1. Cost of goods sold--FIFO LIFO: Difference between LIFO and FIFO ($50,000 $30,000) Average cost: Difference between average cost and FIFO Cost of goods sold Cost of Goods Sold LIFO $555,000 20,000 $575,000 8,000 $563,000 Average Cost $555,000
Chapter 10 16
2. FIFO $950,000 (555,000) $395,000 (235,500) (26,000) $133,500 (40,050) $ 93,450 LIFO $950,000 (575,000) $375,000 (235,500) (26,000) $113,500 (34,050) $ 79,450 Average Cost $950,000 (563,000) $387,000 (235,500) (26,000) $125,500 (37,650) $ 87,850
Sales Cost of goods sold Gross profit Operating expenses Interest expenses Net income before taxes Tax expense (30%) Net income 3.
As can be seen, the LIFO method results in the lowest tax expense. If management believes that the prices may continue to increase, and if the main intention is to improve the cash flow (instead of EPS), then LIFO is preferable. Management can change methods from one generally accepted accounting method to another. However, such changes need to be disclosed, including their effect on the financial statements. For tax purposes, management must gain the consent of the IRS Commissioner to make a change from FIFO to another method. ANALYSIS: As discussed in the chapter, this "LIFO conformity rule" was instituted at the time that the IRS first approved LIFO for use in filing tax returns. It is thought that this condition was imposed in order to coerce auditors into being watchdogs for the IRS. The reasoning is as follows: In order to use LIFO for tax purposes, a company must also use it for financial reporting. The independent auditor must approve the financial statements, and would not approve the use of LIFO if it didn't fairly reflect the performance of the company. Presumably, if a company wants to adopt LIFO strictly for the purpose of reducing income tax payments, the auditor would not approve. Hence, the auditor becomes the watchdog for the IRS. In practice, the auditors have not been an effective constraint on the attempt of any company to adopt LIFO strictly to reduce income taxes.
4.
P 10-29 Changing from FIFO to LIFO 1. a. Current ratio b. Gross profit percentage $35,000/$90,000 c. Inventory turnover FIFO $15,000/$9,000 = 1.67 $36,000/$90,000 = 40.0% $54,000/$8,000 = 6.75 times LIFO $14,000/$9,000 = 1.56 = 38.9% $55,000/$7,500 = 7.33 times
Note: Cost of goods sold would increase from $54,000,000 to $55,000,000 if LIFO were used. This results from the fact that ending inventory would be reduced by $1,000,000, indicating that the cost of goods sold was higher by that amount. In this problem, beginning inventory is the same for both LIFO and FIFO--as evidenced by the fact that a $1,000,000 change in ending inventory changes average inventory by $500,000. 2. ANALYSIS: The decrease in the current ratio is a sign of decreased liquidity, and the decrease in the gross profit percentage is an indication of decreased profitability, whereas the increase in the inventory turnover is indicative of an increased efficiency in the management of inventory. If these changes are achieved solely by changing the method of inventory, then they should not have any effect on the decision on the loan. In fact, a very perceptive banker would realize that LIFO would actually improve Alto Teck's operating cash flow by lowering income tax payments. Thus, the
Chapter 10 17
clever banker would ignore the financial statement impact of LIFO and concentrate on the cash flow impact. P 10-30 Inventory and Rising Prices 1. An increase in the selling price of gasoline accompanied by use of the FIFO method of inventory costing would result in increased income being reported by gasoline distributors. This "inflation" profit would be a one-time increase unless selling prices continued to rise. If the prices stabilized, as the distributors purchased additional gasoline at higher prices, the margin between their cost and the selling price would return to normal. Because the Gulf War ended so rapidly, the increase in gasoline prices was short-lived, and the prices declined toward pre-Gulf War prices. The exact effect on a distributor's income depended on the amount of inventory that was held at the time of the price increase. The replacement of sold inventory at higher prices would require a higher cash outflow than would be reported on the income statement as cost of goods sold. Thus, the increase in cash inflow coming from the increased selling price would be offset by the higher cash outflow required for the replacement inventory. ANALYSIS: This is a difficult question to answer definitively. Certainly, increased costs to a distributor must be passed on to the ultimate user if the distributor is to continue to be profitable. In the short run, these pricing differences can lead to inflated profits under some costing systems. If the distributors had used the LIFO method, these inventory profits would not have been reported. Situations such as the Gulf War highlight the improved matching of current revenues with current costs that follows from using the LIFO inventory method.
2.
3.
P 10-31 Inventory Cost Flows and Cash Flows 1. This problem examines the implications of changing prices on financial accounting measures. It illustrates that in periods of rising prices, a portion of the profits from the sale of inventory must be used to replenish inventory levels. While financial accounting and tax accounting compare the cost of a particular item with its subsequent sales price, they do not account for the fact that to maintain inventory levels, some accounting profits must be reinvested into new inventory. Sales (3 @ $2,600) ............................................................................ FIFO cost of goods sold (3 @ $1,200) .............................................. FIFO gross profit ............................................................................... Income tax (40%) .............................................................................. Net income ........................................................................................ 2. Sales (3 @ $2,600) ............................................................................ Replacement cost (3 @ $2,300) ........................................................ Replacement cost gross profit ........................................................... Less taxes paid .................................................................................. Net cash flow from sale $7,800 3,600 $4,200 1,680 $2,520 $7,800 6,900 $ 900 1,680 $ (780)
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3.
ANALYSIS: Large differences between net income and cash flow arise when inventory costs are changing significantly. For example, in times of rapid inflation, FIFO net income will be higher than the net cash flow after considering the replacement cost of goods.
P 10-32 Manipulating Profits Using Inventory Purchases 1. Cost of Goods Sold: (a) Without Purchase Cost of goods sold Beginning inventory Purchases Goods available for sale Ending inventory Cost of goods sold
1
(b) With Purchase $1,200,000
2
$ 1,200,000
1
11,240,000 $12,440,000
3
12,940,000 $14,140,000
4
400,000 $12,040,000
1,600,000 $12,540,000
$4,000,000 + $3,040,000 + $4,200,000 = $11,240,000
2 3 4
$11,240,000 + (5,000 $340) = $12,940,000 2,000 $200 = $400,000 (1,000 $400 = $400,000) + (6,000 $200 = $1,200,000) = $1,600,000 (a) Without Purchase (b) With Purchase $15,300,000 12,540,000 $ 2,760,000 1,000,000 $ 1,760,000 528,000 $ 1,232,000
2.
Net Income:
Sales Cost of goods sold Gross profit on sales Expenses Net income before taxes Taxes (0.30 rate) Net income 3. Cash Flows:
$15,300,000 12,040,000 $ 3,260,000 1,000,000 $ 2,260,000 $ 678,000 1,582,000
(a) (b) Purchase in January Purchase in December Cash flows: Taxes Purchase in December (5,000 $340) Purchase in January (5,000 $300) Net cash flows 4. $ (678,000) (1,500,000) $(2,178,000) $ (528,000) (1,700,000) $(2,228,000)
ANALYSIS: If the forecast for the continued decline in the price of gold is accepted, the firm should wait until January to purchase the gold because this choice results in a lower negative cash flow. Whether the price of gold actually will decline cannot be known until after the decision is made. If the price of gold is expected to remain near the $340 level, it is better to make the purchase in December in order to save the tax dollars.
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P 10-33 Valuing Inventory at the Lower of Cost or Market 1. Item A B C D E Total 2. 3. 4. Original Cost $ 7,920 4,800 3,840 5,760 6,480 $28,800 Net Realizable Value $ 8,280 6,240 3,552 8,400 5,400 $31,872 Replacement Cost $ 8,640 4,224 3,744 7,200 4,800 $28,608 Value of Ending Inventory $ 7,920 4,224 3,552 5,760 4,800 $26,256
For external reporting purposes, the inventory writedown loss of $2,544 ($28,800 $26,256) would probably be lumped in with cost of goods sold. As shown in (1), the lowest total is for the "replacement cost" valuation. Thus, if the inventory were valued as one "portfolio," the value of ending inventory would be $28,608. ANALYSIS: When the inventory items are lumped together and treated as a portfolio, gains on some items offset losses on others. However, when the inventory items are valued separately, all of the losses are recognized and all of the gains are ignored. Thus, the individual item approach always results in a lower inventory valuation. For this reason, the individual item approach sometimes strikes people as being overly conservative.
P 10-34 Analysis of the Operating Cycle 1. 2. Inventory Turnover = [$600,000*(1 0.37)]/[($114,000 + $87,000)/2] = 3.76 Number of days' sales in inventory = 365/3.76 = 97 days Average collection period: 44 days = 365/Accounts receivable turnover Accounts receivable turnover = 8.3 times Accounts receivable turnover: 8.3 = $600,000/[($68,000 + ending accounts receivable)/2] Ending accounts receivable = $76,578 3. Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold ($600,000 [1 0.37]) Purchases = $351,000 Purchases turnover = $351,000/[($36,000 + $42,000)/2] = 9.0 times Number of days' purchases in accounts payable = 365/9.0 = 41 days 4. Dallen pays its suppliers in 41 days, on average. Dallen collects cash from customers in 141 days (97 days + 44 days). So, on average, 100 days (141 days 41 days) elapse between the time suppliers are paid and the time cash is received from customers. $114,000 ?????? $465,000 (87,000) $378,000
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5.
(1) (2)
Inventory Turnover = [$600,000*(1 0.37)]/$87,000 = 4.34 Days sales in inventory = 365/4.34 = 84 days Average collection period: 44 days = 365/Accounts receivable turnover Accounts receivable turnover = 8.3 times Accounts receivable turnover: 8.3 = $600,000/ending accounts receivable Ending accounts receivable = $72,289
(3) Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold Purchases = $351,000 Purchases turnover = $351,000/$42,000 = 8.36 Number of days' purchases in accounts payable = 365/8.36 = 44 days (4) Dallen pays its suppliers in 44 days, on average. Dallen collects cash from customers in 128 days (84 days + 44 days). So, on average, 84 days (128 days 44 days) elapse between the time suppliers are paid and the time cash is received from customers. $114,000 ?????? $465,000 (87,000) $378,000
6.
ANALYSIS: If the number of days' purchases in accounts payable were to double from its current level, then the accounts payable balance would double. This means that accounts payable would increase by $42,000. If Dallen is able to obtain an additional $42,000 in vendor financing, that means that Dallen could be able to eliminate $42,000 in interest-bearing financing. If the interest rate is 10%, this replacement of $42,000 in interest-bearing financing would save Dallen $4,200 ($42,000 0.10) in interest per year.
P 10-35 Budgeting Cash Receipts and Disbursements Inventory Purchase Month November December January February March Sales $450,000 $750,000 $150,000 $ 75,000 $300,000 Cost of Goods Sold (75% of Sales) $337,500 $562,500 $112,500 $ 56,250 $225,000 Purchases (Constant Inventory) $337,500 $562,500 $112,500 $ 56,250 $225,000
Chapter 10 21
1.
Darren Company Cash Receipts Budget for Sales Collections For January, February, and March 2007 January November Sales (0.55 $450,000) December Sales (0.30 $750,000) (0.55 $750,000) January Sales (0.10 $150,000) (0.30 $150,000) (0.55 $150,000) February Sales (0.10 $75,000) (0.30 $75,000) March Sales (0.10 $300,000) Total Receipts February March
$247,500 225,000 $412,500 15,000 45,000 $ 82,500 7,500 22,500 30,000 $135,000
$487,500
$465,000
2.
Darren Company Cash Disbursements Budget for Inventory Purchases For January, February, and March 2007 January November Purchases (0.10 $337,500) December Purchases (0.70 $562,500) (0.10 $562,500) January Purchases (0.20 $112,500) (0.70 $112,500) (0.10 $112,500) February Purchases (0.20 $56,250) (0.70 $56,250) March Purchases (0.20 $225,000) Total Disbursements $ 33,750 393,750 $ 56,250 22,500 78,750 $ 11,250 11,250 39,375 45,000 $ 95,625 February March
$450,000
$146,250
3.
ANALYSIS: Darren would use the information in the cash receipts and cash disbursements budgets to show a potential lender that cash inflow is expected to exceed cash outflow in each month-- January, February, and March. This excess cash inflow can be targeted to be used to repay the short-term loan needed to finance the inventory buildup in November.
Chapter 10 22
APPLICATIONS AND EXTENSIONS SOLUTIONS
Deciphering Actual Financial Statements Deciphering 10-1 (McDonald's) 1. As of December 31, 2003, McDonald's reported total inventory of $129.4 million. This amount is small when compared to total assets of $25.5 billion. McDonald's must certainly carry an inventory of raw materials for its food products, but the perishable nature of those raw materials dictates that the amount held be small. 2. As mentioned in previous chapters, McDonald's Corporation operates only about 30% of the total McDonald's stores worldwide. The remainder are operated by franchisees and affiliates. The inventory of these franchisees and affiliates is not shown in the balance sheet of McDonald's Corporation. 3. Using the same rationale as in (1), it is likely that McDonald's number of days' sales in inventory is quite low. The computation for 2003 is as follows: Inventory Turnover = [$4,314.8 million]/[($111.7 million + $129.4 million)/2] = 35.8 times Number of days' sales in inventory = 365/35.8 = 10.2 days 4. McDonald's does not disclose the inventory valuation method used because the amount of inventory reported in the balance sheet is so low that choice of the inventory valuation method does not have a material impact on the overall financial statements.
Deciphering 10-2 (Circle K) 1. Computation of gross profit percentage for Circle K's gasoline and merchandise is as follows (amounts are in millions): Sales .................................................... Cost of goods sold ............................... Gross profit ......................................... Gross profit percentage: Gross profit Sales 190.4 1,562.5 = 12.2% 517.7 1,710.3 = 30.3% Gasoline $1,562.5 1,372.1 $ 190.4 Merchandise $1,710.3 1,192.6 $ 517.7
Since the gross profit percentage on merchandise is so high compared to that on gasoline, Circle K wishes all customers would pay for their gas inside the store to increase the chance that they will buy some merchandise. 2. Computation of inventory turnover is as follows: Cost of goods sold Ending inventory Gasoline 1,372.1 26.6 = 51.6 times Merchandise 1,192.6 93.9 = 12.7 times
Chapter 10 23
3.
Computation of number of days' sales in ending inventory is as follows: Ending inventory Cost of goods sold/365 Gasoline 26.6 1,372.1/365 = 7.08 days Merchandise 93.9 1,192.6/365 = 28.74 days
Gasoline is much more costly to store than is merchandise. The storage facilities are costly (underground tanks), the potential for disaster is higher (accidents or expensive clean up of leaky tanks), and the gasoline itself degrades if it is stored for a long time. Deciphering 10-3 (Caterpillar and Dow Chemical) 1. Dow Chemical $4,050 = 92.5% Ending LIFO inventory Ending FIFO inventory ($4,050 + $330) Caterpillar $3,047 = 62.1 % ($3,047 + $1,863)
For Dow Chemical, LIFO and FIFO inventory are almost exactly equal to one another. On the other hand, for Caterpillar the LIFO inventory is little more than half of what would be reported under FIFO. 2. For Dow Chemical: Beginning inventory ............................................... + Purchases (same under LIFO and FIFO) ............. = Cost of goods available for sale ........................... Ending inventory.................................................. = Cost of goods sold ............................................... For Caterpillar: Beginning inventory ............................................... + Purchases (same under LIFO and FIFO) ............. = Cost of goods available for sale ........................... Ending inventory.................................................. = Cost of goods sold ............................................... 3. LIFO $2,763 17,229 $19,992 3,047 $16,945 FIFO $2,763 + 1,977 17,229 $ 21,969 3,047 + 1,863 $ 17,059 LIFO $4,208 28,019 $32,227 4,050 $28,177 FIFO $ 4,208 + 209 28,019 $ 32,436 4,050 + 330 $ 28,056
The size of the LIFO reserve is a function of how long a company has used LIFO, how much of its inventories are under LIFO, and the rate of inflation in inventory costs in the company's industry. The LIFO reserve becomes large when there are many old LIFO layers containing old costs. Caterpillar has used LIFO for a long time and uses it for 80% of its inventory (compared to 38 % for Dow Chemical). Conversion of financial statement data from LIFO to FIFO is usually fairly easy because all that is needed is the LIFO reserve, and this can be approximated using the current value of the inventory. Conversion from FIFO to LIFO is quite difficult, if not impossible. The LIFO inventory balance is impacted by the entire history of the company's inventory transactions, back to the beginning of time. There should be LIFO layers for each year in which purchases have exceeded sales. Some of those layers would have been liquidated in subsequent years. The valuation of each layer depends on the inventory costs in the year the layer was created. In short, retroactive conversion from FIFO to LIFO is very difficult.
4.
Chapter 10 24
International Financial Statements 1. As computed by BP Amoco, a stock holding gain or loss is the difference between the replacement cost of inventory sold and the FIFO cost of inventory sold. Subtracting the holding gain from or adding the holding loss to replacement cost of goods sold converts the number to FIFO. Accordingly, the number that BP reports as "historical cost gross profit" is FIFO gross profit: $30,546 in 2003 and $24,322 in 2002. 2. Since replacement cost is computed using the average cost of goods acquired during the year, it closely approximates LIFO cost. Therefore, the reported replacement cost gross profit is an estimate of LIFO gross profit: $30,530 in 2003 and $23,193 in 2002. The gross profit computation presented by BP Amoco is quite interesting in that it essentially shows both FIFO and LIFO and explains that the difference between the two comes from inventory holding gains and losses.
Business Memo: This Is Not the Time for Just In Time To: Controller, Duo-Therm Company From: Assistant Controller RE: Just-in-Time Inventory A just-in-time (JIT) inventory system will reduce our inventory storage and carrying costs, but it will also dramatically increase the amount we pay in income taxes. As you know, we have been using LIFO for the past 25 years. During that time, we have been consistently growing. As a result, we have established many old LIFO layers that are carried in inventory at old costs. If we implement a JIT inventory system, we will liquidate these LIFO layers and the old, low costs will flow into cost of goods sold, increasing our reported gross profit. Because of the LIFO conformity rule, we use LIFO for both book and income tax purposes. Accordingly, the increased gross profit will lead to increased income tax payments. As the board of directors considers adopting a JIT inventory system, you should advise them on the income tax consequences. The tax costs should be factored into the decision of whether to implement a JIT system. If you wish, I will provide detailed computations and estimates to serve as background material for your presentation to the board. Research: How Much Inventory Is There in a Supermarket? Numbers from the 2003 financial statements of Safeway will be used in discussing possible approaches to this research project. 1. 2. The supermarket chain identified is Safeway. Financial statements for the year ended January 3, 2004, were obtained from the SEC's Web site. Gross profit percentage for 2003: Amounts (in millions) $35,552.7 25,018.9 $10,533.8 % 100.0% 70.4% 29.6%
Sales ........................................................................................... Cost of goods sold ...................................................................... Gross profit ................................................................................ 3.
Visit a retail location. Safeway operates U.S. stores in northern California, Oregon, Washington and the Rocky Mountain, Southwest, and Mid-Atlantic regions.
Chapter 10 25
4.
A possible plan for estimating the retail value of inventory in the store is as follows: Randomly choose ten locations throughout the store. Estimate the total retail value of goods located within five shelf-feet on either side of the location chosen. Estimate what proportion of the total store shelf-feet you have sampled. Extrapolate your estimate for the ten random locations to an estimate for the entire store. For example, if you estimate that you have sampled 5% of the goods in the store, multiply your estimate by 20.
5. 6.
In Safeway's case, multiply your retail estimate by the cost/retail percentage of 70.4%. Primary sources of error are:
The samples chosen are not representative of the average retail value of items throughout the store. For example, the shelf space containing pasta has a lower retail total than the shelf space containing organic vitamins. Overlooking of supplemental items like produce, items located in special displays, and the fresh meat, fish, and poultry items. You can check how close your estimate is by using data from the supermarket chain's annual report. Safeway reports that it has 1,817 stores with total inventory of $2,642.2 million, suggesting that the average cost of inventory per store is $1.454 million. Ethics Dilemma: LIFO and the Strategic Timing of Inventory Purchases Clearly you have stumbled upon a ploy to increase Lam Tin's reported profit in order to boost the acquisition price to be paid by Kwun Tong. The dilemma is deciding what you should do with your information. Let's take the questions in reverse order. Should you talk with the negotiation team from Kwun Tong? Probably not. This attempt to manipulate reported profits is part of Lam Tin's bargaining strategy and Kwun Tong should already be aware that such manipulations are possible. To inject yourself into the complex negotiations is probably not a good idea. Should you talk with Lam Tin's independent auditor? Maybe, depending on what the vice president of finance says. This is a matter that is best kept inside the company if possible. It may be that the vice president is just brainstorming about possibilities and hasn't yet decided to insist that you curtail year-end purchases in order to liquidate LIFO layers. Talking to the external auditor is something that should wait until after you have spoken with the vice president. And if you do disclose this LIFO liquidation manipulation attempt to the auditors, rest assured that you also will probably have to find work somewhere else. Should you talk with Lam Tin's vice president of finance? Absolutely. You owe it to the vice president to tell her what your suspicions are and to tell her that you have extreme ethical reservations about the plan. Your best strategy is to acknowledge the attractiveness of the plan, but you should also point out that if the manipulation is discovered before the deal is sealed with Kwun Tong, the scandal could sink the entire deal. In addition, if the manipulation is discovered after the deal is sealed, the vice president and everyone else aware of the manipulation is vulnerable to a lawsuit. Finally, you should help the vice president of finance come up with practical reasons for scuttling the plan. For example, you might point out how costly the plan is, both in terms of extra income taxes and extra purchase costs. Give the vice president of finance every opportunity to back away from this sleazy LIFO manipulation without losing face.
Chapter 10 26
The Debate: Americans, Go Home! And Take LIFO with You! Remember, no arguments can be based on LIFO income tax implications!! Pro-LIFO LIFO most closely matches current costs with current revenues. The matching concept has been the fundamental principle of income measurement for years. LIFO cost of goods sold is a close approximation of current replacement cost of goods sold. Replacement cost gross profit is the best measure of a company's operating performance. Use of LIFO excludes inventory holding gains and losses from the computation of gross profit. These holding gains and losses do not stem from business operations but from price movements in the market for inventory. As such, they should not be included in measures of business operating performance.
Anti-LIFO LIFO was invented in the United States merely as a tool to reduce income tax payments. Acceptable financial accounting practices should not be influenced by techniques used to manipulate taxes. The LIFO inventory values reported in the balance sheet have no correspondence with the current value of inventory. In fact, for a company that has used LIFO for a few years, the reported inventory numbers are almost meaningless. The existence of LIFO layers raises the possibility that LIFO liquidation will drag old LIFO layer costs into cost of goods sold. In any period in which this happens, computed gross profit is not a reflection of performance for that period. Because maintenance of LIFO layers is so important in the computation of LIFO gross profit, companies that use LIFO can manipulate their reported profit by timing end-of-year purchases to either maintain or to liquidate LIFO layers.
Cumulative Spreadsheet Project 1. NOTE: BECAUSE OF SPREADSHEET ROUNDING, NOT ALL OF THE DISPLAYED TOTALS RECONCILE EXACTLY. Year 2006 Balance Sheet Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Total assets Liabilities Accounts payable Short-term loans payable Total current liabilities Forecasted 2007
10 27 153 190 199 9 380 74 10 84
14 38 214 266 279 16 529 104 29 133
Chapter 10 27
Long-term debt Total Liabilities Stockholders' Equity Paid-in capital Retained earnings (as of 12/31) Total liab. and equities Retained earnings (as of 1/1) + Net income Dividends Retained earnings (as of 12/31) Income Statement Sales Cost of goods sold Gross profit Depreciation expense Other operating expenses Operating income Interest expense Income before taxes Income tax expense Net income Statement of Cash Flows Operating Activities Net income Depreciation Change in A/R Change in inventory Change in A/P Cash from operating activities Investing Activities Purchase of new PPE Financing Activities New short-term loans payable New long-term debt New paid-in capital Cash dividends Cash from financing activities Net change in cash
207 291 50 39 380 31 8 0 39
207 340 136 53 529 39 14 0 53
700 519 181 5 155 21 9 12 4 8
980 727 253 7 217 29 9 20 7 14
14 7 11 61 30 21 80 19 0 86 0 105 4
Chapter 10 28
2.
a. Year 2006 Balance Sheet Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Liabilities Accounts payable Short-term loans payable Total current liabilities Long-term debt Total liabilities Stockholders' Equity Paid-in capital Retained earnings (as of 12/31) Total liab. and equities Forecasted 2007
10 7 153 190 199 9 380 74 10 84 207 291 50 39 380
14 38 132 184 279 16 447 93 &2 92 207 299 95 53 447
Retained Earnings (as of 1/1) + Net Income Dividends Retained Earnings (as of 12/31) Income Statements Sales Cost of goods sold Gross profit Depreciation expense Other operating expenses Operating income Interest expense Income tax expense Net Income
31 8 0 39
39 14 0 53
700 519 181 5 155 21 9 12 4 8
980 727 253 7 217 29 9 20 7 14
Chapter 10 29
Statement of Cash Flows Operating Activities Net income Depreciation Change in A/R Change in inventory Change in A/P Cash from operating activities Investing Activities Purchase of new PPE Financing Activities New short-term loans payable New long-term debt New paid-in capital Cash dividends Cash from financing activities Net change in cash b. Year 2006 Balance Sheet Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Total assets Liabilities Accounts payable Short-term loans payable Total current liabilities Long-term debt Total liabilities Stockholders' Equity Paid-in capital Retained earnings (as of 12/31) Total liab. and equities Retained earnings (as of 1/1) + Net income Dividends Retained earnings (as of 12/31) Income Statement 10 27 153 190 199 9 380 74 10 84 207 291 50 39 380 31 8 0 39
14 7 11 21 19 50 80 12 0 45 0 34 4 Forecasted 2007 14 38 299 350 279 16 613 116 60 175 207 382 179 53 613 39 14 0 53
Chapter 10 30
Sales Cost of goods sold Gross profit Depreciation expense Other operating expenses Operating income Interest expense Income before taxes Income tax expense Net income Statement of Cash Flows Operating Activities Net income Depreciation Change in A/R Change in inventory Change in A/P Cash from operating activities Investing Activities Purchase of new PPE Financing Activities New short-term loans payable New long-term debt New paid-in capital Cash dividends Cash from financing activities Net change in cash 3. Numbers of days' Sales in inventory 66.2 days 107.6 days 150.0 days
700 519 181 5 155 21 9 12 4 8
980 727 253 7 217 29 9 20 7 14
14 7 11 146 42 94
80 50 0 129 0 178 4 Forecasted Cash From Operating Activities +$50 21 94
The forecasted amount of cash from operating activities increases as Handyman becomes more efficient at managing its inventory. 4. Numbers of days' Sales in inventory 66.2 days 107.6 days 150.0 days Forecasted Balance in Accounts Payable $ 93 104 116
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As the number of days' sales in inventory increases, the level of inventory increases. As the forecasted level of inventory increases, the forecasted amount of purchases also increases. With more purchases, the forecasted balance in accounts payable goes up. 5. When the forecasted number of days' sales in inventory is 66.2 days, the forecasted balance in short-term loans payable is $2. This unrealistic result occurs because of the constraint that the current ratio be exactly equal to 2.0. With a low level of inventory, the amount of total current assets is also low--so low that, in order for the current ratio to be 2.0, the total of current liabilities has to be less than the amount of accounts payable. Mathematically, this can be accomplished by having a negative amount of short-term loans payable. In a real business, negative loan amounts are not possible. In future spreadsheets, we will consider the implications of constraining the short-term loans payable balance to be $0 or more.
Internet Search: Wal-Mart The information for this Internet solution was obtained on May 26, 2004. 1. 2. The Zip Code "84602" (for Brigham Young University in Provo, Utah) was entered. Wal-Mart's Store Finder listed four locations within 20 miles of BYU: four Wal-Mart Supercenter stores. The "Submit Resume" link was found by clicking on "Jobs at Wal-Mart" under the "Company Information" on the left side of Wal-Mart's homepage. From potential employees, Wal-Mart asks for your name, address, employment objective, education, employment history, and any additional information you think they should know about you. The following comes from Wal-Mart's Supplier Proposal Packet: Suppliers who wish to initiate a business relationship with Wal-Mart Stores, Inc., must complete each of the steps below. After we have received your completed proposal packet in its entirety, including the Supplier Questionnaire and all required paperwork and materials, we will process your information and provide you with a response. Please keep in mind that incomplete packets will be returned at the supplier's expense. No incomplete information will be held by Supplier Development longer than 24 hours. The following steps will assist you in assembling your proposal and detailed explanations follow the listing. Get to Know Wal-Mart In order to best serve Wal-Mart and make a noticeable presentation and impression, it is beneficial that you really get to know our business and understand not only our needs, but also how your firm can help fulfill them. The following will enable you to better understand our core business: 1. Read this information in its entirety. It contains valuable information that will be referential to your business now and in the future. 2. Visit one or more Wal-Mart Stores, SAM'S Clubs or Supercenters. Get to know our product offerings, quality and prices. 3. Compare your product or service to our existing ones. 4. Make sure you understand the Wal-Mart customer and how your product or service will compliment our present assortment.
3.
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Provide the Following Requirements Remember, that it is necessary to provide all required information with the initial proposal of your product or service. 1. Complete the Online Supplier Questionnaire Online. (Resale Product). 2. Non-resale/ Service Suppliers: fill out the Supplier Questionnaire on-line, print, and mail to address below. 3. Obtain a Supplier Evaluation Report with Dun & Bradstreet (D & B) before beginning the questionnaire process. 4. Be able to provide a copy of your product liability certificate of insurance when requested. 5. Provide a copy of your Uniform Code Council (UPC) letter identifying your companies bar code labeling. (mail with your sample) 6. If you are a Minority / Women-Owned Business, FAX a copy of your current minority or women-owned certification to 479-277-2532. Assemble Your Proposal Packet Be sure to provide a sample of your Product with pricing or product literature so an informed decision can be reached regarding your product or service (all samples become the property of Wal-Mart Stores, Inc.). Send copy of UPC Code Letter and product sample(s) to the following address (all together in one mailing). Supplier Development Wal-Mart Stores, Inc. 702 SW 8th St. Bentonville, AR 72716-0145 4. Wal-Mart's number of days' sales in inventory is computed here using end-of-year (instead of average) inventory. (dollars in millions) Cost of sales Ending inventory Number of days' sales in inventory January 31, 2004 $198,747 26,612 48.9 days January 31, 2003 $178,299 24,401 50.0 days
It appears that Wal-Mart has managed its inventory during fiscal 2004 more efficiently than during 2003. You Be the Analyst! Ratios Related to Inventory The data for this solution were gathered on June 25, 2004. Of course, solutions will differ depending on when this exercise is completed.
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1.
Wal-Mart's inventories days held for the most recent five years is as follows. 2003 47.57 2002 44.57 2001 46.22 2000 49.40 1999 52.14
Inventories Days Held
The level of inventories days held in 2003 is higher than the values in the preceding two years, but lower than the values in 1999 and 2000. 2. The number of days' sales in inventory formula can be written as follows. = Inventory / (Cost of goods sold / 365)
Number of days' sales in inventory
Using Wal-Mart's ending inventory balance for 2003, the calculation is as follows: Number of days' sales in inventory = = $26,612 / ($194,895 / 365) 49.84 days
This does not exactly match the 47.57 days reported in Thomson Ratios. Using Wal-Mart's average inventory balance for 2003, the calculation is as follows: Number of days' sales in inventory = = (($26,612 + $24,891)/2) / ($194,895 / 365) 48.23 days
Again, this does not exactly match the 47.57 days reported in Thomson Ratios. It is not unusual to be unable to exactly recreate the calculations used to generate reported ratio values. But in most cases, as we see here, the differences are slight. 3. For 2003, Wal-Mart's inventory turnover as reported in Thomson One was 7.57. In the text, we read that number of days' sales in inventory can be computed by dividing 365 by the inventory turnover value, as follows. Number of days' sales in inventory = = 365 / 7.57 48.22 days
This matches (except for a slight rounding difference) the calculation in (2) using the average inventory balance. 4. For the year ended December 31, 2003, the value of Wal-Mart's inventories days held was 47.57. For the same year, the mean value for Wal-Mart's industry group was 54.39 days. The company with the highest value was Sears with 71.79 days. The company with the lowest value was Costco with 31.59 days. Test Your Intuition The clean separation between product and service companies is disappearing. For example, does Microsoft sell a product or a service? And how about McDonald's: product or service? Microsoft sells both a product and a service. We normally think of Microsoft's products as its software packages, but Microsoft's business and reputation are also linked with the continuing service given to customers. McDonalds' sells products-- food--but the reason we are willing to buy the product is the fast and clean service associated with the "production" process.
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If you buy your groceries with a credit card or a bank debit card, what kind of information can the supermarket accumulate about you? The supermarket already knows each item you have purchased. If you give them a credit card or bank debit card, the supermarket's database computer can then match the list of purchases with your name. Over time, the supermarket can construct a detailed record of your personal buying habits. Over the entire life of a company--from its beginning with zero inventory until its final closeout when the last inventory item is sold--is aggregate cost of goods sold more, less, or the same as aggregate purchases? How is this impacted by the inventory cost flow assumption used? Over the entire life of a company, total cost of goods sold is equal to total inventory purchased. This mathematical fact is not impacted by the inventory cost flow assumption (FIFO, LIFO, or average) used by the company. The inventory cost flow assumption affects only the timing of reported cost of goods sold, not the total lifetime amount. Verify by reference to the original data that FIFO cost of goods sold for 2006 is $1,550. 2004 100 $5 = $500 2005 20 $5 = 100 $10 = 50 $10 2006 50 $10 = $ 500 70 $15 = 1,050 $1,550 90 $15 = $1,350
FIFO cost of goods sold:
$ 100 1,000 $1,100 $ 500
Ending inventory:
20 $5 = $100
=
How exactly can inventory estimates be used to detect underreported sales? If the actual amount of inventory is much lower than the estimated amount, there are three possible explanations: (1) the estimation process is flawed, (2) inventory was lost or stolen, or (3) the missing inventory was sold but the sales were not reported. A clever fraud artist can cover his or her tracks by making sure that the reported gross profit percentage is close to industry norms and by avoiding any large swings in the level of unreported sales from one year to the next. Like anything else, successful fraud requires consistent, patient effort over the course of many years. What dangers, if any, are associated with a just-in-time inventory system? Companies hold inventories in order to make sure that products are available when customers want them, to smooth out the production process, and to take advantage of favorable prices when they are available by buying extra inventory. A company with a just-in-time inventory system is at higher risk of running out of inventory and losing sales to competitors. In addition, a company with low inventory levels runs the risk of being forced to halt or slow production while waiting for the delivery of a key raw material. Business Context 10.1: Inventory Fraud and Instant Profits 1. The higher the ending inventory figure, the lower the reported cost of goods sold, and the higher net income. Thus, if the objective is to inflate profits, counting a lot of inventory and recording higher assets rather than expenses (cost of goods sold) will do just that.
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2. Consider how difficult and costly it would be to have the auditor assume all responsibility for detecting inventory errors. Because auditing involves sampling, the auditor can never be certain that all errors and fraud have been detected. However, an auditor should certainly be responsible for detecting all inventory errors that have a material impact on the financial statements. Business Context 10.2: As American as Mom, Apple Pie, and LIFO 1. Tax authorities are reluctant to permit LIFO because it reduces the amount of tax revenue collected. 2. Income statement distortion caused by a decline in LIFO inventory levels is called LIFO liquidation. This is a conceptual shortcoming of LIFO and may be a valid reason for banning its use. In the United States, the problems of LIFO liquidation are addressed by the requirement of full disclosure of the effects of any LIFO liquidation. It is highly unlikely that the use of LIFO will be disallowed in the United States. LIFO is part of the U.S. accounting tradition. And companies would be vigorously opposed to the elimination of LIFO for financial reporting purposes, out of fear that the IRS would follow and ban LIFO for tax purposes as well.
3.
Data Mining 10.1: Magnitude of the LIFO Reserve 1. LIFO Reserve/ LIFO Inventory Caterpillar Exxon, Mobil General Electric General Motors Sears 61.1% 75.9% 7.2% 14.4% 10.9%
The size of the LIFO reserve is a function of how long a company has used LIFO, how much of its inventories are under LIFO, and the rate of inflation in inventory costs in the company's industry. The LIFO reserve becomes large when there are many old LIFO layers containing old costs. 2. Assuming a 40% tax rate, the cumulative tax savings from using LIFO are (in millions of dollars): Tax Savings Caterpillar Exxon, Mobil General Electric General Motors Sears 3. $ 745.2 2,720.0 252.0 632.4 232.0
If the company had used FIFO instead of LIFO, the LIFO reserve amount would have been reported as a reduction in cost of goods sold, increasing reported net income and retained earnings. Offsetting this would be the increased income tax expense, as estimated in (2). The net effect is as follows:
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Caterpillar Exxon, Mobil General Electric General Motors Sears
Reported Retained Earnings $ 8,450 115,956 82,796 12,752 11,636
Dollar Increase $1,118 4,080 379 949 348
Percentage Increase 13.2% 3.5% 4.6% 7.4% 3.0%
Data Mining 10.2: Inventory Efficiency 1. Using the number of days' sales in total ending inventory, General Motors is the only one of the three automakers that reduced inventory levels from 1992 to 2003. General Motors was able to reduce its number of days' sales in inventory from 32.4 days to 31.9 days. The level increased for Ford and increased significantly for DaimlerChrysler. In fairness, the 1992 numbers reflect only Chrysler's operations while the 2003 numbers reflect the combined operations of DaimlerChrysler. Number of days' sales 2003 1992 31.9 32.4 28.6 24.3 50.5 26.2
General Motors Ford DaimlerChrysler 2.
For each of the three automakers, finished goods inventory is a higher percentage of total inventory in 2003 than in 1992. This suggests that the automakers have made their manufacturing operations more efficient, cutting down the relative amounts of raw materials and work in process. Finished Goods as a Percentage of Total Inventory 2003 1992 60.9% 45.2% 62.2% 45.7% 74.7% 50.9%
General Motors Ford DaimlerChrysler
Web Search Below is a summary of the Just-in-Time inventory management philosophy, as found at http://www.inventorysolutions.org: JIT is a philosophy of continuous improvement in which non-value-adding activities (or wastes) are identified and removed for the purposes of: Reducing Cost Improving Delivery Improving Quality Adding Flexibility Improving Performance Increasing Innovativeness
JIT is not about automation. JIT eliminates waste by providing the environment to perfect and simplify the processes. JIT is a collection of techniques used to improve operations It can also be a new production system that is used to produce goods or services.
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The American Production and Inventory Control Society (APICS) has the following definition of JIT: "a philosophy of manufacturing based on planned elimination of all waste and continuous improvement of productivity. It encompasses the successful execution of all manufacturing activities required to produce a final product, from design engineering to delivery and including all stages of conversion from raw material onward. The primary elements include having only the required inventory when needed; to improve quality to zero defects; to reduce lead time by reducing setup times, queue lengths and lot sizes; to incrementally revise the operations themselves; and to accomplish these things at minimum cost." When the JIT principles are implemented successfully, significant competitive advantages are realized. JIT principles can be applied to all parts of an organization: order taking, purchasing, operations, distribution, sales, accounting, design, etc.
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