CHAPTER 6
REPORTING AND ANALYZING INVENTORY
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
- Determine how to classify inventory and inventory quantities.
- Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
- Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
- Explain the lower-of-cost-or-market basis of accounting for inventories.
- Compute and interpret the inventory turnover.
- Describe the LIFO reserve and explain its importance for comparing results of different companies.
Feature Story
“WHERE IS THAT SPARE BULLDOZER BLADE?”
Let's talk inventory—big, bulldozer-size inventory. Caterpillar Inc. is the world's largest manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. It sells its products in over 200 countries, making it one of the most successful U.S. exporters. More than 70% of its productive assets are located domestically, and nearly 50% of its sales are foreign.
In the past, Caterpillar's profitability suffered, but today it is very successful. A big part of this turnaround can be attributed to effective management of its inventory. Imagine what a bulldozer costs. Now imagine what it costs Caterpillar to have too many bulldozers sitting around in inventory—a situation the company definitely wants to avoid. Conversely, Caterpillar must make sure it has enough inventory to meet demand.
At one time during a 7-year period, Caterpillar's sales increased by 100%, while its inventory increased by only 50%. To achieve this dramatic reduction in the amount of resources tied up in inventory, while continuing to meet customers’ needs, Caterpillar used a two-pronged approach. First, it completed a factory modernization program, which dramatically increased its production efficiency. The program reduced by 60% the amount of inventory the company processed at any one time. It also reduced by an incredible 75% the time it takes to manufacture a part.
Second, Caterpillar dramatically improved its parts distribution system. It ships more than 100,000 items daily from its 23 distribution centers strategically located around the world (10 million square feet of warehouse space—remember, we're talking bulldozers). The company can virtually guarantee that it can get any part to anywhere in the world within 24 hours.
After these changes, Caterpillar had record exports, profits, and revenues. It would have seemed that things couldn't have been better. But industry analysts, as well as the company's managers, thought otherwise. In order to maintain Caterpillar's position as the industry leader, management began another major overhaul of inventory production and inventory management processes. The goal: to cut the number of repairs in half, increase productivity by 20%, and increase inventory turnover by 40%. In short, Caterpillar's ability to manage its inventory has been a key reason for its past success, and inventory management will very likely play a huge part in its ability to succeed in the future.
INSIDE CHAPTER 6…
- A Big Hiccup (p. 285)
- Falsifying Inventory to Boost Income (p. 286)
- Is LIFO Fair? (p. 296)
- Too Many TVs or Too Few? (p. 300)
PREVIEW OF CHAPTER 6
In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual inventory system. In this chapter, we explain the methods used to calculate the cost of inventory on hand at the balance sheet date and the cost of goods sold. We conclude by illustrating methods for analyzing inventory.
The content and organization of this chapter are as follows.
Classifying and Determining Inventory
LEARNING OBJECTIVE 1
Determine how to classify inventory and inventory quantities.
Two important steps in the reporting of inventory at the end of the accounting period are the classification of inventory based on its degree of completeness and the determination of inventory amounts.
CLASSIFYING INVENTORY
How a company classifies its inventory depends on whether the firm is a merchandiser or a manufacturer. In a merchandising company, such as those described in Chapter 5, inventory consists of many different items. For example, in a grocery store, canned goods, dairy products, meats, and produce are just a few of the inventory items on hand. These items have two common characteristics: (1) They are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers need only one inventory classification, merchandise inventory, to describe the many different items that make up the total inventory.
In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: finished goods, work in process, and raw materials. Finished goods inventory is manufactured items that are completed and ready for sale. Work in process is that portion of manufactured inventory that has begun the production process but is not yet complete. Raw materials are the basic goods that will be used in production but have not yet been placed into production.
Helpful Hint Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
For example, Caterpillar classifies earth-moving tractors completed and ready for sale as finished goods. It classifies the tractors on the assembly line in various stages of production as work in process. The steel, glass, tires, and other components that are on hand waiting to be used in the production of tractors are identified as raw materials. Illustration 6-1 shows an excerpt from Note 7 of Caterpillar's annual report, which shows the significant increases in each type of Caterpillar's inventory levels as the economy began to recover during this period.
By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management's production plans. For example, low levels of raw materials and high levels of finished goods suggest that management believes it has enough inventory on hand, and production will be slowing down—perhaps in anticipation of a recession. On the other hand, high levels of raw materials and low levels of finished goods probably signal that management is planning to step up production.
Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, companies manufacture or purchase goods just in time for use. Dell is famous for having developed a system for making computers in response to individual customer requests. Even though it makes computers to meet a customer's particular specifications, Dell is able to assemble the computer and put it on a truck in less than 48 hours. The success of a JIT system depends on reliable suppliers. By integrating its information systems with those of its suppliers, Dell reduced its inventories to nearly zero. This is a huge advantage in an industry where products become obsolete nearly overnight.
The accounting concepts discussed in this chapter apply to the inventory classifications of both merchandising and manufacturing companies. Our focus throughout most of this chapter is on merchandise inventory. Additional issues specific to manufacturing companies are discussed in managerial accounting courses.
Accounting Across the Organization
A Big Hiccup
JIT can save a company a lot of money, but it isn't without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced just such a disruption when a 6.8-magnitude earthquake caused major damage to the company that produces 50% of their piston rings. The rings themselves cost only $1.50, but without them you cannot make a car. No other supplier could quickly begin producing sufficient quantities of the rings to match the desired specifications. As a result, the automakers were forced to shut down production for a few days—a loss of tens of thousands of cars.
Similarly, a major snowstorm halted production at Canadian plants of General Motors and Ford. A Ford spokesperson said, “Because the plants run with just-in-time inventory, we don't have large stockpiles of parts sitting around. When you have a somewhat significant disruption, you can pretty quickly run out of parts.”
Source: Amy Chozick, “A Key Strategy of Japan's Car Makers Backfires,” Wall Street Journal (July 20, 2007); Kate Linebaugh, “Canada Military Evacuates Motorists Stranded by Snow,” Wall Street Journal (December 15, 2010).
What steps might the companies take to avoid such a serious disruption in the future? (See page 331.)
DETERMINING INVENTORY QUANTITIES
No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory for the following reasons. The first is to check the accuracy of their perpetual inventory records. The second is to determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.
Companies using a periodic inventory system must take a physical inventory for two different purposes: to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period.
Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.
Taking a Physical Inventory
Ethics Note In a famous fraud, a salad oil company filled its storage tanks mostly with water. The oil rose to the top, so auditors thought the tanks were full of oil. The company also said it had more tanks than it really did: it repainted numbers on the tanks to confuse auditors.
Companies take the physical inventory at the end of the accounting period. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In many companies, taking an inventory is a formidable task. Retailers such as Target, True Value Hardware, or Home Depot have thousands of different inventory items. An inventory count is generally more accurate when a limited number of goods are being sold or received during the counting. Consequently, companies often “take inventory” when the business is closed or when business is slow. Many retailers close early on a chosen day in January—after the holiday sales and returns, when inventories are at their lowest level—to count inventory. Wal-Mart, for example, has a year-end of January 31.
Ethics Insight
Falsifying Inventory to Boost Income
Managers at women's apparel maker Leslie Fay were convicted of falsifying inventory records to boost net income—and consequently to boost management bonuses. In another case, executives at Craig Consumer Electronics were accused of defrauding lenders by manipulating inventory records. The indictment said the company classified “defective goods as new or refurbished” and claimed that it owned certain shipments “from overseas suppliers” when, in fact, Craig either did not own the shipments or the shipments did not exist.
What effect does an overstatement of inventory have on a company's financial statements? (See page 331.)
Determining Ownership of Goods
One challenge in determining inventory quantities is making sure a company owns the inventory. To determine ownership of goods, two questions must be answered: Do all of the goods included in the count belong to the company? Does the company own any goods that were not included in the count?
GOODS IN TRANSIT. A complication in determining ownership is goods in transit (on board a truck, train, ship, or plane) at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count, the company must determine ownership of these goods.
Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale, as shown in Illustration 6-2 and described on the next page.
- When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
- When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.
CONSIGNED GOODS. In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods.
For example, you might have a used car that you would like to sell. If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold. Under this agreement, the dealer would not take ownership of the car, which would still belong to you. If an inventory count were taken, the car would not be included in the dealer's inventory because the dealer does not own it.
Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell. Today, even some manufacturers are making consignment agreements with their suppliers in order to keep their inventory levels low.
Do it!
RULES OF OWNERSHIP
Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. You have been given the information listed below. Discuss how this information affects the reported cost of inventory.
- Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.
- The company did not include in the count purchased goods of $10,000, which were in transit (terms: FOB shipping point).
- The company did not include in the count inventory that had been sold with a cost of $12,000, which was in transit (terms: FOB shipping point).
Action Plan
- Apply the rules of ownership to goods held on consignment.
- Apply the rules of ownership to goods in transit.
Solution
The goods of $15,000 held on consignment should be deducted from the inventory count. The goods of $10,000 purchased FOB shipping point should be added to the inventory count. Item 3 was treated correctly. Sold goods of $12,000 which were in transit FOB shipping point should not be included in the ending inventory. Inventory should be $195,000 ($200,000 − $15,000 + $10,000).
Related exercise material: BE6-1, 
6-1, E6-1, E6-2, and E6-3.
ANATOMY OF A FRAUD
Ted Nickerson, CEO of clock manufacturer Dally Industries, was feared by all of his employees. Ted had expensive tastes. To support his expensive tastes, Ted took out large loans, which he collateralized with his shares of Dally Industries stock. If the price of Dally's stock fell, he was required to provide the bank with more shares of stock. To achieve target net income figures and thus maintain the stock price, Ted coerced employees in the company to alter inventory figures. Inventory quantities were manipulated by changing the amounts on inventory control tags after the year-end physical inventory count. For example, if a tag said there were 20 units of a particular item, the tag was changed to 220. Similarly, the unit costs that were used to determine the value of ending inventory were increased from, for example, $125 per unit to $1,250. Both of these fraudulent changes had the effect of increasing the amount of reported ending inventory. This reduced cost of goods sold and increased net income.
Total take: $245,000
THE MISSING CONTROL
Independent internal verification. The company should have spot-checked its inventory records periodically, verifying that the number of units in the records agreed with the amount on hand and that the unit costs agreed with vendor price sheets.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 502–509.
Inventory Costing
LEARNING OBJECTIVE 2
Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are added to the cost of inventory, but the cost of shipping goods to a customer are a selling expense. After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to determine the total cost of the inventory and the cost of goods sold. This process can be complicated if a company has purchased inventory items at different times and at different prices.
For example, assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700, $750, and $800. During the year, Crivitz sold two sets at $1,200 each. These facts are summarized in Illustration 6-3.
Cost of goods sold will differ depending on which two TVs the company sold. For example, it might be $1,450 ($700 + $750), or $1,500 ($700 + $800), or $1,550 ($750 + $800). In this section, we discuss alternative costing methods available to Crivitz.
SPECIFIC IDENTIFICATION
If Crivitz can positively identify which particular units it sold and which are still in ending inventory, it can use the specific identification method of inventory costing. For example, if Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 + $800), and its ending inventory is $750 (see Illustration 6-4). Using this method, companies can accurately determine ending inventory and cost of goods sold.
Ethics Note A major disadvantage of the specific identification method is that management may be able to manipulate net income. For example, it can boost net income by selling units purchased at a low cost, or reduce net income by selling units purchased at a high cost.
Specific identification requires that companies keep records of the original cost of each individual inventory item. Historically, specific identification was possible only when a company sold a limited variety of high-unit-cost items that could be identified clearly from the time of purchase through the time of sale. Examples of such products are cars, pianos, or expensive antiques.
Today, with bar coding, electronic product codes, and radio frequency identification, it is theoretically possible to do specific identification with nearly any type of product. The reality is, however, that this practice is still relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost flow assumptions, about which units were sold.
COST FLOW ASSUMPTIONS
Because specific identification is often impractical, other cost flow methods are permitted. These differ from specific identification in that they assume flows of costs that may be unrelated to the actual physical flow of goods. There are three assumed cost flow methods:
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
- Average-cost
There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method.
To demonstrate the three cost flow methods, we will use a periodic inventory system. We assume a periodic system because very few companies use perpetual LIFO, FIFO, or average-cost to cost their inventory and related cost of goods sold. Instead, companies that use perpetual systems, as shown in Chapter 5, often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average-cost as shown in this chapter and adjust cost of goods sold to this recalculated number.1
To illustrate the three inventory cost flow methods, we will use the data for Houston Electronics’ Astro condensers, shown in Illustration 6-5.
From Chapter 5, the cost of goods sold formula in a periodic system is:
Houston Electronics had a total of 1,000 units available to sell during the period (beginning inventory plus purchases). The total cost of these 1,000 units is $12,000, referred to as cost of goods available for sale. A physical inventory taken at December 31 determined that there were 450 units in ending inventory. Therefore, Houston sold 550 units (1,000 − 450) during the period. To determine the cost of the 550 units that were sold (the cost of goods sold), we assign a cost to the ending inventory and subtract that value from the cost of goods available for sale. The value assigned to the ending inventory will depend on which cost flow method we use. No matter which cost flow assumption we use, though, the sum of cost of goods sold plus the cost of the ending inventory must equal the cost of goods available for sale—in this case, $12,000.
First-In, First-Out (FIFO)
The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow of merchandise because it generally is good business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold, regardless of which units were actually sold. (Note that this does not mean that the oldest units are sold first, but that the costs of the oldest units are recognized first. In a bin of picture hangers at the hardware store, for example, no one really knows, nor would it matter, which hangers are sold first.) Illustration 6-6 shows the allocation of the cost of goods available for sale at Houston Electronics under FIFO.
Under FIFO, since it is assumed that the first goods purchased were the first goods sold, ending inventory is based on the prices of the most recent units purchased. That is, under FIFO, companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the most recent prices. The last purchase was 400 units at $13 on November 27. The remaining 50 units are priced using the unit cost of the second most recent purchase, $12, on August 24. Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale.
Illustration 6-7 demonstrates that companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of the first 550 units acquired. Note that of the 300 units purchased on August 24, only 250 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 50 of these units were assumed unsold and thus included in ending inventory.
Last-In, First-Out (LIFO)
The last-in, first-out (LIFO) method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. (Exceptions include goods stored in piles, such as coal or hay, where goods are removed from the top of the pile as they are sold.) Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining cost of goods sold. Illustration 6-8 (page 292) shows the allocation of the cost of goods available for sale at Houston Electronics under LIFO.
Under LIFO, since it is assumed that the first goods sold were those that were most recently purchased, ending inventory is based on the prices of the oldest units purchased. That is, under LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the earliest prices. The first purchase was 100 units at $10 in the January 1 beginning inventory. Then, 200 units were purchased at $11. The remaining 150 units needed are priced at $12 per unit (August 24 purchase). Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale.
Illustration 6-9 demonstrates that we can also calculate cost of goods sold by pricing the 550 units sold using the prices of the last 550 units acquired. Note that of the 300 units purchased on August 24, only 150 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 150 of these units were assumed unsold and thus included in ending inventory.
Under a periodic inventory system, which we are using here, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.
Average-Cost
The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. Illustration 6-10 presents the formula and a sample computation of the weighted-average unit cost.
The company then applies the weighted-average unit cost to the units on hand to determine the cost of the ending inventory. Illustration 6-11 shows the allocation of the cost of goods available for sale at Houston Electronics using average-cost.
We can verify the cost of goods sold under this method by multiplying the units sold times the weighted-average unit cost (550 × $12 = $6,600). Note that this method does not use the simple average of the unit costs. The simple average is $11.50 ($10 + $11 + $12 + $13 = $46; $46 ÷ 4). The average-cost method instead uses the average weighted by the quantities purchased at each unit cost.
Do it!
COST FLOW METHODS
The accounting records of Shumway Ag Implement show the following data.
Determine (a) the cost of goods available for sale and (b) the cost of goods sold during the period under a periodic system using (i) FIFO, (ii) LIFO, and (iii) average-cost.
Action Plan
- Understand the periodic inventory system.
- Allocate costs between goods sold and goods on hand (ending inventory) for each cost flow method.
- Compute cost of goods sold for each cost flow method.
Solution
(a) Cost of goods available for sale: (4,000 × $3) + (6,000 × $4) = $36,000
(b) Cost of goods sold using:
(i) FIFO: $36,000 − (3,000* × $4) = $24,000
(ii) LIFO: $36,000 − (3,000 × $3) = $27,000
(iii) Average-cost: Weighted-average price = ($36,000 ÷ 10,000) = $3.60
$36,000 − (3,000 × $3.60) = $25,200
*(4,000 + 6,000 − 7,000)
Related exercise material: BE6-2, BE6-3, 6-2, E6-4, and E6-5.
FINANCIAL STATEMENT AND TAX EFFECTS OF COST FLOW METHODS
LEARNING OBJECTIVE 3
Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Each of the three assumed cost flow methods is acceptable for use under GAAP. For example, Reebok International Ltd. and Wendy's International currently use the FIFO method of inventory costing. Campbell Soup Company, Krogers, and Walgreens use LIFO for part or all of their inventory. Bristol-Myers Squibb, Starbucks, and Motorola use the average-cost method. In fact, a company may also use more than one cost flow method at the same time. Stanley Black & Decker Manufacturing Company, for example, uses LIFO for domestic inventories and FIFO for foreign inventories. Illustration 6-12 shows the use of the three cost flow methods in 500 large U.S. companies.
The reasons companies adopt different inventory cost flow methods are varied, but they usually involve at least one of the following three factors:
- Income statement effects
- Balance sheet effects
- Tax effects
Income Statement Effects
To understand why companies might choose a particular cost flow method, let's examine the effects of the different cost flow assumptions on the financial statements of Houston Electronics. The condensed income statements in Illustration 6-13 assume that Houston sold its 550 units for $18,500, had operating expenses of $9,000, and is subject to an income tax rate of 30%.
Note the cost of goods available for sale ($12,000) is the same under each of the three inventory cost flow methods. However, the ending inventories and the costs of goods sold are different. This difference is due to the unit costs that the company allocated to cost of goods sold and to ending inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes. For Houston, an $800 difference exists between FIFO and LIFO cost of goods sold.
In periods of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income. In most instances, prices are rising (inflation). In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues. In a period of rising prices (as is the case in the Houston example), FIFO reports the highest net income ($2,310) and LIFO the lowest ($1,750); average-cost falls in the middle ($2,030). If prices are falling, the results from the use of FIFO and LIFO are reversed: FIFO will report the lowest net income and LIFO the highest.
To management, higher net income is an advantage: It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income.
Some argue that the use of LIFO in a period of inflation reduces the likelihood that the company will report paper (or phantom) profit as economic gain. To illustrate, assume that Kralik Company buys 200 units of a product at $20 per unit on January 10 and 200 more on December 31 at $24 each. During the year, Kralik sells 200 units at $30 each. Illustration 6-14 shows the results under FIFO and LIFO.
Under LIFO, Kralik Company has recovered the current replacement cost ($4,800) of the units sold. Thus, the gross profit in economic terms is real. However, under FIFO, the company has recovered only the January 10 cost ($4,000). To replace the units sold, it must reinvest $800 (200 × $4) of the gross profit. Thus, $800 of the gross profit is said to be phantom or illusory. As a result, reported net income is also overstated in real terms.
Balance Sheet Effects
A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost. For example, for Houston Electronics, 400 of the 450 units in the ending inventory are costed under FIFO at the higher November 27 unit cost of $13.
Conversely, a major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods. For example, Caterpillar has used LIFO for 50 years. Its balance sheet shows ending inventory of $14.5 billion. But the inventory's actual current cost if FIFO had been used is $17.0 billion.
Tax Effects
Helpful Hint A tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes, they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.
We have seen that both inventory on the balance sheet and net income on the income statement are higher when companies use FIFO in a period of inflation. Yet, many companies use LIFO. Why? The reason is that LIFO results in the lowest income taxes (because of lower net income) during times of rising prices. For example, in Illustration 6-13 (page 295) income taxes are $750 under LIFO, compared to $990 under FIFO. The tax savings of $240 makes more cash available for use in the business.
International Insight
Is LIFO Fair?
ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its inventory for financial reporting and tax purposes. In one recent year, this resulted in a cost of goods sold figure that was $5.6 billion higher than under FIFO. By increasing cost of goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say that LIFO provides an unfair “tax dodge.” As Congress looks for more sources of tax revenue, some lawmakers favor the elimination of LIFO. Supporters of LIFO argue that the method is conceptually sound because it matches current costs with current revenues. In addition, they point out that this matching provides protection against inflation.
International accounting standards do not allow the use of LIFO. Because of this, the net income of foreign oil companies, such as BP and Royal Dutch Shell, are not directly comparable to U.S. companies, which makes analysis difficult.
Source: David Reilly, “Big Oil's Accounting Methods Fuel Criticism,” Wall Street Journal (August 8, 2006), p. C1.
What are the arguments for and against the use of LIFO? (See page 331.)
KEEPING AN EYE ON CASH
You have just seen that when prices are rising the use of LIFO can have a big effect on taxes. The lower taxes paid using LIFO can significantly increase cash flows. To demonstrate the effect of the cost flow assumptions on cash flow, we will calculate net cash provided by operating activities, using the data for Houston Electronics from Illustration 6-13. To simplify our example, we assume that Houston's sales and purchases are all cash transactions. We also assume that operating expenses, other than $4,600 of depreciation, are cash transactions.
LIFO has the highest net cash provided by operating activities because it results in the lowest tax payments. Since cash flow is the lifeblood of any organization, the choice of inventory method is very important.
LIFO also impacts the quality of earnings ratio. Recall that the quality of earnings ratio is net cash provided by operating activities divided by net income. Here, we calculate the quality earnings ratio under each cost flow assumption.
LIFO has the highest quality of earnings ratio for two reasons: (1) It has the highest net cash provided by operating activities, which increases the ratio's numerator. (2) It reports a conservative measure of net income, which decreases the ratio's denominator. As discussed earlier, LIFO provides a conservative measure of net income because it does not include the phantom profits reported under FIFO.
DECISION TOOLKIT
USING INVENTORY COST FLOW METHODS CONSISTENTLY
Whatever cost flow method a company chooses, it should use that method consistently from one accounting period to another. Consistent application enhances the ability to analyze a company's financial statements over successive time periods. In contrast, using the FIFO method one year and the LIFO method the next year would make it difficult to compare the net incomes of the two years.
Helpful Hint As you learned in Chapter 2, consistency and comparability are important characteristics of accounting information.
Although consistent application is preferred, it does not mean that a company may never change its method of inventory costing. When a company adopts a different method, it should disclose in the financial statements the change and its effects on net income. A typical disclosure is shown in Illustration 6-15 (page 298), using information from recent financial statements of Quaker Oats Company.
LOWER-OF-COST-OR-MARKET
LEARNING OBJECTIVE 4
Explain the lower-of-cost-or-market basis of accounting for inventories.
The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to changes in technology or changes in fashions. These circumstances sometimes call for inventory valuation methods other than those presented so far. For example, in a recent year, purchasing managers at Ford decided to make a large purchase of palladium, a precious metal used in vehicle emission devices. They made this large purchase because they feared a future shortage. The shortage did not materialize, and by the end of the year the price of palladium had plummeted. Ford's inventory was then worth $1 billion less than its original cost. Do you think Ford's inventory should have been stated at cost, in accordance with the historical cost principle, or at its lower replacement cost?
International Note Under U.S. GAAP, companies cannot reverse inventory write-downs if inventory increases in value in subsequent periods. IFRS permits companies to reverse write-downs in some circumstances.
As you probably reasoned, this situation requires a departure from the cost basis of accounting. This is done by valuing the inventory at the lower-of-cost-or-market (LCM) in the period in which the price decline occurs. LCM is a basis whereby inventory is stated at the lower of either its cost or market value as determined by current replacement cost. LCM is an example of the accounting convention of conservatism. Conservatism means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income.
Companies apply LCM to the items in inventory after they have used one of the cost flow methods (specific identification, FIFO, LIFO, or average-cost) to determine cost. Under the LCM basis, market is defined as current replacement cost, not selling price. For a merchandising company, current replacement cost is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Current replacement cost is used because a decline in the replacement cost of an item usually leads to a decline in the selling price of the item.
To illustrate the application of LCM, assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. LCM produces the results shown in Illustration 6-16. Note that the amounts shown in the final column are the lower-of-cost-or-market amounts for each item.
Adherence to LCM is important. Acer Inc. recently took a charge of $150 million on personal computers, which declined in value before they could be sold. A Chinese manufacturer of silicon wafers for solar energy panels, LDK Solar Co., was accused of violating LCM. When the financial press reported accusations that two-thirds of its inventory of silicon was unsuitable for processing, the company's stock price fell by 40%.
Do it!
LCM BASIS
Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.
Determine the value of the company's inventory under the lower-of-cost-or-market approach.
Action Plan
- Determine whether cost or market value is lower for each inventory type.
- Sum the lower value of each inventory type to determine the total value of inventory.
Solution
The lower value for each inventory type is gas $79,000, wood $250,000, and pellet $101,000. The total inventory value is the sum of these figures, $430,000.
Related exercise material: BE6-7, 6-3, and E6-9.
Analysis of Inventory
LEARNING OBJECTIVE 5
Compute and interpret the inventory turnover.
For companies that sell goods, managing inventory levels can be one of the most critical tasks. Having too much inventory on hand costs the company money in storage costs, interest cost (on funds tied up in inventory), and costs associated with the obsolescence of technical goods (e.g., computer chips) or shifts in fashion (e.g., clothes). But having too little inventory on hand results in lost sales. In this section, we discuss some issues related to evaluating inventory levels.
INVENTORY TURNOVER
The inventory turnover is calculated as cost of goods sold divided by average inventory. It indicates the liquidity of inventory by measuring the number of times the average inventory “turns over” (is sold) during the year. Inventory turnover can be divided into 365 days to compute days in inventory, which indicates the average number of days inventory is held.
High inventory turnover (low days in inventory) indicates the company has minimal funds tied up in inventory—that it has a minimal amount of inventory on hand at any one time. Although minimizing the funds tied up in inventory is efficient, too high an inventory turnover may indicate that the company is losing sales opportunities because of inventory shortages. For example, investment analysts at one time suggested that Office Depot had gone too far in reducing its inventory—they said they were seeing too many empty shelves. Thus, management should closely monitor this ratio to achieve the best balance between too much and too little inventory.
In Chapter 5, we discussed the increasingly competitive environment of retailers, such as Wal-Mart and Target. Wal-Mart has implemented just-in-time inventory procedures as well as many technological innovations to improve the efficiency of its inventory management. The following data are available for Wal-Mart.
Illustration 6-17 presents the inventory turnovers and days in inventory for Wal-Mart and Target, using data from the financial statements of those corporations for 2011 and 2010.
The calculations in Illustration 6-17 show that Wal-Mart turns its inventory more frequently than Target and the industry average (9.1 times for Wal-Mart versus 6.2 times for Target and 8.4 for the industry). Consequently, the average time an item spends on a Wal-Mart shelf is shorter (40.1 days for Wal-Mart versus 58.9 days for Target and 43.5 days for the industry).
This analysis suggests that Wal-Mart is more efficient than Target in its inventory management. Wal-Mart's sophisticated inventory tracking and distribution system allows it to keep minimum amounts of inventory on hand, while still keeping the shelves full of what customers are looking for.
Accounting Across the Organization
Too Many TVs or Too Few?
Financial analysts closely monitored the inventory management practices of companies during the recent recession. For example, some analysts following Sony expressed concern because the company built up its inventory of televisions in an attempt to sell 25 million liquid crystal display (LCD) TVs—a 60% increase over the prior year. A year earlier, Sony had cut its inventory levels so that its quarterly days in inventory was down to 38 days, compared to 61 days for the same quarter a year before that. But now, as a result of its inventory build-up, days in inventory rose to 59 days. While management was saying that it didn't think that Sony's inventory levels were now too high, analysts were concerned that the company would have to engage in very heavy discounting in order to sell off its inventory. Analysts noted that the losses from discounting can be “punishing.”
Source: Daisuke Wakabayashi, “Sony Pledges to Corral Inventory,” Wall Street Journal Online (November 2, 2010).
For Sony, what are the advantages and disadvantages of having a low days in inventory measure? (See page 331.)
Do it!
INVENTORY TURNOVER
Early in 2014, Westmoreland Company switched to a just-in-time inventory system. Its sales, cost of goods sold, and inventory amounts for 2013 and 2014 are shown below.
Determine the inventory turnover and days in inventory for 2013 and 2014. Discuss the changes in the amount of inventory, the inventory turnover and days in inventory, and the amount of sales across the two years.
Action Plan
- To find the inventory turnover, divide cost of goods sold by average inventory.
- To determine days in inventory, divide 365 days by the inventory turnover.
- Just-in-time inventory reduces the amount of inventory on hand, which reduces carrying costs. Reducing inventory levels by too much has potential negative implications for sales.
Solution
The company experienced a very significant decline in its ending inventory as a result of the just-in-time inventory. This decline improved its inventory turnover and its days in inventory. However, its sales declined by 10%. It is possible that this decline was caused by the dramatic reduction in the amount of inventory that was on hand, which increased the likelihood of “stockouts.” To determine the optimal inventory level, management must weigh the benefits of reduced inventory against the potential lost sales caused by stockouts.
Related exercise material: BE6-8, 6-4, and E6-10.
ANALYSTS' ADJUSTMENTS FOR LIFO RESERVE
LEARNING OBJECTIVE 6
Describe the LIFO reserve and explain its importance for comparing results of different companies.
Earlier, we noted that using LIFO rather than FIFO can result in significant differences in the results reported in the balance sheet and the income statement. With increasing prices, FIFO will result in higher income than LIFO. On the balance sheet, FIFO will result in higher reported inventory. The financial statement differences from using LIFO normally increase the longer a company uses LIFO.
Use of different inventory cost flow assumptions complicates analysts’ attempts to compare companies’ results. Fortunately, companies using LIFO are required to report the difference between inventory reported using LIFO and inventory using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods.
Illustration 6-18 presents an excerpt from the notes to Caterpillar's 2011 financial statements that discloses and discusses Caterpillar's LIFO reserve.
Caterpillar has used LIFO for over 50 years. Thus, the cumulative difference between LIFO and FIFO reflected in the Inventory account is very large. In fact, the 2011 LIFO reserve of $2,422 million is nearly 17% of the 2011 LIFO inventory of $14,544 million. Such a huge difference would clearly distort any comparisons you might try to make with one of Caterpillar's competitors that used FIFO.
To adjust Caterpillar's inventory balance, we add the LIFO reserve to reported inventory, as shown in Illustration 6-19. That is, if Caterpillar had used FIFO all along, its inventory would be $16,966 million, rather than $14,544 million.
The LIFO reserve can have a significant effect on ratios that analysts commonly use. Using the LIFO reserve adjustment, Illustration 6-20 calculates the value of the current ratio (current assets ÷ current liabilities) for Caterpillar under both the LIFO and FIFO cost flow assumptions.
As Illustration 6-20 shows, if Caterpillar used FIFO, its current ratio would be 1.42:1 rather than 1.33:1 under LIFO. Thus, Caterpillar's liquidity appears stronger if a FIFO assumption were used in valuing inventories. If a similar adjustment is made for the inventory turnover, Caterpillar's inventory turnover actually would look worse under FIFO than under LIFO, dropping from 3.6 times for LIFO to 3.0 times for FIFO.2 The reason: LIFO reports low inventory amounts, which cause inventory turnover to be higher.
CNH Global, a competitor of Caterpillar, uses FIFO to account for its inventory. Comparing Caterpillar to CNH without converting Caterpillar's inventory to FIFO would lead to distortions and potentially erroneous decisions.
Summary of Learning Objectives
- Determine how to classify inventory and inventory quantities. Merchandisers need only one inventory classification, merchandise inventory, to describe the different items that make up total inventory. Manufacturers, on the other hand, usually classify inventory into three categories: finished goods, work in process, and raw materials. To determine inventory quantities, manufacturers (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.
- Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. The primary basis of accounting for inventories is cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost flow methods are specific identification and three assumed cost flow methods—FIFO, LIFO, and average-cost.
- Explain the financial statement and tax effects of each of the inventory cost flow assumptions. The cost of goods available for sale may be allocated to cost of goods sold and ending inventory by specific identification or by a method based on an assumed cost flow. When prices are rising, the first-in, first-out (FIFO) method results in lower cost of goods sold and higher net income than the average-cost and the last-in, first-out (LIFO) methods. The reverse is true when prices are falling. In the balance sheet, FIFO results in an ending inventory that is closest to current value, whereas the inventory under LIFO is the farthest from current value. LIFO results in the lowest income taxes (because of lower taxable income).
- Explain the lower-of-cost-or-market basis of accounting for inventories. Companies use the lower-of-cost-or-market (LCM) basis when the current replacement cost (market) is less than cost. Under LCM, companies recognize the loss in the period in which the price decline occurs.
- Compute and interpret the inventory turnover. Inventory turnover is calculated as cost of goods sold divided by average inventory. It can be converted to average days in inventory by dividing 365 days by the inventory turnover. A higher inventory turnover or lower average days in inventory suggests that management is trying to keep inventory levels low relative to its sales level.
- Describe the LIFO reserve and explain its importance for comparing results of different companies. The LIFO reserve represents the difference between ending inventory using LIFO and ending inventory if FIFO were employed instead. For some companies this difference can be significant, and ignoring it can lead to inappropriate conclusions when using the current ratio or inventory turnover.
DECISION TOOLKIT A SUMMARY
Appendix 6A
Inventory Cost Flow Methods in Perpetual Inventory Systems
LEARNING OBJECTIVE 7
Apply the inventory cost flow methods to perpetual inventory records.
Each of the inventory cost flow methods described in the chapter for a periodic inventory system may be used in a perpetual inventory system. To illustrate the application of the three assumed cost flow methods (FIFO, LIFO, and average-cost), we will use the data shown in Illustration 6A-1 and in this chapter for Houston Electronics’ Astro condensers.
FIRST-IN, FIRST-OUT (FIFO)
Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 24. Illustration 6A-2 shows the inventory under a FIFO method perpetual system.
The ending inventory in this situation is $5,800, and the cost of goods sold is $6,200 [(100 @ $10) + (200 @ $11) + (250 @ $12)].
The results under FIFO in a perpetual system are the same as in a periodic system. (See Illustration 6-6 on page 291 where, similarly, the ending inventory is $5,800 and cost of goods sold is $6,200.) Regardless of the system, the first costs in are the costs assigned to cost of goods sold.
LAST-IN, FIRST-OUT (LIFO)
Under the LIFO method using a perpetual system, the cost of the most recent purchase prior to sale is allocated to the units sold. Therefore, the cost of the goods sold on September 10 consists of all the units from the August 24 and April 15 purchases plus 50 of the units in beginning inventory. The ending inventory under the LIFO method is computed in Illustration 6A-3.
The use of LIFO in a perpetual system will usually produce cost allocations that differ from use of LIFO in a periodic system. In a perpetual system, the latest units purchased prior to each sale are allocated to cost of goods sold. In contrast, in a periodic system, the latest units purchased during the period are allocated to cost of goods sold. Thus, when a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous sale. See Illustration 6-9 (on page 292) where the proof shows the 400 units at $13 purchased on November 27 applied to the sale of 550 units on September 10.
As shown above, under the LIFO perpetual system the 400 units at $13 purchased on November 27 are all applied to the ending inventory.
The ending inventory in this LIFO perpetual illustration is $5,700 and cost of goods sold is $6,300. Compare this to the LIFO periodic illustration (Illustration 6-8 on page 292) where the ending inventory is $5,000 and cost of goods sold is $7,000.
AVERAGE-COST
The average-cost method in a perpetual inventory system is called the moving-average method. Under this method, the company computes a new average after each purchase. The average cost is computed by dividing the cost of goods available for sale by the units on hand. The average cost is then applied to (1) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determine the ending inventory amount. Illustration 6A-4 shows the application of the average-cost method by Houston Electronics.
As indicated above, the company computes a new average each time it makes a purchase. On April 15, after 200 units are purchased for $2,200, a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand. The average unit cost is $10.667 ($3,200 ÷ 300). On August 24, after 300 units are purchased for $3,600, a total of 600 units costing $6,800 ($1,000 + $2,200 + $3,600) are on hand at an average cost per unit of $11.333 ($6,800 ÷ 600). Houston Electronics uses this unit cost of $11.333 in costing sales until another purchase is made, when the company computes a new unit cost. Accordingly, the unit cost of the 550 units sold on September 10 is $11.333, and the total cost of goods sold is $6,233. On November 27, following the purchase of 400 units for $5,200, there are 450 units on hand costing $5,767 ($567 + $5,200) with a new average cost of $12.816 ($5,767 ÷ 450).
Compare this moving-average cost under the perpetual inventory system to Illustration 6-11 (on page 293) showing the weighted-average method under a periodic inventory system.
Summary of Learning Objective for Appendix 6A
7. Apply the inventory cost flow methods to perpetual inventory records. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. Under the average-cost method, a new average cost is computed after each purchase.
Appendix 6B
Inventory Errors
Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because companies do not properly recognize the transfer of legal title to goods that are in transit. When inventory errors occur, they affect both the income statement and the balance sheet.
INCOME STATEMENT EFFECTS
Under a periodic inventory system, both the beginning and ending inventories appear in the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two periods.
The effects on cost of goods sold can be computed by entering incorrect data in the formula in Illustration 6B-1 and then substituting the correct data.
If beginning inventory is understated, cost of goods sold will be understated. If ending inventory is understated, cost of goods sold will be overstated. Illustration 6B-2 shows the effects of inventory errors on the current year's income statement.
Ethics Note Inventory fraud increases during recessions. Such fraud includes pricing inventory at amounts in excess of its actual value, or claiming to have inventory when no inventory exists. Inventory fraud is usually done to overstate ending inventory, thereby understating cost of goods sold and creating higher income.
An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. This is shown in Illustration 6B-3. Note that the understatement of ending inventory in 2013 results in an understatement of beginning inventory in 2014 and an overstatement of net income in 2014.
Over the two years, total net income is correct because the errors offset each other. Notice that total two-year income using incorrect data is $35,000 ($22,000 + $13,000), which is the same as the total two-year income of $35,000 ($25,000 + $10,000) using correct data. Also note in this example that an error in the beginning inventory does not result in a corresponding error in the ending inventory for that period. The correctness of the ending inventory depends entirely on the accuracy of taking and costing the inventory at the balance sheet date under the periodic inventory system.
BALANCE SHEET EFFECTS
The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation: Assets = Liabilities + Stockholders’ Equity. Errors in the ending inventory have the effects shown in Illustration 6B-4.
The effect of an error in ending inventory on the subsequent period was shown in Illustration 6B-3. Recall that if the error is not corrected, the combined total net income for the two periods would be correct. Thus, total stockholders’ equity reported on the balance sheet at the end of 2014 will also be correct.
Summary of Learning Objective for Appendix 6B
8. Indicate the effects of inventory errors on the financial statements. In the income statement of the current year: (1) An error in beginning inventory will have a reverse effect on net income (e.g., overstatement of inventory results in understatement of net income, and vice versa). (2) An error in ending inventory will have a similar effect on net income (e.g., overstatement of inventory results in overstatement of net income). If ending inventory errors are not corrected in the following period, their effect on net income for that period is reversed, and total net income for the two years will be correct.
In the balance sheet: Ending inventory errors will have the same effect on total assets and total stockholders’ equity and no effect on liabilities.
Glossary
Average-cost method (p. 293) An inventory costing method that uses the weighted-average unit cost to allocate the cost of goods available for sale to ending inventory and cost of goods sold.
Consigned goods (p. 287) Goods held for sale by one party although ownership of the goods is retained by another party.
Current replacement cost (p. 298) The cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities.
Days in inventory (p. 299) Measure of the average number of days inventory is held; calculated as 365 divided by inventory turnover.
Finished goods inventory (p. 284) Manufactured items that are completed and ready for sale.
First-in, first-out (FIFO) method (p. 290) An inventory costing method that assumes that the earliest goods purchased are the first to be sold.
FOB destination (p. 287) Freight terms indicating that ownership of goods remains with the seller until the goods reach the buyer.
FOB shipping point (p. 287) Freight terms indicating that ownership of goods passes to the buyer when the public carrier accepts the goods from the seller.
Inventory turnover (p. 299) A ratio that indicates the liquidity of inventory by measuring the number of times average inventory sold during the period; computed by dividing cost of goods sold by the average inventory during the period.
Just-in-time (JIT) inventory (p. 285) Inventory system in which companies manufacture or purchase goods just in time for use.
Last-in, first-out (LIFO) method (p. 291) An inventory costing method that assumes that the latest units purchased are the first to be sold.
LIFO reserve (p. 301) For a company using LIFO, the difference between inventory reported using LIFO and inventory using FIFO.
Lower-of-cost-or-market (LCM) (p. 298) A basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost.
Raw materials (p. 284) Basic goods that will be used in production but have not yet been placed in production.
Specific identification method (p. 288) An actual physical-flow costing method in which particular items sold and items still in inventory are specifically costed to arrive at cost of goods sold and ending inventory.
Weighted-average unit cost (p. 293) Average cost that is weighted by the number of units purchased at each unit cost.
Work in process (p. 284) That portion of manufactured inventory that has begun the production process but is not yet complete.
Do it! Comprehensive
Englehart Company has the following inventory, purchases, and sales data for the month of March.
The physical inventory count on March 31 shows 500 units on hand.
Instructions
Under a periodic inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under (a) the first-in, first-out (FIFO) method; (b) the last-in, first-out (LIFO) method; and (c) the average-cost method. (For average-cost, carry cost per unit to three decimal places.)
Action Plan
Solution to Comprehensive
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS.
Note: All Questions, Exercises, and Problems marked with an asterisk relate to material in the appendices to the chapter.
Self-Test Questions
Answers are on page 331.
(LO 1)
1. When is a physical inventory usually taken?
(a) When the company has its greatest amount of inventory.
(b) When a limited number of goods are being sold or received.
(c) At the end of the company's fiscal year.
(d) Both (b) and (c).
(LO 1)
2. Which of the following should not be included in the physical inventory of a company?
(a) Goods held on consignment from another company.
(b) Goods shipped on consignment to another company.
(c) Goods in transit from another company shipped FOB shipping point.
(d) All of the above should be included.
(LO 1)
3. As a result of a thorough physical inventory, Railway Company determined that it had inventory worth $180,000 at December 31, 2014. This count did not take into consideration the following facts. Rogers Consignment store currently has goods worth $35,000 on its sales floor that belong to Railway but are being sold on consignment by Rogers. The selling price of these goods is $50,000. Railway purchased $13,000 of goods that were shipped on December 27, FOB destination, that will be received by Railway on January 3. Determine the correct amount of inventory that Railway should report.
(a) $230,000.
(b) $215,000.
(c) $228,000.
(d) $193,000.
(LO 2)
4. Kam Company has the following units and costs.
If 9,000 units are on hand at December 31, what is the cost of the ending inventory under FIFO?
(a) $99,000.
(b) $108,000.
(c) $113,000.
(d) $117,000.
(LO 2)
5. From the data in Question 4, what is the cost of the ending inventory under LIFO?
(a) $113,000.
(b) $108,000.
(c) $99,000.
(d) $100,000.
(LO 2)
6. Davidson Electronics has the following:
If Davidson has 7,000 units on hand at December 31, the cost of ending inventory under the average-cost method is:
(a) $84,000.
(b) $70,000.
(c) $56,000.
(d) $75,250.
(LO 3)
7. 
In periods of rising prices, LIFO will produce:
(a) higher net income than FIFO.
(b) the same net income as FIFO.
(c) lower net income than FIFO.
(d) higher net income than average-cost.
(LO 3)
8. Considerations that affect the selection of an inventory costing method do not include:
(a) tax effects.
(b) balance sheet effects.
(c) income statement effects.
(d) perpetual versus periodic inventory system.
(LO 4)
9. The lower-of-cost-or-market rule for inventory is an example of the application of:
(a) the conservatism convention.
(b) the historical cost principle.
(c) the materiality concept.
(d) the economic entity assumption.
(LO 5)
10. Which of these would cause inventory turnover to increase the most?
(a) Increasing the amount of inventory on hand.
(b) Keeping the amount of inventory on hand constant but increasing sales.
(c) Keeping the amount of inventory on hand constant but decreasing sales.
(d) Decreasing the amount of inventory on hand and increasing sales.
(LO 5)
11. Carlos Company had beginning inventory of $80,000, ending inventory of $110,000, cost of goods sold of $285,000, and sales of $475,000. Carlos's days in inventory is:
(a) 73 days.
(b) 121.7 days.
(c) 102.5 days.
(d) 84.5 days.
(LO 6)
12. The LIFO reserve is:
(a) the difference between the value of the inventory under LIFO and the value under FIFO.
(b) an amount used to adjust inventory to the lower-of-cost-or-market.
(c) the difference between the value of the inventory under LIFO and the value under average-cost.
(d) an amount used to adjust inventory to historical cost.
(LO 7)
*13. In a perpetual inventory system,
(a) LIFO cost of goods sold will be the same as in a periodic inventory system.
(b) average costs are based entirely on unit-cost simple averages.
(c) a new average is computed under the average-cost method after each sale.
(d) FIFO cost of goods sold will be the same as in a periodic inventory system.
(LO 8)
*14. Fran Company's ending inventory is understated by $4,000. The effects of this error on the current year's cost of goods sold and net income, respectively, are:
(a) understated and overstated.
(b) overstated and understated.
(c) overstated and overstated.
(d) understated and understated.
(LO 4)
*15. Harold Company overstated its inventory by $15,000 at December 31, 2014. It did not correct the error in 2014 or 2015. As a result, Harold's stockholders’ equity was:
(a) overstated at December 31, 2014, and understated at December 31, 2015.
(b) overstated at December 31, 2014, and properly stated at December 31, 2015.
(c) understated at December 31, 2014, and understated at December 31, 2015.
(d) overstated at December 31, 2014, and overstated at December 31, 2015.
Go to the book's companion website, www.wiley.com/college/kimmel, to access additional Self-Test Questions.
Questions
1. “The key to successful business operations is effective inventory management.” Do you agree? Explain.
2. An item must possess two characteristics to be classified as inventory. What are these two characteristics?
3. 
What is just-in-time inventory management? What are its potential advantages?
4. Your friend Jill Wurtz has been hired to help take the physical inventory in Proehl's Hardware Store. Explain to Jill what this job will entail.
5.
(a) Millar Company ships merchandise to Branyan Corporation on December 30. The merchandise reaches the buyer on January 5. Indicate the terms of sale that will result in the goods being included in (1) Millar's December 31 inventory and (2) Branyan's December 31 inventory.
(b) Under what circumstances should Millar Company include consigned goods in its inventory?
6. Nida Hat Shop received a shipment of hats for which it paid the wholesaler $2,940. The price of the hats was $3,000, but Nida was given a $60 cash discount and required to pay freight charges of $75. What amount should Nida include in inventory? Why?
7. What is the primary basis of accounting for inventories? What is the major objective in accounting for inventories?
8. Stan Koevner believes that the allocation of cost of goods available for sale should be based on the actual physical flow of the goods. Explain to Stan why this may be both impractical and inappropriate.
9. What is the major advantage and major disadvantage of the specific identification method of inventory costing?
10. “The selection of an inventory cost flow method is a decision made by accountants.” Do you agree? Explain. Once a method has been selected, what accounting requirement applies?
11. Which assumed inventory cost flow method:
(a) usually parallels the actual physical flow of merchandise?
(b) divides cost of goods available for sale by total units available for sale to determine a unit cost?
(c) assumes that the latest units purchased are the first to be sold?
12. In a period of rising prices, the inventory reported in Long Company's balance sheet is close to the current cost of the inventory, whereas Windsor Company's inventory is considerably below its current cost. Identify the inventory cost flow method used by each company. Which company probably has been reporting the higher gross profit?
13. Espinosa Corporation has been using the FIFO cost flow method during a prolonged period of inflation. During the same time period, Espinosa has been paying out all of its net income as dividends. What adverse effects may result from this policy?
14. George Orear, a mid-level product manager for Theresa's Shoes, thinks his company should switch from LIFO to FIFO. He says, “My bonus is based on net income. If we switch it will increase net income and increase my bonus. The company would be better off and so would I.” Is he correct? Explain.
15. Discuss the impact the use of LIFO has on taxes paid, cash flows, and the quality of earnings ratio relative to the impact of FIFO when prices are increasing.
16. 
What inventory cost flow method does Tootsie Roll Industries use for U.S. inventories? What method does it use for foreign inventories? (Hint: You will need to examine the notes for Tootsie Roll's financial statements.) Why does it use a different method for foreign inventories?
17. Alison Hinck is studying for the next accounting mid-term examination. What should Alison know about (a) departing from the cost basis of accounting for inventories and (b) the meaning of “market” in the lower-of-cost-or-market method?
18. Rondeli Music Center has five TVs on hand at the balance sheet date that cost $400 each. The current replacement cost is $350 per unit. Under the lower-of-cost-or-market basis of accounting for inventories, what value should Rondeli report for the TVs on the balance sheet? Why?
19. What cost flow assumption may be used under the lower-of-cost-or-market basis of accounting for inventories?
20. Why is it inappropriate for a company to include freight-out expense in the Cost of Goods Sold account?
21. Dipoto Company's balance sheet shows Inventory $162,800. What additional disclosures should be made?
22. Under what circumstances might inventory turnover be too high—that is, what possible negative consequences might occur?
23. What is the LIFO reserve? What are the consequences of ignoring a large LIFO reserve when analyzing a company?
*24. “When perpetual inventory records are kept, the results under the FIFO and LIFO methods are the same as they would be in a periodic inventory system.” Do you agree? Explain.
*25. How does the average-cost method of inventory costing differ between a perpetual inventory system and a periodic inventory system?
*26. Marshall Company discovers in 2014 that its ending inventory at December 31, 2013, was $5,000 understated. What effect will this error have on (a) 2013 net income, (b) 2014 net income, and (c) the combined net income for the 2 years?
Brief Exercises
BE6-1 Tiffee Company identifies the following items for possible inclusion in the physical inventory. Indicate whether each item should be included or excluded from the inventory taking.
(a) 900 units of inventory shipped on consignment by Tiffee to another company.
(b) 3,000 units of inventory in transit from a supplier shipped FOB destination.
(c) 1,200 units of inventory sold but being held for customer pickup.
(d) 500 units of inventory held on consignment from another company.
Compute ending inventory using FIFO and LIFO.
(LO 2), AP
BE6-2 In its first month of operations, Giffin Company made three purchases of merchandise in the following sequence: (1) 300 units at $6, (2) 400 units at $8, and (3) 500 units at $9. Assuming there are 200 units on hand at the end of the period, compute the cost of the ending inventory under (a) the FIFO method and (b) the LIFO method. Giffin uses a periodic inventory system.
Compute the ending inventory using average-cost.
(LO 2), AP
BE6-3 Data for Giffin Company are presented in BE6-2. Compute the cost of the ending inventory under the average-cost method. (Round the cost per unit to three decimal places.)
Explain the financial statement effect of inventory cost flow assumptions.
(LO 3), C
BE6-4 The management of Rosenquist Corp. is considering the effects of various inventory-costing methods on its financial statements and its income tax expense. Assuming that the price the company pays for inventory is increasing, which method will:
(a) provide the highest net income?
(b) provide the highest ending inventory?
(c) result in the lowest income tax expense?
(d) result in the most stable earnings over a number of years?
Explain the financial statement effect of inventory cost flow assumptions.
(LO 3), AP
BE6-5 In its first month of operation, Kuhlman Company purchased 100 units of inventory for $6, then 200 units for $7, and finally 140 units for $8. At the end of the month, 180 units remained. Compute the amount of phantom profit that would result if the company used FIFO rather than LIFO. Explain why this amount is referred to as phantom profit. The company uses the periodic method.
Identify the impact of LIFO versus FIFO.
(LO 3), C
BE6-6 For each of the following cases, state whether the statement is true for LIFO or for FIFO. Assume that prices are rising.
(a) Results in a higher quality of earnings ratio.
(b) Results in higher phantom profits.
(c) Results in higher net income.
(d) Results in lower taxes.
(e) Results in lower net cash provided by operating activities.
Determine the LCM valuation.
(LO 4), AP
BE6-7 Sadowski Video Center accumulates the following cost and market data at December 31.
Compute the lower-of-cost-or-market valuation for Sadowski inventory.
Compute inventory turnover and days in inventory.
(LO 5), AP
BE6-8 Suppose at December 31 of a recent year, the following information (in thousands) was available for sunglasses manufacturer Oakley, Inc.: ending inventory $155,377; beginning inventory $119,035; cost of goods sold $349,114; and sales revenue $761,865. Calculate the inventory turnover and days in inventory for Oakley, Inc.
Determine ending inventory and cost of goods sold using LIFO reserve.
(LO 6), C
BE6-9 Winnebago Industries, Inc. is a leading manufacturer of motor homes. Suppose Winnebago reported ending inventory at August 29, 2014, of $46,850,000 under the LIFO inventory method. In the notes to its financial statements, assume Winnebago reported a LIFO reserve of $30,346,000 at August 29, 2014. What would Winnebago Industries’ ending inventory have been if it had used FIFO?
Apply cost flow methods to perpetual inventory records.
(LO 7), AP
*BE6-10 Hogan's Department Store uses a perpetual inventory system. Data for product E2-D2 include the purchases shown on page 315.
On June 1, Hogan sold 25 units, and on August 27, 30 more units. Compute the cost of goods sold using (a) FIFO, (b) LIFO, and (c) average-cost. (Round the cost per unit to three decimal places.)
Determine correct financial statement amount.
(LO 8), AN
*BE6-11 Nickels Company reports net income of $92,000 in 2014. However, ending inventory was understated by $7,000. What is the correct net income for 2014? What effect, if any, will this error have on total assets as reported in the balance sheet at December 31, 2014?
Do it! Review
Apply rules of ownership to determine inventory cost.
(LO 1), AN
6-1 Dobler Company just took its physical inventory on December 31. The count of inventory items on hand at the company's business locations resulted in a total inventory cost of $300,000. In reviewing the details of the count and related inventory transactions, you have discovered the following items that had not been considered.
- Dobler has sent inventory costing $28,000 on consignment to Phillips Company. All of this inventory was at Phillips's showrooms on December 31.
- The company did not include in the count inventory (cost, $20,000) that was sold on December 28, terms FOB shipping point. The goods were in transit on December 31.
- The company did not include in the count inventory (cost, $13,000) that was purchased with terms of FOB shipping point. The goods were in transit on December 31.
Compute the correct December 31 inventory.
Compute cost of goods sold under different cost flow methods.
(LO 2), AP
6-2 The accounting records of Tuel Electronics show the following data.
Determine cost of goods sold during the period under a periodic inventory system using (a) the FIFO method, (b) the LIFO method, and (c) the average-cost method. (Round unit cost to three decimal places.)
Compute inventory value under LCM.
(LO 4), AP
6-3 Farwell Company sells three different categories of tools (small, medium and large). The cost and market value of its inventory of tools are as follows.
Determine the value of the company's inventory under the lower-of-cost-or-market approach.
Compute inventory turnover and assess inventory level.
(LO 5), AN
6-4 Early in 2014, Defoor Company switched to a just-in-time inventory system. Its sales and inventory amounts for 2013 and 2014 are shown below.
Determine the inventory turnover and days in inventory for 2013 and 2014. Discuss the changes in the amount of inventory, the inventory turnover and days in inventory, and the amount of sales across the two years.
Exercises
E6-1 Columbia Bank and Trust is considering giving Gallup Company a loan. Before doing so, it decides that further discussions with Gallup's accountant may be desirable. One area of particular concern is the Inventory account, which has a year-end balance of $275,000. Discussions with the accountant reveal the following.
- Gallup sold goods costing $55,000 to Bazil Company FOB shipping point on December 28. The goods are not expected to reach Bazil until January 12. The goods were not included in the physical inventory because they were not in the warehouse.
- The physical count of the inventory did not include goods costing $95,000 that were shipped to Gallup FOB destination on December 27 and were still in transit at year-end.
- Gallup received goods costing $25,000 on January 2. The goods were shipped FOB shipping point on December 26 by Lynch Co. The goods were not included in the physical count.
- Gallup sold goods costing $51,000 to Lamey of Canada FOB destination on December 30. The goods were received in Canada on January 8. They were not included in Gallup's physical inventory.
- Gallup received goods costing $42,000 on January 2 that were shipped FOB destination on December 29. The shipment was a rush order that was supposed to arrive December 31. This purchase was included in the ending inventory of $275,000.
Instructions
Determine the correct inventory amount on December 31.
Determine the correct inventory amount.
(LO 1), AN
E6-2 Kevin Farley, an auditor with Koews CPAs, is performing a review of Knight Company's Inventory account. Knight did not have a good year, and top management is under pressure to boost reported income. According to its records, the inventory balance at year-end was $740,000. However, the following information was not considered when determining that amount.
- Included in the company's count were goods with a cost of $228,000 that the company is holding on consignment. The goods belong to Mather Corporation.
- The physical count did not include goods purchased by Knight with a cost of $40,000 that were shipped FOB shipping point on December 28 and did not arrive at Knight's warehouse until January 3.
- Included in the Inventory account was $17,000 of office supplies that were stored in the warehouse and were to be used by the company's supervisors and managers during the coming year.
- The company received an order on December 29 that was boxed and was sitting on the loading dock awaiting pick-up on December 31. The shipper picked up the goods on January 1 and delivered them on January 6. The shipping terms were FOB shipping point. The goods had a selling price of $40,000 and a cost of $29,000. The goods were not included in the count because they were sitting on the dock.
- On December 29, Knight shipped goods with a selling price of $80,000 and a cost of $50,000 to Houchins Sales Corporation FOB shipping point. The goods arrived on January 3. Houchins Sales had only ordered goods with a selling price of $10,000 and a cost of $6,000. However, a sales manager at Knight had authorized the shipment and said that if Houchins wanted to ship the goods back next week, it could.
- Included in the count was $50,000 of goods that were parts for a machine that the company no longer made. Given the high-tech nature of Knight's products, it was unlikely that these obsolete parts had any other use. However, management would prefer to keep them on the books at cost, “since that is what we paid for them, after all.”
Instructions
Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, stating why you did or did not make an adjustment for each item.
Identify items in inventory.
(LO 1), K
E6-3 Mateo Inc. had the following inventory situations to consider at January 31, its year-end.
(a) Goods held on consignment for Schrader Corp. since December 12.
(b) Goods shipped on consignment to Lyman Holdings Inc. on January 5.
(c) Goods shipped to a customer, FOB destination, on January 29 that are still in transit.
(d) Goods shipped to a customer, FOB shipping point, on January 29 that are still in transit.
(e) Goods purchased FOB destination from a supplier on January 25, that are still in transit.
(f) Goods purchased FOB shipping point from a supplier on January 25, that are still in transit.
(g) Office supplies on hand at January 31.
Instructions
Identify which of the preceding items should be included in inventory. If the item should not be included in inventory, state in what account, if any, it should have been recorded.
Compute inventory and cost of goods sold using periodic FIFO and LIFO.
(LO 2), AP
E6-4 Delmott sells a snowboard, Xpert, that is popular with snowboard enthusiasts. Below is information relating to Delmott's purchases of Xpert snowboards during September. During the same month, 102 Xpert snowboards were sold. Delmott uses a periodic inventory system.
Instructions
Compute the ending inventory at September 30 and the cost of goods sold using the FIFO, LIFO, and average-cost methods. (For average-cost, round the average unit cost to three decimal places.) Prove the amount allocated to cost of goods sold under each method.
Calculate inventory and cost of goods sold using FIFO, average-cost, and LIFO in a periodic inventory system.
(LO 2), AP
E6-5 Horne Inc. uses a periodic inventory system. Its records show the following for the month of May, in which 74 units were sold.
Instructions
Calculate the ending inventory at May 31 using the (a) FIFO, (b) LIFO, and (c) average-cost methods. (For average-cost, round the average unit cost to three decimal places.) Prove the amount allocated to cost of goods sold under each method.
Calculate cost of goods sold using specific identification and FIFO periodic.
(LO 2, 3), AN
E6-6 On December 1, Quality Electronics has three DVD players left in stock. All are identical, all are priced to sell at $85. One of the three DVD players left in stock, with serial #1012, was purchased on June 1 at a cost of $52. Another, with serial #1045, was purchased on November 1 for $48. The last player, serial #1056, was purchased on November 30 for $40.
Instructions
(a) Calculate the cost of goods sold using the FIFO periodic inventory method, assuming that two of the three players were sold by the end of December, Quality Electronics’ year-end.
(b) If Quality Electronics used the specific identification method instead of the FIFO method, how might it alter its earnings by “selectively choosing” which particular players to sell to the two customers? What would Quality's cost of goods sold be if the company wished to minimize earnings? Maximize earnings?
(c) Which inventory method, FIFO or specific identification, do you recommend that Quality use? Explain why.
E6-7 Eggers Company reports the following for the month of June.
Instructions
(a) Compute the cost of the ending inventory and the cost of goods sold under (1) FIFO, (2) LIFO, and (3) average-cost. (Round average unit cost to three decimal places).
(b) Which costing method gives the highest ending inventory? The highest cost of goods sold? Why?
(c) How do the average-cost values for ending inventory and cost of goods sold relate to ending inventory and cost of goods sold for FIFO and LIFO?
(d) Explain why the average cost is not $6.
Evaluate impact of LIFO and FIFO on cash flows and earnings quality.
(LO 3), AP
E6-8 The following comparative information is available for Keysor Company for 2014.
Instructions
(a) Determine net income under each approach. Assume a 30% tax rate.
(b) Determine net cash provided by operating activities under each approach. Assume that all sales were on a cash basis and that income taxes and operating expenses, other than depreciation, were on a cash basis.
(c) Calculate the quality of earnings ratio under each approach and explain your findings.
Determine LCM valuation.
(LO 4), AP
E6-9 Birk Camera Shop Inc. uses the lower-of-cost-or-market basis for its inventory. The following data are available at December 31.
Instructions
What amount should be reported on Birk Camera Shop's financial statements, assuming the lower-of-cost-or-market rule is applied?
Compute inventory turnover, days in inventory, and gross profit rate.
(LO 5), AP
E6-10 Suppose this information is available for PepsiCo, Inc. for 2012, 2013, and 2014.
Instructions
Calculate the inventory turnover, days in inventory, and gross profit rate for PepsiCo., Inc. for 2012, 2013, and 2014. Comment on any trends.
Compute inventory turnover and determine the effect of the LIFO reserve on current ratio.
(LO 5, 6), AP
E6-11 Deere & Company is a global manufacturer and distributor of agricultural, construction, and forestry equipment. Suppose it reported the following information in its 2014 annual report.
Instructions
(a) Compute Deere's inventory turnover and days in inventory for 2014.
(b) Compute Deere's current ratio using the 2014 data as presented, and then again after adjusting for the LIFO reserve.
(c) Comment on how ignoring the LIFO reserve might affect your evaluation of Deere's liquidity.
Calculate inventory and cost of goods sold using three cost flow methods in a perpetual inventory system.
(LO 7), AP
*E6-12 Inventory data for Eggers Company are presented in E6-7.
Instructions
(a) Calculate the cost of the ending inventory and the cost of goods sold for each cost flow assumption, using a perpetual inventory system. Assume a sale of 410 units occurred on June 15 for a selling price of $8 and a sale of 50 units on June 27 for $9. (Note: For the moving-average method, round unit cost to three decimal places.)
(b) How do the results differ from E6-7?
(c) Why is the average unit cost not $6 [($5 + $6 + $7) ÷ 3 = $6]?
Apply cost flow methods to perpetual records.
(LO 7), AP
*E6-13 Information about Delmott is presented in E6-4. Additional data regarding the company's sales of Xpert snowboards are provided below. Assume that Delmott uses a perpetual inventory system.
Instructions
Compute ending inventory at September 30 using FIFO, LIFO, and moving-average. (Note: For moving-average, round unit cost to three decimal places.)
Determine effects of inventory errors.
(LO 8), AN
*E6-14 Foyle Hardware reported cost of goods sold as follows.
Foyle made two errors:
- 2013 ending inventory was overstated by $2,000.
- 2014 ending inventory was understated by $5,000.
Instructions
Compute the correct cost of goods sold for each year.
Prepare correct income statements.
(LO 8), AN
*E6-15 Holcomb Company reported these income statement data for a 2-year period.
Holcomb Company uses a periodic inventory system. The inventories at January 1, 2013, and December 31, 2014, are correct. However, the ending inventory at December 31, 2013, is overstated by $8,000.
Instructions
(a) Prepare correct income statement data for the 2 years.
(b) What is the cumulative effect of the inventory error on total gross profit for the 2 years?
(c) 
Explain in a letter to the president of Holcomb Company what has happened—that is, the nature of the error and its effect on the financial statements.
Exercises: Set B and Challenge Exercises
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
Problems: Set A
Determine items and amounts to be recorded in inventory.
(LO 1), AN
P6-1A Aber Limited is trying to determine the value of its ending inventory as of February 28, 2014, the company's year-end. The accountant counted everything that was in the warehouse, as of February 28, which resulted in an ending inventory valuation of $48,000. However, she didn't know how to treat the following transactions so she didn't record them.
(a) On February 26, Aber shipped to a customer goods costing $800. The goods were shipped FOB shipping point, and the receiving report indicates that the customer received the goods on March 2.
(b) On February 26, Landis Inc. shipped goods to Aber FOB destination. The invoice price was $350 plus $25 for freight. The receiving report indicates that the goods were received by Aber on March 2.
(c) Aber had $500 of inventory at a customer's warehouse “on approval.” The customer was going to let Aber know whether it wanted the merchandise by the end of the week, March 4.
(d) Aber also had $400 of inventory at a Newten craft shop, on consignment from Aber.
(e) On February 26, Aber ordered goods costing $750. The goods were shipped FOB shipping point on February 27. Aber received the goods on March 1.
(f) On February 28, Aber packaged goods and had them ready for shipping to a customer FOB destination. The invoice price was $350 plus $25 for freight; the cost of the items was $280. The receiving report indicates that the goods were received by the customer on March 2.
(g) Aber had damaged goods set aside in the warehouse because they are no longer saleable. These goods originally cost $400 and, originally, Aber expected to sell these items for $600.
Instructions
For each of the above transactions, specify whether the item in question should be included in ending inventory, and if so, at what amount. For each item that is not included in ending inventory, indicate who owns it and what account, if any, it should have been recorded in.
Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost with analysis.
(LO 2, 3), AP
P6-2A Dunbar Distribution markets CDs of numerous performing artists. At the beginning of March, Dunbar had in beginning inventory 2,500 CDs with a unit cost of $7. During March, Dunbar made the following purchases of CDs.
During March 12,000 units were sold. Dunbar uses a periodic inventory system.
Instructions
(a) Determine the cost of goods available for sale.
(b) Determine (1) the ending inventory and (2) the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods. (Note: For average-cost, round cost per unit to three decimal places.)
(c) Which cost flow method results in (1) the highest inventory amount for the balance sheet and (2) the highest cost of goods sold for the income statement?
Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost in a periodic inventory system and assess financial statement effects.
(LO 2, 3), AP
P6-3A Groves Company Inc. had a beginning inventory of 100 units of Product MLN at a cost of $8 per unit. During the year, purchases were:
Groves Company uses a periodic inventory system. Sales totaled 1,500 units.
Instructions
(a) Determine the cost of goods available for sale.
(b) Determine the ending inventory and the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods. (Round average unit cost to three decimal places.)
(c) Which cost flow method results in the lowest inventory amount for the balance sheet? The lowest cost of goods sold for the income statement?
Compute ending inventory, prepare income statements, and answer questions using FIFO and LIFO.
(LO 2, 3), AN
P6-4A The management of Tinker Inc. asks your help in determining the comparative effects of the FIFO and LIFO inventory cost flow methods. For 2014, the accounting records show these data.
Units purchased consisted of 35,000 units at $3.70 on May 10; 60,000 units at $3.90 on August 15; and 25,000 units at $4.20 on November 20. Income taxes are 28%.
Instructions
(a) Prepare comparative condensed income statements for 2014 under FIFO and LIFO. (Show computations of ending inventory.)
(b) Answer the following questions for management in the form of a business letter.
(1) Which inventory cost flow method produces the inventory amount that most closely approximates the amount that would have to be paid to replace the inventory? Why?
(2) Which inventory cost flow method produces the net income amount that is a more likely indicator of next period's net income? Why?
(3) Which inventory cost flow method is most likely to approximate the actual physical flow of the goods? Why?
(4) How much more cash will be available under LIFO than under FIFO? Why?
(5) How much of the gross profit under FIFO is illusionary in comparison with the gross profit under LIFO?
Calculate ending inventory, cost of goods sold, gross profit, and gross profit rate under periodic method; compare results.
(LO 2, 3), AP
P6-5A You have the following information for Vincent Inc. for the month ended October 31, 2014. Vincent uses a periodic method for inventory.
Instructions
(a) Calculate (i) ending inventory, (ii) cost of goods sold, (iii) gross profit, and (iv) gross profit rate under each of the following methods.
(1) LIFO.
(2) FIFO.
(3) Average-cost. (Round cost per unit to three decimal places.)
(b) Compare results for the three cost flow assumptions.
Compare specific identification, FIFO, and LIFO under periodic method; use cost flow assumption to influence earnings.
(LO 2, 3), AP
P6-6A You have the following information for Wooderson Gems. Wooderson uses the periodic method of accounting for its inventory transactions. Wooderson only carries one brand and size of diamonds—all are identical. Each batch of diamonds purchased is carefully coded and marked with its purchase cost.
| March 1 | Beginning inventory 150 diamonds at a cost of $310 per diamond. |
| March 3 | Purchased 200 diamonds at a cost of $350 each. |
| March 5 | Sold 180 diamonds for $600 each. |
| March 10 | Purchased 330 diamonds at a cost of $375 each. |
| March 25 | Sold 390 diamonds for $650 each. |
Instructions
(a) Assume that Wooderson Gems uses the specific identification cost flow method.
(1) Demonstrate how Wooderson could maximize its gross profit for the month by specifically selecting which diamonds to sell on March 5 and March 25.
(2) Demonstrate how Wooderson could minimize its gross profit for the month by selecting which diamonds to sell on March 5 and March 25.
(b) Assume that Wooderson uses the FIFO cost flow assumption. Calculate cost of goods sold. How much gross profit would Wooderson report under this cost flow assumption?
(c) Assume that Wooderson uses the LIFO cost flow assumption. Calculate cost of goods sold. How much gross profit would the company report under this cost flow assumption?
(d) Which cost flow method should Wooderson Gems select? Explain.
Compute inventory turnover and days in inventory; compute current ratio based on LIFO and after adjusting for LIFO reserve.
(LO 5, 6), AP
P6-7A Suppose this information (in millions) is available for the Automotive and Other Operations Divisions of General Motors Corporation for a recent year. General Motors uses the LIFO inventory method.
Instructions
(a) Calculate the inventory turnover and days in inventory.
(b) Calculate the current ratio based on inventory as reported using LIFO.
(c) Calculate the current ratio after adjusting for the LIFO reserve.
(d) Comment on any difference between parts (b) and (c).
Calculate cost of goods sold, ending inventory, and gross profit for LIFO, FIFO, and moving-average under the perpetual system; compare results.
(LO 3, 7), AP
*P6-8A Pember Inc. is a retailer operating in Edmonton, Alberta. Pember uses the perpetual inventory method. Assume that there are no credit transactions; all amounts are settled in cash. You are provided with the following information for Pember Inc. for the month of January 2014.
Instructions
(a) For each of the following cost flow assumptions, calculate (i) cost of goods sold, (ii) ending inventory, and (iii) gross profit.
(1) LIFO.
(2) FIFO.
(3) Moving-average. (Round cost per unit to three decimal places.)
(b) Compare results for the three cost flow assumptions.
*P6-9A Lambert Center began operations on July 1. It uses a perpetual inventory system. During July, the company had the following purchases and sales.
Instructions
(a) Determine the ending inventory under a perpetual inventory system using (1) FIFO, (2) moving-average (round unit cost to three decimal places), and (3) LIFO.
(b) Which costing method produces the highest ending inventory valuation?
Problems: Set B
Determine items and amounts to be recorded in inventory.
(LO 1), AN
P6-1B Sun Company is trying to determine the value of its ending inventory as of March 31, 2014, the company's year-end. The following transactions occurred, and the accountant asked your help in determining whether they should be recorded or not.
(a) On March 30, Sun shipped to a customer goods costing $1,000. The goods were shipped FOB destination, and the receiving report indicates that the customer received the goods on April 1.
(b) On March 28, Wholesale Inc. shipped goods to Sun FOB shipping point. The invoice price was $600 plus $20 for freight. The receiving report indicates that the goods were received by Sun on April 2.
(c) Sun had $750 of consigned goods from Frederick Inc.
(d) Sun had $380 of inventory at Stephen's Variety, on consignment from Sun.
(e) On March 29, Sun ordered goods costing $640. The goods were shipped FOB destination on March 31. Sun received the goods on April 3.
(f) A customer returned goods to Sun on March 31. Upon inspection, the goods were found to be undamaged and were accepted as returned goods. These goods originally cost $400 and Sun sold them for $640.
Instructions
For each of the above transactions, specify whether the item in question should be included in ending inventory, and if so, at what amount. For each item that is not included in ending inventory, indicate who owns it and what account, if any, it should have been recorded in.
Determine cost of goods sold and ending inventory using FIFO, LIFO, and average cost, with analysis.
(LO 2, 3), AP
P6-2B Lifetime Distribution markets classic children's books. At the beginning of June, Lifetime had in beginning inventory 1,200 books with a unit cost of $3. During June, Lifetime made the following purchases of books.
During June, 10,500 books were sold. Lifetime uses a periodic inventory system.
Instructions
(a) Determine the cost of goods available for sale.
(b) Determine (1) the ending inventory and (2) the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods. (Note: For average-cost, round cost per unit to three decimal places.)
(c) Which cost flow method results in (1) the highest inventory amount for the balance sheet and (2) the highest cost of goods sold for the income statement?
Determine cost of goods sold and ending inventory using FIFO, LIFO, and average-cost in a periodic inventory system and assess financial statement effects.
(LO 2, 3), AP
P6-3B Smythe Company Inc. had a beginning inventory of 200 units of Product ERV at a cost of $6 per unit. During the year, purchases were:
Smythe Company uses a periodic inventory system. Sales totaled 1,900 units.
Instructions
(a) Determine the cost of goods available for sale.
(b) Determine the ending inventory and the cost of goods sold under each of the assumed cost flow methods (FIFO, LIFO, and average-cost). Prove the accuracy of the cost of goods sold under the FIFO and LIFO methods. (Round average unit cost to three decimal places.)
(c) Which cost flow method results in the lowest inventory amount for the balance sheet? The lowest cost of goods sold for the income statement?
Compute ending inventory, prepare income statements, and answer questions using FIFO and LIFO.
(LO 2, 3), AN
P6-4B The management of Weigel Inc. asks your help in determining the comparative effects of the FIFO and LIFO inventory cost flow methods. For 2014 the accounting records show these data.
Units purchased consisted of 35,000 units at $4.21 on March 20; 65,000 units at $4.60 on July 24; and 5,000 units at $4.83 on December 12. Income taxes are 30%.
Instructions
(a) Prepare comparative condensed income statements for 2014 under FIFO and LIFO. (Show computations of ending inventory.)
(b) Answer the following questions for management in the form of a business letter.
(1) Which inventory cost flow method produces the most meaningful inventory amount for the balance sheet? Why?
(2) Which inventory cost flow method produces the most meaningful net income? Why?
(3) Which inventory cost flow method is most likely to approximate the actual physical flow of the goods? Why?
(4) How much more cash will be available under LIFO than under FIFO? Why?
(5) How much of the gross profit under FIFO is illusionary in comparison with the gross profit under LIFO?
Calculate ending inventory, cost of goods sold, gross profit, and gross profit rate under periodic method; compare results.
(LO 2, 3), AP
P6-5B You have the following information for Crystal Inc. for the month ended May 31, 2014. Crystal uses a periodic method for inventory.
Instructions
(a) Calculate (i) ending inventory, (ii) cost of goods sold, (iii) gross profit, and (iv) gross profit rate under each of the following methods.
(1) LIFO.
(2) FIFO.
(3) Average-cost. (Round cost per unit to three decimal places.)
(b) Compare results for the three cost flow assumptions.
Compare specific identification, FIFO, and LIFO under periodic method; use cost flow assumption to influence earnings.
(LO 2, 3), AP
P6-6B You have the following information for Limex Watches. Limex uses the periodic method of accounting for its inventory transactions. Limex carries only one brand of hand-crafted jeweled watches—all are identical. Each batch of watches purchased is carefully coded and marked with its purchase cost.
Instructions
(a) Assume that Limex uses the specific identification cost flow method.
(1) Demonstrate how Limex could maximize its gross profit for the month by specifically selecting which watches to sell on July 5 and July 28.
(2) Demonstrate how Limex could minimize its gross profit for the month by selecting which watches to sell on July 5 and July 28.
(b) Assume that Limex uses the FIFO cost flow assumption. Calculate cost of goods sold. How much gross profit would Limex report under this cost flow assumption?
(c) Assume that Limex uses the LIFO cost flow assumption. Calculate cost of goods sold. How much gross profit would the company report under this cost flow assumption?
(d) Which cost flow method should Limex Watches select? Explain.
Compute inventory turnover and days in inventory; compute current ratio based on LIFO and after adjusting for LIFO reserve.
(LO 5, 6), AP
P6-7B Suppose this information is available for the Automotive Sector of NoGo Motor Company for 2014. NoGo uses the LIFO inventory method.
Instructions
(a) Calculate the inventory turnover and days in inventory.
(b) Calculate the current ratio based on inventory as reported using LIFO.
(c) Calculate the current ratio after adjusting for the LIFO reserve.
(d) Comment on any difference between parts (b) and (c).
Calculate cost of goods sold, ending inventory, and gross profit for LIFO, FIFO, and moving-average under the perpetual system; compare results.
(LO 3, 7), AP
*P6-8B Liberty Inc. is a retailer operating in Centralia. Liberty uses the perpetual inventory method. All sales returns from customers result in the goods being returned to inventory. (Assume that the inventory is not damaged.) Assume that there are no credit transactions; all amounts are settled in cash. You are provided with the following information for Liberty Inc. for the month of January 2014.
Instructions
(a) For each of the following cost flow assumptions, calculate (i) cost of goods sold, (ii) ending inventory, and (iii) gross profit.
(1) LIFO.
(2) FIFO.
(3) Moving-average. (Round cost per unit to three decimal places.)
(b) Compare results for the three cost flow assumptions.
Determine ending inventory under a perpetual inventory system.
(LO 3, 7), AP
*P6-9B Shiraz Rugs began operations on February 1. It uses a perpetual inventory system. During February, the company had the following purchases and sales.
Instructions
(a) Determine the ending inventory under a perpetual inventory system using (1) FIFO, (2) moving-average (round unit cost to three decimal places), and (3) LIFO.
(b) Which costing method produces the highest ending inventory valuation?
Problems: Set C
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problem Set C.
Comprehensive Problem
CP6 On December 1, 2014, Harrisen Company had the account balances shown below.
The following transactions occurred during December.
| Dec. 3 | Purchased 4,000 units of inventory on account at a cost of $0.72 per unit. |
| 5 | Sold 4,400 units of inventory on account for $0.90 per unit. (It sold 3,000 of the $0.60 units and 1,400 of the $0.72.) |
| 7 | Granted the December 5 customer $180 credit for 200 units of inventory returned costing $150. These units were returned to inventory. |
| 17 | Purchased 2,200 units of inventory for cash at $0.80 each. |
| 22 | Sold 2,000 units of inventory on account for $0.95 per unit. (It sold 2,000 of the $0.72 units.) |
Adjustment data:
- Accrued salaries and wages payable $400.
- Depreciation on equipment $200 per month.
- Income tax expense was $215, to be paid next year.
Instructions
(a) Journalize the December transactions and adjusting entries, assuming Harrisen uses the perpetual inventory method.
(b) Enter the December 1 balances in the ledger T-accounts and post the December transactions. In addition to the accounts mentioned above, use the following additional accounts: Income Taxes Payable, Salaries and Wages Payable, Sales Revenue, Sales Returns and Allowances, Cost of Goods Sold, Depreciation Expense, Salaries and Wages Expense, and Income Tax Expense.
(c) Prepare an adjusted trial balance as of December 31, 2014.
(d) Prepare an income statement for December 2014 and a classified balance sheet at December 31, 2014.
(e) Compute ending inventory and cost of goods sold under FIFO, assuming Harrisen Company uses the periodic inventory system.
(f) Compute ending inventory and cost of goods sold under LIFO, assuming Harrisen Company uses the periodic inventory system.
Continuing Cookie Chronicle
(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 5.)
CCC6 Natalie is busy establishing both divisions of her business (cookie classes and mixer sales) and completing her business degree. Her goals for the next 11 months are to sell one mixer per month and to give two to three classes per week. Natalie has decided to use a periodic inventory system and now must choose a cost flow assumption for her mixer inventory.
Go to the book's companion website, at www.wiley.com/college/kimmel, to see the completion of this problem.
Broadening Your Perspective
Financial Reporting and Analysis
FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries, Inc.
BYP6-1 The notes that accompany a company's financial statements provide informative details that would clutter the amounts and descriptions presented in the statements. Refer to the financial statements of Tootsie Roll and the accompanying Notes to Consolidated Financial Statements in Appendix A.
Instructions
Answer the following questions. (Give the amounts in thousands of dollars, as shown in Tootsie Roll's annual report.)
(a) What did Tootsie Roll report for the amount of inventories in its Consolidated Balance Sheet at December 31, 2011? At December 31, 2010?
(b) Compute the dollar amount of change and the percentage change in inventories between 2010 and 2011. Compute inventory as a percentage of current assets for 2011.
(c) What are the (product) cost of goods sold reported by Tootsie Roll for 2011, 2010, and 2009? Compute the ratio of (product) cost of goods sold to net (product) sales in 2011.
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey
BYP6-2 The financial statements of The Hershey Company appear in Appendix B, following the financial statements for Tootsie Roll in Appendix A.
Instructions
(a) Based on the information in the financial statements, compute these 2011 values for each company. (Do not adjust for the LIFO reserve.)
(1) Inventory turnover. (Use product cost of goods sold and total inventory.)
(2) Days in inventory.
(b) What conclusions concerning the management of the inventory can you draw from these data?
RESEARCH CASE
BYP6-3 The July 15, 2010, edition of CFO.com contains an article by Marie Leone entitled “Sucking the LIFO out of Inventory.”
Instructions
Read the article, which can be found at www.cfo.com/printable/article.cfm/14508745, and answer the following questions.
(a) What type of company benefits most from the use of LIFO?
(b) What is the estimated boost in federal tax receipts over 10 years if the use of LIFO for taxes was not allowed?
(c) If the United States decides to adopt International Financial Reporting Standards (IFRS), what would be the implications for IFRS?
(d) What conceptual justification for LIFO do its proponents provide?
(e) What types of companies prefer to use FIFO?
INTERPRETING FINANCIAL STATEMENTS
BYP6-4 Suppose the following information is from the 2014 annual report of American Greetings Corporation (all dollars in thousands).
The notes to the company's financial statements also include the following information.
Finished products, work in process, and raw material inventories are carried at the lower-of-cost-or-market. The last-in, first-out (LIFO) cost method is used for approximately 75% of the domestic inventories in 2014 and approximately 70% in 2013. The foreign subsidiaries principally use the first-in, first-out (FIFO) method. Display material and factory supplies are carried at average-cost.
Instructions
(a) Define each of the following: finished goods, work in process, and raw materials.
(b) What might be a possible explanation for why the company uses FIFO for its nondomestic inventories?
(c) Calculate the company's inventory turnover and days in inventory for 2013 and 2014. (2012 inventory was $182,618.) Discuss the implications of any change in the ratios.
(d) What percentage of total inventory does the 2014 LIFO reserve represent? If the company used FIFO in 2014, what would be the value of its inventory? Do you consider this difference a “material” amount from the perspective of an analyst? Which value accurately represents the value of the company's inventory?
(e) Calculate the company's 2014 current ratio with the numbers as reported, then recalculate after adjusting for the LIFO reserve.
REAL-WORLD FOCUS
BYP6-5 Purpose: Use SEC filings to learn about a company's inventory accounting practices.
Address: http://biz.yahoo.com/p/_capgds-bldmch.html, or go to www.wiley.com/college/kimmel
Steps
- Go to this site and click on the name of an equipment manufacturer other than those discussed in the chapter.
- Click on SEC filings.
- Under “Recent filings” choose Form 10K (annual report) and click on Full Filing at Edgar Online.
- Choose option “3,” Online HTML Version.
If the 10K is not listed among the recent filings, then click on View All Filings on EDGAR Online.
Instructions
Review the 10K to answer the following questions.
(a) What is the name of the company?
(b) How has its inventory changed from the previous year?
(c) What is the amount of raw materials, work in process, and finished goods inventory?
(d) What inventory method does the company use?
(e) Calculate the inventory turnover and days in inventory for the current year.
(f) If the company uses LIFO, what was the amount of its LIFO reserve?
Critical Thinking
DECISION-MAKING ACROSS THE ORGANIZATION
BYP6-6 Heineken Electronics has enjoyed tremendous sales growth during the last 10 years. However, even though sales have steadily increased, the company's CEO, Beth Dains, is concerned about certain aspects of its performance. She has called a meeting with the corporate controller and the vice presidents of finance, operations, sales, and marketing to discuss the company's performance. Beth begins the meeting by making the following observations:
We have been forced to take significant write-downs on inventory during each of the last three years because of obsolescence. In addition, inventory storage costs have soared. We rent four additional warehouses to store our increasingly diverse inventory. Five years ago inventory represented only 20% of the value of our total assets. It now exceeds 35%. Yet, even with all of this inventory, “stockouts” (measured by complaints by customers that the desired product is not available) have increased by 40% during the last three years. And worse yet, it seems that we constantly must discount merchandise that we have too much of.
Beth asks the group to review the following data and make suggestions as to how the company's performance might be improved.
Instructions
Using the information provided, answer the following questions.
(a) Compute the current ratio, gross profit rate, profit margin, inventory turnover, and days in inventory for 2012, 2013, and 2014.
(b) Discuss the trends and potential causes of the changes in the ratios in part (a).
(c) Discuss potential remedies to any problems discussed in part (b).
(d) What concerns might be raised by some members of management with regard to your suggestions in part (c)?
COMMUNICATION ACTIVITIES
BYP6-7 In a discussion of dramatic increases in coffee-bean prices, a Wall Street Journal article noted the following fact about Starbucks.
Before this year's bean-price hike, Starbucks added several defenses that analysts say could help it maintain earnings and revenue. The company last year began accounting for its coffee-bean purchases by taking the average price of all beans in inventory.
Prior to this change, the company was using FIFO.
Instructions
Your client, the CEO of Supreme Coffee, Inc., read this article and sent you an e-mail message requesting that you explain why Starbucks might have taken this action. Your response should explain what impact this change in accounting method has on earnings, why the company might want to do this, and any possible disadvantages of such a change.
*BYP6-8 You are the controller of Fagan Inc. K. L. Howard, the president, recently mentioned to you that she found an error in the 2013 financial statements which she believes has corrected itself. She determined, in discussions with the purchasing department, that 2013 ending inventory was overstated by $1 million. K. L. says that the 2014 ending inventory is correct, and she assumes that 2014 income is correct. K. L. says to you, “What happened has happened—there's no point in worrying about it anymore.”
Instructions
You conclude that K. L. is incorrect. Write a brief, tactful memo to her, clarifying the situation.
ETHICS CASE
BYP6-9 Reagen Wholesale Corp. uses the LIFO cost flow method. In the current year, profit at Reagen is running unusually high. The corporate tax rate is also high this year, but it is scheduled to decline significantly next year. In an effort to lower the current year's net income and to take advantage of the changing income tax rate, the president of Reagen Wholesale instructs the plant accountant to recommend to the purchasing department a large purchase of inventory for delivery 3 days before the end of the year. The price of the inventory to be purchased has doubled during the year, and the purchase will represent a major portion of the ending inventory value.
Instructions
(a) What is the effect of this transaction on this year's and next year's income statement and income tax expense? Why?
(b) If Reagen Wholesale had been using the FIFO method of inventory costing, would the president give the same directive?
(c) Should the plant accountant order the inventory purchase to lower income? What are the ethical implications of this order?
ALL ABOUT YOU
BYP6-10 Some of the largest business frauds ever perpetrated have involved the misstatement of inventory. Two classics were at Leslie Fay and McKesson Corporation.
Instructions
There is considerable information regarding inventory frauds available on the Internet. Search for information about one of the two cases mentioned above, or inventory fraud at any other company, and prepare a short explanation of the nature of the inventory fraud.
FASB CODIFICATION ACTIVITY
BYP6-11 If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following.
(a) The primary basis for accounting for inventories is cost. How is cost defined in the Codification?
(b) What does the Codification state regarding the use of consistency in the selection or employment of a basis for inventory?
(c) What does the Codification indicate is a justification for the use of the lower-of-cost-or-market for inventory valuation?
CONSIDERING PEOPLE, PLANET, AND PROFIT
BYP6-12 Caterpillar publishes an annual Sustainability Report to explain its position on sustainability, describe its goals, and report on its achievements. The report can be found at http://www.caterpillar.com/sustainability/sustainability-report.
Instructions
Access the report and answer the following questions.
(a) Page 24 of the report describes Caterpillar's efforts in the area of coke oven gas. Read this section and discuss how the company's efforts address both sustainability and profitability.
(b) Page 43 describes the company's goals for the year 2020. What are these goals?
(c) Page 44 describes the company's results relative to 2003 with regard to worker safety. Summarize the company's progress in this area.
(d) Page 48 describes the company's results regarding energy use. Explain how the company measures its progress, and comment on its results thus far.
Answers to Insight and Accounting Across the Organization Questions
p. 285 A Big Hiccup Q: What steps might the companies take to avoid such a serious disruption in the future? A: The manufacturer of the piston rings should spread its manufacturing facilities across a few locations that are far enough apart that they would not all be at risk at once. In addition, the automakers might consider becoming less dependent on a single supplier as well as having weather contingency plans.
p. 286 Falsifying Inventory to Boost Income Q: What effect does an overstatement of inventory have on a company's financial statements? A: The balance sheet looks stronger because inventory and retained earnings are overstated. The income statement looks better because cost of goods sold is understated and income is overstated.
p. 296 Is LIFO Fair? Q: What are the arguments for and against the use of LIFO? A: Proponents of LIFO argue that it is conceptually superior because it matches the most recent cost with the most recent selling price. Critics contend that it artificially understates the company's net income and consequently reduces tax payments. Also, because most foreign companies are not allowed to use LIFO, its use by U.S. companies reduces the ability of investors to compare U.S. companies with foreign companies.
p. 300 Too Many TVs or Too Few? Q: For Sony, what are the advantages and disadvantages of having a low days in inventory measure? A: If Sony has a low days in inventory, it reduces the amount of cash it has tied up in inventory. It also minimizes the risk that it will be stuck with excess inventory that could force it to provide big discounts, resulting in punishing losses. Sony also faces the risk that the TVs will become obsolete before they are sold. However, Sony increases the risk that it will encounter “stockouts,” that is, it will not have adequate inventory to meet customer demand.
Answers to Self-Test Questions
- d
- a
- b ($180,000 + $35,000)
- c ((5,000 × $13) + (4,000 × $12))
- d ((8,000 × $11) + (1,000 × $12))
- d ((5,000 × $8) + (15,000 × $10) + (20,000 × $12)) ÷ 40,000 = $10.75; $10.75 × 7,000
- c
- d
- a
- d
- b ($285,000 ÷ (($80,000 + $110,000) ÷ 2) = 3; 365 ÷ 3)
- a
- *d
- *b
- *b
A Look at IFRS
LEARNING OBJECTIVE 9
Compare the accounting procedures for inventories under GAAP and IFRS.
The major IFRS requirements related to accounting and reporting for inventories are the same as GAAP. The major differences are that IFRS prohibits the use of the LIFO cost flow assumption and determines market in the lower-of-cost-or-market inventory valuation differently.
KEY POINTS
- The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.
- The definitions for inventory are essentially similar under IFRS and GAAP. Both define inventory as assets held-for-sale in the ordinary course of business, in the process of production for sale (work in process), or to be consumed in the production of goods or services (e.g., raw materials).
- Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory, are accounted for the same under IFRS and GAAP.
- Both GAAP and IFRS permit specific identification where appropriate. IFRS actually requires that the specific identification method be used where the inventory items are not interchangeable (i.e., can be specifically identified). If the inventory items are not specifically identifiable, a cost flow assumption is used. GAAP does not specify situations in which specific identification must be used.
- A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS.
- IFRS requires companies to use the same cost flow assumption for all goods of a similar nature. GAAP has no specific requirement in this area.
- In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and estimated selling expenses. In other words, net realizable value is the best estimate of the net amounts that inventories are expected to realize. GAAP, on the other hand, defines market as essentially replacement cost.
- Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new value becomes its cost basis. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement as an expense. An item-by-item approach is generally followed under IFRS.
- An example of the use of lower-of-cost-or-net realizable value under IFRS follows.
Mendel Company has the following four items in its ending inventory as of December 31, 2014. The company uses the lower-of-cost-or-net realizable value approach for inventory valuation following IFRS.
The computation of the ending inventory value to be reported in the financial statements at December 31, 2014, is as follows.
- Unlike property, plant, and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost.
- Similar to GAAP, certain agricultural products and mineral products can be reported at net realizable value using IFRS.
- IFRS allows companies to report inventory at standard cost if it does not differ significantly from actual cost. Standard cost is addressed in managerial accounting courses.
LOOKING TO THE FUTURE
One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.
With a new conceptual framework being developed, it is highly probable that the use of the concept of conservatism will be eliminated. Similarly, the concept of “prudence” in the IASB literature will also be eliminated. This may ultimately have implications for the application of the lower-of-cost-or-net realizable value.
IFRS PRACTICE
IFRS SELF-TEST QUESTIONS
- Which of the following should not be included in the inventory of a company using IFRS?
(a) Goods held on consignment from another company.
(b) Goods shipped on consignment to another company.
(c) Goods in transit from another company shipped FOB shipping point.
(d) None of the above.
- Which method of inventory costing is prohibited under IFRS?
(a) Specific identification.
(b) LIFO.
(c) FIFO.
(d) Average-cost.
- Yang Company purchased 2,000 phones and has 400 phones in its ending inventory at a cost of $90 each and a current replacement cost of $80 each. The net realizable value of each phone in the ending inventory is $70. The ending inventory under lower-of-cost-or-net realizable value is:
(a) $36,000.
(b) $32,000.
(c) $28,000.
(d) None of the above.
- Specific identification:
(a) must be used under IFRS if the inventory items are not interchangeable.
(b) cannot be used under IFRS.
(c) cannot be used under GAAP.
(d) must be used under IFRS if it would result in the most conservative net income.
- IFRS requires the following:
(a) Ending inventory is written up and down to net realizable value each reporting period.
(b) Ending inventory is written down to net realizable value but cannot be written up.
(c) Ending inventory is written down to net realizable value and may be written up in future periods to its net realizable value but not above its original cost.
(d) Ending inventory is written down to net realizable value and may be written up in future periods to its net realizable value.
IFRS CONCEPTS AND APPLICATION
IFRS6-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for inventories.
IFRS6-2 LaTour Inc. is based in France and prepares its financial statements in accordance with IFRS. In 2014, it reported cost of goods sold (in euros) of €578 million and average inventory of €154 million. Briefly discuss how analysis of LaTour's inventory turnover (and comparisons to a company using GAAP) might be affected by differences in inventory accounting between IFRS and GAAP.
IFRS6-3 Franklin Company has the following four items in its ending inventory as of December 31, 2014. The company uses the lower-of-cost-or-net realizable value approach for inventory valuation following IFRS.
Compute the lower-of-cost-or-net realizable value.
INTERNATIONAL FINANCIAL REPORTING PROBLEM: Zetar plc
IFRS6-4 The financial statements of Zetar plc are presented in Appendix C. The company's complete annual report, including the notes to its financial statements, is available in the Investors section at www.zetarplc.com.
Instructions
Using the notes to the company's financial statements, answer the following questions.
(a) What cost flow assumption does the company use to value inventory?
(b) What was the amount of expense that the company reported for inventory write-downs during 2011?
(c) What amount of raw materials, work in process, and finished goods inventory did the company report at April 30, 2011?
Answers to IFRS Self-Test Questions
- a
- b
- c
- a
- c
Remember to go back to The Navigator box on the chapter opening page and check off your completed work.
1Also, some companies use a perpetual system to keep track of units, but they do not make an entry for perpetual cost of goods sold. In addition, firms that employ LIFO tend to use dollar-value LIFO, a method discussed in upper-level courses. FIFO periodic and FIFO perpetual give the same result. Therefore, firms should not incur the additional cost to use FIFO perpetual. Few firms use perpetual average-cost because of the added cost of record-keeping. Finally, for instructional purposes, we believe it is easier to demonstrate the cost flow assumptions under the periodic system, which makes it more pedagogically appropriate.
2The LIFO reserve also affects cost of goods sold although typically by a much less material amount. The cost of goods sold adjustment is discussed in more advanced financial statement analysis texts.