INVENTORIES, DISCUSSION QUESTIONS

Transcription

1 INVENTORIES, DISCUSSION QUESTIONS Cristina Maslach Zampetakis Laschinger 1. The receiving report should be reconciled to the initial purchase order and the vendor s invoice before recording or paying for inventory purchases. This procedure will verify that the inventory received matches the type and quantity of inventory ordered. It also verifies that the vendor s invoice is charging the company for the actual quantity of inventory received at the agreed-upon price. 2. A physical inventory should be taken periodically to test the accuracy of the perpetual records. In addition, a physical inventory will identify inventory shortages or shrinkage. 3. No, they are not techniques for determining physical quantities. The terms refer to cost flow assumptions, which affect the determination of the cost prices assigned to items in the inventory. 4. a. LIFO c. LIFO b. FIFO d. FIFO 5. FIFO 6. LIFO. In periods of rising prices, the use of LIFO will result in the lowest net income and thus the lowest income tax expense. 7. Net realizable value (estimated selling price less any direct cost of disposition, such as sales commissions). 8. a. Gross profit for the year was understated by $23,950. b. Merchandise inventory and owner s equity were understated by $23, Mistletoe Company. Since the merchandise was shipped FOB shipping point, title passed to Mistletoe Company when it was shipped and should be reported in Mistletoe Company s financial statements at October 31, the end of the fiscal year. 10. Manufacturer s; The manufacturer retains title until the goods are sold. Thus, any unsold merchandise at the end of the year is part of the manufacturer s (consignor s) inventory, even though the merchandise is in the hands of the retailer (consignee). 320

2 PRACTICE EXERCISES PE 7 1A Gross Profit Ending Inventory July July 31 a. First-in, first-out (FIFO) $65 ($225 $160) $344 ($168 + $176) b. Last-in, first-out (LIFO) $49 ($225 $176) $328 ($160 + $168) c. Average cost $57 ($225 $168) $336 ($168 2) PE 7 1B Gross Profit Ending Inventory April April 30 a. First-in, first-out (FIFO) $19 ($29 $10) $26 ($12 + $14) b. Last-in, first-out (LIFO) $15 ($29 $14) $22 ($10 + $12) c. Average cost $17 ($29 $12) $24 ($12 2) PE 7 2A a. of merchandise sold (August 28): 20 $80 $ 1,600 5 $ $2,025 b. Inventory, August 31: $2,975 = 35 units $85 PE 7 2B a. of merchandise sold (March 24): 12 $15 $ $18 1, $1,

3 b. Inventory, March 31: $1,116 = 62 units $18 PE 7 3A a. of merchandise sold (November 26): $5,040 = (84 units $60) b. Inventory, November 30: 18 $50 $ $ $1,860 PE 7 3B a. of merchandise sold (January 27): $1,440 = (80 units $18) b. Inventory, January 31: 15 $17 $ $ $1,065 PE 7 4A a. First-in, first-out (FIFO) method: $594 = 11 units $54 b. Last-in, first-out (LIFO) method: $495 = 11 units $45 c. Average cost method: $550 (11 units $50), where average cost = $50 = $2,250/45 units PE 7 4B 322

4 a. First-in, first-out (FIFO) method: $2,722 = (20 units $119) + (3 units $114) b. Last-in, first-out (LIFO) method: $2,682 = (10 units $120) + (13 units $114) c. Average cost method: $2,645 (23 units $115), where average cost = $115 = $18,400/160 units PE 7 5A A B C D E F G 1 2 Inventory Market Lower 3 Commodity Quantity Price Price Market of C or M 4 IA $40 $38 $ 8,000 $ 7,600 $ 7,600 5 TX ,250 9,000 8,250 6 $16,250 $16,600 $15,850 PE 7 5B A B C D E F G 1 2 Inventory Market Lower 3 Commodity Quantity Price Price Market of C or M 4 MT22 1,500 $ 7 $ 4 $10,500 $ 6,000 $ 6,000 5 WY ,800 22,500 19,800 6 $30,300 $28,500 $25,800 PE 7 6A 323 Amount of Misstatement Overstatement (Understatement) Balance Sheet: Merchandise inventory understated*... $(7,525) Current assets understated... (7,525) assets understated... (7,525) Owner s equity understated... (7,525)

5 Income Statement: of merchandise sold overstated... $ 7,525 Gross profit understated... (7,525) Net income understated... (7,525) *$90,700 $83,175 = $7,

6 PE 7 6B Amount of Misstatement Overstatement (Understatement) Balance Sheet: Merchandise inventory overstated*... $35,000 Current assets overstated... 35,000 assets overstated... 35,000 Owner s equity overstated... 35,000 Income Statement: of merchandise sold understated... $(35,000) Gross profit overstated... 35,000 Net income overstated... 35,000 *($580,000 $545,000 = $35,000) PE 7 7A a. Inventory Turnover of merchandise sold... $882,000 $680,000 Inventories: Beginning of year... $200,000 $140,000 End of year... $290,000 $200,000 Average inventory... $245,000 $170,000 [($200,000 + $290,000) 2] [($140,000 + $200,000) 2] Inventory turnover ($882,000 $245,000) ($680,000 $170,000) b. Number of Days Sales in Inventory of merchandise sold... $882,000 $680,000 Average daily cost of merchandise sold... $2,416.4 $1,863.0 ($882, days) ($680, days) Average inventory... $245,000 $170,000 [($200,000 + $290,000) 2] [($140,000 + $200,000) 2] 325

7 Number of days sales in inventory days 91.3 days ($245,000 $2,416.4) ($170,000 $1,863.0) 326

8 PE 7 7A (Concluded) c. The decrease in the inventory turnover from 4.0 to 3.6 and the increase in the number of days sales in inventory from 91.3 days to days indicate unfavorable trends in managing inventory. PE 7 7B a. Inventory Turnover of merchandise sold... $1,800,000 $1,428,000 Inventories: Beginning of year... $570,000 $450,000 End of year... $630,000 $570,000 Average inventory... $600,000 $510,000 [($570,000 + $630,000) 2] [($450,000 + $570,000) 2] Inventory turnover ($1,800,000 $600,000) ($1,428,000 $510,000) b. Number of Days Sales in Inventory of merchandise sold... $1,800,000 $1,428,000 Average daily cost of merchandise sold... $4,931.5 $3,912.3 ($1,800, days) ($1,428, days) Average inventory... $600,000 $510,000 [($570,000 + $630,000) 2] [($450,000 + $570,000) 2] Number of days sales in inventory days days ($600,000 $4,931.5) ($510,000 $3,912.3) c. The increase in the inventory turnover from 2.8 to 3.0 and the decrease in the number of days sales in inventory from days to days indicate favorable trends in managing inventory. 327

9 EXERCISES Ex. 7 1 Switching to a perpetual inventory system will strengthen A4A Hardware s internal controls over inventory, since the store managers will be able to keep track of how much of each item is on hand. This should minimize shortages of good-selling items and excess inventories of poor-selling items. On the other hand, switching to a perpetual inventory system will not eliminate the need to take a physical inventory count. A physical inventory must be taken to verify the accuracy of the inventory records in a perpetual inventory system. In addition, a physical inventory count is needed to detect shortages of inventory due to damage or theft. Ex. 7 2 a. Appropriate. The inventory tags will protect the inventory from customer theft. b. Inappropriate. The control of using security measures to protect the inventory is violated if the stockroom is not locked. c. Inappropriate. Good controls include a receiving report, prepared after all inventory items received have been counted and inspected. Inventory purchased should only be recorded and paid for after reconciling the receiving report, the initial purchase order, and the vendor s invoice. 328

10 Ex. 7 3 a. Portable Video Players Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity June , , , , , , , , ,470 3, Balances 5,310 5,070 b. Since the prices rose from $40 for the June 1 inventory to $45 for the purchase on June 30, we would expect that under last-in, first-out the inventory would be lower. Note to Instructors: Exercise 7 4 shows that the inventory is $5,040 under LIFO. 329

11 Ex. 7 4 Portable Video Players Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity June , , , , , , , , Balances 5,340 5,

12 Ex. 7 5 a. Prepaid Cell Phones Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity July , , ,000 25, , , , , , , ,500 23, , ,500 10, Balances 60,500 23,900 b. Since the prices rose from $45 for the July 1 inventory to $52 for the purchase on July 20, we would expect that under first-in, first-out the inventory would be higher. Note to Instructors: Exercise 7 6 shows that the inventory is $25,900 under FIFO. 331

13 Ex. 7 6 Prepaid Cell Phones Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity July , , ,000 25, , ,500 25, ,500 10, , , ,000 23, , ,500 23, Balances 58,500 25,

14 Ex. 7 7 a. $15,540 ($ units) b. $15,100 [($80 60 units) + ($ units) + ($84 25 units)] = $4,800 + $8,200 + $2,100 Ex. 7 8 a. $7,812 (12 units at $495 plus 4 units at $468) = $5,940 + $1,872 b. $6,138 (9 units at $360 plus 7 units at $414) = $3,240 + $2,898 c. $7,056 (16 units at $441; $26,460/60 units = $441) of merchandise available for sale: 9 units at $ $ 3, units at $ , units at $ , units at $ , units (at average cost of $441)... $26,

15 Ex. 7 9 Merchandise Merchandise Inventory Method Inventory Sold a. FIFO... $4,986 $ 9,639 b. LIFO... 4,365 10,260 c. Average cost... 4,680 9,945 of merchandise available for sale: 21 units at $ $ 3, units at $ , units at $ , units at $ , units (at average cost of $195)... $14,625 a. First-in, first-out: Merchandise inventory: 15 units at $ $3,150 9 units at $ , units... $4,986 Merchandise sold: $14,625 $4, $9,639 b. Last-in, first-out: Merchandise inventory: 21 units at $ $3,780 3 units at $ units... $4,365 Merchandise sold: $14,625 $4, $10,260 c. Average cost: Merchandise inventory: 24 units at $195 ($14,625/75 units)... $4,680 Merchandise sold: $14,625 $4, $9,

16 Ex a. 1. FIFO inventory > (greater than) LIFO inventory 2. FIFO cost of goods sold < (less than) LIFO cost of goods sold 3. FIFO net income > (greater than) LIFO net income 4. FIFO income tax > (greater than) LIFO income tax b. In periods of rising prices, the income shown on the company s tax return would be lower than if FIFO were used; thus, there is a tax advantage of using LIFO. Note to Instructors: The federal tax laws require that if LIFO is used for tax purposes, LIFO must also be used for financial reporting purposes. This is known as the LIFO conformity rule. Thus, selecting LIFO for tax purposes means that the company s reported income will also be lower than if FIFO had been used. Companies using LIFO believe the tax advantages from using LIFO outweigh any negative impact of reporting a lower income to shareholders. Ex A B C D E F G 1 2 Inventory Market Lower 3 Commodity Quantity Price Price Market of C or M 4 AL65 40 $28 $30 $ 1,120 $ 1,200 $ 1,120 5 CA ,500 3,250 3,250 6 LA SC , UT ,500 4,650 4,500 9 $10,980 $10,550 $10,320 Ex The merchandise inventory would appear in the Current Assets section, as follows: Merchandise inventory at lower of cost (FIFO) or market... $10,320 Alternatively, the details of the method of determining cost and the method of valuation 335

17 could be presented in a note. 336

18 Ex a. Balance Sheet Merchandise inventory... $11,350* understated Current assets... $11,350 understated assets... $11,350 understated Owner s equity $11,350 understated *$11,350 = $451,000 $439,650 b. Income Statement of merchandise sold... Gross profit... Net income... $11,350 overstated $11,350 understated $11,350 understated c. Income Statement of merchandise sold... Gross profit... Net income... $11,350 understated $11,350 overstated $11,350 overstated d. The December 31, 2013, balance sheet would be correct, since the 2012 inventory error reverses itself in Ex a. Balance Sheet Merchandise inventory... $12,000* overstated Current assets... $12,000 overstated assets... $12,000 overstated Owner s equity $12,000 overstated *$12,000 = $350,000 $338,000 b. Income Statement of merchandise sold... $12,000 understated Gross profit... $12,000 overstated Net income... $12,000 overstated c. Income Statement of merchandise sold... $12,000 overstated Gross profit... $12,000 understated 337

19 Net income... $12,000 understated d. The December 31, 2013, balance sheet would be correct, since the 2012 inventory error reverses itself in

20 Ex When an error is discovered affecting the prior period, it should be corrected. In this case, the merchandise inventory account should be debited and the owner s capital account credited for $18,000. Failure to correct the error for 2011 and purposely misstating the inventory and the cost of merchandise sold in 2012 would cause the income statements for the two years to not be comparable. The balance sheet at the end of 2012 would be correct, however, since the 2011 inventory error reverses itself in Ex a. Apple: 48.5 {$23,397,000,000/[($455,000,000 + $509,000,000)/2]} American Greetings: 3.9 {$809,956,000/[($203,873,000 + $216,671,000)/2]} b. Lower. Although American Greetings business is seasonal in nature, with most of its revenue generated during the major holidays, much of its nonholiday inventory may turn over very slowly. Apple, on the other hand, turns its inventory over very fast because it maintains a low inventory, which allows it to respond quickly to customer needs. Additionally, Apple s computer products can quickly become obsolete, so it cannot risk building large inventories. 339

21 Ex a. Number of Days Sales in Inventory = / 2 $4,857 Kroger, $4,859 $4,855 $58,564/365 Safeway, $2,591 $2,798 $31,589/ / 2 $2,694.5 Winn-Dixie, $665 $649 / 2 $5,269/365 Average Inventory of Goods Sold/ $ days 46 days 31 days Inventory Turnover = of Goods Sold Average Inventory Kroger, Safeway, $58,564 ($4,859 $4,855)/2 $31,589 ($2,591 $2,798)/ Winn-Dixie, $5,269 ($665 $649)/2 8.0 b. The number of days sales in inventory and inventory turnover ratios are relatively the same for Kroger and Safeway. Winn-Dixie has significantly higher number of days sales in inventory and significantly lower inventory turnover than Kroger and Safeway. These results suggest that Kroger and Safeway are more efficient than Winn- Dixie in managing inventory. 340

22 Ex (Concluded) c. If Winn-Dixie matched Kroger s days sales in inventory, then its hypothetical ending inventory would be determined as follows, Number of Days Sales in Inventory = Average Inventory of Goods Sold/365 X 30 days = $5,269/365 X = 30 ($5,269/365) = 30 $14.4 per day X = $432 Thus, the additional cash flow that would have been generated is the difference between the actual average inventory and the hypothetical average inventory, as follows: Actual average inventory... $657 million Hypothetical average inventory Positive cash flow potential... $225 million That is, a lower average inventory amount would have required less cash than actually was required. Appendix Ex $507,000 ($780,000 65%) Appendix Ex $380,000 ($475,000 80%) Appendix Ex $648,000 ($900,000 72%) 341

23 Appendix Ex A B C 1 Retail 2 Merchandise inventory, November 1 $ 300,000 $ 400,000 3 Purchases in November (net) 2,100,000 2,800,000 4 Merchandise available for sale $2,400,000 $3,200,000 5 $2,400,000 Ratio of cost to retail price: 75% $3,200,000 6 Sales for November (net) 2,750,000 7 Merchandise inventory, November 30, at retail price $ 450,000 8 Merchandise inventory, November 30, at estimated cost ($450,000 75%) $ 337,500 Appendix Ex a. A B C 1 2 Merchandise inventory, January 1 $ 500,000 3 Purchases (net), January 1 December 11 4,280,000 4 Merchandise available for sale $4,780,000 5 Sales (net), January 1 December 11 $6,500,000 6 Less estimated gross profit ($6,500,000 36%) 2,340,000 7 Estimated cost of merchandise sold 4,160,000 8 Estimated merchandise inventory, December 11 $ 620,000 b. The gross profit method is useful for estimating inventories for monthly or quarterly financial statements. It is also useful in estimating the cost of merchandise destroyed by fire or other disasters. Appendix Ex Merchandise available for sale... $3,380,000 Less cost of merchandise sold [$5,260,000 (100% 40%)]... 3,156,000 Estimated ending merchandise inventory... $ 224,

24 Appendix Ex Merchandise available for sale... $1,400,000 Less cost of merchandise sold [$2,080,000 (100% 37%)]... 1,310,400 Estimated ending merchandise inventory... $ 89,

25 Prob. 7 1A 1. PROBLEMS Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity Mar , , ,000 10, , , , , ,150 Apr , , , ,470 9, , , , , ,640 May , ,640 4, , , , ,240 3,

26 Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity , , Balances 30,725 3,

27 Prob. 7 1A (Concluded) 2. Accounts Receivable... 59,450 Sales... 59,450 of Merchandise Sold... 30,725 Merchandise Inventory... 30, $28,725 ($59,450 $30,725) 4. $3,625 (145 units $25) 5. Since the prices rose from $20 for the March 1 inventory to $25 for the purchase on May 25, we would expect that under last-in, first-out the inventory would be lower. Note to Instructors: Problem 7 2A shows that the inventory is $3,110 under LIFO. 346

28 Prob. 7 2A 1. Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity Mar , , , , , , , , , ,000 Apr , , , , , , , , , ,400 May , , ,100 1,400 1,100 4,200 1,400 1,

29 Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity , ,400 1, ,750 Continued 348

30 Prob. 7 2A (Concluded) Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity ,400 May , , Balances 31,240 3, sales... $59,450 cost of merchandise sold... 31,240 Gross profit... $28, $3,110 = [(70 units $20) + (50 units $22) + (15 units $24) + (10 units $25)] = $1,400 + $1,100 + $360 + $

31 Prob. 7 3A 1. First-In, First-Out Method Model Quantity AZ09 4 $ 38 $ GA HI KS ,331 MS ,170 ND WV , $6, Last-In, First-Out Method Model Quantity AZ09 4 $ 32 $ GA HI KS , MS ND WV $6,

32 Prob. 7 3A (Concluded) 3. Average Method Model Quantity * AZ09 5 $ 35 $ 175 GA HI KS ,277 MS ,118 ND WV , $6,505 *Computations of unit costs: AZ09: $35 = [(4 $32) + (4 $35) + (4 $38)] ( ) GA85: $87 = [(8 $88) + (4 $79) + (3 $85) + (6 $92)] ( ) HI71: $69 = [(3 $75) + (3 $65) + (15 $68) + (9 $70)] ( ) KS32: $253 = [(7 $242) + (6 $250) + (5 $260) + (10 $259)] ( ) MS17: $86 = [(12 $80) + (10 $82) + (16 $89) + (16 $90)] ( ) ND52: $121 = [(2 $108) + (2 $110) + (3 $128) + (3 $130)] ( ) WV63: $172 = [(5 $160) + (4 $170) + (4 $175) + (7 $180)] ( ) 4. a. During periods of rising prices, the LIFO method will result in a lower cost of inventory, a greater amount of cost of merchandise sold, and a lesser amount of net income than the other two methods. For Bulldog Appliances, the LIFO method would be preferred for the current year, since it would result in a lesser amount of income tax. b. During periods of declining prices, the FIFO method will result in a lesser amount of net income and would be preferred for income tax purposes. 351

33 Prob. 7 4A A B C D E F G 1 Inventory Sheet December 31, Inventory Market Lower 4 Description Quantity Price Price Market of C or M 5 Alpha $ 60 $ 57 $ 1,800 $ 1, $ ,272 2,166 $ 2,166 8 Beta ,500 3,600 3,500 9 Charlie ,600 2, ,290 1, ,890 3,750 3, Echo ,000 3,250 3, Frank ,650 5, ,480 4, ,130 9,900 9, George ,125 1,275 1, Killo ,925 1,950 1, Quebec ,000 2,250 2, Romeo ,760 1, ,970 1,620 1, Sierra ,250 1, ,510 1,410 1, Whiskey ,100 2, ,860 2,800 2, X-Ray ,500 7, ,725 3, ,225 11,175 11, $46,407 $45,146 $44,

34 Prob. 7 5A Appendix 1. A B C 1 MYRINA CO. 2 Retail 3 Merchandise inventory, May 1 $ 130,000 $ 185,000 4 Net purchases 1,382,000 1,975,000 5 Merchandise available for sale $1,512,000 $2,160,000 6 Ratio of cost to retail price: $1,512,000 $2,160,000 70% 7 Sales $1,950,000 8 Less sales returns and allowances 40,000 9 Net sales 1,910, Merchandise inventory, May 31, at retail $ 250, Merchandise inventory, at estimated cost ($250,000 70%) $ 175, A B C 1 LEMNOS CO. 2 a. 3 Merchandise inventory, July 1 $ 280,000 4 Net purchases 3,400,000 5 Merchandise available for sale $3,680,000 6 Sales $5,300,000 7 Less sales returns and allowances 100,000 8 Net sales $5,200,000 9 Less estimated gross profit ($5,200,000 35%) 1,820, Estimated cost of merchandise sold 3,380, Estimated merchandise inventory, September 30 $ 300, b. 14 Estimated merchandise inventory, September 30 $ 300, Physical inventory count, September , Estimated loss due to theft or damage, July 1 September 30 $ 30,

35 354

36 Prob. 7 1B 1. Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity July , , , , ,500 1, , , , , , , ,800 27, ,800 81, , ,000 Aug , , ,800 2, , , , , , , ,000 40, , , ,000 50, , , ,000 2,200 50, ,000 Sept ,000 50, ,200 77, , , , , ,200 33, , , ,200 2,400 33, , ,200 33, , , , , Balances 1,032, ,

37 356

38 2. Accounts Receivable... 1,675,000 Sales... 1,675,000 of Merchandise Sold... 1,032,500 Merchandise Inventory... 1,032, $642,500 ($1,675,000 $1,032,500) 4. $252,000 (105 units $2,400) 5. Since the prices rose from $1,500 for the July 3 inventory to $2,400 for the purchase on September 21, we would expect that under last-in, first-out the inventory would be lower. Note to Instructors: Problem 7 2B shows that the inventory is $238,500 under LIFO. 357

39 Prob. 7 2B 1. Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity July , , , , ,500 1, , , , , ,500 1, , , ,800 81, ,500 1, ,500 27,000 Aug , , ,500 1,800 2, ,500 27, , , , ,000 1,800 1, , , ,500 1,800 2, ,500 27,000 30,000 30,000 27,000 75, ,500 37,500 1,500 2,200 Continued 37, ,

40 Prob. 7 2B (Concluded) Purchases of Merchandise Sold Inventory Date Quantity Quantity Quantity Sept , , ,500 2,200 37,500 88, ,200 1,500 88,000 15, ,500 22, , , ,500 2,400 22, , , , ,500 2,400 22, , Balances 1,046, , sales... $1,675,000 cost of merchandise sold... 1,046,000 Gross profit... $ 629, $238,500 = [(15 units $1,500) + (90 units $2,400)] = $22,500 + $216,

41 Prob. 7 3B 1. First-In, First-Out Method Model Quantity AK82 3 $535 $ 1, ,060 CO , ,332 DE FL ,268 ME , NM TN $11, Last-In, First-Out Method Model Quantity AK82 3 $520 $ 1, ,054 CO , DE FL ,220 ME , NM TN $10,

42 Prob. 7 3B (Concluded) 3. Average Method Model Quantity * AK82 5 $528 $ 2,640 CO ,616 DE FL ,244 ME ,738 NM TN $11,003 *Computations of unit costs: AK82: $528 = [(3 $520) + (3 $527) + (3 $530) + (3 $535)] ( ) CO62 $218 = [(9 $213) + (7 $215) + (6 $222) + (6 $225)] ( ) DE03: $63 = [(5 $60) + (3 $65) + (1 $65) + (1 $70)] ( ) L100: $311 = [(6 $305) + (3 $310) + (3 $316) + (4 $317)] ( ) ME09: $534 = [(6 $520) + (8 $531) + (4 $549) + (6 $542)] ( ) NM57: $227 = [(4 $222) + (4 $232)] (4 + 4) TN33: $37 = [(4 $35) + (6 $36) + (8 $37) + (7 $39)] ( ) 4. a. During periods of rising prices, the LIFO method will result in a lower cost of inventory, a greater amount of the cost of merchandise sold, and a lesser amount of net income than the other two methods. For Artic Appliances, the LIFO method would be preferred for the current year, since it would result in a lesser amount of income tax. b. During periods of declining prices, the FIFO method will result in a lesser amount of net income and would be preferred for income tax purposes. 361

43 Prob. 7 4B A B C D E F G 1 Inventory Sheet December 31, Inventory Market Lower 4 Description Quantity Price Price Market of C or M 5 Alpha $ 60 $ 57 $ 1,800 $ 1, ,272 2,166 $ 2,166 8 Beta ,400 3,600 3,400 9 Charlie ,600 2, ,280 1, ,880 3,750 3, Echo ,125 3,250 3, Frank ,300 3, ,480 6, ,780 9,900 9, George ,200 1,275 1, Killo ,975 1,950 1, Quebec ,250 2,250 2, Romeo ,875 1, ,265 1,620 1, Sierra ,250 1, ,510 1,410 1, Whiskey ,700 2, ,340 2,800 2, X-Ray ,500 7, ,700 3, ,200 11,175 11, $45,197 $45,146 $44,

44 Prob. 7 5B Appendix 1. A B C 1 SEGAL CO. 2 Retail 3 Merchandise inventory, March 1 $ 298,000 $ 375,000 4 Net purchases 4,850,000 6,225,000 5 Merchandise available for sale $5,148,000 $6,600,000 6 $5,148,000 Ratio of cost to retail price: 78% $6,600,000 7 Sales $6,320,000 8 Less sales returns and allowances 245,000 9 Net sales 6,075, Merchandise inventory, March 31, at retail $ 525, Merchandise inventory, at estimated cost ($525,000 78%) $ 409, A B C 1 IROQUOIS CO. 2 a. 3 Merchandise inventory, January 1 $ 300,000 4 Net purchases 4,150,000 5 Merchandise available for sale $4,450,000 6 Sales $6,900,000 7 Less sales returns and allowances 175,000 8 Net sales $6,725,000 9 Less estimated gross profit ($6,725,000 40%) 2,690, Estimated cost of merchandise sold 4,035, Estimated merchandise inventory, March 31 $ 415, b. 14 Estimated merchandise inventory, March 31 $ 415, Physical inventory count, March , Estimated loss due to theft or damage, January 1 March 31 $ 18,

45 CASES & PROJECTS CP 7 1 Since the title to merchandise shipped FOB shipping point passes to the buyer when the merchandise is shipped, the shipments made before midnight, July 31, 2012, should properly be recorded as sales for the fiscal year ending July 31, Hence, Mark Irwin is behaving in a professional manner. However, Mark should realize that recording these sales in 2012 precludes them from being recognized as sales in Thus, accelerating the shipment of orders to increase sales of one period will have the effect of decreasing sales of the next period. CP 7 2 In developing a response to Gary s concerns, you should probably first emphasize the practical need for an assumption concerning the flow of cost of goods purchased and sold. That is, when identical goods are frequently purchased, it may not be practical to specifically identify each item of inventory. If all the identical goods were purchased at the same price, it wouldn t make any difference for financial reporting purposes which goods we assumed were sold first, second, etc. However, in most cases, goods are purchased over time at different prices, and, hence, a need arises to determine which goods are sold so that the price (cost) of those goods can be matched against the revenues to determine operating income. Next, you should emphasize that accounting principles allow for the fact that the physical flow of the goods may differ from the flow of costs. Specifically, accounting principles allow for three cost flow assumptions: first-in, first-out; last-in, firstout; and average. Each of these methods has advantages and disadvantages. One primary advantage of the last-in, first-out method is that it better matches current costs (the cost of goods purchased last) with current revenues. Therefore, the reported operating income is more reflective of current operations and what might be expected in the future. Another reason that the last-in, first-out method is often used is that it tends to minimize taxes during periods of price increases. Since for most businesses prices tend to increase, the LIFO method will generate lower taxes than will the alternative cost flow methods. The preceding explanation should help Gary better understand LIFO and its impact on the financial statements and taxes. 364

46 CP a. First-in, first-out method: 16,000 units at $ $ 256,000 16,000 units at $ ,200 25,600 units at $ ,200 6,400 units at $ ,200 64,000 units... $ 957,600 b. Last-in, first-out method: 62,000 units at $ $ 756,400 2,000 units at $ ,000 64,000 units... $ 782,400 c. Average cost method: 64,000 units at $13.58*... $ 869,120 *($5,432,000/400,000) = $ Average FIFO LIFO Sales... $5,200,000 $5,200,000 $5,200,000 of merchandise sold*... 4,474,400 4,649,600 4,562,880 Gross profit... $ 725,600 $ 550,400 $ 637,120 * of merchandise available for sale... $5,432,000 $5,432,000 $5,432,000 Less ending inventory , , ,120 of merchandise sold... $4,474,400 $4,649,600 $4,562, a. The LIFO method is often viewed as the best basis for reflecting income from operations. This is because the LIFO method matches the most current cost of merchandise purchases against current sales. The matching of current costs with current sales results in a gross profit amount that many consider to best reflect the results of current operations. For White Dove Company, the gross profit of $550,400 reflects the matching of the most current costs of the product of $4,649,600 against the current period sales of $5,200,000. This matching of current costs with current sales also tends to minimize the effects of price trends on the results of operations. The LIFO method will not match current sales and the current cost of merchandise sold if the current-period quantity of sales exceeds the current-period quantity of purchases. In this case, the cost of merchandise sold will include a portion of the cost of the beginning inventory, which may have a unit cost from purchases made several years prior to the current period. The results of operations may then be distorted in the sense of the current matching concept. This situation occurs rarely in most businesses because of consistently increasing quantities of year-end inventory from year to year. 365

47 CP 7 3 (Continued) While the LIFO method is often viewed as the best method for matching revenues and expenses, the FIFO method is often consistent with the physical movement of merchandise in a business, since most businesses tend to dispose of commodities in the order of their acquisition. To the extent that this is the case, the FIFO method approximates the results that will be attained by a specific identification of costs. The average cost method is, in a sense, a compromise between LIFO and FIFO. The effect of price trends is averaged, both in determining net income and in determining inventory cost. Which inventory costing method best reflects the results of operations for White Dove Company depends upon whether one emphasizes the importance of matching revenues and expenses (the LIFO method) or whether one emphasizes the physical flow of merchandise (the FIFO method). The average cost method might be considered best if one emphasizes the matching and physical flow of goods concepts equally. b. The FIFO method provides the best reflection of the replacement cost of the ending inventory for the balance sheet. This is because the amount reported on the balance sheet for merchandise inventory will be assigned costs from the most recent purchases. For most businesses, these costs will reflect purchases made near the end of the period. For example, White Dove Company s ending inventory on December 31, 2012, is assigned costs totaling $957,600 under the FIFO method. These costs represent purchases made during the period of August through December. This FIFO inventory amount ($957,600) more closely approximates the replacement cost of the ending inventory than either the LIFO ($782,400) or the average cost ($869,120) figures. c. During periods of rising prices, such as shown for White Dove Company, the LIFO method will result in a lesser amount of net income than the other two methods. Hence, for White Dove Company, the LIFO method would be preferred for the current year, since it would result in a lesser amount of income tax. During periods of declining prices, the FIFO method will result in a lesser amount of net income and would be preferred for income tax purposes. 366

48 CP 7 3 (Continued) d. The advantages of the perpetual inventory system include the following: (1) A perpetual inventory system provides an effective means of control over inventory. A comparison of the amount of inventory on hand with the balance of the subsidiary account can be used to determine the existence and seriousness of any inventory shortages. (2) A perpetual inventory system provides an accurate method for determining inventories used in the preparation of interim statements. (3) A perpetual inventory system provides an aid for maintaining invent-ories at optimum levels. Frequent review of the perpetual inventory records helps management in the timely reordering of merchandise, so that loss of sales and excessive accumulation of inventory are avoided. An analysis of White Dove Company s purchases and sales, as shown below, indicates that the company may have accumulated excess inventory from May through August because the amount of month-end inventory increased materially, while sales remained relatively constant for the period. Increase Next (Decrease) in Inventory at Month s Month Purchases Sales Inventory End of Month Sales April 62,000 units 32,000 units 30,000 units 30,000 units 32,000 units May 66,000 32,000 34,000 64,000 40,000 June 80,000 40,000 40, ,000 48,000 July 80,000 48,000 32, ,000 56,000 August 54,400 56,000 (1,600) 134,400 56,000 September 56,000 (56,000) 78,400 36,000 October 25,600 36,000 (10,400) 68,000 20,000 November 16,000 20,000 (4,000) 64,000 16,000 December 16,000 16, ,000 It appears that during April through July, the company ordered inventory without regard to the accumulation of excess inventory. A perpetual inventory system might have prevented this excess accumulation from occurring. The primary disadvantage of the perpetual inventory system is the cost of maintaining the necessary inventory records. However, computers may be used to reduce this cost. 367

49 CP 7 4 a. Inventory Turnover = of Goods Sold Average Inventory Number of Days Sales in Inventory = Average Inventory of Goods Sold/365 Dell Inventory Turnover: $50,144 $50,144 ($1,180 $867)/2 $1, $1,180 $867 / 2 $50,144/365 $1, Days Sales in Inventory: 7.4 days Hewlett-Packard Inventory Turnover: $87,524 $87,524 ($7,879 $6,128)/2 $7, $7,879 $6,128 $87,524/365 / 2 $7, Days Sales in Inventory: 29.2 days b. Dell builds its computers primarily to a customer order, called a build-to-order strategy. Customers place their orders on the Internet. Dell then builds and delivers the computer, usually in a matter of days. HP, in contrast, builds computers before actual orders are received. This is called a build-to-stock strategy. HP must forecast the type of computers customers want before it receives the orders. This strategy results in greater inventory for HP, since the computers are built before there is a sale. HP has significant finished goods inventory, while Dell has less finished goods. It also explains the difference in their inventory efficiency ratios. Note to Instructors: While Dell sells most of its computers online, it has also begun selling its computers through Best Buy. As a result, Dell s inventory turnover has decreased and its days sales in inventory has increased from prior years. 368

50 CP 7 5 a. Inventory Turnover Number of Days Sales in Inventory Tiffany Co Amazon.com Computations: Tiffany Co. Inventory Turnover = of Goods Sold Average Inventory $1, 215 $ Inventory Turnover = 1,601 $1,242 / 2, or 0.85 Average Inventory Number of Days Sales in Inventory = of Goods Sold / 365 Number of Days Sales in Inventory = $ 1,601 $1,242 / 2, or days $1,215/ 365 Amazon.com Inventory Turnover = of Goods Sold Average Inventory $14, 896 $ Inventory Turnover = 1,399 $1,200 / 2 Number of Days Sales in Inventory = 369, or Average Inventory of Goods Sold / 365 Number of Days Sales in Inventory = $ 1,399 $1,200 / 2, or days $14,896/ 365 b. Amazon.com has a smaller investment in inventory for its volume than does Tiffany. Amazon.com s inventory turnover is faster (larger), and the number of days sales in inventory is shorter (smaller). This is due to the fact that Amazon.com uses a different business model than Tiffany. That is, Amazon.com sells through the Internet, while Tiffany uses the traditional retail store model which requires Tiffany to stock more inventory.

51 CP 7 6 a. co Wal-Mart JCPenney 1. of merchandise sold... $ 62,335 $ 306,158 $ 11,571 Merchandise inventory, beginning... $ 5,039 $ 35,180 $ 3,641 Merchandise inventory, ending... 5,405 34,511 3, $ 10,444 $ 69,691 $ 6, Average merchandise inventory (/2)... $ 5,222.0 $ 34,845.5 $ 3,450.0 Inventory turnover b. co Wal-Mart JCPenney 1. Average merchandise inventory [from part (a)]... $ 5,222.0 $ 34,845.5 $ 3,450.0 of merchandise sold... $ 62,335 $ 306,158 $ 11, Average daily cost of merchandise sold (COMS/365)... $ $ $ 31.7 Number of day s sales in inventory c. Both the inventory turnover ratio and the number of day s sales in inventory reflect the merchandising approaches of the three companies. co is a club warehouse. Its approach is to hold only mass appeal items that are sold quickly off the shelf. Most items are sold in bulk quantities at very attractive prices. co couples thin margins with very fast inventory turnover. Wal-Mart has a traditional discounter approach. It has attractive pricing, but the inventory moves slower than would be the case at a club warehouse. For example, many purchases made at Wal-Mart would not be packaged in the same bulk as would be the case at co. JCPenney is a traditional department store with a wider assortment of goods that will not necessarily appeal to the mass market. That is, some of the merchandise items will be more specialized and unique. As such, its inventory moves slower, but at a higher price (and margin). 370