Assume that widgets inc uses a perpetual fifo inventory system

Perpetual Inventory System And Inventory Valuation Methods

Present a detailed explanation of the recording of purchases under a perpetual inventory system. Use hypothetical figures to illustrate the perpetual inventory system. After presenting your hypothetical figures, discuss how a perpetual inventory system is different from a periodic inventory system. Your answer should illustrate understanding of the perpetual inventory system.

Part 2: Inventory Valuation Methods

Identify the differences between F.I.F.O., L.I.F.O., and the average-cost method of inventory valuation. Be sure to include the effects of each method on cost of goods sold and net income in your answer. Also discuss the differences between the physical movement of goods and cost flow assumptions. Your answer should illustrate understanding of the three major inventory valuation methods, and the relationship between physical inventory flow and cost flow assumptions.

Required Resource

Text

Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2016). Financial accounting: Tools for business decision making (8th ed.). Retrieved from https://content.ashford.edu/

Chapter 5: Merchandising Operations and the Multiple-Step Income Statement

Chapter 6: Reporting and Analyzing Inventory

(Chapters 5 & 6 are in the attachments)

Recommended Resources

Article

Bloom, R., & Cenker, W. J. (2008, December 31). The death of LIFO?. Journal of Accounting. Retrieved from http://www.journalofaccountancy.com/issues/2009/jan/deathoflifo.htm

Website

Textbook Student Companion Site . http://bcs.wiley.com/he-bcs/Books?action=index&itemId=1118953908&bcsId=9831

Review the PowerPoint presentations for Chapter 5 and Chapter 6 found on the textbook publisher’s website.

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6

Reporting and Analyzing Inventory

 CHAPTER PREVIEW 

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.

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“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.

In the past, Caterpillar's pro�itability suffered, but today it is very successful. A big part of this turnaround can be attributed to effective management of its inventory. Imagine what it costs Caterpillar to have too many bulldozers sitting around in inventory—a situation the company de�initely wants to avoid. Yet, Caterpillar must also 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 ef�iciency. 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.

These changes led to record exports, pro�its, and revenues for Caterpillar. 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 will very likely play a huge part in its future pro�itability as well.

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LEARNING OBJECTIVE 1

Discuss how to classify and determine inventory. 

Two important steps in the reporting of inventory at the end of the accounting period are the classi�ication of inventory based on its degree of completeness and the determination of inventory amounts.

CLASSIFYING INVENTORY How a company classi�ies its inventory depends on whether the �irm is a merchandiser or a manufacturer. In a merchandising company, such as those described in Chapter 5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05#ch05) , 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 classi�ication, 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: �inished 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.

For example, Caterpillar classi�ies earth-moving tractors completed and ready for sale as �inished goods. It classi�ies 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 identi�ied as raw materials. Illustration 6-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo1#c06- �ig-0001) shows an excerpt from Note 7 of Caterpillar's annual report.

ILLUSTRATION 6-1 Composition of Caterpillar's inventory

By observing the levels and changes in the levels of these three inventory types, �inancial statement users can gain insight into management's production plans. For example, low levels of raw materials and high levels of �inished goods suggest that management believes it has enough inventory on hand, and production will be slowing down—perhaps in anticipation of a recession. Conversely, high levels of raw materials and low levels of �inished goods probably signal that management is planning to step up production.

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Many companies have signi�icantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, companies manufacture or purchase goods only when needed. 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 speci�ications, 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 classi�ications of both merchandising and manufacturing companies. Our focus throughout most of this chapter is on merchandise inventory. Additional issues speci�ic to manufacturing companies are discussed in managerial accounting courses.

 ACCOUNTING ACROSS THE ORGANIZATION 

FORD

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 you cannot make a car without them. 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 the Canadian plants of 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 signi�icant disruption, you can pretty quickly run out of parts.”

Sources: Amy Chozick, “A Key Strategy of Japan's Car Makers Back�ires,” Wall Street Journal (July 20, 2007); and 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? (Go to WileyPLUS for this answer and additional questions.)

▼ HELPFUL HINT

Regardless of the classi�ication, companies report all inventories under Current Assets on the balance sheet.

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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 �irst 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

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 NOTE

In a famous fraud, a salad oil company �illed 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.

 ETHICS INSIGHT 

Leslie Fay

Falsifying Inventory to Boost Income

Managers at women's apparel maker Leslie Fay were convicted of falsifying inventory records to boost net income in an attempt to increase management bonuses. In another case, executives at Craig Consumer Electronics were accused of defrauding lenders by manipulating inventory records. The indictment said the company classi�ied “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.

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What effect does an overstatement of inventory have on a company's �inancial statements? (Go to WileyPLUS for this answer and additional questions.)

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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo1#c06-�ig-0002) and described below.

ILLUSTRATION 6-2 Terms of sale

1. 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.

2. 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

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consignment agreements with their suppliers in order to keep their inventory levels low.

ANATOMY OF A FRAUD

Ted Nickerson, CEO of clock manufacturer Dally Industries, had expensive tastes. To support this habit, 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 �igures and thus maintain the stock price, Ted coerced employees in the company to alter inventory �igures. 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 veri�ication. 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.

DO IT! 1

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.

1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.

2. The company did not include in the count purchased goods of $10,000, which were in transit (terms: FOB shipping point).

3. 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).

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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, DO IT! 6-1, E6-1, E6-2, and E6-3.

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LEARNING OBJECTIVE 2

Apply inventory cost �low methods and discuss their �inancial effects. 

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 is 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 TVs at $1,200 each. These facts are summarized in Illustration 6-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0003) .

ILLUSTRATION 6-3 Data for inventory costing example

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 speci�ic identi�ication 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0004) ). Using this method, companies can accurately determine ending inventory and cost of goods sold.

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ILLUSTRATION 6-4 Speci�ic identi�ication method

Speci�ic identi�ication requires that companies keep records of the original cost of each individual inventory item. Historically, speci�ic identi�ication was possible only when a company sold a limited variety of high-unit- cost items that could be identi�ied 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 identi�ication, it is theoretically possible to do speci�ic identi�ication 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 �low assumptions, about which units were sold.

ETHICS NOTE

A major disadvantage of the speci�ic identi�ication 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.

COST FLOW ASSUMPTIONS Because speci�ic identi�ication is often impractical, other cost �low methods are permitted. These differ from speci�ic identi�ication in that they assume �lows of costs that may be unrelated to the actual physical �low of goods. There are three assumed cost �low methods:

1. First-in, �irst-out (FIFO)

2. Last-in, �irst-out (LIFO)

3. Average-cost

There is no accounting requirement that the cost �low assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost �low method.

To demonstrate the three cost �low 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05#ch05) , 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06ifrs#c06-note-0004)

To illustrate the three inventory cost �low methods, we will use the data for Houston Electronics' Astro condensers, shown in Illustration 6-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0005) .

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ILLUSTRATION 6-5 Data for Houston Electronics

From Chapter 5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05#ch05) , the cost of goods sold formula in a periodic system is:

(Beginning Inventory+Purchases)−Ending Inventory=Cost of Goods Sold

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 depends on which cost �low method we use. No matter which cost �low 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 �irst-in, �irst-out (FIFO) method assumes that the earliest goods purchased are the �irst to be sold. FIFO often parallels the actual physical �low of merchandise because it generally is good business practice to sell the oldest units �irst. Under the FIFO method, therefore, the costs of the earliest goods purchased are the �irst 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 �irst, but that the costs of the oldest units are recognized �irst. In a bin of picture hangers at the hardware store, for example, no one really knows, nor would it matter, which hangers are sold �irst.) Illustration 6-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig- 0006) shows the allocation of the cost of goods available for sale at Houston Electronics under FIFO.

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ILLUSTRATION 6-6 Allocation of costs—FIFO method

Under FIFO, since it is assumed that the �irst goods purchased were the �irst 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0007) demonstrates that companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of the �irst 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.

ILLUSTRATION 6-7 Proof of cost of goods sold

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▼ HELPFUL HINT

Note the sequencing of the allocation: (1) compute ending inventory, and (2) determine cost of goods sold.

▼ HELPFUL HINT

Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.

Last-In, First-Out (LIFO)

The last-in, �irst-out (LIFO) method assumes that the latest goods purchased are the �irst to be sold. LIFO seldom coincides with the actual physical �low 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 �irst to be recognized in determining cost of goods sold. Illustration 6-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0008) shows the allocation of the cost of goods available for sale at Houston Electronics under LIFO.

ILLUSTRATION 6-8 Allocation of costs—LIFO method

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Under LIFO, since it is assumed that the �irst 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 �irst 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0009) 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.

ILLUSTRATION 6-9 Proof of cost of goods sold

Under a periodic inventory system, which we are using here, all goods purchased during the period are assumed to be available for the �irst sale, regardless of the date of purchase.

▼ HELPFUL HINT

Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—�irst in still here.

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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0010) presents the formula and a sample computation of the weighted-average unit cost.

ILLUSTRATION 6-10 Formula for weighted-average unit cost

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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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0011) shows the allocation of the cost of goods available for sale at Houston Electronics using average-cost.

ILLUSTRATION 6-11 Allocation of costs—average-cost method

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.

FINANCIAL STATEMENT AND TAX EFFECTS OF COST FLOW METHODS Each of the three assumed cost �low 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 �low 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0012) (in the margin) shows the use of the three cost �low methods in 500 large U.S. companies.

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ILLUSTRATION 6-12 Use of cost �low methods in major U.S. companies

The reasons companies adopt different inventory cost �low methods are varied, but they usually involve at least one of the following three factors: (1) income statement effects, (2) balance sheet effects, or (3) tax effects.

DECISION TOOLS

Analyzing �inancial statement and tax effects helps users determine which inventory costing method best meets the company's objectives.

Income Statement Effects

To understand why companies might choose a particular cost �low method, let's examine the effects of the different cost �low assumptions on the �inancial statements of Houston Electronics. The condensed income statements in Illustration 6-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06- �ig-0013) 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%.

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ILLUSTRATION 6-13 Comparative effects of cost �low methods

Note the cost of goods available for sale ($12,000) is the same under each of the three inventory cost �low 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 �low assumption can have signi�icant impacts both on income and on evaluations of income, such as the following.

1. In a period of in�lation, FIFO produces a higher net income because lower unit costs of the �irst units purchased are matched against revenue.

2. In a period of in�lation, LIFO produces a lower net income because higher unit costs of the last goods purchased are matched against revenue.

3. 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.

4. Regardless of whether prices are rising or falling, average-cost produces net income between FIFO and LIFO.

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.

Others believe that LIFO presents a more realistic net income number. That is, LIFO matches the more recent costs against current revenues to provide a better measure of net income. During periods of in�lation, many challenge the quality of non-LIFO earnings, noting that failing to match current costs against current revenues leads to an understatement of cost of goods sold and an overstatement of net income. As some indicate, net income computed using FIFO creates “paper or phantom pro�its”—that is, earnings that do not really exist.

Balance Sheet Effects

A major advantage of the FIFO method is that in a period of in�lation, 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 in�lation, the costs allocated to ending inventory may be signi�icantly understated in terms of current cost. The understatement becomes greater over prolonged periods of in�lation 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.

▼ HELPFUL HINT

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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 �inancial 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 �inancial statements.

Tax Effects

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 in�lation. 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0013) 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 

ExxonMobil Corporation

Is LIFO Fair?

ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its inventory for �inancial reporting and tax purposes. In one recent year, this resulted in a cost of goods sold �igure 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 in�lation.

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 can make analysis dif�icult.

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? (Go to WileyPLUS for this answer and additional questions.)

KEEPING AN EYE ON CASH

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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 signi�icantly increase cash �lows. To demonstrate the effect of the cost �low assumptions on cash �low, we will calculate net cash provided by operating activities using the data for Houston Electronics from Illustration 6-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0013) . 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.

FIFO LIFO Average-Cost Cash received from customers $18,500 $18,500 $18,500 Cash purchases of goods 11,000 11,000  11,000 Cash paid for operating expenses ($9,000 − $4,600) 4,400 4,400   4,400 Cash paid for taxes 990 750 870 Net cash provided by operating activities $ 2,110 $ 2,350 $ 2,230

LIFO has the highest net cash provided by operating activities because it results in the lowest tax payments. Since cash �low 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 of earnings ratio under each cost �low assumption.

FIFO LIFO Average- Cost

Net income (from Illustration 6-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06- �ig-0013) )

$2,310 $1,750 $2,030

Quality of earnings ratio 0.91 1.34     1.1

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 pro�its reported under FIFO.

USING INVENTORY COST FLOW METHODS CONSISTENTLY Whatever cost �low 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 �inancial statements over successive time periods. In contrast, using the FIFO method one year and the LIFO method the next year would make it dif�icult to compare the net incomes of the two years.

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 �inancial statements the change and its effects on net income. A typical disclosure is shown in Illustration 6-14

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(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo2#c06-�ig-0014) , using information from recent �inancial statements of Quaker Oats (now a unit of PepsiCo).

ILLUSTRATION 6-14 Disclosure of change in cost �low method

▼ HELPFUL HINT

As you learned in Chapter 2 (c02.xhtml) , consistency and comparability are important characteristics of accounting information.

DO IT! 2

Cost Flow Methods

The accounting records of Shumway Ag Implement show the following data.

Beginning inventory 4,000 units at $3 Purchases 6,000 units at $4 Sales 7,000 units at $12

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 �low method.

✓ Compute cost of goods sold for each cost �low method.

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Related exercise material: BE6-2, BE6-3, BE6-5, DO IT! 6-2, E6-4, E6-5, E6-6, E6-7, and E6-8.

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LEARNING OBJECTIVE 3

Explain the statement presentation and analysis of inventory. 

PRESENTATION As indicated in Chapter 5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05#ch05) , inventory is classi�ied in the balance sheet as a current asset immediately below receivables. In a multiple-step income statement, cost of goods sold is subtracted from net sales. There also should be disclosure of (1) the major inventory classi�ications, (2) the basis of accounting (cost, or lower-of-cost-or-market), and (3) the cost method (FIFO, LIFO, or average-cost).

Wal-Mart Stores, Inc., for example, in its January 31, 2014, balance sheet reported inventories of $44,858 million under current assets. The accompanying notes to the �inancial statements, as shown in Illustration 6-15 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo3#c06-�ig-0015) , disclosed the following information.

ILLUSTRATION 6-15 Inventory disclosures by Wal-Mart

As indicated in this note, Wal-Mart values its inventories at the lower-of-cost-or-market using LIFO and FIFO.

LOWER-OF-COST-OR-MARKET 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, at one time, 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?

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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 �low methods (speci�ic identi�ication, FIFO, LIFO, or average-cost) to determine cost. Under the LCM basis, market is de�ined 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo3#c06-�ig-0016) . Note that the amounts shown in the �inal column are the lower-of-cost-or-market amounts for each item.

ILLUSTRATION 6-16 Computation of lower-of-cost-or-market

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 �inancial press reported accusations that two-thirds of its inventory of silicon was unsuitable for processing, the company's stock price fell by 40%.

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.

DO IT! 3a

LCM Basis

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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.

Cost Market

Gas $ 84,000 $ 79,000 Wood  250,000  280,000 Pellet  112,000  101,000

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 �igures, $430,000.

Related exercise material: BE6-7, DO IT! 6-3a, E6-9, and E6-10.

ANALYSIS 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

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inventory is ef�icient, 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 Of�ice 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 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05#ch05) , 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 ef�iciency of its inventory management. The following data are available for Wal-Mart.

(in millions) 2014 2013

Ending inventory $ 44,858 $43,803 Cost of goods sold 358,069

Illustration 6-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo3#c06-�ig-0017) presents the inventory turnovers and days in inventory for Wal-Mart and Target, using data from the �inancial statements of those corporations for 2014 and 2013.

ILLUSTRATION 6-17 Inventory turnovers and days in inventory

The calculations in Illustration 6-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo3#c06-�ig-0017) show that Wal-Mart turns its inventory more frequently than Target (8.1 times for Wal-Mart versus 6.1 times for Target). Consequently, the average time an item spends on a Wal-Mart shelf is shorter (45.1 days for Wal-Mart versus 59.8 days for Target).

This analysis suggests that Wal-Mart is more ef�icient 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.

DECISION TOOLS

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Inventory turnover and days in inventory help users determine how long an item is in inventory.

 ACCOUNTING ACROSS THE ORGANIZATION 

Sony

Too Many TVs or Too Few?

Financial analysts closely monitor the inventory management practices of companies. 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 in the next year, as a result of its inventory build-up, days in inventory rose to 59 days. Management said that it didn't think that Sony's inventory levels were too high. However, 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? (Go to WileyPLUS for this answer and additional questions.)

ADJUSTMENTS FOR LIFO RESERVE Earlier, we noted that using LIFO rather than FIFO can result in signi�icant 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 �inancial statement differences from using LIFO normally increase the longer a company uses LIFO.

Use of different inventory cost �low 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 �low methods.

Illustration 6-18 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch06lo3#c06-�ig-0018) presents an excerpt from the notes to Caterpillar's 2014 �inancial statements that discloses and discusses Caterpillar's LIFO reserve.

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