Manufacturers usually classify inventory into

study objectives

After studying this chapter, you should be able to:

1 Describe the steps in determining inventory quantities.

2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

4 Explain the lower-of-cost-or-market basis of accounting for inventories.

5 Compute and interpret the inventory turnover ratio.

6 Describe the LIFO reserve and explain its importance for comparing results of different companies.

chapter

REPORTING AND ANALYZING INVENTORY

6

280

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● Answer Self-Test Questions

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feature story

281

Let’s talk inventory—big, bulldozer-size inventory.

Caterpillar Inc. is the world’s largest manufacturer of

construction and mining equipment, diesel and natu-

ral 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.

During the 1980s, Caterpillar’s

profitability suffered, but today it is

very successful. A big part of this

turnaround can be attributed to ef-

fective 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 contin-

uing 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

● A Big Hiccup (p. 283) ● Falsifying Inventory to Boost Income (p. 284) ● Is LIFO Fair? (p. 294) ● Improving Inventory Control with RFID (p. 298)

INSIDE CHAPTER 6 . . .

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 lo-

cated around the world (10 million square feet of ware-

house space—remember, we’re talk-

ing bulldozers). The company can

virtually guarantee that it can get any

part to anywhere in the world within

24 hours.

After these changes, Cater-

pillar had record exports, profits, and revenues. It

would have seemed that things couldn’t have been

better. But industry analysts, as well as the com-

pany’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 rea-

son for its past success, and inventory management

will very likely play a huge part in its ability to suc-

ceed in the future.

“W H E R E I S THAT S PAR E B U L LDOZ E R

B LAD E?”

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Helpful Hint Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

Reporting and Analyzing Inventory

In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual inventory sys- tem. 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 Inventory How a company classifies its inventory depends on whether the firm is a mer- chandiser or a manufacturer. In a merchandising company, such as those de- scribed 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 character- istics: (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: fin- ished 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 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 trac- tors are identified as raw materials.

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.

By observing the levels and changes in the levels of these three inven- tory 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 reces- sion. On the other hand, high levels of raw materials and low levels of finished goods probably indicate that management is planning to step up production.

preview of chapter 6

• Merchandising • Manufacturing • Just-in-time

Classifying Inventory

• Taking a physical inventory • Determining ownership of

goods

Determining Inventory Quantities

• Specific identification • Cost flow assumptions • Financial statement and tax

effects • Consistent use • Lower-of-cost-or-market

Inventory Costing

• Inventory turnover ratio • LIFO reserve

Analysis of Inventory

282

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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 spec- ifications, 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 in- tegrating its information systems with those of its suppliers, Dell reduced its in- ventories to nearly zero. This is a huge advantage in an industry where products become obsolete nearly overnight.

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 two purposes: The first purpose 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 in- ventory 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. Tak- ing a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In many companies, taking an inventory is a formi- dable task. Retailers such as Target, True Value Hardware, or Home Depot have thousands of different inventory items. An inventory count is generally more ac- curate 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 low- est level—to count inventory. Recall from Chapter 5 that Wal-Mart had a year- end of January 31.

Determining Inventory Quantities 283

A Big Hiccup

JIT can save a company a lot of money, but it isn’t without risk. An unex- pected disruption in the supply chain can cost a company a lot of money. Japanese au- tomakers 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 them- selves 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 specifi- cations. As a result, the automakers were forced to shut down production for a few days—a loss of tens of thousands of cars.

Source: Amy Chozick, “A Key Strategy of Japan’s Car Makers Backfires,” Wall Street Journal (July 20, 2007).

Accounting Across the Organization

?What steps might the companies take to avoid such a serious disruption in the future?(See page 330.)

1 Describe the steps in determining inventory quantities.

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.

study objective

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284 chapter 6 Reporting and Analyzing Inventory

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 6-1 and described below.

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

What effect does an overstatement of inventory have on a company’s financial statements? (See page 330.)

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 com- pany classified “defective goods as new or refurbished” and claimed that it owned cer- tain shipments “from overseas suppliers” when, in fact, Craig either did not own the shipments or the shipments did not exist.

Ethics Insight

?

FOB Shipping Point FOB Destination

Public Carrier Co.

Seller Buyer

Ownership passes to

buyer here

Public Carrier Co.

Seller Buyer

Ownership passes to

buyer here

Buyer pays freight costs Seller pays freight costs

Illustration 6-1 Terms of sale

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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 be- cause 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 won’t be able to sell. Today, even some manufacturers are making consignment agree- ments with their suppliers in order to keep their inventory levels low.

Determining Inventory Quantities 285

Action Plan

• Apply the rules of ownership to goods held on consignment.

• Apply the rules of ownership to goods in transit.

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).

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. 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).

RULES OF OWNERSHIP

before you go on...

Do it!

Related exercise material: BE6-1, 6-1, E6-1, E6-2, and E6-3.Do it!

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.

ANATOMY OF A FRAU D

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.

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286 chapter 6 Reporting and Analyzing Inventory

Inventory Costing 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 quan- tities 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 dif- ferent 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 6-2.

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 6-3). Using this method, companies can accurately de- termine ending inventory and cost of goods sold.

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 identi- fication, 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.

2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

study objective

Purchases Feb. 3 1 TV at $700 March 5 1 TV at $750 May 22 1 TV at $800

Sales June 1 2 TVs for $2,400 ($1,200 � 2)

Illustration 6-2 Data for inventory costing example

Illustration 6-3 Specific identification method

SOLD SOLD

$700

Cost of goods sold = $700 + $800 = $1,500 Ending inventory = $750

$800$750

Ending Inventory

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.

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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:

1. First-in, first-out (FIFO) 2. Last-in, first-out (LIFO) 3. 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 inven- tory system. We assume a periodic system for two main reasons. First, many small companies use periodic rather than perpetual systems. Second, 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 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 inven- tory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average- cost 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 6-4.

Inventory Costing 287

HOUSTON ELECTRONICS Astro Condensers

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total units available for sale 1,000 $12,000 Units in ending inventory 450

Units sold 550

Illustration 6-4 Data for Houston Electronics

(Beginning Inventory � Purchases) � Ending Inventory � Cost of Goods Sold

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 Decem- ber 31 determined that there were 450 units in ending inventory. Therefore, Hous- ton 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

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.

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288 chapter 6 Reporting and Analyzing Inventory

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 FIFO (first-in, first-out) method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow of merchan- dise because it generally is good business practice to sell the oldest units first. Un- der the FIFO method, therefore, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold, regardless 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 6-5 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 pur- chased. 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

COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total 1,000 $12,000

Illustration 6-5 Allocation of costs—FIFO method

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

Unit Total Date Units Cost Cost

Nov. 27 400 $13 $ 5,200 Cost of goods available for sale $12,000 Aug. 24 50 12 600 Less: Ending inventory 5,800

Total 450 $5,800 Cost of goods sold $ 6,200

Cost of goods sold

$6,200

$1,000

$2,200

$5,200

$600

$3,000

Ending inventory

Warehouse$5,800

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.

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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 6-6 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 LIFO (last-in, first-out) 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 6-7 shows the allocation of the cost of goods available for sale at Houston Electronics under LIFO.

Inventory Costing 289

COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total 1,000 $12,000

Illustration 6-7 Allocation of costs—LIFO method

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

Unit Total Date Units Cost Cost

Jan. 1 100 $10 $ 1,000 Cost of goods available for sale $12,000 Apr. 15 200 11 2,200 Less: Ending inventory 5,000 Aug. 24 150 12 1,800 Cost of goods sold $ 7,000

Total 450 $5,000

$1,000

$2,200

$5,200

$1,800

$1,800 Cost ofgoods sold

$7,000

Warehouse$5,000

Ending inventory

Helpful Hint Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here.

Illustration 6-6 Proof of cost of goods soldDate Units Unit Cost Total Cost

Jan. 1 100 $10 $ 1,000 Apr. 15 200 11 2,200 Aug. 24 250 12 3,000

Total 550 $6,200

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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 avail- able 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 6-8 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 as- sumed 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 pur- chased during the period are assumed to be available for the first sale, re- gardless 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 6-9 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 6-10 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. That av- erage 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.

Illustration 6-8 Proof of cost of goods sold

Illustration 6-9 Formula for weighted-average unit cost

Date Units Unit Cost Total Cost

Nov. 27 400 $13 $ 5,200 Aug. 24 150 12 1,800

Total 550 $7,000

Cost of Goods Total Units Weighted- Available � Available � Average for Sale for Sale Unit Cost

$12,000 � 1,000 � $12.00

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Inventory Costing 291

COST OF GOODS AVAILABLE FOR SALE

Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 $10 $ 1,000 Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200

Total 1,000 $12,000

Illustration 6-10 Allocation of costs— average-cost method

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

$12,000 � 1,000 � $12.00 Cost of goods available for sale $12,000 Unit Total Less: Ending inventory 5,400

Units Cost Cost Cost of goods sold $ 6,600 450 $12.00 $5,400

Cost of goods sold

$12,000 – $5,400 = $6,600

Warehouse 450 units × $12= $5,400

Ending inventory

Cost per unit

$12,000––––––––– 1,000 units

= $12 per unit

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.

The accounting records of Shumway Ag Implement show the follow- ing 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.

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)

COST FLOW METHODS

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Do it!

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FINANCIAL STATEMENT AND TAX EFFECTS OF COST FLOW METHODS

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 invento- ries and FIFO for foreign inventories. Illustration 6-11 shows the use of the three cost flow methods in the 600 largest 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:

1. Income statement effects

2. Balance sheet effects

3. 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 state- ments of Houston Electronics. The condensed income statements in Illustration 6-12 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%.

Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

study objective 3

33% LIFO

44% FIFO

19% Average-

Cost

4% Other

Illustration 6-11 Use of cost flow methods in major U.S. companies

HOUSTON ELECTRONICS Condensed Income Statements

FIFO LIFO Average-Cost

Sales revenue $18,500 $18,500 $18,500

Beginning inventory 1,000 1,000 1,000 Purchases 11,000 11,000 11,000

Cost of goods available for sale 12,000 12,000 12,000 Less: Ending inventory 5,800 5,000 5,400

Cost of goods sold 6,200 7,000 6,600

Gross profit 12,300 11,500 11,900 Operating expenses 9,000 9,000 9,000

Income before income taxes 3,300 2,500 2,900 Income tax expense (30%) 990 750 870

Net income $ 2,310 $ 1,750 $ 2,030

Illustration 6-12 Comparative effects of cost flow methods

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 dol- lar 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 signifi- cant 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

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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 ex- ample), 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 re- sults 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 likeli- hood 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 6-13 shows the results un- der 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. How- ever, 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, re- ported 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 under- stated in terms of current cost. The understatement becomes greater over pro- longed 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 $4,675 million. But, the in- ventory’s actual current cost if FIFO had been used is $6,799 million.

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 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 6-12, 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.

Inventory Costing 293

Illustration 6-13 Income statement effects comparedFIFO LIFO

Sales revenue (200 � $30) $6,000 $6,000 Cost of goods sold 4,000 (200 � $20) 4,800 (200 � $24)

Gross profit $2,000 $1,200

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.

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What are the arguments for and against the use of LIFO? (See page 330.)

Is LIFO Fair?

ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its in- ventory 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 di- rectly 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.

International Insight

? 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 6-12. To simplify our example, we assume that Houston’s sales and purchases are all cash transactions. We also assume that op- erating 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 mea- sure of net income because it does not include the phantom profits reported under FIFO.

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

FIFO LIFO Average-Cost

Net income (from Illustration 6-12) $2,310 $1,750 $2,030 Quality of earnings ratio 0.91 1.34 1.1

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USING INVENTORY COST FLOW METHODS CONSISTENTLY

Whatever cost flow method a company chooses, it should use that method con- sistently from one accounting period to another. Consistent application enhances the ability to analyze a company’s financial statements over successive time pe- riods. 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.

Although consistent application is preferred, it does not mean that a com- pany 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 6-14, us- ing information from recent financial statements of the Quaker Oats Company.

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, 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 cost principle, or at its lower replacement cost?

As you probably reasoned, this situation requires a departure from the cost basis of accounting. When the value of inventory is lower than its cost, compa- nies write down the inventory to its market value. 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 an example of the accounting concept of conservatism, which means that the best choice 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 de- termine cost. Under the LCM basis, market is defined as current replacement cost, not selling price. For a merchandising company, market is the cost of

Inventory Costing 295

DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Which inventory costing method should be used?

Are prices increasing, or are they decreasing?

Income statement, balance sheet, and tax effects

Depends on objective. In a period of rising prices, income and inventory are higher and cash flow is lower under FIFO. LIFO provides opposite results. Average-cost can moderate the impact of changing prices.

INFO NEEDED FOR DECISION

Helpful Hint As you learned in Chapter 2, consistency and comparability are important characteristics of accounting information.

QUAKER OATS COMPANY Notes to the Financial Statements

Note 1: Effective July 1, the Company adopted the LIFO cost flow assumption for valuing the majority of U.S. Grocery Products inventories. The Company believes that the use of the LIFO method better matches current costs with current revenues. The effect of this change on the current year was to decrease net income by $16.0 million.

Illustration 6-14 Disclosure of change in cost flow method

Explain the lower-of-cost- or-market basis of accounting for inventories.

study objective 4

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.

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296 chapter 6 Reporting and Analyzing Inventory

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 replace- ment 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 fol- lowing lines of merchandise with costs and market values as indicated. LCM produces the results shown in Illustration 6-15. 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. 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%.

Analysis of Inventory 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 fash- ion (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 RATIO

The inventory turnover ratio is calculated as cost of goods sold divided by average inventory. It indicates how quickly a company sells its goods—the num- ber of times the average inventory “turns over” (is sold) during the year.

Illustration 6-15 Computation of inventory at lower-of-cost-or-market

Lower-of- Cost Market Cost-or-Market

Flat-panel TVs $60,000 $55,000 $ 55,000 Satellite radios 45,000 52,000 45,000 DVD recorders 48,000 45,000 45,000 DVDs 15,000 14,000 14,000

Total inventory $159,000

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.

Tracy Company sells three different types of home heating stoves (wood, gas, 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.

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.

LCM BASIS

before you go on...

Do it!

Related exercise material: BE6-7, 6-3, and E6-9.Do it!

Compute and interpret the inventory turnover ratio.

study objective 5

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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 ratio may indicate that the company is losing sales opportunities because of inventory shortages. For example, invest- ment analysts at one time suggested that Office Depot had gone too far in re- ducing its inventory—they said they were seeing too many empty shelves. Thus, management should closely monitor this ratio to achieve the best balance be- tween too much and too little inventory.

In Chapter 5, we discussed the increasingly competitive environment of retailers like 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 6-16 presents the inventory turnover ratios and days in inventory for Wal-Mart and Target, using data from the financial statements of those corpora- tions for 2009 and 2008.

The calculations in Illustration 6-16 show that Wal-Mart turns its inven- tory more frequently than Target and the industry average (8.8 times for Wal- Mart versus 6.5 times for Target and 8.6 for the industry). Consequently, the average time an item spends on a Wal-Mart shelf is shorter (41.5 days for Wal- Mart versus 56.2 days for Target and 42.4 days for the industry). This suggests that Wal-Mart is more efficient than Target in its inventory management.

Analysis of Inventory 297

(in millions) 2009 2008

Ending inventory $ 34,511 $35,159 Cost of goods sold 306,158

Wal-Mart Industry Ratio ($ in millions) Target Average

2009 2008 2009 2009

Inventory Turnover Ratio � Cost of Goods Sold Average Inventory

Days in Inventory � 365 Inventory Turnover

Ratio

Inventory turnover $306,158 � 8.8 times 7.8 times 6.5 times 8.6 times ratio ($34,511 � $35,159)/2

Days in inventory 365 days � 41.5 days 46.8 days 56.2 days 42.4 days 8.8

Illustration 6-16 Inventory turnover ratio and days in inventory

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Accounting Across the Organization

?Why is inventory control important to managers such as those at Wal-Mart andBest Buy? (See page 330.)

DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

How long is an item in inventory? Cost of goods sold; beginning and ending inventory

A higher inventory turnover ratio or lower average days in inventory suggests that management is reducing the amount of inventory on hand, relative to cost of goods sold.

INFO NEEDED FOR DECISION

DECISION TOOLKIT

Cost of Inventory

� goods sold

turnover ratio Average inventory

Days in �

365 days inventory Inventory

turnover ratio

Early in 2012, Westmoreland Company switched to a just-in-time inven- tory system. Its sales, cost of goods sold, and inventory amounts for 2011 and 2012 are shown below.

2011 2012

Sales revenue $2,000,000 $1,800,000 Cost of goods sold 1,000,000 910,000 Beginning inventory 290,000 210,000 Ending inventory 210,000 50,000

Determine the inventory turnover and days in inventory for 2011 and 2012. Discuss the changes in the amount of inventory, the inventory turnover and days in inventory, and the amount of sales across the two years.

INVENTORY TURNOVER

before you go on...

Do it!

Note also that Wal-Mart’s inventory turnover, which was already very good in 2008, improved significantly in 2009. 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.

Improving Inventory Control with RFID

Wal-Mart improved its inventory control with the introduction of radio frequency identification (RFID). Much like bar codes, which tell a retailer the number of boxes of a specific product it has, RFID goes a step farther, helping to distinguish one box of a spe- cific product from another. RFID uses technology similar to that used by keyless remotes that unlock car doors.

Companies currently use RFID to track shipments from supplier to distribution center to store. Other potential uses include monitoring product expiration dates and acting quickly on product recalls. Wal-Mart also anticipates faster returns and warranty processing us- ing RFID. This technology will further assist Wal-Mart managers in their efforts to ensure that their store has just the right type of inventory, in just the right amount, in just the right place. Other companies are also interested in RFID. Best Buy has spent millions research- ing possible applications in its stores.

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ANALYSTS’ ADJUSTMENTS FOR LIFO RESERVE

Earlier we noted that using LIFO rather than FIFO can result in significant dif- ferences 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 bal- ance sheet, FIFO will result in higher reported inventory. The financial state- ment differences from using LIFO normally increase the longer a company uses LIFO.

Use of different inventory cost flow assumptions complicates analysts’ at- tempts to compare companies’ results. Fortunately, companies using LIFO are required to report the difference between inventory reported using LIFO and in- ventory 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 6-17 presents an excerpt from the notes to Caterpillar’s 2009 financial statements that discloses and discusses Caterpillar’s LIFO reserve.

Analysis of Inventory 299

2011 2012

Inventory turnover $1,000,000 �4

$910,000 � 7ratio ($290,000 � $210,000)/2 ($210,000 � $50,000)/2

Days in 365 � 4 � 91.3 days 365 � 7 � 52.1 days inventory

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 ratio 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 “stock-outs.” To determine the optimal inventory level, man- agement must weigh the benefits of reduced inventory against the potential lost sales caused by stock-outs.

Solution Action Plan

• To find the inventory turnover ratio, divide cost of goods sold by average inventory.

• To determine days in inventory, divide 365 days by the inventory turnover ratio.

• 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.

Related exercise material: BE6-8, 6-4, and E6-10.Do it!

Describe the LIFO reserve and explain its importance for comparing results of different companies.

study objective 6

Caterpillar has used LIFO for over 50 years. Thus, the cumulative differ- ence between LIFO and FIFO reflected in the Inventory account is very large. In fact, the 2009 LIFO reserve of $3,003 million is 47% of the 2009 LIFO in- ventory of $6,360 million. Such a huge difference would clearly distort any comparisons you might try to make with one of Caterpillar’s competitors that used FIFO.

CATERPILLAR INC. Notes to the Financial Statements

Inventories: Inventories are stated at the lower of cost or market. Cost is prin- cipally determined using the last-in, first-out (LIFO) method . . . . If the FIFO (first-in, first-out) method had been in use, inventories would have been $3,003, $3,183, and $2,617 million higher than reported at December 31, 2009, 2008, and 2007, respectively.

Illustration 6-17 Caterpillar LIFO reserve

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The LIFO reserve can have a significant effect on ratios that analysts com- monly use. Using the LIFO reserve adjustment, Illustration 6-19 calculates the value of the current ratio (current assets � current liabilities) for Caterpillar un- der both the LIFO and FIFO cost flow assumptions.

As Illustration 6-19 shows, if Caterpillar used FIFO, its current ratio would be 1.54:1 rather than 1.39:1 under LIFO. Thus, Caterpillar’s liquidity appears stronger if a FIFO assumption were used in valuing inventories. If a similar ad- justment is made for the inventory turnover ratio, Caterpillar’s inventory turnover actually would look worse under FIFO than under LIFO, dropping from 3.2 times for LIFO to 2.3 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 inven- tory. Comparing Caterpillar to CNH without converting Caterpillar’s inventory to FIFO would lead to distortions and potentially erroneous decisions.

Illustration 6-18 Conversion of inventory from LIFO to FIFO

(in millions) 2009 inventory using LIFO $ 6,360 2009 LIFO reserve 3,003

2009 inventory assuming FIFO $9,363

Illustration 6-19 Impact of LIFO reserve on ratios

Current ratio $26,789 �1.39:1 $26,789 � $3,003 � 1.54:1 $19,292 $19,292

($ in millions) LIFO FIFO

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.

DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

What is the impact of LIFO on the company’s reported inventory?

LIFO reserve, cost of goods sold, ending inventory, current assets, current liabilities

If these adjustments are material, they can significantly affect such measures as the current ratio and the inventory turnover ratio.

INFO NEEDED FOR DECISION

DECISION TOOLKIT

LIFO �

LIFO �

FIFO inventory reserve inventory

To adjust Caterpillar’s inventory balance, we add the LIFO reserve to reported inventory, as shown in Illustration 6-18. That is, if Caterpillar had used FIFO all along, its inventory would be $9,363 million, rather than $6,360 million.

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Using the Decision Toolkit 301

The Manitowoc Company is located in Manitowoc, Wisconsin. In recent years, it has made a series of strategic acquisitions to grow and enhance its market-leading positions in each of its three business segments. These include: cranes and related products (crawler cranes, tower cranes, and boom trucks); food service equipment (commercial ice-cube machines, ice-beverage dispensers, and commercial refrig- eration equipment); and marine operations (shipbuilding and ship-repair services). The company reported inventory of $595.5 million for 2009 and of $925.3 million for 2008. Here is the inventory note taken from the 2009 financial statements.

USING THE DECISION TOOLKIT

THE MANITOWOC COMPANY Notes to the Financial Statements

Inventories: The components of inventories at December 31 are summarized as fol- lows (in millions).

2009 2008

Inventories—gross Raw materials $244.5 $ 416.0 Work-in-process 163.5 262.9 Finished goods 310.8 352.3

Total 718.8 1,031.2 Less: Excess and obsolete inventory reserve (90.9) (70.1)

Net inventories at FIFO cost 627.9 961.1 Less: Excess of FIFO costs over LIFO value (32.4) (35.8)

Inventories—net (as reported on balance sheet) $595.5 $ 925.3

Manitowoc carries inventory at the lower-of-cost-or-market using the first-in, first-out (FIFO) method for approximately 90% of total inventory for 2009 and 2008. The remainder of the inventory is costed using the last-in, first-out (LIFO) method.

Additional facts:

2009 Current liabilities $1,142.2 2009 Current assets (as reported) 1,259.9 2009 Cost of goods sold 2,958.0

Instructions Answer the following questions.

1. Why does the company report its inventory in three components? 2. Why might the company use two methods (LIFO and FIFO) to account for its

inventory? 3. Perform each of the following.

(a) Calculate the inventory turnover ratio and days in inventory using the LIFO inventory.

(b) Calculate the 2009 current ratio using LIFO and the current ratio using FIFO. Discuss the difference.

Solution 1. The Manitowoc Company is a manufacturer, so it purchases raw materials and

makes them into finished products. At the end of each period, it has some goods that have been started but are not yet complete (work in process).

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By reporting all three components of inventory, a company reveals impor- tant information about its inventory position. For example, if amounts of raw materials have increased significantly compared to the previous year, we might assume the company is planning to step up production. On the other hand, if levels of finished goods have increased relative to last year and raw materials have declined, we might conclude that sales are slowing down—that the com- pany has too much inventory on hand and is cutting back production.

2. Companies are free to choose different cost flow assumptions for different types of inventory. A company might choose to use FIFO for a product that is expected to decrease in price over time. One common reason for choosing a method other than LIFO is that many foreign countries do not allow LIFO; thus, the company cannot use LIFO for its foreign operations.

302 chapter 6 Reporting and Analyzing Inventory

3. (a) Inventory turnover �

Cost of goods sold �

$2,958.0 � 3.9

ratio Average inventory ($595.5 � $925.3)/2

Days in �

365 �

365 � 93.6 days

inventory Inventory turnover ratio 3.9

Summary of Study Objectives 1 Describe the steps in determining inventory quantities.

The steps are (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.

2 Explain the basis of accounting for inventories and ap- ply the inventory cost flow methods under a periodic inventory system. The primary basis of accounting for inventories is cost. Cost includes all expenditures nec- essary 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.

3 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) meth- ods. 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).

4 Explain the lower-of-cost-or-market basis of account- ing for inventories. Companies use the lower-of-cost- or-market (LCM) basis when the current replacement cost (market) is less than cost. Under LCM, compa- nies recognize the loss in the period in which the price decline occurs.

5 Compute and interpret the inventory turnover ratio. The inventory turnover ratio 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 ratio. A higher turnover ratio or lower average days in inventory suggests that man- agement is trying to keep inventory levels low relative to its sales level.

6 Describe the LIFO reserve and explain its importance for comparing results of different companies. The LIFO reserve represents the difference between ending in- ventory 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 ratio.

(b) Current ratio

LIFO FIFO

Current assets �

$1,259.9 � 1.10:1 $1,259.9 � $32.4 � 1.13:1

Current liabilities $1,142.2 $1,142.2

This represents a 2.7% increase in the current ratio (1.13 � 1.10) /1.10.

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Appendix 6A: Inventory Cost Flow Methods in Perpetual Inventory Systems 303

DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

Which inventory costing method should be used?

Are prices increasing, or are they decreasing?

Income statement, balance sheet, and tax effects

Depends on objective. In a period of rising prices, income and inventory are higher and cash flow is lower under FIFO. LIFO provides opposite results. Average-cost can moderate the impact of changing prices.

INFO NEEDED FOR DECISION

DECISION TOOLKIT A SUMMARY

How long is an item in inventory?

Cost of goods sold; beginning and ending inventory

Cost of Inventory

� goods sold

turnover ratio Average inventory

Days in �

365 days inventory Inventory

turnover ratio

A higher inventory turnover ratio or lower average days in inventory suggests that management is reducing the amount of inventory on hand, relative to cost of goods sold.

What is the impact of LIFO on the company’s reported inventory?

LIFO reserve, cost of goods sold, ending inventory, current assets, current liabilities

LIFO �

LIFO �

FIFO inventory reserve inventory

If these adjustments are material, they can significantly affect such measures as the current ratio and the inventory turnover ratio.

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.

appendix 6A

Inventory Cost Flow Methods in Perpetual Inventory Systems

Apply the inventory cost flow methods to perpetual inventory records.

study objective 7

HOUSTON ELECTRONICS Astro Condensers

Unit Total Balance Date Explanation Units Cost Cost in Units

1/1 Beginning inventory 100 $10 $ 1,000 100 4/15 Purchase 200 11 2,200 300 8/24 Purchase 300 12 3,600 600 9/10 Sale 550 50

11/27 Purchase 400 13 5,200 450

$12,000

Illustration 6A-1 Inventoriable units and costs

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304 chapter 6 Reporting and Analyzing Inventory

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 6-5 on page 288 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 in- ventory 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

Illustration 6A-2 Perpetual system—FIFO Date Purchases Cost of Goods Sold Balance

Jan. 1 (100 @ $10) $1,000 Apr. 15 (200 @ $11) $2,200 (100 @ $10)

(200 @ $11) $3,200

Aug. 24 (300 @ $12) $3,600 (100 @ $10) (200 @ $11) $6,800 (300 @ $12)

Sept. 10 (100 @ $10) (200 @ $11) (250 @ $12) ( 50 @ $12) $ 600

$6,200 Nov. 27 (400 @ $13) $5,200 ( 50 @ $12) $5,800

(400 @ $13)

}

}

}

⎧ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎩

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 con- sists 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 perpet- ual system.

Date Purchases Cost of Goods Sold Balance

Jan. 1 (100 @ $10) $1,000 Apr. 15 (200 @ $11) $2,200 (100 @ $10) $3,200

(200 @ $11) Aug. 24 (300 @ $12) $3,600 (100 @ $10)

(200 @ $11) $6,800 (300 @ $12)

Sept. 10 (300 @ $12) (200 @ $11)

(50 @ $10) (50 @ $10) $ 500

$6,300 Nov. 27 (400 @ $13) $5,200 (50 @ $10) $5,700

(400 @ $13)

Illustration 6A-3 Perpetual system—LIFO

}

}

}

⎧ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎩

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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 6-8 (on page 290) where the proof shows the 400 units at $13 pur- chased 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 pur- chased 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 (Illustra- tion 6-7 on page 289) 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 avail- able 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 to- tal 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 Electron- ics 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 6-10 (on page 291) showing the weighted-average method under a periodic inventory system.

Summary of Study Objective for Appendix 6A 305

Date Purchases Cost of Goods Sold Balance

Jan. 1 (100 @ $10) $ 1,000 Apr. 15 (200 @ $11) $2,200 (300 @ $10.667) $ 3,200 Aug. 24 (300 @ $12) $3,600 (600 @ $11.333) $ 6,800 Sept. 10 (550 @ $11.333) (50 @ $11.333) $ 567

$6,233 Nov. 27 (400 @ $13) $5,200 (450 @ $12.816) $5,767

Illustration 6A-4 Perpetual system—average- cost method

Summary of Study Objective for Appendix 6A 7 Apply the inventory cost flow methods to perpetual in-

ventory 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.

study objective 8

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306 chapter 6 Reporting and Analyzing Inventory

If beginning inventory is understated, cost of goods sold will be understated. If ending inventory is understated, cost of goods sold will be overstated. Illus- tration 6B-2 shows the effects of inventory errors on the current year’s income statement.

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 Illus- tration 6B-3. Note that the understatement of ending inventory in 2011 results in an understatement of beginning inventory in 2012 and an overstatement of net income in 2012.

Over the two years, total net income is correct because the errors offset each other. Notice that total income using incorrect data is $35,000 ($22,000 � $13,000), which is the same as the total income of $35,000 ($25,000 � $10,000) using correct data. Also note in this example that an error in the beginning in- ventory does not result in a corresponding error in the ending inventory for that period. The correctness of the ending inventory depends entirely on the accu- racy of taking and costing the inventory at the balance sheet date under the pe- riodic inventory system.

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 trans- fer 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 invento- ries appear in the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, in- ventory 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.

appendix 6B

Inventory Errors

Indicate the effects of inventory errors on the financial statements.

study objective 8

Beginning Cost of

Ending Cost of

Inventory � Goods �

Inventory = Goods

Purchased Sold

Illustration 6B-1 Formula for cost of goods sold

Cost of Inventory Error Goods Sold Net Income

Beginning inventory understated Understated Overstated Beginning inventory overstated Overstated Understated Ending inventory understated Overstated Understated Ending inventory overstated Understated Overstated

Illustration 6B-2 Effects of inventory errors on 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.

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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 2012 will also be correct.

Summary of Study Objective for Appendix 6B 307

SAMPLE COMPANY Condensed Income Statements

Illustration 6B-3 Effects of inventory errors on two years’ income statements

2011 2012 Incorrect Correct Incorrect Correct

Sales revenue $80,000 $80,000 $90,000 $90,000 Beginning inventory $20,000 $20,000 $12,000 $15,000 Cost of goods purchased 40,000 40,000 68,000 68,000

Cost of goods available for sale 60,000 60,000 80,000 83,000 Ending inventory 12,000 15,000 23,000 23,000

Cost of goods sold 48,000 45,000 57,000 60,000

Gross profit 32,000 35,000 33,000 30,000 Operating expenses 10,000 10,000 20,000 20,000

Net income $22,000 $25,000 $13,000 $10,000

$(3,000) $3,000 Net income Net income understated overstated

The errors cancel. Thus, the combined total income for the 2-year period is correct.

Ending Inventory Error Assets Liabilities Stockholders’ Equity

Overstated Overstated No effect Overstated Understated Understated No effect Understated

Illustration 6B-4 Effects of ending inventory errors on balance sheet

Summary of Study 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 in- ventory 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 fol- lowing period, their effect on net income for that pe- riod 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 stock- holders’ equity and no effect on liabilities.

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308 chapter 6 Reporting and Analyzing Inventory

Glossary Average-cost method (p. 290) An inventory costing method that uses the weighted-average unit cost to allo- cate the cost of goods available for sale to ending inven- tory and cost of goods sold.

Consigned goods (p. 284) Goods held for sale by one party although ownership of the goods is retained by an- other party.

Current replacement cost (p. 295) The cost of pur- chasing the same goods at the present time from the usual suppliers in the usual quantities.

Days in inventory (p. 297) Measure of the average number of days inventory is held; calculated as 365 di- vided by inventory turnover ratio.

Finished goods inventory (p. 282) Manufactured items that are completed and ready for sale.

First-in, first-out (FIFO) method (p. 288) An inven- tory costing method that assumes that the earliest goods purchased are the first to be sold.

FOB destination (p. 284) Freight terms indicating that ownership of goods remains with the seller until the goods reach the buyer.

FOB shipping point (p. 284) Freight terms indicating that ownership of goods passes to the buyer when the public carrier accepts the goods from the seller.

Inventory turnover ratio (p. 296) A ratio that measures 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. 283) Inventory system in which companies manufacture or purchase goods just in time for use.

Last-in, first-out (LIFO) method (p. 289) An inven- tory costing method that assumes that the latest units purchased are the first to be sold.

LIFO reserve (p. 299) For a company using LIFO, the difference between inventory reported using LIFO and inventory using FIFO.

Lower-of-cost-or-market (LCM) (p. 295) 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. 282) Basic goods that will be used in production but have not yet been placed in production.

Specific identification method (p. 286) An actual physical flow costing method in which 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. 290) Average cost that is weighted by the number of units purchased at each unit cost.

Work in process (p. 282) That portion of manufac- tured inventory that has begun the production process but is not yet complete.

Comprehensive

Englehart Company has the following inventory, purchases, and sales data for the month of March.

Inventory, March 1 200 units @ $4.00 $ 800 Purchases

March 10 500 units @ $4.50 2,250 March 20 400 units @ $4.75 1,900 March 30 300 units @ $5.00 1,500

Sales March 15 500 units March 25 400 units

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.)

Do it!

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Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS

Self-Test Questions 309

Solution to Comprehensive Do it! Action Plan

• For FIFO, allocate the latest costs to inventory.

• For LIFO, allocate the earliest costs to inventory.

• For average-cost, use a weighted average.

• Remember, the costs allocated to cost of goods sold can be proved.

• Total purchases are the same under all three cost flow assumptions.

The cost of goods available for sale is $6,450:

Inventory Purchases 200 units @ $4.00 $ 800 March 10 500 units @ $4.50 2,250 March 20 400 units @ $4.75 1,900 March 30 300 units @ $5.00 1,500

Total cost of goods available for sale $6,450

(a) FIFO Method Ending inventory:

Date Units Unit Cost Total Cost

Mar. 30 300 $5.00 $1,500 Mar. 20 200 4.75 950 $2,450

Cost of goods sold: $6,450 � $2,450 � $4,000

(b) LIFO Method Ending inventory:

Date Units Unit Cost Total Cost

Mar. 1 200 $4.00 $ 800 Mar. 10 300 4.50 1,350 $2,150

Cost of goods sold: $6,450 � $2,150 � $4,300

(c) Average-Cost Method

Weighted-average unit cost: $6,450 � 1,400 � $4.607 Ending inventory: 500 � $4.607 � $2,303.50

Cost of goods sold: $6,450 � $2,303.50 � $4,146.50

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 330.

1. When is a physical inventory usually taken? (a) When the company has its greatest amount of in-

ventory. (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).

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.

3. As a result of a thorough physical inventory, Railway Company determined that it had inventory worth $180,000 at December 31, 2012. 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

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310 chapter 6 Reporting and Analyzing Inventory

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 inven- tory that Railway should report. (a) $230,000. (b) $215,000. (c) $228,000. (d) $193,000.

4. Kam Company has the following units and costs.

Units Unit Cost

Inventory, Jan. 1 8,000 $11 Purchase, June 19 13,000 12 Purchase, Nov. 8 5,000 13

If 9,000 units are on hand at December 31, what is the cost of the ending inventory under FIFO? (a) $99,000. (c) $113,000. (b) $108,000. (d) $117,000.

5. From the data in question 4, what is the cost of the ending inventory under LIFO? (a) $113,000. (c) $99,000. (b) $108,000. (d) $100,000.

6. Davidson Electronics has the following:

Units Unit Cost

Inventory, Jan. 1 5,000 $ 8 Purchase, April 2 15,000 10 Purchase, Aug. 28 20,000 12

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. (c) $56,000. (b) $70,000. (d) $75,250.

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.

8. Considerations that affect the selection of an inven- tory costing method do not include: (a) tax effects. (b) balance sheet effects. (c) income statement effects. (d) perpetual versus periodic inventory system.

9. The lower-of-cost-or-market rule for inventory is an example of the application of: (a) the conservatism constraint. (b) the historical cost principle. (c) the materiality constraint. (d) the economic entity assumption.

10. Which of these would cause the inventory turnover ratio to increase the most?

(a) Increasing the amount of inventory on hand. (b) Keeping the amount of inventory on hand con-

stant but increasing sales. (c) Keeping the amount of inventory on hand con-

stant but decreasing sales. (d) Decreasing the amount of inventory on hand and

increasing sales.

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.

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.

*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 sim-

ple 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.

*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.

*15. Harold Company overstated its inventory by $15,000 at December 31, 2012. It did not correct the error in 2012 or 2013. As a result, Harold’s stockholders’ equity was: (a) overstated at December 31, 2012, and under-

stated at December 31, 2013. (b) overstated at December 31, 2012, and properly

stated at December 31, 2013. (c) understated at December 31, 2012, and under-

stated at December 31, 2013. (d) overstated at December 31, 2012, and overstated

at December 31, 2013.

Go to the book’s companion website, www. wiley.com/college/kimmel, to access addi- tional Self-Test Questions.

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Questions 311

Questions 1. “The key to successful business operations is effec-

tive inventory management.” Do you agree? Explain.

2. An item must possess two characteristics to be classified as inventory. What are these two character- istics?

3. What is just-in-time inventory management? What are its potential advantages?

4. Your friend Sara Hovey has been hired to help take the physical inventory in Malaby’s Hardware Store. Explain to Sara what this job will entail.

5. (a) Brandt Company ships merchandise to England 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) Brandt’s December 31 inventory and (2) England’s December 31 inventory.

(b) Under what circumstances should Brandt Com- pany include consigned goods in its inventory?

6. Katz Hat Shop received a shipment of hats for which it paid the wholesaler $2,940. The price of the hats was $3,000, but Katz was given a $60 cash discount and required to pay freight charges of $75. What amount should Katz include in inventory? Why?

7. What is the primary basis of accounting for invento- ries? What is the major objective in accounting for inventories?

8. Brad Watters believes that the allocation of cost of goods available for sale should be based on the ac- tual physical flow of the goods. Explain to Brad 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 mer-

chandise? (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 King Company’s balance sheet is close to the current cost of the inventory, whereas Ritchie Company’s in- ventory 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. Azenabor Corporation has been using the FIFO cost flow method during a prolonged period of inflation. During the same time period, Azenabor has been pay-

ing out all of its net income as dividends. What ad- verse effects may result from this policy?

14. Thomas Holme, a mid-level product manager for Dorothy’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 bet- ter 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 Toot- sie 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. Olivia Dietz is studying for the next accounting midterm examination. What should Olivia know about (a) departing from the cost basis of account- ing for inventories and (b) the meaning of “market” in the lower-of-cost-or-market method?

18. Cataldi 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 Cataldi 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 account- ing for inventories?

20. Why is it inappropriate for a company to include freight-out expense in the Cost of Goods Sold account?

21. Berges Company’s balance sheet shows Inventory $162,800. What additional disclosures should be made?

22. Under what circumstances might the inventory turnover ratio 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 re- sults 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. Nicholas Company discovers in 2012 that its ending inventory at December 31, 2011, was $5,000 under- stated. What effect will this error have on (a) 2011 net income, (b) 2012 net income, and (c) the com- bined net income for the 2 years?

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312 chapter 6 Reporting and Analyzing Inventory

Brief Exercises BE6-1 Susan Cashin 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 Cashin 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.

BE6-2 In its first month of operations, Cisler Company made three purchases of mer- chandise 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. Cisler uses a periodic inventory system.

BE6-3 Data for Cisler Company are presented in BE6-2. Compute the cost of the end- ing inventory under the average-cost method, assuming there are 300 units on hand. (Round the cost per unit to three decimal places.)

BE6-4 The management of Easterling Corp. is considering the effects of various inven- tory-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?

BE6-5 In its first month of operation, Moraine Company purchased 100 units of inven- tory 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 com- pany used FIFO rather than LIFO. Explain why this amount is referred to as phantom profit. The company uses the periodic method.

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.

BE6-7 Olsson Video Center accumulates the following cost and market data at December 31.

Inventory Cost Market Categories Data Data

Cameras $12,500 $13,400 Camcorders 9,000 9,500 DVDs 13,000 12,200

Compute the lower-of-cost-or-market valuation for Olsson inventory.

BE6-8 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 ratio and days in inventory for Oakley, Inc.

BE6-9 Winnebago Industries, Inc. is a leading manufacturer of motor homes. Win- nebago reported ending inventory at August 29, 2009, of $46,850,000 under the LIFO inventory method. In the notes to its financial statements, Winnebago reported a LIFO reserve of $30,346,000 at August 29, 2009. What would Winnebago Industries’ ending in- ventory have been if it had used FIFO?

*BE6-10 Dewey’s Department Store uses a perpetual inventory system. Data for product E2-D2 include the purchases shown on page 313.