The understatement of the beginning inventory balance causes

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

● Scan Study Objectives

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● Read Text and Answer p. 285 p. 291 p. 296 p. 298

● Work Using the Decision Toolkit

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● Answer Self-Test Questions

● Complete Assignments

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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 LLDOZ 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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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?