Download Inventory Cost Flow Assumptions: FIFO, LIFO, and Average Cost Methods - Prof. Imran and more Lecture notes Marketing Business-to-business (B2B) in PDF only on Docsity!
Brief Learning Exercises Objectives
B. Ex. 8.1 FIFO inventory 1, 4 B. Ex. 8.2 LIFO inventory 1, 4 B. Ex. 8.3 Average inventory 4 B. Ex. 8.4 FIFO and LIFO inventory 4 Analysis B. Ex. 8.5 FIFO and Average inventory 4 B. Ex. 8.6 Inventory shrinkage 3 Analysis B. Ex. 8.7 Inventory error 5 Analysis B. Ex. 8.8 Inventory error 5 B. Ex. 8.9 Inventory turnover 7 B. Ex. 8.10 Inventory turnover 7
8.1 Accounting terminology 1– 8.2 Cost flow assumptions 1 8.3 Physical flows vs. cost flows 4 8.4 Effects of different cost flows 4 8.5 Transfer of title 2 8.6 Inventory write-downs 3 8.7 Periodic inventory systems 4 8.8 Inventory errors 5 8.9 Gross profit method 6 8.10 Retail method 6 8.11 1, 7
Analysis
Analysis
Analysis Analysis
CHAPTER 8
INVENTORIES AND THE
Topic
Analysis Analysis Analysis
COST OF GOODS SOLD
OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL
THINKING CASES
Topic Skills
Analysis
Exercises
Real World: Home Depot, Inc. Examining an annual report
Analysis
Analysis Analysis
Analysis
Analysis, communication, judgment
Analysis
Real World: General Motors Corporation Evaluating cost flow assumptions
Analysis, communication, judgment
Skills
Learning Objectives
Analysis Analysis, judgment
Analysis Analysis
Real World: Ford Motor Company FIFO vs. LIFO analysis Real World: Kraft Foods, Inc. Inventory turnover Real World: Wal-Mart LIFO reserves
Analysis Analysis
Analysis, communication
© The McGraw-Hill Companies, Inc., 2010 Overview
8.1 A,B Inventory cost flow assumptions 1
8.2 A,B Cost flow assumptions: Perpetual
8.3 A,B Cost flow assumptions: Periodic 4 8.4 A,B Inventory shrinkage 1– 8.5 A,B Periodic inventory systems 4 8.6 A,B Effects of inventory errors 5 8.7 A,B Retail method 2, 3, 6 8.8 A,B 1, 7
8.1 Inventory errors 5 8.2 LIFO Liquidation 4 Dealing with the bank
Inventory turnover
8.5 7
Problems Sets A, B Analysis, judgment
Topic
Learning Objectives (^) Skills
Analysis, judgment
Real World: Wal-Mart/J.C. Penney FIFO vs. LIFO comparisons
Analysis, judgment Analysis, communication, judgment Analysis, judgment Analysis, communication Analysis Analysis, communication, judgment
(Business Week)
Analysis, communication, judgment
Real World: EMC Corporation
Analysis, communication, technology
Real World: Safeway, Inc., and Staples, Inc. Inventory turnover rates (Internet)
Critical Thinking Cases Analysis, communication, judgment
(Ethics, fraud & corporate governance) Analysis, communication, judgment
Analysis, communication, judgment 3
© The McGraw-Hill Companies, Inc., 2010 Overview(p.2)
Critical Thinking Cases
Inventory Errors
LIFO Liquidation
Dealing with the Bank Ethics, Fraud & Corporate Governance
EMC Corporation Business Week
Safeway and Staples No time limit Internet Strong
20 Medium Dramatic illustration of the potential effect of a LIFO liquidation. Excellent case for illustrating why finance and marketing majors should understand accounting.
Students are required to evaluate ethical implications of manipulating financial statement information in order to be in compliance with bank covenants. Also requires analytical understanding of working capital relationships. 10 Easy
15 Medium
30 Strong While interviewing for a position as controller, the job applicant learns that the employer has an inventory “problem.” Inventories have been understated consistently in past income tax returns.
Students are asked to consider trade-offs between inventory turnover and product quality.
Requires an analytical interpretation of inventory performance measures reported by a grocery chain and an office supply chain.
© The McGraw-Hill Companies, Inc., 2010 Desc. of Cases
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
a.
b.
c.
The specific identification method should be used by the art gallery. Each item is unique and prices vary widely. Therefore, the gross profit on a sale can be determined logically only by a method that offsets the cost of a specific painting against its sales price. The ending inventory will be stated at the cost incurred for the individual paintings on hand at the end of the year.
In measuring the results of operations, accountants consider the flow of costs to be more important than the physical flow of specific units of merchandise. Therefore, a cost flow assumption need not correspond to the physical movement of the company’s merchandise.
During a period of rising purchase costs, FIFO results in the highest reported profits, as the cost of goods sold is measured using the oldest (and lowest) costs. LIFO results in the lowest taxable income, as the cost of goods sold consists of the most recent (and highest) purchase costs.
As the FIFO method assigns the oldest costs to the cost of goods sold, the most recent purchase costs remain in the Inventory account. Therefore, FIFO results in a valuation of inventory that is closest to current replacement costs. Under these unusual circumstances of unchanging purchase prices throughout the year, FIFO and LIFO would produce exactly the same results in the financial statements. The ending inventory under both methods would be equal to the number of units on hand at year-end multiplied by the same unit price.
LIFO means “last-in, first-out.” Thus, the most recently acquired units are assumed to be the first sold, and the cost of goods sold is based upon the most recent cost layers.
The cost of merchandise represents an asset—inventory—until the merchandise is sold. At the date of sale, the cost of the merchandise is reclassified as an expense—cost of goods sold—which is “matched” against the related sales revenue. The use of a cost flow assumption eliminates the need for separately identifying each unit sold and looking up its cost. Thus, the time and effort involved in recording the cost of goods sold can be reduced significantly. In addition, the use of a flow assumption enables management to match sales revenue with relatively current merchandise costs and also to minimize the company's income taxes expense.
Under the average-cost method, all units in the inventory are valued at the same average cost. (The average cost is recomputed after every purchase transaction.) Therefore, the cost of goods sold is based upon this average cost per unit. The FIFO flow assumption means “first-in, first-out.” Therefore, each sale is assumed to consist of the oldest units in the inventory, and the unit costs in the oldest cost layers are transferred to the cost of goods sold.
Generally accepted accounting principles permit the use of inventory cost flow assumptions whenever the items comprising the inventory are similar in terms of cost, function, and sales price.
© The McGraw-Hill Companies, Inc., 2010 Q1-
- a.
b.
c.
Errors in the valuation of ending inventory are said to be “counterbalancing” or “self-correcting” because these errors have opposite effects upon the gross profit (and net income) reported in each of two successive years. The cumulative amount of gross profit reported over the two-year period will be correct, and the balance sheet will be correct at the end of the second year.
The inventory turnover is computed by dividing the cost of goods sold by the average amount of inventory maintained during the period. The higher the inventory turnover, the more efficient is management’s use of the asset to generate sales. This measurement is of interest to short-term creditors because it indicates how quickly the company is able to sell its merchandise. This is a major step in converting the inventory into cash, which, in turn, can be used to pay the short-term creditors’ claims.
The average-cost method begins with a determination of the average per-unit cost of all units available for sale during the year (cost of goods available for sale divided by the number of units available for sale). The units in the year-end inventory then are priced at this average per-unit cost. Under the FIFO flow assumption, the oldest goods (first-in) are assumed to be the first sold. Therefore, the ending inventory is assumed to consist of the most recently purchased units.
Ending inventory $56,000 , computed as follows: $40,000 + $100,000 ($112,000 .75) = $56,000.
No. The inventory must be presented in the balance sheet at cost. The inventory stated at retail price will be reduced to a cost basis by applying the cost percentage, which is the ratio prevailing between cost and selling price during the current period.
This “counterbalancing” effect stems from the fact that an error in the valuation of the ending inventory of one year represents an error in the beginning inventory of the following year. Ending and beginning inventory amounts have opposite effects on the calculation of cost of goods sold.
Under the gross profit method, the cost of goods sold is estimated by applying the historical cost ratio (100% minus the gross profit rate) to the net sales of the current period. Subtracting this estimated cost of goods sold from the cost of goods available for sale (beginning inventory plus purchases) provides an estimate of ending inventory. Companies that use a periodic inventory system find the gross profit method useful in preparing interim financial statements. These companies also may use this method in estimating the inventory on hand at the date of a fire, theft, or other casualty. The method also may be used to confirm the reasonableness of the amount determined by a year-end physical inventory.
Under the LIFO method, the most recently acquired merchandise is assumed to be the first sold. Therefore, the ending inventory is assumed to consist of the oldest units (including the beginning inventory). Relative to a perpetual inventory system, periodic LIFO costing procedures usually result in more recent (higher) costs being assigned to the cost of goods sold. In fact, even goods purchased on the last day of the year are assumed to have been sold under periodic costing procedures. A higher cost of goods sold, in turn, means less taxable income. Thus, a company usually can maximize the income tax benefits of LIFO by restating its year-end inventory to the costs indicated by periodic LIFO costing procedures.
© The McGraw-Hill Companies, Inc., 2010 Q14-
- a.
b.
c.
- a.
b.
- a.
b.
c.
Using LIFO during a period of rising costs should result in a lower net income than would be reported under the FIFO method. LIFO assigns the most recent purchase costs to the cost of goods sold. When costs are rising, the most recent costs also tend to be the highest costs. LIFO assigns the more recent (higher) costs to the cost of goods sold, and the older (lower) costs to inventory. The inventory turnover rate is computed by dividing the cost of goods sold by the average inventory. Therefore, use of the LIFO method should indicate a higher inventory turnover rate than would the FIFO method. By assigning the more recent (higher) purchase prices to the cost of goods sold, LIFO minimizes taxable income and income taxes expense. This is, perhaps, the primary reason for the popularity of the LIFO method. In a period of declining prices, use of the FIFO method will minimize the reported rate of gross profit. This is because the oldest (and therefore highest) purchase costs will be assigned to the cost of goods sold.
Again the answer is the first company. As LIFO minimizes net income during a period of rising prices, it also minimizes the amount of income taxes that a company must pay. The Internal Revenue Service allows a company to use the LIFO method in its income tax returns only if the company also uses the LIFO method in its financial statements. Thus, only the company using LIFO is eligible to receive the income tax benefits of the LIFO method. By using FIFO in its financial statements, the second company is precluded from using the LIFO method in its income tax returns.
The first company is using the more conservative method—LIFO—in pricing its inventory. The LIFO (last-in, first-out) method of pricing inventory assigns older costs to inventory and more recent costs to the cost of goods sold. The FIFO method (first-in, first-out), in contrast, assigns the more recent costs to inventory and the older costs to the cost of goods sold. Thus, during a period of rising prices, the LIFO method results in a lower valuation of inventory and a higher valuation of the cost of goods sold than does the FIFO method.
The net cash flow from operating activities will be higher than if Computer Products had used LIFO. This is because the flow assumption in use has no effect upon the cash receipts from customers or cash payments to suppliers, but it does affect income taxes. By using FIFO in this period of declining prices, the older and higher costs will be assigned to the cost of goods sold, thereby minimizing taxable income. This, in turn, will minimize income tax payments—a cash outflow that enters into the determination of net cash flow from operating activities.
( Note to instructor: In the more common situation of rising replacement costs, it would be LIFO that would minimize the gross profit rate and increase net cash flow from operating activities.)
No. An inventory flow assumption affects only the allocation of costs between ending inventory and the cost of goods sold. It has no effect upon the amounts of cash, either collected from customers or paid to merchandise suppliers.
© The McGraw-Hill Companies, Inc., 2010 Q21-
B.Ex. 8.
B.Ex. 8.
Inventory turnover: $500,000 / $128,000 = 3.
Inventory turnover for 2009: $90 / $35 = 2.
The turnover inventory is higher in 2008, indicating that management did a better job of managing its inventory in 2008 than in 2009. This same relationship can be seen by calculating the average number of days to sell inventory, which is lower in 2008, as indicated below:
Average number of days to sell inventory: 365 / 3.91 = 93.
Average days to sell inventory:
Inventory turnover for 2008: $85 / $27 = 3.
© The McGraw-Hill Companies, Inc., 2010 BE8.9,
Ex. 8.1 a. b. c. d. LIFO method e. FIFO method f.
Ex. 8.2 a. 137, 137,
Cost of goods sold …………… $137,
b. 137, 137,
c. 137, 137,
Cost of goods sold …………… $137,
d. 138, Inventory …………………………………… 138,
To record the cost of 90 Millenium computers sold to Apex Publishers. Cost determined by the LIFO flow assumption:
60 @ $1,500 ………………… Cost of goods sold ……………
SOLUTIONS TO EXERCISES
Inventory ……………………………………
Inventory ……………………………………
Average-cost method
Inventory ……………………………………
Cost of Goods Sold …………………………………………
Flow assumption
Cost of Goods Sold …………………………………………
Specific identification
To record the cost of 90 Millenium computers sold to Apex Publishers. Cost determined by the FIFO flow assumption:
Retail method
To record the cost of 90 Millenium computers sold to Apex Publishers. Cost determined by the specific identification method:
To record the cost of 90 Millenium computers sold to Apex Publishers. Cost determined by the average-cost method:
Cost of Goods Sold …………………………………………
Cost of Goods Sold …………………………………………
90 @ $1,530 ($153,000 100 units)
© The McGraw-Hill Companies, Inc., 2010 E8.1,
Ex. 8.4 a.
b.
- $125,
15, $110,
taxes x 40%)…………………………………………………… $44,
- $110, 44, Net income (assuming LIFO) ………………………………… $66,
- $123,
8, $131,
Ex. 8.5 The inventory at December 31 amounts to $725,000, computed by adding the $125, inbound shipment of merchandise to $600,000 of merchandise on hand. Terms of the $125,000 shipment were F.O.B. shipping point; therefore, title passed at the point of shipment on December 28 and the goods were the property of the buyer (Jensen) while in transit. The $95,000 outbound shipment was correctly handled. Title to these goods passed to the customer on December 30 when the goods were shipped, so they are not part of the Jensen inventory at December 31. This shipment was billed on December 30, so the account receivable is properly included in the balance sheet. In addition to the $125,000 increase in inventory, accounts payable should be increased by $125,000. Jensen owns the merchandise at December 31 and has a liability to pay for it.
Income before income taxes (as reported under FIFO) ……… Less: Additional cost of goods sold had LIFO been in use use ($1,865,000 - $1,850,000)…………………………………… Income before income taxes (assuming LIFO) ……………… Income taxes expense under LIFO ($110,000 income before
Income before income taxes (LIFO basis, part 1 ) …………… Less: Income taxes expense under LIFO (part 2 ) ……………
paid, minus $44,000 from part 2)……………………………. Net cash provided by operating activities (assuming LIFO) …
LIFO results in a higher cost of goods sold than does FIFO when the replacement costs of merchandise are rising. Under LIFO, the most recent (higher) costs are assigned to the cost of goods sold, and the oldest (lower) costs to inventory. This situation reverses under FIFO. Because LIFO assigns the oldest (lowest) costs to inventory, it is reasonable to expect that the LIFO inventory would be lower than that resulting from FIFO valuation, not higher. Dollar amounts stated in thousands:
Net cash provided by operating activities (as reported) under FIFO)…………………………………………………… Add: Income tax savings had LIFO been in use ($52,
© The McGraw-Hill Companies, Inc., 2010 E8.4,
Ex. 8.6 a. 1. 2, 2,
Replacement cost (28 units @ $250) …… 7, $2,
- 5, 5,
b. 1. 1, 1,
Loss from Write-down of Inventory ……………………
Cost …………………………………….
Cost of Goods Sold ………………………………………. Inventory ………………………………………
Inventory ……………………………………… To write down the inventory of 28 units of WordCrafter to the lower-of-cost-or-market:
To recognize the sales revenue from the sale of 15 WordCrafter programs @ $350, cash.
Cost of Goods Sold …………………………………………
Sales ……………………………………………
To record shrinkage loss of 3 units of WordCrafter software using the FIFO flow assumption (3 units @ $400).
To record shrinkage loss of 3 units of WordCrafter software using the LIFO flow assumption (3 units @ $310). Using the FIFO method would result in a $270 lower net income figure than using the LIFO method ($1,200 $930 = $270). This is due to the reduction in price paid for the second purchase. Although the company would report a lower net income figure using FIFO, it would not really be any less efficient in conducting operations. An inventory valuation method affects only the allocation of costs between ending inventory and cost of goods sold. It has no effect upon the total costs actually incurred in purchasing or manufacturing inventory.
Cost of Goods Sold ………………………………………… Inventory ………………………………………
Reduction in carrying value ……………
To record cost of 15 WordCrafter programs sold on January 9 using the FIFO flow assumption. (All units are carried in inventory at $250 following the year-end reduction to the lower-of-cost-or-market.)
Inventory ………………………………………
Cash …………………………………………………………
© The McGraw-Hill Companies, Inc., 2010 E8.
Ex. 8.9 a. Beginning inventory, January 1 …………………………… $ 50, Net purchases, January 1–29 ………………………………… 80, Cost of goods available for sale………………………… $ 130,
$ 70, 55% Estimated cost of goods sold…………………………… 38, Estimated ending inventory (at cost):………………… $ 91,
b.
a. 58% $348,
b.
Ex. 8.11 a.
b.
c. By using LIFO, the company’s inventories are reported in the balance sheet at an amount $1.4 billion lower than if LIFO had not been used. The LIFO method assigns the most recent inventory replacement costs to the cost of goods sold, and reports the older inventory cost layers in the balance sheet. Thus, if the LIFO method decreases the company’s ending inventory reported in the balance sheet, replacement costs must be increasing.
Deduct: Estimated cost of goods sold:
Rapp must use the periodic inventory method. Had the perpetual method been used, Rapp would have had the actual inventory figure at January 29, making it unnecessary to compute an estimated figure using the gross profit method.
Net sales………………………………………………… Cost percentage (100% - 45%)…………………………
No. A company may use different inventory methods for different types of inventory. With respect to inventories, the consistency principle means only that the method used to value a particular type of inventory should not be changed from one year to the next. The notes accompanying the company’s financial statements reveal that total inventories would have been $1.4 billion higher had the LIFO method not been used. Accordingly, the company’s cost of goods sold would have been lower, and gross profit would have been higher had the LIFO method not been used.
Estimated cost of goods sold ($600,000 58%) ………………………
Estimated ending inventory ……………………………………… It appears that the cost of Phillips’ inventory as a percentage of retail sales in July is lower than it was in June. At June 30, the percentage was 60% ($300,000 $500,000). During July, however, the percentage was only 55.5%, based upon Phillips’ purchases ($222,000 $400,000).
Estimated ending inventory (at cost): Cost of goods available for sale during July ……………………… Less: Estimated cost of goods sold (above) ………………………
Inventory at time of theft is $91,500, computed as follows:
Ex. 8.10 (^) Cost ratio during July ($522,000 $900,000) ………………………
© The McGraw-Hill Companies, Inc., 2010 E8.9,10,
Ex. 8.12 a. 1.
b.
Although Ford has reported less net income as a result of using LIFO, it actually is better off than if it had used FIFO. There are only two differences in the company’s financial position that result from the flow assumption in use. One is a difference in cash position. As explained above, Ford has made lower tax payments and therefore retained more cash as a result of using LIFO. This indeed makes the company “better off.”
The only manner in which an inventory flow assumption affects solvency is through its effect upon cash flows. The higher or lower cost that might be assigned to inventory is not relevant , as it does not affect the amount for which that inventory can be sold. As explained in item 7 , above, the only cash flow affected by inventory flow assumptions is income tax payments. As LIFO has resulted in lower tax payments, it has left the company more solvent than it would have been if it were using FIFO.
The gross profit rate would have been higher had the company been using FIFO because older (and therefore lower) costs would have been charged to the Cost of Goods Sold account. This would have resulted in a higher dollar amount of gross profit and a higher gross profit rate. Net income would have been higher under FIFO for the same reason as explained above. However, net income would not have been increased as much as gross profit, because income tax expense would have been higher had FIFO been in use. The current ratio also would have been higher under FIFO because inventory would have been valued at more current costs, which are higher than the older costs included in a LIFO inventory valuation. The inventory turnover rate would have been lower had the company used FIFO. This rate is the cost of goods sold, divided by average inventory. Under FIFO, the cost of goods sold would have been lower, and the average inventory value would have been higher. Both factors result in a lower inventory turnover rate. The accounts receivable turnover rate (net sales divided by average accounts receivable) would be unaffected by the inventory flow assumption in use. A flow assumption allocates the cost of merchandise purchases between the Cost of Goods Sold account and the Inventory account. It has no effect upon sales revenue or accounts receivable. Cash payments to suppliers are unaffected by the inventory flow assumption in use. These cash flows are affected by the terms of purchase, not the manner in which the purchaser chooses to account for the acquisition costs. Net cash flow from operating activities would have been lower had the company used FIFO. The only cash flow affected by the inventory flow assumption in use is income taxes. By recording a lower cost of goods sold, the use of FIFO would have resulted in higher taxable income and, therefore, larger tax payments.
© The McGraw-Hill Companies, Inc., 2010 E8.
b.
c.
365 days / 8.14 = 44. Year ended January 31, 2007:
365 days / 7.84 = 46.
The company was more efficient in managing its inventory in the year ended January 31, 2008. The inventory turnover in the most recent year was 8.14, compared to 7.84 in the previous year. This resulted in an average number of days required to sell inventory being approximately two days less in the current year (44.8) compared to the most recent prior year (46.6). The shorter the time required to sell inventory, the more efficient the company is.
- Supplemental Topic , "LIFO Reserves."
Inventory turnover:
Year ended January 31, 2008:
Cost of goods sold ($286,515)/Inventory ($35,180) = 8.
Year ended January 31, 2007: Cost of goods sold ($264,152)/Inventory ($33,685) =7. Average number of days required to sell inventory:
Year ended January 31, 2008:
© The McGraw-Hill Companies, Inc., 2010 E8.
Ex. 8.15 a. (1) $51, 12, 11, $24, ÷ 2 (2) $12, (3) 4.18 times
b. (1) 365 days 87.3 days
c. 87.3 days 10.6 days * 97.9 days
÷ 2
34.5 times 10.6 days
Given an operating cycle of approximately 98 days, inventory accounts for almost 90% of the company's total operating cycle. Accounts receivable days account for only about 11% of the total time in the operating cycle. Thus, the accounts receivable turnover influences the company's operating cycle much less than does its inventory turnover.
Net sales year ended 2/3/
Average days merchandise is in inventory (see b) Average days receivables remain outstanding Days in operating cycle
- The average days a receivable remains outstanding is computed as follows:
Days in a year
Average inventories year ended 2/3/
Cost of sales year ended 2/3/
Average days in inventory (365 ÷ 4.18)
Inventories 1/28/ Inventories 2/3/
Inventory turnover (1) ÷ (2)
Receivables turnover rate (1) ÷ (2) Average days outstanding 365 ÷ 34.
Accounts receivable 1/28/ Accounts receivable 2/3/
Average inventories year ended 2/3/
© The McGraw-Hill Companies, Inc., 2010 E8.
