anthonyIM_06

CHAPTER 6 COST OF SALES AND INVENTORIES Changes from Eleventh Edition Editorial and updated changes have been made. Approach This chapter can be assigned in two parts, if the instructor wishes to spend several sessions on these topics. The second assignment can begin with the section titled “Inventory Costing Methods.” By now, students will have had to deduce cost of goods sold if they have tackled the cases in previous chapters. Nevertheless, for some students this deduction process is a difficult one to grasp, and it is important that it be understood. Also, the mechanics of flows through a manufacturing company are difficult to grasp. Students will encounter this topic again in Chapter 17, however, so it doesn’t matter too much if they don’t get it here. This is another one of the topics that seems to be mastered only after drill with a number of problems. The choice between LIFO and FIFO also causes problems, perhaps because LIFO obviously does not match the physical flow of goods. It should perhaps be emphasized that, regardless of the conceptual merit of one method or the other, LIFO defers incomes taxes, and it defers them forever in an inflationary economy. The discussion also provides a way of highlighting the fact that accounting focuses on the measurement of income, even though the result is an unrealistic balance sheet (as is the case with LIFO inventories). Cases Browning Manufacturing Company requires recording a complete cycle of transactions in a manufacturing company. It is straightforward. Lewis Corporation is a problem that contrasts FIFO and LIFO in a clear-cut way. Morgan Manufacturing deals with the adjustment, comparison, and interpretation of financial statements for two firms, one prepared using LIFO and the other using FIFO. Joan Holtz (B) is the second set of discrete problems, from which the instructor can select those he or she wants to discuss in class. VAL Corporation deals with accounting for mileage programs.

Problems Problem 6-1 The completed table is shown below. Each deduction involves the basic inventory equation. Ending inventory = Beginning Inventory + Purchase – Shipments (COGS) as well as the basic relationships inherent in any income statement, that is:,

1

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Income = Revenues – Expenses

Co. W Co. X Co. Y Co. Z Sales...................................................................................................................................................................................... $2,250 $1,800 $1,350 $2,100 Cost of goods sold:................................................................................................................................................................ Beginning inventory......................................................................................................................................................... 300 225 500 300 Plus: Purchases................................................................................................................................................................. 975 975 850 1,200 Less: Ending inventory..................................................................................................................................................... 225 300 300 150 Cost of good sold......................................................................................................................................................... 1,050 900 1,050 1,350 Gross margin......................................................................................................................................................................... 1,200 900 300 750 Period expenses..................................................................................................................................................................... 300 400 150 800 Net income (Loss)................................................................................................................................................................. $ 900 $ 500 $ 150 $ (50) Problem 6-2 The required income statement is reproduced below. The closing entries are: a.

Beginning inventory balance is $50,000

b.

dr. Inventory......................................................................................................................................................... 167,000 cr. Purchases.................................................................................................................................................... 167,000

c.

dr. Inventory......................................................................................................................................................... 4,000 cr. Freight-in.................................................................................................................................................... 4,000

d.

dr. Returns (to Suppliers)..................................................................................................................................... 8,000 cr. Inventory.................................................................................................................................................... 8,000

e.

dr. Cost of Goods Sold......................................................................................................................................... 135,500 cr. Inventory...................................................................................................................................................... 135,500

f.

dr. Income Summary............................................................................................................................................ 135,500 cr. Cost of Goods Sold..................................................................................................................................... 135,500

g.

dr. Income Summary............................................................................................................................................ 95,000 cr. Other Expenses........................................................................................................................................... 95,000

h.

dr. Tax expense.................................................................................................................................................... 28,350 cr. Taxes Payable............................................................................................................................................. 28,350

i.

dr. Sales................................................................................................................................................................ 325,000 cr. Income Summary........................................................................................................................................ 325,000

j.

dr. Income Summary............................................................................................................................................ 28,350 cr. Tax Expense............................................................................................................................................... 28,350

GARDNER PHARMACY Income Statement for the Year ----. Sales............................................................................................................................................................................... $325,000 Cost of goods sold:......................................................................................................................................................... Beginning inventory................................................................................................................................................. $ 50,000 Plus: Purchase, gross........................................................................................................................................ $167,000

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©2007 McGraw-Hill/Irwin

Chapter 6

Freight-in................................................................................................................................... 4,000 171,000 Less: Purchase returns......................................................................................................................... 8,000 Net purchases.............................................................................................................................................. 163,000 Goods available for sale.............................................................................................................................. 213,000 Less: Ending inventory........................................................................................................................ 77,500 Cost of goods sold............................................................................................................................. 135,500 Gross margin..................................................................................................................................................... 189,500 Other expenses.................................................................................................................................................. 95,000 Income before taxes.......................................................................................................................................... 94,500 Income tax expense........................................................................................................................................... 28,350 Net income........................................................................................................................................................ 66,150 Problem 6-3 a.

dr. Inventory....................................................................................................................................... 85,500 cr. Cash (or Payables).................................................................................................................... 85,500

dr. Cash (or Receivables).................................................................................................................... 133,400 cr. Sales.......................................................................................................................................... 133,400

dr. Sales Returns................................................................................................................................. 1,840 Inventory........................................................................................................................................ 1,200 cr. Cash (or Receivables)............................................................................................................... 1,840 Cost of Goods Sold................................................................................................................... 1,200 b.

GOULD’S COMPANY Income Statement Gross sales.......................................................................................................................................... $133,400 Less: Sales returns........................................................................................................................ 1,840 Net sales................................................................................................................................ $131,560 Cost of goods sold........................................................................................................................ 85,800 Gross margin................................................................................................................................ $ 45,760

c. The perpetual inventory records indicate ending inventory should have been 673 + 5,700 – 5,800 + 80 = 653 units. Inventory shrinkage has therefore been 653 – 610 = 43 units.

dr. Inventory Shrinkage 645 .......................................................... ................................................................................................................................................................................. cr. Inventory........................................................................................................................................................ 645 The inventory shrinkage entry reduces gross margin by $645 (or shrinkage could be shown below the gross margin line as a general expense). Problem 6-4 Purchases: 50 units @ 75 units @ Avg: 125 units @ Sales: 100 units

$14 = $12 = $12.80 =

$ 700 900 $1,600

3



Ending inventory: 25 units

Avg. Cost Fifo Lifo July 31 inventory............................................................................................................................................................................ $ 320 $ 300 $ 350 Cost of goods sold.......................................................................................................................................................................... 1,280 1,300 1,250 Available for sale........................................................................................................................................................................... 1,600 1,600 1,600 Problem 6-5 a.

Fifo Av. Cost Lifo Sales..................................................................................................................................................................................... $52,125 $52,125 $52,125 Cost of goods sold................................................................................................................................................................ 27,310 27,053 26,960 Gross margin........................................................................................................................................................................ $24,815 $25,072 $25,165

Fifo Av. Cost Lifo b. Gross margin percentage...................................................................................................................................................... 47.6% 48.1% 48.3% c. Net cash flow = $21,465 ($52,125 - $30,660) No change in pretax cash flow figure using different inventory methods. d.

Fifo Av. Cost Lifo Pretax cash flow................................................................................................................................................................... $21,465 $21,465 $21,465 Tax payment 7,445 7,522 7,550 ................................................. ............................................................................................................................................................................................. After-tax cash flow............................................................................................................................................................... $14,020 $13,943 $13,915

The tax payment in 30 percent of the gross margin dollars. The cash flow using Fifo for tax purposes is the lowest of the three after tax cash flow amounts because the unit cost of computers is falling, producing the highest taxable gross margin of the three methods. Problem 6-6 a. Ending inventory balances are:

Materials Work in Finished Inventory Process Goods Beginning balance........................................................................................................................................................ $ 100,000 $ 370,000 $ 60,000 (1) Purchases...................................................................................................................................................................... 872,000 Delivery charge............................................................................................................................................................ 22,000 (2) Direct labor................................................................................................................................................................... 565,000 (3) Materials transfer.......................................................................................................................................................... (900,000) 900,000 (4) Indirect labor................................................................................................................................................................ 27,000 Factory supplies............................................................................................................................................................ 46,000 Depreciation–factory.................................................................................................................................................... 54,000 Factory utilities............................................................................................................................................................. 147,000 Depreciation–Mfg........................................................................................................................................................ 46,000 Property taxes............................................................................................................................................................... 14,000 (5) Finished goods–transfers.............................................................................................................................................. ________ (2,035,000) 2,035,000 $ 94,000 134,000 2,095,000 Cost of goods sold........................................................................................................................................................ --(2,002,000) Ending balance............................................................................................................................................................. $ 94,000 $ 134,000 $ 93,000 b. Gross margin was 23 percent. 4


Chapter 6

Sales................................................................................................................................................................ $2,600,000 Cost of goods sold........................................................................................................................................... 2,002,000 Gross margin................................................................................................................................................... $ 598,000

Problem 6-7 Item A B C D

Units 30 40 20 40

Valuation Basis/Unit $145 173 131 113

Historical Cost/Unit $150 183 134 113 Total adjustment

Total Adjustment $150 400 60 0 $610

Cases Case 6-1: Browning Manufacturing Company* Note: This case is updated from the Eleventh Edition. Approach This is a straightforward complete accounting cycle in a manufacturing company, although it is considerably longer than previous cases of the same type. Students may find it helpful to refer back to the journal entries described in the text as a guide. Tracing through these entries is intended to give the student an understanding of what goes on in a manufacturing company and how these events are reflected in the accounts. I make a concerted attempt to link the problem’s numbers to Illustrations 6-3 and 6-4 in the text, placing the T-accounts side-by-side (if board space permits) and using arrows to denote flows from one inventory account to another. Simply because of its length, two days may be necessary for this case. In any event, it is desirable that some time be left for Question 3, which asks the students to use the information they have built up. In effect, this case is a miniature practice set and can be treated as such if desired. It is a key case. Comments on Questions Question 1 1.

Accounts Receivable........................................................................................................................... 2,562,000 Sales (Retained Earnings)............................................................................................................. 2,562,000 Sales Returns and Allowances (R/E) 19,200 .............................................................................. ............................................................................................................................................................ Accounts Receivable.................................................................................................................... 19,200 Sales Discounts (R/E)......................................................................................................................... 49,200 Accounts Receivable.................................................................................................................... 49,200

*

This Teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

5


2.

(a)

(b)


Manufacturing Plant Equipment...................................................................................................................... 144,000 Cash........................................................................................................................................................... 144,000 Prepaid Taxes and Insurance........................................................................................................................... 78,000 Cash........................................................................................................................................................... 78,000 Materials Inventory......................................................................................................................................... 825,000 Accounts Payable...................................................................................................................................... 825,000 Supplies Inventory........................................................................................................................................... 66,000 Accounts Payable...................................................................................................................................... 66,000 Direct Manufacturing Labor............................................................................................................................ 492,000 Indirect Manufacturing Labor ......................................................................................................................... 198,000 Social Security Taxes...................................................................................................................................... 49,200 Power, Heat, and Light.................................................................................................................................... 135,600 Cash........................................................................................................................................................... 874,800

Since in a manufacturing company, inventory is assumed to increase in value by the amounts spent to convert materials into salable products, the following entry should be made; or the debit entry above could have been made to Work in Process Inventory directly, as is done in the T-accounts to follow.

(c) 3.

4. 5. 6.

7. 8.

9.

Work in process inventory....................................................................................................................................... 874,800 Direct Manufacturing Labor.............................................................................................................................. 492,000 Indirect Manufacturing Labor............................................................................................................................ 198,000 Social Security Taxes........................................................................................................................................ 49,200 Power, Heat, and Light...................................................................................................................................... 135,600 Selling and Administrative Expense (R/E).............................................................................................................. 522,000 Cash................................................................................................................................................................... 522,000 Work in Process Inventory...................................................................................................................................... 140,400 Accumulated Depreciation................................................................................................................................ 140,400 Work in Process Inventory...................................................................................................................................... 52,800 Prepaid Taxes and Insurance............................................................................................................................. 52,800 Work in Process Inventory...................................................................................................................................... 61,200 Supplies Inventory............................................................................................................................................. 61,200 Work in Process Inventory...................................................................................................................................... 811,000 Materials Inventory............................................................................................................................................ 811,000 Finished Goods Inventory........................................................................................................................................ 1,901,952 Work in Process Inventory................................................................................................................................ 1,901,952 Cost of Goods Sold (R/E)........................................................................................................................................ 1,806,624 Finished Goods Inventory.................................................................................................................................. 1,806,624 Cash......................................................................................................................................................................... 264,000 Notes Payable.................................................................................................................................................... 264,000 Notes Payable.......................................................................................................................................................... 300,000 Cash................................................................................................................................................................... 300,000 Interest Expense (R/E)............................................................................................................................................. 38,400 Cash................................................................................................................................................................... 38,400 Cash ........................................................................................................................................................................ 2,604,000 Accounts Receivable......................................................................................................................................... 2,604,000 Accounts Payable.................................................................................................................................................... 788,400 Cash................................................................................................................................................................... 788,400 Income Taxes Payable (2005).................................................................................................................................. 9,000 Cash................................................................................................................................................................... 9,000 Estimated Federal Income Taxes Expense (R/E) 58,000 (2006)....................................................................................................................................................................

6


10.

Chapter 6

Income taxes payable (2006)................................................................................................................ 5,800 Cash...................................................................................................................................................... 52,200 Dividends (Retained Earnings) 30,000 .............................................................................. .................................................................................................................................................................... Cash...................................................................................................................................................... 30,000

Question 2 (see pages 102 - 104.) Question 3 1. Net sales are expected to increase 11.6 percent. 2. Gross profit margin is expected to decrease slightly from 29.8 percent of net sales in 2005 to 27.5 percent in 2006. 3. There is a l9.4 percent increase in selling and administrative expenses. This seems high, relative to the sales increase; perhaps R&D expense in increasing. 4. The net effect of the foregoing is an anticipated decrease in profit before taxes. Profit would be increased by judicious reductions in the anticipated selling and administrative expense, or by actions to restore (or improve) the gross margin percentage. 5. It is expected that more funds will be tied up in inventories. Inventory turnover in 2005 was 2.82 times; it is projected at 2.55 times for 2006. Why the slowdown (about 13 days’ increase)? Bal. (6) (7)

Bal.

Cash 118,440 (2) 264,000 (2) 2,604,000 (2) (2) (6) (6) (8) (8) (9) (10) ________ Bal. 2,986,440 149,640

144,000 78,000 874,800 522,000 300,000 38,400 788,400 9,000 52,200 30,000 149,640 2,986,440

Bal.

Materials Inventory 110,520 (3) 811,000 825,000 Bal. 124,520 935,520 935,520 124,520

Bal. (4)

Finished Goods Inventory 257,040 (5) 1,806,624 1,901,952 Bal. 352,368

Bal. (2)

Accounts Receivable (Net) Bal. 311,760 (1) 19,200 (1) 2,562,000 (1) 49,200 (7) 2,604,000 ________ Bal. 201,360 2,873,760 2,873,760 Bal. 201,360 Work in Process Inventory 172,200 (1) 1,901,952 874,800 Bal. 210,448 140,400 52,800 61,200 811,000 ________ 2,112,400 2,112,400 Bal. 210,448 Bal. (2) (3) (3) (3) (3)

Bal. (2) Bal.

7

Supplies Inventory 17,280 (3) 66,000 Bal. 83,280 22,080

61,200 22,080 83,280


Bal.

2,158,992 352,368


2,158,992 Bal. (2)

Prepaid Taxes and Insurance 66,720 (3) 52,800 78,000 Bal. 91,920 144,720 144,720 Bal. 91,920 Bal. (2)

Bal.

(8) Ba1.

Bal. (6) Bal.

Accumulated Depreciation 1,047,600 Bal. 907,200 ________ (3) 140,400 1,047,600 1,047,600 Bal. 1,047,600

(8) Bal.

Accounts Payable 788,400 Bal. 185,760 288,350 (2) 825,000 ________ (2) 66,000 1,076,760 1,076,760 Bal. 288,360 Capital Stock Bal.

(1) (1) (2) (5) (6) (9) (10) Bal.

1,512,000

Manufacturing Plant 2,678,400 Bal. 2,822,400 144,000 ________ 2,822,400 2,822,400 2,822,400 Notes Payable 300,000 Bal. 252,840 (6) 552,840 Bal.

288,840 264,000 552,840 252,840

Fed. Inc. Taxes Payable 9,000 Bal. 5,800 (9) 14,800 Bal.

9,000 5,800 14,800 5,800

Retained Earnings 19,200 Bal. 829,560 49,200 (1) 2,562,000 522,000 1,806,624 38,400 58,000 30,000 868,136 ________ 3,391,560 3,391,560 Bal. 868,136

6. It is planned to reduced notes payable. Whether this is wise may depend on the notes payable interest vis-à-vis the return being earned on marketable securities. 7. Additions to plant are slightly greater than depreciation expense. This is not unusual in an inflationary era. 8. The accounts receivable balance will decline by about 35 percent even though there is an expected increase in sales. Is the collection department being overly optimistic about collections on account? BROWNING MANUFACTURING CORPORATION Projected Balance Sheet as of December 2006 Assets

Current Assets Cash and marketable securities................................................................................................................................................ $ 449,640 Accounts receivable (net)........................................................................................................................................................ 201,360 Inventories:.............................................................................................................................................................................. Materials............................................................................................................................................................................ $124,520 Work in process................................................................................................................................................................. 210,448 Finished goods.................................................................................................................................................................. 352,368

8


Chapter 6

Supplies 22,080 709,416 ........................................................................ .............................................................................................................................................................................. Prepaid taxes and insurance......................................................................................................................................... 91,920 Total current assets............................................................................................................................................... $1,452,336 Manufacturing plant.................................................................................................................................................... 2,822,400 Less: Accumulated depreciation........................................................................................................................... ( 1,047,600) 1,774,800 Total assets..................................................................................................................................................... $2,927,136 Liabilities and Shareholders’ Equity Current liabilities Accounts payable $ 288,360 Notes payable 252,840 Income taxes payable 5,800 Total current liabilities $ 547,000 Shareholders’ equity: Capital stock 1,512,000 Retained earnings 868,136 2,380,136 Total Liabilities and Shareholders’ Equity $2,927,136

BROWNING MANUFACTURING CORPORATION Projected 2006 Income Statement Sales.................................................................................................................................................................................. $2,562,000 Less: Sales returns and allowances.............................................................................................................................. $19,200 Sales discount allowed....................................................................................................................................... 49,200 68,400 Net sales............................................................................................................................................................................ 2,493,600 Less: Cost of goods sold (per schedule)...................................................................................................................... 1,806,624 Gloss margin...................................................................................................................................................................... 686,976 Less: Selling and administrative expense.................................................................................................................... 522,000 Operating income.............................................................................................................................................................. 164,976 Less: Interest expense.................................................................................................................................................. $ 38,400 Income before federal income tax...................................................................................................................................... 126,576 Less: Estimated income tax expense 58,000 ................................................................................................... .................................................................................................................................................................................... Net income........................................................................................................................................................................ $ 68,576

BROWNING MANUFACTURING CORPORATION Projected 2006 Statement of Cost of Goods Sold Finished goods inventory, 1/1/06....................................................................................................................................... $ 257,040 Work in process inventory, 1/1/06..................................................................................................................................... $ 172,200 Materials inventory, l/1/06................................................................................................................................................. $110,520 Plus: Purchases............................................................................................................................................................ 825,000 935,520 Less: Materials inventory 12/31/06............................................................................................................................. 124,520 Materials used ................................................................................................................................................................... 811,000 Plus: Factory expenses:...............................................................................................................................................

9



Direct manufacturing labor................................................................................................................................................ 492,000 Factory overhead:.................................................................................................................................................................... Indirect manufacturing labor............................................................................................................................................. $198,000 Power, heat, and light........................................................................................................................................................ 135,600 Depreciation of plant......................................................................................................................................................... 140,400 Social security taxes.......................................................................................................................................................... 49,200 Taxes and insurance, factory............................................................................................................................................. 52,800 Supplies............................................................................................................................................................................. 61,200 637,200 2,112,400 Less: Work in process inventory, 12/31/06.............................................................................................................................. 210,448 Cost of goods manufactured................................................................................................................................................. 1,901,952 2,158,992 Less: Finished goods inventory, 12/31/06................................................................................................................................ 352,368 Cost of goods sold.......................................................................................................................................................................... $1,806,624

10


Chapter 6

Case 6-2: Lewis Corporation* Note: Updated from Eleventh Edition. Approach We have found it useful for students to perform some comparative FIFO/LIFO average cost calculations, rather than only read about the differences among these methods. This case presents that opportunity, with an emphasis on the income tax—hence, cash flow—implications of the choice of a method. Via Question 3, the student can see the impact of a sales decline causing a “stripping off” of LIFO layers with the result that LIFO reports a lower cost of goods sold, and thus would result in higher income taxes that year, than would FIFO. Question 4 introduces the significance of the LIFO reserve. Students can discover that the LIFO reserve is useful in analyzing financial statements. It can be used to estimate the cumulative tax savings realized by adopting LIFO; and when trying to compare the financial performance of a company using LIFO to another using FIFO, the LIFO reserve can be used to adjust the LIFO financial statements to a FIFO basis. This adjustment will be explored in more detail in Case 6-3 Finally, Question 5 presents the opportunity to challenge the widely held notion that almost all companies use LIFO (the instructor can update the text footnote on LIFO usage by referring to the latest edition of Accounting Trends & Techniques and to discuss the reasons for many companies’ use of FIFO. For those who wish to do so, this discussion can bring in the Efficient Markets Hypothesis. In our view, one reason some companies continue to use FIFO in circumstances when LIFO would improve cash flows is that their managements do not believe that EMH premise that the lower reported earnings from LIFO would not diminish shareholder value. Calculations for Questions Question 1 The approach below reflects how most students perform these calculations. At some point I show them (to their chagrin) that a lot of effort can be saved if the amount of each year’s purchases is calculated first, and then the equation Beg. Invent + Purchases = COGS + End Invent. is applied year-by-year. With the more detailed approach students take, class time allows showing only a couple of years for FIFO and LIFO, and one year for average cost. FIFO:

COGS

Inventory

LIFO:

COGS

2005 1,840 600 380 2,820

@ @ @ @

$20.00 20.25 21.00

= = =

$36,800.00 12,150.00 7,980.00 $56,930.00

420 400 200 1,020

@ @ @

21.00 21.25 21.50

= = =

8,820.00 8,500.00 4,300.00 $21,620.00

200 400 800 600

@ @ @ @

$21.50 21.25 21.00 20.25

= = = =

$4,300.00 8,500.00 16,800.00 12,150.00

*

This Teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

11


AVERAGE COST:


820 2,820

@

20.00

=

16,400.00 $58,150.00

Inventory

1,020

@

20.00

=

$20,400.00

COGS

2,820

@

$20.456 =

$57,685.92

Inventory 1,020 @ 20.456 = $20,865.12 Note in all three cases that the sum of the cost of goods sold and ending inventory amounts is the same: $78,550 (slightly different with average cost because of rounding errors), which is the sum of the beginning inventory and purchases (i.e., available for sale). FIFO:

LIFO:

AVERAGE COST:

FIFO:

2006 420 400 200 700 700 660 3,080

@ @ @ @ @ @

$ 21.00 21.25 21.50 21.50 21.50 22.00

= = = = = =

$ 8,820.00 8,500.00 4,300.00 15,050.00 15,050.00 14,520.00 $66,240.00

Inventory

40 1,000 1,040

@ @ @

22.00 22.25

= =

$

COGS

1,000 700 700 680 3,080

@ @ @ @

$ 22.25 22.00 21.50 21.50

= = = =

$22,250.00 15,400.00 15,050.00 14,620.00 $67,320.00

Inventory

20 1,020 1,040

@ @ @

$ 21.50 20.00 20.00

= = =

$

COGS

3,080

@

$21.509

=

$66,247.72

Inventory

1,040

@

21.509

=

$22,369.36

2007 40 1,000 1,000 700 210 2,950

@ @ @ @ @

$ 22.00 22.25 22.50 22.75 23.00

= = = = =

$

@ @

23.00 23.50

= =

$11,270.00 16,450.00 $27,720.00

COGS

COGS

Inventory

490 700 1,190

12

880.00 22,250.00 $23,130.00

430.00 20,400.00 $20,830.00

880.00 22,250.00 22,500.00 15,925.00 4,830.00 $66,385.00


LIFO:

Chapter 6

COGS

700 700 700 850 2,950 1,020

@ @ @ @

$23.50 23.00 22.75 22.50

= = = =

@

20.00

=

$16,450.00 16,100.00 15,925.00 19,125.00 $67,600.00 $20,400.00

20 150

@ @

21.50 22.50

= =

430.00 3,375.00

COGS

1,190 2,950

@

$22.547

=

$24,205.00 $66,513.65

Inventory

1,190

@

22.547

=

$26,830.93

Inventory

AVERAGE COST:

COGS Inventory

2005 2006 2007 2007

Check on Calculations FIFO $ 56,930 66,240 66,385 27,720 $217,275

LIFO $ 58,150 67,320 67,600 24,205 $217,275

AVG.COST $ 57,685.92 66,247.72 66,513.65 26,830.93 $217,278.22

Question 2 The calculation of the $1,406 tax difference for 2005-07 is shown below. However, this difference is really irrelevant for deciding what to do in future years. 2005

2006

FIFO LIFO Sales............................................................................................................................................................. $95,880 $95,880 COGS........................................................................................................................................................... 56,930 58,150 Gross Margin............................................................................................................................................... 38,950 37,730 Tax Expense................................................................................................................................................. 15,580 15,092 Net Income................................................................................................................................................... $23,370 $22,638

Sales............................................................................................................................................................. $110,110 $110,110 COGS........................................................................................................................................................... 66,240 67,320 Gross Margin............................................................................................................................................... 43,870 42,790 Tax Expense................................................................................................................................................. 17,548 17,116 Net Income................................................................................................................................................... $ 26,322 $ 25,674

2007

Sales............................................................................................................................................................. $105,462.50 $105,462.50 COGS........................................................................................................................................................... 66,385.00 67,600.00 Gross Muffin................................................................................................................................................ 39,077.50 37,862.50 Tax Expense................................................................................................................................................. 15,631.00 15,145.00 Net Income .................................................................................................................................................. $ 23,446.50 $ 22,717.50 Total Tax Expense Savings: 2005 $ 488 2006 432 2007 486 $1,406

13



An easier approach, which most students will overlook, is to note that the three-year difference in COGS is $3,515, and 40 percent of this is $1,406. Even easier, but much more subtle, is realizing that the threeyear COGS difference is equal to the difference in 2007 year-end inventories ($27,720 - $24,205 = $3,515). Question 3 Purchases for 2008 forecasted at 1,910* cartons @ 24.00 FIFO

COGS

Inventory LIFO:

COGS

Inventory

490 700 1,510 2,700

@ @ @

$23.00 23.50 24.00

= = =

$11,270 16,450 36,240 $63,960

400

@

$24.00

=

$9,600

1,910 150 20 620 2,700

@ @ @ @

$24.00 22.50 21.50 20.00

= = = =

$45,840 3,375 430 12,400 $62,045

400

@

20.00

=

$8,000

FIFO LIFO 2008 Sales (2,700 @ $35.75).................................................................................................................................................. $96,525 $96,525 COGS............................................................................................................................................................................... 63,960 62,045 Gross margin..................................................................................................................................................................... 32,565 34,480 Tax expense ..................................................................................................................................................................... 13,026 13,792 Net income ....................................................................................................................................................................... $19,539 $20,688 In 2008, LIFO would cause an increase in tax expense of $766. Question 4 The LIFO reserve is the difference between inventory calculated under the FIFO method, and inventory calculated under the LIFO method. 2005 2006

LIFO Reserve $1,220 $2,300

= = =

FIFO Inventory $21,620 $23,130

-

LIFO Inventory $20,400 $20,830

Another way to look at the LIFO reserve is that it represents the cumulative difference between LIFO cost of goods sold and FIFO cost of goods sold. We can see that in 2005, the LIFO reserve ($1,220) is equal to the difference between LIFO cost of goods sold and FIFO cost of goods sold ($58,150 - $56,930 = $1,220). Similarly, in 2000, the LIFO reserve ($2,300) is equal to the sum of the differences between LIFO and FIFO cost of goods sold for 2005 and 2000, as shown on the next page.

*

2,700 sales + 400 ending inventory - 1,190 beginning inventory = 1,910.

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Chapter 6

2005 2006 LIFO cost of goods sold.............................................................................................................................................. $58,150 $67,320 FIFO cost of goods sold.............................................................................................................................................. 56,930 66,240 Difference................................................................................................................................................................... $ 1,220 + $ 1,080 = $2,300 Therefore, if you are given LIFO cost of goods sold and inventory, and you are also given the LIFO reserve for that year (year X) and the previous year (year X-1), you can estimate the following: FIFO inventory (year X) = LIFO inventory (year X) + LIFO reserve (year X) FIFO COGS (year X) = LIFO COGS (year X) - [LIFO reserve (year X) - LIFO reserve (year X-l)] Tax savings (year X) = [LIFO reserve (year X) - LIFO reserve (year X-1)] *(1 – tax rate) Cumulative tax savings due to the use of LIFO = LIFO reserve (year X) Most companies on LIFO report the LIFO reserve in their financial statements, often in the inventory footnote. Understanding the significance of the LIFO reserve can be very useful when trying to compare the financial performance of companies using different inventory accounting methods. Question 5 See “Why More LIFO?” section of the text, plus comments earlier in this note. Case 6-3: Morgan Manufacturing* Note: Updated from Eleventh Edition. Morgan Manufacturing is a straightforward case to illustrate how information on the LIFO Reserve can be used to adjust the results of a company on LIFO to make them more comparable to those of a company on FIFO. This case extends the learning developed in question 4 of Case 6-2, Lewis Corporation. Morgan Manufacturing may not require a full class for discussion, and the instructor may want to assign it in conjunction with Lewis Corporation. Answers to questions: 1. Westwood’s gross margin percentage = $900 divided by $2,000 = 45%; pretax return on sales = $300 divided by $2,000 = 15%; pretax return on assets = $300 divided by $2,240 = 13.4%. 2. Students will quickly recognize that both the inventory and the cost of goods sold accounts are affected. You are likely, however, to have to guide them to recognize what other accounts and financial items are also affected. For example, if inventory is affected, then some other balance sheet account must be affected to keep the balance sheet balanced. Students will likely conclude it must be retained earnings or owners’ equity. If cost of goods sold is affected, then clearly items such as gross margin, pretax net income, tax expense and net income will also be affected. Typically, assuming the norm of continuing inflation and growing inventory, LIFO produces higher cost of goods sold and lower inventory, owners’ equity, gross margin, pretax net income, tax expense, and net income than FIFO. It is possible, therefore, for two companies to have identical underlying economic performance, but the financial measures of performance of the firm using the LIFO method will look worse than the financial measures of the firm using the FIFO method (or the underlying economic performance of the LIFO firm might be even better than that of the FIFO firm, and the LIFO firm’s financial measures can still look worse!). 3. Adjustment to 2006 inventory: $100 LIFO inventory + $70 LIFO reserve = $170 FIFO inventory. *

This teaching note was prepared by Julie H. Hertenstein. Copyright © Julie H. Hertenstein.

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Adjustment to 2006 total assets: $2,170 + $70 = $2,240 Amount to adjust COGS:

$70 -10 $60

2006 LIFO reserve 2005 LIFO reserve Difference between 2006 LIFO and FIFO COGS

Adjustment to 2006 COGS: $1,110 - $60 = $1,050 Adjustment to 2006 gross margin: $890 + $60 = $950 Adjustment to 2006 pretax net income: $290 + $60 = $350 Adjusted gross margin percentage = $950 divided by $2,000 = 47.5% Adjusted pretax return on sales $350 divided by $2,000 = 17.5% Adjusted pretax return on assets $350 divided by $2,240 = 15.6% 4. Once adjusted to FIFO, Morgan’s performance exceeds Westwood’s on each of the three measures, as shown in Exhibit 1. In addition, Morgan has paid less in taxes than Westwood. Pedagogical Approach You can begin with a general discussion of why we often want to compare the financial performance of different companies and how our ability to compare companies is affected by the different accounting choices that they make; this issue, of course, is much broader than simply the choice of LIFO or FIFO. In Chapter 5, students encountered different revenue recognition choices which produce different financial results for the same underlying economic events. When firms choose different inventory accounting methods, these affect financial measures, as well. When trying to compare one company on LIFO with another on FIFO, one is trying to compare “apples and oranges.” For purposes of comparison, you would like to get the companies on a common basis. The LIFO reserve, which is frequently available in the inventory footnote or elsewhere in the annual report of a firm using LIFO, allows you to make adjustments to achieve a common basis for comparison. The three key measures for Morgan are given in the case. You can write them on the board, and put up Westwood’s for comparison when students answer question 1, as shown in the first two lines of Exhibit 1. As indicated in the answer to question 2, you may need to draw students out on which accounts and measures will be affected by the choice of inventory accounting method, and how this choice affects the financial statement reader’s ability to compare the two companies. Before proceeding to the calculations in question 3, you may wish to first discuss, conceptually, how you can adjust results to make them more comparable. The first point regarding the adjustments is that you have LIFO reserve information, (and since there is not an analogous FIFO reserve), you must adjust the LIFO company to a FIFO basis. Since the LIFO reserve is the difference between the LIFO and FIFO inventory, it can be used directly to adjust inventory, and similarly, it is also the adjustment to total assets; a comparable adjustment can be made to owners’ equity to keep the balance sheet in balance. The LIFO reserve represents not only the difference between LIFO and FIFO inventory, but also the cumulative difference between LIFO and FIFO cost of goods sold. Thus, the LIFO reserve for two consecutive years can be used to compute the difference between LIFO and FIFO cost of goods sold for the more recent of the two years, which allows you to make adjustments to the income statement as well. You may want to raise the issue of what to do if you want to compare after-tax results, instead of the pretax measures that the case suggests. Some students may want to adjust the tax expense of the LIFO firm, for example, using the same ratio of tax expense to pretax net income as shown on the LIFO income

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statement. Others may argue that the tax expense should be unchanged, reflecting the fact that the LIFO company paid lower taxes due to its choice of the LIFO inventory accounting method, a true economic difference between the two firms. Following the conceptual discussion, the actual calculations can be examined and the results posted on the board, as shown in Exhibit 1. From these results, students will quickly observe that Morgan’s performance was better on all three measures. They may also conclude that the productivity improvements that Charles Crutchfield had implemented were, indeed, reflected in Morgan’s financial performance measures.

Exhibit 1 Gross Margin % Pretax Return on Sales Pretax Return on Assets Morgan (LIFO).................................................................................................................................................................. 44.5% 14.5% 13.4% Westwood (LIFO).............................................................................................................................................................. 45.0% 15.0% 13.4% Morgan (Adjusted)............................................................................................................................................................ 47.5% 17.5% 15.6% Case 6-4: Joan Holtz (B)* Note: In discussing some of these questions. it may be useful to construct simple numerical examples, perhaps related to the illustrations in the text. Joan Holtz (B) is an extension of Joan Holtz (A) in Chapter 5. The case is unchanged from the Eleventh Edition. 1. The ultimate effect, over the life of an entity, is the same under all three methods. For a given accounting period, however, the methods result in different net income. If purchase discounts are deducted from purchases, they reduce the net purchase costs, and affect net income in the period in which the goods are sold. If reported as other income of the period, they affect net income in an earlier period than in the first method. If discounts not taken are recorded as an expense, cost of goods sold reflects the full amount of the discount, and discounts not taken decrease income in what is perhaps a later period. Another difference is that cost of goods sold, and hence the gross margin percentage, differs under each of these methods. Of course, the amounts involved are usually small, so the above differences often are not material 2. There should be a credit to Inventory, to reduce it to the amount found from the physical inventory. The debit may be either to Cost of Goods Sold or to an operating expense item. Literally, the shrinkage cost could not have been a cost of the goods that actually were sold, for these goods were not sold. The practice of debiting of Cost of Goods Sold is often followed, however. For management purposes, it is desirable to identify the amount of shrinkage, wherever it is reported. 3. It is incorrect to say that the LIFO method “assumes” anything about the physical flow of the goods. LIFO advocates know that physically the goods tend to move on a FIFO basis. LIFO is based on a belief about economic flows, as explained in the text. 4. In the examples given, the economics of the operations of the automobile dealer are best reflected by the FIFO method (or even better by the specific identification method, which probably approximates FIFO), and the economics of the operations of the hardware dealer are best reflected by the LIFO method. Even so, the automobile dealer would not necessarily be wrong to use LIFO; it might regard the income tax savings as being more important than a correct showing of economic income. *

This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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5. a. This generalization is valid. b. This generalization is usually valid, as indicated in the text. However, any such generalization about LIFO may not be valid if the physical size of the inventory is reduced so that the original “LIFO layers” are carried to Cost of Goods Sold. c. Assuming that income tax rates remain unchanged, and that the physical size of the inventory remains unchanged, and disregarding the present value of money, this generalization is valid. 6. Although the LIFO inventory as a whole will normally be reported at less than current costs, it can easily happen that individual items are worth less than their LIFO cost because of obsolescence or damage. These items should be written down. 7. Since there would be no additional revenue for four years, and since barrels, warehousing costs, and interest are charged to expense, profit would be reduced by the amount of these additional costs. In the first full year, these amounts of 200,000 additional gallons would be:

Barrels @ $0.70.......................................................................................................................................... $140,000 Warehousing @ $0.20................................................................................................................................ 40,000 Interest @ $0.10.......................................................................................................................................... 20,000 On each gallon added to inventory, the warehousing and interest costs would cumulate for four years, and profits would be decreased correspondingly. The argument against including these costs in inventory is that they are not costs of producing whiskey. The production process has been completed before the whiskey is stored. The contrary argument is that these costs are incurred in order to bring the whiskey to a salable condition and they therefore should be included as inventory cost. This argument is strongest for the barrels, and next strong for the warehousing costs. Many people argue that in no circumstances can interest be considered a cost of production; rather, it is a cost of financing. Yet, if this were a four-year construction project rather than aging whiskey, GAAP would require capitalization of construction debt financing costs. (This is not described in the text until Chapter 7.) In any event, unless these costs are included in inventory, profits will decrease at the very time that the increase in production indicates that the company is prospering. 8. There is now a rule (from FASB-53) for determining cost of sales for T.V. movies. It is to amortize film cost in the ratio of Gross revenue for the film for the current period Anticipated total gross revenues for the film from the beginning of the current period until the end of its useful life The denominator of this ratio must be reviewed periodically to reflect current information. The new ratio is then applied to unrecovered film costs. Arguments can be made for ratios of 10/13 or 10/16 in the first year. The 10/16 ratio ($625,000) is perhaps better due to the belief that at least $300,000 in revenue will come from reruns. Correspondingly, the ratio to be used in the second year would be 1/2 ($300,000/$600,000). This would result in amortization of $187,500 in year two [1/2 x ($1,000,000 $625,000)], with the final $187,500 of cost matched against the final $300,000 of revenue. The $100,000 spent on advertising and promotion of the initial showing does not benefit the future showings of the film. This is therefore not a capitalizable cost and should be expensed in the period incurred. Therefore it does not affect the ratios used above.

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