Chapter 109 CHAPTER QUESTIONS Four questions associated with accounting for inventory are as follows: are allocated to the cost of inventory, and costs incurred outside the factory wall (e.g., in the finished goods warehouse) are expensed as incurred • When is inventory considered to have been purchased? • Similarly, when is inventory considered to have been sold? • Which costs are considered to be part of the cost of inventory, and which are simply business expenses for that period? • How should total inventory cost be divided between the inventory that was sold (cost of goods sold) and the inventory that remains (ending inventory)? Computers are characteristic of perpetual inventory systems The recordkeeping requirements of a perpetual system are greater than those for a periodic system, so a computer can greatly aid in managing the data In fact, periodic systems can be operated with just an old-fashioned cash register The decrease in computing costs over the past 20 years has greatly increased the use of perpetual systems The inventory system must be cost effective That is, cost vs benefit must be considered Also, it should provide effective control over the use and management of the asset The perpetual inventory system, because it is more costly to maintain and implement, should be used for items of relatively high unit value and for which management of the asset’s use is desired Therefore, items (a), (b), and (d) would most likely use the perpetual method However, with information technology constantly bringing down the cost of perpetual inventory systems, it is possible that a perpetual system is used in all the cases Vehicles are classified as inventory on the balance sheets of companies that sell vehicles in the normal course of business However, for a firm that uses vehicles but does not sell them, such as a delivery service business, the vehicles would be shown as property, plant, and equipment instead of as inventory Direct materials are applied directly to the manufacturing process and become part of the finished product Indirect materials are auxiliary materials, or materials that are not incorporated directly into the finished product They include such items as oil, fuels, and cleaning supplies They may also include materials of minor significance that are embodied in the final product but are too immaterial to account for as direct materials When a perpetual inventory system is used, the company knows how much inventory should be on hand at any point in time Comparing the inventory records to the result of a physical count allows the company to compute the amount of inventory shrinkage (a) The three cost elements found in work in process and finished goods are direct materials, direct labor, and manufacturing overhead (b) Manufacturing overhead is composed of all manufacturing costs other than direct materials and direct labor It includes indirect labor, indirect materials, depreciation, repairs, insurance, taxes, and the portion of managerial costs identified with production efforts (a) Merchandise in transit is legally reported as inventory by the seller if it was shipped FOB destination (b) Merchandise in transit is legally reported as inventory by the buyer if it was shipped FOB shipping point or if it was shipped FOB destination and received before the year-end but not yet unloaded or moved into the inventory storage area The general rule of thumb is that inventoryrelated costs incurred inside the factory wall 109 110 Chapter 10 (a) Consigned goods should be included in the inventory of the shipper/consignor, not in the inventory of the dealer holding the goods The consigned inventory should be reported in the shipper's inventory at the sum of its cost and the handling and shipping costs incurred in the transfer to the dealer (b) Inventory sold under an installment sale may continue to be shown in the inventory of the seller because the seller retains title to the goods If the seller reports the inventory, it should be reduced by the buyer’s equity in the inventory as established by collections However, in the usual case when the possibilities of returns and defaults are very low, the seller, anticipating completion of the contract and the ultimate passing of title, recognizes the transaction as a regular sale and removes the goods from reported inventory at the time of the sale 11 The substance of an inventory sale accompanied by a repurchase agreement is that the inventory is being used as collateral for a loan Accordingly, the inventory continues to be reported as part of the seller's inventory The proceeds from the "sale" are reported as a loan A note describes the repurchase agreement 12 An activity-based cost (ABC) system is one in which overhead costs are allocated to inventory based on clearly identified cost drivers, which are characteristics of the production process known to create overhead costs 13 (a) Cash discounts may be accounted for under the gross method or the net method Under the gross method, purchases of merchandise are recorded at the gross amount of the invoice and discounts taken at the time of payment are recognized in a contra purchases account Under the net method, purchases of merchandise are recorded at the net amount of the invoice and any discounts not taken are recognized as an expense of the period (b) The net method of accounting for purchases is strongly preferred By separately reporting purchase discounts lost, the failure of a company to take advantage of cash discounts is highlighted It is normally considered advantageous for a company to take the purchase discount Failure to so is considered a lapse in efficient financial management of a company 14 Although the specific identification method may be considered a highly satisfactory approach in matching costs with revenues, it is often difficult or even impossible to apply If there are many items in the inventory with acquisition occurring at different times and at different prices, cost identification procedures may be very slow, burdensome, and costly When the units are in effect identical, the specific identification method opens the door to possible profit manipulation through the choice of specific units for sale 15 The average cost method of inventory valuation has the advantage of evening out the fluctuations of inventory pricing and generally is easier to apply than either the FIFO or LIFO method As prices vary, the average price used to cost inventory sold is automatically adjusted Because the cost of purchases during a period is usually several times more than the value of the opening inventory, the price used is heavily influenced by current costs 16 For most businesses, a FIFO assumption better matches the physical flow of goods A LIFO physical flow would mean that the oldest inventory would never be recycled but instead would stay in the company for years On the other hand, a LIFO assumption better matches current costs with current revenues because cost of goods sold is computed based on the costs of the most recently acquired inventory 17 Computation of average cost and LIFO under a perpetual system is complicated because the average cost of units available for sale changes every time a purchase is made, and the identification of the "last in" units also changes with every purchase 18 (a) A new LIFO layer is created in each year in which the number of units purchased or manufactured exceeds the number of units sold As long as inventory continues to grow, a new LIFO layer is created each year and the old LIFO layers remain untouched (b) LIFO reserve is the difference between the LIFO ending inventory amount and the amount obtained using another 110 Chapter 111 inventory valuation method (such as FIFO or average cost) 111 19 (a) The LIFO conformity rule requires companies using the LIFO method for tax reporting to also use it for financial reporting (b) In 1981, the IRS relaxed the LIFO conformity rule by permitting companies to use non-LIFO disclosures as long as they are not presented on the face of the income statement and to apply LIFO differently for book purposes than for tax purposes presented for recording gains in value if they occur 23 Movement in replacement cost (entry cost) may not result in immediate movement in sales price (exit value) If sales price does not change, no downward adjustment to cost is justified Thus, the floor limitation prevents charging a loss in one period to obtain a higher than normal profit in a subsequent period On the other hand, sales price may decline and replacement cost may not Thus, the net realizable value for an item might fall below replacement cost This decline should be recognized in the period when the loss occurs, not in a subsequent period when the sale takes place 20 In periods of increasing prices, FIFO historical cost flow will reflect the greatest dollar value of ending inventory because the historical unit cost assigned to the asset reflects the most recent unit price LIFO inventory will reflect the oldest relevant unit costs, thereby causing the highest cost of goods sold Even though the quantity of inventory does not change, the dollar value of the asset will change when using FIFO because the beginning inventory reflects the most recent unit prices for the prior year and the current year’s ending inventory reflects the most recent unit prices for the current year LIFO inventory value would not change since there has been no change in LIFO quantities and layers LIFO will result in higher cost of goods sold and lower payment of income taxes 24 Application of the lower-of-cost-or-market method to individual inventory items results in a lower inventory value When LCM is applied to the inventory as a whole, the increased market value of some inventory items offsets decreases in the value of other items 25 The value assigned to inventory can be very important in determining how profits and losses are allocated among different reporting units within the business A manager wants any inventory he or she receives from another department to be transferred at the lowest possible value When transferred inventory is reported at a low value, higher profits are recognized on the subsequent sale of the item Reported profits of a department may be used in the evaluation and bonus computation for the manager of the department 21 The primary reason for using LIFO is to decrease income taxes paid during times of inflation For firms with small inventory levels or with flat or decreasing inventory costs, LIFO gives little, if any, tax benefit Such firms are unlikely to use LIFO 22 The lower-of-cost-or-market rule is an application of the general valuation concept for inventories that they should not be valued at a price that would exceed the net realizable values If market is defined as replacement cost and there is no evaluation of net realizable value, the resulting valuation using the lower-of-cost-or-market concept could be ultraconservative On the other hand, if a decline in value has occurred, such decline should be reflected in the year the loss occurred Similar arguments could be 26 In developing a reliable gross profit percentage, reference is made to the historical percentage, with adjustments for changes in current circumstances For example, the historical gross profit percentage would be adjusted if the pricing strategy has changed (e.g., because of increased competition), if the sales mix has changed, or if a different inventory valuation method has been adopted (e.g., a switch from FIFO to LIFO) 112 113 Chapter 27 (1) Effect on Statements of Current Period (2) Effect on Statements of Succeeding Period (a) Ending inventory over-stated because of a miscount Net income is overstated by the amount of the error Current assets and owners' equity are overstated by the amount of the error Net income is understated by the amount of the error No effect on the balance sheet (b) Failure to record purchase of merchandise on account, and the merchandise purchased was not recognized in recording ending inventory No effect on net income, although both ending inventory and purchases are understated by the amount of the omission Both current assets and current liabilities are understated by the amount of the omission No effect on net income because the understatement in the beginning inventory is counterbalanced by the overstatement of purchases No effect on the balance sheet (c) Ending inventory understated because of a miscount Net income is understated by the amount of the error Current assets and owners’ equity are understated by the amount of the error Nature of Error 28 Generally, a higher inventory turnover ratio is a sign of a company that is managing its inventory more efficiently Therefore, Company B, with an inventory turnover ratio of 10.0 times, is managing its inventory more efficiently than Company A, with a ratio of 8.0 times However, as illustrated in the chapter, inventory turnover ratios for companies that not use the same inventory valuation method cannot be compared For example, comparison of the ratios for Companies A and B would not be valid if one company used FIFO and the other used LIFO 29.‡ No journal entry is made when a purchase commitment is originally entered into A purchase commitment is not an inventory purchase but a commitment to purchase inventory in the future This type of contract Net income is overstated by the amount of the error No effect on the balance sheet is an exchange of promises about future actions and is known as an executory contract 30 ‡ No, all transactions with foreign companies are not classified as foreign currency transactions The currency specified by the invoice determines if a transaction is a foreign currency transaction For example, if an invoice is denominated in U.S dollars, then—for a U.S company—the transaction is a domestic transaction regardless of to whom the merchandise is sold 31 ‡ The FASB requires an adjustment on the balance sheet date to ensure that gains and losses from exchange rate changes are included in the period in which the changes took place ‡ Relates to Expanded Material PRACTICE EXERCISES PRACTICE 9−1 PERPETUAL AND PERIODIC JOURNAL ENTRIES Periodic: Purchases Accounts Payable 3,000 3,000 Accounts Receivable Sales 10,000 10,000 Cash 9,000 Accounts Receivable 9,000 Perpetual: Inventory Accounts Payable 3,000 3,000 Accounts Receivable Sales 10,000 10,000 Cost of Goods Sold Inventory 4,500 Cash 9,000 4,500 Accounts Receivable PRACTICE 9−2 9,000 PERPETUAL AND PERIODIC COMPUTATIONS Beginning inventory Plus: Purchases Cost of goods available for sale Less: Ending inventory Cost of goods sold $100,000 550,000 650,000 130,000 $520,000 Beginning inventory Plus: Purchases Cost of goods available for sale Less: Preliminary cost of goods sold Ending inventory, predicted Less: Ending inventory, actual Cost of missing inventory $100,000 550,000 650,000 460,000 190,000 130,000 $ 60,000 Cost of Goods Sold (or Inventory Shrinkage Expense)60,000 Inventory 60,000 PRACTICE 9−3 GOODS IN TRANSIT AND ON CONSIGNMENT Before adjustment $200,000 Consignment no adjustment needed, correctly excluded Sold, FOB destination + $20,000 Purchased, FOB shipping point + $30,000 Sold, FOB shipping point no adjustment needed, correctly excluded Adjusted total $250,000 PRACTICE 9−4 SCHEDULE OF COST OF GOODS MANUFACTURED Direct materials: Beginning raw materials inventory Plus: Purchases of raw materials Less: Ending raw materials inventory Raw materials used in production $ 40,000 230,000 (34,000) $ 236,000 Direct labor 198,000 Manufacturing overhead: Depreciation on factory building Factory supervisor’s salary Indirect labor Total manufacturing overhead $ 32,000 56,000 36,000 124,000 Total manufacturing costs Plus: Beginning work-in-process inventory Less: Ending work-in-process inventory Cost of goods manufactured PRACTICE 9−5 $ 558,000 76,000 (100,000) $ 534,000 ACCOUNTING FOR PURCHASE DISCOUNTS Net method, paid within discount period Inventory Accounts Payable 98,000 Accounts Payable Cash 98,000 98,000 98,000 Net method, paid after discount period Inventory Accounts Payable 98,000 Accounts Payable Discounts Lost Cash 98,000 2,000 98,000 100,000 PRACTICE 9−5 (Concluded) Gross method, paid within discount period Inventory Accounts Payable 100,000 Accounts Payable Inventory Cash 100,000 100,000 2,000 98,000 Gross method, paid after discount period Inventory Accounts Payable 100,000 Accounts Payable Cash 100,000 PRACTICE 9−6 Beginning inventory Purchases: March 23 September 16 100,000 100,000 INVENTORY VALUATION: FIFO, LIFO, AND AVERAGE Units 300 900 1,200 2,400 Cost per Unit $17.50 Total Cost $ 5,250 18.00 18.25 16,200 21,900 $43,350 Units remaining: 400, meaning that 2,000 (2,400 – 400) units were sold a FIFO Cost of Goods Sold 300 × $17.50 900 × 18.00 800 × 18.25 Total 400 × $18.25 = $7,300 1,200 × $18.25 = $21,900 800 × 18.00 = 14,400 Total = $ 36,300 300 × $17.50 = 100 × 18.00 = Total = $7,050 $5,250 1,800 c Average Cost $43,350/2,400 units = $18.0625 2,000 × $18.0625 = $36,125 400 × $18.0625 = $7,225 b LIFO = $ 5,250 = 16,200 = 14,600 = $ 36,050 Ending Inventory PRACTICE 9−7 INVENTORY VALUATION: COMPLICATIONS WITH A PERPETUAL SYSTEM a FIFO January 16 (100 units) Cost of Goods Sold Ending Inventory 100 × $17.50 = $ 1,750 200 × $17.50 = $3,500 July 15 (600 units) 200 × $17.50 = $ 3,500 400 × 18.00 = 7,200 500 × $18.00 = $9,000 November (1,300 units) 500 × $18.00 = $ 9,000 800 × 18.25 = 14,600 400 × $18.25 b LIFO January 16 (100 units) July 15 (600 units) November (1,300 units) c Average Cost January 16 (100 units) = Total = $36,050 Total = $7,300 100 × $17.50 = $ 1,750 200 × $17.50 = $3,500 600 × $18.00 = $10,800 300 × 18.00 = 5,400 200 × $17.50 = $3,500 1,200 × $18.25 = $21,900 100 × 18.00 = 1,800 200 × $17.50 = $3,500 200 × 18.00 = 3,600 Total = $36,250 Total = $7,100 100 × $17.50 = $ 1,750 200 × $17.50 = $3,500 $7,300 July 15 (600 units) 200 × $17.50 = $ 3,500 900 × 18.00 = 16,200 1,100 $19,700 $19,700/1,100 = $17.909 per unit 600 × $17.909 = $10,745 $8,955 500 × $17.909 = November (1,300 units) 500 × $17.909 = $ 8,955 1,200 × 18.25 = 21,900 1,700 $ 30,855 $30,855/1,700 = $18.150 per unit 1,300 × $18.150 = $23,595 400 × $18.150 = $7,260 Total = $36,090 Total = $7,260 PRACTICE 9−8 LIFO LAYERS Year Units Purchased 100 Cost per Unit $1.00 Units Sold 80 Year 150 $1.50 100 20 × $1.00 = 50 × $1.50 = 20 75 Year 150 $2.50 150 20 × $1.00 = 50 × $1.50 = 20 75 Ending Inventory 20 × $1.00 = $ 20 Note: No new LIFO layer was created in this year Year 200 PRACTICE 9−9 $4.00 20 × $1.00 = 20 50 × $1.50 = 75 40 × $4.00 = 160 Total = $255 160 LIFO RESERVE AND LIFO LIQUIDATION LIFO reserve: Difference between LIFO ending inventory and ending inventory computed using FIFO (which approximates current replacement cost) FIFO ending inventory (110 × $4.00) LIFO ending inventory (see Practice 9−8 solution) LIFO reserve $440 255 $185 Cost of goods sold in Year 4: 160 units sold × $4.00 = $640 Cost of goods sold in Year if the number of units purchased had been 90: Purchases during the year: 90 units × $4.00 Beginning LIFO inventory of 70 units Total cost of goods sold $360 95 $455 It can be seen that dipping into the LIFO layers, as in (3), increases reported profit as the old LIFO layers, with low costs, are assumed to be sold PRACTICE 9−10 LIFO AND INCOME TAXES LIFO income taxes Year Year Year Year Total Sales $400 500 750 800 Cost of Goods Sold $ 80 150 375 640 Income before Taxes $320 350 375 160 Income Taxes (40%) $128 140 150 64 $482 Chapter 175 SOLUTIONS TO STOP & THINK Stop & Think (p 485): What was the motivation of the IRS in adopting the 1986 inventory cost capitalization rules described above? A good rule of thumb is that whenever the IRS makes a technical change to its rules, the effect is to increase tax revenue In this case, because the change in the inventory cost capitalization rules caused more costs to be capitalized, taxable income and tax revenue were increased The revenue increase is only a one-time acceleration of tax receipts—costs capitalized because of the new rules are then expensed in the following year when the inventory is sold Stop & Think (p 488): If perpetual inventory systems have so many clear advantages, why aren't they used by all companies? Choosing between two acceptable accounting procedures is an exercise in cost-benefit analysis Perpetual inventory systems provide better information, but they also usually cost more to operate For some businesses, the costs exceed the benefits, so they use a periodic system Businesses most likely to use the periodic system are those with lots of low-value identical items with a high turnover In addition, very small businesses, because they don't make much profit, are less likely to be able to afford a computer inventory system Stop & Think (p 503): Verify by reference to the original data that FIFO cost of goods sold for 2004 is $1,550 2002 2003 2004 FIFO cost of goods sold: 100 × $5 = $500 20 × $5 = $ 100 50 × $10 = $ 500 100 × $10 = 1,000 70 × $15 = 1,050 $1,100 $1,550 Ending inventory: 20 × $5 = $100 50 × $10 = $500 90 × $15 = $1,350 Stop & Think (p 509): How about using LIFO for the income statement and FIFO for the balance sheet? Why wouldn't this work? Or would it? Use of LIFO for the income statement and FIFO for the balance sheet would result in a cost allocation discrepancy In essence, the FIFO inventory valuation on the balance sheet includes inventory holding gains, but the LIFO gross profit on the income statement excludes those holding gains Unless this discrepancy is handled appropriately, the balance sheet will not balance A possible way to handle this discrepancy is to create a separate equity account This equity account would normally have a credit balance (unrecognized inventory holding gain), reflecting the fact that FIFO ending inventory is typically greater than LIFO ending inventory Stop & Think (p 517): How exactly can inventory estimates be used to detect underreported sales? If the actual amount of inventory is much lower than the estimated amount, there are three possible explanations: (1) the estimation process is flawed, (2) inventory was lost or stolen, or (3) the missing inventory was sold but the sales were not reported A clever fraud artist can cover his or her tracks by making sure that the reported gross profit percentage is close to industry norms and by avoiding any large swings in the level of unreported sales from one year to the next Like anything else, successful fraud requires consistent, patient effort over the course of many years 176 Chapter Stop & Think (p 519): Why would a manager risk his or her reputation by fraudulently overstating inventory in light of the fact that the resulting income increase is completely counterbalanced in the following year? All managers are confident that any current difficulties are only temporary They think that if they can just get past their immediate problems, business will turn around in the future Thus, managers don't worry about the counterbalancing impact of inventory errors because they know (or think they know) that business will be better next year In addition, when a manager is facing termination for missing this year's profit target, concerns about the counterbalancing effort of any inventory error next year are of no significance Stop & Think (p 525): Have the authors picked realistic exchange rates for the U.S dollar relative to the Swiss franc? Check in The Wall Street Journal On July 1, 2002, the exchange rate was 1.4849 Swiss francs for each U.S dollar So, the exchange rates used by the authors differ substantially from the rate as of July 1, 2002 ( Historical note: This illustration was originally written using French francs However, the business currency in France is now the euro.) Chapter 177 SOLUTIONS TO STOP & RESEARCH Stop & Research (p 497): The physical flow of goods in a supermarket is FIFO; the department managers must continue to circulate their merchandise so that old lettuce, milk, and frozen goods don’t get pushed to the back and spoil The three largest supermarket chains in the United States are Kroger, Albertson’s, and Safeway Access the most recent annual report of each of these three supermarkets and determine whether they use the FIFO method of inventory valuation For 2001, all three supermarkets used the LIFO method of inventory valuation Kroger“Inventories are stated at the lower of cost (principally on a last-in, first-out, “LIFO” basis) or market In total, approximately 94% of inventories for 2001 and 2000 were valued using the LIFO method.” Albertson’s“The Company values inventories at the lower of cost or market Cost of substantially all inventories is determined on a last-in, first-out (LIFO) basis.” Safeway”Merchandise inventory of $1,906 million at year-end 2001 and $1,846 million at year-end 2000 is valued at the lower of cost on a last-in, first-out ("LIFO") basis or market value.” Stop & Research (p 514): In its 10-K with the SEC, Cisco includes a separate schedule (Schedule II) that details changes in the company’s “allowance for excess and obsolete inventory.” Access the most recent 10-K filing of Cisco and determine how much was added to this allowance in the most recent year In its 10-K for the year ended July 28, 2001, Cisco Systems reported the following with respect to its allowance for excess and obsolete inventory: (in millions) Beginning balance Charged to expenses or other accounts Deductions Ending balance $ 395 2,775 (891) $2,279 The $2.775 billion addition was reported as part of cost of sales 178 Chapter SOLUTION TO NET WORK EXERCISE Net Work Exercise (p 526) On January 1, 1999, one U.S dollar equaled 0.60870 British pounds On December 6, 2002, U.S dollar equaled 0.63470 British pounds This means that the British pound has weakened relative to the U.S dollar because one dollar can buy more pounds This exchange rate change would reduce the recorded dollar amount of a liability denominated in British pounds Thus, a U.S company with a liability denominated in British pounds would have experienced an economic gain from this exchange rate change Chapter 179 SOLUTIONS TO BOXED ITEMS The History of LIFO—Part I (pp 500–501) If ending inventory levels are constant from one year to the next, LIFO is equivalent to the base stock method The constant base stock of inventory is valued at the historical cost of the original amount of inventory required If the inventory level is consistently growing from one year to the next, LIFO is not the same as the base stock method because the "base stock," instead of remaining constant, increases each year From a conceptual standpoint, an accounting standard setter might oppose LIFO for some or all of the following reasons • LIFO usually does not accurately reflect the physical flow of goods in the business • LIFO can result in the reporting of grossly undervalued inventory amounts in the balance sheet • The possibility of LIFO liquidation means that old LIFO layer costs can be drawn into cost of goods sold, resulting in poor matching of current costs with current revenues A government official might use the same arguments given above, but from a tax standpoint, LIFO is bad for tax collectors because it usually results in the payment of lower taxes The LIFO conformity rule sticks out like a sore thumb There are many areas in which financial accounting and tax accounting differ and no attempt is made to align the two Why should inventory valuation be any different? The LIFO conformity rule is a holdover from a time when the prevailing assumption was that financial statement users were unable to understand the impact of accounting assumptions History of LIFO—Part II (pp 504–505) Recall that LIFO is the conceptual descendant of the base stock method The base stock method makes some conceptual sense when a company must maintain a certain minimum quantity (base stock) of inventory in order to stay in business This base stock will never be liquidated as long as the business is a going concern Accordingly, the base stock should be valued at its original acquisition cost, that is, independent of subsequent fluctuations in market value This argument applies to LIFO as well The primary objection by the IRS to the introduction of the dollar-value LIFO retail method was that it extended the use of LIFO to many companies that were outside the original user group envisioned by the IRS It is the same old story—use of LIFO reduces tax payments, and the IRS was opposed to any expansion of LIFO use The IRS could also have been opposed to dollar-value LIFO retail for conceptual reasons The use of LIFO pools transforms inventory valuation from the valuation of identifiable inventory units to the valuation of dollar units in a pool In addition, the use of retail instead of cost adds an additional element of estimation to the process In the more common case—rising inventory prices—LIFO is indeed equivalent to HIFO (highest in, first out), because the most recently purchased goods have the highest prices With falling inventory prices, the combination of LIFO and lower of cost or market can also result in HIFO For example, consider an example of a LIFO company that purchased two units during the year: first, one unit for $5, and then one unit for $3 Assume that the market value per unit at the end of the year is $3 In this case, use of lower of cost or market dictates that the ending inventory be recorded at no more than $3 In essence, this means that the $3 unit remains in inventory even though it was purchased last So, in times of rising prices, LIFO is always the same as HIFO In times of declining prices, the combination of LIFO and lower of cost or market can also result in a HIFO result 180 Chapter As American as Mom, Apple Pie, and LIFO (pp 508–509) Tax authorities are reluctant to permit LIFO because it reduces the amount of tax revenue collected Income statement distortion caused by a decline in LIFO inventory levels is called LIFO liquidation in the United States This is a conceptual shortcoming of LIFO and may be a valid reason for banning its use In the United States, the problems of LIFO liquidation are addressed by the requirement of full disclosure of the effects of any LIFO liquidation It is highly unlikely that the use of LIFO will be disallowed in the United States LIFO is part of the U.S accounting tradition And companies would be vigorously opposed to the elimination of LIFO for financial reporting purposes, fearing that the IRS would ban LIFO for tax purposes as well Inventory Fraud and Instant Profits (pp 518–519) The higher the ending inventory figure, the lower the reported cost of goods sold and the higher net income Thus, if the objective is to inflate profits, counting a lot of inventory and recording higher assets rather than expenses (cost of goods sold) will just that With an emphasis on historical costs, attention is turned away from the subjective task of valuation and instead is focused on the proper application of LIFO, FIFO, or average cost If accountants were required to use current values to account for inventory, the focus on the actual value of inventory would make it more difficult to perpetuate an inventory fraud using bogus or obsolete inventory items Consider how difficult and costly it would be to have the auditor assume all responsibility for detecting inventory errors Because auditing involves sampling, the auditor can never be certain that all errors and fraud have been detected However, an auditor should certainly be responsible for detecting all inventory errors that have a material impact on the financial statements Chapter 181 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 9–1 (The Walt Disney Company) In its note on significant accounting policies, Disney states: "Carrying amounts of merchandise, materials and supplies inventories are generally determined on a moving average cost basis and are stated at the lower of cost or market." In the statement of cash flows, inventories are shown as an addition of $54 million from cash from operating activities Therefore, inventories must have decreased during the year This is verified by looking at the balance sheet—inventories decreased from $702 million to $671 million The discrepancy in amount is most likely a result of acquisition or disposal of subsidiaries during the year Disney does not disclose its costs and expenses by functional category (e.g., cost of goods sold, salaries, etc.) Instead, Disney lists all operating costs and expenses together In the notes, Disney presents information by business segment This presentation makes it impossible to analyze individual expense categories such as cost of goods sold However, the presentation does emphasize the distinct nature of the different types of businesses in which Disney has operations The best of all possible worlds would be a 2-way expense categorization—by business segment and by functional category within each business segment Deciphering 9–2 (Circle K) Computation of gross profit percentage for Circle K's gasoline and merchandise is as follows (amounts are in millions): Gasoline Merchandise Sales $1,562.5 $1,710.3 Cost of goods sold 1,372.1 1,192.6 Gross profit $ 190.4 $ 517.7 Gross profit percentage: Gross profit Sales $190 $517.7 $1,562.5 $1,710.3 = 12.2% = 30.3% Because the gross profit percentage on merchandise is so high compared to that on gasoline, Circle K would have wished that all customers would pay for their gas inside the store to increase the chance that they would have bought some merchandise Computation of inventory turnover is as follows: Cost of goods sold Ending inventory Gasoline Merchandise 1,372.1 26.6 1,192.6 93.9 = 51.6 times = 12.7 times Computation of number of days' sales in ending inventory is as follows: 365 Inventory turnover Gasoline Merchandise 365 51.6 365 12.7 = 7.1 days = 28.7 days Gasoline is much more costly to store than is merchandise The storage facilities are costly (underground tanks), the potential for disaster is higher (accidents or expensive cleanup of leaky tanks), and the gasoline itself degrades if it is stored for a long time 182 Chapter Deciphering 9–2 (Concluded) Gross profit percentage: Gasoline Merchandise Overall 1993 1988 9.9% 31.6 20.9 10.6% 37.5 27.6 The more current set of numbers from 1993 is likely to yield a better estimate of 1994 gross profit percentage Two factors caused Circle K's overall gross profit percentage to decrease from 1988 to 1993 First, the gross profit percentages on the individual products, gasoline and merchandise, declined Second, the sales mix changed In 1993, more gasoline was sold, in proportion to merchandise sold, than in 1988 Because gasoline has a lower gross profit percentage, this change in the sales mix lowered the overall gross profit percentage The 1994 sales mix and gross profit percentages on the individual products are more likely to be closer to 1993 levels than to 1988 levels Total sales Estimated cost of goods sold (79.1%) Estimated gross profit (20.9%) Beginning inventory + Purchases = Cost of goods available for sale – Cost of goods sold (estimated) = Ending inventory (estimated) 1994 $ 3,272.8 2,588 $ 684.0 $ 131.2 2,554.0 $ 2,685.2 2,588 $ 96.4 Actual ending inventory for 1994 for Circle K was $120.5 million The underestimate results from the fact that actual gross profit percentage for Circle K for 1994 was 21.6% instead of the estimated 20.9% A better estimate could be generated if we had separate 1993 inventory and 1994 purchases data for gasoline and merchandise Deciphering 9–3 (3M: Minnesota Mining and Manufacturing Company) Computation of cost of goods manufactured: Finished goods inventory, beginning $1,231 + Cost of goods manufactured ? = Subtotal $ ? – Finished goods inventory, ending 1,103 = Cost of goods sold $ 8,749 Cost of goods manufactured = $8,621 Computation of total manufacturing costs: Work in process inventory, beginning + Total manufacturing costs = Subtotal – Work in process inventory, ending = Cost of goods manufactured Total manufacturing costs = $8,569 $ 663 ? $ ? 611 $ 8,621 Chapter Deciphering 9–3 183 (Concluded) Computation of number of days' sales in inventory is as follows: Average inventory Average daily cost of goods sold a Total Inventory ($2,312 + $2,091)/2 $8,749/365 = 91.8 days b Finished Goods ($1,231 + $1,103)/2 $8,749/365 = 48.7 days The number of days' sales in average finished goods inventory (48.7 days) is a more meaningful number The comparison between finished goods and cost of goods sold is a natural one, and the ratio computation produces exactly what it claims to produce—the average number of days' sales that are stored in the form of finished goods inventory The number of days' sales in average total inventory (91.8 days) has no intuitive meaning Raw materials inventory is not available for sale nor is work in process inventory This ratio only serves to show the general level of inventory (compared to prior years); it has no natural interpretation like that for the finished goods ratio Deciphering 9–4 (Caterpillar and Sara Lee) Sara Lee Ending LIFO inventory $2,882 Ending FIFO inventory ($2,882 + $8) Caterpillar = 99.7% $2,842 ($2,842 + $1,978) = 59.0% For Sara Lee, LIFO and FIFO inventories are almost exactly equal to one another On the other hand, for Caterpillar the LIFO inventory amount is just 59% of what would be reported under FIFO For Sara Lee: Beginning inventory + Purchases (same under LIFO and FIFO) = Cost of goods available for sale – Ending inventory = Cost of goods sold LIFO $ 2,973 12,240 $15,213 2,882 $12,331 FIFO $(2,973 + 32) 12,240 $ 15,245 (2,882 + 8) $ 12,355 LIFO $ 2,603 15,270 $17,873 2,842 $15,031 FIFO $(2,603 + 2,067) 15,270 $ 19,940 (2,842 + 1,978) $ 15,120 For Caterpillar: Beginning inventory + Purchases (same under LIFO and FIFO) = Cost of goods available for sale – Ending inventory = Cost of goods sold 184 Deciphering 9–4 Chapter (Concluded) The size of the LIFO reserve is a function of how long a company has used LIFO, how much of its inventories are under LIFO, and the rate of inflation in inventory costs in the company's industry The LIFO reserve becomes large when there are many old LIFO layers containing old costs Caterpillar has used LIFO for a long time and uses it for 90% of its inventory (compared to 19% for Sara Lee) Conversion of financial statement data from LIFO to FIFO is usually fairly easy because all that is needed is the LIFO reserve, and this can be approximated using the current value of the inventory Conversion from FIFO to LIFO is quite difficult, if not impossible The LIFO inventory balance is impacted by the entire history of the company's inventory transactions, back to the beginning of time LIFO layers should exist for each year in which purchases have exceeded sales Some of those layers would have been liquidated in subsequent years The valuation of each layer depends on the inventory costs in the year the layer was created In short, retroactive conversion from FIFO to LIFO is very difficult Deciphering 9–5 (British Petroleum Amoco) As computed by BP Amoco, an inventory holding gain is the difference between the replacement cost of inventory sold and the FIFO cost of inventory sold Subtracting the holding gain from replacement cost of goods sold converts the number to FIFO Accordingly, the number that BP Amoco reports as "historical cost gross profit" is FIFO gross profit—$25,425 in 2001 and $28,070 in 2000 Because replacement cost is computed using the average cost of goods acquired during the year, it closely approximates LIFO cost Therefore, the reported replacement cost gross profit is an estimate of LIFO gross profit—$27,325 in 2001 and $27,342 in 2000 The gross profit computation presented by BP Amoco is quite interesting in that it essentially shows both FIFO and LIFO and explains that the difference between the two comes from inventory holding gains Deciphering 9–6 (ExxonMobil) ExxonMobil uses LIFO for most of its inventories The reported LIFO cost of inventory can be substantially less than current replacement cost if old LIFO layers were established when costs were lower For ExxonMobil, the LIFO reserve (difference between LIFO cost and current replacement cost) was $6.7 billion for 2000 and $4.2 billion for 2001 Even though replacement cost of inventory decreased substantially in 2001 because of a decline in oil prices, the LIFO cost of inventory was still lower than replacement cost Thus, no lower-of-cost-ormarket adjustment was needed Chapter 185 Writing Assignment: This is not the time for “just in time.” To: Controller, Duo-Therm Company From: Assistant Controller RE: Just-in-Time Inventory A just-in-time (JIT) inventory system will reduce our inventory storage and carrying costs, but it will also dramatically increase the amount we pay in income taxes As you know, we have been using LIFO for the past 25 years During that time, we have been consistently growing As a result, we have established many old LIFO layers that are carried in inventory at old costs If we implement a JIT inventory system, we will liquidate these LIFO layers and the old low costs will flow into cost of goods sold, increasing our reported gross profit Because of the LIFO conformity rule, we use LIFO for both book and income tax purposes Accordingly, the increased gross profit will lead to increased income tax payments As the board of directors considers adopting a JIT inventory system, you should advise them of the income tax consequences The tax costs should be factored into the decision of whether to implement a JIT system If you wish, I will provide detailed computations and estimates to serve as background material for your presentation to the board Research Project: How much inventory is there in a supermarket? Numbers from the 1998 financial statements of Safeway will be used in discussing possible approaches to this research project Financial statements for the year ended December 31, 1998, were obtained from the SEC's Web site Gross profit percentage for 1998: Sales Cost of goods sold Gross profit Amounts (In millions) $24,484.2 17,359 $ 7,124.5 Percent 100.0% 70.9 29.1% Visit a retail location Safeway operates stores in northern California, Oregon, Washington, and in the Rocky Mountain, Southwest, and Mid-Atlantic regions A possible plan for estimating the retail value of inventory in the store is as follows: • Randomly choose 10 locations throughout the store • Estimate the total retail value of goods located within “shelf-feet” on either side of the location chosen • Estimate what proportion of the total store “shelf-feet” you have sampled • Extrapolate your estimate for the 10 random locations to an estimate for the entire store For example, if you estimate that you have sampled 5% of the goods in the store, multiply your estimate by 20 In Safeway's case, multiply your retail estimate by the cost/retail percentage of 70.9% Primary sources of error are: • The samples chosen are not representative of the average retail value of items throughout the store For example, the shelf space containing pasta has a lower retail total than the shelf space containing organic vitamins • Overlooking of supplemental items like produce, items located in special displays, and the fresh meat, fish, and poultry items You can check how close your estimate is by using data from the supermarket chain's annual report Safeway reports that it has 1,497 stores with total inventory of $1,856 million, suggesting that the average cost of inventory per store is $1.24 million 186 Chapter Chapter 187 The Debate: Americans, go home! And take LIFO with you! Remember, no arguments can be based on LIFO income tax implications!! Pro-LIFO: • LIFO most closely matches current costs with current revenues The matching concept has been the fundamental principle of income measurement for years • LIFO cost of goods sold is a close approximation of current replacement cost of goods sold Replacement cost gross profit is the best measure of a company's operating performance • Use of LIFO excludes inventory holding gains and losses from the computation of gross profit These holding gains and losses not stem from business operations but from price movements in the market for inventory As such, they should not be included in measures of business operating performance Anti-LIFO: • LIFO was invented in the United States merely as a tool to reduce income tax payments Acceptable financial accounting practices should not be influenced by techniques used to manipulate taxes • The LIFO inventory values reported in the balance sheet have no correspondence with the current value of inventory In fact, for a company that has used LIFO for a few years, the reported inventory numbers are almost meaningless • The existence of LIFO layers raises the possibility that LIFO liquidation will drag old LIFO layer costs into cost of goods sold In any period in which this happens, computed gross profit is not a reflection of performance for that period • Because maintenance of LIFO layers is so important in the computation of LIFO gross profit, companies that use LIFO can manipulate their reported profit by timing end-of-year purchases to either maintain or liquidate LIFO layers Ethical Dilemma #1: LIFO and the strategic timing of inventory purchases Clearly, you have stumbled upon a ploy to increase Lam Tin's reported profit in order to boost the acquisition price to be paid by Kwun Tong The dilemma is deciding what you should with your information Let's take the questions in reverse order Should you talk with the negotiation team from Kwun Tong? Probably not This attempt to manipulate reported profits is part of Lam Tin's bargaining strategy, and Kwun Tong should already be aware that such manipulations are possible To inject yourself into the complex negotiations is probably not a good idea Should you talk with Lam Tin's independent auditor? Maybe, depending on what the vice president of finance says This is a matter that is best kept inside the company if possible It may be that the vice president is just brainstorming about possibilities and hasn't yet decided to insist that you curtail yearend purchases in order to liquidate LIFO layers Talking to the external auditor is something that should wait until after you have spoken with the vice president And if you disclose this LIFO liquidation manipulation attempt to the auditors, rest assured that you also will probably have to find work somewhere else Should you talk with Lam Tin's vice president of finance? Absolutely You owe it to the vice president to tell her what your suspicions are and to tell her that you have extreme ethical reservations about the plan Your best strategy is to acknowledge the attractiveness of the plan, but you should also point out that if the manipulation is discovered before the deal is sealed with Kwun Tong, the scandal could sink the entire deal In addition, if the manipulation is discovered after the deal is sealed, the vice president and everyone else aware of the manipulation are vulnerable to a lawsuit Finally, you should help the vice president of finance come up with practical reasons for scuttling the plan For example, you might point out how costly the plan is, both in terms of extra income taxes and extra purchase costs Give the vice president 188 Chapter of finance every opportunity to back away from this sleazy LIFO manipulation without losing face Chapter 189 Ethical Dilemma #2: Just cut me the check! Your friend is engaging in the common practice of inflating expense reimbursement requests The rationale is that you deserve the money anyway, and the large organization paying the reimbursement can certainly afford to pay a little extra Your best response is to keep the discussion on a rational, quantitative level Don't accuse your friend of cheating Don't question your friend's morals Something like the following would be appropriate: "My company is happy to reimburse all reasonable, documented losses What we need to is to document your loss Of course, if there is some uncertainty about the estimates, you will get the benefit of the doubt." At this point, show your friend exactly how the amount of inventory destroyed can be estimated This shifts the focus from the attempt to cheat the insurance company to the work of gathering the data to compile a supportable estimate of the inventory destroyed Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search Using Google as the search engine, a search including ABC, JIT, LCM, FIFO, and LIFO as search terms had 41 hits on September 14, 2002 Many of the hits were for glossaries (in a variety of languages) The search also identified several lists of acronyms and found a syllabus for a collegiate accounting course In its January 31, 2002 10-K filing, Wal-Mart discussed inventory in the following contexts: a Wal-Mart reported that it recorded a $67 million reduction in cost of sales in fiscal 2002 because of a LIFO inventory adjustment Wal-Mart reported that this reduction indicates that fiscal 2002 was a time of deflation in inventory purchase prices b Wal-Mart reported that its interest cost decreased in fiscal 2002, partly because an effort to control inventory levels reduced the need for debt financing During fiscal 2002, sales increased 14% but the inventory level only increased 5% c The company reported that it had less inventory shrinkage in fiscal 2002 d The company reported that its segment in Germany was experiencing low operating profitability, partly because of excess inventory levels e Wal-Mart reported that it has rarely experienced inventory obsolescence in the past f Wal-Mart reported that its biggest exposure to foreign exchange risk arises from cross-border inventory purchases on credit ... overstated by Cost of goods sold understated by Net income correct correct correct $2,000 $2,000 overstated by $2,000 Correct net income: $3,000 − $2,000 = $1,000 Year Beginning inventory overstated by. .. of goods available for saleoverstated by $2,000 Less: Ending inventory understated by $450 Cost of goods sold overstated by $2,450 Net income understated by $2,450 Correct net income: $3,000 +... understated by $450 Plus: Purchases correct Cost of goods available for saleunderstated by $450 Less: Ending inventory correct Cost of goods sold understated by $450 Net income overstated by $450