BUS312A/612A Financial Reporting I. Homework Inventory Chapter 8

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1 BUS312A/612A Financial Reporting I Homework Inventory Chapter 8

2 Objectives Chapter 8 You should be able to Discuss the relevance of inventory methods Compare the periodic and perpetual inventory systems Identify the effects of inventory errors on financial statements Identify the items included as inventory costs Compare FIFO, LIFO, Average cost, Dollar Value LIFO, specific identification and pooling methods) Extract inventory information from financial statements Convert COGS and inventory from LIFO to FIFO using information in the financial statements

3 Inventory & Cost of Sales

4 Types of Inventories Retail Firms Merchandise Inventory Manufacturing Firms Raw Materials Work-In-Process Finished Goods All Firms Supplies Inventory Office Supplies Inventory Etc.

5 Retail Firm Inventories

6 Manufacturing Firm Inventories

7 E8-1 (Inventoriable Costs) Which of these items is part of inventory? 1. Goods out on consignment at another company s store. 2. Goods sold on an installment basis (bad debts can be reasonably estimated.) 3. Goods purchased f.o.b. shipping point that are in transit at December Goods purchased f.o.b. destination that are in transit at December Goods sold to another company, for which our company has signed an agreement to repurchase at a set price that covers all costs related to the inventory. 6. Goods sold where large returns are predictable. 7. Goods sold f.o.b. shipping point that are in transit at December Freight charges on goods purchased. 9. Interest costs incurred for inventories that are routinely manufactured. 10. Costs incurred to advertise goods held for resale. 11. Materials on hand not yet placed into production by a manufacturing firm. 12. Office supplies. 13. Raw materials in production, but not completely processed. 14. Factory supplies. 15. Goods held on consignment from another company. 16. Costs identified with units completed by a manufacturing firm, but not yet sold. 17. Goods sold f.o.b. destination that are in transit at December Temporary investments in stocks and bonds that will be resold in the near future.

8 Valuation Cost-Flow Assumptions: Physical flow versus FIFO, LIFO, Average cost, Dollar Value LIFO, specific identification and pooling methods Lower of Cost of Market Periodic vs. Perpetual

9 E8-9 (Periodic versus perpetual Entries) Company sells one product on account, and uses FIFO. Presented below is information for January. Jan.1 Inventory 100 units at $5 each 4 Sale 80 units at $8 each 11 Purchase 150 units at $6 each 13 Sale 120 units at $8.75 each 20 Purchase 160 units at $7 each 27 Sale 100 units at $9 each a) Periodic system: Prepare all JEs, including COGS. Ending inventory physical count is 110 units. b) Compute gross profit, periodic. c) Perpetual system: Prepare all JEs, including COGS. d) Compute gross profit: perpetual.

10 Periodic JEs

11 Perpetual JEs

12 E8-11 (Inventory Errors) At 12/31/13 Corp. reported CA of $370,000 and CL of $200,000, including: 1. Bought goods for $22,000 FOB shipping point on 12/28. Received and recorded invoice on 12/29, but the goods were not received until 01/04/ Bought goods for $15,000 FOB destination on 12/26. Received and recorded invoice on 12/31, but the goods were not received until Jan Goods held on consignment included in physical count at $13, Freight-in of $3,000 was debited to advertising expense on 12/28. (a) Current ratio (CA/CL) before correction. (b) Current ratio (CA/CL) after correction. (c) By what pretax amount will NI change?

13 E8-10 (Inventory Errors Periodic) Martin Co. errors (current year). Evaluate independently. 1. Ending inventory overstated, but purchases recorded correctly. 2. Both ending inventory and purchases on account understated. (purchase recorded following year.) 3. Ending inventory correct, but purchase on account not recorded. (purchase recorded following year.) 1. BB + Purchases -COGS=EB WC=CA-CL CA/CL RE NI Yr1 Yr2 2. Yr1 Yr2 3. Yr1 Yr2

14 Inventory Valuation and Consequences Same total $$ amount over the life of the company is allocated differently to cost of goods sold and ending inventory. Is Cost of Goods Sold Correct? Is Ending Inventory Correct? Income and Asset Measurement How much does it cost? Valuation: Cost-original or replacement, Lower of Cost or Market Economic Consequences Income Taxes and Liquidity Bookkeeping Costs LIFO Liquidation and Inventory Purchasing Practices Debt and Compensation Practices The Capital Market- Current ratio, Profit margin ratio

15 P8-4 (FIFO, LIFO, and Average Cost-Periodic and Perpetual) Purchases April 1 (balance on hand) $ (a) Compute the inventory (kept in units only) at 04/ FIFO 2. LIFO 3. Average Cost. Sales April (b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each withdrawal, what amount would be shown as ending inventory in 1, 2, and 3 above?

16 Problem 8-4 FIFO-periodic

17 Problem 8-4 LIFO-periodic

18 Problem 8-4 Average Cost -periodic

19 P8-4 Recap Periodic Inventory Method Weighted Average FIFO LIFO Cost of Goods Sold Balance Sheet Inventory Perpetual Inventory Method Weighted Average FIFO LIFO Cost of Goods Sold Balance Sheet Inventory

20 Problem 8-4 FIFO-perpetual

21 Problem 8-4 LIFO-perpetual

22 Problem 8-4 Average Cost -perpetual

23 Cost-Flow Assumptions Periodic Vs. Perpetual FIFO No difference LIFO COGS: Last units purchased EB: Last units purchased this period. prior to sale. Average COGS: Average across the EB: Average across the part of whole period. of the period prior to the sale Rising cost implications for IS: COGS & NI BS: Current Assets FIFO LIFO Average cost

24 Summary of LIFO, FIFO, Average cost Managers have wide latitude in inventory cost flow decisions. Specific identification is generally considered appropriate where items of inventory are unique (low volume, high cost items) because of the potential for income manipulation. LIFO is generally used when prices are rising because of the tax advantages and the requirement that it be used in the financial statements if it is used for tax purposes. The only theoretical defense for LIFO is that in times of extreme inflation, it minimizes the inflationary distortions in the income statement by matching current dollars of revenues and expenses. However, the LIFO method, over time, misrepresents the balance sheet by understating inventory values.

25 Summary of FIFO, LIFO, Average cost If a company adopts LIFO, it must disclose in its footnotes the LIFO reserve which is the difference between ending inventory s FIFO value and LIFO value. FIFO s advantage is that it provides a valuation for ending inventory that more closely approximates its current replacement cost. FIFO s disadvantage is that it does not provide a good match of revenues and expenses in current dollars during periods of changing prices. Weighted average is a good compromise in that it generally provides a fairly good match of revenues and expenses as long as inventory is turning over fairly fast which keeps inventory levels fairly low. In such cases, it will tend to give an inventory value on the balance sheet that is closer to FIFO, since current purchases normally have more influence than beginning inventories on determining the average cost.

26 LIFO to FIFO Inventory Conversion The difference between LIFO and FIFO inventory values is called the LIFO Reserve. Assuming prices rise over time, the effect on the balance sheet of using LIFO is that assets and shareholders equity (Retained Earnings) are lower than they would be under FIFO. The reduction is not equal to the LIFO reserve because of tax consequences. Inventory values may be lower but cash is higher by the amount of the LIFO reserve times the tax rate. Thus, total assets are lower by the LIFO reserve times (1-tax rate) and Retained Earnings is lower by the LIFO reserve times (1-tax rate).

27 FIFO V. LIFO General Electric uses LIFO inventory cost flow assumption, reporting inventories on its 2012 balance sheet of $15.4 billion and a LIFO reserve of approximately $398 million. What would be GE s 2012 inventory balance if it used FIFO assumption instead? Why is disclosure of the LIFO reserve useful to financial statement users?

28 International Perspective Cost Flow Assumptions Under IFRS the LIFO method is prohibited. This poses an important potential impediment to the adoption of IFRS in the US. Most LIFO users in the US have chosen LIFO because it results in an income tax savings. DuPont, for example, has saved over $150 million in income taxes because it uses LIFO. A shift to IFRS could impose a huge and immediate tax burden on LIFO users in the US.

29 LIFO Liquidation and Hidden Reserves In the early 1980s, an oil glut caused Texaco, a LIFO user, to delay drilling, which cut it oil inventory levels by 16%. The LIFO cushion (i.e., the difference between LIFO and FIFO inventory values) that was built into those barrels over the year amounted to $454 million and transformed what would have been a drop in net income to a modest gain. Explain how using LIFO could be interpreted as building hidden reserves.

30 Dollar-value LIFO Lose verifiability BUT Reduce cost of measurement

31 Dollar-value LIFO Periodic Determine ending inventory (EI) Use EI to determine COGS Ending Inventory Need units Inventory in base-year dollars Need cost per unit Price index

32 P8-8 (Dollar-Value LIFO) Norman s Televisions produces television sets in three categories: portable, midsize, and flat screen. On January 1, 2014, Norman adopted dollar-value LIFO and decided to use a single inventory pool. The company s January 1 inventory consists of: Category Quantity Cost per Unit Total Cost Portable 6,000 $100 $ 600,000 Midsize 8, ,000,000 Flat screen 3, ,200,000 17,000 $3,800,000 During 2014, the company had the following purchases and sales: Category No. Purchased Cost per Unit No. Sold Sales Price/Unit Portable 15,000 $110 14,000 $150 Midsized 20, , Flat screen 10, , ,000 44,000 (a) Compute ending inventory, cost of goods sold, and gross profit.

33 P8-8 (Dollar-Value LIFO) Norman s Televisions produces television sets in three categories: portable, midsize, and flat screen. On January 1, 2014, Norman adopted dollar-value LIFO and decided to use a single inventory pool. The company s January 1 inventory consists of: Category Quantity Cost per Unit Total Cost Portable 6,000 $100 $ 600,000 Midsize 8, ,000,000 Flat screen 3, ,200,000 17,000 $3,800,000 During 2014, the company had the following purchases and sales: Category No. Purchased Cost per Unit No. Sold Sales Price/Unit Portable 15,000 $110 14,000 $150 Midsized 20, , Flat screen 10, , ,000 44,000 (b) Assume the company uses three inventory pools instead of one. Compute ending inventory, cost of goods sold, and gross profit.

34 Disclosure Method(s) used If using LIFO, LIFO reserve information (LIFO reserve=difference between LIFO inventory balances and balances if either FIFO or current costs had been used)

35 Coca Cola Inventory Disclosures Income Statement: Balance Sheet:

36 Coca Cola Inventory Disclosures continued Footnotes:

37 Walmart Inventory Disclosures Income Statement: Balance Sheet

38 Walmart Inventory Disclosures continued Footnotes:

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