CHAPTER 6 Solutions INVENTORIES

CHAPTER 6 Solutions INVENTORIES Chapter 6, SE 1. 1. c 3. d 5. 2. c 4. b a Chapter 6, SE 2. Inventory Turnover Days' Inventory on Hand = = = = Cost of Goods Sold Average Inventory $2,200,000 ( $560,000 + $480,000 ) 2 $2,200,000 = 4.2 Times $520,000 Number of Days in a Year Inventory Turnover 365 Days = = 86.9 Days 4.2 Times Chapter 6, SE 3. Inventory Turnover = = Cost of Goods Sold Average Inventory $6,500,000 ( $1,780,000 + $1,440,000 ) 2 = $6,500,000 $1,610,000 = 4.0 Times Days' Inventory on Hand = Number of Days in a Year Inventory Turnover 365 = 4.0 Days Times = 91.3 Days 295

Chapter 6, SE 4. Specific identification method: Less ending inventory From August 8 purchase From August 22 purchase $1,370 ( 30 units $11 ) $330 ( 25 units $12 ) 300 630 $ 740 Chapter 6, SE 5. Average-cost method periodic inventory system: $1,370 Less ending inventory Average cost times units on hand 55 units $10.96 * = $603** 603 $ 767 * $1,370 125 units = $10.96 ** Rounded Chapter 6, SE 6. FIFO method periodic inventory system: $1,370 Less ending inventory From August 22 purchase ( 35 units $12 ) $420 From August 8 purchase ( 20 units $11 ) 220 640 $ 730 Chapter 6, SE 7. LIFO method periodic inventory system: Less ending inventory From beginning inventory From August 8 purchase $1,370 ( 40 units $10 ) $400 ( 15 units $11 ) 165 565 $ 805 296

Chapter 6, SE 8. Ending inventory Specific Identification Method $630 740 Periodic Inventory System Average- Cost FIFO LIFO Method Method Method $603 $640 $565 767 730 805 The cost of goods sold figures range from $730 to $805, a difference of $75, or 10.3 percent. All the results are different. Because this is a period of rising prices, LIFO produces the highest cost of goods sold and will therefore produce the lowest net income and the lowest income taxes. LIFO also produces the lowest ending inventory valuation. The average-cost method produces results between LIFO and FIFO. Chapter 6, SE 9. Average-cost method perpetual inventory system: Cost Units per Unit* Amount* Aug. 1 Inventory 40 $10.00 $400 8 Purchase 50 11.00 550 8 Balance 90 10.56 $950 15 Sale (45) 10.56 ( 475) 15 Balance 45 10.56 $475 22 Purchase 35 12.00 420 22 Balance 80 11.19 $895 28 Sale (25) 11.19 ( 280) 31 Inventory 55 11.18 $615 ( $475 + $280 ) $755 *Rounded 297

Chapter 6, SE 10. FIFO method perpetual inventory system: Cost Units per Unit Aug. 1 Inventory 40 $10 $400 8 Purchase 50 11 550 8 Balance 40 10 $400 50 11 550 $950 15 Sale (40) 10 ($400) ( 5) 11 ( 55) ( 455) 15 Balance 45 11 $495 22 Purchase 35 12 420 22 Balance 45 11 $495 35 12 420 $915 28 Sale (25) 11 ( 275) 31 Inventory 20 11 $220 35 12 420 55 $640 ( $455 + $275 ) $730 298

Chapter 6, SE 11. LIFO method perpetual inventory system: Units Cost per Unit Aug. 1 Inventory 40 $10 $400 8 Purchase 50 11 550 8 Balance 40 10 $400 50 11 550 $950 15 Sale (45) 11 ( 495) 15 Balance 40 10 $400 5 11 55 $455 22 Purchase 35 12 420 22 Balance 40 10 $400 5 11 55 35 12 420 $875 28 Sale (25) 12 ( 300) 31 Inventory 40 10 $400 5 11 55 10 12 120 55 $575 ( $495 + $300 ) $795 299

Chapter 6, SE 12. Ending inventory Specific Identification Method $630 740 Perpetual Inventory System Average- Cost FIFO LIFO Method Method Method $615 $640 $575 755 730 795 The cost of goods sold figures range from $730 to $795, a difference of $65, or 8.9 percent. All the results are different. Because this is a period of rising prices, LIFO produces the highest cost of goods sold and will therefore produce the lowest net income and the lowest income taxes. LIFO also produces the lowest ending inventory valuation. The average-cost method produces results between LIFO and FIFO. 300

Chapter 6, E 1. 1. 2. 3. 4. It is both good and bad for a retail store to have a large inventory. It is good from the standpoint that customers want a large selection and they want the items to be available. It is bad from the standpoint that it is more costly to have a large inventory than a smaller inventory. In addition to storage and insurance costs, there is the cost of interest on money borrowed to finance the inventory. The flow of costs is more important because inventory costing ignores the actual flow of goods and assumes a flow of costs. For one thing, the value put on inventory has a direct dollar-for-dollar effect on net income. For another, it is relatively easy to falsify the value placed on the ending inventory and to cover up the falsification. It probably is not. A reduction in the current period ending inventory amount, which results in a lower income, will cause the beginning inventory in the next period to be smaller and will thus increase income in that period. Chapter 6, E 2. 1. 2. 3. The four methods would produce the same results if there were no price changes after the purchase of the beginning inventory. Under the perpetual inventory method, the cost of goods sold and the inventory balance are determined after every transaction. In theory, the perpetual inventory method does not require a physical inventory because the amount of inventory is adjusted after each transaction. In practice, a good control is to periodically take a physical inventory to verify the balance in as the records. The gross profit method does require a physical inventory to match against the estimated inventory to determine the amount of the loss for which a physical inventory is not possible. Both the periodic and the retail methods require physical inventories. 301

Chapter 6, E 3. 1. 2. 3. 4. 5. 6. 7. c d c b a b a Chapter 6, E 4. Inventory Turnover = 2010 = Cost of Goods Sold Average Inventory $450,000 ( $81,000 + $69,000 ) 2 2011 Days' Inventory on Hand 2010 2011 = $450,000 = 6.0 Times $75,000 $480,000 = ( $96,000 + $81,000 ) 2 $480,000 = = 5.4 Times $88,500 Number of Days in a Year = Inventory Turnover = 365 Days 6.0 Times = 60.8 Days = 365 Days 5.4 Times = 67.6 Days Just a Buck Discount Stores' inventory is increasing much faster than its sales. As a result, the inventory turnover is decreasing and days' inventory on hand is increasing. This is a negative trend that will reduce profitability and require the company to commit more funds to inventories. 302

Chapter 6, E 5. Sales Gross margin Operating expenses Income before income taxes 2011 2010 $252,000 $210,000 168,000 90,000 $ 84,000 $120,000 60,000 60,000 $ 24,000 $ 60,000 The error in understating the ending inventory for 2010 will not affect the results for 2012. Chapter 6, E 6. According to the convention of consistency, a company must follow the same accounting principles from year to year. Thus, a change to FIFO would violate this convention. If the company does decide to change to FIFO, the full disclosure convention requires that the change be disclosed and the effects of the change described. Following the lower-of-cost-or-market rule for valuing inventory is a conservative method of accounting because it anticipates losses. Fewer adjustments will be anticipated in the future because under FIFO, the most recent prices, which are declining, are used to price inventory. As a result, this is a conservative inventory method in these circumstances as well. Under LIFO, the earlier higher prices in inventory needed to be adjusted downward. 303

Chapter 6, E 7. 1. Inventory costs assigned by the specific identification method June 15 Purchase 200 cases @ $28 $ 5,600 Jan. 1 Inventory 100 cases @ $23 2,300 Oct. 15 Purchase 100 cases @ $28 2,800 Dec. 15 Purchase 100 cases @ $30 3,000 $13,700 Ending inventory $18,275 $13,700 = $4,575 2. Inventory costs assigned by the average-cost method Average unit cost: $18,275 675 cases = $27.07* Less Dec. 31 inventory 175 cases $27.07 $18,275 4,737 $13,538 *Rounded 3. Inventory costs assigned by the FIFO method Less Dec. 31 inventory 100 cases @ $30 from Dec. 15 purchase 75 cases @ $28 from Oct. 15 purchase 175 cases $3,000 2,100 $18,275 5,100 $13,175 4. Inventory costs assigned by the LIFO method Less Dec. 31 inventory 125 cases @ $23 from Jan. 1 inventory 50 cases @ $26 from Feb. 25 purchase 175 cases $2,875 1,300 $18,275 4,175 $14,100 304

Chapter 6, E 7. (Continued) In this period of rising prices, the FIFO method resulted in the highest value for inventory on the balance sheet and the lowest cost of goods sold on the income statement, bringing about the highest net income. The LIFO method resulted in the lowest value for inventory on the balance sheet and the highest value for cost of goods sold on the income statement, bringing about the lowest net income. The averagecost method falls between both measures. The specific identification method is randomly related to periods of changing prices. Chapter 6, E 8. 1. computed by FIFO method Beginning inventory Purchases Ending inventory Year 1 Year 2 Year 3 $ 21,000 $ 24,000 $117,600 144,000 150,000 $117,600 $165,000 $174,000 21,000 24,000 30,000 $ 96,600 $141,000 $144,000 2. computed by LIFO method Beginning inventory Purchases Ending inventory Year 1 Year 2 Year 3 $ 21,000 $ 21,000 $117,600 144,000 150,000 $117,600 $165,000 $171,000 21,000 21,000 21,000 $ 96,600 $144,000 $150,000 Under the FIFO method, the ending inventory takes on the unit price of the purchases each year. Under the LIFO method, the ending inventory retains the original purchase price of $42 per unit in each of the three years, and the number of units in the ending inventory stays at 500 each year. As a result, cost of goods sold in years 2 and 3 equals purchases. 305

Chapter 6, E 9. Sales 1,300 Beginning inventory 150 Purchases 400 800 300 1,650 units $60 $78,000 units $30 $ 4,500 units $33 13,200 units $36 28,800 units $39 11,700 units $58,200 Periodic inventory system average-cost method: Sales $58,200 Less ending inventory ( 350* units $35.27** ) 12,345 Gross margin $78,000 45,855 $32,145 Periodic inventory system FIFO method: Sales Less ending inventory Gross margin $58,200 13,500 $78,000 44,700 $33,300 * 1,650 units 1,300 units = ** $58,200 1,650 units = 350 $35.27 units (rounded) 300 units $39 = 50 units $36 = $11,700 1,800 $13,500 306

Chapter 6, E 9. (Continued) Periodic inventory system LIFO method: Sales Less ending inventory* Gross margin * 150 units $30 = $ 4,500 200 units $33 = 6,600 $11,100 $58,200 11,100 $78,000 47,100 $30,900 The unit cost of merchandise rose steadily during the month of June. When prices are rising, LIFO results in the most recent (highest) costs being assigned to cost of goods sold and the earliest (lowest) costs being carried forward as inventory. As a result, the gross margin under LIFO was $2,400 ($33,300 $30,900) less than it was under FIFO. The average-cost method falls between the other two methods. 307

Chapter 6, E 10. FIFO Method LIFO Method Sales 120,000 $20 $2,400,000 $2,400,000 Beginning inventory 20,000 $12 $ 240,000 $ 240,000 Purchases 60,000 $14 840,000 840,000 50,000 $15 750,000 750,000 $1,830,000 $1,830,000 Less ending inventory FIFO ( 10,000 $15 ) 150,000 LIFO ( 10,000 $12 ) 120,000 $1,680,000 $1,710,000 Gross margin $ 720,000 $ 690,000 Operating expenses 550,000 550,000 Income before income taxes $ 170,000 $ 140,000 Income taxes expense (30%) 51,000 42,000 Net income $ 119,000 $ 98,000 FIFO produces the higher reported net income, but from a cash flow standpoint, the only difference under FIFO and LIFO is the amount of income taxes paid (note that sales, purchases, and operating expenses are the same under both methods). Therefore, LIFO produces a more favorable cash flow of $9,000 ($51,000 $42,000). The reason is that under LIFO, the most recent purchases (at $15) are included in cost of goods sold and deducted from sales instead of beginning inventory (at $12). As long as prices are increasing, LIFO usually results in lower income taxes and thus a better cash flow than FIFO does. 308

Chapter 6, E 10. (Continued) If a year-end purchase of 10,000 cases at $15 per case is made, the following will result: Sales FIFO Method LIFO Method 120,000 $20 $2,400,000 $2,400,000 Beginning inventory 20,000 $12 $ 240,000 $ 240,000 Purchases 60,000 $14 840,000 840,000 50,000 $15 750,000 750,000 10,000 $15 150,000 150,000 $1,980,000 $1,980,000 Less ending inventory FIFO ( 20,000 $15 ) 300,000 LIFO ( 20,000 $12 ) 240,000 $1,680,000 $1,740,000 Gross margin $ 720,000 $ 660,000 Operating expenses 550,000 550,000 Income before income taxes $ 170,000 $ 110,000 Income taxes expense (30%) 51,000 33,000 Net income $ 119,000 $ 77,000 The reason for this outcome under LIFO is that a LIFO liquidation is avoided by buy- ing the 10,000 cases at the end of the year. In this way, all 20,000 cases of the LIFO beginning inventory at $12 per case are maintained as the ending inventory. Without this purchase, 10,000 units at $12 per case are included in the cost of goods sold beusing the LIFO method try to avoid letting the ending inventory fall below the begin- cause the ending inventory is below the beginning inventory level. Many companies ning level to avoid paying increased income taxes. The results under the FIFO method are the same with or without the purchase, but income taxes under LIFO are $9,000 less ($42,000 $33,000) with the year-end purchase, and net income is $21,000 less ($98,000 $77,000). 309

Chapter 6, E 11. Perpetual inventory system average-cost method Date Units Cost* Amount June 1 Inventory 150 $30.00 $ 4,500 4 Purchase 400 33.00 13,200 4 Balance 550 32.18 $17,700 12 Purchase 800 36.00 28,800 12 Balance 1,350 34.44 $46,500 16 Sale (1,300) 34.44 ( 44,772) 16 Balance 50 34.56 $ 1,728 24 Purchase 300 39.00 11,700 30 Inventory 350 $38.37 $13,428 Sales** Gross margin $78,000 44,772 $33,228 * Rounded ** 1,300 $60 = $78,000 310

Chapter 6, E 11. (Continued) Perpetual inventory system FIFO method Date June Units Cost Amount 1 Inventory 150 $30.00 $ 4,500 4 Purchase 400 33.00 13,200 4 Balance 150 30.00 400 33.00 $17,700 12 Purchase 800 36.00 28,800 12 Balance 150 30.00 400 33.00 800 36.00 $46,500 16 Sale (150) 30.00 (400) 33.00 (750) 36.00 ( 44,700) 20 Balance 50 36.00 $ 1,800 24 Purchase 300 39.00 11,700 30 Inventory 50 36.00 300 39.00 350 $13,500 Sales* Gross margin $78,000 44,700 $33,300 * 1,300 $60 = $78,000 311

Chapter 6, E 11. (Continued) Perpetual inventory system LIFO method Date Units Cost Amount June 1 Inventory 150 $30.00 $ 4,500 4 Purchase 400 33.00 13,200 4 Balance 150 30.00 400 33.00 $17,700 12 Purchase 800 36.00 28,800 12 Balance 150 30.00 400 33.00 800 36.00 $46,500 16 Sale (800) 36.00 (400) 33.00 (100) 30.00 ( 45,000) 16 Balance 50 30.00 $ 1,500 24 Purchase 300 39.00 11,700 30 Inventory 50 30.00 300 39.00 350 $13,200 Sales* Gross margin $78,000 45,000 $33,000 * 1,300 $60 = $78,000 The difference in gross margin under FIFO and LIFO of $300 ($33,300 $33,000) results from the difference in ending inventory under the two methods. Since prices rose from $30 to $39 per unit during the period, the LIFO method, which charges the most recent prices to cost of goods sold, resulted in the lowest gross margin from sales. The average-cost method produced a gross margin of $33,228, which is between those of FIFO and LIFO. 312

Chapter 6, E 12. Goods available for sale and ending inventory in units Beginning inventory Purchase 1 Purchase 2 Purchase 3 Purchase 4 Goods available for sale Sale in units Ending inventory in units Units Cost Total 100 $ 4 $ 400 40 8 320 60 12 720 150 18 2,700 90 24 2,160 440 $6,300 250 190 313

Chapter 6, E 12. (Continued) 1. Periodic inventory system a. Specific identification method: Sales Less ending inventory* Gross margin $6,300 3,200 $8,000 3,100 $4,900 * Purchase 1 40 units $8 = Purchase 2 60 units $12 = Purchase 4 90 units $24 = $ 320 720 2,160 $3,200 b. Average-cost method: Sales Less ending inventory* Gross margin $6,300 2,721 $8,000 3,579 $4,421 * Average cost = $6,300 440 units = 190 units $14.32 = $2,721 ** Rounded $14.32** c. FIFO method: Sales Less ending inventory* Gross margin $6,300 3,960 $8,000 2,340 $5,660 * Purchase 4 90 units $24 = Purchase 3 100 units $18 = $2,160 1,800 $3,960 314

Chapter 6, E 12. (Continued) d. LIFO method: Sales Less ending inventory* Gross margin * Beginning inventory 100 units $ 4 = $ 400 Purchase 1 40 units $ 8 = 320 Purchase 2 50 units $12 = 600 $1,320 $6,300 1,320 $8,000 4,980 $3,020 2. a. * Perpetual inventory system Average-cost method: Sales Gross margin Beginning inventory Purchase 1 Balance Purchase 2 Balance Purchase 3 Balance Sale Balance Purchase 4 Ending inventory Rounded $8,000 2,958 $5,042 Units Cost* Amount* 100 $ 4.00 $ 400 40 8.00 320 140 5.14 $ 720 60 12.00 720 200 7.20 $1,440 150 18.00 2,700 350 11.83 $4,140 (250) 11.83 ( 2,958) 100 11.82 $1,182 90 24.00 2,160 190 17.59 $3,342 315

Chapter 6, E 12. (Continued) b. FIFO method: Sales * Gross margin $8,000 2,340 $5,660 * Sale 1 From beginning inventory 100 units $ 4 $ 400 From purchase 1 40 units $ 8 320 From purchase 2 60 units $12 720 From purchase 3 50 units $18 900 250 units $2,340 Ending inventory = $6,300 $2,340 = $3,960 c. LIFO method: Sales * Gross margin $8,000 3,740 $4,260 * Sale 1 From purchase 3 150 units $18 $2,700 From purchase 2 60 units $12 720 From purchase 1 40 units $ 8 320 250 units $3,740 Ending inventory = $6,300 $3,740 = $2,560 316

Chapter 6, E 13. 1. Ending inventory estimated by retail method Beginning inventory Net purchases (excluding freight-in) Freight-in Goods available for sale Ratio of cost to retail price: $190,400 $280,000 = 68% Net sales during the period Estimated ending inventory at retail Ratio of cost to retail Estimated cost of ending inventory Cost Retail $ 40,000 $ 60,000 140,000 220,000 10,400 $190,400 $280,000 68% $ 20,400 250,000 $ 30,000 2. Loss estimated Estimated cost of ending inventory Physical inventory at retail Ratio of cost to retail Estimated cost of physical inventory Estimated cost of inventory shrinkage $18,000 68% $20,400 12,240 $ 8,160 Chapter 6, E 14. Beginning inventory at cost Purchases at cost (including freight-in of $27,400) Less estimated cost of goods sold: Sales at selling price Less estimated gross margin of 40% Estimated cost of goods sold Estimated loss of inventory in fire $900,000 360,000 $ 90,000 587,400 $677,400 540,000 $137,400 317

Chapter 6, P 1. 1. Schedule of cost of goods available for sale prepared Beginning inventory Purchases February April June August October November Units 130 225 350 700 300 400 250 2,355 Price $56 $62 $65 $70 $66 $68 $72 Total Cost $ 7,280 13,950 22,750 49,000 19,800 27,200 18,000 $157,980 2. Income before income taxes computed a. Average-cost method: Sales ( 2,200 $160 ) $352,000 (see schedule) $157,980 Ending inventory* 10,397 147,583 Gross margin Selling and administrative expenses Income before income taxes $204,417 101,000 $103,417 * Divided by total units available Cost per unit Multiplied by units in ending inventory ( 2,355 2,200 ) Ending inventory $157,980 2,355 $ 67.08 155 $ 10,397 ** ** ** Rounded 318

Chapter 6, P 1. (Continued) b. FIFO method: Sales (see schedule) Ending inventory* Gross margin Selling and administrative expenses Income before income taxes * 155 units from November purchase $72 = $11,160 $157,980 11,160 $352,000 146,820 $205,180 101,000 $104,180 c. LIFO method: Sales (see schedule) Ending inventory* Gross margin Selling and administrative expenses Income before income taxes $157,980 8,830 $352,000 149,150 $202,850 101,000 $101,850 * Beginning inventory ( 130 units $56 ) February purchase ( 25 units $62 ) Ending inventory $7,280 1,550 $8,830 319

Chapter 6, P 1. (Continued) 3. User Insight: Financial ratios computed and discussed Days' inventory on hand Average-Cost $147,583 Average inventory Inventory turnover FIFO $146,820 $149,150 $8,839 $9,220 $8,055 ( $10,397 + $7,280 ) 2 ( $11,160 + $7,280 ) 2 ( $8,830 + $7,280 ) 2 16.7 Times 15.9 Times 18.5 Times ( $147,583 $8,839 ) ( $146,820 $9,220 ) ( $149,150 $8,055 ) 21.9 Days 23.0 Days 19.7 Days ( 365 Days 16.7 Times ) ( 365 Days 15.9 Times ) ( 365 Days 18.5 Times ) LIFO In periods of rising prices, the LIFO method will always result in a higher inventory turnover and lower days' inventory on hand. When inventory ratios are compared for two or more companies, the inventory methods used by the companies should be considered. 320

Chapter 6, P 2. 1. Periodic inventory system average-cost method March 1 beginning inventory Purchase March 10 * Sale March 19 March 31 ending inventory* for March Unit Units Price Amount 60 $49.00 $ 2,940 100 52.00 5,200 160 50.88 $ 8,140 90 70 50.88 3,562 $ 4,578 *Rounded April 1 beginning inventory Unit Units Price Amount Purchases 70 $50.88 $ 3,562 April 4 120 $53 $6,360 April 15 50 54 2,700 April 25 100 55 5,500 270 14,560 340 53.30 $18,122 Sale April 23 April 30 ending inventory for April 200 140 53.30 7,462 $10,660 321

Chapter 6, P 2. (Continued) 2. Periodic inventory system FIFO method March 1 beginning inventory Purchase March 10 Sale March 19 March 31 ending inventory* for March Unit Units Price Amount 60 $49 $ 2,940 100 52 5,200 160 $ 8,140 90 70 52 3,640 $ 4,500 *From purchase on March 10 April 1 beginning inventory Units Unit Price Amount 70 $52 $ 3,640 Purchases April 4 120 $53 $6,360 April 15 50 54 2,700 April 25 100 55 5,500 270 14,560 340 $18,200 Sale April 23 April 30 ending inventory* for April 200 140 7,660 $10,540 * From April 25 purchase: 100 units $55 = $5,500 From April 15 purchase: 40 units $54 = 2,160 $7,660 322

Chapter 6, P 2. (Continued) 3. Periodic inventory system LIFO method March 1 beginning inventory Purchase March 10 Sale March 19 March 31 ending inventory* for March Unit Units Price Amount 60 $49 $ 2,940 100 52 5,200 160 $ 8,140 90 70 3,460 $ 4,680 * March 1 beginning inventory ( 60 units $49 ) March 10 purchase ( 10 units $52 ) Total $2,940 520 $3,460 April 1 beginning inventory 70 $ 3,460 Unit Units Price Amount Purchases April 4 April 15 April 25 120 50 100 $53 54 55 $6,360 2,700 5,500 270 14,560 340 $18,020 Sale April 23 April 30 ending inventory* for April 200 140 7,170 $10,850 * March 1 beginning inventory: ( 60 units $49 ) $2,940 March 10 purchase: ( 10 units $52 ) 520 April 4 purchase: ( 70 units $53 ) 3,710 Total $7,170 323

Chapter 6, P 2. (Continued) 4. User Insight: Effects on cash flows discussed The inventory costing method chosen by a company does not affect cash flows from operations from the purchase and sale of goods because the amount actually paid for the purchases or the amount for which goods are sold is the same regardless of the method used. The purpose of the inventory costing method is to assign the costs that have been incurred. However, the amount of cash paid for income taxes can differ under the methods because they affect the computation of taxable income, which will differ depending on the inventory costing method used. 324

Chapter 6, P 3. 1. Perpetual inventory system average-cost method Date Mar. Apr. *Rounded Units Cost* Amount* 1 Beginning inventory 60 $49.00 $ 2,940 10 Purchase 100 52.00 5,200 10 Balance 160 50.88 $ 8,140 19 Sale ( 90) 50.87 ( 4,578) 31 Ending inventory 70 50.88 $ 3,562 4 Purchase 120 53.00 6,360 4 Balance 190 52.22 $ 9,922 15 Purchase 50 54.00 2,700 15 Balance 240 52.59 $12,622 23 Sale (200) 52.59 ( 10,518) 23 Balance 40 52.58 $ 2,103 25 Purchase 100 55.00 5,500 25 Balance 140 54.31 $ 7,603 30 Ending inventory 140 54.31 $ 7,603 for March equals the total cost of the sale made on March 19, or $4,579. for April equals the total cost of the sale made on April 23, or $10,518. 325

Chapter 6, P 3. (Continued) 2. Perpetual inventory system FIFO method Date Mar. Apr. Units Cost Amount 1 Beginning inventory 60 $49 $ 2,940 10 Purchase 100 52 5,200 10 Balance 60 49 100 52 $ 8,140 19 Sale ( 60) 49 ( 30) 52 ( 4,500) 31 Ending inventory 70 52 $ 3,640 4 Purchase 120 53 6,360 4 Balance 70 52 120 53 $10,000 15 Purchase 50 54 2,700 15 Balance 70 52 120 53 50 54 $12,700 23 Sale ( 70) 52 (120) 53 ( 10) 54 ( 10,540) 23 Balance 40 54 $ 2,160 25 Purchase 100 55 5,500 25 Balance 40 54 100 55 $ 7,660 30 Ending inventory 40 54 100 55 140 $ 7,660 for March equals the total cost of the sale made on March 19, or $4,500. for April equals the total cost of the sale made on April 23, or $10,540. 326

Chapter 6, P 3. (Continued) 3. Perpetual inventory system LIFO method Date Units Cost Amount Mar. 1 Beginning inventory 60 $49 $ 2,940 10 Purchase 100 52 5,200 10 Balance 60 49 100 52 $ 8,140 19 Sale ( 90) 52 ( 4,680) 31 Ending inventory 60 49 10 52 $ 3,460 Apr. 4 Purchase 120 53 6,360 4 Balance 60 49 10 52 120 53 $ 9,820 15 Purchase 50 54 2,700 15 Balance 60 49 10 52 120 53 50 54 $12,520 23 Sale ( 50) 54 (120) 53 ( 10) 52 ( 20) 49 ( 10,560) 23 Balance 40 49 $ 1,960 25 Purchase 100 55 5,500 25 Balance 40 49 100 55 $ 7,460 30 Ending inventory 40 49 100 55 140 $ 7,460 for March equals the total cost of the sale made on March 19, or $4,680. for April equals the total cost of the sale made on April 23, or $10,560. 327

Chapter 6, P 3. (Continued) 4. User Insight: Inventory valuation discussed In a long period of rising prices, how realistic the inventory value of the balance sheet is will depend on the inventory method used by the company. For instance, if the company uses the average method, the inventory should reflect the average price paid over the past year. If the LIFO method is used, the inventory prices will likely reflect lower prices paid many years before. If the FIFO method is used, the ininto the higher cost of goods ventory will reflect the most recent prices. Thus, FIFO will reflect the most realistic current prices, and LIFO will reflect the oldest and most unrealistic prices. Further, since the LIFO inventory cost is lower than the FIFO inventory cost, the inventory turnover will appear higher under LIFO because the lower number will be divided sold. 328

Chapter 6, P 4. 1. Month-end inventory at cost estimated Beginning inventory Net purchases for the period: Purchases Purchases returns and allowances Freight-in Goods available for sale $488,512 Ratio of cost to retail price: $718,400 Net sales during the period: Sales Sales returns and allowances Net sales Estimated ending inventory at retail Ratio of cost to retail 68% Cost Retail $205,952 $297,200 286,932 434,000 ( 8,172) ( 12,800) 3,800 $488,512 $718,400 68% Estimated cost of ending inventory $285,400 68% = $194,072 = $436,732 ( 3,732) $433,000 $285,400 2. October 31 physical inventory $249,800 68% = 169,864 249,800 3. Estimated inventory shortage at cost and retail $ 24,208 $ 35,600 4. User Insight: Retail method discussed The retail method is an efficient way for companies to operate because sales employees in many locations can take the inventory in their store or outlet simply by recording the retail price of all the goods at their location. They don't need to know the cost, which can be estimated by the home office. 329

Chapter 6, P 5. 1. Inventory loss estimated Gonzo Furniture Schedule to Estimate Inventory Destroyed April 22, 2011 Beginning inventory at cost $181,850 Purchases at cost $301,525 Purchases returns ( 1,338) Freight-in 6,638 Net purchases 306,825 $488,675 Less estimated cost of goods sold Sales $494,881 Sales returns ( 3,725) Net sales $491,156 Less estimated gross margin of 44% 216,109 Estimated cost of goods sold Estimated cost of ending inventory Less merchandise in showroom Estimated loss of inventory in fire 275,047 $213,628 50,370 $163,258 2. User Insight: Reasons for estimating inventory Management may want to estimate the cost of inventory for interim reports or estimate the amount of inventory lost or destroyed by theft or other hazards. Insurance companies often estimate inventories to verify loss claims. 330

Chapter 6, P 6. 1. Schedule of cost of goods available for sale prepared Beginning inventory Purchases February March May July September November Total purchases Units 34,000 40,000 80,000 60,000 100,000 80,000 30,000 390,000 424,000 Total Price Cost $11.00 $ 374,000 12.00 $ 480,000 12.40 992,000 12.60 756,000 12.80 1,280,000 12.60 1,008,000 13.00 390,000 $4,906,000 $5,280,000 2. a. Income before income taxes computed Average-cost method: Sales 393,000 $20 (see schedule) Less ending inventory* Gross margin Selling and administrative expenses Income before income taxes $5,280,000 385,950 $7,860,000 4,894,050 $2,965,950 2,551,000 $ 414,950 * ** $5,280,000 Divided by total units available 424,000 Cost per unit $ 12.45 Multiplied by units in ending inventory ( 424,000 393,000 ) 31,000 Ending inventory $ 385,950 Rounded ** 331

Chapter 6, P 6. (Continued) b. FIFO method: Sales (see schedule) Less ending inventory* Gross margin Selling and administrative expenses Income before income taxes $5,280,000 402,600 $7,860,000 4,877,400 $2,982,600 2,551,000 $ 431,600 * November purchases ( 30,000 units $13.00 ) September purchases ( 1,000 units $12.60 ) Ending inventory $390,000 12,600 $402,600 c. LIFO method: Sales (see schedule) Less ending inventory* Gross margin Selling and administrative expenses Income before income taxes $5,280,000 341,000 $7,860,000 4,939,000 $2,921,000 2,551,000 $ 370,000 * 31,000 units from beginning inventory $11.00 = $341,000 332

Chapter 6, P 6. (Continued) 3. User Insight: Financial ratios computed and discussed Average-Cost $4,894,050 FIFO $4,877,400 LIFO $4,939,000 Average inventory $379,975 $388,300 $357,500 ( $385,950 + $374,000 ) 2 ( $402,600 + $374,000 ) 2 ( $341,000 + $374,000 ) 2 Inventory turnover 12.9 Times 12.6 Times 13.8 Times ( $4,894,050 $379,975 ) ( $4,877,400 $388,300 ) ( $4,939,000 $357,500 ) Days' inventory 28.3 Days 29.0 Days 26.4 Days on hand ( 365 Days 12.9 Times ) ( 365 Days 12.6 Times ) ( 365 Days 13.8 Times ) In periods of rising prices, the LIFO method will always result in a higher inventory turnover and lower days' inventory on hand. When comparing inventory ratios for two or more companies, the inventory methods used by the companies should be considered. 333

Chapter 6, P 7. 1. Periodic inventory system average-cost method April 1 beginning inventory Purchase April 10 Sale April 17 April 30 ending inventory* for April Unit Units Price* Amount 50 $204.00 $10,200 100 220.00 22,000 150 214.67 $32,200 90 60 214.67 12,880 $19,320 May 1 beginning inventory Unit Units Price Amount Purchases 60 $214.67 $12,880 May 2 100 $216 $21,600 May 14 50 224 11,200 May 22 60 234 14,040 210 46,840 270 221.19 $59,720 Sale May 30 May 31 ending inventory* for May 200 70 221.19 15,483 $44,237 *Rounded 334

Chapter 6, P 7. (Continued) 2. Periodic inventory system FIFO method April 1 beginning inventory Purchase April 10 Sale April 17 April 30 ending inventory* for April Unit Units Price Amount 50 $204 $10,200 100 220 22,000 150 $32,200 90 60 220 13,200 $19,000 *From purchase on April 10 May 1 beginning inventory Purchases Units Unit Price Amount 60 $220 $13,200 May 2 100 $216 $21,600 May 14 50 224 11,200 May 22 60 234 14,040 210 46,840 270 $60,040 Sale May 30 May 31 ending inventory* for May 200 70 16,280 $43,760 * May 22 purchase ( 60 units $234 ) May 14 purchase ( 10 units $224 ) Total $14,040 2,240 $16,280 335

Chapter 6, P 7. (Continued) 3. Periodic inventory system LIFO method April 1 beginning inventory Purchase April 10 Sale April 17 April 30 ending inventory* for April Unit Units Price Amount 50 $204 $10,200 100 220 22,000 150 $32,200 90 60 12,400 $19,800 *April 1 beginning inventory ( 50 units $204 ) $10,200 April 10 purchase ( 10 units $220 ) 2,200 Total $12,400 May 1 beginning inventory 60 $12,400 Unit Units Price Amount Purchases May 2 100 $216 $21,600 May 14 50 224 11,200 May 22 60 234 14,040 210 46,840 270 $59,240 Sale May 30 May 31 ending inventory* for May 200 70 14,560 $44,680 *April 1 beginning inventory ( 50 units $204 ) $10,200 April 10 purchase ( 10 units $220 ) 2,200 May 2 purchase ( 10 units $216 ) 2,160 Total $14,560 336

Chapter 6, P 7. (Continued) 4. User Insight: Effects on cash flows discussed The inventory costing method chosen by a company does not affect cash flows from operations from the purchase and sale of goods because the amount actually paid for the purchases or the amount for which goods are sold is the same regardless of the method used. The purpose of the inventory costing method is to assign the costs that have been incurred. However, the amount of cash paid for income taxes can differ under the methods because they affect the computation of taxable income, which will differ depending on the inventory costing method used. 337

Chapter 6, P 8. 1. Perpetual inventory system average-cost method Apr. May Date *Rounded Units Cost* Amount* 1 Beginning inventory 50 $204.00 $10,200 10 Purchase 100 220.00 22,000 10 Balance 150 214.67 $32,200 17 Sale ( 90) 214.67 ( 19,320) 30 Ending inventory 60 214.67 $12,880 2 Purchase 100 216.00 21,600 2 Balance 160 215.50 $34,480 14 Purchase 50 224.00 11,200 14 Balance 210 217.52 $45,680 22 Purchase 60 234.00 14,040 22 Balance 270 221.19 $59,720 30 Sale (200) 221.19 ( 44,238) 31 Ending inventory 70 221.19 $15,482 for April equals the total cost of the sale made on April 17, or $19,320. for May equals the total cost of the sale made on May 30, or $44,238. 338

Chapter 6, P 8. (Continued) 2. Perpetual inventory system FIFO method Apr. May Date Units Cost Amount 1 Beginning inventory 50 $204 $10,200 10 Purchase 100 220 22,000 10 Balance 50 204 100 220 $32,200 17 Sale ( 50) 204 ( 40) 220 ( 19,000) 30 Ending inventory 60 220 $13,200 2 Purchase 100 216 21,600 2 Balance 60 220 100 216 $34,800 14 Purchase 50 224 11,200 14 Balance 60 220 100 216 50 224 $46,000 22 Purchase 60 234 14,040 22 Balance 60 220 100 216 50 224 60 234 $60,040 30 Sale ( 60) 220 (100) 216 ( 40) 224 ( 43,760) 31 Ending inventory 10 224 60 234 70 $16,280 for April equals the total cost of the sale made on April 17, or $19,000. for May equals the total cost of the sale made on May 30, or $43,760. 339

Chapter 6, P 8. (Continued) 3. Perpetual inventory system LIFO method Date Units Cost Amount Apr. 1 Beginning inventory 50 $204 $10,200 10 Purchase 100 220 22,000 10 Balance 50 204 100 220 $32,200 17 Sale ( 90) 220 ( 19,800) 30 Ending inventory 50 204 10 220 $12,400 May 2 Purchase 100 216 21,600 2 Balance 50 204 10 220 100 216 $34,000 14 Purchase 50 224 11,200 14 Balance 50 204 10 220 100 216 50 224 $45,200 22 Purchase 60 234 14,040 22 Balance 50 204 10 220 100 216 50 224 60 234 $59,240 30 Sale ( 60) 234 ( 50) 224 ( 90) 216 ( 44,680) 31 Ending inventory 50 204 10 220 10 216 70 $14,560 for April equals the total cost of the sale made on April 17, or $19,800. for May equals the total cost of the sale made on May 30, or $44,680. 340

Chapter 6, P 8. (Continued) 4. User Insight: Inventory valuation discussed In a long period of rising prices, how realistic the inventory value of the balance sheet is will depend on the inventory method used by the company. For instance, if the company uses the average-cost method, the inventory should reflect the average price paid over the past year. If the LIFO method is used, the inventory prices will likely reflect lower prices paid many years before. If the FIFO method is used, the inventory will reflect the most recent prices. Thus, FIFO ending inventory will reflect the most realistic current prices, and LIFO ending inventory will reflect the oldest and most unrealistic prices. Inventory turnover ratios would normally be higher under LIFO than they would under FIFO. The reason for this is that the denominator in computing inventory turnover is the average value of the inventory during the year. LIFO normally has lower values than FIFO does. 341

Chapter 6, P 9. 1. Month-end inventory at cost estimated Cost Retail Beginning inventory $ 51,488 $ 74,300 Net purchases for the period: Purchases 71,733 108,500 Purchases returns and allowances Freight-in ( 2,043) ( 3,200) 950 Goods available for sale $122,128 $179,600 Ratio of cost to retail price: $122,128 $179,600 = 68% Net sales during the period: Sales Sales returns and allowances Net sales $109,183 ( 933) $108,250 Estimated ending inventory at retail $ 71,350 Ratio of cost to retail 68% Estimated cost of ending inventory $71,350 68% = $ 48,518 2. August 31 physical inventory $62,450 68% = 42,466 62,450 3. Estimated inventory shortage at cost and retail $ 6,052 $ 8,900 4. User Insight: Retail method discussed The retail method is an efficient way for companies to operate because sales employees in many locations can take the inventory in their store or outlet simply by recording the retail price of all the goods at their location. They don't need to know the cost, which can be estimated by the home office. 342

Chapter 6, P 10. 1. Inventory loss estimated Beginning inventory at cost Pearly Tooth Corporation Schedule to Estimate Inventory Destroyed May 5, 2011 $ 727,400 Purchases at cost $1,206,100 Purchases returns ( 5,353) Freight-in 26,550 Net purchases 1,227,297 $1,954,697 Less estimated cost of goods sold Sales $1,979,525 Sales returns ( 14,900) Net sales $1,964,625 Less estimated gross margin of 48% 943,020 Estimated cost of goods sold 1,021,605 Estimated cost of ending inventory Less merchandise in showroom $ 933,092 201,480 Estimated loss of inventory in fire $ 731,612 2. User Insight: Reasons for estimating inventory Management may want to estimate the cost of inventory for interim reports or estimate the amount of inventory lost or destroyed by theft, fire, or other hazards. Insurance companies often estimate inventories to verify loss claims. 343

Chapter 6, C 1. Comparison among companies is important because it enables the management of the companies to benchmark themselves against other well-managed com- panies. Dell's inventory management provides a challenge to JCPenney's management, but it is probably not the best match because although they both sell to the end customer, the nature of their businesses is very different. JCPenney must display inventory for customers to see and try on and is subject to seasonal fashions. It would be more useful to compare JCPenney with a company like Sears. Since JCPenney's inventory turnover is 3.4, its average inventory on hand is about 107 days compared to Dell's, which is about 7 days. This is a big business advantage to Dell because Dell does not incur the cost of maintaining an inventory for about 100 days less than JCPenney does. Further, it customizes its com- puters to what customers want at the moment and avoids the problem of inventory obsolescence, or having more inventory than people want. Using supply-chain management in a just-in-time operating environment allows companies to use technology to attempt to reduce their levels of inventory. Under supply-chain management, a company uses the Internet for business-to- business (B2B) e-commerce to manage its inventory and purchasing. In a justin-time operating environment, the company uses supply-chain management to work closely with suppliers to coordinate and schedule shipments so that goods arrive just in time as they are needed. This strategy has enabled Dell to become one of the most efficient companies in history. 344

Chapter 6, C 2. 1. 2. The effect of an overstatement of ending merchandise inventory is to overstate the reported net income (or reduce the net loss) of the business. In the case of Crazy Eddie, the overstatement of inventory by $52 million means that income before income taxes had been overstated (or losses understated) in prior ac- counting periods by $52 million. Yes, it would be expected in a company that is experiencing financial difficulty. An overstatement of ending inventory is a way in which a company can cover up disappointing results and inflate the reported net income. This is possible because the amount of the overstatement is a cost that is carried forward to future accounting periods as an asset (inventory) rather than being charged as part of cost of goods sold in the current period. In fact, Crazy Eddie was experiencing severe operating losses prior to the takeover by the new management team. The discovery of the missing inventory required an immediate write-down of the inventory cost by $52 million and the reporting of a corresponding loss on the income statement. A further investigation should have been conducted to determine what really happened to the $52 million in merchandise inventory. Was the shortfall caused by bookkeeping errors, or was there an actual physical loss? Chapter 6, C 3. These tendencies explain the difference in the inventory costing methods used by the chemical and computer industries since an important motivation in both indus- tries is to reduce income taxes. Although costs fluctuate in the chemical industry, the long-term trend is upward. Thus, LIFO will generally enable companies in this industry to pay less in income taxes. In the computer industry, however, costs have headed downward for many years as a result of technological advances; so LIFO is not the most appropriate method to use. LIFO or last-in, first-out is an inventory pricing method that transfers the costs of the most recent purchases to cost of goods sold while retaining the costs of the earliest purchases in ending inventory. It represents an assumption about cost flows that usually does not correspond to the actual flow of goods. Since the costs of the most recent purchases, which are charged against revenues through cost of goods sold, are usually higher in times of rising prices, the reported income and the re- sulting cash outflow from income taxes is lower. The opposite effects result in times of declining prices. 345

Chapter 6, C 4. The LCM rule resulted in a write-down in the first year of $325 million because the market value of the inventory was $325 million less than cost under the LIFO costing method. The inconsistency between the two years is that in the first year when the market value was down, income was reduced by the amount that cost exceeded market value. However, in the next year when market value exceeded the LIFO cost, income was not increased by the amount that market value exceeded cost. This inconsistency is a prime example of the application of the accounting convention of conservatism, which states that losses (cost exceeds market) are recorded, but gains (market exceeds cost) are not recorded until a definite transaction occurs. If prices decline enough in the third year so that market falls below cost, another write-down would appear on the income statement. Chapter 6, C 5. A company like ExxonMobil may choose LIFO because management believes that LIFO is more closely tied to the reality that goods must be replaced when sold and that LIFO may result in lower income taxes. When the most recent cost of a good is charged against the sales price, an amount approximating replacement cost is used. In periods of rising prices, the cost of the most recent purchase will be higher than the costs of earlier purchases, resulting in a lower income before income taxes. Consequently, in this situation, income taxes will be less under LIFO. Thus, although the actual transactions during the year (sales, net purchases, operating expenses, and so on) are the same, income taxes will be less if LIFO is used. In recent years, oil prices have been going up, which would be advantageous under LIFO. 346

Chapter 6, C 6. It is unlikely that very much of the inventory is valued at market. Market value would normally come into play for CVS if it bought inventory that it was unable to sell at regular prices but had to sell at prices below cost. The retail inventory method is ideal for retail companies that use a standard markup on each item of merchandise inventory. Employees can take the physical inventory by recording quantity and sell- ing prices. These data can then be converted to cost by the company's accountants. The inventory turnover slightly decreased, from 8.1 times in 2008 to 8.0 times in 2009, resulting in a slight increase in days' inventory on hand of 0.5 day. CVS uses the lower-of-fifo-cost-or-market rule as determined by the retail inventory method. When there are no changes in prices, LIFO and FIFO will produce the same results. This is the case with CVS. CVS's Inventory Turnover (dollar amounts in millions): Inventory Turnover = Cost of Goods Sold Average Inventory 2009 = $78,349 ( $10,343 + $9,153 ) 2 = $78,349 $9,748 = 8.0 Times 2008 = $69,182 ( $9,153 + $8,008 ) 2 $69,182 = = 8.1 $8,581 Times CVS's Days' Inventory on Hand Days' Inventory on Hand t 2009 2008 = Number of Days in a Year Inventory Turnover = = 365 Days 8.0 Times 365 Days 8.1 Times = = 45.6 45.1 Days Days 347

Chapter 6, C 7. 1. Inventory turnover and days' inventory on hand calculated (dollar amounts in millions) CVS's Inventory Turnover (from C 6): 2009 8.0 times 2008 8.1 times CVS's Average Days' Inventory on Hand (from C 6): 2009 45.6 days 2008 45.1 days Walgreens' Inventory Turnover: Inventory Turnover = Cost of Goods Sold Average Inventory 2009 = $45,722 ( $6,789 + $7,249 ) 2 = 2008 = $45,722 = 6.5 Times $7,019 $42,391 ( $7,249 + $6,790 ) 2 $42,391 = = 6.0 $7,020 Times t Walgreens' Days' Inventory on Hand: 2. Inventory ratios discussed Days' Inventory on Hand = Number of Days in a Year 365 Days 2009 = = 6.5 Times 2008 Inventory Turnover 56.2 Days 365 Days = = 60.8 Days 6.0 Times CVS's inventory turnover slightly decreased from 8.1 times in 2008 to 8.0 times in 2009, but Walgreens' inventory turnover increased from 6.0 times in 2008 to 6.5 times in 2009. The most important conclusion to draw is that CVS makes more efficient use of inventory as measured by its inventory turnovers. It only had to finance inventory for 45.6 days in 2009, whereas Walgreens had to finance its inventory for 56.2 days, a difference of about 10 days. 348

Chapter 6, C 8. Because the goods ordered by The Executive Woman have not been separated, they will be included in the inventory count on December 31. If the auditors do not detect this situation, the 2011 ending inventory will be overstated. This overcounting, combined with the inclusion of the sale in 2011, will lead to an overstatement of 2011 income before income taxes by the amount of the cost of the inventory not separated for shipment. This overstatement will lead, in turn, to an understatement of 2012 income before income taxes because the 2012 beginning inventory will be overstated by the amount of the shipment. Lutz's action not only was unethical, but also is an example of fraudulent financial reporting, or deliberate misstatement of financial records. 349

Chapter 6, C 9. 1. Income statements and balance sheets prepared Sales Gross margin Operating expenses Income before income taxes Income taxes expense (40%) Net income RT Company Income Statement For the Month Ended July 31, 2011 (a) FIFO (b) LIFO $195,000 $195,000 150,000 160,000 $ 45,000 $ 35,000 15,000 15,000 $ 30,000 $ 20,000 12,000 8,000 $ 18,000 $ 12,000 Assets Cash* Inventory Total assets RT Company Balance Sheet July 31, 2011 (All figures in thousands) (a) (b) (a) (b) FIFO LIFO Stockholders' Equity FIFO LIFO $258 $262 Common stock $400 $400 160 150 Retained earnings 18 12 Total stockholders' $418 $412 equity $418 $412 Since there was a rise in the cost of the product, the LIFO method produces a lower net income and a lower asset value for inventory. (a) (b) FIFO LIFO * Cash balance, July 1 $400 $400 Add receipt: sale of truck 195 195 Deduct payments: $595 $595 Inventory purchases $150 160 $310 15 325 325 Operating expenses Subtotal Income taxes paid Cash balance, July 31 $270 $270 12 8 $258 $262 350

Chapter 6, C 9. (Continued) 2. Dividend policy discussed In the FIFO case, a dividend of $18,000 would be declared. This transaction would reduce cash and retained earnings by the same amount. In the LIFO case, a dividend exactly equal to net income would reduce Cash and Retained Earnings by $12,000. After payment of the dividend, the balance sheets under FIFO and LIFO would appear as follows: Cash Inventory Total assets Assets RT Company Balance Sheet July 31, 2011 (All figures in thousands) Stockholders' Equity FIFO LIFO FIFO LIFO $240 $250 Common stock $400 $400 160 150 Total stockholders' $400 $400 equity $400 $400 Compared with the beginning of the month, RT still has $400,000 in assets and $400,000 in stockholders' equity, but the composition of the assets has changed. On July 31, RT has assets of $240,000 in cash and one truck worth $160,000 in the FIFO case and assets of $250,000 in cash and one truck worth $150,000 in the LIFO case. Under this dividend policy and the FIFO method, the company has shrunk more of its liquid assets by returning part of them to the stockholders. Economically, the company is less well off using the FIFO method. It is for this reason that some authorities believe that in periods of generally rising prices, the LIFO method should be used. The LIFO method is also more realistic in representing RT's income because it matches the more current costs against revenues. 351

Chapter 6, C 9. (Continued) 3. Consequences of additional price increase discussed A further increase in cost compounds the problem discussed in 2. The question is whether management should declare cash dividends equal to net income under the LIFO method when the business must pay more to replenish its inventory. A going concern must have inventory in order to stay in business. Some authorities would argue that a profit has not been made until the inventory has been replaced. Thus, the proper figure to use in determining cost of goods sold and valuing inventory, according to these authorities, is replacement cost in this case, $170,000. The company's board of directors should pay a dividend of only $10,000 less income taxes (sales of $195,000 replacement cost of goods sold of $170,000 expenses of $15,000 = $10,000; $10,000 taxes of $4,000 = $6,000). (For purposes of illustration, it is assumed here that replacement cost is acceptable for income tax purposes.) Under these assumptions, the company would have $260,000 in cash plus one truck after the dividend and taxes were paid. In this way, the company can pay $170,000 for another truck in the next accounting period and be equally well off. (Note: We have not considered the complicated question of whether the company can raise selling prices to its customers to partially or totally offset the increases in the cost of the trucks.) 352