Chapter 7 Reporting and Analyzing Inventory Learning Objectives coverage by question Miniexercises Exercises Problems Cases LO1 Interpret disclosures of information concerning operating expenses, including manufacturing and retail inventory costs. 13, 14, 15, 17 LO2 Account for inventory and cost of goods sold using different costing methods. 18, 19, 20, 21, 23 26, 27, 29, 30, 31 33, 34, 36 37, 38 LO3 Apply the lower of cost or market rule to value inventory. 24 28 LO4 Evaluate how inventory costing affects management decisions and outsiders interpretations of financial statements. 18 26, 29, 30, 31 33, 34, 36 37, 38 LO5 Define and interpret gross profit margin and inventory turnover ratios. Use inventory footnote information to make appropriate adjustments to ratios. 16, 22 25, 31, 32 33, 34, 35 37 LO6 Appendix 6A: Analyze LIFO liquidations and the impact they have on the financial statements. 36 37 Solutions Manual, Chapter 7 7-1
QUESTIONS Q7-1. Q7-2. Q7-3. Q7-4. Q7-5. Q7-6. Q7-7. Q7-8. If a company fails to take a cash discount that is offered by a supplier, it is effectively paying a penalty for taking additional time to pay the account payable. Depending on the size of the discount, this penalty (an implicit interest rate) can be quite high. The net-of-discount method records the inventory at the purchase cost less the discount. If the discount is lost, the extra cost is treated as part of cost of goods sold of the period. This has two benefits: (1) the lost discount is not capitalized as part of the cost of inventory, and (2) the lost discount is highlighted, which is useful information that may be helpful in managing accounts payable. If stable purchase prices prevail, the dollar amount of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding (inflationary) profit in inventory. FIFO holding gains occur when the costs of earlier inventory acquisitions are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be less holding (inflationary) profit in inventory. (a) Last-in, first-out, (b) Last-in, first-out, (c) First-in, first-out, (d) First-in, first-out, (e) Last-in, first-out. A significant tax benefit results from using LIFO when costs are consistently rising. LIFO results in lower pretax income and, therefore, lower taxes payable, than other inventory costing methods. Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to the lower replacement costs (market value). The various inventory costing methods would produce the same results (inventory values and cost of goods sold) if prices were stable. The inventory costing methods produce differing results when prices are changing. Inventory shrink refers to the loss of inventory due to theft, spoilage, damage, etc. Shrink costs are part of cost of goods sold but do not represent goods that were actually sold. 7-2 Financial Accounting, 3rd Edition
Q7-9. The LIFO reserve is the difference between the cost of inventory determined using the last-in, first-out (LIFO) method and the cost determined using another method (either FIFO or average cost). Companies that report inventory cost using the LIFO method must also report the LIFO reserve. This allows the financial statement reader to convert from LIFO to another method for comparison purposes. The LIFO reserve represents the difference between the historical, LIFO cost of inventory and its current cost. This disparity between the book value and the current value represents a gain from holding the inventory that has not yet been recognized in income or in equity an unrealized holding gain. Q7-10. Because LIFO assigns the last units purchased during the year to cost of goods sold (COGS) changing prices can make it difficult to forecast earnings. Companies have discretion as to when and how much inventory they purchase during an accounting period. LIFO is always applied on a periodic, annual basis, so a purchase made during the final days of the year will end up in COGS and affect current earnings. However, if that purchase is delayed until the first week of the next year, it could be several years before those units are transferred to COGS. Unlike other inventory methods, LIFO requires that the quantity and price of inventory purchases be predicted to make accurate earnings forecasts. Q7-11 A. LIFO liquidation is involuntary when it is caused by events that are beyond management s control. Examples of such events include labor strikes, natural disasters, or wars which could interrupt the delivery of inventory by suppliers or shut down production facilities. Q7-12 A. In periods of rising prices, LIFO liquidation results in older, lower-cost goods being expensed as cost of goods sold, yielding higher profits. This may be the result of a management decision to reduce inventory levels for efficiency purposes. However, it may also be an earnings management tactic. Management may be trying to avoid violating bond covenants, or it may be trying to manipulate management compensation. In any case, this practice is costly, in that the additional profits lead to higher income taxes. Solutions Manual, Chapter 7 7-3
M7-13 (15 minutes) a. b. MINI EXERCISES 11/15 Inventory (+A) 6,076 Accounts payable (+L) 6,076 11/23 Accounts payable (-L) 6,076 Cash (-A) 6,076 $6,076 = $6,200 x 0.98. + Inventory (A) - - Accounts Payable (L) + 11/15 6,076 6,076 11/15 11/23 6,076 + Cash (A) - 6,076 11/23 c. [($6,200 - $6,076)/$6,076] x [365/(30-10)] = 37.24%. (With interest compounding, the annual rate of interest r can be solved from (1+r) (20/365) =1.02. The value that solves this relationship is r = 43.5%.) M7-14 (15 minutes) a. 1/20 Inventory (+A) 12,250 Accounts payable (+L) 12,250 b. 2/15 Accounts payable (-L) 12,250 Interest expense, discounts lost (+E, -SE) 250 Cash (-A) 12,500 $12,250 = $12,500 x 0.98. + Inventory (A) - - Accounts Payable (L) + 1/20 12,250 12,250 1/20 2/15 12,250 + Cash (A) - + Interest Expense, Discounts Lost (E) - 12,500 2/15 2/15 250 7-4 Financial Accounting, 3rd Edition
c. [($12,500- $12,250)/$12,250] x [365/(60-15)] = 16.55%. (With interest compounding, the annual rate of interest r can be solved from (1+r) (45/365) =1.02. The value that solves this relationship is r = 17.4%.) M7-15 (20 minutes) RAW MATERIALS INVENTORY Beginning inventory $ 0 Purchases + 84,000 Materials used - 63,000 Ending inventory $ 21,000 WORK IN PROCESS INVENTORY Beginning inventory $ 0 Materials used + 63,000 Labor costs + 58,000 Overhead costs + 28,000 Cost of goods produced - 130,000 Ending inventory $ 19,000 FINISHED GOODS INVENTORY Beginning inventory $ 0 Cost of goods produced + 130,000 Cost of goods sold - 95,000 Ending inventory $ 35,000 M7-16 (10 minutes) 2008: 2007: 2006: $63,747-18,511 $$63,747 $61,095-17,751 $61,095 $53,324-15,057 $53,324 = 0.7096 = 0.7095 = 0.7176 Solutions Manual, Chapter 7 7-5
M7-17 (15 minutes) a. Purchases are understated. If ending inventory is correctly valued, cost of goods sold will also be understated and current income will be overstated. There would be no effect in the following year. If, however, ending inventory is understated (due to the mistakenly recorded purchase) then there is no effect on income in either period. b. Purchases are overstated. Cost of goods sold will be overstated and current income is understated. Income in the following year is unaffected. c. Shrink (part of cost of goods sold) is overstated and ending inventory is understated. Consequently, current period income is understated. If the inventory is counted correctly the following year, the error will reverse itself and income will be overstated. This is an example of a self-correcting inventory error. 7-6 Financial Accounting, 3rd Edition
M7-18 (20 minutes) a. Balance Sheet December 2010 Assets Cash $12,000 Inventory 50,000 Shareholders equity Contributed capital $62,000 b. All monetary amounts in $ thousands. Year 2011 2012 2013 Income statement: Revenue 75 85 95 COGS-FIFO 50 60 70 Earnings before tax 25 25 25 Tax expense 10 10 10 Net income 15 15 15 Cash flows: Receipts 75 85 95 Inventory purchases -60-70 -80 Tax payments -10-10 -10 Cash from operations 5 5 5 Dividends -9-9 -9 Cash from financing -9-9 -9 Net change in cash -4-4 -4 Balance sheet: Assets Cash 8 4 0 Inventory 60 70 80 Total 68 74 80 Shareholders equity Contributed capital 62 62 62 Retained earnings 6 12 18 Total 68 74 80 Clearly there is a problem with this business model. The company is showing profits, and assets and retained earnings are increasing. However, there is a cash flow problem. The net change in cash every year is -$4 thousand and, by the end of 2013, the company would have a cash balance of zero. In 2014, it would not be possible to replenish the inventory and to pay the dividend. Solutions Manual, Chapter 7 7-7
c. All monetary amounts in $ thousands. Year 2011 2012 2013 Income statement: Revenue 75 85 95 COGS-LIFO 60 70 80 Earnings before tax 15 15 15 Tax expense 6 6 6 Net income 9 9 9 Cash flows: Receipts 75 85 95 Inventory purchases -60-70 -80 Tax payments -6-6 -6 Cash from operations 9 9 9 Dividends -9-9 -9 Cash from financing -9-9 -9 Net change in cash 0 0 0 Balance sheet: Assets Cash 12 12 12 Inventory 50 50 50 Total 62 62 62 Shareholders equity Contributed capital 62 62 62 Retained earnings 0 0 0 Total 62 62 62 Interestingly, the use of LIFO reduces profits, and the company s reported assets (and net assets) are not growing like the FIFO case above. However, the cash flow situation is improved. The company can pay the desired dividends and continue to replace its inventory at the end of every year. The difference between LIFO and FIFO is that FIFO profits include a gain from holding inventory while prices are rising. When the company is taxed on that gain, it has less cash available to maintain its physical assets (inventory). In essence, paying taxes based on FIFO (when inventory costs are increasing) can cause a firm s ability to stay in business to be taxed away. LIFO profits exclude holding gains, so the company could continue to stay in business. (The tax authorities will catch up when the business decides to stop investing in inventory, and the LIFO liquidation profits get taxed.) 7-8 Financial Accounting, 3rd Edition
M7-19 (20 minutes) a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000 FIFO ending inventories = $400,000 - $205,000 = $195,000 b. LIFO cost of goods sold = 1,700 @ $150 = $255,000 LIFO ending inventories = $400,000 - $255,000 = $145,000 c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667 AC ending inventories = $400,000 $226,667 = $173,333 M7-20 (15 minutes) a. $1,320,000 + purchases - $6,980,000 = $1,460,000; purchases = $7,120,000. b. 1. Inventory (+A) 7,120,000 Cash or Accounts payable (-A or +L) 7,120,000 2. Cost of goods sold (+E, -SE) 6,980,000 Inventory (-A) 6,980,000 c. + Cash (A) - + Cost of Goods Sold (E) - 7,120,000 (1) (2) 6,980,000 + Inventory (A) - Balance 1,320,000 (1) 7,120,000 6,980,000 (2) Balance 1,460,000 d. Transaction a. Purchase inventory. c. Cost of inventory sold. Cash Asset -7,120,000 Cash + Noncash Assets 7,120,000 Inventory Balance Sheet -6,980,000 Inventory = = Liabilities + Contrib. Capital + Earned Capital Income Statement Revenues - Expenses = = - = -6,980,000 Retained Earnings - +6,980,000 Cost of Goods Sold Net Income = -6,980,000 Solutions Manual, Chapter 7 7-9
M7-21 (10 minutes) a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400 FIFO ending inventories = $12,400 - $6,400 = $6,000 b. LIFO cost of goods sold = 600 @ $12 = $7,200 LIFO ending inventories = $12,400 - $7,200 = $5,200 c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764 AC ending inventories = $12,400 $6,764 = $5,636 M7-22 (20 minutes) a. Inventory Turnover-2008 Inventory Turnover-2007 Wal-Mart 306,158/[(34,511+35,159)/2] = 8.79 286,350/[(35,159+33,685)/2] = 8.32 Target 45,766/[(6,705+6,780)/2] = 6.79 43,766/[(6,780+6,254)/2] = 6.72 b. Wal-Mart s inventory turnover rate is higher than Target s. There can be several reasons for this. Wal-Mart s product lines may be oriented toward lowermargin/higher-turnover goods (Wal-Mart does report a lower gross profit margin than Target). And, as the economy deteriorated in 2008, Wal-Mart s product offerings and pricing strategies may have been more attractive to consumers. Wal-Mart s inventory turnover improved more than Target s in 2008, and its gross profit margin increased, while Target s decreased. After years of steady increases, both companies have reduced year-end 2008 inventories from the previous year, probably in anticipation of lower levels of consumer spending in fiscal 2009. c. Inventory turns improve as the dollar volume of goods sold increases relative to the dollar volume of goods on hand. Inventory reductions can be realized by reducing the depth and breadth of product lines carried (e.g., not every style, size and color), eliminating slow-moving product lines, working with suppliers to arrange for delivery when needed rather than inventorying for a longer holding period, and marking down goods for sale at the end of product seasons. Retailers must balance the cost savings from inventory reductions against the marketing implications of lower inventory levels on hand. It would be possible to stock only those items that turn over very quickly, but those items may have low margins. Or, there may be items that turn over slowly, but have sufficient margins to make offering them attractive, even though it reduces inventory turnover. Whenever ratios are used as incentive measures, it is important to recognize that they may cause cherry-picking of only those activities that provide the highest ratio outcome. 7-10 Financial Accounting, 3rd Edition
M7-23 (15 minutes) a. Cost of goods sold (+E, -SE) 142,790,000 Inventory (-A) 142,790,000 b. + Inventory - + Cost of Goods Sold - Balance 25,790,000 (a) 142,790,000 142,790,000 (a) (c) 140,560,000 Balance 23,560,000 c. Inventory (+A) 140,560,000 Cash or Accounts payable (-A or +L) 140,560,000 d. ($000) Transaction c. Purchase inventory. a. Cost of inventory sold. Cash Asset -140,560 Cash + Noncash Assets +140,560 Inventory -142,790 Inventory = Balance Sheet = Liabilities + Contrib. Capital + Earned Capital Income Statement Revenues - Expenses = = - = -142,790 Retained Earnings - Net Income +142,790 Cost of = -142,790 Goods Sold M7-24 (10 minutes) a. (60 x $45) + (210 x $34) + (300 x $20) + (100 x $27) = $18,540 b. Cost: (60 x $45) + (210 x $38) + (300 x $22) + (100 x $27) = $19,980 Market: (60 x $48) + (210 x $34) + (300 x $20) + (100 x $32) = $19,220 Therefore, the ending inventory balance should be $19,220. Solutions Manual, Chapter 7 7-11
b. EXERCISES E7-25 (30 minutes) a. Fiscal year 2007: Gross profit margin = ($679,561 $484,676) $679,561 = 28.7% Inventory turnover ratio = $484,676 [($253,063 + $248,307) 2] = 1.93 times Fiscal year 2008: Gross profit margin = ($631,258 $463,812) $631,258 = 26.5% Inventory turnover ratio = $463,812 [($248,307 + $222,601) 2] = 1.97 times b. Fiscal year Quarter Gross profit Gross profit margin 1 $ 27,090 21.5% 2007 2 85,906 34.8% 3 57,916 30.7% 4 23,973 20.3% 1 22,485 19.9% 2008 2 78,411 34.6% 3 49,731 27.6% 4 16,819 15.1% The gross profit and gross profit margin numbers show that West Marine is significantly more profitable in the second and third quarters. While the revenues from these quarters are 80% higher than the other quarters, the gross profit from quarters two and three are three times that of quarters one and four. Unlike many retailers, who make most of their sales and profits in the fourth calendar quarter, West Marine must discount its prices and run promotions in order to generate sales in the first and fourth quarters. c. Inventory is lowest at the end of the fiscal year. At the end of the first quarter (end of March), inventory has increased in anticipation of the busy second quarter, and inventory stays high through the second quarter (end of June). By the end of September (third quarter), inventory has declined, and it continues to decline through the fourth quarter. It is common for seasonal businesses to choose fiscal year-ends when inventories (and other balances like receivables) are lower. But it can mean that annual ratios (like those calculated in part a) do not reflect the inventory investment that was necessary to generate the sales reported for the year. Understanding these seasonal effects can be important for cash management over the year. 7-12 Financial Accounting, 3rd Edition
d. One approach to calculating an inventory turnover ratio is to use an average of averages approach. For the first quarter of 2007, the average inventory was ($253,063 + $279,500) 2 = $266,282. Follow the same process to determine the average inventory for quarters two, three and four. Then average the averages. The effect of this process is the following: The weighted average inventory levels are greater than the simple annual averages for both years because the fiscal year-end is set when inventory is predictably low. When these inventory values are divided into annual cost of goods sold, the inventory turnover ratios are lower than those calculated in part a. Weighted average inventory turnover ratio: 2007: $484,676 $266,379 = 1.82 times 2008: $463,812 $261,121 = 1.78 times The annual ratios show a slight improvement in turnover from 2007 to 2008, perhaps indicating an improvement in the speed with which inventory translated into sales. However, on an average inventory basis, that improvement is no longer evident. The reduction in inventory at the end of 2008 is probably not due to West Marine being able to maintain sales with lower inventories, but rather an indication that the company expects the sales declines of 2008 to continue in the future. Solutions Manual, Chapter 7 7-13
E7-26 (30 minutes) Units Cost Beginning Inventory 1,000 $ 20,000 Purchases: #1 1,800 39,600 #2 800 20,800 #3 1,200 34,800 Goods available for sale 4,800 $115,200 Units in ending inventory = 4,800 2,800 = 2,000 a. First-in, first-out Units Cost Total 1,200 @ $29 = $34,800 800 @ $26 = 20,800 Ending Inventory 2,000 $55,600 Cost of goods available for sale $115,200 Less: Ending inventory 55,600 Cost of goods sold $ 59,600 b. Last-in, first-out Units Cost Total 1,000 @ $20 = $20,000 1,000 @ $22 = 22,000 Ending inventory 2,000 $42,000 Cost of goods available for sale $115,200 Less: Ending inventory 42,000 Cost of goods sold $ 73,200 c. Average cost $115,200/4,800 = $24 average unit cost 2,000 x $24 = $48,000 ending inventory $115,200 - $48,000 = $67,200 cost of goods sold (or 2,800x$24) d. 1. The first-in, first-out method in most circumstances represents physical flow. This inventory system applies to perishables or to situations in which the earliest items acquired are moved out first because of risk of deterioration or obsolescence. 2. Last-in, first-out results in the lowest inventory amount during periods of rising unit costs, which in turn results in the lowest net income and the lowest income tax. 3. The first-in, first-out results in the lowest cost of goods sold in periods of rising prices. This is the inventory method Chen should use to report the largest amount of income. Of course, this assumes that prices will continue to rise. Companies cannot change inventory costing methods without justification, and the change may be prohibited by tax laws as well. 7-14 Financial Accounting, 3rd Edition
E7-27 (25 minutes) Units Cost Total Beginning inventory 100 @ $46 = $ 4,600 Purchases: Purchase #1 650 @ 42 = 27,300 Purchase #2 550 @ 38 = 20,900 Purchase #3 200 @ 36 = 7,200 Cost of goods available for sale 1,500 $60,000 a. First-in, first-out Units Cost Total 200 @ $36 = $ 7,200 150 @ 38 = 5,700 Ending inventory... 350 $12,900 Cost of goods available for sale... $60,000 Less: Ending inventory... 12,900 Cost of goods sold... $47,100 b. Average cost Cost of Goods Available for Sale/Total Units Available for Sale = $60,000/1,500 = $40 Average Unit Cost Ending Inventory = 350 units x $40 = $14,000 Cost of goods available for sale $60,000 Less: Ending inventory 14,000 Cost of goods sold $46,000 c. Last-in, first-out Units Cost Total 100 @ $46 = $ 4,600 250 @ 42 = 10,500 Ending inventory 350 $15,100 Cost of goods available for sale $60,000 Less: Ending inventory 15,100 Cost of goods sold $44,900 Solutions Manual, Chapter 7 7-15
E7-28 (20 minutes) a. 1. (70 x $190) + (45 x $268) + (20 x $350) + (120 x $60) + (80 x $88) + (50 x $126) = $52,900. 2. Desks: (70 x $190) + (45 x $280) + (20 x $350) = $32,900 (70 x $210) + (45 x $268) + (20 x $360) = $33,960 Chairs: (120 x $60) + (80 x $95) + (50 x $130) = $21,300 (120 x $64) + (80 x $88) + (50 x $126) = $21,020 Therefore, inventory would be reported at $32,900 + $21,020 = $53,920. 3. (70 x $190) + (45 x $280) + (20 x $350) + (120 x $60) + (80 x $95) + (50 x $130) = $54,200 (70 x $210) + (45 x $268) + (20 x $360) + (120 x $64) + (80 x $88) + (50 x $126) = $54,980 Therefore, inventory would be reported at $54,200. b. Applying the lower of cost or market rule to individual items in inventory results in the lowest inventory amount, the highest cost of goods sold and the lowest net income. Under either of the other two methods, the inventory may be valued at the higher of cost or market for some items in inventory. E7-29 (20 minutes) a. $13,042 million b. $14,275 million c. Pretax income has been reduced by $1,233 million cumulatively since GM adopted LIFO inventory costing. This is because it has matched current inventory costs against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used. If LIFO has put $1,233 million less into ending inventory than FIFO, it must have put $1,233 more into cost of goods sold than FIFO. d. Pretax income has been reduced by $1,233 million (see part c). Assuming a 35% tax rate, taxes have been reduced by $1,233 x 0.35 = $431.6 million. Cumulative taxes have been decreased by the use of LIFO inventory costing. 7-16 Financial Accounting, 3rd Edition
E7-30 (25 minutes) a. $3,506 million b. $3,436 million ($3,506 million - $70 million); the LIFO inventory carrying amount is greater than the FIFO carrying amount, which is uncommon. It implies deflation or reduction in Kraft s inventory costs. Although uncommon, it does occur, and we cannot blindly assume that inventory costs always rise. Further, this situation can lead to losses on LIFO liquidation, the opposite of what we would normally expect. c. Pretax income has been increased by $70 million cumulatively since Kraft adopted LIFO inventory costing. This is because it has matched current inventory costs against current selling prices, thus avoiding the recognition of holding losses that would have resulted had FIFO inventory costing been used. d. Pretax income has been increased by $70 million (see part c). Assuming a 35% tax rate, taxes have been increased by $70 x 0.35 = $24.5 million. Cumulative taxes have been increased by use of LIFO inventory costing. e. For 2006, the change in the LIFO reserve is a reduction of $1 million ($70 million - $71 million). Pretax income has been decreased by this amount, thus decreasing taxes by $1 million x 0.35 = $0.35 million. Postscript: If Kraft s inventory was expected to continue to be more highly valued under LIFO than under FIFO, the company could reduce its tax expense by switching to FIFO costing. However, the 2006 situation did not continue. By 2007 (and continuing into 2008), Kraft s inventory was more highly valued under FIFO than under LIFO. E7-31 (20 minutes) a. ($ millions) $288 + Purchases - $5,247 = $327. Purchases = $5,286. b. ($ millions) As reported (LIFO) Pro forma (FIFO) Sales revenue $7,954 $7,954.0 Cost of goods sold 5,247 5,234.3 Gross profit $2,707 $2,719.7 $5,247 - ($32.7 - $20.0) = $5,234.3 c. As reported (LIFO): $2,707 / $7,954 = 34.03% Solutions Manual, Chapter 7 7-17
Pro forma (FIFO): $2,719.7 / $7,954 = 34.19% The small differences between LIFO and FIFO reflect both the rate of price change for Whole Foods inventories and the fact that its inventory moves through very quickly (about 17 times per year). E7-32 (30 minutes) a. Tiffany Zale Blue Nile 2008 2007 2008 2007 2008 2007 Revenue $2860 $2939 $2138 $2153 $295 $319 COGS 1215 1282 1090 1030 235 254 Gross profit 1645 1657 1048 1123 60 65 Gross profit margin (GPM) 57.5% 56.4% 49.0% 52.2% 20.3% 20.4% b. (Usually, one would use average inventory to calculate the inventory turnover ratio, but Tiffany & Co. changed its inventory accounting method from LIFO to average cost in 2008. As a result, comparable inventory balances are available only for 2008 and 2007.) Tiffany Zale Blue Nile 2008 2007 2008 2007 2008 2007 COGS 1215 1282 1090 1030 235 254 Ending inventory 1601 1372 780 1021 19 21 Inventory turnover 0.76 0.93 1.40 1.01 12.37 12.10 c. Fiscal years 2007 and 2008 were not easy times for fine jewelry retailers. After years of increasing revenues, all three of these companies experienced declining sales. Tiffany reports that the small improvement in margin is due to (1) an inventory charge in 2007 that was not present in 2008, (2) a product mix change in which their wholesale diamond sales (a lower-margin business) decreased and (3) precious metals hedging that reduced cost of goods sold. Zale s gross profit margin dropped, and the company attributed the decline to (1) an aggressive inventory clearance program, (2) liquidation of inventories for discontinued product lines and (3) a decline in sales of lifetime warranties (probably a higher margin product). Blue Nile s small decline in GPM was attributed to a product mix change engagement jewelry sales performed relatively well in 2008, and these sales earn a lower margin than non-engagement jewelry. Tiffany s inventory turnover declined substantially from 2007 to 2008. An inventory turnover value of 0.76 means that Tiffany holds an item of inventory for 481 days (on average) before sale. Zale s inventory turnover ratio is quicker and improved significantly. This change might reflect the same inventory clearance program described above. (Inventory turnover ratios are also affected by the cost flow assumption. Tiffany uses average 7-18 Financial Accounting, 3rd Edition
cost, Zale s uses LIFO and Blue Nile uses specific identification, probably close to average cost. Zale s LIFO reserves were $12.2 million in 2008 and $37.5 million in 2007.) As an Internet retailer, Blue Nile earns a significantly lower gross profit on every dollar of sales, but its volume of sales is very high relative to its inventory. Compared to Tiffany s 481 days inventory, Blue Nile has less than 30 days inventory. One of the ways that Blue Nile keeps its turnover high can be seen in the following from their 2008 10-K. The Company also lists loose diamonds on its websites that are typically not included in inventory until the Company receives a customer order for those diamonds. Upon receipt of a customer order, the Company purchases a specific diamond and records it in inventory until it is delivered to the customer, at which time the revenue from the sale is recognized and inventory is relieved. Blue Nile does not disclose the amount of such consignment or agency diamonds. Zale discloses consignment inventories of $114 million and $159 million at the end of 2008 and 2007, respectively. Tiffany s financial reports make no mention of consignment inventories. d. In a business where the costs of inventory fluctuate significantly and where inventory is routinely held for a year before it is sold, setting prices based on average cost could be hazardous. If inventory costs have fallen recently, a competitor who reduces prices accordingly (but maintains margins) would be able to take business from Tiffany. Or, if costs have risen recently, Tiffany s prices might be more attractive than those of competitors who have raised prices in response to costs. So, Tiffany may be more attractive to customers, but it may be less able to replace inventory than its competitors. Solutions Manual, Chapter 7 7-19
c. PROBLEMS P7-33 (25 Minutes) a. Caterpillar: $38,415/[($7,503 + $8,781)/2] = 4.72 Komatsu: 1,590,963/[( 518,441 + 437,894)/2] = 3.33 As calculated, Caterpillar s turnover is more than 40% higher than Komatsu s, and there is a 32-day difference in the companies average inventory days outstanding. This difference could be attributed to differential production efficiencies or to differential component sourcing strategies. Perhaps Caterpillar purchased more components from outside suppliers. b. When there are no LIFO liquidation effects, changes in the LIFO reserve can be attributed to changes in the company s costs. Caterpillar s LIFO reserve went up in 2008, implying that its costs increased. c. Pretax income has been reduced by $3,183 million cumulatively since CAT adopted LIFO inventory costing. This is because it has matched current inventory costs against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used. Each year, the difference between FIFO cost of goods sold and LIFO cost of goods sold is added to the LIFO reserve. Assuming a 35% tax rate, cumulative taxes have been reduced by $3,183 x 0.35 = $1,114 million by the use of LIFO inventory costing. d. For 2008, the change in the LIFO reserve is an increase of $566 million ($3,183 million - $2,617 million). Pretax income has been decreased by this amount (relative to FIFO), thus decreasing taxes by $566 million x 0.35 = $198 million. e. Komatsu s use of specific identification probably approximates a FIFO inventory costing method. As a result, the comparison in part a above is not valid because Caterpillar s use of LIFO produces distortions. We should use the LIFO reserve information to construct Caterpillar s inventory turnover based on FIFO. FIFO 2008 cost of goods sold = $38,415 ($3,183 $2,617) = $37,849 FIFO 2008 average inventory = [($8,781+$3,183)+($7,503+$2,617)] 2 = $11,042 FIFO 2008 inventory turnover = $37,849 $11,042 = 3.43 times So, Caterpillar s inventory turnover is only 3% faster than Komatsu s once we take into account the differences in their inventory cost flow assumptions. 7-20 Financial Accounting, 3rd Edition
P7-34 (20 minutes) a. $5,659 million - $800 million = $4,859 million b. $800 million c. $800 million x 0.35 = $280 million d. $1,249 million + [($800 million - $604 million) x (1-0.35)] = $1,376.4 million e. $58,564 / [($4,859 + $4,849) / 2] = 12.07 f. [$58,564 - ($800 - $604)] / [($5,659 + $5,453) / 2] = 10.51 P7-35 (30 minutes) a. Dell Hewlett-Packard Apple 2008 2007 2006 2008 2007 2006 2008 2007 2006 Revenue $61,101 $61,133 $57,420 $91,697 $84,229 $73,557 $32,479 $24,006 $19,315 COGS 50,144 49,462 47,904 69,342 63,435 55,248 21,334 15,852 13,717 Gross profit Gross profit margin (GPM) 10,957 11,671 9,516 22,355 20,794 18,309 11,145 8,154 5,598 17.9% 19.1% 16.6% 24.4% 24.7% 24.9% 34.3% 34.0% 29.0% b. Dell Hewlett-Packard Apple 2008 2007 2008 2007 2008 2007 COGS 50,144 49,462 69,342 63,435 21,334 15,852 Average ending 1,023.5 920.0 7,956.0 7,891.5 427.5 308.0 inventory Inventory turnover 49.0 53.8 8.7 8.0 49.9 51.5 c. Gross profit margins reflect the companies cost control and their relative ability to create differentiated products. Dell spends only 1% of revenues on research and development (R&D), while Hewlett-Packard spends about 4%. Apple s R&D is about 3.5% of revenues, but its recent growth in sales and margins may be tied to the popularity of the iphone. Inventory turnover differences may be tied to Dell s founding strategy of only producing a computer after a customer has placed an order, and to Apple s practice of outsourcing a great deal of its production to Asia. In fact, Apple reports The Company s inventories consist primarily of Solutions Manual, Chapter 7 7-21
finished goods for all periods presented. Over the past few years, Hewlett-Packard has increased its inventory turnover from around 4 to above 8. P7-36 A (45 minutes) ($ thousands) a. Inventories as a percent of current assets follows: 30% ($81,925/$270,100) of current assets in 2003 39% ($98,213/$254,122) of current assets in 2002 As long as the Stride Rite retailing outlets have sufficient product to meet demand, the reduction of inventories is positive as it likely represents more efficient manufacturing processes. The reduction of inventories might be of concern, however, if Stride Rite is in financial difficulty and is unable to purchase the raw materials necessary for its production. We have no evidence of its financial difficulty for 2003. b. The inventory turnover rate follows: 2003: $340,614 3.78 $81,925 $98,213 2002: 2 $337,951 $98,213 $112,481 2 3.21 The inventory turnover rate has increased from 2002 to 2003. This is positive as it represents increased manufacturing/retailing efficiency. c. Stride Rite uses the LIFO inventory costing method. The LIFO reserve the difference between LIFO and FIFO inventories decreased by $1,610 from 2002 to 2003 and by $758 from 2001 to 2002. As a result, reported profits actually increased rather than decreased, as we would expect in a period of rising prices. Note: a decrease in the LIFO reserve does not, by itself, indicate a drop in inventory costs, as the decrease in the reserve may also be due to LIFO liquidation (see d an e below). From 2000 to 2001 the LIFO reserve increased by $314, thus reducing gross profit by that amount. d. Stride Rite s reduction in its quantities of inventories is positive, as the holding costs of inventories (financing, insurance, handling costs, etc.) are substantial. As a general rule, companies should keep inventories at the lowest level possible without impairing their manufacturing efficiency or reducing the stock of finished goods to the point that sales are adversely impacted. e. Stride Rite s reduction of inventory quantities resulted in matching lower-cost inventories against higher current selling prices. This increased its profits by $141 for 2003. This reduction in inventory quantities is called LIFO liquidation. In 2002, however, the reduction of inventory quantities actually decreased reported profits by $120 as Stride Rite dipped into higher-cost inventory layers. As inventory costs fluctuate, higher- and lower-cost layers are established, thus leading to fluctuating effects on profits as inventory quantities are reduced. As this example demonstrates, it is not always the 7-22 Financial Accounting, 3rd Edition
case that reported profits increase as inventory quantities are reduced, as this outcome is predicated on the assumption of continually rising prices. Solutions Manual, Chapter 7 7-23
CASES C7-37 A (30 minutes) a. Pretax earnings would be higher by the change in the LIFO reserve, but in 2008 the LIFO reserve went down from $25.4 billion to $10.0 billion, for a decline of $15,400 million. The 2008 pretax income that would have been reported if FIFO had been used would thus be $81,750 million - $15,400 million = $66,350 million. b. The inventory turnover would be as follows: $249,454 [($9,331+$2,315)+($8,863+$2,226 )]/2 = 21.94 c. BP s inventory turnover is calculated as follows: $266,982 ($15,409+$24,557) 2 = 13.36 d. Based on calculations from their financial statements, it appears that Exxon Mobil s inventory turns over much more quickly than BP s. However, Exxon Mobil s use of LIFO makes such a comparison invalid, because BP is not allowed to use LIFO under IFRS. To make a better comparison, we adjust Exxon Mobil s inventory turnover ratio to FIFO. We need to increase the cost of goods sold by the decrease in the LIFO reserve and increase the value of the inventories by the balance in the LIFO reserve each year: $249,454+ $15,400 [(9,331+$2,315+$10,000)+ ($8,863+$2,226+$25,400)]/2 = 9.11 This ratio shows that Exxon Mobil s inventory is turning over less than half as quickly as the original calculation implied. And, rather than turning over its inventory much more quickly than BP, it appears that Exxon Mobil s inventory is turning over significantly less quickly than BP. 7-24 Financial Accounting, 3rd Edition
C7-38 (40 minutes) a. The effects of the change in accounting method are reported as of the beginning of 2005, which is the earliest balance sheet presented in Hormel s 2006 10-K report. This is due to the GAAP requirement that LIFO abandonment decisions be presented using the retrospective method. That is, all of the financial statements that are presented must be restated using the new accounting method (FIFO). As a result, Hormel s 2005 balance sheet and its 2004 and 2005 income statements were restated in its 2006 10-K to reflect the switch to FIFO. However, note that the decision to abandon LIFO was made in the first quarter of 2006. In its 2005 10-K report, Hormel reported inventory and cost of goods sold using the LIFO method. Because 2005 earnings were originally reported using LIFO, the company had to restate its 2005 income statement, increasing 2005 net earnings by $1.1 million. Hormel s 2005 10-K reveals that the LIFO reserve at that time was $38.5 million, indicating an increase of $1.8 million in 2005 ($38.5 - $36.7). Therefore, the tax effect of the LIFO-FIFO switch was $0.7 million ($1.8-$1.1) in 2005. Hormel reports that total assets increased by $36.7 million at the beginning of 2005. This is the amount of the LIFO reserve that was added to inventories to restate the inventory to FIFO as of that date. However, since the decision to switch methods was made at the end of 2005 (beginning of 2006), the effect of the switch was that assets (inventories) increased by $38.5 million. The balance in retained earnings was increased by $23.0 million as of the beginning of 2005, reflecting the cumulative difference in earnings since the adoption of LIFO. Retained earnings increased by $24.1 million ($23.0 + $1.1) as of the end of 2005 (beginning of 2006). The additional tax liability that results from the change is $13.7 million ($36.7 23.0) as of the beginning of 2005. By the end of 2005, tax liabilities were increased by $14.4 million ($13.7 + $0.7). These changes are summarized in the table below: ($ millions) Total assets (inventory) Effect as of the beginning of 2005 (as reported) Effect as of the end of 2005/beginning of 2006 +$36.7 +$38.5 Retained earnings +$23.0 +$24.1 Tax liabilities +13.7 +$14.4 Solutions Manual, Chapter 7 7-25
C7-38 continued. b. Hormel argues (correctly) that the FIFO method presents a better measure of current inventory value in the balance sheet. It should be noted that in earlier 10-K reports, Hormel justified the use of LIFO by noting that it provided a better matching of current costs to current revenues in the income statement (also a correct statement). The company also argued that FIFO more accurately reflects the physical flow of inventory (oldest product is sold first). c. The effect on 2006 net income was not reported. However, assuming that inventory costs continued to rise, the switch to FIFO would have increased net earnings. In the past two years, earnings were increased by $1.1 million (2005) and $1.9 million (2004). d. There are several possible motivations other than those provided by the company. Obviously, earnings management (the desire to report higher earnings) immediately comes to mind. In addition, one would want to know what effect the change had on Hormel s proximity to debt covenants and on management compensation formulae. Ultimately, the decision cost Hormel $14.4 million in back taxes and may cost the company additional taxes moving forward, if prices continue to rise. However, there is substantial empirical evidence that companies that use LIFO carry greater quantities of inventory than those using FIFO. This is due to the desire to avoid the tax effects of LIFO liquidation profits. Ultimately, using FIFO allows companies to reduce inventory quantities (for efficiency reasons or in response to economic cycles) without paying a tax penalty for liquidating LIFO inventory layers. Hormel management may feel that the costs of using LIFO (including bookkeeping costs, contracting costs, and the costs of carrying excess inventory) are greater than the benefits of using LIFO (the tax savings). This would especially be true if management expects future inventory cost increases to be small. Finally, it should be noted that, historically, many LIFO abandonment decisions have been made by companies facing financial distress. However, in recent years, there has been an increase in healthy companies switching to FIFO due to low levels of inflation. When expected cost increases are small, the tax benefits of LIFO are small relative to the perceived costs of using LIFO. 7-26 Financial Accounting, 3rd Edition