Fa4e Sm Ch07

Chapter 7

Reporting and Analyzing Inventory

Learning Objectives – coverage by questionMini-

ExercisesExercises Problems

Cases and Projects

LO1 – Interpret disclosures of information concerning operating expenses, including manufacturing and retail inventory costs.

13 - 15, 17

LO2 – Account for inventory and cost of goods sold using different costing methods.

18 - 21, 2326, 27,

29 - 3133, 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 - 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 - 35 37

LO6 – Appendix 7A: Analyze LIFO liquidations and the impact they have on the financial statements.

36 37

©Cambridge Business Publishers, 2014

Solutions Manual, Chapter 7 7-1

DISCUSSION QUESTIONSQ7-1. When company A purchases inventory from company B, the buyer and seller

must agree on which firm is responsible for the transportation costs. The terminology “freight on board shipping point” or FOB is used to indicate the buyer assumes responsibility for the transportation cost once notice of delivery to the shipper is received. In addition, the buyer assumes responsibility for any delay or damage during transit.

When goods are shipped FOB, the seller normally can recognize revenue unless the seller has not fulfilled all requirements of the purchase agreement. An example is when an equipment installation and/or up-and-running properly is part of that agreement.

Q7-2. 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.

Q7-3. 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.

Q7-4. (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.

Q7-5. 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.

Q7-6. 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).

Q7-7. 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.

Q7-8. 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, 4th 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.

Q7-11A. 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.

Q7-12A. 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.



MINI EXERCISES

M7-13. (15 minutes)

The cost to be assigned to the inventory is $535 ($500 + $30 + $5).

+ Inventory (A) - - Accounts Payable (L) +(a) 500 50 (b)(b)(d)

505

105

(c)(d)

- Notes Payable (L) + + Interest Expense, Discounts Lost (E) -500 (a) (c) 10

M7-14. (15 minutes)

The only cost that should be included in inventory is the cost of merchandise to be sold.

M7-15. (20 minutes)

RAW MATERIALS INVENTORYBeginning inventory $ 0Purchases + 84,000Materials used - 63,000Ending inventory $ 21,000

WORK IN PROCESS INVENTORYBeginning inventory $ 0Materials used + 63,000Labor costs + 58,000Overhead costs + 28,000Cost of goods produced - 130,000Ending inventory $ 19,000

FINISHED GOODS INVENTORYBeginning inventory $ 0Cost of goods produced + 130,000Cost of goods sold - 95,000Ending inventory $ 35,000



M7-16. (10 minutes)

2011:$65,030 -20,360

= 0.6869$65,030

2010:$61,587 -18,792

= 0.6949$61,587

2009:$61,897 -18,447

= 0.7020$61,897

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. The effect on income, assuming normal inventory levels, depends on the inventory costing system being used by the company. Assuming rising prices, income would be reduced in the current year under LIFO or average costing but unaffected under FIFO costing. Income in the following year would not be affected. (The solution assumes the error is not discovered and corrected in the current year.)

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.



M7-18. (20 minutes)

a. Balance Sheet December 2013AssetsCash $12,000Inventory 50,000

Shareholders’ equityContributed capital $62,000

b. All monetary amounts in $ thousands.Year 2014 2015 2016Income 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.

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M7-18. concluded

c. All monetary amounts in $ thousands.Year 2011 2012 2013Income 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 -9Cash 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.)



M7-19. (20 minutes)

a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000FIFO ending inventories = $400,000 - $205,000 = $195,000

b. LIFO cost of goods sold = 1,700 @ $150 = $255,000LIFO ending inventories = $400,000 - $255,000 = $145,000

c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667AC 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) 6,980,000Inventory (-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.Balance Sheet Income Statement

TransactionCash Asset + Noncash

Assets = Liabi-lities + Contrib.

Capital + Earned Capital Revenues - Expenses = Net

Incomea. Purchase inventory. -7,120,000

Cash7,120,000Inventory

= - =

c. Cost of inventory sold. -6,980,000Inventory =

-6,980,000Retained Earnings

-+6,980,000

Cost of Goods Sold

=-6,980,000



M7-21. (10 minutes)

a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400FIFO ending inventories = $12,400 - $6,400 = $6,000

b. LIFO cost of goods sold = 600 @ $12 = $7,200LIFO ending inventories = $12,400 - $7,200 = $5,200

c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764AC ending inventories = $12,400 – $6,764 = $5,636

M7-22. (20 minutes)

a. Inventory Turnover-2012 Inventory Turnover-2011

Wal-Mart 335/[(40.7+36.4)/2] = 8.69 315/[(36.4+32.7)/2] = 9.12Target 47.9/[(7.92+7.60)/2] = 6.17 45.7/[(7.60+7.18)/2] = 6.18

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 lower-margin/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 while Target’s remained level in 2011, and its gross profit margin increased, while Target’s was essentially unchanged. Both companies increased year-end 2012 inventories from the previous year, probably in anticipation of increased sales in 2013.

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.



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) 142,790,000142,790,000 (a)

(c) 140,560,000Balance 23,560,000

c. Inventory (+A) 140,560,000

Cash or Accounts payable (-A or +L) 140,560,000

d. ($000)Balance Sheet Income Statement

TransactionCash Asset + Noncash

Assets = Liabil-ities + Contrib.

Capital + Earned Capital Revenues - Expenses = Net

Incomec. Purchase

inventory-140,560

Cash+140,560Inventory

= - =

a. Cost of inventory sold

-142,790Inventory =

-142,790Retained Earnings

-+142,790Cost of

Goods Sold=

-142,790

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) = $19,980Market: (60 x $48) + (210 x $34) + (300 x $20) + (100 x $32) = $19,220Therefore, the ending inventory balance should be $19,220.

b.



EXERCISES

E7-25. (45 minutes)

a. Fiscal year 2010:Gross profit margin = ($623 – $447) ÷ $623 = 28.3%Inventory turnover ratio = $447 ÷ [($197 + $202) ÷ 2] = 2.24 times

Fiscal year 2011:Gross profit margin = ($643 – $458) ÷ $643 = 28.8%Inventory turnover ratio = $458 ÷ [($202 + $193) ÷ 2] = 2.32 times

b.

Fiscal year Quarter Gross profitGross profit

margin

2010

1 $ 25 22.7%2 82 35.2%3 50 28.9%4 18 16.8%

2011

1 25 21.9%2 85 36.0%3 54 30.0%4 20 17.7%

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.

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E7-25. concluded

d. One approach to calculating an inventory turnover ratio is to use an “average of averages” approach. For the first quarter of 2010, the average inventory was ($197 + $243) ÷ 2 = $220. 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:

2010: Weighted average inventory = [197 + 2x(243+240+209+202) +202)]/10 = $219

2011: Weighted average inventory = [202 + 2x(248+242+212+194)+194)]/10 = $219

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

Weighted average inventory turnover ratio:

2010: $447 ÷ $219 = 2.04 times2011: $458 ÷ $219 = 2.10 times

The annual ratios showed a slight increase in turnover from 2010 to 2011, perhaps indicating an increase in the speed with which inventory translated into sales. The reduction in inventory at the end of 2011 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 revenue declines of 2011 to continue in the future.

E7-26. (30 minutes)

Units CostBeginning Inventory 1,000 $ 20,000Purchases: #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

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E7-26. concluded

a. First-in, first-outUnits Cost Total1,200 @ $29 = $34,800 800 @ $26 = 20,800

Ending Inventory 2,000 $55,600

Cost of goods available for sale $115,200Less: Ending inventory 55,600 Cost of goods sold $ 59,600

b. Last-in, first-outUnits Cost Total

1,000 @ $20 = $20,000 1,000 @ $22 = 22,000

Ending inventory 2,000 $42,000

Cost of goods available for sale $115,200Less: Ending inventory 42,000Cost of goods sold $ 73,200

c. Average cost$115,200/4,800 = $24 average unit cost2,000 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.



E7-27. (25 minutes)

Units Cost TotalBeginning inventory 100 @ $46 = $ 4,600Purchases: Purchase #1 650 @ 42 = 27,300

Purchase #2 550 @ 38 = 20,900Purchase #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.......... $60,000Less: Ending inventory....................... 12,900Cost of goods sold.............................. $47,100

b. Average costCost 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 $60,000Less: Ending inventory 14,000Cost 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 $60,000Less: Ending inventory 15,100 Cost of goods sold $44,900



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 were decreased by the use of LIFO inventory costing.

e. During this period GM was experiencing declining earnings while inventory costs were not keeping pace. Under these conditions, FIFO reporting mitigates the effect on income.



E7-30. (25 minutes)

a. $3,063 million

b. $4,461 million. the FIFO inventory carrying amount is greater than the LIFO carrying amount, which is common. It implies Deere’s current inventory costs are rising. Although common, a lower FIFO carrying amount can occur We cannot blindly assume that inventory costs always rise. When costs decline as is true in the computer chip industry, losses can occur if LIFO layer- liquidation occurs, the opposite of what we would normally expect.

c. Pretax income has been decreased by $1,398 million cumulatively since Deere adopted LIFO inventory costing. This result occurs because higher current inventory costs are matched against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used.

d. Pretax income has been decreased by $1,398 million (see part c). Assuming a 35% tax rate, taxes have been decreased by $1,398 x 0.35 = $489.3 million.

Cumulative taxes have been decreased by use of LIFO inventory costing.

e. For 2010, the change in the LIFO reserve is an increase of $31 million [($4,461-$2,777) – ($3,764-$2,437)]. Pretax income has been decreased by this amount, thus decreasing taxes by $31 million x 0.35 = $10.9 million.

Observation: If Deere’s inventory were at some future date to be more highly valued under LIFO than under FIFO, the company could reduce its tax expense by switching to FIFO costing. This is, however, unlikely for Deere or other industries facing continued price increases or even essentially constant prices.

E7-31. (20 minutes)

a. ($ millions)$323 + Purchases - $6,571 = $337. Purchases = $16,356.

b.($ millions) As reported (LIFO) Pro forma (FIFO)Sales revenue $10,108 $10,108Cost of goods sold 6,571 6,560 .7 Gross profit $ 3,537 $ 3,547.3

$6,571 - ($29.7 - $19.4) = $6,560.7

c. As reported (LIFO): $3,537 / $10,108 = 35.0%Pro forma (FIFO): $3,547.3 / $10,108 = 35.1%

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 27 times per year).



E7-32. (30 minutes)

a. Tiffany Zale Blue Nile

2011 2010 2011 2010 2011 2010

Revenue $3643 $3085 $1743 $1616 $348 $333

COGS 1492 1262 862 802 276 261

Gross profit 2151 1823 881 814 72 72

Gross profit margin (GPM) 59.0% 59.1% 50.5% 50.4% 20.7% 21.6%

b. Usually, we would use average inventory to calculate the inventory turnover ratio. In this case, the 2009 values are not supplied. So we use the 2010 final inventory value only to estimate the 2010 COGS.

Tiffany Zale Blue Nile2011 2010 2011 2010 2011 2010

COGS 1492 1262 862 802 276 261Ending inventory 2073 1625 721 703 29 20Inventory turnover 0.81 0.78 1.21 1.14 11.27 13.05

c. The recent fiscal years have not been easy times for fine jewelry retailers. After years of increasing revenues, all three of these companies experienced declining sales until 2011. Even the modest sales increases in the last two years have not led to a noticeable increase in GPM and Blue Nile’s GPM even declined.

Inventory turnover ratios increased for Tiffany and Zale perhaps reflecting attention to improved inventory management. This improvement was not the case for Blue Nile.

A turnover value of 0.81 means that Tiffany holds an item in inventory for 452 days (on average) before sale. Zale’s inventory turnover ratio is quicker and improved significantly. This improvement might reflect an inventory clearance program similar to one Zale engaged in during the period before 2009. Inventory turnover ratios are also affected by the cost flow assumption. Tiffany uses average cost, Zale’s uses LIFO and Blue Nile uses specific identification, probably close to average cost. Zale’s LIFO reserves were $35.9 million in 2011 and $18.9 million in 2010.)

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 452 days’ inventory, Blue Nile has less than 32 days’ inventory. One of the ways that Blue Nile keeps its turnover high can be seen in the following from their 2011 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

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E7-32. concluded

c. continuedpurchases 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 $53.5 million and $81.1 million at the end of 2011 and 2010, respectively. Tiffany’s financial reports make no mention of consignment inventories.

d. Zale has saved 0.35($619.8) = $216.93 million in taxes to date by using LIFO. Of this amount, 0.35($619.8 - $606.4) = $4.69 million during 2010.

e.



PROBLEMS

P7-33. (25 Minutes)

a. Caterpillar: $43,578/[($9,587 + $14,544)/2] = 3.61

Komatsu: ¥1,440,765/[(¥612,359 + ¥473,876)/2] = 2.65

As calculated, Caterpillar’s turnover is almost 1.0 times faster than Komatsu’s, and there is a 37-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 increased in 2011, implying that its costs increased.

c. Pretax income has been reduced by $2,422 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 $2,422 x 0.35 = $847.7 million by the use of LIFO inventory costing.

d. For 2011, the change in the LIFO reserve is a decrease of $153 million ($2,422 million - $2,575 million). Pretax income has been increased by this amount (relative to FIFO), thus increasing taxes by $153 million x 0.35 = $53.6 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 2011 cost of goods sold = $43,578 – ($2,422 – $2,575) = $43,731FIFO 2011 average inventory = [($14,544+$2,422)+($9,587+$2,575)]÷2 = $14,564FIFO 2011 inventory turnover = $43,731 ÷ $14,564 = 3.00 times

So, Caterpillar’s inventory turnover is only 0.35 times faster than Komatsu’s once we take into account the differences in their inventory cost flow assumptions.



P7-34. (20 minutes)

a. $6,157 million - $1,043 million = $5,114 million

b. $1,043 million

c. $1,043 million x 0.35 = $365 million

e. $602 million + [($1,043 million - $827 million) x (1 - 0.35)] = $531.7 million

e. $71,494 / [($5,114 + $4,966) / 2] = 14.19

f. [$71,494 - ($1,043 - $827)] / [($6,157 + $5,793) / 2] = 11.97

P7-35. (30 minutes)

a.Dell Hewlett-Packard Apple

2012 2011 2010 2012 2011 2010 2012 2011 2010

Revenue $62,071 $61,494 $52,902 $127,245 $126,033 $114,552 $108,249 $65,225 $42,905

COGS 48,260 50,098 43,641 65,167 65,064 56,503 64,431 39,541 25,683

Gross profit

13,811 11,396 9,261 62,078 60,969 58,049 43,818 25,884 17,229

Gross profit margin (GPM)

22.3% 18.5% 17.5% 48.8% 48.4% 50.7% 40.5% 39.4% 40.1%

b.Dell Hewlett-Packard Apple

2012 2011 2012 2011 2012 2011COGS 48.260 50,098 65,167 65,064 64,431 39,341Average ending inventory 1,352.5 1,176 6,978 6,297 912.5 753Inventory turnover 35.7 42.6 9.3 10.3 70.5 52.5

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P7-35. concluded

c. Gross profit margins reflect the companies’ cost control and their relative ability to create differentiated products. Dell spends just over 1% of revenues currently on research and development (R&D), while Hewlett-Packard spends about 2.5%. Apple’s R&D is currently just over 2% of revenues, but its recent growth in sales and margins is due to the popularity of the iPhone® with sales up 87%,iPod sales up 113% and iMAC sales up 25% in 2011 alone. Apple does not expect these growth trends to continue however.

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 finished goods for all periods presented.” Over the past five years, Hewlett-Packard has increased its inventory turnover from around 4 to above 9 while Apple’s has mushroomed to 70.

P7-36.A (45 minutes) ($ thousands)

a. Inventories as a percent of current assets follows:80% ($432,433/$543,260) of current assets in 201282% ($455,236/$556,267) of current assets in 2011

As long as Seneca’s customers have sufficient product to meet demand, the reduction of inventories reflects a positive development as it likely represents more efficient manufacturing processes. The reduction of inventories might be of concern, however, if Seneca is facing price declines, crop yield decreases due to weather, a demand slowdown forcing the company to dispose of perishable product, or financial difficulty in securing sufficient harvesting labor or to purchase the raw materials necessary for production.

The decline in 2012, however, is due to the firm’s use of LIFO whereby the LIFO reserve for finished goods increased.

b. The inventory turnover rate follows:

2012:$1,169,102

$432,433 + $455,2362

=2 .632011:

$1,101,387$455,236+$446,460

2

= 2 .44

The inventory turnover rate has increased slightly from 2011 to 2012. This increase is positive because it represents increased manufacturing/retailing efficiency.

c. Seneca uses the LIFO inventory costing method.

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P7-36.A concluded

d. The LIFO reserve – the difference between LIFO and FIFO inventories – increased by $47,339 from 2011 to 2012 ($137,227 - $89,888). As a result, reported profits decreased in 2012 by $30,771. In 2011, the LIFO reserve decreased by $5,104. 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.

During 2012, there was in fact a decrease in the LIFO reserve due to the liquidation of certain LIFO layers. Had this liquidation not occurred, LIFO reported profits would have decreased earnings by an additional $2,899.

Seneca’s use of LIFO has led to a reduction of its taxes as indicated by the $137,227 amount in the LIFO reserve. (See parts d and e.) Furthermore, the reduction in Seneca’s 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. We might also examine Seneca’s cash and quick ratios. (Using data from the 10k, not supplied in the problem statement, we report the following. Seneca’s cash increased by 98.7% in 2012 – from the cash-flow statement - thereby increasing cash as a percent of current assets from 28.8% to 38.2%. The company’s quick ratio increased from 28.0% to 87.3%.) All the data for 2012 support the importance Seneca places on cash. However, we only explore one year in any detail here and so definitive conclusions await a review of previous years and comparisons with competitors.

e. Senaca’s cash savings due to the use of LIFO over the past 5 years (when it switched to LIFO from FIFO), and assuming a constant tax rate of 35% amount to $48,029 thousand = $137,227 X (0.35).

nstas



CASES and PROJECTS

C7-37.A (30 minutes)

a. Pretax earnings would be higher by the change in the LIFO reserve. In 2011 the LIFO reserve increased from $21.3 billion to $25.6 billion, for an increase of $4.3 billion. The 2011 pretax income that would have been reported if FIFO had been used would thus be $73.257 billion - $4.3 billion = $68.957 billion.

b. The inventory turnover would be as follows:

$266,534

= 19.24[($11,365+$3,359)+($9,852+$3,124)]/2

c. BP’s inventory turnover is calculated as follows:

$285,618= 11.01

($25,661+$26,218)÷2

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:

$266,534- $4,300= 7.00

[(11,665+$3,359+$25,600)+ ($9,852+$3,124+$21,300)]/2

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.

e. The statement refers to the impact of LIFO liquidation on Exxon-Mobil’s profits.



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)Effect as of the beginning

of 2005 (as reported)Effect as of the end of

2005/beginning of 2006Total assets (inventory) +$36.7 +$38.5

Retained earnings +$23.0 +$24.1

Tax liabilities +13.7 +$14.4

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C7-38. concluded

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.



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