Ch. 8 Valuation of Inventories A Cost - Basis Approach Solutions to Concepts for Analysis

SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 8-1 (a) Purchased merchandise in transit at the end of an accounting period to which legal title has passed should be recorded as purchases within the accounting period. If goods are shipped f.o.b. shipping point, title passes to the buyer when the seller delivers the goods to the common carrier. Generally when the terms are f.o.b. shipping point, transportation costs must be paid by the buyer. This liability arises when the common carrier completes the delivery. Thus, the client has a liability for the merchandise and the freight. (b) Inventory................................................................................................ Accounts Payable (Supplier).............................................................. 35,300 Inventory................................................................................................ Accounts Payable (Transportation Co.).............................................. 1,500 35,300 1,500 (c) Possible reasons to postpone the recording of the transaction might include: 1. Desire to maintain a current ratio at a given level which would be affected by the additional inventory and accounts payable. 2. Desire to minimize the impact of the additional inventory on other ratios such as inventory turnover. 3. Possible tax ramifications. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, Communication, Relective Thinking, AICPA BB: None Reporting, AICPA PC: Communication CA 8-2 (a) If the terms of the purchase are f.o.b. shipping point (manufacturer’s plant), Strider Enterprises should include in its inventory goods purchased from its suppliers when the goods are shipped. For accounting purposes, title is presumed to pass at that time. (b) Freight-in expenditures should be considered an inventoriable cost because they are part of the price paid or the consideration given to acquire the asset. (c) Theoretically the net approach is the more appropriate because the net amount (1) provides a correct reporting of the cost of the asset and related liability and (2) presents the opportunity to measure the inefficiency of financial management if the discount is not taken. Many believe, however, that the difficulty involved in using the somewhat more complicated net method is not justified by the resulting benefits. (d) Products on consignment represent inventories owned by Strider Enterprises, which are physically transferred to another enterprise. However, Strider Enterprises retains title to the goods until their sale by the other company (Chavez Inc.). The goods consigned are still included by Strider Enterprises in the inventory section of its balance sheet. Often the inventory is reclassified from regular inventory to consigned inventory (Note to instructor: Additional coverage of consignments is presented in chapter 18.) LO: 2, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication 8-62 CA 8-3 (a) According to FASB ASC 330-10-30-1: “As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.” The discussion includes the following: “Selling expenses constitute no part of the inventory costs.” To the extent that warehousing is a necessary function of importing merchandise before it can be sold, certain elements of warehousing costs might be considered an appropriate cost of inventory in the warehouse. For example, if goods must be brought into the warehouse before they can be made ready for sale, the cost of bringing such goods into the warehouse would be considered a cost of inventory. Similarly, if goods must be handled in the warehouse for assembly or for removal of foreign packaging, etc., it would be appropriate to include such costs in inventory. However, costs involved in storing the goods for any additional period would appear to be period costs. Costs of delivering the goods from the warehouse would appear to be selling expenses related to the goods sold, and should not under any circumstances be allocated to goods that are still in the warehouse. In theory, warehousing costs are considered a product cost because these costs are incurred to maintain the product in a salable condition. However, in practice, warehousing costs are most frequently treated as a period cost. Under the Tax Reform Act of 1986, warehousing and off-site storage of inventory, including finished goods, are specifically included in the “production and resale activities” that are to be capitalized for tax purposes. (b) It is correct to conclude that obsolete items are excludable from inventory. Cost attributable to such items is “nonuseful” and “nonrecoverable” cost (except for possible scrap value) and should be written off. If the cost of obsolete items was simply excluded from ending inventory, the resultant cost of goods sold would be overstated by the amount of these costs. The cost of obsolete items, if immaterial, should be commingled with cost of goods sold. If material, these costs should be separately disclosed. (c) The primary use of the airplanes should determine their treatment on the balance sheet. Since the airplanes are held primarily for sale, and chartering is only a temporary use, the airplanes should be classified as current assets. Depreciation would not be appropriate if the planes are considered inventory. FASB ASC Glossary entry for “Inventory” states in part that the term Inventory “excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified.” (d) The transaction is a product financing arrangement and should be reported by the company as inventory with a related liability. The substance of the transaction is that inventory has been purchased and the fact that a trust is established to purchase the goods has no economic significance. Given that the company agrees to buy the coal over a certain period of time at specific prices, it appears clear that the company has the liability and not the trust. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analysis, Communication, Relective Thinking, AICPA BB: None Reporting, AICPA PC: Communication CA 8-4 (a) Cash discounts should not be accounted for as financial income when payments are made. Income should be recognized when the company sells the inventory. Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded. 8-63 CA 8-4 (Continued) (b) Cash discounts should not be accounted for as a reduction of cost of goods sold for the period when payments are made. Cost of goods sold should be reduced when the company sells the inventory which has been reduced by the cash discounts. Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded. (c) Cash discounts should be accounted for as a direct reduction of purchase cost because they reduce the cost of acquiring the inventories. Purchases should be recorded net of cash discounts to reflect the net cash to be paid. The primary basis of accounting for inventories is cost, which represents the price paid or consideration given to acquire an asset. LO: 2, Bloom: AN, Difficulty: Simple, Time: 15-25, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication CA 8-5 (a) 1. Inventories are unexpired costs and represent future benefits to the owner. A balance sheet includes a listing of unexpired costs and future benefits of the owner’s assets at a specific point in time. Because inventories are assets owned at the specific point in time for which a balance sheet is prepared, they must be included in order that the owner’s financial position will be presented fairly. 2. Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues recognized during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed. (b) Financial accounting has as its goal the proper reporting of financial transactions and events in accordance with generally accepted accounting principles. Income tax accounting has as its goal the reporting of taxable transactions and events in conformity with income tax laws and regulations. While the primary purpose of an income tax is the production of tax revenues to finance the operations of government, income tax laws and regulations are often produced by various forces. The income tax may be used as a tool of fiscal policy to stimulate all of the segments of the economy or to decelerate the economy. Some income tax laws may be passed because of political pressures brought to bear by individuals or industries. When the purposes of financial accounting and income tax accounting differ, it is often desirable to report transactions or events differently and to report the deferred tax consequences of any existing temporary differences as assets or liabilities. (c) FIFO and LIFO are inventory costing methods employed to measure the flow of costs. FIFO matches the first cost incurred with the first revenue produced while LIFO matches the last cost incurred with the first revenue produced after the cost is incurred. (This, of course, assumes a perpetual inventory system is in use and may not be precisely true if a periodic inventory system is employed.) If prices are changing, different costs would be matched with revenue for the same quantity sold depending upon whether the LIFO or FIFO system is in use. (In a period of rising or falling prices FIFO tends to value inventories at approximate market value in the balance sheet and LIFO tends to match approximately the current replacement cost of an item with the revenue produced.) LO: 2,3, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication CA 8-6 (a) Inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The cost of goods sold therefore is understated and net income is considered overstated. By using LIFO (rather than some method such as FIFO), more recent costs are matched against revenues and inventory profits are thereby reduced. 8-64 CA 8-6 (Continued) (b) As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs under LIFO because the items most recently purchased at the higher price level are matched against revenues. It should be noted that where unit costs tend to decrease as production increases, the tax benefits that LIFO might provide are nullified. Also, where the inventory turnover is high, the difference between inventory methods is negligible. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, Communication, Relective Thinking, AICPA BB: None Reporting, AICPA PC: Communication CA 8-7 (a) The average-cost method assumes that inventories are sold or issued evenly from the stock on hand; the FIFO method assumes that goods are sold or used in the order in which they are purchased (i.e., the first goods purchased are the first sold or used); and the LIFO method matches the cost of the last goods purchased against revenue. (b) The weighted-average-cost method combines the cost of all the purchases in the period with the cost of beginning inventory and divides the total costs by the total number of units to determine the average cost per unit. The moving-average-cost method, on the other hand, calculates a new average unit cost when a purchase is made. The moving-average-cost method is used with perpetual inventory records. (c) When the purchase prices of inventoriable items are rising for a significant period of time, the use of the LIFO method (instead of FIFO) will result in a lower net income figure. The reason is that the LIFO method matches most recent purchases against revenue. Since the prices of goods are rising, the LIFO method will result in higher cost of goods sold, thus lower net income. On the balance sheet, the ending inventory tends to be understated (i.e., lower than the most recent replacement cost) because the oldest goods have lower costs during a period of rising prices. In addition, retained earnings under the LIFO method will be lower than that of the FIFO method when inflation exists. LO: 3, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication CA 8-8 (a) 1. The LIFO method (periodic) allocates costs on the assumption that the last goods purchased are used first. If the amount of the inventory is computed at the end of the month under a periodic system, then it would be assumed that the total quantity sold or issued during the month would have come from the most recent purchases, and ordinarily no attempt would be made to compare the dates of purchases and sales. 2. The dollar-value method of LIFO inventory valuation is a procedure using dollars instead of units to measure increments or reductions in inventory. The method presumes that goods in the inventory can be classified into pools or homogenous groups. After the grouping into pools the ending inventory is priced at the end-of-year prices and a price index number is applied to convert the total pool to the base-year price level. Such a price index might be obtained from government sources, if available, or computed from the company’s records. The pools or groupings of inventory are required where a single index number is inappropriate for all elements of the inventory. After the closing inventory and the opening inventory have been placed on the same base-year price level, any difference between the two inventories is attributable to an increase or decrease in inventory quantity at the base-year price. An increase in quantity so determined is converted to the current-year price level and added to the amount of the opening inventory as 8-65 a separate inventory layer. A decrease in quantity is deducted from the appropriate layer of opening inventory at the price level in existence when the layer was added. 8-66 CA 8-8 (Continued) (b) The advantages of the dollar-value method over the traditional LIFO method are as follows: 1. The application of the LIFO method is simplified because, under the pooling procedure, it is not necessary to assign costs to opening and closing quantities of individual items. As a result, companies with inventories comprised of thousands of items may adopt the dollar-value method and minimize their bookkeeping costs. 2. Base inventories are more easily maintained. The dollar-value method permits greater flexibility because each pool is made up of dollars rather than quantities. Thus, the problem of LIFO liquidation is less possible. The disadvantages of the dollar-value method as compared to the traditional LIFO method are as follows: 1. Due to technological innovations and improvements over time, material changes in the composition of inventory may occur. Items found in the ending inventory may not have existed during the base year. Thus, conversion of the ending inventory to base-year prices may be difficult to calculate or to justify conceptually. This may necessitate a periodic change in the choice of base year used. 2. Application of a year-end index, although widely used, implies use of the FIFO method. Other indexes used include beginning-of-year index and average indexes. 3. Determination of the degree of similarity between items for the purpose of grouping them into pools may be difficult and may be based upon arbitrary management decisions. (c) The basic advantages of LIFO are: 1. Matching—In LIFO, the more recent costs are matched against current revenues to provide a better measure of current earnings. 2. Tax benefits—As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs. 3. Improved cash flow—By receiving tax benefits from use of LIFO, the company may reduce its borrowings and related interest costs. 4. Future earnings hedge—With LIFO, a company’s future reported earnings will not be affected substantially by future price declines. LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases because the inventory value ordinarily will be much lower than net realizable value, unlike FIFO. The major disadvantages of LIFO are: 1. Reduced earnings—Because current costs are matched against current revenues, net income is lower than it is under other inventory methods when price levels are increasing. 2. Inventory understated—The inventory valuation on the balance sheet is ordinarily outdated because the oldest costs remain in inventory. 3. Physical flow—LIFO does not approximate physical flow of the items except in peculiar situations. 4. Real income not measured—LIFO falls short of measuring real income because it is often not an adequate substitute for replacement cost. 5. Involuntary liquidation—If the base or layers of old costs are partially liquidated, irrelevant costs can be matched against current revenues. 6. Poor buying habits—LIFO may cause poor buying habits because a company may simply purchase more goods and match the cost of these goods against revenue to insure that old costs are not charged to expense. LO: 4, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication 8-67 CA 8-9 (a) A LIFO pool is a group of similar items which are combined and accounted for together under the LIFO inventory method. (b) It is possible to use a LIFO pool concept without using dollar-value LIFO. For example, the specific goods pooled approach utilizes the concept of a LIFO pool with quantities as its measurement basis. (c) A LIFO liquidation occurs when a significant drop in inventory level leads to the erosion of an earlier or base inventory layer. In a period of inflation (as usually is the case) LIFO liquidation will distort net income (make it higher) and incur substantial tax payments. (d) Price indexes are used in the dollar-value LIFO method to: (1) convert the ending inventory at current year-end cost to base-year cost, and (2) determine the current-year cost for each inventory layer other than the base-year layer. (e) The dollar-value LIFO method measures the increases and decreases in a pool in terms of total dollar value, not by the physical quantity of the goods in the inventory pool. As a result, the dollarvalue LIFO approach has the following advantages over specific goods LIFO pool. First, the pooled approach reduces record keeping and clerical costs. Second, replacement is permitted if it is a similar material, or similar in use, or interchangeable. Thus, it is more difficult to erode LIFO layers when using dollar-value LIFO techniques. LO: 4,, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication CA 8-10 (a) FIFO (Amounts in thousands, except earnings per share) 2017 $11,000 2018 $12,000 2019 $15,600 Sales revenue Cost of goods sold Beginning inventory 8,000 7,200 9,000 Purchases 8,000 9,900 12,000 Cost of goods available for sale 16,000 17,100 21,000 1. Ending inventory* (7,200) (9,000) (9,000) Cost of goods sold 8,800 8,100 12,000 Gross profit 2,200 3,900 3,600 Operating expense (15% of sales) 1,650 1,800 2,340 Depreciation expense 300 300 300 Income before taxes 250 1,800 960 Income tax expense (40%) 100 720 384 2. Net income $ 150 $ 1,080 $ 576 8-68 CA 8-10 (Continued) 2017 3. Earnings per share 4. Cash balance Beginning balance Sales proceeds Purchases Operating expenses Property, plant, and equipment Income taxes Dividends Ending balance $ 0.15 2018 $ 1.08 $ 400 $ 1,150 11,000 12,000 (8,000) (9,900) (1,650) (1,800) (350) (350) (100) (720) (150) (150) $ 1,150 $ 230 2019 $ 0.58 $ 230 15,600 (12,000) (2,340) (350) (384) (150) $ 606 *2017 = $ 8 X (1,000 + 1,000 – 1,100) = $7,200. 2018 = $ 9 X ( 900 + 1,100 – 1,000) = $9,000. 2019 = $10 X (1,000 + 1,200 – 1,300) = $9,000. LIFO (Amounts in thousands, except earnings per share) Sales revenue Cost of goods sold Beginning inventory Purchases Cost of goods available for sale 1. Ending inventory** Cost of goods sold Gross profit Operating expense Depreciation expense Income before taxes Income tax expense 2. Net income 3. Earnings per share 2017 $11,000 8,000 8,000 16,000 (7,200) 8,800 2,200 1,650 300 250 100 $ 150 $ 0.15 2018 2019 $12,000 $15,600 7,200 8,100 9,900 12,000 17,100 20,100 (8,100) (7,200) 9,000 12,900 3,000 2,700 1,800 2,340 300 300 900 60 360 24 $ 540 $ 0.54 $ 36 $ 0.04 8-69 CA 8-10 (Continued) 2017 4. Cash balance Beginning balance Sales proceeds Purchases Operating expenses Property, plant, and equipment Income taxes Dividends Ending balance $ 400 11,000 (8,000) (1,650) (350) (100) (150) $ 1,150 2018 $ 1,150 12,000 (9,900) (1,800) (350) (360) (150) $ 590 2019 $ 590 15,600 (12,000) (2,340) (350) (24) (150 ) $ 1,326 **2017 = $8 X (1,000 + 1,000 – 1,100) = $7,200. 2018 = ($8 X 900) + ($9 X 100) = $8,100. 2019 = $8 X 900 = $7,200. (b) According to the computation in (a), Harrisburg Company can achieve the goal of income tax savings by switching to the LIFO method. As shown in the schedules, under the LIFO method, Harrisburg will have lower net income and thus lower income taxes for 2018 and 2019 (tax savings of $360,000 in each year). As a result, Harrisburg will have a better cash position at the end of 2018 and especially 2019 (year-end cash balance will be higher by $360,000 for 2018 and $720,000 for 2019). However, since Harrisburg Company is in a period of rising purchase prices, the LIFO method will result in significantly lower net income and earnings per share for 2018 and 2019. The management may need to evaluate the potential impact that lower net income and earnings per share might have on the company before deciding on the change to the LIFO method. LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication 8-70 CA 8-11 (a) Major stakeholders are investors, creditors, Wilkens’ management (including the president and plant accountant), and other employees of Wilkens Company. The inventory purchase in this instance reduces net income substantially and lowers Wilkens Company’s tax liability. Current stockholders and company management benefit during the current year by this decision. However, the purchasing department may be concerned about inventory management and complications such as storage costs and possible inventory obsolescence. Assuming awareness of these benefits and possible complications, the plant accountant may follow the president’s recommendation without violating GAAP. The plant accountant also must consider whether this action is in the long-term best interests of the company and whether inventory amounts would provide a meaningful picture of Wilkens Company’s financial condition. (b) No, the president would not recommend a year-end inventory purchase because under FIFO there would be no effect on net income. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Communication, Reflective Thinking Professional Demeanor Reporting, AICPA PC: Communication, Professional Demeanor 8-71