Old Inventory

Horizon Corporation manufactures personal computers. The company began operations in 2003 and reported profits for the years 2003 through 2010. Due primarily to increased competition and price slashing in the industry, 2011's income statement reported a loss of $20 million. Just before the end of the 2012 fiscal year, a memo from the company's chief financial officer to Jim Fielding, the company controller, included the following comments:

If we don't do something about the large amount of unsold computers already manufactured, our auditors will require us to record a write down. The resulting loss for 2012 will cause a violation of our debt covenants and force the company into bankruptcy. I suggest that you ship half of our inventory to J.B. Sales, Inc., in Oklahoma City. I know the company's president, and he will accept the inventory and acknowledge the shipment as a purchase. We can record the sale in 2012 which will boost our loss to a profit. Then J.B. Sales will simply return the inventory in 2013 after the financial statements have been issued.

Please answer the questions:

[1] Discuss the ethical dilemma faced by Jim Fielding.

[2] Discuss the revenue recognition principle.

[3] Discuss and provide any adjusting journal entry, if required (hint: from the inventory chapter).

2017/4/3 IEB Wireframe Page 266 PART PART A UNDERSTANDING A INVENTORY AND COST OF GOODS SOLD PART A UNDERSTANDING INVENTORY AND COST OF GOODS SOLD In preceding chapters, we dealt with companies that provide a service. Service companies such as FedEx, United Healthcare, Allstate Insurance, and Marriott Hotels earn revenues by providing services to their customers. FedEx delivers your packages, United Healthcare treats your medical needs, Allstate provides insurance coverage, and Marriott offers you a place to stay the night. Many companies, though, earn revenues by selling inventory rather than a service. Part A of this chapter introduces the concept of inventory and demonstrates the different methods used to calculate the cost of inventory for external reporting. Once you understand this, then you're ready to see, in Part B and Part C, how companies actually maintain their own (internal) records of inventory transactions and the adjustments that are sometimes needed to prepare financial statements. bch_ha Inventory Inventory LO6-1 Trace the flow of inventory costs from manufacturing companies to merchandising companies. Companies that earn revenue by selling inventory are either manufacturing or merchandising companies. Inventory includes items a company intends for sale to customers. You already are familiar with several types of inventoryclothes at The Limited, shoes at Payless ShoeSource, grocery items at Publix Super Markets, digital equipment at Best Buy, building supplies at The Home Depot, and so on. Inventory also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer, steel at a construction firm, and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers. We report inventory as a current asset in the balance sheetan asset because it represents a valuable resource to the company, and current because the company expects to convert it to cash in the near term. At the end of the period, the amount the company reports for inventory is the cost of inventory not yet sold. But what happens to the cost of the http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 1/22 2017/4/3 IEB Wireframe inventory sold during the period? The company reports the cost of the inventory it sold as cost of goods sold in the income statement. Common Terms Cost of goods sold is also referred to as cost of sales, cost of merchandise sold, or cost of products sold. Determining the amount of ending inventory and cost of goods sold is a critical task in accounting for inventory. For companies that earn revenues by selling inventory, ending inventory is often the largest asset in the balance sheet, and cost of goods sold often is the largest expense in the income statement. Before we explore how companies calculate these amounts, we first need to consider the different types of inventory between merchandising and manufacturing companies. MERCHANDISING COMPANIES Merchandising companies purchase inventories that are primarily in finished form for resale to customers. These companies may assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install the inventory, but they do not manufacture it. They simply serve as intermediaries in the process of moving inventory from the manufacturer, the company that actually makes the inventory, to the end user. We can broadly classify merchandising companies as wholesalers or retailers. Wholesalers resell inventory to retail companies or to professional users. For example, a wholesale food service company like Sysco Corporation supplies food to restaurants, schools, and sporting events but generally does not sell food directly to the public. Also, Sysco does not transform the food prior to sale; it just stores the food, repackages it as necessary, and delivers it. Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users. You probably are more familiar with retail companies because these are the companies from which you buy products. Best Buy, Target, Lowe's, Macy's, Gap, Sears, and McDonald's are retailers. Merchandising companies typically hold their inventories in a single category simply called inventory. Common Terms Inventory is also referred to as merchandise inventory. Page 267 MANUFACTURING COMPANIES Manufacturing companies manufacture the inventories they sell, rather than buying them in finished form from suppliers. Apple Inc., Coca-Cola, Harley-Davidson, ExxonMobil, Ford, Sony, and Intel are manufacturers. Manufacturing companies buy the inputs for the products they manufacture. Thus, we classify inventory for a manufacturer into three categories: (1) raw materials, (2) work in process, and (3) finished goods: Raw materials inventory includes the cost of components that will become part of the finished product but have not yet been used in production. http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 2/22 2017/4/3 IEB Wireframe Work-in-process inventory refers to the products that have been started in the production process but are not yet complete at the end of the period. The total costs include raw materials, direct labor, and indirect manufacturing costs called overhead. Finished goods inventory consists of items for which the manufacturing process is complete. Intel manufactures the components that are used to build computers. At any given time, Intel's inventory includes the cost of materials that will be used to build computer components (raw materials), partially manufactured components (work-in-process), and fully assembled but unsold components (finished goods). These separate inventory accounts are added together and reported by Intel as total inventories. Other companies, such as Best Buy, don't manufacture computers or their components. Instead, Best Buy purchases finished computers from manufacturers. These computers represent merchandise ready for sale to customers like you. Illustration 6-1 shows the different inventory accounts for Intel and Best Buy as reported in their balance sheets. ILLUSTRATION 6-1 Inventory Amounts for a Manufacturing Company (Intel) Versus a Merchandising Company (Best Buy) ILLUSTRATION 6-1 Inventory Amounts for a Manufacturing Company (Intel) Versus a Merchandising Company (Best Buy) INVENTORY (from balance sheets) Inventory accounts ($ in millions) Intel Best Buy Raw materials $ 462 Work in process 2,375 Finished goods 1,436 Merchandise inventories http://textflow.mheducation.com/parser.php?secload=6.1&fake&print $5,174 3/22 2017/4/3 IEB Wireframe Total inventories $4,273 $5,174 KEY POINT Service companies record revenues when providing services to customers. Merchandising and manufacturing companies record revenues when selling inventory to customers. FLOW OF INVENTORY COSTS Illustration 6-2 shows the flow of inventory costs for the three types of companies service, merchandising, and manufacturing. ILLUSTRATION 6-2 Types of Companies and Flow of Inventory Costs ILLUSTRATION 6-2 Types of Companies and Flow of Inventory Costs http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 4/22 2017/4/3 IEB Wireframe Inventory's journey begins when manufacturing companies purchase raw materials, hire workers, and incur manufacturing overhead during production. Once the products are finished, manufacturers normally pass inventories to merchandising companies, whether wholesalers or retailers. Merchandising companies then sell inventories to you, the end user. In some cases, manufacturers may sell directly to end users. Some companies sell goods and also provide services to customers. For example, IBM generates about half its revenues from selling its inventories of hardware and software, and the other half from providing services like consulting, systems maintenance, and financing. In this chapter, we focus on merchandising companies, both wholesalers and retailers. Still, most of the accounting principles and procedures discussed here also apply to manufacturing companies. We do not attempt to address all the unique problems of accumulating the direct costs of raw materials and labor and allocating manufacturing overhead. We leave those details for managerial and cost accounting courses. In this course, we focus on the financial reporting implications of inventory cost flows. Page 268 bch_ha Cost of Goods Sold Cost of Goods Sold LO6-2 Understand how cost of goods sold is reported in a multiple-step income statement. Let's think a little more about the relationship between ending inventory in the balance sheet and cost of goods sold in the income statement. To do this, we'll use a simple example for a local Best Buy, depicted in Illustration 6-3. Assume the store begins the year with $20,000 of DVD player inventory. That amount represents how much Best Buy spent to purchase the inventory of DVD players on hand at the beginning of the year. During the year, the company purchases additional DVD players for $90,000. The total cost of inventory (DVD players) available for sale is $110,000 (= $20,000 + $90,000). ILLUSTRATION 6-3 Relationship between Inventory and Cost of Goods Sold http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 5/22 2017/4/3 IEB Wireframe ILLUSTRATION 6-3 Relationship between Inventory and Cost of Goods Sold Now, here's where we'll see the direct relationship between ending inventory and cost of goods sold. Of the $110,000 in inventory available for sale, assume that by the end of the year the purchase cost of the remaining DVD players not sold equals $30,000. This is the amount reported for ending inventory. What is the amount reported for cost of goods sold? If $30,000 of the inventory available for sale was not sold, then the remaining portion of $80,000 (= $110,000 $30,000) was sold. This is the amount reported for cost of goods sold. Page 269 KEY POINT Inventory is a current asset reported in the balance sheet and represents the cost of inventory not yet sold at the end of the period. Cost of goods sold is an expense reported in the income statement and represents the cost of inventory sold. MULTIPLE-STEP INCOME STATEMENT To see how Best Buy actually reports its cost of goods sold as an expense, as well as its other income statement items, let's look at Illustration 6-4. ILLUSTRATION 6-4 Multiple-Step Income Statement for Best Buy http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 6/22 2017/4/3 IEB Wireframe ILLUSTRATION 6-4 Multiple-Step Income Statement for Best Buy Page 270 The format of Best Buy's income statement is called the multiple-step income statement, referring to the fact that the income statement reports multiple levels of income (or profit). Most companies choose to report their income statement similar to the one shown for Best Buy. The reason why companies choose the multiple-step format is to show the revenues and expenses that arise from different types of activities. By separating revenues and expenses into their different types, investors and creditors are better able to determine the source of a company's profitability. Understanding the source of current profitability often enables a better prediction of future profitability. Let's review each level of profitability. Gross Profit. Gross Profit.Inventory transactions are typically the most important activities of a merchandising company. For this reason, companies report the revenues and expenses directly associated with these transactions in the top section of a multiple-step income statement. Sales of inventory are commonly reported as sales revenue, while services provided are recorded as service revenue. Best Buy has mostly sales revenue, but some service revenue, and reports them together as Revenues. Best Buy reports these revenues after subtracting customer returns, allowances, and discounts, as discussed in Chapter 5, although the company does not list these amounts separately in the income statement. The net amount of revenues is commonly referred to as net sales. Next, the cost of inventory sold is reported as an expense called Cost of goods sold. Best Buy's cost of goods sold includes not only the cost of the physical merchandise purchased from suppliers, but also costs related to getting inventory ready for sale, such as shipping and other costs for its distribution network. http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 7/22 2017/4/3 IEB Wireframe Net revenues (or net sales) minus cost of goods sold equals gross profit. Gross profit is the first level of profit shown in the multiple-step income statement. Gross profit provides a key measure of profitability for the company's primary business activities. Best Buy's gross profit is just over $9 billion for approximately $40 billion in sales. Operating Income. Operating Income.After gross profit, the next items reported are Selling, general, and administrative expenses, often referred to as operating expenses. We discussed several types of operating expenses in earlier chaptersadvertising, salaries, rent, utilities, supplies, and depreciation. These costs are normal for operating most companies. Best Buy has total operating expenses of $7,597 million, and like most companies, does not list individual operating expense amounts in the income statement. Gross profit reduced by these operating expenses is referred to as operating income (or sometimes referred to as income from operations). It measures profitability from normal operations, a key performance measure for predicting the future profit-generating ability of the company. Income Before Income Taxes. Income Before Income Taxes.After operating income, a company reports nonoperating revenues and expenses. Best Buy refers to these items as Other income (expense). Other income items are shown as positive amounts, and other expense items are shown as negative amounts (in parentheses). Nonoperating revenues and expenses arise from activities that are not part of the company's primary operations. Best Buy reports two nonoperating revenuesgain on the sale of investments and investment income. Gains on the sale of long-term assets (such as investments, land, equipment, and buildings) occur when assets are sold for more than their recorded amounts. Investment income includes earnings from dividends and interest. Nonoperating revenues are not typical operating activities, but they do represent a source of profitability, so they are included in the income statement. Nonoperating expenses most commonly include interest expense. Best Buy reports interest expense of $90 million. Nonoperating expenses could also include losses on the sale of investments or long-term assets. Investors focus less on nonoperating revenues and expenses than on income from operations, because nonoperating activities often do not have long-term implications on the company's profitability. Combining operating income with nonoperating revenues and expenses yields income before income taxes. For Best Buy, the amount of nonoperating expenses exceeds the amount of nonoperating revenues, so income before income taxes is lower than operating income. Page 271 Net Income. Net Income.Next, a company subtracts income tax expense to find its bottom-line net income2. Income tax expense is reported separately because it represents a significant expense. It's also the case that most major corporations (formally referred to as C corporations) are tax-paying entities, while income taxes of sole proprietorships and http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 8/22 2017/4/3 IEB Wireframe partnerships are paid at the individual owner level. By separately reporting income tax expense, the income statement clearly labels the difference in profitability associated with the income taxes of a corporation. Best Buy's income tax expense equals 10.2% of income before taxes (= $141 $1,387). The actual corporate tax rate for Best Buy's level of income is 35%. The reason Best Buy's income tax expense is only 10.2% is because companies sometimes operate in foreign jurisdictions with lower tax rates or because tax rules differ from financial reporting rules. Differences in reporting rules can result in financial income differing from taxable income in any particular year. A more realistic tax expense for Best Buy can be calculated by looking at amounts over the three-year period ending January 31, 2015. Best Buy's cumulative tax expense divided by cumulative income before income taxes for 2013, 2014, and 2015 equaled 32.0%. KEY POINT A multiple-step income statement reports multiple levels of profitability. Gross profit equals net revenues (or net sales) minus cost of goods sold. Operating income equals gross profit minus operating expenses. Income before income taxes equals operating income plus nonoperating revenues and minus nonoperating expenses. Net income equals all revenues minus all expenses. Decision Maker's Perspective Investors Understand One-Time Gains Investors typically take a close look at the components of a company's profits. For example, Ford Motor Company announced that it had earned a net income for the fourth quarter (the final three months of the year) of $13.6 billion. Analysts had expected Ford to earn only $1.7 to $2.0 billion for that period. The day that Ford announced this earnings news, its stock price fell about 4.5%. Why would Ford's stock price fall on a day when the company reported these seemingly high profits? A closer inspection of Ford's income statement shows that it included a onetime gain of $12.4 billion for the fourth quarter. After subtracting this one-time gain, Ford actually earned only about $1.2 billion from normal operations, easily missing analysts' expectations. This disappointing earnings performance is the reason the company's stock price fell. bch_ha Inventory Cost Methods Inventory Cost Methods LO6-3 Determine the cost of goods sold and ending inventory using different inventory cost methods. To this point, we've discussed the cost of inventory without considering how we determine that cost. We do that now by considering four methods for inventory costing: http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 9/22 2017/4/3 IEB Wireframe 1. Specific identification 2. First-in, first-out (FIFO) 3. Last-in, first-out (LIFO) 4. Weighted-average cost SPECIFIC IDENTIFICATION The specific identification method is the method you might think of as the most logical. It matchesidentifieseach unit of inventory with its actual cost. For example, an automobile has a unique serial number that we can match to an invoice identifying the actual purchase price. Fine jewelry and pieces of art are other possibilities. Specific identification works well in such cases. Page 272 However, the specific identification method is practicable only for companies selling unique, expensive products. Consider the inventory at The Home Depot or Macy's: large stores and numerous items, many of which are relatively inexpensive. Specific identification would be very difficult for such merchandisers. Although bar codes and RFID tags now make it possible to identify and track each unit of inventory, the costs of doing so outweigh the benefits for multiple, small inventory items. For that reason, the specific identification method is used primarily by companies with unique, expensive products with low sales volume. FIRST-IN, FIRST-OUT For practical reasons, most companies use one of the three inventory cost flow assumptionsFIFO, LIFO, or weighted-average costto determine cost of goods sold and inventory. Note the use of the word assumptions: Each of these three inventory cost methods assumes a particular pattern of inventory cost flows. However, the actual flow of inventory does not need to match the assumed cost flow in order for the company to use a particular method. To see how the three cost flow assumptions work, let's begin with FIFO. We'll examine the inventory transactions in Illustration 6-5 for Mario's Game Shop, which sells video game controllers. Mario has 100 units of inventory at the beginning of the year and then makes two purchases during the yearone on April 25 and one on October 19. (Note the different unit costs at the time of each purchase.) There are 1,000 game controllers available for sale. ILLUSTRATION 6-5 Inventory Transactions for Mario's Game Shop http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 10/22 2017/4/3 IEB Wireframe ILLUSTRATION 6-5 Inventory Transactions for Mario's Game Shop Date Transaction Jan. 1 Beginning inventory Number of Unit Total Units Cost Cost 100 $ 7 $ 700 Apr. 25 Purchase 300 9 2,700 Oct. 19 Purchase 600 11 6,600 Total goods available for sale Jan. 1- Dec. 31 Total sales to customers Dec. 31 Ending inventory 1,000 $10,000 800 200 During the year, Mario sells 800 video game controllers for $15 each. This means that 200 controllers remain in ending inventory at the end of the year. But which 200? Do they include some of the $7 units from beginning inventory? Are they 200 of the $9 units from the April 25 purchase? Or, do they include some $11 units from the October 19 purchase? We consider these questions below. Using the first-in, first-out (FIFO) method, we assume that the first units purchased (the first in) are the first ones sold (the first out). We assume that beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on. In our example, which 800 units did Mario's Game Shop sell? Using the FIFO method, we assume they were the first 800 units purchased, and that all other units remain in ending inventory. These calculations are shown in Illustration 6-6. http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 11/22 2017/4/3 IEB Wireframe mhhe.com/4fa22 ILLUSTRATION 6-6 Inventory Calculation Using the FIFO Method ILLUSTRATION 6-6 Inventory Calculation Using the FIFO Method We assume that all units from beginning inventory (100 units) and the April 25 purchase (300 units) were sold. For the final 400 units sold, we split the October 19 purchase of 600 units into two groups400 units assumed sold and 200 units assumed not sold. We calculate cost of goods sold as the units of inventory assumed sold times their respective unit costs. [That is: (100 $7) + (300 $9) + (400 $11) in our example.] Similarly, ending inventory equals the units assumed not sold times their respective unit costs (200 $11 in our example). The amount of cost of goods sold Mario reports in the income statement will be $7,800. The amount of ending inventory in the balance sheet will be $2,200. Page 273 You may have noticed that we don't actually need to directly calculate both cost of goods sold and inventory. Once we calculate one, the other is apparent. Because the two amounts always add up to the cost of goods available for sale ($10,000 in our example), knowing either amount allows us to subtract to find the other. Realize, too, that the amounts reported for ending inventory and cost of goods sold do not represent the actual cost of inventory sold and not sold. That's okay. Companies are allowed to report inventory costs by assuming which units of inventory are sold and not sold, even if this does not match the actual flow. This is another example of using estimates in financial accounting. LAST-IN, FIRST-OUT Using the last-in, first-out (LIFO) method, we assume that the last units purchased (the last in) are the first ones sold (the first out). If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 12/22 2017/4/3 IEB Wireframe from beginning inventory assumed to remain in ending inventory (not sold). Illustration 6- 7 shows calculations of cost of goods sold and ending inventory for the LIFO method. mhhe.com/4fa23 ILLUSTRATION 6-7 Inventory Calculation Using the LIFO Method ILLUSTRATION 6-7 Inventory Calculation Using the LIFO Method Page 274 COMMON MISTAKE Many students find it surprising that companies are allowed to report inventory costs using assumed amounts rather than actual amounts. Nearly all companies sell their actual inventory in a FIFO manner, but they are allowed to report it as if they sold it in a LIFO manner. Later, we'll see why that's advantageous. WEIGHTED-AVERAGE COST Using the weighted-average cost method, we assume that both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale. We assume each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items. We calculate that cost at the end of the year as: Illustration 6-8 demonstrates the calculation of cost of goods sold and ending inventory using the weighted-average cost method. Notice that the weighted-average cost of each game controller is $10, even though none of the game controllers actually cost $10. However, on average, all the game controllers cost $10, and this is the amount we use to http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 13/22 2017/4/3 IEB Wireframe calculate cost of goods sold and ending inventory under the weighted-average cost method. ILLUSTRATION 6-8 Inventory Calculation Using the Weighted-Average Cost Method ILLUSTRATION 6-8 Inventory Calculation Using the Weighted-Average Cost Method COMMON MISTAKE In calculating the weighted-average unit cost, be sure to use a weighted average of the unit cost instead of the simple average. In the example above, there are three unit costs: $7, $9, and $11. A simple average of these amounts is $9 [= (7 + 9 + 11) 3]. The simple average, though, fails to take into account that more units were purchased at $11 than at $7 or $9. So we need to weight the unit costs by the number of units purchased. We do that by taking the total cost of goods available for sale ($10,000) divided by the total number of units available for sale (1,000) for a weighted average of $10. Illustration 6-9 depicts the concept behind the three inventory cost flow assumptions for Mario's Game Shop. Mario begins the year with 100 units previously purchased for $7 per unit. During the year Mario makes two additional purchases with unit costs of $9 and $11. The total inventory available for sale is $10,000. If Mario sells 800 units of inventory, which 800 are they? Using FIFO, we assume inventory is sold in the order purchased: Beginning inventory is sold first, the first purchase during the year is sold second, and part of the second purchase during the year is sold third. Using LIFO, we assume inventory is sold in the opposite order that we purchased it: The last purchase is sold first, and part of the second-to-last purchase is sold second. Using average cost, we assume inventory is sold using an average of all inventory purchased, including the beginning inventory. mhhe.com/4fa24 http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 14/22 2017/4/3 IEB Wireframe ILLUSTRATION 6-9 Comparison of Cost of Goods Sold and Ending Inventory under the Three Inventory Cost Flow Assumptions for Mario's Game Shop ILLUSTRATION 6-9 Comparison of Cost of Goods Sold and Ending Inventory under the Three Inventory Cost Flow Assumptions for Mario's Game Shop Page 275 COMMON MISTAKE FIFO and LIFO describe more directly the calculation of cost of goods sold, rather than ending inventory. For example, FIFO (first-in, first-out) directly suggests which inventory units are assumed sold (the first ones in) and therefore used to calculate cost of goods sold. It is implicit under FIFO that the inventory units not sold are the last ones in and are used to calculate ending inventory. KEY POINT Companies are allowed to report inventory costs by assuming which specific units of inventory are sold and not sold, even if this does not match the actual flow. The three http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 15/22 2017/4/3 IEB Wireframe major inventory cost flow assumptions are FIFO (first-in, first-out), LIFO (last-in, first-out), and weighted-average cost. Page 276 Let's Review NASCAR Unlimited sells remote-control cars. The company has the following beginning inventory and purchase for the year. mhhe.com/4fa25 Date Transaction Number of Unit Units Cost Total Cost Jan. 1 Beginning inventory 120 $20 $2,400 Aug. Purchase 15 180 15 2,700 Total 300 $5,100 Because of technological advances, NASCAR Unlimited has seen a decrease in the unit cost of its inventory. Throughout the year, the company maintained a selling price of $30 for each remote-control car and sold a total of 280 units, which leaves 20 units in ending inventory. Required: 1. Calculate cost of goods sold and ending inventory using the FIFO method. 2. Calculate cost of goods sold and ending inventory using the LIFO method. 3. Calculate cost of goods sold and ending inventory using the weighted-average cost method. Solution: 1. Cost of goods sold and ending inventory using the FIFO method: http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 16/22 2017/4/3 IEB Wireframe 2. Cost of goods sold and ending inventory using the LIFO method: 3. Page 277 Cost of goods sold and ending inventory using the weighted-average cost method: Suggested Homework: BE6-5, BE6-6; E6-4, E6-5; P6-1A&B, P6-2A&B bch_ha Effects of Inventory Cost Methods Effects of Inventory Cost Methods http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 17/22 2017/4/3 IEB Wireframe Companies are free to choose FIFO, LIFO, or weighted-average cost to report inventory and cost of goods sold. However, because inventory costs generally change over time, the reported amounts for ending inventory and cost of goods sold will not be the same across inventory reporting methods. These differences could cause investors and creditors to make bad decisions if they are not aware of differences in inventory assumptions. LO6-4 Explain the financial statement effects and tax effects of inventory cost methods. Illustration 6-10 compares the FIFO, LIFO, and weighted-average cost methods for Mario's Game Shop (assuming rising costs). (Recall from earlier discussion in this chapter that gross profit is a key measure of profitability, calculated as the difference between revenues and cost of goods sold.) ILLUSTRATION 6-10 Comparison of Inventory Cost Methods, When Costs Are Rising ILLUSTRATION 6-10 Comparison of Inventory Cost Methods, When Costs Are Rising FIFO LIFO WeightedAverage Balance sheet: Ending inventory $ 2,200 $ 1,600 $ 2,000 Sales revenue (800 $12,000$12,000 $15) $12,000 Income statement: Cost of goods sold Gross profit 7,800 8,400 8,000 $ 4,200 $ 3,600 $ 4,000 When inventory costs are rising, Mario's Game Shop will report both higher inventory in the balance sheet and higher gross profit in the income statement if it chooses FIFO. The reason is that FIFO assumes the lower costs of the earlier purchases become cost of goods http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 18/22 2017/4/3 IEB Wireframe sold first, leaving the higher costs of the later purchases in ending inventory. Under the same assumption (rising inventory costs), LIFO will produce the opposite effect: LIFO will report both the lowest inventory and the lowest gross profit. The weighted-average cost method typically produces amounts that fall between the FIFO and LIFO amounts for both cost of goods sold and ending inventory. Accountants often call FIFO the balance-sheet approach: The amount it reports for ending inventory (which appears in the balance sheet) better approximates the current cost of inventory. The ending inventory amount reported under LIFO, in contrast, generally includes \"old\" inventory costs that do not realistically represent the cost of today's inventory. FIFO has a balance-sheet focus. Accountants often call LIFO the income-statement approach: The amount it reports for cost of goods sold (which appears in the income statement) more realistically matches the current costs of inventory needed to produce current revenues. Recall that LIFO assumes the last purchases are sold first, reporting the most recent inventory cost in cost of goods sold. However, also note that the most recent cost is not the same as the actual cost. FIFO better approximates actual cost of goods sold for most companies, since most companies' actual physical flow follows FIFO. LIFO has an income-statement focus. Page 278 CAREER CORNER Many career opportunities are available in tax accounting. Because tax laws constantly change and are complex, tax accountants provide services to their clients not only through income tax statement preparation but also by formulating tax strategies to minimize tax payments. The choice of LIFO versus FIFO is one such example. Tax accountants need a thorough understanding of legal matters, business transactions, and the tax code. Large corporations increasingly are looking to hire individuals with both an accounting and a legal background in tax. For example, someone who is a Certified Public Accountant (CPA) and has a law degree is especially desirable in the job market. In addition, people in nonaccounting positions also benefit greatly from an understanding of tax accounting. Whether you work in a large corporation or own a small business, virtually all business decisions have tax consequences. http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 19/22 2017/4/3 IEB Wireframe BananaStock/JupiterImages, RF Decision Maker's Perspective FIFO or LIFO? Management must weigh the benefits of FIFO and LIFO when deciding which inventory cost flow assumption will produce a better outcome for the company. Here we review the logic behind that decision. Why Choose FIFO? Most companies' actual physical flow follows FIFO. Think about a supermarket, sporting goods store, clothing shop, electronics store, or just about any company you're familiar with. These companies generally sell their oldest inventory first (first-in, first-out). If a company wants to choose an inventory method that most closely approximates its actual physical flow of inventory, then for most companies FIFO makes the most sense. Another reason managers may want to use FIFO relates to its effect on the financial statements. During periods of rising costs, which is the case for most companies (including our example for Mario's Game Shop), FIFO results in a (1) higher ending inventory, (2) lower cost of goods sold, and (3) higher reported profit than does LIFO. Managers may want to report higher assets and profitability to increase their bonus compensation, decrease unemployment risk, satisfy shareholders, meet lending agreements, or increase stock price. FIFO matches physical flow for most companies. FIFO generally results in higher assets and higher net income when inventory costs are rising. Why Choose LIFO? If FIFO results in higher total assets and higher net income and produces amounts that most closely follow the actual flow of inventory, why would any company choose LIFO? The primary benefit of choosing LIFO is tax savings. LIFO results in the lowest amount of reported profits (when inventory costs are rising). While that might not look so good in the http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 20/22 2017/4/3 IEB Wireframe income statement, it's a welcome outcome in the tax return. When taxable income is lower, the company owes less in taxes to the Internal Revenue Service (IRS). LIFO generally results in greater tax savings. Can a company have its cake and eat it too by using FIFO for financial reporting and LIFO for the tax return? No. The IRS established the LIFO conformity rule, which requires a company that uses LIFO for tax reporting to also use LIFO for financial reporting. REPORTING THE LIFO DIFFERENCE As Mario's Game Shop demonstrates, the choice between FIFO and LIFO results in different amounts for ending inventory in the balance sheet and cost of goods sold in the income statement. This complicates the way we compare financial statements: One company may be using FIFO, while a competing company may be using LIFO. To determine which of the two companies is more profitable, investors must adjust for the fact that managers' choice of inventory method has an effect on reported performance. Because of the financial statement effects of different inventory methods, companies that choose LIFO must report the difference in the amount of inventory a company would report if it used FIFO instead of LIFO. (This difference is sometimes referred to as the LIFO reserve.) For some companies that have been using LIFO for a long time or for companies that have seen dramatic increases in inventory costs, the LIFO difference can be substantial. For example, Illustration 6-11 shows the effect of the LIFO difference reported by Rite Aid Corporation, which uses LIFO to account for most of its inventory. ILLUSTRATION 6-11 Impact of the LIFO Difference on Reported Inventory of Rite Aid Corporation ILLUSTRATION 6-11 Impact of the LIFO Difference on Reported Inventory of Rite Aid Corporation Page 279 If Rite Aid had used FIFO instead of LIFO, reported inventory amounts would have been $998 million greater and $1,019 million greater in 2015 and 2014, respectively. The magnitude of these effects can have a significant influence on investors' decisions. Decision Point Question Accounting information Analysis http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 21/22 2017/4/3 IEB Wireframe When The LIFO When inventory costs are comparing difference rising, FIFO results in a inventory reported in higher reported inventory. amounts the notes to The LIFO difference can be between two the financial used to compare inventory companies, statements of two companies if one does the choice uses FIFO and the other of inventory uses LIFO. method matter? CONSISTENCY IN REPORTING Companies can choose which inventory method they prefer, even if the method does not match the actual physical flow of goods. However, once the company chooses a method, it is not allowed to frequently change to another one.1 For example, a retail store cannot use FIFO in the current year because inventory costs are rising and then switch to LIFO in the following year because inventory costs are now falling. However, a company need not use the same method for all its inventory. International Paper Company, for instance, uses LIFO for its raw materials and finished pulp and paper products, and both FIFO and weighted-average cost for other inventories. Because of the importance of inventories and the possible differential effects of different methods on the financial statements, a company informs its stockholders of the inventory method(s) being used in a note to the financial statements. KEY POINT Generally, FIFO more closely resembles the actual physical flow of inventory. When inventory costs are rising, FIFO results in higher reported inventory in the balance sheet and higher reported income in the income statement. Conversely, LIFO results in a lower reported inventory and net income, reducing the company's income tax obligation. Page 280 INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) SHOULD LIFO BE ELIMINATED? LIFO is not allowed under IFRS because it tends not to match the actual physical flow of inventory. FIFO and weighted-average cost are allowable inventory cost methods under IFRS. This distinction will become increasingly important as the United States continues to consider whether to accept IFRS for financial reporting. Will LIFO eventually disappear as a permitted inventory cost flow method? Perhaps so . . . stay tuned. For more discussion, see Appendix E. http://textflow.mheducation.com/parser.php?secload=6.1&fake&print 22/22