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LEARNING OBJECTIVES Calculate the cost of goods sold and ending inventory using the specific identification, FIFO, LIFO, and weighted average methods. Contrast the effect of each on income determination, taxes, and cash flow during periods of inflation, deflation, and stable prices. Identify the source and effect of inventory ("fictitious") profits. Identify the effect of last-minute purchases on income determination. PROBLEM DATA Del Rio began Rio Enterprises on January 1 with 200 units of inventory. During the year, 500 additional units were purchased, 500 units were sold, and Del ended the year with 200 units. Del is very satisfied with his first year of business although the cost of replacing his inventory rose continually throughout the year. The 500 units sold for a total of $320,000 and the 500 units purchased to replace them cost $256,000, so his cash account has increased by $64,000. Del is concern however because has three obligations yet to meet: taxes, dividends, and his wife. Federal and state income taxes will take 40% of his income. His investors are to receive dividends equal to half of any income after taxes are paid. And finally, Del promised his wife a big trip to Hawaii if she let him quit his job as a professor and start his own business. He promised her he'd "make at least $50,000 after taxes. That will give us $25,000 after paying off the investors." Del kept fairly good records during the year and knows the specific cost of each inventory unit sold. He has prepared the following table to summarize his purchases and sales. Purchase Date Unit Quantity Unit Cost Total Cost Specific Units Sold Cost of Units Sold $ 400 $ 440 200 50 $ 80,000 22,000 480 200 100 50 200 150 500 $ 80,000 $ 44,000 24,000 104,000 84,000 256,000 520 560 Beginning Mar. 7 May 13 Aug. 28 Nov. 20 Total purchased Total available Sales Ending balance 200 50 104,000 28,000 700 $336,000 500 500 $234,000 200 54 A quick calculation shows that Rio's net income will be $51,600 using specific costs for the inventory sold. Sales minus cost of goods sold equals gross profit ($320,000 $234,000 = $86,000). Taxes to be paid are 40% ($86,000 .4 = $34,400). Subtract taxes from gross profit to get net income ($86,000 - $34,400 = $51,600). Next, Del calculates his ending cash balance. He currently has $64,000 from his sales less his inventory replacement purchases ($320,000 $256,000 = $64,000). He needs to pay taxes ($34,400) and dividends to his investors ($51,600 X.5 = $25,800). Subtracting $34,400 and $25,800 from $64,000 leaves him with only $3,800. Yikes! Del is shocked by the computations. He cannot figure out how he will ever explain to his wife that he has net income in excess of $50,000 and yet after paying off the investors he will have only $3,800 to show for it! Del knows you are taking an accounting class and comes to you for help. REQUIREMENT 1. Del has heard that the choice of an inventory cost flow assumption can have a significant effect on net income and taxes. He asks you to show him the differences between the specific identification method and the cost flow assumptions of FIFO, LIFO, and weighted average methods. Review the worksheet FIFOLIFO that follows these requirements. Note that all of the problem data have been entered in the Data Section of the worksheet. 2. Using a pencil, fill in columns F and G in the Data Section of the worksheet printout at the end of this problem. 3. Open the file FIFOLIFO from the website for this book at cengagebrain.com. Fill in columns F and G in the Data Section. Then enter all 14 formulas where indicated on the worksheet. Be careful to write FORMULAS 1 through 8 broadly enough to include different sales quantities (i.e., suppose all inventory was sold or no inventory was sold). Enter your name in cell A1. Save the results as FIFOLIFO3. Print the worksheet when done. Also print your formulas. Check figure: FIFO net income (cell E36), $56,400. 4. Examine your completed worksheet and answer the following questions: a. Which inventory cost flow assumption produces the most net income? b. Which inventory cost flow assumption produces the least net income? C. What caused the difference between your answers to a and b? d. Which inventory cost flow assumption produces the highest ending cash balance? 55 e. Which inventory cost flow assumption produces the lowest ending cash balance? f. Does the assumption that produces the highest net income also produce the highest cash balance? Explain. g. As you recall, Del originally used the specific identification method in his initial calculations when he projected $51,600 net income. According to Del's reckoning, that should have left him cash of $25,800 (50% of $51,600) after paying his investors. Why would he only have $3,800 left? Explain. h. Which inventory cost flow assumption would you suggest Del use? Explain. WHAT-IF ANALYSIS 5. What changes would have taken place if Del's purchase prices had fallen rather than risen? To find out, enter the following values in cells C11 through C14, respectively: 390, 380, 370, and 360. Print the results. Explain what the changes are and why they have taken place. 6. Suppose Del's purchase prices had remained constant. Enter 400 in cells C11 through C14. Explain what changes take place and why. 7. Reset the purchase prices to their original values (cells C11 through C14). Suppose Del had purchased 250 units on November 20 rather than 150. Enter 250 in cell C14 and alter column G in the Data Section. Explain what happens to net income under each inventory cost flow assumption and why. Also, what management implications might this have for Del? 56 8. Reset the November 20 purchase to 150 units, including column G. To test your formulas, suppose that Del had sold 600 units rather than 500. Sales now total $384,000. The extra units sold come from the May 13 purchase (25 units) and the November 20 purchase (75 units). Change cell B17 to 600 and cells D32 through G32 to $384,000. Alter columns E, F, and G in the Data Section to reflect the change. Your formulas should automatically redo the Calculations and Answer sections. Print the results again. CHART ANALYSIS 9. Click the Chart sheet tab. On the screen is a column chart showing ending inventory costs. During a deflationary period, which bar (A, B, or C) represents FIFO costing, which represents LIFO costing, and which represents weighted average? Explain your reasoning. When the assignment is complete, close the file without saving it again. TICKLERS (OPTIONAL) Worksheet. On January 4 following year-end, Rio Enterprises received a shipment of 60 units of product costing $580 each. These units had been ordered by Del in December and had been shipped to him on December 27. They were shipped FOB shipping point. Revise the FIFOLIFO3 worksheet to include this shipment. Preview the printout to make sure that the worksheet will print neatly on one page, and then print the worksheet. Save the completed file as FIFOLIFOT. Chart. Using the FIFOLIFO3 file, prepare a 3-D bar (stacked) chart showing the cost of goods sold and ending inventory under each of the four inventory cost flow assumptions. No Chart Data Table is needed. Use the values in the Calculations Section of the worksheet for your chart. Enter your name somewhere on the chart. Save the file again as FIFOLIFO3. Print the chart. 57 B D E F G 1 2 FIFOLIFO 3 Inventory Cost Flow Assumptions 4 5 Data Section 6 7 Specific FIFO LIFO 8 Purchase Unit Unit Total Units Units Units 9 Date Quantity Cost Cost Sold Sold Sold 10 Beginning Balance 200 $400 $80,000 200 11 Mar 7 100 $440 $44,000 50 12 May 13 50 480 24,000 13 Aug 28 200 520 104,000 200 14 Nov 20 150 560 84,000 50 15 Total purchased 500 256,000 16 Total available 700 $336,000 17 Sales 500 500 0 0 18 Ending balance 200 these totals must agree 19 with cell B17 20 21 Calculations 22 23 Specific ID FIFO LIFO Average 24 Cost of goods sold FORM1 FORM2 FORM3 FORM4 25 Ending inventory cost FORM5 FORM6 FORM7 FORM8 26 Total goods available $0 $0 $0 $0 27 these totals must agree with cell D16 28 Answer Section 29 30 Income Statement 31 Specific ID FIFO LIFO Average 32 Sales $320,000 $320,000 $320,000 $320,000 33 Cost of goods sold FORM9 FORM10 0 0 34 Gross profit FORM11 FORM12 $0 $0 35 Taxes (40%) FORM13 FORM14 0 0 36 Net income $0 $0 $0 $0 37 38 39 Cash Flow Analysis 40 Specific ID FIFO LIFO Average 41 Sales $320,000 $320,000 $320,000 $320,000 42 Less inventory replacement (256,000) (256,000) (256,000) (256,000) 43 $64,000 $64,000 $64,000 $64,000 44 Less taxes 0 0 0 0 45 Less dividends 0 0 0 0 46 Change in cash account $0 $0 $0 $0 47 48 B C D E F G . Ending Inventory Costs $120,000 $100,000 $80,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 $60,000 $40,000 $20,000 $0 A B 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 Chart Data Table A B 110000 80000 98000 LEARNING OBJECTIVES Calculate the cost of goods sold and ending inventory using the specific identification, FIFO, LIFO, and weighted average methods. Contrast the effect of each on income determination, taxes, and cash flow during periods of inflation, deflation, and stable prices. Identify the source and effect of inventory ("fictitious") profits. Identify the effect of last-minute purchases on income determination. PROBLEM DATA Del Rio began Rio Enterprises on January 1 with 200 units of inventory. During the year, 500 additional units were purchased, 500 units were sold, and Del ended the year with 200 units. Del is very satisfied with his first year of business although the cost of replacing his inventory rose continually throughout the year. The 500 units sold for a total of $320,000 and the 500 units purchased to replace them cost $256,000, so his cash account has increased by $64,000. Del is concern however because has three obligations yet to meet: taxes, dividends, and his wife. Federal and state income taxes will take 40% of his income. His investors are to receive dividends equal to half of any income after taxes are paid. And finally, Del promised his wife a big trip to Hawaii if she let him quit his job as a professor and start his own business. He promised her he'd "make at least $50,000 after taxes. That will give us $25,000 after paying off the investors." Del kept fairly good records during the year and knows the specific cost of each inventory unit sold. He has prepared the following table to summarize his purchases and sales. Purchase Date Unit Quantity Unit Cost Total Cost Specific Units Sold Cost of Units Sold $ 400 $ 440 200 50 $ 80,000 22,000 480 200 100 50 200 150 500 $ 80,000 $ 44,000 24,000 104,000 84,000 256,000 520 560 Beginning Mar. 7 May 13 Aug. 28 Nov. 20 Total purchased Total available Sales Ending balance 200 50 104,000 28,000 700 $336,000 500 500 $234,000 200 54 A quick calculation shows that Rio's net income will be $51,600 using specific costs for the inventory sold. Sales minus cost of goods sold equals gross profit ($320,000 $234,000 = $86,000). Taxes to be paid are 40% ($86,000 .4 = $34,400). Subtract taxes from gross profit to get net income ($86,000 - $34,400 = $51,600). Next, Del calculates his ending cash balance. He currently has $64,000 from his sales less his inventory replacement purchases ($320,000 $256,000 = $64,000). He needs to pay taxes ($34,400) and dividends to his investors ($51,600 X.5 = $25,800). Subtracting $34,400 and $25,800 from $64,000 leaves him with only $3,800. Yikes! Del is shocked by the computations. He cannot figure out how he will ever explain to his wife that he has net income in excess of $50,000 and yet after paying off the investors he will have only $3,800 to show for it! Del knows you are taking an accounting class and comes to you for help. REQUIREMENT 1. Del has heard that the choice of an inventory cost flow assumption can have a significant effect on net income and taxes. He asks you to show him the differences between the specific identification method and the cost flow assumptions of FIFO, LIFO, and weighted average methods. Review the worksheet FIFOLIFO that follows these requirements. Note that all of the problem data have been entered in the Data Section of the worksheet. 2. Using a pencil, fill in columns F and G in the Data Section of the worksheet printout at the end of this problem. 3. Open the file FIFOLIFO from the website for this book at cengagebrain.com. Fill in columns F and G in the Data Section. Then enter all 14 formulas where indicated on the worksheet. Be careful to write FORMULAS 1 through 8 broadly enough to include different sales quantities (i.e., suppose all inventory was sold or no inventory was sold). Enter your name in cell A1. Save the results as FIFOLIFO3. Print the worksheet when done. Also print your formulas. Check figure: FIFO net income (cell E36), $56,400. 4. Examine your completed worksheet and answer the following questions: a. Which inventory cost flow assumption produces the most net income? b. Which inventory cost flow assumption produces the least net income? C. What caused the difference between your answers to a and b? d. Which inventory cost flow assumption produces the highest ending cash balance? 55 e. Which inventory cost flow assumption produces the lowest ending cash balance? f. Does the assumption that produces the highest net income also produce the highest cash balance? Explain. g. As you recall, Del originally used the specific identification method in his initial calculations when he projected $51,600 net income. According to Del's reckoning, that should have left him cash of $25,800 (50% of $51,600) after paying his investors. Why would he only have $3,800 left? Explain. h. Which inventory cost flow assumption would you suggest Del use? Explain. WHAT-IF ANALYSIS 5. What changes would have taken place if Del's purchase prices had fallen rather than risen? To find out, enter the following values in cells C11 through C14, respectively: 390, 380, 370, and 360. Print the results. Explain what the changes are and why they have taken place. 6. Suppose Del's purchase prices had remained constant. Enter 400 in cells C11 through C14. Explain what changes take place and why. 7. Reset the purchase prices to their original values (cells C11 through C14). Suppose Del had purchased 250 units on November 20 rather than 150. Enter 250 in cell C14 and alter column G in the Data Section. Explain what happens to net income under each inventory cost flow assumption and why. Also, what management implications might this have for Del? 56 8. Reset the November 20 purchase to 150 units, including column G. To test your formulas, suppose that Del had sold 600 units rather than 500. Sales now total $384,000. The extra units sold come from the May 13 purchase (25 units) and the November 20 purchase (75 units). Change cell B17 to 600 and cells D32 through G32 to $384,000. Alter columns E, F, and G in the Data Section to reflect the change. Your formulas should automatically redo the Calculations and Answer sections. Print the results again. CHART ANALYSIS 9. Click the Chart sheet tab. On the screen is a column chart showing ending inventory costs. During a deflationary period, which bar (A, B, or C) represents FIFO costing, which represents LIFO costing, and which represents weighted average? Explain your reasoning. When the assignment is complete, close the file without saving it again. TICKLERS (OPTIONAL) Worksheet. On January 4 following year-end, Rio Enterprises received a shipment of 60 units of product costing $580 each. These units had been ordered by Del in December and had been shipped to him on December 27. They were shipped FOB shipping point. Revise the FIFOLIFO3 worksheet to include this shipment. Preview the printout to make sure that the worksheet will print neatly on one page, and then print the worksheet. Save the completed file as FIFOLIFOT. Chart. Using the FIFOLIFO3 file, prepare a 3-D bar (stacked) chart showing the cost of goods sold and ending inventory under each of the four inventory cost flow assumptions. No Chart Data Table is needed. Use the values in the Calculations Section of the worksheet for your chart. Enter your name somewhere on the chart. Save the file again as FIFOLIFO3. Print the chart. 57 B D E F G 1 2 FIFOLIFO 3 Inventory Cost Flow Assumptions 4 5 Data Section 6 7 Specific FIFO LIFO 8 Purchase Unit Unit Total Units Units Units 9 Date Quantity Cost Cost Sold Sold Sold 10 Beginning Balance 200 $400 $80,000 200 11 Mar 7 100 $440 $44,000 50 12 May 13 50 480 24,000 13 Aug 28 200 520 104,000 200 14 Nov 20 150 560 84,000 50 15 Total purchased 500 256,000 16 Total available 700 $336,000 17 Sales 500 500 0 0 18 Ending balance 200 these totals must agree 19 with cell B17 20 21 Calculations 22 23 Specific ID FIFO LIFO Average 24 Cost of goods sold FORM1 FORM2 FORM3 FORM4 25 Ending inventory cost FORM5 FORM6 FORM7 FORM8 26 Total goods available $0 $0 $0 $0 27 these totals must agree with cell D16 28 Answer Section 29 30 Income Statement 31 Specific ID FIFO LIFO Average 32 Sales $320,000 $320,000 $320,000 $320,000 33 Cost of goods sold FORM9 FORM10 0 0 34 Gross profit FORM11 FORM12 $0 $0 35 Taxes (40%) FORM13 FORM14 0 0 36 Net income $0 $0 $0 $0 37 38 39 Cash Flow Analysis 40 Specific ID FIFO LIFO Average 41 Sales $320,000 $320,000 $320,000 $320,000 42 Less inventory replacement (256,000) (256,000) (256,000) (256,000) 43 $64,000 $64,000 $64,000 $64,000 44 Less taxes 0 0 0 0 45 Less dividends 0 0 0 0 46 Change in cash account $0 $0 $0 $0 47 48 B C D E F G . Ending Inventory Costs $120,000 $100,000 $80,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 $60,000 $40,000 $20,000 $0 A B 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 Chart Data Table A B 110000 80000 98000