anthonyIM_06

CHAPTER 6COST OF SALES AND INVENTORIES

Changes from Eleventh Edition

Editorial and updated changes have been made.

Approach

This chapter can be assigned in two parts, if the instructor wishes to spend several sessions on these topics. The second assignment can begin with the section titled “Inventory Costing Methods.”

By now, students will have had to deduce cost of goods sold if they have tackled the cases in previous chapters. Nevertheless, for some students this deduction process is a difficult one to grasp, and it is important that it be understood. Also, the mechanics of flows through a manufacturing company are difficult to grasp. Students will encounter this topic again in Chapter 17, however, so it doesn’t matter too much if they don’t get it here. This is another one of the topics that seems to be mastered only after drill with a number of problems.

The choice between LIFO and FIFO also causes problems, perhaps because LIFO obviously does not match the physical flow of goods. It should perhaps be emphasized that, regardless of the conceptual merit of one method or the other, LIFO defers incomes taxes, and it defers them forever in an inflationary economy. The discussion also provides a way of highlighting the fact that accounting focuses on the measurement of income, even though the result is an unrealistic balance sheet (as is the case with LIFO inventories).

Cases

Browning Manufacturing Company requires recording a complete cycle of transactions in a manufacturing company. It is straightforward.

Lewis Corporation is a problem that contrasts FIFO and LIFO in a clear-cut way.

Morgan Manufacturing deals with the adjustment, comparison, and interpretation of financial statements for two firms, one prepared using LIFO and the other using FIFO.

Joan Holtz (B) is the second set of discrete problems, from which the instructor can select those he or she wants to discuss in class.

VAL Corporation deals with accounting for mileage programs.

Problems

Problem 6-1

The completed table is shown below. Each deduction involves the basic inventory equation.

Ending inventory = Beginning Inventory + Purchase – Shipments (COGS)

as well as the basic relationships inherent in any income statement, that is:,

Income = Revenues – Expenses

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Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant

Co. W Co. X Co. Y Co. Z

Sales.........................................................................................................................................................................................................$2,250 $1,800 $1,350 $2,100Cost of goods sold:..................................................................................................................................................................................

Beginning inventory...........................................................................................................................................................................300 225 500 300Plus: Purchases...................................................................................................................................................................................975 975 850 1,200Less: Ending inventory....................................................................................................................................................................... 225 300 300 150

Cost of good sold........................................................................................................................................................................... 1,050 900 1,050 1,350Gross margin...........................................................................................................................................................................................1,200 900 300 750Period expenses.......................................................................................................................................................................................300 400 150 800Net income (Loss)...................................................................................................................................................................................$ 900 $ 500 $ 150 $ (50)

Problem 6-2

The required income statement is reproduced below.

The closing entries are:

a. Beginning inventory balance is $50,000

b. dr. Inventory............................................................................................................................................................................................167,000cr. Purchases.......................................................................................................................................................................................167,000

c. dr. Inventory............................................................................................................................................................................................4,000cr. Freight-in.......................................................................................................................................................................................4,000

d. dr. Returns (to Suppliers)........................................................................................................................................................................8,000cr. Inventory........................................................................................................................................................................................8,000

e. dr. Cost of Goods Sold............................................................................................................................................................................135,500cr. Inventory.........................................................................................................................................................................................135,500

f. dr. Income Summary...............................................................................................................................................................................135,500cr. Cost of Goods Sold........................................................................................................................................................................135,500

g. dr. Income Summary...............................................................................................................................................................................95,000cr. Other Expenses..............................................................................................................................................................................95,000

h. dr. Tax expense........................................................................................................................................................................................28,350cr. Taxes Payable................................................................................................................................................................................28,350

i. dr. Sales...................................................................................................................................................................................................325,000cr. Income Summary...........................................................................................................................................................................325,000

j. dr. Income Summary...............................................................................................................................................................................28,350cr. Tax Expense...................................................................................................................................................................................28,350

GARDNER PHARMACYIncome Statement for the Year ----.

Sales.........................................................................................................................................................................................................$325,000Cost of goods sold:..................................................................................................................................................................................

Beginning inventory..........................................................................................................................................................................$ 50,000Plus: Purchase, gross.................................................................................................................................................................$167,000

Freight-in......................................................................................................................................................................... 4,000171,000

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©2007 McGraw-Hill/Irwin Chapter 6

Less: Purchase returns............................................................................................................................................................... 8,000Net purchases.................................................................................................................................................................................... 163,000Goods available for sale....................................................................................................................................................................213,000

Less: Ending inventory.............................................................................................................................................................. 77,500Cost of goods sold................................................................................................................................................................... 135,500

Gross margin...........................................................................................................................................................................................189,500Other expenses........................................................................................................................................................................................ 95,000Income before taxes................................................................................................................................................................................. 94,500Income tax expense................................................................................................................................................................................. 28,350Net income.............................................................................................................................................................................................. 66,150

Problem 6-3

a. dr. Inventory............................................................................................................................................................................................85,500cr. Cash (or Payables).........................................................................................................................................................................85,500

dr. Cash (or Receivables)........................................................................................................................................................................133,400cr. Sales...............................................................................................................................................................................................133,400

dr. Sales Returns......................................................................................................................................................................................1,840Inventory.............................................................................................................................................................................................1,200cr. Cash (or Receivables)....................................................................................................................................................................1,840

Cost of Goods Sold........................................................................................................................................................................1,200

b. GOULD’S COMPANYIncome Statement

Gross sales...............................................................................................................................................................................................$133,400Less: Sales returns............................................................................................................................................................................ 1,840

Net sales.....................................................................................................................................................................................$131,560Cost of goods sold............................................................................................................................................................................. 85,800Gross margin.....................................................................................................................................................................................$ 45,760

c. The perpetual inventory records indicate ending inventory should have been 673 + 5,700 – 5,800 + 80 = 653 units. Inventory shrinkage has therefore been 653 – 610 = 43 units.

dr. Inventory Shrinkage...........................................................................................................................................................................645cr. Inventory........................................................................................................................................................................................645

The inventory shrinkage entry reduces gross margin by $645 (or shrinkage could be shown below the gross margin line as a general expense).

Problem 6-4

Purchases:50 units @ $14 = $ 700

75 units @ $12 = 900Avg: 125 units @ $12.80 = $1,600

Sales: 100 unitsEnding inventory: 25 units

Avg. Cost Fifo LifoJuly 31 inventory.....................................................................................................................................................................................$ 320 $ 300 $ 350Cost of goods sold................................................................................................................................................................................... 1,280 1,300 1,250

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Available for sale..................................................................................................................................................................................... 1,600 1,600 1,600

Problem 6-5

Fifo Av. Cost Lifoa. Sales.........................................................................................................................................................................................................$52,125 $52,125 $52,125

Cost of goods sold................................................................................................................................................................................... 27,310 27,053 26,960Gross margin...........................................................................................................................................................................................$24,815 $25,072 $25,165

Fifo Av. Cost Lifob. Gross margin percentage.........................................................................................................................................................................47.6% 48.1% 48.3%c. Net cash flow = $21,465 ($52,125 - $30,660)

No change in pretax cash flow figure using different inventory methods.

d. Fifo Av. Cost LifoPretax cash flow......................................................................................................................................................................................$21,465 $21,465 $21,465Tax payment............................................................................................................................................................................................ 7,445 7,522 7,550After-tax cash flow..................................................................................................................................................................................$14,020 $13,943 $13,915

The tax payment in 30 percent of the gross margin dollars. The cash flow using Fifo for tax purposes is the lowest of the three after tax cash flow amounts because the unit cost of computers is falling, producing the highest taxable gross margin of the three methods.

Problem 6-6

a. Ending inventory balances are:

Materials Inventory

Work in Process

Finished Goods

Beginning balance...................................................................................................................................................................................$ 100,000 $ 370,000 $ 60,000(1) Purchases.................................................................................................................................................................................................872,000

Delivery charge.......................................................................................................................................................................................22,000(2) Direct labor..............................................................................................................................................................................................565,000(3) Materials transfer.....................................................................................................................................................................................(900,000) 900,000(4) Indirect labor...........................................................................................................................................................................................27,000

Factory supplies.......................................................................................................................................................................................46,000Depreciation–factory...............................................................................................................................................................................54,000Factory utilities........................................................................................................................................................................................147,000Depreciation–Mfg...................................................................................................................................................................................46,000Property taxes..........................................................................................................................................................................................14,000

(5) Finished goods–transfers.........................................................................................................................................................................________ (2,035,000) 2,035,000$ 94,000 134,000 2,095,000

Cost of goods sold................................................................................................................................................................................... -- -- (2,002,000)Ending balance........................................................................................................................................................................................$ 94,000 $ 134,000 $ 93,000

b. Gross margin was 23 percent.Sales.........................................................................................................................................................................................................$2,600,000Cost of goods sold................................................................................................................................................................................... 2,002,000Gross margin...........................................................................................................................................................................................$ 598,000

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Problem 6-7

Item Units Valuation Basis/Unit

Historical Cost/Unit

Total Adjustment

A 30 $145 $150 $150B 40 173 183 400C 20 131 134 60D 40 113 113 0

Total adjustment $610

Cases

Case 6-1: Browning Manufacturing Company *

Note: This case is updated from the Eleventh Edition.

Approach

This is a straightforward complete accounting cycle in a manufacturing company, although it is considerably longer than previous cases of the same type. Students may find it helpful to refer back to the journal entries described in the text as a guide. Tracing through these entries is intended to give the student an understanding of what goes on in a manufacturing company and how these events are reflected in the accounts. I make a concerted attempt to link the problem’s numbers to Illustrations 6-3 and 6-4 in the text, placing the T-accounts side-by-side (if board space permits) and using arrows to denote flows from one inventory account to another.

Simply because of its length, two days may be necessary for this case. In any event, it is desirable that some time be left for Question 3, which asks the students to use the information they have built up.

In effect, this case is a miniature practice set and can be treated as such if desired. It is a key case.

Comments on Questions

Question 1

1. Accounts Receivable...............................................................................................................................................................................2,562,000Sales (Retained Earnings).................................................................................................................................................................2,562,000

Sales Returns and Allowances (R/E).......................................................................................................................................................19,200Accounts Receivable.........................................................................................................................................................................19,200

Sales Discounts (R/E)..............................................................................................................................................................................49,200Accounts Receivable.........................................................................................................................................................................49,200

2. (a) Manufacturing Plant Equipment.............................................................................................................................................................144,000Cash...................................................................................................................................................................................................144,000

Prepaid Taxes and Insurance...................................................................................................................................................................78,000Cash...................................................................................................................................................................................................78,000

Materials Inventory.................................................................................................................................................................................825,000Accounts Payable..............................................................................................................................................................................825,000

Supplies Inventory...................................................................................................................................................................................66,000Accounts Payable..............................................................................................................................................................................66,000

*This Teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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(b) Direct Manufacturing Labor....................................................................................................................................................................492,000Indirect Manufacturing Labor ................................................................................................................................................................198,000Social Security Taxes..............................................................................................................................................................................49,200Power, Heat, and Light............................................................................................................................................................................135,600

Cash...................................................................................................................................................................................................874,800

Since in a manufacturing company, inventory is assumed to increase in value by the amounts spent to convert materials into salable products, the following entry should be made; or the debit entry above could have been made to Work in Process Inventory directly, as is done in the T-accounts to follow.

Work in process inventory......................................................................................................................................................................874,800Direct Manufacturing Labor.............................................................................................................................................................492,000Indirect Manufacturing Labor...........................................................................................................................................................198,000Social Security Taxes........................................................................................................................................................................49,200Power, Heat, and Light......................................................................................................................................................................135,600

(c) Selling and Administrative Expense (R/E).............................................................................................................................................522,000Cash...................................................................................................................................................................................................522,000

3. Work in Process Inventory......................................................................................................................................................................140,400Accumulated Depreciation................................................................................................................................................................140,400

Work in Process Inventory......................................................................................................................................................................52,800Prepaid Taxes and Insurance.............................................................................................................................................................52,800

Work in Process Inventory......................................................................................................................................................................61,200Supplies Inventory............................................................................................................................................................................61,200

Work in Process Inventory......................................................................................................................................................................811,000Materials Inventory...........................................................................................................................................................................811,000

4. Finished Goods Inventory.......................................................................................................................................................................1,901,952Work in Process Inventory................................................................................................................................................................1,901,952

5. Cost of Goods Sold (R/E)........................................................................................................................................................................1,806,624Finished Goods Inventory.................................................................................................................................................................1,806,624

6. Cash.........................................................................................................................................................................................................264,000Notes Payable....................................................................................................................................................................................264,000

Notes Payable..........................................................................................................................................................................................300,000Cash...................................................................................................................................................................................................300,000

Interest Expense (R/E).............................................................................................................................................................................38,400Cash...................................................................................................................................................................................................38,400

7. Cash ........................................................................................................................................................................................................2,604,000Accounts Receivable.........................................................................................................................................................................2,604,000

8. Accounts Payable....................................................................................................................................................................................788,400Cash...................................................................................................................................................................................................788,400

Income Taxes Payable (2005).................................................................................................................................................................9,000Cash...................................................................................................................................................................................................9,000

9. Estimated Federal Income Taxes Expense (R/E) (2006)....................................................................................................................................................................................................

58,000

Income taxes payable (2006)............................................................................................................................................................5,800Cash...................................................................................................................................................................................................52,200

10. Dividends (Retained Earnings)...............................................................................................................................................................30,000Cash...................................................................................................................................................................................................30,000

Question 2 (see pages 102 - 104.)

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Question 3

1. Net sales are expected to increase 11.6 percent.

2. Gross profit margin is expected to decrease slightly from 29.8 percent of net sales in 2005 to 27.5 percent in 2006.

3. There is a l9.4 percent increase in selling and administrative expenses. This seems high, relative to the sales increase; perhaps R&D expense in increasing.

4. The net effect of the foregoing is an anticipated decrease in profit before taxes. Profit would be increased by judicious reductions in the anticipated selling and administrative expense, or by actions to restore (or improve) the gross margin percentage.

5. It is expected that more funds will be tied up in inventories. Inventory turnover in 2005 was 2.82 times; it is projected at 2.55 times for 2006. Why the slowdown (about 13 days’ increase)?

Cash Accounts Receivable (Net)Bal. 118,440 (2) 144,000 Bal. 311,760 (1) 19,200(6) 264,000 (2) 78,000 (1) 2,562,000 (1) 49,200(7) 2,604,000 (2) 874,800 (7) 2,604,000

(2) 522,000 ________ Bal. 201,360(6) 300,000 2,873,760 2,873,760(6) 38,400 Bal. 201,360(8) 788,400(8) 9,000 Work in Process Inventory(9) 52,200 Bal. 172,200 (1) 1,901,952

(10) 30,000 (2) 874,800 Bal. 210,448________ Bal. 149,640 (3) 140,4002,986,440 2,986,440 (3) 52,800

Bal. 149,640 (3) 61,200(3) 811,000 ________

Materials Inventory 2,112,400 2,112,400Bal. 110,520 (3) 811,000 Bal. 210,448(2) 825,000 Bal. 124,520

935,520 935,520 Supplies InventoryBal. 124,520 Bal. 17,280 (3) 61,200

(2) 66,000 Bal. 22,080Finished Goods Inventory 83,280 83,280

Bal. 257,040 (5) 1,806,624 Bal. 22,080(4) 1,901,952 Bal. 352,368

2,158,992 2,158,992 Manufacturing PlantBal. 352,368 Bal. 2,678,400 Bal. 2,822,400

(2) 144,000 ________Prepaid Taxes and Insurance 2,822,400 2,822,400

Bal. 66,720 (3) 52,800 Bal. 2,822,400(2) 78,000 Bal. 91,920

144,720 144,720 Notes PayableBal. 91,920 (6) 300,000 Bal. 288,840

Bal. 252,840 (6) 264,000Accumulated Depreciation 552,840 552,840

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Bal. 1,047,600 Bal. 907,200 Bal. 252,840________ (3) 140,4001,047,600 1,047,600 Fed. Inc. Taxes Payable

Bal. 1,047,600 (8) 9,000 Bal. 9,000Bal. 5,800 (9) 5,800

14,800 14,800Bal. 5,800

Accounts Payable Retained Earnings(8) 788,400 Bal. 185,760 (1) 19,200 Bal. 829,560Ba1. 288,350 (2) 825,000 (1) 49,200 (1) 2,562,000

________ (2) 66,000 (2) 522,0001,076,760 1,076,760 (5) 1,806,624

Bal. 288,360 (6) 38,400(9) 58,000

Capital Stock (10) 30,000Bal. 1,512,000 Bal. 868,136 ________

3,391,560 3,391,560Bal. 868,136

6. It is planned to reduced notes payable. Whether this is wise may depend on the notes payable interest vis-à-vis the return being earned on marketable securities.

7. Additions to plant are slightly greater than depreciation expense. This is not unusual in an inflationary era.

8. The accounts receivable balance will decline by about 35 percent even though there is an expected increase in sales. Is the collection department being overly optimistic about collections on account?

BROWNING MANUFACTURING CORPORATIONProjected Balance Sheet as of December 2006

AssetsCurrent Assets

Cash and marketable securities.........................................................................................................................................................$ 449,640Accounts receivable (net).................................................................................................................................................................201,360Inventories:.......................................................................................................................................................................................

Materials.....................................................................................................................................................................................$124,520Work in process..........................................................................................................................................................................210,448Finished goods............................................................................................................................................................................352,368Supplies...................................................................................................................................................................................... 22,080 709,416

Prepaid taxes and insurance.............................................................................................................................................................. 91,920Total current assets.....................................................................................................................................................................$1,452,336

Manufacturing plant..........................................................................................................................................................................2,822,400Less: Accumulated depreciation................................................................................................................................................( 1,047,600) 1,774,800

Total assets...........................................................................................................................................................................$2,927,136Liabilities and Shareholders’ Equity

Current liabilitiesAccounts payable $ 288,360

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Notes payable 252,840Income taxes payable 5,800

Total current liabilities $ 547,000Shareholders’ equity:

Capital stock 1,512,000Retained earnings 868,136 2,380,136

Total Liabilities and Shareholders’ Equity $2,927,136

BROWNING MANUFACTURING CORPORATIONProjected 2006 Income Statement

Sales.........................................................................................................................................................................................................$2,562,000Less: Sales returns and allowances...................................................................................................................................................$19,200

Sales discount allowed............................................................................................................................................................ 49,200 68,400Net sales..................................................................................................................................................................................................2,493,600

Less: Cost of goods sold (per schedule)........................................................................................................................................... 1,806,624Gloss margin............................................................................................................................................................................................686,976

Less: Selling and administrative expense......................................................................................................................................... 522,000Operating income....................................................................................................................................................................................164,976

Less: Interest expense.......................................................................................................................................................................$ 38,400Income before federal income tax...........................................................................................................................................................126,576

Less: Estimated income tax expense................................................................................................................................................ 58,000Net income..............................................................................................................................................................................................$ 68,576

BROWNING MANUFACTURING CORPORATIONProjected 2006 Statement of Cost of Goods Sold

Finished goods inventory, 1/1/06............................................................................................................................................................$ 257,040Work in process inventory, 1/1/06..........................................................................................................................................................$ 172,200Materials inventory, l/1/06......................................................................................................................................................................$110,520

Plus: Purchases................................................................................................................................................................................. 825,000935,520

Less: Materials inventory 12/31/06.................................................................................................................................................. 124,520Materials used .........................................................................................................................................................................................811,000

Plus: Factory expenses:.....................................................................................................................................................................Direct manufacturing labor........................................................................................................................................................492,000

Factory overhead:.............................................................................................................................................................................Indirect manufacturing labor......................................................................................................................................................$198,000Power, heat, and light.................................................................................................................................................................135,600Depreciation of plant..................................................................................................................................................................140,400Social security taxes...................................................................................................................................................................49,200Taxes and insurance, factory...................................................................................................................................................... 52,800Supplies...................................................................................................................................................................................... 61,200 637,200

2,112,400Less: Work in process inventory, 12/31/06...................................................................................................................................... 210,448

Cost of goods manufactured.......................................................................................................................................................... 1,901,9522,158,992

Less: Finished goods inventory, 12/31/06........................................................................................................................................ 352,368

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Cost of goods sold...................................................................................................................................................................................$1,806,624

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Case 6-2: Lewis Corporation *

Note: Updated from Eleventh Edition.

Approach

We have found it useful for students to perform some comparative FIFO/LIFO average cost calculations, rather than only read about the differences among these methods. This case presents that opportunity, with an emphasis on the income tax—hence, cash flow—implications of the choice of a method. Via Question 3, the student can see the impact of a sales decline causing a “stripping off” of LIFO layers with the result that LIFO reports a lower cost of goods sold, and thus would result in higher income taxes that year, than would FIFO.

Question 4 introduces the significance of the LIFO reserve. Students can discover that the LIFO reserve is useful in analyzing financial statements. It can be used to estimate the cumulative tax savings realized by adopting LIFO; and when trying to compare the financial performance of a company using LIFO to another using FIFO, the LIFO reserve can be used to adjust the LIFO financial statements to a FIFO basis. This adjustment will be explored in more detail in Case 6-3

Finally, Question 5 presents the opportunity to challenge the widely held notion that almost all companies use LIFO (the instructor can update the text footnote on LIFO usage by referring to the latest edition of Accounting Trends & Techniques and to discuss the reasons for many companies’ use of FIFO. For those who wish to do so, this discussion can bring in the Efficient Markets Hypothesis. In our view, one reason some companies continue to use FIFO in circumstances when LIFO would improve cash flows is that their managements do not believe that EMH premise that the lower reported earnings from LIFO would not diminish shareholder value.

Calculations for Questions

Question 1

The approach below reflects how most students perform these calculations. At some point I show them (to their chagrin) that a lot of effort can be saved if the amount of each year’s purchases is calculated first, and then the equation Beg. Invent + Purchases = COGS + End Invent. is applied year-by-year. With the more detailed approach students take, class time allows showing only a couple of years for FIFO and LIFO, and one year for average cost.

2005FIFO: COGS 1,840 @ $20.00 = $36,800.00

600 @ 20.25 = 12,150.00 380 @ 21.00 = 7,980.002,820 @ $56,930.00

Inventory 420 @ 21.00 = 8,820.00400 @ 21.25 = 8,500.00

200 @ 21.50 = 4,300.001,020 $21,620.00

LIFO: COGS 200 @ $21.50 = $4,300.00400 @ 21.25 = 8,500.00800 @ 21.00 = 16,800.00600 @ 20.25 = 12,150.00

*This Teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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820 @ 20.00 = 16,400.002,820 $58,150.00

Inventory 1,020 @ 20.00 = $20,400.00

AVERAGE COST: COGS 2,820 @ $20.456 = $57,685.92

Inventory 1,020 @ 20.456 = $20,865.12Note in all three cases that the sum of the cost of goods sold and ending inventory amounts is the same: $78,550 (slightly different with average cost because of rounding errors), which is the sum of the beginning inventory and purchases (i.e., available for sale).

2006FIFO: COGS 420 @ $ 21.00 = $ 8,820.00

400 @ 21.25 = 8,500.00200 @ 21.50 = 4,300.00700 @ 21.50 = 15,050.00700 @ 21.50 = 15,050.00

660 @ 22.00 = 14,520.003,080 $66,240.00

Inventory 40 @ 22.00 = $ 880.001,000 @ 22.25 = 22,250.001,040 @ $23,130.00

LIFO: COGS 1,000 @ $ 22.25 = $22,250.00700 @ 22.00 = 15,400.00700 @ 21.50 = 15,050.00

680 @ 21.50 = 14,620.003,080 $67,320.00

Inventory 20 @ $ 21.50 = $ 430.001,020 @ 20.00 = 20,400.001,040 @ 20.00 = $20,830.00

AVERAGE COST: COGS 3,080 @ $21.509 = $66,247.72

Inventory 1,040 @ 21.509 = $22,369.36

2007FIFO: COGS 40 @ $ 22.00 = $ 880.00

1,000 @ 22.25 = 22,250.001,000 @ 22.50 = 22,500.00

700 @ 22.75 = 15,925.00 210 @ 23.00 = 4,830.002,950 $66,385.00

Inventory 490 @ 23.00 = $11,270.00 700 @ 23.50 = 16,450.001,190 $27,720.00

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LIFO: COGS 700 @ $23.50 = $16,450.00700 @ 23.00 = 16,100.00700 @ 22.75 = 15,925.00

850 @ 22.50 = 19,125.002,950 $67,600.001,020 @ 20.00 = $20,400.00

Inventory 20 @ 21.50 = 430.00 150 @ 22.50 = 3,375.00

1,190 $24,205.00AVERAGE COST: COGS 2,950 @ $22.547 = $66,513.65

Inventory 1,190 @ 22.547 = $26,830.93

Check on CalculationsFIFO LIFO AVG.COST

COGS 2005 $ 56,930 $ 58,150 $ 57,685.922006 66,240 67,320 66,247.722007 66,385 67,600 66,513.65

Inventory 2007 27,720 24,205 26,830.93$217,275 $217,275 $217,278.22

Question 2

The calculation of the $1,406 tax difference for 2005-07 is shown below. However, this difference is really irrelevant for deciding what to do in future years.

FIFO LIFO2005 Sales.........................................................................................................................................................................................................$95,880 $95,880

COGS...................................................................................................................................................................................................... 56,930 58,150Gross Margin...........................................................................................................................................................................................38,950 37,730Tax Expense............................................................................................................................................................................................ 15,580 15,092Net Income..............................................................................................................................................................................................$23,370 $22,638

2006 Sales.........................................................................................................................................................................................................$110,110 $110,110COGS...................................................................................................................................................................................................... 66,240 67,320Gross Margin...........................................................................................................................................................................................43,870 42,790Tax Expense............................................................................................................................................................................................ 17,548 17,116Net Income..............................................................................................................................................................................................$ 26,322 $ 25,674

2007 Sales.........................................................................................................................................................................................................$105,462.50 $105,462.50COGS...................................................................................................................................................................................................... 66,385.00 67,600.00Gross Muffin...........................................................................................................................................................................................39,077.50 37,862.50Tax Expense............................................................................................................................................................................................ 15,631.00 15,145.00Net Income .............................................................................................................................................................................................$ 23,446.50 $ 22,717.50

Total Tax Expense Savings:2005 $ 4882006 4322007 486

$1,406

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An easier approach, which most students will overlook, is to note that the three-year difference in COGS is $3,515, and 40 percent of this is $1,406. Even easier, but much more subtle, is realizing that the three-year COGS difference is equal to the difference in 2007 year-end inventories ($27,720 - $24,205 = $3,515).

Question 3

Purchases for 2008 forecasted at 1,910* cartons @ 24.00

FIFO COGS 490 @ $23.00 = $11,270700 @ 23.50 = 16,450

1,510 @ 24.00 = 36,2402,700 $63,960

Inventory 400 @ $24.00 = $9,600

LIFO: COGS 1,910 @ $24.00 = $45,840150 @ 22.50 = 3,37520 @ 21.50 = 430

620 @ 20.00 = 12,4002,700 $62,045

Inventory 400 @ 20.00 = $8,000

FIFO LIFO2008 Sales (2,700 @ $35.75)..................................................................................................................................................................$96,525 $96,525

COGS................................................................................................................................................................................................ 63,960 62,045Gross margin.....................................................................................................................................................................................32,565 34,480Tax expense ..................................................................................................................................................................................... 13,026 13,792Net income .......................................................................................................................................................................................$19,539 $20,688

In 2008, LIFO would cause an increase in tax expense of $766.

Question 4

The LIFO reserve is the difference between inventory calculated under the FIFO method, and inventory calculated under the LIFO method.

LIFO Reserve = FIFO Inventory - LIFO Inventory2005 $1,220 = $21,620 - $20,4002006 $2,300 = $23,130 - $20,830

Another way to look at the LIFO reserve is that it represents the cumulative difference between LIFO cost of goods sold and FIFO cost of goods sold. We can see that in 2005, the LIFO reserve ($1,220) is equal to the difference between LIFO cost of goods sold and FIFO cost of goods sold ($58,150 - $56,930 = $1,220). Similarly, in 2000, the LIFO reserve ($2,300) is equal to the sum of the differences between LIFO and FIFO cost of goods sold for 2005 and 2000, as shown on the next page.

*2,700 sales + 400 ending inventory - 1,190 beginning inventory = 1,910.

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2005 2006LIFO cost of goods sold..........................................................................................................................................................................$58,150 $67,320FIFO cost of goods sold..........................................................................................................................................................................56,930 66,240Difference................................................................................................................................................................................................$ 1,220 + $ 1,080 = $2,300

Therefore, if you are given LIFO cost of goods sold and inventory, and you are also given the LIFO reserve for that year (year X) and the previous year (year X-1), you can estimate the following:

FIFO inventory (year X) = LIFO inventory (year X) + LIFO reserve (year X)FIFO COGS (year X) = LIFO COGS (year X) - [LIFO reserve (year X) - LIFO reserve (year X-l)] Tax savings (year X) = [LIFO reserve (year X) - LIFO reserve (year X-1)] *(1 – tax rate)Cumulative tax savings due to the use of LIFO = LIFO reserve (year X)

Most companies on LIFO report the LIFO reserve in their financial statements, often in the inventory footnote. Understanding the significance of the LIFO reserve can be very useful when trying to compare the financial performance of companies using different inventory accounting methods.

Question 5

See “Why More LIFO?” section of the text, plus comments earlier in this note.

Case 6-3: Morgan Manufacturing *

Note: Updated from Eleventh Edition.

Morgan Manufacturing is a straightforward case to illustrate how information on the LIFO Reserve can be used to adjust the results of a company on LIFO to make them more comparable to those of a company on FIFO. This case extends the learning developed in question 4 of Case 6-2, Lewis Corporation. Morgan Manufacturing may not require a full class for discussion, and the instructor may want to assign it in conjunction with Lewis Corporation.

Answers to questions:

1. Westwood’s gross margin percentage = $900 divided by $2,000 = 45%; pretax return on sales = $300 divided by $2,000 = 15%; pretax return on assets = $300 divided by $2,240 = 13.4%.

2. Students will quickly recognize that both the inventory and the cost of goods sold accounts are affected. You are likely, however, to have to guide them to recognize what other accounts and financial items are also affected. For example, if inventory is affected, then some other balance sheet account must be affected to keep the balance sheet balanced. Students will likely conclude it must be retained earnings or owners’ equity. If cost of goods sold is affected, then clearly items such as gross margin, pretax net income, tax expense and net income will also be affected. Typically, assuming the norm of continuing inflation and growing inventory, LIFO produces higher cost of goods sold and lower inventory, owners’ equity, gross margin, pretax net income, tax expense, and net income than FIFO. It is possible, therefore, for two companies to have identical underlying economic performance, but the financial measures of performance of the firm using the LIFO method will look worse than the financial measures of the firm using the FIFO method (or the underlying economic performance of the LIFO firm might be even better than that of the FIFO firm, and the LIFO firm’s financial measures can still look worse!).

3. Adjustment to 2006 inventory: $100 LIFO inventory + $70 LIFO reserve = $170 FIFO inventory.

*This teaching note was prepared by Julie H. Hertenstein. Copyright © Julie H. Hertenstein.

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Adjustment to 2006 total assets: $2,170 + $70 = $2,240

Amount to adjust COGS: $70 2006 LIFO reserve-10 2005 LIFO reserve$60 Difference between 2006 LIFO and FIFO COGS

Adjustment to 2006 COGS: $1,110 - $60 = $1,050

Adjustment to 2006 gross margin: $890 + $60 = $950

Adjustment to 2006 pretax net income: $290 + $60 = $350

Adjusted gross margin percentage = $950 divided by $2,000 = 47.5%

Adjusted pretax return on sales $350 divided by $2,000 = 17.5%

Adjusted pretax return on assets $350 divided by $2,240 = 15.6%

4. Once adjusted to FIFO, Morgan’s performance exceeds Westwood’s on each of the three measures, as shown in Exhibit 1. In addition, Morgan has paid less in taxes than Westwood.

Pedagogical Approach

You can begin with a general discussion of why we often want to compare the financial performance of different companies and how our ability to compare companies is affected by the different accounting choices that they make; this issue, of course, is much broader than simply the choice of LIFO or FIFO. In Chapter 5, students encountered different revenue recognition choices which produce different financial results for the same underlying economic events. When firms choose different inventory accounting methods, these affect financial measures, as well. When trying to compare one company on LIFO with another on FIFO, one is trying to compare “apples and oranges.” For purposes of comparison, you would like to get the companies on a common basis. The LIFO reserve, which is frequently available in the inventory footnote or elsewhere in the annual report of a firm using LIFO, allows you to make adjustments to achieve a common basis for comparison.

The three key measures for Morgan are given in the case. You can write them on the board, and put up Westwood’s for comparison when students answer question 1, as shown in the first two lines of Exhibit 1.

As indicated in the answer to question 2, you may need to draw students out on which accounts and measures will be affected by the choice of inventory accounting method, and how this choice affects the financial statement reader’s ability to compare the two companies.

Before proceeding to the calculations in question 3, you may wish to first discuss, conceptually, how you can adjust results to make them more comparable. The first point regarding the adjustments is that you have LIFO reserve information, (and since there is not an analogous FIFO reserve), you must adjust the LIFO company to a FIFO basis. Since the LIFO reserve is the difference between the LIFO and FIFO inventory, it can be used directly to adjust inventory, and similarly, it is also the adjustment to total assets; a comparable adjustment can be made to owners’ equity to keep the balance sheet in balance. The LIFO reserve represents not only the difference between LIFO and FIFO inventory, but also the cumulative difference between LIFO and FIFO cost of goods sold. Thus, the LIFO reserve for two consecutive years can be used to compute the difference between LIFO and FIFO cost of goods sold for the more recent of the two years, which allows you to make adjustments to the income statement as well.

You may want to raise the issue of what to do if you want to compare after-tax results, instead of the pretax measures that the case suggests. Some students may want to adjust the tax expense of the LIFO firm, for example, using the same ratio of tax expense to pretax net income as shown on the LIFO income

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statement. Others may argue that the tax expense should be unchanged, reflecting the fact that the LIFO company paid lower taxes due to its choice of the LIFO inventory accounting method, a true economic difference between the two firms.

Following the conceptual discussion, the actual calculations can be examined and the results posted on the board, as shown in Exhibit 1. From these results, students will quickly observe that Morgan’s performance was better on all three measures. They may also conclude that the productivity improvements that Charles Crutchfield had implemented were, indeed, reflected in Morgan’s financial performance measures.

Exhibit 1

Gross Margin % Pretax Return on Sales Pretax Return on AssetsMorgan (LIFO)........................................................................................................................................................................................44.5% 14.5% 13.4%Westwood (LIFO)...................................................................................................................................................................................45.0% 15.0% 13.4%Morgan (Adjusted)..................................................................................................................................................................................47.5% 17.5% 15.6%

Case 6-4: Joan Holtz (B) *

Note: In discussing some of these questions. it may be useful to construct simple numerical examples, perhaps related to the illustrations in the text. Joan Holtz (B) is an extension of Joan Holtz (A) in Chapter 5. The case is unchanged from the Eleventh Edition.

1. The ultimate effect, over the life of an entity, is the same under all three methods. For a given accounting period, however, the methods result in different net income. If purchase discounts are deducted from purchases, they reduce the net purchase costs, and affect net income in the period in which the goods are sold. If reported as other income of the period, they affect net income in an earlier period than in the first method. If discounts not taken are recorded as an expense, cost of goods sold reflects the full amount of the discount, and discounts not taken decrease income in what is perhaps a later period.

Another difference is that cost of goods sold, and hence the gross margin percentage, differs under each of these methods.

Of course, the amounts involved are usually small, so the above differences often are not material

2. There should be a credit to Inventory, to reduce it to the amount found from the physical inventory. The debit may be either to Cost of Goods Sold or to an operating expense item. Literally, the shrinkage cost could not have been a cost of the goods that actually were sold, for these goods were not sold. The practice of debiting of Cost of Goods Sold is often followed, however. For management purposes, it is desirable to identify the amount of shrinkage, wherever it is reported.

3. It is incorrect to say that the LIFO method “assumes” anything about the physical flow of the goods. LIFO advocates know that physically the goods tend to move on a FIFO basis. LIFO is based on a belief about economic flows, as explained in the text.

4. In the examples given, the economics of the operations of the automobile dealer are best reflected by the FIFO method (or even better by the specific identification method, which probably approximates FIFO), and the economics of the operations of the hardware dealer are best reflected by the LIFO method. Even so, the automobile dealer would not necessarily be wrong to use LIFO; it might regard the income tax savings as being more important than a correct showing of economic income.

*This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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5. a. This generalization is valid.

b. This generalization is usually valid, as indicated in the text. However, any such generalization about LIFO may not be valid if the physical size of the inventory is reduced so that the original “LIFO layers” are carried to Cost of Goods Sold.

c. Assuming that income tax rates remain unchanged, and that the physical size of the inventory remains unchanged, and disregarding the present value of money, this generalization is valid.

6. Although the LIFO inventory as a whole will normally be reported at less than current costs, it can easily happen that individual items are worth less than their LIFO cost because of obsolescence or damage. These items should be written down.

7. Since there would be no additional revenue for four years, and since barrels, warehousing costs, and interest are charged to expense, profit would be reduced by the amount of these additional costs. In the first full year, these amounts of 200,000 additional gallons would be:

Barrels @ $0.70.......................................................................................................................................................................................$140,000Warehousing @ $0.20.............................................................................................................................................................................40,000Interest @ $0.10......................................................................................................................................................................................20,000

On each gallon added to inventory, the warehousing and interest costs would cumulate for four years, and profits would be decreased correspondingly.

The argument against including these costs in inventory is that they are not costs of producing whiskey. The production process has been completed before the whiskey is stored. The contrary argument is that these costs are incurred in order to bring the whiskey to a salable condition and they therefore should be included as inventory cost. This argument is strongest for the barrels, and next strong for the warehousing costs. Many people argue that in no circumstances can interest be considered a cost of production; rather, it is a cost of financing. Yet, if this were a four-year construction project rather than aging whiskey, GAAP would require capitalization of construction debt financing costs. (This is not described in the text until Chapter 7.) In any event, unless these costs are included in inventory, profits will decrease at the very time that the increase in production indicates that the company is prospering.

8. There is now a rule (from FASB-53) for determining cost of sales for T.V. movies. It is to amortize film cost in the ratio of

Gross revenue for the film for the current periodAnticipated total gross revenues for the film fromthe beginning of the current period until the end

of its useful life

The denominator of this ratio must be reviewed periodically to reflect current information. The new ratio is then applied to unrecovered film costs. Arguments can be made for ratios of 10/13 or 10/16 in the first year. The 10/16 ratio ($625,000) is perhaps better due to the belief that at least $300,000 in revenue will come from reruns. Correspondingly, the ratio to be used in the second year would be 1/2 ($300,000/$600,000). This would result in amortization of $187,500 in year two [1/2 x ($1,000,000 - $625,000)], with the final $187,500 of cost matched against the final $300,000 of revenue. The $100,000 spent on advertising and promotion of the initial showing does not benefit the future showings of the film. This is therefore not a capitalizable cost and should be expensed in the period incurred. Therefore it does not affect the ratios used above.

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