Cost of Sales & inventories

Chapter 06 - Cost of Sales and Inventories

CHAPTER 6COST OF SALES AND INVENTORIES

Changes from Twelfth Edition

Editorial and updated changes have been made. The VAL accounting for mileage program topic is now covered in the Kim Park case (Case 8-5). VAL Corporation has been dropped.

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 in an inflationary economy, LIFO defers payment of 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.

ProblemsProblem 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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Co. W Co. X Co. Y Co. ZSales.........................................................................................................................................................................................................$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:

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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

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

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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 1,250Available for sale..................................................................................................................................................................................... 1,600 1,600 1,600Problem 6-5

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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 Twelfth Edition. Please see the printed Instructor’s Resource Manual for the Harvard Teaching Notes.

Case 6-2: Lewis Corporation *

Note: Updated from Twelfth 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.

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

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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.

2009FIFO: 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

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).

2010FIFO: 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

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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

2011FIFO: 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

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 2009 $ 56,930 $ 58,150 $ 57,685.922010 66,240 67,320 66,247.722011 66,385 67,600 66,513.65

Inventory 2011 27,720 24,205 26,830.93$217,275 $217,275 $217,278.22

Question 2

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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 LIFO2009 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

2010 Sales.........................................................................................................................................................................................................$110,110 $110,110COGS...................................................................................................................................................................................................... 66,240 67,320Gross Margin...........................................................................................................................................................................................43,870 42,790Tax Expense............................................................................................................................................................................................ 17,548 17,116Net Income..............................................................................................................................................................................................$ 26,322 $ 25,674

2011 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:2009 $ 4882010 4322011 486

$1,406An 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 2011 year-end inventories ($27,720 - $24,205 = $3,515).

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Question 3

Purchases for 2012 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 LIFO2012 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 2012, 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 Inventory2009 $1,220 = $21,620 - $20,4002010 $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 2009, 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 2010, the LIFO reserve ($2,300) is equal to the sum of the differences between LIFO and FIFO cost of goods sold for 2009 and 2010, as shown on the next page.

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

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2009 2010LIFO 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)

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 Not More LIFO?” section of the text, plus comments earlier in this note.

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

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

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belief about economic flows, as explained in the text.

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4.

5. 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.

6. 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.

7. 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.

8. 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.

9. There is a rule (from FASB Statement No.-53) for determining cost of sales for T.V. movies. It is to amortize film costs 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

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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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Cost of Sales & inventories

Business

Transcript of Cost of Sales & inventories