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                              CHAPTER 7
                       MERCHANDISE INVENTORY-2008
                                      BRIEF EXERCISES

BE7–3
    If General Electric used the FIFO inventory cost flow assumption instead of LIFO, its inventory
    balance for 2006 would be ($11.4 + 0.622) = $12.022 billion. This disclosure is useful to
    financial statement users because it can make it easier to compare GE’s results with a company
    that uses a FIFO assumption. It also tells the reader the financial statement and tax liability
    impact on GE if it were to switch to a FIFO assumption.


                                           EXERCISES
E7–1
(1) Since the goods were shipped FOB shipping point, legal title to the goods passes to the buyer
    when the goods are shipped on December 30, 2008. Since Dallas is the buyer, Dallas has legal
    title to the inventory as of December 31, 2008. Further, Dallas rightfully included the items in its
    inventory. There will be no misstatement on any of the financial statements.

(2) The goods were shipped FOB shipping point, so legal title passes to the buyer when the goods
    are shipped on December 31, 2008. Since Dallas is the seller, not the buyer, legal title passed
    from Dallas on December 31, 2008. Dallas, wrongfully included the items in its ending inventory.
    This would result in an overstatement of inventory on the balance sheet. Assuming


E7–1      Concluded
    that Dallas has properly recorded the sale but did not yet record the COGS, there will be an
    understatement of COGS on the income statement and an overstatement of net income and
    retained earnings.

(3) Since the goods were shipped FOB destination, legal title to the goods passes to the buyer
    when the goods reach their destination on January 2, 2009. Since Dallas is the seller, not the
    buyer, Dallas has legal title to the inventory as of December 31, 2008. Dallas has rightfully
    included the items in its inventory. Assuming no other entries regarding the sale have been
    made, there will not be any misstatement on any of the financial statements.

(4) The goods were shipped FOB destination, so legal title to the goods passes to the buyer when
    the goods reach their destination on December 31, 2008. Since Dallas is the buyer, Dallas has
    legal title to the inventory as of December 31, 2008. Dallas has rightfully included the items in its
    inventory, and assuming that the goods were correctly included in purchases as of December
    31, 2008, there will not be any misstatement on any of the financial statements.


(5) The goods were shipped FOB destination, so legal title to the goods passes to the buyer when
    the goods reach their destination on January 3, 2009. Since Dallas is the buyer, Dallas does not
    have legal title to the inventory as of December 31, 2008. Dallas has wrongfully included the
    items in its ending inventory. This would result in an overstatement of inventory on the balance
    sheet. Assuming that Dallas has also improperly recorded the purchases, there will be no effect
    on the COGS or the net income.



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E7–4
   12/31/04:
   Ending inventory:
   Cost of Goods Sold    =   Goods available for sale – Ending Inventory
   $10,002               =   $11,899 – Ending Inventory
   Ending Inventory      =   $1,897

   12/31/05:
   Goods available for sale:
   Goods available for sale = Cost of Goods Sold + Ending Inventory
   Goods available for sale = $10,408 + $2,162
   Goods available for Sale = $12,570

   Purchases:
   Purchases                  =   Goods available for Sale – Beginning Inventory*
   Purchases                  =   $12,570 - $1,897
   Purchases                  =   $10,673

   * Beginning inventory for 2005 is the Ending Inventory for 2004

   12/31/06:
   Goods available for sale:
   Goods available for sale =     Beginning Inventory** + Purchases
   Goods available for sale =     $2,162 + $12,152
   Goods available for sale =     $14,314

   **Beginning inventory for 2006 is the Ending inventory for 2005

   Ending inventory:
   Ending Inventory =     Goods available for sale – Cost of goods sold
   Ending Inventory =     $14,314 - $11,713
   Ending Inventory =     $2,601

E7–7
a. If Marian wants to maximize profits and ending inventory, she should sell the customer the
   lowest priced coat (i.e., Coat 4). If she sells Coat 4, Marian would report the following gross
   profit and ending inventory.


                    Gross Profit                               Ending Inventory
           Revenues              $ 12,000                    Coat 1      $ 8,400
           COGS of Coat 4           6,800                    Coat 2         7,100
           Gross profit          $ 5,200                     Coat 3         7,600
                                                             Total       $ 23,100

   Marian may have several reasons to maximize profits and ending inventory. If Marian's Furs has
   borrowed money and entered into debt covenants, the debt covenants may contain clauses
   stipulating a certain current ratio, debt/equity ratio, and so forth. By maximizing profits and
   inventory, Marian can also minimize the probability that she will violate one of these ratios,
   thereby decreasing the chance that she will violate her debt covenants. Further, if Marian has a
   bonus linked to accounting earnings, she could maximize her bonus by maximizing profits.
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b. If Marian wants to minimize profits and ending inventory, she should sell the customer the
   highest priced coat (i.e., Coat 1). If she sells Coat 1, Marian would report the following gross
   profit and ending inventory.

                       Gross Profit                                              Ending Inventory
              Revenues              $ 12,000                                   Coat 2      $ 7,100
              COGS of Coat 1           8,400                                   Coat 3         7,600
              Gross profit          $ 3,600                                    Coat 4         6,800
                                                                               Total       $ 21,500

    The most likely reason Marian would want to minimize profits and ending inventory is to
    minimize taxes. Minimizing profits would minimize current tax payments, thereby minimizing the
    present value of tax payments. Further, some states charge taxes on a company's assets,
    thereby providing an incentive to minimize assets.

E7–9
    2007                                         FIFO      Weighted Average              LIFO

    Cost of goods sold                           160                 170                 180
    Gross profit (Sales – COGS)                  290                 280                 270
    Ending inventory                             180                 170                 160

    2008                                         FIFO      Weighted Average              LIFO

    Cost of goods sold                           245                 262.5               290
    Gross profit (Sales – COGS)                  455                 437.5               410
    Ending inventory                             290                 262.5               225


    If the business is growing (inventory levels rising) and the cost of inventory is increasing, then if
    LIFO is chosen, the company will lower its net income which will reduce its tax liability. This
    increases the cash flow of the company. Using FIFO will increase its reported net income and
    tax liability but will also increase its current assets.     This choice impacts the company’s
    operating and liquidity ratios.

E7–11
a. Inventories on LIFO basis....................................................    $6,351
   Add: Adjustment to LIFO basis............................................         2,403
   Inventories on FIFO basis ...................................................   $ 8,754

b. Accumulated tax savings can be computed by multiplying the tax rate by the total decrease in
   net income due to LIFO adoption.

    Accumulated Tax Savings                 =    Tax Rate  (2006 LIFO Reserve)
                                            =    .29  ($2,403)
                                            =    $697

c. The 2006 reported net income under the FIFO cost flow assumption would be $5,940 ($3,537 +
   $2,403) even if Caterpillar had chosen to change from LIFO to FIFO years earlier.
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d. The information generated in parts (a), (b), and (c) could be useful to the users from several
   perspectives. First, users could use the information to compare Caterpillar with other companies
   within the industry that use FIFO cost flow assumption. Second, the users can readily see the
   tax savings that the company has generated as a result of its choice of LIFO cost flow
   assumption. Thirdly, along with other information, users can use this information to assess the
   quality of earnings of Caterpillar.


ID7–2
a. The choice of LIFO or FIFO will affect the amounts a company reports both in its balance sheet
   for inventory and in its income statement for cost of goods sold (and consequently net income).
   Thus, in order to evaluate a company's financial position and performance, particularly in
   comparison with other companies' performances, investors and creditors need to know which
   cost-flow assumption the company is using. In addition, the choice of LIFO or FIFO can have a
   large effect on the company's cash flows. If inventory costs are rising, a company will have lower
   taxable income—and hence lower cash outflows for taxes—if it uses LIFO than if it uses FIFO.
   For some companies the difference can be several million dollars a year in tax savings.

b. Under LIFO, the cost of the inventory sold is assumed to be the cost of the inventory purchased
   most recently. This implies that the cost of the inventory still on hand is assumed to be the cost
   of inventory purchased long ago. If inventory costs are rising, one would expect the costs
   assigned to the inventory still on hand to be very low relative to the most recent inventory costs.
   If a company sells more inventory than it acquires during the year, the company will have to dip
   into those older inventory costs (i.e., liquidate LIFO layers) when calculating the cost of inventory
   sold during the year. Because those older costs are less—in some cases much less—than the
   most recent inventory costs, a LIFO liquidation will result in Cost of Goods Sold being less than
   it would have been in the absence of the LIFO liquidation. This means that the company's
   income will be much greater which, in turn, implies higher tax payments. Thus, investors would
   be interested in LIFO liquidations because they have implications for the amount of cash the
   company will have to pay out in taxes.

c. According to the footnote, Deere’s 2006 ending inventory under FIFO would be $1,140 million
   more than under LIFO. Therefore, COGS under FIFO would be lower by the same amount and
   net income before tax higher by the same amount. Based on a 34% tax rate, therefore, Deere
   would have to pay an additional income tax of $387.6 million ($1,140  .34).

ID7–3
   In times of rising inventory costs, LIFO allows companies to "hide" the value of their inventory.
   That is, the inventory value reported on the balance sheet is assumed to consist of "old"
   inventory costs; the most recent costs of inventory are allocated to cost of goods sold. However,
   the inventory is really worth its current market value. Thus, the difference between the "old"
   inventory costs and the current market value represents a "hidden reserve" of profits. By
   manipulating its inventory acquisition, a company can dip into this reserve and increase its
   reported income.

								
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