96d1671a-3bd2-465a-84fe-70ec6c9dade0.doc. Page 1 of 4. 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. 1 96d1671a-3bd2-465a-84fe-70ec6c9dade0.doc. Page 2 of 4. 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. 96d1671a-3bd2-465a-84fe-70ec6c9dade0.doc. Page 3 of 4. 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. 96d1671a-3bd2-465a-84fe-70ec6c9dade0.doc. Page 4 of 4. 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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