CHAPTER 7 - INVENTORY PROBLEM SOLUTIONS
Assessing Your Recall
7.1
Under GAAP, inventory is carried at the lower of cost and market.
Market is most commonly either replacement cost or net realizable
value. When the calculated cost figure is materially different from
recent cost figures, companies should be applying the lower of cost and
market valuation method.
7.2
The lower of cost and market rule can be applied to individual items, to
pools of similar items or to the inventory as a whole. Because it is not
practical to apply it on an individual basis, most companies use either
pools of inventory or the whole inventory. The cost of the inventory
which has been assigned using either specific identification, FIFO,
LIFO or weighted average is compared to the market value (usually
either replacement cost or net realizable value). The lower value is
used. If the market value is used because it is lower, then subsequent
recoveries can be recognized to the extent of the write-down(s). This
treatment is similar to that of temporary investments, in which
recoveries are also recorded back to the original cost, if subsequent
increases in market value occur.
7.3
Replacement cost is the price at which an item could be replaced in
inventory. This price is sometimes referred to as an entry price since
it describes the price at which units of inventory enter the company.
Net realizable value is the selling price of an item less any costs
necessary to complete and sell the item. This price is sometimes
referred to as an exit price since it describes the price at which units
exit the company.
7.4
In a perpetual inventory system, when a new inventory item is
purchased, it is added to the inventory account. When an inventory
item is sold, the cost of the item that is sold is immediately identified
and deducted from the inventory account. Because of this the
inventory account is perpetually kept up to date with the changes in
inventory. In a periodic system when a new inventory item is
purchased it is added to a purchases account. When an inventory item
is sold, no entry is made to the inventory account until the end of the
period when the ending inventory is counted and costed. The cost of
the ending inventory is then used to calculate the amount that should
be removed from the inventory account for the sales during the period.
During the period the inventory account retains its beginning or period
balance. See the answer to Question 7.5 for the advantages and
disadvantages of the two methods.
1
7.5
The advantage of the perpetual system over the periodic system is that
management has continuously updated information available
concerning inventories and cost of goods sold. This is very important
for inventory management purposes. The disadvantage is that
perpetual systems are more costly to implement. Prior to the advent of
low-cost computing power perpetual systems were only used for lowvolume, high unit cost types of inventories (such as in a car
dealership). Another advantage of the perpetual system is that
inventory shrinkage can be independently determined by combining
the perpetual information with a physical count. An additional cost of
the perpetual system is that the company also has to count its
inventory periodically to verify shrinkage and to assess the integrity of
the perpetual information.
The advantage of the periodic system is that it is less costly. However,
management does not have updated information about inventory
levels. It also has a difficult time determining the amount of inventory
shrinkage. The cost of goods sold is determined by adding the
purchases for the period to the beginning inventory and then
subtracting the inventory cost determined from the physical count. It
is assumed that any inventory that is not there to be counted has been
sold.
7.6
The three major cost flow assumptions are FIFO, LIFO and weighted
average. FIFO (first-in, first-out) assumes that the cost of the first
unit purchased is the first cost to appear in the income statement (in
Cost of goods sold). LIFO (last-in, last-out) assumes that the cost of
the last unit purchased is the first cost to appear in the income
statement. Weighted average computes an average cost for all units in
beginning inventory and the purchases during the period and assigns
this average cost to the units sold during the period. It is important to
remember that cost flow does not have to match the physical flow of
goods. In fact, in most cases inventory physically flows in a FIFO
manner as companies rotate their inventory and attempt to sell older
items first.
7.7
For reporting purposes management typically has an incentive to
report the highest possible income, particularly if there is a
management incentive program based on reported income. Therefore,
management would probably like to report the lowest amount of cost of
goods sold so as to produce the highest net income. This incentive is
obviously at odds with the incentive for tax purposes.
For tax purposes a company typically would like to choose the cost flow
assumption that would result in the highest cost of goods sold since
2
that would produce the lowest taxable income and the lowest amount
of taxes paid. In Canada, Revenue Canada will not allow LIFO to be
used for tax purposes. This narrows the choice of methods that
companies can use to achieve a low taxable income. The actual choice
of methods for tax purposes would depend on whether prices are
increasing or decreasing and whether inventory levels are expected to
remain stable, increase, or decrease. Expected future changes in tax
rates might also have some influence on the decision.
The choice of inventory methods is constrained because a company
cannot switch back and forth between inventory methods at will. The
accounting characteristic, consistency, discourages companies from
switching methods frequently and a company’s auditors would object to
frequent switches for reporting purposes.
7.8
A holding gain in the context of inventory is a gain that is experienced
by the company as it holds inventory. If the inventory is then sold the
company realizes this holding gain in income. If the company
continues to hold the inventory the holding gain is unrealized. Under
LIFO most holding gains are unrealized since the cost shown in income
is the current cost. Ending inventory is carried at older prices and
thus contains most of the holding gains. Under FIFO most holding
gains are realized (included in income) since the cost of goods sold
figure is based on older unit prices. Whereas ending inventory is
carried at the most recent prices. The weighted average cost flow
assumption would produce results closer to FIFO but some holding
gains would remain in ending inventory and be unrealized.
7.9
The three main reasons that a company would need to estimate cost of
goods sold or inventory would be: a) the inventory has been destroyed
or stolen and it is impossible to count it; 2) the company wants to
prepare monthly financial statements but does not want to incur the
cost of counting the inventory; and 3) the company wants to have an
estimate of the inventory it has before it begins the physical count so
that it can determine whether goods have been lost or stolen.
7.10
Assuming a trend of rising prices LIFO will produce balance sheet
values of inventory that are significantly lower than those under FIFO.
The cost of goods sold under LIFO will generally be higher than that
under FIFO in any given year. The effect on balance sheet ratios, such
as the current ratio are that a LIFO company will report a lower
inventory value (relative to a FIFO company) and therefore a lower
current ratio (all other things held constant). Ratios that involve total
assets (such as Return on assets) will also be affected by the choice of
LIFO versus FIFO.
3
The inventory turnover ratio is directly impacted by the choice of LIFO
versus FIFO. The inventory turnover matches units sold in the
numerator with average units on hand in the denominator. The ideal
ratio would be to compute the ratio using the unit figures.
Unfortunately this information is not available in the annual report.
The cost futures are therefore used. Under LIFO the cost of goods in
the numerator is based on new unit cost, however, the denominator is
based on old unit costs (sometimes very old depending on how long ago
the first inventory was purchased). The ratio is therefore distorted and
typically is biased upward (in periods of rising prices). Under FIFO, on
the other hand the numerator is based on slightly old unit prices,
whereas the denominator is based on current prices. The bias under
FIFO is not as severe as that under LIFO because the disparity
between unit prices in the numerator and denominator is not as great.
4
7.11
a) Weighted average
Total units purchased
Unit cost
8,000
$18.00
4,000
17.50
12,000
15.00
6,000
14.50
30,000
Average cost = $481,000 / 30,000 = $16.03 per unit
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = 20,000 x $16.03 = $320,066.67
Total cost
$144,000
70,000
180,000
87,000
$481,000
b) FIFO
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = (8,000 x $18.00) + (4,000 x $17.50 ) + (8,000 x
$15.00) = $334,000
c) LIFO
Units sold = 30,000 - 10,000 = 20,000
Cost of goods sold = (6,000 x $14.50 ) + (12,000 x $15.00 )+ (2,000 x
$17.50) = $302,000
d) Because unit costs of purchases have been declining, LIFO
produces the greatest net income for August and FIFO produces the
smallest net income for August.
d) LIFO results in the largest inventory balance at August 31, because
the high cost purchases made at the beginning of August are
assigned to inventory. FIFO results in the smallest inventory
balance at August 31 because the low cost purchases made at the
end of August are assigned to inventory.
7.12
a) FIFO
Ending inventory = $19,000 + 1500 x (42,500 / 2,500)
= $44,500
b) LIFO
Ending inventory = 30,000 + 500 (45,000/3,000)
= $37,500
c) Weighted average
Ending inventory = 2,500 x [(30,000 + 45,000 + 16,000 + 66,000 +
42,500 + 19,000) / 13,500]
= $40,462.96
5
7.13
a) FIFO
Total units sold = 270
Cost of Goods sold = (60 x 4) + (200 x 5) + (10 x 9)
= $1,330
Gross profit = (100 x 9) + (170 x 10) - 1,330
= $1,270
b) LIFO
Total units sold = 270
Cost of goods sold = (60 x 7) + (40 x 9) + (170 x 5)
= $1,630
Gross profit = (100 x 9) + (170 x 10) - 1,630
= $970
c) LIFO provides the most conservative estimate of the carrying value
of
inventory because it assigns lower costs from earlier purchases to
ending inventory. Because inventory is stated at a lower amount
under LIFO, there is less risk of overstatement, and a more
conservative value results. LIFO also provides the best estimate of the
current cost of replacing the inventory because cost of goods sold under
this method reflects the cost of more recent purchases. As a result,
gross profit is more representative of true profits, after allowing for the
replacement of goods sold at their current costs.
d) LIFO provides the most conservative estimate of reported income,
provided that prices are rising. If prices are in fact falling, FIFO
provides the most conservative estimate of reported income.
7.14
a)
Average cost
Cost of goods sold
Ending inventory
$11,200
$ 5,600
Specific
Identification
$8,800
$8,000
Average cost
(1,800 + 6,000 + 2,800 + 3,000 + 2,000 + 1,200) / 6 = $2,800
Cost of goods sold = 4 x 2,800 = $11,200
Ending inventory = 2 x 2,800 = $5,600
Specific Identification
Cost of goods sold = 1,800 + 2,800 + 3,000 + 1,200 = $8,800
Ending inventory = 6,000 + 2,000 = $8,000
6
b) For specific identification to be used, it must be possible to keep
track of each batch of units received and the cost of that particular batch of
units. In general, this is feasible only if the units are high-priced, so that such
a tracking system can be justified based on the additional information that the
system provides.
c) Specific identification best represents the operating results for
Exquisite Jewelers because cost of goods sold represents the actual
cost of the physical units sold during the period.
7.15
a) FIFO
Total units sold
= 11,500
Cost of goods sold
= $60,000 + $44,000 + 1,500($60,000 / 5,000)
= $122,000
Ending inventory
= 3,500 x (60,000 / 5,000)
= $42,000
b) LIFO
Total units sold
= 11,500
Cost of goods sold
= $60,000 + $44,000 + 2,500($60,000 / 6,000)
= $129,000
Ending inventory
= 3,500 x ($60,000 / 6,000)
= $35,000
c) Weighted average
Total units sold
= 11,500
Average cost
= ($60,000 + $44,000 + $60,000) / 15,000
= $10.93
Cost of goods sold = 11,500 x $10.93
= $125,733.33
Ending inventory
= $38,266.67
7
7.16
a) Computation of Cost of Goods Sold
Beginning inventory
Purchases:
Jan. 1
Jan. 10
Jan. 12
Jan. 14
Transportation-in:
Jan. 1 purchase
Jan. 14 purchase
Goods available for sale
Ending inventory
Cost of goods sold
Units
200
1,500
200
800
200
Unit cost
$17.00
17.10
20.00
22.00
23.00
Total cost
$ 3,400
25,650
4,000
17,600
4,600
1,500
400
57,150
( 20,000)
$37,150
2,900
900
2,000
Composition of ending inventory
Jan. 14 purchase
Jan. 12 purchase
200
700
23
22
$ 4,600
15,400
$20,000
b) LIFO
Cost of goods sold
= (200 x $23) + (800 x $22) + (200 x $20) + (800 x
$17.10) + $1,500 + $400
= $41,780
Ending inventory
= (700 x $17.10) + (200 x $17)
= $15,370
c) Weighted average
Average cost
= $57,150 / 2,900
= $19.71
(The average cost is calculated here by including the
transportation-in costs in the amount used to determine the unit cost.
It is also possible to calculate the unit cost without the transportationin costs and then to add them to the cost of goods sold.)
Cost of goods sold = 2,000 x $19.71 = $39,420
Ending inventory = $57,150 - $39,420 = $17,730
8
7.17
a) Acquisition cost
Year
Sales
1
2
3
4
Cost of goods sold
$145,000
$ 65,0001
$175,000
$ 80,0002
$253,000
$163,0003
$225,000
$155,0004
1 $140,000 - $75,000 = $65,000
2$75,000 + $85,000 - $80,000 = $80,000
3$80,000 + $155,000 - $72,000 = $163,000
4$72,000 + $104,000 - $21,000 = $155,000
b) Lower of cost and market
Year
Sales
Cost of goods sold
1
2
3
4
$145,000
$ 70,0001
$175,000
$ 90,0002
$253,000
$148,0003
$225,000
$155,0004
1
 $140,000 - $70,000 = $70,000
2$70,000 + $85,000 - $65,000 = $90,000
3$65,000 + $155,000 - $72,000 = $148,000
4$72,000 + $104,000 - $21,000 = $155,000
Gross margin
$80,000
$95,000
$90,000
$70,000
Gross margin
$ 75,000
$ 85,000
$105,000
$ 70,000
c) The gross margin is higher using the acquisition cost basis in year
one
because market value has fallen below cost. If cost is used as the
basis of valuation, that ending inventory is higher and cost of goods
sold is lower than under the lower of cost and market basis. In year
two, the higher inventory value is carried forward as beginning
inventory, so that cost of goods sold is higher under the acquisition
cost basis. However, the market value of ending inventory is again
below cost, making cost of goods sold lower (and gross margin
higher) under the acquisition basis. In year three, the cost of ending
inventory is below its market value, so that cost (rather than
market) is used under both the acquisition cost and the lower of cost
and market methods. Still, the gross margin is higher under the
lower of cost and market basis because a lower value of inventory is
carried forward from the prior year as beginning inventory. In the
final year, the gross margin is the same under both methods because
the cost and market values of inventory are the same, and beginning
inventory is also the same for both methods.
9
7.18
7.19
a)
If the lower of cost and market valuation basis is to be applied, and the market
is defined as replacement cost then the inventory should be valued at $18,000 ($6
x 3,000). If market is defined as net realizable value, then the NRV amount
would need to be determined before the lower of cost and market decision can be
made. Other information needed to determine the year-end reporting amount
includes the cost of damaged or obsolete screwdrivers.
b) The decline in replacement cost is relevant because replacement
cost
represents the amount that is required in order to re-purchase the
current number of screwdrivers. If replacement cost has fallen, this
might be indicative of a decline in the realizable value of the
screwdrivers.
c) In deciding the dollar amount of inventory to report, several
accounting
concepts are relevant, including the historical cost principle (value
assets at their acquisition cost) and conservatism (during uncertain
conditions, it is better to risk understatement of assets than
overstatement).
a) For 20x1, prices went down, because LIFO results in a higher
inventory value than FIFO.
b) For 20x4, prices went up, because FIFO results in a higher
inventory
value than LIFO.
c) In 20x1 and 20x2, LIFO shows the highest income. In 20x3, FIFO
shows the highest income. In 20x4, the lower of FIFO cost and market
shows the highest net income. (HINT: to answer this question,
assume purchases in each of the four years was $500,000. Calculate
the COGS for each of the four years under each method. Remember
that ending inventory from the previous year is the beginning
inventory of the current year. The lowest COGS will produce the
highest net income.)
d) LIFO shows the lowest income for the four years combined.
10
7.20
a)
Units
Beginning inventory
Production
Additional production
Ending inventory
Cost of goods sold
15,000
85,000
25,000
0
125,000
Unit cost
$15
18
20
Cost
$ 225,000
1,530,000
500,000
0
$2,255,000
Gross profit = (125,000 x $30) - $2,255,000 = $1,495,000
b)
Units
Beginning inventory
Production
Additional production
Ending inventory
Cost of goods sold
15,000
85,000
100,000
(75,000)
125,000
Unit cost
Cost
$15
18
20
$ 225,000
1,530,000
2,000,000
(1,305,000)
$2,450,000
Gross profit = (125,000 x $30) - $2,450,000 = $1,300,000
Ending inventory = (15,000 x $15) + (60,000 x $18) = $1,305,000
c) Cost of goods sold and gross profit are different at different
production levels, even though sales remains constant. When
production equals sales, all production costs are expensed in the
current period, and no costs are carried forward as inventory. When
production exceeds sales, however, the total production costs must
be allocated to cost of goods sold and to ending inventory. Because
LIFO is used during a time when unit costs are rising, the higher,
more recent costs are allocated to cost of goods sold, causing gross
profit to be smaller. Ending inventory is assigned costs from the
early production when inventory was produced at $15 and $18 per
unit.
11
7.21
a)
Beginning inventory
Purchases
Transportation-in
Ending inventory
Cost of goods sold
40% of $490,000
$ 30,000
210,000
1,200
(??)
$196,000
Therefore, ending inventory should be $45,200
b) Since actual inventory is only $38,500 vs. the estimate of $45,200,
missing
inventory could be a problem. To determine is this is a serious
problem, the accountant might attempt to identify other reasons for
the cost to sales ratio to be higher this year compared to previous
years. The accountant would also want to determine if $6,700 in
inventory is worth the cost of doing an in depth investigation of the
potential problem. The cost of any possible solutions to the problem
should also be realistic compared to the potential cost of lost inventory
if a solution is not put in place. One option open to Sammellias is to
implement a perpetual inventory system to keep track of clothes on
hand after each sale. This provides a more accurate point of
comparison for the physical count but may be too costly to implement.
7.22
a)
Beginning inventory
Purchases
Ending inventory
Cost of goods sold
64% of $140,000
$28,000
84,000
(??)
$89,600
Therefore, ending inventory should be $22,400
b) Insurance claim = $22,400 - $9,500 = $12,900
c) The estimate of ending inventory might be inaccurate if currentyear
conditions caused the cost-to-sales ratio to differ significantly from the
estimate of 64%. Additional factors resulting in a potential error
include errors in the count of beginning inventory and errors in the
sales amount.
12
7.23
a) FIFO
Units
Cost per Unit
Total Cost
Beginning Inventory
Add: Produced
3,500
5,000
$250
400
$ 875,000
2,000,000
Goods for Sale
Less: End. Inventory
8,500
4,500
400
2,875,000
1,800,000
Cost of Goods Sold
4,000
Sales
Less: Cost of Goods Sold
4,000
$1,075,000
$600
Gross Margin
$2,400,000
1,075,000
$1,325,000
LIFO
Units
Cost per Unit
Total Cost
Beginning Inventory
Add: Produced
3,500
5,000
$250
400
$ 875,000
2,000,000
Goods for Sale
Less: End. Inventory1
8,500
4,500
See Note
2,875,000
1,275,000
Cost of Goods Sold
4,000
Sales
Less: Cost of Goods Sold
4,000
$1,600,000
$600
Gross Margin
1 $1,275,000
$2,400,000
1,600,000
$ 800,000
= (1,000 x $400) + (3,500 x $250)
13
b)
FIFO
Sales
Less: Replacement COGS
Units
Cost per Unit
Total Cost
4,000
4,000
$600
4001
$2,400,000
1,600,000
Operating Margin
$ 800,000
Add: Realized Holding Gains:
Replacement COGS
Less: Historical COGS2
1,600,000
1,075,000
525,000
$1,325,000
Gross Margin3
LIFO
Sales
Less: Replacement COGS
Units
Cost per Unit
Total Cost
4,000
4,000
$600
4001
$2,400,000
1,600,000
Operating Margin
Add: Realized Holding Gains
Replacement COGS
Less: Historical COGS2
Gross Margin3
$ 800,000
1,600,000
1,600,000
0
$ 800,000
1 Based
on average production cost during the year.
solution to part a)
3 Note that this is the same as the gross margin in part a).
2 From
14
c) Unrealized Holding Gains
Replacement Cost of Ending
Inventory1
Less: Historical Cost of Inventory2
Unrealized Holding Gain on
Ending Inventory
Total Gains:
Operating Margin
Add: Realized Gain
Unrealized Gain
Total Gain
1 4,500
2 From
FIFO
LIFO
$2,250,000
1,800,000
$2,250,000
1,275,000
$ 450,000
$ 975,000
$ 800,000
525,000
450,000
$ 800,000
0
975,000
$1,775,000
$1,775,000
units x $500/unit (Replacement Cost) = $2,250,000
solution to part a).
d) The total gains under both cost flow assumptions are the same.
The reason is that economic income is independent of the cost flow
assumption and the cost flow assumption only affects the timing as to
when income is realized. Note that under LIFO the income reported is
less ($800,000) than that under FIFO ($1,325,000), however, the
unrealized gains are higher ($975,000) than that under FIFO
($450,000). This suggests that when the LIFO layers are liquidated,
the difference ($525,000) will be realized.
7.24
a)
Inventory turnover
Stream Ltd. $470 / [($200 + $160) / 2] = 2.61
Competitor $900 / [($400 + $450) / 2} = 2.12
b)
Gross margin percentage
Stream Ltd. ($600 - $470) / $600 = 21.7%
Competitor ($1,250 - $900) / $1,250 = 28%
c) On the basis of inventory turnover, Stream is superior because it turns over its
inventory more often.
d) On the basis of gross margin percentage, the competitor is superior.
e) Based on the information available, it is not possible to determine which company
is managed better. It does, however, make sense that the company which
has the higher gross margin percentage also experiences lower turnover.
Thus, management of each company is based on the competitive
15
strategies adopted. It appears that Stream is attempting to sell more
goods at a lower price while the competitor earns higher margins on
inventory that turns over less often.
7.25
a) The inventory turnover ratio is calculated by dividing cost of goods
sold by the average inventory balance. The ratio gives information on
how long cash is tied-up in inventory. The more quickly inventory
turns over the less the amount of cash that must be invested in
inventory.
b) Generally, a high inventory turnover ratio is desirable. The type of
company and products sold must be taken into consideration in evaluating the
turnover ratios. An exceptionally high ratio may mean that the company is not
carrying an adequate stock of inventory and may be losing sales as a result. It
may also mean that production is required to constantly change from one
product to another to meet customer demands. For example. A fruit and
vegetable store should have a high inventory turnover, whereas you would
expect a car dealership to have a much lower one.
c) Without looking at past data on the companies and industry and
regional statistics, it is not possible to provide a detailed evaluation of the
individual companies. However, companies in different types of businesses
should be expected to have different inventory turnover ratios. A manufacturing
company is likely to have a lower turnover ratio than a grocery chain. Grocery
stores normally have relatively low profit margins but have high volume and sell
most of their products quickly. A car dealership may have some vehicles sold in
advance but the majority of its inventory likely takes several weeks to sell.
Vehicles tend to have a large profit margin and therefore can still contribute
handsomely to net income for the year.
d) The two most important measures of operating inefficiency are
likely to be the gross margin and gross profit ratio. The
composition of the inventory also is very important. Are
appropriate amounts of inventory carried for those products that
sell quickly versus those that sell slowly? If it is a manufacturing
company, are there appropriate balances in the amounts of raw
materials, work-in-process and finished goods inventories? Another
measure of operating success is the amount of inventory that has
been returned by customers as unsatisfactory.
7.26
The foreign competitor might use different accounting policies, such as
different valuation bases for inventory. Different accounting policies
will mean that it is difficult to compare the two companies. A good
understanding of the accounting policies in Canada and in the foreign
country will enable a better understanding of ratios.
16
Management Perspective Problems
7.27
In comparing a Canadian and a Japanese company you would first want to
make sure that there were not significant differences in the accounting
principles used by the two companies. If there are significant differences
then the best adjustment would be to convert them to the same principles if
enough information is supplied to do so. For many ratios, such as ROI,
current and quick ratio, etc., there is no need to convert from yen to dollars
as the units of currency are canceled in the calculation of the ratio. Common
size statements could also be used without any adjustment. The only time
you might want to convert would be if you wanted to make some direct
comparisons of balance sheet or income figures as a direct comparison of
sales.
7.28
As an auditor, you would be concerned about the potential misstatement of
inventories at year-end. In particular, you would confirm that the inventory
exists through a sample count, test for obsolete or damaged goods, and
ensure that the balance recorded represents the minimum realizable amount
of the goods that will be sold in the following year. Misstatements in these
amounts affect both the income statement through cost of goods sold and the
balance sheet in terms of the goods on hand recorded as an asset at year-end.
For example, if inventory is overstated at year-end, then cost of goods sold is
understated and net income is overstated.
7.29
As a lender, you would be concerned if the company switched from LIFO
to FIFO because this could be a signal that the company would not otherwise
meet the restrictive debt covenant, and its sole motivation for switching
accounting methods is to remain within the covenant. However, FIFO does
result in a more accurate representation of the cost of inventory on hand,
because it allocates more recent costs to inventory. LIFO, on the other hand,
can understate the current ratio because, during a period of rising prices,
inventory is composed of the oldest costs. If the company was in financial
distress, you would be much more concerned about an accounting change
from LIFO to FIFO, because this change is likely an attempt to satisfy the
debt covenants and improve reported operating profits.
7.30
Ratios are very useful as they draw on relationships within the financial
statements. For instance, inventory turnover relates the cost of goods sold to
the level of inventory on the balance sheet. Auditors are very interested in
these relationships. The auditor would be particularly interested in changes
in the ratios over time as these might signal potential problems or changes in
the recording of amounts in the financial statements.
7.31
a)The lower of cost and market rule should be followed if Proposal 1 is
adopted with the inventory reduced from the current carrying value of $3,500,000 to its
expected selling prices of $2,000,000. A loss of $1,500,000 should be reported when the
carrying value is reduced. With Proposal 2, it appears the company will make a profit if
the inventory is sold to third-world countries and no reduction in carrying value would
be needed.
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b) One alternative is for the company to continue to market the
product in
the normal manner. It does have low fat content. A high salt content
is a relative judgment and it is not the only product on the market
with high salt content. Many popular products also have
preservatives. It is not clear whether or not the chemical preservatives
actually are harmful to those who consume the product. Since sales
apparently have fallen dramatically, the company would need to either
launch a new sales campaign, redesign the product, or discontinue the
product and sell the remaining inventory as suggested in Proposal 1.
Selling the remainder of the product to the public may involve other
losses beside those absorbed on this product. The company has lost
sales due to the publicity and additional adverse publicity is likely to
hurt the sales of other products. The company may be much better off
if it pulls the product from the market and sells it to be blended into
cattle or hog feed.
If management has concluded the product is unhealthy, the company
might elect to remove the product from the consumer market as well in
response to a sense of social responsibility.
The second proposal by the company is to sell the product in thirdworld countries. If the standards are not sufficient to protect the
consumers in those countries, the consumers may currently be buying
products of much poorer quality or that may be much more harmful
than this product. This line of reasoning leads to the conclusion that
everyone would be better off if the product is sold in the third-world
countries. Our government would even be better off since sale in the
international markets would help Canada by contributing to its level
of exports.
However, it is worth noting that though the product has not been
banned in Canada, its popularity has dropped as a result of adverse
publicity associated with selling what some regard as an unhealthy
product. If it is argued that the company should not sell the product in
Canada because it is not healthful, the same argument would apply to
sales in third-world countries.
Many other perspectives may be presented for this case. As suggested
above, it might be suggested the company go back to the test labs and
redesign the product to reduce the salt content and amount of
preservatives. It could then produce a new improved version of the
product and advertise that it is sensitive to the dietary needs and
health of its customers and wishes to market only products of highest
quality.
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This case is intended to raise a spectrum of questions faced daily by
business entities. At one end of the spectrum of thought, virtually no
product in the marketplace is as good as it could be. Automobiles could
have better brake systems and accident restraint devices than are
currently employed. Most breakfast cereals could have less sugar
content and more vitamins. Nearly all of the pieces of clothing you
wear can be set on fire and will burn. At what level of flammability
should clothing be kept from the market? How does a conscientious
management conclude that one piece of clothing should be produced
and another not, that it should reduce the sugar content of its most
popular cereal, or put better brake systems on its automobiles? In
some cases, standards have been developed by industry or government
agencies and products are rated. However in many cases such guides
are not available.
Management is responsible for the quality of the product it sells to
customers and also is responsible for earning a fair return to the
investors who created the company. Neither the customers nor the
investor is well served if products of poor quality are produced, nor are
they well served if the company attempts to sell a product of such high
quality that the company eventually goes out of business.
c) The management discussion and analysis section of the annual
report and the footnotes should provide a discussion of the current
status of the product and management’s intent toward the future.
Unless proposal 2 is adopted, an inventory loss would need to be
recorded in the current period. In addition, company management
should discuss with legal counsel the possibilities that the adverse
publicity will lead to litigation being filed against the company. If
litigation is already in process, disclosure should be made in the
footnotes to the financial statements.
7.32
a) The estimated cost of Black Light’s inventory on hand at the end of
the first quarter of 2001 is $510,000 estimated using the gross profit
method as follows:
Cost of goods sold:
Beginning inventory
Purchases
Goods available for sale
Sales during the first quarter
Less estimated gross profit
($700,000 x 30%)
Estimated cost of goods sold
Estimated inventory at end of
first quarter
$ 250,000
750,000
1000,000
$700,000
(210,000)
(490,000)
$ 510,000
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b) The gross profit method works reasonably well for interim
estimates of
inventory on hand, but it is not accurate enough to use regularly in
annual financial statements. Changes in underlying cost patterns and
other changes could easily result in highly inaccurate dollar amounts
being reported if only estimates were used in determining the balance
in inventory over a longer period of time. Some companies use the
gross profit method to estimate inventory on a regular basis, but
sometime during the year, they will conduct a physical count to adjust
the estimate to the actual inventory on hand.
c) The gross profit method will provide reliable results so long as cost
patterns remain stable, and the selling price and mark-ups are
predictable. In general, all factors affecting the gross profit percentage
must remain more or less unchanged for this method to provide
reliable results.
d) Conditions that might cause the gross profit method to provide
unreliable results include:
1. price changes that were not recorded or taken into account in
determining the gross profit margin
2. special merchandise purchases that are sold at a different gross
profit margin.
3. Losses of inventory due to damage.
4. Losses of inventory due to theft and other causes.
5. Errors in recording inventory sales or purchases.
The gross profit method of inventory estimation is relevant and timely
but it is not objective and accurate enough for complete reliance.
e) Based on the estimate of Black Light’s inventory at the end of the
first
quarter, the company’s inventory position appears to be very high. It
is twice as large as the balance on hand at the beginning of the quarter
and, at the level of sales in the first quarter, it is enough inventory for
almost one and a fourth more quarters.
It may be that Black Light’s business is seasonal and the inventory is
needed for higher seasonal sales in the second quarter.
7.33 The financial statement implications of your decision to implement
just-intime are that that cost flow method used is less significant. For
example, your use of LIFO becomes less important, because under justin-time there is no real need for allocating the total cost of goods
purchased between those that were sold and those that remain on
20
hand. Almost no goods will remain on hand at the end of the period.
The tradeoffs that you should consider in implementing your decision
include the fact that inventory might not be available for a large
unexpected order, and that spoilage or theft can lead to the loss of
customers.
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Reading and Interpreting Published Financial Statements
7.34
a) In 1999, the inventory turnover was 101 days which was slightly
slower than 1998. This turnover rate means that inventory sells in
just over three months. Based in the product life of beer, just over
three months is probably reasonable.
b) The fourth item is promotional goods and dispensing units. The
dispensing units are likely sold but probably not as quickly as the
alcoholic products. The promotional goods are probably not sold at all.
This item represents approximately 12% of the total inventory in 1999
($239,111 / $2,050,703). If the inventory turnover is recalculated for
1999 omitting the fourth item, the turnover rate increases:
$7,691,231 / [($1,811,592 + $2,068,711) / 2] = 3.96
92 days
365 / 3.96 =
The number of days inventory is held decreases by 9 days. The
inclusion of the fourth item does make a difference.
c) Big Rock records returnable bottles as part of inventory and
amortizes them over their useful lives. Some alternative ways that it
could account for these bottles are:
1. to expense them as they are purchased.
2. to record them at cost then expense them when they are
used.
d) From Note 3, the raw materials and returnable glass totalled
$1,026,863 in a total inventory amount of $2,050,703. If the
replacement cost was $970,000, the new inventory amount would be:
$2,050,703 - $1,026,843 + $970,000 = $1,993,860.
The new inventory turnover ratio becomes:
$7,691,231 / [($1,993,860 + $2,270,909) / 2] = 3.6
365 / 3.6 = 101 days
Recording the raw materials at the lower replacement had no effect on
the inventory turnover.
7.35
a)
Inventory Turnover 1999
$1,546,723 / [($160,092 + $254,690) / 2] = 7.46
days
365 / 7.46 = 49
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Inventory Turnover 1998
$1,370,773 / [($254,690 + $244,074) / 2] = 5.50
days
365 / 5.50 = 66
b) The turnover ratio in 1998 was just over two months; in 1999 it was
about a month and a half. For some items (computers, printers, etc.)
this is probably a reasonable turnover rate. For items like
televisions and appliances this may seem to be too rapid. It is likely
that Future Shop has an arrangement with its suppliers to get
inventory quickly. If this is the case, it would be able to operate with
a lower inventory level because of these arrangements.
c) Future Shop’s inventory turnover is much faster than Big Rock’s.
This comparison is not very useful because the two companies are in
different industries with different products.
d) Future Shop is using the lower of average cost and net realizable
value. Costs consist of invoiced cost plus freight and duty, net of
discounts. This information is found in Note 1 (e).
7.36 a)
Inventory Turnover
1997
1996
Ratio
$9,794 / $1,628 = 6.02
$2,585 / $410 = 6.30
Days
60.70
57.89
b) Based on the rapid changes that occur in software, a higher
turnover is
preferred in order to avoid carrying obsolete inventories. Thus, the
fact that SoftQuad Inc.’s turnover has declined in 1997 might indicate
ineffective management. However, three days extra should not cause a
lot of concern. Selling its entire stock in approximately two months
would appear to provide a reasonable level of risk management
regarding obsolescence.
7.37
a) It is appropriate for Comac to include the franchise stores in its
inventory because these stores are held for resale rather than for use.
While most companies use stores in order to conduct their operations,
Comac’s operations consist of selling such stores to other businesses,
and these stores are thus appropriately included in inventory.
b) It is not meaningful to calculate an inventory turnover for Comac
because its inventory is comprised of franchise stores under
construction, franchise stores held for resale, and ingredients,
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uniforms and supplies. Franchise stores under construction would
have no relationship to cost of sales, because these stores cannot be
sold until completed. Furthermore, franchise stores held for resale
would have a far slower turnover than ingredients, distorting the
calculation, and preventing a meaningful interpretation of the results.
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7.38
a)
1998
1997
Inventory Turnover
Based on total inventory
Based on finished goods
$385.9 / $162.2 = 2.38
385.9 / 48.5 = 7.96
$297.4 / $83.1 = 3.58
297.4/ 26.8 = 11.10
b) Inventory turnover based on finished goods is more useful for users
because the turnover ratio relates cost of sales to goods on hand that
are ready for sale. Since only finished goods are sold, raw materials
and work in process bear no relationship to cost of sales, and might
distort the ratio.
7.39
a)
1998
1997
Current Ratio
$31,485,630 / $10,407,217 = 3.03
$35,181,221 / $15,824,046 = 2.22
In 1998, inventory was $16,549,615 compared to $16,211,219 in 1997.
They were almost the same. Because total current assets decreased in
1998, the inventory amount had a greater impact on the current ratio.
The decrease in current liabilities of greater than $5 million had more
impact on the current ratio pushing it above 3.0.
b) The accumulated costs associated with the ginseng that is expected
to be
sold in the following year is an inventory item, because the ginseng
crops are being cultivated for resale rather than for use. The situation
is no different than a manufacturing company including in inventory
the costs of producing the goods it intends to resell (work-in-process).
c)
1998
1997
Gross profit percentage
$1,174,874 / $17,294,375 = 6.8%
851,047 / 9,052,647 = 9.4%
In 1998, the gross profit declined to 6.8%. The reason for the decline is
that sales did not quite double from 1997 but the cost of goods sold
more than doubled thus reducing the gross profit. Costs increased
proportionately more than sales.
Beyond the Book
7.40
Answers to this question will depend on the company selected.
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26
CASE
7.41
Bema Gold Company
a) Current ratio
1998
$30,166 / $12,737 = 2.37
1997
$48,044 / $14,821 = 3.24
Proportion of inventory to current assets
1998
$6,858 / $30,166 = 22.7%
1997
$11,115 / $48,044 = 23.1%
Inventory represents almost a quarter of the current assets. This
means that its value has a significant impact on the current ratio.
b) List of questions for an investment advisor:
1. Have there been any recent reports about Bema find reclaimable
deposits of gold?
2. In what parts of the world is Bema operating?
3. Are there any political risks in any of the countries in which Bema
is operating?
4. Why are the investors willing to buy new shares issued by Bema
when it has not had a profit in 1996, 1997 or 1998?
5. What has been the recent trend in the market price of Bema’s
shares?
6. Because this company is not operating at a profit, it is not likely
that it will be paying any dividends in the near future. As an
investor, should I just be looking for the market price of shares to
increase?
7. What exploitable mineral properties does Bema own?
8. What is the mineral content of these properties?
9. Is it economical for Bema to extract these minerals?
10. Why did the company write down mineral properties, inventory and
notes receivable in 1998?
7.42
Critical Thinking Question
There are many possible items that could be included in this report.
The following is a list of suggested items:
1. what kind of inventory are you going to sell?
2. who will select and buy the inventory?
3. who will arrange for transportation from the Czech Republic of
Canada?
4. who will contact the government about import duties?
5. who will arrange financing?
6. what impact will the change from Czech currency to Canadian
dollars have on the decision making?
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7. how much financing will be needed?
8. where will the inventory be stored in Canada?
9. who will contact stores in Canada about selling the inventory?
10. how will you decide on an appropriate selling price?
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