Dmp3e Ch07 Solutions 01.28.10 Final

7/27/2019 Dmp3e Ch07 Solutions 01.28.10 Final

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Chapter 7

Reporting and Analyzing InventoryLearning Objectives coverage by question

Mini-exercises

Exercises Problems Cases

LO1 Interpret disclosures ofinformation concerningoperating expenses, includingmanufacturing and retail

inventory costs.

13, 14, 15, 17

LO2 Account for inventory and costof goods sold using different costingmethods.

18, 19, 20,

21, 23

26, 27, 29,

30, 3133, 34, 36 37, 38

LO3 Apply the lower of cost ormarket rule to value inventory.

24 28

LO4 Evaluate how inventory

costing affects managementdecisions and outsidersinterpretations of financialstatements.

18 26, 29, 30,31

33, 34, 36 37, 38

LO5 Define and interpret grossprofit margin and inventory turnoverratios. Use inventory footnoteinformation to make appropriateadjustments to ratios.

16, 22 25, 31, 32 33, 34, 35 37

LO6 Appendix 6A: Analyze LIFOliquidations and the impact they haveon the financial statements.

36 37

Cambridge Business Publishers, 2011

Solutions Manual, Chapter 7 7-1


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QUESTIONS

Q7-1. If a company fails to take a cash discount that is offered by a supplier, itis effectively paying a penalty for taking additional time to pay theaccount payable. Depending on the size of the discount, this penalty (animplicit interest rate) can be quite high.

The net-of-discount method records the inventory at the purchase costless the discount. If the discount is lost, the extra cost is treated as partof cost of goods sold of the period. This has two benefits: (1) the lostdiscount is not capitalized as part of the cost of inventory, and (2) the lostdiscount is highlighted, which is useful information that may be helpful inmanaging accounts payable.

Q7-2. If stable purchase prices prevail, the dollar amount of inventories(beginning or ending) tends to be approximately the same under differentinventory costing methods and the choice of method does not materially

affect net income.To see this, remember that FIFO profits include holdinggains on inventories. If the inflation rate is low (or inventories turn quickly),there will be less holding (inflationary) profit in inventory.

Q7-3. FIFO holding gains occur when the costs of earlier inventory acquisitionsare matched against current selling prices. Holding gains on inventoriesincrease with an increase in the inflation rate and a decrease in theinventory turnover rate. Conversely, if the inflation rate is low or inventoriesturn quickly, there will be less holding (inflationary) profit in inventory.

Q7-4. (a) Last-in, first-out, (b) Last-in, first-out, (c) First-in, first-out, (d) First-in,first-out, (e) Last-in, first-out.

Q7-5. A significant tax benefit results from using LIFO when costs areconsistently rising. LIFO results in lower pretax income and, therefore,lower taxes payable, than other inventory costing methods.

Q7-6. Kaiser Aluminum Corporation is using the lower of cost or market (LCM)rule. When the replacement cost for inventory falls below its (FIFO orLIFO) historical cost, the inventory must be written down to the lowerreplacement costs (market value).

Q7-7. The various inventory costing methods would produce the same results(inventory values and cost of goods sold) if prices were stable. Theinventory costing methods produce differing results when prices arechanging.

Q7-8. Inventory shrink refers to the loss of inventory due to theft, spoilage,damage, etc. Shrink costs are part of cost of goods sold but do notrepresent goods that were actually sold.


Financial Accounting, 3rd Edition7-2


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MINI EXERCISES

M7-13 (15 minutes)

a.

11/15 Inventory (+A) 6,076Accounts payable (+L) 6,076

11/23 Accounts payable (-L) 6,076Cash (-A) 6,076

$6,076 = $6,200 x 0.98.

b.+ Inventory (A) - - Accounts Payable (L) +

11/15 6,076 6,076 11/15

11/23 6,076

+ Cash (A) -

6,076 11/23

c. [($6,200 - $6,076)/$6,076] x [365/(30-10)] = 37.24%. (With interestcompounding, the annual rate of interest r can be solved from (1+r)(20/365)=1.02. The value that solves this relationship is r = 43.5%.)

M7-14 (15 minutes)a.

1/20 Inventory (+A) 12,250Accounts payable (+L) 12,250

2/15 Accounts payable (-L) 12,250Interest expense, discounts lost (+E, -SE) 250

Cash (-A) 12,500

$12,250 = $12,500 x 0.98.

b.+ Inventory (A) - - Accounts Payable (L) +

1/20 12,250 12,250 1/202/15 12,250

+ Cash (A) - + Interest Expense, Discounts Lost (E) -

12,500 2/15 2/15 250




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c. [($12,500- $12,250)/$12,250] x [365/(60-15)] = 16.55%. (With interestcompounding, the annual rate of interest r can be solved from (1+r)(45/365)=1.02. The value that solves this relationship is r = 17.4%.)

M7-15 (20 minutes)

RAW MATERIALS INVENTORYBeginning inventory $ 0Purchases + 84,000Materials used - 63,000Ending inventory $ 21,000

WORK IN PROCESS INVENTORYBeginning inventory $ 0

Materials used + 63,000Labor costs + 58,000Overhead costs + 28,000Cost of goods produced - 130,000Ending inventory $ 19,000

FINISHED GOODS INVENTORYBeginning inventory $ 0Cost of goods produced + 130,000Cost of goods sold - 95,000

Ending inventory $ 35,000

M7-16 (10 minutes)

2008:$63,747 -18,511

= 0.7096$$63,747

2007:$61,095 -17,751

= 0.7095$61,095

2006:

$53,324 -15,057

= 0.7176$53,324




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M7-18 (20 minutes)a. Balance Sheet December 2010

AssetsCash $12,000Inventory 50,000

Shareholders equityContributed capital $62,000

b. All monetary amounts in $ thousands.Year 2011 2012 2013Income statement:Revenue 75 85 95COGS-FIFO 50 60 70

Earnings before tax 25 25 25Tax expense 10 10 10

Net income 15 15 15

Cash flows:Receipts 75 85 95Inventory purchases -60 -70 -80Tax payments -10 -10 -10

Cash fromoperations

5 5 5

Dividends -9 -9 -9Cash from financing -9 -9 -9

Net change in cash -4 -4 -4

Balance sheet:AssetsCash 8 4 0Inventory 60 70 80

Total 68 74 80

Shareholders equityContributed capital 62 62 62Retained earnings 6 12 18

Total 68 74 80

Clearly there is a problem with this business model. The company is showingprofits, and assets and retained earnings are increasing. However, there is acash flow problem. The net change in cash every year is -$4 thousand and, bythe end of 2013, the company would have a cash balance of zero. In 2014, itwould not be possible to replenish the inventory and to pay the dividend.




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c. All monetary amounts in $ thousands.Year 2011 2012 2013Income statement:Revenue 75 85 95COGS-LIFO 60 70 80

Earnings before tax 15 15 15Tax expense 6 6 6

Net income 9 9 9

Cash flows:Receipts 75 85 95Inventory purchases -60 -70 -80Tax payments -6 -6 -6

Cash from operations 9 9 9

Dividends -9 -9 -9Cash from financing -9 -9 -9Net change in cash 0 0 0

Balance sheet:AssetsCash 12 12 12Inventory 50 50 50

Total 62 62 62

Shareholders equityContributed capital 62 62 62Retained earnings 0 0 0

Total 62 62 62

Interestingly, the use of LIFO reduces profits, and the companys reported assets(and net assets) are not growing like the FIFO case above. However, the cashflow situation is improved. The company can pay the desired dividends andcontinue to replace its inventory at the end of every year. The difference betweenLIFO and FIFO is that FIFO profits include a gain from holding inventory whileprices are rising. When the company is taxed on that gain, it has less cashavailable to maintain its physical assets (inventory). In essence, paying taxesbased on FIFO (when inventory costs are increasing) can cause a firms ability tostay in business to be taxed away. LIFO profits exclude holding gains, so thecompany could continue to stay in business. (The tax authorities will catch upwhen the business decides to stop investing in inventory, and the LIFOliquidation profits get taxed.)




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M7-19 (20 minutes)

a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000FIFO ending inventories = $400,000 - $205,000 = $195,000

b. LIFO cost of goods sold = 1,700 @ $150 = $255,000LIFO ending inventories = $400,000 - $255,000 = $145,000

c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667AC ending inventories = $400,000 $226,667 = $173,333

M7-20 (15 minutes)

a. $1,320,000 + purchases - $6,980,000 = $1,460,000; purchases = $7,120,000.

b.1. Inventory (+A) 7,120,000

Cash or Accounts payable (-A or +L) 7,120,000

2. Cost of goods sold (+E, -SE) 6,980,000Inventory (-A) 6,980,000

c.

+ Cash (A) - + Cost of Goods Sold (E) -7,120,000 (1) (2) 6,980,000

+ Inventory (A) -

Balance 1,320,000(1) 7,120,000

6,980,000 (2)

Balance 1,460,000

d.Balance Sheet Income Statement

Transaction CashAsset +NoncashAssets =

Liabi-lities +

Contrib.Capital +

EarnedCapital Revenues - Expenses =

NetIncome

a. Purchaseinventory.

-7,120,000Cash

7,120,000Inventory

= - =

c. Cost of inventorysold.

-6,980,000Inventory =

-6,980,000RetainedEarnings

-+6,980,000

Cost ofGoods Sold

=-6,980,00




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M7-21 (10 minutes)

a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400FIFO ending inventories = $12,400 - $6,400 = $6,000

b. LIFO cost of goods sold = 600 @ $12 = $7,200LIFO ending inventories = $12,400 - $7,200 = $5,200

c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764AC ending inventories = $12,400 $6,764 = $5,636

M7-22 (20 minutes)a.

Inventory Turnover-2008 Inventory Turnover-2007

Wal-Mart 306,158/[(34,511+35,159)/2] = 8.79 286,350/[(35,159+33,685)/2] = 8.32Target 45,766/[(6,705+6,780)/2] = 6.79 43,766/[(6,780+6,254)/2] = 6.72

b. Wal-Marts inventory turnover rate is higher than Targets. There can be severalreasons for this. Wal-Marts product lines may be oriented toward lower-margin/higher-turnover goods (Wal-Mart does report a lower gross profitmargin than Target). And, as the economy deteriorated in 2008, Wal-Martsproduct offerings and pricing strategies may have been more attractive toconsumers. Wal-Marts inventory turnover improved more than Targets in2008, and its gross profit margin increased, while Targets decreased. Afteryears of steady increases, both companies have reduced year-end 2008

inventories from the previous year, probably in anticipation of lower levels ofconsumer spending in fiscal 2009.

c. Inventory turns improve as the dollar volume of goods sold increases relativeto the dollar volume of goods on hand. Inventory reductions can be realizedby reducing the depth and breadth of product lines carried (e.g., not everystyle, size and color), eliminating slow-moving product lines, working withsuppliers to arrange for delivery when needed rather than inventorying for alonger holding period, and marking down goods for sale at the end of productseasons.

Retailers must balance the cost savings from inventory reductions against themarketing implications of lower inventory levels on hand. It would be possibleto stock only those items that turn over very quickly, but those items mayhave low margins. Or, there may be items that turn over slowly, but havesufficient margins to make offering them attractive, even though it reducesinventory turnover. Whenever ratios are used as incentive measures, it isimportant to recognize that they may cause cherry-picking of only thoseactivities that provide the highest ratio outcome.




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M7-23 (15 minutes)

a. Cost of goods sold (+E, -SE) 142,790,000Inventory (-A) 142,790,000

b.

+ Inventory - + Cost of Goods Sold -Balance 25,790,000 (a) 142,790,000

142,790,000 (a)(c) 140,560,000

Balance 23,560,000

c. Inventory (+A) 140,560,000Cash or Accounts payable (-A or +L) 140,560,000

d. ($000)

Balance Sheet Income Statement

Transaction CashAsset + NoncashAssets = Liabil-ities + Contrib.Capital + EarnedCapital Revenues - Expenses = NetIncomec. Purchase

inventory.-140,560

Cash+140,560Inventory

= - =

a. Cost of inventorysold.

-142,790Inventory =

-142,790RetainedEarnings

-+142,790

Cost ofGoods Sold

=-142,790

M7-24 (10 minutes)

a. (60 x $45) + (210 x $34) + (300 x $20) + (100 x $27) = $18,540

b. Cost: (60 x $45) + (210 x $38) + (300 x $22) + (100 x $27) = $19,980Market: (60 x $48) + (210 x $34) + (300 x $20) + (100 x $32) = $19,220Therefore, the ending inventory balance should be $19,220.




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b.

EXERCISES

E7-25 (30 minutes)

a. Fiscal year 2007:Gross profit margin = ($679,561 $484,676) $679,561 = 28.7%Inventory turnover ratio = $484,676 [($253,063 + $248,307) 2] = 1.93 timesFiscal year 2008:Gross profit margin = ($631,258 $463,812) $631,258 = 26.5%Inventory turnover ratio = $463,812 [($248,307 + $222,601) 2] = 1.97 times

b.

Fiscal year Quarter Gross profitGross profit

margin

2007

1 $ 27,090 21.5%

2 85,906 34.8%3 57,916 30.7%4 23,973 20.3%

2008

1 22,485 19.9%2 78,411 34.6%3 49,731 27.6%4 16,819 15.1%

The gross profit and gross profit margin numbers show that West Marine issignificantly more profitable in the second and third quarters. While the revenuesfrom these quarters are 80% higher than the other quarters, the gross profit from

quarters two and three are three times that of quarters one and four. Unlike manyretailers, who make most of their sales and profits in the fourth calendar quarter,West Marine must discount its prices and run promotions in order to generatesales in the first and fourth quarters.

c. Inventory is lowest at the end of the fiscal year. At the end of the firstquarter (end of March), inventory has increased in anticipation of the busysecond quarter, and inventory stays high through the second quarter (end ofJune). By the end of September (third quarter), inventory has declined, and itcontinues to decline through the fourth quarter.

It is common for seasonal businesses to choose fiscal year-ends when

inventories (and other balances like receivables) are lower. But it can mean thatannual ratios (like those calculated in part a) do not reflect the inventoryinvestment that was necessary to generate the sales reported for the year.Understanding these seasonal effects can be important for cash managementover the year.




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d. One approach to calculating an inventory turnover ratio is to use anaverage of averages approach. For the first quarter of 2007, the averageinventory was ($253,063 + $279,500) 2 = $266,282. Follow the same process todetermine the average inventory for quarters two, three and four. Then averagethe averages. The effect of this process is the following:

The weighted average inventory levels are greater than the simple annualaverages for both years because the fiscal year-end is set when inventory ispredictably low. When these inventory values are divided into annual cost ofgoods sold, the inventory turnover ratios are lower than those calculated in parta.

Weighted average inventory turnover ratio:2007: $484,676 $266,379 = 1.82 times2008: $463,812 $261,121 = 1.78 times

The annual ratios show a slight improvement in turnover from 2007 to 2008,perhaps indicating an improvement in the speed with which inventory translatedinto sales. However, on an average inventory basis, that improvement is nolonger evident. The reduction in inventory at the end of 2008 is probably not dueto West Marine being able to maintain sales with lower inventories, but rather anindication that the company expects the sales declines of 2008 to continue in thefuture.




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E7-26 (30 minutes)

Units CostBeginning Inventory 1,000 $ 20,000Purchases: #1 1,800 39,600

#2 800 20,800

#3 1,200 34,800Goods available for sale 4,800 $115,200

Units in ending inventory = 4,800 2,800 = 2,000

a. First-in, first-out

Units Cost Total

1,200 @ $29 = $34,800800 @ $26 = 20,800

Ending Inventory 2,000 $55,600

Cost of goods available for sale $115,200Less: Ending inventory 55,600Cost of goods sold $ 59,600

b. Last-in, first-out

Units Cost Total

1,000 @ $20 = $20,0001,000 @ $22 = 22,000

Ending inventory 2,000 $42,000

Cost of goods available for sale $115,200

Less: Ending inventory 42,000Cost of goods sold $ 73,200

c. Average cost$115,200/4,800 = $24 average unit cost2,000 x $24 = $48,000 ending inventory$115,200 - $48,000 = $67,200 cost of goods sold (or 2,800x$24)

d. 1. The first-in, first-out method in most circumstances represents physical flow.This inventory system applies to perishables or to situations in which theearliest items acquired are moved out first because of risk of deterioration orobsolescence.

2. Last-in, first-out results in the lowest inventory amount during periods ofrising unit costs, which in turn results in the lowest net income and thelowest income tax.

3. The first-in, first-out results in the lowest cost of goods sold in periods ofrising prices. This is the inventory method Chen should use to report thelargest amount of income. Of course, this assumes that prices will continueto rise. Companies cannot change inventory costing methods without

justification, and the change may be prohibited by tax laws as well.




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E7-27 (25 minutes)

Units Cost Total

Beginning inventory 100 @ $46 = $ 4,600Purchases: Purchase #1 650 @ 42 = 27,300

Purchase #2 550 @ 38 = 20,900

Purchase #3 200 @ 36 = 7,200Cost of goods available for sale 1,500 $60,000

a. First-in, first-out

Units Cost Total

200 @ $36 = $ 7,200150 @ 38 = 5,700

Ending inventory.................................... 350 $12,900

Cost of goods available for sale............ $60,000Less: Ending inventory.......................... 12,900Cost of goods sold................................. $47,100

b. Average cost

Cost of Goods Available for Sale/Total Units Available for Sale= $60,000/1,500 = $40 Average Unit Cost

Ending Inventory = 350 units x $40 = $14,000

Cost of goods available for sale $60,000Less: Ending inventory 14,000

Cost of goods sold $46,000

c. Last-in, first-out

Units Cost Total

100 @ $46 = $ 4,600250 @ 42 = 10,500

Ending inventory 350 $15,100

Cost of goods available for sale $60,000Less: Ending inventory 15,100

Cost of goods sold $44,900




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E7-28 (20 minutes)a.1. (70 x $190) + (45 x $268) + (20 x $350) + (120 x $60) + (80 x $88) + (50 x $126)

= $52,900.

2. Desks: (70 x $190) + (45 x $280) + (20 x $350) = $32,900

(70 x $210) + (45 x $268) + (20 x $360) = $33,960

Chairs: (120 x $60) + (80 x $95) + (50 x $130) = $21,300(120 x $64) + (80 x $88) + (50 x $126) = $21,020

Therefore, inventory would be reported at $32,900 + $21,020 = $53,920.

3. (70 x $190) + (45 x $280) + (20 x $350) + (120 x $60) + (80 x $95) + (50 x $130)= $54,200

(70 x $210) + (45 x $268) + (20 x $360) + (120 x $64) + (80 x $88) + (50 x $126)= $54,980

Therefore, inventory would be reported at $54,200.

b. Applying the lower of cost or market rule to individual items in inventoryresults in the lowest inventory amount, the highest cost of goods sold and thelowest net income. Under either of the other two methods, the inventory maybe valued at the higherof cost or market for some items in inventory.

E7-29 (20 minutes)

a. $13,042 million

b. $14,275 million

c. Pretax income has been reduced by $1,233 million cumulatively since GMadopted LIFO inventory costing. This is because it has matched currentinventory costs against current selling prices, thus avoiding the recognition ofholding gains that would have resulted had FIFO inventory costing been used.If LIFO has put $1,233 million less into ending inventory than FIFO, it musthave put $1,233 more into cost of goods sold than FIFO.

d. Pretax income has been reduced by $1,233 million (see part c). Assuming a35% tax rate, taxes have been reduced by $1,233 x 0.35 = $431.6 million.

Cumulative taxes have been decreased by the use of LIFO inventory costing.




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E7-30 (25 minutes)

a. $3,506 million

b. $3,436 million ($3,506 million - $70 million); the LIFO inventory carryingamount is greater than the FIFO carrying amount, which is uncommon. It

implies deflation or reduction in Krafts inventory costs. Although uncommon,it does occur, and we cannot blindly assume that inventory costs always rise.Further, this situation can lead to losses on LIFO liquidation, the opposite ofwhat we would normally expect.

c. Pretax income has been increased by $70 million cumulatively since Kraftadopted LIFO inventory costing. This is because it has matched currentinventory costs against current selling prices, thus avoiding the recognition ofholding losses that would have resulted had FIFO inventory costing beenused.

d. Pretax income has been increased by $70 million (see part c). Assuming a 35%tax rate, taxes have been increased by $70 x 0.35 = $24.5 million.

Cumulative taxes have been increased by use of LIFO inventory costing.

e. For 2006, the change in the LIFO reserve is a reduction of $1 million ($70million - $71 million). Pretax income has been decreasedby this amount, thusdecreasing taxes by $1 million x 0.35 = $0.35 million.

Postscript: If Krafts inventory was expected to continue to be more highly valuedunder LIFO than under FIFO, the company could reduce its tax expense byswitching to FIFO costing. However, the 2006 situation did not continue. By 2007(and continuing into 2008), Krafts inventory was more highly valued under FIFOthan under LIFO.

E7-31 (20 minutes)

a. ($ millions)$288 + Purchases - $5,247 = $327. Purchases = $5,286.

b.($ millions) As reported (LIFO) Pro forma (FIFO)Sales revenue $7,954 $7,954.0Cost of goods sold 5,247 5,234.3Gross profit $2,707 $2,719.7

$5,247 - ($32.7 - $20.0) = $5,234.3

c. As reported (LIFO): $2,707 / $7,954 = 34.03%




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Pro forma (FIFO): $2,719.7 / $7,954 = 34.19%

The small differences between LIFO and FIFO reflect both the rate of pricechange for Whole Foods inventories and the fact that its inventory movesthrough very quickly (about 17 times per year).

E7-32 (30 minutes)

a.Tiffany Zale Blue Nile

2008 2007 2008 2007 2008 2007Revenue $2860 $2939 $2138 $2153 $295 $319COGS 1215 1282 1090 1030 235 254Gross profit 1645 1657 1048 1123 60 65Gross profit margin (GPM) 57.5% 56.4% 49.0% 52.2% 20.3% 20.4%

b. (Usually, one would use average inventory to calculate the inventoryturnover ratio, but Tiffany & Co. changed its inventory accounting methodfrom LIFO to average cost in 2008. As a result, comparable inventorybalances are available only for 2008 and 2007.)

Tiffany Zale Blue Nile2008 2007 2008 2007 2008 2007

COGS 1215 1282 1090 1030 235 254Ending inventory 1601 1372 780 1021 19 21Inventory turnover 0.76 0.93 1.40 1.01 12.37 12.10

c. Fiscal years 2007 and 2008 were not easy times for fine jewelry retailers.After years of increasing revenues, all three of these companiesexperienced declining sales. Tiffany reports that the small improvement inmargin is due to (1) an inventory charge in 2007 that was not present in2008, (2) a product mix change in which their wholesale diamond sales (alower-margin business) decreased and (3) precious metals hedging thatreduced cost of goods sold. Zales gross profit margin dropped, and thecompany attributed the decline to (1) an aggressive inventory clearanceprogram, (2) liquidation of inventories for discontinued product lines and(3) a decline in sales of lifetime warranties (probably a higher marginproduct). Blue Niles small decline in GPM was attributed to a product mixchange engagement jewelry sales performed relatively well in 2008, andthese sales earn a lower margin than non-engagement jewelry.Tiffanys inventory turnover declined substantially from 2007 to 2008. Aninventory turnover value of 0.76 means that Tiffany holds an item ofinventory for 481 days (on average) before sale. Zales inventory turnoverratio is quicker and improved significantly. This change might reflect thesame inventory clearance program described above. (Inventory turnoverratios are also affected by the cost flow assumption. Tiffany uses average




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cost, Zales uses LIFO and Blue Nile uses specific identification, probablyclose to average cost. Zales LIFO reserves were $12.2 million in 2008 and$37.5 million in 2007.)

As an Internet retailer, Blue Nile earns a significantly lower gross profit onevery dollar of sales, but its volume of sales is very high relative to its

inventory. Compared to Tiffanys 481 days inventory, Blue Nile has lessthan 30 days inventory. One of the ways that Blue Nile keeps its turnoverhigh can be seen in the following from their 2008 10-K. The Company alsolists loose diamonds on its websites that are typically not included ininventory until the Company receives a customer order for thosediamonds. Upon receipt of a customer order, the Company purchases aspecific diamond and records it in inventory until it is delivered to thecustomer, at which time the revenue from the sale is recognized andinventory is relieved. Blue Nile does not disclose the amount of suchconsignment or agency diamonds. Zale discloses consignmentinventories of $114 million and $159 million at the end of 2008 and 2007,

respectively. Tiffanys financial reports make no mention of consignmentinventories.

d. In a business where the costs of inventory fluctuate significantly and whereinventory is routinely held for a year before it is sold, setting prices basedon average cost could be hazardous. If inventory costs have fallenrecently, a competitor who reduces prices accordingly (but maintainsmargins) would be able to take business from Tiffany. Or, if costs haverisen recently, Tiffanys prices might be more attractive than those ofcompetitors who have raised prices in response to costs. So, Tiffany maybe more attractive to customers, but it may be less able to replace

inventory than its competitors.




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c.

PROBLEMS

P7-33 (25 Minutes)

a. Caterpillar: $38,415/[($7,503 + $8,781)/2] = 4.72

Komatsu: 1,590,963/[(518,441 + 437,894)/2] = 3.33

As calculated, Caterpillars turnover is more than 40% higher than Komatsus,and there is a 32-day difference in the companies average inventory daysoutstanding. This difference could be attributed to differential productionefficiencies or to differential component sourcing strategies. PerhapsCaterpillar purchased more components from outside suppliers.

b. When there are no LIFO liquidation effects, changes in the LIFO reserve canbe attributed to changes in the companys costs. Caterpillars LIFO reservewent up in 2008, implying that its costs increased.

c. Pretax income has been reduced by $3,183 million cumulatively since CATadopted LIFO inventory costing. This is because it has matched currentinventory costs against current selling prices, thus avoiding the recognition ofholding gains that would have resulted had FIFO inventory costing been used.Each year, the difference between FIFO cost of goods sold and LIFO cost ofgoods sold is added to the LIFO reserve.Assuming a 35% tax rate, cumulative taxes have been reduced by $3,183 x0.35 = $1,114 million by the use of LIFO inventory costing.

d. For 2008, the change in the LIFO reserve is an increase of $566 million ($3,183million - $2,617 million). Pretax income has been decreased by this amount(relative to FIFO), thus decreasing taxes by $566 million x 0.35 = $198 million.

e. Komatsus use of specific identification probably approximates a FIFOinventory costing method. As a result, the comparison in part a above is notvalid because Caterpillars use of LIFO produces distortions. We should usethe LIFO reserve information to construct Caterpillars inventory turnoverbased on FIFO.

FIFO 2008 cost of goods sold = $38,415 ($3,183 $2,617) = $37,849

FIFO 2008 average inventory = [($8,781+$3,183)+($7,503+$2,617)]2 = $11,042FIFO 2008 inventory turnover = $37,849$11,042 = 3.43 times

So, Caterpillars inventory turnover is only 3% faster than Komatsus once wetake into account the differences in their inventory cost flow assumptions.




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P7-34 (20 minutes)

a. $5,659 million - $800 million = $4,859 million

b. $800 million

c. $800 million x 0.35 = $280 million

d. $1,249 million + [($800 million - $604 million) x (1 - 0.35)] = $1,376.4 million

e. $58,564 / [($4,859 + $4,849) / 2] = 12.07

f. [$58,564 - ($800 - $604)] / [($5,659 + $5,453) / 2] = 10.51

P7-35 (30 minutes)a.

Dell Hewlett-Packard Apple2008 2007 2006 2008 2007 2006 2008 2007 2006

Revenue $61,101 $61,133 $57,420 $91,697 $84,229 $73,557 $32,479 $24,006 $19,315

COGS 50,144 49,462 47,904 69,342 63,435 55,248 21,334 15,852 13,717

Grossprofit

10,957 11,671 9,516 22,355 20,794 18,309 11,145 8,154 5,598

Grossprofitmargin

(GPM)

17.9% 19.1% 16.6% 24.4% 24.7% 24.9% 34.3% 34.0% 29.0%

b.Dell Hewlett-Packard Apple

2008 2007 2008 2007 2008 2007COGS 50,144 49,462 69,342 63,435 21,334 15,852Average endinginventory

1,023.5 920.0 7,956.0 7,891.5 427.5 308.0

Inventory turnover 49.0 53.8 8.7 8.0 49.9 51.5

c. Gross profit margins reflect the companies cost control and their relativeability to create differentiated products. Dell spends only 1% of revenueson research and development (R&D), while Hewlett-Packard spends about4%. Apples R&D is about 3.5% of revenues, but its recent growth in salesand margins may be tied to the popularity of the iPhone.Inventory turnover differences may be tied to Dells founding strategy ofonly producing a computer after a customer has placed an order, and toApples practice of outsourcing a great deal of its production to Asia. Infact, Apple reports The Companys inventories consist primarily of




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finished goods for all periods presented. Over the past few years,Hewlett-Packard has increased its inventory turnover from around 4 toabove 8.

P7-36A (45 minutes) ($ thousands)

a. Inventories as a percent of current assets follows:30% ($81,925/$270,100) of current assets in 2003

39% ($98,213/$254,122) of current assets in 2002

As long as the Stride Rite retailing outlets have sufficient product to meetdemand, the reduction of inventories is positive as it likely represents moreefficient manufacturing processes. The reduction of inventories might be ofconcern, however, if Stride Rite is in financial difficulty and is unable topurchase the raw materials necessary for its production. We have no evidenceof its financial difficulty for 2003.

b. The inventory turnover rate follows:

2003:3.78

2$98,213$81,925

$340,614=

+ 2002:3.21

2$112,481$98,213

$337,951=

+

The inventory turnover rate has increased from 2002 to 2003. This is positive as itrepresents increased manufacturing/retailing efficiency.

c. Stride Rite uses the LIFO inventory costing method.

The LIFO reserve the difference between LIFO and FIFO inventories decreased by $1,610 from 2002 to 2003 and by $758 from 2001 to 2002. As aresult, reported profits actually increasedrather than decreased, as we wouldexpect in a period of rising prices. Note: a decrease in the LIFO reserve doesnot, by itself, indicate a drop in inventory costs, as the decrease in the reservemay also be due to LIFO liquidation (see d an e below).

From 2000 to 2001 the LIFO reserve increased by $314, thus reducing grossprofit by that amount.

d. Stride Rites reduction in its quantities of inventories is positive, as theholding costs of inventories (financing, insurance, handling costs, etc.) aresubstantial. As a general rule, companies should keep inventories at thelowest level possible without impairing their manufacturing efficiency orreducing the stock of finished goods to the point that sales are adversely

impacted.e. Stride Rites reduction of inventory quantities resulted in matching lower-cost

inventories against higher current selling prices. This increased its profits by$141 for 2003. This reduction in inventory quantities is called LIFO liquidation.

In 2002, however, the reduction of inventory quantities actually decreasedreported profits by $120 as Stride Rite dipped into higher-cost inventorylayers. As inventory costs fluctuate, higher- and lower-cost layers areestablished, thus leading to fluctuating effects on profits as inventory




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quantities are reduced. As this example demonstrates, it is not always thecase that reported profits increase as inventory quantities are reduced, as thisoutcome is predicated on the assumption of continually rising prices.




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C7-38 (40 minutes)

a. The effects of the change in accounting method are reported as of thebeginning of 2005, which is the earliest balance sheet presented in Hormels2006 10-K report. This is due to the GAAP requirement that LIFO

abandonment decisions be presented using the retrospective method. Thatis, all of the financial statements that are presented must be restated usingthe new accounting method (FIFO). As a result, Hormels 2005 balance sheetand its 2004 and 2005 income statements were restated in its 2006 10-K toreflect the switch to FIFO.

However, note that the decision to abandon LIFO was made in the firstquarter of 2006. In its 2005 10-K report, Hormel reported inventory and costof goods sold using the LIFO method. Because 2005 earnings wereoriginally reported using LIFO, the company had to restate its 2005 incomestatement, increasing 2005 net earnings by $1.1 million.

Hormels 2005 10-K reveals that the LIFO reserve at that time was $38.5million, indicating an increase of $1.8 million in 2005 ($38.5 - $36.7).Therefore, the tax effect of the LIFO-FIFO switch was $0.7 million ($1.8-$1.1)in 2005.

Hormel reports that total assets increased by $36.7 million at the beginningof 2005. This is the amount of the LIFO reserve that was added toinventories to restate the inventory to FIFO as of that date. However, sincethe decision to switch methods was made at the end of 2005 (beginning of2006), the effect of the switch was that assets (inventories) increased by$38.5 million.

The balance in retained earnings was increased by $23.0 million as of the

beginning of 2005, reflecting the cumulative difference in earnings since theadoption of LIFO. Retained earnings increased by $24.1 million ($23.0 + $1.1)as of the end of 2005 (beginning of 2006).

The additional tax liability that results from the change is $13.7 million ($36.7 23.0) as of the beginning of 2005. By the end of 2005, tax liabilities wereincreased by $14.4 million ($13.7 + $0.7).

These changes are summarized in the table below:

($ millions)Effect as of the

beginning of 2005 (asreported)

Effect as of the end of2005/beginning of 2006

Total assets(inventory)

+$36.7 +$38.5

Retained earnings +$23.0 +$24.1

Tax liabilities +13.7 +$14.4




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C7-38continued.

b. Hormel argues (correctly) that the FIFO method presents a better measure ofcurrent inventory value in the balance sheet. It should be noted that inearlier 10-K reports, Hormel justified the use of LIFO by noting that it

provided a better matching of current costs to current revenues in theincome statement (also a correct statement).

The company also argued that FIFO more accurately reflects the physicalflow of inventory (oldest product is sold first).

c. The effect on 2006 net income was not reported. However, assuming thatinventory costs continued to rise, the switch to FIFO would have increasednet earnings. In the past two years, earnings were increased by $1.1 million(2005) and $1.9 million (2004).

d. There are several possible motivations other than those provided by thecompany. Obviously, earnings management (the desire to report higher

earnings) immediately comes to mind. In addition, one would want to knowwhat effect the change had on Hormels proximity to debt covenants and onmanagement compensation formulae.

Ultimately, the decision cost Hormel $14.4 million in back taxes and may costthe company additional taxes moving forward, if prices continue to rise.However, there is substantial empirical evidence that companies that useLIFO carry greater quantities of inventory than those using FIFO. This is dueto the desire to avoid the tax effects of LIFO liquidation profits. Ultimately,using FIFO allows companies to reduce inventory quantities (for efficiencyreasons or in response to economic cycles) without paying a tax penalty forliquidating LIFO inventory layers.

Hormel management may feel that the costs of using LIFO (includingbookkeeping costs, contracting costs, and the costs of carrying excessinventory) are greater than the benefits of using LIFO (the tax savings). Thiswould especially be true if management expects future inventory costincreases to be small.

Finally, it should be noted that, historically, many LIFO abandonmentdecisions have been made by companies facing financial distress. However,in recent years, there has been an increase in healthy companies switchingto FIFO due to low levels of inflation. When expected cost increases aresmall, the tax benefits of LIFO are small relative to the perceived costs of

using LIFO.

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