Fae3e SM ch06

Chapter 6.
Operating Expenses, Inventory Valuation, and Accounts

Payable
Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Difficulty Rating for Exercises and Problems:
Easy: E6.12; E6.13; E6.14; E6.15

Medium: E6.16; E6.17; E6.18; E6.19; E6.21
P6.23; P6.25; P6.28; P6.29; P6.32
Difficult: E6.20; E6.22
P6.24; P6.26; P6.27; P6.30; P6.31
QUESTIONS
Q6.1 The Consistency Principle. The consistency principle is important to
shareholders and investment professionals because it facilitates inter-period
comparisons of data. When an accounting policy change (e.g., a LIFO to FIFO
switch) occurs, a firms reported performance and financial condition will, in
most cases, be altered as a consequence of the policy change, making inter-
period comparisons difficult. To help overcome this data comparability problem,
accounting policy changes are usually implemented for all periods of data
included in the annual report. Thus, if a company reports two years of balance
sheet data and three years of income statement data (as is customary in the
U.S.), all of the data will reflect the use of the new accounting policy. This
practice facilitates two-year balance sheet comparisons and three-year income
statement comparisons, but comparisons of longer duration are usually unwise.
A change in a companys inventory accounting policy is reported in three ways

in the annual report:
1. The policy change is customarily mentioned in the auditors report
(assuming it is a method change).
2. The policy change, and its financial effect, is explained in the footnotes
to the financial statements.
3. The policy change is implemented in the financial statement data, as
noted above.
Cambridge Business Publishers, 2014

Solutions Manual, Chapter 6 6-1
Q6.2 Physical Inventory Counts. Periodically counting a companys inventory
serves several important functions:
1. It serves as a verification of the data provided by a firms inventory
management software; and,
2. It helps identify if there is inventory theft, spoilage, or wastage.
Thus, regardless of which inventory management system is in use (i.e., periodic
or perpetual), physically counting a companys inventory is considered best
practice.
Q6.3 Inventory Valuation Method Changes and Share Prices. There is a growing
body of literature, called Signaling Theory, which suggests that the
management of a company sends unintended signals to the capital markets
regarding a firms future financial performance by the actions and decisions that
the management team undertakes. Signaling Theory has been extended to
include voluntary accounting policy decisions and changes by B. Dharan and B.
Lev in The Valuation Consequences of Accounting Changes, Journal of
Accounting, Auditing and Finance (1993). What these researchers discovered
is that the capital market acts counter intuitively to accounting policy changes,
as follows:
For voluntary accounting policy changes that result in an increase in
accounting earnings (i.e., a LIFO-to-FIFO switch), the share price of a
firm tends to decline as the market anticipates that the method change is
being undertaken to hide future poor operating performance.
For voluntary accounting policy changes that result in a decrease in
accounting earnings (i.e., a FIFO-to-LIFO switch), the share price tends
to rise as the market hypothesizes that firm performance is exceeding
market expectations and management is attempting to bank the higher
anticipated future performance by creating an earnings reserve.

6-2 Financial Accounting for Executives & MBAs, 3 rd Edition
Q6.4 Lower-of-Cost-or-Market Method. The lower-of-cost-or-market (LCM) method
provides a good illustration of the conservatism principle in that losses in
inventory value are reported as a component of earnings but gains in value are
not. LCM, however, is also a violation of the cost principle, which stipulates that
assets should be recorded at their historical cost.
Under current U.S. GAAP, marketable securities may be written up or written

down as their fair value changes; and, thus, there exists a precedent to convert
LCM into a two-way street, recognizing both inventory-value gains and losses.
Under current U.K. GAAP, inventory may be written up or down on an annual
basis; and thus, U.K. GAAP provides a good model for the implementation of a
two-way street approach to inventory valuation.
The danger of not allowing inventories to be written up, as well as written down
is that a firms current assets may be misvalued (i.e., undervalued),
consequently also misstating such financial ratios as the current ratio.
Q6.5 Earnings Management and Inventory Valuation. An inventory valuation

policy change from LIFO to FIFO is very likely to result in an increase in current
and future earnings. Similarly, a LIFO layer liquidation is also likely to produce
higher current net earnings. In the case of a LIFO to FIFO switch, if inventory
costs are rising, use of the FIFO method will yield the highest level of reported
profit as compared to either LIFO or the weighted-average cost method. And, in
the case of a LIFO layer liquidation, the cost of sales will be reduced (assuming
rising input prices), and consequently, pretax earnings will be increased.
When would these policy changes not indicate the presence of earnings
management? In the case of a LIFO to FIFO switch, when inventory costs are
declining; and, in the case of a LIFO layer liquidation, when a restructuring or
downsizing of a business is undertaken to reflect a reduction in demand or
change in consumer tastes.

Q6.6 LIFO Inventory Reserve. The LIFO inventory reserve is a valuable tool for
investment professionals and shareholders because:
1. The absolute value of the inventory reserve can be used to restate a
firms ending inventory to reflect its current value and to restate a firms
retained earnings to reflect the level of retained earnings that would have
been reported if the firm used FIFO instead of LIFO.
2. The change in the reserve from one period to the next can be used to
restate cost of sales and operating income to reflect the performance of
the firm as if it had been using FIFO instead of LIFO.
Since LIFO tends to cause a firm to report the lowest level of net income and to
understate the value of its ending inventory, these restatements enable
investment professionals and shareholders to obtain a less conservative
assessment of firm performance. In addition, the LIFO inventory reserve also
facilitates necessary financial statement restatements to enable an apples-to-
apples comparison of interfirm performance when other comparable firms are
using the FIFO method of inventory valuation.
Q6.7 LIFO and Earnings Management. Under the LIFO approach to inventory
valuation, the most recent inventory purchase prices are charged to cost of
goods sold when inventory is sold, while the oldest prices are taken to the
balance sheet as the value of ending inventory. Since most firms try to avoid
liquidating all of their inventory (i.e., they try to maintain some minimal level of
inventory on hand to meet customer demand), in a period of rising inventory
purchase prices, the first-in prices that are retained on the balance sheet under
LIFO as the value of ending inventory may become very outdated and
significantly undervalued relative to their replacement cost. The amount of this
undervaluation is captured by the LIFO inventory reserve, and in essence,
represents the hidden earnings reserve referred to by investment
professionals.
Management may access the LIFO earnings reserve by reducing the quantity
of its LIFO price layers that is, by undertaking a LIFO layer liquidation. When
analysts identify from a companys footnote information that a LIFO layer
liquidation has occurred, it is often interpreted as earnings management (i.e.,
an attempt by management to make the firms performance look better than it
really is).

Q6.8 Inventory Valuation Policy Change. FIFO might enable Riverwood
International to more closely match its inventory costs with revenue if:
1. The companys inventory of paperboard physically flows through the
business on a FIFO basis.
2. The company is able to utilize lean-manufacturing techniques, such as
just-in-time inventory management.
3. The companys inventory purchase prices are relatively stable or
declining.
Q6.9 LIFO Layer Liquidations. When a company using the LIFO method to value
its inventory reduces the quantity of inventory on hand, the result is that lower
costs (i.e., lower than current replacement cost) are transferred to cost of goods
sold when inventory is sold, thereby lowering the cost of sales. (This assumes
the presence of inflation or rising inventory replacement prices). In 2012 and
2011, the LIFO layer liquidation actually resulted in an increase in cost of sales
for Alleghany. A LIFO layer liquidation does not always indicate that a firm is
trying to manage its earnings. For instance, if consumer tastes change and
demand for a companys products declines, an appropriate managerial
response would be to lower the amount of inventory that is normally kept on
hand to service customers. Thus, this type of inventory downsizing is an
appropriate managerial response to a decline in demand but has the
unintended consequence of raising operating income as if the goal were to
manage the companys earnings.
Q6.10 Inventory Value Write-Down. Delphis decision to write down the value of its
inventory reflects the lower-of-cost-or-market (LCM) method, which is founded
on the conservatism concept. When Delphi executes the write-down, it will
reduce the value of its inventory on hand by $100 million and report a loss on
inventory write-down on its income statement. If the $100 million write-down is
immaterial in amount, it may be reported as an increase in Delphis cost of
goods sold instead. The write-down will increase the companys inventory
turnover ratio and lower its inventory-on-hand period. The write-down lowers
the cost basis of the inventory on hand, and thus, assuming retail prices do not
materially decline, increases the profit margin on those goods when they are
ultimately sold in a future period. In short, an inventory write-down has the
effect of transferring a portion of the expected profit from the sale of inventory
from the current period to a future period (i.e., recognizing a loss now in
exchange for higher profits in a later period). As a consequence, some
companies have used an inventory write-down as a way to manage the amount
and timing of their earnings.

Q6.11 (Ethics Perspective) A Code of Ethics. A codes of ethics serves multiple
purposes. A code provides guidance for the professional as to what is
considered proper behavior under a range of differing situations. Codes of
conduct also serve to provide a level of assurance to the external customers of
these professionals that the profession is held to a standard of ethical conduct.
It can be argued that it should not make any difference if the professional (e.g
an accountant working for an organization rather than directly for the public)
should also be subject to an ethical code of conduct. Ethical dilemmas are not
limited to dealing with the public, rather they appear in many situations. A code
of ethics, detailing proper conduct in such situations, could greatly benefit the
professional. Just because a professional does not deal directly with the public
does not mean that the public does not rely on their work, at least indirectly.
For example, internal auditors provide assurance that controls are in place and
functioning properly so that an organizations financial reporting can be relied
upon. This work, in turn, serves to provide assurance to a firms external
auditors whose work is directly relied upon by the public.

EXERCISES
E6.12 Compute the Missing Inventory Values.

2012 2011 2010
Beginning inventory 9,655 10,485 --
Purchases of inventory -- 41,650 --
Inventory available for sale 55,505 52,135 --
Ending inventory 41,905 -- 10,485
Cost-of-goods sold -- -- --
E6.13 Calculating FIFO Inventory Values.

a. Periodic
2011
Purchases: 200 @ $10 $2,000
100 @ $14 1,400
300 $3,400 Total available for sale
Sales: 120 @ $10 (1,200)

80 @ $10 (800)
50 @ $14 (700)
250 $2,700 Cost of goods sold
50 @ $14 $700 Ending inventory
2012
Purchases: 100 @ $16 1,600
100 @ $18 1,800
250 $4,100 Total available for sale
Sales: 50 @ $14 (700)
30 @ $16 (480)
70 @ $16 (1,120)
30 @ $18 (540)
180 $2,840 Cost of goods sold
70 @ $18 $1,260 Ending inventory

b Perpetual
.
2011
Purchases: 20 @ $10
0
Sales: 120 @ $10 $1,200
Purchases: 10 @ $14
0
Sales: 80 @ $10 800
50 @ $14 700
Ending Inventory 50 @ $14 = $700 Cost of Goods Sold $2,700
2012
Purchases 10 @ $16
0
Sales: 50 @ $14 $700
30 @ $16 480
Purchases: 10 @ $18
0
Sales: 70 @ $16 1,120
30 @ $18 540
Ending inventory: 70 @ $18 = $1,260 Cost of goods sold $2,840
Summary:
Periodic Perpetual
2011:
Cost of goods sold $2,700 $2,700
Ending inventory 700 700
2012:
Ending inventory 1,260 1,260

E6.14 Calculating LIFO Inventory Values.
a. Periodic
2011
Purchases: 20 @ $10
0
10 @ $14
0
Sales: 100 @ $14 = $1,400
30 @ $10 = 300
120 @ $10 = 1,200
Ending inventory 50 @ $10 = $500 Cost of goods sold $2,900
2012
Purchases: 10 @ $16
0
10 @ $18
0
Sales: 100 @ $18 = $1,800
80 @ $16 = 1,280
Ending inventory 20 @ $16 = $320 Cost of goods sold = $3,080
50 @ $10 = 500
$820
b. Perpetual
2011
Purchases: 200 @ $10
Sales: 120 @ $10 = $1,200
Sales 100 @ $14 = 1,400
30 @ $10 300
Ending inventory 50 @ $10 = $500 Cost of goods sold $2,900
2012
Sales 80 @ $16 = 1,280
Purchases 100 @ $18
Sales 100 @ $18 = 1,800
Cost of goods sold $3,080
Ending inventory 50 @ $10 = $500
20 @ $16 = 320
$820
Summary
Periodic Perpetual
2011:
2012:

E6.15 Calculating Weighted-Average Cost Inventory Values.
a. Periodic
2011
Purchases: 200 @ $10 = $2,000
100 @ $14 = 1,400
300 3,400
Weighted-Average cost per unit = $11.33
COGS: 250 @ $11.33 = $2,832.50

Ending inventory* 50 @ $11.33 = $566.50
2012
Beginning Inventory 50 @ $11.33 = $566.50
Purchases 100 @ $16.00 = 1,600.00
100 @ $18.00 = 1,800.00
250 $3,966.50
COGS: 180 @ $15.87 = $2,856.60

Ending Inventory* 70 @ $15.87 = $1,110.90
b. Perpetual
2011
Purchases: 20 @ $10.00
0
Sales: 120 @ $10.00 = $1,200.00
0
Sales 130 @ $12.22 = $1,588.60
Ending inventory* 50 @ $12.22 = $611
Cost of goods sold $2,788.60
2012
0
Sales: 80 @ $14.74 = $1,179.20
0
Sales 100 @ $16.66 = $1,666.00
Cost of goods sold $2,845.20
Ending inventory* 70 @ $16.66 = $1,16
6
*minor rounding difference
Summary
Periodic Perpetual
2011:
Cost of goods sold $2,832.50 $2,788.60
Ending inventory 566.50 611.00
2012:
Cost of goods sold $2,856.60 $2,845.20
Ending inventory 1,110.90 1,166.00

E6.16 FIFO versus LIFO: Ratio Analysis.
Company X Company Z
(FIFO) (LIFO)
Return on sales 29.0% 18.6%

Inventory turnover 2.5x 6.6x
Inventory-on-hand period 146 days 55.7 days
Current ratio 3.05 2.55
Company X has a higher return on sales and a higher current ratio, suggesting
that its profitability and liquidity are better than Company Z. Company Z, on the
other hand, has a higher inventory turnover, and consequently, a lower
inventory-on-hand period, suggesting superior asset management. Of course,
the firms cash flows are identical as any differences that are observed in the
ratios are merely a manifestation of the cost allocation assumption inherent in
LIFO and FIFO. Thus, the two companies would represent equivalent
investment opportunities if evaluated on the basis of their cash flow.
E6.17 Inventory Management.
Year 1 Year 2
Inventory turnover 5.52x 5.05x
Inventory-on-hand period 66.1 days 72.3 days
Gross profit percentage 57.7% 59.4%
Intels inventory management effectiveness declined as evidenced by a

declining inventory turnover and a lengthening inventory-on-hand period. One
bright spot is that Intels gross profit percentage did increase. Thus, Intel is
doing a better job of controlling the cost of its inventory but not the rate of
production relative to the rate of sales of its inventory.
Yes; Intels inventory management ratios would have looked somewhat better if
the company had used LIFO instead of FIFO to value its inventory. This
outcome results because LIFO assigns a lower cost to ending inventory than
does FIFO.

E6.18 LIFO to FIFO Change. A LIFO-to-FIFO policy change is executed by making a
retroactive adjustment for the difference in inventory and cost of goods sold for
all prior periods. In this case, the retroactive adjustment is $12.6 million. Thus,
cost of sales on the income statements is reduced by $12.6 million and ending
inventory on the balance sheet is increased by $12.6 million. On a retroactive
basis, there is no effect of this change on cash flow; however, assuming that
Riverwood International was using LIFO for income tax purposes, it will now
also have to switch from LIFO to FIFO or the weighted-average cost method for
income tax purposes. Thus, in the year of the policy change, the companys
cash flow from operations will decline as a result of the higher income taxes
that it will pay on the higher FIFO earnings.
After the policy change, Riverwood Internationals results will appear as follows:
For the year
Net sales $298,731.0

Gross profit 49,778.6
Income from operations 10,213.6
Thus, the companys income from operations will increase by 0.124 percent,
which is clearly immaterial.
E6.19 Ratio Analysis: Alternative Inventory Valuation Methods.
Weighted
FIFO LIFO Average
Inventory turnover 3.28x 3.71x 3.51x

Inventory-on-hand period 111.3 days 98.4 days 104.0 days
Gross margin percentage 38.4% 36.8% 37.5%
AICCs profitability, as reflected by the gross margin percentage, is highest

under FIFO; however, the companys asset management effectiveness, as
revealed by its inventory turnover and inventory-on-hand period, looks best
under LIFO.
An interesting discussion question is Which of the methods gives ratio results

closest to reality? The answer to this question is linked to the physical flow of
goods in a business. Thus, if product flows through AICC on a FIFO basis, then
FIFO provides results that are closest to reality. The specific identification
method, of course, provides the best indication of reality, but most businesses
do not find it cost-justified to use this approach.

E6.20 LIFO Reserve: Restating Financial Statements. The Walgreen Company
(results restated from LIFO to FIFO):
Change in the inventory reserve = ($804 - $736) = $68
Cost of sales (restated for FIFO) = ($30,414 - $68) = $30,346
Ending inventory (restated for FIFO) = ($5,593 + $804) = $6,397
Net income before tax (restated for FIFO) = $2,456 + $68 = $2,524
The decision as to which inventory valuation method should be used
must be based on some criterion (eg. report the highest or lowest net
income). Net income under FIFO is higher than under LIFO, although not
significantly so in Year 2. If Walgreens elects to use FIFO for the higher
reported net income, it will be precluded from using LIFO for income tax
purposes under the LIFO compliance rule. So, the decision is not without
some trade-offs.
E6.21 Calculating the Days Payable Period.

Year 1 Year 2
Accounts payable turnover 3.98x 4.24x

Days payable period 91.8 days 86.1 days
Coca-Cola Enterprises (CCE) reduced its days payable period from 91.8 days
to 86.1 days, a reduction of 5.7 days (or 6.2%). This decline indicates that CCE
is paying its current trade obligations more quickly, a positive sign that the
companys credit risk is decreasing (i.e., probably due to increased liquidity in
the form of excess cash on the balance sheet and/or increased cash flow from
operations).
E6.22 LIFO Layer Liquidations and Net Income. The Claremont Corporation:
Year 2 Year 1
Net income before tax $360 $20

Less: LIFO liquidation profit (28) (6)
Restated net income $332 $14
The LIFO layer liquidation profit constituted 7.8 percent and 30 percent of the
companys operating income in Year 2 and Year 1, respectively. This profit is
often referred to as phantom profit because there is no parallel increase in the
cash flow from operations. The profit results from the lowering of the cost of
sales, not from an increase in sales revenue. Thus, profits are increased, but
cash flow is not. And, since the incremental (or phantom) profit is subject to
taxation, the level of operating cash flow is actually reduced by a LIFO

liquidation. In essence, a LIFO liquidation is an event wherein the tax-sheltering
benefit of the LIFO method is foregone.

PROBLEMS
P6.23 Calculating the Value of Ending Inventory and Cost of Goods Sold:
Periodic Method.
1. Cost of steel produced and
sold.
a. FIFO 500 tons @ $40 = $20,000
700 tons @ $35 = 24,500
200 tons @ $33 = 6,600
300 tons @ $30 = 9,000
1,700 $60,100
b. LIFO 350 tons @ $42 = $14,700

450 tons @ $30 = 13,500
200 tons @ $33 = 6,600
700 tons @ $35 = 24,500
1,700 $59,300
c. Weighted average
$79,300 2,200 = $36.05
1,700 @ $36.05 = $61,285
2. Ending Inventory
Replacement cost: 500 tons @ $39 = $19,500
Cost of ending inventory ignoring replacement cost:

FIFO $19,200
LIFO $20,000
Wt. average $18,025
Cost of ending inventory considering replacement cost:
FIFO $19,200
LIFO $19,500
Wt. average $18,015
3. The decision as to which inventory method to use must be predicated on

some criterion (eg. report the highest or lowest net income). Since inventory
input prices generally declined over the period, LIFO produced the lowest
cost of goods sold and hence, the highest net income. Keystone should
consider not only the current period results, but also the future period
results. For instance, prices might reverse and begin an upward spiral, in
which case, FIFO will yield the highest level of net income. Whatever
decision is undertaken, it will constrain Keystones tax reporting options
because of the LIFO compliance rule.

Perpetual Method.
1. Costs of Goods Sold and Ending Inventory
January February
Cost of Ending Cost of Ending
Goods Sold Inventory Goods Sold Inventory
a. FIFO $789,830 $154,560 $910,080 $264,420
b. LIFO 797,190 147,200 958,120 209,020
c. Wt. Average 792,446 151,944 937,888 233,996
a. FIFO
Beginning inventory, January 1 $120,000
Add: Purchases
January 5 207,200
January 20 617,190
Total available (January) 944,390
Less: Cost of goods sold
60,000 @ 2.00 = 120,000
103,600 @ 2.00 = 207,200
220,300 @ 2.10 = 462,630
(789,830)
Ending inventory (January) 154,560
(73,600 @ 2.10)
Add: Purchases
282,200 @ 2.20 620,840
153,500 @ 2.60 399,100
Total available (February) 1,174,500
73,600 @ 2.10 = 154,560
282,200 @ 2.20 = 620,840
51,800 @ 2.60 = 134,680
(910,080)
Ending inventory (February) $264,420

b. LIFO
Total available (January) $944,390
293,900 @ 2.10 = 617,190
90,000 @ 2.00 = 180,000
(797,190)
13,600 @ 2.00
60,000 @ 2.00
Add: Purchases 1,019,940
153,500 @ 2.60 = 399,100
254,100 @ 2.20 = 559,020
(958,120)
Ending inventory (February) $209,020
c. Weighted average
Total available (January) $944,390
$944,390 457,500 = 2.0642
383,900 @ 2.0642 (792,446)
Add: Purchases 1,019,940
73,600 @ 2.064 = 151,925*
282,200 @ 2.20 = 620,840
153,500 @ 2.60 = 399,100
509,300 1,171,865
407,600 @ 2.301 = (937,888)
Ending inventory (February) 233,996
* Rounded

2. Lower of Cost or Market: Ending Inventory
January February
Replacement Replacement
Cost Cost Cost Cost
FIFO 154,560 150,880 264,420 238,995
LIFO 147,200 150,880 209,020 238,995
Wt. Average 151,944 150,880 233,996 238,955
3. The decision to choose one inventory valuation method versus another

must be predicated on some decision criterion (eg. report the highest or
lowest net income). In this instance, as a consequence of rising input costs,
FIFO yields the lowest cost of goods sold and hence the highest net
income. Selecting FIFO, however, will constrain the companys ability to use
LIFO for income tax purposes as a consequence of the LIFO compliance
rule.
Lower-of-Cost-or-Market Method.
1.
Periodic Perpetual
Ending Ending
Inventor Cost of Inventor Cost of
Method y Goods Sold y Goods Sold
a. FIFO $42,000 $310,000 $42,000 $310,000
b. LIFO $30,000 $340,000 $30,000 $340,000
c. Weighted average $39,650 $330,350 $42,000 $321,310

2.
a. FIFO
Periodic:
Total available for sale $370,000
Less: Cost of goods sold:
160,000@ 1.00 = 160,000
60,000 @ 1.50 = 90,000
30,000 @ 2.00 = 60,000
(310,000)
Cost of ending inventory $60,000
Replacement cost:
30,000 @ 1.40 = $42,000
Perpetual: The results are the same as the periodic method.
b. LIFO
Periodic:
60,000 @ 2.00 = 120,000
60,000 @ 1.50 = 90,000
130,000 @ 1.00 = 130,000
(340,000)
Replacement cost $42,000
Perpetual:
Feb. 3: 120,000 @1.00 = 120,000
June 30: 30,000 @1.50 = 45,000
Oct. 5: 60,000 @ 2.00 = 120,000
30,000 @ 1.50 = 45,000
10,000 @ 1.00 = 10,000
(340,000)
Continued next page

2. Continued
c. Weighted Average
Periodic: $370,000 280,000 = $1.3214 per unit
250,000 @ $1.3214 = (330,350)
Cost of ending inventory 39,650
Perpetual:
Cost of goods sold:
Feb. 3 120,000 @ $1.00 = 120,000
Jun. 30 30,000 @ $1.30 = 39,000
Oct. 5 100,000 @ = 162,310
$1.6231
(321,310)
Cost of ending inventory 48,690
Under both the periodic and perpetual methods, LIFO yields the highest
cost of goods sold (i.e., $340,000), and hence the lowest taxable net
income; thus, LIFO would be preferred for tax purposes.
3. In highly inflationary environments, LIFO is to be preferred because it

matches the inflated revenues with the most recent (hence, inflated) cost of
goods sold. Thus, LIFO minimizes the amount of inflationary profits that will
be subject to income taxation currently.
4. Deflationary periodFIFO would have the highest COGS and the lowest
net income

P6.26 Restating Inventory Values Using the LIFO Reserve.
1. If FIFO instead of LIFO had been used in Year 2, the level of inventory on
the balance sheet would have been higher by $2,152. In addition, retained
earnings would have been higher by $1,441.8 ($2,152 x .67). Assuming that
LIFO was still being used for income tax purposes, deferred income taxes
would also be increased by $710.2.
On the income statement, cost of goods sold would be higher by $114
(i.e., $2,152-$2,266) and pretax earnings lower by $114.
2. Under normal conditions of increasing costs and stable (or growing)

inventory levels, FIFO will lead to a higher net income and, thus, higher
income taxes than under LIFO. In Year 1, and again in Year 2, however, the
company experienced a LIFO liquidation (the reasons for which are not
clear) amounting to $114 million on a pretax basis in Year 2. Thus, contrary
to expectation, the companys net income under LIFO in Year 2 is actually
higher by $114 million than under FIFO, creating a negative tax effect of
$37.62 million (i.e., $114 x .33).
The total estimated tax savings (in millions) experienced by the company as
a consequence of using LIFO rather than FIFO are $710.2 as of Year 2.
3. The decision to use LIFO versus FIFO must be predicated on some

decision criterion (eg. report the highest or lowest net income). This
decision, however, may constrain the firms ability to LIFO for income tax
purposes because of the LIFO compliance rule.

P6.27 Restating Inventory Values Using the LIFO Inventory Reserve:
International
1.
a. Ending inventory (LIFO) 6,500
Add: LIFO reserve 600
Ending inventory (FIFO) 7,100
b. Cost of goods sold (LIFO) (27,650)

Add: Increase in LIFO reserve 300
Cost of goods sold (FIFO) (27,350)
c. Net income (LIFO) before tax 1,160

Add: Increase in LIFO reserve 300
Net income (FIFO) before tax 1,460
d. Retained earnings 7,630

(LIFO)
Add: LIFO reserve 600
effective tax rate .26
156
(600 156) = +444
Retained earnings (FIFO) 8,074
2. The cost of using FIFO instead of LIFO is DM156 million, which is the
additional income taxes that BASF would have paid.
P6.28 Inventory Valuation and Earnings.

1. Units purchased in Year 3: 240 units
2. Cost of goods sold -Year 3: $4,200 [240 @ $15 + 60 @ $10]
4. Cost of goods sold: $4,500 [300 @ $15]
5. Cost of goods sold: $4,080 [ 60 @ $8 + 240 @ $15]
P6.29 Inventory Valuation and Earnings.

2. Cost of goods soldYear 3: $6,000 [300 @ $20]
4. Cost of goods sold-Year 3: $5,200 [50 @ $10 + 60 @ $15 + 190 @ $20]

P6.30 FIFO versus LIFO: Ratio Analysis.
FIFO LIFO
Compan Company
y
1. Current ratio 3.0 2.6
2. Inventory turnover 2.4x 6.6x
3. Inventory on-hand period 151 56
4. ROA 18% 12%
5. Total debt to total assets 40% 43%
6. Long-term debt to shareholders 46% 51%

equity
7. Gross margin 54% 44%
8. ROS 29% 19%
9. ROE 30% 21%
10. EPS $2.90 $1.86
Using just the ratios, and ignoring the question of income taxes, FIFO Company
appears to have the best liquidity, profitability, and solvency. But, if FIFO
Company uses FIFO for income tax purposes and LIFO Company uses LIFO
for income tax purposes, the LIFO Company will have a higher cash flow from
operations due to the income tax savings, making the LIFO Company the better
investment, acquisition, and lending opportunity.
P6.31 Evaluating Firm Performance Using FIFO and LIFO.

1. It was a good year. Sales and net earnings both increased from 2011 levels.
The return on sales ratio increased from 1.6 percent in 2011 to 1.7 percent
in 2012.
2. The LIFO reserve increased by $21 ($108-$87); hence NIBT under FIFO
would be higher by $21. NIBT under FIFO in 2012 would have been $2,788
(i.e., $2,767+$21)
The increase in cumulative tax payments would have been $7.58 (i.e., $21 x
36.1%).
CORPORATE ANALYSIS
CA6.32 The Procter & Gamble Company.

a. Inventory Valuation and Cost of Products Sold
Inventories are valued at the lower-of-cost-or-market value.
Product-related inventories are primarily maintained on the first-in,
first-out method. Minor amounts of product inventories . . . are
maintained on the last-in, first-out method. The cost of spare parts
inventories is maintained using the average-cost method. In short,
P&G primarily uses FIFO. In short, P&G uses lower-of-cost-or-
market.
Cost of products sold primarily comprises direct materials and
supplies consumed in the manufacture of product, as well as
manufacturing labor, depreciation expense and direct overhead
expense necessary to acquire and convert the purchased materials
and supplies into finished product. Cost of products sold also
includes the:
o cost to distribute products to customers
o inbound freight costs
o internal transfer costs
o warehousing costs
o other shipping and handling activity
P&Gs inventory represents 4.9 percent and 5.9 percent of total assets in
2007 and 2008, respectively. Given these large percentages, it is somewhat
surprising that P&G is using FIFO to principally value its inventory, foregoing
the tax benefit of using LIFO.

b. Inventory Valuation
2012 2011
Inventory turnover ratio 6.3x 5.4x
Inventory-on-hand period 57.9 days 67.6 days
Accounts payable turnover 5.4x 5.0x
Days payable period 68.2 days 73.5 days
Conclusions:
Inventory turnover improved from 2011 to 20128, reducing the
inventory-on-hand period by 9.7 days from 67.6 days to 57.9 days,
thus reversing a costly prior years trend at P&G.
Payable turnover increased from 2011 to 2012, indicating that the
company paid its payables off more quickly (i.e., by 0.4 days).
The combination of these two trends is positive for P&G. The company
is holding its inventory for a shorter period of time, which recognizes
the time value of money as well as potential storage/warehousing
cost savings. It is taking a shorter time (5.4 days) to pay it accounts
payable, and it may also be taking advantage of any quick pay
incentives.
c. An assumed inventory turnover rate of 7.0 in 2013 implies a COGS of

$46,900 (7 x $6,700). Hence, COGS will increase by ($46,900 - $42,391) =
$4,509 in 2013 from 2012. The gross profit margin percentage for 2012
was 49.3%. With an assumed gross margin percentage of 49.3% for 2013,
2013 revenue must be $92,505 ($46,900/ 0.507) and the gross margin must
be $45,605 ($92,505 - $41,289) as a result of the improvement in the
inventory turnover.
CA6.33.Internet-based Analysis. No solution is provided as any solution would be

unique to the company selected.

CA6.34 IFRS Financial Statements. LVMH Moet Hennessey-Louis Vuitton S.A.
a. If LVMH used U.S. GAAP to prepare its consolidated financial statements, it
is very likely that the company would use the same inventory valuation
method (ie. weighted average cost or FIFO). Given the nature of the
companys business, wherein inventory has a short shelf-life (ie. one fashion
season), there is unlikely to be any income tax advantage to utilizing LIFO;
and since such product likely flows through the companys system on a FIFO
basis, FIFO or weighted average cost is likely to be most representative. A
final consideration is industry standardmost high-end retailers (eg.
Nordstrom) in the U.S. use FIFO or weighted average cost.
b. When LVMH takes a write-down for inventory obsolescence (eg. at the end of
the fashion season), the transaction involves writing down its inventory to its
expected recovery value and recognizing an equivalent loss (ie. the provision
for inventory impairment) in the Other operating income and expenses
section as a reduction from Profit from recurring operations on LVMHs
income statement.


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Chapter 6.

Operating Expenses, Inventory Valuation, and Accounts

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Easy: E6.12; E6.13; E6.14; E6.15

A change in a companys inventory accounting policy is reported in three ways

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Under current U.S. GAAP, marketable securities may be written up or written

Q6.5 Earnings Management and Inventory Valuation. An inventory valuation

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E6.12 Compute the Missing Inventory Values.

E6.13 Calculating FIFO Inventory Values.

Sales: 120 @ $10 (1,200)

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COGS: 250 @ $11.33 = $2,832.50

COGS: 180 @ $15.87 = $2,856.60

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Return on sales 29.0% 18.6%

E6.17 Inventory Management.

Intels inventory management effectiveness declined as evidenced by a

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For the year

Net sales $298,731.0

E6.19 Ratio Analysis: Alternative Inventory Valuation Methods.

Inventory turnover 3.28x 3.71x 3.51x

AICCs profitability, as reflected by the gross margin percentage, is highest

An interesting discussion question is Which of the methods gives ratio results

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E6.21 Calculating the Days Payable Period.

Accounts payable turnover 3.98x 4.24x

Net income before tax $360 $20

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b. LIFO 350 tons @ $42 = $14,700

1,700 @ $36.05 = $61,285

Cost of ending inventory ignoring replacement cost:

3. The decision as to which inventory method to use must be predicated on

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FIFO 154,560 150,880 264,420 238,995

LIFO 147,200 150,880 209,020 238,995

Wt. Average 151,944 150,880 233,996 238,955

3. The decision to choose one inventory valuation method versus another

b. LIFO $30,000 $340,000 $30,000 $340,000

c. Weighted average $39,650 $330,350 $42,000 $321,310

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Perpetual: The results are the same as the periodic method.

Replacement cost $42,000

Replacement cost $42,000

Continued next page

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Replacement cost $42,000

Cost of ending inventory 48,690

Replacement cost $42,000

3. In highly inflationary environments, LIFO is to be preferred because it

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2. Under normal conditions of increasing costs and stable (or growing)