Entire - Chapter - 7.6th

P7–5. (continued)

Req. 4

Either method can be defended reasonably. If one focuses on current income and EPS, FIFO derives a more favorable result (higher than LIFO when prices are rising).

Alternatively, if one focuses on income tax expense and cash position, when prices are rising, LIFO derives more favorable results (lower taxes, better cash position).

However, these comparative results will reverse if prices fall.

FIFO provides a better balance sheet valuation (higher current asset value) but on the income statement does not match current expense (cost of goods sold) with current revenues. Alternatively, LIFO better matches expenses with revenues but produces a less relevant inventory valuation on the balance sheet.

McGraw-Hill/Irwin Financial Accounting, 6/e ? The McGraw-Hill Companies, Inc., 2009 7-33

P7–6.

Req. 1

SMART COMPANY

Income Statement (LCM basis) For the Year Ended December 31, 2010

Sales revenue $280,000 Cost of goods sold: Beginning inventory $ 31,000 Purchases 184,000 Goods available for sale 215,000 Ending inventory 37,850* Cost of goods sold 177,150 Gross profit 102,850 Operating expenses 62,000 Pretax income 40,850 Income tax expense ($40,850 x 30%) 12,255 Net income $ 28,595

*Computation of ending inventory on LCM basis: Replacement Item Quantity Original Cost Cost (Market) LCM Valuation

A 3,050 x $3 = $ 9,150 x $4 = $12,200 $ 9,150 B 1,500 x 5 = 7,500 x3.5 = 5,250 5,250 C 7,100 x1.5 = 10,650 x3.5 = 24,850 10,650 D 3,200 x 6 = 19,200 x 4 = 12,800 12,800 Total $46,500 $55,100 LCM inventory valuation $37,850

Req. 2 Amount of FIFO LCM Change Item Changed Cost Basis Basis (Decrease)

Ending inventory $ 46,500 $ 37,850 ($8,650) Cost of goods sold 168,500 177,150 8,650 Gross profit 111,500 102,850 ( 8,650) Pretax income 49,500 40,850 ( 8,650) Income tax expense 14,850 12,255 ( 2,595) Net income 34,650 28,595 ( 6,055)

McGraw-Hill/Irwin 7-34 ? The McGraw-Hill Companies, Inc., 2009 Solutions Manual

P7–6. (continued)

Req. 2 (continued)

Analysis

Ending inventory, cost of goods sold, gross profit, and pretax income each changed by the change in the valuation of the ending inventory.

Income tax expense decreased because the increase in expense reduced pretax income.

Net income was reduced by $8,650 (increased expense of $8,650) less the income tax savings of $2,595 = $6,055.

Req. 3

The inventory costing methods (weighted average, FIFO, LIFO, and specific identification) apply the cost and matching principles. Cost of goods sold, under these principles, is the actual cost incurred for the merchandise sold during the period; this cost is matched with sales revenue of the period.

LCM is an exception to the cost principle. Conceptually, LCM is based on the view that when replacement is less than the cost incurred for the merchandise, any such goods on hand should be valued at the lower replacement (market) price. The effect is to include the holding loss (i.e., the drop from cost to market) in the cost of goods sold amount for the period in which the replacement cost dropped. LCM recognizes holding losses in this manner; however, it does not recognize holding gains.

Req. 4

LCM reduced pretax income and income tax expense. There was a cash savings of $2,595 for 2010 (assuming the LCM results are included on the income tax return). In subsequent periods pretax income will be greater by the $8,650 and hence, income tax and cash outflow will be more. The only real gain to the company would be the time value of money between 2010 and the subsequent periods when increased income taxes must be paid (of course, a change in tax rates would affect this analysis).

McGraw-Hill/Irwin Financial Accounting, 6/e ? The McGraw-Hill Companies, Inc., 2009 7-35

P7–7.

Req. 1 Projected change No change from beginning of year Inventory = Cost of Goods Sold $7,008,984 = 17.5 $7,008,984 = 14.1 Turnover Average Inventory $400,005* $495,700** * ($495,700 + $304,310) ÷ 2 ** ($495,700 + $495,700) ÷ 2

Req. 2

Projected decrease in inventory = $495,700 – $304,310 = $191,390

A $191,390 increase in cash flow from operating activities, because a decrease in inventory would increase cash, all other items held constant.

Req. 3

An increase in the inventory turnover ratio indicates an increase in the number of times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly through the production process to the ultimate customer. As a consequence, the company can maintain less inventory on hand, all other things being equal. This can benefit the company because less money is tied up in inventory and as a result, cash flow from operations will be higher. The excess cash can be invested, earning interest income, or used to reduce borrowings, reducing interest expense.

McGraw-Hill/Irwin 7-36 ? The McGraw-Hill Companies, Inc., 2009 Solutions Manual