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Chapter 8: Q7CA (page 437)

Prepare a memorandum containing responses to the following items.

(a) Describe the cost flow assumptions used in average-cost, FIFO, and LIFO methods of inventory valuation.

(b) Distinguish between weighted-average-cost and moving-average-cost for inventory costing purposes.

(c) Identify the effects on both the balance sheet and the income statement of using the LIFO method instead of the FIFOmethod for inventory costing purposes over a substantial time period when purchase prices of inventoriable items arerising. State why these effects take place.

Short Answer

Expert verified

The cost flow assumption is related to matching cost flow with the physical flow of goods. Under LIFO ending inventory would be lower during the inflation period, and average cost computation is different under periodic and perpetual systems.

Step by step solution

01

Cost flow assumption

Cost flow assumption is the way of taking the flow of cost for every issue or withdrawal of inventory from the pool. Inventories are acquired at different costs at different times. But the physical flow of goods may be in any sequence. So through the cost flow assumption, the physical flow of goods is matched with the cost flow of goods.

Cost flow assumption under FIFO

Under the FIFO system, it is assumed that the inventories are issued or withdrawn in the same way they were acquired. So the cost flow is matched in the same manner of acquisition,

Cost flow assumption under LIFO

Under the LIFO system, inventories issued or withdrawn are assumed to be in the opposite direction of acquiring them. So, in this system, the cost flow matches the recently acquired inventories.

Cost flow assumption under Average

The average method of inventory valuation assumed that irrespective of the acquisition date, the inventories are always utilized based on average cost. This average cost may be a moving average or weighted average.

02

Weighted average and the moving average cost

Weighted average cost

The weighted average cost is applied in the periodic system. Under this method, all the inventories are average at the end of the period, and the COGS is also determined on that basis.

Moving average cost

The moving average cost is different from the weighted average cost. This is applied under the perpetual system. Under this method, the inventories are averaged at each purchase or sale. The ending inventory and COGFS would be based on the latest average cost.

03

LIFO vs. FIFO effect

Under LIFO, the COGS are valued based on the reverse order of acquiring them. Thus ending inventory under this method would always be lower than the market price. Under FIFO, the ending inventory matches with the current market prices, and COGS would be lower than the market rate.

In the given case, as market prices are rising, there would be a widening gap between the market value of inventory and ending inventory on the balance sheet. Further, the COGS would be kept on increasing. As a result, net gross profit would be lower year on year, and current assets would also start falling.

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Most popular questions from this chapter

(FIFO and LIFO) Harrisburg Company is considering changing its inventory valuation method from FIFO to LIFO because of the potential tax savings. However, management wishes to consider all of the effects on the company, including its reported performance, before making the final decision.

The inventory account, currently valued on the FIFO basis, consists of 1,000,000 units at \(8 per unit on January 1, 2017. There are 1,000,000 shares of common stock outstanding as of January 1, 2017, and the cash balance is \)400,000.

The company has made the following forecasts for the period 2017鈥�2019.

2017

2018

2019

Unit sales (in millions of units)

1.1

1.0

1.3

Sales price per unit

\(10

\)12

\(12

Unit purchases (in millions of units)

1.0

1.1

1.2

Purchase price per unit

\)8

\(9

\)10

Annual depreciation (in thousands of dollars)

\(300

\)300

\(300

Cash dividends per share

\)0.15

\(0.15

\)0.15

Cash payments for additions to and replacement of plant and equipment (in thousands of dollars)

\(350

\)350

$350

Income tax rate

40%

40%

40%

Operating expenses (exclusive of depreciation) as a percent of sales

15%

15%

15%

Common shares outstanding (in millions)

1

1

1

Instructions

a. Prepare a schedule that illustrates and compares the following data for Harrisburg Company under the FIFO and the LIFO inventory method for 2017鈥�2019. Assume the company would begin LIFO at the beginning of 2017.

  1. Year-end inventory balances.
  2. Annual net income after taxes.
  3. Earnings per share.
  4. Cash balance.

Assume all sales are collected in the year of sale and all purchases, operating expenses, and taxes are paid during the year incurred.

b. Using the data above, your answer to (a), and any additional issues you believe need to be considered, prepare a report that recommends whether or not Harrisburg Company should change to the LIFO inventory method. Support your conclusions with appropriate arguments.

Zonker Inc. purchases 500 units of an item at an invoice cost of \(30,000. What is the cost per unit? If the goods are shipped f.o.b. shipping point and the freight bill was\)1,500, what is the cost per unit if Zonker Inc. pays the freight charges? If these items were bought on 2/10, n/30terms and the invoice and the freight bill were paid within the 10-day period, what would be the cost per unit?

Question: In January 2017, Susquehanna Inc. requested and secured permission from the commissioner of the Internal Revenue Service to compute inventories under the last-in, first-out (LIFO) method and elected to determine inventory cost under the dollar-value LIFO method. Susquehanna Inc. satisfied the commissioner that cost could be accurately determined by use of an index number computed from a representative sample selected from the company鈥檚 single inventory pool.

Instructions

(a) Why should inventories be included in (1) a balance sheet and (2) the computation of net income?

(b) The Internal Revenue Code allows some accountable events to be considered differently for income tax reporting purposes and financial accounting purposes, while other accountable events must be reported the same for both purposes. Discuss why it might be desirable to report some accountable events differently for financial accounting purposes than for income tax reporting purposes.

(c) Discuss the ways and conditions under which the FIFO and LIFO inventory costing methods produce different inventory valuations. Do not discuss procedures for computing inventory cost.

The following example was provided to encourage the use of the LIFO method. In a nutshell, LIFO subtracts inflation from inventory costs, deducts it from taxable income, and records it in a LIFO reserve account on the books. The LIFO benefit grows as inflation widens the gap between current-year and past-year (minus inflation) inventory costs.

This gap is:

With LIFO Without LIFO

Revenues \(3,200,000 \)3,200,000

Cost of goods sold 2,800,000 2,800,000

Operating expenses 150,000 150,000

Operating income 250,000 250,000

LIFO adjustment 40,000 0

Taxable income \( 210,000 \) 250,000

Income taxes @ 36% \( 75,600 \) 90,000

Cash flow \( 174,400 \) 160,000

Extra cash \( 14,400 0

Increased cash flow 9% 0%

Instructions

(a) Explain what is meant by the LIFO reserve account.

(b) How does LIFO subtract inflation from inventory costs?

(c) Explain how the cash flow of \)174,400 in this example was computed. Explain why this amount may not be correct.

(d) Why does a company that uses LIFO have extra cash? Explain whether this situation will always exist.

Case 2: Noven Pharmaceuticals, Inc.

Noven Pharmaceuticals, Inc., headquartered in Miami, Florida, describes itself in a recent annual report as follows.

Noven Pharmaceuticals, Inc.

Noven is a place of ideas鈥攁 company where scientific excellence and state-of-the-art manufacturing combine to create new answers to human needs. Our transdermal delivery systems speed drugs painlessly and effortlessly into the bloodstream by means of a simple skin patch. This technology has proven application sinestrogen replacement, but at Noven we are developing a variety of systems incorporating best selling drugs that fight everything from asthma, anxiety and dental pain to cancer, heart disease and neurological illness. Our research portfolio also includes new technologies, such as iontophoresis, in which drugs are delivered through the skin by means of electrical currents, as well as products that could satisfy broad consumer needs, such as our anti-microbial mouth rinse.

Noven also reported in its annual report that its activities to date have consisted of product development efforts, some of which have been independent and some of which have been completed in conjunction with Rhone-Poulenc Rorer (RPR) and Ciba-Geigy. The revenues so far have consisted of money received from licensing fees, 鈥渕ilestone鈥� payments (payments made under licensing agreements when certain stages of the development of a certain product have been completed), and interest on its investments. The company expects that it will have significant revenue in the upcoming fiscal year from the launch of its first product, a transdermal estrogen delivery system.

The current assets portion of Noven鈥檚 balance sheet follows.

Cash and cash equivalents \(12,070,272

Securities held to maturity 23,445,070

Inventory of supplies 1,264,553

Prepaid and other current assets 825,159

Total current assets \)37,605,054

Inventory of supplies is recorded at the lower-of-cost (first-in, first-out)-or-net realizable value and consists mainly of supplies for research and development.

Instructions

(a) What would you expect the physical flow of goods for a pharmaceutical manufacturer to be most like: FIFO, LIFO, or random (flow of goods does not follow a set pattern)? Explain.

(b) What are some of the factors that Noven should consider as it selects an inventory measurement method?

(c) Suppose that Noven had $49,000 in an inventory of transdermal estrogen delivery patches. These patches are from an initial production run and will be sold during the coming year. Why do you think that this amount is not shown in a separate inventory account? In which of the accounts shown is the inventory likely to be? At what point will the inventory be transferred to a separate inventory account?
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