Vol.3 LM5 Inventory Systems

Question 1

List

Companies typically record changes to inventory using either of these two inventory systems

p. 263

Answer 1

• periodic inventory system
  OR
• perpetual inventory system

Question 2

Under a periodic inventory system

when are inventory values and costs of sales determined?

p. 263

Answer 2

at the end of accounting period

Question 3

Under periodic inventory system

quantity of goods in ending inventory

p. 263

Answer 3

usually obtained or verified through a physical count of the units in inventory

Question 4

Under perpetual inventory system

when are inventory values and cost of sales determined?

p. 263

Answer 4

continuously updated to reflect purchases and sales

Question 5

Inventory valuation methods

the allocation of goods available for sale to cost of sales and ending inventory is the same under which inventory valuation methods

p. 263

Answer 5

specific identification
FIFO

Question 6

inventory valuation method

under which inventory valuation methods will allocations to cost of sales and ending inventory be different?

p. 263

Answer 6

LIFO
sometimes for weighted average cost

Question 7

Compare

LIFO vs FIFO

p. 263

Answer 7

• the higher cost of sales under LIFO will result in lower gross profit
• income tax expense will be lower under LIFO, causing the company’s net operating cash flow to be higher
• the lower cost of sales under FIFO will result in higher gross profit
• income tax expense will be higher under FIFO, causing the company’s net operating cash flow to be lower

Question 8

Benefits of using

LIFO in an increasing inventory cost environment

p. 268

Answer 8

• income tax svings
• higher cash flows due to lower income taxes may make the company more valuable based the present value of its future cash flows

Question 9

undesirable outcomes

LIFO in an increasing inventory cost environment

p. 268

Answer 9

• higher cost of sales
• lower gross profit
• lower operating profit
• lower net income

All these consequences may reflect poorly in the balance such as lower current ratio, higher debt-to-equity

Question 10

Reason

publicly traded companies must take care when choosing an inventory valuation method

p. 268

Answer 10

while it may benefit the company to use LIFO during increasing inventory costs, it may not be able to switch inventory methods once inventory costs decrease.

Question 11

Concept

is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used

p. 268

Answer 11

LIFO Reserve

Question 12

Describe

LIFO reserve

p. 268

Answer 12

is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used

Question 13

under US GAAP

companies using LIFO must disclose this either in the notes to the financial statement or on the balance sheet

p. 269

Answer 13

LIFO reserve

Question 14

How to

compare companies using LIFO and FIFO

p. 269

Answer 14

• an analyst must add the LIFO reserve to the inventory balance reported on the balance sheet
• this is because the LIFO inventory balance + LIFO reserve = FIFO balance that would have been reported

Question 15

Explain

LIFO liquidation

p. 269

Answer 15

when the number of units sold exceeds the number of units purchased or manufactured, the number of units in ending inventory is lower than the number of units in beginning inventory and a company using LIFO will experience a LIFO liquidation. Inventory appears to have been sold that has not been sold.

Question 16

what will result if

If inventory unit costs have been rising from period to period and LIFO liquidation occurs

p. 269

Answer 16

• this will produce an inventory-related increase in gross profits
• this will only be a one-time event

Question 17

A decline in the LIFO reserve from the prior period may be indicative of …

p. 270

Answer 17

LIFO liquidation

Question 18

During economic downturns, LIFO liquidation may result in …

p. 270

Answer 18

higher gross profit than would otherwise be realized

Question 19

What inventory values would CAT report for 2017, 2016, and 2015 if had used FIFO instead of LIFO?

Balance Sheet
….Total inventories 2017: 10,018 2016: 8,614
….LIFO reserve 2017: 1,924 2016: 2,189

p. 272

Answer 19

Inventories
2017: 10,018+1,924=11,942
2016: 8,614+2,129=10,753

Question 20

What amount would be added to CAT’s retained earnings (profit employed in the business) at 31 December 2017 if CAT had used the FIFO method instead of the LIFO method?

LESS: increase in cost of goods sold (decrease in operating profit) 2017: -215 2016: -359
Tax reduction on decreased operating profit 2017: 60 2016: 129
FIFO inventories 2017: 1,924 2016 2,137

p. 273

Answer 20

(60/215)=0.28; (129/359)=0.36
(-215 x (1-0.28) + 2,139 x (1-0.36)) = 1,214 retained earnings

Some analysts advocate ignoring the tax consequences and suggest simply adjusting inventory and equity by the same amount.

Question 21

Calculate inventory turnover ratio, days of inventory on hand for 2017 for CAT

Cost of goods sold 2017 31,049 2016 28,309
Inventories 2017 10,018 2016 8,614
FIFO inventories 2017: 1,924 2016 2,137
Sales of Machinery and Engines 2017 42,676 2016 35,773

p. 270

Answer 21

Inventory turnover ratio = cost of goods sold / average inventory
LIFO = 31,049 / [(10,018 + 8,614)/2] = 3.33
FIFO = [31,049 + (2,139-1,924)] / [[(10,018+1,924) + (8,614+1,924)]/2] = 2.76

days of inventory on hand = number of days in period / inventory turnover ratio
LIFO = (365 / 3.33) = 109.6 days
FIFO = (365 / 2.76) = 132.2 days
without adjustment, a company using the LIFO method might appear to manage its inventory more effectively

Question 22

Calculate gross profit margin for 2017 for CAT

Cost of goods sold 2017 31,049 2016 28,309
Inventories 2017 10,018 2016 8,614
FIFO inventories 2017: 1,924 2016 2,137
Sales of Machinery and Engines 2017 42,676 2016 35,773

p. 270

Answer 22

gross profit margin = gross profit / total revenue
LIFO = [(42,676 - 31,049) / 42,676] = 27.24 percent
FIFO = [(42,676 - (31,049+215)) / 42,676] = 26.74 percent

Revenue of financial products is excluded from the calculation of gross profit.
Gross profit is sales of machinery and engines less cost of goods sold.

Question 23

Calculate gross profit margin for 2017 for CAT

Cost of goods sold 2017 31,049 2016 28,309
Inventories 2017 10,018 2016 8,614
FIFO inventories 2017: 1,924 2016 2,137
Sales of Machinery and Engines 2017 42,676 2016 35,773
Net income (loss) (FIFO method) 2017 599 2016 -297
Net income (loss) (LIFO method) 2017 754 2016 -67
Total assets 2017 76,692 2016 74704

p. 270

Answer 23

return on assets = net income / average total assets
LIFO = 754 / [(76,962 +74,704) / 2] = 0.99 percent
LIFO = 754 / [(76,962 +1,924) + (74,704 +2,139)/ 2] = 0.77 percent

The total assets under FIFO are the LIFO total assets increased by the LIFO reserve.
The return on assets is lower under FIFO because of the lower net income due to the higher cost of goods sold as well as higher total assets due to the LIFO reserve adjustment.

Question 24

Under IFRS

a change in the inventory valuation method is acceptable only if

p. 277

Answer 24

the change in method is acceptable only if the change results in the financial statements providing reliable and more relevant information about the effects of transactions, other events, or conditions on the business entity’s financial position

Question 25

Describe

retrospective restatement

p. 277

Answer 25

when a company makes a change in accounting policy in the current period, it must present a comparative financial statements for previous periods as if the new policy had been used the entire time.

Question 26

List reasons

cost of inventory may not be recoverable

p. 278

Answer 26

• spoilage
• obsolescence
• declines in selling prices

Question 27

Concept

is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale

p. 278

Answer 27

net realisable value

Question 28

Describe

net realisable value

p. 278

Answer 28

is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale