Reporting and Analyzing Inventory: Learning Objectives - Coverage by Question

Chapter 7
Reporting and Analyzing Inventory

Learning Objectives coverage by question
MiniExercises
LO1 Interpret disclosures of
information concerning operating
expenses, including manufacturing
and retail inventory costs.
13 - 15, 17
LO2 Account for inventory and cost

of goods sold using different costing
methods.
18 - 21, 23
Exercises
26, 27,
29 - 31
Problems
Cases and
Projects
33, 34, 36
37, 38
LO3 Apply the lower of cost or

market rule to value inventory.
24
28
LO4 Evaluate how inventory costing

affects management decisions and
outsiders interpretations of financial
statements.
18
26, 29 - 31
33, 34, 36
37, 38
16, 22
25, 31, 32
33 - 35
37
36
37
LO5 Define and interpret gross

profit margin and inventory turnover
ratios. Use inventory footnote
information to make appropriate
adjustments to ratios.
LO6 Appendix 7A: Analyze LIFO
liquidations and the impact they have
on the financial statements.
Cambridge Business Publishers, 2014

Solutions Manual, Chapter 7
7-1
DISCUSSION QUESTIONS
Q7-1.
When company A purchases inventory from company B, the buyer and seller
must agree on which firm is responsible for the transportation costs. The
terminology freight on board shipping point or FOB is used to indicate the
buyer assumes responsibility for the transportation cost once notice of delivery
to the shipper is received. In addition, the buyer assumes responsibility for any
delay or damage during transit.
When goods are shipped FOB, the seller normally can recognize revenue
unless the seller has not fulfilled all requirements of the purchase agreement.
An example is when an equipment installation and/or up-and-running properly
is part of that agreement.
Q7-2.
If stable purchase prices prevail, the dollar amount of inventories (beginning or

ending) tends to be approximately the same under different inventory costing
methods and the choice of method does not materially affect net income. To see
this, remember that FIFO profits include holding gains 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 acquisitions are
matched against current selling prices. Holding gains on inventories increase with
an increase in the inflation rate and a decrease in the inventory turnover rate.
Conversely, if the inflation rate is low or inventories turn 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 are consistently
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 or LIFO)
historical cost, the inventory must be written down to the lower replacement
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. The inventory costing
methods produce differing results when prices are changing.
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 not represent goods that
were actually sold.

7-2
Financial Accounting, 4th Edition
Q7-9.
The LIFO reserve is the difference between the cost of inventory determined
using the last-in, first-out (LIFO) method and the cost determined using another
method (either FIFO or average cost). Companies that report inventory cost
using the LIFO method must also report the LIFO reserve. This allows the
financial statement reader to convert from LIFO to another method for comparison
purposes.
The LIFO reserve represents the difference between the historical, LIFO cost of
inventory and its current cost. This disparity between the book value and the
current value represents a gain from holding the inventory that has not yet been
recognized in income or in equity an unrealized holding gain.
Q7-10. Because LIFO assigns the last units purchased during the year to cost of goods
sold (COGS), changing prices can make it difficult to forecast earnings.
Companies have discretion as to when and how much inventory they purchase
during an accounting period. LIFO is always applied on a periodic, annual basis,
so a purchase made during the final days of the year will end up in COGS and
affect current earnings. However, if that purchase is delayed until the first week of
the next year, it could be several years before those units are transferred to
COGS. Unlike other inventory methods, LIFO requires that the quantity and price
of inventory purchases be predicted to make accurate earnings forecasts.
Q7-11A. LIFO liquidation is involuntary when it is caused by events that are beyond
managements control. Examples of such events include labor strikes, natural
disasters, or wars which could interrupt the delivery of inventory by suppliers or
shut down production facilities.
Q7-12A. In periods of rising prices, LIFO liquidation results in older, lower-cost goods being
expensed as cost of goods sold, yielding higher profits. This may be the result of
a management decision to reduce inventory levels for efficiency purposes.
However, it may also be an earnings management tactic. Management may be
trying to avoid violating bond covenants, or it may be trying to manipulate
management compensation. In any case, this practice is costly, in that the
additional profits lead to higher income taxes.

7-3
MINI EXERCISES
M7-13. (15 minutes)
The cost to be assigned to the inventory is $535 ($500 + $30 + $5).
+
(a)
(b)
(d)
-
Inventory (A)
500
50
5
Notes Payable (L)

500
Accounts Payable (L)

50
10
5
+ Interest Expense, Discounts Lost (E)

(c)
10
(a)
(b)
(c)
(d)
-
M7-14. (15 minutes)

The only cost that should be included in inventory is the cost of merchandise to be sold.
M7-15. (20 minutes)
RAW MATERIALS INVENTORY
Beginning inventory
Purchases
Materials used
Ending inventory
WORK IN PROCESS INVENTORY
Beginning inventory
Materials used
Labor costs
Overhead costs
Cost of goods produced
Ending inventory
FINISHED GOODS INVENTORY
Beginning inventory
Cost of goods produced
Cost of goods sold
Ending inventory
$
+
-
0
84,000
63,000
$ 21,000
+
+
+
-
0
63,000
58,000
28,000
130,000
$ 19,000
+
-
$
0
130,000
95,000
$ 35,000

7-4
M7-16. (10 minutes)

2011:
$65,030 -20,360
$65,030
= 0.6869
2010:
$61,587 -18,792
$61,587
= 0.6949
2009:
$61,897 -18,447
$61,897
= 0.7020
M7-17. (15 minutes)

a. Purchases are understated. If ending inventory is correctly valued, cost of goods
sold will also be understated and current income will be overstated. There would be
no effect in the following year.
If, however, ending inventory is understated (due to the mistakenly recorded
purchase) then there is no effect on income in either period.
b. Purchases are overstated. The effect on income, assuming normal inventory levels,
depends on the inventory costing system being used by the company. Assuming
rising prices, income would be reduced in the current year under LIFO or average
costing but unaffected under FIFO costing. Income in the following year would not
be affected. (The solution assumes the error is not discovered and corrected in the
current year.)
c. Shrink (part of cost of goods sold) is overstated and ending inventory is understated.
Consequently, current period income is understated. If the inventory is counted
correctly the following year, the error will reverse itself and income will be
overstated. This is an example of a self-correcting inventory error.

7-5
M7-18. (20 minutes)

a. Balance Sheet
Assets
Cash
Inventory
Shareholders equity
Contributed capital
December 2013
$12,000
50,000
$62,000
b. All monetary amounts in $ thousands.

Year
2014
Income statement:
Revenue
75
COGS-FIFO
50
Earnings before tax
25
Tax expense
10
Net income
15
2015
2016
85
60
25
10
15
95
70
25
10
15
75
-60
-10
5
85
-70
-10
5
95
-80
-10
5
-9
-9
-4
-9
-9
-4
-9
-9
-4
Balance sheet:
Assets
Cash
Inventory
Total
8
60
68
4
70
74
0
80
80
Shareholders equity
Contributed capital
Retained earnings
Total
62
6
68
62
12
74
62
18
80
Cash flows:
Receipts
Inventory purchases
Tax payments
Cash from
operations
Dividends
Cash from financing
Net change in cash
Clearly there is a problem with this business model. The company is showing
profits, and assets and retained earnings are increasing. However, there is a cash
flow problem. The net change in cash every year is -$4 thousand and, by the end of
2013, the company would have a cash balance of zero. In 2014, it would not be
possible to replenish the inventory and to pay the dividend.
continued next page

7-6
M7-18. concluded
c. All monetary amounts in $ thousands.
Year
2011
Income statement:
Revenue
75
COGS-LIFO
60
Earnings before tax
15
Tax expense
6
Net income
9
2012
2013
85
70
15
6
9
95
80
15
6
9
75
-60
-6
9
85
-70
-6
9
95
-80
-6
9
-9
-9
0
-9
-9
0
-9
-9
0
Balance sheet:
Assets
Cash
Inventory
Total
12
50
62
12
50
62
12
50
62
Shareholders equity
Contributed capital
Retained earnings
Total
62
0
62
62
0
62
62
0
62
Cash flows:
Receipts
Inventory purchases
Tax payments
Cash from operations
Dividends
Cash from financing
Net change in cash
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 cash flow
situation is improved. The company can pay the desired dividends and continue to
replace its inventory at the end of every year. The difference between LIFO and
FIFO is that FIFO profits include a gain from holding inventory while prices are
rising. When the company is taxed on that gain, it has less cash available to
maintain its physical assets (inventory). In essence, paying taxes based on FIFO
(when inventory costs are increasing) can cause a firms ability to stay in business to
be taxed away. LIFO profits exclude holding gains, so the company could continue
to stay in business. (The tax authorities will catch up when the business decides to
stop investing in inventory, and the LIFO liquidation profits get taxed.)

7-7
M7-19. (20 minutes)

a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000
FIFO ending inventories = $400,000 - $205,000 = $195,000
b. LIFO cost of goods sold = 1,700 @ $150 = $255,000
LIFO ending inventories = $400,000 - $255,000 = $145,000
c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667
AC 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.
2.
Inventory (+A)
Cash or Accounts payable (-A or +L)
7,120,000
Cost of goods sold (+E, -SE)

Inventory (-A)
6,980,000
7,120,000
6,980,000
c.
+
+
Balance
(1)
Balance
Cash (A) 7,120,000
Inventory (A) 1,320,000

7,120,000
6,980,000
1,460,000
+
(1)
(2)
Cost of Goods Sold (E)

6,980,000
(2)
d.
Transaction
a. Purchase inventory.
c. Cost of inventory sold.
Cash
Asset
-7,120,000
Cash
Balance Sheet
Noncash
LiabiContrib.
+
=
+
+
Assets
lities
Capital
7,120,000
Inventory
-6,980,000
Inventory
Income Statement
Earned
Capital
=
=
Revenues - Expenses =
-
-6,980,000
Retained
Earnings
Net
Income
=
+6,980,000
Cost of
Goods Sold
-6,980,000
=

7-8
M7-21. (10 minutes)

a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400
FIFO ending inventories = $12,400 - $6,400 = $6,000
b. LIFO cost of goods sold = 600 @ $12 = $7,200
LIFO ending inventories = $12,400 - $7,200 = $5,200
c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764
AC ending inventories = $12,400 $6,764 = $5,636
M7-22. (20 minutes)
a.
Wal-Mart
Target
Inventory Turnover-2012
335/[(40.7+36.4)/2] = 8.69
47.9/[(7.92+7.60)/2] = 6.17
Inventory Turnover-2011
315/[(36.4+32.7)/2] = 9.12
45.7/[(7.60+7.18)/2] = 6.18
b. Wal-Marts inventory turnover rate is higher than Targets. There can be several
reasons for this.
Wal-Marts product lines may be oriented toward lowermargin/higher-turnover goods (Wal-Mart does report a lower gross profit margin than
Target). And, as the economy deteriorated in 2008, Wal-Marts product offerings
and pricing strategies may have been more attractive to consumers. Wal-Marts
inventory turnover improved more while Targets remained level in 2011, and its
gross profit margin increased, while Targets was essentially unchanged. Both
companies increased year-end 2012 inventories from the previous year, probably in
anticipation of increased sales in 2013.
c. Inventory turns improve as the dollar volume of goods sold increases relative to the
dollar volume of goods on hand. Inventory reductions can be realized by reducing
the depth and breadth of product lines carried (e.g., not every style, size and color),
eliminating slow-moving product lines, working with suppliers to arrange for delivery
when needed rather than inventorying for a longer holding period, and marking down
goods for sale at the end of product seasons.
Retailers must balance the cost savings from inventory reductions against the
marketing implications of lower inventory levels on hand. It would be possible to
stock only those items that turn over very quickly, but those items may have low
margins. Or, there may be items that turn over slowly, but have sufficient margins to
make offering them attractive, even though it reduces inventory turnover. Whenever
ratios are used as incentive measures, it is important to recognize that they may
cause cherry-picking of only those activities that provide the highest ratio outcome.

7-9
M7-23. (15 minutes)

a. Cost of goods sold (+E, -SE)
Inventory (-A)
142,790,000
142,790,000
b.
Balance
(c)
Balance
c.
+
Inventory
25,790,000
142,790,000
140,560,000
23,560,000
+
(a)
Cost of Goods Sold

142,790,000
(a)
Inventory (+A)
Cash or Accounts payable (-A or +L)
140,560,000
140,560,000
d. ($000)
Transaction
c. Purchase
inventory
a. Cost of
inventory sold
Cash
Asset
Balance Sheet
Noncash
LiabilContrib.
+
=
+
+
Assets
ities
Capital
-140,560
Cash
+140,560
Inventory
-142,790
Inventory
Income Statement
Earned
Capital
Revenues - Expenses =
=
=
-142,790
Retained
Earnings
Net
Income
=
+142,790
Cost of
Goods 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) = $19,980
Market: (60 x $48) + (210 x $34) + (300 x $20) + (100 x $32) = $19,220
Therefore, the ending inventory balance should be $19,220.

7-10
EXERCISES
E7-25. (45 minutes)
a. Fiscal year 2010:
Gross profit margin = ($623 $447) $623 = 28.3%
Inventory turnover ratio = $447 [($197 + $202) 2] = 2.24 times
Fiscal year 2011:
Gross profit margin = ($643 $458) $643 = 28.8%
Inventory turnover ratio = $458 [($202 + $193) 2] = 2.32 times
b.
Fiscal year
2010
2011
Quarter
Gross profit
1
2
3
4
1
2
3
4
$ 25
82
50
18
25
85
54
20
Gross profit
margin
22.7%
35.2%
28.9%
16.8%
21.9%
36.0%
30.0%
17.7%
The gross profit and gross profit margin numbers show that West Marine is
significantly more profitable in the second and third quarters. While the revenues
from 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 many
retailers, 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 generate sales
in the first and fourth quarters.
c. Inventory is lowest at the end of the fiscal year. At the end of the first quarter (end of
March), inventory has increased in anticipation of the busy second quarter, and
inventory stays high through the second quarter (end of June). By the end of
September (third quarter), inventory has declined, and it continues 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 that annual ratios
(like those calculated in part a) do not reflect the inventory investment that was
necessary to generate the sales reported for the year. Understanding these
seasonal effects can be important for cash management over the year.
continued next page

7-11
E7-25. concluded
d. One approach to calculating an inventory turnover ratio is to use an average of
averages approach. For the first quarter of 2010, the average inventory was ($197
+ $243) 2 = $220. Follow the same process to determine the average inventory
for quarters two, three and four. Then average the averages. The effect of this
process is the following:
2010: Weighted average inventory = [197 + 2x(243+240+209+202) +202)]/10 = $219
2011: Weighted average inventory = [202 + 2x(248+242+212+194)+194)]/10 = $219
The weighted average inventory levels are greater than the simple annual averages
for both years because the fiscal year-end is set when inventory is predictably low.
When these inventory values are divided into annual cost of goods sold, the
inventory turnover ratios are lower than those calculated in part
Weighted average inventory turnover ratio:
2010:
2011:
$447 $219 = 2.04 times

$458 $219 = 2.10 times
The annual ratios showed a slight increase in turnover from 2010 to 2011, perhaps
indicating an increase in the speed with which inventory translated into sales. The
reduction in inventory at the end of 2011 is probably not due to West Marine being
able to maintain sales with lower inventories, but rather an indication that the
company expects the sales revenue declines of 2011 to continue in the future.
E7-26. (30 minutes)
Beginning Inventory
Purchases: #1
#2
#3
Goods available for sale
Units
1,000
1,800
800
1,200
4,800
Cost
$ 20,000
39,600
20,800
34,800
$115,200
Units in ending inventory = 4,800 2,800 = 2,000

continued next page

7-12
E7-26. concluded
a. First-in, first-out
Ending Inventory
Units
1,200
800
2,000
@
@
Cost of goods available for sale

Less: Ending inventory
Cost of goods sold
Cost
$29 =
$26 =
Total
$34,800
20,800
$55,600
$115,200
55,600
$ 59,600
b. Last-in, first-out
Ending inventory
Units
1,000 @
1,000 @
2,000

Cost of goods sold
Cost
$20
$22
Total
= $20,000
= 22,000
$42,000
$115,200
42,000
$ 73,200
c. Average cost
$115,200/4,800 = $24 average unit cost
2,000 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 the earliest items
acquired are moved out first because of risk of deterioration or obsolescence.
2. Last-in, first-out results in the lowest inventory amount during periods of rising unit
costs, which in turn results in the lowest net income and the lowest income tax.
3. The first-in, first-out results in the lowest cost of goods sold in periods of rising
prices. This is the inventory method Chen should use to report the largest amount
of income. Of course, this assumes that prices will continue to rise. Companies
cannot change inventory costing methods without justification, and the change may
be prohibited by tax laws as well.

7-13
E7-27. (25 minutes)
Beginning inventory
Purchases:
Purchase #1
Purchase #2
Purchase #3
Units
100
650
550
200
1,500
@
@
@
@
Cost
$46
42
38
36
@
@
Cost
$36
38
=
=
=
=
Total
$ 4,600
27,300
20,900
7,200
$60,000
=
=
Total
$ 7,200
5,700
$12,900
a. First-in, first-out
Ending inventory .................................
Units
200
150
350
Cost of goods available for sale..........

Less: Ending inventory .......................
Cost of goods sold ..............................
$60,000
12,900
$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 sold
$60,000
14,000
$46,000
c. Last-in, first-out
Ending inventory
Cost of goods sold
Units
100
@
250
@
350
Cost
$46
42
=
=
Total
$ 4,600
10,500
$15,100
$60,000
15,100
$44,900

7-14
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 inventory results in the
lowest inventory amount, the highest cost of goods sold and the lowest net income.
Under either of the other two methods, the inventory may be valued at the higher of
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 GM adopted
LIFO inventory costing. This is because it has matched current inventory costs
against current selling prices, thus avoiding the recognition of holding 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 must have 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 a 35% tax
rate, taxes have been reduced by $1,233 x 0.35 = $431.6 million.
Cumulative taxes were decreased by the use of LIFO inventory costing.
e. During this period GM was experiencing declining earnings while inventory costs
were not keeping pace. Under these conditions, FIFO reporting mitigates the effect
on income.
7-15
E7-30. (25 minutes)

a. $3,063 million
b. $4,461 million. the FIFO inventory carrying amount is greater than the LIFO carrying
amount, which is common. It implies Deeres current inventory costs are rising.
Although common, a lower FIFO carrying amount can occur We cannot blindly
assume that inventory costs always rise. When costs decline as is true in the
computer chip industry, losses can occur if LIFO layer- liquidation occurs, the
opposite of what we would normally expect.
c. Pretax income has been decreased by $1,398 million cumulatively since Deere
adopted LIFO inventory costing. This result occurs because higher current inventory
costs are matched against current selling prices, thus avoiding the recognition of
holding gains that would have resulted had FIFO inventory costing been used.
d. Pretax income has been decreased by $1,398 million (see part c). Assuming a 35%
tax rate, taxes have been decreased by $1,398 x 0.35 = $489.3 million.
Cumulative taxes have been decreased by use of LIFO inventory costing.
e. For 2010, the change in the LIFO reserve is an increase of $31 million [($4,461$2,777) ($3,764-$2,437)]. Pretax income has been decreased by this amount, thus
decreasing taxes by $31 million x 0.35 = $10.9 million.
Observation: If Deeres inventory were at some future date to be more highly valued
under LIFO than under FIFO, the company could reduce its tax expense by
switching to FIFO costing. This is, however, unlikely for Deere or other industries
facing continued price increases or even essentially constant prices.
E7-31. (20 minutes)
a. ($ millions)
$323 + Purchases - $6,571 = $337. Purchases = $16,356.
b.
($ millions)
Sales revenue
Cost of goods sold
Gross profit
As reported (LIFO)
$10,108
6,571
$ 3,537
Pro forma (FIFO)

$10,108
6,560.7
$ 3,547.3
$6,571 - ($29.7 - $19.4) = $6,560.7

c. As reported (LIFO): $3,537 / $10,108 = 35.0%
Pro forma (FIFO): $3,547.3 / $10,108 = 35.1%
The small differences between LIFO and FIFO reflect both the rate of price change
for Whole Foods inventories and the fact that its inventory moves through very
quickly (about 27 times per year).
7-16
E7-32. (30 minutes)

a.
Tiffany
Revenue
COGS
Gross profit
Gross profit margin (GPM)
2011
$3643
1492
2151
59.0%
2010
$3085
1262
1823
59.1%
Zale
2011
$1743
862
881
50.5%
2010
$1616
802
814
50.4%
Blue Nile
2011
$348
276
72
20.7%
2010
$333
261
72
21.6%
b. Usually, we would use average inventory to calculate the inventory turnover ratio. In
this case, the 2009 values are not supplied. So we use the 2010 final inventory value
only to estimate the 2010 COGS.
COGS
Ending inventory
Inventory turnover
Tiffany
2011
2010
1492
1262
2073
1625
0.81
0.78
Zale
2011
2010
862
802
721
703
1.21
1.14
Blue Nile
2011
2010
276
261
29
20
11.27
13.05
c. The recent fiscal years have not been easy times for fine jewelry retailers. After
years of increasing revenues, all three of these companies experienced declining
sales until 2011. Even the modest sales increases in the last two years have not led
to a noticeable increase in GPM and Blue Niles GPM even declined.
Inventory turnover ratios increased for Tiffany and Zale perhaps reflecting attention
to improved inventory management. This improvement was not the case for Blue
Nile.
A turnover value of 0.81 means that Tiffany holds an item in inventory for 452 days
(on average) before sale. Zales inventory turnover ratio is quicker and improved
significantly. This improvement might reflect an inventory clearance program similar
to one Zale engaged in during the period before 2009. Inventory turnover ratios are
also affected by the cost flow assumption. Tiffany uses average cost, Zales uses
LIFO and Blue Nile uses specific identification, probably close to average cost.
Zales LIFO reserves were $35.9 million in 2011 and $18.9 million in 2010.)
As an Internet retailer, Blue Nile earns a significantly lower gross profit on every
dollar of sales, but its volume of sales is very high relative to its inventory.
Compared to Tiffanys 452 days inventory, Blue Nile has less than 32 days
inventory. One of the ways that Blue Nile keeps its turnover high can be seen in the
following from their 2011 10-K. The Company also lists loose diamonds on its
websites that are typically not included in inventory until the Company receives a
customer order for those diamonds. Upon receipt of a customer order, the Company
Continued next page

7-17
E7-32. concluded
c. continued
purchases a specific diamond and records it in inventory until it is delivered to the
customer, at which time the revenue from the sale is recognized and inventory is
relieved. Blue Nile does not disclose the amount of such consignment or agency
diamonds. Zale discloses consignment inventories of $53.5 million and $81.1 million
at the end of 2011 and 2010, respectively. Tiffanys financial reports make no
mention of consignment inventories.
d. Zale has saved 0.35($619.8) = $216.93 million in taxes to date by using LIFO. Of
this amount, 0.35($619.8 - $606.4) = $4.69 million during 2010.

7-18
PROBLEMS
P7-33. (25 Minutes)
a. Caterpillar: $43,578/[($9,587 + $14,544)/2] = 3.61
Komatsu: 1,440,765/[(612,359 + 473,876)/2] = 2.65
As calculated, Caterpillars turnover is almost 1.0 times faster than Komatsus, and
there is a 37-day difference in the companies average inventory days outstanding.
This difference could be attributed to differential production efficiencies or to
differential component sourcing strategies. Perhaps Caterpillar purchased more
components from outside suppliers.
b. When there are no LIFO liquidation effects, changes in the LIFO reserve can be
attributed to changes in the companys costs. Caterpillars LIFO reserve increased
in 2011, implying that its costs increased.
c. Pretax income has been reduced by $2,422 million cumulatively since CAT adopted
LIFO inventory costing. This is because it has matched current inventory costs
against current selling prices, thus avoiding the recognition of holding gains that
would have resulted had FIFO inventory costing been used. Each year, the
difference between FIFO cost of goods sold and LIFO cost of goods sold is added to
the LIFO reserve.
Assuming a 35% tax rate, cumulative taxes have been reduced by $2,422 x 0.35 =
$847.7 million by the use of LIFO inventory costing.
d. For 2011, the change in the LIFO reserve is a decrease of $153 million ($2,422
million - $2,575 million). Pretax income has been increased by this amount (relative
to FIFO), thus increasing taxes by $153 million x 0.35 = $53.6 million.
e. Komatsus use of specific identification probably approximates a FIFO inventory
costing method. As a result, the comparison in part a above is not valid because
Caterpillars use of LIFO produces distortions. We should use the LIFO reserve
information to construct Caterpillars inventory turnover based on FIFO.
FIFO 2011 cost of goods sold = $43,578 ($2,422 $2,575) = $43,731
FIFO 2011 average inventory = [($14,544+$2,422)+($9,587+$2,575)]2 = $14,564
FIFO 2011 inventory turnover = $43,731 $14,564 = 3.00 times
So, Caterpillars inventory turnover is only 0.35 times faster than Komatsus once we
take into account the differences in their inventory cost flow assumptions.

7-19
P7-34. (20 minutes)

a. $6,157 million - $1,043 million = $5,114 million
b. $1,043 million
c. $1,043 million x 0.35 = $365 million
e. $602 million + [($1,043 million - $827 million) x (1 - 0.35)] = $531.7 million
e. $71,494 / [($5,114 + $4,966) / 2] = 14.19
f. [$71,494 - ($1,043 - $827)] / [($6,157 + $5,793) / 2] = 11.97
P7-35. (30 minutes)
a.
2012
Dell
2011
$62,071
$61,494
COGS
48,260
50,098
43,641
65,167
65,064
56,503
64,431
39,541
25,683
Gross
profit
13,811
11,396
9,261
62,078
60,969
58,049
43,818
25,884
17,229
Gross
profit
margin
(GPM)
22.3%
18.5%
17.5%
48.8%
48.4%
50.7%
40.5%
39.4%
40.1%
Revenue
2010
Hewlett-Packard
2012
2011
2010
2012
Apple
2011
2010
$52,902 $127,245 $126,033 $114,552 $108,249 $65,225 $42,905
b.
COGS
Average ending inventory
Inventory turnover
Dell
2012
2011
48.260
50,098
1,352.5
1,176
35.7
42.6
Hewlett-Packard
2012
2011
65,167
65,064
6,978
6,297
9.3
10.3
Apple
2012
2011
64,431
39,341
912.5
753
70.5
52.5
continued next page

7-20
P7-35. concluded
c. Gross profit margins reflect the companies cost control and their relative ability to
create differentiated products. Dell spends just over 1% of revenues currently on
research and development (R&D), while Hewlett-Packard spends about 2.5%.
Apples R&D is currently just over 2% of revenues, but its recent growth in sales and
margins is due to the popularity of the iPhone with sales up 87%,iPod sales up
113% and iMAC sales up 25% in 2011 alone. Apple does not expect these growth
trends to continue however.
Inventory turnover differences may be tied to Dells founding strategy of only
producing a computer after a customer has placed an order, and to Apples practice
of outsourcing a great deal of its production to Asia. In fact, Apple reports The
Companys inventories consist primarily of finished goods for all periods presented.
Over the past five years, Hewlett-Packard has increased its inventory turnover from
around 4 to above 9 while Apples has mushroomed to 70.
P7-36.A (45 minutes) ($ thousands)
a. Inventories as a percent of current assets follows:
80% ($432,433/$543,260) of current assets in 2012
82% ($455,236/$556,267) of current assets in 2011
As long as Senecas customers have sufficient product to meet demand, the
reduction of inventories reflects a positive development as it likely represents more
efficient manufacturing processes. The reduction of inventories might be of concern,
however, if Seneca is facing price declines, crop yield decreases due to weather, a
demand slowdown forcing the company to dispose of perishable product, or financial
difficulty in securing sufficient harvesting labor or to purchase the raw materials
necessary for production.
The decline in 2012, however, is due to the firms use of LIFO whereby the LIFO
reserve for finished goods increased.
b. The inventory turnover rate follows:
2012:
$1,169,102
$432,433 $455,236
2
2.63
2011:
$1,101,387
$455,236 $446,460
2
2.44
The inventory turnover rate has increased slightly from 2011 to 2012. This increase
is positive because it represents increased manufacturing/retailing efficiency.
c. Seneca uses the LIFO inventory costing method.
continued next page

7-21
P7-36.A concluded
d. The LIFO reserve the difference between LIFO and FIFO inventories increased
by $47,339 from 2011 to 2012 ($137,227 - $89,888). As a result, reported profits
decreased in 2012 by $30,771. In 2011, the LIFO reserve decreased by $5,104.
Note: a decrease in the LIFO reserve does not, by itself, indicate a drop in inventory
costs, as the decrease in the reserve may also be due to LIFO liquidation.
During 2012, there was in fact a decrease in the LIFO reserve due to the liquidation
of certain LIFO layers. Had this liquidation not occurred, LIFO reported profits would
have decreased earnings by an additional $2,899.
Senecas use of LIFO has led to a reduction of its taxes as indicated by the
$137,227 amount in the LIFO reserve. (See parts d and e.) Furthermore, the
reduction in Senecas quantities of inventories is positive, as the holding costs of
inventories (financing, insurance, handling costs, etc.) are substantial. As a general
rule, companies should keep inventories at the lowest level possible without
impairing their manufacturing efficiency or reducing the stock of finished goods to
the point that sales are adversely impacted. We might also examine Senecas cash
and quick ratios. (Using data from the 10k, not supplied in the problem statement,
we report the following. Senecas cash increased by 98.7% in 2012 from the cashflow statement - thereby increasing cash as a percent of current assets from 28.8%
to 38.2%. The companys quick ratio increased from 28.0% to 87.3%.) All the data
for 2012 support the importance Seneca places on cash. However, we only explore
one year in any detail here and so definitive conclusions await a review of previous
years and comparisons with competitors.
e. Senacas cash savings due to the use of LIFO over the past 5 years (when it
switched to LIFO from FIFO), and assuming a constant tax rate of 35% amount to
$48,029 thousand = $137,227 X (0.35).
nstas

7-22
CASES and PROJECTS

C7-37.A (30 minutes)
a. Pretax earnings would be higher by the change in the LIFO reserve. In 2011 the
LIFO reserve increased from $21.3 billion to $25.6 billion, for an increase of $4.3
billion. The 2011 pretax income that would have been reported if FIFO had been
used would thus be $73.257 billion - $4.3 billion = $68.957 billion.
b. The inventory turnover would be as follows:
$266,534
[($11,365+$3,359)+($9,852+$3,124)]/2
= 19.24
c. BPs inventory turnover is calculated as follows:

$285,618
= 11.01
($25,661+$26,218)2
d. Based on calculations from their financial statements, it appears that Exxon Mobils
inventory turns over much more quickly than BPs. However, Exxon Mobils use of
LIFO makes such a comparison invalid, because BP is not allowed to use LIFO
under IFRS. To make a better comparison, we adjust Exxon Mobils inventory
turnover ratio to FIFO. We need to increase the cost of goods sold by the decrease
in the LIFO reserve and increase the value of the inventories by the balance in the
LIFO reserve each year:
$266,534- $4,300
[(11,665+$3,359+$25,600)+ ($9,852+$3,124+$21,300)]/2
= 7.00
This ratio shows that Exxon Mobils inventory is turning over less than half as
quickly as the original calculation implied. And, rather than turning over its
inventory much more quickly than BP, it appears that Exxon Mobils inventory is
turning over significantly less quickly than BP.
e. The statement refers to the impact of LIFO liquidation on Exxon-Mobils profits.

7-23
C7-38. (40 minutes)

a.
The effects of the change in accounting method are reported as of the beginning of
2005, which is the earliest balance sheet presented in Hormels 2006 10-K report.
This is due to the GAAP requirement that LIFO abandonment decisions be
presented using the retrospective method. That is, all of the financial statements
that are presented must be restated using the new accounting method (FIFO). As
a result, Hormels 2005 balance sheet and its 2004 and 2005 income statements
were restated in its 2006 10-K to reflect the switch to FIFO.
However, note that the decision to abandon LIFO was made in the first quarter of
2006. In its 2005 10-K report, Hormel reported inventory and cost of goods sold
using the LIFO method. Because 2005 earnings were originally reported using
LIFO, the company had to restate its 2005 income statement, increasing 2005 net
earnings by $1.1 million.
Hormels 2005 10-K reveals that the LIFO reserve at that time was $38.5 million,
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 beginning of
2005. This is the amount of the LIFO reserve that was added to inventories to
restate the inventory to FIFO as of that date. However, since the decision to
switch methods was made at the end of 2005 (beginning of 2006), 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 the
adoption 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 were
increased by $14.4 million ($13.7 + $0.7).
These changes are summarized in the table below:
Effect as of the beginning
of 2005 (as reported)
+$36.7
Effect as of the end of

2005/beginning of 2006
+$38.5
Retained earnings
+$23.0
+$24.1
Tax liabilities
+13.7
+$14.4
($ millions)
Total assets (inventory)
continued next page

7-24
C7-38. concluded
b. Hormel argues (correctly) that the FIFO method presents a better measure of
current inventory value in the balance sheet. It should be noted that in earlier 10-K
reports, Hormel justified the use of LIFO by noting that it provided a better matching
of current costs to current revenues in the income statement (also a correct
statement).
The company also argued that FIFO more accurately reflects the physical flow of
inventory (oldest product is sold first).
c. The effect on 2006 net income was not reported. However, assuming that inventory
costs continued to rise, the switch to FIFO would have increased net 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 the company.
Obviously, earnings management (the desire to report higher earnings) immediately
comes to mind. In addition, one would want to know what effect the change had on
Hormels proximity to debt covenants and on management compensation formulae.
Ultimately, the decision cost Hormel $14.4 million in back taxes and may cost the
company additional taxes moving forward, if prices continue to rise. However, there
is substantial empirical evidence that companies that use LIFO carry greater
quantities of inventory than those using FIFO. This is due to the desire to avoid the
tax effects of LIFO liquidation profits. Ultimately, using FIFO allows companies to
reduce inventory quantities (for efficiency reasons or in response to economic
cycles) without paying a tax penalty for liquidating LIFO inventory layers.
Hormel management may feel that the costs of using LIFO (including bookkeeping
costs, contracting costs, and the costs of carrying excess inventory) are greater than
the benefits of using LIFO (the tax savings). This would especially be true if
management expects future inventory cost increases to be small.
Finally, it should be noted that, historically, many LIFO abandonment decisions have
been made by companies facing financial distress. However, in recent years, there
has been an increase in healthy companies switching to FIFO due to low levels of
inflation. When expected cost increases are small, the tax benefits of LIFO are
small relative to the perceived costs of using LIFO.

7-25

Reporting and Analyzing Inventory: Learning Objectives - Coverage by Question

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Chapter 7

Reporting and Analyzing Inventory

LO2 Account for inventory and cost

LO3 Apply the lower of cost or

LO4 Evaluate how inventory costing

LO5 Define and interpret gross

Cambridge Business Publishers, 2014

If stable purchase prices prevail, the dollar amount of inventories (beginning or

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

Cambridge Business Publishers, 2014

Notes Payable (L)

Accounts Payable (L)

+ Interest Expense, Discounts Lost (E)

M7-14. (15 minutes)

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

M7-16. (10 minutes)

M7-17. (15 minutes)

Cambridge Business Publishers, 2014

M7-18. (20 minutes)

b. All monetary amounts in $ thousands.

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

Cambridge Business Publishers, 2014

M7-19. (20 minutes)

Cost of goods sold (+E, -SE)

Cash (A) 7,120,000

Inventory (A) 1,320,000

Cost of Goods Sold (E)

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

M7-21. (10 minutes)

Cambridge Business Publishers, 2014

M7-23. (15 minutes)

Cost of Goods Sold

M7-24. (10 minutes)

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

Cambridge Business Publishers, 2014

$447 $219 = 2.04 times

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

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

Cost of goods available for sale

Cost of goods available for sale

Cambridge Business Publishers, 2014

E7-27. (25 minutes)

Ending inventory .................................

Cost of goods available for sale..........

Cost of goods available for sale

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

E7-28. (20 minutes)

E7-30. (25 minutes)

Pro forma (FIFO)

$6,571 - ($29.7 - $19.4) = $6,560.7

Financial Accounting, 4th Edition

E7-32. (30 minutes)

Cambridge Business Publishers, 2014

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

Cambridge Business Publishers, 2014