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Appendix 9.1: A Closer Look at LIFO's Effects on Financial Statements

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Data for Illustration of LIFO Layers

(Inventory at January 1, 2012)



EXHIBIT 9.8



© Cengage Learning 2014



LIFO Layers



Cost



Year Purchased



Number of Units



Per Unit



Total Cost



2005. . . . . . . . . . . . . . . . . . . . . .

2006. . . . . . . . . . . . . . . . . . . . . .

2007. . . . . . . . . . . . . . . . . . . . . .

2008. . . . . . . . . . . . . . . . . . . . . .



100

110

120

130

460



$ 50

60

80

100



$ 5,000

6,600

9,600

13,000

$34,200



the decline: older, lower costs per unit of prior years’ LIFO layers leave the balance sheet and

become expenses. If a firm reduces end-of-period physical inventory quantities below the beginning-of-period quantities, cost of goods sold will reflect the current period’s purchases plus a

portion of the older and lower costs in the beginning inventory. The firm will have lower cost of

goods sold, implying larger reported income and larger income taxes in that period than if the

firm had maintained its ending inventory at beginning-of-period levels.

To illustrate, assume that LIFO inventory at the beginning of 2012 consists of 460 units

with a total cost of $34,200, as in Exhibit 9.8. Assume that the cost at the end of 2012 is $120

per unit and that the income tax rate is 40%. If 2012 ending inventory drops to 100 units, all

360 units purchased in 2009, 2010, and 2011 will enter cost of goods sold. These 360 units

cost $29,200 (= $6,600 + $9,600 + $13,000), but the current cost of comparable units is

$43,200 (= 360 units × $120 per unit). Cost of goods sold will be $14,000 smaller (= $43,200

– $29,200) than if quantities had not declined because the firm dipped into old LIFO layers.

Income subject to income taxes will be $14,000 larger, and income after taxes will be $8,400

(= [1 – 0.40] × $14,000) larger than if quantities had not declined from 460 to 100 units. LIFO

results in firms deferring taxes as long as they do not dip into LIFO layers.



LIFO BALANCE SHEET

LIFO usually leads to a balance sheet amount for inventory that is materially less than the current cost of that inventory. The U.S. Securities and Exchange Commission (SEC) has worried

that this out-of-date information might mislead readers of financial statements. As a result, the

SEC requires SEC registrants that use LIFO to disclose, in notes to the financial statements, the

amounts by which inventories based on FIFO or current cost exceed their amounts as reported

with a LIFO cost-flow assumption. Some managers refer to the excess of FIFO or current

cost over LIFO cost of inventories as the LIFO reserve. Another term, less commonly used, is

“LIFO valuation allowance.”



CONVERTING FINANCIAL STATEMENT INFORMATION FROM LIFO TO FIFO

Using disclosures of the excess of FIFO or current cost inventories over LIFO inventories,

the analyst can compute inventories and cost of goods sold assuming a FIFO cost flow and

thereby obtain comparable data between a LIFO firm and its FIFO competitor. To illustrate

the conversion, consider the information reported by Super Soap Company (SSC) for the year

ended December 31, 2012. Exhibit 9.9 shows SSC’s income statement, Exhibit 9.10 shows the

asset portion of the balance sheet, and Exhibit 9.11 shows excerpts from the disclosures that

relate to inventories, which the U.S. SEC requires of LIFO firms.

SSC’s disclosures reveal that it uses the FIFO method for about 80% of its inventories and

LIFO for the remainder (20%). When a firm reports using LIFO for a material portion of its

inventory, common practice in the United States describes it as a LIFO firm—even though in

this case SSC uses FIFO for a majority (80%) of its inventories.

Exhibit 9.12 shows the conversion of inventories and cost of goods sold from a LIFO to a

FIFO cost-flow assumption. The inventory amounts in the first column under LIFO appear

on SSC’s balance sheet, and cost of goods sold and sales come from the income statement.

We compute purchases using the inventory equation. The amounts disclosed for the excess of



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Appendix 9.1: A Closer Look at LIFO’s Effects on Financial Statements



EXHIBIT 9.9



Super Soap Company

Consolidated Income Statement

For the Year Ended December 31, 2012



© Cengage Learning 2014



Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Selling, general, and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Other (income) expense, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest expense, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



156.6



Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



2,496.5



Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



759.1



Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



$ 1,737.4



Earnings per common share, basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



$



3.35



Earnings per common share, diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



$



3.20



Based on the financial statements of Colgate Palmolive Company



EXHIBIT 9.10



Super Soap Company

Excerpt from Consolidated Balance Sheet



As of December 31,

Assets

Current Assets

Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Receivables (net of allowances of $50.6 and $46.4, respectively) . . . . . . .

Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



© Cengage Learning 2014



$13,789.7

6,042.3

7,747.4

4,973.0

121.3

2653.1



2012



$



428.7

1,680.7

1,171.0



2011



$ 489.5

1,523.2

1,008.4



Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



338.1



279.9



Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



3,618.5



3,301.0



Property, plant, and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . .



3,015.2



2,696.1



Goodwill, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



2,272.0



2,081.8



Other intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



844.8



831.1



Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



361.5



228.0



Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



$10,112.0



$9,138.0



FIFO over LIFO permit the computation of beginning and ending inventories under FIFO in

the third column. SSC reports that at the end of 2012, the excess of FIFO cost over LIFO cost

was $87.4 million ($46.9 million at the end of 2011). This means that if SSC had used FIFO to

measure all inventories, the inventories would have been $87.4 million higher than reported at

the end of 2012 and $46.9 million higher than reported at the beginning of 2012. Purchases are

the same under LIFO and FIFO. Using the inventory equation, we calculate cost of goods sold

under FIFO as $6,041.8 million, compared to $6,042.3 million under LIFO. The gross margin

under LIFO is $7,747.4, as compared to $7,787.9 under FIFO. The larger gross margin under

FIFO suggests that inventory costs increased during the year.

We can compute inventory turnover ratios under LIFO and FIFO as follows:

LIFO: $6,042.3/[0.5 × ($1,008.4 + $1,171.0)] = 5.5 times per year

FIFO: $6,001.8/[0.5 × ($1,055.3 + $1,258.4)] = 5.2 times per year



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EXHIBIT 9.11



Super Soap Company

Excerpts from Inventory Disclosures



INVENTORIES



Inventories are stated at the lower of cost or market. The cost of approximately 80% of

inventories is measured using the first-in, first-out (FIFO) method. The cost of all other

inventories, predominantly in the United States and Mexico, is measured using the last-in,

first-out (LIFO) method.

16. SUPPLEMENTAL BALANCE SHEET INFORMATION

Inventories



© Cengage Learning 2014



Raw materials and supplies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Work-in-process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



2012



2011



$ 258.2

43.7

869.1

$1,171.0



$ 248.3

45.4

714.7

$1,008.4



Inventories valued under LIFO amounted to $498.8 and $438.2 at December 31, 2012

and 2011, respectively. The excess of current cost over LIFO cost at the end of each year

was $87.4 and $46.9, respectively. The liquidations of LIFO inventory quantities had no

effect on income in 2012, 2011, and 2010.



EXHIBIT 9.12



Super Soap Company

Derivation of FIFO Income from Financial Statements and Notes

(all dollar amounts in millions)



(Amounts shown in boldface appear in SSC’s financial statements. We derive other amounts

as indicated.)

FIFO Cost-Flow

Excess of

LIFO Cost-Flow

Assumption

FIFO over

Assumption

=

+

(hypothetical)

LIFO Amount

(actually used)



© Cengage Learning 2014



Beginning Inventory . . . . . . . . . . . . . . . . .

Purchases . . . . . . . . . . . . . . . . . . . . . . . .

Cost of Goods Available for Sale . . . . . . . . .

Less Ending Inventory . . . . . . . . . . . . . . . .

Cost of Goods Sold . . . . . . . . . . . . . . . . . .

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Less Cost of Goods Sold . . . . . . . . . . . . . . .

Gross Margin on Sales . . . . . . . . . . . . . . . .



$ 1,008.4

6,204.9a

$ 7,213.3

1,171.0

$ 6,042.3

13,789.7

6,042.3

$ 7,747.4



$ 46.9

0.0

$ 46.9

87.4

$(40.5)

0.0

(40.5)

$ 40.5



$ 1,055.3

6,204.9

$ 7,260.2

1,258.4

$ 6,001.8

13,789.7

6,001.8

$ 7,787.9



a



Computation of Purchases not presented in financial statements:



Purchases = Cost of Goods Sold + Ending Inventory – Beginning Inventory

$6,204.9 =

$6,042.3

+

$1,171.0



$1,008.4



The inventory turnover ratio under LIFO is misleading because it uses relatively current

costs in the numerator and the older cost of LIFO layers in the denominator. The inventory

turnover under FIFO more accurately measures the actual turnover of inventory because it

uses relatively current cost data in both the numerator and the denominator.

Consider also the current ratio (= current assets/current liabilities) as a measure of shortterm liquidity. If a firm uses LIFO in periods of rising prices while inventory quantities

increase, the amount of inventory included in the numerator of the current ratio will be smaller

than if the firm measured inventory at more current costs using FIFO. Hence, the unwary

reader may underestimate the liquidity of a company that uses a LIFO cost-flow assumption.



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Solutions to Self-Study Problems



THE LIFO-FIFO CHOICE

U.S. firms face the choice between the LIFO and FIFO cost-flow assumptions because U.S. tax

authorities allow LIFO for tax purposes. (Recall that IFRS forbids LIFO for financial reporting.) For U.S. firms, the decision as to which cost-flow assumption to use will depend on several

factors:

1. The extent of changes in manufacturing or purchase costs: When such costs do not change

significantly, then the three cost-flow assumptions provide similar amounts for inventories

and cost of goods sold.

2. The rate of inventory turnover: The faster the rate of inventory turnover, the smaller are the

differences in inventories and cost of goods sold among the three cost-flow assumptions.

3. The direction of expected changes in costs: FIFO results in higher net income and income

taxes when total costs increase and lower net income and income taxes when costs decrease.

4. The relative emphasis on reporting higher earnings to shareholders versus saving income

taxes: U.S. issue only.

5. The increased record-keeping costs of LIFO (for example, keeping track of LIFO layers for

all of a firm’s products) and its inconsistency with the usual physical flow of inventories: U.S.

issue only.

6. The requirement that U.S. firms must use LIFO for financial reporting if they use LIFO for

income tax reporting.

In recent years more than half of U.S. firms use FIFO for a significant portion of their

inventories, and more than one-quarter use LIFO for a significant portion. Fewer than onethird of the firms use weighted average or specific identification. Industries with many firms

using LIFO include the chemical industry and manufacturers of industrial and farm equipment. Retailing firms also use LIFO extensively. The industries with the smallest proportion

of firms using LIFO include technology-based firms, which experience decreasing production

costs, such as computers and other electronic equipment. Most foreign tax authorities do not

allow LIFO for income tax reporting, so most companies that use LIFO for U.S. inventories

use FIFO for inventories abroad.



PROBLEM 9.6 FOR SELF-STUDY

Assessing the impact of a LIFO layer liquidation. Refer to the data in Problem 9.2 for SelfStudy. During August the firm purchased 600 units for $15 each and sold 725 units.

a. Compute the cost of goods sold and the ending inventory for August using (1) FIFO,

(2) LIFO, and (3) weighted-average cost-flow assumptions.

b. Calculate the effect of the LIFO liquidation on net income before income taxes for

the year.



SOLUTIONS TO SELF-STUDY PROBLEMS

SUGGESTED SOLUTION TO PROBLEM 9.1 FOR SELF-STUDY

(Haskell Ltd; flow of manufacturing costs through the accounts.)



a.



Beginning Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Raw Materials Purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Raw Materials Available for Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Subtract Ending Raw Materials Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cost of Raw Materials Used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



£ 42,400

60,700

£103,100

(46,900)

£ 56,200



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b.



Beginning Work-in-Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cost of Raw Materials Used (from part a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Direct Labor Costs Incurred. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Heat, Light, and Power Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Rental Charges for Factory Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Rental Charges for Factory Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Prepaid Insurance Costs Consumed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Beginning Work-in-Process and Manufacturing Costs Incurred. . . . . . . . . . . . .

Subtract Ending Work-in-Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cost of Units Completed and Transferred to Finished Goods Storeroom. . . . . . . . . . .



£ 75,800

56,200

137,900

1,260

1,800

4,100

1,440

£278,500

(63,200)

£215,300



c.



Beginning Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cost of Units Completed and Transferred to Finished Goods

Storeroom (from part b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Subtract Ending Finished Goods Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



£ 44,200

215,300

(46,300)

£213,200



Income before taxes is £61,800 (= £400,000 – £213,200 – £125,000)



SUGGESTED SOLUTION TO PROBLEM 9.2 FOR SELF-STUDY

(Computing cost of goods sold and ending inventory under various cost-flow assumptions.)

a. See Exhibit 9.13.

b. See Exhibit 9.14.



SUGGESTED SOLUTION TO PROBLEM 9.3 FOR SELF-STUDY

(Effect of cost-flow assumptions on financial ratios.)

a. Current Ratio



EXHIBIT 9.13



Suggested Solution to Problem 9.2 for Self-Study, Part a

Total Cost

Units



Unit

Cost



FIFO



LIFO



Weighted

Average



Beginning Inventory . . . . . . . . . .

Purchases, June 1 . . . . . . . . . . . .

Purchases, June 7 . . . . . . . . . . . .

Purchases, June 18 . . . . . . . . . . .





100

400

100





$10.00

11.00

12.50





$ 1,000

4,400

1,250





$ 1,000

4,400

1,250



$ 1,000

4,400

1,250



Total Goods Available for Sale . . . .

Withdrawals During June . . . . . . .

Ending Inventory . . . . . . . . . . . .



600

(495)

105



$ 6,650

(5,345)a

$ 1,305b



$ 6,650

(5,595)c

$ 1,055d



$ 6,650

(5,486)e

$ 1,164f



(100 × $10.00) + (395 × $11.00) = $5,345.

(100 × $12.50) + (5 × $11.00) = $1,305.

c

(100 × $12.50) + (395 × $11.00) = $5,595.

d

(100 × $10.00) + (5 × $11.00) = $1,055.

e

495 × ($6,650/600) = $5,486.

f

105 × ($6,650/600) = $1,164.

a



© Cengage Learning 2014



b



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Solutions to Self-Study Problems



EXHIBIT 9.14



Suggested Solution to Problem 9.2 for Self-Study, Part b

Total Cost



Beginning Inventory, July 1 . . . .

Purchases, July 5 . . . . . . . . . . .

Purchases, July 15 . . . . . . . . . .

Purchases, July 23 . . . . . . . . . .

Total Goods Available for Sale . . .

Withdrawals During July. . . . . . .

Ending Inventory . . . . . . . . . . .



Units



Unit Cost



FIFO



LIFO



Weighted

Average



105

300

200

250

855

(620)

235



See Exhibit 9.13

$13.00

13.50

14.00



$ 1,305

3,900

2,700

3,500

$11,405

(8,115)a

$ 3,290b



$ 1,055

3,900

2,700

3,500

$11,155

(8,410)c

$ 2,745d



$ 1,164

3,900

2,700

3,500

$11,264

(8,168)e

$ 3,096f



$1,305 + (300 × $13.00) + (200 × $13.50) + (15 × $14.00) = $8,115.

(235 × $14.00) = $3,290.

c

(250 × $14.00) + (200 × $13.50) + (170 × $13.00) = $8,410.

d

$1,055 + (130 × $13.00) = $2,745.

e

620 × ($11,264/855) = $8,168.

f

235 ì ($11,264/855) = $3,096.

a



â Cengage Learning 2014



b



FIFO

June 30

($1,650 + $1,305)/$2,290. . . . . . . . . . . . . . . . . . . . . . . . . . . .

($1,650 + $1,055)/$2,290. . . . . . . . . . . . . . . . . . . . . . . . . . . .

($1,650 + $1,164)/$2,290. . . . . . . . . . . . . . . . . . . . . . . . . . . .

July 31

($3,480 + $3,290)/$4,820. . . . . . . . . . . . . . . . . . . . . . . . . . . .

($3,480 + $2,745)/$4,820. . . . . . . . . . . . . . . . . . . . . . . . . . . .

($3,480 + $3,096)/$4,820. . . . . . . . . . . . . . . . . . . . . . . . . . . .



LIFO



Weighted

Average



1.29

1.18

1.23



1.40

1.29

1.36



b. Inventory Turnover Ratio

July

$8,115/0.5($1,305 + $3,290) . . . . . . . . . . . . . . . . . . . . . . . . .

$8,410/0.5($1,055 + $2,745) . . . . . . . . . . . . . . . . . . . . . . . . . .

$8,168/0.5($1,164 + $3,096) . . . . . . . . . . . . . . . . . . . . . . . . .



3.53

4.43

3.83



SUGGESTED SOLUTION TO PROBLEM 9.4 FOR SELF-STUDY

(Swede Trucks; warranty liabilities.)

a. Swede Trucks’s balance sheet for the year ended December 31, 2013, shows an ending balance in Product Obligations of €1,057 million.

b. Journal entry made to record warranty expense during 2013 (described as “Provisions during the year”):



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Chapter 9



Working Capital



Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Warranty Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

This journal entry reduced Swede Trucks 2013 income by €1,339 million.



1,339

1,339



c. Journal entry made in 2013 for actual expenditures under warranty (described as “Provisions used during the year”):

Warranty Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash (or other assets consumed for repairs) . . . . . . . . . . . . . . . . . .

This journal entry had no effect on Swede Truck’s 2013 income.



1,056

1,056



d. Journal entry made to reverse previously accrued warranty charges (described as “Provisions reversed during the year”):

Warranty Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Warranty Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

This journal entry increased Swede Truck’s 2013 income by €230 million.



230

230



SUGGESTED SOLUTION TO PROBLEM 9.5 FOR SELF-STUDY

(Ashton S.A.; journal entries for transactions involving current liabilities.)

a.



b.



c.



d.



January 2

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Note Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record 90-day, 9% bank loan.

January 3

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record purchases of merchandise on account.

January 10

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Advances from Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record advance from customer on merchandise scheduled for delivery in

February.

Month of January

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record sales on account during January.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record the cost of merchandise sold.



e.



Month of January

Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



10,000

10,000



8,000

8,000



1,500

1,500



12,000

12,000



6,000

6,000



8,000

8,000



To record payments to suppliers for purchases on account.



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Solutions to Self-Study Problems



Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record collections from customers for sales on account.

f.



g.



January 31

Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Warranty Liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record estimated warranty cost for goods sold during January; 0.08 ×

$12,000 = €960.

January 31

Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Withholding Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pension and Welfare Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . .

Withheld Union Dues Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record January wages net of taxes and union dues withheld.

Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pension and Welfare Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . .

Unemployment Taxes Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record employer’s share of payroll taxes.



h.



i.



j.



k.



January 31

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record interest expense on notes payable for January; €10,000 × 0.09 ×

30/360 = €75.

January 31

Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Income Tax Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To accrue income taxes payable for January: 0.40 × (€12,000 – €6,000 –

€960 – €4,000 – €540 – €75) = €170.

February 1

Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To pay employees their January wages net of withholdings.

February 10

Advances from Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record the delivery of merchandise to customer, resulting in revenue

being recognized.

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Merchandise Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record the cost of merchandise sold.



l.



February 15

Withholding Taxes Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pension and Welfare Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



7,000

7,000



960

960



4,000

800

400

200

2,600



540

400

140



75

75



170

170



2,600

2,600



1,500

1,500



800

800



800

800

(continued)



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360



Chapter 9



Working Capital



Unemployment Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Withheld Union Dues Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record payment of payroll taxes and union dues.

m.



140

200

1,940



February 20

Warranty Liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record the cost of warranty repairs on products sold during January.



n.



200

200



March 14

Restructuring Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Restructuring Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record restructuring expense.



o.



50,000

50,000



June 20

Restructuring Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record payments for closing of plants pursuant to restructuring plan.



20,000

20,000



Restructuring Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Restructuring Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



12,500

12,500



To reverse restructuring charges.



SUGGESTED SOLUTION TO PROBLEM 9.6 FOR SELF-STUDY

(Assessing the impact of a LIFO layer liquidation.)

a. See Exhibit 9.15.

b. 125 × ($15 – $13) = $250.



EXHIBIT 9.15



Suggested Solution to Problem 9.6 for Self-Study, Part a

Total Cost



Beginning Inventory . . . . . . . . .

Purchases During August . . . . . .

Total Goods Available for Sale . . .

Withdrawals During August. . . . .

Ending Inventory . . . . . . . . . . .



Units



Unit Cost



235

600

835

(725)

110



See Exhibit 9.14

$15



FIFO

$



3,290

9,000

$ 12,290

(10,640)a

$ 1,650b



LIFO

$



2,745

9,000

$ 11,745

(10,625)c

$ 1,120d



Weighted

Average

$



3,096

9,000

$ 12,096

(10,503)e

$ 1,593f



$3,290 + (490 ×$15) = $10,640.

(110 × $15) = $1,650.

c

(600 × $15) + (125 × $13) = $10,625.

d

$1,055 + (5 × $13) = $1,120.

e

($12,096/835) ì 725 = $10,503.

f

($12,096/835) ì 110 = $1,593.



a



â Cengage Learning 2014



b



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Questions, Exercises, and Problems



KEY TERMS AND CONCEPTS

Working capital

Current ratio, working capital ratio

Liquidity

Operating assets, operating liabilities

Financial assets, financial liabilities

Cash

Cash equivalents

Prepayments, prepaid assets

Inventory

Merchandising firm

Manufacturing firm

Direct materials, raw materials

Direct labor

Manufacturing overhead

Product costs

Period expenses

Raw materials inventory

Work-in-process inventory, work-inprogress inventory

Finished goods inventory

Cost of goods sold

Replacement cost



Lower-of-cost-or-market basis

Specific identification

Cost-flow assumption

Weighted average

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Cost of goods sold percentage

Inventory turnover ratio

Accounts payable, trade payables

Cash cycle, earnings cycle, operating cycle

Note payable

Wages and salaries payable

Income taxes payable, taxes payable

Warranty

Warranty liability, warranty provision

Allowance method for warranties

Restructuring

Restructuring liability, restructuring

provision

LIFO inventory layer

LIFO liquidation

LIFO reserve



QUESTIONS, EXERCISES, AND PROBLEMS

QUESTIONS

1. Review the meaning of the terms and concepts listed above in Key Terms and Concepts.

2. What are the characteristics of prepayments that qualify as assets? What is the accounting

for prepayments?

3. Identify the underlying principle that guides the measurement of the acquisition cost of

inventories. What is the rationale for this accounting principle?

4. Firms may treat depreciation on equipment either as a product cost or as a period expense,

depending on the type of equipment. Explain.

5. Compare and contrast the Merchandise Inventory account of a merchandising firm and

the Finished Goods Inventory account of a manufacturing firm.

6. “Inventory computations require cost-flow assumptions only because specific identification of items sold is costly. Specific identification is theoretically superior to any cost-flow

assumption and eliminates the possibility of income manipulation available with some

cost-flow assumptions.” Comment.

7. Assume no changes in physical quantities during the period. During a period of rising

purchase prices, will a FIFO or a LIFO cost-flow assumption result in the higher ending

inventory balance sheet carrying value? During a period of rising purchase prices, will a

FIFO or a LIFO cost-flow assumption result in the lower balance sheet carrying value?

Which cost-flow assumption will result in the higher cost of goods sold? Which will result

in the lower cost of goods sold?

8. “Firms should obtain as much financing as possible from suppliers through accounts payable because it is a free source of funds.” Do you agree? Why or why not?

9. The Francis W. Parker School, a private lower school, has a reporting year ending June

30. It hires teachers for a 10-month period: September of one year through June of the

following year. It contracts to pay teachers in 12 monthly installments over the period



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Working Capital



September of one year through August of the next year. For the current academic year,

suppose that the school will pay teachers total contractual salaries of $3,600,000. How

should the school account for this amount in the financial statements issued June 30 at the

end of the academic year?

10. A noted accountant once remarked that the optimal number of faulty TV sets for Sony

to sell is “not zero,” even if Sony promises to repair all faulty Sony sets that break down,

for whatever reason, within two years of purchase. Why could the optimal number be “not

zero”?

11. Describe the similarities and differences between the allowance method for uncollectibles

(see Chapter 8) and the allowance method for warranties.

12. What does it mean for a firm to reverse a portion of a previously accrued charge, such as

the expense creating a warranty liability or a restructuring liability? What is the effect of a

reversal on the firm’s income statement, balance sheet, and statement of cash flows in the

period of the reversal?



EXERCISES

13. Accounting for prepayments. A Belgian food distributor reported ending balances in Prepayments of €30.7 million, €25.8 million, and €42.1 million for the years ended December 31, 2012, 2011, and 2010, respectively. Assume that Prepayments pertain to insurance

premiums on warehouses and merchandise. During each of the three years, the firm paid

insurance premiums of €50 million. The firm follows IFRS and reports its results in millions of euros (€).

a. What journal entries did the food distributor make in each of the three years to recognize prepayments?

b. What journal entries did the firm make in 2011 and 2012 to recognize insurance on its

warehouse and inventory?

14. Accounting for prepayments. Liquid Crystal Display Corporation (LCD), a Korean multinational firm, reported an ending balance for Prepayments of KRW345,609 million for the

year ending December 31, 2012. For the year ended December 31, 2011, the ending balance

in this account was KRW260,324. Suppose that at the beginning of 2012, the Prepayments

balance consisted of three months of prepaid rent on factory warehouses; at the end of

the three months, LCD prepaid one year of rent. LCD follows Korean generally accepted

accounting principles and reports its results in million of Korean won (KRW). For purposes of this problem, assume that LCD uses either U.S. GAAP or IFRS (the choice will

not matter).

a. What journal entry did LCD make in each of the three months, January–March of

2012, associated with its prepaid rent?

b. What journal entry did LCD make at the end of March 2012 to reflect its prepayment

of one year of rent?

c. What journal entry did LCD make in each of the months April–December of 2012

associated with its prepaid rent?

15. Identifying inventory cost inclusions. Ringgold Winery is a large U.S.-based winery. In 2012

Ringgold spent $2.2 million to acquire grapes (including transportation costs of $200,000).

Ringgold incurred processing costs of $50,000 in materials (such as barrels, bottles, and

corks), $145,000 in labor, $100,000 in machine costs, and $250,000 in utility charges. During the two- to three-year maturing period, Ringgold incurred additional costs for storage

($600,000), insurance ($120,000), indirect labor ($180,000), and property taxes ($28,000),

a product cost. Ringgold also spent $400,000 on research and development and $200,000

on advertising during this period. Identify the costs Ringgold should include in its Wine

Inventory account, independent of when Ringgold sells the wine.

16. Identifying inventory cost inclusions. Trembly Department Store commenced operations

on January 1, 2012. It engaged in the following transactions during January. Identify the

amount that the firm should include in the valuation of merchandise inventory.

a. Purchases of merchandise on account during January totaled $300,000.

b. The freight cost to transport merchandise to Trembly’s warehouse was $13,800.

c. The salary of the purchasing manager was $3,000.



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Appendix 9.1: A Closer Look at LIFO's Effects on Financial Statements

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