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478 Analysis of Investing Activities

Suppose that the company™s management believes that it can increase sales by reducing
product prices. Cutting the prices relative to the costs of the goods sold would increase the
ratio to 60%, but is expected to increase total sales to $7 million. Operating expenses and in-
terest expense are relatively fixed and would not be affected by these changes. Total assets also
would not be affected. In column C calculate the effects of the changes on the company™s in-
come statement and financial ratios. Copy the data from column B to column C and make
changes as needed. Would the pricing change be advantageous to the company?
Another alternative for the company is to raise prices relative to cost of goods sold and
significantly increase advertising. The increase in prices would reduce cost of goods sold to
50% of sales. The additional advertising expenses would increase operating expenses to $3 mil-
lion. Total sales are expected to increase to $7.5 million. Interest expense and total assets would
not be affected by these changes. In column D calculate the effects of the changes on income
and the financial ratios. Would the company benefit from these changes?


Multiple-Choice Overview of the Chapter
P12-21
1. As defined in this text, return on assets involves a comparison of total assets with
a. net income.
b. net income adjusted for dividends.
c. net income adjusted for income taxes.
d. net income adjusted for interest expense.

2. A high asset turnover indicates that a company
a. buys and sells its long-term assets more frequently than most companies, so that it
tends to operate with state-of-the-art equipment.
b. generates a large amount of profit compared to its total assets.
c. generates a large amount of sales compared to its total assets.
d. uses fixed costs to increase net income as sales increase.

3. The substitution of fixed costs for variable costs affects which of the following most di-
rectly?
a. Stockholders™ equity
b. Financial leverage
c. Gross profit margin
d. Operating leverage

4. A company with good investment opportunities normally can increase its stockholders™
wealth by
a. increasing the portion of net income paid out in dividends
b. investing in new assets.
c. reducing the amount invested in new assets.
d. reducing its rate of return on new assets.

5. Company A has a higher proportion of fixed to variable costs than Company B. Both
have a positive net income. The sales revenues of both companies increased by 10%.
You would expect
a. Company A™s expenses to increase more rapidly than Company B™s.
b. Company A™s expenses to decrease while Company B™s increase.
c. Company A™s net income to decrease while Company B™s increases.
d. Company A™s net income to increase more rapidly than Company B™s.

6. Company A and Company B are similar in size and in many other respects. The com-
panies reported the following net cash flow from (used for) investing activities in their
2005 annual reports.

(In millions) 2005 2004 2003
Company A $(460) $(350) $(265)
Company B 200 35 (80)


(Continued)
F476 SECTION F2: Analysis and Interpretation of Financial Accounting Information
479
Analysis of Investing Activities

From this information, you would expect
a. Company A to be growing more rapidly than Company B.
b. Company B to be growing more rapidly than Company A.
c. Company B to have better investment alternatives than Company A.
d. Company A to pay higher dividends than Company B.

7. Relative to Company A, Company B is more capital-intensive, has a higher debt to asset
ratio, and pays out a smaller portion of its net income as dividends. Company A™s asset
growth rate has been larger than Company B™s. From this information, it is likely that
a. Company A is riskier than Company B.
b. Company B is riskier than Company A.
c. Company A has a higher market value than Company B.
d. Company B has a higher market value than Company A.

8. Which of the following net cash flow patterns is typical of a company with high growth
potential and strong financial performance?
Cash Flow from Cash Flow from
Operating Activities Investing Activities
a. Outflow Outflow
b. Outflow Inflow
c. Inflow Inflow
d. Inflow Outflow

9. Which of the following is evidence of effective use of assets?
a. Earning higher amounts of profit for each dollar of sales
b. Selling long-term assets promptly when sales drop
c. Increasing sales more rapidly than the dollar amount of additional investment
d. Planning for assets that have high fixed cost and low variable cost, in order to make
use of operating leverage

10. Under generally accepted accounting principles in the United States, most assets are
valued on the balance sheet at
a. cost.
b. cost, or a lower value if they are impaired.
c. cost, or a higher value if evidence of increase is verifiable.
d. fair market value.


Projects
CASES
Evaluating Investment Decisions
C12-1
Objs. 1, 3, 4 Appendix B of this book contains a copy of the 2002 annual report of General Mills, Inc.

Required Review the annual report and write a short report in which you cover each of the
following:
A. What major investing decisions did the company make from 2000 to 2002? Include de-
cisions about disposing of as well as acquiring assets. (Hint: See note 2 to the financial
statements, as well as the statement of cash flows.)
B. Evaluate the company™s growth rate for total assets and net income from 2000 to 2002.
(Hint: See the six-year financial summary.)
C. Compute return on assets, asset turnover, and profit margin for the company from
2000 to 2002. Does it appear that the company has made beneficial investing decisions?

Analysis of an Acquisition
C12-2
Obj. 3 You are a financial analyst with a major corporation, High Hopes Company. You have been
assigned the task of evaluating a potential acquisition candidate, Roll-the-Dice, Inc. Selected
accounting information for the two companies is presented on the next page. Information for
2003 and 2004 reports actual company results. Results for 2005 are projected from informa-
tion available at the beginning of the year.
F477
CHAPTER F12: Analysis of Investing Activities
480 Analysis of Investing Activities

(In millions) 2005 2004 2003
High Hopes Company
Depreciation and amortization expense $ 13.4 $ 13.1 $ 11.6
Operating income 46.3 42.7 37.5
Interest expense 4.9 5.1 5.5
Provision for income taxes 14.1 11.8 11.0
Net income 27.3 25.8 21.0
Total assets 305.7 292.1 274.8
Total liabilities 125.9 128.0 135.2
Total stockholders™ equity 179.8 164.1 139.6
Net cash flow from operating activities 40.4 38.5 32.8
Net cash flow used for investing activities (14.1) (12.8) (9.8)
Net cash flow used for financing activities (25.3) (25.7) (23.0)
Roll-the-Dice, Inc.
Depreciation and amortization expense $ 5.4 $ 5.2 $ 4.5
Operating income 22.8 19.3 12.9
Interest expense 3.7 3.5 3.0
Provision for income taxes 6.5 4.7 4.2
Net income 12.6 11.1 5.7
Total assets 114.3 111.0 93.4
Total liabilities 35.8 33.2 31.8
Total stockholders™ equity 78.5 77.8 73.5
Net cash flow from operating activities 18.7 16.4 14.6
Net cash flow used for investing activities (13.7) (7.9) (18.3)
Net cash flow from (used for) financing activities (4.5) (8.6) 3.8

The acquisition, if it were to occur, would result in High Hopes purchasing all of the com-
mon stock of Roll-the-Dice at a price of $130 million. To finance the acquisition, High Hopes
plans to issue $130 million of long-term debt at 10.7% annual interest. The debt principal
would be repaid in equal installments over 10 years. The interest would be paid annually on
the unpaid principal. The fair market value of Roll-the-Dice™s identifiable assets is $107 mil-
lion. The fair market value of its liabilities is $35.8 million. Goodwill from the acquisition will
not be amortized. There are no intercompany transactions between High Hopes and Roll-the-
Dice. Assume that High Hopes™ income tax rate is 34%.

Required Prepare a summary pro forma income statement and statement of cash flows for
High Hopes for 2005, assuming it acquires Roll-the-Dice at the beginning of 2005. What rec-
ommendation would you make to High Hopes™ management concerning the acquisition?

Return-based Bonus, Ethics, and Accounting Standards
C12-3
Objs. 4, 6 Employees of the divisions of JX Controls, Inc. receive a bonus of 4% of their salary in any
year in which the divisional return on assets is above 10%. Toward the end of 2004, accoun-
tants for the fire alarm division projected the following year-end numbers:

Sales $1,230,000
Cost of goods sold* 758,000
Other expenses† 322,000
Total divisional assets 1,590,000
*All products have the same gross margin.
†All are fixed expenses.

At a meeting of divisional managers, Susan Torres, divisional vice president, told the group,
“We™ve never received the bonus, although several other divisions have. Our employees work
just as hard, and many of them really need the extra money for their families; I™d like us to get
the bonus for them, as well as for ourselves. What ideas do you have for pulling it off?”
A variety of ideas were raised:
• “Let™s do what we can about sales. We have an order for $40,000 in goods to be shipped
in early January; could we get those out the door in December, and add that gross mar-
gin to this year™s numbers?”
(Continued)
F478 SECTION F2: Analysis and Interpretation of Financial Accounting Information
481
Analysis of Investing Activities

• “Sure”good idea. We might even accidentally overship by 20% and record the extra in
this year™s sales.”
• “Could we slow down a bit on paying our bills? Wouldn™t a few suppliers be willing to
wait until January”maybe for about $50,000?”
• “We™ve got that old forming machine that hasn™t been used for a year; it™s really useless.
It™s on the books at $60,000 and is 70% depreciated, but it™s worth only about $3,000 as
scrap. Have we written it down?”
• “The projection includes that new $90,000 bending machine that just came in. We should
have delayed ordering it”but we haven™t booked it. Could we forget to record the ma-
chine and the payable until January?”

Required Write a short report reacting to the meeting. Determine which proposals would
both be in accordance with accounting standards and actually raise return on assets. Calcu-
late return on assets for the current projection, and with the inclusion of those measures that
meet these two tests. Also include your thoughts about the advantages and disadvantages of
such a bonus system.
F13
13

OPERATING ACTIVITIES
How do we account for operating activities?

O perating activities involve selling goods and services, using assets, and using other
resources, such as labor. Often these activities include transactions that occur in
different fiscal periods. Accounting for these activities requires determining the ap-
propriate period in which to recognize revenues and expenses and accounting for tim-
ing differences between when revenues and expenses are recognized and when related
events occur. Determining revenues and expenses for a fiscal period sometimes requires es-
timates.


FOOD FOR THOUGHT
Why is it necessary for a company to estimate revenues and expenses for a fiscal period? What factors
should be considered when making the estimates? How do the estimates affect the reported financial
information?


Maria, Stan, and Ellen discuss revenue and expense recognition for Mom™s Cookie Company. Ellen, the vice president of
finance, is aware that some of their activities will require estimates. She discusses these activities with Maria and Stan.

We have to make some decisions about how we will estimate some of our revenue and expense amounts.
Ellen:
Estimates? I thought accounting was all about identifying precise amounts.
Stan:
Actually, quite a few activities require estimation. For example, because we sell goods on credit, we will
Ellen:
have to estimate the amount of doubtful accounts we expect each fiscal period.
Why can™t we just write off accounts after we determine they cannot be collected?
Maria:
Accounting principles require that estimated amounts of doubtful accounts be recognized as expenses in
Ellen:
the same fiscal period in which the goods were sold that created those accounts. Matching expenses with
related revenues is important for proper measurement of operating results during a fiscal period.
Are there a lot of estimation issues we need to consider?
Stan:
There aren™t too many for our company. A major consideration is the method we use for estimating
Ellen:
inventory costs. Unit costs change over time, and we have to decide which costs to associate with goods
sold during a period. It isn™t reasonable for us to identify the exact cost of each unit we sell. Instead, we
will need a systematic method of estimating that cost.
Does it really matter which method we use? Will it affect our income or cash flows?
Maria:
These decisions can affect our income statement and our cash flows, particularly as a result of their effect
Ellen:
on tax payments. Let™s examine some of these issues.
F480 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
484 Activities


OBJECTIVES

Once you have completed this chapter, you reporting of inventories for merchandising
should be able to: and manufacturing companies.
1 Identify the purpose and major 4 Explain and apply rules for measuring cost
components of an income statement. of goods sold and inventories and describe
the effects of income taxes on the choice of
2 Explain and apply rules for measuring
inventory estimation method.
revenues and receivables and reporting
5 Identify routine and nonroutine events
revenue transactions.
that affect a company™s income statement.
3 Describe reporting rules for inventories
and cost of goods sold and compare




BASIC OPERATING ACTIVITIES
The income statement reports the results of operating activities for a fiscal period on
OBJECTIVE 1
an accrual basis. Exhibit 1 provides the income statement for Mom™s Cookie Company
Identify the purpose and for 2004 and 2005. Early in 2005, the company expanded its operations by issuing com-
major components of an mon stock and some long-term debt. The financing was used to acquire property and
income statement. plant to permit the company to produce its own cookies.



Exhibit 1
For the Year Ended December 31, 2005 2004
Income Statement for
Net sales revenue $ 3,235,600 $ 686,400
Mom™s Cookie Company
Cost of goods sold (1,954,300) (457,600)
Gross profit 1,281,300 228,800
Selling, general and administrative expenses (1,094,700) (148,300)
Operating income 186,600 80,500
Interest expense (20,400) (4,800)
Pretax income 166,200 75,700
Income taxes (49,860) (22,710)
Net income $ 116,340 $ 52,990
Earnings per share $ 0.29 $ 0.13




The first item on the income statement is net sales revenues. Companies with large
amounts of service revenues report these in addition to sales revenues. Recall from
Chapter F4, the term “operating revenues” is sometimes used to refer to sales and ser-
vice revenues. Net revenues result from subtracting discounts and returns from gross
revenues, as discussed in a later section. Cost of goods sold is subtracted from net sales
revenue to compute gross profit. The expenses for marketing and distributing a com-
pany™s products and managing its operations are subtracted from gross profit to cal-
culate operating income. Non-operating expenses or losses, such as interest expense,
are subtracted and non-operating income or gains are added, to compute income be-
fore taxes. Income tax expense is subtracted from income before taxes to calculate net
income. Finally, earnings per share is reported on a corporate income statement.
F481
CHAPTER F13: Operating Activities
485
Operating Activities


REVENUES RECEIVABLES
AND
Operating revenues result from the sale of goods and services to customers. Operating
OBJECTIVE 2
revenues are the first items on the income statement and affect both cash and accounts
Explain and apply rules receivable on the balance sheet, as illustrated in Exhibit 2. Cash received from customers
for measuring revenues is reported on the statement of cash flows, either directly, or indirectly as net income
and receivables and adjusted for the change in accounts receivable. Most companies recognize operating
reporting revenue revenues at the time they transfer ownership of goods or services to customers. Own-
transactions.
ership of most goods passes to the buyer at the time the goods are delivered or shipped
to the buyer. Retail companies usually recognize revenues at the time a sale is made,
when the customer takes possession of the goods. Most service companies recognize
revenues at the time services are performed.


Exhibit 2 The Effect of Sales and Services on the Financial Statements
Balance Sheet
Activity Statement of
Income
Cash Flows
Statement

Operating Cash Received
Cash
Sales of Goods and
Revenues from Customers
Accounts Receivable
Services to Customers




Manufacturing companies and some merchandising companies ship goods to cus-
tomers. Ownership of these goods is transferred to the buyer at the location named in
the sales terms. For example: When goods are shipped FOB (free on board) destina-
tion, ownership of goods is transferred to the customer when the goods are delivered
(and the seller usually pays the shipping costs). When goods are shipped FOB shipping
point, ownership passes to the customer when the goods are picked up by the shipper
(and the buyer usually pays the shipping costs).
As a general rule, revenue should be recognized when four criteria have been met:
1. The selling company has completed most of the activities necessary to produce and
sell the goods or services.
2. The selling company has incurred the costs associated with producing and selling
the goods or services or can reasonably measure those costs.
3. The selling company can measure objectively the amount of revenue it has earned.
4. The selling company is reasonably sure that it is going to collect cash from the pur-
chaser.
For most companies, these criteria have been met
when goods are transferred or when services are pro-
LEARNING NOTE
vided to customers who pay for them or who are ob-
If the buyer pays for goods or services before the criteria for rev-
ligated to pay for them.
enue recognition have been met, the seller recognizes unearned
Special measurement and recognition issues arise
revenue (a liability). When the criteria are met, the seller recog-
when revenues are earned over an extended period,
nizes the revenue and reduces the unearned revenue account.
as from a long-term construction or service contract;
when some customers can be expected to return a
portion of goods purchased; when some customers are likely not to pay for their pur-
chases; and when the seller provides a warranty for the goods or services sold.


Recognizing Revenue for Long-Term Contracts
Certain types of revenues create recognition problems because the activities that pro-
duce the revenues occur over more than one fiscal period. Revenues earned from long-
term contracts often are recognized in proportion to the passage of time or in proportion
F482 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
486 Activities

to the amount of the contract that has been completed. For example, if a company con-
tracts to provide maintenance services over a three-year period for $75,000, it might
recognize $25,000 of revenue each year. In this case, the company assumes that it is go-
ing to provide approximately the same amount of service each year.
In the case of construction contracts”to construct an airplane or a building, for
example”the seller usually estimates the portion of the contract that has been com-
pleted during a fiscal period. A corresponding portion of revenues then is recognized
for that period. To illustrate, assume that Constructo Company contracts to construct
a building for $20 million. The project will take three years to complete. At the end of
2004, the first year of the project, Constructo estimates that approximately 20% of the
work has been completed. Therefore, it recognizes $4 million ($20 million 20%) of
revenue on the project for 2004. Also, it recognizes its costs associated with the project
in computing net income for 2004.




Case in Point
In
Revenue Recognition Policies
Companies in the entertainment industry often earn revenues over an extended period
as customers purchase tickets. Walt Disney Company is an example of this type of
company. Disney™s revenue recognition policy states:
http://ingram.
swlearning.com Revenue Recognition
Revenues from the theatrical distribution of motion pictures are recognized when mo-
Learn more about The
tion pictures are exhibited. Revenues from video sales are recognized on the date that
Walt Disney Company.
video units are made widely available for sale by retailers. Revenues from the licens-
ing of feature films and television programming are recorded when the material is
available for telecasting by the licensee and when certain other conditions are met.
Broadcast advertising revenues are recognized when commercials are aired. Revenues
from television subscription services related to the Company™s primary cable pro-
gramming services are recognized as services are provided.
Merchandise licensing advance and guarantee payments are recognized when the un-
derlying royalties are earned.
Revenues from advance theme park ticket sales are recognized when the tickets are
used. Revenues from participants at the theme parks are generally recorded over the
period of the applicable agreements commencing with the opening of the related at-
traction.
Internet advertising revenues are recognized on the basis of impression views in the
period the advertising is displayed, provided that no significant obligations remain and
collection of the resulting receivable is probable. Direct marketing and Internet-based
merchandise revenues are recognized upon shipment to customers.

(2002 Annual Report)



Sales Discounts and Returns
Revenues are reported on the income statement net of discounts and expected returns.
A discount is a reduction in the normal sales price. Companies usually offer discounts
from the normal price to encourage customers to buy large quantities of goods (a quan-
tity discount) or to pay their accounts early (a sales discount). Discounts reduce rev-
enues. Consequently, a company should record as revenue only the amount it actually
expects to receive from a sale.
Suppose that Mom™s Cookie Company sells goods priced at $5,000 to a customer
on November 4, 2004, and offers a 2% discount if the customer pays in full within 10
F483
CHAPTER F13: Operating Activities
487
Operating Activities

days of the purchase. If the customer pays within the discount period (within the 10
days), Mom™s Cookie Company earns revenue of $4,900 after subtracting the discount
of $100 ($5,000 2%). If the customer does not pay within the discount period, Mom™s
Cookie Company earns $5,000.
Many companies record the sale at the full price ($5,000) and then deduct the dis-
count if the customer pays within the discount period. For example, Mom™s Cookie
Company would record the sale as follows:



ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Nov. 4, 2004 Accounts Receivable 5,000
Sales Revenue 5,000




Then, if the customer pays within the discount period, the company would record this:


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Nov. 10, 2004 Cash 4,900
Sales Discount 100
Accounts Receivable 5,000




The sales discount reduces the gross sales revenue of $5,000 to the net sales revenue of
$4,900, the amount actually earned. The company reports net sales revenue on its in-
come statement (see Exhibit 1).
Like sales discounts, sales returns are subtracted from sales revenues in reporting
net operating revenues on the income statement. In certain industries, companies sell
merchandise with the expectation that buyers will return some of that merchandise.
Publishing companies, for example, often allow retailers to return unsold books and
magazines for credit against the amount they owe.
Let™s assume that Textbook Publishing Company sells $5 million of books during
fiscal year 2004. It records sales revenues and accounts receivable in the amount of $5
million. From past experience, the company estimates that $500,000 of its 2004 sales
will be returned in 2005. So Textbook Publishing should record an adjustment to its
revenues and receivables at the end of 2004:



ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Sales Returns 500,000
Allowance for Returns 500,000
F484 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
488 Activities

Allowance for Returns reduces the amount of Accounts Receivable reported on the
balance sheet, and Sales Returns reduces the amount of Sales Revenue on the income
statement.
Future returns are estimated so that revenues for the fiscal period in which the sales
were made can be measured more accurately. If Textbook Publishing waits until re-
turns are received in 2005, its sales revenues for 2004 will be overstated on the 2004 in-
come statement. A major principle of accounting is the matching principle: An effort
is made to match revenues and expenses in the period in which they occur so that rev-
enues, expenses, and net income are not misstated. Sales returns should be matched
with the sales that result in the returns. The matching principle often requires that fu-
ture events be estimated, such as the amount of future returns. These estimates are not
completely accurate, but reported revenues and expenses usually are more correct when
adjusted using these estimates than when no adjustment is made.
The amount of operating revenue a company reports on its income statement
($3,235,600 for Mom™s Cookie Company in 2005 from Exhibit 1, for example) is the
net amount of revenue earned after discounts and returns have been subtracted. Op-
erating revenues usually are labeled “net operating revenues” or “net sales” as an indi-
cation that returns and discounts have been subtracted.
When actual goods are returned to a company, the amount of the return is writ-
ten off against the allowance for returns account. Accounts Receivable is reduced by
the amount of the return if the customer purchased on credit. Otherwise, a cash refund
may be paid. In addition, Cost of Goods Sold and Merchandise are adjusted, assuming
that the goods are put back into inventory to be resold. To illustrate, assume that Text-
book Publishing received a return of $100,000 (sales price) on January 12, 2005, from
a credit customer. The goods cost the company $75,000. Textbook Publishing would
recognize the return in its accounts as follows:



ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 12, Allowance for Returns 100,000
2005 Accounts Receivable 100,000
Jan. 12, Merchandise Inventory 75,000
2005 Cost of Goods Sold 75,000




Observe that the balance of the cost of goods sold account is reduced by the cost
of the goods returned.




Case in Point
In
Merchandise Return Policy
AOL Time Warner produces magazines, books, CDs, and other products. Its revenue
recognition policy notes the following:
http://ingram. In accordance with industry practice, certain products (such as magazines, books, home
swlearning.com videocassettes, compact discs, DVDs, and cassettes) are sold to customers with the
right to return unsold items. Revenues from such sales are recognized when the prod-
Learn more about AOL
ucts are shipped based on gross sales less a provision for future estimated returns.
Time Warner, Inc.
(2001 Annual Report)
F485
CHAPTER F13: Operating Activities
489
Operating Activities

Uncollectible Accounts
Companies that sell goods and services on credit are likely to incur some bad debts.
Some customers will be unable to pay for the goods and services they receive. Compa-
nies estimate the amount of receivables that are likely to be uncollectible and report
this amount as a contra-asset such as Allowance for Doubtful Accounts or a similar
title. This allowance is deducted from Accounts Receivable and the net amount of Ac-
counts Receivable is reported on the balance sheet. The amount of the allowance is es-
timated at the end of fiscal periods, at least at the end of the fiscal year. For example,
assume Mom™s Cookie Company has a balance in Allowance for Doubtful Accounts of
$1,000 at the end of its 2004 fiscal year before adjustments are made for the year. Man-
agement evaluates the company™s credit sales and outstanding receivables and deter-
mines that the amount of the allowance account at the end of the year should be $5,000.
Thus, the account would need to be increased by $4,000 ($5,000 balance needed
$1,000 current balance). As shown here, an expense of $4,000 would also be recognized.


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Doubtful Accounts
Expense 4,000
Allowance for Doubtful
Accounts 4,000




Companies base their estimates of the amount of doubtful accounts they expect on
experience and on analysis of customer accounts. Some companies know from experi-
ence with their customers that a certain percentage of their credit sales is likely to be-
come uncollectible. In other cases, the amount of uncollectible accounts changes in
response to changes in general economic conditions. For example, during economic re-
cessions, more people are out of work and many people earn less money than when the
economy is strong. During these periods, the portion of uncollectible accounts associ-
ated with automobiles, houses, major appliances, and other goods purchased on long-
term contracts increases, and sellers of these goods should increase their expected
uncollectible accounts.
Many companies inspect their accounts receivable at year end to determine which
accounts are at risk. Accounts that remain unpaid over a long period are more likely
to be uncollectible. Consequently, companies often estimate that a higher percentage
of older accounts will become uncollectible and use this information in estimating
Doubtful Accounts Expense.
When a company identifies receivables as being uncollectible, those receivables are
written off and the Allowance for Doubtful Accounts is adjusted. For example, assume
that on February 12, 2005, Mom™s Cookie Company determines that $800 owed by
Home Goods Company cannot be collected because the company has gone out of busi-
ness. Mom™s Cookie Company would record the write off of the account as follows:


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 12, 2005 Accounts Receivable 800
Allowance for Doubtful
Accounts 800
F486 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
490 Activities

The balance of the Allowance for Doubtful Accounts is reduced by the amount
written off. Accounts Receivable are reduced. The specific account for Home Goods
Company is written down to zero by this transaction. Note that an expense is not as-
sociated with this transaction. The expense was recorded at the end of 2004 when doubt-
ful account expense was recorded based on estimates for the year. The sale to Home
Goods Company occurred in 2004. Accordingly, the expense associated with not col-
lecting the account was also recorded (as an estimate) in 2004.
Doubtful accounts expense is a selling expense. It results from a decision to sell
goods to a customer on credit. The cost associated with this decision is the cost of a
bad sales decision. Companies attempt to set credit policies so that they can avoid these
costs. However, they must balance these costs with lost sales that would result if the
company refused to sell goods on credit.


Warranty Costs
Companies, especially manufacturing companies, often offer warranties on goods they
produce. A defective product can be returned to the seller for replacement or can be
returned to the manufacturer for repair or replacement. The manufacturer incurs costs
when goods are replaced or repaired, and these costs should be matched with the rev-
enues resulting from the sale of the defective products. Therefore, companies estimate
expected warranty costs each fiscal period and record these as expenses of the period
in which goods were sold.
For example, when Ford Motor Company ships cars and trucks to dealers, it estimates
the warranty costs it expects on these vehicles. These costs are recorded as expenses in the
period in which revenues are recognized. Liabilities also are recognized for these expected
obligations. Generally, warranty costs are combined with other financial statement items
and are not reported separately in a company™s financial statements. Most companies are
not eager for customers or competitors to have information about their warranty costs.
As an illustration, assume Harris Company, a retailer, sells appliances with a 90-day
warranty. From sales in March 2004, it estimates expected warranty costs of $12,000 will
be incurred in April, May, and June to repair and replace defective parts. To match the
expense with the sales, the expected costs are recorded at the end of March as follows:


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Mar. 31, 2004 Warranty Expense 12,000
Warranty Obligations 12,000




When actual warranty claims are received in April, May, and June, costs of these claims
are written off through the liability account. No new expense is recognized. For exam-
ple, assume that on May 15, Harris replaces a faulty motor on an appliance. The cost
of the motor ($300) and labor to install the motor ($100) are recorded as follows:


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
May 15, 2004 Warranty Obligations 400
Parts Inventory 300
Wages Payable 100
F487
CHAPTER F13: Operating Activities
491
Operating Activities

Revenues and expenses associated with selling goods and services should be rec-
ognized in the fiscal period in which the revenues are earned. Because the outcomes
of some of the events associated with these revenues and expenses are not known un-
til a later fiscal period, it is often necessary to estimate these effects. The estimates are
recorded in the fiscal period in which the revenues are earned, and these amounts are
adjusted in later periods when actual amounts are known. Doubtful accounts expense,
sales returns, and warranty expense are all examples of these required estimates.




1 SELF-STUDY PROBLEM Bonsai Company, a wholesaler of Asian foods, reported the fol-
lowing transactions for 2004:
1. Purchased $400,000 of merchandise inventory on credit.
2. Sold goods priced at $750,000 on credit.
3. The cost of merchandise sold to customers was $388,000.
4. Paid $384,000 to suppliers of merchandise.
5. Received $720,000 in cash from customers.
6. Granted $17,000 of sales discounts to customers for payment within the discount
period.
7. Estimated that $10,000 of the year™s credit sales would be uncollectible.
8. Wrote off $8,000 of accounts as uncollectible.

Required Using the format shown in this chapter, record each of the transactions and
determine the amount of net income and net operating cash flow associated with these
transactions.
The solution to Self-Study Problem 1 appears at the end of the chapter.



INVENTORIES COST GOODS SOLD
AND OF
To generate revenues, merchandising and manufacturing companies have to acquire or
OBJECTIVE 3
produce goods for sale. These activities increase Inventories on the balance sheet and
Describe reporting rules reduce Cash and/or increase Accounts Payable, as illustrated in Exhibit 3. Once goods
for inventories and cost of are sold, Inventories are reduced and Cost of Goods Sold is recognized. Therefore, the
goods sold and compare amount reported for inventories on the balance sheet is related to the amount reported
reporting of inventories for Cost of Goods Sold on the income statement and to Net Operating Cash Flow on
for merchandising and
the cash flow statement.
manufacturing
Accounting for Inventories and Cost of Goods Sold involves measurement and re-
companies.
porting rules. Measurement rules determine how costs are computed; reporting rules
identify how these costs are reported on the income statement and the balance sheet.


Exhibit 3 Balance Sheet
Activity Statement of
Income
The Effect of Inventory Cash Flows
Statement
Transactions on the
Financial Statements Cash Paid
Assets
to Suppliers
Cash
Merchandise or
Purchase of Inventory Materials Inventory
Liabilities
Accounts Payable




Merchandise or
Cost of
Sales of Goods
Finished Goods
Goods Sold
to Customers
Inventory
F488 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
492 Activities

Reporting Inventories and Cost of Goods Sold
Inventories and Cost of Goods Sold are reported by both merchandising and manu-
facturing companies. Inventory transactions of manufacturing companies are more
complex than those of merchandising companies because manufacturing companies
must account for the production of goods. We will begin with merchandising compa-
nies and then examine manufacturing companies.

Merchandising Companies. Accounting for Merchandise Inventory is fairly simple.
When it buys inventory, a company increases the balance of Merchandise Inventory.
When it sells inventory, a company decreases the inventory account balance. Suppose
that Mom™s Cookie Company purchases $10,000 of inventory on May 4, 2004 on credit,
and sells $4,000 of that inventory on May 6. Mom™s Cookie Company would record
these transactions as follows:



ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
May 4, 2004 Merchandise Inventory 10,000
Accounts Payable 10,000
May 6, 2004 Cost of Goods Sold 4,000
Merchandise Inventory 4,000




The second transaction considers only the cost of the sale, not the amount of revenue
earned.
A payment by Mom™s Cookie Company on May 12 for half of the inventory pur-
chased on May 4 would result in the following:


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
May 12, 2004 Accounts Payable 5,000
Cash 5,000




This transaction reduces the payable and results in a cash payment to suppliers, which
would be reported on the statement of cash flows.
In addition to recording the purchase and sales transactions that affect the finan-
cial statements, companies maintain detailed records that describe each item of inven-
tory and the quantity purchased and sold. Those records help a company determine
the number of units on hand, the demand for each item, and when to reorder. Also,
these records are used for control purposes. Periodically, companies verify their inven-
tory records by taking a physical count of inventory to make sure their records are con-
sistent with the amount of inventory actually on hand.
Like sales discounts, purchase discounts, for paying for goods or services within the
discount period, should be subtracted in computing amounts reported in the financial
statements. For example, if Mom™s Cookie Company receives a $200 discount on its
$10,000 purchase for paying the account payable within a discount period, it should record
the inventory at $9,800, reducing Inventory and Accounts Payable by $200.
F489
CHAPTER F13: Operating Activities
493
Operating Activities

Manufacturing Companies. Accounting for the
inventory transactions of a manufacturing company
LEARNING NOTE is more complex than that for a merchandising com-
The cost of inventory includes the amount paid for the goods plus pany because a manufacturing company produces in-
any shipping costs paid by the buyer. Goods in transit between ventory rather than purchasing it from a supplier.
the seller and the buyer should be included as part of the buyer™s Most manufacturing companies separate their in-
inventory at year end if ownership of the goods has been trans- ventories into three categories: raw materials inven-
ferred to the buyer at that time. tory, work-in-process inventory, and finished goods
inventory. Exhibit 4 illustrates the relationships
among these categories.


Exhibit 4 Inventories
Components of
Manufacturing Inventory Finished
Raw
Work-in-Process
Goods
Materials




Labor and
Overhead
Costs




Raw materials inventory includes the costs of component parts or ingredients
that become part of the product being manufactured. Raw materials are reported on
the balance sheet as the cost of the components or ingredients a company has purchased
that have not yet been placed into production. For example, the raw materials for Mom™s
Cookie Company would consist primarily of the flour, sugar, and other ingredients.
Work-in-process inventory includes the costs of materials, labor, and overhead
that have been applied to products that are in the process of being manufactured.
Materials costs are determined from the amounts paid for raw materials. As raw mate-
rials are used in the production process, the costs of these materials are transferred from
Raw Materials Inventory to Work-in-Process Inventory. Labor costs, often referred to
as direct labor, are added to Work-in-Process Inventory based on the amount earned
by factory workers. Overhead costs include the costs of supplies, utilities, depreciation,
maintenance, and similar items that are necessary for the manufacturing process.
Finished goods inventory includes the costs of products that have been completed
in the manufacturing process and are available for sale to customers. These costs in-
clude the costs of the materials, labor, and overhead necessary to produce completed
products.
For example, assume that Mom™s Cookie Company begins producing its own cook-
ies early in January 2005. Exhibit 5 describes production activities for January and Feb-
ruary.
At the beginning of January, Mom™s Cookie Company has no manufacturing in-
ventories. During January, the company purchases $65,000 of materials and uses
$62,000 of materials. At the end of January, the company would report raw materials
inventory of $3,000. That amount becomes the beginning materials inventory for Feb-
ruary. If the company purchases $66,000 of materials in February and uses $67,000 of
materials in production in February, it would report raw materials inventory of $2,000
at the end of February.
Work-in-process for January includes the costs of materials, labor, and overhead
that went into production during January. The cost of goods that are completed dur-
ing the month is transferred to finished goods inventory, leaving a balance of $4,000
for work-in-process inventory at the end of January. February™s production begins with
the $4,000 of inventory. Additional production costs of materials, labor, and overhead
F490 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
494 Activities

Exhibit 5 January February
Computation of
Raw materials inventory
Manufacturing Inventory
Beginning balance $ ” $ 3,000
Costs
Materials purchased during month 65,000 66,000
Material used in production (62,000) (67,000)
Ending balance $ 3,000 $ 2,000
Work-in-process inventory
Beginning balance $ ” $ 4,000
Materials used in production 62,000 67,000
Labor costs 58,000 58,000
Overhead costs 42,000 42,000
Cost of goods completed (158,000) (161,000)
Ending balance $ 4,000 $ 10,000
Finished goods inventory
Beginning balance ” $ 5,000
Cost of goods completed $ 158,000 161,000
Cost of goods sold (153,000) (163,000)
Ending balance $ 5,000 $ 3,000




are added during February. The cost of completed goods is subtracted, leaving a bal-
ance of $10,000 at the end of February.
Finished goods inventory for January is the cost of goods completed during Janu-
ary less the cost of goods sold for the month. The ending balance of $5,000 is carried
over as the beginning balance for February. The cost of goods completed during Feb-
ruary is added and the cost of goods sold during February is subtracted, leaving a bal-
ance of $3,000 for finished goods inventory at the end of February.
Manufacturing companies do not recognize expenses for the materials, labor, and
overhead used in the production process until goods are sold. Those expenses are part
of the company™s inventories until finished goods are sold. At that time, production
costs are transferred to expense as Cost of Goods Sold. This accrual accounting pro-
cedure matches expenses with revenues in the period in which the revenues are rec-
ognized. The costs of goods that have not been sold at the end of the fiscal period are
reported on the balance sheet as part of a company™s inventories. Each inventory cat-
egory (Raw Materials, Work-In-Process, and Finished Goods) may be reported on
the balance sheet. In some cases, manufacturing companies report the amount of to-
tal inventories on the balance sheet and report the amounts of the various categories
in a note.




Case in Point
In
Manufacturing Inventories
Krispy Kreme reported the following total manufacturing inventories in its 2002 an-
nual report.

(In thousands) 2002 2001
Inventories
Raw materials $5,674 $3,809
Work-in-process 28 248
Finished goods 4,280 2,328
Total manufacturing inventories $9,982 $6,385
F491
CHAPTER F13: Operating Activities
495
Operating Activities


MEASURING INVENTORY
The examples presented in the previous sections are relatively straightforward because
OBJECTIVE 4
we assume that we know the cost of each inventory item. If a company sells 10 inven-
Explain and apply rules tory items and each item costs $50, cost of goods sold is $500. A problem arises, how-
for measuring cost of ever, when a company does not know the precise cost of an inventory item and the cost
goods sold and must be estimated. A major reason inventory costs are estimated is that the costs of
inventories and describe merchandise, raw materials, labor, utilities, supplies, and other resources change over
the effects of income taxes
time.
on the choice of inventory
Hydro Company sells and services agricultural irrigation equipment. On March 20,
estimation method.
2004, Hydro purchased 20 pump motors at $200 each. Hydro already had 8 identical
motors on hand, for which it had paid $175 each. On March 22, 2004, a customer pur-
chased one motor. Should the company record the cost of goods sold for the motor as
$175 or as $200?
The decision about which cost to record ($175 or $200) affects both the income
statement and the balance sheet. If $175 is used, this amount is subtracted from Mer-
chandise Inventory and transferred to Cost of Goods Sold. All of the motors that cost
$200 are left in Merchandise Inventory.
Most companies that sell products for which one unit of inventory is like other
units of inventory estimate their cost of goods sold rather than trying to keep track of
the cost of each individual unit. Exceptions to this practice are made when the cost of
individual inventory items is large and one item is easily distinguished from another.
For example, a car dealer keeps track of each car or truck in its inventory. For compa-
nies that estimate inventory costs, common methods are first-in, first-out (FIFO); last-
in, first-out (LIFO); and weighted-average.
The first-in, first-out method assumes that the units of inventory acquired first
are sold first. If Hydro used FIFO, it would record the cost of the motor sold on March
22 as $175 because this is the cost of the oldest items in Hydro™s inventory.
The last-in, first-out method assumes that the last units of inventory acquired
are the first sold. If Hydro used LIFO, it would record the cost of the motor sold on
March 22 as $200 because this is the cost of the most recent items in Hydro™s inven-
tory.
The weighted-average method uses the average cost of units of inventory avail-
able during a period as the cost of units sold. Hydro™s average inventory cost for pump
motors on March 22 would be as follows:

Units Cost per Unit Total Cost
Beginning 8 $175 $1,400
Purchased 20 200 4,000
Total 28 $5,400
Average cost per unit ($5,400 28 units) $192.86

Accordingly, Hydro would record cost of goods sold of $192.86 for the motor it sold
on March 22.
Inventory estimation methods often are used even when a company knows which
items of inventory are being sold. For example, Hydro could use LIFO for its motor
sales even if the salesperson is sure that the motor delivered to the customer is one left
over from last year. Most companies sell their oldest goods first, to avoid spoilage and
obsolescence. But they may use LIFO to account for those goods anyway. LIFO often
is used by companies because of its beneficial income tax effects.


Perpetual and Periodic Inventory Methods
The determination of inventory costs differs depending on whether a company uses
perpetual or periodic inventory systems. Perpetual inventory system refers to a system
of recording cost of goods sold and updating inventory balances at the time goods
F492 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
496 Activities

are sold. Periodic inventory system refers to a system of recording cost of goods sold
and updating inventory balances at the end of a fiscal period. Because technology
makes it feasible to identify costs at the time sales occur, the perpetual system is used
by many companies.
Let™s examine the effects of these inventory systems for Mom™s Cookie Company.
Suppose that the company has finished goods inventory of $3,000 at the end of Febru-
ary 2005. The inventory includes 150 cases of cookies at a cost of $20 per case. During
March, the company completes a batch of 3,000 cases at a cost of $20.30 per case on
March 8, a second batch of 3,000 cases at $20.60 on March 18, and a third batch of
3,000 cases at $20.90 on March 28. It shipped orders for 5,200 cases on March 20 and
3,600 cases on March 31. Exhibit 6 summarizes these events.


Exhibit 6 Units
Unit Costs and Sales for (Cases) Unit Cost Total Cost
Mom™s Cookie Company
March 1 Inventory 150 $20.00 $ 3,000
for March
March 8 Batch 3,000 20.30 60,900
March 18 Batch 3,000 20.60 61,800
March 20 Sales 5,200
March 28 Batch 3,000 20.90 62,700
March 31 Sales 3,600
Total Cost of Goods Available for Sale $188,400




Perpetual System. To determine cost of goods sold using the perpetual system, cal-
culate the cost at the time of each sale. On March 20, the company sold 5,200 cases.
Using FIFO, the cost of these units would be $106,130, as shown in Exhibit 7. Using
FIFO, the earliest inventory batches are sold first. Consequently, the March 1, March
8, and a portion of the March 18 batches are used in the calculation of Cost of Goods
Sold.


Exhibit 7 Calculation of Perpetual Inventory Cost for March 20 Sales

Units
(Cases) Units Sold
Available March 20 Units Left Unit Cost Total Cost

FIFO Inventory Cost
Beginning Inventory 150 150 0 $20.00 $ 3,000
March 8 Batch 3,000 3,000 0 20.30 60,900
March 18 Batch 3,000 2,050 950 20.60 42,230
Cost of Goods Sold 5,200 $106,130
Ending Inventory on March 20
(cost from March 18) 950 20.60 $ 19,570

LIFO Inventory Cost
Beginning Inventory 150 0 150 $20.00 $ 0
March 8 Batch 3,000 2,200 800 20.30 44,660
March 18 Batch 3,000 3,000 0 20.60 61,800
Cost of Goods Sold 5,200 $106,460
Ending Inventory on March 20
(cost from March 1) 150 20.00 $ 3,000
(cost from March 8) 800 20.30 16,240
Total 950 $ 19,240
F493
CHAPTER F13: Operating Activities
497
Operating Activities

The cost of goods sold using LIFO would be $106,460, as shown in Exhibit 7. Us-
ing LIFO, the most recent inventory layers are assumed to be sold first. Thus, for the
March 20 sale, the cost of inventory from March 18 and a portion of cost of inventory
from March 8 are included in cost of goods sold.
After the March 20 sale, Mom™s Cookie Company would have 950 cases left in in-
ventory. Using FIFO, the cost of these units is $20.60 per case, as shown in Exhibit 7.
On March 20, a batch of 3,000 cases was produced. The company sold an additional
3,600 cases on March 31. The cost of these units using FIFO would be $74,955, as shown
in Exhibit 8. The FIFO calculation assumes the units that cost $20.60 were sold along
with a portion of the units from the March 28 batch.
Using LIFO, the inventory available on March 20, after the sales, included 150
cases that cost $20.00 per case and 800 cases that cost $20.30 per case. When goods
are sold on March 31, the most recent goods available, those from March 28, are as-
sumed to be sold first. Exhibit 8 shows the cost of goods sold for March 31 as $74,880,
using LIFO.


Exhibit 8 Calculation of Perpetual Inventory Cost for March 31 Sales

Units
(Cases) Units Sold
Available March 31 Units Left Unit Cost Total Cost

FIFO Inventory Cost
Beginning Inventory 950 950 0 $20.60 $19,570
March 28 Batch 3,000 2,650 350 20.90 55,385
Cost of Goods Sold 3,600 $74,955
Ending Inventory on March 31
(cost from March 28) 350 20.90 $ 7,315

LIFO Inventory Cost
Beginning Inventory 150 0 150 $20.00 $ 0
March 8 Inventory 800 600 200 20.30 12,180
March 28 Batch 3,000 3,000 0 20.90 62,700
Cost of Goods Sold 3,600 $74,880
Ending Inventory on March 31
(cost from March 1) 150 20.00 $ 3,000
(cost from March 8) 200 20.30 4,060
Total 350 $ 7,060




Thus, for the month of March:
FIFO LIFO
$181,0851 $181,3402
Total cost of goods sold
Ending inventory on March 31 7,315 7,060
Total goods available for sale during March $188,400 $188,400
1
($106,130 $74,955)
2
($106,460 $74,880)

The weighted average method would calculate cost of goods sold based on the av-
erage cost of inventory available at the time of each sale. Exhibit 9 provides calculations
for Mom™s Cookie Company for March.
The company™s inventory on March 20 includes 6,150 units at a combined cost of
$125,700. Therefore, the average cost per unit is $20.439 ($125,700 6,150 units). Cost
of goods sold for the March 20 sale is $106,283 (5,200 units $20.439), leaving an in-
ventory of 950 units at a cost of $19,417 (950 units $20.439).
F494 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
498 Activities

Exhibit 9 Units Cost of
Calculation of Perpetual (Cases) Unit Cost Total Cost Goods Sold
Average Inventory Cost
Beginning Inventory 150 $20.00 $ 3,000
for March Sales
March 8 Batch 3,000 20.30 60,900
March 18 Batch 3,000 20.60 61,800
March 20 Average Cost 6,150 20.439 125,700
March 20 Sales 5,200 20.439 106,283 $106,283
March 20 Inventory 950 20.439 19,417
March 28 Batch 3,000 20.90 62,700
March 31 Average Cost 3,950 20.789 82,117
March 31 Sales 3,600 20.789 74,841 74,841
Ending Inventory 350 20.789 $ 7,276 $181,124




When goods are sold on March 31, the average inventory cost is recalculated. March
31 inventory includes 3,950 units at a combined cost of $82,117. Therefore, the average
cost per unit is $20.789 ($82,117 3,950 units). Cost of goods sold for the March 31
sale is $74,841 (3,600 units $20.789). Ending inventory for March is $7,276 (350 units
$20.789). Therefore, total cost of goods available for sale in March is $188,400
($106,283 $74,841 $7,276), which agrees with the total under FIFO and under LIFO.
The average method is sometimes referred to as the moving average method when
the perpetual system is used because the average unit cost is recalculated each time a
sale is made based on units available at that date.

Periodic System. Using the periodic system, a company records inventory costs at the
end of a fiscal period. Thus, Mom™s Cookie Company would record the cost of all the
goods it sold during March at the end of the month. The cost of goods sold for March
would be $181,085 using FIFO and $181,340 using LIFO, as shown in Exhibit 10.


Exhibit 10 Calculation of Periodic Inventory Cost for March

Units
(Cases)
Cost of Goods Sold for March Available Units Sold Units Left Unit Cost Total Cost

FIFO Inventory Cost
Beginning Inventory 150 150 ” $20.00 $ 3,000
March 8 Batch 3,000 3,000 ” 20.30 60,900
March 18 Batch 3,000 3,000 ” 20.60 61,800
March 28 Batch 3,000 2,650 350 20.90 55,385
$181,0851
Cost of Goods Sold for March 8,800
$ 7,3151
Ending Inventory (from March 28) 350 20.90

LIFO Inventory Cost
Beginning Inventory 150 ” 150 $20.00 $ ”
March 8 Batch 3,000 2,800 200 20.30 56,840
March 18 Batch 3,000 3,000 ” 20.60 61,800
March 28 Batch 3,000 3,000 ” 20.90 62,700
$181,3402
Cost of Goods Sold for March 8,800
Ending Inventory (from March 1) 150 20.00 $ 3,000
(from March 8) 200 20.30 4,060
$ 7,0602
Total 350
1
Total goods available for sale for March $181,085 $7,315 $188,400.
2
Total goods available for sale for March $181,340 $7,060 $188,400.
F495
CHAPTER F13: Operating Activities
499
Operating Activities

If the weighted average method is used, the cost of goods sold for a period is cal-
culated from the total units available during the period and the combined cost of these
units, as described in Exhibit 11. Mom™s Cookie Company had 9,150 units available
during March at a combined cost of $188,400. Therefore, the average cost per unit was
$20.59 ($188,400 9,150 units). Cost of goods sold for March is $181,193 (8,800 units
$20.59). Ending inventory for March is $7,207 (350 units $20.59).


Exhibit 11 Units
Calculation of Periodic (Cases) Unit Cost Total Cost
Average Inventory Cost
Beginning Inventory 150 $20.00 $ 3,000
for March Sales
March 8 Batch 3,000 20.30 60,900
March 18 Batch 3,000 20.60 61,800
March 28 Batch 3,000 20.90 62,700
Average Cost 9,150 20.59 188,400*
Cost of Goods Sold 8,800 20.59 181,193
Ending Inventory 350 20.59 $ 7,207
*Total goods available for sale in March




Under the periodic inventory system, as under the perpetual inventory system, all
methods have the same total goods available for sale for March, $188,400.
Companies that use the periodic system may not keep track of units sold during
each fiscal period. Instead, they may count the number of units available at the end of
a period to determine how many units were sold. Generally, this approach is only used
when it is not feasible or cost effective to keep track of units sold.
This method is frequently used for supplies or similar prepaid items for which it is
not feasible to maintain detailed inventory records. For example, assume Mom™s Cookie
Company had 4 cases of copier paper at the beginning of March at a cost of $50 per
case. During March, the company purchased 10 cases at a cost of $52 per case. A count
at the end of March revealed that 2 cases remained on hand. Supplies expense and sup-
plies on hand at the end of March could be calculated using FIFO as follows:

Beginning inventory $ 200 4 cases $50
Purchases 520 10 cases $52
Supplies available 720
Ending inventory (104) 2 cases $52
Supplies expense $ 616


Inventory Estimation and Income Taxes
The primary reason for the use of LIFO is the tax advantage LIFO provides to many
companies. LIFO results in the most recent inventory costs being subtracted when com-
puting net income. FIFO results in the oldest inventory costs being subtracted. In in-
flationary periods, the LIFO method usually produces a higher cost of goods sold and
a lower pretax income than does the FIFO method. Accordingly, income taxes also are
lower.
Exhibit 12 compares income statements for Mom™s Cookie Company assuming the
use of FIFO and LIFO. The LIFO column is identical to the income statement in Ex-
hibit 1, which assumed the company used the LIFO method. If the company had used
FIFO instead of LIFO, its cost of goods sold for 2005 would have been $1,946,800. The
cost is lower because the company would have used the cost of its oldest inventory items
when recording cost of goods sold, and the cost of most of the items it sells has in-
creased during the year. The lower cost of goods sold results in higher gross profit,
F496 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
500 Activities

operating income, and pretax income. Selling, general, and administrative expenses and
nonoperating items are not affected by the choice of inventory estimation method.



Exhibit 12 For the Year Ended December 31, 2005 FIFO LIFO
Income Statement for
Sales revenue $ 3,235,600 $ 3,235,600
Mom™s Cookie Company
Cost of goods sold (1,946,800) (1,954,300)
Using FIFO and LIFO
Gross profit 1,288,800 1,281,300
Inventory Estimation
Selling, general, and administrative expenses (1,094,700) (1,094,700)
Operating income 194,100 186,600
Interest expense (20,400) (20,400)
Pretax income 173,700 166,200
Income taxes (52,110) (49,860)
Net income $ 121,590 $ 116,340




Income tax expense is higher if FIFO is used because the income tax rate Mom™s
Cookie Company pays on its pretax income is the same (about 30%) whether FIFO or
LIFO is used. Therefore, if FIFO is used, income tax expense is $52,110. If LIFO is used,
income tax expense is $49,860. Consequently, if Mom™s Cookie Company used FIFO,
it would incur $2,250 in additional taxes compared with using LIFO. FIFO results in
higher net income for Mom™s Cookie Company, but it also results in higher income
taxes.
Income tax regulations require that, in most cases, a company that uses LIFO to es-
timate cost of goods sold in computing its income taxes also must use LIFO to estimate
cost of goods sold on its income statement. This rule, called a tax conformity rule, is un-
usual. Tax regulations normally permit companies to use different accounting measure-
ment rules for estimating revenues and expenses for tax and income statement purposes.
For example, a company can use accelerated depreciation for computing income taxes
and straight-line depreciation for computing net income. As a result of this tax rule, a
company often has to choose between reporting higher net income by using FIFO and
paying lower taxes by using LIFO. Once a company
INTERNATIONAL

chooses an inventory estimation method, it is re-
LEARNING NOTE quired by GAAP to use the method consistently from
year to year. A change from one method to another
Most countries do not allow the use of LIFO. Therefore, multina-
(from LIFO to FIFO, for example) is permitted only
tional firms, including large U.S. corporations, normally use FIFO
for inventories held in foreign countries even if they use LIFO for in infrequent circumstances when management can
similar inventories held in the United States. Companies can use justify the change because of important changes in the
LIFO for some inventories and FIFO or the weighted-average company™s business.
method for others. It is important to understand why many compa-
nies use LIFO even though it results in lower net in-
come. To understand the reasoning, consider Mom™s
Cookie Company™s operating cash flows. Although the choice of inventory method af-
fects Cost of Goods Sold on the income statement, it has no effect on the amount of
cash paid to suppliers. Assume the company paid $2 million for the inventory it pur-
chased in 2005. Regardless of whether the company uses FIFO or LIFO, it still pays the
same amount for this inventory. Also, the amounts of cash collected from customers
and paid for other resources consumed in 2005 are the same, regardless of which in-
ventory method the company uses. The only effect the company™s inventory method
has on its cash flows is the amount of income taxes it pays. Therefore, using LIFO re-
duces cash payments for taxes and leaves the company with more net cash flow from
operating activities.
Remember that net income is an accrual-basis estimate of the net amount of cash
a company will receive once it has collected cash from customers and paid for all re-
F497
CHAPTER F13: Operating Activities
501
Operating Activities

sources consumed in operating activities. If Mom™s Cookie Company uses FIFO, its net
income is higher than if it uses LIFO, but its net operating cash flow is lower. There-
fore, the higher income results from accounting estimation, not from real economic ac-
tivity that creates additional resources for the company. Thus, if the company used
FIFO, it might look as if it were performing better than if it used LIFO, but the ap-
pearance is deceiving. Actually, the company is performing better if it uses LIFO be-
cause of the lower tax payments. To understand and interpret net income, it is important
to understand accounting measurement rules.
Companies that use FIFO normally do so for sound economic reasons. For example,
if the cost of inventory decreases over time because of improvements in technology or in-
creased competition, FIFO produces a tax advantage over LIFO. The oldest items in in-
ventory cost more than the newest items. Including the cost of the oldest items in cost of
goods sold reduces taxable income and income taxes. Accordingly, computer and other
high-technology companies that experience decreases in inventory costs normally use FIFO.

Lower of Cost or Market Inventory Valuation. GAAP require companies to com-
pare the costs determined through inventory estimation methods with the current mar-
ket cost of the inventories on hand at the end of a fiscal year. If current market costs
are below the costs resulting from the use of an estimation method such as FIFO or
LIFO, the inventories must be written down to the current market costs. This re-
quirement is referred to as the lower of cost or market inventory rule. Such writedowns
are more common when FIFO is used because FIFO normally results in a higher esti-
mated inventory value at year end. Therefore, FIFO inventory costs are more likely than
LIFO costs to be higher than market.
A problem with reporting inventory at the lower of cost or market is that the market
value of inventories is not always easy to determine. GAAP specify a procedure for com-
puting market value that considers the current replacement cost and the amount a com-
pany expects to receive from selling the inventory less the profit it expects to earn from
the inventory. Once a market value has been determined, it is compared with the cost of
inventory. If the market value is less than cost, the inventory is written down to market.
A writedown results in a loss that is recognized
LEARNING NOTE in the period in which the inventory decreases in
value. To illustrate, assume that Tucker Company,
An excess of market value over cost is not recognized through a
which sells electronic equipment through its retail
valuation adjustment. This is another example of the conser-
stores, acquired $500,000 of merchandise on August
vatism of accounting measurement.
18, 2004. By December 31, 2004, the end of the com-
pany™s fiscal year, it had sold $300,000 of the mer-
chandise. It was having difficulty selling the remaining $200,000 of merchandise because
a competitor was marketing newer products at lower prices. Tucker estimated that the
market value of its remaining inventory was $140,000 on December 31. Accordingly, it
would recognize the decline in market value as follows:


ASSETS LIABILITIES OWNERS™ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2004 Loss on Inventory 60,000
Merchandise Inventory 60,000




Comparing Inventory Costs among Companies
GAAP require companies to disclose the methods they use to measure inventories and
cost of goods sold. GAAP also require companies that use LIFO to disclose the effect
F498 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
502 Activities

of the method on the reported value of inventory. For example, Sears, Roebuck & Co.
reported in its annual report for the fiscal year ended in 2001 that it used LIFO to de-
termine most of its inventory costs. It also reported that these inventory costs were $590
million lower in 2001 than if FIFO had been used. Sears™ cost of goods sold was higher
using LIFO. Sears used LIFO because of its tax advantages. Furthermore, managers are
aware that investors, creditors, and other users of accounting information who under-
stand accounting methods recognize that higher net income is not beneficial unless it
results from real economic improvement in a company™s performance. Managers who
use accounting methods to dress up their earnings to make them look better than they
really are often lose the trust of investors and other users of financial statements when
they learn of this type of behavior.



Case in Point
In
The Importance of Reliable Accounting Information
WorldCom, Inc., revealed in June 2002 that it had understated expenses by ap-
proximately $4 billion during 2001 and 2002 and that the company would have re-
ported net losses during this period if the expenses had been stated correctly. The
http://ingram. company™s stock price dropped to around 9¢ per share after the information was re-
swcollege.com leased. At the beginning of 2002, the stock was trading at approximately $14 per
share.
Learn more about
WorldCom.



The FIFO, LIFO, and weighted-average methods are used by both merchandising
and manufacturing companies. In recent years, however, many manufacturing compa-
nies have tried to reduce their inventories. Those companies buy materials as they are
needed, “just in time” to be used in the manufacturing process. Materials are acquired
at a rate sufficient to meet orders without accumulating large amounts of inventories.
Companies that use just-in-time manufacturing procedures report relatively small
amounts of inventory, and they expense almost all of their manufacturing costs each
period as part of the cost of goods sold. For these companies, the method used to es-
timate inventory is less important than it is for companies with large inventories.




2 SELF-STUDY PROBLEM Fashion Mart is a clothing retailer. During 2004, the company
recorded $28 million of cost of goods sold. If it had used LIFO,
it would have reported $30 million of cost of goods sold. The company™s income tax
rate was 35%. Sales revenue for the year was $45 million, and other expenses were $8
million.

Required
A. What would the difference in Fashion Mart™s net income and cash flow from op-
erating activities have been if it had used LIFO instead of FIFO in 2004?
B. What factors should the company consider in deciding which inventory estimation
method to use?
The solution to Self-Study Problem 2 appears at the end of the chapter.




OTHER OPERATING ACTIVITIES INCOME STATEMENT ITEMS
AND
In addition to operating revenues and cost of goods sold, operating expenses, other rev-
enues and expenses, income taxes, and special items affect a company™s income state-
ment. The next two sections describe items that are reported in each of these categories.
F499
CHAPTER F13: Operating Activities
503
Operating Activities

Operating Expenses
OBJECTIVE 5
Most operating expenses other than cost of goods sold are period costs. Period costs
Identify routine and
are expensed in the fiscal period in which they occur. These costs usually reduce cash
nonroutine events that
or other current assets or increase current liabilities on the balance sheet. The use of
affect a company™s
cash is a cash outflow on the statement of cash flows. Exhibit 13 illustrates these rela-
income statement.

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