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Chapter 8: Q10CA (page 437)

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

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

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

2017

2018

2019

Unit sales (in millions of units)

1.1

1.0

1.3

Sales price per unit

\(10

\)12

\(12

Unit purchases (in millions of units)

1.0

1.1

1.2

Purchase price per unit

\)8

\(9

\)10

Annual depreciation (in thousands of dollars)

\(300

\)300

\(300

Cash dividends per share

\)0.15

\(0.15

\)0.15

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

\(350

\)350

$350

Income tax rate

40%

40%

40%

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

15%

15%

15%

Common shares outstanding (in millions)

1

1

1

Instructions

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

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

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

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

Short Answer

Expert verified

S.no.

Data

2017

2018

2019

(a1)

Year-end inventory balances

(7,200)

(9,000) and

(8,100)

(9,000) and

(7,200)

(a2)

Annual net income after taxes

$150

$1,080 and $540

$576 and $36

(a3)

Earnings per share

$0.15

$1.08 and $0.54

$0.58 and $0.04

(a4)

Cash balance

$1,150

$230 and $590

$606 and $1,326

(b)By converting to the LIFO approach, Harrisburg Company may meet its aim of income tax savings, as calculated in (a).

Step by step solution

01

Meaning of LIFO

LIFO is an inventory valuation method in which the last item is sold first. LIFO is not adopted by every business enterprise because at the end of the year items become old and lose value over time

02

(a1) Calculating Year-end inventory balances

Computing data under the FIFO method

2017

2018

2019

Sales revenue

$11,000

$12,000

$15,600

Cost of goods sold

Beginning inventory

8,000

7,200

9,000

Purchases

8,000

9,900

12,000

Cost of goods available for sale

16,000

17,100

21,000

Ending inventory

(7,200)

(9,000)

(9,000)

Cost of goods sold

8,800

8,100

12,000

Working notes:

Calculation of value of ending inventory

Date

Calculation

Amount

2017


$7,200

2018


$9,000

2019


$9,000

Computing data under the LIFO method

2017

2018

2019

Sales revenue

$11,000

$12,000

$15,600

Cost of goods sold

Beginning inventory

8,000

7,200

8,100

Purchases

8,000

9,900

12,000

Cost of goods available for sale

16,000

17,100

20,100

Ending inventory

(7,200)

(8,100)

(7,200)

Cost of goods sold

8,800

9,000

12,900

Working notes:

Calculation of value of ending inventory

Date

Calculation

Amount

2017


$7,200

2018


$8,100

2019


$7,200

03

(a2) Calculating Annual net income after taxes

Computing data under the FIFO method

2017

2018

2019

Sales revenue

$11,000

$12,000

$15,600

Cost of goods sold

Beginning inventory

8,000

7,200

9,000

Purchases

8,000

9,900

12,000

Cost of goods available for sale

16,000

17,100

21,000

Ending inventory

(7,200)

(9,000)

(9,000)

Cost of goods sold

8,800

8,100

12,000

Gross profit

2,200

3,900

3,600

Operating expense

1,650

1,800

2,340

Depreciation expense

300

300

300

Income before taxes

250

1,800

960

Income tax expense (40%)

100

720

384

Net Income

$150

$1,080

$576

Computing data under the LIFO method

2017

2018

2019

Sales revenue

$11,000

$12,000

$15,600

Cost of goods sold

Beginning inventory

8,000

7,200

8,100

Purchases

8,000

9,900

12,000

Cost of goods available for sale

16,000

17,100

20,100

Ending inventory

(7,200)

(8,100)

(7,200)

Cost of goods sold

8,800

9,000

12,900

Gross profit

2,200

3,000

2,700

Operating expense

1,650

1,800

2,340

Depreciation expense

300

300

300

Income before taxes

250

900

60

Income tax expense

100

360

24

Net Income

$150

$540

$36

04

(a3) Calculating Earnings per share

Computing data under the FIFO method

2017

2018

2019

Sales revenue

$11,000

$12,000

$15,600

Cost of goods sold

Beginning inventory

8,000

7,200

9,000

Purchases

8,000

9,900

12,000

Cost of goods available for sale

16,000

17,100

21,000

Ending inventory

(7,200)

(9,000)

(9,000)

Cost of goods sold

8,800

8,100

12,000

Gross profit

2,200

3,900

3,600

Operating expense

1,650

1,800

2,340

Depreciation expense

300

300

300

Income before taxes

250

1,800

960

Income tax expense (40%)

100

720

384

Net Income

$150

$1,080

$576

Earnings per share

$0.15

$ 1.08

$0.58

Notes:

For calculating earnings per share following formula should be used

Computing data under the LIFO method

2017

2018

2019

Sales revenue

$11,000

$12,000

$15,600

Cost of goods sold

Beginning inventory

8,000

7,200

8,100

Purchases

8,000

9,900

12,000

Cost of goods available for sale

16,000

17,100

20,100

Ending inventory

(7,200)

(8,100)

(7,200)

Cost of goods sold

8,800

9,000

12,900

Gross profit

2,200

3,000

2,700

Operating expense

1,650

1,800

2,340

Depreciation expense

300

300

300

Income before taxes

250

900

60

Income tax expense

100

360

24

Net Income

$150

$540

$36

Earnings per share

$0.15

$0.54

$0.04

05

(a4) Calculating Cash balance

Computing data under the FIFO method

2017

2018

2019

Cash balance

Beginning balance

$ 400

$ 1,150

$ 230

Sales proceeds

11,000

12,000

15,600

Purchases

(8,000)

(9,000)

(12,000)

Operating expenses

(1,650)

(1,800)

(2,340)

Property, plant, and equipment

(350)

(350)

(350)

Income taxes

(100)

(720)

(384)

Dividends

(150)

(150)

(150)

Ending balance

$ 1,150

$ 230

$ 606

Computing data under the LIFO method

2017

2018

2019

Cash balance

Beginning balance

$ 400

$ 1,150

$ 590

Sales proceeds

11,000

12,000

15,600

Purchases

(8,000)

(9,900)

(12,000)

Operating expenses

(1,650)

(1,800)

(2,340)

Property, plant, and equipment

(350)

(350)

(350)

Income taxes

(100)

(360)

(24)

Dividends

(150)

(150)

(150)

Ending balance

$ 1,150

$ 590

$ 1,326

06

(b) Explaining the additional issues and the report

Switching to the LIFO approach, according to the computation in (a), will allow Harrisburg Company to meet its aim of saving money on taxes. According to the schedules, Harrisburg will have lower net income and hence fewer income taxes in 2018 and 2019 under the LIFO approach (tax savings of $360,000 each year). As a consequence, Harrisburg's financial position will be stronger at the end of 2018 and especially in 2019 (the year-end cash balance will be higher by $360,000 in 2018 and $720,000 in 2019).

Due to growing purchase costs, the LIFO approach will result in considerably reduced net income and profits per share in 2018 and 2019. Before opting to switch to the LIFO technique, management may need to assess the possible impact on the firm of decreased net income and profits per share.

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Most popular questions from this chapter

The following information relates to the Jimmy Johnson Company.

Ending Inventory Price

Date (End-of-Year Prices) Index

December 31, 2013 $ 70,000 100

December 31, 2014 90,300 105

December 31, 2015 95,120 116

December 31, 2016 105,600 120

December 31, 2017 100,000 125

Instructions

Use the dollar-value LIFO method to compute the ending inventory for Johnson Company for 2013 through 2017.

Distinguish between product costs and period costs as they relate to inventory.

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

This gap is:

With LIFO Without LIFO

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

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

Operating expenses 150,000 150,000

Operating income 250,000 250,000

LIFO adjustment 40,000 0

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

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

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

Extra cash \( 14,400 0

Increased cash flow 9% 0%

Instructions

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

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

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

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

What is a repurchase agreement (product financing) arrangement? How should a product repurchase agreement be reported in the financial statements?

Case 1: T J International

T J International was founded in 1969 as Trus Joist International. The firm, a manufacturer of specialty building products, has its headquarters in Boise, Idaho. The company, through its partnership in the Trus Joist MacMillan joint venture, develops and manufactures engineered lumber. This product is a high-quality substitute for structural lumber and uses lower-grade wood and materials formerly considered waste. The company also is majority owner of the Outlook Window Partnership, which is a consortium of three wood and vinyl window manufacturers.

Following is T J International’s adapted income statement and information concerning inventories from its annual report.

T J International

Sales \(618,876,000

Cost of goods sold 475,476,000

Gross profit 143,400,000

Selling and administrative expenses 102,112,000

Income from operations 41,288,000

Other expense 24,712,000

Income before income tax 16,576,000

Income taxes 7,728,000

Net income \) 8,848,000

Inventories.Inventories are valued at the lower of cost or market and include material, labor, and production overhead costs. Inventories consisted of the following:

Current Year Prior Year

Finished goods \(27,512,000 \)23,830,000

Raw materials and

work-in-progress 34,363,00033,244,000

61,875,000 57,074,000

Reduction to LIFO cost (5,263,000) (3,993,000)

\(56,612,000 \)53,081,000

The last-in, first-out (LIFO) method is used for determining the cost of lumber, veneer, Microllamlumber, TJI joists, and open web joists. Approximately 35 percent of total inventories at the end of the current year were valued using the LIFO method. The first-in, first-out (FIFO) method is used to determine the cost of all other inventories.

Instructions

(a) How much would income before taxes have been if FIFO costing had been used to value all inventories?

(b) If the income tax rate is 46.6%, what would income tax have been if FIFO costing had been used to value all inventories ? In your opinion, is this difference in net income between the two methods material? Explain.

(c) Does the use of a different costing system for different types of inventory mean that there is a different physical flow of goods among the different types of inventory? Explain.
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