Demonstrati ion Prob bl lem
3. Compute Sing Along’s gross profit for the year. (Include inventory shrinkage losses in the
c. What controls might Sing Along implement to reduce inventory shrinkage?
JC Penney Company uses LIFO in applying the lower-of-cost-or-market. Recent financial state- ments were used to compile the following information (dollar figures in millions):
Average inventory (throughout the year) . . . $ 3,142 Current assets (at year-end) . . . 6,652 Current liabilities (at year-end) . . . 3,249 Net sales . . . 17,556 Cost of goods sold . . . 10,646 Gross profit . . . 6,910 Average time required to collect outstanding receivables (approximate) . . . 5 days
Instructions
a. Using the information provided, compute the following measures based upon the LIFO method:
1. Inventory turnover.
2. Current ratio (see Chapter 5 for a discussion of this ratio).
3. Gross profit rate (see Chapter 6 for a discussion of this statistic).
b. Assuming the cost of goods sold would be lower under FIFO, what circumstances must the company have encountered to cause this situation? (Were replacement costs, on average, rising or falling?)
c. How would you expect these ratios to differ (i.e., what direction) had the company used FIFO instead of LIFO?
d. Explain why the average number of days required by JC Penney to collect its accounts receiv- able is so low. (See Chapter 7 for a discussion of the accounts receivable turnover.)
PROBLEM 8.7B Retail Method P
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PROBLEM 8.8B FIFO versus LIFO Comparisons P
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C F LO7 C
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Critical Thinking Cases 379
Critical Thinking Cases
Our Little Secret is a small manufacturer of swimsuits and other beach apparel. The company is closely held and has no external reporting obligations, other than payroll reports and income tax returns. The company’s accounting system is grossly inadequate. Accounting records are main- tained by clerical employees with little knowledge of accounting and with many other job respon- sibilities. Management has decided that the company must hire a competent controller, who can establish and oversee an adequate accounting system.
Amy Lee, CPA, has applied for this position. During a recent interview, Dean Frost, the com- pany’s director of personnel, said, “Amy, the job is yours. But you should know that we have a big inventory problem here.
“For some time now, it appears that we have been understating our ending inventory in income tax returns. No one knows when this all got started, or who was responsible. We never even counted our inventory until a few months ago. But the problem is pretty big. In our latest tax return—that’s for 2010—
we listed inventory at only about half its actual cost. That’s an understatement of, maybe, $400,000.
“We don’t know what to do. We sure don’t want a big scandal—tax evasion, and all that.
Maybe the best thing is to continue understating inventory by the same amount as we did in 2010.
That way, taxable income will be correctly stated in future years. Anyway, this is just something I thought you should know about.”
Instructions
a. Briefly identify the ethical issues raised for Lee by Frost’s disclosure.
b. From Lee’s perspective, evaluate the possible solution proposed by Frost.
c. Identify and discuss the alternative ethical courses of action that are open to Lee.
Jackson Specialties has been in business for more than 50 years. The company maintains a per- petual inventory system, uses a LIFO flow assumption, and ends its fiscal year at December 31.
At year-end, the cost of goods sold and inventory are adjusted to reflect periodic LIFO costing procedures.
A railroad strike has delayed the arrival of purchases ordered during the past several months of 2011, and Jackson Specialties has not been able to replenish its inventories as merchandise is sold.
At December 22, one product appears in the company’s perpetual inventory records at the follow- ing unit costs:
Purchase Date Quantity Unit Cost Total Cost Nov. 14, 1958 . . . 3,000 $6 $18,000 Apr. 12, 1959 . . . 2,000 8 16,000 Available for sale at Dec. 22, 2011 . . . 5,000 $34,000
Jackson Specialties has another 8,000 units of this product on order at the current wholesale cost of $30 per unit. Because of the railroad strike, however, these units have not yet arrived (the terms of purchase are F.O.B. destination). Jackson Specialties also has an order from a customer who wants to purchase 4,000 units of this product at the retail sales price of $47 per unit. Jackson Specialties intends to make this sale on December 30, regardless of whether the 8,000 units on order arrive by this date. (The 4,000-unit sale will be shipped by truck, F.O.B. shipping point.) Instructions
a. Are the units in inventory really more than 50 years old? Explain.
b. Prepare a schedule showing the sales revenue, cost of goods sold, and gross profit that will result from this sale on December 30, assuming that the 8,000 units currently on order (1) arrive before year-end and (2) do not arrive until some time in the following year. (In each computation, show the number of units comprising the cost of goods sold and their related per-unit costs.) CASE 8.1
It’s Not Right, but at Least It’s Consistent C
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CASE 8.2 LIFO Liquidation C
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c. Comment on these results.
d. Might management be wise to delay this sale by a few days? Explain.
Avery Frozen Foods owes the bank $50,000 on a line of credit. Terms of the agreement specify that Avery must maintain a minimum current ratio of 1.2 to 1, or the entire outstanding balance becomes immediately due in full. To date, the company has complied with the minimum require- ment. However, management has just learned that a failed warehouse freezer has ruined thousands of dollars of frozen foods inventory. If the company records this loss, its current ratio will drop to approximately 0.8 to 1.
Whether any or all of this loss may be covered by insurance currently is in dispute and will not be known for at least 90 days—perhaps much longer. There are several reasons why the insurance company may have no liability.
In trying to decide how to deal with the bank, management is considering the following options: (1) postpone recording the inventory loss until the dispute with the insurance company is resolved, (2) increase the current ratio to 1.2 to 1 by making a large purchase of inventory on account, (3) explain to the bank what has happened, and request that it be flexible until things get back to normal.
Instructions
a. Given that the company hopes for at least partial reimbursement from the insurance company, is it really unethical for management to postpone recording the inventory loss in the financial statements it submits to the bank?
b. Is it possible to increase the company’s current ratio from 0.8 to 1 to 1.2 to 1 by purchasing more inventory on account? Explain.
c. What approach do you think the company should follow in dealing with the bank?
A company’s inventory turnover is one measure of its potential to convert inventory into cash. But what is considered a good inventory turnover? The answer to that question depends on a variety of industry and company characteristics.
Access the EDGAR database at the following Internet address:
www.sec.gov
Locate the most recent 10-K reports of Safeway, Inc., and Staples, Inc. Compute the inventory turnover of each company. Does the higher turnover computed for Safeway mean that the com- pany manages its inventory more effectively than Staples ? Explain.
Internet sites are time and date sensitive. It is the purpose of these exercises to have you explore the Internet. You may need to use the Yahoo! search engine http://www.yahoo.com (or another favorite search engine) to find a company’s current Web address.
Answers to Self-Test Questions
1. b 2. a, c, d 3. a 4. b 5. b 6. a, d CASE 8.3
Dealing with the Bank C
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INTERNET CASE 8.4 Inventory Turnover IN
C I LO7
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381
2
Guitar Universe, Inc., is a popular source of musical instruments for professional and amateur musicians. The company’s accountants make necessary adjusting entries monthly, and they make all closing entries annually . Guitar Universe is growing rapidly and prides itself on hav- ing no long-term liabilities.
The company has provided the following trial balance dated December 31, 2011:
GUITAR UNIVERSE, INC.
TRIAL BALANCE DECEMBER 31, 2011
Cash . . . $ 45,000 Marketable securities . . . 25,000 Accounts receivable . . . 125,000
Allowance for doubtful accounts. . . $ 5,000 Merchandise inventory . . . 250,000
Office supplies . . . 1,200 Prepaid insurance . . . 6,600 Building and fixtures . . . 1,791,000
Accumulated depreciation . . . 800,000 Land . . . 64,800
Accounts payable . . . 70,000 Unearned customer deposits . . . 8,000 Income taxes payable. . . 75,000 Capital stock . . . 1,000,000 Retained earnings . . . 240,200 Unrealized holding gain on investments. . . 6,000 Sales . . . 1,600,000 Cost of goods sold . . . 958,000
Bank service charges . . . 200 Uncollectible accounts expense . . . 9,000 Salary and wages expense . . . 395,000 Office supplies expense . . . 400 Insurance expense . . . 6,400 Utilities expense . . . 3,600 Depreciation expense. . . 48,000 Income tax expense . . . 75,000
$3,804,200 $3,804,200
Other information pertaining to Guitar Universe’s trial balance is shown below:
1. The company’s most recent bank statement reports a balance of $46,975. Included with the bank statement was a $2,500 check from Iggy Bates, a professional musician, charged back to Guitar Universe as NSF. The bank’s monthly service charge was $25. Three checks written by Guitar Universe to suppliers of merchandise inventory had not yet cleared the bank for payment as of the statement date. These checks included: no. 507, $4,000;
no. 511, $9,000; and no. 521, $8,000. Deposits made by Guitar Universe of $16,500 had reached the bank too late for inclusion in the current statement. The company prepares a bank reconciliation at the end of each month.
2. Guitar Universe has a portfolio of marketable securities. The initial investment in the port- folio was $19,000. As of December 31, the market value of these securities was $27,500.
Management classifies all short-term investments as “available for sale.”
3. During December, $6,400 of accounts receivable were written off as uncollectible. A recent aging of the company’s accounts receivable helped management to conclude that an allowance for doubtful accounts of $8,500 was needed at December 31, 2011.
COMPREHENSIVE PROBLEM
Guitar Universe, Inc.
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4. The company uses a perpetual inventory system. A year-end physical count revealed that several guitars reported in the inventory records were missing. The cost of the missing units amounted to $1,350. This amount is not considered significant relative to the total cost of inventory on hand.
5. At December 31, approximately $900 in office supplies remained on hand.
6. The company pays for its insurance policies 12 months in advance. Its most recent pay- ment was made on November 1, 2011. The cost of this policy was slightly higher than the cost of coverage for the previous 12 months.
7. Depreciation expense related to the company’s building and fixtures is $5,000 for the month ending December 31, 2011.
8. Although Guitar Universe carries an extensive inventory, it is not uncommon for musicians to order custom guitars made to their exact specifications. Manufacturers do not allow any sales returns of custom-made guitars. Thus, all customers must pay in advance for these special orders. The entire sales amount is collected at the time a custom order is placed, and it is credited to an account entitled “Unearned Customer Deposits.” As of December 31, $4,800 of these deposits remained unearned. Assume that the cost of goods sold and the reduction in inventory associated with all custom orders is recorded when the custom merchandise is delivered to customers. Thus, the adjusting entry requires only a decrease to unearned customer deposits and an increase to sales.
9. Accrued income taxes payable for the entire year ending December 31, 2011, total
$81,000. No income tax payments are due until early in 2012.
Instructions
a. Prepare a bank reconciliation and make the necessary journal entries to update the accounting records of Guitar Universe as of December 31, 2011.
b. Prepare the necessary adjusting entry to update the company’s marketable securities port- folio to its mark-to-market value.
c. Prepare the adjusting entry at December 31, 2011, to report the company’s accounts receivable at their net realizable value.
d. Prepare the entry to account for the guitars missing from the company’s inventory at the end of the year.
e. Prepare the adjusting entry to account for the office supplies used during December.
f. Prepare the adjusting entry to account for the expiration of the company’s insurance poli- cies during December.
g. Prepare the adjusting entry to account for the depreciation of the company’s building and fixtures during December.
h. Prepare the adjusting entry to report the portion of unearned customer deposits that were earned during December.
i. Prepare the adjusting entry to account for income tax expense that accrued during December.
j. On the basis of the adjustments made to the accounting records in parts a through i above, prepare the company’s adjusted trial balance at December 31, 2011.
k. Using the adjusted trial balance prepared in part j above, prepare an annual income state- ment, statement of retained earnings, and a balance sheet dated December 31, 2011.
l. Using the financial statements prepared in part k above, determine approximately how many days an account receivable remains outstanding before it is collected. You may assume that the company’s ending accounts receivable balance on December 31 is a close approximation of its average accounts receivable balance throughout the year.
m. Using the financial statements prepared in part k, determine approximately how many days an item of merchandise remains in stock before it is sold. You may assume that the company’s ending merchandise inventory balance on December 31 is a close approxima- tion of its average merchandise inventory balance throughout the year.
n. Using the financial statements prepared in part k, determine approximately how many days it takes to convert the company’s inventory into cash. Stated differently, what is the length of the company’s operating cycle?
o. Comment briefly upon the company’s financial condition from the perspective of a
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United Parcel Service of America, Inc.
Plant and
Intangible Assets
A F T E R S T U D Y I N G T H I S C H A P T E R , Y O U S H O U L D B E A B L E TO :
Determine the cost of plant assets.
Distinguish between capital expenditures and revenue expenditures.
Compute depreciation by the straight-line and declining-balance methods.
Account for depreciation using methods other than straight-line or declining-balance.
Account for the disposal of plant assets.
Explain the nature of intangible assets, including goodwill.
Account for the depletion of natural resources.
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Learning Objectiv es
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What kind of plant and intangible assets would you expect United Parcel Service to have? Probably the first thing you would think of is vehicles, primarily trucks, because you are used to seeing UPS trucks on the streets and highways virtually every day. In addition, UPS has a very large investment in aircraft. In fact, property, plant, and equipment make up over 56 percent of UPS ’s total assets ($17,979 of $31,883 million), according to the company’s 2009 consolidated balance sheet. Of the $17,979 million, aircraft is the largest single type of asset and another large category is vehicles.
How do the amount of plant assets and percentage of plant assets to total assets for UPS compare with other companies? These amounts vary considerably from company to company as evidenced by the following examples:
Intel —$17,225 million or 32 percent of total assets; Kimberly-Clark —$8,033 million or 42 percent of total assets; Carnival Corporation —$29,870 or 81 percent of total assets.
Plant assets are important for a company such as United Parcel Service to be successful in its daily operations. The exact types and amount of plant assets used by a particular company depend on the nature of the company and its operations. Virtually all companies need some type of plant assets to operate efficiently and be successful. In addition, some companies require certain intangible assets to do business. Intangibles are rights and privileges that have been developed or acquired, such as trade names and patents;
these may be as important to a business as its equipment, buildings, and land. ■