Intermediate Accounting I
· Understand the risks and benefits of holding inventory.
· Explain how cost flow assumptions affect inventory balances and cost of goods sold.
· Analyze the activity in inventory and related accounts.
· Consider the financial statement effects of using different cost flow assumptions and of International Financial Reporting Standards (IFRS) for inventory.
· Restate a company's inventory balances and cost of sales to reflect IFRS-like reporting.
· Calculate inventory ratios under different cost flow assumptions.
Refer to the fiscal 2012 financial statements and notes of Deere & Company (10/31/2012) and CNH Global N.V. (12/31/2012). Note that Deere has an October 31 year end and CNH a December 31 year end.
a. Explain the risks and benefits associated with holding inventory.
. Note 15 reveals that the balance sheet inventory amount consists of three types of inventory. What types of costs do you expect to be in the raw materials inventory? In the work-in-process inventory? In the finished goods inventory?
c. Why do companies use cost flow assumptions to determine inventory cost? What cost flow assumption(s) does Deere and Company use to determine inventory cost?
d. Assume that prices that Deere and CNH Global pay for inventory typically increase over time. CNH uses the first-in, first-out (FIFO) cost flow assumption to measure its inventories. In general terms, how do the balance sheet values for inventories of the two companies differ due to their cost flow assumptions? What numbers on the two companies' income statements would differ? What if prices typically decrease over time?
e. Set up one T-account for Deere's total inventories (that is, combine the three inventory accounts for this analysis). Enter the 2011 (ie, the opening 2012 balance) and 2012 ending balances in the T-account. Use information from the financial statements to recreate the activity that took place in the account during fiscal 2012 and answer the following questions. Deere credits the total inventories account for the entire cost of sales. Note that the income statement line item Cost of Sales includes the labor and overhead needed to manufacture the inventory sold. Assume that the raw material costs represent half of the total cost of manufacturing the inventory.
a. How much raw material inventory did Deere purchase in fiscal 2012? Assume that raw material inventory was acquired in a single purchase. Provide the journal entry Deere made to record that purchase.
. Now set up a T-account for accounts payable and accrued expenses. Enter the 2011 ending balance (i.e., the opening 2012 balance) and 2012 ending balance in the T-account. Assume that "Accounts payable and accrued expenses" includes only inventory-related transactions with suppliers and that all raw material is purchased on account. How much did Deere pay its suppliers for inventory in fiscal 2012? Assume that Deere made a single payment to all its suppliers in fiscal 2012. Provide the journal entry Deere made to record that payment.
f. You want to compare Deere's operations for fiscal 2012 to those of an international competitor, CNH Global, headquartered in the Netherlands. In particular, you want to compare a number of inventory related metrics. However, the two companies do not use the same inventory costing methods: Deere uses LIFO for a large portion of its inventory whereas CNH Global uses FIFO to measure all of its inventory. CNH Global prepares its financial statements according to U.S. GAAP, but it does not use LIFO. In that sense, CNH Global's financial statements report inventory as they would if they followed IFRS, which does not permit the use of LIFO.
To compare the two companies, you first must restate Deere's relevant balance sheet and income statement numbers from LIFO to FIFO. To do this, we assume that Deere had always used the FIFO cost flow method. Use the table below to aggregate the data you need to convert inventory from LIFO to FIFO for Deere. Information and analysis for 2010 and 2011 has been provided as guidance. For these calculations, assume that the marginal tax rate for Deere is 35%. Some data are already provided.
Deere & Company
LIFO cost of goods sold (COGS)
LIFO net income
LIFO inventory from balance sheet
LIFO reserve from financial statement notes
Total assets from the balance sheet
1Information from Deere's 2010 financial statements because 2010 balance sheet not included in the 2012 statements.
Calculations to convert LIFO to FIFO:
FIFO inventory = LIFO inventory + LIFO reserve
FIFO assets = LIFO assets + LIFO reserve
Change in LIFO reserve during the year (end – beg.)
FIFO COGS = LIFO COGS – Change in LIFO reserve
After-tax effect of LIFO method = (1-Marginal tax rate) x Change in LIFO reserve
FIFO net income = LIFO net income + After-tax effect of LIFO method
Complete the table (in Excel) that follows using information from the financial statements and from the table you completed above. Comment on the results comparing CNH Global with Deere's 'As Reported' and 'As if FIFO' income statement and balance sheet information.
Deere & Company
As if FIFO
Common-size cost of goods sold1
Growth in net income
Common-size net income
1To common-size items from the income statement, divide by total revenue attributable to equipment sales (that is, do not include revenues from each company's financing operations).
2To common size items from the balance sheet, divide by total assets.
g. The average inventory holding period is estimated using the following formula (the denominator is refe
ed to as the inventory turnover ratio):
Average Inventory Holding Period =
Use data from the financial statements to estimate the average inventory holding period for Deere and CNH Global for fiscal 2011 and 2012. Calculate the metric for both companies with their reported (ie, unadjusted) numbers. Additional information: CNH Global's inventory balance at the end of fiscal 2010 was $2,937. Evaluate how well Deere manages its inventory relative to its competitor, CNH Global.
Now recalculate the average holding period for Deere using their adjusted (ie, FIFO) numbers. Do you come to a different conclusion about their inventory turnover and management's relative performance?
h. Assume that Deere's inventory balances for accounting and for tax purposes are the same. Estimate the cumulative amount of income taxes through October 31, 2012, that Deere has defe
ed by choosing the LIFO method of inventory costing instead of the FIFO method. For these calculations, assume that the marginal tax rate for Deere is 35%.
i. Assume that you are the CEO of Deere and are considering the potential adoption of IFRS by U.S. firms. With respect to inventory accounting in particular, do you have any concerns about Deere conversion to IFRS? Prepare a short letter to the Chair of the SEC outlining your concerns.