Chapter 8, Problem 8.12P

Integrating problem; inventories and accounts receivable; Chapters 7 and 8

• LO8–4, LO8–6, LO8–7

Inverness Steel Corporation is a producer of flat-rolled carbon, stainless and electrical steels, and tubular products. The company’s income statement for the 2018 fiscal year reported the following information ($ in millions):

Sales	$6,255
Cost of goods sold	5,190

The company’s balance sheets for 2018 and 2017 included the following information ($ in millions):

	2018	2017
Current assets:
Accounts receivable, net	$703	$583
Inventories	880	808

The statement of cash flows reported bad debt expense for 2018 of $8 million. The summary of significant accounting policies included the following notes ($ in millions):

Accounts Receivable (in part)

The allowance for uncollectible accounts was $10 and $7 at December 31, 2018 and 2017, respectively. All sales are on credit.

Inventories

Inventories are valued at the lower of cost or market. The cost of the majority of inventories is measured using the last in, first out (LIFO) method. Other inventories are measured principally at average cost and consist mostly of foreign inventories and certain raw materials. If the entire inventory had been valued on an average cost basis, inventory would have been higher by $480 and $350 at the end of 2018 and 2017, respectively.

During 2018, 2017, and 2016, liquidation of LIFO layers generated income of $6, $7, and $25, respectively.

Required:

Using the information provided:

1. Determine the amount of accounts receivable Inverness wrote off during 2018.

2. Calculate the amount of cash collected from customers during 2018.

3. Calculate what cost of goods sold would have been for 2018 if the company had used average cost to value its entire inventory.

4. Calculate the following ratios for 2018:

a. Receivables turnover ratio

b. Inventory turnover ratio

c. Gross profit ratio

5. Explain briefly what caused the income generated by the liquidation of LIFO layers. Assuming an income tax rate of 35%, what was the effect of the liquidation of LIFO layers on cost of goods sold in 2018?

To determine

Inventory: It refers to the current assets that a company expects to sell during the normal course of business operations, the goods that are under process to be completed for future sale, or currently used for producing goods to be sold in the market.

Accounts Receivable: It is a current asset that reflects the amount due from the customers on account of credit sales by the company.

the amount of accounts receivable that Company I wrote off during 2018.

Explanation of Solution

Determinethe amount of accounts receivable that Company I wrote off during 2018.

Details	Amount (in millions)
Beginning Balance	$7
Add: Bad debt expense for 2018	$8
Less: Ending balance	($10)
Accounts receivable written off	$5

Table (1)

Therefore, the amount of accounts receivable that Company I wrote off during 2018 is $5 million.

To determine

To Calculate: the amount of cash collected from customers during 2018.

Explanation of Solution

Calculate the amount of cash collected from customers during 2018.

Details	Amount (in millions)
Beginning Balance ($583+$7)	$590
Add: Credit Sales	$6,255
Less: Inventory write-offs (Refer Table 1)	($5)
Less: Ending balance	($713)
Cash collected from customers	$6,127

Table (2)

Therefore, the amount of cash collected from customers during 20182018 is $6,127 million.

To determine

To Calculate: the cost of goods sold that would have been for 2018 if the company had used average cost to value its entire inventory.

Explanation of Solution

If the company had used average cost to value its entire inventory, its cost of goods sold for 2018 would have been lower by $130 million ($480 million-$350 million). As per the information provided, the beginning inventory would have been higher by $350 million and the ending inventory would have been higher by $480 million.

An increase in beginning inventory increases the cost of goods sold while an increase in ending inventory decreases the cost of goods sold. Since there is an increase in the ending inventory of $130 million, it reduces the cost of goods sold by the same amount. The purchases during the year is not affected due to change in the inventory method.

Thus, the cost of goods sold would decrease to $5,060 million ($5,190 million-$130 million).

To determine

To Calculate: the given ratios for 2018.

Explanation of Solution

a.

Calculate the receivable turnover ratio.

Sales =$6,255 million

Average accounts receivable =$643 million

$\begin{array}{c}\text{Receivable}\text{turnover}\text{ratio=}\frac{\text{Sales}}{\text{Average}\text{accounts}\text{receivable}}\\ =\frac{\$6,255}{\$643\left(1\right)}\\ =9.73\text{times}\end{array}$

Working note:

Determine the average accounts receivable.

$\begin{array}{c}\text{Average}\text{accounts}\text{receivable = }\frac{\left(\begin{array}{l}\text{Beginning}\text{accounts}\text{receivable}\\ \text{+Ending}\text{accounts}\text{receivable}\end{array}\right)}{\text{2}}\\ \text{=}\frac{\$583\text{million}+\$703\text{million}}{2}\\ \text{=\$643}\text{million}\end{array}$ (1)

b.

Calculate the inventory turnover ratio.

Cost of goods sold =$5,190 million

Average inventory =$844 million

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$5,190}{\$844\left(2\right)}\\ =6.15\text{times}\end{array}$

Working note:

Determine the average inventory.

$\begin{array}{c}\text{Average}\text{Inventory = }\frac{\text{Beginning}\text{inventory+Ending}\text{inventory}}{\text{2}}\\ \text{=}\frac{\$808\text{million}+\$880\text{million}}{2}\\ \text{=\$844}\text{million}\end{array}$ (2)

Calculate the gross profit ratio.

Gross Profit =$1,065 million

Net sales =$6,255 million

$\begin{array}{c}\text{Gross}\text{profit}\text{ratio=}\frac{\text{Gross}\text{profit}}{\text{Net}\text{sales}}\\ =\frac{\$1,065\left(3\right)}{\$6,255}\times 100\\ =17\%\end{array}$

Working note:

Determine the gross profit

$\begin{array}{c}\text{Gross}\text{Proft}=\text{Sales}-\text{Cost}\text{of}\text{goods}\text{sold}\\ \text{=\$6,255}\text{million}-\$5,190\text{million}\\ =\$1,065\text{million}\end{array}$ (3)

Therefore, the receivable turnover ratio for 2018 is 9.73 times, inventory turnover ratio is 6.15 times, and the gross profit ratio is 17%.

To determine

To Explain: the cause of the income generated by the liquidation of LIFO layers and the effect of the liquidation of LIFO layers on cost of goods sold in 2018.

Explanation of Solution

At the time of increasing inventory costs and declining inventory quantities, the LIFO liquidation of the inventory layers purchased at lower costs of the previous years are sold in the current period to match with the current selling prices. Thus, the income generated from this liquidation of inventories is known as LIFO liquidation profit.

In the present case, the LIFO liquidation has decreased the cost of goods sold by $9.23 million ($6 million ÷ (1-35%).