Quiang and his accounting course (B)
Because an earlier discussion with the accounting professor (see Case study in Chapter 5) had cleared up some puzzling matters, Quiang decided to prepare a new list of problems as a basis for a second discussion. As before, he knew that the professor expected students to have worked out tentative answers to their questions prior to the meeting. The professor also required students to use whenever possible numerical examples to illustrate the issues they were raising. The list follows:
1. Evidently, there are two ways of handling purchase discounts. They can be either deducted from the cost of the purchased goods, or reported as other income. But is the effect on net profit not the same under all these methods? If so, why argue about which is preferable?
2. It is said that the LIFO method assumes that the goods purchased last are sold first. If this is so, the assumption is clearly unrealistic because companies ordinarily sell their oldest merchandise first. Can a method based on such an unrealistic assumption be supported, other than as a tax gimmick?
3. Are the following generalisations valid?
(a) The difference between LIFO and FIFO is relatively small if inventory turnover is relatively high.
(b) The AVCO method will result in net profit that is somewhere between that produced by the LIFO method and that produced by the FIFO method.
(c) If prices rise in one year and fall by an equal amount the next year, the total income for the two years is the same under the FIFO method as under the LIFO method.
4. A distillery manufactured bourbon whiskey, which it aged in charred, white oak barrels for four years before bottling and selling it. Whiskey was carried in inventory at approximately EUR 3 per litre, which was the cost of ingredients, labour, and factory overhead of the manufacturing process. Barrels, which could not be reused, cost EUR 1 per litre. The distillery incurred EUR 0.50 of warehousing costs per litre per year, including costs involved in moving and testing the barrels. It also incurred EUR 0.30 per litre of interest costs per year. The costs of barrels, warehousing and interest were charged directly to the income statement.
If the distillery had consistently earned pre-tax profit of EUR 1.5 million per year on annual production and sale of 1 million litres, what would happen to profit if it increased production to 1.2 million litres per year? At what amounts should it carry its whiskey in inventory?
Give your answers to the issues just discussed, supporting them with calculations.