Page 307 - Accounting Principles (A Business Perspective)

7. Measuring and reporting inventories

An ethical perspective:
Dorsey hardware

Terry Dorsey started Dorsey Hardware, a small hardware store, two years ago and has struggled to
make it successful. The first year of operations resulted in a substantial loss; in the second year,
there was a small net income. His initial cash investment was almost depleted because he had to
withdraw money for living expenses. The current year of operations looked much better. His
customer base was growing and seemed to be loyal. To increase sales, however, Terry had to invest
his remaining funds and the proceeds of a USD 40,000 bank loan into doubling the size of his
inventory and purchasing some new display shelves and a new truck.
At the end of the third year, Terry's accountant asked him for his ending inventory figure and later

told him that initial estimates indicated that net income (and taxable income) for the year would be
approximately USD 80,000. Terry was delighted until he learned that the federal income taxes on
that income would be about USD 17,250. He told the accountant that he did not have enough cash
to pay the taxes and could not even borrow it, since he already had an outstanding loan at the bank.
Terry asked the accountant for a copy of the income statement figures so he could see if any items
had been overlooked that might reduce his net income. He noticed that ending inventory of USD
160,000 had been deducted from cost of goods available for sale of USD 640,000 to arrive at cost of

goods sold of USD 480,000. Net sales of USD 720,000 and expenses of USD 160,000 could not be
changed. But Terry hit on a scheme to reduce his net income. The next day he told his accountant
that he had made an error in determining ending inventory and that its correct amount was USD
120,000. This lower inventory amount would increase cost of goods sold by USD 40,000 and
reduce net income by that same amount. The resulting income taxes would be about USD 6,000,
which was just about what Terry had paid in estimated taxes.
To justify his action in his own mind, Terry used the following arguments: (1) federal taxes are too
high, and the federal government seems to be taxing the little guy out of existence; (2) no harm is
really done because, when the business becomes more profitable, I will use correct inventory

amounts, and this loan from the government will be paid back; (3) since I am the only one who
knows the correct ending inventory I will not get caught; and (4) I bet a lot of other people do the
same thing.

Analyzing and using financial results—inventory turnover ratio

An important ratio for managers, investors, and creditors to consider when analyzing a company's inventory is
the inventory turnover ratio. This ratio tests whether a company is generating a sufficient volume of business based
on its inventory. To calculate the inventory turnover ratio:
Costof goodssold
Inventory turnover ratio=
Average inventory
Inventory turnover measures the efficiency of the firm in managing and selling inventory: thus, it gauges the
liquidity of the firm's inventory. A high inventory turnover is generally a sign of efficient inventory management
and profit for the firm; the faster inventory sells, the less time funds are tied up in inventory. A relatively low

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