FINANCIAL DECISION CASE

Course:

Financial Accounting II

RTS COMPANY
Refrigerated Truck Sales Company (RTS Company) buys large refrigerated trucks from the manufacturer and sells them to companies and independent truckers who haul perishable goods such as frozen beef for long distances. RTS has been successful in this specialized niche of the industry because it provides a unique product and specialized service to these truckers. Because of the high cost of these trucks and the high cost of financing inventory, RTS tries to maintain as mall an inventory as possible. In fact, at the beginning of March the company had no inventory or liabilities, as shown by the following balance sheet:
RTS Company Balance Sheet March 1, 19xx
Assets Cash Total Assets Owners Equity $ 500,000 Robert Trinker, Capital $ 500,000 Total Owner's Equity

$ 500,000 $ 500,000

On March 5, RTS takes delivery of a truck at a price of $ 150,000. On March 15 after a rise in price, an identical truck is delivered to the company at a price of $ 160,000. On March 25, the company sells one of the trucks for $ 195,000. During March, expenses totaled $ 15,000. All transactions are paid in cash. Required: 1. Prepare income statements and balance sheets for RTS at March 31 using (a) the FIFO method of inventory valuation and (b) the LIFO method of inventory valuation. Explain the effects that each method has on the financial statements. 2. Assume that Robert Trinker, owner of RTs Company, follows the policy of withdrawing the cash each period that is exactly equal to net income. What effect does this action have on each balance sheet prepared in 1, and how do they compare with the balance sheet at the beginning of the month? Which inventory method, if either, do you feel is more realistic in representing RTSs income? 3. Assume that RTS receives notice of another price increase of $ 10,000 on refrigerated trucks to take effect on April 1. How does this information relate to the withdrawal policy of the owner, and how will it affect next months operations?

SOLUTION:
(a) FIFO Method:
RTS Company Income Statement March 31, 19xx Sales Less: Cost of goods sold ( 0 + 150,000 + 160,000 - 160,000) Gross Margin Less: Expenses Net Income $ $ $ $ 150,000 45,000 15,000 30,000 $ 195,000

RTS Company Balance Sheet March 31, 19xx

Assets Cash ( 500,000 - 150,000 - 160,000 + 195,000 -15000) Inventory Total Assets

Owners Equity Robert Trinker, Capital $ 370,000 $ 160,000 Net Income $ 530,000 Total Owner's Equity

$ 500,000 $ 30,000 $ 530,000

(b) LIFO Method:

RTS Company Income Statement March 31, 19xx Sales Less: Cost of goods sold ( 0 + 150,000 + 160,000 - 150,000) Gross Margin Less: Expenses Net Income $ $ $ $ 160,000 45,000 15,000 20,000 $ 195,000

RTS Company Balance Sheet March 31, 19xx

Assets Cash ( 500,000 - 150,000 - 160,000 + 195,000 -15000) Inventory Total Assets

Owners Equity Robert Trinker, Capital $ 370,000 $ 150,000 Net Income $ 520,000 Total Owner's Equity

$ 500,000 $ 20,000 $ 520,000

EFFECTS OF METHODS ON FINANCIAL STATEMENTS: Under FIFO method, costs of the goods on hand at the end of a period are assumed to be from the most recent purchases and the costs assigned to goods that have been sold are assumed to from the earliest purchases. This result higher cost of ending inventory, lower cost of goods sold and higher gross margin. So, a FIFO method yields the highest possible amount of net income during inflationary times and a smaller net income during deflationary times, in Income statement. In Balance sheet, higher ending inventory results in higher total assets and higher net income increases the retained earnings of the company which result in higher Owners equity. Under LIFO method, costs of the goods on hand at the end of a period are assumed to be from the earliest purchases and the costs assigned to goods that have been sold are assumed to be from the most recent purchases. This result lower cost of ending inventory, higher cost of goods sold and lower gross margin. So, a LIFO method tends to show a smaller net income during inflationary times and a larger net income during deflationary times, in Income statement. In Balance sheet, lower ending inventory results in lower total assets and lower net income increases the retained earnings of the company by smaller proportion as compared to FIFO method. It results in less owners equity compared to FIFO method.

Ans2 EFFECT OF WITHDRAWAL POLICY ON BALANCE SHEET:

RTS Company Balance Sheet (FIFO Method) March 31, 19xx

RTS Company Balance Sheet (LIFO Method) March 31, 19xx

COMPARISON OF BALANCE SHEETS: Balance sheet at the beginning of month of March and Balance sheet prepared at the end of month of March shows the same total assets and Owners equity i.e. $ 500,000. This is because net income which is earned during the month is being withdrawn every month and shows no impact on Balance sheet. REALISTIC INVENTORY METHOD: As shown from the case study, it is the period of rising prices, means inflation, so under such economic situation LIFO inventory method is more realistic in representing RTSs Income.

1. Fairest Determination of Income:

Under LIFO, fairest determination of Income occurs if the current costs of Merchandise are matched against current sales prices, regardless of which physical units of merchandise are sold. In this case, the cost of trucks sold will show costs closer to the price level at the time the sales of trucks are made. So, a LIFO method tend to show a smaller net income during inflationary times and is a better option for Income Statement during inflationary times.

2. Flow of Costs:
LIFO method is more realistic because in inventory valuation the flow of costs and hence income determination is more important than the physical movement of goods and balance sheet valuation.

3. Matching Concept:
In representing RTSs income, LIFO method is best suited for income statement because it best matches cost of goods sold to the revenues generated during the accounting period.

4. Lower Income Taxes:

In period of rising prices, LIFO shows a smaller profit. So, RTSs should use LIFO to reduce the amount of income taxes to be paid. AN INCREASE IN PRICE EFFECT: We will evaluate the effect of price increase of $10,000 on refrigerated trucks, to take effect on April 1 by making an income statement and balance sheet on specific assumptions and then come to a conclusion whether it would be beneficial for the owner to continue or discontinue with the withdrawal policy. ASSUMPTIONS: Selling price is considered to be the same i.e. $195,000 Expenses incurred for the month of April would be the same as in previous months i.e. $15,000 Just bought one truck at an increase price of $10,000 which would now cost $170,000 Used LIFO method to prepare this income statement because it is a more realistic approach in case of inflationary trend. RTS Company Income Statement April 30, 19xx Sales Less: Cost of goods sold ( 150,000 + 170,000 - 150,000) Gross Margin Less: Expenses Net Income $ $ $ $ $ 195,000 170,000 25,000 15,000 10,000

The following Balance sheet shows the effect if the owner chooses to withdraw cash that is equal to net income. RTS Company Balance Sheet April 30, 19xx
Assets Cash ( 370,000 - 170,000 + 195,000 -15000 - 10000) Inventory Total Assets Owners Equity Robert Trinker, Capital $ 370,000 Robert Trinker, Drawings $ 150,000 Net Income $ 520,000 Total Owner's Equity

$520,000 ($10,000) $ 510,000 $ 10,000 $ 520,000

The following Balance sheet shows the effect if the owner doesnt withdraws cash equal to the net income and retains the net income in the business.

RTS Company Balance Sheet April 30, 19xx

Assets Cash ( 370,000 - 170,000 + 195,000 -15000) Inventory Total Assets Owners Equity Robert Trinker, Capital $ 380,000 $ 150,000 Net Income $ 530,000 Total Owner's Equity $ 520,000 $ 10,000

$ 530,000

DECISION: It would be a better decision by RTS to discontinue with the policy of withdrawing cash equal to the net income as we can conclude from the calculations of the two balance sheets that when RTS doesnt withdraws net income from the business it is left with $380,000 in its cash account as compared to $370,000 when it withdraws the net income. This $380,000 gives RTS higher purchasing power to purchase trucks in the coming month if the inflationary trend continues.