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9 CHAPTER INVENTORIES: SPECIAL VALUATION PROBLEMS CONTENT ANALYSIS OF EXERCISES AND PROBLEMS Time Range (minutes) 5-10 5-15 10-15 10-15 5-10 5-15 5-15 5-15 5-10 15-20 10-15 15-20 10-20 10-20 Number E9-1 E9-2 E9-3 E9-4 E9-5 E9-6 E9-7 E9-8 E9-9 E9-10 E9-11 E9-12 E9-13 E9-14 Content Lower of Cost or Market. (Easy) Determination of inventory value. Lower of Cost or Market. (Easy) Inventory value determination for five cases. Inventory values under IFRS. Lower of Cost or Market. (Moderate) Individual items, groups of items, entire inventory. Value determination. Lower of Cost or Market. (Easy) Allowance method, periodic system. Journal entries to record correct inventory value. Purchase Commitment. (Moderate) Loss. Journal entries to record transactions. Estimation of Fire Loss. (Easy) Determination of inventory value immediately prior to fire. (AICPA adapted). Gross Profit Method. (Moderate) Determination of estimated loss on inventory from fire. Gross Profit. (Easy) Determination of price and cost changes, gross profit changes. Gross Profit Percentage. (Moderate) Based on net sales, based on cost of goods sold. Retail Inventory Method. (Moderate) Average cost, FIFO, lower of cost or market, LIFO. Computation of ending inventory. (AICPA adapted). Retail Inventory Method. (Easy) Lower of cost or market. Computation of ending inventory. Retail Inventory Method. (Moderate) Average cost, FIFO, lower of cost or market, LIFO. Computation of ending inventory. Dollar-Value LIFO Retail. (Moderate) Determination of the cost of inventory for one year. Dollar-Value LIFO Retail. (Moderate) Determination of the cost of inventory for one year. 9-1 Number E9-15 E9-16 E9-17 P9-1 Content (AICPA adapted). Dollar-Value LIFO Retail. (Easy) Determination of the cost of inventory for one year. Errors. (Moderate) Impact of misstated purchases and ending inventory on the income statement and balance sheet. (AICPA adapted). Errors. (Easy) Discovery of prior year inventory valuation error. Determination of correct net income. Lower of Cost or Market. (Moderate) Individual items, inventory as whole. Inventory value computation. Inventory values under IFRS. Lower of Cost or Market. (Challenging) Allowance and direct methods, periodic and perpetual systems. Journal entries. Lower of Cost or Market. (Moderate) Interim financial statement disclosure. Lower of Cost or Market. (Challenging) Allowance and direct methods, journal entries, financial statements. Gross Profit. (Moderate) Determination of gross profit as a percentage of net sales. Estimation of Theft Loss. (Moderate) Computation of inventory lost. Estimation of Fire Loss. (Moderate) Computation of inventory lost. Interim financial reporting. Estimation of Flood Loss. (Moderate) Determination of work in process and raw materials inventory value destroyed. (AICPA adapted). Estimation of Flood Loss. (Moderate) Determination of work in process inventory loss in flood. Retail Inventory Method. (Challenging) Average cost, FIFO, lower of cost or market, LIFO. Ending inventory value computation. Comprehensive: Retail Inventory Method. (Challenging) Average cost, FIFO, lower of cost or market, LIFO. Ending inventory value computation. (AICPA adapted). Retail Inventory Method. (Moderate) Lower of average cost or market. Includes estimated normal shrinkage. Retail Inventory and Dollar-Value Methods. (Moderate) Retail inventory method using lower of cost or market. Dollar-value retail LIFO method. Determination of inventory value. Time Range (minutes) 10-15 10-15 10-15 15-20 P9-2 P9-3 P9-4 P9-5 P9-6 P9-7 P9-8 P9-9 P9-10 15-25 5-10 20-25 5-10 5-10 10-15 15-20 10-15 20-30 P9-11 20-30 P9-12 15-20 P9-13 20-30 9-2 Number P9-14 P9-15 P9-16 P9-17 P9-18 Content Dollar-Value LIFO Retail. (Challenging) Determination of cost of ending inventory for three years. Dollar-Value LIFO Retail. (Challenging) Computation of cost of ending inventory for four years. Dollar-Value LIFO Retail and Fire Loss. (Challenging) Computation of cost of inventory destroyed by fire. Errors. (Moderate) Impact of errors on inventory and net income. (AICPA adapted). Comprehensive: Inventory Adjustments. (Challenging) Prepare schedule to adjust inventory, accounts payable, and net sales for various items. Time Range (minutes) 30-40 30-40 20-30 20-30 20-30 ANSWERS TO QUESTIONS Q9-1 Cost is the cost incurred to purchase or manufacture the inventory. Market value of inventory is defined as the current cost of replacing the inventory by either purchasing or manufacturing it. The upper constraint on market value is the net realizable value, which is the estimated selling price less reasonably predictable cost of completion and disposal. The upper constraint is used to ensure that if a decline in the value of the inventory occurs, the full amount of the decline is recognized at that time, therefore preventing the recognition of further losses in the future. The lower constraint is the net realizable value less a normal profit margin. This lower constraint assures that the inventory is not written down too much, which would result in a higher loss at the time of write-down and a higher profit in the future at the time the inventory is sold. A company may apply the lower of cost or market method to inventory in three ways: It may be applied to (1) each individual inventory item, (2) each major category of inventory, or (3) the total inventory. There are several arguments against the lower of cost or market rule. First, the rule is a departure from the principle of historical cost. Second, the rule is inconsistent, because losses are recognized from holding the inventory while gains are not. Finally, the recognition of a loss violates the revenue recognition principle. Since the earning process has not been completed, it may be argued that no loss should be recognized. In applying the lower of cost or market method to value inventory, IFRS define market value as net realizable value - the estimated selling price less estimated costs of completion and disposal. By defining market value in this manner, IFRS do not have to specify a ceiling and a floor, as required under U.S. GAAP. Q9-2 Q9-3 Q9-4 Q9-5 9-3 Q9-6 When inventory is written down under the lower of cost or market method, IFRS differ from U.S. GAAP in two major respects: IFRS do not specify the income statement line item where this write down should be reported. Under U.S. GAAP, this write down will be recognized as part of cost of goods sold. IFRS allow a reversal of a previous write-down which is recognized in income. Under U.S. GAAP, any such reversals are prohibited. A company recognizes anticipated price declines as losses on certain purchase commitments. If a company has entered into a noncancellable purchase commitment at a fixed price and subsequently the market price declines, the company reports a loss in the period that the decline occurs. A company discloses an unconditional purchase obligation made at a definite price in a note to its financial statements. When a company has an unconditional purchase obligation to acquire inventory at a fixed price and the market price is less than the fixed price, it recognizes a loss in the period in which the decline occurs, and writes down the inventory. The "sale" under a product financing agreement is similar to borrowing cash with the inventory being used as collateral. Thus, a company records the proceeds received as a liability. Q9-7 Q9-8 Q9-9 One exception to historical cost valuation of inventory is the lower of cost or market rule. It is applied when the market value of inventory has declined below its original cost. Another exception is the valuation of inventory at current market value even when it is above cost. This method is only allowed in specific industries when it is highly certain that the goods can be sold at current market prices. The gross profit method of inventory estimation would be useful in the following situations: 1. At an interim date, the gross profit method is acceptable for estimating inventory rather than taking a physical count, as long as the method is disclosed. 2. It can be used to check on the reasonableness of the inventory value developed from a physical inventory or a perpetual inventory system. Also, the auditor can take a physical count before the end of the year, and then estimate the ending inventory. 3. If inventory has been lost, stolen, or destroyed, or if inventory records are destroyed a company can estimate inventory on hand before the loss and be able to determine the amount of the loss. 4. If a company wishes to prepare budgets for upcoming periods, the gross profit method can be used to estimate inventories and cost of sales. Q9-10 Q9-11 The underlying assumption of the gross profit method is that the rate of gross profit in the current period is not materially different from the rate in prior periods. If the costs of inventory or the selling price have gone up or down in the current period and thus changed the gross profit rate, the prior percentage should be modified to reflect the change so that a better estimate of inventory can be made. In addition, a separate rate may be used for each type of product sold. Finally, an average rate for several past periods may be used to average out period to period fluctuation. 9-4 Q9-12 To provide valid results for inventory estimation using the retail inventory method, there should be a consistent, observable pattern between the cost of purchases and selling prices. A markup is the original amount added to the cost of inventory to establish the first selling price. An additional markup is an increase above the original selling price. A markup cancellation is a reduction in the additional markup, but it cannot reduce the price below the original selling price. A net markup is the aggregate of all additional markups less markup cancellations. A markdown is a decrease that reduces the price below the original selling price. A markdown cancellation is an increase in the selling price once it has been reduced by a markdown but it cannot be greater than the markdown. A net markdown is the total markdowns less any markdown cancellations. Under the FIFO cost flow assumption, the beginning inventory is not used in computing the cost-to-retail ratio for the period. The ratio for the period includes both net markups and markdowns. This method separately values the beginning inventory and the current purchases and retains the FIFO flow assumption. For average cost, the cost-to-retail ratio is computed using beginning inventory and net markups and net markdowns. The use of beginning inventory, net markups, and net markdowns tends to average out fluctuations in costs. The LIFO method calculates a separate ratio for each layer in the beginning inventory and for current purchases including both net markups and net markdowns. This creates an estimate for the separate layers, which are then handled the same way as regular LIFO inventory. The lower of average cost or market method uses the cost and retail value of the beginning inventory and net markups in the computation of the cost-to-retail ratio. The inclusion of net markups but not net markdowns has the effect of lowering the cost-to-retail ratio and thus lowering the estimated inventory value below cost (however, not exactly to market). Q9-13 Q9-14 Q9-15 For the lower of average cost or market retail inventory method actually to produce an inventory valuation equal to the lower of cost or market, one of two conditions must exist: 1. Markups and markdowns do not exist at the same time; that is, there are either markups or markdowns, but not both. 2. All marked-down items have been sold in the current period. Q9-16 First, it must be remembered that the retail inventory method is an estimate of inventory and thus discrepancies are likely to occur. One cause may be inventory breakage or theft that would not be reflected in the cost-to-retail ratio, but does affect actual physical inventory. Another reason for the discrepancy may be that one or more of the assumptions of the retail inventory method are not true. For example, one such assumption is that items are homogeneous, or at least remain in relatively the same proportion in cost of goods available and ending inventory. If this is not true in a particular period, the retail inventory value will be different than the actual physical inventory valuation. 9-5 Q9-17 O = Overstated; U = Understated; CY = Current Year; SY = Succeeding Year (a) CY SY O O U O O O O O U U CY U U O O U O (b) SY O O U U CY U U (c) SY U O CY (d) SY U U O U U U U U O O Net Income: Beginning inventory Purchases Ending inventory Cost of goods sold Net income Earnings per share Ending inventory Accounts payable Retained earnings Balance Sheet: U U These effects assume that errors are corrected by the end of the following year. ANSWERS TO MULTIPLE CHOICE 1. 2. b c 3. 4. b b 5. 6. c c 7. 8. d a 9. 10. d a 9-6 SOLUTIONS TO REVIEW EXERCISES RE9-1 Selling price Less cost of completion Ceiling Less normal profit margin Floor RE9-2 Ceiling Less normal profit margin Floor $ 8,455 (1,500) $ 6,955 $ 5,000 (275) $ 4,725 (2,500) $ 2,225 The current replacement cost is $6,800. Because this is below the floor, the $6,955 floor should be used as the market value to apply the lower of cost or market value method. RE9-3 Ceiling Less normal profit margin Floor $ 2,850 (1,000) $ 1,850 The current replacement cost is $1,900. Because this is between the ceiling and floor, the $1,900 should be used as the market value to apply the lower of cost or market value method. RE9-4 Year 1 Year 2 RE9-5 Year 1 Loss Due to Market Valuation Allowance to Reduce Inventory To Market *$290,000 - $315,000 25,000* 25,000 Cost of Goods Sold Inventory Cost of Goods Sold Inventory 25,000 17,000 25,000 17,000 9-7 RE9-5 (continued) Year 2 Allowance to Reduce Inventory to Market Loss Recovery Due to Market Valuation *$(283,000 - $300,000) - $25,000 RE9-6 Dec. Jan. 31 02 Loss on Purchase Commitment Accrued Loss on Purchase Commitment Inventory Accrued Loss on Purchase Commitment Accounts Payable (or Cash) 20,000 280,000 20,000 20,000 8,000 8,000* 300,000 RE9-7 Cost of goods available for sale Less: Estimated cost of goods sold: Net sales Gross profit rate Estimated gross profit Estimated cost of goods sold ($80,000 - $28,000) Estimated cost of ending inventory RE9-8 Cost to retail ratio (for purchases): $75,000/$193,000* = 0.389 *$200,000 + $15,000 - $22,000 Ending inventory at retail = $107,000 Ending inventory at FIFO cost: (0.389 x $107,000) = $41,623 RE9-9 Cost to retail ratio: ($35,000 + $75,000)/($92,000 + $200,000 + $15,000 - $22,000) = 0.386 (rounded) Ending inventory at retail = $107,000 Ending inventory at average cost: (0.386 x $107,000) = $41,302 $125,000 $80,000 35% $28,000 (52,000) $ 73,000 9-8 RE9-10 Cost-to-retail ratio (for beginning inventory): $35,000/$92,000 = 0.3804 (rounded) Net purchases: $200,000 + $15,000 - $22,000 = $193,000 Cost-to-retail ratio (for purchases): $75,000/$193,000 = 0.389 (rounded) Ending inventory at retail = $107,000 Ending inventory at LIFO cost: $92,000 x 0.3804 = $35,000 (rounded back to original cost) $15,000 x 0.389 = $ 5,835 Ending inventory $40,835 RE9-11 Beginning inventory Purchases Net markups Cost-to-retail ratio: $110,000/$307,000 = 0.358 Net markdowns Goods available for sale Less: sales Ending inventory at retail Ending inventory at lower of cost or market: (0.358 x $107,000) = $38,306 RE9-12 Beginning inventory Purchases Goods available for sale Sales Ending inventory at retail Ending inventory retail at base-year price: $57,000 x (100/110) = $51,818 Inventory change at retail base-year price: $51,818 - $35,000 = $16,818 Inventory at retail in base-year price conversion to current-year retail price: $16,818 x (110/100) = $18,500 Current costs: Step One: Cost-to-retail for purchases ($180,000/$322,000) = 0.56 Step Two: $18,500 x 0.56 = $10,360 Year-end LIFO inventory: Base-year layer $20,000 Layer added 10,360 Ending inventory $30,360 Cost $ 20,000 180,000 $200,000 Retail $ 35,000 322,000 $357,000 (300,000) $ 57,000 $110,000 (22,000) $285,000 (178,000) $107,000 Cost $ 35,000 75,000 -$110,000 Retail $ 92,000 200,000 15,000 $307,000 9-9 SOLUTIONS TO EXERCISES E9-1 Product A B Cost $68 $91 Replacement Cost $60 $93a Net Realizable Value (Ceiling) $140 - $32 = $108 $200 - $52 = $148 Net Realizable Value Less Normal Markup (floor) $108 - 30% ($140) = $66a $148 - 30% ($200) = $88 aDesignated market value Net realizable value less a normal markup is used because replacement cost is less than the floor and net realizable value less a normal markup is less than cost. Cost is used here because replacement cost, which is between the ceiling and floor, is higher than the cost. Designated Inventory Market Value $5.10 $5.50 $4.80 $4.20 $4.70 $5.00 $5.00 $4.80 $4.20 $4.70 cost cost NRV NRV NRV Inventory valuation: Product A--$66 Product B--$91 E9-2 1. Case 1 2 3 4 5 2. Case 1 2 3 4 5 E9-3 1. Product A B C D E Cost $5.00 $5.00 $5.00 $5.00 $5.00 Cost $5.00 $5.00 $5.00 $5.00 $5.00 Net Realizable Inventory Value Value $5.10 $5.50 $4.80 $4.20 $4.70 $5.00 $5.00 $4.80 $4.20 $4.70 cost cost NRV NRV NRV Units Lower of Cost or Market Inventory Value $ 480 375 750 640 1,968 $4,213 600 $ 0.80 250 $ 1.50 150 $ 5.00 100 $ 6.40 80 $24.60 Total inventory value 9-10 E9-3 (continued) 2. Product A 600 B 250 Total C 150 D 100 Cost $600 375 $975 $ 750 650 $1,400 Market Group 1 $480.00 387.50 $867.50 Group 2 $ 787.50 640.00 $1,427.50 Lower of Cost or Market $ 867.50 $1,400.00 $1,968.00 $4,023.50 Market $ 480.00 387.50 787.50 640.00 1,968.00 $4,263.00 $4,263.00 E 3. 80 Group 3 $2,000 $1,968 Total inventory value Units 600 250 150 100 80 Cost $ 600 375 750 650 2,000 $4,375 Product A B C D E Total Total inventory value E9-4 2010 Dec. 31 Income Summary Inventory To close beginning inventory. 31 Inventory Income Summary To record ending inventory. 10,000 10,000 13,000 13,000 31 Loss Due to Market Valuation Allowance to Reduce Inventory to Market To record inventory at lower of cost or market. 1,500 1,500 9-11 E9-4 (continued) 2011 Dec. 31 Income Summary Inventory To close beginning inventory. 31 Inventory Income Summary To record ending inventory. 31 Allowance to Reduce Inventory to Market Loss Recovery Due to Market Valuation To record inventory at lower of cost or market ($1,500 original allowance $1,000 allowance needed). E9-5 Loss Computation Commitment Market 2010 Dec. 2011 May 10,000 bushels at $5 = 10,000 bushels at $4.50 = $50,000 (45,000) $ 5,000 5,000 13,000 13,000 15,000 15,000 500 500 31 Loss on Purchase Commitment Accrued Loss on Purchase Commitment 1 Accrued Loss on Purchase Commitment Recovery of Accrued Loss on Purchase Commitment a($4.75 5,000 2,500a 2,500 - $4.50) x 10,000 47,500 2,500 1 Inventory (or Purchases) Accrued Loss on Purchase Commitment Accounts Payable 50,000 9-12 E9-6 Beginning inventory Purchases on hand ($465,000 - $60,000 in transit) Cost of goods available for sale Less: Cost of goods solda Inventory on hand September 28, 2010, and destroyed by the fire aSelling $150,000 405,000 $555,000 (450,000) $105,000 price = Cost + 20% Markup on cost $540,000 = 1.20 x Cost, or Cost = $540,000 = $450,000 1.2 E9-7 (AICPA adapted solution) HODGE COMPANY Calculation of Estimated Loss on Inventory in the Fire Using Gross Margin (Profit) Method November 21, 2010 Inventory at November 1, 2010 Purchases from November 1, 2010, to date of fire Cost of goods available for sale Estimated cost of goods sold Net sales from November 1, 2010, to date of fire Less: Estimated gross margin (profit) ($220,000 x 30%) Estimated cost of inventory at date of fire Less: Salvage goods Estimated loss on inventory in the fire E9-8 1. If volume declined by 5%, the sales revenue at the same selling price would be $285,000 ($300,000 x 0.95). Therefore, the selling price increased by 3.9% ($296,000 $285,000 = 1.039). If volume declined by 5%, the cost of goods sold at the same costs would be $190,000 ($200,000 x 0.95). Therefore, costs increased by 7% ($203,300 $190,000 = 1.07). $100,000 140,000 $240,000 $220,000 (66,000) (154,000) $ 86,000 (10,000) $ 76,000 2. 9-13 E9-8 3. (continued) If selling prices increased by 4%, sales revenue at the same volume would be $312,000 ($300,000 x 1.04). Therefore, the gross profit would have increased by $12,000 in the absence of any other changes. If costs increased by 7%, cost of goods sold at the same volume would be $214,000 ($200,000 x 1.07). Therefore, the gross profit would have decreased by $14,000 in the absence of any other changes. 4. E9-9 The following formulas are useful in solving this problem: Gross profit on net sales = Gross profit on cost of goods sold 1 + Gross profit on cost of good sold Gross profit on net sales 1 Gross profit on net sales Gross profit on cost of goods sold = 1. Convert gross profit on net sales to gross profit on cost of goods sold 20%: 0.20 0.20 = = 25% 1 0.20 0.80 0.25 0.25 = = 33 1/3% 1 0.25 0.75 0.40 0.40 = = 66 2/3% 1 0.40 0.60 25%: 40%: 2. Convert gross profit on cost of goods sold to gross profit on net sales 20%: 25%: _ 0.20 0.20 = = 16 2/3% 1+0.20 1.20 0.25 0.25 = = 20% 1 + 0.25 1.25 0.40 0.40 = = 28.6% (rounded) 1 + 0.40 1.40 40%: Note: In any profitable situation, gross profit on net sales is less than gross profit on cost of goods sold. 9-14 E9-10 1. Purchases Markups (net) Markdowns (net) $ 65,200 = 0.642 $101,500 Cost $65,200 $65,200 Retail $100,000 1,900 (400) $101,500 Cost-to-retail ratio: Add: Beginning inventory Goods available for sale Less: Sales Ending inventory at retail Ending inventory at cost ($61,700 x 0.642) 2. Beginning inventory Purchases Markups (net) Markdowns (net) Goods available for sale Cost-to-retail ratio: $ 93,600 = 0.661 $141,700 28,400 $93,600 $39,611 Cost $28,400 65,200 $93,600 40,200 $141,700 (80,000) $ 61,700 Retail $ 40,200 100,000 1,900 (400) $141,700 Less: Sales Ending inventory at retail Ending inventory at cost ($61,700 x 0.661) $40,784 (80,000) $ 61,700 9-15 E9-10 (continued) 3. Beginning inventory Cost-to-retail ratio: $ 28,400 = 0.706 $ 40,200 Cost $28,400 Retail $ 40,200 Purchases Markups (net) Markdowns (net) $ 65,200 = 0.642 $101,500 65,200 100,000 1,900 (400) $101,500 Cost-to-retail ratio: Goods available for sale Less: Sales Ending inventory at retail Ending inventory at LIFO cost [$40,200 x 0.706 (beginning layer)] [$21,500 x 0.642 (new layer)] Total *Adjusted for rounding error to original cost. 4. Beginning inventory Purchases Markups (net) $ 93,600 = 0.659 $142,100 $93,600 $141,700 (80,000) $ 61,700 $28,400* 13,803 $42,203 Cost $28,400 65,200 $93,600 Retail $ 40,200 100,000 1,900 $142,100 Cost-to-retail ratio: Less: Markdowns (net) Sales Ending inventory at retail Ending inventory at LCM ($61,700 x 0.659) $40,660 (400) (80,000) $ 61,700 9-16 E9-11 (AICPA adapted solution) Cost Beginning inventory Purchases Markups Cost-to-retail ratio: $420,000 = 0.70 $600,000 (40,000) (480,000) $ 80,000 $ 90,000 330,000 $420,000 Retail $130,000 460,000 10,000 $600,000 Less: Markdowns Sales Ending inventory at retail Ending inventory at LCM (0.70 x $80,000) E9-12 1. Purchases Freight-in Markups (net) Markdowns (net) $55,440 = 0.604 $91,856 $ 56,000 Cost $54,600 840 $55,440 Retail $ 92,400 600 (1,144) $ 91,856 Cost-to-retail ratio: Beginning inventory Goods available for sale Less: Sales Ending inventory at retail Ending inventory at cost ($15,800 x 0.604) 11,160 $66,600 $ 9,543 18,000 $109,856 (94,056) $ 15,800 9-17 E9-12 (continued) 2. Beginning inventory Purchases Freight-in Markups (net) Markdowns (net) Goods available for sale Cost-to-retail ratio: $ 66,600 = 0.606 $109,856 Cost $11,160 54,600 840 $66,600 Retail $ 18,000 92,400 600 (1,144) $109,856 Less: Sales Ending inventory at retail Ending inventory at average cost ($15,800 x 0.606) 3. Beginning inventory Cost-to-retail ratio: Purchases Freight-in Markups (net) Markdowns (net) $55,440 = 0.604 $91,856 $11,160 = 0.62 $18,000 (94,056) $ 15,800 $ 9,575 Cost $11,160 Retail $ 18,000 $54,600 840 $55,440 $ 92,400 600 (1,144) $ 91,856 Cost-to-retail ratio: Goods available for sale Less: Sales Ending inventory at retail Ending inventory at LIFO cost [$15,800 x 0.62 (all beginning layer)] $66,600 $109,856 (94,056) $ 15,800 $ 9,796 9-18 E9-12 (continued) 4. Beginning inventory Purchases Freight-in Markups (net) $ 66,600 = 0.60 $111,000 Cost $11,160 54,600 840 $66,600 Retail $ 18,000 92,400 600 $111,000 Cost-to-retail ratio: Less: Markdowns (net) Sales Ending inventory at retail Ending inventory at LCM ($15,800 x 0.60) E9-13 Beginning inventory Cost-to-retail ratio: Purchases Markups (net) Markdowns (net) $60,000 = 0.667 $90,000 $20,000 = 0.69 $29,000 $ 9,480 Cost $20,000 (1,144) (94,056) $ 15,800 Retail $ 29,000 $60,000 $ 92,000 1,000 (3,000) $90,000 Cost-to-retail ratio: Goods available for sale Less: Sales Ending inventory at retail Converted to base-year prices = $44,000 x $80,000 $119,000 (75,000) $ 44,000 100 = $40,000 110 There is an $11,000 increase in retail inventory in base year prices ($40,000 - $29,000) 9-19 E9-13 (continued) Ending inventory at retail consists of: $29,000 x $11,000 x 100 100 110 100 = = $29,000 12,100 $41,100 Ending inventory at cost: $29,000 x 0.69 $12,100 x 0.667 = = *Adjusted for rounding error to original cost. E9-14 Beginning inventory Cost-to-retail ratio: Purchases Markups (net) Markdowns (net) $110,000 = 0.659 $167,000 $75,000 = 0.625 $120,000 $20,000* 8,071 $28,071 Cost $ 75,000 Retail $120,000 $110,000 $165,000 8,000 (6,000) $167,000 Cost-to-retail ratio: Goods available for sale Less: Sales Ending inventory at retail Converted to base-year prices = $140,000 x 100 110 $185,000 $287,000 (147,000) $140,000 = $127,272.73 There is a $7,272.73 increase in retail inventory in base year prices ($127,272.73 - $120,000) Ending inventory at retail consists of: $120,000 x $7,272.73 x 100 = $120,000 100 110 = 100 8,000 $128,000 9-20 E9-14 (continued) Ending inventory at cost: $120,000 x 0.625 = $ 75,000 $ 8,000 x 0.659 = 5,272 $ 80,272 E9-15 (AICPA adapted solution) Ending inventory converted to base-year prices = $660,000 x 100 = $600,000 110 There is a $100,000 increase in retail inventory in base year prices ($600,000 - $500,000) Ending inventory at retail consists of: $500,000 x $100,000 x 100 = $500,000 100 110 = $110,000 100 $610,000 Ending inventory at cost: Beginning inventory = $110,000 x 0.70 = E9-16 1. Current year: Income statement: Income is correct because the errors in Purchases and Ending Inventory offset each other. Balance sheet: Ending Inventory and Accounts Payable are understated. Succeeding year: Income Statement: If the purchase is recorded in the succeeding year, income will be correct because the overstatement of Purchases and understatement of Beginning Inventory will offset each other. If the purchase is not recorded in the succeeding year, income will be overstated because Beginning Inventory is understated and therefore Cost of Goods Sold is understated. $360,000 77,000 $437,000 9-21 E9-16 (continued) 1. (continued) Balance sheet: Retained Earnings will be overstated if the purchase is not recorded in the succeeding year because net income will be overstated. Accounts Payable will be understated if the purchase is not recorded. 2. Current year: Income statement: Income is overstated because Purchases are understated and therefore Cost of Goods Sold is understated. Balance sheet: Liabilities (Accounts Payable) are understated because a purchase has not been recorded. Retained Earnings are overstated because net income is overstated. Succeeding year: Income statement: No effect in the succeeding year if the purchase is not recorded. If it is recorded in the succeeding year, income will be understated because Purchases and Cost of Goods Sold will be overstated. This would result in Retained Earnings being correctly stated at the end of the succeeding year. Balance sheet: If the error is not corrected, Accounts Payable will continue to be understated. It will be doubly understated if a debit is made to Accounts Payable when the purchase is actually paid for. Retained Earnings will also be overstated if the error from the previous year is not corrected. 3. Current year: Income statement: Income is overstated because Cost of Goods Sold is understated. Balance sheet: Ending Inventory is overstated, and Retained Earnings is overstated because of the overstatement of current income. Succeeding year: Income statement: Income is understated because Beginning Inventory is overstated and, therefore, Cost of Goods Sold is overstated. Balance sheet: Ending Inventory will be correct if no other errors are made, and Retained Earnings will also be correct since the understatement of income in the second year offsets the overstatement in the first year. 9-22 E9-17 (AICPA adapted solution) Net income before adjustments Adjustments Understatement of beginning inventory Overstatement of ending inventory Overstatement of sales revenue Net income after adjustments $20,000 (6,000) (5,000) (1,000) $ 8,000 Note also that the balance sheet will have to be adjusted to reflect the correction of ending inventory and to show the $1,000 cash advance as a liability (customer deposits). 9-23 SOLUTIONS TO PROBLEMS P9-1 1. Item 1 2 3 4 5 Cost $10.00 8.00 15.00 18.00 25.00 Replacement $ 9.10a 8.10 13.50a 12.00 25.50 NRV $ 9.20 7.80a 14.00 17.00 25.30a NRV Less Markup $ 7.20 6.20 11.00 13.40a 20.30 Lower of Cost or Market $ 9.10 7.80 13.50 13.40 25.00 aDesignated as market Units Valuation 500 $ 9.10 400 7.80 300 13.50 200 13.40 100 25.00 Total inventory valuation Units 500 400 300 200 100 Total value Cost $ 5,000 3,200 4,500 3,600 2,500 $18,800 Total $ 4,550 3,120 4,050 2,680 2,500 $16,900 Market $ 4,550 3,120 4,050 2,680 2,530 $16,930 2. a. If lower of cost or market is applied to individual items Item 1 2 3 4 5 b. If lower of cost or market is applied to whole inventory Item 1 2 3 4 5 Lower of cost or market on inventory as a whole $16,930 The difference of $30 between the two values is caused by item 5. When the items were taken individually, the market values for items 1-4 were used whereas the cost of item 5 was used. Then, when the LCM was applied to the inventory as a whole the total market value of all items was used. Thus, the difference of $30 is accounted for as follows: 100 units x ($25.00 cost - $25.30 market) = $30. 3. Case 1 2 3 4 5 Cost $10.00 $ 8.00 $15.00 $18.00 $25.00 Net Lower Realizable of Cost Value or Market $ 9.20 $ 7.80 $14.00 $17.00 $25.30 $ 9.20 $ 7.80 $14.00 $17.00 $25.00 NRV NRV NRV NRV cost 9-24 P9-2 1. 2010 a. Income Summary Inventory To close beginning inventory. b. Inventory Income Summary To record ending inventory. Loss Due to Market Valuation Allowance to Reduce Inventory to Market To record inventory at lower of cost or market. 50,000 50,000 64,000 64,000 c. 4,000 4,000 2011 a. Income Summary Inventory To close beginning inventory. b. Inventory Income Summary To record ending inventory. Allowance to Reduce Inventory to Market Loss Recovery Due to Market Valuation To record inventory at lower of cost or market. 64,000 64,000 71,000 71,000 c. 3,000 3,000 2012 a. Income Summary Inventory To close beginning inventory. b. Inventory Income Summary To record ending inventory. Allowance to Reduce Inventory to Market Loss Recovery Due to Market Valuation To record inventory at lower of cost or market. 71,000 71,000 75,000 75,000 c. 1,000 1,000 9-25 P9-2 (continued) 2. 2010 Loss Due to Market Valuation Allowance to Reduce Inventory to Market 2011 Allowance to Reduce Inventory to Market Loss Recovery Due to Market Valuation 2012 Allowance to Reduce Inventory to Market Loss Recovery Due to Market Valuation 3. 2010 a. Income Summary Inventory To close beginning inventory. b. Inventory Income Summary To record ending inventory at lower of cost or market. 4,000 4,000 3,000 3,000 1,000 1,000 50,000 50,000 60,000 60,000 2011 a. Income Summary Inventory To close beginning inventory. b. Inventory Income Summary To record ending inventory at lower of cost or market. 60,000 60,000 70,000 70,000 2012 a. Income Summary Inventory To close beginning inventory. b. Inventory Income Summary To record ending inventory at lower of cost or market. 70,000 70,000 75,000 75,000 9-26 P9-2 (continued) 4. 2010 Cost of Goods Sold Inventory 2011 Cost of Goods Sold Inventory 2012 No entry P9-3 1. 2. The decline in the value of inventory below cost is ignored in interim financial statements if the decline is considered to be temporary. 2010 Mar. 31 Loss Due to Market Valuation Allowance to Reduce Inventory to Market a. 500 500 4,000 4,000 1,000 1,000 P9-4 1. 2010 Income Summary Inventory To close beginning inventory. Inventory Income Summary To record ending inventory. Loss Due to Market Valuation Allowance to Reduce Inventory to Market To record inventory at lower of cost or market. 2011 Income Summary Inventory To close beginning inventory. 125,000 125,000 130,000 130,000 2,000 2,000 130,000 130,000 9-27 P9-4 (continued) 1. a. (continued) Inventory Income Summary To record ending inventory. Allowance to Reduce Inventory to Market Loss Recovery Due to Market Valuation To record inventory at lower of cost or market. b. 2010 Income Summary Inventory To close beginning inventory. Inventory Income Summary To record ending inventory at lower of cost or market. 2011 Income Summary Inventory To close beginning inventory. Inventory Income Summary To record ending inventory at lower of cost or market. 135,000 135,000 2,000 2,000 125,000 125,000 128,000 128,000 128,000 128,000 135,000 135,000 9-28 P9-4 (continued) 2. a. Income Statement Beginning inventory Purchases Cost of goods available Less: Ending inventory Loss (loss recovery) due to market valuation Cost of goods sold Balance Sheet Inventory at cost Less: Allowance to reduce inventory to market Inventory lower at of cost or market b. Income Statement Beginning inventory Purchases Cost of goods available Less: Ending inventory Cost of goods sold Balance Sheet Inventory at lower of cost or market 2010 $128,000 2011 $135,000 2010 $125,000 100,000 $225,000 (128,000) $ 97,000 2011 $128,000 110,000 $238,000 (135,000) $103,000 2010 $130,000 (2,000) $128,000 2011 $135,000 $135,000 2010 $125,000 100,000 $225,000 (130,000) $ 95,000 2,000 $ 97,000 2011 $130,000 110,000 $240,000 (135,000) $105,000 (2,000) $103,000 9-29 P9-5 Work in process, January 1, 2010 Add: Production costs Less: Work in process, December 31, 2010 Cost of goods produced Finished goods, January 1, 2010 Add: Cost of goods produced Less: Finished goods, December 31, 2010 Cost of goods sold Sales (net) Less: Cost of goods sold Gross profit Gross profit as a percent of net sales: $ 38,000 = 38% $100,000 $ 25,000 70,000 (40,000) $ 55,000 $ 37,000 55,000 (30,000) $ 62,000 $100,000 (62,000) $ 38,000 P9-6 Beginning inventory Purchases Cost of goods available for sale Cost of goods sold (net sales of $51,000 1.50) Ending inventory before theft Ending inventory after theft Inventory lost P9-7 1. Inventory, July 1, 2010 Purchases (less $6,000 in transit) Less: Purchases returns Purchases discounts taken Freight-in Cost of goods available for sale and on hand Sales Less: Sales returns Net sales Cost of goods sold = $576,400 x (1 - 0.40) = $345,840 9-30 $ 38,000 19,000 $ 57,000 (34,000) $ 23,000 (15,000) $ 8,000 $ 53,600 362,000 (11,200) (5,800) 3,800 $402,400 $583,000 (6,600) $576,400 P9-7 (continued) Cost of goods salvaged = $4,700 x (1 - 0.40) = $2,820 Inventory lost in the fire: Cost of goods available for sale and on hand Less: Cost of goods sold Cost of goods salvaged Inventory lost 2. $402,400 (345,840) (2,820) $ 53,740 When a company uses the periodic inventory method, it is estimating the ending inventory and cost of goods sold in its interim financial reports (unless it took a physical inventory). Therefore, you might be concerned about the accuracy of the reported amounts. The gross profit method assumes that the gross profit percentage from the previous period(s) is applicable to the current period. Using this percentage assumes that there has not been any change in the relationship between gross profit and net sales, due to, for example, cost or productivity changes. Also, if the company uses a single gross profit percentage, it is assuming that inventories across departments are held in the same proportion. P9-8 LRT COMPANY Computation of Value of Inventory Lost February 17, 2010 Sales Less: Gross profit (40%) Cost of goods sold Finished goods, February 17 Cost of goods available for sale Less: Finished goods, December 31, 2009 Cost of goods manufactured and completed Raw materials, December 31, 2009 Raw materials purchases Raw materials available for production Raw materials before flood Raw materials used Direct labor Manufacturing overhead cost Work in process, December 31, 2009 Cost of production Less: Cost of goods completed (from above) Work in process inventory lost in flood 9-31 $ 50,000 (20,000) $ 30,000 79,000 $109,000 (72,000) $ 37,000 $ 70,000 20,000 $ 90,000 (70,000) ($35,000 ) $ 20,000 30,000 15,000 80,000 $145,000 (37,000) $108,000 P9-8 (continued) Total value of inventory = Raw materials lost + Work in process lost destroyed by flood = ($70,000 - $35,000) + $108,000 = $143,000 P9-9 (AICPA adapted solution) PADWAY CORPORATION Computation of Value of Work-in-Process Inventory Lost June 30, 2010 Sales Less: Gross profit (25%) Cost of goods sold Add: Finished goods, June 30, 2010 Cost of goods available for sale Less: Finished goods, January 1, 2010 Cost of goods manufactured and completed Raw materials, January 1, 2010 Purchases Raw materials available Raw materials, June 30, 2010 Raw materials used Direct labor $ 80,000 Manufacturing overhead 40,000 Work-in-process, January 1, 2010 100,000 Cost of production Less: Cost of goods manufactured and completed Work-in-process inventory lost $340,000 (85,000) $255,000 119,000 $374,000 (140,000) $234,000 $ 30,000 115,000 $145,000 (62,000) $ 83,000 220,000 $303,000 (234,000) $ 69,000 9-32 P9-10 1. Purchases Less: Purchases discounts taken Purchases returns Freight-in Net markups ($50,000 - $10,000) Net markdowns ($15,000 - $3,000) $152,000 = 0.724 $210,000 Cost $140,000 (3,000) (5,000) 20,000 $152,000 Retail $190,000 (8,000) 40,000 (12,000) $210,000 Cost-to-retail ratio: Beginning inventory Goods available for sale Less: Sales Employee discounts Ending inventory at retail Ending inventory at cost ($62,000 x 0.724) 2. Beginning inventory Purchases Less: Purchases discounts taken Purchases returns Freight-in Net markups Net markdowns Goods available for sale Cost-to-retail ratio: $181,000 = 0.710 $255,000 29,000 $181,000 $ 44,888 Cost $ 29,000 140,000 (3,000) (5,000) 20,000 $181,000 45,000 $255,000 (190,000) (3,000) $ 62,000 Retail $ 45,000 190,000 (8,000) 40,000 (12,000) $255,000 Less: Sales and employee discounts Ending inventory at retail Ending inventory at cost ($62,000 x 0.710) $ 44,020 (193,000) $ 62,000 9-33 P9-10 (continued) 3. Beginning inventory Cost-to-retail ratio: $29,000 = 0.644 $45,000 Cost $ 29,000 Retail $ 45,000 Purchases Less: Purchases discounts taken Purchases returns Freight-in Net markups Net markdowns $152,000 = 0.724 $210,000 $140,000 (3,000) (5,000) 20,000 $152,000 $190,000 (8,000) 40,000 (12,000) $210,000 Cost-to-retail ratio: Goods available for sale Less: Sales and employee discounts Ending inventory at retail Ending inventory at cost $45,000 x 0.644 = $29,000a $17,000 x 0.724 = $12,308 aAdjusted $181,000 $255,000 (193,000) $ 62,000 $ 41,308 for rounding error to original cost Cost $ 29,000 140,000 (3,000) (5,000) 20,000 $181,000 Retail $ 45,000 190,000 (8,000) 40,000 $267,000 4. Beginning inventory Purchases Less: Purchases discounts taken Purchases returns Freight-in Net markups $181,000 Cost-to-retail ratio: = 0.678 $267,000 Less: Sales and employee discounts Net markdowns Ending inventory at retail Ending inventory at LCM ($62,000 x 0.678) $ 42,036 (193,000) (12,000) $ 62,000 9-34 P9-11 1. Purchases Less: Purchases discounts taken Freight-in Net markups ($60,000 - $12,000) Net markdowns ($15,000 - $4,000) Cost $320,000 (6,000) 16,000 $330,000 Retail $600,000 48,000 (11,000) $637,000 Cost-to-retail ratio: $330,000 = 0.518 $637,000 Beginning inventory Goods available for sale Less: Net sales ($610,000 - $30,000)a Ending inventory at retail Ending inventory at cost ($237,000 x 0.518) aNote: Sales 100,000 $430,000 $122,766 180,000 $817,000 (580,000) $237,000 discounts are ignored because they are considered to be financing items and not part of the original markup. Cost Retail $180,000 600,000 48,000 (11,000) $817,000 2. Beginning inventory Purchases Less: Purchases discounts taken Freight-in Net markups Net markdowns $100,000 320,000 (6,000) 16,000 $430,000 Cost-to-retail ratio: $430,000 = 0.526 $817,000 Less: Net sales ($610,000 - $30,000) Ending inventory at retail Ending inventory at cost ($237,000 x 0.526) $124,662 (580,000) $237,000 9-35 P9-11 (continued) 3. Beginning inventory Cost-to-retail ratio: $100,000 = 0.556 $180,000 Cost $100,000 Retail $180,000 Purchases Less: Purchases discounts taken Freight-in Net markups Net markdowns $330,000 = 0.518 $637,000 $320,000 (6,000) 16,000 $330,000 $600,000 48,000 (11,000) $637,000 Cost-to-retail ratio: Goods available for sale Less: Net sales ($610,000 - $30,000) Ending inventory at retail Ending inventory at cost ($180,000 x 0.556) ($ 57,000 x 0.518) aAdjusted $430,000 $100,000a 29,526 $129,526 $817,000 (580,000) $237,000 for rounding error to original cost Cost Retail $180,000 600,000 48,000 $828,000 4. Beginning inventory Purchases Less: Purchases discounts taken Freight-in Net markups Cost-to-retail ratio: $430,000 = 0.519 $828,000 $100,000 320,000 (6,000) 16,000 $430,000 Less: Net sales ($610,000 - $30,000) Net markdowns Ending inventory at retail Ending inventory at cost ($237,000 x 0.519) $123,003 (580,000) (11,000) $237,000 9-36 P9-12 (AICPA adapted solution) RED DEPARTMENT STORE Computation of Estimated Inventory Using Retail Inventory Method December 31, 2010 Inventory at January 1, 2010 Purchases Freight in Net markups ($60,000 - $10,000) Goods available for sale Cost ratio ($309,600 $720,000) = 0.43 Less: Sales Net markdowns ($25,000 - $5,000) Estimated normal shrinkage (2% x $600,000) Estimated inventory at retail at December 31, 2010 Estimated inventory at December 31, 2010, lower of cost or market ($88,000 x 0.43) P9-13 1. Beginning inventory Net purchases ($75,000 - $2,000; $180,000 - $5,000) Net markups ($3,000 - $1,000) $98,000 = 0.414 $237,000 Cost $ 32,000 270,000 7,600 $309,600 Retail $ 80,000 590,000 50,000 $720,000 (600,000) (20,000) (12,000) $ 88,000 $ 37,840 Cost $ 25,000 73,000 $ 98,000 Retail $ 60,000 175,000 2,000 $237,000 Cost-to-retail ratio: Less: Net sales ($210,000 - $5,000) Net markdowns ($7,000 - $2,000) Ending inventory at retail Ending inventory at cost ($27,000 x 0.414) $ 11,178 (205,000) (5,000) $ 27,000 9-37 P9-13(continued) 2. Ending inventory at retail: $80,000 Ending inventory at retail in base-year prices: $80,000 1.05 = $76,190 Beginning inventory at retail in base-year prices: $60,000 Increase in inventory at retail in base-year prices: $16,190 Increase in inventory at retail in current-year prices: $16,190 x 1.05 = $17,000 Increase in inventory at cost in current-year prices: $17,000 x 0.50 = $8,500 Ending inventory at cost--base: $25,000 --addition: 8,500 Ending inventory, total cost $33,500 P9-14 2010 Beginning inventory Cost-to-retail ratio: $ 50,000 = 0.50 $100,000 Cost $ 50,000 Retail $100,000 Purchases Net markups Net markdowns Cost-to-retail ratio: $200,000 = 0.465 $430,000 $200,000 $200,000 $420,000 20,000 (10,000) $430,000 Goods available for sale Less: Sales Ending inventory at retail Ending inventory at retail at base-year prices: $130,000 x 100 = $120,370 108 $250,000 $530,000 (400,000) $130,000 Inventory change at retail at base-year prices: $120,370 - $100,000 = $20,370 9-38 P9-14(continued) Change at relevant current costs: $20,370 x 108 x 0.465 = $10,230 100 Ending inventory at cost: Base-year layer 2010 layer $50,000 10,230 $60,230 2011 Beginning inventory Purchases Net markups Net markdowns $250,000 Cost-to-retail ratio: = 0.463 $540,000 Cost $ 60,230 $250,000 $250,000 Retail $130,000 $550,000 30,000 (40,000) $540,000 Goods available for sale Less: Sales Ending inventory at retail Ending inventory at retail at base-year prices: $70,000 x 100 = $60,870 115 $310,230 $670,000 (600,000) $ 70,000 Inventory change at retail at base-year prices: $ 60,870 - $120,370 = $(59,500) Change at relevant current costs: $(20,370) x 108 x 0.465 = $(10,230) (all of 2010 layer) 100 $(39,130) 100 $(19,565) (from base-year layer) x x 0.50 = $(59,500) 100 $(29,795) 9-39 P9-14 (continued Ending inventory at cost: $60,230 - $29,795 = $30,435 (remaining base-year layer) 2012 Beginning inventory Purchases Net markups Net markdowns $240,000 = 0.49 $490,000 Cost $ 30,435 $240,000 $240,000 Retail $ 70,000 $500,000 10,000 (20,000) $490,000 Cost-to-retail ratio: Goods available for sale Less: Sales Ending inventory at retail Ending inventory at retail at base-year prices: $100,000 x 100 = $91,667 120 $270,435 $560,000 (450,000) $110,000 Inventory change at retail at base-year prices: $ 91,667 - $ 60,870 = $30,797 Change at relevant current costs: $30,797 x 120 x 0.49 = $18,109 100 Ending inventory at cost: Base layer 2012 layer $30,435 18,109 $48,544 9-40 P9-15 2009 Retail $ 80,000 Cost $ 33,333 Retail $ 70,000 Cost $ 39,999 Retail $ 90,000 Cost $ 44,963 Retail $110,000 2010 2011 2012 Beginning inventory Cost $ 40,000 Cost-to-retail ration: 85,500 $ 92,000 $230,000 = 0.40 $ 40,000 $ 80,000 = 0.59 Purchases $117,600 $280,000 = 0.42 $320,000 = 0.46 $147,200 190,000 92,000 230,000 117,600 280,000 147,200 320,000 Cost-to-retail ration: $ 85,000 $190,000 = 0.45 Goods available for sale Sales Ending inventory at retail Ending inventory at retail at base-year prices: 66,667 81,818 $ 125,500 $270,000 (200,000) $ 70,000 $125,333 $300,000 (210,000) $ 90,000 $157,599 $370,000 (260,000) $110,000 $192,163 $430,000 (300,000) $130,000 $ 70,000 x 100 105 90,000 x 100 110 170,000 x 100 120 91,667 104,000 9-41 (13,333) 15,151 (13,333) 16,666 (6,667) 6,666 4,964 33,333 6,666 $ 39,999 33,333 6,666 4,964 $ 33,333 $ 44,963 33,333 130,000 x 100 125 Inventory change at retail at base-year prices: $ 66,667 - $80,000 81,818 - 66,667 91,667 - 81,818 104,000 - 91,667 Change at retail at relevant current prices: 9,849 12,333 $ 13,333 x 100 100 15,151 x 110 100 9,849 x 120 100 11,819 15,416 12,333 x 125 100 Change at relevant current costs: $(13,333) x 0.50 16,666 x 0.40 11,819 x 0.42 15,416 x 0.46 Year-end LIFO inventory Base-year layer ($40,000 - $6,667) Layer added in 2010 Layer added in 2011 Layer added in 2012 Ending inventory 7,091 33,333 6,666 4,964 7,091 $ 52,054 P9-16 2010 Beginning inventory Cost-to-retail ratio: $40,000 = 0.444 $90,000 Cost $ 40,000 Retail $ 90,000 Purchases Net markups Net markdowns $100,000 = 0.526 $190,000 $100,000 $100,000 $210,000 20,000 (40,000) $190,000 Cost-to-retail ratio: 8-42 Goods available for sale Less: Sales Ending inventory at retail Ending inventory at retail at base-year prices: $80,000 x 100 = $75,472 106 $140,000 $280,000 (200,000) $ 80,000 Inventory change at retail at base-year prices: $75,472 - $90,000 = $(14,528) Change at relevant current costs: $(14,528) x 100 X 0.444 = $(6,450) (from base year layer) 100 Ending inventory at cost: $40,000 - $6,450 = $33,550 (remaining base-year layer) 9-42 P9-16 (continued) 2011 Beginning inventory Purchases Net markups Net markdowns $160,000 = 0.50 $320,000 Cost $ 33,550 $160,000 $160,000 Retail $ 80,000 $350,000 40,000 (70,000) $320,000 Cost-to-retail ratio: Goods available for sale Less: Sales Ending inventory at retail Ending inventory at retail at base-year prices: $120,000 x 100 = $109,091 110 $193,550 $400,000 (280,000) $120,000 Inventory change at retail at base-year prices: $109,091 - $75,472 = $33,619 Change at relevant current costs: $33,619 x 110 X 0.50 = $18,490 100 Ending inventory (September 7, 2011) at cost: Base-year layer 2011 layer $33,550 18,490 $52,040 $ 8,000 5,000 $13,000 $52,040 $39,040 Inventory lost in the fire: Purchases in transit Undamaged goods salvaged ($10,000 x 0.50) Inventory after the fire Inventory before the fire (from above) Inventory lost 9-43 P9-17 1. Current year: Ending inventory is correctly stated. Net income is overstated by $17,500 because purchases are understated and, therefore, cost of goods sold is understated. Following year: Since the purchase is recorded in the Purchases account in this year, net income is understated by $17,500, because cost of goods sold is overstated. 2. Current year: Ending inventory is understated by $4,300. Net income is understated by $4,300, because cost of goods sold is overstated. Following year: Beginning inventory is understated by $4,300, so cost of goods sold will be understated by $4,300 causing net income to be overstated by $4,300. 3. Current and following year: The results for both years will be the same as in 2. Merchandise for which a purchase has been recorded are excluded from ending inventory in current year. Current year: Ending inventory is understated. Net income is correct because the errors in purchases and ending inventory offset each other. Following year: The net income is correct because the errors would again offset each other. 5. Current year: Ending inventory is overstated. Net income is overstated because cost of goods sold is understated. Following year: Beginning inventory is overstated, which causes cost of goods sold to be overstated and net income to be understated. 4. 9-44 P9-18 (AICPA adapted solution) LAYNE CORPORATION Adjustments to Initial Amounts As of December 31, 2010 Accounts Payable $1,200,000 Initial amounts Adjustments [Increase (decrease)] 1 2 3 4 5 6 7 8 Total adjustments Adjusted amounts Inventory $1,750,000 Net Sales $8,500,000 None $ 50,000 20,000 26,000 25,000 30,000 None 2,000 $ 153,000 $1,903,000 None $ 50,000 None None None None 60,000 4,000 $ 114,000 $1,314,000 $ (35,000) None None (40,000) None None None None $ (75,000) $8,425,000 ANSWERS TO CASES C9-1 (AICPA adapted solution) 1. The retail inventory method can be employed to estimate retail, wholesale, and manufacturing finished goods inventories. The valuation of inventory under this method is arrived at by reducing the ending inventory at retail to an estimate of the lower of cost or market. The retail value of ending inventory can be computed by (1) taking a physical inventory, or by (2) subtracting net sales plus net markdowns from the total retail value of merchandise available for sale (that is, the sum of beginning inventory at retail, net purchases at retail, and net markups). The reduction of ending inventory at retail to an estimate of the lower of cost or market is accomplished by applying to it an estimated cost ratio arrived at by dividing the retail value of merchandise available for sale as computed in (2) above into the cost of merchandise available for sale (that is, the sum of beginning inventory, net purchases, and other inventoriable costs). 2. Since the retail method is based on an estimated cost ratio involving total merchandise available during the period, its validity depends on the underlying assumption that the merchandise in ending inventory is a representative mixture of all merchandise handled. If this condition does not exist, the cost ratio may not be appropriate for the merchandise in ending inventory and can result in significant error. 9-45 C9-1 (continued) 2. (continued) Where there are a number of inventory subdivisions for which differing rates of markon are maintained, there is no assurance that the ending inventory mix will be representative of the total merchandise handled during the period. In such cases, accurate results can be obtained by subclassifications by rate of markon. Seasonal variations in the rate of markon will nullify the ending inventory "representative mix" assumption. Since the estimated cost ratio is based on total merchandise handled during the period, the same rate of markon should prevail throughout the period. Because of seasonal variations, it may be necessary to use data for the last 6 months, quarter, or month to compute a cost ratio that is appropriate for ending inventory. Material quantities of special sale merchandise handled during the period may also bias the result of this method because merchandise data included in arriving at the estimated cost ratio may not be proportionately represented in ending inventory. This condition may be avoided by accumulating special sale merchandise data in separate accounts. Distortion of the ending inventory approximation under this method is often caused by an inadequate system of inventory control. Adequate accounting controls are necessary for the accurate accumulation of the data needed to arrive at a valid cost ratio. Physical controls are equally important because, for interim purposes, this method is usually applied without taking a physical inventory. 3. The advantages of using the retail method as compared with cost methods include the following: a. b. c. d. e. 4. Approximate inventory values can be determined without maintaining perpetual inventory records. The preparation of interim financial statements is facilitated. Losses due to fire or other casualty are readily determined. Clerical work in pricing the physical inventory is reduced. The cost of merchandise can be kept confidential in intracompany transfers. The treatments to be accorded net markups and net markdowns must be considered in light of their effects on the estimated cost ratio. If both net markups and net markdowns are used in arriving at the cost ratio, ending inventory will be converted to an estimated average cost figure. Excluding net markdowns will result in the inventory being stated at an estimate of the lower of cost or market. The lower cost ratio arrived at by excluding net markdowns permits the pricing of inventory at an amount that reflects its current utility. The assumption is that net markdowns represent a loss of utility that should be recognized in the period of markdown. Ending inventory is therefore valued on the basis of its revenue-producing potential and may be expected to produce a normal gross profit if sold at prevailing retail prices in the next period. 9-46 C9-2 (AICPA adapted solution) 1. THE SHELLY CORPORATION Computation of Gross Profit Ratio Sales Cost of goods sold Inventory, July 1, 2009 Purchases Purchases Adjustments Shipments received in May but recorded in June Unsalable shipments, no credit memos received at May 31, 2010 Deposit with vendor, recorded as purchase Adjusted purchases to May 31, 2010 Goods available for sale Physical inventory, May 31, 2010 Cost of goods sold Gross profit Gross profit ratio 2. Computation of Cost of Goods Sold During June 2010 Sales for year ended June 30, 2010 Less sale of rain-damaged shipment Net sales Less sales for 11 months ended May 31, 2010 Net sales for June 2010 Less estimated gross profit at 20% Cost of goods sold during June $960,000 (10,000) 950,000 (840,000) 110,000 ( 22,000) $ 88,000 $840,000 $ 87,500 675,000 7,500 (1,000) (2,000) 679,500 767,000 (95,000) (672,000) $168,000 20% 9-47 C9-2 (continued) 3. Computation of Inventory at June 30, 2010, by the Gross Profit Method Inventory, May 31, 2010 Purchases to June 30, 2010 per general ledger Adjustments Unsalable shipments, no credit memos received at June 30, 2010 Deposit made with vendor and charged to purchases in April, 2010; product was shipped in July, 2010 Cost of rain-damaged shipment Adjusted purchases to June 30, 2010 Less adjusted purchases to May 31, 2010 (from schedule 1) Adjusted purchases for June Goods available for sale during June Less cost of goods sold during June (from schedule 2) Inventory at June 30, 2010 C9-3 (AICPA adapted solution) a. 1. For its 2011 models, Blaedon should include in inventory carrying amounts all necessary and reasonable costs. These costs may include design costs, purchase price from contractors, freight-in, and warehousing costs. Blaedon's 2010 model inventory should be assigned a carrying amount equal to its net realizable value, which is its current list price reduced by both its disposition costs and two-thirds of the difference between the $40 allowance given and the carrying amount assigned to trade-ins. The trade-ins' carrying amount should equal the $25 average net realizable value less the profit margin, if any, assigned. Using FIFO, Blaedon would assign the earliest lawnmower costs to cost of goods sold. With rising costs, this would result in matching old, relatively low inventory costs against current revenues. Net income would be higher than that reported using certain other inventory methods. Blaedon would assign the latest costs to ending inventory. Normally, the carrying amount of Blaedon's FIFO ending inventory would approximate replacement cost at December 31, 2010. Retained earnings would be higher than that reported using certain other inventory methods. $ 95,000 800,000 (1,500) (2,000) (10,000) 786,500 (679,500) 107,000 202,000 (88,000) $114,000 2. b. 1. 2. 9-48 C9-4 (AICPA adapted solution) 1. If the terms of the purchase are FOB shipping point (manufacturer's plant), Retail, Inc., includes in its inventory goods purchased from its suppliers when the goods are shipped. For accounting purposes, title is presumed to pass at that time. Freight-in expenditures are considered an inventoriable cost because they are part of the price paid or the consideration given to acquire an asset. Because the cooking utensils were purchased three times during the current year, each time at a higher price than previously, Retail, Inc.'s ending inventory would be lower and the cost of goods sold would be higher using the weighted-average cost method instead of the FIFO method. Because Retail, Inc., calculates the estimated cost of its ending inventory using the conventional (lower-of-cost-or-market) retail inventory method, net markdowns are excluded from the computation of the cost ratio and included in the computation of the ending inventory at retail. Net markdowns are excluded in order to approximate a lowerof-cost-or-market valuation. Excluding net markdowns from the computation of the cost ratio reduces the cost ratio, which in turn reduces the estimated cost of the ending inventory. Products on consignment represent inventories owned by Retail, Inc., which are physically transferred to The Mall Space Company. Retail, Inc., retains title to the goods until their sale by The Mall Space Company. The goods consigned are still included by Retail, Inc., in the inventory section of its balance sheet. Retail, Inc., reclassifies the inventory from regular inventory to consigned inventory. The Mall Space Company, on the other hand, reports neither inventory nor a liability in its balance sheet. C9-5 (AICPA adapted solution) 1. (a) Diane's inventoriable cost includes all costs incurred to get the lighting fixtures ready for sale to the customer. It includes not only the purchase price of the fixtures but also the other associated costs incurred on the fixtures up to the time they are ready for sale to the customer, for example, transportation in. (b) No, administration costs are assumed to expire with the passage of time and not to attach to the product. Furthermore, administrative costs do not relate directly to inventories, but are incurred for the benefit of all functions of the business. 2. (a) The lower of cost or market rule is used for valuing inventories because of the concept of balance sheet conservatism and because the decline in the utility of the inventories below its cost is recognized as a loss in the current period. (b) The net realizable value less a normal profit margin is used to value the inventories because market cannot be less than net realizable value less a normal profit margin. To carry the inventories at net realizable value less a normal profit margin provides a means of measuring residual usefulness of an inventory expenditure. 2. 3. 4. 5. 9-49 C9-5 (continued) 3. Diane's beginning inventories at cost and at retail are included in the calculation of the cost ratio. Net markdowns are excluded from the calculation of the cost ratio. This procedure reduces the cost ratio because there is a larger denominator for the cost ratio calculation. Thus the concept of balance sheet conservatism is being followed. C9-6 (AICPA adapted solution) 1. Purchases from various suppliers are generally included in Caddell's inventory when Caddell receives the goods. For accounting purposes, in the absence of other information, title to goods purchased FOB destination is assumed to pass when the goods are received. Caddell should account for the warehousing costs as an additional cost of inventory. Theoretically, warehousing is a cost of readying the goods for sale and should be included in inventory cost. (a) The advantages of using the dollar value LIFO inventory cost flow method are to reduce the cost of accounting for inventory according to the LIFO method and to minimize the probability of unintentional liquidation of LIFO inventory. (b) The calculation of dollar value LIFO is based on dollars of inventory, a specific price index for each year, and broad inventory pools, whereas the conventional quantity of goods method is applied to individual units of each separate product. The inventory layers are identified with the price index for the year in which the layer was added. 4. Caddell should account for the inventories consigned to Reed Company as part of inventory. Caddell retains title to the goods until their sale by Reed; therefore the earnings process has not been completed. In applying the lower of cost or market method, market does not exceed the ceiling or fall below the floor. The ceiling is equal to the net realizable value, i.e., estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. The floor is equal to the net realizable value reduced by an allowance for an approximately normal profit margin. 2. 3. 5. C9-7 (AICPA adapted solution) 1. The insurance costs on the raw materials while they were in transit from the supplier should be accounted for as part of inventory. Theoretically, insurance cost on raw materials in transit is a cost associated with readying the goods for sale. a. Hanlon's inventory should be reported at net realizable value. According to the lower of cost or market rule, market is defined as replacement cost. However, market cannot exceed net realizable value. In this instance, net realizable value is below original cost. The lower of cost or market rule is used to report the inventory in the balance sheet at its future utility value. It also recognizes a decline in the utility of inventory in the income statement in the period in which the decline occurs. 2. b. 9-50 C9-7 (continued) 3. Generally, ending inventory would have been higher and cost of goods sold would have been lower had Hanlon used the LIFO inventory method. Inventory quantities increased and LIFO associates the oldest purchase prices with inventory. However, in this instance, there would have been no effect on ending inventory or cost of goods sold had Hanlon used the LIFO inventory method, because Hanlon's ending inventory would have been reported at net realizable value according to the lower of cost or market rule. Net realizable value of the inventory is less than either its average cost or LIFO cost. C9-8 (AICPA adapted solution) 1. Hudson should account for the warehousing costs related to its wholesale inventories as part of inventory. All reasonable and necessary costs of preparing inventory for sale should be recorded as inventory cost. This approach results in proper matching of the warehousing costs with revenue when the wholesale inventories are sold. a. The lower of cost or market method produces a more realistic estimate of future cash flows to be realized from assets, which is consistent with the principle of conservatism, and recognizes (matches) the anticipated loss in the income statement in the period in which the price decline occurs. Hudson's wholesale inventories should be reported on the balance sheet at replacement cost. According to the lower of cost or market method, replacement cost is defined as market. However, market cannot exceed net realizable value and cannot be less than net realizable value less the normal profit margin. In this instance, replacement cost is below original cost, below net realizable value, and above net realizable value less the normal profit margin. Therefore, Hudson's wholesale inventories should be reported at replacement cost. Hudson's freight-in costs should be included only in the cost amounts to determine the cost to retail percentage. Hudson's net markups should be included only in the retail amounts to determine the cost to retail percentage. Hudson's net markdowns should not be deducted from the retail amounts to determine the cost to retail percentage. 2. b. 3. a. b. c. 4. By not deducting net markdowns from the retail amounts to determine the cost to retail percentage, Hudson produces a lower cost to retail percentage than would result if net markdowns were deducted. By applying this lower percentage to ending inventory at retail, the inventory is reported at an amount below cost, which approximates lower of average cost or market. 9-51 C9-9 Note to Instructor: This case does not have a definitive answer. From a financial reporting perspective, GAAP is identified and summarized. From an ethical perspective, various issues are raised for discussion purposes. From a financial reporting perspective, there are two primary issues. First, if the purchase is made in the current year, the cost to retail ratio (for purchases) will be reduced because of the lower cost (assuming the retail value of the inventory is not reduced). This lower ratio will result in a lower cost of the ending inventory and a higher cost of goods sold, thereby lowering gross profit and causing Kelly more difficulty with top management. The second issue is that there is the possibility of delaying the purchase, thereby causing an inventory liquidation and "earning" a LIFO liquidation profit. If management chooses to delay the purchase, then GAAP requires the additional gross profit to be included in the income statement (and does not allow it to be ignored as it would be in the quarterly statements if the liquidation was considered to be temporary). From an ethical perspective, both issues involve whether management should make decisions for the purpose of affecting the amount of income that is reported. Obviously management may, but should it? The primary stakeholders are the company's current and potential stockholders and creditors. Kelly has two incentives for delaying the purchase, but the effects are short-run and will be counterbalanced in the next period. Also, since the LIFO liquidation will be replaced and management knows it, it may be considered to be a self-promoting decision that may benefit Kelly and other employees. It may also lead senior management to make inappropriate promotion and/or pay decisions if they are not aware of the reason for the additional profit, and may mislead shareholders, although the disclosure of the LIFO liquidation profit gives them the necessary information. Purchasing three months of inventory also raises issues of obsolescence and the waste of company resources. Finally, the request to meet for a drink after work may be an infringement of the employee's personal time and values. 9-52 ... View Full Document

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