Chapter 8 - Solution Manual

Case 8 5 a cost which has been defined generally as

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Case 8-5 a. Cost, which has been defined generally as the price paid or consideration given to acquire an asset, is the primary basis for accounting for inventories. As applied to inventories, cost means, in principle, the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and production costs but exclude all selling expenses and that portion of general and administrative expenses not clearly related to production. b. Market, as applied to the valuations of inventories, means the current bid price prevailing at the date of the inventory for the particular merchandise in the volume which is usually purchased by the company. The term is applicable to inventories of purchased goods and to the basic elements of cost (materials, labor and overhead) of goods that have been manufactured. Therefore, market means current replacement cost except that it should not exceed the net realizable value (estimated selling price less predicted cost of completion and disposal) and should not be less than net realizable value reduced by an allowance for a normal profit margin. c. The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required, however, when the utility of the goods included in the inventory is less than their cost. This loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower of cost or market rule arose from the accounting convention of providing for all losses and anticipating no profits.) In accordance with the foregoing reasoning the rule of "Cost or market, whichever is lower" may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly interprets operations The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product alternative procedures are suitable. d. The arguments against the use of the lower of cost or market method of valuing inventories include the following: 1. The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over replacement cost) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization a drop in selling price below cost is no more a sustained loss than a rise above cost is a realized gain.
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