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Chapter 8 - Solution Manual

2 a price shrinkage is brought into the income

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2. A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-down is not
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148 made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer. 3. The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of price advances. 4. The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost one year end and at market at the next year end. 5. The lower of cost or market method values the inventory on the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize. Case 8-6 a. The use of the allowance method based on credit sales to estimate bad debt is consistent with the matching principle because bad debts arise from and are a function of making credit sales. Therefore, bad debt expense for the current period should be matched with current credit sales. This is an income statement approach because the balance in the allowance for bad debts account is ignored when computing bad debt expense. The allowance method based on the balance in accounts receivable is not consistent with the matching principle. This method attempts to value accounts receivable at the amount expected to be collected. The method is facilitated by preparing an aging schedule of accounts receivable and plugging bad debt expense with the adjustment necessary to bring the allowance account to the required balance. Alternatively, the ending balance in accounts receivable can be used to determine the required balance in the allowance account without preparing an aging schedule by using composite percentage. Bad debt expense is then determined in the same manner as when an aging schedule is used. However, neither of these approaches associates bad debt expense with the period of sale, especially for sales made in the last month or two of the period. b. On the balance sheet, the allowance for bad debts is presented as a contra asset account to accounts receivable with the resulting difference representing the accounts receivable net (i.e., their net realizable value). Bad debt expense would generally be included on Carme's income statement with the other operating (selling/general and administrative) expenses for the period.
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