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CHAPTER 9 Inventories: Additional Valuation Issues ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions Brief Exercises Exercises Problems Concepts for Analysis 1. Lower-of-cost-or-market. 1, 2, 3, 4, 5, 6 1, 2, 3 1, 2, 3, 4, 5, 6 1, 2, 3, 9, 10 1, 2, 3, 5 2. Inventory accounting changes; relative sales value method; net real-izable value. 7, 8 4 7, 8 3. Purchase commitments. 9 5, 6 9, 10 9 6 4. Gross profit method. 10, 11, 12, 13 7 11, 12, 13, 14, 15, 16, 17 4, 5 5. Retail inventory method. 14, 15, 16 8 18, 19, 20, 22, 23, 26 6, 7, 8, 10, 11 4, 5 6. Presentation and analysis. 17, 18 9 21 9 *7. LIFO retail. 19 10 22, 23 12, 13, 14 *8. Dollar-value LIFO retail. 11 24, 25, 26, 27 11, 13 *9. Special LIFO problems. 28 13, 14 *This material is discussed in an Appendix to the chapter. ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions Brief Exercises Exercises Problems Concepts for Analysis 1. Describe and apply the lower-of-cost-or-market rule. 1, 2, 3, 4 1, 2, 3 1, 2, 3, 4, 5, 6 1, 2, 3, 9, 10 CA9-1, CA9-2, CA9-3, CA9-5 2. Explain when companies value inventories at net realizable value. 5, 6, 7 1, 2, 3 1, 2, 3, 4, 5, 6 1, 2, 3, 9, 10 3. Explain when companies use the relative sales value method to value inventories. 8 4 7, 8 4. Discuss accounting issues related to purchase commitments. 9 5, 6 9, 10 9 CA9-6 5. Determine ending inventory by applying the gross profit method. 10, 11, 12, 13 7 11, 12, 13, 14, 15, 16, 17 4, 5 6. Determine ending inventory by applying the retail inventory method. 14, 15, 16 8 18, 19, 20 6, 7, 8 CA9-4, CA9-5 7. Explain how to report and analyze inventory. 17, 18 9 21 9 *8. Determine ending inventory by applying the LIFO retail methods. 19 10, 11 22, 23, 24, 25, 26, 27, 28 11, 12, 13, 14 *This material is discussed in an Appendix to the chapter. ASSIGNMENT CHARACTERISTICS TABLE Item Description Level of Difficulty Time (minutes) E9-1 Lower-of-cost-or-market. Simple 15–20 E9-2 Lower-of-cost-or-market. Simple 10–15 E9-3 Lower-of-cost-or-market. Simple 15–20 E9-4 Lower-of-cost-or-market—journal entries. Simple 10–15 E9-5 Lower-of-cost-or-market—valuation account. Moderate 20–25 E9-6 Lower-of-cost-or-market—error effect. Simple 10–15 E9-7 Relative sales value method. Simple 15–20 E9-8 Relative sales value method. Simple 12–17 E9-9 Purchase commitments. Simple 05–10 E9-10 Purchase commitments. Simple 15–20 E9-11 Gross profit method. Simple 8–13 E9-12 Gross profit method. Simple 10–15 E9-13 Gross profit method. Simple 15–20 E9-14 Gross profit method. Moderate 15–20 E9-15 Gross profit method. Simple 10–15 E9-16 Gross profit method. Simple 15–20 E9-17 Gross profit method. Moderate 20–25 E9-18 Retail inventory method. Moderate 20–25 E9-19 Retail inventory method. Simple 12–17 E9-20 Retail inventory method. Simple 20–25 E9-21 Analysis of inventories. Simple 10–15 *E9-22 Retail inventory method—conventional and LIFO. Moderate 25–35 *E9-23 Retail inventory method—conventional and LIFO. Moderate 15–20 *E9-24 Dollar-value LIFO retail. Simple 10–15 *E9-25 Dollar-value LIFO retail. Simple 5–10 *E9-26 Conventional retail and dollar-value LIFO retail. Moderate 20–25 *E9-27 Dollar-value LIFO retail. Moderate 20–25 *E9-28 Change to LIFO retail. Simple 10–15 P9-1 Lower-of-cost-or-market. Simple 10–15 P9-2 Lower-of-cost-or-market. Moderate 25–30 P9-3 Entries for lower-of-cost-or-market—cost-of-good- sold and loss. Moderate 30–35 P9-4 Gross profit method. Moderate 20–30 P9-5 Gross profit method. Complex 40–45 P9-6 Retail inventory method. Moderate 20–30 P9-7 Retail inventory method. Moderate 20–30 ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item Description Level of Difficulty Time (minutes) P9-8 Retail inventory method. Moderate 20–30 P9-9 Statement and note disclosure, LCM, and purchase commitment. Moderate 30–40 P9-10 Lower-of-cost-or-market. Moderate 30–40 *P9-11 Conventional and dollar-value LIFO retail. Moderate 30–35 *P9-12 Retail, LIFO retail, and inventory shortage. Moderate 30–40 *P9-13 Change to LIFO retail. Moderate 30–40 *P9-14 Change to LIFO retail; dollar-value LIFO retail. Complex 40–50 CA9-1 Lower-of-cost-or-market. Moderate 15–25 CA9-2 Lower-of-cost-or-market. Moderate 20–30 CA9-3 Lower-of-cost-or-market. Moderate 15–20 CA9-4 Retail inventory method. Moderate 25–30 CA9-5 Cost determination, LCM, retail method. Moderate 15–25 CA9-6 Purchase commitments. Moderate 10–15 SOLUTIONS TO CODIFICATION EXERCISES CE9-1 (a) According to the Master Glossary, Inventory is defined as the aggregate of those items of tangible personal property that have any of the following characteristics: 1. Held for sale in the ordinary course of business 2. In process of production for such sale 3. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory. (b) According to the Master Glossary, the phrase lower-of-cost-or-market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meets both of the following conditions. 1. Market shall not exceed the net realizable value 2. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin. (c) According to the Master Glossary, two definitions are provided for the phrase net realizable value 1. Estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. 2. Valuation of inventories at estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The second definition provides a link to guidance for lower-of-cost-or-market in the agricultural industry (FASB ASC 905-330-35) Growing Crops 35-1 Costs of growing crops shall be accumulated until the time of harvest. Growing crops shall be reported at the lower-of-cost-or-market. > Developing Animals 35-2 Developing animals to be held for sale shall be valued at the lower-of-cost-or-market. CE9-1 (Continued) > Animals Available and Held for Sale 35-3 Animals held for sale shall be valued at either of the following: (a) The lower-of-cost-or-market (b) At sales price less estimated costs of disposal, if all the following conditions exist: 1. The product has a reliable, readily determinable, and realizable market price. 2. The product has relatively insignificant and predictable costs of disposal. 3. The product is available for immediate delivery. Inventories of harvested crops and livestock held for sale and commonly referred to as valued at market are actually valued at net realizable value. > Harvested Crops 35-4 Inventories of harvested crops shall be valued using the same criteria as animals held for sale in the preceding paragraph. CE9-2 According to FASB ASC 330-10-35-1 through 5: Adjustments to Lower-of-Cost-or-Market A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market. Thus, in accounting for inventories, a loss shall be recognized whenever the utility of goods is impaired by damage, deterioration, obsolescence, changes in price levels, or other causes. The measurement of such losses shall be accomplished by applying the rule of pricing inventories at the lower-of-cost-or-market. This provides a practical means of measuring utility and thereby determining the amount of the loss to be recognized and accounted for in the current period. However, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained. Replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility. In addition, when the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss shall be recognized even though replacement or reproduction costs are lower. This might be true, for example, in the case of production under firm sales contracts at fixed prices, or when a reasonable volume of future orders is assured at stable selling prices. In summary, the determination of the amount of the write-off should be based on factors that relate to the net realizable value of the inventory, not the amount that will maximize the loss in the current period. Note that the sale manager’s proposed accounting is an example of “cookie jar” reserves, as discussed in Chapter 4. By writing the inventory down to an unsupported low value, the company can report higher gross profit and net income in subsequent periods when the inventory is sold. CE9-3 According to FASB ASC 330-10-35-6, if inventory has been the hedged item in a fair value hedge, the inventory’s cost basis used in the lower-of-cost-or-market accounting shall reflect the effect of the adjustments of its carrying amount made pursuant to paragraph 815-25-35-1(b). And, according to 815-2-35-1(b), gains and losses on a qualifying fair value hedge shall be accounted for as follows: The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings. CE9-4 See FASB ASC 210-10-S99—Regulation S-X Rule 5-02, Balance Sheets S99-1 The following is the text of Regulation S-X Rule 5-02, Balance Sheets. The purpose of this rule is to indicate the various line items and certain additional disclosures which, if applicable, and except as otherwise permitted by the Commission, should appear on the face of the balance sheets or related notes filed for the persons to whom this article pertains (see § 210.4–01(a)). • ASSETS AND OTHER DEBITS • Current Assets, when appropriate • [See § 210.4–05] • 6. Inventories. – (a) State separately in the balance sheet or in a note thereto, if practicable, the amounts of major classes of inventory such as: • 1. Finished goods; • 2. inventoried cost relating to long-term contracts or programs (see (d) below and § 210.4–05); • 3. work in process (see § 210.4–05); • 4. raw materials; and • 5. supplies. – If the method of calculating a LIFO inventory does not allow for the practical determination of amounts assigned to major classes of inventory, the amounts of those classes may be stated under cost flow assumptions other that LIFO with the excess of such total amount over the aggregate LIFO amount shown as a deduction to arrive at the amount of the LIFO inventory. – (b) The basis of determining the amounts shall be stated. If cost is used to determine any portion of the inventory amounts, the description of this method shall include the nature of the cost elements included in inventory. Elements of cost include, among other items, retained costs representing the excess of manufacturing or production costs over the amounts charged to cost of sales or delivered or in-process units, initial tooling or other deferred startup costs, or general and administrative costs. – The method by which amounts are removed from inventory (e.g., average cost, first-in, first-out, last-in, first-out, estimated average cost per unit) shall be described. If the estimated average cost per unit is used as a basis to determine amounts removed from inventory under a total program or similar basis of accounting, the principal assumptions (including, where meaningful, the aggregate number of units expected to be delivered under the program, the number of units delivered to date and the number of units on order) shall be disclosed. CE9-4 (Continued) – If any general and administrative costs are charged to inventory, state in a note to the financial statements the aggregate amount of the general and administrative costs incurred in each period and the actual or estimated amount remaining in inventory at the date of each balance sheet. – (c) If the LIFO inventory method is used, the excess of replacement or current cost over stated LIFO value shall, if material, be stated parenthetically or in a note to the financial statements. – (d) For purposes of §§ 210.5–02.3 and 210.5–02.6, long-term contracts or programs include • 1. all contracts or programs for which gross profits are recognized on a percentage- of-completion method of accounting or any variant thereof (e.g., delivered unit, cost to cost, physical completion), and • 2. any contracts or programs accounted for on a completed contract basis of accounting where, in either case, the contracts or programs have associated with them material amounts of inventories or unbilled receivables and where such contracts or programs have been or are expected to be performed over a period of more than twelve months. Contracts or programs of shorter duration may also be included, if deemed appropriate. – For all long-term contracts or programs, the following information, if applicable, shall be stated in a note to the financial statements: (i) The aggregate amount of manufacturing or production costs and any related deferred costs (e.g., initial tooling costs) which exceeds the aggregate estimated cost of all inprocess and delivered units on the basis of the estimated average cost of all units expected to be produced under long-term contracts and programs not yet complete, as well as that portion of such amount which would not be absorbed in cost of sales on existing firm orders at the latest balance sheet date. In addition, if practicable, disclose the amount of deferred costs by type of cost (e.g., initial tooling, deferred production, etc.) (ii) The aggregate amount representing claims or other similar items subject to uncertainty concerning their determination or ultimate realization, and include a description of the nature and status of the principal items comprising such aggregate amount. (iii) The amount of progress payments netted against inventory at the date of the balance sheet. ANSWERS TO QUESTIONS 1. Where there is evidence that the utility of goods to be disposed of in the ordinary course of business will be less than cost, the difference should be recognized as a loss in the current period, and the inventory should be stated at market value in the financial statements. 2. The upper (ceiling) and lower (floor) limits for the value of the inventory are intended to prevent the inventory from being reported at an amount in excess of the net realizable value or at an amount less than the net realizable value less a normal profit margin. The maximum limitation, not to exceed the net realizable value (ceiling) covers obsolete, damaged, or shopworn material and prevents overstatement of inventories and understatement of the loss in the current period. The minimum limitation deters understatement of inventory and overstatement of the loss in the current period. 3. The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required 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 reflects 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. The arguments against the use of the lower-of-cost-or-market method of valuing inventories include the following: (a) 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 replacement cost below original cost is no more a sustained loss than a rise above cost is a realized gain. (b) 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-downs is not 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. (c) 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 the price increases. (d) 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 in one year and at market in the next year. (e) The lower-of-cost-or-market method values the inventory in 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. Questions Chapter 9 (Continued) (f) In the application of the lower-of-cost-or-market rule a prospective “normal profit” is used in determining inventory values in certain cases. Since “normal profit” is an estimated figure based upon past experiences (and might not be attained in the future), it is not objective in nature and presents an opportunity for manipulation of the results of operations. 4. The lower-of-cost-or-market rule may be applied directly to each item or to the total of the inventory (or in some cases, to the total of the components of each major category). The method should be the one that most clearly reflects income. The most common practice is to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax requirements require that an individual-item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet purposes. 5. (1) $14.50. (2) $16.10. (3) $13.75. (4) $9.70. (5) $15.90. 6. One approach is to record the inventory at cost and then reduce it to market, thereby reflecting a loss in the current period (often referred to as the loss method). The loss would then be shown as a separate item in the income statement and the cost of goods sold for the year would not be distorted by its inclusion. An objection to this method of valuation is that an inconsistency is created between the income statement and balance sheet. In attempting to meet this inconsistency some have advocated the use of a special account to receive the credit for such an inventory write-down, such as Allowance to Reduce Inventory to Market which is a contra account against inventory on the balance sheet. It should be noted that the disposition of this account presents problems to accountants. Another approach is merely to substitute market for cost when pricing the new inventory (often referred to as the cost-of-goods-sold method). Such a procedure increases cost of goods sold by the amount of the loss and fails to reflect this loss separately. For this reason, many theoretical objections can be raised against this procedure. 7. An exception to the normal recognition rule occurs where (1) there is a controlled market with a quoted price applicable to specific commodities and (2) no significant costs of disposal are involved. Certain agricultural products and precious metals which are immediately marketable at quoted prices are often valued at net realizable value (market price). 8. Relative sales value is an appropriate basis for pricing inventory when a group of varying units is purchased at a single lump-sum price (basket purchase). The purchase price must be allocated in some manner or on some basis among the various units. When the units vary in size, character, and attractiveness, the basis for allocation must reflect both quantitative and qualitative aspects. A suitable basis then is the relative sales value of the units that comprise the inventory. 9. The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made [($6.20 – $5.90) X 150,000] = $45,000: Unrealized Holding Gain or Loss—Income (Purchase Commitments) 45,000 Estimated Liability on Purchase Commitments 45,000 The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet with an appropriate note indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract. Questions Chapter 9 (Continued) 10. The major uses of the gross profit method are: (1) it provides an approximation of the ending inventory which the auditor might use for testing validity of physical inventory count; (2) it means that a physical count need not be taken every month or quarter; and (3) it helps in determining damages caused by casualty when inventory cannot be counted. 11. Gross profit as a percentage of sales indicates that the markup is based on selling price rather than cost; for this reason the gross profit as a percentage of selling price will always be lower than if based on cost. Conversions are as follows: 25% on cost = 20% on selling price 33 1/3% on cost = 25% on selling price 33 1/3% on selling price = 50% on cost 60% on selling price = 150% on cost 12. A markup of 25% on cost equals a 20% markup on selling price; therefore, gross profit equals $1,000,000 ($5 million X 20%) and net income equals $250,000 [$1,000,000 – (15% X $5 million)]. The following formula was used to compute the 20% markup on selling price: Gross profit on selling price = Percentage markup on cost = .25 = 20% 100% + Percentage markup on cost 1 + .25 13. Inventory, January 1, 2014 $ 400,000 Purchases to February 10, 2014 $1,140,000 Freight-in to February 10, 2014 60,000 1,200,000 Merchandise available 1,600,000 Sales revenue to February 10, 2014 1,950,000 Less gross profit at 40% 780,000 Sales at cost 1,170,000 Inventory (approximately) at February 10, 2014 $ 430,000 14. The validity of the retail inventory method is dependent upon (1) the composition of the inventory remaining approximately the same at the end of the period as it was during the period, and (2) there being approximately the same rate of markup at the end of the year as was used throughout the period. The retail method, though ordinarily applied on a departmental basis, may be appropriate for the business as a unit if the above conditions are met. 15. The conventional retail method is a statistical procedure based on averages whereby inventory figures at retail are reduced to an inventory valuation figure by multiplying the retail figures by a percentage which is the complement of the markup percent. To determine the markup percent, original markups and additional net markups are related to the original cost. The complement of the markup percent so determined is then applied to the inventory at retail after the latter has been reduced by net markdowns, thus in effect achieving a lower-of-cost-or-market valuation. An example of reduction to market follows: Assume purchase of 100 items at $1 each, marked to sell at $1.50 each, at which price 80 were sold. The remaining 20 are marked down to $1.15 each. The inventory at $15.33 is $4.67 below original cost and is valued at an amount which will produce the “normal” 33 1/3% gross profit if sold at the present retail price of $23.00. Questions Chapter 9 (Continued) Computation of Inventory Cost Retail Ratio Purchases $100 $150 66 2/3% Sales revenue (120) Markdowns (20 X $.35) (7) Inventory at retail $ 23 Inventory at lower-of-cost-or-market $23 X 66 2/3% = $15.33 16. (a) Ending inventory: Cost Retail Beginning inventory $ 149,000 $ 283,500 Purchases 1,400,000 2,160,000 Freight-in 70,000   Totals 1,619,000 2,443,500 Add net markups _________ 92,000 $1,619,000 2,535,500 Deduct net markdowns 48,000 2,487,500 Deduct sales revenue 2,175,000 Ending inventory, at retail $ 312,500 Ratio of cost to selling price $1,619,000 = 63.85%. $2,535,500 Ending inventory estimated at cost = 64% X $312,500 = $200,000. (b) The retail method, above, showed an ending inventory at retail of $312,500; therefore, merchandise not accounted for amounts to $17,500 ($312,500 – $295,000) at retail and $11,200 ($17,500 X .64) at cost. 17. Information relative to the composition of the inventory (i.e., raw material, work-in-process, and finished goods); the inventory financing where significant or unusual (transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidations of LIFO inventories, pledging inventories as collateral); and the inventory costing methods employed (lower-of-cost-or-market, FIFO, LIFO, average cost) should be disclosed. If Deere Company uses LIFO, it should also report the LIFO reserve. 18. Inventory turnover measures how quickly inventory is sold. Generally, the higher the inventory turnover, the better the enterprise is performing. The more times the inventory turns over, the smaller the net margin can be to earn an appropriate total profit and return on assets. For example, a company can price its goods lower if it has a high inventory turnover. A company with a low profit margin, such as 2%, can earn as much as a company with a high net profit margin, such as 40%, if its inventory turnover is often enough. To illustrate, a grocery store with a 2% profit margin can earn as much as a jewelry store with a 40% profit margin and an inventory turnover of 1 if its turnover is more than 20 times. 19. Two major modifications are necessary. First, the beginning inventory should be excluded from the numerator and denominator of the cost-to-retail percentage and second, markdowns should be included in the denominator of the cost-to-retail percentage. SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 9-1 (a) Ceiling $193.00 ($212 – $19) Floor $161.00 ($212 – $19 – $32) (b) $106.00 (c) $51.00 BRIEF EXERCISE 9-2 Item Cost Designated Market LCM Jokers $2,000 $2,050 $2,000 Penguins 5,000 4,950 4,950 Riddlers 4,400 4,550 4,400 Scarecrows 3,200 3,070 3,070 BRIEF EXERCISE 9-3 (a) Cost-of-goods-sold method Cost of Goods Sold 21,000 Allowance to Reduce Inventory to Market 21,000* *($286,000 – $265,000) (b) Loss method Loss Due to Market Decline of Inventory 21,000 Allowance to Reduce Inventory to Market 21,000 BRIEF EXERCISE 9-4 Group Number of CDs Sales Price per CD Total Sales Price Relative Sales Price Total Cost Cost Allocated to CDs Cost per CD 1 100 $ 5 $ 500 5/100* X $8,000 = $ 400 $ 4** 2 800 $10 8,000 80/100 X $8,000 = 6,400 $ 8 3 100 $15 1,500 15/100 X $8,000 = 1,200 $12 $10,000 $8,000 *$500/$10,000 = 5/100 **$400/100 = $4 BRIEF EXERCISE 9-5 Unrealized Holding Loss—Income (Purchase Commitments) 50,000 Estimated Liability on Purchase Commitments ($1,000,000 – $950,000) 50,000 BRIEF EXERCISE 9-6 Purchases (Inventory) 950,000 Estimated Liability on Purchase Commitments 50,000 Cash 1,000,000 BRIEF EXERCISE 9-7 Beginning inventory $150,000 Purchases 500,000 Cost of goods available 650,000 Sales revenue $700,000 Less gross profit (35% X 700,000) 245,000 Estimated cost of goods sold 455,000 Estimated ending inventory destroyed in fire $195,000 BRIEF EXERCISE 9-8 Cost Retail Beginning inventory $ 12,000 $ 20,000 Net purchases 120,000 170,000 Net markups   10,000 Totals $132,000 200,000 Deduct: Net markdowns 7,000 Sales revenue 147,000 Ending inventory at retail $ 46,000 Cost-to-retail ratio: $132,000 ÷ $200,000 = 66% Ending inventory at lower-of cost-or-market (66% X $46,000) = $30,360 BRIEF EXERCISE 9-9 Inventory turnover: $9,275 = 5.73 times $1,615 + $1,620 2 Average days to sell inventory: 365 ÷ 5.73 = 63.7 days *BRIEF EXERCISE 9-10 Cost Retail Beginning inventory $ 12,000 $ 20,000 Net purchases 120,000 170,000 Net markups 10,000 Net markdowns                 (7,000) Total (excluding beginning inventory) 120,000   173,000 Total (including beginning inventory) $132,000 193,000 Deduct: Sales revenue 147,000 Ending inventory at retail $ 46,000 Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at cost $20,000 X 60% ($12,000/$20,000) = $12,000 26,000 X 69.4% = 18,044 $46,000 $30,044 *BRIEF EXERCISE 9-11 Cost Retail Beginning inventory $ 12,000 $ 20,000 Net purchases 120,000 170,000 Net markups 10,000 Net markdowns                 (7,000) Total (excluding beginning inventory) 120,000   173,000 Total (including beginning inventory) $132,000 193,000 Deduct: Sales revenue 147,000 Ending inventory at retail $ 46,000 *BRIEF EXERCISE 9-11 (Continued) Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at retail deflated to base year prices $46,000 ÷ 1.15 = $40,000 Ending inventory at cost $20,000 X 100% X 60% = $12,000 20,000 X 115% X 69.4% = 15,962 $27,962 SOLUTIONS TO EXERCISES EXERCISE 9-1 (15–20 minutes) Per Unit Lower-of- Part No. Quantity Cost Market Total Cost Total Market Cost-or-Market 110 600 $ 90 $100.00 $ 54,000 $ 60,000 $ 54,000 111 1,000 60 52.00 60,000 52,000 52,000 112 500 80 76.00 40,000 38,000 38,000 113 200 170 180.00 34,000 36,000 34,000 120 400 205 208.00 82,000 83,200 82,000 121 1,600 16 0.20 25,600 320 320 122 300 240 235.00 72,000 70,500 70,500 Totals $367,600 $340,020 $330,820 $330,820. (b) $340,020. EXERCISE 9-2 (10–15 minutes) Item Net Realizable Value (Ceiling) Net Realizable Value Less Normal Profit (Floor) Replacement Cost Designated Market Cost LCM D $90* $70** $120 $90 $75 $75 E 80 60 72 72 80 72 F 65 45 70 65 80 65 G 65 45 30 45 80 45 H 80 60 70 70 50 50 I 60 40 30 40 36 36 *Estimated selling price – Estimated selling expense = $120 – $30 = $90. **Net realizable value – Normal profit margin = $90 – $20 = $70. EXERCISE 9-3 (15–20 minutes) Item No. Cost per Unit Replacement Cost Net Realizable Value Net Real. Value Less Normal Profit Designated Market Value Quantity Final Inventory Value 1320 $3.20 $3.00 $4.15* $2.90** $3.00 1,200 $ 3,600 1333 2.70 2.30 3.00 2.50 2.50 900 2,250 1426 4.50 3.70 4.60 3.60 3.70 800 2,960 1437 3.60 3.10 2.95 2.05 2.95 1,000 2,950 1510 2.25 2.00 2.45 1.85 2.00 700 1,400 1522 3.00 2.70 3.40 2.90 2.90 500 1,450 1573 1.80 1.60 1.75 1.25 1.60 3,000 4,800 1626 4.70 5.20 5.50 4.50 5.20 1,000 4,700*** $24,110 *$4.50 – $.35 = $4.15. **$4.15 – $1.25 = $2.90. ***Cost is used because it is lower than designated market value. EXERCISE 9-4 (10–15 minutes) (a) 12/31/13 Cost of Goods Sold 19,000 Inventory 19,000 12/31/13 Cost of Goods Sold 15,000 Inventory 15,000 (b) 12/31/14 Loss Due to Market Decline of Inventory 19,000 Allowance to Reduce Inventory to Market 19,000 12/31/14 Allowance to Reduce Inventory to Market 4,000* Loss Due to Market Decline of Inventory 4,000 EXERCISE 9-4 (Continued) *Cost of inventory at 12/31/13 $346,000 Lower of cost or market at 12/31/13 (327,000) Allowance amount needed to reduce inventory to market (a) $ 19,000 Cost of inventory at 12/31/14 $410,000 Lower of cost or market at 12/31/14 (395,000) Allowance amount needed to reduce inventory to market (b) $ 15,000 Recovery of previously recognized loss = (a) – (b) = $19,000 – $15,000 = $4,000. (c) Both methods of recording lower-of-cost-or-market adjustments have the same effect on net income. EXERCISE 9-5 (20–25 minutes) (a) February March April Sales revenue $29,000 $35,000 $40,000 Cost of goods sold Inventory, beginning 15,000 15,100 17,000 Purchases 20,000 24,000 26,500 Cost of goods available 35,000 39,100 43,500 Inventory, ending 15,100 17,000 13,000 Cost of goods sold 19,900 22,100 30,500 Gross profit 9,100 12,900 9,500 Gain (loss) due to market fluctuations of inventory* (2,000) 1,100 700 $ 7,100 $14,000 $10,200 EXERCISE 9-5 (Continued) * Jan. 31 Feb. 28 Mar. 31 Apr. 30 Inventory at cost $15,000 $15,100 $17,000 $13,000 Inventory at the lower-of-cost- or-market 14,500 12,600 15,600 12,300 Allowance amount needed to reduce inventory to market $ 500 $ 2,500 $ 1,400 $ 700 Gain (loss) due to market fluctuations of inventory** $ (2,000) $ 1,100 $ 700 **$500 – $2,500 = $(2,000) $2,500 – $1,400 = $1,100 $1,400 – $700 = $700 (b) Jan. 31 Loss Due to Market Decline of Inventory 500 Allowance to Reduce Inventory to Market 500 Feb. 28 Loss Due to Market Decline of Inventory 2,000 Allowance to Reduce Inventory to Market 2,000 Mar. 31 Allowance to Reduce Inventory to Market 1,100 Recovery of Loss Due to Market Decline of Inventory 1,100 Apr. 30 Allowance to Reduce Inventory to Market 700 Recovery of Loss Due to Market Decline of Inventory 700 EXERCISE 9-6 Net realizable value (ceiling) $45 – $14 = $31 Net realizable value less normal profit (floor) $31 – $ 9 = $22 Replacement cost $35 Designated market $31 Ceiling Cost $40 Lower-of-cost-or-market $31 $35 figure used – $31 correct value per unit = $4 per unit. $4 X 1,000 units = $4,000. If ending inventory is overstated, net income will be overstated. If beginning inventory is overstated, net income will be understated. Therefore, net income for 2013 was overstated by $4,000 and net income for 2014 was understated by $4,000. EXERCISE 9-7 (15–20 minutes) Cost Per Lot (Cost Allocated/ No. of Lots) $2,100 2,800 1,680 Cost Allocated to Lots $18,900 42,000 28,560 $89,460 Total Cost $89,460 89,460 89,460 X X X Relative Sales Price $27,000/$127,800 $60,000/$127,800 $40,800/$127,800 $80,000 56,000 24,000 18,200 $ 5,800 Gross Profit $ 3,600 9,600 10,800 $24,000 Total Sales Price $ 27,000 60,000 40,800 $127,800 Sales revenue (see schedule) Cost of goods sold (see schedule) Gross profit Operating expenses Net income Sales $12,000 32,000 36,000 $80,000 Sales Price Per Lot $3,000 4,000 2,400 Cost Cost of Per Lots Lot Sold $2,100 $ 8,400 2,800 22,400 1,680 25,200 $56,000 No. of Lots 9 15 17 Number of Lots Sold* 4 8 15 27 * 9 – 5 = 4 15 – 7 = 8 17 – 2 = 15 Group 1 Group 2 Group 3 Group 1 Group 2 Group 3 Total EXERCISE 9-8 (12–17 minutes) Cost per Chair $56.70 50.40 31.50 Cost Allocated to Chairs $22,680 15,120 22,050 $59,850 Total Cost $59,850 59,850 59,850 Gross Profit $ 6,660 2,960 2,220 $11,840 X X X Relative Sales Price $36,000/$95,000 $24,000/$95,000 $35,000/$95,000 Sales $18,000 8,000 6,000 $32,000 Total Sales Price $36,000 24,000 35,000 $95,000 Cost of Chairs Sold $11,340 5,040 3,780 $20,160 Sales Price per Lot $90 80 50 Cost per Chair $56.70 50.40 31.50 Inventory of straight chairs (700 – 120) X $31.50 = $18,270 No. of Chairs 400 300 700 Number of Chairs Sold 200 100 120 Chairs Lounge chairs Armchairs Straight chairs Chairs Lounge chairs Armchairs Straight chairs EXERCISE 9-9 (5–10 minutes) Unrealized Holding Gain or Loss—Income (Purchase Commitments) 35,000 Estimated Liability on Purchase Commitments ($400,000 – $365,000) 35,000 EXERCISE 9-10 (15–20 minutes) If the commitment is material in amount, there should be a footnote in the balance sheet stating the nature and extent of the commitment. The footnote may also disclose the market price of the materials. The excess of market price over contracted price is a gain contingency which per FASB Statement No. 5 cannot be recognized in the accounts until it is realized. The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made: Unrealized Holding Gain or Loss—Income (Purchase Commitments) 10,800 Estimated Liability on Purchase Commitments [$36,000 X ($3.00 – $2.70)] 10,800 The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet, with an appropriate footnote indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract. Assuming the $10,800 market decline entry was made on December 31, 2014, as indicated in (b), the entry when the materials are received in January 2015 would be: Raw Materials 97,200 Estimated Liability on Purchase Commitments 10,800 Accounts Payable 108,000 EXERCISE 9-10 (Continued) This entry records the raw materials at the actual cost, eliminates the $10,800 liability set up at December 31, 2014, and records the contrac-tual liability for the purchase. This permits operations to be charged this year with the $97,200, the other $10,800 of the cost having been charged to operations in 2014. EXERCISE 9-11 (8–13 minutes) 1. 20% = 16.67% OR 16 2/3%. 100% + 20% 2. 25% = 20%. 100% + 25% 3. 33 1/3% = 25%. 100% + 33 1/3% 4. 50% = 33.33% OR 33 1/3%. 100% + 50% EXERCISE 9-12 (10–15 minutes) (a) Inventory, May 1 (at cost) $160,000 Purchases (at cost) 640,000 Purchase discounts (12,000) Freight-in 30,000 Goods available (at cost) 818,000 Sales revenue (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less: Gross profit (30% of $930,000) 279,000 Net sales (at cost) 651,000 Approximate inventory, May 31 (at cost) $167,000 EXERCISE 9-12 (Continued) Gross profit as a percent of sales must be computed: 30% = 23.08% of sales. 100% + 30% Inventory, May 1 (at cost) $160,000 Purchases (at cost) 640,000 Purchase discounts (12,000) Freight-in 30,000 Goods available (at cost) 818,000 Sales revenue (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less: Gross profit (23.08% of $930,000) 214,644 Net sales (at cost) 715,356 Approximate inventory, May 31 (at cost) $102,644 EXERCISE 9-13 (15–20 minutes) (a) Merchandise on hand, January 1 $ 38,000 Purchases 72,000 Less: Purchase returns and allowances (2,400) Freight-in 3,400 Total merchandise available (at cost) 111,000 Cost of goods sold* 75,000 Ending inventory 36,000 Less: Undamaged goods 10,900 Estimated fire loss $ 25,100 *Gross profit = 33 1/3% = 25% of sales. 100% + 33 1/3% Cost of goods sold = 75% of sales of $100,000 = $75,000. EXERCISE 9-13 (Continued) (b) Cost of goods sold = 66 2/3% of sales of $100,000 = $66,667 Total merchandise available (at cost) [$111,000 (as computed above) – $66,667] $44,333 Less: Undamaged goods 10,900 Estimated fire loss $33,433 EXERCISE 9-14 Beginning inventory $170,000 Purchases 390,000 560,000 Purchase returns (30,000) Goods available (at cost) 530,000 Sales revenue $650,000 Sales returns (24,000) Net sales 626,000 Less: Gross profit (40% X $626,000) (250,400) 375,600 Estimated ending inventory (unadjusted for damage) 154,400 Less: Goods on hand—undamaged (at cost) $21,000 X (1 – 40%) (12,600) Less: Goods on hand—damaged (at net realizable value) (5,300) Fire loss on inventory $136,500 EXERCISE 9-15 (10–15 minutes) Beginning inventory (at cost) $ 38,000 Purchases (at cost) 85,000 Goods available (at cost) 123,000 Sales revenue (at selling price) $116,000 Less sales returns 4,000 Net sales 112,000 Less: Gross profit* (2/7 of $112,000) 32,000 Net sales (at cost) 80,000 Estimated inventory (at cost) 43,000 Less: Goods on hand ($30,500 – $6,000) 24,500 Claim against insurance company $ 18,500 *Computation of gross profit: 40% = 2/7 of selling price 100% + 40% Note: Depending on details of the consignment agreement and Duncan’s insurance policy, the consigned goods might be considered owned for insurance purposes. EXERCISE 9-16 (15–20 minutes) Lumber Millwork Hardware Inventory 1/1/14 (cost) $ 250,000 $ 90,000 $ 45,000 Purchases to 8/18/14 (cost) 1,500,000 375,000 160,000 Cost of goods available 1,750,000 465,000 205,000 Deduct cost of goods sold* 1,664,000 410,000 150,000 Inventory 8/18/14 $ 86,000 $ 55,000 $ 55,000 *(See computations on next page) EXERCISE 9-16 (Continued) Computation for cost of goods sold:* Lumber: $2,080,000 = $1,664,000 1.25 Millwork: $533,000 = $410,000 1.30 Hardware: $210,000 = $150,000 1.40 *Alternative computation for cost of goods sold: Markup on selling price: Cost of goods sold: Lumber: 25% = 20% or 1/5 $2,080,000 X 80% = $1,664,000 100% + 25% Millwork: 30% = 3/13 $533,000 X 10/13 = $410,000 100% + 30% Hardware: 40% = 2/7 $210,000 X 5/7 = $150,000 100% + 40% EXERCISE 9-17 (20–25 minutes) Ending inventory: (a) Gross profit is 45% of sales Total goods available for sale (at cost) $2,100,000 Sales (at selling price) $2,500,000 Less: Gross profit (45% of sales) 1,125,000 Sales (at cost) 1,375,000 Ending inventory (at cost) $ 725,000 (b) Gross profit is 60% of cost 60% = 37.5% markup on selling price 100% + 60% Total goods available for sale (at cost) $2,100,000 Sales (at selling price) $2,500,000 Less: Gross profit (37.5% of sales) 937,500 Sales (at cost) 1,562,500 Ending inventory (at cost) $ 537,500 (c) Gross profit is 35% of sales Total goods available for sale (at cost) $2,100,000 Sales (at selling price) $2,500,000 Less: Gross profit (35% of sales) 875,000 Sales (at cost) 1,625,000 Ending inventory (at cost) $ 475,000 EXERCISE 9-17 (Continued) (d) Gross profit is 25% of cost 25% = 20% markup on selling price 100% + 25% Total goods available for sale (at cost) $2,100,000 Sales (at selling price) $2,500,000 Less: Gross profit (20% of sales) 500,000 Sales (at cost) 2,000,000 Ending inventory (at cost) $ 100,000 EXERCISE 9-18 (20–25 minutes) (a) Cost Retail Beginning inventory $ 58,000 $100,000 Purchases 122,000 200,000 Net markups _______ 10,345 Totals $180,000 310,345 Net markdowns (26,135) Sales price of goods available 284,210 Deduct: Sales revenue 186,000 Ending inventory at retail $ 98,210 (b) 1. $180,000 ÷ $300,000 = 60% 2. $180,000 ÷ $273,865 = 65.73% 3. $180,000 ÷ $310,345 = 58% 4. $180,000 ÷ $284,210 = 63.33% EXERCISE 9-18 (Continued) (c) 1. Method 3. 2. Method 3. 3. Method 3. (d) 58% X $98,210 = $56,962 (e) $180,000 – $56,962 = $123,038 (f) $186,000 – $123,038 = $62,962 EXERCISE 9-19 (12–17 minutes) Cost Retail Beginning inventory $ 200,000 $ 280,000 Purchases 1,375,000 2,140,000 Totals 1,575,000 2,420,000 Add: Net markups Markups $95,000 Markup cancellations _________ (15,000) 80,000 Totals $1,575,000 2,500,000 Deduct: Net markdowns Markdowns 35,000 Markdowns cancellations (5,000) 30,000 Sales price of goods available 2,470,000 Deduct: Sales revenue 2,200,000 Ending inventory at retail $ 270,000 Cost-to-retail ratio = $1,575,000 = 63% $2,500,000 Ending inventory at cost = 63% X $270,000 = $170,100 EXERCISE 9-20 (20–25 minutes) Cost Retail Beginning inventory $30,000 $ 46,500 Purchases 48,000 88,000 Purchase returns (2,000) (3,000) Freight on purchases 2,400 _______ Totals 78,400 131,500 Add: Net markups Markups $10,000 Markup cancellations (1,500) Net markups _______ 8,500 Totals $78,400 140,000 Deduct: Net markdowns Markdowns 9,300 Markdowns cancellations (2,800) Net markdowns 6,500 Sales price of goods available 133,500 Deduct: Net sales ($99,000 – $2,000) 97,000 Ending inventory, at retail $ 36,500 Cost-to-retail ratio = $78,400 = 56% $140,000 Ending inventory at cost = 56% X $36,500 = $20,440 EXERCISE 9-21 (10–15 minutes) Inventory turnover: 2012 2011 $10,436 = 5.7 times $9,390 = 5.5 times $1,870 + $1,803 $1,803 + $1,598 2 2 Average days to sell inventory: 2012 2011 365 ÷ 5.7 = 64 days 365 ÷ 5.5 = 66 days *EXERCISE 9-22 (25–35 minutes) (a) Conventional Retail Method Cost Retail Inventory, January 1, 2013 $ 38,100 $ 60,000 Purchases (net) 130,900 178,000 169,000 238,000 Add: Net markups ________ 22,000 Totals $169,000 260,000 Deduct: Net markdowns 13,000 Sales price of goods available 247,000 Deduct: Sales (net) 167,000 Ending inventory at retail $ 80,000 Cost-to-retail ratio = $169,000 = 65% $260,000 Ending inventory at cost = 65% X $80,000 = $52,000 (b) LIFO Retail Method Cost Retail Inventory, January 1, 2013 $ 38,100 $ 60,000 Net purchases 130,900 178,000 Net markups 22,000 Net markdowns (13,000) Total (excluding beginning inventory) 130,900 187,000 Total (including beginning inventory) $169,000 247,000 Deduct sales (net) 167,000 Ending inventory at retail $ 80,000 Cost-to-retail ratio = $130,900 = 70% $187,000 *EXERCISE 9-22 (Continued) Computation of ending inventory at LIFO cost, 2014: Ending Inventory at Retail Prices Layers at Retail Prices Cost to Retail (Percentage) Ending Inventory at LIFO Cost $80,000 2013 $60,000 X 63.5%* $38,100 2014 20,000 X 70.0% 14,000 $52,100 *$38,100 (prior years cost to retail) $60,000 *EXERCISE 9-23 (15–20 minutes) (a) Cost Retail Inventory, January 1, 2014 $14,000 $ 20,000 Net purchases 58,800 81,000 Freight-in 7,500 Net markups   9,000 Totals $80,300 110,000 Sales revenue (80,000) Net markdowns (1,600) Estimated theft (2,000) Ending inventory at retail $ 26,400 Cost-to-retail ratio: $80,300 = 73% $110,000 Ending inventory at lower-of-average-cost-or-market = $26,400 X 73% = $19,272 *EXERCISE 9-23 (Continued) (b) Cost Retail Purchases $58,800 $81,000 Freight-in 7,500 Net markups 9,000 Net markdowns               (1,600) Totals $66,300 $88,400 Cost-to-retail ratio: $66,300 = 75% $88,400 The increment at retail is $26,400 – $20,000 = $6,400. The increment is costed at 75% X $6,400 = $4,800. Ending inventory at LIFO retail: Cost Retail Beginning inventory, 2014 $14,000 $20,000 Increment 4,800 6,400 Ending inventory, 2014 $18,800 $26,400 *EXERCISE 9-24 (10–15 minutes) (a) Cost-to-retail ratio—beginning inventory: $216,000 = 72% $300,000 *($294,300 ÷ 1.09) X 72% = $194,400 *Since the above computation reveals that the inventory quantity has declined below the beginning level, it is necessary to convert the ending inventory to beginning-of-the-year prices (by dividing by 1.09) and then multiply it by the beginning cost-to-retail ratio (72%). *EXERCISE 9-24 (Continued) (b) Ending inventory at retail prices deflated $365,150 ÷ 1.09 $335,000 Beginning inventory at beginning-of-year prices 300,000 Inventory increase in terms of beginning-of-year dollars $ 35,000 Beginning inventory (at cost) $216,000 Additional layer, $35,000 X 1.09 X 76%* 28,994 $244,994 *($364,800 ÷ $480,000) *EXERCISE 9-25 (5–10 minutes) Ending inventory at retail (deflated) $100,100 ÷ 1.10 $91,000 Beginning inventory at retail 74,500 Increment at retail $16,500 Ending inventory on LIFO basis Cost First layer $36,000 Second layer ($16,500 X 1.10 X 60%) 10,890 $46,890 *EXERCISE 9-26 (20–25 minutes) (a) Cost Retail Beginning inventory $ 30,100 $ 50,000 Net purchases 108,500 150,000 Net markups ________ 10,000 Totals $138,600 210,000 Net markdowns (5,000) Sales revenue (126,900) Ending inventory at retail $ 78,100 Cost-retail ratio = 66% ($138,600/$210,000) Ending inventory at cost ($78,100 X 66%) $ 51,546 (b) Cost Retail Beginning inventory $ 30,100 $ 50,000 Net purchases 108,500 150,000 Net markups 10,000 Net markdowns   (5,000) Total (excluding beginning inventory) 108,500 155,000 Total (including beginning inventory) $138,600 205,000 Sales revenue (126,900) Ending inventory at retail (current) 78,100 Ending inventory at retail (base year) ($78,100 ÷ 1.10) $ 71,000 Cost-to-retail ratio for new layer: $108,500/$155,000 = 70% Layers: Base layer $50,000 X 1.00 X 60.2%* = $ 30,100 New layer ($71,000 – $50,000) X 1.10 X 70% = 16,170 $ 46,270 *($30,100/$50,000) (c) Cost of goods available for sale $138,600 Ending inventory at cost, from (b) 46,270 Cost of goods sold $ 92,330 *EXERCISE 9-27 (20–25 minutes) 2013 Restate to base-year retail ($118,720 ÷ 1.06) $112,000 Layers: 1. $100,000 X 1.00 X 54%* = $ 54,000 2. $ 12,000 X 1.06 X 57% = 7,250 Ending inventory $ 61,250 *$54,000 ÷ $100,000 2014 Restate to base-year retail ($138,750 ÷ 1.11) $125,000 Layers: 1. $100,000 X 1.00 X 54% = $ 54,000 2. $ 12,000 X 1.06 X 57% = 7,250 3. $ 13,000 X 1.11 X 60% = 8,658 Ending inventory $ 69,908 2015 Restate to base-year retail ($125,350 ÷ 1.15) $109,000 Layers: 1. $100,000 X 1.00 X 54% = $ 54,000 2. $ 9,000 X 1.06 X 57% = 5,438 Ending inventory $ 59,438 2016 Restate to base-year retail ($162,500 ÷ 1.25) $130,000 Layers: 1. $100,000 X 1.00 X 54% = $ 54,000 2. $ 9,000 X 1.06 X 57% = 5,438 3. $ 21,000 X 1.25 X 58% = 15,225 Ending inventory $ 74,663 *EXERCISE 9-28 (5–10 minutes) Inventory (beginning) 7,600 Adjustment to Record Inventory at Cost* 7,600 ($212,600 – $205,000) *Note: This account is an income statement account showing the effect of changing from a lower-of-cost-or-market approach to a straight cost basis. TIME AND PURPOSE OF PROBLEMS Problem 9-1 (Time 10–15 minutes) Purpose—to provide the student with an understanding of the lower-of-cost-or-market approach to inventory valuation, similar to Problem 9-2. The major difference between these problems is that Problem 9-1 provides some ambiguity to the situation by changing the catalog prices near the end of the year. Problem 9-2 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the lower-of-cost-or-market approach to inventory valuation. The student is required to examine a number of individual items and apply the lower-of-cost-or-market rule and to also explain the use and value of the lower-of-cost-or-market rule. Problem 9-3 (Time 30–35 minutes) Purpose—to provide a problem that requires entries for reducing inventory to lower-of-cost-or-market under the perpetual inventory system using both the cost-of-goods-sold and the loss methods. Problem 9-4 (Time 20–30 minutes) Purpose—to provide another problem where a fire loss must be computed using the gross profit method. Certain goods remained undamaged and therefore an adjustment is necessary. In addition, the inventory was subject to an obsolescence factor which must be considered. Problem 9-5 (Time 40–45 minutes) Purpose—to provide the student with a complex problem involving a fire loss where the gross profit method must be employed. The problem is complicated because a number of adjustments must be made to the purchases account related to merchandise returned, unrecorded purchases, and shipments in transit. In addition, some cash to accrual computations are necessary. Problem 9-6 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. The problem is relatively straightforward although transfers-in from other departments as well as the proper treatment for normal spoilage complicate the problem. A good problem that summarizes the essentials of the retail inventory method. Problem 9-7 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problem 9-6, except that a few different items must be evaluated in finding ending inventory at retail and cost. Unusual items in this problem are employee discounts granted and loss from breakage. A good problem that summarizes the essentials of the retail inventory method. Problem 9-8 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problems 9-6 and 9-7, except that the student is asked to list the factors that may have caused the difference between the computed inventory and the physical count. Problem 9-9 (Time 30–40 minutes) Purpose—to provide the student with a problem requiring financial statement and note disclosure of inventories, the income statement disclosure of an inventory market decline, and the treatment of purchase commitments. Problem 9-10 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to write a memo explaining what is designated market value and how it is computed. As part of this memo, the student is required to compute inventory on the lower-of-cost-or-market basis using the individual item approach. Time and Purpose of Problems (Continued) *Problem 9-11 (Time 30–35 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. An excellent problem for highlighting the difference between these two approaches to inventory valuation. It should be noted that the cost-to-retail per-centage is given for LIFO so less computation is necessary. *Problem 9-12 (Time 30–40 minutes) Purpose—to provide the student with a comprehensive problem covering the retail and LIFO retail inventory methods, the computation of an inventory shortage, and the treatment of four special items relative to the retail inventory method. *Problem 9-13 (Time 30–40 minutes) Purpose—to provide the student with a basic problem illustrating the change from conventional retail to LIFO retail. This problem emphasizes many of the same issues as Problem 9-11, except that a dollar-value LIFO computation is not needed. A good problem for providing the essential issues related to a change to LIFO retail. *Problem 9-14 (Time 40–50 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. The problem is similar to Problem 9-10, except that the problem involves a three-year period which adds complexity to the problem. This problem provides an excellent summary of the essential elements related to the change of the retail inventory method from conventional retail to LIFO retail and dollar-value LIFO retail. SOLUTIONS TO PROBLEMS PROBLEM 9-1 Item Cost Replacement Cost Ceiling* Floor** Designated Market Lower-of-Cost-or-Market A $470 $ 460 $ 450 $350 $ 450 $450 B 450 430 480 372 430 430 C 830 610 820 640 640 640 D 960 1,000 1,070 830 1,000 960 *Ceiling = 2015 catalog selling price less sales commissions and estimated other costs of disposal. (2015 catalog prices are in effect as of 12/01/14.) **Floor = Ceiling less (20% X 2015 catalog selling price).  PROBLEM 9-2 (a) 1. The balance in the Allowance to Reduce Inventory to Market at May 31, 2014, should be $34,600, as calculated in Exhibit 1 below. Exhibit 1 CALCULATIONS OF PROPER BALANCE in the Allowance to Reduce Inventory to Market At May 31, 2014 Cost Replace-ment Cost NRV (Ceiling) NRV less normal profit (Floor) LCM Aluminum siding $ 70,000 $ 62,500 $ 56,000 $ 50,900 $ 56,000 Cedar shake siding 86,000 79,400 84,800 77,400 79,400 Louvered glass doors 112,000 124,000 168,300 149,800 112,000 Thermal windows 140,000 126,000 140,000 124,600 126,000 Totals $408,000 $391,900 $449,100 $402,700 $373,400 Inventory cost $408,000 LCM valuation 373,400 Allowance at May 31, 2014 $ 34,600 2. For the fiscal year ended May 31, 2014, the loss that would be recorded due to the change in the Allowance to Reduce Inventory to Market would be $7,100, as calculated below. Balance prior to adjustment $27,500 Required balance (34,600) Loss to be recorded $( 7,100) PROBLEM 9-2 (Continued) (b) The use of the lower-of-cost-or-market (LCM) rule is based on both the expense recognition principle and the concept of conservatism. The expense recognition principle applies because the application of the LCM rule allows for the recognition of a decline in the utility (value) of inventory as a loss in the period in which the decline takes place. The departure from the historical cost principle for inventory valuation is permitted on the basis of conservatism. The general rule is that the historical cost principle is abandoned when the future utility of an asset is no longer as great as its original cost.  PROBLEM 9-3 (a) 12/31/14 (Cost-of-Goods-Sold Method) Cost of Goods Sold 68,000 Allowance to Reduce Inventory to Market ($780,000 – $712,000) 68,000 12/31/15 Cost of Goods Sold 75,000 Allowance to Reduce Inventory to Market ($905,000 – $830,000) 75,000 (b) 12/31/14 (Loss Method) To write down inventory to market: Loss Due to Market Decline of Inventory 68,000 Allowance to Reduce Inventory to Market 68,000 12/31/15 To write down inventory to market: Loss Due to Market Decline of Inventory 7,000 Allowance to Reduce Inventory to Market [($905,000 – $830,000) – $68,000] 7,000  PROBLEM 9-4 Beginning inventory $ 80,000 Purchases 290,000 370,000 Purchase returns (28,000) Total goods available 342,000 Sales revenue $415,000 Sales returns (21,000) Net sales 394,000 Less: Gross profit (35% of $394,000) 137,900  (256,100) Ending inventory (unadjusted for damage) 85,900 Less: Goods on hand—undamaged ($30,000 X [1 – 35%]) 19,500 Inventory damaged 66,400 Less: Salvage value of damaged inventory 8,150 Fire loss on inventory $ 58,250  PROBLEM 9-5 STANISLAW CORPORATION Computation of Inventory Fire Loss April 15, 2015 Inventory, 1/1/15 $ 75,000 Purchases, 1/1/ – 3/31/15 52,000 April merchandise shipments paid 3,400 Unrecorded purchases on account 15,600 Total 146,000 Less: Shipments in transit $ 2,300 Merchandise returned 950 3,250 Merchandise available for sale 142,750 Less estimated cost of sales: Sales revenue, 1/1/ – 3/31/15 135,000 Sales revenue, 4/1/ – 4/15/15 Receivables acknowledged at 4/15/15 $46,000 Estimated receivables not acknowledged 8,000 Total 54,000 Add collections, 4/1/ – 4/15/15 ($12,950 – $950) 12,000 Total 66,000 Less receivables, 3/31/15 40,000 26,000 Total sales 1/1/ – 4/15/15 161,000 Less gross profit (45%* X $161,000) 72,450 88,550 Estimated merchandise inventory 54,200 Less: Sale of salvaged inventory 3,500 Inventory fire loss $ 50,700 PROBLEM 9-5 (Continued) *Computation of Gross Profit Rate Net sales, 2013 $390,000 Net sales, 2014 530,000 Total net sales 920,000 Beginning inventory $ 66,000 Net purchases, 2013 235,000 Net purchases, 2014 280,000 Total 581,000 Less: Ending inventory 75,000 506,000 Gross profit $414,000 Gross profit rate ($414,000 ÷ $920,000) 45%  PROBLEM 9-6 (a) Cost Retail Beginning inventory $ 17,000 $ 25,000 Purchases 82,500 137,000 Freight-in 7,000 Purchase returns (2,300) (3,000) Transfers in from    suburban branch 9,200 13,000 Totals $113,400 172,000 Net markups 8,000 180,000 Net markdowns (4,000) Sales revenue $(95,000) Sales returns 2,400 (92,600) Inventory losses due to breakage (400) Ending inventory at retail $ 83,000 Cost-to-retail ratio = $113,400 = 63% $180,000 (b) Ending inventory at lower-of-average-cost-or-market (63% of $83,000) $ 52,290  PROBLEM 9-7 Cost Retail Beginning inventory $ 250,000 $ 390,000 Purchases 914,500 1,460,000 Purchase returns (60,000) (80,000) Purchase discounts (18,000) Freight-in 42,000 Markups $ 120,000 Markup cancellations   (40,000) 80,000 Totals $1,128,500 1,850,000 Markdowns (45,000) Markdown cancellations 20,000 (25,000) Sales revenue (1,410,000) Sales returns 97,500 (1,312,500) Inventory losses due to breakage (4,500) Employee discounts (8,000) Ending inventory at retail $ 500,000 Cost-to-retail ratio = $1,128,500 = 61% $1,850,000 Ending inventory at cost (61% of $500,000) $ 305,000  PROBLEM 9-8 (a) Cost Retail Inventory (beginning) $ 52,000 $ 78,000 Purchases 272,000 423,000 Purchase returns (5,600) (8,000) Freight-in 16,600   Totals $335,000 493,000 Markups 9,000 Markup cancellations (2,000) 7,000 500,000 Net markdowns (3,600) Normal spoilage and breakage (10,000) Sales revenue (390,000) Ending inventory at retail $ 96,400 Cost-to-retail ratio = $335,000 = 67% $500,000 Ending inventory at lower-of-cost-or-market (67% of $96,400) $ 64,588 (b) The difference between the inventory estimate per retail method and the amount per physical count may be due to: 1. Theft losses (shoplifting or pilferage). 2. Spoilage or breakage above normal. 3. Differences in cost/retail ratio for purchases during the month, beginning inventory, and ending inventory. 4. Markups on goods available for sale inconsistent between cost of goods sold and ending inventory. 5. A wide variety of merchandise with varying cost/retail ratios. 6. Incorrect reporting of markdowns, additional markups, or cancellations.  PROBLEM 9-9 (a) The inventory section of Maddox’s balance sheet as of November 30, 2014, including required footnotes, is presented below. Also presented below are the inventory section supporting calculations. Current assets Inventory section (Note 1.) Finished goods (Note 2.) $643,000 Work-in-process 108,700 Raw materials 237,400 Factory supplies 64,800 Total inventories $1,053,900 Note 1. Lower-of-cost (first-in, first-out) or-market is applied on a major category basis for finished goods, and on a total inventory basis for work-in-process, raw materials, and factory supplies. Note 2. Seventy-five percent of bar end shifters finished goods inventory in the amount of $136,500 ($182,000 X .75) is pledged as collateral for a bank loan, and one-half of the head tube shifters finished goods is held by catalog outlets on consignment. PROBLEM 9-9 (Continued) Supporting Calculations Finished Goods Work-in-Process Raw Materials Factory Supplies Down tube shifters at market $266,000 Bar end shifters at cost 182,000 Head tube shifters at cost 195,000 Work-in-process at market $108,700 Derailleurs at market $110,0001 Remaining items at market 127,400 Supplies at cost       $64,8002 Totals $643,000 $108,700 $237,400 $64,800 1$264,000 X 1/2 = $132,000; $132,000 ÷ 1.2 = $110,000. 2$69,000 – $4,200 = $64,800. (b) The decline in the market value of inventory below cost may be reported using one or two alternate methods, the direct write-down of inventory (cost-of-goods-sold method) or the (loss method). An allowance may be used under either method to report inventory on the balance sheet at LCM. The decline in the market value of inventory may be reflected in Maddox’s income statement as a separate loss item for the fiscal year ended November 30, 2014. The loss amount may also be written off directly, increasing the cost of goods sold on Maddox’s income statement. The loss must be reported in continuing operations rather than in extraordinary items. The loss must be included in the income statement since it is material to Maddox’s financial statements. (c) Purchase contracts for which a firm price has been established should be disclosed on the financial statements of the buyer. If the contract price is greater than the current market price and a loss is expected when the purchase takes place, an unrealized holding loss amounting to the difference between the contracted price and the current market price should be recognized on the income statement in the period during which the price decline takes place. Also, an estimated liability on purchase commitments should be recognized on the balance sheet. The recognition of the loss is unnecessary if a firm sales commitment exists which precludes the loss.  PROBLEM 9-10 (a) Schedule A Item On Hand Quantity Replacement Cost/Unit NRV (Ceiling) NRV— Normal Profit (Floor) Designated Market Cost Lower-of-Cost-or-Market A 1,100 $8.40 $9.00 $7.20 $8.40 $7.50 $7.50 B 800 7.90 8.50 7.30 7.90 8.20 7.90 C 1,000 5.40 6.05 5.45 5.45 5.60 5.45 D 1,000 4.20 5.50 4.00 4.20 3.80 3.80 E 1,400 6.30 6.00 5.00 6.00 6.40 6.00 Schedule B Item Cost Lower-of-Cost-or-Market Difference A 1,100 X $7.50 = $8,250 1,100 X $7.50 = $8,250 None B 800 X $8.20 = $6,560 800 X $7.90 = $6,320 $240 C 1,000 X $5.60 = $5,600 1,000 X $5.45 = $5,450 $150 D 1,000 X $3.80 = $3,800 1,000 X $3.80 = $3,800 None E 1,400 X $6.40 = $8,960 1,400 X $6.00 = $8,400 $560 $950 (b) Cost of Goods Sold 950 Allowance to Reduce Inventory to Market 950 or Loss Due to Market Decline of Inventory 950 Allowance to Reduce Inventory to Market 950 PROBLEM 9-10 (Continued) (c) To: Greg Forda, Clerk From: Accounting Manager Date: January 14, 2015 Subject: Instructions on determining lower-of-cost-or-market for inventory valuation This memo responds to your questions regarding our use of lower-of-cost-or-market for inventory valuation. Simply put, value inventory at whichever is the lower: the actual cost or the market value of the inventory at the time of valuation. The term cost is relatively simple. It refers to the amount our company paid for our inventory including costs associated with preparing the inventory for sale. The term market, on the other hand, is more complicated. As you have already noticed, this value could be the inventory’s replacement cost, its net realizable value (selling price minus any estimated costs to complete and sell), or its net realizable value less a normal profit margin. The profession requires that the middle value of the three above costs be chosen as the “designated market value.” This designated market value is then compared to the actual cost in determining the lower-of-cost-or-market. Refer to Item A on the attached schedule. The values for the replacement cost, net realizable value, and net realizable value less a normal profit margin are $8.40, $9.00 ($10.50 – $1.50), and $7.20 ($9.00 – $1.80) respectively. The middle value is the replacement cost, $8.40, which becomes the designated market value for Item A. Compare it with the actual cost, $7.50, choosing the lower to value Item A in inventory. In this case, $7.50 is the value chosen to value inventory. Thus, inventory for Item A amounts to $8,250. (See Schedule B, Item A.) PROBLEM 9-10 (Continued) Proceed in the same way, always choosing the middle value among replacement cost, net realizable value, and net realizable value less a normal profit, and compare that middle value to the actual cost. The lower of these will always be the amount at which you value the particular item. After you have aggregated the total lower-of-cost-or-market for all items, you will be likely to have a loss on inventory which must be accounted for. In our example, the loss is $950. You can journalize this loss in one of two ways: Cost of Goods Sold 950 Allowance to Reduce Inventory to Market 950 or Loss Due to Market Decline of Inventory 950 Allowance to Reduce Inventory to Market 950 This memo should answer your questions about which value to choose when valuing inventory at lower-of-cost-or-market. Schedule A Item On Hand Quantity Replacement Cost/Unit NRV Ceiling NRV—Normal Profit (Floor) Designated Market Cost Lower-of- Cost-or-Market A 1,100 $8.40 $9.00 $7.20 $8.40 $7.50 $7.50 B 800 7.90 8.50 7.30 7.90 8.20 7.90 C 1,000 5.40 6.05 5.45 5.45 5.60 5.45 D 1,000 4.20 5.50 4.00 4.20 3.80 3.80 E 1,400 6.30 6.00 5.00 6.00 6.40 6.00 Schedule B Item Cost Lower-of-Cost-or-Market Difference A 1,100 X $7.50 = $8,250 1,100 X $7.50 = $8,250 None B 800 X $8.20 = $6,560 800 X $7.90 = $6,320 $240 C 1,000 X $5.60 = $5,600 1,000 X $5.45 = $5,450 $150 D 1,000 X $3.80 = $3,800 1,000 X $3.80 = $3,800 None E 1,400 X $6.40 = $8,960 1,400 X $6.00 = $8,400 $560 $950  *PROBLEM 9-11 (a) Cost Retail Inventory, January 1 $ 30,000 $ 43,000 Purchases 104,800 155,000 Purchase returns (2,800) (4,000) Totals 132,000 194,000 Add: Net markups Markups $ 9,200 Markup cancellations   (3,200) 6,000 Totals $132,000 200,000 Deduct: Net markdowns Markdowns $ 10,500 Markdown cancellations (6,500) 4,000 Sales price of goods available 196,000 Sales revenue $154,000 Sales returns and allowances (8,000) (146,000) Ending inventory at retail $ 50,000 Cost-to-retail ratio = $132,000 = 66% $200,000 Inventory at lower-of-cost-or- market (66% X $50,000) $ 33,000 (b) Ending inventory at retail at January 1 price level ($59,400 ÷ 1.08) $ 55,000 Less beginning inventory at retail 43,000 Inventory increment at retail, January 1 price level $ 12,000 Inventory increment at retail, June 30 price level ($12,000 X 1.08) $ 12,960 Beginning inventory at cost $ 30,000 Inventory increment at cost at June 30 price level ($12,960 X 70%*) 9,072 Ending inventory at dollar-value LIFO cost $ 39,072 *70% = $30,000/$43,000  *PROBLEM 9-12 (a) The retail method is appropriate in businesses that sell many different items at relatively low unit costs and that have a large volume of transactions such as Sears or Wal-Mart. The advantages of the retail method in these circumstances include the following: 1. Interim physical inventories can be estimated. 2. The retail method acts as a control as deviations from the physical count will have to be explained. (b) Becker Department Stores’ ending inventory value, at cost, is $83,000, calculated as follows: Cost Retail Beginning inventory $ 68,000 $100,000 Purchases $255,000 $400,000 Net markups 50,000 Net markdowns   (110,000) Net purchases $255,000 340,000 Goods available 440,000 Sales revenue  (320,000) Estimated ending inventory at retail $120,000 Cost-to-retail percentage: $255,000 ÷ $340,000 = 75%. Beginning inventory layer $ 68,000 $100,000 Incremental increase At retail ($120,000 – $100,000) 20,000 At cost ($20,000 X 75%) 15,000   Estimated ending inventory at LIFO cost $ 83,000 $120,000 *PROBLEM 9-12 (Continued) (c) The estimated shortage amount, at retail, for Becker Department Stores is $5,000 calculated as follows: Estimated ending inventory at retail $120,000 Actual ending inventory at retail (115,000) Estimated inventory shortage $ 5,000 (d) When using the retail inventory method, the four expenses and allowances noted are treated in the following manner: 1. Freight costs are added to the cost of purchases. 2. Purchase returns are considered as reductions to both the cost price and the retail price. Purchase allowances are considered a reduction in cost price. 3. Sales returns and allowances are subtracted as an adjustment to sales. 4. Employee discounts are deducted from the retail column in a manner similar to sales. They are not considered in the cost-to-retail percentage because they do not reflect an overall change in the selling price.  *PROBLEM 9-13 (a) Cost Retail Inventory (beginning) $ 15,800 $ 24,000 Purchases 116,200 184,000 Markups   12,000 Totals $132,000 220,000 Markdowns (5,500) Sales revenue (175,000) Ending inventory at retail $ 39,500 Cost-to-retail ratio = $132,000 = 60% $220,000 Ending inventory at cost (60% X $39,500) $ 23,700 (b) Ending inventory for 2014 under the LIFO method: The cost-to-retail ratio for 2014 can be computed as follows: Net purchases at cost = $116,200 = 61% Net purchases plus markups less markdowns at retail $184,000 + $12,000 – $5,500 December 31, 2014, inventory at LIFO cost: Retail Ratio LIFO Cost Beginning inventory $24,000 59% $14,160 Increment in 2014 15,500* 61% 9,455 Ending inventory $39,500 $23,615 *$39,500 – $24,000 = $15,500  *PROBLEM 9-14 (a) DAVENPORT DEPARTMENT STORE COMPUTATION OF COST OF DECEMBER 31, 2013, INVENTORY BASED ON THE CONVENTIONAL RETAIL METHOD At Cost At Retail Beginning inventory, January 1, 2013 $ 29,800 $ 56,000 Add (deduct) transactions affecting cost ratio: Purchases 311,000 554,000 Purchase returns (5,200) (10,000) Purchase discounts (6,000) Freight-in 17,600 Net markups   20,000 Totals $347,200 620,000 Add (deduct) other retail transactions not considered in computation of cost ratio: Gross sales (551,000) Sales returns 9,000 Net markdowns (12,000) Employee discounts (3,000) Totals  (557,000) Inventory, December 31, 2013: At retail $ 63,000 At cost ($63,000 X 56%*) $ 35,280 *Ratio of cost-to-retail = $347,200 ÷ $620,000 = 56% *PROBLEM 9-14 (Continued) (b) COMPUTATION OF COST OF DECEMBER 31, 2013 INVENTORY UNDER THE LIFO RETAIL METHOD Cost Retail Totals used in computing cost ratio under conventional retail method (part a) $347,200 $620,000 Exclude beginning inventory 29,800 56,000 Net purchases 317,400 564,000 Deduct net markdowns   12,000 Totals used in computing cost ratio under LIFO retail method $317,400 $552,000 Cost ratio under LIFO retail method ($317,400 ÷ $552,000) 57.5% Inventory, December 31, 2013: At retail (Conventional) $ 60,000 At cost under LIFO retail method ($60,000 X 57.5%) $ 34,500 *PROBLEM 9-14 (Continued) (c) COMPUTATION OF 2014 AND 2015 YEAR-END INVENTORIES UNDER THE DOLLAR-VALUE LIFO METHOD Computation of retail values on the basis of January 1, 2014, price levels Cost Retail 2014: Inventory at end of year (given) $75,600 Inventory at end of year stated in terms of January 1, 2014 prices ($75,600 ÷ 105%) 72,000 January 1, 2014 inventory base (given) cost ratio of 55.5% ($33,300 ÷ $60,000) $33,300 60,000 Increment in inventory: In terms of January 1, 2014 prices $12,000 In terms of 2014 prices—$12,000 X 105% $12,600 At LIFO cost—61% (2014 cost ratio) X $12,600 7,686 December 1, 2014 inventory at LIFO cost $40,986 2015: Inventory at end of year (given) $62,640 Inventory at end of year stated in terms of January 1, 2015 prices ($62,640 ÷ 108%) $58,000 December 31, 2015 inventory at LIFO cost—55.5%* (January 1, 2014 cost ratio) X $58,000 $32,190 *Based on the beginning inventory for 2014 of $33,300 Cost = 55.5%. $60,000 Retail (Note to instructor: Because the retail inventory stated in terms of January 1, 2014 prices at December 31, 2015, $58,000, has fallen below the January 1, 2015 inventory base at retail, $60,000, under the LIFO theory the 2014 layer has been depleted and only a portion of the original inventory base remains. Hence the LIFO cost at December 31, 2015 is determined by applying the January 1, 2014 cost ratio of 55.5 percent to the retail inventory value of $58,000). TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 9-1 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to discuss the purpose, the application, and the potential disadvantages of the lower-of-cost-or-market method. In addition, the student is asked to discuss the ceiling and floor constraints for determining “market” value. CA 9-2 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to examine ethical issues related to lower-of-cost-or-market on an individual-product basis. A relatively straightforward case. CA 9-3 (Time 15–20 minutes) Purpose—to provide the student with a case that requires an application and an explanation of the lower-of-cost-or-market rule and a differentiation of the LIFO and the average cost methods. CA 9-4 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the main features of the retail inventory system. In this case, the following must be explained: (a) accounting features of the method, (b) conditions that may distort the results under the method, (c) advantages of using the retail method versus using a cost method, and (d) the accounting theory underlying net markdowns and net markups. A relatively straightforward case. CA 9-5 (Time 15–25 minutes) Purpose—the student discusses which costs are inventoriable, the theoretical arguments for the lower-of-cost-or-market rule, and the amount that should be used to value inventories when replacement cost is below the net realizable value less a normal profit margin. The treatment of beginning inventories and net markdowns when using the conventional retail inventory method must be explained. CA 9-6 (Time 10–15 minutes) Purpose—to provide the student with a case that allows examination of ethical issues related to the recording of purchase commitments. SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 9-1 (a) The purpose of using the lower-of-cost-or-market method is to reflect the decline of inventory value below its original cost. A departure from cost is justified on the basis that a loss of utility should be reported as a charge against the revenues in the period in which it occurs. (b) The term “market” in the phrase “the lower-of-cost-or-market” generally means the cost to replace the item by purchase or reproduction. Market is limited, however, to an amount that should not ex-ceed the net realizable value (the “ceiling”) (that is, the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal) and should not be less than net realizable value reduced by an allowance for an approximately normal profit margin (the “floor”). The “ceiling” covers obsolete, damaged, or shopworn material and prevents serious overstatement of inventory. The “floor,” on the other hand, deters serious understatement of inventory. (c) The lower-of-cost-or-market method may be applied either directly to each inventory item, to a category, or to the total inventory. The application of the rule to the inventory total, or to the total components of each category, ordinarily results in an amount that more closely approaches cost than it would if the rule were applied to each individual item. Under the first two methods, increases in market prices offset, to some extent, the decreases in market prices. The most common practice is, however, to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax rules require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet purposes. (d) Conceptually, the lower-of-cost-or-market method has some deficiencies. First, decreases in the value of the asset and the charge to expense are recognized in the period in which loss in utility occurs—not in the period of sale. On the other hand, increases in the value of the asset are recognized only at the point of sale. This situation is inconsistent and can lead to distortions in the presentation of income data. Second, there is difficulty in defining “market” value. Basically, three different types of valuation can be used: replacement cost, net realizable value, and net realizable value less a normal markup. A reduction in the replacement cost of an item does not necessarily indicate a corresponding reduction in the utility (price) of the item. To recognize a loss in one period may misstate the period’s income and also that of future periods because when the merchandise is sold subsequently, the full price for the item is received. Net realizable value reflects the future service potential of the asset and, for that reason, it is conceptually sound. But net realizable value cannot often be measured with any certainty. Therefore, we revert to replacement cost because net realizable value less a normal markup is even more uncertain than net realizable value. From the standpoint of accounting theory there is little to justify the lower-of-cost-or-market rule. Although conservative from the balance sheet point of view, it permits the income statement to show a larger net income in future periods than would be justified if the inventory were carried forward at cost. The rule is applied only in those cases where strong evidence indicates that market declines in inventory prices have occurred that will result in losses when such inventories are disposed of. CA 9-2 (a) The accountant’s ethical responsibility is to provide fair and complete financial information. In this case, the loss method distorts the cost of goods sold and hides the decline in market value. (b) If Wright’s cost-of-goods-sold method is used, management may have difficulty in calculations that involve the cost of goods sold. For example, these calculations are useful in establishing profit margins and determining selling prices; but from the investors’ and stockholders’ viewpoint, it is not good policy to hide declines in market value. (c) Conan should use the loss method to disclose the decline in market value and avoid distorting cost of goods sold. However, she faces an ethical dilemma if Wright will not accept the method Conan wants to use. She should consider various alternatives including the extremes of simply accepting her boss’s decision to quitting if Wright will not change his mind. Conan should assess the consequences of each possible alternative and weigh them carefully before she decides what to do. CA 9-3 (a) 1. Ogala’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. 2. 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. (b) Generally, ending inventory would have been higher and cost of goods sold would have been lower had Ogala used the LIFO inventory method in a period of declining prices. 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 Ogala used the LIFO inventory method because Ogala’s 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. CA 9-4 (a) 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 and net markdowns from the total retail value of merchandise available for sale (i.e., 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 goods available for sale as computed in (2) above into the cost of goods available for sale (i.e., the sum of beginning inventory, net purchases, and other inventoriable costs). CA 9-4 (Continued) (b) 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. Where there are a number of inventory subdivisions for which differing rates of markup 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 sub-classifications by rate of markup. Seasonal variations in the rate of markup 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 markup should prevail throughout the period. Because of seasonal variations it may be necessary to use data for the last six 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. (c) The advantages of using the retail method as compared to cost methods include the following: 1. Approximate inventory values can be determined without maintaining perpetual inventory records. 2. The preparation of interim financial statements is facilitated. 3. Losses due to fire or other casualty are readily determined. 4. Clerical work in pricing the physical inventory is reduced. 5. The cost of merchandise can be kept confidential in intracompany transfers. (d) 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. CA 9-5 (a) 1. Olson’s inventoriable cost should include 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, freight-in. 2. No, administrative 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. (b) 1. The lower-of-cost-or-market rule is used for valuing inventories because of the concept of prudence or conservatism and because the decline in the utility of the inventories below their cost should be recognized as a loss in the current period. 2. The net realizable value less a normal profit margin should be used to value the inventories because market should not 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. (c) Olson’s beginning inventories at cost and at retail would be included in the calculation of the cost ratio. Net markdowns would be 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 conservatism (prudence) is being followed and a lower-of-cost-or-market valuation is approximated. CA 9-6 (a) Accounting standards require that when a contracted price is in excess of market, as it is in this case (market is $5,000,000 and the contract price is $6,000,000), and it is expected that losses will occur when the purchase is effected, losses should be recognized in the period during which such declines in market prices take place. It would be unethical to ignore recognition of the loss now if a loss is expected to occur when the purchase is effected. (b) If the loss is material, new and continuing shareholders are harmed by nonrecognition of the loss. Herman’s position as an accounting professional also is affected if he accepts a financial report he knows violates GAAP. (c) If the preponderance of the evidence points to a loss when the purchase is effected, the controller should recognize the amount of the loss in the period in which the price decline occurs. In this case the loss is measured at $1,000,000 and recorded as follows: Unrealized Holding Gain or Loss—Income (Purchase Commitments) 1,000,000 Estimated Liability on Purchase Commitments 1,000,000 Herman should insist on statement preparation in accordance with GAAP. If Hands will not accept Herman’s position, Herman will have to consider alternative courses of action such as contacting higher-ups at Prophet and assess the consequences of each course of action.  FINANCIAL REPORTING PROBLEM (a) Inventories are valued at the lower-of-cost-or-market value. Product-related inventories are primarily maintained on the first-in, first-out method. Minor amounts of product inventories, including certain cosmetics and commodities are maintained on the last-in, first-out method. The cost of spare part inventories is maintained using the average cost method. (b) Inventories are reported on the balance sheet simply as “inventories” with sub-totals reported for (1) Materials and supplies, (2) Work in process, and (3) Finished goods. (c) In its note describing Cost of Products Sold, P&G indicates that cost of products sold is primarily comprised of direct materials and supplies consumed in the manufacture of product, as well as manufacturing labor, depreciation expense and direct overhead expense necessary to acquire and convert the purchased materials and supplies into finished product. Cost of products sold also includes the cost to distribute products to customers, inbound freight costs, internal transfer costs, warehousing costs and other shipping and handling activity. (d) Inventory turnover = Cost of Goods Sold = $40,768 Average Inventory $7,379 + $6,384 2 = 5.9 or approximately 62 days to turn its inventory, which is a slightly lower than 2010 (5.7 or 64 days). Its gross profit percentages for 2011 and 2010 are as follows: 2011 2010 Net sales $82,559 $78,938 Cost of goods sold 40,768 37,919 Gross profit $41,791 $41,019 Gross profit percentage 50.62% 51.96% P&G had an increase in its gross profit but a decrease gross profit percentage. Sales in 2011 showed a 4.6% increase. It appears that P&G has not been able to manage its costs to increase gross margin levels on these higher sales.  COMPARATIVE ANALYSIS CASE (a) Coca-Cola reported inventories of $3,092 million, which represents 3.9% of total assets. PepsiCo reported inventories of $3,827 million, which represents 5.3% of its total assets. (b) Coca-Cola determines the cost of its inventories on the basis of average cost or first-in, first-out (FIFO) methods; its inventories are valued at the lower-of-cost-or-market. PepsiCo’s inventories are valued at the lower of cost (computed on the average, FIFO or LIFO method) or market. PepsiCo also reported that the cost of 13% of its 2011 inventories was computed using the LIFO method. (c) Coca-Cola classifies and describes its inventories as primarily raw materials and packaging and finished goods. PepsiCo classifies and describes its inventories as (1) raw materials, (2) work-in-process and (3) finished goods. (d) Inventory turnover ratios and days to sell inventory for 2011: Coca-Cola PepsiCo $18,216 = 6.3 times $31,593 = 8.8 times $3,092 + $2,650 $3,827 + $3,372 2 2 365 ÷ 6.3 = 58 days 365 ÷ 8.8 = 41 days A substantial difference between Coca-Cola and PepsiCo exists regarding the inventory turnover and related days to sell inventory. The primary reason is that PepsiCo’s cost of goods sold and related inventories involves food operations as well as beverage cost. This situation is not true for Coca-Cola. Food will have a much higher turnover ratio because food must be turned over quickly or else spoilage will become a major problem.  FINANCIAL STATEMENT ANALYSIS CASE 1 (a) Although no absolute rules can be stated, preferability for LIFO can ordinarily be established if (1) selling prices and revenues have been increasing, whereas costs have lagged, to such a degree that an unrealistic earnings picture is presented, and (2) LIFO has been traditional, such as department stores and industries where a fairly constant “base stock” is present such as refining, chemicals, and glass. Conversely, LIFO would probably not be appropriate: (1) where prices tend to lag behind costs; (2) in situations where specific identification is traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry; and (3) where unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide. Note that where inventory turnover is high, the difference between inventory methods is usually negligible. In this case, it is impossible to determine what conditions exist, but it seems probable that the characteristics of certain parts of the inventory make LIFO desirable, whereas other parts of the inventory provide higher benefits if FIFO is used. (b) It may provide this information (although it is not required to do so) because it believes that this information tells the reader that both its income and inventory would be higher if FIFO had been used. (c) The LIFO liquidation reduces operating costs because low price goods are matched against current revenue. As a result, operating costs are lower than normal because higher operating costs would have normally been deducted from revenues. (d) It would probably have reported more income if it had been on a FIFO basis. For example, its inventory as of December 31, 2014 was stated at $1,635,040. Its inventory under FIFO would have been $364,960 ($2,000,000–$1,635,040) higher in 2014 if FIFO had been used. On the other hand, the LIFO liquidation would not have occurred in 2014 or previous years because FIFO would have been used. Thus, the 2014 reduction in operating costs of $24,000 due to the LIFO liquidation would not have occurred.  FINANCIAL STATEMENT ANALYSIS CASE 2 (a) There are probably no finished goods because gold is a highly liquid commodity, and so it can be sold as soon as processing is complete. Ore in stockpiles is probably a noncurrent asset because processing takes more than one year. (b) Sales are recorded as follows: Accounts Receivable or Cash XXX Sales Revenue XXX AND Cost of Goods Sold XXX Gold in Process Inventory XXX (c) Balance Sheet Income Statement Inventory Overstated Cost of goods sold Understated Retained earnings Overstated Net income Overstated Accounts payable No effect Working capital Overstated Current ratio Overstated  ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting (a) Residential pumps: Ending inventory cost = (300 X $500) + (200 X $475) = $ 245,000 Beginning inventory cost = (200 X $400) = $ 80,000 Purchases = $225,000 + $190,000 + $150,000 = $ 565,000 Cost of goods sold = $80,000 + $565,000 – $245,000 = $ 400,000 Commercial pumps: Ending inventory at cost = (500 X $1,000) = $ 500,000 Beginning inventory at cost = (600 X $800) = $ 480,000 Purchases = $540,000 + $285,000 + $500,000 = $1,325,000 Cost of goods sold = $480,000 + $1,325,000 – $500,000 = $1,305,000 Total ending inventory at cost = $245,000 + $500,000 = $ 745,000 Total cost of goods sold = $1,305,000 + $400,000 = $1,705,000 Lower-of-cost-or-market: Residential pumps Commercial pumps NRV $580 $1,050 Replacement cost $550 $ 900 Normal profit margin 0.1667 X $580.00 = $96.69 0.1667 X $1,050.00 = $175.04 NRV – normal profit margin $580.00 – $96.69 = $483.31 $1,050.00 – $175.04 = $874.96 Designated market value $550 $900 Number of units on hand, Mar. 31 500 500 Designated market value of ending inventory $275,000* $450,000** Required write-down No Yes, $450,000 < $500,000 *($550 X 500) **($900 X 500) Total amount of inventory reported on March 31 balance sheet = $695,000 ($245,000 + $450,000). ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) (b) Inventory at cost = $245,000 + $500,000 = $745,000 Designated market value = $275,000 + $450,000 = $725,000 $725,000 < $745,000, therefore write inventory down to $725,000 Total amount of inventory reported on March 31 balance sheet = $725,000 Analysis In this problem, one product’s market value is above cost and the other one is below. From a conservative perspective, the individual product approach results in a write-down for any product whose designated market value is below cost. So, potentially the individual product approach informs the financial statement reader about any products with weak markets, while the category approach does not. One could argue that the company’s balance sheet inventory amount, if aggregated into one category, is closer to its market value than with the individual product approach. This approach allows unrealized inventory gains to offset inventory losses. It is difficult to say which approach provides better information, but the individual product approach results in a larger write-down. Principles (a) If the designated market value is $1,050, the designated market value of commercial pumps would be above cost. The written-down amount becomes the new cost for that inventory and Englehart would not be allowed to write that inventory back up. (b) The conceptual trade-off inherent in the accounting for inventory as it relates to lower-of-cost-or-market is between relevance and faithful representation. Market is generally thought to be more relevant than cost. Cost is considered less subjective (and a more faithful representation) than market. Under LCM, relevance takes precedence in a down market; however, faithful representation is more important in an up market.  PROFESSIONAL RESEARCH (a) The codification provides guidance at: FASB ASC 330-10-05 (Codification String: Assets > 330 Inventory > 10 Overall > 05 Background). The primary predecessor literature is: “Restatement and Revision of Accounting Research Bulletins.” Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4. (b) According to the FASB ASC 330-10-20, the Glossary indicates the following. Inventory is the aggregate of those items of tangible personal property that have any of the following characteristics: a. Held for sale in the ordinary course of business b. In process of production for such sale c. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory. PROFESSIONAL RESEARCH (Continued) (c) According to the FASB ASC 330-10-20, the Glossary indicates the following for the term Market: As used in the phrase lower-of-cost-or-market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meet both of the following conditions: a. Market shall not exceed the net realizable value b. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin. (d) According to FASB ASC 330-10-35: 35-15 Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability. For: Goods Stated Above Cost 50-3 Where goods are stated above cost this fact shall be fully disclosed. 35-16 It is generally recognized that income accrues only at the time of sale, and that gains may not be anticipated by reflecting assets at their current sales prices. However, exceptions for reflecting assets at selling prices are permissible for both of the following: a. Inventories of gold and silver, when there is an effective government-controlled market at a fixed monetary value b. Inventories representing agricultural, mineral, and other products, with any of the following criteria: (1) Units of which are interchangeable (2) Units of which have an immediate marketability at quoted prices (3) Units for which appropriate costs may be difficult to obtain. Where such inventories are stated at sales prices, they shall be reduced by expenditures to be incurred in disposal.  PROFESSIONAL SIMULATION Resources Journal Entry Cost of Goods Sold 4,000 Allowance to Reduce Inventory to Market 4,000 Note: This entry assumes use of the cost-of-goods-sold method. Explanation Expected selling prices are important in the application of the lower-of-cost-or-market rule because they are used in measuring losses of utility in inventory that otherwise would not be recognized until the period during which the inventory is sold. Declines in replacement cost generally are assumed to foreshadow declines in selling prices expected in the next period and hence in the revenue expected upon the sale of the inventory during the next period. However, the use of current replacement cost as “market” is limited to those situations in which it falls between (1) net realizable value (the “ceiling”) and (2) net realizable value less a “normal” profit (the “floor”), both of which depend upon the selling prices expected in the next period for their computation.  IFRS CONCEPTS AND APPLICATION IFRS9-1 Key similarities are (1) the guidelines on who owns the goods—goods in transit, consigned goods, special sales agreements, and the costs to include in inventory are essentially accounted for the same under IFRS and U.S. GAAP; (2) use of specific identification cost flow assumption, where appropriate; (3) unlike property, plant and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost; (4) certain agricultural products and minerals and mineral products can be reported at net realizable value using IFRS. Key differences are related to (1) the LIFO cost flow assumption—GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS; (2) lower-of-cost-or-market test for inventory valuation—IFRS defines market as net realizable value. GAAP on the other hand defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). That is, IFRS does not use a ceiling or a floor to determine market; (3) inventory write-downs—under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement; (4) the requirements for accounting and reporting for inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting. IFRS9-2 As shown in the analysis below, under IFRS, LaTour’s inventory turnover ratio is computed as follows: Cost of Goods Sold Average Inventory = $578 $154 = 3.75 Difficulties in comparison to a company using GAAP could arise if the U.S. company uses the LIFO cost flow assumption, which is prohibited under IFRS. Generally in times of rising prices, LIFO results in a lower inventory balance reported on the balance sheet (assumes more recently purchased items are sold first). Thus, the GAAP company will report higher inventory turnover ratios. The LIFO reserve can be used to adjust the reported LIFO numbers to FIFO and to permit an “apples to apples” comparison. IFRS9-3 Reed must not be aware of the important convergence issue arising from the use of the LIFO cost flow assumption; IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and therefore a more realistic income is computed. The problem is compounded in the United States because LIFO cannot be used for tax purposes unless it is used for financial reporting purposes. As a result, unless the tax law is changed, it is unlikely that GAAP will eliminate the use of the LIFO cost flow assumption because of its substantial tax advantages for many companies. Also, GAAP has more detailed rules related to accounting and reporting of inventories than IFRS. We expect that these more detailed rules will be used internationally because they provide practical guidance for some inventory accounting and reporting issues. IFRS9-4 (a) Biological assets are measured on initial recognition and at the end of each reporting period at fair value less costs to sell (net realizable value or NRV). Companies record a gain or loss due to changes in the NRV of biological assets in income when it arises. (b) Agricultural produce (which are harvested from biological assets) are measured at fair value less costs to sell (net realizable value or NRV) at the point of harvest. Once harvested, the NRV of the agricultural produce becomes its cost and this asset is accounted for similar to other inventories held for sale in the normal course of business. IFRS9-5 (1) $12.80 ($14.80 – $1.50 – $.50). (2) $16.10. (3) $13.00 ($15.20 – $1.65 – $.55). (4) $ 9.20 ($10.40 – $ .80 – $.40). (5) $15.90. IFRS9-6 Item Net Realizable Value Cost LCNRV D $80* $75 $75 E 62 80 62 F 60 80 60 G 35 80 35 H 70 50 50 I 40 36 36 *Estimated selling price – Estimated selling costs and cost to complete = $120 – $30 – $10 = $80. IFRS9-7 (a) 12/31/14 Cost of Goods Sold 24,000 Allowance to Reduce Inventory to Net Realizable Value 24,000 12/31/15 Allowance to Reduce Inventory to Net Realizable Value 4,000* Cost of Goods Sold 4,000 (b) 12/31/14 Loss Due to Decline of Inventory to Net Realizable Value 24,000 Allowance to Reduce Inventory to Net Realizable Value 24,000 12/31/15 Allowance to Reduce Inventory to NRV 4,000* Recovery of Loss Inventory 4,000 *Cost of inventory at 12/31/14 $346,000 Lower-of-cost-or-NRV at 12/31/14 (322,000) Allowance amount needed to reduce Inventory to NRV (a) $ 24,000 Cost of inventory at 12/31/15 $410,000 Lower-of-cost-or-NRV at 12/31/15 (390,000) Allowance amount needed to reduce Inventory to NRV (b) $ 20,000 Recovery of previously recognized loss = (a) – (b) = $24,000 – $20,000 = $4,000. (c) Both methods of recording lower-of-cost-or-NRV adjustments have the same effect on net income. IFRS9-8 Biological Assets – Shearing Sheep 4,125* Unrealized Holding Gain or    Loss – Income 4,125 *$4,700 – $575 = $4,125. IFRS9-9 (a) Wool Inventory 9,000 Unrealized Holding Gain or    Loss – Income 9,000 (b) Cash 10,500 Cost of Goods Sold 9,000 Wool Inventory 9,000 Sales Revenue 10,500 IFRS9-10 (a) The IFRS requirements related to accounting and reporting for inventories is found in IAS 2 (Inventories), IAS 18 (Revenue) and IAS 41 (Agriculture). Inventories are assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. (IAS 2, paragraph 6) This Standard applies to all inventories, except: (a) work in progress arising under construction contracts, including directly related service contracts (see IAS 11 Construction Contracts); (b) financial instruments (see IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and Measurement); and (c) biological assets related to agricultural activity and agricultural produce at the point of harvest (see IAS 41 Agriculture). (IAS 2, paragraph 2) IFRS9-10 (Continued) (c) Net realisable value refers to the net amount that an entity expects to realise from the sale of inventory in the ordinary course of business. Fair value reflects the amount for which the same inventory could be exchanged between knowledgeable and willing buyers and sellers in the marketplace. The former is an entity-specific value; the latter is not. Net realisable value for inventories may not equal fair value less costs to sell. (IAS 2, paragraph 7). (d) This Standard does not apply to the measurement of inventories held by: (a) producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in profit or loss in the period of the change. (b) commodity broker-traders who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in profit or loss in the period of the change. (IAS 2, paragraph 3). IFRS9-11 (a) Inventories are valued at the lower-of-cost-or-net realisable value using the retail method, which is computed on the basis of selling price less the appropriate trading margin. All inventories are finished goods. (b) Inventories are reported on the statement of financial position simply as “Inventories.” The footnotes indicate that all inventories are finished goods. (c) No information is provided in the annual report regarding what costs are included in inventories or cost of sales. IFRS9-11 (Continued) (d) Inventory turnover = Cost of Sales = £6,179.1 Average Inventory £681.9 + £685.3 2 = 9.04 or approximately 40 days to turn its inventory, which is slightly lower than in 2011 (9.3 or 39 days). Overall, turnover remains high. Its gross profit percentages for 2012 and 2011 are as follows: 2012 2011 Net sales £9,934.3 £9,740.3 Cost of sales 6,179.1 6,015.6 Gross profit £3,755.2 £3,724.7 Gross profit percentage 37.8% 38.2% M&S had a small improvement in its gross profit and a slight decrease in gross profit percentage. Sales in 2012 showed a 2% increase. It appears that M&S has been able to maintain its gross profit percentage on these increased sales. 9-127 Copyright © 2013 John Wiley & Sons, Inc.Kieso, Intermediate Accounting, 15/e, Solutions Manual (For Instructor Use Only) Copyright © 2013 John Wiley & Sons, Inc.Kieso, Intermediate Accounting, 15/e, Solutions Manual (For Instructor Use Only) 9-126