Chapter 09 - Inventories: Additional Issues Question 9-1 Question 9-2 Question 9-3 Question 9-4 Question 9-5 The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an 9-1 Chapter 9 Inventories: Additional Issues QUESTIONS FOR REVIEW OF KEY TOPICS GAAP generally require the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold. The designated market value in the LCM rule is the middle number of replacement cost (RC), net realizable value (NRV) and net realizable value less a normal profit margin (NRV-NP). This is the amount compared with cost to determine LCM. The LCM determination can be made based on individual inventory items, on logical categories of inventory, or on the entire inventory. The preferred method is to record the loss from the write-down of inventory as a separate item in the income statement rather than including the write-down in cost of goods sold. A less desirable alternative is to include the loss in cost of goods sold.
Transcript
Chapter 09 - Inventories: Additional Issues
Question 9-1
Question 9-2
Question 9-3
Question 9-4
Question 9-5 The gross profit method estimates cost of goods sold, which is then subtracted from cost of
goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the reciprocal of the gross profit ratio.
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Chapter 9 Inventories: Additional Issues
QUESTIONS FOR REVIEW OF KEY TOPICSGAAP generally require the use of historical cost to value assets, but a departure from cost is
necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.
The designated market value in the LCM rule is the middle number of replacement cost (RC), net realizable value (NRV) and net realizable value less a normal profit margin (NRV-NP). This is the amount compared with cost to determine LCM.
The LCM determination can be made based on individual inventory items, on logical categories of inventory, or on the entire inventory.
The preferred method is to record the loss from the write-down of inventory as a separate item in the income statement rather than including the write-down in cost of goods sold. A less desirable alternative is to include the loss in cost of goods sold.
Chapter 09 - Inventories: Additional Issues
Question 9-6 The key to obtaining accurate estimates when using the gross profit method is the reliability of
the cost percentage. If the cost percentage is too low, cost of goods sold will be understated and ending inventory overstated. Cost percentages usually are based on relationships of past years, which aren’t necessarily representative of the current relationship. Failure to consider theft or spoilage also could cause an overstatement of ending inventory.
Answers to Questions (continued)
Question 9-7 The retail inventory method first determines the amount of ending inventory at retail by
subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage.
Question 9-8 The main difference between the gross profit method and the retail inventory method is in the
determination of the cost percentage used to convert sales at selling prices to sales at cost. The retail inventory method uses a cost percentage, called the cost-to-retail percentage, which is based on a current relationship between cost and selling price. The gross profit method relies on past data to reflect the current cost percentage.
Question 9-9 Initial markup — Original amount of markup from cost to selling price.Additional markup — Increase in selling price subsequent to initial markup.Markup cancellation — Elimination of an additional markup.Markdown — Reduction in selling price below the original selling price.Markdown cancellation — Elimination of a markdown.
Question 9-10 When using the retail method to estimate average cost, the cost-to-retail percentage is
determined by dividing total cost of goods available for sale by total goods available for sale at retail. By including beginning inventory in the calculation of the cost-to-retail percentage, the percentage reflects the average cost/retail relationship for all inventories, not just the portion acquired in the current period.
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Chapter 09 - Inventories: Additional Issues
Question 9-11 The lower-of-cost-or-market (LCM) retail variation combined with the average cost method is
called the conventional retail method. The LCM rule is incorporated into the retail inventory estimation procedure by excluding markdowns from the calculation of the cost-to-retail percentage.
Question 9-12 When applying LIFO, if inventory increases during the year, none of the beginning inventory
is assumed sold. Ending inventory includes the beginning inventory plus the current year’s layer. To determine layers, we compare ending inventory at retail to beginning inventory at retail and assume that no more than one inventory layer is added if inventory increases. Each layer carries its own cost-to-retail percentage that is used to convert each layer from retail to cost.
Answers to Questions (continued)
Question 9-13Freight-in is added to purchases in the cost column. Net markups are added in the retail
column before the calculation of the cost-to-retail percentage. Normal spoilage is deducted in the retail column after the calculation of the cost-to-retail percentage. If sales are recorded net of employee discounts, the discounts are deducted in the retail column.
Question 9-14 The dollar-value LIFO retail method eliminates the stable price assumption of regular retail
LIFO. In effect, it combines dollar-value LIFO (Chapter 8) with LIFO retail. Before comparing beginning and ending inventory at retail prices, ending inventory is deflated to base year retail using the current year’s retail price index. After identifying the layers in ending inventory with the years they were created, in addition to converting retail prices to cost using the cost-to-retail percentage, the dollar-value LIFO method requires that each layer first be converted from base year retail to layer year retail using the year’s retail price index.
Question 9-15Changes in inventory methods, other than a change to the LIFO method, are reported
retrospectively. This means reporting all previous periods’ financial statements as if the new inventory method had been used in all prior periods.
Question 9-16 When a company changes to the LIFO inventory method from any other method, it usually is
impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted.
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Chapter 09 - Inventories: Additional Issues
Question 9-17 If a material inventory error is discovered in an accounting period subsequent to the period in
which the error is made, any previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders’ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share.
Answers to Questions (concluded)
Question 9-182009: Cost of goods sold overstated
Net income understatedEnding retained earnings understated
2010: Net purchases no effectCost of goods sold understatedNet income overstatedEnding retained earnings correct
Question 9-19 When applying the lower-of-cost-or-market rule for valuing inventory according to U.S.
GAAP, market is defined as replacement cost with a ceiling of net realizable value (NRV) and a floor of NRV less a normal profit margin. However, the designated market value according to IAS No. 2 always is net realizable value. IAS No. 2 also specifies that if circumstances reveal that an inventory write-down is no longer appropriate, it must be reversed. Reversals are not permitted under U.S. GAAP.
Question 9-20 Purchase commitments are contracts that obligate the company to purchase a specified amount
of merchandise or raw materials at specified prices on or before specified dates. These agreements are entered into primarily to secure the acquisition of needed inventory and to protect against increases in purchase price.
Question 9-21
9-4
Purchases made pursuant to a purchase commitment are recorded at the lower of contract price or market price on the date the contract is executed. A loss is recognized if the market price is less than the contract price. For purchase commitments outstanding at year-end, a loss is recognized if the market price at year-end is less than the contract price.
Before-tax income will be lower by $4,000, the amount of the required inventory write-down.
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Brief Exercise 9-1
Brief Exercise 9-2
Chapter 09 - Inventories: Additional Issues
The designated market value according to IFRS always is net realizable value.
Product Cost NRV* LCM
1 $50 $64 $50
2. 30 32 30
* Selling price less disposal costs.
Because cost is lower than market for both products, no LCM adjustment is required. The inventory is valued at its cost of $80,000, determined as follows:
Beginning inventory (from records) $220,000Plus: Net purchases (from records) 400,000 Cost of goods available for sale 620,000Less: Cost of goods sold:
Net sales $600,000Less: Estimated gross profit of 30% (180,000)Estimated cost of goods sold (420,000)
Estimated cost of inventory destroyed $200,000
Beginning inventory (from records) $150,000Plus: Net purchases (from records) 450,000 Cost of goods available for sale 600,000Less: Cost of goods sold:
Net sales $700,000Less: Estimated gross profit ( ? )
9-6
Brief Exercise 9-3
Brief Exercise 9-4
Brief Exercise 9-5
Chapter 09 - Inventories: Additional Issues
Estimated cost of goods sold ( ? )Estimated cost of inventory lost $ 75,000
Estimated cost of goods sold = $600,000 – 75,000 = $525,000*Estimated gross profit = $700,000 – 525,000* = $175,000
$175,000 $700,000 = 25% gross profit ratio
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Chapter 09 - Inventories: Additional Issues
Cost RetailBeginning inventory $300,000 $ 450,000Plus: Net purchases 861,000 1,210,000
Freight-in 22,000Net markups 48,000
Less: Net markdowns ______ (18,000 )Goods available for sale 1,183,000 1,690,000
Less: Net sales (1,200,000 )Estimated ending inventory at retail $ 490,000 Estimated ending inventory at cost (70% x $490,000) (343,000 )Estimated cost of goods sold $ 840,000
Cost RetailBeginning inventory $300,000 $450,000 Plus: Net purchases 861,000 1,210,000
Freight-in 22,000Net markups 48,000
Less: Net markdowns _______ (18,000 )Goods available for sale (excluding beg. Inventory) 883,000 1,240,000 Goods available for sale (including beg. Inventory) 1,183,000 1,690,000
Less: Net sales (1,200,000 )Estimated ending inventory at retail $ 490,000 Estimated ending inventory at cost: Retail CostBeginning inventory $ 450,000 $ 300,000Current period’s layer 40,000 x 71.21 % = 28,484 Total $ 490,000 $328,484 (328,484 )Estimated cost of goods sold $854,516
Cost RetailBeginning inventory $300,000 $ 450,000Plus: Net purchases 861,000 1,210,000
Freight-in 22,000Net markups 48,000
Goods available for sale 1,708,000
$1,183,000Cost-to-retail percentage: = 69.26% $1,708,000Less: Net markdowns ______ (18,000 )Goods available for sale 1,183,000 1,690,000Less: Net sales (1,200,000 )Estimated ending inventory at retail $ 490,000 Estimated ending inventory at cost (69.26% x $490,000) (339,374 )Estimated cost of goods sold $ 843,626
Net markups 6,000Less: Net markdowns _______ (8,000 )Goods available for sale (excluding beginning inventory) 155,440 268,000 Goods available for sale (including beginning inventory) 196,240 336,000
Less: Net sales (250,000)Estimated ending inventory at current year retail prices $ 86,000
Estimated ending inventory at cost (calculated below) (50,451 )Estimated cost of goods sold $145,789 ___________________________________________________________________________
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$86,000 $86,000 = $84,314 $68,000 (base) x 1.00 x 60% = $40,800(above) 1.02 16,314 (2011) x 1.02 x 58% = 9,651
Total ending inventory at dollar-value LIFO retail cost ...................... $50,451
Net markups 3,000Less: Net markdowns _______ (4,000 )Goods available for sale (excluding beginning inventory) 168,000 300,000 Goods available for sale (including beginning inventory) 218,451 386,000
Less: Net sales (280,000 )Estimated ending inventory at current year retail prices $106,000
Estimated ending inventory at cost (calculated below) (59,762 )Estimated cost of goods sold $158,689 ___________________________________________________________________________
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$106,000$106,000 = $100,000 $68,000 (base) x 1.00 x 60%* = $40,800(above) 1.06 16,314 (2011) x 1.02 x 58% = 9,651 15,686 (2012) x 1.06 x 56% = 9,311
Total ending inventory at dollar-value LIFO retail cost ...................... $59,762
*$40,800 $68,000 = 60%
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Chapter 09 - Inventories: Additional Issues
Hopyard applies the FIFO cost method retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods that are included for comparison with the current financial statements are revised for period-specific effects of the change.
Then, the cumulative effects of the new method on periods prior to those presented are reflected in the reported balances of the assets and liabilities affected as of the beginning of the first period reported and a corresponding adjustment is made to the opening balance of retained earnings for that period.
The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes, as well as the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.
2011 cost of goods sold is $7,000 higher than it would have been if Hopyard had not switched to FIFO. This is because beginning inventory is $18,000 higher ($145,000 – 127,000) and ending inventory is $11,000 higher ($162,000 – 151,000). An increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. Purchases for 2011 are the same regardless of the inventory valuation method used.
When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted, $150,000 in this case.
A disclosure note is needed to explain (a) the nature of and justification for the change, (b) the effect of the change on current year's income and earnings per share, and (c) why retrospective application was impracticable.
The 2009 error caused 2009 net income to be overstated, but since 2009 ending inventory is 2010 beginning inventory, 2010 net income was understated the same amount. So, the income statement was misstated for 2009 and 2010, but the balance
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Brief Exercise 9-12
Brief Exercise 9-13
Brief Exercise 9-14
Chapter 09 - Inventories: Additional Issues
sheet (retained earnings) was incorrect only for 2009. After that, no account balances are incorrect due to the 2009 error.
Analysis: U = UnderstatedO = Overstated
2009 2010Beginning inventory Beginning inventory OPlus: net purchases Plus: net purchases Less: ending inventory O Less: ending inventoryCost of goods sold U Cost of goods sold O
Revenues RevenuesLess: cost of goods sold U Less: cost of goods sold OLess: other expenses Less: other expensesNet income O Net income U Retained earnings O Retained earnings corrected
9-14
Chapter 09 - Inventories: Additional Issues
Brief Exercise 9-14 (concluded)
However, the 2010 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error.
Analysis: U = UnderstatedO = Overstated
2010Beginning inventory Plus: net purchases Less: ending inventory O Cost of goods sold U
RevenuesLess: cost of goods sold ULess: other expensesNet income O Retained earnings O
Retained earnings on January 1, 2011, in this case, would be overstated by $500,000 (ignoring income taxes).
The financial statements that were incorrect as a result of both errors (effect of one error in 2009 and effect of two errors in 2010) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
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Brief Exercise 9-15
Chapter 09 - Inventories: Additional Issues
EXERCISES
(1) (2) (3) (4) (5)
Product RC
Ceiling
NRV (*)
Floor
NRV-NP(**)
Designated Market Value[Middle value of (1), (2) &
(3)]Cost
Per UnitInventory
Value[Lower of
(4) and (5)]
1 $18 $ 34 $29 $29 $20 $20
2 85 80 50 80 90 80
3 40 60 48 48 50 48
* Selling price less disposal costs.
** NRV less normal profit margin
The designated market value according to IAS No. 2 always is net realizable value. Inventory valuation for the three products would be as follows:
Product NRV Cost Lower of Cost or Market 1 $34 $20 $202 80 90 803 60 50 50
Product 3 would be valued at $50 under IAS No. 2, but $48 according to U.S. GAAP. The inventory values of the other two products would be the same under U.S. and the international standard.
Requirement 1
(1) (2) (3) (4) (5)
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Exercise 9-1
Exercise 9-2
Exercise 9-3
Chapter 09 - Inventories: Additional Issues
Product RC
Ceiling
NRV
Floor
NRV-NP(NP=25%
of cost)
Designated Market Value[Middle value of (1), (2) &
Designated Market Value[Middle value of (1), (2) &
(3)]Cost
Per UnitInventory
Value[Lower of
(4) and (5)]
A $35 $52 $34 $35 $40 $35
B 70 86 56 70 80 70
C 55 70 46 55 40 40
D 70 112 73 73 100 73
E 28 26 17 26 20 20
* Selling price less disposal costs. Disposal costs = 10% of selling price + 5% of cost.
** NRV less normal profit margin
Requirement 1
FASB ASC 330–10–35–1: “Inventory–Overall–Subsequent Measurement.”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.
Requirement 2The specific citations that discuss the level of aggregation that should be used in
applying the lower-of-cost-or-market rule are FASB ASC 330–10–35–8 to11: “Inventory–Overall–Subsequent Measurement.”
9-18
Exercise 9-5
Exercise 9-6
Chapter 09 - Inventories: Additional Issues
Requirement 3
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Chapter 09 - Inventories: Additional Issues
Depending on the character and composition of the inventory, the rule of lower of cost or market may properly be applied either 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 shall be that which most clearly reflects periodic income. The purpose of reducing inventory to market is to reflect fairly the income of the period. The most common practice is to apply the lower of cost or market rule separately to each item of the inventory. However, if there is only one end-product category the cost utility of the total stock—the inventory in its entirety—may have the greatest significance for accounting purposes. Accordingly, the reduction of individual items to market may not always lead to the most useful result if the utility of the total inventory to the business is not below its cost. This might be the case if selling prices are not affected by temporary or small fluctuations in current costs of purchase or manufacture.
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Chapter 09 - Inventories: Additional Issues
Exercise 9-6 (concluded)Similarly, where more than one major product or operational category exists, the application of the
lower of cost or market rule to the total of the items included in such major categories may result in the most useful determination of income. When no loss of income is expected to take place as a result of a reduction of cost prices of certain goods because others forming components of the same general categories of finished products have a market equally in excess of cost, such components need not be adjusted to market to the extent that they are in balanced quantities. Thus, in such cases, the rule of lower of cost or market may be applied directly to the totals of the entire inventory, rather than to the individual inventory items, if they enter into the same category of finished product and if they are in balanced quantities, provided the procedure is applied consistently from year to year.To the extent, however, that the stocks of particular materials or components are excessive in relation to others, the more widely recognized procedure of applying the lower of cost or market to the individual items constituting the excess shall be followed. This would also apply in cases in which the items enter into the production of unrelated products or products having a material variation in the rate of turnover. Unless an effective method of classifying categories is practicable, the rule shall be applied to each item in the inventory. The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is:The income statement presentation of losses from the write-down of inventory:
FASB ASC 330–10–50–2: “Inventory–Overall–Disclosure”When substantial and unusual losses result from the application of the rule of lower of cost or market it will frequently be desirable to disclose the amount of the loss in the income statement as a charge separately identified from the consumed inventory costs described as cost of goods sold.
1. The determination of market value for applying LCM to inventory:
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 meets 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.
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Chapter 09 - Inventories: Additional Issues
Exercise 9-7 (concluded)
2. The accounting treatment required for a correction of an inventory error in previously issued financial statements:
FASB ASC 250–10–50–45–23: “Accounting Changes and Error Corrections–Overall–Disclosure–Other Presentation Matters.”
Any error in the financial statements of a prior period discovered after the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) shall be reported as an error correction, by restating the prior-period financial statements. Restatement requires all of the following:
a. The cumulative effect of the error on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
b. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
c. Financial statements for each individual prior period presented shall be adjusted to reflect correction of the period-specific effects of the error.
3. The use of the retail method to value inventory:
FASB ASC 330–10–30–13: “Inventory–Overall–Initial Measurement–Determination of Inventory Costs.”In some situations a reversed mark-up procedure of inventory pricing, such as the retail inventory method, may be both practical and appropriate. The business operations in some cases may be such as to make it desirable to apply one of the acceptable methods of determining cost to one portion of the inventory or components thereof and another of the acceptable methods to other portions of the inventory.
Beginning inventory (from records) $140,000
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Exercise 9-8
Chapter 09 - Inventories: Additional Issues
Plus: Net purchases (from records) 370,000 Cost of goods available for sale 510,000Less: Cost of goods sold:
Net sales $550,000Less: Estimated gross profit of 25% (137,500)Estimated cost of goods sold (412,500)
Estimated cost of inventory destroyed $ 97,500
Beginning inventory (from records) $100,000Plus: Net purchases (from records) 140,000 Cost of goods available for sale 240,000Less: Cost of goods sold:
Net sales $220,000Less: Estimated gross profit of 35% (77,000)Estimated cost of goods sold (143,000)
Estimated ending inventory 97,000Less: Value of usable damaged goods (12,000)Estimated loss from fire $ 85,000
Merchandise inventory, January 1, 2011 $1,900,000Purchases 5,800,000Freight-in 400,000
Cost of goods available for sale 8,100,000Less: Cost of goods sold:
Sales $8,200,000 Less: Estimated gross profit of 20% (1,640,000) (6,560,000)
Freight-in (from records) 3,000 Cost of goods available for sale 167,500Less: Cost of goods sold:
Net sales ($180,000 – 5,000) $175,000Less: Estimated gross profit of 50%* (87,500)Estimated cost of goods sold (87,500)
Estimated cost of inventory before theft 80,000Less: Stolen inventory (8,000)Estimated ending inventory $ 72,000
*Gross profit as a % of cost (1 + Gross profit as a % of cost) = Gross profit as a % of sales. 100% 200% = 50%
9-25
Chapter 09 - Inventories: Additional Issues
Beginning inventory + Net purchases - Ending inventory = Cost of goods sold
$27,000 + 31,000 - 28,000 = $30,000 = Cost of goods sold
Cost of goods soldCost percentage =
Net sales
$30,000Cost percentage = = 60%
$50,000
Cost RetailBeginning inventory $35,000 $50,000Plus: Net purchases 19,120 31,600
Net markups 1,200Less: Net markdowns ______ (800 )Goods available for sale 54,120 82,000
$54,120Cost-to-retail percentage: = 66% $82,000
Less: Net sales (32,000 )Estimated ending inventory at retail $50,000 Estimated ending inventory at cost (66% x $50,000) (33,000 )Estimated cost of goods sold $21,120
Net markups 20,000Less: Net markdowns _______ (4,000 )Goods available for sale (excluding beg. Inventory) 607,760 856,000 Goods available for sale (including beg. Inventory) 767,760 1,136,000
$607,760Cost-to-retail percentage: = 71% $856,000
Less: Net sales (800,000 )Estimated ending inventory at retail $ 336,000 Estimated ending inventory at cost: Retail CostBeginning inventory $280,000 $160,000Current period’s layer 56,000 x 71% = 39,760 Total $336,000 $199,760 (199,760 )Estimated cost of goods sold $568,000
Net markups 6,000Less: Net markdowns _______ (11,000 )Goods available for sale (excluding beginning inventory) 112,500 250,000 Goods available for sale (including beginning inventory) 183,780 382,000
$71,280Base year cost-to-retail percentage: = 54%
$132,000
$112,5002011 cost-to-retail percentage: = 45%
$250,000
Less: Net sales (232,000 )Estimated ending inventory at current year retail prices $150,000
Estimated ending inventory at cost (below) (77,004 )Estimated cost of goods sold $106,776
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$150,000$150,000 = $144,231 $132,000 (base) x 1.00 x 54% = $71,280(above) 1.04 12,231 (2011) x 1.04 x 45% = 5,724
Total ending inventory at dollar-value LIFO retail cost ...................... $77,004
Requirement 1
$15,000Cost-to-retail percentage = = 80%
$18,750
Requirement 2
2011
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$25,000 $25,000 = $20,000 $18,750 (base) x 1.00 x 80% = $15,000 (given) 1.25 1,250 (2011) x 1.25 x 82% = 1,281
Total ending inventory at dollar-value LIFO retail cost ............. $16,281
2012
$28,600 $28,600 = $22,000 $18,750 (base) x 1.00 x 80% = $15,000 (given) 1.30 1,250 (2011) x 1.25 x 82% = 1,281 2,000 (2012) x 1.30 x 85% = 2,210
Total ending inventory at dollar-value LIFO retail cost ............. $18,491
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Exercise 9-20
Chapter 09 - Inventories: Additional Issues
Cost RetailBeginning inventory $160,000 $250,000 Plus: Net purchases 350,200 510,000
Net markups 7,000Less: Net markdowns _______ (2,000 )Goods available for sale (excluding beginning inventory) 350,200 515,000 Goods available for sale (including beginning inventory) 510,200 765,000
Less: Net sales (380,000 )Estimated ending inventory at current year retail prices $385,000
Estimated ending inventory at cost (calculated below) (234,800 )Estimated cost of goods sold $275,400 ___________________________________________________________________________
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$385,000$385,000 = $350,000 $250,000 (base) x 1.00 x 64% = $160,000(above) 1.10 100,000 (2011) x 1.10 x 68% = 74,800
Total ending inventory at dollar-value LIFO retail cost ...................... $234,800
Cost-to-retail percentage, 1/1/11:
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Exercise 9-21
Exercise 9-22
Chapter 09 - Inventories: Additional Issues
$21,000 = 75%$28,000
Cost-to-retail percentage, 12/31/11:
$33,600 = $30,000 = Ending inventory at base year retail 1.12
$30,000 - 28,000 = $2,000 = LIFO layer added during 2011 at base year retail
$2,000 x 1.12 = $2,240 = LIFO layer added at current year retail
$22,792 - 21,000 = $1,792 = LIFO layer added at current year cost
$1,792 = 80% = Cost-to-retail percentage for the year 2011 layer$2,240
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Chapter 09 - Inventories: Additional Issues
Exercise 9-22 (concluded)
2012 ending inventory:
Cost Retail
Beginning inventory $22,792 $ 33,600 Plus: Net purchases 60,000 88,400 Goods available for sale (including beginning inventory) $82,792 122,000
$60,000Cost-to-retail percentage: = 67.87%
$88,400
Less: Net sales (80,000 )Estimated ending inventory at current year retail prices $ 42,000 Estimated ending inventory at cost (below) $26,864 ___________________________________________________________________________ Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$42,000 $42,000 = $35,000 $28,000 (base) x 1.00 x 75.00% = $21,000 (above) 1.20 2,000 (2011) x 1.12 x 80.00% = 1,792 5,000 (2012) x 1.20 x 67.87% = 4,072
Total ending inventory at dollar-value LIFO retail cost .................. $26,864
Requirement 1
To record the change: ($ in millions)Retained earnings.......................................................... 8.2
Inventory ($32 million - 23.8 million)............................. 8.2
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Exercise 9-23
Chapter 09 - Inventories: Additional Issues
Requirement 2CPS applies the average cost method retrospectively; that is, to all prior periods
as if it always had used that method. In other words, all financial statement amounts for individual periods that are included for comparison with the current financial statements are revised for period-specific effects of the change.
Then, the cumulative effects of the new method on periods prior to those presented are reflected in the reported balances of the assets and liabilities affected as of the beginning of the first period reported and a corresponding adjustment is made to the opening balance of retained earnings for that period. Let’s say CPS reports 2009-2011 comparative statements of shareholders’ equity. The $8.2 million adjustment above is due to differences prior to the 2011 change. The portion of that amount due to differences prior to 2009 is subtracted from the opening balance of retained earnings for 2009.
The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes, as well as the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.
Decrease in beginning inventory ($78,000 - 71,000) - $7,000
Decrease in ending inventory ($83,000 - 78,000) + 5,000Decrease in cost of goods sold $2,000
Cost of goods sold for 2010 would be $2,000 lower in the revised income statement.
Requirement 1
9-35
Exercise 9-24
Exercise 9-25
Chapter 09 - Inventories: Additional Issues
The 2009 error caused 2009 net income to be understated, but since 2009 ending inventory is 2010 beginning inventory, 2010 net income was overstated by the same amount. So, the income statement was misstated for 2009 and 2010, but the balance sheet (retained earnings) was incorrect only for 2009. After that, no account balances are incorrect due to the 2009 error.
Analysis: U = UnderstatedO = Overstated
2009 2010Beginning inventory Beginning inventory UPlus: net purchases Plus: net purchases Less: ending inventory U Less: ending inventoryCost of goods sold O Cost of goods sold U
Revenues RevenuesLess: cost of goods sold O Less: cost of goods sold ULess: other expenses Less: other expensesNet income U Net income O Retained earnings U Retained earnings corrected
9-36
Chapter 09 - Inventories: Additional Issues
Exercise 9-25 (concluded)
However, the 2010 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error.
Analysis: U = UnderstatedO = Overstated
2010Beginning inventory Plus: net purchases Less: ending inventory O Cost of goods sold U
RevenuesLess: cost of goods sold ULess: other expensesNet income O Retained earnings O
Requirement 2
Retained earnings (overstatement of 2010 income).............. 150,000Inventory (overstatement of 2011 beginning inventory).... 150,000
Requirement 3 The financial statements that were incorrect as a result of both errors (effect of
one error in 2009 and effect of two errors in 2010) would be retrospectively restated to report the correct inventory amount, cost of goods sold, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
U = understated
9-37
Exercise 9-26
Chapter 09 - Inventories: Additional Issues
O = overstatedNE = no effect
Cost of Net RetainedGoods Sold Income Earnings
1. Overstatement of ending inventory U O O2. Overstatement of purchases O U U3. Understatement of beginning inventory U O O4. Freight-in charges are understated U O O5. Understatement of ending inventory O U U6. Understatement of purchases U O O7. Overstatement of beginning inventory O U U8. Understatement of purchases +
understatement of ending inventory by the same amount NE NE NE
1. To include the $4 million in year 2011 purchases and increase retained earnings to what it would have been if 2010 cost of goods sold had not included the $4 million purchases.
Analysis:2010 2011
Beginning inventory Beginning inventoryPurchases O Purchases ULess: Ending inventoryCost of goods sold O
RevenuesLess: Cost of goods sold O U = UnderstatedLess: Other expenses O = OverstatedNet income U
2. The 2010 financial statements that were incorrect as a result of the errors would be retrospectively restated to reflect the correct cost of goods sold, (income tax
9-38
Exercise 9-27
Chapter 09 - Inventories: Additional Issues
expense if taxes are considered), net income, and retained earnings when those statements are reported again for comparative purposes in the 2011 annual report.
3. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
Requirement 1
The $42,000 should have been charged to purchases instead of advertising expense. This error caused 2010 net purchases and thus cost of goods sold to be understated and advertising expense to be overstated by $42,000. The understatement of ending inventory for the $30,000 in merchandise held on consignment caused 2010 cost of goods sold to be overstated.
Analysis: U = UnderstatedO = Overstated
2010Beginning inventory Plus: net purchases U by 42,000 Less: ending inventory U by 30,000Cost of goods sold U by 12,000
RevenuesLess: cost of goods sold U by 12,000Less: other expenses O by 42,000Net income U by 30,000 Retained earnings U by 30,000
Requirement 2
Inventory (understatement of 2011 beginning inventory) 30,000Retained earnings (understatement of 2010 income) 30,000
Requirement 3 The 2010 financial statements that were incorrect as a result of the two errors
would be retrospectively restated to report the correct inventory amount, cost of goods sold, advertising expense, net income, and retained earnings when those statements
9-39
Exercise 9-28
Chapter 09 - Inventories: Additional Issues
are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
9-40
Chapter 09 - Inventories: Additional Issues
List A List B
e 1. Gross profit ratio a. Reduction in selling price below the originalselling price.
i 2. Cost-to-retail percentage b. Beginning inventory is not included in thecalculation of the cost-to-retail percentage.
l 3. Additional markup c. Deducted in the retail column after thecalculation of the cost-to-retail percentage.
a 4. Markdown d. Requires base year retail to be converted tolayer year retail and then to cost.
k 5. Net markup e. Gross profit divided by net sales. b 6. Retail method, f. Material inventory
FIFO & LIFO error discovered in a subsequent year. j 7. Conventional retail g. Must be deducted in the retail column if sales
method are recorded net of discounts. n 8. Change from LIFO h. Deducted in the retail column to arrive at
goods available for sale at retail. d 9. Dollar-value LIFO retail i. Divide cost of goods available for sale by
goods available at retail. c 10. Normal spoilage j. Average cost, LCM. f 11. Requires retrospective k. Added to the retail column to arrive at goods
restatement available for sale. g 12. Employee discounts l. Increase in selling price subsequent to initial
markup. h 13. Net markdowns m. Ceiling in the determination of market. m 14. Net realizable value n. Accounting change requiring retrospective
treatment.
Requirement 1
If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference.
December 31, 2011
9-41
Exercise 9-29
Exercise 9-30
Chapter 09 - Inventories: Additional Issues
Estimated loss on purchase commitment ($60,000 - 56,000) . . . 4,000Estimated liability on purchase commitment .................. 4,000
Requirement 2If market price on purchase date declines from year-end price, the purchase is recorded at market price.
March 21, 2012Inventory............................................................................ 54,000Loss on purchase commitment ($56,000 - 54,000)................. 2,000Estimated liability on purchase commitment...................... 4,000
1. c. In applying the lower of cost or market method, market is defined as current replacement cost, except that:
Upper limit: Market is not to exceed net realizable value (estimated selling price less costs of completion and disposal).Lower limit: Market should not be less than net realizable value less a normal profit margin.
If inventory is reported at replacement cost, it is the market value, and must be less than the original cost and greater than the net realizable value less a normal profit margin.
2. b. The inventory would be valued at $360,000, the “market” (replacement cost) as it is lower than the $400,000 FIFO cost.
Replacement cost, $360,000, is “market” as it is:
a. not greater than the upper limit, $388,000 net realizable value ($408,000 selling price – $20,000 cost of disposal); and
b. not less than the lower limit, $328,000 ($388,000 net realizable value – $60,000 normal profit).
3. c.
Inventory, 1/1 $ 80,000
Add: Purchases 330,000Good available for sale 410,000Less: Cost of goods sold ($360,000 120%) 300,000Estimated inventory, 5/2 $110,000
Note: Although the estimated inventory is $110,000, the estimated fire loss would be $70,000 because of the $40,000 of goods in transit included in inventory.
9-44
CPA / CMA REVIEW QUESTIONS
Chapter 09 - Inventories: Additional Issues
CPA Exam Questions (concluded)
4. d.
Cost RetailBeginning inventory and purchases $600,000 $920,000Net markups _______ 40,000Available for sale 600,000 960,000Cost-to-retail percentage: $600,000 $960,000 = 62.5%Less: Net markdowns (60,000) Sales (780,000)Estimated ending inventory at retail $120,000Estimated ending inventory at cost: ($120,000 x 62.5%) 75,000Estimated cost of goods sold $525,000
Conventional retail is the lower of average cost or market. For a lower of cost or market retail method, net markdowns are excluded from the cost to retail ratio.
5. c. The understatement of beginning inventory and the overstatement of ending inventory both cause the cost of goods sold to be understated. The total understatement is $78,000 ($26,000 + $52,000).
9-45
Chapter 09 - Inventories: Additional Issues
CMA Exam Questions
1. d. The failure to record a sale means that both accounts receivable and sales will be understated. However, inventory was correctly counted, so that account and cost of goods sold were unaffected.
2. d. The overstatement (double counting) of inventory at the end of year 1 caused year 1 cost of goods sold (BI + Purchases – EI) to be understated and both inventory and income to be overstated. The year 1 ending inventory equals year 2 beginning inventory. Thus, the same overstatement caused year 2 beginning inventory and cost of goods sold to be overstated and income to be understated. This is an example of a self-correcting error. By the end of year 2, the balance sheet is correct.
3. b. The conventional retail inventory method adds beginning inventory, net purchases, and markups (but not markdowns) to calculate a cost percentage. The purpose of excluding markdowns is to approximate a lower-of-average-cost-or-market valuation. The cost percentage is then used to reduce the retail value of the ending inventory to cost. FCL’s cost-retail ratio is 40% ($90,000 $225,000), and ending inventory at cost is therefore $20,000 (40% x $50,000 ending inventory at retail).
9-46
Chapter 09 - Inventories: Additional Issues
PROBLEMSRequirement 1
Product NRV per unit NRV-NP per unitA $16 - (15% x $16) = $13.60 $13.60 - (40% x $16) = $7.20B $18 - (15% x $18) = $15.30 $15.30 - (40% x $18) = $8.10C $ 8 - (15% x $8) = $ 6.80 $ 6.80 - (40% x $ 8) = $3.60D $ 6 - (15% x $6) = $ 5.10 $ 5.10 - (40% x $ 6) = $2.70E $13 - (15% x $13) = $11.05 $11.05 - (40% x $13) = $5.85
(1) (2) (3) (4) (5)
Product(units) RC
Ceiling
NRV
Floor
NRV-NP
Designated Market Value[Middle value
of (1), (2) & (3)]
Cost
Inventory Value
[Lower of (4) and (5)]
A (1,000) $12,000 $13,600 $7,200 $12,000 $10,000 $10,000
B (800) 8,800 12,240 6,480 8,800 12,000 8,800
C (600) 1,200 4,080 2,160 2,160 1,800 1,800
D (200) 800 1,020 540 800 1,400 800
E (600) 7,200 6,630 3,510 6,630 8,400 6,630
Totals $30,390 $33,600 $28,030
Inventory carrying value would be $28,030.
Requirement 2Inventory carrying value would be $30,390, the lower of aggregate inventory cost
($33,600) and aggregate inventory market ($30,390). The amount of the loss from inventory write-down is $3,210 ($33,600 - 30,390).
Less: Net markdowns ________ (150,000 )Goods available for sale 1,497,500 2,300,000Less:
Normal shrinkage (15,000)Sales:
Sales to customers $1,750,000Sales to employees 250,000Employee discounts
(2,000,000) (62,500 )
Estimated ending inventory at retail $ 222,500 Estimated ending inventory at cost (61.12% x $222,500) (135,992 ) Estimated cost of goods sold $1,361,508
Less: Net markdowns _______ (800 )Goods available for sale $123,151 175,130Less:
Normal spoilage (4,500)Net sales (135,730 )
Estimated ending inventory at retail $ 34,900 Estimated ending inventory at cost (70% x $34,900) $24,430
Requirement 2The difference between the inventory estimate per retail method and the amount
per physical count may be due to:1. Theft losses.2. Spoilage or breakage above normal.3. Differences in cost-to-retail percentage for purchases during the month, beginning
inventory, and ending inventory.4. Markups on goods available for sale inconsistent between cost of goods sold and
ending inventory.5. A wide variety of merchandise with varying cost-to-retail percentages.6. Incorrect reporting of markdowns, additional markups or cancellations.
($ in 000s) Cost Retail
Beginning inventory $ 80 $ 125Purchases 671 1,006Freight-in on purchases 30Purchase returns (1) (2)Net markups 4Net markdowns ___ (8)Goods available for sale $780 1,125
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$209$209 = $190 $125 (base) x 1.00 x 64% = $ 80
(above) 1.10 65 (2011) x 1.10 x 70% = 50
Total ending inventory at dollar-value LIFO retail cost ...................... $130
Employee discounts must be deducted in the retail column.
Less: Net markdowns ______ (2,000 )Goods available for sale (excluding beginning inventory) 87,000 116,000 Goods available for sale (including beginning inventory) 115,000 156,000
$ 87,000Cost-to-retail percentage: = 75%
$116,000
Less: Net sales ($100,000 + 2,400) Employee discounts
(102,400) (600 )
Estimated ending inventory at current year retail prices $ 53,000 Estimated ending inventory at cost (below) (35,950 ) Estimated cost of goods sold $79,050
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$53,000 $53,000 = $50,000 $40,000 (base) x 1.00 x 70% = $28,000 (above) 1.06 10,000 (2011) x 1.06 x 75% = 7,950
Total ending inventory at dollar-value LIFO retail cost ............ $35,950
Less: Net markdowns ______ (2,200 )Goods available for sale (excluding beginning inventory) 92,500 119,800 Goods available for sale (including beginning inventory) 128,450 172,800
$ 92,500Cost-to-retail percentage: = 77.21%
$119,800
Less: Net sales ($104,000 + 4,000) Employee discounts
(108,000) (1,000 )
Estimated ending inventory at current year retail prices $ 63,800 Estimated ending inventory at cost (below) (42,744 ) Estimated cost of goods sold $85,706 ___________________________________________________________________________
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$63,800 $63,800 = $58,000 $40,000 (base) x 1.00 x 70% = $28,000 (above) 1.10 10,000 (2011) x 1.06 x 75% = 7,950
8,000 (2012) x 1.10 x 77.21% = 6,794
Total ending inventory at dollar-value LIFO retail cost ............ $42,744
Purchase discounts (5,000)Plus: Net markups 25,000Less: Net markdowns _______ (10,000 )Goods available for sale (excluding beg. inventory) 297,000 495,000 Goods available for sale (including beg. inventory) $324,500 540,000
$297,000Cost-to-retail percentage: = 60%
$495,000Less:
Net sales ($492,000 – 5,000)Employee discounts
(487,000 (3,000 )
Estimated ending inventory at retail $ 50,000 Estimated ending inventory at cost:
Retail CostBeginning inventory $45,000 $27,500Current period’s layer 5,000 x 60% = 3,000 Total $50,000 $30,500
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Chapter 09 - Inventories: Additional Issues
Problem 9-10 (concluded)
Requirement 3
2010
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$56,100 $56,100 = $55,000 $50,000 (base) x 1.00 x 61%* = $30,500 1.02 5,000 (2010) x 1.02 x 62% = 3,162
Total ending inventory at dollar-value LIFO retail cost .............. $33,662
* $30,500 = 61%
$50,000
2011
$48,300 $48,300 = $46,000 $46,000 (base) x 1.00 x 61% = $28,060 1.05
Total ending inventory at dollar-value LIFO retail cost ............... $28,060
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Chapter 09 - Inventories: Additional Issues
Requirement 1
Employee discounts must be deducted in the retail column.2011:
Freight-in 6,960Less: Purchase returns (2,500) (3,500)Plus: Net markups 8,500Less: Net markdowns _______ (4,000 )Goods available for sale (excluding beg. inventory) 482,460 731,000 Goods available for sale (including beg. inventory) 572,460 881,000
(6,000 )Estimated ending inventory at retail $206,000 Estimated ending inventory at cost (below) 123,990 Estimated cost of goods sold $448,470
9-62
Problem 9-11
Chapter 09 - Inventories: Additional Issues
Problem 9-11 (continued)
2011
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$206,000 $206,000 = $200,000 $150,000 (base) x 1.00 x 60% = $90,000 (above) 1.03 50,000 (2011) x 1.03 x 66% = 33,990
Total ending inventory at dollar-value LIFO retail cost ............ $123,990
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Chapter 09 - Inventories: Additional Issues
Problem 9-11 (continued)
Employees must be deducted in the retail column.2012:
Freight-in 8,000Less: Purchase returns (2,200) (4,000)Plus: Net markups 10,000Less: Net markdowns _______ (6,000 )Goods available for sale (excluding beg. inventory) 516,800 760,000 Goods available for sale (including beg. inventory) 640,790 966,000
Employee discounts (7,500 )Estimated ending inventory at retail $254,400 Estimated ending inventory at cost (below) 152,822 Estimated cost of goods sold $487,968
9-64
Chapter 09 - Inventories: Additional Issues
Problem 9-11 (continued)
2012
Step 1 Step 2 Step 3 Ending Ending Inventory Inventory Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost
$254,400 $254,400 = $240,000 $150,000 (base) x 1.00 x 60% = $90,000 (above) 1.06 50,000 (2011) x 1.03 x 66% = 33,990
40,000 (2012) x 1.06 x 68% = 28,832
Total ending inventory at dollar-value LIFO retail cost ............ $152,822
9-65
Chapter 09 - Inventories: Additional Issues
Problem 9-11 (continued)
Requirement 2
Employee discounts must be deducted in the retail column.2011:
Freight-in 6,960Less: Purchase returns (2,500) (3,500)Plus: Net markups 8,500Less: Net markdowns _______ (4,000 )Goods available for sale 572,460 881,000
Cost of goods available for sale $530,000Less ending inventory: 5,000 units @ $40 $200,000 2,000 units @ $36 72 ,000 (272 ,000 )Cost of goods sold $258 ,000
5,000 units @ $36 $180,000 5,000 units @ $40 200,000 380,000
Cost of goods available for sale (15,000 units) 510,000Less ending inventory (below) ( 238,000 )Cost of goods sold $272,000
Cost of ending inventory:
$510,000Weighted average unit cost = = $34
15,000 units
7,000 units x $34 = $238,000
The effect of the change for the year 2011 is a $14,000 increase in cost of goods sold ($272,000 - 258,000) resulting in a $14,000 decrease in income before tax and a $8,400 decrease in income after tax [$14,000 x (1 - .40)].
Requirement 1
9-68
Problem 9-12
Problem 9-13
Chapter 09 - Inventories: Additional Issues
Analysis: U = UnderstatedO = Overstated
2009 2010Beginning inventory Beginning inventory U-6,000Plus: Net purchases Plus: Net purchases U-3,000Less: E nding inventory U-6,000 Less: E nding inventory O-9,000Cost of goods sold O-6,000 Cost of goods sold U-18,000
Revenues RevenuesLess: Cost of goods sold O-6,000 Less: Cost of goods sold U-18,000Less: O ther expenses Less: O ther expenses Net income U-6,000 Net income O-18,000
Requirement 3The financial statements that were incorrect as a result of both errors (effect of
one error in 2009 and effect of three errors in 2010) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2011 annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
Requirement 1
December 31, 2011 inventory, based on a physical count $450,000Add: Merchandise shipped f.o.b. shipping point in 2011 20,000
Merchandise shipped f.o.b. shipping point in 2011 80,000Correct ending inventory $550,000
9-69
Problem 9-14
Chapter 09 - Inventories: Additional Issues
Analysis: U = UnderstatedO = Overstated
2011Beginning inventory Plus: Net purchases U-130,000 ($50,000 + 80,000) Less: Ending inventory U-100,000Cost of goods sold U -30,000
RevenuesLess: Cost of goods sold U -30,000Less: Other expensesNet income O -30,000 Retained earnings O -30,000
The 2010 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2011 annual report. A “prior period adjustment” to 2011 beginning retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on 2010 net income and earnings per share.
An understatement of ending inventory causes cost of goods sold to be overstated. Therefore, 2010 before-tax income was understated by $62,000.
Requirement 1
a. $10.50
If market price is equal to or greater than the contract price, the purchase is recorded at cost.
Purchases ($10.00 x 10,000 units)...................................... 100,000Cash.......................................................................... 100,000
b. $9.50
If market price is less than the contract price, the purchase is recorded at the market price.
Purchases ($9.50 x 10,000 units)........................................ 95,000Loss on purchase commitment (difference)...................... 5,000
No entry is required. Market price is greater than contract price.
b. $10.30
If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference.
December 31, 2011Estimated loss on purchase commitment [($11.00 x 20,000 units) - ($10.30 x 20,000 units)]................. 14,000
Estimated liability on purchase commitment............. 14,000
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Chapter 09 - Inventories: Additional Issues
Problem 9-16 (concluded)
Requirement 3a. $11.50
If market price on purchase date has not declined from year-end price, the purchase is recorded at the year-end market price.
Purchases ($10.30 x 20,000 units)...................................... 206,000Estimated liability on purchase commitment................. 14,000
Cash ($11.00 x 20,000 units).......................................... 220,000
b. $10.00
If market price on purchase date declines from year-end price, the purchase is recorded at market price.
Purchases ($10.00 x 20,000 units)...................................... 200,000Loss on purchase commitment ($220,000 - 200,000 -14,000)*.......................................... 6,000Estimated liability on purchase commitment................. 14,000
Cash ($11.00 x 20,000 units).......................................... 220,000
* or, ($10.30 - $10.00) x 20,000 units = $6,000
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Chapter 09 - Inventories: Additional Issues
CASES1. Hudson should account for the warehousing costs
related to its wholesale inventories as part of inventory. All reasonable and necessary costs of preparing inventory for
sale should be recorded as inventory cost. This approach results in proper matching of the warehousing costs with revenue when the wholesale inventories are sold.
2. a. The lower-of-cost-or-market method produces a more realistic estimate of future cash flows to be realized from assets, which is consistent with the principle of conservatism, and recognizes (matches) the anticipated loss in the income statement in the period in which the price decline occurs.
b. Hudson’s wholesale inventories should be reported in the balance sheet at replacement cost. According to the lower-of-cost-or-market method, replacement cost is defined as market. However, market cannot exceed net realizable value and cannot be less than net realizable value less the normal profit margin. In this instance, replacement cost is below original cost, below net realizable value, and above net realizable value less the normal profit margin. Therefore, Hudson’s wholesale inventories should be reported at replacement cost.
3. Hudson’s freight-in costs should be included only in the cost amounts to determine the cost-to-retail percentage. Hudson’s net markups should be included only in the retail amounts to determine the cost-to-retail-percentage. Hudson’s net markdowns should not be deducted from the retail amounts to determine the cost-to-retail percentage.
4. By not deducting net markdowns from the retail amounts to determine the cost-to-retail percentage, Hudson produces a lower cost-to-retail percentage than would result if net markdowns were deducted. By applying this lower percentage to ending inventory at retail, the inventory is reported at an amount below cost, which approximates lower of average cost or market.
Arguments for the LCM approach versus historical cost should focus on the loss of utility concept. A departure from cost is warranted when
the utility of an asset (its probable future economic benefits) is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. So, deterioration, obsolescence, changes in price levels, or any situation that might compromise the inventory’s salability impairs utility. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market (LCM) approach to valuing inventory was developed. Reporting inventories at LCM causes losses to be recognized when the value of inventory declines below its cost, rather than in the period in which the goods ultimately are sold.
A difference between LCM and a market value approach is that a market value approach would recognize income as market value increases above cost. This results
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Judgment Case 9-1
Communication Case 9-2
Chapter 09 - Inventories: Additional Issues
in recognizing income before the inventory is sold. Arguments for the LCM approach should focus on the realization principle. That is, in most situations, until inventory is sold, there exists significant uncertainty about the ultimate cash to be collected.
It is important that each student actively participate in the process of arriving at a solution. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.
Goods available for sale 421,500Less: Ending inventory (176,000) (1)Cost of goods sold $245,500
York Co.Supporting Schedule of Ending Inventory
December 31, 2011
Inventory at cost (LIFO): Cost Total
Units per unit costBeginning inventory, January 1, 8,000 $8.20 $ 65,600Purchases, quarter ended March 31 12,000 8.25 99,000Purchases, quarter ended June 30 2,000 7.90 15,800
22,000 $180,400
Inventory at market:22,000 units @ $8 = $176,000 (1)
Requirement 2Inventory should be valued at the lower of cost or market. Market means current
replacement cost, except that:
(1) Market should not exceed the net realizable value; and
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(2) Market should not be less than net realizable value reduced by an allowance for a normal profit margin.
In this situation, because replacement cost ($8 per unit) is less than net realizable value, but greater than net realizable value reduced by a normal profit margin, replacement cost is used as market. Because inventory valued at market ($176,000) is lower than inventory valued at cost ($180,400), inventory should be reported in the financial statements at market.
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1. a. The advantages of using the dollar-value LIFO method are to reduce the cost of accounting for inventory and to minimize the probability of liquidation of LIFO
inventory layers.b. The application of dollar-value LIFO is based on dollars of inventory, an
inventory cost index for each year, and broad inventory pools. The inventory layers are identified with the inventory cost index for the year in which the layer was added. In contrast, traditional LIFO is applied to individual units at their cost.
2. a. Huddell’s net markups should be included only in the retail amounts (denominator) to determine the cost-to-retail percentage. Huddell’s net markdowns should be ignored in the calculation of the cost-to-retail percentage.
b. By not deducting net markdowns from the retail amounts to determine the cost-to-retail percentage, Huddell produces a lower cost-to-retail percentage than would result if net markdowns were deducted. Applying this lower percentage to ending inventory at retail, the inventory is reported at an amount below cost. This amount is intended to approximate the lower of average cost or market.
Suggested Grading Concepts and Grading Scheme:
Content (70%)_______ 30 Describes the method.
______ Determining ending inventory at retail. Multiply ending inventory at retail by the cost percentage.
______ Markups and markdowns.
_______ 10 Discusses the conditions that may distort results.______ Possible inaccurate cost percentage. Does not explicitly consider theft, breakage, etc.
_______ 30 Describes the advantages of using the method whencompared to other methods.
______ Avoids physical inventory count.______ Acceptable for financial reporting and income taxes.______ Can explicitly incorporate cost flow methods, taxes,
and LCM.______
_______ 70 points
Writing (30%)_______ 6 Terminology and tone appropriate to the audience of a company
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Communication Case 9-5
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president._______ 12 Organization permits ease of understanding.
______ Introduction that states purpose.______ Paragraphs that separate main points.
_______ 12 English______ Sentences grammatically clear and well organized, concise.______ Word selection.______ Spelling.______ Grammar and punctuation.
_____________ 30 points
For changes not involving LIFO or changes from the LIFO method to another, the event is accounted for as a normal change in accounting principle. In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods’ financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. More specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we make an adjustment to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change.
The advantage of retrospective application is to enhance comparability of the statements from year to year. The recast statements appear as if the newly adopted accounting method had been applied in all previous years.
Consistency and comparability suggest that accounting choices once made should be consistently followed from year to year. So, any change requires that the new method be justified as clearly more appropriate. In the first set of financial statements after the change, a disclosure note is needed to provide that justification. The disclosure note also should point out that comparative information has been revised and report any per share amounts affected for the current period and all prior periods presented, as well as the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.
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Analysis Case 9-6
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When a company changes to the LIFO inventory method from any other method, it usually is impracticable to calculate the cumulative effect of the change. Revising balances in prior years would require knowing what those balances should be. LIFO inventory, though, consists of “layers” added in prior years at costs existing in those years. If another method has been used, the company probably hasn’t kept a record of those costs. Accordingly, accounting records of prior years usually are inadequate to report the change retrospectively. Because of this difficulty, a company changing to LIFO usually does not report the change retrospectively. Instead, the base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted. Then, the LIFO method is applied prospectively from that point on. The disclosure note must include an explanation as to why retrospective application was impracticable.
We report most voluntary changes in accounting principles retrospectively. This means recasting all previous periods’ financial statements as if the new
method were used in those periods. For each year in the comparative statements reported, we revise the balance of each account affected so that those statements appear as if the newly adopted accounting method had been applied all along. Then we create a journal entry to adjust all account balances affected as of the date of the change.
GAAP require retrospective application to enhance comparability of the statements from year to year. The revised statements are made to appear as if the newly adopted accounting method (FIFO method in this case) had been applied in all previous years.
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Requirement 1
Inventories are valued primarily at the lower of cost (using the last-in, first-out or “LIFO” method) or market, determined by the retail method for department stores, regional warehouses and store distribution centers, and standard cost, representing average vendor cost, for Direct.
Requirement 2To estimate the effects of inflation/deflation on ending inventory, an internal
index measuring price changes from the beginning to the end of the year is calculated using merchandise cost data at the item level.
Requirement 3The lower of cost or market is applied on an aggregate basis for similar types of
merchandise.
Requirement 4The disclosure note states that if the first-in, first-out or “FIFO” method of
inventory valuation had been used instead of the LIFO method, inventories would have been $2 million and $1 million higher at January 31, 2009 and February 2, 2008, respectively.
Therefore, 2009 cost of goods sold would have been lower (and income before tax higher) by $1 million ($2 million – 1 million) if J.C. Penney had used FIFO to value its inventory instead of LIFO.
Requirement 6For changes not involving LIFO or changes from the LIFO method to another, the
event is accounted for as a normal change in accounting principle. In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods’ financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. More specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we make an adjustment to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change.
Requirement 1
Change in Inventory MethodDuring 2011, the Company changed the method of valuing its inventories from the first-in, first-out (FIFO) method, to the last-in, first-out (LIFO) method, determined by the retail method. To estimate the effects of changing retail prices on inventories, the Company utilizes internally developed price indexes. The impact of the change was to decrease 2011 net income by $13.2 million and to decrease earnings per share by $0.13. Management has determined that retrospective application of the change is impracticable because the cumulative effect of the change on prior years was not determinable.
The Company believes that the change to the LIFO method provides a more consistent matching of merchandise costs with sales revenue and also provides a more comparable basis of accounting with competitors.
Note: Because cost of goods sold would have been $22 million lower if the change had not been made, income before tax would have been $22 million higher, and net income would have been $13.2 million higher ($22 million multiplied by 60% [1 - .40]).
Requirement 2It usually is impracticable to calculate the cumulative effect of a change to LIFO.
To do so would require assumptions as to when specific LIFO inventory layers were
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created in years prior to the change. Accounting records usually are inadequate for a company to create the appropriate LIFO inventory layers. That’s why a change to LIFO usually can’t be applied retrospectively.
Despite the self-correcting feature of certain inventory errors, the errors cause the financial statements of the year of the error as well as the financial statements
in the subsequent year to be incorrect. For example, an overstatement of ending inventory at the end of 2010 will correct itself in 2011 and retained earnings at the end of 2011 will be correct. However, cost of goods sold and net income will be incorrect in both years. In addition, inventory and retained earnings on the 2010 balance sheet will be incorrect.
If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance of retained earnings in the statement of shareholders’ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share.
Requirement 1
Bonuses will be negatively affected because if the error is corrected, a lower ending inventory results in higher cost of goods sold and lower income. The effect of the error would be an overstatement of pre-tax income by $665,000 ($3,265,000 - 2,600,000).
Requirement 2It will be reported as a prior period adjustment to the beginning retained earnings
balance for the year beginning July 1, 2011. Financial statements for the year ending June 30, 2011, will be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings.
Requirement 3
Ethical Dilemma:Should John recognize his obligation to disclose the inventory error to Danville
shareholders, the local bank, auditors, and taxing authorities or remain quiet, enabling him and other company employees to receive originally computed year-end bonuses?
GAAP requires that purchase commitments be evaluated in the same way as inventory on hand for the
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Ethics Case 9-11
Analysis Case 9-12
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purpose of determining any lower-of-cost-or-market (LCM) adjustment. Purchases are recorded at market price when market price is lower than the agreed upon contract price, and a loss is recognized for the difference between market price and contract price. Also, losses must be recognized for any purchase commitments outstanding at the end of a reporting period when market price is less than contract price.
In this case, the contract price of $.80 per gallon is compared to the market price at December 31. If market is less than $.80, an estimated loss is recognized for the difference multiplied by the million gallon commitment. An estimated liability is recorded for the loss. If market price is greater than $.80, then no year-end adjustment is necessary.
As the heating oil is purchased in 2012, if an estimated loss is recorded at year-end, the purchases are recorded at the lower of market price and year-end price. If no loss is recorded at year-end, the purchases are recorded at the lower of market price and contract price.
When applying the lower-of-cost-or-market approach to valuing inventory, under U.S. GAAP market is defined as replacement cost with a ceiling of net
realizable value (NRV) and a floor of NRV less a normal profit margin.
