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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-net realizable value
- Lower-of-cost-or-market. 6, 7 4, 5 7, 8 4, 5 4
- Inventory accounting changes; relative sales value method; net real- izable value.
- Purchase commitments. 10 7, 8 11, 12 11 7
- Gross profit method. 11, 12, 13, 14
- Retail inventory method. 15, 16, 17 10 20 21,, 22, 8, 9, 10 5, 6
- Presentation and analysis.
*8. LIFO retail. 20 12 24, 25 13, 14
*9. Dollar-value LIFO retail. 13 26, 27, 28, 29
Special LIFO problems. 30 14, 15
*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
- Understand and apply the lower-of-cost-or net realizable value rule.
- Understand and apply the lower-of-cost-or-market rule.
- Understand other inventory valuation issues
- Determine ending inventory by applying the gross profit method.
- Determine ending inventory by applying the retail inventory method.
- Explain how to report and analyze inventory.
*7. Determine ending inventory by applying the LIFO retail methods.
*This material is discussed in an Appendix to the chapter.
ASSIGNMENT CHARACTERISTICS TABLE (Continued)
Item Description
Level of Difficulty
Time (minutes)
P9-10 Retail inventory method. Moderate 20– P9-11 Statement and note disclosure, LCM, and purchase commitment.
Moderate 30–
*P9-12 Conventional and dollar-value LIFO retail. Moderate 30– *P9-13 Retail, LIFO retail, and inventory shortage. Moderate 30– *P9-14 Change to LIFO retail. Moderate 30– *P9-15 Change to LIFO retail; dollar-value LIFO retail. Complex 40–
CA9-1 LCNRV. Moderate 15– CA9-2 LCNRV. Moderate 20– CA9-3 LCNRV. Moderate 15– CA9-4 LCNRV. Moderate 15- CA9-5 Retail inventory method. Moderate 25– CA9-6 Cost determination, LCM, retail method. Moderate 15– CA9-7 Purchase commitments. Moderate 10–
ANSWERS TO QUESTIONS
- 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 net realizable value in the financial statements.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required; however, when the utility of the goods included in the inventory is less than their cost, this loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower-of-cost-and-net realizable value 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 and net realizable value, 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-and-net realizable value 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 net realizable value) 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 net realizable value 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 net realizable value in the next year. (e) The lower-of-cost-and-net realizable value 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.
LO: 1, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 9 (Continued)
- 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.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
- 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, Estimated Liability on Purchase Commitments ............................... 45,
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.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
- 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.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
- 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
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
- 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 +.
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Questions Chapter 9 (Continued)
- Inventory, January 1, 2017 .................................................................... $ 400,
Purchases to February 10, 2017 ............................................................ $1,140, Freight-in to February 10, 2017.............................................................. 60,000 1,200, Merchandise available.................................................................... 1,600, Sales revenue to February 10, 2017 ...................................................... 1,950, Less gross profit at 40% ................................................................. 780, Sales at cost .............................................................................. 1,170, Inventory (approximately) at February 10, 2017 ......................... $ 430,
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: AICPA BB: None
- 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.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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.
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.
LO: 5, Bloom: C, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 9-
Item Cost NRV LCNRV
Skis $190.00 $161.00 $161.
Boots 106.00 108.00 106.
Parkas 53.00 50.00 50.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
BRIEF EXERCISE 9-
(a) Item Cost NRV LCNRV
Item-by-item
Jokers $ 2,000 $ 2,100 $ 2,
Penguins 5,000 4,950 4,
Riddlers 4,400 4,625 4,
Scarecrows 3,200 3,830 3,
Total $14,600 $15,505 $14,
(b) 1. Penguins only: $
2. None on a whole group: $15,505 > $14,600.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
BRIEF EXERCISE 9-
(a) Cost-of-goods-sold-method
Cost of Goods Sold .............................................. 21,000,
Allowance to Reduce Inventory to NRV..... 21,000,
(b) Loss method
Loss Due to Decline of Inventory to NRV ........... 21,000,
Allowance to Reduce Inventory to NRV..... 21,000,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
BRIEF EXERCISE 9-
(a) Ceiling $193.00 ($212 – $19)
Floor $161.00 ($212 – $19 – $32)
(b) $106.
(c) $51.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
BRIEF EXERCISE 9-
(a) Cost-of-goods-sold method
Cost of Goods Sold .................................................. 21,
Allowance to Reduce Inventory to Market .... 21,000*
(b) Loss method
Loss Due to Market Decline of Inventory ............... 21,
Allowance to Reduce Inventory to Market .... 21,
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
BRIEF EXERCISE 9-
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 $
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
BRIEF EXERCISE 9-
Unrealized Holding Loss—Income (Purchase
Commitments) .......................................................... 50,
Estimated Liability on Purchase
Commitments ($1,000,000 – $950,000) .......... 50,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
BRIEF EXERCISE 9-
Inventory turnover:
= 5.32 times
Average days to sell inventory:
365 ÷ 5.32 = 68.6 days
LO: 6, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
*BRIEF EXERCISE 9-
Cost Retail
Beginning inventory.............................................. $ 12,000 $ 20,
Net purchases ....................................................... 120,000 170,
Net markups .......................................................... 10,
Net markdowns ..................................................... (7,000)
Total (excluding beginning inventory) ................. 120,000 173,
Total (including beginning inventory).................. $132,000 193,
Deduct: Sales revenue ......................................... 147,
Ending inventory at retail ..................................... $ 46,
Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4%
Ending inventory at cost
$20,000 X 60% ($12,000/$20,000) = $12,
26,000 X 69.4% = 18,
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
*BRIEF EXERCISE 9-
Cost Retail
Beginning inventory .............................................. $ 12,000 $ 20,
Net purchases........................................................ 120,000 170,
Net markups........................................................... 10,
Net markdowns...................................................... (7,000)
Total (excluding beginning inventory) ................. 120,000 173,
Total (including beginning inventory) .................. $132,000 193,
Deduct: Sales revenue ......................................... 147,
Ending inventory at retail...................................... $ 46,
Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4%
Ending inventory at retail deflated to base year prices
$46,000 ÷ 1.15 = $40,
Ending inventory at cost
$20,000 X 100% X 60% = $12,
20,000 X 115% X 69.4% = 15,
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
EXERCISE 9-3 (15–20 minutes)
Item No.
Cost per Unit
Net Realizable Value LCNRV Quantity
Final Inventory Value
1320 $3.20 $2.90* $2.90 1,200 $ 3, 1333 2.70 2.40 2.40 900 2, 1426 4.50 3.60 3.60 800 2, 1437 3.60 1.85 1.85 1,000 1, 1510 2.25 1.85 1.85 700 1, 1522 3.00 3.10 3.00 500 1, 1573 1.80 1.30 1.30 3,000 3, 1626 4.70 4.50 4.50 1,000 4, $21,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
EXERCISE 9-4 (10–15 minutes)
December 31, 2017
(a) Cost of Goods Sold ($346,000 – $322,000) ............ 24,
Allowance to Reduce Inventory to NRV........ 24,
December 31, 2018
Allowance to Reduce Inventory to NRV ................. 4,
Cost of Goods Sold ........................................ 4,
December 31, 2017
(b) Loss Due to Decline of Inventory to NRV .............. 24,
Allowance to Reduce Inventory to NRV........ 24,
December 31, 2018
Allowance to Reduce Inventory to NRV ................. 4,000*
Recovery of Inventory Loss .......................... 4,
EXERCISE 9-4 (Continued)
*Cost of inventory at 12/31/17 .................................... $346,
LCNRV at 12/31/17 .................................................... (322,000)
Allowance amount needed to reduce inventory
to NRV (a) ............................................................... $ 24,
Cost of inventory at 12/31/18.................................... $410,
LCNRV at 12/31/18 .................................................... (390,000)
Allowance amount needed to reduce inventory
to NRV (b) ............................................................... $ 20,
Recovery of previously recognized loss = (a) – (b)
(c) Both methods of recording lower-of-cost-or-NRV adjustments have
the same effect on net income.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
EXERCISE 9-5 (20–25 minutes)
(a) February March April
Sales $29,000 $35,000 $40,
Cost of goods sold
Inventory, beginning 15,000 15,100 17,
Purchases 17,000 24,000 26,
Cost of goods available 32,000 39,100 43,
Inventory, ending 15,100 17,000 14,
Cost of goods sold 16,900 22,100 29,
Gross profit 12,100 12,900 10,
Gain (loss) due to market
fluctuations of inventory* (2,000) 1,100 700
EXERCISE 9-6 (10–15 minutes)
Net realizable value $50 – $14 = $
Cost $
Lower-of-cost-or-NRV $
$38 figure used – $36 correct value per unit = $2 per unit.
$2 X 1,000 units = $2,000.
If ending inventory is overstated, net income will be overstated.
If beginning inventory is overstated, net income will be understated.
Therefore, net income for 2017 was overstated by $2,000 and net income
for 2018 was understated by $2,000.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
EXERCISE 9-7 (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, 1333 2.70 2.30 3.00 2.50 2.50 900 2, 1426 4.50 3.70 4.60 3.60 3.70 800 2, 1437 3.60 3.10 2.95 2.05 2.95 1,000 2, 1510 2.25 2.00 2.45 1.85 2.00 700 1, 1522 3.00 2.70 3.40 2.90 2.90 500 1, 1573 1.80 1.60 1.75 1.25 1.60 3,000 4, 1626 4.70 5.20 5.50 4.50 5.20 1,000 4,700*** $24,
***Cost is used because it is lower than designated market value.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
EXERCISE 9-8 (10–15 minutes)
(a) 12/31/16 Cost of Goods Sold ............................... 19,
Allowance to Reduce Inventory
to Market ....................................
12/31/17 Allowance to Reduce Inventory
to Market ....................................
Cost of Goods Sold...................... 4,
(b) 12/31/16 Loss Due to Market Decline of
Inventory ............................................. 19,
Allowance to Reduce Inventory
to Market .................................... 19,
12/31/17 Allowance to Reduce Inventory
to Market ............................................. 4,
Loss Due to Market Decline
of Inventory ............................... 4,
*Cost of inventory at 12/31/16 $346,
Lower of cost or market at 12/31/16 (327,000)
Allowance amount needed to reduce inventory
to market (a) $ 19,
Cost of inventory at 12/31/17 $410,
Lower of cost or market at 12/31/17 (395,000)
Allowance amount needed to reduce inventory
to market (b) $ 15,
Recovery of previously recognized loss = (a) – (b)
(c) Both methods of recording lower-of-cost-or-market adjustments
have the same effect on net income.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
