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Chapter 09 - Inventories: Additional Issues

Chapter 9
Question 9-1

Inventories: Additional Issues QUESTIONS FOR REVIEW OF KEY

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.

Question 9-2
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.

Question 9-3
The LCM determination can be made based on individual inventory items, on logical categories of inventory, or on the entire inventory.

Question 9-4
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.

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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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 arent 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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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 years 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 costto-retail percentage that is used to convert each layer from retail to cost.

Answers to Questions (continued) Question 9-13


Freight-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 years 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 years retail price index.

Question 9-15
Changes 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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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 9-18


2009: 2010: Cost of goods sold Net income Ending retained earnings Net purchases Cost of goods sold Net income Ending retained earnings overstated understated understated no effect understated overstated 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
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.

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BRIEF EXERCISES
Brief Exercise 9-1
RC = $18 The designated market is the middle value of NRV, NRV-NP, and RC, which is $18. Since this is lower than the cost of $20, the unit value is $18. NRV = $30 - 4 = $26 NRV NP = $26 (30% x $30) = $17

Brief Exercise 9-2


(1)

(2) Ceiling

(3) Floor

(4) Designated Market Value [Middle value of (1), (2) & (3)] $54 26

(5) Per Unit Inventory Value [Lower of (4) and (5)] $50 26

Product 1 2

RC $48 26

NRV (*) $64 32

NRV-NP (**) $54 24

Cost $50 30

* Selling price less disposal costs. ** NRV less normal profit margin Cost $50,000 30,000 $80,000 LCM $50,000 26,000 $76,000

Product 1 (1,000 units) Product 2 (1,000 units) Cost LCM value

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Before-tax income will be lower by $4,000, the amount of the required inventory write-down.

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Brief Exercise
Product 1 2.

The designated market value according to IFRS always is 9-3net realizable value. NRV* $64 32 LCM $50 30

Cost $50 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: Product 1 (1,000 units) Product 2 (1,000 units) Cost $50,000 30,000 $80,000

Brief Exercise 9-4


Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 30% Estimated cost of goods sold Estimated cost of inventory destroyed $220,000 400,000 620,000

$600,000 (180,000) (420,000) $200,000

Brief Exercise 9-5


Beginning inventory (from records) Plus: Net purchases (from records)
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$150,000 450,000

Chapter 09 - Inventories: Additional Issues

Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit Estimated cost of goods sold Estimated cost of inventory lost

600,000 $700,000 ( ? ) ( ? ) $ 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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Brief Exercise 9-6


Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale $1,183,000 Cost-to-retail percentage: $1,690,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (70% x $490,000) Estimated cost of goods sold (1,200,000) $ 490,000 (343,000) $ 840,000 = 70% Cost $300,000 861,000 22,000 ______ 1,183,000 Retail $ 450,000 1,210,000 48,000 (18,000) 1,690,000

Brief Exercise 9-7


Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale (excluding beg. Inventory) Goods available for sale (including beg. Inventory)

Cost $300,000 861,000 22,000 _______ 883,000 1,183,000

Retail $450,000 1,210,000 48,000 (18,000) 1,240,000 1,690,000

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$883,000 Cost-to-retail percentage: $1,240,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $ 450,000 $ 300,000 Current periods layer 40,000 x 71.21 % = 28,484 Total $ 490,000 $328,484 (328,484) Estimated cost of goods sold $854,516 (1,200,000) $ 490,000 = 71.21%

Brief Exercise 9-8


Beginning inventory Plus: Net purchases Freight-in Net markups Goods available for sale $1,183,000 Cost-to-retail percentage: $1,708,000 Less: Net markdowns ______ Goods available for sale 1,183,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (69.26% x $490,000) (339,374) (18,000) 1,690,000 (1,200,000) $ 490,000 = 69.26% Cost $300,000 861,000 22,000 Retail $ 450,000 1,210,000 48,000 1,708,000

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Estimated cost of goods sold

$ 843,626

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Brief Exercise 9-9


Beginning inventory Plus: Purchases Freight-in Plus: Net markups $877,800 Cost-to-retail percentage: $1,596,000 Less: Net markdowns Goods available for sale Less: Normal spoilage Net sales Employee discounts _______ 877,800 (6,000) 1,590,000 (3,000) (1,300,000) (15,000) $272,000 = 55% Cost $220,000 640,000 17,800 Retail $ 400,000 1,180,000 16,000 1,596,000

Estimated ending inventory at retail Estimated ending inventory at cost (55% x $272,000) (149,600) Estimated cost of goods sold $728,200

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Brief Exercise 9-10


Cost $ 40,800 155,440 _______ 155,440 196,240 Retail $ 68,000 270,000 6,000 (8,000) 268,000 336,000

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory) $40,800 Base layer cost-to-retail percentage: $68,000 $155,440 2011 layer cost-to-retail percentage: $268,000 Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold = 58% = 60%

(250,000) $ 86,000 (50,451) $145,789

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___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $86,000 $86,000 (above) = $84,314 1.02 $68,000 (base) 16,314 (2011) x 1.00 x 60% = x 1.02 x 58% = $40,800 9,651 $50,451 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ......................

Brief Exercise 9-11


Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory) $155,440 2011 layer cost-to-retail percentage: $268,000 $168,000 2012 layer cost-to-retail percentage: $300,000 Less: Net sales
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Cost $ 50,451 168,000 _______ 168,000 218,451

Retail $ 86,000 301,000 3,000 (4,000) 300,000 386,000

= 58%

= 56%

(280,000)

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Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold (59,762) $158,689

$106,000

___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $106,000 $106,000 (above) = $100,000 1.06 $68,000 (base) 16,314 (2011) 15,686 (2012) x 1.00 x 60%* = x 1.02 x 58% = x 1.06 x 56% = $40,800 9,651 9,311 $59,762 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ......................

*$40,800 $68,000 = 60%

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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 periodspecific 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.

Brief Exercise 9-12

Brief Exercise 9-13

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.

Brief Exercise 9-14


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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 sheet (retained earnings) was incorrect only for 2009. After that, no account balances are incorrect due to the 2009 error. Analysis: 2009 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income O U U O O U = Understated O = Overstated 2010 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income O O O U corrected

Retained earnings

Retained earnings

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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: 2010 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income U = Understated O = Overstated

O U U O O

Retained earnings 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 years net income, income before extraordinary items, and earnings per share.

Brief Exercise 9-15

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EXERCISES
Exercise 9-1 (1)
(2) Ceiling (3) Floor (4) Designated Market Value [Middle value of (1), (2) & (3)] $29 80 48 (5) Per Unit Inventory Value [Lower of (4) and (5)] $20 80 48

Product 1 2 3

RC $18 85 40

NRV (*) $ 34 80 60

NRV-NP (**) $29 50 48

Cost $20 90 50

* Selling price less disposal costs. ** NRV less normal profit margin

Exercise 9-2
be as follows: Product 1 2 3

The designated market value according to IAS No. 2 always is net realizable value. Inventory valuation for the three products would

NRV $34 80 60

Cost $20 90 50

Lower of Cost or Market $20 80 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.

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Requirement 1

Exercise 9-3
(1) (2) Ceiling (3) Floor (4) (5)

Product 101 102 103 104

RC $110,000 85,000 40,000 28,000

NRV $100,000 110,000 50,000 50,000

NRV-NP Designated (NP= Market Value 25% [Middle value of cost) of (1), (2) & (3)] $70,000 87,500 35,000 42,500 $100,000 87,500 40,000 42,500 Totals

Cost $120,000 90,000 60,000 30,000 $300,000

Inventory Value [Lower of (4) and (5)] $100,000 87,500 40,000 30,000 $257,500

The inventory value is $257,500. Requirement 2 Loss from write-down of inventory: $300,000 - 257,500 = $42,500 The designated market value according to IFRS always is net 9-4realizable value. Cost $120,000 90,000 60,000 NRV $100,000 110,000 50,000 LCM $100,000 90,000 50,000

Exercise
101 102 103

Product

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104 Totals

30,000 $300,000

50,000

30,000 $270,000

The inventory value is $270,000 so the required write-down is $30,000 ($300,000 270,000). The following journal entry accomplishes the write-down: Inventory write-down expense Inventory valuation allowance 30,000 30,000

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Exercise 9-5
(1) (2) Ceiling (3) Floor (4) (5) Per Unit Inventory Value [Lower of (4) and (5)] $35 70 40 73 20

Product A B C D E

RC $35 70 55 70 28

NRV (*) $52 86 70 112 26

NRV-NP (**) $34 56 46 73 17

Designated Market Value [Middle value of (1), (2) & (3)] $35 70 55 73 26

Cost $40 80 40 100 20

* Selling price less disposal costs. Disposal costs = 10% of selling price + 5% of cost. ** NRV less normal profit margin

Exercise 9-6Requirement 1
FASB ASC 33010351: InventoryOverallSubsequent 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

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generally accomplished by stating such goods at a lower level commonly designated as market. Requirement 2 The specific citations that discuss the level of aggregation that should be used in applying the lower-of-cost-or-market rule are FASB ASC 33010358 to11: InventoryOverallSubsequent Measurement. Requirement 3

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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 stockthe inventory in its entiretymay 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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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.

Exercise 9-7

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: 1. The income statement presentation of losses from the write-down of inventory:

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FASB ASC 33010502: InventoryOverallDisclosure 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. 2. The determination of market value for applying LCM to inventory: FASB ASC 3301020: InventoriesOverallGlossary. 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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Exercise 9-7 (concluded)

3. The accounting treatment required for a correction of an inventory error in previously issued financial statements: FASB ASC 25010504523: Accounting Changes and Error CorrectionsOverallDisclosureOther 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.

4. The use of the retail method to value inventory: FASB ASC 330103013: InventoryOverallInitial 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

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cost to one portion of the inventory or components thereof and another of the acceptable methods to other portions of the inventory.

Exercise 9-8
Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 25% Estimated cost of goods sold Estimated cost of inventory destroyed $140,000 370,000 510,000

$550,000 (137,500) (412,500) $ 97,500

Exercise 9-9
Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 35% Estimated cost of goods sold Estimated ending inventory Less: Value of usable damaged goods Estimated loss from fire $100,000 140,000 240,000

$220,000 (77,000) (143,000) 97,000 (12,000) $ 85,000

Exercise 9-10
400,000 Cost of goods available for sale

Merchandise inventory, January 1, 2011 $1,900,000 Purchases 5,800,000 Freight-in 8,100,000

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Less: Cost of goods sold: Sales Less: Estimated gross profit of 20% Estimated loss from fire

$8,200,000 (1,640,000)

(6,560,000) $1,540,000

Exercise 9-11Requirement 1
Beginning inventory (from records) Plus: Net purchases ($110,000 4,000) Freight-in (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales ($180,000 5,000) Less: Estimated gross profit of 40% Estimated cost of goods sold Estimated cost of inventory before theft Less: Stolen inventory Estimated ending inventory $ 58,500 106,000 3,000 167,500 $175,000 (70,000) (105,000) 62,500 (8,000) $ 54,500

Requirement 2

Beginning inventory (from records) Plus: Net purchases ($110,000 4,000) Freight-in (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales ($180,000 5,000) Less: Estimated gross profit of 50%* Estimated cost of goods sold
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$ 58,500 106,000 3,000 167,500 $175,000 (87,500) (87,500)

Chapter 09 - Inventories: Additional Issues

Estimated cost of inventory before theft Less: Stolen inventory Estimated ending inventory

80,000 (8,000) $ 72,000

*Gross profit as a % of cost (1 + Gross profit as a % of cost) = Gross profit as a % of sales. 100% 200% = 50%

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Exercise

Beginning inventory + Net purchases - Ending inventory = Cost of 9-12goods sold

$27,000 + 31,000 - 28,000 = $30,000 = Cost of goods sold Cost of goods sold Cost percentage = Net sales $30,000 Cost percentage = $50,000 = 60%

Exercise 9-13
Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale $54,120 Cost-to-retail percentage: $82,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (66% x $50,000) Estimated cost of goods sold (32,000) $50,000 (33,000) $21,120 = 66% Cost $35,000 19,120 ______ 54,120 Retail $50,000 31,600 1,200 (800) 82,000

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Exercise 9-14
Beginning inventory Plus: Purchases Freight-in Net markups $798,000 Cost-to-retail percentage: $1,140,000 Less: Net markdowns Goods available for sale Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (70% x $336,000) _______ 798,000 (4,000) 1,136,000 (800,000) $ 336,000 $235,200 = 70% Cost $190,000 600,000 8,000 Retail $ 280,000 840,000 20,000 1,140,000

Exercise 9-15
Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beg. Inventory) Goods available for sale (including beg. Inventory) $607,760 Cost-to-retail percentage: $856,000 = 71% Cost $160,000 607,760 _______ 607,760 767,760 Retail $ 280,000 840,000 20,000 (4,000) 856,000 1,136,000

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Chapter 09 - Inventories: Additional Issues

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $280,000 $160,000 Current periods layer 56,000 x 71% = 39,760 Total $336,000 $199,760 Estimated cost of goods sold

(800,000) $ 336,000

(199,760) $568,000

Exercise 9-16
Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups $114,080 Cost-to-retail percentage: $184,000 Less: Net markdowns Goods available for sale Less: Normal spoilage Net sales Estimated ending inventory at retail Estimated ending inventory at cost (62% x $24,800) Estimated cost of goods sold _______ 114,080 (3,000) 181,000 (4,200) (152,000) $ 24,800 (15,376) $ 98,704 = 62% Cost $ 12,000 102,600 3,480 (4,000) Retail $ 20,000 165,000 (7,000) 6,000 184,000

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Chapter 09 - Inventories: Additional Issues

Exercise 9-17Requirement 1
Cost $ 40,000 207,000 14,488 (4,000) Retail $ 60,000 400,000 (6,000) 5,800 459,800

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups

$257,488 Cost-to-retail percentage: $459,800 Less: Net markdowns Goods available for sale Less: Normal breakage Sales: Net sales Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (56% x $168,500) Estimated cost of goods sold _______ 257,488 (3,500) 456,300 (6,000) (280,000) (1,800) $168,500 (94,360) $163,128 = 56%

Requirement 2 Net markdowns are included in the cost-to-retail percentage: $257,488 Cost-to-retail percentage: $456,300
9-35

= 56.43%

Chapter 09 - Inventories: Additional Issues

Net purchases:

Exercise 9-18
Using LIFO, the beginning inventory is excluded from the calculation of the cost-to-retail percentage: Cost of goods available (excluding beg. inventory) Cost-to-retail percentage = Goods available at retail (excluding beg. inventory) $10,500 50% = x Net purchases at retail equals $21,000 less markups plus markdowns. Net purchases = $21,000 - 4,000 + 1,000 = $18,000 Net sales: The cost-to-retail percentage can be calculated as follows: Cost Retail $21,000.00 $ 35,000 10,500.00 18,000 4,000 _________ (1,000) 31,500.00 56,000 $31,500 Cost-to-retail percentage: $56,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (56.25% x ?) = ( ? ? $17,437.50 ) = 56.25% , and x = $21,000.

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale

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Chapter 09 - Inventories: Additional Issues

Estimated ending inventory at retail is: $17,437.50 = $31,000 .5625 Net sales = $56,000 - 31,000 = $25,000

Exercise 9-19
Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory) $71,280 Base year cost-to-retail percentage: $132,000 $112,500 2011 cost-to-retail percentage: $250,000 Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below) Estimated cost of goods sold = 45% = 54%

Cost $ 71,280 112,500 _______ 112,500 183,780

Retail $132,000 255,000 6,000 (11,000) 250,000 382,000

(232,000) $150,000 (77,004) $106,776

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Chapter 09 - Inventories: Additional Issues

___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $150,000 $150,000 (above) = $144,231 1.04 $132,000 (base) 12,231 (2011) x 1.00 x 54% = x 1.04 x 45% = $71,280 5,724 $77,004 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ......................

Exercise 9-20Requirement 1
Cost-to-retail percentage = $18,750 Requirement 2 $15,000 = 80%

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Chapter 09 - Inventories: Additional Issues

2011 Step 1 Ending Inventory at Base Year Retail Prices $25,000 $25,000 (given) = $20,000 1.25 $18,750 (base) x 1.00 x 80% = 1,250 (2011) x 1.25 x 82% = $15,000 1,281 $16,281 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ............. 2012 $28,600 $28,600 (given) = $22,000 1.30 $18,750 (base) x 1.00 x 80% = 1,250 (2011) x 1.25 x 82% = 2,000 (2012) x 1.30 x 85% =

$15,000 1,281 2,210 $18,491

Total ending inventory at dollar-value LIFO retail cost .............

Exercise 9-21
Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory) Cost $160,000 350,200 _______ 350,200 510,200 Retail $250,000 510,000 7,000 (2,000) 515,000 765,000

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Chapter 09 - Inventories: Additional Issues

$160,000 Base layer cost-to-retail percentage: $250,000 $350,200 2011 layer cost-to-retail percentage: $515,000 Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold (234,800) $275,400 (380,000) $385,000 = 68% = 64%

___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $385,000 $385,000 (above) = $350,000 1.10 $250,000 (base) 100,000 (2011) x 1.00 x 64% = x 1.10 x 68% = $160,000 74,800 $234,800 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ......................

Cost-to-retail percentage, 1/1/11:

Exercise 9-22
$21,000 = 75% $28,000 Cost-to-retail percentage, 12/31/11:
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Chapter 09 - Inventories: Additional Issues

$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 Beginning inventory Plus: Net purchases Goods available for sale (including beginning inventory) $60,000 Cost-to-retail percentage: $88,400 Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below) (80,000) $ 42,000 $26,864 = 67.87% $22,792 60,000 $82,792 Retail $ 33,600 88,400 122,000

___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $42,000 $42,000 (above) = $35,000 1.20 $28,000 (base) 2,000 (2011) 5,000 (2012) x 1.00 x 75.00% = x 1.12 x 80.00% = x 1.20 x 67.87% = $21,000 1,792 4,072 $26,864 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ..................

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Chapter 09 - Inventories: Additional Issues

Requirement 1

Exercise 9-23
To record the change: Retained earnings............................................................ Inventory ($32 million - 23.8 million)..............................
($ in millions)

8.2 8.2

Requirement 2 CPS 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. Lets 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.

Exercise 9-24Requirement 1
Retained earnings................................................................... Inventory ($83,000 78,000)............................................. Requirement 2 Effect on cost of goods sold: Decrease in beginning inventory ($78,000 - 71,000)
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5,000 5,000

- $7,000

Chapter 09 - Inventories: Additional Issues

Decrease in ending inventory ($83,000 - 78,000) Decrease in cost of goods sold

+ 5,000 $2,000

Cost of goods sold for 2010 would be $2,000 lower in the revised income statement.

Exercise 9-25Requirement 1
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: 2009 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income U O O U U U = Understated O = Overstated 2010 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income U U U O corrected

Retained earnings

Retained earnings

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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: 2010 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income U = Understated O = Overstated

O U U O O

Retained earnings Requirement 2 Retained earnings (overstatement of 2010 income)............... 150,000 Inventory (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 years net income, income before extraordinary items, and earnings per share.

Exercise 9-26

U O

= =

understated overstated
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Chapter 09 - Inventories: Additional Issues

NE = no effect Cost of Goods Sold U O U U O U O Net Income O U O O U O U Retained Earnings O U O O U O U

1. Overstatement of ending inventory 2. Overstatement of purchases 3. Understatement of beginning inventory 4. Freight-in charges are understated 5. Understatement of ending inventory 6. Understatement of purchases 7. Overstatement of beginning inventory 8. Understatement of purchases + understatement of ending inventory by the same amount

NE

NE

NE

Exercise 9-271. 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.

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Chapter 09 - Inventories: Additional Issues

Analysis: 2010 Beginning inventory Purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income Retained earnings 2011 Beginning inventory Purchases

O O

O U U

U = Understated O = Overstated

($ in millions)

Purchases .......................................................... Retained earnings ..........................................

4 4

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 expense if taxes are considered), net 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 years net income, income before extraordinary items, and earnings per share.

3.

Exercise 9-28Requirement 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.

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Chapter 09 - Inventories: Additional Issues

Analysis: 2010 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income

U = Understated O = Overstated U by U by U by U by O by U by U by 42,000 30,000 12,000 12,000 42,000 30,000 30,000

Retained earnings Requirement 2 Inventory (understatement of 2011 beginning inventory) Retained earnings (understatement of 2010 income) 30,000 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 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 years net income, income before extraordinary items, and earnings per share.

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Chapter 09 - Inventories: Additional Issues

Exercise 9-29
e 1. Gross profit ratio i l 2. 3.

List A

List B

a 4. k 5. b 6. j 7.

n 8. d 9. c 10. f 11. g 12. h 13. m 14.

a. Reduction in selling price below the original selling price. Cost-to-retail percentage b. Beginning inventory is not included in the calculation of the cost-to-retail percentage. Additional markup c. Deducted in the retail column after the calculation of the cost-to-retail percentage. Markdown d. Requires base year retail to be converted to layer year retail and then to cost. Net markup e. Gross profit divided by net sales. Retail method, f. Material inventory FIFO & LIFO error discovered in a subsequent year. Conventional retail g. Must be deducted in the retail column if sales method are recorded net of discounts. Change from LIFO h. Deducted in the retail column to arrive at goods available for sale at retail. Dollar-value LIFO retail i. Divide cost of goods available for sale by goods available at retail. Normal spoilage j. Average cost, LCM. Requires retrospective k. Added to the retail column to arrive at goods restatement available for sale. Employee discounts l. Increase in selling price subsequent to initial markup. Net markdowns m. Ceiling in the determination of market. Net realizable value n. Accounting change requiring retrospective treatment.

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Chapter 09 - Inventories: Additional Issues

Requirement 1 Exercise 9-30 If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference.

December 31, 2011 Estimated loss on purchase commitment ($60,000 - 56,000) .... Estimated liability on purchase commitment ...................

4,000 4,000

Requirement 2 If market price on purchase date declines from year-end price, the purchase is recorded at market price.

March 21, 2012 Inventory.............................................................................. Loss on purchase commitment ($56,000 - 54,000).................. Estimated liability on purchase commitment....................... Cash .................................................................................

54,000 2,000 4,000 60,000

Exercise

If market price is less than the contract price, the purchase is 9-31recorded at the market price.

June 15, 2011 Purchases (market price)......................................................... Loss on purchase commitment (difference)............................ Cash..................................................................................

85,000 15,000 100,000

If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference.

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Chapter 09 - Inventories: Additional Issues

June 30, 2011 Estimated loss on purchase commitment ($150,000 - 140,000). Estimated liability on purchase commitment...................

10,000 10,000

If market price on purchase date declines from year-end price, the purchase is recorded at market price.

August 20, 2011 Purchases (market price)......................................................... 120,000 Loss on purchase commitment ($140,000 - 120,000)............... 20,000 Estimated liability on purchase commitment....................... 10,000 Cash ................................................................................. 150,000

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Chapter 09 - Inventories: Additional Issues

CPA / CMA REVIEW QUESTIONS


CPA Exam Questions
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 330,000 Good available for sale 410,000 Less: Cost of goods sold ($360,000 120%) 300,000 Estimated 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.

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Chapter 09 - Inventories: Additional Issues

CPA Exam Questions (concluded)

4.

d. Cost Retail Beginning inventory and purchases $600,000 $920,000 Net markups _______ 40,000 Available for sale 600,000 960,000 Cost-to-retail percentage: $600,000 $960,000 = 62.5% Less: Net markdowns (60,000) Sales (780,000) Estimated ending inventory at retail $120,000 Estimated ending inventory at cost: ($120,000 x 62.5%) 75,000 Estimated 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).

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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-averagecost-or-market valuation. The cost percentage is then used to reduce the retail value of the ending inventory to cost. FCLs 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).

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Chapter 09 - Inventories: Additional Issues

PROBLEMS
Problem 9-1Requirement 1
Product A B C D E NRV per unit $16 - (15% x $16) = $13.60 $18 - (15% x $18) = $15.30 $ 8 - (15% x $8) = $ 6.80 $ 6 - (15% x $6) = $ 5.10 $13 - (15% x $13) = $11.05 NRV-NP per unit $13.60 - (40% x $16) = $7.20 $15.30 - (40% x $18) = $8.10 $ 6.80 - (40% x $ 8) = $3.60 $ 5.10 - (40% x $ 6) = $2.70 $11.05 - (40% x $13) = $5.85

(1)

(2) Ceiling

(3) Floor

(4)

(5)

Product (units) A (1,000) B (800) C (600) D (200) E (600)

RC $12,000 8,800 1,200 800 7,200

NRV $13,600 12,240 4,080 1,020 6,630

Designated Market Value [Middle value NRV-NP of (1), (2) & (3)] $7,200 6,480 2,160 540 3,510 Totals $12,000 8,800 2,160 800 6,630 $30,390

Cost $10,000 12,000 1,800 1,400 8,400 $33,600

Inventory Value [Lower of (4) and (5)] $10,000 8,800 1,800 800 6,630 $28,030

Inventory carrying value would be $28,030.

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Chapter 09 - Inventories: Additional Issues

Requirement 2 Inventory 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).

Problem 9-2Requirement 1
Lower-of-cost-or-market (a) (b) (c) By By Individual Product By Total Products Type Inventory

Product Tools: Hammers Saws Screwdrivers Total tools Paint products: 1-gallon cans Paint brushes Total paint Total

Cost

Designated Market Value

500 2,000

$ 550 1,800 780 $3,130

500 1,800 600 $3,100

600 $3,100

$3,000 400 $3,400 $6,500

$2,500 450 $2,950 $6,080

2,500 400 2,950 $5,800 $6,050 $6,080

Requirement 2 (a) Individual products $6,500 - 5,800 = $700

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Chapter 09 - Inventories: Additional Issues

(b) Product type $6,500 - 6,050 = $450 (c) Total inventory


$6,500 - 6,080 = $420

Problem 9-3Requirement 1
Fruit Toppings
Estimate of cost of goods sold: Cost percentage x Net sales

Marshmallow Toppings

Chocolate Topping

80% $200,000 $160,000 $ 20,000 150,000 170,000 160,000 $ 10,000

70% $55,000 $38,500 $ 7,000 36,000 43,000 38,500 $ 4,500

65% $20,000 $13,000 $ 3,000 12,000 15,000 13,000 $ 2,000

Beginning inventory Plus: Net purchases Cost of goods available for sale Less: Estimate of cost of goods sold Estimate of cost of inventory lost

Requirement 2 The two main factors that could cause the estimates of the inventory lost to be over or understated are: 1. The historical cost percentages used may not be representative of the current relationship between cost and selling price. 2. Theft or spoilage losses may not be appropriately considered in the cost percentage.

Problem 9-4
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Chapter 09 - Inventories: Additional Issues

1. Average cost Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Abnormal spoilage Goods available for sale $442,200 Cost-to-retail percentage: $745,000 Less: Normal spoilage Sales: Net sales ($540,000 - 10,000) Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (59.36% x $208,000) Estimated cost of goods sold (3,000) (530,000) (4,000) $208,000 (123,469) $318,731 = 59.36% Cost $ 90,000 355,000 9,000 (7,000) Retail $180,000 580,000 (11,000) 16,000 (12,000) (8,000) 745,000

(4,800) 442,200

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Chapter 09 - Inventories: Additional Issues

Problem 9-4 (concluded) 2. Conventional (average, LCM) Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Abnormal spoilage $442,200 Cost-to-retail percentage: $757,000 Less: Net markdowns Goods available for sale Less: Normal spoilage Sales: Net sales ($540,000 - 10,000) Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (58.41% x $208,000) Estimated cost of goods sold _______ 442,200 (12,000) 745,000 (3,000) (530,000) (4,000) $208,000 (121,493) $320,707 = 58.41% Cost $ 90,000 355,000 9,000 (7,000) (4,800) Retail $180,000 580,000 (11,000) 16,000 (8,000) 757,000

Problem 9-5Requirement 1
Employee discounts must be deducted in the retail column. $250,000 = $312,500 250,000 = $62,500 = Employee discounts
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Chapter 09 - Inventories: Additional Issues

.80

Beginning inventory Plus: Purchases Freight-in Plus: Net markups $1,497,500 Cost-to-retail percentage: $2,450,000 Less: Net markdowns Goods available for sale Less: Normal shrinkage Sales: Sales to customers Sales to employees Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost
(61.12% x $222,500)

Cost $ 100,000 1,387,500 10,000

Retail $ 150,000 2,000,000 300,000 2,450,000

= 61.12%

________ 1,497,500

(150,000) 2,300,000 (15,000)

$1,750,000 250,000

(2,000,000) (62,500) $ 222,500 (135,992) $1,361,508

Estimated cost of goods sold

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Chapter 09 - Inventories: Additional Issues

Problem 9-5 (concluded) Requirement 2

Beginning inventory Plus: Purchases Freight-in Plus: Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory) $1,397,500 Cost-to-retail percentage: $2,150,000 Less: Normal shrinkage Sales: Sales to customers $1,750,000 Sales to employees 250,00 Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $150,000 $100,000 Current periods layer 72,500 x 65% = 47,125 Total $222,500 $147,125 Estimated cost of goods sold = 65%

Cost $ 100,000 1,387,500 10,000 ________ 1,397,500 1,497,500

Retail $ 150,000 2,000,000 300,000 (150,000) 2,150,000 2,300,000

(15,000)

(2,000,000) (62,500) $ 222,500

(147,125) $1,350,375

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Chapter 09 - Inventories: Additional Issues

Requirement 1

Problem 9-6
Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups ($2,500 - 265) $123,151 Cost-to-retail percentage: $175,930 Less: Net markdowns Goods available for sale Less: Normal spoilage Net sales Estimated ending inventory at retail Estimated ending inventory at cost (70% x $34,900) _______ $123,151 (800) 175,130 (4,500) (135,730) $ 34,900 $24,430 = 70% Cost $ 20,000 100,151 5,100 (2,100) Retail $ 30,000 146,495 (2,800) 2,235 175,930

Requirement 2 The 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

Problem 9-7
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Chapter 09 - Inventories: Additional Issues

Beginning inventory Purchases Freight-in on purchases Purchase returns Net markups Net markdowns Goods available for sale Cost-to-retail percentages: Average cost ratio: $780 $1,125 = Average (LCM) cost ratio: $780 ($1,125 + $8) = Deduct: Net sales Ending inventory: At retail (sales price) At Average cost At Average (LCM)

$ 80 671 30 (1) ___ $780

$ 125 1,006 (2) 4 (8) 1,125

.6933 .6884 (916) $ 209

($209 x .6933) ($209 x .6884)

$144.90 $143.88

Note that the lower of cost or market cost-to-retail percentage is approximated by excluding net markdowns.

Problem 9-8
($ in 000s)

Beginning inventory Plus: Net purchases Freight-in Net markups Less: Purchase returns Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)
9-63

Cost $80 671 30 (1) ___ 700 780

Retail $125 1,006 4 (2) (8) 1,000 1,125

Chapter 09 - Inventories: Additional Issues

$80 Base layer cost-to-retail percentage: $125 $700 2011 layer cost-to-retail percentage: $1,000 Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold (130) $650 (916) $209 = 70% = 64%

___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $209 $209 (above) = $190 1.10 $125 (base) 65 (2011) x 1.00 x 64% = x 1.10 x 70% = $ 80 50 $130 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ......................

Employee discounts must be deducted in the retail column. Problem 9-92011: $2,400 = $3,000 2,400 = $600 = Employee discounts .80

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Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory) $ 87,000 Cost-to-retail percentage: $116,000 Less: Net sales ($100,000 + 2,400) Employee discounts Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below) Estimated cost of goods sold = 75%

Cost $28,000 85,000 2,000 ______ 87,000 115,000

Retail $ 40,000 108,000 10,000 (2,000) 116,000 156,000

(102,400) (600) $ 53,000 (35,950) $79,050

___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $53,000 $53,000 (above) = $50,000 1.06 $40,000 (base) 10,000 (2011) x 1.00 x 70% x 1.06 x 75% = = $28,000 7,950 $35,950 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ............

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Problem 9-9 (concluded) 2012: $4,000 = $5,000 4,000 = $1,000 = Employee discounts .80

Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory) $ 92,500 Cost-to-retail percentage: $119,800 Less: Net sales ($104,000 + 4,000) Employee discounts Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below) Estimated cost of goods sold = 77.21%

Cost $35,950 90,000 2,500 ______ 92,500 128,450

Retail $ 53,000 114,000 8,000 (2,200) 119,800 172,800

(108,000) (1,000) $ 63,800 (42,744) $85,706

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___________________________________________________________________________ Step 1 Ending Inventory at Base Year Retail Prices $63,800 $63,800 (above) = $58,000 1.10 $40,000 (base) 10,000 (2011) 8,000 (2012) x 1.00 x 70% = x 1.06 x 75% = x 1.10 x 77.21% = $28,000 7,950 6,794 $42,744 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ............

Problem 9-10Requirement 1
Cost $ 27,500 282,000 26,500 (6,500) (5,000) Retail $ 45,000 490,000 (10,000) 25,000 550,000 $324,500 Cost-to-retail percentage: $550,000 Less: Net markdowns Goods available for sale Less: _______ $324,500 (10,000) 540,000 = 59%

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Purchase discounts Plus: Net markups

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Net sales ($492,000 5,000) Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (59% x $50,000)

(487,000) (3,000) $ 50,000 $ 29,500

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Problem 9-10 (continued) Requirement 2 Cost $ 27,500 282,000 26,500 (6,500) (5,000) _______ 297,000 $324,500 Retail $ 45,000 490,000 (10,000) 25,000 (10,000) 495,000 540,000

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Purchase discounts Plus: Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory) $297,000 Cost-to-retail percentage: $495,000 Less: Net sales ($492,000 5,000) Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $45,000 $27,500 Current periods layer 5,000 x 60% = 3,000 Total $50,000 $30,500 = 60%

(487,000 (3,000) $ 50,000

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Problem 9-10 (concluded) Requirement 3

2010 Step 1 Ending Inventory at Base Year Retail Prices $56,100 $56,100 1.02
= $55,000 Step 2 Inventory Layers at Base Year Retail Prices

Ending Inventory at Year-end Retail Prices

Step 3 Inventory Layers Converted to Cost

$50,000 (base) 5,000 (2010)

x 1.00 x 61%* = $30,500 x 1.02 x 62% = 3,162 $33,662

Total ending inventory at dollar-value LIFO retail cost ..............

* $30,500
= 61% $50,000 2011

$48,300 $48,300 1.05 Total ending inventory at dollar-value LIFO retail cost ............... $28,060
= $46,000

$46,000 (base)

x 1.00 x 61% = $28,060

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Problem 9-11Requirement 1
Employee discounts must be deducted in the retail column. 2011: $14,000 = $20,000 14,000 = $6,000 = Employee discounts .70

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory) $90,000
Base layer cost-to-retail percentage:

Cost $ 90,000 478,000 6,960 (2,500) _______ 482,460 572,460

Retail $150,000 730,000 (3,500) 8,500 (4,000) 731,000 881,000

= 60% $150,000 $482,460

2011 layer cost-to-retail percentage:

= 66% $731,000

Less: Normal spoilage Net sales ($650,000 + 14,000) Employee discounts Estimated ending inventory at retail
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(5,000) (664,000) (6,000) $206,000

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Estimated ending inventory at cost (below) Estimated cost of goods sold

123,990 $448,470

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Problem 9-11 (continued)

2011 Step 1 Ending Inventory at Base Year Retail Prices $206,000 $206,000 (above) = $200,000 1.03 $150,000 (base) 50,000 (2011) x 1.00 x 60% x 1.03 x 66% = = $90,000 33,990 $123,990 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ............

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Problem 9-11 (continued) Employees must be deducted in the retail column. 2012: $17,500 = $25,000 17,500 = $7,500 = Employee discounts .70

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory) $90,000
Base layer cost-to-retail percentage:

Cost $123,990 511,000 8,000 (2,200) _______ 516,800 640,790

Retail $206,000 760,000 (4,000) 10,000 (6,000) 760,000 966,000

= 60% $150,000 $482,460

2011 layer cost-to-retail percentage:

= 66% $731,000 $516,800

2012 layer cost-to-retail percentage:

= 68% $760,000

Less:

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Normal spoilage Net sales ($680,000 + 17,500) Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (below) Estimated cost of goods sold

(6,600) (697,500) (7,500) $254,400 152,822 $487,968

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Problem 9-11 (continued)

2012 Step 1 Ending Inventory at Base Year Retail Prices $254,400 $254,400 (above) = $240,000 1.06 $150,000 (base) 50,000 (2011) 40,000 (2012) x 1.00 x 60% x 1.03 x 66% x 1.06 x 68% = = = $90,000 33,990 28,832 $152,822 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

Ending Inventory at Year-end Retail Prices

Total ending inventory at dollar-value LIFO retail cost ............

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Problem 9-11 (continued)

Requirement 2 Employee discounts must be deducted in the retail column. 2011: $14,000 = $20,000 14,000 = $6,000 = Employee discounts .70

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Goods available for sale

Cost $ 90,000 478,000 6,960 (2,500) _______ 572,460

Retail $150,000 730,000 (3,500) 8,500 (4,000) 881,000

$572,460 Cost-to-retail percentage: $881,000 Less: Normal spoilage Net sales ($650,000 + 14,000) Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (64.98% x $206,000) Estimated cost of goods sold (5,000) (664,000) (6,000) $206,000 133,859 $438,601 = 64.98%

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Problem 9-11 (concluded)

Requirement 3 Employee discounts must be deducted in the retail column. 2011: $14,000 = $20,000 14,000 = $6,000 = Employee discounts .70

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups

Cost $ 90,000 478,000 6,960 (2,500) _______ 572,460

Retail $150,000 730,000 (3,500) 8,500 885,000

$572,460 Cost-to-retail percentage: $885,000 Less: Markdowns Goods available for sale Less: Normal spoilage Net sales ($650,000 + 14,000) Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (64.68% x $206,000) Estimated cost of goods sold (4,000) 881,000 (5,000) (664,000) (6,000) $206,000 133,241 $439,219 = 64.68%

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Problem 9-12Requirement 1
Retained earnings................................................................... Inventory ($150,000 130,000)......................................... Requirement 2 20,000 20,000

FIFO method cost of goods sold: Cost of goods available for sale Less ending inventory:
5,000 units @ $40 2,000 units @ $36

$530,000 $200,000 72,000

Cost of goods sold Average cost method cost of goods sold: Beginning inventory (5,000 units) Purchases:
5,000 units @ $36 5,000 units @ $40

(272,000) $258,000

$130,000 $180,000 200,000

Cost of goods available for sale (15,000 units) Less ending inventory (below) Cost of goods sold Cost of ending inventory: $510,000 Weighted average unit cost =

380,000 510,000 (238,000) $272,000

= $34

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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)].

Problem 9-13Requirement 1
Analysis: 2009 6,000
Plus: Net purchases

U = Understated O = Overstated 2010 Beginning inventory Beginning inventory U Plus: Net purchases U-

3,000
Less: Ending inventory U-6,000Less: Ending inventory O-9,000 Cost of goods sold O-6,000Cost of goods sold

U-18,000 Revenues Revenues Less: Cost of goods sold O-6,000 Less: Cost of goods sold U-18,000 Less: Other expenses Less: Other expenses Net income U-6,000 Net income O-18,000

Retained earnings Retained earnings

U-6,000 O-12,000

Requirement 2

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Retained earnings............................................................ Inventory..................................................................... Purchases....................................................................

12,000 9,000 3,000

Requirement 3 The 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 years net income, income before extraordinary items, and earnings per share.

Problem 9-14Requirement 1
December 31, 2011 inventory, based on a physical count $450,000 Add: Merchandise shipped f.o.b. shipping point in 2011 20,000 Merchandise shipped f.o.b. shipping point in 2011 80,000 Correct ending inventory $550,000

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Analysis: 2011

U = Understated O = Overstated
Beginning inventory Plus: Net purchases U-130,000

($50,000 + 80,000)

Less: Ending inventory U-100,000 Cost of goods sold U -30,000

Revenues Less: Cost of goods sold U -30,000 Less: Other expenses Net income O -30,000

Retained earnings O -30,000

Requirement 2

Retained earnings............................................................ 30,000 Inventory......................................................................... 100,000 Accounts payable........................................................ 130,000

Problem 9-15Requirement 1

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Unadjusted balance Item: 1. (32,000) 2. (27,000) (27,000) 3. (25,000) (25,000) 4. 36,000* 5. Corrected by a prior period adjustment. 6. 22,000 7. 18,000 18,000 18,000 Adjusted balance $370,000 $586,000 $176,000 * 1,000 units 100 units = 900 units x $40 = $36,000 Requirement 2 Beginning inventory ($352,000 + 62,000) Plus: Purchases (from requirement 1) Less: Ending inventory (from requirement 1) Cost of goods sold

Inventory $326,000

Purchases $620,000

Accounts payable $210,000

Accounts receivable $225,000

Sales revenue $840,000

(40,000) $185,000

(40,000) $800,000

$414,000 586,000 (370,000) $630,000

Requirement 3 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.

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Problem

Requirement 1 9-16 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)....................................... 100,000 Cash............................................................................ 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)......................................... Loss on purchase commitment (difference)...................... Cash............................................................................ Requirement 2 a. $12.50

95,000 5,000 100,000

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, 2011

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Estimated loss on purchase commitment


[($11.00 x 20,000 units) - ($10.30 x 20,000 units)]..................

14,000 14,000

Estimated liability on purchase commitment..............

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Problem 9-16 (concluded) Requirement 3 a. $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)....................................... 206,000 Estimated 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)....................................... 200,000 Loss on purchase commitment ($220,000 - 200,000 -14,000)*............................................ 6,000 Estimated 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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CASES
1. Hudson should account for the warehousing costs Judgment Case 9-1related 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. Hudsons 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, Hudsons wholesale inventories should be reported at replacement cost. 3. Hudsons freight-in costs should be included only in the cost amounts to determine the cost-to-retail percentage. Hudsons net markups should be included only in the retail amounts to determine the cost-to-retail-percentage. Hudsons net markdowns should not be deducted from the retail amounts to determine the cost-toretail 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 Communication Case 9-2historical 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.
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So, deterioration, obsolescence, changes in price levels, or any situation that might compromise the inventorys 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 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.

Integrating Case 9-3Requirement 1


York Co. Schedule of Cost of Goods Sold For the Year Ended December 31, 2011 Beginning inventory Add: Purchases Less: Purchase discounts Add: Freight-in Goods available for sale Less: Ending inventory Cost of goods sold $ 65,600 368,900 (18,000) 5,000 421,500 (176,000) (1) $245,500

York Co. Supporting Schedule of Ending Inventory December 31, 2011

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Inventory at cost (LIFO): Units 8,000 12,000 2,000 22,000 Cost per unit $8.20 8.25 7.90 Total cost $ 65,600 99,000 15,800 $180,400

Beginning inventory, January 1, Purchases, quarter ended March 31 Purchases, quarter ended June 30

Inventory at market: 22,000 units @ $8 = $176,000 (1) Requirement 2 Inventory 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 (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 Judgment Case 9-4method 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. Huddells net markups should be included only in the retail amounts (denominator) to determine the cost-to-retail percentage. Huddells 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:

Communication Case 9-5

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 when compared to other methods. ______ Avoids physical inventory count. ______ Acceptable for financial reporting and income taxes.
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______ Can explicitly incorporate cost flow methods, taxes, and LCM. ______ _______ 70 points Writing (30%) _______ 6 Terminology and tone appropriate to the audience of a company 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 theyre presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change.

Analysis Case 9-6

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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. 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 hasnt 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 Real World Case 9-7principles 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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Real World Case 9-8Requirement 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 2 To 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 3 The lower of cost or market is applied on an aggregate basis for similar types of merchandise. Requirement 4 The 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 ($2 million 1 million) if J.C. Penney had used FIFO to value its inventory instead of LIFO. Requirement 5 ($ in millions) Inventory turnover =

$11,571 = 3.35 $3,450*

*($3,259 + 3,641) 2

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Case 9-8 (concluded)

Requirement 6 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 theyre presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change.

Communication Case 9-9Requirement 1


Change in Inventory Method During 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]).

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Requirement 2 It 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 created in years prior to the change. Accounting records usually are inadequate for a company to create the appropriate LIFO inventory layers. Thats why a change to LIFO usually cant be applied retrospectively. Despite the self-correcting feature of certain Judgment Case 9-10inventory 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.

Ethics Case 9-11Requirement 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 2 It 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.
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Chapter 09 - Inventories: Additional Issues

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 Analysis Case 9-12evaluated in the same way as inventory on hand for the 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 yearend, 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 British Airways Caseto 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.

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