Solution Manual for Intermediate Accounting

Principles and Analysis 2nd Edition by Warfield

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Solution Manual for Intermediate Accounting Principles and Analysis 2nd Edition by Warfield

CHAPTER 9
Accounting for Inventories

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Brief
Topics Questions Exercises Exercises Problems

1. Inventory accounts; determining 1, 2, 4, 1, 3 1, 2, 3, 1

quantities, costs, and items to be 5, 6 4, 5, 6
included in inventory; the inventory
equation; balance sheet
disclosure.

2. Perpetual vs. periodic. 3 2 8, 9, 10, 13 2, 3, 4

3. Manufacturing costs. 7

4. Flow assumptions. 7, 8, 9, 4, 5, 6 9, 10, 11, 12, 2, 3, 4, 5

11, 13 13, 14, 15, 16,
17, 18

5. Inventory accounting changes. 5, 7

6. Dollar-value LIFO methods. 10, 12 7, 8 18, 19, 20, 21 6, 8

7. Lower of cost or market. 14, 15, 9, 10 22, 23, 24 9, 10, 11

16, 17

8. Presentation and analysis. 18, 19 11 25 11

*9. Gross profit method. 20, 21 12 26 12

*This material is presented in the appendix.

9-1

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ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Brief
Learning Objectives Exercises Exercises Problems

1. Identify major classifications of 1, 2 1, 2, 3, 4, 7

inventory.

2. Distinguish between perpetual and 2, 4, 5, 6 5, 6, 7, 8, 2, 3, 4, 5

periodic inventory systems. 9, 13

3. Understand the items to include as 3 1, 2, 3, 4, 5, 1

inventory cost. 6, 7, 16

4. Describe and compare the cost flow 4, 5, 6 8, 9, 10, 11, 12, 1, 2, 3, 4,

assumptions used to account for 13, 14, 15, 16, 5, 7
inventories. 17, 18

5. Explain the significance and use of 17

a LIFO reserve.

6. Understand the effect of LIFO 6, 7

liquidations.

7. Explain the dollar-value LIFO 7, 8 18, 19, 1, 6, 8

method. 20, 21

8. Explain the major advantages and 16

disadvantages of LIFO.

9. Describe and apply the lower of cost 9, 10 22, 23, 24 9, 10, 11

or market rule.

10. Explain how to report and analyze 10 14, 25 5, 11

inventory.

*11. Determine ending inventory by 12 26 12

applying the gross profit method.

*This material is discussed in the appendix.

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ASSIGNMENT CHARACTERISTICS TABLE

Level of Time
Item Description Difficulty (minutes)
E9-1 Inventoriable costs. Moderate 15–20
E9-2 Inventoriable costs. Moderate 10–15
E9-3 Inventoriable costs. Simple 10–15
E9-4 Inventoriable costs. Moderate 15–25
E9-5 Inventoriable costs—perpetual. Simple 10–15
E9-6 Determining merchandise amounts—periodic. Simple 10–20
E9-7 Financial statement presentation of manufacturing Moderate 20–25
amounts—periodic.
E9-8 Periodic versus perpetual entries. Moderate 15–25
E9-9 FIFO and LIFO—periodic and perpetual. Moderate 15–20
E9-10 FIFO, LIFO and average cost determination. Moderate 20–25
E9-11 FIFO, LIFO, average cost inventory. Moderate 15–20
E9-12 Compute FIFO, LIFO, average cost—periodic. Moderate 15–20
E9-13 FIFO and LIFO; periodic and perpetual. Simple 10–15
E9-14 FIFO and LIFO; income statement presentation. Simple 15–20
E9-15 FIFO and LIFO effects. Moderate 15–20
E9-16 FIFO and LIFO—periodic. Simple 10–15
E9-17 LIFO effect. Moderate 10–15
E9-18 Alternate inventory methods—comprehensive. Moderate 25–30
E9-19 Dollar-value LIFO. Simple 5–10
E9-20 Dollar-value LIFO. Simple 15–20
E9-21 Dollar-value LIFO. Moderate 20–25
E9-22 Lower of cost or market. Simple 15–20
E9-23 Lower of cost or market. Simple 10–15
E9-24 Lower of cost or market. Simple 15–20
E9-25 Analysis of inventories. Simple 10–15
*E9-26 Gross profit method. Moderate 15–20

P9-1 Various inventory issues. Moderate 30–40

P9-2 Compute FIFO, LIFO, and average cost—periodic and Complex 40–55
perpetual.
P9-3 Compute FIFO, LIFO, and average cost—periodic and Complex 40–55
perpetual.
P9-4 Compute FIFO, LIFO, and average cost—periodic and Moderate 25–35
perpetual.
P9-5 Financial statement effects of FIFO and LIFO. Moderate 30–40
P9-6 Dollar-value LIFO. Moderate 30–40
P9-7 LIFO effect on income. Moderate 30–35
P9-8 Dollar-value LIFO. Moderate 40–50
P9-9 Lower of cost or market. Simple 10–15
P9-10 Lower of cost or market. Complex 30–40
P9-11 Statement and note disclosure, LCM. Moderate 30–40
*P9-12 Gross profit method. Moderate 20–30
*These topics are dealt with in the appendix to the Chapter.

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CHAPTER STUDY OBJECTIVES

1. Identify major classifications of inventory.

2. Distinguish between to perpetual and periodic inventory systems.
3. Understand the items include as inventory cost.
4. Describe and compare the flow assumptions used to account for inventories.
5. Explain the significance and use of a LIFO reserve.
6. Explain the effect of LIFO liquidations.
7. Explain the dollar-value LIFO method.
8. Identify the major advantages and disadvantages of LIFO.
9. Describe and apply the lower-of-cost-or-market rule.
10. Explain how to report and analyze inventory.
*11. Determine ending inventory by applying the gross profit method.

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CHAPTER REVIEW
1. Careful attention is given to the inventory account by many business organizations
because it represents one of the most significant assets held by the enterprise. Inventories
are of particular importance to merchandising and manufacturing companies because
they represent the primary source of revenue for the organization. Inventories are also
significant because of their impact on both the balance sheet and the income statement.

*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.

Inventory Classification and Systems

2. (L.O. 1) Inventories are asset items held for sale in the ordinary course of business or
goods that will be used or consumed in the production of goods to be sold. Merchandise
inventory refers to the goods held for resale by a trading concern. The inventory of a
manufacturing firm is composed of three separate items: raw materials, work in
process, and finished goods.

3. (L.O. 2) Inventory records may be maintained on a perpetual or periodic inventory

system basis. A perpetual inventory system provides a means for generating up-to-
date records related to inventory quantities. Under this inventory system, data are
available at any time relative to the quantity of material or type of merchandise on hand.
In a perpetual inventory system, purchases and sales of goods are recorded directly in
the Inventory account as they occur. A Cost of Goods Sold account is used to accumulate
the issuances from inventory. The balance in the Inventory account at the end of the year
should represent the ending inventory amount.

4. When the inventory is accounted for on a periodic inventory system, the acquisition of
inventory is debited to a Purchases account. Cost of goods sold must be calculated when
a periodic inventory system is in use. The computation of cost of goods sold is made by
adding beginning inventory to net purchases and then subtracting ending inventory.
Ending inventory is determined by a physical count at the end of the year under a periodic
inventory system. Even in a perpetual inventory system, a physical inventory count at
year-end is normally taken due to the potential for loss, error, or shrinkage of inventory
during the year.

5. Reconciliation between the recorded inventory amount and the actual amount of
inventory on hand is normally performed at least once a year. This is called a physical
inventory and involves counting all inventory items and comparing the amount counted
with the amount shown in the detailed inventory records. Any errors in the records are
corrected to agree with the physical count.

6. The cost of goods sold during any accounting period is defined as all the goods
available for sale during the period less any unsold goods on hand at the end of the
period (ending inventory). The process of computing cost of goods sold is complicated
by the determination of (a) the physical goods to be included in inventory, (b) the costs to
be included in inventory, and (c) the cost flow assumption to be used.

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Physical Goods to be Included in Inventory

7. Normally, goods are included in inventory when they are received from the supplier.
However, at the end of the period, proper accounting requires that all goods to which the
company has legal title be included in ending inventory.

8. Goods in transit at the end of the period, shipped f.o.b. shipping point, should be
included in the buyer’s ending inventory. If goods are shipped f.o.b. destination, they
belong to the seller until actually received by the buyer. Inventory out on consignment
belongs to the consignor’s inventory.

Costs Included in Inventory

9. (L.O. 3) Inventories are recorded at cost when acquired. Cost in terms of inventory
acquisition includes all expenditures necessary in acquiring the goods and converting
them to a saleable condition. Product costs are those costs that “attach” to the inventory
and are recorded in the inventory account. These costs include freight charges on goods
purchased, other direct costs of acquisition, and labor and other production costs incurred
in processing the goods up to the time of sale. Period costs, such as selling expenses
and general and administrative expenses, are not considered inventoriable costs. The
reason these costs are not included as a part of the inventory valuation concerns the fact
that, in most instances, these costs are unrelated to the immediate production process.

10. FASB Statement No. 34, “Capitalization of Interest Cost,” allows for the capitalization of
interest costs related to assets constructed for internal use or assets produced as discrete
projects (such as ships or real estate projects) for sale or lease. In the case of inventories
that are routinely manufactured or produced in large quantities on a repetitive basis,
interest costs should not be capitalized.

Cost Flow Assumptions

11. (L.O. 4) Inventory cost flow assumptions include (a) specific identification, (b) average
cost, (c) first-in, first-out (FIFO), (d) last-in, first-out (LIFO), and (e) dollar-value LIFO. It
should be remembered that these assumptions relate to the flow of costs and not the
physical flow of inventory items into and out of the company.

12. Specific identification calls for identifying each item sold and each item in inventory.
The costs of the specific items sold are included in the cost of goods sold, and the costs
of the specific items on hand are included in the inventory. The average cost method
prices items in the inventory on the basis of the average cost of all similar goods available
during the period.

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FIFO

13. Use of the FIFO inventory method assumes that the first goods purchased are the first
used or sold. In all cases where FIFO is used, the inventory and cost of goods sold would
be the same at the end of the month whether a perpetual or periodic system is used. A
major advantage of the FIFO method is that the ending inventory is stated in terms of an
approximate current cost figure. However, because FIFO tends to reflect current costs on
the balance sheet, a basic disadvantage of this method is that current costs are not
matched against current revenues on the income statement.

LIFO

14. Use of the LIFO inventory method assumes that the most recent inventory costs are the
first costs recorded for goods manufactured or sold. When inventory records are kept on
a periodic basis, the ending inventory would be priced by using the total units as a basis
of computation, disregarding the exact dates of purchases. The calculation of ending
inventory and cost of sales changes somewhat when the LIFO method is used in con-
nection with perpetual inventory records.

LIFO Reserve

15. (L.O. 5) Many companies use LIFO for tax and external reporting purposes, but maintain
a FIFO, average cost, or standard cost system for internal reporting purposes. The
difference between the inventory method used for internal reporting purposes and LIFO is
referred to as the Allowance to Reduce Inventory to LIFO or the LIFO Reserve. The
change in the allowance balance from one period to the next must be made each year.

LIFO Liquidation

16. (L.O. 6) When the LIFO inventory method is used, many companies combine inventory
items into natural groups or pools. Each pool is assumed to be one unit for the purpose
of costing the inventory. Any increment above beginning inventory is normally identified
as a new inventory layer and priced at the average cost of goods purchased during the
year. When the inventory is decreased, the most recently added inventory layer is the first
layer eliminated (last-in, first-out). LIFO liquidation occurs when prior years’ layers are
eliminated. The pooled approach reduces record keeping and, accordingly, the cost of
utilizing the LIFO inventory method.

Dollar-Value LIFO

17. (L.O. 7) Use of the pooled approach can result in problems for companies that often
change the mix of their products, materials, and production methods. To overcome these
problems, the dollar-value LIFO method has been developed. The important feature of
the dollar-value LIFO method is that increases and decreases in a pool are determined
and measured in terms of total dollar value, not the physical quantity of the goods as is
done in the traditional LIFO pool approach.

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18. In computing inventory under the dollar-value LIFO method, the ending inventory is first
priced at the most current cost. Current cost is then restated to prices prevailing when
LIFO was adopted. This is accomplished by using a price index. A new inventory layer is
formed when the ending inventory, stated in base-year costs, exceeds the base-year
costs of beginning inventory. Increases are priced at current cost. If the ending inventory,
stated at base-year costs, is less than beginning inventory, the decrease is subtracted
from the most recently added layer. A price index for the current year is computed by
dividing Ending Inventory for the Period at Current-Year Costs by Ending Inventory
for the Period at Base-Year Costs. The dollar-value method is a more practical way
of valuing a complex, multiple-item inventory than the traditional LIFO method. The
Comprehensive Dollar-Value LIFO Illustration in the text should be studied as it
provides an excellent means of understanding the dollar-value LIFO computation.

Advantages and Disadvantages of LIFO

19. (L.O. 8) Proponents of the LIFO method advocate its use on the basis of its (a) proper
matching of recent costs with current revenue, and (b) tax benefits/improved cash flow.
Those opposed to the LIFO method claim that it (a) lowers reported earnings, (b) under-
stated inventory, (c) is contrary to normal physical flow, and (d) creates involuntary
liquidation problems/invites poor buying habits.

Lower of Cost or Market

20. (L.O. 9) When the future revenue-producing ability associated with inventory is below
its original cost, the inventory should be written down to reflect this loss. Thus, the
historical cost principle is abandoned when the future utility of the asset is no longer as
great as its original cost. This is known as the lower of cost or market (LCM) method of
valuing inventory and is an accepted accounting practice. When inventory declines in
value below its original cost, the inventory should be written down to reflect the loss. This
loss of utility in inventory should be charged against revenue in the period in which the
loss occurs.

21. The term “market” in lower of cost or market generally refers to the replacement cost of
an inventory item. However, market value should not exceed net realizable value (NRV),
nor should it be less than net realizable value less a normal markup. These are known
as the upper (ceiling) and lower (floor) limits of market. Market is defined as replacement
cost if such cost falls between the upper and lower limits. Should replacement cost be
above the upper limit, market would be defined as net realizable value. If replacement
cost falls below the lower limit, market is defined as net realizable value less a normal
markup.

22. For example, consider the following illustration.

Inventory at sales value $ 800
Less: Cost to complete and sell 200
Net realizable value (NRV) 600
Less: Normal markup 100
NRV less normal markup $ 500

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 To arrive at the final inventory valuation, market value must be determined and then
compared to cost. Market value is determined by comparing replacement cost of the
inventory with the upper and lower limits. If replacement cost of the inventory in the
example is $550, then $550 is compared to cost in determining lower of cost or market
because replacement cost falls between the upper ($600) and lower ($500) limits. If
replacement cost of the inventory is $650, it would exceed the upper limit; thus, the upper
limit ($600) would be compared to cost in determining lower of cost or market. Similarly, if
replacement cost of the inventory is $450, it would be lower than the lower limit and thus
the lower limit ($500) would be compared to cost in determining lower of cost or market.
The amount that is compared to cost, often referred to as designated market value, is
always the middle value of the three amounts: replacement cost, net realizable value, and
net realizable value less a normal profit margin.

23. The cost or market rule may be applied (a) directly to each item, (b) to each category, or
(c) to the total inventory. The individual-item approach is preferred by many companies
because tax rules require its use when practical, and it produces the most conservative
inventory valuation on the balance sheet. When inventory is written down to market, this
new basis is considered to be the cost basis for future periods. The method selected
should be the one that most clearly reflects income.

Presentation and Analysis

24. (L.O. 10) Inventories normally represent one of the most significant assets held by a
business entity. Therefore, the accounting profession has mandated certain disclosure
requirements related to inventories. Some of the disclosure requirements include: the
composition of the inventory, the inventory financing, the inventory costing methods
employed, and whether costing methods have been consistently applied. Currently, there
is a great deal of interest in the effects of inflation on inventory holdings. Two common
financial ratios used to analyze inventory are (1) the inventory turnover ratio and (2) the
average days to sell inventory.

Appendix 9A—The Gross Profit Method

*25. (L.O. 11) The gross profit method is used to estimate the amount of ending inventory.
Its use is not appropriate for financial reporting purposes; however, it can serve a useful
purpose when an approximation of ending inventory is needed. Such approximations are
sometimes required by auditors or when inventory and inventory records are destroyed by
fire or some other catastrophe. The gross profit method should never be used as a
substitute for a yearly physical inventory unless the inventory has been destroyed. The
gross profit method is based on the assumptions that (a) the beginning inventory plus
purchases equal total goods to be accounted for; (b) goods not sold must be on hand;
and (c) if sales, reduced to cost, are deducted from the sum of the opening inventory plus
purchases, the result is the ending inventory.

9-9
LECTURE OUTLINE
This chapter can be covered in three to four class sessions. Students should have had
previous exposure to inventory accounting topics except for dollar-value LIFO and the lower-
of-cost or market valuation rule.

A. (L.O. 1) Among the most significant assets of many enterprises, inventories are asset items
held for sale in the ordinary course of business or goods that will be used or consumed in
the production of goods to be sold.

1. For manufacturing firms the inventory amount may be broken down into raw materials,
work in process, and finished goods.

2. Management is vitally interested in inventories in order to prevent stocking up on

excessive and unsaleable inventories.

B. (L.O. 2) Inventory Record Systems.

TEACHING TIP
Contrast the accounting procedures under the perpetual and periodic inventory systems by
using Illustration 9-1. This example is based on Illustration 9-2 in the textbook on page 424.

1. Perpetual inventory system—The costs of purchases and sales are recorded directly
in the Inventory account (perpetual record kept in units and dollars).

2. Modified perpetual inventory system—The cost of purchases is recorded directly in

the inventory account. The cost of sales is not recorded at the time of sale, but a
record is kept of the number of units sold (perpetual record kept in units only).

3. Periodic inventory system—The cost of purchases is recorded in a Purchases (nominal

or temporary) account. The balance in the Inventory account remains unchanged
during the period. No record is kept at the time of sale of the number or cost of the
units sold. At the end of the period, the quantity of goods on hand is determined by
physical count and the cost of ending inventory is recorded. Cost of goods sold is
determined by adding the beginning inventory to the purchases and deducting the
ending inventory.

C. Basic Issues in Inventory Valuation. These include the determination of the (1) items to be
included in inventory, (2) the costs to be included in inventory, and (3) the cost flow assump-
tion to be adopted.

D. Items to be Included in Inventory. Technically, purchases should be recorded when legal

title passes to the buyer. The following items require careful judgment:

1. Goods in Transit: If the goods are shipped f.o.b. shipping point, title passes to the
buyer when the seller delivers the goods to the common carrier. If the goods are
shipped f.o.b. destination, title passes when the buyer receives the goods.

2. Consigned Goods: Goods out on consignment remain the property of the consignor.

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E. (L.O. 3) Costs to be Included in Inventory.

1. Distinguish between product costs and period costs. Product costs or inventoriable
costs are those costs directly connected with bringing goods to the buyer’s place of
business and converting them to a saleable condition. Period costs such as selling
and general and administrative expenses are not considered to be directly related to
the acquisition or production of goods.

2. Interest costs associated with getting inventories ready for sale are usually expensed
as incurred. However, SFAS No. 34 requires capitalization of interest cost related to
construction of discrete projects such as ships or real estate projects. (Capitalization of
interest is discusses in detail in Chapter 10.)

3. Manufacturing Costs: Includes all costs which are traceable to the production of the
product. These costs are classified as direct materials, direct labor, and manufacturing
overhead.

F. (L.O. 4) Choice of a Flow Assumption. This problem arises when numerous purchases
have been made at different prices and it is necessary to identify which goods remain on
hand and which have been sold.

TEACHING TIP
Illustration 9-2 provides a comparison of ending inventory computations under FIFO, LIFO,
and average cost under periodic and perpetual systems.

1. Specific Identification: Used where a small number of costly, distinctive items are
sold. It offers the opportunity to manipulate income.

2. Average Cost: Items in the ending inventory and items sold are priced at the average
cost of goods available during the period. Either weighted average (periodic) or moving
average (perpetual) procedures may be used.

3. First-In, First-Out: Assumes goods are used in the order purchased. While this
method presents ending inventory at approximately current cost, it does not match
current costs against current revenues.

a. Ending Inventory and cost of goods sold will be the same under both periodic and
perpetual inventory systems.

4. Last-In, First-Out: Assumes that the last goods purchased are used first. Specific
Goods or Unit LIFO—Each item in the inventory is individually costed on a LIFO
basis.

G. (L.O. 5) LIFO Reserve or (Allowance to Reduce Inventory to LIFO). Used when a company
maintains a FIFO, average cost, or standard cost system for internal reporting purposes
and LIFO for tax and external reporting purposes.

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H. (L.O. 6) LIFO Liquidations. A frequent occurrence when specific goods LIFO is used.
When the inventory balance is reduced (liquidated), the cost of the old inventory layers is
included in cost of goods sold, resulting in higher net income.

1. Specific Goods Pooled LIFO—Inventory items are combined in pools of similar items.
This approach may help prevent LIFO liquidations because decreases in one quantity
may be offset by increases in another quantity.

I. (L.O. 7) Dollar-value LIFO—This differs from specific goods pooled LIFO in that increases
and decreases in a pool are measured in terms of the total dollar value and not the
physical quantity of goods in the pool.

1. Discuss the steps involved in the dollar-value LIFO approach.

TEACHING TIP
Illustration 9-3, which is based on the Bismark Company data in the textbook, shows a
straightforward method for presenting the dollar-value LIFO computations.

a. Compute the quantity of ending inventory at current cost. (This approximates

FIFO.)

b. Divide (a) by the current price index to obtain the ending inventory at base-year
cost.

c. Split (b) into layers depending on the year the items were acquired.

d. Multiply each layer in (c) by the appropriate price index (price index in the year of
acquisition) to obtain the ending inventory at dollar-value LIFO cost.

TEACHING TIP
Under certain circumstances the dollar-value LIFO approach produces the same inventory
cost as the specific goods LIFO approach. This can be demonstrated by using the example in
Illustration 9-4. (See also Bainbridge, bibliography reference 19.)

J. (L.O. 8.) Choosing Among Alternative Inventory Methods.

1. Point out that the major conceptual problem with inventory accounting arises from the
inability of double-entry accounting to show current values on both the balance sheet
and the income statement.

2. Advantages of LIFO.

a. Matching. LIFO matches current costs against current revenue to provide a better
measure of current earnings.

b. Tax benefits. During times of rising prices, LIFO provides a deferral of income
taxes payable.

c. Improved cash flow. This arises because of the tax benefits.

9-12
 d. Future earnings hedge. LIFO virtually eliminates write downs of inventory to
market as a result of price declines because LIFO inventory is usually carried at
much less than net realizable value.

3. Disadvantages of LIFO.

a. Reduced earnings. During times of rising prices, reported earnings under LIFO
are less than they would be under FIFO. However, because the IRS has now
relaxed the LIFO conformity rule, companies are permitted to make supplementary
disclosure of non-LIFO income numbers in the financial statements.

b. Inventory understated. Under LIFO the oldest costs (which are the lowest costs
if prices are rising) remain in inventory.

c. Physical flow. LIFO does not approximate the actual physical flow of items
except in unusual situations.

d. Current cost income not measured. LIFO falls short of measuring current cost
(replacement cost) income. However, LIFO does this better than either FIFO or
average cost methods.

e. Involuntary liquidation. If layers of old costs are eliminated, distortions in reported

income can occur. Many companies experienced LIFO liquidations in the early
1980s. (See Saunders and Rohmann and also Schiff, bibliography reference 24.)

f. Poor buying habits. A company may adopt an uneconomic pattern of purchases

in order to avoid the liquidation problem or in order to manipulate net income.

4. The variety of inventory methods that exist have been devised to provide an accurate
measure of net income rather than to permit manipulation of reported income.

K. (L.O. 9) Lower of Cost or Market (LCM).

1. The general rule is that the historical cost principle is abandoned when the future utility
of the asset is no longer as great as its original cost.

2. The term “market” in the LCM rule means the cost to replace the item by purchase or
reproduction. This is a measurement of entry value.

a. The market amount is limited by ceiling and floor restrictions that are based on
measurements of exit value.

(1) The ceiling is equal to net realizable value: estimated selling price less
estimated disposal cost.

(2) The floor is equal to the net realizable value less normal profit margin.

b. Point out the reasons for this lower of cost or “constrained market” rule:

(1) A decline in the selling price of an item is not always accompanied by a

decline in cost. That is, entry values do not always respond immediately and
proportionately to changes in exit values. (See Warner and Whitehurst,
bibliography reference 27.)
9-13
 (2) If an item has not lost its revenue-producing power, a writedown to replacement
cost in the current period would understate current income and overstate
income in the period of sale.

3. Describe the two-step computational approach to LCM valuation:

TEACHING TIP
Illustration 9-5 can be used to discuss the lower of cost or market technique. The 2-step
approach is demonstrated for two different examples.

a. First find the designated “market” figure: This is the middle value of replacement
cost, the ceiling, and the floor.

b. Then find the lower of historical cost or “designated market.”

4. The LCM rule may be applied either (a) directly to each item or (b) to the total of the
inventory or (c) in some cases, to the total of the components of each major category.
As soon as the inventory is written down to market, the new basis is considered to be
the cost basis for future periods.

5. The conceptual deficiencies of the LCM rule include:

a. Inconsistent treatment of recognizing a loss in the period when inventory values

decrease but delaying inventory value increases until the period when inventory is
sold.

b. Application of the rule results in inconsistency because the inventory may be valued
at cost in one year and at market in the next year.

c. LCM inventory valuation results in a conservative inventory value on the balance

sheet but it may have the opposite effect on the income statement in subsequent
periods if expected sales price declines do not materialize.

d. Subjectivity in calculating a “normal profit” that may present opportunities for income
manipulation.

L. (L.O. 10) Analysis of Inventories.

Cost of goods sold

1. Inventory turnover = Average inventory

365 days
2. Average days to sell inventory = Inventory turnover

M. APPENDIX 9A—(L.O. 9) Gross Profit Method.

1. This method is used when an estimate of a firm’s inventory is required. The resulting
estimate is acceptable for interim reporting purposes but not generally for annual
reporting.

9-14
 2. Point out that four items of information are sufficient to estimate the cost of ending
inventory:

a. Cost of beginning inventory.

b. Cost of purchases for the period.

c. Sales during the period.

d. Markup, expressed either as a percentage of cost or as a percentage of sales.

3. Point out that in this context the terms “gross margin,” “gross profit,” and “markup” are
synonymous. Discuss the distinction between markup expressed as a percentage of
cost and markup expressed as a percentage of sales. Describe how the percentage
markup is computed.

For example, an item that costs $60 and is sold for $75 has a gross profit or markup
of $15.

Markup as a Percentage of Sales

Markup $15
= Selling Price = $75 = 20%.

Markup as a Percentage of Cost

Markup $15
= Cost = $60 = 25%.

4. Describe how to convert a markup on cost to a markup on sales.

a. From markup cost to markup on sales.

markup on cost
1 + markup on cost = markup on sales

b. From markup sales to markup on cost.

markup on sales
= markup on cost
1 – markup on sales

TEACHING TIP
Discuss the steps in solving gross profit problems as demonstrated by the example in
Illustration 9-6.

5. Appraisal of the gross profit method.

a. It provides an estimate based on past percentages.

b. Use of a blanket gross profit rate is not appropriate when a company handles
different lines of merchandise with widely varying rates of gross margin.
9-15
ILLUSTRATION 9-1
INVENTORY RECORDING SYSTEMS

Transaction A: Beginning inventory 100 units at $6 = $600

B: Purchases 900 units at $6 = $5,400
C: Sales 600 units at $12 = $7,200
D: Ending inventory 400 units at $6 = $2,400

PERIODIC

SALES ACCOUNTS RECEIVABLE INVENTORY

A 600
7,200 C C 7,200
600 D
D 2,400

COST OF
GOODS SOLD ACCOUNTS PAYABLE PURCHASES
B 5,400
D 3,600 5,400 B 5,400 D

PERPETUAL

SALES ACCOUNTS RECEIVABLE INVENTORY

A 600
7,200 C C 7,200
B 5,400
3,600 C
D 2,400
COST OF
GOODS SOLD ACCOUNTS PAYABLE

C 3,600 5,400 B NO CLOSING

ENTRY REQUIRED

9-16
ILLUSTRATION 9-2
COMPUTATION OF ENDING INVENTORY

REVIEW OF ENDING INVENTORY COST FLOW CALCULATIONS

Inventory Data:
1/01/08 Beginning Inventory: 1,000 units @ $5 per unit
1/10/08 Purchase: 200 units @ $8 per unit
1/15/08 Sale: 500 units @ $12 per unit
1/20/08 Purchase: 300 units @ $6 per unit
1/31/08 Ending Inventory: 1,000 units (= 1,000 + 200 – 500 + 300)
Ending Inventory Calculations:
LIFO—periodic: = (1,000 @ $5): $5,000
Weighted Average = {[1,000 @ $5) + (200 @ $8) + (300 @ $6)]/1,500} × 1,000 $5,600
= FIFO—periodic: = (300 @ $6) + (200 @ $8) + (500 @ $5): $5,900
FIFO—perpetual: = (300 @ $6) + (200 @ $8) + (500 @ $5): $5,900
Moving Average: = {[(1,000 @ $5) + (200 @ $8)]/1,200} × 700 + (300 @ $6): $5,650
LIFO—perpetual: = (700 @ $5) + (300 @ $6): $5,300

Income Statement Effects—Summary:

PERIODIC INVENTORY PERPETUAL INVENTORY

Weighted Weighted
LIFO Average FIFO FIFO Average LIFO

Sales $6,000 $6,000 $6,000 $6,000 $6,000 $6,000

Goods Available for Sale
($5 × 1,000 + $8 × 200 + $6 × 300) 8,400 8,400 8,400 8,400 8,400 8,400
Ending Inventory (5,000) (5,600) (5,900) (5,900) (5,650) (5,300)
Cost of Goods Sold 3,400 2,800 2,500 2,500 2,750 3,100
Gross Profit 2,600 3,200 3,500 3,500 3,250 2,900
Operating Expenses 1,800 1,800 1,800 1,800 1,800 1,800
Income before Taxes 800 1,400 1,700 1,700 1,450 1,100
Income Taxes (@ 35%) 280 490 595 595 508 385
Net Income $520 $910 $1,105 $1,105 $942 $715
Cash Savings over FIFO: $315 $105 $ 87 $210
=

9-17
 DOLLAR VALUE LIFO
(a) (b) (c) (d)
Quantity in Quantity in Quantity in
Ending Ending Ending
Inventory Current Inventory Split Proper Inventory at
at Current Price at Base Into Price Dollar-Value
Date Prices ÷ Index 1 = Prices Layers × Index = LIFO
2005 $200,000 ÷ 1.00 = $200,000 $200,000 × 1.00 = $200,000
ILLUSTRATION 9-3

2006 $299,000 ÷ 1.15 = $260,000 $200,000 × 1.00 = $200,000

DOLLAR-VALUE LIFO

$ 60,000 × 1.15 = 69,000

$269,000
2007 $300,000 ÷ 1.20 = $250,000 $200,000 × 1.00 = $200,000
$ 50,000 × 1.15 = 57,500
$257,500

9-18
2008 $351,000 ÷ 1.30 = $270,000 $200,000 × 1.00 = $200,000
$ 50,000 × 1.15 = 57,500
$ 20,000 × 1.30 = 26,000
$283,500
Computational Steps:
(a) Compute the quantity of ending inventory at current cost.
(b) Divide (a) by the current price index to obtain the quantity in ending inventory at
base-year cost.
(c) Split (b) into layers depending on the year the items were acquired.
(d) Multiply each layer in (c) by the appropriate price index (price index in the year
of acquisition) to obtain the quantity in ending inventory at dollar-value LIFO
cost.
Ending Inventory for the Period at Current Cost
1 Current Price Index =
Ending Inventory for the period at Base Year Cost
ILLUSTRATION 9-4
COMPARISON OF UNIT LIFO AND DOLLAR-VALUE LIFO

In teaching the dollar-value method it might be good to first explain what a price index
is and what it does. The next step might be to point out the difference between a real
increase and a nominal increase in the value of inventory. The essence of the method
can be presented in the following fashion:
Assume that on 1/1/08 a firm had 100 units of an item bought at $10. At the end of its
first year on 12/31/08 it had 120 units of that item and the current price at which the
last purchase had taken place was $11. The current value of the inventory is
therefore:
$11 × 120 = $1,320
The application of the unit LIFO technique to the end of year inventory would yield the
following amount:
$10 × 100 = $1,000
$11 × 20 = 220
$1,220
The point of the presentation should be to show that in this situation the dollar-value
LIFO method will yield the same result. The relevant price index for this item should
be as follows:
1/1/08: 100
12/31/08: 110
The value of the inventory at 1/1/08 prices (i.e., at base prices) is
$1,320 ÷ 1.10 = $1,200
Therefore the "real" increase in the inventory during 2008 is $1,200 – $1,000 = $200
stated in base prices. Stating this real increase in current prices:
$200 × 1.10 = $220
Therefore the dollar-value LIFO cost will be:
1/1/08 in base prices: $1,000
2008 increase in current prices: 220
12/31/08 LIFO inventory: $1,220
This should reinforce the point that the dollar-value LIFO is a quick estimation
technique with many useful applications.

9-19
ILLUSTRATION 9-5
LCM INVENTORY VALUATION

APPLICATION OF LOWER OF COST OR MARKET

CEILING

Net Realizable Replace-

Value (NRV) ment NRV—Normal
Cost Profit Margin
COST
FLOOR

Select the Middle Value

STEP 1:
Designated
Determine the
Market
Designated
Value
Market Value

STEP2: Select the Lower of Cost or Designated Market Value

Balance Sheet Inventory Value

NET REALIZABLE VALUE (NRV)—estimated selling price less costs of

completion and disposal (covers obsolete, damaged and shopworn goods).

NRV LESS NORMAL PROFIT MARGIN—generally measured as a percentage of

selling price (represents achievable gross profit even if replacement cost is
lower.)

NRV prevents overstatement of inventory and understatement of current period loss;

NRV—NPM prevents understatement of inventory and overstatement of current loss.

9-20
ILLUSTRATION 9-5 (continued)

SITUATION A

Net
Realizable Replacement NRV Less
COST Cost Normal Profit
$30 Value
$40 $35 $20

Market
Value
$35

Balance Sheet Inventory Value = $30

SITUATION B

Net
Realizable Replacement NRV Less
COST Cost Normal Profit
$30 Value
$40 $18 $20

Market
Value
$20

Balance Sheet Inventory Value = $20

9-21
Solution Manual for Intermediate Accounting Principles and Analysis 2nd Edition by Warfield

ILLUSTRATION 9-6
THE GROSS PROFIT METHOD

THE GROSS PROFIT METHOD

There is one general approach to estimating the cost of ending inventory using the
gross profit method. It makes use of the gross profits on sales. If given the markup
on cost, compute the gross profit on sales.

Assume that the following information is given:

Beginning inventory $ 60,000
Purchases 90,000
Sales 100,000
Markup on cost 25%

You are to use the gross profit method to solve for the cost of ending inventory.

1. Compute gross profit on sales (if not given):

Gross profit on Sales = Markup on cost

100% + Markup on cost

= 25% = 25% = 20%

100% + 25% 125%

2. Compute cost of goods sold:

Cost of Goods Sold = Sales × (100 % – Gross profit on Sales)
= $100,000 × (100% – 20%)
= $100,000 × 80%
= $80,000

3. Compute estimated cost of ending inventory:

Cost of beginning inventory $ 60,000
+ Cost of purchases 90,000
Cost of goods available for sale 150,000
– Cost of goods sold 80,000
Estimated cost of ending inventory $ 70,000

9-22

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