Chapter 9

Inventories: Additional Issues

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 9-1
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.

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.

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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 inventory, not just the portion acquired in the current period.

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 cost-toretail percentage that is used to convert each layer from retail to cost.

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 added to net sales before sales are deducted in the retail column.

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Answers to Questions (continued) 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
For changes not involving LIFO, the cumulative after-tax effect on prior years income is reported as a separate item of income between extraordinary items and net income. This is the difference between the balance in retained earnings and what that balance would have been if the new inventory method had been used previously. The effect of the change on certain key income numbers should be reported on a pro forma (as if) basis for the financial statements of all prior periods included. In addition, a disclosure note should describe the change and justification for the change along with the effect of the change on current years income numbers.

Question 9-16
When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the cumulative effect because of the assumptions that would have to be made as to when specific LIFO inventory layers were created in years prior to the change. Because of this, a company changing to LIFO doesnt report the cumulative income effect. Instead, the base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted. The only disclosure required is a note describing the nature of and justification for the change, the effect of the change on current year's income and earnings per share, and an explanation as to why the cumulative income effect was omitted. A change from the LIFO inventory method to any other inventory method is a change in accounting principle that is accounted for retroactively. Financial statements for each year reported for comparative purposes are restated to reflect the use of the new method, and the income effect for years prior to those reported is accounted for as an adjustment to beginning retained earnings of the earliest year reported. All financial statements are therefore presented on a comparable basis. Also, a description of the change and justification for the change, along with the effect of the change on income for all years presented, should be provided in the disclosure notes to the financial statements.

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 retroactively 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.
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Answers to Questions (concluded) Question 9-18

2001: 2002: 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
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 9-20
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.

Exercise 9-1
(1) (2) Ceiling (3) Floor (4) Designated Market Value [Middle value of (1)-(3)] $29 85 48 (5) Per Unit Inventory Value [Lower of (4) or (5)] $20 85 48

Product 1 2 3

RC $18 85 40

NRV (*) $ 34 110 60

NRV-NP (**) $29 80 48

Cost $20 90 50

* Selling price less disposal costs. ** NRV less normal profit margin
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Exercise 9-2
Requirement 1 (1) (2) Ceiling (3) Floor (4) (5) Inventory Value [Lower of (4) or (5)] $100,000 87,500 40,000 30,000 $257,500

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)-(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

The inventory value is $257,500. Requirement 2 Loss from write-down of inventory: $300,000 - 257,500 = $42,500

Exercise 9-3
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 20% Estimated cost of goods sold Estimated cost of inventory destroyed $120,000 370,000 490,000 $500,000 (100,000) (400,000) $ 90,000

Exercise 9-6
Beginning inventory + Net purchases - Ending inventory = Cost of goods sold $27,000 + 31,000 - 28,000 = $30,000 = Cost of goods sold
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Cost of goods sold Cost percentage = Net sales $30,000 Cost percentage = $50,000 = 60%

Exercise 9-10
Cost $ 12,000 102,600 3,480 (4,000) $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 $20,800) Estimated cost of goods sold _______ 114,080 (3,000) 181,000 (4,200) (156,000) $ 20,800 (12,896) $101,184 = 62% Retail $ 20,000 165,000 (7,000) 6,000 184,000

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

Exercise 9-14
Cost $ 71,280 120,000 _______ 120,000 191,280 Retail $132,000 255,000 6,000 (11,000) 250,000 382,000

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

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$71,280 Base year cost-to-retail percentage: $132,000 $120,000 2003 cost-to-retail percentage: $250,000 Less: Net sales Estimated ending inventory at current year retail prices (230,000) $152,000 = 48% = 54%

Estimated ending inventory at cost (below) (78,346) Estimated cost of goods sold $112,934 ___________________________________________________________________________ Ending Inventory at Year-end Retail Prices $152,000 (above) Step 1 Ending Inventory at Base Year Retail Prices $152,000 = $146,154 1.04 $132,000 (base) 14,154 (2003) x 1.00 x 54% = x 1.04 x 48% = $71,280 7,066 $78,346 Step 2 Inventory Layers at Base Year Retail Prices Step 3 Inventory Layers Converted to Cost

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

Exercise 9-17
Cost-to-retail percentage, 1/1/03: $21,000 = 75% $28,000 Cost-to-retail percentage, 12/31/03: $33,600 = $30,000 = Ending inventory at base year retail 1.12 $30,000 - 28,000 = $2,000 = LIFO layer added during 2003 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
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Exercise 9-17 (concluded) $1,792 = 80% = Cost-to-retail percentage for the year 2003 layer $2,240 2004 ending inventory: Beginning inventory Plus: Net purchases Goods available for sale (including beginning inventory) $60,000 Cost-to-retail percentage: $88,400 Less: Net sales (80,000) Estimated ending inventory at current year retail prices $ 42,000 Estimated ending inventory at cost (below) $26,864 ___________________________________________________________________________ Ending Inventory at Year-end Retail Prices $42,000 (above) Step 1 Ending Inventory at Base Year Retail Prices $42,000 = $35,000 1.20 $28,000 (base) 2,000 (2003) 5,000 (2004) 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 = 67.87% Cost $22,792 60,000 $82,792 Retail $ 33,600 88,400 122,000

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

Exercise 9-19
Requirement 1 The cumulative effect is a $5,000 decrease in income ($83,000 - 78,000). Requirement 2 Effect on cost of goods sold: Decrease in beginning inventory ($78,000 - 71,000)
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Decrease in ending inventory ($83,000 - 78,000) Decrease in cost of goods sold

+ 5,000 $2,000

Cost of goods sold for 2002 would have been $2,000 lower, therefore income before taxes in 2002 would have been $2,000 higher if the average cost method had been used.

Exercise 9-21
U = understated O = overstated NE = no effect 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 Cost of Goods Sold U O U U O U O NE Net Income O U O O U O U NE Retained Earnings O U O O U O U NE

Exercise 9-22
1. To include the $3 million in year 2003 purchases and increase retained earnings to what it would have been if 2002 cost of goods sold had not included the $3 million purchases. Analysis: 2002 Beginning inventory Purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income Retained earnings O O O U U ($ in millions) 3 3 U = Understated O = Overstated 2003 Beginning inventory Purchases U

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

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2.

The 2002 financial statements that were incorrect as a result of the errors would be retroactively 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 2003 annual report. Because retained earnings is one of the accounts incorrect, the correction to that account is reported as a prior period adjustment to the 2002 retained earnings balance in the comparative statements of shareholders equity. Also, 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.

4.

Exercise 9-24
List A e i l a k b j n d 1. Gross profit ratio 2. 3. 4. 5. 6. 7. 8. 9. a. price. Cost-to-retail percentage b. of the cost-to-retail percentage. Additional markup c. the cost-to-retail percentage. Markdown d. retail and then to cost. Net markup e. Retail method, FIFO & LIFO f. year. Conventional retail method g. discounts. Change from LIFO h. available for sale at retail. Dollar-value LIFO retail i. available at retail. Normal spoilage j. Requires retroactive k. restatement Employee discounts l. Net markdowns m. Net realizable value n. List B Reduction in selling price below the original selling Beginning inventory is not included in the calculation Deducted in the retail column after the calculation of Requires base year retail to be converted to layer year Gross profit divided by net sales. Material inventory error discovered in a subsequent Must be added to sales if sales are recorded net of Deducted in the retail column to arrive at goods Divide cost of goods available for sale by goods Average cost, LCM. Added to the retail column to arrive at goods available for sale. Increase in selling price subsequent to initial markup. Ceiling in the determination of market. Accounting change requiring retroactive restatement.

c 10. f 11. g 12. h 13. m 14.

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Problem 9-1
Requirement 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 (1) (2) Ceiling Product (units) A (1,000) B (800) C (600) D (200) E (600) (3) Floor Designated Market Value NRV-NP [Middle value of (1)-(3)] $7,200 6,480 2,160 540 3,510 Totals Inventory carrying value would be $28,030. 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). $12,000 8,800 2,160 800 6,630 $30,390 Inventory Value [Lower of (4) or (5)] $10,000 8,800 1,800 800 6,630 $28,030 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 (4) (5)

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

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

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

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Problem 9-4
1. Average cost Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Net markdowns Abnormal spoilage Goods available for sale $447,000 Cost-to-retail percentage: $745,000 Less: Normal spoilage Sales: Net sales ($540,000 - 10,000) $530,000 Add back employee discounts 4,000 Estimated ending inventory at retail Estimated ending inventory at cost (60% x $208,000) Estimated cost of goods sold 2. Conventional (average, LCM) Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups Less: Abnormal spoilage $447,000 Cost-to-retail percentage: $757,000 Less: Net markdowns Goods available for sale Less: Normal spoilage Sales: Net sales ($540,000 - 10,000) Add back employee discounts Estimated ending inventory at retail _______ 447,000 (12,000) 745,000 (3,000) $530,000 4,000 (534,000) $208,000
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Cost $ 90,000 355,000 9,000 (7,000) _______ 447,000 = 60%

Retail $180,000 580,000 (11,000) 16,000 (12,000) (8,000) 745,000

(3,000) (534,000) $208,000 (124,800) $322,200

Cost $ 90,000 355,000 9,000 (7,000)

Retail $180,000 580,000 (11,000) 16,000 (8,000) 757,000

= 59.05%

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Estimated ending inventory at cost (59.05% x $208,000) Estimated cost of goods sold

(122,824) $324,176

Problem 9-6
Requirement 1 Cost $ 20,000 100,151 5,100 (2,100) $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% Retail $ 30,000 146,495 (2,800) 2,235 175,930

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups ($2,500 - 265)

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.

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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) $80 Base layer cost-to-retail percentage: $125 $700 2003 layer cost-to-retail percentage: $1,000 Less: Net sales Estimated ending inventory at current year retail prices (916) $209 = 70% = 64% Cost $80 671 30 (1) ___ 700 780 Retail $125 1,006 4 (2) (8) 1,000 1,125

Estimated ending inventory at cost (calculated below) (130) Estimated cost of goods sold $650 ___________________________________________________________________________ Ending Inventory at Year-end Retail Prices $209 (above) Step 1 Ending Inventory at Base Year Retail Prices $209 = $190 1.10 $125 (base) 65 (2003) 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

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

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Integrating Case 9-3

Requirement 1 York Co. Schedule of Cost of Goods Sold For the Year Ended December 31, 2003 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, 2003 Inventory at cost (LIFO): 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. 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

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Judgment Case 9-4

1. a. The advantages of using the dollar-value LIFO method are to reduce the cost of accounting for inventory and to minimize the probability of liquidation of LIFO inventory layers. b. The application of dollar-value LIFO is based on dollars of inventory, an inventory cost index for each year, and broad inventory pools. The inventory layers are identified with the inventory cost index for the year in which the layer was added. In contrast, traditional LIFO is applied to individual units at their cost. 2. a. 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.

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