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CHAPTER9
Inventories:Valuationand
EstimationConcepts
ASSIGNMENTCLASSIFICATIONTABLE(BYTOPIC)
BriefConcepts
TopicsQuestionsExercisesExercisesProblemsforAnalysis
TOC
1.Lowerofcostormarket.1,2,3,1,2,3-UO1,2,3,1,2,3
寸OL9
4,5,69,10
2.Inventoryaccounting7,847,87,114
changes;relativesales
valuemethod;netreal
izablevalue.
3.Purchasecommitments.95,69,109
4.Grossprofitmethod.10,11,711,12,13,4,5
12,1314,15,16,
17
5.Retailinventorymethod.14,15,16818,19,20,6,7,8,4,5,6
22,23,2610,11
6.Presentationand17,189219
analysis.
*7.LIFOretail.191022,2312,13,147
*8.Dollar-valueLIFOretail.1124,25,11,13
26,27
*9.SpecialLIFOproblems.2813,14
*ThismaterialisdiscussedinanAppendixtothechapter.
ASSIGNMENTCLASSIFICATIONTABLE(BYLEARNINGOBJECTIVE)
Brief
LearningObjectivesExercisesExercisesProblems
L23
1.Describeandapplythelower-of-cost-ormarketrule.1,2,3461,2,3,
52,9,10
13
2.Explainwhencompaniesvalueinventoriesatnet1,2,3458,61,2,3,
realizablevalue.9,10
乙
3.Explainwhencompaniesusetherelativesalesvalue4
methodtovalueinventories.
ao
4.Discussaccountingissuesrelatedtopurchase5,69
commitments.
5.Determineendinginventorybyapplyingthegross711,12,13,4,5
profitmethod.14,15,16,
17
6.Determineendinginventorybyapplyingtheretail818,19,206,7,8
inventorymethod.
7.Explainhowtoreportandanalyzeinventory.9219
*8.DetermineendinginventorybyapplyingtheLIFO10,1122,23,24,11,12,
retailmethods.25,26,27,13,14
28
*ThismaterialisdiscussedinanAppendixtothechapter.
ASSIGNMENTCHARACTERISTICSTABLE
LevelofTime
ItemDescriptionDifficulty(minutes)
E9-1Lower-of-cost-or-market.Simple15-20
E9-2Lower-of-cost-or-market.Simple10-15
E9-3Lower-of-cost-or-market.Simple15-20
E9-4Lower-of-cost-or-market—journalentries.Simple10-15
E9-5Lower-of-cost-or-market—valuationaccount.Moderate20-25
E9-6Lower-of-cost-or-market—erroreffect.Simple10-15
E9-7Relativesalesvaluemethod.Simple15-20
E9-8Relativesalesvaluemethod.Simple12-17
E9-9Purchasecommitments.Simple05-10
E9-10Purchasecommitments.Simple15-20
E9-11Grossprofitmethod.Simple8-13
E9-12Grossprofitmethod.Simple10-15
E9-13Grossprofitmethod.Simple15-20
E9-14Grossprofitmethod.Moderate15-20
E9-15Grossprofitmethod.Simple10-15
E9-16Grossprofitmethod.Simple15-20
E9-17Grossprofitmethod.Moderate20-25
E9-18Retailinventorymethod.Moderate20-25
E9-19Retailinventorymethod.Simple12-17
E9-20Retailinventorymethod.Simple20-25
E9-21Analysisofinventories.Simple10-15
*E9-22Retailinventorymethod-conventionalandLIFO.Moderate25-35
*E9-23Retailinventorymethod—conventionalandLIFO.Moderate15-20
*E9-24Dollar-valueLIFOretail.Simple10-15
*E9-25Dollar-valueLIFOretail.Simple5-10
*E9-26Conventionalretailanddollar-valueLIFOretail.Moderate20-25
*E9-27Dollar-valueLIFOretail.Moderate20-25
*E9-28ChangetoLIFOretail.Simple10-15
P9-1Lower-of-cost-or-market.Simple10-15
P9-2Lower-of-cost-or-market.Moderate25-30
P9-3Entriesforlower-of-cost-or-market-directModerate30-35
andallowance.
P9-4Grossprofitmethod.Moderate20-30
P9-5Grossprofitmethod.Complex40-45
P9-6Retailinventorymethod.Moderate20-30
P9-7Retailinventorymethod.Moderate20-30
ASSIGNMENTCHARACTERISTICSTABLE(Continued)
LevelofTime
ItemDescriptionDifficulty(minutes)
P9-8Retailinventorymethod.Moderate20-30
P9-9Statementandnotedisclosure,LCM,andpurchaseModerate30-40
commitment.
P9-10Lowerofcostormarket.Moderate30-40
*P9-11Conventionalanddollar-valueLIFOretail.Moderate30-35
*P9-12Retail,LIFOretail,andinventoryshortage.Moderate30-40
*P9-13ChangetoLIFOretail.Moderate30-40
*P9-14ChangetoLIFOretail;dollar-valueLIFOretail.Complex40-50
CA9-1Lower-of-cost-or-market.Moderate15-25
CA9-2Lower-of-cost-or-market.Moderate20-30
CA9-3Lower-of-cost-or-market.Moderate15-20
CA9-4Retailinventorymethod.Moderate25-30
CA9-5Costdetermination,LCM,retailmethod.Moderate15-25
CA9-6Purchasecommitment.Moderate20-25
*CA9-7RetailinventorymethodandLIFOretail.Simple10-15
ANSWERSTOQUESTIONS
1.Wherethereisevidencethattheutilityofgoodstobedisposedofintheordinarycourseofbusi
nesswillbelessthancost,thedifferenceshouldberecognizedasalossinthecurrentperiod,and
theinventoryshouldbestatedatmarketvalueinthefinancialstatements.
2.Theupper(ceiling)andlower(floor)limitsforthevalueoftheinventoryareintendedtopreventthe
inventoryfrombeingreportedatanamountinexcessofthenetrealizablevalueoratanamount
lessthanthenetrealizablevaluelessanormalprofitmargin.Themaximumlimitation,notto
exceedthenetrealizablevalue(ceiling)coversobsolete,damaged,orshopwornmaterialand
preventsoverstatementofinventoriesandunderstatementofthelossinthecurrentperiod.The
minimumlimitationdetersunderstatementofinventoryandoverstatementofthelossinthecurrent
period.
3.Theusualbasisforcarryingforwardtheinventorytothenextperiodiscost.Departurefromcostis
required,however,whentheutilityofthegoodsincludedintheinventoryislessthantheircost.
Thislossinutilityshouldberecognizedasalossofthecurrentperiod,theperiodinwhichit
occurred.Furthermore,thesubsequentperiodshouldbechargedforgoodsatanamountthat
measurestheirexpectedcontributiontothatperiod.Inotherwords,thesubsequentperiodshould
bechargedforinventoryatpricesnohigherthanthosewhichwouldhavebeenpaidifthe
inventoryhadbeenobtainedatthebeginningofthatperiod.(Historically,thelowerofcostor
marketrulearosefromtheaccountingconventionofprovidingforalllossesandanticipatingno
profits.)
Inaccordancewiththeforegoingreasoning,theruleof“costormarket,whicheverislower”may
beappliedtoeachitemintheinventory,tothetotalofthecomponentsofeachmajorcategory,or
tothetotaloftheinventory,whichevermostclearlyreflectsoperations.Theruleisusuallyapplied
toeachitem,butifindividualinventoryitemsenterintothesamecategoryorcategoriesoffinished
product,alternativeproceduresaresuitable.
Theargumentsagainsttheuseofthelowerofcostormarketmethodofvaluinginventories
includethefollowing:
(1)Themethodrequiresthereportingofestimatedlosses(alloraportionoftheexcessofactual
costoverreplacementcost)asdefiniteincomechargeseventhoughthelosseshavenotbeen
sustainedtodateandmayneverbesustained.Underaconsistentcriterionofrealizationa
dropinreplacementcostbeloworiginalcostisnomoreasustainedlossthanariseabovecost
isarealizedgain.
(2)Apriceshrinkageisbroughtintotheincomestatementbeforethelosshasbeensustained
throughsale.Furthermore,ifthechargefortheinventorywrite-downsisnotmadetoaspecial
lossaccount,thecostfigureforgoodsactuallysoldisinflatedbytheamountoftheestimated
shrinkageinpriceoftheunsoldgoods.Thetitle“CostofGoodsSold^^thereforebecomesa
misnomer.
(3)Themethodisinconsistentinapplicationinagivenyearbecauseitrecognizestheproprietyof
impliedpricereductionsbutgivesnorecognitionintheaccountsorfinancialstatementstothe
effectofthepriceincreases.
(4)Themethodisalsoinconsistentinapplicationinoneyearasopposedtoanotherbecausethe
inventoryofacompanymaybevaluedatcostinoneyearandatmarketinthenextyear.
(5)Thelowerofcostormarketmethodvaluestheinventoryinthebalancesheetconservatively.
Itseffectontheincomestatement,however,maybetheopposite.Althoughtheincome
statementfortheyearinwhichtheunsustainedlossistakenisstatedconservatively,thenet
incomeontheincomestatementofthesubsequentperiodmaybedistortediftheexpected
reductionsinsalespricesdonotmaterialize.
QuestionsChapter9(Continued)
(6)Intheapplicationofthelowerofcostormarketruleaprospective“normalprofifisusedin
determininginventoryvaluesincertaincases.Since“normalprofifisanestimatedfigure
baseduponpastexperiences(andmightnotbeattainedinthefuture),itisnotobjectivein
natureandpresentsanopportunityformanipulationoftheresultsofoperations.
4.Thelowerofcostormarketrulemaybeapplieddirectlytoeachitemortothetotalofthein
ventory(orinsomecases,tothetotalofthecomponentsofeachmajorcategory).Themethod
shouldbetheonethatmostclearlyreflectsincome.Themostcommonpracticeistopricethe
inventoryonanitem-by-itembasis.Companiesfavortheindividualitemapproachbecausetax
requirementsrequirethatanindividualitembasisbeusedunlessitinvolvespracticaldifficulties.In
addition,theindividualitemapproachgivesthemostconservativevaluationforbalancesheet
purposes.
5.1.$14.30.
2.$16.10.
3.$13.75.
4.$9.70.
5.$15.90.
6.Oneapproachistorecordtheinventoryatcostandthenreduceittomarket,therebyreflectinga
lossinthecurrentperiod(oftenreferredtoastheindirectmethod).Thelosswouldthenbeshown
asaseparateitemintheincomestatementandthecostofgoodssoldfortheyearwouldnotbe
distortedbyitsinclusion.Anobjectiontothismethodofvaluationisthataninconsistencyis
createdbetweentheincomestatementandbalancesheet.Inattemptingtomeetthisinconsistency
somehaveadvocatedtheuseofaspecialaccounttoreceivethecreditforsuchaninventory
write-down,suchasAllowancetoReduceInventorytoMarketwhichisacontraaccountagainst
inventoryonthebalancesheet.Itshouldbenotedthatthedispositionofthisaccountpresents
problemstoaccountants.
Anotherapproachismerelytosubstitutemarketforcostwhenpricingthenewinventory(often
referredtoasthedirectmethod).Suchaprocedureincreasescostofgoodssoldbytheamountof
thelossandfailstoreflectthislossseparately.Forthisreason,manytheoreticalobjectionscanbe
raisedagainstthisprocedure.
7.Anexceptiontothenormalrecognitionruleoccurswhere(1)thereisacontrolledmarketwitha
quotedpriceapplicabletospecificcommoditiesand(2)nosignificantcostsofdisposalare
involved.Certainagriculturalproductsandpreciousmetalswhichareimmediatelymarketableat
quotedpricesareoftenvaluedatnetrealizablevalue(marketprice).
8.Relativesalesvalueisanappropriatebasisforpricinginventorywhenagroupofvaryingunitsis
purchasedatasinglelumpsumprice(basketpurchase).Thepurchasepricemustbeallocatedin
somemanneroronsomebasisamongthevariousunits.Whentheunitsvaryinsize,character,
andattractiveness,thebasisforallocationmustreflectbothquantitativeandqualitativeaspects.A
suitablebasisthenistherelativesalesvalueoftheunitsthatcomprisetheinventory.
9.Thedropinthemarketpriceofthecommitmentshouldbechargedtooperationsinthecurrentyear
ifitismaterialinamount.Thefollowingentrywouldbemade[($6.40-$5.90)X150,000]=$75,000:
UnrealizedHoldingGainorLoss—Income(PurchaseCommitments)75,000
EstimatedLiabilityonPurchaseCommitments75,000
Theentryismadebecausealossinutilityhasoccurredduringtheperiodinwhichthemarket
declinetookplace.Theaccountcreditedintheaboveentryshouldbeincludedamongthecurrent
liabilitiesonthebalancesheetwithanappropriatenoteindicatingthenatureandextentofthe
commitment.Thisliabilityindicatestheminimumobligationonthecommitmentcontractatthe
presenttime-theamountthatwouldhavetobeforfeitedincaseofbreachofcontract.
QuestionsChapter9(Continued)
10.Themajorusesofthegrossprofitmethodare:(1)itprovidesanapproximationoftheendingin
ventorywhichtheauditormightusefortestingvalidityofphysicalinventorycount;(2)itmeansthat
aphysicalcountneednotbetakeneverymonthorquarter;and(3)ithelpsindetermining
damagescausedbycasualtywheninventorycannotbecounted.
11.Grossprofitasapercentageofsalesindicatesthatthemarginisbasedonsellingpriceratherthan
cost;forthisreasonthegrossprofitasapercentageofsellingpricewillalwaysbelowerthanif
basedoncost.Conversionsareasfollows:
20%oncost=162/3%onsellingprice
331/3%oncost=25%onsellingprice
331/3%onsellingprice=50%oncost
60%onsellingprice=150%oncost
12.Amarkupof25%oncostequalsa20%markuponsellingprice;therefore,grossprofitequals
$1,200,000($6millionX20%)andnetincomeequals$300,000[$1,200,000-(15%X$6million)].
Thefollowingformulawasusedtocomputethe20%markuponsellingprice:
crxirPercentagemarkuponcost.25=20/o
Grossprofitonsellingprice=!Oo%+Percentagemarkuponcost=1+,25
13.Inventory,January1,2008$400,000
PurchasestoFebruary10,2008$1,140,000
Freight-intoFebruary10,200860,0001,200,000
Merchandiseavailable1,600,000
SalestoFebruary10,20081,750,000
Lessgrossprofitat40%700,000
Salesatcost1,050000
Inventory(approximately)atFebruary10,2008$550.000
14.Thevalidityoftheretailinventorymethodisdependentupon(1)thecompositionoftheinventory
remainingapproximatelythesameattheendoftheperiodasitwasduringtheperiod,and
(2)therebeingapproximatelythesamerateofmarkupattheendoftheyearaswasused
throughouttheperiod.
Theretailmethod,thoughordinarilyappliedonadepartmentalbasis,maybeappropriateforthe
businessasaunitiftheaboveconditionsaremet.
15.Theconventionalretailmethodisastatisticalprocedurebasedonaverageswherebyinventory
figuresatretailarereducedtoaninventoryvaluationfigurebymultiplyingtheretailfiguresbya
percentagewhichisthecomplementofthemarkuppercent.
Todeterminethemarkuppercent,originalmarkupsandadditionalnetmarkupsarerelatedtothe
originalcost.Thecomplementofthemarkuppercentsodeterminedisthenappliedtothe
inventoryatretailafterthelatterhasbeenreducedbynetmarkdowns,thusineffectachievinga
lowerofcostormarketvaluation.
Anexampleofreductiontomarketfollows:
Assumepurchaseof100itemsat$1each,markedtosellat$1.50each,atwhichprice80were
sold.Theremaining20aremarkeddownto$1.15each.
Theinventoryat$15.33is$4.67beloworiginalcostandisvaluedatanamountwhichwillproduce
the“normal"331/3%grossprofitifsoldatthepresentretailpriceof$23.00.
QuestionsChapter9(Continued)
ComputationofInventory
CostRetailRatio
Purchases$100$150662/3%
Sales(120)
Markdowns(20X$.35),JZ)
Inventoryatretail$23
Inventoryatlowerofcostormarket$23X662/3%=$15.33
16.(a)Endinginventory:
CostRetail
Beginninginventory$149,000$283,500
Purchases1,400,0002,160,000
Freight-in70,0000
Totals1,619,0002,443,500
Addnetmarkups92,000
$1.619.0002,535,500
Deductnetmarkdowns48,000
2,487,500
Deductsales2,235,000
Endinginventory,atretail$252,500
cr,…$1,619,000…
Ratioofcosttosellingprice6门匚”ucc=64%.
Endinginventoryestimatedatcost=64%X$252,500=$161,600.
(b)Theretailmethod,above,showedanendinginventoryatretailof$252,500;therefore,
merchandisenotaccountedforamountsto$12,500($252,500-$240,000)atretailand
$8,000($12,500X.64)atcost.
17.Informationrelativetothecompositionoftheinventory(i.e.,rawmaterial,work-in-process,and
finishedgoods);theinventoryfinancingwheresignificantorunusual(transactionswithrelated
parties,productfinancingarrangements,firmpurchasecommitments,involuntaryliquidationsof
LIFOinventories,pledginginventoriesascollateral);andtheinventorycostingmethodsemployed
(lowerofcostormarket,FIFO,LIFO,averagecost)shouldbedisclosed.BecauseDeere
CompanyusesLIFO,itshouldalsoreporttheLIFORESERVE.
18.Inventoryturnovermeasureshowquicklyinventoryissold.Generally,thehighertheinventory
turnover,thebettertheenterpriseisperforming.Themoretimestheinventoryturnsover,the
smallerthenetmargincanbetoearnanappropriatetotalprofitandreturnonassets.Forexample,
acompanycanpriceitsgoodslowerifithasahighinventoryturnover.Acompanywithalowprofit
margin,suchas2%,canearnasmuchasacompanywithahighnetprofitmargin,suchas40%,
ifitsinventoryturnoverisoftenenough.Toillustrate,agrocerystorewitha2%profitmargincan
earnasmuchasajewelrystorewitha40%profitmarginandaninventoryturnoverof1ifits
turnoverismorethan20times.
*19.Twomajormodificationsarenecessary.First,thebeginninginventoryshouldbeexcludedfromthe
numeratoranddenominatorofthecosttoretailpercentageandsecond,markdownsshouldbe
includedinthedenominatorofthecosttoretailpercentage.
SOLUTIONSTOBRIEFEXERCISES
BRIEFEXERCISE9-1
(a)Ceiling$198.00($217-$19)
Floor$166.00($217-$19-$32)
(b)$106.00
(c)$51.00
BRIEFEXERCISE9-2
Designated
ItemCostMarketLCM
Jokers$2,000$1,900$1,900
Penguins5,0004,9504,950
Riddlers4,4004,5504,400
Scarecrows3,2003,0703,070
BRIEFEXERCISE9-3
(a)Directmethod
CostofGoodsSold17,000
Inventory17,000
(b)Indirectmethod
LossDuetoMarketDeclineofInventory17,000
AllowancetoReduceInventorytoMarket.….17,000
BRIEFEXERCISE9-4
SalesTotalRelativeCost
NumberPriceSalesSalesTotalAllocatedCost
GroupofCDsperCDPricePriceCosttoCDsperCD
1100$5$5005/100*X$6,000=$300$3**
2800$108,00080/100X$6,000=4,800$6
3100$151,50015/100X$6,000=900$9
$10.000$6.000
*$500/$10,000=5/100**$300/100=$3
BRIEFEXERCISE9-5
UnrealizedHoldingLoss-Income(Purchase
Commitments)70,000
EstimatedLiabilityonPurchase
Commitments70,000
BRIEFEXERCISE9-6
Purchases(Inventory)930,000
EstimatedLiabilityonPurchaseCommitments70,000
Cash1,000,000
BRIEFEXERCISE9-7
Beginninginventory
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