Chapter 9 Inventories: Additional IssuesQuestion 9-5The 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 9-6The 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 aren’t necessarily representative of the curren t relationship. Failure to consider theft or spoilage also could cause an overstatement of ending inventory.Answers to Questions (continued)Question 9-7The 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 9-8The 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 9-9Initial 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.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.Question 9-11The 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 9-12When 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 year’s 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-to-retail percentage that is used to convert each layer from retail to cost.Answers to Questions (continued)Question 9-13Freight-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 9-14The 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 year’s 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 year’s retail price index.Question 9-15Changes 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.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.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.Question 9-17If 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 9-182009: Cost of goods sold overstatedNet income understatedEnding retained earnings understated2010: Net purchases no effectCost of goods sold understatedNet income overstatedEnding retained earnings correctQuestion 9-19When 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. 2always is net realizable value. IAS No. 2also 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 9-20Purchase 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.BRIEF EXERCISESBrief Exercise 9-1NRV = $30 - 4 = $26NRV – NP = $26 – (30% x $30) = $17RC = $18The 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.Brief Exercise 9-2* Selling price less disposal costs.** NRV less normal profit marginCost LCMProduct 1 (1,000 units) $50,000 $50,000Product 2 (1,000 units) 30,000 26,000Cost $80,000LCM value $76,000Before-tax income will be lower by $4,000, the amount of the required inventory write-down.Brief Exercise 9-3The designated market value according to IFRS always is net realizable value.Product Cost NRV* LCM1 $50 $64 $502. 30 32 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) $50,000Product 2 (1,000 units) 30,000Cost $80,000Brief Exercise 9-4Brief Exercise 9-5Estimated 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 ratioBrief Exercise 9-6Brief Exercise 9-7Brief Exercise 9-8Brief Exercise 9-9Brief Exercise 9-10Brief Exercise 9-11*$40,800 $68,000 = 60%Brief Exercise 9-12Hopyard 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 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.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 9-13When 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 9-14The 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: U = UnderstatedO = Overstated2009 2010Beginning inventory →Beginning inventory OPlus: net purchases ↑Plus: net purchasesLess: ending inventory O →Less: ending inventoryCost of goods sold U Cost of goods sold ORevenues RevenuesLess: cost of goods sold U Less: cost of goods sold OLess: other expenses Less: other expensesNet income O Net income U↓↓Retained earnings O Retained earnings correctedBrief 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: U = UnderstatedO = Overstated2010Beginning inventoryPlus: net purchasesLess: ending inventory OCost of goods sold URevenuesLess: cost of goods sold ULess: other expensesNet income ORetained earnings ORetained earnings on January 1, 2011, in this case, would be overstated by$500,000 (ignoring income taxes).Brief Exercise 9-15The 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 year’s ne t income, income before extraordinary items, and earnings per share.EXERCISESExercise 9-1* Selling price less disposal costs.** NRV less normal pr ofit marginExercise 9-2The designated market value according to IAS No. 2always is net realizable value. Inventory valuation for the three products would be as follows: Product NRV Cost Lower of Cost or Market1 $34 $20 $202 80 90 803 60 50 50Product 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.Exercise 9-3Requirement 1The inventory value is $257,500.Requirement 2Loss from write-down of inventory: $300,000 - 257,500 =$42,500Exercise 9-4The designated market value according to IFRS always is net realizable value.Product Cost NRV LCM101 $120,000 $100,000 $100,000102 90,000 110,000 90,000103 60,000 50,000 50,000104 30,000 50,000 30,000Totals $300,000 $270,000The inventory value is $270,000so the required write-down is $30,000 ($300,000 – 270,000). The following journal entry accomplishes the write-down: Inventory write-down expense 30,000Inventory valuation allowance 30,000Exercise 9-5* Selling price less disposal costs. Disposal costs = 10% of selling price + 5% of cost.** NRV less normal profit marginExercise 9-6Requirement 1FASB ASC 330–10–35–1: ―Inventory–Overall–Subsequent 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 generally accomplished by stating such goods at a lower level commonly designated as market.Requirement 2The specific citations that discuss the level of aggregation that should be used in applying the lower-of-cost-or-market rule are FASB ASC 330–10–35–8 to11: ―Inventory–Overall–Subsequent Measurement.‖Requirement 3Depending 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 stock—the inventory in its entirety—may 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.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 9-7The FASB Accounting Standards Codification represents the single sourceof authoritative U.S. generally accepted accounting principles. The specificcitation for each of the following items is:1.The income statement presentation of losses from the write-down ofinventory:FASB ASC 330–10–50–2: ―Inventory–Overall–Disclosure‖When substantial and unusual losses result from the application of therule of lower of cost or market it will frequently be desirable to disclosethe amount of the loss in the income statement as a charge separatelyidentified from the consumed inventory costs described as cost of goods sold.2.The determination of market value for applying LCM to inventory:FASB ASC 330–10–20: ―Inventories–Overall–Glossary.‖As used in the phrase lower of cost or market, the term market means current replacement cost (by purchase or by reproduction, as the casemay 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 anallowance for an approximately normal profit margin.Exercise 9-7 (concluded)3.The accounting treatment required for a correction of an inventoryerror in previously issued financial statements:FASB ASC 250–10–50–45–23: ―Accounting Changes and ErrorCorrections–Overall–Disclosure–Other Presentation Matters.‖Any error in the financial statements of a prior period discovered after thefinancial statements are issued or are available to be issued (as discussedin Section 855-10-25) shall be reported as an error correction, byrestating the prior-period financial statements. Restatement requires all ofthe following:∙ a. The cumulative effect of the error on periods prior to thosepresented shall be reflected in the carrying amounts of assets andliabilities as of the beginning of the first period presented.∙ b. An offsetting adjustment, if any, shall be made to the openingbalance of retained earnings (or other appropriate components ofequity or net assets in the statement of financial position) for thatperiod.∙ c. Financial statements for each individual prior period presented shall be adjusted to reflect correction of the period-specific effects ofthe error.4.The use of the retail method to value inventory:FASB ASC 330–10–30–13: ―Inventory–Overall–Initial 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 andappropriate. The business operations in some cases may be such as tomake it desirable to apply one of the acceptable methods of determiningcost to one portion of the inventory or components thereof and another ofthe acceptable methods to other portions of the inventory.Exercise 9-8Exercise 9-9Exercise 9-10Exercise 9-11Requirement 1Requirement 2*Gross profit as a % of cost ÷ (1 + Gross profit as a % of cost) = Gross profit as a % of sales.100% ÷ 200% = 50%Exercise 9-12Beginning inventory + Net purchases - Ending inventory = Cost of goods sold $27,000 + 31,000 - 28,000 = $30,000 = Cost of goods soldCost of goods soldCost percentage =Net sales$30,000Cost percentage = = 60%$50,000Exercise 9-13Exercise 9-14Exercise 9-15Exercise 9-16Exercise 9-17Requirement 1Requirement 2Net markdowns are included in the cost-to-retail percentage:$257,488Cost-to-retail percentage: = 56.43%$456,300Exercise 9-18Net purchases: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) $10,50050% =, and x = $21,000.xNet purchases at retail equals $21,000 less markups plus markdowns.Net purchases = $21,000 - 4,000 + 1,000 = $18,000Net sales:The cost-to-retail percentage can be calculated as follows:Estimated ending inventory at retail is:$17,437.50= $31,000.5625Net sales = $56,000 - 31,000 = $25,000Exercise 9-19Exercise 9-20Requirement 1$15,000Cost-to-retail percentage = = 80%$18,750 Requirement 2Exercise 9-21Exercise 9-22Cost-to-retail percentage, 1/1/11:$21,000= 75%$28,000Cost-to-retail percentage, 12/31/11:$33,600= $30,000 = Ending inventory at base year retail1.12$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 $2,240Exercise 9-22 (concluded) 2012 ending inventory:Exercise 9-23Requirement 1To record the change:($ in millions)Retained earnings ........................................................... 8.2Inventory($32 million - 23.8 million).............................. 8.2 Requirement 2CPS 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 per iod. Let’s 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 1Retained earnings .................................................................. 5,000Inventory ($83,000 – 78,000) ............................................. 5,000 Requirement 2Effect on cost of goods sold:Decrease in beginning inventory ($78,000 - 71,000)- $7,000Decrease in ending inventory ($83,000 - 78,000) + 5,000Decrease in cost of goods sold $2,000Cost of goods sold for 2010 would be $2,000 lower in the revised income statement.Exercise 9-25Requirement 1The 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: U = UnderstatedO = Overstated2009 2010Beginning inventory →Beginning inventory UPlus: net purchases ↑Plus: net purchasesLess: ending inventory U →Less: ending inventoryCost of goods sold O Cost of goods sold URevenues RevenuesLess: cost of goods sold O Less: cost of goods sold ULess: other expenses Less: other expensesNet income U Net income O↓↓Retained earnings U Retained earnings correctedExercise 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: U = UnderstatedO = Overstated2010Beginning inventoryPlus: net purchasesLess: ending inventory OCost of goods sold URevenuesLess: cost of goods sold ULess: other expensesNet income ORetained earnings ORequirement 2Retained earnings (overstatement of 2010 income) .............. 150,000Inventory (overstatement of 2011 beginning inventory) ... 150,000 Requirement 3The 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 year’s net income, income before extraordinary items, and earnings per share.Exercise 9-26U = understatedO = overstatedNE = no effectCost of Net RetainedGoods Sold Income Earnings1. Overstatement of ending inventory U O O2. Overstatement of purchases O U U3. Understatement of beginning inventory U O O4. Freight-in charges are understated U O O5. Understatement of ending inventory O U U6. Understatement of purchases U O O7. Overstatement of beginning inventory O U U8. Understatement of purchases +understatement of ending inventory bythe same amount NE NE NEExercise 9-271. To include the $4 million in year 2011 purchases and increase retained earningsto what it would have been if 2010 cost of goods sold had not included the $4 million purchases.2.The 2010 financial statements that were incorrect as a result of the errors wouldbe 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.3. A “prior period adjustment”to retained earnings would be reported, and adisclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.。
