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門匚”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