Spiceland SM 7ech09.pdf

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The McGraw-Hill Companies, Inc., 2007

Solutions Manual, Vol.1, Chapter 9 9-1

Question 9-1

Question 9-2

Question 9-3

Question 9-4

Question 9-5The gross profit methodestimates 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 goodssold is found by multiplying sales by the historical ratio of cost to selling prices. The cospercentage 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 andending inventory overstated. Cost percentages usually are based on relationships of past yearswhich arent necessarily representative of the current relationship. Failure to consider theft ospoilage also could cause an overstatement of ending inventory.

Chapter 9 Inventories: Additional Issues

QUESTIONS FOR REVIEW OF KEY TOPICS

GAAP generally require the use of historical cost to value assets, but a departure from cost isnecessary when the utility of an asset is no longer as great as its cost. The utility or benefits frominventory result from the ultimate sale of the goods. This utility could be reduced below cost due todeterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amoungreater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventorywas developed. This approach results in the recognition of losses when the value of inventorydeclines below its cost, rather than in the period in which the goods are ultimately sold.

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 isthe amount compared with cost to determine LCM.

The LCM determination can be made based on individual inventory items, on logicalcategories of inventory, or on the entire inventory.

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 desirablealternative is to include the loss in cost of goods sold.
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9-2 Intermediate Accounting,4/e

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 isthen converted tocostby 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 retailinventory method uses a cost percentage, called the cost-to-retail percentage, which is based on a currentrelationship between cost and selling price. The gross profit method relies on past data toreflect 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.

Question 9-10When 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 atretail. By including beginning inventory in the calculation of the cost-to-retail percentage, thepercentage reflects the average cost/retail relationship for all inventory, not just the portion acquiredin 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 inventoryestimation 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 years layer.To determine layers, we compare ending inventory at retail to beginning inventory at retail andassume that no more than one inventory layer is added if inventory increases. Each layer carries itsown cost-to-retail percentage that is used to convert each layer from retail to cost.

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 theretail column after the calculation of the cost-to-retail percentage. If sales are recorded net ofemployee discounts, the discounts are added to net sales before sales are deducted in the retailcolumn.


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Answers to Questions (continued)

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 comparingbeginning and ending inventory at retail prices, ending inventory is deflated to base year retail usingthe current years retail price index. After identifying the layers in ending inventory with the yearsthey were created, in addition to converting retail prices to cost using the cost-to-retail percentagethe dollar-value LIFO method requires that each layer first be converted from base year retail tolayer year retail using the years retail price index.

Question 9-15Changes in inventory methods, other a change to the LIFO method, are reported

retrospectively. This means reporting all previous periods financial statements as if the newinventory method had been used in all prior periods.

Question 9-16When a company changes tothe LIFO inventory methodfrom any other method, it usually is

impossible to calculate the income effect on prior years. To do so would require assumptions as towhen specific LIFO inventory layers were created in years prior to the change. As a result, acompany changing to LIFO usually does not report the change retrospectively. Instead, the LIFOmethod simply is used from that point on. The base year inventory for all future LIFOdeterminations is the beginning inventory in the year the LIFO method is adopted.

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 balancesthat are incorrect as a result of the error are corrected by journal entry. If retained earnings is one ofthe incorrect accounts, the correction is reported as a prior period adjustment to the beginningbalance in the statement of shareholders equity. In addition, a disclosure note is needed to describethe nature of the error and the impact of its correction on net income, income before extraordinaryitem, and earnings per share.


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Answers to Questions (concluded)

Question 9-182004: Cost of goods sold overstated

Net income understatedEnding retained earnings understated2005: Net purchases no effect

Cost of goods sold understatedNet income overstatedEnding retained earnings correct

Question 9-19

Question 9-20

Purchase commitments are contracts that obligate the company to purchase a specified amountof merchandise or raw materials at specified prices on or before specified dates. These agreementsare entered into primarily to secure the acquisition of needed inventory and to protect againstincreases in purchase price.

Purchases made pursuant to a purchase commitment are recorded at the lower of contract priceor market price on the date the contract is executed. A loss is recognized if the market price is lessthan the contract price. For purchase commitments outstanding at year-end, a loss is recognized ithe market price at year-end is less than the contract price.


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Brief Exercise 9-1

NRV = $30 - 4 = $26NRV NP = $26 (30% x $30) = $17RC = $18

The 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

(1) (2) (3) (4) (5)

Product RC

Ceiling

NRV (*)

Floor

NRV-NP(**)

DesignatedMarket Value

[Middle valueof (1), (2) & (3)] Cost

Per UnitInventory

Value

[Lower of (4)and (5)]

1 $48 $64 $54 $54 $50 $50

2 26 32 24 26 30 26

* Selling price less disposal costs.

**NRV less normal profit margin

Cost LCMProduct 1 (1,000 units) $50,000 $50,000Product 2 (1,000 units) 30,000 26,000

Cost $80,000LCM value $76,000

Before-tax income will be lower by $4,000, the amount of the required inventorywrite-down.

BRIEF EXERCISES


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Brief Exercise 9-3

Beginning inventory (from records) $220,000

Plus: Net purchases (from records) 400,000Cost of goods available for sale 620,000

Less: Cost of goods sold:Net sales $600,000Less: Estimated gross profit of 30% (180,000)Estimated cost of goods sold (420,000)

Estimated cost of inventory destroyed $200,000

Brief Exercise 9-4

Beginning inventory (from records) $150,000Plus: Net purchases (from records) 450,000

Cost of goods available for sale 600,000Less: Cost of goods sold:

Net sales $700,000Less: Estimated gross profit ( ? )Estimated cost of goods sold ( ? )

Estimated cost of inventory lost $ 75,000

Estimated 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 ratio


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Brief Exercise 9-5

Cost RetailBeginning inventory $300,000 $ 450,000Plus: Net purchases 861,000 1,210,000

Freight-in 22,000Net markups 48,000

Less: Net markdowns ______ (18,000)Goods available for sale 1,183,000 1,690,000

$1,183,000Cost-to-retail percentage: = 70%

$1,690,000

Less: Net sales (1,200,000)Estimated ending inventory at retail $ 490,000Estimated ending inventory at cost(70% x $490,000) (343,000)Estimated cost of goods sold $ 840,000


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Brief Exercise 9-6

Cost RetailBeginning inventory $300,000 $450,000Plus: Net purchases 861,000 1,210,000


Less: Net markdowns _______ (18,000)Goods available for sale (excluding beg. Inventory) 883,000 1,240,000Goods available for sale (including beg. Inventory) 1,183,000 1,690,000

$883,000Cost-to-retail percentage: = 71.21%

$1,240,000

Less: Net sales (1,200,000)Estimated ending inventory at retail $ 490,000Estimated ending inventory at cost:

Retail CostBeginning inventory $ 450,000 $ 300,000Current periods layer 40,000 x 71.21 %= 28,484

Total $ 490,000 $328,484 (328,484)Estimated cost of goods sold $854,516


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Brief Exercise 9-7

Cost RetailBeginning inventory $300,000 $ 450,000Plus: Net purchases 861,000 1,210,000


Goods available for sale 1,708,000

$1,183,000Cost-to-retail percentage: = 69.26%

$1,708,000

Less: Net markdowns ______ (18,000)Goods available for sale 1,183,000 1,690,000Less: Net sales (1,200,000)Estimated ending inventory at retail $ 490,000Estimated ending inventory at cost(69.26% x $490,000) (339,374)Estimated cost of goods sold $ 843,626


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Brief Exercise 9-8

Cost RetailBeginning inventory $220,000 $ 400,000Plus: Purchases 640,000 1,180,000

Freight-in 17,800Plus: Net markups 16,000

1,596,000$877,800

Cost-to-retail percentage: = 55%

$1,596,000Less: Net markdowns _______ (6,000)Goods available for sale 877,800 1,590,000Less:

Normal spoilage (3,000)Net sales* (1,315,000)

Estimated ending inventory at retail $272,000Estimated ending inventory at cost (55% x $272,000) (149,600)Estimated cost of goods sold $728,200

*$1,300,000 + 15,000 (employee discounts) = $1,315,000


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Brief Exercise 9-9

Cost RetailBeginning inventory $ 40,800 $ 68,000Plus: Net purchases 155,440 270,000

Net markups 6,000Less: Net markdowns _______ (8,000)Goods available for sale (excluding beginning inventory) 155,440 268,000Goods available for sale (including beginning inventory) 196,240 336,000

$40,800Base layer cost-to-retail percentage: = 60%

$68,000

$155,4402006 layer cost-to-retail percentage: = 58%

$268,000

Less: Net sales (250,000)

Estimated ending inventory at current year retail prices $ 86,000

Estimated ending inventory at cost (calculated below) (50,451)Estimated cost of goods sold $145,789___________________________________________________________________________

Step 1 Step 2 Step 3Ending Ending Inventory Inventory

Inventory Inventory Layers Layersat Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost

$86,000$86,000 = $84,314 $68,000 (base) x 1.00 x 60% = $40,800(above) 1.02 16,314 (2006) x 1.02 x 58% = 9,651

Total ending inventory at dollar-value LIFO retail cost ...................... $50,451


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Brief Exercise 9-10

Cost RetailBeginning inventory $ 50,451 $ 86,000Plus: Net purchases 168,000 301,000


$155,4402006 layer cost-to-retail percentage: = 58%$268,000


$300,000

Less: Net sales (280,000)Estimated ending inventory at current year retail prices $106,000




$106,000$106,000 = $100,000 $68,000 (base) x 1.00 x 60%* = $40,800(above) 1.06 16,314 (2006) x 1.02 x 58% = 9,651

15,686 (2007) x 1.06 x 56% = 9,311



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*$40,800 $68,000 = 60%

Brief Exercise 9-11Hopyard 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 amountsfor individual periods that are included for comparison with the current financialstatements are revised for period-specific effects of the change.

Then, the cumulative effects of the new method on periods prior to thosepresented are reflected in the reported balances of the assets and liabilities affected asof the beginning of the first period reported and a corresponding adjustment is madeto the opening balance of retained earnings for that period.

The effect of the change on each line item affected should be disclosed for eachperiod reported as well as any adjustment for periods prior to those reported. Also, thenature of and justification for the change should be described in the disclosure notes.

2006 cost of goods sold is $7,000 higher than it would have been if Hopyard hadnot 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 anincrease in ending inventory causes a decrease in cost of goods sold. Purchases for2006 are the same regardless of the inventory valuation method used.

Brief Exercise 9-12

When a company changes tothe LIFO inventory methodfrom any other methodit usually is impossible to calculate the income effect on prior years. To do so wouldrequire assumptions as to when specific LIFO inventory layers were created in yearsprior to the change. As a result, a company changing to LIFO usually does not reportthe change retrospectively. Instead, the LIFO method simply is used from that point

on. The base year inventory for all future LIFO determinations is the beginninginventory 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.


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Brief Exercise 9-13

The 2004 error caused 2004 net income to be overstated, but since 2004 endinginventory is 2005 beginning inventory, 2005 net income was understated the same

amount. So, the income statement was misstated for 2004 and 2005, but the balancesheet (retained earnings) was incorrect only for 2004. After that, no account balancesare incorrect due to the 2004 error.

Analysis: U = UnderstatedO = Overstated

2004 2005Beginning inventory ! Beginning inventory O

Plus: net purchases " Plus: net purchases

Less: ending inventory O ! Less: ending inventory

Cost of goods sold U Cost of goods sold O

Revenues RevenuesLess: cost of goods sold U Less: cost of goods sold OLess: other expenses Less: other expenses

Net income O Net income U

! !Retained earnings O Retained earnings corrected


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Brief Exercise 9-13 (concluded)

However, the 2005 error has not yet self-corrected. Both retained earnings andinventory still are overstated as a result of the second error.


2005Beginning inventoryPlus: net purchasesLess: ending inventory OCost of goods sold U

RevenuesLess: cost of goods sold ULess: other expenses

Net income O

!Retained earnings O

Retained earnings on January 1, 2006, in this case, would be overstated by$500,000 (ignoring income taxes).

Brief Exercise 9-14

The financial statements that were incorrect as a result of both errors (effect ofone error in 2004 and effect of two errors in 2005) would be retrospectively restatedto report the correct inventory amounts, cost of goods sold, income, and retainedearnings when those statements are reported again for comparative purposes in thecurrent annual report. A prior period adjustment to retained earnings would bereported, and a disclosure noteshould describe the nature of the error and the impactof its correction on each years net income, income before extraordinary items, and

earnings per share.


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Exercise 9-1

(1) (2) (3) (4) (5)

Product RC

Ceiling

NRV (*)

Floor

NRV-NP(**)

DesignatedMarket Value[Middle value

of (1), (2) & (3)] Cost

Per UnitInventory

Value[Lower of (4)

and (5)]

1 $18 $ 34 $29 $29 $20 $20

2 85 80 50 80 90 80

3 40 60 48 48 50 48

* Selling price less disposal costs.

**NRV less normal profit margin

EXERCISES


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Exercise 9-2

Requirement 1

(1) (2) (3) (4) (5)

Product RC

Ceiling

NRV

Floor

NRV-NP(NP=25%

of cost)


of (1), (2) & (3)] Cost

InventoryValue

[Lower of(4) and (5)]

101 $110,000 $100,000 $70,000 $100,000 $120,000 $100,000

102 85,000 110,000 87,500 87,500 90,000 87,500

103 40,000 50,000 35,000 40,000 60,000 40,000

104 28,000 50,000 42,500 42,500 30,000 30,000Totals $300,000 $257,500

The inventory value is $257,500.

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

Exercise 9-3

Beginning inventory (from records) $140,000Plus: Net purchases (from records) 370,000

Cost of goods available for sale 510,000


Estimated cost of inventory destroyed $ 97,500


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Exercise 9-4

Beginning inventory (from records) $100,000

Plus: Net purchases (from records) 140,000Cost of goods available for sale 240,000


Estimated ending inventory 97,000Less: Value of usable damaged goods (12,000)Estimated loss from fire $ 85,000

Exercise 9-5

Merchandise inventory, January 1, 2006 $1,900,000Purchases 5,800,000Freight-in 400,000

Cost of goods available for sale 8,100,000Less: Cost of goods sold:

Sales $8,200,000Less: Estimated gross profit of 20% (1,640,000) (6,560,000)Estimated loss from fire $1,540,000


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Exercise 9-6Beginning inventory + Net purchases - Ending inventory = Cost of goods sold

$27,000 + 31,000 - 28,000 = $30,000 = Cost of goods sold

Cost of goods soldCost percentage =

Net sales

$30,000Cost percentage = = 60%

$50,000

Exercise 9-7

Cost RetailBeginning inventory $35,000 $50,000Plus: Net purchases 19,120 31,600

Net markups 1,200Less: Net markdowns ______ (800)Goods available for sale 54,120 82,000

$54,120Cost-to-retail percentage: = 66%

$82,000

Less: Net sales (32,000)Estimated ending inventory at retail $50,000Estimated ending inventory at cost (66% x $50,000) (33,000)Estimated cost of goods sold $21,120


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Exercise 9-8

Cost RetailBeginning inventory $190,000 $ 280,000Plus: Purchases 600,000 840,000


1,140,000$798,000

Cost-to-retail percentage: = 70%$1,140,000

Less: Net markdowns _______ (4,000)

Goods available for sale 798,000 1,136,000Less: Net sales (800,000)

Estimated ending inventory at retail $ 336,000Estimated ending inventoryat cost(70% x $336,000) $235,200


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Exercise 9-9

Cost Retail

Beginning inventory $160,000 $ 280,000Plus: Net purchases 607,760 840,000

Net markups 20,000Less: Net markdowns _______ (4,000)Goods available for sale (excluding beg. Inventory) 607,760 856,000Goods available for sale (including beg. Inventory) 767,760 1,136,000


$856,000

Less: Net sales (800,000)Estimated ending inventory at retail $ 336,000Estimated ending inventory at cost:

Retail CostBeginning inventory $280,000 $160,000Current periods layer 56,000 x 71% = 39,760

Total $336,000 $199,760 (199,760)Estimated cost of goods sold $568,000


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Exercise 9-10

Cost Retail

Beginning inventory $ 12,000 $ 20,000Plus: Purchases 102,600 165,000

Freight-in 3,480Less: Purchase returns (4,000) (7,000)Plus: Net markups 6,000

184,000$114,080

Cost-to-retail percentage: = 62%$184,000

Less: Net markdowns _______ (3,000)Goods available for sale 114,080 181,000Less:

Normal spoilage (4,200)Net sales (152,000)

Estimated ending inventory at retail $ 24,800Estimated ending inventory at cost (62% x $24,800) (15,376)Estimated cost of goods sold $ 98,704


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Exercise 9-11

Requirement 1

Cost RetailBeginning inventory $ 40,000 $ 60,000Plus: Purchases 207,000 400,000

Freight-in 14,488Less: Purchase returns (4,000) (6,000)Plus: Net markups 5,800

459,800

$257,488Cost-to-retail percentage: = 56%$459,800

Less: Net markdowns _______ (3,500)Goods available for sale 257,488 456,300Less:

Normal breakage (6,000)Sales:

Net sales $280,000Add back employee discounts 1,800 (281,800)

Estimated ending inventory at retail $168,500Estimated ending inventory at cost (56% x $168,500) (94,360)Estimated cost of goods sold $163,128

Requirement 2Net markdowns are included in the cost-to-retail percentage:

$257,488

Cost-to-retail percentage: = 56.43%$456,300


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Exercise 9-12Net 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.

x

Net purchases at retail equals $21,000 less markups plus markdowns.Net purchases = $21,000 - 4,000 + 1,000 = $18,000

Net sales:

The cost-to-retail percentage can be calculated as follows:

Cost RetailBeginning inventory $21,000.00 $ 35,000Plus: Net purchases 10,500.00 18,000

Net markups 4,000Less: Net markdowns _________ (1,000)Goods available for sale 31,500.00 56,000


$56,000Less: Net sales ( ? )Estimated ending inventory at retail ?Estimated ending inventory at cost (56.25% x ?) = $17,437.50

Estimated ending inventory at retail is:

$17,437.50= $31,000

.5625


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Net sales = $56,000 - 31,000 = $25,000

Exercise 9-131. b2. c

3. d4. c

Exercise 9-14

Cost RetailBeginning inventory $ 71,280 $132,000Plus: Net purchases 112,500 255,000


$71,280Base year cost-to-retail percentage: = 54%

$132,000

$112,5002006 cost-to-retail percentage: = 45%

$250,000

Less: Net sales (232,000)

Estimated ending inventory at current year retail prices $150,000

Estimated ending inventory at cost (below) (77,004)Estimated cost of goods sold $106,776___________________________________________________________________________



$150,000$150,000 = $144,231 $132,000 (base) x 1.00 x 54% = $71,280(above) 1.04 12,231 (2006) x 1.04 x 45% = 5,724



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Exercise 9-15

Requirement 1$15,000

Cost-to-retail percentage = = 80%$18,750

Requirement 2

2006


Inventory Inventory Layers Layers

at Year-end at Base Year at Base Year Converted toRetail Prices Retail Prices Retail Prices Cost

$25,000$25,000 = $20,000 $18,750 (base) x 1.00 x 80% = $15,000(given) 1.25 1,250 (2006) x 1.25 x 82% = 1,281

Total ending inventory at dollar-value LIFO retail cost ............. $16,281

2007

$28,600$28,600 = $22,000 $18,750 (base) x 1.00 x 80% = $15,000(given) 1.30 1,250 (2006) x 1.25 x 82% = 1,281

2,000 (2007) x 1.30 x 85% = 2,210

Total ending inventory at dollar-value LIFO retail cost ............. $18,491


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Exercise 9-16

Cost RetailBeginning inventory $160,000 $250,000Plus: Net purchases 350,200 510,000


$160,000Base layer cost-to-retail percentage: = 64%

$250,000


$515,000

Less: Net sales (380,000)Estimated ending inventory at current year retail prices $385,000




$385,000

$385,000 = $350,000 $250,000 (base) x 1.00 x 64% = $160,000(above) 1.10 100,000 (2006) x 1.10 x 68% = 74,800



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Exercise 9-17Cost-to-retail percentage, 1/1/06:

$21,000= 75%

$28,000

Cost-to-retail percentage, 12/31/06:

$33,600= $30,000 = Ending inventory at base year retail

1.12

$30,000 - 28,000 = $2,000 = LIFO layer added during 2006 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 2006 layer

$2,240


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Exercise 9-17 (concluded)

2007 ending inventory:

Cost Retail

Beginning inventory $22,792 $ 33,600Plus: Net purchases 60,000 88,400Goods available for sale (including beginning inventory) $82,792 122,000


$88,400

Less: Net sales (80,000)Estimated ending inventory at current year retail prices $ 42,000Estimated ending inventory at cost (below) $26,864___________________________________________________________________________



$42,000$42,000 = $35,000 $28,000 (base) x 1.00 x 75.00% = $21,000(above) 1.20 2,000 (2006) x 1.12 x 80.00% = 1,792

5,000 (2007) x 1.20 x 67.87% = 4,072

Total ending inventory at dollar-value LIFO retail cost .................. $26,864


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Exercise 9-18

Requirement 1

To record the change: ($ in millions)Retained earnings.......................................................... 8.2

Inventory($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 amountsfor individual periods that are included for comparison with the current financialstatements are revised for period-specific effects of the change.

Then, the cumulative effects of the new method on periods prior to thosepresented are reflected in the reported balances of the assets and liabilities affected asof the beginning of the first period reported and a corresponding adjustment is madeto the opening balance of retained earnings for that period. Lets say CPS reports2006-2004 comparative statements of shareholders equity. The $8.2 millionadjustment above is due to differences prior to the 2006 change. The portion of thatamount due to differences prior to 2004 is subtracted from the opening balance ofretained earnings for 2004.

The effect of the change on each line item affected should be disclosed for eachperiod reported as well as any adjustment for periods prior to those reported. Also, thenature of and justification for the change should be described in the disclosure notes.


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Exercise 9-19

Requirement 1

Retained earnings................................................................ 5,000Inventory ($83,000 78,000) ........................................... 5,000

Requirement 2Effect on cost of goods sold:

Decrease in beginning inventory ($78,000 - 71,000) - $7,000

Decrease in ending inventory ($83,000 - 78,000) + 5,000Decreasein cost of goods sold $2,000

Cost of goods sold for 2005 would be $2,000 lower in the revised incomestatement.


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Exercise 9-20

Requirement 1

The 2004 error caused 2004 net income to be understated, but since 2004 endinginventory is 2005 beginning inventory, 2005 net income was overstated the sameamount. So, the income statement was misstated for 2004 and 2005, but the balancesheet (retained earnings) was incorrect only for 2004. After that, no account balancesare incorrect due to the 2004 error.


2004 2005Beginning inventory ! Beginning inventory U

Plus: net purchases " Plus: net purchases

Less: ending inventory U ! Less: ending inventory

Cost of goods sold O Cost of goods sold U

Revenues RevenuesLess: cost of goods sold O Less: cost of goods sold ULess: other expenses Less: other expenses

Net income U Net income O

! !Retained earnings U Retained earnings corrected


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Exercise 9-20 (concluded)

However, the 2005 error has not yet self-corrected. Both retained earnings andinventory still are overstated as a result of the second error.


2005Beginning inventoryPlus: net purchasesLess: ending inventory OCost of goods sold U

RevenuesLess: cost of goods sold ULess: other expenses

Net income O

!Retained earnings O

Requirement 2

Retained earnings (overstatement of 2005 income) ............. 150,000

Inventory (overstatement of 2006 beginning inventory) ... 150,000

Requirement 3

The financial statements that were incorrect as a result of both errors (effect ofone error in 2004 and effect of two errors in 2005) would be retrospectively restatedto report the correct inventory amounts, cost of goods sold, income, and retainedearnings when those statements are reported again for comparative purposes in thecurrent annual report. A prior period adjustment to retained earnings would bereported, and a disclosure noteshould describe the nature of the error and the impactof its correction on each years net income, income before extraordinary items, andearnings per share.


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Exercise 9-21U = understatedO = overstatedNE = no effect

Cost of Net RetainedGoods Sold Income Earnings

1. 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 U

8. Understatement of purchases +understatement of ending inventory bythe same amount NE NE NE


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Exercise 9-22

1. To include the $4 million in year 2006 purchases and increase retained earningsto what it would have been if 2005 cost of goods sold had not included the $4million purchases.

Analysis:2005 2006

Beginning inventory Beginning inventoryPurchases O Purchases ULess: Ending inventoryCost of goods sold O

RevenuesLess: Cost of goods sold O U = UnderstatedLess: Other expenses O = OverstatedNet income U

"Retained earnings U

($ in millions)Purchases ........................................................ 4

Retained earnings ........................................ 4

2. The 2005 financial statements that were incorrect as a result of the errors wouldberetrospectivelyrestated to reflect the correct cost of goods sold, (income taxexpense if taxes are considered), net income, and retained earnings when thosestatements are reported again for comparative purposes in the 2006 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 itscorrection on each years net income, income before extraordinary items, andearnings per share.

Exercise 9-231. a2. c


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Exercise 9-24

List A List B

e 1. Gross profit ratio a. Reduction in selling price below the original selling

price.i 2. Cost-to-retail percentage b. Beginning inventory is not included in the calculation

of the cost-to-retail percentage.l 3. Additional markup c. Deducted in the retail column after the calculation of

the cost-to-retail percentage.a 4. Markdown d. Requires base year retail to be converted to layer year

retail and then to cost.k 5. Net markup e. Gross profit divided by net sales.b 6. Retail method, FIFO & LIFO f. Material inventory error discovered in a subsequent

year.j 7. Conventional retail method g. Must be added to sales if sales are recorded net of

discounts.n 8. Change from LIFO h. Deducted in the retail column to arrive at goods

available for sale at retail.d 9. Dollar-value LIFO retail i. Divide cost of goods available for sale by goods

available at retail.c 10. Normal spoilage j. Average cost, LCM.f 11. Requires retrospective k. Added to the retail column to arrive at goods

restatement available for sale.g 12. Employee discounts l. Increase in selling price subsequent to initial markup.h 13. Net markdowns m. Ceiling in the determination of market.

m 14. Net realizable value n. Accounting change requiring retrospective treatment.


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Exercise 9-25

1. d. The failure to record a sale means that both accounts receivable and sales willbe understated. However, inventory was correctly counted, so that account and

cost of goods sold were unaffected.

2. d. The overstatement (double counting) of inventory at the end of year 1 causedyear 1 cost of goods sold (BI + Purchases EI) to be understated and bothinventory and income to be overstated. The year 1 ending inventory equalsyear 2 beginning inventory. Thus, the same overstatement caused year 2beginning inventory and cost of goods sold to be overstated and income to beunderstated. This is an example of a self-correcting error. By the end of year 2the balance sheet is correct.

3.

b. The conventional retail inventory method adds beginning inventory, netpurchases, and markups (but not markdowns) to calculate a cost percentage.The purpose of excluding markdowns is to approximate a lower-of-average-cost-or-market valuation. The cost percentage is then used to reduce the retailvalue of the ending inventory to cost. FCLs cost-retail ratio is 40% ($90,000 /$225,000), and ending inventory at cost is therefore $20,000 (40% x $50,000ending inventory at retail).


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Exercise 9-26

Requirement 1If market price at year-end is less than contract price for outstanding purchase

commitments, a loss is recorded for the difference.

December 31, 2006Estimated loss on purchase commitment ($60,000 - 56,000).... 4,000

Estimated liability on purchase commitment .................. 4,000

Requirement 2If market price on purchase date declines from year-end price, the purchase isrecorded at market price.

March 21, 2007Inventory............................................................................ 54,000Loss on purchase commitment ($56,000 - 54,000) ................. 2,000Estimated liability on purchase commitment ...................... 4,000

Cash .............................................................................. 60,000


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Exercise 9-27If market price is less than the contract price, the purchase is recorded at themarket price.

June 15, 2006Purchases (market price) ....................................................... 85,000Loss on purchase commitment(difference)........................... 15,000

Cash ............................................................................... 100,000

If market price at year-end is less than contract price for outstanding purchasecommitments, a loss is recorded for the difference.

June 30, 2006Estimated loss on purchase commitment ($150,000 - 140,000) . 10,000

Estimated liability on purchase commitment .................. 10,000

If market price on purchase date declines from year-end price, the purchase isrecorded at market price.

August 20, 2006Purchases(market price)........................................................ 120,000Loss on purchase commitment ($140,000 - 120,000) .............. 20,000Estimated liability on purchase commitment ...................... 10,000

Cash .............................................................................. 150,000


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Problem 9-1

Requirement 1

Product NRV per unit NRV-NP per unitA $16 - (15% x $16) = $13.60 $13.60 - (40% x $16) = $7.20B $18 - (15% x $18) = $15.30 $15.30 - (40% x $18) = $8.10C $ 8 - (15% x $8) = $ 6.80 $ 6.80 - (40% x $ 8) = $3.60D $ 6 - (15% x $6) = $ 5.10 $ 5.10 - (40% x $ 6) = $2.70E $13 - (15% x $13) = $11.05 $11.05 - (40% x $13) = $5.85

(1) (2) (3) (4) (5)

Product(units) RC

Ceiling

NRV

Floor

NRV-NP


of(1), (2)&(3)] Cost

InventoryValue

[Lower of(4) and (5)]

A (1,000) $12,000 $13,600 $7,200 $12,000 $10,000 $10,000

B (800) 8,800 12,240 6,480 8,800 12,000 8,800

C (600) 1,200 4,080 2,160 2,160 1,800 1,800

D (200) 800 1,020 540 800 1,400 800

E (600) 7,200 6,630 3,510 6,630 8,400 6,630

Totals $30,390 $33,600 $28,030

Inventory carrying value would be $28,030.

Requirement 2Inventory 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 frominventory write-down is $3,210 ($33,600 - 30,390).

PROBLEMS


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Problem 9-2

Requirement 1

Lower-of-cost-or-market

Product Cost

DesignatedMarketValue

(a)By

IndividualProducts

(b)By

ProductType

(c)

By TotalInventory

Tools:Hammers $ 500 $ 550 $ 500

Saws 2,000 1,800 1,800

Screwdrivers 600 780 600Total tools $3,100 $3,130 $3,100

Paint products:1-gallon cans $3,000 $2,500 2,500

Paint brushes 400 450 400Total paint $3,400 $2,950 2,950

Total $6,500 $6,080 $5,800 $6,050 $6,080

Requirement 2

(a) Individual products

$6,500 - 5,800= $700

(b) Product type

$6,500 - 6,050= $450

(c) Total inventory

$6,500 - 6,080 = $420


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Problem 9-3

Requirement 1

Fruit Marshmallow ChocolateToppings Toppings Topping

Estimate of cost of goods sold:Cost percentage 80% 70% 65%

x Net sales $200,000 $55,000 $20,000$160,000 $38,500 $13,000

Beginning inventory $ 20,000 $ 7,000 $ 3,000Plus: Net purchases 150,000 36,000 12,000Cost of goods available for sale 170,000 43,000 15,000

Less: Estimate of cost of goods sold 160,000 38,500 13,000

Estimate of cost of inventory lost $ 10,000 $ 4,500 $ 2,000

Requirement 2The two main factors that could cause the estimates of the inventory lost to be

over or understated are:

1. The historical cost percentages used may not be representative of the currentrelationship between cost and selling price.

2. Theft or spoilage losses may not be appropriately considered in the costpercentage.


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Problem 9-4

1. Average cost

Cost RetailBeginning inventory $ 90,000 $180,000Plus: Purchases 355,000 580,000

Freight-in 9,000Less: Purchase returns (7,000) (11,000)Plus: Net markups 16,000Less: Net markdowns (12,000)

Abnormal spoilage (4,800) (8,000)Goods available for sale 442,200 745,000

$442,200

Cost-to-retail percentage: = 59.36%$745,000

Less:Normal spoilage (3,000)Sales:

Net sales ($540,000 - 10,000) $530,000Add back employee discounts 4,000 (534,000)

Estimated ending inventory at retail $208,000Estimated ending inventory at cost (59.36% x $208,000) (123,469)

Estimated cost of goods sold $318,731


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Problem 9-4 (concluded)

2. Conventional (average, LCM)

Cost Retail

Beginning inventory $ 90,000 $180,000Plus: Purchases 355,000 580,000

Freight-in 9,000Less: Purchase returns (7,000) (11,000)Plus: Net markups 16,000Less: Abnormal spoilage (4,800) (8,000)

757,000$442,200

Cost-to-retail percentage: = 58.41%

$757,000Less: Net markdowns _______ (12,000)Goods available for sale 442,200 745,000Less:

Normal spoilage (3,000)Sales:

Net sales ($540,000 - 10,000) $530,000Add back employee discounts 4,000 (534,000)

Estimated ending inventory at retail $208,000Estimated ending inventory at cost (58.41% x $208,000) (121,493)

Estimated cost of goods sold $320,707


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Problem 9-5

Requirement 1Sales to employees must be deducted in the retail column at their gross amount:

$250,000= $312,500*

.80

Cost RetailBeginning inventory $ 100,000 $ 150,000Plus: Purchases 1,387,500 2,000,000

Freight-in 10,000Plus: Net markups 300,0002,450,000

$1,497,500Cost-to-retail percentage: = 61.12%

$2,450,000

Less: Net markdowns ________ (150,000)Goods available for sale 1,497,500 2,300,000Less:

Normal shrinkage (15,000)Sales:

Sales to customers $1,750,000Sales to employees 312,500* (2,062,500)

Estimated ending inventory at retail $ 222,500Estimated ending inventory at cost

(61.12% x $222,500) (135,992)Estimated cost of goods sold $1,361,508


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Requirement 2

Cost RetailBeginning inventory $ 100,000 $ 150,000Plus: Purchases 1,387,500 2,000,000

Freight-in 10,000Plus: Net markups 300,000Less: Net markdowns ________ (150,000)Goods available for sale (excluding beginninginventory)

1,397,500 2,150,000

Goods available for sale (including beginning inventory) 1,497,500 2,300,000

$1,397,500Cost-to-retail percentage: = 65%

$2,150,000Less:

Normal shrinkage (15,000)Sales:

Sales to customers $1,750,000Sales to employees 312,500 (2,062,500)

Estimated ending inventory at retail $ 222,500Estimated ending inventory at cost:

Retail CostBeginning inventory $150,000 $100,000Current periods layer 72,500 x 65% = 47,125

Total $222,500 $147,125 (147,125)Estimated cost of goods sold $1,350,375


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Problem 9-6

Requirement 1


Freight-in 5,100Less: Purchase returns (2,100) (2,800)Plus: Net markups ($2,500 - 265) 2,235

175,930$123,151


Less: Net markdowns _______ (800)Goods available for sale $123,151 175,130Less:

Normal spoilage (4,500)Net sales (135,730)

Estimated ending inventory at retail $ 34,900Estimated ending inventory at cost (70% x $34,900) $24,430

Requirement 2The 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 9-7($ in 000s) Cost Retail

Beginning inventory $ 80 $ 125

Purchases 671 1,006Freight-in on purchases 30Purchase returns (1) (2)Net markups 4Net markdowns ___ (8)Goods available for sale $780 1,125

Cost-to-retail percentages:Average cost ratio: $780 $1,125 = .6933Average (LCM) cost ratio: $780 ($1,125 + $8) = .6884

Deduct: Net sales (916)Ending inventory:

At retail (sales price) $ 209At Average cost ($209 x .6933) $144.90At Average (LCM) ($209 x .6884) $143.88

Note that lower of cost or market is approximated by excludingnet markdowns.


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Problem 9-8

($ in 000s)

Cost RetailBeginning inventory $80 $125Plus: Net purchases 671 1,006

Freight-in 30Net markups 4

Less: Purchase returns (1) (2)Net markdowns ___ (8)

Goods available for sale (excluding beginning inventory) 700 1,000Goods available for sale (including beginning inventory) 780 1,125

$80Base layer cost-to-retail percentage: = 64%

$125

$7002006 layer cost-to-retail percentage: = 70%

$1,000

Less: Net sales (916)

Estimated ending inventory at current year retail prices $209

Estimated ending inventory at cost (calculated below) (130)Estimated cost of goods sold $650___________________________________________________________________________



$209$209 = $190 $125 (base) x 1.00 x 64% = $ 80

(above) 1.10 65 (2006) x 1.10 x 70% = 50

Total ending inventory at dollar-value LIFO retail cost ...................... $130


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Problem 9-9Sales to employees must be deducted in the retail column at their gross amount.2006:

$2,400= $3,000 = Gross sales to employees

.80

Cost RetailBeginning inventory $28,000 $ 40,000Plus: Net purchases 85,000 108,000


Less: Net markdowns ______ (2,000)Goods available for sale (excluding beginning inventory) 87,000 116,000Goods available for sale (including beginning inventory) 115,000 156,000

$ 87,000Cost-to-retail percentage: = 75%

$116,000

Less: Net sales ($100,000 + 3,000) (103,000)Estimated ending inventory at current year retail prices $ 53,000Estimated ending inventory at cost (below) (35,950)Estimated cost of goods sold $79,050___________________________________________________________________________



$53,000$53,000 = $50,000 $40,000 (base) x 1.00 x 70% = $28,000(above) 1.06 10,000 (2006) x 1.06 x 75% = 7,950

Total ending inventory at dollar-value LIFO retail cost ............ $35,950


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2007:

$4,000

= $5,000 = Gross sales to employees.80

Cost RetailBeginning inventory $35,950 $ 53,000Plus: Net purchases 90,000 114,000


Less: Net markdowns ______ (2,200)Goods available for sale (excluding beginning inventory) 92,500 119,800Goods available for sale (including beginning inventory) 128,450 172,800

$ 92,500Cost-to-retail percentage: = 77.21%

$119,800

Less: Net sales ($104,000 + 5,000) (109,000)Estimated ending inventory at current year retail prices $ 63,800

Estimated ending inventory at cost (below) (42,744)Estimated cost of goods sold $85,706___________________________________________________________________________



$63,800

$63,800 = $58,000 $40,000 (base) x 1.00 x 70% = $28,000(above) 1.10 10,000 (2006) x 1.06 x 75% = 7,950

8,000 (2007) x 1.10 x 77.21% = 6,794

Total ending inventory at dollar-value LIFO retail cost ............ $42,744


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Problem 9-10

Requirement 1


Freight-in 26,500Less: Purchase returns (6,500) (10,000)

Purchase discounts (5,000)Plus: Net markups 25,000

550,000$324,500


Less: Net markdowns _______ (10,000)Goods available for sale $324,500 540,000Less:

Gross sales $492,000Less: Returns (5,000)Plus: Employee discounts 3,000 (490,000)

Estimated ending inventory at retail $ 50,000

Estimated ending inventory at cost(59% x $50,000)

$ 29,500


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Problem 9-10 (continued)

Requirement 2


Freight-in 26,500Less: Purchase returns (6,500) (10,000)

Purchase discounts (5,000)Plus: Net markups 25,000Less: Net markdowns _______ (10,000)Goods available for sale (excluding beg. inventory) 297,000 495,000Goods available for sale (including beg. inventory) $324,500 540,000


$495,000Less:

Gross sales $492,000Less: Returns (5,000)Plus: Employee discounts 3,000 (490,000)

Estimated ending inventory at retail $ 50,000

Estimated ending inventory at cost:Retail Cost

Beginning inventory $45,000 $27,500Current periods layer 5,000 x 60% = 3,000

Total $50,000 $30,500


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Requirement 3

2005



$56,100

$56,100 = $55,000 $50,000 (base) x 1.00 x 61%*= $30,5001.02 5,000 (2005) x 1.02 x 62% = 3,162

Total ending inventory at dollar-value LIFO retail cost .............. $33,662

* $30,500= 61%

$50,000

2006

$48,300$48,300 = $46,000 $46,000 (base) x 1.00 x 61% = $28,060

1.05

Total ending inventory at dollar-value LIFO retail cost ............... $28,060


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Problem 9-11

Requirement 1

Retained earnings................................................................ 20,000Inventory ($150,000 130,000) ....................................... 20,000

Requirement 2

FIFO method cost of goods sold:

Cost of goods available for sale $530,000Less ending inventory:

5,000 units @ $40 $200,000

2,000 units @ $36 72,000 (272,000)Cost of goods sold $258,000

Average cost method cost of goods sold:

Beginning inventory (5,000 units) $130,000Purchases:

5,000 units @ $36 $180,0005,000 units @ $40 200,000 380,000

Cost of goods available for sale (15,000 units) 510,000Less ending inventory (below) (238,000)Cost of goods sold $272,000

Cost of ending inventory:

$510,000Weighted average unit cost = = $34

15,000units

7,000 units x $34 = $238,000

The effect of the change for the year 2006 is a $14,000 increase in cost of goodssold ($272,000 - 258,000) resulting in a $14,000 decrease in income before tax and a$8,400 decrease in income after tax[$14,000 x (1 - .40)].


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Problem 9-12

Requirement 1


2004 2005Beginning inventory ! Beginning inventory U-6,000

Plus: Net purchases " Plus: Net purchases U-3,000

Less: Ending inventory U-6,000 Less: Ending inventory O-9,000Cost of goods sold O-6,000 Cost of goods sold U-18,000

Revenues Revenues

Less: Cost of goods sold O-6,000 Less: Cost of goods sold U-18,000Less: Other expenses Less: Other expensesNet income U-6,000 Net income O-18,000

" "Retained earnings U-6,000 Retained earnings O-12,000

Requirement 2

Retained earnings.......................................................... 12,000Inventory................................................................... 9,000Purchases .................................................................. 3,000

Requirement 3The financial statements that were incorrect as a result of both errors (effect of

one error in 2004 and effect of three errors in 2005) would beretrospectivelyrestatedto report the correct inventory amounts, cost of goods sold, income, and retained

earnings when those statements are reported again for comparative purposes in the2006 annual report. A prior period adjustment to retained earnings would bereported, and a disclosure noteshould describe the nature of the error and the impactof its correction on each years net income, income before extraordinary items, andearnings per share.


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Problem 9-13

Requirement 1December 31, 2006 inventory, based on a physical count $450,000

Add: Merchandise shipped f.o.b. shipping point in 2006 20,000Merchandise shipped f.o.b. shipping point in 2006 80,000

Correct ending inventory $550,000


2006Beginning inventoryPlus: Net purchases U-130,000 ($50,000 + 80,000)Less: Ending inventory U-100,000Cost of goods sold U -30,000

RevenuesLess: Cost of goods sold U -30,000Less: Other expensesNet income O -30,000

"Retained earnings O -30,000

Requirement 2

Retained earnings.......................................................... 30,000Inventory....................................................................... 100,000

Accounts payable ...................................................... 130,000


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Problem 9-14

Requirement 1a. $10.50

If market price is equal to or greater than the contract price, the purchase isrecorded at cost.

Purchases ($10.00 x 10,000 units) ...................................... 100,000Cash .......................................................................... 100,000

b. $9.50

If market price is less than the contract price, the purchase is recorded at themarket price.

Purchases ($9.50 x 10,000 units) ........................................ 95,000Loss on purchase commitment (difference)...................... 5,000

Cash .......................................................................... 100,000


No entry is required. Market price is greater than contract price.

b. $10.30

If market price at year-end is less than contract price for outstanding purchasecommitments, a loss is recorded for the difference.

December 31, 2006Estimated loss on purchase commitment[($11.00 x 20,000 units) - ($10.30 x 20,000 units)] ................. 14,000

Estimated liability on purchase commitment ............. 14,000


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If market price on purchase date has not declined from year-end price, thepurchase is recorded at the year-end market price.

Purchases ($10.30 x 20,000 units) ...................................... 206,000Estimated liability on purchase commitment ................. 14,000

Cash ($11.00 x 20,000 units) .......................................... 220,000

b. $10.00

If market price on purchase date declines from year-end price, the purchase isrecorded at market price.

Purchases ($10.00 x 20,000 units) ...................................... 200,000Loss on purchase commitment

($220,000 - 200,000 -14,000)*........................................... 6,000

Estimated liability on purchase commitment ................. 14,000Cash ($11.00 x 20,000 units) .......................................... 220,000

* or, ($10.30 - $10.00) x 20,000 units = $6,000


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Judgment Case 9-11. Hudson should account for the warehousing costs related to its wholesale

inventories as part of inventory. All reasonable and necessary costs of preparinginventory for sale should be recorded as inventory cost. This approach results inproper matching of the warehousing costs with revenue when the wholesaleinventories are sold.

2. a.The lower-of-cost-or-market method produces a more realistic estimate offuture cash flows to be realized from assets, which is consistent with the principle ofconservatism, and recognizes (matches) the anticipated loss in the income statement inthe period in which the price decline occurs.

b.Hudsons wholesale inventories should be reported in the balance sheet at

replacement cost. According to the lower-of-cost-or-market method, replacement costis defined as market. However, market cannot exceed net realizable value and cannotbe less than net realizable value less the normal profit margin. In this instance,replacement cost is below original cost, below net realizable value, and above netrealizable value less the normal profit margin. Therefore, Hudsons wholesaleinventories should be reported at replacement cost.

3. Hudsons freight-in costs should be included only in the cost amounts todetermine the cost-to-retail percentage. Hudsons net markups should be includedonly in the retail amounts to determine the cost-to-retail-percentage. Hudsons netmarkdowns should not be deducted from the retail amounts to determine the cost-to-retail percentage.

4. By not deducting net markdowns from the retail amounts to determine thecost-to-retail percentage, Hudson produces a lower cost-to-retail percentage thanwould result if net markdowns were deducted. By applying this lower percentage toending inventory at retail, the inventory is reported at an amount below cost, whichapproximates lower of average cost or market.

CASES


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Communication Case 9-2Arguments for the LCM approach versus historical cost should focus on the loss

of utility concept. A departure from cost is warranted when the utility of an asset (itsprobable future economic benefits) is no longer as great as its cost. The utility orbenefits from inventory result from the ultimate sale of the goods. So, deteriorationobsolescence, changes in price levels, or any situation that might compromise theinventorys salability impairs utility. To avoid reporting inventory at an amountgreater than the benefits it can provide, the lower-of-cost-or-market (LCM) approachto valuing inventory was developed. Reporting inventories at LCM causes losses tobe recognized when the value of inventory declines below its cost, rather than in theperiod in which the goods ultimately are sold.

A difference between LCM and a market value approach is that a market valueapproach would recognize income as market value increases above cost. This results

in recognizing income before the inventory is sold. Arguments for the LCM approachshould focus on the realization principle. That is, in most situations, until inventory issold, there exists significant uncertainty about the ultimate cash to be collected.

It is important that each student actively participate in the process of arriving at asolution. Domination by one or two individuals should be discouraged. Studentsshould be encouraged to contribute to the group discussion by (a) offering informationon relevant issues, and (b) clarifying or modifying ideas already expressed, or (c)suggesting alternative direction.


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Integrating Case 9-3

Requirement 1

York Co.

Schedule of Cost of Goods SoldFor the Year Ended December 31, 2006

Beginning inventory $ 65,600Add: Purchases 368,900Less: Purchase discounts (18,000)Add: Freight-in 5,000

Goods available for sale 421,500

Less: Ending inventory (176,000) (1)

Cost of goods sold $245,500

York Co.Supporting Schedule of Ending Inventory

December 31, 2006

Inventory at cost (LIFO):Cost Total

Units per unit cost

Beginning inventory, January 1, 8,000 $8.20 $ 65,600

Purchases, quarter ended March 31 12,000 8.25 99,000Purchases, quarter ended June 30 2,000 7.90 15,800

22,000 $180,400

Inventory at market:22,000 units @ $8 = $176,000 (1)

Requirement 2Inventory 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, butgreater than net realizable value reduced by a normal profit margin, replacement cost is used as


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market. Because inventory valued at market ($176,000) is lower than inventory valued at cos($180,400), inventory should be reported in the financial statements at market.

Judgment Case 9-41. 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 ofLIFO inventory layers.

b.The application of dollar-value LIFO is based on dollars of inventory, aninventory cost index for each year, and broad inventory pools. The inventory layersare identified with the inventory cost index for the year in which the layer was addedIn 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 markdownsshould be ignored in the calculation of the cost-to-retail percentage.

b.By not deducting net markdowns from the retail amounts to determine thecost-to-retail percentage, Huddell produces a lower cost-to-retail percentage thanwould result if net markdowns were deducted. Applying this lower percentage toending inventory at retail, the inventory is reported at an amount below cost. Thisamount is intended to approximate the lower of average cost or market.


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Communication Case 9-5Suggested Grading Concepts and Grading Scheme:

Content (70%)______ 30 Describes the method.

_____ Determining ending inventory at retail.Multiply ending inventory at retail by the cost percentage.

_____ Markups and markdowns.

______ 10 Discusses the conditions that may distort results._____ Possible inaccurate cost percentage.

Does not explicitly consider theft, breakage, etc.

______ 30 Describes the advantages of using the method when

compared to other methods._____ Avoids physical inventory count._____ Acceptable for financial reporting and income taxes._____ Can explicitly incorporate cost flow methods, taxes,

and LCM.____

______ 70 points

Writing (30%)

______ 6 Terminology and tone appropriate to the audience of a companypresident.______ 12 Organization permits ease of understanding.

_____ Introduction that states purpose._____ Paragraphs that separate main points.

______ 12 English_____ Sentences grammatically clear and well organized,

concise._____ Word selection.

_____ Spelling._____ Grammar and punctuation.

__________ 30 points


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Analysis Case 9-6

For changes not involving LIFO or changes from the LIFO method to another, theevent is accounted for as a normal change in accounting principle. In general, we

report voluntary changes in accounting principles retrospectively. This meansrevising all previous periods financial statements as if the new method were used inthose periods. In other words, for each year in the comparative statements reportedwe revise the balance of each account affected. More specifically, we make thosestatements appear as if the newly adopted accounting method had been applied allalong. Also, if retained earnings is one of the accounts whose balance requiresadjustment (and it usually is), we make an adjustment to the beginning balance ofretained earnings for the earliest period reported in the comparative statements ofshareholders equity (or statements of retained earnings if theyre presented instead).Then we create a journal entry to adjust all account balances affected as of the date of

the change.The advantage of retrospective application is to enhance comparability of thestatements from year to year. The recast statements appear as if the newly adoptedaccounting method had been applied in all previous years.

Consistency and comparability suggest that accounting choices once made shouldbe consistently followed from year to year. So, any change requires that the newmethod be justified as clearly more appropriate. In the first set of financial statementsafter the change, a disclosure note is needed to provide that justification. The footnotealso should point out that comparative information has been revised and report any pershare amounts affected for the current period and all prior periods presented.

When a company changes to the LIFO inventory method from any other method,it usually is impracticable to calculate the cumulative effect of the change. Revising

balances in prior years would require knowing what those balances should be. LIFOinventory, though, consists of layers added in prior years at costs existing in thoseyears. If another method has been used, the company probably hasnt kept a record ofthose costs. Accordingly, accounting records of prior years usually are inadequate toreport the change retrospectively. Because of this difficulty, a company changing toLIFO usually does not report the change retrospectively. Instead, the base yearinventory for all future LIFO calculations is the beginning inventory in the year theLIFO method is adopted. Then, the LIFO method is applied prospectively from that

point on. The disclosure note must include an explanation as to why retrospectiveapplication was impracticable.


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Real World Case 9-7

Requirement 1We report most voluntary changes in accounting principles retrospectively. This

means recasting all previous periods financial statements as if the new method wereused in those periods. For each year in the comparative statements reported, we revisethe balance of each account affected so that those statements appear as if the newlyadopted accounting method had been applied all along. Then we create a journalentry to adjust all account balances affected as of the date of the change.

GAAP require retrospective application to enhance comparability of the statementsfrom year to year. The revised statements are made to appear as if the newly adoptedaccounting method (average cost method in this case) had been applied in all previousyears.

Requirement 2The note reports that the switch to the average cost method caused an increase in

earnings per share of 17 cents for the first nine months of 2000. In order for theaverage method to result in higher earnings (lower cost of goods sold) than LIFO(assuming the quantity of inventory did not change), the cost of inventory must haveincreasedduring the year.

Real World Case 9-8

Requirement 3a.

During the fourth quarter of its fiscal year ended June 30, 2003, the Companychanged its method of accounting for inventories from LIFO to the averagecost method for all inventories not previously accounted for on the averagecost method.

b. The change in method increased retained earnings as of July 1, 2000 by$451,000.

c. The effect of the change was to increase net income for fiscal 2002 by $6,000.


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Communication Case 9-9

Requirement 1

Change in Inventory MethodDuring 2006, the Company changed the method of valuing its inventories from thefirst-in, first-out (FIFO) method, to the last-in, first-out (LIFO) method, determined

by the retail method. To estimate the effects of changing retail prices oninventories, the Company utilizes internally developed price indexes. The impactof the change was to decrease 2006 net income by $13.2 million and to decreaseearnings per share by $0.13. Management has determined that retrospectiveapplication of the change is impracticable because the cumulative effect of thechange on prior years was not determinable.

The Company believes that the change to the LIFO method provides a more

consistent matching of merchandise costs with sales revenue and also provides amore comparable basis of accounting with competitors.

Note: Because cost of goods sold would have been $22 million lower if the changehad not been made, income before tax would have been $22 million higherand net income would have been $13.2 million higher ($22 million multiplied

by 60% [1 - .40]).

Requirement 2

It usually is impracticable to calculate the cumulative effect of a change to LIFO

To do so would require assumptions as to when specific LIFO inventory layers werecreated in years prior to the change. Accounting records usually are inadequate for acompany to create the appropriate LIFO inventory layers. Thats why a change toLIFO usually cant be applied retrospectively.


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Judgment Case 9-10Despite the self-correcting feature of certain inventory errors, the errors cause the

financial statements of the year of the error as well as the financial statements in thesubsequent year to be incorrect. For example, an overstatement of ending inventory atthe end of 2005 will correct itself in 2006 and retained earnings at the end of 2006 willbe correct. However, cost of goods sold and net income will be incorrect in bothyears. In addition, inventory and retained earnings on the 2005 balance sheet will beincorrect.

If a materialinventory error is discovered in an accounting period subsequent tothe period in which the error is made, previous years financial statements that wereincorrect as a result of the error are retrospectively restatedto reflect the correction.And, of course, any account balances that are incorrect as a result of the error arecorrected 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 of retainedearnings in the statement of shareholders equity. In addition, a disclosure note isneeded to describe the nature of the error and the impact of its correction on netincome, income before extraordinary item, and earnings per share.


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Ethics Case 9-11

Requirement 1Bonuses will be negatively affected because if the error is corrected, a lower

ending inventory results in higher cost of goods sold and lower income. The effect ofthe error would be an overstatement of pre-tax income by $665,000 ($3,265,000 -2,600,000).

Requirement 2It will be reported as a prior period adjustment to the beginning retained earnings

balance for the year beginning July 1, 2006. Financial statements for the year endingJune 30, 2006, will be retrospectivelyrestated to reflect the correct inventory amountcost of goods sold, net income, and retained earnings.

Requirement 3

Ethical Dilemma:Should John recognize his obligation to disclose the inventory error to Danville

shareholders, the local bank, auditors, and taxing authorities or remain quiet, enablinghim and other company employees to receive originally computed year-end bonuses?


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Analysis Case 9-12ARB 43 requires that purchase commitments be evaluated in the same way as

inventory on hand for the purpose of determining any lower-of-cost-or-market (LCM)adjustment. Purchases are recorded at market price when market price is lower thanthe agreed upon contract price, and a loss is recognized for the difference betweenmarket price and contract price. Also, losses must be recognized for any purchasecommitments outstanding at the end of a reporting period when market price is lessthan contract price.

In this case, the contract price of $.80 per gallon is compared to the market priceat December 31. If market is less than $.80, an estimated loss is recognized for thedifference multiplied by the million gallon commitment. An estimated liability isrecorded for the loss. If market price is greater than $.80, then no year-end adjustmentis necessary.

As the heating oil is purchased in 2007, if an estimated loss is recorded at year-end, the purchases are recorded at the lower of market price and year-end price. If noloss is recorded at year-end, the purchases are recorded at the lower of market priceand contract price.

Documents

Spiceland SM 7ech09.pdf