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Who owns the goods, as well as
in transit, consigned goods, special sales agreements).
the costs to include in inventory,
2. The costs to include in inventory (product vs. period costs).
are essentially accounted for the
3. The cost fl ow assumption to adopt (specifi c identifi cation, average-cost, same under IFRS and GAAP.
FIFO, LIFO, retail, etc.)
We explore these basic issues in the next three sections.
PHYSICAL GOODS INCLUDED IN INVENTORY
Technically, a company should record purchases when it obtains legal title to the
3 LEARNING OBJECTIVE
goods. In practice, however, a company records acquisitions when it receives the
Determine the goods included in
goods. Why? Because it is difficult to determine the exact time of legal passage of
inventory and the effects of inventory
title for every purchase. In addition, no material error likely results from such a
errors on the financial statements.
practice if consistently applied. Illustration 8-6 indicates the general guidelines
companies use in evaluating whether the seller or buyer reports an item as inventory.
Exceptions to the general guidelines can arise for goods in transit and consigned goods.
ILLUSTRATION 8-6
Guidelines for
Whose inventory
General Rule Determining Ownership
is it?
Inventory is buyer’s when received, except:
FOB shipping point—Buyer’s at time of delivery to
common carrier
Consignment goods—Seller’s, not buyer’s
Sales with buybacks—Seller’s, not buyer’s
Sales with high rates—Buyer’s, if you can estimate
of returns returns
Sales on installments—Buyer’s, if you can estimate
collectibility
Goods in Transit
Sometimes purchased merchandise remains in transit—not yet received—at the end of
a fiscal period. The accounting for these shipped goods depends on who owns them.
For example, a company like Walgreens determines ownership by applying the “pas-
sage of title” rule. If a supplier ships goods to Walgreens f.o.b. shipping point, title
passes to Walgreens when the supplier delivers the goods to the common carrier, who
acts as an agent for Walgreens. (The abbreviation f.o.b. stands for free on board.) If the
supplier ships the goods f.o.b. destination, title passes to Walgreens only when it re-
ceives the goods from the common carrier. “Shipping point” and “destination” are often
designated by a particular location, for example, f.o.b. Denver.
When Walgreens obtains legal title to goods, it must record them as purchases in that
fiscal period, assuming a periodic inventory system. Thus, goods shipped to Walgreens
f.o.b. shipping point, but in transit at the end of the period, belong to Walgreens. It
should show the purchase in its records because legal title to these goods passed to
422 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Walgreens upon shipment of the goods. To disregard such purchases results in under-
stating inventories and accounts payable in the balance sheet, and understating pur-
chases and ending inventories in the income statement.
Consigned Goods
Companies market certain products through a consignment shipment. Under this
arrangement, a company like Williams’ Art Gallery (the consignor) ships various art
merchandise to Sotheby’s Holdings (the consignee), who acts as Williams’ agent in
selling the consigned goods. Sotheby’s agrees to accept the goods without any liability,
except to exercise due care and reasonable protection from loss or damage, until it sells
the goods to a third party. When Sotheby’s sells the goods, it remits the revenue, less a
selling commission and expenses incurred in accomplishing the sale, to Williams.
Goods out on consignment remain the property of the consignor (Williams in the
example above). Williams thus includes the goods in its inventory at purchase price or
production cost. Occasionally, and only for a significant amount, the consignor shows
the inventory out on consignment as a separate item. Sometimes a consignor reports the
inventory on consignment in the notes to the financial statements. For example, Eagle
Clothes, Inc. reported the following related to consigned goods: “Inventories consist of |
finished goods shipped on consignment to customers of the Company’s subsidiary
April-Marcus, Inc.”
The consignee makes no entry to the inventory account for goods received. Remember,
these goods remain the property of the consignor until sold. In fact, the consignee should
be extremely careful not to include any of the goods consigned as a part of inventory.
Special Sales Agreements
As we indicated earlier, transfer of legal title is the general guideline used to determine
whether a company should include an item in inventory. Unfortunately, transfer of
legal title and the underlying substance of the transaction often do not match. For exam-
ple, legal title may have passed to the purchaser, but the seller of the goods retains the
risks of ownership. Conversely, transfer of legal title may not occur, but the economic
substance of the transaction is such that the seller no longer retains the risks of ownership.
Two special sales situations are illustrated here to indicate the types of problems
companies encounter in practice:
1. Sales with buyback agreement.
2. Sales with high rates of return.
Sales with Buyback Agreement
Sometimes an enterprise finances its inventory without reporting either the liability or
the inventory on its balance sheet. This approach, often referred to as a product financing
arrangement, usually involves a “sale” with either an implicit or explicit “buyback”
agreement.
To illustrate, Hill Enterprises transfers (“sells”) inventory to Chase, Inc. and
Underlying Concepts
simultaneously agrees to repurchase this merchandise at a specified price over
Recognizing revenue at the a specified period of time. Chase then uses the inventory as collateral and
time the inventory is “parked” borrows against it. Chase uses the loan proceeds to pay Hill, which repurchases
violates the revenue recognition the inventory in the future. Chase employs the proceeds from repayment to
principle. That is, a performance
meet its loan obligation.
obligation is met when the risks
The essence of this transaction is that Hill Enterprises is financing its
and rewards of ownership are
inventory—and retaining risk of ownership—even though it transferred to
transferred to the buyer.
Chase technical legal title to the merchandise. By structuring a transaction in
Physical Goods Included in Inventory 423
this manner, Hill avoids personal property taxes in certain states. Other advantages of
this transaction for Hill are the removal of the current liability from its balance sheet
and the ability to manipulate income. For Chase, the purchase of the goods may solve
a LIFO liquidation problem (discussed later), or Chase may enter into a similar recipro-
cal agreement at a later date.
These arrangements are often described in practice as “parking transactions.” In See the FASB
this situation, Hill simply parks the inventory on Chase’s balance sheet for a short Codification section
period of time. Generally, when a repurchase agreement exists, Hill should report the (page 449).
inventory and related liability on its books. [1] The reason? Hill has retained the risks
and rewards of ownership.
Sales with High Rates of Return
In industries such as publishing, music, toys, and sporting goods, formal or informal agree-
ments often exist that permit purchasers to return inventory for a full or partial refund.
To illustrate, Quality Publishing Company sells textbooks to Campus Bookstores
with an agreement that Campus may return for full credit any books not sold. Histori-
cally, Campus Bookstores returned approximately 25 percent of the textbooks from
Quality Publishing. How should Quality Publishing report its sales transactions?
One alternative is to record the sale at the full amount and establish an estimated
sales returns and allowances account until the return period has expired. A second pos-
sibility is to not record any sales until circumstances indicate the amount of inventory
the buyer will return. The key question is: Under what circumstances should Quality
Publishing consider the inventory sold? The answer is that when Quality Publishing |
can reasonably estimate the amount of returns, it should consider the goods sold but
establish a return liability for the amount of the estimated returns. Conversely, if returns
are unpredictable, Quality Publishing should not consider the goods sold and it should
not remove the goods from its inventory. [2]
What do the numbers mean? NO PARKING!
In one of the more elaborate accounting frauds, employees the goods were returned by customers. When auditors un-
at Kurzweil Applied Intelligence Inc. booked millions of covered the fraud, the bottom dropped out of Kurzweil’s
dollars in phony inventory sales during a two-year period stock.
that straddled two audits and an initial public stock offering. Similar inventory shenanigans occurred at Delphi, which
They dummied up phony shipping documents and logbooks used side-deals with third parties to get inventory off its
to support bogus sales transactions. Then they shipped high- books and to record sales. The overstatement in income
tech equipment, not to customers, but to a public warehouse eventually led to a bankruptcy fi ling for Delphi.
for “temporary” storage, where some of it sat for 17 months. More recently and with an international twist, concerns
(Kurzweil still had ownership.) about inventory shenanigans are surfacing in China. Following
To foil auditors’ attempts to verify the existence of the years of torrid growth, the global economic slowdown has re-
inventory, Kurzweil employees moved the goods from sulted in a huge buildup of unsold goods that is cluttering shop
warehouse to warehouse. To cover the fraudulently recorded fl oors, clogging car dealerships, and fi lling factory warehouses.
sales transactions as auditors closed in, the employees The large inventory overhang is raising alarms about phantom
brought back the still-hidden goods, under the pretense that profi ts and suspect economic data coming out of China.
Sources: Adapted from “Anatomy of a Fraud,” BusinessWeek (September 16, 1996), pp. 90–94; J. McCracken, “Delphi Executives Named in
Suit over Inventory Practices,” Wall Street Journal (May 5, 2005), p. A3; and K. Bradsher, “China Confronts Mounting Piles of Unsold Goods,”
New York Times (August 23, 2012).
Effect of Inventory Errors
Items incorrectly included or excluded in determining cost of goods sold through inven-
tory misstatements will result in errors in the financial statements. Let’s look at two
cases, assuming a periodic inventory system.
424 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Ending Inventory Misstated
What would happen if IBM correctly records its beginning inventory and purchases,
but fails to include some items in ending inventory? In this situation, we would have the
following effects on the financial statements at the end of the period.
ILLUSTRATION 8-7
Balance Sheet Income Statement
Financial Statement
Inventory Understated Cost of goods sold Overstated
Effects of Misstated
Retained earnings Understated
Ending Inventory
Working capital Understated Net income Understated
Current ratio Understated
If ending inventory is understated, working capital (current assets less current liabili-
ties) and the current ratio (current assets divided by current liabilities) are understated.
If cost of goods sold is overstated, then net income is understated.
To illustrate the effect on net income over a two-year period (2013–2014), assume
that Jay Weiseman Corp. understates its ending inventory by $10,000 in 2013; all other
items are correctly stated. The effect of this error is to decrease net income in 2013 and to
increase net income in 2014. The error is counterbalanced (offset) in 2014 because begin-
ning inventory is understated and net income is overstated. As Illustration 8-8 shows,
the income statement misstates the net income figures for both 2013 and 2014 although
the total for the two years is correct.
ILLUSTRATION 8-8
JAY WEISEMAN CORP.
Effect of Ending
(All Figures Assumed)
Inventory Error on Two
Periods Incorrect Recording Correct Recording
2013 2014 2013 2014
Revenues $100,000 $100,000 $100,000 $100,000 |
Cost of goods sold
Beginning inventory 25,000 20,000 25,000 30,000
Purchased or produced 45,000 60,000 45,000 60,000
Goods available for sale 70,000 80,000 70,000 90,000
Less: Ending inventory 20,000* 40,000 30,000 40,000
Cost of goods sold 50,000 40,000 40,000 50,000
Gross profit 50,000 60,000 60,000 50,000
Administrative and selling
expenses 40,000 40,000 40,000 40,000
Net income $ 10,000 $ 20,000 $ 20,000 $ 10,000
Total income Total income
for two years 5 $30,000 for two years 5 $30,000
*Ending inventory understated by $10,000 in 2013.
If Weiseman overstates ending inventory in 2013, the reverse effect occurs. Inventory,
working capital, current ratio, and net income are overstated, and cost of goods sold is
understated. The effect of the error on net income will be counterbalanced in 2014, but
the income statement misstates both years’ net income figures.
Purchases and Inventory Misstated
Suppose that Bishop Company does not record as a purchase certain goods that it owns
and does not count them in ending inventory. The effect on the financial statements
(assuming this is a purchase on account) is as follows.
∂ ∂
Costs Included in Inventory 425
ILLUSTRATION 8-9
Balance Sheet Income Statement
Financial Statement
Inventory Understated Purchases Understated
Effects of Misstated
Retained earnings No effect Cost of goods sold No effect
Purchases and Inventory
Accounts payable Understated Net income No effect
Working capital No effect Inventory (ending) Understated
Current ratio Overstated
Omission of goods from purchases and inventory results in an understatement of
inventory and accounts payable in the balance sheet. It also results in an understate-
ment of purchases and ending inventory in the income statement. However, the omis-
sion of such goods does not affect net income for the period. Why not? Because Bishop
understates both purchases and ending inventory by the same amount—the error is
thereby offset in cost of goods sold. Total working capital is unchanged, but the current
ratio is overstated because of the omission of equal amounts from inventory and
accounts payable.
To illustrate the effect on the current ratio, assume that Bishop understated accounts
payable and ending inventory by $40,000. Illustration 8-10 shows the understated and
correct data.
ILLUSTRATION 8-10
Purchases and Ending Purchases and Ending
Effects of Purchases and
Inventory Understated Inventory Correct
Ending Inventory Errors
Current assets $120,000 Current assets $160,000
Current liabilities $ 40,000 Current liabilities $ 80,000
Current ratio 3 to 1 Current ratio 2 to 1
The understated data indicate a current ratio of 3 to 1, whereas the correct ratio is 2 to 1.
Thus, understatement of accounts payable and ending inventory can lead to a “window-
dressing” of the current ratio. That is, Bishop can make the current ratio appear better
than it is.
If Bishop overstates both purchases (on account) and ending inventory, then Underlying Concepts
the effects on the balance sheet are exactly the reverse. The financial statements
When inventory is misstated, its
overstate inventory and accounts payable, and understate the current ratio. The
presentation is not representa-
overstatement does not affect cost of goods sold and net income because the
tionally faithful.
errors offset one another. Similarly, working capital is not affected.
We cannot overemphasize the importance of proper inventory measure-
ment in presenting accurate financial statements. For example, Leslie Fay, a women’s
apparel maker, had accounting irregularities that wiped out one year’s net income and
caused a restatement of the prior year’s earnings. One reason: It inflated inventory and
deflated cost of goods sold. Anixter Bros. Inc. had to restate its income by $1.7 million
because an accountant in the antenna manufacturing division overstated the ending
inventory, thereby reducing its cost of sales. Similarly, AM International allegedly
recorded as sold products that were only being rented. As a result, inaccurate inventory
and sales figures inappropriately added $7.9 million to pretax income. |
COSTS INCLUDED IN INVENTORY
4 LEARNING OBJECTIVE
One of the most important problems in dealing with inventories concerns the dol-
Understand the items to include as
lar amount at which to carry the inventory in the accounts. Companies generally
inventory cost.
account for the acquisition of inventories, like other assets, on a cost basis.
426 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Product Costs
Product costs are those costs that “attach” to the inventory. As a result, a company
records product costs in the inventory account. These costs are directly connected with
bringing the goods to the buyer’s place of business and converting such goods to a
salable condition. Such charges include freight charges on goods purchased, other direct
costs of acquisition, and labor and other production costs incurred in processing the
goods up to the time of sale.
It seems proper also to allocate to inventories a share of any buying costs or ex-
penses of a purchasing department, storage costs, and other costs incurred in storing or
handling the goods before their sale. However, because of the practical difficulties in-
volved in allocating such costs and expenses, companies usually exclude these items in
valuing inventories.
A manufacturing company’s costs include direct materials, direct labor, and manufac-
turing overhead costs. Manufacturing overhead costs include indirect materials, indirect
labor, and various costs, such as depreciation, taxes, insurance, and heat and electricity.
Period Costs
Period costs are those costs that are indirectly related to the acquisition or production of
goods. Period costs such as selling expenses and, under ordinary circumstances, general
and administrative expenses are therefore not included as part of inventory cost.
International Yet, conceptually, these expenses are as much a cost of the product as the
Perspective initial purchase price and related freight charges attached to the product. Why
then do companies exclude these costs from inventoriable items? Because
GAAP has more detailed rules
companies generally consider selling expenses as more directly related to the
related to the accounting for
inventories, compared to IFRS. cost of goods sold than to the unsold inventory. In addition, period costs, espe-
cially administrative expenses, are so unrelated or indirectly related to the im-
mediate production process that any allocation is purely arbitrary.2
Interest is another period cost. Companies usually expense interest costs associated
with getting inventories ready for sale. Supporters of this approach argue that interest
costs are really a cost of financing. Others contend that interest costs incurred to finance
activities associated with readying inventories for sale are as much a cost of the asset as
materials, labor, and overhead. Therefore, they reason, companies should capitalize in-
terest costs.
The FASB ruled that companies should capitalize interest costs related to assets
constructed for internal use or assets produced as discrete projects (such as ships or
real estate projects) for sale or lease [4].3 The FASB emphasized that these discrete proj-
ects should take considerable time, entail substantial expenditures, and be likely to in-
volve significant amounts of interest cost. A company should not capitalize interest
costs for inventories that it routinely manufactures or otherwise produces in large quan-
tities on a repetitive basis. In this case, the informational benefit does not justify the cost.
Treatment of Purchase Discounts
The use of a Purchase Discounts account in a periodic inventory system indicates that
the company is reporting its purchases and accounts payable at the gross amount. If a
2Companies should not record abnormal freight, handling costs, and amounts of wasted
materials (spoilage) as inventory costs. If the costs associated with the actual level of spoilage
or product defects are greater than the costs associated with normal spoilage or defects, the
company should charge the excess as an expense in the current period. [3] |
3The reporting rules related to interest cost capitalization have their greatest impact in accounting
for long-term assets. We therefore discuss them in Chapter 10.
Costs Included in Inventory 427
company uses this gross method, it reports purchase discounts as a deduction from
purchases on the income statement.
Another approach is to record the purchases and accounts payable at an amount net
of the cash discounts. In this approach, the company records failure to take a purchase
discount within the discount period in a Purchase Discounts Lost account. If a company
uses this net method, it considers purchase discounts lost as a financial expense and
reports it in the “Other expenses and losses” section of the income statement. This treat-
ment is considered better for two reasons. (1) It provides a correct reporting of the cost
of the asset and related liability. (2) It can measure management inefficiency by holding
management responsible for discounts not taken.
To illustrate the difference between the gross and net methods, assume the follow-
ing transactions.
ILLUSTRATION 8-11
Gross Method Net Method
Entries under Gross
and Net Methods
Purchase cost $10,000, terms 2/10, net 30
Purchases 10,000 Purchases 9,800
Accounts Payable 10,000 Accounts Payable 9,800
Invoices of $4,000 are paid within discount period
Accounts Payable 4,000 Accounts Payable 3,920
Purchase Discounts 80 Cash 3,920
Cash 3,920
Invoices of $6,000 are paid after discount period
Accounts Payable 6,000 Accounts Payable 5,880
Cash 6,000 Purchase Discounts Lost 120
Cash 6,000
Many believe that the somewhat more complicated net method is not justi- Underlying Concepts
fied by the resulting benefits. This could account for the widespread use of the
Not using the net method
less logical but simpler gross method. In addition, some contend that manage-
because of resultant diffi culties
ment is reluctant to report in the financial statements the amount of purchase
is an example of the application
discounts lost.
of the cost constraint.
What do the numbers mean? YOU MAY NEED A MAP
Does it really matter where a company reports certain costs in reported $265 million of these costs in one quarter. Some ex-
its income statement as long as it includes them all as expenses perts thought Amazon should include those charges in costs
in computing income? of goods sold, which would substantially lower its gross
For e-tailers, such as Amazon.com or Drugstore.com, profi t, as shown below (in millions).
where they report certain selling costs does appear to be im-
E-tailer Reporting Traditional Reporting
portant. Contrary to well-established retailer practices, these
Sales $2,795 $2,795
companies insist on reporting some selling costs—fulfi llment
Cost of goods sold 2,132 2,397
costs related to inventory shipping and warehousing—as
Gross profit $ 663 $ 398
part of administrative expenses, instead of as cost of goods
Gross margin % 24% 14%
sold. This practice is allowable within GAAP, if applied con-
sistently and adequately disclosed. Although the practice Similarly, if Drugstore.com and eToys.com made similar ad-
doesn’t affect the bottom line, it does make the e-tailers’ justments, their gross margins would go from positive to
gross margins look better. For example, at one time Amazon negative.
428 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Thus, if you want to be able to compare the operating navigate their income statements and how they report
results of e-tailers to other traditional retailers, it might be certain selling costs.
a good idea to have a good accounting map in order to
Source: Adapted from P. Elstrom, “The End of Fuzzy Math?” BusinessWeek, e.Biz—Net Worth (December 11, 2000). According to GAAP [5],
companies must disclose the accounting policy for classifying these selling costs in income.
WHICH COST FLOW ASSUMPTION TO ADOPT?
During any given fiscal period, companies typically purchase merchandise at
LEARNING OBJECTIVE 5
several different prices. If a company prices inventories at cost and it made numer-
Describe and compare the cost flow |
ous purchases at different unit costs, which cost price should it use? Conceptually,
assumptions used to account for
a specific identification of the given items sold and unsold seems optimal. But this
inventories.
measure often proves both expensive and impossible to achieve. Consequently,
companies use one of several systematic inventory cost flow assumptions.
Indeed, the actual physical flow of goods and the cost flow assumption often greatly
differ. There is no requirement that the cost flow assumption adopted be consistent
with the physical movement of goods. A company’s major objective in selecting a
method should be to choose the one that, under the circumstances, most clearly reflects
periodic income. [6]
To illustrate, assume that Call-Mart Inc. had the following transactions in its first
month of operations.
Date Purchases Sold or Issued Balance
March 2 2,000 @ $4.00 2,000 units
March 15 6,000 @ $4.40 8,000 units
March 19 4,000 units 4,000 units
March 30 2,000 @ $4.75 6,000 units
From this information, Call-Mart computes the ending inventory of 6,000 units and
the cost of goods available for sale (beginning inventory 1 purchases) of $43,900 [(2,000
at $4.00) 1 (6,000 at $4.40) 1 (2,000 at $4.75)]. The question is, which price or prices
should it assign to the 6,000 units of ending inventory? The answer depends on which
cost flow assumption it uses.
Specifi c Identifi cation
Specific identification calls for identifying each item sold and each item in inventory.
A company includes in cost of goods sold the costs of the specific items sold. It includes
in inventory the costs of the specific items on hand. This method may be used only in
instances where it is practical to separate physically the different purchases made. As a
result, most companies only use this method when handling a relatively small number
of costly, easily distinguishable items. In the retail trade, this includes some types of
jewelry, fur coats, automobiles, and some furniture. In manufacturing, it includes spe-
cial orders and many products manufactured under a job cost system.
To illustrate, assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000
units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from
the March 30 purchase. Illustration 8-12 shows how Call-Mart computes the ending
inventory and cost of goods sold.
Which Cost Flow Assumption to Adopt? 429
ILLUSTRATION 8-12
Date No. of Units Unit Cost Total Cost
Specifi c Identifi cation
March 2 1,000 $4.00 $ 4,000
Method
March 15 3,000 4.40 13,200
March 30 2,000 4.75 9,500
Ending inventory 6,000 $26,700
Cost of goods available for sale
(computed in previous section) $43,900
Deduct: Ending inventory 26,700
Cost of goods sold $17,200
This method appears ideal. Specific identification matches actual costs against
actual revenue. Thus, a company reports ending inventory at actual cost. In other words,
under specific identification the cost flow matches the physical flow of the goods. On
closer observation, however, this method has certain deficiencies.
Some argue that specific identification allows a company to manipulate net International
income. For example, assume that a wholesaler purchases identical plywood Perspective
early in the year at three different prices. When it sells the plywood, the whole-
IFRS indicates specifi c
saler can select either the lowest or the highest price to charge to expense. It
identifi cation is the preferred
simply selects the plywood from a specific lot for delivery to the customer. A
inventory method, unless it is
business manager, therefore, can manipulate net income by delivering to the impracticable to use.
customer the higher- or lower-priced item, depending on whether the company
seeks lower or higher reported earnings for the period.
Another problem relates to the arbitrary allocation of costs that sometimes occurs
with specific inventory items. For example, a company often faces difficulty in relating
shipping charges, storage costs, and discounts directly to a given inventory item. This |
results in allocating these costs somewhat arbitrarily, leading to a “breakdown” in the
precision of the specific identification method.4
Average-Cost
As the name implies, the average-cost method prices items in the inventory on the basis
of the average cost of all similar goods available during the period. To illustrate use of
the periodic inventory method (amount of inventory computed at the end of the period),
Call-Mart computes the ending inventory and cost of goods sold using a weighted-
average method as follows.
ILLUSTRATION 8-13
Date of Invoice No. Units Unit Cost Total Cost
Weighted-Average
March 2 2,000 $4.00 $ 8,000
Method—Periodic
March 15 6,000 4.40 26,400
Inventory
March 30 2,000 4.75 9,500
Total goods available 10,000 $43,900
$43,900
Weighted-average cost per unit 5 $4.39
10,000
Inventory in units 6,000 units
Ending inventory 6,000 3 $4.39 5 $26,340
Cost of goods available for sale $43,900
Deduct: Ending inventory 26,340
Cost of goods sold $17,560
4The motion picture industry provides a good illustration of the cost allocation problem. Often
actors receive a percentage of net income for a given movie or television program. Some actors,
however, have alleged that their programs have been extremely profitable to the motion picture
studios but they have received little in the way of profit-sharing. Actors contend that the studios
allocate additional costs to successful projects to avoid sharing profits.
430 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
In computing the average cost per unit, Call-Mart includes the beginning inventory, if
any, both in the total units available and in the total cost of goods available.
Companies use the moving-average method with perpetual inventory records.
Illustration 8-14 shows the application of the average-cost method for perpetual
records.
ILLUSTRATION 8-14
Date Purchased Sold or Issued Balance
Moving-Average
March 2 (2,000 @ $4.00) $ 8,000 (2,000 @ $4.00) $ 8,000
Method—Perpetual
March 15 (6,000 @ 4.40) 26,400 (8,000 @ 4.30) 34,400
Inventory
March 19 (4,000 @ $4.30)
$17,200 (4,000 @ 4.30) 17,200
March 30 (2,000 @ 4.75) 9,500 (6,000 @ 4.45) 26,700
In this method, Call-Mart computes a new average unit cost each time it makes a
purchase. For example, on March 15, after purchasing 6,000 units for $26,400, Call-Mart
has 8,000 units costing $34,400 ($8,000 plus $26,400) on hand. The average unit cost is
$34,400 divided by 8,000, or $4.30. Call-Mart uses this unit cost in costing withdrawals
until it makes another purchase. At that point, Call-Mart computes a new average unit
cost. Accordingly, the company shows the cost of the 4,000 units withdrawn on March
19 at $4.30, for a total cost of goods sold of $17,200. On March 30, following the purchase
of 2,000 units for $9,500, Call-Mart determines a new unit cost of $4.45, for an ending
inventory of $26,700.
Companies often use average-cost methods for practical rather than conceptual
reasons. These methods are both simple to apply and objective. They are not as subject
to income manipulation as some of the other inventory pricing methods. In addition,
proponents of the average-cost methods reason that measuring a specific physical flow
of inventory is often impossible. Therefore, it is better to cost items on an average-price
basis. This argument is particularly persuasive when dealing with similar inventory
items.
First-In, First-Out (FIFO)
The FIFO (first-in, first-out) method assumes that a company uses goods in the order
in which it purchases them. In other words, the FIFO method assumes that the first
goods purchased are the first used (in a manufacturing concern) or the first sold (in a
merchandising concern). The inventory remaining must therefore represent the most
recent purchases.
To illustrate, assume that Call-Mart uses the periodic inventory system. It deter-
mines its cost of the ending inventory by taking the cost of the most recent purchase and
working back until it accounts for all units in the inventory. Call-Mart determines its
ending inventory and cost of goods sold as shown in Illustration 8-15. |
ILLUSTRATION 8-15
Date No. Units Unit Cost Total Cost
FIFO Method—Periodic
March 30 2,000 $4.75 $ 9,500
Inventory
March 15 4,000 4.40 17,600
Ending inventory 6,000 $27,100
Cost of goods available for sale $43,900
Deduct: Ending inventory 27,100
Cost of goods sold $16,800
Which Cost Flow Assumption to Adopt? 431
If Call-Mart instead uses a perpetual inventory system in quantities and dollars, it
attaches a cost figure to each withdrawal. Then the cost of the 4,000 units removed on
March 19 consists of the cost of the items purchased on March 2 and March 15. Illustra-
tion 8-16 shows the inventory on a FIFO basis perpetual system for Call-Mart.
ILLUSTRATION 8-16
Date Purchased Sold or Issued Balance
FIFO Method—Perpetual
March 2 (2,000 @ $4.00) $ 8,000 2,000 @ $4.00 $ 8,000
Inventory
March 15 (6,000 @ 4.40) 26,400 2,000 @ 4.00
34,400
6,000 @ 4.40
¶
March 19 2,000 @ $4.00
4,000 @ 4.40 17,600
2,000 @ 4.40
¶
($16,800)
March 30 (2,000 @ 4.75) 9,500 4,000 @ 4.40
27,100
2,000 @ 4.75
¶
Here, the ending inventory is $27,100, and the cost of goods sold is $16,800 [(2,000 @
$4.00) 1 (2,000 @ $4.40)].
Notice that in these two FIFO examples, the cost of goods sold ($16,800) and ending
inventory ($27,100) are the same. In all cases where FIFO is used, the inventory and
cost of goods sold would be the same at the end of the month whether a perpetual or
periodic system is used. Why? Because the same costs will always be first in and, there-
fore, first out. This is true whether a company computes cost of goods sold as it sells
goods throughout the accounting period (the perpetual system) or as a residual at the
end of the accounting period (the periodic system).
One objective of FIFO is to approximate the physical flow of goods. When the phys-
ical flow of goods is actually first-in, first-out, the FIFO method closely approximates
specific identification. At the same time, it prevents manipulation of income. With FIFO,
a company cannot pick a certain cost item to charge to expense.
Another advantage of the FIFO method is that the ending inventory is close to cur-
rent cost. Because the first goods in are the first goods out, the ending inventory amount
consists of the most recent purchases. This is particularly true with rapid inventory
turnover. This approach generally approximates replacement cost on the balance sheet
when price changes have not occurred since the most recent purchases.
However, the FIFO method fails to match current costs against current revenues
on the income statement. A company charges the oldest costs against the more current
revenue, possibly distorting gross profit and net income.
Last-In, First-Out (LIFO)
The LIFO (last-in, first-out) method matches the cost of the last goods pur- International
chased against revenue. If Call-Mart Inc. uses a periodic inventory system, it Perspective
assumes that the cost of the total quantity sold or issued during the month
IFRS does not permit
comes from the most recent purchases. Call-Mart prices the ending inventory
LIFO.
by using the total units as a basis of computation and disregards the exact dates
of sales or issuances. For example, Call-Mart would assume that the cost of the
4,000 units withdrawn absorbed the 2,000 units purchased on March 30 and 2,000 of the
6,000 units purchased on March 15. Illustration 8-17 (page 432) shows how Call-Mart
computes the inventory and related cost of goods sold, using the periodic inventory
method.
If Call-Mart keeps a perpetual inventory record in quantities and dollars, use of the
LIFO method results in different ending inventory and cost of goods sold amounts
432 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
ILLUSTRATION 8-17
Date of Invoice No. Units Unit Cost Total Cost
LIFO Method—Periodic
March 2 2,000 $4.00 $ 8,000
Inventory
March 15 4,000 4.40 17,600
Ending inventory 6,000 $25,600
Goods available for sale $43,900
Deduct: Ending inventory 25,600
Cost of goods sold $18,300
than the amounts calculated under the periodic method. Illustration 8-18 shows these
differences under the perpetual method.
ILLUSTRATION 8-18 |
Date Purchased Sold or Issued Balance
LIFO Method—Perpetual
March 2 (2,000 @ $4.00) $ 8,000 2,000 @ $4.00 $ 8,000
Inventory
March 15 (6,000 @ 4.40) 26,400 2,000 @ 4.00
34,400
6,000 @ 4.40
¶
March 19 (4,000 @ $4.40) 2,000 @ 4.00
16,800
$17,600 2,000 @ 4.40
¶
March 30 (2,000 @ 4.75) 9,500 2,000 @ 4.00
2,000 @ 4.40 26,300
2,000 @ 4.75
¶
The month-end periodic inventory computation presented in Illustration 8-17
(inventory $25,600 and cost of goods sold $18,300) shows a different amount from the
Gateway to perpetual inventory computation (inventory $26,300 and cost of goods sold $17,600).
the Profession The periodic system matches the total withdrawals for the month with the total pur-
Tutorial on Inventory chases for the month in applying the last-in, first-out method. In contrast, the perpetual
Methods
system matches each withdrawal with the immediately preceding purchases. In effect,
the periodic computation assumed that Call-Mart included the cost of the goods that it
purchased on March 30 in the sale or issue on March 19.
SPECIAL ISSUES RELATED TO LIFO
LIFO Reserve
Many companies use LIFO for tax and external reporting purposes. However, they
LEARNING OBJECTIVE 6
maintain a FIFO, average-cost, or standard cost system for internal reporting pur-
Explain the significance and use of
poses. There are several reasons to do so. (1) Companies often base their pricing
a LIFO reserve.
decisions on a FIFO, average, or standard cost assumption, rather than on a LIFO
basis. (2) Recordkeeping on some other basis is easier because the LIFO assump-
tion usually does not approximate the physical flow of the product. (3) Profit-sharing
and other bonus arrangements often depend on a non-LIFO inventory assumption.
(4) The use of a pure LIFO system is troublesome for interim periods, which require
estimates of year-end quantities and prices.
The difference between the inventory method used for internal reporting purposes
and LIFO is the Allowance to Reduce Inventory to LIFO account or the LIFO reserve.
The change in the allowance balance from one period to the next is the LIFO effect. The
LIFO effect is the adjustment that companies must make to the accounting records in a
given year.
Special Issues Related to LIFO 433
To illustrate, assume that Acme Boot Company uses the FIFO method for internal
reporting purposes and LIFO for external reporting purposes. At January 1, 2014, the
Allowance to Reduce Inventory to LIFO balance is $20,000. At December 31, 2014, the
balance should be $50,000. As a result, Acme Boot realizes a LIFO effect of $30,000 and
makes the following entry at year-end.
Cost of Goods Sold 30,000
Allowance to Reduce Inventory to LIFO 30,000
Acme Boot deducts Allowance to Reduce Inventory to LIFO from inventory to ensure
that it states the inventory on a LIFO basis at year-end.
Companies should disclose either the LIFO reserve or the replacement cost of the
inventory, as shown in Illustration 8-19. [7]
ILLUSTRATION 8-19
American Maize-Products Company
Note Disclosures of LIFO
Inventories (Note 3) $80,320,000 Reserve
Note 3: Inventories. At December 31, $31,516,000 of inventories were valued using the LIFO method.
This amount is less than the corresponding replacement value by $3,765,000.
Brown Shoe Company, Inc.
(in thousands)
Current Year Previous Year
Inventories, (Note 1) $365,989 $362,274
Note 1 (partial): Inventories. Inventories are valued at the lower of cost or market determined principally
by the last-in, first-out (LIFO) method. If the first-in, first-out (FIFO) cost method had been used, inventories
would have been $11,709 higher in the current year and $13,424 higher in the previous year.
What do the numbers mean? COMPARING APPLES TO APPLES
Investors commonly use the current ratio to evaluate a com- for a company using FIFO. It would be like comparing ap-
pany’s liquidity. They compute the current ratio as current ples to oranges since the two companies measure inventory
assets divided by current liabilities. A higher current ratio in- (and cost of goods sold) differently.
dicates that a company is better able to meet its current obli- To make the current ratio comparable on an apples-to- |
gations when they come due. However, it is not meaningful apples basis, analysts use the LIFO reserve. The following
to compare the current ratio for a company using LIFO to one adjustments should do the trick:
Inventory Adjustment: LIFO inventory 1 LIFO reserve 5 FIFO inventory
(For cost of goods sold, deduct the change in the LIFO reserve the current ratio using LIFO is $487.8 4 $217.8 5 2.2. After
from LIFO cost of goods sold to yield the comparable FIFO adjusting for the LIFO effect, Brown Shoe’s current ratio
amount.) under FIFO would be ($487.8 1 $11.7) 4 $217.8 5 2.3.
For Brown Shoe, Inc. (see Illustration 8-19), with current Thus, without the LIFO adjustment, the Brown Shoe
assets of $487.8 million and current liabilities of $217.8 million, current ratio is understated.
434 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
LIFO Liquidation
Up to this point, we have emphasized a specific-goods approach to costing LIFO
LEARNING OBJECTIVE 7
inventories (also called traditional LIFO or unit LIFO). This approach is often
Understand the effect of LIFO
liquidations. unrealistic for two reasons:
1. When a company has many different inventory items, the accounting cost of track-
ing each inventory item is expensive.
2. Erosion of the LIFO inventory can easily occur. Referred to as LIFO liquidation, this
often distorts net income and leads to substantial tax payments.
To understand the LIFO liquidation problem, assume that Basler Co. has 30,000
pounds of steel in its inventory on December 31, 2014, with cost determined on a
specific-goods LIFO approach.
Ending Inventory (2014)
Pounds Unit Cost LIFO Cost
2011 8,000 $ 4 $ 32,000
2012 10,000 6 60,000
2013 7,000 9 63,000
2014 5,000 10 50,000
30,000 $205,000
As indicated, the ending 2014 inventory for Basler comprises costs from past peri-
ods. These costs are called layers (increases from period to period). The first layer is
identified as the base layer. Illustration 8-20 shows the layers for Basler.
ILLUSTRATION 8-20
Layers of LIFO Inventory
2014 $50,000
Layer (5,000 × $10)
2013 $63,000
Layer (7,000 × $9)
2012 $60,000
Layer (10,000 × $6)
2011 $32,000
Base layer (8,000 × $4)
Note the increased price of steel over the four-year period. In 2015, due to metal short-
ages, Basler had to liquidate much of its inventory (a LIFO liquidation). At the end of
2015, only 6,000 pounds of steel remained in inventory. Because the company uses LIFO,
Basler liquidates the most recent layer, 2014, first, followed by the 2013 layer, and so on.
The result: Basler matches costs from preceding periods against sales revenues reported
in current dollars. As Illustration 8-21 shows, this leads to a distortion in net income and
increased taxable income in the current period. Unfortunately, LIFO liquidations can
occur frequently when using a specific-goods LIFO approach.
Special Issues Related to LIFO 435
ILLUSTRATION 8-21
LIFO Liquidation
$50,000 Sold
(5,000 × $10) 5,000 lbs.
Result
$63,000 Sold Sales Revenue
(7,000 × $9) 7,000 lbs. (All Current Prices) Higher income
= and probably
higher tax bill
Cost of Goods Sold
$60,000 Sold (Some Current, Some
(10,000 × $6) 10,000 lbs. Old Prices)
Sold
2,000 lbs.
$32,000
(8,000 × $4)
(6,000 lbs. remaining)
To alleviate the LIFO liquidation problems and to simplify the accounting, compa-
nies can combine goods into pools. A pool groups items of a similar nature. Thus,
instead of only identical units, a company combines, and counts as a group, a number
of similar units or products. This method, the specific-goods pooled LIFO approach,
usually results in fewer LIFO liquidations. Why? Because the reduction of one quantity
in the pool may be offset by an increase in another.
The specific-goods pooled LIFO approach eliminates some of the disadvantages of
the specific-goods (traditional) accounting for LIFO inventories. This pooled approach,
using quantities as its measurement basis, however, creates other problems.
First, most companies continually change the mix of their products, materials, and
production methods. As a result, in employing a pooled approach using quantities, |
companies must continually redefine the pools. This can be time-consuming and costly.
Second, even when practical, the approach often results in an erosion (“LIFO liquida-
tion”) of the layers, thereby losing much of the LIFO costing benefit. Erosion of the
layers occurs when a specific good or material in the pool is replaced with another good
or material. The new item may not be similar enough to be treated as part of the old
pool. Therefore, a company may need to recognize any inflationary profit deferred on
the old goods as it replaces them.
Dollar-Value LIFO
The dollar-value LIFO method overcomes the problems of redefining pools and
8 LEARNING OBJECTIVE
eroding layers. The dollar-value LIFO method determines and measures any
Explain the dollar-value LIFO
increases and decreases in a pool in terms of total dollar value, not the physical
method.
quantity of the goods in the inventory pool.
Such an approach has two important advantages over the specific-goods pooled
approach. First, companies may include a broader range of goods in a dollar-value LIFO
pool. Second, a dollar-value LIFO pool permits replacement of goods that are similar
items, similar in use, or interchangeable. (In contrast, a specific-goods LIFO pool only
allows replacement of items that are substantially identical.)
436 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Thus, dollar-value LIFO techniques help protect LIFO layers from erosion. Because
of this advantage, companies frequently use the dollar-value LIFO method in practice.5
Companies use the more traditional LIFO approaches only when dealing with few
goods and expecting little change in product mix.
Under the dollar-value LIFO method, one pool may contain the entire inventory.
Gateway to However, companies generally use several pools.6 In general, the more goods included
the Profession
in a pool, the more likely that increases in the quantities of some goods will offset
Tutorial on Dollar-Value decreases in other goods in the same pool. Thus, companies avoid liquidation of the
LIFO
LIFO layers. It follows that having fewer pools means less cost and less chance of a
reduction of a LIFO layer.7
Dollar-Value LIFO Example
To illustrate how the dollar-value LIFO method works, assume that Enrico Company
first adopts dollar-value LIFO on December 31, 2013 (base period). The inventory at cur-
rent prices on that date was $20,000. The inventory on December 31, 2014, at current
prices is $26,400.
Can we conclude that Enrico’s inventory quantities increased 32 percent during the
year ($26,400 4 $20,000 5 132%)? First, we need to ask: What is the value of the ending
inventory in terms of beginning-of-the-year prices? Assuming that prices have increased
20 percent during the year, the ending inventory at beginning-of-the-year prices
amounts to $22,000 ($26,400 4 120%). Therefore, the inventory quantity has increased
only 10 percent, or from $20,000 to $22,000 in terms of beginning-of-the-year prices.
The next step is to price this real-dollar quantity increase. This real-dollar quantity
increase of $2,000 valued at year-end prices is $2,400 (120% 3 $2,000). This increment
(layer) of $2,400, when added to the beginning inventory of $20,000, totals $22,400 for
the December 31, 2014, inventory, as shown below.
First layer—(beginning inventory) in terms of 100 $20,000
Second layer—(2014 increase) in terms of 120 2,400
Dollar-value LIFO inventory, December 31, 2014 $22,400
Note that a layer forms only when the ending inventory at base-year prices
exceeds the beginning inventory at base-year prices. And only when a new layer forms
must Enrico compute a new index.
5A study by James M. Reeve and Keith G. Stanga disclosed that the vast majority of respondent
companies applying LIFO use the dollar-value method or the dollar-value retail method to
apply LIFO. Only a small minority of companies use the specific-goods (unit LIFO) approach
or the specific-goods pooling approach. See J.M. Reeve and K.G. Stanga, “The LIFO Pooling
Decision,” Accounting Horizons (June 1987), p. 27. |
6The Reeve and Stanga study (ibid.) reports that most companies have only a few pools—the
median is six for retailers and three for nonretailers. But the distributions are highly skewed;
some companies have 100 or more pools. Retailers that use LIFO have significantly more pools
than nonretailers. About a third of the nonretailers (mostly manufacturers) use a single pool for
their entire LIFO inventory.
7A later study shows that when quantities are increasing, multiple pools over a period of time
may produce (under rather general conditions) significantly higher cost of goods sold deduc-
tions than a single-pool approach. When a stock-out occurs, a single-pool approach may lessen
the layer liquidation for that year, but it may not erase the cumulative cost of goods sold
advantage accruing to the use of multiple pools built up over the preceding years. See William
R. Coon and Randall B. Hayes, “The Dollar Value LIFO Pooling Decision: The Conventional
Wisdom Is Too General,” Accounting Horizons (December 1989), pp. 57–70.
Special Issues Related to LIFO 437
Comprehensive Dollar-Value LIFO Example
To illustrate the use of the dollar-value LIFO method in a more complex situation,
assume that Bismark Company develops the following information.
End-of-Year
Inventory at Price Index Inventory at
December 31 End-of-Year Prices 4 (percentage) 5 Base-Year Prices
(Base year) 2011 $200,000 100 $200,000
2012 299,000 115 260,000
2013 300,000 120 250,000
2014 351,000 130 270,000
At December 31, 2011, Bismark computes the ending inventory under dollar-value
LIFO as $200,000, as Illustration 8-22 shows.
ILLUSTRATION 8-22
Ending Inventory Layer at Ending Inventory
Computation of 2011
at Base-Year Price Index at
Base-Year Prices Prices (percentage) LIFO Cost Inventory at LIFO Cost
$200,000 $200,000 3 100 5 $200,000
At December 31, 2012, a comparison of the ending inventory at base-year prices
($260,000) with the beginning inventory at base-year prices ($200,000) indicates that the
quantity of goods (in base-year prices) increased $60,000 ($260,000 2 $200,000). Bismark
prices this increment (layer) at the 2012 index of 115 percent to arrive at a new layer of
$69,000. Ending inventory for 2012 is $269,000, composed of the beginning inventory of
$200,000 and the new layer of $69,000. Illustration 8-23 shows the computations.
ILLUSTRATION 8-23
Ending Inventory Layers Ending Inventory
Computation of 2012
at at Price Index at
Base-Year Prices Base-Year Prices (percentage) LIFO Cost Inventory at LIFO Cost
$260,000 2011 $200,000 3 100 5 $200,000
2012 60,000 3 115 5 69,000
$260,000 $269,000
At December 31, 2013, a comparison of the ending inventory at base-year prices
($250,000) with the beginning inventory at base-year prices ($260,000) indicates a
decrease in the quantity of goods of $10,000 ($250,000 2 $260,000). If the ending in-
ventory at base-year prices is less than the beginning inventory at base-year prices, a
company must subtract the decrease from the most recently added layer. When a
decrease occurs, the company “peels off” previous layers at the prices in existence
when it added the layers. In Bismark’s situation, this means that it removes $10,000
in base-year prices from the 2012 layer of $60,000 at base-year prices. It values the
balance of $50,000 ($60,000 2 $10,000) at base-year prices at the 2012 price index of
115 percent. As a result, it now values this 2012 layer at $57,500 ($50,000 3 115%).
Therefore, Bismark computes the ending inventory at $257,500, consisting of the
beginning inventory of $200,000 and the second layer of $57,500. Illustration 8-24
(page 438) shows the computations for 2013.
438 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
ILLUSTRATION 8-24
Ending Inventory Layers Ending Inventory
Computation of 2013
at at Price Index at
Inventory at LIFO Cost Base-Year Prices Base-Year Prices (percentage) LIFO Cost
$250,000 2011 $200,000 3 100 5 $200,000
2012 50,000 3 115 5 57,500
$250,000 $257,500
Note that if Bismark eliminates a layer or base (or portion thereof), it cannot rebuild |
it in future periods. That is, the layer is gone forever.
At December 31, 2014, a comparison of the ending inventory at base-year prices
($270,000) with the beginning inventory at base-year prices ($250,000) indicates an
increase in the quantity of goods (in base-year prices) of $20,000 ($270,000 2 $250,000).
After converting the $20,000 increase, using the 2014 price index, the ending inventory
is $283,500, composed of the beginning layer of $200,000, a 2012 layer of $57,500, and a
2014 layer of $26,000 ($20,000 3 130%). Illustration 8-25 shows this computation.
ILLUSTRATION 8-25
Ending Inventory Layers Ending Inventory
Computation of 2014
at at Price Index at
Inventory at LIFO Cost Base-Year Prices Base-Year Prices (percentage) LIFO Cost
$270,000 2011 $200,000 3 100 5 $200,000
2012 50,000 3 115 5 57,500
2014 20,000 3 130 5 26,000
$270,000 $283,500
The ending inventory at base-year prices must always equal the total of the layers
at base-year prices. Checking that this situation exists will help to ensure correct dollar-
value computations.
Selecting a Price Index
Obviously, price changes are critical in dollar-value LIFO. How do companies deter-
mine the price indexes? Many companies use the general price-level index that the
federal government prepares and publishes each month. The most popular general
external price-level index is the Consumer Price Index for Urban Consumers (CPI-U).8
Companies also use more-specific external price indexes. For instance, various organi-
zations compute and publish daily indexes for most commodities (gold, silver, other
metals, corn, wheat, and other farm products). Many trade associations prepare indexes
for specific product lines or industries. Any of these indexes may be used for dollar-
value LIFO purposes.
When a relevant specific external price index is not readily available, a company
may compute its own specific internal price index. The desired approach is to price end-
ing inventory at the most current cost. Therefore, a company that chose to compute its
own specific internal price index would ordinarily determine current cost by referring
to the actual cost of the goods it most recently had purchased. The price index provides
a measure of the change in price or cost levels between the base year and the current
year. The company then computes the index for each year after the base year. The general
formula for computing the index is as follows.
8Indexes may be general (composed of several commodities, goods, or services) or specific (for
one commodity, good, or service). Additionally, they may be external (computed by an outside
party, such as the government, commodity exchange, or trade association) or internal (computed
by the enterprise for its own product or service).
Special Issues Related to LIFO 439
ILLUSTRATION 8-26
Ending Inventory for the Period at Current Cost
5 Price Index for Current Year Formula for Computing
Ending Inventory for the Period at Base-Year Cost
a Price Index
This approach is generally referred to as the double-extension method. As its name
implies, the value of the units in inventory is extended at both base-year prices and
current-year prices.
To illustrate this computation, assume that Toledo Company’s base-year inventory
(January 1, 2014) consisted of the following.
Items Quantity Cost per Unit Total Cost
A 1,000 $ 6 $ 6,000
B 2,000 20 40,000
January 1, 2014, inventory at base-year costs $46,000
Examination of the ending inventory indicates that the company holds 3,000 units of
Item A and 6,000 units of Item B on December 31, 2014. The most recent actual purchases
related to these items were as follows.
Quantity
Items Purchase Date Purchased Cost per Unit
A December 1, 2014 4,000 $ 7
B December 15, 2014 5,000 25
B November 16, 2014 1,000 22
Toledo double-extends the inventory as shown in Illustration 8-27.
ILLUSTRATION 8-27
12/31/14 Inventory at 12/31/14 Inventory at
Double-Extension
Base-Year Costs Current-Year Costs
Method of Determining
Base-Year Current-Year
a Price Index
Cost Cost
Items Units per Unit Total Units per Unit Total |
A 3,000 $ 6 $ 18,000 3,000 $ 7 $ 21,000
B 6,000 20 120,000 5,000 25 125,000
B 1,000 22 22,000
$138,000 $168,000
After the inventories are double-extended, Toledo uses the formula in Illustra-
tion 8-26 to develop the index for the current year (2014), as follows.
ILLUSTRATION 8-28
Ending Inventory for the Period at Current Cost $168,000
5 5 121.74% Computation of 2014
Ending Inventory for the Period at Base-Year Cost $138,000
Index
Toledo then applies this index (121.74%) to the layer added in 2014. Note in this
illustration that Toledo used the most recent actual purchases to determine current cost.
Alternatively, it could have used other approaches such as FIFO and average-cost.
Whichever flow assumption is adopted, a company must use it consistently from one
period to another.
440 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Use of the double-extension method is time-consuming and difficult where sub-
stantial technological change has occurred or where many items are involved. That is, as
time passes, the company must determine a new base-year cost for new products, and
must keep a base-year cost for each inventory item.9
What do the numbers mean? QUITE A DIFFERENCE
As indicated, signifi cant differences can arise in inventory As indicated, consistent with LIFO costing in times of
measured according to current cost and dollar-value LIFO. rising prices, the dollar-value LIFO inventory amount is
Let’s look at an additional summary example. less than inventory stated at end-of-year prices. The com-
Truman Company uses the dollar-value LIFO method of pany did not add layers at the 2014 prices. This is because
computing its inventory. Inventory for the last three years is the increase in inventory at end-of-year (current) prices was
as shown below. primarily due to higher prices. Also, establishing the LIFO
layers based on price-adjusted dollars relative to base-year
Year Ended Inventory at Price
layers reduces the likelihood of a LIFO liquidation.
December 31 Current-Year Cost Index
2012 $60,000 100
2013 84,000 105
2014 87,000 116
The values of the 2012, 2013, and 2014 inventories using the
dollar-value LIFO method are presented in the table below.
Inventory at Inventory at Layers at Price-Index Dollar-Value
End-of-Year Base-Year Base-Year 3 Layers at LIFO
Year Prices Prices Prices LIFO Cost Inventory
2012 $60,000 $60,000 4 100 5 $60,000 2012 $60,000 3 100 5 $60,000 $60,000
2013 84,000 $84,000 4 105 5 $80,000 2012 $60,000 3 100 5 $60,000
2013 20,000 3 105 5 $21,000 $81,000
2014 87,000 $87,000 4 116 5 $75,000 2012 $60,000 3 100 5 $60,000
2013 15,000 3 105 5 $15,750 $75,750
Comparison of LIFO Approaches
We present three different approaches to computing LIFO inventories in this
chapter—specific-goods LIFO, specific-goods pooled LIFO, and dollar-value LIFO. As
we indicated earlier, the use of the specific-goods LIFO is unrealistic. Most companies
have numerous goods in inventory at the end of a period. Costing (pricing) them on a
unit basis is extremely expensive and time-consuming.
The specific-goods pooled LIFO approach reduces recordkeeping and clerical costs.
In addition, it is more difficult to erode the layers because the reduction of one quantity
in the pool may be offset by an increase in another. Nonetheless, the pooled approach
using quantities as its measurement basis can lead to untimely LIFO liquidations.
As a result, most companies using a LIFO system employ dollar-value LIFO. Al-
though the approach appears complex, the logic and the computations are actually
quite simple, after determining an appropriate index.
9To simplify the analysis, companies may use another approach, initially sanctioned by the
Internal Revenue Service for tax purposes. Under this method, a company obtains an index from
an outside source or by double-extending only a sample portion of the inventory. For example,
the IRS allows all companies to use as their inflation rate for a LIFO pool 80 percent of the
inflation rate reported by the appropriate consumer or producer price indexes prepared by the |
Bureau of Labor Statistics (BLS). Once the company obtains the index, it divides the ending
inventory at current cost by the index to find the base-year cost. Using generally available
external indexes greatly simplifies LIFO computations, and frees companies from having to
compute internal indexes.
Special Issues Related to LIFO 441
However, problems do exist with the dollar-value LIFO method. The selection of
the items to be put in a pool can be subjective.10 Such a determination, however, is
extremely important because manipulation of the items in a pool without conceptual
justification can affect reported net income. For example, the SEC noted that some com-
panies have set up pools that are easy to liquidate. As a result, to increase income, a
company simply decreases inventory, thereby matching low-cost inventory items to
current revenues.
To curb this practice, the SEC has taken a much harder line on the number of pools
that companies may establish. In a well-publicized case, Stauffer Chemical Company
increased the number of LIFO pools from 8 to 280, boosting its net income by $16,515,000
or approximately 13 percent. Stauffer justified the change in its annual report on the
basis of “achieving a better matching of cost and revenue.” The SEC required Stauffer to
reduce the number of its inventory pools, contending that some pools were inappropriate
and alleging income manipulation.
Major Advantages of LIFO
One obvious advantage of LIFO approaches is that the LIFO cost flow often ap-
9 LEARNING OBJECTIVE
proximates the physical flow of the goods in and out of inventory. For instance, in
Identify the major advantages and
a coal pile, the last coal in is the first coal out because it is on the top of the pile. The
disadvantages of LIFO.
coal remover is not going to take the coal from the bottom of the pile! The coal
taken first is the coal placed on the pile last.
However, this is one of only a few situations where the actual physical flow corre-
sponds to LIFO. Therefore, most adherents of LIFO use other arguments for its wide-
spread use, as follows.
Matching
LIFO matches the more recent costs against current revenues to provide a better mea-
sure of current earnings. During periods of inflation, many challenge the quality of non-
LIFO earnings, noting that failing to match current costs against current revenues
creates transitory or “paper” profits (“inventory profits”). Inventory profits occur
when the inventory costs matched against sales are less than the inventory replacement
cost. This results in understating the cost of goods sold and overstating profit. Using
LIFO (rather than a method such as FIFO) matches current costs against revenues,
thereby reducing inventory profits.
Tax Benefi ts/Improved Cash Flow
LIFO’s popularity mainly stems from its tax benefits. As long as the price level increases
and inventory quantities do not decrease, a deferral of income tax occurs. Why? Because
a company matches the items it most recently purchased (at the higher price level)
against revenues. For example, when Fuqua Industries switched to LIFO, it realized a
tax savings of about $4 million. Even if the price level decreases later, the company still
temporarily deferred its income taxes. Thus, use of LIFO in such situations improves a
company’s cash flow.11
10It is suggested that companies analyze how inventory purchases are affected by price changes,
how goods are stocked, how goods are used, and if future liquidations are likely. See William R.
Cron and Randall Hayes, ibid., p. 57.
11In periods of rising prices, the use of fewer pools will translate into greater income tax benefits
through the use of LIFO. The use of fewer pools allows companies to offset inventory reductions
on some items and inventory increases in others. In contrast, the use of more pools increases the
likelihood of liquidating old, low-cost inventory layers and incurring negative tax consequences.
See Reeve and Stanga, ibid., pp. 28–29.
442 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
The tax law requires that if a company uses LIFO for tax purposes, it must also use |
LIFO for financial accounting purposes12 (although neither tax law nor GAAP requires
a company to pool its inventories in the same manner for book and tax purposes). This
requirement is often referred to as the LIFO conformity rule. Other inventory valuation
methods do not have this requirement.
Future Earnings Hedge
With LIFO, future price declines will not substantially affect a company’s future
reported earnings. The reason: Since the company records the most recent inventory as
sold first, there is not much ending inventory at high prices vulnerable to a price
decline. Thus LIFO eliminates or substantially minimizes write-downs to market as a
result of price decreases. In contrast, inventory costed under FIFO is more vulnerable to
price declines, which can reduce net income substantially.
Major Disadvantages of LIFO
Despite its advantages, LIFO has the following drawbacks.
Reduced Earnings
Many corporate managers view the lower profits reported under the LIFO method in in-
flationary times as a distinct disadvantage. They would rather have higher reported prof-
its than lower taxes. Some fear that investors may misunderstand an accounting change
to LIFO, and that the lower profits may cause the price of the company’s stock to fall.
Inventory Understated
LIFO may have a distorting effect on a company’s balance sheet. The inventory valua-
tion is normally outdated because the oldest costs remain in inventory. This understate-
ment makes the working capital position of the company appear worse than it really is.
A good example is Caterpillar, which uses LIFO costing for most of its inventory,
valued at $14.5 billion at year-end 2011. Under FIFO costing, Caterpillar’s inventories
have a value of $16.7 billion—approximately 5 percent higher than the LIFO amount.
The magnitude and direction of this variation between the carrying amount of
inventory and its current price depend on the degree and direction of the price changes
and the amount of inventory turnover. The combined effect of rising product prices and
avoidance of inventory liquidations increases the difference between the inventory
carrying value at LIFO and current prices of that inventory. This magnifies the balance
sheet distortion attributed to the use of LIFO.
Physical Flow
LIFO does not approximate the physical flow of the items except in specific situations
(such as the coal pile discussed earlier). Originally, companies could use LIFO only in
certain circumstances. This situation has changed over the years. Now, physical flow
characteristics no longer determine whether a company may employ LIFO.
Involuntary Liquidation/Poor Buying Habits
If a company eliminates the base or layers of old costs, it may match old, irrelevant costs
against current revenues. A distortion in reported income for a given period may result,
as well as detrimental income tax consequences. For example, Caterpillar recently
experienced a LIFO liquidation, resulting in an increased tax bill of $60 million.13
12Management often selects an accounting procedure because a lower tax results from its use,
instead of an accounting method that is conceptually more appealing. Throughout this textbook,
we identify accounting procedures that provide income tax benefits to the user.
13Companies should disclose the effects on income of LIFO inventory liquidations in the notes to
the financial statements. [8]
Basis for Selection of Inventory Method 443
Because of the liquidation problem, LIFO may cause poor buying habits. A com-
pany may simply purchase more goods and match these goods against revenue to avoid
charging the old costs to expense. Furthermore, recall that with LIFO, a company may
attempt to manipulate its net income at the end of the year simply by altering its pattern
of purchases.14
One survey uncovered the following reasons why companies reject LIFO.15
ILLUSTRATION 8-29
Reasons to Reject LIFO Number % of Total*
Why Do Companies
No expected tax benefits
Reject LIFO? Summary
No required tax payment 34 16%
of Responses
Declining prices 31 15
Rapid inventory turnover 30 14 |
Immaterial inventory 26 12
Miscellaneous tax related 38 17
159 74%
Regulatory or other restrictions 26 12%
Excessive cost
High administrative costs 29 14%
LIFO liquidation–related costs 12 6
41 20%
Other adverse consequences
Lower reported earnings 18 8%
Bad accounting 7 3
25 11%
*Percentage totals more than 100% as some companies offered more than one explanation.
BASIS FOR SELECTION OF INVENTORY METHOD
How does a company choose among the various inventory methods? Although no
10 LEARNING OBJECTIVE
absolute rules can be stated, preferability for LIFO usually occurs in either of the
Understand why companies select
following circumstances: (1) if selling prices and revenues have been increasing
given inventory methods.
faster than costs, thereby distorting income, and (2) in situations where LIFO has
been traditional, such as department stores and industries where a fairly constant “base
stock” is present (such as refining, chemicals, and glass).16
Conversely, LIFO is probably inappropriate in the following circumstances:
(1) where prices tend to lag behind costs; (2) in situations where specific identification is
traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry;
or (3) where unit costs tend to decrease as production increases, thereby nullifying the
tax benefit that LIFO might provide.17
14For example, General Tire and Rubber accelerated raw material purchases at the end of the
year to minimize the book profit from a liquidation of LIFO inventories and to minimize income
taxes for the year.
15Michael H. Granof and Daniel Short, “Why Do Companies Reject LIFO?” Journal of Accounting,
Auditing, and Finance (Summer 1984), pp. 323–333 and Table 1, p. 327.
16Accounting Trends and Techniques—2012 reports that of 669 inventory method disclosures, 163
used LIFO, 312 used FIFO, 133 used average-cost, and 56 used other methods. As discussed in
the opening story, because of steady or falling raw materials costs and costs savings from
electronic data interchange and just-in-time technologies in recent years, many businesses using
LIFO no longer experience substantial tax benefits. Even some companies for which LIFO is
creating a benefit are finding that the administrative costs associated with LIFO are higher than
the LIFO benefit obtained. As a result, some companies are moving to FIFO or average-cost.
17See Barry E. Cushing and Marc J. LeClere, “Evidence on the Determinants of Inventory
Accounting Policy Choice,” The Accounting Review (April 1992), pp. 355–366 and Table 4, p. 363,
for a list of factors hypothesized to affect FIFO–LIFO choices.
444 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Tax consequences are another consideration. Switching from FIFO to LIFO usually
results in an immediate tax benefit. However, switching from LIFO to FIFO can result in
a substantial tax burden. For example, when Chrysler changed from LIFO to FIFO, it
became responsible for an additional $53 million in taxes that the company had deferred
over 14 years of LIFO inventory valuation. Why, then, would Chrysler, and other com-
panies, change to FIFO? The major reason was the profit crunch of that era. Although
Chrysler showed a loss of $7.6 million after the switch, the loss would have been $20
million more if the company had not changed its inventory valuation from LIFO to FIFO.
It is questionable whether companies should switch from LIFO to FIFO for the sole
purpose of increasing reported earnings. Intuitively, we would assume that companies
with higher reported earnings would have a higher share valuation (common stock
price). However, some studies have indicated that the users of financial data exhibit a
much higher sophistication than might be expected. Share prices are the same and, in
some cases, even higher under LIFO in spite of lower reported earnings.18
The concern about reduced income resulting from adoption of LIFO has even less
substance now because the IRS has also relaxed the LIFO conformity rule which re-
quires a company employing LIFO for tax purposes to use it for book purposes as well. |
The IRS has also relaxed restrictions against providing non-LIFO income numbers as
supplementary information. As a result, companies now provide supplemental non-
LIFO disclosures. While not intended to override the basic LIFO method adopted for
financial reporting, these disclosures may be useful in comparing operating income and
working capital with companies not on LIFO.
For example, Sherwin-Williams Company, a LIFO user, presented the information
in its annual report as shown in Illustration 8-30.
ILLUSTRATION 8-30
Sherwin-Williams Company
Supplemental Non-LIFO
Disclosure Inventories were stated at the lower of cost or market with cost determined principally on the last-in,
first-out (LIFO) method. The following presents the effect on inventories, net income and net income per
common share had the Company used the first-in, first-out (FIFO) inventory valuation method adjusted
for income taxes at the statutory rate and assuming no other adjustments.
2011 2010
Percentage of total inventories on LIFO 77% 76%
Excess of FIFO over LIFO $378,986 $277,164
(Decrease) increase in net income due to LIFO (62,636) (16,394)
(Decrease) increase in net income per common share due to LIFO (.59) (.15)
International
Relaxation of the LIFO conformity rule has led some companies to select
Perspective
LIFO as their inventory valuation method because they will be able to disclose
Many U.S. companies that have FIFO income numbers in the financial reports if they so desire.19
international operations use LIFO Companies often combine inventory methods. For example, John Deere
for U.S. purposes but use FIFO uses LIFO for most of its inventories, and prices the remainder using FIFO. The
for their foreign subsidiaries. Hershey Company follows the same practice. One reason for these practices is
18See, for example, Shyam Sunder, “Relationship Between Accounting Changes and Stock Prices:
Problems of Measurement and Some Empirical Evidence,” Empirical Research in Accounting:
Selected Studies, 1973 (Chicago: University of Chicago), pp. 1–40. But see Robert Moren Brown,
“Short-Range Market Reaction to Changes to LIFO Accounting Using Preliminary Earnings
Announcement Dates,” The Journal of Accounting Research (Spring 1980), which found that
companies that do change to LIFO suffer a short-run decline in the price of their stock.
19Note that a company can use one variation of LIFO for financial reporting purposes and
another for tax without violating the LIFO conformity rule. Such a relaxation has caused many
problems because the general approach to accounting for LIFO has been “whatever is good for
tax is good for financial reporting.”
Basis for Selection of Inventory Method 445
that certain product lines can be highly susceptible to deflation instead of inflation.
In addition, if the level of inventory is unstable, unwanted involuntary liquidations
may result in certain product lines if using LIFO. Finally, for high inventory turnover
in certain product lines, a company cannot justify LIFO’s additional recordkeeping
and expense. In such cases, a company often uses average-cost because it is easy to
compute.20
Although a company may use a variety of inventory methods to assist in accurate
computation of net income, once it selects a pricing method, it must apply it consis-
tently thereafter. If conditions indicate that the inventory pricing method in use is
unsuitable, the company must seriously consider all other possibilities before selecting
another method. It should clearly explain any change and disclose its effect in the
financial statements.
Evolving Issue REPEAL LIFO!
In some situations, use of LIFO can result in significant tax reduce the federal deficit. Why pick on LIFO? Well, one
savings for companies. For example, Sherwin-Williams recent budget estimate indicates that repeal of LIFO would
Company estimates its tax bill would increase by $16 million help plug the budget deficit with over $61 billion in addi-
if it were to change from LIFO to FIFO. The option to use tional tax collections. In addition, since IFRS does not |
LIFO to reduce taxes has become a political issue permit LIFO, its repeal will contribute to international
because of the growing federal deficit. Some are proposing accounting convergence.
elimination of LIFO (and other tax law changes) to help
Source: R. Bloom and W. Cenker, “The Death of LIFO?” Journal of Accountancy (January 2009), pp. 44–49.
Inventory Valuation Methods—Summary Analysis
The preceding sections of this chapter described a number of inventory valuation
methods. Here we present a brief summary of the three major inventory methods to
show the effects these valuation methods have on the financial statements. This
comparison assumes periodic inventory procedures and the following selected data.
Selected Data
Beginning cash balance $ 7,000
Beginning retained earnings $10,000
Beginning inventory: 4,000 units @ $3 $12,000
Purchases: 6,000 units @ $4 $24,000
Sales: 5,000 units @ $12 $60,000
Operating expenses $10,000
Income tax rate 40%
Illustration 8-31 (page 446) shows the comparative results on net income of the use
of average-cost, FIFO, and LIFO. Notice that gross profit and net income are lowest
under LIFO, highest under FIFO, and somewhere in the middle under average-cost.
20For an interesting discussion of the reasons for and against the use of FIFO and average-cost,
see Michael H. Granof and Daniel G. Short, “For Some Companies, FIFO Accounting Makes
Sense,” Wall Street Journal (August 30, 1982); and the subsequent rebuttal by Gary C. Biddle,
“Taking Stock of Inventory Accounting Choices,” Wall Street Journal (September 15, 1982).
446 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
ILLUSTRATION 8-31
Average-
Comparative Results of
Cost FIFO LIFO
Average-Cost, FIFO, and
LIFO Methods Sales $60,000 $60,000 $60,000
Cost of goods sold 18,000a 16,000b 20,000c
Gross profit 42,000 44,000 40,000
Operating expenses 10,000 10,000 10,000
Income before taxes 32,000 34,000 30,000
Income taxes (40%) 12,800 13,600 12,000
Net income $19,200 $20,400 $18,000
a4,000 @ $3 5 $12,000 b4,000 @ $3 5 $12,000 c5,000 @ $4 5 $20,000
6,000 @ $4 5 24,000 1,000 @ $4 5 4,000
$36,000 $16,000
$36,000 4 10,000 5 $3.60
$3.60 3 5,000 5 $18,000
Illustration 8-32 shows the final balances of selected items at the end of the period.
ILLUSTRATION 8-32
Gross Net Retained
Balances of Selected
Inventory Profit Taxes Income Earnings Cash
Items under Alternative
Inventory Valuation Average- $18,000 $42,000 $12,800 $19,200 $29,200 $20,200a
Methods Cost (5,000 3 $3.60) ($10,000 1 $19,200)
FIFO $20,000 $30,400
$44,000 $13,600 $20,400 $19,400a
(5,000 3 $4) ($10,000 1 $20,400)
$16,000
$28,000
LIFO (4,000 3 $3) $40,000 $12,000 $18,000 $21,000a
($10,000 1 $18,000)
(1,000 3 $4)
aCash at year-end 5 Beg. Balance 1 Sales 2 Purchases 2 Operating expenses 2 Taxes
Average-cost—$20,200 5 $7,000 1 $60,000 2 $24,000 2 $10,000 2 $12,800
FIFO—$19,400 5 $7,000 1 $60,000 2 $24,000 2 $10,000 2 $13,600
LIFO—$21,000 5 $7,000 1 $60,000 2 $24,000 2 $10,000 2 $12,000
LIFO results in the highest cash balance at year-end (because taxes are lower). This ex-
ample assumes that prices are rising. The opposite result occurs if prices are declining.
KEY TERMS
SUMMARY OF LEARNING OBJECTIVES
average-cost method, 429
consigned goods, 422
cost flow
1 Identify major classifications of inventory. Only one inventory account, In-
assumptions, 428
ventory, appears in the financial statements of a merchandising concern. A manufacturer
dollar-value LIFO, 435
normally has three inventory accounts: Raw Materials, Work in Process, and Finished
double-extension
Goods. Companies report the cost assigned to goods and materials on hand but not yet
method, 439
placed into production as raw materials inventory. They report the cost of the raw ma-
finished goods
terials on which production has been started but not completed, plus the direct labor cost
inventory, 416
applied specifically to this material and a ratable share of manufacturing overhead costs,
first-in, first-out (FIFO)
as work in process inventory. Finally, they report the costs identified with the completed
method, 430 |
but unsold units on hand at the end of the fiscal period as finished goods inventory.
f.o.b. destination, 421
f.o.b. shipping point, 421 2 Distinguish between perpetual and periodic inventory systems. A per-
gross method, 427 petual inventory system maintains a continuous record of inventory changes in the
inventories, 416 Inventory account. That is, a company records all purchases and sales (issues) of goods
last-in, first-out (LIFO) directly in the Inventory account as they occur. Under a periodic inventory system,
method, 431 companies determine the quantity of inventory on hand only periodically. A company
debits a Purchases account, but the Inventory account remains the same. It determines
Summary of Learning Objectives 447
cost of goods sold at the end of the period by subtracting ending inventory from cost of LIFO effect, 432
goods available for sale. A company ascertains ending inventory by physical count. LIFO liquidation, 434
3 Determine the goods included in inventory and the effects of inven- LIFO reserve, 432
tory errors on the financial statements. Companies record purchases of inventory merchandise
inventory, 416
when they obtain legal title to the goods (generally when they receive the goods). Shipping
modified perpetual
terms must be evaluated to determine when legal title passes, and careful consideration
inventory system, 419
must be made for cost of goods sold on consignment and sales with buy-back agreements
and high rates of return. If the company misstates ending inventory: (1) In the balance sheet, moving-average
method, 430
the inventory and retained earnings will be misstated, which will lead to miscalculation of
net method, 427
the working capital and current ratio, and (2) in the income statement, the cost of goods
sold and net income will be misstated. If the company misstates purchases (and related net of the cash
discounts, 427
accounts payable) and inventory: (1) In the balance sheet, the inventory and accounts
payable will be misstated, which will lead to miscalculation of the current ratio, and (2) in period costs, 426
the income statement, purchases and ending inventory will be misstated. periodic inventory
system, 418
4 Understand the items to include as inventory cost. Product costs are
perpetual inventory
those costs that attach to the inventory and are recorded in the Inventory account. Such
system, 418
charges include freight charges on goods purchased, other direct costs of acquisition,
product costs, 426
and labor and other production costs incurred in processing the goods up to the time of
Purchase Discounts, 426
sale. Period costs are those costs that are indirectly related to the acquisition or produc-
raw materials
tion of goods. These changes, such as selling expense and general and administrative
inventory, 416
expenses, are therefore not included as part of inventory cost.
specific-goods pooled
5 Describe and compare the cost flow assumptions used to account LIFO approach, 435
for inventories. (1) Average-cost prices items in the inventory on the basis of the aver- specific identification, 428
age cost of all similar goods available during the period. (2) First-in, first-out (FIFO) weighted-average
assumes that a company uses goods in the order in which it purchases them. The inven- method, 429
tory remaining must therefore represent the most recent purchases. (3) Last-in, first-out work in process
(LIFO) matches the cost of the last goods purchased against revenue. inventory, 416
6 Explain the significance and use of a LIFO reserve. The difference be-
tween the inventory method used for internal reporting purposes and LIFO is referred
to as Allowance to Reduce Inventory to LIFO, or the LIFO reserve. The change in LIFO
reserve is referred to as the LIFO effect. Companies should disclose either the LIFO
reserve or the replacement cost of the inventory in the financial statements.
7 Understand the effect of LIFO liquidations. LIFO liquidations match costs
from preceding periods against sales revenues reported in current dollars. This distorts |
net income and results in increased taxable income in the current period. LIFO liquida-
tions can occur frequently when using a specific-goods LIFO approach.
8 Explain the dollar-value LIFO method. For the dollar-value LIFO method,
companies determine and measure increases and decreases in a pool in terms of total
dollar value, not the physical quantity of the goods in the inventory pool.
9 Identify the major advantages and disadvantages of LIFO. The major
advantages of LIFO are the following. (1) It matches recent costs against current revenues
to provide a better measure of current earnings. (2) As long as the price level increases
and inventory quantities do not decrease, a deferral of income tax occurs in LIFO.
(3) Because of the deferral of income tax, cash flow improves. Major disadvantages are
(1) reduced earnings, (2) understated inventory, (3) does not approximate physical flow
of the items except in peculiar situations, and (4) involuntary liquidation issues.
10 Understand why companies select given inventory methods. Compa-
nies ordinarily prefer LIFO in the following circumstances: (1) if selling prices and
revenues have been increasing faster than costs and (2) if a company has a fairly constant
“base stock.” Conversely, LIFO would probably not be appropriate in the following
circumstances: (1) if sale prices tend to lag behind costs, (2) if specific identification is
traditional, and (3) when unit costs tend to decrease as production increases, thereby
nullifying the tax benefit that LIFO might provide.
448 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
DEMONSTRATION PROBLEM
Clinton Company makes specialty cases for smart phones and other handheld devices. The company has
experienced strong growth, and you are especially interested in how well Clinton is managing its inven-
tory balances. You have collected the following information for the current year.
Inventory at the beginning of year $ 1,555 million
Inventory at the end of year, before any adjustments $ 1,267 million
Total cost of goods sold, before any adjustments $17,844 million
The company values inventory at lower-of-cost (using LIFO cost flow assumption)-or-market.
Instructions
Prepare a schedule (a computer worksheet would serve well) showing the impact of the following items on
Clinton’s inventory turnover.
(a) Shipping contracts changed 2 months ago from f.o.b. shipping point to f.o.b. destination. At the end
of the year, $5 million of products are en route to China (and will not arrive until after financial
statements are released). Current inventory balances do not reflect this change in policy.
(b) During the year, Clinton recorded sales and costs of goods sold on $2 million of units shipped to
various wholesalers on consignment. At year-end, none of these units have been sold by wholesalers.
(c) To be more consistent with industry inventory valuation practices, Clinton changed from LIFO to
FIFO for its inventory of iPad cases. This inventory is currently carried at $724 million. Data for this
item of inventory for the year are as follows.
Month Units Purchased Inventory Sold Price per Unit Units Balance
January 1 100 $3.10 100
April 15 150 3.20 250
October 25 130 120
November 10 250 3.50 370
December 20 150 220
(d) Explain to Clinton management the advantages of adopting the LIFO cost flow assumption. Are
there any drawbacks? Explain.
Solution
(a)–(c)
CClliinnttoonn..xxllss
Home Insert Page Layout Formulas Data Review View
P18 fx
A B C D E F
1 Unadjusted
2 Balance Adjustment (a) Adjustment (b) Adjustment (c) Adjusted Balance
3 Beginning inventory $ 1,555.00 – – – $ 1,555.00
4 Ending inventory 1,267.00 $ 5.00 $ 2.00 $ 46.00 1,320.00
5 Average inventory 1,411.00 – – – 1,437.50
6 Cost of goods sold 17,844.00 $(5.00) $(2.00) $(46.00) 17,791.00
7 Inventory turnover 12.65 – – – 12.38
8
Ending inventory
under FIFO would
Goods officially Clinton should
be $770
change hands at include the goods
Explana!on (220 @ $3.50),
the point of on consignment
which is $46
des!na!on. to other sellers.
($770 - $724)
9 lower than LIFO.
10 |
FASB Codifi cation 449
(d) The major advantages of the LIFO inventory method include better matching of costs with reve-
nues, deferral of income taxes, improved cash flow, and minimization of the impact of future price
declines on future earnings. Better matching arises in the use of LIFO because the most recent
costs are matched with current revenues. In times of rising prices, this matching will result in lower
taxable income, which in turn will reduce current taxes. The deferral of taxes under LIFO contrib-
utes to a higher cash flow. As illustrated in the analysis above, the switch to FIFO resulted in a
higher ending inventory, which leads to a lower cost of goods sold and higher income. Thus,
Clinton’s reported income will be higher but so will its taxes. Note that under LIFO, future taxes
may be higher when lower cost items of inventory are sold in future periods and matched with
higher sales prices.
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 470-40-05. [Predecessor literature: “Accounting for Product Financing Arrangements,” Statement of Financial
Accounting Standards No. 49 (Stamford, Conn.: FASB, 1981).]
[2] FASB ASC 605-15-15. [Predecessor literature: “Revenue Recognition When Right of Return Exists,” Statement of Financial
Accounting Standards No. 48 (Stamford, Conn.: FASB, 1981).]
[3] FASB ASC 330-10-30-7. [Predecessor literature: “Inventory Costs: An Amendment of ARB No. 43, Chapter 4,” Statement of
Financial Accounting Standards No. 151 (Norwalk, Conn.: FASB 2004).]
[4] FASB ASC 835-20-05. [Predecessor literature: “Capitalization of Interest Cost,” Statement of Financial Accounting Standards
No. 34 (Stamford, Conn.: FASB, 1979).]
[5] FASB ASC 645-45-05. [Predecessor literature: “Accounting for Shipping and Handling Fees and Costs,” EITF No. 00–10
(2000).]
[6] FASB ASC 330-10-30. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Accounting
Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, Statement 4.]
[7] FASB ASC 330-10-S99-1. [Predecessor literature: “AICPA Task Force on LIFO Inventory Problems, Issues Paper (New York:
AICPA, November 30, 1984), pp. 2–24.]
[8] FASB ASC 330-10-S99-3. [Predecessor literature: “AICPA Task Force on LIFO Inventory Problems, Issues Paper (New York:
AICPA, November 30, 1984), pp. 36–37.]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to
the following. Provide Codification references for your responses.
CE8-1 Access the glossary (“Master Glossary”) to answer the following.
(a) What is the definition provided for inventory?
(b) What is a customer?
(c) Under what conditions is a distributor considered a customer?
(d) What is a product financing arrangement? What inventory measurement issues are raised through these arrange-
ments?
CE8-2 Due to rising fuel costs, your client, Overstock.com, is considering adding a charge for shipping and handling costs on
products sold through its website. What is the authoritative guidance for reporting these costs?
CE8-3 What guidance does the Codification provide concerning reporting inventories above cost?
CE8-4 What is the nature of the SEC guidance concerning the reporting of LIFO liquidations?
An additional Codification case can be found in the Using Your Judgment section, on page 471.
Be sure to check the book’s companion website for a Review and Analysis Exercise,
with solution.
Brief Exercises, Exercises, Problems, and many more learning and assessment tools
and resources are available for practice in WileyPLUS.
450 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
QUESTIONS
1. In what ways are the inventory accounts of a retailing com- terms and the invoice and the freight bill were paid within
pany different from those of a manufacturing company? the 10-day period, what would be the cost per unit?
2. Why should inventories be included in (a) a statement of 12. Specific identification is sometimes said to be the ideal
financial position and (b) the computation of net income? method of assigning cost to inventory and to cost of goods |
sold. Briefly indicate the arguments for and against this
3. What is the difference between a perpetual inventory and
method of inventory valuation.
a physical inventory? If a company maintains a perpetual
13. FIFO, average-cost, and LIFO methods are often used
inventory, should its physical inventory at any date be
instead of specific identification for inventory valua-
equal to the amount indicated by the perpetual inventory
tion purposes. Compare these methods with the specific
records? Why?
identification method, discussing the theoretical propriety
4. Mishima, Inc. indicated in a recent annual report that ap-
of each method in the determination of income and asset
proximately $19 million of merchandise was received on
valuation.
consignment. Should Mishima, Inc. report this amount on
14. How might a company obtain a price index in order to
its balance sheet? Explain.
apply dollar-value LIFO?
5. What is a product financing arrangement? How should
15. Describe the LIFO double-extension method. Using the
product financing arrangements be reported in the finan-
following information, compute the index at December 31,
cial statements?
2014, applying the double-extension method to a LIFO
6. Where, if at all, should the following items be classified on pool consisting of 25,500 units of product A and 10,350
a balance sheet? units of product B. The base-year cost of product A is
(a) Goods out on approval to customers. $10.20 and of product B is $37.00. The price at December 31,
2014, for product A is $21.00 and for product B is $45.60.
(b) Goods in transit that were recently purchased f.o.b.
(Round to two decimal places.)
destination.
16. As compared with the FIFO method of costing invento-
(c) Land held by a realty firm for sale.
ries, does the LIFO method result in a larger or smaller net
(d) Raw materials.
income in a period of rising prices? What is the compara-
(e) Goods received on consignment. tive effect on net income in a period of falling prices?
(f) Manufacturing supplies. 17. What is the dollar-value method of LIFO inventory valu-
7. At the balance sheet date, Clarkson Company held title to ation? What advantage does the dollar-value method
goods in transit amounting to $214,000. This amount was have over the specific goods approach of LIFO inventory
omitted from the purchases figure for the year and also valuation? Why will the traditional LIFO inventory cost-
from the ending inventory. What is the effect of this omis- ing method and the dollar-value LIFO inventory costing
sion on the net income for the year as calculated when the method produce different inventory valuations if the
books are closed? What is the effect on the company’s fi- composition of the inventory base changes?
nancial position as shown in its balance sheet? Is material- 18. Explain the following terms.
ity a factor in determining whether an adjustment for this
(a) LIFO layer.
item should be made?
(b) LIFO reserve.
8. Define “cost” as applied to the valuation of inventories.
(c) LIFO effect.
9. Distinguish between product costs and period costs as
19. On December 31, 2013, the inventory of Powhattan
they relate to inventory.
Company amounts to $800,000. During 2014, the com-
10. Ford Motor Co. is considering alternate methods of pany decides to use the dollar-value LIFO method of
accounting for the cash discounts it takes when paying costing inventories. On December 31, 2014, the inventory
suppliers promptly. One method suggested was to report is $1,053,000 at December 31, 2014, prices. Using the
these discounts as financial income when payments are December 31, 2013, price level of 100 and the December
made. Comment on the propriety of this approach. 31, 2014, price level of 108, compute the inventory value at
11. Zonker Inc. purchases 500 units of an item at an invoice December 31, 2014, under the dollar-value LIFO method.
cost of $30,000. What is the cost per unit? If the goods are 20. In an article that appeared in the Wall Street Journal, the
shipped f.o.b. shipping point and the freight bill was phrases “phantom (paper) profits” and “high LIFO prof- |
$1,500, what is the cost per unit if Zonker Inc. pays the its” through involuntary liquidation were used. Explain
freight charges? If these items were bought on 2/10, n/30 these phrases.
Brief Exercises 451
BRIEF EXERCISES
1 BE8-1 Included in the December 31 trial balance of Rivera Company are the following assets.
Cash $ 190,000 Work in process $200,000
Equipment (net) 1,100,000 Accounts receivable (net) 400,000
Prepaid insurance 41,000 Patents 110,000
Raw materials 335,000 Finished goods 170,000
Prepare the current assets section of the December 31 balance sheet.
2 BE8-2 Matlock Company uses a perpetual inventory system. Its beginning inventory consists of 50 units
that cost $34 each. During June, the company purchased 150 units at $34 each, returned 6 units for credit,
and sold 125 units at $50 each. Journalize the June transactions.
4 BE8-3 Stallman Company took a physical inventory on December 31 and determined that goods costing
$200,000 were on hand. Not included in the physical count were $25,000 of goods purchased from Pelzer
Corporation, f.o.b. shipping point, and $22,000 of goods sold to Alvarez Company for $30,000, f.o.b. desti-
nation. Both the Pelzer purchase and the Alvarez sale were in transit at year-end. What amount should
Stallman report as its December 31 inventory?
3 BE8-4 Bienvenu Enterprises reported cost of goods sold for 2014 of $1,400,000 and retained earnings of
$5,200,000 at December 31, 2014. Bienvenu later discovered that its ending inventories at December 31,
2013 and 2014, were overstated by $110,000 and $35,000, respectively. Determine the corrected amounts for
2014 cost of goods sold and December 31, 2014, retained earnings.
5 BE8-5 Amsterdam Company uses a periodic inventory system. For April, when the company sold 600
units, the following information is available.
Units Unit Cost Total Cost
April 1 inventory 250 $10 $ 2,500
April 15 purchase 400 12 4,800
April 23 purchase 350 13 4,550
1,000 $11,850
Compute the April 30 inventory and the April cost of goods sold using the average-cost method.
5 BE8-6 Data for Amsterdam Company are presented in BE8-5. Compute the April 30 inventory and the
April cost of goods sold using the FIFO method.
5 BE8-7 Data for Amsterdam Company are presented in BE8-5. Compute the April 30 inventory and the
April cost of goods sold using the LIFO method.
8 BE8-8 Midori Company had ending inventory at end-of-year prices of $100,000 at December 31, 2013;
$119,900 at December 31, 2014; and $134,560 at December 31, 2015. The year-end price indexes were 100 at
12/31/13, 110 at 12/31/14, and 116 at 12/31/15. Compute the ending inventory for Midori Company for
2013 through 2015 using the dollar-value LIFO method.
8 BE8-9 Arna, Inc. uses the dollar-value LIFO method of computing its inventory. Data for the past 3 years
follow.
Year Ended December 31 Inventory at Current-Year Cost Price Index
2013 $19,750 100
2014 22,140 108
2015 25,935 114
Instructions
Compute the value of the 2014 and 2015 inventories using the dollar-value LIFO method.
452 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
EXERCISES
4 E8-1 (Inventoriable Costs) Presented below is a list of items that may or may not be reported as inventory
in a company’s December 31 balance sheet.
1. Goods out on consignment at another company’s store.
2. Goods sold on an installment basis (bad debts can be reasonably estimated).
3. Goods purchased f.o.b. shipping point that are in transit at December 31.
4. Goods purchased f.o.b. destination that are in transit at December 31.
5. Goods sold to another company, for which our company has signed an agreement to repurchase at
a set price that covers all costs related to the inventory.
6. Goods sold where large returns are predictable.
7. Goods sold f.o.b. shipping point that are in transit at December 31.
8. Freight charges on goods purchased.
9. Interest costs incurred for inventories that are routinely manufactured.
10. Costs incurred to advertise goods held for resale.
11. Materials on hand not yet placed into production by a manufacturing firm. |
12. Office supplies.
13. Raw materials on which a manufacturing firm has started production but which are not completely
processed.
14. Factory supplies.
15. Goods held on consignment from another company.
16. Costs identified with units completed by a manufacturing firm but not yet sold.
17. Goods sold f.o.b. destination that are in transit at December 31.
18. Short-term investments in stocks and bonds that will be resold in the near future.
Instructions
Indicate which of these items would typically be reported as inventory in the financial statements. If an
item should not be reported as inventory, indicate how it should be reported in the financial statements.
4 E8-2 (Inventoriable Costs) In your audit of Jose Oliva Company, you find that a physical inventory on
December 31, 2014, showed merchandise with a cost of $441,000 was on hand at that date. You also dis-
cover the following items were all excluded from the $441,000.
1. Merchandise of $61,000 which is held by Oliva on consignment. The consignor is the Max Suzuki
Company.
2. Merchandise costing $38,000 which was shipped by Oliva f.o.b. destination to a customer on
December 31, 2014. The customer was expected to receive the merchandise on January 6, 2015.
3. Merchandise costing $46,000 which was shipped by Oliva f.o.b. shipping point to a customer on
December 29, 2014. The customer was scheduled to receive the merchandise on January 2, 2015.
4. Merchandise costing $83,000 shipped by a vendor f.o.b. destination on December 30, 2014, and
received by Oliva on January 4, 2015.
5. Merchandise costing $51,000 shipped by a vendor f.o.b. shipping point on December 31, 2014, and
received by Oliva on January 5, 2015.
Instructions
Based on the above information, calculate the amount that should appear on Oliva’s balance sheet at
December 31, 2014, for inventory.
4 E8-3 (Inventoriable Costs) Assume that in an annual audit of Harlowe Inc. at December 31, 2014, you find
the following transactions near the closing date.
1. A special machine, fabricated to order for a customer, was finished and specifically segregated in
the back part of the shipping room on December 31, 2014. The customer was billed on that date and
the machine excluded from inventory although it was shipped on January 4, 2015.
2. Merchandise costing $2,800 was received on January 3, 2015, and the related purchase invoice recorded
January 5. The invoice showed the shipment was made on December 29, 2014, f.o.b. destination.
3. A packing case containing a product costing $3,400 was standing in the shipping room when the
physical inventory was taken. It was not included in the inventory because it was marked “Hold for
shipping instructions.” Your investigation revealed that the customer’s order was dated December
18, 2014, but that the case was shipped and the customer billed on January 10, 2015. The product
was a stock item of your client.
Exercises 453
4. Merchandise received on January 6, 2015, costing $680 was entered in the purchase journal on
January 7, 2015. The invoice showed shipment was made f.o.b. supplier’s warehouse on December 31,
2014. Because it was not on hand at December 31, it was not included in inventory.
5. Merchandise costing $720 was received on December 28, 2014, and the invoice was not recorded. You
located it in the hands of the purchasing agent; it was marked “on consignment.”
Instructions
Assuming that each of the amounts is material, state whether the merchandise should be included in the
client’s inventory, and give your reason for your decision on each item.
2 4 E8-4 (Inventoriable Costs—Perpetual) Colin Davis Machine Company maintains a general ledger ac-
count for each class of inventory, debiting such accounts for increases during the period and crediting them
for decreases. The transactions below relate to the Raw Materials inventory account, which is debited for
materials purchased and credited for materials requisitioned for use.
1. An invoice for $8,100, terms f.o.b. destination, was received and entered January 2, 2014. The receiv-
ing report shows that the materials were received December 28, 2013. |
2. Materials costing $28,000, shipped f.o.b. destination, were not entered by December 31, 2013, “be-
cause they were in a railroad car on the company’s siding on that date and had not been unloaded.”
3. Materials costing $7,300 were returned to the supplier on December 29, 2013, and were shipped
f.o.b. shipping point. The return was entered on that date, even though the materials are not
expected to reach the supplier’s place of business until January 6, 2014.
4. An invoice for $7,500, terms f.o.b. shipping point, was received and entered December 30, 2013. The
receiving report shows that the materials were received January 4, 2014, and the bill of lading shows
that they were shipped January 2, 2014.
5. Materials costing $19,800 were received December 30, 2013, but no entry was made for them
because “they were ordered with a specified delivery of no earlier than January 10, 2014.”
Instructions
Prepare correcting general journal entries required at December 31, 2013, assuming that the books have not
been closed.
3 4 E8-5 (Inventoriable Costs—Error Adjustments) Craig Company asks you to review its December 31,
2014, inventory values and prepare the necessary adjustments to the books. The following information is
given to you.
1. Craig uses the periodic method of recording inventory. A physical count reveals $234,890 of inven-
tory on hand at December 31, 2014.
2. Not included in the physical count of inventory is $13,420 of merchandise purchased on December
15 from Browser. This merchandise was shipped f.o.b. shipping point on December 29 and arrived
in January. The invoice arrived and was recorded on December 31.
3. Included in inventory is merchandise sold to Champy on December 30, f.o.b. destination. This mer-
chandise was shipped after it was counted. The invoice was prepared and recorded as a sale on account
for $12,800 on December 31. The merchandise cost $7,350, and Champy received it on January 3.
4. Included in inventory was merchandise received from Dudley on December 31 with an invoice
price of $15,630. The merchandise was shipped f.o.b. destination. The invoice, which has not yet
arrived, has not been recorded.
5. Not included in inventory is $8,540 of merchandise purchased from Glowser Industries. This
merchandise was received on December 31 after the inventory had been counted. The invoice was
received and recorded on December 30.
6. Included in inventory was $10,438 of inventory held by Craig on consignment from Jackel
Industries.
7. Included in inventory is merchandise sold to Kemp f.o.b. shipping point. This merchandise was
shipped after it was counted. The invoice was prepared and recorded as a sale for $18,900 on
December 31. The cost of this merchandise was $10,520, and Kemp received the merchandise on
January 5.
8. Excluded from inventory was a carton labeled “Please accept for credit.” This carton contains mer-
chandise costing $1,500 which had been sold to a customer for $2,600. No entry had been made to
the books to reflect the return, but none of the returned merchandise seemed damaged.
Instructions
(a) Determine the proper inventory balance for Craig Company at December 31, 2014.
(b) Prepare any correcting entries to adjust inventory to its proper amount at December 31, 2014.
Assume the books have not been closed.
454 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
4 E8-6 (Determining Merchandise Amounts—Periodic) Two or more items are omitted in each of the
following tabulations of income statement data. Fill in the amounts that are missing.
2013 2014 2015
Sales revenue $290,000 $ ? $410,000
Sales returns and allowances 11,000 13,000 ?
Net sales ? 347,000 ?
Beginning inventory 20,000 32,000 ?
Ending inventory ? ? ?
Purchases ? 260,000 298,000
Purchase returns and allowances 5,000 8,000 10,000
Freight-in 8,000 9,000 12,000
Cost of goods sold 233,000 ? 293,000
Gross profi t on sales 46,000 91,000 97,000
4 E8-7 (Purchases Recorded Net) Presented below are transactions related to Tom Brokaw, Inc.
May 10 Purchased goods billed at $15,000 subject to cash discount terms of 2/10, n/60. |
11 Purchased goods billed at $13,200 subject to terms of 1/15, n/30.
19 Paid invoice of May 10.
24 Purchased goods billed at $11,500 subject to cash discount terms of 2/10, n/30.
Instructions
(a) Prepare general journal entries for the transactions above under the assumption that purchases are
to be recorded at net amounts after cash discounts and that discounts lost are to be treated as finan-
cial expense.
(b) Assuming no purchase or payment transactions other than those given above, prepare the adjusting
entry required on May 31 if financial statements are to be prepared as of that date.
4 E8-8 (Purchases Recorded, Gross Method) Cruise Industries purchased $10,800 of merchandise on
February 1, 2014, subject to a trade discount of 10% and with credit terms of 3/15, n/60. It returned $2,500
(gross price before trade or cash discount) on February 4. The invoice was paid on February 13.
Instructions
(a) Assuming that Cruise uses the perpetual method for recording merchandise transactions, record
the purchase, return, and payment using the gross method.
(b) Assuming that Cruise uses the periodic method for recording merchandise transactions, record the
purchase, return, and payment using the gross method.
(c) At what amount would the purchase on February 1 be recorded if the net method were used?
2 E8-9 (Periodic versus Perpetual Entries) Fong Sai-Yuk Company sells one product. Presented below is
information for January for Fong Sai-Yuk Company.
Jan. 1 Inventory 100 units at $5 each
4 Sale 80 units at $8 each
11 Purchase 150 units at $6 each
13 Sale 120 units at $8.75 each
20 Purchase 160 units at $7 each
27 Sale 100 units at $9 each
Fong Sai-Yuk uses the FIFO cost flow assumption. All purchases and sales are on account.
Instructions
(a) Assume Fong Sai-Yuk uses a periodic system. Prepare all necessary journal entries, including the
end-of-month closing entry to record cost of goods sold. A physical count indicates that the ending
inventory for January is 110 units.
(b) Compute gross profit using the periodic system.
(c) Assume Fong Sai-Yuk uses a perpetual system. Prepare all necessary journal entries.
(d) Compute gross profit using the perpetual system.
3 E8-10 (Inventory Errors—Periodic) Ann M. Martin Company makes the following errors during the
current year. (Evaluate each case independently and assume ending inventory in the following year is cor-
rectly stated.)
1. Ending inventory is overstated, but purchases and related accounts payable are recorded correctly.
2. Both ending inventory and purchases and related accounts payable are understated. (Assume this
purchase was recorded and paid for in the following year.)
3. Ending inventory is correct, but a purchase on account was not recorded. (Assume this purchase
was recorded and paid for in the following year.)
Exercises 455
Instructions
Indicate the effect of each of these errors on working capital, current ratio (assume that the current ratio is
greater than 1), retained earnings, and net income for the current year and the subsequent year.
3 E8-11 (Inventory Errors) At December 31, 2013, Stacy McGill Corporation reported current assets of
$370,000 and current liabilities of $200,000. The following items may have been recorded incorrectly.
1. Goods purchased costing $22,000 were shipped f.o.b. shipping point by a supplier on December 28.
McGill received and recorded the invoice on December 29, 2013, but the goods were not included in
McGill’s physical count of inventory because they were not received until January 4, 2014.
2. Goods purchased costing $15,000 were shipped f.o.b. destination by a supplier on December 26.
McGill received and recorded the invoice on December 31, but the goods were not included in
McGill’s 2013 physical count of inventory because they were not received until January 2, 2014.
3. Goods held on consignment from Claudia Kishi Company were included in McGill’s December 31,
2013, physical count of inventory at $13,000.
4. Freight-in of $3,000 was debited to advertising expense on December 28, 2013.
Instructions |
(a) Compute the current ratio based on McGill’s balance sheet.
(b) Recompute the current ratio after corrections are made.
(c) By what amount will income (before taxes) be adjusted up or down as a result of the corrections?
3 E8-12 (Inventory Errors) The net income per books of Linda Patrick Company was determined without
knowledge of the errors indicated.
Net Income Error in Ending
Year per Books Inventory
2009 $50,000 Overstated $ 3,000
2010 52,000 Overstated 9,000
2011 54,000 Understated 11,000
2012 56,000 No error
2013 58,000 Understated 2,000
2014 60,000 Overstated 8,000
Instructions
Prepare a worksheet to show the adjusted net income figure for each of the 6 years after taking into account
the inventory errors.
2 5 E8-13 (FIFO and LIFO—Periodic and Perpetual) Inventory information for Part 311 of Monique Aaron
Corp. discloses the following information for the month of June.
June 1 Balance 300 units @ $10 June 10 Sold 200 units @ $24
11 Purchased 800 units @ $12 15 Sold 500 units @ $25
20 Purchased 500 units @ $13 27 Sold 300 units @ $27
Instructions
(a) Assuming that the periodic inventory method is used, compute the cost of goods sold and ending
inventory under (1) LIFO and (2) FIFO.
(b) Assuming that the perpetual inventory method is used and costs are computed at the time of each
withdrawal, what is the value of the ending inventory at LIFO?
(c) Assuming that the perpetual inventory method is used and costs are computed at the time of each
withdrawal, what is the gross profit if the inventory is valued at FIFO?
(d) Why is it stated that LIFO usually produces a lower gross profit than FIFO?
5 E8-14 (FIFO, LIFO and Average-Cost Determination) John Adams Company’s record of transactions for
the month of April was as follows.
Purchases Sales
April 1 (balance on hand) 600 @ $ 6.00 April 3 500 @ $10.00
4 1,500 @ 6.08 9 1,400 @ 10.00
8 800 @ 6.40 11 600 @ 11.00
13 1,200 @ 6.50 23 1,200 @ 11.00
21 700 @ 6.60 27 900 @ 12.00
29 500 @ 6.79
4,600
5,300
456 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Instructions
(a) Assuming that periodic inventory records are kept in units only, compute the inventory at April 30
using (1) LIFO and (2) average-cost.
(b) Assuming that perpetual inventory records are kept in dollars, determine the inventory using
(1) FIFO and (2) LIFO.
(c) Compute cost of goods sold assuming periodic inventory procedures and inventory priced at FIFO.
(d) In an inflationary period, which inventory method—FIFO, LIFO, average-cost—will show the high-
est net income?
5 E8-15 (FIFO, LIFO, Average-Cost Inventory) Shania Twain Company was formed on December 1, 2013.
The following information is available from Twain’s inventory records for Product BAP.
Units Unit Cost
January 1, 2014 (beginning inventory) 600 $ 8.00
Purchases:
January 5, 2014 1,200 9.00
January 25, 2014 1,300 10.00
February 16, 2014 800 11.00
March 26, 2014 600 12.00
A physical inventory on March 31, 2014, shows 1,600 units on hand.
Instructions
Prepare schedules to compute the ending inventory at March 31, 2014, under each of the following inven-
tory methods.
(a) FIFO. (b) LIFO. (c) Weighted-average (round unit costs to two decimal places).
5 E8-16 (Compute FIFO, LIFO, Average-Cost—Periodic) Presented below is information related to
Blowfish radios for the Hootie Company for the month of July.
Units Unit Units Selling
Date Transaction In Cost Total Sold Price Total
July 1 Balance 100 $4.10 $ 410
6 Purchase 800 4.20 3,360
7 Sale 300 $7.00 $ 2,100
10 Sale 300 7.30 2,190
12 Purchase 400 4.50 1,800
15 Sale 200 7.40 1,480
18 Purchase 300 4.60 1,380
22 Sale 400 7.40 2,960
25 Purchase 500 4.58 2,290
30 Sale 200 7.50 1,500
Totals 2,100 $9,240 1,400 $10,230
Instructions
(a) Assuming that the periodic inventory method is used, compute the inventory cost at July 31 under
each of the following cost flow assumptions.
(1) FIFO.
(2) LIFO.
(3) Weighted-average.
(b) Answer the following questions.
(1) Which of the methods used above will yield the lowest figure for gross profit for the income
statement? Explain why.
(2) Which of the methods used above will yield the lowest figure for ending inventory for the |
balance sheet? Explain why.
2 5 E8-17 (FIFO and LIFO—Periodic and Perpetual) The following is a record of Pervis Ellison Company’s
transactions for Boston Teapots for the month of May 2014.
May 1 Balance 400 units @ $20 May 10 Sale 300 units @ $38
12 Purchase 600 units @ $25 20 Sale 540 units @ $38
28 Purchase 400 units @ $30
Exercises 457
Instructions
(a) Assuming that perpetual inventories are not maintained and that a physical count at the end of
the month shows 560 units on hand, what is the cost of the ending inventory using (1) FIFO and
(2) LIFO?
(b) Assuming that perpetual records are maintained and they tie into the general ledger, calculate the
ending inventory using (1) FIFO and (2) LIFO.
5 E8-18 (FIFO and LIFO; Income Statement Presentation) The board of directors of Ichiro Corporation is
considering whether or not it should instruct the accounting department to shift from a first-in, first-out
(FIFO) basis of pricing inventories to a last-in, first-out (LIFO) basis. The following information is available.
Sales 21,000 units @ $50
Inventory, January 1 6,000 units @ 20
Purchases 6,000 units @ 22
10,000 units @ 25
7,000 units @ 30
Inventory, December 31 8,000 units @ ?
Operating expenses $200,000
Instructions
Prepare a condensed income statement for the year on both bases for comparative purposes.
5 E8-19 (FIFO and LIFO Effects) You are the vice president of finance of Sandy Alomar Corporation, a retail
company that prepared two different schedules of gross margin for the first quarter ended March 31, 2014.
These schedules appear below.
Sales Cost of Gross
($5 per unit) Goods Sold Margin
Schedule 1 $150,000 $124,900 $25,100
Schedule 2 150,000 129,400 20,600
The computation of cost of goods sold in each schedule is based on the following data.
Cost Total
Units per Unit Cost
Beginning inventory, January 1 10,000 $4.00 $40,000
Purchase, January 10 8,000 4.20 33,600
Purchase, January 30 6,000 4.25 25,500
Purchase, February 11 9,000 4.30 38,700
Purchase, March 17 11,000 4.40 48,400
Jane Torville, the president of the corporation, cannot understand how two different gross margins can be
computed from the same set of data. As the vice president of finance, you have explained to Ms. Torville
that the two schedules are based on different assumptions concerning the flow of inventory costs,
i.e., FIFO and LIFO. Schedules 1 and 2 were not necessarily prepared in this sequence of cost flow
assumptions.
Instructions
Prepare two separate schedules computing cost of goods sold and supporting schedules showing the com-
position of the ending inventory under both cost flow assumptions.
5 E8-20 (FIFO and LIFO—Periodic) Johnny Football Shop began operations on January 2, 2014. The follow-
ing stock record card for footballs was taken from the records at the end of the year.
Units Unit Invoice Gross Invoice
Date Voucher Terms Received Cost Amount
1/15 10624 Net 30 50 $20 $1,000
3/15 11437 1/5, net 30 65 16 1,040
6/20 21332 1/10, net 30 90 15 1,350
9/12 27644 1/10, net 30 84 12 1,008
11/24 31269 1/10, net 30 76 11 836
Totals 365 $5,234
A physical inventory on December 31, 2014, reveals that 100 footballs were in stock. The bookkeeper
informs you that all the discounts were taken. Assume that Johnny Football Shop uses the invoice price less
discount for recording purchases.
458 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Instructions
(a) Compute the December 31, 2014, inventory using the FIFO method.
(b) Compute the 2014 cost of goods sold using the LIFO method.
(c) What method would you recommend to the owner to minimize income taxes in 2014, using the
inventory information for footballs as a guide?
6 E8-21 (LIFO Effect) The following example was provided to encourage the use of the LIFO method. In a
nutshell, LIFO subtracts inflation from inventory costs, deducts it from taxable income, and records it in a
LIFO reserve account on the books. The LIFO benefit grows as inflation widens the gap between current-
year and past-year (minus inflation) inventory costs. This gap is:
With LIFO Without LIFO |
Revenues $3,200,000 $3,200,000
Cost of goods sold 2,800,000 2,800,000
Operating expenses 150,000 150,000
Operating income 250,000 250,000
LIFO adjustment 40,000 0
Taxable income $ 210,000 $ 250,000
Income taxes @ 36% $ 75,600 $ 90,000
Cash fl ow $ 174,400 $ 160,000
Extra cash $ 14,400 0
Increased cash fl ow 9% 0%
Instructions
(a) Explain what is meant by the LIFO reserve account.
(b) How does LIFO subtract inflation from inventory costs?
(c) Explain how the cash flow of $174,400 in this example was computed. Explain why this amount
may not be correct.
(d) Why does a company that uses LIFO have extra cash? Explain whether this situation will always
exist.
5 8 E8-22 (Alternative Inventory Methods—Comprehensive) Tori Amos Corporation began operations on
December 1, 2013. The only inventory transaction in 2013 was the purchase of inventory on December 10,
2013, at a cost of $20 per unit. None of this inventory was sold in 2013. Relevant information is as follows.
Ending inventory units
December 31, 2013 100
December 31, 2014, by purchase date
December 2, 2014 100
July 20, 2014 50 150
During the year, the following purchases and sales were made.
Purchases Sales
March 15 300 units at $24 April 10 200
July 20 300 units at 25 August 20 300
September 4 200 units at 28 November 18 150
December 2 100 units at 30 December 12 200
The company uses the periodic inventory method.
Instructions
(a) Determine ending inventory under (1) specific identification, (2) FIFO, (3) LIFO, and (4) average-cost.
(b) Determine ending inventory using dollar-value LIFO. Assume that the December 2, 2014, purchase cost
is the current cost of inventory. (Hint: The beginning inventory is the base layer priced at $20 per unit.)
8 E8-23 (Dollar-Value LIFO) Oasis Company has used the dollar-value LIFO method for inventory cost
determination for many years. The following data were extracted from Oasis’ records.
Price Ending Inventory Ending Inventory
Date Index at Base Prices at Dollar-Value LIFO
December 31, 2014 105 $92,000 $92,600
December 31, 2015 ? 97,000 98,350
Instructions
Calculate the index used for 2015 that yielded the above results.
Problems 459
8 E8-24 (Dollar-Value LIFO) The dollar-value LIFO method was adopted by Enya Corp. on January 1, 2014.
Its inventory on that date was $160,000. On December 31, 2014, the inventory at prices existing on that date
amounted to $140,000. The price level at January 1, 2014, was 100, and the price level at December 31, 2014,
was 112.
Instructions
(a) Compute the amount of the inventory at December 31, 2014, under the dollar-value LIFO method.
(b) On December 31, 2015, the inventory at prices existing on that date was $172,500, and the price level
was 115. Compute the inventory on that date under the dollar-value LIFO method.
8 E8-25 (Dollar-Value LIFO) Presented below is information related to Dino Radja Company.
Ending Inventory Price
Date (End-of-Year Prices) Index
December 31, 2011 $ 80,000 100
December 31, 2012 115,500 105
December 31, 2013 108,000 120
December 31, 2014 122,200 130
December 31, 2015 154,000 140
December 31, 2016 176,900 145
Instructions
Compute the ending inventory for Dino Radja Company for 2011 through 2016 using the dollar-value LIFO
method.
8 E8-26 (Dollar-Value LIFO) The following information relates to the Jimmy Johnson Company.
Ending Inventory Price
Date (End-of-Year Prices) Index
December 31, 2010 $ 70,000 100
December 31, 2011 90,300 105
December 31, 2012 95,120 116
December 31, 2013 105,600 120
December 31, 2014 100,000 125
Instructions
Use the dollar-value LIFO method to compute the ending inventory for Johnson Company for 2010 through
2014.
EXERCISES SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of exercises.
PROBLEMS
4 5 P8-1 (Various Inventory Issues) The following independent situations relate to inventory accounting.
8 1. Kim Co. purchased goods with a list price of $175,000, subject to trade discounts of 20% and 10%,
with no cash discounts allowable. How much should Kim Co. record as the cost of these goods?
2. Keillor Company’s inventory of $1,100,000 at December 31, 2014, was based on a physical count of |
goods priced at cost and before any year-end adjustments relating to the following items.
(a) G oods shipped from a vendor f.o.b. shipping point on December 24, 2014, at an invoice cost of
$69,000 to Keillor Company were received on January 4, 2015.
(b) T he physical count included $29,000 of goods billed to Sakic Corp. f.o.b. shipping point on
December 31, 2014. The carrier picked up these goods on January 3, 2015.
What amount should Keillor report as inventory on its balance sheet?
3. Zimmerman Corp. had 1,500 units of part M.O. on hand May 1, 2014, costing $21 each. Purchases of
part M.O. during May were as follows.
Units Unit Cost
May 9 2,000 $22.00
17 3,500 23.00
26 1,000 24.00
460 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
A physical count on May 31, 2014, shows 2,000 units of part M.O. on hand. Using the FIFO method,
what is the cost of part M.O. inventory at May 31, 2014? Using the LIFO method, what is the inven-
tory cost? Using the average-cost method, what is the inventory cost?
4. Ashbrook Company adopted the dollar-value LIFO method on January 1, 2014 (using internal price
indexes and multiple pools). The following data are available for inventory pool A for the 2 years
following adoption of LIFO.
At Base- At Current-
Inventory Year Cost Year Cost
1/1/14 $200,000 $200,000
12/31/14 240,000 264,000
12/31/15 256,000 286,720
Computing an internal price index and using the dollar-value LIFO method, at what amount should
the inventory be reported at December 31, 2015?
5. Donovan Inc., a retail store chain, had the following information in its general ledger for the year 2015.
Merchandise purchased for resale $909,400
Interest on notes payable to vendors 8,700
Purchase returns 16,500
Freight-in 22,000
Freight-out (delivery expense) 17,100
Cash discounts on purchases 6,800
What is Donovan’s inventoriable cost for 2015?
Instructions
Answer each of the preceding questions about inventories, and explain your answers.
3 4 P8-2 (Inventory Adjustments) Dimitri Company, a manufacturer of small tools, provided the following
information from its accounting records for the year ended December 31, 2014.
Inventory at December 31, 2014 (based on physical count of goods
in Dimitri’s plant, at cost, on December 31, 2014) $1,520,000
Accounts payable at December 31, 2014 1,200,000
Net sales (sales less sales returns) 8,150,000
Additional information is as follows.
1. Included in the physical count were tools billed to a customer f.o.b. shipping point on December 31,
2014. These tools had a cost of $31,000 and were billed at $40,000. The shipment was on Dimitri’s
loading dock waiting to be picked up by the common carrier.
2. Goods were in transit from a vendor to Dimitri on December 31, 2014. The invoice cost was $76,000,
and the goods were shipped f.o.b. shipping point on December 29, 2014.
3. Work in process inventory costing $30,000 was sent to an outside processor for plating on December
30, 2014.
4. Tools returned by customers and held pending inspection in the returned goods area on December
31, 2014, were not included in the physical count. On January 8, 2015, the tools costing $32,000 were
inspected and returned to inventory. Credit memos totaling $47,000 were issued to the customers on
the same date.
5. Tools shipped to a customer f.o.b. destination on December 26, 2014, were in transit at December 31,
2014, and had a cost of $26,000. Upon notification of receipt by the customer on January 2, 2015,
Dimitri issued a sales invoice for $42,000.
6. Goods, with an invoice cost of $27,000, received from a vendor at 5:00 p.m. on December 31, 2014,
were recorded on a receiving report dated January 2, 2015. The goods were not included in the
physical count, but the invoice was included in accounts payable at December 31, 2014.
7. Goods received from a vendor on December 26, 2014, were included in the physical count. How-
ever, the related $56,000 vendor invoice was not included in accounts payable at December 31, 2014,
because the accounts payable copy of the receiving report was lost.
8. On January 3, 2015, a monthly freight bill in the amount of $8,000 was received. The bill specifically |
related to merchandise purchased in December 2014, one-half of which was still in the inventory at
December 31, 2014. The freight charges were not included in either the inventory or in accounts
payable at December 31, 2014.
Problems 461
Instructions
Using the format shown below, prepare a schedule of adjustments as of December 31, 2014, to the initial
amounts per Dimitri’s accounting records. Show separately the effect, if any, of each of the eight transac-
tions on the December 31, 2014, amounts. If the transactions would have no effect on the initial amount
shown, enter NONE.
Accounts Net
Inventory Payable Sales
Initial amounts $1,520,000 $1,200,000 $8,150,000
Adjustments—increase
(decrease)
1
2
3
4
5
6
7
8
Total adjustments
Adjusted amounts $ $ $
(AICPA adapted)
4 P8-3 (Purchases Recorded Gross and Net) Some of the transactions of Torres Company during August
are listed below. Torres uses the periodic inventory method.
August 10 Purchased merchandise on account, $12,000, terms 2/10, n/30.
13 Returned part of the purchase of August 10, $1,200, and received credit on account.
15 Purchased merchandise on account, $16,000, terms 1/10, n/60.
25 Purchased merchandise on account, $20,000, terms 2/10, n/30.
2 8 Paid invoice of August 15 in full.
Instructions
(a) Assuming that purchases are recorded at gross amounts and that discounts are to be recorded when
taken:
(1) Prepare general journal entries to record the transactions.
(2) Describe how the various items would be shown in the financial statements.
(b) Assuming that purchases are recorded at net amounts and that discounts lost are treated as financial
expenses:
(1) Prepare general journal entries to enter the transactions.
(2) Prepare the adjusting entry necessary on August 31 if financial statements are to be prepared at
that time.
(3) Describe how the various items would be shown in the financial statements.
(c) Which of the two methods do you prefer and why?
2 5 P8-4 (Compute FIFO, LIFO, and Average-Cost) Hull Company’s record of transactions concerning
part X for the month of April was as follows.
Purchases Sales
April 1 (balance on hand) 100 @ $5.00 April 5 300
4 400 @ 5.10 12 200
11 300 @ 5.30 27 800
18 200 @ 5.35 28 150
26 600 @ 5.60
30 200 @ 5.80
Instructions
(a) Compute the inventory at April 30 on each of the following bases. Assume that perpetual inventory
records are kept in units only. Carry unit costs to the nearest cent.
(1) First-in, first-out (FIFO).
(2) Last-in, first-out (LIFO).
(3) Average-cost.
(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each with-
drawal, what amount would be shown as ending inventory in (1), (2), and (3) above? (Carry average
unit costs to four decimal places.)
462 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
2 5 P8-5 (Compute FIFO, LIFO, and Average-Cost) Some of the information found on a detail inventory card
for Slatkin Inc. for the first month of operations is as follows.
Received
Issued, Balance,
Date No. of Units Unit Cost No. of Units No. of Units
January 2 1,200 $3.00 1,200
7 700 500
10 600 3.20 1,100
13 500 600
18 1,000 3.30 300 1,300
20 1,100 200
23 1,300 3.40 1,500
26 800 700
28 1,600 3.50 2,300
31 1,300 1,000
Instructions
(a) From these data compute the ending inventory on each of the following bases. Assume that
perpetual inventory records are kept in units only. (Carry unit costs to the nearest cent and ending
inventory to the nearest dollar.)
(1) First-in, first-out (FIFO).
(2) Last-in, first-out (LIFO).
(3) Average-cost.
(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each with-
drawal, would the amounts shown as ending inventory in (1), (2), and (3) above be the same?
Explain and compute. (Round average unit costs to four decimal places.)
2 5 P8-6 (Compute FIFO, LIFO, Average-Cost—Periodic and Perpetual) Ehlo Company is a multiproduct
firm. Presented below is information concerning one of its products, the Hawkeye.
Date Transaction Quantity Price/Cost
1/1 Beginning inventory 1,000 $12
2/4 Purchase 2,000 18 |
2/20 Sale 2,500 30
4/2 Purchase 3,000 23
11/4 Sale 2,200 33
Instructions
Compute cost of goods sold, assuming Ehlo uses:
(a) Periodic system, FIFO cost flow. (d) Perpetual system, LIFO cost flow.
(b) Perpetual system, FIFO cost flow. (e) Periodic system, weighted-average cost flow.
(c) Periodic system, LIFO cost flow. (f) Perpetual system, moving-average cost flow.
5 P8-7 (Financial Statement Effects of FIFO and LIFO) The management of Tritt Company has asked its ac-
counting department to describe the effect upon the company’s financial position and its income statements
of accounting for inventories on the LIFO rather than the FIFO basis during 2014 and 2015. The accounting
department is to assume that the change to LIFO would have been effective on January 1, 2014, and that the
initial LIFO base would have been the inventory value on December 31, 2013. Presented below are the com-
pany’s financial statements and other data for the years 2014 and 2015 when the FIFO method was employed.
Financial Position as of
12/31/13 12/31/14 12/31/15
Cash $ 90,000 $130,000 $154,000
Accounts receivable 80,000 100,000 120,000
Inventory 120,000 140,000 176,000
Other assets 160,000 170,000 200,000
Total assets $450,000 $540,000 $650,000
Accounts payable $ 40,000 $ 60,000 $ 80,000
Other liabilities 70,000 80,000 110,000
Common stock 200,000 200,000 200,000
Retained earnings 140,000 200,000 260,000
Total liabilities and equity $450,000 $540,000 $650,000
Problems 463
Income for Years Ended
12/31/14 12/31/15
Sales revenue $900,000 $1,350,000
Less: Cost of goods sold 505,000 756,000
Other expenses 205,000 304,000
710,000 1,060,000
Income before income taxes 190,000 290,000
Income taxes (40%) 76,000 116,000
Net income $114,000 $ 174,000
Other data:
1. Inventory on hand at December 31, 2013, consisted of 40,000 units valued at $3.00 each.
2. Sales (all units sold at the same price in a given year):
2014—150,000 units @ $6.00 each 2015—180,000 units @ $7.50 each
3. Purchases (all units purchased at the same price in given year):
2014—150,000 units @ $3.50 each 2015—180,000 units @ $4.40 each
4. Income taxes at the effective rate of 40% are paid on December 31 each year.
Instructions
Name the account(s) presented in the financial statements that would have different amounts for 2015 if
LIFO rather than FIFO had been used, and state the new amount for each account that is named. Show
computations.
(CMA adapted)
8 P8-8 (Dollar-Value LIFO) Norman’s Televisions produces television sets in three categories: portable,
midsize, and flat-screen. On January 1, 2014, Norman adopted dollar-value LIFO and decided to use a
single inventory pool. The company’s January 1 inventory consists of:
Category Quantity Cost per Unit Total Cost
Portable 6,000 $100 $ 600,000
Midsize 8,000 250 2,000,000
Flat-screen 3,000 400 1,200,000
17,000 $3,800,000
During 2014, the company had the following purchases and sales.
Quantity Quantity Selling Price
Category Purchased Cost per Unit Sold per Unit
Portable 15,000 $110 14,000 $150
Midsize 20,000 300 24,000 405
Flat-screen 10,000 500 6,000 600
45,000 44,000
Instructions
(Round to four decimals.)
(a) Compute ending inventory, cost of goods sold, and gross profit.
(b) Assume the company uses three inventory pools instead of one. Repeat instruction (a).
8 P8-9 (Internal Indexes—Dollar-Value LIFO) On January 1, 2014, Bonanza Wholesalers Inc. adopted the
dollar-value LIFO inventory method for income tax and external financial reporting purposes. However,
Bonanza continued to use the FIFO inventory method for internal accounting and management purposes.
In applying the LIFO method, Bonanza uses internal conversion price indexes and the multiple pools ap-
proach under which substantially identical inventory items are grouped into LIFO inventory pools. The
following data were available for inventory pool no. 1, which comprises products A and B, for the 2 years
following the adoption of LIFO.
464 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
FIFO Basis per Records
Unit Total
Units Cost Cost
Inventory, 1/1/14 |
Product A 10,000 $30 $300,000
Product B 9,000 25 225,000
$525,000
Inventory, 12/31/14
Product A 17,000 36 $612,000
Product B 9,000 26 234,000
$846,000
Inventory, 12/31/15
Product A 13,000 40 $520,000
Product B 10,000 32 320,000
$840,000
Instructions
(a) Prepare a schedule to compute the internal conversion price indexes for 2014 and 2015. Round
indexes to two decimal places.
(b) Prepare a schedule to compute the inventory amounts at December 31, 2014 and 2015, using the
dollar-value LIFO inventory method.
(AICPA adapted)
8 P8-10 (Internal Indexes—Dollar-Value LIFO) Presented below is information related to Kaisson Corpo-
ration for the last 3 years.
Quantities Base-Year Cost Current-Year Cost
in Ending
Item Inventories Unit Cost Amount Unit Cost Amount
December 31, 2013
A 9,000 $2.00 $18,000 $2.20 $19,800
B 6,000 3.00 18,000 3.55 21,300
C 4,000 5.00 20,000 5.40 21,600
Totals $56,000 $62,700
December 31, 2014
A 9,000 $2.00 $18,000 $2.60 $23,400
B 6,800 3.00 20,400 3.75 25,500
C 6,000 5.00 30,000 6.40 38,400
Totals $68,400 $87,300
December 31, 2015
A 8,000 $2.00 $16,000 $2.70 $21,600
B 8,000 3.00 24,000 4.00 32,000
C 6,000 5.00 30,000 6.20 37,200
Totals $70,000 $90,800
Instructions
Compute the ending inventories under the dollar-value LIFO method for 2013, 2014, and 2015. The base
period is January 1, 2013, and the beginning inventory cost at that date was $45,000. Compute indexes to
two decimal places.
8 P8-11 (Dollar-Value LIFO) Richardson Company cans a variety of vegetable-type soups. Recently, the
company decided to value its inventories using dollar-value LIFO pools. The clerk who accounts for inven-
tories does not understand how to value the inventory pools using this new method, so, as a private con-
sultant, you have been asked to teach him how this new method works.
Concepts for Analysis 465
He has provided you with the following information about purchases made over a 6-year period.
Ending Inventory
Date (End-of-Year Prices) Price Index
Dec. 31, 2010 $ 80,000 100
Dec. 31, 2011 111,300 105
Dec. 31, 2012 108,000 120
Dec. 31, 2013 128,700 130
Dec. 31, 2014 147,000 140
Dec. 31, 2015 174,000 145
You have already explained to him how this inventory method is maintained, but he would feel better
about it if you were to leave him detailed instructions explaining how these calculations are done and why
he needs to put all inventories at a base-year value.
Instructions
(a) Compute the ending inventory for Richardson Company for 2010 through 2015 using dollar-value
LIFO.
(b) Using your computation schedules as your illustration, write a step-by-step set of instructions
explaining how the calculations are done. Begin your explanation by briefly explaining the theory
behind this inventory method, including the purpose of putting all amounts into base-year price levels.
PROBLEMS SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of problems.
CONCEPTS FOR ANALYSIS
CA8-1 (Inventoriable Costs) You are asked to travel to Milwaukee to observe and verify the inventory of
the Milwaukee branch of one of your clients. You arrive on Thursday, December 30, and find that the inven-
tory procedures have just been started. You spot a railway car on the sidetrack at the unloading door and
ask the warehouse superintendent, Buck Rogers, how he plans to inventory the contents of the car. He
responds, “We are not going to include the contents in the inventory.”
Later in the day, you ask the bookkeeper for the invoice on the carload and the related freight bill. The
invoice lists the various items, prices, and extensions of the goods in the car. You note that the carload was
shipped December 24 from Albuquerque, f.o.b. Albuquerque, and that the total invoice price of the goods
in the car was $35,300. The freight bill called for a payment of $1,500. Terms were net 30 days. The book-
keeper affirms the fact that this invoice is to be held for recording in January.
Instructions
(a) Does your client have a liability that should be recorded at December 31? Discuss.
(b) Prepare a journal entry(ies), if required, to reflect any accounting adjustment required. Assume a |
perpetual inventory system is used by your client.
(c) For what possible reason(s) might your client wish to postpone recording the transaction?
CA8-2 (Inventoriable Costs) Brian Erlacher, an inventory control specialist, is interested in better under-
standing the accounting for inventories. Although Brian understands the more sophisticated computer
inventory control systems, he has little knowledge of how inventory cost is determined. In studying the
records of Strider Enterprises, which sells normal brand-name goods from its own store and on consign-
ment through Chavez Inc., he asks you to answer the following questions.
Instructions
(a) Should Strider Enterprises include in its inventory normal brand-name goods purchased from its
suppliers but not yet received if the terms of purchase are f.o.b. shipping point (manufacturer’s
plant)? Why?
(b) Should Strider Enterprises include freight-in expenditures as an inventory cost? Why?
(c) If Strider Enterprises purchases its goods on terms 2/10, net 30, should the purchases be recorded
gross or net? Why?
(d) What are products on consignment? How should they be reported in the financial statements?
(AICPA adapted)
466 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
CA8-3 (Inventoriable Costs) George Solti, the controller for Garrison Lumber Company, has recently
hired you as assistant controller. He wishes to determine your expertise in the area of inventory accounting
and therefore asks you to answer the following unrelated questions.
(a) A company is involved in the wholesaling and retailing of automobile tires for foreign cars. Most of
the inventory is imported, and it is valued on the company’s records at the actual inventory cost
plus freight-in. At year-end, the warehousing costs are prorated over cost of goods sold and ending
inventory. Are warehousing costs considered a product cost or a period cost?
(b) A certain portion of a company’s “inventory” is composed of obsolete items. Should obsolete items
that are not currently consumed in the production of “goods or services to be available for sale” be
classified as part of inventory?
(c) A company purchases airplanes for sale to others. However, until they are sold, the company char-
ters and services the planes. What is the proper way to report these airplanes in the company’s
financial statements?
(d) A company wants to buy coal deposits but does not want the financing for the purchase to be
reported on its financial statements. The company therefore establishes a trust to acquire the coal
deposits. The company agrees to buy the coal over a certain period of time at specified prices. The
trust is able to finance the coal purchase and pay off the loan as it is paid by the company for the
minerals. How should this transaction be reported?
CA8-4 (Accounting Treatment of Purchase Discounts) Shawnee Corp., a household appliances dealer,
purchases its inventories from various suppliers. Shawnee has consistently stated its inventories at the
lower-of-cost (FIFO)-or-market.
Instructions
Shawnee is considering alternate methods of accounting for the cash discounts it takes when paying
its suppliers promptly. From a theoretical standpoint, discuss the acceptability of each of the following
methods.
(a) Financial income when payments are made.
(b) Reduction of cost of goods sold for the period when payments are made.
(c) Direct reduction of purchase cost.
(AICPA adapted)
CA8-5 (General Inventory Issues) In January 2014, Susquehanna Inc. requested and secured permission
from the commissioner of the Internal Revenue Service to compute inventories under the last-in, first-out
(LIFO) method and elected to determine inventory cost under the dollar-value LIFO method. Susquehanna
Inc. satisfied the commissioner that cost could be accurately determined by use of an index number com-
puted from a representative sample selected from the company’s single inventory pool.
Instructions
(a) Why should inventories be included in (1) a balance sheet and (2) the computation of net income?
(b) The Internal Revenue Code allows some accountable events to be considered differently for in- |
come tax reporting purposes and financial accounting purposes, while other accountable events
must be reported the same for both purposes. Discuss why it might be desirable to report some
accountable events differently for financial accounting purposes than for income tax reporting
purposes.
(c) Discuss the ways and conditions under which the FIFO and LIFO inventory costing methods pro-
duce different inventory valuations. Do not discuss procedures for computing inventory cost.
(AICPA adapted)
CA8-6 (LIFO Inventory Advantages) Jane Yoakam, president of Estefan Co., recently read an article
that claimed that at least 100 of the country’s largest 500 companies were either adopting or considering
adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms
were switching to LIFO to (1) neutralize the effect of inflation in their financial statements, (2) eliminate
inventory profits, and (3) reduce income taxes. Ms. Yoakam wonders if the switch would benefit her
company.
Estefan currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inven-
tory system. The company has a high inventory turnover rate, and inventories represent a significant pro-
portion of the assets.
Ms. Yoakam has been told that the LIFO system is more costly to operate and will provide little benefit
to companies with high turnover. She intends to use the inventory method that is best for the company in
the long run rather than selecting a method just because it is the current fad.
Concepts for Analysis 467
Instructions
(a) Explain to Ms. Yoakam what “inventory profits” are and how the LIFO method of inventory valua-
tion could reduce them.
(b) Explain to Ms. Yoakam the conditions that must exist for Estefan Co. to receive tax benefits from a
switch to the LIFO method.
CA8-7 (Average-Cost, FIFO, and LIFO) Prepare a memorandum containing responses to the following
items.
(a) Describe the cost flow assumptions used in average-cost, FIFO, and LIFO methods of inventory
valuation.
(b) Distinguish between weighted-average-cost and moving-average-cost for inventory costing purposes.
(c) Identify the effects on both the balance sheet and the income statement of using the LIFO method
instead of the FIFO method for inventory costing purposes over a substantial time period when
purchase prices of inventoriable items are rising. State why these effects take place.
CA8-8 (LIFO Application and Advantages) Geddes Corporation is a medium-sized manufacturing com-
pany with two divisions and three subsidiaries, all located in the United States. The Metallic Division
manufactures metal castings for the automotive industry, and the Plastic Division produces small plastic
items for electrical products and other uses. The three subsidiaries manufacture various products for other
industrial users.
Geddes Corporation plans to change from the lower of first-in, first-out (FIFO)-cost-or market method
of inventory valuation to the last-in, first-out (LIFO) method of inventory valuation to obtain tax benefits.
To make the method acceptable for tax purposes, the change also will be made for its annual financial
statements.
Instructions
(a) Describe the establishment of and subsequent pricing procedures for each of the following LIFO
inventory methods.
(1) LIFO applied to units of product when the periodic inventory system is used.
(2) Application of the dollar-value method to LIFO units of product.
(b) Discuss the specific advantages and disadvantages of using the dollar-value LIFO application as
compared to specific goods LIFO (unit LIFO). (Ignore income tax considerations.)
(c) Discuss the general advantages and disadvantages claimed for LIFO methods.
CA8-9 (Dollar-Value LIFO Issues) Arruza Co. is considering switching from the specific-goods LIFO
approach to the dollar-value LIFO approach. Because the financial personnel at Arruza know very little
about dollar-value LIFO, they ask you to answer the following questions.
(a) What is a LIFO pool?
(b) Is it possible to use a LIFO pool concept and not use dollar-value LIFO? Explain. |
(c) What is a LIFO liquidation?
(d) How are price indexes used in the dollar-value LIFO method?
(e) What are the advantages of dollar-value LIFO over specific-goods LIFO?
CA8-10 (FIFO and LIFO) Harrisburg Company is considering changing its inventory valuation method
from FIFO to LIFO because of the potential tax savings. However, management wishes to consider all of
the effects on the company, including its reported performance, before making the final decision.
The inventory account, currently valued on the FIFO basis, consists of 1,000,000 units at $8 per unit on
January 1, 2014. There are 1,000,000 shares of common stock outstanding as of January 1, 2014, and the cash
balance is $400,000.
The company has made the following forecasts for the period 2014–2016.
2014 2015 2016
Unit sales (in millions of units) 1.1 1.0 1.3
Sales price per unit $10 $12 $12
Unit purchases (in millions of units) 1.0 1.1 1.2
Purchase price per unit $8 $9 $10
Annual depreciation (in thousands of dollars) $300 $300 $300
Cash dividends per share $0.15 $0.15 $0.15
Cash payments for additions to and replacement of
plant and equipment (in thousands of dollars) $350 $350 $350
Income tax rate 40% 40% 40%
Operating expenses (exclusive of depreciation) as a
percent of sales 15% 15% 15%
Common shares outstanding (in millions) 1 1 1
468 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Instructions
(a) Prepare a schedule that illustrates and compares the following data for Harrisburg Company under
the FIFO and the LIFO inventory method for 2014–2016. Assume the company would begin LIFO
at the beginning of 2014.
(1) Year-end inventory balances. (3) Earnings per share.
(2) Annual net income after taxes. (4) Cash balance.
Assume all sales are collected in the year of sale and all purchases, operating expenses, and taxes are
paid during the year incurred.
(b) Using the data above, your answer to (a), and any additional issues you believe need to be consid-
ered, prepare a report that recommends whether or not Harrisburg Company should change to the
LIFO inventory method. Support your conclusions with appropriate arguments.
(CMA adapted)
CA8-11 (LIFO Choices) Wilkens Company uses the LIFO method for inventory costing. In an effort to
lower net income, company president Mike Wilkens tells the plant accountant to take the unusual step of
recommending to the purchasing department a large purchase of inventory at year-end. The price of the
item to be purchased has nearly doubled during the year, and the item represents a major portion of inven-
tory value.
Instructions
Answer the following questions.
(a) Identify the major stakeholders. If the plant accountant recommends the purchase, what are the
consequences?
(b) If Wilkens Company were using the FIFO method of inventory costing, would Mike Wilkens give
the same order? Why or why not?
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Statement Analysis Cases
Case 1 T J International
T J International was founded in 1969 as Trus Joist International. The firm, a manufacturer of specialty
building products, has its headquarters in Boise, Idaho. The company, through its partnership in the Trus
Joist MacMillan joint venture, develops and manufactures engineered lumber. This product is a high-quality
substitute for structural lumber and uses lower-grade wood and materials formerly considered waste. The
company also is majority owner of the Outlook Window Partnership, which is a consortium of three wood
and vinyl window manufacturers.
Following is T J International’s adapted income statement and information concerning inventories
from its annual report.
T J International
Sales $618,876,000
Cost of goods sold 475,476,000
Gross profit 143,400,000
Selling and administrative expenses 102,112,000
Income from operations 41,288,000
Other expense 24,712,000
Income before income tax 16,576,000
Income taxes 7,728,000
Net income $ 8,848,000
Using Your Judgment 469
Inventories. Inventories are valued at the lower of cost or market and include material, labor, and
production overhead costs. Inventories consisted of the following: |
Current Year Prior Year
Finished goods $27,512,000 $23,830,000
Raw materials and
work-in-progress 34,363,000 33,244,000
61,875,000 57,074,000
Reduction to LIFO cost (5,263,000) (3,993,000)
$56,612,000 $53,081,000
The last-in, first-out (LIFO) method is used for determining the cost of lumber, veneer, Microllam lumber,
TJI joists, and open web joists. Approximately 35 percent of total inventories at the end of the current year
were valued using the LIFO method. The first-in, first-out (FIFO) method is used to determine the cost of
all other inventories.
Instructions
(a) How much would income before taxes have been if FIFO costing had been used to value all
inventories?
(b) If the income tax rate is 46.6%, what would income tax have been if FIFO costing had been used to
value all inventories? In your opinion, is this difference in net income between the two methods mate-
rial? Explain.
(c) Does the use of a different costing system for different types of inventory mean that there is a different
physical flow of goods among the different types of inventory? Explain.
Case 2 Noven Pharmaceuticals, Inc.
Noven Pharmaceuticals, Inc., headquartered in Miami, Florida, describes itself in a recent annual report as
follows.
Noven Pharmaceuticals, Inc.
Noven is a place of ideas—a company where scientific excellence and state-of-the-art manufacturing
combine to create new answers to human needs. Our transdermal delivery systems speed drugs painlessly
and effortlessly into the bloodstream by means of a simple skin patch. This technology has proven
applications in estrogen replacement, but at Noven we are developing a variety of systems incorporating
bestselling drugs that fight everything from asthma, anxiety and dental pain to cancer, heart disease and
neurological illness. Our research portfolio also includes new technologies, such as iontophoresis, in
which drugs are delivered through the skin by means of electrical currents, as well as products that could
satisfy broad consumer needs, such as our anti-microbial mouthrinse.
Noven also reported in its annual report that its activities to date have consisted of product
development efforts, some of which have been independent and some of which have been completed in
conjunction with Rhone-Poulenc Rorer (RPR) and Ciba-Geigy. The revenues so far have consisted of
money received from licensing fees, “milestone” payments (payments made under licensing agreements
when certain stages of the development of a certain product have been completed), and interest on its
investments. The company expects that it will have significant revenue in the upcoming fiscal year from
the launch of its first product, a transdermal estrogen delivery system.
The current assets portion of Noven’s balance sheet follows.
Cash and cash equivalents $12,070,272
Securities held to maturity 23,445,070
Inventory of supplies 1,264,553
Prepaid and other current assets 825,159
Total current assets $37,605,054
Inventory of supplies is recorded at the lower-of-cost (first-in, first-out)-or-net realizable value and consists
mainly of supplies for research and development.
470 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Instructions
(a) What would you expect the physical flow of goods for a pharmaceutical manufacturer to be most like:
FIFO, LIFO, or random (flow of goods does not follow a set pattern)? Explain.
(b) What are some of the factors that Noven should consider as it selects an inventory measurement
method?
(c) Suppose that Noven had $49,000 in an inventory of transdermal estrogen delivery patches. These
patches are from an initial production run and will be sold during the coming year. Why do you think
that this amount is not shown in a separate inventory account? In which of the accounts shown is the
inventory likely to be? At what point will the inventory be transferred to a separate inventory account?
Case 3 SUPERVALU
SUPERVALU reported the following data in its annual report.
Feb. 27, Feb. 26, Feb. 25,
2010 2011 2012
Total revenues $40,597 $37,534 $36,100
Cost of sales (using LIFO) 31,444 29,124 28,010 |
Year-end inventories using FIFO 2,606 2,552 2,492
Year-end inventories using LIFO 2,342 2,270 2,150
(a) Compute SUPERVALU’s inventory turnovers for 2011 and 2012, using:
(1) Cost of sales and LIFO inventory.
(2) Cost of sales and FIFO inventory.
(b) Some firms calculate inventory turnover using sales rather than cost of goods sold in the numerator.
Calculate SUPERVALU’s 2011 and 2012 turnover, using:
(1) Sales and LIFO inventory.
(2) Sales and FIFO inventory.
(c) Describe the method that SUPERVALU’s appears to use.
(d) State which method you would choose to evaluate SUPERVALU’s performance. Justify your choice.
Accounting, Analysis, and Principles
Englehart Company sells two types of pumps. One is large and is for commercial use. The other is smaller
and is used in residential swimming pools. The following inventory data is available for the month of
March.
Price per
Units Unit Total
Residential Pumps
Inventory at Feb. 28: 200 $ 400 $ 80,000
Purchases:
March 10 500 $ 450 $225,000
March 20 400 $ 475 $190,000
March 30 300 $ 500 $150,000
Sales:
March 15 500 $ 540 $270,000
March 25 400 $ 570 $228,000
Inventory at March 31: 500
Commercial Pumps
Inventory at Feb. 28: 600 $ 800 $480,000
Purchases:
March 3 600 $ 900 $540,000
March 12 300 $ 950 $285,000
March 21 500 $1,000 $500,000
Sales:
March 18 900 $1,080 $972,000
March 29 600 $1,140 $684,000
Inventory at March 31: 500
Using Your Judgment 471
Accounting
(a) Assuming Englehart uses a periodic inventory system, determine the cost of inventory on hand at
March 31 and the cost of goods sold for March under first-in, first-out (FIFO).
(b) Assume Englehart uses dollar-value LIFO and one pool, consisting of the combination of residential
and commercial pumps. Determine the cost of inventory on hand at March 31 and the cost of goods
sold for March. Assume Englehart’s initial adoption of LIFO is on March 1. Use the double-extension
method to determine the appropriate price indices. (Hint: The price index for February 28/March 1
should be 1.00.) (Round the index to three decimal places.)
Analysis
(a) Assume you need to compute a current ratio for Englehart. Which inventory method (FIFO or dollar-
value LIFO) do you think would give you a more meaningful current ratio?
(b) Some of Englehart’s competitors use LIFO inventory costing and some use FIFO. How can an analyst
compare the results of companies in an industry, when some use LIFO and others use FIFO?
Principles
Can companies change from one inventory accounting method to another? If a company changes to an
inventory accounting method used by most of its competitors, what are the trade-offs in terms of the con-
ceptual framework discussed in Chapter 2 of the textbook?
BRIDGE TO THE PROFESSION
Professional Research: FASB Codifi cation
In conducting year-end inventory counts, your audit team is debating the impact of the client’s right of
return policy both on inventory valuation and revenue recognition. The assistant controller argues that
there is no need to worry about the return policies since they have not changed in a while. The audit senior
wants a more authoritative answer and has asked you to conduct some research of the authoritative litera-
ture before she presses the point with the client.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and
prepare responses to the following. Provide Codification references for your responses.
(a) What is the authoritative guidance for revenue recognition when right of return exists?
(b) When is this guidance important for a company?
(c) Sales with high rates of return can ultimately cause inventory to be misstated. Why are returns
allowed? Should different industries be able to make different types of return policies?
(d) In what situations would a reasonable estimate of returns be difficult to make?
Additional Professional Resources
See the book’s companion website, at www.wiley.com/college/kieso, for professional
simulations as well as other study resources.
Remember to check the book’s companion website to fi nd additional |
resources for this chapter.
Inventories: Additional
Valuation Issues
1 Describe and apply the lower-of-cost-or-market rule. 5 Determine ending inventory by applying the gross
profit method.
2 Explain when companies value inventories at net
realizable value. 6 Determine ending inventory by applying the retail
inventory method.
3 Explain when companies use the relative sales
value method to value inventories. 7 Explain how to report and analyze inventory.
4 Discuss accounting issues related to purchase
commitments.
Not What It Seems to Be
Investors need comparable information about inventory when evaluating a retailer’s financial statements.
To do so, investors need to determine what inventory method a retailer is using (FIFO, LIFO, average-cost,
or a combination of methods) and then adjust the company to a common method. That is a good start.
What investors often then do is compute relevant information about the company such as inventory turn-
over, number of days sales in inventory, gross profit rate, and liquidity measures such as the acid-test ratio.
These calculations are critical. Inventory is a significant component of working capital and the gross profit
resulting from sales of inventory is often viewed as the most important income component in measuring a
retailer’s progress. For example, consider the financial statements of Best Buy shown in the following
table. Inventory comprises over 50 percent of current assets, and gross profit represents 24 percent of
sales revenue.
Therefore, analysis is based on these numbers. However, there often are still questions about the
reliability of the information reported in the financial statements. That is, subjective estimates are involved
because of the possible impairment of the inventory. For example, Best Buy provides disclosures related to
inventory in its annual report, shown on the next page.
RETPAHC 9
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
BEST BUY
($ IN MILLIONS)
Consolidated Balance Sheets Consolidated Statements of Earnings
Current Assets Revenue $50,705
Cash and cash equivalents $ 1,199 Cost of goods sold 38,132
Receivables 2,288
Gross profit $12,573
Merchandise inventories 5,731
Other current assets 1,101 Net income (loss) $ (1,231)
Total current assets $10,319
CONCEPTUAL FOCUS
> See the Underlying Concepts on pages 479,
480, and 484.
INTERNATIONAL FOCUS
As indicated in the table below, subjective estimates con-
cerning the measurement and valuation of inventory (related to
> See the International Perspectives on
markdowns and inventory losses) could have a significant im-
pages 474, 475, and 482.
pact on an investor’s ability to compare inventory levels (and their
> Read the IFRS Insights on pages 525–534
impact on gross profit) at Best Buy relative to other retailers.
for a discussion of:
Thus, inventory balances may not be what they seem, not only
— Lower-of-cost-or-net
due to the cost flow assumptions (e.g., LIFO/FIFO) you learned
realizable value (LCNRV)
about in Chapter 8 but also due to significant markdowns and
—Agricultural inventory
losses that you will learn about in this chapter.
Critical Accounting Estimates in Preparation
of the Financial Statements: Inventory Judgments and Uncertainties
We value our inventory at the lower of cost or market through the
establishment of markdown and inventory loss adjustments.
Our inventory valuation reflects markdowns for the excess of the cost Our markdown adjustment contains uncertainties because the
over the amount we expect to realize from the ultimate sale or other calculation requires management to make assumptions and to apply
disposal of the inventory. Markdowns establish a new cost basis for our judgment regarding inventory aging, forecast consumer demand, the
inventory. Subsequent changes in facts or circumstances do not result promotional environment and technological obsolescence.
in the reversal of previously recorded markdowns or an increase in that
∂
newly established cost basis.
Our inventory valuation also reflects adjustments for anticipated physical Our inventory loss adjustment contains uncertainties because the |
inventory losses (e.g., theft) that have occurred since the last physical calculation requires management to make assumptions and to apply
inventory. Physical inventory counts are taken on a regular basis to judgment regarding a number of factors, including historical results and
ensure that the inventory reported in our consolidated financial current inventory loss trends.
∂
statements is properly stated.
As our opening story indicates, information on inventories is
PREVIEW OF CHAPTER 9
important to investors. In this chapter, we discuss some of the
valuation and estimation concepts that companies use to develop
relevant inventory information. The content and organization of the chapter are as follows.
Inventories: Additional
Valuation Issues
Lower-of-Cost- Valuation Gross Profit Retail Inventory Presentation
or-Market Bases Method Method and Analysis
• Ceiling and floor • Net realizable value • Gross profit • Concepts • Presentation
• How LCM works • Relative sales value percentage • Conventional method • Analysis
• Application of LCM • Purchase • Evaluation of • Special items
• “Market” commitments method • Evaluation of method
• Use of allowance
• Multiple periods
• Evaluation of rule
473
474 Chapter 9 Inventories: Additional Valuation Issues
LOWER-OF-COST-OR-MARKET
Inventories are recorded at their cost. However, if inventory declines in value
LEARNING OBJECTIVE 1
below its original cost, a major departure from the historical cost principle occurs.
Describe and apply the lower-of-
Whatever the reason for a decline—obsolescence, price-level changes, or damaged
cost-or-market rule.
goods—a company should write down the inventory to market to report this loss.
A company abandons the historical cost principle when the future utility (revenue-
producing ability) of the asset drops below its original cost. Companies therefore report
inventories at the lower-of-cost-or-market at each reporting period.
Illustration 9-1 shows how Target and Best Buy reported this information.
ILLUSTRATION 9-1
Target
Lower-of-Cost-or-Market
(in millions) As of January 28, 2012
Disclosures
Current Assets
Inventory $7,918
Notes to Consolidated Financial Statements (in part)
11. Inventory
Substantially all inventory and the related cost of sales are accounted for under the retail inventory
accounting method (RIM) using the last-in, first-out (LIFO) method. Inventory is stated at the lower of LIFO
cost or market. Cost includes purchase price as reduced by vendor income. Inventory is also reduced for
estimated losses related to shrinkage and markdowns. The LIFO provision is calculated based on inventory
levels, markup rates and internally measured retail price indices.
Best Buy
(in millions) March 3, 2012
Current Assets
Merchandise inventories $5,731
Summary of Significant Accounting Policies (in part)
Merchandise inventories are recorded at the lower of cost using either the average cost or first-in-first-out
method, or market.
International Recall that cost is the acquisition price of inventory computed using one of
Perspective the historical cost-based methods—specific identification, average-cost, FIFO, or
LIFO. The term market in the phrase “the lower-of-cost-or-market” (LCM) gener-
IFRS defi nes market as net
realizable value; GAAP defi nes ally means the cost to replace the item by purchase or reproduction. For a retailer
market as replacement cost like Nordstrom, the term “market” refers to the market in which it purchases
subject to certain constraints. goods, not the market in which it sells them. For a manufacturer like William
Wrigley Jr., the term “market” refers to the cost to reproduce. Thus the rule really
means that companies value goods at cost or cost to replace, whichever is lower.
For example, say Target purchased a Timex wristwatch for $30 for resale. Target can
sell the wristwatch for $48.95 and replace it for $25. It should therefore value the wrist-
watch at $25 for inventory purposes under the lower-of-cost-or-market rule. Target can
use the lower-of-cost-or-market rule of valuation after applying any of the cost flow |
methods discussed above to determine the inventory cost.
A departure from cost is justified because a company should charge a loss of utility
against revenues in the period in which the loss occurs, not in the period of sale. Note
Lower-of-Cost-or-Market 475
also that the lower-of-cost-or-market method is a conservative approach to inventory
valuation. That is, when doubt exists about the value of an asset, a company should use
the lower value for the asset, which also reduces net income.
Ceiling and Floor
Why use replacement cost to represent market value? Because a decline in the replace-
ment cost of an item usually reflects or predicts a decline in selling price. Using replace-
ment cost allows a company to maintain a consistent rate of gross profit on sales (normal
profit margin). Sometimes, however, a reduction in the replacement cost of an item fails
to indicate a corresponding reduction in its utility. This requires using two additional
valuation limitations to value ending inventory—net realizable value and net realizable
value less a normal profit margin.
Net realizable value (NRV) is the estimated selling price in the ordinary course of
business, less reasonably predictable costs of completion and disposal (often referred to
as net selling price). A normal profit margin is subtracted from that amount to arrive at
net realizable value less a normal profit margin.
To illustrate, assume that Jerry Mander Corp. has unfinished inventory with a sales
value of $1,000, estimated cost of completion and disposal of $300, and a normal profit
margin of 10 percent of sales. Jerry Mander determines the following net realizable value.
ILLUSTRATION 9-2
Inventory—sales value $1,000
Computation of Net
Less: Estimated cost of completion and disposal 300
Realizable Value
Net realizable value 700
Less: Allowance for normal profit margin (10% of sales) 100
Net realizable value less a normal profit margin $ 600
The general lower-of-cost-or-market rule is: A company values inventory at the See the FASB
lower-of-cost-or-market, with market limited to an amount that is not more than net Codification section
(page 504).
realizable value or less than net realizable value less a normal profit margin. [1]
The upper limit (ceiling) is the net realizable value of inventory. The lower limit
(floor) is the net realizable value less a normal profit margin. What is the rationale for
these two limitations? Establishing these limits for the value of the inventory prevents
companies from over- or understating inventory.
The maximum limitation, not to exceed the net realizable value (ceiling), prevents
overstatement of the value of obsolete, damaged, or shopworn inventories. That is, if
the replacement cost of an item exceeds its net realizable value, a company should not
report inventory at replacement cost. The company can receive only the selling price
less cost of disposal. To report the inventory at replacement cost would result in an over-
statement of inventory and understatement of the loss in the current period.
To illustrate, assume that Staples paid $1,000 for a color laser printer that it can now
replace for $900. The printer’s net realizable value is $700. At what amount should
Staples report the laser printer in its financial statements? To report the replacement cost
of $900 overstates the ending inventory and understates the loss for the period. Therefore,
Staples should report the printer at $700.
The minimum limitation (floor) is not to be less than net realizable value International
reduced by an allowance for an approximately normal profit margin. The Perspective
floor establishes a value below which a company should not price inventory,
IFRS does not use a ceiling or
regardless of replacement cost. It makes no sense to price inventory below net
fl oor to determine market.
realizable value less a normal margin. This minimum amount (floor) measures
476 Chapter 9 Inventories: Additional Valuation Issues
what the company can receive for the inventory and still earn a normal profit. Use of a
floor deters understatement of inventory and overstatement of the loss in the current
period. |
Illustration 9-3 graphically presents the guidelines for valuing inventory at the
lower-of-cost-or-market.
ILLUSTRATION 9-3
Inventory Valuation—
Ceiling
Lower-of-Cost-or-Market
NRV
Not
More
Than
Cost Market Replacement
Cost
Not
Less
Than
GAAP
NRV Less
Lower-of-Cost- Normal Profit
or-Market Margin
Floor
How Lower-of-Cost-or-Market Works
The designated market value is the amount that a company compares to cost. It is
always the middle value of three amounts: replacement cost, net realizable value, and
net realizable value less a normal profit margin. To illustrate how to compute desig-
nated market value, assume the information relative to the inventory of Regner Foods,
Inc., as shown in Illustration 9-4.
ILLUSTRATION 9-4
Net Realizable
Computation of
Net Value Less a
Designated Market Value
Realizable Normal Profit Designated
Replacement Value Margin Market
Food Cost (Ceiling) (Floor) Value
Spinach $ 88,000 $120,000 $104,000 $104,000
Carrots 90,000 100,000 70,000 90,000
Cut beans 45,000 40,000 27,500 40,000
Peas 36,000 72,000 48,000 48,000
Mixed vegetables 105,000 92,000 80,000 92,000
Designated Market Value Decision:
Spinach N et realizable value less a normal profit margin is selected because it is the middle
value.
Carrots Replacement cost is selected because it is the middle value.
Cut beans Net realizable value is selected because it is the middle value.
Peas Net realizable value less a normal profit margin is selected because it is the middle
value.
Mixed vegetables Net realizable value is selected because it is the middle value.
Regner Foods then compares designated market value to cost to determine the lower-
of-cost-or-market. It determines the final inventory value as shown in Illustration 9-5.
Lower-of-Cost-or-Market 477
ILLUSTRATION 9-5
Net Realizable
Determining Final
Net Value Less a
Inventory Value
Realizable Normal Profit Designated Final
Replacement Value Margin Market Inventory
Food Cost Cost (Ceiling) (Floor) Value Value
Spinach $ 80,000 $ 88,000 $120,000 $104,000 $104,000 $ 80,000
Carrots 100,000 90,000 100,000 70,000 90,000 90,000
Cut beans 50,000 45,000 40,000 27,500 40,000 40,000
Peas 90,000 36,000 72,000 48,000 48,000 48,000
Mixed
vegetables 95,000 105,000 92,000 80,000 92,000 92,000
$350,000
Final Inventory Value:
Spinach C ost ($80,000) is selected because it is lower than designated market value (net
realizable value less a normal profit margin).
Carrots D esignated market value (replacement cost, $90,000) is selected because it is
lower than cost.
Cut beans Designated market value (net realizable value, $40,000) is selected because it is
lower than cost.
Peas Designated market value (net realizable value less a normal profit margin, $48,000)
is selected because it is lower than cost.
Mixed vegetables Designated market value (net realizable value, $92,000) is selected because it is
lower than cost.
The application of the lower-of-cost-or-market rule incorporates only losses in value
that occur in the normal course of business from such causes as style changes, shift in
demand, or regular shop wear. A company reduces damaged or deteriorated goods to net
realizable value. When material, it may carry such goods in separate inventory accounts.
Methods of Applying Lower-of-Cost-or-Market
In the Regner Foods illustration, we assumed that the company applied the lower-of-
cost-or-market rule to each individual type of food. However, companies may apply the
lower-of-cost-or-market rule either directly to each item, to each category, or to the total
of the inventory. If a company follows a major category or total inventory approach in
applying the lower-of-cost-or-market rule, increases in market prices tend to offset
decreases in market prices. To illustrate, assume that Regner Foods separates its food
products into two major categories, frozen and canned, as shown in Illustration 9-6.
ILLUSTRATION 9-6
Lower-of-Cost-or-Market by:
Alternative Applications
Designated Individual Major Total
of Lower-of-Cost-or-
Cost Market Items Categories Inventory
Market
Frozen
Spinach $ 80,000 $104,000 $ 80,000
Carrots 100,000 90,000 90,000 |
Cut beans 50,000 40,000 40,000
Total frozen 230,000 234,000 $230,000
Canned
Peas 90,000 48,000 48,000
Mixed
vegetables 95,000 92,000 92,000
Total canned 185,000 140,000 140,000
Total $415,000 $374,000 $350,000 $370,000 $374,000
If Regner Foods applied the lower-of-cost-or-market rule to individual items, the
amount of inventory is $350,000. If applying the rule to major categories, it jumps to
478 Chapter 9 Inventories: Additional Valuation Issues
$370,000. If applying LCM to the total inventory, it totals $374,000. Why this difference?
When a company uses a major categories or total inventory approach, market values
higher than cost offset market values lower than cost. For Regner Foods, using the major
categories approach partially offsets the high market value for spinach. Using the total
inventory approach totally offsets the high market value for spinach.
Companies usually price inventory on an item-by-item basis. In fact, tax rules
require that companies use an individual-item basis barring practical difficulties. In
addition, the individual-item approach gives the most conservative valuation for balance
sheet purposes.1 Often, a company prices inventory on a total-inventory basis when it
offers only one end product (comprised of many different raw materials). If it produces
several end products, a company might use a category approach instead. The method
selected should be the one that most clearly reflects income. Whichever method a
company selects, it should apply the method consistently from one period to another.2
Recording “Market” Instead of Cost
One of two methods may be used to record the income effect of valuing inventory at
market. One method, referred to as the cost-of-goods-sold method, debits cost of goods
sold for the write-down of the inventory to market. As a result, the company does not
report a loss in the income statement because the cost of goods sold already includes the
amount of the loss. The second method, referred to as the loss method, debits a loss
account for the write-down of the inventory to market. We use the following inventory
data for Ricardo Company to illustrate entries under both methods.
Cost of goods sold (before adjustment to market) $108,000
Ending inventory (cost) 82,000
Ending inventory (at market) 70,000
Illustration 9-7 shows the entries for both the cost-of-goods-sold and loss methods,
assuming the use of a perpetual inventory system.
ILLUSTRATION 9-7
Cost-of-Goods-Sold Method Loss Method
Accounting for the
Reduction of Inventory To reduce inventory from cost to market
to Market—Perpetual
Inventory System Cost of Goods Sold 12,000 Loss Due to Decline of Inventory to Market 12,000
Inventory 12,000 Inventory 12,000
The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The
loss method, by identifying the loss due to the write-down, shows the loss separate from
Cost of Goods Sold in the income statement.
Illustration 9-8 contrasts the differing amounts reported in the income statement
under the two approaches, using data from the Ricardo example.
1If a company uses dollar-value LIFO, determining the LIFO cost of an individual item may be
more difficult. The company might decide that it is more appropriate to apply the lower-of-cost-
or-market rule to the total amount of each pool. The AICPA Task Force on LIFO Inventory
Problems concluded that the most reasonable approach to applying the lower-of-cost-or-market
provisions to LIFO inventories is to base the determination on reasonable groupings of items.
A pool constitutes a reasonable grouping.
2Inventory accounting for financial statement purposes can be different from income tax
purposes. For example, companies cannot use the lower-of-cost-or-market rule with LIFO for
tax purposes. However, companies may use the lower-of-cost-or-market and LIFO for financial
accounting purposes.
Lower-of-Cost-or-Market 479
ILLUSTRATION 9-8
Cost-of-Goods-Sold Method
Income Statement
Sales revenue $200,000
Presentation—Cost-of-
Cost of goods sold (after adjustment to market*) 120,000
Goods-Sold and Loss |
Gross profit on sales $ 80,000
Methods of Reducing
Inventory to Market
*Cost of goods sold (before adjustment to market) $108,000
Difference between inventory at cost and market
($82,000 2 $70,000) 12,000
Cost of goods sold (after adjustment to market) $120,000
Loss Method
Sales revenue $200,000
Cost of goods sold 108,000
Gross profit on sales 92,000
Loss due to decline of inventory to market 12,000
$ 80,000
GAAP does not specify a particular account to debit for the write-down. We Underlying Concepts
believe the loss method presentation is preferable because it clearly discloses
The income statement under
the loss resulting from a decline in inventory to market.
the cost-of-goods-sold method
presentation lacks representa-
Use of an Allowance tional faithfulness. The
cost-of-goods-sold method
Instead of crediting the Inventory account for market adjustments, companies
does not indicate what it
generally use an allowance account, often referred to as Allowance to Reduce
purports to represent. However,
Inventory to Market. For example, using an allowance account under the loss
allowing this presentation
method, Ricardo Company makes the following entry to record the inventory illustrates the concept of
write-down to market. materiality.
Loss Due to Decline of Inventory to Market 12,000
Allowance to Reduce Inventory to Market 12,000
Use of the allowance account results in reporting both the cost and the market of the
inventory. Ricardo reports inventory in the balance sheet as follows.
ILLUSTRATION 9-9
Inventory (at cost) $ 82,000
Presentation of Inventory
Allowance to reduce inventory to market (12,000)
Using an Allowance
Inventory (at market) $ 70,000
Account
The use of the allowance under the cost-of-goods-sold or loss method permits the bal-
ance sheet to reflect inventory measured at $82,000, although the balance sheet shows a
net amount of $70,000. It also keeps subsidiary inventory ledgers and records in corre-
spondence with the control account without changing prices. For homework purposes, use
an allowance account to record market adjustments, unless instructed otherwise.
With respect to accounting for the allowance in the subsequent period, if the com-
pany still has on hand the merchandise in question, it should retain the allowance ac-
count. If it does not keep that account, the company will overstate beginning inventory
and cost of goods. However, if the company has sold the goods, then it should close the
account. It then establishes a “new allowance account” for any decline in inventory
value that takes place in the current year.3
3The AICPA Task Force on LIFO Inventory Problems concluded that for LIFO inventories,
companies should close the allowance from the prior year and should base the allowance at the
end of the year on a new lower-of-cost-or-market computation. [2]
480 Chapter 9 Inventories: Additional Valuation Issues
Use of an Allowance—Multiple Periods
Underlying Concepts In general, accountants leave the allowance account on the books. They
merely adjust the balance at the next year-end to agree with the discrepancy
The inconsistency in the presen-
between cost and the lower-of-cost-or-market at that balance sheet date.
tation of inventory is an example
Thus, if prices are falling, the company records an additional write-down. If
of the trade-off between
prices are rising, the company records an increase in income, as shown in
relevance and faithful represen-
tation. Market is more relevant Illustration 9-10.
than cost, and cost is more We can think of the net increase in income as the excess of the credit effect
representationally faithful than of closing the beginning allowance balance over the debit effect of setting up the
market. Apparently, relevance current year-end allowance account. Recognizing the increases and decreases
takes precedence in a down has the same effect on net income as closing the allowance balance to beginning
market, and faithful representa- inventory or to cost of goods sold.
tion is more important in an up
market.
ILLUSTRATION 9-10
Amount Adjustment |
Effect on Net Income of
Required in of Valuation Effect
Reducing Inventory to
Inventory Inventory Valuation Account on Net
Market Date at Cost at Market Account Balance Income
Dec. 31, 2013 $188,000 $176,000 $12,000 $12,000 inc. Decrease
Dec. 31, 2014 194,000 187,000 7,000 5,000 dec. Increase
Dec. 31, 2015 173,000 174,000 0 7,000 dec. Increase
Dec. 31, 2016 182,000 180,000 2,000 2,000 inc. Decrease
What do the numbers mean? “PUT IT IN REVERSE”
The lower-of-cost-or-market rule is designed to provide For Transwitch, the reversal of fortunes amounted to
timely information about the decline in the value of inven- 23 percent of net income. The problem is that the $600,000
tory. When the value of inventory declines, income takes a credit had little to do with the company’s ongoing opera-
hit in the period of the write-down. tions, and the company did not do a good job disclosing the
What happens in the periods after the write-down? For effect of the reversal on current-year profi tability.
some companies, gross margins and bottom lines get a boost Even when companies do disclose a reversal, it is some-
when they sell inventory that had been written down in a times hard to determine the impact on income. For example,
previous period. For example, as the table below shows, Intel disclosed that it had sold inventory that had been
Vishay Intertechnology, Transwitch, and Cisco Systems written down in prior periods but did not specify how much
reported gains from selling inventory that had previously reserved inventory was sold.
been written down. The table also evaluates how clearly Transparency of fi nancial reporting should be a top priority.
these companies disclosed the effects of the reversal of With better disclosure of the reversals that boost profi ts in the
inventory write-downs. current period, fi nancial transparency would also get a boost.
Gain from
Company Reversal Disclosure
Vishay Not available Poor—The semiconductor company did not mention the gain in its earnings announcement.
Intertechnology Two weeks later in an SEC fi ling, Vishay disclosed the gain on the inventory that it had written
down.
Transwitch $600,000 P oor—The company did not mention the gain in its earnings announcement. Three weeks later
in an SEC fi ling, the company disclosed the gain on the inventory that it had written down.
Cisco Systems $525 million Good—The networking giant detailed in its earnings release and in SEC fi lings the gains from
selling inventory it had previously written off.
Source: S. E. Ante, “The Secret Behind Those Profi t Jumps,” BusinessWeek Online (December 8, 2003).
Valuation Bases 481
Evaluation of the Lower-of-Cost-or-Market Rule
The lower-of-cost-or-market rule suffers some conceptual deficiencies:
1. A company recognizes decreases in the value of the asset and the charge to expense
in the period in which the loss in utility occurs—not in the period of sale. On the
other hand, it recognizes increases in the value of the asset only at the point of sale.
This inconsistent treatment can distort income data.
2. Application of the rule results in inconsistency because a company may value the
inventory at cost in one year and at market in the next year.
3. Lower-of-cost-or-market values the inventory in the balance sheet conservatively,
but its effect on the income statement may or may not be conservative. Net income
for the year in which a company takes the loss is defi nitely lower. Net income of the
subsequent period may be higher than normal if the expected reductions in sales
price do not materialize.
4. Application of the lower-of-cost-or-market rule uses a “normal profi t” in determin-
ing inventory values. Since companies estimate “normal profi t” based on past expe-
rience (which they may not attain in the future), this subjective measure presents an
opportunity for income manipulation.
Many financial statement users appreciate the lower-of-cost-or-market rule because
they at least know that it prevents overstatement of inventory. In addition, recognizing
all losses but anticipating no gains generally avoids overstating income. |
VALUATION BASES
Valuation at Net Realizable Value
For the most part, companies record inventory at cost or at the lower-of-cost-or-
2 LEARNING OBJECTIVE
market.4 However, many believe that for purposes of applying the lower-of-cost-
Explain when companies value
or-market rule, companies should define “market” as net realizable value (selling
inventories at net realizable value.
price less estimated costs to complete and sell) rather than as replacement cost.
This argument is based on the fact that the amount that companies will collect from this
inventory in the future is the net realizable value.5
Under limited circumstances, support exists for recording inventory at net realiz-
able value, even if that amount is above cost. GAAP permits this exception to the
4Manufacturing companies frequently employ a standardized cost system that predetermines
the unit costs for material, labor, and manufacturing overhead and that values raw materials,
work in process, and finished goods inventories at their standard costs. For financial reporting
purposes, it is acceptable to price inventories at standard costs if there is no significant differ-
ence between the actual costs and standard costs. If there is a significant difference, companies
should adjust the inventory amounts to actual cost. In Accounting Research and Terminology
Bulletin, Final Edition, the profession notes that “standard costs are acceptable if adjusted at
reasonable intervals to reflect current conditions.” Burlington Industries and Hewlett-Packard
use standard costs for valuing at least a portion of their inventories.
5“The Accounting Basis of Inventories,” Accounting Research Study No. 13 (New York: AICPA,
1973) recommends that companies adopt net realizable value. We also should note that compa-
nies frequently fail to apply the rules of lower-of-cost-or-market in practice. For example,
companies rarely compute and apply the lower limit—net realizable value less a normal
markup—because it is a fairly subjective computation. In addition, companies often do not
reduce inventory to market unless its disposition is expected to result in a loss. Furthermore, if
the net realizable value of finished goods exceeds cost, companies usually assume that both
work in process and raw materials do also. In practice, therefore, authoritative literature [3] is
considered a guide, and accountants often exercise professional judgment in lieu of following
the pronouncements literally.
482 Chapter 9 Inventories: Additional Valuation Issues
International normal recognition rule under the following conditions: (1) when there is a con-
Perspective trolled market with a quoted price applicable to all quantities, and (2) when no
significant costs of disposal are involved. For example, mining companies ordi-
Similar to GAAP, certain
narily report inventories of certain minerals (rare metals, especially) at selling
agricultural products and mineral
prices because there is often a controlled market without significant costs of
products can be reported at net
disposal. Similar treatment is given agricultural products that are immediately
realizable value using IFRS.
marketable at quoted prices.
A third reason for allowing valuation at net realizable value is that sometimes it is
too difficult to obtain the cost figures. Cost figures are not difficult to determine in, say,
a manufacturing plant, where the company combines various raw materials and pur-
chased parts to create a finished product. The manufacturer can use the cost basis to
account for various items in inventory because it knows the cost of each individual
component part. The situation is different in a meat-packing plant, however. The “raw
material” consists of, say, cattle, each unit of which the company purchases as a whole
and then divides into parts that are the products. Instead of one product out of many
raw materials or parts, the meat-packing company makes many products from one
“unit” of raw material. To allocate the cost of the animal “on the hoof” into the cost of,
say, ribs, chuck, and shoulders, is a practical impossibility. It is much easier and more |
useful for the company to determine the market price of the various products and value
them in the inventory at selling price less the various costs necessary to get them to
market (costs such as shipping and handling). Hence, because of a peculiarity of the
industry, meat-packing companies sometimes carry inventories at sales price less
distribution costs.
Valuation Using Relative Sales Value
A special problem arises when a company buys a group of varying units in a single
LEARNING OBJECTIVE 3
lump-sum purchase, also called a basket purchase. To illustrate, assume that
Explain when companies use the
Woodland Developers purchases land for $1 million that it will subdivide into
relative sales value method to value
400 lots. These lots are of different sizes and shapes but can be roughly sorted into
inventories.
three groups graded A, B, and C. As Woodland sells the lots, it apportions the
purchase cost of $1 million among the lots sold and the lots remaining on hand.
You might wonder why Woodland would not simply divide the total cost of $1 mil-
lion by 400 lots, to get a cost of $2,500 for each lot. This approach would not recognize
that the lots vary in size, shape, and attractiveness. Therefore, to accurately value each
unit, the common and most logical practice is to allocate the total among the various
units on the basis of their relative sales value.
Illustration 9-11 shows the allocation of relative sales value for the Woodland Devel-
opers example.
ILLUSTRATION 9-11
Number Sales Total Relative Cost Cost
Allocation of Costs,
of Price Sales Sales Total Allocated per
Using Relative Sales
Lots Lots per Lot Price Price Cost to Lots Lot
Value
A 100 $10,000 $1,000,000 100/250 $1,000,000 $ 400,000 $4,000
B 100 6,000 600,000 60/250 1,000,000 240,000 2,400
C 200 4,500 900,000 90/250 1,000,000 360,000 1,800
$2,500,000 $1,000,000
Woodland determines the cost of lots sold and the gross profit, using the amounts
given in the “Cost per Lot” column, as follows.
Valuation Bases 483
ILLUSTRATION 9-12
Number of Cost per Cost of
Determination of Gross
Lots Lots Sold Lot Lots Sold Sales Gross Profit
Profi t, Using Relative
A 77 $4,000 $308,000 $ 770,000 $ 462,000
Sales Value
B 80 2,400 192,000 480,000 288,000
C 100 1,800 180,000 450,000 270,000
$680,000 $1,700,000 $1,020,000
The ending inventory is therefore $320,000 ($1,000,000 2 $680,000).
Woodland also can compute this inventory amount another way. The ratio of cost to
selling price for all the lots is $1 million divided by $2,500,000, or 40 percent. Accord-
ingly, if the total sales price of lots sold is, say $1,700,000, then the cost of the lots sold is
40 percent of $1,700,000, or $680,000. The inventory of lots on hand is then $1 million less
$680,000, or $320,000.
The petroleum industry widely uses the relative sales value method to value (at
cost) the many products and by-products obtained from a barrel of crude oil.
Purchase Commitments—A Special Problem
In many lines of business, a company’s survival and continued profitability de-
4 LEARNING OBJECTIVE
pends on its having a sufficient stock of merchandise to meet customer demand.
Discuss accounting issues related to
Consequently, it is quite common for a company to make purchase commitments,
purchase commitments.
which are agreements to buy inventory weeks, months, or even years in advance.
Generally, the seller retains title to the merchandise or materials covered in the
purchase commitments. Indeed, the goods may exist only as natural resources as
unplanted seed (in the case of agricultural commodities), or as work in process (in the
case of a product).6
Usually, it is not necessary for the buyer to make any entries to reflect commit-
ments for purchases of goods that the seller has not shipped. Ordinary orders, for
which the buyer and seller will determine prices at the time of shipment and which are
subject to cancellation, do not represent either an asset or a liability to the buyer.
Therefore, the buyer need not record such purchase commitments or report them in the
financial statements.
What happens, though, if a buyer enters into a formal, noncancelable purchase con- |
tract? Even then, the buyer recognizes no asset or liability at the date of inception,
because the contract is “executory” in nature: Neither party has fulfilled its part of the
contract. However, if material, the buyer should disclose such contract details in a note
to its financial statements. Illustration 9-13 shows an example of a purchase commit-
ment disclosure.
ILLUSTRATION 9-13
Note 1: Contracts for the purchase of raw materials in 2014 have been executed in the amount of
Disclosure of Purchase
$600,000. The market price of such raw materials on December 31, 2013, is $640,000.
Commitment
In the disclosure in Illustration 9-13, the contract price was less than the market
price at the balance sheet date. If the contract price is greater than the market price
and the buyer expects that losses will occur when the purchase is effected, the buyer
6One study noted that about 30 percent of public companies have purchase commitments
outstanding, with an estimated value of $725 billion (“SEC Staff Report on Off-Balance Sheet
Arrangements, Special Purpose Entities, and Related Issues,” http://www.sec.gov/news/ studies/
soxoffbalancerpt.pdf, June 2005). Purchase commitments are popular because the buyer can secure
a supply of inventory at a known price. The seller also benefits in these arrangements by
knowing how much to produce.
484 Chapter 9 Inventories: Additional Valuation Issues
should recognize losses in the period during which such declines in market prices
take place. [4]7
As an example, at one time many Northwest forest-product companies such as
Boise Cascade, Georgia-Pacific, and Weyerhaeuser signed long-term timber-cutting
contracts with the U.S. Forest Service. These contracts required that the compa-
Underlying Concepts
nies pay $310 per thousand board feet for timber-cutting rights. Unfortunately,
Reporting the loss is conserva- the market price for timber-cutting rights in the latter part of the year dropped
tive. However, reporting the
to $80 per thousand board feet. As a result, a number of these companies had
decline in market price is
long-term contracts that, if fulfilled, would result in substantial future losses.
debatable because no asset
To illustrate the accounting problem, assume that St. Regis Paper Co. signed
is recorded. This area demon-
timber-cutting contracts to be executed in 2015 at a price of $10,000,000. Assume
strates the need for good defi ni-
further that the market price of the timber cutting rights on December 31, 2014,
tions of assets and liabilities.
dropped to $7,000,000. St. Regis would make the following entry on December
31, 2014.
Unrealized Holding Gain or Loss—Income
(Purchase Commitments) 3,000,000
Estimated Liability on Purchase Commitments 3,000,000
St. Regis would report this unrealized holding loss in the income statement under
“Other expenses and losses.” And because the contract is to be executed within the next
fiscal year, St. Regis would report the Estimated Liability on Purchase Commitments in
the current liabilities section on the balance sheet. When St. Regis cuts the timber at a
cost of $10 million, it would make the following entry.
Purchases (Inventory) 7,000,000
Estimated Liability on Purchase Commitments 3,000,000
Cash 10,000,000
The result of the purchase commitment was that St. Regis paid $10 million for a
contract worth only $7 million. It recorded the loss in the previous period—when the
price actually declined.
If St. Regis can partially or fully recover the contract price before it cuts the timber, it
reduces the Estimated Liability on Purchase Commitments. In that case, it then reports in
the period of the price increase a resulting gain for the amount of the partial or full recov-
ery. For example, Congress permitted some of the forest-products companies to buy out
of their contracts at reduced prices in order to avoid potential bankruptcies. To illustrate,
assume that Congress permitted St. Regis to reduce its contract price and therefore its
commitment by $1,000,000. The entry to record this transaction is as follows. |
Estimated Liability on Purchase Commitments 1,000,000
Unrealized Holding Gain or Loss—Income
(Purchase Commitments) 1,000,000
If the market price at the time St. Regis cuts the timber is more than $2,000,000
below the contract price, St. Regis will have to recognize an additional loss in the period
of cutting and record the purchase at the lower-of-cost-or-market.
7There is a long-standing controversy on the accounting in this area. See, for example, Yuji Ijiri,
Recognition of Contractual Rights and Obligations, Research Report (Stamford, Conn.: FASB, 1980),
who argues that companies should capitalize firm purchase commitments. “Firm” means that it
is unlikely that companies can avoid performance under the contract without a severe penalty.
Also, see Mahendra R. Gujarathi and Stanley F. Biggs, “Accounting for Purchase Commitments:
Some Issues and Recommendations,” Accounting Horizons (September 1988), pp. 75–78. They
conclude, “Recording an asset and liability on the date of inception for the noncancelable purchase
commitments is suggested as the first significant step towards alleviating the accounting problems
associated with the issue. At year-end, the potential gains and losses should be treated as contin-
gencies which provide a coherent structure for the reporting of such gains and losses.”
The Gross Profi t Method of Estimating Inventory 485
Are purchasers at the mercy of market price declines? Not totally. Purchasers
can protect themselves against the possibility of market price declines of goods under
contract by hedging. In hedging, the purchaser in the purchase commitment simultane-
ously enters into a contract in which it agrees to sell in the future the same quantity of
the same (or similar) goods at a fixed price. Thus the company holds a buy position in a
purchase commitment and a sell position in a futures contract in the same commodity.
The purpose of the hedge is to offset the price risk of the buy and sell positions. The
company will be better off under one contract by approximately (maybe exactly) the
same amount by which it is worse off under the other contract.
For example, St. Regis Paper Co. could have hedged its purchase commitment con-
tract with a futures contract for timber rights of the same amount. In that case, its loss of
$3,000,000 on the purchase commitment could have been offset by a $3,000,000 gain on
the futures contract.8
As easy as this makes it sound, accounting for purchase commitments is still
unsettled and controversial. Some argue that companies should report purchase com-
mitments as assets and liabilities at the time they sign the contract. Others believe that
the present recognition at the delivery date is more appropriate. FASB Concepts State-
ment No. 6 states, “a purchase commitment involves both an item that might be recorded
as an asset and an item that might be recorded as a liability. That is, it involves both a
right to receive assets and an obligation to pay. . . . If both the right to receive assets and
the obligation to pay were recorded at the time of the purchase commitment, the nature
of the loss and the valuation account that records it when the price falls would be clearly
seen.” Although the discussion in Concepts Statement No. 6 does not exclude the possibility
of recording assets and liabilities for purchase commitments, it contains no conclusions
or implications about whether companies should record them.9
THE GROSS PROFIT METHOD
OF ESTIMATING INVENTORY
Companies take a physical inventory to verify the accuracy of the perpetual
5 LEARNING OBJECTIVE
inventory records or, if no records exist, to arrive at an inventory amount.
Determine ending inventory by applying
Sometimes, however, taking a physical inventory is impractical. In such cases,
the gross profit method.
companies use substitute measures to approximate inventory on hand.
One substitute method of verifying or determining the inventory amount is the gross
profit method (also called the gross margin method). Auditors widely use this method
in situations where they need only an estimate of the company’s inventory (e.g., interim |
reports). Companies also use this method when fire or other catastrophe destroys either
inventory or inventory records. The gross profit method relies on three assumptions:
1. The beginning inventory plus purchases equal total goods to be accounted for.
2. Goods not sold must be on hand.
3. The sales, reduced to cost, deducted from the sum of the opening inventory plus
purchases, equal ending inventory.
To illustrate, assume that Cetus Corp. has a beginning inventory of $60,000 and
purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross
profit on selling price is 30 percent.
8Appendix 17A provides a complete discussion of hedging and the use of derivatives such as
futures.
9“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford,
Conn.: FASB, 1985), paras. 251–253.
486 Chapter 9 Inventories: Additional Valuation Issues
Cetus applies the gross profit method as follows.
ILLUSTRATION 9-14
Beginning inventory (at cost) $ 60,000
Application of Gross
Purchases (at cost) 200,000
Profi t Method
Goods available (at cost) 260,000
Sales (at selling price) $280,000
Less: Gross profit (30% of $280,000) 84,000
Sales (at cost) 196,000
Approximate inventory (at cost) $ 64,000
The current period’s records contain all the information Cetus needs to compute
inventory at cost, except for the gross profit percentage. Cetus determines the gross
profit percentage by reviewing company policies or prior period records. In some cases,
companies must adjust this percentage if they consider prior periods unrepresentative
of the current period.10
Computation of Gross Profi t Percentage
In most situations, the gross profit percentage is stated as a percentage of selling price.
The previous illustration, for example, used a 30 percent gross profit on sales. Gross profit
on selling price is the common method for quoting the profit for several reasons. (1) Most
companies state goods on a retail basis, not a cost basis. (2) A profit quoted on selling price
is lower than one based on cost. This lower rate gives a favorable impression to the
consumer. (3) The gross profit based on selling price can never exceed 100 percent.11
In Illustration 9-14, the gross profit was a given. But how did Cetus derive that
figure? To see how to compute a gross profit percentage, assume that an article cost $15
and sells for $20, a gross profit of $5. As shown in the computations in Illustration 9-15,
this markup is ¼ or 25 percent of retail, and 1/3 or, 331/3 percent of cost.
ILLUSTRATION 9-15
Markup $5 Markup $5
Computation of Gross 5 525% at retail 5 5331/ % on cost
Retail $20 Cost $15 3
Profi t Percentage
Although companies normally compute the gross profit on the basis of selling price, you
should understand the basic relationship between markup on cost and markup on
10An alternative method of estimating inventory using the gross profit percentage is considered by
some to be less complicated than the traditional method. This alternative method uses the standard
income statement format as follows. (Assume the same data as in the Cetus example above.)
Relationships Solution
Sales revenue $280,000 $280,000
Cost of sales
Beginning inventory $ 60,000 $ 60,000
Purchases 200,000 200,000
Goods available for sale 260,000 260,000
Ending inventory (3) ? (3) 64,000 Est.
Cost of goods sold (2) ? (2)196,000 Est.
Gross profi t on sales (30%) (1) ? (1) 84,000 Est.
Compute the unknowns as follows: fi rst the gross profi t amount, then cost of goods sold, and
fi nally the ending inventory, as shown below.
(1) $280,000 3 30% 5 $84,000 (gross profi t on sales).
(2) $280,000 2 $84,000 5 $196,000 (cost of goods sold).
(3) $260,000 2 $196,000 5 $64,000 (ending inventory).
11The terms gross margin percentage, rate of gross profit, and percentage markup are synonymous,
although companies more commonly use markup in reference to cost and gross profit in reference
to sales.
The Gross Profi t Method of Estimating Inventory 487
selling price. For example, assume that a company marks up a given item by 25 percent. |
What, then, is the gross profit on selling price? To find the answer, assume that the item
sells for $1. In this case, the following formula applies.
Cost 1Gross profit 5Selling price
C1.25C5SP
(11.25)C5SP
1.25C5$1.00
C5$0.80
The gross profit equals $0.20 ($1.00 2 $0.80). The rate of gross profit on selling price is
therefore 20 percent ($0.20/$1.00).
Conversely, assume that the gross profit on selling price is 20 percent. What is the
markup on cost? To find the answer, again assume that the item sells for $1. Again, the
same formula holds:
Cost 1Gross profit 5Selling price
C1.20SP5SP
C5 (12.20)SP
C 5.80SP
C5.80($1.00)
C5$0.80
As in the previous example, the markup equals $0.20 ($1.00 2 $0.80). The markup on
cost is 25 percent ($0.20/$0.80).
Retailers use the following formulas to express these relationships:
ILLUSTRATION 9-16
Percentage markup on cost
1. Gross profit on selling price 5 Formulas Relating to
100% 1 Percentage markup on cost
Gross Profi t
Gross profit on selling price
2. Percentage markup on cost 5
100% 2 Gross profit on selling price
To understand how to use these formulas, consider their application in the follow-
ing calculations.
ILLUSTRATION 9-17
Gross Profit on Selling Price Percentage Markup on Cost Application of Gross
Profi t Formulas
.20
Given: 20% 525%
1.002.20
.25
Given: 25% 1.002.255331/ 3%
.25
520% Given: 25%
1.001.25
.50
1.001.505331/ 3% Given: 50%
Because selling price exceeds cost and with the gross profit amount the same for both,
gross profit on selling price will always be less than the related percentage based on
cost. Note that companies do not multiply sales by a cost-based markup percentage.
Instead, they must convert the gross profit percentage to a percentage based on selling
price.
488 Chapter 9 Inventories: Additional Valuation Issues
Evaluation of Gross Profi t Method
What are the major disadvantages of the gross profit method? One disadvantage is that
it provides an estimate. As a result, companies must take a physical inventory once a
year to verify the inventory. Second, the gross profit method uses past percentages in
determining the markup. Although the past often provides answers to the future, a cur-
rent rate is more appropriate. Note that whenever significant fluctuations occur, compa-
nies should adjust the percentage as appropriate. Third, companies must be careful in
applying a blanket gross profit rate. Frequently, a store or department handles mer-
chandise with widely varying rates of gross profit. In these situations, the company may
need to apply the gross profit method by subsections, lines of merchandise, or a similar
basis that classifies merchandise according to their respective rates of gross profit. The
gross profit method is normally unacceptable for financial reporting purposes because
it provides only an estimate. GAAP requires a physical inventory as additional verifica-
tion of the inventory indicated in the records. Nevertheless, GAAP permits the gross
profit method to determine ending inventory for interim (generally quarterly) reporting
purposes, provided a company discloses the use of this method. Note that the gross
profit method will follow closely the inventory method used (FIFO, LIFO, average-cost)
because it relies on historical records.
What do the numbers mean? THE SQUEEZE
Managers and analysts closely follow gross profi ts. A small As another, more recent example, Nike—the largest global
change in the gross profi t rate can signifi cantly affect the manufacturer of athletic footwear—in a recent quarter re-
bottom line. At one time, Apple suffered a textbook case of ported earnings that indicated falling gross profi t, leading
shrinking gross profi ts. In response to pricing wars in the market analysts to adjust Nike’s stock price downward. The
personal computer market, Apple had to quickly reduce the cause—continuing downward pressure on its gross profi t. On
price of its signature Macintosh computers—reducing prices the positive side, an increase in the gross profi t rate provides
more quickly than it could reduce its costs. As a result, its a positive signal to the market. For example, just a 1 percent |
gross profi t rate fell from 44 percent to 40 percent in one year. boost in Dr. Pepper’s gross profi t rate cheered the market,
Though the drop of 4 percent seems small, its impact on the i ndicating the company was able to avoid the squeeze of
bottom line caused Apple’s stock price to drop from $57 per increased commodity costs by raising its prices.
share to $27.50 per share in a two-month period (with a
recent share price over $500, it would have been great to get
into Apple stock at those lower prices!)
Sources: Trefi s, “Nike’s Earnings Reiterate Gross Margin Pressure,” http://seekingalpha.com (March 23, 2011); and D. Kardous, “Higher Pricing
Helps Boost Dr. Pepper Snapple’s Net,” Wall Street Journal Online (June 5, 2008).
RETAIL INVENTORY METHOD
Accounting for inventory in a retail operation presents several challenges. Retailers
LEARNING OBJECTIVE 6
with certain types of inventory may use the specific identification method to value
Determine ending inventory by applying
their inventories. Such an approach makes sense when a retailer holds significant
the retail inventory method.
individual inventory units, such as automobiles, pianos, or fur coats. However,
imagine attempting to use such an approach at Target, Home Depot, Sears Holdings,
or Bloomingdale’s—high-volume retailers that have many different types of merchan-
dise. It would be extremely difficult to determine the cost of each sale, to enter cost
codes on the tickets, to change the codes to reflect declines in value of the merchandise,
to allocate costs such as transportation, and so on.
An alternative is to compile the inventories at retail prices. For most retailers, an
observable pattern between cost and price exists. The retailer can then use a formula to
convert retail prices to cost. This method is called the retail inventory method. It requires
Retail Inventory Method 489
that the retailer keep a record of (1) the total cost and retail value of goods purchased,
(2) the total cost and retail value of the goods available for sale, and (3) the sales for the
period. Use of the retail inventory method is very common. For example, Safeway super-
markets, Target, Wal-Mart, and Best Buy use the retail inventory method.
Here is how it works at a company like Best Buy. Beginning with the retail value of
the goods available for sale, Best Buy deducts the sales revenue for the period. This cal-
culation determines an estimated inventory (goods on hand) at retail. It next computes
the cost-to-retail ratio for all goods. The formula for this computation is to divide the
total goods available for sale at cost by the total goods available at retail price. Finally, to
obtain ending inventory at cost, Best Buy applies the cost-to-retail ratio to the ending
inventory valued at retail. Illustration 9-18 shows the retail inventory method calcula-
tions for Best Buy (assumed data).
ILLUSTRATION 9-18
BEST BUY
Retail Inventory Method
(current period)
Cost Retail
Beginning inventory $14,000 $ 20,000
Purchases 63,000 90,000
Goods available for sale $77,000 110,000
Deduct: Sales revenue 85,000
Ending inventory, at retail $ 25,000
Cost-to-retail ratio ($77,000 4 $110,000) 5 70%
Ending inventory at cost (70% of $25,000) 5 $17,500
There are different versions of the retail inventory method. These include the con-
ventional method (based on lower-of-average-cost-or-market), the cost method, the
LIFO retail method, and the dollar-value LIFO retail method. Regardless of which ver-
sion a company uses, the IRS, various retail associations, and the accounting profession
all sanction use of the retail inventory method. One of its advantages is that a company
like Best Buy can approximate the inventory balance without a physical count. How-
ever, to avoid a potential overstatement of the inventory, Target makes periodic inven-
tory counts. Such counts are especially important in retail operations where loss due to
shoplifting or breakage is common.
The retail inventory method is particularly useful for any type of interim report
because such reports usually need a fairly quick and reliable measure of the inventory. |
Also, similar to use of the gross profit method, insurance adjusters often use this method
to estimate losses from fire, flood, or other type of casualty. This method also acts as
a control device because a company will have to explain any deviations from a physical
count at the end of the year. Finally, the retail method expedites the physical inventory
count at the end of the year. The crew taking the physical inventory need record only the
retail price of each item. The crew does not need to look up each item’s invoice cost,
thereby saving time and expense.
Retail-Method Concepts
The amounts shown in the “Retail” column of Illustration 9-18 above represent the orig-
inal retail prices, assuming no price changes. In practice, though, retailers frequently
mark up or mark down the prices they charge buyers.
For retailers, the term markup means an additional markup of the original retail
price. (In another context, such as the gross profit discussion on pages 485–488, we often
think of markup on the basis of cost.) Markup cancellations are decreases in prices of
merchandise that the retailer had marked up above the original retail price.
490 Chapter 9 Inventories: Additional Valuation Issues
In a competitive market, retailers often need to use markdowns, which are
decreases in the original sales prices. Such cuts in sales prices may be necessary because
of a decrease in the general level of prices, special sales, soiled or damaged goods, over-
stocking, and market competition. Markdowns are common in retailing these days.
Markdown cancellations occur when the markdowns are later offset by increases in the
prices of goods that the retailer had marked down—such as after a one-day sale, for
example. Neither a markup cancellation nor a markdown cancellation can exceed the
original markup or markdown.
To illustrate these concepts, assume that Designer Clothing Store recently purchased
100 dress shirts from Marroway, Inc. The cost for these shirts was $1,500, or $15 a shirt.
Designer Clothing established the selling price on these shirts at $30 a shirt. The shirts
were selling quickly in anticipation of Father’s Day, so the manager added a markup of
$5 per shirt. This markup made the price too high for customers, and sales slowed. The
manager then reduced the price to $32. At this point we would say that the shirts at
Designer Clothing have had a markup of $5 and a markup cancellation of $3.
Right after Father’s Day, the manager marked down the remaining shirts to a sale
price of $23. At this point, an additional markup cancellation of $2 has taken place, and
a $7 markdown has occurred. If the manager later increases the price of the shirts to
$24, a markdown cancellation of $1 would occur.
Retail Inventory Method with Markups
and Markdowns—Conventional Method
Retailers use markup and markdown concepts in developing the proper inventory
valuation at the end of the accounting period. To obtain the appropriate inventory
figures, companies must give proper treatment to markups, markup cancellations,
markdowns, and markdown cancellations.
To illustrate the different possibilities, consider the data for In-Fusion Inc., shown in
Illustration 9-19. In-Fusion can calculate its ending inventory at cost under two assump-
tions, A and B. (We’ll explain the reasons for the two later.)
Assumption A: Computes a cost ratio after markups (and markup cancellations)
but before markdowns.
Assumption B: Computes a cost ratio after both markups and markdowns (and
cancellations).
The computations for In-Fusion are:
Ending inventory at retail3Cost ratio 5Value of ending inventory
Assumption A: $12,500353.9% 5$6,737.50
Assumption B: $12,500354.7% 5$6,837.50
The question becomes: Which assumption and which percentage should In-Fusion
use to compute the ending inventory valuation? The answer depends on which retail
inventory method In-Fusion chooses.
One approach uses only assumption A (a cost ratio using markups but not mark-
downs). It approximates the lower-of-average-cost-or-market. We will refer to this
approach as the conventional retail inventory method or the lower-of-cost-or-market
approach. |
To understand why this method considers only the markups, not the markdowns, in
the cost percentage, you must understand how a retail business operates. A markup
normally indicates an increase in the market value of the item. On the other hand, a
markdown means a decline in the utility of that item. Therefore, to approximate the
lower-of-cost-or-market, we would consider markdowns a current loss and so would not
Retail Inventory Method 491
ILLUSTRATION 9-19
Cost Retail
Retail Inventory Method
Beginning inventory $ 500 $ 1,000
with Markups and
Purchases (net) 20,000 35,000
Markdowns
Markups 3,000
Markup cancellations 1,000
Markdowns 2,500
Markdown cancellations 2,000
Sales (net) 25,000
IN-FUSION INC.
Cost Retail
Beginning inventory $ 500 $ 1,000
Purchases (net) 20,000 35,000
Merchandise available for sale 20,500 36,000
Add: Markups $3,000
Less: Markup cancellations 1,000
Net markups 2,000
20,500 38,000
$20,500
(A) Cost-to-retail ratio5 553.9%
$38,000
Deduct:
Markdowns 2,500
Markdown cancellations (2,000)
Net markdowns 500
$20,500 37,500
$20,500
(B) Cost-to-retail ratio5 554.7%
$37,500
Deduct: Sales (net) 25,000
Ending inventory at retail $12,500
include them in calculating the cost-to-retail ratio. Omitting the markdowns would make
the cost-to-retail ratio lower, which leads to an approximate lower-of-cost-or-market.
An example will make the distinction between the two methods clear. In-Fusion
purchased two items for $5 apiece; the original sales price was $10 each. One item was
subsequently written down to $2. Assuming no sales for the period, if markdowns are
considered in the cost-to-retail ratio (assumption B—the cost method), we compute the
ending inventory in the following way.
ILLUSTRATION 9-20
Markdowns Included in Cost-to-Retail Ratio
Retail Inventory Method
Cost Retail Including Markdowns—
Purchases $10 $20 Cost Method
Deduct: Markdowns 8
Ending inventory, at retail $12
$10
Cost-to-retail ratio 5 583.3%
$12
Ending inventory at cost ($12 3 .833) 5 $10
This approach (the cost method) reflects an average cost of the two items of the com-
modity without considering the loss on the one item. It values ending inventory at $10.
492 Chapter 9 Inventories: Additional Valuation Issues
If markdowns are not considered in the cost-to-retail ratio (assumption A—the
conventional retail method), we compute the ending inventory as follows.
ILLUSTRATION 9-21
Markdowns Not Included in Cost-to-Retail Ratio
Retail Inventory Method
Excluding Markdowns— Cost Retail
Conventional Method Purchases $10 $20
(LCM)
$10
Cost-to-retail ratio 5 550%
$20
Deduct: Markdowns 8
Ending inventory, at retail $12
Ending inventory at cost ($12 3 .50) 5 $6
Under this approach (the conventional retail method, in which markdowns are not
considered), ending inventory would be $6. The inventory valuation of $6 reflects two
inventory items, one inventoried at $5 and the other at $1. It reflects the fact that In-
Fusion reduced the sales price from $10 to $2, and reduced the cost from $5 to $1.12
To approximate the lower-of-cost-or-market, In-Fusion must establish the cost-to-
retail ratio. It does this by dividing the cost of goods available for sale by the sum of the
original retail price of these goods plus the net markups. This calculation excludes
markdowns and markdown cancellations. Illustration 9-22 shows the basic format for
the retail inventory method using the lower-of-cost-or-market approach along with the
In-Fusion Inc. information.
ILLUSTRATION 9-22
IN-FUSION INC.
Comprehensive
Conventional Retail Cost Retail
Inventory Method Beginning inventory $ 500 $ 1,000
Format Purchases (net) 20,000 35,000
Totals 20,500 36,000
Add: Net markups
Markups $3,000
Markup cancellations 1,000 2,000
Totals $20,500 38,000
Deduct: Net markdowns
Markdowns 2,500
Markdown cancellations 2,000 500
Sales price of goods available 37,500
Deduct: Sales (net) 25,000
Ending inventory, at retail $12,500
Cost of goods available
Cost-to-retail ratio5
Original retail price of goods available, plus net markups
$20,500
5 553.9%
$38,000
Ending inventory at lower-of-cost-or-market (53.9% 3 $12,500) 5 $6,737.50 |
12This figure is not really market (replacement cost), but it is net realizable value less the normal
margin that is allowed. In other words, the sale price of the goods written down is $2, but
subtracting a normal margin of 50 percent ($5 cost, $10 price), the figure becomes $1.
Retail Inventory Method 493
Because an averaging effect occurs, an exact lower-of-cost-or-market inventory
valuation is ordinarily not obtained, but an adequate approximation can be achieved. In
contrast, adding net markups and deducting net markdowns yields approximate cost.
Special Items Relating to Retail Method
The retail inventory method becomes more complicated when we consider such items
as freight-in, purchase returns and allowances, and purchase discounts. In the retail
method, we treat such items as follows.
• Freight costs are part of the purchase cost.
• Purchase returns are ordinarily considered as a reduction of the price at both cost
and retail.
• Purchase discounts and allowances usually are considered as a reduction of the
cost of purchases.
In short, the treatment for the items affecting the cost column of the retail inventory
approach follows the computation for cost of goods available for sale.13
Note also that sales returns and allowances are considered as proper adjustments
to gross sales. However, when sales are recorded gross, companies do not recognize
sales discounts. To adjust for the sales discount account in such a situation would pro-
vide an ending inventory figure at retail that would be overvalued.
In addition, a number of special items require careful analysis:
• Transfers-in from another department are reported in the same way as purchases
from an outside company.
• Normal shortages (breakage, damage, theft, shrinkage) should reduce the retail
column because these goods are no longer available for sale. Such costs are reflected
in the selling price because a certain amount of shortage is considered normal in a
retail enterprise. As a result, companies do not consider this amount in computing
the cost-to-retail percentage. Rather, to arrive at ending inventory at retail, they
show normal shortages as a deduction similar to sales.
• Abnormal shortages, on the other hand, are deducted from both the cost and retail
columns and reported as a special inventory amount or as a loss. To do otherwise
distorts the cost-to-retail ratio and overstates ending inventory.
• Employee discounts (given to employees to encourage loyalty, better performance,
and so on) are deducted from the retail column in the same way as sales. These dis-
counts should not be considered in the cost-to-retail percentage because they do not
reflect an overall change in the selling price.14
Illustration 9-23 (page 494) shows some of these concepts. The company, Extreme
Sport Apparel, determines its inventory using the conventional retail inventory method.
Evaluation of Retail Inventory Method
Companies like Gap Inc., Home Depot, or your local department store use the retail
inventory method of computing inventory for the following reasons: (1) to permit the
computation of net income without a physical count of inventory, (2) as a control mea-
sure in determining inventory shortages, (3) in regulating quantities of merchandise on
hand, and (4) for insurance information.
13When the purchase allowance is not reflected by a reduction in the selling price, no adjustment
is made to the retail column.
14Note that if employee sales are recorded gross, no adjustment is necessary for employee
discounts in the retail column.
494 Chapter 9 Inventories: Additional Valuation Issues
ILLUSTRATION 9-23
EXTREME SPORT APPAREL
Conventional Retail
Inventory Method— Cost Retail
Special Items Included Beginning inventory $ 1,000 $ 1,800
Purchases 30,000 60,000
Freight-in 600 —
Purchase returns (1,500) (3,000)
Totals 30,100 58,800
Net markups 9,000
Abnormal shortage (1,200) (2,000)
Totals $28,900 65,800
Deduct:
Net markdowns 1,400
Sales revenue $36,000
Sales returns (900) 35,100
Employee discounts 800
Normal shortage 1,300
$27,200
$28,900
Cost-to-retail ratio5 543.9%
$65,800 |
Ending inventory at lower-of-cost-or-market (43.9% 3 $27,200) 5 $11,940.80
One characteristic of the retail inventory method is that it has an averaging effect
on varying rates of gross profit. This can be problematic when companies apply the
method to an entire business, where rates of gross profit vary among departments.
There is no allowance for possible distortion of results because of such differences.
Companies refine the retail method under such conditions by computing inventory
separately by departments or by classes of merchandise with similar gross profits. In
addition, the reliability of this method assumes that the distribution of items in inven-
tory is similar to the “mix” in the total goods available for sale.
PRESENTATION AND ANALYSIS
Presentation of Inventories
Accounting standards require financial statement disclosure of the composition
LEARNING OBJECTIVE 7
of the inventory, inventory financing arrangements, and the inventory costing
Explain how to report and analyze
methods employed. The standards also require the consistent application of
inventory.
costing methods from one period to another.
Manufacturers should report the inventory composition either in the balance sheet
or in a separate schedule in the notes. The relative mix of raw materials, work in process,
and finished goods helps in assessing liquidity and in computing the stage of inventory
completion.
Significant or unusual financing arrangements relating to inventories may require
note disclosure. Examples include transactions with related parties, product financing
arrangements, firm purchase commitments, involuntary liquidation of LIFO invento-
ries, and pledging of inventories as collateral. Companies should present inventories
pledged as collateral for a loan in the current assets section rather than as an offset to the
liability.
A company should also report the basis on which it states inventory amounts
(lower-of-cost-or-market) and the method used in determining cost (LIFO, FIFO,
average-cost, etc.). For example, the annual report of Mumford of Wyoming contains
the following disclosures.
Presentation and Analysis 495
ILLUSTRATION 9-24
Mumford of Wyoming
Disclosure of Inventory
Methods
Note A: Significant Accounting Policies
Live feeder cattle and feed—last-in, first-out (LIFO) cost,
which is below approximate market $854,800
Live range cattle—lower of principally identified cost or market $1,240,500
Live sheep and supplies—lower of first-in, first-out (FIFO) cost
or market $674,000
Dressed meat and by-products—principally at market less
allowances for distribution and selling expenses $362,630
Illustration 9-24 shows that a company can use different pricing methods for different
elements of its inventory. If Mumford changes the method of pricing any of its inventory
elements, it must report a change in accounting principle. For example, if Mumford
changes its method of accounting for live sheep from FIFO to average-cost, it should
separately report this change, along with the effect on income, in the current and prior
periods. Changes in accounting principle require an explanatory paragraph in the
auditor’s report describing the change in method.
Fortune Brands, Inc. reported its inventories in its annual report as follows (note
the “trade practice” followed in classifying inventories among the current assets).
ILLUSTRATION 9-25
Fortune Brands, Inc.
Disclosure of Trade
Current assets Practice in Valuing
(in millions) December 31 Inventories
Inventories
Maturing spirits $1,243.0
Other raw materials, supplies
and work in process 322.7
Finished products 450.9
Total inventories $2,016.6
Significant Accounting Policies (in part)
Inventories The first-in, first-out (FIFO) inventory method is our principal inventory method across all
segments. In accordance with generally recognized trade practice, maturing spirits inventories are
classified as current assets, although the majority of these inventories ordinarily will not be sold within one
year, due to the duration of aging processes. Inventory provisions are recorded to reduce inventory to the |
lower of cost or market value for obsolete or slow moving inventory based on assumptions about
future demand and marketability of products, the impact of new product introductions, inventory turns,
product spoilage and specific identification of items, such as product discontinuance or engineering/
material changes.
Analysis of Inventories
As our opening story illustrates, the amount of inventory that a company carries can
have significant economic consequences. As a result, companies must manage inven-
tories. But, inventory management is a double-edged sword. It requires constant atten-
tion. On the one hand, management wants to stock a great variety and quantity of items.
Doing so will provide customers with the greatest selection. However, such an inven-
tory policy may incur excessive carrying costs (e.g., investment, storage, insurance,
taxes, obsolescence, and damage). On the other hand, low inventory levels lead to stock-
outs, lost sales, and disgruntled customers.
496 Chapter 9 Inventories: Additional Valuation Issues
Using financial ratios helps companies to chart a middle course between these two
dangers. Common ratios used in the management and evaluation of inventory levels
are inventory turnover and a related measure, average days to sell inventory.
Inventory Turnover
The inventory turnover measures the number of times on average a company sells the
inventory during the period. It measures the liquidity of the inventory. To compute
inventory turnover, divide the cost of goods sold by the average inventory on hand dur-
ing the period.
Barring seasonal factors, analysts compute average inventory from beginning and
ending inventory balances. For example, in its 2011 annual report Kellogg Company
reported a beginning inventory of $1,056 million, an ending inventory of $1,132 million,
and cost of goods sold of $7,750 million for the year. Illustration 9-26 shows the inventory
turnover formula and Kellogg Company’s 2011 ratio computation below.
ILLUSTRATION 9-26
Cost of Goods Sold $7,750
Inventory Turnover Inventory Turnover 5 5 5 7.08 times
Average Inventory ($1,1321$1,056)/2
You will Average Days to Sell Inventory
want to
A variant of the inventory turnover is the average days to sell inventory. This measure
read the
represents the average number of days’ sales for which a company has inventory on
IFRS INSIGHTS
on pages 525–534 hand. For example, the inventory turnover for Kellogg Company of 7.08 times divided
into 365 is approximately 51.6 days.
for discussion of
There are typical levels of inventory in every industry. However, companies that
IFRS related to
keep their inventory at lower levels with higher turnovers than those of their competi-
inventories.
tors, and that still can satisfy customer needs, are the most successful.
KEY TERMS
SUMMARY OF LEARNING OBJECTIVES
average days to sell
inventory, 496
conventional retail
inventory method, 490 1 Describe and apply the lower-of-cost-or-market rule. If inventory de-
clines in value below its original cost, for whatever reason, a company should write
cost-of-goods-sold
method, 478 down the inventory to reflect this loss. The general rule is to abandon the historical cost
principle when the future utility (revenue-producing ability) of the asset drops below its
cost-to-retail ratio, 489
original cost.
designated market
value, 476 2 Explain when companies value inventories at net realizable value.
gross profit method, 485 Companies value inventory at net realizable value when (1) there is a controlled market
gross profit with a quoted price applicable to all quantities, (2) no significant costs of disposal are
percentage, 486 involved, and (3) the cost figures are too difficult to obtain.
hedging, 485
3 Explain when companies use the relative sales value method to value
inventory turnover, 496
inventories. When a company purchases a group of varying units at a single lump-
loss method, 478
sum price—a so-called basket purchase—the company may allocate the total purchase
lower limit (floor), 475
price to the individual items on the basis of relative sales value. |
lower-of-cost-or-market
(LCM), 475 4 Discuss accounting issues related to purchase commitments. Account-
lump-sum (basket) ing for purchase commitments is controversial. Some argue that companies should
purchase, 482 report purchase commitment contracts as assets and liabilities at the time the contract
markdown, 490 is signed. Others believe that recognition at the delivery date is most appropriate. The
Appendix 9A: LIFO Retail Methods 497
FASB neither excludes nor recommends the recording of assets and liabilities for pur- markdown
chase commitments. However, companies record losses when market prices fall relative cancellations, 490
to the commitment price. market (for LCM), 474
markup, 489
5 Determine ending inventory by applying the gross profit method. Com-
markup cancellations, 489
panies follow these steps to determine ending inventory by the gross profit method.
net realizable value
(1) Compute the gross profit percentage on selling price. (2) Compute gross profit by
(NRV), 475
multiplying net sales by the gross profit percentage. (3) Compute cost of goods sold by
net realizable value less a
subtracting gross profit from net sales. (4) Compute ending inventory by subtracting
normal profit
cost of goods sold from total goods available for sale.
margin, 475
6 Determine ending inventory by applying the retail inventory method. purchase
Companies follow these steps to determine ending inventory by the conventional retail commitments, 483
method. (1) To estimate inventory at retail, deduct the sales for the period from the retail retail inventory
value of the goods available for sale. (2) To find the cost-to-retail ratio for all goods pass- method, 488
ing through a department or firm, divide the total goods available for sale at cost by the upper limit (ceiling), 475
total goods available at retail. (3) Convert the inventory valued at retail to approximate
cost by applying the cost-to-retail ratio.
7 Explain how to report and analyze inventory. Accounting standards
require financial statement disclosure of (1) the composition of the inventory (in the
balance sheet or a separate schedule in the notes), (2) significant or unusual inventory
financing arrangements, and (3) inventory costing methods employed (which may dif-
fer for different elements of inventory). Accounting standards also require the consis-
tent application of costing methods from one period to another. Common ratios used in
the management and evaluation of inventory levels are inventory turnover and average
days to sell inventory.
APPENDIX 9A LIFO RETAIL METHODS
A number of retail establishments have changed from the more conventional treat-
8 LEARNING OBJECTIVE
ment to a LIFO retail method. For example, the world’s largest retailer, Wal-Mart
Determine ending inventory by applying
Stores, Inc., uses the LIFO retail method. The primary reason to do so is for the
the LIFO retail methods.
tax advantages associated with valuing inventories on a LIFO basis. In addition,
adoption of LIFO results in a better matching of costs and revenues.
The use of LIFO retail is made under two assumptions: (1) stable prices and
(2) fluctuating prices.
STABLE PRICES—LIFO RETAIL METHOD
It is much more complex to compute the final inventory balance using a LIFO flow than
using the conventional retail method. Under the LIFO retail method, companies like
Wal-Mart or Target consider both markups and markdowns in obtaining the proper
cost-to-retail percentage. Furthermore, since the LIFO method is concerned only with
the additional layer, or the amount that should be subtracted from the previous layer,
the beginning inventory is excluded from the cost-to-retail percentage.
A major assumption of the LIFO retail method is that the markups and mark-
downs apply only to the goods purchased during the current period and not to the
beginning inventory. This assumption is debatable and may explain why some compa-
nies do not adopt this method.
498 Chapter 9 Inventories: Additional Valuation Issues
Illustration 9A-1 presents the major concepts involved in the LIFO retail method |
applied to the Hernandez Company. Note that, to simplify the accounting, we have as-
sumed that the price level has remained unchanged.
ILLUSTRATION 9A-1
Cost Retail
LIFO Retail Method—
Beginning inventory—2014 $ 27,000 $ 45,000
Stable Prices
Net purchases during the period 346,500 480,000
Net markups 20,000
Net markdowns . (5,000)
Total (excluding beginning inventory) 346,500 495,000
Total (including beginning inventory) $373,500 540,000
Net sales during the period (484,000)
Ending inventory at retail $ 56,000
Establishment of cost-to-retail percentage under
assumptions of LIFO retail ($346,500 4 $495,000) 5 70%
Illustration 9A-2 indicates that the inventory is composed of two layers: the beginning
inventory and the additional increase that occurred in the inventory this period (2014).
When we start the next period (2015), the beginning inventory will be composed of those
two layers. If an increase in inventory occurs again, an additional layer will be added.
ILLUSTRATION 9A-2
Ending Inventory at Ending Inventory Layers Ending Inventory
at at Cost-to-Retail at
LIFO Cost, 2014—Stable
Retail Prices—2014 Retail Prices (Percentage) LIFO Cost
Prices
$56,000 2013 $45,000 3 60%* 5 $27,000
2014 11,000 3 70 5 7,700
$56,000 $34,700
*$27,000
(p r ior year’s cost-to-retail)
$45,000
However, if the final inventory figure is below the beginning inventory, Hernandez
must reduce the beginning inventory starting with the most recent layer. For example,
assume that the ending inventory for 2015 at retail is $50,000. Illustration 9A-3 shows
the computation of the ending inventory at cost. Notice that the 2014 layer is reduced
from $11,000 to $5,000.
ILLUSTRATION 9A-3
Ending Inventory at Ending Inventory Layers Ending Inventory
at at Cost-to-Retail at
LIFO Cost, 2015—Stable
Retail Prices—2015 Retail Prices (Percentage) LIFO Cost
Prices
$50,000 2013 $45,000 3 60% 5 $27,000
2014 5,000 3 70 5 3,500
$50,000 $30,500
FLUCTUATING PRICES—DOLLAR-VALUE LIFO
RETAIL METHOD
The previous example simplified the LIFO retail method by ignoring changes in the
selling price of the inventory. Let us now assume that a change in the price level of
the inventories occurs (as is usual). If the price level does change, the company must
Appendix 9A: LIFO Retail Methods 499
eliminate the price change so as to measure the real increase in inventory, not the dollar
increase. This approach is referred to as the dollar-value LIFO retail method.
To illustrate, assume that the beginning inventory had a retail market value of
$10,000 and the ending inventory had a retail market value of $15,000. Assume further
that the price level has risen from 100 to 125. It is inappropriate to suggest that a real
increase in inventory of $5,000 has occurred. Instead, the company must deflate the
ending inventory at retail, as the computation in Illustration 9A-4 shows.
ILLUSTRATION 9A-4
Ending inventory at retail (deflated) $15,000 4 1.25* $12,000
Ending Inventory at
Beginning inventory at retail 10,000
Retail—Defl ated and
Real increase in inventory at retail $ 2,000
Restated
Ending inventory at retail on LIFO basis:
First layer $10,000
Second layer ($2,000 3 1.25) 2,500 $12,500
*1.25 5 125 4 100
This approach is essentially the dollar-value LIFO method discussed in Chapter 8.
In computing the LIFO inventory under a dollar-value LIFO approach, the company
finds the dollar increase in inventory and deflates it to beginning-of-the-year prices.
This indicates whether actual increases or decreases in quantity have occurred. If an
increase in quantities occurs, the company prices this increase at the new index, in order
to compute the value of the new layer. If a decrease in quantities happens, the company
subtracts the increase from the most recent layers to the extent necessary.
The following computations, based on those in Illustration 9A-1 for Hernandez
Company, illustrate the differences between the dollar-value LIFO retail method and
the regular LIFO retail approach. Assume that the current 2014 price index is 112
(prior year 5 100) and that the inventory ($56,000) has remained unchanged. In com- |
paring Illustrations 9A-1 and 9A-5 (see below), note that the computations involved in
finding the cost-to-retail percentage are exactly the same. However, the dollar-value
method determines the increase that has occurred in the inventory in terms of base-
year prices.
ILLUSTRATION 9A-5
Cost Retail
Dollar-Value LIFO Retail
Beginning inventory—2014 $ 27,000 $ 45,000
Method—Fluctuating
Net purchases during the period 346,500 480,000 Prices
Net markups 20,000
Net markdowns . (5,000)
Total (excluding beginning inventory) 346,500 495,000
Total (including beginning inventory) $373,500 540,000
Net sales during the period at retail (484,000)
Ending inventory at retail $ 56,000
Establishment of cost-to-retail percentage under
assumptions of LIFO retail ($346,500 4 $495,000) 5 70%
A. Ending inventory at retail prices deflated to base-year prices
($56,000 4 1.12) $50,000
B. Beginning inventory (retail) at base-year prices 45,000
C. Inventory increase (retail) from beginning of period $ 5,000
500 Chapter 9 Inventories: Additional Valuation Issues
From this information, we compute the inventory amount at cost:
ILLUSTRATION 9A-6
Ending Inventory at Ending Inventory Layers Ending
at Base-Year at Base-Year Price Index Cost-to-Retail Inventory at
LIFO Cost, 2014—
Retail Prices—2014 Retail Prices (percentage) (percentage) LIFO Cost
Fluctuating Prices
$50,000 2013 $45,000 3 100% 3 60% 5 $27,000
2014 5,000 3 112 3 70 5 3,920
$50,000 $30,920
As Illustration 9A-6 shows, before the conversion to cost takes place, Hernandez must
restate layers of a particular year to the prices in effect in the year when the layer was
added.
Note the difference between the LIFO approach (stable prices) and the dollar-value
LIFO method as indicated below.
ILLUSTRATION 9A-7
LIFO (stable prices) LIFO (fluctuating prices)
Comparison of Effect of
Beginning inventory $27,000 $27,000
Price Assumptions
Increment 7,700 3,920
Ending inventory $34,700 $30,920
The difference of $3,780 ($34,700 2 $30,920) results from an increase in the price of
goods, not from an increase in the quantity of goods.
SUBSEQUENT ADJUSTMENTS UNDER
DOLLAR-VALUE LIFO RETAIL
The dollar-value LIFO retail method follows the same procedures in subsequent periods
as the traditional dollar-value method discussed in Chapter 8. That is, when a real
increase in inventory occurs, Hernandez adds a new layer.
To illustrate, using the data from the previous example, assume that the retail value
of the 2015 ending inventory at current prices is $64,800, the 2015 price index is 120
percent of base-year, and the cost-to-retail percentage is 75 percent. In base-year dollars,
the ending inventory is therefore $54,000 ($64,800/120%). Illustration 9A-8 shows the
computation of the ending inventory at LIFO cost.
ILLUSTRATION 9A-8
Ending Inventory at Ending Inventory Layers Ending
at Base-Year at Base-Year Price Index Cost-to-Retail Inventory at
LIFO Cost, 2015—
Retail Prices—2015 Retail Prices (percentage) (percentage) LIFO Cost
Fluctuating Prices
$54,000 2013 $45,000 3 100% 3 60% 5 $27,000
2014 5,000 3 112 3 70 5 3,920
2015 4,000 3 120 3 75 5 3,600
$54,000 $34,520
Conversely, when a real decrease in inventory develops, Hernandez “peels off” pre-
vious layers at prices in existence when the layers were added. To illustrate, assume that
Appendix 9A: LIFO Retail Methods 501
in 2015 the ending inventory in base-year prices is $48,000. The computation of the LIFO
inventory is as follows.
ILLUSTRATION 9A-9
Ending Inventory Layers Ending Ending Inventory at LIFO
at Base-Year at Base-Year Price Index Cost-to-Retail Inventory at
Cost, 2015—Fluctuating
Retail Prices—2015 Retail Prices (percentage) (percentage) LIFO Cost
Prices
$48,000 2013 $45,000 3 100% 3 60% 5 $27,000
2014 3,000 3 112 3 70 5 2,352
$48,000 $29,352
The advantages and disadvantages of the lower-of-cost-or-market method (conven-
tional retail) versus LIFO retail are the same for retail operations as for non-retail opera-
tions. As a practical matter, a company’s selection of which retail inventory method to
use often involves determining which method provides a lower taxable income. It might |
appear that retail LIFO will provide the lower taxable income in a period of rising prices.
But this is not always the case. LIFO will provide an approximate current cost matching,
but it states ending inventory at cost. The conventional retail method may have a large
write-off because of the use of the lower-of-cost-or-market approach, which may offset
the LIFO current cost matching.
CHANGING FROM CONVENTIONAL
RETAIL TO LIFO
Because conventional retail is a lower-of-cost-or-market approach, the company must
restate beginning inventory to a cost basis when changing from the conventional retail
to the LIFO method.15 The usual approach is to compute the cost basis from the pur-
chases of the prior year, adjusted for both markups and markdowns.16
To illustrate, assume that Hakeman Clothing Store employs the conventional retail
method but wishes to change to the LIFO retail method beginning in 2015. The amounts
shown on the company’s books are as follows.
At Cost At Retail
Inventory, January 1, 2014 $ 5,210 $ 15,000
Net purchases in 2014 47,250 100,000
Net markups in 2014 7,000
Net markdowns in 2014 2,000
Sales revenue in 2014 95,000
Illustration 9A-10 (page 502) shows computation of ending inventory under the
conventional retail method for 2014.
15Changing from the conventional retail method to LIFO retail represents a change in accounting
principle. We provide an expanded discussion of accounting principle changes in Chapter 22.
16A logical question to ask is, “Why are only the purchases from the prior period considered
and not also the beginning inventory?” Apparently, the IRS believes that “the purchases-only
approach” provides a more reasonable cost basis. The IRS position is debatable. However,
for our purposes, it seems appropriate to use the purchases-only approach.
502 Chapter 9 Inventories: Additional Valuation Issues
ILLUSTRATION 9A-10
Cost Retail
Conventional Retail
Inventory January 1, 2014 $ 5,210 $ 15,000
Inventory Method
Net purchases 47,250 100,000
Net additional markups . 7,000
$52,460 122,000
Net markdowns (2,000)
Sales revenue (95,000)
Ending inventory at retail $ 25,000
Establishment of cost-to-retail percentage
($52,460 4 $122,000) 5 43%
December 31, 2014, inventory at cost
Inventory at retail $ 25,000
Cost-to-retail ratio 3 43%
Inventory at cost under conventional retail $ 10,750
Hakeman Clothing can then quickly approximate the ending inventory for 2014
under the LIFO retail method, as shown in Illustration 9A-11.
ILLUSTRATION 9A-11
December 31, 2014, Inventory at LIFO Cost
Conversion to LIFO
Retail Inventory Method Retail Ratio LIFO
Ending inventory 5 3 5
$25,000 45%* $11,250
*The cost-to-retail ratio was computed as follows.
Net purchases at cost $47,250
5 545%
Net purchases at retail plus $100,000 1 $7,000 2 $2,000
markups less markdowns
The difference of $500 ($11,250 2 $10,750) between the LIFO retail method and the
conventional retail method in the ending inventory for 2014 is the amount by which the
company must adjust beginning inventory for 2015. The entry to adjust the inventory to
a cost basis is as follows.
Inventory 500
Adjustment to Record Inventory at Cost 500
KEY TERMS
SUMMARY OF LEARNING OBJECTIVE
dollar-value LIFO retail
method, 499 FOR APPENDIX 9A
LIFO retail method, 497
8 Determine ending inventory by applying the LIFO retail methods. The
application of LIFO retail is made under two assumptions: stable prices and fluctuating
prices.
Procedures under stable prices: (a) Because the LIFO method is a cost method, both
markups and markdowns must be considered in obtaining the proper cost-to-retail per-
centage. (b) Since the LIFO method is concerned only with the additional layer, or the
amount that should be subtracted from the previous layer, the beginning inventory is
excluded from the cost-to-retail percentage. (c) The markups and markdowns apply only
to the goods purchased during the current period and not to the beginning inventory.
Demonstration Problem 503
Procedures under fluctuating prices: The steps are the same as for stable prices except
that in computing the LIFO inventory under a dollar-value LIFO approach, the dollar |
increase in inventory is found and deflated to beginning-of-the-year prices. Doing so
will determine whether actual increases or decreases in quantity have occurred. If
quantities increase, this increase is priced at the new index to compute the new layer. If
quantities decrease, the decrease is subtracted from the most recent layers to the extent
necessary.
DEMONSTRATION PROBLEM
Norwood Company makes miniature circuit boards that are components of wireless phones and personal
organizers. The company has experienced strong growth, and you are especially interested in how well
Norwood is managing its inventory balances. You have collected the following information for the current
year.
Inventory at the beginning of year $ 1,026,000
Inventory at the end of year, before any adjustments 1,007,000
Total cost of goods sold, before any adjustments 11,776,000
The company values inventory at lower-of-cost (using LIFO cost flow assumption)-or-market.
Instructions
(a) Compute Norwood’s inventory turnover before any adjustment.
(b) Recompute the inventory turnover after adjusting Norwood’s inventory information for the follow-
ing items.
1. During the year, Norwood recorded sales and costs of goods sold on $22,000 of units shipped
to various wholesalers on consignment. At year-end, none of these units have been sold by
wholesalers.
2. Shipping contracts changed 2 months ago from f.o.b. shipping point to f.o.b. destination point.
At the end of the year, $25,000 of products are en route to China and will not arrive until after
financial statements are released. Current inventory balances do not reflect this change in policy.
3. At the end of the year, Norwood determined that a certain section of inventory with an his-
torical cost of $112,000 has a replacement cost of $100,800, net realizable value of $101,000 and
net realizable value less a normal profit margin of $90,400. There is no need to make a lower-
of-cost-or-market adjustment to other inventory.
Solution
$11,776,000
(a) 511.6 times
($1,026,0003$1,007,000)/2
(b) Adjustments to ending inventory
Adjustment to
Item Ending Inventory Explanation
1. Consigned goods $22,000 Norwood should count the goods it has consigned in other stores.
2. Goods in transit $25,000 Goods offi cially change hands at the point of destination. Norwood
should still show these goods in inventory (not cost of goods sold),
until they reach the destination.
3. Lower-of-cost-or- $(11,200) ($112,000 2 $100,800). The correct valuation is $100,800 since
market the market designation of $100,800 is less than the original
cost.
504 Chapter 9 Inventories: Additional Valuation Issues
$11,740,000a
Adjusted inventory turnover5
($1,026,0003$1,042,800b)/2
511.3 times
aCost of goods sold: $11,776,0002$22,0002$25,0001$11,2005$11,740,200
bEnding inventory: $1,007,0001$22,0001$25,0002$11,2005$1,042,800
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 330-10-35. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Accounting
Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 8.]
[2] FASB ASC 330-10-S99-3. [Predecessor literature: “AICPA Task Force on LIFO Inventory Problems,” Issues Paper (New York:
AICPA, November 30, 1984), pp. 50–55.]
[3] FASB ASC 330-10-35. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,” Accounting
Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4.]
[4] FASB ASC 330-10-35-16 through 18. [Predecessor literature: “Restatement and Revision of Accounting Research Bulletins,”
Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 16.]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to
the following. Provide Codification references for your responses.
CE9-1 Access the glossary (“Master Glossary”) to answer the following.
(a) What is the definition of inventory?
(b) What is the definition of market as it relates to inventory?
(c) What is the definition of net realizable value?
CE9-2 Based on increased competition for one of its key products, Tutaj Company is concerned that it will not be able to sell its |
products at a price that would cover its costs. Since the company is already having a bad year, the sales manager proposes
writing down the inventory to the lowest level possible, so that all the bad news will be in the current year. Explain to the
sales manager the rationale for lower-of-cost-or-market adjustments, according to GAAP.
CE9-3 What are the provisions for subsequent measurement of inventory in the context of a hedging transaction?
CE9-4 What is the nature of the SEC guidance concerning inventory disclosures?
An additional Codification case can be found in the Using Your Judgment section, on page 525.
Be sure to check the book’s companion website for a Review and Analysis Exercise,
with solution.
Brief Exercises, Exercises, Problems, and many more learning and assessment tools
and resources are available for practice in WileyPLUS.
Questions 505
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
QUESTIONS
1. Where there is evidence that the utility of inventory sales price to gross profit percentages based on cost:
goods, as part of their disposal in the ordinary course of 331/3% and 60%.
business, will be less than cost, what is the proper 12. Adriana Co., with annual net sales of $5 million, main-
accounting treatment?
tains a markup of 25% based on cost. Adriana’s expenses
2. Explain the rationale for the ceiling and floor in the lower- average 15% of net sales. What is Adriana’s gross profit
of-cost-or-market method of valuing inventories. and net profit in dollars?
3. Why are inventories valued at the lower-of-cost-or- 13. A fire destroys all of the merchandise of Assante Com-
market? What are the arguments against the use of the pany on February 10, 2014. Presented below is informa-
LCM method of valuing inventories? tion compiled up to the date of the fire.
4. What approaches may be employed in applying the
Inventory, January 1, 2014 $ 400,000
lower-of-cost-or-market procedure? Which approach is Sales revenue to February 10, 2014 1,950,000
normally used and why? Purchases to February 10, 2014 1,140,000
Freight-in to February 10, 2014 60,000
5. In some instances, accounting principles require a depar-
Rate of gross profi t on selling price 40%
ture from valuing inventories at cost alone. Determine the
proper unit inventory price in the following cases.
What is the approximate inventory on February 10, 2014?
14. What conditions must exist for the retail inventory
Cases method to provide valid results?
1 2 3 4 5
15. The conventional retail inventory method yields results
Cost $15.90 $16.10 $15.90 $15.90 $15.90
that are essentially the same as those yielded by the lower-
Net realizable value 14.50 19.20 15.20 10.40 16.40
of-cost-or-market method. Explain. Prepare an illustra-
Net realizable value
less normal profi t 12.80 17.60 13.75 8.80 14.80 tion of how the retail inventory method reduces inventory
Market (replacement to market.
cost) 14.80 17.20 12.80 9.70 16.80
16. (a) Determine the ending inventory under the conven-
tional retail method for the furniture department of
6. What method(s) might be used in the accounts to record a Mayron Department Stores from the following data.
loss due to a price decline in the inventories? Discuss.
Cost Retail
7. What factors might call for inventory valuation at sales
Inventory, Jan. 1 $ 149,000 $ 283,500
prices (net realizable value or market price)?
Purchases 1,400,000 2,160,000
8. Under what circumstances is relative sales value an Freight-in 70,000
Markups, net 92,000
appropriate basis for determining the price assigned to
Markdowns, net 48,000
inventory?
Sales revenue 2,175,000
9. At December 31, 2014, Ashley Co. has outstanding pur-
chase commitments for 150,000 gallons, at $6.20 per (b) If the results of a physical inventory indicated an in-
gallon, of a raw material to be used in its manufacturing ventory at retail of $295,000, what inferences would
process. The company prices its raw material inventory at you draw?
cost or market, whichever is lower. Assuming that the 17. Deere and Company reported inventory in its balance |
market price as of December 31, 2014, is $5.90, how would
sheet as follows.
you treat this situation in the accounts?
Inventories $1,999,100,000
10. What are the major uses of the gross profit method?
What additional disclosures might be necessary to present
11. Distinguish between gross profit as a percentage of cost
the inventory fairly?
and gross profit as a percentage of sales price. Convert the
18. Of what significance is inventory turnover to a retail store?
following gross profit percentages based on cost to gross
profit percentages based on sales price: 25% and 331/3%. * 19. What modifications to the conventional retail method are
Convert the following gross profit percentages based on necessary to approximate a LIFO retail flow?
506 Chapter 9 Inventories: Additional Valuation Issues
BRIEF EXERCISES
1 2 BE9-1 Presented below is information related to Rembrandt Inc.’s inventory.
(per unit) Skis Boots Parkas
Historical cost $190.00 $106.00 $53.00
Selling price 212.00 145.00 73.75
Cost to distribute 19.00 8.00 2.50
Current replacement cost 203.00 105.00 51.00
Normal profi t margin 32.00 29.00 21.25
Determine the following: (a) the two limits to market value (i.e., the ceiling and the floor) that should
be used in the lower-of-cost-or-market computation for skis, (b) the cost amount that should be used in
the lower-of-cost-or-market comparison of boots, and (c) the market amount that should be used to value
parkas on the basis of the lower-of-cost-or-market.
1 2 BE9-2 Floyd Corporation has the following four items in its ending inventory.
Replacement Net Realizable NRV Less
Item Cost Cost Value (NRV) Normal Profi t Margin
Jokers $2,000 $2,050 $2,100 $1,600
Penguins 5,000 5,100 4,950 4,100
Riddlers 4,400 4,550 4,625 3,700
Scarecrows 3,200 2,990 3,830 3,070
Determine the final lower-of-cost-or-market inventory value for each item.
1 2 BE9-3 Kumar Inc. uses a perpetual inventory system. At January 1, 2014, inventory was $214,000 at both cost
and market value. At December 31, 2014, the inventory was $286,000 at cost and $265,000 at market value.
Prepare the necessary December 31 entry under (a) the cost-of-goods-sold method and (b) the loss method.
3 BE9-4 Bell, Inc. buys 1,000 computer game CDs from a distributor who is discontinuing those games. The
purchase price for the lot is $8,000. Bell will group the CDs into three price categories for resale, as indi-
cated below.
Group No. of CDs Price per CD
1 100 $ 5
2 800 10
3 100 15
Determine the cost per CD for each group, using the relative sales value method.
4 BE9-5 Kemper Company signed a long-term noncancelable purchase commitment with a major supplier
to purchase raw materials in 2015 at a cost of $1,000,000. At December 31, 2014, the raw materials to be
purchased have a market value of $950,000. Prepare any necessary December 31, 2014, entry.
4 BE9-6 Use the information for Kemper Company from BE9-5. In 2015, Kemper paid $1,000,000 to obtain
the raw materials which were worth $950,000. Prepare the entry to record the purchase.
5 BE9-7 Fosbre Corporation’s April 30 inventory was destroyed by fire. January 1 inventory was $150,000,
and purchases for January through April totaled $500,000. Sales revenue for the same period were $700,000.
Fosbre’s normal gross profit percentage is 35% on sales. Using the gross profit method, estimate Fosbre’s
April 30 inventory that was destroyed by fire.
6 BE9-8 Boyne Inc. had beginning inventory of $12,000 at cost and $20,000 at retail. Net purchases were
$120,000 at cost and $170,000 at retail. Net markups were $10,000; net markdowns were $7,000; and sales
revenue was $147,000. Compute ending inventory at cost using the conventional retail method.
7 BE9-9 In its 2012 annual report, Gap Inc. reported inventory of $1,615 million on January 25, 2012, and
$1,620 million on January 29, 2011, cost of sales of $9,275 million for fiscal year 2012, and net sales of $14,549
million. Compute Gap’s inventory turnover and the average days to sell inventory for the fiscal year 2012.
8 * BE9-10 Use the information for Boyne Inc. from BE9-8. Compute ending inventory at cost using the LIFO |
retail method.
8 * BE9-11 Use the information for Boyne Inc. from BE9-8, and assume the price level increased from 100 at
the beginning of the year to 115 at year-end. Compute ending inventory at cost using the dollar-value LIFO
retail method.
Exercises 507
EXERCISES
1 2 E9-1 (Lower-of-Cost-or-Market) The inventory of 3T Company on December 31, 2014, consists of the
following items.
Part No. Quantity Cost per Unit Cost to Replace per Unit
110 600 $ 90 $100
111 1,000 60 52
112 500 80 76
113 200 170 180
120 400 205 208
121a 1,600 16 14
122 300 240 235
aPart No. 121 is obsolete and has a realizable value of $0.20 each as scrap.
Instructions
(a) Determine the inventory as of December 31, 2014, by the lower-of-cost-or-market method, applying
this method directly to each item.
(b) Determine the inventory by the lower-of-cost-or-market method, applying the method to the total
of the inventory.
1 2 E9-2 (Lower-of-Cost-or-Market) Smashing Pumpkins Company uses the lower-of-cost-or-market
method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2014,
consists of products D, E, F, G, H, and I. Relevant per-unit data for these products appear below.
Item Item Item Item Item Item
D E F G H I
Estimated selling price $120 $110 $95 $90 $110 $90
Cost 75 80 80 80 50 36
Replacement cost 120 72 70 30 70 30
Estimated selling expense 30 30 30 25 30 30
Normal profi t 20 20 20 20 20 20
Instructions
Using the lower-of-cost-or-market rule, determine the proper unit value for balance sheet reporting
purposes at December 31, 2014, for each of the inventory items above.
1 2 E9-3 (Lower-of-Cost-or-Market) Michael Bolton Company follows the practice of pricing its inventory at
the lower-of-cost-or-market, on an individual-item basis.
Item Cost Cost to Estimated Cost of Completion Normal
No. Quantity per Unit Replace Selling Price and Disposal Profi t
1320 1,200 $3.20 $3.00 $4.50 $0.35 $1.25
1333 900 2.70 2.30 3.50 0.50 0.50
1426 800 4.50 3.70 5.00 0.40 1.00
1437 1,000 3.60 3.10 3.20 0.25 0.90
1510 700 2.25 2.00 3.25 0.80 0.60
1522 500 3.00 2.70 3.80 0.40 0.50
1573 3,000 1.80 1.60 2.50 0.75 0.50
1626 1,000 4.70 5.20 6.00 0.50 1.00
Instructions
From the information above, determine the amount of Bolton Company inventory.
1 2 E9-4 (Lower-of-Cost-or-Market—Journal Entries) Corrs Company began operations in 2013 and deter-
mined its ending inventory at cost and at lower-of-cost-or-market at December 31, 2013, and December 31,
2014. This information is presented below.
Cost Lower-of-Cost-or-Market
12/31/13 $346,000 $327,000
12/31/14 410,000 395,000
508 Chapter 9 Inventories: Additional Valuation Issues
Instructions
(a) Prepare the journal entries required at December 31, 2013, and December 31, 2014, assuming that
the inventory is recorded at market, and a perpetual inventory system (direct method) is used.
(b) Prepare journal entries required at December 31, 2013, and December 31, 2014, assuming that the
inventory is recorded at cost and an allowance account is adjusted at each year-end under a per-
petual system.
(c) Which of the two methods above provides the higher net income in each year?
1 2 E9-5 (Lower-of-Cost-or-Market—Valuation Account) Presented below is information related to
Candlebox Enterprises.
J an. 31 Feb. 28 M ar. 31 A pr. 30
Inventory at cost $15,000 $15,100 $17,000 $13,000
Inventory at the lower-of-cost-or-market 14,500 12,600 15,600 12,300
Purchases for the month 20,000 24,000 26,500
Sales revenue for the month 29,000 35,000 40,000
Instructions
(a) From the information, prepare (as far as the data permit) monthly income statements in columnar
form for February, March, and April. The inventory is to be shown in the statement at cost, the gain
or loss due to market fluctuations is to be shown separately, and a valuation account is to be set up
for the difference between cost and the lower of cost or market.
(b) Prepare the journal entry required to establish the valuation account at January 31 and entries to
adjust it monthly thereafter.
1 2 E9-6 (Lower-of-Cost-or-Market—Error Effect) Winans Company uses the lower-of-cost-or-market |
method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2013,
included product X. Relevant per-unit data for product X appear below.
Estimated selling price $45
Cost 40
Replacement cost 35
Estimated selling expense 14
Normal profi t 9
There were 1,000 units of product X on hand at December 31, 2013. Product X was incorrectly valued at
$35 per unit for reporting purposes. All 1,000 units were sold in 2014.
Instructions
Compute the effect of this error on net income for 2013 and the effect on net income for 2014, and indicate
the direction of the misstatement for each year.
3 E9-7 (Relative Sales Value Method) Phil Collins Realty Corporation purchased a tract of unimproved
land for $55,000. This land was improved and subdivided into building lots at an additional cost of $34,460.
These building lots were all of the same size but owing to differences in location were offered for sale at
different prices as follows.
Group No. of Lots Price per Lot
1 9 $3,000
2 15 4,000
3 17 2,400
Operating expenses for the year allocated to this project total $18,200. Lots unsold at the year-end were
as follows.
Group 1 5 lots
Group 2 7 lots
Group 3 2 lots
Instructions
At the end of the fiscal year Phil Collins Realty Corporation instructs you to arrive at the net income
realized on this operation to date.
Exercises 509
3 E9-8 (Relative Sales Value Method) During 2014, Pretenders Furniture Company purchases a carload of
wicker chairs. The manufacturer sells the chairs to Pretenders for a lump sum of $59,850 because it is dis-
continuing manufacturing operations and wishes to dispose of its entire stock. Three types of chairs are
included in the carload. The three types and the estimated selling price for each are listed below.
Type No. of Chairs Estimated Selling Price Each
Lounge chairs 400 $90
Armchairs 300 80
Straight chairs 700 50
During 2014, Pretenders sells 200 lounge chairs, 100 armchairs, and 120 straight chairs.
Instructions
What is the amount of gross profit realized during 2014? What is the amount of inventory of unsold straight
chairs on December 31, 2014?
4 E9-9 (Purchase Commitments) Marvin Gaye Company has been having difficulty obtaining key raw ma-
terials for its manufacturing process. The company therefore signed a long-term noncancelable purchase
commitment with its largest supplier of this raw material on November 30, 2014, at an agreed price of
$400,000. At December 31, 2014, the raw material had declined in price to $365,000.
Instructions
What entry would you make on December 31, 2014, to recognize these facts?
4 E9-10 (Purchase Commitments) At December 31, 2014, Indigo Girls Company has outstanding non-
cancelable purchase commitments for 36,000 gallons, at $3.00 per gallon, of raw material to be used in its
manufacturing process. The company prices its raw material inventory at cost or market, whichever is
lower.
Instructions
(a) Assuming that the market price as of December 31, 2014, is $3.30, how would this matter be treated
in the accounts and statements? Explain.
(b) Assuming that the market price as of December 31, 2014, is $2.70, instead of $3.30, how would you
treat this situation in the accounts and statements?
(c) Give the entry in January 2015, when the 36,000-gallon shipment is received, assuming that the situ-
ation given in (b) above existed at December 31, 2014, and that the market price in January 2015 was
$2.70 per gallon. Give an explanation of your treatment.
5 E9-11 (Gross Profit Method) Each of the following gross profit percentages is expressed in terms of cost.
1. 20%. 3. 331/3%.
2. 25%. 4. 50%.
Instructions
Indicate the gross profit percentage in terms of sales for each of the above.
5 E9-12 (Gross Profit Method) Mark Price Company uses the gross profit method to estimate inventory for
monthly reporting purposes. Presented below is information for the month of May.
Inventory, May 1 $ 160,000
Purchases (gross) 640,000
Freight-in 30,000
Sales revenue 1,000,000
Sales returns 70,000
Purchase discounts 12,000
Instructions
(a) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of sales. |
(b) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of cost.
5 E9-13 (Gross Profit Method) Tim Legler requires an estimate of the cost of goods lost by fire on March 9.
Merchandise on hand on January 1 was $38,000. Purchases since January 1 were $72,000; freight-in,
$3,400; purchase returns and allowances, $2,400. Sales are made at 331/3% above cost and totaled $100,000
to March 9. Goods costing $10,900 were left undamaged by the fire; remaining goods were destroyed.
Instructions
(a) Compute the cost of goods destroyed.
(b) Compute the cost of goods destroyed, assuming that the gross profit is 331/3% of sales.
510 Chapter 9 Inventories: Additional Valuation Issues
5 E9-14 (Gross Profit Method) Rasheed Wallace Company lost most of its inventory in a fire in December
just before the year-end physical inventory was taken. The corporation’s books disclosed the following.
Beginning inventory $170,000 Sales revenue $650,000
Purchases for the year 390,000 Sales returns 24,000
Purchase returns 30,000 Rate of gross profi t on net sales 40%
Merchandise with a selling price of $21,000 remained undamaged after the fire. Damaged merchandise
with an original selling price of $15,000 had a net realizable value of $5,300.
Instructions
Compute the amount of the loss as a result of the fire, assuming that the corporation had no insurance
coverage.
5 E9-15 (Gross Profit Method) You are called by Tim Duncan of Spurs Co. on July 16 and asked to prepare
a claim for insurance as a result of a theft that took place the night before. You suggest that an inventory be
taken immediately. The following data are available.
Inventory, July 1 $ 38,000
Purchases—goods placed in stock July 1–15 85,000
Sales revenue—goods delivered to customers (gross) 116,000
Sales returns—goods returned to stock 4,000
Your client reports that the goods on hand on July 16 cost $30,500, but you determine that this figure
includes goods of $6,000 received on a consignment basis. Your past records show that sales are made at
approximately 40% over cost. Duncan’s insurance covers only goods owned.
Instructions
Compute the claim against the insurance company.
5 E9-16 (Gross Profit Method) Gheorghe Moresan Lumber Company handles three principal lines of
merchandise with these varying rates of gross profit on cost.
Lumber 25%
Millwork 30%
Hardware and fi ttings 40%
On August 18, a fire destroyed the office, lumber shed, and a considerable portion of the lumber stacked in
the yard. To file a report of loss for insurance purposes, the company must know what the inventories were
immediately preceding the fire. No detail or perpetual inventory records of any kind were maintained. The
only pertinent information you are able to obtain are the following facts from the general ledger, which was
kept in a fireproof vault and thus escaped destruction.
Lumber Millwork Hardware
Inventory, Jan. 1, 2014 $ 250,000 $ 90,000 $ 45,000
Purchases to Aug. 18, 2014 1,500,000 375,000 160,000
Sales revenue to Aug. 18, 2014 2,080,000 533,000 210,000
Instructions
Submit your estimate of the inventory amounts immediately preceding the fire.
5 E9-17 (Gross Profit Method) Presented below is information related to Aaron Rodgers Corporation for
the current year.
Beginning inventory $ 600,000
Purchases 1,500,000
Total goods available for sale $2,100,000
Sales revenue 2,500,000
Instructions
Compute the ending inventory, assuming that (a) gross profit is 45% of sales; (b) gross profit is 60% of cost;
(c) gross profit is 35% of sales; and (d) gross profit is 25% of cost.
Exercises 511
6 E9-18 (Retail Inventory Method) Presented below is information related to Bobby Engram Company.
Cost Retail
Beginning inventory $ 58,000 $100,000
Purchases (net) 122,000 200,000
Net markups 10,345
Net markdowns 26,135
Sales revenue 186,000
Instructions
(a) Compute the ending inventory at retail.
(b) Compute a cost-to-retail percentage (round to two decimals) under the following conditions.
(1) Excluding both markups and markdowns.
(2) Excluding markups but including markdowns. |
(3) Excluding markdowns but including markups.
(4) Including both markdowns and markups.
(c) Which of the methods in (b) above (1, 2, 3, or 4) does the following?
(1) Provides the most conservative estimate of ending inventory.
(2) Provides an approximation of lower-of-cost-or-market.
(3) Is used in the conventional retail method.
(d) Compute ending inventory at lower-of-cost-or-market (round to nearest dollar).
(e) Compute cost of goods sold based on (d).
(f) Compute gross margin based on (d).
6 E9-19 (Retail Inventory Method) Presented below is information related to Ricky Henderson Company.
Cost Retail
Beginning inventory $ 200,000 $ 280,000
Purchases 1,375,000 2,140,000
Markups 95,000
Markup cancellations 15,000
Markdowns 35,000
Markdown cancellations 5,000
Sales revenue 2,200,000
Instructions
Compute the inventory by the conventional retail inventory method.
6 E9-20 (Retail Inventory Method) The records of Ellen’s Boutique report the following data for the month
of April.
Sales revenue $99,000 Purchases (at cost) $48,000
Sales returns 2,000 Purchases (at sales price) 88,000
Markups 10,000 Purchase returns (at cost) 2,000
Markup cancellations 1,500 Purchase returns (at sales price) 3,000
Markdowns 9,300 Beginning inventory (at cost) 30,000
Markdown cancellations 2,800 Beginning inventory (at sales price) 46,500
Freight on purchases 2,400
Instructions
Compute the ending inventory by the conventional retail inventory method.
7 E9-21 (Analysis of Inventories) The financial statements of ConAgra Foods, Inc.’s 2012 annual report
disclose the following information.
(in millions) May 27, 2012 May 29, 2011 May 30, 2010
Inventories $1,870 $1,803 $1,598
Fiscal Year
2012 2011
Net sales $13,263 $12,303
Cost of goods sold 10,436 9,390
Net income 474 818
512 Chapter 9 Inventories: Additional Valuation Issues
Instructions
Compute ConAgra’s (a) inventory turnover and (b) the average days to sell inventory for 2012 and 2011.
8 *E 9-22 (Retail Inventory Method—Conventional and LIFO) Helen Keller Company began operations on
January 1, 2013, adopting the conventional retail inventory system. None of the company’s merchandise
was marked down in 2013 and, because there was no beginning inventory, its ending inventory for 2013 of
$38,100 would have been the same under either the conventional retail system or the LIFO retail system.
On December 31, 2014, the store management considers adopting the LIFO retail system and desires
to know how the December 31, 2014, inventory would appear under both systems. All pertinent data
regarding purchases, sales, markups, and markdowns are shown below. There has been no change in the
price level.
Cost Retail
Inventory, Jan. 1, 2014 $ 38,100 $ 60,000
Markdowns (net) 13,000
Markups (net) 22,000
Purchases (net) 130,900 178,000
Sales (net) 167,000
Instructions
Determine the cost of the 2014 ending inventory under both (a) the conventional retail method and (b) the
LIFO retail method.
8 * E9-23 (Retail Inventory Method—Conventional and LIFO) Leonard Bernstein Company began opera-
tions late in 2013 and adopted the conventional retail inventory method. Because there was no beginning
inventory for 2013 and no markdowns during 2013, the ending inventory for 2013 was $14,000 under both
the conventional retail method and the LIFO retail method. At the end of 2014, management wants to com-
pare the results of applying the conventional and LIFO retail methods. There was no change in the price
level during 2014. The following data are available for computations.
Cost Retail
Inventory, January 1, 2014 $14,000 $20,000
Sales revenue 80,000
Net markups 9,000
Net markdowns 1,600
Purchases 58,800 81,000
Freight-in 7,500
Estimated theft 2,000
Instructions
Compute the cost of the 2014 ending inventory under both (a) the conventional retail method and (b) the
LIFO retail method.
8 * E9-24 (Dollar-Value LIFO Retail) You assemble the following information for Seneca Department Store,
which computes its inventory under the dollar-value LIFO method.
Cost Retail
Inventory on January 1, 2014 $216,000 $300,000
Purchases 364,800 480,000 |
Increase in price level for year 9%
Instructions
Compute the cost of the inventory on December 31, 2014, assuming that the inventory at retail is
(a) $294,300 and (b) $365,150.
8 *E 9-25 (Dollar-Value LIFO Retail) Presented below is information related to Langston Hughes Corporation.
Price LIFO
Index Cost Retail
Inventory on December 31, 2014,
when dollar-value LIFO is adopted 100 $36,000 $ 74,500
Inventory, December 31, 2015 110 ? 100,100
Problems 513
Instructions
Compute the ending inventory under the dollar-value LIFO method at December 31, 2015. The cost-to-
retail ratio for 2015 was 60%.
8 * E9-26 (Conventional Retail and Dollar-Value LIFO Retail) Amiras Corporation began operations on
January 1, 2014, with a beginning inventory of $30,100 at cost and $50,000 at retail. The following informa-
tion relates to 2014.
Retail
Net purchases ($108,500 at cost) $150,000
Net markups 10,000
Net markdowns 5,000
Sales revenue 126,900
Instructions
(a) Assume Amiras decided to adopt the conventional retail method. Compute the ending inventory to
be reported in the balance sheet.
(b) Assume instead that Amiras decides to adopt the dollar-value LIFO retail method. The appropriate
price indexes are 100 at January 1 and 110 at December 31. Compute the ending inventory to be
reported in the balance sheet.
(c) On the basis of the information in part (b), compute cost of goods sold.
8 *E 9-27 (Dollar-Value LIFO Retail) Connie Chung Corporation adopted the dollar-value LIFO retail inven-
tory method on January 1, 2013. At that time the inventory had a cost of $54,000 and a retail price of
$100,000. The following information is available.
Year-End Current Year Year-End
Inventory at Retail Cost—Retail % Price Index
2013 $118,720 57% 106
2014 138,750 60% 111
2015 125,350 61% 115
2016 162,500 58% 125
The price index at January 1, 2013, is 100.
Instructions
Compute the ending inventory at December 31 of the years 2013–2016. (Round to the nearest dollar.)
8 * E9-28 (Change to LIFO Retail) John Olerud Ltd., a local retailing concern in the Bronx, New York, has
decided to change from the conventional retail inventory method to the LIFO retail method starting on
January 1, 2015. The company recomputed its ending inventory for 2014 in accordance with the procedures
necessary to switch to LIFO retail. The inventory computed was $212,600.
Instructions
Assuming that John Olerud Ltd.’s ending inventory for 2014 under the conventional retail inventory
method was $205,000, prepare the appropriate journal entry on January 1, 2015.
EXERCISES SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of exercises.
PROBLEMS
1 2 P9-1 (Lower-of-Cost-or-Market) Remmers Company manufactures desks. Most of the company’s desks
are standard models and are sold on the basis of catalog prices. At December 31, 2014, the following
finished desks appear in the company’s inventory.
514 Chapter 9 Inventories: Additional Valuation Issues
Finished Desks A B C D
2014 catalog selling price $450 $480 $900 $1,050
FIFO cost per inventory list 12/31/14 470 450 830 960
Estimated current cost to manufacture (at December 31, 460 430 610 1,000
2014, and early 2015)
Sales commissions and estimated other costs of disposal 50 60 80 130
2015 catalog selling price 500 540 900 1,200
The 2014 catalog was in effect through November 2014, and the 2015 catalog is effective as of December 1,
2014. All catalog prices are net of the usual discounts. Generally, the company attempts to obtain a 20%
gross profit on selling price and has usually been successful in doing so.
Instructions
At what amount should each of the four desks appear in the company’s December 31, 2014, inventory,
assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of
inventories on an individual-item basis?
1 2 P9-2 (Lower-of-Cost-or-Market) Garcia Home Improvement Company installs replacement siding,
windows, and louvered glass doors for single-family homes and condominium complexes in northern
New Jersey and southern New York. The company is in the process of preparing its annual financial state- |
ments for the fiscal year ended May 31, 2014, and Jim Alcide, controller for Garcia, has gathered the
following data concerning inventory.
At May 31, 2014, the balance in Garcia’s Raw Materials Inventory account was $408,000, and Allowance
to Reduce Inventory to Market had a credit balance of $27,500. Alcide summarized the relevant inventory
cost and market data at May 31, 2014, in the schedule below.
Alcide assigned Patricia Devereaux, an intern from a local college, the task of calculating the amount
that should appear on Garcia’s May 31, 2014, financial statements for inventory under the lower-of-cost-
or-market rule as applied to each item in inventory. Devereaux expressed concern over departing from the
historical cost principle.
Replacement Sales Net Realizable Normal
Cost Cost Price Value Profit
Aluminum siding $ 70,000 $ 62,500 $ 64,000 $ 56,000 $ 5,100
Cedar shake siding 86,000 79,400 94,000 84,800 7,400
Louvered glass doors 112,000 124,000 186,400 168,300 18,500
Thermal windows 140,000 126,000 154,800 140,000 15,400
Total $408,000 $391,900 $499,200 $449,100 $46,400
Instructions
(a) (1) Determine the proper balance in Allowance to Reduce Inventory to Market at May 31, 2014.
(2) For the fiscal year ended May 31, 2014, determine the amount of the gain or loss that would be
recorded due to the change in Allowance to Reduce Inventory to Market.
(b) Explain the rationale for the use of the lower-of-cost-or-market rule as it applies to inventories.
(CMA adapted)
1 2 P9-3 (Entries for Lower-of-Cost-or-Market—Cost-of-Goods-Sold and Loss) Malone Company deter-
mined its ending inventory at cost and at lower-of-cost-or-market at December 31, 2013, December 31,
2014, and December 31, 2015, as shown below.
Cost Lower-of-Cost-or-Market
12/31/13 $650,000 $650,000
12/31/14 780,000 712,000
12/31/15 905,000 830,000
Instructions
(a) Prepare the journal entries required at December 31, 2014, and at December 31, 2015, assuming that
the cost-of-goods-sold method of adjusting to lower-of-cost-or-market is used.
(b) Prepare the journal entries required at December 31, 2014, and at December 31, 2015, assuming that
the loss method of adjusting to lower-of-cost-or-market is used.
Problems 515
5 P9-4 (Gross Profit Method) Eastman Company lost most of its inventory in a fire in December just before
the year-end physical inventory was taken. Corporate records disclose the following.
Inventory (beginning) $ 80,000 Sales revenue $415,000
Purchases 290,000 Sales returns 21,000
Purchase returns 28,000 Gross profi t % based on
net selling price 35%
Merchandise with a selling price of $30,000 remained undamaged after the fire, and damaged merchandise
has a net realizable value of $8,150. The company does not carry fire insurance on its inventory.
Instructions
Prepare a formal labeled schedule computing the fire loss incurred. (Do not use the retail inventory
method.)
5 P9-5 (Gross Profit Method) On April 15, 2015, fire damaged the office and warehouse of Stanislaw
Corporation. The only accounting record saved was the general ledger, from which the trial balance below
was prepared.
STANISLAW CORPORATION
TRIAL BALANCE
MARCH 31, 2015
Cash $ 20,000
Accounts receivable 40,000
Inventory, December 31, 2014 75,000
Land 35,000
Buildings 110,000
Accumulated depreciation $ 41,300
Equipment 3,600
Accounts payable 23,700
Other accrued expenses 10,200
Common stock 100,000
Retained earnings 52,000
Sales revenue 135,000
Purchases 52,000
Miscellaneous expense 26,600 .
$362,200 $362,200
The following data and information have been gathered.
1. The fiscal year of the corporation ends on December 31.
2. An examination of the April bank statement and canceled checks revealed that checks written
during the period April 1–15 totaled $13,000: $5,700 paid to accounts payable as of March 31, $3,400
for April merchandise shipments, and $3,900 paid for other expenses. Deposits during the same
period amounted to $12,950, which consisted of receipts on account from customers with the excep-
tion of a $950 refund from a vendor for merchandise returned in April. |
3. Correspondence with suppliers revealed unrecorded obligations at April 15 of $15,600 for April mer-
chandise shipments, including $2,300 for shipments in transit (f.o.b. shipping point) on that date.
4. Customers acknowledged indebtedness of $46,000 at April 15, 2015. It was also estimated that cus-
tomers owed another $8,000 that will never be acknowledged or recovered. Of the acknowledged
indebtedness, $600 will probably be uncollectible.
5. The companies insuring the inventory agreed that the corporation’s fire-loss claim should be based
on the assumption that the overall gross profit rate for the past 2 years was in effect during the
current year. The corporation’s audited financial statements disclosed this information:
Year Ended
December 31
2014 2013
Net sales $530,000 $390,000
Net purchases 280,000 235,000
Beginning inventory 50,000 66,000
Ending inventory 75,000 50,000
516 Chapter 9 Inventories: Additional Valuation Issues
6. Inventory with a cost of $7,000 was salvaged and sold for $3,500. The balance of the inventory was
a total loss.
Instructions
Prepare a schedule computing the amount of inventory fire loss. The supporting schedule of the computa-
tion of the gross profit should be in good form.
(AICPA adapted)
6 P9-6 (Retail Inventory Method) The records for the Clothing Department of Sharapova’s Discount Store
are summarized below for the month of January.
Inventory, January 1: at retail $25,000; at cost $17,000
Purchases in January: at retail $137,000; at cost $82,500
Freight-in: $7,000
Purchase returns: at retail $3,000; at cost $2,300
Transfers in from suburban branch: at retail $13,000; at cost $9,200
Net markups: $8,000
Net markdowns: $4,000
Inventory losses due to normal breakage, etc.: at retail $400
Sales revenue at retail: $95,000
Sales returns: $2,400
Instructions
(a) Compute the inventory for this department as of January 31, at retail prices.
(b) Compute the ending inventory using lower-of-average-cost-or-market.
6 P9-7 (Retail Inventory Method) Presented below is information related to Waveland Inc.
Cost Retail
Inventory, 12/31/14 $250,000 $ 390,000
Purchases 914,500 1,460,000
Purchase returns 60,000 80,000
Purchase discounts 18,000 —
Gross sales revenue (after employee discounts) — 1,410,000
Sales returns — 97,500
Markups — 120,000
Markup cancellations — 40,000
Markdowns — 45,000
Markdown cancellations — 20,000
Freight-in 42,000 —
Employee discounts granted — 8,000
Loss from breakage (normal) — 4,500
Instructions
Assuming that Waveland Inc. uses the conventional retail inventory method, compute the cost of its end-
ing inventory at December 31, 2015.
6 P9-8 (Retail Inventory Method) Fuque Inc. uses the retail inventory method to estimate ending inventory
for its monthly financial statements. The following data pertain to a single department for the month of
October 2015.
Inventory, October 1, 2015
At cost $ 52,000
At retail 78,000
Purchases (exclusive of freight and returns)
At cost 272,000
At retail 423,000
Freight-in 16,600
Purchase returns
At cost 5,600
At retail 8,000
Markups 9,000
Markup cancellations 2,000
Markdowns (net) 3,600
Normal spoilage and breakage 10,000
Sales revenue 390,000
Problems 517
Instructions
(a) Using the conventional retail method, prepare a schedule computing estimated lower-of-cost-or-
market inventory for October 31, 2015.
(b) A department store using the conventional retail inventory method estimates the cost of its ending
inventory as $60,000. An accurate physical count reveals only $47,000 of inventory at lower-of-cost-
or-market. List the factors that may have caused the difference between the computed inventory
and the physical count.
1 2 P9-9 (Statement and Note Disclosure, LCM, and Purchase Commitment) Maddox Specialty Company, a
4 7 division of Lost World Inc., manufactures three models of gear shift components for bicycles that are sold
to bicycle manufacturers, retailers, and catalog outlets. Since beginning operations in 1990, Maddox has
used normal absorption costing and has assumed a first-in, first-out cost flow in its perpetual inventory |
system. The balances of the inventory accounts at the end of Maddox’s fiscal year, November 30, 2014, are
shown below. The inventories are stated at cost before any year-end adjustments.
Finished goods $647,000
Work in process 112,500
Raw materials 264,000
Factory supplies 69,000
The following information relates to Maddox’s inventory and operations.
1. The finished goods inventory consists of the items analyzed below.
Cost Market
Down tube shifter
Standard model $ 67,500 $ 67,000
Click adjustment model 94,500 89,000
Deluxe model 108,000 110,000
Total down tube shifters 270,000 266,000
Bar end shifter
Standard model 83,000 90,050
Click adjustment model 99,000 97,550
Total bar end shifters 182,000 187,600
Head tube shifter
Standard model 78,000 77,650
Click adjustment model 117,000 119,300
Total head tube shifters 195,000 196,950
Total fi nished goods $647,000 $650,550
2. One-half of the head tube shifter finished goods inventory is held by catalog outlets on con-
signment.
3. Three-quarters of the bar end shifter finished goods inventory has been pledged as collateral for a
bank loan.
4. One-half of the raw materials balance represents derailleurs acquired at a contracted price 20%
above the current market price. The market value of the rest of the raw materials is $127,400.
5. The total market value of the work in process inventory is $108,700.
6. Included in the cost of factory supplies are obsolete items with an historical cost of $4,200. The
market value of the remaining factory supplies is $65,900.
7. Maddox applies the lower-of-cost-or-market method to each of the three types of shifters in finished
goods inventory. For each of the other three inventory accounts, Maddox applies the lower-of-cost-
or-market method to the total of each inventory account.
8. Consider all amounts presented above to be material in relation to Maddox’s financial statements
taken as a whole.
Instructions
(a) Prepare the inventory section of Maddox’s balance sheet as of November 30, 2014, including any
required note(s).
(b) Without prejudice to your answer to (a), assume that the market value of Maddox’s inventories is
less than cost. Explain how this decline would be presented in Maddox’s income statement for the
fiscal year ended November 30, 2014.
518 Chapter 9 Inventories: Additional Valuation Issues
(c) Assume that Maddox has a firm purchase commitment for the same type of derailleur included in
the raw materials inventory as of November 30, 2014, and that the purchase commitment is at a
contracted price 15% greater than the current market price. These derailleurs are to be delivered to
Maddox after November 30, 2014. Discuss the impact, if any, that this purchase commitment would
have on Maddox’s financial statements prepared for the fiscal year ended November 30, 2014.
(CMA adapted)
1 2 P9-10 (Lower-of-Cost-or-Market) Fiedler Co. follows the practice of valuing its inventory at the
lower-of-cost-or-market. The following information is available from the company’s inventory records as
of December 31, 2014.
Estimated Completion Normal
Unit Replacement Selling & Disposal Profit
Item Quantity Cost Cost/Unit Price/Unit Cost/Unit Margin/Unit
A 1,100 $7.50 $8.40 $10.50 $1.50 $1.80
B 800 8.20 7.90 9.40 0.90 1.20
C 1,000 5.60 5.40 7.20 1.15 0.60
D 1,000 3.80 4.20 6.30 0.80 1.50
E 1,400 6.40 6.30 6.70 0.70 1.00
Instructions
Greg Forda is an accounting clerk in the accounting department of Fiedler Co., and he cannot understand
why the market value keeps changing from replacement cost to net realizable value to something that he
cannot even figure out. Greg is very confused, and he is the one who records inventory purchases and
calculates ending inventory. You are the manager of the department and an accountant.
(a) Calculate the lower-of-cost-or-market using the “individual item” approach.
(b) Show the journal entry he will need to make in order to write down the ending inventory from cost
to market.
(c) Then write a memo to Greg explaining what designated market value is as well as how it is computed.
Use your calculations to aid in your explanation. |
8 * P9-11 (Conventional and Dollar-Value LIFO Retail) As of January 1, 2014, Aristotle Inc. installed the
retail method of accounting for its merchandise inventory.
To prepare the store’s financial statements at June 30, 2014, you obtain the following data.
Cost Selling Price
Inventory, January 1 $ 30,000 $ 43,000
Markdowns 10,500
Markups 9,200
Markdown cancellations 6,500
Markup cancellations 3,200
Purchases 104,800 155,000
Sales revenue 154,000
Purchase returns 2,800 4,000
Sales returns and allowances 8,000
Instructions
(a) Prepare a schedule to compute Aristotle’s June 30, 2014, inventory under the conventional retail
method of accounting for inventories.
(b) Without prejudice to your solution to part (a), assume that you computed the June 30, 2014, inven-
tory to be $59,400 at retail and the ratio of cost to retail to be 70%. The general price level has
increased from 100 at January 1, 2014, to 108 at June 30, 2014. Prepare a schedule to compute the
June 30, 2014, inventory at the June 30 price level under the dollar-value LIFO retail method.
(AICPA adapted)
8 * P9-12 (Retail, LIFO Retail, and Inventory Shortage) Late in 2011, Joan Seceda and four other investors
took the chain of Becker Department Stores private, and the company has just completed its third year of
operations under the ownership of the investment group. Andrea Selig, controller of Becker Department
Stores, is in the process of preparing the year-end financial statements. Based on the preliminary financial
statements, Seceda has expressed concern over inventory shortages, and she has asked Selig to determine
whether an abnormal amount of theft and breakage has occurred. The accounting records of Becker
Department Stores contain the following amounts on November 30, 2014, the end of the fiscal year.
Problems 519
Cost Retail
Beginning inventory $ 68,000 $100,000
Purchases 255,000 400,000
Net markups 50,000
Net markdowns 110,000
Sales revenue 320,000
According to the November 30, 2014, physical inventory, the actual inventory at retail is $115,000.
Instructions
(a) Describe the circumstances under which the retail inventory method would be applied and the
advantages of using the retail inventory method.
(b) Assuming that prices have been stable, calculate the value, at cost, of Becker Department Stores’
ending inventory using the last-in, first-out (LIFO) retail method. Be sure to furnish supporting
calculations.
(c) Estimate the amount of shortage, at retail, that has occurred at Becker Department Stores during the
year ended November 30, 2014.
(d) Complications in the retail method can be caused by such items as (1) freight-in costs, (2) purchase
returns and allowances, (3) sales returns and allowances, and (4) employee discounts. Explain how
each of these four special items is handled in the retail inventory method.
(CMA adapted)
8 * P9-13 (Change to LIFO Retail) Diderot Stores Inc., which uses the conventional retail inventory method,
wishes to change to the LIFO retail method beginning with the accounting year ending December 31, 2014.
Amounts as shown below appear on the store’s books before adjustment.
Cost Retail
Inventory, January 1, 2014 $ 15,800 $ 24,000
Purchases in 2014 116,200 184,000
Markups in 2014 12,000
Markdowns in 2014 5,500
Sales revenue in 2014 175,000
You are to assume that all markups and markdowns apply to 2014 purchases, and that it is appropriate to
treat the entire inventory as a single department.
Instructions
Compute the inventory at December 31, 2014, under the following methods.
(a) The conventional retail method.
(b) The last-in, first-out retail method, effecting the change in method as of January 1, 2014. Assume
that the cost-to-retail percentage for 2013 was recomputed correctly in accordance with procedures
necessary to change to LIFO. This ratio was 59%.
(AICPA adapted)
8 * P9-14 (Change to LIFO Retail; Dollar-Value LIFO Retail) Davenport Department Store converted from
the conventional retail method to the LIFO retail method on January 1, 2014, and is now considering con-
verting to the dollar-value LIFO inventory method. During your examination of the financial statements |
for the year ended December 31, 2015, management requested that you furnish a summary showing
certain computations of inventory cost for the past 3 years.
Here is the available information.
1. The inventory at January 1, 2013, had a retail value of $56,000 and cost of $29,800 based on the
conventional retail method.
2. Transactions during 2013 were as follows.
Cost Retail
Purchases $311,000 $554,000
Purchase returns 5,200 10,000
Purchase discounts 6,000
Gross sales revenue (after employee discounts) 551,000
Sales returns 9,000
Employee discounts 3,000
Freight-in 17,600
Net markups 20,000
Net markdowns 12,000
520 Chapter 9 Inventories: Additional Valuation Issues
3. The retail value of the December 31, 2014, inventory was $75,600, the cost ratio for 2014 under the
LIFO retail method was 61%, and the regional price index was 105% of the January 1, 2014, price
level.
4. The retail value of the December 31, 2015, inventory was $62,640, the cost ratio for 2015 under the
LIFO retail method was 60%, and the regional price index was 108% of the January 1, 2014, price
level.
Instructions
(a) Prepare a schedule showing the computation of the cost of inventory on hand at December 31, 2013,
based on the conventional retail method.
(b) Prepare a schedule showing the recomputation of the inventory to be reported on December 31,
2013, in accordance with procedures necessary to convert from the conventional retail method to the
LIFO retail method beginning January 1, 2014. Assume that the retail value of the December 31,
2013, inventory was $60,000.
(c) Without prejudice to your solution to part (b), assume that you computed the December 31, 2013,
inventory (retail value $60,000) under the LIFO retail method at a cost of $33,300. Prepare a schedule
showing the computations of the cost of the store’s 2014 and 2015 year-end inventories under the
dollar-value LIFO method.
(AICPA adapted)
PROBLEMS SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of problems.
CONCEPTS FOR ANALYSIS
CA9-1 (Lower-of-Cost-or-Market) You have been asked by the financial vice president to develop a short
presentation on the lower-of-cost-or-market method for inventory purposes. The financial VP needs
to explain this method to the president because it appears that a portion of the company’s inventory has
declined in value.
Instructions
The financial VP asks you to answer the following questions.
(a) What is the purpose of the lower-of-cost-or-market method?
(b) What is meant by “market”? (Hint: Discuss the ceiling and floor constraints.)
(c) Do you apply the lower-of-cost-or-market method to each individual item, to a category, or to the
total of the inventory? Explain.
(d) What are the potential disadvantages of the lower-of-cost-or-market method?
CA9-2 (Lower-of-Cost-or-Market) The market value of Lake Corporation’s inventory has declined below
its cost. Sheryl Conan, the controller, wants to use the loss method to write down inventory because it more
clearly discloses the decline in market value and does not distort the cost of goods sold. Her supervisor,
financial vice president Dick Wright, prefers the cost-of-goods-sold method to write down inventory
because it does not call attention to the decline in market value.
Instructions
Answer the following questions.
(a) What, if any, is the ethical issue involved?
(b) Is any stakeholder harmed if Dick Wright’s preference is used?
(c) What should Sheryl Conan do?
Concepts for Analysis 521
CA9-3 (Lower-of-Cost-or-Market) Ogala Corporation purchased a significant amount of raw materials
inventory for a new product that it is manufacturing.
Ogala uses the lower-of-cost-or-market rule for these raw materials. The replacement cost of the raw
materials is above the net realizable value, and both are below the original cost.
Ogala uses the average-cost inventory method for these raw materials. In the last 2 years, each pur-
chase has been at a lower price than the previous purchase, and the ending inventory quantity for each
period has been higher than the beginning inventory quantity for that period. |
Instructions
(a) (1) At which amount should Ogala’s raw materials inventory be reported on the balance sheet?
Why?
(2) In general, why is the lower-of-cost-or-market rule used to report inventory?
(b) What would have been the effect on ending inventory and cost of goods sold had Ogala used the
LIFO inventory method instead of the average-cost inventory method for the raw materials?
Why?
CA9-4 (Retail Inventory Method) Saurez Company, your client, manufactures paint. The company’s
president, Maria Saurez, has decided to open a retail store to sell Saurez paint as well as wallpaper and
other supplies that would be purchased from other suppliers. She has asked you for information about the
conventional retail method of pricing inventories at the retail store.
Instructions
Prepare a report to the president explaining the retail method of pricing inventories. Your report should
include the following points.
(a) Description and accounting features of the method.
(b) The conditions that may distort the results under the method.
(c) A comparison of the advantages of using the retail method with those of using cost methods of
inventory pricing.
(d) The accounting theory underlying the treatment of net markdowns and net markups under the
method.
(AICPA adapted)
CA9-5 (Cost Determination, LCM, Retail Method) Olson Corporation, a retailer and wholesaler of
national brand-name household lighting fixtures, purchases its inventories from various suppliers.
Instructions
(a) (1) What criteria should be used to determine which of Olson’s costs are inventoriable?
(2) Are Olson’s administrative costs inventoriable? Defend your answer.
(b) (1) Olson uses the lower-of-cost-or-market rule for its wholesale inventories. What are the theo-
retical arguments for that rule?
(2) The replacement cost of the inventories is below the net realizable value less a normal profit
margin, which, in turn, is below the original cost. What amount should be used to value the
inventories? Why?
(c) Olson calculates the estimated cost of its ending inventories held for sale at retail using the conven-
tional retail inventory method. How would Olson treat the beginning inventories and net mark-
downs in calculating the cost ratio used to determine its ending inventories? Why?
(AICPA adapted)
CA9-6 (Purchase Commitments) Prophet Company signed a long-term purchase contract to buy timber
from the U.S. Forest Service at $300 per thousand board feet. Under these terms, Prophet must cut and pay
$6,000,000 for this timber during the next year. Currently, the market value is $250 per thousand board feet.
At this rate, the market price is $5,000,000. Jerry Herman, the controller, wants to recognize the loss in value
on the year-end financial statements, but the financial vice president, Billie Hands, argues that the loss is
temporary and should be ignored. Herman notes that market value has remained near $250 for many
months, and he sees no sign of significant change.
Instructions
(a) What are the ethical issues, if any?
(b) Is any particular stakeholder harmed by the financial vice president’s decision?
(c) What should the controller do?
522 Chapter 9 Inventories: Additional Valuation Issues
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report,
including the notes to the financial statements, can be accessed at the book’s companion website, www.
wiley.com/college/kieso.
Instructions
Refer to P&G’s financial statements and the accompanying notes to answer the following questions.
(a) How does P&G value its inventories? Which inventory costing method does P&G use as a basis for
reporting its inventories?
(b) How does P&G report its inventories in the balance sheet? In the notes to its financial statements, what
three descriptions are used to classify its inventories?
(c) What costs does P&G include in Inventory and Cost of Products Sold?
(d) What was P&G’s inventory turnover in 2011? What is its gross profit percentage? Evaluate P&G’s in- |
ventory turnover and its gross profit percentage.
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book’s companion website and use information found there to answer the following questions
related to The Coca-Cola Company and PepsiCo, Inc.
(a) What is the amount of inventory reported by Coca-Cola at December 31, 2011, and by PepsiCo at
December 31, 2011? What percent of total assets is invested in inventory by each company?
(b) What inventory costing methods are used by Coca-Cola and PepsiCo? How does each company value
its inventories?
(c) In the notes, what classifications (description) are used by Coca-Cola and PepsiCo to categorize their
inventories?
(d) Compute and compare the inventory turnovers and days to sell inventory for Coca-Cola and PepsiCo
for 2011. Indicate why there might be a significant difference between the two companies.
Financial Statement Analysis Cases
Case 1 Robots, Inc.
Robots, Inc. reported the following information regarding 2013–2014 inventory.
Robots, Inc.
2014 2013
Current assets
Cash $ 153,010 $ 538,489
Accounts receivable, net of allowance for doubtful accounts
of $46,000 in 2014 and $160,000 in 2013 1,627,980 2,596,291
Inventories (Note 2) 1,340,494 1,734,873
Other current assets 123,388 90,592
Assets of discontinued operations — 32,815
Total current assets 3,244,872 4,993,060
Notes to Consolidated Financial Statements
Note 1 (in part): Nature of Business and Significant Accounting Policies
Inventories—Inventories are stated at the lower-of-cost-or-market. Cost is determined by the last-in, first-out (LIFO)
method by the parent company and by the first-in, first-out (FIFO) method by its subsidiaries.
Using Your Judgment 523
Note 2: Inventories
Inventories consist of the following.
2014 2013
Raw materials $1,264,646 $2,321,178
Work in process 240,988 171,222
Finished goods and display units 129,406 711,252
Total inventories 1,635,040 3,203,652
Less: Amount classified as long-term 294,546 1,468,779
Current portion $1,340,494 $1,734,873
Inventories are stated at the lower of cost determined by the LIFO method or market for Robots, Inc. Inventories
for the two wholly-owned subsidiaries, Robot Command, Inc. (U.S.) and Robot Limited (U.K.), are stated on the FIFO
method which amounted to $566,000 at October 31, 2013. No inventory is stated on the FIFO method at October
31, 2014. Included in inventory stated at FIFO cost was $32,815 at October 31, 2013, of Robot Command inventory
classified as an asset from discontinued operations (see Note 14). If the FIFO method had been used for the entire
consolidated group, inventories after an adjustment to the lower-of-cost-or-market would have been approximately
$2,000,000 and $3,800,000 at October 31, 2014 and 2013, respectively.
Inventory has been written down to estimated net realizable value, and results of operations for 2014, 2013, and
2012 include a corresponding charge of approximately $868,000, $960,000, and $273,000, respectively, which
represents the excess of LIFO cost over market.
Inventory of $294,546 and $1,468,779 at October 31, 2014 and 2013, respectively, shown on the balance sheet
as a noncurrent asset represents that portion of the inventory that is not expected to be sold currently.
Reduction in inventory quantities during the years ended October 31, 2014, 2013, and 2012 resulted in
liquidation of LIFO inventory quantities carried at a lower cost prevailing in prior years as compared with the cost
of fiscal 2011 purchases. The effect of these reductions was to decrease the net loss by approximately $24,000,
$157,000, and $90,000 at October 31, 2014, 2013, and 2012, respectively.
Instructions
(a) Why might Robots, Inc., use two different methods for valuing inventory?
(b) Comment on why Robots, Inc., might disclose how its LIFO inventories would be valued under FIFO.
(c) Why does the LIFO liquidation reduce operating costs?
(d) Comment on whether Robots, Inc. would report more or less income if it had been on a FIFO basis for
all its inventory.
Case 2 Barrick Gold Corporation |
Barrick Gold Corporation, with headquarters in Toronto, Canada, is the world’s most profitable and
largest gold mining company outside South Africa. Part of the key to Barrick’s success has been due
to its ability to maintain cash flow while improving production and increasing its reserves of gold-
containing property. In the most recent year, Barrick achieved record growth in cash flow, production,
and reserves.
The company maintains an aggressive policy of developing previously identified target areas
that have the possibility of a large amount of gold ore, and that have not been previously developed.
Barrick limits the riskiness of this development by choosing only properties that are located in politi-
cally stable regions, and by the company’s use of internally generated funds, rather than debt, to
finance growth.
Barrick’s inventories are as follows.
Barrick Gold Corporation
Inventories (in millions, US dollars)
Current
Gold in process $133
Mine operating supplies 82
$215
Non-current (included in Other assets)
Ore in stockpiles $65
524 Chapter 9 Inventories: Additional Valuation Issues
Instructions
(a) Why do you think that there are no finished goods inventories? Why do you think the raw material,
ore in stockpiles, is considered to be a non-current asset?
(b) Consider that Barrick has no finished goods inventories. What journal entries are made to record
a sale?
(c) Suppose that gold bullion that cost $1.8 million to produce was sold for $2.4 million. The journal entry
was made to record the sale, but no entry was made to remove the gold from the gold in process inven-
tory. How would this error affect the following?
Balance Sheet Income Statement
Inventory ? Cost of goods sold ?
Retained earnings ? Net income ?
Accounts payable ?
Working capital ?
Current ratio ?
Accounting, Analysis, and Principles
Englehart Company sells two types of pumps. One is large and is for commercial use. The other is smaller
and is used in residential swimming pools. The following inventory data is available for the month of
March.
Price per
Units Unit Total
Residential Pumps
Inventory at Feb. 28: 200 $ 400 $ 80,000
Purchases:
March 10 500 $ 450 $225,000
March 20 400 $ 475 $190,000
March 30 300 $ 500 $150,000
Sales:
March 15 500 $ 540 $270,000
March 25 400 $ 570 $228,000
Inventory at March 31: 500
Commercial Pumps
Inventory at Feb. 28: 600 $ 800 $480,000
Purchases:
March 3 600 $ 900 $540,000
March 12 300 $ 950 $285,000
March 21 500 $1,000 $500,000
Sales:
March 18 900 $1,080 $972,000
March 29 600 $1,140 $684,000
Inventory at March 31: 500
In addition to the above information, due to a downturn in the economy that has hit Englehart’s commer-
cial customers especially hard, Englehart expects commercial pump prices from March 31 onward to be
considerably different (and lower) than at the beginning of and during March. Englehart has developed the
following additional information.
Commercial Pumps Residential Pumps
Expected selling price (per unit,
net of costs to sell) $1,050 $580
Replacement cost $ 900 $550
The normal profit margin is 16.67% of cost. Englehart uses the FIFO accounting method.
IFRS Insights 525
Accounting
(a) Determine the dollar amount that Englehart should report on its March 31 balance sheet for inventory.
Assume Englehart applies lower-of-cost-or-market at the individual product level.
(b) Repeat part (a) but assume Englehart applies lower-of-cost-or-market at the major category level.
Englehart places both commercial and residential pumps into the same (and only) category.
Analysis
Which of the two approaches above (individual product level or major categories) for applying LCM do
you think gives the financial statement reader better information?
Principles
Assume that during April, the replacement cost of commercial pumps rebounds to $1,050 (assume this will
be designated market value).
(a) Briefly describe how Englehart will report in its April financial statements the inventory remaining
from March 31.
(b) Briefly describe the conceptual trade-offs inherent in the accounting in part (a).
BRIDGE TO THE PROFESSION |
Professional Research: FASB Codifi cation
Jones Co. is in a technology-intensive industry. Recently, one of its competitors introduced a new product
with technology that might render obsolete some of Jones’s inventory. The accounting staff wants to follow
the appropriate authoritative literature in determining the accounting for this significant market event.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahg.org/asclogin.cfm to log in and
prepare responses to the following. Provide Codification references for your responses.
(a) Identify the primary authoritative guidance for the accounting for inventories. What is the predecessor
literature?
(b) List three types of goods that are classified as inventory. What characteristic will automatically exclude
an item from being classified as inventory?
(c) Define “market” as used in the phrase “lower-of-cost-or-market.”
(d) Explain when it is acceptable to state inventory above cost and which industries allow this practice.
Additional Professional Resources
See the book’s companion website, at www.wiley.com/college/kieso, for professional
simulations as well as other study resources.
IFRS INSIGHTS
The major IFRS requirements related to accounting and reporting for inventories
9 LEARNING OBJECTIVE
are found in IAS 2 (“Inventories”), IAS 18 (“Revenue”), and IAS 41 (“Agriculture”).
Compare the accounting procedures
In most cases, IFRS and GAAP are the same. The major differences are that IFRS
related to valuation of inventories
prohibits the use of the LIFO cost flow assumption and records market in the under GAAP and IFRS.
lower-of-cost-or-market differently.
526 Chapter 9 Inventories: Additional Valuation Issues
RELEVANT FACTS
Following are the key similarities and differences between GAAP and IFRS related to
inventories.
Similarities
• IFRS and GAAP account for inventory acquisitions at historical cost and evaluate
inventory for lower-of-cost-or-market subsequent to acquisition.
• Who owns the goods—goods in transit, consigned goods, special sales agreements—
as well as the costs to include in inventory are essentially accounted for the same
under IFRS and GAAP.
Differences
• The requirements for accounting for and reporting inventories are more principles-
based under IFRS. That is, GAAP provides more detailed guidelines in inventory
accounting.
• A major difference between IFRS and GAAP relates to the LIFO cost fl ow assump-
tion. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its
use. FIFO and average-cost are the only two acceptable cost fl ow assumptions
permitted under IFRS. Both sets of standards permit specifi c identifi cation where
appropriate.
• In the lower-of-cost-or-market test for inventory valuation, IFRS defi nes market as
net realizable value. GAAP, on the other hand, defi nes market as replacement cost
subject to the constraints of net realizable value (the ceiling) and net realizable value
less a normal markup (the fl oor). IFRS does not use a ceiling or a fl oor to determine
market.
• Under GAAP, if inventory is written down under the lower-of-cost-or-market valua-
tion, the new basis is now considered its cost. As a result, the inventory may not be
written back up to its original cost in a subsequent period. Under IFRS, the write-
down may be reversed in a subsequent period up to the amount of the previous
write-down. Both the write-down and any subsequent reversal should be reported on
the income statement. IFRS accounting for lower-of-cost-or-market is discussed more
fully in the About the Numbers section below.
• IFRS requires both biological assets and agricultural produce at the point of harvest
to be reported at net realizable value. GAAP does not require companies to account
for all biological assets in the same way. Furthermore, these assets generally are not
reported at net realizable value. Disclosure requirements also differ between the two
sets of standards. IFRS accounting for agriculture and biological assets is discussed
more fully in the About the Numbers section. |
ABOUT THE NUMBERS
Lower-of-Cost-or-Net Realizable Value (LCNRV)
Inventories are recorded at their cost. However, if inventory declines in value below its
original cost, a major departure from the historical cost principle occurs. Whatever the
reason for a decline—obsolescence, price-level changes, or damaged goods—a company
should write down the inventory to net realizable value to report this loss. A company
abandons the historical cost principle when the future utility (revenue-producing
ability) of the asset drops below its original cost.
IFRS Insights 527
Net Realizable Value
Recall that cost is the acquisition price of inventory computed using one of the historical
cost-based methods—specific identification, average-cost, or FIFO. The term net realiz-
able value (NRV) refers to the net amount that a company expects to realize from the
sale of inventory. Specifically, net realizable value is the estimated selling price in the
normal course of business less estimated costs to complete and estimated costs to make
a sale.
To illustrate, assume that Mander Corp. has unfinished inventory with a cost of
$950, a sales value of $1,000, estimated cost of completion of $50, and estimated selling
costs of $200. Mander’s net realizable value is computed as follows.
Inventory value—unfinished $1,000
Less: Estimated cost of completion $ 50
Estimated cost to sell 200 250
Net realizable value $ 750
Mander reports inventory on its statement of financial position (balance sheet) at $750.
In its income statement, Mander reports a Loss on Inventory Write-Down of $200
($9502$750).
A departure from cost is justified because inventories should not be reported at
amounts higher than their expected realization from sale or use. In addition, a company
like Mander should charge the loss of utility against revenues in the period in which the
loss occurs, not in the period of sale. Companies therefore report their inventories at the
lower-of-cost-or-net realizable value (LCNRV) at each reporting date.
Illustration of LCNRV
As indicated, a company values inventory at LCNRV. A company estimates net realiz-
able value based on the most reliable evidence of the inventories’ realizable amounts
(expected selling price, expected costs to completion, and expected costs to sell). To
illustrate, Regner Foods computes its inventory at LCNRV, as shown in Illustra-
tion IFRS9-1.
ILLUSTRATION
Net Final
IFRS9-1
Realizable Inventory
Food Cost Value Value LCNRV Data
Spinach $ 80,000 $120,000 $ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
$384,000
Final Inventory Value:
Spinach Cost ($80,000) is selected because it is lower than net realizable value.
Carrots Cost ($100,000) is selected because it is lower than net realizable value.
Cut beans Net realizable value ($40,000) is selected because it is lower than cost.
Peas Net realizable value ($72,000) is selected because it is lower than cost.
Mixed vegetables Net realizable value ($92,000) is selected because it is lower than cost.
As indicated, the final inventory value of $384,000 equals the sum of the LCNRV for
each of the inventory items. That is, Regner Foods applies the LCNRV rule to each
528 Chapter 9 Inventories: Additional Valuation Issues
individual type of food. Similar to GAAP, under IFRS, companies may apply the
LCNRV rule to a group of similar or related items, or to the total of the inventory. If a
company follows a group-of-similar-or-related-items or total-inventory approach in
determining LCNRV, increases in market prices tend to offset decreases in market
prices. In most situations, companies price inventory on an item-by-item basis. In fact,
tax rules in some countries require that companies use an individual-item basis, barring
practical difficulties.
In addition, the individual-item approach gives the lowest valuation for statement
of financial position purposes. In some cases, a company prices inventory on a total-
inventory basis when it offers only one end product (comprised of many different raw |
materials). If it produces several end products, a company might use a similar-or-related
approach instead. Whichever method a company selects, it should apply the method
consistently from one period to another.
Recording Net Realizable Value Instead of Cost
Similar to GAAP, one of two methods may be used to record the income effect of valuing
inventory at net realizable value. One method, referred to as the cost-of-goods-sold
method, debits cost of goods sold for the write-down of the inventory to net realizable
value. As a result, the company does not report a loss in the income statement because
the cost of goods sold already includes the amount of the loss. The second method,
referred to as the loss method, debits a loss account for the write-down of the inventory
to net realizable value. We use the following inventory data for Ricardo Company to
illustrate entries under both methods.
Cost of goods sold (before adjustment to net realizable value) $108,000
Ending inventory (cost) 82,000
Ending inventory (at net realizable value) 70,000
Illustration IFRS9-2 shows the entries for both the cost-of-goods-sold and loss
methods, assuming the use of a perpetual inventory system.
ILLUSTRATION
Cost-of-Goods-Sold Method Loss Method
IFRS9-2
LCNRV Entries To reduce inventory from cost to net realizable value
Cost of Goods Sold 12,000 Loss Due to Decline
Inventory 12,000 of Inventory to Net
Realizable Value 12,000
Inventory 12,000
The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The
loss method, by identifying the loss due to the write-down, shows the loss separate from
Cost of Goods Sold in the income statement. Illustration IFRS9-3 contrasts the
differing amounts reported in the income statement under the two approaches, using
data from the Ricardo example.
IFRS Insights 529
ILLUSTRATION
Cost-of-Goods-Sold Method
IFRS9-3
Sales revenue $200,000
Income Statement
Cost of goods sold (after adjustment to net realizable value*) 120,000
Reporting—LCNRV
Gross profit on sales $ 80,000
*Cost of goods sold (before adjustment to net realizable value) $108,000
Difference between inventory at cost and net realizable value
($82,000 2 $70,000) 12,000
Cost of goods sold (after adjustment to net realizable value) $120,000
Loss Method
Sales revenue $200,000
Cost of goods sold 108,000
Gross profit on sales 92,000
Loss due to decline of inventory to net realizable value 12,000
$ 80,000
IFRS does not specify a particular account to debit for the write-down. We believe the
loss method presentation is preferable because it clearly discloses the loss resulting from
a decline in inventory net realizable values.
Use of an Allowance
Instead of crediting the Inventory account for net realizable value adjustments, compa-
nies generally use an allowance account, often referred to as Allowance to Reduce
Inventory to Net Realizable Value. For example, using an allowance account under the
loss method, Ricardo Company makes the following entry to record the inventory write-
down to net realizable value.
Loss Due to Decline of Inventory to Net Realizable Value 12,000
Allowance to Reduce Inventory to Net Realizable Value 12,000
Use of the allowance account results in reporting both the cost and the net realizable
value of the inventory. Ricardo reports inventory in the statement of financial position
as follows.
ILLUSTRATION
Inventory (at cost) $82,000
IFRS9-4
Allowance to reduce inventory to net realizable value (12,000)
Presentation of Inventory
Inventory (at net realizable value) $70,000
Using an Allowance
Account
The use of the allowance under the cost-of-goods-sold or loss method permits both the
income statement and the statement of financial position to reflect inventory measured
at $82,000, although the statement of financial position shows a net amount of $70,000.
It also keeps subsidiary inventory ledgers and records in correspondence with the con-
trol account without changing prices. For homework purposes, use an allowance account to
record net realizable value adjustments, unless instructed otherwise.
Recovery of Inventory Loss |
In periods following the write-down, economic conditions may change such that the net
realizable value of inventories previously written down may be greater than cost or there
530 Chapter 9 Inventories: Additional Valuation Issues
is clear evidence of an increase in the net realizable value. In this situation, the amount
of the write-down is reversed, with the reversal limited to the amount of the original
write-down.
Continuing the Ricardo example, assume that in the subsequent period, market
conditions change, such that the net realizable value increases to $74,000 (an increase of
$4,000). As a result, only $8,000 is needed in the allowance. Ricardo makes the following
entry, using the loss method.
Allowance to Reduce Inventory to Net Realizable Value 4,000
Recovery of Inventory Loss ($74,000 2 $70,000) 4,000
Valuation Bases
For the most part, companies record inventory at LCNRV. However, there are some situ-
ations in which companies depart from the LCNRV rule. Such treatment may be justi-
fied in situations when cost is difficult to determine, the items are readily marketable at
quoted market prices, and units of product are interchangeable. In this section, we dis-
cuss agricultural assets (including biological assets and agricultural produce), for which
net realizable value is the general rule for valuing inventory.
Agricultural Inventory
Under IFRS, net realizable value measurement is used for inventory when the inven-
tory is related to agricultural activity. In general, agricultural activity results in two
types of agricultural assets: (1) biological assets or (2) agricultural produce at the point
of harvest.
A biological asset (classified as a non-current asset) is a living animal or plant, such
as sheep, cows, fruit trees, or cotton plants. Agricultural produce is the harvested prod-
uct of a biological asset, such as wool from a sheep, milk from a dairy cow, picked fruit
from a fruit tree, or cotton from a cotton plant.
Biological assets are measured on initial recognition and at the end of each report-
ing period at fair value less costs to sell (net realizable value). Companies record a
gain or loss due to changes in the net realizable value of biological assets in income
when it arises. For example, a gain may arise on initial recognition of a biological
asset, such as when a calf is born. A gain or loss may arise on initial recognition of
agricultural produce as a result of harvesting. Losses may arise on initial recognition
for agricultural assets because costs to sell are deducted in determining fair value less
costs to sell.
Agricultural produce (which are harvested from biological assets) are measured at
fair value less costs to sell (net realizable value) at the point of harvest. Once harvested,
the net realizable value of the agricultural produce becomes its cost, and this asset is
accounted for similar to other inventories held for sale in the normal course of busi-
ness. Measurement at fair value or selling price less point-of-sale costs corresponds to
the net realizable value measure in the LCNRV test (selling price less estimated costs to
complete and sell) since at harvest, the agricultural product is complete and is ready
for sale.
Illustration of Agricultural Accounting at Net Realizable Value
To illustrate the accounting at net realizable value for agricultural assets, assume that
Bancroft Dairy produces milk for sale to local cheese-makers. Bancroft began operations
on January 1, 2014, by purchasing 420 milking cows for $460,000. Bancroft provides the
following information related to the milking cows.
IFRS Insights 531
ILLUSTRATION
Milking cows
IFRS9-5
Carrying value, January 1, 2014* $460,000
Change in fair value due to growth and price changes $35,000 Agricultural Assets—
Decrease in fair value due to harvest (1,200) Bancroft Dairy
Change in carrying value 33,800
Carrying value, January 31, 2014 $493,800
Milk harvested during January** $ 36,000
*The carrying value is measured at fair value less costs to sell (net realizable value). The fair value of milking cows is |
determined based on market prices of livestock of similar age, breed, and genetic merit.
**Milk is initially measured at its fair value less costs to sell (net realizable value) at the time of milking. The fair value of
milk is determined based on market prices in the local area.
As indicated, the carrying value of the milking cows increased during the month. Part
of the change is due to changes in market prices (less costs to sell) for milking cows. The
change in market price may also be affected by growth—the increase in value as the
cows mature and develop increased milking capacity. At the same time, as mature cows
are milked, their milking capacity declines (fair value decrease due to harvest). For
example, changes in fair value arising from growth and harvesting from mature cows
can be estimated based on changes in market prices of different age cows in the herd.
Bancroft makes the following entry to record the change in carrying value of the
milking cows.
Biological Asset—Milking Cows ($493,800 2 $460,000) 33,800
Unrealized Holding Gain or Loss—Income 33,800
As a result of this entry, Bancroft’s statement of financial position reports Biological
Asset—Milking Cows as a non-current asset at fair value less costs to sell (net realizable
value). In addition, the unrealized gains and losses are reported as other income and
expense on the income statement. In subsequent periods at each reporting date, Bancroft
continues to report Biological Asset—Milking Cows at net realizable value and records
any related unrealized gains or losses in income. Because there is a ready market for
the biological assets (milking cows), valuation at net realizable value provides more
relevant information about these assets.
In addition to recording the change in the biological asset, Bancroft makes the
following summary entry to record the milk harvested for the month of January.
Milk Inventory 36,000
Unrealized Holding Gain or Loss—Income 36,000
The milk inventory is recorded at net realizable value at the time it is harvested,
and Unrealized Holding Gain or Loss—Income is recognized in income. As with the
biological assets, net realizable value is considered the most relevant for purposes of
valuation at harvest. What happens to the milk inventory that Bancroft recorded upon
harvesting the milk from the cows? Assuming the milk harvested in January was sold to
a local cheese-maker for $38,500, Bancroft records the sale as follows.
Cash 38,500
Cost of Goods Sold 36,000
Milk Inventory 36,000
Sales Revenue 38,500
Thus, once harvested, the net realizable value of the harvested milk becomes its cost,
and the milk is accounted for similar to other inventories held for sale in the normal
course of business.
A final note: Some animals or plants may not be considered biological assets but
would be classified and accounted for as other types of assets (not at net realizable
value). For example, a pet shop may hold an inventory of dogs purchased from breeders
532 Chapter 9 Inventories: Additional Valuation Issues
that it then sells. Because the pet shop is not breeding the dogs, these dogs are not con-
sidered biological assets. As a result, the dogs are accounted for as inventory held for
sale (at LCNRV).
ON THE HORIZON
One issue that will be difficult to resolve relates to the use of the LIFO cost flow assump-
tion. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow
assumption is widely used in the United States because of its favorable tax advantages.
In addition, many argue that LIFO from a financial reporting point of view provides a
better matching of current costs against revenue and therefore enables companies to
compute a more realistic income.
IFRS SELF-TEST QUESTIONS
1. All of the following are key similarities between GAAP and IFRS with respect to accounting for in-
ventories except:
(a) costs to include in inventories are similar.
(b) LIFO cost flow assumption where appropriate is used by both sets of standards.
(c) fair value valuation of inventories is prohibited by both sets of standards. |
(d) guidelines on ownership of goods are similar.
2. All of the following are key differences between GAAP and IFRS with respect to accounting for in-
ventories except the:
(a) definition of the lower-of-cost-or-market test for inventory valuation differs between GAAP
and IFRS.
(b) average-cost method is prohibited under IFRS.
(c) inventory basis determination for write-downs differs between GAAP and IFRS.
(d) guidelines are more principles-based under IFRS than they are under GAAP.
3. Starfish Company (a company using GAAP and the LIFO inventory method) is considering chang-
ing to IFRS and the FIFO inventory method. How would a comparison of these methods affect
Starfish’s financials?
(a) During a period of inflation, working capital would decrease when IFRS and the FIFO inven-
tory method are used as compared to GAAP and LIFO.
(b) During a period of inflation, the taxes will decrease when IFRS and the FIFO inventory method
are used as compared to GAAP and LIFO.
(c) During a period of inflation, net income would be greater if IFRS and the FIFO inventory
method are used as compared to GAAP and LIFO.
(d) During a period of inflation, the current ratio would decrease when IFRS and the FIFO inven-
tory method are used as compared to GAAP and LIFO.
4. Assume that Darcy Industries had the following inventory values.
Inventory cost (on December 31, 2014) $1,500
Inventory market (on December 31, 2014) $1,350
Inventory net realizable value (on December 31, 2014) $1,320
Under IFRS, what is the inventory carrying value on December 31, 2014?
(a) $1,500.
(b) $1,570.
(c) $1,560.
(d) $1,320.
5. Under IFRS, agricultural activity results in which of the following types of assets?
I. Agricultural produce
II. Biological assets
(a) I only.
(b) II only.
(c) I and II.
(d) Neither I nor II.
IFRS Insights 533
IFRS CONCEPTS AND APPLICATION
IFRS9-1 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to
the accounting for inventories.
IFRS9-2 LaTour Inc. is based in France and prepares its financial statements in accordance with IFRS. In
2014, it reported cost of goods sold of $578 million and average inventory of $154 million. Briefly discuss
how analysis of LaTour’s inventory turnover (and comparisons to a company using GAAP) might be
affected by differences in inventory accounting between IFRS and GAAP.
IFRS9-3 Reed Pentak, a finance major, has been following globalization and made the following observa-
tion concerning accounting convergence: “I do not see many obstacles concerning development of a single
accounting standard for inventories.” Prepare a response to Reed to explain the main obstacle to achieving
convergence in the area of inventory accounting.
IFRS9-4 Briefly describe the valuation of (a) biological assets and (b) agricultural produce.
IFRS9-5 In some instances, accounting principles require a departure from valuing inventories at cost
alone. Determine the proper unit inventory price in the following cases.
Cases
1 2 3 4 5
Cost $15.90 $16.10 $15.90 $15.90 $15.90
Sales price 14.80 19.20 15.20 10.40 17.80
Estimated cost
to complete 1.50 1.90 1.65 .80 1.00
Estimated cost .50 .70 .55 .40 .60
to sell
IFRS9-6 Riegel Company uses the LCNRV method, on an individual-item basis, in pricing its inventory
items. The inventory at December 31, 2014, consists of products D, E, F, G, H, and I. Relevant per unit data
for these products appear below.
Item Item Item Item Item Item
D E F G H I
Estimated selling price $120 $110 $95 $90 $110 $90
Cost 75 80 80 80 50 36
Cost to complete 30 30 25 35 30 30
Selling costs 10 18 10 20 10 20
Using the LCNRV rule, determine the proper unit value for statement of financial position reporting
purposes at December 31, 2014, for each of the inventory items above.
IFRS9-7 Dover Company began operations in 2014 and determined its ending inventory at cost and at
LCNRV at December 31, 2014, and December 31, 2015. This information is presented below.
Cost Net Realizable Value
12/31/14 $346,000 $322,000
12/31/15 410,000 390,000
(a) Prepare the journal entries required at December 31, 2014, and December 31, 2015, assuming that |
the inventory is recorded at LCNRV and a perpetual inventory system using the cost-of-goods-sold
method is used.
(b) Prepare journal entries required at December 31, 2014, and December 31, 2015, assuming that the
inventory is recorded at cost and a perpetual system using the loss method is used.
(c) Which of the two methods above provides the higher net income in each year?
IFRS9-8 Keyser’s Fleece Inc. holds a drove of sheep. Keyser shears the sheep on a semiannual basis and
then sells the harvested wool into the specialty knitting market. Keyser has the following information
related to the shearing sheep at January 1, 2014, and during the first six months of 2014.
534 Chapter 9 Inventories: Additional Valuation Issues
Shearing Sheep
Carrying value (equal to net realizable value), January 1, 2014 $74,000
Change in fair value due to growth and price changes 4,700
Change in fair value due to harvest (575)
Wool harvested during the fi rst 6 months (at NRV) 9,000
Prepare the journal entry(ies) for Keyser’s biological asset (shearing sheep) for the first six months of 2014.
IFRS9-9 Refer to the data in IFRS9-8 for Keyser’s Fleece Inc. Prepare the journal entries for (a) the wool
harvested in the first six months of 2014, and (b) the wool harvested that is sold for $10,500 in July 2014.
Professional Research
IFRS9-10 Jones Co. is in a technology-intensive industry. Recently, one of its competitors introduced a new
product with technology that might render obsolete some of Jones’s inventory. The accounting staff wants
to follow the appropriate authoritative literature in determining the accounting for this significant market
event.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and
then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the
search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
(a) Identify the authoritative literature addressing inventory pricing.
(b) List three types of goods that are classified as inventory. What characteristic will automatically
exclude an item from being classified as inventory?
(c) Define “net realizable value” as used in the phrase “lower-of-cost-or-net realizable value.”
(d) Explain when it is acceptable to state inventory above cost and which industries allow this practice.
International Financial Reporting Problem
Marks and Spencer plc
IFRS9-11 The financial statements of Marks and Spencer plc (M&S) are available at the book’s
companion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/
Marks-and-Spencer-Annual-report-and-financial-statements-2012.pdf.
Instructions
Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
(a) How does M&S value its inventories? Which inventory costing method does M&S use as a basis
for reporting its inventories?
(b) How does M&S report its inventories in the statement of financial position? In the notes to its
financial statements, what three descriptions are used to classify its inventories?
(c) What costs does M&S include in Inventory and Cost of Sales?
(d) What was M&S’s inventory turnover in 2012? What is its gross profit percentage? Evaluate
M&S’s inventory turnover and its gross profit percentage.
ANSWERS TO IFRS SELF-TEST QUESTIONS
1. b 2. b 3. c 4. d 5. c
Remember to check the book’s companion website to fi nd additional
resources for this chapter.
This page is intentionally left blank
Acquisition and Disposition of
Property, Plant, and Equipment
1 Describe property, plant, and equipment. 5 Understand accounting issues related to acquiring
and valuing plant assets.
2 Identify the costs to include in initial valuation
of property, plant, and equipment. 6 Describe the accounting treatment for costs
subsequent to acquisition.
3 Describe the accounting problems associated
with self-constructed assets. 7 Describe the accounting treatment for the disposal
of property, plant, and equipment. |
4 Describe the accounting problems associated
with interest capitalization.
Watch Your Spending
Investments in long-lived assets, such as property, plant, and equipment, are important elements in many companies’ balance
sheets. As Table 1 shows, capital expenditures on structures and equipment (whether new or used) are starting to grow again
after the effects of the 2008 financial crisis.
RETPAHC 10
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
$1,500
1,200
488.7 525.3 562.4
900 363.7 358.5 344.5 368.7 401.7 449.5 428.7
600
300 745.3 639.4 630.4 673.4 821.2 829.5 811.8 641.2 677.0
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Equipment Structures
Unfortunately, Table 1 also shows that capital expenditures’ growth is overall stagnant in the last 10 years. However,
better times may be ahead. To illustrate, the food and beverage industry increased its capital expenditures by 20 percent in
2011 and is estimated to increase them again by 4 percent in 2012. Table 2 identifies the five companies in this industry with
the largest capital expenditures in 2011 and 2012.
sralloD
tnerruC
fo
snoilliB
Table 1: Total Capital Expenditures by Type for All U.S. Businesses, 2001 to 2010
743.1
Year
Sources: Annual Capital Expenditures Survey, 2012 Capital Spending Report and, U.S. Census (2012).
Table 2: Capital Spending ($ in millions)
% Change % Change from
Company 2012 Budget from 2011 2011 Actual 2011 Budget 2010 Actual 2010 Actual
Anheuser-Busch InBev $3,200 2% $3,256 $2,800 31% $2,350
Coca-Cola 3,100M 6 2,920 3,100 40 2,215
PepsiCo 3,000 9 3,300 3,700 14 3,253
Kraft Foods 2,000 13 1,771 1,800 9 1,661
Tyson 825 28 643 700 27 550
CONCEPTUAL FOCUS
> See the Underlying Concepts on pages 538,
Capital expenditures are significant for many companies.
542, and 557.
For example, at Jet Blue Airways, plant assets are 69 percent
of its total assets. For Wal-Mart Stores, Inc., it’s 53 percent.
INTERNATIONAL FOCUS
Conversely, Microsoft’s percentage is just 3 percent. Amounts
for companies’ capital expenditures are reported on a com-
> See the International Perspectives on
pany’s balance sheet and directly affect such items as total
pages 538, 542, 546, 550, and 555.
assets, depreciation expense, cash flows, and net income.
> IFRS Insights related to property, plant, and
Companies that overspend in this area find that income is reduced
equipment are presented in Chapter 11.
as depreciation increases without corresponding increases in
revenues. As a result, these companies often lose financial flexi-
bility. That is, they find themselves in a cash bind as their cash
flows from operations can no longer meet their obligations.
A good example is Baker Hughes, Inc. (an oilfield-services company), which in the first half of 2012 reported cash
flow from operations of $24 million but capital expenditures of $1,442 million. Although the company is presently stable, the
unfavorable relationship of cash flow from operations to capital expenditures is a cause for concern.
Companies can also affect income by reducing capital expenditures. For example, Cintas (a uniform rental business) cut
back on capital expenditures in recent years. In response, depreciation expense declined to $152 million in 2010 relative to
$158 million in the prior year. That lifted its earnings per share by seven cents. Similarly, Norfolk Southern added eight cents
per share to its bottom line through lower depreciation charges.
Thus, not only do companies have to be careful in planning the proper amount of capital expenditures, but users must
understand the impact of these expenditures on measures of financial performance. As illustrated by the examples above, the
level of capital expenditures, depreciation expense, cash flow from operations, and net income all play a role in assessing a
company’s ability to generate future cash flows.
Sources: Adapted from L. Strauss, “Depreciation: An Appreciation,” Barrons Online (April 30, 2011); and D. Phelps, “Top 100 Capital Spending
Report: Greek Yogurt Plants Are Stacking Up,” www.FoodProcessing.com (April 9, 2012). |
As we indicate in the opening story, a company like Jet Blue Airways
PREVIEW OF CHAPTER 10
has a substantial investment in property, plant, and equipment.
Conversely, other companies, such as Microsoft, have a minor invest-
ment in these types of assets. In this chapter, we discuss the proper accounting for the acquisition, use, and
disposition of property, plant, and equipment. The content and organization of the chapter are as follows.
Acquisition and Disposition of
Property, Plant, and Equipment
Costs Subsequent
Acquisition Valuation Disposition
to Acquisition
• Acquisition costs: land, • Cash discounts • Additions • Sale
buildings, equipment • Deferred contracts • Improvements and • Involuntary conversion
• Self-constructed assets • Lump-sum purchases replacements • Miscellaneous problems
• Interest costs • Stock issuance • Rearrangement and
• Observations • Nonmonetary exchanges reinstallation
• Contributions • Repairs
• Other valuation methods • Summary
537
538 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
PROPERTY, PLANT, AND EQUIPMENT
Companies like Boeing, Target, and Starbucks use assets of a durable nature.
LEARNING OBJECTIVE 1
Such assets are called property, plant, and equipment. Other terms commonly
Describe property, plant, and
used are plant assets and fixed assets. We use these terms interchangeably.
equipment.
Property, plant, and equipment include land, building structures (offices, factories,
warehouses), and equipment (machinery, furniture, tools). The major characteristics of
property, plant, and equipment are as follows.
1. They are acquired for use in operations and not for resale. Only assets used in normal
business operations are classifi ed as property, plant, and equipment. For example,
an idle building is more appropriately classifi ed separately as an investment. Land
developers or subdividers classify land as inventory.
2. They are long-term in nature and usually depreciated. Property, plant, and equipment
yield services over a number of years. Companies allocate the cost of the investment
in these assets to future periods through periodic depreciation charges. The
Underlying Concepts
exception is land, which is depreciated only if a material decrease in value
Fair value is relevant to inventory occurs, such as a loss in fertility of agricultural land because of poor crop
but less so for property, plant, rotation, drought, or soil erosion.
and equipment which, consistent
3. They possess physical substance. Property, plant, and equipment are tangi-
with the going-concern
ble assets characterized by physical existence or substance. This differenti-
assumption, are held for use in
ates them from intangible assets, such as patents or goodwill. Unlike raw
the business, not for sale like
material, however, property, plant, and equipment do not physically become
inventory.
part of a product held for resale.
Acquisition of Property, Plant, and Equipment
Most companies use historical cost as the basis for valuing property, plant, and equip-
LEARNING OBJECTIVE 2
ment. Historical cost measures the cash or cash equivalent price of obtaining the
Identify the costs to include in initial
asset and bringing it to the location and condition necessary for its intended use.
valuation of property, plant, and
For example, companies like Kellogg Co. consider the purchase price, freight costs,
equipment.
sales taxes, and installation costs of a productive asset as part of the asset’s cost. It
then allocates these costs to future periods through depreciation. Further, Kellogg
International
adds to the asset’s original cost any related costs incurred after the asset’s acquisi-
Perspective
tion, such as additions, improvements, or replacements, if they provide future
Under international accounting service potential. Otherwise, Kellogg expenses these costs immediately.1
standards, historical cost is the Subsequent to acquisition, companies should not write up property, plant,
benchmark (preferred) treatment and equipment to reflect fair value when it is above cost. The main reasons for |
for property, plant, and equipment.
this position are as follows.
However, companies may also
use revalued amounts. When 1. Historical cost involves actual, not hypothetical, transactions and so is the
using revaluation, companies most reliable.
must revalue the class of assets
2. Companies should not anticipate gains and losses but should recognize
regularly.
gains and losses only when the asset is sold.
Even those who favor fair value measurement for inventory and financial instru-
ments often take the position that property, plant, and equipment should not be reval-
ued. The major concern is the difficulty of developing a reliable fair value for these types
1Additional costs to be included in the cost of property, plant, and equipment are those related
to asset retirement obligations (AROs). These costs, such as those related to decommissioning
nuclear facilities or reclamation or restoration of a mining facility, reflect a legal requirement to
retire the asset at the end of its useful life. The expected costs are recorded in the asset cost and
depreciated over the useful life (see Chapter 13).
Property, Plant, and Equipment 539
of assets. For example, how does one value a General Motors automobile manufacturing
plant or a nuclear power plant owned by Consolidated Edison?
However, if the fair value of the property, plant, and equipment is less than its carry-
ing amount, the asset may be written down. These situations occur when the asset is
impaired (discussed in Chapter 11) and in situations where the asset is being held for sale.
A long-lived asset classified as held for sale should be measured at the lower of its carrying
amount or fair value less costs to sell. In that case, a reasonable valuation for the asset can
See the FASB
be obtained, based on the sales price. A long-lived asset is not depreciated if it is classified Codification section
as held for sale. This is because such assets are not being used to generate revenues. [1] (page 564).
Cost of Land
All expenditures made to acquire land and ready it for use are considered part of the
land cost. Thus, when Wal-Mart Stores, Inc. or Home Depot purchases land on which
to build a new store, its land costs typically include (1) the purchase price; (2) closing
costs, such as title to the land, attorney’s fees, and recording fees; (3) costs incurred in
getting the land in condition for its intended use, such as grading, filling, draining, and
clearing; (4) assumption of any liens, mortgages, or encumbrances on the property; and
Gateway to
(5) any additional land improvements that have an indefinite life.
the Profession
For example, when Home Depot purchases land for the purpose of constructing
Expanded Discussion
a building, it considers all costs incurred up to the excavation for the new building as of Alternative Valuation
land costs. Removal of old buildings—clearing, grading, and filling—is a land cost Methods
because this activity is necessary to get the land in condition for its intended purpose.
Home Depot treats any proceeds from getting the land ready for its intended use, such
as salvage receipts on the demolition of an old building or the sale of cleared timber, as
reductions in the price of the land.
In some cases, when Home Depot purchases land, it may assume certain obligations
on the land such as back taxes or liens. In such situations, the cost of the land is the cash
paid for it, plus the encumbrances. In other words, if the purchase price of the land is
$50,000 cash but Home Depot assumes accrued property taxes of $5,000 and liens of
$10,000, its land cost is $65,000.
Home Depot also might incur special assessments for local improvements, such as
pavements, street lights, sewers, and drainage systems. It should charge these costs to
the Land account because they are relatively permanent in nature. That is, after installa-
tion, they are maintained by the local government. In addition, Home Depot should
charge any permanent improvements it makes, such as landscaping, to the Land ac-
count. It records separately any improvements with limited lives, such as private |
driveways, walks, fences, and parking lots, as Land Improvements. These costs are
depreciated over their estimated lives.
Generally, land is part of property, plant, and equipment. However, if the major
purpose of acquiring and holding land is speculative, a company more appropriately
classifies the land as an investment. If a real estate concern holds the land for resale, it
should classify the land as inventory.
In cases where land is held as an investment, what accounting treatment should be
given for taxes, insurance, and other direct costs incurred while holding the land? Many
believe these costs should be capitalized. The reason: They are not generating revenue
from the investment at this time. Companies generally use this approach except when
the asset is currently producing revenue (such as rental property).
Cost of Buildings
The cost of buildings should include all expenditures related directly to their acquisition
or construction. These costs include (1) materials, labor, and overhead costs incurred
during construction, and (2) professional fees and building permits. Generally, companies
540 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
contract others to construct their buildings. Companies consider all costs incurred, from
excavation to completion, as part of the building costs.
But how should companies account for an old building that is on the site of a newly
proposed building? Is the cost of removal of the old building a cost of the land or a cost
of the new building? Recall that if a company purchases land with an old building on
it, then the cost of demolition less its salvage value is a cost of getting the land ready
for its intended use and relates to the land rather than to the new building. In other
words, all costs of getting an asset ready for its intended use are costs of that asset.
Cost of Equipment
The term “equipment” in accounting includes delivery equipment, office equipment,
machinery, furniture and fixtures, furnishings, factory equipment, and similar fixed
assets. The cost of such assets includes the purchase price, freight and handling charges
incurred, insurance on the equipment while in transit, cost of special foundations if
required, assembling and installation costs, and costs of conducting trial runs. Costs thus
include all expenditures incurred in acquiring the equipment and preparing it for use.
Self-Constructed Assets
Occasionally, companies construct their own assets. Determining the cost of such
LEARNING OBJECTIVE 3
machinery and other fixed assets can be a problem. Without a purchase price or
Describe the accounting problems
contract price, the company must allocate costs and expenses to arrive at the cost
associated with self-constructed
of the self-constructed asset. Materials and direct labor used in construction pose
assets.
no problem. A company can trace these costs directly to work and material orders
related to the fixed assets constructed.
However, the assignment of indirect costs of manufacturing creates special prob-
lems. These indirect costs, called overhead or burden, include power, heat, light, insur-
ance, property taxes on factory buildings and equipment, factory supervisory labor,
depreciation of fixed assets, and supplies.
Companies can handle indirect costs in one of two ways:
1. Assign no fi xed overhead to the cost of the constructed asset. The major argument
for this treatment is that indirect overhead is generally fi xed in nature. It does not
increase as a result of a company constructing its own plant or equipment. This
approach assumes that the company will have the same costs regardless of whether
it constructs the asset or not. Therefore, to charge a portion of the overhead costs to
the equipment will normally reduce current expenses and consequently overstate
income of the current period. However, the company would assign to the cost of the
constructed asset variable overhead costs that increase as a result of the construction.
2. Assign a portion of all overhead to the construction process. This approach, called |
a full-costing approach, follows the belief that costs should attach to all products
and assets manufactured or constructed. Under this approach, a company assigns a
portion of all overhead to the construction process, as it would to normal produc-
tion. Advocates say that failure to allocate overhead costs understates the initial cost
of the asset and results in an inaccurate future allocation.
Companies should assign to the asset a pro rata portion of the fixed overhead to
determine its cost. Companies use this treatment extensively because many believe that
it results in a better recognition of these costs in periods benefited.
If the allocated overhead results in recording construction costs in excess of the costs
that an outside independent producer would charge, the company should record the
Property, Plant, and Equipment 541
excess overhead as a period loss rather than capitalize it. This avoids capitalizing the
asset at more than its probable fair value.2
Interest Costs During Construction
The proper accounting for interest costs has been a long-standing controversy.
4 LEARNING OBJECTIVE
Three approaches have been suggested to account for the interest incurred in
Describe the accounting problems
financing the construction of property, plant, and equipment:
associated with interest capitalization.
1. Capitalize no interest charges during construction. Under this approach, interest is
considered a cost of fi nancing and not a cost of construction. Some contend that if a
company had used stock (equity) fi nancing rather than debt, it would not incur this
cost. The major argument against this approach is that the use of cash, whatever its
source, has an associated implicit interest cost, which should not be ignored.
2. Charge construction with all costs of funds employed, whether identifi able or not.
This method maintains that the cost of construction should include the cost of fi -
nancing, whether by cash, debt, or stock. Its advocates say that all costs necessary to
get an asset ready for its intended use, including interest, are part of the asset’s cost.
Interest, whether actual or imputed, is a cost, just as are labor and materials. A major
criticism of this approach is that imputing the cost of equity capital (stock) is subjec-
tive and outside the framework of an historical cost system.
3. Capitalize only the actual interest costs incurred during construction. This ap-
proach agrees in part with the logic of the second approach—that interest is just as
much a cost as are labor and materials. But this approach capitalizes only interest
costs incurred through debt fi nancing. (That is, it does not try to determine the cost
of equity fi nancing.) Under this approach, a company that uses debt fi nancing will
have an asset of higher cost than a company that uses stock fi nancing. Some con-
sider this approach unsatisfactory because they believe the cost of an asset should
be the same whether it is fi nanced with cash, debt, or equity.
Illustration 10-1 shows how a company might add interest costs (if any) to the cost
of the asset under the three capitalization approaches.
ILLUSTRATION 10-1
Increase to Cost of Asset
Capitalization of Interest
$ 0 $ ?
Costs
Capitalize Capitalize
no interest all costs
Capitalize actual
during of funds
costs incurred
construction
during construction
GAAP
2A committee of the AICPA argues against allocation of overhead. Instead, it supports capitaliza-
tion of only direct costs (costs directly related to the specific activities involved in the construc-
tion process). AcSEC was concerned that the allocation of overhead costs may lead to overly
aggressive allocations and therefore misstatements of income. In addition, not reporting these
costs as period costs during the construction period may affect comparisons of period costs and
resulting net income from one period to the next. See Accounting Standards Executive Committee,
“Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment,”
Exposure Draft (New York: AICPA, June 29, 2001). |
542 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
GAAP requires the third approach—capitalizing actual interest (with modification).
This method follows the concept that the historical cost of acquiring an asset includes
all costs (including interest) incurred to bring the asset to the condition and location
necessary for its intended use. The rationale for this approach is that during construc-
tion, the asset is not generating revenues. Therefore, a company should defer (capitalize)
interest costs. [2] Once construction is complete, the asset is ready for its
Underlying Concepts intended use and a company can earn revenues. At this point, the company
should report interest as an expense and match it to these revenues. It follows
The objective of capitalizing
that the company should expense any interest cost incurred in purchasing an
interest is to obtain a measure
asset that is ready for its intended use.
of acquisition cost that refl ects
To implement this general approach, companies consider three items:
a company’s total investment in
the asset and to charge that cost
1. Qualifying assets.
to future periods benefi ted.
2. Capitalization period.
3. Amount to capitalize.
Qualifying Assets
To qualify for interest capitalization, assets must require a period of time to get them
ready for their intended use. A company capitalizes interest costs starting with the first
expenditure related to the asset. Capitalization continues until the company substan-
tially readies the asset for its intended use.
Assets that qualify for interest cost capitalization include assets under construction
for a company’s own use (including buildings, plants, and large machinery) and assets
intended for sale or lease that are constructed or otherwise produced as discrete projects
(e.g., ships or real estate developments).
Examples of assets that do not qualify for interest capitalization are (1) assets that
are in use or ready for their intended use, and (2) assets that the company does not use
in its earnings activities and that are not undergoing the activities necessary to get them
ready for use. Examples of this second type include land remaining undeveloped and
assets not used because of obsolescence, excess capacity, or need for repair.
International
Capitalization Period
Perspective
The capitalization period is the period of time during which a company must
Recently, IFRS changed to capitalize interest. It begins with the presence of three conditions:
require companies to capitalize
borrowing costs related to 1. Expenditures for the asset have been made.
qualifying assets. These changes 2. Activities that are necessary to get the asset ready for its intended use are in
were made as part of the IASB’s
progress.
and FASB’s convergence project.
3. Interest cost is being incurred.
Interest capitalization continues as long as these three conditions are present. The
capitalization period ends when the asset is substantially complete and ready for its
intended use.
Amount to Capitalize
The amount of interest to capitalize is limited to the lower of actual interest cost
incurred during the period or avoidable interest. Avoidable interest is the amount of
interest cost during the period that a company could theoretically avoid if it had not
made expenditures for the asset. If the actual interest cost for the period is $90,000 and
the avoidable interest is $80,000, the company capitalizes only $80,000. Or, if the actual
Property, Plant, and Equipment 543
interest cost is $80,000 and the avoidable interest is $90,000, it still capitalizes only
$80,000. In no situation should interest cost include a cost of capital charge for stock-
holders’ equity. Furthermore, GAAP requires interest capitalization for a qualifying asset
only if its effect, compared with the effect of expensing interest, is material. [3]
To apply the avoidable interest concept, a company determines the potential amount
of interest that it may capitalize during an accounting period by multiplying the interest
rate(s) by the weighted-average accumulated expenditures for qualifying assets during |
the period.
Weighted-Average Accumulated Expenditures. In computing the weighted-average
accumulated expenditures, a company weights the construction expenditures by the
amount of time (fraction of a year or accounting period) that it can incur interest cost on
the expenditure.
To illustrate, assume a 17-month bridge construction project with current-year
payments to the contractor of $240,000 on March 1, $480,000 on July 1, and $360,000 on
November 1. The company computes the weighted-average accumulated expenditures
for the year ended December 31 as follows.
ILLUSTRATION 10-2
Expenditures
Capitalization Weighted-Average Computation of
Date Amount 3 Period* 5 Accumulated Expenditures Weighted-Average
March 1 $ 240,000 10/12 $200,000 Accumulated
July 1 480,000 6/12 240,000 Expenditures
November 1 360,000 2/12 60,000
$1,080,000 $500,000
*Months between date of expenditure and date interest capitalization stops or end of year,
whichever comes first (in this case December 31).
To compute the weighted-average accumulated expenditures, a company weights
the expenditures by the amount of time that it can incur interest cost on each one. For
the March 1 expenditure, the company associates 10 months’ interest cost with the
expenditure. For the expenditure on July 1, it incurs only 6 months’ interest costs. For the
expenditure made on November 1, the company incurs only 2 months of interest cost.
Interest Rates. Companies follow the below principles in selecting the appropriate
interest rates to be applied to the weighted-average accumulated expenditures:
1. For the portion of weighted-average accumulated expenditures that is less than or
equal to any amounts borrowed specifi cally to fi nance construction of the assets,
use the interest rate incurred on the specifi c borrowings.
2. For the portion of weighted-average accumulated expenditures that is greater
than any debt incurred specifi cally to fi nance construction of the assets, use a
weighted average of interest rates incurred on all other outstanding debt during
the period.3
3The interest rate to be used may rely exclusively on an average rate of all the borrowings, if
desired. For our purposes, we use the specific borrowing rate followed by the average interest
rate because we believe it to be more conceptually consistent. Either method can be used; GAAP
does not provide explicit guidance on this measurement. For a discussion of this issue and
others related to interest capitalization, see Kathryn M. Means and Paul M. Kazenski, “SFAS 34:
Recipe for Diversity,” Accounting Horizons (September 1988); and Wendy A. Duffy, “A Graphical
Analysis of Interest Capitalization,” Journal of Accounting Education (Fall 1990).
544 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
Illustration 10-3 shows the computation of a weighted-average interest rate for debt
greater than the amount incurred specifically to finance construction of the assets.
ILLUSTRATION 10-3
Principal Interest
Computation of
12%, 2-year note $ 600,000 $ 72,000
Weighted-Average
9%, 10-year bonds 2,000,000 180,000
Interest Rate
7.5%, 20-year bonds 5,000,000 375,000
$7,600,000 $627,000
Total interest $627,000
Weighted-average interest rate 5 5 58.25%
Total principal $7,600,000
Comprehensive Example of Interest Capitalization
To illustrate the issues related to interest capitalization, assume that on November 1,
2013, Shalla Company contracted Pfeifer Construction Co. to construct a building for
$1,400,000 on land costing $100,000 (purchased from the contractor and included in
the first payment). Shalla made the following payments to the construction company
during 2014.
January 1 March 1 May 1 December 31 Total
$210,000 $300,000 $540,000 $450,000 $1,500,000
Pfeifer Construction completed the building, ready for occupancy, on December 31,
2014. Shalla had the following debt outstanding at December 31, 2014.
Specifi c Construction Debt
1. 15%, 3-year note to fi nance purchase of land and construction of the
building, dated December 31, 2013, with interest payable annually on |
December 31 $750,000
Other Debt
2. 10%, 5-year note payable, dated December 31, 2010, with interest
payable annually on December 31 $550,000
3. 12%, 10-year bonds issued December 31, 2009, with interest payable
annually on December 31 $600,000
Shalla computed the weighted-average accumulated expenditures during 2014 as
shown in Illustration 10-4.
ILLUSTRATION 10-4
Expenditures Current-Year
Computation of
Capitalization Weighted-Average
Weighted-Average Date Amount 3 Period 5 Accumulated Expenditures
Accumulated
January 1 $ 210,000 12/12 $210,000
Expenditures
March 1 300,000 10/12 250,000
May 1 540,000 8/12 360,000
December 31 450,000 0 0
$1,500,000 $820,000
Note that the expenditure made on December 31, the last day of the year, does not have
any interest cost.
Shalla computes the avoidable interest as shown in Illustration 10-5.
Property, Plant, and Equipment 545
ILLUSTRATION 10-5
Weighted-Average
Computation of
Accumulated Expenditures 3 Interest Rate 5 Avoidable Interest
Avoidable Interest
$750,000 .15 (construction note) $112,500
70,000a .1104 (weighted average of 7,728
$820,000 other debt)b $120,228
aThe amount by which the weighted-average accumulated expenditures exceeds the specific
construction loan.
bWeighted-average interest rate computation: Principal Interest
10%, 5-year note $ 550,000 $ 55,000
12%, 10-year bonds 600,000 72,000
$1,150,000 $127,000
Total interest $127,000
Weighted-average interest rate5 5 511.04%
Total principal $1,150,000
The company determines the actual interest cost, which represents the maximum
amount of interest that it may capitalize during 2014, as shown in Illustration 10-6.
ILLUSTRATION 10-6
Construction note $750,000 3 .15 5 $112,500
Computation of Actual
5-year note $550,000 3 .10 5 55,000
Interest Cost
10-year bonds $600,000 3 .12 5 72,000
Actual interest $239,500
The interest cost that Shalla capitalizes is the lesser of $120,228 (avoidable interest)
and $239,500 (actual interest), or $120,228.
Shalla records the following journal entries during 2014:
January 1
Land 100,000
Gateway to
Buildings (or Construction in Process) 110,000
the Profession
Cash 210,000
Tutorial on Interest
Capitalization
March 1
Buildings 300,000
Cash 300,000
May 1
Buildings 540,000
Cash 540,000
December 31
Buildings 450,000
Cash 450,000
Buildings (Capitalized Interest) 120,228
Interest Expense ($239,500 2 $120,228) 119,272
Cash ($112,500 1 $55,000 1 $72,000) 239,500
Shalla should write off capitalized interest cost as part of depreciation over the
useful life of the assets involved and not over the term of the debt. It should disclose the
total interest cost incurred during the period, with the portion charged to expense and
the portion capitalized indicated.
At December 31, 2014, Shalla discloses the amount of interest capitalized either as
part of the nonoperating section of the income statement or in the notes accompanying
546 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
the financial statements. We illustrate both forms of disclosure, in Illustrations 10-7
and 10-8.4
ILLUSTRATION 10-7
Income from operations XXXX
Capitalized Interest
Other expenses and losses:
Reported in the Income
Interest expense $239,500
Statement Less: Capitalized interest 120,228 119,272
Income before income taxes XXXX
Income taxes XXX
Net income XXXX
ILLUSTRATION 10-8
Note 1: Accounting Policies. Capitalized Interest. During 2014, total interest cost was $239,500, of
Capitalized Interest
which $120,228 was capitalized and $119,272 was charged to expense.
Disclosed in a Note
What do the numbers mean? WHAT’S IN YOUR INTEREST?
The requirement to capitalize interest can signifi cantly Anadarko Petroleum Corporation capitalized nearly 30 per-
impact fi nancial statements. For example, when earnings of cent of its total interest costs in a recent year and provided
building manufacturer Jim Walter’s Corporation dropped the following footnote related to capitalized interest.
from $1.51 to $1.17 per share, the company offset 11 cents per
share of the decline by capitalizing the interest on coal min-
Financial Footnotes |
ing projects and several plants under construction.
Total interest costs incurred during the year were $82,415,000.
How do statement users determine the impact of interest Of this amount, the Company capitalized $24,716,000.
capitalization on a company’s bottom line? They examine the Capitalized interest is included as part of the cost of oil and
notes to the fi nancial statements. Companies with material gas properties. The capitalization rates are based on the
Company’s weighted-average cost of borrowings used to
interest capitalization must disclose the amounts of capital-
finance the expenditures.
ized interest relative to total interest costs. For example,
Special Issues Related to Interest Capitalization
Two issues related to interest capitalization merit special attention:
1. Expenditures for land.
2. Interest revenue.
Expenditures for Land. When a company purchases land with the intention of develop-
ing it for a particular use, interest costs associated with those expenditures qualify for
interest capitalization. If it purchases land as a site for a structure (such as a plant
International
Perspective site), interest costs capitalized during the period of construction are part of the
cost of the plant, not the land. Conversely, if the company develops land for lot
IFRS requires that interest
sales, it includes any capitalized interest cost as part of the acquisition cost of the
revenue earned on specifi c
developed land. However, it should not capitalize interest costs involved in pur-
borrowings should offset interest
chasing land held for speculation because the asset is ready for its intended use.
costs capitalized. The rationale
is that the interest revenue
Interest Revenue. Companies frequently borrow money to finance construction
earned is directly related to the
of assets. They temporarily invest the excess borrowed funds in interest-bearing
interest cost incurred on the
securities until they need the funds to pay for construction. During the early
specifi c borrowing.
stages of construction, interest revenue earned may exceed the interest cost
incurred on the borrowed funds.
4In subsequent years of a multi-year project, Shalla would follow the same procedures as presented
for year 1. That is, interest to be capitalized each year is determined, based on weighted-average
expenditures in that year multiplied by the appropriate interest rate, and then compared to actual
interest. Total interest for the year is then allocated to interest expense and capitalized interest.
Valuation of Property, Plant, and Equipment 547
Should companies offset interest revenue against interest cost when determining
the amount of interest to capitalize as part of the construction cost of assets? In general,
companies should not net or offset interest revenue against interest cost. Temporary
or short-term investment decisions are not related to the interest incurred as part of the
acquisition cost of assets. Therefore, companies should capitalize the interest incurred
on qualifying assets whether or not they temporarily invest excess funds in short-term
securities. Some criticize this approach because a company can defer the interest cost
but report the interest revenue in the current period.
Observations
The interest capitalization requirement is still debated. From a conceptual viewpoint,
many believe that, for the reasons mentioned earlier, companies should either capitalize
no interest cost or all interest costs, actual or imputed.
VALUATION OF PROPERTY, PLANT,
AND EQUIPMENT
Like other assets, companies should record property, plant, and equipment at
5 LEARNING OBJECTIVE
the fair value of what they give up or at the fair value of the asset received,
Understand accounting issues related
whichever is more clearly evident. However, the process of asset acquisition
to acquiring and valuing plant assets.
sometimes obscures fair value. For example, if a company buys land and buildings
together for one price, how does it determine separate values for the land and build-
ings? We examine these types of accounting problems in the following sections. |
Cash Discounts
When a company purchases plant assets subject to cash discounts for prompt payment,
how should it report the discount? If it takes the discount, the company should consider
the discount as a reduction in the purchase price of the asset. But should the company
reduce the asset cost even if it does not take the discount?
Two points of view exist on this question. One approach considers the discount—
whether taken or not—as a reduction in the cost of the asset. The rationale for this ap-
proach is that the real cost of the asset is the cash or cash equivalent price of the asset. In
addition, some argue that the terms of cash discounts are so attractive that failure to take
them indicates management error or inefficiency.
Proponents of the other approach argue that failure to take the discount should not
always be considered a loss. The terms may be unfavorable, or it might not be prudent
for the company to take the discount. At present, companies use both methods though
most prefer the former method.
Deferred-Payment Contracts
Companies frequently purchase plant assets on long-term credit contracts, using notes,
mortgages, bonds, or equipment obligations. To properly reflect cost, companies ac-
count for assets purchased on long-term credit contracts at the present value of the
consideration exchanged between the contracting parties at the date of the transaction.
For example, Greathouse Company purchases an asset today in exchange for a
$10,000 zero-interest-bearing note payable four years from now. The company would
not record the asset at $10,000. Instead, the present value of the $10,000 note establishes
the exchange price of the transaction (the purchase price of the asset). Assuming an
appropriate interest rate of 9 percent at which to discount this single payment of $10,000
548 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
due four years from now, Greathouse records this asset at $7,084.30 ($10,000 3 .70843).
[See Table 6-2 (page 337) for the present value of a single sum, PV 5 $10,000 (PVF ).]
4,9%
When no interest rate is stated or if the specified rate is unreasonable, the company
imputes an appropriate interest rate. The objective is to approximate the interest rate
that the buyer and seller would negotiate at arm’s length in a similar borrowing transac-
tion. In imputing an interest rate, companies consider such factors as the borrower’s
credit rating, the amount and maturity date of the note, and prevailing interest rates.
The company uses the cash exchange price of the asset acquired (if determinable) as
the basis for recording the asset and measuring the interest element.
To illustrate, Sutter Company purchases a specially built robot spray painter for its
production line. The company issues a $100,000, five-year, zero-interest-bearing note to
Wrigley Robotics, Inc. for the new equipment. The prevailing market rate of interest for
obligations of this nature is 10 percent. Sutter is to pay off the note in five $20,000 install-
ments, made at the end of each year. Sutter cannot readily determine the fair value of
this specially built robot. Therefore, Sutter approximates the robot’s value by establish-
ing the fair value (present value) of the note. Entries for the date of purchase and dates
of payments, plus computation of the present value of the note, are as follows.
Date of Purchase
Equipment 75,816*
Discount on Notes Payable 24,184
Notes Payable 100,000
*Present value of note 5 $20,000 (PVF-OA )
5,10%
5 $20,000 (3.79079); Table 6-4
5 $75,816
End of First Year
Interest Expense 7,582
Notes Payable 20,000
Cash 20,000
Discount on Notes Payable 7,582
Interest expense in the first year under the effective-interest approach is $7,582
[($100,000 2 $24,184) 3 10%]. The entry at the end of the second year to record interest
and principal payment is as follows.
End of Second Year
Interest Expense 6,340
Notes Payable 20,000
Cash 20,000
Discount on Notes Payable 6,340
Interest expense in the second year under the effective-interest approach is $6,340 |
[($100,000 2 $24,184) 2 ($20,000 2 $7,582)] 3 10%.
If Sutter did not impute an interest rate for deferred-payment contracts, it would
record the asset at an amount greater than its fair value and overstate depreciation
expense. In addition, Sutter would understate interest expense in the income statement
for all periods involved.
Lump-Sum Purchases
A special problem of valuing fixed assets arises when a company purchases a group of
plant assets at a single lump-sum price. When this common situation occurs, the com-
pany allocates the total cost among the various assets on the basis of their relative fair
values. The assumption is that costs will vary in direct proportion to fair value. This is
Valuation of Property, Plant, and Equipment 549
the same principle that companies apply to allocate a lump-sum cost among different
inventory items.
To determine fair value, a company should use valuation techniques that are
appropriate in the circumstances. In some cases, a single valuation technique will be
appropriate. In other cases, multiple valuation approaches might have to be used.5
To illustrate, Norduct Homes, Inc. decides to purchase several assets of a small heat-
ing concern, Comfort Heating, for $80,000. Comfort Heating is in the process of liquida-
tion. Its assets sold are:
Book Value Fair Value
Inventory $30,000 $ 25,000
Land 20,000 25,000
Building 35,000 50,000
$85,000 $100,000
Norduct Homes allocates the $80,000 purchase price on the basis of the relative fair values
(assuming specific identification of costs is impracticable) in the following manner.
ILLUSTRATION 10-9
$25,000
Inventory 3 $80,0005$20,000 Allocation of Purchase
$100,000
Price—Relative Fair
$25,000 Value Basis
Land 3$80,0005$20,000
$100,000
$50,000
Building 3$80,0005$40,000
$100,000
Issuance of Stock
When companies acquire property by issuing securities, such as common stock, the par
or stated value of such stock fails to properly measure the property cost. If trading of the
stock is active, the market price of the stock issued is a fair indication of the cost of the
property acquired. The stock is a good measure of the current cash equivalent price.
For example, Upgrade Living Co. decides to purchase some adjacent land for
expansion of its carpeting and cabinet operation. In lieu of paying cash for the land, the
company issues to Deedland Company 5,000 shares of common stock (par value $10)
that have a fair value of $12 per share. Upgrade Living Co. records the following entry.
Land (5,000 3 $12) 60,000
Common Stock 50,000
Paid-In Capital in Excess of Par—Common Stock 10,000
If the company cannot determine the market price of the common stock exchanged,
it establishes the fair value of the property. It then uses the value of the property as the
basis for recording the asset and issuance of the common stock.
5The valuation approaches that should be used are the market, income, or cost approach, or a
combination of these approaches. The market approach uses observable prices and other relevant
information generated by market transactions involving comparable assets. The income approach
uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a
single present value amount (discounted). The cost approach is based on the amount that
currently would be required to replace the service capacity of an asset (often referred to as
current replacement cost). In determining the fair value, the company should assume the
highest and best use of the asset. [4]
550 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
Exchanges of Nonmonetary Assets
The proper accounting for exchanges of nonmonetary assets, such as property, plant,
and equipment, is controversial.6 Some argue that companies should account for these
types of exchanges based on the fair value of the asset given up or the fair value of the
asset received, with a gain or loss recognized. Others believe that they should account
for exchanges based on the recorded amount (book value) of the asset given up, with no
gain or loss recognized. Still others favor an approach that recognizes losses in all cases |
but defers gains in special situations.
Ordinarily, companies account for the exchange of nonmonetary assets on the basis
of the fair value of the asset given up or the fair value of the asset received, whichever
is clearly more evident. [5] Thus, companies should recognize immediately any gains
or losses on the exchange. The rationale for immediate recognition is that most transac-
tions have commercial substance, and therefore gains and losses should be recognized.
International Meaning of Commercial Substance
Perspective As indicated above, fair value is the basis for measuring an asset acquired in
a nonmonetary exchange if the transaction has commercial substance. An
The FASB changed its account-
ing for exchanges to converge exchange has commercial substance if the future cash flows change as a result
with IFRS. Previously, the FASB of the transaction. That is, if the two parties’ economic positions change, the
used a “similar in nature” transaction has commercial substance.
criterion for exchanged assets For example, Andrew Co. exchanges some of its equipment for land held by
to determine whether gains Roddick Inc. It is likely that the timing and amount of the cash flows arising for
should be recognized. With use the land will differ significantly from the cash flows arising from the equip-
of the commercial substance
ment. As a result, both Andrew Co. and Roddick Inc. are in different economic
test, GAAP and IFRS are now
positions. Therefore, the exchange has commercial substance, and the compa-
very similar.
nies recognize a gain or loss on the exchange.
What if companies exchange similar assets, such as one truck for another
truck? Even in an exchange of similar assets, a change in the economic position
of the company can result. For example, let’s say the useful life of the truck received is
significantly longer than that of the truck given up. The cash flows for the trucks can
differ significantly. As a result, the transaction has commercial substance, and the com-
pany should use fair value as a basis for measuring the asset received in the exchange.
However, it is possible to exchange similar assets but not have a significant differ-
ence in cash flows. That is, the company is in the same economic position as before the
exchange. In that case, the company recognizes a loss but generally defers a gain.
As we will see in the following examples, use of fair value generally results in
recognizing a gain or loss at the time of the exchange. Consequently, companies must
determine if the transaction has commercial substance. To make this determination,
they must carefully evaluate the cash flow characteristics of the assets exchanged.7
Illustration 10-10 summarizes asset exchange situations and the related accounting.
6Nonmonetary assets are items whose price in terms of the monetary unit may change over time.
Monetary assets—cash and short- or long-term accounts and notes receivable—are fixed in
terms of units of currency by contract or otherwise.
7The determination of the commercial substance of a transaction requires significant judgment.
In determining whether future cash flows change, it is necessary to do one of two things.
(1) Determine whether the risk, timing, and amount of cash flows arising for the asset received
differ from the cash flows associated with the outbound asset. Or, (2) evaluate whether cash
flows are affected with the exchange versus without the exchange. Also note that if companies
cannot determine fair values of the assets exchanged, then they should use recorded book values
in accounting for the exchange.
Valuation of Property, Plant, and Equipment 551
ILLUSTRATION 10-10
Type of Exchange Accounting Guidance
Accounting for
Exchange has commercial Recognize gains and losses Exchanges
substance. immediately.
Exchange lacks commercial Defer gains;recognize losses
substance—no cash received. immediately.
Exchange lacks commercial Recognize partial gain;
substance—cash received. recognize losses immediately.*
*If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process is
complete. |
As Illustration 10-10 indicates, companies immediately recognize losses they incur
on all exchanges. The accounting for gains depends on whether the exchange has com-
mercial substance. If the exchange has commercial substance, the company recognizes
the gain immediately. However, the profession modifies the rule for immediate recogni-
tion of a gain when an exchange lacks commercial substance: If the company receives
no cash in such an exchange, it defers recognition of a gain. If the company receives
cash in such an exchange, it recognizes part of the gain immediately.
To illustrate the accounting for these different types of transactions, we examine
various loss and gain exchange situations.
Exchanges—Loss Situation
When a company exchanges nonmonetary assets and a loss results, the company recog-
nizes the loss immediately. The rationale: Companies should not value assets at more
than their cash equivalent price. If the loss were deferred, assets would be overstated.
Therefore, companies recognize a loss immediately whether the exchange has commer-
cial substance or not.
For example, Information Processing, Inc. trades its used machine for a new model
at Jerrod Business Solutions Inc. The exchange has commercial substance. The used ma-
chine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated deprecia-
tion) and a fair value of $6,000. The new model lists for $16,000. Jerrod gives Information
Processing a trade-in allowance of $9,000 for the used machine. Information Processing
computes the cost of the new asset as follows.
ILLUSTRATION 10-11
List price of new machine $16,000
Computation of Cost of
Less: Trade-in allowance for used machine 9,000
New Machine
Cash payment due 7,000
Fair value of used machine 6,000
Cost of new machine $13,000
Information Processing records this transaction as follows.
Equipment 13,000
Accumulated Depreciation—Equipment 4,000
Loss on Disposal of Equipment 2,000
Equipment 12,000
Cash 7,000
We verify the loss on the disposal of the used machine as follows.
ILLUSTRATION 10-12
Fair value of used machine $6,000
Computation of Loss on
Less: Book value of used machine 8,000
Disposal of Used
Loss on disposal of used machine $2,000
Machine
552 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
Why did Information Processing not use the trade-in allowance or the book value of
the old asset as a basis for the new equipment? The company did not use the trade-in
allowance because it included a price concession (similar to a price discount). Few indi-
viduals pay list price for a new car. Dealers such as Jerrod often inflate trade-in allow-
ances on the used car so that actual selling prices fall below list prices. To record the car
at list price would state it at an amount in excess of its cash equivalent price because of
the new car’s inflated list price. Similarly, use of book value in this situation would over-
state the value of the new machine by $2,000.8
Exchanges—Gain Situation
Has Commercial Substance. Now let’s consider the situation in which a nonmonetary
exchange has commercial substance and a gain is realized. In such a case, a company
usually records the cost of a nonmonetary asset acquired in exchange for another non-
monetary asset at the fair value of the asset given up and immediately recognizes a
gain. The company should use the fair value of the asset received only if it is more
clearly evident than the fair value of the asset given up.
To illustrate, Interstate Transportation Company exchanged a number of used trucks
plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost
$64,000 less $22,000 accumulated depreciation). Interstate’s purchasing agent, experi-
enced in the secondhand market, indicates that the used trucks have a fair value of
$49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi-truck.
Interstate computes the cost of the semi-truck as follows.
ILLUSTRATION 10-13
Fair value of trucks exchanged $49,000
Computation of
Cash paid 11,000
Semi-Truck Cost |
Cost of semi-truck $60,000
Interstate records the exchange transaction as follows.
Trucks (semi) 60,000
Accumulated Depreciation—Trucks 22,000
Trucks (used) 64,000
Gain on Disposal of Trucks 7,000
Cash 11,000
The gain is the difference between the fair value of the used trucks and their book
value. We verify the computation as follows.
ILLUSTRATION 10-14
Fair value of used trucks $49,000
Computation of Gain on
Cost of used trucks $64,000
Disposal of Used Trucks
Less: Accumulated depreciation 22,000
Book value of used trucks (42,000)
Gain on disposal of used trucks $ 7,000
In this case, Interstate is in a different economic position, and therefore the transac-
tion has commercial substance. Thus, it recognizes a gain.
Lacks Commercial Substance—No Cash Received. We now assume that the Interstate
Transportation Company exchange lacks commercial substance. That is, the economic
8Recognize that for Jerrod (the dealer), the asset given up in the exchange is considered inventory.
As a result, Jerrod records a sale and related cost of goods sold. The used machine received by
Jerrod is recorded at fair value.
Valuation of Property, Plant, and Equipment 553
position of Interstate did not change significantly as a result of this exchange. In this
case, Interstate defers the gain of $7,000 and reduces the basis of the semi-truck.
Illustration 10-15 shows two different but acceptable computations to illustrate this
reduction.
ILLUSTRATION 10-15
Fair value of semi-truck $60,000 Book value of used trucks $42,000
Basis of Semi-Truck—Fair
Less: Gain deferred 7,000 OR Plus: Cash paid 11,000
Value vs. Book Value
Basis of semi-truck $53,000 Basis of semi-truck $53,000
Interstate records this transaction as follows.
Trucks (semi) 53,000
Accumulated Depreciation—Trucks 22,000
Trucks (used) 64,000
Cash 11,000
If the exchange lacks commercial substance, the company recognizes the gain
(reflected in the basis of the semi-truck) through lower depreciation expense or when it
later sells the semi-truck, not at the time of the exchange.
Lacks Commercial Substance—Some Cash Received. When a company receives cash
(sometimes referred to as “boot”) in an exchange that lacks commercial substance, it
must immediately recognize a portion of the gain.9 Illustration 10-16 shows the general
formula for gain recognition when an exchange includes some cash.
ILLUSTRATION 10-16
Cash Received (Boot) Recognized
3Total Gain5 Formula for Gain
Cash Received (Boot)1Fair Value of Other Assets Received Gain
Recognition, Some Cash
Received
To illustrate, assume that Queenan Corporation traded in used machinery with a
book value of $60,000 (cost $110,000 less accumulated depreciation $50,000) and a fair
value of $100,000. It receives in exchange a machine with a fair value of $90,000 plus
cash of $10,000. Illustration 10-17 shows calculation of the total gain on the exchange.
ILLUSTRATION 10-17
Fair value of machine given up $100,000
Computation of Total
Less: Book value of machine given up 60,000
Gain
Total gain $ 40,000
Generally, when a transaction lacks commercial substance, a company defers any
gain. But because Queenan received $10,000 in cash, it recognizes a partial gain. The
portion of the gain a company recognizes is the ratio of monetary assets (cash in this
case) to the total consideration received. Queenan computes the partial gain as follows.
ILLUSTRATION 10-18
$10,000
3$40,0005$4,000 Computation of Gain
$10,0001$90,000
Based on Ratio of Cash
Received to Total
Consideration Received
9When the monetary consideration is significant, i.e., 25 percent or more of the fair value of the
exchange, both parties consider the transaction a monetary exchange. Such “monetary”
exchanges rely on the fair values to measure the gains or losses that are recognized in their
entirety. [6]
554 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment
Because Queenan recognizes only a gain of $4,000 on this transaction, it defers the
remaining $36,000 ($40,000 2 $4,000) and reduces the basis (recorded cost) of the new
machine. Illustration 10-19 shows the computation of the basis. |
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