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					Lesson 5
Problem 5-1

Review of Perpetual Inventory Accounting and Costing Methods
Respond to the following:

Lesson 5
Cost of Goods Sold and Inventory

1. What does it mean to account for inventory perpetually and what are the benefits of such an approach? 2. What kinds of companies use specific identification in the costing of their inventory and how does it work? 3. What is an inventory cost flow assumption and when is it appropriate for a company to use such an assumption rather than specific identification?

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Problem 5-1 - Answer

Problem 5-1 - Answer

Review of Perpetual Inventory Accounting and Costing Methods
1. What does it mean to account for inventory perpetually and what are the benefits of such an approach?
Answer: Accounting for inventory perpetually means that the company's inventory general ledger account and corresponding subsidiary ledgers maintained for each type of inventory item, are immediately updated for every inventory transaction to keep a running balance of not only the number of units on hand but their associated cost. The primary benefit of perpetual accounting is more effective inventory management. Excess inventory can be expensive. It takes up valuable space, increases handling costs, requires financing and increases the risk of loss from obsolescence and theft. On the other hand, insufficient inventory can result in dissatisfied customers and declining sales volume. Effective inventory management and control is crucial to a company's success, and having immediately available information on inventory quantities and costs is a valuable management tool. Another benefit of perpetual inventory accounting is that it allows companies to determine the amount of inventory loss incurred due to waste, theft or other loss. This is commonly referred to as inventory shrinkage, and the only way it can be quantified is through periodic comparison of a company's perpetual inventory records to an actual physical count. In fact, a periodic physical inventory is required at least once a year, even when using a perpetual inventory system, in order to verify, and, if necessary, adjust a company's inventory records to reflect actual quantities on hand.

2. What kinds of companies use specific identification in the costing of their inventory and how does it work?
Answer: Specific identification is an inventory costing method used by companies that have distinctive inventory where each item is different in nature or cost from every other item in stock. For example, a used car dealership uses specific identification to cost its inventory because every car in stock is different from the others and has its own specific cost. Fine art dealers also use specific identification because of the unique nature and cost of each item of inventory. Actual implementation of specific identification requires that the cost of each inventory item purchased be recorded and included in inventory until its sale, at which time that specific cost is removed from inventory and accounted for as the cost of goods sold.

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Problem 5-1 - Answer

Problem 5-2

3. What is an inventory cost flow assumption and when is it appropriate for a company to use such an assumption rather than specific identification?
Answer: Companies that sell products that are similar in nature and cost will often account for their inventory and cost of goods sold using an inventory cost flow assumption, such as FIFO (first-in, first-out), LIFO (last-in, first-out) or some weighted average. In these cases, a cost is assigned to the units sold that may not be that specific unit's cost. This is justified on the basis that the costs are not significantly different, and, in some cases, keeping a record of the specific cost of each individual item of inventory may be difficult, if not impossible. For example, a jelly bean retailer will find it pretty much impossible to accountant for inventory and cost of goods sold using specific identification. How do you keep track of the cost of each individual jelly bean? Instead, either the cost of the first units purchased, the last units purchased or an average cost of the units purchased and available for sale will be used for the cost of goods sold.

Review of Perpetual Inventory Accounting and Cost Flows
Harris Appliances has the following inventory balance of EZ Clean washing machines as of 1/1/X4: 8 units @ $192/unit (purchased 10/21/X3) 20 units @ $194/unit (purchased 12/15/X3) 28 units on hand at 1/1/X4 A. Prepare journal entries to record the transactions noted below assuming Harris uses a perpetual FIFO inventory accounting method:
1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on account, terms of 2/10, n/30. 1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount. 1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry Services for $400/unit on account, terms of 2/10, n/30, FOB shipping point. 1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on account. The machines are unused and can be resold at full price. 1/31 Harris receives payment in full, net of the discount on the 1/20 sale to Jim's.

B. Determine Harris' gross margin, gross margin percentage and percentage markup on the sale to Jim's Laundry Services.

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5-1

Problem 5-2

Problem 5-2 - Answer

C. If Harris had incurred freight costs in the purchase and receipt of EZ Clean washing machines and delivery costs in the subsequent sale to Jim's, how would such costs have been accounted for and what effect would they have had on Harris' gross margin? D. Determine the gross margin on the sale to Jim's if the (1) perpetual LIFO method, and (2) moving-weighted average (MWA) methods had been used? Which method (FIFO, LIFO, MWA) would have produced the highest gross margin? Which method (FIFO, LIFO, MWA) would have produced the highest gross margin if there had been decreasing inventory costs over time (deflation) instead of inflation? Which method would have produced the highest gross margin if all inventory had been sold during the period? E. Which inventory cost flow assumption is required for financial reporting purposes? Which inventory cost flow assumption is required for income tax purposes? Which assumption would be best for a private company that typically faces increasing inventory costs and is interested in minimizing its cash outflows? Would the use of LIFO in a time of rising inventory costs tend to over or understate the company's assets relative to current costs?

Review of Perpetual Inventory Accounting and Cost Flows
A.
1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on account, terms of 2/10, n/30.

Inventory Accounts Payable

10,000 10,000

1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount.

Accounts Payable Cash Inventory

10,000 9,800 200

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Problem 5-2 - Answer

Problem 5-2 - Answer

A. (Continued)
1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry Services for $400/unit on account, terms of 2/10, n/30, FOB shipping point.

A. (Continued)
1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on account. The machines are unused and can be resold at full price.

Accounts Receivable Sales Revenues Cost of Goods Sold Inventory

16,000 7,768* 16,000 7,768

Sales Returns and Allowances Accounts Receivable Inventory (2 units @196) Cost of Goods Sold

800 392 800 392

* Inventory available for sale: 8 units @ $192/unit (purchased 10/21/X3) 20 units @ $194/unit (purchased 12/15/X3) 50 units @ $196/unit (purchased 1/5/X4) Cost of Goods Sold (FIFO): 8 units @ $192/unit = $ 1,536 3,880 20 units @ $194/unit = 2,352 12 units @ $196/unit = $ 7,768 40

1/31 Harris receives payment in full, net of the discount on the 1/20 sale to Jim's.

Cash ($15,200 x 98%) Sales Discounts ($15,200 x 2%) Accounts Receivable

14,896 304

15,200

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Problem 5-2 - Answer

Problem 5-2 - Answer

B. Sales Revenues $ 16,000 Less: Sales Returns (800) Sales Discounts (304) Net Sales Revenues 14,896 Less: Cost of Goods Sold (7,376) Gross Margin $ 7,520

C. If Harris had incurred freight costs in the purchase and receipt of EZ Clean washing machines and delivery costs in the subsequent sale to Jim's, how would such costs have been accounted for and what effect would they have had on Harris' gross margin? Answer: Any costs incurred in the acquisition of an asset, such as inventory, and any costs associated with getting that asset ready for its original intended use (ready to sell) are to be capitalized as part of the asset's original historical cost. As a result, any freight costs incurred in receiving the inventory should be included as part of the inventory's cost and debited to the inventory account. This would ultimately reduce Harris' gross margin in that cost of goods sold would be higher upon the sale of that inventory. Costs incurred in the delivery of inventory sold to a customer are not costs incurred in the acquisition of the inventory. Such delivery costs are actually selling costs and are reported as operating expenses below gross margin on a multi-step formatted income statement.

Gross margin percentage:

Percentage markup:

Gross Margin Net Sales Revenues
$ 7,520 = 50% $ 14,896

Gross Margin Cost of Goods Sold
$ 7,520 = 102% $ 7,376

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5-2

Problem 5-2 - Answer

Problem 5-2 - Answer

D. Determine the gross margin on the sale to Jim's if the (1) perpetual LIFO method, and (2) moving-weighted average (MWA) methods had been used? Which method (FIFO, LIFO, MWA) would have produced the highest gross margin? LIFO:

D. (Continued) MWA:

Sales Revenues $ 16,000 Less: Sales Returns (800) Sales Discounts (304) Net Sales Revenues 14,896 Less: Cost of Goods Sold (7,448) Gross Margin $ 7,448

Sales Revenues $ 16,000 Less: Sales Returns (800) Sales Discounts (304) Net Sales Revenues 14,896 Less: Cost of Goods Sold (7,413) Gross Margin $ 7,483

Inventory available/sold:
8 units @ $192/unit = $ 1,536 3,880 20 units @ $194/unit = 9,800 50 units @ $196/unit = $15,216 78 MWA: $15,216 78 = $195.08/unit

Inventory available/sold:
8 units @ $192/unit (purchased 10/21/X3) 20 units @ $194/unit (purchased 12/15/X3) 50 units @ $196/unit (purchased 1/5/X4)

Cost of Goods Sold (LIFO):
38 units @ $196/unit = $ 7,448

Cost of Goods Sold (MWA):
38 units @ $195.08/unit = $ 7,413 (rounded)

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Problem 5-2 - Answer

Problem 5-2 - Answer

D. Which method (FIFO, LIFO, MWA) produced the highest gross margin? Answer: FIFO: $ 7,520 highest LIFO: $ 7,448 MWA: $ 7,483 Which method (FIFO, LIFO, MWA) would have produced the highest gross margin if there had been decreasing inventory costs over time (deflation) instead of inflation? Answer: LIFO, the opposite effect. Which method would have produced the highest gross margin if all inventory was sold during the period? Answer: No difference.

E. Which inventory cost flow assumption is required for financial reporting purposes? Answer: Any of the inventory cost flow assumptions can be used for financial reporting purposes, regardless of the actual physical flow of goods, as long as the method selected is used consistently from year-to-year. Which inventory cost flow assumption is required for income tax purposes? Answer: Current tax law requires that the method used for financial reporting must also be used for income tax purposes. Which assumption would be best for a private company that typically faces increasing inventory costs and is interested in minimizing its cash outflows? Answer: LIFO Would the use of LIFO in a time of rising inventory costs tend to over or understate the company's assets relative to current costs? Answer: Understate ending inventory

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Mary's Hobby Shop
On 12/31/X5, Mary's inventory balance is $40,000 based on an actual physical count of inventory on hand at the end of the year 'X5. Prepare the journal entries for Mary's summarized inventory transactions for the year 20X6, assuming the business uses a periodic instead of a perpetual inventory accounting system. Purchased a total of $200,000 of inventory on account with terms of 2/10, n/30:
Purchases Accounts Payable 200,000 200,000

Periodic Method of Accounting for Inventory

Paid a total of $5,000 of freight costs to have the purchased inventory delivered to her store:
Freight-In Cash 5,000 5,000

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Returned $20,000 of previously purchased inventory to suppliers receiving full credit on account:
Accounts Payable Purchase Returns 20,000 20,000

Merchandise sold to customers at a price $10,000 is returned to Mary for full credit on account:
Sales Returns and Allowances Accounts Receivable Inventory Cost of Goods Sold 10,000 10,000 XXX XXX

Paid off the $180,000 balance of accounts payable, net of the discount, with a $176,400 cash payment. (98% X $180,000 = $176,400)
Accounts Payable Cash Purchase Discounts* * (2% x $180,000) 180,000 176,400 3,600

Total sales for the year amounted to $320,000, all made on account.
Accounts Receivable Sales Revenues Cost of Goods Sold Inventory 320,000 320,000 XXX XXX

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Inventory
1/1/X6 Purchases Freight-in 40,000 200,000 5,000 20,000 3,600 Purchase returns Purchase discounts
Cost of goods available for sale

Inventory
1/1/X6 Purchases Freight-in 40,000 200,000 5,000 20,000 3,600 221,400 178,400 12/31/X6 43,000 Closing Cost of goods sold Purchase returns Purchase discounts

Purchases
1/1/X6 12/31/X6 0 200,000 0 200,000

Freight-In
1/1/X6 12/31/X6 0 5,000 0 5,000 Closing

Assume that at the end of the year 20X6, a physical inventory is performed and produces a $43,000 total.
Cost of Goods Sold
1/1/X6 12/31/X6 0 178,400 178,400

Purchase Returns
Closing 20,000 0 20,000 0 1/1/X6 12/31/X6

Purchase Discounts
Closing 3,600 0 3,600 0 1/1/X6 12/31/X6

The key to the periodic method is the year-end physical inventory.

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Mary's Hobby Shop
12/31/X6 Physical Inventory:
Inventory Description # of Units

Should the cost of items sold and the cost of any inventory still on hand be determined based on specific identification, or an inventory cost flow assumption?

Porsche Model Car Ferrari Model Car Mustang Model Car

17 25 22

Ferrari Model Car: Beginning inventory: 20 units @ $5.00/ea. = $ 100.00 20X6 Invoices:
Date # Units Cost/Unit

3/5 9/13

30 30

$6.00/ea. $7.00/ea.

= $180.00 = $210.00

Ending Inventory: FIFO assumption: 25 units @ $7.00 = $175.00 LIFO assumption: 20 units @ $5.00 = $100.00 5 units @ $6.00 = $ 30.00 $130.00 W/A assumption: $490 80 units = $6.125/unit 25 units @ $6.125 = $153.13 rounded

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5-4

Problem 5-3

Problem 5-3

Periodic Inventory Accounting
Erickson, Inc., a wholesaler of battery chargers has beginning inventory on 1/1/X8, which includes: 100 units @ $25/unit = $ 2,500 200 units @ $26/unit = 5,200 $ 7, 700 A. Prepare Erickson's journal entries for the transactions provided below using the periodic method of inventory accounting. 1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a $2/unit freight charge, all on account with terms of 2/10, n/30. 1/15: Returned 10 of the 1,200 units purchased for full credit on account at $27/unit. 1/19: Paid the net account payable due on the 1/10 purchase, net of the discount. 1/21: Made a $57,000 sale to a customer on account. 1/29: Purchased and paid cash for 300 units of inventory, at $26/unit with free shipping.

B. Calculate Erickson's cost of goods sold for the month of January under periodic FIFO and LIFO inventory cost flow assumptions, assuming a total of 350 units of ending inventory based on a physical count at the end of the month. C. Explain how a company's cost of inventory theft or waste is determined and accounted for under both the perpetual and periodic inventory accounting methods.

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Problem 5-3 - Answer

Problem 5-3 - Answer

A.

Periodic Inventory Accounting
1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a $2/unit freight charge, all on account with terms of 2/10, n/30. Purchases (1,200 @ $25/ea.) 30,000 Freight-In (1,200 @ $2/ea.) 2,400 Accounts Payable 32,400 1/15: Returned 10 of the 1,200 units purchased for full credit on account at $27/unit. Accounts Payable (10 @ $27/ea.) 270 Purchase Returns 270 1/19: Paid the net account payable due on the 1/10 purchase, net of the discount. Accounts Payable Cash ($32,130 x 98%) Purchase Discounts 32,130 31,487 643

B.
Cost of Goods Sold (Periodic FIFO): $37,864 Inventory
Beginning balance Purchases Freight-in 7,700 37,800 2,400 270 643 Goods Available Ending balance 46,987 ? 9,123 Cost of goods sold Purchase returns Purchase discounts

1/21: Made a $57,000 sale to a customer on account. Accounts Receivable 57,000 Sales Revenues

57,000

1/29: Purchased and paid cash for 300 units of inventory, at $26/unit with free shipping. Purchases (300 @ $26/ea.) Cash 7,800 7,800

Cost applied to the 350 units of ending inventory: 300 units @ $26/unit = $ 7,800 50 units @ $26.46/unit* = $ 1,323 $ 9,123 350 * ($25 + $2) X .98 = $26.46

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Problem 5-3 - Answer

Problem 5-3 - Answer

Cost of Goods Sold (Periodic LIFO): $37,964 Inventory
Beginning balance Purchases Freight-in 7,700 37,800 2,400 270 643 Goods Available Ending balance 46,987 ? 9,023 Cost of goods sold Purchase returns Purchase discounts

C. Explain how a company's cost of inventory theft or waste is determined and accounted for under both the perpetual and periodic inventory accounting methods. Answer: Inventory shrinkage can be easily quantified when accounting for inventory perpetually. This is done through a simple comparison of the perpetual records and the physical inventory. Although discrepancies are sometimes the result of accounting errors rather than theft or waste, any adjustment required to lower the perpetual inventory records is accounted for as an expense commonly referred to as inventory shrinkage. This would include the cost of any theft or waste. Under the periodic method, inventory shrinkage can't be determined. Without perpetual records, no comparison of what should be on hand and what's actually on hand is possible. However, any costs of inventory theft and waste are accounted for as an expense under the periodic method through cost of goods sold. Because cost of goods sold is based on the difference between the cost of goods available for sale and the ending physical inventory balance, any cost of inventory shrinkage is automatically included in this amount. It just can't be separately distinguished.

Cost applied to the 350 units of ending inventory: 100 units @ $25/unit = $ 2,500 200 units @ $26/unit = $ 5,200 50 units @ $26.46/unit* = $ 1,323 $ 9,023 350 * ($25 + $2) X .98 = $26.46

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5-5

Gross Margin Method of Estimation
The essence of the method is to estimate a company's ending inventory by first estimating cost of goods sold based on a gross margin percentage.
Net sales revenues Less: Cost of goods sold Gross margin $ XXX XXX $ XXX % Estimate

Problem 5-4

Inventory Estimation
Given the following information for Jonas, Inc for the quarter ended 3/31/X8: Purchases Purchase discounts Freight-out Beginning inventory Net sales revenues Purchase returns Freight-in $ 44,267 $ 2,345 $ 2,486 $ 8,648 $ 83,455 $ 1,512 $ 3,990

Ending inventory (estimated):
Actual cost of goods available for sale: Beginning inventory $ XXX Add: Purchases XXX Freight-in XXX Less: Purchase returns (XXX) Purchase discounts (XXX) XXX Less: Cost of goods sold (estimated) (XXX) Ending inventory (estimated) $ XXX

A. Estimate Jonas' ending inventory and cost of goods sold for the quarter assuming Jonas historically prices their products to produce a 60% gross margin. B. Given the assumptions above, what is Jonas' average markup on cost?

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Problem 5-4 - Answer

Problem 5-4 - Answer

Inventory Estimation
A. Estimate Jonas' ending inventory and cost of goods sold for the quarter assuming Jonas historically prices their products to produce a 60% gross margin. Cost of goods sold estimate: $33,382 Net sales revenues $83,455 Less: Cost of goods sold 33,382 $50,073 Gross margin Ending inventory estimate: $19,666 Inventory
Beginning balance Purchases Freight-In 8,648 44,267 3,990 1,512 2,345 Goods Available Ending balance 53,048 33,382 19,666 Cost of goods sold Purchase returns Purchase discounts

Inventory Estimation
B. Given the assumptions above, what is Jonas' average markup on cost? Markup on cost:

100% 40% 60%

Gross Margin (markup) $50,073 = = 1.5 or 150% markup $33,382 Cost of Goods Sold
Given that this problem originally indicated that Jonas historically set sales prices to produce a 60% gross margin, then what we're really saying is that a 150% markup on cost produces a 60% gross margin.

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Inventory
1/1/X5 Purchases Freight-in 64,000 320,000 10,000 12,000 3,000 Purchase returns Purchase discounts Cost of Goods Sold

Padding or overstatement of inventory is an easy way to make a company's profits look better than they really are.

Goods Available 12/31/X5

379,000 283,000 96,000

Net Income
Inventory
1/1/X6 Purchases Freight-in 96,000 350,000 12,000 15,000 5,000 Goods Available 12/31/X6 438,000 366,000 72,000 Cost of Goods Sold Purchase returns Purchase discounts

Net Income

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5-6

Sometimes mistakes are made unintentionally when accounting for inventory.
Example: On 12/31/X5, $5,000 of inventory purchased from a supplier is received and properly counted and included in the company's ending physical inventory totaling $76,000. However, the purchase isn't recorded until 1/1/X6.
Inventory
1/1/X5 Purchases Freight-in 64,000 320,000 10,000 12,000 3.000 Goods Available 12/31/X5 379,000 303,000 76,000 Cost of Goods Sold Purchase returns Purchase discounts

Example: Inventory costing $2,000 and selling for $3,000 is shipped FOB destination and is in transit to a customer on 12/31/X5. The sale is recorded on 12/31 and the goods excluded from the year-end physical inventory.

20X5

20X6
understatement understatement understatement

Sales Revenues Cost of Goods Sold Net Income

overstatement overstatement overstatement

$3,000

$3,000

$2,000 $1,000

$2,000 $1,000

20X5: $5,000 overstatement of net income. Inventory
1/1/X6 Purchases Freight-in 76,000 350,000 12,000 15,000 5.000 Goods Available 12/31/X6 418,000 346,000 72,000 Cost of Goods Sold Purchase returns Purchase discounts

20X6: $5,000 understatement of net income.

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Problem 5-5

Problem 5-5 - Answer

Effect of Inventory Errors
Calculate the amount of Richin, Inc.'s net income over or understatement in 'X7 and 'X8 given the following: a. Inventory on hand at 12/31/X7 was mistakenly excluded from the yearend physical inventory. The inventory cost was $1,235. b. Goods costing $3,532 were received from a supplier on 1/1/X8 (FOB destination) but recorded as a purchase in 20X7. The goods were excluded from the 12/31/X7 physical inventory. c. Consigned goods from a supplier were included in Richin's 12/31/X7 physical inventory at a cost of $6,000. d. Goods in transit from a supplier on 12/31/X7 were excluded from purchases and the ending 12/31/X7 physical inventory. The goods cost $5,245 and were shipped FOB shipping point. e. Goods costing $3,222 in transit to a customer at 12/31/X7, FOB destination, were recorded as a sales at their $5,486 sales price in 'X7 and excluded from the 12/31/X7 physical inventory.

Effect of Inventory Errors
Effect of errors in 20X7 (under or overstated ):
Sales Revenues Cost of Goods Sold Net Income Ending Inventory

a. b. c. d. e. 5,486

1,235 3,532 6,000 5,245 5,245 3,222

1,235 1,235 3,532 6,000 6,000 5,245 5,245 5,245 5,486 3,222 3,222 3,497 (Net income overstated)
Net Income Beginning Inventory

Effect of errors in 20X8 (under or overstated ):
Sales Revenues Cost of Goods Sold

a. b. c. d. e. 5,486

1,235 3,532 6,000 5,245 5,245 3,222

1,235 1,235 3,532 6,000 6,000 5,245 5,245 5,245 5,486 3,222 3,222 3,497 (Net income understated)

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The performance and accuracy of a company's physical inventory is the sole responsibility of management. The external auditor's role is to independently review and observe the process and then spot check enough of the actual counts so that they can express an opinion as to the overall accuracy of the company's financial statements.

In addition to a correct inventory count, an accurate physical inventory requires the application of an appropriate cost to each item of inventory counted. That cost is based on specific identification, or, a LIFO, FIFO or weighted average cost flow assumption, except in those cases where the inventory is damaged, obsolete, or simply worth less than it's original historical cost. In those cases, the inventory's lower current market value is used.

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5-7

Lower of Cost or Market or "LCM" Rule
Requires the use of historical cost in accounting for inventory unless its market value has dropped below that cost. What are market values and how are they determined? Ceiling Not higher than the item's current net realizable value. (The price the inventory could be sold for today, in its current condition, less any selling costs.). Replacement Cost: The cost that would be paid today to buy that identical item. Not lower than its net realizable value less a normal profit margin.

Assume a retailer of high tech consumer products has an inventory item on hand that cost $200, but can now be purchased for $180 due to increased competition among suppliers. Also assume the retailer can sell the product for $300, paying a 10% sales commission and normally makes about a 20% profit margin on the sale of such a product after all other costs are considered. LCM Rule: NRV $270 ($300 - $30) Market Value $210

Cost $200

Replacement Cost $180

Market Value =

NRV - Profit $210 ($270 - $60) This product had a declining replacement cost but hadn't lost its resale value in the marketplace. In this case, no write-down is necessary given the higher expected future benefit.

Floor

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Consider the lower of cost or market value to be used for an inventory item that originally sold to customers for $150, but is now technically obsolete and is currently offered at a discounted price of just $20. The item was purchased at a cost of $90 and replacement units, if they can be found, cost $5 or less. Assume a 10% sales commission and a normal profit margin of 20% on this product. NRV $18 ($20 - $2) Cost $90 Market Value $14

Assume used inventory is on hand at the end of the year that can be sold for $450. Its original cost was $500 and inventory in a similar "used" condition can be bought from suppliers at a cost of $350. Assume a 10% sales commission and a normal profit margin of 16% on this product. NRV $405 ($450 - $45) Cost $500 Market Value $350

Replacement Cost $350

Replacement Cost $5 NRV - Profit $333 ($405 - $72) NRV - Profit $14 ($18 - $4) This used inventory is written down because it's worth less than its original cost. When writing inventory down it's valued at its replacement cost, but never above its resale value, net of selling costs, and never below that net realizable value less a normal profit margin.

In this case the obsolete inventory is written down to what it can be sold for, net of selling costs and a normal profit margin.

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Inventory Items 2

3

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Inventory Items 2

3

Cost per unit Market value per unit Replacement Cost NRV NRV - Profit LCM per unit # of units Inventory at cost Inventory at LCM Write-down (item-by-item) Total inventory at market: Replacement cost NRV NRV - Profit Inventory at LCM (total inventory) Write-down (total inventory) Adjusting Entry: (Item by item basis) Adjusting Entry: (Total inventory basis)

$200 $210 $180 $270 $210 $200 100 $20,000 $20,000 0 $18,000 $27,000 $21,000

$90 $14 $5 $18 $14 $14 10 $900 $140 $760 $50 $180 $140

$500 $350 $350 $405 $333 $350 20 $10,000 $7,000 $3,000 $7,000 $8,100 $6,660
Totals

Cost per unit Market value per unit Replacement Cost NRV NRV - Profit LCM per unit # of units Inventory at cost Inventory at LCM Write-down (item-by-item) Total inventory at market: Replacement cost NRV NRV - Profit Inventory at LCM (total inventory) Write-down (total inventory) Adjusting Entry: (Item by item basis) Adjusting Entry: (Total inventory basis)

$200 $210 $180 $270 $210 $200 100 $20,000 $20,000 0 $18,000 $27,000 $21,000

$90 $14 $5 $18 $14 $14 10 $900 $140 $760 $50 $180 $140

$500 $350 $350 $405 $333 $350 20 $10,000 $7,000 $3,000 $7,000 $8,100 $6,660
Totals

$30,900 $27,140 $3,760 $ $ $ $ xxxx xxxx xxxx xxxx

$30,900 $27,140 $3,760 $27,800 $25,050 $35,280 $27,800 $27,800 $3,100

$ xxxx $3,100 3,760 3,760 3,100 3,100

Loss on Inventory Write-Down Inventory Loss on Inventory Write-Down Inventory

Loss on Inventory Write-Down Inventory Loss on Inventory Write-Down Inventory

3,760 3,760 3,100 3,100

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Problem 5-6

Problem 5-6 - Answer

Inventory Write-Down for Lower of Cost or Market
Given the following information for ZZZ Company at 12/31/X5:
Inventory Items # of units Cost per unit (FIFO) Replacement cost Selling price Selling costs Normal profit margin A 200 $200 $225 $400 $80 $120 B 150 $100 $90 $200 $40 $60 C 550 $300 $250 $275 $100 $50 D 300 $80 $70 $140 $30 $50

Inventory Write-Down for Lower of Cost or Market
A Inventory Items B C D

Prepare the adjusting journal entries to write-down inventory to lower of cost or market: A. Using the item-by-item approach. B. Using the total inventory approach. Questions: 1. Which inventory item was the primary cause of the inventory write-down and why? What are some of the possible causes for its declining value? 2. Why do you think an inventory item's market value is not allowed to go below its net realizable value less a normal profit margin, even if its replacement cost is lower?

Cost per unit Market value per unit Replacement Cost NRV NRV - Profit LCM per unit # of units Inventory at cost Inventory at LCM Write-down (item-by-item) Total inventory at market: Replacement cost NRV NRV - Profit Total inventory at LCM Write-down (total inventory) Item by item: Total inventory:

$200 $225 $225 $320 $200 $200 200 $40,000 $40,000 0 $45,000 $64,000 $40,000

$100 $100 $90 $160 $100 $100 150 $15,000 $15,000 0 $13,500 $24,000 $15,000

$300 $175 $250 $175 $125 $175 550 $165,000 $96,250 $68,750 $137,500 $96,250 $68,750

$80 $70 $70 $110 $60 $70 300 $24,000 $21,000 $3,000 $21,000 $33,000 $12,000

Totals

$244,000 $172,250 $71,750 $217,000 $217,000 $217,250 $141,750 $217,000 $27,000

Loss on Inventory Write-Down Inventory Loss on Inventory Write-Down Inventory

71,750 71,750 27,000 27,000

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Problem 5-6 - Answer

Questions: 1. Which inventory item was the primary cause of the inventory writedown and why? What are some of the possible causes for its declining value?
Answer: Almost all of the write-down was attributable to item C. With a net realizable value of only $175 per unit, this item is clearly worth a lot less than its original $300 per unit cost. Because the item's replacement cost is still relatively high, the lower net resale value, after selling costs, is most likely due to falling customer demand due to changing tastes rather than any physical damage to the inventory itself.

2. Why do you think an inventory item's market value is not allowed to go below its net realizable value less a normal profit margin, even if its replacement cost is lower?
Answer: This floor on the market value of inventory prevents companies from grossly overstating losses in one period in order to realize substantial gains in the next. In some cases, company's experiencing a difficult year will seek to maximize asset write-offs in that year. The thinking is that if things are going to look bad, we might as well make them look really bad, especially if those write-offs can make it easier to show higher profits upon the sale of those assets next year.

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