Inventory – Other Issues

Hard Test

Key Things to Know

j

Practice as You Learn

Self Test

b

Easy Test

h

Medium Test

i

Hard Test

1. Which method of lower of cost or market will most likely give the largest adjustment to inventory?

a. individual items
b. groups of items
c. total of all items
d. all will give the same adjustment

Answer
A. Using the individual items method does not allow for offset of changes in value for each item. Using groups or in total allows for value increases to offset value decreases resulting in a lower net change in the value of inventory.
2. Net realizable value (NRV) is lower than replacement cost and replacement cost is lower than net realizable value less normal profit. “Market” under LCM will be

a. historical cost
b. replacement cost
c. net realizable value
d. net realizable value less normal profit margin

Answer
C. Inventory cannot be valued at more than NRV. Both replacement cost and NRV less profit are higher than cost and inventory cannot be reported at greater than NRV. 
3. Net markdowns are not included in available when using the lower of cost or market (conventional) method because

a. price changes do not matter
b. markdowns are difficult to estimate reliably
c. marking down inventory is an indication of lost value and not including markdowns gives a lower value of ending inventory.
d. changes to price are not considered when determining available inventory

Answer
C. A markdown is an indication that the inventory is losing value and future cash flows will be less. If markdowns are occurring inventory has a lower value. Removing markdowns from the available row will decrease the ratio and decrease the estimated value of ending inventory.
4. The historical cost of an inventory item is higher than both net realizable value and replacement cost. The replacement cost is lower than net realizable value and higher than net realizable value less normal profit. Inventory at LCM will be valued at

a. historical cost
b. net realizable value
c. net realizable value less profit
d. replacement cost

Answer
D. First determine “market” as the one in the middle. Replacement cost is in the middle and is considered “market”. Historical cost is higher than “market” (replacement cost) and the lower of cost or market is the “market” replacement cost. Since replacement cost is lower, the inventory must be written down to replacement cost.
5. One weakness that occurs with using the gross profit method is

a. it is only an estimate and is not 100% accurate
b. it is an estimate based on an average historical gross profit percentage
c. it is an estimate based on average purchases during the period
d. it is only used with a perpetual inventory system

Answer
B. The gross profit method is an estimate of ending inventory using an average historical gross profit percentage. This method assumes the historical gross profit percentage is the same for the current period which does not usually occur. A small percentage change can make a large difference in inventory values. It is proper to estimate an amount if the actual amount is not known.
6. Which method of valuing inventory normally gives the least accurate value of inventory reported on the balance sheet?

a. gross profit method
b. retail inventory method
c. lower of cost or market
d. dollar value LIFO

Answer
A. The gross profit method uses the least amount of actual data and bases the value of ending inventory on prior year information. 
7. The purpose of using a floor when applying lower of cost or market is to ensure inventory is not valued

a. at higher than future cash flows
b. at lower than replacement cost
c. at an amount that gives an abnormal gross profit when sold
d. at higher than replacement cost

Answer
C. When inventory is valued at a lower amount in the current period, gross profit is higher in future periods when sold. The gross profit on a sale should result from proper matching of costs and revenues. Inventory should not be valued at lower than what the company expects to receive from the sale (NRV), less the normal profit. This will give a normal cost for that item.
8. Which accounting principle or assumption does not allow for inventory to be written up above historical cost

a. conservatism
b. consistency
c. full disclosure
d. revenue recognition principle

Answer
A. Gains are recorded when realized under the conservatism principle. A gain can not be recorded until the inventory is actually sold at a price higher than historical cost.
9. Which of the following is not a true statement?

a. when using lower of cost or market, the individual method will always give a larger write down than using the total method
b. the gross profit method is only used when a physical count is taken
c. the retail inventory method uses the cost of available inventory in proportion to the retail value of available inventory to estimate the cost of ending inventory
d. dollar value LIFO requires much less record keeping than LIFO

Answer
B. The gross profit method is only used when the periodic method is used and no physical inventory count is taken. When the perpetual method is used the ending balance is adjusted as inventory moves and the company does not have to use the gross profit method to estimate inventory value.
10. In order to use the retail inventory method, a company must record

a. all markups and markdowns along with all associated cancellations
b. all purchase related items at cost and at retail
c. normal and abnormal spoilage separately
d. all of the above

Answer
D. All of the above information is required to implement the retail inventory method. The only thing that is not required is a record of the cost of each individual item that is sold at the time of sale. 
11. The following data is available for the company for the current year.

 

Sales 310,000 Markups, net 47,000
Markdowns, net 95,000 Salary Expense 180,000
Abnormal spoilage, retail 12,000 Depreciation expense 49,000
Purchases, cost 222,000 Purchases, retail 285,000
Administrative Expense 98,000 Abnormal spoilage, cost 8,000
Beginning Inventory, cost 253,000 Normal Spoilage, retail 11,000
Beginning Inventory, retail 333,000 Employee Discounts 9,000
Sales Returns 13,000 Selling Expenses 112,000
Freight In 17,000 Freight Out 39,000
Normal Spoilage, cost 7,200 Purchase Discounts 19,000

Compute the estimated value of ending inventory using all 4 different retail inventory methods. (Round the cost to retail ratio to 3 decimals)

Answer

1st Set up the format using average cost

Cost Retail
Beginning Inventory 253,000 333,000
+ Purchases 222,000 285,000
+ Freight In  17,000
– Purchase Discounts (19,000)
– Abnormal Spoilage  (8,000) (12,000)
+ Markups, net    47,000
– Markdowns, net ( 95,000)
= Available (83.3%) 465,000 / 558,000
– Sales, net (310,000)
+ Sales Returns   13,000
– Employee Discounts   ( 9,000)
– Normal Spoilage (11,000)
= Ending Inventory ???? 241,000

A. Average Cost

Retail Ending Inventory                     241,000
x Cost to Retail %                                    .833
= Ending Inventory at Cost               200,753

B. Lower of Cost or Market (Conventional):

Do not rewrite the entire calculation.
Adjust from average to lower of cost or market:

Available at Average Cost – retail 558,000
+ Markdowns, net                                        95,000
Available at Lower of Cost or Market –retail 653,000

Then compute the cost to retail percentage

Available at Cost 465,000    =    0.712
Available at Retail 653,000
Ending Inventory at Retail                      241,000
x Cost to Retail %                                       0.712
= Ending Inventory at Cost                   171,592

C. FIFO
Do not include beginning inventory assumed to be sold

Use the average setup

Cost Available – Cost Beg. Inventory
Retail Available – Retail Beg. Inventory

465,000 – 253,000 = 212,000   =  0.942
558,000 – 333,000 = 225,000

Ending Inventory at Retail              241,000
x Cost to Retail %                                  .942
= Ending Inventory at Cost            227,022

D. LIFO
Use the average set up

  Retail  Cost
Beginning Inventory 333,000 253,000
+ Current period layer (92,000)    0   
= Ending Inventory 241,000   ?? ?

Beginning Inventory: 253,000 / 333,000 = 0.760 FIFO ratio

There is no current period layer.
All available inventory is from the beginning inventory layer.

Inventory at Retail            241,000
x FIFO %                                0.760
Inventory at Cost              183,160

12. Following is inventory information related to all the company’s products.

Product Quantity Cost Replacement
Cost
1 100 7 10
2 300 18 16
3 250 19 19
4 500 4 9

The company sells all products for 40% above cost and sales commissions are 5% of the sales price.

Determine the amount that inventory will be reported on the balance sheet
A. By individual product using LCM
B. In Groups: 1 & 2 are group A, 3 & 4 are group B using LCM
C. In Total for the company using Lower of Cost or NRV

Answer

Compute Sales price, than compute commission, than compute NRV, than compute normal profit and the NRV less profit.

 

Product Quantity Cost Replacement
Cost		 Sales
Price		 Cost to
Sell		 Normal
Profit		 NRV
1 100 7 10 9.80   .49 2.31 9.31
2 300 18 16 25.20 1.26 5.94 23.94
3 250 19 19 26.60 1.33 6.27 25.27
4 500 4 9 5.60   0.28 1.32 5.32

Normal profit = Sales price – cost – cost to sell

A. By Individual Product: Determine market and LCM for each individual product

Product Replacement
Cost		 (Ceiling)
NRV		 (Floor)
NRV – Profit **		 Market Cost LCM
1 10 9.31 7 9.31     931 7       700 700
2 16 23.94 18 18     5,400 18    5,400 5,400
3 19 25.27 19 19     4,750 19    4,750 4,750
4 9 5.32  4 5.32     2,660 4    2,000 2,000
Total 12,850 12,850

LCM is not lower than cost. No adjustment is required.

Gray cell – put two blank space rows

B. By Group, 1 & 2, 3 & 4: Determine market and LCM for each group of products

Product Replacement
Cost		 (Ceiling)
NRV		 (Floor)
NRV – Profit **		 Market Cost LCM
1 10     1,000 9.31          931 7        700 7          700
2 16     4,800 23.94    7,182 18    5,400 18     5,400
Group A       5,800              8,113          6,100 6,100          6,100 6,100
3 19     4,750 25.27     6,318 19      4,750 19      4,750
4 9    4,500 5.32      2,660 4       2,000   4      2,000
Group B      9,250            8,978           6,750 8,978           6,750 6,750
Total       12,850 12,850

LCM is not lower than cost. No adjustment is required.

C. In Total: Determine lower of cost or net realizable value

Product Replacement     Cost NRV L of C or NRV
1 10          1,000 9.31          931
2 16         4,800 23.94          7,182
3 19         4,750 25.27          6,318
   4    9          4,500 5,32          2,660 _______
Total  15,050      17,091 15,050

No adjustment is required.

13. The company began valuing ending inventory using dollar value LIFO in the base year. Cost of purchasing inventory increased 5% during the base year and another 12% during the 2nd year. Inventory at first year cost was as follows:

Beginning of Base Year $412,000
End of Base Year $396,000
End of 2nd Year $429,000

Determine the value of inventory that will be reported on the balance sheet for each year.

Answer

1st Determine the price index for each year:

Base                               1.0 always
End of 1st Year             1.05           1.0 + 5%            (1.0 x 1.05)
End of 2nd Year            1.176        1.05 +12%         (1.05 x 1.12)

The price index is used to take last cost and convert it to first year cost (which you do not need to do because that is the value of inventory given) and to value each layer.

                     Inventory at              Price                  Inventory at                              Price
Date             Last Cost        /         Index        =       First Cost               From           Index = Value of EI

Base                                                1.0                      412,000                412,000  x  1.0          412,000 Bal Sheet

Year 1                                             1.05                    396,000                396,000  x  1.0          396,000
                                                                                                       plug                0  x  1.05                   0
                                                                                                                   396,000                    396,000 Bal Sheet

All inventory purchased during the 1st year has been sold

Year 2                                            1.176                  429,000                396,000  x  1.0           396,000
                                                                                                                              0 x 1.05 0
                                                                                                         plug   33,000  x 1.176         38,808
                                                                                                                  429,000                      434,808 Bal Sheet