FAR - Inventory 3

Question 1

Delar Co. completed its year-end physical count of inventory. The inventory was valued at first-in, first-out (FIFO) costs and totaled $500,000. Delar subsequently noted the following two items:

1,000 units of inventory with a FIFO cost of $10 each were shipped and billed to a customer, f.o.b. destination. These items were included in the physical count.

6,000 units at a FIFO cost of $5 each were held on consignment for one of its suppliers, but were excluded from the physical count.

What amount should Delar report as inventory at year end?

Answer 1

$500,000

FOB destination means title and risk of loss pass to the buyer when the seller makes a proper tender of delivery of the goods at the destination. Thus, it was correct to include the inventory that was shipped FOB destination in the inventory physical count because the inventory was not delivered to the customer by year end. Consigned goods are not sold but rather transferred to an agent for possible sale. Consigned goods are included in the inventory of the consignor (owner). Thus, the inventory that is held on consignment for one of the suppliers should be excluded from the inventory physical count. Therefore, Delar should report $500,000 of inventory at year end.

Question 2

Fact Pattern: On November 1, Year 1, Iba Co. entered into a contract with a customer to sell 150 machines for $75 each. The customer obtains control of the machines at contract inception. Iba’s cost of each machine is $45. Iba allows the customer to return any unused machine within 1 year from the sale date and receive a full refund. Iba uses the expected value method to estimate the variable consideration. Based on Iba’s experience and other relevant factors, it reasonably estimates that a total of 20 machines (12 machines in Year 1 and 8 machines in Year 2) will be returned. Iba estimates that (1) the machines are expected to be returned in salable condition and (2) the costs of recovering the machines will be immaterial. During Year 1, 10 machines were returned. At the end of Year 1, Iba continues to estimate that a total of 20 machines will be returned within 1 year from the sale date.

What amount of revenue from this contract will be recognized by Iba in Year 1?

Answer 2

$9,750

Given a right of return, the consideration received from the customer is variable. Revenue from variable consideration is recognized only to the extent that it is probable that a significant reversal will not occur. Iba estimates that 20 machines will be returned. Thus, in Year 1 Iba recognizes revenue only for the sale of 130 machines (150 – 20), and the revenue recognized is $9,750 (130 × $75).

Question 3

Fact Pattern: On November 1, Year 1, Iba Co. entered into a contract with a customer to sell 150 machines for $75 each. The customer obtains control of the machines at contract inception. Iba’s cost of each machine is $45. Iba allows the customer to return any unused machine within 1 year from the sale date and receive a full refund. Iba uses the expected value method to estimate the variable consideration. Based on Iba’s experience and other relevant factors, it reasonably estimates that a total of 20 machines (12 machines in Year 1 and 8 machines in Year 2) will be returned. Iba estimates that (1) the machines are expected to be returned in salable condition and (2) the costs of recovering the machines will be immaterial. During Year 1, 10 machines were returned. At the end of Year 1, Iba continues to estimate that a total of 20 machines will be returned within 1 year from the sale date.

What amount of refund liability, if any, will be reported in Iba’s December 31, Year 1, balance sheet?

Answer 3

$750

A refund liability is reported at a gross amount separately from the revenue account. This liability is the amount of cash expected to be refunded to the customer given a right of return. At the end of Year 1, Iba estimates that 10 machines (20 total machines expected to be returned – 10 machines actually returned in Year 1) will be returned in Year 2. Accordingly, a refund liability of $750 ($75 × 10) is reported in Iba’s December 31, Year 1, balance sheet.

Question 4

Fact Pattern: On November 1, Year 1, Iba Co. entered into a contract with a customer to sell 150 machines for $75 each. The customer obtains control of the machines at contract inception. Iba’s cost of each machine is $45. Iba allows the customer to return any unused machine within 1 year from the sale date and receive a full refund. Iba uses the expected value method to estimate the variable consideration. Based on Iba’s experience and other relevant factors, it reasonably estimates that a total of 20 machines (12 machines in Year 1 and 8 machines in Year 2) will be returned. Iba estimates that (1) the machines are expected to be returned in salable condition and (2) the costs of recovering the machines will be immaterial. During Year 1, 10 machines were returned. At the end of Year 1, Iba continues to estimate that a total of 20 machines will be returned within 1 year from the sale date.

What amount of an asset for the right to recover machines from customers will be reported in Iba’s December 31, Year 1, balance sheet?

Answer 4

$450

An asset for the entity’s right to recover products from the customer must be recognized. This asset is measured after determining the refund liability. It must be presented separately from inventory. The asset is measured at the former carrying amount of inventory minus any expected costs to recover the goods. Accordingly, in its December 31, Year 1, balance sheet, Iba reports a refund asset of $450 [($45 carrying amount per machine × 10 machines expected to be returned in Year 2) – $0 recovery cost].

Question 5

In a time of rising prices, the LIFO method results in higher cost of goods sold than FIFO.

Answer 5

TRUE

LIFO is based on the assumption that CGS consists of the latest purchased (and costliest) goods. It therefore results in lower inventory, higher CGS, and lower gross profit (net income) than FIFO (first-in, first-out).

Question 6

Under the “double-extension” method of calculating a price index, the quantity of each item in the inventory pool at the close of the year is multiplied twice, once by the base-year unit cost and once by the current-year unit cost.

Answer 6

TRUE

Under the double-extension method, the quantity of each item in the inventory pool at the close of the year is multiplied twice, once by the base-year unit cost and once by the current-year unit cost.​

Question 7

Price indexes prepared by the U.S. government must be used in applying the dollar-value LIFO inventory method.

Answer 7

FALSE

Selecting an appropriate price index is crucial to dollar-value LIFO accounting. An entity may choose to use published indexes. Examples are the Consumer Price Index for All Urban Consumers (CPI-U) and indexes published by trade associations. Most often, an index is generated internally for each year.​

Question 8

LIFO may not be applied to groups of inventory items that are substantially identical.

Answer 8

FALSE

The building of inventory over time results in the creation of LIFO layers. Whenever sales outpace purchases, the firm must dip into older layers, called LIFO liquidation. Distortions in net income can result from matching current revenues against the older, lower costs. One way of counteracting LIFO liquidation (and simplifying the accounting) is to treat substantially identical items of inventory as a single accounting unit called a pool.​

Question 9

Inventory need not be written down below cost subsequent to acquisition if its utility is no longer as great as its cost.

Answer 9

FALSE

Inventory must be written down below cost subsequent to acquisition if its utility is no longer as great as its cost. The difference should be recognized as a loss of the current period.

Question 10

Under the principle of lower of cost or market (LCM), market price of inventory must not be greater than a ceiling equal to its fair value reduced by an allowance for an approximately normal profit margin.

Answer 10

FALSE

Market is the current cost to replace inventory, subject to certain limitations. Market should not exceed a ceiling equal to net realizable value (NRV) and should not be less than a floor equal to NRV reduced by an allowance for an approximately normal profit margin.

Question 11

A commitment to acquire goods in the future is recorded at the time of the agreement.

Answer 11

FALSE

A commitment to acquire goods in the future is not recorded at the time of the agreement. GAAP require accrual of a loss in the current year’s income statement on goods subject to a firm purchase commitment if the market price of the goods declines below the commitment price.

Question 12

If a purchase is recorded but is excluded from ending inventory, cost of sales is overstated and net income and current assets are understated.

Answer 12

TRUE

Inventory errors may have a material effect on current assets, working capital (current assets – current liabilities), cost of sales, net income, and equity. A common error is inappropriate timing of the recognition of transactions. If a purchase is recorded but is excluded from ending inventory, cost of sales is overstated and net income and current assets are understated.

Question 13

The gross profit method of estimating inventory may be used to determine inventory for interim statements provided that certain disclosures are made.

Answer 13

TRUE

The gross profit method of estimating inventory is used to determine inventory for interim statements provided that adequate disclosure is made of the method employed and of any significant adjustments that result from reconciliations with the annual physical inventory at year end.

Question 14

In a consignment, the consignor ships merchandise to the consignee, who acts as agent for the consignor in selling the goods. The consignor records the goods as being sold when shipped.

Answer 14

FALSE

The goods are held by the consignee but remain the property of the consignor and are included in the consignor’s inventory at cost. Consigned goods are not sold but rather transferred to an agent for possible sale. The consignor records sales only when the goods are sold to third parties by the consignee.​

Question 15

The following information was obtained from Smith Co.:

Sales

$275,000

Beginning inventory

30,000

Ending inventory

18,000

Smith’s gross margin is 20%. What amount represents Smith purchases?

Answer 15

$208,000

Gross margin equals sales minus cost of goods sold. If it is 20% of sales, cost of goods sold equals $220,000 [$275,000 × (1.0 – .20)]. Cost of goods sold equals beginning inventory, plus purchases, minus ending inventory. Thus, purchases equals $208,000 ($220,000 COGS – $30,000 BI + $18,000 EI).​

Question 16

According to Statements of Financial Accounting Concepts, predictive value relates to

Answer 16

Relevance - YES

Faithful Representation - NO

Relevance is a fundamental qualitative characteristic of useful financial information. It is the capacity of information to make a difference in a decision. It must have (1) predictive value, (2) confirmatory value, or both. Moreover, materiality is an entity-specific aspect of relevance. Something has predictive value if it can be used in a predictive process. Something has confirmatory value with respect to prior evaluations if it provides feedback that confirms or changes (corrects) them.

Question 17

At the end of Year 1, a company reduced its inventory cost from $100 to its net realizable value of $80. As of the end of Year 2, the inventory was still on hand and its net realizable value increased to $150. Under IFRS, what journal entry should the company record for Year 2 to properly report the inventory value?

Answer 17

Debit Inventory for $20

Credit Expense for $20

Under IFRS, inventories are measured at the lower of cost or net realizable value (NRV). NRV is the estimated selling price less the estimated costs of completion and disposal. At the end of Year 1, a loss on write-down of $20 ($100 cost – $80 NRV) was recognized. NRV is assessed each period. Accordingly, a write-down may be reversed but not above original cost. The write-down and reversal are recognized in profit or loss. Therefore, only the original $20 write-down can be reversed by debiting inventory for $20 and crediting the expense account for $20.

Question 18

Which of the following is not valid as it applies to inventory costing methods?

1. LIFO tends to smooth out the net income pattern since it matches current cost of goods sold with current revenue when inventories remain at constant quantities.
2. When a firm using the LIFO method fails to maintain its usual inventory position (reduces stock on hand below customary levels), there may be a matching of old costs with current revenue.
3. If inventory quantities are to be maintained, part of the earnings must be invested (plowed back) in inventories when FIFO is used during a period of rising prices.
4. The use of FIFO permits some control by management over the amount of net income for a period through controlled purchases, which is not true with LIFO.

Answer 18

4.Theuse of FIFO permits some control by management over the amount of net income for a period through controlled purchases, which is not true with LIFO. Under LIFO, the most recent purchases are included in cost of goods sold. Management could affect net income with an end-of-period purchase that would immediately alter cost of goods sold. A last-minute FIFO purchase included in the ending inventory would have no such effect.

1. LIFO tends to smooth out the net income pattern since it matches current cost of goods sold with current revenue when inventories remain at constant quantities.
2. When a firm using the LIFO method fails to maintain its usual inventory position (reduces stock on hand below customary levels), there may be a matching of old costs with current revenue.
3. If inventory quantities are to be maintained, part of the earnings must be invested (plowed back) in inventories when FIFO is used during a period of rising prices.
4. The use of FIFO permits some control by management over the amount of net income for a period through controlled purchases, which is not true with LIFO.

Question 19

Dell Company’s inventory at December 31, Year 1, was $1.2 million based on a physical count of goods priced at cost, and before any necessary year-end adjustments relating to the following:

Included in the physical count were goods billed to a customer FOB shipping point on December 30, Year 1. These goods had a cost of $25,000 and were picked up by the carrier on January 7, Year 2.

Goods shipped FOB shipping point on December 28, Year 1, from a vendor to Dell were received on January 4, Year 2. The invoice cost was $60,000.

What amount should Dell report as inventory in its December 31, Year 1, balance sheet?

Answer 19

$1,260,000

The inventory account balance prior to adjustments is $1.2 million. FOB shipping point means that title to the goods normally passes to the buyer at the time of shipment. The $25,000 of goods shipped by Dell on January 7 should remain in the year-end inventory because title did not pass until after the beginning of the following year. The $60,000 worth of goods shipped to Dell prior to year end (December 28) should be included in Dell’s inventory even though they were not received until the following year (January 4). The title passed to Dell at the time of shipment. Consequently, Dell’s inventory at year end should be reported at $1,260,000 ($1,200,000 + $60,000).

Question 20

The replacement cost of a LIFO basis inventory item is below the net realizable value and above the net realizable value minus the normal profit margin. The original cost of the inventory item is below the net realizable value minus the normal profit margin. Under the lower-of-cost-or-market (LCM) method, the inventory item should be measured at

Answer 20

ORIGINAL COST

Inventory accounted for using LIFO or the retail inventory method is measured at the lower of cost or market. When replacement cost is below the NRV and above the NRV minus the normal profit margin, market equals replacement cost. Given that the original cost of the inventory item is below market, the original cost should be used to measure the inventory item under the LCM method.​

Question 21

On January 2 of the current year, LTTI Co. entered into a 3-year, noncancelable contract to buy up to 1 million units of a product each year at $.10 per unit with a minimum annual guarantee purchase of 200,000 units. At year end, LTTI had only purchased 80,000 units and decided to cancel sales of the product. What amount should LTTI report as a loss related to the purchase commitment as of December 31 of the current year?

Answer 21

$52,000

A commitment to acquire goods in the future is not recorded at the time of the agreement, e.g., by debiting an asset and crediting a liability. But a loss is recognized on a firm, noncancelable, and unhedged purchase commitment if the current market price of the goods is less than the commitment price. The reason for current loss recognition is the same as that for inventory. A decrease (not an increase) in its future benefits should be recognized when it occurs, even if the contract is unperformed on both sides. Material losses expected on purchase commitments are measured in the same way as inventory losses at lower of cost ($.10 per unit) or market (presumably $0), recognized and separately disclosed. The buyer guaranteed the purchase of at least 200,000 units per year for 3 years. It purchased only 80,000 units in the first year before deciding to cancel the purchase commitment. Accordingly, it remains liable for the purchase of 520,000 units [(200,000 units × 3 years) – 80,000 units]. The undiscounted loss is $52,000 (520,000 units × $.10). [However, the guidance for accounting for exit or disposal activities provides for measurement at fair value in this case. Contract termination costs include costs that will continue to be incurred without economic benefit (continuing costs). A liability for continuing costs is recognized and measured at fair value when the right under the contract, e.g., the right to use leased property or to receive future goods, is no longer used. This date is the cease-use date.]