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Flashcards in Inventory Deck (89):
1

During 2005, Kam Co. began offering its goods to selected retailers on a consignment basis. The following information was derived from Kam's 2005 accounting records:

  • Beginning inventory $122,000
  • Purchases $540,000
  • Freight-in $10,000
  • Transportation to consignees $5,000
  • Freight-out $35,000
  • Ending inventory - held by Kam $145,000
  • - held by consignees $20,000

In its 2005 income statement, what amount should Kam report as the cost of goods sold?

  1. $507,000
  2. $512,000
  3. $527,000
  4. $547,000

$512,000

Beg. inventory + Net purchases = End. inventory + Cost of goods sold 
$122,000 + ($540,000 + $10,000 + $5,000) = ($145,000 + $20,000) + $512,000

The freight-in and transportation to consignees is added to net purchases because they are costs of placing the inventory into salable condition (the general rule for capitalizing costs to inventory). The goods on consignment are included in ending inventory because they are owned by Kam.

2

On October 20, 2005, Grimm Co. consigned 40 freezers to Holden Co. for sale at $1,000 each and paid $800 in transportation costs. 
On December 30, 2005, Holden reported the sale of 10 freezers and remitted $8,500. The remittance was net of the agreed 15% commission.

What amount should Grimm recognize as consignment sales revenue for 2005?

  1. $7,700
  2. $8,500
  3. $9,800
  4. $10,000

$10,000

Consignment sales revenue is the revenue recognized on consignment sales.

In this case, total consignment revenue is 10 x $1,000 = $10,000. The commission and transportation costs are expenses that reduce earnings on consignment revenues, but they do not affect total revenues to be recognized.

3

The following items were included in Opal Co.'s inventory account on December 31, 2004: 

  • Merchandise out on consignment, at sales price, including 40% markup on selling price $40,000 
  • Goods purchased, in transit, shipped FOB shipping point $36,000
  • Goods held on consignment by Opal $27,000

By what amount should Opal's inventory account at December 31, 2004 be reduced?

  1. $103,000
  2. $67,000
  3. $51,000
  4. $43,000

$43,000

The merchandise out on consignment is included in inventory at selling price. But inventory must be measured at cost. $40,000 = cost + .40($40,000). Thus, cost = $24,000. Therefore, inventory should be reduced by the $16,000 of markup on the merchandise out on consignment.

The goods held on consignment should be removed from the inventory because these goods do not belong to Opal.

Hence, the total reduction from inventory is $43,000 ($16,000 + $27,000). The goods in transit are properly included in inventory because they were shipped FOB shipping point, which means the goods belong to Opal when the goods reach the common carrier at the shipping point.

4

Jel Co., a consignee, paid the freight costs for goods shipped from Dale Co., a consignor. These freight costs are to be deducted from Jel's payment to Dale when the consignment goods are sold. Until Jel sells the goods, the freight costs should be included in Jel's

  1. Cost of goods sold.
  2. Freight-out costs.
  3. Selling expenses.
  4. Accounts receivable.

Accounts receivable.

Jel will recover the freight costs when Jel deducts the costs from the amount it submits to Dale. Until that happens, the amount spent on freight is recorded in a receivable.

When Jel submits its payment for the sale of Dale's goods (also less a commission), the receivable is credited; thus reducing the amount of cash that must be paid to Dale. Therefore, the freight costs are borne by Dale. Jel simply paid the costs for Dale and will be reimbursed later. This is not a cost or expense of Jel.

5

Southgate Co. paid the in-transit insurance premium for consignment goods shipped to Hendon Co., the consignee. In addition, Southgate advanced part of the commissions that will be due when Hendon sells the goods.

Should Southgate include the in-transit insurance premium and the advanced commissions in inventory costs?

  • Insurance premium    
  • Advanced commissions  

  • Insurance premium - YES 
  • Advanced commissions - NO

The insurance in transit is included in inventory because it is a cost necessary to bring the inventory into a salable condition. This is the criterion for capitalizing inventory costs.

The advance commissions are not inventoriable. They are not incurred to bring the inventory to a salable condition but rather are selling expenses. The costs will be recognized as such when the goods are sold. At that time, the commission is earned by the consignee and is an expense to the consignor. The commissions are never inventoried.

6

Stone Co. had the following consignment transactions during December 2005:

  • Inventory shipped on consignment to Beta Co. $18,000 
  • Freight paid by Stone $900 
  • Inventory received on consignment from Alpha Co. $12,000
  • Freight paid by Alpha $500

No sales of consigned goods were made through December 31, 2005. Stone's December 31, 2005, balance sheet should include consigned inventory at

  1. $12,000
  2. $12,500
  3. $18,000
  4. $18,900

$18,900

The $18,900 amount to be included in consigned inventory (this would be included in Stone's ending inventory) = $18,000 + $900 freight.

This inventory is owned by Stone. The freight is included because it is a cost necessary to bring the inventory into salable condition and location. The inventory Stone received on consignment is not an asset of Stone's and is not included in Stone's inventory. Stone is helping to sell Alpha's inventory, just as Beta is helping to sell Stone's inventory.

7

Nomar Co. shipped inventory on consignment to Seabright Co. that cost $20,000. Seabright paid $500 for advertising that was reimbursable from Nomar. At the end of the year, 70% of the inventory was sold for $30,000. The agreement states that a commission of 20% will be provided to Seabright for all sales.

What amount of net inventory on consignment remains on the balance sheet for the first year for Nomar?

  1. $0
  2. $6,000
  3. $6,500
  4. $20,000

$6,000

Nomar includes in its inventory account items of inventory it owns, regardless of its location. Nomar's inventory on consignment at Seabright continues to be owned by Nomar and is included in Nomar's inventory at cost. 70% of the inventory shipped has been sold.

Therefore, only 30%, or $6,000 (.30 x $20,000), remains in ending inventory. The commission and advertising costs are not inventory costs and are not included in inventory.

8

What is the appropriate treatment for goods held on consignment?

  1. The goods should be included in the ending inventory of the consignor.
  2. The goods should be included in ending inventory of the consignee.
  3. The goods should be included in cost of goods sold of the consignee only when sold.
  4. The goods should be included in cost of goods sold of the consignor when transferred to the consignee.

The goods should be included in the ending inventory of the consignor.

Consigned goods belong to the consignor and are included in the consignor's ending inventory.

9

Garson Co. recorded goods in transit purchased FOB shipping point at year-end as purchases. The goods were excluded from the ending inventory. What effect does the omission have on Garson's assets and retained earnings at year end?

Understated / No Effect / Overstated?

  • Assets
  • Retained earnings  

  • Assets - Understated
  • Retained earnings - Understated

Both responses in this choice are correct. FOB shipping point means that the title passed to the buyer at the selling company's warehouse. Therefore, Garson should have included this inventory in the ending inventory. This leaves inventory (assets) understated. This error also has overstated the cost of goods sold, which understates net income and retained earnings.

10

On December 28, 2005, Kerr Manufacturing Co. purchased goods costing $50,000. The terms were FOB destination. Some of the costs incurred in connection with the sale and delivery of the goods were as follows:

  • Packaging for shipment $1,000
  • Shipping $1,500
  • Special handling charges $2,000

These goods were received on December 31, 2005. In Kerr's December 31, 2005 balance sheet, what amount of cost for these goods should be included in inventory?

  1. $54,500
  2. $53,500
  3. $52,000
  4. $50,000

$50,000

Kerr will pay only $50,000 for the goods. None of the other costs listed are incurred by Kerr. Rather, the seller will incur those costs.

Even the shipping costs are borne by the seller because the terms are FOB destination. This means that title does not transfer to the buyer (Kerr) until the goods reach the destination. The seller owned the goods in transit and therefore incurred the transportation cost. Kerr's recorded cost is $50,000.

11

The following information applied to Fenn, Inc. for 2005:

  • Merchandise purchased for resale $400,000
  • Freight-in $10,000
  • Freight-out $5,000
  • Purchase returns $2,000

Fenn's 2005 inventoriable cost was

  1. $400,000
  2. $403,000
  3. $408,000
  4. $413,000

$408,000

Merchandise purchased for resale $400,000

PLUS Freight-in $10,000

SUBTRACT Purchase returns ($2,000)

= Total inventoriable cost $408,000

12

West Retailers purchased merchandise with a list price of $20,000, subject to trade discounts of 20% and 10%, with no cash discounts allowable.

West should record the cost of this merchandise as

  1. $14,000
  2. $14,400
  3. $15,600
  4. $20,000

$14,400

This is a chain discount and the correct recorded cost is $20,000(1 - .20)(1- .10) = $14,400. Each successive discount in a chain discount is applied to the previous net amount.

13

Seafood Trading Co. commenced operations during the year as a large importer and exporter of seafood. The imports were all from one country overseas. The export sales were conducted as drop shipments and were merely transshipped at Seattle. Seafood Trading reported the following data:

  • Purchases during the year $12.0M
  • Shipping costs from overseas $1.5M
  • Shipping costs to export customers $1.0M
  • Inventory at year end $3.0M

What amount of shipping costs should be included in Seafood Trading's year-end inventory valuation?

  1. $0
  2. $250,000
  3. $375,000
  4. $625,000

$375,000

Only transportation-in is treated as a product cost and included in inventory. This cost is considered a cost necessary to bring the inventory to a salable condition. $1.5 million was incurred for this cost - the cost to import. Inventory represents $3/$12 or 25% of total purchases. Therefore, 25% of $1.5 million, or $375,000, of transportation-in is included in inventory. Shipping costs to customers are treated as a period cost.

14

The following information pertains to Deal Corp.'s 2004 cost of goods sold:

  • Inventory, 12/31/03 $90,000
  • 2004 purchases $124,000
  • 2004 write-off of obsolete inventory $34,000
  • Inventory, 12/31/04 $30,000

The inventory written off became obsolete due to an unexpected and unusual technological advance by a competitor. In its 2004 income statement, what amount should Deal report as cost of goods sold?

  1. $218,000
  2. $184,000
  3. $150,000
  4. $124,000

  • $150,000
  • Beginning inventory $90,000
  • Plus purchases $124,000
  • Less write-off ($34,000)
  • Less ending inventory ($30,000)
  • Equals cost of goods sold $150,000

15

The following information pertained to Azur Co. for the year:

  • Purchases $102,800
  • Purchase discounts $10,280
  • Freight-in $15,420
  • Freight-out $5,140
  • Beginning inventory $30,840
  • Ending inventory $20,560

What amount should Azur report as cost of goods sold for the year?

  1. $102,800
  2. $118,220
  3. $123,360
  4. $128,500

$118,220

Cost of goods sold is determined (in a periodic inventory system) as:

Beginning Inventory 
+ Net Purchases 
= Goods Available for Sale 
- Ending Inventory 
= Cost of Goods Sold

Net Purchases includes any purchase discounts (or allowances) and other cost of getting the goods in place and condition for resale, including freight-in. Freight-out (to customers) is a selling cost. Therefore, Azur Co.'s cost of goods sold would be:

  • Beginning Inventory $30,840 
  • + Purchases $102,800 
  • - Purchases Discounts ($10,280) 
  • + Freight-in $15,420 
  • + Net Purchases $107,940 
  • = Goods Available for Sale $138,780 
  • - Ending Inventory $20,560 
  • = Cost of Goods Sold $118,220

16

The following information was taken from Cody Co.'s accounting records for the year ended December 31, 2005:

  • Decrease in raw materials inventory $15,000
  • Increase in finished goods inventory $35,000
  • Raw materials purchased $430,000
  • Direct labor payroll $200,000
  • Factory overhead $300,000
  • Freight-out $45,000

There was no work-in-process inventory at the beginning or end of the year. Cody's 2005 cost of goods sold is

A.  $895,000

B.  $910,000

$910,000

  • The correct answer is $910,000:
  • Raw materials purchase d$430,000
  • Plus decrease in raw materials $15,000*
  • Direct labor $200,000
  • Factory overhead $300,000
  • Less finished goods increase ($35,000) **
  • Cost of goods sold $910,000

*The decrease in raw materials is added to the amount purchased resulting in the cost of materials incorporated into production. In other words, $15,000 of materials purchased in 2005 were placed into production in 2005. The total cost of materials brought into production in 2005 equals $445,000.

** The increase in finished goods represents costs incurred in the current period to finish inventory that was not sold in the current period. Therefore, these costs must be removed in determining cost of goods sold.

Freight-out is not a manufacturing cost but rather is a distribution cost.

Therefore, freight-out is not inventoried.

There is no change in work-in-process inventory to affect the calculation.

17

During periods of inflation, a perpetual inventory system would result in the same dollar amount of ending inventory as a periodic inventory system under which of the following inventory valuation methods?

  • FIFO    
  • LIFO 

  • FIFO - YES    
  • LIFO - NO

Under a perpetual inventory system, the cost of goods sold (COGS) is determined at the time of each sale. In a perpetual FIFO inventory system, the cost of each sale (COGS) would be based on the cost of the earliest acquired goods on hand at the time of the sales. The cost of the most recently acquired goods would remain in ending inventory. In a perpetual LIFO inventory system, the cost of each sale (COGS) would be based on the cost of goods acquired just prior to the sale. The cost of the earlier acquired goods would remain in inventory.

Under a periodic inventory system, the costs of goods sold (COGS) and ending inventory are determined only at the end of the period. In a periodic FIFO inventory system, the cost of sales for the period (COGS) would be based on the cost of the earliest acquired goods available during the period. The cost of the most recently acquired goods would remain in ending inventory. In a periodic LIFO inventory system, the cost of sales for the period (COGS) would be based on the last goods acquired during the period. The cost of the earliest acquired goods would remain in ending inventory.

 

18

Which of the following statements regarding inventory accounting systems is true?

  1. A disadvantage of the perpetual inventory system is that the inventory dollar amounts used for interim reporting purposes are estimated amounts.
  2. A disadvantage of the periodic inventory system is that the cost of goods sold amount used for financial reporting purposes includes both the cost of inventory sold and inventory shortages.
  3. An advantage of the perpetual inventory system is that the record keeping required to maintain the system is relatively simple.
  4. An advantage of the periodic inventory system is that it provides a continuous record of the inventory balance.

A disadvantage of the periodic inventory system is that the cost of goods sold amount used for financial reporting purposes includes both the cost of inventory sold and inventory shortages.

A periodic system does not record the cost of each item as it is sold; nor does it maintain a continuously current record of the inventory balance. Rather, cost of goods sold is the amount derived from the equation: Beginning inventory + Purchases = Ending inventory + Cost of goods sold. A count of ending inventory establishes the inventory remaining at the end of the period, but there is no recording of cost of goods sold during the period. Cost of goods sold is the amount that completes the equation. Thus, cost of goods sold is really the cost of inventory no longer with the firm at year-end - an amount that includes shrinkage. Inventory shrinkage refers to breakage, waste, and theft. Shrinkage cannot be identified directly with a periodic inventory system.

19

What are the three primary FIFO cost assumptions?

FIFO:

  1. Oldest costs -----> COGS
  2. Recent costs -----> Ending Inventory

Period of rising prices:

  1. Lowest COGS
  2. Highest Net Income
  3. Highest Ending Inventory

20

What are the three primary LIFO cost assumptions?

LIFO:

  1. Recent costs -----> COGS
  2. Oldest costs -----> Ending Inventory

Period of rising prices:

  1. Highest COGS
  2. Lowest Net Income
  3. Lowest Ending Inventory

21

A company decided to change its inventory valuation method from FIFO to LIFO in a period of rising prices. What was the result of the change on ending inventory and net income in the year of the change?

  • Ending inventory
  • Net income 

  • Ending inventory - DECREASE
  • Net income - DECREASE

Ending inventory would decrease because under LIFO, the latest items purchased (and therefore the most costly) are considered sold, leaving the earliest items purchased (and therefore the least costly) in inventory. This is opposite to the effect under FIFO.

The same is true for net income because now, under LIFO, cost of goods sold is increased relative to FIFO because the cost of the latest and most costly items are considered sold first.

22

When the FIFO inventory method is used during periods of rising prices, a perpetual inventory system results in an ending inventory cost that is

  1. The same as in a periodic inventory system.
  2. Higher than in a periodic inventory system.
  3. Lower than in a periodic inventory system.
  4. Higher or lower than in a periodic inventory system, depending on whether physical quantities have increased or decreased.

The same as in a periodic inventory system.

FIFO produces the same results for periodic and perpetual systems. FIFO always assumes the sale of the earliest goods acquired. Therefore, unlike LIFO periodic, goods can never be assumed sold before they are acquired. 
Cost of goods sold and ending inventory are the same under FIFO for both a periodic and a perpetual system.

23

Generally, which inventory costing method approximates most closely the current cost for each of the following?

  • Cost of goods sold
  • Ending inventory

  • Cost of goods sold - LIFO
  • Ending inventory - FIFO

LIFO assumes the sale of the most recent purchases first and thus results in cost of goods sold that is the most current value. FIFO assumes the sale of the earliest purchases first (and beginning inventory before any purchases) and thus results in ending inventory that is the most current value. FIFO is sometimes called LISH: last in still here.

24

Drew Co. uses the average cost inventory method for internal reporting purposes and LIFO for financial statement and income tax reporting.

On December 31, 2005, the inventory was $375,000 using average cost and $320,000 using LIFO. The unadjusted credit balance in the LIFO Reserve account on December 31, 2005 was $35,000.

What adjusting entry should Drew record to adjust from average cost to LIFO on December 31, 2005?

  • Debit
  • Credit

  • Debit - COGS $20,000
  • Credit - LIFO Reserve $20,000

The ending difference between average cost and LIFO is $55,000 ($375,000 - $320,000). This is the required LIFO reserve account.

The balance before adjustment is $35,000. Thus, $20,000 must be added to the account. The conversion to LIFO, for reporting purposes, increases cost of goods sold because, under LIFO, ending inventory is lower. The entry in this answer alternative increases the cost of goods sold. The inventory account itself is not credited. Rather, the LIFO reserve account acts as a valuation account to reduce inventory to LIFO for balance sheet purposes.

25

Which inventory costing method would a company that wishes to maximize profits in a period of rising prices use?

  1. FIFO
  2. Dollar-value LIFO.
  3. Weighted average.
  4. Moving average.

FIFO

FIFO assumes the sale of the earliest goods first. With rising prices, the earliest goods reflect the lowest prices. Therefore, cost of goods sold under FIFO is the lowest of the cost flow assumptions. With the lowest cost of goods sold, gross margin and income are the highest among the available cost flow assumptions (LIFO and average being the others).

26

Estimates of price-level changes for specific inventories are required for which of the following inventory methods?

  1. Conventional retail.
  2. Dollar-value LIFO.
  3. Weighted average cost.
  4. Average cost retail.

Dollar-value LIFO.

DV LIFO is based on price level indices. The ending inventory is determined at current cost, and then reduced to the price level existing at the base-year (the year LIFO was adopted). The ending inventory measured in base-year dollars is compared to beginning inventory measured in base-year dollars. The difference is the increase in inventory measured in base-year dollars. This difference is then raised to the current-year price level and added to beginning inventory DV LIFO, yielding ending inventory DV LIFO.

Thus, price-level changes are used throughout this method.

Price-level changes are used as a means of estimating the ending inventory. Individual item costs are not maintained or used in the valuation of inventory.

27

Walt Co. adopted the dollar-value LIFO inventory method as of January 1, 2005, when its inventory was valued at $500,000.

Walt's entire inventory constitutes a single pool. Using a relevant price index of 1.10, Walt determined that its December 31, 2005, inventory was $577,500 at current-year cost, and $525,000 at base-year cost.

What was Walt's dollar-value LIFO inventory on December 31, 2005?

  1. $525,000
  2. $527,500
  3. $552,500
  4. $577,500

$527,500

  • Ending inventory at current cost $577,500
  • Ending inventory in base-year dollars $577,500/1.10 $525,000
  • Less beginning inventory in base-year dollars $500,000
  • Equals increase in inventory in base-year dollars $25,000
  • Times current price level index x 1.10
  • Equals increase in inventory at current prices $27,500
  • Plus beginning inventory, DV LIFO $500,000
  • Equals ending inventory, DV LIFO $527,500

28

In January, Stitch, Inc. adopted the dollar-value LIFO method of inventory valuation. At adoption, inventory was valued at $50,000. During the year, inventory increased $30,000 using base-year prices, and prices increased 10%. The designated market value of Stitch's inventory exceeded its cost at year-end. What amount of inventory should Stitch report in its year-end balance sheet?

  1. $80,000
  2. $83,000
  3. $85,000
  4. $88,000

$83,000

Beginning inventory of $50,000 is at base-year dollars and the current year increase of $30,000 is also at base-year dollars. The current year layer must be converted to current year costs ($30,000 x 1.10) = $33,000. Ending dollar value LIFO is the beginning dollar value LIFO (in this case it was adopted in January so the beginning inventory must be $50,000) plus the current year layer of $33,000 or $83,000. Note that the sentence "The designated market value of Stitch's inventory exceeded its cost at year end" is a distracter. It is simply stating that there is not an issue with the lower of cost or market since cost is lower.

29

Which of the following statements are correct when a company applying the lower of cost or market method reports its inventory at replacement cost?

  • I. The original cost is less than replacement cost.
  • II. The net realizable value is greater than replacement cost.

II only.

When a company reports its inventory at replacement cost (market value), original cost must exceed replacement cost. Lower of cost or market means the inventory is reported at replacement cost when replacement cost is less than original cost. Thus, statement I is not correct.

When determining market value, net realizable value is the ceiling or maximum amount. If replacement cost is less than net realizable value, then replacement cost is used as market (as long as replacement cost exceeds net realizable value less a normal profit margin - the floor or minimum value for market).

The firm in the question is reporting the inventory at replacement cost. Therefore, replacement cost must be less than net realizable value.

30

The lower of cost or market rule for inventories may be applied to total inventory, to groups of similar items, or to each item. 
Which application generally results in the lowest inventory amount?

  1. All applications result in the same amount.
  2. Total inventory.
  3. Groups of similar items.
  4. Separately to each item.

Separately to each item.

When LCM is applied to each item, the lowest overall inventory amount is achieved because in no case will market exceed cost.

However, when LCM is applied to groups or to the total inventory, the total difference between items with cost exceeding market is partially offset by items with market exceeding cost. Thus, the resulting inventory valuation is not the lowest possible.

31

Based on a physical inventory taken on December 31, 2004, Chewy Co. determined its chocolate inventory on a FIFO basis at $26,000 with a replacement cost of $20,000.

Chewy estimated that, after further processing costs of $12,000, the chocolate could be sold as finished candy bars for $40,000. Chewy's normal profit margin is 10% of sales.

Under the lower of cost or market rule, what amount should Chewy report as chocolate inventory in its December 31, 2004, balance sheet?

  1. $28,000
  2. $26,000
  3. $24,000
  4. $20,000

$24,000

Market is the middle figure of replacement cost - $20,000, net realizable value - $28,000 ($40,000 - $12,000 processing cost), and net realizable value less normal profit margin - $24,000 ($28,000 - .10 x $40,000). Therefore, market is $24,000, the middle value of the three.

The lower of cost ($26,000) or market ($24,000) is market ($24,000), and market is the reported amount for the inventory.

32

The replacement cost of an inventory item is below the net realizable value and above the net realizable value less a normal profit margin. The inventory item's original cost is above the net realizable value. Under the lower of cost or market method, the inventory item should be valued at

  1. Original cost.
  2. Replacement cost.
  3. Net realizable value.
  4. Net realizable value less normal profit margin.

Replacement cost.

The easiest way to answer a question like this is to make up simple numbers. The following simple numbers were made up to fit the abstract information in the question. Lower of cost or market states you record the inventory at the lower of original cost or market value (replacement cost) within the range of a ceiling and a floor. The numbers below show that replacement cost is lower than original cost and within the floor and ceiling. Replacement cost is the correct answer.

  • Original cost $10
  • Net realizable value $9
  • Replacement cost $8
  • NRV less normal PM $7

33

Moss Co. has determined its December 31, 2004 inventory to be $400,000 on a FIFO basis. Information pertaining to that inventory follows:

  • Estimated selling price $408,000
  • Estimated cost of disposal $20,000
  • Normal profit margin $60,000
  • Current replacement cost $360,000

Moss records losses that result from applying the lower of cost or market rule. On December 31, 2004, what should be the net carrying value of Moss' inventory?

  1. $400,000
  2. $388,000
  3. $360,000
  4. $328,000

$360,000

Under the LCM valuation method, market value is the middle figure (in dollar amount) of the following three items:

  • Replacement cost: $360,000
  • Net realizable value: $408,000 - $20,000 = $388,000
  • Net realizable value less normal profit margin: $388,000 - $60,000 = 328,000

Thus, market value is $360,000. This value is less than the cost of $400,000. Thus, LCM equals $360,000, the valuation or carrying value of the inventory at the end of the year.

34

At the end of the year, Ian Co. determined its inventory to be $258,000 on a FIFO (first in, first out) basis. The current replacement cost of this inventory was $230,000. Ian estimates that it could sell the inventory for $275,000 at a disposal cost of $14,000. If Ian's normal profit margin for its inventory was $10,000, what would be its net carrying value?

  1. $244,000
  2. $251,000
  3. $258,000
  4. $261,000

$251,000

The "ceiling" for LCM (lower of cost or market) valuation is $261,000 net realizable value ($275,000 selling price less $14,000 disposal cost). The "floor" is net realizable value less normal profit margin or $251,000 ($261,000 - $10,000). Replacement cost of $230,000 is below the floor so "market" value is the floor, or middle, of the three amounts ($251,000). This amount is less than cost of $258,000. Therefore, the lower of cost or market valuation is $251,000.

35

The original cost of an inventory item is below both replacement cost and net realizable value. The net realizable value less normal profit margin is below the original cost.

Under the lower of cost or market method, the inventory item should be valued at

  1. Replacement cost.
  2. Net realizable value.
  3. Net realizable value less normal profit margin.
  4. Original cost.

Original cost.

Using small numerical examples or a visual helps to solve this type of question. In the diagram below, the higher an amount is listed, the greater its dollar amount.

  • ----> RC and NRV amounts are the highest; although which of the two is the higher is not given
  • ----> Original cost
  • ----> NRV - normal profit margin

Under LCM, the market value of the inventory is the middle figure (in dollar amount) from among RC, NRV and NRV - normal profit margin. Thus, market must be either RC or NRV, and it does not matter which one of the two is the middle amount. Thus, original cost is less than market, meaning the inventory is valued at original cost (which is the lower of cost or market).

36

Kahn Co., in applying the lower of cost or market method, reports its inventory at replacement cost. Which of the following statements are correct?

  • The original cost is greater than replacement cost
  • The net realizable value, less a normal profit margin, is greater than replacement cost  

  • The original cost is greater than replacement cost - YES
  • The net realizable value, less a normal profit margin, is greater than replacement cost - NO

​Under LCM, the market value of inventory is the middle of three figures (in amount):

  • replacement cost
  • net realizable value
  • net realizable value less normal profit margin.

If the middle figure (market) is less than cost, then the inventory is reported at market. The inventory in this question is reported at replacement cost, which means that replacement cost is market value and replacement cost is less than cost. Also, replacement cost is the middle of the three figures (or tied with one of the other two).

Net realizable value less normal profit margin could not exceed replacement cost because that would imply that replacement cost is the lowest of the three figures, which contradicts the fact that replacement cost is market value.

Therefore, in terms of the question, 
(1) original cost is greater than replacement cost, and 
(2) net realizable value less normal profit margin is not greater than replacement cost.

37

Which of the following attributes would not be used to measure inventory?

  1. Historical cost.
  2. Replacement cost.
  3. Net realizable value.
  4. Present value of future cash flows.

Present value of future cash flows.

Discounting is not allowed in the valuation of inventory. Historical cost is the primary valuation basis used in inventory but the other two answer alternatives are also encountered in practice.

38

The replacement cost of an inventory item is below the net realizable value and above the net realizable value less the normal profit margin. The original cost of the inventory item is below the net realizable value less the normal profit margin.

Under the lower of cost or market method, the inventory item should be valued at

  1. Net realizable value.
  2. Net realizable value less the normal profit margin.
  3. Original cost.
  4. Replacement cost.

Original cost.

In LCM, market value is replacement cost if replacement cost is between the ceiling value (net realizable value) and the floor value (net realizable value less normal profit margin).
This is the situation in this question. The original cost is below the floor value. Thus, market exceeds cost and the item is recorded at cost (lower of cost or market).

39

The original cost of an inventory item is above the replacement cost. The inventory item's replacement cost is above the net realizable value. Under the lower of cost or market method, the inventory item should be valued at

  1. Original cost.
  2. Replacement cost.
  3. Net realizable value.
  4. Net realizable value LESS normal profit margin.

Net realizable value.

Inventory must be carried at lower of cost (such as LIFO, FIFO) or market. Market is replacement cost subject to a ceiling and floor. The ceiling for replacement cost is net realizable value (selling price less cost to complete) and the floor is net realizable value less normal profit margin. Use simple numbers to help solve this abstract question. In this question original cost (assume = 100) is greater than market ((replacement cost) assume = 80). Market (80) is greater than net realizable value (assume = 70). Market is subject to a ceiling of net realizable value (70). In this case the inventory would be valued at net realizable value.

40

A flash flood swept through Hat, Inc.'s warehouse on May 1. After the flood, Hat's accounting records showed the following:

  • Inventory, January 1 $35,000
  • Purchases, January 1 through May 1 $200,000
  • Sales, January 1 through May 1 $250,000
  • Inventory not damaged by flood $30,000
  • Gross profit percentage on sales 40%

What amount of inventory was lost in the flood?

  1. $55,000
  2. $85,000
  3. $120,000
  4. $150,000

$55,000

The gross margin method of estimating inventory is used to solve this problem. The cost of inventory lost cannot be identified by count but it can be estimated.

First, an estimate of cost of goods sold is subtracted from the cost of goods available on the date of the flood yielding the total amount of inventory that would have been present on May 1.

Second, the amount of inventory not lost is subtracted from the May 1 estimated total inventory. The result is an estimate of the amount lost.

With gross profit being 40% of sales, cost of goods sold must be 60% of sales, on average. Therefore, the estimate of cost of goods sold is $150,000 (.60 x $250,000). Beginning inventory ($35,000) + Purchases ($200,000) = Goods available = $235,000. Subtracting $150,000 of cost of goods sold yields $85,000 of inventory on May 1 ($235,000 - $150,000).

With $30,000 of inventory still accounted for, the amount of lost inventory at cost is $55,000 ($85,000 - $30,000).

41

When marking up a specific line of household items for resale, a retailer computes its markup as 40% of cost. For purposes of estimating ending inventory using the gross margin method, what percentage is applied to sales when estimating cost of goods sold?

  1. 40
  2. 71
  3. 60
  4. 29

71

The gross margin method applies the cost to sales ratio to sales in order to derive an estimate of cost of goods sold. Subtracting the resulting estimate of cost of goods sold from the cost of goods available for sale yields an estimate of ending inventory without counting the items. This firm determines the selling price to be 140% of cost because the markup is 40% of cost. Cost plus markup yields selling price. Therefore, the cost to sales ratio is 1.00/1.40 or .71.

42

The following two inventory items were purchased as a group in a liquidation sale for $1,000.

Replacement Cost

  • A $400
  • B $700

The firm purchasing the inventory records item A at what amount?

  1. $341
  2. $390
  3. $364
  4. $500

$364

When items are purchased as a group, the total cost of the group is allocated to the individual items based on fair value. Replacement cost is the appropriate value to use in this case. The total replacement cost of the items is $1,100 ($400 + $700). Therefore, Item A is allocated 4/11 of the purchase cost, or $364 = ($400/$1,100)$1,000.

43

How does the retail inventory method establish the lower-of-cost-or-market valuation for ending inventory?

  1. The procedure is applied on a cost basis at the unit level.
  2. By excluding net markups from the cost-to-retail ratio.
  3. By excluding beginning inventory from the cost-to-retail ratio.
  4. By excluding net markdowns from the cost-to-retail ratio.

By excluding net markdowns from the cost-to-retail ratio.

Although the result is approximate, by excluding net markdowns from the denominator of the cost-to-retail ratio, the ratio is a smaller amount, resulting in a lower ending inventory valuation.

44

The retail inventory method includes which of the following in the calculation of both cost and retail amounts of goods available for sale?

  1. Purchase returns.
  2. Sales returns.
  3. Net markups.
  4. Freight in.

Purchase returns.

The retail method measures beginning inventory and net purchases at both cost and retail. It then applies the average relationship between cost and retail (based on beginning inventory and purchases) to ending inventory at retail to determine ending inventory at cost. 

Purchase returns reduce net purchases at both cost and retail because returns represent amounts included in gross purchases that are not available for sale.

45

When an inventory overstatement in year one counterbalances in year two, this means:

  1. There are no reporting errors, even if the overstatement is never discovered.
  2. A prior period adjustment is recorded if the error is discovered in year three.
  3. The year one Balance Sheet does not need to be restated if the error is discovered in year three.
  4. A prior period adjustment is recorded if the error is discovered in year two.

A prior period adjustment is recorded if the error is discovered in year two.

Counterbalancing simply means that the effect of the inventory error in the second year is opposite that of the first year. Discovery in year two provides an opportunity for the firm to correct year two beginning retained earnings, which is overstated by the error in year one. The overstatement of inventory in year one caused cost of goods sold to be understated and income overstated in year one. The prior period adjustment, dated as of the beginning of year two, is a debit to retained earnings for the after-tax effect of the income overstatement in year one. Inventory is credited for the amount of the overstatement. This allows year two to begin with corrected balances.

46

If ending inventory for 20x5 is understated because certain items were missed in the count, then:

  1. Net income for 20x5 will be overstated.
  2. CGS for 20x5 will be understated.
  3. Net income for 20x5 will be understated, but net income for 20x6 will be unaffected.
  4. Net income for 20x5 will be understated and CGS for 20x6 will be understated.

Net income for 20x5 will be understated and CGS for 20x6 will be understated.

Use the equation BI + PUR = EI + CGS. When EI is understated, CGS must be overstated to maintain the equation. Net income, therefore, is understated (20x5). Then next year, BI is also understated because BI for 20x6 is EI for 20x5. Using the equation, if BI is understated, CGS is also understated to maintain the equation.

47

Bren Co.'s beginning inventory at January 1, 2005 was understated by $26,000, and its ending inventory was overstated by $52,000. As a result, Bren's cost of goods sold for 2005 was:

  1. Understated by $26,000.
  2. Overstated by $26,000.
  3. Understated by $78,000.
  4. Overstated by $78,000.

Understated by $78,000.

The effect of the beginning-inventory error is to understate cost of goods sold $26,000. The effect of the ending-inventory error is to understate cost of goods sold $52,000. The total effect then is to understate cost of goods sold $78,000.

These effects are analyzed by using the equation:
Beginning inventory + Purchases-Ending inventory = Cost of goods sold

For example, if beginning inventory is understated, then the right hand side of the equation (cost of goods sold) must also be understated by the same amount.

48

A retailer failed to record a purchase of inventory on credit near the end of the current year. The goods did arrive and were included in the inventory count. The purchase will be recorded next year, when the goods are paid for. As a result,

  1. Cost of goods sold is understated for the current year.
  2. Net income for next year is overstated.
  3. Income tax expense for the next year is overstated.
  4. By the end of next year, all of the effects of the error will be automatically eliminated.

Cost of goods sold is understated for the current year.

The error affects purchases but not ending inventory. Therefore, cost of goods sold for the current period is understated because goods available is understated. When ending inventory (which is not in error) is subtracted from goods available, cost of goods sold is understated by the amount of the understatement in purchases.

49

On January 2 of the current year, LTTI Co. entered into a three-year, non-cancelable 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?

  1. $0
  2. $8,000
  3. $12,000
  4. $52,000

$52,000

This amount represents the amount of the minimum guaranteed amount ($60,000 {200,000 units a year x 3 years x $.10}) less what was already purchased ($8,000 {80,000 units x $.10}) = $52,000.

50

At the end of 20x4, a firm recognized a loss on a contractual commitment to purchase inventory for $60,000. The value of the inventory at the end of 20x4 is $52,000. When the inventory was actually purchased in 20x5, its value had risen to $62,000. Choose the correct statement concerning reporting in 20x5.

  1. A $10,000 gain is recognized.
  2. The inventory is recorded at $60,000.
  3. The inventory is recorded at $52,000.
  4. There is no additional loss or gain recognized.

The inventory is recorded at $60,000.

The maximum recorded value of the inventory is $60,000, which is the contractual amount and, also, the cost. If the firm can sell the inventory for more than $60,000, then gross margin will be recognized. The value of the inventory more than fully recovered, but gains are limited to the amount of previously recognized losses, which in this case, is $8,000.

51

Losses on purchase commitments are recorded at the end of the current year when:

  1. The current cost of the inventory is less than the inventory cost in the purchase contract.
  2. The purchase contract is irrevocable.
  3. The contractual cost of the inventory in an irrevocable purchase contract exceeds the current cost.
  4. The buyer purchased a quantity of inventory that was not sufficient to avoid a LIFO liquidation.

The contractual cost of the inventory in an irrevocable purchase contract exceeds the current cost.

Both qualities are required for a loss to be recognized. The firm must honor a contract in a later period by paying more than current cost and, thus, is in a loss position at the end of the current year.

52

A corporation entered into a purchase commitment to buy inventory. At the end of the accounting period, the current market value of the inventory was less than the fixed purchase price, by a material amount. Which of the following accounting treatments is most appropriate?

  1. Describe the nature of the contract in a note to the financial statements, recognize a loss in the Income Statement, and recognize a liability for the accrued loss.
  2. Describe the nature of the contract and the estimated amount of the loss in a note to the financial statements, but do not recognize a loss in the Income Statement.
  3. Describe the nature of the contract in a note to the financial statements, recognize a loss in the Income Statement, and recognize a reduction in inventory equal to the amount of the loss by use of a valuation account.
  4. Neither describe the purchase obligation nor recognize a loss on the Income Statement or Balance Sheet.

Describe the nature of the contract in a note to the financial statements, recognize a loss in the Income Statement, and recognize a liability for the accrued loss.

The firm has committed to a fixed price but must recognize the loss in the period the decline in price occurred, much like under lower-of-cost-or-market. Inventory is not reduced because the firm has not purchased the inventory under contract. There is no asset to reduce, but the decrease in net assets is accomplished by recording the liability for the portion of the purchase price that has no value.

53

The dollar-value LIFO inventory cost flow method involves computations based on

  • Inventory pools of similar items
  • A specific price index for each year

  • Inventory pools of similar items - YES
  • A specific price index for each year - YES

Dollar-value LIFO uses dollar-value pools which are made up of "similar" items (in terms of interchangeability, type of material, or similarity in use). Dollar-value LIFO determines increases or decreases in ending inventory in terms of dollars of the same purchasing power. Ending inventory is deflated to base-year cost by dividing ending inventory by the current year’s specific conversion price index. The resulting amount is then compared with the beginning inventory which has also been stated in base-year dollars.

54

The moving average inventory cost flow method is applicable to which of the following inventory systems?

  • Periodic
  • Perpetual

  • Periodic - NO
  • Perpetual - YES

The moving average method is used with perpetual records. A new average unit cost is computed each time a purchase is made and this unit cost is used in costing withdrawals of inventory until another purchase is made. The weighted-average method is used with periodic records.

55

During periods of rising prices, a perpetual inventory system would result in the same dollar amount of ending inventory as a periodic inventory system under which of the following inventory cost flow methods?

  • FIFO
  • LIFO

  • FIFO - YES
  • LIFO - NO

Under the FIFO method, ending inventory is the same whether a perpetual or periodic system is used. The inventory flow is always in chronological order, and ending inventory is made up of the latest (most recent) purchases. Under the LIFO method, ending inventory is made up of the first (oldest) purchases. When LIFO periodic is used, the first/last purchase determination is based upon the chronological order of all purchases. When LIFO perpetual is used, this determination is made continuously based on the inventory layers available. Therefore, LIFO periodic ending inventory is usually different from LIFO perpetual ending inventory.

56

The double extension method and the link-chain method are two variations of which of the following inventory cost flow methods?

  1. Moving average.
  2. FIFO.
  3. Dollar-value LIFO.
  4. Conventional (lower of cost or market) retail.

Dollar-value LIFO.

Dollar-value LIFO bases inventory on "dollars" in inventory rather than "units" in inventory. Inventory layers are identified with the price index in the year in which the layer was added. ’Double extension’ and ’link-chain" are two variations of dollar-value LIFO. Link-chain differs from double extension in that inventory values are extended at beginning of the year prices for link-chain and at base year prices for double extension. Because of this difference, link-chain is more appropriate for situations in which inventory is going through rapid technological changes. The two variations are not alternatives and use of the link-chain method should be restricted to situations in which the double extension method is impractical.

57

The calculation of the income recognized in the third year of a five-year construction contract accounted for using the percentage-of-completion method includes the ratio of

  1. Costs incurred in year 3 to total billings.
  2. Costs incurred in year 3 to total estimated costs.
  3. Total costs incurred to date to total billings.
  4. Total costs incurred to date to total estimated costs.

Total costs incurred to date to total estimated costs.

In practice, various procedures are used to measure the extent of progress toward completion under the percentage-of-completion method, but the most widely used one is cost-to-cost which is based on the assumed relationship between a unit of input and productivity.  Under cost-to-cost, either revenue and/or profit to be recognized in the current period can be determined by the following formula.

58

The following data relate to a construction job started by Syl Co. during year 1:

  • Total contract price $100,000
  • Actual costs during year $120,000
  • Estimated remaining costs $40,000
  • Billed to customer during year $130,000
  • Received from customer during year $110,000

Under the completed-contract method, how much should Syl recognize as gross profit for year 1?

  1. $0
  2. $4,000
  3. $10,000
  4. $12,000

$0

When a company uses the completed-contract method of accounting for construction projects, all revenue and expense recognition is deferred until the project is complete or substantially complete (ASC Topic 605). Because there is an estimated $40,000 of remaining costs, the contract cannot be considered to be substantially complete. Thus, no revenue, expenses, or gross profit would be recognized by Syl Co. in year 1 using this method.

59

The following information is available for the Silver Company for the 3 months ended March 31, year 2.

  • Merchandise inventory, January 1, year 2$ 900,000
  • Purchases $3,400,000
  • Freight-in $200,000
  • Sales $4,800,000

The gross margin recorded was 25% of sales. What should be the merchandise inventory at March 31, year 2?

  1. $700,000
  2. $900,000
  3. $1,125,000
  4. $1,200,000

$900,000

When using the gross margin method of inventory valuation, the CGS is estimated as Sales - (Sales × Gross margin).  Silver Company’s estimated CGS is $3,600,000 [$4,800,000 − ($4,800,000 × 0.25)].  Therefore, ending inventory can be calculated as follows:

  1. Beginning inventory $900,000
  2. Add: Purchases $3,400,000 
  3. Add: Freight-in $200,000
  4. = Cost of goods available $4,500,000

Deduct:  

  • Cost of goods sold (estimated) ($3,600,000)
  • Ending inventory $900,000

60

A flash flood swept through Hat, Inc.’s warehouse on May 1. After the flood, Hat’s accounting records showed the following:

  • Inventory, January 1 $35,000
  • Purchases, January 1 through May $1,200,000
  • Sales, January 1 through May 1 $250,000
  • Inventory not damaged by flood $30,000
  • Gross profit percentage on sales 40%

What amount of inventory was lost in the flood?

  1. $55,000
  2. $85,000
  3. $120,000
  4. $150,000

$55,000

The gross profit method should be used to estimate the cost of goods sold and the amount lost in the flood. If the gross profit percentage is 40%, the cost of sales percentage is 60% and cost of goods sold can be estimated to be $150,000 ($250,000 × 60%). Beginning inventory plus purchases equals goods available for sale or $235,000 ($35,000 + $200,000). Goods available for sale of $235,000 less cost of goods sold of $150,000 equals $85,000 (estimated ending inventory). A count of inventory not lost in the flood resulted in $30,000; therefore, the amount lost in the flood equals $55,000 ($85,000 − $30,000), and this is correct.

61

Which of the following statements is false regarding inventory costing methods?

  1. 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.
  2. LIFO tends to smooth out the net income patterns since it matches current cost of goods sold with current revenue, when inventories remain at constant quantities.
  3. 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.
  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.

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.

Under FIFO, current purchases usually become part of ending inventory rather than cost of goods sold and thus do not affect current income. Under LIFO, however, current purchases are normally included in cost of goods sold and thus net income could be affected by controlled purchases.

62

Which of the following statements regarding inventory accounting systems is true?

  1. A disadvantage of the perpetual inventory system is that the inventory dollar amounts used for interim reporting purposes are estimated amounts.
  2. A disadvantage of the periodic inventory system is that the cost of goods sold amount used for financial reporting purposes includes both the cost of inventory sold and inventory shortages.
  3. An advantage of the perpetual inventory system is that the recordkeeping required to maintain the system is relatively simple.
  4. An advantage of the periodic inventory system is that it provides a continuous record of the inventory balance.

A disadvantage of the periodic inventory system is that the cost of goods sold amount used for financial reporting purposes includes both the cost of inventory sold and inventory shortages.

A disadvantage of the periodic inventory system is that the exact amount of inventory shortages cannot be determined. The amount is buried in cost of goods sold.

63

From a theoretical viewpoint, which of the following costs would be considered inventoriable?

  • Freight-In
  • Warehousing

  • Freight-In - YES
  • Warehousing - YES

All costs incurred to acquire goods or to prepare them for sale are inventoriable. Freight-in is a cost incurred to acquire goods, and warehousing is a cost incurred to store goods awaiting sale. Therefore, both freight-in and warehousing are inventoriable costs.

64

Wildwood Company’s usual sales terms are net 60 days, FOB shipping point.  Sales, net of returns and allowances, totaled $2,000,000 for the year ended December 31, year 1, before year-end adjustment.  Additional information is as follows:

  • Goods with an invoice amount of $40,000 were billed to a customer on January 3, year 2. The goods were shipped on December 31, year 1.
  • On January 5, year 2, a customer notified Wildwood that goods billed and shipped to it on December 21, year 1 were lost in transit.  The invoice amount was $50,000.
  • On December 27, year 1, Wildwood authorized a customer to return, for full credit, goods shipped and billed at $25,000 on December 15, year 1.  The returned goods were received by Wildwood on January 4, year 2, and a $25,000 credit memo was issued on the same date.

Wildwood’s adjusted net sales for year 1 should be

  1. $1,965,000
  2. $1,975,000
  3. $1,990,000
  4. $2,015,000

$2,015,000

Since sales terms are FOB shipping point, title passes to the buyer when the seller (Wildwood) delivers the goods to the common carrier. The goods shipped on 12/31/Y1 ($40,000) should be added to sales since the sale was not recorded until year 2. The goods lost in transit ($50,000) were correctly recorded as a sale in year 1. Because the terms were FOB shipping point, Wildwood has a valid receivable, and the buyer must proceed against the common carrier for recovery. The goods returned ($25,000) should be recorded as a return in year 1, when Wildwood authorized the return. Since the return was not recorded until year 2, year 1 net sales must be adjusted downward for the $25,000. Therefore, adjusted net sales are $2,015,000 ($2,000,000 + $40,000 − $25,000).

65

On December 31, year 1, Kern Company adopted the dollar-value LIFO inventory method. All of Kern’s inventories constitute a single pool.  The inventory on December 31, year 1, using the dollar-value LIFO inventory method was $600,000.  Inventory data for year 2 are as follows:

  • 12/31/Y2 inventory at year-end prices $780,000
  • Relevant price index at year-end (base year 1) 1.20

Under the dollar-value LIFO inventory method, Kern’s inventory at December 31, year 2, would be

  1. $650,000
  2. $655,000
  3. $660,000
  4. $720,000

$660,000

The dollar-value LIFO method accounts for inventory by layers. Each layer is valued using the price index for the year the inventory was purchased. To begin, the December 31, year 2 inventory at year-end prices ($780,000) must be restated back to base-year prices ($780,000/1.20 = $650,000). Thus, the ending inventory consists of the base-year layer of $600,000 (December 31, year 1 inventory) and an incremental layer of $50,000 (quantity change holding prices constant) added in year 2 ($650,000 - $600,000). The base-year layer is left at base-year prices, but the year 2 layer must be expressed in terms of year 2 prices.

Base-year layer $600,000

year 2 layer ($50,000 × 1.20) 60,000

12/31/Y2 inventory $660,000

66

The dollar-value LIFO inventory cost flow method involves computations based on

  • Inventory pools of similar items
  • A specific price index for each year

  • Inventory pools of similar items - YES
  • A specific price index for each year - YES

Dollar-value LIFO uses dollar-value pools which are made up of "similar" items (in terms of interchangeability, type of material, or similarity in use). Dollar-value LIFO determines increases or decreases in ending inventory in terms of dollars of the same purchasing power. Ending inventory is deflated to base-year cost by dividing ending inventory by the current year’s specific conversion price index. The resulting amount is then compared with the beginning inventory which has also been stated in base-year dollars.

67

When progress billings are sent on a long-term contract, what type of account should be credited under the completed-contract method and percentage-of-completion method?

Revenue or Contra Asset?

  • Completed-contract
  • Percentage-of-completion

  • Completed-contract - Contra Asset
  • Percentage-of-completion - Contra Asset

Under the percentage-of-completion method, income is recognized periodically on the basis of the percentage of the job that is complete. The completed-contract method recognizes income from the job only when the contract is completed. This is the only difference in accounting for the two methods. For both methods, when progress billings are sent, "Billings on construction in progress" is credited for the amount billed. This is shown on the balance sheet as a contra account to Construction in progress.

68

Moore Company carries product A in inventory on December 31, year 2, at its unit cost of $7.50. Because of a sharp decline in demand for the product, the selling price was reduced to $8.00 per unit. Moore’s normal profit margin on product A is $1.60, disposal costs are $1.00 per unit, and the replacement cost is $5.30. Under the rule of cost or market, whichever is lower, Moore’s December 31, year 2, inventory of product A should be valued at a unit cost of

  1. $5.30
  2. $5.40
  3. $7.00
  4. $7.50

$5.40

Per ASC Topic 330, inventory should be valued using the lower of cost or market (LCM) method. Cost is historical cost ($7.50 in this case). Market value is the replacement cost subject to an upper limit (ceiling) and a lower limit (floor). The ceiling is the net realizable value, which is the selling price less disposal costs. The floor is the net realizable value less a normal profit margin. The ceiling is $7.00 ($8.00 — $1.00) and the floor is $5.40 ($7.00 — $1.60). Since the replacement cost of $5.30 is below the floor, the floor ($5.40) represents market value to be compared with cost. Since market ($5.40) is less than cost ($7.50), the proper valuation is $5.40.

69

On September 30, year 2, fire at Brock Company’s only warehouse caused severe damage to its entire inventory. Based on recent history, Brock has a gross profit of 30% of net sales.  The following information is available from Brock’s records for the 9 months ended September 30, year 2:

  • Inventory at 1/1/Y2 $550,000
  • Purchases $3,000,000
  • Net sales $4,000,000

A physical inventory disclosed usable damaged goods which Brock estimates can be sold to a jobber for $50,000.  Using the gross profit method, the estimated cost of goods sold for the 9 months ended September 30, year 2, should be

  1. $2,050,000
  2. $2,485,000
  3. $2,750,000
  4. $2,800,000

$2,800,000

Since net sales are $4,000,000 and the estimated gross profit rate is 30% of net sales, gross profit can be estimated at $1,200,000. The estimated cost of goods sold is net sales ($4,000,000) less estimated gross profit ($1,200,000), or $2,800,000. A short cut is to realize that if the gross profit rate is 30%, cost of goods sold must be 70% of sales; therefore, CGS is $2,800,000 ($4,000,000 × 70%).

70

In a periodic inventory system that uses the weighted-average cost flow method, the beginning inventory is the

  1. Net purchases minus the ending inventory.
  2. Net purchases minus the cost of goods sold.
  3. Total goods available for sale minus the net purchases.
  4. Total goods available for sale minus the cost of goods sold.

Total goods available for sale minus the net purchases.

In a periodic inventory system (regardless of the cost flow method assumed), the computation of CGS is:

  •  Beginning inventory
  • +Net purchases
  •  Cost of goods available for sale
  • −Ending inventory
  •  Cost of goods sold

From this computation can be derived the equation CGAS minus net purchases equals BI.

71

A company used the percentage-of-completion method to account for a 4-year construction contract. Which of the following would be used in the calculation of the income recognized in the second year?

  • Income previously recognized
  • Progress billings to date

  • Income previously recognized - YES
  • Progress billings to date - NO

ASC Topic 605 suggests a cost-to-cost measure which is a method of recognizing income based on costs incurred. The formula used for the calculation is:

Current year’s profit = ((Costs to date / Total expected cost) × Expected profit) − Profit recognized in previous periods

Based on this formula, only income previously recognized is required in the calculation. Progress billings to date is an accumulation of amounts billed, and the balance in the account does not normally coincide with the costs incurred to date.

72

Fireworks, Inc., had an explosion in its plant that destroyed most of its inventory. Its records show that beginning inventory was $40,000. Fireworks made purchases of $480,000 and sales of $620,000 during the year. Its normal gross profit percentage is 25%. It can sell some of its damaged inventory for $5,000. The insurance company will reimburse Fireworks for 70% of its loss. What amount should Fireworks report as loss from the explosion?

  1. $50,000
  2. $35,000
  3. $18,000
  4. $15,000

$15,000

 

To calculate the loss, you must first determine an estimate of the inventory on hand, and information is provided to estimate the inventory based on the gross profit method.  If the gross profit percent is 25% of sales, an estimate of the loss may be calculated as shown below:

  • Sales $620,000
  • COGS (75%) ($465,000)
  • Gross Profit 25% $155,000
  • Beginning inventory $40,000
  • + Purchases $480,000
  • Goods avail. for sale $520,000
  • − Cost of goods sold (estimated) ($465,000)
  • Ending inventory (estimated) $55,000
  • Ending inventory (estimated) $55,000
  • Less: sales value of damaged goods ($5,000)
  • Estimated loss $50,000
  • × 30% (not reimbursed) × 30%
  • Amount of loss not reimbursed $15,000

73

In accounting for a long-term construction contract using the percentage-of-completion method, the amount of income recognized in any year would be added to

  1. Deferred revenues.
  2. Progress billings on contracts.
  3. Construction in progress.
  4. Property, plant, and equipment

Construction in progress.

When revenue is recognized, the following entry is made: 

  • Construction in progress xxx 
    • Income on long-term contract xxx

74

Lin Co. sells its merchandise at a gross profit of 30%.  The following figures are among those pertaining to Lin’s operations for the 6 months ended June 30, year 2:

  • Sales $200,000
  • Beginning inventory $50,000
  • Purchases $130,000

On June 30, year 2, all of Lin’s inventory was destroyed by fire.  The estimated cost of this destroyed inventory was

  1. $120,000
  2. $70,000
  3. $40,000
  4. $20,000

$40,000

Ending inventory for Lin Co. can be estimated by using the gross profit percentage to convert sales to cost of goods sold (estimated). If gross profit is 30% of sales, then cost of goods sold is 70% (1-30%) of sales.  In this case, estimated cost of goods sold is $140,000 ($200,000 sales × 70%).  Estimated cost of goods sold is then subtracted from actual goods available for sale to determine estimated ending inventory.

  • Beginning inventory $50,000
  • Purchases $130,000
  • Goods available for sale $180,000
  • Less estimated cost of goods sold ($140,000)
  • Estimated ending inventory $$40,000

75

The following information was taken from Baxter Department Store’s financial statements:

  • Inventory at January 1 $100,000
  • Inventory at December 31 $300,000
  • Net sales $2,000,000
  • Net purchases $700,000

What was Baxter’s inventory turnover for the year ending December 31?

  1. 2.5
  2. 3.5
  3. 5
  4. 10

2.5

Average inventory is calculated as beginning of the year inventory plus end of year inventory divided by 2. Cost of goods sold is calculated as purchases plus beginning inventory minus ending inventory, or $500,000 ($700,000 + $100,000 − $300,000). Therefore, this answer is correct because inventory turnover is equal to 2.5 {$500,000/[($100,000 + $300,000)/2]}.

76

Nomar Co. shipped inventory on consignment to Seabright Co. that cost $20,000. Seabright paid $500 for advertising that was reimbursable from Nomar. At the end of the year, 70% of the inventory was sold for $30,000. The agreement states that a commission of 20% will be provided to Seabright for all sales. What amount of net inventory on consignment remains on the balance sheet for the first year for Nomar?

  1. $0
  2. $6,000
  3. $6,500
  4. $20,000

$6,000

The amount of inventory remaining on consignment at the end of the year can be calculated as follows. Consignment inventory was $20,000, and 70% of consignment inventory ($20,000 × 70% = $14,000) was sold. Therefore, ending consignment inventory is equal to $6,000 ($20,000 − $14,000). Therefore, this is correct.

77

The following costs were among those incurred by Woodcroft Corporation during year 2:

  • Merchandise purchased for resale $500,000
  • Salesmen’s commissions $40,000
  • Interest on notes payable to vendors $5,000

How much should be charged to the cost of the merchandise purchases?

  1. $500,000
  2. $505,000
  3. $540,000
  4. $545,000

$500,000

The costs to be charged to merchandise purchases should include those costs necessary to prepare the merchandise for sale. Salesmen’s commissions are a selling expense and not related to the acquisition of the merchandise. These costs are expensed in the period incurred. The interest is a financing expense and is also expensed in the period incurred. Thus, only the $500,000 should be included in the cost of the merchandise purchases.

78

The following data appeared in the accounting records of a retail store for the year ended

December 31, year 2:

  • Sales $150,000
  • Purchases $70,000

Inventories:

  • January 1 $35,000
  • December 31 $50,000

Sales commissions $5,000

How much was the gross margin?

  1. $65,000
  2. $75,000
  3. $90,000
  4. $95,000

$95,000

 

Gross margin is sales minus cost of goods sold and is computed as follows for this question:

  • Sales $150,000
  •  Less cost of goods sold
    •  Beginning inventory $35,000 
    •  Purchases $70,000 
  •  Goods available $105,000 
  • Ending inventory ($50,000) 
  •  Cost of goods sold ($55,000)
  • Gross margin $95,000

79

80

The original cost of an inventory item is above the replacement cost and below the net realizable value. The net realizable value less the normal profit margin is above the replacement cost and the original cost. Using the lower of cost or market method the inventory item should be priced at its

  • Original cost.
  • Replacement cost.
  • Net realizable value.
  • Net realizable value less the normal profit margin.

Original cost.

Under lower of cost or market, market is replacement cost provided that replacement cost is lower than net realizable value (ceiling) and higher than net realizable value less a normal profit margin (floor). Since the replacement cost is below the floor, the floor will be used as market value. Therefore, original cost will be the value of the inventory because it is lower than the market value (floor).

81

Which method of inventory pricing best approximates specific identification of the actual flow of costs and units in most manufacturing situations?

  1. Average cost.
  2. First-in, first-out.
  3. Last-in, first-out.
  4. Base stock.

First-in, first-out.

Most manufacturing operations process and sell inventory in the order it is received, that is the first items in are the first to be sold, which is FIFO.

82

Garnett Co. shipped inventory on consignment to Hart Co. that originally cost $50,000. Hart paid $1,200 for advertising that was reimbursable from Garnett. At the end of the year, 40% of the inventory was sold for $32,000. The agreement stated that a commission of 10% will be provided to Hart for all sales. What amount should Garnett report as net income for the year?

  1. $0
  2. $7,600
  3. $10,800
  4. $12,000

$7,600

Garnett’s net income is $7,600, as calculated below.

  • Revenue $32,000
  • Cost of goods sold ($50,000 × 40%) ($20,000)
  • Commission ($32,000 × 10%) ($3,200)
  • Advertising ($1,200)
  • Net income $7,600

83

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?

  1. $202,000
  2. $208,000
  3. $220,000
  4. $232,000

$208,000

To solve the problem, first calculate cost of sales. Since gross margin is 20%, cost of sales is equal to $220,000 ($275,000 × 80%). Then, purchases are calculated by adding ending inventory and deducting beginning inventory from cost of sales. $208,000 ($18,000 − $30,000 + $220,000).

84

Theoretically, cash discounts permitted on purchased raw materials should be

  1. Added to other income, whether taken or not.
  2. Added to other income, only if taken.
  3. Deducted from inventory, whether taken or not.
  4. Deducted from inventory, only if taken.

Deducted from inventory, whether taken or not.

There are two methods of accounting for cash discounts: the gross method and the net method. The gross method records purchases before any discounts, and records cash discounts only when taken. The net method records purchases net of cash discounts whether taken or not, and any discounts foregone are considered to be financing expenses. Theoretically, purchases and accounts payable should be shown net of cash discounts whether taken or not because this net method allows for a more correct reporting of the related asset and liability, and it allows for a measure of the inefficiency of financial management if the discount is not taken.

85

Selected information from the accounting records of Dalton Manufacturing Company is as follows:

  • Net sales for year 2 $1,800,000
  • Cost of goods sold for year 2 $1,200,000
  • Inventories at December 31, year 1 $336,000
  • Inventories at December 31, year 2 $288,000

Assuming there are 300 working days per year, what is the number of days’ sales in average inventories for year 2?

  1. 78
  2. 72
  3. 52
  4. 48

78

The number of days’ sales in average inventories is calculated using the formula

Days in Year / COGS

or

Average inventory at cost / Average sales per day at cost

Average inventory at cost would be $312,000 [($336,000 + $288,000) ÷ 2].  The average sales per day at cost is $4,000 ($1,200,000 cost of goods sold ÷ 300 days). Therefore, the number of days’ sales in average inventories is 78 days ($312,000 ÷ $4,000).

86

The following information pertains to an inventory item:

  • Cost $12.00
  • Estimated selling price $13.60
  • Estimated disposal cost .20
  • Normal gross margin $2.20
  • Replacement cost $10.90

Under the lower-of-cost-or-market rule, this inventory item should be valued at

  1. $10.70
  2. $10.90
  3. $11.20
  4. $12.00

$11.20

The solutions approach to this problem is to visualize where original and replacement cost (market) lie in respect to the floor and ceiling limitations.

In this situation, replacement cost lies below NRV and NRV less a normal profit margin.  Therefore, NRV less a normal profit margin will be used as the market to determine LCM.  Since original cost is greater than market, market will be used to price the inventory for the period.

87

The following information is available for Cooke Company for year 2:

  • Net sales $1,800,000
  • Freight-in $45,000
  • Purchase discounts $25,000
  • Ending inventory $120,000

The gross margin is 40% of net sales.  What is the cost of goods available for sale?

  1. $840,000
  2. $960,000
  3. $1,200,000
  4. $1,220,000

$1,200,000

Gross margin is 40% of net sales ($1,800,000), or $720,000. Therefore, cost of goods sold is $1,080,000 ($1,800,000 net sales less $720,000 gross margin). Finally, cost of goods available for sale is $1,200,000 ($1,080,000 cost of goods sold plus $120,000 ending inventory). The amounts for freight-in ($45,000) and purchase discounts ($25,000) are not necessary for the computation.

88

Under the lower of cost or market method, the replacement cost of an inventory item would be used as the designated market value

  1. When it is below the net realizable value less the normal profit margin.
  2. When it is below the net realizable value and above the net realizable value less the normal profit margin.
  3. When it is above the net realizable value.
  4. Regardless of net realizable value.

When it is below the net realizable value and above the net realizable value less the normal profit margin.

ASC Topic 330 "market" is equal to current replacement cost, subject to the following constraints: (1) market cannot exceed the net realizable value (NRV) of an item, and (2) market cannot be below NRV less the normal profit margin.

89

At the end of the year, Ian Co. determined its inventory to be $258,000 on a FIFO (first in, first out) basis. The current replacement cost of this inventory was $230,000. Ian estimates that it could sell the inventory for $275,000 at a disposal cost of $14,000. If Ian’s normal profit margin for its inventory was $10,000, what would be its net carrying value?

  1. $244,000
  2. $251,000
  3. $258,000
  4. $261,000

$251,000

ASC Topic 330 requires the use of lower of cost or market (LCM) for reporting inventory.  The market value of inventory is defined as the replacement cost (RC), as long as it is less than the ceiling, net realizable value (NRV), and more than the floor NRV less a normal profit (NRV − NP).  In this case, the amounts are computed as follows:
 
Ceiling: NRV = ($275,000 est. selling price − $14,000 cost to sell) = $261,000
Floor: NRV − NP = $261,000 − $10,000 = $251,000
 
The replacement cost is $230,000, which is lower than the floor.  Therefore, the net carrying value of the inventory should be reported at the floor value of $251,000, which is lower than the cost of $258,000. Therefore, this is the correct answer.