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Flashcards in LCM & Significant Influence Deck (25):
1

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.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

B. 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.

2

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

A. Net realizable value.
B. Net realizable value less the normal profit margin.
C. Original cost.
D. Replacement cost.

C. 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).

3

At the end of the year, Ian Co. determined its inventory to be $258,000 on a LIFO (last 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?

A.
$244,000

B.
$251,000

C.
$258,000

D.
$261,000

B.
$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.

4

Which of the following attributes would not be used to measure inventory?
A. Historical cost.
B. Replacement cost.
C. Net realizable value.
D. Present value of future cash flows.

D. 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.

5

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 The net realizable value,
than replacement cost less a normal profit margin, is
greater than replacement cost
Yes Yes
Yes No
No Yes
No No

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

6

2017 Exam: Moss Co. has determined its December 31, 20x4 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 net realizable value rule. On December 31, 20x4, what should be the net carrying value of Moss' inventory?

A. $400,000
B. $388,000
C. $360,000
D. $328,000

***applying the lower of cost or net realizable value rule
NEW RULES APPLIED "Simplified"

360 <400<408-20=388

Incorrect:
D. $328,000
Lower of cost or net realizable value applies to inventories that are carried at FIFO or Average cost. Net realizable value is selling price less cost of disposal. In this case it is $408,000 ‐ 20,000 = $388,000. This answer is also trying to apply the old rules by calculating net realizable value less normal profit margin (the floor value in LCM). However, this calculation is no longer required and the inventory is reported at the lower of cost or net realizable value with no floor or ceiling test.

Correct:
B. $388,000

Lower of cost or net realizable value applies to inventories that are carried at FIFO or Average cost. Net realizable value is selling price less cost of disposal. In this case it is $408,000 ‐ 20,000 = $388,000.

7

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

A. Replacement cost.
B. Net realizable value.
C. Net realizable value less normal profit margin.
D. Original cost.

Incorrect:
C. Net realizable value less normal profit margin.

Market value is the middle figure of RC, NRV, and NRV less normal profit margin. Therefore, market value is either RC or NRV because cost is less than both of these amounts but higher than NRV less normal profit margin. With cost less than market value, the inventory is valued at cost (the lower of cost or market).

Correct:
D. 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).

8

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
A. Original cost.
B. Replacement cost.
C. Net realizable value.
D. Net realizable value less normal profit margin.

B. Replacement cost.

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.

9

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?
A. All applications result in the same amount.
B. Total inventory.
C. Groups of similar items.
D. Separately to each item.

D. 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

10

Based on a physical inventory taken on December 31, 2004, Chewy Co. determined its chocolate inventory on a LIFO 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?

A. $28,000
B. $26,000
C. $24,000
D. $20,000

C. $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.

11

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
A. Original cost.
B. Replacement cost.
C. Net realizable value.
D. Net realizable value LESS normal profit margin.

C. Net realizable value

Inventory must be carried at lower of cost (such as LIFO) 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.

12

When the fair value of an investment in debt securities exceeds its carrying amount, how should each of the following assets be reported at the end of the year?
Held-to-maturity securities Available-for-sale securities
Fair value Carrying amount
Carrying amount Fair value
Carrying amount Carrying amount
Fair Value Fair Value

Held-to-maturity securities Available-for-sale securities
Carrying amount Fair value

Securities classified as held-to-maturity are reported at amortized cost, which is the carrying amount of the securities. Further, securities classified as available-for-sale are reported at fair value.

13

On January 1, 2004, Purl Corp. purchased, as a long-term investment, $500,000 face value Shaw, Inc. 8% bonds for $456,200. The bonds were purchased to yield 10% interest. Purl has the positive intent and ability to hold the bonds until maturity on January 1, 2010. The bonds pay interest annually on January 1, and Purl uses the interest method of amortization.
What amount (rounded to nearest $100) should Purl report on its December 31, 2005 Balance Sheet for this long-term investment?

A. $468,000
B. $466,200
C. $461,800
D. $456,200

A held-to-maturity (HTM) investment purchased at a discount increases in value as maturity approaches, at which time the book value of the investment must be the face value of the investment. During the life of an HTM investment the investor carries and reports the investment at amortized cost.

The interest and amortization entries for the two years 2004 and 2005 lead to the correct ending balance at December 31, 2005 are:

December 31, 2004:

Interest receivable .08($500,000) 40,000
Investment in HTM bonds 5,620
Interest revenue .10($456,200) 45,620

December 31, 2005:

Interest receivable .08($500,000) 40,000
Investment in HTM bonds 6,182
Interest revenue .10($456,200 + $5,620) 46,182

Thus, the ending investment balance at December 31, 2005 is $456,200 + $5,620 + $6,182 = $468,002, or $468,000 (rounded to the nearest $100 as required by the problem).

14

On December 29, 2005, BJ Co. sold an equity security investment that had been purchased on January 4, 2004. BJ owned no other marketable equity security.
An unrealized loss was reported in the 2004 Income Statement. A realized gain was reported in the 2005 Income Statement.
Was the marketable equity security classified as available-for-sale (AFS), and did its 2004 market price decline exceed its 2005 market price recovery?

AFS 2004 market price decline exceeded 2005 market price recovery
Yes Yes
Yes No
No Yes
No No

No No

The security cannot be classified as available-for-sale because the unrealized gains and losses are recognized in the Income Statement. Unrealized gains and losses on available-for-sale securities are recognized in owners' equity, not earnings.
The second part of the question is somewhat ambiguous. The 2004 price decline could exceed or be exceeded by the 2005 price recovery. The loss in the first year is not related in amount and does not constrain the realized gain in the second year.
The way to answer the question is to read the right column heading as implying that the earlier price decline must exceed the later price recovery. With that interpretation, the correct answer is no.
For example, assume a cost of $10 and a market value of $4 at the end of the first year. An unrealized loss of $6 is recognized in earnings. During the second year, the security is sold for $12. A realized gain of $8 is recognized-the increase in the market value from the end of the first year to the sale in the second year. Thus, the market decline in the first year did not exceed the recovery in year two. (It could have exceeded the recovery in year two but there is no requirement that it must.)

15

For a marketable-equity securities portfolio classified as available-for-sale, which of the following amounts should be included in the period's net income?

I. Unrealized temporary losses during the period.

II. Realized gains during the period.

III. Changes in the valuation allowance during the period.

A. III only.
B. II only.
C. I and II.
D. I, II, and III.

B. II only.

On available-for-sale securities, only realized gains (from sale or reclassification) are recognized in the period.
These securities are not sold for the purpose of relatively quick sale. Rather, they are held for different purposes and may be held long-term. The unrealized changes in market value are recorded in owners' equity


Incorrect:

III. Changes in the valuation allowance during the period.


The change in the valuation allowance is the change in the unrealized gain or loss during the period.

16

On both December 31, 2003 and December 31, 2004, Kopp Co.'s only marketable equity security had the same market value, which was below cost.
Kopp considered the decline in value to be temporary in 2003 but other than temporary in 2004. At the end of both years, the security was classified as a noncurrent available-for-sale investment.

What should be the effects of the determination that the decline was other than temporary on Kopp's 2004 net noncurrent assets and net income?

A. No effect on both net noncurrent assets and net income.
B. No effect on net noncurrent assets and decrease in net income.
C. Decrease in net noncurrent assets and no effect on net income.
D. Decrease in both net noncurrent assets and net income.

B. No effect on net noncurrent assets and decrease in net income.

A permanent decline in the value of an available-for-sale security is recognized as a loss in the Income Statement (whereas nonpermanent declines are treated as reductions in owners' equity).
The security did not change in value during 2004 because the market value had not changed, thus there is no further reduction in assets. The owners' equity account would be reclassified as a loss account; thus, only income is decreased.

17

In year 1, a company reported in other comprehensive income an unrealized holding loss on an investment in available-for-sale securities. During year 2, these securities were sold at a loss equal to the unrealized loss previously recognized. The reclassification adjustment should include which of the following?
A. The unrealized loss should be credited to the investment account.
B. The unrealized loss should be credited to the other comprehensive income account.
C. The unrealized loss should be debited to the other comprehensive income account.
D. The unrealized loss should be credited to beginning retained earnings.

B. The unrealized loss should be credited to the other comprehensive income account.

The unrealized loss would be credited to the other comprehensive income account to reclassify the holding loss as a realized loss in the income statement for year 2.

18

An investor purchased a bond classified as a held-to-maturity investment between interest dates at a discount.
At the purchase date, the carrying amount of the bond is more than the:

Cash paid to seller Face amount of bond
No Yes
No No
Yes No
Yes Yes

Cash paid to seller Face amount of bond
No No


When a bond is purchased at a discount, the price paid is less than face value. Any cash paid to the seller for accrued interest is debited to interest receivable, not to the bond investment. Thus, the carrying value is the portion of the total amount paid attributable to the total bond price, exclusive of accrued interest.
The carrying value must be less than the cash paid to the seller, which includes accrued interest.

19

On October 1, 2004, Park Co. purchased 200 of the $1,000 face value, 10% bonds of Ott, Inc., for $220,000, including accrued interest of $5,000.
The bonds, which mature on January 1, 2011, pay interest semiannually on January 1 and July 1. Park used the straight-line method of amortization and appropriately recorded the bonds as held-to-maturity.
On Park's December 31, 2005 Balance Sheet, the bonds should be reported at:

A. $215,000
B. $214,400
C. $214,200
D. $212,000

D. $212,000

Held-to-maturity investments in bonds are reported at amortized cost. The discount or premium at purchase is amortized during the term of the bonds so that the carrying value is equal to face value at maturity. This is the amount to be received at maturity.

The purchase price, exclusive of accrued interest, is $215,000 ($220,000-$5,000). Accrued interest is not included in the investment carrying value. The premium paid on the bonds is $15,000 because the face value of the bonds is $200,000 (200 x $1,000). The term of holding the bonds is from October 1, 2004 to January 1, 2011, a period of six years and three months or 75 months. The period from purchase to the December 31, 2005 Balance Sheet is 15 months. Amortization of the premium reduces the investment carrying amount because only face value, which is less than the amount paid for the investment, will be received at maturity.

Therefore, the ending 12/31/05 investment carrying value is $212,000 = $215,000-($15,000/75)15.

20

On January 10, 2005, Box, Inc. purchased marketable equity securities of Knox, Inc. and Scot, Inc. Box classified both securities as a noncurrent available-for-sale investments.
At December 31, 2005, the cost of each investment was greater than its fair market value. The loss on the Knox investment was considered permanent and that on Scot was considered temporary. How should Box report the effects of these investing activities in its 2005 Income Statement?

I. Excess of cost of Knox stock over its market value.

II. Excess of cost of Scot stock over its market value.

A. An unrealized loss equal to I plus II.
B. An unrealized loss equal to I only.
C. A realized loss equal to I only.
D. No Income Statement effect.

C. A realized loss equal to I only.

Permanent losses on securities available-for-sale (SAS) are recognized in earnings as if they were realized. This is an example of conservatism. If the market value is not expected to recover, a loss is probable and therefore should be recognized in earnings.
This is in contrast to the treatment for temporary losses, which for SAS, are treated as direct reductions to owners' equity. Thus, only the loss in I. (Knox) is recognized in earnings.

21

At December 31, 2005, Hull Corp. had the following marketable equity securities that were purchased during 2005, its first year of operations:
Cost Market Unrealized gain (loss)
Held-for-trading:
Security A $ 90,000 $ 60,000 $(30,000)
Security B 15,000 20,000 5,000
Totals $105,000 $ 80,000 $(25,000)
======== ======== ========
Available-for-sale:
Security Y $ 70,000 $ 80,000 $ 10,000
Security Z 90,000 45,000 (45,000)
Totals $160,000 $ 125,000 $(35,000)
======== ======== ========
All market declines are considered temporary.

Valuation allowances at December 31, 2005 should be established with a corresponding charge against

Income Stockholders' equity
$60,000 $0
$30,000 $45,000
$25,000 $35,000
$25,000 $0



Income Stockholders' equity
$25,000 $35,000

The $25,000 decline in value (unrealized loss) on trading securities is recognized in earnings for the year.

The $35,000 decline in value (unrealized loss) on securities available for sale is recognized in owners' equity, bypassing earnings.

The reason for the difference in accounting treatment is that trading securities are held for short-term price appreciation. If the value of the trading portfolio increases or decreases, that gain or loss should be recognized in earnings consistent with the purpose for holding the investments.

Securities available for sale are held for purposes other than short-term price appreciation.

Thus, the increases and decreases in the portfolio market value may not be indicative of the intent of holding the securities. Recognition in earnings each year may cause unwarranted volatility in earnings.

22

At the end of year one, Lane Co. held trading securities that cost $86,000 that had a year-end market value of $92,000. During year two, all of these securities were sold for $104,500. At the end of year two, Lane had acquired additional trading securities that cost $73,000 that had a year-end market value of $71,000. What is the impact of these stock activities on Lane's year two Income Statement?
A. Loss of $2,000.
B. Gain of $10,500.
C. Gain of $16,500.
D. Gain of $18,500

* value the first security at the Y.E value for X2

At the end of year one, Lane wrote the trading securities up to their fair value of $92,000. At sale, the gain recognized is, therefore, $104,500-$92,000=$12,500.
In addition, Lane had an unrealized holding loss of $73,000-$71,000=$2,000.
Together, the net impact on Lane's Income Statement is $12,500-$2,000=$10,500 gain.

B. Gain of $10,500.

23

On December 31, 2005, Ott Co. had investments in marketable equity securities as follows:

Cost Market value Lower of cost or market
Man Co. $10,000 $ 8,000 $ 8,000
Kemo, Inc. 9,000 11,000 9,000
Fenn Corp. 11,000 9,000 9,000
$30,000 $28,000 $26,000
====== ====== ======
Ott's December 31, 2005 Balance Sheet should report the marketable equity securities as:

A. $26,000
B. $28,000
C. $29,000
D. $30,000

B. $28,000

Investments in available-for-sale securities are reported at market value under the fair value method ($28,000). The LCM method is no longer applicable to investments.

24

On July 1, 2004, York Co. purchased, as a held-to-maturity investment, $1,000,000 of Park, Inc.'s 8% bonds for $946,000, including accrued interest of $40,000.
The bonds were purchased to yield 10% interest. The bonds mature on January 1, 2011 and pay interest annually on January 1. York uses the effective interest method of amortization.

In its December 31, 2004 Balance Sheet, what amount should York report as investment in bonds?

A. $911,300
B. $916,600
C. $953,300
D. $960,600

A. $911,300
Initial investment cost: $946,000-$40,000 =
$906,000
Interest revenue for 2004: $906,000(.10)(1/2 year) = $45,300
Less cash interest for 6 months: $1,000,000(.08)(1/2) = (40,000)
Equals amortization of discount (increases investment)
5,300
Investment in bonds balance at the end of 2004
$911,300
The initial investment cost or balance excludes accrued interest. The bonds were purchased at the halfway point in the interest period. York must pay for 1/2 a year's interest, and will receive a full year's interest on January 1, 2005. The interest revenue for the year is based on the effective yield of 10%. The difference between interest revenue and the cash interest earned for the second half of 2004 is the growth in the value of the bond over time.

The book value of the bond investment at maturity will be $1,000,000. Thus, the discount amortization increases the investment carrying value each year until it reaches $1,000,000.

25

In 2003, Lee Co. acquired, at a premium, Enfield, Inc. 10-year bonds as a held-to-maturity investment. At December 31, 2004, Enfield's bonds were quoted at a small discount.
Which of the following situations is the most likely cause of the decline in the bonds' market value?

A. Enfield issued a stock dividend.
B. Enfield is expected to call the bonds at a premium, which is less than Lee's carrying amount.
C. Interest rates have declined since Lee purchased the bonds.
D. Interest rates have increased since Lee purchased the bonds.

D. Interest rates have increased since Lee purchased the bonds.