Intermediate Accounting Chapter 9 Solutions

Chapter 9   Inventories: Additional Issues QUESTIONS FOR REVIEW OF KEY TOPICS Question 9–1   GAAP generally requires the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower of cost and net realizable value approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold. Question 9–2 The lower of cost and net realizable value determination can be made based on individual inventory items, on logical categories of inventory, or on the entire inventory. Question 9–3 If inventory write-downs are commonplace for a company, losses usually are included in cost of goods sold. However, when a write-down is substantial and unusual, GAAP requires that the loss be expressly disclosed. This could be accomplished with a disclosure note or, instead of including the loss in cost of goods sold, by reporting the loss in a separate line in the income statement, usually among operating expenses. Even with separate line item reporting, a disclosure note still would be appropriate. Question 9–4 The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the complement of the gross profit ratio (1 – GP%).

Answers to Questions (continued) Question 9–5 The key to obtaining accurate estimates when using the gross profit method is the reliability of the cost percentage. If the cost percentage is too low, cost of goods sold will be understated and ending inventory overstated. Cost percentages usually are based on relationships of past years, which aren’t necessarily representative of the current relationship. Failure to consider theft or spoilage also could cause an overstatement of ending inventory. Question 9–6 The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-toretail percentage. Question 9–7 The main difference between the gross profit method and the retail inventory method is in the determination of the cost percentage used to convert sales at selling prices to sales at cost. The retail inventory method uses a cost percentage, called the cost-to-retail percentage, which is based on a current relationship between cost and selling price. The gross profit method relies on past data to reflect the current cost percentage. Question 9–8 Initial markup—Original amount of markup from cost to selling price. Additional markup—Increase in selling price subsequent to initial markup. Markup cancellation —Elimination of an additional markup. Markdown—Reduction in selling price below the original selling price. Markdown cancellation —Elimination of a markdown. Question 9–9 When using the retail method to estimate average cost, the cost-to-retail percentage is determined by dividing total cost of goods available for sale by total goods available for sale at retail. By including beginning inventory in the calculation of the cost-to-retail percentage, the percentage reflects the average cost/retail relationship for all inventories, not just the portion acquired in the current period.

Answers to Questions (continued) Question 9–10 The lower of cost and net realizable value retail variation combined with the average cost method is called the conventional retail method. The lower of cost and net realizable value rule is incorporated into the retail inventory estimation procedure by excluding markdowns from the calculation of the cost-to-retail percentage. Question 9–11 When applying LIFO, if inventory increases during the year, none of the beginning inventory is assumed sold. Ending inventory includes the beginning inventory plus the current year’s layer. To determine layers, we compare ending inventory at retail to beginning inventory at retail and assume that no more than one inventory layer is added if inventory increases. Each layer carries its own cost-to-retail percentage that is used to convert each layer from retail to cost. Question 9–12 Freight-in is added to purchases in the cost column. Net markups are added in the retail column before the calculation of the cost-to-retail percentage. Normal spoilage is deducted in the retail column after the calculation of the cost-to-retail percentage. If sales are recorded net of employee discounts, the discounts are deducted in the retail column. Question 9–13 The dollar-value LIFO retail method eliminates the stable price assumption of regular retail LIFO. In effect, it combines dollar-value LIFO (Chapter 8) with LIFO retail. Before comparing beginning and ending inventory at retail prices, ending inventory is deflated to base year retail using the current year’s retail price index. After identifying the layers in ending inventory with the years they were created, in addition to converting retail prices to cost using the cost-to-retail percentage, the dollar-value LIFO method requires that each layer first be converted from base year retail to layer year retail using the year’s retail price index. Question 9–14 Changes in inventory methods, other than a change to the LIFO method, are reported retrospectively. This means reporting all previous periods’ financial statements as if the new inventory method had been used in all prior periods.

Answers to Questions (continued) Question 9–15 When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted. Question 9–16 If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, any previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders’ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share.

Answers to Questions (concluded) Question 9–17 2014: Cost of goods sold Net income Ending retained earnings 2015: Net purchases Cost of goods sold Net income Ending retained earnings

overstated understated understated no effect understated overstated correct

Question 9–18 When applying the lower of cost and net realizable value rule for valuing inventory according to IFRS, if circumstances reveal that an inventory write-down is no longer appropriate, it must be reversed. Reversals are not permitted under U.S. GAAP. Also, under U.S. GAAP, the lower of cost and net realizable value rule can be applied to individual items, logical inventory categories, or the entire inventory. Using the international standard, the assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. Question 9–19 Purchase commitments are contracts that obligate the company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. These agreements are entered into primarily to secure the acquisition of needed inventory and to protect against increases in purchase price. Question 9–20 Purchases made pursuant to a purchase commitment are recorded at the lower of contract price or market price on the date the contract is executed. A loss is recognized if the market price is less than the contract price. For purchase commitments outstanding at year-end, a loss is recognized if the market price at year-end is less than the contract price. Purchases made pursuant to a purchase commitment are recorded at the lower of contract price or market price on the date the contract is executed. A loss is recognized if the market price is less than the contract price. For purchase commitments outstanding at year-end, a loss is recognized if the market price at year-end is less than the contract price.

EXERCISES Exercise 9–1 (1)

Product

Cost

(2)

NRV (*)

Per Unit Inventory Value [Lower of (1) and (2)]

1

$ 20

$34

$20

2

90

80

80

3

50

60

50

* Selling price less costs to sell.

Exercise 9–2 Requirement 1 (1)

(2)

Product

Cost

NRV

Inventory Value [Lower of (1) and (2)]

101

$120,000

$100,000

$100,000

102

90,000

110,000

90,000

103

60,000

50,000

50,000

104

30,000 $300,000

50,000

30,000 $270,000

The inventory value is $270,000. Requirement 2 Loss from write-down of inventory: $300,000 – 270,000 = $30,000

Exercise 9–3 (1)

(2) Per Unit Inventory Value [Lower of (1) and (2)]

Product

Cost

NRV (*)

A

$40

$52**

$40

B

90

86

86

C

40

70

40

D

100

112

100

E

20

26

20

* Selling price less costs to sell. Costs to sell = 10% of selling price + 5% of cost. **$60 – (10% x $60) – (5% x $40) = $52

Exercise 9–4 The FASB  Accounting   Standards   Codification®  represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. The accounting treatment required for a correction of an inventory error in previously issued financial statements: FASB ASC 250–10–50–7: “Accounting Changes and Error Corrections–Overall–Disclosure–Other Presentation Matters.” Any error in the financial statements of a prior period discovered after the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) shall be reported as an error correction, by restating the prior-period financial statements. Restatement requires all of the following:  a. The cumulative effect of the error on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.  b. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.  c. Financial statements for each individual prior period presented shall be adjusted to reflect correction of the period-specific effects of the error. 2. The use of the retail method to value inventory: FASB ASC 330–10–30–13: “Inventory–Overall–Initial Measurement– Determination of Inventory Costs.” In some situations a reversed mark-up procedure of inventory pricing, such as the retail inventory method, may be both practical and appropriate. The business operations in some cases may be such as to

make it desirable to apply one of the acceptable methods of determining cost to one portion of the inventory or components thereof and another of the acceptable methods to other portions of the inventory.

Exercise 9–5 Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 25% Estimated cost of goods sold Estimated cost of inventory destroyed

$140,000 370,000 510,000 $550,000 (137,500) (412,500) $ 97,500

Exercise 9–6 Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 35% Estimated cost of goods sold Estimated ending inventory Less: Value of usable damaged goods Estimated loss from fire

$100,000 140,000 240,000 $220,000 (77,000) (143,000) 97,000 (12,000) $ 85,000

Exercise 9–7  

Merchandise inventory, January 1, 2016 Purchases Freight-in Cost of goods available for sale Less: Cost of goods sold: Sales Less: Estimated gross profit of 20% Estimated loss from fire

$1,900,000 5,800,000 400,000 8,100,000 $8,200,000 (1,640,000)

(6,560,000) $1,540,000

Exercise 9–8 Requirement 1 Beginning inventory (from records) Plus: Net purchases ($110,000 – 4,000) Freight-in (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales ($180,000 – 5,000) Less: Estimated gross profit of 40% Estimated cost of goods sold Estimated cost of inventory before theft Less: Stolen inventory Estimated ending inventory

$ 58,500 106,000 3,000 167,500 $175,000 (70,000) (105,000) 62,500 (8,000) $ 54,500

Requirement 2 Beginning inventory (from records) Plus: Net purchases ($110,000 – 4,000) Freight-in (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales ($180,000 – 5,000) Less: Estimated gross profit of 50%* Estimated cost of goods sold Estimated cost of inventory before theft Less: Stolen inventory Estimated ending inventory

$ 58,500 106,000 3,000 167,500 $175,000 (87,500) (87,500) 80,000 (8,000) $ 72,000

*Gross profit as a % of cost  (1 + Gross profit as a % of cost) = Gross profit as a % of sales. 100%  200% = 50%

Exercise 9–9 Beginning inventory + Net purchases – Ending inventory = Cost of goods sold $27,000 + 31,000 – 28,000 = $30,000 = Cost of goods sold Cost of goods sold Cost percentage = Net sales $30,000 Cost percentage =

= 60% $50,000

Exercise 9–10 Cost $35,000 19,120

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale

______ 54,120

Retail $50,000 31,600 1,200 (800) 82,000

$54,120 Cost-to-retail percentage:

= 66% $82,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (66% x $50,000) Estimated cost of goods sold     

(32,000) $50,000 (33,000) $21,120

Exercise 9–11 Cost $190,000 600,000 8,000

Beginning inventory Plus: Purchases Freight-in Net markups

Retail $ 280,000 840,000 20,000 1,140,000

$798,000 Cost-to-retail percentage:

= 70% $1,140,000

Less: Net markdowns Goods available for sale Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (70% x $336,000)

_______ 798,000

(4,000) 1,136,000 (800,000) $ 336,000

$235,200

Exercise 9–12 Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beg. inventory) Goods available for sale (including beg. inventory)

Cost $160,000 607,760 _______ 607,760 767,760

Retail $ 280,000 840,000 20,000 (4,000) 856,000 1,136,000

$607,760 Cost-to-retail percentage:

= 71% $856,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $280,000 $160,000 Current period’s layer 56,000 x 71% = 39,760 Total $336,000 $199,760 Estimated cost of goods sold

(800,000) $ 336,000

(199,760) $568,000

Exercise 9–13 Cost $ 12,000 102,600 3,480 (4,000)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups

Retail $ 20,000 165,000 (7,000) 6,000 184,000

$114,080 Cost-to-retail percentage:

= 62% $184,000

Less: Net markdowns Goods available for sale Less: Normal spoilage Net sales Estimated ending inventory at retail Estimated ending inventory at cost (62% x $24,800) Estimated cost of goods sold

_______ 114,080

(3,000) 181,000 (4,200) (152,000) $ 24,800

(15,376) $ 98,704

Exercise 9–14 Requirement 1 Cost $ 40,000 207,000 14,488 (4,000)

Beginning inventory Plus: Purchases Freight-in Less: Purchase returns Plus: Net markups

Retail $ 60,000 400,000 (6,000) 5,800 459,800

$257,488 Cost-to-retail percentage:

= 56% $459,800

Less: Net markdowns Goods available for sale Less: Normal breakage Sales: Net sales Employee discounts Estimated ending inventory at retail Estimated ending inventory at cost (56% x $168,500) Estimated cost of goods sold

_______ 257,488

(6,000) (280,000) (1,800) $168,500 (94,360) $163,128

Requirement 2 Net markdowns are included in the cost-to-retail percentage: $257,488 Cost-to-retail percentage:

= 56.43% $456,300

(3,500) 456,300

Exercise 9–15 Net purchases: Using LIFO, the beginning inventory is excluded from the calculation of the costto-retail percentage: Cost of goods available (excluding beg. inventory) Cost-to-retail percentage = Goods available at retail (excluding beg. inventory) $10,500 50% =

, and x = $21,000. x

Net purchases at retail equals $21,000 less markups plus markdowns. Net purchases at retail = $21,000 – 4,000 + 1,000 = $18,000 Net sales: The cost-to-retail percentage can be calculated as follows: Cost Retail $21,000.00 $ 35,000 10,500.00 18,000 4,000 _________ (1,000) 31,500.00 56,000

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale $31,500 Cost-to-retail percentage:

= 56.25% $56,000

Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (56.25% x ?) = Estimated ending inventory at retail is: $17,437.50 = $31,000 .5625

( ? ? $17,437.50

)

Net sales = $56,000 – 31,000 = $25,000

Exercise 9–16 Cost $ 71,280 112,500

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

_______ 112,500 183,780

Retail $132,000 255,000 6,000 (11,000) 250,000 382,000

$71,280 Base year cost-to-retail percentage:

= 54% $132,000 $112,500

2016 cost-to-retail percentage:

= 45% $250,000

Less: Net sales Estimated ending inventory at current year retail prices

(232,000) $150,000

Estimated ending inventory at cost (below) (77,004) Estimated cost of goods sold $106,776 ___________________________________________________________________________ Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$150,000 $150,000 (above)

= $144,231 1.04

$132,000 (base) 12,231 (2016)

x 1.00 x 54% = x 1.04 x 45% =

Total ending inventory at dollar-value LIFO retail cost ......................

$71,280 5,724 $77,004

Exercise 9–17 Requirement 1 $15,000 Cost-to-retail percentage =

= 80% $18,750

Requirement 2 2016 Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$25,000 $25,000 (given)

= $20,000 1.25

$18,750 (base) x 1.00 x 80% = $15,000 1,250 (2016) x 1.25 x 82% = 1,281

Total ending inventory at dollar-value LIFO retail cost .............

$16,281

2017 $28,600 $28,600 (given)

= $22,000 1.30

$18,750 (base) x 1.00 x 80% = 1,250 (2016) x 1.25 x 82% = 2,000 (2017) x 1.30 x 85% =

Total ending inventory at dollar-value LIFO retail cost .............

$15,000 1,281 2,210 $18,491

Exercise 9–18 Cost $160,000 350,200

Beginning inventory Plus: Net purchases Net markups Less: Net markdowns Goods available for sale (excluding beginning inventory) Goods available for sale (including beginning inventory)

_______ 350,200 510,200

Retail $250,000 510,000 7,000 (2,000) 515,000 765,000

$160,000 Base layer cost-to-retail percentage:

= 64% $250,000 $350,200

2016 layer cost-to-retail percentage:

= 68% $515,000

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (calculated below) Estimated cost of goods sold

(380,000) $385,000 (234,800) $275,400

___________________________________________________________________________ Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$385,000 $385,000 (above)

= $350,000 1.10

$250,000 (base) 100,000 (2016)

x 1.00 x 64% = x 1.10 x 68% =

Total ending inventory at dollar-value LIFO retail cost ......................

$160,000 74,800 $234,800

Exercise 9–19 Cost-to-retail percentage, 1/1/16: $21,000 = 75% $28,000 Cost-to-retail percentage, 12/31/16: $33,600 = $30,000 = Ending inventory at base year retail 1.12 $30,000 – 28,000 = $2,000 = LIFO layer added during 2016 at base year retail $2,000 x 1.12 = $2,240 = LIFO layer added at current year retail $22,792 – 21,000 = $1,792 = LIFO layer added at current year cost $1,792 = 80% = Cost-to-retail percentage for the year 2016 layer $2,240

Exercise 9–19 (concluded) 2017 ending inventory:

Beginning inventory Plus: Net purchases Goods available for sale (including beginning inventory)

Cost $22,792 60,000 $82,792

Retail $ 33,600 88,400 122,000

$60,000 Cost-to-retail percentage:

= 67.87% $88,400

Less: Net sales Estimated ending inventory at current year retail prices Estimated ending inventory at cost (below)

(80,000) $ 42,000 $26,864

___________________________________________________________________________ Ending Inventory at Year-End Retail Prices

Step 1 Ending Inventory at Base Year Retail Prices

Step 2 Inventory Layers at Base Year Retail Prices

Step 3 Inventory Layers Converted to Cost

$42,000 $42,000 (above)

= $35,000 1.20

$28,000 (base) 2,000 (2016) 5,000 (2017)

x 1.00 x 75.00% = x 1.12 x 80.00% = x 1.20 x 67.87% =

Total ending inventory at dollar-value LIFO retail cost ..................

$21,000 1,792 4,072 $26,864

Exercise 9–20 Requirement 1 To record the change:

($ in

millions)

Retained earnings............................................................ 8.2 ..................................................................Inventory ($32 million – 23.8 million) ........................................................................................ 8.2 Requirement 2 CPS applies the average cost method retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods that are included for comparison with the current financial statements are revised for period-specific effects of the change. Then, the cumulative effects of the new method on periods prior to those presented are reflected in the reported balances of the assets and liabilities affected as of the beginning of the first period reported and a corresponding adjustment is made to the opening balance of retained earnings for that period. Let’s say CPS reports 2014–2016 comparative statements of shareholders’ equity. The $8.2 million adjustment above is due to differences prior to the 2016 change. The portion of that amount due to differences prior to 2014 is subtracted from the opening balance of retained earnings for 2014. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes, as well as the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.

Exercise 9–21 Requirement 1 Retained earnings.................................................................. Inventory ($83,000 – 78,000).............................................

5,000 5,000

Requirement 2 Effect on cost of goods sold: Decrease in beginning inventory ($78,000 – 71,000)

- $7,000

Decrease in ending inventory ($83,000 – 78,000) Decrease in cost of goods sold

+ 5,000 $2,000

Cost of goods sold for 2015 would be $2,000 lower in the revised income statement.

Exercise 9–22 Requirement 1 The 2014 error caused 2014 net income to be understated, but since 2014 ending inventory is 2015 beginning inventory, 2015 net income was overstated by the same amount. So, the income statement was misstated for 2014 and 2015, but the balance sheet (retained earnings) was incorrect only for 2014. After that, no account balances are incorrect due to the 2014 error. Analysis of 2014 ending inventory effects: U = Understated O = Overstated 2014 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income



Retained earnings

  U  O

2015 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold

U

U

U

Revenues Less: cost of goods sold Less: other expenses Net income

U

Retained earnings

O



U O

corrected

Exercise 9–22 (concluded) However, the 2015 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error. Analysis of 2015 ending inventory error effects: U = Understated O = Overstated 2015 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income



Retained earnings

O U U O O

Requirement 2 Retained earnings (overstatement of 2015 income).............. 150,000 Inventory (overstatement of 2016 beginning inventory).... 150,000 Requirement 3 The financial statements that were incorrect as a result of both errors (effect of one error in 2014 and effect of two errors in 2015) would be retrospectively restated to report the correct inventory amount, cost of goods sold, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.

Exercise 9–23 U = understated O = overstated NE = no effect 1. Overstatement of ending inventory 2. Overstatement of purchases 3. Understatement of beginning inventory 4. Freight-in charges are understated 5. Understatement of ending inventory 6. Understatement of purchases 7. Overstatement of beginning inventory 8. Understatement of purchases + understatement of ending inventory by the same amount

Cost of Goods Sold U O U U O U O NE

Net Income O U O O U O U NE

Retained Earnings O U O O U O U NE

Exercise 9–24 1.

To include the $4 million in year 2016 purchases and increase retained earnings to what it would have been if 2015 cost of goods sold had not included the $4 million purchases: Analysis: 2015 Beginning inventory Purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income  Retained earnings

O

2016 Beginning inventory Purchases

U

O O

U = Understated O = Overstated

U U ($ in millions)

Purchases ........................................................... Retained earnings ..........................................

4 4

2.

The 2015 financial statements that were incorrect as a result of the errors would be retrospectively restated to reflect the correct cost of goods sold, (income tax expense if taxes are considered), net income, and retained earnings when those statements are reported again for comparative purposes in the 2016 annual report.

3.

A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.

Exercise 9–25 Requirement 1 The $42,000 should have been charged to purchases instead of advertising expense. This error caused 2015 net purchases and thus cost of goods sold to be understated and advertising expense to be overstated by $42,000. The understatement of ending inventory for the $30,000 in merchandise held on consignment caused 2015 cost of goods sold to be overstated. Analysis:

U = Understated O = Overstated

2015 Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold

U by U by U by

42,000 30,000 12,000

Revenues Less: cost of goods sold Less: other expenses Net income

U by O by U by

12,000 42,000 30,000

Retained earnings

U by

30,000



Requirement 2 Inventory (understatement of 2016 beginning inventory) Retained earnings (understatement of 2015 income)

30,000 30,000

Requirement 3 The 2015 financial statements that were incorrect as a result of the two errors would be retrospectively restated to report the correct inventory amount, cost of goods sold, advertising expense, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its

correction on each year’s net income, income before extraordinary items, and earnings per share.

Exercise 9–26 List A e 1. Gross profit ratio original

List B a. Reduction in selling price below the

i

2. Cost-to-retail percentage b.

l

3. Additional markup

c.

a 4. Markdown

d.

k 5. Net markup b 6. Retail method, FIFO & LIFO j 7. Conventional retail method n 8. Change from LIFO

e. f. g. h.

d 9. Dollar-value LIFO retail i. c 10. Normal spoilage f 11. Requires retrospective goods restatement g 12. Employee discounts initial h 13. Net markdowns m 14. Net realizable value

j. k.

selling price. Beginning inventory is not included in the calculation of the cost-to-retail percentage. Deducted in the retail column after the calculation of the cost-to-retail percentage. Requires base year retail to be converted to layer year retail and then to cost. Gross profit divided by net sales. Material inventory error discovered in a subsequent year. Must be added to sales if sales are recorded net of discounts. Deducted in the retail column to arrive at goods available for sale at retail. Divide cost of goods available for sale by goods available at retail. Average cost, lower of cost and NRV. Added to the retail column to arrive at

available for sale. l. Increase in selling price subsequent to markup. m. Selling price less costs of completion, disposal, and transportation. n. Accounting change requiring retrospective treatment.

Exercise 9–27 Requirement 1 If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference. December 31, 2016 Estimated loss on purchase commitment ($60,000 – 56,000) ... .......................Estimated liability on purchase commitment ......................................................................................4,000

4,000

Requirement 2 If market price on purchase date declines from year-end price, the purchase is recorded at market price. March 21, 2017 Inventory.............................................................................. Loss on purchase commitment ($56,000 – 54,000)................. Estimated liability on purchase commitment....................... .....................................................................................Cash ...................................................................................60,000

54,000 2,000 4,000

Exercise 9–28 If market price is less than the contract price, the purchase is recorded at the market price. June 15, 2016 Purchases (market price)......................................................... Loss on purchase commitment (difference)............................ ......................................................................................Cash .................................................................................100,000

85,000 15,000

If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference. June 30, 2016 Estimated loss on purchase commitment ($150,000 – 140,000). .......................Estimated liability on purchase commitment ...................................................................................10,000

10,000

If market price on purchase date declines from year-end price, the purchase is recorded at market price. August 20, 2016 Purchases (market price)......................................................... 120,000 Loss on purchase commitment ($140,000 – 120,000).............. 20,000 Estimated liability on purchase commitment....................... 10,000 .....................................................................................Cash .................................................................................150,000

CPA / CMA REVIEW QUESTIONS

CPA Exam Questions 1. c. Net realizable value = 388,000 ($408,000 selling price – $20,000 costs to sell.) The inventory would be valued at $388,000, the net realizable value, as it is lower than the $400,000 FIFO cost. 2. c. Inventory, 1/1

$ 80,000

Add: Purchases Goods available for sale Less: Cost of goods sold ($360,000  120%) Estimated inventory, 5/2

330,000 410,000 300,000 $110,000

Note: Although the estimated inventory is $110,000, the estimated fire loss would be $70,000 because of the $40,000 of goods in transit included in inventory.

 CPA Exam Questions (concluded)

3. d. Beginning inventory and purchases Net markups Available for sale Cost-to-retail percentage: $600,000  $960,000 = 62.5% Less: Net markdowns Sales Estimated ending inventory at retail Estimated ending inventory at cost: ($120,000 x 62.5%) Estimated cost of goods sold

Cost $600,000 _______ 600,000

Retail $920,000 40,000 960,000

(60,000) (780,000) $120,000 75,000 $525,000

Conventional retail is the lower of average cost and net realizable value (NRV). For the lower of cost and NRV retail method, net markdowns are excluded from the cost to retail percentage.

4. c. The understatement of beginning inventory and the overstatement of ending inventory both cause the cost of goods sold to be understated. The total understatement is $78,000 ($26,000 + 52,000). 5. b. The write-down can only be reversed under IFRS.

CMA Exam Questions 1. b. The conventional retail inventory method adds beginning inventory, net purchases, and markups (but not markdowns) to calculate a cost percentage. The purpose of excluding markdowns is to approximate a lower of cost and net realizable value valuation. The cost percentage is then used to reduce the retail value of the ending inventory to cost. FCL’s cost-retail ratio is 40% ($90,000  $225,000), and ending inventory at cost is therefore $20,000 (40% x $50,000 ending inventory at retail). 2. d. The failure to record a sale means that both accounts receivable and sales will be understated. However, inventory was correctly counted, so that account and cost of goods sold were unaffected. 3. d. The overstatement (double counting) of inventory at the end of year 1 caused year 1 cost of goods sold (BI + Purchases – EI) to be understated and both inventory and income to be overstated. The year 1 ending inventory equals year 2 beginning inventory. Thus, the same overstatement caused year 2 beginning inventory and cost of goods sold to be overstated and income to be understated. This is an example of a self-correcting error. By the end of year 2, the balance sheet is correct.