7.1 Flashcards
Drew Co. uses the average cost inventory method for internal reporting purposes and LIFO for financial statement and income tax reporting. At December 31, 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 was $35,000. What adjusting entry should Drew record to adjust from average cost to LIFO at December 31?
COGS $20,000
LIFO Reserve $20,000
The LIFO reserve account is an allowance that adjusts the inventory balance stated according to the method used for internal reporting purposes to the LIFO amount appropriate for external reporting. If the LIFO effect is $55,000 ($375,000 average cost – $320,000 LIFO cost) and the account has a $35,000 credit balance, it must be credited for $20,000, with a corresponding debit to cost of goods sold.
When the double-extension approach to the dollar-value LIFO inventory method is used, the inventory layer added in the current year is multiplied by an index number. Which of the following correctly states how components are used in the calculation of this index number?
In the numerator, the ending inventory at current-year cost and in the denominator, the ending inventory at base-year cost.
An entity applying dollar-value LIFO may choose to calculate price indexes rather than use externally determined numbers. The double-extension approach states ending inventory at current-year cost and then divides that amount by the base-year cost to determine the index for the current year. Hence, this method extends the quantity of the inventory at both current-year and base-year unit cost. The indexes determined in this way are then multiplied by the appropriate inventory layers stated at base-year cost.
Dell Company’s inventory at December 31, Year 1, was $1.2 million based on a physical count of goods priced at cost, and before any necessary year-end adjustments relating to the following:
- Included in the physical count were goods billed to a customer FOB shipping point on December 30, Year 1. These goods had a cost of $25,000 and were picked up by the carrier on January 7, Year 2.
- Goods shipped FOB shipping point on December 28, Year 1, from a vendor to Dell were received on January 4, Year 2. The invoice cost was $60,000.
What amount should Dell report as inventory in its December 31, Year 1, balance sheet?
$1,260,000
The inventory account balance prior to adjustments is $1.2 million. FOB shipping point means that title to the goods normally passes to the buyer at the time of shipment. The $25,000 of goods shipped by Dell on January 7 should remain in the year-end inventory because title did not pass until after the beginning of the following year. The $60,000 worth of goods shipped to Dell prior to year end (December 28) should be included in Dell’s inventory even though they were not received until the following year (January 4). The title passed to Dell at the time of shipment. Consequently, Dell’s inventory at year end should be reported at $1,260,000 ($1,200,000 + $60,000).
Fact Pattern:
On November 1, Year 1, Iba Co. entered into a contract with a customer to sell 150 machines for $75 each. The customer obtains control of the machines at contract inception. Iba’s cost of each machine is $45. Iba allows the customer to return any unused machine within 1 year from the sale date and receive a full refund. Iba uses the expected value method to estimate the variable consideration. Based on Iba’s experience and other relevant factors, it reasonably estimates that a total of 20 machines (12 machines in Year 1 and 8 machines in Year 2) will be returned. Iba estimates that (1) the machines are expected to be returned in salable condition and (2) the costs of recovering the machines will be immaterial. During Year 1, 10 machines were returned. At the end of Year 1, Iba continues to estimate that a total of 20 machines will be returned within 1 year from the sale date.
What amount of gross profit from this contract will be recognized by Iba in Year 1?
$3,900.
Because the contract allows the customer a right of return, the consideration received from the customer is variable. Revenue and gross profit from variable consideration is recognized only to the extent that it is probable that a significant reversal will not occur. Iba estimates that 20 machines will be returned. Thus, in Year 1, Iba recognizes gross profit only for the sale of 130 (150 – 20) machines. The gross profit is $3,900 [($75 – $45) × 130].
Garson Co. recorded goods in transit purchased FOB shipping point at year end as purchases. The goods were excluded from ending inventory. What effect does the omission have on Garson’s assets and retained earnings at year end?
Assets:
Retained earnings:
Understated
Understated
FOB shipping point means title transfers to the buyer when the seller delivers the goods to a common carrier. The buyer should include the goods in its inventory upon shipment. Because the goods are in transit (they have already been delivered to the shipping point), the buyer should have included them in inventory. The omission of the goods understates inventory and total assets. Understating ending inventory overstates cost of goods sold (BI + Purchases – EI). Accordingly, net income and retained earnings are understated.
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?
$6,000.
Advertising costs are not part of inventory cost. They are expensed when incurred. Selling costs are likewise not inventoriable. Inventory is primarily accounted for at cost. As applied to inventories, cost is the total of the expenses directly or indirectly incurred in bringing an item to its existing condition and location. Thus, the consignor should report ending net inventory on consignment of $6,000 [$20,000 (100% – 70% sold)].
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?
$83,000.
Dollar-value LIFO determines changes in inventory in terms of dollars of constant purchasing power, not units of physical inventory. The first step is to determine the inventory layers at base-year prices by dividing current-year (year-end) cost amounts by the relevant respective annual price indexes. These layers are calculated using a LIFO assumption. The second step is to restate the layers by multiplying by the relevant indexes. In this case, the layers stated at base-year prices ($50,000 and $30,000) are given, and the relevant indexes are 1.0 for the base year and 1.1 (1 + .10) for the second year. The dollar-value LIFO measurement is $83,000.
Base layer $50,000 × 1.0 = $50,000
Second layer 30,000 × 1.1 = 33,000
$80,000 $83,000
The Hastings Company began operations on January 1, Year 1, and uses the FIFO method in costing its raw material inventory. Management is contemplating a change to the LIFO method and is interested in determining what effect such a change will have on net income. Accordingly, the following information has been developed:
FIFO
Yr 1: $240,000
Yr 2: $270,000
LIFO
Yr 1: $200,000
Yr 2: $210,000
Net Income per FIFO
Yr 1: $120,000
Yr 2: $170,000
$150,000.
A change in accounting principle requires retrospective application. All periods reported must be individually adjusted for the period specific effects of applying the new principle. The difference in income in the second year is equal to the $20,000 difference between the FIFO inventory change and the LIFO inventory change (FIFO: $270,000 – $240,000 = $30,000 change; LIFO: $210,000 – $200,000 = $10,000 change; $30,000 – $10,000 = $20,000 difference). The $170,000 FIFO net income will decrease by $20,000. Net LIFO income will therefore be $150,000 ($170,000 – $20,000).
A firm’s ending inventory balance was overstated by $1,000. Which of the following statements is correct according to a periodic inventory system?
The retained earnings were overstated by $1,000.
Cost of goods sold (COGS) equals beginning inventory, plus purchases during the period, minus ending inventory. Thus, a $1,000 overstatement of the ending inventory results in a $1,000 understatement of cost of goods sold. The $1,000 understatement of COGS results in a $1,000 overstatement of gross profit, and $1,000 overstatement of retained earnings.
Inventory accounted for under which of the following cost flow methods is not measured at the lower of cost or net realizable value?
LIFO
Inventory accounted for using LIFO or the retail inventory method is measured at the lower of cost or market (LCM). Inventory accounted for using any other cost method (e.g., FIFO or average cost) is measured at the lower of cost or net realizable value (NRV).
Lialia Co. has determined the cost of its fiscal year-end unfinished FIFO inventory to be $300,000. Information pertaining to that inventory at year-end is as follows:
Estimated selling price: $330,000 Estimated cost of disposal: 20,000 Normal profit margin: 15% Current replacement cost: 280,000 Estimated completion costs: 15,000
What amount should Lialia report as inventory on its year-end balance sheet?
$295,000.
Inventory accounted for using the FIFO method (or any cost method other than LIFO or retail) is measured at the lower of cost or net realizable value (NRV). NRV is the estimated selling price in the ordinary course of business, minus reasonably predictable costs of completion, disposal, and transportation. At year-end, the NRV of the inventory of $295,000 ($330,000 estimated selling price – $15,000 estimated completion costs – $20,000 estimated costs of disposal) is lower than its cost of $300,000. Thus, the inventory is reported at its NRV of $295,000.
Q Co. prepares monthly income statements. A physical inventory is taken only at year end; hence, month-end inventories must be estimated. All sales are made on account. The rate of markup on cost is 50%. The following information relates to the month of June:
Accounts receivable, June 1: $10,000
Accounts receivable, June 30: 15,000
Collection of accounts receivable during June: 25,000
Inventory, June 1: 18,000
Purchases of inventory during June: 16,000
The estimated cost of the June 30 inventory is
$14,000.
To determine inventory cost, cost of sales must be determined. Sales can be derived from a T-account analysis of accounts receivable; that is, the beginning balance ($10,000) plus credit sales equals the collections ($25,000) plus the ending balance ($15,000). Thus, sales equal $30,000 ($25,000 + $15,000 – $10,000). Because sales equal cost of sales plus the 50% markup on cost, sales equal 150% of cost. Cost of sales therefore equals $20,000 ($30,000 sales ÷ 1.5). Cost of sales deducted from the cost of goods available for sale equals the ending inventory. Beginning inventory: $18,000 Purchases: 16,000 Goods available for sale: $34,000 Cost of goods sold: (20,000) Ending inventory: $14,000
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?
$251,000.
Inventory accounted for using LIFO or the retail inventory method should be reported at the lower of cost or market. Cost is the historical cost paid for the goods. Market is the current cost to replace inventory, subject to certain limitations. Market cannot be greater than net realizable value (NRV), which is the estimated selling price minus the cost of completion and disposal. Market cannot be less than the NRV reduced by a normal profit margin. NRV is $261,000 ($275,000 – $14,000), and NRV minus a normal profit margin is $251,000 ($261,000 NRV – $10,000). Because replacement cost is less than the floor of the range, market is $251,000. The LCM also is $251,000, an amount lower than the $258,000 cost.
The original cost of an inventory item is below both replacement cost and net realizable value. The net realizable value minus normal profit margin is below the original cost. Under the lower-of-cost-or-market (LCM) method, the inventory item that is accounted for using the LIFO method should be measured at
Original cost.
Inventory accounted for using LIFO or the retail inventory method is measured at the lower of cost or market. Market is current replacement cost subject to a ceiling and a floor. The maximum is net realizable value, and the minimum is net realizable value minus normal profit. When replacement cost is within this range, it is used as market. The original cost is above the NRV minus normal profit margin but below the NRV and the replacement cost. Thus, market must be the NRV (if it is less than replacement cost) or the replacement cost (which is greater than NRV minus normal profit), and LCM is equal to original cost.
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:
Decrease
Decrease
In a period of rising prices, the unit costs in LIFO ending inventory are lower than those determined under FIFO because they consist of older, lower costs. Thus, a change from FIFO to LIFO results in decreased ending inventory, increased cost of goods sold, and decreased net income.
