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Chapter 9
Inventories: Additional Issues
QUESTIONS FOR REVIEW OF KEY TOPICS
Question 9-1
GAAP generally require 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-or-market 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 designated market value in the LCM rule is the middle number of replacement cost (RC),
net realizable value (NRV) and net realizable value less a normal profit margin (NRV-NP). This is
the amount compared with cost to determine LCM.
Question 9-3
The LCM determination can be made based on individual inventory items, on logical
categories of inventory, or on the entire inventory.
Question 9-4
The preferred method is to record the loss from the write-down of inventory as a separate item
in the income statement rather than including the write-down in cost of goods sold. A less desirable
alternative is to include the loss in cost of goods sold.
Question 9-5
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 reciprocal of the gross profit ratio.
Question 9-6
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.
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Answers to Questions (continued)
Question 9-7
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-to-retail percentage.
Question 9-8
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 9-9
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 9-10
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 inventory, not just the portion acquired
in the current period.
Question 9-11
The lower-of-cost-or-market (LCM) retail variation combined with the average cost method is
called the conventional retail method. The LCM rule is incorporated into the retail inventory
estimation procedure by excluding markdowns from the calculation of the cost-to-retail percentage.
Question 9-12
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 9-13
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 added to net sales before sales are deducted in the retail
column.
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Answers to Questions (continued)
Question 9-14
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 9-15
Changes in inventory methods, other 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.
Question 9-16
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 9-17
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.
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Answers to Questions (concluded)
Question 9-18
2004:
2005:
Cost of goods sold
Net income
Ending retained earnings
Net purchases
Cost of goods sold
Net income
Ending retained earnings
overstated
understated
understated
no effect
understated
overstated
correct
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.
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BRIEF EXERCISES
Brief Exercise 9-1
NRV = $30 - 4 = $26
NRV – NP = $26 – (30% x $30) = $17
RC = $18
The designated market is the middle value of NRV, NRV-NP, and RC, which is
$18. Since this is lower than the cost of $20, the unit value is $18.
Brief Exercise 9-2
(1)
(2)
Ceiling
NRV (*)
(3)
Floor
NRV-NP
(**)
Product
RC
1
$48
$64
$54
2
26
32
24
(4)
(5)
Cost
Per Unit
Inventory
Value
[Lower of (4)
and (5)]
$54
$50
$50
26
30
26
Designated
Market Value
[Middle value
of (1), (2) & (3)]
* Selling price less disposal costs.
** NRV less normal profit margin
Product 1 (1,000 units)
Product 2 (1,000 units)
Cost
LCM value
Cost
$50,000
30,000
$80,000
LCM
$50,000
26,000
$76,000
Before-tax income will be lower by $4,000, the amount of the required inventory
write-down.
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Brief Exercise 9-3
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 30%
Estimated cost of goods sold
Estimated cost of inventory destroyed
$220,000
400,000
620,000
$600,000
(180,000)
(420,000)
$200,000
Brief Exercise 9-4
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
Estimated cost of goods sold
Estimated cost of inventory lost
$150,000
450,000
600,000
$700,000
( ? )
( ? )
$ 75,000
Estimated cost of goods sold = $600,000 – 75,000 = $525,000*
Estimated gross profit = $700,000 – 525,000* = $175,000
$175,000 ÷ $700,000 = 25% gross profit ratio
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Brief Exercise 9-5
Cost
$300,000
861,000
22,000
Beginning inventory
Plus: Net purchases
Freight-in
Net markups
Less: Net markdowns
Goods available for sale
______
1,183,000
Retail
$ 450,000
1,210,000
48,000
(18,000)
1,690,000
$1,183,000
Cost-to-retail percentage:
= 70%
$1,690,000
Less: Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost (70% x $490,000)
Estimated cost of goods sold
Solutions Manual, Vol.1, Chapter 9
(1,200,000)
$ 490,000
(343,000)
$ 840,000
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9-7
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Brief Exercise 9-6
Beginning inventory
Plus: Net purchases
Freight-in
Net markups
Less: Net markdowns
Goods available for sale (excluding beg. Inventory)
Goods available for sale (including beg. Inventory)
Cost
$300,000
861,000
22,000
_______
883,000
1,183,000
Retail
$450,000
1,210,000
48,000
(18,000)
1,240,000
1,690,000
$883,000
Cost-to-retail percentage:
= 71.21%
$1,240,000
Less: Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost:
Retail
Cost
Beginning inventory $ 450,000
$ 300,000
Current period’s layer
40,000 x 71.21 % = 28,484
Total
$ 490,000
$328,484 (328,484)
Estimated cost of goods sold
$854,516
© The McGraw-Hill Companies, Inc., 2007
9-8
(1,200,000)
$ 490,000
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Brief Exercise 9-7
Cost
$300,000
861,000
22,000
Beginning inventory
Plus: Net purchases
Freight-in
Net markups
Goods available for sale
Retail
$ 450,000
1,210,000
48,000
1,708,000
$1,183,000
Cost-to-retail percentage:
= 69.26%
$1,708,000
Less: Net markdowns
______
Goods available for sale
1,183,000
Less: Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost (69.26% x $490,000) (339,374)
Estimated cost of goods sold
$ 843,626
Solutions Manual, Vol.1, Chapter 9
(18,000)
1,690,000
(1,200,000)
$ 490,000
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9-9
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Brief Exercise 9-8
Cost
$220,000
640,000
17,800
Beginning inventory
Plus: Purchases
Freight-in
Plus: Net markups
Retail
$ 400,000
1,180,000
16,000
1,596,000
$877,800
Cost-to-retail percentage:
= 55%
$1,596,000
Less: Net markdowns
Goods available for sale
Less:
Normal spoilage
Net sales*
_______
877,800
Estimated ending inventory at retail
Estimated ending inventory at cost (55% x $272,000) (149,600)
Estimated cost of goods sold
$728,200
(6,000)
1,590,000
(3,000)
(1,315,000)
$272,000
*$1,300,000 + 15,000 (employee discounts) = $1,315,000
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Brief Exercise 9-9
Cost
$ 40,800
155,440
Beginning inventory
Plus: Net purchases
Net markups
Less: Net markdowns
Goods available for sale (excluding beginning inventory)
Goods available for sale (including beginning inventory)
_______
155,440
196,240
Retail
$ 68,000
270,000
6,000
(8,000)
268,000
336,000
$40,800
Base layer cost-to-retail percentage:
= 60%
$68,000
$155,440
2006 layer cost-to-retail percentage:
= 58%
$268,000
Less: Net sales
Estimated ending inventory at current year retail prices
Estimated ending inventory at cost (calculated below)
Estimated cost of goods sold
(250,000)
$ 86,000
(50,451)
$145,789
___________________________________________________________________________
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
$86,000
$86,000
(above)
= $84,314
1.02
$68,000 (base)
16,314 (2006)
x 1.00 x 60% =
x 1.02 x 58% =
Total ending inventory at dollar-value LIFO retail cost ......................
Solutions Manual, Vol.1, Chapter 9
$40,800
9,651
$50,451
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9-11
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Brief Exercise 9-10
Cost
$ 50,451
168,000
Beginning inventory
Plus: Net purchases
Net markups
Less: Net markdowns
Goods available for sale (excluding beginning inventory)
Goods available for sale (including beginning inventory)
_______
168,000
218,451
Retail
$ 86,000
301,000
3,000
(4,000)
300,000
386,000
$155,440
2006 layer cost-to-retail percentage:
= 58%
$268,000
$168,000
2007 layer cost-to-retail percentage:
= 56%
$300,000
Less: Net sales
Estimated ending inventory at current year retail prices
Estimated ending inventory at cost (calculated below)
Estimated cost of goods sold
(280,000)
$106,000
(59,762)
$158,689
___________________________________________________________________________
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
$106,000
$106,000
(above)
= $100,000
1.06
$68,000 (base)
16,314 (2006)
15,686 (2007)
x 1.00 x 60%* =
x 1.02 x 58% =
x 1.06 x 56% =
Total ending inventory at dollar-value LIFO retail cost ......................
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9-12
$40,800
9,651
9,311
$59,762
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*$40,800 ÷ $68,000 = 60%
Brief Exercise 9-11
Hopyard applies the FIFO 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.
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.
2006 cost of goods sold is $7,000 higher than it would have been if Hopyard had
not switched to FIFO. This is because beginning inventory is $18,000 higher
($145,000 – 127,000) and ending inventory is $11,000 higher ($162,000 – 151,000).
An increase in beginning inventory causes an increase in cost of goods sold, but an
increase in ending inventory causes a decrease in cost of goods sold. Purchases for
2006 are the same regardless of the inventory valuation method used.
Brief Exercise 9-12
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, $150,000 in this case.
A disclosure note is needed to explain (a) the nature of and justification for the
change, (b) the effect of the change on current year's income and earnings per share,
and (c) why retrospective application was impracticable.
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9-13
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Brief Exercise 9-13
The 2004 error caused 2004 net income to be overstated, but since 2004 ending
inventory is 2005 beginning inventory, 2005 net income was understated the same
amount. So, the income statement was misstated for 2004 and 2005, but the balance
sheet (retained earnings) was incorrect only for 2004. After that, no account balances
are incorrect due to the 2004 error.
Analysis:
2004
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
© The McGraw-Hill Companies, Inc., 2007
9-14
U = Understated
O = Overstated
→
↑
O →
U
U
O
O
2005
Beginning inventory
Plus: net purchases
Less: ending inventory
Cost of goods sold
O
O
Revenues
Less: cost of goods sold
Less: other expenses
Net income

Retained earnings
O
U
corrected
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Brief Exercise 9-13 (concluded)
However, the 2005 error has not yet self-corrected. Both retained earnings and
inventory still are overstated as a result of the second error.
Analysis:
2005
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 = Understated
O = Overstated
O
U
U
O
O
Retained earnings on January 1, 2006, in this case, would be overstated by
$500,000 (ignoring income taxes).
Brief Exercise 9-14
The financial statements that were incorrect as a result of both errors (effect of
one error in 2004 and effect of two errors in 2005) would be retrospectively restated
to report the correct inventory amounts, cost of goods sold, 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.
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9-15
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EXERCISES
Exercise 9-1
(1)
(2)
Ceiling
(3)
Floor
(4)
(5)
Cost
Per Unit
Inventory
Value
[Lower of (4)
and (5)]
$29
$20
$20
50
80
90
80
48
48
50
48
NRV-NP
(**)
Product
RC
NRV (*)
1
$18
$ 34
$29
2
85
80
3
40
60
Designated
Market Value
[Middle value
of (1), (2) & (3)]
* Selling price less disposal costs.
** NRV less normal profit margin
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Exercise 9-2
Requirement 1
(1)
(2)
Ceiling
(3)
Floor
(4)
(5)
NRV-NP
Designated
(NP=
Market Value
25%
[Middle value
of cost) of (1), (2) & (3)]
Cost
Inventory
Value
[Lower of
(4) and (5)]
$100,000
$120,000
$100,000
87,500
87,500
90,000
87,500
50,000
35,000
40,000
60,000
40,000
50,000
42,500
42,500
Totals
30,000
$300,000
30,000
$257,500
Product
RC
NRV
101
$110,000
$100,000
$70,000
102
85,000
110,000
103
40,000
104
28,000
The inventory value is $257,500.
Requirement 2
Loss from write-down of inventory: $300,000 - 257,500 = $42,500
Exercise 9-3
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
Solutions Manual, Vol.1, Chapter 9
$140,000
370,000
510,000
$550,000
(137,500)
(412,500)
$ 97,500
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9-17
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Exercise 9-4
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 9-5
Merchandise inventory, January 1, 2006
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
© The McGraw-Hill Companies, Inc., 2007
9-18
$1,900,000
5,800,000
400,000
8,100,000
$8,200,000
(1,640,000)
(6,560,000)
$1,540,000
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Exercise 9-6
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 9-7
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
Solutions Manual, Vol.1, Chapter 9
(32,000)
$50,000
(33,000)
$21,120
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9-19
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Exercise 9-8
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)
© The McGraw-Hill Companies, Inc., 2007
9-20
_______
798,000
(4,000)
1,136,000
(800,000)
$ 336,000
$235,200
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Exercise 9-9
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
Solutions Manual, Vol.1, Chapter 9
(800,000)
$ 336,000
(199,760)
$568,000
© The McGraw-Hill Companies, Inc., 2007
9-21
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Exercise 9-10
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
© The McGraw-Hill Companies, Inc., 2007
9-22
_______
114,080
(3,000)
181,000
(4,200)
(152,000)
$ 24,800
(15,376)
$ 98,704
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Exercise 9-11
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
257,488
Less:
Normal breakage
Sales:
Net sales
$280,000
Add back employee discounts
1,800
Estimated ending inventory at retail
Estimated ending inventory at cost (56% x $168,500)
(94,360)
Estimated cost of goods sold
$163,128
(3,500)
456,300
(6,000)
(281,800)
$168,500
Requirement 2
Net markdowns are included in the cost-to-retail percentage:
$257,488
Cost-to-retail percentage:
= 56.43%
$456,300
Solutions Manual, Vol.1, Chapter 9
© The McGraw-Hill Companies, Inc., 2007
9-23
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Exercise 9-12
Net purchases:
Using LIFO, the beginning inventory is excluded from the calculation of the cost-toretail 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 = $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 ?) =
(
?
?
)
$17,437.50
Estimated ending inventory at retail is:
$17,437.50
= $31,000
.5625
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9-24
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Net sales = $56,000 - 31,000 = $25,000
Exercise 9-13
1.
2.
3.
4.
b
c
d
c
Exercise 9-14
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
2006 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 (2006)
x 1.00 x 54% =
x 1.04 x 45% =
Total ending inventory at dollar-value LIFO retail cost ......................
Solutions Manual, Vol.1, Chapter 9
$71,280
5,724
$77,004
© The McGraw-Hill Companies, Inc., 2007
9-25
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Exercise 9-15
Requirement 1
$15,000
Cost-to-retail percentage =
= 80%
$18,750
Requirement 2
2006
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% =
1,250 (2006) x 1.25 x 82% =
Total ending inventory at dollar-value LIFO retail cost .............
$15,000
1,281
$16,281
2007
$28,600
$28,600
(given)
= $22,000
1.30
$18,750 (base) x 1.00 x 80% =
1,250 (2006) x 1.25 x 82% =
2,000 (2007) x 1.30 x 85% =
Total ending inventory at dollar-value LIFO retail cost .............
© The McGraw-Hill Companies, Inc., 2007
9-26
$15,000
1,281
2,210
$18,491
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Exercise 9-16
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
2006 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 (2006)
x 1.00 x 64% =
x 1.10 x 68% =
Total ending inventory at dollar-value LIFO retail cost ......................
Solutions Manual, Vol.1, Chapter 9
$160,000
74,800
$234,800
© The McGraw-Hill Companies, Inc., 2007
9-27
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Exercise 9-17
Cost-to-retail percentage, 1/1/06:
$21,000
= 75%
$28,000
Cost-to-retail percentage, 12/31/06:
$33,600
= $30,000 = Ending inventory at base year retail
1.12
$30,000 - 28,000 = $2,000 = LIFO layer added during 2006 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 2006 layer
$2,240
© The McGraw-Hill Companies, Inc., 2007
9-28
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Exercise 9-17 (concluded)
2007 ending inventory:
Cost
$22,792
60,000
$82,792
Beginning inventory
Plus: Net purchases
Goods available for sale (including beginning inventory)
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 (2006)
5,000 (2007)
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 ..................
Solutions Manual, Vol.1, Chapter 9
$21,000
1,792
4,072
$26,864
© The McGraw-Hill Companies, Inc., 2007
9-29
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Exercise 9-18
Requirement 1
To record the change:
Retained earnings ..........................................................
Inventory ($32 million - 23.8 million) .............................
($ in millions)
8.2
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
2006-2004 comparative statements of shareholders’ equity. The $8.2 million
adjustment above is due to differences prior to the 2006 change. The portion of that
amount due to differences prior to 2004 is subtracted from the opening balance of
retained earnings for 2004.
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.
© The McGraw-Hill Companies, Inc., 2007
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Exercise 9-19
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 2005 would be $2,000 lower in the revised income
statement.
Solutions Manual, Vol.1, Chapter 9
© The McGraw-Hill Companies, Inc., 2007
9-31
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Exercise 9-20
Requirement 1
The 2004 error caused 2004 net income to be understated, but since 2004 ending
inventory is 2005 beginning inventory, 2005 net income was overstated the same
amount. So, the income statement was misstated for 2004 and 2005, but the balance
sheet (retained earnings) was incorrect only for 2004. After that, no account balances
are incorrect due to the 2004 error.
Analysis:
2004
Beginning inventory
Plus: net purchases
Less: ending inventory
Cost of goods sold
Revenues
Less: cost of goods sold
Less: other expenses
Net income
U = Understated
O = Overstated
→
↑
U →
O
O
U

Retained earnings
© The McGraw-Hill Companies, Inc., 2007
9-32
2005
Beginning inventory
Plus: net purchases
Less: ending inventory
Cost of goods sold
U
U
Revenues
Less: cost of goods sold
Less: other expenses
Net income
U
O

U
Retained earnings
corrected
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Exercise 9-20 (concluded)
However, the 2005 error has not yet self-corrected. Both retained earnings and
inventory still are overstated as a result of the second error.
Analysis:
2005
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 = Understated
O = Overstated
O
U
U
O
O
Requirement 2
Retained earnings (overstatement of 2005 income) ............. 150,000
Inventory (overstatement of 2006 beginning inventory) ...
150,000
Requirement 3
The financial statements that were incorrect as a result of both errors (effect of
one error in 2004 and effect of two errors in 2005) would be retrospectively restated
to report the correct inventory amounts, cost of goods sold, 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.
Solutions Manual, Vol.1, Chapter 9
© The McGraw-Hill Companies, Inc., 2007
9-33
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Exercise 9-21
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
© The McGraw-Hill Companies, Inc., 2007
9-34
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
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Exercise 9-22
1.
To include the $4 million in year 2006 purchases and increase retained earnings
to what it would have been if 2005 cost of goods sold had not included the $4
million purchases.
Analysis:
2005
Beginning inventory
Purchases
Less: Ending inventory
Cost of goods sold
Revenues
Less: Cost of goods sold
Less: Other expenses
Net income

Retained earnings
O
2006
Beginning inventory
Purchases
U
O
O
U = Understated
O = Overstated
U
U
($ in millions)
Purchases ........................................................
Retained earnings ........................................
4
4
2.
The 2005 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 2006 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 9-23
1.
2.
a
c
Solutions Manual, Vol.1, Chapter 9
© The McGraw-Hill Companies, Inc., 2007
9-35
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Exercise 9-24
List A
e
1. Gross profit ratio
i
2.
l
3.
a
4.
k
b
5.
6.
j
7.
n
8.
d
9.
c 10.
f 11.
g 12.
h 13.
m 14.
List B
a. Reduction in selling price below the original selling
price.
Cost-to-retail percentage
b. Beginning inventory is not included in the calculation
of the cost-to-retail percentage.
Additional markup
c. Deducted in the retail column after the calculation of
the cost-to-retail percentage.
Markdown
d. Requires base year retail to be converted to layer year
retail and then to cost.
Net markup
e. Gross profit divided by net sales.
Retail method, FIFO & LIFO f. Material inventory error discovered in a subsequent
year.
Conventional retail method g. Must be added to sales if sales are recorded net of
discounts.
Change from LIFO
h. Deducted in the retail column to arrive at goods
available for sale at retail.
Dollar-value LIFO retail
i. Divide cost of goods available for sale by goods
available at retail.
Normal spoilage
j. Average cost, LCM.
Requires retrospective
k. Added to the retail column to arrive at goods
restatement
available for sale.
Employee discounts
l. Increase in selling price subsequent to initial markup.
Net markdowns
m. Ceiling in the determination of market.
Net realizable value
n. Accounting change requiring retrospective treatment.
© The McGraw-Hill Companies, Inc., 2007
9-36
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Exercise 9-25
1. 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.
2. 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.
3. 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-averagecost-or-market 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).
Solutions Manual, Vol.1, Chapter 9
© The McGraw-Hill Companies, Inc., 2007
9-37
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Exercise 9-26
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, 2006
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, 2007
Inventory............................................................................
Loss on purchase commitment ($56,000 - 54,000) .................
Estimated liability on purchase commitment ......................
Cash ..............................................................................
© The McGraw-Hill Companies, Inc., 2007
9-38
54,000
2,000
4,000
60,000
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Exercise 9-27
If market price is less than the contract price, the purchase is recorded at the
market price.
June 15, 2006
Purchases (market price) .......................................................
Loss on purchase commitment (difference) ...........................
Cash ...............................................................................
85,000
15,000
100,000
If market price at year-end is less than contract price for outstanding purchase
commitments, a loss is recorded for the difference.
June 30, 2006
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, 2006
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
Solutions Manual, Vol.1, Chapter 9
© The McGraw-Hill Companies, Inc., 2007
9-39
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PROBLEMS
Problem 9-1
Requirement 1
Product
A
B
C
D
E
NRV per unit
$16 - (15% x $16) = $13.60
$18 - (15% x $18) = $15.30
$ 8 - (15% x $8) = $ 6.80
$ 6 - (15% x $6) = $ 5.10
$13 - (15% x $13) = $11.05
(1)
(2)
(3)
Ceiling
Floor
NRV-NP per unit
$13.60 - (40% x $16) = $7.20
$15.30 - (40% x $18) = $8.10
$ 6.80 - (40% x $ 8) = $3.60
$ 5.10 - (40% x $ 6) = $2.70
$11.05 - (40% x $13) = $5.85
(4)
Designated
Market Value
[Middle value
NRV-NP of (1), (2) & (3)]
(5)
Cost
Inventory
Value
[Lower of
(4) and (5)]
$12,000
$10,000
$10,000
6,480
8,800
12,000
8,800
4,080
2,160
2,160
1,800
1,800
800
1,020
540
800
1,400
800
7,200
6,630
3,510
6,630
8,400
6,630
$30,390
$33,600
$28,030
Product
(units)
RC
NRV
A (1,000)
$12,000
$13,600
$7,200
B (800)
8,800
12,240
C (600)
1,200
D (200)
E (600)
Totals
Inventory carrying value would be $28,030.
Requirement 2
Inventory carrying value would be $30,390, the lower of aggregate inventory cost
($33,600) and aggregate inventory market ($30,390). The amount of the loss from
inventory write-down is $3,210 ($33,600 - 30,390).
© The McGraw-Hill Companies, Inc., 2007
9-40
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Problem 9-2
Requirement 1
Product
Tools:
Hammers
Saws
Screwdrivers
Total tools
Paint products:
1-gallon cans
Paint brushes
Total paint
Total
Cost
$
Designated
Market
Value
Lower-of-cost-or-market
(a)
(b)
(c)
By
By
Individual
Product
By Total
Products
Type
Inventory
500
$ 550
$
500
2,000
1,800
1,800
600
$3,100
780
$3,130
600
$3,000
$2,500
2,500
400
$3,400
450
$2,950
400
$6,500
$6,080
$5,800
$3,100
2,950
$6,050
$6,080
Requirement 2
(a) Individual products
$6,500 - 5,800 = $700
(b) Product type
$6,500 - 6,050 = $450
(c) Total inventory
$6,500 - 6,080 = $420
Solutions Manual, Vol.1, Chapter 9
© The McGraw-Hill Companies, Inc., 2007
9-41
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Problem 9-3
Requirement 1
Fruit
Toppings
Estimate of cost of goods sold:
Cost percentage
x Net sales
Marshmallow
Toppings
Chocolate
Topping
80%
$200,000
$160,000
70%
$55,000
$38,500
65%
$20,000
$13,000
$ 20,000
150,000
170,000
$ 7,000
36,000
43,000
$ 3,000
12,000
15,000
Less: Estimate of cost of goods sold
160,000
38,500
13,000
Estimate of cost of inventory lost
$ 10,000
$ 4,500
$ 2,000
Beginning inventory
Plus: Net purchases
Cost of goods available for sale
Requirement 2
The two main factors that could cause the estimates of the inventory lost to be
over or understated are:
1. The historical cost percentages used may not be representative of the current
relationship between cost and selling price.
2. Theft or spoilage losses may not be appropriately considered in the cost
percentage.
© The McGraw-Hill Companies, Inc., 2007
9-42
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Problem 9-4
1. Average cost
Cost
$ 90,000
355,000
9,000
(7,000)
Beginning inventory
Plus: Purchases
Freight-in
Less: Purchase returns
Plus: Net markups
Less: Net markdowns
Abnormal spoilage
Goods available for sale
(4,800)
442,200
Retail
$180,000
580,000
(11,000)
16,000
(12,000)
(8,000)
745,000
$442,200
Cost-to-retail percentage:
= 59.36%
$745,000
Less:
Normal spoilage
Sales:
Net sales ($540,000 - 10,000)
$530,000
Add back employee discounts
4,000
Estimated ending inventory at retail
Estimated ending inventory at cost (59.36% x $208,000)
Estimated cost of goods sold
Solutions Manual, Vol.1, Chapter 9
(3,000)
(534,000)
$208,000
(123,469)
$318,731
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Problem 9-4 (concluded)
2. Conventional (average, LCM)
Cost
$ 90,000
355,000
9,000
(7,000)
Beginning inventory
Plus: Purchases
Freight-in
Less: Purchase returns
Plus: Net markups
Less: Abnormal spoilage
(4,800)
Retail
$180,000
580,000
(11,000)
16,000
(8,000)
757,000
$442,200
Cost-to-retail percentage:
= 58.41%
$757,000
Less: Net markdowns
Goods available for sale
Less:
Normal spoilage
Sales:
Net sales ($540,000 - 10,000)
$530,000
Add back employee discounts
4,000
Estimated ending inventory at retail
Estimated ending inventory at cost (58.41% x $208,000)
Estimated cost of goods sold
© The McGraw-Hill Companies, Inc., 2007
9-44
_______
442,200
(12,000)
745,000
(3,000)
(534,000)
$208,000
(121,493)
$320,707
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Problem 9-5
Requirement 1
Sales to employees must be deducted in the retail column at their gross amount:
$250,000
= $312,500*
.80
Cost
$ 100,000
1,387,500
10,000
Beginning inventory
Plus: Purchases
Freight-in
Plus: Net markups
Retail
$ 150,000
2,000,000
300,000
2,450,000
$1,497,500
Cost-to-retail percentage:
= 61.12%
$2,450,000
Less: Net markdowns
Goods available for sale
Less:
Normal shrinkage
Sales:
Sales to customers
Sales to employees
Estimated ending inventory at retail
Estimated ending inventory at cost
(61.12% x $222,500)
Estimated cost of goods sold
Solutions Manual, Vol.1, Chapter 9
________
1,497,500
(150,000)
2,300,000
(15,000)
$1,750,000
312,500*
(2,062,500)
$ 222,500
(135,992)
$1,361,508
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Problem 9-5 (concluded)
Requirement 2
Beginning inventory
Plus: Purchases
Freight-in
Plus: Net markups
Less: Net markdowns
Goods available for sale (excluding beginning
Cost
$ 100,000
1,387,500
10,000
Retail
$ 150,000
2,000,000
________
1,397,500
300,000
(150,000)
2,150,000
1,497,500
2,300,000
inventory)
Goods available for sale (including beginning inventory)
$1,397,500
Cost-to-retail percentage:
= 65%
$2,150,000
Less:
Normal shrinkage
Sales:
Sales to customers
$1,750,000
Sales to employees
312,500
Estimated ending inventory at retail
Estimated ending inventory at cost:
Retail
Cost
Beginning inventory
$150,000
$100,000
Current period’s layer
72,500 x 65% = 47,125
Total
$222,500
$147,125
Estimated cost of goods sold
© The McGraw-Hill Companies, Inc., 2007
9-46
(15,000)
(2,062,500)
$ 222,500
(147,125)
$1,350,375
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Problem 9-6
Requirement 1
Cost
$ 20,000
100,151
5,100
(2,100)
Beginning inventory
Plus: Purchases
Freight-in
Less: Purchase returns
Plus: Net markups ($2,500 - 265)
Retail
$ 30,000
146,495
(2,800)
2,235
175,930
$123,151
Cost-to-retail percentage:
= 70%
$175,930
Less: Net markdowns
Goods available for sale
Less:
Normal spoilage
Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost (70% x $34,900)
_______
$123,151
(800)
175,130
(4,500)
(135,730)
$ 34,900
$24,430
Requirement 2
The difference between the inventory estimate per retail method and the amount
per physical count may be due to:
1. Theft losses.
2. Spoilage or breakage above normal.
3. Differences in cost-to-retail percentage for purchases during the month, beginning
inventory, and ending inventory.
4. Markups on goods available for sale inconsistent between cost of goods sold and
ending inventory.
5. A wide variety of merchandise with varying cost-to-retail percentages.
6. Incorrect reporting of markdowns, additional markups or cancellations.
Solutions Manual, Vol.1, Chapter 9
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Problem 9-7
Cost
$ 80
671
30
(1)
($ in 000s)
Beginning inventory
Purchases
Freight-in on purchases
Purchase returns
Net markups
Net markdowns
Goods available for sale
___
$780
Cost-to-retail percentages:
Average cost ratio:
$780 ÷ $1,125 =
Average (LCM) cost ratio: $780 ÷ ($1,125 + $8) =
Deduct: Net sales
Ending inventory:
At retail (sales price)
At Average cost
At Average (LCM)
Retail
$ 125
1,006
(2)
4
(8)
1,125
.6933
.6884
(916)
$ 209
($209 x .6933)
($209 x .6884)
$144.90
$143.88
Note that lower of cost or market is approximated by excluding net markdowns.
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Problem 9-8
($ in 000s)
Cost
$80
671
30
Beginning inventory
Plus: Net purchases
Freight-in
Net markups
Less: Purchase returns
Net markdowns
Goods available for sale (excluding beginning inventory)
Goods available for sale (including beginning inventory)
(1)
___
700
780
Retail
$125
1,006
4
(2)
(8)
1,000
1,125
$80
Base layer cost-to-retail percentage:
= 64%
$125
$700
2006 layer cost-to-retail percentage:
= 70%
$1,000
Less: Net sales
Estimated ending inventory at current year retail prices
Estimated ending inventory at cost (calculated below)
Estimated cost of goods sold
(916)
$209
(130)
$650
___________________________________________________________________________
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
$209
$209
(above)
= $190
1.10
$125 (base)
65 (2006)
x 1.00 x 64% =
x 1.10 x 70% =
Total ending inventory at dollar-value LIFO retail cost ......................
Solutions Manual, Vol.1, Chapter 9
$ 80
50
$130
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Problem 9-9
Sales to employees must be deducted in the retail column at their gross amount.
2006:
$2,400
= $3,000 = Gross sales to employees
.80
Beginning inventory
Plus: Net purchases
Freight-in
Net markups
Less: Net markdowns
Goods available for sale (excluding beginning inventory)
Goods available for sale (including beginning inventory)
Cost
$28,000
85,000
2,000
______
87,000
115,000
Retail
$ 40,000
108,000
10,000
(2,000)
116,000
156,000
$ 87,000
Cost-to-retail percentage:
= 75%
$116,000
Less: Net sales ($100,000 + 3,000)
Estimated ending inventory at current year retail prices
Estimated ending inventory at cost (below)
Estimated cost of goods sold
(103,000)
$ 53,000
(35,950)
$79,050
___________________________________________________________________________
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
$53,000
$53,000
(above)
= $50,000
1.06
$40,000 (base)
10,000 (2006)
x 1.00 x 70%
x 1.06 x 75%
Total ending inventory at dollar-value LIFO retail cost ............
Solutions Manual, Vol.1, Chapter 9
=
=
$28,000
7,950
$35,950
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Problem 9-9 (concluded)
2007:
$4,000
= $5,000 = Gross sales to employees
.80
Beginning inventory
Plus: Net purchases
Freight-in
Net markups
Less: Net markdowns
Goods available for sale (excluding beginning inventory)
Goods available for sale (including beginning inventory)
Cost
$35,950
90,000
2,500
______
92,500
128,450
Retail
$ 53,000
114,000
8,000
(2,200)
119,800
172,800
$ 92,500
Cost-to-retail percentage:
= 77.21%
$119,800
Less: Net sales ($104,000 + 5,000)
Estimated ending inventory at current year retail prices
Estimated ending inventory at cost (below)
Estimated cost of goods sold
(109,000)
$ 63,800
(42,744)
$85,706
___________________________________________________________________________
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
$63,800
$63,800
(above)
= $58,000
1.10
$40,000 (base)
10,000 (2006)
8,000 (2007)
x 1.00 x 70%
=
x 1.06 x 75%
=
x 1.10 x 77.21% =
Total ending inventory at dollar-value LIFO retail cost ............
© The McGraw-Hill Companies, Inc., 2007
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$28,000
7,950
6,794
$42,744
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Problem 9-10
Requirement 1
Cost
$ 27,500
282,000
26,500
(6,500)
(5,000)
Beginning inventory
Plus: Purchases
Freight-in
Less: Purchase returns
Purchase discounts
Plus: Net markups
Retail
$ 45,000
490,000
(10,000)
25,000
550,000
$324,500
Cost-to-retail percentage:
= 59%
$550,000
Less: Net markdowns
Goods available for sale
Less:
Gross sales
$492,000
Less: Returns
(5,000)
Plus: Employee discounts
3,000
Estimated ending inventory at retail
Estimated ending inventory at cost (59% x $50,000)
Solutions Manual, Vol.1, Chapter 9
_______
$324,500
(10,000)
540,000
(490,000)
$ 50,000
$ 29,500
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Problem 9-10 (continued)
Requirement 2
Beginning inventory
Plus: Purchases
Freight-in
Less: Purchase returns
Purchase discounts
Plus: Net markups
Less: Net markdowns
Goods available for sale (excluding beg. inventory)
Goods available for sale (including beg. inventory)
Cost
$ 27,500
282,000
26,500
(6,500)
(5,000)
_______
297,000
$324,500
Retail
$ 45,000
490,000
(10,000)
25,000
(10,000)
495,000
540,000
$297,000
Cost-to-retail percentage:
= 60%
$495,000
Less:
Gross sales
$492,000
Less: Returns
(5,000)
Plus: Employee discounts
3,000
Estimated ending inventory at retail
Estimated ending inventory at cost:
Retail
Cost
Beginning inventory
$45,000
$27,500
Current period’s layer
5,000 x 60% = 3,000
Total
$50,000
$30,500
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(490,000)
$ 50,000
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Problem 9-10 (concluded)
Requirement 3
2005
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
$56,100
$56,100
= $55,000
1.02
$50,000 (base)
5,000 (2005)
x 1.00 x 61%* = $30,500
x 1.02 x 62% = 3,162
Total ending inventory at dollar-value LIFO retail cost ..............
$33,662
* $30,500
= 61%
$50,000
2006
$48,300
$48,300
= $46,000
$46,000 (base)
x 1.00 x 61% = $28,060
1.05
Total ending inventory at dollar-value LIFO retail cost ............... $28,060
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Problem 9-11
Requirement 1
Retained earnings ................................................................
Inventory ($150,000 – 130,000) .......................................
20,000
20,000
Requirement 2
FIFO method cost of goods sold:
Cost of goods available for sale
Less ending inventory:
5,000 units @ $40
2,000 units @ $36
$530,000
$200,000
72,000
Cost of goods sold
(272,000)
$258,000
Average cost method cost of goods sold:
Beginning inventory (5,000 units)
Purchases:
5,000 units @ $36
5,000 units @ $40
$130,000
$180,000
200,000
Cost of goods available for sale (15,000 units)
Less ending inventory (below)
Cost of goods sold
380,000
510,000
(238,000)
$272,000
Cost of ending inventory:
$510,000
Weighted average unit cost =
= $34
15,000 units
7,000 units x $34 = $238,000
The effect of the change for the year 2006 is a $14,000 increase in cost of goods
sold ($272,000 - 258,000) resulting in a $14,000 decrease in income before tax and a
$8,400 decrease in income after tax [$14,000 x (1 - .40)].
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Problem 9-12
Requirement 1
Analysis:
2004
Beginning inventory
Plus: Net purchases
Less: Ending inventory
Cost of goods sold
Revenues
Less: Cost of goods sold
Less: Other expenses
Net income
→
↑
U-6,000
O-6,000
U-6,000
U-3,000
O-9,000
U-18,000
U-6,000
Revenues
Less: Cost of goods sold U-18,000
Less: Other expenses
Net income
O-18,000
U-6,000
Retained earnings
O-6,000

Retained earnings
U = Understated
O = Overstated
2005
Beginning inventory
Plus: Net purchases
Less: Ending inventory
Cost of goods sold

O-12,000
Requirement 2
Retained earnings ..........................................................
Inventory ...................................................................
Purchases ..................................................................
12,000
9,000
3,000
Requirement 3
The financial statements that were incorrect as a result of both errors (effect of
one error in 2004 and effect of three errors in 2005) would be retrospectively restated
to report the correct inventory amounts, cost of goods sold, income, and retained
earnings when those statements are reported again for comparative purposes in the
2006 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.
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Problem 9-13
Requirement 1
December 31, 2006 inventory, based on a physical count
Add: Merchandise shipped f.o.b. shipping point in 2006
Merchandise shipped f.o.b. shipping point in 2006
Correct ending inventory
Analysis:
2006
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
$450,000
20,000
80,000
$550,000
U = Understated
O = Overstated
U-130,000 ($50,000 + 80,000)
U-100,000
U -30,000
U -30,000
O -30,000
O -30,000
Requirement 2
Retained earnings .......................................................... 30,000
Inventory....................................................................... 100,000
Accounts payable ......................................................
130,000
Solutions Manual, Vol.1, Chapter 9
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Problem 9-14
Requirement 1
a. $10.50
If market price is equal to or greater than the contract price, the purchase is
recorded at cost.
Purchases ($10.00 x 10,000 units) ...................................... 100,000
Cash ..........................................................................
100,000
b. $9.50
If market price is less than the contract price, the purchase is recorded at the
market price.
Purchases ($9.50 x 10,000 units) ........................................
Loss on purchase commitment (difference)......................
Cash ..........................................................................
95,000
5,000
100,000
Requirement 2
a. $12.50
No entry is required. Market price is greater than contract price.
b. $10.30
If market price at year-end is less than contract price for outstanding purchase
commitments, a loss is recorded for the difference.
December 31, 2006
Estimated loss on purchase commitment
[($11.00 x 20,000 units) - ($10.30 x 20,000 units)] .................
Estimated liability on purchase commitment .............
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Problem 9-14 (concluded)
Requirement 3
a. $11.50
If market price on purchase date has not declined from year-end price, the
purchase is recorded at the year-end market price.
Purchases ($10.30 x 20,000 units) ...................................... 206,000
Estimated liability on purchase commitment ................. 14,000
Cash ($11.00 x 20,000 units) ..........................................
220,000
b. $10.00
If market price on purchase date declines from year-end price, the purchase is
recorded at market price.
Purchases ($10.00 x 20,000 units) ...................................... 200,000
Loss on purchase commitment
($220,000 - 200,000 -14,000)* ...........................................
6,000
Estimated liability on purchase commitment ................. 14,000
Cash ($11.00 x 20,000 units) ..........................................
220,000
* or, ($10.30 - $10.00) x 20,000 units = $6,000
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CASES
Judgment Case 9-1
1. Hudson should account for the warehousing costs related to its wholesale
inventories as part of inventory. All reasonable and necessary costs of preparing
inventory for sale should be recorded as inventory cost. This approach results in
proper matching of the warehousing costs with revenue when the wholesale
inventories are sold.
2. a. The lower-of-cost-or-market method produces a more realistic estimate of
future cash flows to be realized from assets, which is consistent with the principle of
conservatism, and recognizes (matches) the anticipated loss in the income statement in
the period in which the price decline occurs.
b. Hudson’s wholesale inventories should be reported in the balance sheet at
replacement cost. According to the lower-of-cost-or-market method, replacement cost
is defined as market. However, market cannot exceed net realizable value and cannot
be less than net realizable value less the normal profit margin. In this instance,
replacement cost is below original cost, below net realizable value, and above net
realizable value less the normal profit margin. Therefore, Hudson’s wholesale
inventories should be reported at replacement cost.
3. Hudson’s freight-in costs should be included only in the cost amounts to
determine the cost-to-retail percentage. Hudson’s net markups should be included
only in the retail amounts to determine the cost-to-retail-percentage. Hudson’s net
markdowns should not be deducted from the retail amounts to determine the cost-toretail percentage.
4. By not deducting net markdowns from the retail amounts to determine the
cost-to-retail percentage, Hudson produces a lower cost-to-retail percentage than
would result if net markdowns were deducted. By applying this lower percentage to
ending inventory at retail, the inventory is reported at an amount below cost, which
approximates lower of average cost or market.
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Communication Case 9-2
Arguments for the LCM approach versus historical cost should focus on the loss
of utility concept. A departure from cost is warranted when the utility of an asset (its
probable future economic benefits) is no longer as great as its cost. The utility or
benefits from inventory result from the ultimate sale of the goods. So, deterioration,
obsolescence, changes in price levels, or any situation that might compromise the
inventory’s salability impairs utility. To avoid reporting inventory at an amount
greater than the benefits it can provide, the lower-of-cost-or-market (LCM) approach
to valuing inventory was developed. Reporting inventories at LCM causes losses to
be recognized when the value of inventory declines below its cost, rather than in the
period in which the goods ultimately are sold.
A difference between LCM and a market value approach is that a market value
approach would recognize income as market value increases above cost. This results
in recognizing income before the inventory is sold. Arguments for the LCM approach
should focus on the realization principle. That is, in most situations, until inventory is
sold, there exists significant uncertainty about the ultimate cash to be collected.
It is important that each student actively participate in the process of arriving at a
solution. Domination by one or two individuals should be discouraged. Students
should be encouraged to contribute to the group discussion by (a) offering information
on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c)
suggesting alternative direction.
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Integrating Case 9-3
Requirement 1
York Co.
Schedule of Cost of Goods Sold
For the Year Ended December 31, 2006
Beginning inventory
Add: Purchases
Less: Purchase discounts
Add: Freight-in
Goods available for sale
Less: Ending inventory
Cost of goods sold
$ 65,600
368,900
(18,000)
5,000
421,500
(176,000) (1)
$245,500
York Co.
Supporting Schedule of Ending Inventory
December 31, 2006
Inventory at cost (LIFO):
Units
Beginning inventory, January 1,
8,000
Purchases, quarter ended March 31 12,000
Purchases, quarter ended June 30
2,000
22,000
Cost
per unit
$8.20
8.25
7.90
Total
cost
$ 65,600
99,000
15,800
$180,400
Inventory at market:
22,000 units @ $8 = $176,000 (1)
Requirement 2
Inventory should be valued at the lower of cost or market. Market means current replacement
cost, except that:
(1) Market should not exceed the net realizable value; and
(2) Market should not be less than net realizable value reduced by an allowance for a normal
profit margin.
In this situation, because replacement cost ($8 per unit) is less than net realizable value, but
greater than net realizable value reduced by a normal profit margin, replacement cost is used as
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market. Because inventory valued at market ($176,000) is lower than inventory valued at cost
($180,400), inventory should be reported in the financial statements at market.
Judgment Case 9-4
1. a. The advantages of using the dollar-value LIFO method are to reduce the
cost of accounting for inventory and to minimize the probability of liquidation of
LIFO inventory layers.
b. The application of dollar-value LIFO is based on dollars of inventory, an
inventory cost index for each year, and broad inventory pools. The inventory layers
are identified with the inventory cost index for the year in which the layer was added.
In contrast, traditional LIFO is applied to individual units at their cost.
2. a. Huddell’s net markups should be included only in the retail amounts
(denominator) to determine the cost-to-retail percentage. Huddell’s net markdowns
should be ignored in the calculation of the cost-to-retail percentage.
b. By not deducting net markdowns from the retail amounts to determine the
cost-to-retail percentage, Huddell produces a lower cost-to-retail percentage than
would result if net markdowns were deducted. Applying this lower percentage to
ending inventory at retail, the inventory is reported at an amount below cost. This
amount is intended to approximate the lower of average cost or market.
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Communication Case 9-5
Suggested Grading Concepts and Grading Scheme:
Content (70%)
______ 30 Describes the method.
_____ Determining ending inventory at retail.
Multiply ending inventory at retail by the cost percentage.
_____ Markups and markdowns.
______
10 Discusses the conditions that may distort results.
_____ Possible inaccurate cost percentage.
Does not explicitly consider theft, breakage, etc.
______
30 Describes the advantages of using the method when
compared to other methods.
_____ Avoids physical inventory count.
_____ Acceptable for financial reporting and income taxes.
_____ Can explicitly incorporate cost flow methods, taxes,
and LCM.
____
______ 70 points
Writing (30%)
______ 6 Terminology and tone appropriate to the audience of a company
president.
______ 12 Organization permits ease of understanding.
_____ Introduction that states purpose.
_____ Paragraphs that separate main points.
______
12 English
_____ Sentences grammatically clear and well organized,
concise.
_____ Word selection.
_____ Spelling.
_____ Grammar and punctuation.
____
______ 30 points
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Analysis Case 9-6
For changes not involving LIFO or changes from the LIFO method to another, the
event is accounted for as a normal change in accounting principle. In general, we
report voluntary changes in accounting principles retrospectively. This means
revising all previous periods’ financial statements as if the new method were used in
those periods. In other words, for each year in the comparative statements reported,
we revise the balance of each account affected. More specifically, we make those
statements appear as if the newly adopted accounting method had been applied all
along. Also, if retained earnings is one of the accounts whose balance requires
adjustment (and it usually is), we make an adjustment to the beginning balance of
retained earnings for the earliest period reported in the comparative statements of
shareholders’ equity (or statements of retained earnings if they’re presented instead).
Then we create a journal entry to adjust all account balances affected as of the date of
the change.
The advantage of retrospective application is to enhance comparability of the
statements from year to year. The recast statements appear as if the newly adopted
accounting method had been applied in all previous years.
Consistency and comparability suggest that accounting choices once made should
be consistently followed from year to year. So, any change requires that the new
method be justified as clearly more appropriate. In the first set of financial statements
after the change, a disclosure note is needed to provide that justification. The footnote
also should point out that comparative information has been revised and report any per
share amounts affected for the current period and all prior periods presented.
When a company changes to the LIFO inventory method from any other method,
it usually is impracticable to calculate the cumulative effect of the change. Revising
balances in prior years would require knowing what those balances should be. LIFO
inventory, though, consists of “layers” added in prior years at costs existing in those
years. If another method has been used, the company probably hasn’t kept a record of
those costs. Accordingly, accounting records of prior years usually are inadequate to
report the change retrospectively. Because of this difficulty, a company changing to
LIFO usually does not report the change retrospectively. Instead, the base year
inventory for all future LIFO calculations is the beginning inventory in the year the
LIFO method is adopted. Then, the LIFO method is applied prospectively from that
point on. The disclosure note must include an explanation as to why retrospective
application was impracticable.
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Real World Case 9-7
Requirement 1
We report most voluntary changes in accounting principles retrospectively. This
means recasting all previous periods’ financial statements as if the new method were
used in those periods. For each year in the comparative statements reported, we revise
the balance of each account affected so that those statements appear as if the newly
adopted accounting method had been applied all along. Then we create a journal
entry to adjust all account balances affected as of the date of the change.
GAAP require retrospective application to enhance comparability of the statements
from year to year. The revised statements are made to appear as if the newly adopted
accounting method (average cost method in this case) had been applied in all previous
years.
Requirement 2
The note reports that the switch to the average cost method caused an increase in
earnings per share of 17 cents for the first nine months of 2000. In order for the
average method to result in higher earnings (lower cost of goods sold) than LIFO
(assuming the quantity of inventory did not change), the cost of inventory must have
increased during the year.
Real World Case 9-8
Requirement 3
a. During the fourth quarter of its fiscal year ended June 30, 2003, the Company
changed its method of accounting for inventories from LIFO to the average
cost method for all inventories not previously accounted for on the average
cost method.
b. The change in method increased retained earnings as of July 1, 2000 by
$451,000.
c. The effect of the change was to increase net income for fiscal 2002 by $6,000.
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Communication Case 9-9
Requirement 1
Change in Inventory Method
During 2006, the Company changed the method of valuing its inventories from the
first-in, first-out (FIFO) method, to the last-in, first-out (LIFO) method, determined
by the retail method. To estimate the effects of changing retail prices on
inventories, the Company utilizes internally developed price indexes. The impact
of the change was to decrease 2006 net income by $13.2 million and to decrease
earnings per share by $0.13. Management has determined that retrospective
application of the change is impracticable because the cumulative effect of the
change on prior years was not determinable.
The Company believes that the change to the LIFO method provides a more
consistent matching of merchandise costs with sales revenue and also provides a
more comparable basis of accounting with competitors.
Note: Because cost of goods sold would have been $22 million lower if the change
had not been made, income before tax would have been $22 million higher,
and net income would have been $13.2 million higher ($22 million multiplied
by 60% [1 - .40]).
Requirement 2
It usually is impracticable to calculate the cumulative effect of a change to LIFO.
To do so would require assumptions as to when specific LIFO inventory layers were
created in years prior to the change. Accounting records usually are inadequate for a
company to create the appropriate LIFO inventory layers. That’s why a change to
LIFO usually can’t be applied retrospectively.
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Judgment Case 9-10
Despite the self-correcting feature of certain inventory errors, the errors cause the
financial statements of the year of the error as well as the financial statements in the
subsequent year to be incorrect. For example, an overstatement of ending inventory at
the end of 2005 will correct itself in 2006 and retained earnings at the end of 2006 will
be correct. However, cost of goods sold and net income will be incorrect in both
years. In addition, inventory and retained earnings on the 2005 balance sheet will be
incorrect.
If a material inventory error is discovered in an accounting period subsequent to
the period in which the error is made, 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 of retained
earnings 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.
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Ethics Case 9-11
Requirement 1
Bonuses will be negatively affected because if the error is corrected, a lower
ending inventory results in higher cost of goods sold and lower income. The effect of
the error would be an overstatement of pre-tax income by $665,000 ($3,265,000 2,600,000).
Requirement 2
It will be reported as a prior period adjustment to the beginning retained earnings
balance for the year beginning July 1, 2006. Financial statements for the year ending
June 30, 2006, will be retrospectively restated to reflect the correct inventory amount,
cost of goods sold, net income, and retained earnings.
Requirement 3
Ethical Dilemma:
Should John recognize his obligation to disclose the inventory error to Danville
shareholders, the local bank, auditors, and taxing authorities or remain quiet, enabling
him and other company employees to receive originally computed year-end bonuses?
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Analysis Case 9-12
ARB 43 requires that purchase commitments be evaluated in the same way as
inventory on hand for the purpose of determining any lower-of-cost-or-market (LCM)
adjustment. Purchases are recorded at market price when market price is lower than
the agreed upon contract price, and a loss is recognized for the difference between
market price and contract price. Also, losses must be recognized for any purchase
commitments outstanding at the end of a reporting period when market price is less
than contract price.
In this case, the contract price of $.80 per gallon is compared to the market price
at December 31. If market is less than $.80, an estimated loss is recognized for the
difference multiplied by the million gallon commitment. An estimated liability is
recorded for the loss. If market price is greater than $.80, then no year-end adjustment
is necessary.
As the heating oil is purchased in 2007, if an estimated loss is recorded at yearend, the purchases are recorded at the lower of market price and year-end price. If no
loss is recorded at year-end, the purchases are recorded at the lower of market price
and contract price.
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