Lesson 5

Problem 5-1

Review of Perpetual Inventory Accounting and Costing Methods

Respond to the following:

1. What does it mean to account for inventory perpetually and what

Lesson 5 are the benefits of such an approach?

2. What kinds of companies use specific identification in the costing

Cost of Goods Sold of their inventory and how does it work?
and Inventory 3. What is an inventory cost flow assumption and when is it
appropriate for a company to use such an assumption rather than
specific identification?

1 2

Problem 5-1 - Answer Problem 5-1 - Answer

Review of Perpetual Inventory Accounting and Costing Methods
1. What does it mean to account for inventory perpetually and what are 2. What kinds of companies use specific identification in the costing of
the benefits of such an approach? their inventory and how does it work?
Answer: Accounting for inventory perpetually means that the company's inventory Answer: Specific identification is an inventory costing method used by
general ledger account and corresponding subsidiary ledgers maintained for each companies that have distinctive inventory where each item is different in
type of inventory item, are immediately updated for every inventory transaction to nature or cost from every other item in stock. For example, a used car
keep a running balance of not only the number of units on dealership uses specific identification to cost its inventory because every
hand but their associated cost. car in stock is different from the others and has its own specific cost.
The primary benefit of perpetual accounting is more effective inventory Fine art dealers also use specific identification because of the unique
management. Excess inventory can be expensive. It takes up valuable space, nature and cost of each item of inventory.
increases handling costs, requires financing and increases the risk of loss from
obsolescence and theft. On the other hand, insufficient inventory can result in Actual implementation of specific identification requires that the
dissatisfied customers and declining sales volume. Effective inventory management
and control is crucial to a company's success, and having immediately available
cost of each inventory item purchased be recorded and included in
information on inventory quantities and costs is a valuable management tool. inventory until its sale, at which time that specific cost is removed from
inventory and accounted for as the cost of goods sold.
Another benefit of perpetual inventory accounting is that it allows
companies to determine the amount of inventory loss incurred due to waste, theft or
other loss. This is commonly referred to as inventory shrinkage, and the only way it
can be quantified is through periodic comparison of a company's perpetual
inventory records to an actual physical count. In fact, a periodic physical inventory
is required at least once a year, even when using a perpetual inventory system, in
order to verify, and, if necessary, adjust a company's inventory records to reflect
actual quantities on hand.

3 4

Problem 5-1 - Answer Problem 5-2

Review of Perpetual Inventory Accounting and Cost Flows

3. What is an inventory cost flow assumption and when is it appropriate
for a company to use such an assumption rather than specific Harris Appliances has the following inventory balance of EZ Clean washing
identification? machines as of 1/1/X4:
8 units @ $192/unit (purchased 10/21/X3)
Answer: Companies that sell products that are similar in nature and cost 20 units @ $194/unit (purchased 12/15/X3)
will often account for their inventory and cost of goods sold using an 28 units on hand at 1/1/X4
inventory cost flow assumption, such as FIFO (first-in, first-out), LIFO
(last-in, first-out) or some weighted average. In these cases, a cost is A. Prepare journal entries to record the transactions noted below assuming
assigned to the units sold that may not be that specific unit's cost. This is Harris uses a perpetual FIFO inventory accounting method:
justified on the basis that the costs are not significantly different, and, in 1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on
some cases, keeping a record of the specific cost of each individual item account, terms of 2/10, n/30.
of inventory may be difficult, if not impossible. For example, a jelly bean 1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount.
retailer will find it pretty much impossible to accountant for inventory 1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry
and cost of goods sold using specific identification. How do you keep Services for $400/unit on account, terms of 2/10, n/30, FOB shipping
track of the cost of each individual jelly bean? Instead, either the cost of point.
the first units purchased, the last units purchased or an average cost of 1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on
the units purchased and available for sale will be used for the cost of account. The machines are unused and can be resold at full price.
goods sold. 1/31 Harris receives payment in full, net of the discount on the 1/20 sale to
Jim's.
B. Determine Harris' gross margin, gross margin percentage and
percentage markup on the sale to Jim's Laundry Services.

5 6

5-1
 Problem 5-2 Problem 5-2 - Answer

C. If Harris had incurred freight costs in the purchase and receipt of EZ Review of Perpetual Inventory Accounting and Cost Flows
Clean washing machines and delivery costs in the subsequent sale to
Jim's, how would such costs have been accounted for and what effect
A.
1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on
would they have had on Harris' gross margin?
account, terms of 2/10, n/30.
D. Determine the gross margin on the sale to Jim's if the (1) perpetual Inventory 10,000
LIFO method, and (2) moving-weighted average (MWA) methods had Accounts Payable 10,000
been used? Which method (FIFO, LIFO, MWA) would have produced
the highest gross margin? Which method (FIFO, LIFO, MWA) would
have produced the highest gross margin if there had been decreasing 1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount.
inventory costs over time (deflation) instead of inflation? Which method
would have produced the highest gross margin if all inventory had been Accounts Payable 10,000
sold during the period? Cash 9,800
Inventory 200
E. Which inventory cost flow assumption is required for financial
reporting purposes? Which inventory cost flow assumption is required
for income tax purposes? Which assumption would be best for a private
company that typically faces increasing inventory costs and is interested
in minimizing its cash outflows? Would the use of LIFO in a time of
rising inventory costs tend to over or understate the company's assets
relative to current costs?

7 8

Problem 5-2 - Answer Problem 5-2 - Answer

A. (Continued) A. (Continued)
1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry 1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on
Services for $400/unit on account, terms of 2/10, n/30, FOB shipping account. The machines are unused and can be resold at full price.
point.
Sales Returns and Allowances 800
Accounts Receivable 16,000 Accounts Receivable 800
Sales Revenues 16,000 Inventory (2 units @196) 392
Cost of Goods Sold 7,768* Cost of Goods Sold 392
Inventory 7,768
* Inventory available for sale:
1/31 Harris receives payment in full, net of the discount on the 1/20 sale to
8 units @ $192/unit (purchased 10/21/X3) Jim's.
20 units @ $194/unit (purchased 12/15/X3)
Cash ($15,200 x 98%) 14,896
50 units @ $196/unit (purchased 1/5/X4)
Sales Discounts ($15,200 x 2%) 304
Accounts Receivable 15,200
Cost of Goods Sold (FIFO):
8 units @ $192/unit = $ 1,536
20 units @ $194/unit = 3,880
12 units @ $196/unit = 2,352
40 $ 7,768

9 10

Problem 5-2 - Answer Problem 5-2 - Answer

B.
Sales Revenues $ 16,000 C. If Harris had incurred freight costs in the purchase and receipt of EZ
Clean washing machines and delivery costs in the subsequent sale to
Less: Sales Returns (800) Jim's, how would such costs have been accounted for and what effect
Sales Discounts (304) would they have had on Harris' gross margin?
Net Sales Revenues 14,896
Less: Cost of Goods Sold (7,376) Answer: Any costs incurred in the acquisition of an asset, such as
Gross Margin $ 7,520 inventory, and any costs associated with getting that asset ready for its
original intended use (ready to sell) are to be capitalized as part of the
asset's original historical cost. As a result, any freight costs incurred in
Gross margin percentage: Percentage markup: receiving the inventory should be included as part of the inventory's cost
and debited to the inventory account. This would ultimately reduce
Gross Margin Gross Margin Harris' gross margin in that cost of goods sold would be higher upon the
Net Sales Revenues Cost of Goods Sold sale of that inventory.

$ 7,520 $ 7,520 Costs incurred in the delivery of inventory sold to a customer are not
= 50% = 102% costs incurred in the acquisition of the inventory. Such delivery costs are
$ 14,896 $ 7,376
actually selling costs and are reported as operating expenses below gross
margin on a multi-step formatted income statement.

11 12

5-2
 Problem 5-2 - Answer Problem 5-2 - Answer

D. (Continued)
D. Determine the gross margin on the sale to Jim's if the (1) perpetual
LIFO method, and (2) moving-weighted average (MWA) methods had MWA: Sales Revenues $ 16,000
been used? Which method (FIFO, LIFO, MWA) would have produced
the highest gross margin? Less: Sales Returns (800)
Sales Discounts (304)
LIFO: Sales Revenues $ 16,000 Net Sales Revenues 14,896
Less: Sales Returns (800) Less: Cost of Goods Sold (7,413)
Sales Discounts (304) Gross Margin $ 7,483
Net Sales Revenues 14,896
Inventory available/sold:
Less: Cost of Goods Sold (7,448)
Gross Margin $ 7,448 8 units @ $192/unit = $ 1,536
20 units @ $194/unit = 3,880
Inventory available/sold: 50 units @ $196/unit = 9,800
8 units @ $192/unit (purchased 10/21/X3) 78 $15,216
20 units @ $194/unit (purchased 12/15/X3)
50 units @ $196/unit (purchased 1/5/X4) MWA: $15,216 78 = $195.08/unit

Cost of Goods Sold (LIFO): Cost of Goods Sold (MWA):

38 units @ $196/unit = $ 7,448 38 units @ $195.08/unit = $ 7,413 (rounded)

13 14

Problem 5-2 - Answer Problem 5-2 - Answer

D. Which method (FIFO, LIFO, MWA) produced the highest gross E. Which inventory cost flow assumption is required for financial
margin? reporting purposes?
Answer: Any of the inventory cost flow assumptions can be used
Answer: FIFO: $ 7,520 highest for financial reporting purposes, regardless of the actual physical
LIFO: $ 7,448 flow of goods, as long as the method selected is used consistently
MWA: $ 7,483 from year-to-year.
Which method (FIFO, LIFO, MWA) would have produced the highest
Which inventory cost flow assumption is required for income tax
gross margin if there had been decreasing inventory costs over time
purposes?
(deflation) instead of inflation?
Answer: Current tax law requires that the method used for
Answer: LIFO, the opposite effect. financial reporting must also be used for income tax purposes.

Which method would have produced the highest gross margin if all Which assumption would be best for a private company that typically
inventory was sold during the period? faces increasing inventory costs and is interested in minimizing its cash
outflows?
Answer: No difference. Answer: LIFO

Would the use of LIFO in a time of rising inventory costs tend to over
or understate the company's assets relative to current costs?
Answer: Understate ending inventory

15 16

Mary's Hobby Shop

On 12/31/X5, Mary's inventory balance is $40,000 based on an actual
physical count of inventory on hand at the end of the year 'X5.
Prepare the journal entries for Mary's summarized inventory
Periodic Method transactions for the year 20X6, assuming the business uses a periodic
instead of a perpetual inventory accounting system.
of Purchased a total of $200,000 of inventory on account with
Accounting for Inventory terms of 2/10, n/30:
Purchases 200,000
Accounts Payable 200,000

Paid a total of $5,000 of freight costs to have the purchased

inventory delivered to her store:
Freight-In 5,000
Cash 5,000

17 18

5-3
 Returned $20,000 of previously purchased inventory to Merchandise sold to customers at a price $10,000 is returned
suppliers receiving full credit on account: to Mary for full credit on account:
Accounts Payable 20,000 Sales Returns and Allowances 10,000
Purchase Returns 20,000 Accounts Receivable 10,000
Paid off the $180,000 balance of accounts payable, net of the Inventory XXX
discount, with a $176,400 cash payment. Cost of Goods Sold XXX
(98% X $180,000 = $176,400)
Accounts Payable 180,000
Cash 176,400
Purchase Discounts* 3,600
* (2% x $180,000)
Total sales for the year amounted to $320,000, all made on
account.
Accounts Receivable 320,000
Sales Revenues 320,000

Cost of Goods Sold XXX

Inventory XXX

19 20

Inventory Inventory
1/1/X6 40,000 1/1/X6 40,000
Purchases 200,000 Purchases 200,000
Freight-in 5,000 Freight-in 5,000
20,000 Purchase returns 20,000 Purchase returns
3,600 Purchase discounts 3,600 Purchase discounts
Cost of goods available for sale 221,400
Purchases 178,400 Cost of goods sold
1/1/X6 0 12/31/X6 43,000
200,000 200,000 Closing
12/31/X6 0
Assume that at the end of the year 20X6, a physical
Freight-In inventory is performed and produces a $43,000 total.
1/1/X6 0
5,000 5,000 Closing Cost of Goods Sold
12/31/X6 0 1/1/X6 0
178,400
Purchase Returns 12/31/X6 178,400
0 1/1/X6
Closing 20,000 20,000
The key to the periodic method is the year-end physical
0 12/31/X6
inventory.
Purchase Discounts
0 1/1/X6
Closing 3,600 3,600
0 12/31/X6

21 22

Mary's Hobby Shop

12/31/X6 Physical Inventory:
Inventory Description # of Units
Porsche Model Car 17
Ferrari Model Car 25
Mustang Model Car 22
Should the cost of items sold and the cost of Ferrari Model Car:
any inventory still on hand be determined Beginning inventory: 20 units @ $5.00/ea. = $ 100.00
20X6 Invoices:
based on specific identification, or an Date
3/5
# Units
30
Cost/Unit
$6.00/ea. = $180.00
inventory cost flow assumption? 9/13 30 $7.00/ea. = $210.00
Ending Inventory:
FIFO assumption: 25 units @ $7.00 = $175.00
LIFO assumption: 20 units @ $5.00 = $100.00
5 units @ $6.00 = $ 30.00
$130.00
W/A assumption: $490 80 units = $6.125/unit
25 units @ $6.125 = $153.13 rounded

23 24

5-4
 Problem 5-3

Periodic Inventory Accounting

Erickson, Inc., a wholesaler of battery chargers has beginning inventory on
1/1/X8, which includes:
100 units @ $25/unit = $ 2,500
200 units @ $26/unit = 5,200
$ 7, 700
A. Prepare Erickson's journal entries for the transactions provided below
using the periodic method of inventory accounting.
1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a
$2/unit freight charge, all on account with terms of 2/10, n/30.
1/15: Returned 10 of the 1,200 units purchased for full credit on
account at $27/unit.
1/19: Paid the net account payable due on the 1/10 purchase, net of the
discount.
1/21: Made a $57,000 sale to a customer on account.
1/29: Purchased and paid cash for 300 units of inventory, at $26/unit
with free shipping.

25 26

Problem 5-3 - Answer

Problem 5-3
Periodic Inventory Accounting
A.
B. Calculate Erickson's cost of goods sold for the month of January under 1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a $2/unit freight
periodic FIFO and LIFO inventory cost flow assumptions, assuming a charge, all on account with terms of 2/10, n/30.
total of 350 units of ending inventory based on a physical count at the Purchases (1,200 @ $25/ea.) 30,000
end of the month. Freight-In (1,200 @ $2/ea.) 2,400
Accounts Payable 32,400
C. Explain how a company's cost of inventory theft or waste is determined 1/15: Returned 10 of the 1,200 units purchased for full credit on account at $27/unit.
and accounted for under both the perpetual and periodic inventory
Accounts Payable (10 @ $27/ea.) 270
accounting methods. Purchase Returns 270
1/19: Paid the net account payable due on the 1/10 purchase, net of the discount.
Accounts Payable 32,130
Cash ($32,130 x 98%) 31,487
Purchase Discounts 643
1/21: Made a $57,000 sale to a customer on account.
Accounts Receivable 57,000
Sales Revenues 57,000
1/29: Purchased and paid cash for 300 units of inventory, at $26/unit with free
shipping.
Purchases (300 @ $26/ea.) 7,800
Cash 7,800

27 28

Problem 5-3 - Answer

Problem 5-3 - Answer

B. Cost of Goods Sold (Periodic LIFO): $37,964

Cost of Goods Sold (Periodic FIFO): $37,864
Inventory
Inventory
Beginning balance 7,700
Beginning balance 7,700 Purchases 37,800
Purchases 37,800 Freight-in 2,400
Freight-in 2,400 270 Purchase returns
270 Purchase returns 643 Purchase discounts
643 Purchase discounts Goods Available 46,987
Goods Available 46,987 ? Cost of goods sold
? Cost of goods sold Ending balance 9,023
Ending balance 9,123
Cost applied to the 350 units of ending inventory:
Cost applied to the 350 units of ending inventory: 100 units @ $25/unit = $ 2,500
300 units @ $26/unit = $ 7,800 200 units @ $26/unit = $ 5,200
50 units @ $26.46/unit* = $ 1,323 50 units @ $26.46/unit* = $ 1,323
350 $ 9,123 350 $ 9,023
* ($25 + $2) X .98 = $26.46 * ($25 + $2) X .98 = $26.46

29 30

5-5
 Problem 5-3 - Answer Gross Margin Method of Estimation
C. Explain how a company's cost of inventory theft or waste is
determined and accounted for under both the perpetual and periodic The essence of the method is to estimate a company's ending
inventory accounting methods. inventory by first estimating cost of goods sold based on a
gross margin percentage.
Answer: Inventory shrinkage can be easily quantified when accounting
for inventory perpetually. This is done through a simple comparison of
the perpetual records and the physical inventory. Although discrepancies Net sales revenues $ XXX
are sometimes the result of accounting errors rather than theft or waste, Less: Cost of goods sold XXX
any adjustment required to lower the perpetual inventory records is Gross margin $ XXX % Estimate
accounted for as an expense commonly referred to as inventory
shrinkage. This would include the cost of any theft or waste.
Ending inventory (estimated):
Actual cost of goods available for sale:
Under the periodic method, inventory shrinkage can't be determined. Beginning inventory $ XXX
Without perpetual records, no comparison of what should be on hand Add: Purchases XXX
and what's actually on hand is possible. However, any costs of inventory Freight-in XXX
theft and waste are accounted for as an expense under the periodic Less: Purchase returns (XXX)
method through cost of goods sold. Because cost of goods sold is based Purchase discounts (XXX)
on the difference between the cost of goods available for sale and the
XXX
ending physical inventory balance, any cost of inventory shrinkage is
Less: Cost of goods sold (estimated) (XXX)
automatically included in this amount. It just can't be separately
distinguished. Ending inventory (estimated) $ XXX

31 32

Problem 5-4 Problem 5-4 - Answer

Inventory Estimation
Inventory Estimation A. Estimate Jonas' ending inventory and cost of goods sold for the quarter
Given the following information for Jonas, Inc for the quarter ended 3/31/X8: assuming Jonas historically prices their products to produce a 60%
gross margin.
Purchases $ 44,267
Purchase discounts $ 2,345 Cost of goods sold estimate: $33,382
Freight-out $ 2,486 Net sales revenues $83,455 100%
Beginning inventory $ 8,648 Less: Cost of goods sold 33,382 40%
Net sales revenues $ 83,455 Gross margin $50,073 60%
Purchase returns $ 1,512
Freight-in $ 3,990 Ending inventory estimate: $19,666
Inventory
A. Estimate Jonas' ending inventory and cost of goods sold for the quarter
assuming Jonas historically prices their products to produce a 60% Beginning balance 8,648
gross margin. Purchases 44,267
Freight-In 3,990
B. Given the assumptions above, what is Jonas' average markup on cost? 1,512 Purchase returns
2,345 Purchase discounts
Goods Available 53,048
33,382 Cost of goods sold
Ending balance 19,666

33 34

Problem 5-4 - Answer

Inventory Estimation FYI
B. Given the assumptions above, what is Jonas' average markup on cost? ]
Markup on cost: International accounting standards (IFRS) allow both the
FIFO and Moving Weighted Average inventory costing
Gross Margin (markup) $50,073
= = 1.5 or 150% markup methods but disallow the LIFO approach. This reflects the
Cost of Goods Sold $33,382
IASB’s emphasis on current value reporting in corporate
Given that this problem originally indicated that Jonas historically set balance sheets. (Since LIFO reflects older costs in any
sales prices to produce a 60% gross margin, then what we're really saying
is that a 150% markup on cost produces a 60% gross margin. ending inventory balance it does not reflect current values.)

As the convergence process of IFRS and U.S. accounting

standards (GAAP) continues, this difference in acceptable
methods will have to be addressed and if LIFO is ultimately
disallowed in the U.S. then Congress will also have to
address the resulting tax affects of such a change.

35 36

5-6
 Sometimes mistakes are made unintentionally
Inventory when accounting for inventory.
1/1/X5 64,000
Example: On 12/31/X5, $5,000 of inventory purchased from a supplier is
Purchases 320,000
Freight-in 10,000
received and properly counted and included in the company's ending physical
12,000 Purchase returns
inventory totaling $76,000. However, the purchase isn't recorded until 1/1/X6.
3,000 Purchase discounts Inventory
Goods Available 379,000 1/1/X5 64,000
283,000 Cost of Goods Sold Purchases 320,000
12/31/X5 96,000 Freight-in 10,000
12,000 Purchase returns
Net Income 3.000 Purchase discounts
Goods Available 379,000
Inventory 303,000 Cost of Goods Sold
1/1/X6 96,000 12/31/X5 76,000
Purchases 350,000 20X5: $5,000 overstatement of net income.
Freight-in 12,000 Inventory
15,000 Purchase returns
1/1/X6 76,000
5,000 Purchase discounts
Purchases 350,000
Goods Available 438,000
Freight-in 12,000
366,000 Cost of Goods Sold
15,000 Purchase returns
12/31/X6 72,000
5.000 Purchase discounts
Net Income Goods Available 418,000
346,000 Cost of Goods Sold
12/31/X6 72,000
20X6: $5,000 understatement of net income.
37 38

Problem 5-5
Example: Inventory costing $2,000 and selling for $3,000 is shipped FOB Effect of Inventory Errors
destination and is in transit to a customer on 12/31/X5. The sale is recorded on
12/31 and the goods excluded from the year-end physical inventory. Calculate the amount of Richin, Inc.'s net income over or understatement in
'X7 and 'X8 given the following:
20X5 20X6
a. Inventory on hand at 12/31/X7 was mistakenly excluded from the year-
Sales Revenues $3,000 $3,000 end physical inventory. The inventory cost was $1,235.
overstatement understatement
Cost of Goods Sold $2,000 $2,000 b. Goods costing $3,532 were received from a supplier on 1/1/X8 (FOB
overstatement understatement destination) but recorded as a purchase in 20X7. The goods were
Net Income $1,000 $1,000 excluded from the 12/31/X7 physical inventory.
overstatement understatement
c. Consigned goods from a supplier were included in Richin's 12/31/X7
physical inventory at a cost of $6,000.

d. Goods in transit from a supplier on 12/31/X7 were excluded from

purchases and the ending 12/31/X7 physical inventory. The goods cost
$5,245 and were shipped FOB shipping point.

e. Goods costing $3,222 in transit to a customer at 12/31/X7, FOB

destination, were recorded as a sales at their $5,486 sales price in 'X7
and excluded from the 12/31/X7 physical inventory.
39 40

Problem 5-5 - Answer

Effect of Inventory Errors

Effect of errors in 20X7 (under or overstated ):
Sales Cost of Net Ending
Revenues Goods Sold Income Inventory The performance and accuracy of a company's physical
a. 1,235 1,235 1,235
b. 3,532 3,532 inventory is the sole responsibility of management.
c. 6,000 6,000 6,000
d. 5,245 5,245 5,245
5,245 5,245 The external auditor's role is to independently review and
e. 5,486 5,486 observe the process and then spot check enough of the
3,222 3,222 3,222
3,497 (Net income overstated) actual counts so that they can express an opinion as to the
Effect of errors in 20X8 (under or overstated ): overall accuracy of the company's financial statements.
Sales Cost of Net Beginning
Revenues Goods Sold Income Inventory
a. 1,235 1,235 1,235
b. 3,532 3,532
c. 6,000 6,000 6,000
d. 5,245 5,245 5,245
5,245 5,245
e. 5,486 5,486
3,222 3,222 3,222
3,497 (Net income understated)
41 42

5-7
 Lower of Cost or Market or "LCM" Rule
Requires the use of historical cost in accounting for inventory unless
In addition to a correct inventory count, an accurate its market value has dropped below that cost.
physical inventory requires the application of an
What are market values and how are they determined?
appropriate cost to each item of inventory counted.
Ceiling Not higher than the item's current
That cost is based on specific identification, or, a LIFO, net realizable value. (The price the
FIFO or weighted average cost flow assumption, except inventory could be sold for today,
in its current condition, less any
in those cases where the inventory is damaged, obsolete,
selling costs.).
or simply worth less than it's original historical cost. In
those cases, the inventory's lower current market value is Market Value = Replacement Cost: The cost that
used. would be paid today to buy that
identical item.

Floor Not lower than its net realizable

value less a normal profit margin.

43 44

Assume a retailer of high tech consumer products has an inventory Consider the lower of cost or market value to be used for an
item on hand that cost $200, but can now be purchased for $180 due inventory item that originally sold to customers for $150, but is now
to increased competition among suppliers. Also assume the retailer technically obsolete and is currently offered at a discounted price of
can sell the product for $300, paying a 10% sales commission and just $20. The item was purchased at a cost of $90 and replacement
normally makes about a 20% profit margin on the sale of such a units, if they can be found, cost $5 or less. Assume a 10% sales
product after all other costs are considered. commission and a normal profit margin of 20% on this product.

LCM Rule: NRV $270 ($300 - $30) NRV $18 ($20 - $2)

Cost Market Value Replacement Cost $180 Cost Market Value Replacement Cost $5
$200 $210 $90 $14

NRV - Profit $210 ($270 - $60) NRV - Profit $14 ($18 - $4)

This product had a declining replacement cost but hadn't lost its
In this case the obsolete inventory is written down to what it can be
resale value in the marketplace. In this case, no write-down is
sold for, net of selling costs and a normal profit margin.
necessary given the higher expected future benefit.

45 46

Inventory Items
Assume used inventory is on hand at the end of the year that can be 1 2 3
sold for $450. Its original cost was $500 and inventory in a similar Cost per unit $200 $90 $500

"used" condition can be bought from suppliers at a cost of $350. Market value per unit $210 $14 $350
Replacement Cost $180 $5 $350
Assume a 10% sales commission and a normal profit margin of 16% NRV $270 $18 $405
on this product. NRV - Profit $210 $14 $333
LCM per unit $200 $14 $350
NRV $405 ($450 - $45)
# of units 100 10 20 Totals
Inventory at cost $20,000 $900 $10,000 $30,900
Cost Market Value Inventory at LCM $20,000 $140 $7,000 $27,140
Replacement Cost $350 Write-down (item-by-item) 0 $760 $3,000 $3,760
$500 $350
Total inventory at market: $
Replacement cost $18,000 $50 $7,000 $
NRV - Profit $333 ($405 - $72) NRV $27,000 $180 $8,100 $
NRV - Profit $21,000 $140 $6,660 $

This used inventory is written down because it's worth less than its Inventory at LCM (total inventory) $
original cost. When writing inventory down it's valued at its Write-down (total inventory) $3,100

replacement cost, but never above its resale value, net of selling costs, Loss on Inventory Write-Down 3,760
and never below that net realizable value less a normal profit Inventory 3,760

margin.

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5-8
 Inventory Items
1 2 3
Cost per unit $200 $90 $500
Market value per unit
Replacement Cost
$210
$180
$14
$5
$350
$350
FYI
NRV $270 $18 $405
NRV - Profit $210 $14 $333
U.S. GAAP does not allow the reversal of any
LCM per unit $200 $14 $350 previously recorded write-downs of inventory due to
# of units 100 10 20 Totals lower of cost or market, even when inventory values
Inventory at cost $20,000 $900 $10,000 $30,900 subsequently increase. However, under international
Inventory at LCM $20,000 $140 $7,000 $27,140
Write-down (item-by-item) 0 $760 $3,000 $3,760 accounting standards (IFRS) subsequent increases in
Total inventory at market: $27,800 inventory values may be recorded but only to the
Replacement cost $18,000 $50 $7,000 $25,050
NRV $27,000 $180 $8,100 $35,280 extent of any previously recorded losses.
NRV - Profit $21,000 $140 $6,660 $27,800

Inventory at LCM (total inventory) $27,800

Write-down (total inventory) $3,100

Adjusting Entry: Loss on Inventory Write-Down 3,760

(Item by item basis) Inventory 3,760

Adjusting Entry: Loss on Inventory Write-Down 3,100

(Total inventory basis) Inventory 3,100

49 50

Problem 5-6 Problem 5-6 - Answer

Inventory Write-Down for Lower of Cost or Market Inventory Write-Down for Lower of Cost or Market
Inventory Items
Given the following information for ZZZ Company at 12/31/X5: A B C D
Inventory Items A B C D Cost per unit $200 $100 $300 $80
Market value per unit $225 $100 $175 $70
# of units 200 150 550 300
Replacement Cost $225 $90 $250 $70
Cost per unit (FIFO) $200 $100 $300 $80 NRV $320 $160 $175 $110
Replacement cost $225 $90 $250 $70 NRV - Profit $200 $100 $125 $60
Selling price $400 $200 $275 $140 LCM per unit $200 $100 $175 $70
Selling costs $80 $40 $100 $30 # of units 200 150 550 300 Totals
Inventory at cost $40,000 $15,000 $165,000 $24,000 $244,000
Normal profit margin $120 $60 $50 $50
Inventory at LCM $40,000 $15,000 $96,250 $21,000 $172,250
Prepare the adjusting journal entries to write-down inventory to lower of cost Write-down (item-by-item) 0 0 $68,750 $3,000 $71,750
or market: Total inventory at market: $217,000
Replacement cost $45,000 $13,500 $137,500 $21,000 $217,000
A. Using the item-by-item approach. NRV $64,000 $24,000 $96,250 $33,000 $217,250
B. Using the total inventory approach. NRV - Profit $40,000 $15,000 $68,750 $12,000 $141,750
Total inventory at LCM $217,000
Questions: Write-down (total inventory) $27,000
1. Which inventory item was the primary cause of the inventory write-down
and why? What are some of the possible causes for its declining value? Loss on Inventory Write-Down 71,750
Item by item:
Inventory 71,750
2. Why do you think an inventory item's market value is not allowed to go
below its net realizable value less a normal profit margin, even if its Loss on Inventory Write-Down 27,000
Total inventory:
Inventory 27,000
replacement cost is lower?
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Problem 5-6 - Answer

Questions:
1. Which inventory item was the primary cause of the inventory write-
down and why? What are some of the possible causes for its declining
value?
Answer: Almost all of the write-down was attributable to item C. With a
net realizable value of only $175 per unit, this item is clearly worth a lot
less than its original $300 per unit cost.
Because the item's replacement cost is still relatively high, the lower net
resale value, after selling costs, is most likely due to falling customer
demand due to changing tastes rather than any physical damage to the
inventory itself.
2. Why do you think an inventory item's market value is not allowed to go
below its net realizable value less a normal profit margin, even if its
replacement cost is lower?
Answer: This floor on the market value of inventory prevents companies
from grossly overstating losses in one period in order to realize substantial
gains in the next. In some cases, company's experiencing a difficult year
will seek to maximize asset write-offs in that year. The thinking is that if
things are going to look bad, we might as well make them look really bad,
especially if those write-offs can make it easier to show higher profits upon
the sale of those assets next year.

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