Ch. 8 Valuation of Inventories A Cost - Basis Approach Answers to Questions

ANSWERS TO QUESTIONS 1. In a retailing concern, inventory normally consists of only one category that is the product awaiting resale. In a manufacturing company, inventories consist of raw materials, work in process, and finished goods. Sometimes a manufacturing or factory supplies inventory account is also included. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 2. (a) Inventories are unexpired costs and represent future benefits to the owner. A statement of financial position includes a listing of all unexpired costs (assets) at a specific point in time. Because inventories are assets owned at the specific point in time for which a statement of financial position is prepared, they must be included in order that the owners’ financial position will be presented fairly. (b) Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues recognized during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 3. In a perpetual inventory system, data are available at any time on the quantity and dollar amount of each item of material or type of merchandise on hand. A physical inventory is a physical count of inventory on hand at a point in time. In a periodic system, the inventory is periodically counted (at least once a year) but that up-to-date records are not necessarily maintained. Discrepancies often occur between the physical count and the perpetual records because of clerical errors, theft, waste, misplacement of goods, etc. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 4. No, Mishima, Inc. should not report this amount on its balance sheet. As consignee, it does not own this merchandise and therefore it is inappropriate for it to recognize this merchandise as part of its inventory. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analysis, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 5. Repurchase agreements (product financing arrangements) are essentially off-balance-sheet financing devices. These arrangements make it appear that a company has sold its inventory or never taken title to it so they can keep loans off their balance sheets. A repurchase agreements arrangement should not be recorded as a sale. Rather, the inventory and related liability should be reported on the balance sheet. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 6. (a) (b) (c) (d) (e) (f) Inventory. Not shown, possibly in a note to the financial statements if material. Inventory. Inventory, separately disclosed as raw materials. Not shown, possibly a note to the financial statements. Inventory or manufacturing supplies. LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB:, AICPA BB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC:, AICPA BB: None 8-5 7. Cost, which has been defined generally as the price paid or consideration given to acquire an asset, is the primary basis for accounting for inventories. As applied to inventories, cost means the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and production costs but exclude all selling expenses and that portion of general and administrative expenses not clearly related to production. Freight charges applicable to the product are considered a cost of the goods. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication 8. By their nature, product costs “attach” to the inventory and are recorded in the inventory account. These costs are directly connected with the bringing of goods to the place of business of the buyer and converting such goods to a salable condition. Such charges would include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs are not considered to be directly related to the acquisition or production of goods and therefore are not considered to be a part of inventories. Conceptually, these expenses are as much a cost of the product as the initial purchase price and related freight charges attached to the product. While selling expenses are generally considered as more directly related to the cost of goods sold than to the unsold inventory, in most cases, though, the costs, especially administrative expenses, are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary. Interest costs are considered a cost of financing and are generally expensed as incurred, when related to getting inventories ready for sale. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication 9. Cash discounts (purchase discounts) should not be accounted for as financial income when payments are made. Income should be recognized when the performance obligation is satisfied (when the company sells the inventory). Furthermore, a company does not recognize revenue from purchasing goods. Cash discounts should be considered as a reduction in the cost of the items purchased. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication 10. $60.00, $63.00, $61.80*. (Freight-In not included for discount.) * $63.00 − ($60 .02) = $61.80 LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB:, AICPA BB: None, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC:, AICPA BB: None 11. Arguments for the specific identification method are as follows: (1) It provides an accurate and ideal matching of costs and revenues because the cost is specifically identified with the sales price. (2) The method is realistic and objective since it adheres to the actual physical flow of goods rather than an artificial flow of costs. (3) Inventory is valued at actual cost instead of an assumed cost. Arguments against the specific identification method include the following: (1) The cost of using it restricts its use to goods of high unit value. (2) The method is impractical for manufacturing processes or cases in which units are commingled and identity lost. (3) It allows an artificial determination of income by permitting arbitrary selection of the items to be sold from a homogeneous group. (4) It may not be a meaningful method of assigning costs in periods of changing price levels. 8-6 LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB:, AICPA BB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC:, AICPA BB: None 12. The first-in, first-out method approximates the specific identification method when the physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or deterioration, FIFO is particularly appropriate. In comparison to the specific identification method, an attractive aspect of FIFO is the elimination of the danger of artificial determination of income by the selection of advantageously priced items to be sold. The basic assumption is that costs should be charged in the order in which they are incurred. As a result, the inventories are stated at the latest costs. Where the inventory is consumed and valued in the FIFO manner, there is no accounting recognition of unrealized gain or loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations upon reported income because current revenue is matched with the oldest costs which are probably least similar to current replacement costs. On the other hand, this method produces a balance sheet value for the asset close to current replacement costs. It is claimed that FIFO is deceptive when used in a period of rising prices because the reported income is not fully available since a part of it must be used to replace inventory at higher cost. The results achieved by the average-cost method resemble those of the specific identification method where items are chosen at random or there is a rapid inventory turnover. Compared with the specific identification method, the average-cost method has the advantage that the goods need not be individually identified; therefore accounting is not so costly and the method can be applied to fungible goods. The average-cost method is also appropriate when there is no marked trend in price changes. In opposition, it is argued that the method is illogical. Since it assumes that all sales are made proportionally from all purchases and that inventories will always include units from the first purchases, it is argued that the method is illogical because it is contrary to the chronological flow of goods. In addition, in periods of price changes there is a lag between current costs and costs assigned to income or to the valuation of inventories. If it is assumed that actual cost is the appropriate method of valuing inventories, last-in, first-out is not theoretically correct. In general, LIFO is directly adverse to the specific identification method because the goods are not valued in accordance with their usual physical flow. An exception is the application of LIFO to piled coal or ores which are more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better matching of current costs and revenues. During periods of sharp price movements, LIFO has a stabilizing effect upon reported income figures because it eliminates paper income and losses on inventory and smoothes the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figures can be artificially influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 13. A company may obtain a price index from an outside source (external index)—the government, a trade association, an exchange—or by computing its own index (internal index) using the double extension method. Under the double extension method the ending inventory is priced at both base-year costs and at current-year costs, with the total current cost divided by the total base cost to obtain the current year index. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 8-7 14. Under the double extension method, LIFO inventory is priced at both base-year costs and currentyear costs. The total current-year cost of the inventory is divided by the total base-year cost to obtain the current-year index. The index for the LIFO pool consisting of product A and product B is computed as follows: Base-Year Cost Product Units Unit Total A 25,500 $10.20 $260,100 B 10,350 $37.00 382,950 December 31, 2017 inventory $643,050 Current-Year Cost Base-Year Cost = $1,007,460 $643,050 Current-Year Cost Unit Total $21.00 $ 535,500 $45.60 471,960 $1,007,460 = 156.67, index at 12/31/17. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analysis, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication 15. The LIFO method results in a smaller net income because later costs, which are higher than earlier costs, are matched against revenue. Conversely, in a period of falling prices, the LIFO method would result in a higher net income because later costs in this case would be lower than earlier costs, and these later costs would be matched against revenue. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 16. The dollar-value method uses dollars instead of units to measure increments, or reductions in a LIFO inventory. After converting the closing inventory to the same price level as the opening inventory, the increases in inventories, priced at base-year costs, is converted to the current price level and added to the opening inventory. Any decrease is subtracted at base-year costs to determine the ending inventory. The principal advantage is that it requires less record-keeping. It is not necessary to keep records or make calculations of opening and closing quantities of individual items. Also, the use of a base inventory amount gives greater flexibility in the makeup of the base and eliminates many detailed calculations. The unit LIFO inventory costing method is applied to each type of item in an inventory. Any type of item removed from the inventory base (e.g., magnets) and replaced by another type (e.g., coils) will cause the old cost (magnets) to be removed from the base and to be replaced by the more current cost of the other item (coils). The dollar-value LIFO costing method treats the inventory base as being composed of a base of cost in dollars rather than of units. Therefore, a change in the composition of the inventory (less magnets and more coils) will not change the cost of inventory base so long as the amount of the inventory stated in base-year dollars does not change. LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 17. (a) LIFO layer—a LIFO layer (increment) is formed when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices. (b) LIFO reserve—the difference between the inventory method used for internal purposes and LIFO. (c) LIFO effect—the change in the LIFO reserve (Allowance to Reduce Inventory to LIFO) from one period to the next. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 8-8 18. December 31, 2017 inventory at December 31, 2016 prices, $1,053,000 ÷ 1.08............ $975,000 Less: Inventory, December 31, 2016.............................................................................. 800,000 Increment added during 2017 at base prices.................................................................. $175,000 Increment added during 2017 at December 31, 2017 prices, $175,000 X 1.08............... $189,000 Add:Inventory at December 31, 2016............................................................................. 800,000 Inventory, December 31, 2017, under dollar-value LIFO method.................................... $989,000 LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 19. Phantom inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The cost of goods sold therefore is understated and profit is considered overstated. Phantom profits are said to occur when FIFO is used during periods of rising prices. High inventory profits through involuntary liquidation occur if a company is forced to reduce its LIFO base or layers. If the base or layers of old costs are eliminated, strange results can occur because old, irrelevant costs can be matched against current revenues. A distortion in reported income for a given period may result, as well as consequences that are detrimental from an income tax point of view. LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 20. This omission would have no effect upon the net income for the year, since the purchases and the ending inventory are understated in the same amount. With respect to financial position, both the inventory and the accounts payable would be understated. Materiality would be a factor in determining whether an adjustment for this item should be made as omission of a large item would distort the amount of current assets and the amount of current liabilities. It, therefore, might influence the current ratio to a considerable extent. LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 8-9