Distinguish between gross profit as a percentage of cost and gross profit as a percentage of sales price.

Distinguish between gross profit as a percentage of cost and gross profit as a percentage of the sales price.

Gross profit as a percentage of sales indicates that the markup is based on selling price rather than cost; for this reason, the gross profit as a percentage of the selling price will always be lower than if based on cost.

What are the major uses of the gross profit method?

What are the major uses of the gross profit method?

The major uses of the gross profit method are: (1) it provides an approximation of the ending inventory which the auditor might use for testing validity of physical inventory count; (2) it means that a physical count need not be taken every month or quarter; and (3) it helps in determining damages caused by casualty when inventory cannot be counted.

Under what circumstances is relative sales value an appropriate basis for determining the price assigned to inventory?

Under what circumstances is relative sales value an appropriate basis for determining the price assigned to inventory?

Relative sales value is an appropriate basis for pricing inventory when a group of varying units is purchased at a single lump-sum price (basket purchase). The purchase price must be allocated in some manner or on some basis among the various units. When the units vary in size, character, and attractiveness, the basis for allocation must reflect both quantitative and qualitative aspects. A suitable basis then is the relative sales value of the units that comprise the inventory.

What approaches may be employed in applying the LCNRV procedure? Which approach is normally used and why?

What approaches may be employed in applying the LCNRV procedure? Which approach is normally used and why?

The lower-of-cost-and-net realizable value rule may be applied directly to each item or to the total of the inventory (or in some cases, to the total of the components of each major category). The method should be the one that most clearly reflects income. The most common practice is to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax requirements in some countries require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation on the statement of financial position.

Why are inventories valued at the lower-of-cost-or-net realizable value (LCNRV)? What are the arguments against the use of the LCNRV method of valuing inventories?

Why are inventories valued at the lower-of-cost-or-net realizable value (LCNRV)? What are the arguments against the use of the LCNRV method of valuing inventories?

The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required; however, when the utility of the goods included in the inventory is less than their cost, this loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower-of-cost-and-net realizable value rule arose from the accounting convention of providing for all losses and anticipating no profits.)

In accordance with the foregoing reasoning, the rule of "cost and net realizable value, whichever is lower" may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly reflects operations. The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product, alternative procedures are suitable.

The arguments against the use of the lower-of-cost-and-net realizable value method of valuing inventories include the following:

(a) The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over net realizable value) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization, a drop in net realizable value below original cost is no more a sustained loss than a rise above cost is a realized gain.
(b) A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-downs is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer.
(c) The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of the price increases.
(d) The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost in one year and at net realizable value in the next year.
(e) The lower-of-cost-and-net realizable value method values the inventory in the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize.

Why will the traditional LIFO inventory costing method and the dollar-value LIFO inventory costing method produce different inventory valuations if the composition of the inventory base changes?

Why will the traditional LIFO inventory costing method and the dollar-value LIFO inventory costing method produce different inventory valuations if the composition of the inventory base changes?

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 (fewer 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.

(a) LIFO layer.
(b) LIFO reserve.
(c) LIFO effect.
(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.

What advantage does the dollar-value method have over the specific goods approach of LIFO inventory valuation?

What advantage does the dollar-value method have over the specific goods approach of LIFO inventory valuation?

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.

What is the dollar-value method of LIFO inventory valuation?

What is the dollar-value method of LIFO inventory valuation?

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.

FIFO, average-cost, and LIFO methods are often used instead of specific identification for inventory valuation purposes. Compare these methods with the specific identification method, discussing the theoretical propriety of each method in the determination of income and asset valuation.

FIFO, average-cost, and LIFO methods are often used instead of specific identification for inventory valuation purposes. Compare these methods with the specific identification method, discussing the theoretical propriety of each method in the determination of income and asset valuation.

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 smoothies 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

Distinguish between product costs and period costs as they relate to inventory.

Distinguish between product costs and period costs as they relate to inventory.

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 labour 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.

Define "cost" as applied to the valuation of inventories.

Define "cost" as applied to the valuation of inventories.

Cost, which has been defined generally as the price paid or consideration is 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.

Where, if at all, should the following items be classified on a balance sheet?

Where, if at all, should the following items be classified on a balance sheet?

(a) Goods out on approval to customers.
(b) Goods in transit that were recently purchased f.o.b. destination.
(c) Land held by a realty firm for sale.
(d) Raw materials.
(e) Goods received on consignment.
(f) Manufacturing supplies.
(a) Inventory.

(b)
Not shown, possibly in a note to the financial statements if material.

(c) Inventory.

(d) Inventory, separately disclosed as raw materials.

(e)
Not shown, possibly a note to the financial statements.

(f) Inventory or manufacturing supplies.

What is a repurchase agreement (product financing) arrangement? How should a product repurchase agreement be reported in the financial statements?

What is a repurchase agreement (product financing) arrangement? How should a product repurchase agreement be reported in the financial statements?

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.

What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?

What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?

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

In what ways are the inventory accounts of a retailing company different from those of a manufacturing company?

In what ways are the inventory accounts of a retailing company different from those of a manufacturing company?

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.

What is the fair value option? Where do companies that elect the fair value option report unrealized holding gains and losses?

What is the fair value option? Where do companies that elect the fair value option report unrealized holding gains and losses?

The fair value option gives companies the option of using fair value as the measurement basis for financial instruments. The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. If companies choose the fair value option, the receivables are recorded at fair value, with unrealized gains or losses reported as part of net income.

Indicate three reasons why a company might sell its receivables to another company.
A company might sell receivables because money is tight and access to normal credit is not available or prohibitively expensive. Also, a company may have to sell its receivables, instead of borrowing, to avoid violating existing lending arrangements. In addition, billing and collection of receivables are often time-consuming and costly.

Indicate how the percentage-of-receivables method, based on an ageing schedule, accomplishes the objectives of the allowance method of accounting for bad debts. What other methods, besides an ageing analysis, can be used for estimating uncollectible accounts?

Indicate how the percentage-of-receivables method, based on an ageing schedule, accomplishes the objectives of the allowance method of accounting for bad debts. What other methods, besides an ageing analysis, can be used for estimating uncollectible accounts?

The percentage of receivables method based on an aging schedule calculates each year's debit to the expense account and credit to the allowance account by evaluating the collectability of open accounts receivable at the close of the year. An analysis of the accounts according to their due dates is a common procedure. For each of the age categories established in the analysis, average percentage rates may be developed on the basis of past experience and applied to the accounts in the respective age categories. This method may also utilize individual analysis for some accounts, especially those that are considerably past due, in arriving at estimated uncollectible receivables. On the basis of the foregoing analysis the balance in the valuation account is then adjusted to the amount estimated to be uncollectible.

This method of providing for uncollectible accounts is quite accurate for purposes of reporting accounts receivable at their estimated net realizable value in the balance sheet. From the stand-point of the income statement, however, the aging method may not match accurately bad debt expenses with the sales which caused them because the charge to bad debt expense is not based on sales. The accuracy of both the charge to bad debt expense and the reported value of receiv-ables depends on the current estimate of uncollectible accounts. The accuracy of the expense charge, however, is additionally dependent upon the timing of actual write-offs.

Other methods that companies may use employ estimates based on historical loss ratios for customers with different credit ratings as a basis for estimating uncollectible accounts. Or a company may utilize a probability-weighted discounted cash flow model (as illustrated in Chapter 6) to estimate expected credit losses.

What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts?

What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts?

The theoretical superiority of the allowance method over the direct write-off method of accounting for bad debts is two-fold. First, since revenue is considered to be recognized at the point of sale on the assumption that the resulting receivables are valid liquid assets merely awaiting collection, periodic income will be overstated to the extent of any receivables that eventually become uncollectible. The proper matching of revenue and expense requires that gross sales in the income statement be partially offset by a charge to bad debt expense that is based on an estimate of the receivables arising from gross sales that will not be converted into cash.

Second, accounts receivable on the balance sheet should be stated at their estimated net realizable value. The allowance method accomplishes this by deducting from gross receivables the allowance for doubtful accounts. The latter is derived from the charges for bad debt expense on the income statement.

What are the basic problems that occur in the valuation of accounts receivable?

What are the basic problems that occur in the valuation of accounts receivable?

The basic problems that relate to the valuation of receivables are (1) the determination of the face value of the receivable, (2) the probability of future collection of the receivable, and (3) the length of time the receivable will be outstanding. The determination of the face value of the receivable is a function of the trade discount, cash discount, and certain allowance accounts such as the Allowance for Sales Returns and Allowances.

What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?

What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?

Two methods of recording accounts receivable are:

1. Record receivables and sales gross.
2. Record receivables and sales net.

The net method is desirable from a theoretical standpoint because it values the receivable at its net realizable value. In addition, recording the sales at net provides a better assessment of the revenue that was recognized from the sale of the product. If the purchasing company fails to take the discount, then the company should reflect this amount as income. The gross method for receivables and sales is used in practice normally because it is expedient and its use does not generally have any significant effect on the presentation of the financial statements.