The original cost of an inventory item is above the replacement
cost and the net realizable value. The replacement cost is
below the net realizable value less the normal profit margin. As a
result, under the lower of cost or market method, the inventory
item should be reported at the
(b) Inventory is priced at market when market value is
less than cost. Market value is defined as current replacement cost,
subject to a ceiling of net realizable value (NRV) and a floor of net
realizable value minus a normal profit margin.
In this situation, replacement cost lies outside of (below) the floor
and ceiling limitations. Therefore, NRV less a normal profit margin
(the floor), will be used as the market to determine LCM.
Since original cost is greater than market, market will be used to
price the inventory for the period.
On January 1, year 2, Card Corp. signed a three-year noncancelable
purchase contract, which allows Card to purchase up
to 500,000 units of a computer part annually from Hart Supply
Co. at $.10 per unit and guarantees a minimum annual purchase
of 100,000 units. During year 2, the part unexpectedly became
obsolete. Card had 250,000 units of this inventory at December
31, year 2, and believes these parts can be sold as scrap for
$.02 per unit. What amount of probable loss from the purchase
commitment should Card report in its year 2 income statement?
(c) The requirement is to determine the amount of probable
loss from the purchase commitment that Card should report
in its year 2 income statement. When there is a decline in market
value below the contract price at the balance sheet date and the
contract is noncancelable, an unrealized loss should be recorded in
the period of decline and reported in the income statement. In this
case, Card has a contract to purchase a minimum of 100,000 units
both in year 3 and year 4 at $.10 per unit. The $20,000 loss
(200,000 × $.10) on these obsolete units should be reduced by the
amount Card believes is realizable from the sale of these units.
Therefore, the loss on purchase commitment is $16,000
[$20,000 – (200,000 × .02)]. Additionally, Card Corp. would
need to record a loss of $20,000 ($.08 × 250,000) from inventory
Thread Co. is selecting its inventory system in preparation
for its first year of operations. Thread intends to use either the
periodic weighted-average method or the perpetual movingaverage
method, and to apply the lower of cost or market rule
either to individual items or to the total inventory. Inventory
prices are expected to generally increase throughout year 2, although
a few individual prices will decrease. What inventory
system should Thread select if it wants to maximize the inventory
carrying amount at December 31, year 2?
Cost or market application
(a) To maximize its inventory carrying amount at
December 31, year 2, Thread should use the perpetual movingaverage
method with the lower of cost or market rule applied to
the total inventory. First, when using the perpetual movingaverage
method, the cost of sales throughout the year are determined
using the average cost of purchases up to the time of the
sale. On the other hand, under the periodic weighted-average
method, the cost of each item is the weighted-average of all units
purchased during the year. During a period of rising prices, the
perpetual moving-average method results in a lower cost of goods
sold and a higher ending inventory because the cost of items sold
throughout the year is the average of the earlier, lower prices. Second,
the application of the lower of cost or market rule to the total
inventory will result in a higher ending inventory because market
values lower than cost are offset against market values higher than
A company decided to change its inventory valuation
method from FIFO to LIFO in a period of rising prices. What
was the result of the change on ending inventory and net income
in the year of the change?
Ending inventory Net income
(c) In a change to LIFO, no recognition is given to any
cumulative effect associated with the change because it is usually
not determinable. Thus, the effect on ending inventory and net
income is the result solely of current year effects. In a period of
rising prices, LIFO will result in a lower ending inventory
amount than FIFO because the earlier lower costs are assumed to
remain in ending inventory. LIFO will also result in a lower net
income because the more recent higher costs are assigned to cost
of goods sold.
Generally, which inventory costing method approximates
most closely the current cost for each of the following?
Cost of goods sold Ending inventory
(a) The inventory costing method which most closely
approximates the current cost for cost of goods sold is LIFO, while
the method which more accurately reflects ending inventory is
FIFO. Under LIFO, the most recent purchases are assumed to be
the first goods sold; thus, cost of goods sold contains relatively
current costs. On the other hand, since FIFO assumes that the
goods from beginning inventory and the earliest purchases are sold
first, the ending inventory is made up of more recent purchases
and thus represents a more current value.
During periods of rising prices, a perpetual inventory system
would result in the same dollar amount of ending inventory as a
periodic inventory system under which of the following inventory
cost flow methods?
(a) Under the FIFO method, the first goods purchased
are considered to be the first goods used or sold. Ending inventory
is thus made up of the latest (most recent) purchases. Whenever
the FIFO method is used, the ending inventory is the same
whether a perpetual or periodic system is used. This is true even
during periods of rising or falling prices because the inventory flow
is always in chronological order. Under the LIFO method, the
latest (most recent) purchases are considered to be the first goods
used or sold. Ending inventory is thus made up of the first (oldest)
purchases. When a periodic method is used, the first/last purchase
determination is made only at the end of the year, based upon the
actual chronological order of all purchases. When a perpetual
method is used, however, the first/last purchase determination is
made continuously throughout the year. When inventory levels
get low under the perpetual method, early purchase costs will often
be assigned to goods sold, a situation that is much less likely to
occur in a periodic system. Therefore, in times of either rising or
falling prices, LIFO ending inventory is usually different under a
periodic system than under a perpetual system.
Estimates of price-level changes for specific inventories are
required for which of the following inventory methods?
(b) The requirement is to determine which inventory
method requires estimates of price level changes for specific inventories.
In accordance with the dollar-value LIFO method, the
ending inventory is first converted to the base year cost so that the
incremental layers can be determined. The incremental layers are
then restated using the price index which was in effect at the time
each of the layers were added to the inventory. Thus, the specific
layers of the ending inventory are adjusted to the current price
level. Therefore, answer (b) is correct. Answers (a), (c), and (d)
are incorrect because these methods do not specifically adjust for
price level changes.
When the double-extension approach to the dollar-value
LIFO inventory method is used, the inventory layer added in the
current year is multiplied by an index number. Which of the
following correctly states how components are used in the calculation
of this index number?
(b) The requirement is to determine the appropriate use
of ending inventory at current year cost and ending inventory at
base year cost in calculating the dollar-value LIFO index. The
index number used to convert the current year’s inventory layer is
calculated as follows:
Ending inventory at current year cost
Ending inventory at base year cost
This index indicates the relationship between current and base
year prices as a percentage, and when multiplied by the new layer
(which is the increase in inventory in base year dollars), it will
convert the layer to current dollars.
Jones Wholesalers stocks a changing variety of products.
Which inventory costing method will be most likely to give Jones
the lowest ending inventory when its product lines are subject to
specific price increases?
(c) During periods of rising prices, the inventory costing
methods which will give Jones the lowest ending inventory balance are LIFO methods, because inventory items that were purchased
at the earliest date (when prices were lower) will remain in inventory
and the most recently purchased and more expensive items
will be expensed through cost of goods sold. Any FIFO method
will produce a higher ending inventory balance during inflation
since the items purchased earliest (at lower prices) will be expensed
through CGS, while the more expensive items remain in
inventory. Answers (a) and (b) are incorrect because neither will
give Jones a lower ending inventory balance than dollar-value
LIFO, particularly as Jones’ inventory changes (because dollarvalue
LIFO allows the LIFO “layers” to be made up of similar, not
necessarily identical, items).
Dart Company’s accounting records indicated the following
Inventory, 1/1/Y2 $ 500,000
Purchases during year 2 2,500,000
Sales during year 2 3,200,000
A physical inventory taken on December 31, year 2, resulted in
an ending inventory of $575,000. Dart’s gross profit on sales has
remained constant at 25% in recent years. Dart suspects some
inventory may have been taken by a new employee. At December
31, year 2, what is the estimated cost of missing inventory?
(a) The gross profit method can be used to estimate the
cost of missing inventory. The first step is to compute the cost of
goods available for sale.
Beginning inventory $ 500,000
Cost of goods available for sale $3,000,000
The second step is to estimate cost of goods sold based on the
gross profit percentage.
Estimated gross profit ($3,200,000 × 25%) (800,000)
Cost of goods sold ($3,200,000 × 75%) $2,400,000
Note that a shortcut is to realize that if gross profit is 25% of sales,
cost of goods sold must be 75% of sales. The third step is to compute
estimated ending inventory.
Cost of goods available for sale $ 3,000,000
Estimated cost of goods sold (2,400,000)
Estimated ending inventory $ 600,000
Since the actual count of ending inventory at December 31 was
only $575,000, the estimated shortage in inventory is $25,000
($600,000 – $575,000).