9

Inventories: Additional
Valuation Issues

CHAPTER LEARNING OBJECTIVES

1. Describe and apply the lower-of-cost-or-net realizable value rule.

2. Describe and apply the lower-of-cost-or-market rule.
3. Identify other inventory valuation issues.
4. Determine ending inventory by applying the gross profit method.
5. Determine ending inventory by applying the retail inventory method.
6. Explain how to report and analyze inventory.

7. Determine ending inventory by applying the LIFO retail methods.
*8. Compare the accounting procedures related to valuation of inventories under GAAP and
IFRS.

CHAPTER REVIEW

1. Chapter 9 concludes the discussion of inventories by addressing certain unique valuation

problems not covered in Chapter 8. Chapter 9 also includes a description of the development and
use of various estimation techniques used to value ending inventory without a physical count.

Lower-of-Cost-or-Net Realizable Value (LCNRV)

2. (L.O. 1) Inventories are recorded at their cost. However, if inventory declines in value
below its original cost, a major departure from the historical cost principle occurs. Whatever the
reason for a decline—a company should write down the inventory to net realizable value to report
this loss.
3. The term net realizable value (NRV) refers to the net amount that a company expects to
realize from the sale of inventory. Specifically, NRV is the estimated selling price in the ordinary
course of business, less reasonably predictable costs of completion, disposal, and transportation.

Methods of Applying LCNRV

4. Companies may apply the LCNRV rule either directly to each item, to each category, or to
the total of the inventory. If a company follows a major category or total inventory approach in
applying the LCNRV rule, increases in selling prices tend to offset decreases in selling prices.
Companies usually price inventory on an item-by-item basis. In fact, tax rules require that
companies use an individual-item approach barring practical difficulties. In addition, the individual-


Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
9-2 Student Study Guide for Intermediate Accounting, 17th Edition

item approach gives the most conservative valuation for balance sheet purposes. Whichever
method a company selects, it should apply the method consistently from one period to another.

Recording NRV Instead of Cost

5. One of two methods may be used to record the income effect of valuing inventory at NRV.
One method, referred to as the cost-of-goods-sold method, debits cost of goods sold for the
write-down of the inventory to net realizable value. As a result, the company does not report a
loss in the income statement because the cost of goods sold already includes the amount of the
loss. The second method, referred to as the loss method, debits a loss account for the write-
down of the inventory to NRV.

Use of an Allowance

6. Instead of crediting the Inventory account for market adjustments, companies generally
use an allowance account, often referred to as Allowance to Reduce Inventory to NRV. Use of the
allowance account results in reporting both the cost and the NRV of the inventory. With respect to
accounting for the allowance in the subsequent period, if the company still has on hand the
merchandise in question, it should retain the allowance account. If it does not keep the account,
the company will overstate beginning inventory and cost of goods sold. However, if the company
has sold the goods, then it should close the account. It then establishes a “new allowance
account” for any decline in inventory value that takes place in the current year.
7. In general, accountants leave the allowance account on the books. They merely adjust the
balance at the next year-end to agree with the discrepancy between cost and lower-of-cost-or-net
realizable value at that balance sheet date. Thus, if prices are falling, the company records an
additional write-down. If prices are rising, the company records an increase in income.

Lower-of-Cost-or-Market (LCM)

8. (L.O. 2) Companies that use the LIFO or retail inventory methods are allowed to use a
lower-of-cost-or-market (LCM) approach. This approach begins with replacement cost, then
applies two additional limitations to value ending inventory—net realizable value and net
realizable value less a normal profit margin. Net realizable value (NRV) is the estimated selling
price in the ordinary course of business, less reasonably predictable costs of completion and
disposal (often referred to as net selling price). A normal profit margin is subtracted from that
amount to arrive at net realizable value less a normal profit margin. In general: A company values
inventory at the lower-of-cost-or-market, with market limited to an amount that is not more than
net realizable value or less than net realizable value less a normal profit margin.
9. For example, consider the following illustration.
Inventory at sales value $800
Less: Cost to complete and sell 200
Net realizable value (NRV) 600
Less: Normal markup 100
NRV less normal markup $500
To arrive at the final inventory valuation, market value must be determined and then compared
to cost. Market value is determined by comparing replacement cost of the inventory with the
upper and lower limits. If replacement cost of the inventory in the example is $550, then $550 is
compared to cost in determining lower of cost or market because replacement cost falls between
 Chapter 9: Inventories: Additional Valuation Issues 8-3

the upper ($600) and lower ($500) limits. If replacement cost of the inventory is $650, it would
exceed the upper limit; thus the upper limit ($600) would be compared to cost in determining
lower of cost or market. Similarly, if replacement cost of the inventory is $450, it would be lower
than the lower limit and thus the lower limit ($500) would be compared to cost in determining
lower of cost or market. The amount that is compared to cost, often referred to as designated
market value, is always the middle value of the three amounts: replacement cost, net realizable
value, and net realizable value less a normal profit margin.
10. The cost or market rule may be applied (a) directly to each item, (b) to each category, or
(c) to the total inventory. The individual-item approach is preferred by many companies because,
as indicated before, tax rules require its use when practical, and it produces the most
conservative inventory valuation on the balance sheet. When inventory is written down to market,
this new basis is considered to be the cost basis for future periods. The method selected should
be the one that most clearly reflects income.
11. (L.O. 3) Recording inventory at net realizable value, even it that amount is above cost, is
acceptable in certain instances. To be accorded this treatment, the item should (a) have a
controlled market with a quoted price applicable to all quantities (b) have no significant disposal
costs, and (c) have a product that is available for immediate delivery. Certain minerals sold in a
controlled market and agricultural products that are marketable at fixed prices provide examples
of inventory items carried at net realizable value.
12. When a group of varying inventory items is purchased for a lump sum price, a problem
exists relative to the cost per item. The relative sales value method apportions the total cost to
individual items on the basis of the selling price of each item.

Purchase Commitments

13. Purchase commitments represent contracts for the purchase of inventory at a specified
price in a future period. If material, the details of the contract should be disclosed in a note of the
buyer’s balance sheet. If the contract price is in excess of the market price and it is expected that
losses will occur when the purchase is effected, the loss should be recognized in the period
during which the market decline took place.

The Gross Profit Method

14. (L.O. 4) The gross profit method is used to estimate the amount of ending inventory. Its
use is not appropriate for financial reporting purposes; however, it can serve a useful purpose
when an approximation of ending inventory is needed. Such approximations are sometimes
required by auditors or when inventory and inventory records are destroyed by fire or some other
catastrophe. The gross profit method should never be used as a substitute for a yearly physical
inventory unless the inventory has been destroyed. The gross profit method is based on the
assumptions that (a) the beginning inventory plus purchases equal total goods to be accounted
for; (b) goods not sold must be on hand; and (c) if sales, reduced to cost, are deducted from the
sum of the opening inventory plus purchases, the result is the ending inventory.

The Retail Inventory Method

15. (L.O. 5) The retail inventory method is an inventory estimation technique based upon an
observable pattern between cost and sales price that exists in most retail concerns. This method
requires that a record be kept of (a) the total cost and retail of goods purchased, (b) the total cost
and retail value of the goods available for sale, and (c) the sales for the period.
9-4 Student Study Guide for Intermediate Accounting, 17th Edition

16. Basically, the retail method requires the computation of the cost-to-retail ratio of
inventory available for sale. This ratio is computed by dividing the cost of the goods available for
sale by the retail value (selling price) of goods available for sale. Once the ratio is determined,
total sales for the period are deducted from the retail value of inventory available for sale. The
resulting amount represents ending inventory priced at retail. When this amount is multiplied by
the cost to retail ratio, an approximation of the cost of ending inventory results. Use of this
method eliminates the need for a physical count of inventory each time an income statement is
prepared. However, physical counts are made at least yearly to determine the accuracy of the
records and to avoid overstatements due to theft, loss, and breakage.
17. To obtain the appropriate inventory figures under the retail inventory method, proper
treatment must be given to markups, markup cancellations, markdowns, and markdown
cancellations.
18. When the cost to retail ratio is computed after net markups (markups less markup
cancellations) have been added, the retail inventory method approximates lower of cost or
market. This is known as the conventional retail inventory method. If both net markups and net
markdowns are included before the cost to retail ratio is computed, the retail inventory method
approximates cost.
19. The retail inventory method becomes more complicated when such items as freight-in,
purchase returns and allowances, and purchase discounts are involved. In essence, the
treatment of the items affecting the cost column of the retail inventory approach follows the
computation of cost of goods available for sale. Freight costs are treated as a part of the
purchase cost; purchase returns and allowances are ordinarily considered a reduction of the price
at both cost and retail; and purchase discounts usually are considered as a reduction of the cost
of purchases.
20. Other items that require careful consideration include transfers-in, normal shortages,
abnormal shortages, and employee discounts. Transfers-in from another department should
be reported in the same way as purchases from an outside enterprise. Normal shortages should
reduce the retail column because these goods are no longer available for sale. Abnormal
shortages should be deducted from both the cost and retail columns and reported as a special
inventory amount or as a loss. Employee discounts should be deducted from the retail column in
the same way as sales.
21. The retail inventory method is widely used (a) to permit the computation of net income
without a physical count of inventory, (b) as a control measure in determining inventory
shortages, (c) in regulating quantities of inventory on hand, and (d) for insurance information.

Presentation and Analysis

22. (L.O. 6) Inventories normally represent one of the most significant assets held by a
business entity. Therefore, the accounting profession has mandated certain disclosure
requirements related to inventories. Some of the disclosure requirements include: the
composition of the inventory, the inventory financing, the inventory costing methods employed,
and whether costing methods have been consistently applied. Two common financial ratios used
to analyze inventory are (1) the inventory turnover ratio and (2) the average days to sell inventory.

LIFO Retail

*23. (L.O. 7) Many accountants suggest a LIFO assumption be adopted for use with the
application of the retail inventory method. Use of LIFO in connection with the retail inventory
 Chapter 9: Inventories: Additional Valuation Issues 8-5

method is thought to result in a better matching of costs and revenues. The application of LIFO
retail is made under two assumptions (a) stable prices, and (b) fluctuating prices. Because the
LIFO method is a cost method, not a cost or market approach, both the markups and markdowns
must be considered in obtaining the proper cost to retail percentage. Beginning inventory is
excluded from the computation of the cost to retail percentage because of the layer effect that
results from the use of the LIFO method.
*24. If changes in the price level occur, the effect of such changes must be eliminated when
using the LIFO retail method. If an enterprise wishes to change from conventional retail to LIFO
retail, the beginning inventory must be restated to conform with the LIFO assumption. In effecting
the change, the inventory of the prior period must be recomputed on the LIFO basis. This amount
then serves as the beginning inventory for the LIFO retail method applied in the current period.
The advantages and disadvantages of the lower-of-cost-or-market method (conventional retail)
versus LIFO retail are the same as for nonretail operations. In the final analysis, the ultimate
decision concerning which retail inventory method to use is often based on the method that
results in the lower taxable income.

IFRS Insights

*25. (L.O. 8) IFRS prohibits the use of LIFO for inventory valuation, whereas GAAP permits its
use. In the lower-of-cost-or-market test for inventory valuation, IFRS does not have an exception
to the LCNRV rule for the LIFO or retail inventory methods, whereas GAAP permits the use of
lower-of-cost-or-market (LCM) rule. Under GAAP, if inventory is written down under the LCNRV
or lower-of-cost-or-market valuations, the new basis is now considered its cost; under IFRS, the
write down may be reversed in a subsequent period up to the amount of the previous write down.
IFRS requires both biological assets and agricultural produce at the point of harvest to be
reported at net realizable value; GAAP differs.

GLOSSARY

Cost-to-retail ratio. Total goods available for sale at cost divided by the total
goods available at retail.
*Dollar-value LIFO retail method. A method of estimating the cost of ending inventory by
calculating the dollar increase in retail inventory layers with
price indexes.
Gross profit method. A method for estimating the ending inventory.
*LIFO retail method. A method of estimating the cost of ending inventory which
excludes the beginning inventory in the cost-to-retail ratio.
Lower (floor) limit. In applying the lower-of-cost-of-market method, the market
cannot be valued less than net realizable value less a
normal profit margin.
Lower of cost or market (LCM). A basis whereby inventory is stated at the lower of cost or
market (current replacement cost).
Markdown. A decrease below the original retail price.
Markdown cancellation. An increase in the selling price that follows a markdown. A
markdown cancellation will never increase the selling price
9-6 Student Study Guide for Intermediate Accounting, 17th Edition

above the original retail price.

Markup. An increase above the original retail price.
Markup cancellation. A decrease in the selling price of an item that had been
previously marked up above the original retail price. A
markup cancellation will never reduce the selling price
below the original retail price.
Net realizable value. The estimated selling price in the ordinary course of
business less reasonably predictable costs of completion,
disposal, and transportation.
Original retail price. The price at which the item was originally marked for sale.
Purchase commitments. Agreements to buy inventory weeks, months, years in
advance.
Retail inventory method. A method used to estimate the cost of the ending inventory
by applying a cost to retail ratio to the ending inventory at
retail.
Upper (ceiling) limit. In applying the lower-of-cost-or-market method, the market
cannot be valued more than net realizable value.
 Chapter 9: Inventories: Additional Valuation Issues 8-7

CHAPTER OUTLINE

Fill in the outline presented below.

(L.O. 1) Lower-of-Cost-or-Net Realizable Value

(L.O. 2) Lower of Cost or Market—Ceiling and Floor

(L.O. 3) Valuation Using Net Realizable Value or Relative Sales Value

Purchase Commitments

(L.O. 4) The Gross Profit Method of Estimating Inventory

Computation of Gross Profit Percentage

(L.O. 5) The Retail Inventory Method

Conventional Method—With Markups and Markdowns

(L.O. 6) Presentation and Analysis of Inventories

*(L.O. 7) Dollar-Value LIFO Retail Method—Stable Prices

*Dollar-Value LIFO Retail Method—Fluctuating Prices

*(L.O. 8) IFRS Insights

9-8 Student Study Guide for Intermediate Accounting, 17th Edition

DEMONSTRATION PROBLEMS

1. (L.O. 1) Presented below is information related to Schwarz’s inventory.

(per unit) Tables Chairs Rugs
Historical cost $200 $50 $ 80
Selling price 253 54 86
Cost to sell 24 12 13
Cost to complete 18 6 2
Determine the following: (a) the net realizable value for each item, and (b) the carrying value of
each item under LCNRV.
Solution:
(per unit) Tables Chairs Rugs
net realizable value $211 $36 $71
carrying value 200 36 71
2. (L.O. 2) Determine the lower of cost or market inventory valuation on the basis of the
following facts: quantity, 1,500 units; cost per unit, $4.45; replacement cost, $4.40; selling price,
$5.75; cost to complete and sell, $.65; normal profit, $1.00.
Solution:
Upper Limit: Selling price $5.75
Less cost to complete and sell .65
Net realizable value (upper limit) $5.10

Lower Limit: Net realizable value (NRV) $5.10

Less normal profit 1.00
NRV less profit (lower limit) $4.10
Decision rule: 1. If replacement cost is between the upper ($5.10) and lower ($4.10) limits,
compare replacement cost to cost in deciding on the lower of cost or market. In the problem
above, replacement cost ($4.40) is between the upper and lower limits, so it would be compared
to cost ($4.45) and inventory would be valued at the lower ($4.40) of these two numbers.
2. If replacement cost exceeds the upper limit, then the upper limit is used to
compare to cost in determining LCM.
3. If replacement cost is lower than the lower limit, then the lower limit is used
to compare to cost in determining LCM.
 Chapter 9: Inventories: Additional Valuation Issues 8-9

3. (L.O. 4) Compute the approximate ending inventory for the Fox Department Store assuming:
beginning inventory (cost), $85,000; purchases (cost), $226,000; sales at selling price, $345,000;
average gross profit rate on selling prices is 38%.
Solution:
Beginning inventory $ 85,000
Purchases 226,000
Goods available 311,000
Sales $345,000
Less gross profit 131,100*
Sales at cost 213,900
Approximate ending inventory $ 97,100
*(38% × $345,000)

REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.
_____ 1. (L.O. 1) Net realizable value is the estimated selling price in the ordinary course of
business, less reasonably predictable costs of completion, disposal, and
transportation.
_____ 2. (L.O. 1) The application of the LCNRV to the inventory as a whole would yield a
more conservative inventory value than would application of the rule to each
individual item.
_____ 3. (L.O. 1) Instead of crediting the Inventory account for market adjustments,
companies generally use an allowance account.
_____ 4. (L.O. 2) As used in the lower-of-cost-or-market rule, market should not exceed net
realizable value.
_____ 5. (L.O. 2) Net realizable value is the estimated selling price in the normal course of
business less the normal profit margin.
_____ 6. (L.O. 2) It is acceptable practice to write down inventory to market when market is
lower than cost, but it is not acceptable to write up inventory to market when
market is higher than cost.
_____ 7. (L.O. 2) When inventory is written down to market, this new basis is considered to
be the cost basis for future periods.
_____ 8. (L.O. 2) Under the lower-of-cost-or-market rule, the income statement may show a
larger net income in future periods than would be justified if the inventory were
carried forward at cost.
_____ 9. (L.O. 2) Under the lower-of-cost-or-market rule, an item of inventory should not be
valued at an amount in excess of net realizable value.
9 - 10 Student Study Guide for Intermediate Accounting, 17th Edition

_____ 10. (L.O. 3) The recognition of inventories at selling price less cost of disposal means
that income is usually recognized before the goods are transferred to an outside
party.
_____ 11. (L.O. 3) The allocation of a lump sum cost among the individual units on the basis
of relative sales value assumes that each individual unit should show the same
dollar amount of profit.
_____ 12. (L.O. 3) No asset or liability is recognized at the inception of a purchase
commitment because the contract is “executory” in nature.
_____ 13. (L.O. 3) The account Unrealized Holding Gain or Loss (Purchase Commitments)
should be included in the stockholders’ equity section of the balance sheet.
_____ 14. (L.O. 3) If the contracted price under a purchase commitment is less than market
and it is expected that gains will occur when the purchase is effected, gains should
be recognized in the period during which such increases in market prices take
place.
_____ 15. (L.O. 4) Gross margin is the excess of selling price over cost.
_____ 16. (L.O. 4) The gross margin expressed as a percentage of cost is normally less than
the gross margin expressed as a percentage of sales.
_____ 17. (L.O. 4) The use of the gross profit method for interim reports does not preclude
the need for a physical inventory to be taken at least annually.
_____ 18. (L.O. 5) Regardless of which version is used, the retail inventory method is
sanctioned by the IRS.
_____ 19. (L.O. 5) The retail inventory method is not useful for interim reports.
_____ 20. (L.O. 5) The conventional retail method includes net markdowns but excludes net
markups in the computation of the cost to retail percentage.
_____ 21. (L.O. 5) The inclusion of both net markups and net markdowns in the computation
of the cost to retail percentage yields an inventory valuation that approximates
cost.
_____ 22. (L.O. 5) The retail method assumes that the mix of the ending inventory is the
same as the mix of the total goods available for sale.
_____ 23. (L.O. 5) The conventional retail inventory method is designed to approximate the
lower of average cost or market.
_____ 24. (L.O. 6) The basis upon which inventory amounts are stated (lower of cost or
market) and the method used in determining cost (LIFO, FIFO, average cost, etc.)
should be disclosed in the notes of the financial statements.
_____ *25. (L.O. 7) A major assumption of the LIFO retail method is that the markups and
markdowns apply only to the goods purchased during the current period, not to
the beginning inventory.
 Chapter 9: Inventories: Additional Valuation Issues 8 - 11

MULTIPLE CHOICE

Select the best answer for each of the following items and enter the corresponding letter in the
space provided.
_____ 1. (L.O. 1) Franiuk Co. has unfinished inventory with a cost of $600, a sales value of
$800, estimated cost of completion of $40, and estimated selling costs of $170.
Franiuks’ net realizable value and loss due to decline in NRV are:
NRV Loss due to
decline in NRV
A. $800 $ 0
B. $600 $ 0
C. $590 $ 10
D. $390 $ 210
_____ 2. (L.O. 1) Which of the following represents the best justification for the departure
from the historical cost principle that results when lower-of-cost-or-net realizable is
used?
A. It is easier to keep track of market value than it is to keep track of cost as
market value is available from any supplier.
B. Cost loses its relevance for the determination of cost of goods sold if the cost
of inventory has been incurred in an earlier accounting period.
C. The balance sheet valuation of inventory is the most important consideration in
the preparation of financial statements.
D. The loss in utility (revenue-producing ability) that results from a decline in the
market value of inventory should be charged against revenues in the period in
which it occurs.
_____ 3. (L.O. 2) Replacement cost is the designated market value used to compare to cost
in determining lower of cost or market when its relationship to the items shown
below is:
Net Realizable Value NRV less Normal Profit
A. Lower Higher
B. Higher Higher
C. Higher Lower
D. Lower Lower
_____ 4. (L.O. 2) When using the lower-of-cost-or-market method, what is the meaning of
“designated market”?

A. Discounted present value.

B. Net realizable value.
C. The middle value of replacement cost, net realizable value, and net realizable
value less a normal profit margin.
D. Net realizable value less a normal profit margin.
_____ 5. (L.O. 2) A dudad has an original cost of $15 and a replacement cost of $12. The
cost of completion and disposal is $2. If the dudad has a net realizable value of
$16 and a normal profit margin of $5, its inventory value should be:
A. $15.
B. $12.
9 - 12 Student Study Guide for Intermediate Accounting, 17th Edition

C. $16.
D. $14.
_____ 6. (L.O. 2) If a unit of inventory has declined in value below original cost, and the
replacement cost is less than the net realizable value less a normal profit margin,
the amount to be used for purposes of inventory valuation under LCM is:
A. original cost.
B. replacement cost.
C. net realizable value.
D. net realizable value less a normal profit margin.
_____ 7. (L.O. 2) Let A equal the reported inventory value if the lower-of-cost-or-market rule
is applied to individual items of inventory; B equals the reported inventory value if
the lower of cost or market rule is applied to the inventory as a whole. Which of the
following best describes the relationship between A and B?
A. A will always be equal to B.
B. A will always be equal to or less than B.
C. A will always be equal to or greater than B.
D. A can never be equal to B.
_____ 8. (L.O.2) Martinez Corporation has two products in its ending inventory. A profit
margin of 30% on selling price is considered normal for each product. Specific
data with respect to each product follows:
Product A Product B
Historical cost $22.00 $ 55.00
Replacement cost 20.00 56.00
Estimated cost to dispose 7.00 31.00
Estimated selling price 35.00 110.00
In pricing its ending inventory using the lower-of-cost-or-market method, what unit
values should Martinez use for products A and B respectively?
A. $17.50 and $55.00
B. $20.00 and $46.00
C. $20.00 and $55.00
D. $28.00 and $56.00
_____ 9. (L.O. 2) Under the lower-of-cost-or-market-rule, designated market will be
replacement cost except when replacement cost is:
A. higher than cost.
B. less than net realizable value.
C. less than net realizable value less a normal profit margin.
D. less than cost.
_____ 10. (L.O. 2) The fact that it is accepted practice to recognize decreases in the value of
inventory prior to the point of sale, but not increases,
A. illustrates the materiality concept.
B. can distort income data.
C. emphasizes relevance over representational faithfulness.
D. emphasizes representational faithfulness over relevance.
_____ 11. (L.O. 3) Recording inventory at net realizable value is permitted, even if it is above
cost, when there are no significant costs of disposal involved and:
A. the ending inventory is determined by a physical inventory count.
B. a normal profit is not anticipated.
 Chapter 9: Inventories: Additional Valuation Issues 8 - 13

C. there is a controlled market with a quoted price applicable to all quantities.

D. the internal revenue service is assured that the practice is not used only to
distort reported net income.
_____ 12. (L.O. 3) Maricel Company has a noncancelable purchase commitment to buy
10,000 units of a particular product during the next three years. The contract was
signed one year prior to the first year in which the purchase commitment must be
honored. At the end of the year in which the contract was signed Maricel Company
should formally recognize in its balance sheet:
An Asset A Liability
A. Yes Yes
B. No No
C. Yes No
D. No Yes
_____ 13. (L.O. 4) Which of the following is not a basic assumption of the gross profit
method?
A. The beginning inventory plus the purchases equal total goods to be accounted
for.
B. Goods not sold must be on hand.
C. If the sales, reduced to the cost basis, are deducted from the sum of the
opening inventory plus purchases, the result is the amount of inventory on
hand.
D. The total amount of purchases and the total amount of sales remain relatively
unchanged from the comparable previous period.
_____ 14. (L.O. 4) On January 31, fire destroyed the entire inventory of Mojares Company.
The following data are available:
Sales for January $60,000
Inventory, January 1 10,000
Purchases for January 55,000
Markup on cost 25%
The amount of the loss is estimated to be:
A. $17,000.
B. $20,000.
C. $15,000.
D. $16,250.
_____ 15. (L.O. 4) Devers Company sells its product for $25.00 per unit. This price is set to
yield a gross margin on selling price of 25%. What is the cost of the product and
what is the markup on cost for the product?
Cost of Product Markup on Cost
A. $ 6.25 40%
B. $ 9.75 75%
C. $12.50 20%
D. $18.75 33%
_____ 16. (L.O. 5) Which of the following is not required when using the retail inventory
method?
A. All inventory items must be categorized according to the retail markup
percentage which reflects the item’s selling price.
9 - 14 Student Study Guide for Intermediate Accounting, 17th Edition

B. A record of the total cost and retail value of goods purchased.

C. A record of the total cost and retail value of the goods available for sale.
D. Total sales for the period.
_____ 17. (L.O. 5) To determine an inventory valuation that approximates lower of average
cost or market using the retail method, the computation of the cost to retail
percentage should:
A. include markups but not markdowns.
B. include markups and markdowns.
C. include markdowns but not markups.
D. exclude markups but not markdowns.
_____ 18. (L.O. 5) The retail method has been used by a retail department store during its
first year of operations. As of the end of the year, compare (A) the markdowns with
(B) the markdown cancellations:
A. A will be equal to B.
B. A will be less than or equal to B.
C. A will be greater than or equal to B.
D. A cannot be equal to B.
_____ 19. (L.O. 5) Phair Co., a specialty clothing store, uses the retail inventory method. The
following relates to 2020 operations:
Inventory, January 1, 2020, at cost $14,200
Inventory, January 1, 2020 at sales price 20,100
Purchases in 2020 at cost 32,600
Purchases in 2020 at sales price 50,000
Additional markups on normal sales price 1,900
Sales (including $4,200 of items that were marked
down from $6,400) 60,000
The cost of the December 31, 2020 inventory determined by the conventional retail
method is:
A. $9,800
B. $6,370
C. $6,743
D. $6,543
_____ 20. (L.O. 5) One of the basic assumptions of the conventional retail method is that:
A. net markups apply to the goods sold.
B. net markdowns apply to the total goods available for sale.
C. markdowns are considered a current loss.
D. the cost to retail percentage is unchanged from that of prior years.
_____ 21. (L.O. 5) Under the retail inventory method, purchase returns and allowances are
normally considered a reduction of price at:
Cost Retail
A. No No
B. No Yes
C. Yes No
D. Yes Yes
 Chapter 9: Inventories: Additional Valuation Issues 8 - 15

Items 22 and 23 are based on the following information:

The Stipes Company uses the retail-inventory method to value its merchandise inventory. The
following information is available:
Cost Retail
Beginning inventory $ 30,000 $ 60,000
Purchases 190,000 300,000
Freight-in 1,000 -
Markups (net) - 2,000
Markdowns (net) 4,000
Employee discounts 1,000
Sales 290,000
_____ 22. (L.O. 5) What is the ending inventory at retail?
A. $66,000
B. $67,000
C. $69,000
D. $71,000
_____ 23. (L.O. 5) If the ending inventory is to be valued at the lower of cost or market, what
is the cost-to-retail ratio?
A. $221,000/$362,000
B. $221,000/$360,000
C. $221,000/$358,000
D. $221,000/$357,000
_____ 24. (L.O. 5) Which of the following is not a reason the retail inventory method is used
widely:
A. as a control measure in determining inventory shortages.
B. for insurance information.
C. to permit the computation of net income without a physical count of inventory.
D. to defer income tax liability.
9 - 16 Student Study Guide for Intermediate Accounting, 17th Edition

REVIEW EXERCISES

1. (L.O. 2) You are given the following information regarding four inventory items:
Inventory Items
A B C D
Cost $62 $41 $46 $85
Replacement cost 48 42 40 80
Net realizable value 59 47 42 78
Normal profit margin 8 4 4 5
Instructions:
In the space provided, indicate the inventory value for each item in accordance with the lower-
of-cost-or-market rule.
A _____ B _____ C _____ D _____

2. (L.O.2) Josie Bisset Company determines its inventory using the lower of cost or market
inventory valuation. For the years ended 12/31/19 and 12/31/20 the data for inventory values at
cost and lower of cost or market are as follows:
Cost Lower of Cost or
Market
12/31/19 $296,000 $272,000
12/31/20 $321,000 $306,000
Instructions:

a. Prepare the journal entries required at 12/31/19 and 12/31/20, assuming that the cost-
of-goods-sold method is used and the company does not use an allowance account.
b. Prepare the journal entries required at 12/31/19 and 12/31/20, assuming that the loss
method is used and an allowance account is adjusted at each year-end.

a.
General Journal
J1
Date Account Title Debit Credit
 Chapter 9: Inventories: Additional Valuation Issues 8 - 17

b.
General Journal
J1
Date Account Title Debit Credit
9 - 18 Student Study Guide for Intermediate Accounting, 17th Edition

3. (L.O. 4) Scholl Company uses the gross profit method to estimate monthly inventory
balances. During recent months, gross profit has averaged 30% of net sales. The following data
for January are obtained from the ledger:
Inventory, January 1 ........................................................ $ 30,000
Purchases ........................................................................ 100,000
Purchase returns ............................................................. 2,000
Freight-in ......................................................................... 3,000
Sales ................................................................................ 120,000
Sales returns ................................................................... 4,000
Instructions:
Compute the January 31 inventory.
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 Chapter 9: Inventories: Additional Valuation Issues 8 - 19

4. (L.O. 4) Calabro Inc. had a majority of its inventory destroyed by a fire just prior to year-
end. The company controller had kept the accounting records current and provided you with the
following account balances.
Beginning inventory $ 67,500
Purchases for the year 235,700
Purchase returns 17,500
Sales 326,800
Sales returns 16,200
Gross profit rate on sales 36%
Inventory with a selling price of $18,000 was undamaged by the fire. Damaged inventory
with an original selling price of $10,000 had a net realizable value of $4,800.
Instructions:
Compute the amount of the loss caused by the fire, assuming no insurance coverage is
carried by the company.
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9 - 20 Student Study Guide for Intermediate Accounting, 17th Edition

5. (L.O. 5) The following information for the month of April is available from the records of
Ireland Department Store:
At Cost At Retail
Inventory, April 1 $ 8,400 $12,000
Purchases 48,810 80,000
Freight-in 2,000
Additional markups 4,300
Markup cancellations 800
Markdowns 6,600
Markdowns cancellations 200
Sales 72,600
Instructions:
Compute the April 30 inventory at the lower of approximate cost or market using the
conventional retail method.
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 Chapter 9: Inventories: Additional Valuation Issues 8 - 21

*6. (L.O. 7) The following information pertains to the records of the Zuniga Company.
Beginning inventory $ 46,000 $ 65,000
Net purchases 374,000 535,000
Markups 35,000
Markup cancellations 10,000
Markdowns 26,000
Markdown cancellations 16,000
Net sales 520,000
Instructions:
Compute the ending inventory under each of the following methods.

a. Conventional retail method.

b. LIFO retail method assuming stable prices.
c. Dollar-value LIFO method assuming the price index was 100 at the beginning of the
year and 120 at year end.

a.
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9 - 22 Student Study Guide for Intermediate Accounting, 17th Edition

b.
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c.
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 Chapter 9: Inventories: Additional Valuation Issues 8 - 23

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SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

1. (T)
2. (F) The lower-of-cost-or-net realizable value (LCNRV) rule may be applied directly to
each item or to the total of the inventory. When the LCNRV rule is applied to the
inventory as a whole, increases in the market prices of some items offset decreases
in the market prices in other items to some extent. Thus, the application of the
LCNRV rule to individual inventory items gives the most conservative valuation for
balance sheet purposes.
3. (T)
4. (T)
5. (F) Net realizable value is defined as selling price less the estimated cost of completion
disposal, and transportation. When the normal profit margin is subtracted from net
realizable value, the resulting amount is referred to as net realizable value less a
normal profit margin.
6. (T)
7. (T)
8. (T)
9. (T)
10. (T)
11. (F) When the relative sales value method is used, it is used because the items being
valued vary in terms of such characteristics as shape, size, attractiveness, and so
on. Because of these types of differences, the amount of gross profit generated by
each item will be different.
12. (T)
13. (F) If the contracted price of a purchase commitment is in excess of market price and it
is expected that losses will occur when the purchase is effected, an Unrealized
Holding Gain or Loss (Purchase Commitments) should be recognized and an
Estimated Liability on Purchase Commitments should be credited. The loss is
reported on the income statement under other expenses and losses, and the liability
is reported in the liability section of the balance sheet.
14. (F) If the contracted price is in excess of market and it is expected that losses will occur
when the purchase is effected, losses should be recognized in the period during
which such declines in market prices take place.
15. (T)
16. (F) Because selling price is greater than cost and the gross margin amount is the same
for both, gross margin percentage based on selling price will always be less than the
related percentage based on cost.
9 - 24 Student Study Guide for Intermediate Accounting, 17th Edition

17. (T)
18. (T)
19. (F) Because a fairly quick and reliable measure of inventory value is usually needed, the
retail inventory method is particularly useful for any type of interim report.
20. (F) The conventional retail inventory method is designed to approximate the lower of
average cost or market. Thus, the cost percentage computation includes markups
but not markdowns. When a company has an additional markup, it normally
indicates that the market value of that item had increased. If the company has a net
markdown, it means that a decline in the utility of that item has occurred. Therefore,
if the attempt is to approximate lower of cost or market, markdowns are considered a
current loss and are not involved in the calculation of the cost to retail ratio.
21. (T)
22. (T)
23. (T)
24. (T)
*25. (T)

MULTIPLE CHOICE

1. (C) Franiuk’s net realizable value is computed as follows:

Inventory value—unfinished $800
Less: Estimated cost of completion $ 40
Estimated cost to sell 170 210
Net realizable value $590

The loss due to a decline in NRV is $600 − $590 = $10

2. (D) The general rule is that the historical cost principle is abandoned when the future
utility (revenue producing ability) of the inventory is no longer as great as its original
cost. It is no easier to keep track of market value than it is to keep track of cost, and
cost does not lose its relevance if market value remains in excess. The balance
sheet valuation is not the most significant reason for lower-of-cost-or-net realizable.
3. (A) The amount that is compared to cost is always the middle value of the three
amounts: replacement cost, net realizable value, and NRV less a normal profit.
Because NRV is greater than NRV less a normal profit, replacement cost can only
be the middle value when it is lower than NRV and higher than NRV minus a normal
profit.
4. (C) “Designated market” as used in the lower-of-cost-or-market method is the middle
value of replacement cost, net realizable value, and net realizable value less a
normal profit margin.
5. (B)
Net Realizable Value $16
NRV Minus Profit $11
 Chapter 9: Inventories: Additional Valuation Issues 8 - 25

Replacement Cost $12

Market is defined in this case as replacement cost because the replacement cost is
between the upper limit (NRV) and the lower limit (NRV minus profit). Thus, when
the replacement cost ($12) is compared to cost ($15), the inventory is valued at $12.
6. (D) “Designated market” is middle value of replacement cost, net realizable value, and
net realizable value less a normal profit margin. Therefore, in this question where
replacement cost is below cost and less than the floor, net realizable value less a
normal profit margin is the amount that should be used for purposes of inventory
valuation.
7. (B) Increases in the market prices of some inventory items tend to offset decreases in
other inventory items when the lower-of-cost-or-market (LCM) rule is applied to the
inventory as a whole. Thus, the inventory valuation that results from applying the
LCM method to individual items in inventory (alternative A) will always be equal to or
less than the inventory valuation that results from applying the LCM rule to the
inventory as a whole (alternative B).
8. (C) The unit values Martinez should use for products A and B can be determined as
follows:
Market
Replacem Net Net Amount Selected for
ent Cost Realizable Realizable Market
Value Value Less
Normal Profit
Product A $20.00 $28.00* $17.50** $20.00
Product B $56.00 $79.00* $46.00** $56.00
*Computation of net realizable value:
Estimated selling price $35.00 $110.00
Less: estimated cost to dispose 7.00 31.00
Net Realizable Value $28.00 $ 79.00
**Computation of net realizable value less normal profit:
Product A: $28.00 - .30($ 35.00) = $17.50
Product B: $79.00 - .30($110.00) = $46.00

Applying lower of cost or market:

Market Cost Amount Selected
Product A $20.00 $22.00 $20.00
Product B $56.00 $55.00 $55.00
9. (C) If replacement cost is less than net realizable value less a normal profit margin, then
replacement cost is below the lower limit for market value. When this occurs, market
is defined as the lower limit (NRV minus a normal profit margin).
10. (B) The fact that it is accepted practice to recognize decreases in the value of inventory
prior to the point of sale, but not increases can distort income data. The tradeoff
between relevance and representational faithfulness is best illustrated by the
differences between the cost-of-goods-sold and the loss method of recognizing
inventory write downs.
9 - 26 Student Study Guide for Intermediate Accounting, 17th Edition

11. (C) With no significant disposal costs and a controlled market, net realizable value is an
appropriate inventory valuation approach. For example, inventories of certain
minerals are ordinarily reported at selling prices because there is often a controlled
market without significant costs of disposal. A similar treatment is given to
agricultural products that are immediately marketable at fixed prices. Also, this
method proves to be valuable when cost figures are too difficult to obtain.

12. (B) Even with formal, noncancelable purchase contracts, no asset or liability is
recognized at the date of inception, because the contract is “executory” in nature;
neither party has fulfilled its part of the contract. However, if material, such
commitment details should be disclosed in the buyer’s balance sheet in a footnote.
13. (D) The gross profit method assumes a constant gross profit percentage, but makes no
assumptions about the total amount of sales or purchases. Alternatively (A), (B), and
(C) are basic assumptions of the gross profit method.
14. (A) A 25% markup on cost is equivalent to a 20% markup on selling price:
%markup on cost
GP on selling price =
100% + % markup on cost

.25
GP on selling price =
1.25
GP on selling price = .20

Sales .......................................................................... $60,000

GP ($60,000 × .20) .................................................... 12,000
Cost of goods sold ..................................................... $48,000
Goods available for sale............................................. 65,000
Inventory loss ............................................................. $17,000
15. (D) C + .25SP = SP
C = (1 - .25)SP
C = .75SP
C = .75($25)
C = $18.75
SP $25.00
C 18.75
GP $ 6.25
Markup on Cost = $6.25 ÷ $18.75 = 33%
16. (A) Inventory items need not be categorized in any manner. The major benefit of the
retail inventory method is that inventory items are accumulated without the need to
separate them into distinct classifications. Alternatives B, C and D reflect the
requirements for use of the retail inventory method.
17. (A) See explanation of True-False question No. 20.
18. (C) Markdown cancellations represent the cancellation of previous markdowns applied
to a product. Therefore, markdown cancellations are limited to the total amount of
markdowns previously recorded. Thus, for any entity, markdowns will be greater
than or equal to markdown cancellations.
 Chapter 9: Inventories: Additional Valuation Issues 8 - 27

19. (B)
Cost Retail
Inventory 1/1/20 .................................................... $14,200 $20,100
Purchase ............................................................... 32,600 50,000
.............................................................................. $46,800 $70,100
Additional Markups................................................ 1,900
Totals .................................................................... $46,800 $72,000

(Cost-to-retail ratio: $46,800 ÷ 72,000 = 65%)

Deduct Markdowns ............................................... 2,200

Sales Price of Goods Available ............................. $69,800
Deduct Sales ......................................................... 60,000
Ending Inventory at Retail ..................................... $ 9,800
Ending Inventory at LCM: $9,800 × .65 = $6,370
20. (C) When the attempt is to approximate lower of cost or market, under the retail
inventory method, markdowns are considered a current loss and are not involved in
the calculation of the cost to retail ratio.
21. (D) Purchase returns and allowances are ordinarily considered both as a reduction of
the price at cost and retail.
22. (B) Stipes Company’s ending inventory at retail can be calculated as follows:
Retail
Beginning inventory $ 60,000
Purchases 300,000
Available $360,000
Add:
Markups, net 2,000
$362,000
Less:
Markdowns, net $4,000
Employee discounts 1,000
5,000
$357,000
Less: Sales 290,000
Ending inventory at retail $ 67,000
23. (A) Stipes Company’s cost-to-retail ratio approximating lower of cost or market can be
determined as follows:

Cost Retail
Beginning inventory $ 30,000 $ 60,000
Purchases 190,000 300,000
Freight-in 1,000 -
$221,000 360,000
Add: Markups, net 2,000
$362,000
9 - 28 Student Study Guide for Intermediate Accounting, 17th Edition

The cost-to-retail ratio approximating lower of cost or market includes net markups
but not net markdowns: $221,000/$362,000 = 61.05%.
24. (D) The retail inventory method is used widely (1) to permit the computation of net
income without a physical count of inventory, (2) as a control measure in
determining inventory shortages, (3) in regulating quantities of merchandise on
hand, and (4) for insurance information. The retail inventory method does not
necessarily cause a decrease in income taxes like LIFO during a period of rising
prices.

REVIEW EXERCISES

1.
A. $51 B. $41 C. $40 D. $78

2. a.
12/31/19
Cost of Goods Sold ................................................... 24,000
Inventory ................................................................ 24,000
12/31/20 Cost of Goods Sold ................................................... 15,000
Inventory ................................................................ 15,000
b.
12/31/19 Loss Due to Market Decline of Inventory ................... 24,000
Allowance to Reduce Inventory to Market ............. 24,000
12/31/20 Allowance to Reduce Inventory to Market ................. 9,000*
Recovery of Market Decline of Inventory ............... 9,000

* Cost of inventory 12/31/19 ......................................................................... $296,000

Lower of Cost or Market at 12/31/19 ......................................................... 272,000
Allowance amount needed to reduce inventory to market ........................ $ 24,000

Cost of inventory at 12/31/20 .................................................................... $321,000

Lower of cost or market at 12/31/20 .......................................................... 306,000
Allowance amount needed to reduce inventory to market ........................ $ 15,000
Recovery of previously recognized loss: $24,000 − 15,000 = $9,000
 Chapter 9: Inventories: Additional Valuation Issues 8 - 29

3.
Inventory, January ........................................................................... $ 30,000
Purchases ........................................................................................ 100,000
Freight-in.......................................................................................... 3,000
Purchase returns ............................................................................. (2,000)
Goods available (at cost) ........................................................... $131,000
Sales ................................................................................................ $120,000
Sales returns .................................................................................... 4,000
Net sales .......................................................................................... $116,000
Less gross profit (30% of 116,000) .................................................. 34,800
Cost of goods sold ..................................................................... 81,200
Inventory, January 31 (at cost) (131,000 - 81,200) .......................... $ 49,800

4.
Sales ............................................................................................... $326,800
Sales returns ................................................................................... (16,200)
Net sales ......................................................................................... 310,600
Gross profit rate .............................................................................. .36
Gross profit ..................................................................................... $111,816

Cost of goods sold: $310,600 - $111,816 = $198,784

Beginning inventory ........................................................................ $ 67,500

Purchases ....................................................................................... 235,700
Purchase returns ............................................................................ 17,500
Net purchases ................................................................................. 218,200
Goods available for sale ................................................................. $285,700
Estimated ending inventory: $285,700 - $198,784 = $86,916
Inventory loss due to fire:
Estimated ending inventory....................................................... $86,916
Undamaged inventory [$18,000 - ($18,000 × 36%)] ................. (11,520)
NRV of damaged goods............................................................ (4,800)
Loss due to fire ......................................................................... $70,596
9 - 30 Student Study Guide for Intermediate Accounting, 17th Edition

5.
Cost Retail
Inventory, April 1 .................................................................... $ 8,400 $12,000
Purchases .............................................................................. 48,810 80,000
Freight-in ................................................................................ 2,000
Net markups ........................................................................... 3,500
Goods available...................................................................... $59,210 $95,500

Cost to retail ratio $59,210/$95,500 = 62.0%

Less:
Sales ................................................................................. 72,600
Net markdowns ................................................................. 6,400
.......................................................................................... 79,000
Inventory, April 30, at retail..................................................... $16,500

Inventory, April 30, at lower of cost or market

($16,500 ×.62) ..................................................................... $10,230

6. a. Conventional Retail
Cost Retail
Beginning inventory $ 46,000 $ 65,000
Purchases (net) 374,000 535,000
Totals 420,000 600,000
Add net markups
Markups 35,000
Markup cancellations 10,000 25,000
$420,000 625,000
Deduct net markdowns
Markdowns 26,000
Markdown cancellations 16,000 10,000
Sales price of goods available 615,000
Deduct sales 520,000
Ending inventory at retail $ 95,000
420,000
Cost - to - retail ratio = = 67.2%
625,000
Ending inventory at lower of cost or market: $95,000 × .672 = $63,840
 Chapter 9: Inventories: Additional Valuation Issues 8 - 31

b. LIFO Retail Method (Stable Prices)

Cost Retail
Beginning inventory $ 46,000 $ 65,000
Purchases (net) 374,000 535,000
Net markups 25,000
Net markdowns (10,000)
Total excluding beginning inventory 374,000 550,000

Total including beginning inventory $420,000 615,000

Net sales $520,000
Ending inventory at retail $ 95,000

Establishment of cost-to-retail percentage

under assumption of LIFO retail $374,000 ÷ $550,000 = 68%

Ending inventory at cost:

Ending inventory $ 46,000
Additional increment $ 95,000
Beginning inventory 65,000
Ending inventory 30,000
Cost to retail percentage × .68 20,400
Ending inventory at LIFO cost (stable prices) $ 66,400

c. Dollar-value LIFO (Fluctuating Prices)

Cost Retail
Beginning inventory $ 46,000 $ 65,000
Purchases (net) 374,000 535,000
Net markups 25,000
Net markdowns (10,000)
Total excluding beginning inventory 374,000 550,000
Total including beginning inventory $420,000 615,000
Net sales 520,000
Ending inventory at retail $ 95,000

Establishment of cost-to-retail percentage under

assumption of LIFO retail $374,000 ÷ $550,000 = 68%

A. Ending inventory at retail prices deflated to

base-year prices $95,000 × 100/120 = $79,167
B. Beginning inventory at base-year prices 65,000
C. Inventory increase from beginning of period $14,167
D. Increment priced in terms of end-of-year prices $17,000
$14,167 × 120/100 =

Ending inventory at cost:

First layer $46,000
Second layer (increase at new price level
times cost to retail percentage) $17,000 × .68 = 11,560
Ending inventory at LIFO cost (fluctuating prices) $57,560
9 - 32 Student Study Guide for Intermediate Accounting, 17th Edition