Chapter 8: Cost-Based Inventories and Cost of Sales

Chapter 8: Cost-Based Inventories and Cost of Sales Case 8-1 Love Your Pet, Inc. 8-2 Alliance Appliance Ltd. 8-3 Terrific Titles Inc. Suggested Time Technical Review TR-1 Right to Recovery Asset... 5 TR-2 Inventory Cutoff... 5 TR-3 Cost of Inventory Item... 5 TR-4 Cost of Manufactured Item... 5 TR-5 Inventory Holding Gains/Losses... 5 TR-6 Lower of Cost or NRV... 15 TR-7 Damaged Inventory... 5 TR-8 Onerous Contract... 5 TR-9 Gross Margin Method... 10 TR-10 Retail Inventory Method... 10 Assignment A8-1 Inventory Cost Items to Include in Inventory... 10 A8-2 Inventory Cost Items to Include in Inventory... 10 A8-3 Inventory Cost Items to Include in Inventory... 20 A8-4 Inventory Discounts and Rebates... 10 A8-5 Inventory Policy Issues... 20 A8-6 Lower of Cost or NRV... 10 A8-7 Lower of Cost or NRV Income Effects... 15 A8-8 Lower of Cost or NRV Direct Writedown versus Allowance Method... 20 A8-9 Lower of Cost or NRV Allowance Method... 20 A8-10 Lower of Cost or NRV Allowance Method (*W).. 20 A8-11 Lower of Cost or NRV Two Ways to Apply... 20 A8-12 Lower of Cost or NRV and Foreign Currency... 25 A8-13 Obsolete Inventory... 10 A8-14 Purchase Commitment... 10 A8-15 Loss on Purchase Commitment... 10 A8-16 Inventory Error Correction... 25 A8-17 Inventory-Related Errors... 10 A8-18 Inventory Errors... 10 A8-19 Gross Margin Method... 10 A8-20 Gross Margin Method (*W)... 20 A8-21 Retail Inventory Method... 15 A8-22 Retail Inventory Method (*W)... 30 A8-23 Gross Margin and Retail Inventory Methods... 35 A8-24 Inventory Concepts Recording, Adjusting, Closing, Reporting... 35 A8-25 Statement of Cash Flows... 20 A8-26 ASPE Accounting Policies... 30 A8-27 Inventory Cost Methods (Appendix) (*W)... 20 A8-28 Inventory Cost Methods (Appendix)... 40 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-1

A8-29 Inventory Cost Methods (Appendix)... 30 A8-30 Inventory Policy Comparison (Appendix)... 30 *W The solution to this assignment is on the text website, Connect. This solution is marked WEB. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-2 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Cases Case 8-1 Love Your Pet Inc. Suggested Solution Overview LPI is preparing IFRS-compliant financial statements for the first time, and will be audited for the first time. The company has a line of credit that is limited to 70% of accounts receivable and 50% of inventory, and thus accounts receivable and inventory balances are important. Then company uses its financial statements for tax purposes, and tax minimization might be a reporting objective. Issues 1. Loyalty program 2. Rebates 3. Manufacturing costs 4. Recall 5. FIFO versus average cost 6. Consignment goods Analysis and recommendations 1. The free bags should be treated as a separate performance obligation in the sales transaction at the time of the initial sale (IFRS 15). LPI does not account for the free bags until the time of customer redemption. Instead, the fair value of the consideration in respect of the initial sale must be allocated between the award credits and the other components of the sale. LPI will need to apportion the sales revenue on each bag so that 10% of the sales amount is deferred and recorded as unearned revenue until the customer claims the free 11 th bag. No deferral is required for the 40% of sales that have not been drawn to the program. LPI has been tracking redemptions, so the percentage of bags actually redeemed by the customers who take part in the program should be verifiable. This is a change in accounting policy, to be accounted for retrospectively (IAS 8). This change in accounting policy not have any impact on accounts receivable or inventory for purposes of the line of credit calculation, but it will reduce earnings because sales are being deferred. 2. Rebates for inventory must be deducted in determining the cost of purchase (IAS 2). LPI s current policy is to defer recognition until the subsequent quarter when the amount of the rebate is known and received. Volumes have historically been met and purchases are increasing with sales continuing to grow in recent months. It is very likely that the minimum volumes will continue to be met, so the purchase discount should be recorded Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-3

based on the estimated rebate expected, resulting in a 10% decrease in inventory and accounts payable at the time of purchase. Again, this is a change in accounting policy, to be accounted for retrospectively (IAS 8). The new policy will have the impact of decreasing inventory for purposes of calculating the maximum line of credit available. Earnings will increase, because of the growing volumes; larger discounts are being accrued earlier. 3. LPI has been expensing all manufacturing costs related to production other than direct labour and direct materials. The costs of conversion of inventories include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods (IAS 2). Accordingly, all costs of manufacturing operations should not be expensed during the period, as is presently the case. Any costs of conversion that are presently expensed need to be allocated to units produced based on the normal capacity of the production facilities. Any units held in ending inventory should have a fixed manufacturing overhead component that is part of the total cost of these units. This is a change in accounting policy to comply with the GAAP requirement for absorption costing and must be applied retrospectively. If production is higher than sales in a given year this method, this will result in a higher amount in ending inventory for purposes of calculating the line of credit, as compared to expensing all costs during the period other than direct labour and direct materials. 4. The recall of the dry dog food brings two issues into question. The first issue is one of inventory valuation. LPI has chosen to remove all products from the supplier from its shelves due to health concerns, rendering them unsaleable, and therefore having no net realizable value. Given that the supplier has gone out of business, it is unlikely that there is any avenue for LPI to recover costs on this product. The carrying amount of these products must be removed from inventory completely and recorded as a loss in the current period; this is an impairment (IAS 2). If there is any subsequent reversal of any write-down of the inventory because amounts become recoverable, this is recognized in the reversal year. It seems unlikely there will be a reversal in this situation. The impairment will result in lower inventory in the current period for purposes of calculating the available line of credit amount. Earnings will also decrease. The second issue is the potential for contingent liabilities arising if customers file suit against LPI in their role as a distributor for the contaminated food. The batches held by LPI included some that were suspected of contamination. Presently, no action has been launched against LPI and there are no Canadian incidents. Lacking a loss incident, no 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-4 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

accrual or note disclosure is required in the financial statements. This may be an issue for consideration in future periods. 5. This is a voluntary change in accounting policy, from FIFO to average cost. A voluntary change in accounting policy should be made if it results in information that is more relevant and reliable to the users of the financial statements (IAS 8). In this instance, a change from FIFO to the average cost method would arguably make LPI s statements more comparable to competitors in the industry, making financial statements more relevant to users. Once more, this is a change in accounting policy, to be accounted for retrospectively (IAS 8). Given that prices are rising, a switch to average cost would result in higher cost of goods sold expense and lower ending inventory as compared to FIFO where the newer, higher costs would be averaged in cost of goods sold and not deferred in ending inventory. This would lower the gross margin in the current period and decrease the current ratio, decreasing the maximum borrowing amount based on the line of credit agreement. Earnings would decrease. 6. LPI does not pay for the rabbit food product until it is sold, giving Carly 80% of the retail price at that time. The inventory held at LPI locations has not actually been purchased, and therefore is not an asset to be recorded by LPI. This is consignment inventory and should not be recorded in LPI s records. As an agent, the company will record only their sales commission as revenue, not the amount charged to the customer in-store. Because the rabbit food is not recorded as inventory, it will not be included for purposes of calculating the maximum line of credit available. Conclusion Many of the issues above affect income and inventory. If tax minimization is important, the overall impact will have cash flow implications, increasing or decreasing the tax paid. Inventory is significant with respect to the operating line of credit. The company s cash flow requirements over the coming year should be determined, using a cash budget. If the line of credit is close to its limits, the bank should be consulted in advance. Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-5

Case 8-2 Alliance Appliance Ltd. Overview This case is designed to highlight the differences in financial reporting under IFRS as compared to ASPE. The student must adopt an advisory role and prepare a report to the CFO concerning ten specific issues. The issues mostly are general presentation issues, but a few also include more specific treatments, such as held-for-sale properties, inventory valuation, and an onerous contract. Sample response To: Chief Financial Officer, Alliance Appliance Ltd. From: Maxwell Davies, Henry & Higgins Date: 04 April 20X7 I have reviewed the reporting issues that you raised concerning a potential switch from ASPE to IFRS. I am happy to provide my advice, enumerated in the points that follow: a. IFRS does not require specific financial statement titles; the titles you presently use are quite acceptable, with one exception. The exception is that instead of Statement of Retained Earnings, AAL would need to provide a statement of changes in shareholders equity. Retained earnings would be just one column within this statement. b. On the income statement, expenses would need to be organized either by function within AAL or by nature (that is, by type of expense). For example, a functional classification could be by assembly and by distribution. A classification by type of expense would, in contrast, be items such as employee expense (that is, wages, salaries, and benefits) and by depreciation expense. Consistent classification is necessary. c. There will be no change in reporting preferred dividends under IFRS. Retained earnings will be one column in the statement of changes in shareholders equity, and dividends paid will continue to be a component displayed in that column. d. The warranty is a separate performance obligation. Revenue must be allocated to this in the initial sale, and recognized over the warranty period. e. Gains and losses from foreign currency transactions would continue to be shown on the income statement under IFRS, unless they are hedged, in which case they may pass through Other Comprehensive Income, which is a category of shareholders equity and be shown in the statement of changes in shareholders equity rather than on the income statement. f. The Japanese contract would qualify as an onerous contract under IFRS; the amount by which the contract price is greater than the fair value would be recognized as a loss at the SFP date. ASPE doesn t use that particular terminology, but the potential loss would also be recorded under ASPE. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-6 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

g. Under both ASPE and IFRS, inventory written down can be written back up if fair value recovers, but no higher than their originally recorded cost. No adjustment or change in practice would be required. h. Under ASPE, the asset exchange can be valued at either the value of the consideration or the value of the asset acquired, whichever is the more reliable measure. In contrast, IFRS requires that the value of the consideration be used, regardless of which measure is more reliable. The carrying value of the acquired lot will need to restated to the value of the Ottawa property, if and when AAL switches to IFRS. i. The cumulative currency translation difference is treated essentially the same under ASPE and IFRS a separate component of shareholder s equity. The only difference is that under IFRS, the cumulative amount is shown on the statement of changes in shareholders equity as one component of other comprehensive income. j. The building has been written down prematurely. It should continue to be reported at its depreciated cost (and depreciation should continue) until it has been abandoned. Once it is abandoned in 20X7, depreciation can cease and the asset should be written down to its recoverable value. Under IFRS, however, it cannot be reclassified as a held-for-sale asset unless it is likely to be sold within the next year. If no process for sale has begun, then the asset cannot be reclassified but must remain in the buildings account as an idle asset. I hope my responses will help you in AAL s potential shift to IFRS. Please do not hesitate to contact me if you d like more information. Best wishes, Maxwell Davies, staff auditor Henry & Higgins Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-7

Case 8-3 Terrific Titles Inc. Overview The issues are: Inventory valuation Revenue recognition Expense recognition Intangible assets and deferred charges If TTI acquires TLC, TLC will need to change its policies to conform with IFRS since TLC will be consolidated into TTI s results, and therefore must follow IFRS. There is some conflict between the accounting policies that TLC will have to adopt in the future and TTI s immediate objective to establish a bid price based on earnings projections. A bid price would be based on TTI s evaluation of (1) earnings potential and (2) volatility of earnings and/or cash flows. High earnings is good, but volatility is bad the risk vs. return trade-off. Sample response Dear Ms. O Malley: I am pleased to report my findings concerning TLC s accounting policies and practices. I believe that it will be necessary to make some adjustments to TLC s reported numbers for 20X3 as well as take some additional factors into account when we project the company s earnings into the future in order to establish a bid price. One overriding consideration is that TLC, as a private company, seems to use a combination of Canadian accounting standards for private enterprises and some eclectic accounting policies that appear to be rather unorthodox. In effect, TLC uses a disclosed basis of accounting. If we acquire TLC, the company will need to change its accounting policies to conform with IFRS, since we use IFRS and we will need to consolidate TLC. My discussion of the major issues is as follows: a. Inventory valuation. TLC develops and produces its own books. All of the cost of development, production, and printing are included in inventory and allocated over the number of copies in each edition s initial press run. The result is that the first print run has a huge unit cost while succeeding press runs (if any) bear only the cost of that particular print run. As a result, cost of goods sold will be very high for the initial run, quite likely yielding a negative gross margin for that initial run, even for a very successful book. For performance evaluation and for earnings prediction, these numbers are apt to be very misleading. As well, loading all of these costs into the inventoriable cost will usually result in an inventory value that is significantly higher than net realizable value. Therefore, the development costs should be removed from inventory and accounted for separately. Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-1

b. Development and production costs. We have a dichotomy in this regard. For financial reporting purposes, TLC will have to change their accounting policy for development costs to accord with IFRS, once we acquire them. One option is to expense development costs when they are incurred even for historically successful books. An edition s success may not be predictable with assurance, because new competitors enter the market regularly. On the other hand, spreading the development and production costs over the 3-year life span of the book will assist with our prediction of future earnings (on which we base the bid price) as well as ongoing evaluation of TLC s management. However, it is questionable as to whether these costs can properly be considered as an intangible asset, and thereby capitalized and amortized. IFRS discourages treating expenditures for new products as intangible assets (IAS 38, paragraph 69). Every new edition is, in effect, a new product, and therefore I recommend that TLC s policy for these costs should be to expense them when incurred. For our analytical purposes in developing a bid price, however, I suggest that we remove development and pre-production costs from inventories in recent prior years and amortize them over 3-year periods so we can discern the underlying earnings. Then we can look at the cash flow volatility over the years to measure the risk potential of the erratic production levels. c. Revenue recognition. TLC recognizes revenue when books are shipped. However, there is a 6-month official return policy that is unofficially stretched for college and university bookstores, which account for 90% of total sales. The return rate seems to be difficult to predict. If it is not feasible to make a reliable estimate of the return rate, either overall or book-by-book, revenue recognition probably should be deferred until the 6-month official return period has ended. This will create a right to recovery asset on the books, for the books that can be returned, d. Supporting material for instructors. The cost of providing free supporting materials for instructors can be considerable. They have no inventory value in the usual sense because their net realizable value is zero (even though students would love to get their hands on solutions manuals). The significant cost of these items suggests that instead of inventorying the costs, TLC should instead defer some of the revenue and treat each book s sale as really having multiple performance obligations: (1) a book delivered to the students when they buy them, and (2) supporting material prepared and made available for instructors. While there is no measurable value for the second deliverable, an allocation of revenue could be based on the relative costs of the two deliverables. e. Inventory valuation of returned books. TLC restores returned books to inventory at the unit cost they originally bore. This has two problems: (1) the original assigned cost is too high, as discussed above, and (2) if large quantities of a book are returned, it probably indicates that the book is unsuccessful and therefore that its net realizable value is much lower than the original unit cost. We will need to determine how much of the current inventory is comprised of returned books, and probably write off those books for our estimation process. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-2 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

f. Inventory of old editions. An inventory of old editions should not be assigned any value as assets. By definition, they are obsolete, even if there may be some residual sales. By retaining some inventory at normal cost, TLC management may be tempted to retain more than necessary in order to avoid depressing earnings by a write-down. g. Website development costs. It is doubtful that these costs would qualify as an intangible asset under IFRS. The success of the website is not predictable with reasonable assurance. The costs should be expensed when incurred. However, we should take into account in our projections that delivering support material electronically will significantly reduce the cost of printing and distributing instructors supporting materials. That cost reduction may be offset, however, by the necessity to put more resources into development of electronic learning aids in order to keep up with the competition. h. Sales discounts. The company currently is charging discounts taken on accounts receivable to interest expense. Instead, the discounts should be deducted from revenue. I hope that I have identified the major issues that I see with TLC accounting. Sincerely, Ian Fanwick Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-3

Technical Review Technical Review 8-1 Requirement 1 50 units (500 units x 10%) x $75 cost = $3,750 Requirement 2 50 units (500 units x 10%) x $40 realizable value = $2,000 Requirement 3 A right to recovery asset is not typical inventory because it has been transferred to the customer, who may or may not keep it. Technical Review 8-2 Description Cost Decision Explanation Shipment from supplier, arrived in April 29, but inspected, found defective, and will be returned. Shipment from supplier, in transit April 30, arrived May 2, shipped FOB destination. Shipment from supplier, in transit April 30, arrived May 10, shipped FOB shipping point. Shipment to customer, shipped April 29, in transit April 30, FOB destination. Estimated shipping time is one week. Shipment to customer, shipped April 29, in transit April 30, FOB shipping point. Estimated shipping time is one week. $43,200 Exclude Goods about to be returned; presumably segregated $16,900 Exclude FOB destination means that supplier owns the goods in transit. $5,300 Include FOB shipping point means that Max owns the goods in transit. $22,600 Include FOB destination means that Max owns the goods in transit. $33,100 Exclude FOB shipping point means that customer owns the goods in transit. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-4 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Technical Review 8-3 Invoice price; the amount was prepaid when the goods were ordered because the supplier offered a 5% discount for payment up front. The invoice price was for $38,000, less 5% (Cost is net of discount) HST on invoice price, $5,415 (Value added tax; refundable) Interest on borrowed money between the time the deposit was paid and the goods were delivered, $510 (Goods were customized after the order date and qualify for interest capitalization) Delivery charges, paid by the supplier, $1,100 (Paid by supplier) Cost $36,100 -- 510 -- $36,610 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-5

Technical Review 8-4 Direct material $12.00 Direct labour 18.00 Variable overhead 22.00 Fixed overhead ($1,450,000/200,000*) 7.25 *Normal capacity Total $59.25 General and administrative costs are not a product cost. Technical Review 8-5 The holding loss (gain) can be computed as follows: (a) (b) Allowance to reduce Allowance to reduce (b) (a) inventory to NRV inventory to NRV Holding loss Year-end Opening balance Amount required* (recovery) 20x4$ 0$ 0**$ 0 20x5 0 2,000 2,000 20x6 2,000 1,000 (1,000) 20x7 1,000 4,000 3,000 20x8 4,000 0** (4,000) * Cost less NRV, if NRV is less than cost. ** NRV is in excess of cost; no allowance is required. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-6 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Technical Review 8-6 Computations: Type # Cost NRV LCNRV Per unit Total Per unit Total By type By class Class 1 Basic 50 $ 100 $ 5,000 $ 120 $ 6,000 $ 5,000 Super 30 150 4,500 140 4,200 4,200 Total, Class 1 $ 9,500 $10,200 $ 9,500 Class 2 Regular 120 90 $ 10,800 100 $ 12,000 10,800 Deluxe 60 130 7,800 140 8,400 7,800 Super deluxe 40 200 8,000 150 6,000 6,000 Total, Class 2 $ 26,600 $ 26,400 $ 26,400 Totals $ 36,100 $ 33,800 $ 35,900 Requirement 1 By item, the writedown is the total cost for all items minus the sum of the individual LCNRV: Writedown = $36,100 $33,800 = $2,300 Requirement 2 By class, the writedown is the sum of the cost of all items minus the sum of the LCNRV for each class: Writedown = $36,100 ($9,500 + $26,400) = $200 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-7

Technical Review 8-7 Requirement 1 Estimated sale price $42 Less: Estimated cost to repair $18 Estimated selling costs 4 (22) NRV for inventory $20 Requirement 2 Damaged inventory is segregated in a separate account as part of the writedown entry: Inventory, damaged goods (800 $20),,,,,,,,,,,,,,,,,,, 16,000 Loss from water damage,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, 25,600 Inventory (800 $52),,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, 41,600 Technical Review 8-8 31 October: Loss on onerous purchase commitment (350 kg $3 loss)... 1,050 Provision for onerous purchase contract... 1,050 27 November: Inventory (350 kg $18)... 6,300 Provision for onerous purchase commitment... 1,050 Accounts payable (or cash) (350 kg $20)... 7,000 Recovery of holding loss (350 kg $1)... 350 Note: Any inventory remaining in storage at year-end should be written down to market price if fair value is lower than cost. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-8 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Technical Review 8-9 Cost data (known) Partially estimated amounts Sales revenue [1] $1,460,000 $1,460,000 Cost of goods sold: Beginning inventory $ 400,000 $ 400,000 Purchases [2] 966,000 966,000 Goods available for sale 1,366,000 1,366,000 Ending inventory [5] 344,000 Cost of sales [4] 1,022,000 Gross margin [3] $ 438,000 (in thousands of dollars) [1] $1,500 gross sales $40 returns = $1,460 [2] $900 purchases + $26 shipping + $40 import duties = $966 [3] $1,460 net sales 30% gross margin = $438 [4] $1,460 net sales $438 gross margin = $1,022 [5] $1,366 goods available for sale $1,022 cost of sales = $344 Notes: Students may be tempted to include HST on both sales and purchases in their calculations. However, those amounts are credited/charged directly to the HST Payable account and are not included in either sales amounts or in inventory. Import duties are included in purchases, however, because they must be absorbed by the vendor (i.e., Tate Tasers Inc.) Storage costs are not included in inventory but are expensed as a period cost. Shipping to customers is a selling cost, not part of goods available for sale. Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-9

Technical Review 8-10 At cost At retail Inventory, 1 July 20x6 $ 362,000 $ 537,000 + Purchases 830,000 1,500,000 Purchase returns and allowances (16,000) (25,000) + Markups (net) ($195,000 $38,000) 157,000 Retail value goods available for sale 2, 169,000 Markdowns (net) ($60,000 $23,000) (37,000) Goods available for sale $ 1,176,000 $2,132,000 Sales (net of returns: $1,680,000 $80,000) (1,600,000) Inventory, 30 September, at retail $ 532,000 Inventory, 30 September, at cost: ($532,000 54 % cost ratio*) $ 287,280 * Cost ratio = $1,176,000 $2,169,000 = 54% Since the retail method is an estimate, there is no point in carrying the cost ratio out to more than two significant digits. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-10 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignments Assignment 8-1 Cost of inventory: a. Goods counted in the physical inventory b. Provincial sales tax on the amount in a. c. Federal GST on the amount in a. d. Goods that arrived from a supplier on December 2, shipped FOB shipping point e. Goods that were shipped to a customer on November 28, shipped FOB shipping point Corrected inventory Explanation $280,000 $280,000 Goods counted and presumably controlled by RL 22,400 22,400 PST is not refundable and is an inventory cost 16,800 -- GST is a value added tax and is not inventoriable 43,000 43,000 51,000 -- FOB shipping point from a supplier means that RL controlled the goods while shipped. FOB shipping point to a customer means that the customer controlled the goods when shipped. Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-11

f. Goods that were on consignment with a customer but sold by the customer on December 10. 14,500 14,500 g. Interest cost on goods in a, incurred during lengthy delivery period from supplier 1,600 1,600 h. Goods that were in RL s warehouse on November 30, about to be shipped back to the supplier because of defects. 23,200 i. Cost of operating and heating the warehouse facility for the year so that goods are available for sale when needed. 66,200 -- j. Cost of freight to ship goods in a, from suppliers to RL, where RL is responsible for freight. 27,800 27,800 k. Cost of freight to ship goods from RL to customers during the year, where RL is responsible for freight. 44,100 -- -- The goods belonged to RL on November 30. Borrowing cost during shipment is inventoriable The goods were about to be returned and are excluded from RL s inventory This is an operating cost, an expense of the period. Freight in is inventoriable Freight out is a selling cost; the goods are no longer owned by RL. Total inventory $389,300 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-12 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-2 Items to be included in inventory: Notes: Physical count $ 60,000 California sales tax 1,500 Import excise tax 2,000 Bonded inventory in U.S. dollars: US$11,000 C$1.05 11,550 Total $75,050 Payments in advance (item b) are a receivable (or prepaid asset) until the goods are received. HST (item c) is not included as it decreases the amount of HST on sales that is due to the government. California sales tax (item d) is not recoverable and should be included as part of the cost of inventory. The items being tested (item e) are already included in the physical count and should not be added in again. Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-13

Assignment 8-3 Requirement 1 Inventory Accounts Payable Preliminary value $689,600 $456,300 (a) Sale not recorded (54,300) (b) Goods in transit 37,500 37,500 (c) Invoice unrecorded 51,100 (d) Freight for goods in inventory* 5,000 5,000 (e) Goods on consignment (21,900) (f) Purchase discount accrued (4,000) (4,000) Revised total $651,900 $545,900 (g) Net realizable value 605,000 Required allowance 46,900 Existing allowance 32,200 Holding loss $ 14,700 Inventory would be reported net on the SFP at $605,000. Accounts payable has a corrected balance of $545,900. * An alternative would be to charge this amount to a separate expense account as freight in, a practice often used when it is impracticable to allocate shipping costs to various inventory items. Requirement 2 The holding loss on inventory is $14,700. See calculations in requirement 1. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-14 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-4 Requirement 1 Cost per unit of inventory... $500.00 Less: 2% discount (note 2)... (10.00) Less: Quantity rebate... (25.00) $465.00 Total cost 30 units $465... $13,950 Notes: 1. The freight charges are not included because the shipping is FOB destination, wherein destination is at Majestic Store, and thus the shipper pays the freight cost. 2. The discount must be deducted regardless of whether or not the company takes the discount. Requirement 2 Accounts receivable... 5,000 Cost of sales (170 $25)... 4,250 Inventory (30 $25)... 750 Because receipt of the rebate is certain by the end of the year, inventory and cost of goods sold should reflect the net cost. Requirement 3 Cash... 5,000 Accounts receivable (consistent with requirement 2)... 5,000 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-15

Assignment 8-5 Case A Case B Case C Case D Inventory cost should be recorded net of early-payment discount regardless of whether it was taken or not. Inventory should be reduced by $56,000 2% = $1,120. The restated inventory will be $54,880. The policy of defining market value as replacement cost is not acceptable. Market value should be defined as net realizable value. If sales price has not declined, NRV is likely unimpaired and no NRV write-down would be needed. As a result of the write-down, inventory is potentially understated and earnings understated. Company policy is unacceptable. Goods on consignment belong to the company, and cannot be regarded as sold until re-sold to a final customer. Inventory is understated, accounts receivable overstated, and earnings is overstated by the $32,000 gross profit on the sale. Company policy is unacceptable. The company is recording goods at cost, but has not recognized the onerous purchase commitment agreement or recorded the purchases at fair value. In 20x5, the company should have recognized a loss on the purchase agreement of $160,000 (i.e., $2,000 per unit 80 units remaining in the commitment). In 20X6, the company should have recognized a recovery of $1,500 per unit, or $120,000 total, which is calculated on the remaining units from year-end 20x5, not 20x6. The 45 units acquired at $16,000 in 20x6 should be written down by $500 per unit 45 units = $22,500, to their current value at year-end. Earnings and retained earnings are overstated in 20x5 and liabilities are understated. Currently, inventory is overstated in 20x6. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-16 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-6 Requirement 1 Average discount 40% of sales at 10% discount; 60% of sales at 3% discount = (0.40 0.10) + (0.60 0.03) = 0.04 + 0.018 = 5.8% average discount NRV = [($140,000 $10,000) (1.0 0.058) discount] (1.06) commission = $130,000 0.942 94% = $122,460 94% = $115,112 Writedown = ($120,000 $115,112) 20 = $4,888 20 = $97,760 Requirement 2 Revenue = $126,000 94% 5 = $592,200 Cost of goods sold = $115,112 5 = $575,560 Gross profit = $16,640 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-17

Assignment 8-7 Requirement 1 Requirement 2 Requirement 3 Holding loss on inventory (COS)... 8,000 Inventory... 8,000 Accounts receivable ($40,000 150% 60% sold)... 36,000 Sales... 36,000 Cost of goods sold ($32,000 60% sold)... 19,200 Inventory... 19,200 Inventory (40% $8,000 original writedown)... 3,200 Recovery of holding loss (COS)... 3,200 The writedown had the effect of reducing earnings by $8,000 in 20X4. In 20X5, earnings was increased by $4,800 through the sale of 60% of the written-down inventory. Earnings increased again in 20X5 by the write-up of the $3,200 for year-end inventory. The effect was to transfer all of amount of the writedown from 20X4 to 20X5, based on the best estimates at the time. Therefore, 20X5 earnings increased by $8,000, the full amount of the 20X4 writedown. Without the writedown, 20X4 earnings would have been $108,000 while 20X5 earnings would have been $112,000. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-18 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-8 Calculations: Item # Cost NRV Individual NRV Individual writedown A 100 $ 17,000 $ 16,000 $ 16,000 $ 1,000 B 260 20,800 23,400 20,800 Group NRV Group writedown A + B $37,800 $ 39,400 $37,800 nil C 150 21,000 15,000 15,000 6,000 D 200 20,000 24,000 20,000 C + D $41,000 $39,000 $39,000 $ 2,000 Total $78,800 $71,800 $ 7,000 $76,800 $ 2,000 Requirement 1 Item-by-item, the writedown would be $7,000: Requirement 2 Holding loss (COS)... 7,000 Inventory... 7,000 Treating the four items as two classes, the write down would be: $78,800 $76,800 = $2,000 Holding loss (COS)... 2,000 Allowance to reduce inventory to NRV... 2,000 Note to instructors; If the writedown is by class, an allowance must be used. Either an allowance or inventory is acceptable as a credit in requirement 1. Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-19

Requirement 3 a. With an individual writedown, the recovery for Item A can be reversed, but only to the extent of the original writedown: Inventory... 1,000 Recovery of holding loss (COS)... 1,000 b. When inventory is grouped by class, no recovery is recorded because none of the writedown (of $2,000) pertains to class A+B. Requirement 4 The advantage of using an allowance is that the individual subsidiary inventory records do not need to be adjusted for the writedown (nor for any subsequent recovery in value). The allowance method is essential when NRV is performed by inventory class rather than item-by-item, because there would be no way to make the detailed inventory records conform to the general ledger control account. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-20 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-9 20X4 NRV: $150,000 (1.00 0.10 0.05) = $150,000 85% = $127,500 Cost NRV: $170,000 $127,500 = $42,500 writedown at the end of 20X4 20X5 Holding loss on inventory (COS)... 42,500 Allowance to reduce inventory to NRV... 42,500 Cost (without writedown): $170,000 + $25,000 = $195,000 NRV: $195,000 90% = $175,500 Allowance required at the end of 20X5: $195,000 $175,500 = $19,500 Adjustment from 20X4 allowance balance to 20X5 balance: $42,500 $19,500 = $23,000 reversal of writedown Allowance to reduce inventory to NRV... 23,000 Reversal of holding loss on inventory (COS)... 23,000 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-21

Assignment 8-10 (WEB) Requirement 1 Loss for 20X1 a) Individual items Allowance A... $1,000 B... 5,000 C... 0 D... 1,500 E... 16,000 F... 0 Total... $23,500 b) Category A - C Cost, $75,000, NRV, $77,000... 0 D - F Cost, $80,000, NRV, $62,500... $17,500 Total... $17,500 Requirement 2 a) Individual items: b) Category: Holding loss on inventory (COS)... 23,500 Allowance to reduce inventory to NRV... 23,500 Holding loss on inventory (COS)... 17,500 Allowance to reduce inventory to NRV... 17,500 Requirement 3 Loss for 20X2 a) Individual items Allowance A... $2,000 B... 1,000 C... 0 D... 1,500 E... 3,000 F... 2,000 Total... $9,500 b) Category A - C Cost, $60,000, NRV, $64,000... 0 D - F Cost, $72,000, NRV, $65,500... $6,500 Total... $6,500 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-22 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Journal entries a) Individual items: b) Category: Allowance to reduce inventory to NRV ($23,500 to $9,500) 14,000 Inventory... 14,000 Allowance to reduce inventory to NRV ($17,500 to $6,500) 11,000 Inventory... 11,000 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-23

Assignment 8-11 Requirement 1 Lower of cost or NRV applied by Cost NRV Items Classification Req. (a) Req. (b) Keyboards: A $ 1,128$ 960 $ 960 B 1,520 1,400 1,400 C 1,800 1,9801,800 4,448 4,340 $ 4,340 Hard drives: X 5,400 5,100 5,100 Y 9,600 10,800 9,600 15,000 15,900 15,000 CD Burners: D 4,560 3,960 3,960 E 20,000 23,200 20,000 24,560 27,160 24,560 Total cost $44,008 Lower of cost or NRV $42,820 $43,900 Requirement 2 (a) (b) Items Classification Periodic inventory; allowance method: Holding loss on inventory 1,188* 108** Allowance to reduce inventory to NRV 1,188 108 * $44,008 $42,820 = $1,188 ** $44,008 $43,900 = $108 Requirement 3 The application of lower of cost or NRV to individual items may be theoretically preferable because this represents a pure application of the method and is entirely consistent with the concepts underlying the method. Item-by-item application is preferable. In some cases, however, items can be grouped because they are similar or sold together. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-24 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-12 Requirement 1 Direct writedown December 20X6: June 20X7: Holding loss on inventory (COS)... 300,000 Inventory, Class A... 200,000 Inventory, Class B... 100,000 Inventory Class B... 40,000 Recovery of holding loss (COS)... 40,000 November 20X7: March 20X8: April 20X8: Accounts receivable... 190,000 Cost of goods sold... 182,500 Sales revenue... 190,000 Inventory Class B... 182,500 Accounts receivable ( 100,000 C$1.70)... 170,000 Cost of goods sold... 150,000 Sales revenue... 170,000 Inventory, Class A... 150,000 Cash ( 100,000 C$1.62)... 162,000 Foreign currency loss [ 100,000 (1.70 1.62)]... 8,000 Accounts receivable... 170,000 Requirement 2 Allowance method December 20X6: June 20X7: Holding loss on inventory (COS)... 300,000 Allowance to reduce inventory to NRV... 300,000 Allowance to reduce inventory to NRV... 40,000 Recovery of holding loss (COS)... 40,000 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-25

November 20X7: March 20X8: April 20X8: Accounts receivable... 190,000 Cost of goods sold... 182,500 Allowance to reduce inventory to NRV... 30,000 Sales revenue... 190,000 Inventory, Class B... 212,500 Accounts receivable ( 100,000 C$1.70)... 170,000 Cost of goods sold... 150,000 Allowance to reduce inventory to NRV... 200,000 Sales revenue... 170,000 Inventory, Class A... 350,000 Cash ( 100,000 C$1.62)... 162,000 Foreign currency loss [ 100,000 (1.70 1.62)]... 8,000 Accounts receivable... 170,000 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-26 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-13 The inventory that is being sold through the distributor must be written down to lower of cost or NRV. Net realizable value is $220 minus $44 commission per unit, which yields a NRV of $176. Original cost was $250. Therefore, the writedown is as follows: Writedown = ($250 $176) 600 units = $44,400. Holding loss on inventory... 44,400 Inventory, Model T (or allowance)... 44,400 No adjustment is necessary for the remaining 400 units because the new sales price is still higher than production cost. However, this assumes there is evidence that the Model Ts actually can be sold at the reduced price of $280. Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-27

Assignment 8-14 Requirement 1 To record the purchase of 50,000 crates @ $24: Crate Inventory (including 7% PST)... 1,284,000 GST payable ($1,200,000 5%)... 60,000 Accounts payable... 1,344,000 Requirement 2 The potential loss on the onerous contract is ($24 x $1.07) (18 x 1.07) = $6.42 150,000 = $963,000: Estimated loss on onerous purchase contract... 963,000 Provision for onerous contract... 963,000 The provision could also be recorded before sales tax, at $900,000. The loss must be likely and material, and reasonably measurable. The contract must be not subject to cancellation or renegotiation. Therefore, this loss should be recorded only if the low price of the crates is expected to continue throughout the fiscal period and the supplier refuses to renegotiate the contract. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-28 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-15 Requirement 1 The necessary contractual and economic conditions that would require only disclosure of the contract terms by means of a note in the financial statements would be either: (a) the contract is subject to revision or cancellation, or (b) a future loss is not likely and material, and (c) the loss cannot be reasonably estimated. Note: At the end of 20x7, a purchase contract for a maximum of $1,800,000 for subassemblies during 20x8 was in effect. At the end of 20x7, the subassemblies had a current replacement cost of $1,700,000. Requirement 2 The necessary contractual and economic conditions that would require accrual of a loss would be (a) the contract is not subject to revision or cancellation, (b) a future loss is likely and material, and (c) the loss can be reasonably estimated. Loss on purchase commitment*...100,000 Provision for onerous purchase commitment... 100,000 *The amount of the loss is based on the estimated current replacement cost ($1,800,000 $1,700,000). Requirement 3 Purchases...1,660,000 Provision for onerous purchase commitment... 100,000 Loss on purchase commitment... 40,000 Cash... 1,800,000 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-29

Assignment 8-16 Requirement 1 Cost of Inventory: 1. Merchandise in store ($490,000 retail 1.4)... $350,000* 2. Goods held for later shipment ($16,800 1.4)... 12,000 3.Merchandise on consignment [$24,000 (1.50)]... 12,000 4.Goods out on approval (not yet accepted by customer), at cost... 4,000 Corrected inventory, 31 December 20x5... $378,000 * Goods in transit (b) are not included because they were shipped FOB destination, which means that title has not yet transferred to the buyer. Office equipment (e) is not inventory. Requirement 2 Statement of Comprehensive Income: 1. Ending inventory overstatement ($490,000 $378,000)... $112,000 2. Cost of goods sold understated... 112,000 3. Gross margin overstated... 112,000 4. Pretax earnings overstated... 112,000 5. Income taxes overstated ($112,000.30)... 33,600 6. Earnings overstated ($112,000 $33,600)... 78,400 7. Amortization expense understated on office equipment; amount not determinable. Also affects tax expense and earnings. 8. Sales may be overstated, depending on how consignment and on approval items have been accounted for. Also affects gross margin, tax expense and earnings. Statement of Financial Position: Current assets: inventory overstated... $112,000 Capital assets, understated... 20,000 [Also understated is accumulated amortization, amount undeterminable. This also affects deferred income taxes and retained earnings.] Current liabilities: income taxes payable overstated... 33,600 Retained earnings overstated... 78,400 Note: there is also a potential overstatement of accounts receivable, and, as a result, incorrect deferred income taxes and retained earnings, if sales were improperly recorded. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-30 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-17 Requirement 1 Corrected earnings: Draft earnings, 20X6 $ 1,100,000 a. Understatement of purchases (and cost of sales) 50,000 b. Cut-off error: sale not recognized until 20X7, mismatch of revenue and expense + 240,000 c. Understatement of 20X6 ending inventory (overstatement of cost + 100,000 of sales) d. Consignment recorded as a sale ($250,000 revenue $160,000 90,000 COS) Corrected earnings $ 1,300,000 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-31

Assignment 8-18 Case A 1. The year-end inventory was properly stated in the 20X3 financial statements, which means that the $800,000 of inventory was not included in ending inventory on the 20X3 SFP. When the physical count was compared to the perpetual inventory records, there would have been a $800,000 discrepancy that would have been viewed as either missing inventory or a recording error. As a result, the cost of sales will have been properly calculated for that year because it is based on the physical count. Although COS was correct (using the physical count of the ending inventory), 20X3 revenue and accounts receivable were both understated by $1,280,000, the unrecorded sale. Earnings for 20X3 was similarly understated by $1,280,000. 2. Correcting entry in 20X4: Accounts receivable 1,280,000 Retained earnings (to restate 20X3 earnings) 1,280,000 The 20X3 financial statements must be restated by increasing (1) sales revenue and (2) accounts receivable by $1,280,000. Since the inventory was properly stated at year-end 20X3, the shipment must have been recorded in cost of sales on 31 December 20X3 when the goods left the warehouse. We ve assumed that the 4 January 20X4 entry was only for issuance of the sales invoice and not for cost of sales, and therefore no correction is needed for cost of sales in 20X4. Case B 1. The inventory in transit was recorded as a 20X4 purchase but was not included in the ending inventory. Therefore, the 20X4 ending inventory was understated and 20X4 cost of sales was overstated. 2. Correcting entry in 20X5: Inventory (opening) 530,000 Retained earnings 530,000 The 20X4 financial statements must be restated. 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-32 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition

Assignment 8-19 Cost of goods available for sale: Beginning inventory... $160,000 Purchases... $250,000 Freight-in... 8,000 258,000 Less: Purchase returns and allowances... 7,000 251,000 Cost of goods available for sale... 411,000 Deduct estimated cost of goods sold: Sales revenue... 400,000 Less: Returns... 17,500 Net sales... 382,500 Less: Estimated gross margin ($382,500 30%)... 114,750 267,750 Estimated cost of ending inventory... $143,250 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition 8-33

Assignment 8-20 (WEB) Requirement 1 Gross margin: $750,000 33.3% = $250,000 Cost of goods sold: $750,000 $250,000 = $500,000 Cost of goods available for sale: $140,000 + $800,000 + $7,000 = $947,000 Ending inventory: $947,000 $500,000 = $447,000 Requirement 2 Fiction: Gross margin: $590,000 28.6% = $168,740 Cost of goods sold: $590,000 $168,740 = $421,260 Cost of good available for sale: $100,000 + $600,000 + $5,000 = $705,000 Ending inventory: $705,000 $421,260 = $283,740 Non-fiction: Gross margin: $160,000 37.5% = $60,000 Cost of goods sold: $160,000 $60,000 = $100,000 Cost of goods available for sale: $40,000 + $200,000 + $2,000 = $242,000 Ending inventory: $242,000 $100,000 = $142,000 Total ending inventory (fiction and non-fiction) $283,740 + $142,000 = $425,740 Requirement 3 In this situation, applying the gross margin method separately to fiction and non-fiction and aggregating the results is preferable because (1) the markup percentages are different for the two categories and (2) the categories represent different proportions of total sales, purchases, and inventory on hand. A physical count should be much closer to the separate application of the gross margin method ($425,740) than the aggregate application ($447,000). 2017 McGraw-Hill Ryerson Ltd. All rights reserved 8-34 Solutions Manual to accompany Intermediate Accounting, Volume 1, 7 th edition