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Unit 7 Inventory Practice Questions and Answers
Compare the cost flow assumptions used to account for inventories
- The following information is available for a company that uses a specific identification inventory system: - October 1: Beginning inventory consisted of 200 units at a cost of $7. each. - October 7: 500 units were purchased at a cost of $8.00 each. - October 18: 250 units were sold from the October 7 purchase. - October 22: 600 units were purchased at a cost of $8.50 each. - October 24: 300 units were purchased at a cost of $9.00 each. - October 26: 350 units were sold from the October 22 purchase. What is the cost of goods sold (COGS) and the value of ending inventory for October? $4,975 = CGS: (350 x $8.50) + (250 x $8.00). Ending Inventory: $8,225 = (200 x $7)
- ((500 - 250) x 8) + ((600 - 350) x $8.5) + (300 x $9) Accounting Rule: The specific identification inventory valuation method tracks every single item in an inventory individually from the time it enters the inventory until the time it leaves it. This inventory method is suitable for companies with expensive, easily distinguishable low-volume merchandise such as jewelry, fur coats, automobiles, unique furniture, special manufactured made products. Consider the following inventory activity: The 9 units of ending inventory are identified with the purchase of May
Using the specific identification method, what is the value of the ending inventory and the cost of goods sold. a. $126 and $430, respectively. b. $126 and $530, respectively. c. $126 and $544, respectively. d. $56 and $474, respectively. Ans c Determine the effects of inventory errors on the financial statements
- A company that used the periodic inventory system overstated its beginning inventory but correctly stated its ending inventory. What will be the effect of this error on the financial statements at the end of the period? A company mistakenly understated ending inventory by $25,000 in a year but verified the correct ending inventory was recorded in the following year.
The cost of goods sold will be overstated and gross profit/net income will be understated. The ending inventory on the balance sheet is correct according to the facts. Accounting Rule: Inventory errors come in two forms: understatements or overstatements. Beginning inventory errors affect only the income statement because cost of goods sold is calculated using beginning inventory + purchases – ending inventory. Ending inventory errors affect both the income statement and the balance sheet and will affect two periods because 1) the ending inventory of one period will become the beginning inventory for the following period, and 2) the calculation of the cost of goods sold is beginning inventory + purchases – ending inventory. As shown in the table below, errors in calculating beginning inventory have a direct effect on cost of goods sold and inverse effect on gross profit and net income. On the other hand, errors in calculating ending inventory have an inverse effect on cost of goods sold and a direct effect on gross profit and net income. Errors in purchases have the same effect as errors in beginning inventory, that is a direct effect on cost of goods sold and inverse effect on gross profit and net income Error CGS GP/NI Beginning Inventory understated understated overstated overstated overstated understated Purchases understated understated overstated overstated overstated understated Ending Inventory understated Overstated understated overstated Understated overstated What is the effect of this on the total net income for the two years combined? No effect at the end of year 2. The error counterbalances each other as net income will be understated by $25,000 in Year 1 and overstated by $25,000 in Year 2: $25,000 + ($25,000). Accounting Rule: Inventory errors come in two forms: understatements or overstatements. Beginning inventory errors affect only the income statement because cost of goods sold is calculated using beginning inventory + purchases – ending inventory. Ending inventory errors affect both the income statement and the balance sheet and will affect two periods because 1) the ending inventory of one period will become the beginning inventory for the following period, and 2) the calculation of the cost of goods sold is beginning inventory + purchases – ending inventory. As shown in the table below, errors in calculating beginning inventory have a direct effect on cost of goods sold and inverse effect on gross profit and net income. On the other hand, errors in calculating ending inventory have an inverse effect on cost of goods sold and a direct effect on gross profit and net income. Errors in purchases have the same effect as errors in beginning inventory, which is a direct effect on cost of goods sold and inverse effect on gross profit and net income Error CGS GP/NI Beginning Inventory understated understated overstated overstated overstated understated Purchases understated understated overstated overstated overstated understated Ending Inventory understated Overstated understated overstated Understated overstated
- A company uses a periodic inventory system. The company is holding $100 of consigned goods and incorrectly includes them in its ending inventory count. The company discovers the error the following year and excludes the goods in its inventory count for that year. What is the effect of this error on the company’s financial statements? Year 1 Year 2 Beginning Inventory Not affected Overstated by $ (+) Purchases Not affected Not affected (-) (Ending Inventory Overstated by $100 Not affected Cost of Goods Sold Understated by $100 Overstated by $ Income Overstated by $100 Understated by $ The overstatement of ending inventory in the first-year results in the understatement of cost of goods sold in that year. Because beginning inventory in the second year is overstated, cost of goods sold will be overstated in the second year by the same amount that it was understated in the first year. Consequently, the impact on net income over the two-year period nets to zero. A company uses a periodic inventory system. The company incorrectly records inventory item purchases that were not received by the company’s warehouse as of the last day of the most recent reporting period. The items were purchased under free on board (FOB) destination terms. Therefore, they were not legally owned by the company on the period-ending date. The cost of the inventory purchased was $100,000. The company balance sheet reports the following balances at the end of the reporting period: Current assets: $600, Current liabilities: $300, What are two effects of the error on the company’s balance sheet a. retained earnings are overstated. b. net working capital is understated. c. the current ratio is understated. d. total purchases are overstated. Ans c & d Beginning Inventory Not affected (+) Purchases Overstated by $100, (-) Ending Inventory Overstated by $100, Cost of Goods Sold Not affected Income Not affected Accounts Payable Overstated by $100, The error resulted in the overstatement of purchases, inventory, and accounts payable. Because purchases (goods available for sale) and
ending inventory are overstated by the same amount, cost of goods sold is unaffected. Therefore, net income is not affected. The current ratio is understated. The current ratio formula is current assets /current liabilities. Ending inventory is a current asset and accounts payable is a current liability. Since both are understated by the same amount, the current ratio is smaller. For example, assume a correct current ratio of 50 / 20 = 2.5. Now, assume both current assets and current liabilities is overstated by 10. The current ratio now is 60 / 30 =2. Increasing the numerator and denominator by the same amount lowers the current ratio.
- A company uses the periodic inventory costing system. The company includes goods shipped to them f.o.b. shipping point in purchases, but not ending inventory. What is the effect on the current ratio? a. no effect. b. understated. c. overstated. d. there is not enough information to determine the effect. Ans b Beginning Inventory Not affected (+) Purchases Not affected (-) Ending Inventory) Understated Cost of Goods Sold Overstated Income Understated Accounts Payable Not affected A company uses the periodic inventory costing system and has a calendar year-end. The company starts the year with a beginning inventory that is understated. There are no other errors in the year. What is the effect of this inventory error on the company’s net income for the calendar year? a. no effect. b. understated. c. overstated. d. there is not enough information to determine the effect. Ans c Beginning Inventory Understated (+) Purchases Not affected (-) Ending Inventory Not affected Cost of Goods Sold Understated Income Overstated Accounts Payable Not affected
Ans d The formula for working capital is current assets minus current liabilities. Assume current assets is 12 and current liabilities is 5. Working capital would be 7. If inventory is overstated, this would increase the numerator from 12 to say 1 4. Working capital would now be 9. Hence, working capital is overstated. The current ratio formula is current assets/current liabilities. Assume current assets is 12 and current liabilities is 5. The current ratio would be 2.4. If inventory is overstated, this would increase the numerator from 12 to say 14. The current ratio would now be 2.8. Hence, the current ratio is overstated. c. accounts payable will be understated. d. net income will be understated. Ans b Ending inventory on the balance sheet would be overstated. Beginning Inventory not affected (+) Purchases not affected (-) Ending Inventory overstated Cost of Goods Sold understated There is an inverse relationship between ending inventory and cost of goods sold. If ending inventory is overstated, then cost of goods sold is understated. If ending inventory is understated, then cost of goods sold is overstated.
- A company that is using the periodic inventory system correctly records ending inventory but double counts some items in purchases. What will be the effect on the financial statements at the end of this period? a. current ratio will be overstated. b. cost of goods sold will be overstated. c. accounts payable will be understated. d. net income will be overstated. Ans b Ending inventory on the balance sheet would be overstated. Beginning Inventory not affected (+) Purchases overstated (-) Ending Inventory not affected Cost of Goods Sold overstated There is direct relationship between purchases and cost of goods sold. If purchases are overstated, then cost of goods sold is overstated. If purchases are understated, then cost of goods sold is understated. The following table shows the effect of understated/overstated inventory errors. Please study and memorize the material. Inventory Error COGS Gross Profit/Net Income Relationship Beginning Inventory Understatement (U) U O Direct relationship to CGS Overstatement (O) O U Inverse relationship to GP/NI Purchases
Understatement (U) U O (^) Direct relationship to CGS Overstatement (O) O U Inverse relationship to GP/NI Ending Inventory Understatement (U) O U Inverse relationship to CGS Overstatement (O) U O Direct relationship to GP/NI
- The failure to record a purchase of merchandise on account even though the goods are properly included in the physical inventory results in a. an overstatement of assets and net income. b. an understatement of assets and net income. c. an understatement of cost of goods sold and liabilities and an overstatement of assets. d. an understatement of liabilities and an overstatement of net income. Ans d A company received merchandise on consignment. As of March 31, the company recorded the transaction as a purchase on account and included the goods in its periodic inventory. The effect of this on the company’s financial statements for March 31st^ is a. no effect. b. net income was correct and current assets and current liabilities were overstated. c. net income, current assets, and current liabilities were overstated. d. net income and current liabilities were overstated. Ans b
- A company recorded the purchase of 500 units on December 28, Year 1, free on board (FOB) shipping point. The units were shipped immediately and expected to arrive on January 3, Year 2. The company did not include these units in December's ending inventory.
- Beginning inventory of $40,000 plus purchases of $30,000 equals which of the following? a. cost of sales of $70,000. b. cost of goods sold of $70,000. c. cost of goods available for sale of $70,000. Ans c Accounting Rule: Beginning inventory plus purchases equals goods available for sale. Cost of sales and cost of goods sold mean the same thing and are used interchangeably. Make sure you know the following formula Beginning Inventory (+) Net Purchases^1 (=) Goods Available for Sale (-) Ending Inventory (=) Cost of Goods Sold (^1) Net Purchases = Purchases + Freight In- Purchase Discounts – Purchase Returns and Allowances The ending inventory of a merchandiser is $50,000. The beginning inventory was $200,000. If the income statement for the year reported cost of goods sold of $350,000, how much were purchases during the year? 200,000+P=350,000+50,000, and thus P=$200, Accounting Rule: Purchases is calculated as beginning inventory minus ending inventory plus cost of goods sold. Make sure you know the following formula Beginning Inventory (+) Net Purchases^1 (=) Goods Available for Sale (-) Ending Inventory (=) Cost of Goods Sold (^1) Net Purchases = Purchases + Freight In- Purchase Discounts – Purchase Returns and Allowances Determine the goods and costs included in inventory
- A manufacturing company incurred the following costs:
- direct materials: $2,
- depreciation on factory equipment: $
- selling expenses: $1,
- freight charges on direct materials: $ What are the total period costs? $1, Accounting Rule: Period costs include any costs not related to the manufacture or acquisition of a product, i.e., nonmanufacturing costs. Sales commissions, administrative costs, advertising and rent of office space are all period costs. These costs are not included as part of the cost of either purchased or manufactured goods but are recorded as expenses on the income statement in the period they are incurred. A manufacturing company incurred the following costs: - direct materials: $2, - depreciation on factory equipment: $ - selling expenses: $1, - freight charges on direct materials: $ What are the total product costs? $3, Accounting Rule: Product Costs include any cost of acquiring and producing a product. These costs include direct materials, direct labor, and manufacturing overhead. Manufacturing overhead costs include indirect materials, indirect labor, and various manufacturing related costs such as depreciation, taxes, insurance, and utilities.
- Which of the following is a period cost? a. direct costs. Which of the following is a product cost as it relates to inventory? a. freight out.
b. freight in. c. production costs. d. selling costs. Ans d Accounting Rule: Period costs include any costs not related to the manufacture or acquisition of a product, i.e., nonmanufacturing costs. Sales commissions, administrative costs, advertising and rent of office space are all period costs. These costs are not included as part of the cost of either purchased or manufactured goods but are recorded as expenses on the income statement in the period they are incurred. b. interest costs. c. raw materials. d. abnormal spoilage. Ans c Accounting Rule: Product Costs include any cost of acquiring and producing a product. These costs include direct materials, direct labor, and manufacturing overhead. Manufacturing overhead costs include indirect materials, indirect labor, and various manufacturing related costs such as depreciation, taxes, insurance, and utilities. Costs of normal shrinkage and scrap incurred in the manufacture of a product is a product cost. Interest cost incurred in the production process is a product cost, but the question would have to specifically indicate this. Freight out is a selling cost and a period cost but freight in is a product cost.
- Which of the following is correct? a. selling costs are product costs. b. manufacturing overhead costs are product costs. c. interest costs for routine inventories are product costs. d. all these answers are correct. Ans b
- A manufacturing company has the following inventory-related costs:
- direct materials: $10,
- direct labor: $3,
- indirect labor: $2,
- indirect materials: $1,
- manufacturing depreciation: $1,
- manufacturing utilities: $2,
- storage costs: $1,
- purchasing department costs: $1,
- interest expense: $ How much is included in inventory? $20,000 = $10,000 + $3,000 + $2,000 + $1,000 + $1,500 + $2,
- In a perpetual inventory system, the cost of inventory sold is: a. Debited to accounts receivable. b. Credited to cost of goods sold. c. Debited to cost of goods sold. d. Not recorded at the time goods are sold. Ans c In a perpetual inventory system, which of the following is recorded at the time of the sale? a. Sales revenue only. b. Both sales revenue and cost of goods sold. c. Cost of goods sold only. d. Neither sales revenue nor cost of goods sold. Ans b
- In a periodic inventory system, the cost of inventories sold is: a. Debited to accounts receivable. b. Credited to cost of goods sold. c. Debited to cost of goods sold. d. Not recorded at the time goods are sold. Ans d One difference between periodic and perpetual inventory systems is: a. Cost of goods sold is not recorded under a perpetual system until the end of the period. b. Cost of goods sold is not recorded under a periodic system until the end of the period. c. Cost of goods sold is always significantly higher under a perpetual system. d. Cost of goods sold is always significantly higher under a periodic system. Ans b Determine the goods and costs included in inventory
- On January 10, a company purchased $5,000 of inventory on terms 1/10, net 30. Payment was made on January 18. The company uses the periodic system. What are the journal entries to record the purchase and the payment using the gross method? Jan 10 debit purchases for $5,000; credit accounts payable for $5, Jan 18 debit accounts payable for $5,000; credit cash for $4,950; credit purchase discounts for $ Accounting Rule: The gross method records purchase at full price without regard to the cash discounts offered. In other words, the gross method assumes that the customer will not take advantage of the cash or early payment discount. On January 10, a company purchased $5,000 of inventory on terms 1/10, net 30. Payment was made on January 18. The company uses the periodic system. What are the journal entries to record the purchase and the payment using the net method? Jan 10 debit purchases for $4,950; credit accounts payable for $4, Jan 18 debit accounts payable for $4,950; credit cash for $4, Accounting Rule: The net method records the purchase net of the cash discount. In other words, the net method assumes that the customer will take advantage of the cash or early payment discount.
- On January 10, a company purchased $5,000 of inventory on terms 1/10, net 30. Payment was made on January 30. The company uses the periodic system. What are the journal entries to record the purchase and the payment using the net method? Jan 10 debit purchases for $4,950; credit accounts payable for $4, Jan 18 debit accounts payable for $4,950; debit purchase discounts lost $50; credit cash for $5, Accounting Rule: The failure to take the discount within the discount period is recorded in a purchase discount lost account and reported in the “other expenses and losses” section of the income statement. On the first day of a period, $20,000 of purchases were made on an account with terms 2/10, n/30. The company uses the gross method and has the following payment history: - $10,000 was paid on day 5 - $4,000 was paid on day 9 - $6,000 was paid on day 28 What is the total amount of purchase discounts at the end of the 30-day period? $280 = ($10,000 x 2%) + ($4,000 x 2%)
- A company purchased dresses on July 17th^ and received an invoice with a list price amount of $6,000 and payment terms of 2/10, n/30. The company uses the net method to record purchases. The company should record the purchase at a. $5,940. b. $5,880. c. $6,000. d. $6,120. Ans b $5,880 = $6,000 – ($6,000 x 2%) Make sure you fully understand the gross and net method for recording purchase discounts.
The following information is given: Date Quantity Cost per Unit Total Cost 12/31/2018 Year-end balance 200 $7.00 $1, 1/17/2019 Purchase 500 $8.00 $4, 1/18/2019 Sale 250 1/22/2019 Purchase 600 $8.50 $5, 1/24/2019 Purchase 300 $9.00 $2, 1/30/2019 Sale 350 What is the cost of goods sold (COGS) and the value of ending inventory for January 2019? COGS = $5,250; ending inventory = $7,950. A total of 600 units were sold (250 +
- so COGS is $5,250 = (300 x $9) + (300 x $8.50). There is a total of 1,000 in ending inventory (200 + 500 - 250 + 600 + 300 - 350) so ending inventory is $7,950 = (300 x $8.5 0 ) + (500 x $8) + (200 x $7). Accounting Rule: The LIFO method of inventory valuation for a periodic inventory system assumes that the last items purchased are used to value the items sold and the earliest items purchased are used to value ending inventory. The following information is given: Date Quantity Cost per Unit Total Cost 12/31/2018 Year-end balance 200 $7.00 $1, 1/17/2019 Purchase 500 $8.00 $4, 1/18/2019 Sale 250 1/22/2019 Purchase 600 $8.50 $5, 1/24/2019 Purchase 300 $9.00 $2, 1/30/2019 Sale 350 What is the cost of goods sold (COGS) and the value of ending inventory for January 2019? COGS = $4,600; ending inventory = $8,600. A total of 600 units were sold (250 + 350) so COGS is $4,600 = ( 2 00 x $ 7 ) + ( 4 00 x $8. 0 0). There is a total of 1,000 units in ending inventory (200 + 500 - 250 + 600 + 300 -
- so ending inventory is $8,600 = ( 1 00 x $8) + (600 x $8.50) + ( 300 x $ 9 ). Accounting Rule: The FIFO method of inventory valuation for a periodic inventory system assumes that the earliest items purchased are used to value the items sold and the last items purchased are used to value ending inventory.
- A company is an online retailer that sells video game equipment. The figure below shows the company's beginning inventory and purchases of game controllers during the year ended December 31, 2018. As shown below, the company sold 7,000 controllers to various customers during the year. The retail price of each controller was $. Date Transaction Number of Controllers Cost Per Controller Number Sold 1/5/2018 Beginning inventory 1,000 $30 800 2/7/2018 Purchase 1,000 $31 900 A company using the moving-average method has the following information for a month:
- no beginning inventories
- purchases of 10,000 units at $1 per unit in the first week
- purchases of 15,000 units at $1.50 per unit in the third week
- purchase of 12,000 units at $1.40 per unit and sales of 13, units on the last day of the month What is this month’s ending balance in the inventory account, rounded to the nearest hundred? $32,
3/10/2018 Purchase 2,000 $32 1, 5/30/2018 Purchase 3,000 $33 2, 7/25/2018 Purchase 1,500 $34 1, 9/12/2018 Purchase 500 $35 500 Total 7, What is the company's ending inventory and cost of goods sold for the year ended December 31, 2018, using the periodic weighted average method? COGS = $227,500; ending inventory = $65,000. A total of 9,000 units were purchased at a total cost of $292,500 ((1,000 x $30) + (1,000 x $31) + (2,000 x $32) + (3,000 x $33) + (1,500 x $34) + (500 x $35)) for an average unit cost of $32.50 = ($292,500 / 9,000). So, COGS is $227,500 = ( 7 ,000 x $32.50). There is a total of 2 ,000 in ending inventory (9,000 – 7,000)) so ending inventory is $65, = (2,000 x $32.50). Accounting Rule: When using the weighted average method in a periodic inventory system, cost of goods available for sale is divided by the number of units available for sale, which yields the weighted-average cost per unit. The cost of goods available for sale is the sum of beginning inventory and net purchases. This weighted average figure is then used to assign a cost to both ending inventory and cost of goods sold. Week Purchases/(Sold) Cost Average Unit Cost 1 st^ 10,000 @ $1 $10, 3 rd^ 15,000 @ $1.50 $22, Total 25,000 $32,500 $ 1. 4 th^ 12,000 @ $1.4 0 $16, 800 Total 37,000 $49, 300 $1. (13,000) @ $1.33 ($17,290) Total 24,000 $32,010 $1. Identify inventory classification and different inventory systems
- As of March 1, a company had an inventory balance of $100,000. During March, purchases were $40,000, and inventory was sold for $50,000 that had an original purchase price of $30,000. The company uses a perpetual inventory system. What is the amount in the inventory account as of March 31st? $ 110 ,000 = $100,000 + $40,000 - $30, Accounting Rule: To calculate the ending balance in inventory, start with the beginning add purchases and subtract the goods sold using their cost value. As of March 1, a company had an inventory balance of $100,000. During March, purchases were $40,000, and inventory was sold for $50,000 that had an original purchase price of $30,000. The company uses a perpetual inventory system. What was the amount transferred from the inventory account to the cost of goods sold account during March? $30, The company sold inventory with an original cost of $30,000. The journal entry to record the sale is Debit cost of goods sold 30, Credit inventory 30,
d. none of these answer choices are correct. Ans b Accounting Rule: In a FOB shipping point, the seller transfers title of ownership to the buyer upon the product leaving the seller's location. d. None of these answers are correct. Ans a Accounting Rule: In a FOB destination, the seller retains title of ownership until the product reaches the buyer's location.
- Goods on consignment are a. included in the consignee's inventory. b. included in the consignor’s inventory. c. included in the consignee’s revenue. d. included in both the consignee’s and the consignor’s inventory. Ans b Accounting Rule: In a consignment, the seller (consignor) retains title of ownership until the product is sold. Company A received a $6,000 shipment of inventory designated free on board (FOB) shipping point on November 1. The details for the shipment include the following:
- Shipment was in transit on October 31.
- The shipping costs were $200.
- Company A added $3,000 in direct labor to complete the finished product. How much should be included in Company A's October 31 inventory? $6,200 = $6,000 + $ Accounting Rule: In a FOB shipping point, the seller transfers title of ownership to the buyer upon the product leaving the seller's location. Shipping costs, freight-in is also included. The direct labor is not because it occurred after October 31st. Apply the lower of cost or market principle to inventory
- A company is analyzing its inventory and wants to apply the lower-of-cost-or- market rule to the value of its inventory given below: Product Cost Replacement Costs Net Realizable Value Net Realizable Value Less a Normal Profit Margin Group 1 A $10,000 $12,000 $15,000 $13, B $15,000 $13,000 $15,000 $12, Group 2 C $5,000 $6,000 $4,000 $3, D $6,000 $3,000 $5,000 $4, A company is analyzing its inventory and wants to apply the lower-of- cost-or-market rule to the value of its inventory given below: Product Cost Replacement Costs Net Realizable Value Net Realizable Value Less a Normal Profit Margin Group 1 A $10,000 $1 3 ,000 $15,000 $13, B $15,000 $13,000 $15,000 $1 4 , Group 2 C $5,000 $6,000 $ 5 ,000 $3, D $6,000 $3,000 $5,000 $4,
What is the inventory adjustment for the period assuming this company applies the lower-of-cost-or-market rule to the total amount of inventory? $2,000 ($36,000 - $34,000); total cost = $36,000; total replacement costs = $34,000; total net realizable value = $39,000; total net realizable value less a normal profit margin = $32, Accounting Rule: Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventory is greater than the net realizable value (market value), and thus the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The term "lower of cost or market" is now obsolete and is officially replaced by "lower of cost and net realizable value” for companies that use the FIFO (first-in, first-out) and average-cost inventory valuation methods. Companies that use the LIFO (last-in, first-out) inventory valuation method still use "lower of cost or market". The market value can be replacement cost, net realizable value (ceiling) or floor. The net realizable value (NRV) is the expected selling price of an item minus any selling costs or costs to complete the item. The floor is the NRV minus a normal profit on the item. Normal profit is calculated by taking sales value times normal gross profit percentage. The middle value becomes the designated market value and is compared to historical cost. The lower of these two amounts becomes the inventory value. The amount by which the inventory item is written down is recorded under cost of goods sold if nonmaterial or loss beneath gross profit on the income statement if material. The lower of cost or market (LCM) can be applied to the entire inventory, or group of inventory items, or individual inventory items. What is the inventory value for Groups 1 and 2 applying the lower-of- cost-or-market rule? Group 1: $25,000 = total cost = $25,000; total replacement costs = $26,000; total net realizable value = $30,000; total net realizable value less a normal profit margin = $27, Group 2: $9,000 = total cost = $11,000; total replacement costs = $9,000; total net realizable value = $10,000; total net realizable value less a normal profit margin = $7, Accounting Rule: Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventory is greater than the net realizable value (market value), and thus the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The term "lower of cost or market" is now obsolete and is officially replaced by "lower of cost and net realizable value” for companies that use the FIFO (first-in, first-out) and average-cost inventory valuation methods. Companies that use the LIFO (last-in, first-out) inventory valuation method still use "lower of cost or market". The market value can be replacement cost, net realizable value (ceiling) or floor. The net realizable value (NRV) is the expected selling price of an item minus any selling costs or costs to complete the item. The floor is the NRV minus a normal profit on the item. Normal profit is calculated by taking sales value times normal gross profit percentage. The middle value becomes the designated market value and is compared to historical cost. The lower of these two amounts becomes the inventory value. The amount by which the inventory item is written down is recorded under cost of goods sold if nonmaterial or loss beneath gross profit on the income statement if material.
