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Intermediate Accounting: Chapter 9, Exams of Advanced Education

Abilene Christian University (ACU)Advanced Education

Intermediate Accounting: Chapter 9

Typology: Exams

2025/2026

Available from 02/16/2026

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Intermediate Accounting: Chapter 9
Lower-of-cost-or-market - correct answer Lower-of-cost-or-market - 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—obsolescence, price-level changes, or damaged goods—a company
should write down the inventory to market to report this loss. A company abandons
the historical cost principle when the future utility (revenue-producing ability) of the
asset drops below its original cost. Companies therefore report inventories at the
lower-of-cost-or-market at each reporting period.
Cost - correct answer Recall that cost is the acquisition price of inventory computed
using one of the historical cost-based methods—specific identification, average
cost, FIFO, or LIFO.
Market (for LCM) - correct answer Market (for LCM)
The cost to replace an inventory item by purchase or reproduction. For a retailer,
"market" refers to the market in which a company purchases goods, not the market
in which it sells them. For a manufacturer, the term "market" refers to the cost to
reproduce. Thus, lower-of-cost-or-market means that companies value goods at cost
or cost to replace, whichever is lower.
Market - correct answer INTERNATIONAL PERSPECTIVE
IFRS defines market as net realizable value; GAAP defines market as replacement
cost subject to certain constraints.
Net realizable value (NRV) (inventories) - correct answer Net realizable value (NRV)
(inventories)
In the lower-of-cost-or-market approach, the estimated selling price in the ordinary
course of business, less reasonably predictable costs of completion and disposal.
The NRV represents the ceiling (upper limit) under LCM.
Net realizable value less a normal profit margin - correct answer Net realizable
value less a normal profit margin
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Intermediate Accounting: Chapter 9

Lower-of-cost-or-market - correct answer Lower-of-cost-or-market - 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—obsolescence, price-level changes, or damaged goods—a company should write down the inventory to market to report this loss. A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. Companies therefore report inventories at the lower-of-cost-or-market at each reporting period. Cost - correct answer Recall that cost is the acquisition price of inventory computed using one of the historical cost-based methods—specific identification, average cost, FIFO, or LIFO. Market (for LCM) - correct answer Market (for LCM) The cost to replace an inventory item by purchase or reproduction. For a retailer, "market" refers to the market in which a company purchases goods, not the market in which it sells them. For a manufacturer, the term "market" refers to the cost to reproduce. Thus, lower-of-cost-or-market means that companies value goods at cost or cost to replace, whichever is lower. Market - correct answer INTERNATIONAL PERSPECTIVE IFRS defines market as net realizable value; GAAP defines market as replacement cost subject to certain constraints. Net realizable value (NRV) (inventories) - correct answer Net realizable value (NRV) (inventories) In the lower-of-cost-or-market approach, the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal. The NRV represents the ceiling (upper limit) under LCM. Net realizable value less a normal profit margin - correct answer Net realizable value less a normal profit margin

In the lower-of-cost-or-market approach, the floor (lower limit), calculated as the NRV minus a normal profit margin. Lower-of-cost-or-market (LCM) - correct answer Lower-of-cost-or-market (LCM) Rule that dictates that a company value 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. Thus, companies abandon the historical cost principle when the revenue-producing ability of an asset drops below its original cost. Upper limit (ceiling) - correct answer Upper limit (ceiling) In the lower-of-cost-or-market (LCM) approach, the highest amount at which inventory can be reported, which is the inventory's net realizable value. The ceiling prevents overstatement of inventories and understatement of the loss in the current period. Lower limit (floor) - correct answer Lower limit (floor) In the lower-of-cost-or-market (LCM) rule, the lowest amount at which inventory can be reported; computed as the net realizable value less a normal profit margin. This minimum amount measures what the company can receive for the inventory and still earn a normal profit. Designated market value - correct answer Designated market value The amount that a company compares to cost, when using the lower-of-cost-or- market (LCM) rule. The designated market value is the middle value of three amounts: replacement cost, net realizable value, and net realizable value less a normal profit margin. Final market value - correct answer Final market value = lower of designated market value and cost Cost-of-goods-sold method - correct answer Cost-of-goods-sold method A method of valuing inventory in which cost of goods sold is debited for the write- down of inventory to market. 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 loss.

  • Many financial statement users appreciate the lower-of-cost-or-market rule because they at least know that it prevents overstatement of inventory. In addition, recognizing all losses but anticipating no gains generally results in lower income. Valuation At Net Realizable Value - correct answer Under limited circumstances, support exists for recording inventory at net realizable value, even if that amount is above cost. GAAP permits this exception to the normal recognition rule under the following conditions: (1) when there is a controlled market with a quoted price applicable to all quantities, and (2) when no significant costs of disposal are involved. For example, mining companies ordinarily report inventories of certain minerals (rare metals, especially) at selling prices because there is often a controlled market without significant costs of disposal. (3) A third reason for allowing valuation at net realizable value is that sometimes it is too difficult to obtain the cost figures. Purchase commitments - correct answer Purchase commitments Agreements to buy inventory weeks, months, or years in advance. The seller generally retains title to the merchandise or materials covered in the purchase commitments.
  • If the contract price is greater than the market price, and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize losses in the period during which such declines in market prices take place. Hedging (purchase commitments) - correct answer Hedging (purchase commitments) The purchaser in the purchase commitment simultaneously enters into a contract in which it agrees to sell in the future the same quantity of the same (or similar) goods at a fixed price. The company holds a buy position in a purchase commitment and a sell position in a futures contract in the same commodity. Purchase Commitments—a Special Problem - correct answer Some argue that companies should report purchase commitments as assets and liabilities at the time they sign the contract.8 Others believe that the present recognition at the delivery date is more appropriate. FASB Concepts Statement No. 6 states, "a purchase commitment involves both an item that might be recorded as an asset and an item that might be recorded as a liability. That is, it involves both a right to receive assets and an obligation to pay. ... If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be clearly seen." Although the discussion in Concepts Statement No. 6 does not exclude the

possibility of recording assets and liabilities for purchase commitments, it contains no conclusions or implications about whether companies should record them. Gross profit method - correct answer Gross profit method Method of determining inventory amount, often used when it is impossible or impractical to take a physical inventory. In this method, companies compute the gross profit percentage on selling price, multiply that percentage times net sales to determine gross profit, subtract gross profit from net sales to find cost of goods sold, and subtract cost of goods sold from total goods available for sale to determine ending inventory. Also called the gross margin method. Gross profit method - correct answer Gross profit method (assumptions) The gross profit method relies on three assumptions:

  1. The beginning inventory plus purchases equal total goods to be accounted for.
  2. Goods not sold must be on hand.
  3. The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory. Gross profit percentage - correct answer Gross profit percentage Measure used in the gross profit method; it represents the rate (percentage) of profit a company expects from some convenient measure, usually sales. This rate is determined by company policy and prior-period experience. Gross profit on selling price - correct answer Gross profit on selling price = % markup on cost / 100% + % markup on cost Percentage markup on cost - correct answer Percentage markup on cost = Gross profit on selling price / 100% - gross profit on selling price The Gross Profit Method of Estimating Inventory - correct answer Because selling price exceeds cost, and with the gross profit amount the same for both, gross profit on selling price will always be less than the related percentage based on cost. Note that companies do not multiply sales by a cost-based markup percentage. Instead, they must convert the gross profit percentage to a percentage based on selling price.

crew does not need to look up each item's invoice cost, thereby saving time and expense. Markup - correct answer Markup An additional markup of the original retail price. Markup cancellations - correct answer Markup cancellations Decreases in the prices of merchandise that the retailer had marked up above the original retail price. Markdown cancellations - correct answer Markdown cancellations Markdowns that are later offset by increases in the prices of goods that the retailer had marked down. Conventional retail inventory method - correct answer Conventional retail inventory method A method of valuing ending inventory that uses only a cost ratio using markups but not markdowns, thereby approximating the lower-of-average-cost-or-market. Special Items Relating to Retail Method - correct answer The retail inventory method becomes more complicated when we consider such items as freight-in, purchase returns and allowances, and purchase discounts. In the retail method, we treat such items as follows.

  • Freight costs are part of the purchase cost.
  • Purchase returns are ordinarily considered as a reduction of the price at both cost and retail.
  • Purchase discounts and allowances usually are considered as a reduction of the cost of purchases. Special Items Relating to Retail Method - correct answer In addition, a number of special items require careful analysis:
  • Transfers-in from another department are reported in the same way as purchases from an outside enterprise.
  • Normal shortages (breakage, damage, theft, shrinkage) should reduce the retail column because these goods are no longer available for sale. Such costs are reflected in the selling price because a certain amount of shortage is considered normal in a retail enterprise. As a result, companies do not consider this amount in computing the cost-to-retail percentage. Rather, to arrive at ending inventory at retail, they show normal shortages as a deduction similar to sales.
  • Abnormal shortages, on the other hand, are deducted from both the cost and retail columns and reported as a special inventory amount or as a loss. To do otherwise distorts the cost-to-retail ratio and overstates ending inventory.
  • Employee discounts (given to employees to encourage loyalty, better performance, and so on) are deducted from the retail column in the same way as sales. These discounts should not be considered in the cost-to-retail percentage because they do not reflect an overall change in the selling price. Evaluation of Retail Inventory Method - correct answer Companies like Gap Inc., Home Depot, or your local department store use the retail inventory method of computing inventory for the following reasons: (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. Evaluation of Retail Inventory Method - correct answer One characteristic of the retail inventory method is that it has an averaging effect on varying rates of gross profit. This can be problematic when companies apply the method to an entire business, where rates of gross profit vary among departments. There is no allowance for possible distortion of results because of such differences. Companies refine the retail method under such conditions by computing inventory separately by departments or by classes of merchandise with similar gross profits. In addition, the reliability of this method assumes that the distribution of items in inventory is similar to the "mix" in the total goods available for sale. Presentation of Inventories - correct answer Accounting standards require financial statement disclosure of the composition of the inventory, inventory financing arrangements, and the inventory costing methods employed. The standards also require the consistent application of costing methods from one period to another. Presentation of Inventories - correct answer Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes. The relative mix of raw materials, work in process, and finished goods helps in assessing liquidity and in computing the stage of inventory completion.

A measure that represents the average number of days' sales for which inventory is on hand. A variant of the inventory turnover ratio, it is computed by dividing the inventory turnover ratio by the number of days in the year (365 or sometimes for simplicity, 360). Describe and Apply the Lower-of-cost-or-market Rule. - correct answer Describe and Apply the Lower-of-cost-or-market Rule. If inventory declines in value below its original cost, for whatever reason, a company should write down the inventory to reflect this loss. The general rule is to abandon the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. Explain When Companies Value Inventories At Net Realizable Value. - correct answer Companies value inventory at net realizable value when: (1) there is a controlled market with a quoted price applicable to all quantities, (2) no significant costs of disposal are involved, and (3) the cost figures are too difficult to obtain. Explain When Companies Use the Relative Sales Value Method to Value Inventories.

  • correct answer When a company purchases a group of varying units at a single lump-sum price—a so-called basket purchase—the company may allocate the total purchase price to the individual items on the basis of relative sales value. Discuss Accounting Issues Related to Purchase Commitments. - correct answer Accounting for purchase commitments is controversial. Some argue that companies should report purchase commitment contracts as assets and liabilities at the time the contract is signed. Others believe that recognition at the delivery date is most appropriate. The FASB neither excludes nor recommends the recording of assets and liabilities for purchase commitments, but it notes that if companies recorded such contracts at the time of commitment, the nature of the loss and the valuation account should be reported when the price falls. Determine Ending Inventory By Applying the Gross Profit Method. - correct answer Companies follow these steps to determine ending inventory by the gross profit method: (1) Compute the gross profit percentage on selling price. (2) Compute gross profit by multiplying net sales by the gross profit percentage. (3) Compute cost of goods sold by subtracting gross profit from net sales. (4) Compute ending inventory by subtracting cost of goods sold from total goods available for sale. Determine Ending Inventory By Applying the Retail Inventory Method. - correct answer Companies follow these steps to determine ending inventory by the conventional retail method: (1) To estimate inventory at retail, deduct the sales for

the period from the retail value of the goods available for sale. (2) To find the cost- to-retail ratio for all goods passing through a department or firm, divide the total goods available for sale at cost by the total goods available at retail. (3) Convert the inventory valued at retail to approximate cost by applying the cost-to-retail ratio. Explain How to Report and Analyze Inventory. - correct answer Accounting standards require financial statement disclosure of: (1) the composition of the inventory (in the balance sheet or a separate schedule in the notes); (2) significant or unusual inventory financing arrangements; and (3) inventory costing methods employed (which may differ for different elements of inventory). Accounting standards also require the consistent application of costing methods from one period to another. Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory.