CALCULATION OF ESTIMATED LOSS ON INVENTORY IN THE FIRE USING GROSS MARGIN (PROFIT) METHOD

November 21, 19X8

Inventory at November 1, 19X8 $100,000 Purchases from November 1, 19X8 to date of fire 140,000 Cost of goods available for sale 240,000 Estimated cost of goods sold

Net sales from Nov. 1, 19X8 to date of fire $220,000 Less estimated gross margin (profit)

($220,000 × 30%) 66,000 154,000 Estimated cost of inventory at date of fire 86,000 Less salvage goods 10,000 Estimated loss on inventory in the fire $ 76,000

NUMBER 3

a. 1. When LIFO i s applied to units of product , the total inventory value is determined by pricing individual

items within the inventory. This forms the base layer o f the LIFO i nventory. When there is an increase in the number of any given unit in the inventory at the end of a period, it is theoretically consistent to value the increase as if it occurred as earl y in the period as possible. In other words, if the volume of the first purchase of the period exceeds the amount of increase in units, the increase is added to the beginni ng inventory priced at the unit cost of the first purchase. If the size of the incr ease exceeds the volume of the first purchase, then the entire cost of the first purchase plus sufficient units priced at the unit cost from the next purchas e would be used, etc. In practice, however, the increase is sometimes priced at either the most recent purchase cost or at the average cost for the year. However priced, the increased units represent a new layer of the inventory. Decreases in inventory quantities are removed from the inventory layers in the reverse order of additions.

2. The dollar-value method is applied to a retail LIFO inventory and to LIFO units of product utilizes a number of procedures in common. At the time of adoption of either application, inventory consists of a base pool (or group of pools) to which is assigned a dollar value that is an inherent element of all subsequent inventory amounts, unless a reduction below the original inventory level is sustained. An i mportant element of establishing the pool is segmentation of the inventory into appropriate classes or homogeneous groupings (i.e., similar markups or goods sold to the same type of customer for the same general purpose). It is also essential to compute or ascertain an index value of relevant prices at the time these applications are adopted. Subsequent increments or increases above the basic inventory level are valued through the use of related price-index values. The base-year price index is used in comparison with the current price index prevailing when the inventory increase occurs to determine how much of an apparent change is solely due to price changes and how much represents an actual change in the volume of the inventory. Volume increases (new layers) are then added to the basic inventory at price levels actually prevailing when the physical increases took place. If a decrease should occur in a later period after there has been a succession of increases above the basic inventory, the most recent layers added are the firs t layers presumed to have been sold or consumed.

b. The pool concept of the dollar-value LIFO applications discussed above makes it unnecessary to m atch opening

and closing quantities of individual items, thereby simplifying recordkeeping. This advantage is lim ited by the necessity to maintain appropriate classes of inventory within the particular pool, but this is less cumbersome than accounting for i ndividual items of inventory. Under these applications, changes i n the specific types of goods making up a particular inventory classification do not affect total inventory pricing unless such changes result in an increase in ending inventory priced at base-year prices. Thus, continuous substitution of new elements of inventory may have little or no effect on the total inventory am ount. This is in some contrast with what would occur under a LIFO system maintained strictly on a unit basis where the new units would come into inventory at substantially higher values when prices were rising.

c. The advantage usually cited for the LIFO method and its applications is that it does match current costs against

current revenues. Stated another way, its usage, when prices are rising, results in the highest costs being matched against current revenue; conversely, when prices are falli ng, the lowest costs are matched against current revenue. This minimizes recognition of profits or losses from mere fluctuations in the value of inventories which an entity must continue to hold if it is to remain a going concern. A second advant age of the method is that it provides a better measure of disposable incom e. Under other m ethods which, given parallel c onditions, would show higher amounts of ending inventory and hence correspondi ngly higher amounts of income, the income is not as good an indication of the am ount that is disposable. Additional investment (perhaps from retained earnings) in inventory must be made if the same quantity is to be maintained on hand. A third advantage of the method is that in conditions of rising prices it tends to give lower inventory valuations. In the event th ese valuations are accepted for property- tax-valuation purposes there would be an attendant tax saving.

The principal disadvantage concerns the valuation of the inventory for balance-sheet purposes. As more time elapses from the date of adoption of the method, the value reflected on the balance sheet grows more out-of-date. This would mean that if prices changed much over the interval from the date of adoption to the date of the current balance sheet, the balance-sheet value would be som ewhat meaningless. Further, LIFO perm its a deferral in

recognition of gains or losses from the holding of inventories when prices of specific goods are changi ng at rates different than the rate of prices generally. This has also been criticized as a secret reserve.

Some object to LIFO because it se ldom accords with the physical flow of goods. This can be countered by noting that it is said to represent a flow of costs, not a physical flow, but the inconsistency is still there and does not rest easily with some theorists.

The company to com pany differences in pricing of various layers, because of differences in the tim ing of adding those layers, may cause significant distortions of comparability even among LIFO companies.

It is possible to manipulate net income to some degree under LIFO si mply by refraining from buying or by resorting to heavy buying near the end of an account ing period. Under other flow methods this is not possible and such actions would be reflected simply as inventory variations rather than as variations in cost of goods sold.

In the event inventories are reduced below the level when LIFO was adopted, assuming substantial intervening price rises, the long-term cumulative benefit of having been under such a m ethod can be wi ped out in a si ngle period. Ancient costs would be matched against current revenues and highly distorted results would ensue.

While some see the m atching of current costs against current revenues as a m ajor advantage of LIFO, others contend that this is a means of achieving an artificial smoothing of income.

NUMBER 4

a. Purchases from various suppliers generally should be included in Huddell' s inventory when Huddell receives the

goods. Title to goods purchased FOB destination is assumed to pass when the goods are received.

b. Huddell should account for the wa rehousing costs as additional cost of i nventory. All necessary and reasonable

costs of readying goods for sale should be included in inventory.

c. 1. The advantages of using the dollar value LIFO method are to reduce the cost of accounting for inventory

and to minimize the probability of reporting the liquidation of LIFO inventory layers.

2. The application of dollar value LIFO is based on dollars of inventory, an inventory cost index for each year, and broad inventory pools. The inventory layers are identified with the inventory cost index for the year in which the layer was added. In contrast, traditional LIFO is applied to individual units at their cost.

d. 1. Huddell's net markups should be included only in the retail amounts (denominator) to determine the cost to

retail percentage.

Huddell's net markdowns should be ignored in the calculation of the cost to retail percentage.

2. By not deducting net markdowns from the retail amounts to determine the cost to retail percentage, Huddell produces a lower cost to retail percentage than would result if net markdowns were deducted. Applying this lower percentage to ending inventory at retail, the inventory is reported at an amount below cost. This amount is intended to approximate lower of average cost or market.

NUMBER 5

Acute Company

COMPUTATION OF INVENTORIES UNDER THE DOLLAR-VALUE LIFO