Question

Corrs Company began operations in 2016 and determined its ending inventory at cost and at lower-of-LIFO cost-or-market at December 31, 2016, and December 31, 2017. This information is presented below. Cost Lower-of-Cost-or-Market 12/31/16 \(356,000 \)327,000 12/31/17 420,000 395,000 Instructions (a) Prepare the journal entries required at December 31, 2016, and December 31, 2017, assuming that the inventory is recorded at market, and a perpetual inventory system (cost-of-goods-sold method) is used. (b) Prepare journal entries required at December 31, 2016, and December 31, 2017, assuming that the inventory is recorded at market under a perpetual system (loss method is used). (c) Which of the two methods above provides the higher net income in each year?

Short answer

(a) Cost of goods sold account debited and inventory account credited by $29,000 respectively in 2017. In 2018, amount will be $29,000.

(b) Loss due to market decline of inventory is debited and Allowance to reduce inventory to market is credited by $25,000. In 2018, Allowance to reduce inventory to market will be debited and Recovery of loss due to market decline of inventory is credited by $4,000.

(c) Both the method will have higher net income in year 2017.

Step-by-step solution

Calculate reduction in the value of inventory in 2016 and 2017

Reduction in value of inventory in 2016 is calculated as follows:

$\begin{array}{rcl}\mathrm{Reduction}\mathrm{in}\mathrm{inventory}& =& \mathrm{Inventory}\mathrm{at}\mathrm{cost}-\mathrm{Inventory}\mathrm{as}\mathrm{per}\mathrm{lower}\mathrm{of}\mathrm{cost}\mathrm{or}\mathrm{market}\\ & =& \$356,000-\$327,000\\ & =& \$29,000\end{array}$

Reduction in value of inventory in 2017 is calculated as follows:

$\begin{array}{rcl}\mathrm{Reduction}\mathrm{in}\mathrm{inventory}& =& \mathrm{Inventory}\mathrm{at}\mathrm{cost}-\mathrm{Inventory}\mathrm{as}\mathrm{per}\mathrm{lower}\mathrm{of}\mathrm{cost}\mathrm{or}\mathrm{market}\\ & =& \$420,000-\$395,000\\ & =& \$25,000\end{array}$

Journal entries in both year using cost of goods sold method

(a) Journal entries for both years are as follows:

Date	Accounts	Debit	Credit
12/31/16	Cost of goods sold	$29,000
	Inventory		$29,000
12/31/17	Cost of goods sold	$25,000
	Inventory		$25,000

Journal entries in both year using loss method

(b) Journal entries for both years are as follows:

Date	Accounts	Debit	Credit
12/31/16	Loss due to market decline of inventory	$29,000
	Allowance to reduce inventory to market		$29,000
12/31/17	Allowance to reduce inventory to market	$4,000
	Recovery of loss due to market decline of inventory		$4,000

Calculation of loss recovery in 2017

Loss recovery in 2017 is calculated as follows:

$\begin{array}{rcl}\mathrm{Loss}\mathrm{recovery}\mathrm{in}2017& =& \mathrm{Reduction}\mathrm{in}2016-\mathrm{Decline}\mathrm{in}2017\\ & =& \$29,000-\$25,000\\ & =& \$4,000\end{array}$

Effect on net income

(c) In 2016, ending inventory wasrecorded at $327,000 which is higher than the actual cost of $356,000, hence it will increase the cost of goods sold and will decrease the net income. This scenario is applicable to both the methods.

In year 2017, beginning inventory equals $327,000 and ending inventory equals $395,000, which will decrease the cost of goods sold, and will overall result in increased net income. This effect is applicable on both methods.