Question

Referring to the situation in P9-2 for Garcia Home Improvement Company, consider the following expanded data at May 31, 2017. Assume Garcia uses LIFO inventory costing. Problems 483 Replacement Sales Net Realizable Normal Cost Cost Price Value Profi t Aluminum siding \( 70,000 \) 62,500 \( 64,000 \) 56,000 \( 5,100 Cedar shake siding 86,000 79,400 94,000 84,800 7,400 Louvered glass doors 112,000 124,000 186,400 168,300 18,500 Thermal windows 140,000 126,000 154,800 140,000 15,400 Total \)408,000 \(391,900 \)499,200 \(449,100 \)46,400 Instructions (a) (1) Determine the proper balance in Allowance to Reduce Inventory to Market at May 31, 2017. (2) For the fiscal year ended May 31, 2017, determine the amount of the gain or loss that would be recorded due to the change in Allowance to Reduce Inventory to Market. (b) Explain the rationale for the use of the lower-of-cost-or-market rule as it applies to inventories

Short answer

(a1) The proper balance equals $34,600.

(a2) The loss to be recorded equals $7,100.

(b) Under the Lower-of-cost-or-market method, inventories are recorded at the lowest of cost and market value to report inventory value correctly in the financial statements. And to report loss or gain incurred due to an increase or reduction in the inventory value.

Step-by-step solution

Calculation of Lower-of-cost-or-market

Lower-of-cost-or-market is calculated as follows:

	Cost	Replacement Cost	Net Realizable Value	Normal Profit	Net Realizable value less Normal Profit	Designated Market Value	Lower-of-Cost-or-Market
Aluminium siding	$70,000	$62,500	$56,000	$5,100	$50,900	$56,000	$56,000
Cedar shake siding	86,000	79,400	84,800	7,400	77,400	79,400	79,400
Louvered glass doors	112,000	124,000	168,300	18,500	149,800	149,800	112,000
Thermal windows	140,000	126,000	140,000	15,400	124,600	126,000	126,000
Total	$408,000						$373,400

Calculation of proper balance in allowance

(a1) Proper balance in allowance is calculated as follows:

$\begin{array}{rcl}\mathbf{Proper}\mathbf{}\mathbf{Balance}\mathbf{}\mathbf{in}\mathbf{}\mathbf{Allowance}& \mathbf{=}& \mathbf{Cost}-\mathbf{Lower}\mathbf{-}\mathbf{of}\mathbf{-}\mathbf{Cost}\mathbf{-}\mathbf{or}\mathbf{-}\mathbf{Market}\\ & \mathbf{=}& \mathbf{\$}\mathbf{408}\mathbf{,}\mathbf{000}-\mathbf{\$}\mathbf{373}\mathbf{,}\mathbf{400}\\ & \mathbf{=}& \mathbf{\$}\mathbf{34}\mathbf{,}\mathbf{600}\end{array}$

Calculation of loss to be recorded due to change in allowance

(a2) Loss due to change in the allowance is calculated as follows:

$\begin{array}{rcl}\mathbf{Loss}\mathbf{}\mathbf{to}\mathbf{}\mathbf{be}\mathbf{}\mathbf{Recorded}& \mathbf{=}& \mathbf{Proper}\mathbf{}\mathbf{Allowance}\mathbf{}\mathbf{Balance}\mathbf{-}\mathbf{Allowance}\mathbf{}\mathbf{Balance}\\ & \mathbf{=}& \mathbf{\$}\mathbf{34}\mathbf{,}\mathbf{600}\mathbf{-}\mathbf{\$}\mathbf{27}\mathbf{,}\mathbf{500}\\ & \mathbf{=}& \mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{100}\\ & & \end{array}$

Rationale of Lower-of-cost-or-market

In case the future utility of the inventory is below the original cost of the inventory. Then, in this case, the loss is recorded by the business.

In this case, the expense recognition principle is followed as an expense related to a decline in the value of inventory is recorded in the year in which loss is incurred. As the future utility of inventory reduces, inventories are recorded per the market value, not at the original costs, which is against the cost principle.