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C. Items to Include in Inventory

C. Items to Include in Inventory

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Module 10: Inventory



227



2. Consignment sales revenue should be recognized by the consignor when the consignee sells the consigned

goods to the ultimate customer. Therefore, no revenue is recognized at the time the consignor ships the goods

to the con­sign­ee.

NOTE: Sales commission made by the consignee would be reported as a selling expense by the consignor

and would not be netted against the sales revenue recognized by the consignor.



NOTE: The UCC rules concerning consignments should be used for the law portion, not the financial ac­

counting and reporting portion, of the exam.







E.Ratios

The two ratios below relate to inventory.



1.

Inventory turnover—Measures the number of times inventory was sold and reflects inventory order and

invest­ment policies

Cost of goods sold

Average inventory

2.

Number of days’ supply in average inventory—Number of days inventory is held before sale; reflects on

effi­ciency of inventory policies

365

Inventory turnover



NOW REVIEW MULTIPLE-CHOICE QUESTIONS 38 THROUGH 50









F. Long-Term Construction Contracts

1. Long-term contracts are accounted for by two methods: completed-contract method and percentage-ofcompletion method.



a.

Completed-contract method—Recognition of contract revenue and profit at contract completion. All re­

lated costs are deferred until completion and then matched to revenues.







(1) The completed-contract method is preferable in circumstances in which estimates cannot meet the crite­

ria for reasonable dependability or one of the above conditions does not exist.

(2) The advantage of the completed-contract method is that it is based on results, not estimates, and the dis­

advantage is that current performance is not reflected and income recognition may be irregular.



b.

Percentage-of-completion—Recognition of contract revenue and profit during construction based on ex­

pected to­tal profit and estimated progress towards completion in the current period. All related costs are

recognized in the period in which they occur.















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(1) The use of the percentage-of-completion method depends on the ability to make reasonably dependable

esti­mates of contract revenues, contract costs, and the extent of progress toward completion. For entities

which customarily operate under contractual arrangements and for whom contracting represents a

signifi­cant part of their operations, the presumption is that they have the ability to make estimates that

are suffi­ciently dependable to justify the use of the percentage-of-completion method of accounting.

(2) The percentage-of-completion method is preferable in circumstances in which reasonably dependable

esti­mates can be made and in which all of the following conditions exist:

(a) Contracts executed by the parties normally include provisions that clearly specify the enforceable

rights re­garding goods or services to be provided and received by the parties, the consideration to

be ex­changed, and the manner and terms of settlement.

(b) The buyer can be expected to satisfy obligations under the contract.

(c) The contractor can be expected to perform contractual obligation.



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(3) The advantage of percentage-of-completion is periodic recognition of income, and the disadvantage is

de­pendence on estimates.

(4) In practice, various procedures are used to measure the extent of progress toward completion under the

per­cen­tage-of-completion method, but the most widely used one is cost-to-cost which is based on the

as­sumed relationship between a unit of input and productivity. Under cost-to-cost, either revenue and/or

profit to be recognized in the current period can be determined by the following formula:







NOTE: Revenue and profit are two different terms. Profit is calculated by subtracting construction ex­penses

from revenue. Revenue is the contract price. Therefore, pay particular attention to what item the CPA exam

asks you to calculate.







2. The ledger account titles used in the following discussion are unique to long-term construction contracts.

In prac­tice, there are numerous account titles for the same item (e.g., “billings on LT contracts” vs. “partial

billings on construction in progress”) and various methodologies for journalizing the same transactions (e.g.,

separate revenue and expense control accounts in lieu of an “income on LT contracts” account). The following

example has been simplified to highlight the main concepts.



EXAMPLE 1

Assume a 3-year contract at a contract price of $500,000 as well as the following data:

Year 1

$135,000

-0$315,000

$450,000

$200,000

$175,000



Year 2

$225,000

135,000

40,000

400,000

$200,000

$200,000



Year 3

$ 45,000

360,000

-0$405,000

$100,000

$125,000



    From the above information, the following may be determined.

    Percent of completion (costs to date/total costs)

    

Year 1: $135,000/$450,000 = 30%

    

Year 2: $360,000/$400,000 = 90%

    

Year 3: $405,000/$405,000 = 100%

Total revenue

$ 500,000

× Percent of completion

× 30%

Total revenue to be recognized by end of year

$ 150,000



Revenue recognized in prior periods

-Current year’s revenue (to be recognized)

$ 150,000

Contract price

$ 500,000



Total estimated costs

(450,000)

Estimated profit

$ 50,000

× Percent of completion

× 30%

Total profit to be recognized by end of year

$ 15,000



Profit recognized in prior periods

-Current year’s profit (to be recognized)

$ 15,000



$ 500,000

× 90%

$ 450,000

(150,000)

$ 300,000

$ 500,000

(400,000)

$ 100,000

× 90%

$ 90,000

(15,000)

$ 75,000



$ 500,000

× 100%

$ 500,000

$(450,000)

$ 50,000

$ 500,000

(405,000)

$ 95,000

× 100%

$ 95,000

(90,000)

$ 5,000



Cost incurred this year

Prior years’ costs

Estimated costs to complete

Total costs

Progress billings made during the year

Collection of billings each year



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229



Percentage-of-completion

Year 1 Costs

Year 1 Progress

billings

Year 1 Cash

collected

Year 1 Profit

recog­nition

Year 2 Costs

Year 2 Progress

billings

Year 2 Cash

collected

Year 2 Profit

recog­nition

Year 3 Costs

Year 3 Progress

billings

Year 3 Cash

col­lected

Year 3 Profit

recog­nition and

closing of special

ac­counts







Construction in progress

Cash

Accounts receivable

Billings on LT contracts

Cash

Accounts receivable

Construction expenses

Construction in progress

Construction revenue

Construction in progress

Cash

Accounts receivable

Billings on LT contracts

Cash

Accounts receivable

Construction expenses

Construction in progress

Construction revenue

Construction in progress

Cash

Accounts receivable

Billings on LT contracts

Cash

Accounts receivable

Construction expenses

Construction in progress

Construction revenue

Billings on LT contracts

Const. in progress

Construction expenses

Const. in progress

Billings on LT contracts

Construction revenue



135,000



Completed-contract

135,000



135,000

200,000



135,000

200,000



200,000

175,000



200,000

175,000



175,000

135,000

15,000



175,000

none



150,000

225,000



225,000

225,000



200,000



225,000

200,000



200,000

200,000



200,000

200,000



200,000

225,000

75,000



200,000

none



300,000

45,000



45,000

45,000



100,000



45,000

100,000



100,000

125,000



100,000

125,000



125,000



125,000



45,000

5,000

50,000

500,000

500,000

405,000

405,000

500,000

500,000



3. The “construction in progress” (CIP) account is a cost accumulation account similar to “work in process” for

job-or­der costing, except that the percentage-of-completion method includes interim profits in the account. The

“bil­lings on LT contracts” account is similar to an unearned revenue account. At each financial statement date,

the “construction in progress” account should be netted against the “billings on LT contracts” account on a

project-by-project basis, resulting in a net current asset and/or a net current liability.



EXAMPLE



Under the percentage of completion method in the above example, a net current asset of $50,000

[($135,000 + $15,000 + $225,000 + $75,000) – ($200,000 + $200,000)] would be reported at the end of

year 2. A net current liability of $40,000 would result under the completed-contract method [($200,000 +

$200,000) – ($135,000 + $225,000)] for the same year.



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SUMMARY OF ACCOUNTS USED IN CONSTRUCTION ACCOUNTING

(NO LOSS EXPECTED OR INCURRED)



Balance sheet

Construction in Progress

A/P, Materials, etc.

(A)

(F)



(E)

(G)



Accounts Receivable

(B)



(C)



(D)

(F)



(A)

Billings on LT

Contracts

(D)

(G)



Income statement

Construction Revenue



Construction

Expenses

(E)

(F)



(B)



Cash

(C)



Both methods

(A)To record accumulated

costs

(B) To record progress

billings

(C) To record cash

collections



Explanation of Journal Entries

Completed-contract method

(D)To record revenue upon

completion and to close

billings account

(E) To record expenses upon

completion and to close

construction in progress

account



Percentage-of-completion

method

(F) To record recognition of

interim revenue and expense

(G)To close construction-inprogress and billings accounts

at project completion



Balance Sheet Classification*

Current asset

Projects where CIP at year-end** > Billings



Current liability

Projects where billings > CIP at year-end**

Estimated loss on uncompleted contract***



*  Evaluate and classify on a project-by-project basis.

**  Construction in progress including income (when percentage-of-completion method is used) or loss recognized.

*** When recognizing and reporting losses, it is necessary to use a current liability account instead of reducing CIP in those

cases in which a contract’s billings exceed its accumulated costs.









4. Contract losses

a. In any year when a percentage-of-completion contract has an expected loss on the entire contract, the

amount of the loss reported in that year is the total expected loss on the entire contract plus all profit previ­

ously recog­nized.



EXAMPLE

If the expected costs yet to be incurred at the end of year two were $147,000, the total expected loss is $7,000

[$500,000 – ($135,000 + $225,000 + $147,000)] and the total loss reported in year two would be $22,000 ($7,000 +

$15,000).







c07.indd 230



b. Similarly, under the completed-contract method, total expected losses on the entire contract are recognized

as soon as they are estimated. The loss recognized is similar to that for percentage-of-completion except the

amount is for the expected loss on the entire contract.



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EXAMPLE

In the aforementioned example, the loss to be recognized is only $7,000 (the entire loss on the contract ex­pected in

year two) because interim profits have not been recorded.







c. Journal entries and a schedule for profit or loss recognized on the contract under the percentage-ofcompletion method follow.



EXAMPLE



Journal entry at end of year 2

Construction expenses

Construction in progress (loss)

Construction revenue

Loss on uncompleted LT contracts

Construction in progress (loss)



Percentageof-completion

227,000*

22,000

205,000**



Completed-contract



7,000

7,000



* Year 2 costs

$225,000

Loss attributable to year 3:

Year 3 revenue ($500,000 – $150,000 –

$205,000)

$145,000

Year 3 costs (expected)

147,000

2,000

Total

$227,000

** ($360,000/$507,000) (Costs to date/Total estimated costs) = 71% (rounded); (71% × $500,000) – $150,000

= $205,000



PERCENTAGE-OF-COMPLETION METHOD

Contract price:

Estimated total costs:

Costs incurred this year

Prior year’s costs

Estimated cost yet to be incurred

Estimated total costs for the three-year

period, actual for year 3

Estimated total income (loss) for three-year

period, ac­tual for year 3

Income (loss) on entire contract previously

recog­nized

Amount of estimated income (loss)

recognized in the current period, actual for

year 3



Year 1

$500,000



Year 2

$500,000



Year 3

$500,000



$135,000



315,000



$225,000

135,000

147,000



$144,000***

360,000





$450,000



$507,000



$504,000



$ 15,000



$ (7,000)



$ (4,000)





$ 15,000



15,000

$ (22,000)



(7,000)

$ 3,000



***Assumed



NOW REVIEW MULTIPLE-CHOICE QUESTIONS 51 THROUGH 61









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G. Research Component—Accounting Standards Codification

1. The authoritative literature for inventory is found primarily in two places in the Codification: Topic 330 and

Topic 605.

a. Topic 330 contains the definition of inventory, the significance of inventories, the basis of accounting, cost

flows, and application of lower of cost or market.



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b. Topic 605 focuses on long-term construction contracts and the percentage-of-completion and completedcon­tract methods.

c. Although the weighted-average, moving-average, and gross profit methods of accounting for inventory are

ac­cept­able methods, few, if any, references are made to these methods in the accounting literature.

(1) The only references to methods are first-in first-out, average and last-in first-out.

d. A list of keywords that may be helpful in your research is shown below.

NOTE: Typing the keywords with correct hyphenation should produce faster and more accurate results.



Accumulated costs billings

Basis consistently applied

Clearly reflects income

Completed-contract method

Contract costs loss

Contracts in process

Cost or market

Cost principle inventories







Expected losses contract

Finished goods

Firm purchase commitments

First-in first-out

Held for sale

Inventory obsolescence

Last-in first-out

Lower of cost or market



Mark-up inventory

Net realizable value

Percentage-of-completion method

Physical deterioration

Raw materials

Utility of goods

Work in process



H. International Financial Reporting Standards (IFRS)







1. IFRS accounting for inventory differs from US GAAP in three areas: cost flow assumption, valuation of inven­

tory at year-end, and capitalization of interest.







a. With IFRS, the LIFO cost flow assumption is not permissible. Specific ID is required for inventory of

goods that are not interchangeable, or goods that are produced and segregated for specific projects. FIFO

and weighted-average methods are acceptable methods under IFRS for other types of inventory. The retail

method may only be used for certain industries. In addition, the gross profit method can be used to estimate

ending in­ventory when a physical count is not possible.

b. Inventories are carried at the lower of cost or net realizable value (LCNRV). An exception to the LCNRV

rule ap­plies to agricultural inventories (biological assets) which are carried at fair value less costs to sell at

the point of harvest.













(1) Recall that in US GAAP, lower of cost or market (LCM) is used to value inventories. Market is defined

as re­placement cost, subject to a ceiling and floor. The ceiling is net realizable value (NRV), and the

floor is NRV less a normal profit margin. Once inventory is written down, a loss may not be recovered.

(2) Although IFRS uses a similar valuation concept, IFRS values inventory at the lower of cost or net

realiz­able value (LCNRV). Note that the calculations are different from US GAAP. NRV is calculated

as esti­mated selling price less estimated costs of completion and sale. Generally, LCNRV is applied

on an item-by-item basis. However, under IFRS if there are groups of items that have similar

characteristics, they may be grouped for the application of LCNRV.



EXAMPLE

Assume the following facts for an inventory:

Historical cost

Estimated selling price

Estimated costs to complete and sell

NRV



$100

90

5

$ 85



To apply LCNRV to this example, you compare the cost of $100 to the estimated selling price less estimated costs

to complete and sell ($90 – $5). NRV is $85. Therefore, the LCNRV is $85. The inventory would be written down

to $85 with a corresponding expense on the income statement. If the inventory value at the end of Year 2 was $90, a

recovery of the loss would be recorded by debiting Inventory and crediting an income account.



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