15. Under the lower-of-cost-or-market basis for valuing inventory if the market

Question

15. Under the lower-of-cost-or-market basis for valuing inventory if the market value of an item in inventory has declined during a given accounting period, A) pretax income and the amount of ending inventory will be reduced for the period in which the merchandise is sold. B) pretax income and the amount of ending inventory will be reduced for the period during which the decline in market value occurred. C) pretax income will be reduced for the period during which the decline in market value occurred and the amount of ending inventory will decline for the period in which the merchandise is sold. D) A and B are both correct. E) None of the above is correct.

Explanation / Answer

The answer is B.

If the market value of an item in inventory has declined, and is less than its cost during an accounting period, the value of the ending inventory has to be adjusted for the loss during that period, and the inventory has to be carried at the reduced value in the balance sheet.

The adjusting entry is Debit Inventory Loss and Credit Inventory, by virtue of which the the value of ending inventory is reduced, and the commensurate amount of loss would be recognized in the same period and closed to income summary for the period.

From another angle,

Sales - Cost of Goods Sold = Gross Margin

Cost of Goods Sold ( COGS) = Beginning Inventory + Purchases during the period - Ending Inventory.

If the ending inventory value had to be understated due to decline in market value of any item inventory, COGS would increase.

Suppose, originally, Beginning Inventory = 100, Purchase = 300 , Ending Inventory = 110

COGS = 100 + 300 - 110 = 290.

Now assume that ending inventory is 105.

COGS = 100 + 300 - 105 = 295

If COGS increases, then Gross Margin will also fall. Consequently operating margin also will decline.

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