TFA

Chapter 28 – Gross Profit and Retail Method

QUESTION 28-1

What are the reasons for making an estimate of inventory?

ANSWER 28-1
 Determination of inventory loss due to fire and other catastrophe or theft of merchandise
 Proof of the reasonable accuracy of a physical count. This is popularly known as the
“gross profit test.”
 Preparation of interim statements or statements of less than one year.

However, year-end statements require physical count, not mere estimate of inventory value.
QUESTION 28-2

Explain the gross profit method of estimating cost of ending inventory.

ANSWER 28-2
Under the gross profit method, the ending inventory is computed “goods available for sale minus
cost of goods sold.”
The cost of goods sold is determined through the use of the gross profit rate and this is the reason
the gross profit method is called as such.
This method is based on the major assumption that the rate of gross profit remains approximately
the same from period to period and therefore the ratio of cost of goods sold to net sales is
relatively constant from period to period.
Claren A. Dimayacyac

QUESTION 28-3

Explain the retail method of estimating the cost of ending inventory.

ANSWER 28-3

The retail inventory method came to its name because selling price and retail price is tagged to
each item and therefore the ending inventory is stated at selling price.

The ending inventory is computed using the following formula:

Goods available for sale at selling price minus net sales equals ending inventory at selling price
multiplied by the cost ratio equals the ending inventory at cost.

The cost ratio under the retail method is computed by dividing the goods available for sale at
cost by the goods available for sale at selling price.
QUESTION 28-4

What information is required under the retail inventory method?

ANSWER 28-4

The use of the retail inventory method requires that records to be kept which must show the
following data:

a. Beginning inventory valued at cost and at retail price.

b. Purchases during the period at cost and at retail price.
c. Total goods available for sale for the period at cost and at retail price.
d. Total sales for the period.
e. Adjustments to the original retail price such as additional markup, markup cancelation,
markdown and markdown cancelation
f. Other adjustments, such as departmental transfer, breakage, shrinkage, theft, damaged
goods and employee discount.
QUESTION 28-5

What are the applications of the retail inventory method?

ANSWER 28-5

1. Conservative approach
The cost ratio is determined by including markups and excluding mardowns in computing
the goods available for sale at retail.
This approach is known as the conventional or lower of average cost and net realizable
value approach.

2. Average cost approach

The markups and markdowns are both included in the computation of the cost ratio.

3. FIFO approach
A cost ratio is computed for the current year. Thus, only the current purchases are
considered together with markups and markdowns.
The beginning inventory is excluded in the computation
QUESTION 28-6

Which approach is followed in measuring inventory under retail inventory method?

ANSWER 28-3

PAS 2, paragraph 22; provides that the percentage used under the retail method shall take into
consideration inventory that has been marked down to below the original selling price.

An average percentage for each retail department is often used.

This means that the average cost approach shall be applied in conjunction with the retail
inventory method.

Of course, PAS 2 requires either the FIFO or average method as a cost formula.

The standard prohibits the LIFO cost flow assumption.

QUESTION 28-7

1. The gross margin method of estimating ending inventory may be used for all of the
following, except
a. Internal as well as external interim reports
b. Internal as well as external year-end reports
c. Estimate of inventory destroyed by fire or other casualty
d. Rough test of the validity of an inventory cost determined under either periodic or
perpetual system.

2. The gross profit method assumes that

a. The amount of gross profit is the same as in prior years.
b. Sales and cost of goods sold have not changed from previous years.
c. Inventory values have not increased from previous years.
d. The relationship between selling price and cost of goods sold is similar to prior
years.

3. The gross profit method of estimating inventory would not be useful when
a. A periodic system is in use and inventories are required form interim statements.
b. Inventories have been destroyed or lost by fire, theft or other casualty, and the
specific data required for inventory valuation are not available.
c. There is a significant change in the mix of products being sold.
d. The relationship between gross profit and sales remains stable over time.

4. The gross profit method of estimating inventory is not valid when

a. There is a substantial increase in the quantity of inventory during the year.
b. There is a substantial increase in the cost of inventory during the year.
c. The gross margin percentage changes significantly during the year.
d. All ending inventory is destroyed by fire before it can be counted.
Arianne H. Dorado

5. The gross profit method is invalid when

a. A portion of inventory is destroyed.
b. There is a substantial decrease in inventory.
c. There is no beginning inventory.
d. The gross profit percentage applicable to the goods in ending inventory is
different from the percentage applicable to goods sold during the period.

6. Which statement is not valid about the gross profit method?

a. It may be used by auditors.
b. It is an acceptable accounting procedure.
c. It may be used to estimate inventory for interim statements.
d. It may be used to estimate inventory for annual statements.

7. Which is not a basic assumption of the gross profit method?

a. The beginning inventory plus net purchases equals total good to ne accounted for.
b. Goods not sold must be on hand.
c. The sales reduced to cost basis when deducted from the sum of beginning inventory
and net purchases will result to inventory on hand.
d. The amount of purchases and the amount of sales remain relatively unchanged
from the previous period.

8. How is the gross profit method used in relation to inventory valuation?

a. To verify the accuracy of the perpetual inventory record
b. To verify the accuracy of the physical inventory
c. To estimate the cost of goods sold
d. To provide a FIFO inventory value
QUESTION 28-8 Multiple Choice (AICPA Adopted)

1. An advantage of the retail inventory method is that it

a. Permits entities to avoid taking an annual physical inventory.
b. Gives a more accurate measurement of inventory.
c. Hides costs from customers and employees.
d. Provides a method for inventory control and facilitates determination of the
inventory.

2. To produce an inventory valuation which approximates the lower of cost and NRV using
the retail method, the computation of the ratio of cost to retail should
a. Include markups but not markdowns
b. Include markups and markdowns
c. Ignore both markups and markdowns
d. Include markdowns but not markups

3. When the conventional retail inventory method is used, markdowns are commonly
ignored in the computation of cost to retail ratio because
a. There maybe no markdowns during the year.
b. This tends to give a better approximation of the lower of average cost and net
realizable value.
c. Markups are also ignored.
d. This tends to result in the showing of normal profit margin in a period when no
markdown goods have been sold.

4. The retail inventory method would include which of the following in the calculation of
the goods available for sale at both cost and retail?
a. Freight In
b. Purchase Returns
c. Markups
d. Markdowns

5. With regard to method, which is the most accurate statement?

a. Generally, accountants ignore net markups and net markdowns in computing the cost
ratio.
 b. Generally, accountants exclude net markups and include net markdowns in
computing cost ratio.
c. The retail method results in a lower ending inventory if net markups are
included but net markdowns are excluded in computing the cost ratio.

6. The conventional retail method produces an ending inventory that approximates

a. Lower of average cost and net realizable value
b. Lower of FIFO cost and net realizable value
c. Lower of LIFO cost and net realizable value
d. Lower of cost and net realizable value

7. The retail method is based on the assumption that

a. Final inventory and the total goods available for sale contain the same
proportion of high cost and low cost ratio goods.
b. Gross margin is the same each period
c. Ratio of cost to retail changes at a constant rate.
d. Proportions of markup and markdown to selling price are the same.

8. If the conservative retail inventory method is used, which of the following calculations
would include or exclude net markdowns?

Cost ratio Ending Inventory at Retail

a. Include Include
b. Include Exclude
c. Exclude Include
d. Exclude Exclude
Gonzales, Charlene Jane S.

9. An inventory method which is designed to approximate inventory valuation at the lower

of average cost and net realizable value is
a. Average retail method
b. FIFO retail
c. Conventional retail method
d. LIFO retail

10. Which of the following is not reason why the retail inventory method is used widely?

a. As a control measure in determining inventory shortage

b. For insurance information
c. To permit the computation of net income without a physical count of inventory
d. To defer income tax liability
QUESTION 28-9 Multiple Choice (IAA)

1. Which of the following is not required when using the retail inventory method?
a. All inventory items must be categorized according to the retail markup
percentage
b. Total cost and retail price of goods purchased
c. Total cost and retail price of the goods available for sale
d. Total sales for the period

2. What condition is not necessary when using the retail inventory method?
a. Total cost of goods sold for the period
b. Total cost and retail price of goods purchased
c. Total cost and retail price of goods available for sale
d. Total sales for the period.

3. What is the effect of freight in on the cost-retail ratio when using the conservative retail
method?
a. Increases the cost-retail ratio
b. No effect on the cost-retail ratio
c. Depends on the amount of the net markup
d. Decreases the cost-retail ratio

4. What is the effect of net markup on the cost-retail ratio when using the conservative retail
method?
a. Increases the cost-retail ratio
b. No effect on the cost-retail ratio
c. Depends on the amount of the net markup
d. Decreases the cost-retail ratio

5. Which of the following would cause a decrease in the cost ratio used in the retail
inventory method?
a. Higher retail prices
b. Lower net markups
c. More employee discounts
d. Higher freight in charges