E7—1 1

(The lower-of-cost-ormarket rule and hidden reserves)

Central Incorporated has two items in inventory as of December 31, 1997. Each item was pur2 chased for $40. Company management chose to write down Item #1 to $28, which at year end was assessed to be its market value. Management did not write down Item #2 because its mar¬

ket value was estimated to be greater than $40. During 1998 each item was sold for $50 cash.

346 Part 3 Assets: A Closer Look REQUIRED:

a. Assume that the company uses the perpetual inventory method, and prepare journal entries for each activity (i.e., the write-down, the sale of item #1, and the sale of item #2).

b. Compute the profit or loss associated with each item in 1997 and 1998.

c. Explain how management could manipulate reported earnings when applying the lowerof-cost-or-market rule.