Principles of Accounting II, Chapter 1 Accounting for Inventories

CHAPTER -1-

Accounting for Inventories

Definition: - Inventories can be defined as merchandise held for sale in the normal course of

business which is termed as merchandise inventory or materials in the process of production or

held for production.

Control of Inventory

Two primary objectives of control over inventory are as follows:

1. Safeguarding the inventory from damage or theft.

2. Reporting inventory in the financial statements.

Safeguarding Inventory

Controls for safeguarding inventory begin as soon as the inventory is ordered. The following

documents are often used for inventory control:

(1) Purchase order (2) Receiving report (3) Vendor’s invoice

The purchase order authorizes the purchase of the inventory from an approved vendor. As soon

as the inventory is received, a receiving report is completed.

The receiving report establishes an initial record of the receipt of the inventory. To make sure the

inventory received is what was ordered, the receiving report is compared with the purchase

order. The price, quantity, and description of the item on the purchase order and receiving report

are then compared to the vendor’s invoice. If the receiving report, purchase order, and vendor’s

invoice agree, the inventory is recorded in the accounting records. If any differences exist, they

should be investigated and reconciled.

Recording inventory using a perpetual inventory system is also an effective means of control.

The amount of inventory is always available in the subsidiary inventory ledger. This helps keep

inventory quantities at proper levels. Finally, controls for safeguarding inventory should include

security measures to prevent damage and customer or employee theft.

Reporting Inventory

A physical inventory or count of inventory should be taken near year-end to make sure that the

quantity of inventory reported in the financial statements is accurate.

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Principles of Accounting II, Chapter 1 Accounting for Inventories
After the quantity of inventory on hand is determined, the cost of the inventory is assigned for

reporting in the financial statements. Most companies assign costs to inventory using one of three

inventory cost flow assumptions. If a physical count is not possible or inventory records are not

available, the inventory cost may be estimated.

Importance of inventories

- It is the principal source of revenue for wholesale and retail businesses.

- Cost of merchandise sold is the largest deduction from sells to determine net income.

- A substantial part of merchandising firm’s resources is invested in inventory

- It is the largest of the current assets on merchandisers businesses.

Effect of Inventory Errors on Financial Statements

Any error in the inventory count will affect both the balance sheet and the income statement. For
example, an error in the physical inventory will misstate the ending inventory, current assets,
and total assets on the balance sheet. This is because the physical inventory is the basis for
recording the adjusting entry. Also an error in taking the physical inventory misstates the cost of
goods sold, gross profit, and net income on the income statement. In addition, because net
income is closed to the owner’s equity at the end of the period owner’s equity will also be
misstated on the balance sheet. This misstatement of owner’s equity will equal the misstatement
of the ending inventory, current asset and total assets.

The effect of understatements and overstatements of merchandise inventory at the end of the
period are demonstrated in the following three sets of condensed income statements and balance
sheets.
The first set of statements is based on a correct ending inventory of $60,000;
The second set, on an incorrect ending inventory of 50,000;
The third set, on an incorrect ending inventory of 70,000.
In all three cases, net sales are 980,000, merchandise available for sale is $705,000, and operating
expenses are $100,000.
Income statement for the year Balance Sheet at the end of the year
1. Inventory at the end of the year correctly Stated $60,000
Net sales……………………..980,000 Merchandise inventory………. .$60,000
Cost of goods sold…………..645,000 Other asset……………………..340,000
Gross profit…………......$335,000 Total asset………………….400, 000
Expenses…………………….100,000 Liabilities………………………120,000
Net income………………235,000 Owners equity…………………280,000
Total ………………………400,000
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Principles of Accounting II, Chapter 1 Accounting for Inventories

2. Inventory at the end of period incorrectly stated at $50,000: (understated by 10,000).

Net sales……………………..980,000
Cost of goods sold…………..655,000
Gross profit…………......$325,000
Expenses…………………….100,000
Net income………………225,000
Merchandise inventory………. .$50,000
Other asset…………………….340, 000
Total asset……………...…. 390,000
Liabilities………………………120,000
Owners equity…………………270,000
Total ………………………390,000

3. Inventory at the end of period incorrectly stated at $70,000 (overstated by $10,000).

Net sales……………………..980,000 Merchandise inventory………. .$70,000
Cost of goods sold…………..635,000 Other asset…………………….340, 000
Gross profit…………......$345,000 Total asset……………...… 410,000
Expenses…………………….100,000 Liabilities………………………120,000
Net income………………245,000 Owners equity…………………290,000
Total ………………………410,000
The effect of inventory on the following period’s statements
The inventory at the end of one period becomes the inventory for the beginning of the
following period, thus, if the inventory is incorrectly stated at the end of the period, the
net income of that period will be misstated and so will the net income for the following
period. The amount of the two misstatements will be equal and in opposite directions.

Therefore, the effect on net income of an incorrectly stated inventory, if not corrected, is
limited to the period of the error and the following period.
Example: assume no additional errors, both assets and owner’s equity will be correctly
stated. Assume that the ending inventory for period one was understated by $10,000, and
no other errors are made. The gross profit (and net income) would be understated for
period one and overstated for period two by $10,000, indicates as follows:

2009 2010
Correct Incorrect Incorrect Correct
Net sale 980,000 980,000 1,100,000 1,100,000
Merchandise 55,000 55,000 50,000 60,000
inventory, Jan 1
Purchase 650,000 650,000 700,000 700,000
Merchandise 705,000 705,000 750,000 760,000
available for sale
Less merchandise 60,000 50,000 70,000 70,000
inventory, dec 31
Cost of 645,000 655,000 680,000 690,000
merchandise sold
Gross profit 335,000 325,000 420,000 410,000
Expense 100,000 100,000 120,000 120,000
Net income 235,000 225,000 300,000 290,000
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Principles of Accounting II, Chapter 1 Accounting for Inventories
In the illustration, the $10,000 understatement of inventory at the end of period one resulted in an

over statement of the cost of goods sold and thus an understatement of gross profit by $10,000.

On the balance sheet, merchandise inventory and owner’s equity would be understated by

$10,000. Because the ending inventory of period one becomes the beginning inventory for period

two, the cost of goods sold was understated and gross profit was overstated by $10,000 for period

two. Both merchandise inventory and owner’s equity will be correct at the end of period two.

Inventory Systems

There are two principal system of inventory accounting.

1. Periodic

2. Perpetual.

Periodic inventory system

- In this system, only the revenue from sales is recorded each time a sale is made.

- No entry will be made to record the cost of merchandise sold at the time of sale.

- Physical inventory will be taken to determine the cost of the ending inventory at the end of an

accounting period.

Perpetual inventory system

- Uses according records that continuously disclose the amount of the inventory.

- The cost of merchandise sold will be recorded each time a sale is made.

- Physical inventory is taken to compare the records with the actual quantities on hand.

Determining actual quantities in the inventory

The first stage in the process of “taking “an inventory is to determine the quantity of each kind of

merchandise owned by the enterprise.

All of the merchandise owned by the business on the inventory date and only such merchandise

should be included in the inventory.

Determine who has legal title to merchandise in transit on the inventory date by examining

purchase and sales invoices.

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Shipping terms:

- FOB shipping point – title usually passes to the buyer when goods are shipped.

- FOB destination – title doesn’t pass to the buyer until the good are sold.

Consignments terms:

- Consignee – acts as an agent of the consignor to sell the goods.

- Consignor – retains title until the goods are sold.

Determining the cost of inventory:

The cost of merchandise inventory is made up of the purchase price and all expenditures

incurred in acquiring such merchandise, including transportation, customs duties, and insurance

against losses in transit.

Those cost that are difficult to associate with specific inventory items may be prorated on some

equitable basis. On the other hand, if it is minor cost it can be treated as operating expense of the

period.

One of the most significant problems in determining inventory cost comes about when identical

units of a certain commodity have been acquired at different unit cost prices during the period.

In such a case it is necessary to determine the unit price of the items till on hand. At this time

there are four methods commonly used in assigning costs to inventory and of goods sold.

They are

i. Use of specific identification method

ii. First-in-first-out;

iii. Last-in, first-out;

iv. Weighted average.

The three most common assumptions of determining the cost of merchandise sold are as follows:

1. Cost flow is in the order in which the expenditures were made – first- in, first –out.

2. Cost flow is in the reverse order in which the expenditures were made – last –in, first – out.

3. Cost flow is an average of the expenditures.

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Principles of Accounting II, Chapter 1 Accounting for Inventories
Inventory costing methods under a periodic system

When the periodic inventory system is used, only revenue is recorded each time a sale is made.

No entry is made at the time of the sale to record the cost of the merchandise sold. At the end of

the accounting period, a physical inventory is taken to determine the cost of the inventory and

the cost of merchandise sold.

First- in – first- out method (FIFO)

This method of costing inventory is based on the assumption that costs should be changed

against revenue in the order in which they were incurred. Hence, the inventory remain is

assumed to be made up of the most recent costs and the cost of inventory sold is made up of the

earliest costs.

Example: - The units of an item available for sale during the year were as follows (Assume selling

price of $ 50)

Jan.1 inventor 35 units at $ 23 $805

Mar.4 purchase 10 units at $ 25 $250

Aug.20 purchase 30 units at $28 840

Nov.30 purchase 25 units at $ 30 750

100 2,645

The physical count on December 31 shows that 45 units of the particular commodity are on hand.

In accordance with the assumption that the inventory is composed of the most recent costs, the

cost of the 45 units is determined as follows:

FIFO method: (45 units were on hand).

Most recent cost, Nov. 30………..25 units at $30………. $750

Next most recent costs, Aug. 20…20 units at $28………. $560

Inventory, Dec. 31…………………………………… 1,310

Deduction of the inventory of 1,310 from the 2,645 of merchandise available for sale yields 1,335

as the cost of merchandise sold, which represents the earliest costs incurred for this commodity.

Or

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Earliest cost jan1. 35 units at $ 23 $ 805

Next earliest cost Mar 4, 10 units at $ 25 250

Next earliest cost Aug 20 10 units at $ 28 280

Cost of merchandise sold 55 1335

The cost of inventory at Dec 31= $ 2,645-1,335 = $ 1,310

In most businesses, there is a tendency to dispose of goods in the order of their acquisition. This

would be particularly true of perishable merchandise and goods in which style or model changes

are frequent. Thus, the FIFO, methods is generally in harmony with the physical movement of

merchandise is an enterprise.

Last –In, First–Out method

In this method of costing is based on the assumption that the most recent cost incurred should be

charged against revenue. Hence the inventory remaining is assumed to be composed of the

earthiest costs. Based on the above example the 45 units of inventory is determined in the

following manner:

Earliest costs, Jan. 1 …….........35 units at $ 23…………..$ 805

Next earliest costs, Mar.4 ……10 units at $ 25 ………… $ 250

Inventory, Dec. 31 …………45………………………..1,055

Deduction of the inventory of $1,055 from the $2,645 of merchandise available for sale yields

$1,590 as the cost of merchandise sold, which represents the most recent costs incurred for this

particular commodity. Or

Most recent cost Nov.30 25 units at $ 30 $750

Next most recent costs, Aug 20 30 units at 28 840

Cost of merchandise sold 55 1590

The cost of inventory at Dec 31 = $ 2,645- $ 1,590 = $1055

Average cost method

The average cost method is sometimes called the weighted average method. When this meted is

used, cost is matched against revenue according to the weighted average unit costs of the goods

sold.

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The same weighted average unit cost are used in determine the cost of the merchandise

remaining in the inventory.

The weighted average unit cost is determined by dividing the total cost of the identical units of

each commodity available for sale during the period by the related number of units of that

commodity.

Average unit cost = total cost of the available units

Number of units

= $ 2,645 = $26.45

100 units

The cost of ending inventory at Dec 31= 45* $26.45 = 1190.25

Cost of merchandise sold =55 units at 26.45 = $ 1,454.75

Or 2,645-1,190.25=1,454.75

Accounting for and reporting Inventory under a perpetual system

In a perpetual inventory system, all merchandise increases and decreases are recorded in a

manner similar to the recording of increases and decreases in cash. The merchandise inventory

account at the beginning of an accounting period indicated the merchandise in stock on that date.

Purchases are recorded by debiting merchandise inventory and crediting cash or accounts

payable, on the data of each sale the cost of merchandise sold is recorded by debiting cost of

merchandise sold and crediting merchandise Inventory.

Example: - the following units of item X are available for sale.

Item –X units cost
Jan 1 inventory 20 $ 20
4 sale 14
10 purchase 18 21
22 sale 8
28 sale 6
30 purchase 20 22
The firm used a perpetual inventor system, and there are 30 units of one item on hand at end of

the year. What is the total cost of goods sold and ending inventory according to:

A. FIFO B. LIFO C. Average Cost Method

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First- in, first – out (FIFO) method

Using cost, costs are included in the merchandise sold in the order in which they were incurred.

Purchases Cost of merchandise sold Inventory

Date Quantity Unit Cost Total Cost Quantity Unit Cost Total Cost Quantity Unit Cost Total Cost

1 20 20 400
4 14 20 280 6 20 120
10 18 21 378 6 20 120
18 21 378
22 6 20 120
2 21 42 16 21 336
28 6 21 126 10 21 210
30 10 21 210
20 22 440 20 22 440
Balance $568 $650
Thus cost of merchandise sold = $ 568, cost of ending inventory = $ 650.

Last-in, first- out method (LIFO)

When the LIFO method is used in a perpetual inventory system, the cost of the units sold is the

cost of the most recent purchases.

Purchases Cost of merchandise sold Inventory

Date
Quantity Unit Cost Total Cost Quantity Unit Cost Total Cost Quantity Unit Cost Total Cost

1 20 20 400
4 14 20 280 6 20 120
6 20 120
10 18 21 378 18 21 378
6 20 120
22 8 21 168 10 21 210
6 20 120
28 6 21 126 4 21 84
6 20
120
4 21
84
30 20 22 440 20 22
440
Balance $574 $644

Thus, cost of merchandise sold: $ 574, cost of ending inventory $ 644

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Average cost method

When the average cost method is used in a perpetual inventory system an average unit cost for

each type of item is computed each time a purchase is made. This unit cost is then used to

determine the cost of each sale until another purchase is made and a new average is computed.

This averaging technique is called a moving average.

Average cost method:-

Purchases Cost of merchandise sold Inventory

Date Quantity Unit Cost Total Cost Quantity Unit Cost Total Cost Quantity Unit Cost Total Cost

Jan 1 20 20 400

4 14 20 280 6 20 120

10 18 21 378 24 20.75 498

22 8 20.75 166 16 20.75 332

28 6 20.75 124.5 10 20.75 207.5

30 20 22 440 30 21.57 647.5

Balance $570.5 $647.5

Cost of merchandise sold = 570.5, Cost of ending inventory =647

Comparing inventory costing methods (Optional)

Since a different cost flow is assumed for each of the three alternatives method of costing

inventories, the three methods have yielded a different amount for:-

1. The cost of the merchandise sold for the period

2. The gross profit (and net income ) for the period, and

3. The ending inventory

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Example: - Using the preceding example for the periodic inventory system, the following

partial income statements indicate the effect of each method when prices are rising.

Partial income statements

FI FO AVERAGE COST LIFO
Net sales (150*55 unit) $2,750 $2,750 $2,750
Cost of March sold.
Beginning inv $805 $ 805 $805
Purchases 1,840 1,840 1,840
Mer avail For sale $2,645 $2,645 $2,450
Less ending inventor 1,310 1,190.25 1,055
Cost of merch sold $1,335 $1454.75 $1,590
Gross profit $ 1,415 $1345.25 $1,460

- The FIFO method yielded the lowest amount for the cost of merchandise sold and the highest
amount for gross profit (and net income). It also yielded the highest amount for ending
inventory.
- The LIFO method yielded the highest amount for cost of goods sold, and the lowest amount
for gross profit (and net income), and the lowest amount for ending inventory.
- The average cost method yield results that were b/n those of LIFO and FIFO.
Uses of FIFO
- Corresponds to the actual physical flow of goods.
- Less subject to manipulation than other recent costs
- Ending inventory is shown at the most recent costs
Disadvantages of FIFO
- Older cost is matched against revenues.
- In periods of rising prices, can result in higher income taxes.
Uses of LIFO
- Matches current cost against current sales revenue.
- During periods of rising prices, using LIFO offers an income tax saving b/c LIFO reports the
lowest net income.
Disadvantages of LIFO
- Seldom conforms to actual flow of goods.
- During periods of rising prices, the ending inventors are low (quite different from its current
replacement cost).
- Reported income is generally lower in periods of rising prices.
Uses of average cost method.
- Amounts for cost of goods sold and ending inventory fall b/n FIFO and LIFO values. B/S
values are close to FIFO values (current replacement values)
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Valuation of inventory at other than cost
Cost is the primary basis for valuating inventories. In some cases however, inventor is values at

other than cost. This is when,

A. the cost of replacing items in inventory is below the recorded cost and

B. the inventory is not salable at normal sales prices which may be due to imperfections, shop

wear, style changes, and other causes.

1. Valuation at lower of cost or Market (LCM)

If the cost of replacing inventory is lower than its recorded purchase cost, the lower of- cost-or-

market (LCM) method is used to value the inventory. Market, as used in lower of cost or market,

is the cost to replace the inventory. The market value is based on normal quantities that would be

purchased from suppliers.

The lower-of-cost-or-market method can be applied in one of three ways. The cost, market price,

and any declines could be determined for the following:

1. Each item in the inventory.

2. Each major class or category of inventory.

3. Total inventory as a whole.

The amount of any price decline is included in the cost of merchandise sold. This, in turn,

reduces gross profit and net income in the period in which the price declines occur. This

matching of price declines to the period in which they occur is the primary advantage of using

the lower-of-cost-or-market method.

Example: - On the basis of the following data, determine the value of inventory at the lower of

cost or market.

Commodity Inventory Quantity Unit Cost Price Unit Market Price

A 10 $ 325 $320

B 17 110 115

C 12 275 260

D 15 51 45

E 30 95 100

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Answer

_Total_ ____

Commodity Inventory Unit cost Unit market Cost Market LCM

Quantity Price Price

A 10 $ 325 $320 3,250 3,200 3,200

B 17 110 115 1,870 1,955 1,870

C 12 275 260 3,300 3,120 3,120

D 15 51 45 765 675 675

E 30 95 100 2,850 3,000 2,850

Total ………………………………………………. $12035 $11,950 $11,715

2. Valuation at net realizable value

Merchandise that is out of date, spoiled, or damaged can often be sold only at a price below its

original cost. Such merchandise should be valued at its net realizable value.

Net realizable value is determined as follows:

Net Realizable Value = Estimated Selling Price - Direct Costs of Disposal

Direct costs of disposal include selling expenses such as special advertising or sales commissions

on sale. To illustrate, assume the following data about an item of damaged merchandise:

Original cost $1,000

Estimated selling price 800

Selling expenses 150

The merchandise should be valued at its net realizable value of $650 as shown below.

Net Realizable Value = $800 - $150 = $650

Example: Assume that damaged merchandise costing 1,500 can be sold for only $ 1,250, and

direct selling expenses are estimated to be $ 175. This inventory should be valued at $ 1075 ($

1,250-$ 175)

Presentation of Merchandise inventory on the balance sheet

Merchandise inventory is usually presented in the current asset section of the balance sheet,

following receivables. Both the method of determining the cost of inventory (fifo, lifo, or average)

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and the method of valuing the inventory (cost or the lower of cost or market) should be show.

The details may be disclosed in parentheses on the balance sheet or in a foot note to the financial

statements. The company may change its inventory costing methods for valid reason. In such

cases, the effect of the change and the reason for the change should be disclosed in the financial

statements for period in which the change occurred.

Estimating Inventory Cost

In practical an inventory amount may be need in order to prepare an income statement when it is

impractical or impossible to take a physical inventory or to maintain perpetual inventory records,

the amount of inventory on hand can be estimated.

The two commonly used methods of estimating inventory cost are

1. The retail method

2. The gross profit method.

Retail method of inventory costing

A business may need to estimate the amount of inventory for the following reasons:

1. Perpetual inventory records are not maintained.

2. A disaster such as a fire or flood has destroyed the inventory records and the inventory.

3. Monthly or quarterly financial statements are needed, but a physical inventory is taken

only once a year.

The two widely used methods of estimating inventory cost.

1. Retail Method of Inventory Costing

The retail inventory method of estimating inventory cost requires costs and retail prices to be

maintained for the merchandise available for sale. A ratio of cost to retail price is then used to

convert ending inventory at retail to estimate the ending inventory cost.

The retail inventory method is applied as follows:

Step 1. Determine the total merchandise available for sale at cost and retail.

Step 2. Determine the ratio of the cost to retail of the merchandise available for sale.

Step 3. Determine the ending inventory at retail by deducting the net sales from the

merchandise available for sale at retail.

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Step 4. Estimate the ending inventory cost by multiplying the ending inventory at retail by the

cost to retail ratio.

Example: on the basis of the following data, estimate the cost of the merchandise inventory at

June 30 by the retail method

Cost Retail

June 1. Merchandise inventory $ 428,300 $ 670,500

1-30 purchasers (net) 608,500 949,000

1-30 sales (net) 1,140.000

Solution:
Cost Retail
Merchandise inventory June 1 $ 428,300 $ 670,500

Purchases in June (net) 608,500 949,500

Merchandise available for sale $1,036,800 1,620,000

Ratio of cost to retail price: 1,036,800 = 64%

1,620,000

Sales for June (net) 1,140,000

Merchandise inventory, June 30, at retail 480,000

Merchandise inventory, June 30, at estimated cost

(480.000*64%)…………………................................................................................307,200

When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be
the same as the merchandise available for sale. If the ending inventory is made up of different
classes of merchandise, cost to retail ratios may be developed for each class of inventory.
An advantage of the retail method is that it provides inventory figures for preparing monthly
statements. Department stores and similar retailers often determine gross profit and operating
income each month, but may take a physical inventory only once or twice a year. Thus, the retail
method allows management to monitor operations more closely.

Gross Profit Method of Estimating Inventories

The gross profit method uses the estimated gross profit for the period to estimate the inventory at

the end of the period. The gross profit is estimated from the preceding year, adjusted for any

current-period changes in the cost and sales prices.

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The gross profit method is applied as follows:

Step 1. Determine the merchandise available for sale at cost.

Step 2. Determine the estimated gross profit by multiplying the net sales by the gross profit

percentage.

Step 3. Determine the estimated cost of merchandise sold by deducting the estimated gross profit

from the net sales.

Step 4. Estimate the ending inventory cost by deducting the estimated cost of merchandise sold

from the merchandise available for sale.

Example: The merchandise inventory was destroyed by fire on October 20. The following data

were obtained from the accounting records.

Jan 1. Merchandise inventory $ 160,000

Jan 1. Oct purchases (net) 850,000

Sales (net) 1,080,000

Estimated gross profit rate 36%

Required: Estimate the cost of merchandise destroyed:

Solution:

Merchandise inventory, January $160.000

Purchase (net) 850,000

Merchandise available for sales $1,010,000

Sales (net) $1,080,000

Less estimated gross profit

(1,080,000*36%) (388,800)

Estimated cost of merchandise sold ($691,200)

Estimated merchandise inventory, Oct 20 $318,800

The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements. It is also useful in estimating the cost of merchandise destroyed by fire or other
disasters.

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