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INTERMEDIATE ACCOUNTING Chapter 8 Inventories: Special Valuation Issues © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,

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Presentation on theme: "INTERMEDIATE ACCOUNTING Chapter 8 Inventories: Special Valuation Issues © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,"— Presentation transcript:

1 INTERMEDIATE ACCOUNTING Chapter 8 Inventories: Special Valuation Issues © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2 What is the Lower of Cost or Market Rule? The lower of cost or market (LCM) rule requires that a company write down its inventory to its market value when the inventorys utility has declined. By reporting inventory at the lower of its cost or market value, a company reports a more representationally faithful value for inventory on its balance sheet and a loss (or expense) in its income statement in the period the assets value declines rather than in the period the goods are sold. Therefore, the application of the lower of cost or market rule is consistent with the conservatism principle. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

3 Determining Market Value To apply the lower of cost or market rule, the company must estimate the market value of inventory in order to compare it to cost to determine which amount is lower. Under the lower of cost or market rule, market value is defined as the current replacement costthe cost the company would pay to replace the item. This replacement cost valuation of inventory is a more relevant and representationally faithful value than the original (higher) costs the company actually incurred. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

4 Replacement Cost To measure replacement cost, GAAP imposes an upper (ceiling) and a lower (floor) constraint on the market value as follows: Net Realizable Value (ceiling): The market value should not be more than the net realizable valuethe estimated selling price in the ordinary course of business minus reasonably predictable costs of completion and disposal. Net Realizable Value minus a Normal Profit Margin (floor): The market value should not be less than the net realizable value reduced by an estimate of a normal profit margin or markup. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

5 Application of the Lower of Cost or Market Rule (Slide 1 of 2) Step 1. Determine the market value. Calculate the current replacement cost, ceiling, and floor, and select the middle value of the three. Step 2. Compare the market value to cost. Assign the lower of the selected market value or the historical cost to the value of inventory. Step 3. Report the results in the financial statements. Report the lower value on the balance sheet. If the company recognizes a loss, report the amount on the income statement as either a separate line item for loss from an inventory write-down or by including it in cost of goods sold. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

6 Application of the Lower of Cost or Market Rule (Slide 2 of 2) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

7 A company may apply the lower of cost or market rule to each individual item in inventory, each major inventory category, or to the total of the inventory. When the lower of cost or market rule is applied to each major category or to the total of the inventory, price declines of some of the units in inventory are offset by price increases in other units of inventory in the same category. Therefore, applying the lower of cost or market rule to groups of inventory will usually result in higher inventory valuations and lower losses relative to applying the rule to each individual item of inventory. Approaches to Implementing the Lower of Cost or Market Rule © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

8 Recording the Reduction of Inventory to Market A company can record the write-down of inventory from cost to market value using either of two methods: Direct MethodThe loss is recorded directly by reducing the companys inventory account and increasing its cost of goods sold account. Allowance MethodThe loss is recorded in a separate inventory valuation account and loss account. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

9 Reporting Lower of Cost or Market Under the direct method, the write-down of inventory is recorded directly in inventory and cost of goods sold. Under the allowance method, the write-down is recorded in an allowance account and a loss account. The allowance account is reported as a contra- inventory account in a companys balance sheet. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

10 Can Inventory Be Valued Above Cost? Normally, a company will not value its inventory above cost. However, under certain circumstances, GAAP does allow a company to report its inventory above cost. This exception must be justified by: An inability to determine appropriate costs Immediate marketability of the inventory at a quoted market price The interchangeability of the units of inventory © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

11 How is Inventory Estimated Using the Gross Profit Method? (Slide 1 of 2) The gross profit method may be used in the following situations: To determine the cost of the inventory for interim financial statements. This method is acceptable provided that the company discloses the method used at the interim date and any significant adjustments that result from reconciliations with the annual physical inventory. To check the reasonableness of the reported cost of inventory by an auditor. To estimate the cost of inventory that is destroyed by a casualty, such as a fire. To estimate the cost of the inventory from incomplete records. For example, if a companys inventory records are destroyed, the inventory can be estimated if the cost of goods available for sale and the sales are known or can be reconstructed. To develop budgeted amounts for cost of goods sold and ending inventory from a sales budget. However, the gross profit method is not acceptable for annual financial statements. Instead, a physical count of inventory is required to verify the inventory quantity. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

12 How is Inventory Estimated Using the Gross Profit Method? (Slide 2 of 2) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

13 How is Inventory Estimated Using the Retail Inventory Method? (Slide 1 of 3) As an alternative to the gross profit method, the retail inventory method can be used to estimate the cost of inventory when there is a consistent pattern between the cost of a companys purchases and its selling prices. The retail inventory method has two main advantages compared to the gross profit method: While the gross profit method estimates a profit percentage based on past periods, the retail inventory method uses a current-period estimate of gross profit. This makes the retail inventory method more sensitive to price changes and produces a more accurate estimate of current period ending inventory. The retail inventory method is allowed for both financial reporting and income tax purposes. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

14 How is Inventory Estimated Using the Retail Inventory Method? (Slide 2 of 3) The retail inventory method requires a company to maintain accounting records that contain the following information: beginning inventory at cost and retail value goods purchased at cost and retail value changes in selling price resulting from additional markups and markdowns sales Note that information related to both beginning inventory and purchases must be provided at both cost and retail values, where retail values are the current selling prices of the goods. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

15 How is Inventory Estimated Using the Retail Inventory Method? (Slide 3 of 3) Step 1. Compute the total goods available for sale at both cost and retail value. Step 2. Compute the appropriate cost-to-retail ratio. Step 3. Compute the ending inventory at retail. Retail Value of Goods Available for Sale x Net Sales Revenue Step 4. Compute the ending inventory at cost. Ending Inventory at Retail x Cost-to-Retail Ratio © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

16 Retail Inventory Method Terminology Retail stores typically make changes in selling prices after setting the original price. The following seven terms describe these changes: Markup: the original markup from cost to the original selling price Additional Markup: an increase above the original sales price Markup Cancellation: a reduction in the selling price after there has been an additional markup; the markup cancellation cannot be greater than the additional markup Net Additional Markup: the total additional markups minus the total markup cancellations Markdown: a decrease below the original selling price Markdown Cancellation: an increase in the selling price after there has been a markdown; the markdown cancellation cannot be greater than the markdown Net Markdown: the total markdowns minus the total markdown cancellations © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

17 Application of the Retail Inventory Method (Slide 1 of 2) By changing the inputs of the cost-to-retail ratio, companies can use the retail inventory method to develop inventory valuations under different cost flow assumptions. FIFO. Exclude the cost and the retail value of the beginning inventory from the computation of the cost-to-retail ratio for the period. The ratio should include both net additional markups and net markdowns. Average Cost. Include the cost and the retail value of the beginning inventory and net additional markups and net markdowns in the cost-to- retail ratio. LIFO. Compute separate ratios for each layer in the beginning inventory and for the purchases of the current period. Include both net additional markups and net markdowns in the cost-to-retail ratio for the current period. Lower of Average Cost or Market. Include the cost and retail value of the beginning inventory and net additional markups in the cost-to-retail ratio. Net markdowns are excluded from the cost-to-retail ratio. This method is also known as the conventional retail method. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

18 Application of the Retail Inventory Method (Slide 2 of 2) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

19 Retail Lower of Average Cost or Market The retail inventory method can also be used to approximate the valuation of inventory at the lower of cost or market by excluding net markdowns from the computation of the cost-to-retail ratio. The rationale for excluding net markdowns is that companies will normally mark down inventory to indicate a decrease in utility (e.g., obsolescence, lower demand for the goods). Excluding net markdowns will result in a lower cost-to- retail ratio which, consistent with the lower of cost or market rule, leads to a lower approximation of ending inventory. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

20 Additional Adjustments under the Retail Method The application of the retail method is complicated when a company considers other typical costs and activities such as: freight charges purchase discounts purchase returns and allowances sales returns and allowances sales discounts inventory shrinkage employee discounts © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

21 What is the Dollar-Value Retail Method? The previous discussion of the retail LIFO method assumed that there were no changes in the retail price of inventory during the period. However, when prices change during a period, a company can combine the principles of the retail LIFO method with the dollar-value LIFO method to eliminate the effects of this price change. This combination is called the dollar-value LIFO retail method. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

22 Example: Dollar-Value Retail Method (Slide 1 of 6) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

23 Example: Dollar-Value Retail Method (Slide 2 of 6) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

24 What are the Effects of Inventory Errors? Errors in the valuation of inventory or the recording of purchases can result in inaccurate values on the companys balance sheet and income statement. The discovery of inventory errors requires careful analysis and adjusting entries to correct the companys accounts. If a company discovers an error in the same accounting period that the error was made, it reverses the erroneous entry and records a correct entry. However, if a company discovers a material error after it has closed the books, it treats the correction as a prior period adjustment. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

25 Effects of Inventory Errors (Slide 1 of 2) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

26 Effects of Inventory Errors (Slide 2 of 2) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part


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