# Chapter 9 inventories: additional valuation issues Sommers – ACCT 3311

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Chapter 9 inventories: additional valuation issues Sommers – ACCT 3311
Acct Class 14 Chapter 9 inventories: additional valuation issues Sommers – ACCT 3311 Chapter 1: Environment and Theoretical Structure of Financial Accounting.

LCM Approach Lower-of-cost-or-market approach to valuing inventory GAAP generally require the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.

Discussion Question Q9-2 Explain the rationale for the ceiling and floor in the lower-of-cost-or-market method of valuing inventories.

Determining Market Value
Step 1 Determine Designated Market Step 2 Compare Designated Market with Cost Ceiling NRV Not More Than Replacement Cost Designated Market Cost Or Not Less Than If replacement cost is greater than the ceiling, then market becomes ceiling. If replacement cost is less than the floor, then floor becomes market value. As long as replacement cost falls between the ceiling and the floor, it will be considered market value. Lower of Cost Or Market NRV – NP Floor

Example 1: LCM Tatum Company has four products in its inventory. Information about the Dec 31, 2011, inventory is as follows: The normal gross profit percentage is 25% of cost. Determine the balance sheet inventory carrying value at Dec 31, 2011, assuming the LCM rule is applied to individual products. Product Total Cost Total Replacement Cost Total Net Realizable Value 101 \$ 120,000 \$ 110,000 \$ 100,000 102 90,000 85,000 110,000 103 60,000 40,000 50,000 104 30,000 28,000

Example 1: Continued Product RC Ceiling NRV Floor NRV-NP
Designated Market    Cost Inventory Value 101 \$110,000 \$100,000 \$70,000 102 103 104

Applying Lower of Cost or Market
Lower of cost or market can be applied 3 different ways. Apply LCM to each individual item in inventory. Apply LCM to each class of inventory. Apply LCM to the entire inventory as a group. Part I We can apply lower-of-cost-or-market in one of three different ways. First, we can apply it to individual items of inventory, Part II. or we can apply it to groups of similar items in inventory, Part III or finally, we can apply it to the entire inventory.

Example 2: LCM applications
Almaden Hardware Store sells two distinct types of products, tools and paint products. Information pertaining to its 2011 year-end inventory is as follows: Determine balance sheet inventory carrying value at year-end, assuming the LCM rule is applied to individual products, then product type, and then total inventory. Inventory, by Product Type Quantity Per Unit Cost Designated Market Tools: Hammers 100 \$5.00 \$5.50 Saws 200 10.00 9.00 Screwdrivers 300 2.00 2.60 Paint products: 1-Gallon cans 500 6.00 5.00 Paint brushes 4.00 4.50

Example 2: Continued Inventory, by Product Type Cost Designated Market
Individual LCM Type LCM Total Inventory LCM Tools: Hammers \$500 \$550 Saws 2,000 1,800 Screwdrivers 600 780 Total tools: 3,100 3,130 Paint products: 1-Gallon cans \$3,000 2,500 Paint brushes 400 450 Total paint: 3,400 2,950 Total: \$6,500 \$6,080

Evaluation of LCM Rule Some Deficiencies:
Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale. Inventory valued at cost in one year and at market in the next year. Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize. LCM uses a “normal profit” in determining inventory values, which is a subjective measure.

Valuation at Net Realizable Value
Permitted by GAAP under the following conditions: a controlled market with a quoted price applicable to all quantities, and no significant costs of disposal (rare metals and agricultural products) or too difficult to obtain cost figures (meatpacking).

Purchase Commitments Generally seller retains title to the merchandise. Buyer recognizes no asset or liability. If material, the buyer should disclose contract details in footnote. If the contract price is greater than the market price, and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize a liability and a corresponding loss in the period during which such declines in market prices take place.

Purchase Commitments Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. In July 2011, the Lassiter Company. signed two purchase commitments. The first requires Lassiter to purchase inventory for \$500,000 by November 15, The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of \$425,000. The second requires Lassiter to purchase inventory for \$600,000 by February 15, On December 31, 2011, the market value of the inventory items was \$540,000. On February 15, 2012, the market value of the inventory items was \$510,000. Lassiter uses the perpetual inventory system and is a calendar year-end company. A purchase commitment is a contract between two parties, requiring one of the parties to purchase a specified amount of inventory at a set price, on or before a particular date. Read through the example of the two purchase commitments entered into by Matrix in July of We will look at the accounting for both of these purchase commitments. It is important to note that one of the purchase commitments requires action during 2009, while the other does not require action until 2010.

Purchase Commitments Single-period commitment Multi-period commitment
November 14, 2011 Inventory (market price) 425,000 Loss on purchase commitment 75,000 Accounts payable ,000 December 15, 2011 Accounts payable 500,000 Cash ,000 Single-period commitment December 31, 2011 Unrealized loss on commitment 60,000 Est liab on purch commitment ,000 February 15, 2012 Inventory (market price) 510,000 Loss on purchase commitment 30,000 Est liab on purch commitment 60,000 Cash ,000 Part I Let’s look at the single-period purchase commitment first. On the date of acquisition, the inventory items had a market price of \$425,000, so Lassiter will debit inventory for \$425,000, debit the loss on purchase commitment for \$75,000, and credit accounts payable for \$500,000. Had the market price of the inventory been \$500,000 on the date of acquisition, the company would not experience a loss. The account payable was paid on December 15, 2011, so Lassiter would make the usual entry to debit accounts payable and credit cash for the commitment price of \$500,000. Part II For the multi-period purchase commitment, Lassiter did not acquire the inventory until 2012, so at the end of 2011, the company would determine the market price of the inventory items and, in our case, debit estimated loss on purchase commitment and credit estimated liability on purchase commitment for \$60,000 (\$600,000 commitment price less \$540,000 market price). On February 15, 2012, Lassiter purchase the inventory paying cash. The market price of the inventory at the time of acquisition was \$510,000. Lassiter will prepare a somewhat complex journal entry to debit inventory for \$510,000, debit loss on purchase commitment (\$540,000 previous market price less \$510,000 current market price), debit the estimated liability on purchase commitment for \$60,000, and credit cash for the commitment price of \$600,000. Multi-period commitment

Inventory Estimation Techniques
Estimate instead of taking physical inventory Less costly Less time consuming Sometimes only option! Two popular methods are . . . Gross Profit Method Retail Inventory Method (next time) Most companies estimate their inventories at interim periods. Inventory estimation is less costly than a physical count and less time consuming. The two most popular methods are known as the gross profit method and the retail inventory method.

Gross Profit Method Relies on Three Assumptions:
Beginning inventory plus purchases equal total goods to be accounted for. Goods not sold must be on hand. The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory. The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the reciprocal of the gross profit ratio.

Example 3: Gross Profit Method
Royal Gorge Company uses the gross profit method to estimate ending inventory and cost of goods sold when preparing monthly financial statements required by its bank. Inventory on hand at the end of October was \$58,500. The following information for the month of November was available from company records: Purchases \$ 110,000 Freight-in 3,000 Sales 180,000 Sales returns 5,000 Purchases returns 4,000 In addition, the controller is aware of \$8,000 of inventory that was stolen during November from one of the company’s warehouses. Calculate the estimated inventory at the end of November, assuming a gross profit ratio of 40%.

Example 3: Continued

Evaluation of Gross Profit Method
Disadvantages: Provides an estimate of ending inventory. Uses past percentages in calculation. A blanket gross profit rate may not be representative. Normally unacceptable for financial reporting purposes. GAAP requires a physical inventory as additional verification.

Retail Inventory Method
A method used by retailers, to value inventory without a physical count, by converting retail prices to cost. Requires retailers to keep: Total cost and retail value of goods purchased. Total cost and retail value of the goods available for sale. Sales for the period. Methods Conventional Method LIFO Dollar-value LIFO

Retail Inventory Method
Explain the retail inventory method of estimating ending inventory. The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage.

The Retail Inventory Method
This method was developed for retail operations like department stores. Uses both the retail value and cost of items for sale to calculate a cost-to-retail percentage. Objective: Convert ending inventory at retail to ending inventory at cost. Terminology: Initial markup - Original amount of markup from cost to selling price. Additional markup - Increase in selling price subsequent to initial markup. Markup cancellation - Elimination of an additional markup. Markdown - Reduction in selling price below the original selling price. Markdown cancellation - Elimination of a markdown. As indicated by its name, the retail method was developed for retail establishments such as department stores. There is a major difference between the gross profit and retail method. In the retail method, we need to know both cost and selling price of certain accounts. Our objective in the retail method is to calculate ending inventory at retail, and then convert it from retail to cost.

LCM Practice Decker Company has five products in its inventory. Information about the December 31, 2011, inventory follows. Unit Unit Unit Replacement Selling Product Quantity Cost Cost Price A 1,000 \$10 \$12 \$16 B C D E The selling cost for each product consists of a 15 percent sales commission. The normal profit percentage for each product is 40 percent of the selling price. Determine the balance sheet inventory carrying value at December 31, 2011, assuming the LCM rule is applied to individual products.

Designated Market Value
LCM Practice Product NRV per unit NRV-NP per unit A \$16 - (15% x \$16) = \$13.60 \$ (40% x \$16) = \$7.20 (1) (2) (3) (4) (5)    Product (units) RC  Ceiling NRV  Floor NRV-NP Designated Market Value [Middle value of (1), (2) & (3)] Cost Inventory Value [Lower of (4) and (5)] A (1,000) \$12,000 \$13,600 \$7,200 \$10,000

LCM Practice Decker Company has five products in its inventory. Information about the December 31, 2011, inventory follows. Unit Unit Unit Replacement Selling Product Quantity Cost Cost Price A 1,000 \$10 \$12 \$16 B C D E The selling cost for each product consists of a 15 percent sales commission. The normal profit percentage for each product is 40 percent of the selling price. Determine the balance sheet inventory carrying value at December 31, 2011, assuming the LCM rule is applied to the entire inventory.

LCM Practice