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Inventories: Additional Valuation Issues

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1 Inventories: Additional Valuation Issues

2 Objectives of this Chapter
I. Introduce Inventory estimation methods: the gross profit method and the retail inventory method. II. Determine ending inventory cost by applying the gross profit method. III. Determine ending inventory cost by applying the retail inventory method. Inventories: Additional Issues

3 Objectives of this Chapter (contd.)
IV. Compare the gross profit method and the retail inventory method. V. Explain dollar-value LIFO retail method. VI. Discuss accounting issues related to purchase commitments. Inventories: Additional Issues

4 Inventories: Additional Issues
I. Estimating Inventory: Gross Profit Method and Retail Inventory Method Reasons: For some companies, inventory information is needed between accounting periods . Companies cannot afford to do physical inventory count every quarter. Thus, either the gross profit method or the retail inventory method can be used to estimate value of ending inventory for interim reports. Inventories: Additional Issues

5 Inventories: Additional Issues
Estimating Inventory: Gross Profit Method and Retail Inventory Method (contd.) No physical count of inventory is needed for either method. The value of inventory is based on estimation. Neither method is acceptable for annual financial reporting purposes. Inventories: Additional Issues

6 Inventories: Additional Issues
Estimating Inventory: Gross Profit Method and Retail Inventory Method (contd.) Both methods are acceptable for interim reporting. The insurance adjusters may use the gross profit method to estimate the loss of inventory in case of fire or flood. Inventories: Additional Issues

7 II. The Gross Profit Method
Data Required: Beginning Inventory (at cost) Purchase (net) (at Cost) Sales Price Gross Margin Ratio (Gross Margin/Sales Price) Inventories: Additional Issues

8 Gross Profit Method Example A
Beginning Inv. = $60,000 Purchase (net) = $200,000 Sales = $280,000 Gross Margin Ratio 1= 30% 1. Gross margin ratio is obtained from past years’ experience (assuming the ratio is stable over years). Inventories: Additional Issues

9 Inventories: Additional Issues
Example A (contd.) Using gross profit method to estimate the cost of ending inventory Selling Price Cost Beg. Inventory $60,000 Purchase (net) 200,000 Goods Available for Sale 260,000 Sales 280,000 Less: gross margin1 (84,000) Sales (at cost) ,0002 Estimated Inv. (at cost) ,000 1. gross margin = 280,000x30% 2. also equals 280,000x(1-30%) = 196,000 Inventories: Additional Issues

10 Gross Profit Method Example B
What if the gross margin ratio is based on cost of goods sold (CGS) rather than on sales price? Sales $100 CGS (80) Gross Margin $20 Gross profit ratio (based on Sales)= 20% Gross profit ratio (based on CGS) = 25% Deriving CGS using sales and gross profit ratio based on sales: $100 x (1 - 20%) = $80 Deriving CGS using sales and gross profit ratio based on CGS: $100  (1+25%) = $80 Inventories: Additional Issues

11 Inventories: Additional Issues
Example B (contd.) Sales = CGS + Gross Profit = CGS + 25% x CGS = CGS x (1+25%) CGS = Sales  (1+25%) Inventories: Additional Issues

12 Comments on Gross Profit Method
If the relationship between the gross profit and selling price has been changed, the ratio should be adjusted accordingly. A separate gross profit ratio should be applied to different inventory. Inventories: Additional Issues

13 III. Retail Inventory Method
Terminology related to retail inventory method: Retail Price Original retail price $110 Additional markup $5 115 Markup Cancellations 5 110 Markdowns Markdown Cancellations 5 110 Net Markups = Additional Markups - Markup Cancellations Net Markdowns = Markdowns - Markdown Cancellations Inventories: Additional Issues

14 Retail Inventory Method (contd.)
Data required to apply retail method: Beg. Inv. (both cost and retail price) Purchases (net) (cost and retail) Sales (subtracting sales returns only) Price adjustment data such as additional markups, markup cancellations, markdowns and markdown cancellations Inventories: Additional Issues

15 Retail Inventory Method Example (assuming no price adjustments)
Cost Retail Beg. Inv. $14,000 $20,000 Purchases (net) 63, ,0002 77, ,000 Sales 85,0003 Estimated End. Inv. $25,000 at retail Cost ratio = 77,000/110,000=70% Estimated cost of end. inv. = 25,000x70%=17,500 1. Purchases - Pur. R&A - Pur. Dis. + Freight-in 2. Purchases - Pur R&A 3. Gross sales-Sales Returns +Employee Discounts Inventories: Additional Issues

16 Retail Inventory Method Example (with price adjustments)
Cost Retail Beg. Inv. $14,000 $20,000 Purchases (net) 63, ,000 Goods Avail. 77, ,000 Additional Markups 5,000 Markup Cancel. (4,000) Markdowns (1,500) Markdowns Cancel. 200 Sales (85,000) Estimated End. Inv. at Retail $24,700 Question: What is the cost ratio? Inventories: Additional Issues

17 Retail Inventory Method Example (with price adjustments)
Cost Retail Beg. Inv. $14,000 $20,000 Purchases (net) 63, ,000 Goods Avail. 77, ,000 Net Markups ,000 Goods Avail. after net MU 111,000 Net Markdowns (1,300) Goods Avail. after all price adj. 109,700 Sales* (85,000) End. Inv. at Retail $24,700 *Sales = Sales - Sales R&A Inventories: Additional Issues

18 Cost Ratios for Retail Method
1) Average Method (consider all price adjust.) Cost Ratio = 77,000  109,700 = 70.19%. Esti. End. Inv. at cost = $24,700 x 70.19% = $17,336.93 2) LCM approach (conventional retail method) (consider only net markups) = 77,000 111,000 = 69.37%. 24,700 x 69.37% = 17,134.39 Inventories: Additional Issues

19 Cost Ratios for Retail Method (contd.)
3) FIFO approximation (excluding the beg. inv. in the computation of cost ratio) Cost Ratio = (77,000-14,000)(109,700-20,000) =70.23%. Esti. Inv. at cost = $24,700 x 70.23%=17,346.81 Inventories: Additional Issues

20 Cost Ratios for Retail Method (contd.)
4) LIFO approximation (computing two ratios, one for the beg. inv. and one for others) Cost Ratio 1(for beg.inv.) =14,000/20,000=70% Cost Ratio 2(for other inv.) = (77,000-14,000)(109,700-20,000)=70.23% Esti. End. Inv. at cost = 1) 20,000 x 70% = 14,000 2) 4,700a x 70.23% = 3,301 17,301 a. 24,700-20,000=4,700 Inventories: Additional Issues

21 Comments for Retail Method
4/10/2017 Comments for Retail Method A. Cost Retail Purchases $$$$ $$$$ Pur. Discounts $$$$ Pur. R & A $$$$ $$$$ Freight-In $$$$ 1. Pur. Discounts and freight-in are already considered in the retail price of purchases. Inventories: Additional Issues

22 Comments for Retail Method (contd.)
B. Sales in the retail column should be gross sales - sales returns. This is because the retail prices for beg. inv. and purchases are based on gross sales, not net sales. Also, if employee discounts have been subtracted from sales, they should be added back to sales. Inventories: Additional Issues

23 Comments for Retail Method (contd.)
4/10/2017 Comments for Retail Method (contd.) C. Spoilage Cost Retail Normal Spoilage $$$$ Abnormal Spoilage2 $$$$ $$$$ 1. In computing cost ratios, the normal spoilage will not be considered. 2. In computing cost ratios, the abnormal spoilage will be considered. Inventories: Additional Issues

24 Retail Inventory Method – Special Items Included
Cost Retail Beg. Inv $14, $20,000 Purchases (net) , ,000 Abnormal Spoilage (1,400) (2,000) Goods Avail , ,000 Net Markups ,000 Goods Avail. after net MU 109,000 Net Markdowns (1,300) Goods Avail. after all price adj. 107,700 Sales ,000 Sales returns (2,000) (83,000) Employee Discounts (2,000) Normal Spoilage (1,000) End. Inv. at Retail $21,700 Inventories: Additional Issues

25 Retail Inventory Method –Special Items Included(contd.)
1) Average Method (consider all price adjust.) Cost Ratio = 75,600  107,700 = 70.19%. Esti. End. Inv. at cost = $21,700 x 70.19% = $15,232.23 2) LCM approach (conventional retail method) (consider only net markups) = 75,600 10,900 = 69.36%. 21,700 x 69.36% = $15,051.12 5Inventories: Additional Issues

26 Inventories: Additional Issues
Another Example of Conventional Retail Inventory Method – Special Items Included (Illustration 9-3, KWW, 14th e) Inventories: Additional Issues

27 IV. Comparison of Gross Profit Method and Retail Inventory Method
1. Data required: cost of beg. inv., purchases, sales and gross profit ratio. 1. Data required: Cost and retail price of beg. inv., purchases, sales price and price adjustments. 2. Any company can use this method to estimate ending inventory. 2. Only retail store can apply this method to estimate inventory. Inventories: Additional Issues

28 Comparison of Gross Profit Method and Retail Inventory Method (contd.)
3. Gross profit ratio is estimated from past years’ experience (not updated with the price adjustments of the current year). 3. Cost ratio can be calculated at different stage and is updated with current year’s price adjustment data. Inventories: Additional Issues

29 Comparison of Gross Profit Method and The Retail Method (contd.)
Retail Inventory Method 4. Not acceptable for the annual financial reporting but acceptable for the interim report. 4. Not acceptable for the annual financial reporting but acceptable for the interim report. 5. No physical count of inventory is needed. 5. No physical count of inventory is needed. Inventories: Additional Issues

30 V. Dollar-Value LIFO Retail Method
Applying retail method to estimate cost of ending inventory and also considering price index when prices are fluctuating. Inventories: Additional Issues

31 Dollar-Value LIFO Retail Method Example
Cost Retail Beg. Inv. -20x1 $14,000 $20,000 Purchases (net) 63, ,000 Goods Avail. 77, ,000 Net Markups 1,000 Goods Avail. after net MU 111,000 Net Markdowns (1,300) Goods Avail. after all price adj. 109,700 Sales (85,000) End. Inv. at Retail $24,700 Cost Ratio(CR) 1(for beg. inv.)=14,000/20,000=70% CR2 (for others)=(77,000-14,000)/(109,700-20,000) =70.23% Inventories: Additional Issues

32 Dollar-Value LIFO Retail Method Example (contd.)
Assuming the price indices of 20x0 and 20x1 are 100% and 112%, respectively. Procedures of applying Dollar-Value LIFO concept to Retail method (LIFO approximation): Inventories: Additional Issues

33 Dollar-Value LIFO Retail Method Example (contd.)
1. Ending inventory at retail prices is deflated to base year’s price level: $24,700112% = $22,054 2. Forming Layers based on LIFO cost flows assumption: Beg. inv (retail) at base-year prices (L1) $20,000 Inv. increase (retail) from beg. inv. (L2) 2,054 Inventories: Additional Issues

34 Dollar-Value LIFO Retail Method Example (contd.)
Ending Inv Layers Price Cost End. Inv. at Base-year at Base-year Index Ratio at LIFO Retail Prices Retail Prices (%) (%) Cost $22,054 $20, $14,000 $2, ,616 $15,615 Inventories: Additional Issues

35 Dollar-Value LIFO Retail Method Example (contd.)
Subsequent years under Dollar-Value LIFO Retail The D-V LIFO retail method follows the same procedures in subsequent years as the traditional D-V LIFO method. That is when a real increase in inventory occurs, a new layer is added. Inventories: Additional Issues

36 Dollar-Value LIFO Retail Method Example (contd.)
Using the information on page 27 and assuming the retail value of 20x2 ending inventory at current price is $42,960. The 20x2 price index is 120% (20x0 price index is 100%) and the cost ratio of 20x2 is 75%. In base-year’s dollars(20x0), the ending inventory of 20x2 is $42,960 120% = $35,800 Inventories: Additional Issues

37 Dollar-Value LIFO Retail Method Example (contd.)
Ending Inv. Layers Price Cost End. Inv at Base-Year at Base-Year Index Ratio at LIFO Retail Prices Retail Prices (%) (%) Cost $35,8001 L1 $20, $14,000 L2 2, ,616 L3 13, ,371 $27,987 1. Current cost of ending Inv. of 20x2: $42,9601.12 = $35,800 L1(layer 1) = 20x L2 = 20x L3 = 20x2 Inventories: Additional Issues

38 VI. Purchase Commitments
4/10/2017 VI. Purchase Commitments Purchase contract may be signed a few months (or years) before the actual delivery date (i.e., George Pacific) to secure the supply of inventory. Losses are recognized for any purchase commitments outstanding at the end of a period when market price is less than contract price (i.e., applying a LCM rule in the valuation of purchase commitments). Inventories: Additional Issues

39 Example 1- Contract Period within Fiscal Year
Geteway Co. signed a purchase commitment of $20,000 on 4/30/x5 to buy goods which would be delivered on 9/30/x5. 4/30/x5 No entry required. Disclosure of this firm commitment is required at the end of a reporting period if the amount is significant. Inventories: Additional Issues

40 Inventories: Additional Issues
Example 1 (contd.) Case 1: When the market price of these goods equal or greater than the contract price of $20,000 on 9/30/x5, the journal entry on 9/30/x5, the delivery date, would be: 9/30/x5 Purchases 20,000 Cash 20,000 Inventories: Additional Issues

41 Inventories: Additional Issues
Example 1 (contd.) Case 2: The market price is $18,000 on 9/30/x5. The journal entry would be: Purchases 18,000 Loss on Pur. Commitment 2,000 Cash 20,000 Inventories: Additional Issues

42 Inventories: Additional Issues
Purchase Commitments Example 2 - Contract Period Extends beyond Fiscal Year Geteway Co. signed a firm purchase commitment of $50,000 on 4/15/x5 for goods to be delivered on 10/2/x6. The market price of the contracted goods was $49,000 on 12/31/x5. The purchased commitment loss must be recognized in the year end when the loss first occurred (i.e., 12/31/x5). Inventories: Additional Issues

43 Inventories: Additional Issues
Example 2 (contd.) The following entry would be prepared on 12/31/x5 and disclosure is required when the amount is significant regardless whether a loss is expected or not: Estimated Loss on Purchase Commitments* 1,000 Estimated Liability on Purchase Commitments 1,000 * Reported in the income statement under “Other expenses and losses” Inventories: Additional Issues

44 Inventories: Additional Issues
Example 2 (contd.) At the delivery date (i.e., 10/2/x6): Case 1: The market price remained $1,000 below the contract price, the following journal entry would be prepared on 10/2/x6: Purchases 49,000 Estimated Lia. on Pur. Commit. 1,000 Cash 50,000 Inventories: Additional Issues

45 Inventories: Additional Issues
Example 2 (contd.) Case 2: The market price was $3,000 below the contract price on 10/2/x6: Purchases 47,000 Estimated Lia. on Pur. Commitments ,000 Loss on Pur. Commit. 2,000 Cash 50,000 Inventories: Additional Issues

46 Inventories: Additional Issues
4/10/2017 Example 2 (contd.) Case 3: the market was only $600 below the contract price 0n 10/2/x6: Purchases* ,000 Estimated Lia. on Pur. Commit. 1,000 Cash ,000 *$49,000 became the new cost for the purchase commitment on 12/31/x5 Inventories: Additional Issues

47 Hedging of Purchase Commitments with Future Sales Contracts
In order to offset the potential future loss on purchase commitments, a firm can enter a future sales contract at the same quantity of inventory purchased in a purchase commitment. Inventories: Additional Issues


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