Intermediate Financial Accounting I Inventories: Additional Valuation Issues
Inventories: Additional Issues2 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 Issues3 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 Issues4 I. Estimating Inventory: Gross Profit Method and Retail Inventory Method n Reasons: For some companies, inventory information is needed between accounting periods. Companies cannot afford to do physical inventory count every quarter. n 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 Issues5 Estimating Inventory: Gross Profit Method and Retail Inventory Method (contd.) n No physical count of inventory is needed for either method. The value of inventory is based on estimation. n Neither method is acceptable for annual financial reporting purposes.
Inventories: Additional Issues6 Estimating Inventory: Gross Profit Method and Retail Inventory Method (contd.) n Both methods are acceptable for interim reporting. n The insurance adjusters may use the gross profit method to estimate the loss of inventory in case of fire or flood.
Inventories: Additional Issues7 II. The Gross Profit Method Data Required: u Beginning Inventory (at cost) u Purchase (net) (at Cost) u Sales Price u Gross Margin Ratio (Gross Margin/Sales Price)
Inventories: Additional Issues8 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 Issues9 Example A (contd.) n 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 Sale260,000 Sales280,000 Less: gross margin 1 (84,000) Sales (at cost) 196,000 2 Estimated Inv. (at cost) 64,000 1. gross margin = 280,000x30% 2. also equals 280,000x(1-30%) = 196,000
Inventories: Additional Issues10 Gross Profit Method Example B n 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% u Deriving CGS using sales and gross profit ratio based on sales: $100 x (1 - 20%) = $80 u Deriving CGS using sales and gross profit ratio based on CGS: $100 (1+25%) = $80
Inventories: Additional Issues11 Example B (contd.) Sales = CGS + Gross Profit = CGS + 25% x CGS = CGS x (1+25%) CGS = Sales (1+25%)
Inventories: Additional Issues12 Comments on Gross Profit Method n If the relationship between the gross profit and selling price has been changed, the ratio should be adjusted accordingly. n A separate gross profit ratio should be applied to different inventory.
Inventories: Additional Issues13 III. Retail Inventory Method n Terminology related to retail inventory method: Retail Price Original retail price$110 Additional markup$5115 Markup Cancellations5110 Markdowns5105 Markdown Cancellations5110 u Net Markups= Additional Markups - Markup Cancellations u Net Markdowns= Markdowns - Markdown Cancellations
Inventories: Additional Issues14 Retail Inventory Method (contd.) Data required to apply retail method: u Beg. Inv. (both cost and retail price) u Purchases (net) (cost and retail) u Sales (subtracting sales returns only) u Price adjustment data such as additional markups, markup cancellations, markdowns and markdown cancellations
Inventories: Additional Issues16 Retail Inventory Method Example (with price adjustments) Cost Retail Beg. Inv.$14,000$20,000 Purchases (net)63,000 90,000 Goods Avail.77,000110,000 Additional Markups5,000 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 Issues17 Retail Inventory Method Example (with price adjustments) Cost Retail Beg. Inv.$14,000$20,000 Purchases (net)63,000 90,000 Goods Avail.77,000110,000 Net Markups 1,000 Goods Avail. after net MU111,000 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 Issues18 Cost Ratios for Retail Method 1)Average Method (consider all price adjust.) u Cost Ratio = 77,000 109,700 = 70.19%. u Esti. End. Inv. at cost = $24,700 x 70.19% = $17,336.93 2)LCM approach (conventional retail method) (consider only net markups) u Cost Ratio = 77,000 111,000 = 69.37%. 24,700 x 69.37% = 17,134.39
Inventories: Additional Issues19 Cost Ratios for Retail Method (contd.) 3)FIFO approximation (excluding the beg. inv. in the computation of cost ratio) u Cost Ratio = (77,000-14,000) (109,700-20,000) =70.23%. u Esti. Inv. at cost = $24,700 x 70.23%=17,346.81
Inventories: Additional Issues20 Cost Ratios for Retail Method (contd.) 4)LIFO approximation (computing two ratios, one for the beg. inv. and one for others) u Cost Ratio 1(for beg.inv.) =14,000/20,000=70% u Cost Ratio 2(for other inv.) = (77,000-14,000) (109,700-20,000)=70.23% u Esti. End. Inv. at cost = 1) 20,000 x 70%= 14,000 2) 4,700 a x 70.23%= 3,301 17,301 a. 24,700-20,000=4,700
Inventories: Additional Issues21 Comments for Retail Method A. CostRetail Purchases$$$$$$$$ Pur. Discounts$$$$------ 1 Pur. R & A$$$$$$$$ Freight-In$$$$------ 1 1. Pur. Discounts and freight-in are already considered in the retail price of purchases.
Inventories: Additional Issues22 Comments for Retail Method (contd.) B. Sales in the retail column should be gross sales - sales returns. This is because the retail prices for beg. inv. and purchases are based on gross sales, not net sales. Also, if employee discounts have been subtracted from sales, they should be added back to sales.
Inventories: Additional Issues23 Comments for Retail Method (contd.) C. Spoilage Cost Retail Normal Spoilage 1 ------$$$$ Abnormal Spoilage 2 $$$$$$$$ 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 Issues24 Retail Inventory Method – Special Items Included Cost Retail Beg. Inv. $14,000 $20,000 Purchases (net) 63,000 90,000 Abnormal Spoilage (1,400) (2,000) Goods Avail. 75,600 108,000 Net Markups 1,000 Goods Avail. after net MU109,000 Net Markdowns (1,300) Goods Avail. after all price adj. 107,700 Sales 85,000 Sales returns (2,000) (83,000) Employee Discounts (2,000) Normal Spoilage(1,000) End. Inv. at Retail $21,700
Retail Inventory Method –Special Items Included(contd.) 1)Average Method (consider all price adjust.) u Cost Ratio = 75,600 107,700 = 70.19%. u Esti. End. Inv. at cost = $21,700 x 70.19% = $15,232.23 2)LCM approach (conventional retail method) (consider only net markups) u Cost Ratio = 75,600 10,900 = 69.36%. 21,700 x 69.36% = $15,051.12 5Inventories: Additional Issues25
Another Example of Conventional Retail Inventory Method – Special Items Included (Illustration 9-3, KWW, 14 th e) Inventories: Additional Issues26
Inventories: Additional Issues27 IV. Comparison of Gross Profit Method and Retail Inventory Method Gross-Profit MethodRetail Inventory Method 1. Data required: cost of beg. inv., purchases, sales and gross profit ratio. 2. Any company can use this method to estimate ending inventory. 1.Data required: Cost and retail price of beg. inv., purchases, sales price and price adjustments. 2.Only retail store can apply this method to estimate inventory.
Inventories: Additional Issues28 Comparison of Gross Profit Method and Retail Inventory Method (contd.) Gross-Profit MethodRetail Inventory Method 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 Issues29 Comparison of Gross Profit Method and The Retail Method (contd.) Gross-Profit MethodRetail Inventory Method 4. Not acceptable for the annual financial reporting but acceptable for the interim report. 5. No physical count of inventory is needed. 4.Not acceptable for the annual financial reporting but acceptable for the interim report. 5.No physical count of inventory is needed.
Inventories: Additional Issues30 V. Dollar-Value LIFO Retail Method n Applying retail method to estimate cost of ending inventory and also considering price index when prices are fluctuating.
Inventories: Additional Issues31 Dollar-Value LIFO Retail Method Example Cost Retail Beg. Inv. -20x1$14,000$20,000 Purchases (net)63,000 90,000 Goods Avail.77,000110,000 Net Markups1,000 Goods Avail. after net MU111,000 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 Issues32 Dollar-Value LIFO Retail Method Example (contd.) n 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 Issues33 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 Issues35 Dollar-Value LIFO Retail Method Example (contd.) n 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 Issues36 Dollar-Value LIFO Retail Method Example (contd.) n 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 Issues38 VI. Purchase Commitments n 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. n 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 Issues39 Example 1- Contract Period within Fiscal Year n Geteway Co. signed a purchase commitment of $20,000 on 4/30/x5 to buy goods which would be delivered on 9/30/x5. n 4/30/x5 No entry required. n Disclosure of this firm commitment is required at the end of a reporting period if the amount is significant.
Inventories: Additional Issues40 Example 1 (contd.) u 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 Purchases20,000 Cash20,000
Inventories: Additional Issues41 Example 1 (contd.) u Case 2: The market price is $18,000 on 9/30/x5. The journal entry would be: Purchases18,000 Loss on Pur. Commitment2,000 Cash20,000
Inventories: Additional Issues42 Purchase Commitments Example 2 - Contract Period Extends beyond Fiscal Year n 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 Issues43 Example 2 (contd.) u 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 Commitments1,000 * Reported in the income statement under “Other expenses and losses”
Inventories: Additional Issues44 Example 2 (contd.) At the delivery date (i.e., 10/2/x6): u Case 1: The market price remained $1,000 below the contract price, the following journal entry would be prepared on 10/2/x6: Purchases49,000 Estimated Lia. on Pur. Commit.1,000 Cash50,000
Inventories: Additional Issues45 Example 2 (contd.) u Case 2: The market price was $3,000 below the contract price on 10/2/x6: Purchases47,000 Estimated Lia. on Pur. Commitments 1,000 Loss on Pur. Commit.2,000 Cash50,000
Inventories: Additional Issues46 Example 2 (contd.) u Case 3: the market was only $600 below the contract price 0n 10/2/x6: Purchases* 49,000 Estimated Lia. on Pur. Commit. 1,000 Cash 50,000 *$49,000 became the new cost for the purchase commitment on 12/31/x5
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 Issues47