1. Inventories: Additional Valuation Issues
Chapter 9
Intermediate Accounting
12th Edition
Kieso, Weygandt, and Warfield
Prepared by Coby Harmon, University of California, Santa Barbara

2. Learning Objectives
Describe and apply the lower-of-cost-or-market rule.
Explain when companies value inventories at net realizable value.
Explain when companies use the relative sales value method to value inventories.
Discuss accounting issues related to purchase commitments.
Determine ending inventory by applying the gross profit method.
Determine ending inventory by applying the retail inventory method.
Explain how to report and analyze inventory.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

3. Inventories: Additional Valuation Issues
Lower-of-Cost-or-Market
Valuation Bases
Gross Profit Method
Retail Inventory Method
Presentation and Analysis
Ceiling and floor
How LCM works
Application of LCM
“Market”
Evaluation of rule
Net realizable value
Relative sales value
Purchase commitments
Gross profit percentage
Evaluation of method
Concepts
Conventional method
Special items
Evaluation of method
Presentation
Analysis
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods

4. Lower-of-Cost-or-Market
LCM
A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.
Market = Replacement Cost
Lower of Cost or Replacement Cost
Loss should be recorded when loss occurs, not in the period of sale.
LO 1 Describe and apply the lower-of-cost-or-market rule.

5. Lower-of-Cost-or-Market
Ceiling and Floor
Why use Replacement Cost (RC) for Market?
Decline in the RC usually = decline in selling price.
RC allows a consistent rate of gross profit.
If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used:
Ceiling - net realizable value and
Floor - net realizable value less a normal profit margin.
LO 1 Describe and apply the lower-of-cost-or-market rule.

6. Lower-of-Cost-or-Market
Ceiling = NRV
What is the rationale for the Ceiling and Floor limitations?
Not
>
Illustration 9-3
Replacement
Cost
Cost
Market
Not
<
Floor =
NRV less Normal
Profit Margin
GAAP
LCM
LO 1 Describe and apply the lower-of-cost-or-market rule.

7. Lower-of-Cost-or-Market
Rationale for Limitations
Ceiling – prevents overstatement of the value of obsolete, damaged, or shopworn inventories.
Floor – deters understatement of inventory and overstatement of the loss in the current period.
LO 1 Describe and apply the lower-of-cost-or-market rule.

8. Lower-of-Cost-or-Market
How LCM Works (Individual Items)
Illustration 9-5
LO 1 Describe and apply the lower-of-cost-or-market rule.

9. Lower-of-Cost-or-Market
Methods of Applying LCM
Illustration 9-6
LO 1 Describe and apply the lower-of-cost-or-market rule.

10. Lower-of-Cost-or-Market
Recording LCM (data from Illus. 9-5 and 9-6)
Ending inventory (cost) $ 415,000
Ending inventory (LCM) 350,000
Adjustment to LCM $ 65,000
Allowance
Method
Loss on inventory 65,000
Allowance on inventory 65,000
Direct
Method
Cost of goods sold 65,000
Inventory 65,000
LO 1 Describe and apply the lower-of-cost-or-market rule.

11. Lower-of-Cost-or-Market
Balance Sheet Presentation
LO 1 Describe and apply the lower-of-cost-or-market rule.

12. Lower-of-Cost-or-Market
Income Statement Presentation
LO 1 Describe and apply the lower-of-cost-or-market rule.

13. Lower-of-Cost-or-Market
P9-1 Grant Wood Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2008, the following finished desks appear in the company’s inventory.
Instructions:
At what amount should the desks appear in the company’s December 31, 2008, inventory, assuming that the company has adopted a lower-of-cost-or-market approach for valuation of inventories on an individual-item basis?
LO 1 Describe and apply the lower-of-cost-or-market rule.

14. Lower-of-Cost-or-Market
Ceiling = 455
(500 – 45)
Not
>
Replacement
Cost = 460
Cost = 470
Market = 455
Not
<
Floor = 355
(455-(500 x 20%))
LCM = 455
LO 1 Describe and apply the lower-of-cost-or-market rule.

15. Lower-of-Cost-or-Market
Ceiling = 480
(540 – 60)
Not
>
Replacement
Cost = 440
Cost = 450
Market = 440
Not
<
Floor = 372
(480-(540 x 20%))
LCM = 440
LO 1 Describe and apply the lower-of-cost-or-market rule.

16. Lower-of-Cost-or-Market
Ceiling = 810
(900 – 90)
Not
>
Replacement
Cost = 610
Cost = 830
Market = 630
Not
<
Floor = 630
(810-(900 x 20%))
LCM = 630
LO 1 Describe and apply the lower-of-cost-or-market rule.

17. Lower-of-Cost-or-Market
Ceiling = 1,070
(1,200 – 130)
Not
>
Replacement
Cost = 1,000
Cost = 960
Market = 1,000
Not
<
Floor = 830
(1,070-(1,200 x 20%))
LCM = 960
LO 1 Describe and apply the lower-of-cost-or-market rule.

18. Lower-of-Cost-or-Market
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.
LO 1 Describe and apply the lower-of-cost-or-market rule.

19. Valuation Bases Net Realizable Value or
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
(3) too difficult to obtain cost figures (meatpacking)
LO 2 Explain when companies value inventories at net realizable value.

20. Valuation Bases Relative Sales Value
Used when buying varying units in a single lump-sum purchase.
E9-7 (Relative Sales Value Method) Phil Collins Realty Corporation purchased a tract of unimproved land for $55,000. This land was improved and subdivided into building lots at an additional cost of $34,460. These building lots were all of the same size but owing to differences in location were offered for sale at different prices as follows. Operating expenses allocated to this project total $18,200.
Instructions: Calculate the net income realized on this operation to date.
LO 3 Explain when companies use the relative sales value method to value inventories.

21. Valuation Bases E9-7 (Relative Sales Value Method - Solution) = = =x = x = x =
LO 3 Explain when companies use the relative sales value method to value inventories.

22. Valuation Bases 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 losses in the period during which such declines in market prices take place.
LO 4 Discuss accounting issues related to purchase commitments.

23. Gross Profit Method Substitute Measure to Approximate Inventory
Relies on Three Assumptions:
Beginning inventory plus purchases equal total goods to be accounted for.
Goods not sold must be on hand.
(3) The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.
LO 5 Determine ending inventory by applying the gross profit method.

24. Gross Profit Method
E9-12 (Gross Profit Method) Mark Price Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May.
Instructions:
(a) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of sales.
(b) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of cost.
LO 5 Determine ending inventory by applying the gross profit method.

25. Gross Profit Method E9-12 (Gross Profit Method - Solution)
(a) Compute the estimated inventory assuming gross profit is 30% of sales.
LO 5 Determine ending inventory by applying the gross profit method.

26. Gross Profit Method E9-12 (Gross Profit Method - Solution)
(b) Compute the estimated inventory assuming gross profit is 30% of cost.
30%
100% + 30%
= 23.08% of sales
LO 5 Determine ending inventory by applying the gross profit method.

27. Gross Profit Method Evaluation: Disadvantages:
Provides an estimate of ending inventory.
Uses past percentages in calculation.
A blanket gross profit rate may not be representative.
Only acceptable for interim (generally quarterly) reporting purposes.
LO 5 Determine ending inventory by applying the gross profit method.

28. 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:
the total cost and retail value of goods purchased,
the total cost and retail value of the goods available for sale, and
the sales for the period.
LO 6 Determine ending inventory by applying the retail inventory method.

29. Retail Inventory Method
P9-8 (Retail Inventory Method) Jared Jones Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2008.
Instructions:
Prepare a schedule computing estimate retail inventory using the following methods:
(1) Cost
(2) LCM
(3) LIFO (appendix)
LO 6 Determine ending inventory by applying the retail inventory method.

30. Retail Inventory - Cost Method/ =
LO 6 Determine ending inventory by applying the retail inventory method.

31. Retail Inventory - LCM Method/ =
LO 6 Determine ending inventory by applying the retail inventory method.

32. Retail Inventory - LIFO Method/ = / =
Appendix 9A
LO 8 Determine ending inventory by applying the LIFO retail inventory methods.

33. Retail Inventory Method
Evaluation:
Widely used for the following reasons:
to permit the computation of net income without a physical count of inventory,
as a control measure in determining inventory shortages,
in regulating quantities of merchandise on hand, and
for insurance information.
Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits.
LO 6 Determine ending inventory by applying the retail inventory method.

34. Presentation and Analysis
Accounting standards require disclosure of:
composition of the inventory,
financing arrangements, and
costing methods employed.
Analysis:
Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory.
LO 7 Explain how to report and analyze inventory.

35. Presentation and Analysis
Inventory Turnover Ratio
Measures the number of times on average a company sells the inventory during the period.
Illustration 9-26
LO 7 Explain how to report and analyze inventory.

36. Presentation and Analysis
Average Days to Sell Inventory
Measure represents the average number of days’ sales for which a company has inventory on hand.
Illustration 9-26
Inventory Turnover
Average Days to Sell
365 days / 8 times = every 45.6 days
LO 7 Explain how to report and analyze inventory.

37. Copyright
Copyright © 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.