1. 1 Inventories : Additional Issues Instructor Adnan Shoaib PART II: Corporate Accounting Concepts and Issues Lecture 11

2. 2 1. 1.Describe and apply the lower-of-cost-or-net realizable value rule. 2. 2.Explain when companies value inventories at net realizable value. 3. 3.Explain when companies use the relative sales value method to value inventories. 4. 4.Discuss accounting issues related to purchase commitments. 5. 5.Determine ending inventory by applying the gross profit method. 6. 6.Determine ending inventory by applying the retail inventory method. 7. 7.Explain how to report and analyze inventory. Learning Objectives

3. 3 Net realizable value Relative sales value Purchase commitments 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” Use of an allowance Multiple periods Evaluation of rule Gross profit percentage Evaluation of method Concepts Conventional method Special items Evaluation of method Presentation Analysis Inventories: Additional Valuation Issues

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

5. 5 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Illustration 9-1

6. 6  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. Why use Replacement Cost (RC) for Market? Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Ceiling and Floor

7. 7 Net realizable value (NRV) is the is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal (often referred to as net selling price). Illustration 9-2 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule.

8. 8 Not< Cost Market Ceiling = NRV Replacement Cost Replacement Cost Floor = NRV less Normal Profit Margin Floor = NRV less Normal Profit Margin GAAP LCM GAAP LCM What is the rationale for the Ceiling and Floor limitations? Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Not> Illustration 9-3

9. 9 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. Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Limitations

10. 10 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. How LCM Works (Individual Items) Illustration 9-5

11. 11 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Methods of Applying LCM Illustration 9-6

12. 12 LO 1 Describe and apply the lower-of-cost-or-market rule. Lower-of-Cost-or-MarketLower-of-Cost-or-Market Ending inventory (cost) $ 82,000 Ending inventory (market)70,000 Adjustment to LCM $ 12,000 Allowance to reduce inventory 12,000 Loss due to decline in inventory12,000 Inventory 12,000 Cost of goods sold12,000 Loss Method COGS Method COGS Method Recording “Market” Instead of Cost

13. 13 LO 1 Describe and apply the lower-of-cost-or-market rule. Lower-of-Cost-or-MarketLower-of-Cost-or-Market Balance Sheet Presentation

14. 14 LO 1 Lower-of-Cost-or-MarketLower-of-Cost-or-Market Income Statement Presentation

15. 15 P9-1: Remmers Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2012, the following finished desks appear in the company’s inventory. The 2012 catalog was in effect through November 2012, and the 2013 catalog is effective as of December 1, 2012. Instructions: At what amount should each of the four desks appear in the company’s December 31, 2012, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of inventories on an individual-item basis? Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule.

16. 16 Not< Cost = 470 Market = 450 Ceiling = 450 (500 – 50) Ceiling = 450 (500 – 50) Replacement Cost = 460 Replacement Cost = 460 Floor = 350 (450-(500 x 20%)) Floor = 350 (450-(500 x 20%)) LCM = 450 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Not>

17. 17 Not< Cost = 450 Market = 430 Ceiling = 480 (540 – 60) Ceiling = 480 (540 – 60) Replacement Cost = 430 Replacement Cost = 430 Floor = 372 (480-(540 x 20%)) Floor = 372 (480-(540 x 20%)) LCM = 430 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Not>

18. 18 Not< Cost = 830 Market = 640 Ceiling = 820 (900 – 80) Ceiling = 820 (900 – 80) Replacement Cost = 610 Replacement Cost = 610 Floor = 640 (820-(900 x 20%)) Floor = 640 (820-(900 x 20%)) LCM = 640 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Not>

19. 19 Not< Cost = 960 Market = 1,000 Ceiling = 1,070 (1,200 – 130) Ceiling = 1,070 (1,200 – 130) Replacement Cost = 1,000 Replacement Cost = 1,000 Floor = 830 (1,070-(1,200 x 20%)) Floor = 830 (1,070-(1,200 x 20%)) LCM = 960 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Not>

20. 20 LO 1 Describe and apply the lower-of-cost-or-market rule. Use of an Allowance—Multiple Periods Lower-of-Cost-or-MarketLower-of-Cost-or-Market In general, accountants leave the allowance account on the books. They merely adjust the balance at the next year-end to agree with the discrepancy between cost and the lower-of- cost-or-market at that balance sheet date. Illustration 9-10

21. 21  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. Some Deficiencies: Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 1 Describe and apply the lower-of-cost-or-market rule. Evaluation of LCM Rule

22. 22 (1)a controlled market with a quoted price applicable to all quantities, and (2)no significant costs of disposal (rare metals and agricultural products) or (3)too difficult to obtain cost figures (meatpacking). Permitted by GAAP under the following conditions: Valuation Bases Valuation at Net Realizable Value LO 2 Explain when companies value inventories at net realizable value.

23. 23 Used when buying varying units in a single lump-sum purchase. Valuation Bases Valuation Using Relative Sales Value E9-7: Larsen 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 $30,000. 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.

24. 24 Valuation Bases E9-7 (Relative Sales Value Method): x=x = = x LO 3 Explain when companies use the relative sales value method to value inventories.

25. 25 ► 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. Valuation Bases LO 4 Discuss accounting issues related to purchase commitments. Purchase Commitments—A Special Problem

26. 26 Valuation Bases LO 4 Discuss accounting issues related to purchase commitments. Illustration: St. Regis Paper Co. signed timber-cutting contracts to be executed in 2013 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2012, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2012. Unrealized Holding Gain or Loss—Income3,000,000 Purchase Commitment Liability3,000,000 Other income and expense in the Income statement. Current liabilities on the statement of financial position.

27. 27 Valuation Bases LO 4 Discuss accounting issues related to purchase commitments. Purchases (Inventory) 7,000,000 Purchase Commitment Liability 3,000,000 Cash 10,000,000 Assume the government permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000. Purchase Commitment Liability 1,000,000 Unrealized Holding Gain or Loss—Income1,000,000 Illustration: When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.

28. 28 Relies on Three Assumptions: Gross Profit Method of Estimating Inventory LO 5 Determine ending inventory by applying the gross profit method. Substitute Measure to Approximate Inventory (1)Beginning inventory plus purchases equal total goods to be accounted for. (2)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.

29. 29 Gross Profit Method LO 5 Determine ending inventory by applying the gross profit method. Illustration: Cetus Corp. has a beginning inventory of $60,000 and purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross profit on selling price is 30 percent. Cetus applies the gross margin method as follows. Illustration 9-14

30. 30 Gross Profit Method LO 5 Determine ending inventory by applying the gross profit method. Computation of Gross Profit Percentage Illustration 9-17

31. 31 E9-12: Astaire 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 25% of sales. (b) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of cost. Gross Profit Method LO 5

32. 32 E9-12 (Solution): (a) Compute the estimated inventory assuming gross profit is 25% of sales. Gross Profit Method LO 5 Determine ending inventory by applying the gross profit method.

33. 33 (b) Compute the estimated inventory assuming gross profit is 25% of cost. E9-12 (Solution): Gross Profit Method LO 5 Determine ending inventory by applying the gross profit method. 25% 100% + 25% = 20% of sales

34. 34 Disadvantages: Gross Profit Method LO 5 Determine ending inventory by applying the gross profit method. (1)Provides an estimate of ending inventory. (2)Uses past percentages in calculation. (3)A blanket gross profit rate may not be representative. (4)Normally unacceptable for financial reporting purposes. GAAP requires a physical inventory as additional verification. Evaluation of Gross Profit Method

35. 35 Retail Inventory Method LO 6 Determine ending inventory by applying the retail inventory method. A method used by retailers, to value inventory without a physical count, by converting retail prices to cost. (1)Total cost and retail value of goods purchased. (2)Total cost and retail value of the goods available for sale. (3)Sales for the period. Requires retailers to keep: Methods  Conventional Method  Cost Method  LIFO  Dollar-value LIFO

36. 36 P9-8: Fuque 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 2013. Retail Inventory Method Instructions: Prepare a schedule computing estimate retail inventory using the following methods: (1) Conventional (2) Cost LO 6 Determine ending inventory by applying the retail inventory method.

37. 37 Retail Inventory Method LO 6 Determine ending inventory by applying the retail inventory method. = /

38. 38 Retail Inventory Method LO 6 Determine ending inventory by applying the retail inventory method. = /

39. 39 Retail Inventory Method LO 6 Determine ending inventory by applying the retail inventory method.  Freight costs  Purchase returns  Purchase discounts and allowances  Transfers-in  Normal spoilage  Abnormal shortages  Employee discounts Special Items Relating to Retail Method

40. 40 Special Items Retail Inventory Method LO 6 Illustration 9-23

41. 41 Widely used for the following reasons: (1)To permit the computation of net income without a physical count of inventory. (2)Control measure in determining inventory shortages. (3)Regulating quantities of merchandise on hand. (4)Insurance information. Retail Inventory Method LO 6 Determine ending inventory by applying the retail inventory method. Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits. Evaluation of Retail Inventory Method

42. 42 Accounting standards require disclosure of: Presentation and Analysis LO 7 Explain how to report and analyze inventory. Presentation of Inventories (1)Composition of the inventory, inventory financing arrangements, and the inventory costing methods employed. (2)Consistent application of costing methods from one period to another. (3)Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes.

43. 43 Accounting standards require disclosure of: Presentation and Analysis LO 7 Explain how to report and analyze inventory. Presentation of Inventories (4)Significant or unusual financing arrangements relating to inventories. (5)Companies should present inventories pledged as collateral for a loan in the current assets section rather than as an offset to the liability. (6)Basis on which it states inventory amounts (lower of-cost-or- market) and the method used in determining cost (LIFO, FIFO, average cost, etc.).

44. 44 Presentation and Analysis LO 7 Explain how to report and analyze inventory. Presentation of Inventories Illustration 9-24 Disclosure of Inventory Methods

45. 45 Presentation and Analysis LO 7 Illustration 9-25 Disclosure of Trade Practice in Valuing Inventories Presentation of Inventories

46. 46 Presentation and Analysis LO 7 Explain how to report and analyze inventory. Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory. Analysis of Inventories

47. 47 Measures the number of times on average a company sells the inventory during the period. Presentation and Analysis LO 7 Explain how to report and analyze inventory. Inventory Turnover Ratio Illustration 9-26 Illustration: In its 2009 annual report Kellogg Company reported a beginning inventory of $897 million, an ending inventory of $910 million, and cost of goods sold of $7,184 million for the year.

48. 48 Measure represents the average number of days’ sales for which a company has inventory on hand. Presentation and Analysis LO 7 Explain how to report and analyze inventory. Average Days to Sell Inventory 365 days / 7.95 times = every 45.9 days Average Days to Sell Illustration 9-26

49. 49 LO 8 Determine ending inventory by applying the LIFO retail methods. Primary reason to use LIFO  Tax advantages.  Results in a better matching of costs and revenues.  The use of LIFO retail is made under two assumptions: 1.stable prices and 2.fluctuating prices. LIFO RETAIL METHODS

50. 50 LO 8 Determine ending inventory by applying the LIFO retail methods. Stable Prices—LIFO Retail Method A major assumption of the LIFO retail method is that the markups and markdowns apply only to the goods purchased during the current period and not to the beginning inventory. Beginning inventory is excluded from the cost-to-retail percentage. LIFO RETAIL METHODS

51. 51 LO 8 Determine ending inventory by applying the LIFO retail methods. Illustration 9A-1 LIFO Retail Method—Stable Prices LIFO RETAIL METHODS

52. 52 LO 8 Determine ending inventory by applying the LIFO retail methods. Illustration 9A-2 Ending Inventory at LIFO Cost, 2012—Stable Prices Inventory is composed of two layers. LIFO RETAIL METHODS

53. 53 LO 8 Determine ending inventory by applying the LIFO retail methods. Illustration 9A-3 Ending Inventory at LIFO Cost, 2013—Stable Prices LIFO RETAIL METHODS Assume that the ending inventory for 2013 at retail is $50,000. Notice that the 2012 layer is reduced from $11,000 to $5,000.

54. 54 LO 8 Determine ending inventory by applying the LIFO retail methods. Fluctuating Prices—Dollar-Value LIFO Retail If the price level does change, the company must eliminate the price change so as to measure the real increase in inventory, not the dollar increase. LIFO RETAIL METHODS

55. 55 LO 8 Determine ending inventory by applying the LIFO retail methods. Illustration: Assume that the beginning inventory had a retail market value of $10,000 and the ending inventory had a retail market value of $15,000. Assume further that the price level has risen from 100 to 125. It is inappropriate to suggest that a real increase in inventory of $5,000 has occurred. Instead, the company must deflate the ending inventory at retail. Illustration 9A-4 LIFO RETAIL METHODS

56. 56 Illustration: Assume that the current 2010 price index is 112 (prior year 100) and that the inventory ($56,000) has remained unchanged. Illustration 9A-5 Dollar-Value LIFO Retail Method— Fluctuating Prices LIFO RETAIL METHODS LO 8

57. 57 LO 8 Determine ending inventory by applying the LIFO retail methods. Illustration: From this information, we compute the inventory amount at cost: Illustration 9A-6 Hernandez must restate layers of a particular year to the prices in effect in the year when the layer was added. LIFO RETAIL METHODS

58. 58 LO 8 Determine ending inventory by applying the LIFO retail methods. Illustration 9A-7 Comparison of Effect of Price Assumptions LIFO RETAIL METHODS

59. 59 LO 8 Illustration: Using the data from the previous example, assume that the retail value of the 2013 ending inventory at current prices is $64,800, the 2013 price index is 120 percent of base-year, and the cost-to-retail percentage is 75 percent. Compute the ending inventory at LIFO cost. Illustration 9A-8 Subsequent Adjustments under Dollar-Value LIFO Retail LIFO RETAIL METHODS

60. 60 Illustration: Conversely assume that in 2011 the ending inventory in base-year prices is $48,000. Compute the ending inventory at LIFO cost. Illustration 9A-9 Subsequent Adjustments under Dollar-Value LIFO Retail LIFO RETAIL METHODS LO 8 Determine ending inventory by applying the LIFO retail methods.

61. 61 LO 8 Determine ending inventory by applying the LIFO retail methods. Changing from Conventional Retail to LIFO Illustration: Hackman Clothing Store employs the conventional retail method but wishes to change to the LIFO retail method beginning in 2013. The amounts shown by the firm’s books are as follows. LIFO RETAIL METHODS

62. 62 Conventional Retail Inventory Method Illustration 9A-10 LIFO RETAIL METHODS LO 8

63. 63 Illustration 9A-11 Hakeman Clothing can then quickly approximate the ending inventory for 2012 under the LIFO retail method. The difference of $500 ($11,250 - $10,750) between the LIFO retail method and the conventional retail method is the amount by which the company must adjust beginning inventory for 2013. LO 8 Determine ending inventory by applying the LIFO retail methods. LIFO RETAIL METHODS

64. 64 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 In July 2011, the Lassiter Company. signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2011. 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, 2012. 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. Let’s make the journal entries for these commitments. In In July 2011, the Lassiter Company. signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2011. 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, 2012. 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. Let’s make the journal entries for these commitments.

65. 65 Purchase Commitments Single- period commitment November 14, 2011 Inventory (market price)425,000 Loss on purchase commitment 75,000 Accounts payable 500,000 December 15, 2011 Accounts payable500,000 Cash 500,000 Multi-period commitmen t December 31, 2011 Estimated loss on commitment 60,000 Estimated liability on commitment 60,000 February 15, 2012 Inventory (market price)510,000 Loss on purchase commitment 30,000 Estimated liability on commitment 60,000 Cash 600,000

66. 66 RELEVANT FACTS  GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.  In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.

67. 67 End of Lecture 11