1. 111 Intermediate Accounting, Ninth Edition Kieso and Weygandt Prepared by Catherine Katagiri, CPA The College of Saint Rose Albany, New York John Wiley & Sons, Inc.

2. Chapter 9: Additional Valuation Issues After studying this chapter you should be able to: Explain and apply the lower of cost or market rule. Identify when inventories are valued at net realizable value. Explain when the relative sales value method is used to value inventories. Explain 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 inventory is reported and analyzed.

3. 33 Departure from historical cost. Cost equals the cost to acquire; what you gave up in exchange, cash equivalent price. Market value is a designated market value. This is a replacement cost which is subject to constraints. »Ceiling is the maximum value which can be placed as market. It is the future sales price less costs to dispose (this is known as the NRV--the net realizable value). »Floor is the minimum value which can be placed as market. This is the NRV less the normal profit. Please see text example on pages 450-451. Lower of Cost or Market (LCM)

4. 44 Methods to apply LCM –If writedown item by item (results in the greatest writedown)--most common. Cost Market LCM Chairs $3,900 $8,000 $3,900 Tables 4,800 2,000 2,000 Desks 6,780 5,000 5,000 Total $15,480 $ 15,000 $ 10,900 –If writedown in the aggregate--LCM would be $15,000 Lower of Cost or Market (LCM)

5. 55 Methods to record writedown from cost to market: –Direct method »Adjust inventory itself at the end of the period, no loss explicitly recorded. Journal entries: (Periodic) Lower of Cost or Market (LCM) Inc Summary (or CGS)XX Inventory (beginning) at costXX Inventory (ending at market)XX Inc Summary (or CGS)XX

6. 66 Lower of Cost or Market (LCM) –Allowance method »First record the ending inventory at cost : Inc Summary (or CGS)XX Inventory (beginning) at costXX Inventory (ending at cost)XX Inc Summary (or CGS)XX

7. 7 Lower of Cost or Market (LCM) –and then record the writedown separately: (preferred method) Loss on inventoryXX Allowance to reduce to market value*XX *contra inventory account which contains the same informational benefits as A/R contra account.

8. 8 Lower of Cost or Market (LCM) Perpetual system--writedown entry only required –Writeups to the extent of prior writedowns possible. Problems with LCM –The treatment of losses and gains is not done in a similar manner. Losses are recorded but gains only to the extent of prior losses. –Three market values exist. Tends to be conceptually difficult. –Net Realizable Value (NRV) may not be easy to determine. –NRV less the profit presumes the sale.

9. 9 Other methods to value inventory : Lower of Cost or Market (LCM) NRV with a contracted market. Cost figures may be difficult to obtain so the value to be realizable may constitute the carrying value. Relative sales value (RSV).The question is how to assign costs to products that arise from a common resource (joint products). One way is a ratio of their future salability. Standard Costs. To value inventory according to what things should cost (variances recorded and responsibility assigned.) Ultimately differences closed back to inventory, CGS.

10. 10 Long-term purchase commitments: If the price you have contracted for is greater than the current market price you should recognize a provision for a loss on the contract. (The situation is other than temporary.) If the price you have contracted for is less than the current market price no gain is recorded until the good is sold. Gain incorporated in the gross profit figure. Long-term Purchase Commitments

11. 11 Inventory Estimation Methods The chapter then covers methods to estimate the ending inventory. Why would you wish to estimate an ending inventory? –To confirm expectations. –To estimate interim inventory under a periodic system. –To estimate insurance losses when no records exist. –Other reasons?

12. 12 Inventory Estimation Methods Gross profit method –Stresses % of gross profit based on sales or cost. »Strength of this method is that it is simple to estimate ending inventory. »Drawback is the need to maintain a constant gross profit percentage for all items over time. Example of gross profit method (based on gross profit as a % of sales): Sales of the period were $78,000. The normal gross profit % is 5% of sales. Purchases (at cost) of the period were $89,000. Beginning inventory was $3,600. What is the estimated level of the ending inventory?

13. 13 Follow the CGS calculation: Beginning Inventory (known) $3,600 + Purchases (known) 89,000 Goods Available (known) $92,600 Ending Inventory unknown Cost of Goods Sold unknown Inventory Estimation Methods You do know that 95% (1-GP%) is an estimate of the cost of sales (CGS). Sales $78,000 x.95 = CGS or $74,100. If you plug this figure in...

14. 14 Inventory Estimation Methods the ending inventory is estimated to be $18,500! Following the CGS calculation: Beginning Inventory (known) $3,600 + Purchases (known) 89,000 Goods Available (known) $92,600 Ending Inventory 18,500 (est.) Cost of Goods Sold $74,100 (est.)

15. 15 If a firm is unable to maintain a constant gross profit percentage (remember most firms are price- takers) a better method to estimate the ending inventory would be a form of the retail method. The retail method is more detailed and requires more record keeping than does the gross profit method. Inventory Estimation Methods The retail method will tolerate a varying gross profit percentage and changes in the price level.

16. 16 Inventory Estimation Methods Lets follow along with the information supplied by the text. Methods we will examine follow. Note: We will cover part of Appendix 9-A! –Simple retail (page 462, Illustration 9-17). »This method is used for stable prices, no markups or markdowns present and an average approach is taken. –Conventional retail (also known as Average LCM, page 463, Illustration 9-18). »This method adopts an average approach and assumes stable prices. It is called LCM because of the treatment of the markups (included) and markdowns (excluded) in the calculation of the cost-to-retail percentage.

17. 17 Inventory Estimation Methods –LIFO (non-LCM, page 470, Illustrations 9A-1, 2, 3). »This method is not an average approach. The difference between the beginning inventory and current purchases is maintained (not averaged). »After the ending inventory is initially estimated this method creates the LIFO layers and utilizes varying cost-to-retail percentages. The approach is non-LCM since the markups and markdowns are both included in the cost-to- retail percentage.

18. 18 Inventory Estimation Methods Dollar Value Retail LIFO (page 471-2, Illustrations 9A- 4 to 9). –Most complex method to estimate ending inventory. Please review the portion of Chapter 8 dealing with Dollar-value LIFO. –This method is not an average approach where the difference between the beginning inventory and current purchases is blurred (averaged). –The approach is non-LCM since the markups and markdowns are both included in the cost-to-retail percentage. –After the ending inventory is initially estimated this method creates the LIFO layers and utilizes varying cost-to-retail percentages. It also includes a concern for changing prices, applying the DV method to the estimated ending inventory.

19. 19 Special items in retail method. Please review for sensible treatment. –Freight is included in the cost to purchase. –Purchase returns and allowances are considered at the cost and the retail. Special Concerns –Purchases discounts are considered at cost only. –Sales returns and allowances are an adjustment to the gross sales figure. –Sales discounts are not recorded when gross method is used (would result in overvalued ending inventory).

20. 20 Special Concerns Special items in retail method. Please review for sensible treatment. –Breakages and theft should reduce goods available for sale. Abnormal shortages are deducted at both cost and retail so as not to distort the cost-to-retail percentage. –Employee discounts are deducted from the retail column as sales are. Please review financial statement presentation of inventories.