1. Intermediate Accounting
Prepared by
Coby Harmon
University of California, Santa Barbara

2. 9 Inventories: Additional Valuation Issues Intermediate Accounting
14th Edition
Kieso, Weygandt, and Warfield

3. Learning Objectives
Describe and apply the lower-of-cost-or-net realizable value 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.

4. 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”
Use of an allowance
Multiple periods
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

5. Lower-of-Cost-or-Market
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.

6. Lower-of-Cost-or-Market
Illustration 9-1
LO 1

7. 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.

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

9. Lower-of-Cost-or-Market
Illustration 9-3
What is the rationale for the Ceiling and Floor limitations?
Ceiling = NRV
Not
>
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.

10. Lower-of-Cost-or-Market
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.

11. 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.

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

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

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

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

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

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

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

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

20. 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.

21. Lower-of-Cost-or-Market
Use of an Allowance—Multiple Periods
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
LO 1 Describe and apply the lower-of-cost-or-market rule.

22. 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.

23. Valuation Bases Valuation at 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
too difficult to obtain cost figures (meatpacking).
LO 2 Explain when companies value inventories at net realizable value.

24. Valuation Bases Valuation Using Relative Sales Value
Used when buying varying units in a single lump-sum purchase.
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.

25. 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.

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

27. Valuation Bases
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—Income 3,000,000
Purchase Commitment Liability 3,000,000
Other income and expense in the Income statement.
Current liabilities on the statement of financial position.
LO 4 Discuss accounting issues related to purchase commitments.

28. Valuation Bases
Illustration: When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.
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—Income 1,000,000
LO 4 Discuss accounting issues related to purchase commitments.

29. Gross Profit Method of Estimating Inventory
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.
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.

30. 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
LO 5 Determine ending inventory by applying the gross profit method.

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

32. Gross Profit Method
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.
LO 5

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

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

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

36. 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:
Total cost and retail value of goods purchased.
Total cost and retail value of the goods available for sale.
Sales for the period.
Methods
Conventional Method
Cost Method
LIFO
Dollar-value LIFO
LO 6 Determine ending inventory by applying the retail inventory method.

37. Retail Inventory Method
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.
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.

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

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

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

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

42. Retail Inventory Method
Evaluation of Retail Inventory Method
Widely used for the following reasons:
To permit the computation of net income without a physical count of inventory.
Control measure in determining inventory shortages.
Regulating quantities of merchandise on hand.
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.

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

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

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

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

47. Presentation and Analysis
Analysis of Inventories
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.

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

49. 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
Average Days to Sell
365 days / 7.95 times = every 45.9 days
LO 7 Explain how to report and analyze inventory.

50. Primary reason to use LIFO
APPENDIX 9A
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:
stable prices and
fluctuating prices.
LO 8 Determine ending inventory by applying the LIFO retail methods.

51. Stable Prices—LIFO Retail Method
APPENDIX 9A
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.
LO 8 Determine ending inventory by applying the LIFO retail methods.

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

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

54. APPENDIX 9A
LIFO RETAIL METHODS
Illustration 9A-3
Ending Inventory at LIFO Cost, 2013—Stable Prices
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.
LO 8 Determine ending inventory by applying the LIFO retail methods.

55. Fluctuating Prices—Dollar-Value LIFO Retail
APPENDIX 9A
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.
LO 8 Determine ending inventory by applying the LIFO retail methods.

56. APPENDIX 9A
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 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
LO 8 Determine ending inventory by applying the LIFO retail methods.

57. Dollar-Value LIFO Retail Method—Fluctuating
APPENDIX 9A
LIFO RETAIL METHODS
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
LO 8

58. APPENDIX 9A
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.
LO 8 Determine ending inventory by applying the LIFO retail methods.

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

60. Subsequent Adjustments under Dollar-Value LIFO Retail
APPENDIX 9A
LIFO RETAIL METHODS
Subsequent Adjustments under Dollar-Value LIFO Retail
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
LO 8

61. Subsequent Adjustments under Dollar-Value LIFO Retail
APPENDIX 9A
LIFO RETAIL METHODS
Subsequent Adjustments under Dollar-Value LIFO Retail
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
LO 8 Determine ending inventory by applying the LIFO retail methods.

62. Changing from Conventional Retail to LIFO
APPENDIX 9A
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 The amounts shown by the firm’s books are as follows.
LO 8 Determine ending inventory by applying the LIFO retail methods.

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

64. APPENDIX 9A
LIFO RETAIL METHODS
Hakeman Clothing can then quickly approximate the ending inventory for 2012 under the LIFO retail method.
Illustration 9A-11
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.

65. RELEVANT FACTS
Goods in transit, consigned goods, special sales agreements—as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.
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.

66. RELEVANT FACTS
Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement.
IFRS requires both biological assets and agricultural produce at the point of harvest to be reported to net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards.

67. IFRS SELF-TEST QUESTION
All of the following are key similarities between GAAP and IFRS with respect to accounting for inventories except:
costs to include in inventories are similar.
LIFO cost flow assumption where appropriate is used by both sets of standards.
fair value valuation of inventories is prohibited by both sets of standards.
guidelines on ownership of goods are similar.

68. IFRS SELF-TEST QUESTION
All of the following are key differences between GAAP and IFRS with respect to accounting for inventories except the:
definition of the lower-of-cost-or-market test for inventory valuation differs between GAAP and IFRS.
average cost method is prohibited under IFRS.
inventory basis determination for write-downs differs between GAAP and IFRS.
guidelines are more principles based under IFRS than they are under GAAP.

69. Copyright
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