1 Inventories: Special Valuation Issues C hapter 8

2 1.Understand the lower of cost or market method. 2. Explain the conceptual issues regarding the lower of cost or market method. 3.Understand purchase obligations and product financing arrangements. 4.Explain the valuation of inventory above cost. 5.Use the gross profit method. Objectives

3 6.Understand the retail inventory method. 7.Explain the conceptual issues regarding the retail inventory method. 8.Understand the dollar-value LIFO retail method. 9.Understand the effects of inventory errors on the financial statements. Objectives

4 Lower of Cost or Market Selection of Market Value Ceiling (Net Realizable Value) Replacement Cost Floor (Net Realizable Value - Normal Profit) Comparison to Cost Use lower of (a) cost or (b) selected market value Reporting the Results

5 Lower of Cost or Market A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin40 A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin40

6 Lower of Cost or Market Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Normal profit(40) Floor$100 Normal Profit = $40 Case 1

7 Current Replacement Cost, $120 Lower of Cost or Market Cost $110 Market $120 Current Replacement Cost, $120 Normal Profit = $40 LCM is the cost of $110 Case 1 Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Normal profit(40) Floor$100

8 Lower of Cost or Market Cost $110 What is market? Current Replacement Cost, $150 LCM is the cost of $110 Case 2 $140 Current Replacement Cost, $120 Normal Profit = $40 Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Normal profit(40) Floor$100

9 Lower of Cost or Market Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Ceiling$140 Normal profit(20) Floor$120 Cost $110 What is market? Current Replacement Cost, $75 Normal Profit = $20 LCM is the cost of $110 Case 3 $120

10 Lower of Cost or Market Try one more.

11 Lower of Cost or Market Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Ceiling$140 Normal profit( 40) Floor$100 Cost $110 What is market? Current Replacement Cost, $105 Normal Profit = $40 LCM is the market of $105 Case 4 $105

12 Lower of Cost or Market Inventory Cost Market Category A: Item 1$1,000$ 700$ 700 Item 21,2001,3001,200 $2,200$2,000 Category B: Item 3$2,000$2,4002,000 Item 42,5002,2002,200 $4,500$4,600 Total$6,700$6,600 Inventory valuation$6,100 Individual Items Loss recognition, $600

13 Lower of Cost or Market Inventory Cost Market Category A: Item 1$1,000$ 700 Item 21,2001,300 $2,200$2,000$2,000 Category B: Item 3$2,000$2,400 Item 42,5002,200 $4,500$4,6004,500 Total$6,700$6,600 Inventory valuation$6,500 Category Loss recognition, $200

14 Lower of Cost or Market Inventory Cost Market Category A: Item 1$1,000$ 700 Item 21,2001,300 $2,200$2,000 Category B: Item 3$2,000$2,400 Item 42,5002,200 $4,500$4,600 Total$6,700$6,600$6,600 Inventory valuation$6,600 Total Loss recognition, $100

15 Lower of Cost or Market Recording the Reduction of Inventory to Cost Cost Market December 31, 2000$20,000$20,000 December 31, ,00022,000 December 31, ,00028,000 Cost Market December 31, 2000$20,000$20,000 December 31, ,00022,000 December 31, ,00028,000 Assume the company uses a periodic system.

16 Lower of Cost or Market Direct Method--December 31, 2001 To close beginning inventory: Income Summary20,000 Inventory20,000 To record ending inventory: Inventory22,000 Income Summary22,000

17 Lower of Cost or Market Direct Method--December 31, 2002 To close beginning inventory: Income Summary22,000 Inventory22,000 To record ending inventory: Inventory28,000 Income Summary28000

18 Lower of Cost or Market Allowance Method--December 31, 2001 To close beginning inventory: Income Summary20,000 Inventory20,000 To record ending inventory: Inventory25,000 Income Summary25,000 To record inventory at market: Loss Due to Market Valuation3,000 Allow. to Reduce Inventory to Market3,000

19 Lower of Cost or Market Allowance Method--December 31, 2002 To close beginning inventory: Income Summary25,000 Inventory25,000 To record ending inventory: Inventory30,000 Income Summary30,000 To record inventory at market: Allowance to Reduce Inventory to Market1,000 Loss Recovery Due to Market Valuation1,000

20 Purchasing Obligations and Product Arrangements A company entered into a noncancelable commitment to purchase inventory at a fixed price of $500,000 and the market price at the end of the year is $450,000.

21 Purchasing Obligations and Product Arrangements Year-end adjusting entry: Loss on Purchase Commitments50,000 Accrued Loss on Purchase Commitments50,000 When the goods are purchased: Inventory (or Purchases)450,000 Accrued Loss on Purchase Commitments50,000 Accounts Payable500,000

22 Valuation Above Cost Precious metals having a fixed monetary value with no substantial cost of marketing. Agricultural, mineral and other products, units of which are interchangeable, and have an immediate marketability at quoted price for which appropriate costs may be difficult to obtain. Precious metals having a fixed monetary value with no substantial cost of marketing. Agricultural, mineral and other products, units of which are interchangeable, and have an immediate marketability at quoted price for which appropriate costs may be difficult to obtain. In exceptional cases inventories properly may be stated above cost.

23 Gross Profit Method  To determine the cost of the inventory at the end of an interim period without taking a physical count.  For the internal or external auditor to check the reasonableness of an inventory value developed from a physical inventory or perpetual inventory system. ContinuedContinued A company uses the gross profit method in the following situations:

24 Gross Profit Method  To estimate the cost of inventory that is destroyed by a casualty.  To estimate the cost of inventory from incomplete records.  To develop a budget of cost of goods sold and ending inventory from a sales budget. A company uses the gross profit method in the following situations:

25 Gross Profit Method Step 1:The historical gross profit rate is calculated by dividing the gross profit of the prior period(s) by the net sales of the prior period(s). Assume 40%.

26 Gross Profit Method Step 2:The gross profit for the current period is estimated by multiplying the historical gross profit rate by the actual net sales for the period. Net sales$130,000 Gross profit rate.40 Estimated gross profit$ 52,000

27 Gross Profit Method Step 3:The estimated gross profit is subtracted from the actual net sales to determine the estimated cost of goods sold for the period. Net sales$130,000 Estimated gross profit (from Slide 26) (52,000) Estimated cost of goods sold$ 78,000

28 Gross Profit Method Step 4:Subtract the estimated cost of goods sold from the actual cost of goods available for sale. Beginning inventory$ 10,000 Net purchases 90,000 Cost of goods available for sale$100,000 Less: Estimated cost of goods sold (from Slide 27) (78,000) Estimated cost of ending inventory$ 22,000

29 Enhancing the Accuracy of the Gross Profit Method 1.A company should adjust the gross profit rate for known changes in the relationship between its gross profit and net sales. 2.A company may use a separate gross profit rate for each department or type of inventory that has a different markup percentage. 3.A company may use an average gross profit rate based on several past periods to average out period-to-period fluctuations.

30 Retail Inventory Method Step 1:The total goods available for sale is computed at both cost and retail value. Cost Retail Beginning inventory$ 10,000$ 17,000 Purchases50,000 83,000 Goods available for sale$ 60,000$100,000

31 Retail Inventory Method Step 2:A cost-to-retail ratio is computed. Cost-to-retail ratio: $ 60,000 $100,000 = 0.60 Cost Retail Beginning inventory$ 10,000$ 17,000 Purchases50,000 83,000 Goods available for sale$ 60,000$100,000 Step 2:A cost-to-retail ratio is computed.

32 Retail Inventory Method Step 2:A cost-to-retail ratio is computed. Cost Retail Beginning inventory$ 10,000$ 17,000 Purchases50,000 83,000 Goods available for sale$ 60,000$100,000 Step 3:The ending inventory at retail is computed.

33 Retail Inventory Method Cost Retail Beginning inventory$ 10,000$ 17,000 Purchases50,000 83,000 Goods available for sale$ 60,000$100,000 Less: Sales(80,000) Ending inventory at retail$ 20,000 Step 3:The ending inventory at retail is computed. Step 4:The ending inventory at cost is computed.

34 Retail Inventory Method Cost Retail Beginning inventory$ 10,000$ 17,000 Purchases50,000 83,000 Goods available for sale$ 60,000$100,000 Less: Sales(80,000) Ending inventory at retail$ 20,000 Ending inventory at cost (0.60 x $20,000)$12,000 Step 4:The ending inventory at cost is computed.

35 Retail Inventory Method Terminology Cost ($6) Markup Increased selling price to $11 Additional Markup Original selling price ($10)

36 Retail Inventory Method Terminology Cost ($6) Reduced selling price to $10.25 Net markup =Total additional markups - total markup cancellations Markup Cancella- tion

37 Retail Inventory Method Terminology Cost ($6) Reduced selling price to $9 Markup Cancella- tion Mark- down

38 Retail Inventory Method Terminology Cost ($6) Increased selling price to $9.60 Markdown Cancellation Net markdown =Total additional markdowns - total markdown cancellations

39 Retail Inventory Method--FIFO Cost Retail Purchases$40$ 80 Net markups5 Net markdowns(10) $40$ 75 $40 $75 = Beginning inventory20 35 Goods available for sale$60$110 Less sales (66) Ending inventory at retail$ 44 Ending inventory at FIFO cost (0.533 x $44) = $23.45

40 Retail Inventory Method-- Average Cost Cost Retail Beginning inventory$20$ 35 Purchases40 80 Net markups5 Net markdowns(10) Goods available for sale$60$110 $60 $110 = Ending inventory, average cost (0.545 x $44) = $23.98 Less sales (66) Ending inventory at retail$ 44

41 Purchases40 80 Net markups5 Net markdowns (10) 75 Goods available for sale$60$110 Less sales (66) Ending inventory at LIFO at retail$ 44 Retail Inventory Method--LIFO Cost Retail Beginning inventory$20$ 35 $20 $35 = 0.57 $35 x 0.57 (beginning inventory layer)$20.00 $ 9 x (added layer) 4.80 Ending inventory at LIFO cost$24.80 $35 x 0.57 (beginning inventory layer)$20.00 $ 9 x (added layer) 4.80 Ending inventory at LIFO cost$ = $40 $75 = 0.533

42 Retail Inventory Method--LCM Cost Retail Beginning inventory$20$ 35 Purchases40 80 Net markups 5 $60$120 Net markdowns(10) Goods available for sale$60$110 Less sales (66) Ending inventory at retail$ 44 Ending inventory at LCM (0.50 x $44) = $22 $60 $120 = 0.50

43 Conceptual Evaluation--LCM The lower of cost or market method is accurate only if either markups and markdowns do not exist at the time or if all the marked-down inventory has been sold. Under other conditions the lower of average cost or market produces an inventory value that is less than cost, but only approximates the lower of cost or market.

44 Dollar-Value LIFO Retail Method Calculate the ending inventory at retail. Retail Beginning inventory$12,000 Purchases32,000 Net markups3,000 Net markdowns (1,000)34,000 Goods available for sale$46,000 Sales(29,800) Ending inventory at retail$16,200

45 Dollar-Value LIFO Retail Method Compute ending inventory to base-year retail prices by applying the base-year conversion index. Ending Inventory at Base-Year Retail Prices = Ending Inventory at Retail x Current-Year Price Index Base-Year Price Index $15,000 = $16,200 x

46 Dollar-Value LIFO Retail Method The increase (decrease) in the inventory at retail is computed by comparing the ending inventory with the beginning inventory. Ending inventory at base-year retail price……………………. Beginning inventory, 1/1/ Increase $15,000 12,000 $ 3,000

47 Dollar-Value LIFO Retail Method The increase (decrease) in the inventory at retail is converted to current-year retail prices. Layer Increase at Current-Year Retail Prices = Increase at Base-Year Retail Prices x Current-Year Price Index Base-Year Price Index $3,240 = $3,000 x

48 Dollar-Value LIFO Retail Method The increase (decrease) at current-year retail prices is converted to cost. $3,240 x.60 = $1,944 The ending inventory at cost is computed by adding (subtracting) the increase (decrease) at cost to the beginning inventory at cost. $1,944 + $8,000 = $9,944 Beginning inventory at cost Cost of purchases was $20,400 in 2000 while purchases adjusted for net markups and net markdowns was $34,000 (Slide 44). $20,400 ÷ $34,000 = 60% Cost of purchases was $20,400 in 2000 while purchases adjusted for net markups and net markdowns was $34,000 (Slide 44). $20,400 ÷ $34,000 = 60%

49 Effects of Inventory Errors A purchase on credit is omitted from both the Purchases account and ending inventory and is not recorded in the succeeding year. Current Year Income Statement Income is correct. Balance Sheet Ending inventory and Accounts Payable are understated.

50 Effects of Inventory Errors A purchase on credit is omitted from both the Purchases account and ending inventory and is not recorded in the succeeding year. Succeeding Year Income Statement Income is overstated and cost of goods sold is understated. Balance Sheet Accounts Payable is understated and Retained Earnings is overstated.

51 Effects of Inventory Errors A purchase on credit is omitted from the Purchases account but ending inventory is correct. Current Year Income Statement Income is overstated and cost of goods sold is understated. Balance Sheet Accounts Payable is understated and Retained Earnings is overstated.

52 Effects of Inventory Errors A purchase on credit is omitted from the Purchases account but ending inventory is correct. Succeeding Year Income Statement No effect. Balance Sheet Accounts Payable is understated and Retained Earnings is overstated.

53 Effects of Inventory Errors Ending inventory is over(under)stated due to quantity and/or costing errors, but the Purchases account is correct. Current Year Income Statement Income is over(under)stated and cost of goods sold is under(over)stated. Balance Sheet Ending inventory and Retained Earnings are over(under)stated.

54 Effects of Inventory Errors Succeeding Year Income Statement Income is under(over)stated and cost of goods sold is over(under)stated. Balance Sheet No effect. Ending inventory is over(under)stated due to quantity and/or costing errors, but the Purchases account is correct.

55 C hapter 8