Inventories: Special Valuation Issues 9 hapter Inventories: Special Valuation Issues Intermediate Accounting 10th edition Nikolai Bazley Jones An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Lower of Cost or Market The lower of cost or market rule requires that a company write down its inventory to market value when the inventory’s utility has declined.

Definitions Inventory: estimated selling price in completed condition $1,150 Less: estimated costs to complete and sell 150 Net realizable value-ceiling $1,000 Less: normal profit 100 NRV less normal profit-floor $900 Continue

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 Balance sheet: Inventory at LCM Income statement: Loss (if recognized)

A company’s unit of inventory has the following characteristics: Lower of Cost or Market A company’s unit of inventory has the following characteristics: Selling price $165 Packaging cost 10 Transportation cost 15 Profit margin 40

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

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

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

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

Lower of Cost or Market Try one more.

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

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

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

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

Lower of Cost or Market Recording the Reduction of Inventory to Cost Cost Market December 31, 2006 $20,000 $20,000 December 31, 2007 25,000 22,000 December 31, 2008 30,000 28,000 Assume the company uses a periodic system.

See Example 9-1 on page 416.

Purchase Obligations To lock in prices and assure sufficient quantities of materials, companies often contract with suppliers to purchase a specified quantity of materials in the future at an agreed upon unit cost. See page 424.

See page 343

In exceptional cases inventories properly may be stated above cost. Valuation Above Cost In exceptional cases inventories properly may be stated 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.

Gross Profit Method A company uses the gross profit method in the following situations: 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. Continued

Gross Profit Method A company uses the gross profit method in the following situations: 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.

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%.

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

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 32) (52,000 ) Estimated cost of goods sold $ 78,000

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 Net sales $130,000 Estimated gross profit (52,000) (78,000) Estimated cost of ending inventory $ 22,000

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

Expressing Gross Profit Percentages Divide gross profit by sales to calculate profit as a percentage of sales. Gross Profit = Gross Profit as a Sales Percentage of Sales

Expressing Gross Profit Percentages If the gross margin percentage is expressed as a percentage of cost it must be converted to a gross margin as a percentage of sales Gross Profit as a % of Cost = Gross Profit as a Cost + Gross Profit as a % of Cost % of Sales

Another method of estimating inventory is the retail inventory method, which is widely used because it is allowed under GAAP and for income tax purposes.

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 Purchases 50,000 83,000 Goods available for sale $ 60,000 $100,000

Retail Inventory Method Step 2: A cost-to-retail ratio is computed. Step 2: A cost-to-retail ratio is computed. Cost Retail Beginning inventory $ 10,000 $ 17,000 Purchases 50,000 83,000 Goods available for sale $ 60,000 $100,000 Cost-to-retail ratio: $ 60,000 $100,000 = 0.60

Retail Inventory Method Step 2: A cost-to-retail ratio is computed. Step 3: The ending inventory at retail is computed. Cost Retail Beginning inventory $ 10,000 $ 17,000 Purchases 50,000 83,000 Goods available for sale $60,000 $100,000 Less: Sales (80,000) Ending inventory at retail $ 20,000

Retail Inventory Method Step 4: The ending inventory at cost is computed. Cost Retail Cost Retail Beginning inventory $ 10,000 $ 17,000 Purchases 50,000 83,000 Goods available for sale $60,000 $100,000 Less: Sales (80,000) Ending inventory at retail $ 20,000 Ending inventory at cost $12,000 0.60 x $20,000

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

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

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

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

Retail Inventory Method For methods using cost, such as average cost, FIFO and LIFO, the net markdowns are included in calculating the ratio.

Retail Inventory Method--Average Cost The average cost method includes the beginning inventory in determining the cost-to-retail ratio. Average Cost

Retail Inventory Method--Average Cost Cost Retail Beginning inventory $20 $ 35 Purchases 40 80 Net markups 5 Net markdowns (10) Goods available for sale $60 $110 Less sales (66) Ending inventory at retail $ 44 $60 $110 = 0.545 Ending inventory, average cost (0.545 x $44) = $23.98

Retail Inventory Method-LCM The lower of cost or market method includes the beginning inventory, but excludes any net markdowns in determining the cost-to-retail ratio. Lower of Cost or Market

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.

Retail Inventory Method--LCM Cost Retail Beginning inventory $20 $ 35 Purchases 40 80 Net markups 5 $60 $120 $60 $120 = 0.50 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

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.

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.

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.

Effect 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.

Effect 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.

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

C 9 hapter The End Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.