Intermediate Accounting December 1st, 2010 General Course Questions & Final Group Project, due Thursday Review Quiz #4 Chapter 18 & 8: A. Chapter 18 - Long-term Construction Contracts (Questions 7, 9, 10, 11 , & 12 BE 2, 3, 4, Ex 5, Prob 1, 3 & 6 add’l practice ex 7 & Pr 4) B. Chapter 8 - Inventory Pricing Methods (?12,13,16 BE 5,6,7, P 6) 3. Finish Chapter 9: Inventory – Additional Valuation Issues A. Lower of Cost or Market (LCM) (Brief ex 2, ?2,3,7, Ex 5 Prob 1 & 3) B. Relative Sales Value (Question 8, Brief Ex 4 & 7) C. Estimating Inventory – using Gross profit (?11, Brief Ex 7 Prob 4) Retail Inventory Method (?14, BE 8) D. Purchase Commitments & Disclosures (Brief Ex 5 & 6, ?17, Ex 10) Follow-up Questions to prep Final: Ch 7, 18 and 8 (Cash, Receivables, Revenue Recognition and Dollar Value LIFO, in addition to last quiz) Self, Peer and Course Evaluations

Inventory: Lower of Cost or Market (LCM) GAAP requires inventory to be stated at the lower of cost or market, abandoning the historical cost principle when the future utility (revenue producing ability) of the asset drops below it original cost. Market = Replacement Cost (the cost to replace by purchase or reproduction, not sales price) Thus, LCM is Lower of Cost or Replacement Cost and determined using “Designated Market” Loss should be recorded when loss occurs, not in the period of sale Restate asset at “designated” market to replace cost.

Determining Designated Market for use in assessing LCM Why use Replacement Cost (RC) for Market? Decline in the RC usually results in a decline in selling price. RC allows a consistent rate of gross profit. A reduction in RC may fail to indicate a reduction in utility, thus two additional valuation limitations are used to determine the Designated Market which is then compared to Cost to determine if a LCM write-down is needed. The Designated Market is the middle of the three: Replacement Cost (cost to replace or reproduce) Ceiling - net realizable value (NRV= selling price less disposal cost) and Floor - net realizable value less a normal profit margin.

Finding the Designated Market to Determine Lower of Cost or Market Item Historical Replacement Ceiling Floor Final Cost Cost (NRV) (NRV – profit) Inventory $ A $80,000 $88,000 $120,000 $104,000 $ B $90,000 $88,000 $100,000 $70,000 $ C $90,000 $88,000 $100,000 $90,000 $ D $90,000 $88,000 $87,000 $70,000 $

Rational for Designated Market Ceiling and Floor Limitations Ceiling = NRV 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. Not > Replacement Cost Cost Market Not < Floor = NRV less Normal Profit Margin GAAP LCM

Lower of Cost or Market - Individual Items Illustration 9-5

Lower of Cost or Market - Individual Items Illustration 9-5 $415,000

Recording Decline in Market Value (LCM) Individual Items Ending inventory (cost) $ 415,000 Ending inventory (LCM) 350,000 Adjustment to LCM $ 65,000 Allowance Method Loss on inventory 65,000 Allowance to reduce inventory to market (contra inventory account) 65,000 Direct Method Cost of goods sold 65,000 Inventory 65,000

Lower of Cost or Market – Balance Sheet

Lower of Cost or Market – Income Statement

Lower of Cost or Market Application The lower of cost or market may be applied: Either directly to each item * most conservative approach * generally required for tax purposes To each category, or To the total of the inventory Whichever method is selected, it should be consistently applied.

Lower of Cost or Market - Individual Items, Major Categories or Total Inventory

Lower of Cost or Market - Individual Items, Major Categories or Total Inventory

LCM Example Also Homework today: Brief Ex 2 Assume in each case that the selling expenses are $8 per unit and that the normal profit is $5 per unit. Calculate the limits for each case (ceiling and floor). Then enter the amount that should be used for the lower of cost or market. Designated Market -chose the middle one Selling Price Ceiling (NRV) Replace-ment $ Floor (NRV less profit) Cost Lower of   cost/mkt a $ 54 $ 38 43 b $ 47 $ 36 40 c $ 56 $ 39 d $ 42 1. Compute the Designated Market Ceiling for each item which is its Net Realizable Value (NRV) (NRV = Selling price less costs to complete sale). 2. Compute the Designated Market Floor for each item which is its NRV less any normal profit. 3. Identify each item's Designated Market, which is the middle dollar amount, by circling it. 4. Compare cost to designated market and use Lower of Cost or Designated market. Also Homework today: Brief Ex 2

Evaluation of LCM Rule Some Deficiencies: Expense are recorded when the loss in utility occurs. Profit on sale only recognized at the point of sale. Inventory may be valued at cost in one year and at market the next year. Net income in the 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.

Recording the Decline in Market Value What if the Market Value Recovers? Recording the Decline in Market Value For subsequent increases in inventory value: US GAAP prohibits the reversal of writedowns IFRS requires the reversal of writedowns

Other Valuation Issues Valuation at Net Realizable Value Permitted by GAAP under the following conditions: there is a controlled market with a quoted price for all quantities, and there are no significant costs of disposal (rare metals and agricultural products) or (3) it is too difficult to obtain cost figures (meatpacking) Relative Sales Value – “Basket Purchase” Purchase Commitments

Valuation Basis: Relative Sales Values Appropriate basis when basket purchases are made. Basket purchases involve a group of varying units. The purchase price is paid as a lump sum amount. The lump sum price is allocated to units on the basis of their relative sales values. Quickest approach – determine the percentage total cost to total revenue and use it to allocate cost or gross profit Also Homework today: question 8 and Brief Ex 4

Relative Sales Values: Example Kirby Company buys three different lots (A, B and C) in a basket purchase, paying $297,500 for all three. The lots were sold as follows: Sales Price Cost Gross Profit A $75,000 _______ _________ B $150,000 _______ _________ C $200,000 _______ _________ Total $425,000 _______ _________ What is the cost of A, B and C and the gross profit for each lot? (Suggestion: determine the percentage total cost to total revenue and use it to allocate cost and/or gross profit)

Relative Sales Values: Example Kirby Company buys three different lots (A, B and C) in a basket purchase, paying $297,500 for all three. The lots were sold as follows: % Cost to Sales = $297.5k/$425K = 70% Sales Price Cost Gross Profit A $75,000 x 70% $ 52,500 $22,500 B $150,000 x 70% $105,000 $45,000 C $200,000 x 70% $140,000 $60,000 Total $425,000 $ 297,500 $127,500 What is the cost of A, B and C and the gross profit for each lot?

Relative Sales Values: Example 2 Crawford Furniture Company purchased a carload of wicker chairs. The manufacturer sold the chairs to Crawford for a lump sum of $60,000, because they want to discontinue these items. The three types of chairs and their estimated selling prices are listed below. Given the 2011 sales below, determine how much gross profit Crawford should recognize in 2011 and what amount they should report as unsold chair inventory. Estimated Unit Sales in 2011 2011 Gross Profit Realized Inventory December 31, 2011 # of Chairs Unit Sales Price Total Selling Price Lounge Chairs 400 90 $ 36,000   200 Arm Chairs 300 80 $ 24,000 100 Straight Chairs 800 50 $ 40,000 120 220 $ 100,000 (Suggestion: determine the percentage total cost to total revenue and use it to allocate cost and gross profit)

Relative Sales Values: Example 2 Crawford Furniture Company purchased a carload of wicker chairs. The manufacturer sold the chairs to Crawford for a lump sum of $60,000, because they want to discontinue these items. The three types of chairs and their estimated selling prices are listed below. Given the 2011 sales below, determine how much gross profit Crawford should recognize in 2011 and what amount they should report as unsold chair inventory. Estimated Unit Sales in 2011 2011 Gross Profit Realized Inventory December 31, 2011 # of Chairs Unit Sales Price Total Selling Price Lounge Chairs 400 90 $ 36,000 60% 200 $ 7,200   $ 10,800 Arm Chairs 300 80 $ 24,000 100 $ 3,200 $ 9,600 Straight Chairs 800 50 $ 40,000 120 $ 2,400 $ 20,400 220 $ 100,000 $ 12,800 $ 40,800

Purchase Commitments Cancellable contracts No entry or disclosure required Formal, non-cancelable contracts Seller retains title, buyer recognizes no asset but should disclose contract details in footnote If execution of the contract is expected to result in a loss, buyer must record the loss in the period the market prices decreased: DR Unrealized Holding Loss CR Est liability on purchase commitment Homework today: Brief Ex 5 & 6

Inventory Estimation Techniques Inventory estimation used when: a fire or other catastrophe destroys either inventory or inventory records taking a physical inventory is impractical auditors only need an estimate of the company’s inventory Gross Profit Method Retail Sales Method

Estimate Inventory Using Gross Profit Calculate Cost of Goods Available for Sale (CGA) Estimate Cost of Goods Sold (CGS) using Sales and estimate of Gross Profit Deduct Estimate of CGS from CGA to get Estimate of Ending Inventory

Estimate Inventory Using Gross Profit Whitsunday Company’s warehouse burned and its inventory was completely destroyed. The accounting records were kept in the office building and escaped harm. The following information was available: Net sales $426,000 Beginning inventory 80,000 Net purchases 300,000 Average gross profit on sales 20% Use the above information to estimate the ending inventory lost in the fire using the gross profit method. Calculate Cost of Goods Available for Sale (CGA) Estimate Cost of Goods Sold (CGS) using Sales and estimate of Gross Profit Deduct Estimate of CGS from CGA to get Estimate of Ending Inventory

Estimate Inventory Using Gross Profit Whitsunday Company’s warehouse burned and its inventory was completely destroyed. The accounting records were kept in the office building and escaped harm. The following information was available: Net sales $426,000 Beginning inventory 80,000 Net purchases 300,000 Average gross profit on sales 20% Use the above information to estimate the ending inventory lost in the fire using the gross profit method. Calculate Cost of Goods Available for Sale (CGA) $380,000 Estimate Cost of Goods Sold (CGS) using Sales and estimate of Gross Profit: (CGS 80% if Gross Profit is 20%) Sales x CGS % = CGS: $426,000 x 80% = $340,800 3. Deduct Estimate of CGS from CGA to get Estimate of Ending Inventory $380,000 – 340,800 = $39,200

Gross Profit Method to Determine EI Beginning inventory $80,000 Net purchases 300,000 Cost of goods available for sale 380,000 Estimated cost of goods sold: Net sales 426,000 Less: Est gross profit (85,200) (340,800) Estimated ending inventory $39,200

Example 2: Estimate Inventory Using Gross Profit On December 31, 2010 Carr Company's inventory burned. Sales and purchases for the year had been $1,400,000 and $980,000, respectively. The beginning inventory (Jan. 1, 2010) was $170,000; in the past Carr's gross profit has averaged 40% of selling price. Compute the estimated cost of inventory burned. 1. 2. 3.

Example 2: Estimate Inventory Using Gross Profit On December 31, 2010 Carr Company's inventory burned. Sales and purchases for the year had been $1,400,000 and $980,000, respectively. The beginning inventory (Jan. 1, 2010) was $170,000; in the past Carr's gross profit has averaged 40% of selling price. Compute the estimated cost of inventory burned. Calculate Cost of Goods Available for Sale (CGA) $1,150,000 Estimate Cost of Goods Sold (CGS) using Sales and estimate of Gross Profit: (CGS 60% if Gross Profit is 40%) Sales x CGS % = CGS: $1,400,000 x 60% = $840,000 3. Deduct Estimate of CGS from CGA to get Estimate of Ending Inventory $1,150,000 – 840,000 = $310,000

Gross Profit Method Example 2 On December 31, 2010 Carr Company's inventory burned. Sales and purchases for the year had been $1,400,000 and $980,000, respectively. The beginning inventory (Jan. 1, 2010) was $170,000; in the past Carr's gross profit has averaged 40% of selling price. Compute the estimated cost of inventory burned. BI + Net Purchases = COGA Estimated COGS: Net Sales less estimated gross profit Estimated Ending inventory

Retail Inventory Method This inventory estimation technique is used when: a fire or other catastrophe destroys either inventory or inventory records taking a physical inventory is impractical auditors only need an estimate of the company’s inventory Appropriate for retail concerns with: high volume sales and different types of merchandise Assumes an observable pattern between cost and prices.

Retail Inventory Method Steps: Determine ending inventory at retail price Convert this amount to a cost basis using a cost-to-retail ratio BI (at retail) + Net Purchases (at retail) – Net sales = EI (at retail) EI (at retail) X Cost-to-Retail ratio = estimated “EI” (at cost)

Retail Inventory Method: Example Given for the year 2002: at cost at retail Beginning inventory $2,000 $3,000 Purchases (Net) $10,000 $15,000 Sales (Net) $12,000 What is ending inventory, at retail and at cost?

Retail Inventory Method: Example at cost at retail Beginning inventory $ 2,000 $ 3,000 Purchases (Net) $10,000 $15,000 Goods available for sale $12,000 $18,000 less: Sales (Net) ($12,000) Ending inventory (at retail) $6,000 Times: cost to retail ratio x Ending inventory at cost COGS

Intermediate Accounting November 30th, 2010 General Course Questions & Final Group Project, due Thursday Questions before final 30 minute Quiz: A. Chapter 18 - Long-term Construction Contracts (Questions 7, 9, 10, 11 , & 12 BE 2, 3, 4, Ex 5, Prob 1, 3 & 6 add’l practice ex 7 & Pr 4) B. Chapter 8 - Inventory Pricing Methods (?12,13,16 BE 5,6,7, P 6) Chapter 8 Dollar Value LIFO (homework: ?14, 17-20, BE 9, Ex 26, Prob 11 & Case 9) Chapter 9: Inventory – Additional Valuation Issues A. Lower of Cost or Market (LCM) (Brief ex 2) B. Relative Sales Value (Question 8, Brief Ex 4) C. Estimating Inventory – using Gross profit (question 11, Brief Ex 7) D. Purchase Commitments (Brief Ex 5 & 6) 6. Extra Credit Session - Columbia Sportswear Annual Report Project