Prepared by: Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 9 Inventories: Additional Valuation Issues

Learning Objectives 1.Recognize that the lower of cost and market (LCM) basis is a departure from the historical cost principle, and understand why this is appropriate. 2.Explain various definitions of possible market amounts that may be used when applying lower of cost and market. 3.Explain how LCM works and how it is applied.

Learning Objectives 4.Know how to account for inventory on the LCM basis. 5.Identify when inventories are carried regularly at net realizable value. 6.Explain when the relative sales value method is used to value inventories. 7.Explain accounting issues related to purchase commitments.

Learning Objectives 8.Estimate ending inventory by applying the gross profit method. 9.Explain the limitations of the gross profit method. 10.Estimate ending inventory by applying the retail inventory method. 11.Explain how inventory is reported and analysed.

Inventories: Additional Valuation Issues Lower of Cost and Market What is ‘market’? How LCM works Application of LCM Recording market Evaluation of rule Estimation: Gross Profit Method Gross profit percentage Evaluation of method Other Valuation Issues Net realizable value Relative sales value Purchase commitments Estimation: Retail Inventory Method Terminology Conventional method Special items Evaluation of method Presentation and Analysis Presentation of inventories Analysis of inventories

Part 1: Valuation of Inventories at Lower of Cost or Market

The lower of cost or market (LCM) is an exception to the historical cost principle When the future potential of the asset is less than its original cost: –Re-state asset at cost to replace (market) The loss is charged against revenues of the period

Lower of Cost or Market LCM is justified for two reasons: –Current assets reported at a value approximately equal to the amount of cash they can be converted to –Matching principle: loss of utility reported in the period the loss occurred LCM falls in line with conservatism

What Is Market? CICA Handbook, Section 3030 reflects the desire to provide a more specific description of ‘market’ Use of the terms: –Replacement cost –Net realizable value (NRV) –Net realizable value less a normal profit margin Net realizable value most commonly used –All three are acceptable methods –Method adopted must be disclosed

What Is Market? Replacement: Amount required to obtain an equivalent item NRV: Estimated selling price in the ordinary course of business less costs to complete and dispose of the item NRV less a normal profit margin: NRV (as defined above) less normal profit margin

Possible Market Values ItemReplacementNRV NRV Cost Less Profit Spinach $88,000$120,000$104,000 Carrots 90, ,000 70,000 Cut Beans 45,000 40,000 27,500 Peas 36,000 72,000 48,000 Mixed Veg. 105,000 92,000 80,000 The company first decides which definition of market it will apply to LCM

Final Inventory Value Using NRV ItemHistorical CostNRV LCM Spinach $80,000$120,000 $ 80,000 Carrots 100, , ,000 Cut Beans 50,000 40,000 40,000 Peas 90,000 72,000 72,000 Mixed Veg. 95,000 92,000 92,000 If NRV is chosen and applied on an item-by-item basis, then: Final Inventory Value $384,000

Lower of Cost or Market The lower of cost or market may be applied on a(n): 1.item-by-item basis (as in the example) 2.category basis 3.total inventory basis Whichever method is selected, it should be consistently applied

Alternative Applications of NRV CostNRVItem-by- Item CategoryTotal Inventory Frozen: Spinach $ 80,000 $120,000 $ 80,000 Carrots100,000100,000100,000 Cut beans50,00040,00040,000 Total frozen$230,000$260,000$230,000 Canned: Peas$ 90,000 $ 72,000 Mixed95,00092,00092,000 Total canned$185,000$164,000$164,000 Total$415,000$424,000$415,000 Reported Inventory $384,000$394,000$415,000

Recording Market vs. Cost Under the Direct Method: Ending inventory is recorded at market No loss reported on Income Statement Under the Indirect (Allowance) Method: Inventory reported at cost with a contra account for the LCM write-down Declines and recoveries are recorded through an Allowance (Valuation) account on the Balance Sheet; and Loss Account on Income Statement Recovery of Market value decline is recorded only up to but not exceeding historical cost

Recording the Decline in Market: Example YearInventoryInventory Valuation End at Costat Market Adjustment 2000$65,000$65,000 $ $82,000$70,000 $ 12,000 Under the Allowance Method: Dr.Loss Due to Market Value Decline12,000 Cr. Allowance to Reduce Inventory 12,000

Recording the Decline in Market: Example Date Dec. 31 st CostMarketAllowance Account Balance Adjustment to Allowance Account Effect on Net Income 2001$188,000$176,000$12,000 cr. Loss ,000187,0007,000 cr.5,000 dr.Gain ,000174,00007,000 dr.Gain ,000180,0002,000 cr. Loss Post the required adjustments.

Recording the Decline in Market: Example Inventory – Year End Loss Due to Market Allowance Account 182, , , ,000 12,000 5,000 7,000 2,000 Reported Inventory Value 2001 =$176,000 (188,000 – 12,000) 2002 = $187,000 (194,000 – 7,000) 2003 = $173,000 (173,000 – 0) 2004 = $180,000 (182,000 – 2,000) 12,000 5,000 7,000 2,000 7, ,000 12,000

Part 2: Valuation Basis

Valuation Basis: Relative Sales Values Relative sales values are an 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

Relative Sales Values: Example Intell Company buys three different lots (A, B and C) in a basket purchase, paying $300,000 The lots were then sold as follows: A $ 75,000 B $150,000 C $200,000 for a total of $425,000 Determine the allocated cost to A, B and C and the gross profit for each lot

Relative Sales Values: Example LotSales Value Allocated CostGross Profit A$75,000($75,000/$425,000) X $300,000 = $ 52,941 $ 22,059 B$150,000 ($75,000/$425,000) X $300,000 = $105,882 $ 44,118 C$200,000 ($75,000/$425,000) X $300,000 = $ 141,176 $ 58,824

Purchase Commitments Where a company commits to purchasing inventory, but title has not passed to the buyer If the agreement is subject to cancellation, it is not recorded by buyer or seller Noncancellable purchase contracts are not recorded, but if material, are disclosed in the notes to the financial statements If the contracted price is greater than market price AND the loss can be reasonably estimated, such loss shall be recorded

Part 3: Estimating Ending Inventory – The Gross Profit Method

Gross Profit Method The gross profit method is used to estimate ending inventory This method is used also when an estimate is needed due to a fire loss The method is based on the assumptions that: 1. beginning inventory + net purchases = goods available for sale 2. goods available - sales (at cost) = ending inventory

Gross Profit Method: Example Given: Beginning inventory (at cost):$ 60,000 Net Purchases (at cost) :$ 200,000 Sales (net) :$ 280,000 Gross Profit percentage on sales 30% Estimate the ending inventory using the Gross Profit Method.

Gross Profit Method: Example Beg. Inventory + Net Purchases - COGS= Estimated Ending Inventory $60,000 + $200,000 - ($280,000X0.7) = Ending Inventory $60,000 + $200,000 - ($196,000)= $64,000 Cost of goods sold = Sales X ( )

Understanding Markups Cost of goods sold = Sales X (100/135) = $7,408 Gross Profit= Sales X (35/135) = $2,592 Cost + Gross Profit = Sales ==> 100% + 35% = 135%. Cost of goods sold = Sales X ( )= $6,500 Gross Profit= Sales X (0.35)= $3,500 Given: Gross Profit is 35% of sales. Sales are $10, Given: Gross Profit is 35% of cost. Sales are $10, These calculations are summarized as formulae on Illustration 9-18 of your text.

Limitations of Gross Profit Method Provides only an estimate; physical inventory count still required Uses past information (gross profit percentage) to determine a current inventory value –A current gross profit percentage more relevant A ‘blanket’ gross profit percentage may be applied –Different product lines may have materially different gross profit percentages, which are better suited Not accepted for year-end financial reporting, appropriate for interim reporting (with disclosure)

Part 4: Retail Inventory Method

Is appropriate for retail concerns: with high volume sales with different types of merchandise The method assumes an observable pattern between cost and prices The steps are: 1 determine ending inventory at retail prices 2 convert this amount to a cost basis

Retail Inventory Method: Example Given for the year 2000: At cost At retail Beginning inventory $ 2,000 $ 3,000 Purchases (Net) $10,000 $15,000 Sales (Net) $12,000 Determine 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 2/3 Ending inventory at cost $ 4,000

Markups, Markdowns and Cancellations Given: At costAt retail Goods available $20,500$36,000 Markups$ 3,000 Markup cancellations$ 1,000 Markdowns$ 2,500 Markdown cancellations$ 2,000 Compute the cost-to-retail ratio.

Markups, Markdowns and Cancellations At costAt retail Goods available $20,500$36,000 Add: Markups$ 3,000 Less: Markup cancellations$ 1,000 Goods available (adj.)$20,500$ 38,000 Cost-to-retail ratio ($20,500/ $38,000) = 53.9% Ignore markdowns and markdown cancellations.

Retail Inventory Method 1.Allows for income calculation without a physical inventory count 2.May aid in determining inventory shortages 3.Aid in controlling inventory quantities on hand 4.Interim source of information for specific purposes

Inventory Analysis Inventory Turnover Ratio: Indicates how many times in a year inventory is ‘turning over’ or sold during the year A low number may indicate high stock quantities –Indicative of high cash level invested in inventory –Balance this with customer and sales needs A higher number indicates frequent turnover and therefore lower investment of cash Inventory Turnover = COGS  Average Inventory

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