Chapter 9 Inventories: Special Valuation Issues COPYRIGHT © 2010 South-Western/Cengage Learning Intermediate Accounting 11th edition

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

Lower of Cost or Market 3 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

Lower of Cost or Market 4

5 Lower of Cost or Market (Ex. 9-1 p. 426) A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin 40 A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin 40

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

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

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

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

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

11 Lower of Cost or Market Selling price$115 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$90 Cost = $110 Current Replacement Cost = $105 LCM is the market of $90 Case 5 Market = $90 Ceiling$90 Normal profit (10) Floor$80 Normal Profit = $10

12 Lower of Cost or Market Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Cost = $110 Current Replacement Cost = $80 LCM is the market of $100 Case 6 Market = $100 Ceiling$140 Normal profit (40) Floor$100 Normal Profit=$40

13 Lower of Cost or Market The reduction of the value of the inventory to market and the recognition of a loss are appropriate for both a company’s balance sheet and income statement. GAAP defines assets as “probable future economic benefits.” When the cost of the inventory exceeds the expected benefits, the lower market value is a better measure of the expected benefits. In other words, an unrecoverable cost is not an asset. A company should recognize the decline in value of the inventory as a reduction in the income of the period in which the loss occurs. 13

14 Estimating Inventory Two commonly used methods of estimating inventory costs are (1) the gross profit method and (2) the retail inventory method. 14

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. 15

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

Expressing Gross Profit Percentages 17 Gross Profit as a % of Cost Gross Profit as a Cost + Gross Profit as a % of Cost % of Sales = 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.

18 Retail Inventory Method 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 19 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

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

21 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

22 Retail Inventory Method Step 4:The ending inventory at cost is computed × $20,000 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

Retail Inventory Method Terminology 23 Cost ($6) Markup Increased selling price to $12 Additional Markup Original selling price ($10)

24 Retail Inventory Method Terminology Cost ($6) Reduced selling price to $10.25 Total Additional Markups – Total Markup Cancellations = Net Markup Markup Cancellation

25 Retail Inventory Method Terminology Cost ($6) Reduced selling price to $9 Markup Cancellation Markdown

26 Retail Inventory Method Terminology Cost ($6) Increased selling price to $9.60 Markdown Cancellation Total Additional Markdowns – Total Markdown Cancellations = Net Markdown

Retail Inventory Method 27 For methods using cost, such as average cost, FIFO and LIFO, the net markdowns are included in calculating the cost-to-retail ratio.

28 Retail Inventory Method — FIFO FIFO The FIFO method excludes the beginning inventory in determining the cost-to-retail ratio.

Retail Inventory Method — FIFO 29 Cost Retail Purchases$40$ 80 Net markups5 Net markdowns (10) $40$ 75 Ending inventory at FIFO cost (0.533 × $44) = $23.45 Beginning inventory Goods available for sale$60$110 Less: Sales (66) Ending inventory at retail$ 44 $40 $75 = 0.533

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

Retail Inventory Method — Average Cost 31 Beginning inventory$20$ 35 Purchases4080 Net markups5 Net markdowns (10) Goods available for sale$60$110 Less: Sales (66) Ending inventory at retail$ 44 Cost Retail $60 $110 = Ending inventory at average cost (0.545 × $44) = $24

32 Retail Inventory Method — LIFO LIFO Separate cost-to-retail ratios for the beginning inventory and the purchases must be calculated for the LIFO method.

Retail Inventory Method — LIFO 33 Purchases4080 Net markups5 Net markdowns (10) 75 Goods available for sale$60$110 Less: Sales (66) Ending inventory at retail$ 44 Cost Retail Beginning inventory$20$ 35 $20 $35 = 0.57 $35 × 0.57 (beginning inventory layer)$20.00 $ 9 × (added layer) 4.80 Ending inventory at LIFO cost$24.80 $40 $75 = 0.533

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

Net markdowns (10) Goods available for sale$60$110 Less sales (66) Ending inventory at retail$ 44 Retail Inventory Method — Lower of Average Cost or Market 35 Beginning inventory$20$ 35 Purchases4080 Net markups 5 $60$120 $60 $120 = 0.50 Cost Retail Ending inventory at lower of cost or market (0.50 × $44) = $22

Conceptual Evaluation — Lower of Average Cost or Market 36 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 items 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.

Dollar-Value LIFO Retail Method 37 Information for following slides

Dollar-Value LIFO Retail Method 38 Cost Retail Beginning inventory$ 8,000$ 12,000 Purchases20,40032,000 Net markups3,000 Net markdowns (1,000) Goods available for sale$28,400$ 46,000 Sales (29,800) Ending inventory at retail$ 16,200 Step 1:Calculate the ending inventory at retail.

39 Dollar-Value LIFO Retail Method Ending Inventory at Base-Year Retail Prices = Ending Inventory at Retail × Current-Year Price Index Base-Year Price Index $15,000=$16,200× Step 2:Compute ending inventory to base-year retail prices by applying the base-year conversion index.

40 Dollar-Value LIFO Retail Method Ending inventory at base-year retail price…… Beginning inventory, 1/1/2010 Increase $15,000 12,000 $ 3,000 Step 3:The increase (decrease) in the inventory at retail is computed by comparing the ending inventory with the beginning inventory.

41 Dollar-Value LIFO Retail Method Step 4: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 × Current-Year Price Index Base-Year Price Index $3,240=$3,000×

42 Dollar-Value LIFO Retail Method $3,240 × 0.60 = $1,944 Step 5:The increase (decrease) at current-year retail prices is converted to cost. Cost of purchases was $20,400 in 2010 while purchases adjusted for net markups and net markdowns was $34,000 (32,000 + $3,000 – $1,000) $20,400 ÷ $34,000 = 60% Cost of purchases was $20,400 in 2010 while purchases adjusted for net markups and net markdowns was $34,000 (32,000 + $3,000 – $1,000) $20,400 ÷ $34,000 = 60%

Dollar-Value LIFO Retail Method Step 6: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, Beginning Inventory at Cost