1. Inventories: Additional Issues
Chapter 9
Chapter 9: Inventories: Additional Issues
We covered most of the principal measurement and reporting issues involving the asset inventory and the corresponding expense cost of goods sold in the previous chapter. In this chapter we complete our discussion of inventory measurement by explaining the lower-of-cost-or-market rule used to value inventories. In addition, we investigate inventory estimation techniques, methods of simplifying LIFO, changes in inventory method, and inventory errors.

2. Reporting —Lower of Cost or Market
Inventories are valued at the lower of cost or market (LCM).
LCM is a departure from historical cost. The method causes losses to be recognized in the period the value of inventory declines below its cost rather than in the period that the goods ultimately are sold.
Inventories are to be valued on the balance sheet at lower of cost or market (LCM). Initially, inventory items are recorded at their historical costs, but a departure from cost is warranted when the utility of an asset (the probable future economic benefits) is no longer as great as its cost. Deterioration, obsolescence, changes in price levels, or any situation that might compromise the inventory’s salability impairs the utility of the inventory. Using LCM causes losses to be recognized in the period the value of inventory declines below its cost rather than in the period that the goods ultimately are sold.

3. Determining Market Value
Market Should Not Exceed Net Realizable
Value (Ceiling)
GAAP defines “market value” in terms of current replacement cost.
Market should not be greater than the “ceiling” or less than the “floor.”
Ideally, market would be measured as replacement cost of the inventory item. However, the inventory’s current replacement cost must fall between the net realizable value (estimated selling price in the ordinary course of business less the reasonably predictable costs of completion and disposal), and the net realizable value reduced by normal profit margin. Net realizable value (NRV) is referred to as the ceiling for market, and net realizable value reduced by normal profit margin (NRV ̵ NP) is referred to as the floor for market. Market value is always the middle amount of the three values calculated for replacement cost, net realizable value, and net realizable value reduced by normal profit margin.
Market Should Not Be Less Than Net Realizable Value less Normal Profit (Floor)

4. Determining Market Value
Step 1 Determine Designated Market
Step 2 Compare Designated Market with Cost
Ceiling NRV
Not More Than
Replacement Cost
Designated Market
Cost Or
If replacement cost is greater than the ceiling, then the ceiling becomes market value. If replacement cost is less than the floor, then the floor becomes market value. As long as replacement cost falls between the ceiling and the floor, it will be considered market value. Notice that the designated market value is the middle amount of the three market possibilities. This number is then compared to cost and the lower of the two is the final inventory value.
Not Less Than
Lower of Cost or Market
NRV – NP Floor

5. How would we value this item in the balance sheet?
Lower of Cost or Market
An item in inventory has a historical cost of $20 per unit. At year-end we gather the following per unit information:
Current replacement cost = $21.50
Selling price = $30
Cost to complete and dispose = $4
Normal profit margin = $5
How would we value this item in the balance sheet?
Let’s look at an example to demonstrate application of the lower-of-cost-or-market concept.
Here we have an inventory item that has a historical cost of $20. Its replacement cost is $ The normal selling price of the inventory item is $30, and it will cost $4 dollars to complete and dispose of the item in its current condition. The normal profit margin on this item is $5. Let’s begin by determining market value.

6. Lower of Cost or Market $21.50
Replacement
Cost =$21.50
Designated Market?
$21.50
Historical cost of $20.00 is less than designated market of $21.50, so this inventory item will be valued at cost of $20.00.
We assume the market value will be replacement cost, as long as it falls between the NRV (the ceiling) and NRV – NP (the floor). The NRV is the selling price, $30, less the cost to complete and sell, $4, or $26. The NRV – NP is $26, less normal profit of $5, or $21. Which amount will we select as designated market?
Designated market is replacement cost of $21.50, because it falls between the ceiling of $26.00 and the floor of $21.00.
Because historical cost of $20.00 is less than designated market of $21.50, this inventory item will be valued at its historical cost of $20.00.

7. Applying Lower of Cost or Market
Lower of cost or market can be applied 3 different ways.
We can apply lower of cost or market in one of three different ways. First, we can apply it to individual items of inventory.
1. Apply LCM to each individual item in inventory such as printers.

8. Applying Lower of Cost or Market
Lower of cost or market can be applied 3 different ways.
Second, we can apply lower of cost or market to groups of similar items in inventory, such as desktop and laptop computers.
1. Apply LCM to each individual item in inventory.
2. Apply LCM to logical inventory categories, such as desktop and laptop computers.

9. Applying Lower of Cost or Market
Lower of cost or market can be applied 3 different ways.
Finally, we can apply LCM to the entire inventory.
3. Apply LCM to the entire inventory as a group.
2. Apply LCM to logical inventory categories.
1. Apply LCM to each individual item in inventory.

10. Adjusting Cost to Market
Record the loss as a separate item in the income statement
Loss on write-down of inventory XX Inventory XX
Record the loss as part of cost of goods sold. Cost of goods sold XX Inventory XX
When a company applies the LCM rule and a material write-down of inventory is required, the company has two choices of how to report the reduction. One way is to report the loss as a separate item in the income statement. An alternative is to include the loss as part of the cost of goods sold. If inventory write-downs are commonplace for a company, it usually will include the losses as part of cost of goods sold. However, a write-down loss that is substantial and unusual should be reported as a separate item among operating expenses.

11. U. S. GAAP vs. IFRS
International and U.S. standards for valuing inventory at the lower of cost or market are slightly different.
Inventory is valued at the lower of cost or market with market selected from replacement cost, net realizable value or NRV reduced by the normal profit margin.
Designated market is compared to historical cost to determine LCM.
The LCM rule can be applied to individual items, logical inventory categories, or the entire inventory.
Reversals are not permitted.
Inventory is valued at the lower or cost of market and net realizable value.
The assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances.
If an inventory write-down is no longer appropriate, it must be reversed.
International and U.S. standards for valuing inventory at the lower-of-cost-or-market are slightly different.
From the perspective of the FASB,
Inventory is valued at the lower of cost or market with market selected from replacement cost, net realizable value or NRV reduced by the normal profit margin.
Designated market is compared to historical cost to determine LCM.
Under U.S. GAAP, the LCM rule can be applied to individual items, logical inventory categories, or the entire inventory.
If an inventory write-down is not longer appropriate, it must be reversed.
However, according to international standards:
IAS No. 2, states that inventory is valued at the lower of cost or market and net realizable value.
The assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances.
If an inventory write-down is no longer appropriate, it must be reversed.

12. Inventory Estimation Techniques
Estimate instead of taking physical inventory
Less costly
Less time-consuming
Two popular methods of estimating ending inventory are the . . .
Gross profit method
Retail inventory method
Most companies estimate their inventories at interim periods. In some cases, when inventory is extremely large and spread out over a wide geographical area, inventory estimation may be used to determine year-end inventory. It may be impossible or impractical to physically count such inventories. Inventory estimation is less costly than a physical count and less time-consuming.
The two most popular methods of inventory estimation are known as the gross profit method and the retail inventory method.

13. Gross Profit Method
Estimating inventory and COGS for interim reports.
Auditors in testing the overall reasonableness of client inventories.
Useful when . . .
Determining the cost of inventory lost, destroyed, or stolen.
Preparing budgets and forecasts.
Companies can use the gross profit method when preparing interim reports, and auditors often use it to determine the reasonableness of ending inventory. The gross profit method can be used by insurance companies to estimate lost, destroyed, or stolen inventory. We can use the gross profit method in the budgeting process.
It is important to remember that the gross profit method is not acceptable for use in the annual report distributed to external users.
NOTE: The gross profit method is not acceptable for use in annual financial statements.

14. Estimate the Gross Profit Ratio
Gross Profit Method
This method assumes that the historical gross margin ratio is reasonably constant in the short-run.
Beginning Inventory
(from accounting records)
Plus: Net purchases
Goods available for sale
(calculated)
Less: Cost of goods sold
(estimated)
Ending inventory
Before we can use the gross profit method, there is some information we need to know. First, we need an estimate of the gross profit ratio, often relying on the historical gross profit ratio. Then we need to know the beginning inventory and net purchases that can be obtained from the existing accounting records. In addition, we need to determine net sales from the accounting records. Once we have determined these amounts we can use the gross profit method to estimate ending inventory and cost of goods sold.
Estimate the Gross Profit Ratio

15. Estimate Inventory at May 31.
Gross Profit Method
Matrix Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data:
Net sales for May = $1,213,000
Net purchases for May = $728,300
Inventory at May 1 = $237,400
Estimated gross profit ratio = 43% of sales
Estimate Inventory at May 31.
Matrix is interested in estimating its ending inventory at May 31 using the gross profit method. The controller has provided us with certain information. Perhaps the most critical amount in the process is the estimation of the company’s gross profit ratio. This is usually developed from analysis of historical rates of gross profit. Review this information and make sure it’s adequate for us to apply the gross profit method.

16. Gross Profit Method
NOTE: The key to successfully applying this method is a reliable gross profit ratio.
We were given the historic gross profit percentage, so the first step in our process is to determine the cost of goods available for sale. We add beginning inventory and net purchases for the period determine cost of goods available for sale of $965,700.
The next step is to estimate gross profit for the period. To estimate gross profit multiply sales by the gross profit percentage of 43 percent. Estimated gross profit is $521,590.
The next step is to determine estimated cost of goods sold. To determine this amount subtract estimated gross profit from sales to arrive at estimated cost of goods sold of $691,410.
The final step is to subtract cost of goods sold from cost of goods available for sale to get an estimated ending inventory of $274,290.

17. The Retail Inventory Method
This method was developed for retail operations like department stores.
Uses both the retail value and cost of items for sale to calculate a cost to retail percentage.
As indicated by its name, the retail method was developed for retail establishments such as department stores. There is a major difference between the gross profit and retail method. In the retail method, we need to know both cost and selling price of certain accounts. Our objective in the retail method is to calculate ending inventory at retail, and then convert it from retail to cost.
Objective: Convert ending inventory at retail to ending inventory at cost.

18. The Retail Inventory Method
Retail Terminology
Term
Meaning
Initial markup
Original amount of markup from cost to selling price.
Additional markup
Increase in selling price subsequent to initial markup.
Markup cancellation
Elimination of an additional markup.
Markdown
Reduction in selling price below the original selling price.
Markdown cancellation
Elimination of a markdown.
To apply the retail inventory method properly it is important to understand terminology in the retail industry. A retail company purchases an item for resale at cost. The initial markup is the markup from cost to selling price. For example, if a company purchases an item for $6 and plans to sell it for $10, there is on initial markup of $4. If demand for the product is high, the company may raise the selling price to $12, so there is an additional markup of $2. If demand for the product at $12 slackens the price may be dropped to $10.50, the company would have a markup cancellation of $1.50.

19. An Example of the Terminology
Retail Terminology
An Example of the Terminology
The terms on your screen are associated with changing retail prices of merchandise inventory, and are very common in all retail establishments. We are all familiar with the term markup, we usually associate it with the increase in selling price above the cost to the company. If demand for a product is very strong, the company may feel that an additional markup is in order. A markup cancellation occurs when the company reduces the selling price of a product to induce sales and reduce inventory.

20. The Retail Inventory Method
Sales for the period.
Beginning inventory at retail and cost.
We need to know . . .
Before we can successfully complete the retail inventory method, we need to know four pieces of information. We need to know sales for the period, net purchases at both retail price and cost, the value of beginning inventory at both retail and cost and, finally, whether there’s been an inventory adjustment to the retail price. These adjustments might include additional markups or additional markdowns and other items that apply to retail establishments.
Net purchases at retail and cost.
Adjustments to the original retail price.

21. The Retail Inventory Method
Matrix Inc. uses the retail method to estimate inventory at the end of each month. For the month of May the controller gathers the following information:
Beginning inventory at cost $27,000 (at retail $45,000)
Net purchases at cost $180,000 (at retail $300,000)
Net sales for May $310,000
Estimate the inventory at May 31.
Matrix, a retail establishment, wishes to estimate its ending inventory at May 31. Information is gathered by the controller to help us accomplish this task. Read through the information carefully and we’ll begin the process to estimate ending inventory using the retail inventory method. Please note that purchases are equal to cost less returns and allowances, plus freight-in. Purchases at retail are equal to the selling price of purchased goods less returns at retail. Net sales are equal to gross sales less returns.

22. The Retail Inventory Method
First, we add together beginning inventory and net purchases for May both at cost and retail. We divide the goods available for sale at cost by the retail price of goods available for sale to arrive at the cost-to-retail percentage of 60%. Next, we subtract our sales for May from the selling price of goods available for sale, to arrive at ending inventory at retail.

23. The Retail Inventory Methodx
Finally, we use our cost-to-retail percentage to convert our estimate of ending inventory at retail, $35,000, to our estimate of ending inventory at cost, by multiplying $35,000 by 60% which equals $21,000. ×

24. Retail Inventory Method Markups and Markdowns
Matrix Inc. uses the retail method to estimate inventory at the end of July. The controller gathers the following information:
Beginning inventory at cost $21,000 (at retail $35,000)
Net purchases at cost $200,000 (at retail $304,000)
Net markups $8,000
Net markdowns $4,000
Net sales for July $300,000
Estimate inventory at July 31.
Matrix Inc. uses the retail method to estimate inventory at the end of July. The controller gathers the following information:
Beginning inventory at cost $21,000 (at retail $35,000)
Net purchases at cost $200,000 (at retail $304,000)
Net markups $8,000
Net markdowns $4,000
Net sales for July $300,000
Let’s estimate inventory at July 31 using a method that approximates average cost. Using this method both markups and markdowns are included in the determination of goods available for sale at retail.

25. Conventional Retail Method: Markups and Markdowns
When using the average cost approach, we include the net markups (markups less markup cancellations) and net markdowns (markdowns less markdown cancellations) in the calculation of the cost-to-retail percentage. Notice that net markups and net markdowns only impact only the retail column because they are normally applied to the recorded retail amounts. The first step it to determine the cost-to-retail percentage shown here as percent.

26. Conventional Retail Method: Markups and Markdowns
The next step is to subtract sales for the period from the total retail value of goods available for sale of $343,000. The result is an estimate of the ending inventory at retail amount.
The final step is to convert the estimate of ending inventory at retail to an estimate of ending inventory at cost. To do this we multiply the estimate of ending inventory at retail by the cost-to-retail percentage to arrive at our estimate of ending inventory at cost of $27,705.
Now lets look at an example of the retail inventory method that approximates lower of cost of market.

27. Conventional Retail Method: Markups and Markdowns
When using the conventional retail method to approximate lower-of-cost-or-market, we include the net markups (markups less markup cancellations) but exclude the net markdowns (markdowns less markdown cancellations) in the calculation of the cost-to-retail percentage. Notice that net markups impact only the retail column because they are normally applied to the recorded retail amounts. The first step is to determine the cost-to-retail percentage, which in our case is percent.

28. Conventional Retail Method: Markups and Markdowns
The next step is to subtract the net markdowns for the period to arrive at goods available at cost and retail.
Next, we subtract sales for the month of July from the retail value of goods available for sale to determine the retail value of ending inventory of $43,000.
Finally, we multiply the retail value of ending inventory by the cost-to-retail percent to arrive at the cost of ending inventory of $27,387.
$43,000 × 63.69% = $27,387

29. The LIFO Retail Method
Assume that retail prices of goods remain stable during the period.
Establish a LIFO base layer (beginning inventory) and add (or subtract) the layer from the current period.
Calculate the cost-to-retail percentage for beginning inventory and for adjusted net purchases for the period.
We can also use the retail method to estimate ending inventory using LIFO. Whenever we think about LIFO, we should think about layers.

30. The LIFO Retail Method Beginning inventory has its own
LIFO cost- =
Net purchases
to-retail %
Retail value (Net purchases
+ Net markups - Net markdowns)
Beginning inventory has its own
cost-to-retail percentage.
Under the LIFO retail method, the beginning inventory will have its own cost-to-retail percentage. The cost-to-retail percentage for purchases is calculated by taking net purchases at cost and dividing this amount by the retail value of net purchases plus net markups minus net markdowns.

31. The LIFO Retail Method
When we use LIFO retail, we separate beginning inventory from the activity in the current month. Beginning inventory has its own cost-to-retail percentages. In our case that percentage is 60% ($21,000 divided by $35,000). We include both net markups and net markdowns for the current period with net purchases. The cost-to-retail percentage for the July activity is percent rounded.

32. The LIFO Retail Method
Next, we subtract the sales for July from the net purchases (including markups and markdowns) to determine the LIFO layer for the month of July. In our case, the LIFO layer is $8,000. The final step is to determine the estimated cost of ending inventory using the LIFO approach.

33. The LIFO Retail Method
Beginning inventory contributes $21,000 to the cost of ending inventory. For July the LIFO layer contributed $5,195 – rounded to the cost of ending inventory. In our example we assumed stable prices. If there is an increase in the index used to determine LIFO, we would have to deflate the $8,000 layer back to base-period prices and re-inflate the amount for the current index.

34. Other Issues of Retail Method
Element
Treatment
Before calculating the cost-to-retail percentage
Freight-in
Added to the cost column
Purchase returns
Deducted in both the cost and retail columns
Purchase discounts taken
Deducted in the cost column
Abnormal shortage, spoilage, or theft
After calculating the cost-to-retain percentage
Normal shortage, spoilage, or theft
Deducted in the retail column
Employee discounts
Added to net sales
Other items that impact the retail value of net purchases include purchase returns and allowances, purchase discounts, freight-in, employee discounts, and spoilage or theft. The treatment of these items is shown in the table on your screen.

35. Dollar-Value LIFO Retail
We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.
The purpose of dollar-value LIFO retail is to eliminate the effects of price changes on ending inventory and beginning inventory.

36. Dollar-Value LIFO Retail
Return to our earlier Matrix Inc. example to estimate the ending inventory using dollar-value LIFO retail. Recall that ending inventory was estimated to be $35,000 at retail, and $21,000 at cost with a 60% base layer cost-to-retail percentage.
Net purchases at cost $200,000, at retail $304,000.
Net markups $8,000.
Net markdowns $4,000.
Net sales for July $300,000.
Price index at July 1 is 100 and at July 30
the index is 102.
When we examined LIFO retail as a method to estimate ending inventory we assumed that if the ending inventory was greater than the beginning inventory, we should add a LIFO layer. But this assumption is not always true. It may be that the dollar amount of ending inventory exceeded the beginning inventory amount simply because prices increased during the period, without an actual change in the quantity of goods. We use dollar-value LIFO retail to eliminate the impact of inflation on inventory.
Let’s use this information to estimate the ending inventory of Matrix Inc. using the dollar-value LIFO retail method. Notice that during the month of July there was significant inflation, plus new information relating to the change in prices. At the beginning of July, the price index was 100. At the end of July, it was 102. Let’s use this new information to estimate inventory using dollar-value LIFO retail.

37. Dollar-Value LIFO Retail
The base year is the first year that the DVL method is adopted. In the previous period, the retail price of ending inventory was determined.
The first step is to deflate the $43,000 retail value of ending inventory to base year prices. To accomplish this, we divide the $43,000 by 1.02, the price index at the end of the period. The retail value of ending inventory in base year prices is $42,157.
Beginning inventory at retail was $35,000 and the price index was 100, so the beginning inventory layer will be converted to $21,000 using the 60% base year cost-to-retail percentage. The current layer in base year prices is $7,157. We first re-inflate this amount to the value at the end of the period by multiplying $7,157 times Next, we convert the re-inflated amount from retail to cost by multiplying it by the current year cost-to-retail percentage of 64.94%. We have a current layer, at current prices, of $4, We add the layers together to determine LIFO retail inventory at $25,

38. Changes in Inventory Method
Recall that most voluntary changes in accounting principles are reported retrospectively. This means reporting all previous periods’ financial statements as though the new method had been used in all prior periods.
Most voluntary changes in accounting principles involving inventory are reported retrospectively. This means that all previous financial statements disclosed are restated as though the new principle had been used.
Changes in inventory methods, other than a change to LIFO, are treated retrospectively.

39. Change to the LIFO Method
When a company elects to change to LIFO, it is usually impossible to calculate the income effect on prior years. As a result, the company does not report the change retrospectively. Instead, the LIFO method is used from the point of adoption forward.
A disclosure note is needed to explain (a) the nature of the change, (b) the effect of the change on current year’s income and earnings per share, and (c) why retrospective
application was impracticable.
When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted.
A disclosure note is needed to explain the nature and justification for the change as well as the effect of the change on current year’s income and earnings per share. The note also must explain why retrospective application was impracticable.

40. Inventory Errors
When analyzing inventory errors, it’s helpful to visualize the way cost of goods sold, net income, and retained earnings are determined.
When analyzing inventory errors, it’s helpful to visualize the way cost of goods sold, net income, and retained earnings are determined. Here is an overview of this flow. Beginning inventory and net purchases are added in the calculation of cost of goods sold. If either of these is overstated (understated) then cost of goods sold would be overstated (understated). On the other hand, ending inventory is deducted in the calculation of cost of goods sold, so if ending inventory is overstated (understated) then cost of goods sold is understated (overstated)

41. Overstatement of ending inventory
Inventory Errors
Overstatement of ending inventory
Understates cost of goods sold and
Overstates pretax income.
Understatement of ending inventory
Overstates cost of goods sold and
Understates pretax income.
This slide explains the impact of errors in ending inventory on cost of goods sold and pretax income. Because the error impacts cost of goods sold and therefore pretax net income, it also will impact the balance in retained earnings.

42. Overstatement of beginning inventory
Inventory Errors
Overstatement of beginning inventory
Overstates cost of goods sold and
Understates pretax income.
Understatement of beginning inventory
Understates cost of goods sold and
Overstates pretax income.
Here we show the impact of errors in beginning inventory on cost of goods sold and pretax income. Again, because the error impacts cost of goods sold and therefore pretax net income, it also will impact the balance in retained earnings.

43. When the Inventory Error is Discovered the Following Year
Inventory Errors
When the Inventory Error is Discovered the Following Year
If an error was made in 2013, but not discovered until 2014, the 2013 financial statements were incorrect as a result of the error. The error should be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when the comparative 2014 and 2013 financial statements are issued for 2014.
When the Inventory Error is Discovered Subsequent to the Following Year
If an error was made in 2013, but not discovered until 2015, all previous years’ financial statements that were incorrect as a result of the error also are retrospectively restated to reflect the correct inventory, cost of goods sold, retained earnings, and net income even though no correcting entry is needed in The error has self-corrected and no prior period adjustment is needed.
If an error was made in 2013, but not discovered until 2014, the 2013 financial statements were incorrect as a result of the error. The error should be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when the comparative 2014 and 2013 financial statements are issued for 2014.
If an error was made in 2013, but not discovered until 2015, all previous years’ financial statements that were incorrect as a result of the error also are retrospectively restated to reflect the correct inventory, cost of goods sold, retained earnings, and net income even though no correcting entry is needed in The error has self-corrected and no prior period adjustment is needed.

44. Earnings Quality
Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.
Many financial analysts believe that inventory write-downs or arbitrary changes in inventory methods represent manipulation of the earnings by management. Such a manipulation is considered to impair the earnings quality of the company. A financial analyst must carefully consider the effect of any significant asset write-down on the assessment of a company’s permanent earnings.

45. Appendix 9: Purchase Commitments
Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates.
In July 2013, the Lassiter Company signed two purchase commitments.
The first requires Lassiter to purchase inventory for $500,000 by
November 15, The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000.
The second requires Lassiter to purchase inventory for $600,000 by
February 15, On December 31, 2013, the market value of the inventory
items was $540,000. On February 15, 2014, the market value of the inventory
items was $510,000.
Lassiter uses the perpetual inventory system and is a calendar year-end
company.
Appendix 9: Purchase Commitments
A purchase commitment is a contract between two parties, requiring one of the parties to purchase a specified amount of inventory at a set price, on or before a particular date.
In July 2013, the Lassiter Company signed two purchase commitments.
The first requires Lassiter to purchase inventory for $500,000 by November 15, The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000.
The second requires Lassiter to purchase inventory for $600,000 by February 15, On December 31, 2013, the market value of the inventory items was $540,000. On February 15, 2014, the market value of the inventory items was $510,000.
Lassiter uses the perpetual inventory system and is a calendar year-end company. Let’s make the journal entries for these commitments.

46. Appendix 9: Purchase Commitments
November 14, 2013
Inventory (market price) 425,000
Loss on purchase commitment 75,000
Accounts payable ,000
December 15, 2013
Accounts payable 500,000
Cash ,000
Single-period commitment
Multi-period commitment
December 31, 2013
Estimated loss on commitment 60,000
Estimated liability on commitment ,000
February 15, 2014
Inventory (market price) 510,000
Loss on purchase commitment 30,000
Estimated liability on commitment 60,000
Cash ,000
Let’s look at the single-period purchase commitment first. On the date of acquisition, the inventory items had a market price of $425,000, so Lassiter will debit inventory for $425,000, debit the loss on purchase commitment for $75,000, and credit accounts payable for $500,000. Had the market price of the inventory been $500,000 on the date of acquisition, the company would not experience a loss. The account payable was paid on December 15, 2013, so Lassiter would make the usual entry to debit accounts payable and credit cash for the commitment price of $500,000.
For the multi-period purchase commitment, Lassiter did not acquire the inventory until 2014, so at the end of 2013, the company would determine the market price of the inventory items and, in our case, debit estimated loss on purchase commitment and credit estimated liability on purchase commitment for $60,000 ($600,000 commitment price less $540,000 market price). On February 15, 2014, Lassiter purchased the inventory paying cash. The market price of the inventory at the time of acquisition was $510,000. Lassiter will prepare a somewhat complex journal entry to debit inventory for $510,000, debit loss on purchase commitment ($540,000 previous market price less $510,000 current market price), debit the estimated liability on purchase commitment for $60,000, and credit cash for the commitment price of $600,000.

47. End of Chapter 9
End of Chapter 9.