1. Inventories: Special Valuation Issues9
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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.

2. 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.

3. 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

4. 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)

5. 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

6. 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

7. 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

8. 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

9. 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

10. Lower of Cost or Market Try one more.

11. 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

12. 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

13. Lower of Cost or Market Inventory Cost Market Category Category A:
Item 1 $1,000 $ 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

14. Lower of Cost or Market Inventory Cost Market Total Category A:
Item 1 $1,000 $ 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

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

16. See Example 9-1 on page 416.

17. 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.

18. See page 343

19. 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.

20. 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

21. 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.

22. 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%.

23. 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
Estimated gross profit $ 52,000

24. 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

25. 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

26. 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.

27. 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

28. 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

29. 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.

30. 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
Goods available for sale $ 60,000 $100,000

31. 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
Goods available for sale $ 60,000 $100,000
Cost-to-retail ratio:
$ 60,000
$100,000
= 0.60

32. 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
Goods available for sale $60,000 $100,000
Less: Sales (80,000)
Ending inventory at retail $ 20,000

33. 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
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

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

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

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

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

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

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

40. Retail Inventory Method--Average Cost
Cost Retail
Beginning inventory $20 $ 35
Purchases
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

41. 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

42. 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.

43. Retail Inventory Method--LCM
Cost Retail
Beginning inventory $20 $ 35
Purchases
Net markups
$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

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. 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.

50. C 9
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