1. Inventories: Special Valuation Issues C hapter 9 COPYRIGHT © 2010 South-Western/Cengage Learning Intermediate Accounting 11th edition Nikolai Bazley Jones An electronic presentation By Norman Sunderman and Kenneth Buchanan Angelo State University

2. 2 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. 3

4. 4 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.

5. 5 IFRS vs. U.S. GAAP  IFRS, like U.S. GAAP, require the use of the lower of cost or market method to value inventory.  However, market is defined as net realizable value and should typically be applied to individual items.  By defining market as net realizable value, IFRS eliminate the need to use a ceiling and a floor.  IFRS do not specify the income statement line item under which the write-down should be recorded.  While U.S. GAAP prohibits any reversal of a previous write-down, IFRS do allow the reversal of a previous write-down, which is then recognized in income.

6. 6 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. Purchase Obligations

7. 7 Product Financing In a product financing arrangement, the company “sells” the inventory to another company. Then, in a related transaction, it agrees to purchase the inventory (or a substantially identical item) back from the other company at specified prices over specified periods. Typically the inventory is not delivered to the “buyer” and is repurchased at a higher price, the difference being an interest charge. The company may not record sales revenue but instead must record the proceeds received as a liability.

8. 8 Valuation 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 prices, and for which appropriate costs may be difficult to obtain  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 prices, and for which appropriate costs may be difficult to obtain In exceptional cases, inventories properly may be stated above cost.

9. 9 Estimating Inventory Two commonly used methods of estimating inventory costs are (1) the gross profit method and (2) the retail inventory method.

10. 10 Gross Profit Method 1.To determine the cost of the inventory at the end of an interim period without taking a physical count. 2.For the internal or external auditor to check the reasonableness of an inventory cost developed from a physical inventory or perpetual inventory system. ContinuedContinued A company uses the gross profit method in the following situations:

11. 11 3.To estimate the cost of inventory that is destroyed by a casualty. 4.To estimate the cost of inventory from incomplete records. 5.To develop a budget of cost of goods sold and ending inventory from a sales budget. A company uses the gross profit method in the following situations: Gross Profit Method

12. 12 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%. Gross Profit Method

13. 13 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. Gross Profit Method Net sales$130,000 Gross profit rate 0.40 Estimated gross profit$ 52,000

14. 14 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 Gross Profit Method

15. 15 Step 4:The estimated cost of goods sold is subtracted from the actual cost of goods available for sale to determine the estimated cost of the ending inventory. 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 Gross Profit Method

16. 16 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.

17. 17 Gross Profit Gross Profit as a Sales Percentage of Sales Expressing Gross Profit Percentages Divide gross profit by sales to calculate profit as a percentage of sales. =

18. 18 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 =

19. 19 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

20. 20 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 83,000 Goods available for sale$60,000$100,000

21. 21 Step 2:A cost-to-retail ratio is computed. Retail Inventory Method 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

22. 22 Step 2:A cost-to-retail ratio is computed. Step 3:The ending inventory at retail is computed. Retail Inventory Method 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

23. 23 Step 4:The ending inventory at cost is computed. Retail Inventory Method 0.60 × $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

24. 24 Retail Inventory Method Terminology Cost ($6) Markup Increased selling price to $12 Additional Markup Original selling price ($10)

25. 25 Cost ($6) Reduced selling price to $10.25 Total Additional Markups – Total Markup Cancellations = Net Markup Markup Cancellation Retail Inventory Method Terminology

26. 26 Cost ($6) Reduced selling price to $9 Markup Cancellation Markdown Retail Inventory Method Terminology

27. 27 Cost ($6) Increased selling price to $9.60 Markdown Cancellation Retail Inventory Method Terminology Total Additional Markdowns – Total Markdown Cancellations = Net Markdown

28. 28 Retail Inventory Method For methods using cost, such as average cost, FIFO and LIFO, the net markdowns are included in calculating the cost-to-retail ratio.

29. 29 FIFO The FIFO method excludes the beginning inventory in determining the cost-to-retail ratio. Retail Inventory Method — FIFO

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

31. 31 LIFO The LIFO cost method excludes the beginning inventory in determining the cost-to-retail ratio. Separate cost-to-retail ratios for the beginning inventory and the purchases must be calculated for the LIFO method. Retail Inventory Method — LIFO

32. 32 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. Retail Inventory Method — Lower of Average Cost or Market

33. 33 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. Conceptual Evaluation — Lower of Average Cost or Market

34. 34 Dollar-Value LIFO Retail Method Information for following slides

35. 35 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 Dollar-Value LIFO Retail Method Step 1:Calculate the ending inventory at retail.

36. 36 Ending Inventory at Base-Year Retail Prices = Ending Inventory at Retail × Current-Year Price Index Base-Year Price Index $15,000=$16,200× 100 108 Dollar-Value LIFO Retail Method Step 2:Compute ending inventory to base-year retail prices by applying the base-year conversion index.

37. 37 Ending inventory at base-year retail price…… Beginning inventory, 1/1/2010 Increase $15,000 12,000 $ 3,000 Dollar-Value LIFO Retail Method Step 3:The increase (decrease) in the inventory at retail is computed by comparing the ending inventory with the beginning inventory.

38. 38 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× 100 108

39. 39 $3,240 × 0.60 = $1,944 $1,944 + $8,000 = $9,944 Beginning inventory at cost Dollar-Value LIFO Retail Method Step 5:The increase (decrease) at current-year retail prices is converted to cost. Step 6:The ending inventory at cost is computed by adding (subtracting) the increase (decrease) at cost to the beginning inventory at 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%

40. 40 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. Income Statement Income is correct. Balance Sheet Ending inventory and accounts payable are understated. Balance Sheet Ending inventory and accounts payable are understated. Effects of Inventory Errors

41. 41 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. Income Statement Income is overstated and cost of goods sold is understated. Balance Sheet Accounts payable is understated and retained earnings is overstated. Balance Sheet Accounts payable is understated and retained earnings is overstated. Effects of Inventory Errors

42. 42 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. Income Statement Income is overstated and cost of goods sold is understated. Balance Sheet Accounts payable is understated and retained earnings is overstated. Balance Sheet Accounts payable is understated and retained earnings is overstated. Effects of Inventory Errors

43. 43 A purchase on credit is omitted from the Purchases account but ending inventory is correct. Succeeding Year Income Statement No effect. Income Statement No effect. Balance Sheet Accounts payable is understated and retained earnings is overstated. Balance Sheet Accounts payable is understated and retained earnings is overstated. Effect of Inventory Errors

44. 44 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. 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. Balance Sheet Ending inventory and retained earnings are over(under)stated. Effect of Inventory Errors

45. 45 Succeeding Year Income Statement Income is under(over)stated and cost of goods sold is over(under)stated. Balance Sheet No effect. Balance Sheet No effect. Ending inventory is over(under)stated due to quantity and/or costing errors, but the Purchases account is correct. Effect of Inventory Errors

46. 46 C hapter 9 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.