1. Inventories: Special Valuation Issues C hapter 9 An electronic presentation by Norman Sunderman Angelo State University 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. Intermediate Accounting 10th edition Nikolai Bazley Jones

2. 2 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. Lower of Cost or Market

3. 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 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 ContinueContinue

4. 4 Reporting the Results Balance sheet: Inventory at LCM Income statement: Loss (if recognized) Lower of Cost or Market Comparison to Cost Use lower of (a) cost or (b) selected market value Selection of Market Value Ceiling (Net Realizable Value) Replacement Cost Floor (Net Realizable Value - Normal Profit)

5. 5 A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin40 A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin40 Lower of Cost or Market

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

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

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

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

10. 10 Lower of Cost or Market Try one more.

11. 11 Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Cost $110 What is market? Current Replacement Cost, $105 Normal Profit = $40 LCM is the market of $105 Case 4 $105 Lower of Cost or Market Ceiling$140 Normal profit (40) Floor$100

12. 12 Inventory Cost Market Category A: Item 1$1,000$ 700$ 700 Item 21,2001,3001,200 $2,200$2,000 Category B: Item 3$2,000$2,4002,000 Item 42,5002,2002,200 $4,500$4,600 Total$6,700$6,600 Inventory valuation$6,100 Individual Items Loss recognition, $600 Lower of Cost or Market

13. 13 Inventory Cost Market Category A: Item 1$1,000$ 700 Item 21,2001,300 $2,200$2,000$2,000 Category B: Item 3$2,000$2,400 Item 42,5002,200 $4,500$4,6004,500 Total$6,700$6,600 Inventory valuation$6,500 Category Loss recognition, $200 Lower of Cost or Market

14. 14 Inventory Cost Market Category A: Item 1$1,000$ 700 Item 21,2001,300 $2,200$2,000 Category B: Item 3$2,000$2,400 Item 42,5002,200 $4,500$4,600 Total$6,700$6,600$6,600 Inventory valuation$6,600 Total Loss recognition, $100 Lower of Cost or Market

15. 15 Recording the Reduction of Inventory to Cost Cost Market December 31, 2006$20,000$20,000 December 31, 200725,00022,000 December 31, 200830,00028,000 Cost Market December 31, 2006$20,000$20,000 December 31, 200725,00022,000 December 31, 200830,00028,000 Assume the company uses a periodic system. Lower of Cost or Market

16. 16 See Example 9-1 on page 416.

17. 17 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. Purchase Obligations

18. 18 See page 343

19. 19 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 price 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 price for which appropriate costs may be difficult to obtain. In exceptional cases inventories properly may be stated above cost.

20. 20 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 value developed from a physical inventory or perpetual inventory system. ContinuedContinued A company uses the gross profit method in the following situations:

21. 21 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

22. 22 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

23. 23 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$130,000 Gross profit rate.40 Estimated gross profit$ 52,000 Gross Profit Method

24. 24 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

25. 25 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 Gross Profit Method

26. 26 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.

27. 27 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.

28. 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. 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. 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 Purchases50,000 83,000 Goods available for sale$ 60,000$100,000

31. 31 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 Purchases50,000 83,000 Goods available for sale$ 60,000$100,000 Step 2:A cost-to-retail ratio is computed. Retail Inventory Method

32. 32 Step 2:A cost-to-retail ratio is computed. Cost Retail Step 3:The ending inventory at retail is computed. Retail Inventory Method Beginning inventory$ 10,000$ 17,000 Purchases50,000 83,000 Goods available for sale$60,000$100,000 Less: Sales(80,000) Ending inventory at retail$ 20,000

33. 33 Cost Retail Beginning inventory$ 10,000$ 17,000 Purchases50,000 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 Cost Retail Step 4:The ending inventory at cost is computed. Retail Inventory Method 0.60 x $20,000

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

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

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

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

38. 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. 39 Average Cost The average cost method includes the beginning inventory in determining the cost-to-retail ratio. Retail Inventory Method-- Average Cost

40. 40 Retail Inventory Method-- Average Cost Cost Retail Beginning inventory$20$ 35 Purchases40 80 Net markups5 Net markdowns(10) Goods available for sale$60$110 $60 $110 = 0.545 Ending inventory, average cost (0.545 x $44) = $23.98 Less sales (66) Ending inventory at retail$ 44

41. 41 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-LCM

42. 42 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. Conceptual Evaluation-LCM

43. 43 Retail Inventory Method--LCM Cost Retail Beginning inventory$20$ 35 Purchases40 80 Net markups 5 $60$120 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 $60 $120 = 0.50

44. 44 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

45. 45 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

46. 46 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

47. 47 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

48. 48 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

49. 49 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

50. 50 C hapter 9 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.