Chapter 9 Inventories Special Valuation Issues Intermediate Accounting

Chapter 9 Inventories: Special Valuation Issues Intermediate Accounting 10 th 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 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 Selling price $165 Cost of completion (10) Transportation cost (15) Ceiling (NRV) $140 Normal Profit = $40 Ceiling (NRV) Normal profit Floor $140 (40) $100

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

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

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

10 Lower of Cost or Market Try one more.

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

12 Lower of Cost or Market Inventory Category A: Item 1 Item 2 Cost Market Individual Items $1, 000 $ 700 1, 200 1, 300 $2, 200 Loss$2, 000 Category B: recognition, Item 3 $2, 000 $600$2, 400 Item 4 2, 500 2, 200 $4, 500 $4, 600 Total $6, 700 $6, 600 Inventory valuation $ 700 1, 200 2, 000 2, 200 $6, 100

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

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

15 Lower of Cost or Market Recording the Reduction of Inventory to Cost December 31, 2006 December 31, 2007 December 31, 2008 Cost $20, 000 25, 000 30, 000 Market $20, 000 22, 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 Valuation Above Cost In exceptional cases inventories properly may be stated above cost. v Precious metals having a fixed monetary value with no substantial cost of marketing. v 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: 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. Continued

21 Gross Profit Method A company uses the gross profit method in the following situations: 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.

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 Gross profit rate Estimated gross profit $130, 000. 40 $ 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 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 Expressing Gross Profit Percentages Divide gross profit by sales to calculate profit as a percentage of sales. Gross Profit Sales = Gross Profit as a Percentage of Sales

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 = Cost + Gross Profit as a % of Cost Gross Profit as a % of Sales 28

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 Beginning inventory $ 10, 000 Purchases 50, 000 Goods available for sale$ 60, 000 Retail $ 17, 000 83, 000 $100, 000

31 Retail Inventory Method Step 2: A cost-to-retail ratioisiscomputed. Cost Retail Beginning inventory $ 10, 000 $ 17, 000 Purchases 50, 000 83, 000 Goods available for sale $ 60, 000 $100, 000 Cost-to-retail ratio: $ 60, 000 = 0. 60 $100, 000

32 Retail Inventory Method Step 2: Step 3: A The cost-to-retail ending inventory ratio is computed. at retail is computed. Cost Beginning inventory $ 10, 000 Purchases 50, 000 Goods available for sale $60, 000 Less: Sales Ending inventory at retail Retail $ 17, 000 83, 000 $100, 000 (80, 000) $ 20, 000

33 Retail Inventory Method Step 4: The ending inventory at cost is computed. Cost Beginning inventory $ 10, 000 Purchases 50, 000 Goods available for sale $60, 000 Less: Sales Ending inventory at retail Ending inventory at cost $12, 000 0. 60 x $20, 000 Retail $ 17, 000 83, 000 $100, 000 (80, 000) $ 20, 000

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

35 Retail Inventory Method Terminology Reduced selling price to $10. 25 Markup Cancellation Cost ($6) Net markup =Total additional markups total markup cancellations

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

37 Retail Inventory Method Terminology Net markdown =Total additional markdowns total markdown cancellations Increased selling price to $9. 60 Cost ($6) Markdown Cancellation

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

Retail Inventory Method-Average Cost $20 40 Beginning inventory Purchases Net markups Net markdowns Goods available for sale $60 Less sales Ending inventory at retail $60 = 0. 545 $110 Retail $ 35 80 5 (10) $110 (66) $ 44 Ending inventory, average cost (0. 545 x $44) = $23. 98 40

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 Under other either markups and conditions the lower markdowns do not exist at of average cost or the time or if all the markedmarket produces an down inventory has been sold. inventory value that is less than cost, but only approximates the lower of cost or market.

43 Retail Inventory Method--LCM Cost $20 40 Beginning inventory Purchases Net markups $60 = 0. 50 Net markdowns $120 Goods available for sale $60 Less sales Ending inventory at retail Retail $ 35 80 5 $120 (10) $110 (66) $ 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.

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