Inventories: Special Valuation Issues

1. C 8 hapter Inventories: Special Valuation Issues

2. Objectives 1. Understand the lower of cost or market method. 2. Explain the conceptual issues regarding the lower of cost or market method. 3. Understand purchase obligations and product financing arrangements. 4. Explain the valuation of inventory above cost. 5. Use the gross profit method.

3. Objectives 6. Understand the retail inventory method. 7. Explain the conceptual issues regarding the retail inventory method. 8. Understand the dollar-value LIFO retail method. 9. Understand the effects of inventory errors on the financial statements.

4. Selection of Market Value Comparison to Cost Ceiling (Net Realizable Value) Replacement Cost Floor (Net Realizable Value - Normal Profit) Use lower of (a) cost or (b) selected market value Reporting the Results Lower of Cost or Market

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

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

8. Selling price $165 Cost of completion (10) Transportation cost (15) Ceiling (NRV) $140 Ceiling (NRV) $140 Normal profit (40) Floor $100 Lower of Cost or Market Case 2 Cost $110 Normal Profit = $40 Current Replacement Cost, $150 Current Replacement Cost, $120 What is market? $140 LCM is the cost of $110

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

10. Lower of Cost or Market Try one more.

11. Selling price $165 Cost of completion (10) Transportation cost (15) Ceiling (NRV) $140 Ceiling $140 Normal profit ( 40) Floor $100 Lower of Cost or Market Case 4 Cost $110 Normal Profit = $40 Current Replacement Cost, $105 What is market? $105 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 1,2001,300 1,200 $2,200 $2,000 Category B: Item 3 $2,000 $2,400 2,000 Item 4 2,5002,200 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 $ 700 Item 2 1,2001,300 $2,200$2,000 $2,000 Category B: Item 3 $2,000 $2,400 Item 4 2,5002,200 $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 $ 700 Item 2 1,2001,300 $2,200 $2,000 Category B: Item 3 $2,000 $2,400 Item 4 2,5002,200 $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 CostMarket December 31, 2000 $20,000 $20,000 December 31, 2001 25,000 22,000 December 31, 2002 30,000 28,000 Assume the company uses a periodic system.

16. Lower of Cost or Market Direct Method--December 31, 2001 To close beginning inventory: Income Summary 20,000 Inventory 20,000 To record ending inventory: Inventory 22,000 Income Summary 22,000

17. Lower of Cost or Market Direct Method--December 31, 2002 To close beginning inventory: Income Summary 22,000 Inventory 22,000 To record ending inventory: Inventory 28,000 Income Summary 28000

18. Lower of Cost or Market Allowance Method--December 31, 2001 To close beginning inventory: Income Summary 20,000 Inventory 20,000 To record ending inventory: Inventory 25,000 Income Summary 25,000 To record inventory at market: Loss Due to Market Valuation 3,000 Allow. to Reduce Inventory to Market 3,000

19. Lower of Cost or Market Allowance Method--December 31, 2002 To close beginning inventory: Income Summary 25,000 Inventory 25,000 To record ending inventory: Inventory 30,000 Income Summary 30,000 To record inventory at market: Allowance to Reduce Inventory to Market 1,000 Loss Recovery Due to Market Valuation 1,000

20. Purchasing Obligations and Product Arrangements A company entered into a noncancelable commitment to purchase inventory at a fixed price of $500,000 and the market price at the end of the year is $450,000.

21. Purchasing Obligations and Product Arrangements Year-end adjusting entry: Loss on Purchase Commitments 50,000 Accrued Loss on Purchase Commitments 50,000 When the goods are purchased: Inventory (or Purchases) 450,000 Accrued Loss on Purchase Commitments 50,000 Accounts Payable 500,000

22. 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.

23. 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

24. 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.

25. Assume 40%. 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).

26. Net sales $130,000 Gross profit rate .40 Estimated gross profit $ 52,000 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.

27. Net sales $130,000 Estimated gross profit (from Slide 26) (52,000) Estimated cost of goods sold $ 78,000 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.

28. Beginning inventory $ 10,000 Net purchases 90,000 Cost of goods available for sale $100,000 Less: Estimated cost of goods sold (from Slide 27) (78,000) Estimated cost of ending inventory $ 22,000 Gross Profit Method Step 4: Subtract the estimated cost of goods sold from the actual cost of goods available for sale.

29. 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.

30. Cost Retail Beginning inventory $ 10,000 $ 17,000 Purchases 50,000 83,000 Goods available for sale $ 60,000 $100,000 Retail Inventory Method Step 1: The total goods available for sale is computed at both cost and retail value.

31. Cost-to-retail ratio: $ 60,000 $100,000 = 0.60 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 83,000 Goods available for sale $ 60,000 $100,000

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

33. Retail Inventory Method Step 3: The ending inventory at retail is computed. Step 4: The ending inventory at cost is computed. 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

34. 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 (0.60 x $20,000) $12,000 Retail Inventory Method Step 4: The ending inventory at cost is computed.

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

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

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

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

39. Beginning inventory 20 35 Goods available for sale $60 $110 Less sales (66) Ending inventory at retail $ 44 $40 $75 = 0.533 Retail Inventory Method--FIFO Cost Retail Purchases $40 $ 80 Net markups 5 Net markdowns (10) $40 $ 75 Ending inventory at FIFO cost (0.533 x $44) = $23.45

40. Less sales (66) Ending inventory at retail $ 44 $60 $110 = 0.545 Retail Inventory Method--Average Cost Cost Retail Beginning inventory $20 $ 35 Purchases 40 80 Net markups 5 Net markdowns (10) Goods available for sale $60 $110 Ending inventory, average cost (0.545 x $44) = $23.98

41. Purchases 40 80 Net markups 5 Net markdowns (10) 75 + = Goods available for sale $60 $110 Less sales (66) Ending inventory at LIFO at retail $ 44 $20 $35 $40 $75 = 0.57 = 0.533 Retail Inventory Method--LIFO Cost Retail Beginning inventory $20 $ 35 $35 x 0.57 (beginning inventory layer) $20.00 $ 9 x 0.583 (added layer) 4.80 Ending inventory at LIFO cost $24.80

42. Net markdowns (10) Goods available for sale $60 $110 Less sales (66) Ending inventory at retail $ 44 $60 $120 = 0.50 Retail Inventory Method--LCM Cost Retail Beginning inventory $20 $ 35 Purchases 40 80 Net markups 5 $60 $120 Ending inventory at LCM (0.50 x $44) = $22

43. 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.

44. Retail Beginning inventory $12,000 Purchases 32,000 Net markups 3,000 Net markdowns (1,000) 34,000 Goods available for sale $46,000 Sales (29,800) Ending inventory at retail $16,200 Dollar-Value LIFO Retail Method Calculate the ending inventory at retail. Step 1:

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

46. Ending inventory at base-year retail price……………………. Beginning inventory, 1/1/2000.. Increase $15,000 12,000 $ 3,000 Dollar-Value LIFO Retail Method The increase (decrease) in the inventory at retail is computed by comparing the ending inventory with the beginning inventory. Step 3:

47. Layer Increase at Current-Year Retail Prices Increase at Base-Year Retail Prices Current-Year Price Index x = Base-Year Price Index 108 x $3,000 = $3,240 100 Dollar-Value LIFO Retail Method The increase (decrease) in the inventory at retail is converted to current-year retail prices. Step 4:

48. The ending inventory at cost is computed by adding (subtracting) the increase (decrease) at cost to the beginning inventory at cost. Step 6: Beginning inventory at cost Dollar-Value LIFO Retail Method The increase (decrease) at current-year retail prices is converted to cost. Step 5: $3,240 x .60 = $1,944 Cost of purchases was $20,400 in 2000 while purchases adjusted for net markups and net markdowns was $34,000 (Slide 44). $20,400 ÷ $34,000 = 60% $1,944 + $8,000 = $9,944

49. 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 Balance Sheet Ending inventory and Accounts Payable are understated. Income Statement Income is correct.

50. 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 Balance Sheet Accounts Payable is understated and Retained Earnings is overstated. Income Statement Income is overstated and cost of goods sold is understated.