Inventories: Additional Valuation Issues Chapter 9 Learning Objectives Apply the lower-of-cost-or-market rule. Recoding a Decline in Market Value (2 methods) Purchase commitments Gross profit method of Estimating Inventory Retail inventory method With markups and markdowns
Inventories: Additional Valuation Issues
INVENTORY: Benefit or utility derives from the ultimate sale of the goods.
What if the inventory's salability impairs that utility? Examples: deterioration, obsolescence, changes in price levels.
LCM approach to valuing inventory was developed to avoid reporting inventory at an amount greater than the benefits it can provide.
A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.
Ceiling and Floor
Why use Replacement Cost (RC) for Market?
Rationale for Limitations
Ceiling – prevents overstatement of the value of obsolete, damaged, or shopworn inventories.
Floor – deters understatement of inventory and overstatement of the loss in the current period.
How LCM Works (Individual Items)
Methods of Applying LCM
Recording LCM (data from Illus. 9-5 and 9-6)
Ending inventory (cost) $ 415,000
Ending inventory (LCM)350,000
Adjustment to LCM $ 65,000
Loss on inventory65,000
Allowance on inventory 65,000
Cost of goods sold65,000
Separately recording the loss and a contra account is does not distort the cost of goods sold and clearly displays the loss from market decline.
Balance Sheet Presentation
Income Statement Presentation
Recent Study: "SEC Staff Report on Off-Balance Sheet Arrangements, special Purpose Entities, and Related Issues"
Reports 30% of public companies have purchase commitments outstanding with an estimated value of $725 billion.
Example St. Regis Paper Co. signed timber-cutting contract on 4/15/2004 to be executed in 2005 at a firm price of 10M.
What is the journal entry on 4/15/2004?
NONE (just a note if material)
The market price of the timber cutting rights on 12/31/04 dropped to 7M. What is the journal entry?
UHG/L (Purchase Commitments) 3,000,000
Est. Liability on Purchase Commitments 3,000,000
Unrealized Holding Gain or Loss (UHG/L) is classified on the
Income Statement under “other expense and losses”
Estimated Liability on Purchase Commitments is classified as
Current liability if contract to be executed within YR
Example St. Regis Paper Co. signed timber-cutting contract in 2004 to be executed in 2005 at a firm price of 10M.
What is the journal entry when the timber is cut in 2005?
Purchases (Inventory) 7,000,000
Estimated Liability on Purchase Commitments 3,000,000
Substitute Measure to Approximate Inventory
Relies on Three Assumptions:
E9-12 (Gross Profit Method)Mark Price Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May.
(a)Compute the estimated inventory at May 31, assuming that the gross profit is 30% of sales.
(b)Compute the estimated inventory at May 31, assuming that the gross profit is 30% of cost.
E9-12 (Gross Profit Method - Solution)
(a)Compute the estimated inventory assuming gross profit is 30% of sales.
E9-12 (Gross Profit Method - Solution)
(b)Compute the estimated inventory assuming gross profit is 30% of cost.
100% + 30%
= 23.08% of sales
A method used by retailers, to value inventory without a physical count, by converting retail prices to cost.
Based upon the observable pattern between cost and sales price
This method is very common and used by retailers such as Safeway, Target, Wal-Mart and Best Buy.
Requires retailers to keep:
Is appropriate for retail concerns with:
The steps are:
Markup - The original markup from cost to the first selling price (also known as mark-on).
Markup Cancellation – A reduction in the selling price afterthere has been an additional markup. The markup cancellation cannot be greater than the additional markup.
Markdown – A decrease below the original sales price.
Markdown Cancellation – An increase in the selling price after there has been a mark-down. The markdown cancellation cannot be greater than the markdown.
Example: Company purchased an item for $6 and initially priced the item to sell for $10. The markup is $4. If the company subsequently increases the selling price to $12, there is an additional markup of $2. If it then lowers the selling price to $7, there is a markup cancellation of $2 and a markdown of $3.
P9-8 (Retail Inventory Method)Jared Jones Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2008.
Prepare a schedule computing estimate retail inventory using the LCM conventional retail method:
Widely used for the following reasons:
Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits.
Kirby Company buys three different lots (A, B and C) in a basket purchase, paying $300,000 for all three.
The lots were sold as follows:
A ($75,000); B ($150,000) and C ($200,000) for a total of $425,000
What is the cost of A, B and C and the gross profit for each lot?
LotSales Allocated Gross
Value Cost Profit
* $ 300,000
= $ 52,941 $ 22,059
B$150,000$105,882 $ 44,118
C$200,000$ 141,176 $ 58,824
Totals $425,000$300,000 (rd.) $125,000 (rd.)