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 • Valuation using relative sales value method
Lower-of-Cost-or-Market 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.
Lower-of-Cost-or-Market LCM A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. • Market = Replacement Cost • Lower of Cost or Replacement Cost • Loss should be recorded when loss occurs, not in the period of sale.
Lower-of-Cost-or-Market Ceiling and Floor Why use Replacement Cost (RC) for Market? • Decline in the RC usually = decline in selling price. • If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used: • Ceiling - net realizable value and • Selling Price less costs of completion & disposal • Floor- net realizable value less a normal profit margin. • Net realizable value less a normal profit margin
Lower-of-Cost-or-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.
Lower-of-Cost-or-Market How LCM Works (Individual Items) Illustration 9-5
Lower-of-Cost-or-Market Methods of Applying LCM Illustration 9-6
Lower-of-Cost-or-Market 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 inventory 65,000 Allowance Method Allowance on inventory 65,000 Direct Method Cost of goods sold 65,000 Inventory 65,000
Recording a Decline in Market Value • Under the allowance method, an entry is made debiting a loss and crediting an allowance account for the difference between cost and market. 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. • The direct method substitutes the market value figure for cost when valuing the inventory. Thus, the loss is buried in the cost of goods sold and no individual loss account is reported in the income statement.
Lower-of-Cost-or-Market Balance Sheet Presentation
Lower-of-Cost-or-Market Income Statement Presentation
Purchase Commitments 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.
Purchase Commitments • Purchase commitments represent contracts for the purchase of inventory at a specified price in a future period. • Date of inception: no asset or liability is recorded However, if material, the details of the contract should be disclosed in a note of the buyer's balance sheet . • If a noncancelable contract, any losses should be recognized in the period during which the market decline takes place.
Purchase Commitments • In the early 1980s many Northwest forest product companies (Boise Cascade, Georgia-Pacific, Weyerhaeuser, and St. Regis Paper Co.) signed long-term timber-cutting contracts with the U.S. Forest Service. These contracts required that the companies pay $310 per thousand board feet for timber-cutting rights. • The market price for timber-cutting rights in late 1984 dropped to $80 per thousand board feet. Therefore, these companies had long-term contracts that projected substantial future losses.
Purchase Commitments 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)
Purchase Commitments 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
Purchase Commitments 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 Cash 10,000,000
Gross Profit Method • The gross profit method is used to estimate cost of ending inventory. • This method is not appropriate for financial reporting purposes; however, it can serve a useful purpose when an approximation of ending inventory is needed. • This method is used also when an estimate is needed due to a casualty loss.
Gross Profit Method Substitute Measure to Approximate Inventory Relies on Three Assumptions: • Beginning inventory plus purchases equal total goods to be accounted for. • Goods not sold must be on hand. • (3) The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.
Gross Profit Method 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. Instructions: (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.
Gross Profit Method E9-12 (Gross Profit Method - Solution) (a)Compute the estimated inventory assuming gross profit is 30% of sales.
Gross Profit Method E9-12 (Gross Profit Method - Solution) (b)Compute the estimated inventory assuming gross profit is 30% of cost. 30% 100% + 30% = 23.08% of sales
Gross Profit Method Evaluation: Disadvantages: • Provides an estimate of ending inventory. • Uses past percentages in calculation. • A blanket gross profit rate may not be representative. • Only acceptable for interim (generally quarterly) reporting purposes.
Retail Inventory Method 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.
Retail Inventory Method Requires retailers to keep: • total cost and retail value of goods purchased • total cost and retail value of the goods available for sale • sales for the period. Is appropriate for retail concerns with: • high volume sales and • different types of merchandise. The steps are: • determine ending inventory at retail price • convert this amount to a cost basis using a cost-to-retail ratio
Markups, Markdowns and Cancellations 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.
Markups, Markdowns and Cancellations • We ignore markdowns and markdown cancellations when computing the cost to retail ratio using LCM. • Why? • This is designed to approximate the LCM • Markup normally indicate that the market value of the item has increased. • Markdown indicates that a decline in the utility of that item has occurred. • If we attempt to approximate the LCM, markdowns are considered a current loss and are not involved in the calculation. Thus, the cost-to-retail is lower (when excluding markdowns).
Retail Inventory Method 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. Instructions: Prepare a schedule computing estimate retail inventory using the LCM conventional retail method:
Retail Inventory Method Evaluation: Widely used for the following reasons: • to permit the computation of net income without a physical count of inventory, • as a control measure in determining inventory shortages, • in regulating quantities of merchandise on hand, and • for insurance information. Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits.
Valuation Basis: Relative Sales Value • Relative sales values are an appropriate basis, when basket purchases are made. • Basket purchases involve a group of varying units. • The purchase price is paid as a lump sum amount. • The lump sum price is allocated to units on the basis of their relative sales values.
Valuation Basis: Relative Sales Value 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?
Valuation Basis: Relative Sales Value Lot Sales Allocated Gross Value Cost Profit A $75,000 ($75,000/$425,000) * $ 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.)