9-1 prepared by coby harmon university of california, santa barbara intermediate accounting

9-1

Prepared by Coby Harmon

University of California, Santa Barbara

Intermediate Accounting

9-2

Intermediate Accounting

14th Edition

9Inventories: Additional Valuation Issues

Kieso, Weygandt, and Warfield

9-3

Net realizable value

Relative sales value

Purchase commitments

Lower-of-Cost-or-Market

Valuation Bases

Gross Profit Method

Retail Inventory Method

Presentation and Analysis

Ceiling and floor

How LCM works

Application of LCM

“Market”

Use of an allowance

Multiple periods

Evaluation of rule

Gross profit percentage

Evaluation of method

Concepts

Conventional method

Special items

Evaluation of method

Presentation

Analysis

Inventories: Additional Valuation IssuesInventories: Additional Valuation IssuesInventories: Additional Valuation IssuesInventories: Additional Valuation Issues

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Market = Replacement Cost

Lower of Cost or Replacement Cost

Loss should be recorded when loss occurs, not in the

period of sale.

A company abandons the historical cost principle when

the future utility (revenue-producing ability) of the asset

drops below its original cost.

Lower-of-Cost-or-MarketLower-of-Cost-or-MarketLower-of-Cost-or-MarketLower-of-Cost-or-Market

LO 1 Describe and apply the lower-of-cost-or-market rule.

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LO 1

Illustration 9-1

9-6

Decline in the RC usually = decline in selling price.

RC allows a consistent rate of gross profit.

If reduction in RC fails to indicate reduction in utility, then

two additional valuation limitations are used:

► Ceiling - net realizable value and

► Floor - net realizable value less a normal profit margin.

Why use Replacement Cost (RC) for Market?



Ceiling and Floor

9-7

Net realizable value (NRV) is the is the estimated selling

price in the ordinary course of business, less reasonably

predictable costs of completion and disposal (often referred

to as net selling price).Illustration 9-2



9-8

NotNot<<

CostCost MarketMarket

Ceiling = NRVCeiling = NRV

ReplacementCost

ReplacementCost

Floor =NRV less Normal

Profit Margin

Floor =NRV less Normal

Profit MarginGAAPLCM

GAAPLCM

What is the rationale for the

Ceiling and Floor limitations?



NotNot>>

Illustration 9-3

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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.



Limitations

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How LCM Works (Individual Items)Illustration 9-5

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Methods of Applying LCMIllustration 9-6

9-12 LO 1 Describe and apply the lower-of-cost-or-market rule.


Ending inventory (cost) $ 82,000

Ending inventory (market) 70,000

Adjustment to LCM $ 12,000

Loss MethodLoss

Method

COGSMethodCOGSMethod

Recording “Market” Instead of Cost

9-13

Loss COGS

Method Method

Current assets:

Cash 100,000$ 100,000$

Accounts receivable 350,000 350,000

Inventory 770,000 (758,000)

Less: inventory allowance (12,000)

Prepaids 20,000 20,000

Total current assets 1,175,000 1,175,000



Balance Sheet Presentation

9-14

Loss COGS

Method Method

Sales 300,000$ 300,000$

Cost of goods sold 120,000 132,000

Gross profit 180,000 168,000

Operating expenses:

Selling 45,000 45,000

General and administrative 20,000 20,000

Total operating expenses 65,000 65,000

Other revenue and (expense):

Loss on inventory (12,000) -

Interest income 5,000 5,000

Total other (7,000) 5,000

Income from operations 108,000 108,000

Income tax expense 32,400 32,400

Net income 75,600$ 75,600$

LO 1


Income Statement Presentation

9-15

P9-1: Remmers Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2012, the following finished desks appear in the company’s inventory.

The 2012 catalog was in effect through November 2012, and the 2013 catalog is effective as of December 1, 2012.

Instructions: At what amount should each of the four desks appear in the company’s December 31, 2012, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of inventories on an individual-item basis?



9-16



Finished Desks A

Inventory cost 470$

Est. cost to manufacture 460

Commissions and disposal costs 50

Catalog selling price 500

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Finished Desks B

Inventory cost 450$




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Finished Desks C

Inventory cost 830$




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Finished Desks D

Inventory cost 960$

Est. cost to manufacture 1,000


Catalog selling price 1,200

9-20 LO 1 Describe and apply the lower-of-cost-or-market rule.

Use of an Allowance—Multiple Periods


In general, accountants leave the allowance account on the

books. They merely adjust the balance at the next year-end to

agree with the discrepancy between cost and the lower-of-

cost-or-market at that balance sheet date.Illustration 9-10

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Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale.

Inventory valued at cost in one year and at market in the next year.

Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize.

LCM uses a “normal profit” in determining inventory values, which is a subjective measure.

Some Deficiencies:



Evaluation of LCM Rule

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(1) a controlled market with a quoted price applicable to all quantities, and

(2) no significant costs of disposal (rare metals and agricultural products)

or

(3) too difficult to obtain cost figures (meatpacking).

Permitted by GAAP under the following conditions:

Valuation BasesValuation BasesValuation BasesValuation Bases

Valuation at Net Realizable Value

LO 2 Explain when companies value inventories at net realizable value.

9-23

Used when buying varying units in a single lump-sum purchase.


Valuation Using Relative Sales Value

E9-7: Larsen Realty Corporation purchased a tract of unimproved land for $55,000. This land was improved and subdivided into building lots at an additional cost of $30,000. These building lots were all of the same size but owing to differences in location were offered for sale at different prices as follows. Operating expenses allocated to this project total $18,200.

Instructions: Calculate the net income realized on this operation to date.

No. of Price Lots Unsold

Group Lots per Lot at Year-End

1 9 3,000$ 5

2 15 4,000 7

3 19 2,000 2

LO 3 Explain when companies use the relative sales value method to value inventories.

9-24


E9-7 (Relative Sales Value Method):

No. of Price Selling Relative Total Cost Cost

Group Lots per Lot Price Sales Price Cost Allocated Per Lot

1 9 3,000$ 27,000$ $27,000/125,000 85,000$ 18,360$ 2,040$

2 15 4,000 60,000 60,000/125,000 85,000 40,800 2,720

3 19 2,000 38,000 38,000/125,000 85,000 25,840 1,360

125,000$ 85,000$

Lots Price Total Cost Total Cost Calculation of Net IncomeGroup Sold per Lot Sales Per Lot of Goods Sales 78,000$

1 4 3,000$ 12,000$ 2,040$ 8,160$ Cost of good sold 53,040

2 8 4,000 32,000 2,720 21,760 Gross profit 24,960

3 17 2,000 34,000 1,360 23,120 Expenses 18,200

78,000$ 53,040$ Net income 6,760$

xx == xx ==

==xx

LO 3 Explain when companies use the relative sales value method to value inventories.

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► Generally seller retains title to the merchandise.

► Buyer recognizes no asset or liability.

► If material, the buyer should disclose contract details in

footnote.

► If the contract price is greater than the market price,

and the buyer expects that losses will occur when the

purchase is effected, the buyer should recognize a

liability and a corresponding loss in the period during

which such declines in market prices take place.


LO 4 Discuss accounting issues related to purchase commitments.

Purchase Commitments—A Special Problem

9-26



Illustration: St. Regis Paper Co. signed timber-cutting contracts

to be executed in 2013 at a price of $10,000,000. Assume

further that the market price of the timber cutting rights on

December 31, 2012, dropped to $7,000,000. St. Regis would

make the following entry on December 31, 2012.

Other income and expense in the Income statement.

Current liabilities on the statement of financial position.

9-27



Purchases (Inventory) 7,000,000

Purchase Commitment Liability 3,000,000

Cash 10,000,000

Assume the government permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000.

Purchase Commitment Liability 1,000,000

Unrealized Holding Gain or Loss—Income 1,000,000

Illustration: When St. Regis cuts the timber at a cost of $10

million, it would make the following entry.

9-28

Relies on Three Assumptions:

Gross Profit Method of Estimating InventoryGross Profit Method of Estimating InventoryGross Profit Method of Estimating InventoryGross Profit Method of Estimating Inventory

LO 5 Determine ending inventory by applying the gross profit method.

Substitute Measure to Approximate Inventory

(1) Beginning inventory plus purchases equal total goods to

be accounted for.

(2) 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.

9-29

Gross Profit MethodGross Profit MethodGross Profit MethodGross Profit Method


Illustration: Cetus Corp. has a beginning inventory of $60,000

and purchases of $200,000, both at cost. Sales at selling price

amount to $280,000. The gross profit on selling price is 30

percent. Cetus applies the gross margin method as follows.

Illustration 9-14

9-30



Computation of Gross Profit PercentageIllustration 9-17

9-31

E9-12: Astaire 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 25% of sales.

(b) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of cost.

Inventory, May 1 160,000$ Purchases (gross) 640,000 Freight-in 30,000 Sales 1,000,000 Sales returns 70,000 Purchase discounts 12,000


LO 5

9-32

E9-12 (Solution):

Inventory, May 1 (at cost) $ 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at selling price) $ 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000

Less gross profit (25% of $930,000) 232,500

Sales (at cost) 697,500

Approximate inventory, May 31 (at cost) $ 120,500

(a) Compute the estimated inventory assuming gross profit is 25% of sales.



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(b) Compute the estimated inventory assuming gross profit is 25% of cost.

E9-12 (Solution):

Inventory, May 1 (at cost) $ 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at selling price) $ 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000

Less gross profit (20% of $930,000) 186,000

Sales (at cost) 744,000

Approximate inventory, May 31 (at cost) $ 74,000



25%

100% + 25%= 20% of sales

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Disadvantages:



(1) Provides an estimate of ending inventory.

(2) Uses past percentages in calculation.

(3) A blanket gross profit rate may not be representative.

(4) Normally unacceptable for financial reporting purposes.

GAAP requires a physical inventory as additional

verification.

Evaluation of Gross Profit Method

9-35

Retail Inventory MethodRetail Inventory MethodRetail Inventory MethodRetail Inventory Method

LO 6 Determine ending inventory by applying the retail inventory method.

A method used by retailers, to value inventory without a

physical count, by converting retail prices to cost.

(1) Total cost and retail value of goods purchased.

(2) Total cost and retail value of the goods available for

sale.

(3) Sales for the period.

Requires retailers to keep:

Methods Conventional Method Cost Method LIFO Dollar-value LIFO

9-36

P9-8: Fuque 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 2013.


COST RETAILBeg. inventory, Oct. 1 52,000$ 78,000$ Purchases 272,000 423,000 Freight in 16,600 Purchase returns 5,600 8,000 Additional markups 9,000 Markup cancellations 2,000 Markdowns (net) 3,600 Normal spoilage 10,000 Sales 390,000

Instructions:

Prepare a schedule computing estimate retail inventory using the following methods:

(1) Conventional

(2) Cost


9-37



P9-8 Solution - CONVENTIONAL Method:Cost to

COST RETAIL Retail %Beg. inventory 52,000$ 78,000$ Purchases 272,000 423,000 Freight in 16,600 Purchase returns (5,600) (8,000) Markups, net 7,000

Current year additions 283,000 422,000 Goods available for sale 335,000 500,000 67.00% Markdowns, net (3,600)

Normal spoilage (10,000) Sales (390,000) Ending inventory at retail 96,400$

Ending inventory at Cost:96,400$ x 67.00% = 64,588$

==//

9-38



P9-8 Solution - COST Method:Cost to

COST RETAIL Retail %Beg. inventory 52,000$ 78,000$ Purchases 272,000 423,000 Freight in 16,600 Purchase returns (5,600) (8,000) Markdowns, net (3,600) Markups, net 7,000

Current year additions 283,000 418,400 Goods available for sale 335,000 496,400 67.49%

Normal spoilage (10,000) Sales (390,000) Ending inventory at retail 96,400$

Ending inventory at Cost:96,400$ x 67.49% = 65,056$

==//

9-39



Freight costs

Purchase returns

Purchase discounts and allowances

Transfers-in

Normal spoilage

Abnormal shortages

Employee discounts

Special Items Relating to Retail Method

9-40

Special Items


LO 6

Illustration 9-23

9-41

Widely used for the following reasons:

(1) To permit the computation of net income without a physical count of inventory.

(2) Control measure in determining inventory shortages.

(3) Regulating quantities of merchandise on hand.

(4) Insurance information.



Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits.

Evaluation of Retail Inventory Method

9-42

Accounting standards require disclosure of:

Presentation and AnalysisPresentation and AnalysisPresentation and AnalysisPresentation and Analysis

LO 7 Explain how to report and analyze inventory.

Presentation of Inventories

(1) Composition of the inventory, inventory financing arrangements, and the inventory costing methods employed.

(2) Consistent application of costing methods from one period to another.

(3) Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes.

9-43

Accounting standards require disclosure of:




(4) Significant or unusual financing arrangements relating to inventories.

(5) Companies should present inventories pledged as collateral for a loan in the current assets section rather than as an offset to the liability.

(6) Basis on which it states inventory amounts (lower of-cost-or-market) and the method used in determining cost (LIFO, FIFO, average cost, etc.).

9-44




Illustration 9-24Disclosure of InventoryMethods

9-45


LO 7

Illustration 9-25Disclosure of Trade Practice in Valuing Inventories


9-46



Common ratios used in the management and evaluation of

inventory levels are inventory turnover and average days

to sell the inventory.

Analysis of Inventories

9-47

Measures the number of times on average a company

sells the inventory during the period.



Inventory Turnover Ratio

Illustration 9-26

Illustration: In its 2009 annual report Kellogg Company reported

a beginning inventory of $897 million, an ending inventory of $910

million, and cost of goods sold of $7,184 million for the year.

9-48

Measure represents the average number of days’ sales

for which a company has inventory on hand.



Average Days to Sell Inventory

365 days / 7.95 times = every 45.9 days

Average Days to Sell

Illustration 9-26

9-49 LO 8 Determine ending inventory by applying the LIFO retail methods.

Primary reason to use LIFO

Tax advantages.

Results in a better matching of costs and revenues.

The use of LIFO retail is made under two assumptions:

1. stable prices and

2. fluctuating prices.

APPENDIXAPPENDIX 9A LIFO RETAIL METHODS


Stable Prices—LIFO Retail Method

A major assumption of the LIFO retail method is that the

markups and markdowns apply only to the goods purchased

during the current period and not to the beginning inventory.

Beginning inventory is excluded from the cost-to-retail

percentage.



Illustration 9A-1LIFO Retail Method—Stable Prices

APPENDIX 9A LIFO RETAIL METHODS


Illustration 9A-2Ending Inventory at LIFO Cost, 2012—Stable Prices

Inventory is composed of two layers.



Illustration 9A-3Ending Inventory at LIFO Cost, 2013—Stable Prices


Assume that the ending inventory for 2013 at retail is $50,000. Notice that the 2012 layer is reduced from $11,000 to $5,000.


Fluctuating Prices—Dollar-Value LIFO Retail

If the price level does change, the company must eliminate

the price change so as to measure the real increase in

inventory, not the dollar increase.



Illustration: Assume that the beginning inventory had a retail market

value of $10,000 and the ending inventory had a retail market value of

$15,000. Assume further that the price level has risen from 100 to 125.

It is inappropriate to suggest that a real increase in inventory of

$5,000 has occurred. Instead, the company must deflate the ending

inventory at retail.Illustration 9A-4


9-56

Illustration: Assume that the current 2010 price index is 112

(prior year 100) and that the inventory ($56,000) has remained

unchanged.Illustration 9A-5

Dollar-Value LIFO Retail Method—

FluctuatingPrices


LO 8


Illustration: From this information, we compute the inventory amount at cost:

Illustration 9A-6

Hernandez must restate layers of a particular year to the prices in effect in the year when the layer was added.



Illustration 9A-7

Comparison of Effect of Price Assumptions


9-59 LO 8

Illustration: Using the data from the previous example, assume that

the retail value of the 2013 ending inventory at current prices is

$64,800, the 2013 price index is 120 percent of base-year, and the

cost-to-retail percentage is 75 percent. Compute the ending inventory

at LIFO cost.Illustration 9A-8

Subsequent Adjustments under Dollar-Value LIFO Retail


9-60

Illustration: Conversely assume that in 2011 the ending inventory in

base-year prices is $48,000. Compute the ending inventory at LIFO

cost.Illustration 9A-9

Subsequent Adjustments under Dollar-Value LIFO Retail


LO 8 Determine ending inventory by applying the LIFO retail methods.


Changing from Conventional Retail to LIFO

Illustration: Hackman Clothing Store employs the conventional

retail method but wishes to change to the LIFO retail method

beginning in 2013. The amounts shown by the firm’s books are as

follows.


9-62

Conventional Retail Inventory Method Illustration 9A-10


LO 8

9-63

Illustration 9A-11

Hakeman Clothing can then quickly approximate the ending inventory for 2012 under the LIFO retail method.

The difference of $500 ($11,250 - $10,750) between the LIFO retail method and the conventional retail method is the amount by which the company must adjust beginning inventory for 2013.

LO 8 Determine ending inventory by applying the LIFO retail methods.


9-64

RELEVANT FACTS

Goods in transit, consigned goods, special sales agreements—as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.

GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.

9-65

RELEVANT FACTS

Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement.

IFRS requires both biological assets and agricultural produce at the point of harvest to be reported to net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards.

9-66

All of the following are key similarities between GAAP and IFRS with

respect to accounting for inventories except:

a. costs to include in inventories are similar.

b. LIFO cost flow assumption where appropriate is used by both

sets of standards.

c. fair value valuation of inventories is prohibited by both sets of

standards.

d. guidelines on ownership of goods are similar.

IFRS SELF-TEST QUESTION

9-67

All of the following are key differences between GAAP and IFRS with

respect to accounting for inventories except the:

a. definition of the lower-of-cost-or-market test for inventory

valuation differs between GAAP and IFRS.

b. average cost method is prohibited under IFRS.

c. inventory basis determination for write-downs differs between

GAAP and IFRS.

d. guidelines are more principles based under IFRS than they are

under GAAP.

IFRS SELF-TEST QUESTION

9-68

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9-1 prepared by coby harmon university of california, santa barbara intermediate accounting

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