chapter 9 inventories: special valuation issues copyright © 2010 south-western/cengage learning...

Chapter 9 Inventories: Special Valuation Issues

COPYRIGHT © 2010 South-Western/Cengage Learning

Intermediate Accounting 11th edition

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Lower of Cost or Market

The lower of cost or market rule requires that a company write down its inventory to

its market value when the inventory’s utility has declined.


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Inventory: Estimated selling price in completed condition $1,150

Less: Estimated costs to complete and sell 150Net realizable value (ceiling) $1,000Less: normal profit 100NRV less normal profit (floor) $ 900


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Lower of Cost or Market (Ex. 9-1 p. 426)

A company’s unit of inventory has the following characteristics:

Selling price $165

Packaging cost 10

Transportation cost 15

Profit margin 40

A company’s unit of inventory has the following characteristics:

Selling price $165

Packaging cost 10

Transportation cost 15

Profit margin 40

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Lower of Cost or Market Selling price $165 Cost of completion (10)Transportation cost (15)Ceiling (NRV) $140

Case 1Case 1

Ceiling $140 Normal profit (40)Floor $100

Normal Profit Margin = 40

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Current Replacement Cost = $120

Cost = $110

Market = $120

LCM is the cost of $110

Case 1Case 1Selling price $165 Cost of completion (10)Transportation cost (15)Ceiling (NRV) $140


Normal Profit Margin=$40

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Cost = $110


Case 2Case 2

Market = $140

Selling price $165 Cost of completion (10)Transportation cost (15)Ceiling (NRV) $140


Normal Profit =$40

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Cost = $110

Current Replacement

Cost = $75


Case 3Case 3

Market = $120

Selling price $165 Cost of completion (10)Transportation cost (15)Ceiling (NRV) $140



10

Lower of Cost or Market Selling price $165Cost of completion (10)Transportation cost (15)Ceiling (NRV) $140

Cost = $110


LCM is the market of

$105

Case 4Case 4

Market = $105



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Cost = $110



$90

Case 5Case 5

Market = $90


Normal Profit = $10

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Cost = $110

Current Replacement

Cost = $80


$100

Case 6Case 6

Market = $100


Normal Profit=$40

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The reduction of the value of the inventory to market and the recognition of a loss are appropriate for both a company’s balance sheet and income statement. GAAP defines assets as “probable future economic benefits.” When the cost of the inventory exceeds the expected benefits, the lower market value is a better measure of the expected benefits. In other words, an unrecoverable cost is not an asset. A company should recognize the decline in value of the inventory as a reduction in the income of the period in which the loss occurs.

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Estimating Inventory

Two commonly used methods of estimating

inventory costs are (1) the gross profit method and (2) the retail inventory method.

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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.

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.

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Expressing Gross Profit Percentages

Gross Profit Gross Profit as a Sales Percentage of Sales==

Divide gross profit by sales to calculate profit as a percentage of sales.

Expressing Gross Profit Percentages

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

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.

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Retail Inventory Method

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.


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Step 1: The total goods available for sale is computed at both cost and retail value.

Cost Retail

Beginning inventory $10,000 $ 17,000 Purchases 50,000 83,000

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

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Step 2: A cost-to-retail ratio is computed.

Cost-to-retail ratio: $ 60,000 $100,000

= 0.60

Cost Retail


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

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Step 2: A cost-to-retail ratio is computed.Step 2: A cost-to-retail ratio is computed.Step 3: The ending inventory at retail is computed.

Cost Retail


Goods available for sale $60,000 $ 100,000 Less: Sales (80,000)Ending inventory at retail $ 20,000

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Step 4: The ending inventory at cost is computed.

0.60 0.60 ×× $20,000 $20,000

Cost Retail


Goods available for sale $60,000 $ 100,000 Less: Sales (80,000)Ending inventory at retail $ 20,000Ending inventory at cost

$12,000

Retail Inventory Method Terminology

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Cost ($6)

Markup

Increased selling price to $12 Additional

MarkupOriginal selling price ($10)

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Cost ($6)

Reduced selling price to $10.25

Total Additional Markups – Total Markup Cancellations= Net Markup

Markup Cancellation

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Cost ($6)

Reduced selling price to $9

Markup Cancellation

Markdown

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Cost ($6)

Increased selling price to $9.60

Markdown Cancellation

Total Additional Markdowns – Total Markdown Cancellations= Net Markdown


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For methods using cost, such as average cost, FIFO and LIFO, the net markdowns are included in calculating the cost-to-retail ratio.

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Retail Inventory Method — FIFO

FIFO

The FIFO method excludes the beginning inventory in determining the cost-to-retail ratio.

Retail Inventory Method — FIFO

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Cost RetailPurchases $40 $ 80 Net markups 5 Net markdowns (10)

$40 $ 75

Ending inventory at FIFO cost (0.533 × $44) = $23.45

Beginning inventory 20 35 Goods available for sale $60 $110 Less: Sales (66)Ending inventory at retail $ 44

$40$75

= 0.533

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Retail Inventory Method — Average Cost

Average Cost

The average cost method includes the beginning inventory in determining the cost-to-retail ratio.

Retail Inventory Method — Average Cost

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Beginning inventory $20 $ 35 Purchases 40 80 Net markups 5 Net markdowns (10)Goods available for sale $60 $110 Less: Sales (66)Ending inventory at retail $ 44

Cost Retail

$60$110

= 0.545

Ending inventory at average cost (0.545 × $44) = $24

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Retail Inventory Method — LIFO

LIFO

Separate cost-to-retail ratios for the beginning inventory and the purchases must be calculated for the LIFO method.

Retail Inventory Method — LIFO

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Purchases 40 80 Net markups 5 Net markdowns (10)

75 Goods available for sale $60 $110 Less: Sales (66)Ending inventory at retail $ 44

Cost Retail

Beginning inventory $20 $ 35 $20$35

= 0.57

$35 × 0.57 (beginning inventory layer)

$20.00$ 9 × 0.533 (added layer)

4.80Ending inventory at LIFO cost

$24.80

$40$75

= 0.533

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Retail Inventory Method — Lower of Average Cost or Market


The lower of cost or market method includes the beginning inventory, but excludes any net markdowns in determining the cost-to-retail ratio.

Net markdowns (10)Goods available for sale $60 $110 Less sales (66)Ending inventory at retail $ 44

Retail Inventory Method — Lower of Average Cost or Market

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Beginning inventory $20 $ 35 Purchases 40 80 Net markups 5

$60 $120

$60$120

= 0.50

Cost Retail

Ending inventory at lower of cost or market (0.50 × $44) = $22

Conceptual Evaluation — Lower of Average Cost or Market

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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 items 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.

Dollar-Value LIFO Retail Method

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Information for following slides


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Cost Retail

Beginning inventory $ 8,000 $ 12,000 Purchases 20,400 32,000 Net markups 3,000 Net markdowns (1,000) Goods available for sale $28,400 $ 46,000 Sales (29,800)Ending inventory at retail $ 16,200

Step 1: Calculate the ending inventory at retail.

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Ending Inventory at Base-Year

Retail Prices

=Ending

Inventory at Retail

×Current-Year Price Index

Base-Year Price Index

$15,000 = $16,200 ×100

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Step 2: Compute ending inventory to base-year retail prices by applying the base-year conversion index.

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Ending inventory at base-year retail price……Beginning inventory, 1/1/2010Increase

$15,000 12,000$ 3,000

Step 3: The increase (decrease) in the inventory at retail is computed by comparing the ending inventory with the beginning inventory.

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Step 4: The increase (decrease) in the inventory at retail is converted to current-year retail prices.

Step 4: The increase (decrease) in the inventory at retail is converted to current-year retail prices.

Layer Increase at Current-Year Retail

Prices

=

Increase at Base-Year

Retail Prices

×Current-Year Price Index

Base-Year Price Index

$3,240 = $3,000 ×108

100

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$3,240 × 0.60 = $1,944

Step 5: The increase (decrease) at current-year retail prices is converted to cost.

Step 5: The increase (decrease) at current-year retail prices is converted to cost.

Cost of purchases was $20,400 in 2010 while purchases adjusted for net markups and net markdowns was $34,000 (32,000 +

$3,000 – $1,000)

$20,400 ÷ $34,000 = 60%

Cost of purchases was $20,400 in 2010 while purchases adjusted for net markups and net markdowns was $34,000 (32,000 +

$3,000 – $1,000)

$20,400 ÷ $34,000 = 60%


• Step 6: The ending inventory at cost is computed by adding (subtracting) the increase (decrease) at cost to the beginning inventory at cost. $1,944 + $8,000 = $9,944

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Beginning Inventory at Cost

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