inventories: special valuation issues c hapter 9 an electronic presentation by norman sunderman...

Inventories: Special Valuation Issues

Chapter9

An electronic presentation by Norman Sunderman Angelo State University

An electronic presentation by Norman Sunderman Angelo State University

COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Intermediate AccountingIntermediate Accounting 10th edition 10th edition

Nikolai Bazley JonesNikolai Bazley Jones

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

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

Lower of Cost or Market

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Definitions

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

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

ContinueContinueContinueContinue

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Reporting the Results

Balance sheet: Inventory at

LCM

Income statement:

Loss (if recognized)


Comparison to Cost

Use lower of (a) cost or(b) selected market value

Selection of Market Value

Ceiling (Net Realizable Value)

Replacement Cost

Floor (Net Realizable Value -

Normal Profit)

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

Ceiling (NRV) $140 Normal profit (40)Floor $100

Normal Profit = $40Normal Profit = $40

Case 1Case 1


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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



What is market?

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Current Replacement

Cost, $150

Cost $110

What is market?


Case 2Case 2

$140Normal Profit = $40Normal Profit = $40




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Cost $110

What is market?

Current Replacement

Cost, $75


Case 3Case 3

Mkt. = $120


Ceiling $140 Normal profit (20)Floor $120



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Try one more.Try one more.

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

Cost $110

What is market?

Current Replacement

Cost, $105Normal Profit = $40Normal Profit = $40

LCM is the market of

$105

Case 4Case 4

$105


Ceiling $140 Normal profit (40)Floor $100

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Inventory Cost MarketCategory A:

Item 1 $1,000 $ 700 $ 700Item 2 1,200 1,300 1,200

$2,200 $2,000Category B:

Item 3 $2,000 $2,400 2,000Item 4 2,500 2,200 2,200

$4,500 $4,600Total $6,700 $6,600Inventory valuation $6,100

Individual Items

Loss recognition,

$600

Loss recognition,

$600


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Item 1 $1,000 $ 700Item 2 1,200 1,300

$2,200 $2,000 $2,000Category B:

Item 3 $2,000 $2,400Item 4 2,500 2,200

$4,500 $4,600 4,500Total $6,700 $6,600Inventory valuation $6,500

Category

Loss recognition,

$200

Loss recognition,

$200


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Item 1 $1,000 $ 700Item 2 1,200 1,300

$2,200 $2,000Category B:

Item 3 $2,000 $2,400Item 4 2,500 2,200

$4,500 $4,600Total $6,700 $6,600 $6,600Inventory valuation $6,600

Total

Loss recognition,

$100

Loss recognition,

$100


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Recording the Reduction of Inventory to CostRecording the Reduction of Inventory to Cost

Cost MarketDecember 31, 2006 $20,000 $20,000December 31, 2007 25,000 22,000December 31, 2008 30,000 28,000

Cost MarketDecember 31, 2006 $20,000 $20,000December 31, 2007 25,000 22,000December 31, 2008 30,000 28,000

Assume the company uses a periodic system.

Assume the company uses a periodic system.


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See Example 9-1on page 416.

See Example 9-1on page 416.

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To lock in prices and assure sufficient quantities of materials, companies often contract with suppliers to purchase a specified quantity of materials in the

future at an agreed upon unit cost.

To lock in prices and assure sufficient quantities of materials, companies often contract with suppliers to purchase a specified quantity of materials in the

future at an agreed upon unit cost.

See page 424.See page 424.

Purchase Obligations

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See page 343See page 343

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Valuation 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.

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.

In exceptional cases inventories properly may be stated above cost.

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Gross Profit Method

1. To determine the cost of the inventory at the end of an interim period without taking a physical count.

2. For the internal or external auditor to check the reasonableness of an inventory value developed from a physical inventory or perpetual inventory system.

ContinuedContinuedContinuedContinued

A company uses the gross profit method in the following situations:

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3. To estimate the cost of inventory that is destroyed by a casualty.

4. To estimate the cost of inventory from incomplete records.

5. To develop a budget of cost of goods sold and ending inventory from a sales budget.

A company uses the gross profit method in the following situations:

Gross Profit Method

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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).

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).

Assume 40%.

Assume 40%.

Gross Profit Method

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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.

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.

Net sales $130,000

Gross profit rate .40

Estimated gross profit $ 52,000

Gross Profit Method

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Step 3: The estimated gross profit is subtracted from the actual net sales to determine the estimated cost of goods sold for the period.

Step 3: The estimated gross profit is subtracted from the actual net sales to determine the estimated cost of goods sold for the period.

Net sales $130,000

Estimated gross profit (from

Slide 32) (52,000 )

Estimated cost of goods sold$ 78,000

Gross Profit Method

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Step 4: Subtract the estimated cost of goods sold from the actual cost of goods available for sale.

Step 4: Subtract the estimated cost of goods sold from the actual cost of goods available for sale.

Beginning inventory $ 10,000 Net purchases 90,000 Cost of goods available for sale $100,000 Less: Estimated cost of goods sold

Net sales $130,000Estimated gross profit (52,000) (78,000)

Estimated cost of ending inventory $ 22,000

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

Expressing Gross Profit Percentages

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

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

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Expressing Gross Profit Percentages

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

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

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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.

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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Retail Inventory Method

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

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

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

= 0.60

Cost RetailBeginning inventory $ 10,000 $ 17,000 Purchases 50,000 83,000 Goods available for sale $ 60,000 $100,000



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Cost Retail

Step 3: The ending inventory at retail is computed.

Step 3: The ending inventory at retail is computed.


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

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Cost RetailBeginning 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

$12,000

Cost Retail

Step 4: The ending inventory at cost is computed.

Step 4: The ending inventory at cost is computed.


0.60 x $20,0000.60 x $20,000

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Retail Inventory Method Terminology

Cost ($6)

Markup

Increased selling price to $11 Additional

MarkupOriginal selling price

($10)

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Cost ($6)

Reduced selling price to $10.25

Net markup =Total additional markups - total markup cancellations

Markup Cancella

-tion


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Cost ($6)

Reduced selling price to $9

Markup Cancella

-tion

Mark-down


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Cost ($6)

Increased selling price to $9.60

Markdown Cancellation

Net markdown =Total additional markdowns - total markdown cancellations


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For methods using cost, such as average cost,

FIFO and LIFO, the net markdowns are

included in calculating the ratio.

For methods using cost, such as average cost,

FIFO and LIFO, the net markdowns are

included in calculating the ratio.

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Average Cost

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

ratio.

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

ratio.

Retail Inventory Method--Average Cost

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Retail Inventory Method--Average Cost

Cost RetailBeginning inventory $20 $ 35 Purchases 40 80 Net markups 5 Net markdowns (10)Goods available for sale $60 $110

$60

$110= 0.545

Ending inventory, average cost (0.545 x $44) = $23.98

Less sales (66)Ending inventory at retail $ 44

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The lower of cost or market method includes the beginning inventory,

but excludes any net markdowns in determining the cost-to-retail ratio.

The lower of cost or market method includes the beginning inventory,

but excludes any net markdowns in determining the cost-to-retail ratio.

Retail Inventory Method-LCM

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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 inventory has been

sold.

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.

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.

Conceptual Evaluation-LCM

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Retail Inventory Method--LCM

Cost RetailBeginning inventory $20 $ 35 Purchases 40 80 Net markups 5

$60 $120 Net markdowns (10)Goods available for sale $60 $110 Less sales (66)Ending inventory at retail $ 44

Ending inventory at LCM (0.50 x $44) = $22

$60

$120= 0.50

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A purchase on credit is omitted from both the Purchases account and ending inventory and is

not recorded in the succeeding year.



Current YearCurrent Year

Income StatementIncome is correct.

Income StatementIncome is correct.

Balance SheetEnding inventory and Accounts Payable are understated.

Balance SheetEnding inventory and Accounts Payable are understated.

Effects of Inventory Errors

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Succeeding YearSucceeding Year

Income StatementIncome is overstated and cost of goods sold is understated.


Balance SheetAccounts Payable is understated and Retained Earnings is overstated.



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A purchase on credit is omitted from the Purchases account but ending inventory is

correct.

A purchase on credit is omitted from the Purchases account but ending inventory is

correct.

Current YearCurrent Year






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A purchase on credit is omitted from the Purchases account but ending inventory

is correct.

A purchase on credit is omitted from the Purchases account but ending inventory

is correct.

Succeeding YearSucceeding YearSucceeding YearSucceeding Year

Income StatementNo effect.

Income StatementNo effect.



Effect of Inventory Errors

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Ending inventory is over(under)stated due to quantity and/or costing errors, but the Purchases account is correct.

Ending inventory is over(under)stated due to quantity and/or costing errors, but the Purchases account is correct.

Current YearCurrent YearCurrent YearCurrent Year

Income StatementIncome is over(under)stated and cost of goods sold is under(over)stated.

Income StatementIncome is over(under)stated and cost of goods sold is under(over)stated.

Balance SheetEnding inventory and Retained Earnings are over(under)stated.

Balance SheetEnding inventory and Retained Earnings are over(under)stated.


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Succeeding YearSucceeding YearSucceeding YearSucceeding Year

Income StatementIncome is under(over)stated and cost of goods sold is over(under)stated.

Balance SheetNo effect.

Balance SheetNo effect.

Ending inventory is over(under)stated due to quantity and/or costing errors, but the

Purchases account is correct.

Ending inventory is over(under)stated due to quantity and/or costing errors, but the

Purchases account is correct.


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Chapter9

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inventories: special valuation issues c hapter 9 an electronic presentation by norman sunderman...

Documents

market slide

inventory cost market

market ceiling

current replacement

normal profitfloor

market comparison

market rule

selling price