Unformatted text preview: Inventories: Inventories: Additional Valuation Issues
Professor Dennis Chambers Ch ACC 301 Chapter 9 Objectives Objectives
Explain and apply the lower of cost or market rule Ex Identify Identify when inventories are valued at net realizable value Explain Explain when the relative sales value method is used to value inventories inventories Explain Explain accounting issues related to purchase commitments Determine Determine ending inventory by applying the gross profit method Determine Determine ending inventory by applying the retail inventory method Explain how inventory is reported and analyzed Explain how inventory is reported and analyzed 6/10/2008 ACC 301 2 Inventory Valuation Valuation
What valuation assumptions did we learn about What valuation assumptions did we learn about in in Chapter 8?
Specific identification Specific identification Average Average cost FIFO FIFO LIFO LIFO Inventory Valuation Valuation
When is historical cost abandoned? When is historical cost abandoned?
General General rule: …when the future benefits from selling the inventory is less than historical cost selling the inventory is less than historical cost Conservatism Constraint— Conservatism Constraint—When in doubt choose the accounting that will be least likely to choose the accounting that will be least likely to overstate overstate assets or earnings
In this case, conservatism constraint trumps thi tr historical cost principle All All of these are based on historical cost hi Sometimes Sometimes historical cost is not appropriate
6/10/2008 ACC 301 3 6/10/2008 ACC 301 4 Lower of Cost or Market Lower of Cost or Market
We adopt the “lower of cost or market” rule We
Usually Usually inventory is still valued at historical cost Unless, Unless, market value of the inventory has fallen below historical cost hi Why Why would that happen?
Common Common in retail clothing—out of style clothing— Casualty losses— Casualty losses—flood, etc. Lower Lower demand for a product than expected Lower of Cost or Market of Cost or Market
We need to learn three terms: We need to learn three terms:
Replacement Replacement cost:
The The current cost to replace the inventory item This This is what we use for “market value” Net Net realizable value:
The amount we can sell the inventory item for less the cost (if any) The amount we can sell the inventory item for, less the cost (if any) to to prepare the inventory for sale This This is the net sales price of the inventory General principle: General principle:
When When the market value of inventory drops below historical cost, write the inventory down to market value Normal profit:
This This is the amount of profit we normally make on each item of this type of inventory 6/10/2008 ACC 301 5 6/10/2008 ACC 301 6 Lower of Cost or Market of Cost or Market
Implementation of the LCM Rule: Implementation of the LCM Rule:
1. 2. 3. 4. Why have a ceiling and floor? have ceiling and floor?
Ceiling: NRV Potential profit from profit from future sales Normal Profit Profit Determine the replacement cost Determine the net realizable value Determine the normal profit Market equals replacement cost subject to an upper limit (“ceiling”) and a lower limit (“floor”)
Upper Upper limit = net realizable value (NRV) Lower limit = NRV – normal profi li NRV fit Replacement Cost 5. If Market is lower than historical cost then value inventory at market inventory at market.
ACC 301 7 6/10/2008 Floor: NRV – Normal Profit fi
ACC 301 8 6/10/2008 What What happens if “market” is above the the ceiling?
Replacement Cost Future sales result in a sales result in loss Ceiling: NRV We want to record the total total loss of value when of value when we write inventory down to market What happens if “market” is below the the floor?
Ceiling: NRV Normal Profit Floor: NRV – Normal Profit fi Future sales result in a greater than normal profit profit We don’t want profits to be “created” in the future by taking larger than by taking a larger than needed loss today Replacement Cost
Floor: NRV – Normal Profit fi
6/10/2008 ACC 301 9 6/10/2008 ACC 301 10 Summary of LCM of LCM Applying LCM LCM
Most firms apply LCM to individual products Most firms apply LCM to individual products
Tax Tax code encourages individual application Most Most conservative method GAAP GAAP permits applying LCM to categories of products or to total inventory
Larger Larger pools of items reduces chance of inventory writewrite-downs Drops Drops in value are offset by increases in other products
6/10/2008 ACC 301 11 6/10/2008 ACC 301 12 Example of LCM Example of LCM
Item A Estimated selling price Historical cost Replacement cost Estimated selling expense N ormal profit Replacement Cost N RV - Normal P rofit (floor) Market Historical Cost LCM $ $ $ $ $ $ 700 575 600 50 100 600 650 550 600 575 575 $ $ $ $ $ $ Item B $ 820 700 550 80 150 550 740 590 590 700 590 Item C $1,250 1,180 1,100 100 300 P ooled $ 1,100 $ 1,150 $ 850 $ 2,290 $ 2,455 $ 2,290 $ 1,100 $ 1,180 $ 1,100 Net Realizable Value (ceiling) $ IFRS Differences IFRS Differences
IFRS uses lower of cost or market valuation IFRS uses lower of cost or market valuation— same as US GAAP US GAAP prohibits re-valuation of inventory US GAAP prohibits re valuation of inventory upward upward if the market value increases in the future future IFRS IFRS requires re-valuation upward if market revalue increases Total Indi vidual LCM: $
ACC 301 13 6/10/2008 ACC 301 14 In-Class Exercise #1 Exercise #1
Let’s pause and do exercise #1 Let pause and do exercise #1 Applying LCM LCM
Two methods to account for the reduction to market Two methods to account for the reduction to market
Direct Direct method
Directly Directly reduce inventory by the amount of the write-down writeLoss Loss on reduction in value is part of COGS Indirect Indirect method (Allowance method)
Use an allowance account to reduce net inventories Use an allowance account to reduce net inventories Allowance Allowance account is a “contra” asset account Loss Loss on reduction in value is reported separately from COGS Loss Loss not included in gross profit 6/10/2008 ACC 301 15 6/10/2008 ACC 301 16 Example of Applying LCM Example of Applying LCM
Facts: Beginning Inventory Purchases Ending Inventory At cost At Market $ 120,000 $ 120,000 75,000 75,000 85,000 65,000 Direct Method Periodic System: At end of period: Ending inventory Cost of goods sold Purchases Purchases Beginning inventory Indirect Method Periodic System: At end of period: Ending inventory Cost of goods sold Purchases Purchases Beginning inventory Loss due to market decline in inventory Allowance for reduction to Allowance for reduction to market Perpetual System: Cos t of goods sold Inventory
6/10/2008 In In-Class Exercise #2 Exercise #2
Let’s pause and do exercise #2 Let pause and do exercise #2 65,000 130,000 75, 000 120,000 85,000 110,000 75, 000 120,000 20,000 20,000 20, 000 20,000
ACC 301 Perpetual System: Loss due to market decline in inventory Allowance for reduction to market 20,000 20,000
17 6/10/2008 ACC 301 18 Estimating Ending Inventory Ending Inventory
Sometimes we want to estimate ending inventory instead of physically counting it Why? Why?
For interim reporting (quarters) to reduce the costs For interim reporting (quarters) to reduce the costs When When a physical count is impossible When When a physical count is very costly However, However, a physical count must be made periodically even if we sometimes estimate Two Two methods to estimate ending inventory
Gross Gross Profit Method Retail Retail Method 6/10/2008 ACC 301 20 Gross Profit Method Gross Profit Method
GAAP allows only for interim reporting not for GAAP allows only for interim reporting, not for annual annual Required information: Required information:
Cost Cost of beginning inventory Cost of purchases during the period Sales Sales during the period (valued at retail price) “Normal” “Normal” percentage mark-up (as a % of sales) markGross Gross Profit / Sales Gross Profit Method Profit Method
Computational method: Computational method:
Beginning inventory (at cost) + Purchases (at cost) Purchases (at cost) = Goods available (at cost) - COGS (estimated by applying the GM% of Sales) th GM% = Estimated Ending Inventory COGS = Net Sales – (Net Sales x GM% of Sales) 6/10/2008 ACC 301 21 6/10/2008 ACC 301 22 Example of Gross Profit Method of Gross Profit Method
Facts: Ajax Corporation's warehouse was destroyed by fire including their entire fi th ending inventory. Estimate their ending inventory using the following information Beginning Inventory Purchases during the period Sales (at retail price) during the period Normal percentage mark up (on sales) Normal percentage mark up (on sales) Beginning inventory Purchases Cost of goods available Sales less: gross profit (31% x $700,000) Estimated cost of goods sold Estimated cost of goods sold Estimated ending inventory destroyed in fire
6/10/2008 ACC 301 Margin on Sales vs Margin on Cost Margin on Sales vs Margin on Cost
Sometimes we don’t know the gross margin Sometimes we don know the gross margin percentage percentage on sales We We can take the gross margin on cost and convert it
GM % of sales = GM % of cost (1 + GM % of cost ) $ 150,000 500,000 700,000 31% $ 150,000 500,000 650,000 Make Make sure you read questions carefully to make sure which margin percentage you have! $ 700,000 217,000 483,000 167,000
23 6/10/2008 ACC 301 24 In In-Class Exercise #3 Exercise #3
Let’s pause and do exercise #3 Let pause and do exercise #3 Conventional Retail Method Retail Method
GAAP accepts estimated ending inventory using the GAAP retail method Information Information required:
Beginning Beginning inventory at cost and at retail Purchases Purchases for the period at cost and at retail Sales during the period at retail Sales during the period at retail Markups Markups and Markdowns
Markup: Markup: An increase in the retail price Markdown: Markdown: A reduction in the retail price (e.g., sales) Markup Markup Cancellation: A return to original price Markdown Markdown Cancellation: A return to the original price 6/10/2008 ACC 301 25 6/10/2008 ACC 301 26 Conventional Retail Method Retail Method
First, let’s look at a simple case without markups and First markdowns
1. 2. 3. 4. Example of Retail Method of Retail Method
Facts: Beginning inventory Purchases (net) Net markups Net markdowns Net markdowns Sales Cost Retail $ 58,000 $ 100,000 122,000 200,000 10,345 26,135 186,000 Cost Retail $ 58,000 $ 100,000 122,000 200,000 10,345 $ 180,000 $ 310,345 310 26,135 284,210 186,000 $ 98,210
ACC 301 cost/retail ratio: 180,000/310,345 = 58% Calculate total goods available for sale at cost and at retail Calculate cost/retail percentage cost/retail percentage Subtract sales from goods available (at retail) to get ending inventory at retail EI at cost = (EI at retail) x (cost/retail %) at cost (EI at retail) (cost/retail %) Treatment Treatment of markups and markdowns
Add Add net markups (markups – cancellations) to the retail column before calculating cost/retail percentage before Subtract Subtract net markdowns after calculating the percentage after but before subtracting sales
6/10/2008 ACC 301 27 Beginning inventory add: Purchases (net) add: Net markups Totals less: Net markdowns Goods available (at retail) less: Sales Ending inventory at retail
6/10/2008 Ending Inventory Inventory at cost: $98,210 58% $98,210 x 58% = $56,962 28 Treatment of Markdowns Treatment of Markdowns
Conventional retail method excludes markdowns from the cost/retail ratio. This mimics a lower-of-cost-or-market valuation. Here is a simple example: example: Suppose we have 2 items in inventory, both purchased at a cost of $10, total available to sell equals $20. We plan to sell them for $15 each for a total retail of $30 Now suppose one of the items is damaged and we total retail of $30. Now suppose one of the items is damaged and we’ll only be able to sell it for $5—a $10 markdown cost/retail ratio = 66.7%
Beginning inventory inventory add: Net purchases Totals less: Net markdowns Goods available for sale less: Net sales Estimated EI at retail Cost 0 20 20 20 Retail 0 30 30 10 20 0 20 In-Class Exercise #4 Exercise #4
Let’s pause and do exercise #4 Let pause and do exercise #4 Est. EI = 20 x 66.7% EI 20 66 $13.33 If cost/retail ratio cost/retail ratio includes markdowns: cost/retail ratio = 100% Est. EI = 20 x 100% $20
29 6/10/2008 ACC 301 30 Conventional retail method approximates LCM
6/10/2008 ACC 301 Inventory Valuation Valuation
In most all cases, firms value inventory at LCM In most all cases, firms value inventory at LCM In In some special cases, firms can report inventory at net realizable value instead of at LCM at net realizable value instead of at LCM Permitted Permitted if the following is true:
There is controlled market with quoted price There is a controlled market with a quoted price applicable applicable to all quantities No significant cost of disposal No Relative Sales Value Sales Value
Sometimes Sometimes inventory of different kinds of products are purchased in a lump sum—a “basket purchase” Problem: Problem: How do we determine the individual cost of the items?
We use the Relative Sales Value approach Apply Apply the total cost of the items in proportion to their sale prices
Sales Number of Price Per Products Products Item #1 10,000 $ 1.00 #2 5,000 4.00 #3 3,000 10.00 Total Sales Price $ 10,000 10 20,000 30,000 $ 60,000 Relative Sales Price 1/6 1/6 1/3 1/2 Cost Allocated Total Cost to of Bundle Products $ 42,000 $ 7,000 $ 42,000 $ 14,000 $ 42,000 $ 21,000 $ 42,000 Frequently Frequently true in mineral extraction and commodity industries
6/10/2008 ACC 301 31 Cost Per Unit $ 0.70 2.80 7.00 6/10/2008 ACC 301 32 Purchase Commitments Purchase Commitments
Often firms make commitments to purchase inventory many years in advance
For For example, utilities contract for oil or coal deliveries using multi-year multicontracts Commit Commit to paying a fixed amount over the contract If If prices go down in the future, the committed buyer may have to pay more for their inventory than market value
If If this results in a loss when selling the inventory, the loss must be recorded immediately GAAP does not require recording an asset and liability for the GAAP does not require recording an asset and liability for the purchase purchase commitment, although it should be disclosed if material 6/10/2008 ACC 301 33 ...
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This note was uploaded on 01/20/2011 for the course ACC 301 taught by Professor Staff during the Fall '08 term at Kentucky.
- Fall '08