Chapter Nine

Chapter Nine - Intermediate Accounting Intermediate Chapter...

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Unformatted text preview: Intermediate Accounting Intermediate Chapter 9 Inventories: Additional Valuation Issues Learning Objectives Learning 2 Describe and apply the lower­of­cost­of­market rule Explain when companies value inventories at net realizable value Explain when companies use the relative sales value method to value inventories Discuss accounting issues related to purchase commitments Determine ending inventory by applying the gross profit method Determine ending inventory by applying the retail inventory method Explain how to report inventory Lower-of-Cost-or-Market Lower-of-Cost-or-Market LCM A company abandons the historical cost principle when the future utility (revenue­producing ability) of the asset drops below its original cost. 3 Market = Replacement Cost Lower of Cost or Replacement Cost Loss should be recorded when loss occurs, not in the period of sale. LO 1: Describe and apply the lower­of­cost­or­market rule. Lower-of-Cost-or-Market Lower-of-Cost-or-Market Ceiling and Floor Why use Replacement Cost (RC) for Market? 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 Ceiling Floor – net realizable value less a normal profit margin 4 LO 1: Describe and apply the lower­of­cost­or­market rule. Lower-of-Cost-or-Market Lower-of-Cost-or-Market What is the rationale for the Ceiling and Floor limitations? Cost Market Ceiling = NRV Not > Replacement Replacement Cost Cost GAAP LCM LCM 5 LO 1: Describe and apply the lower­of­cost­or­market rule. Not < Floor = NRV Floor less Normal Profit Margin Profit Lower-of-Cost-or-Market Lower-of-Cost-or-Market Rationale for limitations Ceiling – prevents overstatement of the value of obsolete, damaged, 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 6 LO 1: Describe and apply the lower­of­cost­or­market rule. Lower-of-Cost-or-Market Lower-of-Cost-or-Market Recording LCM (data from Illus. 9­5 and 9­6) (data from Illus. 9­5 and 9­6) Ending inventory (cost) (LCM) $ 415,000 Ending inventory 350,000 Adjustment to LCM $ 65,000 Allowance Allowance Method Method Direct Direct Method Method 7 Loss on inventory Cost of goods sold 65,000 Allowance on inventory 65,000 Inventory LO 1: Describe and apply the lower­of­cost­or­market rule. 65,000 65,000 Lower-of-Cost-or-Market Lower-of-Cost-or-Market Allowance Direct Current assets: Cash receivable receivable inventory allowance inventory Prepaids Prepaids Total current assets Total 8 $ 100,000 $ 100,000 Accounts 350,000 350,000 Inventory 770,000 705,000 Less (65,000) 20,000 20,000 1,175,000 1,175,000 1,175,000 LO 1: Describe and apply the lower­of­cost­or­market rule. Lower-of-Cost-or-Market Lower-of-Cost-or-Market Income Statement Presentation Sales goods sold goods profit profit expenses: expenses: Allowance $ 300,000 Cost of 185,000 Gross 115,000 Operation Selling 45,000 45,000 45,000 General and administrative 20,000 20,000 Total General operating expenses 65,000 65,000 Other operating 65,000 revenue and expense: Loss revenue on inventory 65,000 - Interest on income 5,000 5,000 Total income income (60,000) 5,000 Income from (60,000) operations 55,000 55,000 Income tax operations expense 16,500 16,500 Net income expense 16,500 Net $ 38,500 $ 38,500 38,500 9 $ 300,000 120,000 180,000 Direct LO 1: Describe and apply the lower­of­cost­or­market rule. Lower-of-Cost-or-Market Lower-of-Cost-or-Market Evaluation of LCM Rule Some Deficiencies: 10 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. LO 1: Describe and apply the lower­of­cost­or­market rule. Valuation Bases Valuation Net Realizable Value Permitted by GAAP under the following conditions: (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) 11 LO 2: Explain when companies value inventories at net realizable value. Valuation Bases Valuation Purchase Commitments • Generally seller retains title to the merchandise. 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 losses in the period during which such declines in market prices take place. 12 LO 4: Discuss accounting issues related to purchase commitments. Valuation Bases Valuation Illustration: St. Regis Paper Co. signed timber­cutting contracts to be executed Illustration: St. Regis Paper Co. signed timber­cutting contracts to be executed in 2012 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2011, dropped to $7,000,000. Ts. Regis would make the following entry on December 31, 2011. Unrealized Holding Gain or Loss­­ Income 3,000,000 Estimated Liability on Purchase Commitments 3,000,000 13 LO 4: Discuss accounting issues related to purchase commitments. Valuation Bases Valuation Illustration: When St. Regis cuts the timber at a cost of $10 million, it would make the following entry. Purchases (Inventory) 7,000,000 Estimated Liability 3,000,000 Cash 10,000,000 If Congress permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000. Estimated Liability 1,000,000 Unrealized Holding Gain or Loss—Income 1,000,000 14 LO 4: Discuss accounting issues related to purchase commitments. Gross Profit Method Gross Substitute Measure to Approximate Inventory Relies on Three Assumptions: (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 15 LO 5: Determine ending inventory by applying the gross profit method. Gross Profit Method Gross Evaluation: 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) Only acceptable for interim (generally quarterly) reporting purposes. 16 LO 5: Determine ending inventory by applying the gross profit method. Retail Inventory Method Retail A method used by retailers, to value inventory without a physical count, by converting retail prices to cost. Requires retailers to keep: (1) the total cost and retail value of goods purchased, (2) the total cost and retail value of the goods available for sale, and (3) the sales for the period. 17 LO 6: Determine ending inventory by applying the retail inventory method. Retail Inventory Method Retail Special Items Purchase returns Purchase discounts and allowances Transfer­in Normal spoilage Abnormal shortages 18 Freight costs Employee discounts LO 6: Determine ending inventory by applying the retail inventory method. Retail Inventory Method Retail Evaluation: Widely used for the following reasons (1) to permit the computation of net income without a physical count of inventory, (2) as a control measure in determining inventory shortages, (3) in regulating quantities of merchandise on hand, and (4) for insurance information Some companies refine the retail method by computing inventory separately Some by departments or class of merchandise with similar gross profits. by 19 LO 6: Determine ending inventory by applying the retail inventory method. Presentation and Analysis Presentation Presentation: Accounting standards require disclosure of: (1) composition of the inventory, (2) financing arrangements, and (3) costing methods employed. 20 LO 7: Explain how to report and analyze inventory. ...
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