Unformatted text preview: Intermediate Accounting
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
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
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
What is the rationale for the Ceiling and Floor limitations? Cost Market Ceiling = NRV
Not > Replacement
LCM 5 LO 1: Describe and apply the lowerofcostormarket rule. Not < Floor = NRV
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
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
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
Lower-of-Cost-or-Market Allowance Direct Current assets:
Total current assets
Total 8 $ 100,000
$ 100,000 Accounts
1,175,000 LO 1: Describe and apply the lowerofcostormarket rule. Lower-of-Cost-or-Market
Income Statement Presentation
expenses: Allowance $ 300,000 Cost of
General and administrative
revenue and expense:
5,000 Total income
5,000 Income from
55,000 Income tax
16,500 Net income
9 $ 300,000
180,000 Direct LO 1: Describe and apply the lowerofcostormarket rule. 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
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)
(3) too difficult to obtain cost figures (meatpacking)
11 LO 2: Explain when companies value inventories at net realizable value. Valuation Bases
• 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
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
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
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
(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
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
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
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
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
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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