Inventories: Inventories: Additional Additional Valuation Valuation Issues Issues Chapter Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Chapter 9-1 Prepared by Coby Harmon, University of California, Santa Barbara Learning Learning Objectives Objectives Describe and apply the lower-of-cost-or-market 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 and analyze inventory Chapter 9-2 Inventories: Inventories: Additional Additional Valuation Valuation Issues Issues Lower-ofCost-orMarket Ceiling and floor How LCM works Application of LCM “Market” Evaluation of rule Chapter 9-3 Valuation Bases Net realizable value Relative sales value Purchase commitments Gross Profit Method Gross profit percentage Evaluation of method Retail Inventory Method Concepts Conventional method Special items Evaluation of method Presentation and Analysis Presentation Analysis Lower-of-Cost-or-Market Lower-of-Cost-or-Market LCM A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost Market = Replacement Cost Lower of Cost or Replacement Cost Loss should be recorded when loss occurs, not in the period of sale Chapter 9-4 LO Describe and apply the lower-of-cost-or-market 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: Chapter 9-5  Ceiling - net realizable value and  Floor - net realizable value less a normal profit margin LO Describe and apply the lower-of-cost-or-market rule Lower-of-Cost-or-Market Lower-of-Cost-or-Market What is the rationale for the Ceiling and Floor limitations? Illustration 9-3 Cost Cost Market Market GAAP GAAP LCM LCM Chapter 9-6 Ceiling = NRV Not > Replacement Cost Not < Floor = NRV less Normal Profit Margin LO Describe and apply the lower-of-cost-or-market rule Lower-of-Cost-or-Market Lower-of-Cost-or-Market Rationale for Limitations 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 Chapter 9-7 LO Describe and apply the lower-of-cost-or-market rule Lower-of-Cost-or-Market Lower-of-Cost-or-Market How LCM Works (Individual Items) Illustration 9-5 Chapter 9-8 LO Describe and apply the lower-of-cost-or-market rule Lower-of-Cost-or-Market Lower-of-Cost-or-Market Methods of Applying LCM Illustration 9-6 Chapter 9-9 LO Describe and apply the lower-of-cost-or-market rule Lower-of-Cost-or-Market Lower-of-Cost-or-Market Recording LCM (data from Illus 9-5 and 9-6) Ending inventory (cost) 415,000 Ending inventory (LCM) 350,000 Adjustment to LCM Loss on inventory Allowance Allowance 65,000 Method Allowance on inventory Method 65,000 Direct Direct Method Method Chapter 9-10 Cost of goods sold $ $ 65,000 65,000 Inventory 65,000 LO Describe and apply the lower-of-cost-or-market rule Gross Gross Profit Profit Method 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 Chapter 9-23 LO Determine ending inventory by applying the gross profit method Gross Gross Profit Profit Method Method E9-12 (Gross Profit Method) Mark Price Company uses the gross profit method to estimate inventory for monthly reporting purposes Presented below is information for the month of May Instructions: Inventory, May Purchases (gross) Freight-in Sales Sales returns Purchase discounts $ 160,000 640,000 30,000 1,000,000 70,000 12,000 (a) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of sales (b) Compute the estimated inventory at May 31, assuming that the gross profit is 30% of cost Chapter 9-24 LO Determine ending inventory by applying the gross profit method Gross Gross Profit Profit Method Method E9-12 (Gross Profit Method - Solution) (a) Compute the estimated inventory assuming gross profit is 30% of sales (a) Inventory, May (at cost) $ 160,000 Purchases (gross) (at cost) 640,000 Purchase discounts (12,000) Freight-in 30,000 Goods available (at cost) Sales (at selling price) 818,000 $ 1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less gross profit (30% of $930,000) 279,000 Sales (at cost) Approximate inventory, May 31 (at cost) Chapter 9-25 651,000 $ 167,000 LO Determine ending inventory by applying the gross profit method Gross Gross Profit Profit Method Method E9-12 (Gross Profit Method - Solution) (b) Compute the estimated inventory assuming gross profit is 30% of cost (a) Inventory, May (at cost) Purchases (gross) (at cost) Purchase discounts $ 160,000 30% = 23.08% of sales 100% + 30% Freight-in (12,000) 30,000 Goods available (at cost) Sales (at selling price) 818,000 $ 1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less gross profit (23.08% of $930,000) 214,644 Sales (at cost) Approximate inventory, May 31 (at cost) Chapter 9-26 640,000 715,356 $ 102,644 LO Determine ending inventory by applying the gross profit method Gross Gross Profit Profit Method Method 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 Chapter 9-27 LO Determine ending inventory by applying the gross profit method Retail Retail Inventory Inventory Method 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 Chapter 9-28 LO Determine ending inventory by applying the retail inventory method Retail Retail Inventory Inventory Method Method P9-8 (Retail Inventory Method) Jared Jones Inc uses the retail inventory method to estimate ending inventory for its monthly financial statements The following data pertain to a single department for the month of October 2008 Instructions: Beg inventory, Oct Purchases Freight in Purchase returns Additional markups Markup cancellations Markdowns (net) Normal spoilage Sales COST $ 52,000 262,000 16,600 5,600 RETAIL $ 78,000 423,000 8,000 9,000 2,000 3,600 10,000 380,000 Prepare a schedule computing estimate retail inventory using the following methods: (1) Cost (2) LCM (3) LIFO (appendix) Chapter 9-29 LO Determine ending inventory by applying the retail inventory method Retail Retail Inventory Inventory Cost Cost Method Method P9-8 Solution - Cost Method COST $ 52,000 262,000 16,600 (5,600) Beg inventory Purchases Freight in Purchase returns Markdowns, net Markups, net Current year additions Goods available for sale Normal spoilage Sales Ending inventory at retail Ending inventory at Cost: $ 106,400 x 65.47% Chapter 9-30 RETAIL $ 78,000 423,000 (8,000) (3,600) 7,000 273,000 418,400 325,000 / 496,400 = (10,000) (380,000) $ 106,400 = $ Cost to Retail % 65.47% 69,660 LO Determine ending inventory by applying the retail inventory method Retail Retail Inventory Inventory LCM LCM Method Method P9-8 Solution - LCM (CONVENTIONAL) Method: COST $ 52,000 262,000 16,600 (5,600) Beg inventory Purchases Freight in Purchase returns Markups, net Current year additions Goods available for sale Markdowns, net Normal spoilage Sales Ending inventory at retail Ending inventory at Cost: $ 106,400 x 65.00% Chapter 9-31 RETAIL $ 78,000 423,000 (8,000) 7,000 273,000 422,000 325,000 / 500,000 = (3,600) (10,000) (380,000) $ 106,400 = $ Cost to Retail % 65.00% 69,160 LO Determine ending inventory by applying the retail inventory method Retail Retail Inventory Inventory LIFO LIFO Method Method P9-8 Solution - LIFO Method: COST $ 52,000 / 262,000 16,600 (5,600) Beg inventory Purchases Freight in Purchase returns Markdowns, net Markups, net Current year additions Goods available for sale Normal spoilage Sales Ending inventory at retail Ending inventory at Cost: PY $ 78,000 x 66.67% CY 28,400 x 65.25% $ 106,400 Chapter 9-32 273,000 / 325,000 = = $ $ 52,000 18,531 70,531 Cost to RETAIL Retail % $ 78,000 = 66.67% 423,000 (8,000) (3,600) 7,000 418,400 = 496,400 (10,000) (380,000) $ 106,400 65.25% Appendix 9A LO Determine ending inventory by applying the LIFO retail inventory methods Retail Retail Inventory Inventory Method Method 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 by departments or class of merchandise with similar gross profits Chapter 9-33 LO Determine ending inventory by applying the retail inventory method Presentation Presentation and and Analysis Analysis Presentation: Accounting standards require disclosure of: (1) composition of the inventory, (2) financing arrangements, and (3) costing methods employed Analysis: Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory Chapter 9-34 LO Explain how to report and analyze inventory Presentation Presentation and and Analysis Analysis Inventory Turnover Ratio Measures the number of times on average a company sells the inventory during the period Illustration 9-26 Chapter 9-35 LO Explain how to report and analyze inventory Presentation Presentation and and Analysis Analysis Average Days to Sell Inventory Measure represents the average number of days’ sales for which a company has inventory on hand Illustration 9-26 Inventory Turnover Average Days to Sell 365 days / times = every 45.6 days Chapter 9-36 LO Explain how to report and analyze inventory Copyright Copyright Copyright © 2006 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Chapter 9-37 ... current period Chapter 9-7 LO Describe and apply the lower-of-cost-or-market rule Lower-of-Cost-or-Market Lower-of-Cost-or-Market How LCM Works (Individual Items) Illustration 9-5 Chapter 9-8 LO... recognize losses in the period during which such declines in market prices take place Chapter 9-22 LO Discuss accounting issues related to purchase commitments Gross Gross Profit Profit Method... Lower-ofCost-orMarket Ceiling and floor How LCM works Application of LCM “Market” Evaluation of rule Chapter 9-3 Valuation Bases Net realizable value Relative sales value Purchase commitments Gross