Inventories

1
Inventories

• Chapter 9

2
Lower of Cost or Market

• Historical cost principle is abandoned when the
  future utility of asset is no longer as great as
  its original cost.
• Lower of Cost or Market abbreviated as LCM

3
Market

• Market amount in LCM rule means the cost to
  replace the item by purchase or reproduction.
  This is a measure of entry value.
• Market amount is limited by ceiling and floor
  restrictions that are based on measurements of
  exit value

4
Floor and Ceiling Limits

• The ceiling is equal to net realizable value
  which is estimated selling price less estimated
  disposal cost.
• The floor is equal to the ceiling less normal
  profit margin

5
Floor and Ceiling

• A decline in selling price is not always
  accompanied by a decline in cost (ceiling)
• If an item has not lost its revenue-producing
  power, a writedown to replacement cost in the
  current period would understate current income
  and overstate income in the period of sale (floor)

6
Two-Step Approach to LCM

• First find the designated market value.
  Designated market is the middle value of
  replacement cost, the ceiling, and the floor.
• Second, find the lower of historical cost or
  designated market

7
Applying LCM

• Apply to each item by item
• Apply to the total of the inventory
• As soon as the inventory is written down to
  market, the new basis is considered to be the
  cost basis for future periods

8
Recording Declines

• Direct method
• Show inventory at market in both the balance
  sheet and cost of goods sold section of income
  statement. Market decline included with cost of
  goods sold amount.
• Allowance method
• Record market decline with a debit to a Loss
  account and a credit to an Allowance account
  deducted from Inventory on balance sheet.

9
Other Valuation Bases

• Net Realizable Value
• Certain goods sold in a controlled market with a
  quoted price applicable to all quantities and
  with no significant disposal cost may be reported
  at net realizable value. Applied to minerals and
  agricultural products.

10
Other Valuation Bases

• Relative Sales Value Method
• When several assets are acquired in a lump-sum
  purchase, the joint cost can be allocated on the
  basis of relative sales value.

11
Purchase Commitments

• No recording or reporting for ordinary purchase
  orders subject to cancellation
• Formal purchase orders with firm price
  established
• If market price exceeds contract price disclose
  in notes
• If market price less than contract price record
  loss and record liability

12
Gross Profit method

• Method is used when an estimate of a firms
  inventory is required. The estimate is
  acceptable for interim reporting but not for
  annual reporting
• Requires
• Cost of beginning inventory, cost of purchases
  for period, sales during the period, and markup
  expressed as a percentage of sales

13
Gross Profit Method

• Convert markup on cost to markup on sales
• Provides an estimate of inventory based on past
  percentages
• Use of one blanket gross profit rate is not
  appropriate when company has merchandise with
  varying rates of gross profit

14
Retail Inventory Method

• Provides an estimate of ending inventory
• May be acceptable for annual financial statements
• More detailed records must be kept

15
Retail Inventory Method

• Need
• Beginning inventory at cost and at retail
• Purchases for the period at cost and at retail
• Sales during the period at retail
• Cost and/or retail amounts of special items such
  a markups, markdowns, employee discount,
  spoilage, etc.

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Variations of Retail Method

• Can be adapted for use with
• Any of the cost flow assumptions FIFO, LIFO or
  Average
• Either inventory valuation method cost or LCM
• Either LIFO approach stable prices, or dollar
  value LIFO

17
Retail Inventory Method

• Compute ending inventory at retail. This is the
  same for all variations.
• Compute the cost-to-retail ratio. This step will
  vary.
• Convert ending inventory at retail to estimate
  cost using the cost-to-retail ratio.

18
Cost-to-Retail Ratio

• Numerator at cost
• Beginning inventory plus purchases less purchase
  returns and allowances and discounts plus
  freight-in less abnormal spoilage
• Denominator at retail
• Beginning inventory plus purchases less purchase
  returns, allowances and discounts less abnormal
  spoilage plus net markups

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Financial Statement Presentation

• Disclose
• Composition of manufacture inventory
• Unusual or significant financing arrangements
  including related party transactions, firm
  purchase commitments, involuntary LIFO
  liquidation, etc.
• Inventory costing methods used
• Consistency of costing methods from period to
  period