Chapter 9: Inventories: Additional Valuation Issues

1
Chapter 9 Inventories Additional Valuation
Issues
2
Introduction

• Inventory info important to investors
• Inventories rising faster than sales
• Consumers spending less
• Markdowns made less profit
• Manufactures
• Increases in RM WIP building inventory to
  meet increased demand

3
Lower of Cost or Market

• Lower of cost or market (LOCOM)
• Exception to historical cost principle
• Dont use historical cost when future revenue lt
  cost
• Charge loss in period loss incurred
• Example of conservatism constraint

4
Lower of Cost or Market

• When future potential of asset less than original
  cost
• Restate asset at market to replace cost
• Replacement cost reflects/predicts decline in
  selling price
• The loss must be charged against revenues of the
  period

5
Lower of Cost or Market Ceiling and Floor

• The lower of cost or market rule
• Market value is replacement cost or floor (if NRV
  less margin is less than replacement cost can
  only receive SP)
• Replacement cost must lie between a ceiling
  amount and a floor amount
• The ceiling is net realizable value (selling
  price less disposal cost)
• The floor is net realizable value less a normal
  profit margin
• Rarely calculated in practice too subjective

6
Inventory ValuationLower of Cost or Market
7
Lower of Cost or Market Ceiling and Floor
Example
Item Replacement Historical Ceiling
Floor Final Cost Cost (SP)
Inv
A 88,000 80,000 120,000 104,000
80,000
B 88,000 90,000 100,000 70,000
88,000
C 88,000 90,000 100,000 90,000
90,000
D 88,000 90,000 87,000 70,000
87,000
8
Lower of Cost or Market

• The lower of cost or market may be applied
• Either directly to each item
• Most common IRS required
• To each category (several end products)
• To the total inventory (one end product)
• Method selected should be
• Most clearly reflect income
• Consistently applied
• Illustration 9-5

9
Recording the Decline in Market Value

• Under the direct method
• COGS
• Inventory
• Under the indirect (allowance) method
  (preferred)
• Loss Due to Market Decline
• Allowance (contra-inventory)

10
Exceptions to LOCOM

• Record at NRV (even if above cost)
• Controlled market with quoted price
• No significant costs of disposal
• Cost difficult to obtain
• Examples
• Rare metals
• Meat packing industry
• Agricultural products

11
Valuation Basis Relative Sales Values

• Relative sales values are appropriate when basket
  purchases are made
• Basket purchases involve a group of varying units
• Purchase price is paid as a lump sum amount
• Lump sum price is allocated to units on basis of
  their relative sales values

12
Valuation Basis Relative Sales Values

• Examples
• Developed lots
• Time share units
• Petroleum industry
• Illustration 9-9 9-10

13
Relative Sales Values Example

• Kirby Company buys three different lots (A, B
  and C) in a basket purchase paying 300,000 for
  all three.
• The lots were sold as follows
• A - 75,000 B - 150,000 C - 200,000 for a
  total of 425,000.
• What is the cost of A, B and C and the gross
  profit for each lot?

14
Relative Sales Values Example
Lot Sales Allocated Gross Value
Cost Profit
A 75,000 (75,000/425,000)
300,000 52,941 22,059
B 150,000 105,882 44,118
C 200,000 141,176 58,824 Totals
425,000 300,000 (rd.) 125,000 (rd.)
15
Purchase Commitments

• Agree to buy inventory in advance
• Title does not pass to buyer
• Disclose but do not record purchase contracts if
  they are
• Ordinary
• Price determined at shipment
• Subject to cancellation
• Execution of contract expected to result in a
  loss (contract price gt current market)
• Loss recognition is appropriate

16
Gross Profit Method

• Gross profit method
• Used to estimate cost of ending inventory
• Usually at interim
• Used also when estimate is needed due to casualty
  loss
• Assumptions
• Beginning inventory Purchases Goods to be
  accounted for
• Goods not sold are on hand
• Cost of goods available Sales (at cost) Cost
  of ending inventory

17
Gross Profit Method Example

• Given
• Beginning inventory 50,000
• Net Purchases 125,000
• Sales (net) 112,000
• Gross Profit on sales 40
• (historically derived)
• Estimate the ending inventory

18
Gross Profit Method Example

• Sales 112,000 (given) 1st
• Less COGS - 67,200 (plug) 3rd
• Gross Profit 44,800 (given 112,000
  x 40) 2nd
• COGAS 175,000 (given) 4th
• Less COGS - 67,200 (computed above) 5th
• Ending Inv. 107,800 (result) 6th

19
Notes on Gross Profit Method

• Gross profit rates stated either as
• Percent-of-Sales most used, always lesser
• Retail markup 100, GP 50
• Percent-of-Cost
• Gross profit rates typically estimated based on
  historical data
• Gross profit method not normally acceptable for
  financial reporting
• Permitted for interim

20
Retail Inventory Method

• Appropriate for retail concerns
• With high volume sales AND
• Different types of merchandise
• Method assumes an observable pattern between cost
  prices
• Sanctioned by
• IRS
• Retail associations
• Accounting profession

21
Retail Inventory Method

• Requires records for
• Total cost total retail of purchased goods
• Total cost total retail of GAS
• Sales for period
• The steps are
• Determine ending inventory at retail price
• Convert amount to cost basis using a
  cost-to-retail ratio

22
Retail Inventory Method Example

• Given for the year 20X2
• At cost
  At retail
• Beginning inventory 2,000 3,000
• Purchases (Net) 10,000 15,000
• Sales (Net) 12,000
• What is ending inventory, at retail at cost?

23
Retail Inventory Method Example

• At
  cost At retail
• Beginning inventory 2,000 3,000
• Purchases (Net) 10,000 15,000
• Goods available for sale 12,000 18,000
• less Sales (Net) (12,000)
• Ending inventory (at retail) 6,000
• Times cost to retail ratio x 2/3
• Ending inventory at cost 4,000

24
Markups, Markdowns and Cancellations Example

• Given
• At cost At retail
• Goods available 20,500 36,000
• Markups 3,000
• Markup cancellations 1,000
• Markdowns 2,500
• Markdown cancellations 2,000
• What is the cost-to-retail ratio using the
  conventional method?

25
Markups, Markdowns and Cancellations Example

• At cost At retail
• Goods available 20,500 36,000
• Markups 3,000
• Markup cancellations ( 1,000)
• Goods available (adj.) 20,500 38,000
• Cost-to-retail ratio
• 20,500/ 38,000 53.9
• Ignore markdowns markdown cancellations
  (approximates LOCOM).
• Cost method considers markdowns markdown
  cancellations.

26
Retail Inventory Method

• Other items
• Freight part of purchase
• Purchase returns reduce price (cost retail)
• Purchase discounts/allowances reduce purchases
• Sales returns allowances reduce sales
• Sales discounts no recognition when sales _at_
  gross
• Transfers in part of purchases
• Normal shortages reduce retail column
• Abnormal shortages current cost, not part of
  inventory
• Employee discounts reduce retail column

27
Retail Inventory Method

• Advantages
• Permits computation of NI without physical count
• Control measure for shortages
• Regulates quantities on hand
• Insurance info
• Disadvantages
• Averaging effect on varying GP rates
• Possible distortions

28
Inventory Disclosures

• On face or in notes
• Inventory composition
• Significant/unusual inventory financing
  arrangements
• Basis on which amounts stated
• Examples
• Illustration 9-22, 9-23, 9-24

29
Inventory Analysis

• Help manage inventory
• Also useful for analytical procedures
• Inventory turnover ratio
• Average times inventory sold during period
• COGS / Average inventory
• Average days to sell inventory
• Average number of days of sales in inventory
• Inventory turnover ratio / 365 days

30
Ethics Inventory Valuation

• Earnings pressures
• External internal financial reports
• Debt covenants
• Current operating ratios, etc.
• Changes
• Inventory costing methods
• Method to record LOCOM adjustments

31
Exercises Problems

• E9-2 LOCOM
• E9-7 Relative Sales Value
• E9-10 Purchase Commitments
• E9-13 Gross Profit Method
• E9-20 Retail Inventory Method