Inventories: Additional Valuation Issues

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• Inventories Additional Valuation Issues

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Objectives of this Chapter

• I. Introduce Inventory estimation methods the
  gross profit method and the retail inventory
  method.
• II. Determine ending inventory cost by applying
  the gross profit method.
• III. Determine ending inventory cost by applying
  the retail inventory method.

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Objectives of this Chapter (contd.)

• IV. Compare the gross profit method and the
  retail inventory method.
• V. Explain dollar-value LIFO retail method.
• VI. Discuss accounting issues related to purchase
  commitments.

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I. Estimating Inventory Gross Profit Method and
Retail Inventory Method

• Reasons For some companies, inventory
  information is needed between accounting periods
  . Companies cannot afford to do physical
  inventory count every quarter.
• Thus, either the gross profit method or the
  retail inventory method can be used to estimate
  value of ending inventory for interim reports.

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Estimating Inventory Gross Profit Method and
Retail Inventory Method (contd.)

• No physical count of inventory is needed for
  either method. The value of inventory is based
  on estimation.
• Neither method is acceptable for annual financial
  reporting purposes.

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Estimating Inventory Gross Profit Method and
Retail Inventory Method (contd.)

• Both methods are acceptable for interim
  reporting.
• The insurance adjusters may use the gross profit
  method to estimate the loss of inventory in case
  of fire or flood.

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II. The Gross Profit Method

• Data Required
• Beginning Inventory (at cost)
• Purchase (net) (at Cost)
• Sales Price
• Gross Margin Ratio
• (Gross Margin/Sales Price)

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Gross Profit MethodExample A

• Beginning Inv. 60,000
• Purchase (net) 200,000
• Sales 280,000
• Gross Margin Ratio 1 30
• 1. Gross margin ratio is obtained from past
  years experience (assuming the ratio is stable
  over years).

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Example A (contd.)

• Using gross profit method to estimate the cost of
  ending inventory
• Selling Price Cost
• Beg. Inventory 60,000
• Purchase (net) 200,000
• Goods Available for Sale 260,000
• Sales 280,000
• Less gross margin1 (84,000)
• Sales (at cost) 196,0002
• Estimated Inv. (at cost) 64,000
• 1. gross margin 280,000x30
• 2. also equals 280,000x(1-30) 196,000

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Gross Profit MethodExample B

• What if the gross margin ratio is based on cost
  of goods sold (CGS) rather than on sales price?
• Sales 100
• CGS (80)
• Gross Margin 20
• Gross profit ratio (based on Sales) 20
• Gross profit ratio (based on CGS) 25
• Deriving CGS using sales and gross profit ratio
  based on sales 100 x (1 - 20) 80
• Deriving CGS using sales and gross profit ratio
  based on CGS 100 ? (125) 80

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Example B (contd.)

• Sales CGS Gross Profit
• CGS 25 x CGS
• CGS x (125)
• CGS Sales ? (125)

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Comments on Gross Profit Method

• If the relationship between the gross profit and
  selling price has been changed, the ratio should
  be adjusted accordingly.
• A separate gross profit ratio should be applied
  to different inventory.

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III. Retail Inventory Method

• Terminology related to retail inventory method
• 
  Retail Price
• Original retail price 110
• Additional markup 5 115
• Markup Cancellations 5 110
• Markdowns 5 105
• Markdown Cancellations 5 110
• Net Markups Additional Markups - Markup
  Cancellations
• Net Markdowns Markdowns - Markdown
  Cancellations

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Retail Inventory Method (contd.)

• Data required to apply retail method
• Beg. Inv. (both cost and retail price)
• Purchases (net) (cost and retail)
• Sales (subtracting sales returns only)
• Price adjustment data such as additional markups,
  markup cancellations, markdowns and markdown
  cancellations

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Retail Inventory MethodExample (assuming no
price adjustments)

• Cost
  Retail
• Beg. Inv. 14,000 20,000
• Purchases (net) 63,0001 90,0002
• 77,000 110,000
• Sales 85,0003
• Estimated End. Inv. 25,000
• at retail
• Cost ratio 77,000/110,00070
• Estimated cost of end. inv. 25,000x7017,500
• 1. Purchases - Pur. RA - Pur. Dis. Freight-in
• 2. Purchases - Pur RA
• 3. Gross sales-Sales Returns Employee Discounts

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Retail Inventory MethodExample (with price
adjustments)

• Cost
  Retail
• Beg. Inv. 14,000 20,000
• Purchases (net) 63,000 90,000
• Goods Avail. 77,000 110,000
• Additional Markups 5,000
• Markup Cancel. (4,000)
• Markdowns (1,500)
• Markdowns Cancel. 200
• Sales (85,000)
• Estimated End. Inv. at Retail 24,700
• Question What is the cost ratio?

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Retail Inventory MethodExample (with price
adjustments)

• Cost
  Retail
• Beg. Inv. 14,000 20,000
• Purchases (net) 63,000 90,000
• Goods Avail. 77,000 110,000
• Net Markups 1,000
• Goods Avail. after net MU 111,000
• Net Markdowns (1,300)
• Goods Avail. after all price adj. 109,700
• Sales (85,000)
• End. Inv. at Retail 24,700
• Sales Sales - Sales RA

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Cost Ratios for Retail Method

• 1) Average Method (consider all price adjust.)
• Cost Ratio
• 77,000 ? 109,700 70.19.
• Esti. End. Inv. at cost
• 24,700 x 70.19 17,336.93
• 2) LCM approach (conventional retail method)
  (consider only net markups)
• Cost Ratio
• 77,000 ?111,000 69.37.
• 24,700 x 69.37 17,134.39

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Cost Ratios for Retail Method (contd.)

• 3) FIFO approximation (excluding the beg. inv. in
  the computation of cost ratio)
• Cost Ratio
• (77,000-14,000)?(109,700-20,000)
• 70.23.
• Esti. Inv. at cost
• 24,700 x 70.2317,346.81

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Cost Ratios for Retail Method (contd.)

• 4) LIFO approximation (computing two ratios,
  one for the beg. inv. and one for others)
• Cost Ratio 1(for beg.inv.)
• 14,000/20,00070
• Cost Ratio 2(for other inv.)
• (77,000-14,000)?(109,700-20,000)70.23
• Esti. End. Inv. at cost
• 1) 20,000 x 70 14,000
• 2) 4,700a x 70.23 3,301
• 17,301
• a. 24,700-20,0004,700

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Comments for Retail Method

• A. Cost Retail
• Purchases
• Pur. Discounts ------1
• Pur. R A
• Freight-In ------1
• 1. Pur. Discounts and freight-in are already
  considered in the retail price of purchases.

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Comments for Retail Method (contd.)

• B. Sales in the retail column should be gross
  sales - sales returns. This is because the
  retail prices for beg. inv. and purchases are
  based on gross sales, not net sales.
• Also, if employee discounts have been
  subtracted from sales, they should be added back
  to sales.

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Comments for Retail Method (contd.)

• C. Spoilage
• Cost Retail
• Normal Spoilage1 ------
• Abnormal Spoilage2
• 1. In computing cost ratios, the normal spoilage
  will not be considered.
• 2. In computing cost ratios, the abnormal
  spoilage will be considered.

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Retail Inventory Method Special Items Included

• Cost
  Retail
• Beg. Inv. 14,000
  20,000
• Purchases (net) 63,000
  90,000
• Abnormal Spoilage (1,400) (2,000)
  
• Goods Avail. 75,600
  108,000
• Net Markups 1,000
• Goods Avail. after net MU 109,000
• Net Markdowns (1,300)
• Goods Avail. after all price adj. 107,700
• Sales 85,000
• Sales returns (2,000)
  (83,000)
• Employee Discounts
  (2,000)
• Normal Spoilage (1,000)
• End. Inv. at Retail 21,700

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Retail Inventory Method Special Items
Included(contd.)

• 1) Average Method (consider all price adjust.)
• Cost Ratio
• 75,600 ? 107,700 70.19.
• Esti. End. Inv. at cost
• 21,700 x 70.19 15,232.23
• 2) LCM approach (conventional retail method)
  (consider only net markups)
• Cost Ratio
• 75,600 ?10,900 69.36.
• 21,700 x 69.36 15,051.12

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Another Example of Conventional Retail Inventory
Method Special Items Included (Illustration
9-3, KWW, 14th e)
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IV. Comparison of Gross Profit Method and Retail
Inventory Method

• Gross-Profit Method

• Retail Inventory Method

1. Data required Cost and retail price of beg.
inv., purchases, sales price and price
adjustments.
1. Data required cost of beg. inv., purchases,
sales and gross profit ratio.
2. Any company can use this method to estimate
ending inventory.
2. Only retail store can apply this method to
estimate inventory.
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Comparison of Gross Profit Method and Retail
Inventory Method (contd.)
Gross-Profit Method
Retail Inventory Method
3. Gross profit ratio is estimated from past
years experience (not updated with the price
adjustments of the current year).
3. Cost ratio can be calculated at different
stage and is updated with current years price
adjustment data.
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Comparison of Gross Profit Method and The Retail
Method (contd.)
Gross-Profit Method
Retail Inventory Method
4. Not acceptable for the annual financial
reporting but acceptable for the interim report.
4. Not acceptable for the annual financial
reporting but acceptable for the interim report.
5. No physical count of inventory is needed.
5. No physical count of inventory is needed.
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V. Dollar-Value LIFO Retail Method

• Applying retail method to estimate cost of ending
  inventory and also considering price index when
  prices are fluctuating.

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Dollar-Value LIFO Retail MethodExample

• Cost Retail
• Beg. Inv. -20x1 14,000 20,000
• Purchases (net) 63,000 90,000
• Goods Avail. 77,000 110,000
• Net Markups 1,000
• Goods Avail. after net MU 111,000
• Net Markdowns (1,300)
• Goods Avail. after all price adj. 109,700
• Sales (85,000)
• End. Inv. at Retail 24,700
• Cost Ratio(CR) 1(for beg. inv.)14,000/20,00070
• CR2 (for others)(77,000-14,000)/(109,700-20,000)
• 70.23

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Dollar-Value LIFO Retail MethodExample (contd.)

• Assuming the price indices of 20x0 and 20x1 are
  100 and 112, respectively.
• Procedures of applying Dollar-Value LIFO concept
  to Retail method (LIFO approximation)

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Dollar-Value LIFO Retail MethodExample (contd.)

• 1. Ending inventory at retail prices is deflated
  to base years price level
• 24,700?112 22,054
• 2. Forming Layers based on LIFO cost flows
  assumption
• Beg. inv (retail) at base-year prices
• (L1) 20,000
• Inv. increase (retail) from beg. inv.
• (L2) 2,054

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Dollar-Value LIFO Retail MethodExample (contd.)

• Ending Inv Layers Price Cost End. Inv.
• at Base-year at Base-year Index Ratio at LIFO
• Retail Prices Retail Prices () ()
  Cost
• 22,054 20,000 100 70 14,000
• 2,054 112 70.23 1,616
• 15,615

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Dollar-Value LIFO Retail MethodExample (contd.)

• Subsequent years under Dollar-Value LIFO Retail
• The D-V LIFO retail method follows the same
  procedures in subsequent years as the traditional
  D-V LIFO method. That is when a real increase in
  inventory occurs, a new layer is added.

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Dollar-Value LIFO Retail MethodExample (contd.)

• Using the information on page 27 and assuming the
  retail value of 20x2 ending inventory at current
  price is 42,960. The 20x2 price index is 120
  (20x0 price index is 100) and the cost ratio of
  20x2 is 75.
• In base-years dollars(20x0),
• the ending inventory of 20x2 is
• 42,960 ?120 35,800

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Dollar-Value LIFO Retail MethodExample (contd.)

• Ending Inv. Layers Price Cost End. Inv
• at Base-Year at Base-Year Index Ratio at LIFO
• Retail Prices Retail Prices () ()
  Cost
• 35,8001 L1 20,000 100 70 14,000
• L2 2,054 112 70.23 1,616
• L3 13,746 120 75 12,371
• 27,987
• 1. Current cost of ending Inv. of 20x2
• 42,960?1.12 35,800
• L1(layer 1) 20x0 L2 20x1 L3 20x2

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VI. Purchase Commitments

• Purchase contract may be signed a few months (or
  years) before the actual delivery date (i.e.,
  George Pacific) to secure the supply of
  inventory.
• Losses are recognized for any purchase
  commitments outstanding at the end of a period
  when market price is less than contract price
  (i.e., applying a LCM rule in the valuation of
  purchase commitments).

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Example 1- Contract Period within Fiscal Year

• Geteway Co. signed a purchase commitment of
  20,000 on 4/30/x5 to buy goods which would be
  delivered on 9/30/x5.
• 4/30/x5 No entry required.
• Disclosure of this firm commitment is required
  at the end of a reporting period if the amount is
  significant.

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Example 1 (contd.)

• Case 1 When the market price of these goods
  equal or greater than the contract price of
  20,000 on 9/30/x5, the journal entry on 9/30/x5,
  the delivery date, would be
• 9/30/x5
• Purchases 20,000
• Cash 20,000

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Example 1 (contd.)

• Case 2 The market price is 18,000 on 9/30/x5.
  The journal entry would be
• Purchases 18,000
• Loss on
• Pur. Commitment 2,000
• Cash 20,000

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Purchase CommitmentsExample 2 - Contract
Period Extends beyond Fiscal Year

• Geteway Co. signed a firm purchase commitment of
  50,000 on 4/15/x5 for goods to be delivered on
  10/2/x6. The market price of the contracted
  goods was 49,000 on 12/31/x5. The purchased
  commitment loss must be recognized in the year
  end when the loss first occurred (i.e.,
  12/31/x5).

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Example 2 (contd.)

• The following entry would be prepared on
  12/31/x5 and disclosure is required when the
  amount is significant regardless whether a loss
  is expected or not
• Estimated Loss on
• Purchase Commitments 1,000
• Estimated Liability on
• Purchase Commitments 1,000
• Reported in the income statement under Other
  expenses and losses

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Example 2 (contd.)

• At the delivery date (i.e., 10/2/x6)
• Case 1 The market price remained 1,000 below
  the contract price, the following journal entry
  would be prepared on 10/2/x6
• Purchases 49,000
• Estimated Lia.
• on Pur. Commit. 1,000
• Cash 50,000

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Example 2 (contd.)

• Case 2 The market price was 3,000 below the
  contract price on 10/2/x6
• Purchases 47,000
• Estimated Lia.
• on Pur. Commitments 1,000
• Loss on Pur. Commit. 2,000
• Cash 50,000

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Example 2 (contd.)

• Case 3 the market was only 600 below the
  contract price 0n 10/2/x6
• Purchases 49,000
• Estimated Lia.
• on Pur. Commit. 1,000
• Cash 50,000
• 49,000 became the new cost for the purchase
  commitment on 12/31/x5

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Hedging of Purchase Commitments with Future Sales
Contracts

• In order to offset the potential future loss on
  purchase commitments, a firm can enter a future
  sales contract at the same quantity of inventory
  purchased in a purchase commitment.