Inventories: Additional Valuations Issues Chapter 9 Inventories: Additional Valuations Issues ACCT-3030

1. Lower of Cost or Market Required by GAAP* Theory Inventory must be reported at LCM Theory should not report inventory at a value higher than benefits to be received from selling it Stated reason: “conservative approach” ACCT-3030

1a. Lower of Cost or Market Definition of market cost to replace the item (replacement cost) really “lower of cost or constrained market” Ceiling market can’t exceed NRV NRV = selling price – selling costs Floor market can’t be lower than NRV less normal profit floor = NRV – normal profit margin Can apply to individual items, groups of items, or whole inventory Does not apply to damaged or deteriorated goods ACCT-3030

1b. Lower of Cost or Market Example Selling price $60 Additional selling costs $10 Normal profit margin 40% (of selling price) Cost $36 Current replacement cost Case A $58 Case B $37 Case C $21 ACCT-3030

1c. Other Valuation Bases Valuation at Net Realizable Value e.g., recognizing revenue at completion of production Valuation using Relative Sales Value basket purchase meat-packing plant ACCT-3030

2. Purchase Commitments Generally seller retains title to merchandise Buyer recognizes no asset or liability If material, the buyer should disclose contract details in footnote If contract price > the market price, and buyer expects that losses will occur when purchase made buyer should recognize liability and corresponding loss in period when market declined Omit Hedging ACCT-3030

3. Inventory Estimation Methods Gross profit method based on relationship between sales and gross profit not acceptable for financial reporting or taxes Retail method used by large volume retailers dollar based method – not unit based method acceptable for financial reporting and taxes ACCT-3030

4. Gross Profit Method Based on assumptions that gross profit is constant from period-to-period sales mix of products is constant Used to estimate inventory value ACCT-3030

4a. Gross Profit Method Example Sales $200 Cost of goods sold $120 GP % = 80/200 = 40% CGS% = 120/200 = 60% GP% on sales = 80/200 = 40% GP% on cost = 80/120 = 66⅔% GP on Sales = GP on Costs 1 + GP on Costs ACCT-3030

4a. Gross Profit Method Example A hurricane destroyed the entire inventory stored in a warehouse. The following information is available from the company’s records. Beginning inventory $220,000 Purchases $400,000 Sales $600,000 Historical gross profit rate 30% Required: Estimate the cost of the destroyed inventory. ACCT-3030

4a. Gross Profit Method Example — Solution Beginning inventory (from records) $220,000 Plus: Net purchases (from records) 400,000 Cost of goods available for sale 620,000 Less: Cost of goods sold: Net sales $600,000 Less: Estimated gross profit of 30% (180,000) Estimated cost of goods sold (420,000) Estimated cost of inventory destroyed $200,000 ACCT-3030

5. Retail Method Method is based on the pattern between the cost and retail value of the goods Method requires: total costs of goods purchased total retail value of goods available for sale total sales Companies always keep 1 & 3 with this method also must keep 2 ACCT-3030

5a. Retail Method Basic method Cost Retail Beginning Inventory 600 1,000 Net Purchases 5,000 8,000 Goods Available for Sale 5,600 9,000 Cost Ratio: 5,600/9,000 = .62222 Sales 7,500 Ending Inventory at Retail 1,500 End Inv at Cost (1,500 x .62222) 933 ACCT-3030

5c. Retail Method Retail terminology Net markups and net markdowns Meaning Initial markup Original markup reflected in sales price Additional markup Additional increase in selling price after original markup Markup cancellation Elimination of additional markup Markdown Reduction in selling price below original selling price Markdown cancellation Elimination of markdown Net markups and net markdowns ACCT-3030

5b. Retail Method Ratios – computed as: cost of goods available for sale retail value of goods available for sale Based on how ratio computed, can be used to approximate following methods: average – include everything LCM – exclude markdowns (conventional retail method) FIFO – exclude beginning inventory LIFO – compute separate ratio for each layer ACCT-3030

5d. Retail Method Cost Retail Beginning Inventory + Purchases Purchases Returns - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost ACCT-3030

5e. Retail Method Avg. method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost Avg. method ACCT-3030

5f. Retail Method LCM method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost LCM method ACCT-3030

5g. Retail Method FIFO method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost FIFO method ACCT-3030

5h. Retail Method Example Cost Retail Beginning Inventory 195,000 400,000 Net Purchases 300,000 450,000 Net Markups 50,000 Net Markdowns <20,000> Available for Sale 495,000 880,000 Net Sales 407,000 Ending Inventory at Retail 473,000 Ending Inventory at Cost ACCT-3030