Inventory Valuation at Other Than Cost

2  Apply the lower-of-cost-or-market (LCM) rule to reflect declines in the market value of inventory.  Use the gross profit method to estimate ending inventory.  Compute estimates of FIFO, LIFO, average cost, and lower-of-cost-or-market inventory using the retail inventory method. Learning Objectives

3  Determine the financial statement impact of inventory recording errors. Learning Objectives EXPANDED MATERIAL  Combine the retail inventory method and dollar-value LIFO to compute ending inventory using the dollar-value LIFO retail method.

4 Learning Objectives  Account for the impact of changing prices on purchase commitments.  Record inventory purchase transactions denominated in foreign currencies.

5 Inventory Estimation Methods Lower-of-Cost-or-Market Method Gross Profit Method Retail Inventory Method Dollar-Value LIFO Retail Method Methods for valuing inventory at other than cost

6 Lower of Cost or Market (LCM) What is market?

7 Lower of Cost or Market (LCM) In lower of cost or market, market means replacement cost within limits.

8 When goods remaining in inventory can be replaced with identical goods at a lower cost, the lower (market) cost must be used to value the inventory. What are the replacement cost limits? –Upper limit: Net realizable value. –Lower limit: Net realizable value minus a normal profit. Lower of Cost or Market (LCM)

9 A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin40 A company’s unit of inventory has the following characteristics: Selling price$165 Packaging cost10 Transportation cost15 Profit margin40 LCM Examples

10 Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Normal profit(40) Floor$100 Normal Profit = $40 LCM Examples Net realizable value Example 1

11 Current Replacement Cost, $150 Cost $155 Market $140 Normal Profit = $40 LCM is market, $140 LCM Examples Ceiling (NRV)$140 Normal profit(40) Floor$100 Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140

12 Cost $110 LCM is cost, $110 Market $120 Current Replacement Cost, $120 Normal Profit = $40 LCM Examples Example 2 Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Normal profit(40) Floor$100

13 Current Replacement Cost, $75 Cost $110 LCM is market, $100 Market $100 LCM Example Example 3 Selling price$165 Cost of completion(10) Transportation cost (15) Ceiling (NRV)$140 Normal Profit = $20 Ceiling (NRV)$140 Normal profit(40) Floor$100

14 Recording LCM Revaluations  LCM may be applied to each individual inventory item or to the inventory as a whole.  If LCM is applied to individual items, the difference between cost and market is credited directly to Inventory.  If LCM is applied to the inventory as a whole, the difference is recorded in an allowance account.

15 LCM--Example: Recording Revaluation (data for valuation) A20$10$200$11$200$220 B10$10$100$9$90 C10$10$100$8$80 D20$10$200$9$180 $600$550$570 Original Cost Item Qty Market Ind LCM Mkt LCM Total Cost

16 Journal Entry Loss from Decline in Value of Inventory Inventory LCM--Example: Recording Revaluation (applied individually) A20$10$200$11$200$220 B10$10$100$9$90 C10$10$100$8$80 D20$10$200$9$180 $600$550$570 $50 Original Cost Item Qty Market Ind LCM Mkt LCM Total Cost

17 A20$10$200$11$200$220 B10$10$100$9$90 C10$10$100$8$80 D20$10$200$9$180 $600$550$570 LCM--Example: Recording Revaluation (applied as a whole) Journal Entry Loss from Decline in Value of Inventory Allowance for Decline in Value of Inventory.. 30 $30 Original Cost Item Qty Market Ind LCM Mkt LCM Total Cost

18 Gross Profit Method The gross profit method is an estimation technique to determine the inventory count...  when a physical count is not practical, and  as a validity check.

19 Gross Profit Method Steps  Determine gross profit percentage.  Determine estimated sales.  Determine estimated cost of goods sold.  Determine estimated goods available for sale.  Determine estimated inventory.  Determine gross profit percentage.  Determine estimated sales.  Determine estimated cost of goods sold.  Determine estimated goods available for sale.  Determine estimated inventory.

20 Gross Profit Method-- Example: Basic Data Use the following information to estimate ending inventory: Gross Profit Percentage50% of sales Accounts Receivable Collections$ 5,000 Ending Accounts Receivable$ 1,000 Beginning Accounts Receivable$ 2,000 Beginning Inventory$ 6,000 Payments to Suppliers$ 10,000 Ending Accounts Payable$ 3,000 Beginning Accounts Payable$ 1,000

21 Gross Profit Method-- Solution Given as 50%, and management does not feel any changes are warranted. Step No.1 Determine Gross Profit Percentage

22 Step No.2 Determine Estimated Sales Accounts receivable collections$ 5,000 Add ending accounts receivable 1,000 $ 6,000 Deduct beginning accounts receivables (2,000) Estimated sales$ 4,000 Gross Profit Method-- Solution

23 Estimated sales$ 4,000 Times gross profit percentage x 50% Estimated cost of goods sold$ 2,000 Step No. 3 Determine Estimated Cost of Goods Sold Gross Profit Method-- Solution

24 Gross Profit Method-- Solution Step No. 4 Determine Estimated Goods Available for Sale Beginning inventory$ 6,000 Add payments to suppliers $10,000 Add ending accounts payable 3,000 $13,000 Deduct beginning accts. pay. (1,000) Estimated purchases 12,000 Estimated goods available for sale$18,000

25 Gross Profit Method-- Solution Step No.5 Determine Estimated Inventory Estimated goods available for sale$18,000 Estimated cost of goods sold 2,000 Estimated inventory$16,000

26 Estimated Cost of Goods Sold Gross Profit Method Estimated Cost of Goods Sold Estimated Gross Profit Sales Estimated Ending Inventory Cost of Goods Available for Sale

27 Salad Oil Swindle Tino DeAngelis rented a petroleum tank farm in Bayonne, New Jersey.

28 Salad Oil Swindle He convinced auditors, investors, and investment bankers that the tanks contained $100 million in vegetable oil.

29 Salad Oil Swindle The tanks actually were primarily filled with sea water. There was very little vegetable oil in the tanks.

30 Salad Oil Swindle Tino would pump vegetable oil from one tank to another, depending on his advance knowledge of the auditor’s verification plan.

31 Retail Inventory Method 1. Determine goods available for sale at cost and retail. 2.Determine cost percentage. 3.Determine ending inventory at retail. 4.Determine ending inventory at cost.

32 Retail Inventory Method-- Different Cost Methods Lower-of-Cost-or-Market Approximation: Markups but not markdowns are included in the calculation of goods available for sale. Average Cost Method: Markups and markdowns are included in calculation of goods available for sale.

33 Retail Inventory Method-- Example Use the following information to estimate ending inventory: Cost Retail Beginning inventory$1,000$2,000 Purchases 5,000 8,000 Markups 2,000 Sales 6,000 Markdowns 600

34 Retail Inventory Method--Solution for LCM Approximation Step No.1 Determine Goods Available for Sale at Cost and Retail--LCM Approximation Cost Retail Beginning inventory$1,000$ 2,000 Purchases 5,000 8,000 Markups 2,000 Goods available for sale$6,000$12,000

35 Retail Inventory Method--Solution for LCM Approximation Step No. 2 Determine Cost Percentage Goods available for sale at cost $ 6,000 Divided by goods available for sale12,000 Cost percentage50%

36 Step No.3 Determine Ending Inventory at Retail Retail Inventory Method--Solution for LCM Approximation Goods available for sale$12,000 Less sales (6,000) Less markdowns (600) Ending inventory at retail$ 5,400

37 Retail Inventory Method--Solution for LCM Approximation Ending Inventory at Retail$5,400 Times Cost Percentage x 50% Ending Inventory at Cost$2,700 Step No.4 Determine Ending Inventory at Cost

38 Step No.1 Determine Goods Available for Sale Retail Inventory Method--Solution for Average Cost Method Cost Retail Beginning inventory$1,000$ 2,000 Purchases 5,000 8,000 Markups 2,000 Markdowns (600) Goods available for sale$6,000$11,400

39 Goods available for sale at cost $ 6,000 Divided by goods available for sale at retail11,400 Cost percentage 52.6% Retail Inventory Method--Solution for Average Cost Method Step No. 2 Determine Cost Percentage

40 Step No. 3 Determine Ending Inventory at Retail Retail Inventory Method--Solution for Average Cost Method Goods available for sale$11,400 Less sales (6,000) Less markdowns (600) Ending inventory at retail$ 4,800

41 Step No.4 Determine Ending Inventory at Cost Retail Inventory Method--Solution for Average Cost Method Ending inventory at retail$4,800 Times cost percentage x 52.6% Ending inventory at cost$2,525

42 Retail Inventory Method Beginning Inventory + Purchases = Goods Available for Sale Goods Available for Sale: At Retail Estimated Ending Inventory at Retail Less Sales ContinuedContinued To calculation of cost percentage

43 Retail Inventory Method Beginning Inventory + Purchases = Goods Available for Sale Goods Available for Sale: At Cost ContinuedContinued To calculation of cost percentage

44 Retail Inventory Method Cost Percentage: Cost/Retail x Cost Percentage Estimated Ending Inventory at Retail Estimated Ending Inventory at Cost

45  Freight-in is added to the cost of purchases.  Purchase discounts are subtracted from the cost of purchases.  Purchase returns are subtracted from both the cost and retail amount of purchases.  Purchase allowances normally are subtracted only from the cost of purchases.  Sales returns are subtracted from retail sales.  Sales discounts and sales allowances are not subtracted from retail sales. Retail Inventory Method

46 Dollar-Value LIFO Retail Inventory Method Steps 1. Determine inventory at base-year retail prices. 2.Determine dollar-value LIFO inventory layers at retail. 3.Determine dollar-value LIFO inventory layers at cost.

47 Dollar-Value LIFO Retail Inventory Method--Example Use the following data to estimate Ending Inventory for 2000, 2001, and 2002 (assume 1999 is the base year). Inventory at Year-End Incremental Year-End Year Price Index Cost Percentage Retail Prices $ $ $ $71

48 Dollar-Value LIFO Retail Inventory Method--Example Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 1999$60÷1.00=$60

49 Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 1999$60÷1.00=$60$60x 1.00 x 0.60 =$36 Dollar-Value LIFO Retail Inventory Method--Example

50 Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 1999$60÷1.00=$60$60x 1.00 x 0.60 =$ $69÷1.05=$66 Dollar-Value LIFO Retail Inventory Method--Example

51 Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 1999$60÷1.00=$60$60x 1.00 x 0.60 =$ $69÷1.05=$66$60x 1.00 x 0.60 =$36 6x 1.05 x 0.62 = 4 $66$40 Dollar-Value LIFO Retail Inventory Method--Example

52 Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 1999$60÷1.00=$60$60x 1.00 x 0.60 =$ $69÷1.05=$66$60x 1.00 x 0.60 =$36 6x 1.05 x 0.62 = 4 $66$ $77÷1.10=$70 Dollar-Value LIFO Retail Inventory Method--Example

53 Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 1999$60÷1.00=$60$60x 1.00 x 0.60 =$ $69÷1.05=$66$60x 1.00 x 0.60 =$36 6x 1.05 x 0.62 = 4 $66$ $77÷1.10=$70$60x 1.00 x 0.60 =$36 6x 1.05 x 0.62 =4 4x 1.10 x 0.64 = 3 $70$43 Dollar-Value LIFO Retail Inventory Method--Example

54 Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 2001$77÷1.10=$70$60x 1.00 x 0.60 =$36 6x 1.05 x 0.62 =4 4x 1.10 x 0.64 = 3 $70$ $71÷1.12=$63 Dollar-Value LIFO Retail Inventory Method--Example

55 Dollar- EoYPriceYearLayerCostRetail YearRetailIndexRetailLayersIndex%Cost 2001$77÷1.10=$70$60x 1.00 x 0.60 =$36 6x 1.05 x 0.62 =4 4x 1.10 x 0.64 = 3 $70$ $71÷1.12=$63$60x 1.00 x 0.60 =$36 3x 1.05 x 0.62 = 2 $63$38 Dollar-Value LIFO Retail Inventory Method--Example

56 Foreign Currency Transactions-- Terminology Foreign Currency Transaction: For a U.S. company, a transaction denominated in a currency other than the U.S. dollar. Spot Rate: The exchange rate at which currencies can be traded immediately.

57 Foreign Currency Transactions-- Example: Scenario On March 1, Able, a U.S. company, buys inventory worth 1 million DM from Kraus, a German company. Payment is due on April 30. Able closes its books every month. Using the following exchange rates, prepare all necessary journal entries: March 1Rate: $.58/DM March 31Rate: $.60/DM April 30 Rate: $.59/DM

58 Foreign Currency Transactions-- Example: Solution March 1 Inventory ,000 Accounts Payable ,000 Calculation: DM payable1,000,000 Exchange ratex.58 Accounts payable $ 580,000

59 Foreign Currency Transactions-- Example: Solution March 31 Exchange Loss ,000 Accounts Payable ,000 Calculations: Accounts payable (3/1)$580,000 Accounts payable (3/31) ($1,000,000 x 0.60)600,000 Exchange loss $ 20,000

60 Foreign Currency Transactions-- Example: Solution April 30 Accounts Payable ,000 Exchange Gain ,000 Cash ,000 Calculations: Accounts payable (3/31)$600,000 Cash ($1,000,000 x 0.59)590,000 Foreign exchange gain $ 10,000

61 The End