1. Intermediate Accounting
Chapter 8
Inventories: Special Valuation Issues
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2. What is the Lower of Cost or Market Rule?
The lower of cost or market (LCM) rule requires that a company write down its inventory to its market value when the inventory’s utility has declined.
By reporting inventory at the lower of its cost or market value, a company reports a more representationally faithful value for inventory on its balance sheet and a loss (or expense) in its income statement in the period the asset’s value declines rather than in the period the goods are sold.
Therefore, the application of the lower of cost or market rule is consistent with the conservatism principle.
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3. Determining Market Value
To apply the lower of cost or market rule, the company must estimate the market value of inventory in order to compare it to cost to determine which amount is lower.
Under the lower of cost or market rule, market value is defined as the current replacement cost—the cost the company would pay to replace the item.
This replacement cost valuation of inventory is a more relevant and representationally faithful value than the original (higher) costs the company actually incurred.
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4. Replacement Cost
To measure replacement cost, GAAP imposes an upper (ceiling) and a lower (floor) constraint on the market value as follows:
Net Realizable Value (ceiling): The market value should not be more than the net realizable value—the estimated selling price in the ordinary course of business minus reasonably predictable costs of completion and disposal.
Net Realizable Value minus a Normal Profit Margin (floor): The market value should not be less than the net realizable value reduced by an estimate of a normal profit margin or markup.
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5. Application of the Lower of Cost or Market Rule (Slide 1 of 2)
Step 1. Determine the market value. Calculate the current replacement cost, ceiling, and floor, and select the middle value of the three.
Step 2. Compare the market value to cost. Assign the lower of the selected market value or the historical cost to the value of inventory.
Step 3. Report the results in the financial statements. Report the lower value on the balance sheet. If the company recognizes a loss, report the amount on the income statement as either a separate line item for loss from an inventory write-down or by including it in cost of goods sold.
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6. Application of the Lower of Cost or Market Rule (Slide 2 of 2)
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7. Approaches to Implementing the Lower of Cost or Market Rule
A company may apply the lower of cost or market rule to each individual item in inventory, each major inventory category, or to the total of the inventory.
When the lower of cost or market rule is applied to each major category or to the total of the inventory, price declines of some of the units in inventory are offset by price increases in other units of inventory in the same category.
Therefore, applying the lower of cost or market rule to groups of inventory will usually result in higher inventory valuations and lower losses relative to applying the rule to each individual item of inventory.
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8. Recording the Reduction of Inventory to Market
A company can record the write-down of inventory from cost to market value using either of two methods:
Direct Method—The loss is recorded directly by reducing the company’s inventory account and increasing its cost of goods sold account.
Allowance Method—The loss is recorded in a separate inventory valuation account and loss account.
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9. Reporting Lower of Cost or Market
Under the direct method, the write-down of inventory is recorded directly in inventory and cost of goods sold.
Under the allowance method, the write-down is recorded in an allowance account and a loss account.
The allowance account is reported as a contra- inventory account in a company’s balance sheet.
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10. Can Inventory Be Valued Above Cost?
Normally, a company will not value its inventory above cost.
However, under certain circumstances, GAAP does allow a company to report its inventory above cost.
This exception must be justified by:
An inability to determine appropriate costs
Immediate marketability of the inventory at a quoted market price
The interchangeability of the units of inventory
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11. How is Inventory Estimated Using the Gross Profit Method
How is Inventory Estimated Using the Gross Profit Method? (Slide 1 of 2)
The gross profit method may be used in the following situations:
To determine the cost of the inventory for interim financial statements. This method is acceptable provided that the company discloses the method used at the interim date and any significant adjustments that result from reconciliations with the annual physical inventory.
To check the reasonableness of the reported cost of inventory by an auditor.
To estimate the cost of inventory that is destroyed by a casualty, such as a fire.
To estimate the cost of the inventory from incomplete records. For example, if a company’s inventory records are destroyed, the inventory can be estimated if the cost of goods available for sale and the sales are known or can be reconstructed.
To develop budgeted amounts for cost of goods sold and ending inventory from a sales budget.
However, the gross profit method is not acceptable for annual financial statements.
Instead, a physical count of inventory is required to verify the inventory quantity.
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12. How is Inventory Estimated Using the Gross Profit Method
How is Inventory Estimated Using the Gross Profit Method? (Slide 2 of 2)
Step 1. Calculate the historical gross profit rate, as Gross Profit from Prior Periods Net Sales from Prior Periods
Step 2. Calculate the cost of goods available for sale in the current period, as Beginning Inventory + Net Purchases
Step 3. Estimate the gross profit for the current period, as Historical Gross Profit Rate x Net Sales Revenue (current period)
Step 4. Estimate the cost of goods sold for the period, as Net Sales Revenue (current period) - Estimated Gross Profit
Step 5. Determine the estimated cost of the ending inventory, as Cost of Goods Available for Sale - Estimated Cost of Goods Sold
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13. How is Inventory Estimated Using the Retail Inventory Method
How is Inventory Estimated Using the Retail Inventory Method? (Slide 1 of 3)
As an alternative to the gross profit method, the retail inventory method can be used to estimate the cost of inventory when there is a consistent pattern between the cost of a company’s purchases and its selling prices.
The retail inventory method has two main advantages compared to the gross profit method:
While the gross profit method estimates a profit percentage based on past periods, the retail inventory method uses a current-period estimate of gross profit. This makes the retail inventory method more sensitive to price changes and produces a more accurate estimate of current period ending inventory.
The retail inventory method is allowed for both financial reporting and income tax purposes.
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14. How is Inventory Estimated Using the Retail Inventory Method
How is Inventory Estimated Using the Retail Inventory Method? (Slide 2 of 3)
The retail inventory method requires a company to maintain accounting records that contain the following information:
beginning inventory at cost and retail value
goods purchased at cost and retail value
changes in selling price resulting from additional markups and markdowns
sales
Note that information related to both beginning inventory and purchases must be provided at both cost and retail values, where retail values are the current selling prices of the goods.
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15. How is Inventory Estimated Using the Retail Inventory Method
How is Inventory Estimated Using the Retail Inventory Method? (Slide 3 of 3)
Step 1. Compute the total goods available for sale at both cost and retail value.
Step 2. Compute the appropriate cost-to-retail ratio.
Step 3. Compute the ending inventory at retail. Retail Value of Goods Available for Sale x Net Sales Revenue
Step 4. Compute the ending inventory at cost. Ending Inventory at Retail x Cost-to-Retail Ratio
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16. Retail Inventory Method Terminology
Retail stores typically make changes in selling prices after setting the original price.
The following seven terms describe these changes:
Markup: the original markup from cost to the original selling price
Additional Markup: an increase above the original sales price
Markup Cancellation: a reduction in the selling price after there has been an additional markup; the markup cancellation cannot be greater than the additional markup
Net Additional Markup: the total additional markups minus the total markup cancellations
Markdown: a decrease below the original selling price
Markdown Cancellation: an increase in the selling price after there has been a markdown; the markdown cancellation cannot be greater than the markdown
Net Markdown: the total markdowns minus the total markdown cancellations
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17. Application of the Retail Inventory Method (Slide 1 of 2)
By changing the inputs of the cost-to-retail ratio, companies can use the retail inventory method to develop inventory valuations under different cost flow assumptions.
FIFO. Exclude the cost and the retail value of the beginning inventory from the computation of the cost-to-retail ratio for the period. The ratio should include both net additional markups and net markdowns.
Average Cost. Include the cost and the retail value of the beginning inventory and net additional markups and net markdowns in the cost-to- retail ratio.
LIFO. Compute separate ratios for each layer in the beginning inventory and for the purchases of the current period. Include both net additional markups and net markdowns in the cost-to-retail ratio for the current period.
Lower of Average Cost or Market. Include the cost and retail value of the beginning inventory and net additional markups in the cost-to-retail ratio. Net markdowns are excluded from the cost-to-retail ratio. This method is also known as the conventional retail method.
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18. Application of the Retail Inventory Method (Slide 2 of 2)
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19. Retail Lower of Average Cost or Market
The retail inventory method can also be used to approximate the valuation of inventory at the lower of cost or market by excluding net markdowns from the computation of the cost-to-retail ratio.
The rationale for excluding net markdowns is that companies will normally mark down inventory to indicate a decrease in utility (e.g., obsolescence, lower demand for the goods).
Excluding net markdowns will result in a lower cost-to- retail ratio which, consistent with the lower of cost or market rule, leads to a lower approximation of ending inventory.
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20. Additional Adjustments under the Retail Method
The application of the retail method is complicated when a company considers other typical costs and activities such as:
freight charges
purchase discounts
purchase returns and allowances
sales returns and allowances
sales discounts
inventory shrinkage
employee discounts
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21. What is the Dollar-Value Retail Method?
The previous discussion of the retail LIFO method assumed that there were no changes in the retail price of inventory during the period.
However, when prices change during a period, a company can combine the principles of the retail LIFO method with the dollar-value LIFO method to eliminate the effects of this price change.
This combination is called the dollar-value LIFO retail method.
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22. Example: Dollar-Value Retail Method (Slide 1 of 6)
Step 1. The ending inventory at retail is computed by adding the beginning inventory, purchases, and the markups, and subtracting the markdowns and sales. Alternatively, ending inventory could be computed at year-end by taking a physical inventory and multiplying the units in ending inventory by the current-year retail prices.
Step 2. The ending inventory at retail is converted to base-year retail prices by applying the base-year conversion index: Ending Inventory at Retail x Base−Year Retail Price Index Current−Year Price Index
Step 3. The change in the inventory at retail in base-year prices is computed by comparing the ending inventory with the beginning inventory when both are measured at retail in base-year prices.
Step 4. The change in the inventory at retail in base-year prices is converted to current-year retail prices by multiplying it by the appropriate conversion index. If there is an increase, the current year conversion index is: Increase at Base-Year Retail Prices x Current−Year Price Index Base−Year Price Index
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23. Example: Dollar-Value Retail Method (Slide 2 of 6)
Step 4. (cont’d) If there is an decrease, the current year conversion index for the appropriate LIFO layer is: Decrease at Base-Year Retail Prices x Price Index of Most Recently Added Layer Base−Year Price Index Note that for large decreases that affect more than one layer of inventory, the price index applicable to each layer must be used in the conversion index.
Step 5. The change in inventory at current-year retail prices is converted to cost by multiplying it by the cost-to-retail ratio for the appropriate year.
Step 6. The ending inventory at cost is computed by adding (subtracting) the increase (decrease) in inventory at cost to the beginning inventory at cost.
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24. What are the Effects of Inventory Errors?
Errors in the valuation of inventory or the recording of purchases can result in inaccurate values on the company’s balance sheet and income statement.
The discovery of inventory errors requires careful analysis and adjusting entries to correct the company’s accounts.
If a company discovers an error in the same accounting period that the error was made, it reverses the erroneous entry and records a correct entry.
However, if a company discovers a material error after it has closed the books, it treats the correction as a prior period adjustment.
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25. Effects of Inventory Errors (Slide 1 of 2)
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26. Effects of Inventory Errors (Slide 2 of 2)
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