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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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 %
Required: Estimate the cost of the destroyed inventory.
ACCT-3030

11. 4a. Gross Profit Method Example — Solution
Beginning inventory (from records) $220,000
Plus: Net purchases (from records) ,000
Cost of goods available for sale ,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

12. 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

13. 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 =
Sales
7,500
Ending Inventory at Retail
1,500
End Inv at Cost (1,500 x )
933
ACCT-3030

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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