Inventories: Additional Valuation Issues

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Inventories Additional Valuation Issues

• Chapter
• 9

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Learning Objectives

• Apply the lower-of-cost-or-market rule.
• Recoding a Decline in Market Value (2 methods)
• Purchase commitments
• Gross profit method of Estimating Inventory
• Retail inventory method
• With markups and markdowns
• Valuation using relative sales value method

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Lower-of-Cost-or-Market
INVENTORY Benefit or utility derives from the
ultimate sale of the goods.
What if the inventory's salability impairs that
utility? Examples deterioration, obsolescence,
changes in price levels.
LCM approach to valuing inventory was developed
to avoid reporting inventory at an amount greater
than the benefits it can provide.
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Lower-of-Cost-or-Market
LCM
A company abandons the historical cost principle
when the future utility (revenue-producing
ability) of the asset drops below its original
cost.

• Market Replacement Cost
• Lower of Cost or Replacement Cost
• Loss should be recorded when loss occurs, not in
  the period of sale.

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Lower-of-Cost-or-Market
Ceiling and Floor
Why use Replacement Cost (RC) for Market?

• Decline in the RC usually decline in selling
  price.
• If reduction in RC fails to indicate reduction in
  utility, then two additional valuation
  limitations are used
• Ceiling - net realizable value and
• Selling Price less costs of completion
  disposal
• Floor - net realizable value less a normal profit
  margin.
• Net realizable value less a normal profit margin

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Lower-of-Cost-or-Market
Rationale for Limitations
Ceiling prevents overstatement of the value of
obsolete, damaged, or shopworn inventories. Floor
deters understatement of inventory and
overstatement of the loss in the current period.
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Lower-of-Cost-or-Market
How LCM Works (Individual Items)
Illustration 9-5
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Lower-of-Cost-or-Market
Methods of Applying LCM
Illustration 9-6
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Lower-of-Cost-or-Market
Recording LCM (data from Illus. 9-5 and 9-6)
Ending inventory (cost) 415,000 Ending
inventory (LCM) 350,000 Adjustment to LCM
65,000
Loss on inventory 65,000
Allowance Method
Allowance on inventory 65,000
Direct Method
Cost of goods sold 65,000
Inventory 65,000
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Recording a Decline in Market Value

• Under the allowance method, an entry is made
  debiting a loss and crediting an allowance
  account for the difference between cost and
  market.
• Separately recording the loss and a contra
  account is does not distort the cost of goods
  sold and clearly displays the loss from market
  decline.
• The direct method substitutes the market value
  figure for cost when valuing the inventory.
  Thus, the loss is buried in the cost of goods
  sold and no individual loss account is reported
  in the income statement.

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Lower-of-Cost-or-Market
Balance Sheet Presentation
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Lower-of-Cost-or-Market
Income Statement Presentation
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Purchase Commitments
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Purchase Commitments

• Recent Study "SEC Staff Report on Off-Balance
  Sheet Arrangements, special Purpose Entities, and
  Related Issues"
• Reports 30 of public companies have purchase
  commitments outstanding with an estimated value
  of 725 billion.

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Purchase Commitments

• Purchase commitments represent contracts for the
  purchase of inventory at a specified price in a
  future period.
• Date of inception no asset or liability is
  recorded However, if material, the details of the
  contract should be disclosed in a note of the
  buyer's balance sheet .
• If a noncancelable contract, any losses should be
  recognized in the period during which the market
  decline takes place.

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Purchase Commitments

• In the early 1980s many Northwest forest product
  companies (Boise Cascade, Georgia-Pacific,
  Weyerhaeuser, and St. Regis Paper Co.) signed
  long-term timber-cutting contracts with the U.S.
  Forest Service. These contracts required that
  the companies pay 310 per thousand board feet
  for timber-cutting rights.
• The market price for timber-cutting rights in
  late 1984 dropped to 80 per thousand board feet.
  Therefore, these companies had long-term
  contracts that projected substantial future
  losses.

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Purchase Commitments

• Example St. Regis Paper Co. signed timber-cutting
  contract on 4/15/2004 to be executed in 2005 at a
  firm price of 10M.
• What is the journal entry on 4/15/2004?

NONE (just a note if material)
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Purchase Commitments
The market price of the timber cutting rights on
12/31/04 dropped to 7M. What is the journal
entry? UHG/L (Purchase Commitments)
3,000,000 Est. Liability on Purchase Commitments
3,000,000
Unrealized Holding Gain or Loss (UHG/L) is
classified on the Income Statement under other
expense and losses Estimated Liability on
Purchase Commitments is classified as Current
liability if contract to be executed within YR
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Purchase Commitments
Example St. Regis Paper Co. signed timber-cutting
contract in 2004 to be executed in 2005 at a firm
price of 10M. What is the journal entry when the
timber is cut in 2005? Purchases (Inventory)

7,000,000 Estimated Liability on Purchase
Commitments 3,000,000 Cash
10,000,000
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Gross Profit Method
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Gross Profit Method

• The gross profit method is used to estimate cost
  of ending inventory.
• This method is not appropriate for financial
  reporting purposes however, it can serve a
  useful purpose when an approximation of ending
  inventory is needed.
• This method is used also when an estimate is
  needed due to a casualty loss.

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Gross Profit Method
Substitute Measure to Approximate Inventory
Relies on Three Assumptions

• Beginning inventory plus purchases equal total
  goods to be accounted for.
• Goods not sold must be on hand.
• (3) The sales, reduced to cost, deducted from the
  sum of the opening inventory plus purchases,
  equal ending inventory.

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Gross Profit Method
E9-12 (Gross Profit Method) Mark Price Company
uses the gross profit method to estimate
inventory for monthly reporting purposes.
Presented below is information for the month of
May.
Instructions (a) Compute the estimated inventory
at May 31, assuming that the gross profit is 30
of sales. (b) Compute the estimated inventory at
May 31, assuming that the gross profit is 30 of
cost.
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Gross Profit Method
E9-12 (Gross Profit Method - Solution)
(a) Compute the estimated inventory assuming
gross profit is 30 of sales.
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Gross Profit Method
E9-12 (Gross Profit Method - Solution)
(b) Compute the estimated inventory assuming
gross profit is 30 of cost.
30 100 30
23.08 of sales
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Gross Profit Method
Evaluation
Disadvantages

• Provides an estimate of ending inventory.
• Uses past percentages in calculation.
• A blanket gross profit rate may not be
  representative.
• Only acceptable for interim (generally quarterly)
  reporting purposes.

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Retail Inventory Method
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Retail Inventory Method
A method used by retailers, to value inventory
without a physical count, by converting retail
prices to cost. Based upon the observable
pattern between cost and sales price This method
is very common and used by retailers such as
Safeway, Target, Wal-Mart and Best Buy.
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Retail Inventory Method

• Requires retailers to keep
• total cost and retail value of goods purchased
• total cost and retail value of the goods
  available for sale
• sales for the period.
• Is appropriate for retail concerns with
• high volume sales and
• different types of merchandise.
• The steps are
• determine ending inventory at retail price
• convert this amount to a cost basis using a
  cost-to-retail ratio

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Markups, Markdowns and Cancellations

• Markup - The original markup from cost to the
  first selling price (also known as mark-on).
• 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.
• Markdown A decrease below the original sales
  price.
• Markdown Cancellation An increase in the
  selling price after there has been a mark-down.
  The markdown cancellation cannot be greater than
  the markdown.
• Example Company purchased an item for 6 and
  initially priced the item to sell for 10. The
  markup is 4. If the company subsequently
  increases the selling price to 12, there is an
  additional markup of 2. If it then lowers the
  selling price to 7, there is a markup
  cancellation of 2 and a markdown of 3.

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Markups, Markdowns and Cancellations

• We ignore markdowns and markdown cancellations
  when computing the cost to retail ratio using
  LCM.
• Why?
• This is designed to approximate the LCM
• Markup normally indicate that the market value of
  the item has increased.
• Markdown indicates that a decline in the utility
  of that item has occurred.
• If we attempt to approximate the LCM, markdowns
  are considered a current loss and are not
  involved in the calculation. Thus, the
  cost-to-retail is lower (when excluding
  markdowns).

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Retail Inventory Method
P9-8 (Retail Inventory Method) Jared Jones Inc.
uses the retail inventory method to estimate
ending inventory for its monthly financial
statements. The following data pertain to a
single department for the month of October 2008.
Instructions Prepare a schedule computing
estimate retail inventory using the LCM
conventional retail method
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Retail Inventory - LCM Method

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Retail Inventory Method
Evaluation
Widely used for the following reasons

• to permit the computation of net income without a
  physical count of inventory,
• as a control measure in determining inventory
  shortages,
• in regulating quantities of merchandise on hand,
  and
• for insurance information.

Some companies refine the retail method by
computing inventory separately by departments or
class of merchandise with similar gross profits.
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Valuation Basis Relative Sales Value
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Valuation Basis Relative Sales Value

• Relative sales values are an appropriate basis,
  when basket purchases are made.
• Basket purchases involve a group of varying
  units.
• The purchase price is paid as a lump sum amount.
• The lump sum price is allocated to units on the
  basis of their relative sales values.

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Valuation Basis Relative Sales Value

• Kirby Company buys three different lots (A, B
  and C) in a basket purchase, paying 300,000 for
  all three.
• The lots were sold as follows
• A (75,000) B (150,000) and C (200,000) for a
  total of 425,000
• What is the cost of A, B and C and the gross
  profit for each lot?

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Valuation Basis Relative Sales Value
Lot Sales Allocated Gross Value
Cost Profit
A 75,000 (75,000/425,000)
300,000 52,941 22,059
B 150,000 105,882 44,118
C 200,000 141,176 58,824 Totals
425,000 300,000 (rd.) 125,000 (rd.)