A Review of the Accounting Cycle

1
Inventory Valuation at Other Than Cost
2
Learning Objectives

• 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.

3
Learning Objectives

• Determine the financial statement impact of
  inventory recording errors.

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
Methods for valuing inventory at other than cost

• Lower-of-Cost-or-Market Method
• Gross Profit Method
• Retail Inventory Method
• Dollar-Value LIFO Retail Method

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
Lower of Cost or Market (LCM)

• 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.

9
LCM Examples
A companys unit of inventory has the following
characteristics Selling price 165 Packaging
cost 10 Transportation cost 15 Profit margin 40
10
LCM Examples
Example 1
Normal Profit 40
11
LCM Examples
Cost 155
Normal Profit 40
Current Replacement Cost, 150
Market 140
LCM is market, 140
12
LCM Examples
Example 2
Cost 110
Normal Profit 40
Current Replacement Cost, 120
Market 120
LCM is cost, 110
13
LCM Example
Example 3
Cost 110
Normal Profit 20

Current Replacement Cost, 75
Market 100
LCM is market, 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)
A
20
10
200
11
200
220
B
10
10
100
9
90
90
C
10
10
100
8
80
80
D
20
10
200
9
180
180
600
550
570
16
LCM--Example Recording Revaluation (applied
individually)
A
20
10
200
11
200
220
B
10
10
100
9
90
90
C
10
10
100
8
80
80
D
20
10
200
9
180
180
600
550
570
Journal Entry Loss from Decline in Value of
Inventory..... 50 Inventory.....................
....................... 50
17
LCM--Example Recording Revaluation (applied as a
whole)
A
20
10
200
11
200
220
B
10
10
100
9
90
90
C
10
10
100
8
80
80
D
20
10
200
9
180
180
600
550
570
Journal Entry Loss from Decline in Value of
Inventory.............. 30 Allowance for
Decline in Value of Inventory.. 30
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.

20
Gross Profit Method--Example Basic Data

• Use the following information to estimate ending
  inventory
• Gross Profit Percentage 50 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
Step No.1 Determine Gross Profit Percentage

• Given as 50, and management does not feel any
  changes are warranted.

22
Gross Profit Method--Solution

• Step No.2
• Determine Estimated Sales

23
Gross Profit Method--Solution

• Step No. 3
• Determine Estimated Cost of Goods Sold

Estimated sales 4,000 Times gross profit
percentage x 50 Estimated cost of
goods sold 2,000
24
Gross Profit Method--Solution

• Step No. 4
• Determine Estimated
• Goods Available for Sale

25
Gross Profit Method--Solution

• Step No.5
• Determine Estimated Inventory

Estimated goods available for sale 18,000 Estimat
ed cost of goods sold 2,000 Estimated
inventory 16,000
26
Gross Profit Method
Cost of Goods Available for Sale
Sales
Estimated Cost of Goods Sold
Estimated Cost of Goods Sold
Estimated Ending Inventory
Estimated Gross Profit
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 auditors 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
sale 12,000 Cost percentage 50
36
Retail Inventory Method--Solution for LCM
Approximation
Step No.3 Determine Ending Inventory at Retail

• 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
Step No.4 Determine Ending Inventory at Cost

• Ending Inventory at Retail 5,400
• Times Cost Percentage x 50
• Ending Inventory at Cost 2,700

38
Retail Inventory Method--Solution for Average
Cost Method
Step No.1 Determine Goods Available for
Sale

• 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
Retail Inventory Method--Solution for Average
Cost Method
Step No. 2 Determine Cost Percentage

• Goods available for sale at cost 6,000
• Divided by goods available for sale at
  retail 11,400
• Cost percentage 52.6

40
Retail Inventory Method--Solution for Average
Cost Method
Step No. 3 Determine Ending Inventory at Retail

• Goods available for sale 11,400
• Less sales (6,000)
• Less markdowns (600)
• Ending inventory at retail 4,800

41
Retail Inventory Method--Solution for Average
Cost Method
Step No.4 Determine Ending Inventory at Cost

• Ending inventory at retail 4,800
• Times cost percentage x 52.6
• Ending inventory at cost 2,525

42
Retail Inventory Method
Goods Available for Sale At Retail
Continued
Beginning Inventory Purchases
Goods Available for Sale
43
Retail Inventory Method
Continued
Goods Available for Sale At Cost
Beginning Inventory Purchases
Goods Available for Sale
44
Retail Inventory Method
Estimated Ending Inventory at Retail
45
Retail Inventory Method

• 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.

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 RetailInventory 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 1999 1.00
.60 60 2000 1.05 .62
69 2001 1.10 .64 77 2002
1.12 .65 71
48
Dollar-Value LIFO RetailInventory Method--Example
Dollar- Inv _at_ Value Inv
_at_ Base- Incr. Incr. LIFO EoY Price Year Layer
Cost Retail Year Retail Index Retail Layers Inde
x Cost
1999 60 1.00 60
49
Dollar-Value LIFO RetailInventory Method--Example
Dollar- Inv _at_ Value Inv
_at_ Base- Incr. Incr. LIFO EoY Price Year Layer
Cost Retail Year Retail Index Retail Layers Inde
x Cost
1999 60 1.00 60 60 x 1.00 x 0.60 36
50
Dollar-Value LIFO RetailInventory Method--Example
Dollar- Inv _at_ Value Inv
_at_ Base- Incr. Incr. LIFO EoY Price Year Layer
Cost Retail Year Retail Index Retail Layers Inde
x Cost
1999 60 1.00 60 60 x 1.00 x 0.60
36 2000 69 1.05 66
51
Dollar-Value LIFO RetailInventory Method--Example
Dollar- Inv _at_ Value Inv
_at_ Base- Incr. Incr. LIFO EoY Price Year Layer
Cost Retail Year Retail Index Retail Layers Inde
x Cost
1999 60 1.00 60 60 x 1.00 x 0.60
36 2000 69 1.05 66 60 x 1.00 x 0.60
36 6 x 1.05 x 0.62
4 66 40
52
Dollar-Value LIFO RetailInventory Method--Example

• Dollar- Inv _at_ Value Inv
  _at_ Base- Incr. Incr. LIFO EoY Price Year Layer
  Cost Retail Year Retail Index Retail Layers Inde
  x Cost

1999 60 1.00 60 60 x 1.00 x 0.60
36 2000 69 1.05 66 60 x 1.00 x 0.60
36 6 x 1.05 x 0.62
4 66 40 2001 77 1.10 70
53
Dollar-Value LIFO RetailInventory Method--Example
Dollar- Inv _at_ Value Inv
_at_ Base- Incr. Incr. LIFO EoY Price Year Layer
Cost Retail Year Retail Index Retail Layers Inde
x Cost
1999 60 1.00 60 60 x 1.00 x 0.60
36 2000 69 1.05 66 60 x 1.00 x 0.60
36 6 x 1.05 x 0.62
4 66 40 2001 77 1.10 70 60 x 1.00
x 0.60 36 6 x 1.05 x 0.62 4
4 x 1.10 x 0.64 3 70 43

54
Dollar-Value LIFO RetailInventory Method--Example
Dollar- Inv _at_ Value Inv
_at_ Base- Incr. Incr. LIFO EoY Price Year Layer
Cost Retail Year Retail Index Retail Layers Inde
x Cost
2001 77 1.10 70 60 x 1.00 x 0.60
36 6 x 1.05 x 0.62 4 4 x 1.10
x 0.64 3 70 43 2002 71 1.12 63

55
Dollar-Value LIFO RetailInventory Method--Example
Dollar- Inv _at_ Value Inv
_at_ Base- Incr. Incr. LIFO EoY Price Year Layer
Cost Retail Year Retail Index Retail Layers Inde
x Cost
2001 77 1.10 70 60 x 1.00 x 0.60
36 6 x 1.05 x 0.62 4 4 x 1.10
x 0.64 3 70 43 2002 71 1.12 63
60 x 1.00 x 0.60 36 3 x 1.05 x 0.62
2 63 38
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 1 Rate .58/DM
• March 31 Rate .60/DM
• April 30 Rate .59/DM

58
Foreign Currency Transactions--Example Solution

• March 1
• Inventory..................... 580,000
• Accounts Payable.... 580,000

Calculation DM payable 1,000,000 Exchange
rate x .58 Accounts payable 580,000
59
Foreign Currency Transactions--Example Solution

• March 31
• Exchange Loss................ 20,000
• Accounts Payable......... 20,000

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............... 600,000
• Exchange Gain................ 10,000
• Cash................................ 590,000

Calculations Accounts payable
(3/31) 600,000 Cash (1,000,000 x
0.59) 590,000 Foreign exchange gain 10,000
61
The End