Intermediate Accounting
December 1st, 2010
1.
General Course Questions & Final Group Project, due Thursday
2.
Review Quiz #4 Chapter 18 & 8:
A. Chapter 18 - Long-term Construction Contracts
(Questions 7, 9, 10, 11 , & 12 BE 2, 3, 4, Ex 5, Prob 1, 3 & 6 add’l practice ex 7 & Pr 4)
B. Chapter 8 - Inventory Pricing Methods (?12,13,16 BE 5,6,7, P 6)
3.
Finish Chapter 9: Inventory – Additional Valuation Issues
A. Lower of Cost or Market (LCM) (Brief ex 2, ?2,3,7, Ex 5 Prob 1 & 3)
B. Relative Sales Value (Question 8, Brief Ex 4 & 7)
C. Estimating Inventory – using Gross profit
(?11, Brief Ex 7 Prob 4)
Retail Inventory Method (?14, BE 8)
D. Purchase Commitments & Disclosures
(Brief Ex 5 & 6, ?17, Ex 10)
4. Follow-up Questions to prep Final: Ch 7, 18 and 8 (Cash, Receivables,
Revenue Recognition and Dollar Value LIFO, in addition to last quiz)
5.
Self, Peer and Course Evaluations
Inventory: Lower of Cost or Market (LCM)
GAAP requires inventory to be stated at the lower of
cost or market, abandoning the historical cost
principle when the future utility (revenue producing
ability) of the asset drops below it original cost.
Market = Replacement Cost (the cost to replace by
purchase or reproduction, not sales price)
Thus, LCM is Lower of Cost or Replacement Cost and
determined using “Designated Market”
Loss should be recorded when loss occurs, not in the
period of sale
Restate asset at “designated” market to replace cost.
2
Determining Designated Market
for use in assessing LCM
Why use Replacement Cost (RC) for Market?
Decline in the RC usually results in a decline in selling price.
RC allows a consistent rate of gross profit.
A reduction in RC may fail to indicate a reduction in utility, thus two
additional valuation limitations are used to determine the Designated
Market which is then compared to Cost to determine if a LCM
write-down is needed.
The Designated Market is the middle of the three:

Replacement Cost (cost to replace or reproduce)

Ceiling - net realizable value (NRV= selling price less disposal cost) and

Floor - net realizable value less a normal profit margin.
3
Finding the Designated Market to
Determine Lower of Cost or Market
Item Historical Replacement
Cost
Cost
Ceiling
Floor
(NRV)
(NRV – profit)
Final
Inventory $
A
$80,000
$88,000
$120,000
$104,000
$
B
$90,000
$88,000
$100,000
$70,000
$
C
$90,000
$88,000
$100,000
$90,000
$
D
$90,000
$88,000
$87,000
$70,000
$
4
Rational for Designated Market
Ceiling and Floor 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.
Market
Cost
Ceiling = NRV
Not
>
Replacement Cost
Not
<
GAAP
LCM
Floor =
NRV less Normal
Profit Margin
5
Lower of Cost or Market - Individual Items
•Illustration 9-5
6
Lower of Cost or Market - Individual Items
•Illustration 9-5
$415,000
7
Recording Decline in Market Value (LCM)
Individual Items
Ending inventory (cost)
$ 415,000
Ending inventory (LCM)
350,000
Adjustment to LCM
Allowance
Method
Direct
Method
Loss on inventory
$ 65,000
65,000
Allowance to reduce inventory to 65,000
market (contra inventory account)
Cost of goods sold
Inventory
65,000
65,000
8
Lower of Cost or Market – Balance Sheet
Allowance
Direct
Current assets:
Cash
$
100,000
$
100,000
Accounts receivable
350,000
350,000
Inventory
770,000
705,000
Less: inventory allowance
(65,000)
Prepaids
Total current assets
20,000
20,000
1,175,000
1,175,000
9
Lower of Cost or Market – Income Statement
Allowance
Sales
$
Cost of goods sold
300,000
Direct
$
300,000
120,000
185,000
180,000
115,000
Selling
45,000
45,000
General and administrative
20,000
20,000
Total operating expenses
65,000
65,000
65,000
-
Gross profit
Operating expenses:
Other revenue and expense:
Loss on inventory
Interest income
5,000
Total other
5,000
(60,000)
5,000
Income from operations
55,000
55,000
Income tax expense
16,500
16,500
Net income
$
38,500
$
38,500
10
Lower of Cost or Market
Application
The lower of cost or market may be applied:
1.
Either directly to each item
* most conservative approach
* generally required for tax purposes
2. To each category, or
3. To the total of the inventory
Whichever method is selected, it should
be consistently applied.
11
Lower of Cost or Market - Individual Items,
Major Categories or Total Inventory
12
Lower of Cost or Market - Individual Items,
Major Categories or Total Inventory
13
LCM Example
Assume in each case that the selling expenses are $8 per unit and that the normal profit is $5
per unit. Calculate the limits for each case (ceiling and floor). Then enter the amount that
should be used for the lower of cost or market.
Designated Market -chose the middle one
Selling
Price
Ceiling
(NRV)
Replace- Floor (NRV less
ment $
profit)
Cost
cost/mkt
a
$
54
$
38
43
b
$
47
$
36
40
c
$
56
$
39
40
d
$
47
$
42
40
1.
2.
3.
4.
Lower of
Compute the Designated Market Ceiling for each item which is its Net Realizable Value (NRV)
(NRV = Selling price less costs to complete sale).
Compute the Designated Market Floor for each item which is its NRV less any normal profit.
Identify each item's Designated Market, which is the middle dollar amount, by circling it.
Compare cost to designated market and use Lower of Cost or Designated market.
Also Homework today: Brief Ex 2
14
Evaluation of LCM Rule
Some Deficiencies:
Expense are recorded when the loss in utility occurs. Profit
on sale only recognized at the point of sale.
Inventory may be valued at cost in one year and at market
the next year.
Net income in the year of loss is lower. Net income in
subsequent period may be higher than normal if expected
reductions in sales price do not materialize.
LCM uses a “normal profit” in determining inventory values,
which is a subjective measure.
15
Recording
What ifthe
theDecline
MarketinValue
Market
Value
Recovers?
For subsequent increases in inventory value:
o
US GAAP prohibits the reversal of writedowns
o
IFRS requires the reversal of writedowns
16
Other Valuation Issues
• Valuation at Net Realizable Value
Permitted by GAAP under the following conditions:
(1) there is a controlled market with a quoted price for all
quantities, and
(2) there are no significant costs of disposal (rare metals and
agricultural products) or
(3) it is too difficult to obtain cost figures (meatpacking)
• Relative Sales Value – “Basket Purchase”
• Purchase Commitments
17
Valuation Basis:
Relative Sales Values
• 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.
• Quickest approach – determine the percentage total cost to total
revenue and use it to allocate cost or gross profit
Also Homework today: question 8 and Brief Ex 4
18
Relative Sales Values: Example
Kirby Company buys three different lots (A, B and C)
in a basket purchase, paying $297,500 for all three.
The lots were sold as follows:
Sales Price
Cost
Gross Profit
A $75,000
_______
_________
B $150,000
_______
_________
C $200,000
_______
_________
Total $425,000
_______
_________
What is the cost of A, B and C and the gross profit for each lot?
(Suggestion: determine the percentage total cost to total revenue
and use it to allocate cost and/or gross profit)
19
Relative Sales Values: Example
Kirby Company buys three different lots (A, B and C) in a
basket purchase, paying $297,500 for all three.
The lots were sold as follows:
% Cost to Sales = $297.5k/$425K = 70%
Sales Price
Cost
Gross Profit
A $75,000
x 70%
$ 52,500
$22,500
B $150,000
x 70%
$105,000 $45,000
C $200,000
x 70%
$140,000 $60,000
Total $425,000
$ 297,500 $127,500
What is the cost of A, B and C and the gross profit for each lot?
20
Relative Sales Values: Example 2
Crawford Furniture Company purchased a carload of wicker chairs. The manufacturer sold the
chairs to Crawford for a lump sum of $60,000, because they want to discontinue these items. The
three types of chairs and their estimated selling prices are listed below. Given the 2011 sales
below, determine how much gross profit Crawford should recognize in 2011 and what amount
they should report as unsold chair inventory.
Estimated
Unit
Sales Total Selling
# of Chairs Price
Price
Unit
Sales in
2011
Lounge Chairs
400
90 $ 36,000
200
Arm Chairs
300
80 $ 24,000
100
Straight Chairs
800
50 $ 40,000
120
2011
Gross
Profit
Realized
Inventory
December
31, 2011
220 $ 100,000
(Suggestion: determine the percentage total cost to total revenue
and use it to allocate cost and gross profit)
21
Relative Sales Values: Example 2
Crawford Furniture Company purchased a carload of wicker chairs. The manufacturer sold the
chairs to Crawford for a lump sum of $60,000, because they want to discontinue these items. The
three types of chairs and their estimated selling prices are listed below. Given the 2011 sales
below, determine how much gross profit Crawford should recognize in 2011 and what amount
they should report as unsold chair inventory.
Estimated
Unit
Sales Total Selling
# of Chairs Price
Price
Unit
Sales in
2011
2011
Gross
Profit
Realized
Inventory
December
31, 2011
Lounge Chairs
400
90 $ 36,000
60%
200
$
7,200 $ 10,800
Arm Chairs
300
80 $ 24,000
60%
100
$
3,200 $ 9,600
Straight Chairs
800
50 $ 40,000
60%
120
$
2,400 $ 20,400
220 $ 100,000
$ 12,800
$ 40,800
22
Purchase Commitments
• Cancellable contracts
– No entry or disclosure required
• Formal, non-cancelable contracts
– Seller retains title, buyer recognizes no asset but
should disclose contract details in footnote
– If execution of the contract is expected to result in a
loss, buyer must record the loss in the period the
market prices decreased:
DR
Unrealized Holding Loss
CR
Est liability on purchase commitment
Homework today: Brief Ex 5 & 6
23
Inventory Estimation Techniques
• Inventory estimation used when:
– a fire or other catastrophe destroys either
inventory or inventory records
– taking a physical inventory is impractical
– auditors only need an estimate of the
company’s inventory
• Gross Profit Method
• Retail Sales Method
24
Estimate Inventory Using Gross Profit
1.
2.
3.
Calculate Cost of Goods Available for Sale (CGA)
Estimate Cost of Goods Sold (CGS) using Sales and estimate of Gross Profit
Deduct Estimate of CGS from CGA to get Estimate of Ending Inventory
25
Estimate Inventory Using Gross Profit
Whitsunday Company’s warehouse burned
and its inventory was completely destroyed.
The accounting records were kept in the
office building and escaped harm. The
following information was available:
Net sales
$426,000
Beginning inventory
80,000
Net purchases
300,000
Average gross profit on sales 20%
Use the above information to estimate the ending
inventory lost in the fire using the gross profit method.
1.
2.
3.
Calculate Cost of Goods Available for Sale (CGA)
Estimate Cost of Goods Sold (CGS) using Sales and estimate of
Gross Profit
Deduct Estimate of CGS from CGA to get Estimate of Ending
Inventory
26
Estimate Inventory Using Gross Profit
Whitsunday Company’s warehouse burned
and its inventory was completely destroyed.
The accounting records were kept in the
office building and escaped harm. The
following information was available:
Net sales
$426,000
Beginning inventory
80,000
Net purchases
300,000
Average gross profit on sales 20%
Use the above information to estimate the ending inventory lost in
the fire using the gross profit method.
1.
2.
3.
Calculate Cost of Goods Available for Sale (CGA) $380,000
Estimate Cost of Goods Sold (CGS) using Sales and estimate of
Gross Profit: (CGS 80% if Gross Profit is 20%)
Sales x CGS % = CGS: $426,000 x 80% = $340,800
Deduct Estimate of CGS from CGA to get Estimate of Ending
Inventory $380,000 – 340,800 = $39,200
27
Gross Profit Method to Determine EI
Beginning inventory
Net purchases
Cost of goods available for sale
Estimated cost of goods sold:
Net sales
426,000
Less: Est gross profit
(85,200)
Estimated ending inventory
$80,000
300,000
380,000
(340,800)
$39,200
28
Example 2: Estimate Inventory
Using Gross Profit
On December 31, 2010 Carr Company's
inventory burned. Sales and purchases for the
year had been $1,400,000 and $980,000,
respectively. The beginning inventory (Jan. 1,
2010) was $170,000; in the past Carr's gross
profit has averaged 40% of selling price.
Compute the estimated cost of inventory
burned.
1.
2.
3.
29
Example 2: Estimate Inventory
Using Gross Profit
On December 31, 2010 Carr Company's
inventory burned. Sales and purchases for the
year had been $1,400,000 and $980,000,
respectively. The beginning inventory (Jan. 1,
2010) was $170,000; in the past Carr's gross
profit has averaged 40% of selling price.
Compute the estimated cost of inventory
burned.
1.
2.
3.
Calculate Cost of Goods Available for Sale (CGA) $1,150,000
Estimate Cost of Goods Sold (CGS) using Sales and estimate of
Gross Profit: (CGS 60% if Gross Profit is 40%)
Sales x CGS % = CGS: $1,400,000 x 60% = $840,000
Deduct Estimate of CGS from CGA to get Estimate of Ending
Inventory $1,150,000 – 840,000 = $310,000
30
Gross Profit Method Example 2
On December 31, 2010 Carr Company's inventory burned.
Sales and purchases for the year had been $1,400,000 and
$980,000, respectively. The beginning inventory (Jan. 1,
2010) was $170,000; in the past Carr's gross profit has
averaged 40% of selling price. Compute the estimated cost
of inventory burned.
BI
+ Net Purchases
= COGA
-Estimated COGS:
Net Sales
less estimated gross profit
Estimated Ending inventory
31
Retail Inventory Method
This inventory estimation technique is used when:
– a fire or other catastrophe destroys either inventory or inventory records
– taking a physical inventory is impractical
– auditors only need an estimate of the company’s inventory
Appropriate for retail concerns with:
•
•
high volume sales and
different types of merchandise
• Assumes an observable pattern between cost and
prices.
32
Retail Inventory Method
Steps:
1. Determine ending inventory at retail price
2. Convert this amount to a cost basis using a cost-to-retail
ratio
BI (at retail) + Net Purchases (at retail) – Net sales = EI (at
retail)
EI (at retail) X Cost-to-Retail ratio = estimated “EI” (at cost)
33
Retail Inventory Method: Example
Given for the year 2002:
Beginning inventory
Purchases (Net)
Sales (Net)
at cost
$2,000
$10,000
at retail
$3,000
$15,000
$12,000
What is ending inventory, at retail and at cost?
34
Retail Inventory Method: Example
at cost
Beginning inventory
Purchases (Net)
Goods available for sale
less: Sales (Net)
Ending inventory (at retail)
Times: cost to retail ratio
Ending inventory at cost
COGS
$ 2,000
$10,000
$12,000
at retail
$ 3,000
$15,000
$18,000
($12,000)
$6,000
x
35
Intermediate Accounting
November 30th, 2010
1.
General Course Questions & Final Group Project, due Thursday
2.
Questions before final 30 minute Quiz:
A. Chapter 18 - Long-term Construction Contracts
(Questions 7, 9, 10, 11 , & 12 BE 2, 3, 4, Ex 5, Prob 1, 3 & 6 add’l practice ex 7 & Pr 4)
B. Chapter 8 - Inventory Pricing Methods (?12,13,16 BE 5,6,7, P 6)
4. Chapter 8 Dollar Value LIFO (homework: ?14, 17-20, BE 9, Ex 26, Prob 11 & Case 9)
5. Chapter 9: Inventory – Additional Valuation Issues
A. Lower of Cost or Market (LCM)
(Brief ex 2)
B. Relative Sales Value (Question 8, Brief Ex 4)
C. Estimating Inventory – using Gross profit
(question 11, Brief Ex 7)
D. Purchase Commitments (Brief Ex 5 & 6)
36
6. Extra Credit Session - Columbia Sportswear Annual Report Project